Financial Management - Theory Problems

Financial Management`

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Quest ion : What do you mean by f inancia l management ?

Answer : Meaning of Financial Management :

Financial management deals with procurement of funds and their effective utilisation in the business..

The pr imary task of a Charte red Accountant i s to dea l wi th funds, 'Management o f Funds ' i s

an important aspect o f f inancia l management in a business under taking or any o ther ins t i tut ion l ike

hospi ta l , ar t soc iety, and so on. The term 'F inancia l Management ' has been def ined di fferently by

di fferent authofrs.

According to Solomon "Financial Management is concerned wi th the e ff icient use of an

important economic resource, namely cap ital funds." Phi l l ippa tus has given a more e laborate

def ini t ion of the term, as , "Financial Mana gement, i s concerned wi th the manageria l decis ions that

result s in the acquis i t ion and financing of short and long term credi t s fo r the firm." Thus, i t deals

wi th the si tua tions tha t require select ion of speci fic prob lem of size and gro wth of an enterpr ise. The

analys is o f these decisions i s based on the expected inf lows and out flo ws of funds and the ir e ffect on

manager ia l object ives.

The most accep tab le def ini t ion of f inancia l management i s that given by S.C.Kuchhal

as, "Financial management deals w i th procurement o f funds and the i r effect ive ut i l isat ion in the

business." Thus, there a re 2 basic aspects o f f inancia l management :

1) Procurement of funds : As funds can be obtained from di fferent sources thus, the ir procurement i s a lways c onsidered

as a complex problem by business concerns. These funds procured from d i fferent sources have

di fferent charac ter is t ics in terms of r i sk, cos t and control that a manager must consider whi le

procuring funds. The funds should be procured at minimum cost , a t a balanced r i sk and cont rol

factors.

Funds ra ised by issue of equity shares a re the best fro m r isk po int o f view for the company,

as i t has no repayment l iabi l i ty except on winding up of the company, but from cost point o f view, i t

is most expensive, as dividend expectat ions o f shareholders are higher than prevai l ing interest rates

and dividends are appropriat ion of prof i t s and not al lo wed as expense under the income tax ac t . The

issue of new equity shares may di lute the contro l o f the exis t ing shareholders.

Debentures are compara tively cheaper s ince the interes t i s pa id out o f p rofi ts before tax. But,

they entai l a high degree of r isk s ince they have to be repa id as per the terms of agreement; a lso, the

interes t payment has to be made whether or not the company makes prof i t s .

Funds can a lso be procured from banks and financial inst i tut ions, they provide funds subject

to cer ta in res tr ict ive covenants. These covenants res tr ict f reedom of the borrower to raise loans fro m

other sources. The reform process i s also moving in direct ion of a c loser monitor ing of 'end use ' o f

resources mobil ized through cap ita l markets . Such restr ic t ions are essential for the safety o f funds

provided by ins t i tut ions and investors. There are other f inancia l instruments used for rais ing f inance

e .g . commercial paper , deep discount bonds, etc . The finance manager has to balance the ava ilabil i ty

of funds and the rest r ic t ive provis ions t ied wi th such funds result ing in lack of f lexib il i ty.

In the globali sed co mpet i t ive scenario , i t is no t enough to depend on ava ilable ways of

f inance but resource mobil iza t ion i s to be under taken through innovat ive ways or financial p roducts

that may meet the needs o f investors. Mult iple op tion conver t ib le bonds can be sighted as an

example, funds can be raised indigenously as also fro m abroad. Foreign Direc t Investment (FDI) and

Fore ign Inst i tut iona l Investors (FI I) are two major sources o f f inance from abroad along wi th

Amer ican Depository Receip ts (A DR's) and Global Deposi tory Receipts (GDR's) . The mechanism of

procuring funds i s to be modified in the l ight of requirements o f fore ign investors. Procurement o f

funds inter al ia inc ludes :

- Ident i ficat ion of sources o f finance

- Determinat ion of f inanc e mix

- Raising of funds

- Division of p rofi ts between d ividends and retent ion of p rofi ts i .e . in terna l fund genera tion.

2) Effect ive use of such funds : The f inance manager i s also responsible for e ffect ive ut i l i sa t ion of funds . He must po int out

si tua tions where funds are kep t idle or are used improperly. All funds are p rocured at a cer ta in cost

Chapter : Introduction

CA- IPCC- Financial Management`

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and after entai l ing a cer tain amount o f r i sk. I f the funds are no t ut i l ised in the manner so tha t they

genera te an income higher than cost o f procurement , there i s no meaning in running the business. I t is

an important considerat ion in dividend dec isions also, thus, i t i s cruc ia l to employ funds properly and

prof i tab ly. The funds a re to be employed in the manner so tha t the company can produce a t i t s

optimum level wi thout endangering i t s financia l solvency. Thus, f inancia l implicat ions o f each

decision to invest in fixed asse ts are to be properly ana lysed. For this, the f inance manager must

possess sound knowledge of techniques o f capita l budgeting and mus t keep in view the need of

adequate working capi ta l and ensure that whi le f irms enjoy an op timum leve l o f working cap ita l they

do no t keep too much funds blocked in inventor ies, book debts, cash, etc .

F ixed assets a re to f inanced fro m medium or lon g term funds, and not short term funds, as f ixed

asse ts cannot be so ld in shor t term i .e . wi thin a year , a l so a large amount o f funds would be blocked

in s tock in hand as the company cannot immedia tely sel l i ts finished goods.

Quest ion : Explain the scop e of f inancia l management ?

Answer : Scope of f inancial management : A sound f inancial management is essent ia l in a l l type of f inancia l organisat ions - whether

prof i t or iented or no t , where funds are invo lved and a lso in a central ly p lanned e conomy as also in a

capi tal i st set -up . Firms, as per the commercia l his tory, have not l iquidated because thei r technology

was obso lete or their products had no or lo w demand or due to any o ther factor , but due to lack of

f inancia l management. Even in boom per iod, when a co mpany makes high profi t s , there i s danger o f

l iquidat ion, due to bad f inancia l management. The main cause of l iquidat ion of such companies i s

over - trad ing or over -expanding without an adequate f inancia l base .

Financial management op timises the output f rom the given input o f funds and at tempts to use

the funds in a most productive manner . In a country l ike India, where resources are scarce and

demand on funds are many, the need for proper f inancia l management i s enormous. I f proper

techniques a re used most o f the enterpr ises can reduce the ir capi ta l employed and improve return on

investment. Thus , as men and machine are properly managed, f inances are also to be well managed.

In newly sta r ted companies, i t i s impor tant to hav e sound financial management, as i t ensures

their survival , o ften such companies ignores financia l management a t their own peri l . Even a s imple

act , l ike deposit ing the cheques on the day of the ir receip t i s not per formed. Such organisa t ions pay

heavy inte res t charges on borro wed funds, but a re tardy in real is ing the ir own deb tors. This i s due to

the fac t they lack real isat ion of the concept o f t ime value of money, i t is not appreciated tha t each

va lue of rupee has to be made use o f and that i t has a direct cost o f ut i l i sa t ion. I t must be real i sed

that keeping rupee idle even for a day, resul ts into losses . A non -profi t organisat ion may not be keen

to make profi t , t rad it ionally, but i t does need to cut down i t s cos t and use the funds at i t s disposa l to

their opt imum capaci ty . A sound sense of f inancia l management has to be cul t iva ted among our

bureaucra ts, administrators, engineers, educat ionis ts and public a t large . Unless this i s done, co lossa l

wastage of the capi ta l resources cannot be arrested.

Quest ion : What are the object ives of f inancia l management ?

Answer : Object ives of f inancial management : Eff ic ient f inancia l management requires exis tence of some objectives or goals because

judgment as to whether or not a financial decision i s e f f ic ient i s to be made in l ight o f some

objective . The two main objectives o f financial management are :

1) Profit Maximisat ion : I t is t rad it ional ly being argued, tha t the objec tive o f a company is to earn prof i t , hence the object ive

of f inancia l management i s prof i t maximisat ion. Thus, each a l ternat ive , i s to be seen by the f inance

manager from the view point o f prof i t maximisat ion. But , i t cannot be the only objec tive of a

company, i t i s a t best a l imi ted object ive else a number o f prob lems would ar ise. Some of them are :

a) The term profi t i s vague and does no t c lar i fy what exact ly i t means. I t conveys d i fferent meaning

to di fferent people.

b) Profi t maximisat ion has to be at tempted wi th a real isat ion of r i sks involved . There i s direc t

rela t ion bet ween r isk and profi t ; h igher the r isk, higher i s the prof i t . For maximising profi t , r i sk is

al together ignored, implying tha t f inance manager accep ts highly r isky proposals a lso. Pract ical ly,

r isk i s a very important factor to be balanced wi th profi t objec tive .

c) Profi t maximisat ion is an objec tive not taking into account the t ime pattern o f returns.

E.g. Proposa l X gives re turns higher than that by proposa l Y but , the t ime per iod i s say, 10 years and

7 years respect ively. Thus, the overal l prof i t is onl y considered no t the t ime per iod, nor the f low of

prof i t .

d) Prof i t maximisat ion as an object ive i s too narrow, i t fai l s to take into account the soc ial

considera t ions and obl iga tions to var ious interes ts o f workers , consumers, socie ty, as well as ethica l


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t rade prac tices. Ignor ing these fac tors, a company cannot survive for long. Prof i t maximisa tion at the

cost o f soc ial and moral obliga tions i s a shor t sighted pol icy.

2) Wealth maximisat ion : The companies having profi t maximisa tion as i t s object ive, may adopt po lic ies yielding

exorb itant profi ts in the shor t run which are unheal thy for the growth, survival and overal l interests

of the business. A company may not under take planned and prescr ibed shut -downs of the p lant for

maintenance, and so on for maximis ing profi ts in the shor t run. Thus , the objec tive of a f irm should

be to maximise i t s va lue or weal th.

Accord ing to Van Horne, "Value of a firm is represented by the market pr ice of the

company's common stock. . . . . . . the marke t pr ice of a firm's stock represents the foca l judgment of al l

market par t icipants as to what the value of the par t icular f irm is. I t takes into account present as a lso

prospective future earnings per share, the t iming and r i sk o f these earning, the d ivide nd pol icy of the

f irm and many other fac tors having a bear ing on the market pr ice o f s tock. The market pr ice serves as

a per formance index or report card of the firm's progress . I t ind ica tes how wel l management i s doing

on behal f o f stockholders." Share pr ices in the share market , a t a given point o f t ime, are the resul t o f

a mixture o f many fac tors, as genera l economic outlook, par t icular outlook of the co mpanies under

considera t ion, technica l fac tors and even mass psychology, but , taken on a long term bas is, they

ref lect the value , which var ious par t ies, put on the company.

Normally this va lue i s a funct ion, o f :

- the l ikely rate o f earnings per share o f the company; and

- the capi ta l i sa t ion rate .

The l ikely ra te of earnings per share (EPS) depends upon the assessment as to the profi tably

a company is go ing to operate in the future or what i t i s l ikely to earn aga inst each of i t s ordinary

shares.

The cap ital isat ion ra te re f lec ts the l iking of the investors o f a company. I f a comp any earns a

high rate o f earnings per share through i ts r i sky operat ions or r isky f inancing pa ttern, the investors

wi l l not look upon i t s share wi th favour . To tha t extent , the market va lue of the shares o f such a

company wi l l be lo w. An easy way to de term ine the cap ital i sat ion ra te is to s tar t wi th fixed deposit

in teres t rate o f banks , investor would want a higher re turn i f he invests in shares, as the r i sk

increases . How much higher return is expected, depends on the r i sks involved in the par t icular share

which in turn depends on company po licies, pas t records, type of business and confidence commanded

by the management. Thus, cap ita l i sa t ion ra te i s the cumula tive result o f the assessment o f the var ious

shareholders regard ing the r i sk and o ther quali tat ive fac tors o f a company. I f a co mpany invests i t s

funds in r i sky ventures, the investors wi l l put in thei r money i f they ge t higher re turn as compared to

that f rom a low r i sk share.

The market va lue of a share i s thus, a function of earnings per share and capital i sat ion rate .

Since the profi t maximisat ion cr i ter ia cannot be applied in real wor ld si tua tions because of i ts

technica l l imi tat ion the f inance manager o f a company has to ensure tha t his dec is ions a re such tha t

the market va lue of the shares o f the company is maximum in the long run. This impl ies tha t the

f inancia l policy has to be such tha t i t opt imises the EPS, keeping in view the r i sk and other factors.

Thus, wealth maximisa t ion i s a be tter object ive for a commercial under taking as com pared to return

and r i sk.

There i s a growing emphasis on socia l and other obl igat ions of an enterpr ise. I t cannot be

denied tha t in the case of under takings, especia l ly those in the publ ic sector , the question of weal th

maximisat ion i s to be se en in context o f soc ia l and o ther ob ligat ions o f the enterpr ise .

I t must be unders tood that financial dec is ion making i s re lated to the objec tives of the

business. The finance manager has to ensure tha t there i s a posit ive impact o f each f inanc ia l decision

on the fur therance of the business objec tives . One of the main object ive of an under taking may be to

"progress ive ly bui ld up the capabil i ty to under take the des ign and development o f a ircraft engines,

he licopters, e tc ." A finance manager in su ch cases wi l l a l loca te funds in a way that this object ive i s

achieved a l though such an al loca tion may no t necessar i ly maximise weal th .

Quest ion : What are the funct ions of a Finance Manager ?

Answer : Functions of a Finance Manager : The twin aspects, procurement and effect ive ut i l i sat ion of funds are cruc ial tasks faced by a

f inance manager . The f inancial manager is requi red to look into the f inancial implicat ions o f any

decision in the f irm. Thus al l decisions involve management o f funds under the purview of the

f inance manager . A large number o f dec is ions involve substantial or mater ia l changes in value of

funds procured or employed . The finance manager , has to manage funds in such a way so as to make

their opt imum ut i l isat ion and to ensu re the ir procurement in a way tha t the r isk , cos t and cont rol are

properly balanced under a given s i tuat ion. He may not , be concerned wi th the decis ions , that do no t

affec t the basic financia l management and s truc ture .


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The nature o f job of a n accountant and finance manager i s di ffe rent , an accountant 's job is

pr imar i ly to record the business transactions, prepare financial sta tements sho wing resul t s of the

organisat ion for a given per iod and i t s financia l condi t ion a t a given point o f t ime. H e i s to record

var ious happenings in monetary terms to ensure tha t assets, l iabi l i t ies, incomes and expenses are

properly grouped, c lass i fied and d isclosed in the f inancia l s tatements . Accountant i s not concerned

wi th management o f funds that is a spec ial i sed task and in modern t imes a complex one. The finance

manager or control ler has a task entirely d i fferent from that o f an accountant , he i s to manage funds .

Some of the impor tant decisions as regards f inance are as fo l lo ws :

1) Estimating the requireme nts of funds : A business requires funds for long term purposes i .e .

investment in fixed assets and so on. A careful est imate o f such funds i s required to be made. An

assessment has to be made regard ing requirements o f working cap ita l involving, es t imat io n of amount

of funds blocked in cur rent assets and tha t l ikely to be genera ted for short per iods through current

l iab il i t ies. Forecast ing the requirements o f funds is done by use o f techniques o f budgetary cont rol

and long range planning. Estimates o f requ irements o f funds can be made only i f a l l the physical

act ivi t ies o f the organisat ion are fo recas ted. They can be trans la ted into monetary terms.

2) Decis ion regarding capital structure : Once the requirements o f funds i s es t imated , a decision

regarding var ious sources from where the funds would be ra ised i s to be taken. A proper mix of the

var ious sources i s to be worked out , each source of funds involves di ffe rent i ssues for considerat ion.

The finance manager has to carefully look into the exis t ing c api ta l s tructure and see how the var ious

proposa ls o f ra ising funds wi l l a ffec t i t . He i s to mainta in a proper ba lance between long and shor t

term funds and to ensure that suff ic ient long -te rm funds are raised in order to finance fixed assets

and o ther long-term investments and to provide for permanent needs o f working cap ita l . In the

overal l volume of long -term funds, he i s to ma inta in a proper ba lance between own and loan funds

and to see tha t the overal l cap ita l i sa t ion of the company is such, that the co mpany is ab le to p rocure

funds at minimum cost and is ab le to tolera te shocks of lean per iods . All these decisions are kno wn

as ' f inancing dec is ions ' .

3) Investment dec ision : Funds procured from d i fferent sources have to be invested in var ious kinds

of asse ts. Long term funds are used in a projec t for f ixed and a lso current assets. The investment o f

funds in a project is to be made af ter careful assessment o f var ious projects through capital

budgeting. A par t o f long term funds i s a lso to be kept for f in ancing working capi tal requirements.

Asse t management pol ic ies are to be laid do wn regarding var ious i tems of current asse ts, inventory

policy i s to be de termined by the production and finance manager , while keeping in mind the

requirement o f production an d future pr ice es t imates o f raw mater ials and avai lab il i ty o f funds .

4) Dividend decision : The finance manager is concerned wi th the decis ion to pay or declare

dividend. He i s to assis t the top management in decid ing as to what amount o f dividend should be

paid to the shareholders and what amount be retained by the company, i t involves a large number of

considera t ions. Economica lly speaking, the amount to be retained or be paid to the shareholders

should depend on whether the company or shareholders can make a more profi tab le use o f resources,

a l so considerat ions l ike trend of earnings, the t rend of share market pr ices , requi rement o f funds for

future gro wth, cash f low si tua tion, tax posit ion of share holders, and so on to be kept in mind.

The pr incipal funct ion of a finance manager re lates to decisions regard ing procurement,

investment and dividends.

5) Supply of funds to a l l parts of the organisation or cash management : The finance manager has

to ensure that al l sec t ions i .e . branches , factor ies, unit s or depar tments o f the organisat ion are

suppl ied wi th adequate funds. Sec tions having excess funds contr ibute to the centra l pool for use in

other sect ions that needs funds. An adequate supply of cash at a l l points o f t ime is absolute ly

essentia l for the smooth flo w of business operat ions. Even i f one of the many branches is short of

funds, the whole business may be in danger , thus, cash management and cash d isbursement polic ies

are impor tant wi th a view to supplying adequate funds at a l l t imes and points in an organisa t ion. I t

should ensure that there is no excess ive cash.

6) Evaluating f inancia l performance : Management contro l sys tems are usual ly based on financia l

analys is, e .g. ROI (return on investment) sys tem of d ivisional contro l . A finance manager has to

constant ly review the f inancial per formance of var ious unit s o f the organisat ion. Analys is of the

f inancia l per formance he lps the management for assess ing ho w the funds are ut i l i sed in var ious

divisions and what can be done to imp rove i t .

7) Financial negot iat ions : Finance manager 's major t ime is ut i l i sed in carrying out negotiat ions

wi th financial inst i tut ions, banks and publ ic depositors. He has to furnish a lot o f informat ion to


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these ins t i tut ions and persons in order to ensu re tha t ra ising of funds is wi thin the statutes .

Negot ia t ions for outside f inancing of ten requires spec ia l i sed skil ls .

8) Keeping in touch with stock exchange quotations and behavior of share prices : I t involves

analys is o f major t rends in the s tock mar ket and judging the ir impact on share pr ices o f the

company's shares .

Quest ion : What are the various methods and tools used for f inancia l management ?

Answer : Finance manager uses var ious too ls to discharge his functions as regards financia l

management. In the area o f f inancing there are var ious methods to procure funds from long as also

short term sources. The f inance manager has to decide an op timum cap ital structure tha t can

contr ibute to the maximisat ion of shareholder 's wealth. Financial leverage or t rading on equity is an

important method by which a f inance manager may increase the return to common shareholders.

For eva luat ion of cap ita l proposals, the f inance manager uses capital budgeting techniques

as payback, internal ra te of re turn, ne t present va lue, prof i tab il i ty index, average rate o f return. In

the a rea o f current assets management, he uses methods to check eff icient ut i l isat ion of current

resources a t the enterpr ise 's disposal . An enterpr ise can increase i t s prof i tab il i t y wi thout a ffec t ing i t s

l iquid ity by an efficient management of working cap ital . For ins tance, in the area o f working capital

management, cash management may be central ised or de -central ised; cent ral i sed method i s considered

a bet ter too l o f managing the e nterpr ise 's l iquid resources. In the area o f dividend decis ions , a fi rm is

faced wi th the prob lem of dec larat ion or postponing dec larat ion of d ividend, a problem of interna l

f inancing.

For evaluat ion of an enterpr ise 's per formance, there ar e var ious methods, as rat io ana lys is.

This technique i s used by a l l concerned persons. Different rat ios serving di fferent object ives. An

investor uses var ious rat ios to eva lua te the prof i tabi l i ty o f investment in a par t icular company. They

enable the inve stor , to judge the prof i tab il i ty, solvency, l iquid ity and growth aspec ts o f the firm. A

short - term credi tor i s more inte rested in the l iquid ity aspect o f the firm, and i t i s poss ible by a study

of l iquid ity rat ios - current rat io , quick ra t ios , e tc . The ma in concern of a f inance manager is to

provide adequate funds from best poss ible source, at the r ight t ime and a t minimum cost and to

ensure tha t the funds so acquired are put to best possib le use . Funds f low and cash f low s ta tements

and projected financia l statements help a lo t in this regard.

Quest ion : Discuss the role of a f inance manager ?

Answer : In the modern enterpr ise , a finance manager occupies a key posit ion, he be ing one of the

dynamic member o f corporate manager ial team. His role , i s becom ing more and more pervasive and

signi ficant in so lving complex managerial problems. Tradi t ional ly, the role o f a f inance manager was

confined to rais ing funds from a number o f sources, but due to recent develop ments in the socio -

economic and po li t ical scenario throughout the wor ld, he i s placed in a cent ral posi t ion in the

organisat ion. He i s responsib le fo r shaping the for tunes o f the enterpr ise and i s invo lved in the most

vi ta l decision of a l loca tion of cap ital l ike mergers, acquisi t ions, e tc . A finance m anager , as other

members o f the corpora te team cannot be averse to the fas t developments, around him and has to take

note o f the changes in o rder to take re levant steps in view of the dynamic changes in c ircumstances .

E.g. in troduction of Euro - as a single currency of Europe is an interna tional leve l change, having

impact on the corporate f inancia l plans and pol icies world -wide.

Domest ic developments as emergence of f inancia l services sec tors and SEBI as a watch dog

for investor pro tection an d regula t ing body of capita l markets i s contr ibuting to the importance of the

f inance manager 's job. Banks and f inancia l ins t i tut ions were the major sources o f f inance, monopoly

was the s tate o f a ffa ir s of Indian business, shareholders sat is fact ion was no t the pro moter 's concern

as most o f the co mpanies, were close ly held . Due to the opening of economy, compet i t ion increased ,

se l ler 's market i s being conver ted into buyer 's market . Development of interne t has brought new

chal lenges before the managers. India n concerns no longer have to compete only nat ional ly, i t i s

facing internat ional competi t ion. Thus a new era i s ushered during the recent years, in financia l

management, special ly, wi th the develop ment o f f inancia l too ls, techniques, ins truments and

produc ts. Also due to increasing emphasis on public sec tor under takings to be sel f -suppor t ing and

their dependence on capital market for fund requirements and the increas ing signi f icance of

l iberal isat ion, global i sat ion and deregulat ion.

Quest ion : Draw a typi cal organisat ion chart highl ighting the f inance funct ion of a co mpany ?

Answer : The f inance function i s the same in al l enterpr ises , de ta i l s may di ffer , but major features

are universa l in na ture. The f inance funct ion occupies a s igni f icant posi t ion in a n organisat ion and i s

not the responsibi l i ty o f a sole execut ive. The impor tant aspects o f finance manager a re to carr ied on

by top management i .e . managing d irec tor , chairman, board of directors. The board of directors takes


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decisions involving financia l considerat ions, the f inancia l control ler i s bas ica l ly meant for ass is t ing

the top management and has an important role of contr ibut ing to good decis ion making on i ssues

involving al l funct ional areas of business. He i s to br ing out f inancia l implica t ions o f al l dec is ions

and make them understood. He may be ca lled as the financial cont rol ler , v ice -president ( finance) ,

chief accountant , t reasurer , or by any other des ignation, but has the pr imary responsibi l i ty o f

per forming f inance functions. He i s to dischar ge the responsib il i ty keeping in view the overal l

out look of the o rganisa t ion.

BOARD OF DIRECTORS

PRESIDENT

V.P.(Product ion) V.P.(Finance) V.P.(Sales)

Treasurer Control ler

Cred it

Mgmt.

Cash

Mgmt.

Banking

rela t ions

Portfo l io

Mgmt.

Corpora te

General &

Cost

Accounting

Taxes Interna l

Audi t

Budgeting

Organisation chart o f f inance function The Chief f inance executive works direct ly under the President o r Managing Director o f the company.

Besides routine work, he keeps the Board informed about al l phases o f business ac t ivi ty, inc lus ive of

economic, social and po li t ical developments a ffect ing the business behaviour and fro m t ime to t ime

furnishes informat ion about the financial s tatus o f the co mpany . His functions are : ( i ) Treasury

functions and ( i i) Control functions.

Relat ionship Between f inancial management and other areas of management : There i s close

rela t ionship be tween the areas o f financial and other management l ike product ion, sa les, mar keting,

personnel , e tc . Al l act ivi t ies direc t ly or indi rec tly involve acquis i t ion and use o f funds.

Determinat ion of production, p rocurement and market ing stra tegies are the impor tant prerogat ives o f

the respect ive depar tment heads, but for implement ing, the ir dec isions funds a re required . Like,

replacement o f fixed assets for improving production capaci ty requi res funds. Simi lar ly, the purchase

and sales promotion pol icies are laid down by the purchase and market ing d ivis ions respect ive ly, but

again procurement o f raw mater ials , adver t i sing and o ther sa les promotion require funds. Same is

for , recruitment and promotion of s ta ff by the personnel department would requi re funds for payment

of sa lar ies, wages and other benefi ts . I t may, many t imes, be d i fficu lt to demarca te where one

function ends and other star t s . Although, finance funct ion has a signi f icant impact on the other

functions, i t need no t l imi t or obstruc t the general functions o f the business. A firm fac ing f inancia l

di fficult ies, may give weight age to f inancia l considera t ions and devise i ts own product ion and

market ing strategies to suit the s i tua tion. Whi le a f irm having surplus f inance, would have

compara tively lower r igidity as regards the f inancia l considerat ions vis -a -vis other functions of the

management.

Pervasive Nature of Finance Funct ion : Finance i s the l i fe blood of of an organisat ion, i t i s the

common thread b inding al l o rganisa t ional funct ions. This inter face can be explained as be low :

* Production - Finance : Production function requires a large investment. Productive use o f

resources ensures a cos t advantage for the f irm. Opt imum investment in inventor ies improves p rof i t

margins. Many parameters o f product ion have an impact on cost and can poss ibly be cont rolled

through interna l management, thus enhancing prof i t s . Important production decisions l ike make or

buy can be taken only a f ter the f inancia l implica t ions are considered.

* Market ing - F inance : Various aspects o f market ing management have f inancia l implica t ions,

decisions to hold inventor ies on large scale to provide off the shel f service to customers increases

inventory ho lding cost and a t the same t ime may increase sales, simi lar wi th extension of credit

faci l i ty to customers. Market ing s tra tegies to increase sale in m ost cases, have add it iona l costs that

are to be weighted careful ly agains t incrementa l revenue before taking decision.


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* Personnel - Finance : In the globali sed competi t ive scenario , business organisa t ions are moving to

a f la t ter organisa t ional structure . Investments in human resource developments are also increasing.

Restructur ing of remunerat ion structure, vo luntary ret irement schemes, sweat equi ty, e tc . have

become major financial decisions in the human resource management.

Quest ion : What is the rele vance of t ime va lue of money in f inancia l dec ision making ?

Answer : A finance manager is required to make dec isions on investment, f inancing and d ividend in

view of the company's objectives. The dec is ions as purchase of asse ts or p rocurement o f funds i .e .

the investment/ f inancing decisions a ffect the cash f low in di fferent t ime per iods. Cash out f lows

would be at one point o f t ime and inf low a t some o ther point of t ime, hence, they are not comparable

due to the change in rupee va lue of money. They can b e made comparable by introducing the interest

factor . In the theory of f inance, the interest factor is one of the c rucial and exclus ive concept , kno wn

as the t ime va lue of money.

Time va lue of money means that worth of a rupee received today i s d i fferent from the same

rece ived in future. The preference for money now as compared to future i s known as t ime preference

of money. The concept i s app licable to both individuals and business houses.

Reasons of t ime preference of money :

1) Risk : There is uncer ta inty about the receip t o f money in future.

2) Preference for present consumption : Most o f the persons and companies have a preference for present consumption may be due to urgency

of need.

3) Investment opportunit ies : Most of the persons and companies have preference for present money because of avai lab il i t ies of

opportuni t ies o f investment for earning add it ional cash flo ws.

Importance of t ime va lue of money : The concept o f t ime va lue of money helps in ar r iving at the co mparab le valu e of the di fferent rupee

amount a r i sing at d i fferent points o f t ime into equivalent values o f a par t icular po int o f t ime, p resent

or future. The cash f lows ar i s ing at di fferent points o f t ime can be made comparab le by us ing any one

of the fo l lo wing :

- by compounding the present money to a future date i .e . by find ing out the value of present money.

- by discounting the future money to present da te i .e . by f inding out the present va lue(PV) of future

money.

Notes on:- Finance Function

The finance function is most important for all business enterprises. It remains a focus of all activities. It starts with the

setting up of an enterprise. It is concerned with raising of funds, deciding the cheapest source of finance, utilization of

funds raised, making provision for refund when money is not required in the business, deciding the most profitable

investment, managing the funds raised and paying returns to the providers of funds in proportion to the risks undertaken

by them. Therefore, it aims at acquiring sufficient funds, utilizing them properly, increasing the profitability of the

organization and maximizing the value of the organization and ultimately the shareholder‟s wealth.

Notes on:- Inter-relationship between Investment, Financing and Dividend Decisions

The finance functions are divided into three major decisions, viz., investment, financing and dividend decisions.

It is correct to say that these decisions are inter-related because the underlying objective of these three decisions is the

same, i.e. maximisation of shareholders‟ wealth. Since investment, financing and dividend decisions are all interrelated,

one has to consider the joint impact of these decisions on the market price of the company‟s shares and these decisions

should also be solved jointly. The decision to invest in a new project needs the finance for the investment. The financing

decision, in turn, is influenced by and influences dividend decision because retained earnings used in internal financing

deprive shareholders of their dividends. An efficient financial management can ensure optimal joint decisions. This is

possible by evaluating each decision in relation to its effect on the shareholders‟ wealth.

The above three decisions are briefly examined below in the light of their inter -relationship and to see how they

can help in maximising the shareholders‟ wealth i.e. market price of the company‟s shares.


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Investment decision: The investment of long term funds is made after a careful assessment of the various

projects through capital budgeting and uncertainty analysis. However, only that investment proposal is to be accepted

which is expected to yield at least so much return as is adequate to meet its cost of financing. This have an influence on

the profitability of the company and ultimately on its wealth.

Financing decision: Funds can be raised from various sources. Each source of funds involves different issues.

The finance manager has to maintain a proper balance between long-term and short-term funds. With the total volume of

long-term funds, he has to ensure a proper mix of loan funds and owner‟s funds. The optimum financing mix will

increase return to equity shareholders and thus maximise their wealth.

Dividend decision: The finance manager is also concerned with the decision to pay or declare dividend. He

assists the top management in deciding as to what portion of the profit should be paid to the shareholders by way of

dividends and what portion should be retained in the business. An optimal dividend pay-out ratio maximises

shareholders‟ wealth.

The above discussion makes it clear that investment, financing and dividend decisions are interrelated and are to

be taken jointly keeping in view their joint effect on the shareholders‟ wealth.

INTRODUCTION

Decisions relating to working capital and short term financing are referred to as Working Capital Management. These involve

managing the relationship between a firm.s short-term assets and its short-term liabilities. The goal of working capital

management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both

maturing short-term debt and upcoming operational expenses.

MEANING AND CONCEPT OF WORKING CAPITAL

There are two concepts of working capital - gross and net. Gross working capital refers to the firm.s investment in current

assets. Current assets are those assets which can be converted into cash within an accounting year. Net working capital refers

to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are

expected to mature for payment within an accounting year.

Current Assets include: Stocks of raw materials, Work-in-progress, Finished goods, Trade debtors, Prepayments, Cash

balances .

Current Liabilities include: Trade creditors, Accruals, Taxation payable, Bills Payables, Outstanding expenses, Dividends

payable, short term

Working capital is also known as operating capital. A most important value, it represents the amount of day-to-day operating

liquidity available to a business. A company can be endowed with assets and profitability, but short of liquidity if these assets

cannot readily be converted into cash. A positive working capital means that the company is able to payoff its short-term

liabilities. A negative working capital means that the company currently is unable to meet its short-term liabilities. From the

point of view of time, the term working capital can be divided into two categories viz., Permanent and temporary.

Permanent working capital refers to the hard core working capital. It is that minimum level of investment in the current assets

that is carried by the business at all times to carry out minimum level of its activities.

Temporary working capital refers to that part of total working capital, which is required by a business over and above

permanent working capital. It is also called variable working capital. Since the volume of temporary working capital keeps on

fluctuating from time to time according to the business activities it may be financed from short-term sources.

Importance of Adequate Working Capital:

The importance of adequate working capital in commercial undertakings can be judged from the fact that a

concern needs funds for its day-to-day running. Adequacy or inadequacy of these funds would determine the efficiency with

which the daily business may be carried on. Management of working capital is an essential task of the finance manager. He has

to ensure that the amount of working capital available with his concern is neither too large nor too small for its requirements.

A large amount of working capital would mean that the company has idle funds. Since funds have a cost, the company has to

pay huge amount as interest on such funds. The various studies conducted by the Bureau of Public Enterprises have shown that

one of the reason for the poor performance of public sector undertakings in our country has been the large amount of funds

locked up in working capital This results in over capitalization. Over capitalization implies that a company has too large funds

Chapter : Estimation of Working Capital


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for its requirements, resulting in a low rate of return a situation which implies a less than optimal use of resources. A firm has,

therefore, to be very careful in estimating its working capital requirements.

If the firm has inadequate working capital, it is said to be under-capitalised. Such a firm runs the risk of

insolvency. This is because, paucity of working capital may lead to a situation where the firm may not be able to meet its

liabilities. It is interesting to note that many firms which are otherwise prosperous (having good demand for their products and

enjoying profitable marketing conditions) may fail because of lack of liquid resources. If a firm has insufficient working

capital and tries to increase sales, it can easily over-stretch the financial resources of the business. This is called overtrading.

Early warning signs of

over trading include:

♦ Pressure on existing cash.

♦ Exceptional cash generating activities e.g., offering high discounts for early cash payment.

♦ Bank overdraft exceeds authorized limit.

♦ Seeking greater overdrafts or lines of credit.

♦ Part-paying suppliers or other creditors.

♦ Paying bills in cash to secure additional supplies.

♦ Management pre-occupation with surviving rather than managing.

♦ Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque).

needs enough cash to pay wages and salaries as they fall due and to pay creditors if it is to keep its workforce engaged and

ensure its supplies. Maintaining adequate working capital is not just important in the short-term. Sufficient liquidity must be

maintained in order to ensure the survival of the business in the long-term as well. Even a profitable business may fail if it

does not have adequate cash flow to meet its liabilities as they fall due. Therefore, when business make investment decisions

they must not only

consider the financial outlay involved with acquiring the new machine or the new building, etc., but must also take account of

the additional current assets that are usually required with any expansion of activity. Increased production leads to hold

additional stocks of raw materials and work in progress. Increased sales usually means that the level of debtors will increase. A

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

arises what is an optimum amount of working capital for a firm? We can say that a firm should neither have too high an

amount of working capital nor should the same be too low. It is the job of the finance manager to estimate the requirements of

working capital

carefully and determine the optimum level of investment in working capital.

Optimum Working Capital:

If a company.s current assets do not exceed its current liabilities, then it may run into trouble with creditors

that want their money quickly. The working capital ratio, which measures this ability to pay back can be calculated as current

assets divided by current liabilities.

Current ratio (current assets/current liabilities) has traditionally been considered the best indicator of the

working capital situation. It is understood that a current ratio of 2 (two) for a manufacturing firm implies that the firm has an

optimum amount of working capital. This is supplemented by Acid Test Ratio (Quick assets/Current liabilities) which should

be at least 1 (one). Thus it is considered that there is a comfortable liquidity position if liquid current assets are equal to current

liabilities. Bankers, financial institutions, financial analysts, investors and other people interested in financial statements have,

for years, considered the current ratio at, .two. and the acid test ratio at, .one. as indicators of a good working capital situation.

As a thumb rule, this may be quite adequate. However, it should be remembered that optimum working capital can be

determined only with reference to the particular circumstances of a specific situation. Thus, in a company where the

inventories are easily saleable and the sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet

firm may be sound. An optimum working capital ratio is dependent upon the business situation as such and the nature and

composition of various current assets. A company having short conversion cycle (from cash to cash) my have a lower current

ratio.

In nutshell, a firm needs to maintain a sound working capital position. It should have adequate working capital to run its

business operations. Both excessive as well as inadequate working capital positions are dangerous. Excessive working capital

means holding costs and idle funds which earn no profits for the firm. Paucity of working capital not only impairs the firm.s

profitability but also results in production interruptions, inefficiencies and sales disruptions. The management should therefore

maintain the right amount of working capital continuously.

MANAGEMENT OF WORKING CAPITAL

Working capital management is the functional area of finance that covers all the current accounts of its firm.

It is concerned with management of the level of individual current assets and the current liabilities or in other words the

management of total working capital. Managing Working Capital is a matter of balance. A firm must have sufficient cash on

hand to meet its immediate needs while ensuring that idle cash is invested to the organizations best possible advantage. To

avoid the difficulties, it is necessary to have clear and accurate reports on each of the components of working capital and an

awareness of the potential impact of likely influences. Sound financial and statistical techniques, supported by judgement

should be used to predict the quantum of working capital required at different times. Adequate provisions of working capital

mitigates risk. Working capital management entails short-term decisions generally, relating to its next one year period which

are .reversible.. Management will use a combination of policies and techniques for the management of working capital. These


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require managing the current assets . generally cash and cash equivalents, inventories and debtors. There are also a variety of

short term financing options which are considered. The various steps in the management of working capital involve:

♦ Cash management . Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash

holding costs.

♦ Inventory management . Identify the level of inventory which allows for uninterrupted production but reduces the

investment in raw materials and hence increases cash flow;The techniques like Just In Time (JIT) and Economic order quantity

(EOQ) are used for this.

♦ Debtors management . Identify the appropriate credit policy, i.e., credit terms which will attract customers, such that any

impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice

versa). The tools like Discounts and allowances are used for this.

♦ Short term financing . Inventory is ideally financed by credit granted by the supplier; dependent on the cash conversion

cycle, it may however, be necessary to utilize a bank loan (or overdraft), or to .convert debtors to cash. through .factoring. in

order to finance working capital requirements.

There are, however, certain constraints in the management of working capital such as:

(i) Non-realisation of the importance of working capital.

(ii) Continuous inflation in the economy.

(iii) The existence of seller.s market or monopoly conditions; and

(iv) High profitability.

Determinants of Working Capital: The following factors will generally influence the working capital requirements of the

firm:

(i) Nature of Business.

(ii) Market and demand conditions.

(iii) Technology and manufacturing Policies.

(iv) Credit Policy of the firm.

(v) Availability of credit from suppliers.

(vi) Operating efficiency.

(vii) Price Level Changes.

ISSUES IN THE WORKING CAPITAL MANAGEMENT

Working capital management entails the control and monitoring of all components of working capital i.e. cash, marketable

securities, debtors (receivables) and stocks (inventories) and creditors (payables). The finance manager has to determine the

levels and composition of current assets. He has to ensure a right mix of different current assets and that current

liabilities are paid in time. There are many aspects of working capital management which makes it important function of

financial management.

♦ Time: Working capital management requires much of the finance manager.s time.

♦ Investment: Working capital represents a large portion of the total investment in assets.

♦ Credibility: Working capital management has great significance for all firms but it is very critical for small firms.

♦ Growth: The need for working capital is directly related to the firm.s growth. It is advisable that the finance manager should

take precautionary measures for effective and efficient management of working capital. He has to pay particular attention to

the levels of current assets and their financing. To decide the levels and financing of current assets, the risk return trade off

must be taken into account.

Liquidity versus Profitability:

Risk return trade off − A firm may follow a conservative, aggressive or moderate policy as discussed above. However, these

policies involve risk, return trade off. A conservative policy means lower return and risk. While 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 that is, it will hardly experience a cash shortage or a stock out situation. However, there is a cost associated with

maintaining a sound liquidity position. However, to have higher profitability the firm may have to sacrifice solvency and

maintain a relatively low level of current assets. This will improve firm.s profitability as fewer funds will be tied up in idle

current assets, but its solvency would be threatened and exposed to greater risk of cash shortage and stock outs. The following

illustration explains the risk-return trade off of various working capital management policies, viz., conservative, aggressive

and moderate etc.

OPERATING OR WORKING CAPITAL CYCLE

A useful tool for managing working capital is the operating cycle. The operating cycle analyzes the accounts

receivable, inventory and accounts payable cycles in terms of number of days. In other words, accounts receivable are

analyzed by the average number of days it takes to collect an account. Inventory is analyzed by the average number of days it

takes to turn over the sale of a product (from the point it comes in the store to the point it is converted to cash or an account

receivable). Accounts payable are analyzed by the average number of days it takes to pay a supplier invoice. Most businesses

cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone.

Consequently, working capital financing is needed. This shortfall is typically covered by the net profits generated internally or

by externally borrowed funds or by a combination of the two. Most businesses need short-term working capital at some point


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in their operations. For instance, retailers must find working capital to fund seasonal inventory build-up. But even a business

that is not seasonal occasionally experiences peak months when orders are unusually high. This creates a need for working

capital to fund the resulting inventory and accounts receivable build-up.

Some small businesses have enough cash reserves to fund seasonal working capital needs. However, this is

very rare for a new business. If your new venture experiences a need for short-term working capital during its first few years of

operation, you will have several potential sources of funding. The important thing is to plan ahead. If you get caught off guard,

you might miss out on the one big order. Cash flows in a cycle into, around and out of a business. It is the business.s life blood

and every manager.s primary task is to help keep it flowing and to use the cashflow to generate profits. If a business is

operating profitably, then it should, in theory, generate cash surpluses.

If it doesn.t generate surplus, the business will eventually run out of cash. The faster a business expands, the

more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right

within business. Good management of working capital will generate cash which will help improve profits and reduce risks.

Bear in mind that the cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm.s

total profits. There are two elements in the business cycle that absorb cash . Inventory (stocks and workin- progress) and

Receivables (debtors owing you money). The main sources of cash are Payables (your creditors) and Equity and Loans.

Working Capital Cycle

Each component of working capital (namely inventory, receivables and payables) has two dimensions

..TIME ...and MONEY, when it comes to managing working capital then time is money. If you can get money to move faster

around the cycle (e.g. collect monies due from debtors more quickly) or reduce the amount of money tied up (e.g. reduce

inventory levels relative to sales), the business will generate more cash or it will need to borrow less money to fund working

capital. As a consequence, you could reduce the cost of bank interest or you will have additional free money available to

support additional sales growth or investment. Similarly, if you can negotiate improved terms with suppliers e.g. get longer

credit or an increased credit limit, you are effectively creating free finance to help fund future sales. Working capital cycle

indicates the length of time between a company.s paying for materials, entering into stock and receiving the cash from sales of

finished goods. It can be determined by adding the number of days required for each stage in the cycle. For example, a

company holds raw materials on an average for 60 days, it gets credit from the supplier for 15 days, production process needs

15 days, finished goods are held for 30 days and 30 days credit is extended to debtors. The total of all these, 120 days, i.e., 60 .

15 + 15 + 30 + 30 days is the total working capital cycle. The determination of working capital cycle helps in the forecast,

control and management of working capital. It indicates the total time lag and the relative significance of its constituent parts.

The duration of working capital cycle may vary depending on the nature of the business.

Effect of Double Shift Working on Working Capital requirements:

Increase in the number of hours of production has an effect on the working capital requirements. The

greatest economy in introducing double shift is the greater use of fixed assets-little or marginal funds may be required for

additional assets.

It is obvious that in double shift working, an increase in stocks will be required as the production rises.

However, it is quite possible that the increase may not be proportionate to the rise in production since the minimum level of

stocks may not be very much higher. Thus, it is quite likely that the level of stocks may not be required to be doubled as the

production goes up two-fold. The amount of materials in process will not change due to double shift working since work

started in the first shift will be completed in the second; hence, capital tied up in materials in process will be the same as with

single shift working. As such the cost of work-in-process, will not change unless the second shift.s workers are paid at a higher

rate. Fixed overheads will remain fixed whereas variable overheads will increase in proportion to the increased production.

Semi-variable overheads will increase according to the variable element in them.


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Important Questions

Que:- MNO Ltd. has furnished the following cost data relating to the year ending of 31st March, 2008.

Sales

Material Consumed

Direct wages

Factory overheads (100% variable)

Office and Administrative overheads (100% variable)

Selling overheads

Rs. (in lakhs)

450

150

30

60

60

50

The company wants to make a forecast of working capital needed for the next year and anticipates that:

Sales will go up 100%,

Selling expenses will be Rs. 150 lakhs,

Stock holdings for the next year will be-Raw material for two and half months, Work-in-progress for one month, Finished goods

for half month and Book debts for one and half months,

Lags in payment will be of 3 months for creditors, 1 month for wages and half month for Factory, Office and Administrative and

Selling overheads.

You are required to:

(i) Prepare statement showing working capital requirements for next year, and

(ii) Calculate maximum permissible bank finance as per Tandon Committee guidelines assuming that core current assets of the firm

are estimated to be Rs. 30 lakhs.

Que:- A company is considering its working capital investment and financial policies for the next year. Estimated fixed assets and current

liabilities for the next year are Rs. 2.60 crores and Rs. 2.34 crores respectively. Estimated Sales and EBIT depend on current assets

investment, particularly inventories and book-debts. The financial controller of the company is examining the following alternative Working

Capital Policies:

(Rs. in Crores)

Working Capital Policy Investment in Current Assets Estimated Sales EBIT

Conservative

Moderate

Aggressive

4.50

3.90

2.60

12.30

11.50

10.00

1.23

1.15

1.0

After evaluating the working capital policy, the Financial Controller has advised the adoption of the moderate working capital

policy. The company is now examing the use of long-term and short-term borrowings for financing its assets. The company will use Rs. 2.50

crores of the equity funds. The corporate tax rate is 35%. The Company is considering the following debt alternatives.

(Rs. in Crores)

Financing Policy Short-term Debt Long-term Debt

Conservative

Moderate

Aggressive

Interest Rate-Average

0.54

1.00

1.50

12%

1.12

0.66

0.16

16%

You are required to calculate the following:

(1) Working Capital Investment for each policy:

(a) Net Working Capital Position

(b) Rate of Return on Total Assets

(c) Current Ratio

(2) Financing for each policy:

(a) Net Working Capital position,

(b) Rate of return on Shareholders‟ equity.

(c) Current Ratio.

Que:- An engineering company is considering its working capital investment for the year end 2003-04. The estimated fixed assets and

current liabilities for the next year are Rs. 6.63 crore and Rs. 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:

(Rs. in crore)

Working capital policy

Conservative

Moderate

Aggressive

Investment in C. Assets

11.475

9.945

6.630

Estimated sales

31.365

29.325

25.500

EBIT

3.1365

2.9325

2.5500

You 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 fixed assets ratio.

(iv) Discuss the risk-return trade off of each working capital policy.


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Practical Questions:-

Q. 1. The selling price per unit of a product is computed as follows:

Cost per Unit

Raw Material Rs. 50

Direct Labour 20

Factory overheads (including depreciation of Rs. 10) 20

Admn. Overheads (including depreciation of Rs. 5) 10

Selling Overheads (including depreciation of Rs. 5) 10

Total 110

Profit per unit 20

Selling price per unit 130

Average raw material in stock for one month . Average material in work –in –progress in for half month .

Credit allowed by suppliers is one month and credit allowed to debtors is one month. Average time lag in payment of

wages is 10 days. Average time lag in payment of overheads is 30 days. 25% of the sales are on cash basis. Cash

balance is approximately maintained at Rs. 1,00,000. The finished goods lie in the warehouse for one month.

You are required to prepare a statement of working capital requirement to finance a level of activity of

54,000 units of output.

Q. 2. A company is presently operating at 60% capacity, producing 36,000 units per annum,. It is now decided to operate at

90% capacity. The following information is available:

(1) Existing cost price structure per unit is as follows:

Raw Material Rs. 4

Wages Rs. 2

Variable Overheads Rs. 2

Fixed overheads Re. 1

Profit Re. 1

Rs.10

(2) It is expected that the cost of raw material, wages, expenses and selling price per unit will remain unchanged

in 1997.

(3) Raw material remain in store for 2 months and in production for 1 month.

(4) Finished goods remain in godown for 2 months.

(5) Credit allowed to debtors is 2 months and credit allowed by creditors is 3 months.

(6) Lag in wages and overheads payment is one month.

Required: (a) Prepare Profit Statement at 90% capacity level.

(b) Calculate the working capital requirement at 90% capacity level.

Q. 3. Ess Ltd. sells goods at a gross profit of 25% considering depreciation as part of the cost of production. Its annual figures

are as follows: Rs.

Sales at two months credit 18,00,000

Materials consumed (suppliers extend two months‟ credit) 4,50,000

Wages paid (monthly in arrear) 3,60,000

Manufacturing expenses outstanding at the end of the year 40,000

(cash expenses are paid one month in arrear)

Total Administrative Expenses, paid as above 1,20,000

Sales promotion expenses paid quarterly in advance 60,000

The company keeps one month‟s stock each of raw materials and finished goods, and believes in keeping Rs.

1,00,000 in cash. Assuming a 15% safety margin ascertain the requirements of working capital requirement of the

company on cash costs basis. Ignore work-in-progress.

Q. 4. BS Ltd. has been operating its manufacturing facilities till 31:03:1999 on single shift-working with the following cost

structure: Per Unit

Rs,

Cost of Materials 6.00

Wages (40% fixed) 5.00

Overheads (80% fixed) 5.00

Profit 2.00

Selling Price 18.00

Sales during 1998-1999 – Rs. 4,32,000. As at 31;03:1999 the company held:

Rs.


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Stock of raw materials (at cost) 36,000

Work-in-progress (valued at prime cost) 22,000

Finished goods (valued at total cost) 72,000

Sundry debtors 1,08,000

In view of increased market demand, it is proposed to double production by working an extra shift. It is

expected that a 10% discount will be available from suppliers of raw materials in view of increased volume of business.

Selling price will remain the same. The credit period allowed to customers will remain unaltered. Credit availed of from

suppliers will continue to remain at the present level i.e. 2 months. Lag in payment of wages and expenses will continue

to remain half a month.

You are required to assess the additional working capital requirement, if the policy to increase output is implemented.

Q. 5. The following are the extracts from Balance Sheet of a company as on 31.12.1999.

Fixed Assets:

Land & Building Rs. 5,00,000

Plant & Machinery 3,00,000 Rs. 8,00,000

Working Capital:

Current Assets:

Stock 8,00,000

Debtors 3,00,000

Cash 2,00,000

13,00,000

Current Liabilities:

Creditors 3,40,000

Provision for tax 80,000

Bank Overdraft 1,40,000

Outstanding

Liabilities 1,60,000 7,20,000 5,80,000

Total 13,80,000

Additional Information:-

(1) Sales will increase by 25% next. Year

(2) Maximum Bank Overdraft Rs. 1,60,000

(3) No increase in tax liability for next year.

(4) Period of credit allowed to customers and stock turnover will remain unchanged.

(5) Period of credit allowed by creditors will also remain same.

(6) Outstanding liabilities will remain at the same relative position.

(7) There will be no increase in cash balance.

You are required to computes the additional and total working capital required by the company for the next year.

Q. 6. At the beginning of the year, a company wants to know the working capital that will be required to meet the programme

of activity they have planned for the year. The following information is available

(1) Paid up Share Capital Rs. 2,00,000.

(2) 5% Debentures Rs. 50,000

(3) Fixed Assets Rs. 1,25,000 (at the beginning of year).

(4) Production during the last year was 60,000 units. It is to be maintained during the current year.

(5) Raw Material, Direct Wages and Overheads are 60% ,10% and 20% of selling price.

(6) Each unit is expected to be in production process for one month.

(7) Finished units will stay in warehouse for three months.

(8) Creditors allow credit of two months.

(9) Credit allowed to debtors is 3 months.

(10) Raw Material remains in store for 2 months.

(11) Selling price per unit = Rs. 5.

Prepare: (i) Working Capital requirement forecast.

(ii) An estimated Profit and Loss Account and Balance Sheet as at the end of the year.

Q.7. A company provided the following data:

Cost Per units (Rs.)

Raw materials 52.00

Direct labour 19,50

Overhead 39.00

Total 110.50

Profit 19.50

Selling price 130.00

The following additional information is available:


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1. Average raw materials in stock: one month;

2. Average raw materials in process: half-a-moth;

3. Average finished goods in stock: one month;

4. Credit allowed by suppliers: one month;

5. Credit allowed to debtors: two months;

6. Time lag in payment of wages: one and a half weeks;

7. Overheads; one month;

One-fourth of sales are on cash basis. Cash balance is expected to be Rs. 1.20.000.

You are required to prepare a statement showing the working capital needed to finance a level of activity of 70,000

units of annual output. The production is carried throughout the year on even basis and wages and overheads accrue

similarly. (Calculation be made on the basis on 30 days a months and 52 weeks a year.)

Q.8 Determine the working capital requirement from the following particulars:

Annual budget figures for: (Rs. Lakhs)

Raw materials 360

Supplies and components 120

Manpower 240

Factory expenses 60

Administration 90

Sales 1190

You are given thee following additional information:

(1) Stock- levels planned:

Raw materials 30 days

Supplies and components 90 days

(2) 50% of the sales is for cash; for the remaining, 20 days credit is normal.

(3) Finished goods are held in stock for a period of seven days before they are released for sale.

(4) Goods remain in process for 5 days.

(5) The company enjoys 30 days‟ credit facilities on 20% of the purchase.

(6) Cash/bank balance had been planned to be kept at the rate of half month‟s budgeted expenses.

Q.9. Prepare an estimate of net working capital requirement for the WCM Ltd. Adding 10% for contingencies from the

information given below.

Estimate cost per unit of production Rs. 170, includes raw materials rs.80, direct labour Rs. 30 and overheads

(exclusive of depreciation) Rs. 60. Selling price is Rs.200 per unit. Level of activity per annum 1,04,000 units. Raw

material in stock: average 4 weeks: work-in-progress (assume 50% completion stage) : average 2 weeks; 4 weeks;

credit allowed to debtors: average 8 weeks; lag in payment of wages: average 1.5 weeks, and cash at bank is expected

to be Rs. 25,000. You may assume that production is carried on evenly throughout the year (52 weeks) and wages and

overhead accrue similarly. All dales are on credit basis only. You may state wages and overheads accrue similarly.

All sales are on credit basis only. You may state your assumptions, if any.

Q. 10. On 1st January, the Managing director of A Ltd. wishes to know the amount of working capital that will be required during the year.

From the following information, prepare the working capital requirement forecast:

Production during the previous year was 60,000 units. It is planned that this level of activity would be maintained during the present

year. The expected ratios of the cost to selling prices are Raw Material 60%. Direct Wages 10% and Overheads 20%, Raw Material is

expected to be in store for average of 2 months before issue to production. Each unit is expected to be in process for one month, the

raw material being fed into the pipeline immediately and labour and overheads cost accruing evenly during the month. Finished

goods will stays in the warehouse awaiting dispatch to customers for approximately 3 months credit allowed by creditors is 2 months

from the date of delivery of raw material. Credit allowed to debtors is 3 months from the date of dispatch. The selling price is Rs. 5

per unit. There is regular production and sales cycle. Wages and overheads are paid after one month. The company normally keep

cash in hand to the extent of Rs. 20,000.

Q. 11. A company newly commencing business in 1999 has the under-mentioned Projected Profit & Loss Account;

Rs. Rs.

Sales 21,00,000

Less: Cost of goods sold 15,30,000

Gross Profit 5,70,000

Add: Administration Expenses 1,40,000

Add: Selling Expenses 1,30,000 2,70,000

Profit before Tax 3,00,000

Less: Provision for taxation 1,00,000

Profit after Tax 2,00,000

The cost of goods sold has been arrived at as under:

Materials used 8,40,000

Wages & Manufacturing Expenses 6,25,000

Depreciation 2,35,000


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17,00,000

Less: Stock of finished goods (10% of goods produced not yet sold 1,70,000

15,30,000

The figures given above relates only to finished goods and not to work –in –progress. Goods equal to 15% of year‟s

production (in terms of physical units) will be in process on the average requiring full materials but only 40% of the other expenses.

The company believes in keeping materials equal to two month‟s consumption in stock.

All expenses will be paid one month in arrear; suppliers of material will extend 1 ½ months‟ credit, sales will be 20% for

cash and the rest at two months credit, 70% of the income tax will be paid in advance in quarterly installments. The company wishes

to keep Rs 80,000 in cash . Prepare an estimate of the requirements of working capital.

Que. 12- Varuna & Co. have applied for working Capital limits from M/s Full of Funds Bank Ltd. who have agreed to sanction the same by

retaining the margins as under: Raw Materials – 20%; WIP – 30%; Finished Goods – 25%; Debtors – 10%

From the following projections for the forthcoming year, you are required to work out the following:

Working Capital required by the firm (Cash Cost Approach) and

Working Capital limits likely to be sanctioned by the Bankers

Annual Sales at one month credit Rs. 14,40,000

Cost of production Rs. 12,00,000

Raw Material Purchases (at 15 days credit) Rs. 7,05,000

Monthly Cash Expenditure Rs. 25,000

Anticipated Raw Material Stocks:

Opening Rs. 1,40,000 Closing Rs. 1,25,000

Inventory Norms are: Raw Materials – 2 months, WIP – 15 days; Finished Goods -1 month.

The firm has received an advance of Rs. 15,000 from customers on Sales Orders.

Q. 13. From the following data, calculate the maximum permissible bank finance under the three methods suggested by the Tandon

Committee:-

Current Assets Rs. in lacs Current Liabilities Rs. in lacs

Raw Material

Work –in –progress

Finished goods

Receivables

Other current assets

180

50

100

150

20

Creditors

Other current liabilities

Bank borrowing

120

30

250

Total 500 Total 400

The total core Current Assets (CCA) are Rs. 200 lacs.

Q.14. Following is the Balance Sheet of PBX Ltd. Calculate the amount of maximum permissible Bank Finance by all three methods for

working capital as per Tandon Committee Norms. You are required to assume the level of core current assets to be Rs. 60 lakhs.

You are also required to calculate the current ratios as recommended by the Committee, assuming that the bank has granted MPBF.

Balance Sheet of PBX Ltd

As at 31st March, 1998

Liabilities Amount Assets Amount

Equity shares of Rs. 10 each

Retained earnings

11% Debentures

Public deposits

Trade creditors

Bills payable

400

400

600

200

160

200

Fixed Assets

Current assets:

Raw materials

Work –in –progress

Finished goods

Debtors

Cash at Bank

1,000

200

300

150

200

110

1,960 1,960

Que. 15- You are the management accountant of GANESHA Ltd. The following information is made available to you.

(a) Budgeted Production-600,000 units.

(b) Details of Stock Holding: Raw Materials -2 months; WIP -0.5 month; Finished goods -1 month

(c) Credit granted to customers -2 months; Credit availed from suppliers -1 month

(d) Minimum Cash Balance required at all times –Rs. 25000

(e) Cost Structure of the Product is as under:

Cost Per Unit Rs.

Raw Materials

Direct Labour

Overheads (of which depreciation- 0.25 paise)

Total Costs

Profit Margin

Selling Price

10.00

2.50

7.50

20.00

5.00

25.00

From the above you are required to forecast the working capital requirement of the Company using (a) Total Approach (b) Cash Cost

Approach


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Tight money, escalating interest rates and economic volatility have called for a specialized skills called

Treasury Management. Until recently, no major efforts were made to manage cash. In the wake of the competitive business

environment resulting from the liberalization of the economy, there is a pressure to manage cash. The demand for funds for

expansions coupled with high interest rates, foreign exchange volatility and the growing volume of financial transactions have

necessitated efficient management of money. Treasury management is defined as .the corporate handling of all financial

matters, the generation of external and internal funds for business, the management of currencies and cash flows and the

complex, strategies, policies and procedures of corporate finance.. The treasury management mainly deals with working

capital management and financial risk management. The former constitutes cash management and decides the asset liability

mix. Financial risk management includes forex and interest rate management. The key goal of treasury management is

planning, organizing and controlling cash assets to satisfy the financial objectives of the organization. The goal may be to

maximize the return on the available cash, or minimize interest cost or mobilise as much cash as possible for corporate

ventures. Dealing in forex, money and commodity markets involves complex risks of fluctuating exchange rates, interest rates

and prices which can affect the profitability of the organization.

Treasury managers try to minimize lapses by adopting risk transfer and hedging techniques that suit the

internal policies of the organisation. Options, futures and swaps are a few of the major derivative instruments, the Treasury

Managers use for hedging their risk.

FUNCTIONS OF TREASURY DEPARTMENT

1. Cash Management: The efficient collection and payment of cash both inside the organisation and to third parties is the

function of the treasury department. The involvement of the department with the details of receivables and payables will be a

matter of policy. There may be complete centralization within a group treasury or the treasury may simply advise subsidiaries

and divisions on policy matter viz., collection/payment periods, discounts, etc. Any position between these two extremes

would be possible. Treasury will normally manage surplus funds in an investment portfolio. Investment policy will consider

future needs

for liquid funds and acceptable levels of risk as determined by company policy.

2. Currency Management: The treasury department manages the foreign currency risk exposure of the company. In a large

multinational company (MNC) the first step will usually be to set off intra-group indebtedness. The use of matching receipts

and payments in the same currency will save transaction costs. Treasury might advise on the currency to be used when

invoicing overseas sales. The treasury will manage any net exchange exposures in accordance with company policy. If risks

are to be minimized then forward contracts can be used either to buy or sell currency forward.

3. Funding Management: Treasury department is responsible for planning and sourcing the company.s short, medium and

long-term cash needs. Treasury department will also participate in the decision on capital structure and forecast future interest

and foreign currency rates.

4. Banking: It is important that a company maintains a good relationship with its bankers. Treasury department carry out

negotiations with bankers and act as the initial point of contact with them. Short-term finance can come in the form of bank

loans or through the sale of commercial paper in the money market.

5. Corporate Finance: Treasury department is involved with both acquisition and divestment activities within the group. In

addition it will often have responsibility for investor relations. The latter activity has assumed increased importance in markets

where share-price performance is regarded as crucial and may affect the company.s ability to undertake acquisition activity or,

if the price falls drastically, render it vulnerable to a hostile bid.

MANAGEMENT OF CASH

Management of cash is an important function of the finance manager. The Finance Manager has to provide

adequate cash to each of the units. For the survival of the business it is absolutely essential that there should be adequate cash.

It is the duty of finance manger to have liquidity at all parts of the organization while managing cash. On the other hand, he

has also to ensure that there are no funds blocked in idle cash. Idle cash resources entail a great deal of cost in terms of interest

charges and in terms of opportunities costs. Hence, the question of costs of idle cash must also be kept in mind by the finance

manager. A cash management scheme therefore, is a delicate balance between the twin objectives of liquidity and costs.

The Need for Cash:

The following are three basic considerations in determining the amount of cash or liquidity as have been outlined by Lord

Keynes:

♦ Transaction need: Cash facilitates the meeting of the day-to-day expenses and other debt payments. Normally, inflows of

cash from operations should be sufficient for this purpose. But sometimes this inflow may be temporarily blocked. In such

cases, it is only the reserve cash balance that can enable the firm to make its payments in time.

♦ Speculative needs: Cash may be held in order to take advantage of profitable opportunities that may present themselves and

which may be lost for want of ready cash/settlement.

♦ Precautionary needs: Cash may be held to act as for providing safety against unexpected events. Safety as is explained by

the saying that a man has only three friends an old wife, an old dog and money at bank.

Chapter : Cash Management


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Facets of Cash Management: Cash management is concerned with the managing of (i) Cash flows into and

out of the firm; (ii) Cash flows within the firm; and (iii) Cash balances held by the firm at a point of time by financing deficit

or investing surplus cash. It is generally represented by a cash management cycle. Sales generates cash which has to be

disbursed out.

In recent years, a number of innovations have been made in cash management techniques. An obvious aim

of the firm these days is to mange its cash affairs in such a way as to maintain a minimum balance of cash and to invest the

surplus immediately in profitable investment opportunities.

In order to synchronise the cash receipt and payments. A firm need to develop appropriate strategies for cash management viz:

(i) Cash Planning: The pattern of cash inflows and outflows should be properly predicted in advance. Cash budget is a tool to

achieve this objective.

(ii) Managing the cash flows: The cash inflows should be accelerated, while as far as possible, the outflows should be

decelerated.

(iii) Optimum cash level: In deciding about the appropriate level of cash balances, the cost of idle cash and danger of

shortage should be taken into consideration.

(iv) Investing surplus cash: The surplus cash should be properly invested to earn profits. The firm should decide about the

division of such cash balance between various alternative short term investment opportunities such as, bank deposits,

marketable securities, inter-corporate lending. The ideal cash management system will depend upon various factors viz.,

product, organization structure, competition, culture and options available. The task is really complex. The exact nature of a

cash management system would depend upon the organizational structure of an enterprise. In a highly centralized organization

the system would be such that the central or head office controls the inflows and outflows of cash on a routine and daily basis.

In a decentralized form of organisation, where the divisions have complete responsibility of conducting their affairs, it may not

be possible and advisable for the central office to exercise a detailed control over cash inflows and outflows.

Cash Planning:

Cash Planning is a technique to plan and control the use of cash. This protects the financial conditions of the

firm by developing a projected cash statement from a forecast of expected cash inflows and outflows for a given period. This

may be done periodically either on daily, weekly or monthly basis. The period and frequency of cash planning generally

depends upon the size of the firm and philosophy of management. As firms grows and business operations become complex,

cash planning becomes inevitable for continuing success.

The very first step in this direction is to estimate the requirement of cash. For this purpose cash flow statements and cash

budget are required to be prepared. The technique of preparing cash flow and funds flow statements have been discussed in

this book. The preparation of cash budget has however, been demonstrated here.

Cash Budget:

Cash Budget is the most significant device to plan for and control cash receipts and payments. This

represents cash requirements of business during the budget period.

One of the significant advantage of cash budget is to determine the net cash inflow or outflow so that the firm is enabled to

arrange finances. However, the firm.s decision for appropriate sources of financing should depend upon factors such as cost

and risk. Cash Budget helps a firm to manage its cash position. It also helps to utilise funds in better ways. On the basis of cash

budget, the firm can decide to invest surplus cash in marketable securities and earn profits. The cash budget is prepared on the

basis of receipts and payments method and offers following benefits:

(i) It provides a complete picture of all items of expected cash flows.

(ii) It is a sound tool of managing daily cash operations.

This method, however, suffers from the following limitations:

(i) Its reliability is reduced because of the uncertainty of cash forecasts. For example, collections may be

delayed, or unanticipated demands may cause large disbursements.

(ii) It fails to highlight the significant movements in the Working Capital items.

In order to maintain an optimum cash balance, what is required is (i) a complete and accurate forecast of net cash flows over

the planning horizon and (ii) perfect synchronization of cash receipts and disbursements. Thus, implementation of an efficient

cash management system starts with the preparation of a plan of firm.s operations for a period in future. This plan will help in

preparation of a statement of receipts and disbursements expected at different point of time of that period. It will enable the

management to pin point the time of excessive cash or shortage of cash. This will also help to find out whether there is any

expected surplus cash still unutilized or shortage of cash which is yet to be arranged for. In order to take care of all these

considerations, the firm should prepare a cash budget.

Managing Cash Collection and Disbursements:

The finance manager must control the levels of cash balance at various points in the organization. This task

assumes special importance on account of the fact that there is generally a tendency amongst divisional managers to keep cash

balance in excess of their needs. Hence, the finance manager must devise a system whereby each division of an organization

retains enough cash to meet its day-to-day requirements without having surplus balance on hand. For this, methods have to be

employed to:

(a) Speed up the mailing time of payments from customers;


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(b) Reduce the time during which payments received by the firm remain uncollected and speed up the movement of funds to

disbursement banks.

Having prepared the cash budget, the finance manager should ensure that there does not exists a significant

deviation between projected cash flows and actual cash flows. To achieve this cash management efficiency will have to be

improved through a proper control of cash collection and disbursement. The twin objectives in managing the cash flows should

be to accelerate cash collections as much as possible and to decelerate or delay cash disbursements.

Accelerating Cash Collections:

A firm can conserve cash and reduce its requirements for cash balances if it can speed up its cash collections

by issuing invoices quickly and taking other necessary steps for cash collection. It can be accelerated by reducing the time lag

between a customer pays bill and the cheque is collected and funds become available for the firm.s use. A firm can

decentralized collection system known as concentration banking and lock box system to speed up cash collection and reduce

float time.

(i) Concentration Banking: In concentration banking the company establishes a number of strategic collection centres in

different regions instead of a single collection centre 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. Payments received by

the different collection centers are deposited with their respective local banks which in turn transfer 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 a 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 is a 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 to

eliminate the time between the receipt of remittances by the company and deposited in the bank. A lock box arrangement

usually is on regional basis which a company chooses according to its billing patterns. Under this arrangement, the company

rents the local post-office box and authorizes its bank at each of the locations to pick up remittances in the boxes. Customers

are billed with instructions to mail their remittances to the lock boxes. The bank picks up the mail several times a day and

deposits the cheques in the company.s account. The cheques may be microfilmed for record purposes and cleared for

collection. The company receives a deposit slip and lists all payments together with any other material in the envelope. This

procedure frees the company from handling and depositing the cheques. The main advantage of lock box system is that

cheques are deposited with the banks sooner and become collected funds sooner than if they were processed by the company

prior to deposit. In other words lag between the time cheques are received by the company and the time they are actually

deposited in the bank is eliminated. The main drawback of lock box system is the cost of its operation. The bank provides a

number of services in addition to usual clearing of cheques and requires compensation for them. Since the cost is almost

directly proportional to the number of cheques deposited. Lock box arrangements are usually not profitable if the average

remittance is small. The appropriate rule for deciding whether or not to use a lock box system or for that matter, concentration

banking, is simply to compare the added cost of the most efficient system with the marginal income that can be generated from

the released funds. If costs are less than income, the system is profitable, if the system is not profitable, it is not worth

undertaking.

(iii) Playing the float: Besides accelerating collections, an effective control over payments can also cause faster turnover of

cash. This is possible only by making payments on the due date, making excessive use of draft (bill of exchange) instead of

cheques. Availability of cash can be maximized by playing the float. In this, a firm estimates accurately the time when the

cheques issued will be presented for encashment and thus utilizes the float period to its advantage by issuing more cheques but

having in the bank account only so much cash balance as will be sufficient to honour those cheques which are actually

expected to be

presented on a particular date.

Different Kinds of Float with reference to Management of Cash:

The term float is used to refer to the periods that affect cash as it moves through the different stages of the collection process.

Four kinds of float with reference to management of cash are:

♦ Billing float: An invoice is the formal document that a seller prepares and sends to the purchaser as the payment request for

goods sold or services provided. The time between the sale and the mailing of the invoice is the billing float.

♦ Mail float: This is the time when a cheque is being processed by post office, messenger service or other means of delivery.

♦ Cheque processing float: This is the time required for the seller to sort, record and deposit the cheque after it has been

received by the company.

♦ Banking processing float: This is the time from the deposit of the cheque to the crediting of funds in the sellers account.

Delaying Payments: A firm can increase its net float by speeding up collections. It can also increase the net float by delayed

disbursement of funds from the bank by increasing the mail time. A company may make payment to its outstation suppliers by

a cheque and send it through mail. The delay in transit and collection of the cheque, will be used to increase

the float.

CASH MANAGEMENT MODELS


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In recent years several types of mathematical models have been developed which helps to determine the

optimum cash balance to be carried by a business organization. The purpose of all these models is to ensure that cash does not

remain idle unnecessarily and at the same time the firm is not confronted with a situation of cash shortage. All these models

can be put in two categories-inventory type models and stochastic models. Inventory type models have been constructed to aid

the finance manager to determine optimum cash balance of his firm. William J. Baumol.s economic order quantity model

applies equally to cash management problems under conditions of certainty or where the cash flows are predictable. However,

in a situation where the EOQ Model is not applicable, stochastic model of cash management helps in determining the optimum

level of cash balance. It happens when the demand for cash is stochastic and not known in advance.

William J. Baumol.s Economic Order Quantity Model, (1952): According to this model, optimum cash level is that level of

cash where the carrying costs and transactions costs are the minimum. The carrying costs refers to the cost of holding cash,

namely, the interest foregone on marketable securities. The transaction costs refers to the cost involved in getting the

marketable securities converted into cash. This happens when the firm falls short of cash and has to sell the securities resulting

in clerical, brokerage, registration and other costs.

The optimum cash balance according to this model will be that point where these two costs are minimum. The formula for

determining optimum cash balance is:

C = Optimum cash balance

U = Annual (or monthly) cash disbursement

P = Fixed cost per transaction.

S = Opportunity cost of one rupee p.a. (or p.m.)

Transaction Cost

Holding CostCost(Rs.)

Total Cost

Miller-Orr Cash Management Model (1966): According to this model the net cash flow is completely stochastic. When

changes in cash balance occur randomly the application of control theory serves a useful purpose. The Miller-Orr model is one

of such control limit models. This model is designed to determine the time and size of transfers between an investment account

and cash account. In this model control limits are set for cash balances. These limits may consist of h as upper limit, z as the

return point; and zero as the lower limit. When the cash balance reaches the upper limit, the transfer of cash equal to h . z is

invested in marketable securities account. When it touches the lower limit, a transfer from marketable securities account to

cash account is made. During the period when cash balance stays between (h, z) and (z, 0) i.e. high and low limits no

transactions between cash and marketable securities account is made. The high and low limits of cash balance a re set up on

the basis of fixed cost associated with the securities transactions, the opportunity cost of holding cash and the degree of likely

fluctuations in cash balances. These limits satisfy the demands for cash at the lowest possible total costs.

MANAGEMENT OF MARKETABLE SECURITIES

Management of marketable securities is an integral part of investment of cash as this may serve both the

purposes of liquidity and cash, provided choice of investment is made correctly. As the working capital needs are fluctuating,

it is possible to park excess funds in some short term securities, which can be liquidated when need for cash is felt. The

selection of securities


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should be guided by three principles.

♦ Safety: Return and risks go hand in hand. As the objective in this investment is ensuring liquidity, minimum risk is the

criterion of selection.

♦ Maturity: Matching of maturity and forecasted cash needs is essential. Prices of long term securities fluctuate more with

changes in interest rates and are therefore, more risky.

♦ 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.

The choice of marketable securities is mainly limited to Government treasury bills, Deposits with banks and Intercorporate

deposits. Units of Unit Trust of India and commercial papers of corporates are other attractive means of parking surplus funds

for companies along with deposits with sister concerns or associate companies. Besides this Money Market Mutual Funds

(MMMFs) have also emerged as one of the avenues of short-term investment. They focus on short-term marketable securities

such as Treasury bills, commercial papers certificate of deposits or call money market. There is a lock in period of 30 days

after which the investment may be converted into cash. They offer attractive yields, and are popular with institutional investors

and some big companies


Que. 1: - Tarus Ltd. has an estimated cash payments of Rs. 8,00,000 for a one month period and the payments are expected to steady over

the period. The fixed cost per transaction is Rs. 250 and the interest rate on marketable securities is 12% p.a.

Calculate the optimal transaction size.

Que. 2: - The annual cash requirement of A Ltd. is Rs. 10 lakhs. The company has marketable securities in lot sizes of Rs. 50,000, Rs.

1,00,000, Rs. 2,00,000, Rs. 2,50,000 and Rs. 5,00,000. Cost of conversion of marketable securities per lot is Rs. 1,000. The

company can earn 5% annual yield on its securities.

You are 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 Baumol Model.

Que. 3: - ABC Ltd. has estimated that use of Rs. 24 lakhs of cash during the next budgeted year. If intends to hold cash in a commercial

bank which pay interest @ 10% p.a. For each withdrawal, the Company incur expenditure of Rs. 150. What is the optimal size for

each withdrawal?

INTRODUCTION A firm needs to offer its goods and services on credit to customers as a Business

strategy to boost the sales. This represents a considerable investment of funds so the management of this asset can have

significant effect on the profit performance of the company. The basic objective of management of sundry debtors is to

optimise the return on investment on this assets known as receivables. Large amounts are tied up in sundry debtors, there are

chances of bad debts and there will be cost of collection of debts. On the contrary, if the investment in sundry debtors is low,

the sales may be restricted, since the competitors may offer more liberal terms. Therefore, management of sundry debtors is an

important issue and requires proper policies and their implementation.

Moreover, since cash flows from a sale cannot be invested until the accounts receivable are collected their control

warrants added importance, efficient collection will lead to both profitability and liquidity of the firm.

ASPECTS OF MANAGEMENT OF DEBTORS

There are basically three aspects of management of sundry debtors.

1. Credit policy: The credit policy is to be determined. It involves a trade off between the profits on additional sales that arise

due to credit being extended on the one hand and the cost of carrying those debtors and bad debt losses on the other. This seeks

to decide credit period, cash discount and other relevant matters. The credit period is generally stated in terms of net days. For

example if the firm.s credit terms are .net 50.. It is expected that

customers will repay credit obligations not later than 50 days. Further, the cash discount policy of the firm specifies:

(a) The rate of cash discount.

(b) The cash discount period; and

(c) The net credit period.

For example, the credit terms may be expressed as .3/15 net 60.. This means that a 3% discount will be granted if the customer

pays within 15 days; if he does not avail the offer he must make payment within 60 days.

2. Credit Analysis: This require the finance manager to determine as to how risky it is to advance credit to a particular party.

3. Control of receivable: This requires finance manager to follow up debtors and decide about a suitable credit collection

policy. It involves both laying down of credit policies and execution of such policies.

There is always cost of maintaining receivables which comprises of following costs:

(i) The company requires additional funds as resources are blocked in receivables which involves a cost in the form of interest

(loan funds) or opportunity cost (own funds)

Chapter : Debtors Management


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(ii) Administrative costs which include record keeping, investigation of credit worthiness etc.

(iii) Collection costs.

(iv) Defaulting costs.

FACTORS DETERMINING CREDIT POLICY

The credit policy is an important factor determining both the quantity and the quality of accounts receivables. Various factors

determine the size of the investment a company makes in accounts receivables. They are, for instance:

(i) The effect of credit on the volume of sales;

(ii) Credit terms;

(iii) Cash discount;

(iv) Policies and practices of the firm for selecting credit customers.

(v) Paying practices and habits of the customers

(vi) The firm.s policy and practice of collection.

(vii) The degree of operating efficiency in the billing, record keeping and adjustment function,

other costs such as interest, collection costs and bad debts etc., would also have an impact on the size of the investment in

receivables. The rising trend in these costs would depress the size of investment in receivables.

The firm may follow a lenient or a stringent credit policy. The firm which follows a lenient credit policy sells on credit to

customers on very liberal terms and standards. On the contrary a firm following a stringent credit policy sells on credit on a

highly selective basis only to those customers who have proper credit worthiness and who are financially sound.

Any increase in accounts receivables that is, additional extension of trade credit not only results in higher sales but also

requires additional financing to support the increased investment in accounts receivables. The costs of credit investigations and

collection efforts and the chances of bad debts are also increased.

Use of Financial tools/techniques: The finance manager while managing accounts receivables uses a number of financial

tools and techniques. Some of them have been described hereby as follows:

(i) Credit analysis: While determining the credit terms, the firm has to evaluate individual customers in respect of their credit

worthiness and the possibility of bad debts. For this purpose, the firm has to ascertain credit rating of prospective customers.

Credit rating: An important task for the finance manager is to rate the various debtors who seek credit facility. This involves

decisions regarding individual parties so as to ascertain how much credit can be extended and for how long. In foreign

countries specialized agencies are engaged in the task of providing rating information regarding

individual parties. Dun and Broadstreet is one such source. The finance manager has to look into the credit-worthiness of

a party and sanction credit limit only after he is convinced that the party is sound. This would involve an analysis of the

financial status of the party, its reputation and previous record of meeting commitments. The credit manager here has to

employ a number of sources to obtain credit information.

The following are the important sources:

Trade references; Bank references; Credit bureau reports; Past experience; Published financial statements; and Salesman.s

interview and reports. Once the credit-worthiness of a client is ascertained, the next question is to set a limit of the credit. In all

such enquiries, the credit manager must be discreet and should always have the interest of high sales in view.

(ii) Decision tree analysis of granting credit: The decision whether to grant credit or not is a decision involving costs and

benefits. When a customer pays, the seller makes profit but when he fails to pay the amount of cost going into the product is

also gone. If the relative chances of recovering the dues can be decided it can form a

probability distribution of payment or non-payment. If the chances of recovery are 9 out of 10 then probability of recovery is

0.9 and that of default is 0.1.

(iii) Control of receivables: Another aspect of management of debtors is the control of receivables. Merely setting of

standards and framing a credit policy is not sufficient; it is, equally important to control receivables.

(iv) Collection policy: Efficient and timely collection of debtors ensure that the bad debt losses are reduced to the minimum

and the average collection period is shorter. If a firm spends more resources on collection of debts, it is likely to have smaller

bad debts. Thus, a firm must work out the optimum amount that it should spend on collection of debtors. This involves a trade

off between the level of expenditure on the one hand and decrease in bad

debt losses and investment in debtors on the other. The collection cell of a firm has to work in a manner that it does not create

too much resentment amongst the customers. On the other hand, it has to keep the amount of the

outstandings in check. Hence, it has to work in a very smoothen manner and diplomatically. It is important that clear-cut

procedures regarding credit collection are set up. Such procedures must answer questions like the following:

(a) How long should a debtor balance be allowed to exist before collection process is started.

(b) What should be the procedure of follow up with defaulting customer? How reminders are to be sent and how should each

successive reminder be drafted?

(c) Should there be a collection machinery whereby personal calls by company.s representatives are made?

(d) What should be the procedure for dealing with doubtful accounts? Is legal action to be instituted? How should account be

handled?

Ageing Schedule: When receivables are analysed according to their age, the process is known as preparing the ageing

schedules of receivables. The computation of average age of receivables is a quick and effective method of comparing the

liquidity of receivables with the liquidity of receivables in the past and also comparing liquidity of one


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firm with the liquidity of the other competitive firm. It also helps the firm to predict collection pattern of receivables in future.

This comparison can be made periodically. The purpose of classifying receivables by age groups is to have a closer control

over the quality of individual accounts. It requires going back to the receivables ledger where the

dates of each customer.s purchases and payments are available. The ageing schedule, by indicating a tendency for old accounts

to accumulate, provides a useful supplement to average collection period of receivables/sales analysis. Because an analysis of

receivables in terms of associated dates of sales enables the firm to recognise the recent

increases, and slumps in sales. To ascertain the condition of receivables for control purposes, it may be considered desirable to

compare the current ageing schedule with an earlier ageing schedule in the same firm and also to compare this information

with the experience of other firms.

Notes on :-Credit Rating:

Credit-rating essentially reflects the probability of timely repayment of principal and interest by a

borrower company. It indicates the risk involved in a debt instrument as well its qualities. Higher the credit rating,

greater is the probability that the borrower will make timely payment of principal and interest and vice -versa.

It has assumed an important place in the modern and developed financial markets. It is a boon to the companies as well

as investors. It facilitates the company in raising funds in the capital market and helps the investor to select their risk -

return trade off. By indicating creditworthiness of a borrower, it helps the investor in arriving at a correct and rational

decision about making investments.

Credit rating system plays a vital role in investor protection. Fair and good credit ratings motivate the

public to invest their savings. As a fee based financial advisory service, credit rating is obviously extremely useful to the

investors, the corporates (borrowers) and banks and financial institutions. To the investors, it is an indicator expressing

the underlying credit quality of a (debt) issue programme. The investor is fully informed about the company as any

effect of changes in business/economic conditions on the company is evaluated and published regularly by the rating

agencies. The corporate borrowers can raise funds at a cheaper rate with good rating. It minimizes the role of the „name

recognition‟ and less known companies can also approach the marke t on the basis of their rating. The fund ratings are

useful to the banks and other financial institutions while deciding lending and investment strategies.

Notes on :-Impact of Inflation on Working Capital: The impact of inflation on working capital is direct. For the same

quantity of sales, the value of sundry debtors, closing stock etc. increases as a result of inflation. The valuation of

closing stock progressively on higher amounts would result in the company not being able to maintain its operating

capability unless it finds extra funds to maintain the same stock level. The higher valuation results in acute shortage

of funds as it triggers profit related cash outflows in respect of income tax, dividends and bonus. Unless proper

planning is done, the business is likely to face a condition known as “technical insolvency”.

Notes on:-Factoring: Factoring is a new financial service that is presently being developed in India. Factoring involves

provision of specialised services relating to credit investigation, sales ledger management, purchase and collection

of debts, credit protection as well as provision of finance against receivables and risk bearing. In factoring,

accounts receivables are generally sold to a financial institution (a subsidiary of commerc ial bank-called “Factor”),

who charges commission and bears the credit risks associated with the accounts receivables purchased by it.

Its operation is very simple. Clients enter into an agreement with the “factor” working out a factoring arrangement

according to his requirements. The factor then takes the responsibility of monitoring, follow-up, collection and risk-

taking and provision of advance. The factor generally fixes up a limit customer -wise for the client (seller).

Factoring offers the following advantages which makes it quite attractive to many firms.

(1) The firm can convert accounts receivables into cash without bothering about repayment.

(2) Factoring ensures a definite pattern of cash in flows.

(3) Continuous factoring virtually eliminates the need for the credit department. That is why receivables financing

through factoring is gaining popularly as useful source of financing short -term funds requirements of business

enterprises because of the inherent advantage of flexibility it affords to the borrowing firm. The seller firm

may continue to finance its receivables on a more or less automatic basis. If sales expand or contract it can

vary the financing proportionally.

(4) Unlike an unsecured loan, compensating balances are not required in this case. Another advantage consists of

relieving the borrowing firm of substantially credit and collection costs and to a degree from a considerable

part of cash management.

However, factoring as a means of financing is comparatively costly source of financ ing since its cost of

financing is higher than the normal lending rates.

Notes on :-Effect on Inflation on Inventory Management: The main objective of inventory management is to

determine and maintain the optimum level of investment in inventories. For inventory management a moderate


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inflation rate say 3% can be ignored but if inflation rate is higher it becomes important to take into consideration

the effect of inflation on inventory management. The effect of inflation on goods which the firm stock is rela tively

constant can be dealt easily, one simply deducts the expected annual rate of inflation from the carrying cost

percentage and uses this modified version in the EOQ model to compute the optimum stock. The reason for making

this deduction is that inflation causes the value of the inventory to raise, thus offsetting somewhat the effects of

depreciation and other carrying cost factors. Since carrying cost will now be smaller, the calculated EOQ and hence

the average inventory will increase. However, if rate of inflation is higher the interest rates will also be higher, and

this will cause carrying cost to increase and thus lower the EOQ and average inventories.

Thus, there is no evidence as to whether inflation raises or lowers the optimal level of invent ories of firms in the

aggregate. It should still be thoroughly considered, however, for it will raise the individual firm‟s optimal holdings

if the rate of inflation for its own inventories is above average and is greater than the effects of inflation on i nterest

rates and vice-versa.


Que. 1- A Company has prepared the following projections for a year:

Sales 21,000 units

Selling price per unit Rs. 40

Variable costs per unit Rs. 25

Total cost per unit Rs. 35

Credit period allowed One month

The company proposes to increase the credit period allowed to its customers from one month to two months. It is

envisaged that the change in the policy as above will increase the sales by 8%. The company desires a return of 25% on its

investment.

You are required to examine and advise whether the proposed credit policy should be implemented or not.

Que. 2- A company sells 40,000 units of its products per year @ Rs. 35/ unit. The average cost/unit is Rs. 31 out of which variable cost per

unit is Rs. 28. The average Collection period is 60 days. Bad debts losses are 3% on sales and the collection charges amount to Rs.

15,000.

The company is considering the proposal to follow stricter collection policy which would bring down the losses on account of

Bad Debts to 1% of sales and average collection period to 45 days. It would, however, reduce the sales volume by 1000 units and

increase collect expenses to Rs. 25,000. The company requires a Rate of Return of 20%.

Would you recommend the adoption of the new credit policy? (Assume 360 days in a year for the purpose of your calculation.)

Que. 3- The following are the details regarding the operation of firm during a period of 12 months: Sales Rs. 12,00,000, Selling price per

unit Rs. 10, Variable cost price per unit Rs. 7, Total cost per unit Rs. 9, Credit period allowed to customers One month.

The firm is considering a proposal for a more liberal extension of credit by increasing the average collection period from one

month to two months. This relaxation is expected to increase the sales by 25%.

You are required to advise the firm regarding adopting of the new credit policy, presuming that the firm‟s required return on

investment is 25%.

Que. 4- ABC Ltd. is examining the question of relaxing its credit policy. It sells at present 20,000 units at a price of Rs. 100 per unit, the

variable cost per unit Rs. 88 and average cost per unit at the current sales volume is Rs. 92. All the sales are on credit, the average

collection being 36 days. A relaxed credit policy is expected to increase sales by 10% and the average age of receivables to 60 days.

Assuming 15% return, should the firm relax its credit policy?

Que. 5- ABC Ltd. is considering the following credit policy alternatives:

Particulars Existing Policy Option I Option II

(a) Credit period (days)

(b) Sales (Rs. Lakhs)

(c) Bad debt (% of sales)

(d) Cost of credit administration (Rs. Lakhs)

(e) Average effective collection period (days)

30

10.00

5

0.20

45

41

9.60

3.33

0.12

51

60

12.000

6

0.25

72

The average effective collection period differs from the credit period as all debtors do not strictly adhere to the condition

stipulated. The company achieves a contribution of 40% on sales and the firm requires a 20% p.a. return on investment. You are

required to suggest which period is more suitable to the company. Do you have any suggestions to make to the management in the

context of your finding?

Que. 6- Surya Industries Ltd. is marketing all its products through a network of dealers. All sales are on credit and the dealers are given one

month time to settle bills. The company is thinking of changing the credit period with a view to increase its overall profits. The

marketing department has prepared the following estimates for different periods of credit:

Present Policy Plan I Plan II Plan III

Credit period (in months) 1 1.5 2 3

Sales (Rs. Lakhs) 120 130 150 180

Fixed costs (Rs. Lakhs) 30 30 35 40

Bad debts (% of sales) 0.5 0.8 1 2


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The company has a contribution sales ratio of 40% further it requires a pre-tax return on investment at 20%. Evaluate Balance

each of the above proposals and recommend the best credit period for the company.

Que. 7- Household Appliances Ltd. deals with consumer durable, having an annual turnover of Rs. 80 lakhs, 75% of which area credit sales

effected through a large number of dealers while the balance sales are made through show rooms on reach b Normal credit allowed is

30 days. The company proposes to expend its business substantially and there is good demand as well. However, the mark manager

finds that the dealers have difficulty in holding more stocks due to financial problems. He therefore, pro a change in the credit policy

as follows:

Proposal Credit period Anticipated credit sales

(In Lakhs of rupees)

Plan I

Plan II

60 days

90 days

70

75

The products yield an average contribution of 25% on sales. Fixed costs amount to Rs. 5 lakhs per annum. The company expects a

pre – tax return of 20% on capital employed.

The finance manager after a review of the proposal has recommended increasing the provision for bad debts from current 1% to

1 ½ % for Plan I and to 2% for Plan II.

Evaluate the merits of the new proposals and recommend the best policy

Que. 8- In order to increase sales from the normal level of Rs. 2.40 lakhs per annum, the marketing manager submits a proposal for

liberalizing credit policy as under:

Normal sales Rs. 2.4 lakhs

Normal credit period 30 days

Proposed increase in credit

Period beyond normal

Relevant increase over

Normal sales

15 days

30 days

45 days

60 days

Rs. 12,000

Rs. 18,000

Rs. 21,000

Rs. 24,000

The P.V. ratios of the company is 33.33%. The company expects a pre –tax return of 20 percent On investment Evaluate the

above four alternatives and advise the management (assume 360 days a year).

Que. 9- ABC firm is considering to make certain relaxation in its credit policy. The ABC management has evaluated two new policies. From

the following details advise the ABC management which policy has to be adopted:

(i) Annual credit sales at present Rs. 87.5 lakhs

(ii) Proposed credit sales:

Under alternative –I Under alternative –II

Rs. 105 lakhs Rs. 118 lakhs

(i) Accounts receivable turnover ratio and bad debts losses:

EXISTING I II

7 5.25 times 4.2 times

Rs. 2.63 lakhs Rs. 5.25 lakhs Rs. 7.88 lakhs

(ii) The ABC is required to give a return over 30% on the investment in new accounts receivable.

(iii) Its PV ratio is 30%.

Que. 10- A firm is considering offering 30 days credit to its customers. The firm like to charge them an annualized rate of 24%. The firm

wants to structure the credit in terms of a cash discount for immediate payment. How much would the discount rate have to be?

Que. 11- Garments Ltd. manufactures readymade garments and sells them on credit basis through a network of dealers. Its present sale is Rs.

60 lakh per annum with 20 days credit period. The company is contemplating an increase in the credit period with a view to

increasing sales. Present variable costs are 70% of sales and the total fixed costs Rs. 8 lakh per annum. The company expects pre –tax

return on investment @ 25%. Some other details are given as under:

Proposed Credit Average Collection Expected Annual

Policy Period (days) Sales (Rs. Lakh)

I 30 65

II 40 70

III 50 74

IV 60 75

Required: Which credit policy should the company adopt? Present your answer in a labour form. Assume 360 –day a year.

Calculations should be made upto two digits decimal.

Que. 12- Super Sports Co. dealing in sports goods, have an annual sale of Rs. 50,00,000 and are currently extending 30 day‟s credit to the

dealers. It is felt that sales can pick up considerably if the dealers are willing to carry increased stock, but the dealers have difficulty

in financing their inventory. Super Sports Co. is, therefore considering a shift in credit policy. The following information is available:

The average collection period now is 30 days.

Costs: Variable cost of 80% of sales.

Fixed cost Rs. 6 lace per annum

Required pre tax return an investment = 20%


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Determine which policy should be adopted by the company on the basis of (i) Total Profit, and (ii) Incremental Profit.

Que. 13- XYZ Ltd. makes all sales on a credit basis. Once a year it evaluates the creditworthiness of all its customers. The evaluation

procedure ranks customers from 1 to 5, with 1 indicating the “best” customers, Results of the ranking are as follows:

Customer Percentage of Average Credit Annual Sales Lost

Category Bad Debts Collection Period Decision Due to Credit

(Days) Strictness

1. None 7 Unlimited Credit None

2. 2.0 15 Unlimited Credit None

3. 4.0 20 Limited Credit Rs. 4,00,000



The PV Ratio is 20%. The cost of capital invested in receivables is 18%. What would be the effect on the profitability of

extending unlimited credit to each of the categories 3, 4, and 5?

Que. 14- Easy Limited specialists in the manufacture of computer component . The component is currently sold for Rs. 1,000 and its

variable cost is Rs. 800. For the year ended 31.12.96 the company sold on an average 400 components per month.

At present the company grants one months credit to its customers. The company is thinking of extending the same to two

months on account of which the following is expected:

Increase in Sales 25%

Increase in Stock Rs. 2,00,000

Increase in Creditors Rs. 1,00,000

You are required: To advise the company on whether or not to extend the credit terms if:

(a) all customers avail the extended credit period of two months and

(b) existing customers do not avail the credit terms but only the new customers avail the same. Assume in this case the entire

increase in sales is attributable to the new customers.

The company expects a minimum return of 40% on the investment.

Que. 15- A firm has a current sales of Rs. 2,56,48,750. The firm has unutilized capacity. In order to boost its sales, it is considering the

relation in its credit policy. The proposed terms of credit will be 60 days credit against the present policy of 45 days. As a result, the

bad debts will increase from 1.5% to 2% of sales. The firm‟s sales are expected to increase by 10%. The variable operating costs are

72% of the sales. The firm‟s corporate tax rate is 35%, and it requires an after tax return of 15% on its investment. Should the firm

change its credit period?

Que. 16- Future Kidd Corporation presently gives credit terms of “ net 30 days”. It has Rs. 60 million in credit sales and its average

collection period is 45 days. To stimulate sales, the company may give credit term of “net 60 days”. If it does instigate these terms,

sales are expected to increase by 15%. After the change the average collection period is expected to be 75 days with no difference in

payment habits between old and new customers. Variable cost is Re. 0.80 for every Re. 1.00 of sales; and the company‟s before tax

required rate of return on investment in receivables is 20%.

Should the company extend its credit period? (Assume a 360 – day year).

Que. 17- The present credit terms of P Company are 1/10 net 30. Its annual sales are Rs. 80 lakhs, its average collection period is 20 days.

Its variable costs and average total costs to sales are 0.85 and 0.95 respectively and its cost of capital is 10%. The proportion of sales

on which customers currently take discount is 0.5. P Company is considering relaxing its discount terms to 2/10 net 30. Such

relaxation is expected to increase sales by Rs. 5 lakhs, reduce the average collection period to 14 days and increase the proportion of

discount sales to 0.80. What will be the effect of relaxing the discount policy on company‟s profit? Take year as 360 days.

Que. 18- The credit manager of XYZ Ltd. is reappraising the company‟s credit policy. The company sells its products on terms of net 30.

Cost of goods sold is 85% of sales and fixed costs are further 5% of sales. XYZ classifies its customers on a scale of 1 to 4.

During the past five years, the experience was as under:

Classification Default as Average Collection

A percentage of sales period – (in days)

1 0 45

2 2 42

3 10 40

4 20 80

The average rate of interest is 15%. What conclusions do you draw about the Company‟s Credit Policy? What other factors

should be taken into account before changing the present policy? Discuss.

Que. 19- A company offers standard credit terms of 60 days net. Its cost of short –term borrowings is 16% per annum. Determine whether a

2.5% discount should be offered for payment within 7 days to customers who would normally pay after (i) 60 days, (ii) 80 days, and

(iii) 105 days.

Que. 20- A Company is considering using a factor, the following information is relevant:

Credit Policy Average collection period Annual sales

(Rs. In lacs)

A

B

C

D

45 days

60 days

75 days

90 days

56

60

62

63


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(a) The current average collection period for the company‟s debts is 80 days and ½% of debt-default. The factor has agreed to pay

over money due. After 60 days, and it will suffer loss of any bad debts.

(b) The annual charge for the factoring is 2% of turnover payable annually in arrears. Administration cost saving will total Rs.

1,00,000. per annum.

(c) Annual sales, all on credit, are Rs. 1,00,00,000. Variable costs total 80% of sales price. The company‟s cost of borrowings is

15% per annum. Assume year consisting of 365 days. Should the company enter into a factoring agreement?

Que. 21- Under an advance factoring arrangement Bharat Factors Ltd. (BFL) has advanced a sum of Rs. 14 lakh against the receivables

purchased from ABC Ltd. The Factoring agreement provides for an advance payment of 80% (maintaining „factor reserve of 20% to

provide for disputes and deduction relating to the bills assigned) of the value of factored receivables and for guaranteed payment after

three months from the date of purchasing the receivables. The advance carries a rate of interest of 20% per annum compounded

quarterly and the factoring commission is 1.5% of the value of factored receivables. Both the interest and commission are collected

up –front.

(i) Compute the amount of advance payable to ABC Ltd.

(ii) Calculate per annum the effective cost of funds made available to ABC Ltd.

(iii) Calculate the effective cost of funds made available to ABC Ltd. assuming that the interest is collected in arrear and

commission is collected in advance.

Que. 22- ABC Ltd. currently has a centralized billing system. It takes around 4 days for customers mailed payments to reach the central

billing location. Subsequently, it takes another 1.5 days for processing these payments, only after which deposits are made. ABC

Limited has a daily average collection of Rs. 5,00,000. The company plans to initiate a lock box system in which customers mailed

payments would reach the receipt location 2.5 days earlier. Further the process time would be reduced by another 1 day, since each

lock box bank would collect mailed deposits twice daily.

You are required to;

(i) Determine the reduction in cash balance that can be achieved through the use of a lock box system.

(ii) Determine the opportunity cost of the present system, assuming a 5% return on short –term investments.

(iii) If the annual cost of the lock box system is Rs. 80,000, should the system be initiated?

Que. 23- JK Ltd. has received an order from Green Ltd. which insists that the Rs. 50,000 of machinery ordered by supplied on 60 days

credit. The variable costs of production which would be incurred by JK Ltd. in meeting the order amount to Rs. 40,000. Green‟s

credit worthwhileness is in doubt and the following estimates have been made.

Probability of Green Ltd. paying in full in 60 days 0.6

Probability of Green Ltd. completely defaulting 0.4

However, if the order is accepted by JK Ltd. and if Green Ltd. does not default, then there is felt to be a probality of about 0.7 that a

further eight identical orders will be placed by Green Ltd. in exactly 1 year‟s time, and further orders in later years may also be

forthcoming. Experience has shown that once a firm meets the credit terms on a initial order, the probability of default in the next

year reduces to 0.1. Any work carried out on Green‟s Ltd. order would take place in otherwise idle time and would not encroach

upon JK Ltd. other activities. Should Green Ltd. defaults, the legal and other costs of debt collection would equal any money

obtained. JK Ltd. finances all trade credit with readily available overdrafts at a cost of 12% per annum. An appropriate discount rate

for long –term decisions is 15% per annum. Evaluate the proposal if (i) only one order is expected from Green Ltd. and (ii) if further

orders are also expected from it (year may be taken consisting of 360 days).

Que. 24- The sale of goods to the customer to the value of Rs. 2,000 on 90 days credit terms with an average bad debt rate of 2% and 2% on

administration cost of outstanding balance. Calculate the cost of credit assuming cost of capital is 18% P.A. and discount on cash

sales is 6%.

Que. 25- Jupiter Ltd. is selling its products on credit basis and its customers are associated with 5% credit risk i.e. there is a change of 5

customers out of 100 customers will turn bad. Its annual turnover is expected at Rs. 5,00,000 if credit extended and if no credit is

given the sales would be at 60% there on. Suggest the profitability of extending credit and cash sale assuming cost of capital is 18%

P.A. and variable cost of 75% of sales, credit period is 60 days cost of Administration is 2% of sales.

Que. 26- Star Ltd. are considering the liberation of existing credit terms of there large customers. Relevant data:

Credit Period (Days) Quantity of Sales

A B C

0 1,000 1,000 ----

30 1,000 1,500 ----

60 1,000 2,000 1,000

90 1,000 2,500 1,500

Selling price Rs. 9,000 per unit V.C. is 80 per cent of selling price. Cost of carrying debtors is 20 per cent p.a. Determine the

credit period allowed to each customer. Assume 360 days in a year.

Que. 27- A Bank is analyzing the receivables of Jackson Company in order to identify acceptable collateral for a short –term loan. The

company‟s credit policy is 2/10 net 30. The bank lends 80 per cent on accounts where customers are not currently overdue and where

the average payment period does not exceed 10 days past the net period. A schedule of Jackson‟s receivables has been prepared. How

much will the bank lend on a pledge of receivables, if the bank uses a 10 per cent allowance for cash discount and returns?

Account Amount Days Outstanding Average Payment

Rs. In days Period historically

74 25,000 15 20

91 9,000 45 60


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107 11,500 22 24

108 2,300 9 10

114 18,000 50 45

116 29,000 16 10

123 14,000 27 48

1,08,800

Que. 28- Star Ltd. is manufacturers of various electronic gadgets. The annual turnover for the year 1992 was Rs. 730 lakhs. The company

has a wide network of sales outlets all over the country. The turnover is spread evenly for each of 50 weeks of the working year. All

sales are for credit and sales within the week are also spread evenly over each of the five working days.

All invoicing of credit sales is carried out at the head office in Bombay. Sales documentation is sent by post, daily from each location

to the head office. Delays in preparing and dispatching invoices have come to the notice of management. An analysis of the delay in

invoicing being the interval between the date of sale and the date of dispatch of the invoice indicated the following pattern:

No. of days of delay in invoicing 3 4 5 6

% of weeks sales 20 10 40 30

A further analysis indicated that the debtors take on an average 36 days of credit before paying. The period is measured from the day

of dispatch of the invoice rather then the date of sale. It is proposed to hire an agency for undertaking the invoicing work at various

location. The agency has assured that the maximum delay would be reduced to three days under the following pattern.

No. of days of delay in invoicing 0 1 3

% of weeks sales 40 40 20

The agency has also offered additionally to monitor the collections which will reduce the credit period to 30 days. Star Ltd. expects

to save Rs. 4,000 per month in postage costs. All working funds are borrowed from a local bank at simple interest rate of 20 per cent

p.a. The agency has quoted a fee of Rs. 2,00,000 p.a. for the invoicing work and Rs. 2,50,000 p.a. for monitoring collections and is

willing to offer a discount of Rs. 50,000 providing both the works are given. You are required to advise Star Ltd. about the

acceptance of agency‟s proposal working should form part of the answer.

Que. 29- As a part of the strategy to increase sales and profits, the sales manager of a company proposes to sell goods to a group of new

customers with 10% risk of non –payment. This group would require one and a half months credit and is likely to increase sales by

Rs. 1,00,000 p.a. production and selling expenses amount to 80% of sales and the income –tax rate is 50%. The company‟s minimum

required rate of return (after tax) is 25%. Should the sales manager’s proposal be accepted?

Que. 30- A Firm is considering pushing up its sales by extending credit facilities to the following categories of customers.

(a) Customers with a 10% risk of non –payment, and

(b) Customers with a 30% risk of non –payment

The incremental sales expected in case of category (a) are Rs. 40,000 while in case of category (b) they are Rs. 50,000. The cost of

production and selling costs are 60% of sales while the collection costs amount to 5% of sales in case of category (a) and 10% of

sales in case of category (b). You are required to advice the firm about extending credit facilities to each of the above categories of

customers.

Que. 31- A trader whose current sales are in the region of Rs. 6 lakhs per annum and an average collection period of 30 days wants to purse

a more liberal policy to improve sales. A study made by a management reveals the following information:-

Credit Policy Average Annual Bad Debts as a

Collection Period Sales Percentage of Sales

A 40 days Rs. 6,30,000 1.5%

B 50 days Rs. 6,48,000 2%

C 60 days Rs. 6,75,000 3%

D 75 days Rs. 6,90,000 4%

The P/V Ratio is 33.33%. The current bad debt loss is 1%. Required return on investment is 20%. Assume a 360 days. Which

of the above policies would you recommend for adoption?

Que. 32- A trader is considering to make certain relaxation in his credit policy. He has evaluated four new policies. From the following

details advise him which policy has to be adopted:

(i) Annual credit sales at present Rs. 6,00,000

(ii) Proposed credit sales: Under credit policy A Rs. 6,30,000

Under credit policy B Rs. 6,48,000

Under credit policy C Rs. 6,75,000

Under credit policy D Rs. 6,90,000

(iv) Accounts receivable turnover ratio and bad debts losses:

Accounts receivable Bad debts losses

Turnover ratio

EXISTING 12 times Rs. 6,000

Under credit policy A 9 times Rs. 9,450

Under credit policy B 7.2 times Rs. 12,960

Under credit policy C 6 times Rs. 20,250

Under credit policy D 4.8 times Rs. 27,600

Required return on investment in new accounts receivable is 20%. The P/V Ratio is 33.33%.

Que. 33- Pollock Co. Ltd. , which is operating for the last 5 years, has approached Sundershan Industries for grant of credit limit on account

of goods bought from the latter, annexing Balance Sheet and Income Statement for the last 2 years as below:


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Pollock Co. Pvt. Ltd. – Balance Sheet (Rs. ‘000)st

Current Last Current Last

Year Year Year Year

Share capital Equity Plant & Equipment (less Depr.) 1,500 1,400

(Rs. 10) 600 600 Land 750 750

Share Premium 400 400 Total Fixed Trusts 2,250 2,150

Retained Earnings 900 700 Inventories 580 300

Total Equity 1,900 1,700 Accounts Receivables 350 200

First Mortgage 200 300 Marketable Securities 120 120

Second Mortgage -- 200 Cash 100 80

Bonds 300 300 Total Current Assets 1,150 700

Long –term Liab. 500 800

Account payable 300 60

Notes Payable 600 220

Secured Liab. 100 70

1,000 350

Total Current 3,400 2,850

Liabilities 3,400 2,850

Pollock Co. Pvt. Ltd. – Income Statement (Rs. ‘000)

Current Year Last Year

Sales 5,980 5,780

Income from Investments 20 6,000 20 5,800

Opening inventory 300 400

Total Mfg. Costs 4,200 3,200

Ending Inventory (580) 3,920 (300) 3,300

2,080 2,500

General and Admin. Expenses 950 750

Operating income 1,130 1,750

Interest exp. 60 62

Earnings before Taxes 1,070 1,688

Income Tax 480 674

Net income after Taxes 590 1,014

Dividend declared and paid 250

Sudershan Industries has established the following broad guidelines for granting credit limits to its customers:

(i) Limit credit limit to 10% of net worth and 20% of the net working capital.

(ii) Not to give credit in excess of Rs. 1,00,000 to any single customer.

You are required to detail the steps required for establishing credit limits to Pollock Co. Pvt. Ltd. In this case, what you

consider to be reasonable credit limit?

Question : Discuss the concept of leverage and it s types ?

Answer : The term leverage genera l ly, re fers to a rela t ionship be tween 2 interrela te d var iab les. In

f inancia l analys is, i t r epresents the inf luence of one financial var iable over some other rela ted

f inancia l var iable . These f inancia l var iables may be costs, output , sa les revenue, EBIT (Earnings

Before Interest and Tax) , EPS (Earnings Per Share) , e tc .

Types of leverages : Commonly used leverages are o f the fo l lo wing type :

1) Operat ing Leverage : I t is defined as the " f irm's abi l i ty to use f ixed operat ing costs to magnify

effec ts o f changes in sa les on i t s EBIT " . When there i s an incr ease o r decrease in sa les leve l the

EBIT also changes. The effec t of changes in sales on the leve l EBIT is measured by operat ing

leverage.

Opera ting leverage = % Change in EBIT / % Change in sa les

= [ Increase in EBIT/EBIT] / [ Increase in sa les/sa les]

Signif icance of operat ing leverage : Analysis o f opera t ing leverage of a f irm is useful to the

f inancia l manager . I t te l ls the impact o f changes in sa les on operat ing income. A firm having higher

D.O.L. (Degree of Operating Lever age) can experience a magnified effect on EBIT for even a small

change in sa les leve l . Higher D.O.L. can dramatica l ly increase operat ing profi t s . But , in case o f

decl ine in sales level , EBIT may be wiped out and a loss may be operated. As opera t ing levera ge,

depends on fixed costs , i f they are high, the f irm's opera t ing r i sk and leverage would be high. I f

Chapter : Leverages


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operat ing leverage i s high, i t automat ica l ly means that the b reak -even point would also be reached at

a high level o f sales. Also, in case o f high operat ing leverage, the margin of safety would be low.

Thus, i t i s preferred to opera te suff ic ient ly above the break -even point to avoid the danger o f

f luctuat ions in sa les and prof i t s .

2) Financia l Leverage : I t is def ined as the abi l i ty o f a f irm to use f ixe d financia l charges to magnify the e ffects o f changes

in EBIT/Opera ting prof i t s , on the firm's earnings per share. The financia l leverage occurs when a

f irm's cap ital structure conta ins ob ligat ion of f ixed charges e .g. in terest on debentures , d ividend on

preference shares, e tc . a long wi th o wner 's equity to enhance earnings of equity shareholders . The

f ixed f inancia l charges do no t vary with the operat ing prof i t s or EBIT. They are f ixed and are to be

repaid i r respect ive o f level o f opera t ing prof i t s or EBIT . The ordinary shareholders o f a f irm are

enti t led to residual income i .e . earnings a fter fixed financial charges. Thus, the e ffec t o f changes in

operat ing prof i t or EBIT on the leve l o f EPS is measured by f inancia l leverage.

Financial leverage = % chang e in EPS/% change in EBIT or

= ( Increase in EPS/EPS) /{Increase in EBIT/EBIT}

The f inancia l leverage i s favourab le when the f irm earns more on the investment/asse ts f inanced by

sources having fixed charges. I t i s obvious that sha reholders gain a si tua tion where the company

earns a high ra te o f return and pays a lo wer ra te of return to the suppl ie r of long term funds, in such

cases i t i s ca l led ' t r ading on equity' . The f inancial leverage a t the levels o f EBIT is cal led degree of

f inancia l leverage and i s calcula ted as ra t io o f EBIT to prof i t before tax.

Degree of f inancia l leverage = EBIT/Profi t before tax

Shareholders ga in in a s i tua tion where a company has a high ra te o f re turn and pays a lower rate o f

interes t to the suppl iers o f long term funds. The di ffe rence accrues to the shareholders . However ,

where rate o f re turn on investment fal ls belo w the ra te o f interes t , the shareholders suffer , as their

earnings fal l more sharp ly than the fa l l in the re turn on investment.

Financia l leverage helps the f inance manager in des igning the appropr iate capi tal s truc ture. One of

the objec tive o f planning an appropriate capital s tructure is to maximise return on equity

shareholders ' funds or maximise EPS. Financia l leverage i s double edged s word i .e . i t increases EPS

on one hand, and financia l r i sk on the o ther . A high f inancia l leverage means high fixed costs and

high f inancia l r i sk i .e . as the deb t component in capi tal structure increases, the financial r i sk also

increases i . e . r i sk o f inso lvency increases . The f inance manager thus, is required to trade off i .e . to

br ing a ba lance be tween r isk and re turn for de termining the appropria te amount o f deb t in the capita l

structure o f a firm. Thus, analys is o f financia l leverage i s an important too l in the hands of the

f inance manager who are engaged in f inancing the capi ta l s truc ture of business f irms, keep ing in

view the object ives o f the ir f irm.

3) Co mbined leverage : Opera ting leverage exp lains opera t ing r i sk and financial leverage explains th e financial r isk o f a

f irm. Ho wever , a firm has to look into overal l r isk or total r i sk o f the f irm i .e . operat ing r i sk as also

f inancia l r isk . Hence , the combined leverage i s the resul t o f a combination of operat ing and f inancia l

leverage. The combined le verage measures the e ffect o f a % change in sa les on % change in EPS.

Combined Leverage = Operat ing leverage * Financia l leverage

= (% change in EBIT/% change in sales) * (% change in EPS/% change in EBIT)

= % change in EPS/% change in sa les

The ra t io o f contr ibution to earnings before tax, i s given by a combined effec t o f financial and

operat ing leverage. A high operat ing and high f inancia l leverage i s very r i sky, even a small fal l in

sa les would affec t t remendous f a l l in EPS. A company must thus , maintain a proper ba lance be tween

these 2 leverage. A high operat ing and lo w f inancia l leverage indicates that the management i s

careful as higher amount o f r isk involved in high opera t ing leverage is balanced by lo w f inanc ia l

leverage. But , a more preferab le si tuat ion i s to have a lo w opera ting and a high financial leverage. A

low operat ing leverage automatical ly implies that the company reaches i t s break -even po int a t a low

leve l o f sales , thus, r isk is d iminished. A highl y caut ious and conservat ive manager would keep both

i t s operat ing and f inancial leverage at very low leve ls. The approach may, mean that the company is

los ing prof i tab le oppor tuni t ies.

The study of leverages is essent ia l to define the r isk undertaken by the shareholders. Earnings

avai lable to shareholders fluctua te on account o f 2 r i sks, viz . opera t ing r isk i .e . var iab il i ty o f EBIT


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may ar ise due to var iab il i ty o f sales or /and expenses. In a given environment, operat ing r i sk cannot

be avoided. The var iab il i ty o f EPS or re turn on equity depends on the use o f financial leverage and i s

termed as f inancial r i sk. A f irm financed to ta l ly by equi ty finance has no financial r i sk, hence i t

cannot be avoided by e l iminating use o f borrowed funds. Thus , a company has t o consider i t s l ike ly

prof i tab il i ty posit ion se t before decid ing upon the capi ta l mix of the company, as i t has far reaching

impl ica t ions on the f inancia l posi t ion of the company.

Quest ion : What is the effect of leverage on capita l turnover and working capital rat io ?

Answer : An increase in sales improves the net profi t ra t io , raising the Return on Investment (R.O.I)

to a higher level . This ho wever , i s not possible in al l s i tuat ions, a r ise in cap ital turnover i s to be

supported by adequate capi tal base. Thus, as capital turnover ra t io increases, working capi ta l ra t io

deter iora tes, thus, management cannot increase i t s cap ital turnover ra t io beyond a cer tain l imi t . The

main reasons for a fa l l in ra t ios showing the working capi ta l posi t ion due to incre ase in turnover

rat ios i s that as the ac t ivi ty increases wi thout a corresponding r i se in working cap ital , the working

capi tal posi t ion becomes t ight . As the sa les increases, both cur rent assets and current l iab il i t ies also

increases but not in proport ion t o current rat io . I f current ra t io and acid test ra t io are high, i t i s

apparent tha t the capi ta l turnover ra t io can be increased wi thout any problem. Ho wever , i t may be

very r i sky to increase capita l turnover rat io when, the working cap ital posi t ion i s not sat is fac tory.


Que. 1: - Calculate the operating leverage, financial leverage and combined leverage from the following date under Situations I and II and

financial plans A and B:

Installed Capacity 4,000 units

Actual Production and Sales 75% of the Capacity

Selling Price Rs. 30 Per Unit

Variable Cost Rs. 15 per unit

Fixed Cost:

Under Situation Rs. 15,000

Under Situation Rs. 20,000

Capital Structure (Rs.)

Financial Plan A B

Equity 10,000 15,000

Debt (Rate of Interest at 20%) 10,000 5,000

20,000 20,000

Que. 2: - The following figures relate to two Companies:

Particulars P. Ltd. Q. Ltd.

Sales

Variable Costs

Contribution

Fixed Cost

Interest

Profit before Tax (PBT)

500

200

300

150

150

50

100

1,000

300

700

400

300

100

200

You are required to calculate:

(1) Operating, Financial and Combined Leverages of the two Companies, and

(2) Comment on the relative position of the Companies in respect of the risk.

Que. 3: - Calculate EPS (earning per share) of Solid Ltd. and Sound Ltd. assuming (a) 20% before tax rate of return on assets (b) 10%

before tax rate of return on assets based on the following data:

Particulars Solid Ltd. Sound Ltd.

Assets

Debt

(12% Debenture & 7 Loan)

Equity

100

---

100

(Share of Rs. 10 each)

100

50

50

(Share of Rs. 10 each)

Assume a 50% Income – tax in both cases. Give your comments on the financial leverage.

Que. 4: - XYZ Ltd. has an average selling price of Rs. 10 per unit. Its variable unit costs are Rs. 7, and fixed costs amount to Rs. 1,70,000. It

finances all its assets by equity funds. It pays 35% tax on its income. ABC Ltd. is identical of XYZ Ltd. except in the pattern of

financing. The latter finances it assets 50% by debt, the interest on which amounts to Rs. 20,000

Determine the degree of operating, financial and combined leverage at Rs. 7,00,000 sales for both the firms, and

interpret the results.


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Que. 5: - Saraju Ltd. produces electronic components with price per unit of Rs. 100. Fixed cost amount to Rs. 2,00,000.

5,000 units are produced and sold each year. Annual profits amount to Rs. 50,000. The company‟s all equity –financed assets are

Rs. 5,00,000.

The company proposes to change its production process, adding Rs. 4,00,000 to investment and Rs. 50,000 to fixed operational

costs. The consequences of such a proposal are:

(i) Reduction in variable cost per unit by Rs. 10

(ii) Increase in output by 2,000 units

(iii) Reduction in selling price per unit to Rs. 95

Assuming an average cost of capital 10%, examine the above proposal and advise whether or not the company should make the

change. Also measure the degree of operating leverage and break –even point.

Que. 6: - The balance sheet of Alpha Numeric Company is given below:

Liabilities Rs. Assets Rs.

Equity capital (Rs. 10 per share)

10% Long term Debt.

Retained earnings

Current liabilities

90,000

1,20,000

30,000

60,000

3,00,000

Net fixed assets

Current assets

2,25,000

75,000

3,00,000

The company‟s total assets turnover ratio is 3, its fixed operating cost is Rs. 1,50,000 and its variable operating cost ratio is 50%.

The income –tax rate is 50%.


(1) Calculate the different type of leverages for the company.

(2) Determine the likely level of EBIT if EPS is:

(a) Re. 1 (b) Rs. 2 (c) Re. 0

Que. 7: - A firm has sales of Rs. 75,00,000 variable cost of Rs. 42,00,000 and fixed cost of Rs. 6,00,000. It has a debt of Rs. 45,00,000 at

9% and equity of Rs. 55,00,000.

(i) What are the operating, financial and combined leverages of the firm?

(ii) What is the firm‟s ROI?

(iii) Does it have favourable, financial and combined leverages of the firm?

(iv) If the firm belong to an industry whose asset turnover is 3, does it have a high or low asset leverage?

(v) If the sales drop to Rs. 50,00,000, what will be the new EBIT?

(vi) At what level of sales the EBT of the firm will be equal to zero?

Que. 8: - The following summarizes the percentage changes in operating income, percentage changes in revenues, and betas for four

pharmaceutical firms.

Firm Change in Change in Beta

Revenue operating income

PQR Ltd. 27% 25% 1.00

RST Ltd. 25% 32% 1.15

TUV Ltd. 23% 36% 1.30

WXY Ltd. 21% 40% 1.40

Required:

(i) Calculate the degree of operating leverage for each of these firms. Comment also.

(ii) Use the operating leverage to explain why these firms have different beta.

Que. 9: - The capital structures of the progressive Corporation consists of an ordinary share capital of Rs. 10,00,000 (Shares of Rs. 100 per

value) and Rs. 10,00,000 of 10% debentures. Sales increased by 20% from 1,00,000 units to 1,20,000 units, the selling price is Rs.

10 per unit; variable cost amount to Rs. 6 per unit and fixed expenses amount to Rs. 2,00,000. The income tax rate is assumed to

be Rs. 50%. You are Required to calculate the following:

(i) the percentage increase in earning per share;

(ii) the degree of financial leverage at 1,00,000 units to 1,20,000 units.

(iii) The degree of operating leverage at 1,00,000 units and 1,20,000 units.

Comment on the behavior of operating and financial leverages in relation to increase in production from 1,00,000 units to

1,20,000 units.

Que. 10: -ABC Ltd.‟s capital structure on 31 -3-2001 includes 5,00,000 Equity shares of Rs. 10 each, 10,000 debentures of Rs. 150 each

tarrying 15% rate of interest and term loan of Rs. 20,00,000 repayable in 7 year period with 18% rate of interest. XYZ Ltd.‟s

Balance sheet shows the following capital structure: -

- 2,00,000 Equity shares of Rs. 10 each

- General Reserve of Rs. 5,00,000

- Share premium A/c Rs. 3,00,000

- 32,000 Preference shares of Rs. 100 each (12%)

- 25,000 Non –convertible debentures of Rs. 100 each (fully secoured) (14%)

From the above date you are required to calculate the leverage of both the firms and compare with each other.

Que. 11- The following data are available for the ABC Ltd. and XYZ Ltd.:

ABC Ltd. XYZ Ltd.


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Sales volume 10,000 units 10,000 units

Selling price per unit of output Rs. 200 Rs. 200

Variable cost per unit of output Rs. 120 Rs. 150

Fixed operating cost per unit of output Rs. 60 Rs. 30

Equity Rs. 3,00,000 Rs. 6,00,000

Preference shares Rs. 1,00,000

Debt Rs. 6,00,000 Rs. 4,00,000

Interest rate on debt 16.25% 15%

Dividend rate on Preference share 13%

Tax rate 60% 60%

Required:-

(i) Calculate the ROE, DOL, DFL, DTL, operating break –even point, financial break –even point and overall

break –even point for each company.

(ii) As a financial analyst which of the two companies would you describe as more risky? Give reasons

Que. 12 EXE Limited is considering three financing plans. The key information is as follows:-

(a) Total investment to be raised Rs. 2,00,000.

(b) Plans of Financing Proportion

Plans Equity Debt Preference Shares

A 100%

B 50% 50%

C 50% 50%

(c) Cost of debt 8%

Cost of preference shares 8%

(d) Tax rate 50%.

(e) Equity shares of the face value of Rs. 10 each will be issued at a premium of Rs. 10 per share.

(f) Expected PBIT is Rs. 80,000.

Determine for each Plan

(i) Earnings per share (EPS) and

(ii) The financial break –even point,

(iii) Indicate if any of the plans dominate and compute the PBIT range among the plans for indifference.

Que. 13- Bharat Carpet Company is contemplating an expansion of their business, Current income statement of the company

is given below: Rs.

Sales 8,00,000

Less: Variable expenses 3,60,000 (45% of sales)

Fixed expenses 3,20,000

EBIT 1,20,000

Interest (@ 6%) 24,000

EBT 96,000

Tax (@ 50%) 48,000

EAT 48,000

Shares of common stock

(40,000 shares)

EPS Rs. 1.20

Bharat Carpet Company is currently financed with 50 per cent equity (common stock par value of Rs. 10). In

order to expand the business the company would need Rs. 4,00,000. The management has three following financing

plans in hand:

1. Sell Rs. 4 lakhs of debt at 9 per cent.

2. Sell Rs. 4 lakhs of common stock at Rs. 20 per share.

3. Sell Rs. 2 lakhs of debt @ 8 per cent and Rs. 2 lakhs of common stock @ Rs. 25/- per share.

Variable costs are expected to stay at 45 per cent of sales while fixed costs will increase to Rs. 4,20,000. The

management is not sure how much this expansion will add to sales but they estimate sales will rise to Rs. 9,60,000.The

Management is interested in a though analysis of the expansion plans and methods of financing.

Required: (i) Compile the break –even point before and after expansion:

(ii) Compute the degree of operating leverage before and after expansion;

(iii) Calculate the degree of financial leverage before expansion and for all the three methods of financing

after expansions.


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Quest ion : Explain the concept of capita l structure ?

Answer : A finance manager for procurement of funds, i s requi red to select such a f inance mix or

capi tal s truc ture tha t maximises shareholders wealth. For des igning optimum cap ita l structure he i s

required to se lec t such a mix of sources o f f inance, so that the overal l cos t of cap ital i s minimum.

Capital s truc ture re fers to the mix of sources from where long term funds required by a business may

be raised i . e . what should be the propor t ion of equity share capi ta l , preference share cap ita l , in terna l

sources, debentures and other sources o f funds in to ta l amount o f cap ital which an undertaking may

raise for estab li shing i t s business. In planning the cap ita l structure, fo l lowing must be re ferred to :

1) There i s no defini te model that can be suggested/used as an idea l for al l business under takings.

This i s due to varying circumstances o f var ious business undertakings. Capi ta l s truc ture depends

pr imar i ly on a number of fac tors l ike , na ture o f industry, ges tat ion per iod, cer tainty wi th which the

prof i t s wi l l accrue af ter the under taking commences commercia l production and the l ikely quantum of

return on investment. I t i s thus, impor tant to unders tand t ha t di fferent types o f cap ital s truc ture

would be required for di ffe rent types o f undertakings.

2) Government policy i s a major factor in planning capi ta l s tructure. For instance, a change in the

lending pol icy of f inancia l ins t i tut ions may mean a co mple te change in the f inancia l pa ttern.

Simi lar ly, rules and regulat ions fo r cap ita l market formulated by SEBI affect the capi tal st ruc ture

decisions. The f inance managers o f business concerns are required to plan capi tal s truc ture wi thin

these constra ints.

Optimum capital structure : The capi ta l structure i s sa id to be opt imum, when the company has

se lec ted such a combination of equi ty and deb t , so tha t the company's weal th is maximum. At this,

capi tal st ructure, the cost o f capi tal is minimum and market pr i ce per share is maximum. But , i t i s

d i fficult to measure a fa l l in the market value of an equi ty share on account o f increase in r i sk due to

high debt content in the capi ta l s truc ture. In real i ty, ho wever , instead of opt imum, an appropriate

capi tal s truc ture i s more real i st ic . Features o f an appropria te cap ita l structure are as belo w :

1) Profitabi l ity : The most prof i tab le cap ital structure is one that tends to minimise financing cost

and maximise o f earnings per equi ty share.

2) Flexibi l ity : The capi tals s tructure should be such that the company is able to ra ise funds

whenever needed.

3) Conservation : Debt content in capi tal s truc ture should no t exceed the l imi t which the company

can bear .

4) Solvency : Capital s t ruc ture should be such tha t the b usiness does no t run the r i sk o f insolvency.

5) Control : Capital struc ture should be devised in such a manner tha t i t invo lves minimum r isk o f

loss o f contro l over the company.

Quest ion : Explain the major considerat ions in the planning of capital s tr ucture ?

Answer : The 3 major considerat ions evident in capital s truc ture planning are r i sk, cost and cont rol ,

they ass is t the management in de termining the p roport ion of funds to be raised from various sources.

The finance manager a t tempts to design th e cap ita l structure in a manner , that his r i sk and cost are

least and there i s leas t di lut ion of cont rol fro m the exist ing management . There are also subsidiary

factors as, marketabi l i ty o f the issue, maneuverabil i ty and flexibi l i ty of cap ita l s truc ture an d t iming

of rais ing funds. S truc tur ing capi tal , is a shrewd financia l management decision and i s something tha t

makes or mars the for tunes o f the company. The factors involved in i t are as fol lows :

1) Risk : Risks are o f 2 kinds viz . financial and busin ess r i sk. Financial r isk i s o f 2 kinds as be low :

Chapter : Cost of Capital & Capital Structure


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i ) Risk of cash insolvency : As a business raises more deb t , i t s r i sk of cash inso lvency increases, as

:

a) the higher propor t ion of debt in cap ital struc ture increases the commitments of the company wi t h

regard to f ixed charges. i .e . a company s tands co mmitted to pay a higher amount o f interest

i r respec tive o f the fact whether or no t i t has cash. and

b) the possib il i ty tha t the supplier o f funds may wi thdraw funds at any point o f t ime.

Thus, long term cred ito rs may have to be pa id back in instal lments , even i f suff ic ient cash to do so

does no t exist . Such r i sk is absent in case o f equity shares .

i i ) Risk of variat ion in the expected earnings available to equity share -holders : In case a f irm

has a higher deb t content in cap ital structure, the r i sk o f var iat ions in expected earnings ava ilable to

equity shareholders would be higher; due to t rading on equity. There is a lo wer probabil i ty tha t

equity shareholders ge t a stable dividend i f , the debt content i s high in capi ta l structure as the

f inancia l leverage works both ways i .e . i t enhances shareholders ' r eturns by a high magnitude or

reduces i t depending on whether the re turn on investment i s higher or lower than the interes t rate . In

other words, there i s re lat ive d ispersion of expected earnings avai lable to equity shareholders, tha t

would be grea ter i f capi tal structure o f a f irm has a higher debt content .

The f inancia l r isk involved in var ious sources o f funds may be understood wi th the help o f

debentures. A company has to pay interest charges on debentures even in case o f absence of prof i t s .

Even the pr incipa l sum has to be repaid under the st ipulated agreement. The debenture ho lders have a

charge against the company's assets and th us, they can enforce a sa le o f asse ts in case o f company's

fa i lure to meet i ts contractua l obl iga tions. Debentures also increase the r isk o f var iat ion in expected

earnings avai lable to equi ty shareholders through leverage effect i .e . i f return on investmen t remains

higher than interes t ra te , shareholders get a high re turn and vice versa. As compared to debentures,

preference shares enta i l a sl ight ly lo wer r i sk fo r the company, as the payment o f d ividends on such

shares i s contingent upon the earning of prof i t s by the co mpany. Even in case o f cumulat ive

preference shares , d ividends are to be paid only in the year in which company earns profi t s . Even,

their repayment i s made only i f they are redeemable and after a st ipula ted per iod. However ,

preference shares increase the var ia t ions in expected earnings ava ilable to equity shareholders . From

the co mpany's view point , equity shares are leas t r i sky, as a company does not repay equi ty share

capi tal excep t on i ts l iquida tion and may no t dec lare d ividends for years . Thus , as seen here,

f inancia l r i sk encompasses the volat i l i ty o f earnings ava ilab le to equity shareholders as also, the

probabil i ty of cash inso lvency.

2) Cost of capita l :Cost is an important considerat ion in capi tal s truc ture dec is ions and i t is obvio us

that a business should be at leas t capable o f earning enough revenue to meet i ts cost o f cap ital and

also finance i t s gro wth. Thus, a long wi th r isk, the f inance manager has to consider the cost o f capital

factor for de termination of the cap ita l structure .

3) Control :Along wi th cost and r i sk fac tors, the contro l aspec t i s al so an important factor for capi tal

structure planning. When a company issues equi ty shares, i t automatical ly d i lutes the cont roll ing

interes t o f present owners. In the same manner , p reference shareholders can have vot ing r ights and

thereby affect the composi t ion of Board of directors, i f d ividends a re not pa id on such shares for 2

consecut ive years. F inancia l inst i tut ions normal ly s t ipula te that they shall have one or more directors

on the board. Thus, when management agrees to raise loans from f inancial ins t i tut ions, by impl icat ion

i t agrees to forego a par t o f i ts contro l over the company. I t i s thus, obvious that decisions

concerning cap ital s truc ture are taken after keep ing the con t rol factor in view.

4) Trading on equity :A company may ra ise funds by i ssue of shares or by borro wings, carrying a

f ixed ra te o f interest tha t i s payable ir respec tive o f the fac t whether or no t there i s a prof i t .

Preference shareholders are a lso enti t l ed to a fixed rate o f d ividend , but dividend payment i s subjec t

to the company's profi tabil i ty. In case o f ROI the total cap ita l employed i .e . shareholders ' funds plus

long term borro wings, i s more than the rate o f interes t on borrowed funds or rate o f di vidend on

preference shares, the company is said to t rade on equi ty. I t i s the finance manager 's main object ive

to see tha t the return and overal l weal th o f the company both are maximised, and i t i s to be kept in

view whi le dec iding on the sources o f finan ce . Thus , the e ffect o f each proposed method of new

f inance on EPS is to be careful ly analysed. This, thus, helps in deciding whether funds should be

raised by interna l equity or by borrowings .

5) Corporate taxat ion :Under the Income tax laws, d ividend o n shares i s not deductib le whi le

interes t pa id on borrowed capi tal is a l lowed as deduct ion. Cost o f ra is ing finance through borrowings

is deduct ible in the year in which i t i s incur red. I f i t i s incurred dur ing the pre -co mmencement


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period, i t is to be capi ta l i sed. Cost o f share i ssue is a l lo wed as deduct ion. Owing to such provis ions,

corporate taxa tion , plays an important role in determination of the choice be tween di fferent sources

of f inancing.

6) Government Pol ic ies :Government polic ies i s a major fact or in de termining cap ital struc ture. For

ins tance, a change in the lend ing po lic ies o f f inancia l ins t i tut ions would mean a comple te change in

the f inancia l pattern fo l lo wed by companies. Also, rules and regulat ions framed by SEBI

considerab ly a ffec t the ca pi ta l i ssue po licy of var ious co mpanies . Monetary and fi scal pol icies o f

government also a ffec t the cap ita l structure decisions.

7) Legal requirements :The f inance manager has to keep in view the legal requi rements a t the t ime

of decid ing as regards the cap ita l structure o f the company.

8) Marketabil ity :To obtain a balanced capi ta l structure, i t i s necessary to consider the company's

abil i ty to market corporate securi t ies .

9) Maneuverabil ity :Maneuverab il i ty i s required to have as many al ternatives as possib le at the t ime

of expanding or contrac t ing the requirement o f funds. I t enab les use o f p roper type of funds avai lable

at a given t ime and also enhances the barga ining power when dea ling wi th the prospect ive suppliers

of funds.

10) Flexibi l ity : I t re fers to the capaci ty o f the business and i t s management to adjust to expected and

unexpected changes in circumstances . In other words , the management would l ike to have a capi tal

structure provid ing maximum freedom to changes a t a l l t imes.

11) Timing :Closely re lated to f lexib il i ty i s the t iming for i ssue of securi t ies. Proper t iming of a

securi ty i ssue of ten br ings substantia l savings due to the dynamic nature o f the capi ta l market .

Intel l igent management tr ies to antic ipa te the c l imate in cap ita l ma rket wi th a view to minimise cost

of raising funds and the di lut ion result ing from an issue of new ord inary shares.

12) Size of the co mpany :Smal l companies re ly heavily on owner 's funds whi le large companies are

usua lly considered, to be less r isky by i nvestors and thus, they can issue di fferent types o f secur i t ies.

13) Purpose of f inancing :The purpose of f inancing also, to so me extent a ffec ts the capi ta l s truc ture

of the company. In case funds are required for product ive purposes l ike manufac tur ing, e tc . the

company may ra ise funds through long term sources. On the other hand, i f the funds are required for

non-product ive purposes, l ike welfare faci l i t ies to employees such as schools, hosp ita ls , e tc . the

company may re ly only on inte rnal resources.

14) Period of Finance :The per iod for which f inance i s required a lso affec ts the de termination of

capi tal s truc ture. In case funds are required for long term requi rements say 8 to 10 years, i t would be

appropria te to raise bor rowed funds. Ho wever , i f the f unds are required more or less permanent ly, i t

would be appropr ia te to raise borrowed funds . However , i f the funds are required more or less

permanently, i t would be appropriate to raise them by i ssue of equi ty shares.

15) Nature of enterprise :The na ture o f enterpr ise to a grea t extent affec ts the company's capital

structure. Business enterpr ises having s tab il i ty in earnings or enjoying monopoly as regards the ir

products may go for borrowings or preference shares, as they have adequate profi t s to pay

interes t / f ixed charges. On the contrary, co mpanies not having assured income should preferab ly rely

on inte rnal resources to a large extent .

16) Requirement of investors :Different types o f secur i t ies are i ssued to di fferent c lasses o f

investors accord ing to the ir requirement .

17) Provis ion for future :While p lanning cap ita l structure the provis ion for future requirement o f

capi tal i s a l so required to be considered.

Question : Give in detail the various capita l structure theories ?

Answer : A firm's objective should be di rec ted towards the maximisa tion of the firm's va lue ; the

capi tal s truc ture or leverage decision are to examined fro m the view point o f their impact on the

va lue of the f irm. I f the va lue of the f irm can be a ffected by capi ta l structu re or f inancing decis ion, a

f irm would l ike to have a capital s truc ture that maximises the market va lue of the f irm. There are


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broadly 4 approaches in the regard , which ana lyses rela t ionship be tween leverage, cost o f capi ta l and

the va lue of the firm in di fferent ways , under the fol lowing assumpt ions :

1) There a re only 2 sources of funds viz. debt and equi ty.

2) The total assets o f the f i rm are given and the degree of leverage can be al tered by sel l ing deb t

to repurchase shares or se l l ing shares to re t ire debt .

3) There a re no reta ined earnings implying tha t ent ire prof i t s a re d is tr ibuted among shareholders.

4) The opera ting profi t o f f irm is given and expected to grow.

5) The business r isk i s assumed to be constant and is not a ffec ted by the financing mix decis ion.

6) There a re no corpora te o r personal taxes .

7) The investors have the same subject ive probabi l i ty distr ibut ion of expected earnings .

The approaches are as below :

1) Net Inco me Approach (NI Approach) :The approach i s suggested by Durand. According to i t , a

f irm can increase i t s va lue or lo wer the overal l cos t o f cap ital by increasing the propor t ion of debt in

the capi tal struc ture. In o ther words, i f the degree of financial leverage increases, the weighted

average cost o f cap ital would decl ine wi th every increa se in the debt content in tota l funds employed,

whi le the va lue of the fi rm wi ll increase. Reverse would happen in a converse s i tuat ion. I t i s based on

the fo l lo wing assumptions :

i ) There are no corporate taxes .

i i ) The cost o f deb t i s less than cost o f equity or equity cap ital isat ion ra te .

i i i ) The use o f deb t content does not change the r i sk percep tion of investors as a result o f both the

Kd (Debt cap ita l i sa t ion rate) and K e (equity cap ital i sa t ion rate) remains constant .

The va lue of the f irm on the bas is o f Net Income Approach may be ascer tained as fo l lows :

V = S + D

Where,

V = Value of the f irm

S = Market value of equity

D = Market va lue of deb t

Overa ll cos t o f cap ita l = EBIT/Value of the f irm

2) Net Operating Income Approach (NOI) : This approach i s a lso suggested by Durand , accord ing to i t , the market value of the f irm is

not a ffected by the capita l structure changes . The market va lue of the f irm is ascer tained by

capi tal i sing the ne t operat ing income a t the overal l cos t o f cap ital , which i s constant . The market

va lue of the firm is de termined as :

V = EBIT/Overa ll cost o f capi ta l

Where, V = Market va lue of the firm

S = V - D

Where, S = Value of equity


V = Market va lue of firm

Cost o f equi ty = EBIT/(V - D)

Where, V = Market va lue of the firm

EBIT = Earnings before interes t and tax


I t is based on the fo l lo wing assumptions :

i ) The overa l l cos t o f capita l remains constant f or al l degree of debt equity mix.

i i ) The market capi ta l i ses va lue of the f irm as a whole . Thus, the sp li t between deb t and equi ty i s not

important .

i i i ) The use o f less cost ly deb t funds increases the r i sk o f shareholders. This causes the equi ty

capia l i sat ion rate to increase. Thus, the advantage of debt i s set o ff exact ly by increase in equity

capi tal i sa t ion rate .

iv) There are no corpora te taxes.


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v) The cost o f deb t i s constant .

Under , NOI approach s ince overa l l cost o f capi ta l i s constant , thus, there is no op timal

capi tal struc ture ra ther every capi tal struc ture i s as good as any other and so every cap ital s truc ture

is op timal .

3) Tradit ional Approach :The t radi t ional approach, also ca l led an inte rmedia te approach as i t takes

a midway between NI approach, that the value of the firm can be increased by increasing f inancia l

leverage and NOI approach, that the va lue of the fi rm is constant i r respect ive o f the degree of

f inancia l leverage . According to this approach the firm shoul d s tr ive to reach the op timal capital

structure and i t s to tal va luat ion through a jud icious use of deb t and equi ty in capi ta l s truc ture. At the

optimal cap ita l s truc ture, the overa l l cost o f capital wi l l be minimum and the value of the f irm is

maximum. I t fur ther s ta tes, that the value of the firm increases wi th f inancia l leverage up to a cer tain

point . Beyond this, the increase in f inancial leverage wi l l increase cost of equi ty, the overal l cost o f

capi tal may s t i l l reduce. However , i f f inancial leverage in creases beyond an accep table l imi t , the r isk

of deb t investor may a lso increase, consequent ly cost of deb t also s ta r ts increas ing. The increas ing

cost of equi ty o wing to increased financial r i sk and increas ing cost o f debt makes the overa l l cost o f

capi tal to increase. Thus, as per the trad it ional approach the cost o f capita l i s a funct ion of financia l

leverage and the va lue of f irm can be a ffec ted by the jud ic ious mix of deb t and equi ty in capital

structure. The increase of f inancia l leverage up to a point favourably a ffect the va lue of the fi rm. At

this point , the capi ta l st ruc ture i s opt imal & the overal l cos t o f capi ta l wi l l be the least .

4) Modigliani and Mil ler Approach(MM Approach) :According to this approach, the to tal cost o f

capi tal o f par t icular f irm is independent o f i t s method and leve l o f financing. Modigliani and Mil ler

argued tha t the weighted average cost o f cap ital o f a firm is completely independent o f i t s capi tal

structure. In other words, a change in the deb t equity mix does no t a ffect the cost o f cap ita l . They

argued, in suppor t o f the ir approach, tha t as per the trad it iona l approach, cost o f capi ta l i s the

weighted average of cos t o f deb t and cost o f equi ty, e tc . The cost o f equi ty, i s determined from the

leve l o f shareholder 's expecta t ions. That i s i f , shareholders expect a par t icular ra te o f return, say 15

% fro m a par t icular company, they do no t take into account the debt equi ty rat io and they expect 15

% as they f ind that i t covers the par t icular r isk which this company entai l s . Su ppose, the debt content

in the cap ital structure of the company increases, th is means, that in the eyes o f shareholders, the

r isk o f the company increases, s ince deb t is a more r i sky mode of finance. Thus, the shareholders

would no w, expect a higher rate o f re turn from the shares o f the company. Thus, each change in the

debt equity mix is automatica l ly se t -o ff by a change in the expecta t ions o f the shareholders f rom the

equity share cap ital . This is because, a change in the debt -equi ty rat io changes the r is k e lement of the

company, which in turn changes the expectat ions o f the shareholders from the par t icular shares of the

company. Modigliani and Miller , thus, argue that financial leverage has no thing to do wi th the

overal l cost o f capi ta l and the overa l l co s t o f capita l i s equal to the cap ita l i sa t ion rate o f pure equi ty

stream of i t s c lass o f r i sk. Thus, financial leverage has no impact on share market pr ices nor on the

cost o f capi tal . They make the fol lowing proposi t ions :

i ) The tota l market value of a firm and i t s cost of capi ta l are independent o f i ts capi ta l struc ture. The

tota l market va lue of the firm is given by capi tal i s ing the expected s tream of opera t ing earnings a t a

discount rate considered appropria te for i t s r i sk class.

i i ) The cost o f equ ity (Ke) i s equal to the cap ital isat ion ra te o f pure equi ty s tream plus a premium for

f inancia l r i sk. The f inancia l r i sk increases wi th more deb t content in the capi ta l structure . As a

result , Ke increases in a manner to o ffse t exact ly the use o f less expe nsive sources o f funds.

i i i ) The cut o ff rate fo r investment purposes i s complete ly independent o f the way in which the

investment is financed.

Assumptions :

i ) - The cap ita l markets are assumed to be per fect . This means tha t investors are free to buy and se l l

securi t ies.

- They are wel l -informed about the r isk -return on a l l type of secur i t ies.

- There are no transact ion costs.

- They behave rat iona lly.

- They can borro w wi thout restr ic t ions on the same terms as the f irms do.

i i ) The fir ms can be c lass i fied into 'homogenous r i sk c lass ' . They belong to this c lass, i f their

expected earnings have identical r i sk character i s t ics.


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i i i ) Al l investors have the same expectat ions from a f irms ' EBIT that is necessary to eva lua te the

va lue of a f i rm.

iv) The d ividend payment ra t io is 100 %. i .e . there are no re ta ined earnings.

v) There are no corpora te taxes , but , th is assumption has been removed.

Modigliani and Miller agree tha t whi le companies in di fferent industr ies face d i ffe rent r i sks

result ing in the ir earnings being capi ta l i sed a t di fferent ra tes, i t i s no t poss ible fo r these companies

to a ffec t their market values, and thus, the ir overal l capi ta l i sa t ion ra te by use o f leverage. That i s ,

for a co mpany in a par t icular r i sk c lass, the to tal market value must be same ir respec tive o f

proport ion of debt in company's cap ital structure. The support for this hypothesis l ies in the presence

of arb itrage in the capi tal market . They contend that arb itrage wil l subst i tute personal lever age for

corporate leverage.

For ins tance : There are 2 companies X and Y in the same r i sk c lass. Company X is financed by only

equity and no debt , whi le Company Y is financed by a combinat ion of debt and equity. The market

pr ice o f shares o f Co mpany Y wou ld be higher than that o f Company X, market par t icipants would

take advantage of di fference by se l l ing equity shares o f Company Y, borrowing money to equate the ir

personal leverage to the degree of corporate leverage in Company Y and use them for invest ing in

Company X. The sa le o f shares o f Company Y reduces i ts pr ice unti l the market value of the company

Y, financed by deb t and equity, equals that o f Company X, financed by only equi ty.

Crit ic ism :These proposi t ions have been cr i t ic ised by numerous autho ri t ies. Mostly cr i t ic i sm is as

regards, per fect market and arb itrage assumpt ion. MM hypothesis argue that through personnel

arbitrage investors would quickly el iminate any inequali t ies be tween the va lue of leveraged f irms and

that o f unleveraged f irms in t he same r isk c lass . The bas ic a rgument here, i s that individual

arbitrageurs, through the use o f personal leverage can al ter corporate leverage , which is no t a val id

argument in the pract ical world , as i t is extremely doubtful that personal investors would subst i tute

personal leverage for corporate leverage, as they do not have the same r isk charac ter i s t ics. The MM

approach assumes ava ilabil i ty o f f ree and upto date information, th is a lso is not normal ly va lid .

To conclude, one may say tha t controversy between the trad it iona li s ts and the supporters o f

MM approach cannot be resolved due to lack of empir ica l research. Trad it ional i st s a rgue tha t the cost

of capi tal o f a f irm can be lo wered and the market value of shares increased by use o f finan cia l

leverage. But, a fter a cer tain stage, as the company becomes highly geared i .e . deb t content

increases , i t beco mes too r isky for investors and lenders. Thus , beyond a point , the overal l cost o f

capi tal begins to r ise , th is po int ind ica tes the op timal capi ta l s truc ture. Modigl iani and Miller a rgues,

that in the absence of corporate income taxes, overal l cost o f capi tal begins to r i se .

Question : What kind of relat ionship exist s between taxation and capita l structure ?

Answer : The leverage ir rele vance theory of MM is va lid only in per fect market condi t ions, but , in

face o f imper fec tions charac ter i s ing the real world capi ta l markets, the capi ta l s tructure o f a firm

may affec t i t s valuat ion. Presence of taxes i s a major imper fec tion in the real wor l d. When taxes are

applicable to corpora te inco me, deb t f inancing i s advantageous. This i s because dividends and

reta ined earnings are no t deductib le for tax purposes, interest on deb t i s a deductib le expense for tax

purposes. As a resul t , the total avai lab le income for both stock -holders and deb t -holders i s greater

when deb t cap ita l i s used. I f the deb t employed by a leveraged f irm is permanent in na ture, the

present value of the tax shield associa ted wi th interest payment can be obtained by app lying the

formula for perpe tui ty.

Present va lue of tax shie ld (TD) = (T * k d * D) /k d

Where, T = Corpora te tax rate


kd = Interest rate on deb t

The present value of interest tax shields i s independent o f the cost o f deb t , i t bei ng a

deduct ible expense . I t i s simply the corpora te tax rate t imes the amount of permanent deb t .

Value of an unleveraged f irm :

Vu = [EBIT ( 1 - t ) ] /K 0

Value of leveraged f irm :


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V l = V u + Debt ( t)

Grea ter the leverage, greater wou ld be the value of the f irm, other things be ing equal . This

impl ies that the opt imal s trategy of a fi rm should be to maximise the degree of leverage in i t s capital

structure.

Quest ion : Enumerate the methods to ca lculate the cost of capital from various sources ?

Answer : The cost o f capital i s a s igni f icant factor in des igning the capi tal structure of an

under taking, as bas ic reason of running of a business undertaking i s to earn re turn at leas t equal to

the cost o f cap ital . Commercial undertaking ha s no re levance i f , i t does no t expect to earn i t s cost o f

capi tal . Thus cost o f capi tal consti tutes an impor tant factor in var ious business decisions. For

example, in analys ing f inancial implica t ions o f capi ta l structure proposa ls , cost o f capi ta l may be

taken as the discount ing rate . Obviously, i f a par t icular projec t gives an interna l ra te o f re turn higher

than i ts cos t o f capi ta l , i t should be an a t tract ive opportuni ty. Fol lowing are the cost o f capi tal

acquired from various sources :

1) Cost of debt :The explic i t cos t o f deb t i s the interes t ra te as per contrac t adjus ted for tax and the

cost o f ra ising debt .

- Cost of irredeemable debentures : Cost o f debentures no t redeemable during the l i fe t ime of the company,

Kd = ( I /NP) * (I - T)

Where, K d = Cost o f deb t a f ter tax

I = Annual interest rate

NP = Net proceeds o f debentures

T = Tax ra te

Ho wever , debt has an impl ici t cost a l so, that a r i ses due to the fact that i f the deb t content

r ises above the op timal leve l , investors wou ld star t consider ing the company to be too r i sky and ,

thus, the ir expectat ions from equi ty shares wi l l r ise . This r i se , in the cost o f equi ty shares i s ac tual ly

the impl ici t cos t o f deb t .

Cost of redeemable debentures : I f the debentures a r e redeemable a fter the exp iry o f a fixed per iod the cost o f debentures

would be :

Kd = I (1 - t ) + [(RV - NP)] /N

[ (RV + NP)/2]

Where, I = Annual interes t payment


RV = Redempt ion va lue of debentures

t = tax r ate

N = Life o f debentures

2) Cost of preference shares : In case o f preference shares, the d ividend rate can be taken as i t s cost , as i t i s this amount

that the company intends to pay aga ins t the p reference shares. As, in case o f deb t , the i ssue expenses

or discount /premium on issue /redempt ion i s also to be taken into account.

Cost of irredeemable preference shares : Cost o f ir redeemable preference shares = PD/PO

Where, PD = Annual p reference dividend

PO = Net proceeds o f an issue of p reference shares

Cost of redeemable preference shares : I f the preference shares are redeemable a fter the exp iry o f a

f ixed per iod, the cost o f preference shares would be.

Kp = PD + [(RV - NP)] /N

[ (RV + NP)/2]

Where, PD = Annual p refer ence dividend


RV = Redempt ion va lue of debentures

N = Life o f debentures


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However , s ince d ividend of preference shares i s no t al lowed as deduction fro m income

for income tax purposes, there is no quest ion o f tax advantage in the case of cost o f preference

shares. I t would , thus, be seen that both in case o f debt and preference shares, cost o f cap ital i s

calcula ted by reference to the ob ligat ions incurred and proceeds received. The ne t proceeds received

must be taken into account in working cost o f capital .

3) Cost of ordinary or equity shares : Calculat ion of the cost o f ordinary shares involves a complex procedure, because unl ike

debt and preference shares there i s no f ixed rate o f interes t o r dividend agains t ordinary shares.

Hence , to assign a cer tain cost to equi ty share cap ita l i s no t a quest ion of mere ca lculat ion, i t

requires an unders tand ing of many fac tors basical ly concerning the behaviour o f investors and their

expectat ions. As, ther e can be di fferent interpreta t ions o f investor 's behaviour , there are many

approaches regard ing ca lculat ion of cos t o f equi ty shares. The 4 main approaches are :

i ) D/P ratio (Div idend/Price) approach : This emphasises tha t dividend expected by an inves tor

from a par t icular share determines i ts cost . An investor who invests in the ord inary shares of a

par t icular company, does so in the expectat ion of a cer tain re turn. In o ther words, when an investor

buys ord inary shares o f a cer ta in r isk, he expects a c er ta in return, The expected ra te o f re turn is the

cost of ord inary share capital . Under this approach, thus, the cost of ordinary share cap ita l i s

calcula ted on the basis o f the present value of the expected future s tream of d ividends.

For example, the market pr ice o f the equity shares ( face value Rs. 10) o f a par t icular

company is Rs. 15. I f i t has been paying a d ividend of 20 % and i s expected to maintain the same, i ts

cos t of equity shares a t face va lue i s 0 .2 * 10 /15 = 13.3%, s ince i t i s the maximum ra te o f dividend ,

at which the investor wi l l buy share a t the present value . However , i t can a lso be argued that the cost

of equity capi tal is 20 % for the co mpany, as i t i s on this expecta t ion that the market pr ice o f shares

is mainta ined at R s. 15. Cost o f equity shares o f a company is tha t ra te of d ividend that mainta ins the

present market pr ice of shares. As the objective of financial management is to maximise the weal th o f

shareholders, i t i s rat iona l to assume tha t the company must maintai n the present market value of i t s

share by paying 20 % dividend, which then is i t s cost o f equity capital . Thus, the re la t ionship

between d ividends and market p r ice sho ws the expectat ion of the investors and thereby cost o f equity

capi tal .

This approach co -relates the basic factors o f re turn and investment from view point o f

investor . Ho wever , i t i s too s imple as i t p re -supposes that an investor looks forward only to dividends

as a re turn on his investment . The expected s tream of d ividends i s o f impor tance to an investor but ,

he looks forward to capita l apprecia t ion a lso in the va lue of shares. I t may lead us to ignore the

gro wth in capi ta l value of the share. Under , th is approach, a company which dec lares a higher amount

of dividend out o f a g iven quantum of earnings wi l l be p laced at a premium as compared to a

company which earns the same amount o f prof i t s but ut i l i ses a major par t o f the same in f inancing

i t s expansion programmes. Thus, D/P approach may not be adequate to deal wi th the prob lem of

determining the cost o f ordinary share cap ital .

i i ) E/P (Earnings/Price) rat io approach : The advocates o f this approach co -re lates the earnings o f

the company wi th the market pr ice o f i ts shares. As per i t , the cost o f ordinary share cap ita l woul d be

based on the expected rate o f earnings o f a company. The argument i s that each investor expects a

cer tain amount o f earnings, whether d is tr ibuted or not from the company in whose shares he invests ,

thus, an investor expects that the company in which h e is going to subscr ibe for share should have a t

least 20 % of earning, the cost of ord inary share capi tal can be construed on this bas is . Suppose, a

company is expected to earn 30 % the investor wi l l be prepared to pay Rs 150 (30/20 * 100) fo r each

of Rs. 100 share. This approach i s s imi lar to the dividend pr ice approach, only i t seeks to null i fy the

effec t o f changes in dividend pol icy. This approach a lso does not seem to be a co mple te answer to the

problem of de termining the cost o f ord inary share as i t ignores the fac tor o f cap ita l appreciat ion or

deprec iat ion in the market va lue of shares.

i i i ) D/P + growth approach : The dividend/pr ice + growth approach emphasises what an investor

actua lly expects to rece ive from his investment in a par t icular co mpany 's ord inary share in terms of

dividend p lus the ra te o f gro wth in d ividend/earnings. This gro wth rate in dividend (g) i s taken to be

good to the compound growth rate in earnings per share.

K e = [D 1 /P 0] + g

Where,

K e = Cost o f capi ta l

D1= Dividend for the p er iod 1

P 0 = Pr ice for the per iod 0

g = Gro wth rate


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D/P + g approach seems to answer the prob lem of expecta t ions o f investor sa t i s fac tor i ly,

ho wever , i t poses one problem tha t i s ho w to quant i fy expecta t ion of investor re la t ing to d ividend an d

gro wth in dividend.

iv) Realised y ie ld approach : I t i s suggested tha t many authors tha t the yie ld ac tua lly rea l i sed for a

per iod of t ime by investors in a par t icular company may be used as an indica tor o f cost o f cap ital . In

other words , th is approach t akes into considerat ion the bas ic fac tor o f the D/P + g approach but ,

ins tead of us ing the expected values o f the dividends and cap ital apprecia t ion, pas t yields are used to

denote the cost o f capi tal . This approach i s based upon the assumption that the pa s t behaviour would

be repeated in future and thus , they may be used to measure the cost o f ordinary capi ta l .

Which approach to use ? In case o f companies wi th stable income and s table dividend pol icies the

D/P approach may be a good way of measur ing the c ost o f ordinary share capi tal . In case o f

companies whose earnings accrue in cycles , i t would be bet ter i f the E/P approach i s used , but

representat ive f igures should be taken into account to inc lude complete cycle. In case o f growth

companies , where expec tat ions o f growth are more important , cost o f o rdinary share capi ta l may be

determined as the bas is of the D/P + g approach. In the case o f companies enjoying a steady growth

rate and a steady rate o f dividend, the rea l i sed value approach may be useful . Th e basic fac tor behind

determination of cost o f ordinary share cap ita l is to measure expecta t ion of investors from ordinary

shares o f that par t icular company. Thus, the whole question of de termining the cost o f ordinary

shares hinges upon the factors which go into the expectat ions o f a par t icular group of investors in the

company of a par t icular r isk class.

4) Cost of reserves : The profi ts retained by a company and used in the expansion of business a lso

enta i l cost . Many people tend to fee l tha t reserves h ave no cost . However , i t i s not easy to real i sed

that by depr iving the shareholders o f a par t o f the earnings, a cost is automatical ly incurred on

reserves. This may be termed as the opportunity cost o f retained earnings. Suppose , these earnings

are no t re ta ined and are passed on to shareholders, suppose fur ther tha t shareholders invest the same

in new ordinary shares . This expecta t ion of the investors f rom new ordinary shares should be the

opportuni ty cost of reserves. In other words, i f earnings were paid out as dividends and

simul taneously an offer fo r r ight shares was made shareholders would have subscr ibed to the r ight

share on the expecta t ion of a cer ta in return. This re turn may be taken as the indicator o f the cost of

reserves. People do no t calcula te the cost o f capita l o f re tained earnings as above . They take cost o f

reta ined earnings as the same as tha t o f equi ty shares. However , i f the cost o f equity shares i s

determined on the basis of rea l i sed va lue approach or D/P + g approach, the quest ion of w orking out

a separate cost o f reserves i s not re levant s ince cost of reserves i s automatica l ly included in the cost

of equi ty share cap ita l .

5) Cost of depreciat ion funds : Deprec iat ion funds, cannot be const rued as no t having any cost .

Logica lly speaking, they should be treated on the same foot ing as reserves when i t comes to the i r use ,

though whi le ca lculat ing the cost o f capi ta l these funds may not be considered.

Quest ion : Enumerate the procedure of calculat ing the weighted average cost of capital ?

Answer : The composite or overal l cos t o f cap ita l o f a f irm is the weighted average of the costs o f

var ious sources o f funds. Weights are taken to be proport ion of each source of funds in the capi tal

structure. While , making financial dec isions this overa l l or weighted cost i s used. Each investment i s

f inanced fro m a pool of funds which represents the var ious sources from which funds have been

raised. Any decision of investment thus, has to be made wi th re ference to the overa l l cos t of capita l

and no t wi th re ference to cost o f a speci f ic source of fund used in tha t investment decisions. The

weighted average cost o f capi ta l (WACC) is calcula ted by :

1) Calcula t ing cost o f speci f ic sources o f funds, e .g . cost o f deb t , e tc .

2) Mul t ip lying the cost of eac h source by i t s proport ion in capi tal s truc ture.

3) Adding the weighted component costs to get the f irm's WACC. Thus, WACC is ,

The weights to be used can be ei ther book va lue weights or market va lue weights . Book value weights

are easier to ca lculate an d can be appl ied consis tent ly. Market value weights are supposed to be

super ior to book value weights as component costs are opportunity costs and market va lues ref lect

economic va lues. However , these weights fluc tua te frequent ly and f luc tuations are wide in nature.

Quest ion : What do you mean by marginal cost of capital ?

Answer : The margina l cos t o f cap ita l may be def ined as the cost o f raising an addi t ional rupee of

capi tal . S ince the capi ta l i s raised in substantial amount in pract ice marginal c os t i s re ferred to as the


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cost incurred in rais ing new funds. Margina l cos t o f capi ta l i s der ived, when we calculate the average

cost o f cap ital using the marginal weights. The marginal weights represent the proport ion of funds

the fi rm intends to employ. Thus, the problem of choosing be tween the book value weights and the

market va lue weights does not ar i se in the case of marginal cost o f capi tal computa tion. To calculate

the margina l cost o f capital , the intended financing propor t ion should be app lied as weights to

margina l component cos ts. The marginal cos t of capital should, thus, be calculated in the composi te

sense. When a f irm raises funds in p roport ional manner and the component 's cos t remain unchanged,

there wil l be no di fference between average cos t o f capital o f to ta l funds and the marginal cost o f

capi tal . The component 's cost may remain unchanged, upto a cer tain leve l o f funds ra ised and then

star t increasing wi th amount o f funds raised, e .g. The cost o f debt remains 7 % af ter tax t i l l Rs. 10

lakhs and be tween Rs. 10 - 15 lakhs, the cost may be 8 % and so on. Simi lar ly, i f the firm has to use

the external equi ty when the retained profi t s a re not suff ic ient , the cost o f equity wi l l be higher

because of f lotat ion costs. When the components cos t s tar ts r is ing, the average cost of cap ital would

r ise and marginal cos t o f capi ta l would ho wever , r i se a t a faster ra te .

Question : What is the effect of a f inancing decision on EPS ?

Answer : One of the pr ime object ive o f a finance manager i s to maximise both the re turn on ord inary

shares and the total wealth o f the company. This objec tive has to be kep t in view whi le , taking a

decision on a new source of f inance. Thus, the effec t o f each proposed method of new f inance on the

EPS is to be ca reful ly ana lysed. EPS denotes what has been earned by the co mpany dur ing a

par t icular account ing per iod, on each of i t s ordinary shares. This can be worked out by d ivid ing net

prof i t a fter in teres t , taxes and preference dividends by the number o f equi ty sh ares . I f a company has

a number o f a l ternat ives for new f inancing, i t can compute the impact of the var ious al ternat ives on

earnings per share. I t i s obvious tha t , EPS would be the highest in case o f f inancing tha t has the least

cos t to the company.

1) Expl ic it cost of new capital : I t i s a method that can compare the a l ternat ives avai lab le for raising

capi tal can be through the calcula t ion of the explic i t cos t of new cap ita l . Expl ici t cost o f new capital

is the rate o f return at which the new funds must be employed so tha t the exist ing EPS is not

affec ted. In other words, the ra te o f return of new funds must earn to mainta in EPS at the exis t ing

leve ls . I t i s obvious tha t , i f EPS were Rs. 2 ear l ier , the ra te o f return required to be earned by the

source of new cap ital to mainta in i t a t the o ld level i s to be found. Long term deb t would again be

preferred as even i f a lower rate o f re turn i s earned on the funds so raised, the old EPS wil l be

maintained.

2) Range of earnings chart /Indifference point : Another method of consider ing the impact o f

var ious f inancing a l ternatives on EPS is to prepare the EBIT chart or the range of earnings char t . I t

shows the l ikely EPS a t var ious probable EBIT levels. Thus, under one par t icular al terna tive, EPS

may be Rs. 1 at a given EBIT leve l . Ho wever , the EPS may reduce i f another al ternat ive o f financing

is chosen even though the EBIT under the al terna tive may be drawn. Wherever this l ine intersects, i t

is kno wn as break - even po int . This point i s a useful guide in formula t ing the capi ta l struc ture . This

is kno wn as EPS equivalency po int or indi ffe rence point as, i t shows tha t , be tween the 2 given

al terna tives o f financing i .e . regard less o f leverage in financial p lans, EPS would be the same at the

given EBIT leve l . The equi valency or ind i fference point can a lso be calcula ted a lgebra ical ly as below

:

[X - B] /S 1 = X/S 2

Where,

X = Ind i fference point (EBIT)

S1 = Number o f equity shares outstanding

S2 = Number o f equity shares outstanding when only equi ty capi ta l i s used.

B = Interest on debt cap ita l in rupees.

3) EPS Volati l i ty : EPS Volat i l i ty re fers to the magni tude or extent of fluctua tions in EPS of a

company in var ious years as compared to the mean or average EPS. In o ther words, EPS vo lat i l i ty

shows whether a compa ny enjoys a s table income or not . I t i s obvious that higher the EPS Volati l i ty,

greater would be the r i sk a t tached to the company. A major cause of EPS Vola ti l i ty would be the

f luctuat ions in the sa les volume and the opera t ing leverage. I t i s obvious tha t the net profi t s o f a

company would great ly fluc tua te wi th smal l f luc tua tions in the sales f igures specia l ly i f the fixed

cost content i s very high. Thus, EPS wi l l f luc tuate in such a s i tuat ion. This e ffec t may be heightened

by the f inancia l leverage.


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Important Questions

Que:- From the following information, Calculate the financial leverage:

(a) Existing Capital Structure: Equity Shares Rs. 60,000, 12% Debentures Rs. 40,000

(b) Rate of Return on Risk Free Investment = 10%

(c) Rate of Return on Market Portfolio = 30%

(d) Beta Coefficient = 0.5

(e) Tax Rate = 40%

Que:- Mr. Agent is planning to purchase the shares of X Ltd. Which had paid a dividend of Rs. 2 per share at last year. Dividends are

growing at a rate of 10%. What price would Mr. Agent be willing to pay for X Ltd.‟s shares if he expects a rate of return of 20%?

Que:- Tulsian Ltd. Is foresseing a growth rate of 10% p.a. for next two years. The growth rate is likely to increase to 12% for the next two

years. After that the growth rate is expected to continue atr 8% p.a. The company paid a dividend of Rs. 5 per share last year. Investor‟s

required rater of return is 10%.

Required: At what price would you as investor be ready to buy the shares of this company now (t = 0)?

Que:- The following is the capital structure of a Company:

Source of Capital Book Value

Rs.

Market Value

Rs.

Equity Shares @ Rs. 100 each

9 percent Cumulative Preference Shares @ Rs. 100 each

11 percent Debentures

Retained Earnings

80,00,000

20,00,000

60,00,000

40,00,000

1,60,00,000

24,00,000

66,00,000

--

2,00,00,000 2,50,00,000

The current market price of the company‟s equity share is Rs. 200. For the last year the company had paid equity dividend at 25

per cent and its dividend is likely to grow 5 per cent every year. The corporate tax rate is 30 per cent and shareholders‟ personal income tax

rate is 20 per cent.

You are required to calculate:

(i) Cost of capital for each source of capital.

(ii) Weighted average cost of capital on the basis of book value weights.

Weighted average cost of capital on the basis of market value weights

Que:- The capital structure of the Y Ltd. consists of 40% equity. The after tax cost of the Equity, Preference Shares and Debt are 20%, 15%

and 7.20% respectively. Calculate the proportion of the Preference Shares and Debt in the capital structure of the company if weighted

average cost of capital is 15.44%


Que. 1- D Ltd. is issuing debentures carrying 12% coupon on nominal value Rs. 100. The issue price is Rs. 105. The cost of issue is Re. 1

per debenture. The debentures are redeemable at Rs. 125 after 10 years. Tax rate is 40%. Debenture cost of debt.

Que. 2- (a) A company issues Rs. 10,00,000 16% debentures of Rs. 100 each. The company is in 35% tax bracket. You are required to

calculate the cost of debt after tax. If debentures are issued at (i) Par, (ii) 10% discount and (iii) 10% premium

(b) If brokerage is paid at 2% what will be cost of debentures if issue is at par.

Que. 3- Vishnu steels Ltd. has issued 30,000 irredeemable 14% debentures of Rs. 150 each. The cost of floatation of debentures is 5% of the

total issued amount. The company‟s taxation rate is 40%. Calculate the cost of debt.

Que. 4- C Ltd. debentures carry 2% coupon on nominal value Rs. 100. The current price of the debentures is Rs. 108. The debentures are

redeemable at Rs. 132 after 8 years. Tax rate is 40%. Determine cost of debt.

Que. 5- Surya Industries Ltd. has raised funds through issue of 10,000 debentures of Rs. 150 each at a discount of Rs. 10 per debenture with

10 years maturity. The coupon rate is 16%. The flotation cost is Rs. 5 per debenture. The debentures are redeemable with a 10%

premium. The corporate taxation rate if 40%. Calculate the cost of debenture.

Que. 6- V Ltd. issues preference shares of face value Rs. 100 each carrying 14% dividend and realizes Rs. 92 per share. The shares are

repayable after 20 years at par.

Neumericals : Cost of Capital


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Que. 7- Searock Ltd. has issued 14% convertible debentures of Rs. 100 each at par. Each debenture will be convertible into 8 equity shares

of Rs. 10 each at a premium of Rs. 5 per share,. The conversion will take place at the end of 4 years the corporate tax rate is assumed

to be 40%. Assume that tax savings occur in the same year that the interest payments ar5ise. The flotation cost is 5% of the issue

amount. Calculate the cost of convertible debentures.

Que. 8- The current price of an equity share of Rs. 10 is Rs. 20. The next expected dividend per share is 20%. The dividends are expected to

grow at a rate of 5%. Calculate the cost of equity based on dividend growth model.

Que. 9- M Ltd. has issued 14% debentures and the inflation rate was 5%. The real cost of the loan can be calculated by using the following

formula.

Que. 10- A company‟s share is quoted in market at Rs 40 currently. A company pays a dividend of Rs. 2 per share and investors expect a

growth rate of 10% per year, compute:

(a) The company‟s cost of equity capital.

(b) If anticipated growth rate is 11% p.a. calculate the indicated market price per share

(c) If the company‟s cost of capital is 16% and anticipated growth rate is 10% p.a. . Calculate the market price if dividend of Rs. 2

per share is to be maintained.

Que. 11- Calculate the cost of capital in the following cases:

(i) X Ltd. issues 12% debentures of face value Rs. 100 each and realizes Rs. 95 per debenture. The debentures are redeemable after 10

years at premium of 10%.

(ii) Y Ltd. issues preferences shares of face value Rs. 100 each carrying 14% dividend and he realizes Rs. 92 per share. The shares

are repayable after 12 years at par.

Note: Both companies are paying Income tax at 50%.

Que. 12- X Ltd. has disbursed a dividend of Rs. 30 on each Equity share of Rs. 10. The current market price of share is Rs. 80. Calculate the

cost of equity as per dividend yield method.

Que. 13- A Ltd. plans to use long-term sources of funds in following proportions.

Equity Funds 40%

Preference Capital 10%

Debt Funds 50%

Based on Discussion with its merchant bankers and lenders, the company estimates the cost of its sources of finance for various

levels of uses as follows:

Sources Range of New finance

Rs. lacs Cost

Equity Funds Less than 20 20%

20 or more 22%

Preference Capital Less than 4 10%

4 or moiré 12%

Debt Funds Less than 30 15%

30 or more 16%

Prepare a schedule of marginal cost of capital.

Que. 14- Market price per share (MPS) and Earning per share (EPS) of 5 companies in same industry are given below. The cost of equity for

the industry can be taken as 20%. Identify the company having maximum potential for growth.

Company MPS EPS

Rs. Rs.

A Ltd. 75.00 12.00

B Ltd. 63.00 9.45

C Ltd. 65.00 7.80

D Ltd. 70.00 11.90

E Ltd. 80.00 10.40

Que. 15- Dividends and year –end prices of A Ltd. shares for 5 years are given below. You are required to compute cost of equity by

Realised Yield Approach.

Dividend Price

Year Per Share Per share

2000-01 2.50 40.00

2001-02 3.20 42.00

2002-03 3.63 44.25

2003-04 5.33 46.00

2004-05 6.00 46.90

Que. 16- Sun Ltd. has its shares of Rs. 10 each quoted on the stock exchange, the current price per share is Rs. 24. The gross dividends per

share over the last four years have been Rs. 1.20, Rs. 1.32, Rs. 1.45 and Rs. 1.60. Calculate the cost of equity shares.

Que. 17- Capital of company consists of Rs. 10 lakh in equity funds and Rs. 15 lakh in 10% debt. The rate of return required by holders of

equity is 20%. Compute weighted average cost of capital (WACC) using proportion of debt and equity funds.


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Que. 18- Long-term capital of a company consists of the following. Rs. 000

Equity share capital (Rs. 10) 300

General Reserve 100

12% Debentures (Rs. 100) 100

Equity holders expect 20% return on their investments. The market price of ordinary shares and debentures are Rs. 16 and Rs. 120

respectively. Tax rate is 40%. Compute weighted average cost of capital.

Que. 19- Mr. A is contempolating purchase of 1,000 equity shares of a company. His expectation of return is 10% before tax by way of

dividend with an annual growth of 5%. The company‟s last dividend was Rs. 2 per share. Even as he is contemplating, Mr. A

suddenly finds, due to a budge3t announcement dividends have been exempted from tax in the hands of the recipients. However, the

imposition of dividend distribution tax on the company is likely to lead to a fall in dividend of Re. 0.20 per share. A‟s marginal tax

rate is 30%. Calculate what should be Mr. A‟s estimates of the price per share before and after the budget announcement?

Que. 20: - Modern Ltd.‟s share beta factor is 1.40. The risk free rate of interest on government securities is 9%. The expected rate of return

on company equity is 16%. Calculate cost of equity capital based on capital asset pricing model.

Que. 21: - Modern Ltd.‟s share beta factor is 1.40. the risk free rate of interest on government securities is 9%. The expected rate of return

on company equity shares is 16%. Calculate cost of equity capital based on capital asset pricing model.

Que. 23: - Calculate the return on investment from the following date/information:

Risk – free return 10%

Market Return 12.5%

Beta 1.5

Que. 24: - The Beta coefficient of Computech Ltd. is 1.2. The company has been maintaining 5% rate of growth in dividends and earnings.

Current year expected dividend is Rs. 2.40 per share. Return on Government securities is 10%. Return on market portfolio is 14%.

The current market price of one share of Computech Ltd. is Rs. 28. The earnings per share is Rs. 3.90. Calculate the cost of equity

capital basing on:

(i) Dividend yield method (ii) Dividend growth model

(iii) Capital asset pricing model.

Que. 25: - You are analyzing the beta for ABC Computers Ltd. and have divided the Company into four broad business groups, with market

values and betas for each group.

Business group Market value of equity Unleveraged beta

Main frames Rs. 100 billion 1.10

Personal Computers Rs. 100 billion 1.50

Software Rs. 50 billion 2.00

Printers Rs. 150 billion 1.00

ABC Computers Ltd. had Rs. 50 billion in debt outstanding. Required:

(i) Estimate the beta for ABC Computers Ltd. as a Company.

(ii) If the treasury bond rate is 7.5%, estimate the cost of equity for ABC Computers Ltd. Estimate the cost of equity for each

division. Which cost of equity would you use to value the printer division? The average market risk premium is 8.5%.

Que. 26: - As an investment manager you are given the following information:

Investment in Equity Initial price Dividends Year –ended market Beta risk

Shares of price factor

A Cement Ltd. Rs. 25 Rs. 2 Rs. 50 0.80

Steel Ltd. 35 2 60 0.70

Liquor Ltd. 45 2 135 0.50

B Government of India Bonds 1,000 140 1,005 0.99

Risk – free return, 14 percent

You arte required to calculate (i) expected rate of return of market portfolio, and (ii) expected return in each security, using capital

asset pricing model.

Que. 27: - A company wishes to raise Rs. 100 lakh by either 14% institutional term loan or issue of 13% non – convertible debentures. The

term loan option would not involve any incidental cost but the debentures have to be issued at 2.5% discount and the flotation cost

is estimated at Rs. 1,00,000. Advise the company. Assume tax rate 50%.

Que. 28: - The following is the capital structure of a company as on 31 Dec. 1998. Rs. Lakh

Equity Share Capital (Rs. 100) 10

10% Preference Capital (Rs. 100) 4

12% Debentures 6

20

The market price of the company‟s share is Rs. 110 and it is expected that a dividend of Rs. 10 per share would be declared for the

year 1999. The dividend growth rate is 6%:

(a) If the company is in the 50% tax bracket, compute the weighted average cost of capital.


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(b) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of Rs. 10 lakh bearing 14% rate

of interest, what will be the company‟s revised weighted average cost of capital? This financial decision is expected to

Increase dividend from Rs. 10 to Rs. 12 per share. However, the market price of equity share is expected to decline from Rs.

110 to Rs. 105 per share.

Que. 29: - Amaranth Cements Ltd. has the following capital structure: (Rs. Lakh)

Particulars Market Value Book Value Cost %

Equity Share Capital 80 120 18

Preference Share Capital 30 20 15

Fully secured Debentures 40 40 14

Calculate the Company‟s weighted average cost of capital. Cost of individual sources of capital is net of tax.

Que. 30: - The capital structure of Bombay Ltd. as on 31 -3 -2001 is as: (Rs. Crores)

Equity Capital: 100 lakhs equity shares of Rs. 10 each 10

Reserves 2

14% Debenture of Rs., 100 each 3

For the year ended 31 -3 -2002 the company is likely to paid equity dividend at 20%. As the company is a market leader with good

future, dividend is likely to grow by 5% every year. The equity shares are now treated at Rs. 80 per share in the stock exchange.

Income – tax rate applicable to the company is 50%. Required:

(a) The current weighted cost of capital.

(b) The company has plans to raise a further Rs. 5 crores by way of long term loan at 16% interest. When this takes place the

market value of the equity shares is expected to fall to Rs. 50 per share. What will be the new weighted average cost of capital

of the company?

Que. 31: - M/s. Albert & Co. has the following capital structure as on 31 – 3- 2001:

10% Debentures 3,00,000

9% Preference Shares 2,00,000

Equity – 5,000 shares of Rs. 100 each. 5,00,000

Total 10,00,000

The equity shares of the company are quoted at Rs. 102 and the company is expected to declare a dividend of Rs. 9 per share for

2001. Growth rate is 5%.

(i) Assuming the tax rate applicable to the company at 50%. Calculate the weighted average cost of capital. State your assumptions, if

any.

(ii) Assuming in the exercise, that the company can raise additional term loan at 12% for Rs. 5,00,000 to finance an expansion,

calculate the revised weighted cost of capital. The company‟s assessment is that it will be in a position to increase the dividend

from Rs. 9 per share to Rs. 10 per share, but the business risk associated with new financing way bring down the market price from

Rs. 102 to Rs. 96 per share.

Que. 32: - You are required to determine the weighted average cost of capital (ko) of the K.C. Ltd. using: (i) book value weights; and (ii)

market value weights. The following information is available for your perusal.

The K.C. Ltd.‟s present book value capital structure is: Rs.

Debentures (Rs. 100 per debenture) 8,00,000

Preference shares (Rs. 100 per share) 2,00,000

Equity shares ( Rs. 10 per share) 10,00,000

20,00,000

All these securities are traded in the capital markets. Recent prices are debentures @ Rs. 110, preference shares @ Rs. 120 and

equity shares @ Rs. 22. Anticipated external financing opportunities are: -

(i) Rs. 100 per debentures redeemable at par 20 year maturity, 8% coupon rate, 4% flotation costs, sale price Rs. 100.

(ii) Rs. 100 per Preference share redeemable at par; 15 – year maturity. 10% dividend rate, 5% flotation costs, sale price Rs. 100.

(iii) Equity shares: Rs. 2 per share flotation costs, sale price Rs. 22.

(iv) In addition, the dividend expected on the equity share at the end of the year Rs. 2 per share; the anticipated growth rate in

dividends is 5% and the company has the practice of paying all its earning in the form of dividends. The corporate tax rate is 50%.

Que. 33: - The capital structure of Swan & Co. comprising of 12% debentures, 9% preference shares and equity shares of Rs. 100 each is in

the proportion of 3: 2: 5.

The company is contemplating to introduce further capital to meet the expansion needs by seeking 14% term loan from financial

institutions. As a result of this proposal, the proportions of debentures, preference shares and equity would get reduced by 1/10,

1/15, and 1/6 respectively.

In the light of above proposal, calculate the impact on weighted average cost of capital assuming 50% tax rate, expected dividend

of Rs. 9 per share at the end of the year current market price of equity shares of Rs. 110 and growth rate of dividends 5%. No

change in dividend, dividend growth rate and market price of share is expected after availing the proposed term loan.

Que. 34: - P Ltd. presently pays a dividend of Re. 1.00 per share and has a share price of Rs. 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?

Que. 35: -(a) Three companies A, B & C are in the same type of business and hence have similar operating risks. However, the capital

structure of each of them is different and the following are the details:

A B C


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Equity Share Capital Rs. 4,00,000 2,50,000 5,00,000

(Face value Rs. 10 per share)

Market value per share Rs. 15 20 12

Dividend per share Rs. 2.70 4 2.88

Debentures Rs Nil 1,00,000 2,50,000

(Face value per debenture Rs. 100)

Market value per debenture . ----- 125 80

Interest rate ----- 10% 8%

Assume that the current levels of dividends are generally expected to continue indefinitely and the income – tax rate at

50%. You are required to compute the weighted average cost of capital of each company.

(b) ZED Limited is presently financed entirely by equity shares. The current market value is Rs. 6,00,000. A dividend

Rs. 1,20,000 has just been paid. This level of dividends is expected to be paid indefinitely. The company is thinking of investing in

a new project involving a outlay of Rs. 5,00,000 now and is expected to generate net cash receipts of Rs. 1,05,000 per annum

indefinitely. The project would be financed by issuing Rs. 5,00,000 debentures at the market interest rate of 18%. Ignoring tax

consideration:

a. Calculate the value of equity shares and the gain made by the shareholders if the cost of equity rises to 21.6%.

b. Prove that weighted average cost of capital is not affected by gearing.

Que. 36: - John inherited the following securities on his uncle‟s death:

Nos. Annual Maturity

Types of Security Coupon % Years % Yield

Bond A (Rs. 1,000) 10 9 3 12

Bond B (Rs. 1,000) 10 10 5 12

Preference shares C (Rs. 100) 100 11 --- 13

Preference shares D (Rs. 100) 100 12 --- 13

The yield to preference shares is higher than coupon rate because they are likely to be recalled at a premium. Compute the current

value of John‟s portfolio of investments.


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Important Questions

Que 1 :- X Ltd. Provides you the following information:

1. Funds required : Rs. 10,00,000

2. Financial Plans :

Financial Plan I : 50% Equity Shares of Rs. 10 each, Current Market Price Rs. 20, 50%,

10% Debentures of Rs. 100 each.

Financial Plan II : 40% Equity Shares of Rs. 10 each, Premium in Market 100%, 40%,

10% Debentures of Rs. 100 each, 20%, 15% Preference Shares of Rs. 100 each.

3. Tax Rate : 40%

4. Annual Transfer to : 20% of the Face Value of Debentures.

Debenture Redemption Reserve

Required: Calculate the Indifference Point under uncommitted EPS Approach.

Que 2:- Prepare the Income Statement and Balance-Sheet from the following data:

Price Earning ratio

Market Price per equity share

No. of Equity shares of Rs. 10 each

No. of 12% Pref. Shares of Rs. 100 each

Degree of Financial Leverage

Degree of Operating Leverage

Income-Tax rate

Variable Cost as % of Sales Revenue

Rate of Interest on debt

3 times

Rs. 18

10,000

1,000

2-1

2-1

40%

60%

10%

Practical Questions:- Que. 1: - A firm requires total capital funds of Rs. 25 lacs and has two options; All equity; and half equity and half 15% debt. The equity

shares can be currently issued at Rs. 100 per share. The expected EBIT of the company is Rs. 2,50,000 with tax rate at 40%. Find

out the EPS under both the financial mix.

Que. 2: - The balance sheet of Delta Corporation shows a capital structure as follows:

Rs.

Current liabilities 0

Bonds (6% interest) 1,00,000

Common stock 9,00,000

Total Claims Rs. 1,000,000

Its rate of return before interest and taxes on its assets of Rs. 1 million is 20%. The value of each share (whether market or book

value) is Rs. 30. The firm is in the 50% tax bracket. Calculate its earnings per share.

Que. 3: - Paramount Produces Ltd. wants to raise Rs. 100 lakhs for a diversification project. Current estimate of earnings before interest and

taxes (EBIT) from the new projects is Rs. 22 lakhs per annum. Cost of debt will be 15% for amounts up to and including Rs. 40

lakhs, 16% for additional amounts up to and including Rs. 50 lakhs and 18% for additional amounts above Rs. 50 lakhs. The

equity (face value Rs. 10) of the company have a current market value of Rs. 40. This is expected to fall to Rs. 32 if debts

exceeding Rs. 50 lakhs are raised.

The following options are under consideration of the company.

Option Equity Debt

I 50% 50%

II 60% 40%

III 40% 60%

Determine the earning per share (E.P.S.) for each option and state which option the company should exercise. Tax rate applicable

to the company is 50%.

Que. 4: - A Ltd. has agreed to buy the net assets of B Ltd. for Rs. 18,00,000. In order to finance the purchase the directing of A Ltd. are

considering the following proposals:

(i) To issue Rs. 18,00,000 5% 20 years sinking fund debentures.

(ii) To issue Rs. 18,00,000 5 ½% cumulative preference shares.

(iii) To issue 60,000 equity shares at a premium of Rs. 10

Chapter : EBIT-EBT Analysis


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Summarised balance sheets as on 31st December, 1990 and profits and loss accounts for the year ended for each company are as

follows:

Balance sheet as on 31st December, 1990

Liabilities A Ltd. B Ltd.

(Rs.) (Rs.)

Equity shares issued:

25,000 shares fully paid 5,00,000 -----

50,000 shares fully paid ------- 2,00,000

Profit and loss account

Balance and general reserve 19,00,000 2,00,000

5% debentures 10,00,000 ----

Current liabilities 16,00,000 4,00,000

50,00,000 8,00,000

Assets A Ltd. B Ltd.

(Rs.) (Rs.)

Fixed assets 20,00,000 4,00,000

Current assets 30,00,000 4,00,000

50,00,000 8,00,000

Profit and loss accounts for the year ended 31st December, 1990

A Ltd. B Ltd.

(Rs.) (Rs.)

Sales 28,00,000 60,00,000

Profit before the items given below 15,10,000 2,80,000

Depreciation 2,60,000 50,000

Interest to debentures 50,000 --

Income –tax 6,00,000 1,15,000

9,16,000 1,65,000

Net Profit 6,00,000 1,15,000

Dividends 1,25,000 50,000

Balance transferred to P & L appropriation a/c 4,75,000 65,000


(a) calculate the consolidated net profit per equity share outstanding which would result under each of the above three proposals

assuming the profits before debenture interest and income tax of the combined operation will remain constant;

(b) calculate the additional net annual cash outlay during the next year under each of the above three proposals assuming the rate

of dividend on equity shares will be same as in 1990; and

(c) discuss the advantages and disadvantages of each of the above three proposals.

Que. 5: - A Company‟s capital structure consists of the following: Rs. (in lakhs)

Equity Shares of Rs. 100 each 20

Retained earnings 10

9% Preference shares 12

7% Debentures shares 8

Total 50

The company‟s earnings before interest and tax (EBIT) is at the rate of 12% on its capital employed which is likely to remain

unchanged after expansion. The expansion involves additional finances of Rs. 25 lakhs for which following alternatives are

available to it:

(i) Issue of 20,000 equity shares at a premium of Rs. 25 per share.

(ii) Issue of 10% preference shares.

(iii) Issue of 8% debentures.

It is estimated that P/E ratio in the case of equity shares. Preference shares and debentures financing would be 21.4, 17 and 15.7

respectively. Which of these alternatives of financing would you recommend and why? The income tax rate is 50%.

Que. 6: - A company needs Rs. 12,00,000 for the installation of a new factory which would yield an annual EBIT of Rs. 2,00,000. The

company has the objective of maximizing the earnings per share. It is considering the possibility of issuing equity shares plus

raising a debt of Rs. 2,00,000, Rs. 6,00,000 or Rs. 10,00,000. The current market price per share is Rs. 40 which is expected to

drop to Rs. 25 per share if the market borrowings were to exceed Rs. 7,50,000. Cost of borrowings are indicated as under:

Upto Rs. 2,50,000 ------ 10% p.a.

Between Rs. 2,50,001 and Rs. 6,25,000 ------- 14% p.a.

Between Rs. 6,25,001 and Rs. 10,00,000 ------- 16% p.a.

Assuming the tax rate to be 50%, Work out the EPS.

Que. 7: - A company earns a profit of Rs. 3,00,000 p.a. after meeting its interest liability of Rs. 1,20,000 on 12% debentures. The tax rate is

50%. The number of Equity shares of Rs. 10 each are 80,000 and the retained earnings amount to Rs. 12,00,000. The company

proposes to take up an expansion scheme for which a sum of Rs. 4,00,000 is required. It is anticipated that after expansion, the


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company will be able to achieve the same return on investment as at present. The funds required for expansion can be raised either

through debt at the rate of 12% or by issuing Equity shares at par.

Required:

(i) Compute the Earning per share (EPS), if:

- the additional funds were raised as debt

- the additional funds were raised by issue of equity shares

(ii) Advise the company as to which source of finance is preferable.

Que. 8: - The following figures of Krish Ltd. are presented to you: (Rs.)

Earnings before interest and tax

Less: Debentures interest @ 8% 80,000

Long term loan interest @ 11% 2,20,000

Less: Income Tax

Earnings after tax

23,00,000

3,00,000

20,00,000

10,00,000

10,00,000

No. of equity shares of Rs. 10 each 5,00,000

E.P.S. Rs. 2

Market price of share Rs. 20

P/E Ratio 10

The company has undistributed reserves and surplus of Rs. 20 lakhs. It is in need of Rs. 30 lakhs to payoff debentures

and modernize its plants. It seeks your advice on the following alternative modes of raising finance.

Alternative 1 –Raising entire amount as term loan from banks @ 12%

Alternative 2 –Raising part of the funds by issue of 1,00,000 shares of Rs. 20 each and the rest by term loan at 12%.

The company expects to improve its rate of return by 2% as a result of modernization, but P/E ratio is likely to go, down

to 8 if the entire amount is raised as term loan.

(i) Advice the company on the financial plan to be selected.

(ii) If it is assumed that there will be no change in the P/E ratio if either of the two alternatives are adopted, would

your advice still hold good?

Que. 9: - Bhaskar Manufactures Ltd. has equity share capital of Rs. 5,00,000 (face value Rs. 100). To meet the expenditure of an expansion

programme, the company wishes to raise Rs. 3,00,000 and is having following four alternative sources to raise the funds:

Plan A: To have full money from the equity shares.

Plan B: To have Rs. 1 lakh from equity and Rs. 2 lakhs from borrowing from the financial institutions @ 10% per annum.

Plan C: Full money from borrowing @ 10% per annum

Plan D: Rs. 1 lakh in equity and Rs. 2 lakhs from preference shares @ 8% per annum dividend.

The company is having present earnings of Rs. 1,50,000. The corporate tax is 50%. Suggest a suitable plan of the above

four plans to raise the required funds.

Que. 10: -American Express Ltd. is setting up a project with a capital outlay of Rs. 60,00,000. It has the following two alternatives in

financing the project cost.

Alternatives : 100% Equity finance

Alternative : Debt –Equity ratio 2: 1

The rate of interest payable on the debt is 18% p.a. the corporate rate of tax is 40%. Calculate the indifference point between two

alternative methods of financing.

Que. 11: -PCB Corporation has plans for expansion which calls for 50% increase in assets. The alternatives before the corporation are issued

of equity shares or debt at 14%. Its balance sheet and profit and loss accounts are as given below:

Balance sheet as at 31st December, 1989

Liabilities Rs. in lakhs Assets Rs. in lakhs

12% debentures 25 Total assets 200

Ordinary shares

10 lakh shares of

Rs. 10 each 100

General reserve 75 -----

200 200

Profit and Loss Account for the year ending 31st March, 2001 (Rs. in lakhs)

Sales 750

Total cost excluding interest 675

EBIT 75

Interest on Debentures 3

EBT 72

Taxes 36

EAT 36

Earnings per share = Rs. 36,00,000 = Rs. 3.60


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10,00,000

PIE ratio = 5 times

Market price = Rs. 18 If the Corporation finances the expansion with debt, the incremental financing charges will be at 14% and P/E ratio is expected to

be at 4 times. If the expansion is through equity, the P/E ratio will remain at 5 times. The company expects that its new issues will

be subscribed to at a premium of 25%. The company expects that its new will be subscribed to at a premium of 25%. With the

above information determine the following:

(i) IF EBIT is 10% of sales, calculate EPS at sales levels of Rs. 4 crores, Rs. 8 crores and Rs. 10 crores.

(ii) After expansion determine at what level of EBIT, EPS would remain the same, whether new funds are raised

by equity or debt.

(iii) Using P/E ratios, calculate the market value per share at each sales level for both debt and equity financing.

Que. 12: - ABC Corporation plans to expand assets by 50%; to finance the expansion, it is choosing between a straight 12% debt issue and

equity shares. Its balance sheet and profit and loss account are shown below:

ABC CORPORATION

Balance Sheet as on 31st December, 1996


11% Debentures 40,00,000 Total assets 2,00,00,000

Equity share capital

(10,00,000 shares of Rs.

10 each) 1,00,00,000

Retained earnings 60,00,000

2,00,00,000 2,00,00,000

ABC CORPORATION

Profit & Loss Account for the year ended 31st December, 1996

Rs.

Sales 6,00,00,000

Total costs (excluding interest) 5,40,00,000

Net income before interest and taxes (EBIT) 60,00,000

Interest on debentures @ 11% 4,40,000

Income before taxes 55,60,000

Taxes @ 50% 27,80,000

Profit after tax 27,80,000

Earnings per share Rs. 27,80,000/10,00,000 2.78

Price/earnings ratio 7.5 times

Market price (7.5 x Rs. 2.78) Rs. 20.85

If ABC Corporation finance Rs. 1 crore expansion with debt, the rate of the incremental debt will be 12% and the price/earnings

ratio of the equity shares will be 5 times. If the expansion is financed by equity, the new shares can be sold at Rs. 12 per share and

the price/earnings ratio will remain at 7.5 times.

(d) Assuming that net income before interest and taxes (EBIT) is 10% of sales, calculate earnings per share at sales level of Rs. 4

crores and Rs. 10 crores when financing is with (i) equity shares and (ii) debt.

(e) At what level of earnings before interest and taxes (EBIT), after the new capital is acquired, would earnings per share (EPS)

be the same when new funds are raised by issuing equity shares of raising debt?

(f) Using the P/E ratio, calculate the market value per share for each sales level for the debt and the equity financing.

Que. 13: - ABC Co. has a total capital of Rs. 2,50,000, and it normally earns Rs. 50,000 (before interest and taxes). The financial manager of

the firm wants to take a decision regarding the capital structure. After a study of the capital market, he gathers the following data:

Amount of Debt Interest Rate Equity Capitalization Rate

Rs. % (at given level of debt) %

0 --- 10.00

50,000 8.0 10.50

1,00,000 8.0 11.00

1,50,000 9.0 11.60

2,00,000 9.5 12.30

You are required (i) to determine the weighted average cost of capital and optimum capital structure by traditional approach, (ii)

Determine equity capitalization rate if Modigliani Miller approach is followed.


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Financial Management

Capital Structure


Que. 1- The following is the B/S as at 31st March, 1998 of S. Co. Ltd. : Share Capital: Rs. Rs.

10,000 equity shares of Rs. 100 each fully paid up 10,00,000

25,000 11% Cum. Preference shares of Rs. 10 each

Fully paid up 2,50,000 12,50,000

Reserve & surplus 25,00,000

Secured Loans 20,00,000

Unsecured loans 12,00,000

Trade creditors 18,00,000

Outstanding expenses 7,50,000

95,00,000

Represented by Fixed assets 55,00,000

Current assets 37,00,000

Advances and deposits 3,00,000 95,00,000

The Co. plans to manufacture a new product in line with its current production, the capital cost of which is estimated to be Rs. 25

lakhs. The company desires to finance the new project to the extent of Rs. 16 lakhs by issue of equity shares at a premium of Rs. 100

per share and the balance to be raised from internal sources. Additional information‟s made available to you are.

(a) Rate of dividends declared in the past five years i.e. year ended 31st March, 1998. 31st March, 1997, 31st March, 1996, 31st

March, 1995 and 31st March, 1994 were 24%, 24%, 20%, 20% and 18% respectively.

(b) Normal earning capacity (net of tax) of the business is 10%

(c) Turnover in the last three years was Rs. 80 lakhs (31st March, 1998), Rs. 60 lakhs (31st March, 1997) and Rs. 50 lakhs (31st

March, 1996).

(d) Anticipated additional sales from the new project Rs. 30 lakhs annually.

(e) Net profit before tax from the existing business which was 10% in the last three years is expected to increase to 12% on

account of new product sales.

(f) Income tax rate es 35%

(g) The trend of market price of the equity share of the company quoted on the Stock Exchange was:

Year High Low

1997-98 Rs. 300 Rs. 190

1996-97 Rs. 250 Rs. 180

1995-96 Rs. 240 Rs. 180

You are required to examine whether the company‟s proposal is justified. Do you have any suggestions to offer in this regard ?

All workings must form part of your answer.

Que. 2- The following figures are made available to you:

Rs. Net profits for the year 18,00,000

Less: Interest on secured debentures at 15% p.a.

(debentures were issued 3 months after the commencement of the year) 1,12,500

16,87,500

Less: Income –tax at 35% and dividend distribution tax 8,43,750

Profit after tax 8,43,750

Number of equity shares (Rs. 10 each) 1,00,000

Market quotation of equity share Rs. 109.70

The company has accumulated revenue reserves of Rs. 12 lakhs. The company is examining a project calling for an

investment obligation of Rs. 10 lakhs: this investment is expected to earn the same rate of return as funds already employed.

You are informed that a debt equity ratio (Debt dividend by debt plus equity) higher than 60% will cause the price earning

ratio to come down by 25% and the interest rate on additional borrowals will cost company 300 basic points more than on their

current borrowal on secured debentures. You are required to advise the company on the probable price of the equity share, if

debentures. You are required to advise the company on the probable price of the equity share, if

(a) the additional investment were to be raised by way of loans; or

(b) the additional investment were to be raised by way of equity.

Que. 3- AB Ltd. provides you with following figures:

Rs.

Profit 3,00,000

Less: Interest on Debentures @ 12% 60,000

2,40,000

Income tax @ 50% 1,20,000

1,20,000


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Number of Equity Shares (Rs. 10 each) 40,000

E.P.S (Earning per share) 3

Ruling price in market 30

P/E ratio (Price/EPS) 10

The company has undistributed reserves of Rs. 6,00,000. The company needs Rs., 2,00,000 for expansion. This amount

will earn at the same rate as funds already employed. You are informed that a debt equity ratio (Debt/Debt + Equity) higher than 35%

will push the P/E ratio down to 8 and raise the interest rate on additional amount borrowed to 14%.

You are required to ascertain the probable price of the share: (i) if the additional funds are raised as debt: and (ii) if the

amount is raised by issuing equity shares.

Que. 4- A company’s capital structure consists of the following:

Equity Shares of Rs. 100 each Rs. 20,00,000

Retained earnings Rs. 10,00,000

9% Preference shares Rs. 12,00,000

7% Debentures Rs 8,00,000

Total Rs. 50,00,000

Its capital employed which is likely to remain unchanged after expansion. The expansion involves additional finances of

Rs. 25 lakhs for which following alternatives are available to it:

(i) Issue of 20,000 equity shares at a premium of Rs. 25 per share.

(ii) Issue of 10% preference shares.

(ii) Issue of 8% debentures.

It is estimated that P/E ratio in the case of equity shares, preference shares and debentures financing would be 21.4, 17 and

15.7 respectively. Which of these alternatives of financing would you recommend and why? The income-tax rate is 50%.

Que. 5- The Halda Manufacturing Company Ltd. has to make a choice between debt issue and equity issue for financing its expansion

programme. The existing position of the company is given below:-

Rs. Debt 5% 40,000

Equity share capital (Rs. 10 per share) 1,00,000

Reserves and surplus 60,000

Total capital 2,00,000

Sales 6,00,000

Less: Total cost 5,38,000

Income before interest and taxes 62,000

Less: Interest 2,000

Income before taxes 60,000

Less: Income –tax @ 50% 30,000

Income after taxes 30,000

The expansion programme would require Rs. 1,00,000. If this is financed through debt, the rate of new debt will be 7 per

cent and the price earning ratio will be 6 times. If the expansion programme is financed through equity, new shares can be sold to net

Rs. 25 per share and the price –earning ratio will be 7 times. The expansion will generate additional sales of Rs. 3,00,000, with a

return of 10 per cent on sales before interest and taxes.

If the company is to produce a policy of maximizing the market value of its shares, which form of financing should it

choose? Assume 50% company tax rate.

Que. 6- Diamond Tools Ltd. has developed a financial plan for the next three years based on following estimates:

(Rs. Lakhs)

Year 1 Year 2 Year 3

Sales 600 720 900

Fixed assets 480 570 660

The following assumptions have been made for the purpose of planning:

Gross profit 30%

Return on sales (net of taxes) 10%

Dividend pay-out ratio 50%

Ratios based on year end figures:

Cash and debtors to sales 4 times

Inventory (cost of goods sold) 3 times

Required current ratio 2:1

Required ratio of long-term debt to equity 1:2

At the beginning of Year 1 the firm expects to have equity of Rs. 360 lakhs and long –term debt of Rs. 180 lakhs.

Determine how much additional equity capital the firm will have to raise each year based on above ratios and assumptions.

Assume that the company is not seeking separate finance from bank for additional working capital needs.

Que. 7: - A company has to raise Rs. 2,00,000 to finance an expansion program. It has two options; either to borrow or the issue sufficient

number of ordinary shares at current market price of Rs. 30 per share. Based on date for previous accounting year given below and

additional data provided you are required to evaluate the options.

Data for previous accounting year Rs. lakh

Profit 3.00

Less: 12% Interest on debt 0.60

2.40

Less: 50% Tax 1.20


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1.20

Company‟s present share capital consists of 40,000 ordinary shares of Rs. 10 each. It has undistributed reserves of Rs. 6,00,000.

It is known that debt –equity ratio higher than 40% will pull down P/E ratio to 8 and pre –tax cost of additional borrowings will be

14%.

Que. 8: - A company requires Rs. 25,00,000 for a new plant, which is expected to yield earnings before interest and taxes Rs. 5,00,000. The

company seeks your advice on three financing alternatives under consideration. The company‟s objective is to maximize earnings

per share.

The following particulars regarding the alternatives are available:

Alternative A: Raise Rs. 2,50,000 by debt and the rest by issue of fresh equity

Alternative B: Raise Rs. 10,00,000 by debt and the rest by issue of fresh equity

Alternative C: Raise Rs. 15,00,000 by debt ad the rest by issue of fresh equity

Funds can be borrowed at 10% p.a. upto Rs. 2,50,000, at 15% p.a. beyond Rs. 2,50,000 upto Rs. 10,00,000 and at 20% p.a. beyond

Rs. 10,00,000. The company‟s shares are currently selling at Rs. 150 but are expected to decline to Rs. 125 in case borrowed fund

exceeds Rs. 10,00,000. The tax rate is 50%.

Que. 9: - XYZ Co. has a capital structure of 30% debt and 70% of equity. The company is considering various investment proposals costing

less than Rs. 30 lakhs

The company does not want to disturb its present capital structure. The cost of raising the debt and equity are as follows:

Project Cost Cost of Debt Cost of Equity

Upto Rs. 5 lakhs

Above Rs. 5 lakhs and upto Rs. 20 lakhs

Above Rs. 20 lakhs and upto Rs. 40 lakhs

Above Rs. 40 lakhs and upto Rs. 1 crore

9%

10%

11%

12%

13%

14%

15%

15.5%

Assuming the tax rate is 50%, compute the cost of capital of two projects ABC & XYZ whose fund requirements are Rs. 5 lakhs &

21 lakhs respectively and if a project is expected to yield after tax return of 11%, determine under what conditions it would be

acceptable.

Que. 10: - For varying levels of debt –equity mix, the estimates of the cost of debt and equity capital (after tax) are given below:

Debt as % of total Cost of debt Cost of equity

Capital employed

0 7.0 15.0

10 7.0 15.0

20 7.0 16.0

30 8.0 17.0

40 9.0 18.0

50 10.0 21.0

60 11.0 24.0

You are required to decide on the optimal debt –equity mix for the company by calculating the composite cost of capital.

Que. 11: - XYZ Ltd. intends to set up a project with capital cost of Rs. 50,00,000. It is considering the three alternative proposals of

financing.

Alternative 1 = 100% Equity financing

Alternative 2 = Debt Equity 1: 1

Alternative 3 = Debt Equity 3: 1

The estimated annual net inflow is @ 24% i.e. Rs. 12,00,000 on the project. The rate of interest on debt is 15%. Calculate the

weighted average cost of capital for three different alternatives and analyze the capital structure decision.

Que. 12: - ABC Ltd. with EBIT of Rs. 3,00,000 is evaluating a number of possible capitals below which of the capital structure will you

recommend, and why?

Capital structure Debt (Rs.) Kd % Ke %

I 3,00,000 10.0 12.0

II 4,00,000 10.0 12.5

III 5,00,000 11.0 13.5

IV 6,00,000 12.0 15.0

V 7,00,000 14.0 18.0

Que. 13: - X Ltd. and Y Ltd. are identical expect that the former uses debt while the later does no. Thus levered firm has issued 10%

Debentures of Rs. 9,00,000. Both the firms earn EBIT of 20% on total assets of Rs. 15,00,000. Assuming tax rate of 50% and

capitalization rate of 15% for an all equity firm.

(i) Compute the value of the two firms using NI approach.

(ii) Compute the value of the two firms NOI approach.

(iii) Calculate the overall cost of capital, Ko, for both the firms using NOI approach.

Que. 14: -From the following selected data, determine the value of the firms, P and Q belonging homogeneous risk class under (a) the net

income (NI) approach, and (b) The net operating income approach.

Firm P Firm Q

Rs. Rs.


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EBIT 2,75,000 2,25,000

Interest at 15% 75,000

Equity capitalization rate, Ke 20%

Corporate tax rate 50%

Which of the two firms has an optimal capital structure under the (i) NI approach, and (ii) NOI approach?

Que. 15: - Summer Ltd. and Winter Ltd. are identical in all respects including risk factors expect for debt/equity mix. Summer Ltd. having

issued 12% debentures of Rs. 30 lakhs, while Winter Ltd. issued only equity capital. Both the companies earn 24% before interest

and taxes on their total assets of Rs. 50 lakhs. Assuming the corporate effective tax rate of 40% and capitalization rate of 18% for

an all –equity company. Compute the value of Summer Ltd. and Winter Ltd. using (i) Net Income approach and (ii) Net operating

income approach.

Que. 16: -Cost of equity of an unlevered business is 20%. The cost of debt funds is 10%. Assume different degree of leverage and that net

operating Income approach holds. Hence, compute cost of levered equity (KLE) for each degree of leverage.

Que. 17: -The following data relate to two Companies X and Y

Company X Company Y

Number of ordinary shares 90,000 1,50,000

Market price per share (Rs.) 1.20 1.00

6% Debentures (Rs.) 60,000 -----

Profit before interest (Rs.) 18,000 18,000

Explain how under Modigliani & Miller approach, an investor holding 10% of shares in Company X will be better off in switching

his holding to Company Y. Also show the way equilibrium is restored.

Que. 18: -A company expects to sell 20,000 units of product X at unit selling price Rs. 50. The variable cost of production per unit is Rs. 30.

The annual fixed cost is Rs. 1,50,000. Alternately, the company may sale 20,000 units of product Y at unit selling price Rs. 50. In

this case, the unit variable production cost and annual fixed cost are Rs. 25 and Rs. 2,50,000 respectively. Tax rate is 40%.

Both of the products require same initial investment Rs. 7,50,000. The following two capital structures are under consideration.

Sources of Funds Plan 1 Plan 2

Rs. lakh Rs. lakh

10% Preference Capital 1.50 2.00

Ordinary Share Capital (Rs. 100) 5.00 2.50

15% loan 1.00 3.00

Total Funds 7.50 7.50

Required:

(a) Operating break –even points for products X and Y

(b) Financial break –even points for products X and Y for both of the capital structures

(c) Overall break –even point for products X and Y for both of the capital structure

(d) EBIT –EPS indifference points for two proposed capital structures.

(e) Draw EBIT –EPS indifference chart

(f) % Change in EBIT for 10% change in sales for products X and Y

(g) % Change in EPS for 10% change in sales for products X and Y for both of the capital structures

(h) Return on equity capital employed for products X and Y for both of the capital structures

(i) Return on long –term capital employed for products X and Y for both of the capital structures

(j) Comment on risk and return of the products

Que. 19: - Tow companies, X and Y belong to the equivalent risk group. The two companies are identical in every respect that company Y is

levered, while X is unlevered. The outstanding amount of debt of the levered company is Rs. 6,00,000 in 10% debenture. The

other information for the two companies is as follows:

X (Rs.) Y (Rs.)

Net operating income (EBIT)

- Interest

Earning to equity holders

Equity capitalization rate ke

Market value of equity

Market value of debt

Total value of firm, V,

Overall capitalization rate ke = EBIT/V

Debt equity ratio

1,50,000

---

1,50,000

0.15

10,00,000

----

10,00,000

15.0%

0

1.50.000

60,000

90,000

0.20

4,50,000

6,00,000

10,50,000

14.3%

1.33%

An investor owns 5% equity shares of company Y. Show the process and the amount by which he could reduce his outlay through

use of the arbitrage process, is there any limit to the process?

Que. 20: - Firm A and B are similar except that A is unlevered, while B has Rs. 2,00,000 of 5 percent debenture outstanding. Assume that

the tax rate is 40 percent; NOI is Rs. 40,000 and the cost of equity is 10%. (i) Calculate the value of the firm, if the MM

assumptions are met. (ii) If the value of the firm B is Rs. 3,60,000 then do these values equilibrium values. It not, how will

equilibrium be set? Explain,


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Que. 21: - A firm has a bond outstanding Rs. 300 lakh. The bond has 12 years of life remaining until maturity, and has a 12.5% coupon and

is callable at Rs. 1,050 per bond; it had flotation costs of Rs. 4.2 lakh, which are being amortized at Rs. 30,000 annually. The

floatation costs for a new issue will be Rs. 9 lakh and the current interest rte will be 10%. The after tax cost of the debt is 6%.

Should the firm refund the outstanding debt?

Show detailed workings. Consider Corporate Income –tax rate at 50%.

Que. 22: - X Ltd. and Y Ltd. are identical except for leverage. They earn same operating profit Rs. 4 lakh before tax. Y Ltd. has Rs. 8 lakh

in 10% debt while company X is entirely financed by equity. Assuming a tax rate of 40% and capitalization rate of 16% for an all

– equity company, compute the value of business and overall cost of capital by

(i) Net Income Approach and (ii) Net Operating Income Approach

Que. 23: - A Ltd. expects to earn Rs. 5 lakh annually before interests and taxes. The company is financed entirely by equity funds and cost

of unlevered equity is 15%. Tax rate is 40%. The company wishes to buy back Rs. 10 lakh of its equity and to replace the same by

10% debt. Determine income available to equity and debt –holders of the business before and after buy –back and hence explain

how the value of the company will change after buy –back.

Question : Explain the meaning of capita l budget ing ?

Answer : The term cap ita l budget ing means p lanning for capi tal assets. Capi tal budgeting decision

means the dec is ion as to whether or no t to invest in long -te rm projec ts such as set t ing up of a factory

or insta l l ing a machinery or creat ing add it ional capac it ies to manufac ture a par t which a t present may

be purchased from outs ide and so on. I t inc ludes the f inancia l analysis o f the var ious p roposa ls

regarding capi ta l expenditure to eva lua te their impact on the financial condit ion of the company for

the purpo se to choose the bes t out o f the var ious a l ternat ives. The finance manager has var ious too ls

and techniques by means of which he assis ts the management in taking a proper cap ita l budgeting

decision. Capi ta l budget ing dec is ion i s thus , eva luat ion of expend iture decisions that involve current

out lays but are l ike ly to produce benefi t s over a per iod of t ime longer than one year . The benefi t tha t

ar i ses from cap ital budgeting dec ision may be ei ther in the form of increased revenues or reduced

costs . Such dec is ion requi res evaluat ion of the proposed projec t to forecas t l ikely or expected return

from the project and determine whether return from the projec t is adequate. Also as business is a par t

of soc ie ty, i t i s i t s moral responsib il i ty to undertake only those projec ts tha t are social ly desi rable.

Capital budget ing dec ision is an important , cruc ial and cr i t ical business decision due to :

1) Substantia l expenditure : capi tal budget ing dec is ion involves the investment o f substant ia l amount o f funds and i s thus i t i s

necessary for a firm to make such decis ion af ter a thoughtful considerat ion, so as to resul t in

prof i tab le use o f scarce resources. Hasty and incorrect decisions would not only result in huge losses

but would a lso account for fai lure o f the f irm.

2) long t ime period : capi tal budget ing dec ision has i t s e ffect over a long per iod of t ime, they affec t the future benefi t s

and also the f irm and inf luence the ra te and direct ion of growth of the f i rm.

3) Irreversibi l ity : most o f such decisions are ir reversib le , once taken, the fi rm may not been in a posi t ion to reverse i t s

impact . This may be due to the reason, that i t i s d i ff icult to find a buyer for second -hand capital

i tems.

4) Co mplex decision : capi tal investment decision involves an asses sment o f future events, which in fac t are d i fficul t to

predic t , fur ther , i t i s d i fficult to es t imate in quanti ta t ive terms al l benefi ts or costs rela t ing to a

par t icular investment decision.

Quest ion: discuss the various types o f capita l investment dec isions?

Answer : There are var ious ways to class i fy cap ita l budgeting dec is ions, genera l ly they are

c lassi f ied as :

1) On the basis o f the f irm's existence :

Chapter : Capital Budgeting


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cap ital budget ing decisions are taken by both newly incorporated and exis t in g firms. New

f irms may require to take dec is ion in respec t of selec t ion of p lant to be ins ta l led, whi le exis t ing

f irms may require to take dec ision to meet the requirements o f new envi ronment or to face cha llenges

of competi t ion. These decisions may be cl ass i fied into :

i ) Replacement and modernisat ion dec isions : rep lacement and modernisat ion dec is ions a ims to

improve opera t ing eff ic iency and reduce costs. Usual ly, p lants require replacement due to they been

economical ly dead i . e . no more econo mic l i fe le f t or on they becoming technologica lly outda ted. The

former decis ion i s o f replacement and la t ter one of modernisa t ion , however , both these decisions are

cost reduction dec isions .

i i ) Expansion decision : exis t ing successful firms may experience grow th in demand of the p roduct

and may exper ience shortage or delay in de livery due to inadequate production fac i l i t ies and thus,

would consider proposals to add capac ity to exis t ing product l ines.

i i i ) Diversif icat ion dec is ions : these decisions require e valuat ion proposa ls to divers i fy into new

product l ines, new markets, e tc . to reduce r i sk o f fai lure by dea ling in d i fferent products or operat ing

in severa l markets. expansion and diversi f ica t ion decis ions are revenue expansion decisions.

2) On the basis o f decis ion s ituat ion :

i ) Mutually exclusive dec isions : decisions a re said to be mutua lly exclusive when two or more

al terna tive proposals a re such tha t accep tance of one would exclude the accep tance of the o ther .

i i ) Accept-Reject dec is ions : the accep t -ejec t decisions occurs when proposa ls are independent and

do no t compete wi th each o ther . The f irm may accept or rejec t a proposal on the bas is o f a min imum

return on the required investment. Al l those proposa ls which have a higher return than c er ta in desired

rate o f re turn are accep ted and res t rejec ted.

i i i ) Cont igent dec is ions : contigent decis ions are dependable proposa ls , investment in one requires investment in ano ther .

Quest ion: What are the various projects evaluation techniques expl a in them in deta il ? '

Answer : At each po int of t ime, business manager , has to evalua te a number o f proposa ls as regards

var ious projec ts where he can invest money. He compares and evaluates projects and dec ides which

one to take up and which to rejec t . Apart from f inancia l considera t ions , there are many o ther factors

considered whi le taking a capi tal budget ing decision. At t imes a project may be undertaken only to

es tabl i sh footho ld in the market or for bet ter wel fare o f the soc ie ty as a whole or of t he business or

for increas ing the safe ty and securi ty o f workers, or due to requirements o f law or because of

emotional reasons for instance, many industr ia l sector projec ts are taken up a t home towns even i f

bet ter locat ions are ava ilab le. The major consi derat ion in taking a capita l budgeting decis ion is to

evalua te i t s returns as compared to i t s investments. Evaluat ion of capi tal budgeting proposa ls have

two dimensions i . e . prof i tab il i ty and r i sk, which are direct ly re lated. Higher the prof i tabil i ty, h igh er

would be the r i sk and vice versa. Thus, the f inance manager has to s tr ike a ba lance be tween

prof i tab il i ty and r i sk. Follo wing are some of the techniques used to evalua te f inancia l aspects of a

project :

1) Payback period :

i t i s one of the simples t method to calcula te per iod wi thin which enti re cost o f p roject

would be comple tely recovered. I t i s the per iod wi thin which to ta l cash inf lo ws from projec t would

be equal to total cash out flo w of projec t , cash inf low means prof i t a fter tax but before deprec ia t ion.

Merits:

a) this method of evaluating proposa ls for capi tal budgeting is simple and easy to understand , i t has

an advantage of making clear tha t i t has no prof i t on any project unti l the payback per iod is over i .e .

unt i l cap ital i nvested is recovered . When funds are l imi ted , they may be made to do more by se lect ing

projects having shor ter payback per iods. This method i s par t icular ly sui table in the case o f industr ies

where r i sk o f technologica l services i s very high. In such indust r ies, only those projec ts having a

shorter payback per iod should be financed since changing technology would make the projects to tal ly

obsolete , before a l l cos ts are recovered.


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b) in case o f routine projects also use o f payback per iod method favours pro jec ts tha t genera tes cash

inf lo ws in ear l ier years, thereby e l iminating projects br inging cash inf lows in la ter years tha t

genera l ly are conceived to be r i sky as this tends to increase wi th futur i ty .

c) by st ress ing ear l ier cash inf lo ws, l iquidi ty dimen sion i s a lso considered in select ion cr i te r ia . This

is

important in si tuat ions o f l iquidi ty crunch and high cost o f capi ta l .

d) payback per iod can be compared to break -even point , the po int at which costs are ful ly recovered

but profi t s are yet to com mence.

e) the r i sk assoc ia ted wi th a project ar i ses due to uncertainty assoc ia ted wi th cash inf lows. A shorter

payback per iod means that uncertainty wi th respect to projec t i s reso lved fas ter .

Limitat ions : Technique of payback per iod i s not a sc ient i f ic one due to the fo l lo wing reasons:

a) I t s tresses capi ta l recovery rather than prof i tabil i ty. I t does not take into account returns from the

project a f ter i t s payback per iod. For example : project A may have payback per iod of 3 years and

project B of 8 years, according to this method project A would be selected, however , i t i s possib le

that a fter 3 years projec t B earns returns @ 20 % for ano ther 3 years whi le projec t A stops yie lding

returns a fter 2 years. Thus, payback per iod is no t a good measure t o evalua te where the compar ison i s

between 2 projects, one involving long gestat ion per iod and the other yi elding quick result s but for a

short per iod .

b) this method becomes an inadequate measure o f evalua ting 2 projects where the cash inf lo ws are

uneven.

c) th is method does no t give any considerat ion to t ime value of money, cash f lo ws occurr ing at a l l

points o f t ime are s imply added. This treatment is in contravent ion of the bas ic pr inc iple o f f inancia l

analys is tha t s t ipulates compounding or discoun t ing of cash flo ws and when they ar i se at d i fferent

points o f t ime.

Some accountants ca lculate payback per iod after discount ing cash flo ws by a pre -

determined rate and the payback per iod so calculated i s cal led "discounted payback per iod" .

2) Payback rec iprocal :

i t i s rec iproca l o f the payback per iod. A major drawback of the payback per iod method of

capi tal budget ing i s that i t does not indica te any cut o ff per iod for the purpose of investment

decision. I t is , argued tha t rec iproca l o f payback would be a close approximat ion of the interna l ra te

of return i f the l i fe o f the projec t i s a t leas t twice the payback per iod and projec t genera tes equal

amount o f f inal cash inf lows. In pract ice, payback reciproca l i s a he lpful tool fo r quickly est imating

rate o f return of a project provided i t s l i fe i s at least twice the payback per iod. Payback reciprocal =

average annual cash inf lows/ini t ia l investment

3) Accounting or average rate of return method (ARR) :

Accounting or average ra te o f re turn means average annual yield on the project . Under this

method prof i t a fter tax and deprec ia t ion as percentage of to tal investment i s considered .

Rate o f return = ( total p rof i t * 100)/(ne t investments in the proj ect * number o f years o f prof i t s)

This ra te i s compared wi th the rate expected on the projec ts, had the same funds been

invested al terna tively in those projec ts. Sometimes, the management compares this rate with

minimum ra te kno wn as cut -off rate .

Merits : I t i s a simple and popular method as i t i s easy to understand and inc ludes inco me from the

project throughout i t s l i fe .

Limitations : I t i s based upon crude average prof i t s o f the future years. I t ignores the e ffect o f

f luctuat ions in p rofi t s from year to year . And thus ignores t ime va lue of money which i s very

important in capi tal budgeting dec is ions.

4) Net present value method :

The best method for evaluat ion of investment proposa l i s ne t present va lue method or

discounted cash f low technique. This method takes into account the t ime value of money. The net

present value of investment p roposal may be def ined as sum of the present va lues o f a l l cash inf lows


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as reduced by the present va lues o f a l l cash out f lo ws associa te d wi th the proposa l . Each project

involves cer ta in investments and commitment of cash a t cer ta in point of t ime. This i s kno wn as cash

out f lo ws. Cash inflo ws can be ca lculated by adding depreciat ion to prof i t a fter tax ar i sing out of tha t

par t icular projec t .

Discounting cash inf lows : Once cash inf lows and out f lows are determined, next s tep i s to

discount each cash inf low and work out i t s present va lue. For the purpose, discounting ra tes

must be known. Normally, the discount ing rate equals the opportunity cost o f capi ta l as a

project must earn at leas t that much as i s paid out on the funds locked in the projec t . The

concept o f present va lue i s easy to unders tand .To ca lculate present va lue of var ious cash

inf lo ws reference shal l be had to the present va lue tab le.

Discounting cash outf lows : The cash out f lows a lso requires discount ing as the whole of

investment i s not made at the ini t ia l stage i tsel f and wi l l be spread over a per iod of t ime. This

may be due to interes t - free defer red cred it fac i l i t ies fro m supplie rs o f plant or some other

reasons. Another change in cash flo ws to be considered in the capi tal budget ing dec ision i s

the change due to requirement o f working capi ta l . Apart from investment in fixed assets, each

project invo lves commi tment o f funds in working cap ita l . The commi tment on this account

may ar ise as soon as the plant star t s product ion. The working cap ita l commitment ends a f ter

the fixed assets o f the project are so ld out . Thus, whi le consider ing the to ta l out f lows,

working capi ta l requir ement must a lso be considered in the year the plant s tar t s production. At

the end of the projec t , the working capi tal wi l l be recovered and can be treated as cash inf low

of last year .

Acceptance rule : A project can be accep ted i f NPV is posit ive i .e . NPV > 0 and rejec ted ; i f i t

is negative i .e . NPV < 0 . I f NPV = 0, projec t may be accepted as i t impl ies a project generates

cash flo ws at the rate just equal to the oppor tuni ty cost o f cap ital .

Merits :

1) NPV method takes into account the t ime value of money.

2) The whole s tream of cash flo ws i s considered .

3) NPV can be seen as add it ion to the weal th o f shareholders. The cr i ter ion of NPV is thus in

conformi ty wi th basic financia l objec tives .

4) NPV uses d iscounted cash f lows i .e . expresses cash flo ws in terms of current rupees. NPV's o f

di fferent projects therefore can be compared. I t impl ies that each project can be evalua ted

independent o f o thers on i t s o wn mer it s .

Limitations :

1) I t involves d i fferent calcula t ions.

2) The appl ica t io n of this method necess i tates forecast ing cash flo ws and the discount rate . Thus

accuracy of NPV depends on accura te es t imat ion of these 2 fac tors tha t may be quite di ff icul t in

real i ty.

3) The ranking of projec ts depends on the d iscount ra te .

5) Desirabil ity factor/Profitabi l ity Index : In cases o f, a number o f capi tal expenditure proposals, each involving d i fferent amounts o f

cash inflo ws, the method of working out desi rabil i ty factor or prof i tabil i ty index i s fol lowed. In

genera l ter ms, a project is acceptable i f i t s prof i tabi l i ty index va lue i s greater than 1.

Merits :

1) This method a lso uses the concept o f t ime va lue of money.

2) I t i s a be tter projec t eva lua tion technique than NPV.

Limitations of Profitabi l ity index :


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1) Profi tab il i ty index fa i l s as a guide in resolving 'capi ta l rat ioning ' where projects are ind ivisib le .

Once a single large project wi th high NPV is se lec ted, possib il i ty o f accept ing several smal l projects

that toge ther may have higher NPV, then a s i ngle projec t i s excluded.

2) Situat ions may ar ise where a project se lec ted wi th lower profi tabi l i ty index may generate cash

f lows in such a manner that another project can be taken up one or two years la ter , the total NPV in

such case being more than th e one with a projec t having highest Profi tabil i ty Index.

The prof i tabil i ty index approach thus, cannot be used indiscr iminately but al l o ther type of

al terna tives o f projects would have to be worked out .

6) Internal Rate of Return(IRR) : IRR is that rate o f return a t which the sum to ta l of discounted cash inflo ws equals to

discounted cash out f lows. The IRR of a projec t is the d iscount rate tha t makes the net present va lue

of the projec t equal to zero.

The d iscount rate i .e . cost o f capi tal i s assumed to be kno wn in the de termination of NPV,

whi le in the IRR, the NPV is se t a t 0(zero) and discount ra te sa t i s fying this condi t ion i s determined.

IRR can be interpre ted in 2 ways :

1) IRR represents the ra te o f return on the unrecovered investment ba lance in the p roject .

2) IRR is the ra te o f return earned on the in t ial investment made in the project .

I t may no t be poss ible for a l l f i rms to reinvest in termediate cash f lows at a rate o f return

equal to the project 's IRR, hence the fir s t in terpreta t ion seems to be more rea l i s t ic . Thus, IRR should

be viewed as the ra te o f return on unrecovered balance of projec t rather than co mpounded rate o f

return on ini t ial investment over the l i fe o f the p rojec t .

Acceptance Rule : The use o f IRR, as a c r i ter ion to accept capi tal investment decision involves a comparison of IRR

wi th required ra te o f re turn cal led as Cutoff ra te . The project should the accep ted i f IRR is greater

than cut o ff rate . I f IRR is equal to cut o ff rate the f irm is ind i ffe rent . I f IRR less than cutoff rate , the

project i s rejected.

Merits: 1) This method makes use o f the concept o f t ime value of money.

2) Al l the cash f lo ws in the projec t are considered.

3) IRR is eas ier to use as instantaneous unders tanding of desi rabi l i ty i s de termined by compar ing i t

wi th

the cost o f capi tal .

4) IRR technique helps in achieving the objec tive o f minimisat ion of shareholders wealth .

Demerits:

1) The ca lculat ion process i s ted ious i f there ar e more than one cash out f low interspersed between the

cash inf lows then there would be mul t ip le IRR's , the interpre tat ion of which i s d i ff icul t .

2) The IRR approach crea tes a pecul iar s i tuation i f we compare the 2 projects wi th di fferent

inf lo w/out flo w patte rns.

3) I t i s assumed that under this method a l l future cash inf lows of a proposa l are re invested a t a rate

equal to IRR which i s r idiculous assumption.

4) In case o f mutua lly exclusive projects, investment options have considerably di fferent cash

out lays . A projec t wi th large fund commitments but lo wer IRR contr ibute more in terms of absolute

NPV and increases the shareholders ' wealth then decis ions based only on IRR may not be cor rec t .

Quest ion : What is the signif icance of cut of f rate?


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Answer : Cut o ff rate i s the minimum that the management wishes to have from any projec t , usually i t

is based on cost o f capita l . The technica l ca lculat ion of cos t of capita l involves a co mpl icated

procedure, as a concern procures funds fro m any sources i .e . e quity shares, capi ta l genera ted from it s

own operat ions and reta ined in general reserves i .e . retained earnings, debentures, preference share

capi tal , long/shor t term loans, etc . Thus, the firm's cos t o f cap ital can be kno wn only by working out

weighted average of the var ious costs of ra is ing var ious types o f capita l . A firm should no t and

would no t invest in projects yield ing re turns a t a rate be low the cut o ff rate .

Quest ion : Dist inguish between desirabil ity factor, NPV and IRR method of ranking proje cts?

Answer : In case o f an under taking having 2 o r more compet ing projects and a l imi ted amount o f

funds at i t s disposal , the question of ranking the projects ar i ses. For every projec t , desirabil i ty factor

and NPV method would give the same s ignal i .e . accep t or reject . But, in case o f mutual ly exc lusive

projects , NPV method i s preferred due to the fact that NPV indicates economic contr ibut ion of the

project in absolute terms. The projec t giving higher economic contr ibut ion i s preferred .

As regards NPV vs.IRR method, one has to consider the bas ic presumpt ion under each. In

case o f IRR, the presumption i s that in termediate cash inflo ws wi l l be reinvested at the ra te i . e . IRR,

whi le tha t under NPV is tha t in termedia te cash inf lows are presume d to be reinvested at the cut o ff

rate . I t i s obvious tha t reinvestment o f funds a t cut o ff ra te i s possib le than a t the interna l rate o f

return, which a t t imes may be very high. Hence the NPV obta ined af te r discount ing a t a f ixed cut o ff

rate are more re l iable fo r ranking 2 or more projects than the IRR.

Quest ion : Write a note on capital rat ioning?

Answer :Usually, f irms decide maximum amount that can be invested in cap ital projects, during a

given per iod of t ime, say a year . The f irm, then at tempts to select a combinat ion of investment

proposa ls , tha t wil l be wi thin spec i f ic l imi ts providing maximum profi tab il i ty and rank them in

descending order as per their ra te o f re turn, this i s a cap ital rat ioning s i tuat ion. A f irm should accept

al l investment projects wi th posi t ive NPV, wi th an object ive to maximise the wealth o f shareholders.

However , there may be resource constra ints due to which a firm may have to selec t from amongst

var ious projec ts. Thus, there may ar ise a si tua tion of capi tal ra t ioning wh ere, there may be interna l or

external constraints on procurement o f funds needed to invest in a l l investment proposals with

posi t ive NPV's . Capi ta l rat ioning can be experienced due to externa l fac tors , mainly imper fect ions in

capi tal markets at tr ibutable to non-availab il i ty of market information, investor a t t i tude , and so on.

Interna l capi ta l rat ioning i s due to se l f -imposed restr ic t ions imposed by management as, not to raise

addit iona l debtor lay down a speci f ied minimum rate o f return on each project . Th ere arevar ious ways

of resor t ing to cap ital rat ioning. I t may put up a cei l ing when i t has been financing investment

proposa ls only by way of re tained earnings i .e . p loughing back of prof i t s . Capi ta l rat ioning can also

be introduced by fol lowing the concep t o f 'Responsib il i ty Account ing ' , whereby management may

introduce capi tal ra t ioning by authoris ing a par t icular depar tment to invest upto a speci f ied l imi t ,

beyond which dec isions would be taken by the higher -ups. Se lec tion of a project under capita l

rat ioning involves :

1) Ident i ficat ion of the projects tha t can be accepted byusing eva luat ion technique as d iscussed.

2) Se lec tion of the combinat ion of projec ts.

In cap ital ra t ioning, i t would be desirable to accept several small investment proposa ls than a few

large ones , for a ful ler ut i l i sat ion of the budgeted amount. This would result in accepting

rela t ivelyless prof i table investment proposals i f ful l u t i l i sat ion of budget i s a pr imary considerat ion.

I t may a lso mean tha t the f irm forgoes the next prof i tab le investment fo l lo wing af ter the budget

cei l ing, even i f i t i s es t imated to yie ld a rate of re turn higher than the required rate . Thus capita l

rat ioning does no t a lways lead to opt imum result s .

Quest ion : Discuss the est imation of future cash f lows?

Answer : In order to use any technique of f inancia l evalua tion, da ta as regards cash flo ws from the

project i s necessary, implying that costs o f operat ions and returns f rom the projec t for a considerable

per iod in future should be es t imated . Futur e, i s always uncertain and predic t ions can be made about i t

only wi th re ference to cer ta in probabil i ty levels , but , s t i l l would not be exac t , thus, cash flo ws area t

bes t only a probabil i ty . Fol lowing are the var ious stages or s teps used in develop ing re lev ant

information for cash f low analys is :


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1)Estimat ion of costs : To est imate cash out flows, informat ion as regards fo l lo wing are needed which

may be ob tained from vendors or cont rac tors or by inte rnal est imates :

i ) Cost o f new equipment;

i i ) Cost o f removal and disposa l o f o ld equipment less scrap va lue;

i i i ) Cost o f prepar ing the s i te and mounting of new equipment; and

iv) Cost o f anci l lary services required for new equipment such as new conveyors or new power

suppl ies and so on.

The vendor may have related da ta on costs o f simi lar equipment or the company may have to

es t imate costs from i t s own experience . But, cost o f a new projec t specia l ly the one involving long

ges tat ion per iod, must be es t imated in view of the changes in pr ic e levels in the economy. For

ins tance high ra tes o f inf lat ion has caused very high increases in the cost o f var ious capi tal pro jects .

The impact o f possib le inf lat ion on the value of capi tal goods must thus, be assessed and est imated in

working out es t imat ed cash out f low. Many f irms work out a spec i fic index sho wing changes in pr ice

leve ls o f capi ta l goods such as bui ldings, machinery, p lant and machinery, e tc . The index i s used to

es t imate the l ike ly increase in costs for future years and as per i t , es t ima ted cash out f lows are

adjusted . Another adjus tment required in cash out f lo ws es t imates i s the possibi l i ty o f delay in the

execut ion of a projec t depending on a number o f factors, many of which are beyond the management 's

control . I t is impera tive tha t an e s t imate may be made regarding the increase in project cost due to

delay beyond expected t ime. The increase would be due to many fac tors as inf la t ion, increase in

overhead expendi ture, e tc .

2)Estimat ion of addit ional working capital requirements : The next step i s to ascer tain addi t iona l

working cap ital required for f inancing increased activi ty on account of new cap ital expenditure

project . Project p lanners of ten do not take into account the amount requi red to finance the increase in

addit iona l working cap i tal tha t may exceed amount o f capi ta l expendi ture required. Unless and unti l

th is factor i s taken into account, the cash out flow wi l l remain incomplete. The increase in working

capi tal requirement ar ises due to the need for maintaining higher sundry debtor s, stock-in-hand and

prepaid expenses , e tc . The f inance manager should make a careful es t imate o f the requirements o f

addit iona l working capita l . As the new cap ita l projec t commences operat ion, cash out f lows

requirement should be sho wn in terms of cash ou t f lo ws. At the exp iry o f the useful l i fe o f the p roject ,

the working cap ital would be released and can be thus , t reated as cash inf low. The impact o f inf lat ion

is also to be brought into account, whi le working out cash out flo ws on account o f working cap ita l . In

an inf lat ionary economy, working cap ita l requirements may r i se progressively even though there i s

increase in ac t ivi ty o f a new project . This i s because the va lue of stock, etc . may r i se due to

inf la t ion, hence , addi t iona l working cap ital requi rement s on this account should be sho wn as cash

out f lo ws.

3)Estimat ion of production and sa les : Planning for a new projec t requires an est imate o f the

production that i t would generate and the sa le that i t would enta i l . Cash inf lo ws are highly dependent

on the est imation of production and sales levels. This dependence i s due to peculiar na ture o f f ixed

cost . Cash inf lows tend to increase considerab ly a fter the sa les are above the break -even point . I f in a

year , sales are belo w the break -even point , which is qui te possib le in a large cap ital in tensive project

in the ini t ial year o f i t s commerc ia l production, the company may even have cash out flo ws in terms

of losses. On the bas is o f addit iona l production uni t s that can be so ld and pr ice at which they may be

sold, the gross revenues from a project can be worked out . In do ing so ho wever , possib il i ty o f a

reduct ion in sale pr ice, in troduction of cheaper or more e ff ic ient product by compet i tors, recess ion in

the market condi t ions and such o ther fac tors are to be consi dered .

4)Estimat ion of cash expenses : In this s tep, the amount o f cash expenses to be incurred in running

the projec t a f ter i t goes into co mmerc ia l production are to be est imated. I t i s obvious tha t whichever

leve l of capac ity ut i l i sat ion is a t tained b y the project , f ixed costs remains the same. However ,

var iab le costs vary wi th changes in the level o f capaci ty ut i l i sa t ion.

5)Working out cash inf lows: The d i fference between gross revenues and cash expenses has to be

adjusted for taxa tion before cash i nf lows can be worked out . In view of deprec iat ion and other

taxab le expenses, e tc . the tax l iab il i ty o f the company may be worked out . The cash inflo w would be

revenues less cash expenses and l iabi l i ty for taxation.


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One problem is o f trea tment o f dividends and interest . Some accountants suggest that

in teres t being a cash expense is to be deducted and dividends to be deducted from cash inf lows.

However , this seems to be incorrec t . Both dividends and interes t invo lve a cash out f low, the fac t

remains that these const i tute cost o f capi ta l , hence, i f d iscount ing ra te , is i t se l f based on the cost o f

capi tal , in teres t on long term funds and dividends to equity or preference shareholders should not be

deducted whi le working out cash inf lows. The rate o f return yielded by a project at a cer tain rate o f

return i s compared wi th cost o f capi ta l for de termining whether a par t icular project can be taken up

or not . I f the cost o f capita l becomes par t o f cash out f lows, the co mpar ison becomes vi t ia ted. Thus,

capi tal cos t l ike interest on long term funds and dividends should not be deducted from gross

revenues in order to work out cash inf lows. Cash inf lows can also be worked out back wards, on

adding interes t on long term funds and deprecia t ion to ne t profi t s and deduct ing l iabi l i ty for taxa tion

for the year .

Question : Write a note on soc ial benefit analysis?

Answer : I t i s be ing increasingly recognised that commerc ial eva luat ion of industr ial projec ts is no t

enough to just i fy commitment o f funds to a p roject spec ia l ly, i f i t belongs to the publ ic sector and

ir respec tive of i t s f inancia l viab il i ty, i t i s to be implemented in the long te rm interest o f the nation.

In the context o f the national po licy of making huge public investments in var ious sec tors o f the

economy, the need for a pract ica l method of making social cost benefi t analys is has acquired great

urgency. Hundreds o f c rores o f rupees are commit ted every year to var ious public projects of a l l

types - industr ial , commercial and those providing basi c infras truc ture faci l i t ies , e tc . Analysis o f

such projects has tobe done wi th re ference to socia l cos ts and benefi t s as they cannot be expected to

yield an adequate commercial re turn on the funds employed, at leas t during the short run. Socia l cos t

benefi t analys is i s important for pr iva te corporations having a mora l responsib il i ty to undertake

soc ial ly des irab le p rojects. In analys ing var ious al ternat ives o f capita l expendi ture, a p r ivate

corporat ion should keep in view the social contr ibution aspec t . I t can thus be seen tha t the purpose of

soc ial cost benefi t analys is technique i s no t to replace the exis t ing techniques o f financial ana lys is

but to supplement and strengthen them. The concept o f soc ia l cos t benefi t analys is has progressed

beyond the s tage o f intel lectual specula t ion. The planning commiss ion has already dec ided tha t in

future, the feas ibi l i ty s tudies for publ ic sec tor projects wil l have to include an ana lys is of the socia l

rate o f return. In case of pr iva te sector also , a social ly benefic ia l project may be more easi ly

accep tab le to the government and thus , th is analys is would be relevant whi le grant ing var ious

l icenses and approvals, e tc . Also, i f the pr iva te sector includes socia l cos t benefi t analys is in i t s

project evaluat ion techniques, i t wi l l ensure tha t i t i s no t ignor ing i t s own long -te rm interest , as in

the long run only those projects wi l l survive tha t are socia l ly benefic ial and acceptable to soc ie ty.

Need for Socia l Cost Benef it Analysis (SCBA) :

1) Market pr ices used to measure costs and benefi t s in projec t ana lys is do no t represent soc ia l values

due to market imper fections.

2) Monetary cost benefi t analys is fa i l s to consider the external i t ies or external e ffects o f a project .

The external e ffec ts can be posi t ive l ike developme nt o f infras truc ture or negat ive l ike pol lut ion and

imbalance in environment .

3) Taxes and subsid ies a re monetary costs and gains, but these are only transfer payments f rom soc ial

viewpoint and thus ir re levant .

4) SCBA is essent ia l for measur ing the re dis tr ibut ion effect o f benefi t s of a projec t as benefi t s going

to poorer sect ion are more impor tant than one go ing to sect ions which are economica lly bet ter o f f.

5) Projects manufac tur ing l iqueur and c igare t tes are not d is t inguished fro m those generat ing

elec tr ici ty or producing necessi t ies o f l i fe . Thus, meri t wants are important appra isal cr i ter ion for

SCBA.

I t i s essent ia l to unders tand that ac tual cos t or revenues do not essent ia l ly re f lect cost or

benefi t to the soc iety. I t i s so , because the market pr ice o f goods and services are o ften grossly

dis tor ted due to var ious a r t i fic ia l res tr ict ions and controls f rom authori t ies. Thus, a di f ferent

yards t ick i s to be adopted in eva luat ing a par t icular proposal and i t s cost benefi t ana lys is are usu a lly

va lued a t "opportuni ty cost" or shado w prices to judge the real impact o f the ir burden as costs to

soc iety. The soc ia l cos t va lua tion so met imes completely changes the est imates of working resul t s of a

project .


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Quest ion : Is there any relat ionship be tween r isk and return, if yes, of what sort?

Answer :

Risk: The term r isk wi th re ference to investment decis ion is def ined as the var iabi l i ty in actua l

return emanat ing fro m a project in future over i ts working l i fe in relat ion to the es t imated re turn as

forecasted at the t ime of ini t ia l cap ita l budgeting dec isions. Risk i s d i ffe rent ia ted wi th uncertainty

and i s def ined as a si tuation where the facts and figures are no t avai lable or probabil i t ies cannot be

assigned.

Return: I t cannot be denied that re t urn i s the motivat ing force and the pr inc ipa l reward to the

investment process . The return may be defined in terms of :

1) real i sed re turn i .e . the return which was earned or could have been earned, measuring the real i sed

return a l lo ws a f irm to assess h ow the future expected re turns may be.

2) expected re turn i .e . the re turn tha t the f irm anticipa tes to earn over some future per iod. The

expected re turn is a predicted re turn and may or may not occur .

For , a f irm the return from an inve stment is the expected cash inflo ws. The re turn may be

measured as the total gain or loss to the firm over a given per iod of t ime andmay be defined as

percentage on the ini t ial amount invested.

Relat ionship between r isk and return : The main objec tive o f financial management i s to maximise

wealth o f shareholders ' as re f lected in the market pr ice o f shares , that depends on r i sk -return

charac ter i st ics o f the financia l decisions taken by the f irm. I t a l so emphasizes that r i sk and return are

2 impor tant de ter minants o f value of a share. So , a f inance manager as a lso investor , in genera l has to

consider the r isk and re turn of each and every f inancia l dec ision. Acceptance of any proposa l does

not al ter the business r i sk o f f irm as perce ived by the suppl ier o f ca p i tal , but , d i f ferent investment

projects would have di ffe rent degree of r isk . Thus, the impor tance of r i sk d imension in capital

budgeting can hardly be over -st ressed. In fac t , r isk and re turn are c losely re lated, investment project

that i s expected to yie ld high return may be too r i sky tha t i t causes a signi f icant increase in the

perce ived r i sk o f the f irm. This trade off between r i sk and re turn would have a bear ing on the

investor ' percep tion of the f irm before and af ter accep tance of a spec i fic proposal . The return from an

investment dur ing a given per iod is equal to the change in va lue of investment plus any income

rece ived from investment . I t i s thus , important tha t any capi ta l or revenue income from investments

to investor must be inc luded, otherwise t he measure o f return wi l l be defic ient . The re turn from

investment cannot be fo recasted wi th cer ta inty as there i s r isk tha t the cash inf lows from project may

not be as expected . Greater the var iab il i ty be tween the es t imated and actua l return, more r isky i s the

project .


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Important Questions

Que:- Excel Ltd. manufactures a special chemical for sale at Rs. 30 per kg. The variable cost of manufacture is Rs. 15 per kg. Fixed cost

excluding depreciation is Rs. 2,50,000. Excel Ltd. is currently operating at 50% capacity. It can produce a maximum of 1,00,000 kgs at full

capacity.

The Production Manager suggests that if the existing machines are fully replaced the company can achieve maximum capacity in

the next five years gradually increasing the production by 10% per year.

The Finance Manager estimates that for each 10% increase in capacity, the additional increase in fixed cost will be Rs. 50,000. The

existing machines with a current book value of Rs. 10,00,000 can be disposed of for Rs. 5,00,000. The Vice-President (finance) is willing to

replace the existing machines provided the NPV on replacement is about Rs. 4,53,000 at 15% cost of capital after tax.

(i) You are required to compute the total value of machines necessary for replacement.

For your exercise you may assume the following:

(a) The company follows the block assets concept and all the assets are in the same block. Depreciation will be on straight-

line basis and the same basis is allowed for tax purposes.

(b) There will be no salvage value for the machines newly purchased. The entire cost of the assets will be depreciated over

five year period.

(c) Tax rate is at 40%.

(d) Cash inflows will arise at the end of the year.

(e) Replacement outflow will be at the beginning of the year (year 0).

Year 0 1 2 3 4 5

Discount factor at 15% 1 0.87 0.76 0.66 0.57 0.49

(ii) On the basis of data give above, the managing director feels that the replacement, if carried out, would at least yield post tax return

of 15% in the three years provided the capacity build up is 60%, 80% and 100% respectively. Do you agree?

Que:- A company is planning to set up a Project at a cost of Rs. 3 crores. It has to decide whether to locate the plant in Bombay or Janupur

(a backward district). Locating the plant in Janupur would mean a cash subsidy of Rs. 15 lakhs from the Central Government. In addition,

the taxable profits to the extent of 20% would be exempt for 10 years. The project envisages a borrowings of Rs. 2 crores in either case. The

cost of borrowing would be 12% for Bombay and 10% for Janupur. However, the revenue costs are likely to be higher in Janupur. The

borrowings have to be repaid in four equal annual instalments beginning from the end of the fourth year. With the help of following

information and by using Cost of Equity of 15%, advise as to where the project should be set up:

Profit (Loss) before Interest and Depreciation

(Rs. In Lacs)

Present Value Factors

(at 15%)

Year Bombay Janupur

1

2

3

4

5

6

7

8

9

10

(6.00)

34.00

54.00

75.00

110.00

140.00

150.00

250.00

350.00

450.00

(50.00)

(20.00)

10.00

20.00

50.00

100.00

150.00

200.00

225.00

350.00

0.87

0.76

0.66

0.57

0.50

0.43

0.38

0.33

0.28

0.25

Notes:

(i) Income-tax is payable @ 30% on profits.

(ii) Central subsidy receipt is not to affect depreciation and income-tax.

(iii) Useful Life of the Plant is estimated as 10 years.

Que:- PQR Limited has decided to go in for a new model of Mercedes Car. The cost of the vehicle is Rs. 40 lakhs the company has two

alternatives:

(i) Taking the car on finance lease; or (ii) Borrowing and purchasing the car.

LMN Limited is willing to provide the car on finance lease of PQR Limited for five years at annual rental of Rs. 8.75 lakhs, payable at the

end of the year. The vehicled is expected to have useful life of 5 years, an it will fetch a net salvage value of Rs. 10 lakhs at the end of yeare

five. The depreciation rate for tax purpose is 40% on written – down value basis. The applicable tax rate for the company is 35% and

incremental borrowing rate of the co. is 13.8462%.

What is the net advantage of leasing for the PQR Limited? Ignore Tax on capital profits

The values of Present value interest factor at different rate of discount are as under:

Rate of Discount T1

0.8784

0.9174

T2

0.7715

0.7715

T3

0.6777

0.7722

T4

0.5953

0.7084

T5

0.5229

0.6499


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Que. 1: - Dolly company has an investment opportunity costing Rs. 40,000 with the following expected cash inflow (i.e. after tax and before

depreciation)

Year Inflows (Rs.) PVF (10%)

1 7,000 0.909

2 7,000 0.826

3 7,000 0.731

4 7,000 0.653

5 7,000 0.621

6. 8,000 0.564

7. 10,000 0.513

8. 15,000 0.467

9. 10,000 0.424

10 4,000 0.386

Using 10% as the cost of capital (rate of discount) determine the (i) Net Present value; and (ii) Profitability Index.

Que. 2: - Consider the following investment opportunity: A machine is available for purchase at a cost of Rs. 80,000. We expect it to have a

life of five years and to have a scrap value of Rs. 10,000 at the end of the five –year period. We have estimated that it will generate

additional profits over its life as follows:

Year Amount (Rs.)

1 20,000

2 40,000

3 30,000

4 15,000

5 5,000

These estimates are of profits before depreciation. You are required to calculate the return on capital employed.

Que. 3: - L & T Ltd. has decides to purchase a machine to augment the company‟s installed capacity‟s to meet the growing demand for its

products. There are machine under consideration of the management. The relevant details including estimated yearly expenditure

and sales are given below: All sales are on cash. Corporate Income Tax rate is 40%.

Machine 1 Machine 2 Machine 3

Initial investment required Rs. 3,00,000 Rs. 3,00,000 Rs. 3,00,000

Estimated annual sales 5,00,000 4,00,000 4,50,000

Cost of Production(estimated)

Direct Materials 40,000 50,000 48,000

Direct Labour 50,000 30,000 36,000

Factory Overheads 60,000 50,000 58,000

Administration costs 20,000 10,000 15,000

Selling and distribution costs 10,000 10,000 10,000

The economic life of Machine 1 is 2 years, while it is 3 years for the other two. The scrap values are Rs. 40,000, Rs. 25,000 and

Rs. 30,000 respectively. You are required to find out the most profitable investment based on ‘Pay Back Method”.

Que. 4: - D Company wants to replace the manual operation by new machine. There are two alternative models X and Y of the new

machine. Using Payback period, suggest the most profitable investment. Ignore taxation.

Machine X Machine Y

Original Investment (Rs.) 9,000 18,000

Estimated life of the machine (Years) 4 5

Estimated saving in cost (Rs.) 500 800

Estimated saving in Wages (Rs.) 6,000 8,000

Additional cost of maintenance 800 1,000

Additional cost of supervision (Rs.) 1,200 1,800

Que. 5: - A company is contemplating to purchase a machine. Two machine A and B are available, each costing Rs. 5 lakhs. In comparing

the profitability of the machines, a discounting rate of 10% is to be used and machine is to be written off in five years by straight –

line method of depreciation with nil residual value. Cash inflows after tax are expected as follows:

Year Machine – A Machine – B

(Rs. in lakhs) (Rs. in lakhs)

1 1.5 0.5

2 2.0 1.5

3 2.5 2.0

4 1.5 3.0

5 1.0 2.0

Indicate which machine would be profitable using the following methods of ranking investment proposals:

(i) Pay Back method;

(ii) Net present value method;

(iii) Profitability index method; and


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(iv) Average rate of return method.

The discounting factors at 10% are:

Year 1 2 3 4 5

Discounting factor 0.909 0.826 0.751 0.683 0.621

Que. 6: - S Ltd. have decided to purchase a machine to augment the company‟s installed capacity to meet the growing demand for its

products. There are three machines under consideration of the management. The relevant details including estimated yearly

expenditure and sales are given below. All sales are on cash. Corporate Income Tax rate is 40%, interest on capital may be

assumed to be 10%. Rs.

Particulars Machine

Initial investment required

Estimated annual sales

Cost of production (estimated):

Direct materials

Direct labour

Factory overheads

Administration

Selling and distribution costs

1

3,00,000

5,00,000

40,000

50,000

60,000

20,000

10,000

2

3,00,000

4,00,000

40,000

30,000

50,000

10,000

10,000

3

3,00,000

4,50,000

48,000

36,000

58,000

15,000

10,000

The economic life of Machine 1 is 2 years, while it is 3 years for the other two. The scrap values Rs. 40,000, Rs. 25,000 and Rs.

30,000 respectively.

You are required to find out the most profitable investment based on ‘Payback Method’.

Que. 7: - A machine is purchased six years back for Rs. 1,50,000 has bee depreciated to a book value of Rs. 90,000. It originally had a

projected life of fifteen years and zero salvage. A new machine will cost Rs. 2,50,000 and result in a reduced operating cost of Rs.

30,000 per year for the next nine years. The older machine could be sold for Rs. 50,000. The machine also will be depreciated on a

straight –line method on nine –year life with salvage value of Rs. 25,000. The company‟s tax rate is 50% and cost of capital is

10%. Ignore tax on capital/loss gain. Determine whether the old machine should be replace.

Given – Present value of Re. 1 at 10% on 9th year – 0.424 and present value of an annuity of Re. 1 at 10% for 8 years = 5.335.

Que. 8: - Project A cost Rs. 2,00,000 and Project B costs Rs. 3,00,000 both have a ten –year life. Uniform cash receipts expected are A Rs.

40,000 p.a. and B Rs. 80,000 p.a. salvage values expected area Rs. 1,40,000 declining at an annual rate of Rs. 20,000 and B Rs.

1,60,000 declining at an annual rate of Rs. 40,000. Calculate traditional and bailout payback period.

Que. 9: - Royal Industries is considering the replacement of one of its moulding machines. The existing machine is in good operating

condition, but is smaller than required if the firm is to expand its operations. The old machine is 5 years old, has a current salvage

value of Rs. 30,000 and a remaining depreciable life of 10 Years. The machine was originally purchased for Rs. 75,000 and is

being depreciated on a straight line basis over 10 years, with no salvage value. The management anticipates that with the expended

operations, there will be need for an additional net working capital of Rs. 30,000. The new machine will allow the firm to expand

current operations, and thereby increase revenues of Rs. 40,000, and variable operating costs from Rs. 2,00,000 to Rs. 2,10,000.

The company‟s tax rate is 50% and its cost of capital is 10%. Should the company replace its existing machine, given that capital

taxable at the same rate of tax?

Que. 10: - R Ltd. is implementing a project with an capital outlay of Rs. 7,600. Its cash inflows are as follows:

Years Rs.

1 6,000

2 2,000

3 1,000

4 5,000

The expected rate of return on the capital invested is 12% p.a. Calculate the discounted payback period of the project.

Que. 11: - A Firm can invest Rs. 10,000 in a project with a life of three years.

The project cash inflow are as follows:

Year Rs.

1 4,000

2 5,000

3 4,000

The cost of capital is 10% p.a. Should the investment be made?

Que. 12: - Machine A cost Rs. 1,00,000, payable immediately. Machine B costs Rs. 1,20,000, half payable immediately and half payable in

one year‟s time. The cash receipts expected are as follows:

Year (at the end) A B

1 20,000 -

2 60,000 60,000

3 40,000 60,000

4 30,000 80,000

5 20,000 -

With 7% interest which machine should be selected as per NPV method. Also calculate profitability index.

Que. 13: - A Company has to select one of the following two projects: (Rs.)


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Project A Project B

Cost

Cash in flows

Year 1

2

3

4

11,000

6,000

2,000

1,000

5,000

10,000

1,000

1,000

2,000

10,000

Using the Internal rate of return method suggest which project is preferable.

Que. 14: - The project cash flows from two mutually exclusive Projects A and B are as under:

Period Project A Project B

0 (outflow)

1 to 7 (inflow)

Project life

Rs. 22,000

Rs. 6,000 each year

7 years

Rs. 27,000

Rs. 7,000 each year

7 years

(i) Advice on project selection with reference to internal rate of return.

(ii) Will it make any difference in project selection, if the cash flow from project B is for 8 years instead of 7 years @ Rs.

7,000 each year?

Que. 15: - Following are the data on a capital project being evaluated by the management of X Ltd.:

Project M

Annual cost saving

Useful life

I.R.R.

Profitability Index (P.I.)

NPV

Cost of capital

Cost of project

Payback

Salvage value

Rs. 40,000

4 years

15%

1.064

?

?

?

?

0

Find the missing values considering the following table of discount factor only:

Discount factor 15% 14% 13% 12%

1 year

2 year

3 year

4 year

0.869

0.756

0.658

0.572

0.877

0.769

0.675

0.592

0.885

.0783

0.693

0.613

0.893

0.797

0.712

0.636

0.855 2.913 2.974 3.038

Que. 16: - P Ltd. has a machine having an additional life of 5 years, which costs Rs. 10,00,000 and has a book value of Rs. 4,00,000. A new

machine costing Rs. 20,00,000 is available. Though its capacity is the same as that of the old machine, it will mean a saving in

variable costs to the extent of Rs. 7,00,000 per annum. The life of the machine will be 5 years at the end of which it will have a

scrap value of Rs. 2,00,000. The rate of income tax is 46% and P Ltd.‟s policy is not to make an investment if the yield is less than

12% per annum. The old machine, if sold today, will realise Rs. 1,00,000 it will have no salvage value if sold at the end of 5th year.

Advise P Ltd. whether or not the old machine should be replaced. (Present value of Re. 1 receivable annually for 5 years at 12% =

3.605, present value of Re. 1 receivable at the end of 5 years at 12% per annum = 0.567). Capital gain is tax –free.

Ignore income tax savings on depreciation as well as on loss due to sale of existing machine.

Que. 17: - Arjun Ltd. is considering the question of taking up new project, which requires an investment of Rs. 200 lakhs on machinery and

other assets. The project is expected to yield the following gross profits (before depreciation and tax) over the next five years:

Year Gross profit (in lakhs of rupees)

1 80

2 80

3 90

4 90

5 75

The cost of raising the additional capital is 12% and the assets have to be depreciated at 20% on „written down value‟ basis. The

scrap value at the end of the five –year period may be taken as zero. Income –tax applicable to the company is 50%.

Calculate the Net Present Value of the project and advise the management whether the project has to be implemented. Also of the

project and advise the management whether the project has to be implemented. Also calculate the Internal Rate of Return of the

Project.

Que. 18: - ABC company is having difficulties with an automated grinding machine has 4 years of service life, its operating cost are fairly

sizable compared to its revenues. For the next four years, the revenues generated will be Rs. 5,20,000 annually but the annual cost

expenses will be Rs. 3,80,000. In addition, it must take depreciation of Rs. 80,000 per year until the machine reaches zero book

value. The machine could be sold today for net cash of Rs. 80,000 which is less than its current book value of Rs. 1,60,000. This is

not good since if the machine were held for 4 years it could probably be sold for Rs. 80,000 net cash. The firm‟s alternative is to

invest in a new grinding machine costing Rs. 4,00,000, not counting the Rs. 80,000 needed to transport and install it.

The new machine would generate a revenue of Rs. 9,20,000 with cash expense of Rs. 5,80,000. It would be depreciated over a 4

year period to a book value of Rs. 1,60,000 at which time it could be sold for Rs. 1,40,000 net cash. Depreciation would be by the


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straight line method. The new machine would require tying up an additional Rs. 2,00,000 of inventory and receivable over the 4

year period. What is the differential after tax cash flow stream for this proposal?

Assume tax rate of 50% on Income and Capital gain. Also evaluate the proposal assuming discount rate of 10%.

Que. 19: - A Machine purchased 6 years back for Rs. 1,50,000 has been depreciated to a book value of Rs. 90,000. It originally had as

projected of 15 years (salvage nil). There is a proposal to replace this machine. A new machine will cost Rs. 2,50,000 and result in

reduction of operating cost by Rs. 30,000 p.a. for next 9 years.

The existing machine can now be scrapped away for Rs. 50,000. The new machine will also be depreciated over 9 years period as

per straight line method with salvage of Rs. 25,000. Find out whether the existing machine be replaced given that the tax rate

applicable is 50% and cost of capital 10% (profit or loss on sale of assets is to be ignored for tax purposes).

Que. 20: - New Style Ltd. is considering the replacement of one of its moulding machines. The existing machine is in good operating

condition, but is smaller than required if the firm is to expand its operations. The old machine is 5 years old, and has remaining

depreciable life of 10 years. The machine was originally purchased for Rs. 1,50,000 and is being depreciated at Rs. 10,000 per year

for tax purposes.

The new machine will cost Rs. 2,20,000 or Rs. 1,70,000 if exchanged with the existing machine. It will be depreciated

on a straight –line basis for 10 years, with no salvage value. The management anticipates that, with the increased operations, there

will be need for an additional net working capital of Rs. 30,000. The new machine will allow the company to expand current

operations, thereby increasing annual revenue by Rs. 60,000 and variable operating costs from Rs. 2,00,000 to Rs. 2,20,000.

The company‟s tax rate is 35% and its cost of capital is 10%.

Should the company replace its existing machine? Assume that the loss on exchange of existing machine can be claimed

as short –term capital loss in the current year itself.

Que. 21: - Supersonic Ltd. has decided to diversify its production and wants to invest its surplus funds on the most profitable project. It has

under consideration only two projects “A” and “B”. The cost of project “A” is Rs. 100 lakhs and that of “B” is Rs. 150 lakhs. Both

projects are expected to have a life of 8 years only and at the end of this period. “A” will have a salvage value of Rs. 41 lakhs and

“B” Rs. 14 lakhs. The running expenses of “A” of “A” will be Rs. 35 lakhs per year and that of “B” Rs. 20 lakhs per year. In either

case the company expects a rate of return of 10%. The company‟s tax rate is 50%. Depreciation is charged on straight line basis.

Which project should the company take up?

Present value of annuity of Re. 1 for eight years at 10% is 5.335 and present value of Re. 1 received at the end of the eight year is

0.647.

Que. 22: - A Company proposes to install a machine involving a Capital Cost of Rs. 3,60,000. The life of the machine is 5 years and its

salvage value at the end of the life is nil. The machine will produce the net operating income after depreciation of Rs. 68,000 per

annum. The company‟s tax rate is 45%.

The Net Present Value factors for 5 years 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.

Que. 23: - Supreme Industries Ltd. is manufacturing a fast selling product under the brand name Supreme‟. The variable cost of the product

is Rs. 6 per unit and the total annual fixed cost is Rs. 1,20,000. Current demand is 40,000 units a selling price of Rs. 10 per unit.

As the market for the product is steadily expanding, the company has plans to partly mechanize operations by installing a semi –

automatic machine (life 8 years) at a cost of Rs. 2 lakhs. This will reduce the variable cost to Rs. 4 per unit and the annual fixed

cost will be Rs. 1,80,000.

The company has also an alternative plan to completely mechanize operations by installing a fully automatic machine (life 8 years)

at a cost of Rs. 5 lakhs. The variable cost per unit in this case will be Rs. 2 only and the annual fixed cost will rise to Rs. 3,20,000.

Required:

(a) Current profit earned by the company and its break –even sales.

(b) Minimum level of sales which will make it more profitable to switch over from manual Operations to semi –automatic

machine –

(c) Minimum level of sales for change over from manual operations directly to automatic machine, ignoring consideration of the

semi –automatic machine.

1. Cost of capital of the company is 12%.

2. Present value of an annuity of Re. 1 at 12% for 8 years is 4.97.

Que. 24: - National Bottling Company is contemplating to replace one of its bottling machines was a new and more efficient machine. The

old machine has a cost of Rs. 10 lakhs and useful life of ten year. The machine was bought five years back. The company does not

expect to realise any return from scrapping the old machine at the end of ten years but if it is sold to another company in the

industry, national Bottling Company would receive Rs. 6 lakhs for it.

The new machine has a purchase price of Rs. 20 lakhs. It has an estimated salvage value of Rs. 2 lakhs and has useful life of five

years.

The new machine will have a greater capacity and annual sales are expected to increase from Rs. 10 lakhs to Rs. 12

lakhs. Operating efficiencies with the new machine will also produce savings of Rs. 2 lakhs a year. Depreciation is on a straight –

line basis over a ten –year life.

The cost of capital is 8% and a 50% tax –rate is applicable. The present value interest factor for an annuity for five years,

at 8% is 3.993 and present value interest factor at the end of five years is 0.681. Should the company replace the old machine?

Que. 25: - P Ltd. has a machine having an additional life of 5 years which costs Rs. 10,00,000 and has a book value of Rs. 4,00,000. a new

machine costing Rs. 20,00,000 is available. Though its capacity is the same as that of the old machine, it will mean a saving in

variable costs to the extent of Rs. 7,00,000 per annum. The life of the machine will be 5 years at the end of which it will have a


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scrap value of Rs. 2,00,000. The rate of income –tax is 46% and P Ltd. „s policy is not to make an investment if the yield is less

than 12% per annum. The old machine, if sold today, will realise Rs. 1,00,000; it will have no salvage value if sold at the end of 5th

year. Advice P Ltd. whether or not the old machine should be replaced.

(Present value of Re. 1 receivable annually for 5 years at 12% = 3.605, present value of Re. 1 receivable at the ed of S years at

12% per annum = 0.657). Capital gain is tax –free. Ignore income –tax savings on depreciation as well as on loss due to sale of

existing machine.

Que. 26: - Beta Company Limited is considering replacement of its existing by a new machine, which is expected to cost Rs. 2,64,000. The

new machine will have a life of five years. And will yield annual cash revenues of Rs. 5,68,750 and incur annual cash expenses of

Rs. 2,95,750. The estimated salvage value of the new machine is Rs. 18,200. The existing machine has a book value of Rs. 91,000

and can be sold for Rs. 45,000 today.

The existing machine has a remaining useful life of five years. The cash revenues will be Rs. 4,55,000 and associated cash

expenses will be 3,18,500. The existing machine will have a salvage value of Rs. 4,550 at the end of five years. The Beta

Company is in 35% tax –bracket, and write off depreciation at 25% on 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 Rs. 2 per share in the next year. The current market price of company‟s equity share is Rs. 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? Advice.

Que. 27: - ABC Company is considering the following six proposals:

Project Cost NPV

1

2

3

4

5

6

Rs. 1,000

6,000

5,000

2,000

2,500

500

Rs. 210

1,560

850

260

500

95

You are required to calculate the profitability index for each project and rank them. Which projects would you choose if the total

funds if the total funds are Rs. 8,000. Assume projects are undivisable.

Que. 28-S Ltd. has Rs.10,00,000 allocated for capital budgeting purpose. The following proposals and associated profitability indexes have

been determined :

Project Outflow PI

1

2

3

4

5

6

Rs.3,00,000

1,50,000

3,50,000

4,50,000

2,00,000

4,00,000

1.22

0.95

1.20

1.18

1.20

1.05

Which of the above investment should be undertaken ? Assume that project are indivisible and there is no alternative use of the

money allocated for capital budgeting.

Que. 29: - Navyug Enterprises is considering the introduction of a new product. Generally the company‟s products have a life of about five

–year, after which they are usually dropped from the range of products the company sells. The new product envisages the purchase

of new machinery costing Rs. 4,00,000 including freight and installation charges. The useful life of the equipment is five year,

with an estimated salvage value of Rs. 1,57,000 at the end of that time. The machine will be depreciated for tax purposes by

reducing balance method at a rate of 15% of the book value.

The new product will be produced in a factory which is already owned by the company. The company built the factory

some years ago at Rs. 1,50,000. The book value on the written down value basis is zero. Today, the factory has a resale value of

Rs. 3,50,000 which should remain fairly stable over the next five years. The factory is currently being rented to another company

under a lease agreement, which has five years to run, and which provides for annual rental of Rs. 5,000. Under the lease agreement

if the lessor wishes to cancel the lease, he can do so by paying the lessee compensation equal to one year‟s rental payment. This

amount is not deductible for income tax purpose. Additions to current assets will required Rs. 22,500 at he commencement of the

proposal which, it is assumed, is fully recoverable at the end of year 5. The company will have to spend Rs. 50,000 in year 1

towards market research.

The net cash inflow from operation before depreciation and income tax are:

Year Rs.

1

2

3

4

5

2,00,000

2,50,000

3,25,000

3,00,000

1,50,000


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It may be assumed that all cash flows are received or paid at the end of the each year and that income taxes are paid in the year in

which the inflows occur. The company‟s tax rate may be assumed to be 50% for both revenue and capital gains/losses and the

company‟s required return after tax is 10%. Evaluate the proposal.

Que. 30: - A chemical company is presently paying on outside firm Re. 1 per gallon to dispose off the waste resulting from its

manufacturing operations. At normal operating capacity, the waste is about 50,000 gallons per year.

After spending Rs. 60,000 on research, the company discovered that the waste could be sold for Rs. 10 per gallon if it was

processed further. Additional processing would, however, require an investment of Rs. 6,00,000 in new equipment, which would

have an estimated life of 10 years with no salvage value. Depreciation would be calculated by straight line method.

Expect for the costs incurred in advertising Rs. 20,000 per year, no change in the present selling and administrative

expenses is expected, if the new product is sold. The details of additional processing costs are as follows;

Variable: Rs. 5 per gallon of waste put into process.

Fixed: (excluding depreciation): Rs. 30,000 per year.

In costing the new product, general administrative overheads will be allocated at the rate of Rs. 2 per gallon. There will be no

losses in processing, and it is assumed that the total waste processed in a given year will be sold in that very year. Estimates

indicate that 40,000 gallons of the product could be sold each year.

The management when confronted with the choice disposing off the waste or processing it further and selling it, seeks your advice.

Which alternative would you recommended? Assuming that the firm‟s cost of capital is 15% and it pays on an average 35% tax on

its income.

Que. 31: - A company wish to acquire an asset costing Rs. 1,00,000. The company has an offer from a bank to lend @ 18%. The principal

amount is repayable in 5 years end installments. A leasing Company has also submitted a proposal to the Company to acquire the

asset on lease at yearly rentals of Rs. 280 per Rs. 1,000 of the assets value for 5 years payable at year end. The rate of depreciation

of the asset allowable for tax purposes is 20% on W.D.V. with no extra shift allowance. The salvage value of the asset at the end of

5 years period is estimated to be Rs. 1,000. Whether the Company should accept the proposal of Bank or leasing company, if the

effective tax rate of company is 50% A required rate of return of the company is 18%?

Que. 32: - PQR Limited has decided to go in for a new model of Mercedes Car. The cost of the vehicle is Rs. 40 lakhs the company has two

alternatives:

(i) Taking the car on finance lease; or (ii) borrowing and purchasing the car

LMN Limited is willing to provide the car on finance lease of PQR Limited for five years at annual rental of Rs. 8.75 lakhs,

payable at the end of the year. The vehicle is expected to have useful life of 5 years, an it will fetch a net salvage value of Rs. 10

lakhs at the end of year five. The depreciation rate for tax purpose is 40% on written –down basis. The applicable tax rate for the

company is 35% and incremental borrowing rate of the co. is 13.8462%.

What is the net advantage of leasing for the PQR Limited? Ignore Tax on capital profits

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

Rate of Discount t1 t2 t3 t4 t5

0.138462

0.09

0.8784

0.9174

0.7715

0.7715

0.6777

0.7722

0.5953

0.7084

0.5229

0.6499

Que. 33: - The management of Ram Ltd. is considering an investment project costing Rs. 1,50,000 and it will have a scrap value of Rs.

10,000 at the end of its 5 years life. Transportation charges and installation charges are expected to be Rs. 5,000 and Rs. 25,000

respectively. If the project is accepted, a spare port inventory of Rs. 10,000 must also be maintained. It is estimated that the spare

parts will have an estimated scrap value of 60% of their initial cost after 5 years. Annual revenue from the project is expected to be

Rs. 1,70,000; and annual labour, material and maintenance expenses are estimated to be Rs. 15,000 and Rs. 5,000 respectively.

The depreciation and taxes for five years will be:

Year Depreciation (Rs.) Tax (Rs.)

1

2

3

4

5

72,000

43,200

32,400

21,600

800

11,200

22,720

27,040

31,360

39,680

(a) Calculate the cost of the project and Scrap value of the following after 5 years. (Note: Ignore tax effect on loss in spare ports)

(b) Evaluate the project at 12% rate of interest.

Que 34- A company is reviewing an investment personal in a project involving a capital outlay of Rs. 90,00,000 in plant and machinery .The

project would have at life of 5 year at the end of which the plant and machinery could fetch a resale value of Rs.30,00,000. Father the project

would also need a working capital of Rs. 12,50,000 which would be built during the year I and to be released from the project at the end of

year 5. The project is expected to yield the following cash profit:

Year Cash profit (Rs.)

1.

2.

3.

4.

5.

35,00,000

30,00,000

25,00,000

20,00,000

20,00,000


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A25% deprecation for plant and machinery is available on WDV basis as Income-tax exemption. Assume that the corporate Tax is paid one

year in arrear o the periods to which it relates and the first year deprecation allowance, would be clamed against the profit of year 1. The

assistant Manager Accountant has calculated NPV of the project using the company‟s

corporate target of 20% per-Tax rate of return and has ignored the taxation effect in the cash flows.

As the newly recruited Management Accountant, you realize that the project‟s cash flower should incorporate the effects of tax. The

corporate tax is expected to be 35% during the life of the project and thus the company‟s rate of return post-Tax is 13% (65%of 20%).

Your Assistant is surprised of note the difference between discounting the per-tax cash flows at a per-tax DCF rate and post-tax cash flows at

a post-tax rate.

Required:

a. Calculate he NPV of the project as the Assistant Management Accountant would calculated it‟

b. Re calculate the NPV of the project taking tax into consideration;

c. Comment on the desirability of the project vis-à-vis your finding in (b).

Que 35-Swastik Ltd. manufacturers of special purpose machine tools, have two division which are periodically assistant b visiting teams of

calculation. The Management is worried about the steady increase of expense in this regard over the year. Analysis of last year‟s expenses

reveals the:

Rs.

Consultants‟ Remuneration

Travel and conveyances

Boarding charges

Special Allowances

Accommodation Expenses

2,50,000

1,50,000

2,00,000

50,000

6,00,000

The management estimates accommodation expenses to increase by Rs.2,00,000 annually.

As part of a cast reduction drive, Swastik Ltd. are proposing to construct a consultancy centre to take care of the accommodation

requirements of the consultant. This centre will additionally save the company Rs.50,000 in boarding charges and Rs.2.00.000 in the cost of

Executive training programmes hitherto conducted out side the company‟s premises every year

The following details are available regarding the construction and maintenance of the new center:

(a) Land: at cost of Rs.8,00,000 already owned by the company, will be used.

(b) Construction cost Rs.15,00,000 including special furnishings.

(c) Cost of annual maintenance:Rs.1,50,000.

(d) Construction cost will be written off over 5 years being the useful life.

Assuming that the writ-off of construction cost as aforesaid will be accepted for purpose, that the rate of tax will be 50% and that the desired

rate of return is 15%; you are requested to analyses the feasibility of the proposal and make recommendations.

Que 36-A company is considering which of two mutually exclusive project it should undertake. The finance director think that the project

with the higher NPV should be chosen whereas the Managing Director think that the one with the higher IRR should be undertake especially

as both project have the same initial outlay and length of life.The company anticipates a cost of capital of 10%and the net after-tax cash

flows of the project are as follows:

Year 0 1 2 3 4 5

Cash Flows

Project X

Project Y

(200)

(200)

35

218

80

10

90

10

75

4

20

3

Required:

(a) Calculate the NPV and IRR of each project.

(b) State, with reasons, which project you would recommend.

(c) Explain the inconsistency in the ranking of the two project.

Que 37-SCL Limited, highly profitable company, is engaged he manufacture of power intensive product. As part of its diversification plans

the company propose to put up Windmill to generate electricity. The details of the scheme are as follows:

(1) Cost of the windmill: Rs. 300 lakhs

(2) Cost of land Rs. 15 lakhs

(3) Subside from state Government to be received

At the end of first year of installation Rs. 15 lakhs

(4) Cost of electricity will be Rs.2.25 per unit year 1. this will increase by Rs. 0.25 per unit

every year till year 7. After that it will increase by Rs. 0.50 per unit.

(5) Maintenance cost will be Rs. 4 lakhs in year I and the same will increase by Rs.2 lakhs

every year.

(6) Estimated life 10 years.

(7) Cost of capital 15%.

(8) Residual value of windmill will be nil. However land value will go up to Rs. 60 lakhs, at the end of year 10.

(9) Deprecation will be 100% of the cost windmill in year I and the same will be allowed for tax purpose.

(10) As Windmills are expected to work based on wind velocity, the efficiency is expected to be an average 30%. Gross electricity

generated at this level will be 25 lakhs unite per annum. 4%of this electricity generated will be committed free to this sate Electricity

Board as per the agreement.

(11 )Tax rate 50%.

From the above information you are requested to:


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(a) Calculate the net present value.[Ignore tax on capital profit.]

(b) List down two non-financial factor that should be considered before taking a decision .

For your exercise use the following discount factors:

Year 1 2 3 4 5 6 7 8 9 10

Discount Factors 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25

Que 38-Nine Gems Ltd. has just installed Machine R at accost ofRs.2,00,000.The machine has a five year life with no residual value. The

annual volume of production is estimated at1,50,000 units, which can be sold at Rs. 6 per unit, Annual operating costs are estimated at rs.

20,00 000 (excluding deprecation )at this output level. Fixed costs are estimated at Rs.3 per unit for the same level of production.

Nine Gems Lid has just came across another model called Machine S capable of giving the same output at an annual operating coat of Rs.

1,80,000 (exclusive of deprecation .) There will be no charge in fixed costs. Capital cost of this machine is Rs.2,50,000 and the estimated life

is for five years with nil residual value.

The company has an offer for sale of machine R at Rs. 1,00,000. But the cost of dismantling and removal will amount to Rs.30,000 As the

company has not yet commenced operation, it wants to sell machine R and purchase Machine S.

Nine gems Ltd. will be zero-tax company for seven years in view of several incentives and allowances available.

The cost of capital may be assumed at 14%.

(1) Advise whether the company should opt for the replacement.

(2) Will there be any change in your view, if Machine R has not been installed but the company is in the process of selecting one or the

other machine ?

(3) Support your view with necessary workings.

Que 39-Elite Builders, leading construction company have been approached by a Foreign Embassy to build for them a block of six flats to

be used as guest houses. A per the terms of contract the foreign Embassy would provide Elite Builders the plans and the land costing Rs.25

lakhs. Elite Builders would build the flats at their own cost and lease them out the Foreign Embassy for 15 years at the end of which the flats

will be transferred to the foreign Embassy for a nominal value of Rs. 8 lakhs. Elite Builders estimate the cost of construction as follows:

Area per flat 1,000 sq.ft

Construction cost Rs.400 sq.ft.

Registration and other costs 2.5% of cost construction

Elite Builders will also incur Rs. 4 lakhs each in year 14 and 15 towards repairs.

Elite Builders proposes to charge the lease rentals as follows :

Years Rentals

1 to 5

6 to 10

11 to 15

Norma

120% of normal

150%of normal

Elite builders‟ present tax rate averages at 50%. The full cost of construction will be written off over 15 years and will be allowed for tax

purpose. You are required :

To calculate the normal per flat.

For your exercise assume :

(a) Minimum desired return of 10%

(b) Rentals & repairs will arise on the last day of the year.

(c) Construction registration and other cost will be incurred at time „O‟.

Note :Cumulative discount factors may be used.

Que 40-ABC Limited is considering to acquire an additional sophisticated computer to augment is time share Computer sevices to its

clients. It has two options:

Either, (a) to purchase the Computer at a cost of Rs.44,00,000

Or, (b) to take the Computer on lease for 3 year from leasing company at an annual lease

Rental of Rs. 10 lacs plus 10%of the gross time share service revenue. The

Agreement also requires an additional payment of Rs.12 lacs at the end of the third

Year end and the Computer reverts back to lessor after period of contract.

The company estimates that the computer will be worth Rs.20 lacs at the end of the third year. The gross revenue to be earned

are as follows:-

Year Rs. in lakhs

1

2

3

45

50

55

Annual operating cost (excluding depreciation/lease rental) are estimated at Rs.18 lacs with an additional cost of Rs.2 lacs for start up and

training at the beginning of the first year . These costs are to be borne by purchase of the computer and the repayment are to be made as per

the following schedule:-

Year end Repayment of principal Rs. Interest year Rs. Total Rs.

1

2

3

10,00,000

17,00,000

17,00,000

7,04,000

5,44,000

2,72,000

17,04,000

22,44,000

19,72,000

For the purpose of this computation assume that the company uses the straight line method deprecation on asses and pay 50% tax on its

income.

You are requested to analyes and recommend to the company which of the to option is better. (PV factor @8% for year 1 (0.929), year 2

(0.857),year 3(0.794)and @16% for year 1(0.862), year 2 (0.743)and year 3(0.641)]


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Que. 41- Santosh & Co. is considering setting up a new unit. The following data has been compiled by the company for the purpose of

determining the acceptability of the proposal for setting up the new unit.

(i) Land

(a) To be paid at the time of purchase (t =0) Rs. 2 lakhs

(b) 1st , 2nd & 3rd installments at the end of next 3 following years. Rs. 1 lakh each installment

(ii) Factory buildings (Total Rs. 20 lakhs)

(a) Initial payment on signing of contract Rs. 2 lakhs

(b) At the end of year 2 Rs. 10 lakhs

(c) Balance at the end of year 3 Rs. 8 lakhs

(iii) Plant, Machinery & Equipment:

To be paid at the beginning of

- year 4 Rs. 15 lakhs

- year 5 Rs. 5 lakhs

(iv) Extra margin for working capital (at the end of year 5) Rs. 4 lakhs

(v) Operations will begin in the 6th year and will continue for 10 years upto year 15. Assume revenue and costs at the end of each

year.

(vi) Building, Plant, Machinery and equipment will be depreciated on straight line method over the 10 years starting from year 6,

as under:

Building @ 5% Plant, machinery and equipment @ 10%

(vii) Buildings are expected to be sold Rs. 6 lakhs and land for Rs. 8 lakhs at the end.

(viii) Plant, Machinery & Equipment will have a salvage value of Rs. 2 lakhs.

(ix) Cost of Capital is 12%.

(x) Other operating data:

Annual Sales Rs. 30 lakhs.

Variable costs of operation Rs. 12 lakhs

Fixed costs (excluding depreciation) Rs. 8 lakhs: and Tax rate 50%.

Assuming Profit or loss on sale of assets at end has no tax effect.

Advise whether the company should accept the project or reject it on the basis of NPV of the project.

Que. 42- Sagar industries, is planning to introduce a new product with a projected life of 8 years. The project, to be set up in a backward

region, qualifies for a one – time (as it5s starting) tax – free subsidy from the government of Rs. 20 lakhs equipment cost will be

Rs. 140 lakhs and additional equipment costing Rs. 10 lakhs will be needed at the beginning of the third year. At the end of 8

years the original equipment will have no resale value, but the supplementary equipment can be sold for Rs. 1 lakh. A working

capital of Rs. 15 lakhs will be needed. The sales volume over the eight – year period have been forecasted as follows:

Year Units

0 80,000

1 1,20,000

3-5 3,00,000

6-8 2,00,000

A sale price of Rs. 100 per unit is expected and variable expenses will amount to 40% of sales revenue. Fixed cash operating costs

will amount to Rs. 16 lakhs per year. In addition, an extensive advertising will be implemented, requiring annual outlays as

follows:

Year (Rs. in lakhs)

1 30

2 15

3-5 10

6-8 4

The company is subject to 50% tax and considers 12% to be an appropriate after –tax cost of capital for this project. The company

follows the straight line method of depreciation.

Should the project be accepted? Assume that the company has enough income form its existing products.

You Should Know

1. ADVANTAGES AND DISADVANTAGES OF IRR AND NPV

A number of surveys have shown that, in practice, the IRR method is more popular than the NPV approach. The reason may be that the IRR is straightforward, but it uses cash flows and recognizes the time value of money, like the NPV. In other words, while the IRR method is easy and understandable, it does not have the drawbacks of the ARR and the payback period, both of which ignore the time value of money.

The main problem with the IRR method is that it often gives unrealistic rates of return. Suppose the cutoff rate is 11% and the IRR is calculated as 40%. Does this mean that the management should immediately accept the project because its IRR is 40%. The answer is no! An IRR of 40% assumes that a firm has the opportunity to reinvest future cash flows at 40%. If past experience and the economy indicate that 40% is an unrealistic rate for future reinvestments, an IRR of 40% is suspect. Simply speaking, an IRR of 40% is too good to be true! So


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unless the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a yardstick to accept or reject a project.

Another problem with the IRR method is that it may give different rates of return. Suppose there are two discount rates (two IRRs) that make the present value equal to the initial investment. In this case, which rate should be used for comparison with the cutoff rate? The purpose of this question is not to resolve the cases where there are different IRRs. The purpose is to let you know that the IRR method, despite its popularity in the business world, entails more problems than a practitioner may think.

2. WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT PROJECTS

When comparing two projects, the use of the NPV and the IRR methods may give different results. A project selected according to the NPV may be rejected if the IRR method is used.

Suppose there are two alternative projects, X and Y. The initial investment in each project is $2,500. Project X will provide annual cash flows of $500 for the next 10 years. Project Y has annual cash flows of $100, $200, $300, $400, $500, $600, $700, $800, $900, and $1,000 in the same period. Using the trial and error method explained before, you find that the IRR of Project X is 17% and the IRR of Project Y is around 13%. If you use the IRR, Project X should be preferred because its IRR is 4% more than the IRR of Project Y. But what happens to your decision if the NPV method is used? The answer is that the decision will change depending on the discount rate you use. For instance, at a 5% discount rate, Project Y has a higher NPV than X does. But at a discount rate of 8%, Project X is preferred because of a higher NPV.

The purpose of this numerical example is to illustrate an important distinction: The use of the IRR always leads to the selection of the same project, whereas project selection using the NPV method depends on the discount rate chosen.


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Another important tool in the hands of finance managers for ascertaining the changes in financial position of

a firm between two accounting periods is known as funds flow statement. Funds flow statement analyses the reasons for

change in financial position between two balance sheets. It shows the inflow and outflow of funds i.e., sources and application

of funds during a particular period. Fund Flow Statement summarises for a particular period the resources made available to

finance the activities of an enterprise and the uses to which such resources have been put. A fund flow statement may serve as

a supplementary financial information to the users. Fund. means working capital. Working capital is viewed as the difference

between current assets and current liabilities.

Importance of Funds Flow Statement

The balance sheet and profit and loss account failed to provide the information which is provided by funds flow statement i.e.,

changes in financial position of an enterprise. This statement indicates the changes which have taken place between the two

accounting dates. This statement by giving details of sources and uses of funds during a given period is of great help to the

users of financial information. It is also a very useful tool in the hands of management for judging the financial and operating

performance of the company. It also indicates the working capital position which helps the management in taking policy

decisions regarding dividend etc. The projected funds flow statement can also be prepared and thus budgetary control and

capital expenditure control can be exercised in the organisation.

Funds Flow Statement vs. Cash Flow Statement

Both funds flow and cash flow statements are used in analysis of past transactions of a business firm. The

differences between these two statements are given below:

(a) Funds flow statement is based on the accrual accounting system. In case of preparation of cash flow statements all

transactions effecting the cash or cash equivalents only is taken into consideration.

(b) Funds flow statement analyses the sources and application of funds of long-term nature and the net increase or decrease in

long-term funds will be reflected on the working capital of the firm. The cash flow statement will only consider the increase or

decrease in current assets and current liabilities in calculating the cash flow of funds from

operations.

(c) Funds Flow analysis is more useful for long range financial planning. Cash flow analysis is more useful for identifying and

correcting the current liquidity problems of the firm.

(d) Funds flow statement tallies the funds generated from various sources with various uses to which they are put. Cash flow

statement starts with the opening balance of cash and reach to the closing balance of cash by proceeding through sources and

uses.


Que. 1 From the following particulars, calculate Cash Flows from Operating Activities by Indirect Method.

Dr. Profit & Loss Account of X Ltd. Cr.

For the year ended 31st March, 20X2

Particulars Rs Particulars Rs

To Depreciation

To Discount on Issue of Debentures w/o

To Interest on Long-term Borrowings

To Loss on Sale of Machine

To Patents w/o

To Provision for Tax

To Transfer to Reserve

To Interim Divided

To Proposed Divided

To Premium payable on redemption

of Red. Pre. Share

To Net Profit

1,40,000

1,000

28,000

30,000

1,50,000

1,00,000

90,000

72,000

10,000

By Operating Profit before

Depreciation

By Profit on Sale on Investments

By Dividend on Shares

By Interest on Investments

By Rent from a plot of Land

By Insurance Proceeds from

earthquake disaster settlement

By Refund of Tax

9,18,000

20,000

10,000

6,000

30,000

1,00,000

3,000

Chapter : Fund Flow Statements

Chapter : Cash Flow Statements


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4,36,000

10,87,000 10,87,000

Additional information:

Particulars 31.3.20X1

Rs

31.3.20X2

Rs

Stock

Trade Debtors

Trade Creditors

Provision for Tax

Prepaid Manufacturing Overheads

Outstanding Office & Adm. Expenses

Prepaid Selling & Distribution Expenses

Outstanding Trading Commission Payable

Accrued Trading Commission Receivable

1,00,000

10,000

5,000

50,000

16,000

10,000

10,000

10,000

10,000

1,50,000

6,00,000

1,50,000

82,000

10,000

15,000

14,000

15,000

30,000

Solution

Cash Flows from Opening Activities (Under Indirect Method)

Particulars Rs.

A. Net Profit as per Profit & Loss A/c

Add: Proposed dividend for the current year

Add: Interim dividend paid during the year

Add: Transfer to reserve

Add: Provision for Tax made during the Current Year

Less: Refund of Tax

Less: Extraordinary item (i.e., Insurance proceeds from Earthquake

disaster settlement)

B. Net profit before taxation, and extraordinary item

C. Add: Items to be added:

Depreciation

Interest on Long term borrowings

Discount on Issue of Debenture w/o

Patents written off

Loss on sale of Machinery

Premium payable on redemption of Preference shares

D. Less: Items to be deducted:

Interest Income

Dividend Income

Rental Income

Profit on sale of investments

E. Operation Profit before working capital charges [B + C – D]

F. Add: Decrease in Current Assets & Increase in Current Liabilities:

Decrease in Prepaid Mfg. Overheads

Increase in Creditors for goods

Increase in Outstanding Trading Commission

Increase in Outstanding Office & Adm. Expenses

G. Less: Increase in Current Assets & Decrease in Current Liabilities:

Increase in Stock

Increase in Debtors

Increase in Prepaid Selling & Distribution Expenses

Increase in Accrued Commission

H. Cash generated from operations [E + F – G]

I. Less: Income taxes paid (Net of Refund)

J. Cash flow before extraordinary item [H – I]

K. Extraordinary items

L. Net Cash from Operating Activities

4,36,000

72,000

90,000

1,00,000

1,50,000

3,000

1,00,000

7,45,000

1,40,000

28,000

1,000

30,000

30,000

10,000

10,000

6,000

30,000

20,000

6,000

1,45,000

5,000

5,000

50,000

5,90,000

4,000

20,000

2,39,000

66,000

9,18,000

1,161,000

6,64,000

4,15,000

1,15,000

3,00,000

1,00,000

4,00,000

Que. 2 From the following Balance Sheets of X Ltd., prepare Cash Flow Statement:

Liabilities 31.3.20X1

Rs.

31.3.30X2

Rs

Assets 31.3.20X1

Rs

31.3.20X2

Rs

Equity Share Capital

15% Redeemable Pref.

Share Capital

General Reserve

3,00,000

1,50,000

40,000

4,00,000

1,00,000

70,000

Goodwill

Land & Building

Plant &Machinery

Debtors

1,15,000

2,00,000

80,000

1,60,000

90,000

1,70,000

2,00,000

2,00,000


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79

Profit & Loss A/c

Creditors

Bills Payable

Provision for Taxation

Proposed Dividend

30,000

55,000

20,000

40,000

42,000

48,000

83,000

16,000

50,000

50,000

Stock

Bills Receivable

Cash in Hand

Cash at Bank

77,000

20,000

15,000

10,000

1,09,000

30,000

10,000

8,000

6,77,000 8,17,000 6,77,000 8,17,000

Additional Information:

(a) Depreciation of Rs 10,000 and Rs 20,000 has been charged on plant and land and buildings respectively.

(b) An interim dividend of Rs 20,000 has been paid, and

(c) Income-tax Rs 35,000 has been paid.

Solution

Cash Flow Statement

For the year ended 31st March, 20X2

Particulars Rs. Rs.

I. Cash Flows from Operating Activities:

A. Closing Balance as per Profit & Loss A/c

Less: Opening balance as per Profit & Loss A/c

Add: Proposed dividend during the year (on equity & Preference

shares)

Add: Interim dividend paid during the year

Add: Transfer to reserve

Add: Provision fo Tax

B. Net Profit before taxation, and extraordinary item

C. Add: Items to be added

Depreciation

Goodwill w/o

D. Operating Profit before working capital charges [B + C]

E. Add: Decrease in Current Assets & Increase in Current Liabilities:

Increase in Creditors for goods

F. Less: Increase in Current Assets & Decrease in Current Liabilities:

Increase in Stock

Increase in Debtors (Gross)

Increase in Bills Receivable

Decrease in Bills Payable

G. Cash generated from operations [D + E – F]

H. Less: Income taxes paid (Net of Refund)

I. Net Cash from Operating Activities

II. Cash Flows from Investing Activities:

Purchases of Plant

Proceeds from sale of Building

Net Cash used in investing activities

III. Cash Flows from Financing Activities:

Proceeds from issuance of share capital

Redemption of Preference shares

Interim Dividend Paid

Final Dividend paid (on equity & preference shares)

Net Cash used in financing activities

IV. Net Decrease in Cash and Cash Equivalents [I + II + III]

V. Cash and Cash Equivalents at Beginning of Period

Cash in hand

Cash at Bank

VI. Cash and Cash Equivalents at end of Period [IV + V]

Cash in hand

Cash at bank

30,000

25,000

32,000

40,000

10,000

4,000

15,000

10,000

10,000

8,000

48,000

(30,000)

50,000

20,000

30,000

45,000

1,63,000

55,000

2,18,000

28,000

(86,000)

1,60,000

(35,000)

1,25,000

(1,30,000)

10,000

(1,20,000)

1,00,000

(50,000)

(20,000)

(42,000)

(12,000)

(7,000)

25,000

18,000

Working Notes:

Dr. (i) Plant Account Cr.


To Balance b/d

To Bank A/c (Purchases)

(Balancing figure)

80,000

1,30,000

By Depreciation A/c

By Balance c/d

10,000

2,00,000

2,10,000 2,10,000

Dr. (ii) Land & Building Account Cr.



80

80

To Balance b/d 2,00,000 By Depreciation A/c

By Bank A/c (Sale)

(Balancing figure)

By Balance c/d

20,000

10,000

1,70,000

2,00,000 2,00,000

Que. 3 From the following particulars, prepare Cash Flow Statement.

Liabilities 20X2

Rs.

20X1

Rs

Assets 20X2

Rs

20X1

Rs


12% Pre. Share Capital

General Reserve

Profit & Loss A/c

15% Debentures

Creditors

Provision for Taxation

Proposed Dividend

Bank Overdraft

80,000

20,000

4,000

2,400

14,000

22,000

8,400

11,600

13,600

55,000

25,000

4,000

2,000

12,000

24,000

6,000

10,000

25,000

Fixed Assets

Less: Accumulated

Depreciation

Debtors

Stock

Prepaid Expenses

Cash

80,000

30,000

50,000

48,000

70,000

1,000

7,000

82,000

22,000

60,000

40,000

60,000

600

2,400

1,76,000 1,63,000 1,76,000 1,63,000

Additional Information: (a) Provision for Tax made Rs 9,400, (b) Fixed Assets sold for Rs 10,000, their cost Rs 20,000 and

accumulated depreciation till date of sale of them Rs 6,000 (c) An Interim Dividend paid during the year Rs 9,000.

Que. 4 From the following particulars, prepare the Cash Flows Statement:

Liabilities 20X2

Rs.

20X1

Rs

Assets 20X2

Rs

20X1

Rs

Share Capital

Reserve

10% Loans

10% Public Deposits

Creditors

Outstanding Expenses

Provision for Doubtful

Debts

5,00,000

80,000

3,00,000

30,000

1,50,000

6,000

4,000

5,00,000

1,50,000

1,00,000

50,000

1,40,000

7,000

3,000

Lands & Building

Plant & Machinery

Stock

Debtors

Cash

1,20,000

6,00,000

75,000

1,60,000

1,15,000

80,000

5,00,000

1,00,000

1,50,000

1,20,000

10,70,000 9,50,000 10,70,000 9,50,000

During the year, Rs 50,000 depreciation has been provided on Plant & Machinery and a machine costing Rs 15,000

(Depreciation provided thereon Rs 10,000) was sold at 60% profit on book value.

Que. 5 From the following Balance Sheets of X Ltd. prepare a Cash flow Statement.

Liabilities 20X1

Rs.

20X2

Rs

Assets 20X1

Rs

20X2

Rs


General Reserve

Profit & Loss A/c

10% Debentures

Sundry Creditors

Bills Payable

Provision for Depreciation

On Machinery

30,000

10,000

6,000

15,000

7,500

1,000

9,000

35,000

15,000

7,000

25,000

11,000

1,500

13,000

Goodwill

Machinery

10% Investments

Stock

Debtors

Cash and Bank Balance

Discount on Debentures

10,000

41,000

3,000

4,000

8,000

12,000

500

8,000

54,000

8,000

5,500

19,000

13,000

78,500 1,07,000 78,500 1,07,000

Additional Information: Investments costing Rs 3,000 were sold Rs 2,800 during the year 20X2. A new machine was

purchased for Rs 13,000.

Que. 6 XYZ Ltd. company‟s Comparative Balance Sheet for 2009 and the Company‟s Income Statement for the year follows:

XYZ Ltd.

Comparative Balance Sheet December 31, 2009 and 2008 (Rs. Crores)

Particulars 2009 2008

Sources of Funds:

Share holder‟s Funds:

Share capital

Retained earnings

Loan Funds:

Bonus payable

140

110 250

135

385

140

92 232

40

272


81

81

Application of Funds:

Fixed Assets:

Plant and equipment

Less: Accumulated depreciation

Investments

Current Assets:

Inventory

Accounts receivable

Prepaid expenses

Cash

Less: Current Liabilities and Provisions

Accounts payable

Accrued Liabilities

Deferred income-tax provision

430

(218) 212

60

205

180

17

26

428

230

70

15

315 113

385

309

(194) 115

75

160

270

20

10

460

310

60

8

378 82

272

XYZ Ltd.

Income Statement for the year ended December 31, 2009 (Rs.Crores)

Particulars

Sales

Less: Cost of goods sold

Gross margin

Less: Operating expenses

Net operating income

Non- operating items:

Loss on sale of equipment

Income before taxes

Less: Income- taxes

Net income

1,000

530

470

352

118

(4)

114

48

66


(i) Dividends of Rs 48 crores were paid in 2009.

(ii) The loss on sale of equipment of Rs 4 crore reflects a transaction in which equipment with an original cost of Rs

12 crores and accumulated depreciation Rs 5 crore were sold for Rs 3 crore in cash.

Required: Using the indirect method, determine the net cash provided by operating activities for 2009 and construct a

statement of cash flows.

Que. 7 The following is the Income statement of XYZ Company for the year 2009

(Rs.)

Sales

Add: Equity in ABC Company‟s earning

Expenses:

Cost of goods sold

Salaries

Depreciation

Insurance

Research and development

Patent amortization

Interest

Bad debts

Income tax:

Current

Deferred

Total expenses

Net income

1,62,700

6,000

1,68,700

89,300

34,400

7,450

500

1,250

900

10,650

2,050

6,600

1,550 8,150

1,54,650

14,050

Additional information are;

(i) 70% gross revenue from sales were on credit.

(ii) Merchandise purchases amounting to Rs 92,000 were on credit.

(iii) Salaries payable totaled Rs 1,600 at the end of year.

(iv) Amortisation of premium on bonds payable was Rs 1,350.


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(v) No dividends were received from the other company.

(vi) XYZ Company declared cash dividend of Rs 4,000.

(vii) Charges in Current assets and Current liabilities were as follows: Increase (Decrease)(Rs.)

Cash

Marketable securities

Accounts receivable

Allowance for bad debt

Inventory

Prepaid insurance

Accounts payable (for merchandise)

Salaries payable

Dividends payable

500

1,600

(7,150)

(1,900)

2,700

700

5,650

(2,050)

(3,000)

Prepare a statement showing the amount of cashflow from operations.

Que. 8 From the following summary Cash account of X Ltd. prepare Cashflow statement for the year ended 31st March, 2009

in accordance with AS-3 (Revised) using the direct method. The company does not have any cash equivalents.

Summary Cash Account for the year ended 31.3.2009 (Rs. „000)

Balance on 1-4-2005

Issue of equity Shares

Receipts from customers

Sale of fixed assets

50

300

2,800

100

Payment of suppliers

Purchase of fixed assets

Overhead expenses

Wages and salaries

Taxation

Dividend

Repayment of bank loan

Balance on 31.3.2006

2,000

200

200

100

250

50

300

150

3,250 3,250

Que. 9 Ms. Jyothi of Star Oils Limited has collected the following information for the preparation of Cashflow statement for

the year 2009:

Net Profit

Dividend (including dividend tax) paid

Provision for Income-tax

Income-tax paid during the year

Loss on sale of assets (net)

Book value of the assets sold

Depreciation charged to Profit and Loss A/c

Amortisation of capital grant


Carrying amount of investment sold

Interest income on investments

Interest expenses

Interest paid during the year

Increase in working capital (excluding cash and bank balances)

Purchases of fixed assets

Investment in Joint venture

Expenditure on construction work-in-progress

Proceeds from calls-in-arrear

Receipt of grant for capital projects

Proceeds from long-term borrowings

Proceeds from short-tem borrowings

Opening cash and bank balance

Closing cash and bank balance

25,000

8,535

5,000

4,248

40

185

20,000

6

100

27,765

2,506

10,000

56,075

14,560

3,850

34,740

2

12

25,980

20,575

20,575

5,003

6,988

Required- Prepare the Cashflow statement for the year 2009 in accordance with „AS -3, Cashflow Statements‟ issued by the

Institute of Chartered Accountants of India. (Make necessary assumptions).

Que. 10 From the information contained in Income Statement and Balance Sheet of „A‟ Ltd., prepare cash flow statement:

Income Statement for the year ended March 31, 2009 (Rs)

Net Sales (a)

Less:

Cash cost of sales

Depreciation

Salaries and wages

Operating expenses

2,52,00,000

1,98,00,000

6,00,000

24,00,000

8,00,000


83

83

Provision for taxation

(b)

Net operating profit (a) – (b)

Non-recurring income (profit on sale of equipment)

Retained earnings and profit brought forward

Dividends declared and paid during the year

Profit and Loss account balance as on March 31, 2009

8,80,000

2,44,80,000

7,20,000

1,20,000

8,40,000

15,18,000

23,58,000

7,20,000

16,38,000

(Rs)

Balance Sheet as on March 31

2009

March 31

2008

Assets

Fixed Assets:

Land

Buildings and equipment

Current Assets:

Cash

Debtors

Stock

Advances

Liabilities and Equity

Share capital

Surplus in Profit and Loss account

Sundry creditors

Outstanding expenses

Income-tax payable

Accumulated depreciation on Buildings and equipment

4,80,000

36,00,000

6,00,000

16,80,000

26,40,000

78,000

90,78,000

36,00,000

15,18,000

24,00,000

2,40,000

1,20,000

12,00,000

90,78,000

9,60,000

57,60,000

7,20,000

18,60,000

9,60,000

90,000

1,03,50,000

44,40,000

16,38,000

23,40,000

4,80,000

1,32,000

13,20,000

1,03,50,000

The original cost of equipment sold during the year 2008-09 was Rs 7,20,000.

Que. 11 The Balance Sheet of JK Limited as on 31st March, 2008 and 31

st March, 2009 are given below;

Balance Sheet as on (Rs 000)

Liabilities 31-03-08 31-03-09 Assets 31-09-08 31-03-09

Share Capital

Capital reserve

General reserve

Profit and Loss Account

9% Debentures

Current liabilities

Proposed dividend

Provision for tax

Unpaid dividend

1,440

--

816

288

960

576

144

432

--

1,920

48

960

360

672

624

174

408

18

Fixed Assets

Less: Depreciation

Investment

Cash

Other Current assets

(including stock)

Preliminary expenses

3,840

1,104

2,736

480

210

1,134

96

4,560

1,392

3,168

384

312

1,272

48

4,656 5,184 4,656 5,184


(i) During the year 2008-09, fixed assets with a book value of Rs 2,40,000 (accumulated depreciation Rs 84,000)

was sold for Rs 1,20,000.

(ii) Provided Rs 4,20,000 as depreciation.

(iii) Some investments are sold at a profit of Rs 48,000 and profit was credited to capital reserve.

(iv) It decided that stocks be valued at cost, whereas previously the practice was to value stock at cost less 10 per

cent. The stock was Rs 2,59,200 as on 31-03-08. The stock as on 31-03-09 was correctly valued at Rs 3,60,000.

(v) It decided to write off Fixed assets costing Rs 60,000 on which depreciation amounting to Rs 48,000 has been

provided.

(vi) Debentures are redeemed at Rs 105.

Required; Prepare a Cash flow statement.

Que. 12 The Balance Sheet of X Ltd. as on 31st March, 2009 is as follows:

Liabilities (Rs 000) Assets (Rs 000)


8% Preference share capital

Reserve and surplus

10% Debentures

6,000

3,250

1,400

1,950

Fixed assets (at cost) 16,250

Less: Dep. Written off 5,200

Stock

Sundry debtors

11,050

1,950

2,600


84

84

Sundry creditors 3,250 Cash 250

15,850 15,850

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 fixed assets to sales ratio would be 1.4.

(iii) Fixed assets costing Rs 30,00,000 to be installed on 1st April 2009, payment would be made on March, 31 2010.

(iv) In March, 2010, a dividend of 7 per cent on equity capital would be paid.

(v) Rs 5,50,000, 11% Debentures would be issued on 1st April, 2009.

(vi) Rs 30,00,000, Equity shares would be issued on 31st March, 2010.

(vii) Creditors would be 25% of materials consumed.

(viii) Debtors would be 10% of sales.

(ix) The cost of goods sold would be 90% of sales including material 40% and depreciation 5% of sales.

(x) The profit is subject to debenture interest and taxation @ 30%.

Required:

(i) Prepare the projected balance sheet as on 31st March, 2010.

(ii) Prepare projected cash flow statement in accordance with AS-3.

Que. 13 X Ltd. has the following balances as on 1st April 2009: (Rs)

Fixed assets

Less; Depreciation

Stocks and Debtors

Bank balance

Creditors

Bills payable

Capital (shares of Rs 100 each)

11,40,000

3,99,000

7,41,000

4,75,000

66,500

1,14,000

76,000

5,70,000

The company made the following estimates for financial year 2009-10:

(i) The company will pay a free of tax dividend of 10% the rate of tax being 25%.

(ii) The company will acquire fixed assets costing Rs 1,90,000 after selling one machine for Rs 38,000 costing Rs

95,000 and on which depreciation provided amounted to Rs 66,500.

(iii) Stocks and Debtors, Creditors and Bills Payables at the end of financial year are expected to be Rs 5,60,500, Rs

1,48,200 and Rs 98,800 respectively.

(iv) The profit would be Rs 1,04,500 after depreciation of Rs 1,14,000.

Prepare the projected cash flow statement and ascertain the bank balance of X Ltd. at the end of financial year 2009-10.

Que. 14 Balance sheets of a company as on 31st March, 2007 and 2008 were as follows:

Liabilities 31-03-07

(Rs)

31-03-08

(Rs)

Assets 31-09-07

(Rs)

31-03-08

(Rs)


8% Preference share capital

General reserve

Securities premium

Profit and loss A/c

11% Debentures

Creditors

Provision for taz

Proposed dividend

10,00,000

2,00,000

1,20,000

--

2,10,000

5,00,000

1,85,000

80,000

1,36,000

10,00,000

3,00,000

1,45,000

25,000

3,00,000

3,00,000

2,15,000

1,05,000

1,44,000

Goodwill

Land and Buildings

Plant and Machinery

Investment (Non-trading)

Stock

Debtors

Cash and bank

Prepaid expenses

Premium on redemption

Of Debentures

1,00,000

7,00,000

6,00,000

2,40,000

4,00,000

2,88,000

88,000

15,000

--

80,000

6,50,000

6,60,000

2,20,000

3,85,000

4,15,000

93,000

11,000

24,31,000 25,34,000 24,31,000 25,34,000


(1) Investments were sold during the year at a profit of Rs 15,000.

(2) During the year an old machine costing Rs 80,000 was sold for Rs 36,000. Its written down value was Rs

45,000.

(3) Depreciation charged on plant and machinery @ 20 percent on the opening balance.

(4) There was no purchase or sale of land and buildings.

(5) Provision for tax made during the year was Rs 96,000.

(6) Preference shares were issued for consideration of cash during the year.

You are required to prepare:

(i) Cash flow statement as per AS-3.

(ii) Schedule of Changes in working capital.

Solution

Working Notes


85

85

Provision for Tax A/c

To Bank (paid)

To Balance c/d

Rs

71,000

1,05,000

By Balance b/d

By Profit and loss A/c

Rs.

80,000

96,000

1,76,000 1,76,000

Investment A/c

To Balance b/d

To Profit and loss A/c (profit on sale)

Rs

2,40,000

15,000

By Bank A/c

By Balance c/d

Rs

35,000

2,20,000

2,55,000 2,55,000

Plant and Machinery A/c

To Balance b/d

To Bank A/c (purchase)

Rs

6,00,000

2,25,000

By Bank (sale)

By Profit and loss A/c (loss of sale)

By Depreciation

By Balance c/d

Rs

36,000

9,000

1,20,000

6,60,000

8,25,000 8,25,000

Note- Since the date of redemption of debentures is not mentioned in the question, it is assumed that the debentures are

redeemed at the beginning of the year.

Cash Flow Statement for the year ending 31st March, 2008 (Rs)

(A) Cash flow from Opening Activities

Profit and Loss A/c as on 31-3-2008

Less: Profit and Loss as on 31-3-2007

Add: Transfer to General reserve

Provision for tax

Proposed dividend

Profit before tax

Adjustment for Depreciation:

Land and Buildings

Plant and machinery


Loss on sale of plant and machinery

Goodwill written off

Interest expenses

Operating profit before working capital changes

Adjustment for working capital changes:

Decrease in Prepaid expenses

Decrease in Stock

Increase in Debtors

Increase in Creditors

Cash generated from operations

Income tax paid

Net Cash Inflow from Operating Activities

(B) Cash flow from Investing Activities

Sale of investment

Sale of Plant and machinery

Purchases of Plant and machinery

Net Cash Outflow from Investing Activities

(C) Cash Flow from Financing Activities

Issue of Preference shares

Premium received on issue of securities

Redemption of Debentures at premium

Dividend paid

Interest paid to Debenture holders

Net Cash Outflow from Financing Activities

Net increase in Cash and Cash Equivalents during the year

Cash and Cash Equivalents at the beginning of the year

25,000

96,000

1,44,000

50,000

1,20,000

(a)

(b)

(c)

(a) + (b) + (c)

3,00,000

2,10,000

90,000

2,65,000

3,55,000

1,70,000

(15,000)

9,000

20,000

33,000

5,72,000

4,000

15,000

(1,27,000)

30,000

4,94,000

(71,000)

4,23,000

35,000

36,000

(2,25,000)

(1,54,000)

1,00,000

25,000

(2,20,000)

(1,36,000)

(33,000)

(2,64,000)

5,000

88,000


86

86

Cash and Cash Equivalents at the end of the year 93,000

Schedule of Charges in Working Capital (Rs)

Particulars 31st March Charge in working capital

2007 2008 Increase Decrease

Current Assets:

Stock

Debtors

Prepaid expenses

Cash and bank

Current Liabilities:

Creditors

Working Capital

Increase in Working capital

4,00,000

2,88,000

15,000

88,000

7,91,000

1,85,000

1,85,000

6,06,000

83,000

6,89,000

3,85,000

4,15,000

11,000

93,000

9,04,000

2,15,000

2,15,000

6,89,000

--

6,89,000

--

1,27,000

--

5,000

--

--

1,32,000

15,000

--

4,000

--

30,000

83,000

1,32,000

Que. 15- From the following Balance Sheet and information prepare a Cash Flow Statement

31.3.2003 31.3.2002

Liabilities

Equity Share Capital 6,00,000 5,00,000

10% Redeemable Preference Capital ----- 2,00,000

General Reserve 1,00,000 2,50,000

Profit and Loss A/c 70,000 50,000

Capital Reserve 1,00,000 -----

Capital Redemption Reserve 1,00,000 -----

9% Debentures 2,00,000 -----

Sundry Creditors 95,000 80,000

Outstanding Expenses 30,000 20,000

Provision for Taxation 95,000 60,000

Proposed Dividend 90,000 60,000

Bills Payable 20,000 30,000

15,00,000 12,50,000

Assets

Land & Building 1,50,000 2,00,000

Plant & Machinery 7,65,000 5,00,000

Investments 50,000 80,000

Inventories 95,000 90,000

Bills Receivable 65,000 70,000

Sundry Debtors 1,75,000 1,30,000

Preliminary Expenses 10,000 25,000

Voluntary Separation Payments 1,25,000 65,000

Cash & Bank 65,000 90,000

15,00,000 12,50,000

Other information:

1. A piece of land has been sold out for Rs. 1,50,000 (Cost – Rs. 1,20,000) and the balance land was revalued. Capital reserve

consisted of profit on sale and profit on revaluation.

2. on 1.4.2002 a plant was sold for Rs. 90,000 (original cost – Rs. 70,000 and W.D.V. – Rs. 50,000) and Debenture worth Rs. 1

lakh was issued at par as part consideration for plant of Rs. 4.5 lakhs acquired.

3. Part of investments (Cost – Rs. 50,000) was sold for Rs. 70,000. 50% of the convertible debentures were converted during the

year at par.

4. Pre –acquisition dividend received Rs. 5,000 was adjusted against cost of investment.

5. Directors have proposed 15% dividend for the current year.

6. Voluntary Separation Cost of Rs. 50,000 was adjusted against General Reserve.

7. Income –tax liability for the current year was estimated at Rs. 1,35,000.

8. Depreciation @ 15% has been written off from Plant Account but no depreciation has been charged on Land and Building.

Que. 16:- The Balance Sheet of New Light Ltd. for the years ended 31st March, 2001 and 2002 are as follows:

Liabilities 31-03-01 31-03-02 Assets 31-03-01 31-03-02

Equity share Fixed Assets 32,00,000 38,00,000

Capital 12,00,000 16,00,000 Less: Dep. 9,20,000 11,60,000

10% Pre. Share 22,80,000 26,40,000

Capital 4,00,000 2,80,000 Investment 4,00,000 3,20,000

Capital Reserve ----- 40,000 Cash 10,000 10,000

General Reserve 6,80,000 8,00,000 Other current

P & L A/c 2,40,000 3,00,000 assets 11,10,000 13,10,000

9% Debentures 4,00,000 2,80,000 Preliminary exp. 80,000 40,000


87

87

Current liab. 4,80,000 5,20,000

Proposed dividend 1,20,000 1,44,000

Provision for Tax 3,60,000 3,40,000

Unpaid dividend ---- 16,000

38,80,000 43,20,000 38,80,000 43,20,000


(i) The company sold one fixed asset for Rs. 1,00,000, the cost of which was Rs. 2,00,000 and the depreciation provided en it

was Rs. 80,000.

(ii) The company also decided to write off another fixed asset costing Rs. 56,000 on which depreciation amounting to Rs. 40,000

has been provided.

(iii) Depreciation on fixed assets provided Rs. 3,60,000.

(iv) Company sold some investment at s profit of Rs,. 40,000, which was credited to capital reserve.

(v) Debentures and preference share capital redeemed at 5% premium.

(vi) Company decided to value stock at cost, whereas previously the practice was to value stock at cost less, 10%. The stock

according to books on 31.3.2001 was Rs. 2,16,000. The stock on 31.3.2002 was correctly valued at Rs. 3,00,000.

Prepare cash Flow Statement as per revised Accounting Standard 3 by indirect method.

Que. 17- The Summarized Balance Sheet of LAL & LAL Ltd. for the years ended 31.3.2001and 31.3.2002 are given below:

Liabilities 31.3.01

Rs.

31.3.02

Rs.

Assets 31.3.01

Rs.

31.3.02

Rs.

Share Capital

General reserve

P/L account

Bank loan (long term)

Creditors

Provision for taxation

500

200

40

--

158

45

500

220

32

100

172

30

Land & Buildings

Plant & machinery

Other fixed assets

Investments

Stock

Debtors

Cash at bank

180

210

30

50

200

170

103

200

276

45

50

190

195

98

943 1054 943 1054

Prepare a statement of Cash Flow, given the following additional information relating to the year ended 31.3.2002.

(a) Dividend amounting to Rs. 30,000 was paid during the year.

(b) Provision for taxation made Rs. 12,000.

(c) Machinery Worth Rs. 15,000 (book value) was sold at a loss of Rs. 3,000.

(d) Investment costing Rs. 10,000 was sold for Rs. 12,000.

(e) Depreciation provided on assets:

Land and buildings Rs. 5,000

Plant and Machinery Rs. 20,000

Que. 18- Summarised balance Sheets of Ganga Ltd. for years ending 31.3.2001 and 31.3.2002 are reproduced below:

Liabilities 31.3.2001

Rs.

31.3.2002

Rs.

Assets 31.3.2001

Rs.

31.3.2002

Rs.

Equity Capital

General Reserve

Profit and Loss A/c

16% Debentures

Sundry Creditors

(less depreciation)

60,00,000

30,90,000

1,50,000

--

3,10,000

60,00,000

34,10,000

1,80,000

15,00,000

3,70,000

Land & Buildings,

(less depreciation)

Plant & Machinery

(less depreciation)

Furniture and fixture

Investments

Debtors

Stock

Cash and bank

14,20,000

31,00,000

8,40,000

50,000

30,00,000

3,40,000

8,00,000

17,50,000

37,50,000

9,80,000

60,000

36,00,000

4,20,000

9,00,000

95,50,000 1,14,60,000 95,50,000 1,14,60,000

Additional information for the year ending 31.3.2002

(a) Dividend of Rs. 1,80,000 for the year ended 31.3.2001 was paid during 2002.

(b) Investment costing Rs. 10,000 was sold for Rs. 12,000.

(c) Depreciation on assets for the year ending 31.3.2002 was charged to profit and loss account as follows.

Land and buildings Rs. 42,000

Plant and Machinery Rs. 1,84,000

(d) sales of fixed assets

Machinery: Sale value Rs. 1,00,000 (W.D.V. Rs.2,20,000)

Furniture: Sale value Rs. 30,000 (W.D.V. Rs. 20,000)

Your are required to prepare the cash flow statement for the year ending 31.3.2002 together with the relevant ledger accounts.

Que. 19- The comparative balance sheet of XYZ Company are given below:

Liabilities 1995 1996 Assets 1995 1996

Share Capital 500 500 Fixed assets (net) 850 1,000

Reserve and surplus 425 500 Inventories 340 350

Long term debt 300 330 Debtors 360 330

Short term debt bank Cash 30 35

Borrowings 200 225 other current assets 20 15


88

88

Trade creditors 100 95

Provisions 75 80

1,600 1,730 1,600 1,73

The income statement of XYZ Company for the year 1996 is given below: (Rs. In lakhs)

Net Sales 2,040

Cost of goods sold

Stocks 1,010

Wages and salaries 210

Other manufacturing expenses 140 (1,360)

Gross profit 680

Operating expenses

Depreciation 110

Selling, administration & general 230 (340)

Operating profit 340

Non – operating surplus (25)

Profit before interest and tax 365

Interest (70)

Profit before tax 295

Tax (130)

Profit after tax 165

Dividends 90

Retained earnings 75

Prepare a Cash Flow Statement.

Que. 20- Prepare cash flow statement of R Ltd. for 31.12.2004 (Make necessary assumptions)

(Rs. In Lakhs)

Net Profit 25,000

Dividend (including dividend tax) paid 8,535

Provision for income tax 5,000

Income tax paid during the year 4,248

Loss on sale of assets (net) 40

Book value of the assets sold 185

Depreciation charged to P&L A/c 20,000

Amortization of Capital grant 6

Profit on sale of investments 100

Carrying amount of investment sold 27,765

Interest income on investment 2,506

Interest expenses 10,000

Interest paid during the year 10520

Increase in working capital (excluding cash & bank balance) 56,075

Purchase of fixed assets 14,560

Investment in joint –venture 3,850

Expenditure on construction WIP 34,740

Proceeds from calls in arrear 2

Receipt of grant for capital projects 12

Proceeds from long –term borrowings 25,980

Proceeds from short –term borrowings 20,575

Opening cash and Bank balance 5,003

Closing cash and Bank balance 6,988

Que. 21- The following are the changes in the account balances taken from the Balance Sheets of PQ Ltd. as at the beginning and end of the

year:

Changes in Rupees

In debit or [credit]

Eq. sh. Capital 30,000 shares of Rs. 10 each issued and fully paid 0

Capital reserve [49,200]

8% debentures [50,000]

Debenture discount 1,000

Freehold property at cost/revaluation 43,000

Plant and machinery at cost 60,000

Depreciation on plant and machinery [14,400]

Debtors 50,000

Stock and Work –in-progress 38,500

Creditors [11,800]

Net profit for the year [76,500]

Dividend paid in respect of earlier year 30,000

Provision for doubtful debts [3,300]

Trade investments at cost 47,000

Bank [64,300]

You are informed that:


89

89

(a) Capital reserve as at the end of the year represented realized profits on sale of one freehold property together with surplus

arising on the revaluation of balance of freehold properties.

(b) During the year plant costing Rs. 18,000 against which deprecation provision of Rs. 13,500 was lying, was sold for Rs. 7,000.

(c) During the middle of the year Rs. 50,000 debentures were issued for cash at a discount of Rs. 1,000.

(d) The net profit for the year was after crediting the profit on sale of plant and charging debenture interest. You are required to

prepare a statement which will explain, why bank borrowing has increased by Rs. 64,300 during the year end.

Que. 22- From the following summarized Balance Sheets of a Company , as at 31st March, you are required to prepare Cash Flow

statement. All working should from part of your answer.

Liabilities 1995 Rs. 1996 Rs. Assets 1995 Rs. 1996 Rs.


10% Redeemable

Pref. Share Capital

Profit and Loss Account

Reserve for Replacement of

Machinery

Long Term Loans

Bank Overdraft

Trade Creditors

Proposed Dividend

75,000

1,00,000

1,00,350

15,000

22,000

84,450

12,000

1,20,000

80,000

1,02,700

10,000

40,000

75,550

24,000

Fixed Assets

Less: Depreciation

Bank

Investment

Stock

Trade Debtors

2,40,070

(90,020)

2,53,730

(98,480)

1,50,050

11,750

61,000

98,000

88,000

1,55,250

32,000

76,000

1,04,000

85,000

4,08,800 4,52,250 4,08,800 4,52,250

1. During the year, additional equity capital was issued to the extent of Rs. 25,000 by way of bonus shares fully paid up.

2. Final dividend on preference shares and an interim dividend of Rs. 4,000 on equity shares were paid on 31st March, 1996.

3. Proposed dividends for the year ended 31st March, 1995 were paid in October, 1995.

4. Movement in Reserve for replacement of machinery account represents transfer to Profit and Loss Account.

5. During the year, one item of plant was up valued by Rs. 3,000 and credit for this was taken in the Profit and Loss Account.

6. Rs. 1,700 being expenditure of fixed assets for the year ended 31st March, 1995 wrongly debited to Sundry Debtors then, was

corrected in the next year.

7. Fixed Assets costing Rs. 6,000 (accumulated depreciation Rs. 4,800) were sold for Rs. 250. Loss arising therefrom was written off.

8. Preference shares redeemed in year (June, 1995) were out of a fresh issue of equity shares, Premium paid on redemption was 10%.

Que. 23- The Balance Sheet of Zee Ltd. as on 31st March, 1989 was as follows:


(fully paid shares of Rs. 10 each)

11% Redeemable Preference Share Capital

(fully paid shares of Rs. 100 each)

Capital Redemption Reserve A/c

General Reserve

10% Debentures

Creditors for goods

Provision for Income tax

Proposed Equity Dividend

5,00,000

2,00,000

1,00,000

2,50,000

2,50,000

1,70,000

1,80,000

70,000

Land & Buildings

Plant and Machinery

Patents

Trade Investments

Investments in Government

Securities as current assets

Stock in trade

Trade Debtors

Cash

Preliminary Expenses

2,00,000

6,80,000

1,00,000

2,50,000

70,000

1,20,000

1,60,000

1,30,000

10,000

17,20,000 17,20,000

Trade company has prepared the following Summarised projected Profit and Loss Account for the year ending on 31st March,

1990.

Rs. Rs.

To Opening Stock

To Purchases

To Wages

To Salaries and Other Expenses

To Interest on Debentures

To Provision for Depreciation

To Preliminary Expenses written off

To Provision for Income Tax

To Preference Dividend Paid

To Proposed Equity Dividend

To Balance of Profit

1,20,000

15,00,000

2,60,000

2,62,500

25,000

1,10,500

5,000

1,67,150

22,000

75,000

85,150

By Sales

By Closing Stock

By Income from Investments

By profit on sale of machinery

By savings in provision for income tax

for 19888-89

24,00,000

1,80,000

31,300

6,000

15,000

26,32,300 26,32,300

You are given the under mentioned further information:-

(i) Provision for depreciation as on 31.3.1989 was Rs. 2,30,000 against Plant and Machinery and Rs. 20,000 against Land and

Buildings. Of the amount provided against depreciation in 1989-90, Rs. 10,000 will be for Land and Buildings.

(ii) At the ends of March, 1990 the Redeemable Preference Shares are to be redeemed.


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(iii) New Machinery costing Rs. 1,50,000 will be installed towards the end of March, 1990. The machine, which will be disposed

of , cost Rs. 40,000 against which Rs. 30,000 has been provided as depreciation till 31.3.1989 – the sale will take place in the

beginning of April, 1989.

(iv) The 10% Debentures are to be redeemed at the end of March, 1990. Debenture – holders for half of the amount are expected

to agree to take new 14% Debentures while the remaining debenture – holders are expected to agree to get their debentures

converted into equity shares at par.

(v) The company allows one month‟s credit to its customers and receives one and a half month‟s credit from its suppliers. On

31.3.1990, outstanding wages will be Rs. 45,000.

Prepare the Balance sheet of the company as it likely to be at 31st March, 1990. Also prepare a statement showing sources and

application of funds during the year. Assume that to the necessary extent, government securities will be sold at book value and no bank

overdraft will be raised. Payment of tax should be shown separately.

Que.24- The Balance Sheet of North Mills Ltd. as at 31st March, 1988 was as follows:



General Reserve

Profit and loss account

Trade creditors

Provision for tax

10,00,000

1,50,000

2,50,000

1,62,850

1,95,000

Plant and Machinery (cost)

Less: depreciation

Furniture: fittings and fixtures (cost)

Less: dep.

Long –term investments

Stock

Debtors

Less: provision for bad debts

Cash at Bank

Advance Payment of income tax

6,00,000

2,21,050 3,78,950

1,00,000

27,100 72,900

2,00,000

4,50,000

80,000

4,000 76,000

3,80,000

2,00,000

17,57,850 17,57,850

On 1st April, 1988 the company took over a business for Rs. 5,00,000. The purchase consideration was satisfied by

allotment to vendor 27,000 equity shares of Rs. 10 each at par and a cash payment of Rs. 2,30,000 which was raised by sale of all the

long –term investments. The assets and liabilities taken over and their agreed values were as follows:-

Plant and Machinery 3,00,000

Furniture, fittings and fixtures 40,000

Stock 1,05,000

Trade Debtors 45,000

Trade Creditors 15,000

In July, 1988, the company paid a dividend @ 20% per annum for the year ended 31st March, 1988.

In Dec. 1988 the Income tax officer settled the income tax liability for the accounting year, ended 31st March, 19888 for

Rs. 2,00,000.

In Feb. 1989 the company made a public issue of 1,00,000 equity shares of Rs. 10 each at par, the whole amount being

payable along with applications. The issue was got underwritten for the maximum commission allowed by law. The purpose of the

issue was to finance a new plant which was acquired for Rs. 9,00,000 in last week of march, 1989.

The balance sheet of North Mills Ltd. as at 31st March, 1989 stood as follows:-



(of the above shares, 27,000 shares of Rs.,

10 each have been allotted as fully paid up

pursuant to a contract without payment

being received in cash)

General reserve

Profit and loss a/c

Trade creditors

Provision for income tax

22,70,000

2,00,000

3,00,000

1,43,100

3,10,000

Goodwill

Plant and machinery (cost)

18,00,000

Less: dep. (3,21,893)

Furniture, fittings and fittings

(cost) 1,40,000

Less: dep. (38,390)

Stock

Debtors 98,000

Less: provision

for bad debts 4,900

Cash at Bank

Advance payment of income tax

Underwriting commission

25,000

14,78,107

1,01,610

5,05,283

93,100

6,70,000

3,00,000

50,000

32,23,100 32,23,100

You are required to prepare Cash flow Statement

Que. 25- The Balance sheet of Pragati Ltd. for the year ended 31st March 2001 & 2002 were summarized thus:

Liability 31.3.01 31.3.02 Assets 31.3.01 31.3.02


Pref. share capital

Capital Reserve

General reserve

Profit & Loss

Hire vendor

10% debenture

Creditors

Provision for Tax

5,00,000

2,00,000

----

50,000

20,000

----

-----

95,000

30,000

9,00,000

1,00,000

24,000

70,000

30,000

28,000

2,00,000

85,000

45,000

Goodwill

Land & Building

Plant and machinery

Car

Investments

Stock

Debtors

Cash

Advances tax

10,000

4,50,000

1,70,000

-----

40,000

60,000

75,000

45,000

35,000

14,000

6,90,000

1,60,000

40,000

20,000

1,00,000

1,45,000

2,61,000

50,000


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Unclaimed dividend ----- 7,000 Underwriting

Commission

10,000

9,000

8,95,000 14,89,000 8,95,000 14,89,000

1. Tax for year ended 31st March was assessed to be 50,000.

2. A car of 50,000 was purchased on Hire Purchase and Rs. 25,000 was paid to Hire Vendor during the year.

3. The debentures were issued @ 10% premium which was taken to Capital Reserve on 1st April, 2001.

4. Accumulated Depreciation on Land and Building was 1,50,000 and 2,10,000 respectively.

5. Accumulated Depreciation on Plant and Machinery was 1,30,000 and 1,40,000 respectively.

6. investment was sold @ 20% premium, the profit of which was taken to capital reserve.

7. bonus shares of 1 for every 5 held was issued in the beginning the year.

8. land and building worth 1,50,000

Plant and machinery worth 50,000

Stock worth 20,000

Debtors worth 70,000

Creditors worth 30,000

were purchased by issue of shares of Rs. 2,50,000 shares @ 10% premium

9. Dividend paid during the year = Rs. 43,000

10. The preference shares were redeemed @ 25% premium.

11. Plant and Machinery costing Rs,. 50,000 (WDV 22,000) was disposed off.

12. Bad debts written off Rs. 5,000

13. Dividend received was Rs. 17,000 of which Rs. 7,000 was post acquisition.

Prepare Cash flow Statement.

Ratio Analysis: It is concerned with the calculation of relationships, which after proper identification & interpretation may provide information about the operations and state of affairs of a business enterprise. The analysis is used to provide indicators of past performance in terms of critical success factors of a business. This assistance in decision-making reduces reliance on guesswork and intuition and establishes a basis for sound judgments.

Types of Ratios

Liquidity

Measurement Profitability

Indicators Financial

Leverage/Gearing Operating Performance Investment

Valuation

Current Ratio Profit Margin

Analysis Equity Ratio Fixed Assets Turnover Price/Earnings

Ratio

Quick Ratio Return on Assets Debt Ratio Sales/ Revenue Price/Earnings to

Growth ratio

Return on Equity Debt-Equity Ratio Average Collection Period Dividend Yield

Return on Capital

Employed Capitalization Ratio Inventory Turnover Dividend Payout

Ratio

Interest Coverage Ratio Total assets Turnover

Liquidity Measurement Ratios

Liquidity refers to the ability of a firm to meet its short-term financial obligations when and as they fall due. The main concern

of liquidity ratio is to measure the ability of the firms to meet their short-term maturing obligations. The greater the coverage

of liquid assets to short-term liabilities the better as it is a clear signal that a company can pay its debts that are coming due in

the near future and still fund its ongoing operations. On the other hand, a company with a low coverage rate should raise a red

flag for investors as it may be a sign that the company will have difficulty meeting running its operations, as well as meeting

its obligations.

Ratio Formula Meaning Analysis

Chapter : Ratio Ananlysis


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Current Ratio Current Assets/Current

Liabilities

Current assets includes cash,

marketable securities, accounts

receivable and inventories.

Current liabilities includes

accounts payable, short term

notes payable, short-term

loans, current maturities of

long term debt, accrued income

taxes and other accrued

expenses

The number of times that the

short term assets can cover the

short term debts. In other

words, it indicates an ability to

meet the short term obligations

as & when they fall due

Higher the ratio, the better it is,

however but too high ratio

reflects an in-efficient use of

resources & too low ratio leads

to insolvency. The ideal ratio is

considered to be 2:1.,

Quick Ratio or

Acid Test Ratio (Cash+Cash

Equivalents+Short Term

Investments+Accounts

Receivables) / Current

Liabilities

Indicates the ability to meet

short term payments using the

most liquid assets. This ratio is

more conservative than the

current ratio because it

excludes inventory and other

current assets, which are more

difficult to turn into cash

The ideal ratio is 1:1. Another

beneficial use is to compare the

quick ratio with the current

ratio. If the current ratio is

significantly higher, it is a clear

indication that the company's

current assets are dependent on

inventory.

Profitability Indicators Ratios

Profitability is the ability of a business to earn profit over a period of time.The profitability ratios show the combined effects of

liquidity, asset management (activity) and debt management (gearing) on operating results. The overall measure of success of

a business is the profitability which results from the effective use of its resources.


Gross Profit

Margin (Gross Profit/Net Sales)*100 A company's cost of goods

sold represents the expense

related to labor, raw materials

and manufacturing overhead

involved in its production

process. This expense is

deducted from the company's

net sales/revenue, which

results in a company's gross

profit. The gross profit margin

is used to analyze how

efficiently a company is using

its raw materials, labor and

manufacturing-related fixed

assets to generate profits.

Higher the ratio, the higher is

the profit earned on sales

Operating Profit

Margin (Operating Profit/Net

Sales)*100 By subtracting selling, general

and administrative expenses

from a company's gross profit

number, we get operating

income. Management has

much more control over

operating expenses than its

cost of sales outlays. It

Measures the relative impact of

operating expenses

Lower the ratio, lower the

expense related to the sales

Net Profit Margin (Net Profit/Net Sales)*100 This ratio measures the

ultimate profitability Higher the ratio, the more

profitable are the sales.

Return on Assets Net Income / Average Total This ratio illustrates how well Higher the return, the more


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Assets

( Earnings Before Interest &

Tax = Net Income)

management is employing the

company's total assets to make

a profit.

efficient management is in

utilizing its asset base

Return on Equity Net Income / Average

Shareholders Equity*100 It measures how much the

shareholders earned for their

investment in the company

Higher percentage indicates the

management is in utilizing its

equity base and the better

return is to investors.

Return on Capital

Employed Net Income / Capital

Employed

Capital Employed = Avg. Debt

Liabilities + Avg. Shareholders

Equity

This ratio complements

the return on equity ratio by

adding a company's debt

liabilities, or funded debt, to

equity to reflect a company's

total "capital employed". This

measure narrows the focus to

gain a better understanding of a

company's ability to generate

returns from its available

capital base.

It is a more comprehensive

profitability indicator because

it gauges management's ability

to generate earnings from a

company's total pool of capital.

Financial Leverage/Gearing Ratios

These ratios indicate the degree to which the activities of a firm are supported by creditors‟ funds as opposed to owners as the

relationship of owner‟s equity to borrowed funds is an important indicator of financial strength. The debt requires fixed

interest payments and repayment of the loan and legal action can be taken if any amounts due are not paid at the appointed

time. A relatively high proportion of funds contributed by the owners indicates a cushion (surplus) which shields creditors

against possible losses from default in payment.

Financial leverage will be to the advantage of the ordinary shareholders as long as the rate of earnings on capital employed is

greater than the rate payable on borrowed funds.


Equity Ratio (Ordinary Shareholder’s

Interest / Total assets)*100 This ratio measures the

strength of the financial

structure of the company

A high equity ratio reflects a

strong financial structure of the

company. A relatively low

equity ratio reflects a more

speculative situation because

of the effect of high leverage

and the greater possibility of

financial difficulty arising

from excessive debt burden.

Debt Ratio Total Debt / Total Assets This compares a company's

total debt to its total assets,

which is used to gain a general

idea as to the amount of

leverage being used by a

company. This is the measure

of financial strength that

reflects the proportion of

capital which has been funded

by debt, including preference

shares.

With higher debt ratio (low

equity ratio), a very small

cushion has developed thus not

giving creditors the security

they require. The company

would therefore find it

relatively difficult to raise

additional financial support

from external sources if it

wished to take that route. The

higher the debt ratio the more

difficult it becomes for the

firm to raise debt.


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Debt – Equity

Ratio Total Liabilities / Total

Equity . This ratio measures how

much suppliers, lenders,

creditors and obligors have

committed to the company

versus what the shareholders

have committed.

This ratio indicates the extent

to which debt is covered by

shareholders‟ funds.

A lower ratio is always safer,

however too low ratio reflects

an in-efficient use of equity.

Too high ratio reflects either

there is a debt to a great extent

or the equity base is too small

Capitalization

Ratio Long Term Debt / (Long

Term Debt + Shareholder’s

Equity)

This ratio measures the debt

component of a company's

capital structure, or

capitalization (i.e., the sum of

long-term debt liabilities and

shareholders' equity) to

support a company's

operations and growth.

A low level of debt and a

healthy proportion of equity in

a company's capital structure is

an indication of financial

fitness.

A company too highly

leveraged (too much debt) may

find its freedom of action

restricted by its creditors

and/or have its profitability

hurt by high interest costs.

This ratio is one of the more

meaningful debt ratios because

it focuses on the relationship of

debt liabilities as a component

of a company's total capital

base, which is the capital

raised by shareholders and

lenders.

Interest Coverage

Ratio EBIT / Interest on Long

Term Debt This ratio measures the

number of times a company

can meet its interest expense

The lower the ratio, the more

the company is burdened by

debt expense. When a

company's interest coverage

ratio is only 1.5 or lower, its

ability to meet interest

expenses may be questionable.

Operating Performance Ratios:

These ratios look at how well a company turns its assets into revenue as well as how efficiently a company converts its sales

into cash, i.e how efficiently & effectively a company is using its resources to generate sales and increase shareholder value.

The better these ratios, the better it is for shareholders.

Ratios Formula Meaning Analysis

Fixed Assets

Turnover Sales / Net Fixed Assets This ratio is a rough measure

of the productivity of a

company's fixed assets with

respect to generating sales

High fixed assets turnovers are

preferred since they indicate a

better efficiency in fixed

assets utilization.

Average Collection

Period ( Accounts

Receivable/Annual Credit

Sales )*365 days

The average collection period

measures the quality of

debtors since it indicates the

speed of their collection.

The shorter the average

collection period, the better

the quality of debtors, as a

short collection period implies


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the prompt payment by

debtors. An excessively long

collection period implies a

very liberal and inefficient

credit and collection

performance. The delay in

collection of cash impairs the

firm‟s liquidity. On the other

hand, too low a collection

period is not necessarily

favorable, rather it may

indicate a very restrictive

credit and collection policy

which may curtail sales and

hence adversely affect profit.

Inventory Turnover Sales / Average Inventory It measures the stock in

relation to turnover in order to

determine how often the stock

turns over in the business.

It indicates the efficiency of

the firm in selling its product.

High ratio indicates that there

is a little chance of the firm

holding damaged or obsolete

stock.

Total Assets

Turnover Sales / Total Assets This ratio indicates the

efficiency with which the firm

uses all its assets to generate

sales.

Higher the firm‟s total asset

turnover, the more efficiently

its assets have been utilised.

Investment Valuation Ratios:

These ratios can be used by investors to estimate the attractiveness of a potential or existing investment and get an idea of its

valuation.


Price Earning Ratio

( P/E Ratio ) Market Price per Share /

Earnings Per Share This ratio measures how many

times a stock is trading (its

price) per each rupee of EPS

A stock with high P/E ratio

suggests that investors are

expecting higher earnings

growth in the future compared

to the overall market, as

investors are paying more for

today's earnings in

anticipation of future earnings

growth. Hence, stocks with

this characteristic are

considered to be growth

stocks. Conversely, a stock

with a low P/E ratio suggests

that investors have more

modest expectations for its

future growth compared to the

market as a whole.

Price Earnings to

Growth Ratio ( P/E Ratio ) / Earnings Per

Share The price/earnings to growth

ratio, commonly referred to as

the PEG ratio, is obviously

closely related to the P/E ratio.

The PEG ratio is a refinement

of the P/E ratio and factors in

a stock's estimated earnings

The general consensus is that

if the PEG ratio indicates a

value of 1, this means that the

market is correctly valuing

(the current P/E ratio) a stock

in accordance with the stock's

current estimated earnings per


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growth into its current

valuation. By comparing a

stock's P/E ratio with its

projected, or

estimated, earnings per share

(EPS) growth, investors are

given insight into the degree

of overpricing or under pricing

of a stock's current valuation,

as indicated by the traditional

P/E ratio.

share growth. If the PEG ratio

is less than 1, this means that

EPS growth is potentially able

to surpass the market's current

valuation. In other words, the

stock's price is being

undervalued. On the other

hand, stocks with high PEG

ratios can indicate just the

opposite - that the stock is

currently overvalued.

Dividend Yield

Ratio ( Annual Dividend per Share

/ Market Price per

Share ) *100

This ratio allows investors to

compare the latest dividend

they received with the current

market value of the share as an

indictor of the return they are

earning on their shares

This enables an investor to

compare ratios for different

companies and industries.

Higher the ratio, the higher is

the return to the investor

Dividend Payout

Ratio (Dividend per Share /

Earnings per Share ) * 100 This ratio identifies the

percentage of earnings (net

income) per common share

allocated to paying

cash dividends to

shareholders. The dividend

payout ratio is an indicator of

how well earnings support the

dividend payment.


Que. 1- Following is the Trading and Profit and Loss Account of Adarsh Trading House for the year ended 31st March, 1989:-

Trading and Profit and Loss Account

Rs. Rs.

To Stock on 1.4.1988 75,000 By Sales 5,00,000

To Purchase 3,10,000 By Stocks on 31.3.1989 1,00,000

To Freight 15,000

To Gross Profit c/d 2,00,000

6,00,000 6,00,000

To Administrative Expenses 85,000 By Gross Profit b/d 2,00,000

To Selling and Distribution Exp 40,000 By Interest on Investments 5,000

To Financial Expanses 6,000

To Other Non –operating Exp. 3,000

To Net Profit 71,000

2,05,000 2,05,000

You are required to calculate:-

(i) Gross profit Ratio

(ii) Net Operating Profit Ratio

(iii) Operating Ratio

(iv) Administrative Expenses Ratio

(v) Selling and Distribution Expenses Ratio.

Que. 2- Calculate Debt Equity Ratio from the balance sheet f Prestige Ltd. as at 31st March, 1989:

Liabilities Rs Assets Rs

80,000 Equity Share of Rs. 10 each Land and Buildings 6,20,000

Fully paid up 8,00,000 Plant and Machinery 12,00,000

4,000 11% Redeemable Preference Furniture and Fittings 1,80,000

Shares of Rs. 100 each, fully Stock 5,30,000

Paid up 4,00,000 Trade debtors 4,70,000


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Share Premium Account 80,000 Cash in hand 65,000

General Reserve 5,80,000 Cash at Bank 3,00,000

Profit and Loss A/c 1,40,000 Bills Receivable 1,35,000

10,000 12.5% Convertible Debentures

Of Rs. 100 each, fully paid up 10,00,000

Bills Payable 80,000

Trade Creditors 1,40,000

Outstanding Expenses 60,000

Provision for tax 2,20,000

__

35,00,000 35,00,000

Que. 3- You are required to calculate Return on Investment from the following details of Rahu Ltd. for the year ending 31st March, 1989:

Rs. Net Profit after tax 6,50,000

Rate of Income tax 50%

12.5% Convertible Debentures of Rs. 100 each, fully paid up 8,00,000

Fixed Assets, at cost 24,60,000

Depreciation up to date 4,60,000

Current Assets 15,00,000

Current Liabilities 7,00,000

Que. 4- M/s Jupiter Ltd. intends to supply goods on credit to M/s Pluto Ltd. and M/s Mars Ltd. The relevant details for the year ending 31st

March, 1989 are is follows:-

M/s Pluto Ltd. M/s Mars Ltd.

Rs. Rs.

Trade Creditors 3,00,000 1,60,000

Total Purchases 9,30,000 6,60,000

Cash Purchases 30,000 20,000

Advise with reasons as to which company he should prefer to deal with.

Que. 5- Compute the amount of capital employed from the balance sheet of Mars Ltd. as at 31st March, 1989:-


Equity Share Capital 7,00,000 Land and Buildings 5,00,000

12% Pre. Share Capital 2,60,000 Plant and Machinery 6,00,000

General Reserve 3,20,000 Furniture and Fittings 1,00,000

Profit and Loss A/c 1,60,000 Investments (Non –trading) 1,00,000

11% Debentures 2,00,000 Stock 4,00,000

Bills Payable 1,92,000 Sundry Debtors 3,00,000

Sundry Creditors 3,60,000 Cash in hand 80,000

Income Tax Payable 1,60,000 Cash at Bank 2,00,000

Outstanding Expenses 48,000 Bills Receivable 90,000

Prepaid expenses 10,000

Preliminary Expenses 20,000

_________

24,00,000 24,00,000

Que. 6- The balance sheet of Star Ltd. as at 31st March, 1989 is given below:-


Equity share Capital 6,00,000 Plant and Machinery 4,50,000

Reserves 1,80,000 Furniture 50,000

Creditors 1,20,000 Stock 1,80,000

Debtors 1,20,000

Cash at Bank 1,00,000

9,00,000 9,00,000

The other details are as follows:

(i) Total sales during the year have been Rs. 10,00,000 out of which cash sales amounted to Rs. 2,00,000.

(ii) The Gross Profit has been earned @ 20%.

(iii) Amounts as on 1.4.88: Rs.

Debtors 80,000

Stock 1,40,000

Creditors 30,000

(iv) Cash paid to creditors during the year, Rs. 2,10,000.

You are required to calculate the following ratios:

(i) Debtors Turnover Ratio;

(ii) Creditors Turnover Ratio;

(iii) Stock Turnover Ratio.

Que. 7- (a) Calculate Debt Collection Period of Confident Ltd. for the year ending 31st March, 1989:

Rs. Sales During the year 3,65,000


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Debtors as on 31.3.1989 42,500

Bills Receivable as on 31.3.1989 7,500

(b) Compute Debtors Turnover Ratio and Average Collection Period of Prosperous Ltd. for the year ending 31st March, 1989:

Rs.

Net Credit Sales 8,00,000

Opening Trade Debtors 1,80,000

Closing Trade Debtors 1,40,000

The sixty days credit is common to the industry to which the company belong. State whether the debts are being collected

efficiently or not.

Que. 8- Calculate the following ratios from the financial statements given below for AB Ltd.:

(a) Current Ratio;

(b) Acid Test Ratio;

(c) Stock Turnover Ratio;

(d) Debt Equity Ratio;

(e) Interest Coverage Ratio;

Income Statement of AB Ltd. for the year ending 31st March, 1989:

Rs. Rs.

Sales 5,00,000

Cost of Goods Sold:

Stock, April 1, 1988 40,000

Add: Purchases 2,45,000

Direct Expenses 25,000

3,10,000

Less: Stock, March 31, 1989 60,000 2,50,000

Gross Profit 2,50,000

Operating Expenses 1,10,000

Interest Expenses 20,000 1,30,000

Net Profit before Tax 1,20,000

Provision for Income Tax 60,000

Net Profit 60,000

Balance Sheet of AB Ltd. as at 31st March, 1989:

Assets Rs Rs

Fixed Assets (cost) 5,40,000

Less: Accumulated Depreciation 1,40,000 4,00,000

Stock 60,000

Debtors 2,30,000

Cash at Bank 1,55,000

Bills Receivable 43,000

Prepaid Expenses 12,000

Total Assets 9,00,000 Liabilities

Equity share capital 1,50,000

Reserves and Surplus 3,00,000

10% Debentures 2,00,000

Creditors 1,80,000

Bills Payable 70,000

Total Liabilities 9,00,000

Que. 9- The following data have been abstracted from the annual accounts of a company:

Rs. (in lakhs)

Share Capital:

20,00,000 Equity Shares of Rs. 10 each 200

General Reserve 150

Investment Allowance Reserve 50

15% Long –term Loan 300

Profit before Tax 140

Provision for Tax 84

Proposed Dividend 10

Calculate, from the above, the following ratios:

(i) Return on Capital Employed

(ii) Return on Net Worth

Que. 10- Mr. T Munim is made an offer by the promoters of S Enterprises Ltd. to invest in the project of the company by purchasing a

substantial portion of the share capital. He is promised good return by way of dividends and capital appreciation.

Mr. Munim desires you to compute the following ratios for financial analysis. Working should form part of your answer.

(i) Return on Investment Ratio

(ii) Net Profit Ratio

(iii) Stock Turnover Ratio


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(iv) Current Ratio

(v) Debt Equity Ratio

The figures given to him are as under:

(Rs. „000)

Sales……………………………………………………………….. 16,000

Raw Materials Consumed…………………………………………. 7,800

Consumables………………………………………………………. 800

Direct Labour……………………………………………………… 750

Other Direct Expenses…………………………………………….. 480

Administrative Expenses………………………………………….. 1,200

Selling Expenses………………………………………………….. 260

Interest……………………………………………………………. 1,440

Fixed Assets………………………………………………………. 14,000

Income –tax………………………………………………………... 50

Depreciation……………………………………………………… 700

Share Capital……………………………………………………… 5,000

Reserves and Surplus………………………………………………… 1,500

Secured Term Loans………………………………………………… 12,000

Unsecured Term Loans……………………………………………… 1,500

Trade Creditors……………………………………………………… 3,350

Investments………………………………………………………… 400

Inventories………………………………………………………… 6,000

Receivables………………………………………………………… 3,700

Cash in hand and at Bank…………………………………………… 100

Provisions………………………………………………………… 650

Other Current Liabilities…………………………………………… 200

Que. 11- Some years ago, the sales manager of a company persuaded the management to increase the stocks of finished goods (to improve

delivery period) and to sell more on credit (terms being 6 weeks). The following figures are given to you:

Year Sales Finished Goods Debtors at Gross Profit

Stock end

Rs. Rs. Rs. Rs.

1985-86 5,00,000 50,000 40,000 60,000

1986-87 5,50,000 54,000 45,000 65,000

1987-88 7,00,000 90,000 90,000 75,000

1988-89 7,50,000 1,00,000 1,00,000 80,000

Assuming the stock levels and debtors to be true for the whole year, comment upon the wisdom of the decision taken.

The company financed working capital by borrowing from banks. What remedial action do you suggest?

Que. 12- You are given the following figures:

Current Ratio 2.5

Liquidity Ratio 1.5

Net Working Capital Rs. 3,00,000

Stock Turnover Ratio 6

Ratio of Gross Profit to Sale 20%

Ratio of Turnover to Fixed Assets (net) 2

Average Debt Collection Period 2 months

Fixed Assets to Net Worth 0.80

Reserves and Surplus to Capital .5

Draw up the Balance Sheet of the concern to which the figures relate.

Que. 13- The assets of ABC Ltd. consist of fixed assets and current assets while its current liabilities comprise bank credit and trade credit in

the ratio of 2:1. Form the following figures relating to the company for the year 1988-98, prepare its balance sheet showing the

details of working:

Share Capital Rs. 1,99,500

Working Capital i.e. Current Assets – Current Liabilities Rs. 45,000

Gross Margin 20%

Inventory Turnover 6

Average Collection Period 2 months

Current Ratio 1.5

Quick Ratio 0.9

Reserves and Surplus to Cash 3

Que. 14- You are advised by the Management of ABC Ltd. to project a Trading and Profit and Loss Account and the Balance Sheet on the

basis of the following estimated figures and ratios, for the next financial year ending March 31, 1990:

Ratio of Gross Profit………………………………………………….. 25%

Stock Turnover Ratio………………………………………………… .5 times


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Average Debt Collection Period……………………………………… 3 times

Creditors‟ Velocity…………………………………………………… 3 times

Current Ratio………………………………………………………….. 2

Proprietary Ratio (Fixed Assets to Capital Employed)……………….. 80%

Capital Gearing Ratio (Preference Shares & Debentures to Equity)…. .30%

Net Profit to issued capital (Equity)…………………………………… 10%

General Reserve and P/L to Issued Capital (Equity)…………………… 25%

Preference Share Capital to Debentures…………………………. ……. 2

Cost of Sales consists of 50% for Materials

Gross Profit, Rs. 12,50,000.

Working notes should be clearly shown.

Que. 15- From the following information, prepare the projected Trading and Profit and Loss Account for the next financial year

ending March 31, 1989 and the projected Balance Sheet as on the date:

Gross Profit Ratio……………………………………………………… 25%

Net Profit to Equity Capital…………………………………………….. 10%

Stock Turnover ratio……………………………………………………. 5 times

Average Debt Collection Period………………………………………... 2 times

Creditors Velocity……………………………………………………… 3 times

Current Ratio…………………………………………………………… 2

Proprietary Ratio

(Fixed Assets to Capital Employed)…………………………………. ... 80%

Capital Gearing Ratio

(Preference Shares and Debentures to Equity)…………………………. 30%

General Reserve and Profit and Loss to Issued Equity Capital………… 25%

Preference Share Capital to Debentures………………………………... 2

Cost of Sales consist of 40% for Materials and balance for Wages and Overheads. Gross Profit is Rs. 6,00,000. Working

notes should be clearly shown.

Question 16:-

From the following particulars prepare the Balance Sheet of X ltd:-

Working Capital Rs 300000

Current Ratio 1.6

Current Asset / Fixed Asset 1 : 1.25

Fixed Asset to turnover 1 : 1.5

Gross Profit 20%

Debt Equity ratio 1 : 1.6

Debtors Velocity ratio 2.4 months

Creditors Velocity ratio 3 months

Stock Velocity ratio 2 months

Total Liabilities / Current Liabilities 2

Question 17-

Current Ratio 2

Working Capital Rs 400000

Capital Block to Current Asset 3 : 2

Fixed Asset to Turnover 1 : 3

Sales Cash / Credit 1 : 2

Creditors Velocity ratio 2 months

Stock Velocity Ratio 2 months

Debtors Velocity ratio 3 months

Capital Block:-

Net Profit 10% of turnover

Reserve 2.5% of turnover

Debenture / Share Capital 1 : 2

Gross Profit ratio 25% (to sales)

Question 18-

Prepare Profit & Loss account & Balance sheet with the following information:-

Current asset to Stock 3 : 2

Acid test ratio 1

EPS (Per share @10/) 10

Average Collection Period 30 days

Fixed Asset turnover ratio 1.2

Working Capital Rs 10 lacs

Variable Cost 60%

Taxation Nil

Current Ratio 3

Financial Leverage 2.2

Book Value per Share Rs 40


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Stock Turnover Ratio 5

Total Liabilities to Net Worth 2.75

Net Profit to Sales 10%

Long Term Loan Interest 12%

Quest ion : List down the f inancial needs and the sources available with a business enti ty to

sat isfy such needs ?

Answer : One of the most impor tant considera t ion for an entrepreneur -co mpany in implement ing a

new projec t or undertaking expansion, diversi f ica t ion, modernisat ion and rehab il i ta t ion scheme is

ascer taining the cost o f project and the means of f inance. There are several sources o f finance / funds

avai lable to any company. An effec ti ve appra isa l mechanism of var ious sources o f funds ava ilab le to

a company must be ins t i tuted in the co mpany to achieve i t s main objectives . Such a mechanism is

required to evaluate r i sk, tenure and cost of each and every source of fund. This se lec t ion of f und

source is dependent on the financial s tra tegy pursued by the company, the leverage planned by the

company, the f inancial condi t ions prevalent in the economy & the r isk profi le o f both i . e . the

company and the indust ry in which the company opera tes. Eac h and every source of fund has some

advantages and d isadvantages.

I) F inancial needs of a business are grouped as fo l lows :

1) Long term f inancial needs : Such needs general ly re fer to those requi rements of funds which are

for a per iod exceeding 5 - 10 years. All investments in plant and machinery, land, build ings, e tc . are

considered as long te rm f inancia l needs . Funds required to finance permanent or hard core working

capi tal should a lso be procured from long term sources.

2) Medium term f inancial needs : Such requirements re fer to those funds which are required for a

per iod exceed ing one year but no t exceed ing 5 years. Funds requi red for deferred revenue expenditure

( i .e benefi t o f expense expi res a f ter a per iod of 3 to 5 years) , are class i f ied a s medium term f inancia l

needs . Sometimes long term requirements, for which long term funds cannot be arranged immediately

may be met from medium term sources and thus the demand of medium term financial needs are

genera ted, as and when the desired long -term funds are ava ilable medium term loan may be paid off.

3) Short term f inancia l needs : Such type of f inancia l needs ar i se fo r f inancing current asse ts as,

stock, debtors, cash, e tc . Investment in these asse ts i s known as meet ing of working capita l

requirements o f the concern. Firms require working cap ital to employ f ixed asse ts gainfully . The

requirement o f working capital depends on a number of factors tha t may di ffer from industry to

industry and from company to company in the same industry. The main c haracter i st ic o f short term

f inancia l needs is tha t they ar i se for a shor t per iod of t ime no t exceed ing the accounting per iod i .e .

one year .

The bas ic pr inc iple for categoris ing the f inancia l needs into shor t term, medium term and

long te rm is that they are met from the corresponding viz . short term, medium term and long term

sources respect ive ly. Accordingly the source of f inancing i s dec ided wi th re ference to the per iod for

which funds are required. Basica lly, there are 2 sources o f rais i ng funds for any business enterpr ise

viz . owners capi ta l and borrowed cap ital . The owners cap ita l i s used for meet ing long term financia l

needs and i t pr imar i ly comes from share cap ital and retained earnings. Borro wed cap ita l fo r a l l o ther

types of require ment can be raised from di fferent sources as debentures, publ ic deposi t s , f inancia l

ins t i tut ions , commerc ial banks, etc .

II) Sources of f inance of a business are :

1) Long term : i ) Share capi ta l or Equity share cap ital

i i ) Preference shares

i i i ) Retained earnings

Chapter : Sources of Finances


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iv) Debentures/Bonds of di fferent types

v) Loans from f inancia l ins t i tut ions

vi ) Loans fro m Sta te Financia l Corporat ion

vi i) Loans from commercia l banks

vi i i ) Venture cap ital funding

ix) Asse t secur i t i sat ion

x) Internat ional financing l ike Euro-issues, Foreign currency loans.

2) Medium term : i ) Preference shares

i i ) Debentures /Bonds

i i i ) Public deposi t s / f ixed deposit s for a dura t ion of 3 years

iv) Commercial banks

v) Financial inst i tut ions

vi ) S ta te f inancia l corporations

vi i) Lease f inancing/Hire -purchase f inancing

vi i i ) Externa l commerc ial borro wings

ix) Euro - issues

x)Fore ign currency bonds.

3) Short-term : i ) Trade credi t

i i ) Commercia l banks

i i i ) F ixed deposit s fo r a per iod of 1 year o r less

iv) Advances rece ived from customers

v) Var ious shor t - term provis ions

III) Financia l sources of a business can also be classif ied as fo l lows on using different basis :

1) According to per iod : i ) Long term sources

i i ) Medium term sources

i i i ) Shor t term sources

2) According to ownership : i ) Owners capi ta l or equity capi ta l , re ta ined earnings, etc .

i i ) Borro wed capi ta l such as, debentures, pub lic deposit s , loans, e tc .

3) According to source of generation : i ) Interna l sources e .g. reta ined earnings and depreciat ion funds, e tc .

i i ) Exter nal sources e .g. debentures , loans , e tc .

However , for convenience, the di ffe rent sources of funds can a lso be c lassi f ied into the

fo l lo wing :

a) Securi ty f inancing - f inancing through shares and debentures

b) Internal f inancing - f inancing through re ta ined earning, depreciat ion

c) Loans f inancing - this includes both shor t term and long term loans

d) Internat ional financing

e) Other sources .

Quest ion : Write a note on long term sources of f inance.

Answer : There are di fferent sources o f funds avai lab le to meet long term f inancia l needs o f the

business. These sources may be broad ly class i fied into share capi ta l (both equi ty and preference) and

debt ( includ ing debentures, long term borrowings or other debt instruments) . In Ind ia, many

companies have raised long te rm f inance by offer ing var ious ins truments to publ ic l ike deep discount

bonds, ful ly convert ible debentures, e tc . These new instruments have charac ter i st ics o f both equity

and debt and i t is d i fficult to ca tegor ise them into equit y and debt . Different sources o f long term

f inance are :

1) Owners' capita l or equity capital : A publ ic l imi ted company may raise funds from promoters or from the invest ing public by

way of o wners capi tal o r equi ty cap ital by i ssuing ord inary equi ty shares. Ordinary shareholders are


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owners of the company and they under take r i sks of business. They e lect the d irec tors to run the

company and have the optimum control over the management o f the company. Since equity shares can

be paid o ff only in the event in l iquida tion, th is source has the leas t r i sk involved , and more due to

the fac t tha t the equity shareholders can be paid dividends only when there are dis tr ibutab le prof i t s .

However , the cost o f ordinary shares is usually the highest . This is due to the fac t tha t such

shareholders expect a higher ra te o f re turn on the ir investments co mpared to other suppl iers of long

term funds. The dividend payable on shares i s an appropr ia t ion of prof i t s and not a charge against

prof i t s , meaning that i t ha s to be paid only out o f prof i ts a f ter tax. Ordinary share capi ta l a l so

provides a secur i ty to other suppliers of funds. Thus, a company having substant ial ord inary share

capi tal may f ind i t easie r to raise funds, in view of the fact that the share capi ta l provides a secur i ty

to other suppl iers o f funds. The Companies Act , 1956 and SEBI Guidel ines for d isclosure and

investors ' pro tec tions and the c lar i f icat ions thereto lays do wn a number of provis ions regarding the

issue and management o f equi ty share cap it a l .

Advantages of rais ing funds by i ssue of equity shares are :

i ) I t i s a permanent source of f inance.

i i ) The i ssue of new equity shares increases the company's f lexibil i ty.

i i i ) The company can make fur ther issue of share cap ita l by making a r ig ht i ssue.

iv) There i s no mandatory payments to shareholders o f equi ty shares .

2) Preference share capita l :

These are spec ial kind of shares, the holders o f which enjoy pr ior i ty in both, repayment o f

capi tal a t the t ime of wind ing up of the company and payment o f fixed dividend. Long -term funds

from preference shares can be ra ised through a public i ssue of shares. Such shares are normal ly

cumula tive, i . e . the dividend payable in a year of loss ge ts carr ied over to the next t i l l , there are

adequate profi ts to pay cumulat ive dividends. Rate of dividend on preference shares i s normally

higher than the ra te o f interest on debentures, loans, e tc . Most o f preference shares no w a days carry

a st ipulat ion of per iod and the funds have to be repa id a t the end of a st ipula ted per iod. Preference

share cap ital i s a hybrid form of f inancing tha t par takes some charac ter i st ics o f equi ty capi ta l and

some a t tr ibutes o f debt capital . I t is simi lar to equity because preference dividend, l ike equi ty

dividend i s not a tax deductib le payment. I t resembles debt capital as the ra te o f preference d ividend

is f ixed. When preference dividend i s skipped, i t i s payable in future due to the cumula tive feature

assoc iated wi th most o f preference shares. Cumulat ive Conver t ible P reference Shares (CCPs) may

also be offered, under which the shares would carry a cumulat ive dividend of spec i f ied l imi t for a

per iod of say 3 years , af ter which the shares are converted into equi ty shares. These shares are

at trac t ive for projec ts wi th a long gestat ion per iod. For normal preference shares, the maximum

permissib le rate of dividend i s 14 %. Preference share capi tal may be redeemed at a predecided future

date or at an ear l ier s tage inter al ia out o f the company's prof i ts . This enab les t he promoters to

wi thdraw thei r capi ta l f rom the company which is no w se l f -sufficient , and the wi thdrawn cap ita l may

be re invested in other prof i tab le ventures. I r redeemable preference shares cannot be issued by any

company. Preference shares gained importa nce af ter the Finance Bil l 1997 as dividends became tax

exempted in the hands of the ind ividual investor and are taxable in the hands of the company as tax i s

imposed on dist r ibutable prof i t s a t a f la t rate . The Budget , for 2000 - 01 has doubled the divide nd tax

from 10 % to 20 % besides a surcharge of 10 %. The budget for 2001 - 2002 has reduced the d ividend

tax fro m 20 to 10 %. Many companies fo l lo wed this route dur ing 1997 espec ial ly through pr ivate

placement or preference shares as the capital markets w ere no t vibrant .

The advantages of taking the preference share capita l are as fol lows :

1) No di lut ion in EPS on enlarged cap ital base : I f equity i s i ssued i t reduces EPS, thus a ffec ting the

market percept ion about the co mpany.

2) There i s leveragi ng advantage as i t bears a f ixed charge.

3) There i s no r isk o f takeover .

4) There i s no d ilut ion of manager ia l control .

5) Preference capi tal can be redeemed after a speci f ied per iod.


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3) Retained Earnings : Long term funds may a lso be provided b y accumulat ion of company's prof i t s

and on ploughing them back into business. Such funds be long to the ordinary shareholders and

increases the company's ne t worth. A public l imi ted company must p lough back a reasonable amount

of profi t every year , keeping in view the lega l requirements in this regard , and i t s own expansion

plans. Such funds enta i l a lmost no r i sk and the present o wner 's contro l is mainta ined as there is no

dilut ion of contro l .

4) Debentures or bonds :Loans can be ra ised from publ ic on i ss ue of debentures or bonds by public

l imi ted companies. Debentures are normally i ssued in di fferent deno minations ranging from Rs. 100

to 1000 and carry di fferent ra tes o f interes t . On issue of debentures, a company can raise long term

loans from public . Us ually, debentures are i ssued on the basis o f a debenture trust deed which l i st s

terms and condit ions on which debentures a re floated . They are normal ly secured agains t the

company's asse ts. As compared wi th preference shares , debentures provide a more conv enient mode

of long term funds. Cost o f cap ital raised through debentures i s lo w as the interes t can be charged as

an expense before tax. From the investors ' v iew point , debentures o ffer a more at trac t ive prospec t

than preference shares as interest on debe ntures is payable whether or no t the company makes prof i t s .

Debentures are thus , ins truments for raising long term deb t capi ta l . Secured debentures are pro tected

by a charge on the company's asse ts. Whi le the secured debentures of a wel l -establ ished company

may be a t tract ive to investors , secured debentures o f a new company do not normal ly evoke same

interes t in the invest ing public .

Advantages :

1) The cost o f debentures i s much lower than the cost o f preference or equi ty cap ital as the interest is

tax-deduct ible . Also, investors consider debenture investment safer than equity or prefer red

investment and thus, may require a lower re turn on debenture investment .

2) Debenture financing does no t result in di lut ion of contro l .

3) In a per iod of r i sing pr ices, debenture i ssue is advantageous. The fixed monetary outgo decreases

in rea l terms as the pr ice level increases.

Disadvantages of debenture f inancing are as below :

1) Debenture interest and capi ta l repayment are obliga tory payments.

2) The pro tec tive covenants associated wi th a debenture i ssue may be res tr ic t ive.

3) Debentures f inancing enhances the f inancia l r isk associa ted wi th the f irm.

These days many companies are i ssuing conver t ib le debentures or bonds wi th a number of

schemes/ incentives l ike warrants /opt ions, e tc . These bonds or debentures are exchangeable at the

ordinary share holder 's option under speci f ied terms and condi t ions. Thus, for the fir s t few years

these secur i t ies remain as debentures and late r they can b e conver ted into equi ty shares at a pre -

determined conversion pr ice. The i ssue of conver t ib le debentures has dis t inc t advantages from the

view point o f the i ssuing company.

- such as i ssue enab les the management to raise equity capi tal indirect ly wi thout d i lut ing the equity

holding, unti l the capi ta l ra ised star t s earning an added re turn to suppor t addi t ional shares.

- such secur i t ies can be issued even when the equi ty market i s no t very good.

- conver t ib le bonds are normally unsecured and, thus, the ir i ssuance may ord inar i ly no t impair the

borrowing capaci ty.

These debentures /bonds are i ssued subject to the SEBI guidel ines no ti f ied fro m t ime to t ime.

Publ ic i ssue of debentures and pr ivate p lacement to mutual funds, requi re that the i ssue be ra ted by a

credi t ra t ing agency as CRISIL (Cred it Rat ing and Informat ion Services o f Ind ia Ltd. ) . The cred it

rat ing i s given after evalua ting fac tors as t rack record of the company, profi tabi l i ty, debt service

capac ity, cred it wor thiness and the percei ved r i sk o f lend ing.

5) Loans fro m financial inst itut ions : In Ind ia spec ia l i sed ins t i tut ions provide long -term f inancia l

assis tance to industr ies. Some of them are , Indust r ia l Finance Corporations, Li fe Insurance


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Corpora tion of India, National Smal l Indu str ies Corporat ion Limi ted , Industr ia l Cred it and

Investment Corpora tion, Industr ial Development Bank of Ind ia and Industr ial Reconst ruc tion

Corpora tion of India. Before sanct ioning of a term loan, a company has to sa t i s fy the concerned

f inancia l inst i tut ion regard ing the technical , commerc ia l , economic, f inancia l and manager ia l

viabi l i ty o f the projec t for which the loan i s requi red. Such loans are avai lable at d i fferent ra tes o f

interes t under d i fferent schemes of f inancial inst i tut ions and are to be rep a id as per a s t ipulated

repayment schedule. The loans in many cases st ipula te a number of condit ions as regards the

management and cer ta in other f inancia l polic ies of the company. Term loans represent secured

borrowings and are an important source of funds fo r new projects. They general ly, car ry a ra te o f

interes t inclus ive of inte res t tax, depending on the cred it rat ing of the borrower, the perceived r isk o f

lending and cost o f funds and general ly repayable over a per iod of 6 to 10 years in annual , semi -

annual or quar ter ly insta l lments. Term loans are also provided by banks, Sta te Financial /Development

ins t i tut ions and a l l Ind ia term lend ing financial ins t i tut ions. Banks and State Financia l Corporations

provide term loans to p rojects in the small scale sect or whi le , for medium and large industr ies term

loans are provided by State developmental inst i tut ions alone or in consort ium wi th banks and Sta te

f inancia l corpora tions. For large sca le projects Al l India financial ins t i tut ions provide bulk of term

f inance s ingly or in consort ium wi th other such ins t i tut ions, S tate leve l inst i tut ions and /or banks .

After independence , the inst i tut ional se t up in India for the provis ion of medium and long term credit

for industry has been broadened. The ass istance sanct ioned and d isbursed by these specia l i sed

ins t i tut ions has increased impress ive ly over the years. A number o f special ised ins t i tut ions are

es tabl i shed over the country.

6) Loans fro m co mmercial banks : The pr imary ro le o f the commerc ia l banks i s to cater to the short

term requi rement o f industry. However , o f la te , banks have star ted taking an interest in term

f inancing of industr ies in severa l ways , though the formal term lending i s , s t i l l , smal l and confined to

major banks . Terms lendings by bank i s a cont rover s ial i ssue these days. I t is argued that term loans

do not sat is fy the canon of l iquid ity tha t i s a major considerat ion in al l bank operat ions . Accord ing to

tradi t ional values, banks should provide loans only for short per iods and opera t ions result ing in

automatic l iquida tion of such credi ts over shor t per iods. On the other hand , i t i s contended that the

tradi t ional concept needs modif ica t ion. The proceeds o f term loan are used for what are broadly

kno wn as f ixed asse ts or expansion in p lant capaci ty. Their repayment i s usual ly scheduled over a

long per iod of t ime. The l iquid ity o f such loans i s sa id to depend on the ant ic ipated income of

borrowers.

Working capi tal loan is more permanent and long term as compared to a term loan. The

reason be ing that a term loan i s a lways repayable on a fixed da te and ul t imate ly, the account wi l l be

tota l ly adjus ted. Ho wever , in case o f working capi tal finance , though payable on demand, in actua l

pract ice i t i s not iced that the account i s never adjusted as suc h and i f a t a l l the payment i s asked

back, i t is wi th a clear purpose and intention of re finance being provided a t the beginning of next

year or hal f year . This technique of provid ing long term f inance i s known as, " rol led over for

per iods exceed ing more than one year" . Instead of indulging in term f inancing by the rol led over

method, banks can and should extend credi t te rm af ter a proper appra isal o f appl icat ions for term

loans. The degree of l iquid ity in the provision for regular amort i sa t ion of term loa ns is more than in

some of these so ca l led demand loans which are renewed from year to year . Actual ly, te rm f inancing,

discip lines both the banker and borro wer as long te rm p lanning i s required to ensure that cash

inf lo ws would be adequate to meet the inst ruments o f repayments and al low an ac tive turnover o f

bank loans. The adopt ion of the formal term loan lend ing by commercial banks wi l l not hamper the

cr i ter ia o f l iquidity, and wi l l introduce f lexibi l i ty in the operat ions o f the banking sys tem.

The rea l l imi ta t ion to the scope of bank act ivi t ies i s tha t a l l banks a re not well equipped to

appraise such loan proposa ls . Term loan proposals invo lve an element of r isk because of changes in

condit ions a ffec ting the borrower. The bank making such a loan, thus, has to assess the s i tuat ion to

make a proper appraisal . The decision in such cases depends on var ious fac tors a ffec t ing the

concerned industry 's condit ions and borro wer 's earning po tential .

7) Bridge f inance : I t re fers to loans taken by a company fro m commercia l banks for a short per iod,

pending disbursement of loans sanc tioned by financial inst i tut ions. Normal ly, i t takes t ime for

f inancia l ins t i tut ions to disburse loans to co mpanies. Ho wever , loans once approved by the term

lending inst i tut ions pending the signing of regular term loan agreement , that may be delayed due to

non-co mpl iance of condit ions st ipulated by the ins t i tut ions whi le sanc tioning the loan. The br idge

loans are repaid /adjus ted out o f term loans as and when d isbursed by t he concerned inst i tut ions. They

are secured by hypothecat ing movable asse ts , personal guarantees and demand promissory notes.

General ly, the interes t rate on them is higher than on te rm loans .


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Quest ion : What do you mean by Venture Capita l F inancing ?

Answer : Venture cap i tal f inancing refers to f inancing of new high r isky venture p romoted by

quali f ied entrepreneurs lacking exper ience and funds to give shape to their ideas . Under i t venture

capi tal i st make investment to purchase equi ty or debt secur i t i es from inexperienced entrepreneurs

under taking highly r i sky ventures wi th a potent ial o f success. The venture cap ita l industry in India i s

jus t a decade old. The venture cap ital is t f inance ventures tha t a re in na tional pr ior i ty areas such as

energy conser va tion, quali ty upgradation, e tc . The Government o f India in November 1988 issued the

f irs t set o f guide lines for venture capi ta l companies, funds and made them el igib le for capi tal ga in

concessions. In 1995, cer ta in new c lauses and amendments were made in the guide lines tha t require

the venture cap ita l i s ts to meet the requirements o f di fferent sta tutory bodies and this makes i t

d i f ficult for them to operate as they do not have much flexib il i ty in st ructur ing investments . In 1999,

the exis t ing guide lines we re re laxed for increasing the at trac t iveness of the venture schemes and to

induce high net wor th investors to commit the ir funds to 'sunrise ' sec tors, par t icular ly the

information technology sector . Ini t ia l ly the cont r ibution to the funds avai lab le for ven ture capi tal

investment in the country was from the All Ind ia develop ment f inancia l inst i tut ions, Sta te

development financial inst i tut ions, commercial banks and companies in p r iva te sec tor . Lately many

offshore funds have been star ted in the country and ma ximum contr ibution is from foreign

ins t i tut iona l investors. A few venture cap ita l companies opera te as both investment and fund

management companies, o ther se t up funds and funct ion as asse t management company. I t i s hoped

that changes in the guidelines fo r implementa t ion of venture capi tal schemes in the country would

encourage more funds to be se t up to give the required momentum for venture cap ital investment in

Ind ia. Some common methods of venture capi ta l f inancing are :

1) Equity f inancing : The venture cap ital under takings usual ly require funds for a longer per iod but ,

may not be ab le to provide re turns to investors dur ing the ini t ial s tages. Thus , the venture capital

f inance i s genera l ly provided by way of equi ty share cap ita l . The equi ty contr ibut ion of venture

capi tal f irm does no t exceed 49 % of the to ta l equity capi ta l o f venture cap ita l under takings so that

the e ffec tive cont rol and ownership remains wi th the entrepreneur .

2) Condit ional loan : I t i s repayable in the fo rm of a royalty a f ter t he venture i s ab le to generate

sa les. No interes t i s pa id on such loans. In India venture cap ital f inancers charge royal ty ranging

between 2 and 15 %, actua l rate depends on o ther fac tors o f the venture as ges ta t ion per iod, cash

f low pat terns, r iskiness and other fac tors o f the enterpr ise . So me venture capi ta l financers give a

cho ice to the enterpr ise of paying a high rate of interes t , which can be wel l belo w 20 %, ins tead of

royalty on sales once i t becomes co mmerc ia l ly sounds.

3) Inco me note : I t i s a hybr id secur i ty combining fea tures o f both convent ional and condit ional

loan. The ent repreneur has to pay interes t and royalty on sa les but , a t substant ial ly lo w ra tes. IDBI 's

Venture Capital Fund (VCF) provides funding equal to 80 - 87.5 % of the projec t cos t for commercial

applicat ion of indigenous technology.

4) Participating debentures : Such securi ty carr ies charges in 3 phases - in the star t up phase no

interes t i s charged, next stage - a lo w rate of interest i s charged up to a par t icular leve l o f op erat ion

and after that , a high ra te o f interes t i s required to be pa id.

Question : Write a note on Debt Securit isat ion ?

Answer : Debt secur i t i sat ion i s a method of recycling of funds. I t i s especia l ly beneficial to financia l

in termediar ies to suppor t the lending volumes. Asse ts genera t ing steady cash flo ws are packaged

together and against th is asse t pool market secur i t ies can be i ssued. The basic debt securi t i sa t ion

process can be c lass i fied in the fol lowing 3 functions :

1) The Orig ination funct ion : A borro wer seeks a loan from a finance company, bank, housing

company or a lease from a leasing company. The cred itworthiness o f the borrower i s evaluated and a

contract is entered into wi th repayment schedule s truc tured over the l i fe o f the loan.

2) The Pooling function : Similar loans or receivab les are clubbed together to create an underlying

pool o f assets. This pool i s t ransferred in favour o f a SPV (Specia l Purpose Vehic le) , which ac ts as a

trus tee for the investor . Once the assets are transfer red, they are he ld in the or iginators ' por t fo l io .

3) The Securit isat ion function : I t i s the SPV's job now to structure and i ssue the securi t ies on the

bas is o f the asse t pool . The secur i t ies carry a coupon and an expected matur i ty which can be asse t


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based or mor tgage based. These are general ly so ld to investors through merchant bankers . The

investors interested in this type of securi t ies are general ly ins t i tut iona l investors l ike mutua l funds,

insurance co mpanies , e tc . The or iginator usua lly keeps the sp read ava i lable i .e . d i f ference be tween

yield from secured asse ts and interest pa id to investors. The process of securi t i sat ion i s general ly

wi thout recourse i .e . the investor bears the credit r isk or r isk o f defaul t and the i ssuer i s under an

obliga tion to pay to investors only i f the cash f lows are rece ived by him from the col la tera l . The r i sk

run by the investor can be fur ther reduced through cred it enhancement faci l i t ies as insurance, le t ter s

of cred it and guarantees . In a simple pass through s truc ture, the investor owns a proport ionate share

of the asset pool and cash f lows when generated are passed on d irect ly to the investor . This i s done

by i ssuing pass through cer t i ficates. In mortgage or asse t backed bonds, the investor has a l ien on the

under lying asse t pool . The SPV accumulates payments from borrowers f rom time to t ime and make

payments to investors a t regular predetermined interva ls. The SPV can invest the funds rece ived in

short term inst ruments and improve yie ld when there i s a t ime lag between receip t and payment.

Benef it s to the Orig inator :

1) The assets are shi f ted off the balance shee t , thus, giving the o r iginator recourse to o ff ba lance

shee t funding.

2) I t converts i l l iquid asse ts to l iquid port fo l io .

3) I t faci l i ta tes bet ter bala nce sheet management as assets are t ransferred off balance shee t

faci l i ta t ing sa t i s fact ion of capi ta l adequacy norms.

4) The or igina tor 's credi t ra t ing enhances.

For the investor , secur i t i sat ion opens up new investment avenues. Though the investor bear s the

credi t r i sk. The secur i t ies a re t ied up to def ini te assets. As compared to factor ing or bi l l d iscount ing

which large ly solve the problems of shor t term trade f inancing. Secur i t isat ion he lps to conver t a

stream of cash receivab les into a source of lon g term f inance. For a developed securi t i sat ion market ,

high qual i ty asse ts wi th lo w default rate are essentia l wi th standard ised loan documenta tion and

stable interes t rate structure and suff ic ient da ta on asset per formance, developed secondary debt

markets are essent ial fo r this . In Indian context debt securi t i sa t ion has began to take off. The ideal

candida tes for this are hi re purchase and leasing companies, asset f inance and rea l es ta te finance

companies . ICICI, HDFC, Ci t ibank, Bank of America, e tc . hav e or are planning to ra ise funds by

securi t i sa t ion.

Quest ion : Explain brief ly the term Lease Financing ?

Answer : Leasing i s a genera l contract between the owner and user o f the asset over a spec i fied

per iod of t ime. The asse t i s purchased ini t ia l l y by the lessor ( leasing company) and thereafter leased

to the user ( lessee company) tha t pays a speci f ied rent a t per iodical interva ls . Thus, leasing is an

al terna tive to the purchase of an asse t out o f own or borro wed funds. Moreover , lease f inancing can

be arranged much faster as compared to term loans from financial inst i tut ions. In recent years,

leasing has become a popular source of financing in Ind ia. From the lessee 's view point , leasing has

the at trac t ion of el iminating immediate cash out flow and t he lease rentals can be deducted for

computing the total income under the Income tax act . As against this , buying has the advantages o f

deprec iat ion al lowance inclus ive of addi t ional deprec iat ion and interest on borro wed capi ta l being

tax deduct ible . Thus, an evaluat ion of the 2 al te rna tives i s to be made in order to take a dec is ion.

Quest ion : Explain the various sources of short term f inance ?

Answer : Follo wing are the var ious sources o f shor t term f inance :

1) Trade credit : I t represents credi t granted by suppl iers o f goods , e tc . as an inc ident o f sa le . The

usual durat ion of such credi t i s 15 to 90 days. I t generates automatica l ly, in the course o f business

and i s co mmon to a lmost a l l business opera t ions. I t can be in the form of an 'open account ' or 'b i l l s

payable ' . Trade credi t i s preferred as a source of finance as i t i s wi thout any explici t cos t and t i l l a

business i s a go ing concern, i t keeps on ro tat ing. I t a l so, enhances automatica l ly wi th the increase in

the volume of business.


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2) Advances fro m customers : Manufac turers and cont rac tors engaged in producing or construc ting

cost ly goods involving considerab le length of manufac tur ing or construc tion t ime usual ly, demand

advance money from the ir customers a t the t ime of accep ting th e i r orders for executing the ir

contracts or supplying the goods. This i s a cos t free source of f inance and real ly useful .

3) Bank advances : Banks receive deposi t s from public for di fferent per iods at varying rates o f

interes t there are funds invested and lent in such a manner tha t when required, they may be called

back. Lending result s in gross revenues out o f which costs , such as interes t on deposi t s ,

adminis tra t ive costs, e tc . are met and a reasonable prof i t i s made . A bank 's lend ing pol icy is no t

merely prof i t mot iva ted but has to keep in mind the soc io -economic development o f the country. As a

prudent po licy, banks normal ly spread out their funds as under :

i ) About 9 - 10 % in cash.

i i ) About 32 % in approved government and semi -government securi t ies.

i i i ) About 58 % in advances to the ir credi ts .

Banks advances a re in the fo rm of loan, overdraf t , cash cred it and bil l s

purchased/d iscounted, e tc . Banks do no t sanc tion advances on long term basis beyond a small

proport ion of the i r demand and t ime l iab il i t ies. Advances are granted aga inst tangib le securi t ies such

as goods, shares, government pro missory no tes , b i l l s , e tc . In rare cases, c lean advances may a lso be

al lo wed.

a) Loans : In a loan account, the ent ire advance i s d isburs ed a t one t ime in cash or by transfer to the

cur rent account o f the borrower. I t i s a single advance, except by way of interes t and other charges,

no fur ther adjustments are made in this account. Loan accounts a re not running accounts l ike

overdraft and ca sh credi t accounts, repayment under the loan account, may be ful l amounts or by way

of schedule o f repayments agreed upon as in case o f terms loans. The securi t ies may be shares,

government secur i t ies, l i fe insurance pol icies and f ixed deposit receip ts and so on.

b) Overdrafts : Under this faci l i ty, cus tomers are a l lo wed to wi thdraw in excess o f credi t balance

standing in the ir current deposi t account. A fixed l imi t i s thus, granted to the borro wer wi thin which

the borrower is a l lo wed to overdraw his acc ount . Opening of an overdraft account requires that a

cur rent account is formally opened. Although overdraf ts are repayable on demand, they usually

continue for long per iods by annual renewals of l imi ts. This i s a convenient arrangement for the

borrower, as he i s in a posi t ion to ava il the sanct ioned l imi t as per his requirements. Interest is

charged on dai ly ba lances, cheque books are provided, these accounts being operat ive as cash credi t

and cur rent accounts . Secur i ty, as in case of loan accounts, may be shares, debentures and

government secur i t ies, l i fe insurance pol ic ies and f ixed deposi t rece ipts a re a lso accep ted in specia l

cases.

c) Clean overdrafts : Request for such faci l i ty is enter tained only from financial ly sound par t ies tha t

are reputed for the ir in tegr i ty. Bank i s to re ly on personal secur i ty o f the borrowers , thus, i t has to

exerc ise a good dea l o f res tra int in enter ta ining such proposals, as they have no backing of any

tangib le securi ty. In case par t ies are a lready enjoying secured advanc e faci l i t ies, this may be a point

in favour and may be taken into account whi le screening such proposa ls . The turnover in the account,

sa t i s factory dealings for considerab le per iod and reputat ion in the market are a lso considered by the

bank. As a safeguar d, banks take guarantees from o ther persons who are credi t worthy before granting

this fac i l i ty. A clean advance i s general ly granted for a short per iod and must not be cont inued for

long.

d) Cash credits : Cash credi t i s an arrangement under which, a cu s tomer is al lowed an advance upto

cer tain l imi t aga ins t credit granted by bank. Under i t , a cus tomer need not borro w, the ent ire amount

of advance at one t ime. He can only draw to the extent o f his requi rements and deposit h is surp lus

funds in his account. Interest is not charged on the ful l amount o f advance but , on the amount

actua lly avai led by him. Usually, credi t l imi ts a re sanct ioned aga inst the securi ty o f goods by way of

pledge or hypothecat ion, though they are repayable on demand, banks usual ly do no t recal l them,

unless they are compel led to do so by adverse fac tors. Hypotheca tion i s an equi tab le charge on

movable goods fo r an amount o f deb t where neither possess ion nor ownership i s passed on to the

credi tor . For p ledge, the borrower de livers the g oods to the credi tor as securi ty for repayment o f


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debt. S ince the banker , as credi tor , i s in possession of the goods, he i s ful ly secured and in case o f

emergency he may fal l back on the goods for real isat ion of his advance under proper no tice to the

borrower.

e) Advances against goods : Advances aga ins t goods occupy an impor tant place in total bank credit ,

goods as securi ty have cer ta in dis t inc t advantages :

- they provide a re l iable source of repayment

- advances aga ins t goods are safe and l iquid

Genera lly, goods are charged to the bank by way of pledge or hypotheca tion. The term

'goods ' inc ludes al l fo rms of movables tha t are o ffered to the bank as secur i ty. They may be

agr icultural commodi t ies, industr ial raw mater ials , par t ly f inish ed goods and so on. RBI issues

direc t ives from t ime to t ime imposing res tr ict ions on advances against cer ta in commodit ies. I t is

obliga tory on banks to fol lo w these direct ives in let ter and spir i t , they may so met imes, also st ipulate

changes in margin.

f ) Bil l s purchased/discounted : These advances are al lowed against the secur i ty o f bi l l s tha t may be

clean or documentary. Bi l l s are sometimes, purchased from approved customer, in whose favour

l imi ts are sanc tioned. Before granting a l imi t , the banker sa t i s f ies himsel f as to the credi twor thiness

of the drawer. Al though the term 'b i l ls purchased ' g ives the impress ion that the bank becomes the

owner or purchaser o f such bi l l s , in real i ty, the bank holds the b i l l s as securi ty only, for the advance.

In add it ion to the r ights aga inst the par t ies l iable on the bi l ls , the banks can a lso exerc ise a pledgee 's

r ights over the goods covered by the documents. Usuance bi l l s matur ing at a future da te or s ight are

discounted by the banks for approved par t ies . When a b i l l i s discounted, the borrower i s paid the

present wor th. The bankers, ho wever , col lec t the ful l amounts on maturi ty, the di ffe rence between the

2 i .e . the amount o f the bi l l and the discounted amount represents earnings o f bankers for the per iod;

i t is termed as 'd iscount ' . So met imes, overdraf t or cash credi t l imi ts are al lo wed agains t the secur i ty

of b i l l s . A suitable margin i s usua lly mainta ined. Here the bi l l i s not a pr imary secur i ty but , only a

collate ral one. In such case , the banker does not become a pa r ty to the bi l l , but merely co llects i t as

an agent for i t s customer. When a banker purchases o r discounts a bi l l , he advances agains t the bi l l ,

he thus , has to be very caut ious and grant such faci l i t ies only to cred itworthy customers, having an

es tabl i shed steady rela t ionship wi th the bank. Credit reports are also complied on the drawees.

g) Advance against documents of t it le to goods : A document becomes of document o f t i t le to goods

when i ts possession i s recognised by law or business custo m as possess ion of the goods. These

documents inc lude a b i l l o f lad ing, dock warehouse keeper 's cer t i f icate , ra i lway receip t , e tc . A

person in possession of a document to goods can by endorsement or delivery or both of document,

enables ano ther person to take del ivery of the goods in his r ight . An advance aga ins t p ledge of such

documents i s equivalent to an advance aga inst the pledge of goods themselves.

h) Advance against supply of bi l l s : Advances against b i l l s for supply of goods to government or

semi-government departments aga ins t firm orders a f ter accep tance of tender fal l under this category.

Other type of bi l l s under this ca tegory are bi l l s f rom contrac tors for work executed wholly or

par t ial ly under fi rm contrac ts entered into wi th the here in mentioned governm ent agencies. These are

clean bi l l s , wi thout being accompanied by any document o f t i t le o f goods. But, they evidence supply

of goods direct ly to Governmental agencies. They may, sometimes, be accompanied by inspect ion

notes from representa t ives o f governme nt agencies for inspec ting the goods before despatch. I f b i l l s

are wi thout inspect ion report , banks l ike to examine them wi th the accepted tender or cont ract for

ver i fying that the goods supplied under the bi l l s s tr ict ly conform to the terms and condi t ions in the

accep tance tender . These supply bi l l s represent deb t in favour o f suppliers /cont rac tors, for goods

suppl ied to government bodies or work executed under contrac t fro m the Government bodies . This

debt i s ass igned to the bank by endorsement of supply b il l s and execut ing ir revocable power o f

at torney in favour of banks for rece iving the amount o f supply bil l s f rom the Government

departments. The po wer of at torney has got to be regis tered wi th the depar tment concerned . The

banks a lso take separate let te r from the suppliers/contractors ins truc ting the Government body to pay

the amount o f bi l l s d irect to the bank. Supply b il l s do no t enjoy the legal s ta tus o f negotiab le

ins truments as they are not b i l l s o f exchange. The secur i ty ava ilab le to a banker i s by way of

assignment o f deb ts represented by the supply b il l s .

i ) Term loans by banks : I t i s an instalment credi t repayable over a per iod of t ime in

monthly/quar ter ly/ha l f -year ly or year ly instalments. Banks grant te rm loans for smal l projects fa l l ing

under the pr ior i ty sec tor , small scale sec tor and big unit s . Banks have now been permi tted to sanc tion

term loan for projects as well wi thout assoc ia t ion of financial inst i tut ions. The banks grant loans for


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periods normal ly ranging from 3 to 7 years and at t imes even more. These loans are granted on the

securi ty o f fixed asse ts .

j ) Financing of exports by banks : Advances by commerc ia l banks for expor t f inancing are in the

form of :

a) Pre-shipment f inance i . e . before shipment of goods : This usua l ly, takes the form of packing

credi t fac i l i ty, which i s an advance extended by banks to an exporter for the purpose of buying,

manufac tur ing, process ing, packing, shipping goods to overseas buyers. Any exporter , having at hand

a firm expor t order placed wi th him by his fore ign buyer o r an ir revocable let ter o f credi t opened in

his favour , can approach a bank for ava il ing packing credi t . An advance so taken requires to be

l iquidated wi thin 180 days from the date o f i t s commencement by negotia t ion of export proceeds in

an approved manner . Thus, packing credi t i s essentia l ly a short te rm advance. Usually, banks ins ist

on their cus tomers to lodge wi th them irrevocable le t ter s o f cred it opened in favour o f the customers

by overseas buyers. The le t ter o f cred it and f irm sale contracts no t only serve as evidence of a

def ini te arrangement fo r rea l i sa t ion o f the export proceeds but also indica te the amount o f finance

required by the expor ter . Packing c redi t in case of cus tomers o f long s tand ing, may also be granted

against f irm contracts entered into by them wi th overseas buyers. Fo llowing are the types o f packing

credi t avai lable :

i ) Clean packing credit : This i s an advance avai lable to an expor ter only on product ion of a f irm

expor t order or a le t te r o f credi t wi thou t exercising any charge or control over raw mater ial or

f inished goods. Each proposa l i s weighted according to par t icular requirements o f trade and credit

worthiness o f the expor ter . A sui tab le margin has to be mainta ined. Also, Expor t Credi t Guarantee

Corpora tion (E.C.G.C.) cover should be obtained by the bank.

i i ) Packing credit against hypothecation of goods : Expor t f inance i s made avai lable on cer tain

terms and condi t ions where the expor ter has pledgeable interes t and the goods are hypotheca ted to th e

bank as securi ty wi th s t ipula ted margin. At the t ime of ut i l i sing the advance, the exporter i s requi red

to sub mit , a long wi th the firm export order or le t ter o f credi t , re la t ive s tock s ta tements and thereafter

continue submitt ing them every for tnight and /or whenever there i s any movement in s tocks.

i i i ) Packing credit against pledge of goods : Expor t finance i s made ava ilable on cer ta in terms and

condit ions where the expor table f inished goods are p ledged to the banks wi th approved clear ing

agents who wo uld ship the same from time to t ime as required by the expor ter . Possession of goods

so pledged l ies wi th the bank and are kep t under i t s lock and key.

iv) E.C.G.C. guarantee : Any loan given to an expor ter for the manufacture, process ing, purchasing

or packing of goods meant for export agains t a f irm order quali f ies for packing. Credi t guarantee i s

issued by the Expor t Credit Guarantee Corpora t ion (E.C.G.C.) .

v) Forward exchange contract : Another requi rement o f packing cred i t fac i l i ty is tha t i f the e xpor t

bi l l is to be drawn in a foreign currency, the exporter should enter into a forward exchange cont rac t

wi th the bank, thereby avoiding r i sk involved in a poss ible change in the exchange ra te .

Documents required : - In case o f par tnership f irms, ban ks usua lly requi re the fo l lo wing documents :

Joint and severa l demand pronote s igned on behal f o f the f irm as also by par tners

ind ividual ly;

Let ter o f cont inui ty, signed on behal f o f the f irm and par tners individually;

Let ter o f p ledge to secure deman d cash credi t against stock, in case o f p ledge or agreement

of

hypothecat ion to secure demand cash cred it , in case o f hypothecat ion.

Let ter o f author i ty to operate the account ;

Declarat ion of Par tnership , in case o f so le traders, so le propr ie tors hip declarat ion;

Agreement to ut i l i se the monies drawn in terms of contract ;

Let ter o f hypotheca tion for bi l l s .

- Fol lowing documents a re requi red by banks , in case o f l imi ted companies :

Demand pro -note;

Let ter o f cont inui ty;

Agreement o f hypoth ecation of let ter o f p ledge, signed on behal f o f the company;

General guarantee o f the directors ' resolution;

Agreement to ut i l i se the monies drawn in terms of contract should bear the company's seal;


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Let ter o f hypotheca tion for bi l l s

b) Post shipment f inance : I t takes the be low mentioned forms :

i ) Purchase /Discount ing of documentary export bil ls : Finance i s provided to expor ters by

purchasing expor t bi l ls drawn payable at sight or by discounting usuance export bi l l s cover ing

confirmed sales and backed by documents inclusive of documents o f t i t le to goods such as bi l l o f

lading, post parce l receipts o r a ir consignment notes. Documents to be obtained are :

Let ter o f hypothecat ion covering the goods; and

General guarantee o f directors or par tners o f the f irm, as the case may be.

E.C.G.C. Guarantee : Post -shipment f inance , given to an expor ter by bank through purchase,

negotiat ion or discount of an expor t bi l l aga ins t an order , qua li f ies for post -shipment expor t c redit

guarantee. I t i s necessary, t ha t exporters obta in a shipment or contrac ts r isk pol icy of E.C.G.C. Banks

ins ist on the exporters to take a contracts shipments (co mprehensive r isks) pol icy covering both

poli t ical and commercia l r isks. The Corpora tion, on acceptance of the policy, would fix cred it l imi ts

for ind ividual exporters and the Corporat ion 's l iabi l i ty wi l l be l imi ted to the extent o f the l imit so

f ixed for the exporter concerned ir respect ive o f the policy amount.

i i ) Advance against export bil ls sent for col lect ion : Finance is provided by banks to expor ters by

way of advance agains t expor t bi l ls forwarded through them for col lect ion, taking into account the

par ty's cred itworthiness , na ture o f goods exported, usuance , s tanding of drawee, e tc . appropriate

margin is kept . Document s to be obta ined :

Demand promissory no te;


Let ter o f hypothecat ion covering b il l s;


i i i ) Advance against duty draw backs, cash subsidy, etc . : To finance export losses sustained by

expor ters, bank advance aga inst duty draw -back, cash subsidy, e tc . rece ivable by them against expor t

per formance. Such advances are o f c lean nature, hence, necessary precaut ion is to be exercised .

Condit ions : Bank providing fin ance in this manner should see tha t the rela t ive expor t bi l l s a re e i ther

negotiated or forwarded for col lec t ion through i t so that , i t i s in a posi t ion to ver i fy the exporter 's

c la ims for duty draw-backs, cash subsidy, e tc . An advance so ava iled by an exp orter i s required to be

l iquidated wi thin 180 days from the date o f shipment o f relat ive goods.

Documents to be obtained are :

Demand promissory no te;



Undertaking fro m the borrowers that they wi l l deposit the cheques/payments received from the

appropria te author i t ies immediately wi th the bank and wi l l not ut i l ise such amounts in any

other way.

c) Other faci l it ies extended to exporters :

i ) On behal f o f approved exporters, banks estab li sh le t ter s o f cred it on the ir overseas o r up -country

suppl iers.

i i ) Guarantees for waiver o f excise duty, etc . due per formance of cont rac ts , bond in l ieu of cash

securi ty deposi t , guarantees for advance payments, e tc . are a lso i ssued by banks to approved c l ients.

i i i ) To approved c l ients under taking expor ts on deferred payment terms, banks also provide f inance.

iv) Banks a lso endeavour to secure for their expor ter -customers status repor ts o f their buyers and

trade

information on var ious commodit ies through thei r correspondents .

v) Economic inte l l igence on var ious countr ies is al so provided by banks to the ir exporte r c l ients.

5) Inter corporate deposit s : The companies can borrow funds for a shor t per iod say 6 m onths from

other companies having surp lus l iquidi ty. The rate o f interest on i t var ies depending on the amount

involved and t ime per iod.


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6) Cert if icate of deposi t (CD) : I t i s a document of t i t le s imi lar to a t ime deposit rece ipt issued by a

bank excep t , tha t there i s no prescr ibed interes t rate on such funds. I t s main advantage i s tha t banker

is not required to encash the deposi t before matur i ty per iod and the investor is assured of l iquidity as

he can se l l i t in the secondary market .

7) Public deposit s : They are important source of shor t and medium term f inances par t icular ly due to

credi t squeeze by the RBI. A company can accept such deposi ts subject to the st ipula t ions o f the RBI

from t ime to t ime maximum upto 35 % of i ts paid up capi tal and reserves , fro m the publ ic and the

shareholders. These may be accep ted for a per iod of 6 months to 3 years. Publ ic deposi t s are

unsecured loans, and no t meant to be used for acquisi t ion of fixed asse ts, s ince, they are to be repaid

wi thin a per iod of 3 years. These are mainly used to finance working capita l requirements.

Quest ion : Enumerate and expla in the other sources of f inancing ?

Answer : The o ther sources o f financing are as d iscussed belo w :

1)Seed capital ass istance : The seed cap ita l assis tance scheme is designed by IDBI for

profess ional ly or technical ly quali f ied entrepreneurs and/or persons possess ing relevant exper ience,

ski l l s and entrepreneur ial t ra i t s . All the projects el igib le for financial assis tance from IDBI , d irec t ly

or ind irec tly thro ugh ref inance are el igib le under the scheme. The project cost should not exceed Rs.

2 crores and the maximum ass istance under the project wi l l be res tr icted to 50 % of the requi red

promoter 's cont r ibut ion or Rs. 15 lakhs, whichever i s lower. Seed capi tal a ssis tance is in teres t free,

but carr ies a service charge of 1 % per annum for the f irs t 5 years and at increas ing rate thereaf ter .

However , IDBI wi l l have the op tion to charge interest a t such ra te as determined by i t on the loan i f

the financial posi t ion and prof i tab il i ty o f the company so permi ts dur ing the currency of the loan.

The repayment schedule is f ixed depending on the repaying capacity o f the unit wi th an ini t ia l

morator ium upto 5 years. For projec ts wi th cost exceeding Rs. 200 lakhs, seed cap ita l may be

obtained from the Risk Capital and Technology Corporat ion Ltd. (RCTC). For smal l projec ts cost ing

upto Rs. 5 lakhs , assistance under the National Equity Fund of the SIDBI may be avai led.

2)Internal cash accruals : Exist ing profi t making compani es under taking an

expansion/d ivers i ficat ion programme may be permit ted to invest a par t of the ir accumulated reserves

or cash profi ts for creat ion of cap ita l asse ts . In such cases, the company's pas t per formance permits

capi tal expendi ture from wi thin the company by way of disinvestment of working/invested funds. In

other words, the surp lus generated from operat ions, a f ter meet ing al l the contractua l , s ta tutory and

working requirement o f funds, is ava ilable for fur ther capi ta l expenditure.

3)Unsecured loans : They are provided by promoters to meet the promoters ' contr ibution norm.

These loans are subord inate to inst i tut ional loans and interes t can be paid only a f ter payment o f

ins t i tut iona l dues. These loans cannot be repaid wi thout the pr ior approval o f f inancia l ins t i tut ions.

Unsecured loans are considered as par t o f the equi ty for the purpose of calculat ing deb t equity ra t io .

4)Deferred payment guarantee : Many a t ime supplie rs o f machinery provide a deferred credi t

faci l i ty under which payment for th e purchase of machinery may be made over a per iod of t ime. The

entire cost o f machinery i s f inanced and the company is not required to contr ibute any amount

ini t ia l ly to wards acquis i t ion of machinery. Normally, the supplier o f machinery would insis t that t he

bank guarantee be furnished by the buyer . Such a fac i l i ty does no t have a morator ium period for

repayment. Hence, i t is advisable only for an exis t ing profi t making company.

5)Capital Incent ives : Backward area development incentives avai lab le of ten determine the locat ion

of a new industr ial unit . They usually consist o f a lumpsum subsidy and exemption fro m or deferment

of sa les tax and octro i duty. The quantum of incentives i s de termined by the degree of backwardness

of the loca tion. Specia l capi tal incent ive in the form of a lumpsum subsidy i s a quantum sanct ioned

by the implement ing agency as a percentage of the f ixed capi tal investment subjec t , to an overal l

cei l ing. This amount fo rms a par t o f the long -term means of f inance for the project . Ho weve r , the

viabi l i ty o f the projec t must no t be dependent on the quantum and avai lab il i ty o f incentives.

Inst i tut ions, whi le appraising the projec t , assess i t s viab il i ty per se, without consider ing the impact

of incentives on the cash f lo ws and the project 's p rofi tab il i ty. Specia l capi tal incent ives a re

sanc tioned and released to the unit s only a f te r they have compl ied wi th the requi rements of the

relevant scheme. The requirements may be classi f ied into ini t ial effec t ive s teps, that inc lude

format ion of the f ir m/company, acquis i t ion of land in the backward area and registra t ion for

manufac ture o f the p roducts. The fina l e ffec t ive s teps include obtaining clearances under FEMA,


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capi tal goods clearance/ import l icense , conversion of Let ter o f Intent to Industr ial Li cense, t ie up of

the means of finance, a l l c learances required for the se t t ing up of the uni t , aggregate expenditure

incurred for the projec t should exceed 25 % of the project cos t and a t leas t 10 %, i f the fixed asse ts

should have been crea ted/acquired at si te . The release of spec ia l capi ta l incent ives by the concerned

Sta te Government general ly takes 1 to 2 years. Promoters thus, find i t convenient to avai l the br idge

f inance agains t the cap ita l incent ives. Provis ion for the same should be made in the pre -operat ive

expenses considered in the projec t cost . As the b r idge finance may be available to the extent o f 85 %,

the ba lance i .e . 15 % may have to be brought in by the promoters fro m the ir o wn resources .

6)Various short term provisions/accruals account : Accruals accounts are a spontaneous source of

f inancing as they are sel f -genera t ing. The most common accrual accounts are wages and taxes. In

both cases, the amount becomes due but is not pa id immediate ly.

Quest ion : Write short notes on :

1) Deep Discount Bonds 2) Secured Premium Notes

3) Zero interest fully convert ible debentures 4) Zero Coupon Bonds

5) Double Opt ion Bonds 6) Option Bonds

7) Inflat ion Bonds 8) F loating Rate Bonds

Answer :

1) Deep Discount Bonds : I t i s a form of a zero interes t bond , so ld at a discounted value and on maturi ty face va lue i s

paid to the investors. In such b onds, there i s no interes t paid during lock in per iod . IDBI was the fir st

to issue a deep discount bond in India in January, 1992. I t had a face va lue of Rs. 1lakh and was so ld

for Rs. 2700 wi th a matur i ty per iod of 25 years. The investor could hold the bo nd for 25 years o r

seek redemption at the end of every 5 years wi th matur i ty value as be low :

Holding period (years) 5 10 15 20 25

Maturity value (Rs.) 5700 12000 25000 50000 100000

Annual rate of interest

(%) 16.12 16.09 15.99 15.71 15.54

The investor can se l l the bonds in stock market and rea li se the di fference between face

va lue (Rs. 2700) and the market pr ice as cap ita l ga in.

2) Secured Premium Notes : I t i s i ssued along wi th a detachable warrant and i s redeemable af t er a not i fied per iod of say

4 to 7 years. The conversion of detachable warrant into equity shares wil l have to be done wi thin the

t ime per iod not i fied by the company.

3) Zero interest fully convert ible debentures : These are ful ly convert ib le debentures which do not carry any interest . They are

compulsori ly and automatica l ly conver ted after a speci f ied per iod of t ime and holders thereof are

enti t led to new equi ty shares of the company at predetermined pr ice . From the company's view point ,

th is kind of ins trument i s benefic ia l in the sense , that no interest i s to be paid on i t , i f the share pr ice

of the company in the market i s very high, then the investor tends to get equi ty shares of the

company a t a lower ra te .

4) Zero Coupon Bonds : A zero coupon bond does not carry any interest , but i t i s sold by the i ssuing company at a

discount. The di fference between the discounted and matur ing or face value represents the interes t to

be earned by the investor on them.

5) Double Opt ion Bonds : Double Opt ion Bonds are recent ly issued by the IDBI. The face value of each bond is Rs .

5000, i t carr ies interes t at 15 % per annum compounded hal f year ly from the date o f a l lo tment. The

bond has a matur i ty per iod of 10 years. Each h aving 2 par ts , in the fo rm of 2 separate cer t i f icates,

one for the pr incipa l o f Rs. 5000 and other for interest , inc luding redemption premium of Rs. 16500.

Both these cer t i ficates a re l i sted on al l major stock exchanges. The investor has the fac i l i ty o f se l l ing

ei ther one or both par ts anyt ime he l ikes.


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6) Opt ion bonds : These are cumulat ive and non -cumula tive bonds where inte rest i s payable on matur i ty or

per iodica lly. Redemption premium is a lso o ffered to a t t rac t investors. These were r ecently i ssued b y

IDBI, ICICI, etc .

7) Inflat ion bonds : They are bonds in which interes t ra te is adjusted for inf la t ion. The investor , thus, ge ts an

interes t free fro m the e ffects o f inf lat ion. For instance, i f interest rate i s 12 % and inf la t ion rate i s 5

%, the investor wi l l earn 17 %, meaning that the investor i s pro tec ted aga inst inflat ion.

8) Float ing Rate Bonds : As the name suggests , F loa ting Rate Bonds are ones, where the ra te o f interest i s no t f ixed

and i s al lowed to float depending upon the market condit ions. This is an idea l instrument tha t can be

resor ted to by the i ssuer to hedge themselves against the vola t i l i ty in interest rates. This has become

more popular as a money market inst rument and has been successfull y i ssued by f inancia l inst i tut ions

l ike IDBI, ICICI, e tc .

Question : Give a deta iled account of International Financing ?

Answer : The essence of financial management is to raise & uti l i se the funds raised effec tive ly.

There are var ious avenues for o rganisat ions to raise funds ei ther through interna l or external sources.

Externa l sources inc lude :

Commercial banks : Like domest ic loans, commerc ial banks al l over the world extend

Fore ign Currency (FC) loans, for internat ional operat ions . These banks a l so provide to

overdraw over and above the loan amount .

Development banks : o ffer long and medium term loans includ ing FC loans. Many agencies a t

the na tional leve l o ffer a number o f concessions to foreign companies to invest wi thin their

country and to f inance expor ts from their countr ies e .g. EXIM Bank of USA.

Discounting of trade bil l s :This i s used as a shor t term financing method widely, in Europe

and Asian countr ies to f inance both domest ic and internat ional business.

International agencies : A number of inte rnat ional agencies have emerged over the years to

f inance interna tional t rade and business . The more no table among them inc ludes :

Interna tional Finance Corpora tion ( IFC), Interna tional Bank for Reconstruc tion &

Development ( IBRD), Asian Devel opment Bank (ADB), Interna tional Monetary Fund (IMF),

etc .

International capita l markets : Modern organisat ions inc luding MNC's depend upon s izeable borrowings in Rupees as a lso

Fore ign Currency. In order to ca ter to the needs o f such orga nisat ion , interna tional capi ta l markets

have sprung a l l over the globe such as in London. In Interna tional cap ital market , the ava ilab il i ty o f

FC is assured under the 4 main sys tems, as :

Euro-currency market

Expor t credi t faci l i t ies

Bonds i ssues

Financial Ins t i tut ions

The or igin o f the Euro -currency market was wi th the do llar denominated bank deposi t s &

loans in Europe par t icular ly, London. Euro -dollar deposit s are dol lar denominated t ime deposit s

avai lable a t foreign branches o f US bank s and at some fore ign banks. Banks based in Europe accept &

make dol lar denominated deposit s to the cl ients. This forms the backbone of the Euro -cur rency

market a l l over the globe. In this market , funds are made avai lab le as loans through syndica ted Euro -

credi t o f ins truments as FRN's, FR cer t i f ica tes o f deposit s .

Below ment ioned are some of the f inancial instruments : 1) Euro Bonds : Euro Bonds are deb t instruments denominated in a currency issued outs ide the

country o f tha t currency, fo r instance : a ye n no te floa ted in Germany.

2) Foreign Bonds : These are deb t instruments denominated in a currency which i s fore ign to the

borrower and i s sold in the country o f that currency.


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3) Ful ly Hedged Bonds : In foreign bonds, the r isk o f currency f luc tuations exists . They el iminate

the r isk by sel l ing in forward markets the ent ire stream of pr inc ipa l and interest payments.

4) Floating Rate Notes : They are i ssued upto 7 years matur i ty. Interest rates are adjus ted to re f lec t

the prevai l ing exchange rates. The y provide cheaper money than foreign loans.

5) Euro Co mmercial Papers (ECP) : ECP 's are short term money market instruments, wi th maturi ty

of less than 1 year and des ignated in US dol lars.

6) Foreign Currency Option : A FC Option is the r ight to buy or se l l , spot o r future or forward, a

spec i fied fore ign currency. I t p rovides a hedge aga inst f inancia l and economic r isks.

7) Foreign Currency Futures : FC Futures are obligat ions to buy or sel l a speci f ied currency in the

present for set t lement at a futu re da te.

8) Euro Issues : In the Indian context , Euro Issue denotes tha t the issue is l i s ted on a European Stock

Exchange. Ho wever , subscr ipt ion can come from any par t o f the world excep t India. Finance can be

raised by Global Deposi tory Receipts (GDR), Foreign Currency Conver t ible Bonds (FCCB) and pure

debt bonds. However , GDR's and FCCB's are more popular .

9) Global Depository Receipts : A deposi tory receip t i s basica l ly a negotiab le cer t i f icate ,

denominated in US Dollars representing a non US company 's publicly traded loca l currency (Indian

Rupee) equi ty shares, . Theoret ical ly, though a depository rece ipt can also s igni fy debt instrument,

pract ica l ly i t rare ly does so. DR's are created when the loca l currency shares o f an Ind ian company

are del ivered to the deposi tory's local cus todian bank, against which the deposi tory bank i ssues DR's

in US Dol lars. These DR's may be freely traded in the overseas - markets l ike any o ther dollar

denominated securi ty via ei ther a fore ign stock exchange or through a over the counter market or

among a restr ic ted group as Qual i fied Ins t i tut iona l Buyers (QIB). Rule 144 A of the Secur i t ies and

Exchange Co mmission (SEC) of USA permi ts companies fro m outs ide USA to o ffer the ir GDR's to

cer tain ins t i tut iona l buyers, known as QIBs.

10) GDR with Warrant : These receip ts are more at trac t ive than p la in GDR's in view of add it ional

va lue of at tached warrants.

11) American Deposito ry Receipts (ADR's) : Deposi tory Receipts i ssued by a company in USA is

kno wn as ADR's. Such receip ts have to be i ssued in accordance wi th the provisions st ipulated by the

SEC, USA that are s tr ingent . In a bid to bypass such str ingent d isclosure norms mand ated by the SEC

for equity shares, the Indian companies have, ho wever , chosen the indirec t route to tap the vast

Amer ican financial market through pr iva te debt p lacement o f GDR's l i s ted in London and

Luxembourg stock exchanges .

Indian companies have preferred the GDR's and ADR's as the US market exposes them to a

higher level or responsibil i ty than a European l is t ing in the areas o f disc losure, costs, l iabi l i t ies and

t iming. The SECs regulat ions set up to protec t the retai l investor base are some what more s tr ingent

and onerous, even for companies a lready l i sted and he ld by reta i l investors in the ir home country.

Most onerous aspec t of a US l is t ing for companies i s to provide full , ha l f year ly and quarter ly

accounts in accordance wi th or at le as t reconciled with US GAAPs. However , Ind ian companies are

shedding the ir reluctance to tap the US markets as evidenced by Infosys Technologies Ltd. recent

l i st ing in NASDAQ. Most o f India 's top no tch companies in the pharmaceut ica l , info - tech and other

sunrise indust r ies are p lanning forays into the US markets. Another prohibit ive aspec t o f the ADR's

vis -à -vis GDR's i s the cost involved of prepar ing and f i l l ing US GAAP accounts. Addit iona lly, the

ini t ia l SEC registrat ion fees based on a percentage of issu e size anmd 'Blue Sky' regis tra t ion costs ,

permi tt ing the secur i t ies to be o ffered in al l S tates o f US, wi l l have to be met. The US market i s

wide ly recognised as the most l i t igious market in the wor ld. Accordingly, the broader the targe t

investor base in US, higher i s the potent ia l legal l iabi l i ty. An important aspec t of GDR is tha t they

are non vot ing and hence spe ll s no dilut ion of equi ty. GDRs are se t t led through CEDEL and Euro -

clear Interna tional Book Entry Systems.

Other types of Internat ional i ss ues :

Foreign Euro Bonds : In domestic cap ital markets o f var ious countr ies the Bond issues

referred to above are kno wn by d i fferent names as Yankee Bonds in US, Swiss Frances in

Swi tzer land, Samurai Bonds in Tokyo and Bulldogs in UK.


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Euro Convertible Bonds : A conver t ib le bond i s a deb t ins trument giving the holders o f the

bond an op tion to convert the bonds into a pre -determined number o f equity shares o f the

company. Usual ly, the pr ice o f equi ty shares a t the t ime of conversion wi l l have a premium

element. They car ry a f ixed rate o f interest and i f the i ssuer company so desires may also

include a Call Option, where the i ssuer company has the op tion of ca l l ing/buying the bonds

for redempt ion pr io r to the maturi ty date, or a Put Opt ion, which gives the ho lder the op tion

to put /sel l his bonds to the i ssuer co mpany a t a p re -determined da te and pr ice.

Euro Bonds : Plain Euro Bonds are nothing but debt instruments. These are not very

at trac t ive for an investor who des ires to have va luable add it ions to his inve stments.

Euro Convertible Zero Bonds : These are struc tured as a conver t ib le bond. No interes t i s

payable on the bonds. But convers ion of bonds take place on maturi ty at a pre -determined

pr ice. Usual ly, there i s a 5 years matur i ty per iod and they are treat ed as a deferred equity

issue .

Euro Bonds with Equity Warrants : These car ry a coupon ra te determined by market ra tes.

The warrants are de tachable . Pure bonds are traded at a d iscount. Fixed Income Funds

Management may l ike to invest for the purposes of re gular income.

Important Note for Students

Concentrate equally on theoretical portion of Cost & FM. Near

about 35% to 40% of the questions asked in examination

relates to theory. So, it gives you an assurance to get positive

result in odd situations also.