CA Intermediate

Treasury & Cash Management – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Treasury & Cash Management – CA Inter FM Question Bank

Question 1.
Enumerate the activities which are covered by Treasury Management. (Nov 2002, 3 marks)
OR
Answer the following:
Explain briefly the functions of Treasury Department. (May 2008, 3 marks)
OR
Answer the following:
Write a short note on functions of Treasury Department. (May 2009, 2 marks)
OR
Answer the following:
Explain briefly the functions of Treasury Department. (Nov 2016, 4 marks)
Answer:
Functions of Treasury Department can be as follows:
1. Cash
Planning or forecasting future cash Management requirements through Cash Budgets, Efficient collection of Receivables, and payment of liabilities/claims through Float Management. Monitoring of funds position at various divisions/branches and identifying surplus or idle funds to transfer them to other divisions. Investment Planning or parking of surplus funds in marketable securities to optimise return.

2. Funding Management
Planning of long-term, medium-term, and short-term cash needs. Participation in decisions concerning capital structure, dividend payout, etc. Obtaining the fund requirements from sources like Bank Loans, Public Issues, etc.

3. Currency Management
Managing foreign currency risk exposure through hedging/forwards! futures. Timely settling or setting off of intra-group indebtedness, between divisions in various countries. Matching transactions of receipts and payments in the same currency to save transaction costs. Decision on currency to be used while invoicing Export Sales.

4. Corporate Finance
Advising on various issues such as buy-back, mergers, acquisitions, and divestments, and planning the financial needs thereof Investor Relationships. Capital Market Intelligence-obtaining information on market trends, timing of public issues, etc.

5. Banking
Maintaining cordial and good relationships with Bankers and Financing Institutions. Coordinating, liaising, and negotiating with the Lenders during the course of obtaining finance.

Question 2.
Answer the following:
Evaluate the role of cash budget in effective cash management system. (Nov 2015, 4 marks)
Answer:
Cash Budget
A cash budget is a forecast of estimates showing the amount of cash which will be available for future period taking into account all the sources of cash received and channel in which payments are made. In cash budget no accrual concept is taken under consideration.

Role of Cash

• This Budget helps to determine, whether the cash Budget being collected is sufficient to own the business.
• It helps to preserve liquidity in the business.
• It helps to determine, when & how the funds will be utilized and where also.
• It is known by cash budget the availability of cash discounts and control of quantum of cash.

Question 3.
A new manufacturing company ¡sto be incorporated from January 1, 2000. Its authorized capital will be ₹ 2 crores divided into 20 Iakh equity shares of ₹ 10 each. It intends to raise capital by issuing equity shares of ₹ 1 crore (fully paid) on 1st January. Besides a loan of ₹ 13 lakh @ 12% per annum will be obtained from a financial institution on 1st January and further borrowings will be made at the same rate of interest on the first day of the month in which borrowing is required. All borrowings will be repaid along with interest on the expiry of one year. The company will make payment for the following assets in January:

(2) Gross profit margin will be 25% on sales.
(3) The company will make credit sales only and these will be collected in the second month following sales.
(4) Creditors will be paid in the first month following credit purchases. There will be credit purchases only.
(5) The company will keep minimum stock of raw materials of ₹ 10 lakh.
(6) Depreciation will be charged @ 10% per annum on cost on all Property Plant and Equipment.
(7) Payment of preliminary expenses of ₹ 1 lakh will be made in January.
(8) Wages and salaries will be ₹ 2 lahks each month and will be paid on the first day of the next month.
(9) Administrative expenses of ₹ 1 lakh per month will be paid in the month of their incurrence.
Assume no minimum required cash balance.
You are required to prepare the monthly cash budget (January-June), the projected Income Statement for the 6-month period, and the projected Balance Sheet as on 30th June, 2000. (May 2000, 20 marks)
Answer:

Note: In February 2000 there is a shortage of cash of by ₹ 2.5 Lakhs, so it will be met by borrowing at the beginning of the said month.

2. Computation of Payment to the Creditors:
Purchase = Cost of goods sold – Wages and salaries
Purchases for January = (75% of 35 lakhs) – ₹ 2 = ₹ 20.50 lakhs
Since Creditors are paid in the first month following purchases.
Therefore, payment in February is the purchase of January i.e. ₹ 20.50 lakhs.
Same procedure will be followed for other months.
Total Purchases = ₹ 125 lakhs (for Jan.- May) + ₹ 31.75 lakhs (for June) + ₹ 10 lakhs (stock)
= ₹ 166.75 lakhs

3. Amount of depreciation for six months:
Dep. = ₹ 80,00,000 × 10% × 6/12) = ₹ 4,00,000

Question 4.
Alcobex Metal Company (AMC) does business in three products P₁, P_2, and P₃. Products P₁ and P₂ are manufactured in the company, while product P₃ is procured from outside and resold as a combination with either product P₁ or P₂. The sales volume budgeted for the three products for the year 2000- 2001 (April-March) are as under:

Based on the budgeted Sales value, the cash flow forecast for the company is prepared based on the following assumptions:
1. Sales realization is considered at:
50% Current month
25% Second month
25% Third month

2. Production Programme for each month is based on the sales value of the next month.
3. Raw Material consumption of the company is kept at 59% of the month’s production.
4. 81 % of the raw materials consumed are components.
5. Raw materials and components to the extent, at 25% are procured through import.
6. The Purchases budget is as follows:
(i) Indigenous raw materials are purchased two months before the actual consumption.
(ii) Components are procured in the month of consumption.
(iii) Imported raw materials and components are bought three months prior to the month of consumption.
7. The company avails of the following credit terms from suppliers:
(i) Raw materials are paid for in the month of purchases;
(ii) Company gets one month’s credit for its components,
(iii) For imported raw materials and components payments are made one month prior to the dates of purchases.
8. Currently the company has a cash credit facility of ₹ 140.88 lakhs.
9. Expenses are given below and are expected to be constant throughout the year:
Wages and Salaries ₹ 312 lakhs
Administrative Expenses ₹ 322 lakhs
Selling and Distribution Exp. ₹ 53 Iakhs.
10. Dividend of ₹ 58.03 lakhs is to be paid in October.
11. Tax of ₹ 23.92 lakhs will be paid in equal instalments in four quarters: i.e., January, April, July, and October.
12. The term loan of ₹ 237.32 lakhs is repayable in two equal instalments half-yearly. i.e., June-December.
13. Capital expenditure of ₹ 292.44 lakhs for the year is expected to be spread equally during the 12-month period.
You are required to prepare a Cash Flow Statement (Cash Budget) for the period of June – November 2000. (May 2001, 20 marks)
Answer:
Assumptions: The said problem can be solved on the basis of some assumptions:

1. Since opening cash balance is not given, ¡t is assumed that credit facility received by the company (i.e. ₹ 140.88 lakhs) is its opening balance.
2. For the complete information some working flotes are calculated from December otherwise they have no relevance. .
3. Said problem does not provide information regarding purchase price and payment terms to the creditors of product ‘P₃’ which is procured from outside and sold out as a combined product with P₁ or P₂. So, it is assumed that the product P3 is manufactured within the company and production costs is same as to the other product P₁ or P₂.

Question 5.
The following details are forecasted by a company for the purpose of effective utilization and management of cash:
(i) Estimated sales and manufacturing costs:

Year and month 2010	Sales  ₹	Materials ₹	Wages  ₹	Overheads ₹
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

(ii) 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 ½ (one-half) month and of overheads is 1 (one) month.
(iii) Interest on 12 percent debentures of ₹ 5,00,000 is to be paid half yearly in June and December.
(iv) Dividends on investments amounting to ₹ 25,000 are expected to be received in June, 010.
(v) A new machinery will be installed in June. 2010 at a cost of ₹ 4,00,000 which is payable in 20 monthly instalments from July 2010 onwards.
(vi) Advance income tax to be paid in August 2010 is ₹ 15,000.
(vii) Cash balance on 1st June 2010 is expected to be ₹ 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) being put in fixed deposit. You are required to prepare monthly Cash budget on the basis of above information for four months beginning from June, 2010. (May 2010, 7 marks)
Answer:

(2) Payment of Wages
June = 80,000 + 82,500 = 1,62,500;
July = 82,500 + 82,500 = 1,65,000;
Aug. = 82,500 + 82,500 = 1,65,000; and
Sept. = 82,500 + 85,000 = 1,67,500

(Notes: Its has been assumed that the company wants to keep minimum cash balance of 45,000 at the end of every month.)

Question 6.
Slide Ltd. is preparing a cash flow forecast for the three-month period from January to the end of March. The following sales volumes have been forecasted;

	December	January	February	March	April
Sales (units)	1800	1875	1950	2100	2250

Selling price per unit is ₹ 600. Sales are all on one month’s credit. Production of goods for sale takes place one month before sales. Each unit produced requires two units of raw materials costing ₹ 150 per unit. No raw material inventory is held. Raw materials purchases are on one-month credit. Variable overheads and wages equal to ₹ 100 per unit are incurred during production and paid In the month of production. The opening cash balance on 1st ‚ January is expected to be ₹ 35,000. A long-term loan of ₹ 2,00,000 is expected to be received in the month of March. A machine costing ₹ 3,00,000 will be purchased in March.
(a) Prepare a cash budget for the months of January, February, and March and calculate the cash balance at the end of each month in the three-month period.
(b) Calculate the forecast current ratio at the end of the three-month period. (Nov 2019, 10 marks)
Answer:

Question 7.
Explain the following:
(i) Concentration Banking
(ii) Lock Box System (May 2014, Nov 2017, 2 marks each)
Answer:
(i) Concentration Banking:
In concentration Banking the Company establishes a number of strategic collection centers in different regions instead of a single collection center at the head office. This system reduces the period between the time a customer mails In his remittances and the time when they become spendable funds with the company, payment received by different collection centres are deposited with their local Bank which in turn transfers all surplus funds to the concentration bank of head office.

The concentration bank with which the company has its major bank account is generally located at the headquarters. Concentration banking is one important and popular way of reducing the size of the float.

(ii) Lock Box System:
Another means to accelerate the flow of funds in lock box system. While concentration banking remittances are received by a collection centre and deposited in the bank after processing. The purpose of lock box system is t0 eliminate the time between the receipts of remittances by the company and deposited at bank. A lockbox arrangement usually is on regional basis which a company chooses according to its billing patterns.

Question 8.
Explain four kinds of float with reference to management of cash. (Nov 2014, 4 marks)
Answer:
Different kinds of float with reference to cash management are as under:

1. Billing float	This is the time formal document that a seller prepares and sends to the purchaser as the payment request for goods sold or services provided.
2. Mail float	This is the time when a cheque is being processed by post office, messenger service, or other means of delivery.
3. Cheque processing float	This is the time for the seller to sort, record & deposit the cheque after it has been received by the company.
4. Bank processing float	This is the time from the deposit of the cheque to the crediting of funds in the seller’s A/c.

Question 9.
Given below is summary of the 2007 Accounts of Universal Ltd.:

The company deals In a single product. The following estimates of Trading have been made for the year 2008:
(a) Sales will be 5,00,000 units at a price of ₹ 42 per unit. Sales in Nov. and Dec. will be 50,000 units per month, balance being equally spread for the rest of the year.
(b) The amount of wages and general expenses will be 20 percent higher than in 2007.
(c) ₹ 10 lakhs will be spent on new shop fitting in June 2008. The depreciation charges will be ₹ 7.50 lakhs.
(d) All sales and purchases will, as in the past, be made on credit for settlement two months after sale or purchase. Wages and general expenses will be paid immediately.
(e) Purchase will be 43,000 units por month at a price of ₹ 30 per unit.
(f) An interim dividend of ₹ 2 per share will be paid in Now. 2008.
Required: Prepare the Budgeted Profit and Loss Account, monthly Cash Budget for the year and Balance Sheet as at end of the year 2008.
Answer:

Working Notes:
(i) The Closing Balance of Debtors as on 31.12.2006 ( ₹ 26 lakhs)
represents the sales for two months-Nov. 2007 & Dec. 2007. Taking this balance equally spread over these months, sales for Nov. 2007 ₹ 13.00 lakhs & for Dec. 2007 ₹ 13.00 lakhs.

(iii) The Closing Balance of Creditors as on 31.12.2007 (₹ 20 lakhs) represents the purchases for two months-Nov. 2007 & Dec. 2007. Taking this balance equally spread over these months, purchases for Nov. 2007 ₹ 10 lakhs & for Dec. 2007 ₹ 10 lakhs.

Question 10.
X & Y agree to start a Ltd. Company and to take over partly an existing business of Z. They agreed to contribute ₹ 25,000 each in the form of equity shares and also agree that Z will provide any additional amount required to finance the company in 1 six months and they would not recourse to any bank overdraft. Z will provide funds in the form of 8% debentures, to the nearest ₹ 1,000 above the amount required. The debentures will be secured by freehold premises. The company will purchase freehold premises for ₹ 25,000, Stock for ₹ 8,000, and plant for ₹ 6,000 Settlement is to be made in the month of in corporation.

(b) Gross Profit on sales to be @ 20%. .
(c) Purchase: to be sufficient to secure Stock at the end of each month adequate to supply the sales of the following month.
(d) Creditors: To be paid at the end of month following the month of purchase.
(e) Debtors: To settle their accounts net by the aid of the second month after the month of sales.
(f) Expenses:
(i) Preliminary Expenses ₹ 800 to be paid in Feb.
(ii) General Exp. ₹ 600 per month.
(iii) Salaries and Wages ₹ 800 per month from Jan. to April and ₹ 900 thereafter.
(iv) Rates ₹ 400 per annum payable in June and Dec. to be paid in the month following in which it is due.
(d) Assume shares and debentures are issued on 1st January.
Required: Draw up a Cash budget and Budgeted final account and Balance Sheet to 30th June.
Answer:

Question 11.
Prepare Cash Budget for July-December from the following information:
(a) The estimated sales, expenses, etc. are as follows:

(b) 20% of the sales are on cash and the balance on credit.
(c) 1 % of the credit sales are returned by the customers. 2% of the Gross accounts receivable constitute bad debt losses. 50% of the good accounts receivables are collected in the month of the sales, and the rest in the next month.
(d) The time lag in the payment of misc. expenses and purchases is one month. Wages and salaries are paid fortnightly with a time lag of 15 days.
(e) The company keeps a minimum cash balance of ₹ 5 lakhs. Cash in excess of ₹ 7 Lakhs is invested in Govt. securities In the multiple of ₹ 1 lakh. Shortfalls in the minimum cash balance are made good by borrowing from banks. Ignore interest received and paid.
Answer:

The wordings used ¡n the question may also be interpreted to mean that bad debts at 2% is to be worked out from net credit sales figures after returns.
(ii) Payment of Wages & Salaries (Fortnightly with a lag of 15 days)

Question 12.
From the information given below, prepare a Cash Budget of M/s. Ram Ltd. for the first half year of 2009, assuming that cost would remain unchanged:
(a) Sales are both on credit and for cash the latter being one-third of the former;
(b) Realisations from debtors are 25% in the month of sale, 60% in month following that, and the balance in the month after that;
(c) The company adopts uniform pricing policy of the selling price being 25% over cost;
(d) Budgeted sales of each month are purchase1 and paid for in the preceding month;
(e) The company has outstanding debentures of ₹ 2 lakhs on 1st Jan. which carry interest at 15% per annum payable on the last date of each quarter on calendar years basis. 20% of the debentures are due for redemption on 30th June 2009;
(f) The company has to pay the last instalment of advance tax, for assessment year 2008-2009, amounting to ₹ 54,000;
(g) Anticipated office costs for the six-month period are; Jan. ₹ 25,000 Feb. ₹ 20,000 Mar. ₹ 40,000 Apr. ₹ 35,000 May ₹ 30,000 and June ₹ 45,000;
(h) The operating cash balance of ₹ 10,000 is the minimum cash balance to be maintained Deficits have to be met by borrowers in multiples of ₹ 10,000 on which interest on monthly basis has to be paid on the first date of the subsequent month at 12% p.a. Interest is payable for a minimum period of a month.
(i) Rent payable is ₹ 2,000 per month.
(j) Sales forecast for the different months are:
Oct. 2008 ₹ 1,60,000, Nov. ₹ 1,80,000, Dec. ₹ 2,00,000, Jan. 2009 ₹ 2,20,000, Feb. ₹ 1,40,000 Mar. ₹ 1,60,000, Apr. ₹1,50,000, May ₹ 2,00,000, June ₹ 1,80,000 and July ₹ 1,20,000.
Answer:

Question 13.
JPL has two dates when It receives its cash mf lows. i.e., Feb. 15, and Aug. 15. On each of these dates, it expects to receive ₹ 15 crore. Cash expenditure are expected to be steady throughout the subsequent 6 month period. Presently, the ROI in marketable securities is 8% per annum, and the cost of transfer from securities to cash is ₹ 125 each time a transfer occurs.
(i) What s the optimal transfer size using the EOQ model? what is the average cash balance?
(ii) What would be your answer to part (i), if the ROI were 12% per annum and the transfer costs were 75? Why do they differ from those in part (i)? (May 2001, 10 marks)
Answer:
(I) Computation of optimal transfer size by using EOQ model and the average cash balance:
C = \(\sqrt{\frac{2 F A T}{1}}\)
Where C = Cash required each time to maintain a minimum cash balance.
F = Total annual cash required.
T = Transaction cost of one transfer between cash and securities.
I = Interest rate on securities.
Here, F = 30,00,00,000 I =8% p.a., T = ₹ 125/Transaction
C = \(\sqrt{\frac{2 \times ₹ 30,00,00,000 \times 125}{0.08}} \) = ₹ 9,68,245
∴ Average cash balance = C/2 = \(\frac{₹ 6,12,372}{2}\) = ₹ 4,84,123

(ii) Optimum transfer size if ROI is 12% and T is ₹ 75/Transaction:
C = \(\sqrt{\frac{2 \times ₹ 30,00,00,000 \times ₹ 75}{0.12}}\) = ₹ 6,12,372
Average cash balance = C/2 = \(\frac{₹ 6,12,372}{2}\) = ₹ 3,06,186
Causes of difference In figure (II) from the figure of part (I)
(a) Transaction cost is lower as comparison to part (i)
(b) Higher opportunity cost of holding (ROI =12%) as comparison to part (i).

Question 14.
Write short notes on the following:
(d) William J Baumal vs. Miller-Orr Cash Management Model (May 2004, May 2011, 3 marks)
Answer:
William J Baumal vs. MIlIer-Orr Cash Management Model

Particulars	Baumal’s Model	Miller-Orr Model
1. Aim of the Model	This model tries to balance the income foregone on cash held by the firm against the transaction cost of converting cash into marketable securities or vice-versa.	The Miller Orr model attempts to answer the following two questions about the cash management. 1. When should transfer be effected between cash and marketable securities. 2. How much cash is to be converted into marketable securities and vice-versa.
2. The Model	The optimum cash level is that level of cash where the carrying cost and the transaction cost are the minimum. Where; Carrying cost denotes cost of holding cash i.e. the interest foregone on marketable securities.Transaction cost denotes cost involved in converting marketable securities into cash.	This model operates under uncertainties and random i.e. irregular cash flows. According to the model, control limits for cash transaction is set which when reached trigger off a transaction. There are 2 control limits, the upper control limit and the lower control limit. Within these control limits, the cash balance fluctuates.The optimum cash balance according to this model is the point where the holding cost and transaction cost are equal. When it hits the upper or the lower limit, action should be taken to restore the cash balance to its normal level within the control points.

The Miller-On Model is More realistic:

• The limitation of Baumal Model is that it does not allow cash flows to fluctuate terms do not use their cash balance uniformly nor are they able to predict daily cash inflows and outflows.
• The miller or model overcomes this. This shortcoming and allows for daily cash flow variation within the lower and upper limit set.
• If the firms cash flows fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities to come back to a normal level of cash balance and vice versa.

Question 15.
Discuss Miller-Orr Cash Management model. (Nov 2005, 3 marks)
OR
Explain ‘Miller-Orr Cash Management model’. (May 2015, 4 marks)
Answer:
Miller – Orr Cash Management Model
This stochastic model of cash management was presented by Miller and Orr in 1966. It is an expansion of Baumol’s EOQ model for optimum cash balance.
Aim of the Model: The Miller Orr model attempt to answer the following two questions about the cash management.

1. When should transfer be effected between cash and marketable securities.
2. How much cash is to be converted into marketable securities and vice-versa.

The Model: This model operates under uncertainties and random i.e. irregular cash flows.
According to the model, control limits for cash transaction is set which when reached trigger off a transaction. There are 2 control limits, the upper control limit and the lower control limit.
Within these control limits, the cash balance fluctuates. When it hits the upper or the lower limit, action should be taken to restore the cash balance to its normal level within the control points.

Explanation of the Model: The control limits are fixed on the basis of:

• Fixed cost associated with the securities transacted.
• The opportunity cost of holding cash.
• The degree of fluctuations in cash balances.

The upper limit is denoted by h, the lower limit by zero and the return point is denoted by Z. When the cash balance! reaches the upper limit, cash which is equal to (h-z) is invested in the marketable securities. When the cash balance reaches the lower limit, the cash is generated by selling the marketable securities. When the cash balance remains between the higher and lower levels, no transaction between the marketable securities and cash takes place.

Formula:
Z = \(3 \sqrt{\frac{3 T \sigma^2}{R I}} \)
Where;
R = Return point.
T = Transaction cost.
σ = Variance of daily cash balance.
l = Interest rate ie. carrying cost per rupee of cash.

Assumptions:

• Out of cash and marketable securities, marketable securities has a marginal yield.
• The buying and selling of marketable securities takes place without any delay.

Limitations:

1. It assumes a constant variability of cash flows.
2. It cannot cope up with large transactions such as payment of dividends.

Question 16.
Answer the following:
(i) A firm maintains a separate account for cash disbursement. Total disbursements are ₹ 2,62,500 per month. The administrative and transaction cost of transferring cash to disbursement account is ₹ 25 per transfer. Marketable securities yield is 7.5% per annum. Determine the optimum cash balance according to William J. Baurmol’s model. (May 2009, 3 marks)
Answer:
Determination of Optimal Cash Balance according to William J. Baumol Model
Optimum Cash Balance = \(\sqrt{\frac{2 \mathrm{AB}}{\mathrm{C}}}\)
Where,
A = Annual disbursement
B Administrative and transaction cost
C = Marketable securities yield.
C = \(\sqrt{\frac{2 \times 2,62,500 \times 12 \times 25}{0.075}}\)
= \(\sqrt{\frac{15,75,00,000}{0.075}}\)
= \(\sqrt{2,10,00,00,000} \)
Optimum cash Balance, C = ₹ 45,826

Question 17.
Answer the following:
VK Co. Ltd. has total cash disbursement amounting ₹ 22,50,000 in the year 2017 and maintains a separate account for cash disbursements. Company has an administrative and transaction cost on transferring cash to disbursement account ₹ 15 per transfer. The yield rate on marketable securities is 12% per annum. You are required to determine optimum cash balance according to the William J. Baumol Model. (May 2017, 5 marks)
Answer:
Optimum Cash Balance = \(\sqrt{\frac{2 \times A T \times T}{H}}\)
Where,
A = Annual Cash disbursements
T = Transaction Cost (fixed cost) per transaction
H = Opportunity Cost one rupee per annum (Holding Cost)
Optimum Cash Balance = \(\sqrt{\frac{2 \times 22,50,000 \times 15}{0.12}}=\sqrt{56,25,00,000}\)
Optimum Cash Balance = ₹ 23,717
Thus, Optimum Cash Balance according to William J. Boumol Model is ₹ 23,717.

Question 18.
The annual cash requirement of X Ltd. is ₹ 10 lakhs. The company has marketable secucities in lot size8 of ₹’ 50,000, ₹ 1,00000, ₹’ 2,00,000 ₹ 2,50,000 and ₹’ 5,00,000. Cost of conversion of marketable securities per lot is ₹ 1,000. The company can earn 5% annual yield on its securities. You required to prepare a table indicating which lot size will have to be sold by the company. Also show that the economic lot size can be obtained by the Baumal Model.
Answer:

Economic lot size is ₹ 2,00,000 at which total costs are minimum.
Economic Lot Size = \(\sqrt{\frac{2 \times A \times T}{H}}\)
Where; A = Annual Cash requirement = ₹ 10,00,000
T = Transaction Cost per lot = ₹ 1,000
H = Holding Cost interest earned on marketable securities per annum =5%
Economic Lot Size = \(\sqrt{\frac{2 \times 10,00,000 \times 1,000}{0.05}}\) = ₹ 2,00,000

Question 19.
The annual cash requirement of X Ltd. is ₹ 15 Lakhs. The Company has Marketable Securities in Lot Sizes of ₹ 50,000, ₹ 1,50,000 and ₹ 2,50,000. Cost of conversion of Marketable Securities per lot is ₹ 1,500. The Company can earn 10% annual yield on its securities. Prepare a table indicating which Lot Size will have to be sold by the Company. Also show the Economic Lot Size, which can be obtained by the Baumol’s model.
Answer:

Conclusion: From the above table, the Economic Lot Size is ₹ 2,50,000, since Associated Cost is the least at that level.
2. Optimum Investment Size = \(\sqrt{\frac{2 A T}{1}}\)
Where;
A = Annual Cash Requirement = ₹ 15,00,000
T = Transaction Cost per purchase/sate = 1,500
I = Interest Rate per rupee per annum = 10%
On substitution, Optimum Investment Size = ₹ 2,12,132

Question 20.
X Ltd. requires a minimum cash balance of ₹ 6,000 and the variance of daily cash flows is estimated to be ₹ 22,50000. The interest rate is 0.025% per day and the transaction cost for each sale or purchase of securities is ₹ 20. Calculate the spread, the upper limit, and the return point.
Answer:
(i) Spread = \(3 \times \sqrt[3]{\frac{3}{4} \times \frac{T+\sigma^2}{1}}\)
= \(3 \times \sqrt{\frac{3}{4} \times \frac{20+(22,50,000)^2}{0.025 \%}} \)
= 15,390

(ii) Return Point = Lower Limit +\(\frac{1}{3}\) rd of Spread
= 6,000 + \(\frac{1}{3} \times 15,390\)
= 11,130

(iii) Upper Limit = Lower Limit + Spread
= 6,000 + 15,390
= 21,390

(iv) Average Cash Balance = Lower Limit +\(\frac{4}{9}\) of Spread
= 6,000 + \(\frac{4}{9} \times 15,390 \)
= 12,840

Question 21.
Answer the following:
State the advantages of Electronic Cash Management System. (May 2013, 4 marks)
Answer:
Advantages of Electronic Cash Management System

1. Significant saving in time.
2. Greater accounting accuracy.
3. More control over time and funds:
4. Decrease in interest costs.
5. Less paperwork.
6. Speedy conversion of various instruments into cash.
7. Faster transfer of funds from one location to another, where required.
8. Supports electronic payments.
9. Reduction in the amount of ‘idle float’ to the maximum possible extent.
10. Ensures no idle funds are placed at any place in the organization.
11. It makes inter-bank balancing of funds much easier.
12. Making available funds wherever required, whenever required.
13. Produces faster electronic reconciliation.
14. It is a true form of centralised ‘Cash Management’.
15. Allows for detection of book-keeping errors.
16. Earns interest income or reduces interest expense.
17. Reduces the number of cheques issued.

Question 22.
What is Virtual Banlcing? State its advantages. (Nov 2013, 4 marks)
Answer:
Virtual Banking

Concept	It refers to the provisions of Banking and related services through the use of Information Technology (IT) without direct interaction between Bank employees and customers.
Origin	The origin of virtual banking in the developed countries can be traced back to the seventies with the installation of Automated Teller Machine (ATMS). Subsequently, driven by the competitive market environment as well as various technological and customer pressures, other types of virtual banking services have grown in prominence throughout the world.

Service Offered:

1. Computerized settlement of clearing transactions.
2. Use of Magnetic Ink Character Recognition (MICR) technology.
3. Provision of inter-city clearing facilities and high-value clearing facilities.
4. Electronic Clearing Service Scheme (ECSS).
5. Electronic Funds Transfer (EFT) scheme.
6. Delivery vs. Payment (DVP) for Government securities transactions.
7. Setting up of Indian Financial Network(INFINET) etc.

Advantages:

1. Lower cost of handing a transaction.
2. Virtual banking allows the possibility of improved and a range of services being made available to the customer rapidly, accurately and at his convenience.
3. High speed Leads to prompt services with perfect accuracy
4. Cost Efficiency by lower cost of handling a transaction.

Question 23.
Explain Electronic Cash Management System. (Jan 2021, 4 marks)

Question 24.
Answer the following:
‘Management of marketable securities is an integral part of investment of cash.’ Comment. (Nov 2013, 4 marks)
OR
Describe the three principles relating to selection of marketable securities. (May 2016, 4 marks)
Answer:
Management of marketable securities serves the purpose of liquidity and cash provided choice of investment is done accurately. The selection of securities should be guided by 3 principles:

• Safety
• Maturity
• Marketability

Safety
Returns and risks are directly related to each other. Higher the default risk, higher the return from securities and lower the default risk, lower the return from securities. The default risk means the possibility of default in payment of interest or/and principal on time. To minimize default risk, the access cash should be invested in safe securities.

Maturity
Maturity refers to the time period cover which interest and principal are to be paid. Matching of maturity forecasting cash need is essential. Prices of long-term securities fluctuate more with changes in interest rates therefore, more risky. To avoid the fluctuation in prices of securities the excess cash should be invested in short-term securities.

Marketability
It refers to the convenience, speed, and cost at which a security can be converted into cash. If the security can be sold quickly without loss of time and price it is highly liquid or marketable. Thus, in situations when working capital needs are fluctuating, investment of excess funds should be done in short-term securities, so as to maintain the liquidity.

Introduction to Working Capital Management – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Introduction to Working Capital Management – CA Inter FM Question Bank

Question 1.
An engineering company is considering its working capital investment for the year 2003-04. The estimated Property Plant and Equipment and current liabilities for the next year are ₹ 6.63 crore and ₹ 5.967 crore respectively. The sales, and earnings before interest and taxes (EBIT) depend on investment in its current assets – particularly inventory and receivables. The company is examining the following alternative working capital policies:

Your are required to calculate the following for each policy:
(i) Rate of return on total assets.
(ii) Net working capital position.
(iii) Current assets to Property Plant and Equipment ratio.
(iv) Discuss the risk-return trade-off of each working capital policy. (May 2003, 1+1+1 +3=6 marks)
Answer:

(iv) Risk return trade-off:
The Net working capital or current ratio is a measure of risk. Rate of Return total assets is a measure of return. The expected risk and return are minimum in the case of conservative investment policy and maximum in case of aggressive investment policy. The firm can improve profitability by reducing investment in working capital.

Question 2.
Discuss the liquidity vs. profitability issue in management of working capital. (Nov 2010, 4 marks)
Answer: .
Liquidity Vs Profitability Issue in Management of Working Capital:
Working capital management monitors & controls all the components of working capital i.e. cash, marketable securities, debtors, creditors etc. Finance manager has to pay particular attention to the levels of current ‘assets and their financing.
In order to decide the level of financing of current assets, the risk-return trade-off must be taken into account. The level of current assets can be measured by creating a relationship between current assets and Property Plant and Equipment. A firm may follow a conservative, aggressive or moderate policy.

A conservative policy means lower return arid risk whe an aggressive policy produces higher return and risk. The two important aims of the working capital management are profitability and solvency. A liquid firm has less risk of insolvency i.e. it will hardly experience a cash shortage or a stock out situation. Whereas, there is a cost associated with maintaining a sound liquidity position. Hence, to have a higher profitability the firm may have to sacrifice solvency and maintain a relatively low level of current assets.

Question 3.
Answer the following:
Discuss the risk-return considerations in financing current assets. (Nov 2015, 4 marks)
Answer:
The financing of Current Assets involves a trade-off between risk and return. A firm can choose from short or long-term sources of finance. Short-term financing less expensive than long-term financing, but at the same time, short-term financing involves greater risk than long-term finance. Depending upon the mix of short-term and long-term financing the approach followed by a company may be referred as matching approach, conservative approach and aggressive approach.

1. Matching Approach:
In matching approach, long term finance is used to finance Property Plant and Equipment and permanent current assets and short-term financing to finance temporary or variable current assets.

2. Conservative Approach
Under the conservative plan, the firm finances its permanent assets and also a part of temporary current assets with long-term financing and hence less risk of facing the problem of shortage of funds.

3. Aggressive Approach
An aggressive approach is said to be followed by the firm when it uses more short-term financing than warranted by the matching plan and finances a part of its permanent current assets with short-term financing.

Question 4.
A company is considering its working capital investment and financial policies for the next year. Estimated PPE and current liabilities for the next year are ₹ 2.60 crores and ₹ 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:

After evaluating the working capital policy, the Financial Controller has advised the adoption of the moderate working capital policy. The Company is not examining the use of long-term borrowings for financing its assets. The company will use ₹ 2.50 crores of the equity funds. The corporate tax rate is 34%. The company is considering the following debt alternatives.

You are required to CALCULATE the following:
(i) Working Capital Investment for each policy:
(a) Net Working Capital position.
(b) Rate of Return.
(c) Current ratio.

(ii) Financing for each policy:
(a) Net Working Capital position.
(b) Rate of Return on Shareholders’ equity.
(c) Current ratio.
Answer:

Question 5.
The following annual figures relate to MNP Limited:
Sales (at three months credit) ₹ 90,00,000
Materials consumed (suppliers extend one and half months’ credit ₹ 22,50,000
Wages paid (one month in arrear) ₹ 18,00,000
Manufacturing expenses outstanding at the end of the year (cash expenses are paid one month in arrear) ₹ 2,00,000
Total Administrative expenses for the year (cash expenses are paid one month in arrear) ₹ 6,00,000
Sales Promotion expenses for the year (paid quarterly in advance) ₹ 12,00,000
The company sells its products on gross profit of 25% assuming depreciation as a part of cost of production. It keeps two month’s stock of finished goods and one month’s stock of raw materials as inventory. It keeps cash balance of ₹ 2,50,000. Assume a 5% safety margin, work out the working capital requirements of the company on cash cost basis. Ignore work-in-progress. (May 2004, 6 marks)
Answer:

Question 6.
XYZ Co. Ltd. is a pipe manufacturing company. Its production cycle indicates that materials are introduced in the beginning of the production cycle; wages and overhead accrue evenly throughout the period of the cycle. Wages are paid in the next month following the month of accrual. Work in process includes full units of raw materials used in the beginning of the production process and 50% of wages and overheads are supposed to be conversion costs. Details of production process and the components of working capital are as follows:
Production of pipes 12,00,000 units
Duration of the production cycle One month
Raw materials inventory held One month of consumption
Finished goods inventory held for Two months
Credit allowed by creditors One months
Credit given to debtors Two month
Cost price of raw materials ₹ 60 per unit
Direct wages ₹ 10 per unit
Qver heads ₹ 20 per unit
Selling price of finished pipes ₹ 100 per unit
Required to calculate:
The amount of working capital required for the company. (May 2005, 5 + 5= 10 marks)
Answer:

Question 7.
A proforma cost sheet of a Company provides the following particulars:

	Amount per unit (₹)
Raw materials cost	100
Direct labour cost	37.50
Overheads cost	75
Total cost	212.50
Profit	37.50
Selling Price	250

The Company keeps raw materials in stock, on an average for one month; work-in-progress, on an average for one week; and finished goods in stock, on an average for two weeks. The Credit allowed by suppliers is three weeks and company allows four weeks credit to its debtors. The lag in payment of wages is one week and lag in payment of overhead expenses is two weeks.

The Company sells one-fifth of the output against cash and maintains Cash-in-hand and at bank put together at ₹ 37,500.
Required:
Prepare a statement showing estimate of Working Capital needed to finance an activity level of 1,30,000 units of production. Assume that production is camed on evenly throughout the year, and wages and overheads accrue similarly work-in-progress stock is 80% complete in all respects. (Nov 2006, 12 marks)
Answer:

WIP =5,31,250 × 80%
= 4,25,000.
For calculation purposes, 4 weeks has been taken as equivalent to a month.

Question 8.
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:

Other information:
Raw material in stock: average 4 weeks consumption, Work in progress (completion stage, 50 percent), on an average half a month. Finished goods in stock: on an average, one month.
Credit allowed by suppliers is one month.
Credit allowed to debtors is two months.
Average time lag in payment of wages is 11/2 weeks and 4 weeks in overhead expenses.
Cash in hand and at bank is desired to be maintained at ₹ 50,000.
All Sales are on credit basis only.
Required:
(i) Prepare a statement showing estimate of working capital needed to finance an activity level of 96,000 units of production. Assume that production is carried on evenly throughout the year, and wages and overhead accrue similarly. For the calculation purpose, 4 weeks may be taken as equivalent to a month and 52 weeks in a year.

(ii) From the above information calculate the maximum permissible bank finance by all the three methods for working capital as per Tondon Committee norms; assume the core current assets constitute 25% of the current assets. (Nov 2007, 5 + 3 = 8 marks)
Answer:

Networking Capital = Current Assets – Current Uabilities
= 23,85,385 – 5,58,461
= 18,26,924
Answer:
(ii) Maximum Permissible Bank Finance
1. Method I.75 (CA- CL)
75 (18,26,924)
= ₹ 13,70,193

2. Method II:-
75 CA – CL
75 × 23,85,385 – 5,58,461
= 17,89,038.75 -5,58,461
= ₹ 12,30,577.75

3. Method III
75 (CA- CCA) – CL
[75 (23,85,385- 5,96,346) – 5,58,461]
= 13,41,779 – 5,58,461
= ₹ 7,83,318

Question 9.
MN Ltd. 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 fruit capacity:

In the first year of operations expected production and sales are 40,000 units and 35,000 units respectivety. To assess the need of Working capital, the following additional information is available:
(i) Stock of Raw materials …………………… 3 months consumption.
(ii) Credit allowable for debtors ……………………. 1\(\frac{1}{2}\) months.
(iii) Credit allowable by creditors …………………….. 4 months.
(iv) Lag in payment of wages ……………….. 1 month.
(v) Lag in payment of overheads …………………………. \(\frac{1}{2}\) month.
Cash in hand and Bank is expected to ₹ 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. (Nov 2008, 9 marks)
Answer:

Question 10.
Answer the following:
Discuss the estimation of working capital need based on operating cycle process. (Nov 2010, 4 marks)
Answer: .
Estimation of Working Capital Need based on Operating Cycle Working capital is that part of the firm’s capital which is required for financing short-term assets or current assets such as cash, marketable securities inventories etc.

Forecasting working capital requirements is based on the concept of operating cycle. The determination of operating capital cycle helps in the forecast, control and management of working capital.

The length of operating cycle is the indicator of performance of management. The net operating cycle represents the time interval for which the firm has to negotiate for Working Capital from its Banker. It enables to determine accurately the amount of working capital needed for the continuous operation of business activities.

The duration of working capital cycle may vary depending on the nature of the business. In the form of an equation, the operating cycle process can be expressed as follows:
Operating Cycle = R+W+F+D-C
Where,
R = Raw material storage period.
W = Work-in-progress holding period.
F = Finished goods storage period.
D = Debtors collection period.
C = Credit period availed.

Question 11.
The management of MNP Company Ltd. is planning to expand its business and consult you to prepare an estimated working capital statement. The records of the company reveals the following annual information:

Sales – Domestic at one month’s credit ₹ 24,00,000
Export at three month’s credit (sales price 10% below domestic price) ₹ 10,80,000
Materials used (suppliers extend two months credit) ₹ 9,00,000
Lag in payment of wages -1/2 month ₹ 7,20,000
Lag in payment of manufacturing expenses (cash) -1 month 10,80,000
Lag in payment of Adm. expenses – 1 month 2,40,000
Sales promotion expenses payable quarterly in advance 1,50,000
Income tax payable in four 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) ãnd believes in keeping ₹ 2,50,000 available to it including the overdraft limit of ₹ 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. (May 2011, 16 marks)
Answer:

Question 12.
The Trading and Profit and Loss Account of Beta Ltd. for the year ended 31st March, 2011 is given below:

The opening and closing balances of debtors were ₹ 1,50,000 and ₹ 2,00,000 respectively whereas opening and closing creditors were ₹ 2,00,000 and ₹ 2,40,000 respectively. You are required to ascertain the working capital requirement by operating cycle method. (Nov 2011, 8 marks)
Answer:
Computation of Operating Cycle
1. Raw Material Storage period (R)
= \(\frac{\text { Average Stock of Raw Material }}{\text { Daily Average Consumption of RawMaterial }}\)
= \(\frac{(1,80,000+2,00,000) / 2}{10,80,000 / 360} \)
= 63.33 days
Raw Material Consumed = Opening Stock + Purchases – Closing Stock
= 1,80,000 + 11,00,000-2,00,000= ₹ 10,80,000

2. Conversion/Work-In-Process Period (W)
Conversion/Processing Period = \(\frac{\text { Average Stock of WIP }}{\text { Daily Average Production Cost }}\)
= \(\frac{(60,000+1,00,000) / 2}{15,40,000 / 360}\) = 18.7 Days

3. Finished Goods Storage Period (F)
Finished Goods Storage period = \(=\frac{\text { Average Stock of Finished Goods }}{\text { Daily Average Cost of Good Sold }} \)
= \(\frac{(2,60,000+3,00,000) / 2}{15,00,000 / 360} \)
= 67.19 days

4. Debtors Colledilon Period (D)
Debtors Collection Period = \(\frac{\text { Average Debtors }}{\text { Daily Average Sales }}\)
= \(\frac{(1,50,000+2,00,000) / 2}{20,00,000 / 360} \)
= 31.5 days

5. Creditors Payment Period (C)
Creditors Payment Period = \( \frac{\text { AverageCreditors }}{\text { DailyAveragePurchase }}\)
= \(\frac{(2,00,000+2,40,000) / 2}{11,00,000 / 360}\) = 72 days

6. Duration of Operating Cycle (O)
O = R + W + F+D – C
= 63.33+18.7+67.19+31.5-72
= 108.72 days

Computation of Working Capital
(i) Number of Operation Cycles per Year
= 360/Duration Operating Cycle = 360/108.72 = 3.311

(iii) Working Capital Required
Working Capital Required = \(\frac{\text { Total Operating Expenses }}{\text { Numberd OperatingCyclesperyear }} \)
= \(\frac{17,50,000}{3.311}\) = ₹ 5,28,541
Assumption: No. of days in a year = 360 days.

Question 13.
STN Ltd. is a ready-made garment manufacturing company. Its production cycle indicates that materials are introduced in the beginning of the production phase; wages and overhead accrue evenly throughout the period of cycle. The following figures for the 12 months ending 31st
December 2011 are given.
Production of shirts 54,000 units
Selling price per unit ₹ 200
Duration of the production cycle 1 month
Raw material inventory held 2 month’s consumption
Finished goods stock held for 1 month
Credit allowed to debtors is 1.5 months and credit allowed by creditors is 1 month.
Wages are paid in the next month following the month of accrual.

In the work-in-progress 50% of wage and overheads are supposed to be conversion costs. The ratios of cost to sales price are – raw materials 60%, direct wages 10%, and overheads 20%. Cash ¡s to be held to the extent of 40% of current liabilities and safety margin of 15% will be maintained. Calculate amount of working capital required for the company on a cash-cost basis. (May 2012, 8 marks)
Answer:
Computation of Amount of Working Capital required on a cash-cost basis
Working Notes:
1. Raw material Inventory:
The cost of materials for the whole year is 60% of the Sales value.
Hence, it is 54,000 units x ₹ 200 × \(\frac{60}{100}\) = ₹ 64,80,000. The monthly
consumption of raw materials would be ₹ 5,40,000. Raw material requirements would be for two months; hence raw materials in stock would be ₹ 10,80,000.

2. Debtors: Total Cash Cost of Sales = 97,20,000 × \(\frac{1.5}{12}\) = ₹ 12,15,000.
3. Work-in-process: (Each unit of production is expected to be in process for one month).

5. CredItors: Suppliers allow a one-month’s credit period. Hence, the average amount of creditors would be ₹ 5,40,000 being one month’s purchase of raw materials.

6. Direct Wages payable: The direct wages for the whole year is 54,000 units × ₹ 200 × 10% = 10,80,000. The monthly direct wages would be 90,000 (10,80,000 ÷ 12). Hence, wages payable would be ₹ 90,000.

Question 14.
The following information is provided by the DPS Limited for the year ending 31st March, 2013.
Raw material storage period 55 days
Work-in-progress conversion period 18 days
Finished Goods storage period 22 days
Debt collection period 45 days
Creditors payment period 60 days
Annual Operating cost ₹ 21,00,000
(including depreciation of ₹ 2,10,000)
[1 year = 360 days]
You are required to calculate:
(i) Operating Cycle period.
(ii) Number of Operating Cycle in a year.
(iii) Amount of working capital required for the company on a cash cost basis.
(iv) The company is a market leader in its product, there is virtually no competitor in the market. Based on a market research it is planning to discontinue sales on credit and deliver products based on pre payments. Thereby, it can reduce its working capital requirement substantially. What would be the reduction in working capital requirement due to such decision? (May 2013, 8 marks)
Answer:
(i) Computation of Operating Cycle Period
Operating Cycle Period = R + W + F + D – C
=55 + 18 + 22 + 45 – 60
= 80 days

(ii) Number of Operating Cycles in a Year
= \(\frac{360}{\text { OperatingCyclePeriod }} \)
= \(\frac{360}{80}\) = 4.5

(iii) Amount of Working Capital Required
= \(\frac{\text { Annual OperatingCost }}{\text { Number of Operating Cycle }}\)
= \(\frac{18,90,000}{4.5}\) = 4,20,000

(iv) Reduction in Working Capital
Operating Cycle Period = R + W + F -C
= 55 + 18 + 22 – 60 = 35

Amount of Working Capital Required = \(\frac{18,90,000 \times 35}{360}\) = 1,83,750
Reduction in Working Capital = 4,20,000 – 1,83,750 = 2,36,250

Question 15.
Black Limited has furnished the following cost sheet

Additional Information:
(i) Average raw material in stock 3 weeks
(ii) Average work-in-progress 2 weeks
(% of completion with respect to Material – 75%
Labour & Overhead – 70%)
(iii) Finished goods in stock 4 weeks
(iv) Credit allowed to debtors 2\(\frac{1}{2}\) weeks
(v) Credit allowed by creditors 3\(\frac{1}{2}\) weeks
(vi) Time lag in payments of labour 2 weeks
(vii) Time lag ¡n payments of factory overheads weeks 1 \(\frac{1}{2}\)
(viii) Company sells, 25% of the output against cash.
(ix) Cash in hand and bank is desired to be maintained ₹ 2,25,000.
(x) Provision for contingencies is required @ 4% of working capital requirement including that provision.

You may assume that production is carried on evenly throughout the year and labour and factory overheads accrue similarly. You are required to prepare a statement showing estimate of working capital needed to finance a budgeted activity level of ₹ 1,04,000 units of production. Finished stock, debtors, and overhead are taken at cash cost. (May 2014, 8 marks)
Answer:

(Note: For calculation purpose, 4 weeks may be taken as equivalent to month and 52 weeks in a year.)

Question 16.
The following information is provided by the DVP Ltd. for the year ending 31st March 2015.
Raw Material storage period 50 days
Work in progress conversion period 18 days
Finished Goods storage period 22 days
Debt Collection period 45 days
Creditors’ payment period 55 days
Annual Operating Cost ₹ 21 Lacs
(Including depreciation of ₹ 2,10,000)
(1 year = 360 days)

You are required to calculate:
(i) Operating Cycle period.
(ii) Number of Operating Cycles in a year.
(iii) Amount of working capital required for the company on a cash cost basis.
(iv) The company is a market leader in its product, there is virtually no competitor in the market. Based on a market research, it is planning to discontinue sales on credit and deliver products based on pre-payments. Thereby, it can reduce its working capital requirement substantially. What would be the reduction in working capital requirement due to such decision? (May 2015, 8 marks)
Answer:
(i) Computation for Operating Cycle Period:
Operating Cycle = RM Period + WIP Period + FG Period + Debtor
Collection Period – Creditor Payment period
= 50 days + 18 days + 22 days + 45 days – 55 days
Operating Cycle =80 days.

(ii) No of Operating Cycle in a year:
One operating cycle is for 80 days. So
\(\frac{360}{80}\) = 4.5
No. of Operating Cycle in a year = 4.5 times.

(iii) Computation for Amount of working capital required for company on cash cost basis: –
Annual operating cost =21 lakhs
depreciation = ₹ 2,10,000
Cash operating cost = Annual Cost – Depreciation
= ₹ 21 Lakhs -2,10,000
Cash operating cost =18,90,000
= 18,90,000 × \(\frac{80}{360}\)
= 4,20,000
Working Capital Required = ₹ 4,20,000

(iv) Reduction In working capital:
Operating Cycle Period = R + W + F – C
=50+18+22-55 = 35 days
Amount of Working Capital Required = \(\frac{18,90,000}{360}\) × 35= 1,83,750
Reduction in Working Capital = 4,20,000 – 1,83,750 = 236,250

Question 17.
PQ Limited wants to expand its business and has applied for a loan from a commercial bank for its growing financial requirements. The records of the company reveals that the company sells goods in the domestic market at a gross profit of 25% not counting depreciation as part of the cost of goods sold.

The following additional information is also available for you:
Sales-Home at one month’s credit ₹ 1,20,00,000
Sales-Export at three months’ credit (sale price 10% below home price) ₹ 54,00,000
Material used (suppliers extends two months’ credit) ₹ 45,00,000
Wages paid ½ month in arrear ₹ 36,00,000
Manufacturing Expenses (Cash) paid (one month in arrear) ₹ 54,00,000
Adm. Expenses paid one month in arrear ₹ 12,00,000
Income tax payable in four installments of which one falls in the next financial year ₹ 15,00,000

The company keeps one month’s stock of each of raw materials and finished goods and believes in keeping ₹ 10,00,000 available to it including the overdraft limit of ₹ 5,00,000 not yet utilized by the company. Assume a 15% margin for contingencies. Ignore the work-in-progress. You are required to ascertain the requirement of the working capital of the company. (May 2017, 8 marks)
Answer:

Question 18.
Day Ltd., a newly formed company has applied to the Private Bank for the first time for financing it’s Working Capital Requirements. The following informations are available about the projections for the current year:
Estimated Level of Activity
Completed Units of Production 31200 plus Units of Work In Progress 12000
Raw Material Cost ₹40 per unit
Direct Wages Cost ₹ 15 per unit
Overhead ₹ 40 per unit (inclusive of Depreciation ₹ 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 24000 Units
Credit Allowed by the Suppliers 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 Requirement on a cash-cost basis. (May 2018, 10 marks)
Answer:

3. Raw Material Stock
It is given that raw material in stock is average 30 days consumption. Since, the company is newly formed, the raw material requirement for production and work in progress will be issued and consumed during the year. Hence, the raw material consumption for the year (360 days) is as follows:

Raw material stock = \(\frac{₹ 17,28,000}{360 \text { days }}\) × 30 days
= ₹ 1,44,000

4. FInished goods stock = 24,000 units @ 85 per unit
=₹ 20,40,000

5. Debtors for sale=6,12000 x \(\frac{60}{360}\)
= ₹1,02,000

6. CredItors for raw material:

Credit allowed by Suppliers = \(\frac{₹ 18,72,000}{360 \text { days }}\) × 30 days
= ₹ 1,56,000

7. Creditors for Wages:
Outstanding wage payment = \(\frac{₹ 5,58,000}{360 \text { days }} \times 15 \text { days } \) = ₹ 23,250

Question 19.
Bita Limited manufactures used in the steel industry. The following information regarding the company is given for your consideration:
(i) Expected level of production 9000 units per annum.
(ii) Raw materials are expected to remain in store for an average of two months before issued to production.
(iii) Work-in-progress (50 percent complete as to conversion cost) will approximate to 1/2 month’s production.
(iv) Finished goods remain in warehouse on an average for one month.
(v) Credit allowed by suppliers ¡s one month.
(vi) Two months credit is normally allowed to debtors.
(vii) A minimum cash balance of ₹ 67,500 is expected to be maintained.
(viii) Cash sales are 75 percent less than the credit sales.
(ix) Safety margin of 20 percent to cover unforeseen contingencies.
(x) The production pattern is assumed to be even during the year.
(xi) The cost structure for Bita Limited’s product is as follows:

	₹
Raw Materials	80 per unit
Direct Labour	20 per unit
Overheads (including depreciation ₹ 20)	80 per unit
Total Cost	180 per unit
Profit	20 per unit
Selling Price	200 per unit

You are required to estimate the working capital requirement of Bita Limited. (May 2019, 10 marks)
Answer:

Working Notes:
1. Raw materials = (9,000 units × ₹ 80 × 2/12) = ₹ 1,20,000

2. Work in Progress:
Raw Materials = (9,000 units × ₹ 80 × 0.5/12) = ₹ 30,000
Labour = (9,000 units ×₹ 20 × 0.5/12) × 50% = ₹ 3,750
Overheads (excluding depreciation)
= (9,000 units × ₹ 60 × 0.5/12) × 50% = ₹ 11,250

3. Finished Goods (excluding depreciation)
= (9,000 units × ₹ 160 × 1/12) = ₹ 120,000

4. Receivables = (9,000 units × ₹ 160 × 2/12) × 80% = ₹ 1,92,000

Credit Sales = 80%
i.e. Cash Sales are 75% less than credit sales

So, if credit sales = ₹ 100
Less=75%= ₹ 75
Cash Sales = ₹ 25
So, total Sales = 100 + 25 = 125
Credit Sales = \(\frac{100}{125}\) × 100 = 80%
5. Payment to Supplier = (9,000 units × ₹ 80 × 1/12) = ₹ 60,000

Question 20.
PK Ltd., a manufacturing company, provides the following information:

	(₹)
Sales	1,08,00,000
Raw Material Consumed	27,00,000
Labour Paid	21,60,000
Manufacturing Overhead (Including Depreciation for the year 3,60,000)	32,40,000
Administrative & Selling Overhead	10,80,000

Additional Information:
(a) Receivables are allowed 3 months’ credit.
(b) Raw Material Supplier extends 3 months’ credit.
(c) Lag in payment of Labour is 1 month.
(d) Manufacturing Overhead are paid one month in arrear.
(e) Administrative & Selling Overhead is paid 1 month advance.
(f) Inventory holding period of Raw Materials & Finished Goods are of 3 months.
(g) Work-in-Progress is Nil.
(h) PK Ltd. sells goods at Cost plus 33\(\frac{1}{3}\) %
(i) Cash Balance 3,00,000.
(j) Safety Margin 10%.
You are required to compute the Working Capital Requirements of PK Ltd. on Cash Cost basis. (Nov 2020, 10 marks)

Question 21.
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 ₹ 25,00,000
(Including Depreciation of ₹ 2,50,000)
Assume 360 days in a year.
You are required to calculate:
(i) Operating Cycle period
(ii) Number of Operating Cycle in a year.
(iii) Amount of working capital required for the company on a cost basis.
(iv) The company is a market leader in its product and it has no competitor in the market. Based on a market survey ills planning to discontinue sales on credit and deliver products based on pre-payments in order to reduce its working capital requirement substantiaty. You are required to compute the reduction in working capital requirement in such a scenario. (Jan 2021, 5 marks)

Question 22.
Following information is forecasted by the Puja Limited for the year ending 31st March 2018:

You may take one year as equal to 365 days.
Required:
CALCULATE
(i) Net operating cycle period.
(ii) Number of operating cycles in the year.
(iii) Amount of working capital requirement using operating cycles.
Answer:
(i) Operating Cycle-Period
=R+W+F+D-C
=53+21 +26+41 —55
=86 days

(ii) Number of Operating Cycles in the Year
= \(\frac{365}{\text { OperatingCyclePeriod }}=\frac{365}{86} \) = 4.244

Working Notes:
1. Raw Material Storage Period (R)
= \(\frac{\text { Average Stock of Raw Material }}{\text { Annual Consumption of RawMaterial }} \times 365 \)
= \(\frac{\frac{₹ 45,000+₹ 65,356}{2}}{₹ 3,79,644} \times 365\)
= 53 days.
Annual Consumption of Raw Material Opening Stock + Purchases – Closing Sock
=₹ 45,000 + ₹ 4,00,000 – ₹ 65,356 = ₹ 3,79,644

2. Work-in-Progress (WIP) Conversion Period (W)
WIP Conversion Period = \(\frac{\text { Average Stock of WIP }}{\text { Annual Cost of Production }} \times 365\)
= \(\frac{\frac{₹ 35,000+₹ 51,300}{2}}{₹ 7,50,000} \times 365\)
=21 days.

3. Finished Stock Storage Period (F)
= \(\frac{\text { Average Stock of Finished Goods }}{\text { Cost of Goods Sold }} \times 365 \)
= \(\frac{₹ 65,178}{₹ 9,15,000} \times 365 \)
= 26 days.

Average Stock = \(\frac{₹ 60,181+₹ 70,175}{2} \) = ₹ 65,178.

4. Debtors Collection Period (D)
= \(\frac{\text { Average Debtors }}{\text { Annual Credit Sales }} \times 365 \)
= \(\frac{₹ 1,23,561.50}{₹ 11,00,000} \times 365 \)
= 41 days.

Average debtors = \(\frac{₹ 1,12,123+₹ 1,35,000}{2} \)
= ₹ 1,23,561.50

5. Creditors Payment Period (C)
= \(\frac{\text { Average Creditors }}{\text { Annual Net Credit Purchases }} \times 365 \)
= \(\frac{\left(\frac{(₹ 50,079+₹ 70,469}{2}\right)}{₹ 4,00,000} \times 365 \)
= 55 days.

Dividend Decisions – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Dividend Decisions – CA Inter FM Question Bank

Question 1.
What are the determinants of Dividend Policy?
Answer:
Determinants of Dividend Policy: Many factors determine the dividend policy of a company. The factors determining the dividend policy are as follows:
(i) Dividend Payout Ratio
A certain share of earnings to be distributed as dividends has to be worked out. This involves the decision to payout or to retain. The payment of dividends results in the reduction of cash and therefore depletion of assets. In order to maintain the desired level of assets as well as to enhance the investment opportunities, the company has to decide upon the payout ratio.

(ii) Stability of Dividend
Generally investors favour a stable dividend policy. The policy should be consistent and there should be a certain minimum dividend that should be paid regularly.

(iii) Legal, Contractual and Internal Constraints and Restrictions
Legal and contractual requirements have to be followed. All requirements of the Companies Act, SEBI Guidelines, Capital impairment Guidelines, net profit, and insolvency, etc. have to be kept in mind while declaring dividends. in addition, there may be certain internal constraints which are unique to the firm concerned. There may be growth prospects, financial requirements, availability of funds, earning stability and control etc.

(iv) Capital Market Conditions and inflation
Capital market conditions and rate of inflation also play a dominant role in determining the Dividend payout. Good companies will try to compensate for rate of inflation by paying higher dividends. Replacement decisions of the companies also affect the dividend policy.

(v) Owner’s Consideration
This includes the tax status of shareholders, their opportunities for investments, dilution of ownership etc.

Question 2.
What is meant by Stable Dividend Policy why should it be followed?
Answer:
Stable Dividend Policy means regular payment of dividends annually even if the amount of dividends may fluctuate year to year.
A stable Dividend Policy is followed due to the following reasons:

1. It leads to regular cash flow to shareholders
2. This increases the goodwill of the company thereby commanding a higher market price for its shares
3. Government laws covering pension plans encourage the purchase of stocks with high stable dividends.

Question 3.
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 f100. It expects a net profit of ₹ 2,50,000 for the year and the Board is considering dividend of ₹ 5 per share.

M Ltd. is required to raise ₹ 5,00,000 for an approved investment expenditure. Show, how does the MM approach affects the value of M Ltd., if dividends are paid or not paid. (May 2008, 8 marks)
Answer:
A. When dividend is paid
(a) Price per share at the end of year 1
100 = \(\frac{1}{1.10}\left(₹ 5+P_1\right)\)
110 = ₹ 5 +P₁

(b) Amount required to be from issue of new shares
₹ 5,00,000 – (2,50,000 – 1,25,000)
₹ 5,00,000 – 1,25,000 = ₹ 3,75,000

(c) Number of additional shares to be issued
\(\frac{3,75,000}{105}=\frac{75,000}{21}\) shares or say 3572 shares

(d) Value of M Ltd.
(Number of shares × Expected Price per share)
i.e. (25000 + 3,572) × ₹ 105 = 30,00,060

B. When dividend Is not paid
(a) Price per share at the end of year 1
100= \(\frac{\mathrm{P}_1}{1.10} \)
P₁ = 110

(b) Amount required to be raised from issue of new shares
5,00,000 – 2,50,000 = 2,50,000

(c) Number of additional shares to be issued
\(\frac{2,50,000}{110}=\frac{25,000}{11} \) shares or say 2273 shares.

(d) Value of M Ltd.
(25,000 + 2,273) x ₹ 110
= ₹ 30,00,030

Conclusion:
Whether dividend is paid or not, the value remains the same.

Question 3.
RST Ltd. has a capital of ₹ 10,00,000 in equity shares of ₹ 100 each. The shares are currently quoted at par. The company proposes to declare a dividend of ₹ 10 per share at the end of the current financial year. The capitalization rate for the risk class of which the company belongs is 12%. What will be the market price of the share at the end of the year, if
(i) a dividend is not declared?
(ii) a dividend is declared?
(iii) Assuming that the company pays the dividend and has net profits of ₹ 5,00,000 and makes new investments of ₹ 10,00,000 during the period, how many new shares must be issued? Use the MM model. (Nov 2008, 4 marks)
Answer:
As per MM model, the current market price of equity shares is:
P₀ = \(\frac{1}{1+k_e} \times\left(D_1+P_1\right) \)
(i) If the dividend is not declared:
100 = \(\frac{1}{1+0.12} \times\left(0+P_1\right) \)
100 = \(\frac{P_1}{1.12}\)
P₁ = 112
The Market price of the equity share at the end of the year would be 112.

(ii) lithe dividend is declared:
100 = \(\frac{1}{1+0.12} \times\left(10+P_1\right)\)
100 = \(\frac{10+P_1}{1.12}\)
112 = 10+P₁
P₁ = 112 – 10 = ₹102
The market price of the equity share at the end of the year would be ₹ 102.

(iii) In case the firm pays dividend of ₹ 10 per share out of total profits of ₹ 5,00,000 and plans to make new Investment of ₹ 10,00,000, the number of shares to be Issued may be found as follows:

Question 4.
ABC Limited has a capital of ₹ 10 lakhs ¡n equity shares of ₹ 100 each. The shares are currently quoted at par. The company proposes to declare a dividend of ₹ 15 per share at the end of the current financial year. The capitalisation rate for the risk class of which the company belongs is 10%. What will be the market price of share at the end of the year, if
(i) a dividend is declared?
(ii) a dividend is not declared?
(iii) Assuming that the company pays the dividend and has net profits of ₹ 6,00,000 and makes new investments of ₹ 12,00,000 during the period, how many new shares should be issued? Use the MM model. (May 2013, 6 marks)
Answer:
As per MM model, the current market price of equity shares is:
P₀ = \(\frac{1}{1+k_e} \times\left(D_1+P_1\right)\)
(i) If the dividend is declared:
100 = \(\frac{1}{1+0.10} \times\left(15+P_1\right)\)
100= \(\frac{15+P_1}{1.10} \)
110 = 15 + P₁
P₁ = 110 – 15 = ₹ 95
The market price of the equity share at the end of the year would be ₹ 95.

(ii) If the dividend is not declared:
100 = \(\frac{1}{1+0.10} \times\left(0+P_1\right)\)
100 = \(\frac{P_1}{1.10} \)
P₁ = ₹110
The Market price of the equity share at the end of the year would be no.

(iii) If the firm pays dividend of ₹ 15 per share out of total profits of ₹ 6,00,000 and plans to make new investment of ₹ 12,00000, the number of shares to be issued may be found as follows:

Market price of the share ₹ 95
Number of shares to be issued (₹ 7,50,000 / ₹ 95) 7,894.74
or, the firm would issue 7895 shares at the rate of ₹ 95

Question 5.
Buenos Aires Limited has 10 lakh equity shares outstanding at the beginning of the year 2013. The current market price per share is ₹ 150.
The company is contemplating a dividend of ₹ 9 per share, The rate of capitalization, appropriate to its risk class, is 10%.
(i) Based on MM approach, calculate the market price of the share of the company when:
(1) Dividend is declared
(2) Dividend is not declared
(ii) How many new shares are to be issued by the company, under both the above options, if the Company is planning to invest ₹ 500 lakhs assuming a net income of? 200 lakhs by the end of the year? (Nov 2014, 8 marks)
Answer:
As per MM Model:
P₀ = \(\frac{1}{1+\mathrm{K}_e} \times\left(D_1+P_1\right) \)
(i) If the dividend is not declared
150 = \(\frac{1}{1+0.10} \times\left[0+P_1\right] \)
150 = \(\frac{P_1}{1.10} \)
So P₁ = ₹ 165 Market price per share

(ii) If the dividend is declared
150 = \(\frac{1}{1+0.10} \times\left[₹ 9+P_1\right]\)
150 = \(\frac{₹ 9+P_1}{1.10} \)
= 165 – 9 = P₁
P₁ = ₹ 156 Market price per share

In case the firm pays a dividend of ₹ 9 per share out of total profits of ₹ 200 lakhs and plans to make new investment of ₹ 500 lakhs, the number of shares to be issued
or, Net Income (Nl) = 0.20(₹ 1,140 L- ₹ 200 L)
Market Value of Equity = ₹ 1,140 L
Ke = 20%
\(\frac{\text { Net income (NI) for equity – holders }}{\mathrm{Ke}}\) = Market Value of Equity
\(\frac{\text { Net Income (NI) for equity – holders }}{0.20}\) = ₹ 1,140 L
Net income for equity holders = ₹ 228 L
EBIT = 228/0.7
= ₹ 325.71 L

Present value of tax-shield benefits = ₹ 200 L × 030 = ₹ 60L
(i) Value of Restructured Company = ₹ 1,140 L+ ₹ 60 L = ₹ 1,200 L
The impact is that the market value of the company has increased by ₹ 60 lakhs (₹ 1,200 – ₹ 1,140)

(ii) Cost of Capital
Cost of debt (after tax) = 15% (1 – 0.3) = 10.5%

The impact is that the WACC has fallen by 1% (20% – 19%) due to the benefit of tax relief on debt interest payments.

(iii) Cost of Equity (Ke)
Total Value = ₹ 1200 L
Less: Value of debt = (₹ 200 L)
Value of Equity = ₹ 1,000 L
Ke= \(\frac{207 L}{1,000 L} \times 100 \)
Ke=20.70%
The impact is that cost of equity has risen by 0.7% i.e. (20.7% – 20%) due to the presence of financial risk.

Question 6.
The following data relate to two companies belonging to the same risk class:

Required:
(a) Determine the total market value, Equity capitalization rate, and weighted average cost 01 capital for each company assuming no taxes as per M.M. Approach.
(b) Determine the total market value, Equity capitalization rate, and weighted average cost of capital for each company assuming 40% taxes as per M.M. Approach. (Nov 2018, 10 marks)
Answer:
(a)
(i) Calculation of Total Market Value of A Ltd. and B Ltd. as per MM Approach:
V_u = \(\frac{E B I T(1-t)}{K e} \)
Market value of B Ltd. (Unlevered)
V_u = \(\frac{₹ 18,00,000(1-t)}{18 \%}\) = ₹ 1,00,00,000
Market Value of A Ltd. (Levered)
V_g = V_u +TB
= ₹ 1,00,00,000 + ₹ 54,00,000 x Nil
= ₹ 1,00,00,000

(ii) Calculation of Equity Capitalization Rate of A Ltd. end B Ltd.
Ke for A Ltd.
V_g = \(\frac{\text { EBIT – Interest }}{\mathrm{Ke}}\)
46,00,000 = \(\frac{₹ 18,00,000-₹ 6,48,000}{\mathrm{Ke}} \)
Ke = 25.04%
Ke for B Ltd. = 18%

(iii) Calculation of WACC:
B Ltd. = Ke = WACC =18%
A Ltd.

K_d = 12%
WACC= 11.69%

(b)
(i) Calculation of Total Market Value of A Ltd. and B Ltd. as per MM Approach:
Market Value of B Ltd. (Unlevered)
V_u = \(\frac{E B I T(1-t)}{K e}\)
= \(\frac{₹ 18,00,000(1-0.4)}{18 \%}\) = ₹ 60,00,000

Market Value of A Ltd. (Levered)
V_g =V_u +TB
= ₹ 60,00,000 + (₹ 54,00,000 x 40%)
= ₹ 60,00,000 + ₹ 21,60,000
= ₹ 81,60,000

(ii) Calculation of Equity Capitalisation rate of A Ltd. and B Ltd.
K_e for A Ltd.
V_g = \(\frac{\text { EBIT – Interest }}{\mathrm{Ke}}\)
₹ 81,60,000 = \(\frac{₹ 18,00,000-₹ 6,48,000}{\mathrm{Ke}}\)
K_e = 14.12%
K_e for B Ltd. = 18%

(iii) Calculation of WACC:
B Ltd. = Ke = WACC =18%
A Ltd.

K_d = 12% (1 – 0.4) = 7.2%
WACC = 15.59%

Question 7.
Outline the Dividend Irrelevance Theory of Modigliani and Miller (MM Hypothesis on Dividends)
Answer:
Dividend Irrelevance Theory of Modigliani and Miller: This model explains the irrelevance of the dividend policy. When profits are used to declare dividends, the market price increases. At the same time, there is a fall in the reserves for reinvestment. Hence for expansion, the company raises additional capital by issuing new shares; increase in the overall number of shares will lead to a fall in the market price per share. Hence the shareholders will be indifferent towards the dividend policy.

Modigliani and Miller stated the reason: The value of the firm is determined by its basic earnings power and its risk class, and therefore, the firm’s value depend on its asset investment policy rather than on how earnings are split between dividends and retained earnings.

Question 8.
The following information relates to Maya Ltd.:
Earnings of the company ₹10,00,000
Dividend payout ratio 60%
No. of shares outstanding 2,00,000
Rate of return on investment 15%
Equity capitalization rate 12%
(i) What would be the market value per share as per Walters model?
(ii) What is the optimum dividend payout ratio according to Walter’s model and the market value of company’s share at that payout ratio? (Nov 2010, 8 marks)
Answer:
(i) Computation of market value per share as per Walter’s Model
p = \(\frac{D+(E-D)\left(\gamma / k_e\right)}{k_e}\)
Where, p = Market price per share,
E= Earning per share = ₹ 5
D = Dividend per share = ₹ 3
y = Return earned on investment = 15%

k_e = Cost of equity capital = 12%
p = \(\frac{3+(5-3) \times \frac{0.15}{0.12}}{0.12}=\frac{3+2 \times \frac{.15}{.12}}{0.12} \) = ₹ 45.83

(ii) Optimum Dividend Payout Ratio
As per Walter’s model when the return on investment is more than the cost of equity capital the price per share increases as the dividend payout ratio decreases. Therefore, the optimum dividend payout ratio becomes zero. Therefore, when the payment ratio becomes zero, the market value of the company’s share will be:
= \(\frac{0+(5-0) \times \frac{.15}{.12}}{0.12} \) = ₹ 52.08

Question 9.
X Ltd. earns ₹ 6 per share having a capitalization rate of 10 percent and has a return on investment of 20%. According to Walter’s model, what should be the price of the share at 25% dividend payout? (Nov 2012, 5 marks)
Answer:
Walter’s Model is as follows:
V_e = \(\frac{D+\frac{R_a}{R_b}(E-D)}{R_e} \)
V_e = Market value of the share
R_a = Return on retained earnings
R_e = Capitalisation rate
E = Earnings per share
D = Dividend per share

Therefore, if Walter Model is applied- Market value of the share
V_e = \(\frac{₹ 1.50+\frac{0.20}{0.10}(₹ 6.00-₹ 1.50)}{0.10}\)
or
V_e = \(\frac{₹ 1.50+\frac{0.20}{0.10}(₹ 4.50)}{0.10} \)
or
V_e = \(\frac{₹ 1.50+₹ 9.00}{0.10}=\frac{₹ 10.50}{0.10} \) = ₹ 105

Question 10.
Goldilocks Ltd. was started a year back with equity capital of ₹ 40 lakhs. The other details are as under:
Earnings of the company ₹ 4,00,000
Price Earnings ratio 12.5
Dividend paid ₹ 3,20,000
Number of Shares 40,000
Find the current market price of the share. Use Walter’s Model. Find whether the company’s D/P ratio is optimal, use Walter’s formula. (Nov 2014, 5 marks)
Answer:
Walter’s Model
P₀ = \(\frac{\mathrm{D}}{\mathrm{K}_\theta}+\frac{\frac{\mathrm{r}}{\mathrm{K}_\theta}(E-D)}{\mathrm{K}_\theta} \text { or } \frac{\mathrm{D}+(E-D) \frac{r}{\mathrm{~K}_{\varepsilon}}}{\mathrm{K}_\theta}\)
= \(\frac{₹ 8}{0.08}+\frac{\frac{0.10}{0.08}(1.0-8)}{0.08}\)
= 100 + 31.25
=₹ 131.25

Working Note:
K_e = \(\frac{1}{\text { P/E ratio }} \)
= \(\frac{1}{12.5 \%} \) = 8 %
EPSs = \(\frac{4,00,000}{40,000 \text { shares }}\) = ₹ 10 per share
DPS = \(\frac{3,20,000}{40,000 \text { shares }} \) = ₹ 8 per share
r = \(\frac{4,00,000 \text { (Earnings) }}{40,00,000 \text { (Equity capital) }} \)
= 10%
DIP ratio = \(\frac{₹ 8}{₹ 10}\) x 100 = 80%
As Walter’s Model is in line with the cell or nothing approach and in the present case ‘ r’ ¡s more than ‘k_e’ so it’s a growth firm, so optimal payout ratio for agrowth firm is ‘NIL’.
The company’s DIP ratio is not optimal.
So, at the payout ratio is zero, the market value of the company’s share will be:
= \(\frac{0+(10-0) \frac{0.10}{0.08}}{0.08} \) = ₹ 156.25

Question 11.
You are requested to find out the approximate dividend payment ratio as to have the Share Price at ₹ 56 by using Walter Model, based on following information available for a Company.

	Amount ₹
Net Profit	50 Iakhs
Outstanding 10% Preference Shares	80 Iakhs
Number of Equity Shares	5 Iakhs
Return on Investment	15%
Cost of Capital (after Tax) (ke)	12%

(May 2017, 5 marks)
Answer:
Calculation of Dividend Payout ratio
= \(\frac{\text { Dividend Paid Per Share }}{\text { Earning Per Share }} \times 100 \)
= \(\frac{15.12}{8.4} \times 100\)
= 180%

(1) Calculation of Earning Per Share
= \(\frac{\text { Net Profit }- \text { Preferençe dividend }}{\text { No. of Eq Shares }}\)
= \(\frac{50,00,000-8,00,000}{5,00,000}\)
= 8.4

(2) Calculation of Dividend Per Share
P₀ = \(\frac{D+\frac{r}{k_\theta}(E-D)}{k_e} \)
56 = \(\frac{D+\frac{0.15}{0.12}(8.4-D)}{0.12} \)
56 × 0.12 = D + 10.5 – 1.25 D
6.72 – 10.5 = -0.25 D
D = \(\frac{-3.78}{-0.25}\)
D = 15.12

Question 12.
Following information relating to Jee Ltd. are given:
Particulars
Profit after tax ₹ 10,00,000
Dividend payout ratio 50%
Number of Equity Shares 50,000
Cost of Equity 10%
Rate of Return on Investment 12%
(i) What would be the market value per share as per Wafter’s Model?
(ii) What is the optimum dividend payout ratio according to Walter’s Model and Market value of equity share at that payout ratio? (Nov 2018, 5 marks)
Answer:
(i) Waiter’s model is given by
P = \(\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \mathrm{r} / \mathrm{ke}}{\mathrm{Ke}} \)
Where,
P = Market Price per share
E = Earnings Per Share = 20
D = Dividend Per Share = 10
r = Return earned on investment = 12%
ke = Cost of equity capital = 10%
P = \(\frac{₹ 10+(₹ 20-₹ 10) \times \frac{12}{10}}{10}\)
P = ₹ 220

(ii) According to Walter’s Model where the return on investment is more than the cost of equity capital, the price per share increases as the dividend payout ratio decreases. Hence, the optimum dividend payout ratio in this case is nil. So at a pay-out ratio of zero, the market value of the Company’s Share will be:
\(\frac{0+(20-0) \times \frac{12}{10}}{10} \) = ₹ 240

Question 13.
Following figures and information were extracted from the company A Ltd.
Earnings of the company ₹ 10,00,000
Dividend paid ₹ 6,00,000
No. of shares outstanding 2,00,000
Price earning Ratio 10
Rate of return on investment 20%
You are required to calculate:
(i) Current Market price of the share
(ii) Capitalisation rate of its risk class.
(iii) What should be the optimum payout ratio?
(iv) What should be the market price per share at optimal payout ratio? (use Walter’s Model) (Nov 2019, 5 marks)
Answer:
(i) Current Market Price of the share:
EPS = \(\frac{\text { Earnings of the company }}{\text { No. of shares outstanding }} \)
= \(\frac{₹ 10,00,000}{2,00,000 \text { Shares }} \)
= ₹ 5
PE ratio = \(\frac{\text { Market Price }}{\text { EPS }}\)
10 = \(\frac{\text { Market Price }}{\text { ₹ } 5} \)
Current Market price = ₹ 50

The value of the share as per Walter’s model may be found as
follows:
Walter’s model is given by:
P = \(\frac{D+\frac{r}{K_e}(E-D)}{K_e}\)
Where,
P = Market price per share.
E = Earnings per share = 5
D = DMdend per share = 3
R = Return earned on investment = 20%
K_e = Cost of equity capital = 10% or 0.10
P = \(\frac{3+\frac{0.20}{0.10}(5-3)}{0.10} \) = ₹ 70

(ii) Capitalisation rate of its risk class:
Capitalization rate = \(\frac{\text { Earnings }}{\text { Market price } \times \text { No. of shares }} \times 100 \)
= \(\frac{₹ 10,00,000}{₹ 50 \times 2,00,000} \times 100 \)
Capitalisation rate = 10%.

(iii) According to Walter’s model when the rate of return on investment (20%) is more than the cost of equity capital i.e. capitalization rate (10%), the price per share increases as the dividend payout ratio decreases. Hence, the optimum dividend payout ratio in this case is nil.

(iv) Market price per share at optimal payout ratio:
Dividend payout ratio is nil.
∴ P = \(\frac{0+\frac{0.20}{0.10}(5.0)}{0.10}\)
= ₹ 100.

Question 14.
The following figures are extracted from the annual report of RJ Ltd.:
Net Profit ₹ 50 Lakhs
Outstanding 13% preference shares ₹ 200 lakhs
No. of Equity Shares 6 Lakhs
Return on Investment 25%
Cost of Capital (K0) 15%
You are required to impute the approximate dividend pay-out ratio by keeping the share price at ₹ 40 by using Walter’s Model. (Nov 2020, 5 marks)

Question 15.
The following information relates to Maya Ltd. which has a Equity Capitalization Ratio of 12%

Earnings of the Company	₹ 10,00,000	No. of Shares	2,00,000
Dividend Payout Ratio	60%	Rate of Return on Investment	15%

(a) What would be the Market Value per Share as per Walter’s Model?
(b) What is the Optimum Dividend Payout Ratio according to Walter’s Model, and the Market Value of Company’s Share at the Payout Ratio?
Answer:
Computation of Factors under Walters’ Model:

1. Value per Share (Walter’s Model)
= \(=\frac{D+(E-D) \frac{r}{K_e}}{K_E}=\frac{₹ 3+(₹ 5-₹ 3) \times \frac{0.15}{0.12}}{0.12}\)
= ₹ 45.83

2. Optimum Payout Ratio: Since the Company’s earning capacity i.e:ROI (of 15%) ¡s greater than Shareholder’s Expectation (of 12%), the Shareholder’s Wealth would be maximized at “Zero” payout, i.e. Nil Dividend.

3. Value Per Share at Optimum Payout= \(\frac{₹ 0+(₹ 5-₹ 0) \times \frac{0.15}{0.12}}{0.12}\) = ₹ 52.08

Question 16.
The following information relates to Navya Ltd:
Earnings of the Company ‘ ₹ 20,00,000
Dividend payout 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 payout ratio.
Answer:
(i) Walter’s model is given by –
P = \(\frac{D+(E-D)\left(r / k_e\right)}{K_e}\)
Where, P = Market price per share,
E = Earnings per share = ₹ 20,00,000 ÷ 4,00,000 = ₹ 5

D = Dividend per share = 60% of 5 = ₹ 3
r = Return earned on investment = 15%
K_e = Cost of equity capital = 12%
P = \(\frac{3+(5-3) \times \frac{0.15}{0.12}}{0.12}=\frac{3+2 \times \frac{0.15}{0.12}}{0.12} \) = ₹ 45.83

(ii) According to Walter’s model when the return on investment is more than the cost of equity capital, the price per share increases as the dividend pay-out ratio decreases. Hence, the optimum dividend pay out ratio is this case is Nil. So, at a payout ratio of zero, the market
value of the company’s share will be:
\(\frac{0+(5-0) \times \frac{0.15}{0.12}}{0.12}\) = ₹ 52.08

Question 17.
Sampathi Ltd., an all Equity Company, has a PAT of ₹ 200 Crores and 10,00,000 Shares of ₹ 10 each outstanding as at the end of the financial year. Its Cost of Capital is 12%. CEE Towers can earn 15% on its investment. Ascertain the value of the Company under Walter’s Model, if the payout ratio is – (a) 20%, (b) 40%, (c) 60%, and (d) 80%. Also draw out the inference from the values obtained under different cases.
Answer:
Note: Firm Value under Walter’s Model (P₀) = \(\frac{D+(E-D) \frac{r}{K_e}}{K_e}\)

Inference: Since Company’s Returns 15%> Cost of Equity 12%, Investors stand to gain, if they draw tower amount of dividends. As the Dividend Amount increases, the Value of the Firm decreases for a growth firm (r> K_e)

Question 18.
The earnings per share of a company is ₹ 1o and the rate of capitalization applicable to it is lo per cent. The company has three options of paying dividends 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 percent on its retained earnings. Miscellaneous.
Answer:
Market Price (P) per share as per Walter’s Model is:
P = \(\frac{D+\frac{r}{K_e}(E-D)}{K_e} \)
Where,
P = Price of Share
r = Return on investment or rate of earning
K_e = Rate of Capitalisation or Cost of Equity

Calculation of Market Price (P) under the following dividend payout ratio and earning rates:

Question 19.
A firm had been paid dividend at ₹ 2 per share last year. The estimated growth of the dividends from the company is estimated to be 5% p.a. Determine the estimated market price of the equity share if the estimated growth rato 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%. (Nov 2009, 6 marks)
Answer:
In this case the company has paid dividend of ₹ 2 per share during the last year.
The growth rate (g) is 5%. Then, the current year dividend (D₁) with the expected rate of 5% will be ₹ 2.10.
The share price is P_o – \(\frac{D_1}{K_e-g}\)
= \(\frac{₹ 2.10}{0.155-0.05} \)
= ₹ 20

In case the growth rate to 8% then the dividend for the current year. (D₁) would be ₹ 2.16 and market price would be-
= \(\frac{₹ 2.16}{0.155 \cdot 0.08} \)
= ₹ 28.80

In case growth rate tails to 3% then the dividend for the current year (D₁) would be ₹ 2.06 and market price would be
= \(\frac{₹ 2.06}{0.155-0.03} \)
= ₹16.48

Conclusion:
So, the market price of the share is expected to vary in response to change in expected growth rate is dividends.\

Question 20.
In December 2011 AB Co.’s share was sold for ₹ 146 per share. A long-term earnings growth rate of 7.5% is anticipated. AB Co. is expected to pay dividend of ₹ 3.36 per share.
(i) What rate of return an investor can expect to earn assuming that dividends are expected to grow along with earnings at 7.5% per year in perpetuity?
(ii) It is expected that AB Co. will earn about 10% 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? (May 2012, 6 marks)
Answer:
(i) As per Dividend Discount Model approach the firm’s expected or required return on equity is computed as follows:
K_e = \(\frac{\text { Expected dividend at the end of year } 1\left(D_1\right)}{\text { Current Market Price }\left(P_0\right)} \)
+ Expected Growth Rate of Dividend
Therefore, K_e = + 7.5%
= 0.0230 + 0.075 = 0.098
Or
K_e = 9.80%

(ii) When rate or return of retained earnings (r) is 10% and retention ratio (b) is 60%, new growth rate will be as follows.
g = br i.e.
= 0.10 × 0.60 = 0.06

Thus dividend will also get changed and to calculate this, first, we shall calculate previous retention ratio (b1) and then EPS assuming that rate of return on retained earnings (r) is same. With previous Growth Rate of 7.5% and r = 10% the retention ratio comes out to be:
0.075 = b₁ × 0.10
b₁ = 0.75 and payout ratio = 0.25

With 0.25 payout ratio the EPS will be as follows:
\(\frac{3.36}{0.25} \) = 13.44

With new 0.40(1 -0.60) payout ratio the new dividend will be
D₁ = 13.44 × 0.40 =5.376

Accordingly, new K_e will be
K_e = \(\frac{5.376}{146}\) + 60.%
or, K_e = 9.68%

Question 21.
DEF Ltd. has been regularly paying a dividend of ₹ 19,20,000 per annum for several years and it is expected that same dividend would continue at this level in near future. There are ₹ 12,00,000 equity shares of ₹ 10 each and the share is traded at par.

The company has an opportunity to invest ₹ 8,00,000 in one year’s time as well as further ₹ 8,00,000 in two year’s time in a project as it is estimated that the project will generate cash inflow of ₹ 3,60,000 per annum in three year’s time which will continue forever. This investment is possible it dividend is reduced for next two years. Whether the company should accept the project? Also analyze the effect on the market price of the share, if the company decides to accept the project. (May 2012, 8 marks)
Answer: .
First let us compute cost of Equity (K_e)/PE Ratio
D₁ = \(\frac{19,20,000}{12,00,000}\) = 1.6
P₀ = 10
K_e = \(\frac{D}{P}=\frac{₹ 1.6}{10} \)
P/E = \(\frac{10}{1.6} \) = 6.25

Now we shall compute NPV of the project
NPV = \(\frac{-8,00,000}{(1+0.16)}+\frac{-8,00,000}{(1+0.16)^2}+\frac{3,60,000}{0.16} \times \frac{1}{(1+0.16)^3} \)
= – 6,89,655 – 5,9453O + 14,41,480
= 1,57,295

Conclusion:
As NPV of the project is positive, the value of the firm will increase by ₹ 1,57,295 and spread over the number of shares and the market price per share will increase by 13 paisa.

Question 22.
Following Financial Data for Platinum Ltd. are available:
For the year 2011: (₹ in lakhs)
Equity Shares (₹ 10 each) 100
8% Debentures 125
10% Bonds 50
Reserves and Surplus 200
Total Assets 500
Assets Turnover Ratio 1.1
Effective Tax Rate 30%
Operating Margin 10%
Required rate of return of investors 15%
Dividend payout ratio 20%
Current market price of shares ₹ 13
You are required to:
(i) Draw income statement for the year
(ii) Calculate the sustainable growth rate
(iii) Compute the tair price of the company’s share using dividend discount model, and
(iv) Draw your opinion on investment ¡n the company’s share at current price. (Nov 2012, 8 marks)
Answer:
Working Note:
Asset turnover ratio = 1.1
Total Assets = ₹ 500 lakhs
Turnover 500 lakhs × 1.1 = ₹ 550 lakhs
Interest = ₹ 125 lakhs × 0.08 + ₹ 50 lakhs × 0.10
Operating Margin = 10%
Hence operating cost = (1 – 0.10) ₹ 550 lakhs = ₹ 495 lakh
Dividend Payout = 20%
Tax rate = 30%

(ii) Computation of Sustainable Growth Rate
SGR=G=ROE(1-b)
ROE = \(\frac{\text { PAT }}{\text { NW }}\) and NW = ₹ 1oo lakhs + ₹ 200 lakhs = ₹ 300 lakhs
ROE = \(\frac{₹ 28 \text { lakhs }}{₹ 300 \text { lakhs }} \times 100\) = 9.33%
SGR = 0.0933 (1- 0.20) = 7.47%

(iii) Computation of fair price of share using Dividend Discount Model
P₀ = \(\frac{D_0(1+g)}{K_e-g} \)
Dividends = \(\frac{₹ 5.6 \text { lakhs }}{10 \text { lakhs }} \) = ₹ 0.56
Growth Rate = 7.47%
Hence P₀ = \(\frac{₹ 0.56(1+0.0747)}{0.15-0.0747}=\frac{₹ 0.6018}{0.0753}\) = ₹ 7.99 say ₹ 8.00

(iv) Conclusion:
Since the current market price of share is ₹ 13.00, the share is overvalued. Therefore the investor should not invest in the company.

Question 23.
The following information is collected from the annual reports of J Ltd.:
Profit before tax ₹ 2.50 crore
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 Gordon’s model of dividend policy? ( May 2015, 4 marks)
Answer:
Profit after tax = ₹ 2.5 crore – 40% = ₹ 1.5 crore
Profit per share
= ₹ 1.5 crore/50,00 0 00 shares
(EPS)=₹ 3

Gordon s formula = P₀ = \(\frac{E(1-b)}{k-b r}\)
P₀ = Present market price
E=EPS
k = Cost of Capit&
b = Retention ratio
r=IRR
br = Growth rate
∴ P₀ = \(\frac{₹ 3(1-0.40)}{0.12-(0.4 \times 0.15)} \)
= \(\frac{1.8}{0.12-0.06}\)
= ₹ 30

Question 24.
The following figures are collected from the annual report of XYZ Ltd.:
Net Profit ₹ 30 lakhs
Outstanding 12% preference shares ₹ 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital Le. (Ke) 16%
CALCULATE price per share using Gordon’s Model when dividend pay-out is (i) 25%; (ii) 50% and (iii) 100%.
Answer:

Price per share according to Gordon’s Model is calculated as follows:
P₀ – \(\frac{E_1(1-b)}{K_e-b r}\)
Here, E₁ =6, K_e=16%

(i) Whei dividend pay-out is 25%
P₀ – \(\frac{6 \times 0.25}{0.16-(0.75 \times 0.2)}=\frac{1.5}{0.16-0.15} \) = 150
(ii) When dividend pay-out is 50%
P₀ = \(\frac{6 \times 0.5}{0.16-(0.5 \times 0.2)}=\frac{3}{0.16-0.10}\) = 50

(iii) When dividend pay-out is 100%
P₀ – \(\frac{6 \times 1}{0.16-(0 \times 0.2)}=\frac{6}{0.16}\) = 37.50

Question 25.
Surabhi Ltd follows Lintner’s Model for dividend distribution. Last year it had declared a dividend of ₹ 5 per share. It has a Target Payout Ratio of 70% of its Earnings. If the EPS for the year is ₹ 10, ascertain the Dividend Payout, it the Surabhi Ltd. views that only 50% of the incremental dividend can be maintained in the years to come? What will be the Dividend Payout if Surabhi Ltd. can maintain 70% or 30% of the incremental dividend?
Answer:
Under Lintner’s Model, Dividend for Year 1 (D₁) = D₀ + af × [(E₁ × tp) — D₀]
Where D₁ = Dividend for Year 1 = To be ascertained
D₀ = Dividend for Year 0 = ₹ 5
af = Adjustment Factor = 30%/50%/ 70%
E₁ = Earnings for Year 1 = ₹ 10
tp = Target Payout Ratio = 70%

Question 26.
The following information is given for QB Ltd.
Earning per share ₹ 12
Dividend per share ₹ 3
Cost of capital 18%
Internal Rate of Return on investment 22%
Retention Ratio 40%
Calculate the market price per share using
(i) Gordons formula
(ii) Walters formula (May 2011, 8 marks)
Answer:
(i) Gordons Formula
Where:
P₀ = \(\frac{E(1-b)}{K-b r} \)
P₀= Present value of Market price per share
E = Earnings per share
K = Cost of Capital
b = Retention Ratio (%)
r =IRR
br = Growth Rate
P₀ = \(\frac{₹ 12(1-0.40)}{0.18-(0.40 \times 0.22)}\)
= \(\frac{₹ 7.20}{0.18-0.088}=\frac{₹ 7.20}{0.092} \) = ₹ 78.26
(ii) Walter Formula
V_c = \(\frac{D+\frac{R_a}{R_c}(E-D)}{R_c} \)

Where:
R_c = Market Price
D = Dividend per share
R_a = IRR
R_c = Cost of Capital
E = Earnings per share
= \(\frac{₹ 3+\frac{0.22}{0.18}(₹ 12-₹ 3)}{0.18} \)
= \(\frac{₹ 3+₹ 11}{0.18} \) = ₹ 77.77

Alternative Answer

As per the data provided in the question the retention ratio comes out to be 75% (as computed below) though mentioned in the question as 40%
(i) Gordons Formula
Retention Ratio = \(\frac{\text { EPS – Dividend Per Share }}{\text { EPS }}=\frac{₹ 12-₹ 3}{₹ 12} \) = 0.75 i.e. 75%
With the retention ratio of 75% market price per share using the Gordons Formula shall be as follows:
P₀ = \(\frac{E(1-b)}{K-b r}\)
P₀ = Present value of market price per share
E = Earnings per share
K = Cost of Capital
b = Retention Ratio (%)
r =IRR
br = Growth Rate
P₀ = \(\frac{12(1-0.75)}{0.18-(0.75 \times 0.22)}=\frac{3}{0.18-0.165}\) = ₹ 200

(ii) Walter Formula V_c = \(\frac{D+\frac{R_a}{K_e}(E-D)}{K_e}\)
V_c = Market price
D = Dividend per share
R_a =IRR
K_e= Cost of Capital
E = Earnings per share
= \(\frac{₹ 3+\frac{0.22}{0.18}(₹ 12-₹ 3)}{0.18}=\frac{₹ 3+₹ 11}{0.18}\) = ₹ 77.77

Question 27.
The following information is supplied to you:
Total Earning ₹ 40 Lakhs
No. of quality Shares (of ₹ 1oo each) ₹ 400000
Dividend Per Share ₹ 4
Cost of Capital 16%
Internal rate of return on investment 20%
Retention ratio 60%
Calculate the market price of a share of a company by using:
(i) Walter’s Formula
(ii) Gordon’s Formula (May 2019, 5 marks)
Answer:
(i) Walter’s Formula:
P = \(\frac{D+(E-D) \times \frac{r}{K e}}{K e}\)
P = \(\frac{₹ 4+\left(\frac{₹ 40,00,000}{₹ 4,00,000}-₹ 4\right) \times \frac{20}{16}}{16}\)
P = ₹ 71.875

Gordon’s formula: –
P₀ = \(\frac{E(1-b)}{K-b \cdot r} \)
Where,
P₀ = Present market price per share
E = Earning per share
b = Retention Ratio (% of earnings retained)
r = Internal rate of return
g =b.r
P₀= \(\frac{E(1-b)}{K-b \cdot r}\)
= \(\frac{₹ 10(1-0.60)}{0.16-(0.6 \times 0.20)} \)
= \(\frac{₹ 4}{0.04} \)
P₀ = ₹ 100

Question 28.
Write short note on the following:
Traditional & Walter Approach to Dividend Policy. (May 2014, 4 marks)
Answer:
Traditional and Walter Approach to Dividend Policy
Traditional approach:
The Graham and Dodd model business its arguments on the following assumptions:
1. Investors are rational
2. Under conditions of uncertainty they turn risk arises.

Postulation
According to Graham & Dodd, investors assign more weight on dividends than on retained earnings. Investors discount distant dividends at a higher rate than they discount nearby dividends. This is because nearby dividends are more certain than distant dividends.

Implication
Under this model the weight attached to dividends is equal to four times the weight attached to retained earnings.

Criticism
The weights provided by Graham and Dodd are based on their subjective judgment and not derived from any empirical analysis.

Walter approach:
1. The Walter’s Model propounded in 1963 by Jones Walter champions the cause of relevance and business its arguments on the following assumption

• The firm is an all-equity firm.
• The firm will use only retained earnings to finance its investments.
• The rate of return on investment is constant and so is the cost of equity. This means that with every additional investment, business risk remains unaltered.
• All earnings are either distributed or retained internally.
• The firm has an infinite life.
• Earnings and dividends don’t change over the life of the firm.

Postulation

• Walter argued that the market price of a share is the sum of the present value of the following two cash flow streams:
• Infinite stream of constant future dividends.
• Infinite stream of capital gains.

Implication

• The optimal payout ratio for a growth firm is nil.
• The payout ratio for a normal firm is irrelevant.
• The optimal payout ratio for a declining firm ¡s 100%.

Criticism

• No external financing.
• Constant rate of return.
• Constant Opportunity Cost.

Question 29.
The following information is taken from ABC Ltd.
Net Profit for the year ₹ 30,00000
12% Preference share capital ₹ 1,00,00,000
Equity share capital (Share of ₹ 10 each) ₹ 60,00,000
Internal rate of return on investment 22%
Cost of Equity Capital 18%
Retention Ratio 75%
Calculate the market price of the share using:
(1) Gordon’s Model
(2) Walter’s Model (Jan 2021, 5 marks)

Risk Analysis in Capital Budgeting – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Risk Analysis in Capital Budgeting – CA Inter FM Question Bank

Question 1.
Write two main reasons for considering risk in Capital Budgeting decisions. (Nov 2018, 2 marks)
Answer:
Two main reasons for considering risk In Capital Budgeting decision:

1. There is an opportunity cost involved while investing in a project for the level of risk. Adjustment of risk is necessary to help make the decision as to whether the returns out of the project are proportionate with the risks borne and whether it is worth investing in the project over the other investment options available.
2. Risk adjustment is required to know the real value of the Cash inflows.

Question 2.
A company is considering two mutually exclusive projects X and Y. Project X costs ₹ 30,000 and Project Y ₹ 36,000. You have been given below the net present value probability distribution for each project:

(i) Compute the expected net present value of Projects X and Y.
(ii) Compute the risk attached to each project i.e., Standard Deviation of each probability distribution.
(iii) Which project do you consider more risky and why?
(iv) Compute the probability index of each project. (May 1999, 14 marks)
Answer:

(i) The expected net present value of projects X & Y is ₹ 9,000 each.
(ii) Standard Deviation = \(\sqrt{\text { square of deviation } \times \text { Probability }} \)
In case of Project X-S.D. = \(\sqrt{1,44,00,000} \) = ₹ 3795/-
Project Y-S.D. = \(\sqrt{1,98,00,000} \) = ₹ 4,450/-

Standard deviation
(iii) Coefficient of variation = \(\frac{\text { Standard deviation }}{\text { Expected net P.V. }} \)
Project X = \(\frac{3,795}{9,000}\) = 0.42
Project Y = \(\frac{4,450}{9,000} \) = 0.49 or 0.50
Project Y is riskier since it has a higher coefficient of variation.

(iv) Profitability Index = \(\frac{\text { Discount cash inflow }}{\text { Discount cash outflow }}\)
Project X = \(\frac{9,000+30,000}{30,000}\) = 1.30
Project Y = \(\frac{9,000+36,000}{36,000}\) = 1.25

Question 3.
A Ltd. is considering two mutually exclusive projects X and Y. You have been given below the Net Cash flow probability distribution of each project:

(i) Compute the following:
(a) Expected Net Cash Flow of each project.
(b) Variance of each project.
(c) Standard Deviation of each project.
(d) Coefficient of Variation of each project.
(ii) Identify which project do you recommend. Give reason. (Nov 2020, 10 marks)

Question 4.
What is certainty Equivalent? (May 2018, 4 marks)
Answer:
As per IMA terminology, “An approach to dealing with risk in a capital budgeting context. It involves expressing risky future cash flows in terms of the certain Cash flow which would be considered, by the decision maker, as their equivalént, that is the decision maker would be indifferent between the risky amount and the (lower) riskless amount considered to be its equivalent.”

The Certainty equivalent is a guaranteed return that the management would accept rather than accepting a higher but uncertain return. This approach allows the decision-maker to incorporate his or her utility function into the analysis. In this approach, a set of riskless cash flows is generated in place of the original cash flows.

Question 5.
What is Risk Adjusted Discount Rate? (Nov 2020, 2 marks)

Question 6.
XYZ Ltd. is presently all equity financed. The directors of the company have been evaluating investment in a project which will require ₹ 270 lakhs capital expenditure on new machinery. They expect the capital investment to provide annual cash flows of ₹ 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 ₹ 10 lakhs. The company’s tax rate is 30%.
You are required to calculate:
(i) The adjusted present value of the investment
(ii) The adjusted discount rate and
(iii) Explain the circumstances under which this adjusted discount rate may be used to evaluate future investments. (May 2018, 8 marks)
Answer:
Step 1: Unleavened value of the project
PV CFAT discounted with unleavened Re – initial Investment Present
Value of Perpetuity – Initial Investment
= ₹ 42 L/14°70- ₹ 270L
= ₹ 300 L- ₹ 270L
= ₹ 30 L

Step 2: PV of tax benefit on interest
Tax benefit/Interest rate
= 280 × 10% × 30% / 10%
= 8.4/30%
= ₹ 84L

Note: Amount of debt = amount required for project + amount required
for floatation cost = ₹ 270 + ₹ 10 = 280 L

Step 3: After-tax issue expense = ₹ 10 L
(i) Adjusted present value of investment:
Adjusted Present Value =Unleavened value of the project + value of financing effects
Here, Value financing effects =Tax benefit on interest (-) after tax floatation cost
APV=’₹ 30L + (84-10) = ₹ 30L + ₹ 74L
= ₹ 104 L

(ii) Calculation of Adjusted Discount Rate (ADR)
Annual Income / Savings required to allow an NPV to zero Let the Annual Income be x.
(-) ₹ 280 lakhs × (Annual Income / 0.14) = (-) ₹ 104 lakhs
Annual Income / 0.14 = (-) ₹ 104 + ₹ 280 lakhs
Therefore, Annual Income = ₹ 176 × 0.14 = ₹ 24.64 lakhs
Adjusted Discount Rate = (₹ 24.64 lakhs / ₹ 280 lakhs) x 100 = 8.8%

(iii) 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.

Question 7.
A project requires an initial outlay of ₹ 3,00,000.
The company uses a certainty equivalent method approach to evaluate the project. The risk-free rate is 7%. Following information is available:

Evaluate the above. Is investment in the project beneficial? (Jan 2021, 5 marks)

Question 8.
Gaurav Ltd. using a certainty-equivalent approach in the evaluation of risky proposals. The following information regarding a new project is as follows:

Year	Expected Cash Flow	Certainty-equivalent quotient
0	(4,00,000)	1.0
1	3,20,000	0.8
2	2,80,000	0.7
3	2,60,000	0.6
4	2,40,000	0.4
5	1,60,000	0.3

Riskless rate of interest on the government securities is 6 percent. DETERMINE whether the project should be accepted?
Answer:

As the Ne Present Value (NPV) is positive the project should be accepted.

Question 9.
An enterprise is investing ₹ 1oo lakhs in a project. The risk-free rate of return is 7%. Risk premium expected by the Management is 7%. The life of the project is 5 years. Following are the cash flows that are estimated over the life of the project.

Year	Cash flows (₹ ln lakhs)
1	25
2	60
3	75
4	80
5	65

CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks adjusted discount rate.
Answer:

Now when the risk-free rate is 7 % and the risk premium expected by the Management is 7%. So the risk-adjusted discount rate is 7 % +7 % =14%.
Discounting the above cash flows using the Risk-Adjusted Discount Rate would be as below:

Question 10.
What is sensitivity analysis in Capital budgeting? (May 2009, 6 marks)
Answer:
Sensitivity analysis in Capital Budgeting.
Meaning
Sensitivity analysis is a tool in the hand of firms to analyse change in the project’s NPV or IRR for a given change in one of the variables. It thus shows the measure of sensitivity of a decision due to changes in the values of one or more parameters.

Features

1. Sensitivity analysis shows how sensitive a project’s NPV or IRR is to changes in a particular variable.
2. It takes care of estimation error by using a number of possible outcomes in evaluating a project.
3. It provides different cash flow estimates under the

following assumptions:

• Pessimistic
• Expected
• Optimistic

Concept
Sensitivity analysis starts with a base case scenario i.e. most likely or expected where management determines the estimates of the key primary variables from which it can calculate the base case NPV.

Then, while keeping all other variables equal to their base case values, each variable is changed by a certain percentage below and above its base case value (or, alternatively, is set to its pessimistic and optimistic estimates).

The resulting ‘changed NPV values can then give a picture of the possible variation in or sensitivity of NPV when a given risky variable is mis-estimated.

Steps

1. Identify the variables which have an effect on projects NPV or IRR.
2. Define the mathematical relationship between the variables.
3. Analyse the implication to change in each of the variables on the project’s NPV or IRR.

Advantages
1. Sensitivity Analysis is useful in identifying the crucial variables that could contribute the most to the riskiness of the investment.

2. It indicates how bad a mis-estimating a variable can be before the investment becomes unacceptable.

3. It helps in understanding the project in total.

4. It guides the decision-maker to concentrate only on relevant variables.

Dis advantages
1. The sensitivity analysis does not provide estimate of likelihood for each possible result.

2. Examining the effect of change in each variable in isolation is less meaningful when there are interdependencies among the variables.

3. It may double count the risk if one uses a risk-adjusted discount rate.

4. In addition estimates of a variable may be serially dependent over time so that a forecast error in one year may propagate higher errors in subsequent years, causing a greater impact on NPV.

5. It uses different values of uncertain variables purely on ad-hoc basis. This is unscientific.

6. Its assumption of variable to be completely unrelated is vague and misleading.

Question 11.
From the following details relating to a project, analyse the sensitivity of the project to changes in the Initial Project Cost, Annual Cash Inflow, and Cost of Capital:

Particulars
Initial Project Cost	₹ 2,00,00,000
Annual Cash Inflow	₹ 60,00,000
Project Life	5 years
Cost of Capital	10%

To which of the 3 factors, the project is most sensitive lithe variable is adversely affected by 10%?
The cumulative Present Value Factor for 5 years for 10% is 3.791 and for 11% is 3.696. (Nov 2018, 5 marks)
Answer:
Calculation of NPV through Sensitivity Analysis

Particulars	₹
PV of Cash inflows (₹ 60,00,000 × 3.791) (-) initial Project Cost	2,27,46,000 (2,00,00,000)
NPV	27,46,000

Conclusion: Project is most sensitive to ‘annual cash in flow’.

Question 12.
Explain the steps of Sensitivity Analysis. (May 2019, 4 marks)
Answer:
Steps of Sensitivity Analysis:
Sensitivity Analysis is conducted by following the steps as below:
1. Finding variables
Which have an influence on the NPV (or IRR) of the project.

2. Establishing Mathematical Relationship
Between the variables.

3. Analysing
The effect of the change in each of the variables on the NPV (or IRR) of the project.

Question 12.
XY Ltd. has under Its consideration a project with an initial investment of ₹ 1,00,000. Three probable cash inflow scenarios with their probabilities of occurrence have been estimated as below:

Annual cash inflow (₹)	20,000	30,000	40,000
Probability	0.1	0.7	0.2

The project life Is 5 years and the desired rate of return is 20%. The estimated terminal values for the project assets under the three probability alternatives, respectively are zero, ₹ 20,000 and₹ 30,000.
You are required to:
(i) Find the probable NPV;
(ii) Find the worst-case NPV and the best-case NPV; and
(iii) State the probability occurrence of the worst case, if the cash flows are perfectly positively correlated over time. (May 2010, 12 marks)
Answer:

(i) NPV based on expected cash flows would be as follows:
= \(₹ 1,00,000+\frac{₹ 31,000}{(1+0.20)^1}+\frac{₹ 31,000}{(1+0.20)^2}+\frac{₹ 31,000}{(1+0.20)^3}+\frac{₹ 31,000}{(1+0.20)^4}+\frac{₹ 31,000}{(1+0.20)^5}+\frac{₹ 20,000}{(1+0.20)^5}\)
= -₹ 1,00,000 + ₹ 25,833.33 + ₹ 21,527.78 + ₹ 17,939.81 + ₹ 14,949.85 + ₹ 12,458.20 + ₹ 8,037.55 = 746.52

(ii) For the worst case, the flows from the cash flow column farthest on the left are used to calculate NAV.
= \(-₹ 10,000+\frac{₹ 2,000}{(1+0.20)^1}+\frac{₹ 2,000}{(1+0.20)^2}+\frac{₹ 2,000}{(1+0.20)^3}+\frac{₹ 2,000}{(1+0.20)^4}+\frac{₹ 2,000}{(1+0.20)^5}\)
= – ₹ 10,000 + ₹ 1,666.67+ ₹ 1,388.89+ ₹ 1.157.41 + ₹ 964.51 + ₹ 803.76
N.P.V = ₹ – 4,018.76

For the best case, the cash flows from the cash flow column farthest on the right are used to calculated NPV
= \(₹ 20,000, \frac{₹ 8,000}{(1+0.20)^1}, \frac{₹ 8,000}{(1+0.20)^2} \cdot \frac{₹ 8,000}{(1+0.20)^3}, \frac{₹ 8,000}{(1+0.20)^4}, \frac{₹ 8,000}{(1+0.20)^5}, \frac{₹ 8,000}{(1+0.20)^5}\)
= – ₹ 20,000 + ₹ 6,666.67 + ₹ 5,555.56 + ₹ 4,629.63 + ₹ 3,858.02 + ₹ 3,215.02 + ₹ 2,411.26
N.P.V = ₹ 6,336.16

(iii) If the cash flows are perfectly dependent, then the low cash flow in the first year will mean a low cash flow ¡n every year. Thus, the possibility of the worst case occurring is the probability of getting ₹ 2,000 net cash flow in year 1 or 20%.

Question 13.
Shivam Ltd. is considering two mutually exclusive A and B. Project A costs ₹36,000 and project B ₹ 30,000. You have been given below the net present value probability distribution for each project.

(i) Compute the expected net present values of projects A and B.
(ii) Compute the risk attached to each project i.e. standard deviation of each probability distribution.
(iii) Compute the profitability index of each project.
(iv) Which project do you recommend? State with reasons. (May 2009, 14 marks)
Answer:

Standard Deviation of Project A = \(\sqrt{1,98,00,000}\) = ₹ 4,450

Standard Deviation of Project B = \(\sqrt{1,44,00,000}\) = ₹ 3,795

(iii) Computation of profitability of each project
Profitability index = Discount cash ¡nf low /Initial outlay
In case of Project A: P1 = \(\frac{9,000+36,000}{36,000}=\frac{45,000}{36,000} \) = 1.25
In case of Project B: P1 = \(\frac{9,000+30,000}{30,000}=\frac{39,000}{30,000} \) = 1.30

(iv) Recommendation: Measurement of risk is made by the possible variation of outcomes around the expected value and the decision will be taken in view of the variation in the expected value where two project have the same expected value, the decision will be the project which has smaller variation in expected value. In the selection of one of the two projects A and B, Project B Is preferable because the possible profit which may occur is subject to less variation (or dispersion). Much higher risk is lying with project A.

Question 14.
Indian Newsprint Ltd. (INL) a leading manufacturer of newsprint in the country, is planning to start manufacturing cardboard unit. Planning & Strategy division of the company has placed before the board of directors the “Detail Project Report” of the card board unit. The report, inter alla, includes the following cash flow:

The cost of the capital is 9%. –
You are required to measure the sensitivity of the project to changes ¡n the levels of plant value, recurring cost and savings (considering each factor at a time) such that the NPV becomes zero. The present value factor at 9% are given below:

Advise the board of directors which factor is the most sensitive to affect the acceptability of the project? (Nov 2017, 8 marks)
Answer:

Question 15.
From the following data, Is relating to a project, analyse the sensitivity of the project to changes in initial project cost, annual cash inflow, and cost of capital:

Initial Project Cost (₹)	120,000
Annual Cash Inflow (₹)	45,000
Project Life (Years)	4
(Cost of Capital)	10%

Required:
Examine which of the three factors, the project is most sensitive? (Use annuity factors: for 10% 3.169 and 11% 3.103).
Answer:

Conclusion: The project is most sensitive to annual cash inflows’
(It is assumed that adverse variation is 10%)

Question 16.
Shiv Limited is thinking of replacing its existing machine by a new machine which would cost ₹ 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 ₹ 200 per unit. The following is the cost of producing one unit of product using both the existing and new machine:

The existing machine has an accounting book value of ₹ 1,00,000, and it has been fully depreciated for tax purpose. It is estimated that machine will be useful for 5 years. The supplier of the new machine has offered to accept the old machine for ₹ 2,50,000. However, the market price of old machine today is ₹ 1,50,000 and it is expected to be ₹ 35,000 after 5 years. The new machine has a life of 5 years and a salvage value of ₹ 2,50,000 at the end of its economic life. Assume corporate Income tax rate at 40%, and depreciation is charged on straight-line basis for Income-tax purposè’s. Further assume that book profit is treated as ordinary income for tax purposes. The opportunity cost of capital of the Company is 15%.
Required:
(i) ESTIMATE net present value of the replacement decision.
(ii) CALCULATE the internal rate of return of the replacement decision.
(iii) Should Company go ahead with the replacement decision?
ANALYSE.

Answer:

Market Value of Old Machine: The old machine could be sold for ₹ 1,50,000 in the market. Since the exchange value is more than the market value, this option is not attractive. This opportunity will be lost whether the old machine is retained or replaced. Thus, on incremental basis, it has no impact.

Depreciation Base:
Old machine has been fully depreciated for tax purpose. Thus, the depreciation base of the new machine will be its original cost i.e. ₹ 60,00,000.

Net Cash Flows:
Unit cost includes depreciation and allocated overheads. Allocated overheads are allocated from corporate office therefore they are irrelevant. The depreciation tax shield may be computed separately. Excluding depreciation and allocated overheads, unit costs can be calculated. The company will obtain additional revenue from additional 20,000 units sold.

Thus, after-tax savings, excluding depreciation, tax shield, would be
= (100,000(200- 148) – 80,000(200 – 173)) × (1 – 0.40)
= (52,00,000 – 21 ,60,000) × 0.60
= ₹ 18,24,000
After adjusting depreciation tax shield and salvage value, net cash flows and net present value are estimated.

Alternately Net Cash flows from operation can be calculated as follows:
Profit before depreciation and tax = ₹ 1,00,000 (200 -148) – 80,000 (200 -173)
= ₹ 52,00,000 – 21,60,000
= ₹ 30,40,000

So, profit after depreciation and tax is (30,40,000 -11,50,000) × (1- 0.40) = ₹ 11,34,000
So profit before depreciation and after tax is:
₹ 11,34,000 + ₹ 11,50,000 (Depreciation added back) = ₹ 22,84,000

(iii) Advise:
The Company should go ahead with replacement project, since it is positive NPV decision.

Investment Decisions – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Investment Decisions – CA Inter FM Question Bank

Question 1.
Beta Company Limited is considering replacement of its existing machine by a new machine, which ¡s expected to cost ₹ 2,64,000. The new machine will have a life of five years and will yield annual cash revenues of ₹ 5,68,750 and incùr annual cash expenses of ₹ 2,95,750. The estimated salvage value of the new machine is ₹ 18,200. The existing machine has a book value of ₹ 91,000 and can be sold for ₹ 45,500 today.

The existing machine has a remaining useful life of five years. The cash revenues will be ₹ 4,55,000 and associated cash expenses will be ₹ 3,18,500. The existing machine will have a salvage value of ₹ 4,550, at the end of five years. The Beta Company is in 35% tax bracket, and writes off depreciation at 25% on the written-down value method.

The Beta Company has a target debt-to-value ratio of 15%. The Company in the past has raised debt at 11 % and it can raise fresh debt at 10.5%. Beta Company plans to follow dividend discount model to estimate the cost of equity capital. The Company plans to pay a dividend of ₹ 2 per share in the next year. The current market price of Company’s equity share is ₹ 20 per equity share. The dividend per equity share of the Company is expected to grow at 8% p.a.
Required:
(i) Compute the incremental cash flows of the replacement decision.
(ii) Compute the weighted average cost of Capital of the Company.
(iii) Find out the net present value of the replacement decision.
(iv) Estimate the discounted payback period of the replacement decision.
(v) Should the Company replace the existing machine? Advise. (Nov 2003, 5+3+2+1+1 = 12 marks)
Answer:

Flows of the replacement decision:
(ii) Computation of WACC of the Co.:
K_e = \(\frac{D_1}{P_0}+g\) = \(\frac{₹ 2}{₹ 20}\) + 8 % =18%
K_d = 10.5% (1 – 0.35) = 6.825%
WACC = K_d × \(\frac{D}{D+E}\) + K_e × \(\frac{E}{E+D}\)
= (6.825% × 15%) + (18% × 85%)
= 16.32% or 16.32375%

(iii) Computation of Net Present Value of the replacement decision:
NPV = \(\sum_{t=1}^5 \frac{\text { FCFFt }}{(1+0.1632375)^t}-01 \)
= (2,18,500) + 89,287 + 73,961 + 61,779 + 51,948 + 54,820 = ₹ 1,13,295/-

(iv) Discounted payback period of the replacement decision:
= 2 years + 10 months 22 days approx.

(v) Advise:
The company should replace the existing machine with new machine.

Question 2.
XYZ Ltd. is planning to introduce a new product with a project life of 8 years The project is to be setup in Special Economic Zone (SEZ) and qualifies for one one-time (at starting) tax-free subsidy from the State Government of ₹ 25,00,000 on Capital investment. The initial equipment cost will be ₹ 1.75 crores. Additional equipment cost ₹ 12,50,000 will be purchased at the end of the third year from the cash inflow of this year. At the end of 8 years, the original equipment will have no resale value, but additional equipment can be sold for ₹ 1,25,000. A Working Capital of ₹ 20,00,000 will be needed and it will be released at the end of eighth year. The project will be financed with a 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 ₹ 120 per unit is expected and variable expenses will amount to 60% of sales revenue. Fixed Cash operating costs will amount ₹18,00,000 per year. The loss of any year will be set off from the profits of subsequent two years. The company is subject to 30% 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 net present value of the project and advise the management to take appropriate decision
Note:
The PV factors at 12% are

Year	1	2	3	4	5	6	7	8
	8.893	.797	.712	.636	.567	.507	.452	.404

(Nov 2007, 8 marks)
Answer:

Advise: Since the project has a positive NPV, therefore, it should be accepted.

Question 3.
A company wants to invest in a machinery that would cost ₹ 50,000 at the beginning of year 1. It is estimated that the net cash inflows from operations will be ₹ 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 ₹ 10,000 and the scrap value at the end of year 3 will be ₹ 12,500. However, if the company decides not to services the part, ¡t will have to be replaced at the end of year 2 at ₹ 15,400. But in this case, the machine will work for the 4th year also and get operational cash inflow of ₹ 18,000 for the 4th year. It will have to be scrapped at the end of year 4 at ₹ 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 ₹ 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). (Nov 2008, 7 marks)
Answer:
Option 1: Purchase Machinery and Service Part at the end of Year 1
Net Present value of cash flow @ 10% per annum discount rate.
NPV= \( -50,000+\frac{18,000}{(1.1)}+\frac{18,000}{(1.1)^2}+\frac{18,000}{(1.1)^3}-\frac{10,000}{(1.1)}+\frac{12,500}{(1.1)^3}\)
= – 50,000 + 18,000 (0.9091 + 0.8264 + 0.7513) – (10,000 × 0.9091 + 12,500 × 0.751 3)
= 50,000 + (18,000 x 2.4868) – 9,091 + 9,391
= – 50,000+44,762 – 9,091 + 9,391
NPV=- 4,938
Since, Net Present Value is negative, therefore, this option is not to be considered.

If Supplier gives a discount of ₹ 5,000 then,
NPV=+ 5,000 – 4,938 = + 62
In this case, Net Present Value is positive but very small, therefore, this option may not be advisable.

Option II: Purchase Machinery and Replace Part at the end of Year 2.
NPV = \(-50,000+\frac{18,000}{(1.1)}+\frac{18,000}{(1.1)^2}+\frac{18,000}{(1.1)^3}-\frac{15,400}{(1.1)^2}+\frac{27,000}{(1.1)^4}\)
= – 50,000 + 18,000(0.9091 + 0.8264 + 0.7513) – (15,400 × 0.8264) + (27,000 × 0.6830)
= – 50,000 + 18,000 (2.4868) – (15,400 × 0.8264) + (27,000 × 0.6830)
= – 50,000 + 44,762 – 12,727 +18,441
= – 62,727 + 63,203
= + 476

Net Present Value is positive, but very low as compared to the investment.
If the Supplier gives a discount of ₹ 5,000 then
NPV = 5,000 + 476 = 5,476
Decision: Option II is worth investing as the net present value is positive and higher as compared to Option I.

Question 4.
PD Ltd. an existing company, is planning to introduce a new product with projected life of 8 years. Project cost will be ₹ 2,40,00,000. At the end of 8 years no residual value will be realized. Working capital of ₹ 30,00,000 will be needed. The 100% capacity of the project is ₹ 2,00,000 units p.a. but the Production and Sales Volume is 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:
(i) Selling price per unit ₹ 200.
(ii) Variable cost is 40% of sales.
(iii) Fixed cost p.a. ₹ 30,00,000.
(iv) In addition to these advertisement expenditures will have to be incurred as under:

Year	1	2	3-5	6-8
Expenditure (₹)	50,00,000	25,00,000	10,00,000	5,00,000

(v) Income Tax is 25%.
(vi) Straight line method of depreciation is permissible for tax purposes.
(vii) Cost of capital is 10%.

Advise about the project acceptability. (Nov 2018, 10 marks)
Answer:

Advice: Since the project has a positive NPV, therefore it should be accepted.

Question 5.
Door Ltd. is considering an investment of ₹ 4,00,000. This investment is expected to generate substantial cash inflows over the next five years. Unfortunately, the annual cash flows from this investment is uncertain, but the following probability distribution has been established.

Annual Cash Flow (₹)	Probability
50,000	0.3
1,00,000	0.3
1,50,000	0.4

At the end of its 5 years life, the investment is expected to have a residual value of 40,000.
The cost of capital is 5%.
(i) Calculate NPV under the three different scenarios.
(ii) Calculate Expected Net Present Value
(iii) Advise Door Ltd. on whether the investment is to be undertaken.

Year	1	2	3	4	5
DF @ 5%	0.952	0.907	0.864	0.823	0.784

(Nov 2019, 5 Marks)
Answer:
(i) NPV under the three different scenarios:
(a) When Probability is 0.3
NPV = Annual cash flow (PVAf, 5%,5) + Residual value (Pvif 5%,5) – Initial Investment
= (₹ 50,000 × 4.33) + (₹ 40,000 × 0.784) – 4,00,000
= ₹ 2,16,500 + ₹ 31,360 – ₹ 4,00,000
NPV = – ₹ 1,52,140

(b) When Probability is 0.3
NPV = (₹ 1,00,000 × 4.33) + (₹ 40,000 × 0.784) – ₹ 4,00,000
= ₹ 4,33,000 + ₹ 31,360 – ₹ 4,00,000
NPV = ₹ 64,360

(c) When Probability Is 0.4
NPV = (₹ 1,50,000 × 4.33) + (₹ 40,000 × 0.784) – ₹ 4,00,000
= ₹ 6,49,500 + ₹ 31,360 – ₹4,00000
NPV = ₹ 2,80,860

(ii) Expected Net Present Value:
Annual Expected cash flows
= (₹ 50,000 × 0.3) + (₹ 1,00,000 × 0.3) + (₹ 1,50,000 × 0.4)
= ₹ 1,05,000
NPV = (₹ 1,05,000 × 4.33) + (₹ 40,000 × 0.784) – ₹ 4,00,000
= ₹ 4,54,650 + ₹ 31,360 – ₹ 4,00,000
NPV = ₹ 86,010

(iii) Since the expected NPV from the investment is positive (₹ 86,010), Door Ltd. should undertake the project.

Question 6.
CK Ltd. 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-year
Residual Value Nil
Annual Production Capacity of the Machine 1,00,000 units
Estimated Selling Price per unit. ₹ 6
Estimated Variable Cost per unit ₹ 3
Estimated Annual Fixed Cost ₹ 1,00,000
(Excluding depreciation)
Advertisement Expenses in year in addition of annual fixed cost ₹ 20,000
Maintenance Expenses in 5th year in addition of annual fixed cost ₹ 30,000
Cost of Capital 1 2%
Ignore Tax.
Analyse the above-mentioned proposal using the Net Present Value Method and advice.
P.V. factor @ 12% are as under:

Year	1	2	3	4	5	6	7	8
PV Factor	0.893	0.797	0.712	0.636	0.567	0.507	0.452	0.404

(Nov 2020, 5 marks)

Question 7.
Desirability factor. (Nov 2009, 1.5 marks)
Answer:
In certain cases, we have to compare a number of proposals each involving different amount of cash inflows. One of the methods of comparing such proposals is to work out, what is known as the ‘Desirability Factor’ or ‘Profitability Index’. In general terms, a project is acceptable if the Profitability Index is greater than 1. Mathematically, Desirability Factor = \(\frac{\text { Sum of Discounted Cash inflows }}{\text { Initial Cash Outlay or Total Discounted Cash outflows }} \)

Question 8.
Distinguish Between:
Net Present-value and Internal Rate of Return. (May 2002, 2 marks)
OR
Net present value method and internal rate of return method. (Nov 2011, 4 marks)
OR
Net Present Value (NPV) and Internal Rate of Return (IRR) methods for evaluating projects. (2015 Nov, 4 marks)
Answer:
Difference between NPV and IRR

Basis of Difference	NPV	IRR
1. Nature of Projects accepted	Under NPV, projects with positive NPV are accepted.	Under IRR, projects whose IRR is more than the cost of project are accepted.
2. Measures	NPV measures both quality and scale of investment.	IRR measures only quality of investment.
3. Absolute Vs Relative Measure	NPV provides an absolute measure in quantitative terms.	IRR Provides a relative measure In percentage.
4. ReInvestment Rate	Under NPV, cash flows are re-invested at the rate of cost of capital.	Under IRR, cash flows are re-invested at the rate of IRR
5. Multiple/Negative Rate	NPV cannot yield Multiple or Negative Rate	IRR can yield negative or multiple rate under certain circumstances.

Question 9.
A Company proposes to install a machine involving a Capital Cost of ₹ 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 ₹ 68,000 per annum. The Company4s tax rate is 45%.
The Net Present Value factors for 5 years are as under:
Discounting Rate: 14 15 16 17 18
Cumulative factor: 3.43 3.35 3.27 3.20 3.13
You are required to calculate the internal rate of return of the proposal. (Nov 2002, 4 marks)
Answer:

The IRR of the investment can be found as follows:
NPV =₹ 3,60,000 +₹ 1,09,400 (PVIFA₅.r) = O
PVIFA₅.r (Cumulative factor) = \(\frac{₹ 3,60,000}{₹ 1,09,400}\) = 3.29

IRR = 15+ \(\left(\frac{6,490}{6,490+2,262}\right)\)
= 15 + 0.74 = 15.74%

Question 10.
What is the ‘Internal Rate of Return’? Explain. (Nov 2014, 4 marks)
Answer:
Internal Rate of Return:
It is that rate at which discounted cash inflows are equal to the discounted cash outflows.
It can be stated in the form of a ratio as follows:
\(\frac{\text { Cash inflows }}{\text { Cash Outflows }}\) = 1
This rate is to be found by trial and error method.
This rate is used in the evaluation of investment proposals. In this method, the discount rate is not known but the cash outflows and cash inflows are known. In evaluating investment proposals, internal rate of return is compared with a required rate of return, known as cut-off rate. If it is more than cut-off rate the project is treated as acceptable; otherwise project is rejected.

Question 11.
Define Internal Rate of Return (IRR) (Jan 2021, 4 marks)

Question 12.
Explain the concept of discounted payback period. (May 2009, 3 marks)
Answer:
Concept of Discounted Payback Period
Payback period is time taken to recover the original investment from project cash flows. It is also termed as break-even period. The focus of the analysis is on liquidity aspect and it suffers from the limitation of ignoring time value of money and profitability.

Discounted payback period considers present value of cash flows, discounted at company’s cost of capital to estimate breakeven period i.e. it is that period in which future discounted cash flows equal the initial outflow.

The shorter the period, better it is. It also ignores post-discounted payback period cash flows. it takes care of the time value of money.

Question 13.
Explain the concept of Multiple Internal rate of Return (MIRR). (Nov 2008, 3 marks)
Answer:
Concept of MIRR
MIRR is that rate of compounding which makes the initial cash outflow ¡n zeroth year equal to the terminal value of cash inflows. In order to cope up various limitations of the conventional Internal Rate of Return, Modified Internal Rate of Return was developed. Under this method, all cash flows (except initial investment), are brought to the terminal value using an appropriate discount rate (generally the cost of capital). MIRR results in a single stream of cash inflow in the terminal year. It is obtained by assuming a single outflow in the zero the year and the terminal cash inflow. The discount rate which equates the PV of the terminal cash inflow to the zeroth year outflow is known as MIRR.

Some of the advantages of MIRR are

1. This method makes use of concept of time value of money.
2. All the Cash flows in the project are considered.

Some of the limitations of MIRR are

1. The calculation process is tedious.
2. The IRR approach creates a peculiar situation if we compare two projects with different inflow-outflow patterns.
3. In case of mutually exclusive projects decisions based only on IRR may not be correct.

Question 14.
Define Modified Internal Rate of Return method. (May 2007, 2 marks)
Answer:
In order to cope up various limitations of the conventional internal Rate of Return, Modified Internal Rate of Return was developed.
Limitations of the conventional IRR are,

• it eliminates multiple IRR rates.
• it addresses to reinvestment rate issue and produces results, which are consistent with the Net Present Value (NPV) method.

Under this method, all cash flows (except initial investment), are brought to the terminal value using an appropriate discount rate (generally the cost of capital). MIRR results in a single stream of cash inflow in the terminal year. It is obtained by assuming a single outflow in the zeroth year and the terminal cash inflow. The discount rate which equates the PV of the terminal cash Inflow to the zeroth year outflow is known as MIRR.

Question 15.
The cash flows of projects C and D are reproduced below:

(i) Why there is a conflict of rankings?
(ii) Why should you recommend Project C in spite of lower internal rate of return?

(May 2003, 4+4 = 8 marks)
Answer:

The conflict in ranking arises because of skewness in cash flows, In the case of Project C, Cash flows occurs more late in the life but in the case of Project D, cash flows are skewed towards the beginning.

At lower discount rate, Project C’s NPV will be higher than that of Project D’s. As the discount rate increases, Projects C’s NPV will fall at a faster rate, due to the compounding effect.

After break-even discount rate, Project D has higher NPV as well as higher IRF.
(ii) If the opportunity cost of funds is 10%, Project C should be accepted because the firm’s wealth will increase by ₹ 316 (₹ 4.139 – ₹ 3,823):
The following statement of Incremental analysis will prove the above point:

Hence, the Project C should be accepted, when the opportunity cost of funds is 10%.

Question 16.
The cash flows of two mutually exclusive Projects are as under:

Required:
(i) Estimate the net present value (NPV) of the Project P’ and J’
using 15% as the hurdle rate.
(ii) Estimate the internal rate of return (IRR) of the Project ‘P’ and ‘J’.
(iii) Why there is a conflict in the project choice by using NPV and IRR criterion?
(iv) Which criteria you will use in such a situation? Estimate the value at that criterion. Make a project choice.

The present value interest factor values at different rates of discount are as under:

(May 2004, 2+2+ 1 +2 = 7 marks)
Answer:
(i) Estimation of NPV of the Project ‘P’ & J using 15% as the hurdle rate:
NPV of Project ‘P’:
= – 40,000 + \(\frac{13,000}{(1+15)^1}+\frac{8,000}{(1.15)^2}+\frac{14,000}{(1.15)^3}+\frac{12,000}{(1.15)^4}+\frac{11,000}{(1.15)^5}+\frac{15,000}{(1.15)^6}\)
= – 40,000 + 11.304.35 + 6049.15+ 9205.68+6861.45 + 5469.37 + 6485.65
= ₹ 5375.65
= ₹ 5376/-

NPV of Project J:
=-20,000 + \(\frac{7,000}{(1.15)^1}+\frac{13,000}{(1+15)^2}+\frac{12,000}{(1+15)^3} \)
= -20,000 + 6086.96 + 9829.87 + 7890.58
= ₹ 3807.41

(ii) Estimation of IRR of Project ‘P’ & ‘J’: IRR is the rate at which the sum of cash mf lows after discounting equals to the discounted cash outflows. The value of ‘r1 in the case of given projects can be determined by using the following formula:
Co = \(\frac{C F_0}{(1+r)^0}+\frac{C_1}{(1+r)^1}+\ldots \ldots \ldots \ldots \ldots \ldots+\cdots+\frac{C F_n}{(1+r)^n}+\frac{S V+W C}{(1+r)^n}\)
Where, C₀ = Cash flows at the time 0
CF₁ = Cash inflow at the end of years t.
r = discount rate
n = life of the project
SV & WC = Salvage value & working capital at end of ‘n’ years.

IRR of Project ‘P’:
40,000 = \(\frac{13,000}{(1+r \%)^1}+\frac{8,000}{(1+r \%)^2}+\frac{14,000}{(1+r \%)^3}+\frac{12,000}{(1+r \%)^4}+\frac{11,000}{(1+r \%)^5}+\frac{15,000}{(1+r \%)^6} \)
r = 19.73%

IRR of Project ‘J’:
20000 = \(\frac{7,000}{(1+r \%)^1}+\frac{13,000}{(1+r \%)^2}+\frac{12,000}{(1+r \%)^3} \)
r = 25.20%

(iii) The conflict between NPV & IRR rule in the case of mutually exclusive projects situation arises due to re-investment rate assumptions. NPV rule assumes that intermediate cash flows are reinvested at ‘r’. The assumption of NPV rules is more realistic.

(iv) When there is a conflict in the Project choice by using NPV & IRR criterion, we would prefer to Equal Annualised Criterion’. According to this, the net annual each inflow in the case of Project P & J would be:
= \(\frac{\text { Net Present Value }}{\text { Cumulative P.V. of Re 1 pa@ } 15 \% \text { for } 6 \text { Years }} \)
Project P’ = ₹ 5375.65/3.7845 = ₹ 1,420.44
Project ‘J’ = ₹ 3807.41/2.2832 = ₹ 1,667.58
Since the cash inflow p.a. in case of project ‘J’ is more than that of project ‘P’, so Project ‘J’ is recommended.

Question 17.
MNP Limited is thinking of replacing its existing machine by a new machine, which would cost ₹ 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 ¡s bought. The selling price of the product would remain unchanged at ₹ 200 per unit. The following is the cost of producing one unit of product using both the existing and new machine:

The existing machine has an accounting book value of ₹ 1,00,000 and it has been fully depreciated for tax purpose. It is estimated that machine will be useful for 5 years. The supplier of the new machine has offered to accept the old machine for ₹ 2,50,000. However, the market price of old machine today is ₹ 1,50,000 and it is expected to be ₹ 35,000 after 5 year. The new machine has a life of 5 years and a salvage value of ₹ 2,50,000 at the end of its economic life. Assume corporate Income-tax rate at 40% and depreciation is charged on straight-line basis for Income-tax purposes. Further, assume that book profit is treated as ordinary income for tax purposes. The opportunity cost of capital of the Company is 15%.

Required:
(i) Estimate net present value of the replacement decision.
(ii) Estimate the internal rate of return of the replacement decision.
(iii) Should Company go ahead with the replacement decision? Suggest.

(Nov 2005, 8+3+ 1 =12 marks)
Answer:
(i) Net Cash Outlay of New Machine:-

Market Value of Old Machine: The old machine could be sold for ₹ 1,50,000 in the market. Since the exchange value Is more than the market value, this option is not attractive. This opportunity will be lost whether the old machine is retained or replaced. Thus, on incremental basis, it has no impact.

Depreciation base: Old machine has been fully depreciated for tax purpose. Thus, the depreciation base of the new machine will be its original cost, i.e. ₹ 60,00,000.

Net Cash Flows: Unit cost includes depreciation & allocated overheads. Allocated OHs are allocations from corporate office therefore they are irrelevant. The depreciation tax shield may be computed separately. Excluding depreciation and allocated OHs, unit costs can be calculated. The company will obtain additional revenue from additional 20,000 units sold.

Thus, after-tax saving, excluding depreciation, tax shield, would be,
= (1,00,000 (200 – 148) -80,000 (200 – 173)) × (1 – 0.40)
= (52,00,000 -21,60,000) × 0.60
= 18,24,000.

After adjusting depreciation, tax should and salvage value, net cash flows and net present value is estimated.

IRR = 20% + 10% × \(\frac{1066.94}{1296.82}\) = 28.23%

(iii) Advise: The company should go ahead with replacement project since it is positive NPV decision.

Question 18.
Explain the steps while using the equivalent annualized criterion. (Nov 2019, 3 marks)
Answer:
Equivalent Annualised Criterion involves the following steps:
1. Compute NPV using the WACC or discounting rate
2. Compute present value Annuity Factor (PVAF) of discounting factor used above for the period of each project.
3. Divide NPV computed under step

• by PVAF as compute under step
• and compare the values.

Question 19.
A company has to make a choice between two projects namely A and B. The initial capital outlay of two Projects are ₹ 1,35,000 and ₹ 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 annual incomes are as under:

You are required to calculate for each project:
(i) Discounted payback period
(ii) Profitability index
(iii) Net present value. (Nov 2002, 6 marks)
Answer:

(i) Discounted Payback Period (Refer W. N.-2):
Cost of Project A = ₹ 1,35,000
Cost of Project B = ₹ 2,40,000
Cumulative of PV of cash inflows of Project
A after 4 yrs. = ₹ 1,53,270
Cumulative PV of cash ¡nf lows of Project
B after 5 years = ₹ 2,74,812
A comparison of projects cost with this cumulative PV clearly shows that the Project As cost will be recovered in less than 4 years & that of Project B in less than 5 years. The exact duration of discounted payback period can be computed as follows.

(ii) Profitability Index (P.I.) = \(\frac{\text { Sum of discount cash Inflow }}{\text { Initial cash outlay }} \)
P.I. (Pr.A)= \(\frac{₹ 1,93,254}{₹ 1,35,000}\) = 1.43
P.I. (Pr. B) = \(\frac{₹ 2,74,812}{₹ 2,40,000} \) = 1.15

(iii) Net Present Value:
Pr. A (W.N.-1) = ₹ 58,254
Pr. B(W.N.-1)= ₹ 34,812

Question 20.
A Company is considering a proposal of installing a drying equipment. The equipment would involve a Cash outlay of ₹ 6,00,000 and net Working Capital of ₹ 80,000. The expected lite of the project is 5 years without any salvage value. Assume that the company is allowed to charge depreciation on straight-line basis for Income-tax purpose. The estimated before-tax
cash inflows are given below:

The applicable Income-tax rate to the Company is 35%. If the Company’s opportunity Cost of Capital is 12%, calculate the equipment’s discounted payback period, payback period, net present value and internal rate of return.

(May 2006, 10 Marks)
Answer:
Initial outlay = 6,00,000 + 80,000 = 6,80,000

Payback period = 3 + \(\frac{80,740}{7,58,260-5,99,260} \)
=3+51 =3.51 year.

NPV = 7,09,116 – 6,80,000 = 29,116
IRR = 12% + \(\frac{29,116}{29,116+20,364} \times 3 \%\)
= 12% + \(\frac{29,116}{49,480} \times 3 \%\) =12% + 1.77% = 13.77%

Question 21.
C Ltd. is considering investing in a project. The expected original investment in the project will be ₹ 2,00,000, the life of project will be 5 years 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
₹	85,000	100,000	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, It cost of capital is 10%.
(iii) Calculate internal rate of return.

(May 2008, 2 + 3 +3 = 8 marks)
Answer:

Depreciation = 2,00,000 × 20% = 40,000
Payback period = 1+ (2,00000 – 99,500)/1,10,000 =1.91 years
Computation of Average Rate of Return:

Year	PBT	PAT (PBT × 0.7)
1	85,000	59,500
2	1,00,000	70,000
3	80,000	56,000
4	80,000	56,000
5	40,000	28,000
	Total	2,69,500

Average Annual Profit =2,69,500/5 = 53,900
Average Investment = (2,00,000 +0)/2 = 1,00,000
ARR = \(\frac{\text { Average Annual Profit after tax }}{\text { Average Investment }} \)
ARR = 53,900 ÷ 1,00,000 = 0.539 i.e. 53.9%.

NPV is positive hence C Ltd. can accept the proposal.
NPV Index (PI):
NPV =
NPV Index = \(\frac{1,61,197.50}{2,00,000}\) = 0.81

Calculation of IRR through Interpolation method
IRR= LR + \(\frac{N P V_L}{N P V_L-N P V_H} \times \text { (Rate difference) }\)
IRR=37%+ \(\frac{9,949}{9949-(-305)} \times(40 \%-37 \%)\)
= 37% + \(\frac{9,949}{10,254} \times 3 \%\)
= 37% + 2.91%
IRR = 39.91%

Question 22.
The management of P Limited is considering to select a machine out of the two mutually exclusive machines. The company’s cost of capital is 12 percent and corporate tax rate for the company is 30 percent. Details of the machines are as follows:

	Machine-I	Machine-II
Cost of machine	₹ 10,00,000	₹ 15,00,000
Expected life	5 years	6 years
Annual income before tax and depreciation	₹ 3,45,000	₹ 4,55,000

Depreciation is to be charged on a straight-line basis.

You are required to:
(i) Calculate the discounted pay-back period, net present value, and internal rate of return for each machine.
(ii) Advise the management of P Limited as to which machine they should take up.

(May 2010, 9 Marks)
Answer:

Discounted Payback Period for:
Machine-I
Discounted Payback Period = 4 + \(\frac{(10,00,000-9,15,958)}{1,70,951}\) = 84,042
= 4+0.4916
= 4.49 years or 4 years and 5.9 months

Machine – II
Discounted Payback Period = 5 + \(\frac{(15,00,000-14,18,569)}{1,99,505}\)
= 5 + \(\frac{81,431}{1,99,505}\)
= 5+0.4082
= 5.41 years or 5 years and 4.9 months

Net Present Value for:
Machine – I
NPV = ₹ 10,86,909 – ₹ 10,00,000
=₹ 86,909

Machine – II
NPV = ₹ 16,18,074 – ₹ 15,00,000
= ₹ 1,18,074
Internal Rate of Return (IRR) for:
Machine – I
P.V. Factor = \(\frac{\text { Initial Investment }}{\text { Annual Cash Inflow }}=\frac{10,00,000}{3,01,500}\) = 3.31 67

PV factor falls between 15% and 16%
Present Value of Cash inflow at 15% and 16% will be:
Present Value at 15% = 3.353 × 3,01,500 = 10,10,930
Present Value at 16% = 3.274 × 3,01,500 = 9,87,111
IRR = 15 + \(\frac{10,10,930-10,00,0000}{10,10,930-9,87,111} \times(16-15) \)
= 15+ \(\frac{10,930}{23,819} \times 1\)
= 15.4588% = 15.46%

Machine – II
P.V. Factor = \(\frac{15,00,000}{3,93,500}\) = 3.8119
Present Value of Cash inflow at 14% and 15% will be:
Present Value at 14% = 3.888 x 3,93,500 = 1 529,928
Present Value at 15% = 3.785 x 3,93,500 = 14,89,398

IRR = 14 + \(\frac{15,29,928-15,00,000}{15,29,928-14,89,398} \times(15-14) \)
= 14+ \(\frac{29,928}{40,530} \times 1\)
= 14.7384% = 14.74%

(ii) Advise to the Management
Ranking of Machines in Terms of the Three Methods

	Machine – I	Machine – II
Discounted Payback Period	I	II
Net Present Value	II	I
Internal Rate of Return	I	II

Advise: Since Machine – I has better ranking than Machine – II, therefore,
Machine: I should be selected.

Question 23.
ANP Ltd. is providing the following information:
Annual cost of saving ₹ 96,000
Useful life 5 years
Salvage value zero
Internal rate of return 15%
Profitability index 1.05
Table of discount factors:

You are required to calculate:
(i) Cost of the project
(ii) Payback period
(iii) Net present value of cash inflow
(iv) Cost of capital (May 2012, 8 marks)
Answer:
(i) Cost of Project
At internal rate of return (IRR) of 15%, the amount of total cash
inflows = cost of the project i.e. total cash outflow
Annual cost savings = ₹ 96,000
Useful life = 5 years

Considering the discount factor table @ 15%, cumulative present value of cash inflows for 5 years is 3.353
Hence, Total Cash inflows for 5 years for the Project is
96,000 × 3.353 = ₹ 3,21,888
Hence, Cost of the Project = ₹ 3,21,888

(ii) Payback Period
Payback period = \(\frac{\text { Cost of the Project }}{\text { Annual Cost Savings }}=\frac{₹ 3,21,888}{96,000}\)
Payback Period = 3.353 years

(iii) Net Present Value (NPV)
NPV = Sum of Present Values of Cash inflows – Cost of the Project
= ₹ 3,37,982.40 – 3,21,888 = ₹ 16,094.40
Net Present Value = ₹ 16,094.40

(iv) Cost of Capital
Profitability index = \(\frac{\text { SumofDiscountedCashinflows }}{\text { Cost of theProject }} \)
1.05 = \(\frac{\text { SumofDiscountedCashinflows }}{3,21,888} \)
∴ Sum of Discounted Cash inflows = ₹ 3,37,982.40
Since, Annual Cost Saving = ₹ 96,000
Therefore, cumulative discount factor for 5 years
= \(\frac{₹ 3,37,982.40}{96,000} \)
From the discount factor table, at discount rate of 13%, the cumulative discount factor for 5 years is 3.52 Hence, Cost of Capital = 13%

Question 24.
SS Limited is considering the purchase of a new automatic machine which will carry out some operations which are at present performed by manual labour. NM-A₁ and NM-A₂, two alternative models are available in the market. The following details are collected:

Depreciation will be charged on a straight-line method. The corporate tax rate is 30 percent and the expected rate of return may be 12 percent.
You are required to evaluate the alternatives by calculating the:
(i) Pay-back Period
(ii) Accounting (Average) Rate of Return; and
(iii) Profitability Index or P.V. Index (P.V. factor for 1 @ 12% 0.893;
0.797; 0.712; 0.636; 0.567; 0.507) (Nov 2012, 10 marks)
Answer:
Evaluation of Alternatives
Working Notes:
Depreciation on Machine NM-A₁ = \(\frac{20,00,000}{5} \) = 4,00,000
Depreciation on Machine NM-A₂ = \(\frac{25,00,000}{5}\) = 5,00,000

(i) Payback Period
Machine NM-A₁ = \(\frac{\text { Total Initial Capital Investment }}{\text { Annual expected after-tax net cashflow }} \)
= \(\frac{20,00,000}{5,71,500} \)
= 3.50 Years

Machine NM- A₂ = \(\frac{25,00,000}{6,92,500}\) = 3.61 Years
Decision: Machine NM-A₁ is better.

(ii) Accounting (Average) Rate of Return (ARR)
ARR = \(\frac{\text { Average Annual Net Savings }}{\text { Average Investment }} \times 100 \)
Machine NM-A₁ = \(\frac{1,71,500}{10,00,000} \times 100\) = 17.1 5%
Machine NM-A₂ = \(\frac{1,92,500}{12,50,000} \times 100 \) = 15.4%
Decision: Machine NM-A₁ is better.
(Note: ARR may be computed alternatively by taking initial investment ¡n the denominator.)

(iii) Profitability Index or PV Index
Present Value Cash inflow = Annual Cash Inflow × PV factor at 12%
Machine N M-A₁ = 571,500 × 3.605 = ₹ 20,60,258
Machine NM-A₂ = 6,92,500 × 3.605 = ₹ 24,96,463
PV Index = \(\frac{\text { Present Value of Cashinflow }}{\text { Investment }}\)
Machine NM-A₁ = \(\frac{20,60,258}{20,00,000} \) = 1.03
Machine NM-A₂ = \(\frac{24,96,463}{25,00,000}\) = 0.9
Decision: Machine NM-A₁ is better.

Question 25.
PQR Company Ltd. is considering to select a machine out of two mutually exclusive machines. The company’s cost of capital is 12 percent and corporate tax rate is 30 percent. Other information relating to both machines is as follows:

	Machine-I	Machine-II
Cost of Machine	15,00,000	20,00,000
Expected Life	5 Yrs.	5 Yrs.
Annual Income (Before Tax and Depreciation)	₹ 6,25,000	₹ 8,75,000

Depreciation is to be charged on a straight-line basis:
You are required to calculate:
(i) Discounted Pay Back Period
(ii) Net Present Value
(iii) Profitability Index

(May 2013, 9 Marks)
Answer:
Working Notes:
Depreciation on Machine – I = \(\frac{15,00,000}{5} \) = ₹ 3,00,000
Depreciation on Machine – II = \(\frac{20,00,000}{5}\) = 400 000

(i) Discounted Payback Period
Machine-I
Discounted Payback period = 3 + \(\frac{(15,00,000-12,67,056}{3,35,490)} \)
= 3 + \(\frac{2,32,944}{3,35,490}\)
= 3+0.6943
= 3.69 years or 3 years 8.28 months

Machine – II
Discounted Payback Period = 3 + \(\frac{(20,00,000-17,59,466)}{4,65,870}\)
= 3+ \(\frac{2,40,534}{4,65,870} \)
= 3+0.5163
= 3.52 years or 3 years 6.24 months

(ii) Net Present Value (NPV)
Machine – I
NPV= 19,01,639 – 15,00,000 = ₹ 4,01,639
Machine-II
NPV = 26,40,664 – 2000,000 = ₹ 6,40,664

(iii) Profitability Index
Machine – I
Profitability Index = \(\frac{19,01,639}{15,00,000}\) = 1.268

Machine – II
Profitability Index = \(\frac{26,40,664}{20,00,000}\) = 1.320

Conclusion:

Method	Machine- I	Machine -II	Rank
Discounted Payback Period	3.69 years	3.52 years	II
Net Present Value	4,01,639	6,40,664	II
Profitability Index	1.268	1.320	II

Question 26.
FH Hospital is considering to purchase a CT scan machine. Presently the hospital is outsourcing the CT-Scan Machine and is earning commission of ₹ 15,000 per month (net of tax). The following details are given regarding the machine:

	₹
Cost of CT-Scan machine	15,00,000
Operating cost per annum (excluding Depreciation)	2,25,000
Expected revenue per annum	7,90,000
Salvage value of the machine (after 5 years)	3,00,000
Expected life of the machine	5 years

Assuming tax rate @ 30%, whether it would be profitable for the hospital to purchase the machine?
Give your recommendation under:
(i) Net Present Value Method, and
(ii) Profitability Index Method.
PV factors at 12% are given below:

Year	1	2	3	4	5
PV factor	0.893	0.797	0.712	0.636	0.567

(May 2014, 8 marks)
Answer:

(ii) Calculation of Profitable Index
Profitable Index
= \(\frac{\text { Sum of discounted cash inflows }}{\text { Present value of cash outflows }}=\frac{12,06,537.50}{15,00,000} \)
= 0.804

Advise: Since the net present value is negative and profitability index is also less than 1, therefore, the hospital should not purchase the CT-Scan machine.

Question 27.
Given below are the data on a capital project ‘M’.
Annual cash inflows ₹ 60,000
Useful life 4 years
Internal rate of return 15%
Profitability index 1.064
Salvage value 0
You are required to calculate for this project M:
(I) Cost of project
(ii) Payback period
(iii) Cost of capital
(iv) Net present value
PV factors at different rates are given below:

Discount factor	15%	14%	13%	12%
1 year	0.869	0.877	0.885	0.893
2 year	0.756	0.769	0.783	0.797
3 year	0.658	0.675	0.693	0.712
4 year	0.572	0.592	0.613	0.636

(May 2015, 8 marks)
Answer:
(i) Calculation for Cost of Project:
Cost of project at 15% Internal rate of return, the sum of total cash Inflows = Cost of the Project i.e. initial cash outlay.
Annual cash inflow = ₹ 60,000
Useful life = 4 years
Considering discounting factor @ 15%, cumulative cash inflow for 4 years is 2.855
Hence, total cash flow for 4 years for the project = ₹ 60,000 x 2.855
Cost of Project = ₹ 1,71,300

(ii) Calculation for Payback Period:
Pay-back Period = \(\frac{\text { Cost of Project }}{\text { Annual Cashinflow }}\)
= \(\frac{1,71,300}{60,000}\)
Pay-back Period = 2.855 years.

(iii) Calculation for Cost of Capital:
Profitability Index = \(\frac{\text { SumofDiscountedCashInflow }}{\text { Cost of project }} \)
1064 = \(=\frac{\text { Sumof DiscountedCashInflows }}{1,71,300}\)
Sum of discounted cash inflows = ₹ 1,82,263.20
Hence, Cumulative discount factor for four years
= \(\frac{₹ 1,82,263.20}{60,000}\) = 3.038

From the discount factor table, at discount rate of 12% the cumulative discount factor for 5 years is 3.038
Hence, Cost of Capital is 12%.

(iv) Calculation for Net Present value (NPV):
NPV = Sum of Present values of cash inflows – Cost of Project
= 182263.2- 171300
NPV = ₹ 10963.20

Question 28.
Given below are the data on a capital project ‘C’:
Cost of the project ₹ 2,28,400
Useful life 4 years
Profitability index 1.0417
Internal rate of return 15%
Salvage value 0
You are required to calculate:
(j) Annual cash flow
(ii) Cost of capital
(iii) Net present value(NPV)
(iv) Discounted payback period
Given the following table of discount factors:

Discount Factor	15%	14%	13%	12%
1 year	0.869	0.877	0.885	0.893
2 years	0.756	0.769	0.783	0.797
3 years	0.658	0.675	0.693	0.712
4 years	0.572	0.592	0.613	0.636

(May 2016, 8 marks)
Answer:
At IRR NPV is Zero
Cost of Project = Annual cash flow × Commutative factor IRA
2,28,400 = Annual Cash inflow × 2.855

(i) ∴ Annual Cash Inflow = 80,000
(ii) Cost of Capital
Profitabillty Index (PI) = \(\frac{\text { PV of Cash Inflow }}{\text { PV Cash Outflow }} \)
1.0417 = \(\frac{\text { PV of Casl: Inflow }}{2,28,400} \)

∴ PV of Cash Inflow = 2,37,924.28
Annual Cash Inflow × PV factor = PV of Inflow
80,000 × PV Factor = 2,37,924.28
∴ Commutative PV factor = 2.974

(iii) Cost of Capital = 13%
Net Present Value (NPV) = PV of Inflow – Outflow
= 2,37,924.28 – 2,28,400
NPV = 9,524.28

Discounted Payback Period =3+ \(\frac{39,520}{49,040}\) = 3.8059 years
Or = 3 years, 9 Months and 21 days.

Question 29.
X Limited is considering to purchase of new plant worth ₹ 80,00,000. The expected net cash flows after taxes and before depreciation are as follows:

Year	Net Cash Flows
	₹
1	14,00,000
2	14,00,000
3	14,00,000
4	14,00,000
5	14,00,000
6	16,00,000
7	20,00,000
8	30,00,000
9	20,00,000
10	8,00,000

The rate of cost of capital is 10%.
‘fou are required to calculate:
(i) Pay-back period
(ii) Net preseñt value at 10% discount factor
(iii) Profitability index at 10% discount factor
(iv) Internal rate of return with the help of 10% and 15% discount factor
The following present value table is given for you:

(May 2017, 8 marks)
Answer:

Year	Cash Flow	Cumulative
0	80,00,000	–
1	14,00,000	14,00,000
2	14,00,000	28,00,000
3	14,00,000	42,00,000
4	14,00,000	56,00,000
5	14,00,000	70,00,000
6	16,00,000	86,00,000
7	20,00,000
8	30,00,000
9	20,00,000
10	8,00,000

(i) Calculation of Pay-back Period.
Cash Outlay of the Project = ₹ 80,00,000
Total Cash mf low for the first five years = ₹ 70,00,000
Balance of cash outlay left to be paid back in the 6th year = ₹ 10,00,000
Cash inflow for 6th year = ₹ 16,00,000
So the payback period is between and 6th years, i.e.,
= 5 Years + \(\frac{₹ 10,00,000}{₹ 16,00,000}\) = 5.625 Years or 5 years 7.5 months

(ii) NPV @ 10% = ₹ 17,97,800
(iii) PI @ 10% = \(\frac{\text { PV of CIF }}{P V \text { of } C O F}=\frac{97,97,800}{80,00,000}\) = 1.225
(iv) IRR = 10 + \(\left[\frac{17,97,800}{17,97,800+114,600} \times 5\right]\)
= 10 + \(\left(\frac{17,97,800}{19,12,400} \times 5\right)\)
= 14.70% (Approx.)

Final Answer:

1. Payback Period	5.625 Years
2. NPV	17,97,800
3. PI	1.225
4. IRR	14.70%

Question 30.
Mr. B will require ₹ 30 lakhs after 10 years from now. He wants to ascertain an amount to be invested in a fund which pays interest @ 10% per annum.
Following options are available to him:
(i) to make annual payment into the fund at the end of each year.
(ii) to invest a lumpsum amount in the fund at the end of the year.
(iii) to make annual payment into the fund in the beginning of each year.
Find out the amount to be invested under each of the options given above.
Factors are as under:
FVIF/CVF(10%,10) = 2.594
FVIFA/CVFA(10%,10) = 15.937
PVIF/PVF (10%, 10) = 0.386
PVIFAIPVFA (10%, 10) = 6.145 (Nov 2017, 5 marks)
Answer:
(I) Here,
FVA = 30,00,000
n =10
i =0.10
Since, FVA = R [FVIFA (I, n)]
FVIFA (10%, 10) = 15.937
R = \(\frac{30,00,000}{15.937}\) = 1,88,241.1997

(ii) Fv_n = R [1 + i]ⁿ
R = \(\frac{F V_n}{(1+i)^n}\)
R =30,00,000 x 0.386= ₹ 11,58,000

(iii) R = \(\frac{30,00,000}{17.5307}\)
= ₹ 1,71,128.3634.

Question 31.
Kanoria Enterprises wishes to evaluate two mutually exclusive projects X and Y.
The particulars are as under:

	Project X (₹)	Project Y (₹)
Initial Investment	1,20,000	1,20,000
Estimated cash inflows (per annum for 8 years)
Pessimistic	26,000	12,000
Most Likely	28,000	28,000
Optimistic	36,000	52,000

The cut-off rate is 14%. The discount factor at 14% are:

Year	1	2	3	4	5	6	7	8	9
Discount factor	0.88	0.77	0.68	0.592	0.519	0.456	0.4	0.351	0.308

Advise management about the acceptability of projects X and Y. (May 2019, 5 marks)
Answer:
Calculation of NPV:

In pessimistic situation, project X will be better as it gives low but positive NPV whereas Project Y yields highly negative NPV under this situation. In most likely situation both the project will give same result. However, in optimistic situation, Project Y wilt be better as it will gives very high NPV. So, project X is a risk less project as it gives positive NPV in all the situations where as Y is a risky project as it will result into negative NPV in pessimistic situations and highly positive NPV in optimistic situation. So acceptability of project will largely depend on the risk taking capacity (Risk seeking Risk a version) of the management.

Question 32.
AT Limited is considering three projects A, B and C. The cash flows associated with the projects are given below:
Cash flows associated with the Three Projects (₹)

Project	C0	C1	C2	C3	C4
A	(10,000)	2,000	2,000	6,000	0
B	(2,000)	0	2,000	4,000	6,000
C	(10,000)	2,000	2,000	6,000	10,000

You are required to:
(a) Calculate the payback period of each of the three projects.
(b) If the cut-out period is two years, then which projects should be accepted?
(c) Projects with positive NPVs If the opportunity cost of capital is 10 percent.
(d) “Payback gives too much weight to cash flows that occur after the cut-off date”. True or false?
(e) “If a firm used a single cutoff period for all projects, it is likely to accept too many short-lived projects. True or false?
P.V. Factor @ 10%

Year	0	1	2	3	4	5
P.V.	1.000	0.909	0.826	0.751	0.683	0.621

(May 2019, 10 marks)
Answer:

(b) If the standard payback period is 2 years, Project B is the only acceptable project.

So, Projects with positive NPV are Project B and Project C
(d) False. Payback gives no weightage to cash flows after the cut-off date.
(e) True. The payback rule ignores all cash flows after the cutoff date, meaning that future years’ cash inflows are not considered. Thus, payback is biased towards short-term projects.

Question 33.
A company has ₹ 1,00,000 available for investment and has identified the following four investments ¡n 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
(i) The projects are independent of each other and are divisible.
(ii) The projects are not divisible. (Nov 2019, 5 marks)
Answer:

Question 34.
A company wants to buy a machine, and two different models namely A and B are available. Following further particulars are available:

Particulars	Machine – A	Machine – B
Original Cost (₹)	8,00000	6,00,000
Estimated Life in Years	4	4
Salvage Value (₹ )	0	0

The company provides depreciation under Straight Line Method. Income tax rate applicable is 30%. The present value of 1 at 12% discounting factor and net profit before depreciation and tax are as under:

Calculate:
1. NPV (Net Present Value)
2. Discounted pay-back period
3. PI (Profitability Index)
Suggest: Purchase of which machine is more beneficial under Discounted pay-back period method, NPV method and Pl method. (Jan 2021,10 marks)

Question 35.
A company has to make a choice between two projects namely A and B. The initial capital outlay of two Projects are ₹ 1,35,000 and ₹ 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 annual income are as under:

Required:
CALCULATE for each project:
(i) Discounted payback period
(ii) Profitability index
(iii) Net present value
DECIDE which of these projects should be accepted? (, 10 Marks)
Answer:
(i) Discounted payback period: (Refer to Working note 2)
Cost of Project A = ₹ 1,35,000
Cost of Project B = ₹ 2,40,000
Cumulative PV of cash inflows of Project A after 4 years = ₹ 1,53,270
Cumulative PV of cash inflows of Project B after 5 years = ₹ 2,74,812
A comparison of projects cost with their cumulative PV clearly shows that the project’s cost will be recovered in less than 4 years and that of project B in less than 5 years. The exact duration of discounted payback period can be computed as follows:

(ii) Profitability Index (PI): = \(\frac{\text { Sum of discounted cash inflows }}{\text { Initian cash outlay }} \)
Profitability Index (for Project A) = \(\frac{₹ 1,93,254}{₹ 1,35,000}\) = 1.43
Profitability Index (for Project B) = \(\frac{₹ 2,74,812}{₹ 2,40,000} \) = 1.15

(iii) Net present value (N PV) (for Project A) = ₹ 58,254
Net present value (NPV) (for Project B) =₹ 34,812
(Refer to Working Note 1)
Conclusion: As the NPV, PI of Project A is higher and Discounted Payback is lower, therefore Project a should be accepted.

Question 36.
BT Pathology Lab Ltd. is using an X-ray machine which reached at the end of their useful lives. Following new X-ray machines are of two different brands with same features are available for the purchase.

Residual Value of both of above machines shall be dropped by 1/3 of Purchase price in the first year and thereafter shall be depreciated at the rate mentioned above. Alternatively, the machine of Brand ABC can also be taken on rent to be returned back to the owner after use on the following terms and conditions:
Annual Rent shall be paid in the beginning of each year and for first year it shall be ₹ 1,02,000.
Annual Rent for the subsequent 4 years shall be ₹ 1,02,500.
Annual Rent for the final 5 years shall be ₹ 1,09,950.
The Rent Agreement can be terminated by BT Labs by making a payment of ₹ 1,00,000 as penalty. This penalty would be reduced by ₹ 10,000 each year of the period of rental agreement.
You are required to:
(a) ADVISE which brand of X-ray machine should be acquired assuming that the use of machine shall be continued for a period of 20 years.
(b) STATE which of the option is most economical if machine is likely to be used for a period of 5 years? The cost of capital of BT Labs is 12%.
Answer:
Since the life span of each machine is different and time span exceeds the useful lives of each model, we shall use Equivalent Annual Cost method to decide which brand should be chosen.
(i) If machine Is used for 20 years Present Value (PV) of cost If machine of Brand XYZ is purchased

PVAF for 1-15 years 6.811
Equivalent Annual Cost= \(\frac{₹ 7,62,927}{6.811}\) = ₹ 1,12,014
Present Value (PV) of cost of machine of Brand ABC Is purchased

PVAF for 1-10 years 5.65
Equivalent Annual Cost = \(\frac{₹ 6,51,786}{5.65}\) = ₹ 1,15,360

Present Value (PV) of cost if machine of Brand ABC ¡s taken on Rent

PVAF for 1- 1o years = 5.65
Equivalent Annual Cost = \(\frac{₹ 6,65,188}{5.65} \) = ₹ 1,17,732
Decision: Since Equivalent Annual Cash Outflow is least in case of purchase of Machine of brand XYZ the same should be purchased.

(ii) If machine Is used for 5 years
(a) Scrap Value of Machine of Brand XYZ
= ₹ 6,00,000 – ₹ 2,00,000 – ₹ 6,00,000 × 0.04 × 4= ₹ 3,04,000
(b) Scrap Value of Machine of Brand ABC
= ₹ 4,50,000 – ₹ 1,50,000 – ₹ 4,50,000 × 0.06 × 4 = ₹ 1,92,000

Decision: Since Cash Outflow is least in case of lease of a Machine of brand ABC the same should be taken on rent.

Financing Decisions Leverages – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Financing Decisions Leverages – CA Inter FM Question Bank

Question 1.
What do you understand by Business Risk and Financial Risk? (Nov 2009, 2 marks)
Answer:
Business Risk
It refers to the risk associated with the firm’s operations. It is uncertainty about the future operating income. That is, how well can the operating income be predicted? It can be measured by standard deviation of basic earning power ratio.

Financial Risk
It refers to the additional risk placed on firms shareholders as a result of debt used in financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly by equity. Financial risk can be measured by ratios such as firms financial leverage multiplier, total debt to assets ratio etc.

Question 2.
Distinguish between business risk and financial risk. (Nov 2012, Nov 2014, 4 marks each)
Answer:

Basis	Business Risk	Financial Risk
1. Meaning	It refers to the risk associated with the firm’s operations. It is uncertainty about the future operating income. That is, how well can the operating income be predicted?	It refers to the additional risk placed on firm’s shareholders as a result of debt used in financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly by equity.
2. Measured by	It can be measured by standard deviation of basic earning power ratio.	Financial risk can be measured by ratios such as firm’s financial leverage multiplier, total debt-to-assets ratio etc.

Question 3.
Operating risk is associated with cost structure, whereas financial risk is associated with capital structure of a business concern.” Critically examine this statement. (May 2013, 4 marks)
Answer
Operating risk is associated with cost structure whereas financial risk is associated with capital structure of a business concern”. Operating risk refers to the risk associated with the firm’s operations. It is represented by the variability of earnings before interest and tax (EBIT).

The variability in turn is influenced by revenues and expenses, which are affected by demand of firm’s products, variations In prices and proportion of fixed cost in total cost.

If there is no fixed cost, there would be no operating risk. Whereas financial risk refers to the additional risk placed on firm’s shareholders as a result of debt and preference shares used in the capital structure of the concern.

Companies that issue more debt instruments would have higher financial risk than companies financed mostly by equity.

Question 4.
Discuss the impact of financial leverage on shareholders’ wealth by using return-on-assets (RCA) and return-on-equity (ROE) analytic framework. (May 2003, 3 marks)
Answer:
ROA = \(\frac{\text { NOPAT }}{\text { Sales }} \times \frac{\text { Sales }}{\text { Capital Employed }}\)

ROE = \(\frac{\text { Earning available for Equity shareholders }}{\text { Equity fund Employed }} \)
Also ROE = RCA + \(\frac{\text { Debt }}{\text { Equity }}\) (RCA — Kd)
Where RCA = Return-on-Asset
NOPAT = EBIT – Tax
Capital Employed = Shareholder’s fund + Loan fund
ROE = Return-on-Equity
K_d = Cost of debt
Since ROE = RCA + \(\frac{D}{E} \) (RCA – K_d)

Therefore it is evident that when ROA is high ROE will also be high and the financial leverage will be favourable.
However if K_d> ROA then the leverage wiH work in the opposite direction. Therefore, in order that equity shareholders gain wealth from debt fund the cost of debt should be less than ROA.

Question 5.
Discuss the Return on assets (ROA) and Return on Equity (ROE) by bringing out clearly the impact of financial leverage. (May 2004, 4 marks)
Answer:
Return on assets (ROA) measures the profitability of the firm in terms of asset employed. It is represented as:
ROA = \(\frac{\text { PAT(Profit after tax) }}{\text { Sales }} \times \frac{\text { Sales }}{\text { Assets }}\)
Whereas,
Return on Equity (ROE) i.e. earning per share (EPS) measures the return on shareholders’ funds. This ratio represents how profitability of the shareholder’s funds have been utilized by the firm. It is represented as:
ROE = ROA+ \(\frac{\mathrm{D}}{\mathrm{E}} \)[ROA-i(1-t)]

Where,
i = rate of interest on debt.
D = debt capital utilized.
E = Equity capital utilized.
t = corporate tax rate.

Interpretation: The impact of financial leverage on ROE is favorable, if cost of debt (after tax) is less than ROA and vice versa.
Explanation with the help of an example: If Debt/Equity ratio is 1:3 cost of debt is 10%, tax rate 30%. Show the impact of the financial leverage on ROE if RCA is (i) 16% and (ii) 5%.

(i) ROE = 16% + \(\frac{1}{3}\) [16% – 10% (1 – 30%)]
=16%+ \(\frac{1}{3}\) (16 – 10 × 0.70 )
=19%

In this case, ROA > cost of debt, impact on financial leverage is favorable on return on equity.
(ii) ROE =5% + \(\frac{1}{3}\) [5%-10% (1 -70%)]
= 5% + \(\frac{1}{3}\) [5%-7%]
= 5%-0.667%
=4.333%
If this case when ROA < cost of debt, impact of financial leverage is unfavourable on return on equity.

Question 6.
The following summarizes the percentage changes in operating income, percentage changes in revenues, and betas for four pharmaceutical firms.

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. (Nov 2004, 3+3=6marks)
Answer:

(ii) Beta is an indicator of an investment, systematic risk. It measures systematic risk associated with an investment in relation to total risk associated with market portfolio.
Relation between operating leverage and beta: Increase in operating leverage indicates increase in operating risk & this leads to high beta.

Question 7.
A Company had the following Balance Sheet as on March 31, 2006:

Required:
Calculate the following and comment:
(i) Earnings per share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage. (Nov 2006, 8 marks)
Answer:
Total asset turnover Ratio = 2.5
2.5 = \(\frac{\text { Sales }}{\text { Total assets }}\)
Sales = 2.5 × 40,00,00,000
= 1,00,00,00,000
Variable operating cost Ratio 1,00,00,00,000 × 65% = 65,00,00,000

(i) Earning per shares = \(\frac{14,40,00,000}{1,00,00,000}\) = ₹ 14.40/- Share
(ii) Operating leverage = \(\frac{\text { Contribution }}{\text { EBIT }} \)
= \(\frac{35,00,00,000}{27,00,00,000}\) = 1.30.

(iii) Financial leverage = \(\frac{\text { EBIT }}{\text { EBT }}\)
= \(\frac{35,00,00,000}{27,00,00,000} \)
= 1.13

(iv) Combined leverage = OL × FL
= 1.3 × 1.13
= 1.47.

Operating, Financial, and Combined Leverage are the measurements of risk, where Combined leverage studies the choice of fixed cost in cost structure and choice of debts in capital structure and also studies how sensitive the change in EPS is changes with change in sales.

Question 8.
The following details of RST Limited for the year ended 31 March 2006 are given below:
Operating leverage 1.4
Combined leverage 2.8
Fixed Cost (Excluding interest) ₹ 2.04 lakhs
Sales ₹ 30.00 lakhs
12% Debentures of ₹ 100 each ₹ 21.25 lakhs
Equity Share Capital of ₹ 10 each ₹ 17.00 lakhs
Income tax rate 30 per cent
Required:
(i) Calculate Financial leverage
(ii) Calculate PN ratio and Earnings per Share (EPS)
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or low assets leverage?
(iv) At what level of sales the Earning before Tax (EBT) of the company will be equal to zero? (May 2007, 8 marks)
Answer:
Financial leverage
(i) Combined Leverage = Operating Leverage (OL) × Financial
Leverage (FL)
2.8 = 1.4 × FL
FL = 2
Financial Leverage = 2

(ii) PN Ratio and EPS
PN ratio = \(\frac{\mathrm{C}}{\mathrm{S}}\) × 1 00
2. Operating leverage = x 100
1.4 = \(\frac{\mathrm{C}}{\mathrm{C}-2,04,000} \)
1.4 (C – 2,04,000) = C
1.4 C – 2,85,600 = C

C = \(\frac{2,85,600}{0.4}\)
C = 7.14,000
PN = \(\frac{7,14,000}{30,00,000} \times 100\) = 23.8%
Therefore, PN Ratio = 23.8%
EPS = \(\frac{\text { Profit after tax }}{\text { No. of equity shares }} \)
EBT = Sales – V – FC – Interest
= 30,00,000 – 22,86,000 – 2,04,000 – 2,55,000
= 2,55,000
PAT = EBT – Tax
= 2,55,000- 76,500 = 1,78,500
EPS = \(\frac{1,78,500}{1,70,000}\) = 1.05

3. Assets turnover
Assets turnover = \(\frac{\text { Sales }}{\text { Total Assets }}=\frac{30,00,000}{38,25,000} \) = 0.784
0.784 < 1.5 means lower than industry turnover.

4. Zero EBIT means 100% reduction in EBT, because combined leverage is 2.8 and sales have to be dropped by 100/2.8= 35.71%. Therefore, new sales will be
30,00,000 × (100 – 35.71) = 19,28,700.
Hence at 19,28,700 level of sales, the Earnings before Tax of the company will be equal to zero.

Question 9.
A firm has Sales of ₹ 40 lakhs; Variable cost of ₹ 25 lakhs; Fixed cost of ₹ 6 lakhs; 10% debts of ₹ 30 lakhs; and Equity Capital of ₹ 45 lakhs.
Required:
Calculate operating and financial leverage. ( Nov 2007, 2 marks)
Answer:
Combined Leverage = Operating Leverage x Financial Leverage
= \(\frac{\text { Contribution }}{\mathrm{EBIT}} \times \frac{\mathrm{EB} I \mathrm{~T}}{\mathrm{EBT}}=\frac{\text { Contribution }}{\mathrm{EBT}} \)
Where, contribution = EBIT + Fixed Cost
= ₹ 10 Lacs + ₹ 20 Lacs
= ₹ 30 Lacs
= \(\frac{\text { Contribution }}{\text { EBT }}=\frac{30 \text { Lacs }}{8 \text { Lacs }} \) = 3.75
It shows that for every change ¡n contribution there will be a more than proportionate change on earnings of shareholders i.e., EBT.

Question 10.
A company operates at a production level of 1 ,000 units. The contribution is ₹ 60 per unit, operating leverage is 6, combined leverage is 24. If tax rate is 30%, what would be its earnings after tax? (Nov 2008, 3 marks)
Answer:
Contribution = 1,000 units @ 60 per unit
= ₹ 60,000
Operating leverage = 6
Operating leverage = \(\frac{\text { Contribution }}{\mathrm{EBIT}} \)
6 = \(\frac{60,000}{\mathrm{EBIT}}\)
EBIT = \(\frac{60,000}{6}\) = ₹ 10,000

combined leverage = 24
Combined leverage = Operating leverage × Financial leverage
24 = 6 × FL
Financial leverage = 4
Financial Leverage = \(\frac{\text { EBIT }}{\text { EBT }}\)
4 = \(\frac{10,000}{\text { EBT }} \)
∴ EBT = ₹ 2,500
Earnings before tax = ₹ 2,500
(-)tax@30% = ₹ 750
Earnings after tax (EAT) = ₹ 1,750

Question 11.
From the following Financial data of Company A and Company B:
Prepare their Income statements.

(Nov 2009, 8 Marks)
Answer:

Working Notes:
Company A
(i) Financial Leverage = \(\frac{\text { EBIT }}{\text { EBIT-Interest }}\)
5 = \(\frac{\text { EBIT }}{\text { EBIT }-12,000}\)
5(EBIT-12,000) = EBIT
4 EBIT = 60,000
∴ EBIT = ₹ 15,000

(ii) Contribution = EBIT + Fixed Cost
Contribution = 15,000 + 20,000
∴ Contribution = ₹ 35,000

(iii) Sales = Contribution + Variable Cost
Sales = 35,000 + 56,000
∴ Sale = ₹ 91,000

Company B
(i) Contribution = 40% of Sales (as variable Cost is 60% of Sales)
= 40%of 1,05,000
= ₹ 42,000

(ii) Operating Leverage = \(\frac{\text { Contribution }}{\mathrm{EBIT}} \)
4 = \(\frac{42,000}{E B I T} \)
Hence EBIT = \(\frac{42,000}{4}\) = ₹ 10,500
(iii) Fixed Cost = Contribution – EBIT
= 42,000 – 10,500 = ₹ 31,500

Question 12.
Calculate the degree of operating leverage, degree of financial leverage and the degree of combined leverage for following firms and interpret the results:

(Nov 2010, 4 Marks)
Answer:

Question 13.
You are given two financial plans of a company which has two financial situations. The detailed information are as under:

You are required to calculate operating leverage and financial leverage of both the plans. (May 2011, 5 marks)
Answer:
Computation of Operating and Financial Leverage
Actual Production and Sales:
(60% of 10,000 = 6,000 units)
Contribution per unit:
₹ 30 – ₹ 20 = ₹ 10
Total Contribution:
6,000 × ₹ 10 = ₹ 60,000

Question 14.
Alpha Ltd. has furnished the following Balance Sheet as on March 31, 2011:

Additional informations:
1. Annual Fixed Cost other than Interest 28,00,000
2. Variable Cost Ratio 60%
3. Total Assets Turnover Ratio 2.5
4. Tax Rate 30%
You are required to calculate:
(i) Earning Per Share (EPS), and
(ii) Combined Leverage. (Nov 2011, 8 marks)
Answer:
Total Assets = ₹ 48,00,000
Total Assets Turnover Ratio = 2.5
Total Sales = 48,00,000 x 2.5 = ₹ 1,20,00,000

(i) EPS = \(\frac{\text { PAT }}{\text { No. of EquityShare }}=\frac{11,60,000}{1,00,000} \) = ₹ 11.06

(ii) CL = Operating leverage x Financial leverage
= \(\frac{\text { Contribution }}{\mathrm{EBIT}} \times \frac{\mathrm{EBIT}}{\mathrm{PBT}} \) Or = \(\frac{\text { Contribution }}{\text { PBT }} \)
= \(\frac{48,00,000}{15,80,000}\) = 3.04

Question 15.
The capital structure of JCPL Ltd. is as follows:

Additional Information:
Profit after tax (tax rate 30%) ₹ 1,82,000
Operating expenses (including depreciation ₹ 90,000) being 1.50 times of EBIT
Equity share dividend paid 15%.
Market price per equity share 20.
Required to calculate:
(i) Operating and financial leverage.
(ii) Cover the preference and equity share dividends.
(iii) The earning yield and price earning ratio.
(iv) The net fund flow. (May 2012, 8 marks)
Answer:
[Assumption: All operating expenses (excluding depreciation) are variable]

(i) Operation Leverage = Contribution/EBIT
= (7,50,000 – 3,60,000)13,00,000
= 3,90,000/3,00,000 = 1.30 times.
Financial Leverage = EBIT/EBT = 3,00,000/2,60,000
= 1.15 times
OR
FL = \(\text { EBIT / EBT – }\left(\frac{\text { Pret. Dividend }}{1-t}\right)\)
= \(\frac{3,00,000}{2,60,000-\left(\frac{50,000}{1-0.3}\right)} \)
= \(\frac{3,00,000}{2,60,000-(71,429)} \)
= \(\frac{3,00,000}{1,88,571} \) = 1.59 = 1.6

(ii) Preference Dividend Cover = PAT/Preference share Dividend
= 1,82,000/50,000 = 3.64 times
Equity dividend cover = PAT – Prof. div/Equity dividend
= 1,82,000 – 50,000/1,20,000
= 1. 10 times

(iii) Earning yield = EPS/market price x 100 i.e.
= 1,32,000/80,000 = 1.65/20 = 8.25%
Price Earning Ratio = Market price/EPS = 20/1.65
= 12.1 Times

(iv) Net Funds Flow
Net Funds flow = Net profit after tax + depreciation – Total dividend
= 1,82,000+ 90,000- (50,000 + 1,20,000)
= 2,72,000 – 1,70,000
Net funds flow = 1,02,000

Question 16.
X Limited has estimated that for a new product, its break-even point is 20,000 units if the item is sold for ₹ 14 per unit and variable cost ₹ 9 per unit. Calculate the degree of operating leverage for sales volumes 25,000 units and 30,000 units. (Nov 2012, 5 marks)
Answer:
Computation of Degree of Operating Leverage
Selling Price = ₹ 14/ unit
Variable Cost = ₹ 9/ unit
Fixed Cost = BEP × (Selling price – Variable cost)
= 20,000x(14- 9)= 20,000 × 5
= 1,00,000

Question 17.
The following information related to XL Company Ltd. for the year ended 31st March 2013 are available to you:
Equity share capital of ₹ 10 each ₹ 25 lakh
11% Bonds of ₹ 1,000 each ₹ 18.5 lakh
Sales ₹ 42 lakh
Fixed cost (Excluding Interest) ₹ 3.48 lakh
Financial leverage 1.39
Profit-Volume Ratio 25.55%
Income Tax Rate Applicable 35%
You are required to calculate:
(I) Operating Leverage;
(ii) Combined Leverage; and
(iii) Earning Per Share. (May 2013, 6 marks)
Answer:
Profit – Volume Ratio = \(\frac{\text { Contribution }}{\text { Sales }} \)
25.55 = \(\frac{\text { Contribution }}{42,00,000} \times 100 \)
Contribution = 10,73,100

(i) Operating Leverage = \(\frac{\text { Contribution }}{\text { Contribution – Fixed Cost }}\)
= \(\frac{10,73,100}{10,73,100-3,48,000}\)
= \(\frac{10,73,100}{7,25,100} \)
= 1.48

(ii) Combined Leverage = Operating Leverage × Financial Leverage
= 1.48 × 1.39 = 2.06

(iii) Earnings Per Share (EPS)
Number of Equity Shares = 2,50,000
Earnings Before Tax (EBT) = Sales – Variable Cost – Fixed Cost – interest
EBT = 4200,000 – 31,26,900 – 3,48,000 – 2,03,500 = 5,21,600

Profit After Tax (PAT) = EBT – Tax
= 5,21,600 – 1,82,560
= 3,39,040
EPS = \(\frac{3,39,040}{2,50,000}\) = 1.3561
EPS = 1.36

Question 18.
Calculate the degree of operating leverage, degree of financial leverage and the degree of combined leverage for the following firms:

(Nov 2013, 5 Marks)
Answer:

Question 19.
A company had the following Balance Sheet as on 31st March 2014:

The additional information given is as under:
Fixed Cost per annum (excluding interest) ₹ 4 crores
Variable operating cost ratio 65%
Total assets turnover ratio 2.5
Income Tax rate 30%
Required:
Calculate the following and comment:
(i) Earnings Per Share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage (May 2014, 8 marks)
Answer:
(i) Calculation of Earning Per Share:

Particulars	Amt. (₹ In crores)
Sales (W.N.1)	50.00
Less: Variable cost @ 65%	32.50
Contribution	17.50
Less: Fixed cost	4.00
EBIT	13.50
Less: Interest on Debenture @ 15%	1.50
EBT	12.00
Less: Tax @ 30%	3.60
EAT (Earning After Tax)	8.40
÷ No. of Equity Shares	0.50
EPS	₹ 16.80

Working Note 1:
Calculation ot Sales:
Total Asset Turnover Ratio = \(\frac{\text { Sales }}{\text { TA }} \)
∴ Sales = 2.5 × 20 = 50 (Crores)

Question 20.
The Capital structure of RST Ltd. is as follows:

Additional Information:
Profit after tax (Tax Rate 30%) are ₹ 2,80,000
Operating Expenses (including Depreciation ₹ 96,800) are 1.5 times of EBIT
Equity Dividend paid is 15%
The market price of Equity Share is ₹ 23 Calculate:
(i) Operating and Financial Leverage
(ii) Cover for preference and equity dividend
(iii) The Earning Yield Ratio and Price Earning Ratio
(iv) The Net Fund Flow
Note: All operating expenses (excluding depreciation) are variable. (Nov 2014, 8 marks)
Answer:

(i) Operating Leverage
= \(\frac{\text { Contribution }}{\mathrm{EBIT}} \)
= \(\frac{(12,10,000-6,29,200)}{4,84,000} \)
= \(\frac{5,80,800}{4,84,000}\) = 1.2 times

Financial Leverage = \(\frac{\mathrm{EBIT}}{\mathrm{EBT}}\)
= \(\frac{4,84,000}{4,00,000}\) = 1.21 times
Or
Financial Leverage = \(\frac{\text { EBIT }}{\text { EBT }-\left(\frac{\text { Preference Dividend }}{1-t}\right)}\)
= \(\frac{4,84,000}{4,00,000-\left(\frac{50,000}{1-0.30}\right)} \)
= \(\frac{4,84,000}{4,00,000-71,428.57}\)
= \(\frac{4,84,000}{3,28,571}\) = 1.47 times

(ii) Cover for Preference Dividend
= \(\frac{\text { PAT }}{\text { Preference Share Dividend }} \)
= \(\frac{2,80,000}{50,000} \) = 5.6 times

Cover for Equity Dividend
= \(\frac{(\text { PAT }- \text { Preference Dividend })}{\text { Equity Share Dividend }} \)
= \(\frac{(2,80,000-50,000)}{1,20,000} \)
= \(\frac{2,30,000}{1,20,000} \) = 1.92 times

(iii) Earning Yield Ratio
= \(\frac{\text { EPS }}{\text { MarketPrice }} \times 100\)
= \(\left(\frac{\frac{2,30,000}{80,000}}{23} \times 100\right)\)
= \(\frac{2.875}{23} \times 100 \) = 12.5%

Price – Earnings Ratio (PE Ratio)
= \(\frac{\text { Market Price }}{\text { EPS }}=\frac{23}{2.875} \)

(iv) Net Funds Flow
= Net PAT + Depreciation – Total DMdend
=2,80,000+96,800- (50,000 + 1,20,000)
= 3,76,800 – 1,70,000
Net Funds Flow = 2,06,800

Question 21.
Following information are related to four firms of the same industry:

Find out:
(i) degree of operating leverage, and
(ii) degree of combined leverage for all the firms. (May 2015, 5 marks)
Answer:
(i) Degree of operating leverage:
Degree of operating leverage =

P = \(\frac{25 \%}{27 \%}\) = 0.926 times

Q= \(\frac{32 \%}{25 \%}\) = 1.280 times

R = \(\frac{36 \%}{23 \%}\) = 1.57 times
S = \(\frac{40 \%}{21 \%}\) = 1.905 times

(ii) Degree of combined leverage:
Degree of combined leverage = \(\frac{\text { Percentage change in EPS }}{\text { Percentage change in sales }} \)
P = \(\frac{30 \%}{27 \%}\) = 1.1 1 times
Q = \(\frac{24 \%}{25 \%}\) = 0.960 times
R = \(\frac{21 \%}{23 \%} \) = 0.913 times
S = \(\frac{23 \%}{21 \%}\) = 1.095 times

Question 22.
From the following details of X Ltd., prepare the Income Statement for the year ended 31st December 2014:
Financial Leverage 2
Interest ₹ 2,000
Operating Leverage 3
Variable cost as a percentage of sales 75%
Income tax rate 30% (Nov 2015, 5 marks)
Answer:

Working Note:
Calculation for EBIT:
Financial Leverage = \frac{\text { EBIT }}{\text { EBT }}\(\)
2 = \(\frac{\text { EBIT }}{\text { EBIT – Interest }} \)
2 = \(\frac{\text { EBIT }}{\text { EBIT }-2,000}\)
2 EBIT – 4,000 = EBIT
EBIT = 4,000

2. Calculation for Contribution:
Operating Leverage = \(\frac{\text { Contribution }}{\text { EBIT }} \)
3 = \(\frac{\text { Contribution }}{4,000} \)
Contribution = ₹ 12,000

3. Calculation for Sales & Variable Cost:
Variable cost as a percentage of sales = 75%
So, contribution is 25% of sales
Sales = \(\frac{\text { Contribution }}{25 \%} \)
= \(\frac{12,000}{25 \%}\)
Sales = 48,000
Variable Cost = ₹ 48,000 × 75%
Variable Cost = ₹ 36,000

4. Fixed Cost:
Fixed Cost = Contribution – EBIT
= 12,000 – 4,000
= ₹ 8,000

Question 23.
A company had the following balance sheet as on 31st March 2015.

The additional information given is as under:
Fixed cost per annum (excluding interest) ₹ 32,00,000
Variable operating cost ratio 70%
Total assets turnover ratio 2.5
Income tax rate 30%
Calculate the following:
(i) Operating Leverage
(ii) Financial Leverage
(iii) Combined Leverage
(iv) Earning per share (May 2016, 5 marks)
Answer:

– Operating Leverage
\(\frac{\text { Contribution }}{\text { EBIT }}=\frac{1,20,00,000}{88,00,000}\) = 1.364
– Financial Leverage
\(\frac{\text { EBIT }}{\text { EBT }}=\frac{88,00,000}{76,00,000}\) = 1.158
– Combined Leverage
Operating Leverage × Financial Leverage
(1.364 × 1.158) = 1.58

Question 24.
The following information is related to YZ Company Ltd. for the year ended 31st March, 2016:
Equity is are capital (of ₹ 10 each) ₹ 50 lakhs
12% Bonds of ₹ 1000 each ₹ 37 lakhs
Sales ₹ 84 lakhs
Fixed cost (excluding interest) ₹ 6.96 lakhs
Financial leverage 1.49
Profit-volume Ratio 27.55%
Income Tax Applicable 40%
You are required to câlculate:
(i) Operating Leverage;
(ii) Combined leverage; and
(iii) Earnings per share.
Show calculations upto two decimal points. (Nov 2016, 5 marks)
Answer:
(i) Calculation of Operating leverage:
Degree of operating leverage = \(\frac{\text { Contribution }}{\mathrm{EBIT}}\)
= \(\frac{₹ 23,14,200(\mathrm{WN}-1)}{₹ 16,18,200(\mathrm{WN}-2)} \)
= 1.43.

Working Notes:
1. Calculation of Contribution PN Ratio = \(\frac{\text { Contribution }}{\text { Sales }} \)
27 55% = \(\frac{\text { Contribution }}{₹ 84,00,000}\)
∴ Contribution = 84,00,000 × 27.55%
= ₹ 23,14,200.

2. Calculation of EBIT:
EBIT = Contribution – Fixed Cost (Excluding Interest)
= ₹ 23,14,200 – ₹ (6,96,000)
= ₹ 16,18,200.

(ii) Calculation of Combined leverage:
Degree of combined leverage = Operating Leverage x Financial Leverage
= 1.43 × 1.49
= 2.13.

Question 25.
You are given the following information of 5 firms of the same industry:

Name of the Firm	Change in Revenue	Change In Operating income	Change Earning per in Share
M	28%	26%	32%
N	27%	34%	26%
P	25%	38%	23%
Q	23%	43%	27%
R	25%	40%	28%

You are required to calculate:
(i) Degree of operating leverage and
(ii) Degree of combined leverage for all firms. (May 2017, 5 marks)
Answer:

Question 26.
The following details of a company for the year ended 31st March, 2017 are given below:
Operating leverage, 2:1
Combined leverage 2:5:1
Fixed Cost excluding interest ₹ 3.4 lakhs
Sales ₹ 50 lakhs
8% Debentures of ₹ 100 each ₹ 30.25 lakhs
Equity Share Capital of ₹ 10 each ₹ 34 lakhs
Income Tax Rate 30%
Required:
(i) Calculate Financial Leverage
(ii) Calculate PN ratio and Earning per Share (EPS)
(iii) If the company belongs to an industry, whose assets turnover is 1.5 does it have a high or low assets turnover?
(iv) At what level of sales, the Earning before Tax (EBT) of the company will be equal to zero? ( Nov 2017, 8 marks)
Answer:
(i) Financial Leverage
Combined Leverage = Operating Leverage × Financial Leverage
∴ 2.5 = 2 × FL
∴ FL = \(\frac{2.5}{2}\) = 1.25

(ii) PN Ratio and EPS
P/V Ratio = \(\frac{\text { Contribution }(\mathrm{c})}{\text { Sales }(\mathrm{s})} \times 100 \)
OL = \(\frac{\text { C }}{\text { C-Fixed Cost }}\)
2 = \(\frac{C}{C-3,40,000}\)
2C – 6,80,000=C
∴ C = 6,80,000
P/V Ratio = \(\frac{6,80,000}{50,00,000} \times 100\) = 13.6%
EPS = \(\frac{\text { Profit after tax }}{\text { No. of Equity Shares }}\)
EBT = Sales – V- FC- Interest
50,00,000 – 432O,OOO – 3,40,000 – 2,42,000 = 98,000
PAT=EBT-Tax
= 98,000 – 29,400 = 68,600
EPS = \(\frac{68,600}{3,40,000}\) = 0.201 76.

(iii) Assets Turnover = \( \frac{\text { Sales }}{\text { Total Assets }}\)
= \(\frac{50,00,000}{64,25,000}\) = 0.778
0.778 < 1.5 Means lower than industry turnover.

(iv) EBT zero means 100% production in EBT since combined Leverage 2.5 sales have to be dropped by 100/2.5 = 40. Hence, new sales will be 50,00,000 × [100% – 40%] = 30,00,000. Therefore, at 30,00,000 level of sales, the EBT of company Will be equal to zero.

Question 27.
The following data have been extracted from the books of LM Ltd:
Sales – ₹ 100 lakhs Interest Payable per annum – ₹ 10 lakhs
Operating leverage – 1.2
Combined leverage – 2.16
You are required to calculate:
(i) The financial leverage
(ii) Fixed cost and
(iii) P/V ratio. (May 2018, 5 marks)
Answer:
(i) The financial leverage: Combined Leverage = Operating Leverage x Financial Leverage 2.16 = 1.2 x FL Financial Leverage (FL) = 1.8

(ii) Fixed Cost: Financial Leverage = \(\frac{\text { EBIT }}{\text { EBT }}\) Financial Leverage = \(\frac{\mathrm{EBIT}}{\mathrm{EBIT}-\text { Interest }}\) 1.8 = \(\frac{\text { EBIT }}{\text { EBIT }-10,00,000}\) 1.8 EBIT- 18,00,000 = EBIT 0.8 EBIT = 18,00,000 EBIT = ₹ 22,50,000 Operating Leverage = \(\frac{\text { Contribution }}{\mathrm{EBIT}} \) Operating Leverage = \(\frac{\text { EBIT + FixedCost }}{\text { EBIT }}\) 1.2 = \(\frac{22,50,000+\text { FixedCost }}{22,50,000}\) 27,00,000 = 22,50,000 + Fixed Cost Fixed Cost = ₹ 4,50,000

(iii) P/V ratio = Contribution = EBIT + Fixed Cost = 22,50,000 + 4,50,000 = 27,00,000 P/V ratio = \(\frac{\text { Contribution }}{\text { Sales }} \times 100\) = \(\frac{27,00,000}{1,00,00,000} \times 100\) P/V ratio = 27%

Question 28.
Following is the Balance Sheet of Soni Ltd. as on 31st March, 2018:

Additional Information:
(i) Variable Cost is 60% of Sales.
(ii) Fixed Cost p.a. excluding interest ₹ 20,00,000.
(iii) Total Asset Turnover Ratio is 5 times.
(iv) Income Tax Rate 25%.
You are required to:
(1) Prepare Income Statement
(2) Calculate the following and comment:
(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage. (Nov 2018, 10 marks)
Answer:
1. Income Statement: Total Assets 1,00,00,00 Total Asset Turnover Ratio = 5 times Hence, Total Sales = ₹ 1,00,00,000 × 5 = 5,00,00,000

EPS = \(\frac{\text { PAT }}{\text { No. of Equity Shares }}=\frac{₹ 1,30,50,000}{2,50,000}\) = ₹ 52.50

2. (a) Operating Leverage: Operating Leverage = \(\frac{\text { Contribution }}{\text { EBIT }}=\frac{₹ 2,00,00,000}{₹ 1,80,00,000}\) = 1.111
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.

(b) Financial Leverage: . Financial Leverage = \(\frac{\text { EBIT }}{\text { PBT }}=\frac{₹ 1,80,00,000}{₹ 1,74,00,000}\) = 1.034 The financial leverage is very comfortable since the debt service obligation is small vis-a-vis EBIT.

(c) Combined Leverage: Combined Leverage = \(\frac{\text { Contribution }}{\mathrm{EBIT}} \times \frac{\mathrm{EBIT}}{\mathrm{PBT}}\) Or, = Operating Leverage x Financial Leverage = 1.111 × 1.034 = 1.149
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-a-vis the change in sales. The leverages – operating, financial, and combined are measures of risk.

Question 29.
The capital structure of the Shiva Ltd. consists of equity share capital of ₹ 20,00,000 (Share of ₹ 100 per value) and ₹20,00,000 of 10% Debentures, sales increased by 20% from 2,00,000 units to 2,40,000 units, the selling price is 10 per unit; variable costs amount to 6 per unit and fixed expenses amount to ₹ 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 increasing in production from 2,00,000 units to 2,40,000 units. (May 2019, 10 marks)
Answer:

(i) Earning per share (EPS) = \(\frac{₹ 1,00,000}{20,000} \) = ₹ 5 \(\frac{₹ 1,80,000}{20,000} \) = ₹ 9
(ii) Financial Leverage = \(\frac{E B T}{\text { EBT }}\) \(\frac{₹ 4,00,000}{₹ 2,00,000} \) = 2 \(\frac{₹ 5,60,000}{₹ 3,60,000}\) = 1.56
(iii) Operating Leverage= \(\frac{\text { Contribution }}{\text { BiT }} \frac{₹ 8,00,000}{₹ 4,00,000} \) = 2 \(\frac{₹ 9,60,000}{₹ 5,60,000}\) = 1.71

(b) Financial leverage is represented by organization ability to recover interest component of debt. Here, with the every increase in unit sales, Financial leverage comes down as interest on debenture would remain the same. Operating leverage indicates fixed cost in cost structure. Since, the fixed cost remains the same, every increase in sales volume will decrease the value of operating leverage.

Question 30.
The Balance Sheet of Gita shree Ltd. is given below:

The company’s total asset turnover ratio is 4. Its fixed operating cost is ₹ 2,00,000 and its variable operating cost ratio is 60%. The income tax rate is 30%. Calculate: (i) (a) Degree of Operating leverage. (b) Degree of Financial leverage. (C) Degree of Combined leverage. (ii) Find out EBIT it EPS is (a) ₹ 1 (b) ₹ 2 and (c) ₹ 0. (N0v 2019, 10 marks) Answer: Total Assets = ₹ 6,00,000 Total asset Turnover Ratio = 4 Hence, Total Sales = ₹ 6,00,000 × 4 = ₹ 24,00,000

Question 31.
The information related to XYZ Company Ltd. for the year ended 31st March 2020 are as follows: Equity Share Capital of ₹ 100 each ₹ 50 Lakhs 12% Bonds of ₹ 1000 each ₹ 30 Lakhs Sales ₹ 84 Lakhs Fixed Cost (Excluding Interest) ₹ 7.5 Lakhs Financial Leverage 1.39 Profit – Volume Ratio 25% Market Price per Equity Share ₹ 200 Income Tax Rate Applicable 30% You are required to compute the following:
(i) Operating Leverage
(ii) Combined Leverage
(iii) Earning per share
(iv) Earning Yield (Jan 2021, 10 marks)

Question 32.
Calculate the operating leverage, financial leverage, and combined leverage from the following data under Situation I and II and Financial Plan A and B;
Installed Capacity 4,000 units
Actual Production and Sales 75% of the Capacity
Selling Price ₹ 30 per unit
Variable Cost ₹ 15 per unit
Fixed Cost:
Under Situation – I ₹ 15,000
Under Situation – II ₹ 20,000
Capital Structure: Financial Plan A (₹) B (₹)
Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 20,000
5,000 20,000
Answer:

Question 33.
Financial Leverage is a double-edged sword Discuss.
Answer:
Financial leverage (FL) is defined as the use of funds with a fixed cost in order to increase earnings per share. It is the use of company funds on which it pays a limited return. Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to common stockholders.

Financial Leverage (FL) = \(\frac{\text { Earnings before interest and tax }(\mathrm{EBIT})}{\text { Earnings before tax (EBT) }} \)
Financial Leverage is a double-edged sword. When cost of fixed cost fund’ is less than the return on investment financial leverage will help to increase return on equity and EPS. The firm will also benefit from the saving of tax on interest on debts etc.

However, when cost of debt will be more than the return it will affect return of equity and EPS unfavorably and as a result firm can be under financial distress. This is why financial leverage is known as “double-edged sword.”

Effect on EPS and ROE:
When, ROI> Interest – Favourable – (Advantage)
When, ROI> Interest – Unfavourable – (Disadvantage)
When, ROI> Interest -Neutral- (Neither advantage nor disadvantage)

Question 34.
A Company had the following Balance Sheet as on March 31, 2019:

The additional information given is as under:.
Fixed Costs per annum (excluding interest) ₹ 80 crores
Variable operating costs ratio 65%
Total Assets turnover ratio 2.5
Income-tax rate 40%
Required:
CALCULATE the following and comment:
(i) Earnings per share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage.
Answer:
Total Assets = ₹ 400 crores
Asset Turnover Ratio = 2.5
Hence, Total Sales = 400 x 2.5 = ₹ 1,000 crores

(i) Earnings per share (EPS)
∴ EPS = \(\frac{₹ 144 \text { crores }}{10 \text { crore equity shares }}\) = 14.40
(ii) Operating Leverage
Operating leverage = \(\frac{\text { Contribution }}{\text { EBIT }}=\frac{350}{270} \) = 1.296
It indicates the sensitivity of earnings before interest and tax (EBIT) to changes in sales at a particular level.

(HI). Financial Leverage
Finance Leverage = \(\frac{\mathrm{EBIT}}{\mathrm{EBT}}=\frac{270}{240} \) =1.125
The financial leverage is very comfortable since the debt service obligation is small vis-a-vis EBIT.

(iv) Combined Leverage
Combined Leverage = \(\frac{\text { Contribution }}{\mathrm{EBIT}} \times \frac{\mathrm{EBIT}}{\mathrm{EBT}} \)
Or, Operating Leverage × Financial Leverage =1.296 × 1.125=1.458
The combined leverage studies the choice of fixed cost in cost structure and the choice of debt in capital structure. It studies how sensitive the change ¡n EPS is vis-a-vis change in sales.

Financing Decisions Capital Structure – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Financing Decisions Capital Structure – CA Inter FM Question Bank

Question 1.
Answer the following:
What is Optimum Capital Structure? Explain. (Nov 2007, 2 marks)
OR
Answer the following:
Discuss the concept of ‘Optimál Capital Structure.” (Nov 2008, 2 marks)
Answer:
Capital structure is optimum when the value of the firm is maximum and Cost of capital (debts & equity) is minimum and so market price per share is maximum, Which leads to the maximization of the value of the firm.

An optimal capital structure should possess the following features:

1. Maximization of profitability: by using leverage minimum cost.
2. Flexibility: structure should be flexible so that company may be able to raise fund or reduce fund whenever ¡t is required.
3. Control: It should reduce the risk of dilution of control.
4. Solvency: Excessive debt may threaten the solvency of the company.

According to this:

1. If a company takes on debt, the value of the firm increases up to a certain point. Beyond that value of the firm will start to decrease.
2. If the company is unable to pay the debt within the specified period then it will affect the goodwill of the company in the market. Hence, company should select appropriate capital structure with due consideration of all factors.

Question 2.
Answer the following:
What do you understand by Capital structure? How does it differ from Financial structure? (May 2010, 2 marks)
Answer:
Meaning of Capital Structure and Its Difference from Financial Structure: Capital Structure refers to the combination of debt and equity which a company uses to finance its long-term operations. It is the permanent financing of the company representing long-term sources of capital. owner’s equity and long-term debts but excludes current liabilities. Whereas, Financial Structure is the entire left-hand side of the balance sheet which represents all the long-term and short-term sources of capital. Thus, capital structure is only a part of financial structure.

Question 3.
What do you mean by capital structure? State its significance in financing decisions. (Nov 2013, 4 marks)
Answer:
Capital Structure refers to the composition of long-term sources of funds, such as debentures, long-term debt, preference share capital, and ordinary share capital including reserves and surplus (retained-earning). It is the permanent financing of the firm, represented by long-term debt, preferred stock, and net worth. Thus, capital structure ordinarily implies the proportion of debt and equity in the total capital of a company. Since a company may tap any one or more of the different available sources of funds to meet its total financial requirement. The total capital of a company may, thus, be composed of all such tapped sources.

The capital structure should be planned generally keeping in view the interests of the equity shareholders and the financial requirements of a company. An optimum capital structure can be defined as a financial plan having an appropriate debt-equity mix which minimises overall cost of capital of the firm and maximizes the market price per share or the total value of the firm. Hence, the optimal capital structure is concerned with the two important variables at one time – the minimization of cost as well as maximization of worth.

Question 4.
State three assumptions of Modigliani and Miller’s approach to Cost of Capital. (Nov 2002, 3 marks)
Answer:
The Theory: Franco Modigliani and Meron H. Miller developed a hypothesis which is actually an extension of net operating income approach. “According to the theory, in absence of corporate tax, cost of capital and the market value of equity share is independent to the changes in capital structure or degree of leverage.”

Explanation: The M-M hypothesis gave two propositions, which are as follows:
Proposition I: The market value of the firm (V) and the cost of capital (ko) are independent of its capital structure.
Proposition II: The firm’s cost of equity increases to offset the use by cheaper debt capital. In other words, the firm’s use of debt increases its cost of equity as well.

Assumptions:

1. The investors are free to buy and sell the securities is the securities are traded in perfect market.
2. The expectations of investors are same and homogenous.
3. The firms can be classified into homogeneous dass.
4. The dividend payout ratio is 100%
5. There are no corporate taxes.

Question 5.
Discuss the relationship between the cost of equity and financial leverage in accordance with MM Proposition II. (May 2004, 3 marks)
Answer:
Proposition II: The firm’s cost of equity increase to offset the use by cheaper debt capital. In other words, the firms use of debt increases its cost of equity as well. The cost of capital k0 is equal to sum of constant average cost of capital k0 and a premium for financial risk
Thus k₀ = k₀ + Risk premium

Where,
Risk premium = (k₀ – k_e) D/s
∴ K_e = k₀ + (k₀ – k_e) D/s
The proposition II presumes a linear relationship between k and debt-equity ratio (D/s).
Graphical representation:

Assumptions:

1. The investors are tree to buy and sell the securities ¡s the securities are traded in the perfect market.
2. The expectations of investors are same and homogenous.
3. The firms can be classified into homogeneous class.
4. The dividend payout ratio is 100%
5. There is no corporate taxes.

Question 6.
Explain in brief the assumptions of Modigliani-Miller theory. (Nov 2007, 2 marks)
Answer:
The Theory: Franco Modigliani and Meron H. Miller developed a hypothesis which is actually an extension of net operating income approach. “According to the theory, in absence of corporate tax, cost of capital and the market value of equity share ¡s independent to the changes in capital structure or degree of leverage.”

Explanation: The M-M hypothesis gave two propositions, which are as follows:
Proposition I: The market value of the firm (V) and the cost of capital (ko) are independent of its capital structure.
Proposition II: The firm’s cost of equity increases to offset the use by cheaper debt capital. In other words, the firm’s use of debt increases its cost of equity as well.

Assumptions:

1. The Investors are free to buy and sell the securities is the securities are traded in perfect market.
2. The expectations of investors are same and homogenous.
3. The firms can be classified into homogeneous class.
4. The dividend payout ratio is 100%
5. There are no corporate taxes.

Question 7.
Explain the assumptions of Net Operating Income approach (NOI) theory of capital structure. (Nov 2007, 3 marks)
Answer:
The Theory
According to the net operating income approach, the market value of the firm depends upon the net operating profit or EBIT and the WACC. The financing mix or capital structure is irrelevant and does not affect the value of the firm.

Explanation
The market value of the firm is not affected by the capital structure changes. For a given value of EBIT, the value of the firm remains the same irrespective of the capital composition. It however depends upon the WACC.

Question 8.
What is Net Operating income theory of capital structure? Explain the assumptions on which the NOl theory is based. (May 2012, 4 marks)
Answer:
Net Operating Income (NOI) Theory of Capital Structure
There is no relationship between the cost of capital and value of the firm. Under Net Operating Income (NOI) the value of the firm is independent of the capital structure of the firm.

Assumptions of NOI Approach:

1. There are no taxes.
2. The overall cost of capital remains same for all degrees of debt-equity mix.
3. The market capitalizes the value of the firm as a whole. Thus the split between debt and equity is not important.
4. The increase in proportion of debt in capital structure leads to change in risk perception of the shareholders i.e. increase in cost of equity (K_e). The increase in cost of equity is such as completely offsets the benefits of using cheaper debt.

Question 9.
There are two firms P and Q which are identical except P does not use any debt in its capital structure while Q has ₹ 8,00,000, 9% debentures in its capital structure. Both the firms have earnings before interest and tax of ₹ 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 the MM Hypothesis. (Nov 2009, 3 marks)
Answer:
Calculation of value of firms P and Q according to MM Hypothesis Market value of firm P (Unlevered)
V_u = \(\frac{E B I T(1-t)}{K_e}\)
= \(\frac{2,60,000(1-0.30)}{10 \%}\)
= \(\frac{₹ 1,82,000}{10 \%}\) = ₹ 18,20,000

Market Value of Firm Q (Levered)
V_E =V_u +DT
= ₹ 18,20,000 + (8,00,000 × 0.30)
= ₹ 18,20,000 + 2,40,000 = ₹ 20,60,000

Question 10.
RES Ltd. is an all-equity financed company with a market value of ₹ 25,00,000 and cost of equity, k_e =21%. The company wants to buy back equity shares worth ₹ 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 k_e
(iii) Weighted average cost of capital and comment on it. (May 2012, 5 marks)
Answer:
Computation of Market Value, Cost of Equity and WACC of RES Ltd.
Market Value of Equity = 25,00,000
K_e = 21%
\(\frac{\text { Net income }(\mathrm{NI}) \text { for equity holders }}{\mathrm{K}_e} \) = Market Value of Equity
\(\frac{\text { Net income }(\mathrm{NII}) \text { for equity holders }}{0.21}\) = 25,00,000
Net income for equity holders = 5,25,000
EBIT = 5,25,000/0.7 = 7,50,000

Particulars	All Equity	Debt and Equity
EBIT	7,50,000	7,50,000
Interest to debt-holders	–	75,000
EBT	7,50,000	6,75,000
Taxes (30%)	2,25,000	2,02,500
Income available to equity shareholders	5,25,000	4,72,500
Income to debt holders plus income available to shareholders	5,25,000	5,47,500

Present value of tax-shield benefits = 5,00,000 x 0.30 = 1,50,000
(i) Value of Restructured firm
= 25,00,000 + 1,50,000 = 26,50,000

(ii) Cost of Equity (K_e)
Total Value = 26,50,000
Less: Value of Debt = 5,00,000
Value of Equity = 21,50,000
K_e = \(\frac{4,72,500}{21,50,000}\) = 0.219 = 22%

(iii) WACC
Cost of Debt (after tax) = 15% (1- 0.3) 0.15 (0.70) = 0.105 = 10.5%

Components of Costs	Amount	Cost of Capital	Weight	Weighted COC
Equity	21,50,000	0.22	0.81	0.178
Debt	5,00,000	0.105	0.19	0.020
	26,50,000			0.198

WACC =19.8%
Comment: At present, the company is all equity financed. So, K_e = K_o i.e. 21%. However, after restructuring, the K_o would be reduced to 19.81% and K_e would increase from 21% to 21.98%. Reduction in K_o and increase in K_e is good for the health of the company.

Question 11.
‘A’ Ltd. and ‘B’ Ltd. are identical in every respect except capital structure. ‘A’ Ltd. does not employ debts in its capital structure whereas ‘B’ Ltd. employs 12% Debentures amounting to ₹ 10 lakhs. Assuming that:
(i) All assumptions of M-M model are met.
(ii) Income-tax rate is 30%;
(iii) EBIT is ₹ 2,50,000 and .
(iv) The Equity capitalization rate of ‘A’ Ltd. is 20%.
Calculate the value of both the companies and also find out the Weighted Average Cost of Capital for both the companies. (Nov 2014, 5 marks)
Answer:
(i) Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd.’ according to MM Hypothesis Market Value of ‘A Ltd.’ (Unlevered)
V_u = \(\frac{E B / T(1-t)}{K_e} \)
= \(\frac{2,50,000(1-0.30)}{20 \%}\)
= \(\frac{1,75,000}{20 \%} \) = ₹ 8,75,000.

Market Value of ‘B Ltd.’ (Levered)
VE =Vu × DT
= 8,75,000 + (10,00,000 × 0.30)
= 8,75,000 + 3,00,000 = ₹ 11,75,000

(ii) Computation of Weighted Average Cost of Capital (WACC)
WACC of ‘A Ltd. = 20% (K_e= K_o)
WACC of ‘B Ltd.’

k_d = 12% (1- 0.3) = 12% × 0.7 = 8.4%
WACC = 14.90%.

Question 12.
PNR Limited and PXR Limited are identical in every respect except capital structure. PNR Limited does not employ debts in its capital structure whereas PXR Limited employs 12% Debentures amounting to ₹ 20,00,000. The following additional information are given to you:
(i) Income tax rate is 30%
(ii) EBIT is ₹ 5,00,000
(iii) The equity capitalization rate of PNR Limited is 20% and
(iv) AH assumptions of the Modigliani-Miller Approach are met.

Calculate:
(i) Value of both the companies,
(ii) Weighted average cost of capital for both the companies. (May 2017, 8 marks)
Answer:
Calculation of Value of Firms PNR Ltd. and PXR Ltd. according to MM Hypothesis:
(a) Market velue of Firm PNR (Unlevered)
V_u = \(\frac{E B \mid T(1-t)}{K_e} \)
V_u = \(\frac{5,00,000(1-0.3)}{0.20} \)
V_u = 17,50,000

(b) Market value of Firm PXR (Levered)
V_E = V_U+DT
V_E = 17,50000 + (20,00,000 × 0.30)
V_E = 23,50,000

2. Weighted Average Cost of Capital (According to M-M)
(a) WACC for PNR = 20% (Same as given in Que. Since only equity in capital)
(b) WACC for PXR

EBIT (-) Interest (12%)	5,00,000 (2,40,000)
EBT (-) Tax @ 30%	2,60,000 (78,000)
PAT	1,82,000
Value of Firm (-) Value of Debt	23,50,000 (20,00,000)
Value of Equity	3,50,000

∴ K_e = \(\frac{\text { PAT }}{\text { Value of Equity }}=\frac{1,82,000}{3,50,000}\) = 52%

Weighted Average Cost of Capital
Capital	Amount	Weight	Cost	W x C
Equity	3,50,000	0.1489	52%	7.75%
Debt	20,00,000	0.8511	8.40%	7.15%
	23,50,000		WACC	15%

Question 13
A Limited and B Limited are identical except for capital structures. An Ltd. has 60 percent debt and 40 percent equity, whereas B Ltd. has 20 percent debt and 80 percent equity. (All percentages are in market-value terms.) The borrowing rate for both companies is 8 percent in a no-tax world, and capital markets are assumed to be perfect.
(a)
(i) If X, owns 3 percent of the equity shares of A Ltd., determine his return if the Company has net operating income of ₹ 4,50,000 and the overall capitalization rate of the company, (K₀) is 18 percent.
(ii) Calculate the implied required rate of return on equity of A Ltd.
(b) B Ltd. has the same net operating income as A Ltd.
(i) Calculate the implied required equity return of B Ltd.
(ii) Analyse why does it differ from that of A Ltd. (Jan 2021, 10 marks)

Question 14.
Company P and Q are identical in all respects including risk factors except for debt/equity, company P having issued 10% debentures of ₹ 18 lakhs while company Q is uníevered. Both the companies earn 20% before interest and taxes on. their total assets of ₹ 30 lakhs. Assuming a tax rate of 50% and capitalization rate of 15% from an all-equity company.
Required:
CALCULATE the value of companies’ P and Q using (i) Net Income Approach and
(ii) Net Operating Income Approach.
Answer:
(i) Valuation under Net Income Approach

Particulars	P Amount (₹)	Q Amount (₹)
Earnings before Interest & Tax (EBIT) (20% of 30,00,000)	6,00,000	6,00,000
Less: Interest (10% of 18,00,000)	1,80,000
Earnings before Tax (EBT)	4,20,000	6,00,000
Less: Tax @ 50%	2,10,000	3,00,000
Earnings after Tax (EAT) (available to equity holders)	2,10,000	3,00,000
Value of equity (capitalized @ 15%)	14,00,000 (2,10,000 × 100/15)	20,00,000 (3,00,000 × 100/15)
Add: Total Value of debt	8,00,000	Nil
Total Value of Company	32,00,000	20,00,000

Question 15.
Discuss the major considerations in Capital structure planning. (Nov 2003, 6 marks)
OR
Discuss the major considerations in Capital Structure Planning. (May 2006, 6 marks)
Answer: –
The major considerations in Capital Structure Planning are:
1. Risk
2. Cost of capital
3. Control

1. Risk: Risk is a situation wherein the possibility of happening or non-happening of an event can be measured. With reference to capital structure planning, risk may be defined as the variability in the actual return from an investment and the estimated return as forecasted at the time of capital structure planning. While designing the capital structure the firm tries to keep the risk at minimum.

2. Cost of Capital: The cost of capital is the minimum rate of return that a firm must earn or, its investment to satisfy its various investors. Cost is thus, an important consideration ¡n capital structure planning.

3. Control: The decisions relating to capital structure are taken after keeping the control factor in mind. For e.g. when equity shares are issued the company automatically dilutes its controlling.

Question 16.
List the fundamental principles governing capital structure. (Nov 2012, 4 marks)
OR
State the principles that should be followed while designing the capital structure of a company. (May 2016, 4 marks)
Answer:
Fundamental Principles Governing Capital Structure
1. Cost Principle
According to this principle, an ideal pattern of capital structure is one that minimises cost of capital structure and maximises earnings per share (EPS).

2. Risk Principle
According to this principle, reliance is placed more on common equity for financing capital requirements than excessive use of debt. Use of more and more debt means higher commitment in form of interest payout. This would lead to erosion of shareholders’ value in unfavorable business situations.

3. Control Principle
While designing a capital structure, the finance manager may also keep in mind that existing management control and ownership remains undisturbed.

4. Flexibility Principle
It means that the management chooses such a combination of sources of financing which it finds easier to adjust according to changes in need of funds in future too.

5. Other Considerations
Besides above principles, other factors such as nature of industry, timing of issue, and competition in the industry should also be considered.

Question 17.
Akash Limited provides you the following information:

The company has reserves and surplus of ₹ 7,00,000 and required ₹ 4,00,000 further for modernization. Return on Capital Employed (ROCE) is constant. Debt (Debt/Debt + Equity) Ratio higher than 40% will bring the PIE 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.
(i) If the additional capital are raised as debt; and
(ii) If the amount is raised by issuing equity shares at the ruling market price.

Working Notes:
1. Calculation of existing Return of Capital Employed (ROCE):

2. Number of Equity Shares to be issued In Plan-II:
= \(\frac{₹ 4,00,000}{₹ 40}\) = 10,000 shares
Thus, after the issue total number of shares = 30,000 + 10,000 = 40,000 shares

3. Debt/Equity Ratio if ₹ 4,00,000 is raised as debt:
= \(\frac{₹ 8,00,000}{₹ 18,00,000} \times 100\) = 44.44%
As the debt-equity ratio is more than 40% the PIE ratio will be brought down to 8 in Plan-I.

Question 18.
Discuss the concept of Debt-Equity or EBIT-EPS indifference point, while determining the capital structure of a company. (May 2009, 2 marks)
Answer:
Concept of Debt-Equity or EBIT-EPS Indifference Point while Determining the Capital Structure of a Company The determination of the optimum level of debt 1h the capital structure of a company is a formidable task and is a major policy decision. It ensures that the firm is able to service its debt as well as contain its interest cost. Determination of optimum level of debt involves equalizing between return and risk.

EBIT-EPS analysis is a widely used tool to determine level of debt in a firm. Through this analysis, comparison can be drawn for various methods of financing by obtaining indifference points. It is point to the EBIT level at which EPS remain unchanged irrespective of debt level equity mix. For example indifference point for the capital mix (equity share capital and debt)
can be determined as follows:
\(\frac{\left(E B I T-I_1\right)(1-T)}{E_1}=\frac{\left(E B I T-I_2\right)(1-T)}{E_2} \)

Where,
EBIT = Indifference point
E₁ = Number of equity shares in Alternative 1
E₂ = Number of equity shares ¡n Alternative 2
I₁ = Interest charged in Alternative 1
I₂ = Interest charged in Alternative 2
T = Tax-rate
Alternative 1 = All equity finance
Alternative 2 = Debt-equity finance.

Question 19.
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 combination of proposals to raise its funds. You are given the following proposals of the company.

(ii) Cost of debt – 10%
Cost of preference shares – 10%
(iii) Tax rate – 50%
(iv) Equity shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per share.
(v) Total investment to be raised ₹ 40,00,000.
(vi) Expected earnings before interest and tax ₹ 18,00,000.
From the above proposals the management wants to take advice from you for appropriate plan after computing the following:
Earning per share
Financial break-even-point
Compute the EBIT range among the plans for indifference. Also, indicate if any of the plans dominate. (May 2011, 12 marks)
Answer:

(ii) Computation of Financial Break-even Points
Proposal ‘P’ = 0
Proposal ‘Q’ = ₹ 2,00,000 (Interest charges)
Proposal R’ = Earnings required for payment of preference share dividend i.e.
₹ 2,00,000 ÷ 0.5 (Tax Rate) = ₹ 4,00,000

(iii) Computation of indifference Point between the Proposals
The indifference point
\(\frac{\left(E B I T-1_1\right)(1-T)}{E_1}=\frac{\left(E B I T-1_2\right)(1-T)}{E_2} \)
Where,
EBIT = Earnings before interest and tax
1₁ = Fixed Charges (Interest) under Proposal ‘P’
1₂ = Fixed char3jinterest) under Proposal ‘Q’
T = Tax Rate’
E₁ = Number of Equity shares in Proposal P
E₂ = Number of Equity shares in Proposal Q

Combination of ProposaIs
(A) Indifference point where EBIT of proposal “P” and proposal ‘‘Q’’ is equal \(\frac{(EBIT-0)(1-0.5)}{2,00,000}=\frac{(E B I T-2,00,000)(1-0.5)}{1,00,000}\)
5 EBIT (1,00,000) = (.5 EBIT -1 ,00,000) 2,00,000
5 EBIT= EBIT – 2,00,000
EBIT = ₹ 4,00,000

(B) indifference point where EBIT of proposal ‘P’ and Proposal ‘R’ is equal:
\(\frac{(E B I T-1)(1-T)}{E_1}=\frac{(E B I T-12)(1-T)}{E_2} \) – Preference Share dividend
\(\frac{(E B I T-0)(1-.5)}{2,00,000}=\frac{(E B I T-0)(1-.5)-2,00,000}{1,00,000}\)
\(\frac{5 \mathrm{EBIT}}{2,00,000}=\frac{.5 \mathrm{EBIT}-2,00,000}{1,00,000} \)
25 EBIT = 0.5 EBIT – 2,00,000
EBIT = 2,00,000 ÷ 0.25
= ₹ 8,00,000

(C) Indifference point where EBIT of proposal ‘Q’ and proposal ‘R’ are equal \(\frac{(EBIT-2,00,000)(1-0.5)}{1,00,000}=\frac{(E B I T-0)(1-0.5)-2,00,000}{1,00,000} \)
0.5 EBIT – 1,00,000 = 0.5 EBIT – 2,00,000

There is no indifference point between proposal ‘Q’ and proposal ‘R’ Analysis:
It can be seen that Financial proposal ‘Q’ dominates proposal ‘R’, since the financial break-even point of the former is only ₹ 2,00,000 but in case of latter, it is ₹ 4,00,000.

Question 20.
X Ltd. is considering the following two alternative financing plans:

Particulars	Plan-I ₹	Plan-II ₹
Equity shares of ₹ 10 each	4,00,000	4,00,000
12% Debentures	2,00,000	–
Preference Shares of ₹ 100 each	–	2,00,000
	6,00,000	6,00,000

The indifference point between the plans is ₹ 2,40,000. The corporate tax rate is 30%. Calculate the rate of dividend on preference shares. (Nov 2013, 5 marks)
Answer:

For indifference between the above alternatives, EPS should be equal.
So \(\frac{1,51,200}{40,000 \text { shares }}=3.78=\frac{1,68,000-X}{40,000 \text { shares }}\)
Or 40,000 × 3.78 = 1,68,000 – X
Or X=16,800
So, Rate of Preference Dividend = \(\frac{16,800}{2,00,000} \) = 8.4%.

Question 21.
Alpha Limited requires funds amounting to ₹ 80 lakhs for its new project. To raise the funds, the company has following two alternatives:
(i) to issue Equity Shares (at par) amounting to ₹ 60 lakhs and borrow the balance amount at the interest of 12% p.a.; or
(ii) to issue Equity Shares (at par) and 12% Debentures in equal proportion.
The Income-tax rate is 30%.
Find out the point of indifference between the available two modes of financing and state which option will be beneficial in different situations. (Nov 2014, 5 marks)
Answer:
(i) Let the par value of equity share is be ₹ 1oo
Amount = ₹ 80 Lakhs
Plan I = Equity of ₹ 60 lakhs + Debt of ₹ 20 lakhs
Plan II = Equity of ₹ 40 Iakhs + Debentures of ₹ 40 Lakhs.

Plan I: Interest Payable on Loan
0.12 x 20,00,000 = 2,40,000

Plan II: Interest Payable on Debentures
= 0.12 x 40,00,000 = 4,80,000

Computation of Point of In difference
\(\frac{(E B I T-I)(I-t)}{E_1}=\frac{\left(E B I T-I_2\right)(I-t)}{E_2} \)
\(\frac{(E B I T-2,40,000)(1-0.3)}{60,000}=\frac{(E B I T-4,80,000)(1-0.3)}{40,000} \)
2 (EBIT- 2,40,000) =3 (EBIT – 4,80000)
2 EBIT – 4,80,000 = 3 EBIT – 14,40,000
2 EBIT -3 EBIT = -14,40,000 + 4,80,000
EBIT = 9,60,000

Comment: In situation A, when expected EBIT is less than the EBIT at indifference point then, Plan I is more viable as it has higher EPS. The advantage of EPS would be available from the use of equity capital and not debt capital.

Comment: Situation, when expected EBIT is more than the EBIT at indifference point then, Plan II is more viable as ¡t has higher EPS. The use of fixed costs. source of funds would be beneficial from the EPS viewpoint. In this case, financial leverage would be favourable.

(Note: The problem can also be computed by assuming any other figure of EBIT which is more than 9,60,000 and any other figure less than 9,60,000. Alternatively, the answer may also be based on the factors/governing the capital structure like the cost, risk, control, Principles, etc.)

Question 22.
India Limited requires ₹ 50,00,000 for a new Plant. This Plant is expected to yield earnings before interest and taxes of ₹ 10,00,000. 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 ₹ 5,00,000 or ₹ 20,00,000 or ₹ 30,00,000 and the balance, in each case, by issuing equity shares. The company’s share is currently selling at ₹ 150 but is expected to decline to ₹ 125 in case the funds are borrowed in excess of ₹ 20,00,000. The funds can be borrowed at the rate of 9 percent up to ₹ 5,00,000, at 14 percent over ₹ 500,000 and upto ₹ 20,00,000, and at 19 percent over₹ 20,00,000. The tax rate applicable to the company is 40 percent. Which form of financing should a company choose? Show EPS Amount up to two decimal points. (Nov 2016, 8 marks)
Answer:

Financing Alternatives B (i.e. Raising debt of ₹ 20 lakhs and issue of equity share capital of ₹ 30 lakhs) is the option which maximizes the earnings per share.

Working Notes (WN):
1. Calculation of interest on Debt.

Note: Instead of slab, the relevant interest rate can be applied on total amount.

2. Number of equity shares to be issued
Alternative A: $\frac{₹ 45,00,000}{₹ 150 \text { (Market Price of Share) }}=30,000$ shares
Alternative B: $\frac{₹ 30,00,000}{₹ 150 \text { (MarketPrice of Share) }}=20,000$ shares
Alternative C: $\frac{₹ 20,00,000}{₹ 125 \text { (RevisedMarketPrice of Share) }}=16,000$ shares

Question 23.
The X Ltd. is willing to raise funds for its new project which requires an investment of ₹ 84 lakhs. The company has two options:
Option I: To issue Equity Shares ( 10 each) only
Option II: To avail term loan at an interest rate of 12%. But in this case, as insisted by the financing agencies, the company will have to maintain a debt-equity proportion of 2: 1. The corporate tax rate is 30%. Find out the point of indifference for the project. (Nov 2017, 5 marks)
Answer:
Indifference point is EBIT Level where EPS from two options remains same
Let x be the EBIT Level
Indifference point
\(\frac{x(1-T)}{N_1}=\frac{(x-1)(1-T)}{N_2} \)
T = Tax Rate 30%
I = interest
N₁ = No. of Equity share in option II
\(\frac{84,00,000}{10} \) = 8,40,000 shares
N₂ = No. of Equity in option II
Debt Equity Ratio = 2:1
Amount to be raised by Debt.
84,00,000 × 2/3 = 56,00,000.
Amount to be raised by Equity.
84,00,000 × 1/3 = 28,00,000
N₂ = \(\frac{28,00,000}{10}\) = 2,80,000 shares.
∴ \(\frac{x(1-30)}{8,40,000}=\frac{(x-6,72,000)(1-30)}{2,80,000} \)
∴ \(\frac{7 x}{3}=\frac{7 x-4,70,400}{1}\)
∴ 1.4 x = 14,11,200
x = \(\frac{14,11,200}{1.4} \) = 10,08,000.

Question 24.
Sun Ltd. is considering two financing plans.
Details of which are as under.
(i) Fund’s requirement – ₹ 1oo Lakhs
(ii) Financial Plan

Plan	Equity	Debt
I	100%	–
II	25%	75%

(iii) Cost of debt – 12% p.a.
(iv) Tax Rate – 30%
(v) Equity Share ₹ 10 each, issued at a premium of ₹ 15 per share
(vi) Expected Earnings before Interest and Taxes (EBIT) ₹ 40 Lakhs You are required to compute:
(i) EPS in each of the plan
(ii) The Financial Break Even Point
(iii) Indifference point between Plan I and II (May 2018, 5 marks)
Answer:

(ii) Calculation of Financial Break-even point
The financial break-even point is the earnings which are equal to the fixed finance charges
Plan – I:
Under this plan there is no interest payment, hence the Financial Break-evèn point will be zero.
Plan – II:
Under this plan there is an interest payment of ₹ 9,00,000, hence, the financial Break-even point will be ₹ 9,00,000 (Interest charges)

(iii) Computation of Indifference point between the plans
The indifference between two alternative methods of financing is calculated by applying the following formula.
\(\frac{\left(E B I T-I_1\right)(1-T)}{E_1}=\frac{\left(E B I T-I_2\right)(1-T)}{E_2}\)
Where,
EBIT = Earnings before interest and tax
I₁ = Fixed charges (interest) under Alternative
I₂ = Fixed charges (interest) under Alternative
T=Tax rate
E₁ = No. of equity shares in Alternative 1
E₂ = No. of equity shares in Alternative 2
Now, we cari calculate indifference point between different plans of financing.
\(\frac{(E B I T-0)(1-0.3)}{4,00,000}=\frac{(E B I T-9,00,000)(1-0.3)}{1,00,000}\)
2.8 EBIT – 25,20,000 = 0.7 EBIT
Or 2.1 EBIT = 25,20,000
EBIT = 12,00,000

Question 25.
Y Limited requires ₹ 50,00,000 for a new project. This project is expected to yield earnings before interest and taxes of ₹ 10,00,000. While deciding about the financial plan, the company considers the objective of maximizing earnings per share. It has two alternatives to finance the project – by raising debt ₹ 5,00,000 or ₹ 20,00,000 and the balance, in each case, by issuing Equity Shares. The company’s share is currently selling at ₹ 300, but is expected to decline to ₹ 250 in case the funds are borrowed in excess of ₹ 20,00,000. The funds can be borrowed at the rate of 12 percent upto ₹ 5,00,000 and at 10 percent over ₹ 5,00,000. The tax rate applicable to the company is 25 percent. Which form of financing should the company choose? (Nov 2018, 5 marks)
Answer:
Plan I = Raising Debt of ₹ 5 lakhs + Equity of ₹ 45 lakhs
Plan II = Raising Debt of ₹ 20 lakhs + Equity of ₹ 30 lakhs

Calculation of Earnings Per Share (EPS):

Financial Plan II (i.e. Rising Debt of ₹ 20 lakhs and issue of equity share capital of ₹ 30 lakhs) is the option which maximises the earnings per share.

Working Notes:
1. Calculation of interest on Debt:

Plan I	(₹ 5,00,000 x 12%)		₹ 60,000
Plan II	(₹ 5,00,000 x 12%) (₹ 15,00,000 x 10%)	₹ 60,000 ₹ 1,50,000	₹ 2,10,000

2. Number of Equity Shares to be issued:
Plan I = \(\frac{₹ 45,00,000}{₹ 300 \text { (Market Price of Share) }}\) = 15,000 Shares
Plan II = \(\frac{₹ 30,00,000}{₹ 300} \) = 10,000 Share.

Question 26.
RM Steels Limited requires ₹ 10,00,000 for construction of a new plant.
It is considering three financial plans:
(i) The company may issue 1,00,000 ordinary shares at ₹ 10 per share;
(ii) The company may išsue 50,000 ordinary shares at ₹ 10 per share and 5000 debentures of ₹ 100 denominations bearing a 8 percent rate of interest; and
(iii) The company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 preference shares at ₹ 100 per share bearing a 8 percent rate of dividend.
If RM Steels Limited’s earnings before interest and taxes are ₹ 20,000;
₹ 40,000; ₹ 80,000; ₹ 1,20,000 and ₹ 2,00,000, you are required to compute the earnings per share under each of the three financial plans?
Which alternative would you recommend for RM Steels and why? Tax rate is 50%. (May 2019, 10 marks)
Answer:

In case of Preference shares, the company has to pay dividends to preference shareholders. Here, preference shares are assumed to be cumulative.
(ii) From the above EPS calculations tables under the three financial plans we can see that when EBIT is ₹ 80,000 or more, Plan (ii) i.e., Debt-equity mix is preferable over the Plan (i) and Plan (iii), as rate of EPS is more under this plan.

On the other hand, an EBIT of less than ₹ 80,000, Plan (i), Equity financing has higher EPS than Plan (ii) and Plan (iii) Plan (iii) :
Preference share-Equity mix is not acceptable at any level of EBIT, as EPS under this plan is lower. The choice of the financing plan will depend on the performance of the company and other macroeconomic conditions. If the company is expected to have higher operating profit plan (ii): A debt-equity mix is preferable. Moreover, debt financing gives more benefits due to
availability of tax shield.

Question 27.
J Ltd. is considering three financing plans. The key information is as follows:
(a) Total investment to be raised ₹ 4,00,000.
(b) Plans showing the Financing Proportion:

Plans	Equity	Debt	Preference Shares
X	100%	–	–
Y	50%	50%	–
Z	50%	–	50%

(c) Cost of Debt 10%
Cost of preference shares 10%
(d) Tax Rate 50%
(e) Equity shares of the face value of ₹ 10 each will be issued ata premium of ₹ 10 per share.
(f) Expecte1 EBIT is ₹ 1,00,000.
You are required to compute the following for each plan:
(i) Earnings per share (EPS)
(ii) Financial break-even point
(iii) Indifference Point between the plans and indicate if any of the plans dominate. (Nov 2020, 10 marks)

Question 28.
What is Over capitalization? State its causes and consequences. (Nov 2013, 4 marks)
Answer:
Over Capitaflsetion
Meaning
When a firm has consistently been unable to earn the prevailing rate of return on its capital employed, the situation is termed as Over Capitalisation. In simple words, it means the existence of excess capital as compared to the level of activity and requirement.

Parameters
1. When Actual Rate of Earning < Current Rate of Earning.
2. Real Value of Business < Book Value of Business.

Causes of Over-Capitalisation
1. Under-estimation of the Capitalisation Rate: If the rate of capitalisation is underestimated, it will lead to a situation of over-capitalisation.

2. Over-Issue of Capital: Sometimes, while floating a new company, the promoters overestimate the financial requirements, and as a result, they raise more capital than what is actually needed, resulting in over-capitalization.

3. High Promotion Expreses: Incurring high promotional expenses, excessive preliminary expenses etc. may lead i.e over-capitalization.

4. Liberal Dividend Policy: The company might have followed the lenient dividend policy without bothering much about building up the reserves. As a result, the retained profits of the company may be adversely affected.

5. Inadequate Depreciation: An adequate provision might not have been made for depreciation on the assets. As such, the real value of the assets is less than the book value of the assets.

6. Formation of the Company during Inflationary Period:
If a company is floated under the conditions of inflation, it requires a large fund for acquiring its necessary assets. But when depression sets in, naturally, the prices of the assets fall which ultimately leads to over-capitalisation.

Consequences of Over-Capitalisation
1. Poor Creditworthiness: Reduced earnings of an over-capitalized concern affect its credit worthiness and as a result, it becomes difficult for it to get loans or credit at cheaper rates of interest.

2. Difficulties In Obtaining Capital: For a company faced with a situation of over-capitalization, it is very difficult to obtain further capital for its growth and expansion programmes. it is so because the investors have already lost confidence in the company.

3. Loss of Goodwill: In an over-capitalised company, there is a reduced earning capacity resulting in the fall of market price of its shares and thereby shaking up the investor’s confidence. A company whose shares sell below the face value may find it difficult to improve its goodwill in the market.

4. Loss of Market: Over-capitalised companies fail to produce goods at competitive costs and, hence, often lose their market to competitors.

5. Liquidation of Company: An over-capitalized company goes into liquidation unless drastic steps are taken to re-organize the whole capital structure, and re-organization would itself lead to a lot of problems.

Cost of Capital – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Cost of Capital – CA Inter FM Question Bank

Question 1.
Explain the significance of Cost of Capital. (Nov 2019, 4 marks)
Answer
The cost of capital is important to arrive at correct amount and helps the management or an investor to take an appropriate decision. The correct cost of capital helps in the following decision-making:

1. Evaluation of Investment options	The estimated benefits (Future cash flows)from available investment opportunities (business or project) are converted into the present value of benefits by discounting them with the relevant cost of capital. Here it is pertinent to mention that every investment option may have different cost of capital hence it is very important to use the cost of capital which is relevant to the options available. Here Internal rate of return (IRR) is treated as cost of capital for evaluation of two options (projects).
2. Performance Appraisal	Cost of capital is used to appraise the performance of a particulars project or business. The performance of a project or business in compared against the cost of capital which is known here as cut-off rate or hurdle rate.
3. Designing of optimum credit policy	While appraising the credit period to be allowed to the customers, the cost of allowing credit period is compared against the benefit/profit earned by providing credit to customer of segment of customers. Here cost of capital is used to arrive to the present value of cost and benefits received.

Question 2.
A Company issues ₹ 10,00,000 12% debentures of ₹ 100 each. The debentures are redeemable after the expiry of fixed period of 7 years. The Company is in 35% tax bracket.
Required:
(i) Calculate the cost of debt after tax, if debentures are issued at
(a) Par
(b) 10% Discount
(c) 10% Premium. (5 marks)
(ii) If brokerage is paid at 2%, what will be the cost of debentures, if issue is at par? (May 2006, 1 mark)
Answer:
(i) Cost of debenture after tax when debenture are issued:
(a) At par :-
K_d = \(\frac{1(1-t)+(R V-N P) / n}{(R V – N P) / 2} \)
= \(\frac{12(.65)+(100-100) / 7}{(100+100) / 2} \)
= 7.81%

(b) At 10% discount:-
= \(\frac{12(.65)+(100-90) / 7}{(100+90) / 2}\)
= 9.71%

(c) At 10% premium:-
= \(\frac{12(.65)+(100-110) / 7}{(100+110) / 2} \)
= 6.07%

(ii) Cost of debenture when brokerage paid @ 2% issued at par:
K_d = \(\frac{12(.65)+(100-98) / 7}{(100+98) / 2} \)
= \(\frac{7.8+29}{99}\)
= 8.17%.

Question 3.
Answer the following:
A company issues 25,000, 14% debentures of ₹ 1,000 each. The debentures are redeemable after the expiry period of 5 years. Tax rate applicable to the company ¡s 35% (including surcharge and education cess). Calculate the cost of debt after tax if debentures are issued at 5% discount with 2% flotation cost. (Nov 2015, 5 marks)
Answer:
Calculation of Cost of Debt after Tax:
Cost of Debt (K_d)
= \(\frac{\frac{1(1-t)+\left[\frac{R V-N P}{n}\right]}{R V+N P}}{2}\)
Where, I = Interest payment i.e. 14% of ₹ 1,000 = 140
t = Tax rate applicable to the company i.e. 35%
RV = Redeemable value of debentures i.e. ₹ 1,000
NP = Net proceeds per debentures
= ₹ 1,000 × (1 – (0.05 + 0.02))
= ₹ 1,000 × 0.93= 930
n = Redemption period of debentures i.e 5 years

Therefore, K_d = \(=\frac{₹ 140(1-0.35)+\left[\frac{₹ 1,000-₹ 930}{5 \text { year }}\right]}{\left[\frac{₹ 1,000+₹ 930}{2}\right]} \times 100\)
= \(\frac{₹ 91+₹ 14}{₹ 965} \times 100\) = 10.88 %

The Cost of Debt can also be calculated usinç the formula, where first Cost of Debt before tax is calculated and then tax adjustment is made.

Accordingly:
Cost of Debt = \(\frac{1+\left[\frac{R V-N P}{N}\right]}{\left[\frac{R V-N P}{2}\right]} \times(1-t) \times 100 \)
= \(\frac{₹ 140+14}{₹ 965}(1-0.35) \times 100\) = 10.37%.

Question 4.
TT Ltd. issued 20,000, 10% convertible debentures of ₹ 1oo 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 ₹ 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:

(Nov 2020, 5 Marks)

Question 5.
Answer the following:
A company issued 40,000, 12% Redeemable Preference Shares of ₹ 100 each at a premium of ₹ 5 each, redeemable after 10 years at a premium of 10 each.
The floatation cost of each share is 2.
You are required to calculate cost of preference share capital ignoring dividend tax. (May 2013, 5 marks)
Answer:
Computation of Cost of Preference Shares (K_p)
Preference Dividend (PD) = 0.12 × 40,000 × 1oo = 4,80,000
Floatation Cost = 40,000 × 2 = 80,000
Net Proceeds (NP) = 42,00,000 – 80,000 =41 ,20,000
Redemption Value (RV) = 40,000 × 110= 44,00,000
Cost of Redeemable Preference Shares = \(\frac{\frac{P D+(R V-N P) / N}{R V+N P}}{2} \)
K_p = \(\frac{\frac{4,80,000+(44,00,000-41,20,000) / 10}{44,00,000+41,20,000}}{2}\)
= \(\frac{4,80,000+(2,80,000) / 10}{85,20,000 / 2}\)
= \(\frac{4,80,000+28,000}{42,60,000} \) = \(\frac{5,08,000}{42,60,000} \)
= 0.1192
K_p= 11.92%

Alternative Treatment:
K_p may be computed alternatively by taking the RV and NP for one unit of preferred e-shares. Final figure would remain unchanged.

Question 5.
Discuss the dividend-price approach, and earnings-price approach to estimate cost of Equity Capital. (Nov 2006, 2 marks)
Answer:
Dividend price approach: This approach emphasizes on dividend expected by an investor from a particular share to determines its cost. Cost of ordinary share is calculated on the basis of the present values of the expected future stream of dividend; whereas Earning price approach: Under this approach cost of ordinary share capital would be based on expected ratio of earnings of a company. This approach is similar to dividend price approach, only it seeks to nullify the effect of changes in dividend policy.

Question 6.
Distinguish between Unsystematic Risk and systematic Risk. (Nov 2020, 2 marks)

Question 7.
Piyush Loonker and Associates presently pay a dividend of ₹ 1.00 per share and has a share price of ₹ 20.00.
(i) If this dividend were expected to grow at a rate of 12% per annum forever, what is the firm’s expected or required return on equity using a dividend-discount model approach?
(ii) Instead of this situation in part (i), suppose that the dividends were expected to grow at a rate of 20% per annum for 5 years and 10% per year thereafter. Now what is the firm’s expected, or required, return on equity? (May 2001, 8 marks)
Answer:
(i) Firm’s expected or required return on equity (using a dividend discount model approach):
According to dividend discount model approach, the firm’s expected or required return on equity share capital is computed as follows:
k_e= \(\frac{D_1}{P_0}+g \)
Where,
k_e =Cost of equity share capital
D₁ =Expected dividend at the end of year 1
P₀ =Current market price of the share
g =Expected growth rate of dividend.

Given,
D1 =D₀(1 +g) or ₹ 1(1 +0.12) = 1.12; P₀ = ₹ 2 & g=12%
∴ K_e = \(\frac{1.12}{20}\) + 0.12 = 0.176 = 17.6 %

(ii) Firms expected or required return on equity:
(If dividends were expected to grow at a rate ot 20% p.a. for 5 years & 10% p.a. thereafter): Since in this situation if dividends are expected to grow at a supernormal growth rate gs, for n years & thereafter, at a normal, perpetual growth rate of gn beginning in the year n+l then the cost of equity can be determined by using the following formula:

Where,
g_s =Rate of growth in earlier years
g_n =Rate of constant growth in later years
P₀ =Discounted value of dividend stream
k_e =Firm’s expected required return on equity
g_s =20% for 5 years, gn = 10%

By trial & error, we are required to find out k_e
Now, assume k_e = 18%, then we will have:
P₀ = 1.20 (0.8475) + ₹ 1.44 (0.7182) + ₹ 1.73 (0.6086) + ₹ 2.07
(0.51589) + ₹ 2.49 (0.43710) + ₹ 2.74 (0.4371) × \(\frac{1}{0.18-0.10}\)
=₹ 1.017+ ₹ 1.034+ ₹ 1.052+ ₹ 1.067+ ₹ 1.09+ ₹ 14.97 = ₹ 20.23
Since The Present Value of dividend stream is more than required it indicates that k_e is greater than 18%.

Now, assume k_e = 19% we will have:
P₀ = ₹ 1.20 (0.8403) + ₹ 1.44 (0.7061) +₹ 1.73 (0.5934) + ₹ 2.07
(0.4986) + ₹ 2.49 (0.4190) + ₹ 2.74 (0.4190) × \(\frac{1}{0.19-0.10}\)
= ₹ 1.008 + ₹ 1.016 + ₹ 1.026 + ₹ 1.032 + ₹ 1.043 + ₹ 12.76 = ₹ 17.89
Since the market price of share (expected value of dividend stream) is ₹ 20. Therefore, the discount rate is closer to 18% than it is to 19%, we can get the exact rate by using the interpolation formula:
K_e = \(\frac{r-\left(P V_s-P V_D\right)}{\Delta P V} \times \Delta r \)

Where,
r =Either of two interest rates
PV =Present value of share
PV_D =Present value of dividend stream
Δr =Difference in value of dividend stream
ΔPV = Difference in calculated P.V. of dividend stream
∴ K_e = \(\frac{18 \%-(₹ 20-₹ 20.23)}{₹ 20.23-₹ 1,789} \times 0.01 \)
= \(\frac{18 \%-(₹ 0.23)}{₹ 2.34} \times 0.01 \)
= \(\frac{18 \%+0.23}{2.34} \times 0.01 \)
= 18% + 0.10 = 18.10%
Therefore, the firm’s expected, or required, return on equity is 18.1 0%. At this rate, the present discounted value of dividend stream is equal to the market value of the shares.

Question 8.
D Ltd. is foreseeing a growth rate of 12% per annum in the next two years. The growth rate is likely to be 10% for the third and fourth years. After that, the growth rate is expected to stabilize at 8% per annum. If the last dividend was ₹ 1.50 per share and the investor’s required rate of return is 16%, determine the current value of the equity share of the company.
The P.V. factors at 16%

Year	1	2	3	4
P.V. factor	.862	.743	.641	.552

(May 2005, 6 marks)
Answer:
The current value of the equity share of D Ltd. is a sum of the following:
(a) Present value (PV) of dividends payments during 1- 4 years; and
(b) Present value (PV) of expected market price at the end of the fourth year based on a constant growth rate of 8 percent.

Present value of the market price (P₄) at the end of the 4th year
P₄ = D₅(K_e – g) = 2.28 (1.08)/(16% – 8%) = ₹ 30.78
PV of ₹ 30.78 = 30.78 × 0.552 = ₹ 16.99
Therefore Value of equity shares ₹ 5.44 +₹ 16.99 = ₹ 22.43

Question 9.
Answer the following:
Z Ltd.’s operating income (before interest and tax) is ₹ 9,00,000. The firm’s cost of debts ¡s lo per cent and currently firm employs ₹ 30,00,000 of debts. K₀ is 12 percent.
Required:
Calculate the cost of equity. (Nov 2007, 3 marks)
Answer:
Total Value of firm = \(\frac{₹ 9,00,000}{12}\)
= 75,00,000
Debt capital: 30,00,000
Equity capital 45,00,000
12 = 10 \(\left(\frac{30,00,000}{75,00,000}\right)+K_e\left(\frac{45,00,000}{75,00,000}\right) \)

12 = 10(4)+K_e(6)
12 = 04+K_e. 6
08 = K_e.6
K_e = \(\frac{.08}{.6}]\)
= 0.1333
= 13.33%

Question 10.
Answer the following:
ABC Company’s equity share is quoted in the market at ₹ 25 per share currently. The company pays a divided of ₹ 2 per share and the investor’s market expects a growth rate of 6% per year.
You are required to:
(i) Calculate the company’s cost of equity capital.
(ii) If the anticipated growth rate is 8% per annum, calculate the indicated market price per share.
(iii) If the company issues 10% debentures of face value of ₹ 1oo each and realises ₹ 96 per debenture white 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%. (Nov 2016, 5 marks)
Answer:
(i) Calculation of Cost of Equity Capital:
K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_0}+g\)
= \(\frac{2 \times 1.06}{25}\) + 0.06
= 0.0848 + 0.06
= 0.1448
= 14.48%.

(ii) Calculation the indicated Market price per share:
K_e = \(\frac{D_1}{P_0}+g\)
∴ 0.14 = \(\frac{2}{x}\) + 0.08
∴ 0.14- 0.08 = \(\frac{2}{x}\)
∴ x(0.06) = 2
∴ x = 33.33
Hence, the market price will be ₹ 33.33.

(iii) Calculation of Cost of Debenture:
K_d = \(\frac{I(1-t)+\left(\frac{R V-N P}{N}\right)}{\frac{R V+N P}{2}}\)
= \(\frac{10(1-0.50)+\left(\frac{112-96}{12}\right)}{\frac{112+96}{2}} \)
= \(\frac{5+1.33}{104} \)
= \(\frac{6.33}{104}\)
= 0.0608
= 6.08%.

Question 11.
Answer the following:
Y Ltd. retains ₹ 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 came in 30% tax bracket. Calculate the cost of retained earnings. (Nov 2009, 2 marks)
Answer:
Computation of Cost of Retained Earnings (Kr)
Kr = K (1 -Tp) – Brokerage
Kr = 0.10(1-0.30) 0.03
= 0.04 or 4%
Cost of Retained Earnings = 6.79%

Question 12.
Answer the following:
What do you understand by Weighted Average Cost of Capital? (Nov 2009, 3 marks)
Answer:
Computation of overall cost of capital of a firm involves:
1. Computation of weighted average cost of capital
2. Computation of cost of specific source of finance.

1. Computation of Weighted Average Cost of Capital (WACC): Weighted average cost of capital is the average cost of the costs of various sources of financing. Weighted average cost of capital is also known as composite cost of capital, overall cost of capital or average cost of capital. Once the specific cost of individual sources of finance is determined, we can compute the weighted average cost of capital by putting weights to the specific costs of capital in proportion to the various sources of firm to the total. The weights may be given either by using the book value of the sources or market value of the sources.

WACC = (Proportion of Equity x Cost of Equity) + (Proportion of Preference x Cost of Preference) + (Proportion of Debt x Cost of Debt) For the above formula, we consider some assumptions in order to simplify and make it calculative. These are:
(i) We consider only three types of capital: Equity, non-convertible & non-cancellable preference shares and non-convertible & non-cancellable debts so, we have to ignore other forms of capital. because cost of these forms of capital is very difficult to calculate due to its complexities. Generally, such types of financing covers a minor part only, so it should be excluded as it cannot make any material difference.

(ii) Debts Include: Long-term debts as well as short-term debts (i.e. working capital loan, commercial papers etc.)

(iii) Non-interest: Bearing liabilities such as trade creditors are not included in the calculation of WACC. This is done to ensure the consistency in reality. Such types of securities have costs but such costs are indirectly reflected in the price paid by the co. at the time of getting the goods & services.

Question 13.
XYZ Ltd. has the following book value capital structure:
Equity Capital (in shares of ₹ 1o each, fully paid up – at par) ₹ 15 crores
11 % Preference Capital (in shares of ₹ 1oo each, fully paid up – at par) ₹ 1 crore
Retained Earnings ₹ 20 crores
13.5% Debentures (of ₹ 100 each) ₹ 10 crores
15% Term Loans ₹ 12.5 crores.
The next expected dividend on equity shares per share is 3.60; the
dividend per share is expected to grow at the rate of 7%. The market price per share is 40.
Preference stock, redeemabe after ten years, is currently selling at 75 per share.
Debentures, redeemable after six years, are selling at 80 per debenture.
The Income-tax rate for the company is 40%.
(i) Required:
Calculate the weighted average cost of capital using:
(a) book value proportions; and
(b) market value proportions. (Nov 2000, 6 marks)
Answer:

Note: Since Retained earnings are treated as equity capital for purposes of calculation of the cost of specific sources of finance, the market value of the ordinary shows may be taken to represent the combined market value of equity shares & retained earnings. The separate market values of retained earnings & ordinary shares may also be worked out by allocating to each of these a percentage of total market value equal to their percentage share of the total based on book values.

Question 14.
JKL Ltd. has the following book-value capital structure as on March 31, 2003.
Equity share capital (2,00,000 shares) ₹ 40,00,000
11.5% preference shares 10,00,000

The equity share of the company sells for ₹ 20. It is expected that the company will pay next year a dividend of ₹ 2 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 ₹ 20 lakhs debt by issuing 12% debentures. This would result in increasing the expected equity dividend to ₹ 2.40 and leave the growth rate unchanged, but the price of equity shares will fall to ₹ 16 per share.
(iii) Comment on the use of weights in the computation of weighted average cost of capital. (May 2003, 3+3+2 = 8 marks)
Answer:

Working Notes:
1. Cost of equity capital:
K_e = \(\frac{\text { Dividend }}{\text { Current W.P. }}\) + g
= \(\frac{2}{20}\) + 5 % = 0.15

2. Cost of preference share capital:

= \(\frac{1,15,000}{10,00,000}\) = 0.115

3. Cost of debentures:
\(\frac{1}{\text { Net Proceeds }}\) (Interest Tax) .
= \(\frac{1}{30,00,000}\) (3,00,000 – 1,05,000) = 0.065

4. Weights of equity share capital, preference share capital & debentures in total investment of ₹ 80,00,000:
Weight of equity share capital = \(\frac{\text { Total equity }}{\text { Total Investment }}=\frac{40,00,000}{80,00,000}\) = 0.50
Weight of Preference share capital = \(\frac{\text { Total Preference share }}{\text { Total Investment }} \)
= \(\frac{10,00,000}{80,00,000}\) = 0.15
Weight of debenture = \(\frac{\text { Total debentures }}{\text { Total Investments }}=\frac{30,00,000}{80,00,000}\) = 0.375

Working Notes:
1. Weights of equity, preference & debentures in total Investment of ₹ 1,00,00,000:
Weight of equity hare = \(\frac{40,00,000}{1,00,00,000}\) = 0.4
Weight of Preference share = \(\frac{10,00,000}{1,00,00,000}\) = 0.10

Weight of debenture @ 10% = \(\frac{30,00,000}{1,00,00,000}\) = 0.30
Weight of debenture @ 12% = \(\frac{20,00,000}{1,00,00,000} \) = 0.20

2. Cost of equity capital: ‘
k_e= +g
= \(\frac{2.40}{16}\) + 5 % = 20%

3. Comment:
On the computation of weighted average cost of capital weights are preferred to Book value. e.g. weights representing the capital structure under a corporate financing situation, its cash flows are preferred to earnings & market. Balance sheet is preferred to book value Balance sheet.

Question 15.
ABC Limited has the following book value capital structure:
Equity Share Capital (150 million shares, ₹ 10 par) ₹ 1,500 million
Reserves and Surplus ₹ 2,250 million
10.5% Preference Share Capital
(1 million shares, ₹ 100 par) ₹ 1oo million
9.5% Debentures (1.5 million debentures, ₹ 1000 par) ₹ 1,500 million
8.5% Term Loans from Financial Institutions 500 million
The debentures of ABC Limited are redeemable after three years and are quoting at 981.05 per debenture. The applicable income tax rate for the company is 35%.
The current market price per equity share is ₹ 60. The prevailing default risk-free interest rate on 10-year GOI Treasury Bonds is 5.5%. The average market risk premium is 8%. The beta of the company is 1.1875. The preferred stock of the company is redeemable after 5 years is currently selling at ₹ 98.15 per preference share.

Required:
(i) Calculate weighted average cost of capital of the company using market value weights.
(ii) Define the marginal cost of capital schedule for the firm if it raises ₹ 750 million for a new project. The firm plans to have a target debt-to-value ratio of 20%. The beta of new project is 1.4375. The debt capital will be raised through term loans, It will carry interest rate of 9.5% for the first 100 million and 10% for the next ₹ 50 million. (May 2004, 6 + 3 = 9 marks)
Answer:
Working Notes:
1. Computation of cost of debentures (k_d):
981.05 = \(\frac{95}{(1+\mathrm{YTM})^1}+\frac{95}{(1+\mathrm{YTM})^2}+\frac{1,095}{(1+\mathrm{YTM})^3} \) (yield to maturity (ytm)
= 10% appx.)
k_d = YTM × (1-T_c)
=10% × (1-0.35)
=6.5%

2. Computation of cost of term loans (k_t):
=i × (1 – T_e)
= 8.5% (1 – 0.35)
= 5.525%

3. Computation of cost of Preference capital (k_p):
98.5 = \(\frac{10.5}{(1+Y T M)^1}+\frac{10.5}{(1+Y T M)^2}+\frac{10.5}{(1+Y T M)^3}+\frac{10.5}{(1+Y T M)^4}+\frac{10.5}{(1+Y T M)^5}\)
YTM= 11%App.
K_p = 11%

4. Computation of cost of equity (k_e):
= r_f + Avg. market risk premium x I3eta
= 5.5% + 8% × 1.175
= 15%

5. Computation of proportion of equity capital, preference share, debenture & term loans In the market value of capital structure:

(i) Weighted Average Cost of capital (WACC):
Using market value weights:
WACC = \(\left(k_d \times \frac{D}{V}\right)+\left(k_T \times \frac{T}{V}\right)+\left(k_p \times \frac{P}{V}\right)+\left(k_\sigma \times \frac{E}{V}\right) \)
= (6.5% × 0.1329)+ (5.25% × 0.04517)+(11% × 0.0089)+ (15% × 0.813)
= 0.008638 + 0.002495 + 0.00097 + 0.121 95 = 13.41%
For the values of k_d, k_t,k_p, & k_e & weights refer to W. N. I to 5 respectively.

(ii) Marginal cost of capital (MCC) schedule:
k_e (New project) = 5.5% +8% x 1.4375= 17%
k_d= 9.5% × (1-0.35) = 6.175%
= 10% × (1-0.35)= 6.5%
MCC = 17% × 0.80 + 6.175% × \(\frac{100}{750} \) +6.5% × \(\frac{50}{750} \)
= 14.86% (appx.)

Question 16.
ABC Ltd. wishes to raise additional finance of ₹ 20 Iakhs for meeting its investment plans. The company has ₹ 4,00,000 in the form of retained earnings available for investment purposes. The following are the further details:
Debt-equity ratio 25: 75.
Cost of debt at the rate of 10 percent (before tax) up to ₹ 2,00,000 and 13% (before tax) beyond that.
Earning per share, ₹ 12.
Dividend payout 50% of earnings.
Expected growth rate in dividends 10%.
Current market price per share, ₹ 60.
Company’s tax rate is 30% and shareholder’s personal tax rate is 20%.

Required:
(i) Calculate the post-tax average cost of additional debt.
(ii) Calculate the cost of retained earnings and cost of equity.
(iii) Calculate the overall weighted average (after tax) cost of additional finance. (May 2008, 2+3+3 = 8 marks)
Answer:

(i) K_d = Total Interest (1 – t) /₹ 5,00,000
= [20,000 + 39,000] (1 -0.3)/5,00,000 or (41,300/5,00,000) × 100
= 8.26 %

(ii) K_e = EPS × payout/mp +g= 12 (50%) /60 × 100+ 10% 10% + 10% = 20%
K_r = K_e (1 -tp) = 20(1 -0.2) = 16%

K_o = (3,25,300/20,00,000) × 100 = 16.27%

Question 17.
The capital structure of MNP Ltd. is as under:

Additional information:
(i) ₹ 100 per debenture redeemable at par has 2% floatation cost and 10 years of maturity. The market price per debenture is ₹ 105.
(ii) ₹ 1oo per preference share redeemable at par has 3% floatation cost and 10 years of maturity. The market price per preference share is ₹ 106.
(iii) Equity share has ₹ 4 floatation cost and market price per share of ₹ 24. The next year expected dividend is ₹ 2 per share with annual growth of 5%. The firm has a practice of paying all earnings in the form of dividends.
(vi) Corporate Income- tax rate is 35 %.
Required:
Calculate Weighted Average Cost of Capital (WACC) using market value weights. (May 2009, 9 marks)
Answer:
Calculation of Weighted Average Cost of Capital by using market value weights:

WACC using market value weight = 13.02%
Working Notes:
Calculation of cost of Redeemable debenture:
K_d = \(=\frac{\text { Interest }(1-\text { taxrate })+\left[\frac{\text { Redeemablevalue }- \text { Issueprice }}{\text { No. of years }}\right]}{\left[\frac{\text { Redeemablevalue }+ \text { IssuePrice }}{2}\right]} \times 100\)
OR
k_d = \(\frac{(1-t)+(R V-N P) / N}{(R V+N P) / 2}\)
k_d = \(\frac{9(1-.35)+\left[\frac{100-98}{10}\right]}{\left[\frac{100+98}{2}\right]} \times 100 \)
k_d = 6.11 %

K_p = \(\frac{\text { Preference dividend }+\left[\frac{\text { Redeemablevalue }- \text { Issueprice }}{\text { No. of years }}\right]}{\left[\frac{\text { Redeemablevalue }+ \text { IssuePrice }}{2}\right]} \times 100 \)
Or
K_p = \(\frac{P D+(R V-N P) / N}{(R V+N P) 2} \times 100\)
K_p = \(\frac{11+\frac{(100-97)}{10}}{\frac{100+97}{2}} \times 100\)
K_p = 11.47%

Cost of equity:
K_e = \(\frac{D_1}{P_0}+g \)
K_e = \(\frac{2}{(24-4)}\) + 0.05 = 15%
K_e = \(\frac{\text { Expected Dividend }}{\text { Current market price }} \) + Growth rate

Question 18.
Answer the following:
(i) SK Limited has obtained funds from the following sources, the specific cost are also given against them:
Source of funds Amount ₹ Cost of Capital
Equity shares 30,00,000 15 percent
Preference shares 8,00,000 8 percent
Retained earnings 12,00,000 11 percent
Debentures 10,00,000 9 percent (before tax)
You are required to calculate weighted average cost of capital. Assume that Corporate tax rate is 30 percent. (May 2010, 3 marks)
Answer:

Cost of Debentures (K_d) (after tax) = K_d (before tax) × (1 – T)
=9%(1 – 0.3) = 6.3%
Weighted Average Cost of Capital = 11.81 %

Question 19.
Answer the following:
PQR Ltd. has the following capital structure on October 31, 2010:
Equity Share Capital ₹ 20,00,000
(2,00,000 Shares of ₹ 10 each)

The market price of equity share is ₹ 30. It is expected that the company will pay next year a dividend of ₹3 per share, which will grow at 7% forever.
Assume 40% income tax rate.
You are required to compute weighted average cost of capital using market value weights. (Nov 2010, 5 marks)
Answer:
Computation of Weighted Average Cost of Capital (WACC): Existing Capital Structure
Calculation of Cost of Equity
Cost of Equity = \(\frac{D_1}{P_0}\) + g
= \(\frac{₹ 3}{₹ 30} \) + 0.07 = 0.1 + 0.07 = 0.17 = 17%

K_d = rd (1-Tc) = 9% × (1 -0.4) = 5.4% or 0.054
Weighted Average Cost of Capital =0.1302 or 13.02%

Question 20.
Answer the following:
Beeta Ltd. has furnished the following information:
Earning per share (EPS) ₹ 4
Dividend payout ratio 25%
Market price per share ₹ 40
Rate of Tax 30%
Growth rate of dividend 8%
The company wants to raise additional capital of ₹ 10 lakhs including debt of ₹ 4 lakhs. The cost of debt (before tax) is 10% up to ₹ 2 lakhs and 15% beyond that. Compute the after-tax cost of equity and debt and the weighted average cost of capital. (Nov 2011, 5 marks)
Answer:
Cost of Equity Share Capital (K_e)
K_e (after tax) = \(\left(\frac{\mathrm{DPS}}{\mathrm{MPS}} \times 100\right) \) + G
DPS= 25% of ₹ 4 = ₹ 1.00
K_e = (\(\frac{1}{40}\) × 100) +8
K_e = 10.5%

(ii) Cost of Debt (K_d)
K_d = \(\frac{\text { Interest }}{\text { Net Proceeds }} \times 100 \times(1-\mathrm{T}) \)

K_d = \(\frac{50,000}{4,00,000}\) × 100 × (1 – 0.3) = 8.75 %

Question 21.
The following details are provided by the GPS Limited:
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
The cost of equity capital for the company is 16.30% and the Income Tax rate for the company is 30%. You are required to calculate the Weighted Average Cost of Capital (WACC) of the company. (May 2014, 5 marks)
Answer:

Weighted Average Cost of Capital = \(\frac{\text { Weighted Cost }}{\text { Total Cost }} \)
= \(\frac{14,69,500}{1,05,00,000} \)
= 0.1399 or
= 13.99%

Working Notes:
1. Calculation of Cost of Preference Shares:
K_p = \(\frac{D_p}{N P}=\frac{1,44,000}{12,00,000}\) 1,44,000 = 0.12 = 12%

2. Calculation of Cost of 15% Redeemable Debentures:
K_d = \(\frac{I(1-t)}{N P}=\frac{3,00,000(1-0.30)}{20,00,000} \) = 0.105 = 10.5%

3. Calculation of Cost of 10% Convertible Debentures:
K_d = \(\frac{I(1-t)}{N P}=\frac{80,000(1-0.30)}{8,00,000}\) = 0.07 = 7%

Question 22.
A Ltd. wishes to raise additional finance of ₹ 30 lakhs for meeting its investment plans. The company has ₹ 6,00,000 in the form of retained earnings available for Investment purposes.
The following are the further details:
Debt-equity ratio – 30:70
Cost of debt at the rate of 11 % (before tax) upto ₹ 3,00,000 and 14% (before tax) beyond that.
Earnings per share – 15.
Dividend payout – 70% of earnings.
Expected growth rate in dividend – 10%.
Current market price per share – ₹ 90.
Company’s tax rate is 30% and shareholder’s Personal tax rate is 20%.
You are required to:
(i) Calculate the post-tax average cost of additional debt.
(ii) Calculate the cost of retained earnings and cost of equity.
(iii) Calculate the overall weighted average (after tax) cost of additional finance. (May 2015, 8 marks)
Answer:
Pattern of raising capital = 0.30 x 30,00,000
Debt = 9,00,000
Equity = 21,00,000

(i) K_d = \(\frac{\text { Total Interest }(1-t)}{₹ 9,00,000} \times 100\)
\(\frac{₹ 33,000+₹ 84,000(1-0.3)}{₹ 9,00,000} \times 100\)
Or = \(\frac{₹ 81,900}{₹ 9,00,000} \times 100\) = 9.10%
(ii) K_e = \(\left[\frac{(\text { EPS } \times \text { Payout })(1+g)}{M P} \times 100\right] \) + g
= \(\left[\frac{(₹ 15 \times 0.7) \times 1.1}{₹ 90} \times 100\right]\) + 10%
= \(\left[\frac{₹ 11.55}{₹ 90} \times 100\right] \) + 10% = 22.83%
K_r = K_e (1 – tp) = 22.83%(1 -0.2) = 18.26%

K_e is calculated based on dividend growth model
K_d = Cost of capital; K_e = Cost of equity; K_r = Cost of retained earnings;
M_p = Market price; g = growth; tp = Shareholder’s personal tax;
K₀ = Cost of overall capital

Question 23.
RST Ltd. is expecting an EBIT of ₹ 4 lakhs for F.Y. 2015-16. Presently the company is financed entirely by equity share capital of ₹ 20 lakhs with equity capitalization rate of 16%. The company rs contemplating to redeem part of the capital by introducing debt financing. The company has two options to raise debt to the extent of 30% or 50% of the total fund. It is expected that for debt financing upto 30%, the rate of interest will be 10% and equity capitalization rate will increase to 17%. If the company opts for 50% debt, then the interest rate will be 12% and equity capitalization rate will be 20%. You are required to compute value of the company; its overall cost of capital under different options and also state which is the best option. (Nov 2015, 8 marks)
Answer:

Working Note:
1. Calculation of Market Value of Equity:
Equity Capital Rate = \(\frac{\text { EBIT }}{\text { Market Value }} \)
16% = \(\frac{4,00,000}{\text { Market Value }} \)
Market Value = 25,00,000

Computation of Value of the Company and Overall Cost of Capital under the two options:

Particulars	Option I	Option II
Debt	30%	50%
Equity (existing)	₹ 20,00,000	₹ 20,00,000
Debt	₹ 6,00,000	₹ 10,00,000
Equity capitalization rate	17%	20%
Interest on Debt	10%	12%
EBIT	₹ 4,00,000	₹ 4,00,000
Less: Interest on Debt	₹ 60,000	₹ 1,20,000
Earnings to equity shareholders	₹ 3,40,000	₹ 2,80,000

Since, in Option I value of the Company is more and overall cost of Capital is less compared to Option II, hence Option I is better.

Question 24.
Following is the capital structure of RBT Limited as on 31st March 2016:

Particulars	Book Value (₹)	Market Value (₹)
Equity Shares of ₹ 10 each	50,00,000	1,05,00,000
Retained earnings	13,00,000	–
11% Preference shares of ₹ 100 each	7,00,000	9,00,000
14% debentures of ₹ 100 each	30,00,000	36,00,000

Market price of equity shares is ₹ 40 per share and it is expected that a dividend of ₹ 4 per share would be declared. The dividend per share is expected to grow at the rate of 8% every year. Income tax rate applicable to the company is 40% and shareholder’s personal income tax rate is 20%.
You are required to calculate:
(i) Cost of capital for each source of capital,
(ii) Weighted average cost of capital on the basis of book value weights,
(iii) Weighted average cost of capital on the basis of market value weights. (Nov 2016, 8 marks)
Answer:
(I) Cost of Capital:
(a) Cost of Equity Share Capital (K_e)
K_e = \(\frac{D_0(1+g)}{P_0}+g\)
= \(\frac{4(1+0.08)}{40}\) +0.08
= \(\frac{4.32}{40} \) +0.08
= 0.188 or 18.8%

(b) Cost of Retained earnings (K_s)
K_s = K_e (1 – t_p) = 18.8 (1 .0.2) = 15.04%.

(c) Cost of Preference share (K_p)
K_p = 11%

(d) Cost of debentures (K_d)
K_d = r(1 -t)
=14% (1 -0.4)=0.084 = 8.4%

Question 25.
Alpha Ltd. has furnished the following information:
Earning Per Share (EPS) ₹ 4
Dividend payout ratio 25%
Market price per share 50
Rate of tax 30%
Growth rate of dividend 10%
The company wants to raise additional capital of ₹ 10 lakhs including debt of ₹ 4 lakhs. The cost of debt (before tax) is 10% up to ₹ 2 lakhs and 15% beyond that. Compute the after-tax cost of equity and debt and also weighted average cost of capital. (May 2019, 5 marks)
Answer:
(i) Cost of Equity Share Capital (K_e):
K_e = \(\frac{D_0(1+g)}{P_0}+g \)
= \(\frac{25 \% \text { of } ₹ 4(1+0.1)}{₹ 50}+0.10\)
= \(\frac{₹ 1.10}{₹ 50}+0.10 \)
K_e = 0.122 i.e. 12.20%

(ii) Cost of debt (k_d):
K_d = \(\frac{\text { Interest }}{\text { NetProceeds }} \times 100 \times(1-t) \)
Interest on First ₹ 2,00,000 @ 10% = ₹ 20,000
Interest on next ₹ 2,00,000 @ 15% = ₹ 30,000
K_d = \(\frac{₹ 50,000}{₹ 4,00,000} \times(1-0.3) \)
K_d = 0.0875 i.e. 8.75%

Alternate Solution:
(i) Cost of Equity Share Capital (K_e)
K_e = \(\frac{D_0(1+g)}{P_0}+g=\frac{25 \% \text { of } ₹ 4(1+0.10)}{₹ 50}+0.10 \)
= \(\frac{₹ 1.10}{₹ 50}+0.10 \) = 0.122 or 12.2%

(ii) Cost of Debt (K_d)
K_d = \(\frac{\text { Interest }}{\text { Net Proceeds }} \times 100 \times(1-t) \)
Interest on First ₹ 2,00,000 @ 10% = ₹ 20,000
Interest on next ₹ 2,00,000 @ 15% = ₹ 30,000
K_d = \(\frac{50,000}{4,00,000} \) × (1 – 0.3) = 0.0875 or 8.75%

K_e = \(\frac{\mathrm{D}}{\mathrm{P}_0} \) + g = \(\frac{25 \% \text { of } ₹ 4}{₹ 50}+0.10 \) = \(\frac{₹ 1.00}{₹ 50}+0.10\) = 0.120 or 12.00%
Accordingly Weighted Average Cost of Capital (WACC)

Question 26.
A Company wants to raise additional finance of ₹ 5 crore in the next year.
The company expects to retain ₹ 1 crore earning next year. Further details are as follows:
(i) The amount will be raised by equity and debt in the ratio of 3:1.
(ii) The additional issue of equity shares will result in price per share being fixed at ₹ 25.
(iii) The debt capital raised by way of term loan will cost 10% for the first ₹ 75 lakh and 12% for the next ₹ 50 lakh.
(iv) The net expected dividend on equity shares is ₹ 2.00 per share. The dividend is expected to grow at the rate of 5%.
(v) Income tax rate is 25%.

You are required:
(a) To determine the amount of equity and debt for raising additional finance.
(b) To determine the post-tax average cost of additional debt.
(c) To determine the cost of retained earnings and cost of equity.
(d) To compute the overall weighted average cost of additional finance after tax. (Nov 2019, 10 marks)
Answer:
(a) The amount of equity and debt for raising additional Finance:
Equity = ₹ 5Cr. × \(\frac{3}{4} \) = ₹ 3.75Cr.
Debt = ₹ 5 Cr. × \(\frac{1}{4} \) = ₹ 1.25 Cr.

(b) Determination of post-tax average cost of additional debt:
K_d = I (1-t)
Where, I = Interest Rate
t = Corporate tax rate
on ₹ 0.75 Cr. = 10% (1- 0.25) = 7.5% or 0.075
on ₹ 0.50 Cr. = 12% (1 – 0.25) = 9% or 0.09

The average cost of debt
= \(\frac{(₹ 0.75 \mathrm{Cr} . \times 0.075)+(0.50 \times 0.09)}{₹ 1.25 \mathrm{Cr} .} \times 100\)
K_d = 8.1%.

(c) Determination of cost of retained earnings and cost of equity applying dividend growth model.
K_e = \(\frac{D_1}{P_0} \) +9
Where, K_e = Cost of equity
D₁ = D₀ (1+9)
D₀ = Dividend paid (i.e. 2)
g = Growth rate
P₀ = Current market price per share
Then,
K_e = \(\frac{₹ 2(1.05)}{₹ 25} \) + 005
= 0.084 + 0.05
=0.134
= 13.4%

Question 27.
The Capital structure of PQR Ltd. is as follows:

	₹
10% Debenture	3,00,000
12% Preference Shares	2,50,000
Equity Share (face value ₹ 10 per share)	5,00,000
	10,50,000

Additional Information:
(i) ₹ 1oo per debenture redeemable at par has 2% floatation cost & 10 years of maturity. The market price per debenture is ₹ 110.
(ii) ₹ 100 per preference share redeemable at par has 3% floatation cost & 10 years of maturity. The market price per preference share is ₹ 108.
(iii) Equity share has ₹ 4 floatation cost and market price per share of ₹ 25. The next year expected dividend is ₹ 2 per share with annual growth of 5%. The firm has a practice of paying all earnings in the form of dividends.
(iv) Corporate Income Tax rate is 30%.
Required:
Calculate Weighted Average Cost of Capital (WACC) using market value weights. (Jan 2021, 10 marks)

Question 28.
Navya Limited to wishes to raise additional capital of ₹ 10 lakhs for meeting its modernization plan. it has ₹ 3,00,000 in the form of retained earnings available for investments purposes. The following are the further details:
Debt equity mix 40%/60%
Cost of debt (before tax)
Upto ₹1,80,000 10%
Beyond ₹ 1,80,000 16%
Earnings per share ₹ 4
Dividend payout ₹ 2
Expected growth rate in dividend 10%
Current market price per share ₹ 44
Tax rate 50%
Required:
(i) To determine the pattern for raising the additional finance.
(ii) To calculate the post-tax average cost of additional debt.
(iii) To calculate the cost of retained earning and cost of equity, and
(iv) To determine the overall weighted average cost of capital (after tax).
Answer:
(i) Pattern of Raising Additional Finance
Equity = 10,00,000 × 60/100 = ₹ 600000
Debt = 10,00,000 × 40/100 = ₹ 4,00,000
Capital structure after Raising Additional Finance

Sources of fund	Amount (₹)
Shareholder’s funds
Equity capital (6,00,000 – 3,00,000)	3,00,000
Retained earnings	3,00,000
Debt at 10% p.a.	1,80,000
Debt at 16% p.a. (4,00,000 – 1,80,000)	2,20,000
Total funds	10,00,000

(ii) Post-tax Average Cost of Additional Debt
K_d = I (1- t), where ‘K_d’ is cost of debt, ‘I’ is interest, and ‘t’ tax rate.
On ₹ 1,80,000 = 10% (1- 0.5) = 5% or 0.05
On ₹ 2,20,000 = 16% (1 – 0.5) =8% or 0.08
Average Cost of Debt (Post tax) i.e.
K_d = \(\frac{(1,80,000 \times 0.05)+(2,20,000 \times 0.08)}{4,00,000} \) = 100 = 6.65%

(iii) Cost of Retained Earnings and Cost of equity Applying Dividend Growth Model
K_e \(\frac{1.3865}{20} \) + g Or \(\frac{D_0(1+g)}{P_0}\) + g
Then, K_e = \(\frac{2 .(1.1)}{44}+0.10=\frac{2.2}{44}+0.010\) = 0.15 or 15 %

(iv) Overall Weighted Average Cost of Capital (WACC) (After Tax)

Particular	Amount (₹)	Weights	Cost of Capital	WACC
Equity (including retained earnings)	6,00,000	0.6	15%	9
Debt	4,00,000	0.4	6.65	2.66
Total	10,00,000	1		11.66

Question 29.
As a financial analyst of a large electronics company, you are required to DETERMINE the weighted average cost of capital of the company using (a) book value weights and (b) market value weights. The following information is available for your perusal.
The Company’s present book value capital structure is:
Debentures (₹ 100 per debenture) ₹ 8,00,000
Preference shares (₹ 100 per share) ₹ 2,00,000

All these securities are traded in the capital markets. Recent prices are:
Debentures, ₹ 110 per debenture, Preference shares, ₹ 120 per share, and Equity shares, ₹ 22 per share.
Anticipated external financing opportunities are:
(i) ₹ 100 per debenture redeemable at par; 10-year maturity, 11 percent coupon rate, 4 percent flotation costs, sale price, ₹ 100
(ii) ₹ 100 preference share redeemable at par; 10-year maturity, 12 percent dividend rate, 5 percent flotation costs, sale price, ₹ 100.
(iii) Equity shares: 2 per share flotation costs, sale price = ₹ 22.
In addition, the dividend expected on the equity share at the end of the year is ₹ 2 per share, the anticipated growth rate in dividends is 7 percent and the firm has the practice of paying all its earnings in the form of dividends. The corporate tax rate is 35 percent.
Answer:

(iii) Cost of Equity shares (K_e) = \(\frac{D_1}{P_0}+G=\frac{₹ 2}{₹ 22-₹ 2}+0.07 \) = 0.07 = 0.17 or 17%
I – Interest, t – Tax, RV- Redeemable value, NP- Net proceeds, N- No. of years, PD- Preference dividend, D1 – Expected Dividend, Po- Price of share (net) Using these specific costs we can calculate WACC on the basis of book value and market value weights as follows:
(a) Weighted Average Cost of Capital (K0) based on Book value weights

(b) Weighted Average Cost of Capital (KO) based on market value weights:

Question 30.
Define the weighted marginal cost of capital schedule for the company, if it raises ₹ 10 crores next year, given the following information:
(a) The amount will be raised by equity and debt in equal proportions;
(b) the company expects to retain ₹ 1.5 crores earnings next year;
(c) The additional issue of equity shares results in the net price per share being fixed at ₹ 32;
(d) The debt capital raised by way of term loans will cost 15% for the first ₹ 2.5 crores and 16% for the next ₹ 2.5 crores. (Nov 2000, 12 marks)
Answer:
Statement showing weighted marginal cost of capital schedule for the company, if it raises ₹ 10 crores next year given the following Information:

Working Notes:
1. Cost of equity capital & retained earnings (k_e):
k = \(\frac{\mathrm{D} 1}{\mathrm{P}_0}\) +g
Where;
k_e = Cost of equity capital
D₁ = Expected dividend at the end of year 1
P₀ = Current market price of equity shares
g = Growth rate of dividend
Given,
D₁; = ₹ 360
P₀ = ₹ 40
g = 7%
∴ k_e = \(\frac{₹ 3.60}{₹ 40}+0.07 \) = k_e = 16%

2. Cost of Preference capital (K_p):
k_p = \(\frac{D+\left(\frac{F-P}{n}\right)}{\left(\frac{F+P}{2}\right)} \)
Where,
D = Preference dividend
F = Faæ value of fernce aves
P = Current market price of Preren shares
n = Redemption Period of Preference shares.

Given, D= 11%, F= ₹100, P= ₹ 75 & n= 10 years.
∴ K_p = \(\frac{11+\left(\frac{100-75}{10}\right)}{\left(\frac{100+75}{2}\right)} \times 100 \) = 15.43%

3. Cost of Debentures (k_d):
K_d = \(=\frac{r(1-t)\left(\frac{F-P}{n}\right)}{\left(\frac{F+P}{2}\right)} \)
Where, r = Interest on debentures
t = Tax rate applicable to the co.
F = Face value of debentures
P = Current Market Price of debentures
n = Redemption Period of debentures.
Given,
r= 13.5%,t=40%, F= ₹ 100, P= ₹ 80 & n=6 years.
K_d= \(\frac{13.5(1-0.40)+\left(\frac{100-80}{6}\right)}{\frac{100+80}{2}} \times 100 \)
= 12.70%

4. Cost of term loans (k_t):
k_t = r(1-t)
Where,
r = Rate of Interest on term loans
t =Tax rate applicable to the co.

Given,
r = 15% & t = 40%
∴ k_t =15% (1- 0.40) = 9%

5. Cost of fresh equity share (k_e):
K_e = \(\frac{D_1}{P}\) + g
Give
D₁ = ₹ 3.60,P= ₹ 32 & g = 7%
∴ k_e = \(\frac{3.60}{32}\) + 0.07 = 18.25%

6. Cost of debt (K_d):
k_d = r(1-t)
(for first ₹ 2.5 crores)
r= 15% & t = 40%
∴ (for the next ₹ 2.5 crores)
r = 16% & t+ 14%
₹ k_d = 16% (1- 0.40) = 9.6%

Question 31.
The R & G Company has following capital structure at 31 March, 2004, which is considered to be optimum:
13% debenture 3,60,000
11 % preference share capital 1,20,000
Equity share capital (2,00,000 shares)19,20,000
The company’s share has a current market price of ₹ 27.75 per share. The expected dividend per share in next year is 50 percent of the 2004 EPS. The EPS of last 10 years is as follows. The past trends are expected to continue:

Year	1995	1996	1997	1998	1999	2000	2001	2002	2003	2004
EPS (₹)	1.00	1.120	1.254	1.405	1.574	1.762	1.974	2.211	2.476	2.773

The company can issue 14 percent new debenture. The company’s debenture is currently selling at ₹ 98. The new preference issue can be sold at a net price of ₹ 9.80, paying a dividend of ₹ 1.20 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.
(iii) How much can be spent for capital investment before now ordinary share must be sold? Assuming that retained earnings available for next year’s investment are 50% of 2004 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 ₹ 20 per share? The cost of debt and of preference capital is constant. (May 2005, 2 + 1 + 2 + 2 =7 marks)
Answer:
Assumption: The present capital structure is assumed to be optimum
Existing Capital Structure Analysis

Type of capital	Amount (₹)	Ratio
13% debentures	3,60,000	0.15
11% Preference	1,20,000	0.05
Equity	19,20,000	0.80
	24,00,000	1.00

(i) (a) After tax cost of debt = K_d = \(\frac{14}{98}\) × (1 – 0.5) = 0.071 43
After-tax cost of preference capital (new)
K_p = \(\frac{1.20}{9.80}\) = 0.122449

(b) After-tax cost of retained earnings
= g = 0.05 + 12=0.17 (where g is the growth rate)
= 0.05 + 0.12 = 0.17

(ii)

(iii) The company can pay the following amount without increasing its Marginal cost of capital without selling the new shares.
Retained earnings = 1.3865 × 2,00,000 = 2,77,300
The ordinary equity (retained earnings in this case) is 80% of the total capital.
Therefore, investment before issuing equity (\(\frac{2,77,300}{80} \times 100 \)) = ₹ 3,46,625

(iv) It the company pay more than ₹ 3,46,625, it will have to issue new shares. The cost of new issue of ordinary share is:
K_e = \(\frac{1.3865}{20}\) + 0.12 = 0.1893
The marginal cost of capital of ₹ 3,46,625

Question 32.
The X Company has following capital structure at 31st March 2015 which is considered to be optimum.
14% Debentures ₹ 3,00,000
11 % Preference Shares ₹ 1,00,000
Equity (100000 shares) ₹ 16.00.000
₹ 20,00,000
The company’s share has a current market price of ₹ 23.60 per share. The expected dividend per share next year is 50% of 2015 EPS. The following are the earning per share figure for the company during preceding ten years. The past trends are expected to continue.
Year EPS (₹) Year EPS (₹)
2006 1.00 2011 1.61
2007 1.10 2012 1.82
2008 1.21 2013 1.95
2009 1.33 2014 2.15
2010 1.46 2015 2.36
The company issued new debentures carrying 16% rate of interest and the current market price of debenture is ₹ 96.
Preference share ₹ 9.20 (with dividend of 1.1 per share) were also issued. The company is in 50% tax bracket.
(i) Calculate after-tax cost of
(a) New debt (b) New Preference share (c) New equity share
(consuming new equity from retained earnings)
(ii) Calculate marginal cost of capital when no new shares was issued.
(iii) How much can be spent for capital investment before new ordinary shares must be sold? Assuming the retained earnings for next year’s investment are 50% of 2015.
(iv) What will be the flarginal cost of capital when the funds exceed the amount calculated in (iii) assuming new equity is Issued at ₹ 20 per share? (May 2016, 8 marks)
Answer:
(i) Calculation of after-tax cost of the followings:
(a) New Debentures (K_d) = \(\frac{I(1-t)}{N P}=\frac{₹ 16(1-0.5)}{₹ 96} \times 100\) = 8.33%
New Preference Shares (K_p) = \(\frac{\text { Preference Dividend }}{\text { Net Proceed }} \)
= \(\frac{₹ 1.10}{₹ 9.20} \times 100 \) = 11.96%

(b) Equity Shares (Consuming New Equity from Retained Earnings) (K_e) .
= \(\frac{\text { Expected dividend }\left(D_1\right)}{\text { Current market price }\left(P_\nu\right)} \) + Growth rate (G)
= \(\frac{50 \% \text { of } ₹ 2.36}{₹ 23.60} \times 100+10 \%=5 \%+10 \%\) = 15%

Growth rate (on the basis of EPS) is calculated as below:
\(\frac{\text { EPSin current year – EPSin previousyear }}{\text { EPSin previous year }} \)
= \(\frac{₹ 2.36-₹ 2.15}{₹ 2.15} \times 100 \) = 10% (Approximate 10% figure ¡s taken because of decimal figures)

[Alternative calculation of Growth rate: Growth rate is calculated on basis average growth of EPS i.e. 10 + 10 + 9.92 + 9.77 + 10.27 + 13.04 + 7.14 + 10.25 + 9.76 = 90.15/9 = 10.01 or 10%.
Or,
The EPS for 2006 is given ₹ 1 and whereas for 2015 is given at ₹ 2.36. This has resulted in increase of ₹ 1.36 over a period of 9 years.
The growth rate can be calculated by using formula:
E_t = E₀(1 +g)^t
2.36 = 1 (1 + g)⁹ using the CVF table, ₹ 1 becomes ₹ 2.36 at the end of 9th year at the compound interest rate of 10%. Therefore, the growth rate is taken at 10%.]

(ii) Marginal Cost of Capital at Existing Capital Structure:

(iii) Company can spend the following amount without increasing its NCC and without selling the new share
Retained earning = 1.18 × 1,00,000 = 1,18,000
The ordinary equity is 80% of total capital. Thus, investment before issuing equity
\(\frac{1,18,000}{80}\) × 100 = 1,47,500

(iv) If the company spends more than ₹ 1,47,500 as calculated in part (iii) above, it will have to issue new shares at ₹ 20 per share.
The cost of new issue of equity shares will be:
K_e = \(\frac{\text { Expected dividend }\left(\mathrm{D}_1\right)}{\text {Current market price }\left(\mathrm{P}_{\mathrm{N}}\right)}+\text { Growth rate }(\mathrm{g})=\frac{50 \% \text { of } ₹ 2.36}{₹ 20} \times 100 \) + 10%
= 5.9% + 10% = 15.9%.

Financial Analysis and Planning Ratio Analysis – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Financial Analysis and Planning Ratio Analysis – CA Inter FM Question Bank

Question 1.
Answer the following:
What is quick ratio? What does it signify? (Nov 2008, 2 marks)
Answer:
Quick ratio also termed as “acid test ratio” is one of the best measures of liquidity.
It is worked out as follows:
Quick Ratio = \(\frac{\text { Quick Assets }}{\text { Quick liabilities }}\)
In the above formula:
Quick Assets = Current Assets – Inventories
Quick liabilities = Current liabilities – Bank Overdraft – Cash credit
Quick ratio of 1:1 is an ideal ratio significance:
It indicates whether the firm is in a position to pay its current liabilities within a month or immediately.

Question 2.
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:
(i) Payment of current liability
(ii) Purchase of Property Plant and Equipment by cash
(iii) Cash collected from Customers
(iv) Bills receivable dishonored
(v) Issue of new shares
Answer:
Current Ratio = \(\frac{\text { Current Assets }(\mathrm{CA})}{\text { Current Liabilities }(\mathrm{CL})} \) =2 i.e. 2: 1

Situation	Improve/Decline/No Change	Reason
(i) Payment of Current liability	Current Ratio will improve	Let us assume CA is ₹ 2 lakhs and current CL ₹ 1 lakh. It payment of Current Liability = ₹ 10,000 then, CA = ₹ 1, 90,000 CL = 90,000. Current Ratio = \(\frac{1,90,000}{90,000} \) =2.11 :1. When Current Ratio is 2:1 Payment of Current liability will reduce the same amount in the numerator and denominator. Hence, the ratio will improve.
(ii) Purchase of PPE by cash	Current Ratio will decline	Since the cash being a current asset converted into Property Plant and Equipment, current assets reduced, thus, current ratio will fall.
(iii) Cash collected from Customers	Current Ratio will not change	Cash will increase and Debtors will reduce. Hence, change in Current Asset.
(iv) Bills Receivable dishonored	Current Ratio will not change	Bills Receivable will come down and debtors will increase. Hence, no change in Current Assets.
(v) Issue of New Shares	Current Ratio will improve	As cash will increase, Current Assets will increase and current ratio will increase.

Question 3.
Answer the following:
Explain the need of debt-service coverage ratio. (May 2007, 2 marks)
OR
Answer the following:
How is Debt service coverage ratio calculated? What is its significance? (May 2009, 2 marks)
Answer:
Debt-Service Coverage Ratio:

• This ratio is the vital indicator to the lender to assess the extent of ability of the borrower to service the loan in regard to timely payment of interest and repayment of principal amount.
• It shows whether the business is earning sufficient profits to pay not only the interest charges, but also the instalment due of the principal amount.
• Debt service coverage ratio of 1: 2 is considered ideal by the financial institutions.
  This ratio will enable the lender to take correct view of the borrower’s repayment capacity.
• The ratio is calculated as follows:
  = \(\frac{\text { Earning available for debt service }}{\text { Interest on loan + Instalment of the principal amount }}\)
• Where earning available for debt service = Profit after tax + Depreciation + Interest on Loan.

Question 4.
Answer the following:
Comment on the Debt Service Coverage Ratio. (May 2014, 4 marks)
Answer:
Debt Service Coverage Ratio (DSCR): This ratio indicates the liability of the company to repay the interest and the fixed installments on accounts of the debt fund which is there in the capital structure out of the cash profit earned during the current year.

The higher the ratio the better it is. A ratio of less than one may be taken as a sign of long-term solvency problem as it indicates that the firm does not generate cash internally to repay the debt. High credit rating firms target DSCR to be greater than 2 in its entire loan life. High DSCR facilitates the firm to borrow at the most competitive rates. Lenders are interested in this ratio to judge the firm’s ability to pay off current interest and installments. Debt Service Coverage Ratio = \(\frac{\text { Earning available for Debt Service }}{\text { Interest }+ \text { Installment }}\)

Question 5.
Answer the following:
From the information given below calculate the amount of Property Plant and Equipment and Proprietor’s fund.
Ratio of Property Plant and Equipment to proprietors fund = 0.75
Net working capital = ₹ 6,00,000 (Nov 2009, 2 marks)
Answer:
Calculation of PPE and Proprietors Fund = 0.75
Since Ratio of PPE to Proprietor1s Fund = 0.75 proprietor’s Fund
Therefore, Property Plant and Equipment = 0.25 proprietor’s Fund
Net Working capital 6,00,000 = 0.25 Proprietor’s fund
Therefore, Proprietors fund = \(\frac{₹ 6,00,000}{0.25}\) = ₹ 24,00,000
Proprietor’s Fund = ₹ 24,00,000
Since, PPE = 0.75 Proprietor’s Fund
therefore, PPE = 0.75 × 24,00,000 = ₹ 18,00,000
Property Plant and Equipment = ₹ 18,00,000

Question 6.
Answer the following:
What do you mean by Stock Turnover ratio and Gearing ratio? (Nov 2008, 3 marks)
Answer:
Inventory/Stock turn over ratio
It establishes the relationship between the cost of goods sold during the year and average inventory held during the year.

It is calculated as follows:
Inventory/Stock turnover Ratio = \(\frac{\text { Sales/Turnover }}{\text { Average/inventory }}\)

In above formula:
Average inventory = \(\frac{\text { Opening Stock }+ \text { Closing Stock }}{2} \)
This ratio indicates that how fast inventory is sold.

A high ratio is good from the viewpoint of liquidity and a low ratio would indicate that inventory is not sold and remains in godown for a long time.
Note : Turnover is generally taken as cost of goods sold.

Gearing Ratio:
It is also called as “Capital Gearing Ratio”. It shows the proportion of fixed interest (dividend) bearing capital to funds belonging to equity shareholders funds. This ratio indicate how much of the business is funded by borrowing.
It is calculated as follows:
\(\text { Preference Capital }+\frac{\text { Debentures }+ \text { Longtermloans }}{\text { Equity share capital + Reserves and Surplus – Iosses }} \)
This ratio helps to judge the long-term solvency position of a firm.

Question 7.
Discuss any three ratios computed for investment analysis. (Nov 2004, 3 marks)
Answer:

Question 8.
Discuss the Financial ratios for evaluating company performance on operating efficiency and liquidity position aspects. (Nov 2006, 4 marks)
Answer:
Financial ratios for evaluating company performance on operating efficiency and liquidity position aspects:
1. Operating efficiency: Financial Ratio Analysis helps to determine degree of efficiency and effective utilisation of assets. We measure operational efficiency of an enterprise with the help of activity ratio. It helps to determine solvency position of an enterprise. Following are examples of activity ratio:

• Capital turn over ratio = \(\frac{\text { Net Sales }}{\text { Capital employed }} \)
• Total asset turn over ratio = \(\frac{\text { Net Sales }}{\text { Total Assets }} \)
• Property Plant and Equipment turnover ratio = \(\frac{\text { Net Sales }}{\text { PPE }} \)

2. Liquidity positions :
Ratio analysis also helps to determine liquidity positions. A firm should be able to meet all its short-turn obligations. It is current asset that yields funds in short period. Current assets should not only yield sufficient funds to meet current liabilities as they fall due but also enable the firm to carry on its day-to-day activity. If above qualities are present in an enterprise are then firm can be said to have good liquidity position. Current ratio, liquid ratio, Debt equity ratios mainly used to judge liquidity position. These ratios are particularly useful in credit analysis by banks and other suppliers of short term loans.

Following are the Liquidity Ratios:
Current Ratio = \(\frac{\text { Current Assets }}{\text { Current Liabilities }} \)
Quick Ratio = \(\frac{\text { Quick Assets }}{\text { Current Liabilities }} \)
Cash Ratio = \(\frac{\text { Cast and Bank Balance }+ \text { Marketable Securities }}{\text { Current Liabilities }}\)

Question 9.
Diagrammatically present the DU PONT CHART to calculate return on equity. (May 2007, 3 marks)
Answer:
Du-Pont Chart was developed by the USA-based company Du-Point. This chart is a chart of financial ratios, which analyses the Net Profit Margin in terms of asset turnout. This chart shows that the ROI is ascertained as a product of Net profit margin ratio and investment turnover ratio. There are three components in the calculation of return on equity using the traditional Du Pont model- the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company’s return on equity can be discovered and compared to its competitors.

Return of Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier)

Question 10.
How is return on capital employed calculated? What is its significance? (Nov 2008, 2 marks)
Answer:
Return
Return on capital employed = \(\frac{\text { Return }}{\text { Capital employed }} \times 100 \)
Return = Profit after tax
+Tax
+ Interest
+ Nontrading Expenses
– Non-operating incomes

Capital employed = Equity share capital
+ Preference share capital
+ Reserves & surplus + P & L (Cr. Bal.) + Long term loans
+ Debentures
– Non-trading investment – Fictitious Assets
– P & L (Dr. Bal)

Significance of Return on Capital employed:

1. Overall profitability of the business is highlighted
2. Comparison of Return on capital employed with rate of interest debt leads to financial leverage.

Question 11.
Discuss the composition of Return on Equity (ROE) using the DuPont model. (May 2009, 3 marks)
Answer:
Composition of Return on Equity using the DuPont Model:
There are three components in the computation of return on equity using the traditional DuPont model – the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company’s return on equity can be discovered and compared to its competitors.

1. Net Profit Margin	The net profit margin is simply the after-tax profit a company generates for each rupee of revenue. Net profit margin = Net Income ÷ Revenue Net profit margin is a safety cushion; the lower the margin, lesser the room for error.
2. Asset Turnover	The asset turnover ratio is a measures of how effectively a company converts s assets into sales. It is calculated as follows: Asset Turnover = Revenue ÷ Assets The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset turnover.
3. Equity Multiplier	It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows: Equity Multiplier = Assets ÷ Shareholders’ EquityComputation of Return of Equity To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.) Return on Equity = Net profit margin × Asset turnover × Equity multiplier

Question 12.
Explain the following ratios:
(i) Operating ratio
(ii) Price earning ratio (May 2011, 4 marks)
Answer:
(i) Operating Ratio: A ratio that shows the efficiency of a company’s management by comparing operating expense to net sales is classified as an Operating Ratio.
It Is calculated as follows: \(\frac{\text { Operating expenses }}{\text { Net Sales }} \)

The smaller the ratio, the greater the organization’s ability to generate profit if revenues decrease. when using this ratio, however, investors should be aware that it doesn’t take debt repayment or expansion into account.

(ii) Price Earning Ratio: The price earning ratio indicates the expectation of equity investors about earnings of the firm. It relates earnings to market price and is generally taken as a summary measure of growth potential of an investment, risk characteristics, shareholders’ orientation, corporate image, and degree of liquidity.

It is calculated as:
P.E Ratio = \(\frac{\text { Market price per share }}{\text { Earnings per share }} \)

Question 13.
Answer the following:
MNP Limited has made plans for the next year 2010-11. It is estimated that the company wifl employ total assets of ₹ 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 ₹ 15,00,000 and all other operating expenses are estimated at ₹ 2,40,000. The sales revenue are estimated at ₹ 22,50,000.
Tax rate is assumed to be 40%.
Required to calculate:
(i) Net profit margin
(ii) Return on Assets
(iii) Asset turnover
(iv) Return on equity (Nov 2010, 5 marks)
Answer:

Question 14.
From the following information, prepare a summarised Balance Sheet as at 31st March 2002:
Working Capital ₹ 2,40,000
Bank overdraft ₹ 40,000
PPE to Proprietary ratio 0.75
Reserves and Surplus ₹ 1.60,000
Current ratio 2.5
Liquid ratio 1.5
(Nov 2002, 6 Marks)
Answer:
Working Notes:
1. Current assets and Current liabilities computation:
=\( \frac{\text {Current assets }}{\text {Current liabilities}} \)= \(\frac{2.5}{1}\)
or, Current assets = 2.5 Current liabilities.
or, Working capital = Current assets – Current liabilities
or, ₹ 2,40,000 = 2.5 C.L. – I. C. L.
or, 1.5 C. L. = ₹ 2,40,000
∴ Current liability – ₹ 1,60,000
& Current assets = 2.5 x 1,60,000 = ₹ 4,00,000

2. Computation of stock:
Liquid Ratio = \(\frac{\text { Liquid Assets }}{\text { Current Liabilities }} \)
Or 1.5 = \(=\frac{\text { Current assets – stock }}{₹ 1,60,000}\)
1.5 x 1,60,000 = 4,00,000 – Stock
2,40,000 = 4,00,000 – Stock
∴ Stock = 4,00,000 – 2,40,000 = 1,60,000

3. Computation of Proprietary Fund PPE, creditors & capital:
Proprietary fund = \(\frac{\text { PPE }}{\text { Proprietary Fund }}\) = 0.75
PPE = 0.75 Proprietary fund
& Net working capital = 0.25 Proprietary fund
or, 2,40,000/0.25 = Proprietary fund
Proprietary fund = ₹ 9,60,000
PPE = 0.75 Proprietary fund
= 0.75 × 9,60,000
=₹ 7,20,000
Capital = Proprietary fund – Reserve & surplus
= 9,60,000 – 1,60,000
= ₹ 8,00,000
Sundry Creditors = Current Liabilities – Bank overdraft = 1,60,000 – 40,000 = ₹ 1,20,000
Construction of Balance sheet:
(ReferW.N. 1.3)

Question 15.
With the help of the following information complete the Balance Sheet of MNOP Ltd.
Equity share capital ₹ 1,00,000
The relevant ratios of the company are as follows:
Current debt to total debt 40
Total debt to owner’s equity 60
Property Plant and Equipment to owner’s equity 60
Total assets turnover 2 Times
Inventory turnover 8 Times
(May 2005, 7 marks)
Answer:

Working Notes:
1. Property Plant and Equipment = 0.60 × Owners equity = 0.60 × ₹ 1,00,000 = ₹ 60,000
2. Total equity = Total debt + Owners equity = ₹ 60,000 + ₹ 1,00,000 = ₹ 1,60,000
3. Total assets consisting of PPE and current assets must be equal to ₹ 1,60,000 (Assets = Liabilities + Owners equity). Since PPE are ₹ 60,000 hence, current assets should be ₹ 1,00,000.
4. Total debt = 0.60 × Owners equity = 0.60 × ₹ 1,00,000 = ₹ 60,000
5. Total assets tumover= 2 Times: Inventory turnover = 8 Times Therefore,
Inventory! Total assets = 2/8 = 1/4, Total assets = 1,60,000
Therefore, Inventory = 1,60,000/4 = 40,000 Cash = 1,00,000 – 40,000 = 60,000

Question 16.
Using the following data, complete the Balance Sheet given below:
Gross Profits ₹ 54,000
Shareholders Funds ₹ 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
Long-term Debt of Equity 40%

(Nov 2005, 12 marks)
Answer:

Working Notes:
1. Gross Profit:
GP margin = 20%
GP = ₹ 54,000
∴ Sales = ₹ 2,70,000

2. Credit Sales:
Cr. Sales = 80% of Total Sales
= 2,70,000 × 80%
= ₹ 2,16,000

3. Total Assets:
Total Assets Turnover = \(\frac{\text { Sales }}{\text { Total Assets }}\) = 0.3 times
∴ Total Assets = \(\frac{2,70,000}{0.3}\)
= ₹ 9,00,000

4. Inventory Turnover:
Inventory Turnover = \(\frac{\text { Cash }}{\text { Inventory }} \times 100\)
∴ 4 = \(\frac{2,70,000-54,000}{\text { Inventory }} \)
∴ Inventory = ₹ 54,000

5. Debtors:
Debtors = \(\frac{\text { Credit Sales } \times 20 \text { days }}{360 \text { days }} \)
= \(2,16,000 \times \frac{20}{360} \text { days }\)
= ₹ 12,000

6. Creditors:
Total Assets = 9,00,000
∴ Total of Balance Sheet = 9,00,000
Now, Long Term Debt
∴ \(\frac{\text { Long Term Debt }}{\text { Equity }}\) = 40%

Long term Debt = 40% of equity
= 6,00,000 x 40%
= ₹ 2,40,000

Now Balancing figure of the Liability Side is creditors:
= 9,00,000 – 6,00,000 (Equity) – 2,40,000 (Long Term Debt)
= 60,000
∴ Creditors = ₹ 60,000

7. Current Ratio-Cash:
Current ratio = \(\frac{\text { Current Assets }}{\text { Current Liabilities }} \)
∴ 1.8 = \(\frac{\text { Debtors }+ \text { Inventory }+ \text { Cash }}{\text { Creditors }} \)
∴ 1.8 = \(\frac{12,000+54,000+\text { Cash }}{60,000} \)
∴ 1,08,000 = 66,000+Cash
∴ Cash = 42,000

8. Property Plant and Equipment:
The balancing figure on the Assets Side is Property Plant and Equipment.

9. Sales:
G.P. = COGS
∴ COGS = ₹ 2,70,000 – 54,000 = ₹ 2,16,000

Question 17.
JKL Limited has the following Balance Sheets as on March 31, 2006, and March 31, 2005:

Required:
(i) Calculate for the year 2005-06:
(a) inventory turnover ratio
(b) Financial Leverage
(c) Return on Investment (ROI)
(d) Return on Equity (ROE)
(e) Average Collection period. (May 2006, 10 marks)
(ii) Give a brief comment on the Financial Position of JKL Limited. (May 2006,2 marks)
Answer:

(ii) Financial position of JKL Limited:
A careful analysis of above balance sheet shows that current ratio of company ¡s 1.5 which ¡s less than current ratio (i.e. 2) and short-term solvency ratio is therefore not satisfactory. At the same time lot of capital is blocked in inventory as compared to previous year. This affects liquidity of the firm, As regards utilisation of Debt Capital, the percentage of debts to total assets is not high, but as compared to equity, debt content is more in capital structure. Company is said to be leveraged with higher proportion of debt in its capital structure. This situation involves considerable risk to shareholders. In capital structuring, the company should ensure that cost of debt remains lower than return on investment.

Question 18.
The Balance Sheet of X Ltd. as on 31st March 2007 is as follows:

The following additional information is available:
(i) The stock turnover ratio based on cost of goods sold would be 6 times.
(ii) The cost of PPE to sales ratio would be 1.4.
(iii) PPE costing ₹ 30,00,000 to be installed on 1st April, 2007, payment would be made on March 31, 2008.
(iv) In March 2008, a dividend of 7 percent on equity capital would be paid.
(v) ₹ 5,50,000, 11% Debentures would be issued on 1st April, 2007.
(vi) ₹ 30,00,000, Equity shares would be issued on 31st March, 2008.
(vii) Creditors would be 25% of materials consumed.
(viii) Debtors would be 10% of sales.
(ix) The cost of goods soId would be 90 percent of sales include material 40 percent and depreciation 5 percent of sales.
(x) The profit is subject to debenture interest and taxation @ 30 percent.
Required:
(i) Prepare the projected Balance Sheet as on 31st March, 2008.
(ii) Prepare projected Cash Flow Statement in accordance with AS -3. (Nov 2007, 10 + 5 = 15 marks)
Answer:

Question 19.
The following figures and ratios are related to a company:
(i) Sales for the year (all credit) ₹ 30,00,000
(ii) Gross Profit ratio 25 percent
(iii) PPE turnover (basis on cost of goods sold) 1.5
(iv) Stock turnover (basis on cost of goods sold) 6
(v) Liquid ratio 1: 1
(vi) Current ratio 1.5: 1
(vii) Debtors collection period 2 months
(viii) Reserve and surplus to Share capital 0.6: 1
(ix) Capital gearing ratio 0.5
(X) PPE to net worth 1.20:1
You are required to prepare:
(a) Balance Sheet of the company on the basis of above details. (May 2010, 11 marks)
(b) The statement showing Working capital requirement, if the company wants to make a provision for contingencies @ 10 percent of net working capital including such provision. (May 2010, 4 marks)
Answer:
(a) Preparation of Balance Sheet of a Company
Working Notes:
(i) Cost of Goods Sold = Sales – Gross Profit (= 25% of Sales)
= ₹ 30,00,000 – ₹ 7,50,000
= ₹ 22,50,000

(ii) Closing Stock = Cost of Goods Sold/Stock Turnover
= ₹ 22,50,000/6
= ₹ 3,75,000

(iii) Property Plant and Equipment = Cost of Goods Sold/PPE Turnover
= ₹ 22,50,000/1.5
= ₹ 15,00,000

(iv) Current Assets:
Current Ratio = 1.5 and Liquid Ratio = 1
Stock = 15-1=0.5
Current Assets = Amount of Stock × 1.5/0.5
= 3,75,000 × 1.5/0.5= ₹ 11,25,000

(v) Liquid Assets (Debtors and Cash)
= Current Assets – Stock
= ₹ 11,25,000 – ₹ 3,75,000
= ₹ 7,50,000

(vi) Debtors = Sales x Debtors Collection period/12
= ₹ 30,00,000 × 2/12
= ₹ 5,00,000

(vii) Cash = Liquid Assets – Debtors
= ₹ 7,50,000 – ₹ 5,00,000
= ₹ 2,50,000

(viii) Net worth = PPE/1 .2
= ₹ 15,00,000/1.2 = ₹ 12,50,000

(ix) Reserves and Surplus
Reserves and
Share Capital = 0.6 + 1 = 1.6
Reserves and Surplus = ₹ 12,50,000 × 0.6/1.6
= ₹ 4,68,750

(x) Share Capital = Net worth – Reserves and Surplus
= ₹ 12,50,000 – ₹ 4,68,750
= ₹ 7,81,250

(xi) Current Liabilities = Current Assets/Current Ratio
= ₹ 11,25,000/1.5 = ₹ 7,50,000

(xii) Long-term Debts
Capital Gearing Ratio = Long-term Debts /Equity Shareholders’ Fund
Long-term Debts = ₹ 12,50,000 × 0.5
= ₹ 6,25,000

Question 20.
The financial statements of a company contain the following information for the year ending 31st March 2011 :

You are required to calculate:
(i) Quick Ratio
(ii) Debt-equity Ratio
(iii) Return on Capital Employed, and
(iv) Average collection period (Assuming 360 days in a year). (Nov 2011, 8 marks)
Answer:
Quick Assets
(i) Quick ratio = \(\frac{\text { Quick Assets }}{\text { Current Liabilities }} \)
Quick Assets = Current Assets – Stock- Prepaid Expenses
= 30,50,000 – 21,60,000 – 10,000
Quick Assets = 8,80,000
Quick Ratio = 8,80.000/10,00,000 = 0.88:1

(ii) Debt-Equity Ratio = \(\frac{\text { Longtermdebt }}{\text { ShareholdersFunds }} \)
= \(\frac{16,00,000}{(20,00,000+8,00,000)}\)
= 0.57:1

(iii) Return on Capital Employed (ROCE)
ROCE = \(\frac{\text { PBIT }}{\text { CapitalEmployed }} \times 100 \)
Capital Employed loo
= \(=\frac{12,00,000}{44,00,000} \times 100 \) = 27.27%

(iv) Average Collection Period
= \(\frac{\text { Sundry Debtors }}{\text { Credit Sales }} \times 360 \)
= \(\frac{4,00,000}{32,00,000} \times 360\)
= 45 Days

Question 21.
The following accounting information and financial ratios of M Limited relate to the year ended 31st March. 2012:
Inventory Turnover Ratio 6 Times
Creditors Turnover Ratio 10 Times
Debtors Turnover Ratio 8 Times
Current Ratio 2.4
Gross Profit Ratio 25%
Total sales ₹ 30,00,000: cash sales 25% of credit sales; cash purchases ₹ 2,30,000; working capital ₹ 2,80,000; closing inventory is ₹ 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 (Nov 2012, 8 marks)
Answer:
(i) Computation of Average Inventory
Gross Profit = 25% of 30,00,000
Gross Profit 7,50,000
Cost of goods sold (COGS) = 30,00,000 – 7,50,000
COGS = 22,50,000
Inventory Turnover Ratio = \(\frac{\text { COGS }}{\text { Average Inventory }} \)
6 = \(\frac{22,50,000}{\text { Average Inventory }}\)
Average inventory = 3,75,000

(ii) Computation of Purchases
Purchases = COGS + increase in Stock
= 22,50,000 + 80,000
Purchases = 23,30,000

(iii) Computation of Average Debtors
Let Credit Sales be 100
∴ Cash sales = \(\frac{25}{100} \times 100 \)
∴ Total Sales = 100 + 25 = 125
If Then Total Sales = Credit Sales
125 = 100
30,00,000 = \frac{30,00,000}{125} \times 100 = 24,00,000
Credit Sales = 24,00,000
Cash Sales = 6,00,000
Now Debtors Turnover Ratio = \(\frac{\text { Net Credit Sales }}{\text { Average debtors }}\) = 8
or Debtor Turnover Ratio = \(\frac{24,00,000}{\text { Average debtors }}\) = 8
or Average Debtors = \(\frac{24,00,000}{8}\)
∴ Average Debtors = 3,00,000

(iv) Computation of Average Creditors
Credit Purchases = Purchases – Cash Purchases
= 23,3000 – 2,30000
= 21,00,000

Now Creditors Turnover Ratio = \(\frac{\text { Credit Purchases }}{\text { Average Creditors }} \)
∴ 10 = \(\frac{21,00,000}{\text { Average Creditors }} \)
or Average Creditor = 2,10,000

(v) Computation of Average Payment Period
Average Payment Period = 365/Creditors Turnover Ratio
= \(\frac{365}{10}\)
= 36.5 days
Average payment period = 365 days

(vi) Computation of Average Collection Period
Average collection period = 365/ Debtors Turnover Ratio
= \(\frac{365}{8} \) = 45.625 days
Average collections period = 45.625 days

(vii) Computation of Current Assets
Current Ratio = \(\frac{\text { Current Assets }(C A)}{\text { Current Liabilities }(C L)}\)
or 2.4 = \(\frac{\mathrm{CA}}{\mathrm{CL}} \)
or CL = \(\frac{\mathrm{CA}}{2.4} \)
Working capital = Current Assets – Current liabilities
2,80,000 = \(\quad(\mathrm{CA})-\left(\frac{\mathrm{CA}}{2.4}\right) \)
2,80,000 = \(\frac{1.4 \mathrm{CA}}{2.4}\)
or CA = 4,80,000

(viii) Computation of Current Liabilities
Current liabilities = \(\frac{4,80,000}{2.4}\) = 2,00,000

Question 22.
Answer the following:
The following information relates to Beta Ltd. for the year ended 31st March 2013:
Net Working Capital ₹ 12,00,000
PPE 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:
(i) Proprietor’s Fund
(ii) Property Plant and Equipment
(iii) Net Profit Ratio. (May 2013, 5 marks)
Answer:
(i) Calculation of Proprietor’s Fund
Since Ratio of PPE to Proprietor’s Fund = 0.75
Therefore, PPE = 0.75 Proprietor’s Fund
Net Working Capital = 0.25 Proprietor’s Fund
12,00,000 = 0.25 Proprietor’s Fund
Therefore, Proprietors Fund = \(\frac{12,00,000}{0.25} \) = 48,00,000

(ii) Calculation of Property Plant and Equipment
PPE = 0.75 Proprietor’s Fund
= 0.75 × 48,00.000
= 36,00,000

(iii) Calculation of Net Profit Ratio
Net Working Capital = 0.25 × 48,00,000
= 12,00,000

Work no Capital’ Turnover Ratio = \(\frac{\text { Sales }}{\text { WorkingCapital }} \)
Sale = 60,00,000
ROE = \(\frac{\text { PAT }}{\text { Equity }}\)
015 = \(\frac{\text { PAT }}{48,00,000} \)
PAT = 7,20,000
Net Profit Ratio = \(\frac{\text { NetProfit }}{\text { Sales }} \times 100 \)
= \(\frac{7,20,000}{60,00,000} \times 100\)
Net Profit Ratio = 12%

Alternative Treatment:
PPE may be computed alternatively by (Proprietor’s fund × PPE to Proprietor’s Fund Ratio) and Proprietor’s Fund by (PPE + Net Working Capital.)

Question 23.
The assets of SONA Ltd. consist of Property Plant and Equipment and current assets, while its current liabilities comprise bank credit in the ratio of 2:1. You are required to prepare the Balance Sheet of the company as on 31st March 2013 with the help of following information:
Share Capital – ₹ 5,75,000
Working capital (CA-CL) – ₹ 1,50,000
Gross Margin – 25%
Inventory Turnover – 5 times
Average Collection Period – 1.5 months
Current Ratio – 1.5:1
Quick Ratio – 0.8:1
Reserves & Surplus to Bank & Cash – 4 times (Nov 2013, 8 Marks)
Answer:

Working Note:
1. Current ratio =\(\frac{\text { CurrentAssets }}{\text { CurrentLiabilities }} \) = 1.5 times.
Current Liabilities
Therefore, Current Asset = 1.5 × Current Liabilities

2. Net working capital = Current Assets – Current Liabilities
= 1.5 × CL – CL = 1,50,000
= 0.5 CL = 1,50,000

CL = \(\frac{1,50,000}{0.5}\) = 300000 .
Bank Credit and creditors divided in 2: 1 ratio, 2,00,000 & 1,00,000.

3. Current Assets = 1.5 × Current Liabilities = 1.5 × 3,00,000 = 4,50,000.

4. Quick ratio = \(\frac{\text { QuickAssets }}{\text { CurrentLiabilities }} \) = 0.8 times
∴ \(\frac{\text { Current Assets-Stock }}{\text { CurrentLiabilities }}=0.8\)
So, \(\frac{4,50,000-\text { Stock }}{3,00,000}=0.8 \)
Stock = 2,10,000

5. Inventory Turnover = \(\frac{\text { COGS }}{\text { Stock }}=\frac{\text { COGS }}{2,10,000}\) = 5 times.
So, COGS = 2,10,000 × 5 = 10,50,000

6. Since the Gross Margin is 25%, COGS constitutes 75% of sales.
So, Sales = \(\frac{10,50,000}{75 \%}\) = 14,00,000.

7. Debtors Sales × \(\frac{1.5}{12}\) = 1,75,000.

8. Cash & 3ank = Total current assets – stock – debtors
= 4,50,000 – 2,10,000 – 1,75,000 = 65,000.

9. \(\frac{\text { Reserves& Surplus }}{\text { Cash&Bank }} \) = 4 times
So, R & S = 65,000 × 4 = 2,60,000.

Question 24.
NOOR Limited provides the following information for the year ending 31st March 2014:
Equity Share Capital ₹ 25,00,000
Closing Stock ₹ 6,00,000
Stock Turnover Ratio 5 times
Gross Profit Ratio 25%
Net Profit / Sale 20%
Net Profit / Capital \(\frac{1}{4}\)
You are required to prepare:
Trading and Profit & Loss Account for the year ending 31st March 2014. (May 2014, 5 marks)
Answer:

Working Note:
1. Calculation of Net Profit:
Net profit/capital = 1/4
∴ \(\frac{N P}{25,00,000}=\frac{1}{4}\)
∴ 4 NP = 25,00,000
∴ NP = 6,25,000

2. Calculation of Sales:
Net profit/sales = 20%
∴ Sales =\(\frac{NP}{20 \%}=\frac{6,25,000}{20 \%} \) = ₹ 31,25,000

3. Calculation of GP:
GP Sales x 25% = 31,25,000 x 25% = ₹ 7,81,250

4. Calculation of Opening Stock:
Stock Turnover Ratio = \(\frac{\text { COGS }}{\text { Avg.Stock }} \)
∴ Avg. Stock = \(\frac{23,43,750}{5}\)
∴ Avg. Stock = 4,68,750
∴ \(\frac{\text { Op. Stock }+\mathrm{Cl} \text {. Stock }}{2}\) = 4,68,750
∴ \(\frac{\text { Op. Stock }+6,00,000}{2}\) = 4,68,750
∴ Op. Stock = 9,37,500 – 6,00,000
∴ Op. Stock = 3,37,500

5. Calculation of Purchase:
Purchase = COGS + Closing Stock – Opening Stock
= 23,43,750 + 6,00,000 – 3,37,500
= ₹ 26,06,250

Question 25.
From the following information, prepare Balance Sheet of a firm:
Stock Turnover Ratio (based on cost of goods sold) – 7 times
Rate of Gross Profit to Sales – 25%
Sales to Property Plant and Equipment – 2 times
Average debt collection period – 1.5 months
Current Ratio – 2
Liquidity Ratio – 1.25
Net Working Capital – ₹ 8,00,000
Net Worth to Property Plant and Equipment – 0.9 times
Reserve and Surplus to Capital – 0.25 times
Long Term Debts – Nil
All Sales are on credit basis (Nov 2014, 8 marks)
Answer:

Note: 1 Net Working Capital
₹ 8,00,000 = Current assets – Current liabilities
₹ 8,00,000 = 2CL – CL
CL = 8,00,000
CA =2CL
= 2 (8,00,000)
CA =16,00,000

Note: 2 Liquid Ratio
125 = \(\frac{\mathrm{CA}-\text { Stock }}{\mathrm{CL}} \)
125 = \(\frac{16,00,000-\text { Stock }}{8,00,000} \)
∴ Stock = 16,00,000 – 10,00,000
∴ Stock=₹ 6,00,000

Note: 3 Stock Turnover ratio
7 times = \(\frac{\text { COGS }}{\text { Avg.Stock }}\)
Absence of information about opening Stock considering closing stock as Avg.
7 = \frac{\text { COGS }}{6,00,000}
COGS = 42,00,000
GP = COGS × 33.33%
= 42,00,000 × 33.3%
GP =14,00,000
Sales COGS + GP
= 42,00,000 + 14,00,000
Sales = ₹ 56,00,000

Note: 4 Sales to Property Plant and Equipment
2 = \(\frac{\text { Sales }}{F A} \)
∴ FA = \(\frac{56,00,000}{2} \)
∴ F.A. = 28,00,000

Note: 5 Net worth
Networth Total Assets – CL
= 28,00,000 + 16,00,000 – 8,00,000
= ₹ 36,00,000

Capital = \(\frac{36,00,000}{1.25} \) = ₹ 28,80,000
R&S = 28,80,000 × 0.25 = ₹ 7,20,000.

Question 26.
SSR Ltd. has furnished the following ratios and information relating to the year ended 31st March, 2015.
Sales ₹60 Lacs
Return on Net worth 25%
Rate of Income tax 50%
Share Capital to Reserves 7: 3
Current Ratio 2
Net-Profit to Sales (after tax) 6.25%
Inventory Turnover 12
(Based on cost of goods sold and closing stock)
Cost of goods sold ₹ 18 Lacs
interest on Debentures (@ 15%) ₹ 60,000
Sundry Debtors ₹ 2 Lacs
Sundry Creditors ₹ 2 Lacs
You are required to:
(i) Calculate the operating expenses for the year ended 31st March, 2015.
(ii) Prepare a Bance Sheet as on 31 March. 2015. (May 2015, 8 marks)
Answer:
Workings:
1. Net Profit = 6.25% of 60,00,000 = ₹ 3,75,000
2. Net worth = ₹ 3,75,000 × \(\frac{100}{25}\) = ₹ 15,00,000
Share Capital = ₹ 15,00,000 × \(\frac{7}{10}\) = ₹ 10,50,000
Reserve = ₹ 15,00,000 × \(\frac{3}{10}\) = ₹ 4,50,000
Debentures = ₹ 60,000 × \(\frac{100}{15}\) = ₹ 4,00,000

3. Sundry Creditors = ₹ 2,00,000
Current Ratio = \(=\frac{\text { Current Assets }}{\text { Current Liabilities }} \) = 2
Current Assets = 2 Current Liabilities
2 × ₹ 2,00,000 (assumed creditors is the only current liabilities) = ₹ 4,00,000

4. Inventory Turnover =\(\frac{\text { Cost of Goods Sold }}{\text { ClosingStock }} \) = 12
Hence, Closing Stock = \(\frac{₹ 18,00,000}{12} \) = 1,50,000

Question 27.
VRA Limited has provided the following information for the year ending 31st March 2015.
Debt Equity Ratio 2: 1
14% long-term debt ₹ 50,00,000
Gross Profit Ratio 30%
Return on equity 50%
Income Tax Rate 35%
Capital Turnover Ratio 1.2 times
Opening Stock ₹ 4,50,000
Closing Stock 8% of sales
You are required to prepare Trading and Profit and Loss Account for the year ending 31st March, 2015. (Nov 2015, 8 marks)
Answer:

Working Note:
Debt Equity Ratio = 2:1, \(\frac{\text { Debt }}{\text { Equity }}=\frac{2}{1} \)
Equity = \(\frac{₹ 50,00,000}{2} \) = ₹ 25,00,000

Return on Equity = \(\frac{\text { Net Profit after tax (PAT) }}{\text { Equity }} \) = 50%
25,00,000 × 50% = 12,50,000

Net Profit before tax = ₹ 12,50,000 × \(\frac{100}{65} \) = ₹ 19,23,077
Tax = ₹ 19.23,077 – 12,50,000 = ₹ 6,73,077
Capital Turnover Ratio = \(\frac{\text { Sales }}{\text { Capital }} \) = 1.2
Or, \(\frac{\text { Sales }}{(₹ 25,00,000+₹ 50,00,000)}\) = 1.2
So, Sales = ₹ 75,00,000 x 1.2 = ₹ 90,00,000
Closing Stock = ₹ 90,00,000 x 8% = ₹ 7,20,000
Gross Profit = ₹ 90,00,000 x 30% = ₹ 27,00,000

Question 28.
With the following ratios and further information given below prepare a Trading Account, Profit and Loss Account and Balance Sheet of ABC Company.
Property Plant and Equipment ₹ 40,00,000
Closing stock ₹ 4,00,000
Stock turnover ratio 10
Gross profit ratio 25 percent
Net profit ratio 20 percent
Net profit to capital 1/5
Capital to total liabilities 1/2
Property Plant and Equipment to capital 5/4
PPE/Total current assets 5/7 (May 2016, 8 marks)
Answer:

Working Notes:
(i) \(\frac{\text { Property Plant and Equipment }}{\text { Total Current Asset }}=\frac{5}{7}\)
\(\frac{40,00,000}{\text { Total Current Asset }} \quad=\frac{5}{7}\)
∴ Total Current asset = 56,00,000

(ii) \(\frac{\text { Property Plant and Equipment }}{\text { Capital }}=\frac{5}{4}\)
\(\frac{40,00,000}{\text { Capital }}=\frac{5}{4} \)
∴ Capital = 32,00,000

(iii) \(\frac{\text { Capital }}{\text { Total Liabilities }} \quad=\frac{1}{2} \)
\(\frac{32,00,000}{\text { Total Liabilites }}=\frac{1}{2}\)
∴ Total Liabilites = 64,00,000

(iv) \(\frac{\text { NetProfit }}{\text { Capital }} \quad=\frac{1}{5}\)
\(\frac{\text { Net Profit }}{32,00,000} \quad=\frac{1}{5} \)
∴ Net Profit = 6,40,000

(v) Net Profit Ratio = \(\frac{\text { Net Profit }}{\text { Sales }} \times 100 \)
20 = \(\frac{6,40,000}{\text { Sales }} \times 100\)
∴ Sales = 32,00,000

(vi) Gross Profit Ratio = \(\frac{\text { Gross Profit }}{\text { Sales }} \times 100 \)
25 = \(\frac{\text { GrossProfit }}{32,00,000} \times 100 \)
∴ Gross Profit = 8,00,000

(vii) Cost of Goods Sold = Sales – GP
= 32,00,000 – 8,00,000
= 24,00,000

(viii) Stock T/O Ratio = \(\frac{\text { COGS }}{\text { AverageStock }} \)
10 = \(\frac{24,00,000}{\text { Average Stock }} \)
∴ Average Stock = 2,40,000

(ix) Average Stock = \(\frac{\text { Opening Stock }+ \text { Closing Stock }}{2} \)
2,40,000 = \(\frac{\text { Opening Stock }+4,00,000}{2} \)
∴ Opening Stock = 80,000

(x) Cost of Goods Sold = Opening Stock + Purchase – Closing Stock
24,00,000 = 80,000 + purchase – 4,00,000
∴ Purchase = 27,20,000

Question 29.
The following figures and ratios pertain to ABG Company Limited for the year ending 31st March, 2016:
Annual Sales (credit) ₹ 50,00,000
Gross Profit Ratio 28%
PPE turnover ratio (based on cost of goods sold) 1.5
Stock turnover ratio (based on cost of goods sold) 6
Quick ratio 1: 1
Current ratio 1 .5
The debtor’s collection period is 45 days
Reserves and surplus to Share Capital 0.60: 1
Capital gearing ratio 0.5
Property Plant and Equipment to net worth 1.2: 1
You are required to prepare the Balance Sheet as at 31st’ March 2016 based on the above information. Assume 360 days in a year. (Nov 2016, 8 marks)
Answer:

Working Notes:
Calculation of Debtors:
Average collection period = 45 days.
∴ Debtors T/O Ratio =\(\frac{360}{45} \) = 8
∴ Debtors = \(\frac{\text { Credit Sales }}{\text { Debtors } \mathrm{T} / \mathrm{O}} \)
= \(\frac{₹ 50,00,000}{8} \) = ₹ 6,25,000

2. Calculation of Property Plant and Equipment:
PPE = \(\frac{\text { COGS }}{\text { PPE }} \)
∴ 1.5 = \(\frac{36,00,000}{F A} \)
∴ FA = ₹ 24,00,000.

3. Calculation of Working Capital:
PPE to Networth = 1.2
∴ \(\frac{\mathrm{PPE}}{\mathrm{NW}} \quad=\frac{1.2}{1}\)

∴ Working Capital = ₹ 24,00,000 × 0.2
= ₹ 4,80,000.

4. Current Assets: Current Ratio
= 1.5 and Liquid Ratio 1
Stock =1.5-1=0.5
Current Assets = Amount of Stock × 1.5/0.5
= 6,00,000 × 1.5/0.5 = ₹ 18,00,000

5. Current Liabilities
= Current Assets / Current Ratio
= ₹ 18,00,000/1.5 = ₹ 12,00,000

6. Liquid Assets (Debtors and Cash and cash equivalents)
= Current Assets – Stock
= ₹ 18,00,000 – ₹ 6,00,000
= ₹ 12,00,000

7. Reserves and Surplus
Reserves & Surplus and Share Capital = 0.6 + 1 =1.6
Reserves and Surplus = ₹ 20,00,000 × 0.6/1.6 = ₹ 7,50,000
Share Capital = Net worth – Reserves and Surplus
= ₹ 20,00,000 – ₹ 7,50,000
= ₹ 12,50,000

8. Net Worth
= Property Plant and Equipment / 1.2
= ₹ 24,00,000/1.2
= ₹ 20,00,000

9. Cash & Cash equivalents
= Liquid Assets – Debtors
= ₹ 12,00,000- ₹ 6,25,000
= ₹ 5,75,000

10. Long-term Debts
Capital Gearing Ratio = Long-term Debts/ Equity Shareholders’ Fund (New worth)
Or, Long term Debts = ₹ 20,00,000 x 0.5 = ₹ 10,00,000.

Question 30.
Following information relates to a concern:
Debtors Velocity 3 months
Creditors Velocity 2 months
Stock Turnover Ratio 1.5
Gross Profit Ratio 25%
Bills Receivables ₹ 25,000
Bills Payables ₹ 10,000
Gross Profit ₹ 4,00,000
PPE to turnover Ratio 4
Closing stock of the period is ₹ 10,000 above the opening stock.

Find out:
(i) Sales and cost of goods sold
(ii) Sundry Debtors
(iii) Sundry Creditors
(iv) Closing Stock
(v) Property Plant and Equipment (May 2017, 8 marks)
Answer:
1. Sales and COGS:
GP. Ratio = \(\frac{\text { Gross Profit }}{\text { Sales }} \times 100 \)
25 = \(\frac{4,00,000}{\text { Sales }} \times 100 \)
Sales = \(\frac{4,00,000 \times 100}{25}\)
∴ Sales = 16,00,000
COGS = Sales – Gross Profit
= 16,00,000 – 4,00,000
∴ COGS = 12,00,000

2. Sundry Debtors:
Debtors Velocity = \(\frac{\text { Debtors }}{\text { Sales }} \times 100 \)
3 = \(\frac{\text { Debtors }}{16,00,000} \times 12\)
Debtors = \(\frac{16,00,000 \times 3}{12}\)
∴ Debtors = 4,00,000
Now S. Debtors + OR = 4,00,000
∴ S. Debtors 4,00,000 -25,000 = 3,75,000

3. Sundry Creditors COGS = Opening Stock + Purchase – Closing Stock
12,00,000 = 7,95,000 + Purchase – 8,05,000
∴ Purchase = 12,10,000

Creditors Velocity = \(\frac{\text { Creditors }}{\text { Purchase }} \times 12 \)
2 = \(\frac{\text { Creditors }}{12,10,000} \times 12 \)
Creditors = \(\frac{12,10,000 \times 2}{12} \)
∴ Creditors = 2,01,667
Now S. Creditors + BP = 2,01,667
∴ S. Creditors = 2,01,667 – 10,000 = 1,91,667

4. Closing Stock
Stock Turnover Ratio = \(\frac{\text { COGS }}{\text { AverageStock }} \)
1.5 = \(\frac{12,00,000}{\text { Average Stock }}\)
Average Stock = 8,00,000
Average Stock = \(\frac{\text { Opening Stock }+ \text { Closing Stock }}{2} \)
8,00,000 = \(\frac{\text { Opening Stock }+(\text { Opening Stock }+10,000)}{2} \)
16,00,000 = 2 Opening Stock + 10,000
Opening Stock = 7,95,000
Closing Stock Opening Stock + 10,000
= 7,95,000 + 10,000
∴ Closing Stock = 8,05,000

5. Property Plant and Equipment
PPE TR= \(\frac{\text { COGS }}{\text { Property Plant Equipment }} \)
4 = \(\frac{12,00,000}{\text { PropertyPlant and Equipment }} \)
Property Plant and Equipment = 3,00,000

Question 31.
XY Ltd. provides the following information for the year ending 31st March 2017:
Equity Share Capital ₹ 8,00,000
Closing Stock ₹ 1,50,000
Stock Turnover Ratio 5 times
Gross profit ratio 20%
Net profit/Sales 16%
Net profit/Capital 25%
You are required to prepare:
Trading and Profit & Loss Account for the year ending 31st March 2017. (Nov 2017, 8 marks)
Answer:
Working Notes:
(1) \(\frac{\text { Net Profit }}{\text { Capital }}=\frac{25}{100}\)
\(\frac{\text { NetProfit }}{8,00,000}=\frac{1}{4} \)
Net profit = \(\frac{8,00,000}{4} \) = 2,00,000

(2) \(\frac{\text { Net Profit }}{\text { Sales }}=16 \%\)
Sales = \(\frac{2,00,000}{16 \%}\) = 12,50,000

(3) Gross Profìt Rates = \(\frac{\text { G.P. }}{\text { Sales }} \times 100\) = 20%
Gross Profit = 12,50,000 x \(\frac{20}{100} \) = 2,50,000

(4) Stock Turnover = \(\frac{\text { COGS }}{\text { Average stock }} \)
5 = \(\frac{12,50,000-2,50,000}{\text { Averagestock }} \)
Average Stock = \(\frac{10,00,000}{5} \) = 2,00,000
Average Stock = \(\frac{\text { Opening }+ \text { Closing stock }}{2} \)
Opening Stock = 2,00,000 × 2 – 1,50,000 = 2,50,000

Question 32.
The accountant of Moon Ltd. has reported the following data:
Gross Profit ₹ 60,000
Gross Profit Margin 20 per cent
Total Assets Turnover 0.30:1
Net Worth to Total Assets 0.90:1
Current Ratio 1.5:1
Liquid Assets to Current Liability 1:1
Credit Sales to Total Sales 0.80:1
Average Collection Period 60 days
Assume 360 days in a year
You are required to complete the following:

(May 2018, 5 marks)
Answer:

Working Notes:
Sales = Gross Profit/Gross Profit Margin
= 60000/0.2 = ₹ 3,00,000
Total Assets = Sales/Total Asset Turnover
= 3,00,000/0.3 = ₹ 10,00,000
Net Worth = 0.9× Total Assets
0.9 x 10,00,000 = ₹ 9,00,000

Current Liability = Total Assets – Net Worth
= ₹ 10,00,000 – ₹ 9,00,000
= ₹ 1,00,000

Current Assets = 1.5 × Current Liability
= 1.5 × 1,00,000 = ₹ 1,50,000
Stock = Current Assets – Liquid Assets
= Current Assets – (Liquid Assets/Current Liabilities = 1)
= 1,50,000 – (LA/1 ,00,000 = 1) = ₹ 50,000
Debtors = Average Collection Period × Credit Sales/360
= 60 × 0.8 × 3,00,000/360 = ₹ 40,000
Cash = Current Assets – Debtors – Stock
= ₹ 1,50,000 – ₹ 40,000 – ₹ 50,000
= ₹ 60,000
PPE = Total Assets – Current Assets
= ₹ 10,00,000 – ₹ 1,50,000
= 8,50,000

Question 33.
The following is the information of XML Ltd. related to the year ended 31- 03-2018:
Gross Profit 20% of Sales
Net Profit 10% of Sales
Inventory Holding period 3 months
Receivable 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 Reserve and Surplus 4: 1
Non-current Assets as on 31st March, 2017 ₹ 50,00,000

Assume that:
(i) No change in Non-Current Assets during the year 2017 – 18.
(ii) No depreciation charged on Non-Current Assets during the year 2017-18.
(iii) 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. (Nov 2018, 5 marks)
Answer:
Non Current Assets to Sale = 1 : 4
Non Current Assets = ₹ 50,00,000
Sales = ₹ 50,00,000 × 4
Sales = ₹ 2,00,00,000
Net Profit = 10% of Sales
= 10% of ₹ 2,00,00,000
= ₹ 20,00,000
Cost of goods sold = Sales – GP
= 2.00,00,000 – 20% of 2,00,00,000
= 1,60,00,000

Raw material consumption = 80% of Sales
= 80% of ₹ 2,00,00,000 = ₹ 1,60,00,000
Inventory = ₹ 1,60,00,000 × \(\frac{3}{12}\) = ₹ 40,00,000
Receivables = ₹ 2,00,00,000 × \(\frac{3}{12}\) = ₹ 50,00,000
Cash = Current Asset – Inventory – Receivables
= ₹ 1,00,00,000 – ₹ 40,00,000 – ₹ 50,00,000 = ₹ 10,00,000
Note: It is assumed that all sales are credit sales.

Question 34.
Following figures and ratios are related to a company Q Ltd.:
(I) Sales for the year (all credit) ₹ 30,00,000
(ii) Gross Profit ratio 25 per cent
(iii) PPE turnover (based on cost of goods sold) 1.5
(iv) Stock turnover (based on cost of goods sold) 6
(v) Liquid ratio
(vi) Current ratio 1.5: 1
(vii) Receivables (Debtors) collection period 2 months
(viii) Reserves and surplus to share capital 0.6: 1
(ix) Capital gearing ratio 0.5
(x) PPE to net worth 1.20: 1
You are required to calculate:
Closing Stock, PPE, Current Assets, Debtors, and Net worth. (May 2019, 5 marks)
Answer:
(i) Calculation of Closing Stock:
Sales for the year = ₹ 30,00,000
GP Ratio = 25%
Gross Profit = ₹ 7,50,000

Cost of Goods Sold = S – Gross Profit
= ₹ 30,000 – ₹ 7,50,000
Cost of goods Sold = ₹ 22,50,000
Closing stock = \(\frac{\text { COGS }}{\text { Stock Tumover }}\)
= \(\frac{22,50,000}{6}\)
= ₹ 3,75,000

(ii) Calculation of Fixed Asset:
Fixed Asset Turnover Ratio = \(\frac{\text { Cost of Goods Sold }}{\text { FixedAssets }} \)
∴ 1.5 = \(\frac{₹ 22,50,000}{\text { FixedAssets }}\)
Fixed Assets = \(\frac{₹ 22,50,000}{1.5} \) = ₹ 15,00,000

(iii) Calculation of Current Assets:
Current Ratio = 1.5 and Liquid Ratio = 1
Stock =1.5 – 1=0.5
Current Assets = Amount of Stock × 1.5/0.5
= ₹ 3,75,000 × 1.5/0.5
= ₹ 11,25,000

(iv) Calculation of Debtors:
Debtors = Sales x Debtors Collection period /12
= ₹ 30,00,000 × 2 /12
= ₹ 5,00,000

(v) Calculation of Net Worth:
Net worth = \( \frac{\text { Fixed Assets }}{\text { Net worth }}=\frac{1.20}{1}\)
= \(\frac{₹ 15,00,000}{\text { Net Worth }}=\frac{1.20}{1} \)
Net worth = ₹ 12,50,000

Question 35.
Following information has been gathered from the books of Tram Ltd. the equity share of which is trading in the stock market at ₹ 14.
Particulars Amount (₹)
Equity Share Capital (face value ₹ 10) 10,00,000
10% preference Shares 2,00,000
Reserves 8,00,000
10% Debentures 6,00,000
Profit before Interest and Tax for the year 4,00,000
Interest 60,000
Profit after Tax for the year 2,40,000

Calculate the following:
(i) Return on Capital Employed
(ii) Earnings per share
(iii) PE ratio (Nov 2019, 5 marks)
Answer:
(i) Return on Capital Employed:
ROCE (Pre Tax) = \(\frac{\text { Profits before Interest and Taxes }}{\text { Capital Employed }} \times 100 \)
= \(\frac{₹ 4,00,000}{₹ 10,00,000+₹ 2,00,000+₹ 8,00,000+₹ 6,00,000} \times 100 \)
= \(\frac{₹ 4,00,000}{₹ 26,00,000} \times 100 \)
= 15.38%.
ROCE (POST TAX) = \(\frac{\text { Profit after Tax }}{\text { Capital Employed }} \times 100 \)
= \(\frac{2,40,000}{26,00,000} \times 100\)
= 9.23%

(ii) Earnings per share:

(iii) PE Ratio:
PE Ratio = \(\frac{\text { Market Price }}{\text { Earnings per Share }} \)
= \(\frac{₹ 14}{₹ 2.20}\)
= 6.36 times

Question 36.
The following information relates to RM Co. Ltd.
Total Assets employed ₹ 10,00,000
Direct Cost ₹ 5,50,000
Other Operating Cost ₹ 90,000
Goods are sold to the customers at 150% of direct costs.
50% of the assets being financed by borrowed capital at an interest cost
of 8% per annum.
Tax rate is 30%
You are required to calculate:
(i) Net profit margin
(ii) Return on assets
(iii) Asset turnover
(iv) Return on owners’ equity (Nov 2020, 5 marks)

Question 37.
From the following information, complete the Balance Sheet given below:
(i) Equity Share Capital: ₹ 2,00,000
(ii) Total debt to owner’s equity: 0.75
(iii) Total Assets turnover: 2 times
(iv) Inventory turnover: 8 times
(v) Fixed Assets to owner’s equity: 0.60
(vi) Current debt to total debt: 0.40

(Jan 2021, 5 marks)

Question 38.
XV Ltd. provides the following information for the year ending 31st March, 2017:
PPE turnover ratio 8 times
Capital turnover ratio 2 times
Inventory Turnover 8 times
Receivable turnover 4 times
Payable turnover 6 times
G P Ratio 25%
Gross profit during the year amounts to ₹ 8,00,000. There is no long-term loan or overdraft Reserve and surplus amount ₹ 2,00,000. Ending inventory of the year is ₹ 20,000 above the beginning inventory.

Required:
CALCULATE various assets and liabilities and PREPARE a Balance sheet of Tirupati Ltd.
Answer:
Gross Profit
(a) G.P. ratio = \(\frac{\text { GrossProfit }}{\text {Sale}}\)
Sales = \(\frac{\text { GrossProfit }}{25} \times 100=\frac{₹ 8,00,000}{25} \times 100\) = ₹ 32,00,000

b) Cost of Sales = Sales – Gross profit
= ₹ 32,00,000 – ₹ 8,00,000
= ₹ 24,00,000

(c) Receivable turnover Sale = \(\frac{\text { Sale }}{\text { Receivables }} \) = 4
= Receivables = \(\frac{\text { Sale }}{4}=\frac{₹ 32,00,000}{4}\) = ₹ 8,00,000

(d) PPE turnover = \(\frac{\text { Cost of Sales }}{\text { Property Plant and Equipment }}\) =8
PPE = \(\frac{\text { Cost of Sales }}{8}=\frac{₹ 24,00,000}{8} \) = ₹ 3,00,000

(e) Inventory turnover = \(\frac{\text { Cost of Sales }}{\text { AverageStock }} \) = 8

Average Stock = \(\frac{\text { Cost of Sales }}{8}=\frac{₹ 24,00,000}{8} \) = ₹ 3,00,000
Average Stock = \(\frac{\text { OpeningStock }+ \text { ClosingStock }}{2} \)
Average Stock = \(\frac{\text { OpeningStock }+ \text { Opning Stock }+20,000}{2} \)
Average Stock = Opening Stock + ₹ 10,000
Opening Stock = Average Stock – ₹ 10,000
=₹ 30,00,000 – ₹ 10,000
=₹ 2,90,000
Closing Stock = Opening Stock + ₹ 20,000
=₹ 2,90,000 + ₹ 20,000
= ₹ 3,10,000

(f) Payable turnover = \(\frac{\text { Purchases }}{\text { Payables }} \) = 6
Purchases = Cost of Sales + Increase in Stock = ₹ 24,00,000 + ₹ 20,000 = ₹ 24,20,000
Purchase = ₹ 24,20,000
Payables = \(\frac{\text { Purchase }}{6}=\frac{₹ 24,20,000}{6} \) = ₹ 4,03,333

(g) Capital turnover = \(\frac{\text { Cost of Sales }}{\text { Capital Emloyed }} \) =2
Capital Employed = \(\frac{\text { Cost of Sales }}{2}=\frac{₹ 24,00,000}{2}= \) = ₹ 12,00,000

(h) Share Capital = Capital Employed – Reserves & Surplus
=₹ 12,00,000- ₹ 2,00000 =₹ 10,00,000

(PPE turnover, inventory turnover capital turnover is calculated on cost of sales)

Question 39.
Answer the following:
Explain the important ratios that would be used in each of the following situations.
(i) A bank is approached by a company for a loan of ₹ 50 lakh for working capital purposes.
(ii) A long-term creditor interested in determining whether his claim is adequately secured.
(iii) A shareholder who is examining his portfolio and who is to decide whether he should hold or sell his holding in the company.
(iv) A finance manager is interested to know the effectiveness with which a firm uses its available resources. (May 2012, 4 marks)
Answer:
important Ratios used in different situations

1. Liquidity Ratios	Liquidity short-term solvency ratios would be used by the bank or financial institutions to check the ability of the company to pay its short-term liabilities. A bank may use the Current ratio and Quick ratio to judge the short-term solvency of the firm.
2. Capital Structure/Leverage Ratios	Long-term creditors would use the capital structure/leverage ratio to ensure the long-term stability and structure of the firm. A long-term creditor interested in determining whether his claim is adequately secured may use Debt-service coverage and interest coverage ratio.
3. Profitability Ratios	Generally, shareholders 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, earnings per share, and dividend per share.
4. Activity Ratios	The top financial executive would use these ratios to evaluate the efficiency with which the firm manages and utilizes its assets. Some important ratios are (a) Capital turnover ratio (b) Current and PPE turnover ratio (c) Stock, Debtors, and Creditors turnover ratio.

Question 40.
From the following table of financial ratios of R. Textiles Limited, comment on various ratios given at the end:

COMMENT on the following aspect of R. Textiles Limited
(i) Liquidity
(ii) Operating profits
(iii) Financing
(iv) Return to the shareholders.
Answer:

Ratios	Comment
Liquidity	Current ratio has improved from last year and matching the industry average. Quick ratio also improved than last year and above the industry average. This may happen due to reduction in receivable collection period and quick inventory turnover. However, this also indicates idleness of funds. Overall it is reasonably good. All the liquidity ratios are either better or same in both the year compare to the Industry Average.
Operating Profits	Operating Income-ROI reduced from last year but Operating Profit Margin has been maintained. This may happen due to variability of cost on turnover. However, both the ratio are still higher than the industry average.
Financing	The company has reduced its debt capital by 1% and saved operating profit for equity shareholders. It also signifies that dependency on debt compared to other industry players (57%) is low.
Return to the shareholders	R’s ROE is 24 percent in 2017 and 25 percent in 2018 compared to an industry average of 15 percent. The ROE has stable and improved over the last year.

Question 41.
Answer the following:
(i) Explain briefly the limitations of Financial ratios. (Nov 2009, 2 marks)
Answer:
The limitations of financial ratios are as below:

1. Concept of Ideal Ratio	The concept of ideal ratio is vague and there is no uniformity as to what an ideal ratio is.
2. Thin line of difference between good and bad ratio	The line of difference between good and bad ratios is so thin that they are hardly separable.
3. Financial ratios are not independent	The FR’s cannot be considered in isolation. They are inter related but not independent. Thus, decision taken on the basis of one ratio may not be correct.
4. Misleading	Various firms may follow different accounting policies. In such cases ratio comparison among companies may be misleading.
5. Impact of Seasonal Factors	Seasonal factor brings boom or recession. Ratios may indicate different results during different periods.
6. Impact of Inflation	Under the impact of inflation, the ratios might not present a true picture.
7. Product line diversification	Due to product line diversification, the overall position of the firm may differ from position of individual product line.

Types of Financing – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Types of Financing – CA Inter FM Question Bank

Question 1.
Write short notes on following:
Bridge Finance. (May 2006, Nov 2011, Nov 2016, 3, 2, 2 each marks)
Answer:
Bridge Finance:
Meaning
bridge finance ¡s a short-term loan taken by a firm from commercial banks to disperse loans sanctioned by financial institutions.

Importance or Need for Bridge Finance
Bridge finance as the name suggests bridges the time gap between the date of sanctioning of a term loan and its disbursement.
The reason for such delay is due to procedure formalities.
Such delays result in cost overrun of the project.
Thus, to avoid such cost overruns, firms approach commercial banks for short-term loans for a period for which delay may occur:

• In India Bank of Baroda has introduced a scheme called ‘Bridge Loan’ for top rated corporate clients against expected equity flows/issues.
• Bank can also extend bridge loans against the expected proceeds of Non-Convertible Debentures, External Commercial Borrowings, Global Depository Receipts, and/or funds in the nature of Foreign Direct Investments, provided the borrowing company has already made firm arrangements for raising the aforesaid resources/funds.
• This facility would be available for a period not exceeding 12 months.

Characteristics of Bridge Finance

1. It is a short-term loan.
2. It bridges the gap between the date of sanctioning the loan and the final disbursement of loan.
3. The rate of interest on such loan is usually high.
4. These loans are usually repaid as and when term loans are disbursed.

Advantage

1. It helps in avoiding the cost overruns.
2. Such loans are useful to implement the projects on time.

Disadvantage
1. The rate of interest on such loans is very high.

Question 2.
Explain the term ‘Ploughing back of Profits’. (May 2007, Nov 2009,2 marks,15 marks)
Answer:
Meaning: Ploughing back of profit is an internal source pt finance. It is a phenomenon under which the company does not distribute all the profit earned but retains a part of it, which is re-invested in the business for its development. It is thus known as Retained Earnings. Long-term funds can be provided by accumulating the profits of the company and ploughing them back into business. Such funds belong to the ordinary shareholders and increase the net worth of the company.

A public limited company must plough back a reasonable amount of its profits each year for 2 reasons:
(i) keeping in view the legal requirements in this regard and (II) its own expansion plans.

Question 3.
Answer the following:
Discuss the advantages of preference share capital as an instrument of raising funds. (May 2008, 2 marks)
Answer:
Meaning of Preference Share
As the name suggests, Preference shares are the shares which enjoys certain preferential rights over the equity shares in regards to:

1. Payment of dividends at a fixed rate.
2. Repayment of capital on the winding up of the company.

Advantages

1. It provides a long-term capital to the company.
2. There is no dilution of EPS.
3. As it bears a fixed charge, there is a leveraging advantage.
4. It can be redeemed after a specified time period.
5. It does not carry voting rights hence, there is no dilution of control.
6. It enhances the creditworthiness of the company.

Question 4.
Answer the following:
Financing a business through borrowing is cheaper than using equity. Briefly explain. (Nov 2012, 4 marks)
Answer:

1. When only equity shares are issued the company cannot take advantage of trading on equity.
2. There is a danger of over-capitalisation as equity shares cannot be redeemed.
3. During prosperous period higher profit leads to higher dividends to the shareholders which increases the market value of the share and also the possibility of speculation.
4. The cost of equity shares is high as the shareholders are paid profit after tax and preference shareholders.

Question 5.
Distinguish between the following:
Preference Shares and Debentures (Nov 2015, 2 marks)
Answer
Preference Shares:
Preference shares are the share to which the right to recover money is given prior to the equity shareholders. Shareholders are not owners of the company. A certain percentage of dividends given preference shareholders on shares.

Debentures:
Debentures are the liability of the company. Debenture holders are entitled to receive a fix rate of interest on value. Debentures can be redeemed and having prior right to receive funds than preference shareholders in case of liquidation.

Question 6.
What are Masala Bonds? (May 2018,2 marks)
Answer:

• Masala (means spice) bond is an Indian name used for rupee-denominated bond that Indian corporate borrowers can sell to investors in overseas markets.
• These bonds are issued outside India but do-nominated in Indian rupees.
• NTPC raised 2,000 more via masala bonds for its capital expenditure in the year 2016.

Question 7.
Explain in brief the following bonds:
(i) Callable Bonds
(ii) Puttable Bonds (Jan 2021, 2 marks)

Question 8.
Write a note on Venture Capital Financing. (Nov 2002, May 2005, 3 marks)
OR
What is meant by Venture capital financing” (Nov 2008, 3 marks)
Answer:
Venture Capital Financing
Venture capital financing refers to financing of a new high risky venture promoted by qualified entrepreneurs who lack experience and funds to give shape to their ideas.

The European Venture Capital Association describes venture capital as risk finance for entrepreneurial growth-oriented companies. It is an investment for the medium or long term seeking to maximize the return.

In a broad sense, under venture capital financing, venture capitalist makes investment to purchase debt or equity from inexperienced entrepreneurs, who undertake highly risky ventures with potential of success.

Features
1. It is a long-term investment In growth-oriented but small and new high-risk venture.
2. It’s in form of equity finance.
3. The investors also provide support in form of sales strategy, business networking, etc.

Methods

1. Equity financing
2. Conditional loan
3. Income note
4. Participating in debenture.

Question 9.
Answer the following:
Explain the methods of venture capital financing. (Nov 2007, 3 marks)
OR
What is meant by venture capital financing? State its various methods. (Nov 2015, 4 marks)
OR
Explain In brief the methods of Venture Capital Financing. (Nov 2020, 4 marks)
Answer:
Please refer 2002. Nov (7) (b) on page no. 39
1. Equity financing: Usually venture capital financing takes form of equity financing as equity financing is a long-term financing.

2. Income Note: It is a type of hybrid financing in which the entrepreneur has to pay both interest and royalty on sales but at a low rate.

3. Conditional Loan: It is a type of financing whereby conditional loan is repayable in the form of a royalty after the venture capital is also to generate sales. No interest is paid on such loans.

4. Participating Debenture: It is a type of financing where security carrier charges in three distinct phases:

• Start-up phase: No interest is charged
• 2nd Phase: A low rate of interest is charged up to a particular level of operation
• 3rd Phase: After reaching a particular level of operation high rate of interest.

Question 10.
Discuss factors that a venture capitalist should consider before financing risky project. (May 2012, 4 marks)
OR
Answer the following:
What is venture capital financing? State the factors which are to be considered in financing any risky project. (May 2013, 4 marks)
Answer:
Venture Capital Financing:
Venture capital financing refers to financing of a new high risky venture promoted by qualified entrepreneurs who lack experience and funds to give shape to their ideas. The European Venture Capital Association describes venture capital as risk finance for entrepreneurial growth-oriented companies. It is an investment for the medium or long term seeking to maximize the return.

In a broad sense, under venture capital financing, venture capitalist makes investment to purchase debt or equity from inexperienced entrepreneurs. who undertake highly risky ventures with potential of success.

Features
1. It is a long-term investment in a growth-oriented but small and new high-risk venture.
2. It is in form of equity finance.
3. The investors also provide support in form of sales strategy, business networking, etc.

Factors to be considered before Financing any Risky Project by Venture Capitalist:

1. The technical feasibility of the new product/service should be considered.
2. Research must be carried Out to ensure that there is a market for the new product.
3. Since the risk involved in investing in the company is quite high, venture capitalists should ensure that the prospects for future profits compensate for the risk.
4. The quality of the management team is a very important factor to be considered. They are required to show a high level of commitment to the project.
5. The technical ability of the team is also vital. They should be able to develop and produce a new product/service.

Question 11.
What is Debt Securitisation? Explain the basic Debt securitization process. (Nov 2004, 6 marks)
OR
Write Short Notes of Debt Securitisation (May 2006, 3 marks)
OR
Explain the concept of Debt securitization. (May 2008, 3 marks)
OR
What is debt securitization? And also state its advantages. (May 2013, 4 marks)
OR
State advantages of Debt Securitisation. (Nov 2016, 4 marks)
Answer:
Debt Securitisation
Meaning
Debt securitization is a method of recycling of funds. It is a process whereby loans and other receivables are underwritten and sold in form of assets. It is thus a process of transforming the assets ola lending institution into a negotiable instrument for generation of funds.

Process of debt securitization The process of debt securitization is as follows:

1. The loans are segregated into relatively homogeneous pools.
2. The basis of pool is the type of credit, maturity pattern, interest rate, risk etc.
3. The asset pools are then transferred to a trustee.
4. The trustee then Issues securities which are purchased by investors.
5. Such securities (asset pool) are sold on the undertaking without recourse to seller.

Function of debt securitization
it is a method of recyding of funds. It is especially beneficial to financial intermediaries to support the lending volumes. The basic debt securitization process can be classified in the following three functions:

1. The Origination Function
2. The Pooling Function
3. The Securitisation Function.

1. The origination function
Whenever a bank, financial institution, leasing company, Hire Purchase Company, credit card company, housing finance company, etc. lends money (whether directly of indirectly) to a borrower, there comes into existence an asset in the books of bank. This creation of financial asset is called the origination function.

2. The pooling function
Similar loans or receivables are clubbed together to create an underlying pool of assets. This pool is transferred in favour of a SPV (Special Purpose Vehicle), which acts as a trustee for the investor. This pooling of assets is SPy’s portfolio is called the pooling function.

3. The securitization function
Once the assets are transferred, SPy issues its securities (Called Pass-through certificates) to the investor, This issue of securities is called the securitization function. In this way, we see that conversion of debts to securities is known as debt securitization.

Advantages of Debt Securitisation

1. The asset is shifted off the Balance Sheet, thus giving the originator recourse to oft Balance Sheet funding.
2. It converts liquid assets to liquid portfolios.
3. If facilitate better balance sheet management assets are transferred off balance sheet facilitating satisfaction of capital adequacy norms.
4. The originator’s credit rating enhances.

Question 12.
Answer the following:
Discuss the benefits to the originator of Debt Securitisation. (May 2009, 2 marks)
Answer:
The benefits to the originator of debt securitization are es follows:

1. The assets are shifted oft the balance sheet, thus giving the originator recourse to off-balance sheet funding.
2. It converts illiquid assets to liquid portfolios.
3. It facilitates better balance sheet management as assets are transferred off balance sheet facilitating satisfaction of capital adequacy norms.
4. The originator’s credit rating enhances.

Question 13.
What is the process of Debt Securitisation? (May 2019, 4 marks)
Answer:
The basic debt securitization process can be classified in the following three functions:
1. The Origination Function
2. The Pooling Function
3. The Securitisation Function

1. The origination function:
Whenever a bank, Financial institution, leasing company, Hire Purchase Company, credit card company, housing finance company etc. lends money (whether directly of indirectly) to a borrower, there comes into existence an asset in the books of bank. This creation of financial asset is called the origination function.

2. The pooling function
Similar loans on receivables are dubbed together to create an underlying pool of assets. This pool is transferred in favour of a SPV (Special Purpose Vehicle), which acts as a trustee for the investor. This pooling of assets is SPy’s portfolio is called the pooling function.

3. The securitization function
Once the assets are transferred, SPy issues its securities (Called Pass-through certificates) to the investor. This issue of securities is called the securitization function. In this way we see that conversion of debts to securities is known as debt securitization.

Question 14.
Explain the concept of leveraged lease. (Nov 2007, 2 marks)
OR
Explain what do you mean by Leveraged Lease (May 2016, 2 marks)
Answer:
Leveraged Lease
Meaning
A lease agreement that is partially financed by the lessor through of third-party financial institution. Under a leverage lease transaction, the leasing company (called the equity participant) and a lender (called the loan participant) jointly fund the Investment with assets to be leased to the lessee.

Mechanism
In this form of lease agreement, the lessor undertakes to finance only a part of the money required to purchase the asset. The major part of the finance is arranged with a financier to whom the title deeds for the asset as well as the lease retails are assigned. There are usually three parties involved, the lessor, the lessee, and the financier. The lease agreement is between the lessee and lessor as in any other case. But it is supplemented by another separate agreement between the lesser and the financier who agrees to provide a major part say 80% of the money required.

Such lease agreement which will enable the lessor to undertake and expand volume of lease business with a limited amount of capital and hence it is called leverage leasing.

Question 15.
Distinguish between Operating lease and financial lease. (Nov 2011, 4 marks)
OR
Distinguish between Operating Lease and ‘Financial Lease’. (Nov 2014, 4 marks)
OR
Distinguish between operating lease and finance lease. (May 2016, 4 marks)
Answer:
Difference between Operating Lease and Financial Lease

Basis of Difference	Financial Lease	Operating Lease
1. Lease Term	Lease term Is for the major part of the economic lite of the assets.	Lease term is significantly less than the economic life of the assets.
2. Risk and Rewards transferred	Under finance lease the Lessor transfers substantially all the risk and rewards incidental to ownership of an asset to the Lessee.	Under operating lease,the lessor does not transfer substantially all the risks and rewards incidental to ownership of an assets to the Lessee.
3. Beerer of Risk of obsolescence	The risk of obsolescence falls on the Lessee.	The risk of obsolescence falls on the Lessor.
4..Continuation of Lease	Continuation of lease is reasonably certain,	Continuation of lease is not reasonably certain.
5. Cancellation	Finance Leases are generally non-cancellable unless contract provides otherwise.	Operating leases are generally cancellable unless contract provides otherwise.

Question 16.
State the main elements of leveraged lease. (Nov 2013, 2 marks)
Answer:
Main elements of Leveraged Lease:

1. A third-party lender is involved besides lessor and lessee who agreed to provide a major part of the money required.
2. The lessor borrows a part of purchase cost from lender (third party)
3. The asset is held as security.
4. The lender is paid off by lessee from the lease rental.

Question 17.
Explain Sales and Lease Back’. (May 2015, 4 marks)
Answer:
Sale and Lease Back: Under this type of lease, the owner of an asset sells the asset to a party (the buyer), who in turn leases back the same asset to the owner ¡n consideration of a lease rentals. Under this agreement, the asset is not physically exchanged but it all happens in records only. The main advantage of this method is that the lessee can satisfy himself
completely regarding the quality of an asset and after possession of the asset convert the sale into a lease agreement.

An operating lease is particularly attractive to companies that continually update or replace equipment and want lo use equipment without ownership, but also want to return equipment at lease end and avoid technological obsolescence.

Question 18.
Discuss the Advantages of Leasing. (Nov 2018, 4 marks)
Answer:
Advantages of Leasing:

• Flexibility
• The leasing company may finance 100% cost of the equipment
• Leasing is time-saving and involves quick documentation.
• Operating lease safeguards lessee against obsolescence.
• Leasing does not affect the borrowing capacity of the lessee.
• Leased equipment is an off-the-balance sheet asset being economically used by the lessee and does not affect the debt position of lessee.
• Sale and lease back’ arrangement helps lessee overcomes a financial crisis immediately.
• Leasing is convenient for small equipments where debt financing is impracticable.
• Tax benefits may also sometimes accrue to the lessee depending upon his tax status.

Question 19.
Give any two limitations of leasing. (May 2019, 2 marks)
Answer:
Limitations of leasing:
1. The lease rentals become payable soon after the acquisition of assets and no moratorium period is permissible as in case of term loans from mandal institutions. The lease arrangement may, therefore, not be suitable for setting up of the new projects as it would entail cash outflows even before the project comes into operation.

2. The leased assets are purchased by the lessor who is the owner of equipment. The seller’s warranties for satisfactory operation of the leased assets may sometimes not be available to lessee.

3. Lessor generally obtains credit facilities from banks etc. to purchase the leased equipment which are subject to hypothecation charge in favour of the bank. Default in payment by the lessor may sometimes result In seizure of assets by banks causing loss to the lessee.

4. Lease financing has a very high cost of interest as compared to interest charged on term loans by financial institutions/banks.

Question 20.
Loft Ltd. is considering an investment in new technology that will reduce operating costs through increasing efficiency. The new technology will cost ₹ 5,00,000 and have a tour year life at the end of which it will have a residual value of ₹ 50,000.

An annual license fee of ₹ 52,000 is payable to operate the machine. The purchase can be financed by 10% loan payable in equal installments at the end of each of tour years. The depreciation is to be charged as per reducing balance method. The rate of depreciation is 25% per annum. Alternatively, Loft Ltd. could lease the new technology. ‘The Company
would pay four annual lease rentals 0f ₹ 1,90,000 per year. The annual lease rentals include Ihe cost of license lee. Tax rate is 30%. Compute the incremental cash flows under each option. What would be the appropriate rate at which these cash flows have to be discounted Discount the incremental cash flows under each option and decide which option is better – buy or lease? (Nov 2019, 10 Marks)

Answer:
The PVAE at the rate of 10% for4 year is 3.169, the amotint payable will be Annual Payment = \(\frac{₹ 5,00,000}{3.169} \) = ₹ 1,57,780 (Rounded)
Schedule for Debt Repayment

(2) Lease Alternative:
After-Tax Lease Rent = ₹ 1,90,000 × 0.7
= ₹ 1,33.000
So, outflow = ₹ 1,33,000 × 3.387
= ₹ 4,50,471
Since PV of outflow Is lower in the leasing option loti lid, should prefer leasing option of the new technology.

Note:
Preferable discount rate will be after-tax rate of interest i.e. 7% [10% – (30% of 10%)]
Alternate Answer:
1. The buy or lease decision means computation of NPV arising from lease decision i.e. computation of valuation advantage of lease over buy. If the value is positive then we go for lease, otherwise, we buy.

2. The valuation process involves – (a) finding incremental cash flow of lease over buy, and then, (b) discounting the incremental cash flow by net of tax interest rate of equivalent loan (to purchase the asset in question).

If we go for lease, there would be cash outflow in the form of net of tax lease rent from year 1104. Net of tax lease rent per annum = ₹ 1,90,000
x (1 – 30) = ₹ 1,33,000.
Again, if the equipment had been purchased there would have been tax savings of depreciation = Depreciation x tax rate. Here, the tax saving or tax shield is available for 4 years. But under lease, the benefit accrues to lessor. For lessee, it is a negative cash flow as advantage is not available to him under lease arrangement as lessor is considered the legal owner of the asset for claiming depreciation under Income tax law. The depreciation schedule and tax shield on depreciation are given in Table 1.

3. Further, if the equipment had been purchased there would have been tax saving of interest on loan = interest on loan x tax rate. Here, the tax saving or tax shield is available for 4 years. For lessee, it is a negative cash flow as advantage is not available to him under lease arrangement.

The loan amount would have been repayable together with the interest at the rate of 10% in equal installments at the end of each year. The PVAF at the rate of 10% for 4 years is 3.169(0.909 + 0.826 + 0.751 + 0.683). the amount payable would have been – Annual Installment = \(\frac{₹ 5,00,000}{3.169}\) = ₹ 1,57,778 (approx,)
The interest expense schedule and tax Shield on interest expense are given in Table 2.

4. After 4 years the equipment is sold for ₹ 50,000 which is a cash outflow due to lease over buy Loss on sale = ₹ (1,58,203.12 – 50,000)
= ₹ 1,08,203.12

Tax savings on loss = 30% of ₹ 1,08,203.12 = ₹ 32,460.94
This further tax shield has to be accounted for in the year 4.

5. If the equipment is taken on ease, the cash outflow on a/c of lease rental, and depreciation tax shields given in table 3.

Since, NPV or value of the lease is positive, the equipment should be taken on lease.

Question 20.
What are the sources of short-term financal requirements of the company? (May 2018,4 marks)
Answer:
Source of short-term financial requirements of the company

1. Trade credit
2. Accrued expenses and deferred income
3. Short-term loans like working capital loans form commercial banks
4. Fixed deposits for a period of 1 year or less
5. Advances received from customers
6. Various short-term provisions.

Question 21.
Briefly describe any four sources of short-term finance. (Nov 2019, 4 marks)
Answer:
There are various sources available to meet short-term needs of finance.
The different sources are discussed below:
1. Trade Credit
It represents credit granted by suppliers of goods, etc. as an incident of sale. The usual duration of such credit is 15 to 90 days. it generates automatically in the course of business and is common to almost all business operations. It can be in the form of an open account or bills payable.

Trade credit is preferred as a source of finance because it is without any explicit cost and till a business is a going concern it keeps on rotating. Another very important characteristic of trade credit is that it enhances automatically with the increase in the volume of business.

2. Commercial Paper
A commercial paper is an unsecured money market instrument issued in the form of a promissory note. The Reserve Bank of India introduced the commercial paper scheme in the year 1989 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowing and to provide an additional instrument to investors. Subsequently in addition to the corporate, primary Dealers and All India Financial Institutions have also been allowed to issue commercial papers.

All eligible issuers are required to get the credit rating from Credit Rating Information Services of India Ltd. (CRISIL), or the Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or the FITCH. Ratings India Pvt. Ltd. or any such other credit rating agency as is specified by the Reserve Bank Of India.

3. Bank Advances
Banks receive deposits from public for different periods at varying rates of interest. These funds are invested and lent in such a manner that when required, they may be called back. Lending results in gross revenues out of which costs, such as interest on deposits, administrative costs, etc, are met and a reasonable profit is made. A bank’s lending policy is not merely profit-motivated but has to also keep in mind the socioeconomic development of the country.

4. Treasury Bills
Treasury Bills are a class of Central Government Securities. Treasury bills, commonly referred to as T- Bills are issued by the Government of India to meet short-term borrowing requirements with maturities ranging between 14 to 364 days.

Question 22.
Write short note on Seed capital assistance. (May 2005, 3 marks)
OR
Answer the following:
Briefly discuss the concept of Seed Capital Assistance. (May 2010, 2 marks)
Answer:
Seed Capital Assistance
Scheme designed by
The seed capital assistance scheme is designed by the IDBI for professionally or technically qualified entrepreneurs who lack financial resources.

Project Cost
The project cost should not exceed 2 crores. The maximum assistance under this scheme will be:
(a) 50% of the promotors required contribution, or
(b) ₹15 lacs, whichever is lower

Interest
The assistance is initially interest-free but carries a service Rate charge of 1% pa. for the five years and at an increasing rate thereafter.

However, IDBI will have option to charge interest at such rate as may be determined by it on loan if financial position and profitability of the company so permit during the duration of the loan.

Repayment Schedule
The repayment schedule Is fixed depending upon the repaying capacity of the unit with an initial moratorium of up to 5 years.

Question 23.
Answer the following:
Discuss the features of Deep Discount Bonds. (Nov 2007, 2 marks)
OR
Answer the following:
Write a short note on Deep Discount Bonds. (Nov 2008, May 2012, 2 marks)
Answer:
Deep Discount Bond:
Deep discount bonds are a form of zero-interest bonds.
These bonds are sold at a discounted value and on maturity face value is paid to the investor’ In such bonds, there is no interest payout during lock-in period. When such bonds are sold in the stock market, the difference realised between face value and market price is the capital gain.

IDBI was the first to issue deep discount bonds in India in January 1992. For a deep discount price of ₹ 2,700/- in IDBI the investor got a bond with the face value of ₹ 1,00,000. The bond appreciates to its face value over the maturity period of 25 years. Alternatively, the investor can withdraw from the investment periodically after 5 years. The capital appreciation is charged to tax at capital gains rate which is lower than normal income tax rate. The deep discount bond is considered a safe, solid, and liquid instrument and assigned the best rating by CRISIL.

Question 24.
Answer the following:
Discuss the features of Secured Premium Notes (SPNs). (May 2008, 2 marks)
Answer:
Features of Secured Premium Notes (SPNs).

1. A secured premium Note is issued along with a detachable warrant and is redeemable after a notified period of 4 to 7 years.
2. The conversion of detachable warrants into equity shares will have to be done within time period notified by the company.
3. The warrant attached to SPNs gives the holder the right to apply for and get allotment of equity shares as per the conditions within the time period notified by the company.

Question 25.
Answer the following:
Explain the concept of Indian depository receipts. (Nov 2007, 2 marks)
Answer:
Indian Depository Receipts
Meaning of IDR
An IDR is an Instrument denominated in Indian Rupees in the form of a depository receipt created by a Domestic Depository (custodian of securities registered with the Securities and Exchange Board of India) against the underlying equity cA issuing company to enable foreign companies to raise funds from the Indian Securities Markets.

Legislations governing IDRs
Central Government notified the Companies (Registration of Foreign Companies) Rules, 2014(IDR Rules) pursuant to the Section 390 of the Companies Act. 2013. SEBI issued guidelines for disclosure with respect to (IDRs and notified the model listing agreement to be entered between exchange and the foreign issuer specifying continuous listing requirements.

Question 26.
Answer the following:
Explain briefly the features of External Commercial Borrowings. (ECB) (May 2008, 3 marks)
Answer:
External Commercial Borrowings (ECS):

1. ECB is an instrument used in India to facilitate the access to foreign money by Indian corporations and PSUs.
2. ECBs include commercial loans (in the form of bank loans, buyers’ credit, suppliers’ credit, and securitized instruments (eg. floating rate notes and fixed rate bonds) availed from non-resident lenders with minimum average maturity of 3 years.
3. Borrowers can raise ECBs through internationally recognised sources like (a) International banks, (b) international capital markets (c) multilateral financial institutions such as the IFC, ADB etc, (d) export credit agencies (e) suppliers of equipment, (f) foreign collaborators and (g) foreign equity holders.
4. External Commercial Borrowings can be accessed under two routes viz (a) Automatic route (b) Approval route.
5. Under the Automatic route, there is no need to take the RBI! Government approval whereas such approval Is necessary under the Approval route.
6. Company’s registered under the Companies Act and NGOs engaged In microfinance activities are eligible for the Automatic Route whereas Financial Institutions and Banks dealing exclusively in infrastructure or export finance and the ones which had participated in the textile and steel sector restructuring packages as approved by the government are required to take the Approval Route.

Question 27.
Answer the following:
Name the various financial Instruments dealt with in the international market. (Nov 2008, 2 marks)
OR
Name any four financial instruments, which are related to international financial market. (May 2014, 2 marks)
OR
Answer the following:
Explain in brief following Financial instruments:
(i) Euro Bonds
(ii) Floating Rate Notes
(iii) Euro Commercial paper
(iv) Fully Hedged Bond (Nov 2018, 1 x 4=4 marks)
Answer:
Some of the various financial Instruments dealt with in the International market are discussed below:
1. Euro Issue
An Euro issue is a issue listed on a foreign stock exchange. It Is an instrument which raises foreign currency in the international market. through the issue of:

• Depository Receipts-ADR & GD
• Foreign Currency convertible bonds.

2. Euro Bonds
Euro bonds are long-term loans raised by entities enjoying an excellent credit rating.
These are debt instruments which are not denominated in the currency of the country In Which they are issued. These are issued in a bearer form rather than as registered bond and in such cases they do not contain investor’s name or the country of their origin.

3. Foreign Bonds
Foreign Bonds are debt instruments denominated in a currency which is foreign to the borrower and Is sold In the country of that currency.

4. Fully Hedged Bonds
Fully hedged bonds are the foreign bonds devoid of the risk of currency fluctuation. It eliminates the risk by selling the entire streams of principal and interest payment the forward market.

5. Floating Rate Note
The Floating Rate Notes provide foreign currency at a rate lower than foreign loans. They are Issued for a period up to 7 years. The interest rates are adjusted to reflect the prevailing exchange rate.

6. Euro Commercial Paper
Euro commercial papers are promissory notes with a maturity period of less than one year. These are unsecured instruments issued by a corporate body. The main investors are banks, insurance companies, fund managers, etc. They are usually designated in US Dollars.

7. Foreign Currency option
Foreign currency option is the right to buy or sell spot, future or forward, a specified foreign currency. It provides a hedge against financial and economic risks.

8. Foreign Currency Futures
A foreign currency future is a right to buy or sell a sum of foreign currency at a fixed exchange rate on a specific future date. It is an alternative to forward contract for hedging of exchange risk.

Question 28.
Discuss the concept of American Depository Receipts. (May 2009, 2 marks)
Answer:
American Depository Receipt:
Meaning
A deposit receipt issued by an Indian company in USA is known as American depository receipt (ADRs).
How Issued Such receipts have to be issued in accordance with the provisions stipulated by the security and Exchange Commission of USA.

Created by
An ADR is generally created by the deposit of the securities of an outsider company with a custodian bank in the country of incorporation of issuing company. The custodian bank informs the depository in USA that the ADRs can be issued. ADRs are dollar-denominated and are traded in the same way as are security of U.S. company.

Mode of Trading
ADRs can be traded either by trading existing ADRs or purchasing the shares in the issuer’s home market and having new ADRs created, based upon availability and market conditions. When trading in existing ADRs, the trade is executed on the secondary market on the New York Stock Exchange through Depository Trust Company (DTC) without involvement from foreign brokers or custodians.

Question 29.
Distinguish between the following:
Global Depository Receipts and American Depository Receipts. (Nov 2010, 4 marks)
OR
State the main features of Global Depositary Receipts (GDRs) and American Depositary Receipts (ADRs). (May 2014, 4 marks)
OR
Answer the following:
Explain GDR and ADR. (May 2017, 4 marks)
Answer: