Financial Management

Assignment - A
Question 1a: Should the titles of controller and treasurer be adopted under
Indian context? Would you like to modify their functions in view of the
company practice in India? Justify your opinion?
Answer to 1a:
Controller & Treasurer are independent & they have their own Perspectives & Drivers as detailed below:
Trea flows)
sure Treasurer
works/
Controller
r
forecasts
the
events
Responsibilities include, Double entry accounting,
for regularly (daily / weekly)
financial reporting, Fraud measure, detective controls, Responsible
focus Balance sheet
Liquidity
management
Financial restatement, Compliance with statutory
future
capital
important &
requirements like Rules, Accounting standards, GAAP,(very
capital
function),
Risk structure,
IFRS etc.,
More expenditure etc.,
Controller works & forecasts the events for a long term. Management,
focus
on
financial Treasurer concentrates
Main focus income statement
statements,
follows more on cash availability
leading practices & focus i.e. how to bring
Ex: Cash involved event
for
the in the required cash etc,
Controller looks from compliance angle (how to record, responsible
future performance of
what GAAP provides etc.,)
company (projects cash
Therefore, from the
above it is clear that,
controller & treasurer
have different roles to
play. However, majority
of
the
Indian
companies works with
Financial
Controller
who himself takes care
of
the
treasury
department / Portfolio.
Therefore, as far as
from Indian context, it
can be concluded that,
controller
is
also
responsible for treasury
jobs & there is no
separate treasurer /
treasury
department
exists
Question
1b:
firm
purchases a machinery
for Rs. 8, 00,000 by
making
a
down
payment
of
Rs.1,50,000
and
remainder in equal
installments of Rs.
1,50,000 for six years.
What is the rate of

inte
res
t to
the
fir
m?
Answer to
Q1b:

Particulars
Cost of Machinery
Down Payment
made by firm
Financed through
borrowings
Repayment in equal
instalments every
year
(maximum of six
years)

Ref

Year 0

(a)

800,000

(b)
c = (ab)

150,000

Year 1

Year 2

Year 3
Rs.

Year 4

Year 5

Year 6

150,000

150,000

150,000

150,000

150,000

150,000

650,000

d=6*15
0,000

900,000

Total interest paid

over 6 year period

e=dc

250,000

Rate of Interest
= total interest
/ total
borrowings

f=e/c

38.46%

Rate of interet per annum

g=f/6
yrs

Break of interest cost / principal repayment:

end
2a: Explain the mechanism of calculating the
1) interest cost (can
(prinicpal o/s at
present
value of cash flows. What is annuity
be apportioned year
in beginning
the ratio of
Principal
due? How can you calculate the present and
no of years
repayment) future values of an annuity due? Illustrate
repayment - i.e.
earlier the years
Answer 2a:
more
the interest cost &
RATE OF Calculating Present Value of Cash flows:
vice versa)

INTEREST
Money has time value. For ex: Rs.1000 received today is not
EVERY YEAR
the same worth after a year (actually it is less)

2) Principal
Outstanding
adjustment

Qu

Yearwise Interest
est
rates:
- Principal
ion
Outstanding at year

Present value of cash flows: It indicates the value of expected

worth at current value. (Discounts the expected cash flows at
appropriate discount rate (may be 10%, 20% etc.,)
Discount rate will generally be equal to = Inflation rate + Reqd. rate of
return + risk free premium rate
Details required for calculating Present Value of cash flows:
Cash flows year wise, discount rate. This technique is very useful
for decision-making.

6.41%

Annuity due: Uniform/ Constant/ Equal cash flows every year

Present value of annuity
Worth of Lump sum consideration today which
is going to be received tomorrow
Computation:
Annuity * Present value annuity factor (PVAF)

Future value of annuity

Value of fixed investment every year worth
tomorrow. (i.e. corpus it grows)

PVAF is calculated as = 1-[1/(1+r) to the power

n].
Illustration:

FVAF is calculated as = [(1+r) to the power n] - 1

Mr. A would like to receive Rs.1000/- every

year for 10 years from now.

Mr.X would like to grow a corpus by investment

of Rs.10, 000 10 years from now.

It is assumed discount rate 10%, the present

value annuity factor for 10 years 10% is 6.144.

Rate of interest @10%, the future value annuity

factor for 10 years 10% is 1.594

Present value of annuity = 1000 * 6.144 =

Rs.6145/-

Future value of annuity = 10000 * 1.594=

Rs.15937/-

Annuity * Future value annuity factor (FVAF)

Question 2b: "The increase in the risk-premium of all stocks, irrespective of

their beta is the same when risk aversion increases" Comment with
practical examples
Answer 2b:
The security's beta is a function of the correlation of the security's returns with the market index returns
and the variability of the security's returns relative to the variability of the index returns.
In simple, beta measures the sensitivity of the stock with reference to broad based market index.
For instance: a beta of 1.2 for a stock would indicate that this stock is 20% riskier than the index &
similarly beta of 0.9 for a stock indicates 10% less riskier than the index.
Finally, a beta of 1.0 means, stock is as risky as the stock market index.
Therefore, the given statement is false. Expected risk-premium for stock is beta times the market risk
premium. For ex: let us assume beta = 1.2 times, market risk premium = 10%, then expected risk premium
= 10% * 1.2 times = 12%.

Question 3a: How leverage is linked with capital structure? Take example of
a MNC and analyze.
Answer to 3a:
Leverage: It is an advantage gained (it may be anything)
Leverage is linked with Capital Structure, since an organization having a optimum capital structure (where
WACC (weighted average cost of capital) is minimum) is a great leverage/ advantage both to the company
as well for the investors.
Organizations, generally have two types of risks; operating risks impact of fixed costs & variability of
EBIT & Financial risks impact of interest cost/financial charges & variability of EBT.
Example:
XYZ ltd has the following nos:
Contribution Rs.100 lacs, fixed cost Rs.25 lacs, Financial Charges/debt cost Rs.40 lacs.

Particulars

Value (Rs. In lacs)

100
25
75
35
40

Contribution
Fixed cost
EBIT
Interest cost
EBT
XYZ Ltd. has following:
Operating leverage
Contribution / EBIT = 100 / 75 = 1.33

Financial leverage
EBIT / EBT = 75 / 40 = 1.87

It is always preferable to have low operating risk & high financial risk (subject to Return on capital
employed (ROCE) > Interest cost on debt funds)
We can conclude that, XYZ ltd (MNC) is having a optimum capital structure & manageable risk.

Question 3b: The following figures relate to two companies (10)

P LTD.
Sales
Variable costs

500
200
----300
150
----150
50
----100

Contribution Fixed costs

Fixed Cost
Interest
Profit before tax

Q LTD.
(In Rs. Lakhs)
1,000
300
-------700
400
-------400
100
-------200

You are required to:

(1)

Calculate the operating, financial and combined leverages for the two companies; and
Comment on the relative risk position of them

Answer 3b:
P ltd
Particulars
Sales
Variable costs
Contibution
Fixed cost
PBIT / EBIT
Interest
Profit before Tax / EBT

Q ltd
(in Rs. Lacs)
500
200
300
150
150
50
100

1000
300
700
400
300
100
200

a) Opearting leverage:
= Contribution / EBIT

2.0

2.3

b) Financial leverage:
= EBIT / EBT

1.5

1.5

Computation:

c) Combined leverage:

= Contirbution / EBT

Comments:

3.0

3.5

Operating risk is higher

(i.e. fixed costs are high)

Operating risk is higher than

'P' ltd
(i.e. fixed costs are high)

Financial risk looks low

Financial risk looks low

Overall risk is low as

compared
to 'Q' ltd.

Overall risk is high as

compared
to 'P' ltd.

It is always preferable to have low Operating leverage & high Financial

leverage (provided, Return on capital employed > Interest on debt funds)

Question 4a: Define various concepts of cost of capital. Explain the

procedure of calculating weighted average cost of capital.
Answer 4a:
Concepts of Cost of Capital:

1) All source of finance have its own cost. Out of long source finance, equity mode of sourcing is costlier
than debt financing because of expectation of shareholders.

2) RISK VS. COST: Equity mode of finance will have low risk but costlier as against debt funds which will
3)

have high risk but relatively cheaper & have tax advantage thus reducing the net cost of debt.
Organizations have to effectively trade off between risk, cost & control.
Optimum Capital Structure: When the firm / organization has a combination of debt and equity, such
that the wealth of the firm is maximum. At this point, cost of capital is minimum & market price of a
share is maximum.

Procedure of calculating Weighted Average Cost of Capital (WACC):

It is computed by reference to proportion of each component of capital (book value or market value as
specified) as weights.
WACC = Sum [proportion of each component of capital (weights) * individual cost of capital]
Note: Tax rates needs to be adjusted in respect of debt funds.

Question 4b: The following items have been extracted from the liabilities
st
side of the balance sheet of XYZ Company as on 31 December 2005.
Paid up capital:
4, 00,000 equity shares of Rs each

40,00,000

Loans:
16% non-convertible debentures
12% institutional loans

20,00,000
60,00,000

Other information about the company as relevant is given below:

31st dec
2005

Dividend
Earning
average market price
Per share
per share
per share
7.2
10.50
65
You are required to calculate the weighted average cost of capital, using book values as weights and
earnings/price ratio as the basis of cost of equity. Assume 9.2% tax rate

Answer 4b:
Computation of Weighted Average Cost of Capital (WACC):

Nature of Capital

Value

a) Equity Capital

Weights
(basis of
bookvalues
O/S.)

4,000,000

Cost of capital

33%

Weights * Cost of
Capital

16.15

5.38

(refer W.No.1)
b) 16% non-convertible debentures

2,000,000

17%

14.53
Interest (1-taxrate) =
16% (100%-9.2%)

2.42

c) 12% institutional loans

6,000,000

50%

10.90
Interest (1-taxrate) =
12% (100%-9.2%)

5.45

Total

12,000,000

100%

13.25

Working Note: 1
Cost of equity:
Earnings per
Price earnings approach = share /
Market price
per share
10.50 / 65 =
16.15%

Question 5a: A company has issued debentures of Rs. 50 Lakhs to be repaid

after 7 years. How much should the company invest in a sinking fund
earning 12% in order to be able to repay debentures? Show the procedure
of loan amortization and capital recovery through an example.
Answer 5a:
Debentures to be redeemed after 7 years
Expected rate of return - on sinking fund investment to be created
Discount rate@12%, 7 yrs
Present value of expected repayment of debentures @12% 7 yrs
therefore, company has to invest Rs.22,61,746 @ 12% earning in Sinking fund to cover
the repayment expected 7 years from now.

5,000,000
12%
0.452
2,261,746

Loan Amortization

Capital Recovery

A loan amortization schedule is a repayment plan that

is calculated before repayment of a loan begins.

The reciprocal of Present value annuity factor

(PVAF) is the capital recovery.

Amortization schedules are used for fixed interest long

term loans such as mortgages, expenses like R& D
expenses, Purchase of Goodwill, Voluntary Retirement
payment expenses, Amalgamation expenses etc.
Procedure with Ex:

Below example will clarify better the meaning:

M/s.XYZ ltd has incurred a Rs.50, 00,000 as lump sum

payment towards voluntary retirement separation
charges during the accounting year 2009-2010.
XYZ ltd have planned to amortize the above expenses
for a period of 10 years commencing from FY.09-10
Therefore, the schedule of amortization for 10 year
period as follows:
Rs. 500,000/- per years for 10 years

Procedure with Ex: Mr.X plan to lend Rs.1 lac

today for a period of 5 years @ int.rate of 12%,
how much income Mr.X should receive each year
to recover investment & principal back.
The result is known as capital recovery & which
can be arrived by capital recovery factor.
Calculation:
Present value = Annuity * PVAF @12%,5years
Capital Recovery =
PVAF@12%,5years

Annuity

Therefore, capital recovery = 100,000 * 0.27739

= Rs.27,740 each year for 5 years.

Question 5b: A bank has offered to you an annuity of Rs. 1,800 for 10 years
if you invest Rs. 12,000 today. What is the rate of return you would earn? .
Answer 5b:
Particulars

Rs.

Return expected per annum

Fixed return/annuity for no of years
Total return expected

1800
10
18000

Investment required today

12000

Nett return expected from investment

6000

Percentage of return for 10 years

Percentage of return per annum

50%
5%

Assignment - C

Question 1: The proforma of cost-sheet of HLL provides the following data:

Cost (perunit):

Rs.

Raw materials

52.0

Direct labour

19.5

Overheads

39.0

Total cost (per unit):

110.5

Profit

19.5

Selling price

130.0

The following is the additional information available:

Average raw material in stock: one month; Average materials in process: half month; Credit allowed by
suppliers: one month; Credit allowed to debtors: two months; Time lag in payment of wages: one and half
weeks; Overheads: one month. One-fourth of sales are on cash basis. Cash balance expected to be Rs.
12,000.
You are required to prepare a statement showing the working capital needed o finance a level of activity of
70,000 units of output. You may assume that production is carried on evenly throughout the year and
wages and overheads accrue similarly.

Answer 1:
Particulars

Raw Material
Direct Labour
Prime cost
Overheads
Total cost
Profit
Sales

Cost/unit

Production = 70,000 units

cost (Rs.) for 70000 units

52
19.5

3640000
1365000
5005000
2730000
7735000
1365000
9100000

39
110.5
19.5
130

Statement of Working Capital for HLL - 70,000 units production per year:

Particulars

No of
months

Computation

Rs.

Current Assets: (A)

Raw material stock
Process stock - Work in progress (WIP)
Debtors - customers
Cash balance expected to maintain
Total of CURRENT ASSETS - (A)
Current Liabilities: (B)

1
0.5
2

36,40,000/12*1month
50,05,000/12*0.5 months
91,00,000*3/4 (credit sales)/12*2

303333
208542
1137500
12000
1661375

Creditors - suppliers
Wages Outstanding

Overheads outstanding

1
36,40,000/12*1month
1.5 weeks
or
13,65,000/12*0.34
0.34
month
1
27,30,000/12*1

303333
38675

227500

Total of CURRENT LIABILITIES - (B)

569508

NETT WORKING CAPITAL

REQUIRED

1091867

Question 2a: Through quantitative analysis prove that PI is a better

technique than NPV in Capital Budgeting.
Answer 2a:
PI Profitability Index & NPV Net Present Value both are capital budgeting techniques.
Profitability Index (PI)
PI = Present value of inflows / Present value of
outflows
Ideal = should be > 1

Net Present Value (NPV)

NPV = Present value of inflows Present
value of outflows
Ideal = NPV should be positive, it shows
absolute present value of tomorrows wealth

Quantitative analysis:
Present value of inflows = Rs. 200,000
Present value of outflows = Rs. 100,000

Present value of inflows = Rs. 200,000

Present value of outflows = Rs. 100,000

PI = 2

NPV = Rs.100,000

NPV technique is better than PI technique for capital budgeting decisions. NPV shows wealth at the end in
absolute amount, which will be helpful to make decisions clearly, whereas the same advantage is not
available with PI technique.
However, PI shows return over investment in times, which will be very useful for immediate decision
making.
Generally, over the years, organizations prefer NPV technique for capital budgeting decisions than PI
technique.

Question 2b: A company is considering the following investment projects:

Projects

Cash Flows (Rs.)

Co

C1

C2

C3

- 10,000

+ 10,000

-----

-----

-10,000

+ 7,500

+ 7,500

-----

- 10,000

+ 2,000

+ 4,000

+ 12,000

-10,000

+ 10,000

+ 3,000

+ 3,000

I. according to each of the following methods: (1.) Payback, (2.) ARR, (3.) IRR, (4.) NPV assuming
discount rates of 10 and 30 percent.
II. Assuming the project is independent, which one should be accepted? If the projects are mutually
exclusive, which project is the best?

Answer 2b:
I)
Methods
(1) Payback
@10% discount rate
@30% discount rate
(2) Accounting rate of
return (ARR)
(3) NPV
@10% discount rate
@30% discount rate

Project A

Project B

Project C

Project D

1 + years
1 + years
100%

1.13 years
1.25 years
150%

2.14 years
3 + years
180%

1.7 years
2.8 years
160%

(909)
(2308)

3017
207

4140
(633)

3824
833

0%

32%

26%

38%

(4) IRR

Independent project: Project with higher NPV needs to be selected, which shows wealth in absolute
value at the end of the project
Therefore, Project C needs to be accepted.
II) In case projects are mutually exclusive:
First disparity between projects needs to be resolved. NPV selects Project C whereas IRR selects Project
D, therefore, disparity exists. Since cash outflows (Rs.10, 000/-) are same for both the projects, the
disparity arisen is called as Cash flow disparity.
It can be resolved by using Incremental cash flow technique. After resolving, the right project can be
accepted.
Workings are as follows:
PROJECT A:
The following has been calculated assuming discount rates of
10% & 30% separately:
1) Payback period: time period to recover initial investment
a) Discounted @10%

Years

Cash
flows

b) Discounted @30%

Discount Discounted
rate * cash flows

Unrecover
ed
discounte
d cash
flows

Years

Cash
flows

@
30%

@ 10%

(1)

(2)
0

(10,000)

(3)

(4) =
(2) * (3)

1.000 (10,000)

(5)

Discou
nt rate
*

(1)

(10,000)

1
10,000
0.909 9,091
(909)
* disocunt rate computed using formule = 1 / (1+r) to the power
n; where r = disocunt rate
& n = year

(2)

(3)

Unrecove
red
Discounted
discounte
cashflows d cash
flows

(4) = (2)
* (3)

(5)

(10,000)

1.000

(10,000)

(10,000)

10,000

0.769

7,692

(2,308)

Payback period = Base year + [(unrecovered disocunted cash flow of base year /

disocunted cash flows of next year) *12]

Payback period exceed 1 year, since unrecovered cash flows turns

positive only from IInd yr onwards
where base year = year in which unrecovered cash
flows turns 0 or +ve
Payback period @ 10% & 30%
discount rate = 1 + years
=1+
years

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depreciation & Tax / Initial
investment
Since no information on profits, depreciation & taxes, it is treated cash
inflows considered as profits after depreciation & taxes
therefore (10,000 (inflow) / 10,000

1=

(investment)) * 100

accounting rate of return = 100%; effectively 0%

return (whatever invested taken back)
4) NPV (net present value):
b) Discounted
@30%

a) Discounted @10%

Years

Cash
flows

Discoun
t rate *

Discounte
cashflows

@ 10%
(1)

(2)

(3)

(10,000
)

1.000 (10,000)

10,000

0.909 9,091

NPV

(909)

Cash
flows

Years

Discoun
t rate *

Discounte
d
cashflows

@ 30%
(1)

(2)

(4) =
(2) * (3)

(3)

(10,000)

1.000 (10,000)

10,000

0.769 7,692

NPV
* disocunt rate
computed using formule
= 1 / (1+r) to the power
n; where r = disocunt
rate
1& n = year

3) IRR
(Internal
rate
of
return):
which is the
rate
of
return
at
which NPV
=0

(2,308)
In project A ,
IRR is '0'%
at which
NPV =0
(
i
.
e
.
t
h
e
r
e

i
s
n
o
r
e
t
u
r
n
f
r

o
m
t
h
e
p
r
o
j
e
c
t
)

PROJECT B:
The following has been calculated assuming discount rates of 10%
& 30% separately:
1) Payback period: time period to recover initial investment
b) Discounted
a) Discounted @10% @30%

Years

Cash
flows

Discoun
t rate *
@ 10%

(1)

(2)

(3)

(10,000)

1.000

7,500

0.909

7,500

0.826

Years

Discou
nt rate Discounted
cashflows
*

Cash
flows

@
30%
(1)

(2)

Unrecove
red
discounte
d cash
flows

(4) =
(2) * (3)

(3)

(5)

(10,000)

1.000 (10,000)

(10,000)

7,500

0.769 5,769

(4,231)

7,500

0.592 4,438

207

*
di
s
o
c
u
nt
ra
te
c
o
m
p
ut
e
d

u
s
i
n
g

(
1
+
r
)

f
o
r
m
u
l
e

Payback period =
Base year +
[(unrecovered
disocunted cash
flow of base year /
disocunted cash
flows of next year)
*12]
)*1
2]

t
o

t
h
e

@
where base
year = year 1
in which
0
unrecovered %
cash flows
turns 0 or d
i
+ve
s
Pa
c
yba
o
ck
u
per
n
iod
t
return
on
initial
invest
ment
2)
Accounti made:
ng rate of
g
return:
rate of
i

ower
n;
wher
er=
disoc
unt
rate
& n = year

182/3
017)*
12]

r
a
t
e
=

=
1
.
1
3

y
e
a
r
s

+
[
(
3
v
e
n
a
s
:

A
v
e
r
a
g
e

p
r
o
f
i
t
a

Payb
ack
perio
d@
30%
disco
unt
rate=
1+
[(423
1/207
f r
t i
ec
r i
a
dt
ei
po

=1.25
years

n
&
T
a
x
/
I
n
i
t
i
a
l

i
n
v
e
s
t
m
e
n
t
Since
no
informa
tion on
profits,

deprec
i
iation therefor
n
&
g
(15,000
taxes,
(inflow) /
it is
r
10,000
treated e =
a
cash
t
inflows (investment) e
consid ) * 100
ered
o
a
as
f
profits c
after c
r
o
deprec
e
iation u
t
n
&
u
t
taxes
r

nv
e
=l
y
1
55
00
%%
;
r
ee
f t
f u
er
cn
t
i

4) NPV (net present value):

b)
Disco
a)
Disc unted
ount @30
%
ed
@10
%

Years

(1)

0
1
2
NPV

Years

Cash
flows

Discoun
t rate *

Discounted
cashflows

@ 30%
(1)

(2)

(3)

(4) = (2)
* (3)

(10,0
00)

1.000 (10,000)

7,500

0.769 5,769

7,500

0.592 4,438

NPV
c
*
u
di nt
so r
cu at
nt e
ra 1
te &n
co
m
=
p
ut
y
e
e
a
d
us r
in
g
fo 3
r
)
m
I
ul
e R
= R
1
/
(
(1 I
+r n
)
t
to
e
th
e r
p n
o a
w l
er
n; r
w a
h
t
er
e e
r
= o
di f
so

207
r
e
t
u
r
n
)
:

w
h
i
c
h
N
P
V

w
h =
i
c 0
h
For
project
B , IRR
is
t calculat
h ed as
e below:
i
s

r
a
t
e

I
R
R
=

o
L
f
1
r
e
t
u
r
n
a
t

+
[
N
P
V
L
1

/
(
N
P
V
L
1
N
P
V
L
2
)
]
*
(
L
2
L
1
)
w
h
e
r
e
L
1
=
g
u
e
s
s
r
a
t
e
(
d
e
p
e

n
d

ess
r
ra e
te l

o
n

R
e
l
a
t
i
o
n
s
h
i
p

N
P
V
,
d
i
s
o
c
u
n
t
e
d

b
e
t
w
e
e
n

a
t
g
i
v
e
n

d
i
s
c
o
u
n
t

r
e
q
u
i
r
e
d

r
a
t
e

r
a
t
e

a
n
d

o
f
r
e
t
u
r
n
)
L2
=
on
e
mo
re
gu

a
t
i
o
n
s
h
i
p
:
Discoun
t rate
goes up
NPV
falls

NPV goes
Discoun
t rate
comes
down
up

Let us
assume
L1 =
30%
(why,
because
as could
be seen
at 30%
@
discount
rate
NPV is
+ve
by applying
the
relationship,
increased
disocunt
rate)

N
P
V
: Let us
calculat
e L2 =
i 32%
n
v D
e i
r s
s c
e o
u

n
t
e
d
@
3
2
%
(
a
s
s
u
m
e
d
r
a
t
e
)

Cash
flows

Years

Discoun
t rate *

Discounte
d
cashflows
@ 32%

(1)

(2)

(3)

(4) =
(2) * (3)

(10,000)

1.000 (10,000)

7,500

0.758 5,682

7,500

0.574 4,304

NPV

(14)

ther
efor
e,
IRR
for
Proj
ect
B=
30
%+
[20
7/
( 20
7+1
4)]*
32
%30
%
30% +
1.873

IRR

PROJECT C:
The following has been
calculated assuming
discount rates of 10% &
30% separately:
1) Payback period: time
period to recover initial
investment
s

o
u

31.87%

b
)

Years

(1)

0
1
2
3

D
i
s
c
o
u
n
t
e
d
@
3
0
%

Years

Cash
flows

Discount
rate *

Disco
unted
cashf
lows

Unrecove
red
discounte
d cash
flows

@ 30%

(1)

(2)

d
i
s
o
c
u
n
t
r
a
t
e
c
o
m
p
u
t
e
d

(10,000)

2,000

0.769 1,538 (8,462)

4,000

0.592 2,367 (6,095)

12,000
o i
s
t
o
h c
e u
n
p t
o
w r
e a
r
t
e
n
&n=
year
;

0.455 5,462 (633)

s
i
n
g
f
o
r
m
u
l
e
=
1
/
(
1
+
r
)
t

(5)

(10,0
1.000 00)

3
*

(3)

(4) =
(2) *
(3)

w
h
e
r
e
r
=
d

Payback
period =
Base
year +
[(unrecov
ered
disocunte
d cash
flow of
base year
/
disocunte
d

(10,000)

cash flows of next year) *12]

where base year = year in which unrecovered cash
flows turns 0 or +ve
Payback period @ 10% discount rate= 2 +

Payback period @ 30% discount rate=

[(4876/4140)*12]
exceeds 3 years
=2.14
=3+
yearsyears

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depriciation & Tax / Initial
investment
Since no information on profits, depreciation & taxes, it is treated cash inflows
considered as profits after depreciation & taxes
therefor (18,000 (inflow) / 10,000
e=

(investment)) * 100

accounting rate of return =

180%; effectively 80% return

4) NPV (net present value):

b) Discounted
@30%

a) Discounted @10%

Years

Cash
flows

Discoun
t rate *

Discounted
cash flows

@ 10%

(1)

(2)

(3)

(4) =
(2) * (3)

Years

Cash
flows

Disco
unt
rate *
@
30%

(1)

(2)

(10,000)

2,000

4,000

12,000

NPV
*
disoc
unt
rate

Discoun
ted
cashflo
ws

(4) =
(2) * (3)
c
o
m
1.000 (10,000)
p
0.909 1,818
u
t
0.826 3,306
e
d
0.751 9,016

(3)

u
4,140
s
i
n
g

f
o
r
m
u
l
e
=
1
/
(

1+r
) to
the
po
wer
n;
wh
ere
r=
dis
ocu
nt
rat
e
& n = year

3) IRR (Internal rate of return): which is the rate

of return at which NPV = 0
For project C , IRR is calculated as below:
IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *
(L2 - L1)
where L1 = guess rate (depend on NPV, disocunted at
given required rate of return)
L2 = one more guess
rate
Relationship between discount rate and NPV:
inverse relationship:
Discount rate
goes up

NPV falls

NPV goes
Discount rate comes down

up

Let us assume L1 = 30% (why, because as could be seen at 30% @

discount rate NPV is -ve
by applying the relationship, reduced
disocunt rate)
Let us calculate L2 = 26%
Discounted @26%
(assumed rate)

Years

Cash
flows

Discoun
t rate *

Discounte
d
cashflows

@ 26%
(1)

(2)

(3)

(4) =
(2) * (3)

(10,000)

1.000 (10,000)

2,000

0.794 1,587

4,000

0.630 2,520

12,000

0.500 5,999

NPV

106

therefore, IRR for Project B = 30% + [-633 /(

-633-106)]*26% - 30%
IRR

30% 3.43

26.57

PROJECT D:
The following has been calculated assuming discount rates of 10%
& 30% separately:

1) Payback period: time period to recover initial investment

a) Discounted
@10%

Years

(1)

Cash
flows

(2)

(10,000)

10,000

3,000

3,000

b) Discounted
@30%

Discoun

Years

Cash
flows

Discoun
t rate *

Discou
nted
cashflo
ws

Unrecove
red
discounte
d cash
flows

@ 30%

(1)

(2)

c
o
m
p
u
t
e
d
u
s
i
n
g
f
o
r
m
u
l
e

(5)

(10,000)

1.000

(10,000) (10,000)

10,000

0.769

7,692

(2,308)

3,000

0.592

1,775

(533)

3,000
=

0.455
s
o
c
u
n
t

1,365

r
a
t
e

(3)

*
d
i
s
o
c
u
n
t

(4)
= (2) *
(3)

/
(
1
+
r
)
t
o
t
h
e
p
o
w
e
r
n
;
w
h
e
r
e

r
a
t
e
&n=
year
P
a
y
b
a
c
k
p
e
r
i
o
d
=

B
a
s
e

d
i

y
e

833
ar
+
[(u
nre
cov
ere
d
dis
ocu
nte
d
cas
h
flo
w
of
bas
e
yea
r/
dis
ocu
nte
d
cas
h
flo
ws
of
nex
t
yea
r)
*12
]
w

h
e
r
e
b
a
s
e

s
h
f
l
o
w
s

y
e
a
r

t
u
r
n
s

y
e
a
r

o
r

i
n
w
h
i
c
h
u
n
r
e
c
o
v
e
r
e
d
c
a

made:

g
i
v
e
n

&

a
s
:

A
v
e
r
a
g
e

T
a
x

I
n
i
t
i
a
l

i
n
+
p
v
v
r
e
e
o
s
f
t
Payback period @ 10% discount
rate= 1 +
i
m
[(909/1570)*12]
t
=1.7
e
n
years
a
t
f
Since no
t
information on
e
profits,
r
depreciation &
taxes, it is
d
treated cash
e
inflows
p
considered as
r
profits after
i
2)
depreciation &
c
Accountin
taxes
i
g rate of
return: rate a
therefor (16,000
t
of return
(inflow) / 10,000
on initial
i
e=
(investment))
investment o
* 100

accounting rate of return =

160%; effectively 60% return

4) NPV (net present value):

b)
Disco
a)
Disco unted
unted @30%
@10%

Years

(1)
0
1
2
3
NPV

Disco
unt
rate *
@
30%

Cash
flows

Years

Discounted
cashflows

(4) = (2)
* (3)

(1)

(2)

(3)

(10,000)

1.000

(10,000)

10,000

0.769

7,692

3,000

0.592

1,775

3,000

0.455

1,365

NPV
e
*
r
di
e
s
o
r
c
=
u
nt
d
ra
i
te
s
c
o
o
c
m
u
p
n
ut
t
e
r
d
a
u
t
si
e
n
1
g
&n
fo
r
=
m
ul
y
e
e
a
=
r
1
/
(1
+r
3
)
)
to
I
th
R
e
R
p
o
w
(
er
I
n;
n
w
t
h
e

833
r
n
a
l

r
a
t
e

r
e
t
u
r
n

o
f
r
e
t
u
r
n
)
:

o
f

a
t
w
h
i
c
h

N
w P
h V
i
c =
h
0
i
s
For project
C , IRR is
t
calculated
h as below:
e
I
r R
a R
t

=
L
1
+
[
N
P
V
L
1
/
(
N
P
V
L
1
N
P
V
L
2
)
]
*
(
L
2
L
1
)
w
h
e
r
e
L
1
=

e
g
u
e
s
s
r
a
t
e

o
f
r
e
t
u
r
n
)

(
d
e
p
e
n
d

d
i
s
o
c
u
n
t
e
d
a
t
g
i
v
e
n
r
e
q
u
i
r
e
d
r
a
t

a
n
d
N
P
LV
2
=:
o
ni
en
m
v
or
ee
gr
us
es
e
s

o
n
N
P
V
,

r
a
t
e

rat
e r
e
R l
e a
l t
a i
t o
i n
o s
n h
s i
h p
i :
p
Discount
rate
b
goes up
e
t NPV falls
w
NPV goes
e Discount
e rate comes
n down up
d
i
s
c
o
u
n
t

Let us
assume L1
= 30%
(why,
because
as could
be seen at
30% @
discount
rate NPV

is+ve

relationship, us
increased
Let calculate
by applying
the
disocunt rate)
L2 = 38%

Discounted @38%
(assumed rate)

Years

Cash
flows

Discoun
t rate *

Discounte
d
cashflows

@ 38%
(1)

(2)

(10,000
)

(3)

1.000

10,000 0.725 7,246

3,000 0.525 1,575

3,000 0.381 1,142

(4) =
(2) * (3)

(10,000)

NPV

(37)

therefore, IRR for Project B = 30% + [833 /(

833+37)]*38% - 30%
30% +
7.66

IRR

37.66%

1) NPV (net present value): for increments cash flows

a) Discounted
@10%

Years

(1)

Increme
ntal
Cash
flows
(project
C
project
D)

(2)

(8,000)

1,000

9,000

NPV

b)
Discounted
@30%

Years

Cash
flows

Discou Discounte
nt rate
d
*
cashflows

@
30%
(1)

(2)

(4) =
(2) * (3)

(3)

(8,000)

1,000

0.592 592

9,000

0.455 4,096

NPV
using
* disocunt rate formule
computed
=1/

1.000 0.769 (6,154)

(1,466)
(1+r) to n; where r =
the
disocunt rate
power & n = year

3) IRR (Internal rate of return): which is the rate

of return at which NPV = 0
For project C , IRR is calculated as below:
IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *
(L2 - L1)
where L1 = guess rate (depend on NPV, disocunted at
given required rate of return)
L2 = one more guess
rate
Relationship between discount rate and NPV:
inverse relationship:
Discount rate
goes up
NPV falls
NPV goes
Discount rate comes down

up

Let us assume L1 = 10% (why, because as could be seen at 30% @

discount rate NPV is+ve
by applying the relationship,
increased disocunt rate)
Let us calculate L2 = 13%
Discounted @13%
(assumed rate)

Years

Cash
flows

Discoun
t rate *

Discounte
d
cashflows

@ 13%
(1)

(2)

(4) =
(2) * (3)

(3)

(8,000)

1,000

0.783 783

9,000

0.693 6,237

NPV

1.000 0.885 (7,080)

(59)

therefore, IRR for Project B = 10% + [316 /(

316+59)]*13% - 10%
IRR
Target return =
10%
IRR for incremental
cash flows = 12.5%

10% +
2.5

12.50%

since IRR for incremental cash flows > Target return,

select / accept Project C

Question 3a: "Firm should follow a policy of very high dividend pay-out
Taking example of two organization comment on this statement"
Answer 3a:
The statement not necessarily be true. Let us take 2 companies;
High dividend pay out company 100% payout
a) Less retained earnings
b) Slower / lower growth rate
c) Lower market price
d) Cost of equity (Ke) > IRR (r = rate of return
earned by company on its investment.
e) Indicates that company is declining.

Low dividend payout company 20% payout

a) More retained earnings
b) Accelerated/higher growth rate
c) Higher market price
d) Cost of equity (Ke) < IRR (r = rate of return
earned by company on its investment.
e) Indicates that company is growing.

It must be noted that, dividend is a trade off between retaining money for capital expenditure and issuing
new shares.

Question 3b: An investor gains nothing from bonus share "Critically analyse
the statement through some real life situation of recent past.
Answer 3b:
The statement is false. An investor gains bonus shares at zero cost, However, the market price of the stock
will come down & over the long period, the investor definitely maximizes his wealth due to bonus shares.
From company angle, bonus issue is only an accounting entry & it doesnt change the wealth/value of the
firm.
Recently, Bharti Airtel have issued bonus share 2:1, due to which, the investors have gained Bonus shares
at zero cost & the market have come down to the extent of bonus issue & immediately went up & investors
have cashed the bonus shares thus maximized their wealth. However, currently it is trading down due to
varied reasons.

CASE STUDY

Ques 1: You are required to make these calculations and in the light thereof,
advise the finance manager about the suitability, or otherwise, of machine A
or machine B.
Solution:
Advise to finance manager of Brown metals ltd, to select the appropriate machine:
Particulars
1) NPV
2) Profitability index
3) Pay Back period
4) Discounted pay back period

Machine A (Rs. In lacs)

12
1.48
2 years
3.18 years

Machine B (Rs. In lacs)

14
1.35
3 years
3.21 years

It is advised to go in for Machine B with enhanced capacity, which will add more value to the firm.
NPV is higher in respect of Machine B as compared to Machine A & therefore machine with higher
NPV needs to be invested.
Workings are as follows:
(a) to buy machine A which is similar to the existing machine:

Years

Cash
flows
(Rs. In
lacs)

Unrecovered
cash flows

Discount rate
*

Discounted
cashflows

Unrecovered
discounted
cash flows

@10%
(1)

(2)

0
1

(25)

(3)

(4) = (2) *
(3)

(5)

(25)
(25)

1.000
0.909

(25)
-

(25)
(25)

(20)

0.826

(21)

20

0.751

15

(6)

14

14

0.683

10

5
NPV

14

28

0.621

9
12

12

1* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate
1& n = year
1) Net Present value = Present value of inflows - Present value of outflows = 12 (as computed above)
2) Profitability Index = Present value of inflows / present value of outflows which should be >1
37 / 25 1.48
3) Payback period = Base year + [(unrecovered cash flow of base year / cash flows of next year)
*12] where base year = year in which unrecovered cash flows turns 0 or +ve
Payback period = 2 + [(20/0)*12]

= 2 years

4) Discounted Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted
cash flows of next year) *12]
where base year = year in which unrecovered cash flows turns 0 or +ve
Payback period = 3 + [(6/4)*12]
=3.18 years

(b) to go in for machine B which is more expensive & has much greater capacity:

Years

Cash
flows
(Rs. In
lacs)

Unrecovered
cash flows

Discount rate
*

Discounted
cashflows

Unrecovered
discounted
cash flows

@10%
(1)

(2)

(4) = (2) *
(3)

(3)

(5)

(40)

(40)

1.000

(40)

(40)

10

(30)

0.909

(31)

14

(16)

0.826

12

(19)

16

0.751

12

(7)

17

17

0.683

12

5
NPV

15

32

0.621

9
14

14

1*
disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate
1& n = year
1) Net Present value = Present value of inflows - Present value of outflows = 14 (as computed above)
2) Profitability Index = Present value of inflows / present value of outflows which should be
>1
54 / 40

1.35

3) Payback period = Base year + [(unrecovered cash flow of base year / cash flows of next year)
*12] where base year = year in which unrecovered cash flows turns 0 or +ve
Payback period = 3 + [(16/0)*12]

= 3 years

4) Discounted Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted
cash flows of next year) *12]
where base year = year in which unrecovered cash flows turns 0 or +ve

Payback period = 3 + [(7/4)*12]

=3.21 years

Assignment - C
1.
(1)
(2)
(3)
(4)

The main function of a finance manager is

capital budgeting
capital structuring
management of working capital
(a),(b)and(c)
Answer (d)
2.
Earning per share
(a) refers to earning of equity and preference shareholders.
(b) refers to market value per share of the company.
(c) reflects the value of the firm.
(d) refers to earnings of equity shareholders after all other obligations of the company have been met.
Answer (d)
3.

If the cut off rate of a project is greater than IRR, we may

(1)
(2)
(3)
(4)

accept the proposal.

reject the proposal.
be neutral about it.
wait for the IRR to increase and match the cut off rate.
Answer (b)

4.
(1)
(2)
(3)
(4)

Cost of equity share capital is

equal to last dividend paid to equity shareholders.

equal to rate of discount at which expected dividends are discounted to determine their PV.
less than the cost of debt capital.
equal to dividend expectations of equity shareholders for coming year.
Answer (b)
5.
Degree of the total leverage (DTL) can be calculated by the following formula
[Given degree of operating leverage (DOL) and degree of financial leverage (DFL)]
(1) DOL + DFL
(2) DOL /DFL
(3) DFL-DOL
(4) DOL x DFL
Answer (d)

6.
(1)
(2)
(3)
(4)

Risk- Return trade off implies

7.
(1)
(2)
(3)
(4)

The goal of a firm should be

8.
(1)
(2)
(3)
(4)

Current Assets minus current liabilities is equal to

increasing the profits of the firm through increased production

not taking any loans which increase the risk of the firm
taking decisions in a way which optimizes the balance between risk and return
not granting credit to risky customers
Answer (c)

maximization of profit
maximization of earning per share
maximization of value of the firm
maximization of return on equity
Answer (c)

Gross working capital

Capital employed
Net worth
Net working capital.

Answer (d)

9.
(1)
(2)
(3)

The indifference level of EBIT is one at which

EPS increases
EPS remains the same
EPS decreases

(d) EBIT=EPS.
Answer (d)
10. Money has time value since

(1)
(2)
(3)
(4)

The value of money gets compounded as time goes by

The value of money gets discounted as time goes by
Money in hand today is more certain than money in future
(b) and (c)
Answer (b)
11. Net working capital is

(1)
(2)
(3)
(4)

excess of gross current assets over current liabilities

same as net worth
same as capital employed
same as total assets employed
Answer (a)
12. The internal rate of return of a project is the discount rate at which NPV is

(1)
(2)
(3)
(4)

positive
negative
zero
negative minus positive
Answer (c)
13. Compounding technique is

(1)
(2)
(3)
(4)

same as discounting technique

slightly different from discounting technique
exactly opposite of discounting technique
one where interest is compounded more than once in a year.
Answer (c)
14. For determining the value of a share on the basis of P/E ratio, information is required
regarding:
(1) earning per share
(2) normal rate of return
(3) capital employed in the business
(4) contingent liabilities
Answer (a)
15. Tandon committee suggested inventory and receivable norms for

(1)
(2)
(3)
(4)

15 major industries
20 minor industries
25 major and minor industries
30 major and minor industries
Answer (c)
16. Capital structure of ABC Ltd. consists of equity share capital of Rs. 1,00,000 (10,000 share of
Rs. 10 each) and 8% debentures of Rs. 50,000 & earning before interest and tax is Rs. 20,000. The
degree of financial leverage is

(1)
(2)
(3)
(4)

1.00
1.25
2.50

2.00
Answer (b)
17. The following data is given for a company. Unit SP = Rs. 2, Variable cost/unit = Re. 0.70, Total fixed
cost- Rs. 1,00,000 Interest Charges Rs. 3,668, Output-1,00,000 units. The degree of operating leverage is

(1) 4.00
(2) 4.33

(3) 4.75
(4) 5.33
Answer (b)
18. Market price of equity share of a company is Rs. 25 and the dividend expected a year hence is Rs. 10.

The expected rate of dividend growth is 5%. The cost of equal capital to company will be

(1)
(2)
(3)
(4)

40%
45%
35%
50%
Answer (b)
19. The dilemma of "liquidity Vs profitability" arise in case of

(1)
(2)
(3)
(4)

Potentially sick unit

Any business organization
Only public sector unites
Purely trading companies
Answer (b)
20. The present value of Rs. 15000 receivable in 7 years at a discount rate of 15% is

(1)
(2)
(3)
(4)

5640

5500
5900
5940
Answer (a)
21. A bond of Rs. 1000 bearing coupon rate of 12% is redeemable at par in 10 yrs. If the required
rate of return is 10% the value of bond is
(1) 1000
(2) 1123

(3) 1140
(4) 1150
Answer (a)
22. The EPS of ABC Ltd. is Rs. 10 & cost of capital is 10%.The market price of share at return rate
of 15% and dividend pay out ratio of 40% is
(1) 100
(2) 120
(3) 130
(4) 150
Answer (a)
23. The credit term offered by a supplier is 3/10 net 60.The annualized interest cost of not availing
the cash discount is
(1) 22.58%
(2) 27.45%
(3) 37.75%
(4) 38.50%
Answer (a)
24. The costliest of long term sources of finance is

(1)
(2)
(3)
(4)

Preference share capital

Retained earnings
Equity share capital
Debentures
Answer (c)
25. Which of the following approaches advocates that the cost of equity capital & debit
capital remains the degree of leverages varies
(1) Net income approach
(2) Net operating income approach
(3) Traditional approach
(4) Modigliani-Miller approach
Answer (b) & (d)

26. Which of the following is not a feature of an optimal capital structure.

(1) Profitability
(2) Safety
(3) Flexibility

(d) Control
Answer (b)
27. While calculating weighted average cost of capital

(1)
(2)
(3)
(4)

Retained earnings are excluded

Bank borrowings for working capital are included
Cost of issues are included
Weights are based on market value or on book value
Answer (a)
28. Which of the following factors influence the capital structure of a business entity?

(1)
(2)
(3)
(4)

Bargaining power with suppliers

Demand for product of company
Expected income
Technology adopted
Answer (c)
29. According to the Walters model, a firm should have 100% dividend pay-out ratio when.

(1)
(2)
(3)
(4)

r = ke
r < ke
r > ke
g > ke
Answer (a)
30. Operating cycle can be delayed by

(1)
(2)
(3)
(4)

Increase in WIP period

Decrease in raw material storage period
Decrease in credit payment period
Both a & c above
Answer (d)
31. If net working capital is negative, it signifies that

(1)
(2)
(3)
(4)

The liquidity position is not comfortable

The current ratio is less then 1
Long term uses are met out of short- term sources
All of a, b and c above
Answer (d)
32. Which of the following models on dividend policy stresses on investors preference for the
current dividend
(1) Traditional model
(2) Walters model
(3) Gordon model
(4) MM model
Answer (d)
33. Which of the following is a technique for monitoring the status of receivables

(1)
(2)
(3)
(4)

ageing schedule
outstanding creditors
selection matrix
credit evaluation
Answer (a)
34. Average collection period is equal to

(1)
(2)
(3)
(4)

360/ Receivables Turnover Ratio

Average Creditors / Sales per day
Sales / Debtors
Purchases / Debtors
Answer (a)

35. In IRR, the cash flows are assumed to be reinvested in the project at

(1)
(2)
(3)
(4)

Internal rate of return

cost of capital
Marginal cost of capital
risk free rate

Answer (d)
36. In a capital budgeting decision, incremental cash flow mean
(a) cash flows which are increasing.
(b) cash flows occurring over a period of time
(c) cash flows directly related to the project
(d) difference between cash inflows and outflows for each and every expenditure.
Answer (d)
37. The simple EOQ model will not hold good under which of the following conditions
(a) Stochastic demand
(b) constant unit price
(c) Zero lead time
(d) Fixed ordering costs
Answer (a)
38. The opportunity cost of capital refers to the

(1)
(2)
(3)
(4)

net present value of the investment.

return that is foregone by investing in a project.
required investment in a project.
future value of the investments cash flows.
Answer (b)
39. Which of the following factors does not influence the composition of Working Capital
requirements
(1) Nature of the business
(2) seasonality of operations
(3) availability of raw materials
(4) amount of fixed assets
Answer (d)
40. The capital structure ratio measure the

(1)
(2)
(3)
(4)

Financial Risk
Business Risk
Market Risk
operating risks
Answer (a)