Microsoft Word - Finances

A Management Paradise (un)Ltd. Endeavor ………………………………………………….
I, MP
Authored by Kartik Raichura

&
Pratik Mehta.
It is not Where We Reach, but more importantly How we reach matters………Go on….. - 1
A Management Paradise (un)Ltd. Endeavor …………………………………………………. I, MP
DISCLAIMER
Information contained in this work has been obtained from various sources believed to be
reliable. However, neither Management Paradise nor its authors guarantee the accuracy
or completeness of any information published herein and neither Management Paradise
nor its authors shall be responsible for any errors, omissions, or damages arising out of use
of this information. This work is published with the understanding that Management
Paradise and its authors are supplying information but are not attempting to render
engineering or other professional services. If such services are required, the assistance of
an appropriate professional should be sought.
PREFACE TO THE THIRD EDITIO)
So when
when are you releasing the BOOK, TYBMS students ask me call after call and I tell them
this time we might not release the book. The voice mellows down, a sadness is felt and there is
E--BOOK shortly which
silence for a few seconds. I say, But we are releasing an E which will be free to
download for MP Members. There is a surprising shrill, FREE !? Absolutely FREE ? they ask
in distrust and I go YES, ABSOLUTELY FREE !
The Aim of MP has always been to help students, and during the past years when we SOLD
this book to recover
recover the costs, we realized that students weren’t able to afford it. Things have
changed over the years, the computers and internet penetration has increased by leaps and
bounds and So we decided to release this free ebook.
While we strive to help YOU in all your education needs, WE expect you to support our
endevours, help other fellow management students and build a strong management
students community on ManagementParadise.com
So Spread the word and Get your friends registering and interacting on MP.
You
You must’ve downloaded this ebook for www.ManagementParadise.com . We recommend you
do NOT download it from anywhere else.
Best of Luck for your TYBMS SEM 5 Exams.
Yours Truly,
Kartik Raichura, Pratik

Pratik Mehta,
CEO, ManagementParadise.com Co-

Co-Author, ManagementParadise.com
The book is incomplete without Thanking the Management Paradise Team !
Bhavin Mehta : Marketing Head and Administrator, the stallion,

pursuing his MBA from UTS, Sydney, Australia.
Pratik Mehta: person who Co-authored 2 books for tybms students under
the MP publication umbrella is pursuing his MBA from Lala Lajpatrai
Nilesh Nagdev: Head Forum Moderator and content developer, is

trying to crack the CAT
Roshni Bhatia : This book wouldn’t have been completed without her
help. Doing her TYBMS at Raheja College, Roshni acts as an advisor for
MP.
Nikhil Gadodia: Human Resource Head at MP, works full time with a
media house as senior HR manager.
Vishal Bhawsinghka: Head Public Relations and is pursuing his MBA

from XLRI which has been sponsored by accenture where he is
undergoing training.
Kartik Raichura: Founder and CEO, is juggling with his MBA at

Welingkars and managing this brilliant team that is commited to
revolutionize management education.
Every leader needs followers and its only fair that I mention other
potential leaders in MP which include, Deepak Khanna, Melroy Lopes,
Rahul Parab, Rohan Kachalia and Fatima Khan who played key roles
as Moderators to take MP reach where it is today.
The newly recruited Ankit Gokani is learning through his teeth at MP

and is responsible for answering your project related help requests. So if
your requests don’t get addressed, you know whom to catch ;) !
Your Name HERE ? : Join the MP Team ! Mail your CV on

career@managementparadise.com
Ithaca
When you set out on your journey to Ithaca,

pray that the road is long,
full of adventure, full of knowledge.
The Lestrygonians and the Cyclops,
the angry Poseidon -- do not fear them:
You will never find such as these on your path,
if your thoughts remain lofty, if a fine
emotion touches your spirit and your body.
The Lestrygonians and the Cyclops,
the fierce Poseidon you will never encounter,
if you do not carry them within your soul,
if your soul does not set them up before you.
Pray that the road is long.

That the summer mornings are many, when,
with such pleasure, with such joy
you will enter ports seen for the first time;
stop at Phoenician markets,
and purchase fine merchandise,
mother-of-pearl and coral, amber and ebony,
and sensual perfumes of all kinds,
as many sensual perfumes as you can;
visit many Egyptian cities,
to learn and learn from scholars.
Always keep Ithaca in your mind.

To arrive there is your ultimate goal.
But do not hurry the voyage at all.
It is better to let it last for many years;
and to anchor at the island when you are old,
rich with all you have gained on the way,
not expecting that Ithaca will offer you riches.
Ithaca has given you the beautiful voyage.

Without her you would have never set out on the road.
She has nothing more to give you.
And if you find her poor, Ithaca has not deceived you.
Wise as you have become, with so much experience,
you must already have understood what Ithacas mean.

Constantine P. Cavafy (1911)
Some Untrodden Paths – An MP Archive…
With about a few months or so to go, the question that junta is asking at this point is not "Do I
have it in me to crack CAT?" as much as "Do I have it in me to crack me in crack CAT in a
month?"
Now let us presume that you present your problem to a management consultant like say
McKinsey, what would they come up with? Remember they would give you only strategic
advice, no actual implementation level micromanagement. Here are a few pointers that could
actually turn up in their analysis report:
(1) Don't boil the ocean:
Simply put, don't try to do something unimaginably huge (boil the ocean) to bring results that
are not proportionate (get salt). This ways you will just cause more anguish when you realize
half way through that the latent point of boiling for the ocean is pretty huge. Another way to put
it is: Work smart, not hard.
Try to come up with a list of possible tasks for CAT and try figuring out what the amount of
effort required to do it is. At the end of it, you can either lessen the effort or cross it out
completely. Here is an example. A lot of you may be wondering if it is really wise to "do" the
word-list. Go through a realistic run of where you are. This is a good time to go through the kind
of words given over the last 4 years (over which CAT has kind of streamlined the questions) and
figure if you really need to go through those huge word-lists. Amazingly at the end of the
exercise, you might want to do away with it all together, or go through a selective portion just to
ramp up your rusted skills. (For example, you might decide to do only the "High Frequency"
words from Barron's GRE.)
(2) Pluck the low-hanging fruits first
An important point that many students don't realize at this juncture, due to immense pressure, is
that it makes more sense for one to consolidate what he/she knows, rather than make an
immature attempt to try learning everything. Do not attempt anything that is difficult. We have
seen many students coming to us at the nth moment asking if they should be attempting
"Permutation Combination". My simple answer is - If you have not done it in your schooling, if
you have not done it in college, if you have not done it through out your CAT prep so far, then
the chances that on November 18th the neurons in your brain actually go into a synaptical surge
and the answer will plop in front of you are .........well, to be frank - quite bleak! Rather I would
strengthen topics I know well - percentages, profit-loss, mensuration etc.
On the flip side, is it wise to be completely ignorant about these topics? The answer is a
resounding NO!!!! I strongly suggest you take out some time (a few hours perhaps from an
otherwise eventful study schedule) for each of these dreaded topics and figure out which are the
formulae and basic types of problem. The test-setters of the more diabolic variety are known to
sneak in a few deceptively. Most test-takers are blissfully unaware of this till the coaching
institutes print a bold "SITTER" next to that question a day after the CAT and the cutoff seems
all the more further away. Better safe than sorry!
(3) Think out of the box
Edward De Bono once famously remarked "An expert is someone who has succeeded in making
decisions and judgments simpler through knowing what to pay attention to and what to ignore."
Try to ensure that whatever you do from now on is not something that is mechanical or by rote,
but something that involves you actively in the process. So take up each problem and try
figuring out stuff like - can it work with some variation? How can anyone twist this problem? Is
there a simpler way of doing this? How I can design a problem for someone along these lines?
etc. etc. In short - try to "internalize" the problem you are solving.
A classic example is the mock CATs you have taken so far. Even for those questions which have
helped you inch towards the elusive cut-offs - try to figure which were ill-considered attempts. I
have seen many instances in the past when my reason for choosing a correct answer was
preposterous to say the least (I have, in good humor and on occasions, picked up answers
because, from among others, it "sounded" correct!) and yet managed to get them right. Try to sit
and figure if the same problem has a better way of doing it.
(4) Peel the onion Layer by layer......one thing at a time
Let us presume you have a problem with reading large data in DI. In short, number crunching is
not exactly one of your virtues, (normally these are areas you would not touch with a ten-foot
pole!), yet is a necessary evil which cannot be avoided (like say P&C). We need to figure out
how best to deal with this.
Take a couple of the mocks you have taken and try figuring out how you have done in it. See
what is it that actually stopped you from getting in the top percentile. "I suck at numbers" is an
answer which will neither aid your morale nor help you analyze yourself better. Be more
objective and tough. Speed? Bad at approximation? The questions were too ambiguous?
Whatever the reasons - try making a list of those things. Now instead of racking your brain alone
over what can be done for that, speak to someone at your institute. Better still, catch a
friend/mentor who has "been there and done that" for his/her insights on what can be done to
help bridge this gap. Remember that you may also use the "boiling the ocean" principle here and
remove any ideas of indulging in frivolous activities like learning Vedic mathematics at this
point.
(5) Pareto's principle
The 80/20 rule. Some of the variations are: 20% of the time goes in doing 80% of the tasks, 20%
of the business brings 80% of the revenue, 20% of the world controls 80% of the money etc. The
point here is: Try to figure which is the 80% that is bringing you the marks and focus on that. I
read somewhere what one of the CAT 2003 100%iler had written - he had wanted to maximize
on Verbal and tried to get cutoff in quant. And sure he maximized in Verbal with a score of 45
(and just around 17.5 in QA)!! There is no use spending all 1hour in quant and getting 2 marks
more than the cutoff and spending 20mins in verbal and get barely get the cutoff.
(6) Parkinson's Law
The law states - "Work expands to fill the time available to do it" I think the scourge of every
self-respecting graduate is doing a "night-out" to write that college journal a day before the
submission. And we carry this habit with us to the work place too. Just look around you it keeps
happening all the time - software project, advertising campaigns, government decisions - you
name it! So is it with CAT.
Set yourself challenging schedules and stick to it. Tell yourself you are going to analyze those
dreaded mock cats which have been piling on a corner for the last few months. Sounds
impossible right? But as the Nike ad says "Just do it!" Even if you are not able to complete it, so
be it, at the least you started and finished in a go. Keep challenging yourself; try sneaking out
every last minute you have to get something done. Do those distasteful tables when you are
having your smoke after lunch. Do those obnoxious RC practices when you are reading the
morning newspaper.
And remember you cannot really challenge yourself unless you have a hard target to achieve.
(7) The fish cannot bat and I cannot swim
Words from Boycott could not be truer in the CAT perspective. Realize what your areas of
strength and areas of weaknesses are. But still at the end of the day there will be the odd ball
"stud" who licks the field clean. So in your approach you would be wise if you remember to
steer clear of any ego-issues. Don't try tackling that extra toughie DI problem set which goes
into 3rd decimals of approximation or the arcane RC passage on Madhubani paintings just
because you are out there trying to prove you too are one. The point in case is that if you were
one, you would not have been struggling.
Last year there was this guy in IIT Chennai. He was a math and physics Olympiad with an IIT-
JEE AIR of 12. He ended up with a 100%ile (and a score of 103 in CAT 2003!). He went on to
join IIM-B. Realize that there are always going to be guys like this. Instead of worrying about
them, realize that at the most there are going to be around 100 odd guys like this. Forget about
them. Think about the 1100 others who are vying for the same seat as you. And if you are really
bothered about such guys, then stock your fridge with some cold beer!
(8) Fail to plan then you plan to fail
Put in excruciating detail into the planning/scoping work before you start out. Make sure every
waking hour is accounted for. Doesn't mean you have to go overboard and start planning to
account for each minute. Rather, a detailed account of how you are going to spend time over the
next month. A caveat to the fore-mentioned point. At times we do things just because it was in
the original plan. Make sure your plan is flexible. If a week before CAT you figure that doing
more practice in RC is going to pay off, so be it!! But make sure you constantly check your plan
and ask "Is it the right thing to do?" rather than "Am I doing it correctly?"
(9) Life is what happens when you are busy making plans - John Lennon (1940-1980)
Some words of wisdom that I keep telling myself everyday, CAT or no CAT. "The longer I live,
the more I realize the impact of attitude on life. Attitude, to me, is more important than facts. It
is more important than the past, than education, than money, than circumstances, than failures,
than successes, than what other people think or say or do. It is more important than appearance,
giftedness or skill. It will make or break a company... a church... a home.
The remarkable thing is we have a choice every day regarding the attitude we will embrace for
that day. We cannot change our past... we cannot change the fact that people will act in a certain
way. We cannot change the inevitable. The only thing we can do is play on the one string we
have, and that is our attitude... I am convinced that life is 10% what happens to me and 90% how
I react to it. "
At the end of the day it is a just an exam. Nothing more. Nothing less. No reason why you
should treat it differently. No reason why you should worry more. No reason why you should
not think about other things in life. No reason why you should not keep your cool. If you were
expecting a list of dos and don'ts I am afraid I might have disappointed you. But this is not
meant to serve as one in the first place - the institutes are already doing a pretty good job of that.
Life's battles do not always go
To the faster or to the stronger man;
In the end, the man who wins
Is the one who thinks he can."
P.S: i, remember one of my Friend, who had his password for every site as “iminiim”(I am in IIM). That
has to be the passion to get through. Although he got in to IIM’s is altogether a different issue. But do
have that passion in you, for that will make you a True Winner……….Efforts May Fail, but Don’t Fail to
Put an Effort………
MP Team.
MP - )ever “Most Practical”……..but still “My Place”……….i, MP
If Dreams were a Quantum of Richness/Stinginess, then our Founder would have been the most
Successfully Rich or Miser, as the case would have been. For those who really think the above as
sarcasm, at MP this is just another Great Philosophy.
For us “Getting Successful” was never a thought, atleast not after the Dot Com bust, but getting over and
carrying on was the Mindset. i guess, it was Year 2005, (that Year bookmarked the most difficult CAT
paper), that’s when MP was Born.
)ormally, this is the Tempo, when we read any of the Founder’s Works. But at MP we just feel
Blowing the Trumpet will Undermine our Goal.
Just Like to describe a small story:
A jobless man applied for the position of "office boy" at Microsoft. The HR manager interviewed him then
watched him cleaning the floor as a test.
"You are employed."
He said." Give me your e-mail address and I'll send you the application to fill in, as well as date when you may
start."
The man replied "But I don't have a computer, neither an email."
I'm sorry", said the HR manager, "If you don't have an email, that means you do not exist. And who
doesn't exist, cannot have the job."
The man left with no hope at all. He didn't know what to do, with only $10 in his pocket. He then decided
to go to the supermarket and buy a 10Kg tomato crate.
He then sold the tomatoes in a door to door round. In less than two hours, he succeeded to double his
capital.
He repeated the Operation three times, and returned home with $60. The man realized that he can survive
by this Way, and started to go everyday earlier, and return late Thus, his money doubled or tripled every
day. Shortly, he bought a cart, then a truck, and then he had his own fleet of delivery vehicles.
5 years later, the man is one of the biggest food retailers in the US. He started to plan his family's future,
and decided to have a life insurance. He called an insurance broker, and chose a protection plan. When
the conversation was concluded, the broker asked him his email. The man
replied, "I don't have an email". The broker answered curiously, "You don't have an email, and yet have
succeeded to build an empire. Can you imagine what you could have been if you had an email?!!" The
man thought for a while and replied, "Yes, I'd be an office boy at Microsoft!"
Moral of the story:
M1 - Internet is not the solution to your life.

M2 - If you don't have internet, and work hard, you can be a millionaire.
M3 - If you received this message by email, you are closer to being an office boy, than a millionaire..........
Yes, we did receive this message Via Email, and really gave it a Thought. A heart full of Thanks to the
Sender, we are back on Path and thus Wishing you the same…………Seldom does End justify the
Means, Just Give your Best, and God will do the Rest……..
MP is with You all the Way,……Through out this Book……through SEMS….and Through
Life,,,,,,,,,Thank You for giving us an Opportunity……..
Live as if You are going to die Tomorrow, Learn as if You are going to Live Forever……..
Sd/-
i, Mp
Table of Contents
Financial Management November 2001 Answers. 18
Financial Management November 2004 Answers 90
Financial Management November 2005 Answers 120
Financial Management November 2006 148
Financial Management November 2007 174
Logistics November 2001 Error!

Bookmark not defined.






Service Sector Marketing November 2001 Error!






SERVICE SECTOR MANAGEMENT NOV 2007 Error!

Human Resource Management November 2001 Error!

Human Resource Managemet November 2002 Error!

Human Resource Managemet 0ovember 2003 Error!



Human Resource Management 0ovember 2006 Error!

Rural Marketing November 2001, Error!

Rural Marketing November 2002 Answers Error!



Rural Marketing November 2005 Error!

Rural Marketing November 2006 Error!

RURAL MARKETING NOV 2007 Error!

Management Of Cooperatives November, 2001 Error!

Management Of Cooperatives November 2002 Error!

Management Of Cooperatives November 2003 Error!




MANAGEMENT OF CO-OPERATIVES NOV 2007 Error!

Financial Management
- An Eternal Part of U’n’i Verse
The Beauty of Finance Lies not only in its

Quantitudal Aspect but also, it does take a care to
mention Positives and Negatives…..
Your happiness is your PROFIT,
Your sorrow is your LOSS,
Your soul is your GOODWILL,
You heart is your FIXED ASSET,
Your duties are your OUTSTA)DI)G EXPE)SES,
Your friendship is your HIDDE) ADJUSTME)T,
Your character is your CAPITAL,
Your knowledge is your I)VESTME)T,
Your patience is your I)TEREST,
Your mind is your BA)K BALA)CE,
Your bad thinking is your DEPRECIATIO),

Your behaviour is your JOUR)AL E)TRY,
Your Wisdom is your CLOSI)G STOCK.
Now, Do we need to Learn it?,
Lets Practice IT.
FINANCIAL MANAGEMENT
FINance: A Nuance of Knowledge, or one can also take it as a “New Ounce of

Knowledge”. But today finance is generally considered as one of the terror subjects. It is as
beautiful as the Whistling Woods, as the thoughts of Cooperatives, the Science of Human
Behavior,
Hence today we like to present you with some of the Myths

of Finance and and also its Realities, to just realize our goal of Everybody
being the financial Manager……………….
M(p)T Myths….. MP Facts…..

• Finance is a Tough Subject, • Yep It is Tough, only when
You Don’t Try to
and atleast I am not made for it……..
Understand it.
• Finance is just Playing with

• Finance is Complex Play of
Ideas and Not Numbers.
Numbers.
• No, Nobody can stop You
• I need to Join Classes to Scrape
from Learning, and if You
through the exams need classes, then what’s
wrong. Don’t You ask your
friends to help.
• Even in today’s age,

• It is a Rocket Science. It is
Finance is Evolving Itself,
always X = Y= Z. and Let the Rockets stay

out of Earth.
• I am not Interested in Finance, • Yep, finding your Interests

is Good, but even Finance
Me Made for the Marketing.
has ample of Challenges.
• “Fuh Get It” • Just Do It………..
EPICenter
"The smallest spark can start the largest fire"
The spark in your life is enthusiasm, excitement and positive expectations. If you are
enthusiastic and excited about something, if you have positive expectations of the future, then
nothing is too much trouble, you are capable of anything.
Making this Book was not easy….but it was the belief that made it possible…
Believe that you can do it, because it is belief in yourself and the value of what you are
attempting that's gives meaning to life. So look for the spark in your life. The spark of
enthusiasm, of excitement and positive expectations because
"The smallest spark can start the largest fire".
Thoughts to Live/Work By….:
Financial Management November 2001 Answers.
Strategy for this paper:

paper In this paper the best strategy was to start with Section
II, as it contains long question, but based on conceptuary skills. Hence it is
essential to devote proper 1 hour to this section. Then solve concepts and
lastly, come on case study.
Concept testing: (12 marks) don’t give more than 25 minutes.
Note: in this type of questions, carrying 2 marks, it is enough to write concepts
between ½ - ¾ of a page.
1) Distinguish between Permanent and Temporary working capital: EXPECTA:CY

RATE: 2/5
Solution: Working capital basically means that part of Firm’s capital which is required to
hold or operate firms operations. Basically the concept of installment on loan can be
understood as working capital. How we need to pay regular installments so that we can have
access to resources. Similarly a firm has to pay for factors of production, to hold on good.
Etc.
In Accounting sense Working Capital = Current Assets – Current Liabilities.

The permanent component current assets which are required throughout the year will
generally be financed from long-term debt and equity. This type of working capital is
also referred as ‘Core Current Assets’. Core Current Assets are those required by the firm
to ensure the continuity of operations. It also represents the minimum levels of various
items of current assets viz., stock of raw materials, stock of work-in-process, stock of
finished goods, debtors balances, cash and bank etc. This minimum level of current assets will
be financed by the long-term sources and any fluctuations over the minimum level of
current assets will be financed by the short-term financing. Sometimes core current
assets are also referred to as ‘hard core working capital’.
It is the least minimum amount of working capital required to run the business. Like EMI’s,
you need to pay the minimum amount of installment. That is Permanent Working capital
(P.W.C).
Temporary Working Capital (T.W.C): any changes in permanent working capital will refer
to temporary working Capital. Normally, W.C > P.W.C., hence the difference is termed as
temporary, but the difference can be negative, W.C< P.W.C,
P.W.C is required when business is not functioning, but T.W.C is required on the scale of
operation of business
2) What is a “Business Risk”? E.R: 3/5
Solution: “A MAN WHO MAKES NO MISTAKES IS EITHER UNBORN OR DEAD”

Thus, risk is associated with Day to day issues that companies or corporations address as
they create and deliver products to their customers is known as business risk.
Risk must be considered when defining business strategy and its associated strategic
initiatives. It also refers to the projected variability of the earnings of the firm regardless of
how the firm is financed.
For e.g.: some firms will have higher business risk, just due to its placing in certain industry.
This is due to the fact that industry has higher rate of return or high capital investment etc.
similarly firms in utilities which are regulated have lower business risk.
Thus risk is the extent of uncertainty of operations, accruals,. It is the hidden but implied
cost of running an enterprise.
3) What do leverage ratios indicate? E.R: 3.5/5

Solution: “It is not the load that breaks us, but how we carry it breaks us”
Leverage basically means to take the advantage of. Leverage basically owes it origin from
the word ‘Lever’ which means to ease out. Thus, the employment of an asset or source of fund
for which one has to pay a fixed cost or fixed return may be termed as leverage. Consequently,
the earnings available to the shareholders is also affected. If the earnings after deducting variable
costs exceed fixed costs or earnings before the interests and Taxes exceeds fixed return
requirement, then leverage is favorable, and when they do not, the result is unfavorable.
4) Explain “ Inter-Corporate Deposits” E.R.: 3.5/5

Solution: It is also known as “Parking the Capital”. A deposit made by one company with
another, normally for a period up to six months, is referred to as inter corporate deposit.
Such deposits are usually of three types;
Call Deposits: A call deposit is withdrawable by the lender on giving a days notice.
In Practice, however the lender has to wait for at least three days. The interest rate on
such deposit may be around 16% p.a.
Three Months Deposit: These are more popular in practice. These deposits are
taken from borrowers to tide over a short term cash inadequacy that may be
caused by one or more of the following factors: disruption in production,
excessive imports of raw materials, tax payment, delay in collection, dividend
payment and unplanned capital expenditure. The interest rate on such deposits is
around 18% p.a.
Six Months Deposits: Normally, lending companies do not extend deposits beyond
this time frame. Such deposits usually made with first class borrowers. These
deposits carry an interest rate of around 20% p.a.
EPICenter
"Change your attitude or change your job."
Too many people do not like their job. Too many people do not want to work. Too many people
feel that they are forced to work.
If you really dislike what you do then stop doing it. Do something else. However if circumstances
are such that you do not have the resources to do something else then the next best thing to do is
to change your attitude towards what you do.
Remember this "It is easier to learn to like what you do than it is to do what you like" and as soon
as you have learned to like what you do then you will be doing what you like.
2) You are given the following ratios of AXE Ltd. and you are also given the industry
ratios:
Ratios Considered AXE Ltd. Industry Average
a) Current Ratio: 2.67 2.4
b) Liquid Ratio: 1 1.2
c) Debtors Turnover Ratio: 10 8
d) Inventory Turnover Ratio: 3.33 9.8
e) Total Assets Turnover Ratio: 1.43 2
f) Net Profit Margin: 2.1% 3.3 %
g) Return on Total Assets: 3% 6.6 %
h) Return on Net Worth: 4.8 % 10.7 %
i) Total Debts/ Total Assets: 37.7 % 63.5 %
Using the given ratios indicate the company’s strengths and weaknesses vis a vis the
industry.
Solution:
Books of AXE ltd
Comments:
1) Current Ratio shows the solvency of the firm and effectiveness of the Working Capital
Management. It is an important ratio to Financial Analyst, Financiers and Investors.
The Standard Ratio is 2:1.
The Current Ratio of the Firm Axe Ltd. is 2.67, whereas the Industrial Average is 2.4.
It shows that the solvency position is more than satisfactory; the firm can meet its Current
liabilities.
2) Liquid Ratio: It indicates the immediate solvency of the firm. It is known as Acid Test
as the results are more immediate. Only quick and Liquid Assets are considered and
Stock is included. The Standard ratio for Liquid ratio is 1:1, whereas the industrial
average of Axe Ltd. is 1.2.
The Liquid ratio of Axe Ltd. is 1, which satisfies the Standard Benchmark, but as
compared to Industrial average it is not Satisfactory.
3) )et Profit Ratio: It shows the administrative efficiency and profitability of a business
firm. It indicates the percentage of profit on sales. It is difficult to say or suggest a
standard ratio. However, 8-15% may be considered may be considered satisfactory.
However, in today’s competitive business environment and globalized scenario business
firms operate at low margin of even 5%, which is the same case here. Although the
industrial average is 3.3%, but AXE ltd. has net profit margin of 2.1%.
4) Total Assets Turnover ratio indicates the velocity or speed at which stock is turning
over, faster the better. Here the industry average is 2 times, whereas ratio of Axe Ltd. is
only 1.43% which is quite less. We can say that Axe Ltd. is operating on less than 75%
efficiency, when it comes to total assets turnover.
5) Debtor Turnover Ratio: The components of this ratio are Sundry debtors,
Accounts Receivables like bills receivables and average daily sales. For
computing this ratio, average collection period is to be ascertained.
It shows the velocity or speed at which the debtors are turning over along with Collection
period. It indicates the credit policies of the firm and efficiency of collection department.
Generally, the collection period is 60 days. And Debtors turnover ratio should be 6 times.
The debtor’s turnover ratio of AXE ltd. is 10. Hence the credit period is 36 days. Hence they
follow a tight collection policy as compared to the industry average.
Similarly, other ratios are to be treated as compared to the industry’s average.

3) You have recently joined as a Finance Manager in Alpha Ltd. the top management has
asked you to analyze the funds flow statement of the company for the last financial year and
submit a report. You are primarily asked to reflect on the financing policy of the company.
Given below is the funds flow statement for 2000-01
Sources of Funds Rs. in Lakhs Application of Funds Rs. in Lakhs

i) Increase in 7 year 11 % i) Increase in Fixed Assets: 800
Debentures: 200
ii) Repayment of 9 % Term
ii) Funds from operations: 320 Loans: 100
iii) Increase in 10 % Public iii)Increase in Investments: 100

Deposits: 150
iv) Increase in Working
iv) Increase in Bank Cash Capital: 170
Credit: 500
1170 1170
Solution:
Concept of Fund Flow Statement:
When a transaction affects a current and a non-current account there is a flow of funds, if the
transaction affects current accounts only or non-current only, there will be no flow of funds; that
is they do not affect the current assets or current liabilities and hence the working capital is not
affected.
A flow analysis consists of two distinctly different analysis namely:

a) Working Capital Analysis
b) Cash Flow Analysis.
Books of Alpha Ltd
Analysis:
Sources of Funds:
Increase in 7 years 11% Debenture:
Entry: Cash/Bank a/c Dr. 200

To 11% Debentures a/c 200
(Being Debentures issued by the company)
The company has issued debenture to raise cash. As per the given information, the duration
of borrowed funds is 7 years.
Funds from Operations: The fund from operations means that the company has accrued
profit, which it will either plough back in the business or will distribute to its shareholders.
Increase in 10 % Public Deposits:

Here the company has again raised the money from the public. But these deposits may or
may not be short term.
Entry: Cash/Bank a/c Dr.
To 10% Public Deposits a/c
(Being debt raised from Public)
Increase in Bank Cash Credit:
Cash Credit basically means, that the company has pledged its assets to bank for the required
amount of money. Hence, the company would have to transfer the possession of resources to
bank for raising the required amount of Cash.
Entry: Cash/Bank a/c Dr.

To Bank Cash/Credit a/c
(Being cash credit taken from bank)
Application of Funds:
Increase in Fixed Assets:

The company has purchased the fixed assets. That means the company has gone for
expansion of its current scale of operations:
Entry: Fixed Assets a/c Dr.
To Cash/Bank a/c
(Being fixed assets purchased for cash/bank.)
Repayment of 9 % Term Loans:

Entry: 9 % Term Loans a/c Dr.
To Cash/Bank a/c
(Being Loan repaid by Cash/Bank)
Increase in Investments:
Investments a/c Dr.
To Cash/Bank a/c
(Being investments purchased)
Increase in Working Capital:

An increase in working capital means that either there is an aggregate increase
in Current Assets or there is a decrease in Current liabilities.
Analysis:
As seen from the above balance sheet, the following points are concluded:
a) The company is basically on Expansion mode. i.e. it is going on expanding with an
increase in assets ,but the assets are financed with the help of borrowed funds.
b) It may be possible that the company wants to attain the financial leverage, which is why
it borrowing funds.
c) It is repaying 9 % loans, and raising loans @ 11 % and 10 %. The company is paying
cheap debts and raising money by committing higher interests than the previous one.
d) The company is mortgaging its short term resources to raise its long term Fixed assets.
e) As seen from above, the company seems to expand, hence it can be safely assumed that
there is an increase in the current Assets, which means an increase in working capital.
f) Hence it is quite possible, that the company may have purchased the C.A.’s and which
are mortgaged with bank for a higher amount of value. Hence, the creditworthiness of the
company is quite high.
g) This is proved by the fact that the company has raised the money from public as well.
Hence the company’s image is well established in home industry.
h) The company is highly influenced by the profit it is making in current scenario; hence it
thinks it will continue with the same trend if more money is poured in, which quite
evident from the profit it is making, given the high costs of borrowings it has opted for.
i) The industry, in which it is operating, seems to promise very high returns in short term
i.e. within one year, which may or may not be in direct proportion with the investments it
makes. Hence one can see, public deposits and cash credit are short term sources of
finance. It is also possible that the products of company are of Seasonal Demand.
j) It can be also be seen that the industry in which the company operates deals with a lot of
value addition. i.e. there is an increase of working capital but the increase in fixed assets
by far exceeds the same.
SECTIO: II
The following Question Carries 10 marks. The Difficulty Level is Low; hence go for these
Questions First.
4) The following are the summarized balance sheets of Kevin India Ltd. as on 31st
March, 2000 and 2001.
LIABILITIES 2000 2001 ASSETS 2000 2001

Share Capital 200000 250000 Land 200000 190000
Building
General Reserve 50000 60000 Machinery 150000 169000
Profit and Loss 30500 30600 Stock 100000 74200
Bank Loan ( 70000 ----- Sundry 80000 64200
Term) Debtors
Creditors 150000 135200 Cash 500 800
Provision for Tax 30000 35000 Bank -------- 7800
Goodwill --------- 5000
530500 510800 530500 510800
Additional Information:
During the year ended 31st March, 2001:
i) Dividend of Rs. 23000 was paid.

ii) Assets of another company were purchased for a consideration of Rs. 45000 payable
in shares. The following assets were purchased: Stock – Rs. 20000, and Machinery-
Rs. 25000.
iii) Machinery was further purchased for Rs. 8000.
iv) Depreciation written off on machinery Rs. 12000
v) Income tax provided (Paid) during the year was Rs.33000
vi) Loss on sale of machinery Rs.200 was written off to General Reserve.
You are required to prepare a cash flow statement. E.R: 3.5/5
Solution:
Books of Kevin India Ltd
Journal Entries:
S Particulars L Debit Credit
R. F
.
1 Profit and loss a/c. Dr. 23000
To Cash/bank a/c 23000
( Being Dividend paid by Cash/Bank)
2 Stock a/c Dr. 20000
Machinery a/c Dr. 25000
To Shares a/c 45000
( Being Assets of other company acquired for issue of shares)
3 Machinery a/c Dr. 8000

To Cash/Bank a/c 8000
( Being Additional Machinery purchased for Cash/ Bank)
4 Profit and loss a/c Dr. 12000
To Machinery a/c 12000
( Being Depreciation on Machinery charged for utilization)
5 Provision for Tax a/c Dr. 33000
( Being Income Tax paid for previous Financial Year 1999-00)
6 Bank Loan a/c Dr. 70000
( Being Bank Loan Repaid )
7 Cash/Bank a/c Dr. 10000
To Land and Building a/c 10000
( Being Land and Building sold)
8 Goodwill a/c Dr. 5000
To Share Capital a/c 5000
( Being the difference in share assumed to purchase Goodwill)
General Reserve a/c Dr. 200
( Being Machinery Sold for loss)
10 Profit and Loss a/c Dr. 38000

To Provision for Tax a/c 38000
(Being Excess of the Provision transferred to P/L. a/c )
To General Reserve a/c 10200
(Being Excess of Reserve transferred to P/L. a/c )
12 Funds From Operations a/c Dr. 83300
To Profit and Loss a/c. 83300
((Being P/L a/c closed for the year and balance transferred to
Cash Statement)
13 Bank a/c Dr. 7800
To Cash a/c 7800
( Being excess of Cash Transferred to Bank Account)
Assuming all the Transactions in Cash
14 Cash a/c Dr. 300

To Bank a/c 300
( Being cash transferred from bank to cash in hand)
Assuming all the transactions through Bank
Accounts to be made: 8
(1) Share Capital A/c
Particulars ( Debit) j.f Amount Particulars ( Credit) j.f Amount
By balance b/d 200000
By Stock a/c 20000
By Machinery a/c (7-1) 25000
To balance c/f. 250000 By Goodwill a/c (8-2) 5000
(2) General Reserve A/c

To Machinery a/c (7-3) 200 By Profit and Loss a/c 10200
(3-4)
To balance c/f. 60000
(3) Profit and Loss A/c

To Cash/Bank a/c 23000 By balance b/d 30500
To Machinery a/c (7-2) 12000
To Provision for Tax a/c (5-3) 38000
To General Reserve a/c (2-2) 10200
To balance c/f. 30600 By Funds from 83300
Operation transferred
to Cash Statement.
(4) Bank Loan A/c


To balance c/f. 0
(5) Provision for Tax A/c

To Cash/Bank a/c 33000 By balance b/d 30000
To balance c/f. 35000 By Profit and Loss a/c 38000

(balancing figure) (3-3)
(6) Land and Building A/c

To balance b/d 200000
By Cash/Bank a/c 10000
By balance c/f. 190000
(7) Machinery A/c

To balance b/d 150000 By Profit and Loss a/c 12000
(3-2)
To Cash/Bank a/c 8000 By Cash/Bank a/c 1800
To Shares a/c (1-3) 25000 By General Reserve a/c 200
(2-2)
(8) Goodwill A/c

To balance b/d 0
To Shares a/c (1-4) 5000
CASH FLOW STATEME)T OF KEVI) I)DIA LTD

)ote: Figures if in Bracket indicate a cash outflow.
1 FUND FROM OPERATION 83300
(+) Decrease in Current Asset: Stock + Debtors 26000 +15800

(-) Increase in Current Asset: --
(+) Increase in Current Liabilities: --
(-) Decrease in Current Liabilities: Creditors 14800 110300
2 (-) Income Tax paid: 33000 77300
3 Cash from Operating Activities:
Total: 0 77300
4 Cash from Investing Activities:
i) Machinery Purchased (8000)
ii) Bank loan repaid (70000)
iii) Land and Building Sold 10000
iv) Machinery Sold for Loss 1800
v) Machinery Purchased for Shares (25000)
vi) Goodwill Purchased for Shares (5000)
Total:(96200) (18900)
5 Cash from Financing Activity:
i) Dividend paid (23000)
ii) Shares Issued 50000
Total : 27000 8100
Hence, cash from Business is Rs. 8100. And this can be tallied from the following table:
Particulars 2000 2001 Net Effect
Cash Balance 500 800 + 300
Bank Balance ----- 7800 + 7800
End of Year Effect: = + 8100
5) The Board of Directors of Alka Ltd. require you to prepare a statement showing the
working capital requirements forecasts for a level activity of 1,56,000 units of
production. The following information is available for your calculation:
(Rs. Per Unit)

Raw Materials: 90
(+) Direct Labor: 40
(+) Over Heads: 75
Total: 205
Profit: 60
Selling Price Per Unit: 265
a) Raw Materials are in stock on average one month.

b) Materials are in process, on average two weeks.
c) Finished goods are in stock, average one month.
d) Credit allowed by suppliers – one month.
e) Time lag in payment from debtors- two months.
f) Time lag in payment of wages- 1 ½ weeks.
g) Lag in payment of overheads- one month.
20% of the output is sold against cash. Cash in hand and at bank is expected to be Rs. 60000. it
is to be assumed that production is carried on evenly throughout the year. Wages and overheads
accrue similarly and a time period of 4 weeks equivalent to a month.
E.R: 3.5/5
Solution:
Books of M/s. Alka Ltd
Level of Activity: 156000 (Annually)

Therefore, Monthly = 156000/12 = 13000
Estimate of Working Capital Requirement
Sr. Particulars Amount Amount (Rs.)

A) Current Assets:
i) Stock :
a) Raw Materials: 13000 x 90 x 1 11, 70, 000
b) Finished Goods: 13000 x 205 x 1 26, 65, 000
ii) Work in Progress:

a) Raw Materials: 13000 x 90 x 0.5 585, 000
b) Labor: 13000 x 40 x 0.5 x 0.5 1, 30, 000
c) Overheads: 13000 x 75 x 0.5 x 0.5 2, 43, 750
iii) Debtors: 13000 x 265 x 2 x 80/100 55, 12, 000
iv) Cash in Hand & Bank: 60, 000
Less:
Current Liabilities:
i) Creditors:
a) Raw Materials : 13000 x 90 x 1 11, 70, 000
b) Labor: 13000 x 40 x 3/2 7, 80, 000

c) Overheads : 13000 x 75 x 1 9, 75, 000
EPICenter
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I was confused I did not know that you could lose your soul, and if you could where would you
go looking for it?
Enjoy the little things in life, for one day you may look back and realise they were the big things.
Life is too important not to be enjoyed. Make it a habit in your life to live fully in the moment.
Make it a habit to find the magic. Make it a habit to
"Become aware of the wonder of life."
6) Explain the methods of measuring Cost of Debt Capital and the Cost of Equity Capital
with illustrations? E.R: 4/5
Solutions:
Financing decisions is the second most important function after Investment decision to be
performed by a financial manager. Broadly, he must decide when, where and how to acquire
funds to meet the firm’s investment needs. The central issue before him is to determine the
proportion of the equity and debt. The mix of debt and equity is known as the firm’s “Capital
Structure”.
The assets of the company can be financed either by increasing the owner’s claims or the
creditor’s claims. The former increases when the firm raises funds by issuing ordinary shares
or by retaining the earnings, the latter increases by borrowing.
Cost of Debt:
i) Cost of Debt is the after tax cost of long term funds through Borrowings.
ii) It is the cost of debts raised in the form of debentures or loans from financial institutions.
iii) The cost of debt varies with the nature of debt, which can be of 3 types:
a) Perpetual debt: basically the calculation of perpetual debt is a simple concept because it
is the rate of interest which a lender expects. The rate of interest carried by the debt is the
before tax rate and has to be adjusted accordingly to accommodate the tax effect.
To explain symbolically:
KI = I / SV
KD = I (1-t) SV
Where, KI = Cost of debt before tax. SV = Sales proceeds of the Bonds

KD = Cost of debt after tax t = Tax rate I = Annual Interest
Payment.
b) Redeemable Debt: while calculating the cost, the repayment of principal has to be
considered along with the payment of interest. The repayment of interest can be done in
2 ways :
i) One Lump Sum amount on Maturity:

The formula for this is given as follows: CI o = COI + COPn
(1+ kd)t (1+ kd)n
ii) In ‘n’ number of installments:

CI o = COI t + COPn
(1+ kd)t
Where, CI o = Net Cash inflow from the issue of debentures.

COI t = Interest paid in time periods till the year of maturity after the tax
savings.
COP n = Principal repayment in the year of maturity.
kd = Cost of debt after tax.
The cost of debt is measured because:

i) It indicates the relative cost of pursuing one-line financing over other sources.
ii) From the point of Capital Budgeting, it helps to determine the cost of long term
funds essential for buying fixed assets.
iii) The overall cost of capital can be calculated only when the specific costs of various
sources are known.
For e.g.: a company issues 10% debentures of Rs.1000 face value to be redeemed after 10
years. The debenture is expected to be sold at 5% discount.
Floatation Cost – 5%
Tax rate - 35%
1) Trial and Error method
Face value: 1000

(-) Floatation rate: 50 Interest: 100
(-) Discount rate: 50 (-) Tax Savings: 35
Cash Inflow: 900 Cash outflow: 65
CI o = COI + COPn
(1+ kd)t (1+ kd)n
900 = 65 + 1000
(1+ kd)t (1+ kd)n
On solving, kd falls between 7% and 8%.

Now by using the present values @ 7% and 8%.
Total PV @
Year Outflow 7% 8%
1-10 65 456.56 436.15
10 1000 508.00 463.00
Total: 964.56 899.15
The cost of debt will be 8%, as the total value of outflow is less than the net inflow i.e. Rs.900
2) Shortcut Method:
Kd = I (1-t) + (f + d + pr –pi) / Nm *100

(RV + SV) /2
= 100 (1-0.35) + (50 + 50 + 0- 0) /10 * 100

(1000 + 900)/2
= 75* 100
950
= 7.894 %
Cost of Equity:
i) The cost of equity is defined as the minimum rate of return that a firm must
earn on the equity financed part of an investment in any project.
ii) It is also the rate at which investors discount the expected dividends of the
firm to determine its share value.
Reasons to measure:
i) To determine the amount of capital to be raised through equity so as to maximize
the profits of the company and wealth of the share holders.
ii) The market value of the shares is affected if the company does not give adequate
returns to the investors.
iii) There is lot of financial risk associated with equity Capital, due to the
difficulty in calculating the return on it.
iv) The payment of dividends forms the cost of equity and is measured as the
amount of dividend paid affects the market value of the shares.
Assumptions: i) the market value of shares depends upon expected dividends.

ii) The initial dividend is greater than 0
iii) The dividend payout ratio is constant.
iv) They can accurately measure the risk of the firm so as to agree on the discount
rate for dividends.
Dividend Approach: According to this approach, the cost of equity is calculated on the basis of a
required rate of return in terms of future dividends to be paid on the shares.
Po (1-f) = D (1+g) t-1

(1+ ke) t
On further simplification,: Po = D
Ke-g where, ke = D + g
Po
D = Expected rate of Dividend per share.

Po= Net proceeds per share.
G= Growth in expected dividends.
Ke= Cost of Equity.
Weighted Average Cost of Capital: In financing decision making the after tax cost of capital is
more important. In this, each source of capital fund gets weightage according to its contribution
in the total capital.
Ko = Kd Wd + Kp Wp + Ke We + Kr Wr
Where,
Ko = Weighted Average Cost of Capital
Wd = Percentage of Debt to total Capital
Wp = Percentage of Preference shares to total capital
We = Percentage of external equity to total Capital
Wr = Percentage of Retained Earnings.
7) A business man is anticipating cash surplus in the next 3 months in the range of Rs. 50,
000, Rs. 70, 000, and Rs. 1, 00, 000. Suggest some investment avenues to him where in he can
park his funds and also maintain his Liquidity position.
E.R: 4/5
Solution:
The twin aspects procurement & effective utilization of funds are the crucial tasks, which
the finance manager or the Businessman faces. The financial manager is required to look into
financial implications of any decision in a firm. He has to manage funds in such a way as to
make their optimum utilization & to ensure that their procurement is in a manner so that the
risk, cost & control considerations are properly balanced under a given situation.
Following are the various ways in which he can invest his business proceeds:
Internal Financing: In this, the businessman can plough back the capital he has earned.
Basically in Internal Financing, all the surpluses earned in business are to be Re-invested in the
business. So that the business can continue to give or sustain the Current Growth. This will also
spread the risk on already invested capital.
Another way of investing, which the businessman should be looking, is that to go for Make or
Buy decision. Basically expansion would be an appropriate proposal so as to accrue economies
of scale in future. Like he has been earning Rs.50, 000 or more, hence he can add Rs. 50, 000 to
permanent working capital.
Another policy will be to implement liberal Credit policy to existing customers, as it can
increase the sales or operating activity of the organization.
External Financing:
Businesses often have surplus funds for short periods of time before they are required for
capital expenditures, loan repayment, or some other purpose. These funds may be
deployed in a variety of ways. At one end of the spectrum is the term deposit (to be made for
the minimum period of 46 days) in a bank, virtually a risk free investment that offers a
relatively modest rate of interest: at the other end of the spectrum is the investment in
equity shares, which can produce highly volatile returns. In between are units, public
sector bonds, treasury bills, Intercorporate and bill discounting.
Some of the options for investing surplus funds are as follows: -
(1) Ready Forwards

A commercial bank or some other organization may do a ready forward deal with a
company interested in deploying surplus funds on a short-term basis. Under this
arrangement, the bank sells and repurchases the same securities
(this means the company, in turn, buys and sells securities) at the prices determined
before hand. Hence the name ‘Ready Forward’. Ready Forwards are permitted only in
certain securities. The return on a ready forward deal is closely linked to money market
conditions.
(2) Badla Financing

A company providing badla financing is essentially lending money to a stock market
operator who wishes to carry forward his transaction from one settlement period to
another. Typically such finance is security of shares bought by the stock market operator.
For example, a company may provide Rs. 5 crores of badla finance through a broker with an
understanding that it is only meant for the forward purchases of, say Reliance shares. Based
on the demand and supply funds, the badla financing ratio are determined on the last day of
the settlement. Badla financing offers attractive interest rates.
In Marketable Securities:
Marketable securities are short-term investment instruments to obtain a return on temporarily
idle funds. In other words, they are securities, which can be converted into cash in a short
period of time.
The more prominent marketable/near-cash securities available for investment are as follows: -
(1) Treasury Bills

It is a type of marketable security, which is an obligation of government. They are sold on
discount basis. The investor does not receive an actual interest payment. The return is the
difference between the purchase price and the face value of the bill.
(2) Negotiable Certificates of Deposit

These are marketable receipts for funds that have been deposited in a bank for a fixed period
of time. The deposited funds earn a fixed rate of interest. When the certificates mature, the
owner receives the full amount deposited plus the earned interest.
(3) Commercial paper
It refers to a short-term unsecured promissory note sold by large business firms to raise cash.
As they are unsecured, the issuing side of the market is dominated by large
companies, which typically maintain sound credit ratings. Commercial paper can be
purchased either directly or through dealers.
(4) Bankers Acceptance

These are drafts (order to pay) drawn on a specific bank by an exporter in order to obtain
payment for goods he has shipped to a customer who maintains an account with that
specific bank. They can also be used in financing domestic trade.
(5) Repurchase Agreements

These are legal contracts that involve the actual sale of securities by a borrower to the lender
with a commitment on the part of former to repurchase the securities at the current
price plus a stated interest charge. The securities involved are government securities and
other money market instruments.
(6) Units
The units of Unit Trust of India (UTI) offer a reasonably convenient alternative avenue for
investing surplus liquidity as (a) there is a very active secondary market for them, (b) the
income form units is tax-exempt up to a specified amount and (c) the units appreciate in a
fairly predictable manner.
(7) Inter Corporate Deposits

It is also a type of marketable security. Intercorporate deposits are short-term deposits in
Companies with a fairly attractive form of investment of short-term funds in terms of
rate of return, which may range between 12 to 15 per cent.
(8) Bills Discounting

Surplus funds can be deployed to purchase/discount bills. Bills of Exchange are drawn by
seller (drawer) on the buyer (drawee) for the value of goods delivered to him. During
the pendency of the bill, if the seller is in needs of funds, he may get it discounted. On
maturity, the bill should be presented to the drawee for payment.
(9) Call Market

It deals with funds borrowed/lent overnight/one day (call) money and notice money for the
period upto 14 days. It enables businesses to utilize their float money gainfully. However,
the returns (call rates) are highly volatile.
(In case of a corporate having excess cash, it can also indulge in following:
i) Issue Bonus Shares to its Share Holders or can also have Employee Stock Options (ESOPs).
ii) Can also go for a buy back of shares but according to the rules set by SEBI)
8) Explain the steps involved in Credit Analysis in Detail? E.R: 4/5
Solution:
The objective of Receivables Management is “ to promote sales and profit until that point is
reached where the return on investment in further funding the receivables is less than the cost of
fund raised to finance that additional credit. (Cost of capital)”
The management of receivables involves crucial decision in three areas:

1) Credit Policies
2) Credit Terms
3) Collection Policies
Credit Policies: The Credit Policies of a firm provides the framework to determine
i) Whether to extend Credit to a customer
ii) The amount of Credit to be extended.
The Credit policy of a firm has 2 broad dimensions:
Credit Policy
Credit Standards Credit Analysis
Credit Analysis: basically, it consist of 2 Steps; i) Obtaining Credit Information

ii) Analyzing Credit Information.
i) Obtaining Credit Information: there are basically two sources of Credit Information;
internal and external.
Internal Sources: normally the firms require their customers to fill various forms and documents
giving details about financial operations. They also require to furnish trade references with
whom firms can have contacts to judge the suitability of customer for credit. This type of
information is obtained from internal sources of credit information. Another source of internal
credit information is derived from the records of the firm contemplating an expansion of credit.
It is likely that a particular customer/ applicant may have enjoyed credit facility in the past. In
that case, the firm would have information on the behavior of the applicants in terms of the
historical payment pattern. This type of information may not be adequate and may therefore
have to be supplemented by the information from other sources.
External Sources: the availability of the information form external sources to assess the credit
worthiness of the customers depend upon the development of the institutional facilities and
industry practices. In India, the external sources of credit information are not as developed as in
the industrially advanced countries. Depending upon the availability of the information the
following external sources are used:
Bank references: this is a useful source of credit information. Here the firm’s banker collects the
essential information from the Applicant’s bank. His records of periodic payment, even the
facilities of Stop payment used reflect Applicant’s Behavior. His failure to meet the obligations
will also be reflected in the bank statements.
Financial Statements: other external source of credit information is the published financial
statements. The Balance Sheets and P/L a/c. these financial statements carry very important
information. They throw light on an applicant’s viability, liquidity, profitability, and debt
capacity.
Trade References: basically, this refers to collection of information from firms with whom the
applicant has dealings and who on the basis of their experience would vouch for the applicant.
Credit Bureau Reports: and not to forget, there are these specialized agencies which provide
credit information.
Analysis of Credit Information: once the credit information has been collected form different
source, it is time for its analysis. The analysis should be in both the ways: Qualitative and
Quantitative. This is done to gauge the credit worthiness of the applicant.
EPICenter
I am here and it is now.

I can do nothing to change my past, but I can influence my future.
I am only one and I can't do everything, but I can do something.
I will not refuse to do the things that I can do.
I will do what I can, with what I have; right here where I am and I will do it right
now.
If there is anything bothering you, anything that you complain about, ask yourself "What
can I do about this?" and then go and do it. You can and do make a difference. Make
sure that it is a positive difference. Accept that "I am only one, I can do everything,
and I can do something."
Strategy for this paper:

paper in this paper the best strategy was to start with Section
II, as it contains long question, but based on conceptuary skills. Hence it is
essential to devote proper 1 hour to this section. Then solve case study and
lastly, come on Concepts.
Concept testing: (12 marks) don’t give more than 25 minutes.

Note: in this type of questions, carrying 3 marks, it is enough to write concepts
between ½ - ¾ of a page.
Concepts
1)
A) What are liquidity Ratios and what is their significance? E.R: 4/5
Solution:
“Solids stay, liquid flows,” In Business, Principles Stay, prosperity flows.

It is possible to draw conclusions regarding the firm’s liquidity. A firm is said to have the ability
to meet its short term liabilities if it has sufficient liquid funds to pay for them.
Liquidity refers to the ability of a firm to meet its obligations in the short run
usually one year. Liquidity ratios are generally based on the relationship between
current assets & current liabilities. Some of the important Liquidity ratios are as
follows: i) Current Ratio.
ii) Quick Ratio
b) Why is the cost of Debt normally less than the cost of equity? Is it always so?
E.R:3.5/5
Solution:
Debts are considered as the cheapest source of finance because of following reason:
i) Interest payable on Debts is at fixed rate.
ii) Interest payable on Debts is a deductible as an expense for computation of taxable
income.
iii) The leverages like Financial Leverage can be accrued by debt financing. This can
also attain Capital Gearing to the firm.
But Debt is not always the cheapest source of Finance, there are some disadvantages to it: i)
Non payment of debts on time can lead to bankruptcy and ultimately to loss of Goodwill.
ii) Excess borrowings may lead the company to debt trap.
iii) It is fixed financial commitment.
iv) When the Debt matures, the company has to pay, unless renewed hence; a company
may find itself in a strained financial position.
c) What is meant by “Letter Of Credit”? E.R: 4/5

Solution:
Suppliers, particularly the foreign suppliers insist that the buyer should ensure that his bank
would make the payment if he fails to honor its obligations. This is
ensured through letter of credit (LC) arrangement.
A bank opens a LC in favor of a customer to facilitate his purchase of goods. If the

customer doesn’t pay to the supplier within the credit period, the bank makes the payment
under the LC arrangements. This arrangement passes the risk of supplier to the bank. Bank
charges the amount for opening LC. It will extend such facilities to the financially sound
customers.
d) What are Common-Sized Statements? E.R: 3/5
Solution:
The common size statement is often called as ‘Common Measurement’ or ‘Common

Percentage’ or ‘ 100 Percent’ statement, since each statement is reduced to the total of 100
and each individual component of the statement is represented as a percentage of the total,
which invariable serves as the base.
This facilitates comparison of two or more business entities with a common base. In the
case of Balance sheet, total assets or liabilities or capital can be taken as the common base
and in the case of income statement, net sales can be taken as the base.
Thus, the statement prepared to bring out the ratio of each assets or liability to the tool of the
balance sheet and the ratio of each item of expense or revenue to net sales is known as
common size statement.
2) A company has a current ratio of 2.5 and a liquid ratio of 1.5. Current
liabilities are Rs.100000. give the effect of each of the following
transactions on each of these Ratios. Treat each transaction separately.
E.R: 3.5/5
Given: Current Ratio and liquid Ratio

Solution:
Current Ratio: 2.5 = Current Assets/Current Liabilities
Extra Info: normally the ratio is 2. Hence the company is functioning satisfactorily.
Therefore; Current Assets = 250000
Liquid Ratio: 1.5 = Liquid Assets/Current Liabilities
Normally the ratio is 1. And Liquid Assets = 150000
a) Purchase of Materials Rs.50000 on Credit.

All the transaction in Accounts have 2 effects. Since we follow Double Entry Book-
keeping
Entry:
(Current Assets) Materials/Purchases a/c Dr. 50000

(Current Liabilities) To Creditors a/c 50000
(Being Materials Purchased on Credit)
Therefore, Current Ratio: 2, 50, 000 + 50, 000/ 1, 00, 000 + 50, 000
: 3, 00, 000 / 1, 50, 000
:2
Liquid Ratio: 1, 50, 000 /1, 00, 000 + 50, 000
:1
b) Sale of goods Rs. 1, 00, 000 on Credit
Entry:
(Current Assets) Customer a/c Dr. 1, 00, 000

(Current Assets) To Sales a/c 1, 00, 000
(Being Sales done on Credit)
The effect of this entry will only be in Current Assets. i.e. Less from Stock and Add to
Debtors.
Hence, Current Ratio: 2, 50, 000 + 1, 00, 000 -1, 00, 000 /1, 00, 000
: 2.5
Liquid Ratio: 1, 50, 000 + 1, 00, 000/1, 00, 000
: 2.5
c) Purchase of machinery worth Rs. 1, 00, 000 by making cheque payment of Rs.
25000 and balance by long term bank loan.
Entry:
Machinery a/c Dr. 1, 00, 000

(Current Asset) To Bank a/c. 25, 000
To Loan a/c 75, 000
(Being Machinery Taken on loan and part payment done by bank)
Current Ratio: 2, 50, 000 – 25, 000/ 1, 00, 000

: 2.25
Liquid Ratio: 1, 50, 000 – 25, 000 /1, 00, 000

: 1.25
Note :Buying a machinery is buying a Capital Assets, but Current Assets are only concerned
with the Goods and not Capital, but since cash is also affected hence the ratio changes.
d) Mr. Hrithik accepts a bill for Rs. 40, 000 due from him for purchase of goods on
Credit.
Entry:
(Current Assets) Bills Receivables a/c Dr. 40, 000
(Current Assets) To Sales a/c 40, 000
(Being Goods sold on credit and Bill accepted and received.)
Hence, Current Ratio: 2, 50, 000 – 40, 000 + 40, 000/ 1, 00, 000
: 2.5
Liquid ratio: 1, 50, 000 + 40, 000/ 1, 00, 000

: 1.9
Amount of Closing Stock:

Opening Closing Stock = Current Ratio – Quick Ratio
= 1, 00, 000 (As stock and prepaid Expenses are not included in
Quick ratio. And also assumed that prepaid Expenses are nil.)
Particulars (Dr.) J Amount Particulars (Cr.) J Amount

. .
F F
To bal. b/d 100000
To Purchases a/c 50000 By Sales a/c 100000

By Sales a/c 40000
By Bal. c/f 10000
3) Emar Ltd. has an annual turnover of Rs.84 crores and the same is
spread evenly throughout the year during the 50 working weeks of the
year.
However the pattern within each week is that the daily rate of receipts on Monday
and Tuesday is twice that experienced on other days of the week. The cost of
banking is estimated at Rs.2500 per day. It is suggested that banking should be
done daily or twice a week on Tuesday and Friday instead of the current practice
of banking only on Friday. The company operates on bank overdraft and the
current rate of interest is 15 % per annum. This interest charge is applied on a
simple daily basis. Ignoring taxation, advice the company of the line of action.
Assume 360 days in a year for interest calculation.
Solution:
Annual Sales of Emar Ltd.: 84 crores.
Annual period: 50 weeks.
Therefore, turnover in a week: 84, 00, 00, 000 / 50
Therefore, Sales Accrued in a week: 1, 68, 00, 000 (1.68 crores Rs.)
Given that the receipts on Monday and Tuesday are twice the amount received on other 3
days.
Hence, accrual of sales on daily basis: 1, 68, 00, 000 / 3 = 56, 00, 000
Therefore, Accruals on Monday and Tuesday = 1, 12, 00, 000 (1.12 crores)
But the company is operating on Overdraft facility. Hence for all the income accrued, the
expenses paid are borrowed from the bank @ 15 p.a.
The current practice is to deposit the money on Friday. That means that the company is
holding up the money for an entire working week right from Monday.
Hence, Overdraft interest: 1, 68, 00, 000 x 15 x 4 = 28, 000 Rs.

100 x 360
Hence the company is paying Rs. 28, 000.
Overdraft is calculated on the number of days for which money is used after the day when it
is withdrawn.
(Assuming the shortest manufacturing cycle of 1 day. As the company would have borrowed
on the same day and sales are also on the same day.)
Whereas even if the company deposits its money every day, (the worst possible case), then
its total expense would be = 2500 x 5
= 12, 500 Rs.
Hence the company is not using the Leverage option provided by the Bank.
Hence, on an average the company pays Rs. 5600 (28000/5) per day as Overdraft, which is
far more than transaction fee charged by the bank. (Rs.2500)
Hence the best practice for the company would be to deposit the money everyday.
Section II
4) What are the Motives for holding Cash? E.R: 4/5

Solution:
Motives For Holding Cash
The term “Cash” with reference to cash management is used in two senses. In a narrower
sense it includes coins, currency notes, cheques, bank drafts held by a firm with it and the
demand deposits held by it in banks. In a broader sense it includes “near-cash assets” such as
marketable securities and time deposits with banks. Such securities or deposits can
immediately be sold or converted into cash if the circumstances require.
A distinguishing feature of cash as an asset, irrespective of the firm in which it is held, is

that it does not earn substantial return for the business. In spite of this fact cash is held by the
firm with the following motives: -
(1) Transaction Motive
An important reason for maintaining cash balances is the transaction motive. This refers to
the holding of cash to meet routine cash requirements to finance the transactions, which a
firm carries on in the ordinary course of business. A firm enters into a variety of
transactions to accomplish its objectives, which have to be paid for in the form of cash. For
example, cash payments have to be made for purchases, wages, operating expenses, financial
charges like interest, taxes, dividends and so on. Similarly, there is a regular inflow of cash
to the firm from sales operations, returns on outside investments, etc.
(2) Precautionary Motive
A firm keeps cash balance to meet unexpected contingencies such as floods, strikes,
presentments of bills for payment earlier than the expected date, unexpected slowing
down of collection of accounts receivables, sharp increase in prices of raw materials, etc. The
more is the possibility of such contingencies; more is the amount of cash kept by the firm for
meeting them.
(3) Speculative Motive

A firm keeps cash balance to take advantage of unexpected opportunities, typically
outside the normal course of the business. Such motive is, therefore, of purely a speculative
nature. For example, a firm may like to take advantage of an opportunity of purchase raw
materials at the reduced price on payment of immediate cash or delay purchase of materials
in anticipation of decline in prices. Similarly, it may like to keep some cash balance to
make profit by buying securities in times when their prices fall on account of tight
money conditions, etc.
(4) Compensation Motive

Banks provide a variety of services to business firms, such as clearance of cheque,
supply of credit information, transfer to funds, and so on. While for some of these services
banks charge a commission or fee, for others they seek indirect compensation. Usually
clients are required to maintain a minimum balance of cash at the bank. Since this balance
cannot be utilized by the firms for transaction purposes, the banks themselves can use the
amount to earn a return. Such balances are compensating balances.
Factors Determining Cash )eeds

1. Synchronization of Cash Flows
2. Short Costs
3. Excess Cash Balance
4. Procurement and Management
5. Uncertainty
Synchronization of Cash Flows: The need for maintaining cash balance arises from the
non-synchronization of the inflows and outflows of the cash; if the receipts and payments
of cash perfectly coincide or balance each other, there would be no
need for cash balances.
The first consideration in determining the cash need is, therefore, the extent of
non-synchronization of cash receipts and disbursements. For this purpose, the inflows and
outflows have to be forecast over a period of time, depending upon the planning horizon,
which is typically a one-year period with each of the 12 months being a sub period.
Short Costs: Another general factor to be considered in determining cash needs is the cost
associated with a shortfall in the cash needs. Every shortage of cash - whether expected or
unexpected - involves a cost ‘depending upon the severity, duration and frequency of the
shortfall and how the shortage is covered. Expenses incurred as a result of shortfall are
called short costs’.
Following the various Short Costs:

Transaction costs associated with raising cash to tide over the shortage. This is usually the
brokerage incurred in relation to the sale of some short-term near-cash assets such as
marketable securities.
Borrowing costs associated with borrowing to cover the shortage. These include
items such as interest on loan, commitment charges and other expenses relating to the
loan.
Loss of cash discount, that is, a substantial loss because of a temporary shortage of
cash.
Cost associated with deterioration of the credit rating, which is reflected in higher
bank charges on loans, stoppage of supplies, demands for cash payment, refusal to sell,
loss of image and the attendant decline in sales and profits.
Penalty rates by banks to meet a shortfall in compensating balances.
Excess Cash Balance Costs: The cost of having excessively large cash balances is
known as the excess cash balance cost. If large funds are idle, the implication is that the
firm has missed opportunities to invest those funds and has thereby lost interest, which it
would otherwise have earned. This loss of interest is primarily the excess cost.
Procurement and Management: These are the costs associated with

establishing and operating cash management staff and activities. They are generally
fixed and are mainly accounted for by salary, storage, handling of securities, and so on.
Uncertainty and Cash Management: The impact of uncertainty on cash management

strategy is also relevant, as cash flows cannot be predicted with Complete accuracy. The
first requirement is a precautionary cushion to cope with irregularities in cash flows,
unexpected delays in collections and disbursement, defaults and unexpected cash
needs.
The impact of uncertainty on cash management can, however, be mitigated through:

1. Improved forecasting of tax payments, capital expenditure, dividends, and so on; and
2. Increased ability to borrow through overdraft facility.
EPICenter
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That’s the reason Why we are starting with MP Do it Yourself Questions……..It is easy to
Learn……but difficult to Learn to Learn……
5) What are the factors determining the Working Capital? E.R:3/5

Solution:
Gerstenberg defines Working Capital as “Circulating Capital means Current assets of a
company that are changed in the ordinary course of business from one for m to another, s for
example from cash to inventories to receivables and again to cash.
The accounting principal board of the American Institute of Certified Public Accountants
defines Working Capital as follows:
“Working Capital is represented by the excess of current assets over current liability and
identifies the relatively liquid portion of the total enterprise capital which constitutes a margin
or buffer for maturing obligation within the ordinary operating cycle of business.”
Factors determining Working Capital:

The amount of Working or Circulating Working Capital required by any business depends
upon a number of factors, which are as follows:
1) )ature of Business: the quantum of working capital required by a business organization
is related to the type and nature of its business activities. Public utilities require less
working capital as they sell services on cash basis only. But as it is welfare based, it has to
carry a large number of inventories. A trading organization requires proportionally larger
working capital as it has to carry large inventories and allow credit to consumers. A
manufacturing firm requires more working capital as compared to a firm engaged in a
trading firm. However, the requirement of working capital varies from industry and from
time to time in the same industry.
Current Assets (%) Fixed Assets (%) Industries

10-20 80-90 Hotels and Restaurants
20-30 70-80 Electricity Generation
30-40 60-70 Aluminum, Shipping
40-50 50-60 Iron & Steel, Chemical
50-60 40-50 Tea Plantation
60-70 30-40 Cotton Textiles, Sugar
70-80 20-30 Edible Oil, Tobacco
80-90 10-20 Trading, Construction
2) Production Cycle: the term ‘Production’ refers to time taken to in Manufacturing of
Goods. It covers a time span between the procurement of Raw materials and completion
of the manufacturing process leading to the production of the finished goods. Funds have
to be necessitated, enhanced for Working Capital. In other words there is some time gap
before raw materials become Finished goods. The longer the time span the larger will be
the tied-up funds and therefore the larger is the working capital needed and Vice-versa.
3) Business Cycle: the working Capital requirements are also determined by the nature of
the business cycle. Business Fluctuations lead to cyclical and seasonal changes which in
turn cause a shift in the working capital position, particularly for temporary working
capital requirements. The variations in business conditions may be in two directions:
a) Upward phase when boom condition prevails ( like now, Good Economy, Sensex
rising, good amount of People’s Optimism)
b) Downsizing phase when the economic activity is marked by a decline (The Great
Depression).
During the upswing of business activity, the need for working capital is likely to grow to cover
the lag between sales and receipt of cash as well as to finance purchases of additional material to
cater to the expansion of the level of activity.
Additional Funds may be required to invest in plant and machinery to meet the increased
demand. The downsizing phase of the business activity has an exactly opposite effect on the
level of the working capital requirement.
4) Credit Policy: the Credit Policy relating to the sales and purchases also affects the working
capital. The credit policy influences the requirement of working capital in 2 ways:
a) by the Credit terms of the firm for its customers/ buyer of goods.
b) Credit terms available to the firm from its creditors
The Credit terms granted to customers have a bearing on the magnitude of working capital
by determining the level of book debts. The credit sales result in the higher book debts
(receivables). Higher book debts mean more working capital. On the other hand if liberal credit
terms are available from the Suppliers of goods, the need for working capital is less. The
Working Capital requirements of a business are, thus affected by the terms of purchase and sale,
and the total given to credit by a company in its dealings with Creditors and Debtors.
5) Production Policy: to maintain an efficient level of production the firm may resort to
normal production even during the slack season. This will lead to excess of production and
hence the funds will be blocked on the form of inventories for a long time, hence provisions
should be made accordingly. Since the cost and risk of maintaining a constant production is
high during the slack season. Some firms may even resort to producing different products to
solve their Capital problems.
6) Growth and Expansion Activities: as a company grows, it is logical to accept larger
amount of working capital. It is difficult precisely to determine the relationship between
volumes of sales and need for working capital. The need for working capital does not
follow the growth but precedes it. Hence if a firm is planning to increase its business
activities, it needs to plan its working capital requirements during the growth period.
7) Conditions of supply of Raw materials: if the supply of raw materials is scarce, and the
firm wants to resort to normal production, then the need of working capital is more and
vice-versa.
8) Profit Margin and Profit Appropriation: a high net profit margin contributes towards
less of the working capital needs. Also, tax liability is unavoidable and hence provisions
for its payment must be in the working capital plan, otherwise it may impose a strain on
working capital.
9) Price Level Changes: Changes in the price level also affect the requirements of working
capital. Rising prices necessitates the use of more funds for maintaining an existing level of
activity and lower process necessitates less use of funds for maintaining an existing level of
activity. Rising prices will require higher level of working capital and vice-versa. Also if
the firm’s policy is to retain profits it will increase their working capital and if they decide
to pay the dividends it will weaken their capital position. However this can be avoided by
declaring bonus shares out of past profits. This will help the firm to maintain a good image
and also not part with money immediately, thus not affecting the working capital.
Depreciation policy of the firm though has an effect on tax liability and retained earnings
have an influence on working capital. The firm may charge a high rate of depreciation
which will reduce the tax payable and also retain more cash, as there is no cash flow. If the
dividend policy is linked with net profits, the firm can pay fewer dividends by providing
more depreciation. Thus depreciation is an indirect way of retaining profits and preserving
the firm’s working capital position.
10) Change in Technology: Changes in technology as regards to production have an impact
on the need of working capital.
11) Inflation: a business concern requires more working capital during inflation. This factor
may be compensated to some extent by rise in selling price.
6) What is the meaning of the following terms? E.R: 4/5
a) Commercial Papers: Commercial paper represents short-term unsecured
promissory notes issued by firms, which enjoy a fairly high credit rating. Generally,
large firms with considerable financial strength are able to issue commercial paper. The
important features of commercial paper are as follows:
i. The maturity period of commercial paper ranges from 90 to 180 days.
ii. Commercial paper is sold at a discount from its face value and redeemed at
its face value. Hence, the implicit interest rate is a function of the size of the
discount and the period of maturity.
iii. Commercial paper is either directly placed with investors or sold through
dealers.
iv. Investors who intend holding it till its maturity usually buy commercial paper.
Hence, there is no well-developed secondary market for
commercial paper.
Advantages of Commercial Papers:

i) The advantage of CP lies in its simplicity. It involves hardly any documentation
between the issuer and investor.
ii) The issuer can issue CP with maturities tailored to match the cash flow of the
company.
iii) A well rated company can diversify its sources of finance from banks to short term
money markets at somewhat cheaper rates.
iv) The companies which are able to raise funds through CP become better known in the
financial world and are thereby placed in a more favorable position for raising such
long term capital as they may from time to time require. Thus there is an inbuilt
incentive for companies to remain financially strong.
v) CP provides investors with higher returns that they could get form the banking
system.
vi) CP facilitates securitization of loans resulting in creation of secondary market for the
paper and efficient movement of funds providing cash surplus to cash deficit entities.
Limitations:
i) It is an impersonal method of financing. If a firm is unable to redeem its paper due to financial
difficulties, it may not be possible for it to get the maturity of paper extended.
ii) It is always available to the financially strong and sound companies. A firm facing temporary
liquidity problems may not be able to raise funds.
iii) The amount of loan available in the commercial papers is limited to the amount excess
liquidity of the various purchasers of commercial papers.
iv) It cannot be redeemed until maturity. Thus if a firm doesn’t need the funds anymore, it
cannot repay it until maturity and will have to incur additional interest cost.
b) Bills Discounting: a bill arises out of trade transaction. The seller of goods draws the bill
on the purchaser. The bill may be either clean or documentary and may be payable on
demand or after a usance period which ordinarily does not exceed 90 days. On acceptance of
the bill by the purchaser, the seller offers it to bank for discounts / purchase. When the bank
discounts or purchases the bill, it releases the finds to the seller.
A company may also deploy its surplus funds to discount the bills the way a bank does. As
bills are self-liquidating instrument, bill discounting may be considered superior to lending
in the inter-corporate deposit market. While participating bill discounting a company should
ensure that the bills are trade bills and try to go bills backed by letter of credit rather than
open bills as former are more secure because of guarantee provided by the buyer’s bank.
Bill discounting is of 2 types:

i) Purchase Bills Discounting and
ii) Sales Bill Discounting.

A purchase bill discounting means that the investor discounts the purchase bill of the company
and pays the company, who in turn pay their supplier. The investor gets his money back from
the company at the end of the discounting period.
A sales bill discounting means the investor discounts the sales bill of the company and pays
directly to the company. The investor gets his return from the company at the end of discounting
period.
7) The selected financial data for A, B, and C companies for the year ended 31st March, 2002
were as follows: E.R: 4/5
A B C
i) Variable Cost as a Percentage of Sales 66 2/3 75 50
ii) Interest Expenses
iii) Degree of Operating Leverage 200 300 1000
iv) Degree of Financial Leverage 5 6 2
v) Income Tax Rate % 3 4 2
40 40 40
Prepare an Income Statement of 3 Companies.
Solution:
The Income Statement of 3 companies is presented below:

Income Statement A B C
Sales: 100 (1) 100 (1) 100 (1)
(-) Variable Cost as part of Sales: 662/3 (2/3) 75 (3/4) 50 (1/2)
= Contribution 1/3 1/4 1/2
Formulae Used: i) Contribution (C) = Sales – Variable Cost.

ii) Financial Leverage (F.L) = EBIT / EBT or EBIT / EBIT – I
iii) Operating Leverage (O.L) = C/ EBIT.
Where I = Interest.
Now, for Financial Leverage (F.L) of Respective Firms:

For A, F.L: EBIT / EBIT – I
Therefore, 3 = EBIT / EBIT – 200 (Given, I = 200)
EBIT = 300.
Now,
Operating Leverage (O.L) of A = C / EBIT
5 = C/ 300
Therefore, C = 1500 (that is 1/3 of Sales)
Hence, Sales of A = 4500.
Similarly, for B and C we get the following figures,
For B,
EBIT: 400, and C = 2400 and therefore Sales are Rs. 9600.
For C,
EBIT: 2000, and C = 4000 and therefore Sales are Rs. 8000.
Hence the Income Statement of all the companies is as follows:
A B C
Sales 4500 9600 8000
(-) Variable Cost 3000 7200 4000
Contribution 1500 2400 4000
(-) Fixed Costs 1200 2000 2000
EBIT 300 400 2000
(-) Interest (Given) 200 300 1000
EBT 100 100 1000
(-) Tax @ 40% 40 40 400
EAT 60 60 600
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Remember "Winners Seek Self Development – Whiners Slowly Self-Destruct"
8) The Summarized Balance Sheet of A.J. Ltd. for the years ended 31st March 2002 and 2001
were as follows:
All figures in Rs. ‘, 000s
Liabilities As on As on Assets As on As on
2002 2001 2002 2001
Share Capital 500 500 Land and Building 200 180
General Reserve 220 200 Plant and Machinery 276 210
P & L a/c 32 40 Other Fixed Assets 45 30
Bank Loan (Term Loan) 100 ---- Investments 50 50
Creditors 172 158 Stock 190 200
Provision For Tax 30 45 Debtors 195 170
Bank 98 103
1054 943 1054 943
The following are the additional information given to you:

i) Dividend amount of Rs. 30,000 was paid during the year.
ii) Provision for tax made during the year was Rs. 12,000.
iii) Machinery with a book value of Rs. 15,000 was sold at a loss of Rs. 3000.
iv) Investments costing Rs. 10,000 was sold for Rs. 12,000
v) Depreciation provided-
On land and Buildings Rs. 5,000
On plant and Machinery Rs. 20,000

Prepare cash flow statement during the year ended 31st March 2002.
Solution:
BOOKS OF A.J. LTD FOR THE YEAR E)DED 31/03/02
JOUR)AL E)TRIES
S.R. PARTICULARS L AMOUN AMOUNT
. T
F
To Cash/bank a/c 30000
(Being Dividend declared and paid by Cash/Bank)
(Being Provision for Tax made to an extent of 12000)
Profit and Loss a/c Dr. 3000
(Being Machinery sold for Loss)
To Investments a/c 10000
To Profit and Loss a/c 2000
(Being Investments sold for profit)
To Plant and Machinery a/c 20000
(Being Depreciation provided on Assets)
(Being Income Tax paid for the financial year 2000-01)
To Bank Loan a/c 100000
(Being Bank Loan raised for Long term )
8 Land and Building a/c Dr. 25000
(Being Machinery purchased)

9 Plant and Machinery a/c Dr. 101000
(Being Plant and Machinery purchased)
10 General Reserve a/c Dr. 20000
(Being Excess of General Reserve Transferred to P/L)
11 Fixed Assets a/c Dr. 15000
(Being Fixed Assets purchased)
12 Investments a/c Dr 10000
(Being Investments Purchased)
13 Funds from Operation Dr. 80000
(Being P/L a/c closed for the year and balance
transferred to Cash Statement)
(1) General Reserve a/c
By balance b/d. 200000
To balance c/f 220000
(2) Profit and Loss a/c

To Cash/Bank a/c 30000 By balance b/d. 40000
To Provision For Tax a/c 12000 By Investments a/c 2000
To Plant and Machinery a/c 20000
To General Reserve a/c 20000 By Funds From 80000
Operation transferred
to Cash Statement
(3) Bank Loan a/c

By balance b/d. ----------
(4) Provision for Tax a/c

To balance c/f 30000 By Profit and Loss a/c 12000
(5) Land and Building a/c

To balance b/d 180000 By Profit and Loss a/c 5000
(6) Plant and Machinery a/c

To balance b/d 210000 By Cash/Bank a/c 12000
By Profit and Loss a/c 20000
To Cash/Bank a/c 101000 By Profit and Loss a/c 3000
(7) Fixed Assets a/c

To balance b/d 30000
(8) Investments a/c

To balance b/d 50000 By Cash/Bank a/c 10000
To cash/Bank a/c 10000
By balance c/f 50000
CASH FLOW STATEME)T OF A.J LTD for the Year Ended 31/03/02

1 FUND FROM OPERATION 80000
(+) Decrease in Current Asset: Stock 10000

(-) Increase in Current Asset: Debtors 25000
(+) Increase in Current Liabilities: Creditors 14000
(-) Decrease in Current Liabilities: 79000
2 (-) Income Tax paid: (27000) 52000
0 52000
vii) Plant and Machinery Purchased (101000)
viii) Bank loan Raised 100000
ix) Land and Building Purchased (25000)
x) Machinery Sold for Loss 12000
xi) Investment Sold for Profit 12000
xii) Fixed Assets Purchased (15000)
xiii) Investments Purchased (10000)
25000
v) Dividend paid (30000)
(5000)
Here there is a net Decrease in the Cash from Operation, which can be tallied from the table
below:
Cash Balance 0 0 0
Bank Balance 103000 98000 - 5000
End of Year Effect: = - 5000
EPICenter
"Learn to travel light; all you need is a pocket full of dreams and a heart full of love."
It has been said that life is journey and this is true.

From "not here" we came and to "not here" we are going The measure of our lives will be in how
we behaved on, and how much we enjoyed, our travels, and not in how far, or for how long, we
have travelled.
For far too many people this journey of life is not a journey of joy and excitement but one of worry
and strife. Instead of growing through life as they enthusiastically meet life's challenges, they battle
through life complaining about life's difficulties.
The reason that we often feel that life is hard is that we tend to carry a lot of unnecessary baggage
with us. We end up giving all our energy to the load and complain about how heavy it is, and how
unfair it is that we have to carry this load by ourselves, and somebody ought to help us. We end up
feeling so sorry for ourselves that we have no time, or energy, left to enjoy the scenery.
Strategy:
i) To Start with, Section II still holds the essence of the marks. The
questions again are relatively simpler. Finish it within 1 hour.
ii) After Section II, solve the Case Study and then Concepts.
Section I
1)
a) State in brief any 3 functions of a Finance Manager? E.R.: 3.5/5
Solution:
The finance manager’s main objective is to manage funds in such a way so as to ensure the
optimum utilization and their procurement in a manner that the risk, cost and control
parameters are properly balanced. The following are some of the functions:
i) Investment Decision: the investments of the funds in a project have to be made after
careful assessment of the various projects through Capital budgeting. Asset
Management policies are to be laid down regarding various items of Current Assets.
ii) Dividend Decisions: the finance manager is concerned with the decision as how
much to retain and what portion to pay as dividend depending on the company’s
policy.
iii) Cash Management: the Finance Manager lays down the cash management and
disbursement policies so as to supply adequate funds to all units of organization but
also to ensure that there is no excessive idle cash.
b) What is the meaning and significance of Weighted Average Cost of Capital? E.R.: 4/5
Solution:
Where,
c) What is the difference between Hypothecation and Pledge? E.R: 3.5/5

Solution:
Hypothecation involves movable property, which is given as a security for the loan. Possession
of movable property remains with the debtor. In the case of pledge too, movable property is
security. Here the creditor is given the possession of movable property. The banker’s risk is high
in case of hypothecation as the possession of the goods is not in the hands of the banker.
Whereas, in pledge the banker is fully secured and as possession is in his hands and in case of
emergency he can fall back on the goods for realization of his advance under proper notice to the
borrower.
d) What is the Cash Operating Cycle? E.R: 3/5

Solution:
The operating cycle can be said to be heart of the need of Working Capital. The continuing flow
from Cash to Supplier, to Inventory, to Accounts Receivables and back in to Cash is what is
called as Operating Cycle.
In phase I, Cash gets converted in to inventory. These includes purchase of Raw Materials,
conversion of raw materials in to Work-in-Progress, Finished goods and finally the transfer of
goods to stock at the end of manufacturing process. In the case of trading organizations, this
phase is shorter as there would be no manufacturing activity and cash is directly converted in to
inventory. The phase is of course totally absent in service industry.
2) A firm has sales of Rs. 150 Lakhs, Variable Cost of Rs. 84 Lakhs and fixed cost of Rs. 12
Lakhs. It has a debt of Rs. 90 Lakhs at 9% and equity of Rs. 110 Lakhs.
a) What is the Firm’s ROI?

Solution:
Return on Investments: (EBIT/ Total Funds Employed) x 100
Particulars ( Income Statement) Amount

Sales 150 L
(-) Variable Costs 84 L
Contribution 66 L
(-) Fixed Costs 12 L
EBIT 54 L
Therefore the EBIT of the firm is Rs. 54 Lakhs.

Total Funds Employed = Debt + Equity Capital
= 90 L + 110 L
= 200 Lakhs.
Therefore, EBIT = (54/200) x 100

= 27 %.
b) Does it have a Favorable Financial Leverage?

Solution:
Financial Leverage: EBIT/EBT (Where EBT = EBIT – Interest)
Interest = 9 % of 90 Lakhs
= 9/100 x 90, 00, 000
= 8, 10, 000 Rs.
Therefore,
Financial Leverage = 54/54 – 8.1
= 1.1765 (Approx.)
Financial Leverage is considered to be Favorable when the degree of Financial Leverage is

Greater than 1.
c) If the firm belongs to an industry whose Asset Turnover is 2, does it have high or
low asset leverage?
Solution:
Asset Turnover Ratio = Cost of Sales/ Total Assets. (Total Assets = Owned + Owed Funds)
Cost of Sales = Variable Costs + Fixed Costs

= 84 L + 12 L
= 96 Lakhs
Total Assets = 200 Lakhs.
Asset Turnover = 96/200

= 0.48
The Firm’s Asset Turnover Ratio is very low. It is almost ¼ of the industry’s average.
d) What is the Operating, Financial, and Combined Leverage of the Firm?

Solution:
Financial Leverage = 1.1765 (as found out above)
Operating Leverage = C/EBIT

= 66 L/ 54 L
= 1.222
Combined Leverage = Financial Leverage x Operating Leverage.

= 1.1765 x 1.222
= 1.44 (approx.)
e) If the Sales drop to Rs. 125 Lakhs, what will be the new EBIT?
Solution:
Assumption: it is assumed that the output remains the same, but the Selling Price has
changed, as this will not affect the variable cost)
Particulars ( Income Statement) Amount

Sales 125 L
(-) Variable Costs 84 L
Contribution 41 L
(-) Fixed Costs 12 L
EBIT 29 L
f) At what level the EBT of the firm will be Equal to Zero?
Solution:
EBT = EBIT – I
But we want EBT to be Zero.
0 = EBIT – I
Therefore, EBIT = I
When EBIT of the Firm will be equal to Interest, at that time EBT of the firm will be Zero.
EPICenter
Take charge of your life, realise that no-one has ever cracked under the burden of the day, the
weight only becomes unbearable when you add the load of yesterday and tomorrow so learn to
dump the unnecessary load that you are carrying. Make it easy for yourself "Plant a trouble tree"
Section II
3) You have an established market for a product. A new customer who will buy annually
good worth Rs. 2, 00, 000 from you approaches you. The customer expects a credit period
of 3 months. The ratio of contribution to sales is 25 %. The risk of non payment is 10 %.
You expect a post tax return of 10 % on your investment. The rate of tax applicable to you
is 40%. Would you accept the proposal? Would you accept the proposal if the risk of the
non payment is 5 % only?
Solution:
Here, the strongest point that acts in the marketers favor is that The Product has an
Established market. Hence even before thinking out the customer’s offer, the marketer can
deny the sale. But as it is given, we need to find out the whether he would end up paying the
money that would accrue profit or loss?
Step 1: Don’t get confused with the unnecessary information. Separate out the vital parts
and analyse them. Like one of the point made in the case study is that customer will require
3 months of credit period. We don’t think that holds any relevance, any ways he is paying
and neither will the value of money fall by a noticeable margin.
Given that Ratio of Contribution to sales is 25 %. That means that when the sales are
Rs. 100, at that time contribution is Rs. 25
Hence, the variable cost of the firm is 1, 50, 000 Rs. (Sales – Variable Cost =
Contri.)
Now, as Contribution = 50, 000, but Contribution = Fixed Costs + Profit.
Hence Fixed Costs + Profits = 50, 000.
It is given that, post tax return expected is 10 % on the investment. That is Profit after
Tax needs to be 10 % of investment, which 10 % of 1, 50, 000 (Variable Cost) = 15,
000.
But it is also given that rate of tax applicable is 40 %. Hence, 60 % (Remaining part) is
equal to 15, 000 Rs.
Therefore, if 60 % - 15, 000
Then 100 % - ? (Pre-tax profit).
Therefore, Pretax profit is Equal to 25, 000 Rs.
Therefore, Fixed Costs of the firm = 25, 000
Now, it is given that, there are 10 % chances of Non- Payment.

Hence, from total sales, 10 % will be bad.
Therefore, 10% of 2, 00, 000 = Rs. 20, 000
Therefore, total amount realized will be = 2, 00, 000 - 20, 000 = 1, 80, 000 Rs.
Now, Variable Costs + Fixed Costs = 150, 000 + 25, 000

= 1, 75, 000 Rs.
Therefore, Profit before Tax = 5, 000 Rs. On investment of 1, 75, 000 Rs.
Therefore, the firm fails to keep its Standards of 10 % post tax profits.
Therefore, the deal should be rejected.
Similarly, the deal cannot be accepted even when the rate of non-payment is 5 %.
Hence, reject the deal.
EPICenter
"If a thing is worth doing, it is worth doing badly, until you can do it well."
How many times have you either given up on something or not even started doing something
because you felt that you could not do it well enough?
How many times have you used the excuse of "I can't do this" when you actually meant "I don't
want to do this" or "I'm just too scared to try"?
How quickly we learn to fear "failure". How quickly we learn to fear criticism. How quickly we
learn not to attempt anything new for fear of what we "think" others might think if we don't get it
right. Because of this we deny ourselves many opportunities for growth and development.
If a thing is worth doing it is worth doing badly until you can do it well.
There are very few, if any, of your current skills that you could do perfectly first time. All skills
are learned through a process of trial and error, you learn as you go and you grow as you learn.
4) Explain the concept of Working Capital. How is working capital affected by a) sales,
b) Technology, and manufacturing policy and c) price level changes.
Solution: Refer paper 2002, Q.5.
5) Ratio analysis is only a technique for making judgements and not a substitute to it.
Comment.
Solution:
Ratio Analysis Is Only A Tool And )ot A Final Decision
Ratio analysis is a powerful tool of measuring a company’s performance, but it has certain
limitations, which doesn’t bring out any final decision. There are certain limitations of which
care has to be taken which are as follows:
1. Development of benchmarks: Many firms, particularly the larger ones have
operations spanning a wide range of industries. Given the diversity of product
lines it is difficult to find out suitable benchmarks for evaluating the
financial performance and condition. Hence it appears that meaningful
benchmarks may be available only for firms, which have a well-defined industry
classification.
2. Window dressing: Firms may resort to window dressing to project

favorable financial picture. For example. A firm may prepare its balance sheet
when its inventory level is low. As a result it may appear that he firm has a
very comfortable liquidity position and high turnover of inventories.
3. Price level changes: financial accounting as it is currently practiced in India

and most other countries does not take into account price level changes. As a
result, balance sheet figures are distorted and profits are misreported. Hence
financial statement analysis can be vitiated.
4. Variations in accounting policies: business firms have some latitude in the

accounting treatment like depreciation, valuation of stocks, research and
developmental expenses, foreign exchange transactions installment sales,
preliminary and pre-operative expenses, provision of reserves, and revaluation of
assets. Due to diversity of accounting policies comparative financial statement
analysis may be vitiated.
5. Interpretation of ratios: though industry averages and other yardsticks are
commonly used in financial ratios, it is somewhat difficult to judge whether a
certain ratio is good or bad. E.g. a high current ratio may indicate a strong
liquidity position. Likewise, a high turnover of fixed assets may mean efficient
utilization of plant and machinery. Another problem is that, in interpretation
when a firm has some favorable and some unfavorable ratios. In such a
situation, it may be somewhat difficult to form an overall judgment about its
financial strength and weakness.
6. Correlation among ratios: in view of ratio correlations it is often

confusing to employ a large number of ratios in financial statement analysis.
Hence it is necessary to choose a small group of ratios, consisting of say
six to nine ratios, from the large set of ratios. Such a selection requires a sharp
understanding of the meaning and limitations of various ratios and a good
judgment about the business of the firm.
7. Different Terms/ Formulas:

Various terms like Capital Employed, Operating Net Profit, Quick Assets, should
be properly defined otherwise the comparison becomes meaningless. Similarly
there are various formulae used for calculating the same ratio. For Example:
Quick Ratio is calculated as per any of the formulae mentioned below:
i) Quick Assets/ Quick Liabilities

ii) Quick Assets/ Current Liabilities.
8. Year End Data:
Ratio Analysis is based on financial statements prepared on the accounting year

end. Financial statements might be subject to window dressing to cover up bad
financial position. So ratios based on such figure are not reliable. To avoid this,
ratios should be based on average figures and not on year end figures.
Financial statements do not represent a complete picture of the business but merely a
collection of facts expressed in monetary terms. These may not refer to other factors, which
affect performance of the company.
6) Explain the pros and cons of long term financing by issue of Equity and Preference
Shares?
Solution:
Long Term Sources of Finance
Equity Share Capital: Equity shareholders are the owners of the business. They enjoy the residual
profits of the company after having paid the preference shareholders and other creditors of
the company an their liability is restricted to the amount of share capital they contributed to
the company. The advantage of equity capital to the issuing firm is that without any fixed
obligation for the payment of dividends, it offers permanent capital with limited liability
for repayment. However, the cost of equity capital is higher than other capital.
Firstly, since the equity dividends are not tax-deductible expenses and
secondly, the high costs of issue.
In addition to this since the equity shareholders enjoy voting rights, excess of equity
capital in the firms’ capital structure will lead to dilution of effective control.
The book value of an equity share is equal to:
Paid-up equity capital + Reserves and surplus
)umber of outstanding equity shares
Merits:
i) Payment of dividend on these shares depends on availability of divisible profits and the
discretion of the directors.

ii) It is repayable only in the event of winding up and that too after claims of preference
share are met or on buyback
iii) Equity shares do not carry any charge against the assets of the company. Therefore, the
capacity of the company to raise additional finance through borrowings on security of
assets is not diminished.
iv) Neither the payment of dividend is compulsory nor any provision is required for
repayment of capital.
v) Equity shares con often be sold more easily than debentures.
Demerits:
i) Financing through equity shares is costly as compared to preference shares and
debentures. The expectations of the equity shareholders are very high.
ii) A group of shareholders can corner the shares in order to gain the control of the
company.
iii) The company management which his often very conservative avoids raising capital
through equity shares. As the new shareholders have the right to vote on par with the
existing shareholders to new shareholders.
iv) In case there is excessive reliance on financing through equity shares, the capacity of
company to trade on equity is reduced. This may result in to over-capitalization of the
company.
v) The cost of issuing the equity shares capital is generally higher than cost of issuing
preference share capital or debentures.
vi) Dividend on Equity capital is not deductible for taxation purpose.
Preference Share Capital: Preference shares have some attributes similar to equity
shares and some to debentures. Like in the case of equity shareholders, there is no
obligatory payment to the preference shareholders and the
preference dividend is not tax-deductible (unlike in the case of the debenture holders, wherein
interest payment is obligatory). However similar to the debenture holders the
preference holders earn a fixed rate of return for their dividend payment. In addition to
this, the preference shareholders have preference over equity shareholders to the post-
tax earnings in the form of dividends and assets in the event of liquidation.
Other features of the preference capital include the call feature, wherein the issuing
company has the option to redeem the shares, (wholly or partly) prior to the maturity date,
at a certain price. Prior to the Companies Act, 1956 companies could issue preference
shares with voting rights. However, with the commencement of the Companies Act, 1956 the
issue of preference shares with voting rights has been restricted only to the following cases:
a) There are arrears in dividends for two or more years in case of cumulative
preference shares.
b) Preference dividend is due for a period of two or more consecutive preceding

years, or
c) In the preceding six years including the immediately preceding financial year, if the
company has not paid the preference dividend for a period of three or more years.
Merits:
i) Raising finance through preference is a flexible financial arrangement as the payment
of dividend is not obligatory. In case, the earnings decline, the company can skip the
dividend.
ii) It provides funds for a longer period.
iii) Preference share capital can be raised in addition to equity share capital and thus the
financial condition can be strengthened. Further, a company can raise additional
funds through borrowings.
iv) Preference shares provide a cushion to the debenture capital and the company does
not require paying higher rate of interest.
v) A company can raise finance through preference shares without creating charge
against the assets of the company.
vi) Preference shares carry payment of dividend at a fixed rate. The company may pay
higher rate of dividend to equity shareholders. This rate of dividend can be much
higher than the return on investment and the company can trade on equity. But there
is no obligation to pay dividend.
vii) A company can raise capital through preference share without disturbing the pattern
of Control.
viii) Preference share is cheaper than Equity Share Capital.
ix) Preference share is a useful security to those investors who want higher rate of return
with comparatively low risk.
Demerits:
i) Financing through preference shares suffer form the disadvantages since preference
dividend is not deductible as an expense for taxation purpose out of profits of the
company. Therefore the explicit cost of financing through preference shares is higher
as compared to debentures.
ii) The claim of the equity shareholders over the assets of the company is diluted
because of preference shares.
EPICenter
"Life is a 'do it to yourself' process"
How do you start your day? Do you wake up grateful for your life? Do you take the time to count
your blessings or do you just leap out of bed and rush into your busy day thinking about how
much you have to do, feeling sorry for yourself that you have to work so hard? How does that
make you feel?
Does that put a glow on your day or does that kill the excitement before you start?
Develop a sense of gratitude, remember it is not your circumstances that determine your attitude
but how you interpret, how you feel about, your circumstances that will determine your attitude.
It is so easy to complain and gripe about how tough life is. How you would rather be doing
something else, How you would rather be somewhere else.
7) Krishna is a large retailer of consumer durables, 25 % of its sales are for cash; the
balance is on one month’s credit, though at least 20 % (of the total sales) end up being
collected in the second month following sales. You are given the following data:
Total Sales achieved in Month: Rs. in Lakhs

January 100
February 120
March 160
Total Sales estimated in:

April 200
May 200
June 200
Required:
i) A schedule of Cash Collections expected during April, May, and June.
ii) An estimate of additional collections in April, May, and June, if Credit period of one
month is strictly enforced.
Solution:
i) A schedule of Cash Collections expected during April, May, and June.
S.R Particulars April May June

(Lakhs) (Lakhs) (Lakhs)
1 Sales 200 200 200
CASH FLOWS:
a) 25 % of Current Months Sales: 50 50 50
b) 20 % of Past 2nd Months Sales: 24 (Febr.) 32 (Mar.) 40
st
c) 55 % of Past 1 Months Sales: 88 (Mar.) 110 (Apr.)
(Apr.) 110 (Ma.
Total Inflows: 162 192 200
Explanation:
a) For the first 25 %, it is given that the Sales of Current Month are accrued in the Same
Month to an extent of 25 %.
b) It is also given that 20 % (not assuming at least 20 %) of the sales of 2nd Last Month is
20 %
c) Hence the remaining amount to be realized is 55 % (100 – 25 – 20 )
ii) An estimate of additional collections in April, May, and June, if Credit period of one
month is strictly enforced.
S.R Particulars April May June

(Lakhs) (Lakhs) (Lakhs)
1 Sales 200 200 200
CASH FLOWS:
d) 25 % of Current Months Sales: 50 50 50
e) 75 % of Previous Months Sales 120 (Mar.) 150 150
(Apr.) (May)
Total Inflows: 170 200 200
8) The following are the balance sheets of M/s X ltd. as on 31st March 2002 and 2003
Particulars 2002 2003

Liabilities:
i) Share Capital: 4,00,000 5,20,000
ii) Reserves: 1,00,000 1,00,000
iii) Profit and Loss: 79,380 82,440
iv) Bank overdraft: 1,19,020 ---
v) Sundry Creditors: 79,000 82,270
vi) Bill Payables: 67,560 23,050
vii) Provision for Tax: 80,000 1,00,000
Total: 9, 24,960 9, 07,760
Assets:
i) Buildings: 2,97,000 2,88,500
ii) Machinery: 2,25,900 2,32,400
iii) Stock: 2,22,080 1,94,740
iv) Sundry Debtors: 1,74,980 1,46,720
v) Cash: 5,000 5,400
vi) Goodwill: 40,000
Total: 9, 24,960 9, 07,760
The following additional information is given:

i) During 2003 an interim dividend of Rs. 52,000 was paid.
ii) Assets of another company were purchased for a consideration of Rs. 1, 20,000
payable in fully paid shares of X ltd. The following assets were purchased: Stock Rs.
44, 000, machinery Rs. 36, 000.
iii) Machinery was further purchased for Rs. 11, 200
iv) Income tax paid during the year amounted to Rs. 50, 000
v) The net profit for the year before tax was Rs. 1, 25,060.
Prepare a statement of Sources and Application of Funds for the year 2003 and a schedule
setting out changes in Working Capital.
Solution:
BOOKS OF M/S. X LTD
STATEMENT SHOWING CHANGES IN WORKING CAPITAL

Particulars 2002 2003 Increase Decrease
Current Assets:
i) Stock: 222080 194740 27340
ii) Sundry Debtors: 174980 146720 28260
iii) Cash: 5000 5400 400
i) Bank Overdraft: 119020 ---- 119020
ii) Sundry Creditors: 79000 82270 3270
iii) Bills Payable: 67560 23050 44510
Increase in Working Capital 105060
163930 163930
JOUR)AL OF M/S. X LTD.

S.r Particulars j.f. Amount Amount
(Being Interim Dividend declared to Shareholders)
2 Stock a/c Dr. 44000
Machinery a/c Dr. 36000
Goodwill a/c Dr. 40000
To Equity Shares a/c 120000
(Being Assets of other company purchased. The difference
assumed to raise the goodwill)

3 Machinery a/c Dr. 11200
(Being Machinery purchased for Cash/Bank
(Being Income Tax paid for the year 2002)
(Being Excess of Provision Transferred to P/L a/c )
To Building a/c 8500
(Being Building sold for Cash/Bank)
(Being Machinery sold for Cash/Bank)
8 Funds form Operations Dr. 125060
(Being Fund From Operation Transferred to Fund Flow
Statement at the year end)
(1) Share Capital a/c

By balance b/d. 400000
By Stock a/c 44000
By Machinery a/c 36000
By Goodwill a/c 40000

By Funds From 125060
Operation Transferred
to Fund Flow
Statement.

By Profit and Loss a/c 70000

(4) Buildings a/c.

To balance b/d. 297000
(5) Machinery a/c.

To balance b/d. 225900
To Equity Shares a/c 36000 By Cash/Bank a/c 40700
(6) Goodwill a/c.

To balance b/d. 0
To Equity Shares a/c 40000
Sources Application
i) Equity Shares 120000 i) Increase in 105060

Issued Working Capital
ii) Building Sold 8500 ii) Interim Dividend 52000
iii) Machinery Sold 40700 paid
iv) Funds from iii) Machinery 36000
Operations from 125060 Purchased
P/L a/c. iv) Goodwill Raised 40000
v) Machinery 11200
Purchased
vi) Income Tax Paid 50000
294260 294260
Financial Management November 2004 Answers
Strategy:
i) In this paper, start with Section I, as the Questions are Simple. Around 1 Hour is
enough for this section.
ii) Section II again has the essence for Scoring, but don’t hurry with the Questions.
Section I
1) Concepts:
a) What is Conservative Approach Concept?
Solution:
“ Conservists are good Planners, Extremists are good Implementers.”

An important ingredient of the theory of working capital management is determining the
financing mix. One of the most important decisions involved in the management of working
capital is how current assets will be financed. There are basically 2 approaches to determine
an appropriate financing mix: 1) Hedging Approach 2) Conservative Approach.
Conservative Approach:
This approach suggests that estimated requirements of total funds should be met from the
long term sources, the use of short term sources should be restricted to emergency situation
or when there is unexpected outflow of fund.
b) What is Weighted Average Cost of Capital? E.R:4/5

Solution:
Weighted Average Cost of Capital (WACC) is defined as, “The weighted average of the
cost of various sources of finance, weight being the market value of each source of finance
outstanding cost of various sources of finance refers to the return expected by the respected
investors.”
The Weighted Average Cost of Capital of a company is calculated in two ways:

Based on weight of costs by the book value of the different forms of capital.
Based on weight of market value of each form of capital.
The market value approach is more realistic for the reasons given below:
The cost of funds invested at market prices is familiar with the investors.
Investments are generally rated by the reference to their earnings yield, and the
company has a responsibility to maintain that yield.
Historic book values have no relevance in calculation of real cost of capital.
The market value represents near to the opportunity cost of capital
Where,
c) What is Margin of Safety?

Solution:
Businessmen always try to how much they are above the break-even point. This is
technically called Margin of Safety and is calculated by the difference between the sales or
production units at the selected activity and the break-even sales or production. A large
margin of safety indicates the soundness of the business. Lowering or spreading the Fixed
costs and Variable costs, increasing volumes of sales or selling price and changing the
product mix so as to improve contribution and overall PV ratio, can improve the margin of
safety.
Margin of Safety: Sales at Selected Activity - Sales at B.E.P (Break Even Point)
: Contribution at Selected Activity - Fixed Cost

PV ratio
Where PV ratio: C/Sales
d) What is Owed finds?

Solution:
The prospects of a small business depend almost entirely on the ability, energy and character
of the person in charge. Whoever supplies the business with debt finance is in fact risking his
capital on the accuracy of his judgement of the personal capacity of the owner of the
business.
Thus Owed Funds are those Funds which do not belong to Proprietors or Owners of the
Business. They basically are Facilitators of the goals of the business.
(2) M/s. Orbit Technologies Ltd. has the following Capital Structure: E.R: 4/5
Equity Share Capital (4 Lac Share) Rs. 1, 00, 00, 000
10 % Preference Shares Rs. 20, 00, 000
15 % Debentures Rs. 60, 00, 000
The shares of the company are presently traded at Rs. 25 per share. It is expected that the
company will earn post tax profit of Rs. 20 Lac (Income Tax assumed to be 40%)
The company wishes to raise further funds of Rs. 50 Lac and has following options:
i) Issue new debentures and preference shares in equal proportion.
ii) Issue of preference shares to the extent of 25 %, balance by way of debentures.
iii) Issue of new debentures carrying 14 % interest rate.
As a finance manager, which of the above proposal would you recommend?
Solution:
As a finance manager, the most important function is Wealth Maximization. This

maximization of wealth should be of Equity shareholders. Hence an increase in the Earnings
per Share will increase the value of Equity Shares.
i) Issue new debentures and preference shares in equal proportion.
50 Lac (Funds to be raised)
Equity Shares Debentures

25 Lac 25 Lac
Now, as the market price of the shares is Rs.25, and we need 25 Lac through Equity Shares,
Hence, total number of Equity Floated by the company: 25 Lac/ 25 = 1, 00, 000 shares.
S.R Particulars Amount

i) a) Post Tax Profits after Deducting for Current Debenture (@ Tax 20, 00, 000
Rate of 40 % ) (EAT):
hence 100 % of Profits before Tax: 33, 33, 333
(-) Interest for New Debentures: 25 Lac x 15/100: 3, 75, 000

3, 75, 000
EBT 29, 58, 333
Tax @ 40% 11, 83, 333

EAT
(-) Preference Dividend @ 10 % 17, 75, 000
EPS: 15, 75,000/ 5,00,000: (2, 00, 000)
( 4 Lac + 1 Lac) 3.15
EBT is calculated because the Interest on Debentures is Deductible, and which should be
Deducted.
ii) Issue of preference shares to the extent of 25 %, balance by way of debentures.
50 Lacs
Debentures Preference Shares

37.5 Lac 12.5 Lac

ii) a) Profits before tax: 33, 33, 333
(-) Interest on Debentures worth Rs. 37.5 Lacs @ 15 % : 5, 62, 500

37, 50, 000 x 15/100
EBT 27, 70, 833
Tax @ 40 % 11, 08, 333
EAT 16, 62, 500
(-) Preference Dividend: (20, 00, 000 + 12, 50, 000) @ 10 %

: 32, 50, 000 @ 10 (3, 25, 000)
13, 37, 500
EPS: 13, 37, 500/ 4, 00, 000: 3.344
iii) Issue of new debentures carrying 14 % interest rate.

ii) b) Profits before tax: 33, 33, 333
(-) Interest on Debentures worth Rs. 50 Lacs @ 14 % : 7, 00, 000

50, 00, 000 x 14/100
EBT 26, 33, 333
Tax @ 40 % 10, 53, 333
EAT 15, 80, 000
(-) Preference Dividend: 20, 00, 000 @ 10 %

(2, 00, 000)
13, 80, 000
EPS: 13, 80, 000/ 4, 00, 000: 3.45
As can be seen from the above estimates, the 3rd proposal seems to be the best for Equity
Shareholders, as this increases their wealth, but it also should be noticed that the EPS of
Shareholders have declined from 4.5 (18,00,000/400000) to the current 3.45.
Section II
3) M/s. Sona Chandi Heera Ltd. is a stock exchange listed company making good profits
every year. However the board of directors is very conservative and has declared dividend
at a fixed rate of Rs.2 per share, when EPS is always above Rs. 25 for last five years. The
last bonus issue was made six years ago. The salary structures are not very attractive. As a
result there is a high turnover of employees and low volume of company’s shares on the
bourses. The young members of the director’s family wish to make the company more
dynamic, employee friendly and darling of shareholders so as to make it: most valued one.
What steps you would suggest to achieve these objectives?
Solution:
Conflict of goal between management and owners: Agency problem
A characteristic feature of corporate enterprise is the separation between ownership and
management as a corollary of which the latter enjoys substantial autonomy in regard to the
affairs of the firm. With widely diffused ownership, scattered and ill-organized shareholders
hardly exercise any control/influence on management, which may be inclined to act in its own
interests rather than those of the owners. However shareholders as owners of the enterprise have
the right to change the management. Due to the threat of being dislodged for poor performance,
the management would have a natural inclination to achieve a minimum acceptable level of
performance to satisfy the shareholders requirements/ goals, while focusing primarily on their
own personal goals. Thus in furtherance of their objective of survival, management would aim at
satisfying instead of maximizing shareholders’ wealth.
However, the conflicting goals of management objective of survival and maximizing owner’s
value/wealth can be harmonized. The shareholders delegate the decision-making authority to
professional management on the premise that the latter will work in the best interest of the
former, that is, management is an agent of the owners. In order to ensure that management
would take optimal decisions compatible with the shareholders’ interest of value maximization
and minimize agency problems in terms of conflicts of interest, two remedial measures
commend themselves:
1. Provision of appropriate incentives and
2. Monitoring of agents/managers
1. Incentives to management: the incentive given to management is of various types. Some of

them
are as follows
i) Stock options: confer on management the right to acquire shares of the enterprise at a
Special/concessional price
ii) Performance shares are given based on the performance of the management as reflected
in rates of return.
iii) Cash bonus- linked to specified performance targets
iv) Perquisites- such as company car, expensive offices and fringe benefits
These incentives are closely related to the stake of management in the ownership of the
company. They promote congruence between the personal goals of management and the
interests of the owners.
2. Monitoring of managers:
Since management accounts for a small portion of the ownership of the enterprise, they would
not be oriented to the maximization of the value of the shareholders. Monitoring of the activities
of management can be done by:
i) Bonding the agent
ii) Auditing financial statements and limiting decision making by the management
In case of bonding, the enterprise obtains a fidelity bond from a bonding company to the effect
that the latter will compensate the former up to a certain specified amount of losses caused by
dishonest acts of managers. The audit and control procedures and limiting managerial decisions
are intended to ensure that the actions of management sub serve the interests of shareholders.
But, ROI cannot be considered as the end of financial objectives because of the following
reasons.
ROI is calculated from financial statements which are affected by the financial bases and
policies adopted on such matters as depreciation and the valuation of stocks.
Financial statements do not represent a complete picture of the business, but merely a
collection of facts, which can be expressed in monetary terms. These may not refer to other
factors, which affect performance.
Over use of ROI as control on managers could be dangerous, in that management might
concentrate more on simply improving the ratio than on dealing with the significant issues. E.g.
the return on total assets can be improved by reducing assets rather than increasing sales.
ROI is a comparison of two figures, a numerator and a denominator. In comparing ROI, it
may be difficult to determine whether differences are due to change in the numerator, or in the
denominator or in both.
Thus, ROI should be considered only as a tool for analysis rather than as the end of financial
objectives.
The Solution for Shareholders Satisfaction is following:
Dividend can be defined as:

A cash payment using profits that’s announced by a company’s Board of Directors to be

distributed among the stockholders.
Conceptually, dividends may be in the form of cash, stock or property. The Board of
Directors must declare all dividends. Through the stocks, an investor can make income either
through the capital gains or through the periodic dividends. The company should announce
dividend either quarterly, semiannually or yearly. Thus it is a steady periodic source of
income. It is in the proportion to the share of capital, which the investor actually holds in the
company. Though dividend is usually offered, it is necessary to note that a company is under
no obligation to pay the dividends. It may or may not pay the dividends. Even if it pays; there
is no set level as to the payment of dividend. That is there is no minimum or maximum limit
on the amount of dividend that can be paid.
Most often, the dividend comes in the form of cash: a company will pay a small percentage of its
profits to the owner of each share of stock. However, it is not unheard of for companies to pay
dividends in the form of stock. Dividends can be determined by a fixed rate known as preferred
dividends, or a variable rate based on the company's latest profits known as common
dividends.
Usually, amount of profit made is announced in the AGMs or quarterly/semi-annual result. The
company declares amount of dividend on each share (Usually as percentage of face value).
As mentioned earlier, the dividend can be paid out either quarterly, semiannually or even
annually. Sometimes, the companies may also declare an extra or special dividend, usually to
share profits made due to some temporary changes in the market, or on special occasions in the
company-genesis (E.g.: HDFC completing 25 years).
FACTORS EFFECTI)G DIVIDE)D POLICY:

Following reasons result into payment of dividends.
• Investor Preference for dividends: If taxes and transaction costs are ignored, dividends and
capital receipts could be perfect substitutes. Yet, according to Hersh Shefrin and Meir Statman
principles of self-control and aversion for regret lead to investor preference for dividends.
o Self Control and dividends: Individuals often lack self-control. So they rely on rules and
programmes, which check their temptations. In the realm of personal financial management,
individuals like to protect their principal from their spending tendencies. A simple way to do this
is to limit their spending to the dividend income so that the capital amount is maintained intact.
o Aversion to regret and dividends: Although the dividend and the capital receipts are perfectly
substitutable, when taxes and transaction costs are abstracted away, empirical evidence suggests
that most people feel more regret when they sell the stock because they can readily imagine the
consequences of that action.
• Information Signaling: Management often has significant information about the prospects of
the firm that it cannot (or prefers not to) disclose to the investors. The information gap between
management and shareholders generally causes stock prices to be less than what they would be
under conditions of information symmetry. According to signaling theory, these firms need to
take actions that cannot be easily imitated by firms that do not have such promising projects.
One such action is to pay more dividends. Increasing dividends suggest to the market that the
firm is confident of its earning prospects that will enable it to maintain higher dividends in
future as well. By the same token, a decrease in dividends is perceived as a negative signal,
because firms are reluctant to cut dividends. This leads to consequent drop in stock prices.
• Clientele Effect: Investors have diverse preferences. Some want more dividend income; others
want more capital gains; still others want a balanced mix of both. Over a period of time,
investors naturally migrate to the firms, which have a dividend policy that matches their
preferences. The concentration of investors in companies with dividend policies that are
matched to their preferences is called clientele effect. The existence of clientele effect implies
that: A) Firms get the investors they deserve and B) It will be difficult for firm to change an
established dividend policy.
Bonus Shares are the shares issued top existing shareholders as a result of capitalization of
reserves. In the wake of a bonus issue:
• The shareholders’ proportional ownership remains unchanged.
• The book value per share, the earnings per share, the market price per share decrease, but the
number of shares increases.
Following are the reasons for issue of bonus shares.
• The bonus issue tends to bring the market price per share within a more popular range.
• It increases the number of outstanding shares. This promotes more active trading.
• The nominal rate of dividend tends to decline. This may dispel the impression of profiteering.
• The share capital base increases and the company may achieve a more respectable size in the
eyes of investing community.
• Shareholders regard a bonus issue as a firm indication that the prospects of the company have
brightened and they can reasonably look for increase in total dividends.
• It improves the prospects of raising additional funds. In recent years many firms have issued
bonus shares prior to issue of convertible debentures or other financing instruments. Thus the
motives differ as regards to the issue of bonus shares and payment of dividends. Since compared
to receipt of dividends, receipt of additional stock is a risk. Hence investors do not prefer it.
Similarly, in case of a closely held company, since no active trading occurs, there is no point in
increasing the investor liquidity. Thus practice of issuing bonus shares is rarely followed in a
closely held company.
But Rewarding the Shareholder’s costs the company. i.e. nor Dividends neither Bonus shares is
the best policy. Neither is it best to keep money. But the company should act as to what the
situation demands.
RETAI)ED EAR)I)GS AS A PRUDE)T I)VESTME)T POLICY:
DRIPs: These days, because of lack of investment initiatives, industries are encouraging the
investors to reinvest their dividends. The concept is called DRIP or the Dividend Re-
Investment Plan. As per this plan, the shareholder will be given choice of accepting dividend or
reinvesting it. If he/she opts for the latter, his dividend is credited to his /her individual DRIP
A/c and the equivalent shares will be allotted to him.
To pay or not to pay: Since the company is under no obligation as to payment of dividend,
‘Should a company pay dividend’ is an important issue of discussion. In general it can be said
that the younger companies in growth markets are far more likely to pay a small or no dividend
so that they can find further expansion. In contrast, more mature companies in slower growing
markets are likely to pay higher dividends because they do not have opportunity to invest in the
expansion. Thus regular dividends are paid out to make holding the stock more appealing to
investors, a move the company hopes will increase demand for the stock and therefore increase
the stock's price.
EPICenter
"You ought to get as much satisfaction from striving to fulfil your dreams as you get from
achieving them"
We are inclined to be so focussed on the completion of a project, a task, a journey or what ever it
is that we are doing, so goal oriented, that we often miss the magic, the wonder of the process.
What we must realise is that without the process the goal cannot be achieved.
We must learn that success is not only in the completion but is mostly in the attempt, in the
process.
Every "BIG" success is made up of many small successes. Every step that we take on the path to
our goal is a success, for without it we could never reach our destination. We must learn to
recognize and acknowledge our successes as that helps us to build enthusiasm, confidence and
optimism for the journey ahead.
Just like an athlete will not be able to win, or even participate with confidence, without constant
practice, without constantly striving to improve his/her performance. So each one of us must
realise that life is like a race, a race against ourselves.
4) Discuss various Cash Management Models?

Solution:
Cash Management: Finance manager has to ensure that all sections & units of organization
are supplied with adequate funds. Sections, which have an excess of funds, have to contribute
to the central pool for use in other sections, which needs funds. Even if one of the 200 retail
branches does not have sufficient funds whole business may be in danger. Hence the need
for laying down cash management & cash disbursement policies with a view to supply
adequate funds at all times is an important function of a finance manager.
Objectives of Cash Management
A sound cash management scheme maintains the balance between the twin objective of
liquidity and cost. These are two basic objectives of cash management.
To meet the cash disbursement needs as per the payment schedule –

In the normal course of business, firms have to make payment in cash on a continuous and
regular basis to the suppliers of goods, employees and so on. At the same time there is
constant flow of cash through collection of debtors. Cash is, therefore aptly described as the
‘oil to lubricate the ever-turning wheels of business: without the process grinds to a stop.
To minimize the amount locked up as cash balance –

The second objective of cash management is to minimize the cash balances. In minimizing
the cash balances, two conflicting aspects to be reconciled. A high level of cash
balances ensures prompt payment together with all the
advantages. But it also implies that large funds will remain idle as cash is the non-earning
asset and the firm will have to forego profits. A low level of cash balances, on the other
hand, may mean failure to meet the payment schedule. The aim of cash management
therefore should be to have an optimal amount of cash balances.
The term “Cash” with reference to cash management is used in two senses. In a narrower
sense it includes coins, currency notes, cheques, bank drafts held by a firm with it and the
demand deposits held by it in banks. In a broader sense it includes “near-cash assets” such as
marketable securities and time deposits with banks. Such securities or deposits can
immediately be sold or converted into cash if the circumstances require.
A distinguishing feature of cash as an asset, irrespective of the firm in which it is held, is

that it does not earn substantial return for the business.
The following are the various Cash management Models which hare recommended to
used in Business:
1. Synchronization of Cash Flows
2. Short Costs
3. Excess Cash Balance
4. Procurement and Management
5. Uncertainty
Synchronization of Cash Flows: The need for maintaining cash balance arises from the
non-synchronization of the inflows and outflows of the cash: if the receipts and payments
of cash perfectly coincide or balance each other, there would be no
need for cash balances. The first consideration in
determining the cash need is, therefore, the extent of non-synchronization of cash receipts
and disbursements. For this purpose, the inflows and outflows have to be forecast over a
period of time, depending upon the planning horizon, which is typically a one-year period
with each of the 12 months being a sub period.
Short Costs: Another general factor to be considered in determining cash needs is the
cost associated with a shortfall in the cash needs. Every shortage of cash - whether expected
or unexpected - involves a cost ‘depending upon the severity, duration and frequency of
the shortfall and how the shortage is covered. Expenses incurred as a result of shortfall are
called short costs’.
Following are the various Short Costs:

Transaction costs associated with raising cash to tide over the shortage. This is usually the
brokerage incurred in relation to the sale of some short-term near-cash assets such as
marketable securities.
Borrowing costs associated with borrowing to cover the shortage. These include
items such as interest on loan, commitment charges and other expenses relating to the
loan.
Loss of cash discount, that is, a substantial loss because of a temporary shortage of
cash.
Cost associated with deterioration of the credit rating, which is reflected in higher
bank charges on loans, stoppage of supplies, demands for cash payment, refusal to sell,
loss of image and the attendant decline in sales and profits.
Penalty rates by banks to meet a shortfall in compensating balances.
Excess Cash Balance Costs: The cost of having excessively large cash balances is
known as the excess cash balance cost. If large funds are idle, the implication is that the
firm has missed opportunities to invest those funds and has thereby lost interest, which it
would otherwise have earned. This loss of interest is primarily the excess cost.
Procurement and Management: These are the costs associated with

establishing and operating cash management staff and activities. They are generally
fixed and are mainly accounted for by salary, storage, handling of securities, and so on.
Uncertainty and Cash Management: The impact of uncertainty on cash management

strategy is also relevant, as cash flows cannot be predicted with
Complete accuracy.
The first requirement is a precautionary cushion to cope with irregularities in cash
flows, unexpected delays in collections and disbursement,
defaults and unexpected cash needs.
The impact of uncertainty on cash management can, however, be mitigated through:
1. Improved forecasting of tax payments, capital expenditure, dividends, and so on; and
2. Increased ability to borrow through overdraft facility
5) Discuss in Brief the Sources of Long Term Finance and Short term Finance.
Solution:
Note: Short term sources are those source that have maturity period of less than a year,
whereas long term sources have a maturity period of more than one year.
Short Term Sources of Finance

Short-term finance is concerned with decisions relating to current assets and current
liabilities. The main sources of short-term finance are as follows:
Letter of Credit: Suppliers, particularly the foreign suppliers insist that the buyer should
ensure that his bank would make the payment if he fails to honor its obligations.
This is ensured through letter of credit (LC) arrangement. A
bank opens a LC in favor of a customer to facilitate his purchase of goods. If the
customer doesn’t pay to the supplier within the credit period, the bank makes the payment
under the LC arrangements. This arrangement passes the risk of supplier to the bank. Bank
charges the amount for opening LC. It will extend such facilities to the financially sound
customers.
Cash Credit: cash credit is the arrangement under which a customer is allowed an advance
up to certain limits against credit granted by the bank. Under this arrangement, a customer
need not borrow entire amount of advance at one go, he can only draw to the extent of his
requirement and deposits his surplus funds in his account. Interest is charged not on the full
amount of advance but on the amount actually availed by him. Generally cash credit
limits are sanctioned against the security of goods by way of pledge or hypothecation.
Overdraft: Overdraft arrangement is similar to the cash credit arrangement. Under the overdraft
arrangements, the customer is permitted to overdraw up to a prefixed limit. Interest is
charged on the amounts overdrawn subject to some charge as in the case of cash credit
arrangements. Overdraft account operates against security in the form of pledging of share
security, assignment of the LIC policies and sometimes even mortgage of fixed assets.
Bills Discounting: Under this system, a borrower can obtain credit from the bank against
the bills. The amount provided under this system is covered within the
overall cash credit or overdraft limit. Before purchasing or
discounting the bills, the bank satisfies itself as to the creditworthiness of the drawer.
Though the term “bills payable” implies that the bank becomes owner of the bills but in
practice the bank holds bills as security for the credit. A bill when discounted, the borrower
is paid the discounted amount of the bill. A bank collect full amount of maturity.
Factoring: A factor is the financial institution, which offer services related to

management and financing of debts arising from credit sales. Factoring provide resources to
finance receivables which could help company in short period to finance their working
capital.
Commercial Paper: Commercial paper represents short-term unsecured

promissory notes issued by firms, which enjoy a fairly high credit rating. Generally,
large firms with considerable financial strength are able to issue commercial paper. The
important features of commercial paper are as follows:
i. The maturity period of commercial paper ranges from 90 to 180 days.
ii. Commercial paper is sold at a discount from its face value and redeemed at
its face value. Hence, the implicit interest rate is a function of the size of the
discount and the period of maturity.
iii. Commercial paper is either directly placed with investors or sold through
dealers.
iv. Investors who intend holding it till its maturity usually buy commercial paper.
Hence, there is no well-developed secondary market for
commercial paper.
Inter Corporate Deposits: A deposit made by one company with another, normally
for a period up to six months, is referred to as inter corporate deposit. Such deposits are
usually of three types;
a) Call Deposits: A call deposit is withdrawable by the lender on giving a days notice.
In Practice, however the lender has to wait for at least three days. The interest rate
on such deposit may be around 16% p.a.
b) Three Months Deposit: These are more popular in practice. These deposits
are taken from borrowers to tide over a short term cash inadequacy that may
be caused by one or more of the following factors: disruption in production,
excessive imports of raw materials, tax payment, delay in collection, dividend
payment and unplanned capital expenditure. The interest rate on such deposits is
around 18% p.a.
c) Six Months Deposits: Normally, lending companies do not extend deposits
beyond this time frame. Such deposits usually made with first class borrowers.
These deposits carry an interest rate of around 20% p.a.
Long Term Sources of Finance
Equity Share Capital: Equity shareholders are the owners of the business. They enjoy
the residual profits of the company after having paid the preference shareholders and other
creditors of the company an their liability is restricted to the amount of share capital they
contributed to the company. The advantage of equity capital to the issuing firm is that
without any fixed obligation for the payment of dividends, it offers permanent capital
with limited liability for repayment. However, the cost of equity capital is higher than
other capital. Firstly, since the equity dividends are not tax-deductible expenses
and secondly, the high costs of issue. In addition to this
since the equity shareholders enjoy voting rights, excess of equity capital in
the firms’ capital structure will lead to dilution of effective control.
The book value of an equity share is equal to:
Paid-up equity capital + Reserves and surplus
Number of outstanding equity shares
Preference Share Capital: Preference shares have some attributes similar to equity
shares and some to debentures. Like in the case of equity shareholders, there is no
obligatory payment to the preference shareholders and the
preference dividend is not tax-deductible (unlike in the case of the debenture holders,
wherein interest payment is obligatory). However similar to the debenture holders the
preference holders earn a fixed rate of return for their dividend payment. In addition to
this, the preference shareholders have preference over equity shareholders to the post-
tax earnings in the form of dividends and assets in the event of liquidation.
Other features of the preference capital include the call feature, wherein the issuing
company has the option to redeem the shares, (wholly or partly) prior to the maturity date,
at a certain price. Prior to the Companies Act, 1956 companies could issue preference
shares with voting rights. However, with the commencement of the Companies Act, 1956 the
issue of preference shares with voting rights has been restricted only to the following cases:
a) There are arrears in dividends for two or more years in case of cumulative
preference shares.
b) Preference dividend is due for a period of two or more consecutive preceding

years, or
c) In the preceding six years including the immediately preceding financial year, if the
company has not paid the preference dividend for a period of three or more years.
Term loans: Term loans are directly from the banks and financial institutions in India.
Term loans are generally obtained for financing large expansions, modernization, and
diversification projects. Therefore, this method of financing is also called as project
financing. Term loans have majority of more than one year. Financial institutions provide
term loans for the period of six to ten years and in some cases a grace period of one to
two years is also granted. Commercial banks advance term loans for the period of three to
five years.
Debentures: Another way of raising a loan is to issue a financial instrument called

“debentures”. A debenture is the loan raised by the company from the capital market
against which, assets of the company are mortgaged with the trustees. Debentures carry a
fixed rate of interest. Debenture holders are the creditors of the company. There exist
obligation on the part of the company to pay contractual interest as well as to repay the
principle amount. Debenture finance is also cheaper than share capital. It also command a
tax benefit as a debenture interest is allowed as deductible business expenses.
Types of Debentures:
1. Registered Debentures
2. Bearer
3. Mortgage or Secured
4. Simple
5. Redeemable
6. Irredeemable
7. Convertible
8. Non-Convertible
Lease Financing: A lease is a form of financing employed to acquire the economies

use of assets for a stated period without owing them. Every lease involves two parties: the
lessee and the lessor. Leasing is the contractual arrangement between the lessor and
lessee; where in companies can enter into a lease deal with the manufacturer of the
instrument or through some intermediary. This deal will give the company, the right to use
the asset till the maturity of the lease deal and can later retain the asset or buy it from the
manufacturer. During the lease period the company will have to pay lease rentals, which
generally be at negotiated rate and payable every month.
Hire purchase: Finance company usually offers the facility of leasing as well as hire purchase
to the clients. The features of hire purchase are given as follows:
Features:
The hiree purchases the assets and gives it on hire to the hiree.
The hiree pays regularly the hire purchase installments cover interest as well as
repayment of the principle amount. When the hiree pays the last installments, the title
of the asset is transferred to the hirer.
The hiree charges interest on a flat basis. This means a certain rate of interest
usually around 14% is charged on the initial investment and not on diminishing
balance.
The total interest collected by the hiree is allotted over various years. For this purpose
‘sum of years digits’ method is commonly employed.
Retained Earnings: Retained earnings represent the internal sources of finance

available to the company. Retained earnings represent the only internal source of financing,
expansion and growth. Infact they are an important source of long- term finance for corporate
enterprises.
Global Depository Receipt (GDR): GDR is a new financial instrument. It made its
appearance in 1991 and become an instant success. It all started when companies in
countries like South Korea and Malaysia began attracting investors from Europe and
USA. Inspite of the investor interest companies faced difficulties. A novel way was found and
it works in this way.
A bank in Europe acquires the shares of such a company and then issues its own “receipts”
or “certificates” to the investors. This bank is also called “depository” and such
certificates are called “GDR”. These GDR’s can be traded on the European exchange or in
private placement in USA. A GDR is a dollar denominated instrument tradable on a stock
exchange in Europe or private placement in USA. A GDR represents one or more shares
of the issuing company.
Reliance was the first Indian company to issue GDR’s in May 1992. To raise US $100 million.
The bookings were about five times the size of issue and Reliance retained US $150 million.
Arvind mills issued GDR’s worth US $125 million in February 1994. The issue price of
GDR was $9.78. One GDR represent one share of Arvind mills.
American Depository Receipts (ADR): ADR is an instrument similar to GDR. It is

issued in the capital markets of USA alone. Generally, far mare stringent rules and
regulation prevail for bringing out an ADR issue.
ADR is defined as, “a receipt or the certificate issued by the bank, representing title to the
specified number of shares of a non-US company. The US bank is the depository in this
case. ADR is the evidence of ownership of underlying shares. ADR is freely traded in the
US without actual delivery of underlying non-US shares.
In this case the issuing company actively promotes the company’s ADR in USA. A single
depository bank is normally chosen and the ADR are routed through this bank.
The organization with ADR’s with Security Exchange Commission (SEC) is not
compulsory. Technically ADR’s are different from GDR’s. The size of ADR’s can be
expanded or reduced, generally it depends upon demand as depository banks can issue or
withdraw corresponding shares in the local market.
Fixed Deposits: Fixed deposits are of two types: -
Banks Fixed Deposits and
Corporate Fixed Deposits
Banks Fixed Deposit provides interest at specified rate depending upon the tenure. Banks
also provide loan facility, which is known as demand loan to the investor for which extra
interest of 2% is charged in addition to the principle amount.
Corporate fixed deposits are the fixed deposits given by the companies. Interest is dependent
upon the company policy and regulations. Generally, it differs from company to company.
EPICenter
"To get a sense of fulfilment learn to look 'in here' instead of 'out there'"
Have you ever felt an inner sense of lack. A feeling that there should be more. A feeling
that life is incomplete.
All too often this is because you are looking for fulfilment in the wrong places.
We have become very materialistically centred and therefore try to find our sense of
significance in what we posses, and the position that we attain, rather than in who we are
and what we do. However, we need emotional fulfilment and this can never be found in
material possessions and achievement.
The sense of fulfilment generated by possessions and position is short lived so you try
harder, to achieve more, to acquire more, and this just leads to greater frustration as
nothing seems to satisfy you. You don't know what it is that you want, you just know
that you haven't got it and you won't be happy until you do.
A true sense of fulfilment can only be achieved when you acknowledge the value of the
service that you render. When you base your sense of significance on what you do and
the way that you do it. When you start doing what you do what you do because of who
you are and not for what you can get.
7) Find out the missing figures in the following Income Statement and Balance Sheet of M/S.
Anil Starch Ltd. for the year ended 31- 03- 2004 and Re-write the statement.
Income Statement
Sales: Rs. ?
Cost of Sales: Rs. ?
Gross Profit: Rs. ?
Overheads: Rs. ?
Net Profits: Rs. ?
Balance Sheet As on 31/03/04
Share Capital: 5, 00, 000 Fixed Assets: ?

General Reserve: 3, 00, 000 Stock: ?
Loans: ? Debtors: ?
Sundry Creditors: 6, 00, 000 Bank Balance: ?
Cash: ?
? ?
Additional Information:
i) Debt Equity Ratio 1.25: 1.00
ii) Gross Profit Ratio 30 %
iii) Net Profit 20 % of Gross Profit.
iv) Total Assets Turnover Ratio 2
v) Average Collection Period 1 Month
vi) Liquid Ratio 1:1
vii) Current Ratio 2:1
viii) Bank Balance is 7 times the cash in hand.
Solution:
Books of M/S. Anil Starch Ltd. for the Period Ended 31/03/04
1) Ratios Based on relationship between Borrowed Funds and Owner’s Capital

The Debt Equity Ratio is given as 1.25.
Debt Equity Ratio = Debt Funds / Proprietors Funds
1.25 = Debt/ (5, 00,000 + 3, 00, 000) (Since Proprietors Funds = Shares +
Reserves)
Debt = 10, 00, 000 Rs.
Share Capital: 5, 00, 000 Fixed Assets: 12, 00, 000

General Reserve: 3, 00, 000 Stock: 6, 00, 000
Loans: 10, 00, 000 Debtors: 2, 85, 715
Sundry Creditors: 6, 00, 000 Bank Balance: 2, 75, 000
Cash: 39, 285
24, 00, 000 24, 00, 000
2) Liquidity Ratios:
Current Ratio: 2 Liquid Ratio: 1

Current Ratio: Current Assets Liquid Ratio: Liquid Assets
Current Liabilities Current Liabilities
Now, Current Liabilities: Sundry Creditors + Bank Overdraft + Bills Payable

: 6, 00, 000 + 0 + 0 = 6, 00, 000
Current Assets: Stock + Debtors + Bank + Cash

From the Current Ratio, we get Current Assets: 12, 00, 000.
Liquid Assets: Cash + Bank Balance + Debtors

From the Liquid Ratio, we get Liquid Assets: 6, 00, 000
Therefore, the Value of Stock is Rs. 6, 00, 000

And when the value of Current Assets is Rs. 12, 00, 00, then the value of Fixed Assets will
also be 12, 00, 000 Rs. (Because here the Assets Comprises of Current Assets + Fixed
Assets.)
3) Turnover Ratios:
Total Assets Turnover: 2

Therefore, 2 = Cost of Goods Sold
Average Total Assets {Where Average Total Assets = Total Assets }
2
2 = COGS/ 12, 00, 000 {24, 00, 000/2}
Therefore, Costs of Goods Sold: 24, 00, 000.
Sales: Rs. 34, 28, 580 (Approx.)

(-) Cost of Sales: Rs. (24, 00, 000)
Gross Profit: Rs. 10, 28, 580
(-) Overheads: Rs. (8, 22, 860)
Net Profits: Rs. 2, 05, 720
Given that Gross Profit is 30 %. Therefore Costs of Goods Sold is 70 %.

Therefore total Sales: 34, 28, 580 Rs.
To find out Overheads, it is the difference between Gross and Net Profits.
Net Profit: 20 % of Gross Profit
: 1/5 x 10, 28, 580
: 2, 05, 720 Rs.
Now, Average Collection Period = 1 Month.

Therefore in a Year, we will get the payment for 11 Months. (There is Lag of 1 Month.)
Assume the Sales to be Even all throughout the Year.
Hence,
Monthly Sales: 34, 28, 580 / 12
: 2, 85, 715 Rs.
The Amount Pending from Debtors is Rs. 2, 85, 715 (Assuming No Previous Debtors)
But Liquid Assets: 6, 00, 000
Cash + Bank = 6, 00, 000 – 2, 85, 715 = 3, 14, 285 Rs.

But, Bank Balance is 7 times Cash Balance.
Therefore, 3, 14, 285/8
Cash: 39, 285 Rs.
And, Bank Balance: 2, 75, 000 Rs.
8) M/s Jay Retailing Business Ltd. gives you the following data for the last three years of
operations. You are required to prepare Trend Analysis Statement.
Balance Sheet as on -/-/- (in Thousands.)

Liabilities 2001 2002 2003
Share Capital: 750 750 1050
Reserves: 300 450 540
Term Loans: 270 240 210

Current Liabilities: 90 150 120
1410 1590 1920
Assets 2001 2002 2003

Fixed Assets: 1050 1080 1320
Investments: 270 430 410
Current Assets: 90 80 190
1410 1590 1920
Income Statement for the Year --

Particulars 2001 2002 2003
Sales: 3450 3690 3550
Cost of Sales: 2410 2560 2440
Overheads: 490 360 520
PBIT: 550 770 590
Interest: 140 210 180
PBT: 410 560 410
Tax: 200 300 210
PAT: 210 260 200
Solution:
Trend Analysis:
Study of one year’s financial statements in isolation hardly serves any purpose. An analyst should
study three to five years’ financial statements and compare the trend of sales, cost of production and
different ratios etc. during the year.
The trend will reveal whether the unit is prospering or deteriorating year after year. Such analysis
of the trend is known as trend analysis. For example by comparing the sales figures of last 5-6
years one can find out what is the growth pattern of the sales and what is the percentages of
increase year after year. Similarly by studying trend of cost of sales, cost of production and other
parameters one can infer whether the business is progressing or deteriorating.
A Management Paradise (un) Ltd .Endeavor…………………………………………….I,MP
Books of M/s. Jay Retailing Business for the year ended 2003
VERTICAL BALA)CE SHEET AS O) 2003 (Rs. in Thousands)
S.R Particulars 2001 2002 2003 % for % for % for
(Base) 2001 2002 2003
1 Sources of Funds:
a) Proprietors Funds:
i) Share Capital: 750 750 1050 100 100 140
ii) (+) Reserves: 300 450 540 100 150 180
Proprietors Funds: 1050 1200 1590 100 114 151
b) Borrowed Funds:
i) Term Loans: 270 240 210 100 89 78
Total Capital Employed: 1320 1440 1800 100 109 136

2 Application of Funds:
a) Fixed Assets: 1050 1080 1320 100 103 126
b) Investments: 270 430 410 100 159 152
c) Net Working Capital: 0 (70) 70 100 (∞) ∞

i) Current Assets: 90 80 190 100 89 211
ii) Current Liabilities: (90) (150) (120) (100) 167 133
Total Application of Funds: 1320 1440 1800 100 109 136
It is not Where We Reach, but more importantly How we reach matters………Go on………….. 120
Income Statement of M/s. Jay Retailing Business for the Period ended 2003
(Rs. in Thousands)
S.r Particulars 2001 (Base) 2002 2003 % for % for % for
‘01 ‘02 ‘03
1 Sales: 3450 3690 3550 100 107 103
(-) i) Cost of Sales: (2410) (2560) (2440) (100) (106) 101

ii) Overheads: (490) (360) (520) (100) (73) 106
(=) PBIT 550 770 590 100 140 107
(-) Interest: (140) (210) (180) (100) (150) (129)
(=)PBT: 410 560 410 100 137 100
(-) Tax: (200) (300) (210) (100) (150) (105)
(=)PAT: 210 260 200 100 124 95
Financial Management November 2005 Answers
STRATEGY: Here again stick to our usual Strategy. Start with Section II,
give around 55-60 minutes. After Section II, go for Concepts, and then Case
Study. The Case Study seems to be easy but go with best of the minds.
STRATEGY II: Here, start with the Case Study. After that, leave some pages,
and go for Section II. See to it that you are able to attempt complete paper.
1)
a) Cost of Debt:
Solution:
The cost structure of a firm normally includes the debt component also. Debt may
be in the form of debentures, bonds, term loans from financial institutions and banks
etc. The debt is carried a fixed rate of interest payable to them, irrespective of the
profitability of the company. Since upon rate is fixed, the firm increases its earnings
through debt financing. Then after payment of fixed interest charges more
surplus is available for the equity shareholders and hence EPS will increase. An
important point to be remembered that dividends payable to equity shareholders
and preference shareholders is an appropriation of profit, where as the interest
payable on debt is a charge against profit. Therefore any payment towards
interest payable on debt is a charge against profit. Therefore, any payment
towards interest will reduce the profit and ultimately the company’s liability
would decrease. This phenomenon is called ‘Tax shield’. The tax shield is viewed as a
benefit accrued to the company which is geared. To gain the full tax shield the
following conditions apply:
The company must be able to show a taxable profit every year to take full
advantage of the tax shield.
If the company makes loss, the tax shield goes down and cost borrowings
increases.
b) Trading on Equity:
Solution:
A company may raise funds either by issue of shares or by borrowings. Borrowings carry a
fixed rate of interest and this interest is payable irrespective of the fact whether there is profit
or not. Of course, preference shareholders are also entitled to a fixed rate of dividend but
payment of dividend is, subject to profitability of the company. In case the rate of return on
total capital employed i.e. shareholders funds plus long term borrowings, is more than the
rate of interest on borrowed funds or rate of dividend on preference shares, it is said that the
company is trading on equity. In such case equity shareholders would get high returns.
One of the prime objectives of the finance manager is to maximize both the return on
ordinary shares and the total wealth of a company. This thus helps in deciding whether funds
should be raised by internal equity or by borrowings.
c) Inter-corporate Deposits:
Solution :Apart from CPs, corporates also have access to another market called the Inter
Corporate Deposits (ICD) market. An ICD is an unsecured loan extended by one corporate to
another. Existing mainly as a refuge for low rated corporates, this market allows funds surplus
corporates to lend to other corporates. Also the better-rated corporates can borrow from the
banking system and lend in this market. As the cost of funds for a corporate in much higher than
a bank, the rates in this market are higher than those in the other markets. ICDs are unsecured,
and hence the risk inherent in high. The ICD market is not well organised with very little
information available publicly about transaction details.
c) Profit Maximization:
It means the rupee income of firms. Firms may function in the market economy or government
economy. In market economy prices are determined in
competitive markets and those are expected to produce goods and services desired by the
society.
In accounting sense it tends to become a long-term objective, which measure not only the
success of the products but also development of the market for it. The word profit implies a
comparison of the operation of the business between two specific dates, which are usually
separated by an interval of one year. In order to optimize those
corporate sources of wealth on which national prosperity depends, the basic
financial objectives of the companies is to maximize within socially acceptable limits,
profit from the funds use of funds employed to them.

2) M/s. Bharat Industries Ltd. has annual credit sales of Rs. 24 Lacs,. Mr. Patil, the newly
appointed sales manager has ambitious plans to increase the Sales and also the
profitability of the company.
At present the sales price per unit is Rs. 20 and present age of accounts receivables is one
month. And the Variable Cost is @ 50 % and the net profit is @ 20 %
Mr. Patil has put forward the following two proposals before the management.
Proposal I: Increase the Credit period to debtors from one month to 3 months. The expected
sales will be Rs. 30 Lacs. Chances of bad Debts @ 2 % of Credit Sales.
Proposal II: Reduce the Selling Price by 5 % per unit. Expected Sales would be Rs. 28.50
Lacs. All Cash sales, no Credit sales.
Assuming that the costs of the funds is 12 % p.a and other conditions remaining same, which
would you recommend?
Solution:
Books of M/s. Bharat Industries Ltd
Given:
The Variable Costs of the Company is 50 %
And, the Net profit is 20 %, hence the Fixed Costs are 30 %.
The most important instruction in the question, is that “Other Conditions remaining same.”
Hence the above parameters will remain same in any case.
Therefore, the current Profits of the firm are 20 % of Sales: 20 % of 24 Lacs
: 4.8 Lacs.
Proposal I: Increase the Credit period to debtors from one month to 3 months. The expected
sales will be Rs. 30 Lacs. Chances of bad Debts @ 2 % of Credit Sales.
Production Quantity: 30, 00, 000/ 20: 1, 50, 000 units.
Income Statement of M/s. Bharat Industries Ltd. for Proposal I

Particulars Amount
Sales: (Estimated) 30, 00, 000
(-) Variable Cost: (15, 00, 000)
(=) Contribution: 15, 00, 000
(-) Fixed Costs: (9, 00, 000)

EBIT: 6, 00, 000
(-) Bad Debts @ 2 % of Sales: (60, 000)
Adjusted EBIT: 5, 40, 000

(-) Interest: 30, 00, 000 x 12 x 3 (90, 000)
100 12
EBT ()et Profit): 4, 50, 000
Another way to find out Net profit was by following the Instructions:
Given that, Net Profit is 20 % of Sales: 20 % of 30, 00, 000
: 6, 00, 000
Deducting the bad debts and interest, one will again get the same figure.
The Above proposal won’t be Accepted, unless and until the policy of the firm is Sales
Maximization. As the Current Profits of the firm itself are 4.8 Lacs. And here there is
reduction on the profits.
Proposal II: Reduce the Selling Price by 5 % per unit. Expected Sales would be Rs. 28.50 Lacs.
All Cash sales, no Credit sales.
Sales price: Rs. 20 – 5 % of 20
: Rs. 19
The Sales are expected to be 28.5 Lacs.
Hence the Production Quantity: 28, 50, 000
19
: 1, 50, 000 Units.

As the production remains the same. There will be no change in Variable costs.
Hence, the Net Profits will be 20 % of Sales.
Income Statement of M/s. Bharat Industries Ltd. for Proposal II
Particulars Amount
Sales:(Estimated) 28, 50, 000
(-) Variable Cost: (14, 25, 000)
(=) Contribution: 14, 25, 000
(-) Fixed Costs: (8, 55, 000)

EBIT: 5, 70, 000
Another way to find out Net Profit was to directly calculate 20 % of Sales.
Here one can see the trade off between the Sales Price and the Sales.
A Decrease of 5 % in Selling Price, bought an Increase of 19 % (Approx.) in Cash Sales.
Hence the elasticity of the sales of the product can be seen.
From the above proposals, it can be easily seen that Proposal II seems to be a better one, unless
and until the Policy of the Firm is not Wealth Maximization.
EPICenter
"It's the start that stops most people"
How often have you heard people complain about their circumstances, they don't like their job, they
don't like their relationships, they haven't got enough money, and so on and so on. Yet offer them
an opportunity to change and the answer is "I'd like to, BUT…." or "Sounds like a great idea,
BUT…."
You will be amazed, at the number of reasons that people can come up with, to explain why they
can't do anything right now. I'm too busy right now. Wait until after the rugby season. The school
sports take up so much of my time.
I'm too old. And so on and so on.

Some people are extremely creative at inventing excuses not to do something. The tragedy is, that
most people use their intelligence to justify their uselessness rather than using their intelligence to
identify their usefulness.
If they would apply the same creativity to getting things done as they do to inventing excuses, their
performance would be phenomenal.
3) At the time of the interview, the director of the company hands over to you the printed copy
of the audited statement of account, and asks you to ascertain at least 3 of such ratios which
could help you to take the decision in joining that company as an executive. Present a suitable
reply.
Solution:
In the last few years, the complexion of the economic and financial environment has altered in
many ways. The important changes has been as follows:
The industrial licensing framework has been considerably relaxed.

The Monopolies and Restrictive Trade Practices (MRTP) Act has been virtually
abolished.
The Foreign Exchange Regulation Act (FERA) has been substantially liberalized.
Considerable freedom has been given to companies in pricing their equity issues.
The scope for designing new financing instruments has been
substantially widened.
Interest rate ceilings have been largely removed.

The rupee was devalued and, in two stages, has been made fully convertible on
the current account.
Investors have become more demanding and discerning.

The system of cash credit is being replaced by a system of syndicated loans.
A number of new investment opportunities have emerged in the money market.
The relative dependence on the capital market has increased.
The following Parameters are to be considered for the company:
Profit Maximization
It means the rupee income of firms. Firms may function in the market economy or
government economy. In market economy prices are determined in

competitive markets and those are expected to produce goods and services desired by the
society.
In accounting sense it tends to become a long-term objective, which measure not only the
success of the products but also development of the market for it. The word profit implies a
comparison of the operation of the business between two specific dates, which are usually
separated by an interval of one year. In order to optimize those corporate
sources of wealth on which national prosperity
depends, the basic financial objectives of the companies is to
maximize within socially acceptable limits, profit from the funds use of funds employed to
them.
Accounts receivables
When goods are sold on credit, finished goods get converted into accounts receivables in
the books of the seller. A firm’s investment in accounts receivables depends upon how
much a firm sells on credit and how long it will take to collect receivable. For example, if a
firm sells Rs. 1 million worth of goods on credit a day and its average collection period is
40 days, its accounts receivables will be Rs. 40 million. Accounts receivables (or sundry
debtors) constitute the third most important asset category for business firms after plant
equipment and inventories. Hence, it behoove a firm to mange its credit well.
Control of receivables: Monitoring and controlling of accounts receivables is often neither
very thorough nor systematic. Very few firms have well- defined systems for monitoring
and controlling accounts receivables. The measures generally adopted by firms for
judging whether accounts receivables are in control are:
Bad Debt Losses
Average Collection Period
Ageing Schedule.
Room For Improvement: Management of receivables should be accorded the importance it

deserves. A senior executive should shoulder this responsibility.
Credit policies need to revise periodically in the light of internal as well a external
changes.
Firms g r a n t i n g credit should examine the published statements of prospective
customers with greater rigors.
Reference provided by the customers should be consulted and necessary follow-up
should be taken.
A well defined programmed must be developed.
)et Worth
While there is no doubt that the preference shareholders are the owners of the firm, the real
owners are the ordinary shareholders who bear all the risk, participate in the management
and are entitled to all the profits remaining after all possible claims of preference shareholders
are met in full.
Thus it can be said that,
Average Ordinary Shareholders Equity = Net Worth Of Company
Return on Net Worth = Net Profit After Tax – Preference Dividend
Average Equity of the Ordinary Shareholders Equity or Net Worth
It is probably the single most important ratio to judge whether the firm has earned
satisfactory return for its equity shareholders or not. Its adequacy is judge by
Comparing with the past records of the same firm
Inter-firm comparison
Comparison with the overall industry average
Capital Employed
Total resources are also known as total capital employed and sometimes as gross capital
employed or total assets before depreciation. Thus total capital consists of all assets fixed and
current. In other words, the total of the assets side of the balance sheet is considered as total
assets employed.
While calculating capital employed on the basis of assets, following points must be noted.
Any asset which is not in use should be excluded.
Intangible assets like goodwill, patents, trademarks etc should be excluded. If

they have some potential sales value, they should be included.
Investments which are not concerned with business, should be excluded
Fictitious assets are to be excluded
Return on Capital Employed (ROCE) or Return on Investment (ROI) The strategic aim of
a business enterprise is to earn a return on capital. If in any particular case, the return in
the long-run is not satisfactory, then the deficiency should be corrected or the activity
be abandoned for a more favorable one. Measuring the historical performance of an
investment centre calls for a comparison of the profit that has been earned with capital
employed. The rate of return on investment is determined by dividing net profit or income by
the capital employed or investment made to achieve that profit.
ROI = Net Profit x 100

Capital Employed
Wealth Maximization
Wealth Maximization is also known as Value Maximization or Net Present Worth
Maximization. The company, which has profit Maximization as its objective, may adopt
the policies fielding exorbitant profit in the short run which are unhealthy for the
growth survival and overall interest of the business. Hence it is commonly agreed that the
objective of the firm should be to maximize its value or health of the firm.
Features of Wealth Maximization:

It measures the benefit in terms of cash flow and avoids the ambiguity associated with
the accounting profits.
It consider both quality and quantity dimensions of benefits.
It also incorporates the time value of money.
4)
a) What are the Financial Statements?
b) What is the importance of Financial Statements?
c) Parties interested in Financial Statements.
Solution:
According to Feroz Ahmed and Dilip Maitra in “Money from Money”, Business
Today, “Clearly, the clout of the finance manager is growing along with the change in
his role. And as the reforms in the financial sector gather pace, this trend will only
increase. If the 1970s were the age of the Organization Man and the 1980s that of
the Marketing Man, the 1990s will be the age of the Finance Man.”
According to the Institute of Chartered Accountants of India, ‘ A Financial Statement is the

one which summarizes for the period covered by it, the changes including resources from
which funds were obtained by an enterprise and the specific funds were applied.’
Thus Financial Statements are basically concerned with the funds which are raised and the
purposes for which they were applied.
The term Finance has different meaning attached to it:
i) It refers to Cash.
ii) It refers to Working Capital.
iii) It refers to Total Resources.
Until about the turn of the century, preparation of financial statements was a part of the
work to be done by a bookkeeper. In due course of time, bankers began to request balance
sheets of applicants obviously with a view to consider the desirability of granting credit. In
spite of this, the statements were hardly used, analyzed and interpreted in the real sense of
these terms. However, in due course of time, they started to prescribe certain minimum
current and liquid ratios for the purpose of lending and which eventually led to the practice
of analysis and interpretation of financial statements. The growth and
development of management as a science and decision –making accepted as the most
important function of management, have contributed to the extensive use of analysis of
financial statements.
Analysis of financial statements means a systematic and specialized treatment of the

information found in financial statement so as to derive useful conclusion on the profitability
and solvency of the business entity concerned
Objective Of Financial Statement Analysis
Financial statement analysis is an integral part of interpretation of results disclosed by

financial statements. It supplies to decision makers crucial financial information and
points out the problems areas, which can be investigated
Methods and devices used in analysis of financial statements
1. Comparative Financial Statement
2. Common Size Statement
3. Trend Analysis
4. Cash Flow
5. Fund Flow And Many More
Comparative Financial Statement

Comparative financial statements are statements of the financial position of a business so
designed as to facilitate comparison of different accounting variables for drawing useful
inferences.
Financial statements of tow or more business enterprises may be compared over a period of
years. This is known as “inter-firm comparison.”
Common Size Statements
With a view to overcome the serious limitations of comparative financial statements

common size statements came into use.
The common size statements are prepared to bring out the ratio of each asset or liability to the
total of the balance sheet and the ratio of each item of expense or revenue to net sales is know
as the common-size statements.
The analysis, which employs these statements as a tool, is called “vertical analysis” or
“static analysis” because it is a study of relationship between accounts as existing at a
particular date.
Trend Analysis
Study of one year’s financial statements in isolation hardly serves any purpose. An analyst
should study three to five years’ financial statements and compare the trend of sales, cost of
production and different ratios etc. during the year. The trend will reveal whether the unit is
prospering or deteriorating year after year. Such analysis of the trend is known as trend analysis.
For example by comparing the sales figures of last 5-6 years one can find out what is
the growth pattern of the sales and what is the percentages of increase year after year.
Similarly by studying trend of cost of sales, cost of production and other parameters one can
infer whether the business is progressing or deteriorating.
The parties interested in Financial Statement will include all the Stakeholders of the company.
The Stakeholders of the company will include Employees, Customers, Debtors, Creditors,
Government, Debenture Holders, Equity and Preference Shareholders, and most importantly
the Investors and the Promoters.
EPICenter
"Behind the darkest, heaviest clouds the sun still shines"
There comes a time in the lives of each one of us when we just feel that we cannot carry on. That
there are just too many things going wrong. Too little money, too much month. Marriage is
breaking up. Lost your job. Failed the exam. Relationships turn sour. You get the feeling that it
doesn't matter which way you turn, just closed doors, just more trouble.
It is at times like these when we are inclined to question "Why me? Why must
I struggle so?" We are often inclined to blame someone or something else for our situation. We feel
sorry for ourselves because life is so "unfair" and people are so "unsympathetic".
There will be times in our lives, when we will face situations that are not in our control, and not of
our doing. The one thing that must be learned and accepted is that things will happen that we are
neither responsible for nor in control of, things we would have preferred not to happen.
Believe that there is something that you can do. Never lose your dignity, your self respect. Take
stock of all the resources, material and emotional, that you still have. How can you best apply them
to improve the situation, to change your circumstances. Look for the solution confident in the
knowledge that
"Behind the darkest, heaviest clouds the sun still shines"
5) a) Explain the importance of Leverage.

b) Distinguish between Operating Leverages and Financial Leverages.
Solution:
The purpose to understand and learn the concept of leverages is to set forth the framework for
the financing decision of a firm.
Financing decision is the second most important function after Investment decision to be
performed by a finance manager. Broadly he must decide where and how to acquire funds to
meet the firm’s investment needs. The central issue before him is to determine the
proportion of the equity and debt. The mix of equity and debt is known as the firm’s Capital
Structure. The finance manager must strive to obtain the best financing mix or the optimum
capital structure for his firm. The firm’s capital structure is considered to be optimum when
the market value of the shares is maximized. Once the financial manager is able to determine
the bets combination of debt and equity he must raise the opportunity of the appropriate
amount through best available sources.
A firm can make use if different sources if financing whose costs are different. These sources
may be, for the purpose of exposition be classified in to two :-
a) Sources which carry a fixed rate of return.
b) Sources on which the return vary.
Given the Capital Budgeting decision of a firm, it has to decide the way in which the
capital projects will be financed. Every time the firm makes an investment decision, it is at
the same time making the financing decision also.
Leverage: The employment of an asset or source of funds for which one has to pay a fixed
costs or fixed return may be termed as Leverage. Leverage basically means Advantage.
Consequently, the earnings available to the shareholders as also the risk are affected. If
earnings less variable cost exceed the fixed cost, or earnings before interest and taxes exceed
the fixed return requirement, the leverage is favorable. When they do not, the result is
unfavorable.
There are two types of Leverage:
i) Operating Leverage: it may be defined as, “The Firm’s ability to use Fixed Operating costs
to magnify the effects of changes in Sales on its earnings before interest and tax.”
Or
“The Leverage associated with Investment (Asset Acquisition) Activities is referred to as
Operating Leverage.
Or
“The extent to which Fixed Costs are part of a company’s cost structure, the higher the
proportion of fixed Costs, the faster the income increases or decreases with sales volumes”
Operating Leverage results from the operating costs of a firm.

The operating costs may be classified as:
a) Fixed Costs: Fixed Costs are those costs, which do not vary with sales volume and must
be paid regardless of the amount of return available.
b) Variable Costs: these are the costs that are directly affected or related to sales volume.
c) Semi-Fixed/Variable Costs: these are those costs that remain fixed over the certain range
of sales volume and start increasing beyond that. I.e. become Variable.
Operating leverage is determined by the relationship between the firm’s sales revenues and its
earnings before interests and taxes. The earnings before interests and taxes are also called as
Operating profits. Operating leverage is the tendency of operating profits (EBIT) to vary
disproportionately with the sales. The basic reason behind the operating leverage effect is that
in a cost structure of a company certain costs are fixed. As such these costs would not alter in
cases where volume of sales changes. This results in a disproportionately higher change in the
operating profit, consequent to the change in the level of sales.
When a company has fixed assets, in spite of increase or decrease in sales, its fixed costs
remain same. So by increasing sales the amount of fixed costs can be spread over a
larger number of units. Thus resulting in Operating Leverage.
Let us take an example, a base year has been taken and 2 years have been taken. In case 1
sales have been decreased by 50 % and in case 2 it has been increased by 50 %. Fixed costs
remaining same we will see the effect of increase and decrease in sales on the firm’s operating
profits (EBIT).
Case 1 (- 50% ) Base Case 2 (+ 50 %)

i) Sales: 1000 2000 3000
ii) Sales
Revenue: 1, 00, 000 2, 00, 000 3, 00, 000
iii) (-) Variable
Costs 50, 000 1, 00, 000 1, 50, 000
iv) Contribution: 50, 000 1, 00, 000 1, 50, 000
v) (-) Fixed Cost 50, 000 50, 000 50, 000
vi) EBIT 0 50, 000 1, 00, 000
(- 100 %) (+ 100 %) *
*: without considering the Economies of Scales. As that will alter the Variable Costs.
Observation: Higher the Sales, Higher the Earnings. This is because fixed cost remains same
for all 3 cases, so the additional revenue earned adds up to the operating profits of the firm.
The Degree of Operating Leverage in Quantitative terms the extent or degree of operating
leverage:
i) Percentage change in EBIT = Operating Leverage
Percentage change in Sales
But it can also be expressed in the following way:
Contribution = Operating Leverage.

EBIT
Note: Operating Leverage exists only when there is Fixed Operating Costs. If there are no
fixed operating costs, there will be no operating leverage.
Financial Leverage:
Leverage associated with Financing activities is called as Financial Leverage. Financial
leverage represents the relationships between the firm’s earnings before the interest and taxes
(Operating Profits) and the earnings available for the shareholders. The operating profits are
thus used as pivotal in defining operating leverage. In a way, Operating and Financial
leverage represents the process of determining the earnings available to the equity
shareholders.
Financial leverage refers to the extent to which the firm has fixed financing costs arising from
the use of debt capital. A firm with high financial leverage will have relatively high fixed
financing costs compared to a firm with low financial leverage.
A company can finance its investments by debt and/or Equity. The company may also use
preference capital. The rate of interest on debt is fixed irrespective of the company’s rate of
return on assets. The company has a legal binding to pay interest on debt. The rate of
preference dividend is also fixed; but preference dividend is paid when the company earns
profits. The ordinary shareholders are entitled to the residual income. That is, earnings after
interest and taxes (less preference dividend) belong to them. The rate of equity dividend is not
fixed and depends on the dividend policy of the company.
The use of fixed charges sources of funds, such as debt and preference capital along with the
owner’s equity in the capital structure is called “Financial Leverage or Gearing or Trading On
Equity” (the use of the term ‘Trading On Equity’ is derived from the fact that it is owner’s
capital or equity that is used as a basis to raise debt; that is Equity is traded upon). The
supplier of debt has limited participation in the company’s profits and therefore, he will insist
on protection in earnings and protection in values represented by ownership equity.
The financial leverage employed by a company is intended to earn more on the fixed charges
funds than their costs. The surplus or deficit will increase or decrease the return on the
owner’s equity. The rate of return on the owner’s equity is levered up or down the rate of
return on total assets.
Thus financial leverage is “ability of a firm to use fixed financial charges to magnify the
effects of changes in EBIT on the earnings per share (EPS).”
In Quantitative form, Financial Leverage: EBIT / EBT

Or
F.L: Percentage Change in EPS / Percentage Change in EBIT.
6) What are the factors determining Working Capital Requirements?

Solution: Refer Paper 2002
7) The condensed balance sheet of Dixit Ltd. As on 31/3/05 is as follows:
Liabilities Rs. Assets Rs.

Equity Share Capital: 6, 00, 000 Fixed Assets: 9, 00, 000
Reserves: 2, 00, 000 Stock: 3, 00, 000
6 % Debentures: 5, 00, 000 Marketable Investments: 1, 00, 000
Current Liabilities: 2, 00, 000 Debtors: 1, 50, 000
Bank Overdraft: 50, 000 Cash and Bank: 1, 00, 000
Fixed Deposit Repayable within Preliminary Expenses: 50, 000
one year: 50, 000
16, 00, 000 16, 00, 000
Prepare Vertical Common Size Statement and Comment on Short Term Solvency of the
Company.
Solution:
Common Size Statement
The common size statement is often called as ‘Common Measurement’ or

‘Common Percentage’ or ‘ 100 Percent’ statement, since each statement is
reduced to the total of 100 and each individual component of the statement is
represented as a percentage of the total, which invariable serves as the base.
This facilitates comparison of two or more business entities with a common

base. In the case of Balance sheet, total assets or liabilities or capital can be
taken as the common base and in the case of income statement, net sales can be
taken as the base.
Thus, the statement prepared to bring out the ratio of each assets or liability to the
tool of the balance sheet and the ratio of each item of expense or revenue to net sales
is known as common size statement
Books of M/s. DIXIT Ltd

Vertical Balance Sheet and Common Size Statement as on 31/3/05
S.r Particulars Amount Amount % Funds Emp.
1 Sources of Funds:
48
i) Equity Capital: 6, 00, 000
ii) (+) Reserves 2, 00, 000 16
iii) (-) Preliminary Expenses: (50, 000)
(4)
iv) (=) Proprietors Funds: 7, 50, 000 60
v) (+) Borrowed Funds (Deben.): 5, 00, 000
40
vi) (=) Total Funds Employed: 12, 50, 000 100
2 Application of Funds:
72
a) Fixed Assets: 9, 00, 000
b) Investments (Marketable): 1, 00, 000 8
c) Working Capital:
i) Current Assets:
12
Debtors: 1, 50, 000
(+) Cash and Bank: 1, 00, 000 8
(+) Stock: 3, 00, 000
24
Total: 5, 50, 000 44
(-) ii) Current Liabilities: (2, 00, 000) (16)

(+) Bank Overdraft: (50, 000)
(4)
(+) Fixed Deposit Rep. (50, 000) (4)
(3, 00, 000)
(24)
12, 50, 000

100
The Short Term Solvency of the Company is as follows:

Quick Ratio: Quick Assets
Current Liabilities {Where Quick Assets = Current Assets – Stock – Prepaid Exp.}
: 5, 50, 000 - 3, 00, 000

3, 00, 000
: 0.83 < 1
Hence the Short Term Solvency of the Firm is not satisfactory.
Note: Fixed Deposit Repayable within a year is a short term Liability; hence it is included in
Current Liabilities.
8) The following is the balance sheet of X Ltd.
Particulars 31/3/03 31/03/04

Liabilities:
i) Share Capital: 10, 00, 000 12, 00, 000
ii) Profit and Loss a/c: 2, 60, 000 3, 20, 000
iii) Secured Loans: 2, 00, 000 ---
iv) Unclaimed Dividends: --- 10, 000
v) Bank Overdraft: 2, 00, 000 7, 00, 000
vi) Sundry Creditors: 3, 00, 000 4, 50, 000
vii) Provision for Tax: 1, 20, 000 2, 00, 000
viii) Proposed Dividend: 1, 00, 000 1, 20, 000
Total: 21, 80, 000 30, 00, 000
Assets:
i) Fixed Assets: 11, 00, 000 18, 60, 000
ii) (-) Provision for Depreciation: (4, 20, 000) (7, 00, 000)
iii) Long Term Investment: 2, 00, 000 ---
iv) Stock: 4, 50, 000 6, 50, 000
v) Sundry Debtors: 6, 20, 000 8, 60, 000
vi) Prepaid Expenses: 20, 000 30, 000
vii) Cash and Bank Balance: 2, 10, 000 3, 00, 000
21, 80, 000 30, 00, 000
Prepare Cash Flow statement and Comment on Cash Utilization.
Solution:
Books of X Ltd for the Year Ended 31/03/04
Journal Entries
S.r Particulars l.f Amount Amount
1 Cash/Bank a/c Dr. 2, 00, 000
To Equity Shares a/c 2, 00, 000
(Being Shares issued to raise money)
2 Secured Loans a/c Dr. 2, 00, 000
To Cash/Bank a/c 2, 00, 000
(Being Loans repaid)
3 Provision for Tax a/c Dr. 1, 20, 000
(Being Tax Paid by Cash/Bank)
4 Profit and Loss a/c Dr. 2, 00, 000
To Provision for Tax a/c 2, 00, 000
(Being Excess of Provision Transferred to P/L a/c )
5 Proposed Dividend a/c Dr. 1, 00, 000
To Cash/Bank a/c 90, 000
To Unclaimed Dividend a/c 10, 000
(Being Dividend declared, and part of it Unclaimed
To Proposed Dividend a/c 1, 20, 000
(Being Excess of Reserve Transferred to P/L a/c )
To Provision for Depreciation a/c 2, 80, 000
(Being depreciation provided for Fixed Assets)
8 Fixed Assets a/c Dr. 7, 60, 000
(Being Fixed Assets purchased for Cash/Bank)
9 Cash/Bank a/c Dr. 2, 00, 000
To Long Term Investment a/c 2, 00, 000
(Being Investments sold off)
10 Funds from Operation Dr. 6, 60, 000
To Profit and Loss a/c 6, 60, 000
(Being P/L a/c closed for the year and balance
transferred to Cash Statement)
11 Cash a/c Dr. 90, 000
To Bank a/c 90, 000
(Being Bank Balance withdrawn at end of Year)
Assumed that all transactions are by Bank

12 Bank a/c Dr. 90, 000
To Cash a/c 90, 000
(Being Extra Cash Deposited in to Bank)
Assumed that all transactions are in Cash
Account to be made: 9
(1) Share Capital a/c
By balance b/d. 10, 00, 000
By Cash/Bank a/c 2, 00, 000
To balance c/f 12, 00, 000

To Provision for Tax a/c 2, 00, 000 By balance b/d. 2, 60, 000
To Proposed Dividend a/c 1, 20, 000
To Provision for Depreciation 2, 80, 000 By Funds from 6, 60, 000
a/c Operation
Transferred to Cash
Flow Stat.
(3) Secured Loans a/c

To balance c/f 0
(4) Unclaimed Dividend a/c

By balance b/d. 0
By Proposed 10, 000
Dividend a/c
To balance c/f 10, 000

To balance c/f 2, 00, 000 By Profit and Loss a/c 2, 00, 000
(6) Proposed Dividend a/c

To Cash/Bank a/c 90, 000 By balance b/d. 1, 00, 000
To Unclaimed Dividend a/c 10, 000 By Profit and Loss a/c 1, 20, 000
(7) Provision for Depreciation a/c

By Profit and Loss a/c 2, 80, 000
(8) Fixed Assets a/c

To balance b/d 11, 00, 000
By balance c/f 18, 60, 000
(9) Long Term Investment a/c

To balance b/d 2, 00, 000
By Cash/Bank a/c 2, 00, 000
By balance c/f 0
Cash Flow Statement Of X LTD. for the year ended 31/03/04

1 FUND FROM OPERATION 6, 60, 000
(+) Decrease in Current Asset:

(-) Increase in Current Asset: Stock + Debtors + (2, 00, 000
Prepaid Expenses + 2, 40, 000
+ 10, 000)
(+) Increase in Current Liabilities: Creditors + 1, 50, 000

Bank Overdraft + 5, 00, 000
(-) Decrease in Current Liabilities:
8, 60, 000
2 (-) Income Tax paid: (1, 20, 000) 7, 40, 000

xiv) Fixed Assets Purchased (7, 60, 000)
xv) Secured loan Repaid (2, 00, 000)
xvi) Land and Building Purchased 0
xvii) Machinery Sold 0
xviii) Investment Sold 2, 00, 000
xix) Fixed Assets Purchased 0
xx) Investments Purchased 0
(20, 000)

vi) Dividend paid (90, 000)
vii) Shares Issued 2, 00, 000
90, 000
Here there is a net Increase in the Cash from Operation, which can be tallied from the
table below:
Cash & Bank Bal. 2, 10, 000 3, 00, 000 90, 000
End of Year Effect: = + 90, 000
Cash Utilization Policy of the firm:

i) The Cash Utilization Policy of the firm is Quite Satisfactory.
ii) The firm has repaid the loans and raised the difference through Equity shares.
iii) It has also declared the dividend to attract more shareholders,
iv) The firm is on Expansion mode. Basically there is an increase in Fixed Assets and
along with Current Assets and Liabilities.
v) It has also taken an Overdraft from bank so as to increase the level of activity.
vi) And hence because of all this, there is Surplus balance of Cash at the end of year.
Here the firm should see to it that the surplus in utilized to reduce the overdraft
balance.
EPICenter
"Every 'BIG' success is made up of many 'small' successes"
Often we will look at what we are trying to achieve but we feel that it is just too big, just too much
to do, and that we just can't do it, I mean I am only one person, I can't do everything, and there is
still so much to do.
Never worry about how far you still have to go, always congratulate yourself on how far you have
come, reaffirm the value of your goals and concentrate on the next step of the journey. All journeys
are the same, they can only be completed one step at a time. The destinations may be different but
the process never changes.
You must persevere, so often we give up just before the finish line. We become discouraged and
lose faith in the possibility of achievement. We stop believing in the value of the attempt. You must
believe that your goal is not only achievable, but is worth the effort that you are making and still
have to make.
Without this faith you cannot succeed. Just as vitamins strengthen your body so faith strengthens
your life for where there is faith in the future, there is power in the present.
Financial Management November 2006
Strategy for the Paper:
1) Start with Section 1 and go with the flow of the paper, as the Section 1 is the Cash Cow
of the Paper.
1. Attempt the Following:
a) What are the different types of Risks involved in Financial Management?

Solution: Refer Paper 2001.
b) What is Break-Even Point?
Solution:
The break-even point of a business is the level of output or sales at which the revenue
received by the business is exactly equal to the cost of making (or selling) that output. In the
examples below we show you how to calculate the break-even point of a retailer. However,
the process described is exactly the same for other types of firms such as manufacturers who
will be concerned to find the break-even level of output when they produce goods.
The sales revenue of the business is calculated at any level of sales by multiplying the price
of the item, by the number of units sold.
Costs are divided into two main types:
Fixed costs are ones that do not vary with sales. For example, one of the fixed costs of a high
street shop is the rent paid for the property. The rent is still the same whether the shop sells
one item or thousands.
Variable costs are ones that vary with sales. For example, imagine that a bookshop buys in
books for an average price of Rs.5 each. It then resells the books for a higher price. For the
bookshops the variable cost is Rs,5 per unit.
Total costs are found by adding together fixed and variable costs.
To calculate break-even we now need to find out the point at which sales revenue just covers
total cost i.e. fixed and variable costs combined.
A bookshop has fixed costs of Rs.5,000 per week. It buys books from the publishers at an
average cost of £5 each and sells them for an average price of Rs.10 each.
How many books does it need to sell to break even? or every book sold the bookshop takes
in Rs.5 more of revenue, than it pays out in variable costs:
Calculation: Rs. 10 (sales revenue) – Rs. 5 (variable cost) = Rs. 5 (contribution)
We use the term contribution to describe the difference between sales revenue per item and
variable cost per item. This is because each Rs.5 is contributing Rs.5 to paying off fixed
costs of Rs.5,000. You should now be able to calculate that to break-even the bookshop will
need to sell exactly 1,000 books a week. Because:
Fixed Cost per week

--------------------------- = Break Even Point
Contribution per book
Breakeven chart records the amount of fixed costs, variable costs, total costs and total revenue at
all volumes of sales and at a given sales price as follows:
Figure 5.1 Breakeven chart
The 'breakeven point' is where revenues and total costs are exactly the same, so there is no profit
or loss. It may be expressed in terms of units of sale or in terms of sales revenue. Reading from
the graph, the breakeven point is 3,000 units of sale and Rs.18,000 in sales revenue.
The 'margin of safety' is the amount which actual output/sales may fall short of the budget
without a loss being made, often expressed as a percentage of the budgeted sales volume. It is a
rough measure of the risk that a company might make a loss if it fails to achieve its budget.
c) Explain the Convention of Conservatism?

Solution:
In business, investment, and accounting, the principle or convention of Conservatism has at

least two meanings.
In investment and finance, it is a strategy which aims at long-term capital appreciation with low
risk. It can be characterized as moderate or cautious and is the opposite of aggressive behavior.
In accounting, it states that when choosing between two solutions, the one that will be least
likely to overstate assets and income should be selected.
d) What is ICRA?
Solution:
ICRA, basically is an Acronym for Investment Information and Credit Rating Agency.
ICRA Limited (an Associate of Moody's Investors Service) was incorporated in 1991 as an
independent and professional company. ICRA is a leading provider of investment information
and credit rating services in India. ICRA’s major shareholders include Moody's Investors
Service and leading Indian financial institutions and banks. With the growth and globalisation of
the Indian capital markets leading to an exponential surge in demand for professional credit risk
analysis, ICRA has been proactive in widening its service offerings, executing assignments
including credit ratings, equity gradings, specialised performance gradings and mandated studies
spanning diverse industrial sectors. In addition to being a leading credit rating agency with
expertise in virtually every sector of the Indian economy, ICRA has broad-based its services for
the corporate and financial sectors, both in India and overseas
2. Capital Gearing Ratio is 125%. Which of the following transaction would :
a. Improve,
b. Reduce,
c. :ot Alter, the capital gearing Ratio.
State the Reasons, consider each transaction separately:
Solution:
Gearing, or leverage, describes the mix of long-term corporate funding provided internally (by
shareholders) to that contributed externally (by lenders). Interpreting financial statements using
ratio analysis demands considerably more than just the ability to calculate key gearing ratios.
Ratios are a set of tools to enable the user to gain a deeper insight into a company (to facilitate
planning, decision-making and control) — they are a means to an end, not the end in
themselves. An appreciation of the factors that influence a company’s gearing and the effects of
gearing on shareholders returns are vital to interpreting gearing ratios. To prevent students from
adopting a piecemeal approach to the interpretations of financial statements, the article places
the gearing ratios into a systematic framework of analysis, which highlights the inter-
relationships between the key categories of ratios. Factors affecting the level of gearing
employed by a company Before gearing ratios can be properly understood, it is instructive to
analyse the factors
• Sales and profits — companies that have a stable or growing rate of sales and profits are
in a better position to finance the interest charges and capital repayments than those with
volatile or declining rates of sales. Higher profits make it feasible to sustain higher levels
of gearing.
• Interest costs— if the company is perceived as being risky, for whatever reason, lenders
are likely to demand higher returns to compensate for the risks involved. Where a very
high rate of interest is demanded, the costs become prohibitive and effectively place a
ceiling on the amount borrowed.
• Cash flow — the need to service financial obligations (interest payments and repayment
of the amount borrowed) render a strong, reliable cash flow necessary.
• Borrowing restrictions — companies may have restrictions placed upon them regarding
the amount of debt that can be raised (loan covenants). These may form part of the
company’s articles of association, or may be stipulated in the terms of earlier loan
agreements.
• Industry norms — lenders will assess ‘norms’ for the particular industry before
advancing funds. Companies in highly volatile industries would be expected to have
lower gearing than those in more stable sectors.
• Security — companies wishing to raise debt finance usually have to offer some kind of
security (collateral) to the lender. Lenders will normally require good quality assets (ones
that will not depreciate in value) as security. If such assets are not available, or are
already secured, it may not be possible for a company to borrow additional funds.
• Attitudes of key stakeholders — with day-to-day control in their hands, it is managers
who will normally determine the level of gearing a company adopts. However, the
attitudes of owners (particularly towards the financial risk associated with gearing) and
lenders (who are concerned with security, cashflow of the company and its future
prospects), must be considered.
• Availability of equity funding— companies unable to secure additional funding from
their owners may be forced to borrow to fund expansion.
Measuring gearing — key

ratios
Capital gearing ratio = Prior charge capital
Capital employed
Debt-equity ratio = Prior charge capital
Ordinary share capital + reserves
Interest cover = Profit before interest and tax
Interest charges
Cash flow ratio = Net cash flow from operations
Total debts
The capital gearing ratio measures the proportion of a company’s capital that is prior charge
capital. Prior charge capital represents capital carrying a right to a fixed return (e.g., debentures
and preference shares). Capital employed represents the long-term funding of a business —
ordinary share capital and reserves, preference shares and long-term liabilities and provisions. In
group accounts, minority interests would also be included. There is no limit to what the capital
gearing ratio should be, though a benchmark to differentiate low from high gearing is 50%.
Above 50%, a company would be highly-geared and if the company’s gearing was rising, it
could encounter difficulties in the future in raising additional debt finance unless it could also
raise shareholders’ funds, either through a share issue or retained profits.
Gearing — the advantages
• Gearing effect — it is possible to greatly increase the returns available to shareholders

through the use of loan capital. A 50% increase in profit margin in year 2 resulted in a
commensurate 50% rise in ROSF in company 1, but for company 3 (highly-geared), the
ROSF increased 120%. This can be achieved when the returns generated through the use
of the borrowed funds exceed the interest charges that must be paid, with the surplus
accruing to the ordinary shareholders.
• Tax relief — loan interest (unlike dividends) is an allowable expense for taxation
purposes, meaning that companies only have to meet the net (after tax) cost of interest
charges.
• Lower required returns — investors usually require a lower rate of return from loan
capital than equity due to the lower risk attaching to debt. This is the product of lenders
obtaining security on their loans and also the fact that if the company found itself in
difficulty, loan creditors woud be ahead of ordinary shareholders in the queue for
payment.
• Asset matching — where a loan is employed to finance the purchase of a particular asset,
the period of the loan may be matched against the expected life of the asset, enabling the
asset to generate returns to service the interest payments.
• 0o dilution of control — by issuing debt each shareholders’s proportionate share of the
company remains intact.
Gearing — the disadvantages
• Financial risk — whilst all companies face business risk ( general risk within their
industry — e.g., all house builders suffer from bad weather, increases in the price of
land/materials/labour, low consumer confidence, problems in obtaining planning
permission to build houses, etc), financial risk is a company-specific risk resulting from
the way in which assets are financed. With debt-finance comes the dual obligations to
pay interest charges at regular intervals and to make capital repayments at particular
dates.
If these conditions are flouted the consequences can be serious for the company leading
ultimately to liquidation. Where interest rates rise, or when the economic cycle is at its
low point (sales and profits are depressed), the costs of borrowing can prove
burdensome. For example, shareholders in company 3 see their returns all but disappear,
representing a fall of 84% relative to year 1. Company 1’s shareholders are unaffected by
the events of year 3, while with more modest gearing, shareholders in company 2 see
ROSF fall 20% on year 1. Interest cover in companies 2 and 3 also declines sharply
(from 1.71 in year 1 for company 3 to just 1.07 in year 3).
• Loan covenants — designed to protect the lender’s investment in the business, these
place restrictions on the company’s actions, present and future (discussed above).
• Shareholders returns — facing increased financial risk from a higher level of gearing,
shareholders are likely to react by demanding higher returns from their investment. This
may offset any cost savings gained by the company from the use of loan capital.
Now, Basically, Gearing as defined by the above is given by; Gearing — ratio of external to
internal funds.
Hence, Gearing = Borrowed Funds (Liabilities with Fixed Obligations) / Owned Funds.
a. Redemption of Redeemable Debenture.
The Entry for this will be; Debentures A/c Dr.

To Cash/Bank A/c
(Being Debentures redeemed for Cash/bank)
As the Result, the Borrowed Funds will Go Down, whereas there will be No Effect on the
Owned Funds.
Hence, in this case the Gearing Ratio will Improve, and it will certainly be less than 125%.
b. Issue of Preference Share Capital.
The Entry for Issuing Preference Shares is given by,
Cash/Bank A/c. Dr.

To Preference Shares A/c @ X Rs. A/c.
(Being Preference Shares Issued.)
Now, Preference Shares, form a Part of Borrowed Funds as well as Owned Funds as the
Company if it declares profits, it has to shell out a fixed Amnt, similarly also it is a part of
Owned Funds.
Hence, for the Gearing Ratio, both, Numerator as well as Denominator will Increase, as the
Result there will be No Change.
c. Obtained Long Term Loan from Financial Institution.
The Entry for obtaining the Long Term Loan is given by.:
Cash/ Bank A/c. Dr.

To Long Term Borrowings A/c.
(Being Long Term Liability Raised)
Now, Because of Long Term Liability, there is an Increase in Borrowed Funds, but the Owned
Funds Remain the same.
Hence, the Gearing Ratio is Going to Increase, as the same base will now divide a Higher
Amount.
d. Repayment of Term Loan.
The Entry for the Repayment of Term Loan will be;
Term Loan A/c. Dr.

To Cash/ Bank A/c.
(Being Term Loan Repaid)
As the result of this, there will be a Decrease in the Borrowed Funds, whereas there will be no
effect on the Owner’s Wealth,
Hence, here the Gearing Ratio will Decrease.
e. Conversion of Convertible Preference Shares in to Equity Share capital.
The Entry for the Conversion of Preference shares to Equity Shares is Given by;
Preference Shares @ X Rs. A/c. Dr.

To Equity Shares A/c.
(Being Equity shares issued in Lieu of Preference Shares)
Here, the Gearing Ratio will Decrease. As the Preference Shares for the part of both, the
Borrowed as well as Owners Funds, but the once they are converted in Equity Shares, they will
only be reflected in the Owner’s Wealth.
Hence, at the Cost of Borrowed Funds, the Owner’s Wealth is Increasing, as the Result of
which, the Capital Gearing Ratio will Decrease.
f. Issue of Bonus Shares out of General Reserve.
The Entry for Issuing the Bonus Shares from General Reserve will as follows;
General Reserve A/c. Dr.
To Bonus Shares A/c.

(Being Bonus Shares issued for Reserves)
Here, in this case, when Bonus Shares are issued from General Reserve, there will no Change.
Because the Reserves as well as Equity Shares (Assumed to Equity Shares, as nothing is
mentioned) are part of Owner’s Funds only, hence as far Gearing ratio is concerned, there is just
a Transfer of Amounts from one head to Another, but the Equation remains the same.
Hence, the Gearing Ratio wont Alter.
g. Conversion of Partly Paid Equity Shares in to Fully Paid Shares out of General reserves.
For this, the Gearing Ratio will Decrease. Because, the Partly paid out shares are still a part of
Owner’s Funds but only to the Extent to Investments. Hence when they are fully converted,
there will be an Increase in Owner’s Funds, but there will be corresponding effect on the
Borrowed Funds.
Hence, here the Gearing ratio will Decrease.
h. Conversion of Convertibles Debentures in to Equity Share Capital

The Entry for Conversion of Debentures to Equity Shares is given by.;
Debentures A/c. Dr.

To Equity Shares A/c.
(Being Debentures converted in to Equity Shares.)
In this case, the Gearing Ratio will Decrease. Because, initially Debentures were a part of
Borrowed Funds. Now when they are converted to Equity Shares, they are no more a part of
Borrowed Funds, but they are a part of Onwer’s Capital.
Hence there will be an Decrease in the Gearing Ratio.
i. Issue of Debentures
The Entry for the issue of the Debentures will be as follows;
Cash/Bank A/c. Dr.

To Debentures A/c.
(Being Debentures issued)
Now, in this case, the company has gone in to issue a Fixed Liability, where is there is no
change in the Owner’s funds. Hence, only the borrowed funds will Increase, while Owner’s
Wealth Remaining Same.
As the result, the Gearing ratio will Increase.
3. Mr. Ravi Saxena completed his study in a Prestigious Management Institute. His
placement was made as a Vice President (Marketing). On his very first day, he has
been asked to make a presentation on “Sources and Application of Funds” on basis of
the Quarterly financial statements of the Company. Prepare the Checklist for him for
the presentation.
Solution: (Ideally this should have been the first of the Questions, but anyways, this will be a
Tutorials for making both the Cash Flow and the Fund Flow Statements)
As Mr. Saxena has been appointed as Vice President in Marketing for the Firm, he should take
in care that although marketing is the heart bat of Organisation, Finance is no also of no Less
importance. Hence this presentation should be as much as from Finance Point of view as that of
Marketing. All in all a Balance mixture of underlining the importance of Marketing as well as
Finance Functions.
Funds use and credit planning
Funds (or capital) is a collective term applied to the assortment of productive inputs that have
been produced. Funds may be broadly categorised into operating (or working) capital (difference
between current assets and current liabilities), and ownership (or investment) capital.
Operating capital in a company or firm usually refers to production inputs that are normally
used up within a production year. On the other hand, investment capital (or funds) refers to
durable resources like machines and buildings in which money invested is tied up for several
years. Funds are generally quantified in monetary value terms.
Funds use, especially borrowed capital, is usually influenced by many factors, namely: the
alternative demands for it; the availability of credit as and when needed; the time and interest
rate payable on it; the types of loans that might be needed to generate it; and the cost of funds
and business ownership cost. Thus, careful credit planning is essential in the successful
operations of any company.
In general, this requires the application of what, in strategic company management, has come to
be known as the strategic four-factor model called "SORS". The letters that make up SORS
stand for:-
Strategic planning (S)

Organisational planning (O)
Resource requirements (R)
Strategic control (S).
In general terms, SORS is influenced or determined by four major factors: the external
environment, the internal environment, organisational culture and resource (especially funds)
availability. These four factors interact to create four inter-related components which normally
determine the success or failure of any given company. These are:
a) competitive environment
b) strategic thrust
c) product/market dynamics
d) competitive cost position and restructuring.
A proper and pragmatic manipulation of these four component parts requires:
assessing the external environment

understanding the internal environment
adopting a leadership strategy
strategically planning the finances of the company.
Alternative uses of funds

Dealing with alternatives is what management is all about. Some of the tools for evaluating
alternatives (e.g. partial budgets, cash flow budgets and financial statements), are covered in this
text.
Aim of a Fund flow statement
The aim of a cash flow statement should be to assist users:
to assess the company's ability to generate positive cash flows in the future
to assess its ability to meet its obligations to service loans, pay dividends etc
to assess the reasons for differences between reported and related cash flows
to assess the effect on its finances of major transactions in the year.
The statement therefore shows changes in cash and cash equivalents rather than working capital
Statements of source and application of funds
Although cash flow statements have now superseded statements of source and application of
funds, funds flow statements may not disappear entirely. Some businesses or industries will
continue to find fund flow statements useful and informative. For this reason, it is necessary to
examine funds flow statements.
Funds statement on a cash basis
Funds statements on a cash basis can be prepared by classifying and/or consolidating:
a) Net balance sheet changes that occur between two points in time into changes that increase
cash and changes that decrease cash
b) From the Income statement and the surplus (profit and loss) statement, the factors that
increase cash and the factors that decrease cash and
c) This information in a sources and uses of funds statement form.
Step (a) involves comparing two relevant Balance sheets side by side and then computing the
changes in the various accounts.
Sources of funds that increase cash
Sources of funds which increase cash are as follows:
a net decrease in any asset other than cash or fixed assets

a gross decrease in fixed assets
a net increase in any liability
proceeds from the sale of preferred or common stock
funds provided by operations (which usually are not expressed directly in the income
statement).
To determine funds provided by operations, we have to add back depreciation to net income
after taxes.
But then, depreciation is not a source of funds, since funds are generated only from operations.
Thus, if a company sustains an operating loss before depreciation, funds are not provided
regardless of the magnitude of the depreciation charges.
Application of funds of a company usually includes:
a net increase in any asset other than cash or fixed assets

a gross increase in fixed assets
a net decrease in any liability
a retirement or purchase of stock and
the payment of cash dividends.
To avoid double counting, we usually compute gross changes in fixed assets by adding
depreciation for the period to net fixed assets at the ending financial statement date and subtract
from the resulting amount the net fixed assets at the beginning financial statement date. The
residual represents the gross change in fixed assets for the period. If the residual is positive, it
represents a use of funds; if it is negative, it represents a source of funds.
Once all sources and applications of funds are computed, they may be arranged in statement
form so that we can analyse them better.
Source and application of funds I
Given below are some different sources and applications of funds finance items purposely
scattered for an Agribusiness Company K for the year ended 31 December, 200X
1) Identify them as sources and applications of funds, and arrange them in a proper manner with
the Sources of funds on the left and the Applications on the right of a tabulated statement for the
said period.
2) Comment briefly on some of the uses of the tabulated statement.
Increase in cash position = 12,000
Decrease in debtors = 8,000
Increase in long term debt = 2,500
Increase in stocks = 26,500
Increase in tax prepayments = 2,000
Net profit = 35,000
Increase in other accruals = 3,000
Additions to fixed assets = 4,500
Cash dividends = 15,000
Increase in bank loans = 20,000
Increase in prepaid expenses = 2,500
Increase in investments = 9,000
Increase in creditors = 5,000
Decrease in accrued taxes = 8,000
Depreciation = 6,000
Note: The above figures are based on the balance sheet and income statement of Company K,
which are not shown in this exercise.
Sources and applications of funds II
Using the data and information in the annual reports given above, Mark out the Sources and the
Applications of Funds.
a) compute and identify the sources and applications of funds;
"Cash flow" is one of the most vital elements in the survival of a business. It can be positive, or
negative, which is obviously a most undesirable situation. The chapter develops the concept of
cash flow and then shows how the funds can be used in the business. Funds are not only
generated internally; they may be externally generated, and so the chapter finishes with a
discussion of externally generated funds.
4 A . What are the Advantages of the Vertical form of the presenting financial statements ?
b. Draw a typical format of Balance Sheet in Vertical Format.
Solution:
THE ACCOUNTING EQUATION: The basic features of the accounting model we use today
trace their roots back over 500 years. Luca Pacioli, a Renaissance era monk, developed a
method for tracking the success or failure of trading ventures. The foundation of that system
continues to serve the modern business world well, and is the entrenched cornerstone of even the
most elaborate computerized systems. The nucleus of that system is the notion that a business
entity can be described as a collection of assets and the corresponding claims against those
assets. The claims can be divided into the claims of creditors and owners (i.e., liabilities and
owners' equity). This gives rise to the fundamental accounting equation:
Assets = Liabilities + Owners' Equity
ASSETS: Assets are the economic resources of the entity, and include such items as cash,
accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings,
equipment, and even intangible assets like patents and other legal rights and claims. Assets are
presumed to entail probable future economic benefits to the owner.
LIABILITIES: Liabilities are amounts owed to others relating to loans, extensions of credit, and
other obligations arising in the course of business.
OWNERS' EQUITY: Owners' equity is the owner's "interest" in the business. It is sometimes
called net assets, because it is equivalent to assets minus liabilities for a particular business.
Who are the "owners?" The answer to this question depends on the legal form of the entity;
examples of entity types include sole proprietorships, partnerships, and corporations. A sole
proprietorship is a business owned by one person, and its equity would typically consist of a
single owner's capital account. Conversely, a partnership is a business owned by more than one
person, with its equity consisting of a separate capital account for each partner. Finally, a
corporation is a very common entity form, with its ownership interest being represented by
divisible units of ownership called shares of stock. These shares are easily transferable, with the
current holder(s) of the stock being the owners. The total owners' equity (i.e., "stockholders'
equity) of a corporation usually consists of several amounts, generally corresponding to the

owner investments in the capital stock (by shareholders) and additional amounts generated
through earnings that have not been paid out to shareholders as dividends (dividends are
distributions to shareholders as a return on their investment). Earnings give rise to increases in
"retained earnings," while dividends (and losses) cause decreases.
Balance Sheet: The balance sheet focuses on the accounting equation by revealing the economic
resources owned by an entity and the claims against those resources (liabilities and owners'
equity). The balance sheet is prepared as of a specific date, whereas the income statement and
statement of retained earnings cover a period of time. Accordingly, it is sometimes said that
balance sheets portray financial position (or condition) while other statements reflect results of
operations.Now, While preparing the Balance sheet, Businesses follow a Dual Approach,
1. Horizontal Approach.
2. Vertical Approach.
The
follow
ing the
Exam
ple of
the
Horiz
ontal
One:
Whereas the following is the example of a Vertical Balance Sheet:
The apparent precision of a balance sheet is misleading. The techniques of accounting, if they
are carried out correctly, ensure that a balance sheet always balances. But the information that is
disclosed can be deceptive. The problems of inflation and changing money values affect the
accuracy of Balance sheets. Fixed assets, such as premises, do not necessarily represent their
actual values. Similarly the value of stocks and the allowance for bad debts can only be
estimated. It would be unwise to assume that the guesses of accountants fairest view of the
position of a company. Like the profit and loss account, it is not an absolute record.
The presentation of the balance sheet in a vertical format is a relatively recent practice. The
traditional form of presentation is a horizontal format. The information included in both the
vertical and the horizontal formats is similar: it is customary in both formats to show assets and
liabilities in order of liquidity – the least liquid item is shown first, and the most liquid last. The
two advantages of the vertical format are firstly, it is generally easier to understand. For
example, the horizontal layout shows shareholders’ capital as a liability and this can cause
confusion. Secondly it emphasises important features such as the working capital and net worth
of the company.
5. Evaluate the merit and demerits of Equity Shares as a Source of Long term finance.
Refer Paper 2003
6. Explain in brief importance of Cash Management.
Refer Paper 2001
7. Complete the following Trend Analysis (Statement) and offer your comments thereon:
2005 2004 2003 2002 (Base)

Rs ( % Rs ( % Rs ( % Rs ( %
1000’s) 1000’s) 1000’s) 1000’s) (100)
Assets:
Fixed 100
Assets:
(-) 100
Accumulated
Depreciation:
@20 % of
Original Cost
Written 800 80 160 100 100
Down
Value:
Current 100 80 100
Assets:
(-) Current 140 100 500 100
Liabilities
Working 500 100
Capital:
Capital 1500 100

Employed:
Liabilities: 100
Share 1000 110 100

Capital:
Reserves 150 200
Net Worth 110 100
Debts: 800 160 300 100
Capital 100
Employed:
Solution: The Most Effective Solution is to Start from Base Year, Calculate the Current Assets for 2002, Then Go for 2003, as
the Percentages are Given, that should make the task Easier, and also You can calculate the WDV by 2005 Stats. That will
give WDV for 2002 (Which has to be 100), Once done, get 120 % of it, to Find the Asset Value.
But there is a Catch in the Problem, for the Year 2004, some vital stats are Missing, But that’s the importance of a Trend
Statement (Effectively this is an Error) But then, Trend Analysis, is also a Predictive tool and not only based on Historical
Costs.
2005 2004 2003 2002 (Base)

Rs ( % Rs ( % Rs ( % Rs ( %
1000’s) 1000’s) 1000’s) 1000’s) (100)
Assets:
Fixed 1000 80 2000 160 1250 100 1250 100
Assets:
(-) 200 80 400 160 250 100 250 100
Accumulated
Depreciation:
@20 % of
Original Cost
Written 800 80 1600 160 1000 100 1000 100
Down
Value:
Current 1400 120 1000 100 800 80 1000 100
Assets:
(-) Current 700 140 ? ? 500 100 500 100
Liabilities
Working 700 70 ? ? 300 500 100
Capital:
Capital 1500 100 ? ? 1300 1500 100

Employed:
Liabilities: 100
Share 1000 100 1100 110 520 1000 100

Capital:
Reserves 320 160 ? ? 300 150 200
Net Worth 1320 110 ? ? 820 1200 100
Debts: 180 60 800 80 480 160 300 100
Capital 1500 100 ? ? 1300 1500 100

Employed:
Here You have to assume Values, Keeping in Mind Both the Preceding Year and Following Year’s Constraints, only
then will Purpose of Trend Analysis get Justified. Assumption Part is Left to You.
8. The Following is the Cost Sheet of the Company, Producing 48000 Similar types of
products every year.
Amount Per Unit in Rs.
Raw Materials 80
Labour 40
Factory Overheads 30
Selling and Distribution Costs: 20
:et Profit 30
The Following further particulars are given to you:
2) Raw Materials remain in stock for 2 months, while the finished goods stock is
carried for 3 months.
3) Credit allowed to the customers is 3 months while Credit allowed by suppliers of
materials is 2 months.
4) Factory Overheads are paid at the end of the month.
5) Company has the policy to have bank balance of at least Rs. 1, 50, 000 on any
date and cash holding worth 3 months factory Overheads.
6) 20% of the total sales is for Cash.
You are required to prepare a statement of working capital requirements.
Solution:
Yearly Activity : 48000 Units : 4000 Units Every Month.

Estimate of Working Capital Requirement (Monthly)
Sr. Particulars Amount Amount (Rs.)

B) Current Assets:
i) Stock :
a) Raw Materials: 4000 x 80 x 2 6, 40, 000
b) Finished Goods: 4000 x 170 x 3 20, 40, 000
ii) Debtors: 4000 x 200 x 3 x 80/100 19, 20, 000

iii) Cash in Hand (30 x 4000 x 3) 3, 60, 000
iv) Bank Balance 1, 50, 000 51, 10, 000
Less:
i) Creditors:
a) Raw Materials : 4000 x 80 x 2 6, 40, 000
b) Overheads: 4000 x 30 x 1 1, 20, 000 (7, 60, 000)
Net Working Capital: 43, 50, 000

Financial Management November 2007
1)
a) Letter of Credit:
Sol.:
Letter of Credit refers to a written undertaking made by the importer's bank to the exporter that
the payment shall be made to him provided the shipment is sent by him in strict compliance with
the terms and conditions of the export contract. The terms and conditions of the export contract
form part of the letter of credit and are known as the terms and conditions of the letter of credit.
The essential characteristic of the Letter of Credit is that it relies on the doctrine of strict
compliance for release of payment to the exporter against the draft( s ) drawn by him. The banks
do not deal in goods; they deal in documents. As such, the importer has to specify to the bank
the documents which it should examine as an evidence to the effect that the exporter has sent the
shipment in strict compliance with the terms and conditions of the export contract.
The operations of Letters of Credit have been regulated and are governed by the articles of
'Uniform .Customs and Practice for Documentary Credits' of International Chamber of
Commerce adopted by more than 165 countries which were latest revised in 1993 for
implementation w.e.f. 1st January 1994.
The D /P (Delivery against Payment) and the D / A (Delivery against Acceptance) modes of
payment suggest that there is a certain degree of lack of confidence of the parties in each other.
The exporter is not willing to send the goods on D /P or D / A basis because he is not sure as to
whether the importer would make the payment and if the importer doesn't pay, then he runs the
risk of non-payment. Similarly, importer may also have the feeling that if he makes advance
payment to the exporter and he does not supply the goods of the quality desired by him on the
due date, then he would also suffer loss. Both the parties would be able to conduct their part of
the transaction smoothly if there is an assurance to them as regards protection of their interests.
The exporter requires an assurance for payment of the goods if he has sent the shipment as per
export order. The importer on the other hand, requires an assurance that the payment would be
released to the exporter only when he has supplied the goods as per the terms and conditions
stipulated in the export contract. This assurance is provided by the importer's bank and is known
as Letter of Credit or the Documentary Credit.
PROCEDURE FOR OPE)I)G LETTER OF CREDIT
The following is the procedure for opening a letter of credit:
(a) Importer's Request: - If the method of payment agreed between the importer and exporter
is through letter of credit then the importer requests his bank to open a letter of credit in favour
of exporter, either by paying the amount of letter of credit or by requesting credit to that extent.
(b) Issue of Letter of Credit: - The issuing bank issues letter of credit in favour of the exporter
and sends it to its -branch located in exporter's country (advising bank). The issuing bank may
also request advising bank to add its confirmation, if desired by the beneficiary.
(c) Receipt of Letter of Credit: - The exporter takes the possession of the letter of credit fr6m
the advising bank. He should check the relevant details in the letter of credit and in case there is
any discrepancy, the same should be brought to the notice of the advising bank..
(d) Shipment of Goods: - The exporter fulfils the shipping and customs procedure and collects
the required documents from various authorities for negotiation.
(e) )egotiation of Documents: - The exporter submits the required documents to the
negotiating Bank, which scrutinises the documents and makes payment to the exporter.
(f) Re-imbursement of Payment:- The negotiating bank gets the payment reimbursed from the
issuing bank..
(g) Documents to Importer :- The documents forwarded to the issuing bank by the negotiating
bank are handed over to the importer and the amount is debited to his account.
b) )on Diversifiable Risk:

Sol.:
Risk which is common to an entire class of assets or liabilities. The value of investments may
decline over a given time period simply because of economic changes or other events that
impact large portions of the market. Asset allocation and diversification can protect against
nondiversifiable risk because different portions of the market tend to underperform at different
times. also called systematic risk or market risk.
Basically, there are 2 types of market risk, Diversifiable and Non Diversifiable. Diversifiable is
where you can eliminate the risk by investing in securities.
c) Trading on Equity:
Sol.:
Financial leverage involves the use of fixed cost financing. Interestingly, financial leverage is
acquired by choice, but operating leverage sometimes is not. The amount of operating leverage
(the amount of fixed operating costs) employed by a firm is sometimes dictated by the physical
requirements of the firm's operations. For example, a steel mill by way of its heavy investment
in plant and equipment will have a large fixed operating cost component consisting of
depreciation. Financial leverage, on the other hand, is always a choice item. No
firm is required to have any long-term debt or preferred stock financing. Firms can, instead,
finance operations and capital expenditures from internal sources and the issuance of common
stock. Nevertheless, it is a rare firm that has no financial leverage. Why, then, do we see such
reliance on financial leverage?
Financial leverage is employed in the hope of increasing the return of common shareholders.
Favorable or positive leverage is said to occur when the firm uses funds obtained at a fixed cost
(funds obtained by issuing debt with a fixed interest rate or preferred stock with a constant
dividend rate) to earn more that the fixed financing costs paid. Any profits left after meeting
fixed financing costs then belong to common shareholders. Unfavorable or negative leverage
occurs when the firm does not earn as much as the fixed financing costs. The favor ability of
financial leverage, or "trading on the equity" as it is sometimes called, is judged in terms of the
effect that it has on earnings per share to the common shareholders
d) Float:
Sol.:
The total number of shares publicly owned and available for trading. The float is calculated by
subtracting restricted shares from outstanding shares.
For example, a company may have 10 million outstanding shares, but only 7 million are trading
on the stock market. So, the float would be 7 million.
Stocks with small floats, under 3 million shares, tend to be a lot more volatile than others.
Also known as "free float."
2) Prepare the Monthly forecast of Cash of Raja Ltd. For the Quarter ended 31st
December, 2007 from the following information
a) Opening Balance as on 1st Oct., 2007 is Rs. 52, 000
b) The Budgeted and Actual sales were Rs. 1, 00, 000 each for august and September, October
Rs. 1, 20, 000, November Rs. 1, 35, 000 and December Rs. 1, 40, 000. 30 % of the sales were
for Cash and out of the balance 50 % in the subsequent month of the sale and remaining 50 % in
the second month subsequent of the sale.
c) Dividend on the Investments is being declared on the 20th December, amounting to Rs. 1200
d) Machinery Sale in the month of December is Rs. 15, 000
e) Materials worth Rs. 40, 000 each is being purchased in August and September, 50 % of which
is payable on 1st October, and proposed purchases for the quarter October to December evenly
spread out to Rs. 1, 50, 000. Vendors offer 5 % discount for the cash payments. It is decided to
maintain the cash balance at Rs. 10, 000 each month and the balance to be utilized for payment
to vendors.
f) Wages are expected to be Rs. 12, 000 per month payable a month in arrear
g) Manufacturing expenses payable in the month incurred Rs. 15, 000 per month.
h) General Selling expenses are expected to be Rs. 5, 000 per month
i) Machine costing Rs. 55, 000 is proposed to be purchased for cash in December.
Sol.:
Points to Note:
The Last Point of purchasing is Just a proposal, hence if we don’t have enough balance, it wont
be purchased.
Secondly, The Payment for Materials follows the pattern of Sales. 1 and 2 Months Arrears.
Also, Remember, When Preparing the Cash Outflows, tackle Vendor Payment after all other
flows are settled.
Months October November December January
Opening Balance 52, 000 38, 500 56, 500 53, 250
Cash Inflows
Sales: 1, 20, 000 1, 35, 000 1, 40, 000 -
Cash Sales (30% of Above) 36, 000 40, 500 42, 000 -
Sales (1 Month Arrear) 35, 000 (Sep.) 42, 000 (Oct.) 47, 250 (Nov.) 49, 000 (Dec.)
Sales ( 2 Month Arrear) 35, 000 (Aug.) 35, 000 (Sep.) 42, 000 (Oct.) 47, 250 (Nov.)
Dividend 1, 200
Miscellaneous 15, 000 (Machine Sold)
Total: 1, 58, 000 1, 56, 000 1, 87, 750
Cash Outflows
Wages 12, 000 (Sep.) 12, 000 (Oct.) 12, 000 (Nov.) 12, 000 (Dec.)
Manufacturing 15, 000 15, 000 15, 000 15, 000
General Exp. 5, 000 5, 000 5, 000 5, 000
Vendor Paymnts:
Total Supplies: 50, 000 (Don’t Count this) 50, 000 50, 000
Cash Supplies - CD @ 5 % 47, 500 47, 500 47, 500
1 Month Arrear 20, 000 (Sep.) -----
2 Month Arrear 20, 000 (Aug.) 20, 000 (Sep.)
Capital Investments
(If any) -- 55, 000
Closing Balance 38, 500 56, 500 53, 250
3) Money Manager Ltd. Has projected the following figures to Access Bank for procuring
Working Capital Finance:
2001 2002 2003 2004 2005 2006 2007
Current Ratio
MM Ltd. 2 2 2.5 2.2 2 2.5 2
Industry Avg. 1.8 1.8 2 2 2.5 2.5 2.5
Debt Equity
Rati. 1.8 1.8 1.6 1.6 1.5 1.5 1.2
MM Ltd. 1.5 1.5 1.8 1.8 1.8 1.6 1.8
Industry
Average
Return on
Invest. 20 20 18 18 15 15 18
MM Ltd. 18 18 20 20 18 18 18
Industry
Average
You are Required to ascertain the Trend and Interpret the Result.
Sol.:
Points to Note:
1) Keeping the Current Ratio Constant, in the first 2 Years, MM has higher debt equity ratio
than required in the Industry, but it is also earning more than the Industry standards, the
firm is basically taking advantages of the Leverages, and that also certainly means that
Debt is coming at a much lower cost than equity.
2) When the D/E Ratio is kept constant, in the next 2 years, there is a inverse relation
between the Current and ROI. By increasing the investment in working capital, there is a
decrease in the ROI., whereas in 2005, 2006, there is no effect on ROI, even though there
is an increase in Current Ratio.
3) The Above pattern basically signifies the following transitions the firm has undergone
through:
a) Initially, the firm focused on the Financial Leverage, and that is why having high debt
equity mix, was contributing more to the bottom line or ROI of the firm.
It is not Where We Reach, but more importantly How we reach matters………Go on…………- 181 -.
b) In 2005, 2006, it also started focusing on the Operating Leverage, thus reducing its
investments in the inventories, and coming at par with the industry standards.
c) Thus, it began to achieve the benefits of Combined Leverage, thus optimizing its ROI
with the Industry Average.
4) What is Lease Finance? Distinguish between the Finance Lease and Operating
Lease
Sol.:
A lease is a form of financing employed to acquire the economies use of assets for a
stated period without owing them. Every lease involves two parties: the lessee and the
lessor. Leasing is the contractual arrangement between the lessor and lessee; where in
companies can enter into a lease deal with the manufacturer of the instrument or
through some intermediary. This deal will give the company, the right to use the asset till
the maturity of the lease deal and can later retain the asset or buy it from the
manufacturer. During the lease period the company will have to pay lease rentals, which
generally be at negotiated rate and payable every month.
A finance lease is a lease that is primarily a method of raising finance to pay for assets, rather
than a genuine rental. The latter is an operating lease.
The key difference between a finance lease and an operating lease is whether the lessor (the
legal owner who rents out the assets) or lessee (who uses the asset) takes on the risks of
ownership of the leased assets. The classification of a lease (as an operating or finance lease)
also affects how it is reported in the accounts
The UK, like many other countries, has tax rules that attempt to control the use of finance
leases to reduce tax (reduced compared to what would have been paid if an asset had been
financed in a different way).
From an accounting point of view the classification of leases as finance leases is very
important. With a finance lease assets must be shown on the balance sheet of the lessee, with
the amounts due on the lease also shown on the balance sheet as liabilities. This is intended to
prevent the use of lease finance to keep the lease liabilities off-balance sheet.
The only difference between an operating lease and a Finance Lease is that the primary period
rentals do not cover substantially all of the capital cost and hire charges. For example a lease
for a printing press costing 400,000 may include a residual value at the end of the primary
period of 150,000. The primary rentals are thus based on 250,000 and not the capital cost of
400,000.
Due to the fact that the asset needs to be sold on at the end of the primary period to recover
the residual value, it is very rare for an operating lease to have a secondary rental period. In
some instances the funder may structure a finance lease for you to 'wash-out' the residual
position.
With an Operating Lease you may source the supplier, but it is often the case that the leasing
company can acquire the asset for you cheaper (for example car leasing companies). You will
have to pay any documentation fee and an initial payment of a multiple of rentals. The rentals
attract VAT that can be recovered subject to eligibility. As the finance company is the owner
of the asset, you will not need to pay the purchase VAT at inception.
5) “Financial Management is more than procurement of Funds”. What do you think

are the responsibilities of a finance manager?
Sol.:
Please Refer Paper 2006
6) Explain the Arbitrage Process as propounded by the Miller – Modigliani in their

)OI Approach to the Capital Structure Theory
Sol.:
The Modigliani-Miller Theorem is a cornerstone of modern corporate finance. At its heart,
the theorem is an irrelevance proposition: The Modigliani-Miller Theorem provides
conditions under which a firm’s financial decisions do not affect its value. Modigliani
explains the Theorem as follows:
“… with well-functioning markets (and neutral taxes) and rational investors, who can ‘undo’
the corporate financial structure by holding positive or negative amounts of debt, the market
value of the firm – debt plus equity – depends only on the income stream generated by its
assets. It follows, in particular, that the value of the firm should not be affected by the share
of debt in its financial structure or by what will be done with the returns – paid out as
dividends or reinvested (profitably).”
In fact what is currently understood as the Modigliani-Miller Theorem comprises four

distinct results from a series of papers (1958, 1961, 1963). The first proposition establishes
that under certain conditions, a firm’s debt-equity ratio does not affect its market value. The
second proposition establishes that a firm’s leverage has no effect on its weighted average
cost of capital (i.e., the cost of equity capital is a linear function of the debt-equity ratio). The
third proposition establishes that firm market value is independent of its dividend policy.
The fourth proposition establishes that equity-holders are indifferent about the firm’s
financial policy.
Miller explains the intuition for the Theorem with a simple analogy. “Think of the firm as a
gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or he can separate
out the cream, and sell it at a considerably higher price than the whole milk would bring.”
He continues, “The Modigliani-Miller proposition says that if there were no costs of
separation, (and, of course, no government dairy support program), the cream plus the skim
milk would bring the same price as the whole milk.” The essence of the argument is that
increasing the amount of debt (cream) lowers the value of outstanding equity (skim milk) –
selling off safe cash flows to debt-holders leaves the firm with more lower valued equity,
keeping the total value of the firm unchanged. Put differently, any gain from using more of
what might seem to be cheaper debt is offset by the higher cost of now riskier equity. Hence,
given a fixed amount of total capital, the allocation of capital between debt and equity is
irrelevant because the weighted average of the two costs of capital to the firm is the same for
all possible combinations of the two.
Detailed Explanation:
The cost of capital of a firm is fundamental in the decision as to whether a proposed project
is acceptable. If the return from a project (r) exceeds the cost of capital (ko) then the project
should be accepted. If the cash flows from the project were to be discounted at ko then the
project would have a positive net present value (N.P.V.).
This would be profitable for the firm and will mean an increase in the present net worth.
Illustration 1.1
A firm has $200,000 of cash available for investment, ko = 10%. If the company were to
invest the $200,000 in a project with a return greater than ko, then the present value of the
firm would increase.
Consider a project that will require all the $200,000 now and will return $30,000 per annum
indefinitely.
$30,000
Using i = ko = .10 the present value of the income stream = .10 = $300,000
(The IRR equals 15%)
The present value of the projects inflows exceeds the present value of costs by $100,000 and
this is an increase in the present value of the firm and the market price of its shares would
reflect this increase (provided that shareholders perceive the situation).
The increase would be even greater if ko could be reduced. In present value terms the value
of the firm is at a maximum when the cost of capital is at a minimum.
There are a number of different views on capital structures and financing risk.
Initial assumptions of all models

(1) No taxation
(2) Immediate change in gearing
(3) All earnings distributed
(4) All shareholders expect same future earnings
(5) No growth in earnings
Basic equations
annual interest charges
kd =
Market value of debt
earnings available to shareholders

ks =
Market value of equity
Net operating earnings

ko =
Total market value of firm
ko is the WACC weighted by market values.
THE NET INCOME APPROACH
According to this approach the average cost of capital (ko) declines as gearing increases. The
cost of shareholders funds (ks) and the cost of debt (kd) are independent. Since kd is usually less
than ks as debt is less risky than equity from the investor’s point of view, an increase in gearing
should lead to a decrease in ko.
The strict net income approach assumes that ks and kd remain constant.
Illustration
A company has $9,000, 5% debt with EBIT of $3,000 ks = 10%
Current required yields on debt = 5%.
∴ The value of the firm is $

EBIT 3,000
Interest 450
---------
Equity earnings 2,550
Capitalization rate (ks) .10
---------
Equity value 25,500
Market value of debt 9,000
---------
Value of firm 34,500
=====
$3,000
= 8.7%
$34,500
Say the company has 2,500 $10 shares, then each one is valued at par.
Another company with the same capital requirement has only 1,650 $10 shares and $18,000 of
5% debt.
The business risk and EBIT of this company is the same as the first one. So,
$
EBIT 3,000
Interest 900
---------
Equity earnings 2,100
Capitalization rate (ks) .10
---------
21,000
Market value of debt 18,000
---------
Value of firm 39,000
=====
$3,000
ko = = 7.7%
$39,000
Note: 7.7% can also be found by calculating the WACC.

This firm has a share price of 21,000 ÷ 1,650 = $12.73 per share and a lower ko because of
increased gearing.
The net income approach can be demonstrated graphically as:
k
ks
ko
kd
gearing
This approach suggests that gearing should be maximized.
THE NET OPERATING INCOME APPROACH
According to this approach, there is no optimal capital structure. The financing mix does not
effect the average cost of capital of the company; and the total value of the firm remains
unchanged with changes in the gearing.
i.e. ko remains constant.
This can be shown graphically as:
k
ks
ko
kd
gearing
All capital structures are optimal.
The increase in ks is exactly sufficient to offset the effect of the increased importance of kd so ko
is constant.
Illustration 3.1
Firm R.C. has an EBIT of $900,000. There is debt of $4 million in the capital structure. kd =
7.5% and WACC (ko) = 10%.
The total value of the firm V is given by:
EBIT
V= = $9,000,000
ko
The value of debentures = $4,000,000

Thus equity is worth $5,000,000
9,000,000 − (4 m x .075)
ks = = .12 or 12%
5,000,000
$4 m x .075 + $5 m x .12
WACC = = 10%
$9 m
If debt is increased to $5 million, ko remains constant.
Value of the firm is still $9 m.
EBIT $900,00
as V = = = $9m.
ko .10
The value of equity goes up:

9 m - (5 m x .075)
ks = = 13.12%
4m
5 m x .075 + .1312 x 4 m
ko = = 10% (as before)
9m
The Modigliani – Miller Model
One of the leading arguments in favor of the net operating income approach is the
behavioural model developed by Modigliani and Miller.
Modigliani and Miller favor the net operating income approach that ko is constant.
Their model has some crucial assumptions:
(1) Capital Markets are perfect – All investors have perfect cost-free information
(2) Expected future earnings constant
(3) Initial assumption of no taxes
(4) Firms can be classified into ‘equivalent risk’ classes.
Their propositions are
(1) Total market value of firm is independent of capital structure

(2) ks increases to exactly offset use of cheaper debt
(3) Required rate of return for investment is independent of the financing decision.
Illustration 3.2(a)
Two companies (A & B) have identical capital requirements of $500,000. Company B is 30%
geared with 5% debt; Company a is ungeared.
Company A Company B
Net operating income 50,000 50,000

Debt interest - 7,500
----------- -----------
Equity earnings = 50,000 42,500
assumed equity capitalization rate = .10 .11
---------- -----------
Market value of equity 500,000 386,364
Market value of debt - 150,000
----------- -----------
Market value of firm $500,000 $536,364
50,000 50,000
ko = = 10% = 9. 3%
500,000 536,364
Modigliani – Miller argue that the above situation is not stable. A shareholder in
company B will take advantage of the better share price the lower ko for company B
gives him, by selling shares in B and buying them in A. This process is called arbitrage
and will have the effect of decreasing the market value of shares in B and increasing the
market value of shares in A (supply and demand function). This process will continue
until the share prices stabilize at a value that gives an equal ko in both companies.
Illustration (b)
Assume that a shareholder owns 10% of company B. This has a market value of
$38,636, and gives him a return of $4,250 (10% of $42,500).
Note that he owns 10% of a company that is 30% geared and is presumably satisfied
with the risk of a 30% gearing.
He will now substitute a personal gearing of 30% for the corporate gearing and invest
in company A in the following way:
Step I - He will sell his shares in company B and realize $38,636.
Step II - He will borrow $15,000 at 5% giving him total funds of $53,636.
N.B. He is now geared in the same proportion as company B.
$150,000 $15,000
i.e. =
$536,364 $53,636
Step III - He will buy 10% of company A, which will cost $50,000.
This will give him a return of $5,000 from which he must pay his debt
interest of $750 leaving a net return of $4,250.
This is the same as he was receiving in company B but he now has $3,636
available for consumption.
The behavioral model suggests that the arbitrage process will continue until no
shareholder can make a gain from the process and at that point ko will be identical in
both companies.
Assumptions and criticism of the Modigliani – Miller Model
Assumptions
(1) Shareholders can obtain the same personal gearing as companies at the same
cost. This is very unlikely.
(2) Firms can be classified into equivalent risk classes.
Note: it is possible to demonstrate that the arbitrage proof of the M-M thesis is
not dependent on equivalent risk classes. All propositions can be illustrated by
general equilibrium analysis where arbitrage occurs across firms with different
risk.
(3) Capital markets are perfect. All investors have access to perfect, cost-free
information.
(4) There are no transaction costs in the arbitrage process.
The crucial factor is the assumption of rational investors who will substitute personal
gearing for corporate gearing.
Arguments against the Modigliani – Miller position
These are based on reasons why the arbitrage process may not work perfectly
(1) If there is a possibility of bankruptcy and if these costs are significant a geared
firm may be less attractive.
In perfect markets if the firm is liquidated all assets are realized with zero costs.
(2) The perceived risks of personal and corporate gearing may be different because
of limited liability on corporate debt.
(3) Personal borrowing costs are generally higher than corporate costs.
(4) Transaction costs restrict arbitrage.
(5) Some institutional investors may be precluded from ‘personal’ borrowing by the
articles or by law.
(6) Investors do not have access to perfect, cost-free information.
M-M deny the importance of these criticisms by arguing that they are too general.
They suggest that as long as there are enough market participants at the margin to
behave in a manner consistent with ‘homemade’ gearing the total value of the firm
cannot be altered through gearing. The M-M approach is most vulnerable at extreme
levels of gearing.
Extreme Gearing
When gearing reaches a certain level kd will rise as debt investors expect the firm to pay
a higher interest rate on debt. The greater the gearing the lower the coverage of fixed
charges and the riskier the loan.
Even if kd rises, M-M maintain the ko will be constant because ks will increase at a
decreasing rate to offset the increase in kd.
Many authorities object strongly to the contention that shareholders became relatively
less risk-averse with extreme gearing. Modigliani – Miller are on much weaker ground
in defending their thesis for the extreme gearing case.
7) The Capital of R Ltd. Consist of 9 % preference shares of Rs. 10 each Rs. 3, 00, 000.
Equity Shares of Rs. 10 each, Rs. 8, 00, 000. The Profit after tax is Rs. 2, 70, 000,
Equity Dividend is 20 % and the Market price of the firm is Rs. 40. You are
required to calculate the following ratios and coment on them:
a) Dividend Yield
b) Preference and Equity Dividend Cover
c) Earnings per share
d) Price to Earnings Ratio
Sol.:
a) Dividend Yield: Dividend / Stock Price

Dividend = 20% of face value = Rs. 2
Therefore, Dividend Yield : 2/ 40 = 5 %
b) Preference and Equity Dividend Cover:

This is the number of times that the profit left over to the ordinary shareholders covers the
dividend paid out to those same shareholders.
The formula is Earnings per share
Dividends per share
Hence, Preference Dividend Cover = 9 / 0.9 = 10
Equity Dividend Cover = 2, 70, 000 – 27, 000 / 1, 60, 000 = 1.518
c) Earnings Per Share = 2, 43, 000 / 80, 000 = 3.0375

d) P/E Ratio = 40 / 3.0375 = 13.17
8) Calculate the Operating Leverage and the Financial Leverage under the Situations
A, B, C and Financial Plans I, II, and III respectively from the following figures
relating to the operation and capital structures of Rani Ltd. Also find out the
combinations of operating and financial leverages, which gives the highest value
and the least value, how are these calculations useful to the finance manager.
Sol.:
Installed Capacity (No. of Units) 1200
Actual Production and Sales (No. of Units) 800
Selling Price Per Unit (Rs.) 15
Variable Cost Per Unit (Rs.) 10
Fixed Cost – Situation A (Rs.) 1000
Fixed Cost – Situation B (Rs.) 2000
Fixed Cost – Situation C (Rs.) 3000
Financial Plans
I : Equity : Debt = 5000 : 5000
II: Equity : Debt = 7500 : 2500
III: Equity : Debt = 2500 : 7500
Sol.:
(Students are requested to Solve this Question on their Own)

Hint: Objectivity of the Firm is to maximize the Shareholders Wealth; hence Option 3 is the
Best Option.

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PREFACE TO THE THIRD EDITIO)

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Financial Management November 2002 Answers. 46

Financial Management November 2003 Answers. 70

Financial Management November 2004 Answers 90

Financial Management November 2005 Answers 120

Financial Management November 2006 148

Financial Management November 2007 174

Logistics November 2001 Error!

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Service Sector Marketing November 2001 Error!

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