TIME VALUE OF MONEY

1. Find Out the future value if Mr. X deposits today Rs. 20,000 for 5 years @ interest rate
8% and the compounding is done annually.
2. Find out the number of years if Mr. Y deposits Rs. 30,000 today expecting the future value
to be Rs. 2,01,825 with an interest rate @ 10% compounding annually.
3. At what % of interest rate compounded annually, principal amount of Rs. 20,000 becomes
Rs. 30,772 in 5 years?
4. Mr. Bond is investing today a sum Rs. 20,000 for the 5 years period with an interest rate
of 10% find out the future value at the end of the 5 th year under the following each
situation;
(a) If compounding is done monthly,
(b) If compounding is done quarterly,
(c) If compounding is done half yearly (semi annually).
5. Find out the future value at the end of the 5 th year if Kushal deposits Rs. 25,000 p.a. for
the next five years starting from the end of the next year at an interest rate of 10%
compounded annually.
6. Mr. A starts to deposit 10 annal installment each of Rs. 30,000 from the 4 th year end. The
rate of interest is 9% compounded annually. Find out the future value at the end of the
year 13th and 15th
7. Darshan starts to deposit Rs. 10,000 p.a. for the next 3 year, Rs. 12,000 p.a. from 4 th year
to 7th year. Find out the future value assuming the interest rate being 11.5% compound
annually.
8. Mr. X expecting to receive Rs. 5,00,000 at the end of the 5 th year from now with an interest
rate of 8% compounded annually, how much should he invest today to receive above sum?
9. If Murli pays Rs. 10,000 p.a. for 10 years from now to payoff the loan amount, what would
be the loan amount if interest rate is 11% p.a. compounded annually?
10. If A pays Rs. 10,000 p.a. for 10 years from now to payoff the loan amount which is Rs.
58,892. Find out the compounded interest rate.
11. A has invested into a project a sum of Rs. 41,088 today for which he is expecting to have
the future cash infloes as under:
Rs. 6,000 p.a. for the next 5 years, Rs. 8,000 p.a. from the 6 th year to the 9th year, Rs.
9,000 p.a. from the 10th year to the 12th year. Find out the interest rate compounded
annually.
12.
Mr. Dinanath deposit Rs.15,000 p.a. from the end of the 5 th year for 5 years with an
interest rate of 9% compounded annually. Find out the Present value as on today.
13.
Mr. Y deposits 10 annual installment each of Rs. 10,000 from the end of the 5 th
year. Find out the present value at the beginning of the 4 th year and also as on today. Rate
of interest is 11% compounded annually.
14.
Diya starts to deposit Rs. 20,000 p.a. for the next 4 years, Rs. 25,000 p.a. from the
th
5 year to the 9th year. Find out the present value assuming the interest rate being 9%
compounded annually.
15.
An investor is likely to retire at the end of the 15 th year. In order to receive Rs.
1,50,000 annually for 10 years after the date of retirement, how much amount should he
have at the time of retirement? Interest rate is 10% compounded annually.

16.
An investor is likely to retire at the end of the 15 th year. In order to receive Rs.
1,50,000 annually for 10 years after the date of retirement, how much amount should he
save annually for 15 years till the date of retirement? Interest rate is 10% compounded
annually.
17.
Y starts to deposit Rs. 10,000 per annum from today onwords and he would like to
continue the same upto 15th year. Calculate the future value and also the present value of
the sum invested if interest is 10% compounded annually.
18.
A company offeres a fixed deposit scheme whereby Rs. 20,000 matures to Rs.
28,858 after 3 years, on a yearly compounding basis. If the company wishes to amend he
scheme by compounding interest every quarter what will be the revised maturity value?
19.
A person opened an account on April 1 st 2010 with a deposit of Rs. 8000. The bank
paid 9% interest compounded quarterly. On October 1st 2010, he closed the account and
added enough money to invest in a 6-month Time Deposit for Rs. 10,000 earning 9%
compounded monthly.
(a) How much additional amount did the person invest on October 1st ?
(b) What was the maturity value of this time deposit on April 1st 2011?
(c) How much total interest was earned?
20.
If Rs. 5,000 is invested at the end of each month having 9% interest rate
compounded monthly what would be the future value at the end of 10 th payment or 10th
month?
21.
Mr. B plans to receive an annuity of Rs. 10,000 semi-annually for 0 years after he
retires
in 18 years. Money is worth 9% compounded semi-annually.
(a) How much amount is required to finance the annuity?
(b) What amount of single deposit made now would provide the funds for the annuity?
(c) How much will Mr. B receive from the annuity?
22.
Mr. A has retired recently. He received Rs. 5,00,000 as his retirement benefit from
the company, which he invested in a bank at 15% p.a. interest rate. He expect to live
independently for another 15 years. How much amount he can withdraw at the end of
each year, so as to leave nil balance in his account at the time of maturity?
23.
A person deposit a fixed sum in a bank at the begginning of every year up to 5 th yar.
Maturity amount at the end of 5 th year would be equal to Rs. 10,00,000. The interest rate
is 12% p.a. Calculate the amount of investment for each year to get Rs. 10,00,000.
24.
Mr. X has made investment in real estate for Rs. 12,000 which he expects will have
a maturity value equivalent to interest at 12% compounded monthly for 5 years. If most
savings institutions currently pay 8% compounded quaterly on 5 years term, what is the
least amount for which Mr. X should sell his property?
25.
Mr. A wants to retire and receive Rs. 3,00,000 p.a. till death. He can earn an
interest of 9% compounded annually. How much will he needed to set aside to achieve his
perpetuity goal?

COST OF CAPITAL
Cost of Capital:
The main object of the business is to maximize the wealth of shareholder in the long run; the
management should only invest in projects, which give a return in excess of cost of funds
invested in the business. The various sources of funds to the company are in the form of equity
and debt.

Cost of the Equity:

Cost is an important consideration in capital structure decisions. The funds required for the
project are raised from the Equity shareholders, which are of permanent nature. These funds
need not to be repayable during the life time of the organization. The main objective of the firm
is to maximize the wealth of the shareholders. Equity share capital is the risk capital of the
company. If the companys business is doing well the ultimate beneficiaries are the equity
shareholders who will get the return in the form of dividends from the company and the capital
appreciation for their investment. If company comes for liquidation, the ultimate sufferers are
the equity shareholders. Sometimes they may not get their investment back during the
liquidation process.
Profit after tax less dividends paid out to the shareholders which have been reinvested in the
company therefore those retained funds should be invested in the category of equity. Thus, Cost
of equity may be defined as the minimum rate of return that a company must earn on the equity
financed portion of an investment project so that market price of the shares remains
unchanged. Following Methods are used in calculation of Cost of equity:
3

1. Dividend Price Method:

The dividend yield per share is expected on the Current market price per share. The company is
expected to earn at least this yield to keep the shareholders content. The main drawback with
this method, as it does not allow for any growth rate. This approach has no relevance to the
company.

l. Earning Price Method:

2. Dividend Price + growth Method:
In this Method, an allowance for future growth in dividend is added to the current dividend
yield. It is recognized that the current market price of share reflects expected future dividend.
Which approach to use: In the case of companies with stable income and with stable dividend
policies, the D/P approach may be good way of measuring the cost of ordinary share capital
In the case of companies whose earnings accrue in cycles, it would be better if the E/P
approach is used, but representative figure should be taken into account to include one
complete cycle. In case of growth companies, where expectations of growth are more important,
the cost of ordinary than capital may be determined on the basis of the DP + G approach.
Cost of the equity by IRR Method:
Where, Po = current market (purchase) price of the share
D = dividend of the respective years
Pn = price of the share after n year
This means, current market price of shares must equal to all future benefit (i.e. Dividend +
realized value) of that shares.
If there is a constant growth rate in Dividend:
By solving it, Po = (D1 / Ke g, this formula is when there is constant growth and Growth < Ke
G=b.r
Where b = retention rate and r = rate of return

Earning Price Method:

Cost of the Retained Earnings:
The retained earnings is one of` the major sources of finance available for the established
companies to finance its expansion and diversification programme. These are funds
accumulated over the years of the company by keeping part of the funds generated without
distribution. So profit retained by company and used in expansion also entail cost. This may be
termed as opportunity cost of retained earnings. i.e. suppose these earnings are not retained
4

and are passed on to share holders; suppose further that share holder invest same in new
ordinary shares. This expectation of the investor from the new ordinary share should be
opportunity cost. Kr = Ke

Cost of Preferred Capital:

The cost of preference capital is the rate of return that must be earned on preference capital
financed investments to keep unchanged the earnings available to the ordinary shareholders. `

CDT = Corporate Dividend Tax

Cost of redeemable preference shares - The cost of redeemable preference shares is
calculated as follows:

Where,
Kp = Cost of redeemable preference shares
D = Constant annual dividend payment
N = Years of life to redemption of preference shares
Rv = Redeemable value of preference shares at the time of maturity
Sv = Sale out value of preference shares less discount and flotation expenses.

Cost of Debt:
The cost of Debt is defined as the rate of return that must be earned on debt financed
investments to keep unchanged the earning available to the equity shareholders. In calculation
of cost of debt, the cost of debt raised from FIS, Banks or Issue of debs are to be calculated
which requires the following information.
Net cash inflow from each source of debt and
The amount of, periodic interest payment and principal repayment on maturity
Cost of Irredeemable debt,
Where,
KD = Cost of Debt
I = Annual interest payment
T = Companys effective corporate tax rate
D = Net proceeds of issue of debt

Cost of redeemable debt: If debt raised is certain of its redemption at the end of specified period,
the cost of capital can be calculated on, internal rate of return basis i.e. cost of redeemable debt
is rate of discount at which present value of all inflows equals to present value of cash out
flows.
OR
Where,
KD = Cost of debt
I = Annual interest payment
N = Term of maturity period
T = Companys effective tax rate
Rv = Redeemable value of debt at the time of maturity
Sv = Sale value less discount and flotation expenses.
This formula is for the traditional type of debt only, i.e. only one issue price realize, regular
interest payment, repayment of principal at maturity.

Weighted Average Method: The composite or overall cost of capital of a firm is the weighted
average of the cost of the various sources of funds. Weights are taken to be the proportion of
each source of funds in the capital structure.
Ko = KdWd + KpWp + KeWe + KrWr
Marginal Cost of capital:
The marginal cost of capital is the cost of obtaining an extra Re l of finance. The theory of
capital budgeting leads to the conclusion that projects should be accepted if they have a positive
net present value calculated after discounting the revenue and cost streams at the marginal cost
of capital to the firm.
Using the alternative, IRR criteria, all projects would be accepted that have an IRR greater than
the marginal cost of capital. Emphasis is being placed on the marginal cost of capital, for its
only earning above this cost that add to the total profits of the firm. The economic theory of firm
operates via the principal that the firm should operate at a level where marginal revenue is
equal to marginal costs. When this is applied to capital investment decisions, shareholders
wealth is maximized.

Arbitrage:
The term arbitrage is used in many areas of finance. It refers to the process of buying and
selling securities. The sales purchase takes place within an unstable capital market. The prices
are affected by supply and demand and arbitrage helps in adjusting the market to equilibrium.
6

The process of buying in one market and selling the same in another market is known as
arbitrage.
M & M have suggested that if two companies have the same level of business, as such they
must, all things being equal have the same weighted average cost of capita, and if they also have
the same level of earnings, the companies will have the same total market value. Lf this
situation does not prevail, as is proposed by the traditional theory, M & M argue that
shareholders will undertake arbitrage operation, which will result in share prices returning to
equilibrium.
The transaction involved in arbitrage process are that shareholders in a company with the lower
weighted average cost of capital sell their shares and purchase shares in the company with the
higher weighted average cost of capital borrowing and leading to maintain the same level of risk
return before and after. Security prices are adjusts as market participants search for arbitrage
profits. When such opportunities have been exhausted, security prices indifferent.

(CAPM )
The expected returns can of two types,
1. Based on market analysis.
2. Based on our Risk factor.
In CAPM we take only the risk factor analysis. It shows the relationship between the risk
and the expected return and also the behaviour of the security prices.
CAPM is applied to find out desired (expected ) return on a particular security based on
its risk level or systematic risk which is measured by Beta.
Beta is a measure of systematic risk / non diversifiable risk. It is the sensitivity of%
change in return of a particular security ( Rj ) and the l % change in the return of market
portfolio as a whole ( Rm ),

Eg. On the basis of the following information find out the Beta.
NSE Nifty

On 01-1-2007 = 5,000
On 31-l-2007 = 5,200

Price of a security( Share ) Hindalco

On 01-l-2007 = 190 Rs.
On 31-l-2007 = 220 Rs.

Rm-Market Return
Rj-Return on Share Hindalco
7

Beta=
So we can say that the Beta of share Hindalco is 3.95 times higher than that of the market beta.
i.e. return on individual security is higher than that of the market return. It can be reversed
also. Market portfolio is a well diversified portfolio which includes different securities - shares
in the same ratio as they are in the market index.
Risk is a fluctuation either on the positive or negative side.

Impact of Beta :

If
If
If
If

Beta
Beta
Beta
Beta

is
is
is
is

very high then the security is said to be very risky.

very low then the security is said to be less risky.
Zero then there is no risk at all.
l Risk involved is equal to the risk involved in the market portfolio.

Relation between Beta & Operating Leverage :

Beta is the measure of volatility of the risk of a particular security against the market
risk.
Whereas the Operating Leverage implies the Operating risk i.e. impact on the fixed
overheads cost.-Both implies the measure of risk. Therefore we can say that,

DOL

RISK

BETA

HIGH

HIGH

HIGH

LOW

LOW

LOW

The Beta concept is used to estimate the expected return of a security ( Rj ) or ( Ke )"using the
CAPM. SO, Ke according to this model is as under;

Ke=Rf+B(Rm-Rf)
Ke = Expected return on basis of risk factor beta .
Rf = Risk free return on securities like Govt. Sec./bonds, Treasury bills etc.
B = Beta factor (risk factor)
Rm = Market risk return as a whole
(Rm-Rf ) = Risk Premium i.e. Premium on market portfolio over risk free return security
( Ke-Rf ) = Premium of a particular security over risk tree security.

Example :
8

 Suppose an investor wants to invest in Govt. Bonds then he can earn say 5% on it.
But if he invest into a particular security say SAIL ( Steel Authority of India Limited ) then
his investment would be considered to be risky then the Govt. Bonds. So naturally he
would expect more return on SAIL than on Bonds.
Suppose overall market return 15% and return on SAIL is l.5 times higher than the
market return then his expectation would be higher than that of the market return, which
is as under on the basis of CAPM;
Rf=5%, Rm=l5%, Beta=l.5,
Ke=Rf+Beta(Rm-Rf)
=5%+1.5(15%-5%)
=20%

From the above graph we can say that if a particular security provides higher return then
by introduction of such security in such portfolio expected return is also increased. i.e.
more risk more return.
Same way if the risk is lower for a particular security then by introducing such security
the overall return is also reduced due to lower return of such security.
If a security is correctly priced, then its risk return combinations must lie on Security
Market Line otherwise it is not a correctly priced security.
Any risk - return combination lying above SML represents an undervalue of security while
any Risk return combination lying below SML represents over value of security.

Levered Beta
It is the Beta of equity of a levered company having equity and debt in its capital structure. As
outside debt Introduced in the capital structure, risk is increased to that extent and therefore
the financial risk of the Beta, in such company is always higher.

Unlevered Beta
It is the Beta of equity of unlevered company having only equity capital in its capital structure.
So the risk of Beta of such company is less compared to the financial risk of Beta of levered
company.

QUESTION
Q~1
A company has 10 per cent perpetual debt of Rs. 1,00,000. The tax rate is 30 per cent.
Determine Kd (before tax as well as after tax) assuming the debt is issued at (i) par, (ii) 10%
discount, and (iii) 10%premium.
Q~2
9

A company issues a new 10 per cent debentures of Rs. 1,000 face value to be redeemed after 10
years. The debenture is' expected to be sold at 5 per cent discount. It will also invoice floatation
costs of 5 per cent of face value. The companys tax rate is 30 per cent. What would the cost of
debt be? Illustrate the computations using (i) trial and error approach and (ii) shortcut method.
Also calculate Kd( shortcut method) if in above case if the debentures are sold at a premium of
10%.
Q~3
A Ltd. issued 10,00,000 equity shares each of Rs. 100 at par. The current market price of the
share is Rs.
140. The company has recently declared 20% dividend. The company has an opportunity to
issue the same type of shares at a premium of 30%. The floatation cost in this C356 would be
5% of the face value. It is expected that A Ltd. will grow at a constant rate of 5%p.a.
Calculate the cost of equity.
Q~4
A company issues ll per cent irredeemable preference shares of the face value of Rs 100 each.
Flotation costs are estimated at 5 per cent of the expected sale price. (a) What is the kp if
preference shares are issued 10 per cent premium,? (b) Also, compute kp in these situations
assuming 15 per cent dividend tax. Calculate Kp in above case if it is assumed that the
preference shares are redeemable at par after five years.
Q~5
The following is the information relates to X Ltd.:
(i.) Current market price of a share = Rs 150.
(ii.) Cost of floatation per share on new shares, Rs 3.
(iii.)Dividend paid on the outstanding shares over the past five years.
`

Year

Dividend per share

Rs 10.50

11.02

11.58

12.16

12.76

13.40

(iv.) Assume a fixed dividend pay out ratio.

(v.) Expected dividend on the new shares at the end of the current year is Rs 14.10 per share.
10

You are required to;

(1) Determine the cost of equity shares.
(2) Calculate the current dividend yield.
(3) Calculate the rate of return of Mr. X on his equity investments.
Q~6
The following is the capital structure of Co. A:
8% Debt Rs. 3,00,000
Source
8% Debt
14% Preference capital
Equity
Total

Amount
Rs. 3,00,000
2,00,000
5,00,000
10,00,000

The expected dividend for the next year is Rs.5 and the current market price of the share is
Rs.50.The constant growth of 5%p.a. is expected. The corporate tax rate is 30%.
Calculate the weighted average cost of capital( ko).
Q~7
A company is considering raising Rs 100 lakh by one of the two alternative methods, viz. 14 per
cent institutional term loan and 13 per cent non-convertible debentures. The term loan option
would attract no major incidental cost. The debentures would have to be issued at a discount of
2.5 per cent and would involve Rs 1 lakh as cost of issue.
Advice the company as to the better option based on the effective cost of capital in each case.
Assume a tax rate of 30 per cent.
Q-8
A company has on its books the following amounts and specific costs of each type of capital.
Type of Capital
Debt
Preference
Equity
Retained Earning

Book value
Market Value
Specific Costs(%)
Rs 4,00,000
Rs 3,80,000
5
1,00,000
1,10,000
8
6,00,000
15
2,00,000
12,00,000
13
13,00,000
16,90,000
Determine the weighted average cost of capital using (a) Book value weights and, (b) Market
value weights. Why are they different? Can you think of a situation where the weighted average
cost of capital would be the same using either of the weights?
Q~9
11

Two companies A and B are in the same business and hence have similar operating risks.
However, the capital structure of each of them is different. The following are the details:

A
4,00,000

Equity share capital (Rs.)

(Face value Rs l0 per share)
Market value per share (Rs.)
Dividend per share (Rs.)
Debentures(Rs)(Face
value

Rs.

100

15
2.70
per NIL

debenture)
Market value (MV) per debenture (Rs)
Interest Rate

B
2,50,000
20
4
1,00,000
125
10

Assume the current levels of dividends are generally expected to continue indefinitely and the
income-tax rate is 30 per cent You are required to compute the weighted average cost of capital
(ko) of each company.
Q~10
As a financial analyst of a large electronics company, you are required todetermine the weighted
average cost of capital of the company using (a) book value weights and (b) market value
weights. The following information is available for your perusal.
The companys present book value capital structure is:
Debentures (Rs 100 per debenture)
Preference shares (Rs 100 per share)
Equity shares (Rs 10 per share)

Rs 16,00,000
4,00,000
20,00,000
40,00,000

All these securities are traded in the capital markets. Recent prices are:
Debentures, Rs 110 per debenture
Preference shares, Rs 120 per share
Equity shares, Rs 22 per share

Anticipated external financing opportunities are: , _

(i)Rs 100 per debenture redeemable at par; 10 year maturity, 11 per cent coupon rate, 4per cent
flotation costs, sale price, Rs 105 .
(ii)Rs 100 preference share redeemable at par; 10 year maturity, 12 per cent dividend rate, 5
per cent flotation costs, sale price Rs 110.
12

(iii)Equity shares: Rs 2 per share flotation costs, sale price = Rs 20.

In addition the dividend expected on the equity share at the year end is Rs 2 per share; the
anticipated growth rate in dividends is 7 per cent and the firm has the practice of paying all its
earnings in the form of dividends. The corporate tax rate is 30 per cent.
Q~11
Malaysian Paints (India) Limited has paid a dividend of_30 per cent on its shares of Rs I0 each
in the current financial year. In the opinion of Choksi, finance director the dividend is expected
to grow @ 5 percent annum. The required rate of return of the company is 15 per cent.
It suggested the following alternative courses of action for the consideration of the Board:
(i.)
(ii.)
(iii.)
(iv.)

To increase the dividend growth rate to 6 per cent and lower the required rate
return to l4 per cent.
To increase the dividend growth rate 7 per cent and raise the required rate
return to 17 per cent.
To raise the required rate of return to 16 per cent and reduce the growth rate
dividend to 4 per cent.
(To increase the dividend growth rate to 8 per cent and increase the required rate
return to 17 per cent.

of
of
of
of

You are the finance manager of the company. The Board of Directors have confidence in your
abilities because in the past you have helped the Board in making such decisions. The Board
has requested you to Suggest, with calculations the most suitable course of action for the
company (assuming the firm has an objective of maximizing its shareholders wealth).
Q~l2 . '
(a) A companys debentures of the face value of Rs 100 bear an 8 per cent coupon rate.
Debentures of this type currently yield l0 per cent. What is the market price of debentures of the
company?
(b) What would happen to the market price of the debentures if interest rises to (i) 16 per cent
and (ii)Drops to 12percent?
(c) What would be the market price of the debentures in situation (a) if it is assumed that
debentures
were originally having a 15 year maturity period and the maturity period is 4 years away from
now?
(d) Would you pay Rs 90 to purchase debentures specified in situation (c)? Explain.
Q~13
XYZ Ltd is contemplating a debenture issue on the following terms:
Face value
Term of maturity

Rs 100 per debenture

4 years
13

Yearly coupon rate of interest

Years 1 - 2
3-4

9%
10 %

The current market rate on similar debentures is 11 per cent per annum. The company
proposes to price the issue so as to yield a (compounded) return of 12 per annum to the
investors. Determine the Debentures issue price. Assume the redemption premium of 5 per cent
on face value. The corporate tax rate is 30%.
Q~l4
XYZ Ltd (in 30% Tax bracket) has the following book value capital structure:
Equity Capital (in shares ofRs.10 each, fully paid-up at par)

Rs. 15crores

11% Preference Capital (in shares ofRs.100 each, fully paid-up at par)

Rs. 1 crore

Retained Earnings

Rs. 20 crores

13.5% Debentures (ofRs.l00 each)

Rs. 10 crore

15% Terms Loans

Rs. 12.5 crores

The net expected dividend on equity shares is Rs.3.60 per share. Dividends are expected
to grow at 7% and the Market price per share is Rs.40.
Preference Stock, redeemable after ten years, is currently selling at Rs_75 per share.
Debentures, redeemable after 6 years, are selling at Rs.8O per debenture.
Required :
l. Compute the present WACC Market Value Proportions.
2. Compute the weighted Marginal Cost of Capital if the Company raises Rs.10 Crores , given
the following information:
The amount will be raised by equity and debt in equal proportions.
The Company expects to invest Rs.l.5 Crores retained earnings.
The additional issue of equity shares will result in the net price per share being fixed at
Rs.32.
The Debt capital raised by way of term loans will cost 15% for the first Rs.2.5 Crores and
16% for the next Rs.2.5 Crores.
Q~15
A Limited wishes to raise additional finance of Rs. 10 lakhs for meeting its investment plans. It
has Rs. 2,l0,000 in the form of retained earnings available for investment purposes. The
following are the further details:
(1) Debt/equity mix

30%: 70%

(2) Cost of debt

14

Up to Rs. l,80,000

10% (before tax)

beyond Rs. l,80,000

16% (before tax)

(3) Earnings per share

Rs. 4

(4) Dividend Pay Out

50% of earnings

(5) Expected growth rate in dividend

10%

(6) Current market price per share

RS_ 44

(7) Tax rate

30%

(8) Personal Tax rate of the investor

20%

You are required:

(a) To determine the pattern for raising the additional finance.
(b) To determine the post-tax( after tax ) average cost of additional debt.
(c) To determine the cost of retained earnings and cost of equity, and
(d) Compute the overall-weighted average after tax cost of additional Finance.
Q~16
Suppose the required rate of return on a portfolio with beta of 1.2 is 18 per cent and the riskfree rate is 6per cent. According to the CAPM :
(a) What is the expected rate of return on the market portfolio?
(b) What is the expected return of a zero beta security?
(c) Suppose you choose to buy a stock Z for Rs. 50. The stock is expected to pay Rs. 2 as
dividend next year and is hoped to sell at Rs. 53. The stock has been evaluated at B = -0.5. Is
the stock fairly priced?
What is the implication of including stock Z in the portfolio?
Q~17
Mr. Azad holds the following portfolio
Share
Beta
Investment
Alpha
0.6
Rs.3,00,000
Beta
1.0
1,80,000
Carrot
1.2
1,20,000
What is the expected rate of return his port folio, if the risk-free rate is 6per cent and the
expected return on market portfolio is 15 per cent?
Q~18
The following facts are available
15

Risk-free rate, 9 per cent

Required rate of return on market portfolio, 18 per cent
Beta coefficient of the shares of ABC Ltd., 1.5
Expected dividend during the next year, Rs. 3
Growth rate in dividends/ earnings, 8 per cent

Compute the price at which the shares of ABC Ltd. should sell.
Q~19
Assume the following facts :
Risk -free return, rf 7.75 per cent
Beta 2,Expected return of investors, r, 16 per cent
Applying CAPM, compute the expected market return (rm).
Q~20
B Limited, an all equity firm, is evaluating the following projects:
Project
P
Q
R
S

Beta
0.6
0.9
1.5
1.5

Expected return (%)

13
14
16
20

The risk-free rate is 10 per cent and the expected market premium is 8 per cent. The co.s cost of
capital is 18 per cent. Which projects would be accepted or rejected on the basis of the firms
cost of capital as a hurdle rate?

Q~21
You are analysing 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

Unleveraged

of equity beta
Main frames

Rs. 100 billion

l.l0

Personal Computers

Rs. 100 billion

1.50

Software

Rs. 50 billion

2.00

Printers

Rs. l50 billion

1.00

ABC Computers Ltd. had Rs. 50 billion in debt outstanding.

16

Required :
(i) Estimate the beta for ABC Computers Ltd. as a Company. Is this beta going to be equal to the
beta estimated by regressing past returns on ABC Computers stock against a market index. Why
or why not ?
(ii) If the treasury bond rate is 7.5%, estimate the cost of equity for ABC Computers Ltd.
Estimate thecost 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%.

CAPITAL STRUCTURE
The capital structure of a company refers to the mix of the long term finances used by the firm.
It is the financing plan of the company. The objective of any company is to mix the permanent
source of funds used by it in a manner that will maximize the companys market price. In other
words companies seek to minimize their cost of capital. This proper mix of funds referred to as
the optimum capital structure.
In planning the capital structure, the following issues must be kept in mind:
1. There is no definite model, which can be used as an ideal for all business undertakings. This
is because the circumstances of various business undertakings differ. The capital structure
17

depends primarily on a number of factors like the nature of industry, gestation period, certainty
with which the profits will accrue after the undertaking goes in to commercial production & the
likely quantum of return on investment. It is, therefore, important to understand that different
types of capital structure would be required for different types of undertakings.
2. Government policy is a major factor in planning capital structure. For example, a change in
the lending policy of financial institutions may mean a complete change in the financial pattern.

Capital Structure planning

The three major considerations in Capital Structure Planning are z
(a) Risk, (b) Cost and (c) control
These differ for various components of Capital i.e. Own Funds and Loan Funds. A comparative
analysis is given as under :
Types of Risk

Cost

Control

fund
Equity

Low Risk - no question of of Most

Capital

capital except the company is dividend

under liquidation- Hence best of
from viewpoint of risk.

expensive

Expectations Since the capital base

shareholders

higher
rates.

- Dilution of control

than

are might

be

expanded

interest and new shareholders

Also,

dividends / public are involved.

are not taxdeductible.

Preference Slightly higher risk when

Slightly

Capital

than

compared to Equity Capital -

cheaper

cost No dilution of control

since voting rights are

is redeemable after a certain Equity but higher than

period even if

restricted

Interest rate on loan

dividend payment is based on funds.

profit.

Further,

preference

dividends
are not tax-deductible.
Loan

High risk - Capital should be

Comparatively

cheaper No dilution of control

funds

repaid as per agreement;

prevailing interest rates - but

,Interest should be paid

are considered only to some

irrespective of performance

the extent of after tax institutions may insist

or profits.

impact.

on
their

financial
nomination

of

representatives

in the
Board of Directors.
18

Features of optimum capital structure:

1. Profitability ._
2. Flexibility
3. Conservation
4. Solvency
5. Control

Peeking order theory of capital structure

The pecking order theory was proposed by Donaldson in 1961. The pecking order theory
suggests that firm rely for finance, as much as they can, on internally generated funds. If
internally generated funds are not enough then they will move to additional debt finance then
equity. This is because the issue cost of internally generated funds have the lowest issue cost
and cost of new equity is the highest. Myers has suggested that the firm follows a 'modified
pecking order' in their approach to financing. Myers has suggested asymmetric information as a
reason for heavy reliance on internal generated funds. He demonstrate that with asymmetric
information, equity shares are interpreted by the market as bad news since managers are only
motivated to issue equity share when share markets are undeveloped. Further, the use of
internal finance ensure that there is regular source of finance which might be in line with
companys expansion programme. If additional funds are required over and above internally
generated funds, then borrowings will be next alternative in this theory.
Thus pecking order theory rests on:
1. Stickly dividend policy.
2. A preference for internal funds.
3. An aversion to issue equity shares.

Financial Engineering
'Financial Engineering' involves the design, development and implementation of innovative
financial instruments and processes and the formulation of creative solutions to problems in
finance. Financial Engineering lies in innovation and creativity to promote market efficiency. It
involves construction of innovative asset-liability structures using a combination of basic
instruments so as to obtain instruments which may either provide a risk-return configuration
otherwise unviable or result in gain by heading efficiently, possibly by creating an arbitrage
opportunity. It is of great help in corporate finance, investment management, money
management, trading activities and risk management.
Over the years, Financial Managers have been coping up with the challenges of changing
situations. Different new techniques of financial analysis and new financial instruments have
been developed. The process that seeks to adopt existing financial instruments and develop new
ones so as to enable financial market participants to cope more effectively with changing
conditions is known as financial engineering.
19

In recent years, the rapidity with which corporate finance and investment finance have changed
in practice has given birth to a new area of study known financial engineering. It involves use of
complex mathematical modelling and high speed computer solutions. Financial Engineering
refers to and includes all this. It also involves any moral twist to an existing idea and is not
limited to corporate finance. It has been practised by commercial banks in offering new and
tailor made products to different types of customers. Financial engineering has been used in
schemes of mergers and acquisitions.
The term financial engineering is often used to refer to risk management also because it involves
a strategic approach to risk management.

QUESTIONS
Q~1
The Hypothetical Ltd.s current earnings before interest and taxes are Rs. 4,00,000. It currently
has outstanding debts of Rs. 15 lakh at an average cost (Ki) of 10 per cent. Its cost of equity
capital is estimated to be 16 per cent.
(i) Determine the current value of the firm using the traditional approach.
(ii) The firm is considering reducing its leverage by selling Rs. 5 lakh of equity shares in order to
redeem Rs. 5 lakh debt. The cost of debt is expected to be unaffected. However, the cost of
equity capital is to be reduced to I4 per cent. Would you recommend the proposed action ?
Q-2
The following information is relates to X Ltd.
Expected Net Operating Income

Rs. 4,80,000

10% Debt

Rs. 14,40,000

Ke ( Equity Capitalization Rate)

20%

You are required to calculate:

i) The value of firm and Ko as per NI Approach.
ii) Calculate the value of firm and Ko under the following situations:
i. If the company raises the debt by Rs. 7,60,000 to buyback the shares
ii. If the company issues the equity shares by Rs.7,60,000 to redeem the debt.
Q-3
The following information is relates to Y Ltd.
Expected Net Operating Income( EBIT)

Rs. l,20,()O0

10% Debt

Rs. 3,60,000

Ko ( The Overall Capitalization Rate)

20%
20

You are required to calculate:

i)The value of firm and Ke as per NOI Approach.
ii) Calculate the value of firm and Ke under the following situations:
a) If the company raises the debt by Rs. 1,90,000 to buyback the shares
b) If the company issues the equity shares by Rs. l ,90,000 to redeem the debt.
Q-4
The following information is relates to Y l,td.
Expected Net Operating Income( EBIT)

Rs. l2,00,000

10% Debt

Rs. 36,00,000

Ke

20%

You are required to calculate:

(1) The value of fiRM and Ko as per Traditional Approach.
(2) Determine the Firms leverage ratios 1 (a) B/S and (b) B/V.
(3) State how the following will effect on the value of firm and Ko.
a) If the company raises the debt by Rs. 750,000 to buy back the shares and due to this the
financial risk(kd) and Ke to would increase to 11% and 21% respectively.
b) lf the company raises the debt by Rs.8,50,000 to buy back the shares and due to this the
financial risk(kd) and Ke to would increase to 12% and 2l% respectively.
Q-5
R Ltd. is an all equity firm with a market value of Rs. 25,00,000 and the Ke = 21%. The firm
wants to buyback the shares worth Rs.5,00,000 by issuing and raising 15% perpetual debt of
the same amount. The tax rate may be taken as 30%. After the capital restructuring and
applying MM Model (with tax ), you are required to calculate :
l. Market value of R Ltd.
2. Ke
3. Ko and comment on it.
Q~6
The earnings before interest and taxes are Rs. 20 lakh for companies L and U. they are alike in
all respects except that firm L uses 15 per cent Debt aggregating Rs. 40 lakh. Given a tax rate of
30 percent, determine the income to be received by the stakeholders of the two firms.
Q~7
21

From the following selected data, determine the value of the firms, P and Q belonging to the
homogeneous risk class under (a) NI approach, and (b) the NOI approach.

EBIT
Interest (0.15)

Firm P

Firm Q

Rs. 2,25,000

Rs. 2,25,000

75,000

Equity capitalisation rate (Ke)

0.20

Tax rate

0.30

Which of the two firms has an optimal capital structure?

Q~8
The following are the equilibrium values of two firms belonging to the homogeneous risk class
according to the NOI approach.

Expected NOI (net operating income)

Less cost of debt (I)= (Ki x B)
Net income for equity-holders(EBIT-I)
Equilibrium cost of capital (Ko)
Total value (V), ENIT/Ko
Market value of debt (B)
Market value of equity (V-B)
Cost of equity

X
Rs. 25,000
5,000
20,000
0.125
2,00,000
1,00,000
1,00,000
0.20

y
Rs. 25,000
25,000
0.125
2,00,000
2,00,000
0.125

Determine the values of the firms, X and Y under the traditional approach, assuming the Ke for
company Y as 11 per cent and for X as 14 per cent.
Q~9
Two companies, X and Y belong to equivalent risk group. The two companies are identical in
every respect except 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 per cent debentures. The other information
for the two companies is as follows :
NOI (net operating income)
Interest on debt
Earnings equity-holders(EBIT-I)
Earnings to capitalisation rate
Market value of equity

x
Rs. 1,50,000
1,50,000
0.15
2,00,000

y
Rs. 1,50,000
-60,000
90,000
0.20
4,50,000
22

Market value of debt (B)

Total value of firm
Overall capitalisation rate
Debt/ equity ratio

1,00,000
0.15
0

6,00,000
10,50,000
0.143
1.33

An investor owns 5 per cent equity shares of company Y. Show the process and the amount by
which he could reduce his outlay through use of the arbitrage process. Are there any limits to
the process?
Q~10
The value of a firm is independent of the proportion of debt to total capitalisation. The arbitrage
process will establish a market equilibrium in which the total value of the firm will depend only
on investors estimate of the firms business risk, and its expected future income. Explain the
above mentioned statement with the help of the following data regarding two companies, A and
B with the same expected annual income and same risk class.
Variables
Expected annual income(Y)
Market value of debt(L)
Rate of interest on debt(i)
Required rate of return on

Company A
RS 30,000
--0.15

Company B
RS 30,000
1,20,000
0.125
0.16

equity (K)
Market value equity (E)
?
Market value of company(V), ?

?
?

where v= L+E
Q-11
The King Ltd has to make a choice between debt issue and equity issue and equity issue for its
expansion programme. Its current position is as follows:
5% Debt
Equity capital (Rs. 10 per share)
Surpluses
Total capitalization
Sales
Total costs
Income before interest and taxes
Interest
Earnings before taxes
Income tax
Income after taxes

Rs 20,000
50,000
30,000
1,00,000
3,00,000
2,69,000
31,000
1,000
30,000
10,500
19,500

23

The expansion programme is estimated to cost Rs. 50,000. If this is financed through debt,
rate of interest on new debt will be 7 per cent and the price-earnings ratio will be 6. If
expansion programme is financed through equity, new shares can be sold netting Rs. 25
share; and the price-earnings ratio will be 7. The expansion will generate additional sales of
l,50,000 with a return of 10 per cent on sales before interest and taxes.

the
the
per
Rs.

If the company is to follow a policy of maximizing the market value of its shares, which form of
financing should it choose ?
Q~l2
AB Limited provides you with the following information :
Profit
Less Interest on debenture (0.12)
Earnings before taxes
Les taxes (0.35)
Earnings after taxes
No. Of Equity shares (Rs. 10 per share)
Earnings per share
Ruling market price
P/E ratio (Price/ EPS)

Rs 3,00,000
60,000
2,40,000
84,000
1,56,000
40,000
3.9
39
10 times

The company has undistributed reserves, Rs. 6,00,000. It needs Rs. 2,00,000 for expansion
which will earn the same rate as funds already employed.
You are informed that a debt-equity ratio (debt/debt equity) higher than 35 per cent will push
the P/E ratio down to 8 and raise the interest rate on additional amount borrowed to 14 per
cent.
You are required to ascertain the probable price of the shares:
(a) If the additional funds are raised as debt; and
(b) If the amount is raised by rising equity shares (at current market price).
Q~13
The Evergreen Company has the choice of raising an additional sum of Rs. 50 lakh either by the
sale of 10 per cent debentures or by issue of additional equity shares of Rs. 50 per share. The
current capital structure of the company consists of 10 lakh ordinary shares.
At what level of earnings before interest and tax (EBIT) after the new capital is required, would
earnings per share (EPS) be the same whether new funds are raised by issuing ordinary shares
or by issuing debentures? Also, determine the level of EBIT at which uncommitted earnings per
share (UEPS) would be the same if sinking fund obligations amount to Rs. 5 lakhs per year.
Assume a 35 per cent tax rate. Discuss the relevance of the calculation.
Q~14
24

ABC Ltd. wants to raise Rs. 5,00,000 as additional capital. It has two mutually exclusive
alternative financial plans. The current EBIT is Rs. l7,00,000 which is likely to remain
unchanged. The relevant information is 2
Present capital structure : 3,00,000 Equity shares of Rs. 10 each and 10% Bonds of
Rs.20,00,000
Tax rate : 50%
Current EBIT

: Rs. l7,00,000

Current EPS

: RS_ 2_50

Current market price

: Rs. 25 per share

Financial Plan I

: 20,000 Equity Shares at Rs. 25 per share

Financial Plan II

: 12% Debentures of Rs. 5,00,000.

What is the indifference level of EBIT? Identify the financial break-even levels and plot the
EBlT~EPS line son graph paper. Which alternative financial plan is better ?
Q~15
In considering the most desirable capital structure of a company, the following estimates of the
cost of debt and equity capital (after tax) have been made at various levels of debt-equity mix :
Debts as percentage of total Cost of debt (percent)

Cost of equity

capital employed
0
10
20
30
40
50
60

12.0
12.0
12.5
13.0
14.0
16.0
20.0

5.0
5.0
5.0
5.5
6.0
6.5
7.0

Q~17
Excel Limited is considering three financing plans. The key information is as follows:
(a) Total funds to be raised, Rs. 2,00,000.
(b) Financing plans
Plans
A
B
C

Equity
100 percent
50
50

Debt
-50 percent
--

Preferences
--50 percent

25

(c) Cost of debt 8 per cent; cost of preference shares 8 per cent
(d) Tax rate, 30 per cent
(e) Equity shares of the face value of Rs. 10 each will be issued at a premium of Rs. 10 per
share.
(f) Expected EBIT, Rs. 80,000.
Determine for each plan :
(i) Earnings per share (EPS).
(ii) Compute the EBIT range among the plans for indifference and indicate if any of the plans
dominate.
(iii) Compute the financial break-even point.

LEVERAGE
CONCEPT OF LEVERAGE
The term Leverage in general refers to a relationship between two interrelated variables. In
financial analysis it represents the influence of one financial variable over some other related
financial variable. These financial variables may be costs, output, sales revenue, Earnings
Before Interest & Tax (E.B.I.T.), Earning Per Share (E.P.S.) etc.
In financial analysis. These are
(i) Operating Leverage
(ii) Financial Leverage
(iii) Combined Leverage
26

OPERATING LEVERAGE
Operating leverage is defined as the firms ability to use fixed operating costs to magnify effects
of changes in sales on its earnings before interest and taxes.
When there is an increase or decrease in sales level the E.B.I.T. also changes. The effect of
change in sales on the level E.B. I. T. is measured by operating leverage. The operating leverage
is calculated as :
A firm will not have an operating leverage if there are not fixed costs and the total cost is
variable in nature. In such cases, the operating profits or E.B.I.T. varies in direct proportion to
the changes is sales level.

Significance of operating leverage : Analysis of operating leverage of a firm is very

useful to the financial manager. It tells the impact of changes in sales on operating income. A
firm having higher D.O.L. (Degree of Operating Leverage) can experience a magnified effect on
E.B.I.T. for even a small change in sales level. Higher D.O.L. can dramatically increase the
operating profits. But if there is decline in sales level, E.B.I.T. may be wiped out and a loss may
be operated.
As explained earlier the operating leverage depends on fixed costs. If the fixed costs are higher,
the higher would be firms operating leverage and its operating risks. If Operating leverage is
high, it automatically means that the break-even point would also be reached at a high level of
sales. Also, in the case of higher operating leverage, the margin of safety would be low.
Therefore, it is preferred to operate sufficiently above break-even point to avoid the danger of
fluctuations in sales and profits.

FINANCIAL LEVERAGE
Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the
effects of changes in E.B.I.T. / Operating profits, on the firms earning per share. The financial
leverage occurs when a fim1s capital structure contains obligation of fixed financial charges e.g.
interest on debentures, dividend on preference shares etc. along with owners equity to enhance
earnings of equity shareholders. The fixed financial charges do not vary with the operating
profits or E.B.I.T. They are fixed and are to be paid irrespective of level of operating profits or
E.B.I.T. The ordinary shareholders of firm are entitled to residual income i.e. Earnings after
fixed financial charges.
The financial leverage is favourable when the firm earn more on the investment/assets financed
by the sources having fixed charges. It is obvious that shareholders gain in a situation where
the company earns a high rate of return and pays a lower rate of return to the supplier of long
term funds. Financial leverage in such cases is therefore also called Trading on Equity.
Thus gain from financial leverage has arisen due to :
(a) Excess of return on investment over effective cost (cost after considering taxation effect of
funds.)
(b) Reduction in the number of share issued due to the use of debt funds.
27

The financial leverage at the levels of E.B.I.T. is called degree of financial leverage and it is
calculated as ratio of E.B.I.T. to the Profit before tax.

Significance of Financial Leverage : Financial leverage helps the finance manager in

designing the appropriate Capital Structure. One of the objective of planning an appropriate
capital structure is to maximize the return on equity shareholders funds or maximize the
earning per share.

Financial leverage is double edged sword. On the one hand it increases earning per share and
on the other hand it increases financial risk. A high financial leverage means high fixed financial
costs and high financial risk i.e. as the debt component in capital structure increases, the
financial leverage increases and at the same time the financial risk also increases i.e. risk of
insolvency increases.
The finance manager therefore is required to trade off i.e. has to bring a balance between risk
and return for determining the appropriate amount of debt in the capital structure of a firm.
Thus the analysis of financial leverage is most important tool in the hands of finance managers
who are engaged in financing the capital structure of business firms, keeping in view the
objectives of their firm.

COMBINED LEVERAGE
We have seen above that operating leverage explains the operating risk and financial leverage
explains the financial risk of firm. However, a firm has to look into overall risk or total risk of
the firm i.e. Operating risk as well as Financial risk. Hence, if we combine the operating
leverage and financial leverage the result is combined leverage.

Significance of combined leverage :

The ratio of contribution to earnings before tax, given by combined leverage shows the combined
effect of financial and operating leverage. A high operating leverage and a high financial leverage
combination is very risky. If the company is producing and selling at a high level, it will make
extremely high profit for its shareholders. But even a small fall in the level of operations would
result in a tremendous fall in earnings per share. A company must, therefore maintain a proper
balance between these two leverage.
A high operating leverage and a low financial leverage indicate that the management is careful
since the higher amount of risk involved in high operating leverage has been sought to be
balanced by low financial leverage. However, a more preferable situation would be to have a low
operating leverage and a high financial leverage. A low operating leverage would automatically
imply that the company reaches its break-even point at a low level of sales. Therefore, risk is
diminished. A highly cautious and conservative manager will keep both its operating and
financial leverage at very low levels. The approach may, however, mean that the company is
losing profitable opportunities.

IMPACT OF LEVERAGE ON CAPITAL TURNOVER RATIO AND WORKING

CAPITAL RATIO
28

An Increase in sales improves the net profit ratio, raising the Return on Investment (R.O.I.) to a
higher level. A student may rightly wonder that this situation should be very attractive for the
management, which may be tempted to try to raise their Capital Turnover Ratio without
restraint. This however, is not possible in all situations-a-rise in capital turnover must be
supported by an adequate capital base. Normally, therefore, as capital turnover ratio increases,
working capital ratio deteriorates. Thus management cannot increase its capital turnover ratio
beyond a certain limit.
The main reasons for a fall in ratios showing the working capital position due to increase in
turnover ratios is that as the activity increases without a corresponding rise in working capital,
the working capital position becomes tight. As the sales increases, both the current assets, and
current liabilities also increases but not in proportion to the current ratio. If current ratios is to
be maintained at 2, each increase in sales must result in a two-fold rise in the current assets as
compared to current liabilities. But this does not happen with the same amount of funds; hence
a fall in the current ratio.
Therefore, it must be ensured that when the capital turnover ratio is sought to be increased, its
effect on the working capital situation is to be carefully considered. If the current ratio and the
acid test ratio are high, it is apparent that the capital turnover ratio can be increased without
any problem. However, it may be very risky to increase capital turnover ratio when the working
capital position is not satisfactory.

Discuss the relationship between the financial leverage and fi1ms required
rate of return to equity shareholders as per Modigliani and Miller Proposition
II.
Relationship between the financial leverage and firm's required rate of return to equity
shareholders with corporate taxes is given by the following relation.
where,
rg = required rate of return to equity shareholders
ro = required rate of return for an all equity firm
D = Debt amount in capital structure
E = Equity amount in capital structure
TC = Corporate tax rate
rg = required rate of return to lenders

Discuss the Return on assets (ROA) and Ret1u'n on Equity (ROE) by bringing
out clearly the unpact of financial leverage
Return on assets is a ratio which measures the profitability of the firm in terms of assets
employed in the firm. Mathematically:
29

Return on equity measures the profitability of equity funds invested in the firm. This ratio
reveals how profitability of the owner's funds have been utilized by the firm. This ratio is
computed as:
Return on equity (ROE) = ROA + Debt/Equity (ROA - i x (l - Tc))
Where (i) is the rate of interest on debt and Tc is the tax rate.

Impact of financial leverage on return on equity:

Let ROA be 15% and 5%, the ratio of (debt/equity) be equal to (0.2/0.8); 9% be the rate of
interest of the debt and 35% is the tax rate, then the impact of financial leverage on return on
equity will be as follows:

Positive or favourable impact of financial leverage on return on equity.

And at ROA = 5%

QUESTIONS
Q1
The following summarizes the percentage in operating income, percentage changes in revenues
and betas four pharmaceutical firms
Firm

Change in

Change in

revenue

operating income

Beta

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.
Q~2
The following figures relate to two companies:
Rs . in lakhs
30

Sale
Less: variables costs
Contribution
Less Fixed costs
E.B.I.T
Less : Interest
Profit before tax (PBT)

P. LTD
500
200
300
150
150
50
100

Q. Ltd
1,000
300
700
400
300
100
200

You are required to:

(i) Calculate the operating financial and combined leverages for the two companies: and
(ii) Comment on the relative risk position of them.
Q~3
The capital structure of ABC Ltd. consist of an ordinary share capital of Rs.5,00,000 (equity
shares of Rs.100 each at par value) and Rs.5,00,000 (10% debenture of Rs.100 each). Sales
increased from 50,000 units to 60 000 units the selling rice is Rs.12 per unit, variable cost
amounts to Rs.8 per unit and fixed expenses amount to Rs.1,00,000. The income tax rate is
assumed to be 30%.
You are required to calculate the following:
(a) The percentage increase in earning per share:
(b) The degree of financial leverage at 50,000 units and 60,000 units;
(c) The degree of operating leverage at 50,000 units and 60,000 units;
(d) Comment on the behaviour E.P.S., operating and financial from 50,000 units to 60,000
units.
Q~4
A firm has sales of Rs.75,00,000 variable cost of Rs of Rs.45,00,000 at 9% and equity of
Rs.55,00,000.
(i) What is the firms R.O.I.?
(ii) Does it have favourable financial leverage?
(iii) What are the operating, financial and combined leverage of the firm?
(iv) If the sales drop to Rs.50,00,000, what will be the new E.B.I.T. ?
Q~5
Calculate the operating leverage, financial leverage and combined leverage from the following
data under situations I and II and Financial Plan A and B:
31

Installed Capacity

4,000 units

Actual Production and Sales

75% of the Capacity

Selling Price

Rs.30 Pei Unit

Variable Cost

Rs. 15 Per Unit

Fixed Cost:
Under Situation I

Rs.l5,000

Under Situation II

Rs.20,000
Financial Plan
A

Rs.

Rs.

Equity

10,000

15,000

Debt (Rate of Interest at 20%)

10,000

5,000

20,000

20,000

Q~6
From the following prepare Income statement of Company A,B and C.
Company

Financial Leverage

321

421

2:1

Interest

Rs.200

Rs.300

Rs.l,000

Operating Leverage

4:1

5:1

3:1

Variable cost as a percentage to sales

66 2/3%

75%

50%

Income tax rate

30%

30%

30%

Comment on the financial position and structure of these companies.

Q~7
A Ltd. Furnished the following balance sheet as on 315' March 2011.
Liabilities
Equity share capital

Rs
5,00,000

Assets
Fixed Assets

Rs.
15,00,000

1,00,000
14,00,000

Current assets

9,00,000

(50,000 Equity share

each of rs. 10)
General Reserves
15% debts

32

Current liabilities

4,00,000
24,00,000

24,00,000

3. The total Assets Turnover ratio is 2.5.

4. Tax rate is 30%.
Required:
Calculate EPS and Combined Leverage.
Q~8
Average Kd ( before tax ) 10%
Tax rate 30%
Financial Leverage ratio = 0.60
ROI = 20% ( before tax )
Calculate ROE.
Q~9
The financial manager of the Hypothetical Ltd. expects that its earnings before interest and
taxes (EBIT) in the current year would amount to Rs.l0,000. The firm has capital of 5 per cent
bonds aggregating Rs.40,000, while the 10 per cent preference shares amount to Rs.20,000.
What would be the earnings per share (EPS)? Assuming the EBIT being (i) Rs.6,000 and (ii)
Rs.l4,000 how would the EPS be affected? The firm can be assumed to be in the 30 per cent tax
bracket. The number of outstanding ordinary shares is l,000.
Q~10
Suppose a firm has a capital structure exclusively comprising of ordinary shares amounting to
Rs.10,00,000.
For expansion it wants to raise additional l0,00,000. The firm has four alternative financial
plans:
(A) It can raise the entire amount in the form of Equity Capital.
(B) It can raise 50 per cent as equity capital and 50 per cent as 5% debentures.
(C) It can raise the entire amount as 6% debentures.
(D) It can raise 50 per cent as equity capital and 50 per cent as 5% preference capital.
Further assume that the existing EBIT are Rs.l,20,000 and the tax rate is 30 per cent,
outstanding ordinary shares are l0,000 and the market price per share is Rs. |00 under all the
four alternatives.
33

Which financing plan should the firm select? (take suitable assumptions if required)
Q~11
The following is the income statement of X Ltd. for the year ended 31st March, 2011.
Sales
Less: Opening Expenses
Variables
Fixed
EBIT
Interest @18%
EBT
Tax @ 35%
PAT
Numbers of shares outstanding

225.00
45
90

135.00
90.00
22.50
65.50
23.63
43.87
10,00,000

The company is wishing to raise Rs. 1.20 crore during 2011-12 for up gradation of its spinning
unit. It is considering the following two alternative for raising funds :
1. Issue only equity shares
ii. 50 percent equity and 50 percent debt.
Equity can be issued at a premium of Rs. 5 and interest rate on debt up to Rs.50 lakhs is 18%
and above that is 20%. That are expected to increased by 20% during 2011-12, fixed operating
cost remains constant and the variable cost ratio and the tax rate remains unchanged.

Required :
a. Calculate the DOL, DFL, and DTL for the above two plans.
b. If sales are expected to increase by 15% during 2012-2013, then forecast the EPS for the year
2012- 2013.
Q~12 '
The following estimates are made of Elxi India Ltd. for the year 2010-2011 :
i. The degree of operating leverage is expected to be 1.30.
ii. Fixed costs are estimated to be Rs. 2.50 lakhs.
iii. Interest on Rs. 30 lakhs debt will be paid @ 15% p.a.
iv. The EPS of the company is expected to be Rs. 2.
You are required to calculate
a. Degree of financial leverage for the company.
b. Degree of total average for the company.
34

c. Percentage decline in sales which will wipe out profit before tax.
Q-13
The operating and financial break even points of a firm are 48000 units and Rs. 30,000
respectively. Its degree of operating leverage at a sale level of Rs. 4,00,000 is 2.5. Its fixed costs
are Rs. 1,20,000.
You are required to calculate
a. Degree to total leverage.
b. Percentage change in EPS if quantity increases by 5%.
Q-l4
Madan, Mohan, Finance Controller of Big Five Ltd. recently attended a seminar on the benefits
of financial leverage. The Company has assets of Rs. 40 lakhs financed entirely with 2,00,000
shares of equity currently selling at Rs. 20 per share. Madan is considering retiring some of the
shares with borrowed funds, which he can obtain at an interest rate of 18%. He expects the
company to earn Rs. 10 lakhs next year before interest and taxes. The companys tax rate is
30%.
(a) What would be the effect of leverage on expected EPS and ROE?
(b) Madan is considering two alternative leverage ratios, 25% debt and 50% debt (percent debt to
total assets).
Calculate expected EPS and ROE for each of these debt ratios at next years expected EBIT.
Q~l5
The following data is given is respect of a company. Compute (a) Degree of Financial Leverage (b)
EPS if rate of EBIT on Capital Employed is 8%.
Particulars
Equity shares capital
10% Debentures
Total capital Employed
Q~l6

Rs.
Rs. 1 lakh
Rs. 9 lakhs
Rs. 10 lakhs

The ABC Ltd. has the following balance sheet and income statement information
Liabilities
Equity capital (Rs, 10 per share)
10% debt
Retained earning
Current Liabilities

Rs 8,00,000
6,00,000
3,50,000
1,50,000
19,00,000

Assets
Net fixed assets Rs. 10,00,000
Current assets

9,00,000

19,00,000

35

Income statement for the year ending March

Sales Rs,

3,40,000

Operating expenses (including Rs. 60,000 depreciation)

l,20,000

EBIT

2,20,000

Less interest

60,000

Earnings before tax

1,60,000

Less taxes

56 000

Net earnings (EAT)

l,04,000

(a) Determine the degree of operating, financial and combined sales level if all the operating
expenses, other than depreciation. are variable costs.
(b) If total assets remain at the same level, but sales (i) increase by 20 per cent and (ii) decrease
b 20%, what will be the earnings per share in the new situation?
Q-17
The Net Sales of A Ltd is Rs 30 Cr. EBIT of the Company as the % of Net Sales is l2%. The
Capital Employed comprises Rsl0 Cr. Equity Share Capital, Rs 2 Cr 13% Cumulative Pref. Share
Capital & Rs 6 Cr. l5% Debt. The tax-Rate is 30%
Required :
l) Calculate ROE for the Company & indicate its segments due to presence of Pref. Share Capital
& Debt.
2) Calculate the operating leverage if the combined leverage is 3.

CAPITAL BUDGETING
MEANING OF CAPITAL BUDGETING
The term capital budgeting means planning for capital assets. The capital budgeting decision
means a decision as to whether or not money should be invested in long-term projects. Such
projects may include the setting up of a factory or installing a machinery or creating additional
capacities to manufacture a part which at present may be purchased from outside. It includes a
financial analysis of the various proposals regarding capital expenditure to evaluate their impact
on the financial condition of the company for the purpose to choose the best out of the various
alternatives. The finance manager has various tools and techniques by means of which he
assists the management in taking a proper capital budgeting decisions.
The capital budgeting decisions therefore evaluate expenditure decisions which involve current
outlays but are likely to produce benefits over a period of time longer than one year. The benefit
which may arise from capital budgeting decisions may be either in the firm of increased
36

revenues or reduction in costs. A capital budgeting decision requires evaluation of a proposed

project to forecast the likely or expected return from the project and determine whether return
from the project is adequate. Further, since business is a part of society, it is therefore also the
moral responsibility of a finance manager to undertake only those projects which are socially
desirable.

REASONS FOR THE IMPORTANCE OF CAPITAL BUDGETING DECISIONS

The capital budgeting decisions are important, crucial and critical business decisions due to
following cases:
l. Substantial expenditure: Capital budgeting decisions involves the investment of substantial
amount of funds. It is therefore necessary for a firm to make such decisions after a thoughtful
consideration so as to result in the profitable use of its scarce resources.
The hasty and incorrect decisions would not only result into huge losses but may also account
for the failure of the firm.
2. Long time period: The capital budgeting decision has its effect over a long period of time.
These decisions not only affect the future benefits and costs of the firm but also influence the
rate and direction of growth of the firm.
3. Irreversibility: Most of the investment decisions are irreversible. Once they are taken, the
firm may not be in a position to reverse them back. This is because, as it is difficult to find a
buyer for the second- hand capital items.
4. Complex decision: The capital investment decisions involves an assessment of future events,
which in fact is difficult to predict. Further it is quite difficult to estimate in quantitative terms
all the benefits or the costs relating to a particular investment decision.
TYPES OF CAPITAL INVESTMENTS
There are many ways to classify the capital budgeting decision. Generally capital investments
are classified in two ways. One way is to classify them on the basis of firms existence. Another
way is to classify them on the basis of decision situation.
On the basis of Firms existence : The capital budgeting decisions are taken by both newly
firms as well as by existing firms. The new firms may be required to take decision in respect of a
plant to be installed. The existing firm may be required to take decisions to meet the
requirement of new environment or to face the challenges of competition. These decisions may
be classified into:

(i) Replacement and Modernisation decisions

(ii) Expansion decisions
(iii) Diversification decisions

37

On the basis of decision situation: The capital budgeting decisions on the basis of decision
situation are classified as follows:
(i) Mutually exclusive decisions
(ii) Accept-reject decisions
(iii) Contingent decisions
Investment Appraisal Techniques
The techniques available for appraisal of investment proposals are classified under three heads :
1. Techniques that recognize payback of capital employed:
Payback period method
2. Techniques that use accounting profit for project evaluation:
a. Accounting rate of return method
b. Earnings per share
3. Techniques that recognize time value of money:
a. Net present value method
b. Internal rate of return method
c. Net terminal value method
d Profitability index method
e. Discounted payback period method
Each of the above methods are discussed below in detail:

Payback period method

The payback period is usually expressed in years, which it takes the cash inflows from a capital
investment project to equal the cash outflows. When deciding between two or more competing
projects the usual decision is to accept the one with the shortest payback. Payback is commonly
used as a first screening method. It is a rough measure of liquidity and rate of profitability.
This method recognizes the recovery of the original capital invested in a project. The basic
element of this method is a calculation of recovery time; by accumulation the cash inflows
(inclusive of depreciation) year by year until the cash flows equal the amount of the original
investment. The length of time this process takes gives the payback period for the project. In
simple terms it can be defined as the number of years required to recover the cost of the
investment.
Merits and Demerits The merits and demerits in using payback period method are
summarized below:
38

Merits
It is simple to apply, easy to understand and of particular importance to business which
lack the appropriate skills necessary for more sophisticated techniques.
In case of capital rationing, a company is compelled to invest in projects having shortest
payback period.
This method is most suitable when the future is very uncertain. The shorter the payback
period, the less risky is the project. Therefore, it can be considered as an indicator of risk.
This method gives an indication to the prospective investors specifying when their funds
are likely to be rapid.
It does not involve assumptions about future interest rates.
Ranking projects according to their ability to repay quickly may be useful to firms when
experiencing liquidity constraints. They will need to exercise careful control over cash
requirements.

Demerits
It does not indicate whether an investment should be accepted or rejected, unless the
payback period is compared with an arbitrary managerial target.
The method ignores cash generation beyond the payback period and this can be seen
more a measure of liquidity than of profitability.
It fails to take into account the timing of returns and the cost of capital. It fails to consider
the whole life time of a project. It is based on a negative approach and gives reduced
importance to the going concern concept and stress on the return of capital invested
rather than on the profits occurring from the venture. The object of the business
organisation is certainly not to recover the capital but to earn profits on it.
The traditional payback approach does not consider the salvage value of an investment. It
fails to determine the payback period required in order to recover the initial outlay if
things go wrong. The bailout payback method concentrates on this abandonment
alternative.
This method make no attempt to measure a percentage return on the capital invested and
is often used in conjunction with other methods.
The projects with long payback periods are characteristically those involved in long-term
planning. And which determine an enterprises future. However. they may not yield their
highest returns for a number of years and the result is that the payback method is biased
against the very investments that are most important to long-term,
Payback Period Reciprocal - An alternative way of expressing the payback period the 'payback
period reciprocal which is expressed as :
Thus if a project has a payback period of 2.5 years, then the payback period reciprocal would be
:
The higher the payback period reciprocal (and hence the lower the payback period) the more
worth while the project becomes. The only real relevance of this calculation is that laymen may
be happier in discussing percentages measure.

39

Accounting Rate of Return Method

The Accounting rate of return (also known as return on investment or return on capital
employed) method
employ the normal accounting technique to measure the increase in profit expected to result
from an investment by expressing the net accounting profit arising from the investment as a
percentage Of that capital investment. In this method, most often the following formulas is
applied to arrive at the accounting rate of return.

Sometimes, initial investment is used in place of average investment. Of the various accounting
rates of return on different alterative proposals, the one having highest rate of return is taken to
the best investment proposal. For example, in three alternative proposals. A, B and C with
expected accounting rates of return of 10%, 20% and 18% respectively. Projects will be selected
in order of B, C and A. If the prevailing rates of interest is taken to be 15% p.a., only proposals
B and C will qualify for consideration and in that order.
Merits and Demerits - The merits and demerits of accounting rate of return method are
summarized as follows:
Merits
It is easy to calculate because it makes use of readily available accounting information.
It is not concerned with cash flows but rather based upon profits which are reported in
annual accounts and sent to shareholders.
Unlike payback period method. This method does take into consideration all the years
involved in the life of a project.
Where a number of capital investment proposals are being considered, a quick decision
can be taken by use of ranking the investment proposals.
If high profits are required, this is certainly a way of achieving them.
Demerits
It does not take into account time value of money.
It fails to measure properly the rates of return on a project even if the cash flows are even
over the project life.
It uses the straight line method of depreciation Once a change in method of depreciation
takes place, the method will not be easy to use and will not work practically.
This method fails to distinguish the size of investment required for individual projects.
Competing investment proposals with the same accounting rate of return may require
different amounts of investment.
It is biased against short-term projects in the same way that payback is biased against
longer-term ones.
Several concepts of investment are used for working out accounting rates of return. Thus,
there is no full agreement on the proper measure of the term investment. Thus different
managers have different meanings when they refer to accounting rate of return.
40

 The accounting rates of return does not indicate whether an investment should be
accepted or rejected, unless the rates of return is compared with the arbitrary
management target. It measures the returns in relation to the outlay and does not
evaluate the absolute worth of the returns. Problem the returns in relation to the outlay
and does not evaluate the absolute worth of the returns. Problem can arise in defining
yearly profits, which will depend, to a certain extent, on the accounting policies adopted
by the firm with respect to such items as stock valuation, treatment of depreciation,
research and development etc.

Earnings per Share (EPS)

EPS is calculated the dividing Accounting Profit by the number of shares in issue. The value of
the firm is maximized when market price of equity shares is maximized. EPS has been
advocated as an appropriate and operationally feasible criterion to choose among the alternative
financial actions. In practice, the performance of a corporation is better judged in terms of EPS.
EPS is one of the important measures of capital investment appraisal.
EPS is calculated as follows:
Where,
EBIT = Earnings before interest and tax
I = Interest
T = Corporate tax rate
D = Preference dividend
N = Number of Equity shares
The main drawback of this method is it ignores cash flows, timing and risk.

Net Present Value (NPV) Method

The objective of the firm is to create wealth by using existing and future resources to produce
goods and services. To create wealth, inflows must exceed the present value of all anticipated
cash outflows. Net present value is obtained by discounting all cash outflows and inflows
attributable to a capital investment project by a chosen percentage e. g., the entity weighted
average cost of capital. The method discounts the net cash flows from the investment by the
minimum required rate of return, and deducts the initial investment to give the yield from the
funds invested lf yields positive the project is acceptable. If it is negative the project is unable to
pay for itself and is thus unacceptable.
The exercise involved in calculating the present value is known as discontinuing and the factors
by which we have multiplied the cash flows are known as the discount factors. The discount
factor is given by the following expression:
Where r is the rate of interest per annum and n is the number of years over which we are
discontinuing.
41

Discounted cash flow is an evaluation of the future net cash flows generated by a capital project,
by discontinuing them to their present day value. One of the main disadvantages of both
payback and accounting rates of return methods is that they ignore the fact that money has
time value. The discontinuing technique converts cash inflows and outflows for different years
into their respective values at the same point of time, allows for the time value of money.

Merits and demeritsThe merits and demerits of NPV methods are summarized below:

Merits
It is based on the assumption that cash flows, and hence dividends, determine
shareholders wealth.
Cash flows are subjective than profits.
It recognizes the time value of money.
It considers the total benefits arising out of proposals over its lifetime.
The future discount rate normally varies due to longer time span. This rate can be applied
in calculating the NPV by altering the denominator.
This method is particularly useful for the selection of mutually exclusive projects. (In
mutually exclusive projects acceptance of one project tantamount to rejection of the other
project).
This method of project selection is instrument in achieving the financial objective, i.e. the
maximization of the shareholders wealth.
In brief; the NPV method is a sound technique for the selection of investment projects.

Demerits
It is difficult to calculate as well as understand it as compared to accounting rate of
return method or payback method.
Calculation of the desired rates of return presents serious problems. Generally cost of
capital is the basis of determining the desired rate. The calculation of cost of capital is
itself complicated. Moreover. desired rates of return will vary from year to year.
This method is an absolute measure. When two projects are being considered, this
method will Ravour the project which has higher NPV.
This method may not give satisfactory results where two projects having different effective
lives are being compared. Normally, the project with shorter economic life is preferred, if
other things are equal.
This method does not attach importance to the shorter economic life of the project.
This method emphasizes the comparison of net present value and disregards the initial
investment involved. Thus, this method may not give dependable results.

Internal Rate of Return (IRR) Method

42

Internal rate of return is a percentage discount rate used in capital investment appraisals which
brings the cost of a project and its future cash inflows into equality. lt is the rate of return which
equates the present value of anticipated net cash flows with the initial outlay. The IRR is also
defined as the rate at which the net present value is zero. The rate for computing IRR depends
as bank lending rate or opportunity cost of funds to invest which is often called as personal
discontinuing rate or accounting rate. The test of profitability of a project is the relationship
between the internal rate of return (%) of the project and the minimum acceptable rate of return
(%)

Merits and Demerits - The merits and demerits of IRR method are summarized as below:
Merits
It considers the time value of money.
It takes into account the total cash inflows and cash outflows.
It is easier to understand by executives and non-technical personnel. For example,
business executives will understand the investment proposal on a better way if told that
IRR of an investment is 20% against the desired rate of an investment is Rs. l5,396.
It does not use the concept of desired rate of return whereas it provides the rate of return
which is indicative of the profitability of investment proposal.

Demerits
It involves tedious calculations, based on trial and error method.
It produces multiple rates which can be confusing.
Projects selected based on higher IRR may not be profitable.
Unless the life of the project can be accurately estimated, assessment of cash flows cannot
be correctly made.
Single discount rate ignores the varying future interest rates.

Relative ranking of projects : IRR vs. NPV : The relative ranking of projects. using the
different DCF methods will be considered initially in simple accept / reject situations. This will
be extended later to a detailed assessment of situations where a choice has to be made between
two or more alternatives. In simple accept / reject situations a firm is able to implement all
projects showing a return at or above the firms cost of capital. Both NPV and IRR would appear
to be equally valid in the sense that they will both lead to accept or reject the same periods.
Using NPV, all projects with a positive net present value, when discounted at the firms cost of
capital, will be accepted. Using IRR all projects which yield an internal rate of return in excess of
the firms cost of capital will be chosen.
However, although IRR and NPV lead to the same conclusion regarding project acceptability, the
ranking of a set of projects obtained from IRR does not necessarily agree with that produced
using NPV, Since. In the latter case, the ranking may vary according to particular discount rate
used.
Argument about the merits of the relative rankings in simple accept/ reject situations is thus
concerned with the question of value. It is argued that the IRR measures only the quality of the
43

investment while NPV takes into account both the quality and the scale. This is because the IRR
provides a relative measure of value (% IRR) while the NPV provides an absolute measure (Rs.
surplus). Thus the IRR would rank, for example. At 100% return on an investment of Re. I
considerably higher than a 20% return on an investment of Rs. 10 lakhs, whereas the reverse
would be true using NPV (as long as the cost of capital is below 20%).
While one project may have a higher rate of profit per unit of capital invested than another. it` it
has fewer units of capital invested in it, it may make a smaller contribution to the wealth of the
firm. Thus it the objective is to maximize the finds wealth, then the ranking of project NPVs
provides the correct measure It the objective is to maximize the rate of profitability per unit of
capital invested, then IRR would provide the correct ranking of projects, but this objective could
be achieved by rejecting all but the most highly profitable projects. This is clearly unrealistic
and, therefore, one would conclude that NPV ranking is correct and IRR unsatisfactory as a
measure of relative project value.

When two investment proposals are mutually exclusive, both methods will give contradictory
results When two mutually exclusive projects are not expected to have the same life, NPV and
IRR methods will give conflicting ranking.

Profitability index (PI) method

It is a method of assessing capital expenditure opportunities in the profitability index,
sometimes called the cost-benefit ratio. The profitability index is the present value of an
anticipated net future cash flows divided by the initial outlay. The only difference between the
Net Present Value method and profitability index method is that when using the NPV technique
the initial outlay is deducted from the present value of anticipated cash flows, whereas with
profitability index approach the initial outlay is used as a divisor, In general terms, a project is
acceptable if its profitability index value is greater than 1 clearly a project offering a profitability
index greater than l must also offer a net present value which is positive.
Mathematically, PI (profitability index) can be expressed as follows:
Present value of cash inflow
Profitability Index (PI) = Present value of cash outlay

This method is also called cost-benefit ratio or desirability ratio method

Discounted payback period method

In this method the cash flows involved in a project are discounted back to present value tends
are discussed below. The cash inflows are then directly compared to the original investment in
order to identify the period taken to pay back the original investment in present values tends.
This method overcomes one of the main objections to the original payback method in that it now
fully allows for the timing of the cash flows, but it still does not take into account those cash
flows which occur subsequent to the payback period and which may be substantial.
44

This method is a variation of payback period method, which can be used if DCF methods are
employed. This is calculated in much the same way as the payback, except that the cash flows
accumulated are the base year value cash flows which have been discounted at the discount
rate used in the NPV method (i.e., the required return on investment). Thus, in addition to the
recovery of cash investment, the cost of financing the investment during the time that part of
the investment remains unrecovered is also provided for. It thus, unlike the ordinary payback
method, ensures the achievement of at least the minimum required return, as long as nothing
untoward happens after the payback period.

Assumptions in use of DCF techniques

In use of discounted cash flow techniques the following assumptions should be given
consideration:
The discount rate is constant over the life of the investment.
All cash flows can be predicted with certainty so that a risk premium need not be added
to the discount rate in order to compensate for risk. The unadjusted rate represents the
risk free and is the discount rate used to allow for time value of money.
In project appraisal, managers work with uncertain future events and estimated cash
flows expected to occur in future years. This involves a substantial amount of estimation
which in practical terms, means that spurious accuracy is something which needs to be
avoided.
The discount figures used can be calculated with great accuracy but when they are
applied to these future estimated cash flows, the resultant calculation is only as accurate
as the cash flows estimates.
In many companies there is a tendency to produce discounted cash flow computation with
several decimal places on each of the present values. This creates a totally fallacious
appearance of accuracy in the evaluation process.
To enable convenient calculations, to be performed, it is normal practice is capital project
evaluations to assume that all cash flows take place at the end of the year. The initial
cash outflows or investment in a project is assumed to take place now. The cash flows
which go out now are taken to be at year O. The concept of year O does not mean a year in
general tem1s, but a point in time, i.e., today. Year 1 cash flows are assumed to take place
at the end of the first year. The second year cash flows occurring at the end of the year 2
and similarly for subsequent years.
In appraising long projects, it is normal to use an arbitrary horizon period of 10 to l5
years. Finns do not consider cash flows beyond the horizon even if they expect the project
to last longer.

Capital Rationing
Capital rationing is a situation where a constraint or budget ceiling is placed on the total size of
capital expenditures during a particular period. Often firms draw up their capital budget under
the assumption that the availability of financial resources is limited.
Capital rationing refers to a situation where a company cannot undertake all positive NP V
projects it has identified because of shortage of capital. Under this situation, a decision maker is
45

compelled to reject some of the viable projects having positive net present value because of
shortage of funds. It is known as a situation involving capital rationing.
In terms of financing investment projects, the following important questions are to be answered:
What would be the requirement of funds for capital investment decisions in the
forthcoming planning period?
How much quantum of funds available for capital investment
How to assign the available funds to the acceptable proposals which require more funds
than are available?
The answer to the first and second questions is given with reference to the capital investment
appraisal decisions made by the top management. The third question is answered with specific
reference to the appraisal of investment decisions from the angle of capital rationing.

What do you understand by the term Capital Rationing? How are investment
decisions made in such a case?
Resource Constraint: When the most important resource in investment decisions, i.e. funds, are
not fully available, it is said to be a Resource Constraint situation. Generally, firms fix up
maximum amount that can be invested in capital projects, during a given period of time, say a
year.
Return Maximisation: In case of restricted availability of funds, the objective of the firm is to
maximise the wealth of shareholders with the available funds. Such investment planning is
called Capital Rationing.

Classification of Investment Proposals: For Capital Rationing purposes, the investment

proposals are classified as under.
Nature of project
Meaning

Indivisible
Divisible
Investment should be made in Partial Investment is possible
full, partial or Proportionate and proportionate NPV can be

Steps
Making

involved

in

investment is not possible

generated
decisions Determine the combination of Compute PI of various projects
projects
available.

to

utilise

Compare

amount and rank them. Projects are

NPV

of selected based on maximum.

each combination. Select the Profitability.

combination with maximum
NPV

Write short notes on Social Cost Benefit Analysis (SCBA).

Meaning: In evaluation of investment proposals, the return on investment factor is considered
dominant. However, since scarce resources are employed, the social impact of investment
proposals should also be considered. Such analysis is called Social Cost Benefit Analysis
46

(SCBA). The purpose of SCBA is not to replace the existing techniques of financial analysis but
to supplement and strengthen them.

Need for Social Cost Benefit Analysis (SCBA):

(a) Market prices used to measure costs and benefits in project analysis, they do not represent
social values due to imperfections in market.
(b) Monetary Cost Benefit Analysis fails to consider the external effects of a project, which may
be positive like development of infrastructure or negative like pollution and imbalance in
environment.
(c) Taxes and subsidies are monetary costs and gains, but these are only transfer payments from
social point of view and therefore irrelevant.
(d) SCBA is essential for measuring the redistribution effect of benefits of a project as benefits
going to poorer section are more important than one going to sections which are economically
better off.
(e) Projects manufacturing life necessities like medicines, or creating infrastructure like
electricity generation are more important than projects for manufacture of liquor and cigarettes.
Thus merit wants are important appraisal criterion for SCBA.
Procedure : Social Cost Benefit Analysis involves the following steps :
Step
Step
Step
Step
Step

l
2
3
4
5

Determine the problem to be considered.

Ascertain alternative solutions to the problem.
Estimate and analyst the social costs and benefits.
Appraise the estimated social costs and benefits.
Decide on the optimal solution.

Case Study in SCBA : A transportation project in the U.K., known as the Victoria Line Project
was being evaluated. From the commercial angle, the project was found to run into an annual
deficit of 2.14 million on the basis of interest at 6% p.a. capital cost. This evaluation was
adjusted on account of the unrealistic fare structure which did not reflect truly the money value
which the users placed on the services provided.
Based on SCBA, an estimate was made for the resultant saving in time and increase in comfort.
The SCBA analysis proved that the project was socially desirable and its estimated benefits
exceed the costs even at a discount rate of 8 %. Hence the project was evaluated as acceptable.

List the indicators of social desirability of a project.

A capital investment project should both be commercially viable and socially desirable. The
indicators of social desirability are:
l. Employment Potential: In developing countries, projects which have higher employment
potential are generally preferred. Labour intensive technology may be considered slightly
preferable in this regard.
47

2. Capital Output Ratio : This ratio shows the value of expected output in relation to the Capital
employed. A project with higher output per rupee of capital employed is given preference.
3. Valued added per unit of Capital: The value added by the project in terms of output produced,
income and purchasing power generated, taxes remitted to Government etc. are measured and
divided by the Capital Employed. The project with the higher value added per unit is preferable.
4. Foreign Exchange Benefit: The contribution of the project to the overall foreign exchange of
the country is measured. The higher the contribution, the more preferred the project is.
5. Cost Benefit Ratio : The social benefits of the project are compared with the social costs
thereon. Projects with high social surplus are considered better.

What is Project Report? What items form part of the cost of a project?
Project Report : Project Report is a document which contains a comprehensive study of
investment proposals of an organisation encompassing a thorough investigation relating to
economic, technical, financial, social. managerial and commercial aspects. It is a working plan
for implementation of project proposals after an organisation has decided to undertake an
investment project. It seeks to evaluate the socio- economic and technical viability of a project
before it is undertaken.
A project report deals with the various aspects of the new project with reference to:
(l) Location of the project, (2) the size and capacity level, (3) the technological aspects-production
process, availability of raw materials, requirements of labour and machines and (4) Management
policies regarding organisation and control aspects of the project.
Items forming part of the cost of a project: The cost of a project is the sum of the outlays on
the following items. _ _
Land and Site Development; This cost includes for instance, the cost of land including
conveyance
expenses, premium payable on leasehold land, cost of levelling and site development expenses,
cost of constructing approach and internal roads, cost of fencing, compound wall and gates etc.
Building and Civil Works: This includes main factory building and building for other auxiliary
services, administrative bloc, laboratories, workshops, godowns, warehouses and open yard
facilities etc. This also includes miscellaneous non-factory buildings, like canteen, guest house,
rest rooms, staff quarters, garages,
sewers, drainages and other civil works. The cost of building and civil works would depend on
the kind of structures required.
Plant and Machinery.' The major cost items in this category include cost of imported and
indigenous machinery, stores and spares, foundation and installation charges.
Technical know-how and Engineering fees : The technical know-how and engineering fee payable
to foreign/Indian technical collaborators is included in this category.
48

Expenses on foreign technicians and training of Indian technicians abroad : Foreign technicians
may be required in India during project implementation and trial runs. Expenses on their travel,
boarding, lodging and other miscellaneous expenses are included under this category.
Miscellaneous fixed assets.' This includes expenses on furniture, office machinery and
equipments, miscellaneous tools including erection-tools etc.
Preliminary and capital issue expenses: This includes brokerage and commission on capital
issues, other expenses on capital issues such as legal, advertising, printing & stationery etc.,
expenses in respect of incorporation etc.
Pre-operative expenses.' Expenses on trial production, establishment, rent, rates and taxes,
travelling expenses and other miscellaneous expenses are included under this category.
Provision for contingencies: This category represents expenses to meet any unforeseen expenses.
margin money for working capital: Under this category provision is made for margin money for
working capital as per stipulations of banks & financial institutions

Discuss briefly the impact of taxation on Corporate Financial Management

The Impact of taxation on Corporate Financial Management:
The tax payments represent a Cash outflow from business and therefore, these tax cash
outflows are critical part of the financial decision making in a business. Taxation affects a firm
in numerous ways, the most significant effects are as under:
l. Tax implications and Financial Planning: While considering the financial aspects or arranging
the funds for carrying out the business, the tax implications arising there from should also be
taken into account. The Income of all business undertakings is subject to tax at the rates given
in Finance Act. The weighted average cost of capital is reduced because interest payments are
allowable for computing taxable income.
2. Where a segment of the firm incurs loss, but the firm gets overall profits from other segments,
loss of loss making segment will reduce the overall tax liability of the firm by set off of losses.
3. The Income Tax Act allows depreciation on machinery. plant, furniture and buildings owned
by the asses see and used by him for carrying on his business, occupation, profession. This
depreciation is allowed for full year if an asset was used for the purposes of business or
profession for more than 180 days. Unabsorbed depreciation can be carried forward for eight
years. Further, depreciation will also be available on intangible assets acquired on or after
1.4.1998 owned by the assessed and used for the purpose of his business.
4. Capital Budgeting decisions: The setting up of a new project involves consideration of the tax
effects. The decision to set up a project under a particular form of business organization, at a
particular place, choice of the nature of the business and the type of activities to be undertaken
etc. requires that a number of tax considerations should be taken into account before arriving
at the appropriate decision from the angle of sound financial management. The choice of a
particular manufacturing activity may be influenced by the special tax concessions available
such as
49

(i) Higher depreciation allowance

(ii) Amortisation of expenditures on know-how, scientific research related to business,
preliminary
Expenses, etc.
(iii) Deductions in respect of profit derived from the publications of books etc.
(iv) Deductions in respect of profit derived from export business.

QUESTION
Q~1
(Replacement Decision). A company is considering the replacement of its existing machine which
is obsolete and unable to meet the rapidly demand for its product. The company is faced with
two alternatives: to buy Machine A which is similar to the existing machine or to go for Machine
B which is more expensive and has much greater capacity. The cash flows at the present level of
operations under the two alternatives are as follows:
Machine

Immediate

Cash flows(in lakhs of Rs,) at the end of

Cash outflows

(in lakhs of Rs.)

Machine A
Machine B

Year

25
40

II

III

IV

Year Year Year Year

10

14

20
16

14
17

I4
15

The companys cot of capital is l0%

The Financial Manager tries to apprise the management by calculating the following:
(i) Net Present Value;
(ii) Profitability Index;
(iii) Payback Period and
(iv) Discount Payback Period
At the end of the calculation, however, the finance Manager is unable to make up his mind as to
which machine to recommend.
You are required to make these calculations and in the light thereof to advise the finance
manager about the proposed investment.
Note: Present value of Re.1 at 10% discount rate are as follows:
Year

5
50

Present Value (PV) l.00

0.9l

0.83

0.75

0.68

0.62

Q~2
The MN Company Limited has decided to increase its productive capacity to meet as anticipated
increase in demand for its products. The extent of this increase in capacity is still to be
determined and a management meeting has been called to decide which of the following two
mutually exclusive proposals I and II should be undertaken. On the basis of the information
given below you are required to:
(a) evaluate the profitability (ignoring taxation) of each of the proposals, and
(b) on the assumption of a cost of capital of 8% .
Proposal I

Proposal II

Rs. 50,000
2,00,000
10,000
50,000

Rs. 1,00,000
3,00,000
15,000
65,000

70,000

95,000

income/expenditure
Sales promotion Note (B)
Plant scrap value
10,000
Buildings disposable value 30,500

15,000
15,000
60,000

Capital expenditure
Building
Plant
Installation
Working capital
Net income
Annual pre-depreciation profit
note (a)
Other

relevant

Note (C)
Notes:
(a) The investment life is ten years;
(b) An exceptional amount of expenditure on sales promotion of Rs.I5,000 will require to be
spent in year 2 on proposal II. This has not been taken into account in calculating predetermination profits.
(c) It is not the intention to dispose of the building in ten years time. However, it is companys
policy to take notional figure into account for project evaluation purposes.
The present value of Re.1 at 8% discount rate:
Year

PV 0.926 0.857 0.794 0.735 0.681

0.630 0.583 0.540

l0

ll

0.500 0.463 0.429

Q~3
XYZ Ltd. is a transport company whose "cost of money is l5.5%.
51

The inflation rate is of 10% per year and this rate is expected to continue for the next ten years.
All the given cash flows are the real cash flows.
XYZ Ltd is considering the purchase of a new truck which will the required to travel 50,000 km
per year. The details of which are as follows:
The truck has a life of4 years and a price ofRs.24,000
The running cost is Re.0.2l per km. But this figure will rise by Re.0.05 per km for each year the
truck is in service.
A new engine (cost Rs.6.000) will have to be fitted at the end of the second year in which the
truck has been in service;
Model S: which has a life ot"6 years and a price of Rs.42,000;
The running cost is Re.0.l8 per km but this figure will rise by 3_6 paise per km for each year the
truck is in service.
There is a 30% tax on corporate profits with Writing Down allowances in respect of equipment
being 25% per year on a reducing balance basis. The cost of` spare parts is treated as revenue
expenditure for tax purposes. Loan interest is fully tax deductible. You may assume that tax is
payable twelve months after the end of the financial year in which the associated profits were
earned. XYZ Ltd s financial year ends on 31 December.
You are required to advise XYZ Ltd s management as to which truck it should buy.

Q~4
In the manufacture of a companys range of products, the processes give rise to two main types
of waster materials.
Type A is the outcome of the companys original processes. This wastage is sold at Rs.2 per
tonne, but this amount is treated as sundry income and no allowance for this is made in
calculating product costs.
Type B is the outcome of newer processes in the companys manufacturing activity. It is
classified as hazardous, has needed one employee costing Rs.9,000 per year specially employed
to organize its handling in the factory, and has required special containers whose current resale
value is assessed at Rs.l8,000. At present the company pays a contractor Rs.l4 per tonne for its
collection and disposal.
Company management has been concerned with both types of waste and after much research
has developed the following proposals.
Type A Waste
This could be further processed by installing plant and equipments costing Rs.20,000 and
incurring extra direct costs of Rs.2.50 per tonne and extra fixed costs of Rs.l0,000 per annum.
52

Extra space would be needed, but his could be obtained by taking up some of the space
currently used as a free car park for employees. The apportioned rental cost of that land is
Rs.2,500 per annum and a compensation payment total Rs.500 per annum would need to be
paid to those employees who would lose their car parking facilities.
The selling price of the processed waste would be Rs.l2.50 per tonne and the quantity available
would be Rs.2,000 tonnes per annum.
Type B waste
Using brand new technology, this could be further processed into a non-hazardous product by
installing a plant costing Rs.l,20,000 on existing factory space whose apportioned rental cost is
Rs.l2,500 per annum.
This plant cost includes a pipeline that would eliminate any special handling of the hazardous
waste. Extra direct cost would be Rs.l3.50 per tonne and extra fixed cost of Rs.20,000 per
annum would be incurred.
This would be sell at price of Rs.11 per tones and the output over the next few years is expected
to be 4,000 tonnes per year.
For Type A waste. project, the board wants to achieve an 8% DCF return over four years. For
Type B waster project, it wants a 15% DCF return over six years.
You are required to recommend whether the company should invest in either or both of the two
projects.
Give supporting figures and comments.
Assume that no capital rationing exists.
Ignore inflation and taxation.
P.V. of an annuity for four years @ 8% is 3.3 l and P.V. of an annuity for six years @ 15% is 3.78
Q~5
RS Ltd. is considering using a machine made by BC Ltd. The machine would cost Rs.60,000
and at the end Of a four year life is expected to have a resale value of Rs.4,000, the money to be
received in year 5. It would save Rs.29,000 cost per year over the method that RS Ltd. currently
uses. RS Ltd. expects to earn a DCF return of 20% before tax on this type of investment.
RS. Ltd. is currently earning good profits, but does not expect to have Rs.60,000 available to
spend on this machine over the next few years. It is subject to corporation tax at 30% and
receives capital allowances of 25% on a reducing balance basis.
You are required to
(a) recommend whether, from an economic viewpoint, RS Ltd. should invest in the machine from
BC Ltd.
(b) Calculate which of the following options RS Ltd. would be financially better off to adopt:
53

Option I - Buy the machine and borrow the Rs.60,000 from the bank, repaying at the end of
each year a standard annual amount that would comprise principal and interest at 18% per
annum;
OR
Option II- Lease the machine for four years at an annual lease payment equal to the annual
amount it would need to pay the bank under Option -l
Show your calculations.
Note: Assume that lease payments or loan repayments are made gross at the end of each year
and that tax is paid and tax allowances received one year after those profits are earned.
Q-6
S engineering Company is considering to replace or repair a particular machine, which has just
broken down. Last year this machine coasted Rs.20,000 to run and maintain, These costs have
been increasing in real terms in recent years with the age of the machine. A further useful life of
5 years is expected, if immediate repairs of Rs.l9,000 are carried out. If the machine is not
repaired it can be sold immediately to realize about Rs.5,000 (Ignore loss/gain on such
disposal).
Alternatively, the company can buy a new machine for Rs.49,000 with an expected life of 10
years with no salvage value alter providing depreciation on straight line basis. In this case,
running and maintenance costs will reduce to Rs.14,000 each year and are not expected to
increase much in real terms for a few years at least.
S Engineering Company regard a normal return of 10% p.a. after tax as a minimum
requirement on any new investment. Considering capital budgeting techniques, which
alternative will you choose? Take corporate tax rate of 30% and assume that depreciation on
straight line basis will be accepted for tax purpose also.
Given cumulative present value ofRe.1 p.a. at 10% for 5 years Rs.3.79l 10 years Rs.6.145
Q-7
Elite Builders, a leading construction company have been approached by a foreign Embassy to
build for them a block of six flats to be used as guest house. As 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 least them out to the Foreign Embassy for
15 years at the end of which the flats will transferred to the Foreign Embassy for a normal value
of Rs.8 lakhs. Elite Builders estimates the cost of construction as follows:
Area per flats 1,000 sq. ft.
Construction cost1 Rs.400 per sq. ft.
Registration and other costs 2.5% of cost of construction
Elite Builders will also incur Rs.4 lakhs each in year 14 and 15 towards repairs. Elite Builders
proposes to charge the lease rental as follows:
54

Year

Rental

1 to 5

Normal

6 to 10

120% ofNom1al

11 to 15

150% of Normal

Elite Builders present tax rate averages at 30%. The full cost of construction and
registration will be written off over 15 years and will be allowed for tax purposes.
You are required :
To calculate the normal lease rental per flat.
For your exercise assume
(a) The desired return of 10% (IRR)
(b) Rentals & repairs will arise on the last day of the year.
(c) Construction registration and other costs will be incurred at time O
(d) The relevant discount factors are:
Year

Discount

Year

Discount

Factor

Year

Factor

Discount
Factor

0-9

0-56

11

0-35

0-8

0-51

12

0-32

0-75

0-47

13

0-29

0-68

0-42

14

0-26

0-62

10

0-39

15

0-24

Note: Cumulative discount factors may be used.

Q~8
A company is considering which of the two mutually exclusive projects it should undertakes.
The Finance Director thinks that the project with the higher NPV should be chosen whereas the
Managing Directors thinks that the one with the higher IRR should be undertaken especially as
both projects have the same initial outlay and length of life. The company anticipates a cost of
capital of 10% and the net after tax cash follows:

Year

(200)

35

90

75

20

(Cash flow fig 000)

Project X

80

55

Project Y

(200)

218

10

10

Q~9
XYZ Ltd. an existing company, is considering a new project for manufacture of pocket video
games involving a capital expenditure of Rs.600 Lakhs and working capital of Rs.l50 lakhs. The
capacity of the plants is for an annual production of 12 lakhs units and capacity utilization
during the 6 years working life of the project is expected to be as indicated below:
Year

Capacity utilization %

33- l /3%

66-2/3%

90%

100%

The average price per unit of the product is expected to be Rs.200 netting a contribution
of 40%. Annual fixed costs, excluding depreciation are estimated to be Rs.480 lakhs per annum
from the third year onwards, for the first and second year it would be Rs.240 lakhs and Rs.360
lakhs respectively. The average rate of depreciation for tax purposes is 33-1/3% on the capital
assets. The rate of income-tax may be taken at 30%.
At the end of the third year, an additional investment of Rs. 1 00 lakhs would be required
for working capital. The company has targeted for a rate of return of 15%
You are requested to indicate whether the proposals is viable, giving your working notes
an analysis. The present value factor at 15% discount rate, year wise, are extracted below:
0.869, 0.756, 0.657, 0.571, 0.497, 0.432
Terminal value for the fixed assets may be taken at 10% and for the current assets at
100%.
Q~10
Fill in the blanks for each of the following independent cases. Assume in all cases that there are
no salvage values for the investments, and income taxes are to be ignored.
CASE

Life of the Annual

Initial

Cost

project

case

investment capital

(years ) 1

inflows

(Rs) 3

(%) 4

3,00,000
3,61,000

16%
12%

of IRR (%) 5

NTV

(Rs) Profitabilit

y index 7

60,000
-

1.1089
1.10

(Cost
saving)
A
B
C

10
13
-

(Rs.) 2
1,00,000
80,000

20%
-

56

Q-l1
A large sized chemical company is considering investing in a project that costs Rs.4,00,000. The
estimated salvage value is zero; tax rate is 30%. The company uses straight line depreciation
and the proposed project has cash flows before tax (C FBT) as follows:
Year CFBT
1 Rs. 1 ,00,000
2 l,00,000
3 l,50,000
4 1,50,000
5 2,50,000
Determine the following
(i) Payback period
(ii) Average rate of return
(iii) internal rate of return
(iv) Net present value at 15%
(v) Profitability index
Q-12 .
Company XYZ Ltd. has to make a choice between two identical machines in terms of capacity, X
and Y. Machine X cost Rs. 7,50,000 and will last for 3 years. It costs Rs. 2,00,000 p.a. to run
and maintain.
Machine Y is an economy model costing only Rs.5,00,000, but will last only for 2 years. lt costs
Rs. 3,00,000 p.a. to run and maintain. The above given cash flows are the real cash flows. The
costs are forecasted in rupees of constant purchasing power. Ignore taxes. The opportunity cost
of capital is 9%.

Q-13 .
3 Ltd, has Rs. l0,00,000 allocated for capital budgeting purposes. The following proposals and
associated indexes have been determined :
Project

Amount

Profitability index

1
2
3

Rs.
3,00,000
1,50,000
3,50,000

1.22
0.95
1.20
57

4
4,50,000
1.18
5
2,00,000
1.20
6
4,00,000
1.05
Which of the above investments should be undertaken? Assume that projects are indivisible and
l:here is no alternative use of the money allocated for capital budgeting.
Q~l4.
A company is currently considering modernization of a machine originally costing Rs. 50,000
(current book value zero). However, it is in a good working condition and can be sold for Rs.
25,000. Two choices are available. One is to rehabilitate the existing machine at a cost of Rs.
l,80,000; and the other is to replace the existing machine with a new machine costing Rs.
2,l0,000 and requiring Rs. 30,000 to install. The rehabilitated machine as well as the new
machine would have a six year life and no salvage value. The projected alter-tax profits under
the various alternatives are :
Expected after tax profits
Year
Existing Machine
Rehabilitated Machine New machine
1
Rs. 2,00,000
Rs. 2,20,000
Rs. 2,40,000
2
2,50,000
2,90,000
3,10,000
3
3,10,000
3,50,000
3,50,000
4
3,60,000
4,00,000
4,10,000
5
4,10,000
4,50,000
4,30,000
6
5,00,000
5,40,000
5,10,000
The firm is taxed at 30 per cent. The company uses the straight line depreciation method and
the same is allowed for tax purposes. ignore block assets concept. The cost of capital is I2 per
cent. Advise the company whether it should rehabilitate the existing machine or should replace
it with the new machine. Also, state the situation in which the company would like to continue
with the existing machine.
Q-15.
An existing company has a machine which has been in operation for 2 years; its estimated
remaining useful life is 4 years with no salvage value in the end. Its current market value is Rs.
25,000 The management is considering a proposal to purchase an improved model of the
machine which gives increased output. The relevant particulars are as follows :
Purchase price (Rs.)
Estimated life (Years)
Salvage value
Annual operating hours
Selling price per unit (Rs.)
Material per unit (Rs)
Out per hour
Labour cost per hour
Consumable store per year(Rs)
Repair and maintenance per year (Rs)

Existing machine
60,000
6
0
1,000
3
0.40
15
11
2,000
3,000

New machine
1,07,500
4
0
1,000
3
0.40
30
16
1,000
2,000
58

Working capital (Rs)

Income tax rate

10,000
30

20,000
30

Should the existing machine be replaced? Assume that (i) required rate of return in l0 per cent,
and (ii) the company uses written down value method of depreciation @ 25 per cent and it has
several machines in the 25 per cent block.
Q~l6.
Cost of Power Generation
SCL Limited is a highly profitable company engaged in the manufacture of power intensive
products As part of its diversification plans, it proposes to put up a Windmill to generate
electricity. The details of the scheme are:
0 Cost of Windmill - Rs.300 lakhs; Cost of Land - Rs. 15 lakhs; Subsidy from State Government
to be received at the end of first year of installation - Rs. I5 lakhs.
Estimated life is 10 years and Cost of Capital is 15%. The Company's tax rate is 50%.
Residual value of Windmill will be Nil. However, land value will go up to Rs.60 lakhs at the end
of year 10.
Cost of Electricity will be Rs.2.25 per unit in Year 1. This will increase by Re.0.25 per unit every
year till year 7. After that it will increase by Re.O.50 per unit per annum.
Maintenance Cost will be Rs.4 lakhs in Year l and the same will increase by Rs.2 lakhs every
year.
Depreciation will be lO0% of the cost of the Windmill in Year l and the same will be allowed for
tax purposes.
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 lakh units per annum. 4% of
this electricity generated will be committed free to the State Electricity Board as per the
agreement.
From the above, you are required to calculate the NPV of the project. (Ignore tax on Capital
Profits). Also
list a few non-financial factors that should be considered before taking a decision. Use the
following table:

Year

10

PVF

0.87

0.76

0.66

0.57

0.50

0.43

0.38

0.33

0.28

0.25

59

WORKING CAPITAL MANAGEMENT

MEANING AND CONCEPT OF WORKING CAPITAL
Working capital refers to tl1e funds invested in current assets, i.e., investment in stocks, sundry
debtors, cash and other current assets. Current assets are essential to use fixed assets
profitably.
Working capital : Meaning
Working capital is defined as the excess of current assets over current liabilities.
Current assets are those assets which will be convened into cash within the next year as a
result of the ordinary operations of the business. They are cash or near cash resources. This
includes:

Cash and Bank balances

Receivables
Inventory
Raw Materials, stores and spares
Work-in-progress
Finished goods
Pre-paid expenses
Short-term advances
Temporary investments

The value represented by these assets circulates among several items. Cash is used to buy rawmaterials, to pay wages and to meet other manufacturing expense. Finished goods are
produced. These are held as inventories. When these are sold, accounts receivables are created.
'The collection of accounts receivable brings cash into the firm. The cycle starts again. This is
shown in below figure.

Current liabilities are the debts of the firms that have to be paid during the current accounting
period or within a year. These include :
Creditors for goods purchased
Outstanding expenses i.e.. expenses due but not paid
Short-tern borrowings
Advances received against sales
Taxes and dividends payable
Other liabilities maturing within a year.

Objectives of Working Capital Management

The basic objectives of working capital management are as follows :
60

 By optimizing the investment in current assets and by reducing the level of current
liabilities, the company can reduce the locking up of funds in working capital thereby, it
can improve the return on capital employed in the business.
The second important objective of working capital management is that the company
should always be in a position to meet its current obligations which should properly be
supported by the current assets available with the firm. But maintaining excess funds in
working capital means locking of fund without return.

Gross and Net Working Capital

Generally the working capital has its significance. in two perspectives - Gross working capital
and Networking capita1'. the term Gross working capital' refers to the firms investment in
current assets. The term Net working capital' refers to the excess of current assets over current
liabilities These gross working capital and net working capital are called Balance sheet approach
of working capital.

From the point of view of time, the term working capital can be dividend
into two categories :
Permanent working capital : it also refers to the Hard core working capital. lt is that minimum
level of investment in the current assets that is carried by the business at all times to curry out
minimum level of its activities.
Permanent working capital : It also refers to the Hard core working capital. It is that minimum
level of investment in the current assests that is carried by the business at all times to carry out
minimum level of its activities.
Temporary working capital : It 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 capital keeps on fluctuating from time to time according to the
business activities it may be financed from short term sources.
The following diagrams shows Permanent and Temporary or fluctuating or variable working
capital
Operating Cycle Concept
A new concept which is gaining more and more importance in recent years is the Operating
Cycle Concept' of Working Capital. The operating cycle refers to the average time elapses
between the acquisition of raw materials and the final cash realization.
Cash is used to buy raw materials and other stores, so cash is convened into raw materials and
stores inventory. Then the raw materials and stores are issued to the production department.
Wages are paid and other expenses are incurred in the process and work-in-process comes into
existence. Work-in-process becomes finished goods. Finished goods are sold to customers on
credit. In the course of time, these customers pay cash for the goods purchased by them. 'Cash'
is retrieved and the cycle is completed. Thus, operating cycle consists of four stages:
61

The
The
The
The

raw materials and stores inventory stage

work-in-progress stage
finished goods inventory stage
receivable stage

Importance of Operating Cycle Concept - The application of operating cycle concept is

mainly useful to ascertain the requirement of cash working capital to meet the operating
expenses of a going concern This concept is based on the continuity of the lion of values in a
business operation. Those values usually a flow in a going concern. Centre, mainly around the
operational activities of a business in any period this is an important concept because the
longer the operating cycle, the more working capital funds the firm needs Management must
ensure that this cycle does not become too long This concept more precisely measures the
working capital fund requirements, traces its changes and determines the optimum level of
working capital requirements.

Reasons for Prolonged operating Cycle : The following could be the reasons for longer
operating period:

Purchase of materials in excess/ short of requirements

Buying interior, defective materials
Failure to get trade discount, cash discount
Inability to purchase during seasons
Defective inventory policy
Use of protracted manufacturing cycle
Lack of production planning, coordination and control
Mismatch between production policy and demand
Use of outdated machinery, technology
Poor maintenance and upkeep of plant, equipment and infrastructural facilities
Defective credit policy and slack collection policy
Inability to get credit from suppliers, employees
Lack of proper monitoring of external environment etc.

Practical utility of Operating Cycle Concept

The net operating cycle represents the net time gap between investment of cash and its recovery
of sales revenue. If depreciation is excluded from expenses in the computation of operating
cycle, the net operating cycle also represents the cash conversion cycle It is the net time interval
between cash collections from sale of product and cash payments for resources acquired by the
firm.
It is the task of Finance Manager to manage the operating cycle effectively and efficiently. The
length of operating cycle is the indicator of operating management performance. The net
operating cycle represents the time interval for which the limit has to negotiate for working
capital from its Bankers. It enables to determine accurately the amount of working capital
needed for the continuous operation of its activities. The operating cycle calls for proper
62

monitoring of external environment of the business Changes in Government policies like

taxation. import restrictions, credit policy of Central Bank. Price trend, technological
advancement etc. have their own impact on the length of operating cycle.
The duration of the operating cycle for the purpose of estimating working capital is equal to the
sum of the duration of each of the above said events. less the credit period allowed by the
suppliers,
In the form of am equation, the operating cycle process can be expressed as follows
Operating Cycle = R + W +F + D - C
R = Raw material storage period
W = Work-n-progress holding period
F = Finished goods storage period
D = Debtors collection period
C = Credit period availed.
The various components of operating cycle may be calculated as shown below:

FACTORS TO BE TAKEN INTO CONSIDERATION WHILE DETERMINING THE

REQUIREMENT OF WORKING CAPITAL

Production policies
Nature of the business
Credit policy
Inventory' policy
Abnormal policy
Market conditions
Conditions of supply
Business cycle
Growth and expansion
Level of taxes
Dividend policy
Price level changes
Operating efficiency

Working capital requirement estimation based on cash cost

We know that working capital is the different between current assets and current liabilities to
estimate requirements of` working capital, we have to forecast the amount required for each item
of current assets and current liabilities However. in practice another approach may also be
useful in estimating working capital requirements. This approach is based on the fact that in
the case of current assets, like sundry debtors and finished goods, etc _ the exact amount of
funds blocked is less than the amount of such current assets. Thus if we have sundry debtors
63

worth Rs l lakh and our cost of production is Rs 75,000 the actual amount of funds blocked in
sundry debtors is Rs 75,000 the cost of sundry debtors( the rest (Rs 25_00l)) is profit Again
some of the cost items also are non-cash costs. depreciation is a non-cash cost item. Suppose
out of Rs. 75.000, Rs. 5.000 is depreciation; then it is obvious that the actual funds blocked in
terms of sundry debtors totalling RS. l lakh is only Rs. 70,000. In other words Rs, 70.000 is the
amount of funds required to finance sundry debtors worth Rs. 1Lakh. Similarly, in the case of
finished goods which are valued at cost, non-cash costs may be excluded to work out the
amount of funds blocked. Many experts, therefore, calculate the working the capital
requirements by working out the cash costs of finished goods and sundry debtors. Under this
approach, the debtors are calculated not as a percentage of sales value but as a percentage of
cash costs. Similarly, finished goods are valued according to cash costs.

Disadvantages if insufficient Working Capital

The disadvantages suffered by a company with insufficient working capital are as follows:
The company is unable to take advantage of new opportunities or adapt to changes.
Trade discounts are lost. A company with ample working capital is able to finance large
stocks and therefore place large orders.
Cash discounts are lost. Some companies will try to persuade their debtors to pay early by
offering them a cash discount off the price owed.
The advantages of being able to offer a credit line to customers are foregone.
Financial reputation is lost result in non-cooperation from trade creditors is times of
difficulty.
There may be concerted action by creditors and will apply to court for winding up.

Impact of Inflation on Working Capital Requirement

When the inflation rate is high, it will have its direct impact on the requirement of working
capital as explained below;
Inflation will cause to show the turnover figure at higher level even if there is no increase
in the quantity of sales. The higher the sales mean the higher levels of balances in
receivables.
Inflation will result in increase of raw material prices and hike in payment for expenses
and as a result.
Increase in balances of trade creditors and creditors for expenses
Increase in valuation of closing stocks result m showing higher profits without its
realization into cash causing the firm to pay higher tax dividends and bonus. This will
lead the firm in serious problems of funds shortage and firm may unable to meet its short
term and long-term obligations.
Increase in my investments is current assets means the increase in requirement of
working capital without corresponding increase in sales or profitability of the firm.
Keeping in view of the above, the Finance Manager should be very careful about the impact of
inflation in assessment of working capital requirements and its management.
64

Impact of double shift working on Working Capital Requirement

lf the limit which is presently running in single shift. Plans to go for working in double shift the
following factors should be considered while assessing the working capital requirements of the
firm.
Working in double shift means requirement of raw materials will be doubled and other
variable expenses will also increase drastically.
With the increase in raw materials requirement and expenses, the raw material inventor)
and work-in-progress will increase simultaneously the creditors for goods and creditors for
expenses balances will also increase.
Increase in production to meet the increased demand which will also increase the stock of
finished goods. The increase in sales means increase in debtors balances.
Increase in production will result in increased requirement of working capital.
The fixed expenses will increase with the working on double shift basis.
The finance Manager should re-assess the working capital requirements if the change is
contemplated from single shift operation to double shift.

Zero Working capital

This is one of the latest firms in working capital management. The idea is to have zero working
capital, i.e. all times the current assets shall equal the current liabilities. Excess investment in
current assets is avoided and firm meets its current liabilities out of the matching current
assets.
As current ratio is l and the quick ratio below l, there may be apprehensions about the liquidity,
but if all current assets are performing and are accounted at their realizable values, these fears
are misplaced. The firm saves opportunity cost on excess investments in current assets and as
bank cash credit limits are linked to the inventory levels. Interest costs are also saved. There
would be a self-imposed financial discipline on the firm to manage their activities within their
current liabilities and current assets and there may not be a tendency to over borrow or divert
funds.
Zero working capital also ensures a smooth and uninterrupted working capital cycle, and it
would pressure the Finance Managers to improve the quality of the current assets at all time, to
keep them l0O% realisable. There would also be a constant displacement in the current
liabilities and the possibility of having over dues may diminish. The tendency to postpone
current liability payments has to be curbed and working capital always maintained at zero. Zero
working capital would call for a fine balancing act in financial management, and the success in
this endeavour would get reflected in healthier bottom-lines.

Overtrading
Overtrading arises when a business expands beyond the level of funds available Overtrade
means an attempt to finance a certain volume of production and sales with inadequate working
capital. lf the company does not have enough funds of its own to finance stock and debtors it is
forced. if it wishes to expand to borrow from creditors and front the bank overdraft sooner or
65

later such expansion. Financed completely by the funds ofot|1ers_ will lead to .t chronic
imbalance in the working capital ratio.
Expansion is advantageous so long as the business has the fund available to finance the stocks
and debtors involved. Overtrading begins at the point where the business relies on extra trade
credit and increased turnover are financed by taking longer periods of credit from suppliers
and / or negotiating an extension of overdraft limits with the Bank.
Overdependence on outside finance is a sign of weakness, unless the expansion is curtailed,
suppliers may refuse credit beyond certain limits. And the bank may call for a reduction of the
overdraft. If this happens the business may be insolvent in that it does not have sufficient liquid
resources (cash) to pay for current operations or to repay current liabilities until customers pay'
for sales made on credit terms. Or unless stock is sold at a loss for immediate cash payment
The following ratios will analyse the situation properly :
Working capital

Current assets

Current liabilities

Acid test

Quick assets

Current liabilities

Stock turnover

Stock

Cost of sales

Debtors turnover =

Debtors

Credit purchases

Debtors

Creditors

The object of using these ratios is to detect a deterioration of the liquidity position of the
business and an increasing reliance upon trade creditors and overdraft facilities.

Overcapitalization and Working Capital

If there are excessive stocks, debtors and cash, and very few creditors, there will be an over
investment in current assets. The inefficiency in managing working capital will cause this
excessive working capital in lower return on capital employed and long-term funds will be
unnecessarily tied up when they could invested elsewhere to cam profit.

Symptoms of Poor Working Capital Management

In general the following causes are seen in inefficient management of working capital:
Excessive carriage of inventory over the normal levels required for the business will result
in more balance in trade creditors accounts management of cash.
Working capital problems will arise when there is a slow-down in the collection of debtors
Sometimes capital goods will be purchased from the funds available for working capital.
This will result in shortage of working capital and its impact is on operations of the
company.
Unplanned production schedules will cause excessive stocks of finished goods or failures
in meeting dispatch schedules. More funds kept in the form of cash will not generate any
profit for the business.
Inefficiency in using potential trade credit require more funds for financing working
capital
66

 Overtrading will cause shortage of working capital and its ultimate effect on the
operations of the company.
Dependence in short-term sources of financing permanent working causes profitability
and will increase strain on the management in maintaining capital.
Inefficiency in cash management cause embezzlement of cash
Inability to get working capital limits will cause serious concern to the company and
sometimes may turn out to be sick.

Under capitalization
Under capitalization is a situation where the company does not hate funds sufficient to rim its
normal operations smoothly. This may happen due to insufficient working capital or diversion of
working capital funds to finance capital items. If' the company faces the situation of under
capitalisation it will face difficulties in meeting current obligations, procurement of raw material
and stores items. Meeting day-to day running expenses etc. Its impact will ultimately be the
reduced turnover and reduced profitability. The Finance Manager should take immediate and
proper steps to overcome the situation of under capitalisation by making arrangement for the
sufficient working capital, For this purpose he should prepare the cash flow and funds flow
statements of the company.

TREASURY MANAGEMENT
Treasury management once viewed as a peripheral activity conducted by back-office today plays
a very vital role in corporate management can be defined in many ways. The association of
Corporate Treasures defines "Treasury management as the efficient management of liquidity
and financial risk in business. All firms to some degree are involved in treasury management,
although in smaller companies. It may not be separately defined job
Treasury management is responsible for :
1. Management of cash while obtaining the optimum return from any surplus funds;
2. Management of exchange rate risks in accordance with group policy;
3. Providing both long and short term funds for the business at minimum cost;
4. Maintaining good relationships with banks and other providers of finance including
shareholders;
5. Advising on aspects of corporate finance including capital structure, mergers and
acquisitions.

FUNCTIONS OF TREASURY DEPARTMENT :

1. Cash management

The efficient collection and payment of cash both inside the group and to third parties is the
function of the treasury department. The involvement of the department with the detail of
receivables and payables will be a matter of policy. Tl1ere may be complete centralization within
a group treasury or the treasury may simply advise subsidiaries and divisions on policy
67

(collection / payment periods, discounts. etc). Any position between these two extremes would
be possible, Treasury will normally manage surplus funds ir1 an investment portfolio.
Investment policy will consider future need for liquid funds and acceptable levels of risk as
determined by company policy.

2. Currency management
The treasury department manage the foreign currency risk exposure of the company in a large
multinational company (MNC) the first step will usually be to act 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. lf
risks are to be minimized then toward contracts can be used either to buy or sell currency to be
used when invoicing overseas sales

3. Funding management
Treasury department is responsible for planning and sourcing the companys 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 tor investor relations the latter activity has
assumed increased importance in markets where share-price performance is regarded its
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.

Function of treasury ministry

The important functions of a modem Treasury Management Department of a Multinational
Company are as follows :
Setting up of corporate financial objectives
Financial aim and strategies
Financial and treasury policies
Financial and treasury systems
68

Liquidity Management

Working capital Management

Money transmission management
Banking relationships and arrangements
Money arrangement

Funding Management
Funding policies and procedures
Sources of funds
Types of funds
Currency Management
Exposure policies and procedures
Exchange dealing, including futures and options
International monetary economies and exchange regulations
Corporate Finance
Equity capital management
Business acquisitions and Sales
Project finance and Joint ventures
Other related subjects
Corporate taxation
Risk management and insurance
Pension fund investment management

MONEY MARKET INSTRUMENT

Treasury Bills (T-Bills)
T-Bills are one of the most important instruments in virtually all the money markets in the
world T-Bills are issued by the Government for periods ranging from 9ldays to 364 days through
regular auctions They are highly liquid instruments and demand is largely from banks, financial
institutions and corporations. Fundamentally T-Bills are short-term instruments issued by RBI
on behalf of the Government of India to tide over short-term liquidity shortfalls. T-Bills market is
much more liquid than that for dated Government of India securities because of shorter tenure
of T-Bills.
There are three categories of I-Bills _
Qn-Top T-Bills - Can be brought from the RBI at any time at an interest yield of 4,663 per
cent But, with the deregulation of the interest rates, they have lost much of their
relevance.
Ad hoc T-Bills: Are created to replenish the governments cash balances with the RBI
Thus. They essential are just an accounting measure in RBI`s books They have a
69

maturity period of 91 days. but can be redeemed prior to the final date of maturity,
because for them the dealing is only between the government and the RBI
Auctioned T-Bills: First introduced in April, 1992 are the most active of the three
categories. In effect, they are the only one among the three categories which can actually
be called an active money market instrument.
Repurchase Agreement (Repos) - Repurchase agreements or "repos" arises when one party
sells a security to mother party with an agreement to buy it back at a specified time and price.
Repos are active between the commercial banks.
In a ready forward deal or repos transactions, a bank avails itself of funds against the pledge of
securities. Basically it is pledge transaction, with the bank committing itself to buy back the
security, therefore, paying back the amount borrowed on pledge at a mutually agreed price after
a specified period. This period ranges between one and l4 days. The difference between the sale
and buy-back price is the interest cost. The basic advantage of a repo is that a collateral
security is offered to the lender eliminating counterparty risk, especially in a volatile market.
Repo is a risk free short-term instrument for balancing short-term liquidity needs.
Banks have often resorted to ready forward deals among themselves, as also with Discount and
Finance. Home of India (DFHI) and Securities Trading Corporation of India (STCI) to overcome
short-term fund mismatches. At present, the RBI permits repos between banks, cooperative
banks and eligible institutions, i.e., the DFHI and the STCI.

Call Money Markets

With a majority of the total turnover of the money market being accounted for by call loans, it is
not surprising that this is by far the most visible market-where the day-today surplus funds are
traded. It is highly liquid market, with the liquidity being exceeded only by cash. Other features
include the highly risky nature and the extreme volatility.
Interbank trading accounts for more than 80 per cent of the total transactions. Other than the
banks, the major players include the major players include Discount and Finance House of
India (DFHI) UTI, LIC etc. State bank of India and UTI are the major lenders to this market.
Among the average daily outstanding of this market is about Rs 10,000 crore. Its fluid nature
can be assessed by the extremely small maturity periods varying from overnight to a fortnight
Also. These large and very short-term call loans are redeemable on demand at the option of
either the buyer or the seller.
Along with this exponential growth in the total volumes has been a similar rise in the volatility
of call rates .i..e, the rates of interest paid on call loans. The volatility arises mainly due to
unplanned demand of banks for funds to meet their reserve requirements. Since the banks have
to meet their reserve requirements at the end of every fortnight, these periods see big spurts in
the call rates. The high volatility of the call rates can be attributed to some cyclical and
structural factors too. The cyclical factors include the personalisation of the demand and supply
of funds in the macro-economy (e g _ tax payments). The structural factors refer to government
legislations, conditions of the stock markets (i e_ whether a boom phase or a slump in the
market), liquidity present in the economy etc

70

Certificates of Deposit (CDS) - CDs are time deposits of specific maturity similar in nature to
the commonly available fixed deposits (FDS) of the banks with the major difference between the
two being that CDs are easily transferable from one party to another, whereas FDs are nontransferable CDs are unsecured negotiable promissory notes issued by commercial banks and
Development Financial Institutions (DFIs) while the commercial bank CDS are issued on
discount to face value basis The CDs issued by DFIs can be coupon bearing. The discount rates
of CDs are market determined the maturity period ranges from 91 days for the CSs issued by
banks to 1-3 for those by DFIs. CDs can be issued in multiplies of rs. 5 lakh subject to
minimum investment of rs. 25 lakhs. The primary investors are retail customer and corporate
with surplus funds.

Commercial Paper: (CPs) A CP is essentially a promissory note with a fixed maturity period, and is generally issued by the
leading, nationally reputed credit worthy, and highly rated corporations. Depending upon which
company is issuing it finance or non-finance companies. The CP is also known as finance paper,
industrial paper or corporate paper.
It is an unsecured and negotiable instrument and is usually issued in bearer firm, on discount
to face value basis. The maturity period varies between 3 to 6 months, the most popular being
91 days. The discount is freely determined by market conditions. The CPS can be issued in
multiplies of Rs. 5 lakh subject to the minimum issue size of Rs. 50 lakhs. The high turnover of
CPs makes them one of the most liquid money market instruments in India. The primary
investors, in CPs are mutual funds and commercial banks.

What are the valuation norms for various elements of Working Capital for
estimation purposes?
Estimation of working capital requirements by determination of each component of current
assets and current liabilities involves the following steps.
Step 1

Determine the various items of Current Assets

and Current Liabilities. which are required to
be estimated.

Step 2

Determine the period of holding or quantity for

each of the above items. For example. 1 Raw
Material Storage Period, WIP Holding Period,
Finished

Goods

Storage

Period.

Average

Collection Period, Creditors Payment Period.

Lag in Outstanding Expenses etc.
Determine the rate at which the above items
are to be valued. [See Table below]
Step 3

Ascertain the amount of each item as Period or

71

Quantity X Rate of Valuation.

Step 4

Find out Net Working Capital, after considering

amounts such as cash balances, loans and
advances, advances to suppliers, advances

Step 5

from customers etc.

Rates of Valuation of various items :

Component
Raw Materials

Total Approach
Purchase
Price

Work in Progress

discounts
discounts
Raw Materials + 50% of [Direct Raw Materials + 50% of [Direct

net

Cash Cost Approach

of Purchase
Price
net

of

Labour + Direct Expenses + Labour + Direct Expenses +

All

Finished Goods
Sundry Debtors
Sundry Creditors

Direct

Expenses

+ All

Direct

Expenses

Production Overheads]

Production depreciation]

Cost of Production
Selling Price

Cost of depreciation
Selling
Price
Less

Purchase

Price

net

discounts

Margin Less Depreciation

of Purchase
price
net

Profit
of

discounts

What are the factors to be taken into account while determining working
capital requirement ?
A number of factor determine whether the amount of working Capital held by a firm is high or
low. Some illustrative factors are listed below.

Factor
1. Production Policies

High Working Capital

High

Production

during

season
2. Production Process
3.
Length
manufacturing process

e.g. diaries, calendars etc.

Labour Intensive Process
of Long manufacturing process or
Production cycle

Low or Moderate Working

Capital
peak Uniform Production over the
year
Capital Intensive Process
Short
and
quick
manufacturing
process, more batch runs etc.
72

4. Nature of Business
5. Credit Policy

Manufacturing concerns
Liberal Credit Policy and low

Trading Concerns
Strict Credit and

6. Market Standing

efforts for debtors follow-up

Newly established concerns - Credit

credit collection mechanism

Reputed
and
established

efficient

Sales are made but purchases are companies-better

settle in cash

advantageous

and

credit

terms

with debtors and suppliers.

7. Inventory Policy

8. Market conditions

High Storage period or

Just in Time Inventory Policy

Stockholding period

and

Fierce Competition or Buyer's

moderate stockholding period

Seller's
market
quick

Market

disposal of
stocks

and

immediate

collection of
9.Inflationary conditions

In

case

l0. Business Cycle

conditions.
During peak
conditions

of

highly
or

receivables
inflationary For
moderate
boom

and

mild

inflationary conditions.
active During
moderately
active
conditions

What do you understand by MPBF? How is MPBF computed presently ? \

Write short notes on recent changes in MPBF computed presently ?
MPBF stands for Maximum Permissible Bank Finance, i.e. the maximum amount that Banks
can lend a borrower towards his working capital requirements.
The RBI had constituted various study groups / committees to study the trends of working
capital financing by banks and recommend the norms to be followed in lending. The
recommendations of the Tendon Committee (formed in .July 1974) have had far-reaching impact
in lending norms.

MPBF based on Tendon Committee's recommendations:

This Committee suggested three different methods of computing the MPBF
Method l: MPBF = 75% of[Current Assets Less Current Liabilities] i e 75% of Networking Capital
Method ll; MPBF = [75% of Current Assets] Less Current Liabilities
Method lll: MPBF = [75% of Fluctuating Current Assets] Less Current Liabilities
The Committee suggested gradual shift from Method l to Method III, in order to make the
borrower more self-reliant in financing his working capital requirements.
73

Current Trends in MPBF : In 1997, the RBI scrapped the concept of MPBF and introduced a
new system of lending. The salient features of the new system are :
Up to Rs.25 lakh: : For borrowers with requirements of up to Rs.25 lakhs, credit limits
will be computed after detailed discussions with borrower, without going into detailed
evaluation.
Upto R.s.5 Crores : For borrowers with requirements above Rs.25 lakhs but up to Rs.5
Crores, credit limit can be offered up to 20% of die projected gross sale gj of the borrower.
Above Rn.5 crores : For large borrowers not falling in the above categories, i.e. more than
Rs.5Crores, cash budget system may be used to identify the working capital needs.
Consortium arrangements between different banks and financial institutions are now
optional for this category. However, Tendon Committee guidelines may also be followed
with necessary modifications.

QUESTIONS
Q-1
From the following information of XYZ Ltd.
Calculate:
(i) Net operating cycle period.
(ii) Number of operating cycles in a year.

Rs.

l. Raw material inventory consumed during the year

6,00,000

2. Average stock of raw material

50,000

3. Work-in-progress inventory

5,00,000

4. Average work-in-progress inventory

5. Finished goods inventory

30,000
8,00,000

6. Average finished goods stock held

40,000

7. Average collection period from debtors

45 days

8. Average credit period availed

30 days

9. No. of days in a year

360 days

Q~2
From the following data. compute the duration of the operating cycle comment on the increase/
decrease:
Year 1

Year 2

Average scope of :
74

Raw materials
Work in process
Finished goods
Purchase of raw materials
Cost of goods sold
Sales
Debtors
Creditors

Rs 20,000
14,000
21,000
96,000
1,40,00
1,60,000
32,000
16,000

Rs. 27,000
18,000
24,000
1,35,000
1,80,000
2,00,000
50,000
18,000

Assume 360 days per year for computations purposes

Q-3
Calculate the amount of working capital requirements for M Ltd. from the following information
Raw materials

160

Direct labours

60

Overheads

120

Total cost

340

Profit

60

Selling price

400

Raw materials are held in Stock on an average tor one month. Materials are in process on an
average for half-a-month. Finished goods are in stock on an average for one month. Credit
allowed by suppliers is one month and credit allowed to debtors is two months Time lag is
payment I of wages is IA week. Time lag in payment of overhead expenses is one month. One
fourth of the finished goods is sold against cash.
Cash in hand and at bank is expected to be Rs.50,000; and expected level of production
amounts to l,04,000 units.
You may assume that production is carried on evenly throughout the year, wages and overheads
accrue similarly and a time period of four weeks is equivalent to a month.
Q4
On lst 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
requirements 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 materials 60%, Direct wages 10% and Overheads 20%. Raw materials are expected to
remain in store for an average of 2 months before issue to production. Each unit is expected to
be in process for one month, the raw materials being fed into the pipeline immediately and the
75

labour and overhead costs accounting evenly during the month. Finished goods will stay in the
warehouse awaiting despatch to customers for approximately 3 months. Credit allowed by
creditors is 2 months from the date of delivery of raw materials. Credit allowed to debtors is 3
months from the date of despatch. Selling price is Rs.5 per unit. There is a regular production
and sales cycle. Wages and overheads are paid on the 1" of each month for the previous month.
The company normally keeps cash in hand to the extent of Rs.20,000.
Q~5
While preparing a project report on behalf of a client you have collected the following facts.
Estimate the net working capital required for that project Add 10 per cent to your computed
figure to allow contingencies'
Amount per unit
Estimated cost per unit of production is
Raw material

Rs 80

Direct labour

30

Overheads (exclusive of depreciation. Rs. l0 per unit)

60

Total cash cost

170

Additional information:
Selling price. Rs. 200 per unit
Level of activity. l,04.000 units of production per annum
Raw materials in stock, average 4 weeks
Work in progress (assume 50 per cent completion state in respect of conversion costs and l00
per cent completion in respect of materials). Average 2 weeks
Finished goods in stock. Average 4 weeks
Credit allowed by suppliers, average 4 weeks
Credit allowed to debtors. Average 8 weeks
Lag in payment of wages, average l 5 weeks
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 overheads accrue similarly. All sales are on credit basis only.
Q-6
A newly formed company has applied for a loan to a commercial bank for financing its working
capital requirements. You are requested by the bank to prepare an estimate of the requirements
of the working capital for the company. Add l0 per cent to your estimated figure to cover
76

unforeseen contingencies. The information about the projected profit and loss account of this
company is as under:
Sales
Cost of goods sold
Gross profit
Administrative expenses
Selling expenses
Profit before tax
Provision for tax

Rs. 21,00,000
15,30,000
5,70,000
Rs 1,40,000
1,30,000

2,70,000
3,00,000
1,00,000

Note : Cost of goods sold has been derived as follows

Material cost
Wages and manufacturing expense
Depreciation
Less stock of finished goods (10 percent not yet sold)

8,40,000
6,25,000
2,35,000
17,00,000
1,70,000
15,30,000

The figures given above relate only to the goods that have been finished and not to work in
progress; goods equal to 15 per cent of the year`s production (in terms of physical units) are in
progress on an average. requiring full materials but only 40 per cent of other expenses. The
company believes in keeping two months consumption of material in stock; desired cash
balance, Rs 40.000
Average time-lag in payment of all expenses is l month. Suppliers of materials extend l 5 months
credit. Sales are 20 per cent cash; rest are at two months credit; 70 per cent of the income tax
has to be paid in advance in quarterly instalments.
You can make such other assumptions as you deem necessary for estimating working capital
requirements.
Q-7
You are supplied with the following information in respect of XYZ Ltd for the ensuing year
Production of the year, 69.000 units
Finished goods in store. 3 months
Raw material in store. 2 months' consumption
Production process, l month
Credit allowed by creditors. 2 months
Credit given to debtors, 3 months
77

Selling price per unit, Rs. 50

Raw material, 50 per cent of selling price
Direct wages, 10 per cent of selling price
Manufacturing and administrative overheads, 16 per cent of selling price
Selling over buds, 4 per mi of selling price
There is regular production and sales cycle and wages overheads accrue evenly. Wages are paid
in the next month of accrual. Material | introduced in the beginning of the production cycle.
You are required to assertion working capital requirement.
Q-8
Food Ltd is presently operating at 60 per cent level, producing 36,000 packets of snack foods
and proposes to increase its capacity utilization in the coming year by 33.33 per cent over the
existing level of production.

The following data has been supplied:

(i) Unit cost structure of the product at current level:
Raw material

Rs,

Wages (variable)

Overheads (variable)

Fixed overhead

Profit

Selling price

12

(ii) Raw materials will remain in stores for l month before being issued for production. Material
will remain in process for further l month. Suppliers grant 3 months credit to the company.
(iii) Finished goods remain in godown for l month.
(iv) Debtors are allowed credit for 2 months
(V) Average time-lag in wages and overhead payments is l month and these expenses accrue
evenly throughout the production cycle.
(vi) No increase either in cost of inputs or selling price is envisaged.
Prepare a projected profitability statement and a statement showing working capital requirement
at the new level, assuming cash balance of Rs. l9.500 has to be maintained.

78

Q~9
Marks Limited is launching a new project for the manufacture of a unique component At full
capacity of 24,000 units. the cost per unit will be as follows;
Material

Rs.

80

Labour and variable expenses

40

Fixed manufacturing and administrative expenses

20

Depreciation

10
150

The selling price per unit is expected at Rs 200 and the selling expenses per unit will be Rs. l0,
80 per cent being variable
In the first two years, production and sales are expected to be as follows:
Year

Production units

Sales units

15,000

14,000

20,000

18,000

To assess working capital requirement, the following additional information is given:

(a) Stock of raw material - 3 months average consumption.
(b) Work-in-process- Nil
(e) Debtors- l month average cost of sales.
(d) Creditors for supply of materials - 2 months average purchases of the year.
(e) Creditors for expenses - I month average of all expenses during the year.
(f) Minimum desired cash balance - Rs. 20,000
(g) Stock of finished goods is taken at average cost.
You are required to prepare a projected statement of working capital requirements for two years.
Q-10
On April l of the current year, the board of directors of Dowell Ltd wishes to know the amount of
working capital that will be required to meet the programme of activity they have planned for the
year. The following information is available:
(i) Issued and paid-up capital, Rs 2.00.000.
(ii) 5% Debentures (secured on assets), Rs 50,000.
(iii)Fixed assets valued at Rs l,25,000 on March 31 of the previous year.
79

(iv)Production during the previous year was 60,000 units; it is planned that this level of activity
should be maintained during the present year.
(v)The expected ratios of cost to selling price are - raw materials 60 per cent, direct wages 10 per
cent over heads 20percent
(vi)Raw materials are expected to remain in store for an average of two months before these are
issued for production
(vii)Each unit of production is expected to be in process for one month. Full unit of raw
materials is required in the beginning of production
(viii)Finished goods will stay in warehouse for approximately three months
(ix)Creditors allow credit for 2 months from the date of delivery of raw materials
(x)Credit allowed to debtors is 3 months from the date of dispatch.
(xi) Selling price per unit is Rs 5
(xii) There is a regular production and sales cycle
Prepare:
(a) working capital requirement forecast; and
(b) an estimated profit and loss account and balance sheet at the end of the year
Q~11
BS Ltd. has been operating its manufacturing facilities till 31. 3.1999 on a single shift working
with the following cost structure ,
Per unit
Rs
Cost of Materials

6.00

Wages (40% fixed)

5.00

Overheads (80/a fixed)

5.00

Profit

2.00

Selling Price

18.00

Sales during 1998-1999- Rs. 432,000 As at 31.3.99 the company held: Rs.
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
80

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 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-12
Find out maximum permissible bank finance as per Tondon Committee recommendation
Current liabilities
Creditors for purchases
Other current liabilities

Rs.
100
50
150
Bank borrowings, including bills 200

Current assets
Raw materials

Rs.
200

discounted with bankers

discounted with bankers

Other current assets

Finished goods
Receivables,
including

90
bills 50

350

10
350

Q-13
Following is the balance sheet of XYZ Ltd. Calculate the amount of maximum permissible bank
finance by all the three methods for working capital as per Tondon Committee norms You are
required to assume the level of core current assets to be Rs 30 lakhs
You are also required to calculate the current ratios under each method and compare the same
with the current ratios as recommended b) the Committee. assuming that the bank has granted
MPBF
Liabilities
Equity shares Rs 10 200
each
Retained earning
11% debentures
Public deposits
Trade creditors
Bills payable

200
300
100
80
100

Assets
Fixed assets
Current assets
Inventory :
Raw materials 100
W.I.P. 150
Finished goods 75
Debtors
100
Cash/bank

980

500

55

480
980

81

Receivable Management
Introduction
A typical manufacturing company has a debtors to total assets ratio in the region of 20% to
25%. This represents a considerable investment of funds and so the management of this asset
can have a significance effect on the profit performance of the company.
Debtors balance as shown in the Balance Sheet of a Company relates to sales made on credit for
which payment has not yet received. They arise from the sale of goods and services on credit
basis. Sales on credit depends upon the nature of business. To increase the sales volume,
generally the credit facility will be offered to the customers which result in investment in debtors
to maximize return on capital employed. The balance in debtors account is determined by the
number of customers, length of credit, amount of credit allowed to each customers etc.
To achieve growth in sales and to meet competition in the industry, a limit may resort to credit
sales. A retail under will do his business mainly on cash basis where as a manufacturing
concern will have heavy balance in Debtors. Firms offer credit to customers to attract more
business, and the increased turnover will result in increased profit to the firm. The market in
82

which the firm is doing business is the ultimate determination in credit sales and debtors
balances.

Cost of extending credit

The costs involved in extension of credit to the customers are as follows :
Carrying cost : This cost includes the interest on capital blocked in the debtors balances.
The administration costs associated with the credit decision making and controlling of
debtors balances cost of keeping the records of credit decision making and controlling of
debtors balances. cost of keeping the records of credit sales and payments. cost of
collection of payments from customers, opportunity cost of capital that can be employed
elsewhere than in debtors balances
Default risk - There are also costs associated with the risk of default in certain portion of
debtors it will never pay. and will become `bad debts` which has to be written off of the
profits of the firm.

Administration costs of Debtors Management

The costs relating to the administration of debtors is as follows:
Screening the potential customers for granting credit.
Accounting. recording and processing costs of debtor balances
Expenditure incurred for credit control checks.
Cost incurred for sending invoices and statements of accounts to individual customers
Chasing up slow paying debtors
Costs incurred for classification of Quarries
Recording receipt of cash and processing on recording individual records
Use of office space, processing equipment and remuneration of sales force involved in
debtors collection etc.

Cost Benefit analysis of credit sales

When the sales on credit terms are extended to the customers, the firm will consider the level of
default risk attached to it. With every sale there is some risk that the customer will not be able
to pay, but with most large companies the risk is minimal and with small and illiquid companies
the risk if non-payment might be high.

Credit Policy
A firm must establish its own credit policy for proper management of Debtors, otherwise it will
lead to more outstanding balances in debtors account and the risk of bad debts will also arise.
A credit policy can be established by a firm keeping in view of the following:
Credit period to be allowed to the general customers.
Credit period to be allowed to the special customers and the nature of speciality of the
customers and the nature if speciality of the customers to be predetermined.
83

 Credit rating system to be established.

Cash discount Policy for cash purchases and early payment of debt by customer to be
established.
Establishment of collection policy of Debtor balances
Establishment of proper accounting system for close security of debtors balances.
Management of information system to be established for increase in efficiency in Debtor
management.
Establishment of Policy for taking necessary steps in case of bad and doubtful debts.
Credit insurance cover to avoid the risk of bad debts to be considered.
Establishment of Policy in appointing sales recovery force.
Establishment of proper documentation for credit sales.

Debtors Collection Policy

Some times a customer fails to pay on the due date. The following procedure will help in ellicient
collection of overdue debtors.

A reminder
A personal letter
Several telephone calls
Personal visit of salesman
Restriction of credit
Use of collection agencies
Legal action 1 as a last resort.

Process of Receivable Management

The following process will help in efficient management of the receivables.

Take the opinion of the sales force and internal staff

Frame the credit terms for the customer if credit is sanctioned.
Establish the initial creditworthiness.
Check the credit before the dispatch of consignment.
Close monitoring of the credit terms and customer compliance.
Review the customer credit ill required.
Develop the reports for internal appraisal of the customer.

FACTORING
Factoring is a continuing arrangement between a financial intermediary called a "Factor" and
a Seller (also called a client) of goods or services. Based on the type of factoring, the factor
performs the following services in respect of the Accounts Receivables arising from the sale of
such goods or services.

Purchases all accounts receivables of the seller for immediate cash.

Administers the sales ledger of the seller.
Collects the accounts receivable.
Assumes the losses which may arise from bad debts.
84

 Provides relevant advisory services to the seller.

Factors are usually subsidiaries of banks or private financial companies. It is to be noted that
factoring is a continuous management and not related to a specific transaction. This means that
the factor handles all the receivables arising out of the credit sales of the seller company and
not just some specific bills or invoices as is done in a bills discontinuing agreement.

Mechanics of Factoring
The factoring arrangement starts when the seller (client) concludes an agreement with the
factor, wherein the limits, charges and other terms and conditions are mutually agreed upon
From then onwards, the client will pass on all credit sales to the factor When the customer
places the order, and the goods along with invoices are delivered by the client to the customer.
the client sells the customers account to the factor and also informs the customer that payment
has to be made the factor A copy of the invoice is also sent in the factor purchases the invoices
and makes prepayment generally up to 80% of the invoice amount, (Just as in the case of cash
credit for factoring also_ a "drawing power" is fixed based on margin which is normally around
20%. The client is free to withdraw funds up to the drawing power) the factor sends monthly
statements slowing outstanding balances to the customer. copies of which the also sent to the
customer copies of which are also sent to the client The factor also carries follow-up if the
customer does not pay by the due date. Once the customer makes payment to the factor, the
balance amount due to the client is paid by the factor.
The following process is explained in the following diagram:

Servicing and Discount Charges

For rendering the services of collection and maintenance of sales ledger. the factor charges
commission which varies between 0.4% to l% of the invoice value_ depending upon the volume
to operations. This service charge is collected at the time of purchase of invoices by the factor
For making an immediate part payment to the client, the factor collects discount charges from
the client. These discount charges are comparable to bank interest rates in that it is calculated
for the period between the date of advance payment by the factor to the client and the date of
collection by the factor from the customer. These are collected monthly.

Types of Factoring
Factoring can be classified into many types. This section covers only those forms of factoring
which more prevalent in India today.
1.Recourse Factoring : Under recourse factoring, the factor purchases the receivables on the
condition that any loss arising out of irrecoverable receivables will be borne by the client. In
other words. The factor has recourse to the client, in other words. the factor has recourse to the
client it the receivables purchased turn out to be irrecoverable.
2. Non-recourse or Full Factoring : As the same implies, the factor has no recourse to the
client if the receivables are not recovered, i.e., the client gets total credit protection. In this type
85

of factoring. all the components of service viz., short-term finance, administration of sales ledger
and credit protection are available to the client.
3. Maturity Factoring : Under this type of factoring arrangement, the factor does not make any
advance or pre-payment. The factor pays the client either on a guaranteed payment date or on
the date of collection from the customer. This is as opposed to "Advance factoring" where the
factor makes prepayment of around 80% of the invoice value of the client.
4. Invoice Discontinuing : Strictly speaking, this is not a form of factoring because it does not
carry the service elements of factoring. Under this arrangement, the factor provides a prepayment to the client against the purchase of accounts receivables and collects interest (service
charges) for the period extending from the date of prepayment to the date of collection. The sales
ledger administration and collection are carried out by the client.
In terms of the services available to the client, these 4 types of factoring can be illustrated with
table:
The

Short-term

Sense

Credit

Service

finance

Ledger

Protection

Types

administration

Of Factoring
Resources factoring

Non-recourses

factoring
Maturity factoring
Invoice discounting

X
X

There are also other types of factoring such as Bank participation factoring Supplier Guarantee
Factoring and Cross Border or International Factoring which are beyond the scope of this
lesson.

Factoring in India
While factoring in the modem sense is more than three decades old m Europe and other
developed countries, it came to India as a result of the recommendation of the `Kalyansundaram
Committee a study group set up at the request of RBI, much later. The first two factoring
companies in India. Viz, SBI Factors and Commercial Services Ltd. and Can bank Factors Ltd.
commenced operations in 1991 These companies provide only recourse factoring at present.
Private financial companies are also planning to enter the factoring arena.

Discount Policy.
Meaning: In the context of Debtors Management. Discount Policy involves decisions relating to
Percentage 0fCash Discount to be offered as incentive for early settlement of invoice
Period within which cash discount can be availed.
86

Role : Discounts are given to speed up the collection of debts. Hence. it improves the liquidity of
the seller. It also ensures prompt collection and reduces risk of bad debts.

Expression: Normally, credit terms are expressed in this order: (a) the rate of cash discount,
(b) the cash discount period and (c) the net credit period. For example, credit terms of "2/10' net
60" means that a cash discount of 2% will be granted if customer pays within 10 days; if he
does not avail the offer he must pay within 60 days, being the credit period.

Ageing Schedule.
Meaning: In a 'Ageing Schedule', the receivables are classified according to their age, i.e. period
for which they have been outstanding, e.g. less than 30 days, 30-45 days, 45-60 days, above 60
days etc.
Role : Preparation of ageing schedule helps management in the following ways :

(a)Analysis of quality of individual accounts

(b)Intra-firm and Inter-firm comparison, i.e. comparing liquidity of present receivables with the
past periods and also comparing current liquidity of receivables of one limit with that of other
firms.
(c)Trend Analysis of debtors
(d)Supplement to average collection period of receivables / sales analysis
(e)Recognition of recent increase and slump in sales.
An illustrative Ageing Schedule is given below

Period due

No.

<15 days

parties
65

16-30 days
31-45 days

Of No of bills

12
86

70
80
241

Amount due

% of total

remarks

34,180

3.42%

<

4.68%

credit period
<
normal

38.37%

credit period
Normal credit

46,840
3,83,690

normal

debts
Period due
46-60 days
61-90 days
91-180 days

No. Of parties

No

91
43
12

bills
196
52
22

of Amount
due
3,59,960
97,100
41,350

of remarks

total
36.00 %
9.71 %
4.13%

Regular remainders sent

Special remainders sent
Rs. 18,150 doubtful- party
87

181-365 days
>1 year
>2 years

6
3
2

9
3
2

8,000
17,860
11,020

0.80 %

may be insolvent
Legal notice sent-reply

1.79 %

due
Suit

field

decisions

1.10 %

awaited
Suit field

decisions

awaited
Total

320

675

10,00,000 100.00 %

The above schedule shows that about 75% of the company's receivables are about 31 -60 days
due. It can be compared with corresponding schedules for previous years so as to analyse trend
of Collection Management.

Briefly explain the meaning and importance of 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 modem 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-05. By indicting credit-worthiness
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 corporate (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 minimises the role of the 'name
recognition' and less known companies can also approach the market on the basis of their
rating. The fund ratings are useful to the ban s and other financial institutions while deciding
lending and investment strategies

Questions
Q~1
What is the annual percentage interest cost associated with the following credit terms?
(i) 2/10 net 50

(ii) 2/15 net 40

(iii) 1/15 net 30

(iv) l/l0 net 30

88

Assume that the firm does not avail of the cash discount but pays on the last day of the net
period. Assume 360 days to a year.
Q-2
Golden Syntax has annual sales of Rs. 24,00_000. The selling price per unit is Rs l0 and the
variable cost is 70 per cent of the selling price. The required rate of return on investment is 20
per cent, average cost, Rs 9 per unit: annual collection expenditure, Rs. 50,000 and percentage
of default, 3 per cent; credit terms, 2 months. Golden Syntax is considering the change in credit
policy by following Programme A or Programme B.

Av. Collection period (months)

Annual collection expenditure (Rs.)
% of default (Rs.)
Q~3

Programme
A
1.5
75,000
2

B
1
1,50,000
1

Sagar company currently makes all sales on credit and offers no cash discount It is considering
a 2 per cent cash discount for payment within 10 days The firms current average collection
period is 60 days, sales are 2,00,000 units. selling price is Rs 30 per unit. variable cost per unit
is Rs 20 and average Cost per unit is Rs.25 at the current sales volume.
It is expected that the change in credit terms will result in increase in sales to 2,25,5000 units
and the average collection period will fall to 45 days However, due to increased sales_ increased
working capital required will be Rs l,00,000 (it does not take into account the effect on debtors)
Assuming that 50 per cent of the total sales will be on cash discount and 20 per cent is the
required return on investment. Should the proposed discount be offered?
Q-4
H ltd. has at present annual sales level of Rs l0.000 units at Rs 300 per unit The variable cost is
Rs 200 per unit and fixed cost amount to Rs 100,000 per annum, The present credit period
allowed by the company is l month, The company is considering a proposal to increase the
credit period to 2 months and 3 months and has made the following estimates.
Existing
Credit period (month) 1
Increasing in sales --

Propose
2
15

3
30

(per cent)
Bad Debts (%)

There will be increase in fixed cost by Rs 50,000 on account of increase in sales beyond 25 per
cent of present level. The company plans a pre-tax return of 20 per cent on investment in
receivables.
You are required to calculate the most paying credit policy for the company.
Q-5
89

XYZ Corporation is considering relaxing its present credit policy and is in the process of
evaluating two alternative policies. Currently, the firm has annual credit sales of Rs 50 lakh and
accounts receivables turnover ratio of 4 times a year. The current level of loss due to bad debts
is Rs l,50,000. The firm is required to give a return of 25 per cent on the investment in new
accounts receivables. The companys variable costs are 70 per cent of the selling price. Given
the following information, which is a better option?
Annual credit sales
Account receivables turnover ratio
Bad debts losses

Present policy
Rs. 50,00,000
4
1,50,000

Policy option I
Rs. 60,00,000
3
3,00,000

Policy option II
Rs. 67,50,000
2.4
4,50,000

Q~6
Easy Limited specializes in the manufacture of a computer component. The component is
currently sold for Rs. 1,000 and its variable cost is Rs 800. For the current year ended
December 31. the company sold on an average 400 components per month.
At present, the company grants one month`s credit to its customers. lt is thinking of extending
the same to two months on account of which the following are expected:
Increase in sales, 25 per cent
Increase in stocks, Rs 2,00,000
Increase in creditors, Rs |,00.000
You are required to advise the company on whether or not to extend credit terms if (a) all
customers avail of the extended credit period of two months and (b) existing customers do not
avail of the credit terms but only the new customers avail of the same Assume the entire
increase in sales is attributable to the new customers.
The company expects a minimum return of 40 per cent on the investments.
Q~7
Star Limited, manufactures of colour TV sets, are considering the liberalization of existing credit
terms to three of their large customers. The credit period and likely quantity of TV sets that will
be lifted by the customers are as follows:
Credit period(days)
0
30
60
90

Quantity lifted
A
1,000
1,000
1,000
1,000

B
1,000
1,500
2,000
2,500

C
--1,000
1,500

The selling price per TV set is Rs. 9,000. The expected contribution is 20 percent of the selling
price. The cost of carrying debtors averages 20 percent per annum.
90

You are required:

(a) To determine the credit period to be allowed to each customer (assume 360 days in a year for
calculation purposes).
(b) What other problems the company might face in allowing the credit period as determined in
(a)above?
Q~8
Super Sports, dealing in sports goods, has an annual sale of Rs 50 lakh and currently
extending 30 days credit to the dealer. It is felt that sales can pick up considerably if the dealers
are willing to carry increased stocks, but the dealers have difficulty in financing their inventory.
The firm shifts in credit policy. The following information is available:
The average collection period now is 30 days.
Variable costs, 80 per cent of sales.
Fixed costs, Rs 6 lakh per annum.
Required (pre-tax) return on investment; 20 per cent
Credit policy
A
B
C
D

Average collection period (days)

45
60
75
90

Annual sales (Rs lakh)

56
60
62
63

Q~9
A firm is contemplating stricter collection policies. The following details are available:
l. At present, the firm is selling 36.000 units on credit at a price of Rs. 32 each; the variable cost
per unit is Rs 25 while the average cost per unit is Rs 29; average collection period is 58 days;
and collection expenses amount to Rs l0_000; bad debts are 3 per cent.
2. lf the collection procedures are tightened, additional collection charges amounting to Rs
20,000 would be required, bad debts will be l per cent; the collection period will be 40 days;
sales volume is likely to decline by 500 units.
Assuming a 20 per cent rate of return on investments, what would be your recommendation?
Should the firm implement the decision?
Q-10

91

A company currently has an annual turnover of Rs. 10 lakhs and an average collection period of
45 days. The company wants to experiment with a more liberal credit policy on the ground that
increase in collection period will generate additional sales. From the following information,
kindly indicate which of the policies you would like the company to adopt:
Credit

Increase in

Increase in

Percentage of

policy
1
2
3
4

Collection period
15 Days
30 Days
40 Days
60 Days

Sales (Rs.)
50,000
80,000
1,00,000
1,25,000

Default
2%
3%
4%
6%

The selling price of the product is Rs. 5,'average costs per unit at current level is Rs 4 and the
variable costs per unit is Rs. 3
The current bad debt loss is 1% and the required rate of return on investment is 20%. A year
can be taken to of 360 days.
Q-11
A group of new customers with l0% risk of non-payment desires to establish business
connections with you. This group would require one and a half month of credit and is likely to
increase your sales by Rs. 60,000 p.a. Production, administrative and selling expenses amount
to 80% of sales. You are required to pay income tax @ 50%. Should you accept the offer if the
required rate of return is 40% (after tax)?
Also state the degree of risk of non-payment that you would be willing to assume if the required
rate of return (after tax) were:
(i) 30% , `
(ii) 20%
Q-12

Reduction in Bill Float- Hiring of Agency

Star Limited is manufacturer of various electronic gadgets. The annual turnover for the last year
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 the 50 weeks of the working year. All sales are of 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 for the past two years. Delays in
preparing and dispatching invoices were noticed. As a result only some of the invoices were
dispatched in the same week and the remainder the following week. i
An analysis of the delay in invoicing (being the interval between the date of sale and the date of
despatch of the invoice) indicated the following pattern:
92

No of days of delay in invoicing

% of weeks sales

3
20

410

40

30

A further analysis indicated that the debtors take that the debtors take on an average 36 days of
credit before paying. This period is measure from the day of despatch of the invoice rather than
the date of sale.
It is proposed to hire an agency for undertaking the invoicing work at various locations. The
agency has assured that the maximum delay would be reduced to three days under the
following pattern :
N0 of days of delay in invoicing

% of weeks sales

40

-3

40

20

The agency has also offered additionally to monitor collections, which will reduce the credit
period to 30 days. Star Limited 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% p.a.
The agency has quoted a fee of Rs. 2,00,000 ,p.a. for the invoicing work Rs. 2,50,000 p.a. for
monitoring collection and is willing to offer a discount of Rs. 50,000 provided both the works are
given. You are required to advice Star Limited about the acceptance of agencys proposal.
Workings should form part of the answer.

Factoring
Q-13
The Udar Ltd. sells goods on credit. Its current annual credit sales amount to Rs. 900 lakh. The
variable cost 80 per cent. The credit terms are 2/10 net 30. On the current level of sales, the
bad debts are 0.75 percent. The past experience has been that 50 per cent of the customers
avail of the cash discount, the remaining customers avail of the cash discount, the remaining
customers pay on an average 50 days after the date of sale.
The book debts (receivables) of the firm are presently being financed in the ratio of 2:1 by a mix
of bank borrowings and owned funds which cost per annum 25 per cent and 28 per cent
respectively.
As an alternative to the in-house management of receivables, Udar Ltd. is contemplating use of
full advance non-recourse factoring deal with the Indbank Factors Ltd. The main elements of
such a deal structured by factor are (r) factor reserve, 15 per cent; (ii) guaranteed payment
date, 24 days after the date of purchase; (iii) discount charge, 22 per cent and (iv) commission
for other services (payable up-front). 4 per cent of the value of receivables.
The finance manager of Udar Ltd seeks your advice, as a consultant, on the cost-benefit of the
factoring arrangement. What advice would you give? You can make your own assumptions,
where necessary.
Q-14
93

The Reliance Industries Ltd. (RIL) is presently managing its accounts receivable internally by the
sales and credit department. Its credit terms for sales are 2/l0 net, 30. The past experience of
RIL. has been that on an average 30 per cent of the customers avail of the discount. while the
balance of the receivables is collected on an average 60 days after the invoice date. Further 2
percent of the sales turnover results in bad debts.
The firm is financing its investment in receivables through a mix of bank finance and long-term
finance (own funds) in the ratio of 2:l. The effective rate of interest on bank finance is 22 per
cent and the cost of own funds is 30 per cent.
The projected sales for the next year is Rs. 500 lakh. The credit and collection department
spends on an average one-fourth of its time on collection of receivables. `
A proposal to avail of factoring service from Fairgrowth Factors Ltd. (FFL) as an alternative to inhouse management of receivables collection and credit and collection department spends on an
average one-fourth of its time on collection of receivables.
A proposal to avail of factoring service from Fairgrowth Factors Ltd (FFL) as an alternative to inhouse management of receivables collection and credit monitoring is under the consideration of
the Board of Directors of the RIL. lf the proposal, details of which are given as follows, is
accepted, it is expected that the projected sales for the next year can increase by Rs. 50 lakh as
a result of the diversion of the time of the executives of the sales, credit and collection
department to sales promotion. For the type of product the RIL is producing, the gross margin
on sales in the past has been 20 per cent. Moreover, there would be a saving in administrative
overheads amounting to Rs. 2.5 lakh due to discontinuance of sales ledger administration and
credit monitoring.
According to the factoring proposal, the FFL offers a guaranteed payment of 30 days. The other
details are listed as follows:
The FFL would advance 80 per cent and 85 per cent in case of recourse and non-recourse
factoring deals respectively, the balance would be retained as factor reserve. The discount
charge in advance (up-front) would be 22 per cent of recourse type and 21 per cent for nonrecourse type of service. The FFL would also charge a commission @ 2 per cent (recourse) and 4
per cent (non-recourse). The commission is payable upfront.
Before taking a decision on the proposal, the Board seeks your advice as a financial consultant,
on the course of action. What advice would you give? Why?
Q-15.
XYZ & Company is making a sales of Rs. 50,00,000 by extending a credit to its customers
resulting in average debtors of Rs. 4,29,604. It has a variable cost of 70%. It is believed that
sales can be increased by liberalizing the credit terms from present position upto 90 days.- The
sales manager, has given following estimates of sales under different credit period.

94

Policy
I
II
III
IV

Terms
45 days

Sales
Rs.

60 days

56,00,000
Rs.

75 days

60,00,000
Rs.

90 days

65,00,000
Rs.
72,00,000

Which policy is best for the firm given that the cost of capital of the firm is 20%(Year1360 days)
Q-16.
A company currently has Rs. l0,00,000 per annum of sales, all on credit terms of 60 days. The
average
credit taken is, however; 80 days. It is considering offering a. discount of 3% within 7 days. and
it expects that 60% of existing customers will take the discount. The remainder will be equally
split between those paying after 80 days and those paying after 100 days. The new credit terms
are also expected to generate an additional Rs. 50,000 of sales. Variable costs are 80%, of sales
price and the company's bank overdraft costs 14%.
The company wishes to know .whether offering the discount is worthwhile if
(a) No new sales are obtained.
(b) New sales are as described above (year may be taken consisting of365 days)
Q-17.
At present, the customers of the X Department take, on average. 90 days credit before paying.
New credit terms are being considered which would allow a 5% cash discount for payment
within 30 days with the alternative of full payment due alter 60 days it is expected that 60% of
al Lutoniera will take advantage of the discount terms. Customers not taking the discount
would be equally split between those paying after 60 days and those taking 90 days credit. The
new policy would increase sales by 20% from the current level of Rs.l,00,000 per annum, but
bad debts would rise from 1% to 2%.of total sales. X Departments products have-variables costs
amounting to 80% of sales values.
Evaluate the proposal of X Department, assuming the year to be consisting of 360 days and rate
of interest The Company's collection pattern is as follows is 12%.
Q-18.
95

From the following details, calculate the average age of receivables and comment the results.

Month
First
Second
Third
Total
Working days

Sales for the first 3 quarters of year

Quarter -1
Quarter -2
15,000
7,500
15,000
15,000
15,000
22,000
45,000
45,000
90
90

Quarter -3
22,500
15,000
7,500
45,000
90

(1) l0% of the Sales in the same month; (2) 20% of the Sales in the 2nd month; (3) 30% of the
Sales in the 3rd month; (4) 40% of the Sales in the 4th month.
Q-19.
A bank is analyzing the receivables of Jackson company in order to identify acceptable collateral
for a short-term loan. The con1pany's credit .policy is 2/l0 11et 30. The bank lends 80 per cent
on accounts where customers are not currently overdue and where the average payment period
does 11ot exceed l0 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 I0 per cent
allowance for cash 'discount and returns?
Account Amount

Day

Average payment period

74
91
107
108
114
116
123

outstanding
15
45
22
9
50
16
27

Historically (in days)

20
60
24
10
45
10
48

Rs. 25,000
9,000
11,500
2,300
18,000
29,000
14,000
1,00,800

Q~20.
A group of customers want to enter into a, contract with you to buy goods worth Rs: 20 lakh
during 1987
96

the deliveries to be made in tour equal instalments quarterly. 'l he price of the commodity is Rs.
20 per unit on which you expect a, profit of Rs: l0. The acceptance of this proposal would mean
an additional recurring expenditure of Rs. 10,000
p.a. on your part.
The ageing schedule of accounts receivables in respect of this group" of customers i11 tl1e past
was as follows

Period

Percentage of bills for which payment received

At the cod of3.0 days

15%,

At the end of 60 days

25%

At the end of 90 days

40%

At the end of 100 days

20%

Assuming an opportunity cost of 20% of the funds locked up in accounts receivables, will it be
desirable to accept this proposal?
Assuming an opportunity cost of 20% of the funds locked up in accounts receivables, will it be
desirable to accept this proposal?

97

INVENTORY MANAGEMENT
INTRODUCTION
Inventory Management involves the control of assets being produced for the purposes of sale in
the normal course of the companys operations. Inventories include raw material inventory,
work-in-process inventory and finished goods inventory. The goal of effective inventory
management is to minimize the total costs - direct and indirect - that are associated with
holding inventories.
PURPOSE OF INVENTORIES
The purpose of holding inventories is to allow the firm to separate the processes of purchasing,
manufacturing, and marketing of its primary products. The goal is to achieve efficiencies in
areas where costs are involved and to achieve sales at competitive prices in the market place.
Within this broad statement of purpose, we can identify specific benefits that accrue from
holding inventories.
l. Avoiding Lost Sales : Without goods on hand which are ready to be sold, most firms would
lose business. Some customers are willing to wait, particularly when an item must be made to
wait, particularly when an item must be made to order or is not widely available from
competitors. In most cases, however, a firm must be prepared to deliver goods on demand. Shelf
Stock refers to items that are stored by the firm and sold with little or no modification to
customers. An automobile is an item of shelf stock. Even though customers may specify minor
variations, the basic item leaves a factory and is sold as a standard item. The same situation
exists for many items of heavy machinery, consumer products, and light industrial goods.
98

2. Gaining Quantity Discounts : in return for making bulk purchases, many suppliers will
reduce the price of supplies and component pans. The willingness to place large orders may
allow the firm to achieve discounts on regular prices. These discounts will reduce the cost of
goods sold and increase the profits earned on a sale.
3. Reducing Order Costs : Each time a firm places an order. it incurs certain expense. Forms
have to be completed, approvals have to be obtained, and goods that arrive must be accepted.
Inspected. And counted. Later. an invoice must be processed and payment made. Each of these
costs w ill vat) with the number of orders placed. By placing fewer orders, the firm will pay less
to process each order.
4. Achieving Efficient Production Runs : Each time a firm sets up workers and machines to
produce an item, start-up costs are incurred. These are then absorbed as production begins.
The longer the run, the smaller the costs to begin producing the goods. As an example, suppose
it costs Rs. 12.000 to move machinery and begin an assembly line to produce electronic
printers. lf l,200 printers are produced in a single three-day run, the cost of absorbing the startup expenses is Rs. I0 per unit ( 12.000

1,200)_ If the run could be doubled to 2.400 units, the

absorption cost would drop to Rs. 5 per unit (11000 / ZAO0). Frequent setups produce high
start up costs; longer runs involve lower costs.
These benefits arise because inventories provide a buffet between purchasing. producing and
marketing goods, Raw materials and other inventory items can be purchased at appropriate
times and in proper amounts to take advantage of economic conditions and price incentives.
The manufacturing process can occur in sufficiently long production runs and with pre-planned
schedules to achieve efficiency and economies. The sales force can respond to customer needs
and demands based on existing finished products. To allow each area to function effectively,
inventory separates the three functional areas and facilitates the interaction among them.
5. Reducing Risk of Production Shortages: Manufacturing firms frequently produce goods with
hundreds or even thousands of components. lf any of these are missing, the entire production
operation can be halted, with consequent heavy expenses. To avoid starting a production run
and then discovering the shortage of a vital raw material or other component, the firm can
maintain larger than needed inventories.
To distinguish EOQ from other order quantities, we can say
In the above formula, when U is considered as the annual usage of material, the value of Q*
indicates the size of the order to be placed for the material which minimizes the total inventoryrelated costs. When U is considered as the annual demand Q* denotes the size of production
run.

99

Suppose a firm expects a total demand for its product over the planning period to be l0000
units, while the ordering cost per order is Rs. 100 and the carrying cost per unit is Rs. 2.
Substituting these values.
Thus if the firm orders in 1000 unit lot sizes, it will minimize its total inventory Costs.

Examination of EOQ Assumptions

The major weaknesses of the EOQ model are associated with several assumptions, in spite of
which the model tends to yield quite good results. If these assumptions are dramatically
violated, the EOQ model can be easily modified to accommodate the situation. The model`s
assumptions are as follows :
1. Constant or uniform demand : Although the EOQ model assumes constant demand.
demand max vary from day to day. lf demand is stochastic that is. not known in advance model must be modified through the inclusion of a safety stock
2. Constant unit price : The EQQ Formula derived is based on the assumption that the
purchase price Rs. P per unit of material will remain unaltered irrespective of the order
size. Quite often, bulk purchase discounts or quantity discounts are offered by suppliers
to induce customers for buying in larger quantity
The inclusion of variable prices resulting from quantity discounts can be handled quite easily
through a modification of the original EOQ model, redefining total costs and solving for the
optimum order quantity.
3. Constant carrying costs : Unit carrying costs may vary substantially as the size of the
inventory rises, perhaps decreasing because of economies of scale or storage efficiency or
increasing as storage space runs out and new warehouses have to be hired. This situation can
be handled through a modification in the original model similar to the one used for variable unit
price.
4. Constant ordering costs: While this assumption is generally valid, its violation can be
accommodated by modifying the original EOQ model in a manner similar to the one used for
variable unit price.
5. Instantaneous delivery: If delivery is not instantaneous, which is generally the case, the
original EOQ model must be modified to allow the inclusion of a safety stock.
6. In dependent orders: lf multiple orders result in cost savings by reducing paperwork and
transportation cost, the original EOQ model must be further modified. While this modification is
somewhat complicated, special EOQ models have been developed to deal with it.
These assumptions have been pointed out to illustrate the limitations of the basic EOQ model
and the ways in which it can easily be modified to compensate for them. Moreover an
100

understanding of the limitations and assumptions of the EOQ model will provide the Finance
Manager with a strong base for making inventory decisions

Determination of Optimum Production Quantity:

The EOQ Model can be extended to production runs to determine the optimum production
quantity. The two costs involved in this process are : (i) set up cost and (ii) inventory carrying
cost. The set-up cost is of the nature of fixed cost and is to be incurred at the time of
commencement of each production run. The larger the size of the production run, the lower will
be the set-up cost per unit. However, the carrying cost will increase with increase in the size of
the production run. Thus, there is an inverse relationship between the set-up cost and inventory
carrying cost. The optimum production size is at that level where the total of the set-up cost and
the inventory carrying cost is the minimum, In other words, at this level the two costs will be
equal.
The formula for EOQ can also be used for determining the optimum production quantity as
given below :

Safety Stock
In real life situations one rarely comes across lead times and usage rates that are known with
certainty. When usage rate and/ or lead time vary, then the reorder level should naturally be at
a sufficient level to cater to the production needs during the procurement period and also to
provide some measure of safety for at least partially neutralizing the degree of uncertainty.
The question will naturally arise as to the magnitude of safety stock. There is no specific answer
to this question. However, it depends, inter alia, upon the degree of uncertainty surrounding the
usage rate and lead time. It is possible to a certain extent to quantify the values that usage rate
and lead time can take along with the corresponding chances of occurrence. known as
probabilities. These probabilities can be ascertained based on previous experiences and / or the
judgmental ability of astute executives, Based on the above values and estimates of stock out
costs and carrying cost of inventory it is possible to work out the total cost associated with
different levels of safety stock.
Once we realize that the higher the quantity of safety stock, the lower will be the stock out cost
and the higher will be the incidence of carrying costs, the formula for estimating the reorder
level will call for a trade-off between stock out costs and carrying costs. The reorder level will
then become one at which the total stock out costs (to be more precise, the expected stock out
costs) and the carrying costs will be at its minimum. We consider an illustration to arrive at the
reorder level in a situation where both usage rate and lead time are subject to variation.

QUESTIONS
101

Q~1.
A firms inventory planning period is one year. Its inventory requirement for this period is 1,600
units. Assume that its acquisition costs are Rs. 50 per order. The carrying costs are expected to
be Re l per unit per year for an item.
The firm can procure inventories in various lots as follows: (i) 1,600 units, (ii) 800 units, (iii) 400
units, (iv) 200 units, and (v) l00 units. Which of these order quantities is the economic order
quantity?
Q-2.
The following details are available in respect of a firm:
l. Inventory requirement per year, 6,000 units
2. Cost per unit (other than carrying and ordering costs), Rs. 5
3. Carrying costs per item for one year, Re l
4. Cost of placing each order, Rs. 60
5. Alternative order sizes: (units) 6000, 3000, 2000, l200, 1000, 600 and 200.
Determine the economic order quantity.
Q~3.
The experience of a being out of stock is summarized below:
(a) Stock-out (number of units)

Number of times

500

l (1)

400

2 (2)

250

3 (3)

100

4 (4)

50

10 (10)

80 (80)

Total

100 (100)

Carrying Cost per unit I0 Rs. and stock out cost per unit |00 Rs.
Figures in brackets represents percentage of time the firm has been out of stock.
102

Q~4.
Economic Enterprises require 90,000 units of certain items annually. The cost per unit is Rs. 3.
The cost per purchase order is Rs. 300 and the inventory carrying cost is Rs. 6 per unit per
year.
(a) What is me EOQ?
(b) What should the firm do if the suppliers offer discounts as detailed below:
Order quantity

Discount

4,500 - 5,999

2 per cent

6000 and above

Q~5.
The following information is available relating to the stock-out of a firm:
Stock-out (units)

Number of' times

800

600

400

200

10

30
50

The selling price of each unit is Rs. 200. The carrying costs are Rs. 20 per unit. The stock-out
costs are Rs.50 per unit. The profit percentage on sale price is 20% and extra cost of placing an
order is Rs.l0.
(a) If the firm wishes never loss of sale, what should be its safety stock? What is the total cost
associated with this level of safety stock?
(b) What is the optimum safety stock level?
Q~6.
Below are presented the daily usage rate of a material and the lead time required to procure the
material along with their respective probabilities (which are independent) for Sigma Company
Ltd. The probabilities and the values of usage rate and lead time are based on optimistic,
realistic and pessimistic perceptions of the concerned executives.
103

Average Daily Usage

Probability of

Rate (units)
200
500
800

Occurrence
0.25
0.50
0.25

Lead Time

Probability of

(No. Of days)
12
16
20

occurrence
0.25
0.50
0.25

The stock out cost is estimated to be Rs. I0 per unit while carrying cost for the period under
consideration is Rs.3 per unit. What should be the reorder level based on financial
considerations?
Q~7.
Annual Consumption 40,000
Expected Ordering cost per order Rs. 2
Expected carrying cost per unit Rs. l
Find out Cost of errors:
i) if actual ordering cost per order is Rs. 4
ii) if actual carrying cost per unit is Rs. 2
Q~8
DB p. 1, c, operates a conventional stock control system based on re-order level and economic
ordering quantities The various control levels were set originally based on estimates which did
not allow for any uncertainty and this has caused difficulties because, in practice, lead times,
demands and other factors do vary,
As part of a review of the system, a typical stock item. Part No : X 206 has been studied in
details as follows :
Data for Part No. X 206
Lead times
I5 working days

probabilities
0.2
104

20 working days

0.5

25 working days

0.3

Demand per working day

5,000 units

0.5

7.000 units

0.5

Note: it can be assumed that the demands would apply for the whole of the appropriate lead
time. D.B. p. I.e. works for 240 days per year and it costs 0.15p, a. to carry a unit of X 206 in
stock. The re-order level for this part is currently l,50,000 units and the re-order cost is l,000.
You are required:
a) to calculate the level of buffer stock implicit in a re-order level of l,50,000 units.
b) to calculate the probabilities of a stock-out,
c) to calculate the expected annual stork-outs in units,
d) to calculate the stock~ out cost pet unit at which it would be worthwhile raising the re-order
level to l,75,000 units.
Q~9.
ROL with probability.
ABC Ltd. distributes a wide range of Water purifier systems. One of its selling items is a
standard water purifier. The management of ABC Ltd. uses the EOQ decision model to
determine optimal number of standard water purifies to order. Management now wants to
determine how much safety stock to hold.
ABC Ltd estimates annual demand (360 working days) to be 36,000 standard water purifies.
Using the [EOQ decision model, the company orders 3,600 standard water purifiers at a time.
The lead-time for an order is 6 days. The annual carrying cost of one standard purifier is Rs.
450 Management has also estimated that the additional stock out costs would be Rs. 900 for
shortage of each standard water purifier.
ABC Ltd. has analyzed the demand during 200 past re-order periods. The records indicate the
following patterns:
Demand during lead time
Number of times quantity was demanded

540
6

560
12

580
16

600
130

620
20

640
10

660
6

Total
200

105

(i) Determine the level of safety stock for standard water purifier that ABC Ltd. should maintain
in order to minimize expected stock out costs and carrying costs. When computing carrying
costs, assume that the safety stock is on hand at all times and that there is no overstocking
caused by decrease in expected demand (consider safety stock levels ol`0_ 20, 40 and 60 units).
(ii) What would be ABC`s new re-order point?
(iii) What factors ABC Ltd. should have considered in estimating stock out costs?

CASH MANAGEMENT (CASH BUDGET)

Cash Management Control aspects

We have already seen that 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 financial managers must devise a system
whereby each division of an organization retains enough cash to meet its day-to-day
requirements without having surplus balances on hand. For this methods have to be
employed to:

(a) speed up the mailing time of payments from customers,

(b) reduce the time during which payments received by the firm remain uncollected and speed
up the movement funds to disbursement banks.
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 I 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.

Float
106

The float is of two types (i) collection float and (ii) payment float.
Collection Float : The term Collection Float' means the time between the payment made by the
debtors or customers and the time when funds available for use in the companys bank account.
in other words, the amount tied-up in cheques and drafts that have been remitted by the
customers to the company but has not converted into cash for use in the companys operations.
The reasons for the lengthy float are as follows:

The delay or time taken in postal transaction from customer to company`s head office.
The delay in presentation of cheques and drafts into the bank for collection.
The time needed by the bank to clear a cheque.

To reduce the float. the company can adopt the techniques like Concentration banking. lock box
system. Zero balance accounts, computerized cash management services etc., which will
improve the efficiency in cash management of a company.
Payment Float - Cheques issued but not paid by the bank at any particular time is called
Payment Float 'The company can make use of the payment float called Paying the float ', in the
sense that the company can issue cheques, even it means as per books of account an overdraw
beyond permissible bank limits. The payment float can be used to the advantage of the firm in
times of shortage of fund as it helps to stretch resources in times of necessity. But the company
should be very cautious in playing the float in view of the stringent provisions regarding
dishonour of cheques, loss of reputation etc.

Concentration Banking
When a firm is to receive payment over a wide geographical area then instead of single collection
centre located at the head office, the firm can instruct its customers to remit payments to the
collection centre of their area. For this purpose the firm will open accounts with the branches of
Banks where it ha collection potential. The collection centers are advised to deposit collections
in local banks as soon as the payments are received. Surplus funds in the bank accounts will
be transferred firm these local banks telegraphically to the companys head office. This system
of collection and remittance of funds will accelerate the cash inflows and efficient management
of cash is possible.

Lock Box System

In a Lock box system ', the customers are advised to mail their payment to a post office box,
hired by the firm for collection purpose, near their area. The payments are collected by local
banks, who are authorized to do so, which credit the payments quickly and report the
transactions to the head office. This eliminates the time gap of remittances received by the firm
and deposit into the bank.
107

Zero Balance Account

For efficient cash management some firms employ an extensive policy of substituting
marketable securities for cash by the use of zero balance accounts in which zero balance is
maintained. Every day the firm totals all cheques presented for payment against the account
and transfers the balance amount of cash in the account by buying marketable securities. ln
case of shortage of cash the firm will sell the marketable securities depending on the need for
cash.

Computerized Cash Management

With the developments took place in the computer technology, the present banking system l also
being switched over to the computer network of banks to offer efficient Banking services and
cash management services to their customers. The net work will be linked to the different
branches, banks. This will help the customers in the following steps :
Instant updating of accounts and reporting of account balances as and when required
without any delay.
The transfer of funds will take place very fast and there will be substantial reduction of
float.
Information about foreign exchange rates, interest rates, etc. can be easily accessed by the
customers.

Explain briefly, William J. Baumors EOQ model for optimum cash balance.
The Baumol model on Optimum Cash Balance is similar Wilson's model on raw material EOQ.

Assumptions : The Optimum Cash Balance model is based on the following assumptions 1
(a) Uniform Cash Flows: Cash payments arise uniformly during a year, for example, if the total
annual cash outflow is Rs.36,00,000 and there are 300 working days. the average payment per
day = Rs.36,00.000 / 300 days = Rs. l2,000 per day.
(b) Fixed Transaction Costs: Surplus cash can be invested in short-term marketable
securities. However, for every purchase of securities (i.e. investments) and for every sale (i .e.
disposal of investments), fixed transaction costs are incurred e.g. brokerage, registration costs,
clerical expenses etc. Hence, these costs rise along with the number of transactions (i.e.
purchase and sale of securities).
(c) Fixed Holding Costs: Surplus cash, if held by the firm, entails loss of interest at a fixed
rate. This constitutes the carrying costs of cash, i.e. the interest foregone On marketable
securities.

108

(d) Free marketability: Short-term instruments can be freely traded. The firm can invest them
at any time and sell off / dispose investments at any time.
Theory : According to this model, optimum investment size is that level of investment where the
total of carrying costs and transactions costs per annum are the minimum. At that point, these
two costs are equal and constitute half of the total costs.
Formula:
Optimum Investment =
Where A = Annual Cash Requirement
T = Costs per Transaction
I = Interest rate, i.e. Carrying cost per rupee of Cash

Write short notes on the Miller-Orr Cash Management Model.

Stochastic Cash Flow Assumption: Under this model, cash payments are presumed at different
amounts on different days, i.e. stochastic. In practice, the payment flow is not uniform. For
example, age and salary payment arises in the first week, telephone bills fall due for payment
once in a month etc. With this assumption, this model is designed to determine the time and
size of transfers between an investment account and cash account.
Theory : This model operates as under :
(a) Cash outflows are not uniform during the year.
(b) Upper and lower limits can be fixed for cash balances, as outflows do not exceed a certain
limit on any day. These limits are determined based on fixed transaction costs, interest foregone
on marketable securities and the degree of likely fluctuations in cash balances.
(c) When cash balance reaches the upper limit, surplus cash is invested in marketable
securities, to bring down the cash balance to the average limit or return point.
(d) When cash balance touches the lower limit, investments (marketable securities) are
that cash balances goes up to the average limit or return point.

05 so

(e) During the period when cash balance stays between high and low limits, there are no
transaction between cash and marketable securities.

Formula:
R=

Level of return point

T=

Transaction cost i.e. cost per order of converting marketable securities into cash or cash
into marketable securities

2 = Variance of daily cash balances

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I=

Interest rate i.e. Carrying Cost per Rupee of cash.

QUESTIONS

Q-1.
From the information set out below, prepare a monthly cash budget for the period January to
June, Plan Ahead Ltd.
(a) Prices and costs are assumed to remain unchanged during the period.
(b) Credit sales effected are 75% and cash sales effected are 25% of the total of each month.
(c) The companys collections of credit sales is made as under :
60% - First month after sale.
30% - Second month after sale.
5% - Third month alter sale.
(d) The sales forecast along with probability of achieving the success:
Month

October02
November02
December02
January03
February03

Sales

Probability

Rs.

Of achieving

(000s)
240
175
200
150
250

Success(%)
50
80
80
40
32

Month

March97
April97
May97
June97
July97

Sales

Probability

(Rs.000)

Of achieving

125
200
125
100
160

Success (%)
64
60
80
80
75

(e) The company maintains a gross profit margin of twenty percent.

(f) The probable sales of each month that could be achieved are purchased and settled in the
preceding month.
(g) The salaries and wages to be paid are as follows:

Rs.

Rs.

January. 2003

12.000

Apri1,2003

20.000

February.2003

16,000

May, 2003

16.000

March , 2003

20,000

June,2003

14.000

(h) Interest on 12% convertible debentures of Rs.1,00,000/- is due for payment on 31 st March,
2003 and 30th June, 2003,
110

(i) The company has to pay Rs.1,00,000/- as tax on income of year, 1998, but is disputed.
However, it is decided that 20% of the disputed amount will be paid in April, 2003.
(j) The company intends to import a machine at a capital cost of Rs.8,000/- which along with
the import duty of50% will be payable in June, 2003.
(k) Rent of the company per annum amounts to Rs.9,600/- payable monthly.
(l) Company is expecting a cash balance of Rs.40,000 on 3 151 December, 2002
Q~2
On 30th September, 2002, the Balance Sheet of Melodies Pvt. Ltd., retailers of musical
instruments, was as under :
Rs.
Ordinary,
Rs. 10 each fully paid
Reserves and Surplus
Proposed Dividend
Trade Creditors

70,000
10,000
15,000
40,000
1,35,000

Rs.
Equipment (at cost) 20,000
Less: Depreciation
5,000
Stock
Trade debtors
Balance at bank

15,000
20,000
15,000
85,000
1,35,000

The company is developing a system of forward planning and on 1 st October, 2002 it supplies
the following information:

1996
1996
1996
1996

(actual)
(budget)
(budget)
(budget)

Credit sales

Cash sales

Credit purchases

Rs.
15,000
18,000
20,000
25,000

Rs.
14,000
5,000
6,000
8,000

Rs.
40,000
23,000
27,000
26,000

On 1st October. 2002 the equipment will be replaced at a cost of Rs.30,000 . Rs.l4,000 will be
allowed in exchange for the old equipment and a net payment of Rs.16,000 will be made.
Depreciation is to be provided at the rate of 10% per annum.
The proposed dividend will be paid in December, 2002.
The following expenses will be paid :
Wages Rs.3,000 per month
Administration Rs. l ,500 per month
Rent Rs.3.600 (for the year to 30' September, 2003 to be paid in October, 2002)
The gross profit percentage on sales is estimated at 25%
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You are Required :

(a) to prepare a cash budget for the months of October, November and December.
(b) to prepare income Statement for the three months ended 315' December, 2002.
(c) to prepare budget balance sheet as at 315' December, 2002.
Q~3
The directors of a wholesaling business have approved the following budget programmer for the
six months up to 30m June.
(a)

Per months

Sales :

(Rs)
January

10,000

February

l5,000

March to June
(b)

Expenses :

Salary

25,000
Other expenses
excluding rent

January to March

Rs.2,000

Rs.2,400

April to June

Rs.3,000

Rs.4,500

One- eighth of months salaries and one quarter of the other expenses would be outstanding
at the end of each month.
(c) Rent at the rate of Rs.2,000 per annum is payable quarterly in arrears at 31" March, 30 th
June etc.
(d) Stock at the end of the month
(Rupees)
January

l0,000

February

11,000

March to June

l8,000

(e) New fixed assets will be purchased for Rs.30,000, which will be paid on 31 st March These
assets are
to be brought into operation on 31st March.
(f) Bank overdraft facilities have been arranged up to a limit of Rs.5,000. The chairman has
agreed to subscribe in cash on 31 st March for such additional share capital as may be required
to keep the overdraft within the limit, during the six months.
112

(g) It has to be assumed that the existing terms of credit will continue and be complied with,
(h) The gross profit has to be taken at the constant rate of 20% on sale.
(i) The balance sheet as at 31st December of the previous year is as follows:
Issued share capital
Profit and loss A/c
Trade creditors
Charges accrued :
Salaries
250
General expenses 200

Rs.
30,000
11,550
8,000

Rss.
Fixed assets
Cost (Rs.25,000)
Stock
Debtors
Cash in hand

19,000
9,000
20,000
2,000

450
50,000

50,000

The trade creditors represent the purchase for December of the previous year and the debtors,
the sale for November and December of the previous year at Rs. 10,000 per month.
(j) Depreciation on the fixed assets at 10% .a_ on cost has to be provided.
(k) Ignore interest on the bank overdraft.
Required :
(i) Prepare a cash budget month by month for the six months to 30th June of the budget year.
(ii) Prepare a budget trading and profit and loss account for the six months and budget balance
sheet as at 30th June for the budget year.
Q~4
The following figures have been extracted from a manufacturing companys budget schedules:

2002 October
Nov
Dec
2003 Jan
Feb
Mar

Sales including

Wages and

Purchases of

Producing

Selling and

VAT

Salaries

Materials

Overhead

Administration

Rs.000
1,200
1,100
1,000
1,400
1,200
1,100

Rs.000
55
50
65
60
60
60

Rs.000
210
280
240
210
240
230

Rs.000
560
500
640
560
500
560

Rs.000
125
125
125
125
130
130

Other relevant information:

1. All sales are on credit terms of net settlement within 30 days of the date of the sale. However,
Only 60% of indebtedness is paid by the end of the calendar month in which the sale is made:
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Another 30% is paid in the following calendar month:

5% in the second calendar month after the invoice date;
and 5% become bad debts.
2. Assume all months are of equal number of 30 days for the allocation of the receipts from
debtors.
3. Wages and salaries are paid within the month they are incurred.
4. Creditors for materials are paid within the month following the purchase.
5. Of the production overhead, 35% of the figure represents variable expenses which are paid in
the month after they were incurred. Rs.1,64,000 per month is depreciation and is included in
the 65% which represents fixed costs. The payment of fixed costs is made in the month in which
the cost is incurred.
6. Selling and administration overhead which is payable is paid in the month it is incurred
Rs.l5,000 each month is depreciation
7. Corporation tax of Rs.7,50,000 is payable in January.
8. A dividend is payable in March; Rs.5,00,000 net. (Ignore advance corporation tax).
9. Value added tax (VAT), payable monthly one month later than the sales are made, is to be
calculated as follows:
Output Tax
7/47ths of the sales including VAT figure
Less: Input Tax of Rs.1,36,000 for January
Rs. 1,25,000 for February and
Rs. l ,2l,000 for March
10. Capital expenditure commitments are due for payment:
Rs.l0,00,000 in January and Rs.7,00,000 in March.
Both are payments for machinery to be imported from Japan and thus no VAT is involved.
ll. Assume that overdraft facilities, if required, are available
12. The cash at bank balance at December 31 is expected to be Rs. l4,50,000
You are required:
(a) to prepare, in columnar form, cash budgets for each of the months of January, February and
March
(working to nearest Rs.000)
114

(b) to recommend action which could be suggested to management to effect

(i) a permanent improvement in cash flow, and
(ii) a temporary solution to minimize any overdraft requirements revealed by your answer to (a)
above.
Q~5
Following budgeted sales values have been extracted from the budget of AZ Limited for the year
ending 31st December 2002:
April Rs.4,00,000
May Rs.4,50,000
June Rs.5,20,000
July Rs.4,20,000
August Rs.4,80,000
The contribution / sales ratio is 40% Fixed costs are budgeted to be Rs.l2,00,000 for the year
arising at a constant rate per month and including depreciation of Rs.3,00,000 per annum.
40% of each month`s sales are produced in the month prior to sale, and 60% are produced in
the month of sale. 50% of the direct materials required for production are purchased in the
month prior to their being used in production.
30% of the variable costs are labour costs, which are paid in the month they are incurred.
60% of the variable costs are direct material costs. Suppliers of direct materials are paid in the
month after purchase.
The remaining variable costs are variable overhead costs. 40% of the variable overhead costs are
paid in the month they are incurred, the balance being paid in the month after they are
incurred.
Fixed costs are paid in the month they are incurred.
Capital expenditure expected in June is Rs.l,90,000
Sales receipts for the three months of May, June and July are budgeted as follows:
May

Rs.4,0l,700

June

Rs.4,50,280

July

Rs.4,25,880

The bank balance on l May 2002 is expected to be Rs.40,000

Requirement:
Prepare a cash budget for AZ Limited.
115

Your budget should be in columnar format showing separately the receipts, payments and
balances for each Of the months of May, June and July 2002.
Q~6
KRISHNA Co. has a annual cash outflow of Rs. 37.5 lakhs arising uniformly during the year. lt
plans to meet these demands for cash by periodically selling marketable securities from its
investment portfolio. The firms marketable securities are invested to earn l2% Transaction cost
of convening investments to cash is Rs. 40.
(a) Use Baumol model to find out the optimal transaction size for transfer from marketable
securities to cash.
(b) What will be the Companys average cash balance?
(c)How many transfers per year will be required?
(d)What is the same interval between two transfers?
(e) What will be the total transaction cost during the year ?
Q~7
JPL has two dates when it receives its cash inflows. i.e., Feb. l5, and Aug. 15. On each of these
dates. It expects to receive Rs. 15 crore. Cash expenditures are expected to be steady
throughout the subsequent 6 month period. Presently, the ROI in marketable securities is 8 per
cent annum, and the cost of transfer from securities to cash is Rs. 125 each time a transfer
occurs.
(i) What is the optimal transfer size using the EOQ model? What is the average cash balance?
(ii) What would be your answer to part (i) if the ROI were I2 per cent per annum and the transfer
Costs
were Rs. 75? Why do they differ from those in part (i)?
Q~8
VAMANA & Co. currently has a centralized billing system. All customers make payments to the
central billing location. it requires, on the average. 4 days for customers` mailed payment to
reach the central location. An additional l.5 days are required to process payments before a
deposit can be made. The firm has a daily average collection of Rs. 5,00,000. it has recently
analysed the possibility of initiating a lock-box system.
It is estimated that with a loc-box system, customers` mailed payments would reach the receipt
location 2.5 days sooner. Further, the processing time could be reduced by l additional day,
because each lock-box bank would pick up mailed deposits twice daily. From the above
information, answer the following questions :
(a) Determine the reduction in cash balances that can be achieved through the use of a lock-box
system.
116

(b) Determine the opportunity cost of the present system, assuming a 5% return on short-term
instruments.
(c) If the annual cost of the lock-box system were Rs. 75.000, should such a system be initiated?
Q-9
Hypothetical Ltd. uses a continuous billing system that results in an average daily receipt of Rs.
40,00,000. It is contemplating the institution of concentration banking, instead of the current
system of centralized billing and collection. It is estimated that such a system would reduce the
collection period of accounts receivable by 2 days.
Concentration banking would cost Rs. 75,000 annually, and 8 per cent can be earned by the
firm on its investments. It is also found that a lock-box system could reduce it overall collection
time by 4 days and would cost annually Rs. l,20,000.
(i) How much would cash be released with the concentration banking system?
(ii) How much money can be saved due to reduction in the collection period by 2 days? Should
the firm institute the concentration banking system?
(iii) How much would cash be freed by lock-box system?
(iv) How much can be saved with lock-box?
(v) Between concentration banking and lock-box system, which is better?
Q-l0
The _following data pertain to a shop. The owner has made the following sales forecasts for the
first 5 months of the coming year :
January

Rs. 40,000

February

45,000

March

55,000

April

60,000

May

50,000

Other data are as follows :

(a) Debtors and creditors balances at the beginning of the year are Rs. 30.000 and Rs l4_000_
respectively The balances of other relevant assets and liabilities are :
Cash balance
Stock
Accrued sales commission

Rs. 7.500
51,000
3,500

(b) 40 per cent sales are on cash basis. Credit sales are collected in the month following sale.
117

(c) Cost of sales is 60 per cent of sales.

(d) The only other variable cost is a 5 per cent commission to sales agents. The sales
commission is paid in month after it is earned.
(e) Inventory (stock) is kept equal to sales requirements for the next two months` budgeted
sales.
(f) Trade creditors are paid in the following month after purchases.
(g) Fixed costs are Rs. 5,000 per month, including Rs. 2,000 depreciation.
You are required to prepare a cash budget for each of the first three months of coming year.
Q~11
Prepare the cash budget for .July-December from the following information;
(i) The estimated sales, expenses, etc. are as follows : (Rs. lakh)
Sales
Purchases
Wages and salaries
Miscellaneous expenses
Interest received
Sales of shares

(ii)

June
35
14
12
5
2
--

July
40
16
14
6
---

August
40
17
14
6
-20

Sept.
50
20
18
6
2
--

Oct.
50
20
18
7
---

Nov.
60
25
20
7
---

Dec.
65
28
22
7
2
--

20 per cent of the sales are Oh cash and the balance on credit.

(iii) 1 percent of the credit sales are returned by the customers, 2 per cent debts are
uncollectable; 50 per cent of the good accounts receivable are collected in the month ofthe sales
and the rest during next month.
(iv) The time-lag in payment of miscellaneous expenses and purchase is one month. Wages and
salaries are paid fortnightly with a time-lag of I5 days.
(v) The company keeps a minimum cash balance of Rs. 5 lakhs. Cash in excess of Rs. 7 lakh is
invested in government securities in multiples of Rs. l lakh. Shortfalls in the minimum cash
balance are made good by borrowings from the banks. Ignore interest received and paid.
Q~12
A firm is contemplating various actions, each of which will have different effects on the average
age of inventory, accounts receivable and accounts payable. Which of the following 4 plans is
better if the changes indicated below are expected ?
Particulars
Plan

Change in average age

Inventory (days)
Accounts receivable (days)

Accounts payable (days)

118

A
B
C
D

+30
-10
0
-15

-20
0
-30
+10

+35
-20
+5
+15

Q~13
Hanuman Ltd has an annual turnover of Rs. 84 crores and the same is spread over evenly each
of the 50 weeks of the working year. However, the pattern within each week is that the daily rate
of receipts on Mondays and Tuesdays is twice that experienced on the other three days of the
week. The cost of banking is estimated at Rs. 2,500. It is suggested that banking should be done
daily or twice a week Tuesdays and Fridays as compared to the current practice of banking only
on Fridays, Hanuman Ltd. always operates on bank overdraft and the current rate of interest is
15% per annum. This interest charge is applied by the bank on a simple daily basis.
Ignoring taxation, advise Hanuman Ltd. the best course of banking. For your exercise, use 360
days a year for computational purposes.

FINANCIAL ANALYSIS
(RATIO ANALYSIS)
Techniques of financial Statement Analysis
The following techniques are adopted in analysis of financial statements of a business
organization :

Comparative statements
Common size statements
Trend Analysis
Funds flow Analysis
Cash flow Analysis
119

 Ratio Analysis
Value Added Analysis
Comparative Financial Statements : Comparative financial statements are statements of
financial position of a business designed to provide time perspective to the consideration of
various statements of financial position embodied in such statements. Comparative statements
reveal the following :
(i) Absolute data (money values or rupee amounts).
(ii) Increase or reduction in absolute data (in terms of money values)
(iii) Increase or reduction in absolute data (in terms of percentages)
(iv) Comparison (in terms of ratios)
(v) Percentage of totals
(a) Comparative Income Statement or Profit and Loss Account: A comparative income
statement shows the absolute figures for two or more periods and the absolute change from one
period to another. Since the figures are shown side by side, the user can quickly understand the
operational performance of the firm in different periods and draw conclusions.
(b) Comparative balance sheet : Balance sheets as on two or more different dates are used for
comparing the assets, liabilities and the net worth of the company. Comparative balance sheet is
useful for studying the trends of an undertaking.
Financial statements of two or more firms can also be compared for drawing inferences. This is
called inter-fim1 comparison.

Advantages
Comparative statements indicate trends in sales, cost of production, profits etc. and help
the analyst to evaluate the performance of the company.
Comparative statements can also be used to compare the performance of the firm with the
average performance of the industry or inter-firm comparison. This helps in identification
o f the weaknesses of the firm and remedial measures can be taken accordingly.

Weaknesses
Inter-firm comparison can be misleading if the firms are not identical in size and age and
when they follow different accounting procedures with regard to depreciation, inventory
valuation etc.
Inter-period comparison may also be misleading if the period has witnessed changes in
accounting policies, inflation, recession etc.

Common size Statements: The figures shown in financial statements viz. Profits and Loss

Account and Balance Sheet are converted to percentages so as to establish each element to the
total figure of the statement and these statement are called Common Size Statements. These
statements are useful in analysis of the performance of the company by analyzing each
120

individual element of the total figure of the statement. These statements will also assist in
analysing the performance over years and also with the figures of the competitive firm m the
industry for making analysis of relative efficiency. The following statements show the method of
presentation of the data.

Trend Analysis : In t:rend analysis ratios of different items are calculated for various periods
for comparison purpose. Trend analysis can be done by trend percentages, trend ratios and
graphic and diagrammatic representation. The trend analysis is a simple technique and does
not involve tedious calculations.

Ratio Analysis : Introduction

The financial statements viz., the income statement, the Balance Sheet. The Income Statement,
the Statement of retained earnings and the Statement of changes in financial position report
what has actually happened to earnings during a specified period. The balance sheet presents a
summary of financial position of the company at a given point of time. The statement of retained
earnings reconciles income earned during the year and any dividends distributed with the
change in retained earnings between the start and end of the financial year under study. The
statement of changes in financial position provides a summary of funds flow during the period
of financial statements.
Ratio analysis is a very powerful analytical tool for measuring performance of an organization.
The ratio analysis concentrates on the inter-relationship among the figures appearing in the
aforementioned four financial statements. The ratio analysis helps the management to analyse
the past performance of the firm and to make further projections. Ratio analysis allow
interested parties like shareholders, investors creditors. Government and analysis to make an
evaluation of certain aspects of a firm`s performance.
Ratio analysis is a process of comparison of one figure against another. which make a ratio, and
the appraisal of the ratios to make proper analysis about the strengths and weaknesses of the
firms operations. The calculation of ratios is a relatively easy and simple task but the proper
analysis and interpretation of the ratios can be made only by the skilled analyst. while
interpreting the financial information, the analyst has to be careful in limitations imposed by
the accounting concepts and method of valuation. Information of non-financial nature will also
be taken into consideration before a meaningful analysis is made.
Ratio analysis is extremely helpful in providing valuable insight into a companys financial
picture. Ratios normally pinpoint a business strengths and weakness in two ways :
Ratios provide an easy way to compare today`s performance with past.
Ratios depict the areas in which a particular business is competitively advantaged or
disadvantaged through comparing ratios to those of other business of the same size
within the same industry.

Ratios are not everything in financial analysis. Discuss, [or]

Outline the limitations of Financial Ratio Analysis.
Ratios are useful tools for financial analysis. However the following limitations do exist.
121

(a) Window Dressing: Ratios depict the picture of performance at a particular point of time.
Sometimes, a business can make year-end adjustments in order to result in favourable ratios
(e.g. current ratio, operating profit ratio, debt-equity ratio etc.)
(b) Impact of Inflation: Financial Statements are affected by inflation. Ratios may not depict
the correct picture. For example, fixed assets are accounted at historical cost while profits are
measured in current rupee terms. In inflationary situations, the Return on Assets or Return on
Capital Employed may be very high due to less investment in fixed assets. Ratios may not
indicate the true position in such situations.
(c) Product Line diversification: Detailed ratios for different divisions, products and market
segments etc. may not be available to the users in order to make an informed judgement. For
example, loss in one product may be set off by substantial profits in another product line. But,
the overall net profit ratio may be favourable.
(d) Impact of Seasonal Factors : When the operations do not follow a uniform pattern during
the financial period, ratios may not indicate the correct situation. For example, if the peak
supply season of a business is between February to June, it will hold substantial stocks on the
balance sheet date. This will lead to a very favourable current ratio on that date. But the
position for the rest of the year may be entirely different.
(e) Differences in Accounting Policies: Different firms follow different accounting policies, eg.
rate and methods of depreciation. Strait-jacket comparison of ratios may lead to misleading
results.
(F) Lack of Standards: Even though some norms can be set for ratios, there is no uniformity as
to what an "ideal" ratio is. Generally it is said that Current Ratio should be 2:l. But if a Hun
supplies mainly to Government Departments where debt collection period is high, a Current
Ratio of 4:1 or 5: l, may also be considered normal.
(g) High or Low: A number by itself cannot be "high" or "low". Hence, a ratio by it sell cannot
become "good" or "bad". The line of difference between "good ratio" and "bad ratio" is very thin.
(h) Interdependence: Financial Ratios cannot be considered in isolation. Decision taken on the
basis of one ratio may be incorrect when a set of ratios are analysed.

Multiple discriminate analysis

The traditional study of performance of a firm through financial ratios provide lor working out a
number of separate clues - such as ratios to sickness or failure. It would be more useful to
combine the different ratios into a single measure of the probability of sickness, failure or
insolvency. The technique of multiple discriminate analysis (MDA) helps to do so.
Edward I. Altman developed an empirical model to predict corporate bankruptcy using Multiple
Discriminate Analysis (MDA), Altman stated that univariate ratio analysis is susceptible to
faulty interpretation and is potentially confusing because the order of importance of financial
ratios was not clear. Obviously, an independent assessment of some ratios does not lead to any
conclusive opinion without analysing the behaviour of other relevant ratios. Altman derived the
final discriminate function as follows:
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Z = l.2 X; + l.4X2+ 3.3X3+ 0.60X4+ .999X5

Where
X; = Working capital/Total Assets
X2 = Retained Earnings/Total Assets
X3 = EBIT/Total Assets
X4= Market Value of Equity/Book value of Total Debt
X5 = Sales/Total Assets
Z = Overall index, Z > 2.675 is non-bankrupt region,
Z 5 2.675 is the bankruptcy region and 1.81 5 Z 2.99 is the zone of ignorance.

QUESTION
Q-1
From the following details, prepare Comparative Balance Sheets in vertical form showingsource and employment of fund with broad break-up of the components of working capitals:31-3-2002
Current Ratio
Liquid Ratio
Fixed Assets

to

2.50
1.20
Proprietary 0.70

Fund
Bank Overdraft
Working Capital

31-3-2003
1.80
0.60
0.80

Rs. 80,000
Rs. 2,25,000

Rs. 1,20,000
Rs. 2,40,000

There was no term loan or intangible asset.

Commence on fund utilization.
Q~2
Based on the following information of the financial ratios, prepare Balance Sheet of Star
Enterprises Ltd. As on December 31, 2002. Explain your working and assumptions:
Current Ratio

2.5

Liquidity Ratio '

1.5'

Net Working Capital

Rs.6,00,000

Stock Turnover Ratio

5
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Ratio of Gross Profit to Sales

20%

Turnover Ratio to Net Fixed Assets

Average Debt Collection Period

2.4 months

Fixed Assets to Net Worth

0.80

Long -term Debt to Capital and Reserve

7/25

Q-3
Prepare Balance Sheet and Profit and Loss Account from the following information:
Capital
Working Capital
Bank Overdraft

Rs.
4,00,000
1,80,000
30,000

There is no fictitious asset. In current assets there is no asset other than stock, debtors and
cash.
Closing stock is 20% higher than opening stock.
l. Current Ratio - 2.5
2. Quick Ratio - 2
3. Proprietary Ratio 0.6
4. (Fixed Assets : Proprietary Fund)
5. Gross Profit Ratio - 20% (to Sales)
6. Stock Velocity 5
7. Debtors Velocity - 73 days
8. Net Profit Ratio - 10% of Capital employed
Q-4
From the information relating to Wise Limited, you are required to prepare its summarized
Balance Sheet'
(a) Current Ratio

2.5

(b) Acid Test Ratio

1.5

(c) Gross Profit/ Sales Ratio

0.2

(d) Net Working Capital /Net Worth Ratio

0.3
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(e) Sales / Net Fixed Assets Ratio

2.0

(f) Sales / Net Worth Ratio

1.5

(g) Sales/ Debtors Ratio

6.0

(h) Reserves /' Capital Ratio

1.0

(i) Net Worth / Long - term Loan Ratio

20.0

(j) Stock Velocity

2 months

(k) Paid - up Share Capital

Rs.10 lakhs

Q~5
From the following particulars prepare the balance sheet of Shri Mohan Ram & Co. Ltd.: _
Current Ratio

Working Capital

Rs.4,00,000

Capital block to Current Assets

3:2

Fixed Assets to Turnover

1:3

Sales Cash /Credit

1:2

Debentures / Shares Capital

1:2

Stock Velocity

2 months

Creditors Velocity

2months

Debtors Velocity

3months

Gross profit Ratio

25% (to sale)

Capital Block:
Net profit

10% of turnover

Reserve

2 (1/2) % of turnover

Q-6
From the following information and Ratios, prepare the profit and loss account for the year
ended 31st March, 2002, and the Balance Sheet as on that date of M/s. Stan & Co., an export
company:
Current Assets to Stock

3:2

Current Ratio

3.0
125

Acid Test Ratio

1.00

Financial Leverage

2.20

Earnings per Share (each of Rs.10)

10.00

Book Value per Share (Rs)

40.00

Average Collection Period (assume 360 days in the year) 30. days

30, days

Stock Turnover Ratio ( Sales/ Stock)

5.00

Fixed Assets to Turnover Ratio

1.20

Total Liabilities to Net Worth

2.75

Net Working Capitals.

10.00 lakhs

Net profit to sales

10%

Variable Cost

60%

Long Term Loan Interest

12%

Taxation

NIL

Q~7
From the following particulars you are required to prepare the balance sheet of a Zinc company.
Fixed assets (alter writing off 30%)

Rs. 1050000

Fixed assets turnover ratio ( on cost of sales )

Finished goods turnover ratio (on cost of sales)

G.P rate on sales.

25%

Net profit (before interest ) to sales

8%

Fixed charges cover (debenture interest 7%)

Debt collection period

1.5 months

Material consumed to sales

30%

Stock of raw materials (in terms of months consumption)

Current ratio

2.4

Quick ratio

1.0

Reserves to capital ratio

0.21

Q:8
From the following information prepare the projected Trading and Profit and Loss Ac
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financial year ending March 31, 2008 and the projected Balance Sheet as on that date :Gross Profit Ratio ...........................................................

25%

Net Profit to Equity Capital .................,.............................

10%

Stock Turnover Ratio .................................................,......

5times

Average Debt Collection Period ..... ...................................

2months

Creditors Velocity ..........................................................,..

3months

Current Ratio ............................................,.....

Propriety 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 ............................

Cost of goods sold consists of 40% for materials and balance for Wages and Overheads. Gross
profit
Rs. 6,00,000. Working notes should be clearly shown.
Q-9
Form the following information, draw the Balance Sheet of M/s. Ravi & Co., as on 31" March,
2007 :
Current ratio

2:1

Liquid ratio

1:1

Return on capital employed

10%

Fixed assets turnover ratio

8:5

Closing stock was 12.5% of sales

Owner's equity to fixed assets

8:15

Debtors turnover

1month

Debt equity ratio

5:4

127

For the year ended 31 March, 2007, M /s. Ravi & Co. made a profit of Rs.1,00,000 after paying
interest of Rs.1,20,000 on tem1 loan but before tax. Tax paid for the year was Rs.40,000. Bank
balance stood at Rs. l,00,000 besides stock and debtors of the concern.
Q: 10
Following particulars have been extracted from the Balance Sheet and Profit and Loss Account
of a Company:
Rs.
14% Debentures

2,00,000

15% Loans from U.P.F.C.

4,00,000

10% Preference Shares

3,00,000

Equity Shares of Rs.l0 each

8,00,000

Profit after tax ( @ 40%)

2,70,000

Depreciation

60,000

Preliminary Expenses written off

10,000

Equity Dividend @ 20% Lease Rent p.a.

80,000

Loan instalment of Rs. l ,00,000 is payable at the end of the year. Dividend Tax 10%
Calculate : (i) Interest Coverage Ratio (ii) Dividend Coverage Ratio (iii) Equity shareholders
coverage (iv) Debt-Service Coverage Ratio and (v) Total Cash Flow C overage.

Q-11
(1)

Bank Balance
Cash
Investment (Total)
Current Liabilities
Trade Investments
Market value of quoted Total investments

Yr.1

Yr.2

RS.
50,000
15,000
1,50,000
4,00,000
20,000
1,35.000

Rs.
70,000
5,000
1,20,000
5,00,000
30,000
96,000

Calculate Absolute Cash Ratio.

(2)
Relevant figures derived from the Balance sheet of A Ltd. as on 31-3-2007 are as under:
128

Total Assets (including preliminary Expenses of Rs. 10 lacs) = Rs. 190 lacs
Cash in hand

RS.5 Lacs.

Bank Balance

Rs12 Lacs.

Total Investments.

Rs.6 Lacs.

Details of Investments : Trade - Rs.4 Lacs, Non-Trade Rs.2 Lacs, Quoted Rs.3 Lacs out of which
Non- Trade is Rs.l.50 Lacs. Market quotations are Rs.4.50 Lacs of which R.l.75 Lacs are for NonTrade Investments. Other investments are not readily marketable. Calculate Cash Position to
Total Assets Ratio. Industry average if the ratio is. 18
(3)
Following is Profit and Loss Account of A. B. C. Ltd. for the year ended 31st March, 2007.
Rs.
4,00,000
16,00,000
12,00,000
32,00,000

To Opening Stock
To Purchases
To Gross Profit

To
To
To
To
To
To
To
To
To
To

salaries, allowance and bonus

Stationery
Telegram, Postage Telephones
Advertisements
Commission
Depreciation
Preliminary expenses written off
Loss on sell of fixed assets
Provision for taxation
Net Profit

3,20,000
32,000
8,000
8,000
4,000
16,000
4,000
8,000
4,00,000
4,00,000
12,00,000

By Sales
By Closing stock

Rs.
24,00,000
8,00,000
32,00,000

By Gross Profit

12,00,000

12,00,000

Advance tax paid Rs 3.40.00(l. Cash Reservoir Rs 1,40,000. Find out average daily cash
expenses and calculate cash interval
Q-12
The balance sheet of A company Ltd as on 3 l 3.2007 is as under :-

Liabilities
Share Capital:
Equity Shares
14% Preference share
General Reserve

Rs.
1,00,000
50,000
20,000

Assets
Fixed Assets:
At cost
2,50,000
Less Depreciation
80,000
Stock in Trade

Rs.

1,70,000
30,000
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12% Debenture
Current Liabilities

30,000
50,000
2,50,000

Sundry Debtors
Bank

40,000
10,000
2,50,000

The company wishes to forecast Balance Sheet as on 31.3.2008

The following additional particulars are available (i) Fixed assets costing Rs, 50.000 have been installed on I 4 07. but the payment will be made
on 31.3.08.
(ii) The Fixed Assets Turnover Ratio on the basis of gross value of fixed assets would be I 5
(iii) The Stock Turnover Ratio would be l4.4 (calculated on the basis of average stock.
(iv) The break-up of cost profit would be as follows ; Materials

40%

Labour

25%

Manufacturing Expense

10%

Office and Selling Expense

10%

Depreciation(items of trading account)

Profit

5%
10%
100%

The profit is subject to interest and taxation @ 50%

(V) Debtors would be 1/9 of sales.
(v) Creditors would be 1/5 of material consumed.
(vii) In March 2003, a dividend @ 10% on equity capital would be paid.
(viii) Rs, 25,000 12% debentures have been issued on l.4_2007.
Prepare the forecast Balance Sheet as on 31.1.2008 and show the following resultant ratio :(a) Current Ratio.
(b) Fixed Assets/Net Worth Ratio, and
(c) Debt Equity Ratio.
Q~l3
Given below the Profit and Loss A/c and Balance Sheet of Sewak Ltd.:

130

Profit and loss A/c for the year ended 31st March,2008
Particular
To
To
To
To
To
To
To
To
To
To
To
To

Opening Stock
raw material consumed
wages and salaries
manufacturing
gross profit
salaries
stationery
Printing, Advertisement
electricity
selling and distribution
interest
net profit

Amount Rs. Particulars

Amount (Rs. In

In Lakhs
50
400
200
150
475
1,275
50
2
4
0.5
1
90
329
477.0

By sales (net of excise)

By closing stock

Lakhs)
1,200
75

By
By
By
By

1,275
475
0.5
0.5
1.0

gross profit
miscellaneous Income
profit on sale of investment
Interest/Div. From investment

477.0

Liabilities

Amount Rs. Assets

Amount (Rs.
In lakhs)

Share Capital
Reserves and Surplus
10% Debentures
Current Liabilities and Provisions

In lakhs
400
100
900
200

Fixed Assets
Less : Depreciation
Investment
Trade Investment
Others
Current Assets, Loans and
Advances
Preliminary Expenses

1,600

800
200
200
300
100
1,600

You are required to find out profitability ratio and compare the result with following industry
average ratios.
ROI

40%

Gross profit ratio

37.42%

Operating profit ratio

26.52%

Net profit ratio

30.12%

Return/Sales

33.12%

Q~14
131

Given below the profit and Loss Statement of OM Ltd. For the year ended 31 st March, 2007 and
Balance sheet as on that date.

Rs. In lakhs
Sales
Less : Cost of goods sold
Gross profit
Less : Administrative Expenses
Selling & Distribution Expenses
Finance Charge
Depreciation
Profit before tax
Less : Tax provision
Net profit
Less : Proposed dividend
Retained Earnings

240
545
280
540

Rs. In lakhs
7,850
5,232
2,618

1,605
1,013
500
513
400
113

Balance sheet
Liabilities

Rs.

In Rs.

lakhs
Share capital (Rs. 10 each)
Reserve Surplus
Add :Retained Earning
Secured loans
Unsecured loans
Current liabilities and
provisions :
Sundry Creditor
550
Tax Dividend
500
Proposed Dividend 400

2,000
113
2,500
1,500

lakhs
4,000
2,113

1,450
11,563

In Assets
Gross Block
Less : Accumulated depn.
Net Block

Rs.
lakhs
6,550
1,540

In Rs.

In

lakhs

5,010

Investment
Stock

2,500
1,500

Debtors
Cash at Bank
Cash at hand

1.800
700
53

4,504
11,563

You are required to show the following ratios:

l.

Gross yield percentage

2.

Market value to book value per share

3.

Price-earning ratio

4.

Market price to cash flow

Market price per share may be taken as Rs. 30 which was arrived at by taking average share
price for the month of March, 2000.
132

Q~15
A Ltd. and B Ltd. are two Companies belonging to the same industry. In 2007~08 each of them
has maintained the inventory almost at the same level at the beginning of the year.
The industry has developed the following accounting ratios for inter-firm comparison:
Current Ratio 1.8; Liquid Ratio 1.1 (liquid liability is taken after excluding overdraft, Gross
Profit Ratio to Sales .25 (after considering only material cost); Return on Own Capital 40;
Debtors Velocity 80 days;
Creditors Velocity 75 days and Stock turnover 4 times.
From the following details of A Ltd. and B Ltd. relating to 2007-08 comment upon the financial
management and operational efficiency of the two companies in terms of the norms of the
industry as stated above :
Sales
Bank overdraft
Debtors velocity
Gross profit % on sales (considering only material cost)
Stock
Expenses
Own capital velocity (with respect to sales)
Trade creditors
Expenses creditors
Liquid assets (other than Book Debts)

A Ltd.
Rs. 250 lakhs
Rs. 25 lakhs
3 months
20%
Rs. 35 lakhs
Rs. 30 lakhs
8
Rs. 65 lakhs
Rs. 3 lakhs
Rs. 4 lakhs

B Ltd.
Rs. 200 lakhs
Rs. l0 lakhs
2 months
Rs.
Rs.
2
Rs.
Rs.
Rs.

40 lakhs
25 lakhs
28 lakhs
2 lakhs
8 lakhs

Note : For calculation of velocity in days 365 in a year have been considered in all the cases.
Q~16
In connection with a proposal to secure additional finance for meeting its working capital
requirements, the following figures have been projected to a batik by a borrower. The figures
have been adjusted for borrower, dept redemption and interest payments:
Current Ratio

Debt Equity
Ratio
Return on
Investment

Borrower
Industrys
Average
Borrower
Industrys
Average
Borrower
Industrys
Average

2000
2.0

2001
2.0

2002
2.5

2003
2.2

2004
2.0

2005
2.5

2006
2.0

1.8
1.8

1.8
1.8

2.0
1.6

2.0
1.6

2.5
1.5

2.5
1.5

2.5
1.2

1.5
20

1.5
20

1.8
18

1.8
18

1.8
15

1.6
15

1.8
18

18

18

20

20

18

18

18
133

You are required to ascertain the trend and interpret the result. Kindly indicate how the Bank
would react to the proposal of financing put forward by the borrower.
Q~17
Sumit Industries Ltd. had a tire during January 1995, that destroyed most of its accounting
records. Management asks you to try to prepare a balance sheet and an income statement for
the year ended December 31, 1994. You have been able to uncover the following accounting
data:
Balance sheet as on 31" December, 1994
Share Capital
Profit and Reserves
10% Debentures
Current liabilities
Bills payable

Rs.
2,00,000
3,00,000
?
?

Rs.
Fixed assets:
Net plant and equipment
Current assets:
Cash
Debtors
Inventory

?
?
?
?
?

Profit and Loss Account for the year ended 31st Dec. 1994
Cost of goods sold
Gross profit
Operating expenses
Net opening income
Interest
Net opening income
Income tax at 50%
Net income after tax

Rs.
?
?
11,25,000
?
?
?
?
?
?
?
?
?

Net sales

Rs.
11,25,000

Gross profit

11,25,000
?

Net income before tax

?
?

Net income before tax

?
?
?

Others financial data:

(a) Debtors at the beginning of 2007 were Rs.1,00,000 and based on a 360 day year, it took
40 days to collect accounts receivable during 2007.
(b) Gross margin was 30 percent of sales for 2007.
(c) Inventory at the beginning of 2007 was Rs.2,37,500 and the inventory turnover for 1994
was 3.15.
(d) Total debt to equity for 2007 was 50 percent.
(e) For 2007, operating expenses were 6% of sales.
134

(f) Interest was earned 20 times during 2007.

(g) The acid - test ratio for 2007 was 3.75.

You are required to:

Reconstruct balance sheet as on 31 December 2007 and profit and loss account for the year
2007 using the above financial data only.

FUND FLOW
In View of recognized importance of capital inflows and outflows, which often involve large
amounts of money should be reported to the stakeholders. the funds flow statement is devised.
This statement is also called Statement of Sources and application of funds and statement of
changes in financial Position'
The funds flow statement contain all the details of the financial resources which have become
available during an accounting period and the ways in which those resources which those
resources have been used up. This statement discloses the amounts raised from various sources
of finance during a period and then explains how that finance has been used in the business.
This statement is valuable in interpretation of the accounts.
It is a very useful too in analysis of financial statements which analyses the changes taking
place between two balance sheet dates. The statement analyses the changes between the
opening and closing balance sheets for the period.
A balance sheet sets out the financial position at a point of time, setting liabilities from which
funds have been raised against assets acquired by the use of those funds. A funds flow
statement analyses the changes which have taken place in the assets and liabilities during
certain period as disclosed by a comparison of the opening and closing balance sheets.

Use of Fund Flow Statement

To determine financial consequences of operations : Funds Flow Analysis determines the
financial consequences of business operations. In the following cases, Funds Flow analysis
helps the management to understand the movement of funds and in effective funds
management
(a) Many a time, a company inspire of earning large profits may have unsatisfactory liquidity
position. The reasons for such a position and the financial consequences of business
operations can be ascertained with the help of funds flows statement.
135

(b) The company may be incurring losses but its liquidity position is sound or the firm will be
investing in fixed assets despite losses.
(c) The firm may declare dividend inspire of losses or low profits.
(d) The profit earned by the firm from different sources is not easily understood by the
management.
(e) There may be sufficient cash in the business. But how such high liquidity is existing is
not
(f) known.
To fill financial blind spots - The funds flow statement is designed to fill financial blind spots
of the operating statement. It translates the economic consequences of operations into financial
information as a basis for action.
Working capital utilization - The funds flow statement helps the management in assessing the
activity of working capital and whether the working capital has been effectively used to the
maximum
extent in business operations or not. The statement also depicts the surplus or deficit in
working capital than required. This helps the management to use the surplus working capital
profitably or to locate the sources working capital in case of scarcity.
To aid in securing new finances : A statement of changes in financial position in useful for the
creditor in considering the companys request for new term loan.
Helps in allocation of financial resources : Funds flow statement helps the management in
talking decisions regarding allocation of the limited financial resources among different projects
on priority basis.
late the time factor to
Helps in deciding the urgency of a problem : Funds flow analysis helps to relate the time
factor to financial planning. This enables the management to identify critical points throughout
the passage Of time. The management as also the outsiders concern themselves with the
information system geared up towards strategic planning and control of the firm. This places
emphasis on the importance of the statement of changes in financial position as the behaviour
of funds flow figures relates to the criteria upon which management strategy is based.
Helps in evaluation of operational issues : The statement of changes functions as an
analytical guide for evaluating operational issues. The statement enables the management to
ascertain in which the study of trends of success or failure of operations and available
resources.

Drawbacks of Funds flow analysis

Historical nature : The funds flow statement is historical in nature like any other financial
statement. It does not estimate the sources and application of funds for the near future.
Structural changes are not disclosed : The funds flow statement does not disclose the
structural changes in financial relationship in a firm nor it discloses the major policy changes
136

with regard to investment in current assets and shout term financing. Significant additions to
inventories financed by short term creditors are not furnished in the statement as they are
offset by each other while computing net changes in working capital.
New items are not disclosed: The funds flow statement does not disclose any new or original
items which affect the financial position of the business. The funds flow statement simply
rearranges the data given in conventional financial statements and schedules.
Not relevant: A study of changes in cash is more relevant than a study of changes in funds for
the purpose of managerial decision making.
Not foolproof: The funds flow statement is prepared from the data provided in the balance
sheet and profit and loss account. Hence, the defects in financial statements will be carried over
to funds flow statement also.

Question
Q~1
The summarized balance sheets of Omega Ltd. As on 31 st March, 2002,2003 and 2004 are given
below:

Liabilities
Paid-up equity capital
Long-term borrowing:
-from banks
-from others
Current liabilities
Assets
Gross block
Less: Depreciation
Net block
Current assets
Profit & loss account

(Rs. In lakhs)
As on 31st March
1992
1993

1994

194

194

194

68
281
52
595

97
343
54
688

124
379
99
796

355
69
286
143
166
595

356
95
261
199
228
688

361
122
239
234
323

Prepare statement of net sources and uses of funds for the years ended on 31 st March, 2003 and
2004 and give your comments on the same.
Q~2
The financial position of the Alpha Company Ltd. as on 31 st December, 2007 and 31st December,
2008 and the profit and loss account for the year ended on 31st December, 2008 are given below:
137

Assets
Land and building
Plant and machinery
Less: Accumulated depreciation
Inventory
Debtors
Cash

2008
Rs.
1,50,000
2,20,000
(82,000)
1,25,000
40,000
70,000
5,23,000

2007
Rs.
1,00,000
2,00,000
(80,000)
90,000
45,000
50,000
4,05,000

Liabilities
Share Capital
Share premium
Reserves and surplus
Institutional loan
Debentures
Creditors
Salaries payable
Provision for tax
Provision for dividend

1,75,000
12,500
62,000
23,000
1,20,000
25,000
15,000
50,000
40,000
5,23,000
st
Profit and loss Account for the year ended 31 December, 2008
Rs.
Sales
Less: Cost of goods sold
Gross profit
Less: Operating expenses:
Office and administrative
Selling and distribution
Interest
Depreciation
Operating profit
Add: Gain on sale of plant
Total profit
Less: Income-tax
Net profit

45,000
25,000
12,000
22,000

75,000
7,500
17,500
15,000
1,50,000
30,000
10,000
60,000
40,000
4,05,000
Rs.
5,00,000
2,10,000
2,90,000

1,04,000
1,86,000
6,000
1,92,000
87,000
1,05,000

The additional information is given below:

During the year, plant costing Rs. 50,000 (accumulated depreciation of Rs. 20,000)
was sold.
The debentures of the face value of Rs. 30,000 were converted into share capital at per.
The Company paid a dividend of Rs. 40,000 and issued bonus shares of Rs. 20,000
during the year.
138

 The company further issued 5,000 shares of Rs. 10 each at a premium of Re. 1 per
share during the year.
You are required to prepare a statement of sources and application of funds.
Q-3
From the figures given below, prepare a statement showing the application and sources of funds
during the year 2007:
Assets
Fixed assets
Investment
Current assets
Discount on debentures

Liabilities
Share capital (Equity)
Share capital (Preference)
Debentures
Reserves
Provision for doubtful
Current liabilities

31st March,2006
Rs.
5,10,000
30,000
2,40,000
10,000
7,90,000

3,00,000
2,00,000
1,00,000
1,10,000
10,000
70,000
7,90,000

31st March, 2007

Rs.
6,20,000
80,000
3,75,000
5,000
10,80,000

3,50,000
1,00,000
2,00,000
2,70,000
15,000
1,45,000
7,90,000

You are informed the during the year:

A machine costing Rs. 70,000 (book at Rs. 40,000) was disposed off for Rs. 25,000
Preference share redemption was carried out at a premium of 25%
Dividend at 15% was paid on equity shares for the year 2006.
Further
The provision for depreciation stood at Rs. 1,50,000 on 31.3.2006 and at Rs. 1,90,000 on
31.3.2007
Stock which was valued at Rs. 90,000 as on 31.3.2006 was written up to its cost Rs.
1,00,000 for preparing the profit and loss account for 2007.

Q-4
The following balance sheets of Chandan Products Ltd. for the year 2006 and 2007 are
available:
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Liabilities
Share capital
General reserve
Capital reserve (profit on sale of investment)
Profit and loss account
7% debentures
Creditors for expenses
Creditors for supply of goods
Proposed dividend
Provision for taxation
Assets
Fixed assets
Less: Accumulated depreciation

Investments (at cost)

Stock (at cost)
Sundry debtors
(Less provision for

Rs.20,000

respectively)
Bills receivable
Pre payment of expenses
Misc. expenditure

2006
Rs.
6,00,000
2,00,000
---1,00,000
3,00,000
10,000
1,60,000
30,000
70,000
14,70,000

2007
Rs.
7,00,000
2,50,000
10,000
2,00,000
2,00,000
12,000
2,50,000
35,000
75,000
17,32,000

10,00,000 12,00,000
2,00,000
2,50,000
8,00,0 9,50,000

and

00
1,80,000
2,00,000

1,80,000
2,70,000

Rs.25,000 2,25,000

2,45,000

40,000
10,000
15,000
14,70,000

65,000
12,000
10,000
17,32,000

Other information:
i. During the year 2007, fixed assets (WDV Rs.10,000 depreciation written ot`fRs.30,000)
was sold for Rs. 8,000
ii. The proposed dividend of last year was paid in 2007.
iii. During the year 2007. Investments costing Rs_80_000 were sold and later in the year
investments of the same cost were purchased.
iv. Debentures were redeemed at a premium of l0% in 2007.
v. Liability for taxation for 2006 come to Rs.55.000
vi. During the year 2007, bad debts written off were Rs. 15,000 against the provision
account.
Prepare a funds - flow statement
Q~5
Following are the summarized balance sheets of the Ganges Ltd. as on 31 December, 2006 and
2007:
140

Balance Sheets
Liabilities
Share capital
General reserve
Profit and loss a/c
Bank loan
Sundry creditors
Provisions for taxation

2006
(Rs.000)
200
50
30.5
70
150
30

2007

Assets

250
60
30.6
--135.2
35

Land & building

Plant and machinery
Stock
Sundry debtors
Cash Balance
Bank balance
Goodwill

530.5

510.8

2006
(Rs.000)
200
150
100
80
0.5
----530.5

2007
190
169
74
64.2
0.6
8
5
510.8

The following additional information is available:

(a) During the year ended 31 Deeember,2007 (i)
Dividend of Rs.23_000 was paid
(ii)
Assets of other company were purchased for Rs.50,000 payable in shares. Assets
purchased were stock, Rs.20,000 and machinery Rs.25,000
(iii)
Machinery of Rs.8,000 was purchased in addition to that of (ii) above.
(b) (b) Depreciation written off during the year 2007 - Building Rs.l0,000; and machinery
Rs.l4,000
(c) The net profit for the year 2007 was Rs.66,l00
(d) Income - tax paid during the year 2007 was Rs.28,000 and provision of Rs.33,000 was
made to profit and loss account.
(e) Prepare statement of sources and application of funds for the year ended 31 st
December,1997 and a schedule setting out the change in working capital.
Q~6
You have been given the following financial statement of Adarji Estates Limited as at 31 st March ,
2007 and 31st March 2008Liabilities

31-3-2008

31-3-2007

Rs.
Sundry Creditors
2,98,000
Provision for taxation 1,72,000
Secured loan from ---Bank
Reserve and Surplus
Share capital:
Ordinary shares of
Rs. 100 each
Total

3,12,000

2,30,000
10,12,000

31-3-

31-3-

Rs.

2008

2007

2,51,450
65,000
87,000

Cash in hand
Sundry Debtors
Stock in Trade

Rs.
45,000
1,40,000
1,96,000

Rs.
1,30,000
90,700
1,42,500

1,48,000

Fixed Assets at cost

Less Depreciation
Investment
Prepaid expenses
Total

6,00,000
10,000
21,000
10,12,00

3,60,000
11,250
14,000
7,48,450

1,97,000
7,48,450

Assets

0
141

The following further information is available from the records i.

The position in respect of Reserves and Surplus is as under

Rs.
Balance as on 1st April, 1997

1,48,000

Net profit for the year

2,02,500
3,50,000

Less: Dividend (inclusive of tax on dividend)

38,500
3,12,000

(i) On 3151 March 2008 the accumulated depreciation on fixed assets was Rs. 1,550,000
and on 31st March, 2007 Bs. l.60.000. Machinery costing Rs.20,000 which was one-half
depreciated was discarded and written off in 2007-08. Depreciation for the year 2007-08
amounted to Rs.30,000
(ii) Investment costing Rs.5,000 were sold during the year 2007-08 for Rs.4,800 and
Government securities of the face value of Rs.4,000 were purchased during the year for
Rs.3,750.
(iii)
Interest on loan from bank during the year 2007-08 amounted to Rs.4,750.
You are required to prepare Cash flow Statement.

Q~7
From the information as contained in the Statement of income and the Balance Sheets of
G.C.Ltd., you are required to prepare a fund flow statement i.e. Statement of sources and
application of Funds and to describe the significant developments revealed by this statement.
You are also required to prepare Fund Flow Statement.

Statement of Income and reconciliation of earning for 2007-08 :

142

Liabilities

31.3.2004

Share capital
Reserve
Profit & Loss Account
Debentures
I.T. Provisions
Trade Creditors
Proposed Dividend

Rs.
4,00,000
1,00,000
50,000
1,00,000
40,000
70,000
40,000
8,00,000

Net sales
Less : Cost of sale
Depreciation
Salaries and Wages
Operating Expenses
Provision for taxation
Non-recurring income
Profit on sale of an item of equipment
Retained earnings
ASSETS
Balance in profit and Loss Account b/f

Rs.

19,80,000
60,000
2,40,000
80,000
88,000

Fixed assetsDivided declared and paid during the

Land
Year (Inclusive of tax on dividend)
Building and equipment
Current AssetsCash
Debtors
Stocks
Advances
Total

LIABILITIES:

Capital
Surplus in profit and loss account
Sundry

31.3.2003
Rs.
3,00,000
80,000
30,000
1,50,000
50,000
90,000
30,000
Rs.
7,30,000
25,20,000

Comparative

24,48,000
balance sheet72,000
12,000
84,000 As at 31-3-2008
As at 31-3-2007
1,51,000
Rs.
Rs.
2,35,000
48,000
3,60,000
60,000
1,68,000
2,64,000
7,800
9,07,800

96,000
72,600
5,76,000
1,62,000
72,000
1,86,000
96,000
9,000
10,35,000

As at

As at

31-3-2007

31-3-2008

Rs.
3,60.800
1,51,000
2,40,000

Rs.
4,45,000
1,62,400
2,34,000
143

Outstanding Expenses
Income tax payable
Accumulated
Depreciation

24,000
12,000
on 1,20,000

building & equipment

Total

9,07,800

48,000
13,000
1,32,000
10,35,000

Cost of equipment sold was Rs. 72,000

Q~8
From the following details relating to the accounts of z & Co. Ltd. Prepare statement of sources
and application of funds:-

Liabilities
Share Capital
Reserve
Profit & Loss Accounts
Debentures
I.T. Provisions
Trade Creditors
Proposed Dividend
Assets
Plant & Machinery
Discount on issue of Deb.
Prepaid Expenses
Investment
Sundry
Stock
Cash and Bank

31.3.2004

31.3.2003

Rs.
4,00,000
1,00,000
50,000
1,00,000
40,000
70,000
40,000
8,00,000
31.3.2004

Rs.
3,00,000
80,000
30,000
1,50,000
50,000
90,000
30,000
7,30,000
31.3.2003

Rs.
4,29,000
5,000
5,750
60,000
1,10,000
80,000
1,10,000
8,00,000

Rs.
2,98,000
8,000
4,000
1,00,000
1,60,000
50,000
1,10,000
7,30,000

1. 15% Depreciation has been charged in tl1e accounts on plant & Machi11ery.
2. Old machine costing Rs.50,000 (WDV Rs.20,000) have been sold for Rs.3 5,000
144

3. A machines costing Rs.l0,000 (WDV Rs.3,000) has been discarded.

4. Rs. 10,000 profit has been earned by sale of investments
5. Debentures have been redeemed at 5% premium.
6. Rs.45,000 income tax has been paid and against tax provision account.
Q~9
The Balance sheet of AB Ltd. As on 315' Marcl1 2003 and 2004 are as under:
31.3.200

31.3.200

31.3.200

31.3.200

Rs.

Rs.

Rs.

Rs.

60,000
1,00,000

47,000
75,000

90,000
10,000

191,000
35,000

Share Capital
Equity
1,50,000
8%
Redeemable 1,50,000

2,50,000
1,00,000

Fixed Assets
Goodwill
Land & Bldg.

preference
Reserve & Surplus
Gen. Reserve
Cap. Reserve
P & L A/c

-----------30,000
25,000
27,000

Plant & Machinery

Trade investment
Current Assets
Loans & Advances

-----------20,000
-----------18,000

Current Leb. &

Provisions
Sundry
Bills payable
Prov. For tax
Prov. Dividend

26,000
18,000
28,000
27,000
4,37,000

53,000
12,000
32,000
33,000
5,62,000

Stock

85,000

78,000

Sundry
Bills Receivable
Cash at bank
Cash in Hand

60,000
15,000
10,000
7,000
4,37,000

90,000
18,000
22,000
6,000
5,62,000

The following further particulars are given:

(1) In 2004 Rs,l8.000 depreciation has been Written off plant & Machinery no depreciation
has been charged on Land Building.
(2) A place of Land has been sold out and the balance has been revalue profit on such sale
and revaluation being transferred to capital Reserve. There is no other entry in capital
reserve account.
(3) A plant was Said for Rs.l2.000 (WDV Rs.15_000)
(4) Dividend received amounted to Rs.2,100 which includes pre acquisition dividend of
Rs.600
(5) An interim dividend of Rs.10.000 has been paid in 2004
You are required to prepare:145

(1) Statement of Sources and applications of funds and

(2) Statement of changes in working capital for the year 2004.
All working should form part of your answer.
Q~l0
The financial portion of M/s A and B on Jan. 1. and Dec. 31,2003 as follows:1st Jan.
Rs.
Current Liabilities for goods 36,000
Mrs. As Loan
----Loan from Bank
30,000
Hire Purchase Vendor
Capital
1,48,000

31st Jan.

1st Jan.

31st Jan.

Rs.
40,600
20,000
25,000
20,000
1,54,000

Rs.
4,000
35,000
25,000
20,000
50,000
80,000
-----2,14,000

Rs.
3,600
38,000
22,000
30,000
55,000
86,000
25,000
2,59,600

Cash
Debtors
Stock
Land
Building
Machinery
Delivery Van

2,14,000 2,59,600

The delivery van was purchased in December 2003 on Hire purchased basis a payment of
Rs.5,000 made immediately and the balance of the amount is to be paid in 20 monthly
instalment of Rs.l,000 each together with interest at the rate of 12% p.a. During the year the
partners withdrew Rs.26,000 for domestic expenditure. The provision for depreciation against
machinery as on 1.1.2003 was Rs.27,000 and 31.12.2003 Rs.36,000.
You are required to prepare the cash flow statement. Show also the fund flow statement.
Q~11
The balance sheet of Z Ltd. As on 31st December 2003 and 2004 are given below:

Liabilities
Share Reserve
Capital Reserve
General Reserve
Profit & Loss Account
Debentures
Current Liabilities
Provision for Income Tax
Proposed Dividend
Unpaid Dividend
Fixed Assets : At Cost

31.12.2003
3,00,000
-----1,70,000
60,000
2,00,000
1,20,000
90,000
30,000
----9,70,000
8,00,000

31.12.2004
4,00,000
10,000
2,00,000
75,000
1,40,000
1,30,000
85,000
36,000
4,000
10,80,000
9,50,000
146

Lee: Depreciation
Trade Investment
Current Assets
Preliminary Expenses

2,30,000
1,00,000
2,80,000
20,000
9,70,000

2,90,000
80,000
3,30.000
10,000
10,80,000

During the year 2004 the company:

(1) Sold one machine for Rs.25,000 the cost of which was Rs.50,000 and the depreciation
provided on it was Rs.21,000
(2) Provided Rs.95,000 as depreciation
(3) Redeemed 30% of the Debentures @ 103
(4) Sold some Trade Investments at a profit which was credited reserve.
(5) Decided to value stock at cost whereas previously the practice was to value stock at cost
10%. The stock value at 54,000 are included in op. Cur. Assets.
(6) Decided write off Fixed Assets costing Rs.l4.000 (fully depreciated)
You are required to prepare the statement of sources and application of funds during 2004,
showing the changes in the working capital.
Q~12
The following funds statement and additional information pertain to the operation of the Core
Ltd. During the year ended 31.3.2004.

CORE LIMITED
STATEMENT OF SOURCICS & APPLICATION OF NET INCOME WORKING
CAPITAL FOR THE YEAR ENDED MARCH 2004.

RS.
Sources:
Funds provided by operations
51,500
From issue of debentures
1,00,000
From issue of equity shares (15,000 72.210000 3,9l,500 2,40,000

RS.

3,91,500

fully paid)
Uses:
147

For acquisition of plant & equipment

1,70,000

For payment of dividend

Net Increase in Working Capital

15,000

1,85,000
2,06,500

Additional Information:
1. The Core Ltd. Was incorporated on April 1,2003
2. Plant was purchased on April 1,2003 and plant of the valued of Rs.l0,000 was destroyed
by tire on March 31,2004
3. Expected life of plant was 10 years. The company uses the straight line method of
depreciation.
You are required:
(a) To compute the balance of net income of Core Ltd.
(b) Prepare a balance sheet as on 31.3.2004
Q~13
Given below are the change in account balance of Ahmed a retailer in general merchandise for
the fiscal year ended October 31,2004

Cash
Debtors
Provision for doubtful debts.
Stock - in Trade
Equipment

Rs.
48,000
(8,000)
(200)
(15,000)
25,000

Accumulated Dep.
Account Payable
Accrued Liabilities
Ahmeds Capital

Rs.
10,000
(5,000)
400
44,800

The brackets denotes a decrease in the debit or credit balance normal to a given account
Debtors of Rs.1,000 were written off as uncollectable. Equipment costing Rs.7,500 was sold for
Rs.3,000 resulting in a loss of Rs.600. Net income including the loss on equipment amount to
Rs.64,800
You are required to prepare statement of sources and uses of fund.
Q~14
Below is given the balance sheet of Kotak & Co. Ltd. As at 31 st March 2004 and its estimated
profit & loss account for the year ended 31st March 2005.

148

BALANCE SHEET AS AT 31ST MARCH 2004.

Liabilities
Rs.
Share Capital (fully Paid)
7% Redeemable Pref. Share Rs.100
Equity Share
S
General Reserve
6%
C
O
Provision for Taxation
Proposed Dividend (equity)
ESTIMATED P & L A/C 2004-05
DEBIT
Opening Stock
Purchase
Wages
Manufacturing Exps.
Depreciation
Selling & Distribution Exps.
Office & Admini. Exps.
Interest
Goodwill W/O
Patents W/O
Prov. For Taxation
Preference Dividend
Proposed Dividend
Balance of Profit

Assets

Rs.
13,60,000
3,10,000
10,50,000
1,50,000
60,000
2,80,000
85,000
20,000
2,80,000

3,50,000
6,00,000
80,000
1,80,000
2,50,000
1,60,000
40,000
1,75,000
90,000
19,25,000
Rs.
2,80,000
16,80,000
1,00,000
1,50,000
1,80,000
1,30,000
1,10,000
25,000
30,000
15,000
1,90,000
24,000
90,000
95,000
30,99,500

19,25,000
CREDIT
Sales:
Cash sales
Credit Sales

Rs.
4,60,000
23,40,000

Stock
Misc. Income
Profit on Sales of Machinery

28,00,000
2,70,000
25,000
4,500

30,99,500

Additional information:
(a) Both preference shares and debentures are due for redemption on 315 March 2005. Half
the debentures holders in value will accept net 9% redeemable preferring shares. The
company also proposes to issue equity capital with a nominal value of Rs.2,00,000 at a
premium of l0%
(b) There will be addition to fixed assets for Rs.l,80,000 The cost of assets to be sold in the
year 2004 - 05 is Rs.75,000 (accumulated depreciation thereon Rs.38,000)
(c) Tax liability up to 31.3.2004 will be settled for Rs.l,70,000
(d) Book debts on 315' March 05 are to be taken at 10% more than as warranted by the
period of months.
149

(e) Creditors for goods will continue to extend one months credit. Outstanding and prepared
exps. On 31.3.05 will be Rs.30,000 and Rs.4,000 respectively.
You are required to prepare a projected balance sheet and a projected Fund How statement for
the year ending 31 March, 2005.

SOURCES OF FINANCE
150

INTRODUCTION
A major consideration for any company in implementing a new project or undertaking
expansion, diversification, modernization and rehabilitation scheme is determining the cost of
project and the means of financing it. The selection of the fund source is dependent on various
factors like risk, tenure and cost of each and every source of fund.

NEEDS OF FINANCE
The financial needs of a business may be grouped into the following categories:
Long Term Financial Needs
1. l. Such needs refer to those requirements of funds which are for a period exceeding 5
years.
2. Investments in plant, machinery. land, buildings, etc., are considered as long term
financial needs.
3. Funds required to finance permanent or hard core working capital should also be
procured from long term sources.
Medium Term Financial Needs
1. l. Such needs refer to those requirements of funds which are for a period of 1-5 years.
2. Expenditure required for publicity and advertisement campaign are classified in the
category ; of medium term financial needs.
3. In case of delay in arranging long term finances, medium term sources could be used.
Short Term Financial Needs
l. The need to finance current assets such as stock, debtors, cash, etc, are known as short term
finance needs.
2. They meet the working capital requirements of the concern.
3. They arise for a short period of time not exceeding the accounting period. i.e., l year.
SOURCES OF FINANCE
The various categories of needs should be met respective source. The method of raising funds is
to be decided with reference to the period for which funds are required. Some of them are
outlined below:
Long Term Sources of Finance
l. Share capital or Equity share.
2. Preference shares.
151

3. Retained earnings.
4. Debentures/Bonds of different types.
5. Loans from financial institutions. _
6. Loans from State Financial Corporation.
7. Loans from commercial banks.
8. Venture capital funding.
9. Asset securitization.
10. International financing like Euro-issues, foreign currency loans.
Medium Term Sources of Finance
1. Preference shares.
2. Debentures/Bonds.
3. Public deposits/fixed deposits for a duration of three years.
4. Commercial banks.
5. Financial institutions.
6. State financial corporations.
7. Lease financing/Hire-Purchase financing.
8. External commercial borrowings.
9 Euro-issues.
10. Foreign Currency bonds.
Short Term Sources of Finance
1. Trade credit.
2. Commercial banks. f
3. Fixed deposits for a period of I year or less.
4. Advances received from customers.
5. Various short-term provisions.

Long Term Sources of Finance

152

1. Owners capital or equity capital

(a) Ordinary shareholders are owners of the company
(b) They undertake the risks of business.
(c) They elect the directors to run the company
(d) They have the optimum control over the management of the company.
(e) This source has the least risk involved.
(f) They can be paid dividends only when there are distributable profits.
(g) Cost of ordinary shares is usually the highest.
(h) Such shareholders expect a higher rate of return
(i) Dividend payable on shares is an appropriation of profits and not a charge against profits.
(j) Ordinary share capital also provides a security to other suppliers of funds.
(k) It is a permanent source of finance.
(l) The issue of new equity shares increases flexibility of the company.
(m) The company can make further issue of share capital by making a right issue.
(n) There are no mandatory payments to shareholders of equity shares.
2. Preference share capital
(a) The preference shareholders enjoy priority, both as regards to the payment of a fixed
amount of dividend and repayment of capital on winding up of the company.
(b) No dilution in EPS on enlarged capital base
(c) If equity is issued it reduces EPS, thus affecting the market perception about the I
(d)
(e)
(f)
(g)

company.
There is leveraging advantage as it bears a fixed charge.
There is no risk of takeover.
There is no dilution of managerial control.
Preference capital can be redeemed after a specified period.

3. Retained Earnings
(a) Long-term funds may also be provided by accumulating the profits of the company and by
ploughing them back into business.
(b) Such funds belong to equity shareholders.
(c) Such funds increase the net worth of the company.
(d) Further, control of present owners is also not diluted by retaining profits.
4. Debentures or Bonds
(a) The cost of debentures is much lower than the cost of preference or equity capital as the
interest is tax-deductible.
(b) Investors consider debenture investment safer than equity or preferred investment and,
hence, may require a lower return on debenture investment.
153

(c) Debenture financing does not result in dilution of control.

(d) In a period of rising prices, debenture issue is advantageous. The fixed monetary outgo
decreases in real terms as the price level increases.
(e) Debenture interest and capital repayment are obligatory payments.
(f) The protective covenants associated with a debenture issue may be restrictive.
(g) Debenture financing enhances the financial risk associated with the firm

5. Loans from financial institutions

(a) Specialized institutions provide long term financial assistance to industry. E.g. - IFCI,
SFCS, LICI, NSICL, ICICI, IDBI etc.
(b) Company has to satisfy the concerned financial institution regarding the technical,
commercial, economic, financial and managerial viability of the project for which the loan
is required.
(c) Loans are available at different rates of interest under different schemes
(d) They generally carry a rate of interest inclusive of interest tax.
(e) These loans are generally repayable over a period ol`6 to IO years
6. Loans from Commercial Banks
(a) The primary role of the commercial banks is to cater to the short term requirements of
industry.
(b) Banks should provide loans only for short periods and for operations which result in the
automatic liquidation of such credits over short periods.
(c) The proceeds of the term loan are generally used for what are broadly known as fixed
assets or for expansion in plant capacity
(d) Their repayment is usually scheduled over a long period of time.
(e) The liquidity of such loans is said to depend on the anticipated income of the borrowers.
(f) A working capital loan is more permanent and long term than a term loan because a
term loan is always repayable on a fixed date and ultimately, a day will come when the
account will be totally adjusted. However. in the case of working capital finance, though it
is payable on demand, yet in actual practice it is noticed that the account is never
adjusted as such and, if at all the payment is asked back, it is with a clear purpose and
intention of refinance being provided at the beginning of the next year or half year.
7. Bridge Finance
(a) It refers to loans taken by a company normally from commercial banks for a short period,
pending disbursement of loans sanctioned by financial institutions.

154

(b) Financial institutions take time to disburse loans to companies. However, once the loans
are approved by the term lending institutions, companies, in order not to lose further time
in starting their projects, arrange short term loans from commercial banks.
(c) The bridge loans are repaid/ adjusted out of the term loans as and when disbursed by the
concerned institutions.
(d) Bridge loans are normally secured by hypothecating movable assets, personal guarantees
and demand promissory notes.
(e) Generally, the rate of interest on bridge finance is higher as compared with that on term
loans.
VENTURE CAPITAL FINANCING
It refers to financing of new high risky venture promoted by qualified entrepreneurs who lack
experience and funds to give shape to their ideas. In broad sense, under venture capital
financing venture capitalist make investment to purchase equity or debt securities from
inexperienced entrepreneurs who undertake highly risky ventures with a potential of success.
Some common methods of venture capital financing are as follows :(a) Equity financing
When funds are required for a longer period but the firm fails to provide returns to the investors
during the initial stages, the venture capital finance is provided by way of equity share capital.
(b) Conditional Loan
A conditional loan is repayable in the form of a royalty after the venture is able to generate
'sales'. Here royalty ranges between 2% and 15%. No interest is paid on such loans.
(c) Income Note
It combines the features of both conventional and conditional loans. The concern has to pay
both viz., interest and royalty on sales but at substantially low rates.
(d) Participating debentures
Such a security carries charges in three phases - in the start up phase, no interest is charged,
next stage a low rate of interest is charged up to a particular level of operation, after that, a high
rate of interest is required to be paid.
DEBT SECURITIZATION
Meaning : It is a mode of financing, wherein securities are issued on the basis of a package of
assets (called Asset Pool). In this method of recycling funds, assets generating steady cash flows
are packaged together and against this asset pool, market securities can be issued.
Process : The debt securitisation process has the following functions / activities 1
155

(i)

The Origination Function : A borrower seeks a loan from a lending institution (finance
company or bank). The credit worthiness of the borrower is evaluated and the loan is
sanctioned. A contract is signed between the parties, with repayment schedule spread
over the life of the loan. The lender is called the Originator, to whom the loan
constitutes an asset (receivable).
The Pooling Function : The Originator (Lender) clubs together similar loans or

(ii)

receivables, to create an underlying pool of assets. This pool is transferred in favour of

a SPV (Special Purpose Vehicle), which acts as a trustee for the investor. Once the
(iii)

assets are transferred, they are held in the Originators' portfolios.

The Securitisation Function: The SPV issues securities on the basis of the asset pool.
The securities carry a coupon and an expected maturity, which can be asset based or
mortgage based. These are generally sold to investors through merchant bankers.

Features :
(a) Generally institutional investors like mutual funds, LIC etc. (not individuals) are
interested in Debt Securitisation.
(b) The Originator usually keeps the spread available (i.e. difference) between yield from
secured assets (interest received from borrower) originators income.
(c) The Securitisation process is generally without recourse i.e. the investor bears the credit
risk or risk of default and the issuer is under an obligation to pay to investors only if the
cash flows are received by him from the asset pool.
(d) The Originator has a right to legal recourse against the borrower in the event of default
(e) (C) The risk run by the investor can be further reduced through credit enhancement
facilities like insurance, letters of credit and guarantees.
(f) In a simple "pass through structure", the investor owns a proportionate share of the asset
pool and the cash flows when generated are passed on directly to the investor. This is
done by issuing "pass through certificates".
(g) In mortgage or asset backed bonds, the investor has a lien on the underlying asset pool.
The SPV accumulates collections from borrowers from time to time and makes payments
to investors at regular predetermined intervals. The SPV can invest the funds received in
short term instruments and improve yield when there is time lag between receipt and
payment.
Benefits:
To the Originator:

The assets are shifted off the balance sheet, thus giving the originator recourse to off

balance sheet funding.

It converts illiquid assets to liquid portfolio.
It facilitates better balance sheet management as assets are transferred off balance sheet

facilitating satisfaction of capital adequacy norms.

The originators credit rating enhances.
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To the Investor:

Securities are tied up to definite assets (asset pool).

New investment avenues are opened up.

Role of Lease Financing.

Meaning : Leasing is a contract where one party (owner/ Lessor / Leasing Company) purchases
the assets and permits its use by another party (Lessee) over a specified period of time. Thus,
leasing is an alternative to the purchase of an asset out of own or borrowed funds.
Consideration : The Lessee pays a specified rent at periodical intervals as consideration for the
use of the asset. The Lessee claims Lease Rental Charges as his revenue expenses. The Lessor
is entitled to claim depreciation as he is the owner of the asset.
Types : Lease may be classified into Operating Lease and Financial Lease.
Advantages to Lessee:

Immediate Cash Outflow i,e. investment in Capital Asset is eliminated.

Lease Rentals are tax deductible expenses.

LEASE FINANCING
(a) Leasing is a general contract between the owner and user of the asset over a specified
period of time the asset os purchased initially by the lessor and leased to the user which
pays a specified rent at periodical intervals.
(b) From the lessee's point of view, leasing has the attraction of eliminating immediate cash
outflow, and the lease rentals are also tax deductible expenses.
(c) Buying has the advantages of depreciation allowance (including additional depreciation)
and interest on borrowed capital being tax-deductible.
(d) Evaluation of the two alternatives is to be made in order to take a decision.

SHORT TERM SOURCES OF FINANCE

Cash Credit
(a) The customer is allowed borrow up to a pre-fixed limit called the cash credit limit.
(b) He is charged interest only on the amount actually utilized.
(c) He has to pay some minimum service charges.
(d) He has to maintain some minimum balance, also known as compensatory balance. _
(e) It operates against security of inventory and accounts receivables in the form of
hypothecation or pledge.
Overdraft
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(a) The customer is allowed to overdraw up to a pre-fixed limit.

(b) He is charged interest only on the amount overdrawn.
(c) It operates against security in the form of pledge of shares and securities, assignment of
Life Insurance Policies and sometimes even mortgage of fixed assets.
Note Lending
(a) Unlike cash credit and overdraft, which are running accounts, note lending rs for a
specified period - usually 2 to 3 months.
(b) Customer takes a loan against a promissory note.
(c) Interest is charged on the entire amount sanctioned as loan.
(d) It is not very popular.
Bills Finance
(a) The bank provides finance to the customer by purchasing or discounting the trade bills of
exchange.
(b) The bank will scrutinize the authenticity of the bill and creditworthiness of the concerned
parties.
(c) Credit is given alter deducting charges.
Letter of Credit
(a) It is opened by a bank in favour of its customer, undertaking the responsibility to pay to
the supplier in case its customer fails to make the payment within stipulated time.
(b) In other finances, arrangement is between the customer and bank and the bank assumes
the risk of non-payment and also provides finance. Under letter of credit, the bank
assumes the risk and the supplier provides the credit.
Security
(a) Before giving the financial assistance, the bank enquires about the creditworthiness of
the parties concerned and also the nature of security provided.
(b) For financing current assets of a company, the bank will ask for security in the form of
hypothecation and / or pledge.
Hypothecation
(a) Security is limited to movable property like inventories.
(b) The goods hypothecated will be in possession of the borrower.
(c) Borrower has to prominently display that the items are hypothecated with such bank.
(d) Limited companies have to register the hypothecation charge with the Registrar of
Companies.
Pledge
(a) Security is usually in the form of share certificates, debtors, insurance policies, etc.
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(b) The goods pledged will be in the possession of the lending bank.
Working Capital Demand Loan [WCDL]
(a) Banks grant only a small part of the fund based working capital facilities, to a borrower
by the way running cash credit account. A major portion is in the form of WCDL
(b) This arrangement is applicable to borrowers having working capital facilities of Rs l0
crores or above.
(c) It is granted for a fixed term, after which it is renewed or rolled over.

FINANCING OF EXPORT 'I`RADE BY BANKS

Pre-Shipment Finance
The purpose of this credit is to provide the necessary funds to the exporter to procure raw
material and meet the costs involved in manufacturing the goods. This credit may be initially
extended without any security in which case it is known as extended packing credit. At this
stage it remains a clean advance.
The funds so lent are used to procure the raw material, which then is charged to the bank. Then
the advance becomes a secured advance. The advance is given either in the form of a loan or in
the form of an operating account. The advance so given has to be adjusted with the proceeds of
the export.
Hence it is necessary to ensure that the loan given for executing a particular export order is
adjusted out of the sale proceeds of that export. However the banker is vested with the authority
by RBI to waive this condition and to allow the advance to be adjusted from the proceeds of any
export transaction.
Pre-shipment credit is extended for the period which matches with the operating cycle of the
activity. However the period of credit is normally restricted to a maximum of l80 days. It is
envisaged that the export will be materialized within the due date and the loan will be adjusted
from the export proceeds.
However, the banks have the discretion to extend the period of credit up to 360 days under
special circumstances. In order to ensure that export will materialize banks normally insist for a
Letter of Credit opened in the name of the exporter or a confirmed order before releasing the
pre-shipment credit.

Post-Shipment Finance
Post-shipment finance is defined as "any loan or advance granted or any other credit provided
by an institution to an exporter from the date of extending the credit after shipment of the goods
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to the date of realization of the export proceeds". It is basically meant for financing export
receivables of` the exporter.
Post-shipment finance can be availed on submission of commercial documents evidencing
export of goods, from the authorized dealer. The exporter is required to submit the documents
to the bank within 21 days from the date _of shipment of goods. The documents to be submitted
include all shipping documents and an extra copy of invoice, relating to any export declaration
form endorsed by Customs/Postal authorities.

Post-shipment finance can be extended as under:

i. Negotiation/Payment/Acceptance of export documents under letter of credit
ii. Purchase/discount of export documents under confirmed orders/export contracts, etc.
iii. Advances against export bills sent on collection basis
iv. Advances against exports on consignment basis
v. Advances against cash incentives
vi. Advances against undrawn balances
vii.Advances against deemed exports.

OTHER SOURCES OF FINANCING

Seed Capital Assistance
(a) It is designed by IDBI for professionally or technically qualified entrepreneurs and/or
persons possessing relevant experience, skills and entrepreneurial traits.
(b) The project cost should not exceed Rs. 2 crores and the maximum assistance under the
project will be restricted to 50% of the required promoter's contribution or Rs I5 lacs
whichever is lower.
(c) The Seed Capital Assistance is interest free but carries a service charge of 1% p.a. for the
first 5 years and at increasing rate thereafter. However, IDBI will have the option to charge
interest at such rate as may be determined by IDBI oil the loan if the financial position
and profitability of the company so permits.
(d) For projects with a project cost exceeding Rs 200 lakhs, seed capital may be obtained
from the Risk Capital and Technology Corporation Ltd. (RCTC)
(e) For small projects costing up to Rs 5 lacs, assistance under the National Equity Fund of
the SIDBI may be availed.
Internal Cash Accruals
(a) Existing

profit

making

companies

may

undertake

an

expansion/diversification

programme by investing a part of their accumulated reserves or cash profits.

(b) In such cases, the surplus generated from operations, after meeting all the contractual,
statutory and working requirement of funds is available for further capital expenditure.
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Unsecured Loans
(a) These are provided by promoters to meet the promoters' contribution norm.
(b) These loans are subordinate to institutional loans.
(c) The rate of interest should be less than or equal to the rate of interest on institutional
loans and interest can be paid only after payment of institutional dues.
Deferred Payment Guarantee
(a) Payment for the purchase of an asset can be made over a period of time.
(b) The entire cost of the machinery is financed and the company is not required to
contribute any amount initially towards acquisition of the asset.
(c) Normally, the supplier of machinery insists that batik guarantee should be furnished by
die buyer.
Capital Incentives
(a) These incentives usually consist of a lump sum subsidy and exemption from or deferment
of sales tax and octroi duty.
(b) The quantum of incentives is determined by the degree of backwardness of the location.
(c) Institutions, while appraising the project, assess the viability of the project per se, without
considering the impact of incentives on the cash flows and profitability of the project.
(d) Special capital incentives are sanctioned and released to the units only after they have
complied with the requirements of the relevant scheme.
Various Short Term Provisions/Accruals Account
(a) The most common accrual accounts are wages and taxes.
(b) In both cases, the amount becomes due but is not paid immediately.

NEW INSTRUMENTS
Deep Discount Bonds
(a) These are zero-interest bonds.
(b) These bonds are sold at a discounted value and on maturity face value is paid to the
investors.
(c) In such bonds, there is no interest payout during lock-in period.
(d) IDBI was the first to issue a deep discount bond in India in January, 1992. The bond of a
n n 6 face value of Rs l lakh was sold for Rs 2,700 with a maturity period of 25 years. The
investor could hold the bond for 25 years or seek redemption at the end of every live years
a. In th( with a specified maturity values.
Secured Premium Notes
(a) These are issued along with a detachable warrant,
(b) These are redeemable after a notified period of say 4 to 7 years.
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(c) The conversion of detachable warrant into equity shares will have to be done within
notified |< ,,, time.
Zero Interest Fully Convertible Debentures
(a) These are fully convertible debentures.
(b) These do not carry any interest. 11191
(c) The debentures are compulsorily and automatically converted after a specified period of
time -^ and holders thereof are entitled to new equity shares of the company at
predetermined price.
Zero Coupon Bonds
(a) These do not carry any interest.
(b) These are sold by the issuing company at a discount.
Double Option Bonds
(a) These have also been recently issued by the IDBI.
(b) The face value of each bond is Rs 5,000.
(c) The bond carries interest at 15% p.a. compounded half yearly from the date of allotment,
(d) The bond has maturity period of 10 years,
(e) Each bond has 2 parts in the form of two separate certificates, one for principal of Rs 5,000
nd other for interest of Rs l6,500.
(f) The investor has the facility of selling either one or both parts anytime he likes.
Inflation Bonds
(a) In these bonds, interest rate is adjusted for inflation.
(b) The investor gets all interest, free from the effects of inflation.
Floating Rate Bonds
(a) The interest rate is not fixed
(b) The interest rate is depends upon the market conditions.
(c) lt can be used by the issuer to hedge himself against the volatility in the interest rates.

INTERNATIONAL FINANCING
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The external sources of financing are Commercial Banks

(a) They provide foreign currency [ FC ] loans also for international operations.
(b) These banks also provide to overdraw over and above the loan amount.
Development Banks
(a) They offer long and medium term loans including FC loans.
(b) They offer a number of concessions to foreign companies to invest within their country and I
to finance
exports from their countries. E.g. - EXIM Bank of USA.
Discounting of Trade Bills
(a) They are used as a short term financing method.
(b) Refer Bills Finance
International Agencies
(a) They finance international trade & business.
(b) E.g. - Asian Development Bank [ ADB ], International Finance Corporation [ IFC ]

FINANCIAL INSTRUMENTS
(a) Euro bonds
Euro bonds are debt instruments denominated in a currency issued outside the country of that
currency.
Example 1 A Yen note floated in Germany.
(b) Foreign Bonds
These are debt instruments denominated in a currency which is foreign to the borrower and is
sold in the currency of that currency. Example A British firm placing Dollar denominated bonds
in USA.
(c) Fully Hedged Bonds
In foreign bonds, the risk of currency fluctuations exists. Fully hedged bonds eliminate the \
risk by selling in forward markets the entire stream of principal and interest payments.
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(d) Floating Rate Notes

These are issued up to 7 years maturity. Interest rates are adjusted to reflect the prevailing
exchange rates.
(e) Euro Commercial Papers (ECP)
ECPS are short term money market instruments. They are for maturities less than I year. They
are usually designated in US Dollars.
(f) Foreign Currency Option
A FC Option is the right to buy or sell, spot, future or forward, a specified foreign currency. It
provides a hedge against financial and economic risks.
(g) Foreign Currency Futures
FC futures are obligations to buy or sell a specified currency in the present for settlement at a
future date.
GLOBAL DEPOSIT ORY RECEIPT S [GDRS]
(a) It is a negotiable certificate. denominated in US Dollars. that represents a non-US
Company's publicly traded local currency equity.
(b) They are created when the local currency shares of an Indian company are delivered to
the depository's local custodian bank, against which the depository bank issues DRs
(Depository Receipts) in US Dollars.
(c) These DRS maybe freely traded in the overseas markets like any other dollar denominated
security either on a foreign stock exchange or through an over the counter market or
among a restricted group such as Qualified Institutional Buyers (QIB).
(d) These help Indian companies to tap global equity market to raise foreign currency funds
by way pf equity.
(e) It has a distinct advantage over debt as there is no repayment of principal and the service
costs are lower.
AMERICAN DEPOSITORY RECEIPTS [ ADRS]
(a) These issued by a US-Company and are governed by the provisions of SEC, USA
(b) As the regulations are severe, Indian companies tap the American market through private
debt placement of GDRs listed in London and Luxembourg Stock Exchanges.
(c) These are costlier than QDRs. d. Legal and registration fees are considerably higher for US
listing.
OTHER INTERNATIONAL ISSUES
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(a) Foreign Euro Bonds

They are also known as Yankee Bonds in the US, Swiss Frances in Switzerland, Samurai Bonds
in Tokyo and Bulldogs in UK.

(b) Euro Convertible Bonds

They give the holders of the bonds an option to convert the bonds into a pre-determined number
of equity shares of the company. The price of the equity shares at the time of conversion will
have a premium element. These bonds carry a fixed rate of interest and if the issuer company so
desires may also include a Call Option or a Put Option.
(c) Euro Bonds
These are not very attractive for an investor who desires to have valuable additions to his
investments.
(d) Euro Convertible Zero Bonds
They are structured as a convertible bond with no interest. Conversion of` bonds take place on
maturity at a predetermined price. Usually there is a 5 years maturity period and they are
treated as a deferred equity issue.
(e) Euro Bonds with Equity Warrants
They carry a coupon rate determined by market rates. The warrants are detachable, Pure bonds
are traded at a discount. Fixed Income Funds Management may like to invest for the purposes
of regular income.

Financial Intermediation
It involves financial institutions acquiring funds from the public by issuing their own
instruments and then using the funds to buy primary securities. It is a. sort of indirect
financing in which savers deposit funds with financial institutions rather than directly buying
bonds and the financial institutions, in turn, lend to the ultimate borrowers.
Financial intermediaries are in a better position than individuals to bear and spread the risks of
primary security ownership. Because of their large size, intermediaries can diversify their
portfolios and minimize the risk involved in holding any security. They employ skilled portfolio
managers, posses expertise in evaluation of borrower credit characteristics and take advantage
of economies in large scale buying and selling.
Financial intermediaries are firm that provide services and products that customers may not be
able to get more efficiently by themselves in the financial market. A good example of a financial
165

intermediary is a mutual fund, which pools the financial resources of a number of people and
invests in a basket of securities.

166