CA IPCC Cost Accounting Financial Management Theory Notes by 6W5984ZJ

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“It’s Time To Be Busy BECAUSE Today Will Be Yesterday Very Soon ”
When nothing seems to help,I go & look at a stonecutter hammering away at his rock ,
perhaps a hundred times, with no crack showing in it.Yet, at the hundred-and-one blow it will
spilt into two , and I know it was not that blow that did it but all that had gone before.
Remember ,Failure is not final –until you make it final.
“I’ve missed more than 9000 shots in my career. I’ve lost almost 300 games. Twenty-six times
I’ve been trusted to take the game winning shot and missed.
I’ve failed over and over and over again in my life.
And that is why I succeed.”
Michael Jordan
"A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty."
You must motivate yourself EVERYDAY! "Always do what you are afraid to do."
" We all walk the same ground.
It's just the path we take that makes us different."
Index
Page No.
CHAPTER 1 SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT 3
CHAPTER 2 TIME VALUE OF MONEY 8
CHAPTER 3 APPLICATION OF RATIO ANALYSIS 10
CHAPTER 4 CASH FLOW AND FUNDS FLOW ANALYSIS 20
CHAPTER 5 COST OF CAPITAL 22
CHAPTER 6 CAPITAL STRUCTURE DECISIONS 25
CHAPTER 7 LEVERAGE 33
CHAPTER 8 TYPES OF FINANCING 35
CHAPTER 9 CAPITAL BUDGETING DECISIONS 57
CHAPTER 10 MEANING, CONCEPT AND POLICIES OF WORKING CAPITAL 62
CHAPTER 11 TREASURY AND CASH MANAGEMENT 66
CHAPTER 12 MANAGEMENT OF RECEIVABLES 74
CHAPTER 13 FINANCING OF WORKING CAPITAL 75
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1.SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT
Question 1 Discuss the functions of a Chief Financial Officer.

(3 Marks,May, 2004)
Answer
Functions of a Chief Financial Officer :
The twin aspects viz procurement and effective utilization of funds are the crucial
tasks, which the CFO faces.
The Chief Finance Officer is required to look into financial implications of any
decision in the firm.
Thus all decisions involving management of funds comes under the purview of
finance manager.
These are namely:
- Estimating requirement of funds
- Decision regarding capital structure
- Investment decisions
- Dividend decision
- Cash management
- Evaluating financial performance
- Financial negotiation
- Keeping touch with stock exchange quotations and behaviour of share prices.
Question 2 What are the main responsibilities of a Chief Financial Officer of an

organisation? (3 Marks; 4 Marks, May, 2007; May, 2010 & November, 2011)
Answer
Responsibilities of Chief Financial Officer (CFO):
The chief financial officer of an organisation plays an important role in the company’s
goals, policies, and financial success. His main responsibilities include:
(a) Financial analysis and planning: Determining the proper amount of funds to
be employed in the firm.
(b) Investment decisions: Efficient allocation of funds to specific assets.
(c) Financial and capital structure decisions: Raising of funds on favourable
terms as possible, i.e., determining the composition of liabilities.
(d) Management of financial resources (such as working capital).
(e) Risk Management: Protecting assets.
Question 3 Explain the limitations of profit maximization objective of Financial

Management.(3 Marks, November, 2007)
OR
Question 3 “The profit maximization is not an operationally feasible criterion.
“ Comment on it.(4 Marks, May, 2012)
Answer
Limitations of Profit Maximisation Objective of Financial Management
“The profit maximisation is not an operationally feasible criterion.” This statement

is true because Profit maximisation can be a short-term objective for any organisation
and cannot be its sole objective. Profit maximization fails to serve as an operational
criterion for maximizing the owner’s economic welfare. It fails to provide an
operationally feasible measure for ranking alternative courses of action in terms of
their economic efficiency.
It suffers from the following limitations:
(i)Vague term: The definition of the term profit is ambiguous. Does it mean short term
or long term profit? Does it refer to profit before or after tax? Total profit or profit per
share?
(ii)Timing of Return: The profit maximization objective does not make distinction
between returns received in different time periods. It gives no consideration to the time
value of money, and values benefits received today and benefits received after a period
as the same.
(iii)It ignores the risk factor.
(iv)The term maximization is also vague.
Question 4 Discuss conflict in profit versus wealth maximization objective.
( 2 M a r k s; 4 M a r k s, J u n e 2 0 0 9 ; N o v em b e r , 2 0 1 0 & N o v em b e r , 2 0 1 2 ) (May 2015,4
Marks)
Answer
Conflict in Profit versus Wealth Maximization Objective:
Profit maximisation is a shortterm objective and cannot be the sole objective of a

company. It is at best a limited objective. If profit is given undue importance, a number
of problems can arise like the term profit is vague, profit maximisation has to be
attempted with a realisation of risks involved, it does not take into account the time
pattern of returns and as an objective it is too narrow.
Whereas, on the other hand, wealth maximisation, is a long-term objective and

means that the company is using its resources in a good manner. If the share value is to
stay high, the company has to reduce its costs and use the resources properly. If the
company follows the goal of wealth maximisation, it means that the company will
promote only those policies that will lead to an efficient allocation of resources.
Question 5 Differentiate between Financial Management and Financial

Accounting. (2 Marks, November, 2009)
Answer
Differentiation between Financial Management and Financial Accounting:
Though financial management and financial accounting are closely related, still they
differ in the treatment of funds and also with regards to decision - making.
Treatment of Funds: In accounting, the measurement of funds is based on the

accrual principle. The accrual based accounting data do not reflect fully the financial
conditions of the organisation. An organisation which has earned profit (sales less
expenses) may said to be profitable in the accounting sense but it may not be able to
meet its current obligations due to shortage of liquidity as a result of say, uncollectible
receivables. Whereas, the treatment of funds, in financial management is based on
cash flows. The revenues are recognised only when cash is actually received (i.e. cash
inflow) and expenses are recognised on actual payment (i.e. cash outflow). Thus, cash
flow based returns help financial managers to avoid insolvency and achieve desired
financial goals.
Decision-making: The chief focus of an accountant is to collect data and present

the data while the financial manager’s primary responsibility relates to financial
planning, controlling and decisionmaking. Thus, in a way it can be stated that financial
management begins where financial accounting ends.
Question 6 Explain the two basic functions of Financial Management.

(2 Marks, November, 2009)
Answer
Two Basic Functions of Financial Management
Procurement of Funds: Funds can be obtained from different sources having

different characteristics in terms of risk, cost and control. The funds raised from the
issue of equity shares are the best from the risk point of view since repayment is
required only at the time of liquidation. However, it is also the most costly source of
finance due to dividend expectations of shareholders. On the other hand, debentures
are cheaper than equity shares due to their tax advantage. However, they are usually
riskier than equity shares. There are thus risk, cost and control considerations which a
finance manager must consider while procuring funds. The cost of funds should be at
the minimum level for that a proper balancing of risk and control factors must be
carried out.
Effective Utilization of Funds: The Finance Manager has to ensure that funds are
not kept idle or there is no improper use of funds. The funds are to be invested in a
manner such that they generate returns higher than the cost of capital to the firm.
Besides this, decisions to invest in fixed assets are to be taken only after sound analysis
using capital budgeting techniques. Similarly, adequate working capital should be
maintained so as to avoid the risk of insolvency.
Question 7 Discuss emerging issues affecting the future role of Chief Financial
Officer (CFO). (4 Marks, May, 2014) (4 Marks, Nov, 2016)
Answer
Emerging Issues/Priorities Affecting the Future Role of Chief Financial Officer

(CFO)
(i)Regulation: Regulation requirements are increasing and CFOs have an increasingly

personal stake in regulatory adherence.
(ii)Globalisation: The challenges of globalisation are creating a need for finance
leaders to develop a finance function that works effectively on the global stage and
that embraces diversity.
(iii)Technology: Technology is evolving very quickly, providing the potential for CFOs
to reconfigure finance processes and drive business insight through ‘big data’ and
analytics.
(iv)Risk: The nature of the risks that organisations face is changing, requiring more
effective risk management approaches and increasingly CFOs have a role to play in
ensuring an appropriate corporate ethos.
(v)Transformation: There will be more pressure on CFOs to transform their finance
functions to drive a better service to the business at zero cost impact.
(vi)Stakeholder Management: Stakeholder management and relationships will
become important as increasingly CFOs become the face of the corporate brand.
(vii)Strategy: There will be a greater role to play in strategy validation and execution,
because the environment is more complex and quick changing, calling on the analytical
skills CFOs can bring.
(viii)Reporting: Reporting requirements will broaden and continue to be burdensome
for CFOs.
(ix)Talent and Capability: A brighter spotlight will shine on talent, capability and
behaviours in the top finance role.
2.TIME VALUE OF MONEY
Q u est i o n 1 Explain the relevance of time value of money in financial decisions?

(4 Marks May, 2008; May,2011)(Nov 2016)
Answer
Time value of money means that worth of a rupee received today is different from
the worth of a rupee to be received in future. The preference of money now as compared
to future money is known as time preference for money.
A rupee today is more valuable than rupee after a year due to several reasons:
(i)Risk:There is uncertainty about the receipt of money in future.
(ii)Preference for present consumption: Most of the persons and companies in

general, prefer current consumption over future consumption.
(iii)Inflation: In an inflationary period a rupee today represents a greater real

purchasing power than a rupee a year hence.
(iv)Investment opportunities: Most of the persons and companies have a preference

for present money because of availabilities of opportunities of investment for earning
additional cash flow.
Many financial problems involve cash flow accruing at different points of time for
evaluating such cash flow an explicit consideration of time value of money is required.
Question 2 Why money in the future is worth less than similar money today?
Give the reasons and explain. (4 Marks, November, 2014)
Answer
Money in the Future is worth less than the Similar Money Today due to several
reasons:
Risk: There is uncertainty about the receipt of money in future.

Preference for Present Consumption: Most of the persons and companies in general,
prefer current consumption over future consumption.
Inflation: In an inflationary period a rupee today represents a greater real purchasing
power than a rupee a year hence.
Investment Opportunities: Most of the persons and companies have a preference for
present money because of availabilities of opportunities of investment for earning
additional cash flow.
Question 3 What is a sinking fund and how is it calculated ?

(4 Marks, May, 2016)
Answer
It is the fund created for a specified purpose by way of sequence of periodic pay-
ments over a time period at a specified interest rate.
Size of the sinking fund is calculated as follows:FVA = R[FVIFA (i,n)]
Where, ‘FVA’ is the amount to be saved, ‘R’ is the periodic payment and ‘n’ the
payment period.
Alternatively, the sinking fund amount can be calculated by using following for-
mula.
(1  i) n  1
M at u r i t y v a l u e o f S i n k i n g F u n d = S i n k i n g F u n d d ep o si t ×
i
Question 4 Define ‘Present Value’ and ‘Perpetuity’.(4 Marks, May, 2015)
Answer
Present Value:
Present Value” is the current value of a “Future Amount”.
It can also be defined as the amount to be invested today (Present Value) at a given
rate over specified period to equal the “Future Amount”.
Perpetuity:
Perpetuity is an annuity in which the periodic payments or receipts begin on a fixed
date and continue indefinitely or perpetually.
Fixed coupon payments received permanently(irredeemable) is prime examples of
perpetuities
3.RATIO ANALYSIS
Discuss the financial ratios for evaluating company performance on

Q u est i o n 1
operating efficiency and liquidity position aspects. (4 Marks, November, 2006)
Answer
Financial ratios for evaluating performance on operational efficiency and liquidity

position aspects are discussed as:
Operating/Turnover Efficiency:
Ratio analysis throws light on the degree of efficiency in the management and
utilization of its assets.
The various activity ratios (such as turnover ratios) measure this kind of operational
efficiency.
These ratios are employed to evaluate the efficiency with which the firm manages
and utilises its assets.
These ratios usually indicate the frequency of sales with respect to its assets.
These assets may be capital assets or working capital or average inventory.
Some of the important turnover ratios are Capital Turnover Ratio,Stock Turnover
Ratio,Debtor Turnover Ratio etc
Liquidity Position:
With the help of ratio analysis, one can draw conclusions regarding liquidity position
of a firm.
The liquidity position of a firm would be satisfactory, if it is able to meet its current
obligations when they become due.Inability to pay-off short-term liabilities affects its
credibility as well as its credit rating. Continuous default on the part of the business
leads to commercial bankruptcy. Eventually such commercial bankruptcy may lead to
its sickness and dissolution.
Liquidity ratios are current ratio, liquid ratio and cash to current liability ratio.
These ratios are particularly useful in credit analysis by banks and her suppliers of
short-term loans.
Question 2 Diagrammatically present the DU PONT CHART to calculate return
on equity. (3 Marks, May, 2007)
OR
Question 2 Discuss the composition of Return on Equity (ROE) using the DuPont
model. (3 Marks, June, 2009)
Answer
Du Pont Chart
There are three components in the calculation of return on equity using the traditional
DuPont model- the net profit margin, asset turnover, and the equity multiplier.
Calculation of Return on Equity
To calculate the return on equity using the DuPont model, simply multiply the three
components (net profit margin, asset turnover, and equity multiplier.)
Return on Equity = Net profit margin× Asset turnover × Equity multiplier

Composition of Return on Equity using the DuPont Model
a) Net Profit Margin:

The net profit margin is simply the after-tax profit a company generates for each
rupee of revenue.
Net profit margin = Net Income ÷ Revenue
Net profit margin is a safety cushion; the lower the margin, lesser the room for error.
(b) Asset Turnover:

The asset turnover ratio is a measure of how effectively a company converts its
assets into sales.
It is calculated as follows:Asset Turnover = Revenue ÷ Assets
The asset turnover ratio tends to be inversely related to the net profit margin; i.e.,
the higher the net profit margin, the lower the asset turnover.
(c)Equity Multiplier:
It is possible for a company with terrible sales and margins to take on excessive debt
and artificially increase its return on equity.
The equity multiplier, a measure of financial leverage, allows the investor to see
what portion of the return on equity is the result of debt.
The equity multiplier is calculated as follows: Equity Multiplier = Assets ÷
Shareholder's Equity.
Question 3 How return on capital employed is calculated? What is its

significance?(2 Marks, November, 2008)
Answer
What it Measure/Indicate:It is the most important ratio of all. It is the percentage

of return on funds invested in the business by its owners. In short, it indicates what
returns management has made on the resources made available to them before making
any distribution of those returns.
Return
Formula:Return on Capital Employed =  100
Capital Employed
Where,
Return = Net Profit ± Non-trading adjustments + Interest on long term debts + Provision
for tax - Interest/Dividend from non-trade investments or simply EBIT
Capital Employed = Equity Share Capital + Reserve and Surplus + Pref. Share Capital
+ Debentures and other long term loan - Misc. expenditure and losses - Non-trade
Investments.
Intangible assets (assets which have no physical existence like goodwill, patents and
trade marks) should be included in the capital employed provided they have some
value. But no fictitious asset should be included within capital employed.
Remark: Higher ratio indicates better efficiency in using long term funds.
Significance Of Capital Employed:

1. It is a prime test of managerial efficiency or the efficiency of a business as a whole.
2. It measures overall profitability and profitability of different departments,and thus
the performance is evaluated.
3. Inter-firm and Intra- firm comparison can easily be made and important decisions
taken after suitable comparisons.
4. Company's borrowing policy may be formulated,since the borrowing rate must be
less than the return on capital employed.
5. The rate of return is meaningful for owners, as they can know the utility of their
money.
6. Bankers,financial institutions and other creditors can ascertain to what extent the
firm is a viable unit and whether it is worthwhile to grant loans.
7. Return on capital employed can become an integral part of the system of budgetary
control.
Question 4 What is quick ratio? What does it signify?

Answer
Quick Ratio:
Quick Assets
Formula : Quick Ratio or Acid Test Ratio =
Current Liabilities
Where,Quick Assets = Current Assets-Inventories-Prepaid Expenses;
What it Measure/Indicate: It is a measurement of a firm's ability to convert its

current assets quickly into cash in order to meet its quick liabilities.Quick Ratio is a
more penetrating test of liquidity than current ratio.A ratio less than one indicates low
liquidity and hence is a danger sign.
Remark: An acid-test of 1:1 is considered satisfactory .
Question 5 What do you mean by Stock Turnover ratio and Gearing ratio?(3
Marks, November, 2008)
Answer
Stock Turnover Ratio
This ratio also known as stock turnover ratio establishes the relationship between
the cost of goods sold during the year and average inventory held during the year.
Cost Of Goods Sold Turnover
Formula:Inventory Turnover Ratio= OR
Average Stock Average Stock
Opening Stock  Closing Stock
Where,Average Inventory =
2
What it Measure/Indicate:Stock Turnover Ratio helps to find out if there is too

much inventory build-up. An increasing stock turnover figure or one which is much
larger than the “average” for an industry may indicate poor stock management.
Gearing Ratio
What it Measure/Indicate:This ratio indicate or measure the proportion of fixed

interest (dividend) bearing capital to funds belonging to equity shareholders.Gearing
Ratio indicates how much of the business is funded by borrowing. In theory, the
higher the level of borrowing (gearing), the higher are the risks to a business, since the
payment of interest and repayment of debts are not “optional” in the same way as
dividends.However, gearing can be a financially sound part of a business’s capital
structure particularly if the business has strong, predictable cash flows. The formula
for the Gearing Ratio is as follows:
Formula :
Borrowings (all long term debts including normal overdraft)
Capital Gearing Ratio =
Net Assets or Shareholders' funds
Question 6 How is Debt service coverage ratio calculated? What is its

significance? (2 Marks, June, 2009)
OR
Question 6 Explain the need of debt-service coverage ratio.(2Marks,May, 2007)
OR
Question 6 Comment on the Debt Service Coverage Ratio.(4Marks,May,2014)
Answer
Calculation of Debt Service Coverage Ratio (DSCR) and its Significance
What it Measure/Indicate:Debt Service Coverage Ratio measures or judge the

firm's ability to pay off current interest and instalments. Lenders are interested in this
ratio to judge the firm’s ability to pay off current interest and installments.
Earnings Available For Debt Service

Formula :Debt Service Coverage Ratio =
Interest  Installments
EBITDA
=
Interest  Principal Repayment Due
Where,
Earning for debt service = Net profit
+ Non-cash operating expenses like depreciation and other amortizations
+ Non-operating adjustments like loss on sale of
+ Fixed assets + Interest on Debt Fund.
Significance/Need Of Debt Service Coverage Ratio :Debt service coverage ratio
indicates the capacity of a firm to service a particular level of debt i.e. repayment of
principal and interest. High credit rating firms target DSCR to be greater than 2 in its
entire loan life. High DSCR facilitates the firm to borrow at the most competitive
rates.
Remark:The higher the ratio,more is the Margin of Safety for the lenders.
Question 7 Explain briefly the limitations of financial ratios.

Answer
Limitations of Financial Ratios :The limitations of financial ratios are listed below:
(i) Diversified product lines : Many businesses operate a large number of divisions
in quite different industries. In such cases ratios calculated on the basis of aggregate
data cannot be used for inter-firm comparisons.
(ii) Financial data are badly distorted by inflation
(iii) Seasonal factors may also influence financial data:
(iv) Window Dressing -To give a good shape to the popularly used financial
ratios (like current ratio, debt- equity ratios, etc.)
(v) Differences in accounting policies and accounting period : It can make the
accounting data of two firms non-comparable as also the accounting ratios.
(vi) There is no standard set of ratios against which a firm's ratios can be
compared : Some times a firm's ratios are compared with the industry average. But if
a firm desires to be above the average, then industry average becomes a low standard.
On the other hand, for a below average firm, industry averages become too high a
standard to achieve.
(vii) It is very difficult to generalise whether a particular ratio is good or bad :
For example, a low current ratio may be said 'bad' from the point of view of low
liquidity, but a high current ratio may not be 'good' as this may result from inefficient
working capital management.
(viii) Financial ratios are inter-related, not independent : Viewed in isolation one
ratio may highlight efficiency. But when considered as a set of ratios they may speak
differently.
Financial ratios provide clues but not conclusions. These are tools only in the hands
of experts because there is no standard ready-made interpretation of financial ratios.
Question 8 Explain the following ratios:
(i) Operating ratio (ii) Price earnings ratio ( 4 M a r k s, M a y , 2 0 11 )
Answer
(i) Concept of Operating Ratio
Operating Expenses  Cost Of Goods sold

Operating ratio=  100
Net Sales
This is the test of the operational efficiency with which the business is being carried;
the operating ratio should be low enough to leave a portion of sales to give a fair return
to the investors.
(ii)Concept of Price-Earnings ratio
Market Price Per Share

Formula:P/E Ratio =
Earning Per Share
This ratio indicates the number of times the earnings per share is covered by its
market price. It indicates the expectation of equity investors about the earnings of the
firm.
Question 9 Explain the important ratios that would be used in each of the following
situations:
1. A bank is approached by a company for a loan of Rs. 50 lakhs for working

capital purposes.
2. A long term creditor interested in determining whether his claim is

adequately secured.
3. A shareholder who is examining his portfolio and who is to decide whether

he should hold or sell his holding in the company.
4. A finance manager interested to know the effectiveness with which a firm
uses its available resources. (4 Marks, May, 2012)
Answer
Important Ratios used in different situations
(i)Liquidity Ratios- Here Liquidity or short-term solvency ratios would be used by

the bank to check the ability of the company to pay its short-term liabilities. A bank
may use Current ratio and Quick ratio to judge short terms solvency of the firm.
(ii)Capital Structure/Leverage Ratios- Here the long-term creditor would use the
capital structure/leverage ratios to ensure the long term stability and structure of the
firm. A long term creditors interested in the determining whether his claim is
adequately secured may use Debt-service coverage and interest coverage ratio.
(iii)Profitability Ratios- The shareholder would use the profitability ratios to measure
the profitability or the operational efficiency of the firm to see the final results of
business operations. A shareholder may use return on equity, earning per share and
dividend per share.
(iv)Activity Ratios- The finance manager would use these ratios to evaluate the
efficiency with which the firm manages and utilises its assets. Some important ratios
are (a) Capital turnover ratio (b) Current and fixed assets turnover ratio (c) Stock,
Debtors and Creditors turnover ratio.
Question 10 Discuss any three ratios computed for investment analysis. (3 Marks,
November, 2004)
Answer
Three ratios computed for investment analysis are as follows:

Profit After Tax
(i) Earning Per Share =
Number of Equity Shares Outstanding
Equity Dividend Per Share

(ii) Dividend Yield Ratio =  100
Market Price Per Share
Net Profit Before Interest & Tax
(iii) Return on Capital Employed =  100
Capital Employed
Question 11 Discuss the impact of financial leverage on shareholders wealth by

using return-on-assets (ROA) and return-on-equity (ROE) analytic framework.
(PE-II-May 2003 & May 2004) (3 marks)
The impact of financial leverage on ROE is positive, if cost of debt (after-tax) is less
than ROA. But it is a double-edged sword.
NOPAT Sales D
ROA =  ;ROE = ROA  (ROA  Kd)
Sales Capital Employed E
Where,NOPAT = EBIT x ( 1 - Tax Rate) ,
Capital Employed = Shareholder's Funds + Loan Funds,
D = Debt amount in capital structure;
E = Equity capital amount in capital structure,
Kd = Interest Rate x ( 1 - Tax Rate) in case of fresh loans of a company,
Kd = Yield to Maturity x (1-Tax Rate) in case of existing loans of a company.
Note:It may be observed from the above relation that ROE varies directly with a
change in the financial leverage.
4. CASH FLOW AND FUNDS FLOW ANALYSIS
Question 1 Distinguish between Funds Flow Statement and Cash Flow Statement.
(3 Marks, May 2004; May 2010)
Answer
Differentiation between Funds Flow Statement and Cash Flow Statement
Both funds flow and cash flow statements are used in analysis of past transactions of
a business firm. The differences between these two statements are given below:
(a)Funds flow statement is based on the accrual accounting system. In case of

preparation of cash flow statements all transactions effecting the cash or cash
equivalents only is taken into consideration.
(b)FFS analyses the sources & application of funds.CFS shows inflows & outflows of
cash.
(c)Funds Flow analysis is more useful for long range financial planning.Cash Flow
Statements is an important tool for short term analysis.
(d)Cash Flow Statements analyses the reasons for changes in balance of cash in hand
and bank.Funds flow statement analyses the reasons for change in financial position
between two balance sheets.
(e)Change in current items are adjusted in the changes in working capital;these are
separately shown in a schedule,apart from the main funds flow statement.Changes in
current assets and current liabilities are shown by way of adjustment in profit to arrive
at cash from operations in the main statement itself.There is no separate statement
prepared for this.
Question 2 (May 2016,4 Marks) State, which of the following would result in
inflow/outflow of funds, if the funds were defined as working capital.
(i) Purchase of a fixed asset on credit of two months.

(ii) Sale of a fixed asset (book value ‘ 8,000) at a loss of ‘7,000.
(iii) Payment of final dividend already declared.
(iv) Writing off Bad debts against a provision for doubtful debts.
Answer
Sl. No. Result in Inflow/ Outflow of Funds

(i) outflow, Total current liabilities are increased but total current assets
remain unchanged.
(ii) Inflow, current assets are increased but total current liabilities remain
unchanged.
(iii) No effect, Both the total current assets and current liabilities remain
unchanged.
OR
If examinees assumed that proposed dividend as Non- current liability
then payment of final dividend is considered as out flow of fund.
(iv) No effect, Neither the total current assets nor the total current liabilities
are affected.
5. COST OF CAPITAL
What do you understand by Weighted Average Cost of Capital?(3

Q u est i o n 1
Marks, November, 2009)
Answer
Weighted Average Cost of Capital
Meaning:WACC is the minimum return that a company must earn on existing

asset base to satisfy its debenture holders, owners,and other providers of capital.
In other words, Weighted Average Cost of Capital represents the investors' opportunity
cost of taking on the risk of putting money into a company.
WACC is calculated taking into account the relative weights of each component
of the capital structure - debt and equity, and is used to see if the investment is
worthwhile to undertake.
Formula :WACC is calculated by multiplying the cost of each capital component

by its proportional weight and then summing :
Weighted Average Cost Of Capital = K e  We  K d  Wd  K p  WP + Kr x Wrr
Where
Ke = Cost Of Equity;Kd=Cost Of Debt;Kp=Cost Of Preference Capital;Kr=Cost Of
Retained Earning;We=Weights Of Equity;Wd=Weights of Debt;Wp=Weight of
Preference Capital ; Wr = Weight Of Retained Earnings
Used As Discount Rate : Businesses often discount cash flows at WACC to determine
the Net Present Value (NPV) of a project, using the formula
Expressed As Percentage:WACC is expressed as a percentage, like interest. For

example, if a company works with a WACC of 12%, than this means that only
investments should be made and all investments should be made, that give a return
higher than the WACC of 12%.
Question 2 Discuss the dividend-price approach, and earnings price approach
to estimate cost of equity capital.(2 Marks, November, 2006)
Answer
(a) Dividend Price Approach:
Here, cost of equity capital is computed by dividing the current dividend by average
market price per share.
This dividend price ratio expresses the cost of equity capital in relation to what
yield the company should pay to attract investors.
However, this method cannot be used to calculate cost of equity of units suffering
losses.
D
Formula: Ke  1
Po
Where,D1 = Dividend per share in period 1 ;

P0 = Market price per share today;
Ke = Cost of Equity
This model assumes that dividends are paid at a constant rate to perpetuity. It
ignores taxation.
(b) Earning/ Price Approach:
The advocates of this approach co-relate the earnings of the company with the
market price of its share.
Accordingly, the cost of ordinary share capital would be based upon the expected
rate of earnings of a company.
The argument is that each investor expects a certain amount of earnings, whether
distributed or not from the company in whose shares he invests.
EPS1
Formula: Ke  P0
Where EPS1= Annual Earning Per Share at year end 1,
P0 = Current Market Price as on today,,
Ke = Cost of Equity
This approach is similar to dividend price approach, only it seeks to nullify the
effect of changes in dividend policy.
SPOKEN WORDS CAN’T BE RETRIEVED

A farmer insulted his neighbor. Realizing his mistake, he went to the preacher
to ask for forgiveness. The preacher told him to take a bag of feathers and
drop them in the center of town. The farmer did as he was told. Then the
preacher asked him to go and collect the feathers and put them back in the
bag. The farmer tried but couldn’t as the feathers had all blown away. When
he returned with the empty bag, the preacher said, “The same thing is true
about your words. You dropped them rather easily but you cannot retrieve
them, so be very careful in choosing your words.”
6.CAPITAL STRUCTURE DECISIONS
Question 1 Discuss the relationship between the financial leverage and firms
required rate of return to equity shareholders as per Modigliani and Miller
Proposition II.(3 Marks, May 2003; May 2004)
Answer
Relationship between the financial leverage and firm’s required rate of return
to equity shareholders with corporate taxes is given by the following relation:
D
Ke  Ko  (1  Tax Rate)( Ko  Kd)
E
Where,
Ke = Cost Of Equity;
Ko= Cost Of Capital;
D=Debt amount in capital structure;
E = Equity amount in capital structure;
Kd = Cost Of Debt
Question 2 Discuss the major considerations in capital structure planning.

OR
Question 2 List the fundamental principles governing capital structure.

OR
Question 2 State the principles that should be followed while designing the capi-
tal structure of a company.(4 Marks, November, 2016)
Answer
Major considerations in capital structure planning:
The decisions regarding the forms of financing, their requirements and their relative
proportions in total capitalisation are known as capital structure decisions.
Constraints to Capital Structure/Major Considerations in Capital Structure

Planning/Fundamental Principle Governing Capital Structure :
There are three major considerations, i.e. risk, cost of capital and control, which help
the finance manager in determining the proportion in which he can raise funds from
various sources. While choosing a suitable financing pattern,certain fundamental
principles should be kept in mind, which are discussed below:
(a)Cost Principle : According to this principle an ideal capital structure is one that
minimises cost of capital structure and maximises earnings per share (EPS). Debt
capital is cheaper than equity capital from the point of its cost and interest being
deductible for income tax purpose, where no such deduction is allowed for dividends.
Consequently effective rate of interest which the company has to bear would be less
than the nominal rate at which debentures are issued. This requires the mix of debt
finance with equity finance so as to reduce the aggregate cost of capital.
(b) Risk Principle: According to this principle, reliance is placed more on common
equity for financing capital requirements than excessive use of debt. Use of more and
more debt and preference capital affects share values and in unfavourable situation
share prices may consequently drop. There are two risks associated with this principle:
(i) Business Risk : It is an unavoidable risk because of the environment in which the
firm has to operate.Business risk is represented by the variability of earnings before
interest and tax (EBIT).
(ii) Financial risk : It is a risk associated with the variability of earnings per share
caused by use of financial leverage.
Generally, a firm should neither be exposed to high degree of business risk and low
degree of financial risk or vice-versa, so that shareholders do not bear a higher risk.
(c) Control Principle : While designing a capital structure, the finance manager may
also keep in mind that existing management control and ownership remains undisturbed.
Issue of new equity will dilute existing control pattern and also it involves higher cost.
Issue of more debt causes no dilution in control, but causes a higher degree of financial
risk.
(d)Flexibility Principle: It means that the management chooses such a combination

of sources of financing which it finds easier to adjust according to changes in need of
funds in future too.
(e) Other Considerations: Besides above principles, other factors such as nature of
industry, timing of issue and competition in the industry should also be considered.
Question 3 Explain in brief the assumptions of Modigliani-Miller theory.

Answer
Assumptions of Modigliani – Miller Theory
(a)Capital markets are perfect. All information is freely available and there is no
transaction cost.
(b) All investors are rational.
(c) No existence of corporate taxes.
(d) Firms can be grouped into “Equivalent risk classes” on the basis of their business
risk.
Question 4 What is optimum capital structure? Explain.

(2 Marks, November, 2007 & 2008)
Answer
Optimum Capital Structure:
The Optimum Capital Structure is that Capital Structure or combination of debt

and equity that leads to the maximisation of the Value of the Firm and minimisation of
Overall Cost of Capital.
Optimum capital structure deals with the issue of right mix of debt and equity in the
long-term capital structure of a firm. According to this, if a company takes on debt,
the value of the firm increases upto a certain point. Beyond that value of the firm will
start to decrease. If the company is unable to pay the debt within the specified period
then it will affect the goodwill of the company in the market.Therefore, company
should select its appropriate capital structure with due consideration of all factors.
Question 5 Explain the assumptions of Net Operating Income approach (NOI)

theory of capital structure. (3 Marks, November, 2007)
OR
Question 5 What is Net Operating Income (NOI) theory of capital structure?
Explain the assumptions of Net Operating Income approach theory of capital
structure. (4 Marks, May, 2012)
Answer
Assumptions of Net Operating Income (NOI) Theory of Capital Structure
According to NOI approach, there is no relationship between the cost of capital and
value of the firm i.e. the value of the firm is independent of the capital structure of the
firm.
Assumptions
(a) The corporate income taxes do not exist.
(b) The market capitalizes the value of the firm as whole. Thus the split between
debt and equity is not important.
(c) The increase in proportion of debt in capital structure leads to change in risk
perception of the shareholders.
(d) The overall cost of capital (Ko) remains constant for all degrees of debt equity
mix.
Question 6 Explain the principles of “Trading on equity”.(2 Marks, May, 2008)
Answer
(a)The term trading on equity means debts are contracted and loans are raised mainly
on the basis of equity capital. Those who provide debt have a limited share in the
firm’s earning and hence want to be protected in terms of earnings and values
represented by equity capital.
(b)Since fixed charges do not vary with firms earnings before interest and tax, a magnified
effect is produced on earning per share. Whether the leverage is favourable, in the
sense, increase in earnings per share more proportionately to the increased earnings
before interest and tax, depends on the profitability of investment proposal. If the rate
of returns on investment exceeds their explicit cost, financial leverage is said to be
positive.
Question 7 Discuss the concept of Debt-Equity or EBIT-EPS indifference point,

while determining the capital structure of a company. (2 Marks, June, 2009)
OR
Question 7 Discuss financial break-even and EBIT-EPS indifference analysis.
Answer
Concept of Debt-Equity
The determination of optimum level of debt in the capital structure of a company is

a formidable task and is a major policy decision.
It ensures that the firm is able to service its debt as well as contain its interest cost.
Determination of optimum level of debt involves equalizing between return and risk.
EBIT-EPS Indifference Point
EBIT – EPS analysis is a widely used tool to determine level of debt in a firm.
Through this analysis, a comparison can be drawn for various methods of financing
by obtaining indifference point.
It is a point to the EBIT level at which EPS remains unchanged irrespective of debt
-equity mix.
The indifference point for the capital mix (equity share capital and debt) can be
(EBIT  I1)(1  T) (EBIT  I2 )(1  T)
d et er m i n ed as f o l l o w s:

E1 E2
Where,
EBIT =Indifference point
E1 =Number of equity shares in Alternative 1
E2 =Number of equity shares in Alternative 2
I1=Interest charges in Alternative 1
12 =Interest charges in Alternative 2
T =Tax-rate
Financial break-even point
Financial break-even point is the minimum level of EBIT needed to satisfy all the
fixed financial charges i.e. interest and preference dividend.
It denotes the level of EBIT for which firm’s EPS equals zero.
If the EBIT is less than the financial breakeven point, then the EPS will be negative
but if the expected level of EBIT is more than the breakeven point, then more fixed
costs financing instruments can be taken in the capital structure, otherwise, equity
would be preferred.
Question 8 What do you understand by Capital structure? How does it differ

from Financial structure? (2 Marks, May, 2010)
Answer
Meaning of Capital Structure and its Differentiation from Financial Structure
Capital Structure refers to the combination of debt and equity which a company
uses to finance its long-term operations. It is the permanent financing of the company
representing long-term sources of capital i.e. owner’s equity and long-term debts but
excludes current liabilities.
On the other hand, Financial Structure is the entire left- hand side of the balance
sheet which represents all the long-term and short-term sources of capital. Thus,
capital structure is only a part of financial structure.
OR
Question 8 What do you mean by capital structure? State its significance in

financing decision.(4 Marks, November, 2013)
Answer
Concept of Capital Structure
Capital structure refers to the mix of a firm’s capitalisation i.e. mix of long-term
sources of funds such as debentures, preference share capital, equity share capital and
retained earnings for meeting its total capital requirement.
Significance in Financing Decision
The capital structure decisions are very important in financial management as they
influence debt – equity mix which ultimately affects shareholders return and risk.
These decisions help in deciding the forms of financing (which sources to be tapped),
their actual requirements (amount to be funded) and their relative proportions (mix)
in total capitalisation. Therefore, such a pattern of capital structure must be chosen
which minimises cost of capital and maximises the owners’ return.
Question 9 What is Over-capitalisation? State its causes and consequences.

Answer
Overcapitalization and its Causes and Consequences
It is a situation where a firm has more capital than it needs or in other words assets are
worth less than its issued share capital, and earnings are insufficient to pay dividend
and interest.
Causes of Over Capitalization
Over-capitalisation arises due to following reasons:

(i) Raising more money through issue of shares or debentures than company can
employ profitably.
(ii) Borrowing huge amount at higher rate than rate at which company can earn.
(iii) Excessive payment for the acquisition of fictitious assets such as goodwill etc.
(iv) Improper provision for depreciation, replacement of assets and distribution of

dividends at a higher rate.
(v) Wrong estimation of earnings and capitalization.
Consequences of Over-Capitalisation
Over-capitalisation results in the following consequences:
(i) Considerable reduction in the rate of dividend and interest payments.

(ii) Reduction in the market price of shares.
(iii) Resorting to “window dressing”.
(iv) Some companies may opt for reorganization. However, sometimes the matter
gets worse and the company may go into liquidation.
7.LEVERAGE
Difference Between Business Risk and Financial Risk ?(PCC May

Q u e st i o n 1
2007,2Marks) or What do you understand by Business Risk & Financial Risk ?
(IPCC/PCC Nov 2009 ) (Nov 2012) OR Distinguish between ’Business Risk’
and ’Financial Risk’.(4 Marks, November, 2014)
Answer
(i) Meaning
Business Risk refers to the risk associated with the firm’s operations.In other words
Business Risk is defined as the risk of running a business.It is the uncertainty about the
future operating income (EBIT), i.e. how well can the operating income be predicted?
Financial Risk refers to the additional risk placed on the firm’s shareholders as a
result of debt use i.e. the additional risk a shareholder bears when a company uses
debt in addition to equity financing
(ii) Avoidable or Unavoidable :
Business Risk is generally unavoidable.
Financial Risk can be avoided if the Firm does not use fixed charge sources of
finance
(iii)Measurement:
Business risk can be measured by variability of earnings before interest and tax
(EBIT). variability of earnings before interest and tax (EBIT). The variability in turn is
influenced by revenues and expenses. Revenues and expenses are affected by demand
of firm’s products, variations in prices and proportion of fixed cost in total cost.
Financial risk can be measured by ratios such as the firm’s financial leverage multi-
plier, total debt to assets ratio or degree of financial leverage.
(iv)Higher Risk:
Business/ Operating Risk :Higher the fixed operating cost,higher the Business Risk.
Financial Risk :Companies that issue more debt instruments would have higher fi-
nancial risk than companies financed mostly or entirely by equity .
(v)Business risk alters income from operations, while financial risk alters net income.
Question 2 (May 2013) “Operating risk is associated with cost structure, whereas
financial risk is associated with capital structure of a business concern.” Critically
examine this statement.
Answer
Operating risk refers to the risk associated with the firm’s operations. It is represented
by the variability of earnings before interest and tax (EBIT). The variability in turn is
influenced by revenues and expenses, which are affected by demand of firm’s products,
variations in prices and proportion of fixed cost in total cost. If there is no fixed cost,
there would be no operating risk.
Whereas financial risk refers to the additional risk placed on firm’s shareholders as
a result of debt and preference shares used in the capital structure of the concern.
Companies that issue more debt instruments would have higher financial risk than
companies financed mostly by equity.
8.TYPES OF FINANCING
Question 1 What is debt securitisation? Explain the basics of debt securitisation

process. (6 Marks, 3 Marks, 4 Marks, May 2004; November, 2004; May, 2006;
May, 2008; May 2011)
or
Question 1 What is debt securitisation? Also state its advantages.
(4 Marks, May, 2013)(4 Marks, Nov, 2016)
or
Question 1 Discuss the benefits to the originator of Debt Securitization.
(2 Marks, June, 2009)
Answer
Debt Securitisation:
It is a method of recycling of funds. It is especially beneficial to financial intermediaries

to support the lending volumes. Assets generating steady cash flows are packaged
together and against this asset pool, market securities can be issued, e.g. housing
finance, auto loans, and credit card receivables.
Process of Debt Securitisation:
(i)The origination function – A borrower seeks a loan from a finance company,

bank, HDFC. The credit worthiness of borrower is evaluated and contract is entered
into with repayment schedule structured over the life of the loan.
(ii) The pooling function – Similar loans on receivables are clubbed together to
create an underlying pool of assets. The pool is transferred in favour of Special purpose
Vehicle (SPV), which acts as a trustee for investors.
(iii)The securitisation function – SPV will structure and issue securities on the basis
of asset pool. The securities carry a coupon and expected maturity which can be asset-
based/mortgage based. These are generally sold to investors through merchant bankers.
Investors are – pension funds, mutual funds, insurance funds.
The process of securitization is generally without recourse i.e. investors bear the
credit risk and issuer is under an obligation to pay to investors only if the cash flows
are received by him from the collateral. The benefits to the originator are that assets
are shifted off the balance sheet, thus giving the originator recourse to off-balance
sheet funding.
The advantages of debt securitisation to the originator are the following:
(i)The asset is shifted off the Balance Sheet, thus giving the originator recourse to off
balance sheet funding.
(ii) It converts illiquid assets to liquid portfolio.
(iii)It facilitates better balance sheet management; assets are transferred off balance
sheet facilitating satisfaction of capital adequacy norms.
(iv)The originator’s credit rating enhances.
For the investors securitisation opens up new investment avenues. Though the investor
bears the credit risk, the securities are tied up to definite assets.
Benefits to the Originator of Debt Securitization:
The benefits to the originator of debt securitization are as follows:
(a) The assets are shifted off the balance sheet, thus giving the originator recourse to
off balance sheet funding.
(b) It converts illiquid assets to liquid portfolio.
(c) It facilitates better balance sheet management as assets are transferred off balance
sheet facilitating satisfaction of capital adequacy norms.
(d) The originator’s credit rating enhances.

Question 2 Discuss the eligibility criteria for issue of commercial paper.

or
Question 2 Explain in brief the features of Commercial Paper.
Answer
Features of Commercial Paper (CP)
A commercial paper is an unsecured money market instrument .

It issued in the form of a promissory note.
It is sold at a discount but redeemed at its par value.
It is issued (sold) by large corporations to obtain funds to meet short-term debt
obligations.
Since the CP represents an unsecured borrowing in the money market, the regulation
of CP comes under the purview of the Reserve Bank of India which issued guidelines
in 1990 on the basis of the recommendations of the Vaghul Working Group.
These guidelines were aimed at:
(i) Enabling the highly rated corporate borrowers to diversify their sources of short
term borrowings, and
(ii) To provide an additional instrument to the short term investors.
It can be issued for maturities between 7 days and a maximum upto one year from
the date of issue.
These can be issued in denominations of Rs.5 lakh or multiples therefore.
All eligible issuers are required to get the credit rating from credit rating agencies.
Eligibility Criteria for Issuer of Commercial Paper

(i) The companies satisfying the following conditions are eligible to issue commercial
paper.
(ii) The tangible net worth of the company is 5 crores or more as per audited balance
sheet of the company.
(iii) The fund base working capital limit is not less than 5 crores.
(iv) The company is required to obtain the necessary credit rating from the rating
agencies such as CRISIL, ICRA etc.
(v) The issuers should ensure that the credit rating at the time of applying to RBI
should not be more than two months old.
(vi) The minimum current ratio should be 1.33:1 based on classification of current
assets and liabilities.
(vii) For public sector companies there are no listing requirement but for companies
other than public sector, the same should be listed on one or more stock exchanges.
(viii) All issue expenses shall be borne by the company issuing commercial paper.
Question 3 Write a short note on Euro Convertible Bonds.(3 Marks, May, 2004)
Euro Convertible Bond:
Euro Convertible bonds are quasi-debt securities (unsecured) which can be converted
into depository receipts or local shares.In Other Words they are bonds issued by
Indian companies in foreign market with the option to convert them into pre-determined
number of equity shares of the company.
ECBs offer the investor an option to convert the bond into equity at a fixed price
after the minimum lock in period.
The price of equity shares at the time of conversion will have a premium element.
The bonds carry a fixed rate of interest.

These are bearer securities and generally the issue of such bonds may carry two
options viz. call option and put option.
A call option allows the company to force conversion if the market price of the
shares exceeds a particular percentage of the conversion price.
A put option allows the investors to get his money back before maturity.
Inthe case of ECBs, the payment of interest and the redemption of the bonds will be
made by the issuer company in US dollars.
ECBs issues are listed at London or Luxemburg stock exchanges.
An issuing company desirous of raising the ECBs is required to obtain prior permission
of the Department of Economic Affairs, Ministry of Finance, Government of India,
Companies having 3 years of good track record will only be permitted to raise funds.
The condition is not applicable in the case of projects in infrastructure sector.
The proceeds of ECBs would be permitted only for following purposes:
(i) Import of capital goods
(ii) Retiring foreign currency debts
(iii)Capitalising Indian joint venture abroad
(iv)25% of total proceedings can be used for working capital and general corporate
restructuring.
(v)The impact of such issues has been to procure for the issuing companies’ finances
at very competitive rates of interest. For the country a higher debt means a forex outgo
in terms of interest.
Question 4 Write a short note on American Depository Receipts (ADRs)
(6 Marks, May, 2004; May 2006)
or
Question 4 Discuss the concept of American Depository Receipts.
or
Question 4 Write short notes on Global Depository Receipts ?
or
Question 4 State the main features of Global Depository Receipts (GDRs) and
American Depository Receipts (ADRs). (4 Marks,
May, 2014)
or
Question 4 Distinguish between Global Depository Receipts and American
Depository Receipts. (4 Marks, November, 2010)
American Depository Receipts (ADRs) & Its Features:
These are depository receipts issued by a company in USA and are governed by the
provisions of Securities and Exchange Commission of USA.
Apart from legal impediments, ADRs are costlier than Global Depository Receipts
(GDRs). Legal fees are considerably high for US listing. Registration fee in USA is
also substantial. Hence ADRs are less popular than GDRs.
American Depository Receipts (ADRs) are securities offered by non- US companies

who want to list on any of the US exchanges.
Each ADR represents a certain number of a company’s regular shares.
These are used by depository bank against a fee income.
ADRs are listed on either NYSE or NASDAQ.
ADRs allow US investors to buy shares of these companies without the costs of
investing directly in a foreign stock exchange.
The pictorial representation of the process is given in Figure given below
Indian Company
Securities & Dividend
 Domestic Depository Bank

Overseas Depository Bank

Overseas Investor
It facilitates integration of global capital markets.
The company can use the ADR route either to get international listing or to raise
money in international capital market.
Example of Indian ADRs :Only few Indian companies have gone for ADRs so
far.Some of which are (1) Infosys, (2) Wipro, (3) MTNL, (4) VSNL, (5) Silverline, (6)
Dr. Reddy.These are listed on two stock exchanges (i) NASDAQ (National Associa-
tion of Securities Dealers Automatic Quotes) and (ii) New York Stock Exchange, both
have their head offices at New York.
Global Depository Receipts (GDRs) & Its Features
It is a negotiable certificate denominated in US dollars which represents a Non-US

company’s publically traded local currency equity shares.
The mechanics of a GDR issue may be described with the help of following
diagram.
Company issues

Ordinary shares

Kept with Custodian/depository banks

against which GDRs are issued

to Foreign investors
GDRs are created when the local currency shares of an Indian company are delivered
to Depository’s local custodian Bank against which the Depository bank issues
depository receipts in US dollars.
The GDRs may be traded freely in the overseas market like any other dollar-expressed
security either on a foreign stock exchange or in the over-the-counter market or among
qualified institutional buyers.
By issue of GDRs Indian companies are able to tap global equity market to raise
foreign currency funds by way of equity.
It has distinct advantage over debt as there is no repayment of the principal and
service costs are lower.
Indian Example :Among the Indian companies,Reliance Industries Ltd. was the
first company (1992) to raise funds through a GDR Issue.Recently Tata Motors on 9th
Oct 2009 raised $375 million through a GDR issue,becoming the third company from
the Tata Empire,after Tata Steel and Tata Power.
Distinguish between Global Depository Receipts and American Depository

Receipts
ADR GDR
(i)The depository receipts in US market is ADR The depository receipts in world market is GDR
(ii)Issued in accordance with the provision of SEC Not to comply with any of the condition of SEC of USA.
(Securities & Exchange Commission)of USA.
(iii)It has very strict provision regarding disclosure & Accounting Disclosure requirement is less stringent.
norms.
(iv)Cost of issuing ADR is high Cost is not high
(v)It is not so popular among Indian companies. It is much preferable than ADR
(vi)ADR are listed only in American Stock Exchange.(ASE) Listed in any foreign stock exchange other than the
American StockExchange.Example:London Stock
Exchange,
Luxemburg Stock Exchanges etc
Question 5 Write short notes on Bridge Finance

(6 Marks; 2 Marks May 2006; Nov. 2011)(Nov 2016)
Bridge Finance:
Meaning : Bridge Finance refers to loans taken by a company normally from

commercial banks for a short period, pending disbursement of loans sanctioned by
financial institutions.
Why it is Taken : Normally, it takes time for financial institutions to disburse loans
to companies. However, once the loans are approved “in -principle” by the term
lending institutions, companies, in order not to lose further time in starting their
projects, arrange short term loans from commercial banks. Bridge loans are also pro-
vided by financial institutions pending the signing of regular term loan agreement,
which may be delayed due to non-compliance of conditions stipulated by the institu-
tions while sanctioning the loan.
Terms :
(a) Interest : The rate of interest on bridge finance is higher as compared with that on
term loans.
(b) Repayment : The bridge loans are repaid/adjusted out of the term loans as and
when disbursed by the concerned institutions.
(c) Secuity : Bridge loans are normally secured by hypothecating movable assets,
personal guarantees and promissory notes.
Recent Example : Tata Motors acquiring Jaguar & Land Rover for $ 2 billion
under Bridge Loan Arrangement.
Question 6 Write short notes on Deep Discount Bonds & Zero Coupon Bonds(3
Marks, May, 2004)
or
Question 4 Write short notes on the features of deep discount bonds.
(2 Marks, November, 2007 & 2008; May, 2012)
Deep Discount Bonds & Its Features
Deep Discount Bonds (DDBs) are in the form of zero interest bonds.
These bonds are sold at a discounted value and on maturity face value is paid to the
investors.
In such bonds, there is no interest payout during lock-in period.
The investors can sell the bonds in stock market and realise the difference between
face value and market price as capital gain.
IDBI was first to issue a Deep Discount Bonds (DDBs) in India in January 1992.
The bond of a face value of Rs.1 lakh was sold for Rs.2,700 with a maturity period of
25 years.
Zero Coupon Bonds & Its Features

A zero coupon bond (ZCB) does not carry any interest but it is sold by the issuing
company at a discount.
The difference between discounted value and maturing or face value represents the
interest to be earned by the investor on such bonds.
It operates in the same manner as a Deep Discount Bonds(DDB) but in this case
lock-in period is comparatively less.
Question 7 Write short notes on Venture Capital Financing(2 Marks, May,

2005; May, 2008)
or
Question 7 What is venture capital financing? Discuss the factors that a venture
capitalist should consider before financing any risky project. (4 Marks, May,
2013)(4 Marks, May, 2012)
or
Question 7 Explain the methods of venture capital financing.
(4 Marks, November, 2015)(3 Marks, November, 2007)
Venture Capital Financing:
Meaning : The Venture Capital Financing refers to financing of new high risky
ventures promoted by qualified entrepreneurs who lack experience & funds to give
shape to their ideas.
Some of the characteristics of Venture Capital Funding are:

•It is basically equity finance in new companies.
•It can be viewed as a long-term investment in growth-oriented small/medium firms.
•Apart from providing funds, the investor also provides support in form of sales strategy,
business networking and management expertise, enabling the growth of the entrepreneur.
Other Points:
•The risk associated with the enterprise could be so high as to entail total loss or be so
insignificant as to lead to high gains.
•The European Venture Capital Association describes venture capital as risk finance
for entrepreneurial growth oriented companies. It is an investment for the medium or
long term seeking to maximise the return.
•High technology industry is more attractive to venture capital financing due to the
high profit potential.
Factors to be considered by a Venture Capitalist before financing any Risky
P r o j ec t :
(i) Quality of the management team is a very important factor to be considered.

They are required to show a high level of commitment to the project.
(ii) The technical ability of the team is also vital. They should be able to develop and
produce a new product / service.
(iii) Technical feasibility of the new product / service should be considered.
(iv) Since the risk involved in investing in the company is quite high, venture capitalists
should ensure that the prospects for future profits compensate for the risk.
(v) A research must be carried out to ensure that there is a market for the new product.
(vi) The venture capitalist himself should have the capacity to bear risk or loss, if the
project fails.
(vii) The venture capitalist should try to establish a number of exist routes.
(viii) In case of companies, venture capitalist can seek for a place on the Board of
Directors to have a say on all significant matters affecting the business.
Some Common Methods of Venture Capital Financing

Methods of Venture Capital Financing : The venture capitalist generally finance
ventures which are in national priority areas such as energy conservation, quality
upgradation, etc,. Some common methods of venture capital financing are as follows:
(i) Equity Financing The venture capital undertakings generally requires funds for a
longer period but may not be able to provide returns to the investors during the initial
stages. Therefore, the venture capital finance is generally provided by way of equity
share capital. The equity contribution of venture capital firm does not exceed 49% of
the total equity capital of venture capital undertakings so that the effective control and
ownership remains with the entrepreneur. Hence such a mode is useful since there is
no compulsion to pay dividend or interest in initial stages.
(ii) Conditional Loan : A conditional loan is repayable in the form of a royalty after
the venture is able to generate sales. No interest is paid on such loans. In India venture
capital financers charge royalty ranging between 2 and 15 per cent; actual rate de-
pends on factors such as gestation period, cash flow patterns, riskiness and any other
factors of the enterprise.
(iii) Income Note : It is a hybrid security which combines the features of both conven-
tional loan and conditional loan. The entrepreneur has to pay both interest and roy-
alty on sales but at substantially low rates.
(iv) Participating Debenture : Such security carries charges in three phases - in the
start up phase, no interest is charged, next stage a low rate of interest is charged upto
a particular level of operations, after that, a high rate of interest is required to be paid.
Example of Indian Venture Capital Funds : Infosys Technologies co-founder

and chairman NR Narayana Murthy recently sold company shares worth around $37
million to set up a VC fund for incubating Indian start-ups.A statement issued by
Infosys said the VC fund would encourage & support young entrepreneurs having
brilliant business ideas.
Question 8 Write short notes on Seed Capital Assistance(3 Marks; 2 Marks,

May, 2005; May 2010)
Seed Capital Assistance:
Applicability : The Seed Capital Assistance scheme is designed by IDBI for

professionally or technically qualified entrepreneurs and/or persons possessing rel-
evant experience, skills and entrepreneurial traits. All the projects eligible for finan-
cial assistance from IDBI, directly or indirectly through refinance are eligible under
the scheme.
Amount Of Finance : 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. 15 lacs whichever is lower.
Interest & Charge : The Seed Capital Assistance is interest free but carries a
service charge of one per cent per annum for the first five years and 10% p.a. thereaf-
ter. However, IDBI will have the option to charge interest at such rate as may be
determined by IDBI keeping in view the financial position and profitability of the
company.
Repayment : The repayment schedule is fixed depending upon the repaying capac-
ity of the unit with an initial moratorium of upto five years .
Other Agencies : For projects with a project cost exceeding Rs. 2 Crores, seed
capital may be obtained from the Risk Capital and Technology Corporatiobn Ltd. (
RCTC ) . For smnall projects costng upoto Rs. 5 Lakhs, assistance under the national
equity Fund of the SIDBI may be availed.
Question 9 Explain the term ‘Ploughing back of Profits’.

(2 Marks, May, 2007; November, 2009)
Answer
Ploughing back of Profits:
Meaning:Ploughing back of Profits or Retained earnings means retention of profit

.In other words that part of surplus profit which is not distributed as dividend are
termed as Retained Profit or Ploughing back of Profits.
Various Features of Retained Earnings are :
(i)Retained Earnings are an internal source of long term financing and are treated as
long term funds.
(ii) Such funds belong to the ordinary shareholders and increase the net worth of the
company.
(iii)A public limited company must plough back a reasonable amount of profit every
year keeping in view the legal requirements in this regard and its own expansion plans.
(iv)Such funds also entail almost no risk.
(v)Further,control of present owners is also not diluted by retaining profits.
Question 10 Explain the concept of Indian depository receipts.

Answer
Concept of Indian Depository Receipts:
IDR means any instrument in the form of depository receipt created by the domestic
depository in India against the underlying equity shares of the issuing foreign company
Companies incorporated outside the country can now raise resources from the Indian
capital market through the issue of Indian Depository Receipts (IDRs).
An IDR is a financial instrument similar to a Global Depository Receipt (GDR) and
American Depository Receipt (ADR), the objective of which is to provide a platform
to foreign firms to directly raise capital in India. For Indian investors, IDRs would
provide a route to invest in foreign firms.
In an IDR, foreign companies would issue shares, to an Indian Depository (say
National Security Depository Limited – NSDL), which would in turn issue depository
receipts to investors in India.
Recent Example:Standard Chartered is planning to list its shares in India through
an issue of Indian Depository Receipts (IDRs).The UK bank had recently received an
approval from the RBI for the issue.
Listing: These IDRs would be listed on stock exchanges in India and would be
freely transferable.
Benefits to Indian Investors: IDR is an additional investment opportunity for
Indian investors for overseas investment.Indian citizens will be able to easily improve
their portfolio diversification as well as a chance to sample new companies that would
otherwise not be available for investment.
Question 11 Discuss the features of Secured Premium Notes (SPNs).
Answer
(a) Meaning: Secured Premium Notes are debt instruments issued along with a de-
tachable warrant and is redeemable after a specified period (4 to 7 Years)
(b) Option to Convert: SPN’s carry an option to convert into Equity Shares, i.e. the
detachable warrant can be converted into Equity Shares.
(c) Period for Conversion: Conversion of detachable warrant into Equity Shares
should be done within a time period specified by the company
(d)This was first introduced by TISCO which issued SPNs aggregating Rs.346.50
crore to existing shareholders on a rights basis.
Question 12 Explain the concept of closed and open- ended lease.

Answer
In the close-ended lease, the assets gets transferred to the lessor at the end of lease,
the risk of obsolescence, residual values etc. remain with the lessor being the legal
owner of the assets.
In the open -ended lease, the lessee has the option of purchasing the assets at the
end of lease period.
Question 13 Discuss the advantages of preference share capital as an instrument

of raising funds. (2 Marks, May, 2008)
Answer
Preference Share Capital : These are a special kind of shares; the holders of such
shares enjoy priority, both as regards to the payment of a fixed amount of dividend and
repayment of capital on winding up of the company over ordinary equity capital.
Advantages of Issue of Preference Shares
(i) No dilution in EPS on enlarged capital base.
(ii) There is no risk of takeover as the preference shareholders do not have voting
rights.
(iii) There is leveraging advantage as it bears a fixed charge.
(iv) The preference dividends are fixed and pre-decided. Preference shareholders do
not participate in surplus profit as the ordinary shareholders
(v) Preference capital can be redeemed after a specified period.
Question 14 Explain briefly the features of External Commercial Borrowings

(ECBs). (3 Marks, May, 2008)
Answer
External Commercial Borrowings are loans taken from non-resident lenders in
accordance with exchange control regulations.
These loans can be taken from:
International banks Capital markets
Multilateral financial institutions like IFC, ADB, IBRD etc. Export Credit Agencies
Foreign collaborators Foreign Equity Holders.
ECBs can be accessed under automatic and approval routes depending upon the
purpose and volume.
In automatic there is no need for any approval from RBI / Government while approval
is required for areas such as textiles and steel sectors restructuring packages.
Question 15 Name the various financial instruments dealt with in the international
market.(2 Marks, November, 2008)
or
Question 15 Name any four financial instruments, which are related to
international financial market. (2 Marks, May, 2014)
Answer
Financial Instruments in the International Market
Some of the various financial instruments dealt with in the international market are:
(a) Euro Bonds

(b) Foreign Bonds
(c) Fully Hedged Bonds
(d) Medium Term Notes
(e) Floating Rate Notes
(f) External Commercial Borrowings
(g) Foreign Currency Futures
(h) Foreign Currency Option
(i)Euro Commercial Papers.
Question 16 Differentiate between Factoring and Bills discounting.

(May 2015,4 Marks) (2 Marks; 4 Marks, November, 2009; May 2013)
Answer
Differentiation between Factoring and Bills Discounting
(i)Invoice factoring/discounting:Factoring is called as 'Invoice factoring' whereas

bills discounting is known as 'Invoice discounting'
(ii)Parties: In factoring the parties are known as client, factor and debtor whereas in
bills discounting they are known as Drawer, Drawee and Payee.
(iii)Nature:Factoring is a sort of management of book debts whereas bills discounting
is a sort of borrowing from commercial banks.
(iv)Act:For factoring there is no Specific Act;whereas in the case of bills discounting,
the Negotiable Instrument Act is applicable.
(v)Grace Period: Grace time is not given under Factoring.Grace time of 3 days is
given under Bill Discounting.
(vi)Risk of Bad Debt:Bad debts may be borne by factor in case of extra commission
as agreed.No such provision under Bill Discounting.The risk of bad debts is still
retained by the business.
(vii)Service Offered:Factoring finances and manages the receivables of the client.Bill
Discounting does not offer any non-financial services
(viii)Basis of Financing:In factoring the basis of financing is turnover.Whereas in
bill discounting it is the security provision as well as the requirement of finance which
determine the amount of financing.
(ix)Continuity:Factoring is generally continuous.Bills discounting is specific and not
continuous.
(x)Income To Financier : Factor earns “Interest” for the financing service,and Com-
mission for other services rendered.Under Bill discounting Banker earns “ Discount-
ing Charges” on the transaction.
(xi)With-Without Recourse:Factoring may be With or Without Recourse. But Bills
Discounting is always With Recourse.
Question 17 What is factoring? Enumerate the main advantages of factoring.

Answer
Concept of Factoring and its Main Advantages:
Factoring involves provision of specialized services relating to credit investigation,

sales ledger management purchase and collection of debts, credit protection as well as
provision of finance against receivables and risk bearing. In factoring, accounts
receivables are generally sold to a financial institution (a subsidiary of commercial
bank – called “factor”), who charges commission and bears the credit risks associated
with the accounts receivables purchased by it.
Advantages Of Factoring :
(i)Convertibility:The biggest advantages of factoring are the immediate conversion

of receivables into cash.
(ii)Reduction in Collection and Administration Costs:Continuous factoring virtually

eliminates the need for the credit department
(iii)Financing receivables with the help of factoring can help a company having liquidity
without creating a net liability on its financial condition.
(iv)Besides, factoring is a flexible financial tool providing timely funds, efficient record
keepings and effective management of the collection process.
(v)This is not considered to be as a loan.There is no debt repayment, no compromise

to balance sheet, no long term agreements or delays associated with other methods of
raising capital.
(vi)Definite Pattern Of Cash Inflows: Factoring ensures a definite pattern of cash in

flows.
(vii)No Compensating Balance Requirement: Unlike an unsecured loan,

compensating balances are not required in this case.
Question 18 Distinguish between Operating lease and financial lease.

(4 Marks, November, 2011)(4 Marks, November, 2014)(4 Marks, May, 2016)
Answer
Distinguish between Operating Lease and Financial Lease
Point :Ownership
Operating Lease :The lessee is only provided the use of the asset for a certain time.
Risk incident to ownership belongs only to the lessor.
Finance Lease :The risk and reward incidental to ownership are passed on to the
lessee. The lessor only remains the legal owner of the asset.
Point :Bearing Risk

Operating Lease :The lessor bears the risk of obsolescence.
Finance Lease :The lessee bears the risk of obsolescence.
Point :Purchase option

Operating Lease :The lessee does not have any option to buy the asset during the
lease period.
Finance Lease :It allows the lessee to have a purchase option during the lease period.
Point :Expenses borne

Operating Lease :Usually, the lessor bears the cost of repairs, maintenance or
operations.
Finance Lease :The lessor does not bear the cost of repairs, maintenance or operations.
Point :Treatment
Operating Lease :Lease payment is treated like operating expenses like rent.
Finance Lease :Finance lease is generally treated like a loan.
Question 19 Explain the concept of leveraged lease.(2Marks,November 2007)

or
Question 19 State the main elements of leveraged lease.
(4 Marks, May, 2016)(4 Marks, November, 2013)
Answer
Leveraged Lease & Main Elements of Leveraged Lease: :
Leveraged lease involves lessor, lessee and financier.

In leveraged lease, the lessor makes a substantial borrowing, even upto 80 per cent
of the assets purchase price.
Lessor provides remaining amount – about 20 per cent or so – as equity to become
the owner.
The lessor claims all tax benefits related to the ownership of the assets. The lessor
is entitled to claim depreciation allowance.
Lenders, generally large financial institutions, provide loans on a non recourse basis
to the lessor.
Their debt is served exclusively out of the lease proceeds.The lender is paid off from
the lease rentals directly by the lessee and the surplus after meeting the claims of the
lender goes to the lessor.
To secure the loan provided by the lenders, the lessor also agrees to give them a
mortgage on the asset.
Leveraged lease are called so because the high non-recourse debt creates a high
degree of leverage.
Question 20 “Financing a business through borrowing is cheaper than using
equity.” Briefly explain. ( 4 M a r k s, N o v e m b e r , 2 0 1 2 )
Answer
“Financing a business through borrowing is cheaper than using equity”

(i) Debt capital is cheaper than equity capital from the point of its cost and interest
being deductible for income tax purpose, whereas no such deduction is allowed for
dividends.
(ii)Issue of new equity dilutes existing control pattern while borrowing does not result
in dilution of control.
(iii) In a period of rising prices, borrowing is advantageous. The fixed monetary
outgo decreases in real terms as the price level increases.
Question 21 Write Short Note On (1) Sales and Lease Back Leasing & (2) Sales-
aid Lease ? (May 2015,4 Marks)
Answer
(1) Sales and Lease Back Leasing :
Meaning : Under this type of lease, the owner of an asset sells the asset to a party (the
buyer), who in turn leases back the same asset to the owner in consideration of a lease
rentals. Under this arrangement, the asset are not physically exchanged but it all
happen in records only.
Parties:Under this transaction, the seller assumes the role of lessee and the buyer
assumes the role of a lessor. The seller gets the agreed selling price and the buyer gets
the lease rentals.
Necessity/Purpose : This is a method of raising funds immediately required by lessee
for working capital or other purposes. Sometimes it is also used as Tax Saving Mecha-
nism .
Benefit : The lessee continues to make economic use of assets against payment of
lease rentals while ownership vests with the lessor. The main advantage of this method
is that the lessee can satisfy himself completely regarding the quality of an asset and
after possession of the asset convert the sale into a lease agreement.
Sales-aid Lease:
M ea n i n g : When the leasing company (lessor) enters into an arrangement with the
seller, usually manufacturer of equipment, to market the later’s product through its
own leasing operations, it is called a ‘sales-aid-lease’.
Benefit : In consideration of the aid in sales,the manufacturers may grant either credit,or
a commission to the lessor.Thus,the lessor earns from both sources i.e.from lessee as
well as the manufacturer doubles its profit.
Question 22 Distinguish between the following: Preference Shares and

Debentures. (Nov 2015,4 Marks)
Difference between Preference Shares and Debentures

Basis of difference
Ownership Preference Share Capital is a special kind of share
Debenture is a type of loan which can be raised
from the public
Payment of Dividend/ Interest Preference Share Capital holders enjoy priority

both as regard to the payment of a fixed amount
of dividend and also towards repayment of capital
in case of winding up of a company
Debenture carries fixed percentage of interest.

Nature Preference shares are a hybrid form of financing
with some characteristic of equity shares and some
attributes of Debt Capital.
Debentures are instrument for raising long term
capital with a period of maturity.
9.CAPITAL BUDGETING
Question 1 Discuss the need for social cost benefit analysis.

Answer
Meaning : Social Cost Benefit Analysis is a systematic evaluation of an organisation’s

social performance as distinguished from its economic performance.
Several hundred crores of rupees are committed every year to various public projects.
Analysis of such projects has to be done with reference to social costs and benefits.
Social cost benefit analysis is important for the private corporations also who have
a moral responsibility to undertake socially desirable projects.
The need for social cost benefit analysis arises due to the following:
(i)The market prices used to measure costs & benefits in project analysis, may not
represent social values due to market imperfections.
(ii)Monetary cost benefit analysis fails to consider the external positive & negative
effects of a project.
(iii)Taxes & subsidies are transfer payments & hence irrelevant in national economic
profitability analysis.
(iv)The redistribution benefits because of project needs to be captured.
(v)The merit wants are important appraisal criteria for social cost benefit analysis.
Question 2 Decision tree analysis is helpful in managerial decisions.” Explain

with an example. (5 Marks, May, 2005)
Answer
Significance of Decision Tree Analysis:
Decision may have several implicationsinvestment decisions involve a sequence of

decisions over time. It is also argued that since present choices modify future alternatives,
industrial activity cannot be reduced to a single decision and must be viewed as a
sequence of decisions extending from the present time into the future. These sequential
decisions are taken on the bases of decision tree analysis. While constructing and
using decision tree, some important steps to be considered are as follows:
(i) Investment proposal should be properly defined.
(ii) Decision alternatives should be clearly clarified.
(iii) The decision tree should be properly graphed indicating the decision points,
chances, events and other data.
(iv) The results should be analysed and the best alternative should be selected.
Question 3 Define Modified Internal Rate of Return method.

Answer
Modified Internal Rate of Return (MIRR):
Under MIRR,we aim at converting Non-conventional Cash Flows into Conventional

Cash Flows,thereby eliminating the problem of Multiple IRRs.
There were several limitations attached with the concept of the conventional IRR.The
MIRR addresses some of these deficiencies e.g, it eliminates multiple IRR rates; it
addresses the reinvestment rate issue and produces results which are consistent with
the Net Present Value method.
Procedure:Under this method,all cash flows,apart from the initial investment,are
brought to the terminal value using an appropriate discount rate.This results in a
single stream of cash inflow in the terminal year. The discount rate which equates the
present value of the terminal cash inflow to the zeroth year outflow is called the
MIRR.
Question 4 Explain the concept of Multiple Internal Rate of Return.

Answer
There can be more than one internal rate of return under certain cercumstances.
In cases where project cash flows change signs or reverse during the life of a project
e.g. an initial cash outflow is followed by cash inflows and subsequently followed by
a major cash outflow,there may be more than one IRR.
In such situations if the cost of capital is less than the two IRRs,a decision can be
made easily and the project should be accepted. Similarly if the cost of capital is more
than all the internal rates of return,the project is to be rejected.However the problem
arises when the cost of capital is in between the two internal rates of return.In such
case IRR decision rule may turn out to be misleading.This problem of Multiple IRRs
can be solved by using Modified Internal Rate of Return(MIRR).
To understand the concept of multiple IRRs it is necessary to understand the implicit
reinvestment assumption in both NPV and IRR techniques.
NPV
IRR1 IRR2
Discount Role
Question 5 Explain the concept of discounted payback period.

Answer
Concept of Discounted Payback Period
 When the pay back period is computed after discounting the cash flows by a pre-
determined rate (cut-off rate) it is called as the “discounted pay back period.
The discounted payback period is similar to payback period except that the future
cash inflows are first discounted and then payback is calculated.It is superior than
Payback period as under this time value of money is also considered.
In this we have to find out the cash flows earnings over the years and get it dis-
counted by multiplying those inflows with the discounting factor. After that we have
to get the cumulative figures of those discounted cash flows and find the pay back
period by interpolation. It obviously takes care of the time value of money.
Decision : The lower the Discounted Payback Period better the project
Hence, if interest on long-term debt and dividend on equity capital are deducted in
defining the cash flows, the cost of long-
Question 6 Explain the term “Desirability factor/Profitability Index”.

(1.5 Marks, November, 2009)
Answer
Meaning:Profitability Index signifies present value of inflow per rupee of outflow.

It therefore help us to compare projects involving different amount of initial investments.
Present Value Of Inflows
Formula:Profitability Index (PI) 
Present Value Of Outflows
Decision:Where PI > 1 Accept the proposal ; PI = 1 Indifference point ; PI < 1
Reject the proposal .
Merits :
(i) This method considers the time value of money.
(ii) It focuses on maximum return per rupee of investment and hence is useful in case
of investment in divisible projects, when funds are not fully available.
Demerits :
(i) PI as a guide in resolving capital rationing fails where projects are indivisible. Once
a single large project with high NPV is selected, possibility of accepting several small
projects which together may have higher NPV than the single project is excluded.
(ii) Situations may arise where a project with a lower Profitability Index selected may
generates cash flows in such a way that another project can be taken up one or two
years later, the total NPV in such case being more than the one with a project with
highest Profitability Index. The Profitability Index approach thus cannot be used
indiscriminately.
Question 7 Distinguish between Net present value method and internal rate of
return method. (4 Marks, November, 2015)(4 Marks, November, 2011)
Answer
Difference between Net Present Value (NPV) Method and Internal Rate of Return
(IRR) Method
Meaning:The Net Present Value is the difference between the present value of cash
inflows and cash outflows. Whereas Internal Rate of Return (IRR) is that rate at which
the discounted cash inflows are equal to the discounted cash outflows.
Cost Of Capital : NPV uses the firm’s cost of capital as Interest rate. Unless the
cost of capital is known, NPV method cannot be used. Calculating cost of capital is
not required for computing IRR.
Expression:The NPV is expressed in financial values whereas Internal Rate of
Return (IRR) is expressed in percentage terms.
Assumption : NPV assumes that intermediate cash flows are re-invested at firm’s
cost of capital whereas IRR assumes that intermediate cash inflows are reinvested at
the internal rate of the project.
Multiple Rates : IRR may give negative rate or multiple rates under certain circum-
stances whereas NPV does not suffer from the limitation of multiple rates.
Different Ranking : In case of mutually exclusive investment projects, in certain
situations, they may give contradictory results such that if the NPV method finds one
proposal acceptable, IRR favours another. The different rankings given by the NPV
and IRR methods could be due to size disparity problem, time disparity problem and
unequal expected lives.
10.MEANING, CONCEPT AND POLICIES OF WORKING CAPITAL
Question 1 Discuss the liquidity vs. profitability issue in management of working

capital. (4 Marks, November, 2010)
Answer
Liquidity versus Profitability Issue in Management of Working Capital
Working capital management entails the control and monitoring of all components of
working capital i.e. cash, marketable securities, debtors, creditors etc. Finance manager
has to pay particular attention to the levels of current assets and their financing. To
decide the level of financing of current assets, the risk return trade off must be taken
into account. The level of current assets can be measured by creating a relationship
between current assets and fixed assets. A firm may follow a conservative, aggressive
or moderate policy.
A conservative policy means lower return and risk while an aggressive policy produces
higher return and risk. The two important aims of the working capital management are
profitability and solvency. A liquid firm has less risk of insolvency i.e. it will hardly
experience a cash shortage or a stock out situation. However, there is a cost associated
with maintaining a sound liquidity position. So, to have a higher profitability the firm
may have to sacrifice solvency and maintain a relatively low level of current assets.
Question 2 Discuss the risk-return considerations in financing of current assets.

(4 Marks, November, 2015)(4 Marks, November, 2004)
Answer
(i) The financing of current assets involves a trade off between risk and return. A
firm can choose from short or long term sources of finance. Short term financing is less
expensive than longterm financing but at the same time, short term financing involves
greater risk than long term financing.
(ii) Depending on the mix of short term and long term financing, the approach
followed by a companymay be referred as matching approach, conservative approach
and aggressive approach.
(iii) In matching approach, long- term finance is used to finance fixed assets and
permanent current assets and short term financing to finance temporary or variable
current assets. Under the conservative plan, the firm finances its permanent assets and
also a part of temporary current assets with long term financing and hence less risk of
facing the problem of shortage of funds.
(iv) An aggressive policy is said to be followed by the firm when it uses more short
term financing than warranted by the matching plan and finances a part of its permanent
current assets with short term financing.
Question 3 Discuss the estimation of working capital need based on operating

cycle process. (4 Marks, November, 2010)
Answer
Estimation of Working Capital Need based on Operating Cycle

Meaning :Working Capital Cycle or Cash Cycle or Operating Cycle is the time
duration for conversion of cash into cash equivalents like Raw Materials,Work-In-
Progress,Finished Goods,Sundry Debtors and thereafter back in cash.
Computation:In the form of an equation, the operating cycle process can be
expressed as follows:
Operating Cycle = R + W + F + D - C
Where,R = Raw Material Storage Period ;W = Work-in-Progress Holding Period ; F =

Finished Goods Storage Period ; D = Debtors Collection Period ; C = Credit Period
Availed.
The various components of operating cycle may be calculated as shown below:
(i) Raw Material (RM) Storage Period or RM Conversion Period

Average Stock Of Raw Material
=
Average Cost Of Raw Material Consumed Per Day
(ii) WIP Storage Period or WIP Conversion Period =

Average Stock Of WIP
Average Cost Of Production Per Day
(iii) FG Storage Period or FG Conversion Period

Average Stock Of FG
=
Average Cost Of Goods Sold Per Day
Average Debtors
(iv) Debtors Collection Period =
Average Credit Sales Per Day
Average Payables
(v) Accounts Payables Period =
Average Credit Purchases Per Day
The determination of working capital cycle helps in the forecast, control and
management of working capital.
It indicates the total time lag and the relative significance of its constituent parts.
The duration of working capital cycle may vary depending on the nature of the
business.
Cash Cycle Of Manufacturing Firm
Inventory of Inventory of Inventory of

Cash
Raw-materials Work-in-progress Finished goods
Raw-materials Work-in-progress Finished goods
Receivables
Cash Cycle Of Trading Firm
Cash Inventory of Finished goods Receivables
10 Marvellous Quotations..!!
1. I am a great believer in luck, and i find that the harder i work, the more i
have of it!
2. Whenever you fall, pick something up!
3. No one can climb the ladder of success, with both hands in the pocket!
4. I am a slow walker but i never walked back!
5. Tough times never last, but tough people do!
6. A winner never quits, and a quitter never wins!
7. Not failure, but low aim is a crime!
8. Your aspirations are your possibilities!
9. The highest result of education is tolerence!
10. Control your destiny or somebody else will...
11.TREASURY AND CASH MANAGEMENT
Question 1 Write short note on William J. Baumal vs. Miller-Orr cash

management model. (3 Marks; 4 Marks, May, 2004; May 2011)
Answer
William J. Baumol's Economic Order Quantity Model (1952) :
According to this model,optimum cash level is that level of cash where the carrying
costs & transactions costs are the minimum.
The carrying costs refers to the cost of holding cash, namely, the interest foregone
on marketable securities.
The transaction costs refers to the cost involved in getting the marketable securities
converted into cash. This happens when the firm falls short of cash and has to sell the
securities resulting in clerical, brokerage, registration and other costs.
2AT
Formula Optimum Cash Balance =
H
Where,
C = Optimum cash balance ;
U = Annual (or monthly) cash disbursement ;
P = Fixed cost per transaction ;
S = Opportunity cost of one rupee p.a. (or p.m.)
Assumptions :
(i) Cash needs of the firm are known with certainty.
(ii)The cash is used uniformly over a period of time and it is also known with certainty.
(iii)The holding cost is known and it is constant.
(iv)The transaction cost also remains constant.
Limitations:The limitation of the Baumol's model is that it does not allow the cash
flows to fluctuate. Firms in practice do not use their cash balance uniformly nor they
are able to predict daily cash inflows and outflows. The Miller-Orr (MO) model
overcomes this shortcoming and allows for daily cash flow variation.
Y Minimum total cost
Transaction Cost
X
O Lot Size
Question 2 Discuss Miller-Orr Cash Management model.

(May 2015,4 Marks) (2 Marks, November, 2005)
Answer
Miller-Orr Cash Management Model (1966) :
According to this model the net cash flow is completely stochastic. When changes
in cash balance occur randomly the application of control theory serves a useful
purpose. The Miller-Orr model is one of such control limit models.
This model is designed to determine the time and size of transfers between an
investment account and cash account.
The diagram given below illustrates the Miller-Orr model.
In this model control limits are set for cash balances.These limits may consist of h as
upper limit, z as the return point; and zero as the lower limit.
When the cash balance reaches the upper limit, the transfer of cash equal to h-z is
invested in marketable securities account. When it touches the lower limit, a transfer
from marketable securities account to cash account is made.
During the period when cash balance stays between (h, z) and (z, 0) i.e. high and low
limits no transactions between cash and marketable securities account is made.
Upper control limit
(Rs.)
Cash Balance
Return point
Lower control limit
The high and low limits of cash balance are set up on the basis of fixed cost associated
with the securities transactions, the opportunity cost of holding cash and the degree of
likely fluctuations in cash balances.
These limits satisfy the demands for cash at the lowest possible total costs.
The MO Model is more realistic since it allows variations in cash balance within
lower and upper limits. The finance manager can set the limits according to the firm's
liquidity requirements i.e., maintaining minimum and maximum cash balance.
The formula for calculation of the spread between the control limits is:
1/3
 3/4  Transactio n cost  Variance of Cash flows 
Spread = 3   
 Interest R ate 
And, the return point can be calculated using the formula:
Spread
Return point = Lower Limit +
3
Question 3 Explain briefly the functions of Treasury Department.

(3 Marks, May, 2008 & June, 2009 & Nov 2016)
Answer
The functions of treasury department management is to ensure proper usage, storage
and risk management of liquid funds so as to ensure that the organisation is able to
meet its obligations, collect its receivables and also maximize the return on its
investments. Towards this end the treasury function may be divided into the following:
(i) Cash Management: The efficient collection and payment of cash both inside the
organization and to third parties is the function of treasury department. Treasury
normally manages surplus funds in an investment portfolio.
(ii) Currency Management: The treasury department manages the foreign currency
risk exposure of the company. It advises on the currency to be used when invoicing
overseas sales. It also manages any net exchange exposures in accordance with the
company policy.
(iii) Fund Management: Treasury department is responsible for planning and

sourcing the company’s short, medium and long-term cash needs. It also participates
in the decision on capital structure and forecasts future interest and foreign currency
rates.
(iv) Banking: Since short-term finance can come in the form of bank loans or through
the sale of commercial paper in the money market, therefore, treasury department
carries out negotiations with bankers and acts as the initial point of contact with them.
(v) Corporate Finance: Treasury department is involved with both acquisition and
disinvestment activities within the group. In addition, it is often responsible for investor
relations.
Question 4 State the advantage of Electronic Cash Management System.

Answer
Advantages of Electronic Cash Management System
(i) Significant saving in time.
(ii) Decrease in interest costs.
(iii) Less paper work.
(iv) Greater accounting accuracy.

(v) More control over time and funds.
(vi) Supports electronic payments.
(vii) Faster transfer of funds from one location to another, where required.
(viii) Speedy conversion of various instruments into cash.
(ix) Making available funds wherever required, whenever required.
(x) Reduction in the amount of ‘idle float’ to the maximum possible extent.
(xi) Ensures no idle funds are placed at any place in the organization.
(xii) It makes inter-bank balancing of funds much easier.
(xiii) It is a true form of centralised ‘Cash Management’.
(xiv) Produces faster electronic reconciliation.
(xv) Allows for detection of book-keeping errors.
(xvi) Reduces the number of cheques issued.
(xvii)Earns interest income or reduce interest expense.
Question 5 What is Virtual Banking? State its advantages.

Answer
Virtual Banking and its Advantages
Virtual banking refers to the provision of banking and related services through the
use of information technology without direct recourse to the bank by the customer.
The advantages of virtual banking services are as follows:
(i) Lower cost of handling a transaction.
(ii) The increased speed of response to customer requirements.
(iii) The lower cost of operating branch network along with reduced staff costs leads
to cost efficiency.
(iv) Virtual banking allows the possibility of improved and a range of services being
made available to the customer rapidly, accurately and at his convenience.
Question 6 ‘Management of marketable securities is an integral part of investment

of cash.’ Comment. (4 Marks, November, 2013)
Answer
“Management of Marketable Securities is an Integral Part of Investment of

Cash”
Management of marketable securities is an integral part of investment of cash as it

serves both the purposes of liquidity and cash, provided choice of investment is made
correctly. As the working capital needs are fluctuating, it is possible to invest excess
funds in some short term securities, which can be liquidated when need for cash is felt.
The selection of securities should be guided by three principles namely safety, maturity
and marketability.
Question 7 Explain the Lock Box System.

Answer
Lock Box System:

Another means to accelerate the flow of funds is a lock box system. The purpose of
lock box system is to eliminate the time between the receipts of remittances by the
company and deposited in the bank. A lock box arrangement usually is on regional
basis which a company chooses according to its billing patterns.
Question 8 Explain four kinds of float with reference to management of cash?
Answer
Four Kinds of Float with reference to Management of Cash
The four kinds of float are:
(i) Billing Float: The time between the sale and the mailing of the invoice is the
billing float.
(ii) Mail Float: This is the time when a cheque is being processed by post office,
messenger service or other means of delivery.
(iii)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.
(iv)Bank processing float: This is the time from the deposit of the cheque to the
crediting of funds in the seller’s account.
Question 9 Describe the three principles relating to selection of marketable

securities.(4 Marks, November, 2016)(4 Marks, May, 2016)
Answer
Three principles relating to selection of marketable securities are as follows:
Safety: Return and risks go hand in hand. As the objective in this investment is
ensuring liquidity, minimum risk is the criterion of selection.
Maturity: Matching of maturity and forecasted cash needs is essential. Prices of long
term securities fluctuate more with changes in interest rates and are therefore, more
risky.
Marketability: It refers to the convenience, speed and cost at which a security can be
converted into cash. If the security can be sold quickly without loss of time and price
it is highly liquid or marketable.
Question 10 Evaluate the role of cash budget in effective cash management
system.(4 Marks, November, 2015)
Answer
Cash Budget is the most significant device to plan for and control cash receipts and
payments. It plays a very significant role in effective Cash Management System. This
represents cash requirements of business during the budget period.
The various role of cash budgets in Cash Management System are:-
(i)Coordinate the timings of cash needs. It identifies the period(s) when there might
either be a shortage of cash or an abnormally large cash requirement;
(ii)It also helps to pinpoint period(s) when there is likely to be excess cash;
(iii)It enables firm which has sufficient cash to take advantage like cash discounts on
its accounts payable; and
(iv)Lastly it helps to plan/arrange adequately needed funds (avoiding excess/shortage
of cash) on favorable terms.
" When I was 5 years old, my mother always told me that happiness was the key
to life. When I went to school, they asked me what I wanted to be when I grew
up. I wrote down 'happy'. They told me I didn't understand the assignment, and I
told them they didn't understand life."
12.MANAGEMENT OF RECEIVABLES
Question 1 Explain the ‘Ageing Schedule’ in the context of monitoring of

receivables. (3 Marks, November, 2004)
Answer
1.An important means to get an insight into the collection pattern of debtors is the
preparation of their ‘Ageing Schedule’. Receivables are classified according to their
age from the date of invoicing e.g. 0 – 30 days, 31 – 60 days, 61 – 90 days, 91 – 120
days and more. The ageing schedule can be compared with earlier month’s figures or
the corresponding month of the earlier year.
2.This classification helps the firm in its collection efforts and enables management to
have a close control over the quality of individual accounts. The ageing schedule can
be compared with other firms also.
Question 2 Explain briefly the accounts receivable systems.(2 Marks, May, 2010)
Answer
Accounts Receivable Systems
1.Manual systems of recording the transactions and managing receivables are

cumbersome and costly.
2.The automated receivable management systems automatically update all the

accounting records affected by a transaction.
3.This system allows the application and tracking of receivables and collections to
store important information for an unlimited number of customers and transactions,
and accommodate efficient processing of customer payments and adjustments.
13.FINANCING OF WORKING CAPITAL
Enumerate the various forms of bank credit in financing the working

Q u est i o n 1
capital of a business organization. (2 Marks, May, 2010)
OR
Question 1 What are the forms of bank credit?(4 Marks, November, 2012)
Answer
Forms of Bank Credit

The bank credit will generally be in the following forms:
(i) Cash Credit: This facility will be given by the banker to the customers by giving
certain amount of credit facility on continuous basis. The borrower will not be allowed
to exceed the limits sanctioned by the bank.
(ii) Bank Overdraft: It is a short-term borrowing facility made available to the
companies in case of urgent need of funds. The banks will impose limits on the amount
they can lend. When the borrowed funds are no longer required they can quickly and
easily be repaid.The banks issue overdrafts with a right to call them in at short notice.
(iii) Bills Discounting: The company which sells goods on credit, will normally draw
a bill on the buyer who will accept it and sends it to the seller of goods. The seller, in
turn discounts the bill with his banker. The banker will generally earmarks the
discounting bill limit.
(iv) Bills Acceptance: To obtain finance under this type of arrangement a company
draws a bill of exchange on bank. The bank accepts the bill thereby promising to pay
out the amount of the bill at some specified future date.
(v) Line of Credit: Line of Credit is a commitment by a bank to lend a certain amount
of funds on demand specifying the maximum amount.
(vi) Letter of Credit: It is an arrangement by which the issuing bank on the instructions
of a customer or on its own behalf undertakes to pay or accept or negotiate or
authorizes another bank to do so against stipulated documents subject to compliance
with specified terms and conditions.
(vii) Bank Guarantees: Bank guarantee is one of the facilities that the commercial
banks extend on behalf of their clients in favour of third parties who will be the
beneficiaries of the guarantees.
Question 2 Explain the Concentration Banking. (2 Marks, May, 2014)
Answer
Concentration Banking:
In concentration banking the company establishes a number of strategic collection
centres in different regions instead of a single collection centre at the head office. This
system reduces the period between the time a customer mails in his remittances and
the time when they become spendable funds with the company. Payments received by
the different collection centers are deposited with their respective local banks which
in turn transfer all surplus funds to the concentration bank of head office.
Question 3 State the different types of Packing Credit.

Answer
Different Types of Packing Credit : Packing credit may be of the following types:
(i) Clean Packing credit: This is an advance made available to an exporter only on
production of a firm export order or a letter of credit without exercising any charge or
control over raw material or finished goods. It is a clean type of export advance. Each
proposal is weighted according to particular requirements of the trade and credit
worthiness of the exporter. A suitable margin has to be maintained. Also, Export
Credit Guarantee Corporation (ECGC) cover should be obtained by the bank.
(ii) Packing credit against hypothecation of goods: Export finance is made available
on certain terms and conditions where the exporter has pledgeable interest and the
goods are hypothecated to the bank as security with stipulated margin. At the time of
utilising the advance, the exporter is required to submit alongwith the firm export
order or letter of credit, relative stock statements and thereafter continue submitting
them every fortnight and whenever there is any movement in stocks.
(iii) Packing credit against pledge of goods: Export finance is made available on
certain terms and conditions where the exportable finished goods are pledged to the
banks with approved clearing agents who will ship the same from time to time as
required by the exporter. The possession of the goods so pledged lies with the bank
and is kept under its lock and key.
(iv) E.C.G.C. guarantee: Any loan given to an exporter for the manufacture,
processing, purchasing, or packing of goods meant for export against a firm order
qualifies for the packing credit guarantee issued by Export Credit Guarantee
Corporation.
(v) Forward exchange contract: Another requirement of packing credit facility is

that if the export bill is to be drawn in a foreign currency, the exporter should enter
into a forward exchange contact with the bank, thereby avoiding risk involved in a
possible change in the rate of exchange.
Life isn't about what you couldn't do so far...

I was Conductor - Rajnikanth
I didn't completed my University - Bill Gates
I Stitched Shoes in childhood - Abraham Lincoln
I was the 1 who served in Hotels - Oberoi
I worked in a Petrol Pump - Ambani
I Failed in class 10 - Sachin Tendulkar
Drop-Out n Keyboard Player - A.R.Rahman
I Slept On a Bench n borrowed Rs20 evrydy 4m friend 2 travel to filmcity - SRK
I used 2 serve Tea @ Shop 2 support my Football Training" - Messi
"Life isn't about what you couldn't do so far, its about what you still can"
back
“If you have a dream,

don’t just sit there.
Gather courage to believe
that you can succeed and
leave no stone unturned
to make it a reality.”
AADITYA JAIN
INDIA’S BEST
COACH &
GUIDE
FOR CA / CS /
CMA FINANCE
STUDENTS

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CHAPTER 2 TIME VALUE OF MONEY 8

CHAPTER 3 APPLICATION OF RATIO ANALYSIS 10

CHAPTER 4 CASH FLOW AND FUNDS FLOW ANALYSIS 20

CHAPTER 5 COST OF CAPITAL 22

CHAPTER 6 CAPITAL STRUCTURE DECISIONS 25

CHAPTER 8 TYPES OF FINANCING 35

CHAPTER 9 CAPITAL BUDGETING DECISIONS 57

CHAPTER 10 MEANING, CONCEPT AND POLICIES OF WORKING CAPITAL 62

CHAPTER 11 TREASURY AND CASH MANAGEMENT 66

CHAPTER 12 MANAGEMENT OF RECEIVABLES 74

CHAPTER 13 FINANCING OF WORKING CAPITAL 75

Welcome to the amazing world of finance.................................

STOCK MARKET TRADER

THEY ARE GREAT ACHIEVERS ..BUT THANKS TO

Question 1 Discuss the functions of a Chief Financial Officer.

Functions of a Chief Financial Officer :

Question 2 What are the main responsibilities of a Chief Financial Officer of an

Responsibilities of Chief Financial Officer (CFO):

Question 3 Explain the limitations of profit maximization objective of Financial

Limitations of Profit Maximisation Objective of Financial Management

“The profit maximisation is not an operationally feasible criterion.” This statement

It suffers from the following limitations:

Conflict in Profit versus Wealth Maximization Objective:

Profit maximisation is a short­term objective and cannot be the sole objective of a

Whereas, on the other hand, wealth maximisation, is a long-term objective and

Question 5 Differentiate between Financial Management and Financial

Differentiation between Financial Management and Financial Accounting:

Treatment of Funds: In accounting, the measurement of funds is based on the

Decision-making: The chief focus of an accountant is to collect data and present

Question 6 Explain the two basic functions of Financial Management.

Two Basic Functions of Financial Management

Procurement of Funds: Funds can be obtained from different sources having

Emerging Issues/Priorities Affecting the Future Role of Chief Financial Officer

(i)Regulation: Regulation requirements are increasing and CFOs have an increasingly

Q u est i o n 1 Explain the relevance of time value of money in financial decisions?

(i)Risk:There is uncertainty about the receipt of money in future.

(ii)Preference for present consumption: Most of the persons and companies in

(iii)Inflation: In an inflationary period a rupee today represents a greater real

(iv)Investment opportunities: Most of the persons and companies have a preference

Risk: There is uncertainty about the receipt of money in future.

Question 3 What is a sinking fund and how is it calculated ?

Question 4 Define ‘Present Value’ and ‘Perpetuity’.(4 Marks, May, 2015)

Discuss the financial ratios for evaluating company performance on

Financial ratios for evaluating performance on operational efficiency and liquidity

Calculation of Return on Equity

Return on Equity = Net profit margin× Asset turnover × Equity multiplier

a) Net Profit Margin:

(b) Asset Turnover:

Question 3 How return on capital employed is calculated? What is its

What it Measure/Indicate:It is the most important ratio of all. It is the percentage

Significance Of Capital Employed:

Question 4 What is quick ratio? What does it signify?

What it Measure/Indicate: It is a measurement of a firm's ability to convert its

Remark: An acid-test of 1:1 is considered satisfactory .

Stock Turnover Ratio

What it Measure/Indicate:Stock Turnover Ratio helps to find out if there is too

What it Measure/Indicate:This ratio indicate or measure the proportion of fixed

Question 6 How is Debt service coverage ratio calculated? What is its

Calculation of Debt Service Coverage Ratio (DSCR) and its Significance

What it Measure/Indicate:Debt Service Coverage Ratio measures or judge the

Earnings Available For Debt Service

Question 7 Explain briefly the limitations of financial ratios.

Profit maximisation is a shortterm objective and cannot be the sole objective of a