Scanner CAP II Financial Management

THE INSTITUTE OF CHARTERED
ACCOUNTANTS OF NEPAL
COMPILATION OF
SUGGESTED ANSWER
2010-2015
FINANCIAL MANAGEMENT
CAP –II
1
The Institute of Chartered Accountants of Nepal
Compiler of Suggested Answer CAP II- Financial Management
Contents
INTRODUCTION AND FUNDAMENTAL CONCEPTS OF FINANCIAL MANAGEMNT .................................. 3
STRATEGIC FINANCE AND POLICY ......................................................................................................... 13
ANALYSIS OF FINANCIAL STATEMENTS ................................................................................................. 53
VALUATION OF SECURITIES................................................................................................................... 81
CAPITAL INVESTMENT DECISION ........................................................................................................ 102
WORKING CAPITAL MANAGEMENT AND FINANCIAL FORECASTING ................................................. 139
DIVIDEND POLICY ................................................................................................................................ 176
OVERVIEW OF CAPITAL MARKET ........................................................................................................ 186
INVESTMENT OPPORTUNITIES IN NEPALESE CAPITAL MARKET. ........................................................ 194
The Institute of Chartered Accountants of Nepal 2

CHAPTER 1
INTRODUCTION AND FUNDAMENTAL CONCEPTS OF FINANCIAL

MANAGEMNT
3
Theoretical Questions
Question No 1:
Distinguish between
a. Profit Maximization and Wealth Maximization Objective
(December 2011) ( 2.5 Marks)
Answer
The company may pursue profit maximization goal but that may not result into creation of
shareholder value. The profits will be maximized if company grows through diversification
and expansion. But all growth may not be profitable. Only that growth is profitable where
ROA > WACC or ROE > KE or Firms invest in project with positive
NPV,
However, profit maximization cannot be the sole objective of a company. It is at best a
limited objective. If profit is given undue importance, a number of problems can arise like the
term profit is vague, profit maximization has to be attempted with a realization of risks
involved, it does not take into account the time pattern of returns and as an objective it is too
narrow.
Whereas, on the other hand, wealth maximization, as an objective, means that the company is
using its resources in a good manner. If the share value is to stay high, the company has to
reduce its costs and use the resources properly. If the company follows the goal of wealth
maximization, it means that the company will promote only those policies that will lead to an
efficient allocation of resources.
b. Risk aversion Vs. Risk diversification ( June 2012) ( 2.5 Marks)

Answer
Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather
than another bargain with a more certain, but possibly lower, expected payoff. For example, a
risk-averse investor might choose to put his or her money into a bank account with a low but
guaranteed interest rate, rather than into a stock that may have high returns, but also has a
chance of becoming worthless. An investor is said to be risk averse if he prefers less risk to
more risk, all else being equal.
Risk Diversification refers to minimization of risk which an investor may choose by investing
in various types of securities. An investor may not want to concentrate his investment in a
single risky security, as a result of which he may choose to invest in various other securities
to minimize his level of risk and harmonize his returns.
c. Promised Yield and Realized Yield (December 2013) ( 2.5 Marks)

Answer
Promised Yield indicates the total rate of return earned on bond if it is held to maturity. It is
also known as Yield-to-Maturity. This is the rate of return anticipated on a bond if held until
the end of its lifetime. YTM is considered a long-term bond yield expressed as an annual rate.
The YTM calculation takes into account the bond‘s current market price, par value, coupon
interest rate and time to maturity. It is also assumed that all coupon payments are reinvested at
the same rate as the bond‘s current yield. YTM is a complex but accurate calculation of a
bond‘s return that helps investors to compare bonds with different maturities and coupons.
Realized Yield is the actual amount of return earned on a security investment over a period of
time. This period of time is typically the holding period which may differ from the expected
yield at maturity. The realized yield also includes the returns that have been earned from
reinvested interest, dividends and other cash distributions.

Chapter 1: Introduction and Fundamental concepts of Financial Management
The realized yield tends to differ from the yield at maturity in scenarios where the holding
period is less than that of the maturity date. In other words, the security is settled or sold prior
to the maturity date given at the time of purchase. For example, suppose an investor
purchases a 10-year bond for Rs. 1,000 that issues a 5% annual coupon. Furthermore, if the
investor sells the bond for Rs.1,000 at the end of the first year (and after receiving the first
coupon payment), his realized yield would only include the Rs. 50 coupon payment
d. Risk and Uncertainty (December 2013) ( 2.5 Marks)

Answer
In common parlance, the terms ‗Risk‘ and ‗Uncertainty‘ have synonymous meaning.
However, they differ from each other.
Risk may be defined as ―the chance of future loss that can be foreseen‖. In other word, in
case of risk an estimate can be made about the degree of happening of the loss. This is
usually done by assigning probabilities to the risk on the basis of past data and the probable
trends.
Uncertainty may be defined as‖ the unforeseen chance for future loss or damages.‖ In case of
uncertainty, since the firm cannot anticipate the future loss, and hence it cannot directly deal
with it in its planning process, as is possible in the case of risk. For example, a firm can not
foresee the loss which may be due to destruction of its plant in account of earthquake.
e. Business Risk and Financial risk (June 2015) ( 2.5 Marks)

Answer
Business risk refers to the risk associated with the firm‘s operations. It is the uncertainty
about the future operating income; how well can the operating income be predicted. Business
risk can be calculated using statistical techniques such as standard deviation of the basic
earning power ratio.
Financial risk refers to the additional risk placed on the firm‘s shareholders as a result of debt
use i.e. the additional risk a shareholder bears when a company uses debt in addition to equity
financing. Companies that issue more debt instruments would have higher financial risks than
the companies financed mostly or entirely by equity. Financial risks can be measured using
various financial ratios.
Question No 2:
Write short notes on:
a) Annuities and annuities due
b) The risk-return trade off (December 2012) (5 Marks)
Answer:
a) The term annuity refers to any terminating stream of fixed payments over a specified
period of time. This usage is most commonly seen in discussions of finance,
usually in connection with the valuation of the stream of payments, taking into
account time value of money concepts, such as interest rate and future value.
Examples of annuities are regular deposits to a savings account, monthly home
mortgage payments, and monthly insurance payments. Annuities are classified by
the frequency of payment dates. The payments (deposits) may be made weekly,
monthly, quarterly, yearly, or at any other interval of time.
An annuity-due is an annuity whose payments are made at the beginning of each
period. Deposits in savings, rent or lease payments, and insurance premiums are
examples of annuities due.
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b) This principle steps that potential return rises with an increase in risk. Low levels
of uncertainty (low-risk) are associated with low potential returns, whereas high
levels of uncertainty (high-risk) are associated with high potential returns.
According to the risk-return tradeoff, invested money can render higher profits only if
it is subject to the possibility of being lost. Because of the risk-return trade off, you
must be aware of your personal risk tolerance when choosing investments for your
portfolio. Taking on some risk is the price of achieving returns; therefore, if you want
to make money, you can't cut out all risk. The goal instead is to find an appropriate
balance - one that generates some profit, but still allows you to sleep at night
Question No 3:
Whether the present value decreases at a linear rate, at an increasing rate, or at a decreasing
rate with the discount rate and why? (June 2013) ( 2.5 Marks)
Answer
The present value decreases at a decreasing rate with discount rate. As the discount rate
increases, the discount factor goes on decreasing. It is because the denominator of the
present value equation increases at an increasing rate with multiple of increase in period
‗n‘.
Question No 4:
What is the Two basic functions of financial management (December 2013) ( 2.5 Marks)
Answer
Financial management deals with the procurement of funds and their effective utilization in
the business. The first basic function of financial management is procurement of funds and
the other is their effective utilization.
i) Procurement of Funds: Funds can be procured from different sources. The
procurement is a complex problem for business concerns. Funds procured from different
sources have different characteristics in terms of risk, cost and control.
ii) Effective utilization of Funds: Since all the funds are procured at a certain cost, it is
necessary for the finance manager, to take appropriate and timely actions so that the funds do
not remain idle. If these funds are not utilized in manner so that they generate an income
higher than the cost of procuring, then there is no point in running the business.
Question No 5:
Distinguish between the Annuity and Perpetuity (June 2014) (2.5 Marks)
Answer
S.No Annuity Perpetuity
1 An annuity is a stream of regular Perpetuity is a stream of payments or
periodic cash flows (either payments type of annuity that starts payments on
made or received) for a specified period fixed date and such payments continue
of time forever, i.e. perpetually. Thus,
Perpetuity is a constant stream of
identical cash flows with no end.
2 Future value of Annuity can be Perpetuity is a type of annuity which is
computed using Compounding never-ending, its sum if future value
Technique cannot be calculated
3 Examples Examples
a) Recurring Deposit installments paid a) Dividend on Irredeemable

to bank. Preference Share Capital.

b) Life insurance premium per annum b) Interest on Irredeemable
Debt/Bonds.
c) Scholarships paid perpetually from
an endowment Fund, etc.
Question No 6:
What is the Limitations of profit maximization objective of Financial Management
Solution
Profit maximization objective of financial management has following limitations:
 It ignores time factor.
 It ignores the risk factors.
 It focuses on short term profits and overlooks long term vision.
 This is vague because it is not clear whether the term relates to economic profit,
accounting profit, profit after tax or before tax.
 The term profit is also ambiguous.
Question No 7:
Distinguished between Systematic risk and Unsystematic risk (December 2014) ( 2.5
Marks)
Answer
Systematic Risk Unsystematic Risk

A part of the risk that arises from
A part of the risk that arises on account of the
uncertainties which are unique to individual
economy-wide uncertainties and the tendency
securities, and which are diversifiable if large
of individual securities to move together with
number of securities is combined to form
changes in the market. This part of risk cannot
well-diversified portfolios. The unique risks
be reduced through diversification, and it is called
of individual securities in a portfolio cancel
systematic or market risk. Investors are exposed to
out each other. This part of the risk can be
market risk even when they hold well-diversified
totally reduced through diversification and
portfolios of the securities.
is called unsystematic or unique risk.
Examples of systematic risk are: Examples of unsystematic risk are:
 The Government changes the interest rate
 workers declare strike in a company
policy
 The corporate tax rate is increased  the R&D expert of the company leaves
 The Government resorts to massive deficit
 a formidable competitor enters the market
financing
 The inflation rate increases  the company loses a big contract in a bid
 The Nepal Rastra bank promulgates a  the company makes a breakthrough in
restrictive credit policy process innovation
 the Government increases custom duty on
the material used by the company
 the company is not able to obtain adequate
quantity of raw materials from the suppliers.
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Question No 8:
What is Social Cost benefit Analysis (December 2015) (2.5 Marks)
Answer
Social cost benefit analysis is the method of evaluating the use of public fund. It considers
monetary as well as non-monetary returns.
Large amount of public fund is committed every year for various public projects. Analysis of
such projects has to be done with reference to social costs and benefits. Such projects are not
merely considered based on commercial returns, instead considered for various social returns
in the form of employment generation, access to market, increase in life styles, access to
basic requirements such as health, education, drinking water. So, such projects are analyzed
based on what social benefits that particular project will provide. Based on such returns
decision as to whether to implement projects or not is made by the competent authorities.
Practical Questions
Question No 9:
An investor saw an opportunity to invest in a new security with excellent growth potential.
He wants to invest more than he had, which was only Rs. 100,000. He sold another security
short with an expected rate of return of 15%. The total amount he sold was Rs. 400,000, and
the total amount he invested in the growth security, which had an expected rate of return of
30%, was Rs. 500,000. Assuming no margin requirements, what is the investor‘s expected
rate of return? (June 2011) ( 4 Marks)
Answer
Computing the portfolio weights for each security is done with the formula:
From the given problem, we find:

WA = - Rs, 400,000/ Rs. 100,000 = - 4.0
WB = Rs. 500,000 / Rs. 100,000 = 5.0
Rp = (- 4 x 0.15) + (5 x 0.30) = - 0.60 + 1.50 = 0.90, or 90%.
Thus, the expected rate of return on this portfolio is 90%.
Question No 10:
A bank offers a fixed deposit scheme whereby Rs. 100,000 matures to Rs. 126,250 after 2
years, on half-yearly compounding basis. If the bank wishes to amend the scheme by
compounding interest every quarter, what will be the revised maturity value?
(December 2011) (6 Marks)
Answer:
Computation of Rate of Interest:
Principal = Rs. 100,000
Amount = Rs. 126,250
Pn = A X (PVF n, i)

100,000 = 126,250 (PV 4, i)

(PV 4, i) = 0.7921
According to the Table on Present Value Factor (PVF4, i), a PVF of 0.7921 for
half-yearly interest of 6 per cent becomes a lump sum of Re. 1. Therefore, the
annual interest rate is 2 X 0.06 = 12 per cent.
Revised maturity value, if interest is compounded quarterly:
( )
( )
= 100,000 × (1.03) 8
= 100,000 × 1.267 [since (CVF 8, 3) = 1.267]
= Rs. 126,700
Therefore, the revised maturity value will be Rs. 126,700.
Question No 11:
Mohan has just own a lottery and has three award options to choose from:
1. To receive a lump sum payment today of Rs. 61 million, or
2. To receive 10 annual end of year payment of Rs. 9.5 million, or
3. To receive 30 annual end of year payment of Rs. 5.5 million. He expects to earn 8%
annual return on his investment.
Required:
Recommend the best option for him. ( December 2012) ( 5 Marks)
Answer
Calculation of present value of each option
1. Lump sum payment of Rs. 61 million; PV = Rs. 61 million
2. 10 annual end of year payment of Rs. 9.5 million;
PV= PMT x (PVIFA 8%, 10 years)
= Rs. 9.5 Million x 6.7101
= Rs. 63.75 Million
3. 30 annual end of year payment of Rs. 5.5 million;

PV= PMT x (PVIFA 8%, 30 years)
= Rs. 5.5 million x 11.2578
= Rs. 61.92 million
Since, option 2 provides highest present value, he should choose to receive 10 year
annuity plan.
Question No 12:
A company offers a fixed deposit scheme whereby Rs. 10,000 matures to Rs. 12,625 after
2 years, on a half-yearly compounding basis. If the company wishes to amend the scheme by
compounding interest every quarter, what will be the revised maturity value?
(June 2013) ( 3 Marks)
Answer
9
Computation of Revised Maturity Value
Principal = Rs. 10,000
Amount = Rs. 12,625
[ ]
Pn = A × (PVFn, i)
10,000 = 12,625 (PVF4, i)
0.7921 = (PVF4, i)
According to the Table on Present Value Factor (PVF4,i) of a lump sum of Re. 1, a
PVF of 0.7921 for half year at interest (i) = 6 percent. Therefore, the annual interest rate
is 2 ×0.06 = 12 percent.
i = 6% for half year
i = 12% for full year.
Therefore, Rate of Interest = 12% per annum
( )
( )
=10,000×1.267 [considering (CVF 8,3)=1.267]

Revised Maturity Value = 12,670.
Question No 13:
Madhu opened an account on Shrawan 1, 2069 with a deposit of Rs. 800. The account paid
6% interest compounded quarterly. On Magh 1, 2069, she closed the account and added
enough additional money to invest in a 6-month time deposit for Rs. 1,000 earning 6%
interest compounded monthly.
Required
i) How much additional amount did Madhu invest on Magh 1?
ii) What was the maturity value of her time deposit on Shrawan 1, 2070?
iii) How much total interest was earned during the period?
(Given that (1+ i) n is 1.03022500 for, i= 1.5%, n=2, and is 1.03037751 for i=0.5% and n =6)
(December 2013) ( 5 Marks)
Answer
The initial investment earned interest from Shrawan to Poush, i.e. for two quarters.
In this case,
i=6/4=1.50%, n=2, P= Rs. 800;
and the compounded amount =800×1.03022500= Rs. 824.18
The additional amount invested on Magh 1= Rs. (1,000 - 824.18)
=Rs. 175.82

a In this case, the time deposit earned interest compounded monthly for 6 months
Here, i =6/12=0.5%, n=6 , P=Rs. 1,000
Required maturity value = 1000×1.03037751= Rs. 1,030.38
b Total interest earned = Rs. 24.18 + Rs.30.38= Rs. 54.56
Question No 14:
A company has to make the payment of Rs. 2,000,000 on 5th of March 2015. It has some
surplus money today i.e.,4th December 2014 and it has decided to invest in a deposit of bank
at 8% per annum to meet the amount for payment. What money is required to be invested
now? Take year as 365 days. (December 2014) ( 2 Marks)
Answer
Target money: Rs. 2,000,000
The amount to be invested now is in fact the present money of this targeted money. The FVF
may be ascertained as follows:
FVF = 1+ [(annual rate of interest × (Deposit period/365)]
=1+[(0.08x(90/365)]
=1.01972
Now the present value of the target amount can be ascertained as follows:
Present value = Target amount/1.01972
= Rs. 1,961,323
Note: Student may use PVF and in such case present value = Target money x PVF
The deposit of Rs. 1,961,323 at the rate of 8% for a period of 90 days will accumulate to Rs.
2,000,000. Therefore, amount to be invested is Rs. 1,961,323
Question No 15:
Pradeep's brother Sandeep has promised to give him Rs. 100,000 in cash on his 25 th birthday.
Today is Pradeep's 16th birthday.
Required: Help Sandeep with the following calculation:
i) If Sandeep wants to make annual payment into a fund after one year, how much will
each payment has to be if the fund pays 8% interest?
ii) If Sandeep decides to invest a lump sum in the fund after one year and let it compound
annually, how much will the lump sum be?
If in i) above the payments are made in the beginning of the year, how much will be the value
of annuity.
( June 2015) (5 Marks)
Answer
i. Rs. 1,00,000=A(CVAF9,0.08)= A(12.488)
Thus A=100,000/12.488= Rs. 8,007.69
ii. Rs. 100,000=P(CVF8,0.08)=P(1.8509)

Thus P=100,000/1.8509=Rs. 54,027.78
iii. This is a problem of annuity due since payment is made at the beginning of the year.
Rs. 100,000=A (CVAF9,0.08)(1.08)
Rs. 100,000=A (13.487)
A=Rs. 100,000/13.487
11
= Rs. 7414.55
Question No 16:
Mr. Liberal, an established Development Planning Consultant, was approached by the officer
of N Investment Banking Ltd. for his wealth management. Mr. Liberal is currently aged
exactly 57 years and is planning to retire from his profession after the age of 60. He is
currently living with his wife and a daughter, who is settled in US. He wants to set aside
some funds and let the Investment Bank manage his funds for guaranteed return from 61st
year for at least 10 years for his and his wife's living.
Mr. Liberal estimates the requirement of Rs. 120,000 per month to cover up his living from
the 1st year of retirement. The officer of the Investment Bank has offered 3 schemes of which
he has chosen fixed income scheme with 0% risk and yields 10% interest per annum
compounded annually during the entire scheme period from the beginning of 61st birthday till
70th birthday while 9.5% compounded quarterly from the beginning of deposit till the end of
60th birthday. The proceeds by the Investment Bank are paid in lump-sums and at the
beginning of every year. Ignore management fees of Investment Bank and taxation.
Required:
What is the amount Mr. Liberal needs to deposit at the Investment Bank as of today under the
scheme? Present your calculations on Rs. in thousands ( December 2015) (5 Marks)
Answer:
10% is the discount rate which is Mr. Liberal's yield after retirement.
Amount Mr. Liberal needs to deposit at the Investment Bank is Rs. 7,346.70 K. as below:
Total Present Value of Annuity Due @ 10% for 10 yrs. 6.761

Rs. In '000
Annual Payment (120,000×12) 1,440.00
Total Sum at the beginning of 61st Birthday 9,735.84
Annual Interest Rate = 9.50%

Quarterly Compounded Annual Interest Rate = (1+9.5%/4)4 - 1
= 9.84%
Age Beginning Balance Interest Closing Balance
60th 8,863.66 872.18 9,735.84
59th 8,069.61 794.05 8,863.66
58th 7,346.70 722.91 8,069.61
Interest is calculated as:
= Rs. 872.18 ('000) and so on...

Chapter 2: Strategic Finance and Policy
CHAPTER 2
STRATEGIC FINANCE AND POLICY
13
Question No 1:
Distinguished between
a. Operating leverage and financial leverage (June 2010)(December 2010)(2.5 Marks)
Answer
Operating leverage occurs when there is fixed operating cost associated with the production
of goods and services. Fixed operating costs are incurred with an assumption that sales
volume will produce revenues more than sufficient to cover all fixed and variable operating
costs.
Fixed operating costs do not vary with the change in the volume. On the other hand, variable
operating costs vary directly with the level of output. Therefore, if volume is to change, it is
the effect of fixed operating costs which causes the profit of a firm to change.
The effect of presence of fixed operating costs (or operating leverage) is that a change in the
volume of sales will bring about more than proportional change in operating profit (or loss)
of the company.
Financing leverage is due to the use of fixed financing costs by the firm. It is employed with
a view to increase the return to ordinary shareholders. Favourable leverage occurs when the
firm used funds obtained at a fixed cost to earn more than the fixed cost of financing paid by
it. If any profit is left after paying the fixed financing costs, it belongs to the ordinary
shareholders.
There is no choice for the management on the operating fixed costs. For example, a heavy
industry requires huge investment resulting in a large operating cost in the form of
depreciation. This cannot be avoided. On the other hand, financial leverage is always a choice
item. Firms need not have financing through long-term debt or preference share. They have
the option to finance their operations and capital expenditures from internal sources and
through the issue of equity shares.
b. Operating breakeven point Vs. Financial breakeven point ( June 2012) ( 2.5
Marks)
Answer:
The operating breakeven point is defined as the units of output at which total revenues are
equal to total operating costs (fixed costs plus variable costs). The operating breakeven point
is calculated as follows:
Financial breakeven point is the situation where EBIT equals to financing cost. In this
analysis, the firms needs to just cover all of its financing costs and produce earnings per share
equal to zero. Financial Breakeven analysis can be used to help determine the impact of the
firm's financing mix on the earnings available to common stockholders.
c. Capital structure and Financial structure ( December 2014) ( 2.5 Marks)

Answer
Capital Structure is the permanent long term financing of the company including Long term
debt, equity capital, preferential shares and retained earnings is called capital structure. It can
be also termed as a mix of long term finances used by the company. It is the financing plan of

the company. It differs from Financial Structure which includes short term debt and accounts
payable also.
Whereas, financial Structure entails the ways the assets of the companies are financed such as
trade accounts payable, short terms borrowings as well as long term borrowings and
ownership equity. Financial structure is distinguished from capital structure where only long
term debt and equity are included. A company‘s financial structure is influenced by many
factors such as growth rate, stability of sales. It is the basic frame of references for analysis
concerned with financial leveraging decisions.
d. Financial Distress Vs. Insolvency (June 2015) ( 2.5 Marks)

Solution
Financial distress is a situation where a firm‘s operating cash flows are insufficient to meet its
current obligations (and so the firm must take some kind of corrective action) financial
distress may lead a firm to default on a contract, and it may involve financial restructuring
between the firm, its creditors, and its shareholders in most cases, the firm is forced to take
actions that it would not have taken if it had sufficient cash flow.
Insolvency is a term which generally means an inability to repay debts stock-based

insolvency occurs when the value of a firm‘s assets is less than what is owed on its debt flow-
based insolvency occurs when the firm‘s cash flows are insufficient to cover contractually
required payments.
Question No 2:
Write short note on
a. Leveraged Buyout (December 2010)(2.5 Marks)
Answer
It is an ownership transfer consummated primarily with debt. Sometimes it is also called as
asset- based financing, the debt is secured by the assets of the enterprise involved. While
some leveraged buyouts involve the acquisition of an entire company, many involve the
purchase of a division of a company or some other subunit. Frequently the sale is to the
management of the division being sold, the company having decided that the division no
longer fits its strategic objectives. Another distinct feature is that leveraged buyouts are cash
purchases, as opposed to stock purchases. Finally the business unit involved invariably
becomes a privately held as opposed to a publicly held company
b. Direct and indirect costs associated with financial distress

(December 2010)(2.5 Marks)
Answer
Financial distress arises when a firm is not able to meet its obligations towards the payment
of interest and principal to the debt providers which can lead to bankruptcy. Direct costs of
financial distress include the costs of insolvency.
Following are the other direct costs of financial distress:
i. Long period taken in the bankruptcy cases may cause deterioration of the conditions of
the company‘s assets.
15
ii. Liquidation of the assets may be delayed due to conflicting interests of creditors and
other stakeholders.
iii. When the assets are sold under distress prices, they may fetch a price that is
significantly lower than their current values.
iv. Legal and administrative costs related to the bankruptcy proceedings are generally quite
high.
c. Financial Distress (June 2012) (2.5 Marks)

Answer:
Financial distress is a term used to indicate a condition when promises to creditors of a
company are broken or honored with difficulty. Sometimes financial distress can lead to
bankruptcy. Financial distress is usually associated with some costs to the company; these are
known as costs of financial distress.
This is a situation where a firm‘s operating cash flows are not sufficient to satisfy current
obligations and the firm is forced to take corrective action. Financial distress may lead a firm
to default on a contract, and it may involve financial restructuring between the firm, its
creditors, and its equity investors
d. Gearing Ratio (June 2013) ( 2.5 Marks)

Answer
A general term describing a financial ratio that compares some form of owner's equity (or
capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the
degree to which a firm's activities are funded by owner's funds versus creditor's funds.
The higher a company's degree of leverage, the more the company is considered risky. As for
most ratios, an acceptable level is determined by its comparison to ratios of companies in the
same industry. The best known examples of gearing ratios include the debt-to-equity ratio
(total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity
/assets), and debt ratio (total debt /total assets).
A company with high gearing (high leverage) is more vulnerable to downturns in the business
cycle because the company must continue to service its debt regardless of how bad sales are.
A greater proportion of equity provides a cushion and is seen as a measure of financial
strength.
e. Debt trap (June 2015) ( 2.5 Marks)

Answer:
Debt Trap is a situation where you add on a new debt in order to pay an existing debt.
Generally, when the firm in overleveraged all the credit sources are exhausted, firm arrives at
a situation of debt trap. It is a situation in which an entity borrows money, but does not have
enough money to make the interest payments on the loan, so it takes out another loan--with
its own interest payments--to cover the first loan's payments. They will likely have to borrow
again to pay off the second loan, creating a crippling cycle. It is an incentive structure that
lures individuals into accepting long-term debt obligations under conditions that strongly
favor the lender. Victims of debt traps are often prevented from discharging the debt through
techniques such as unusually high or variable interest rates, changing payment plans, and
unreasonably high penalties for late payments
f. financial leverage (December 2015) ( 2.5 Marks)

Answer

Financial Leverage may be defined as "the use of funds with a fixed cost in order to increase
earnings per share". In other words, it is the use of company funds on which it pays a limited
return. Financial leverage involves the use of funds obtained at a fixed cost in the hope of
increasing the return to common stockholders.
Degree of the financial leverage is the ratio of the percentage increase in earnings per share
(EPS) to the percentage increase in earnings before interest and taxes (EBIT).
Or
g. Assumptions of Capital Asset Pricing Model (CAPM)

Answer
The capital asset pricing model (CAPM) is based upon the following assumptions:
i. The investors are basically risk averse and diversification is needed to reduce the risk.
ii. All investors want to maximize the wealth and therefore choose a portfolio solely on
the basis of assessment of risk and return.
iii. All investors can borrow or lend an unlimited amount of funds at risk-free rate of
interest.
iv. All investors have identical estimates of risk and return of all securities.
v. All securities are perfectly divisible and liquid and there is no transaction cost or tax.
vi. The security market is efficient and purchases and sales by a single investor can not
affect the prices which also mean that there is perfect competition in the market.
vii. All investors are efficiently diversified and have eliminated the unsystematic risk.
Thus, only the systematic risk is relevant in the determination of estimated return
Question No 3:
Explain the Miller and Modigliani as irreverence theory of Dividend policy.( June 2014) ( 5
Marks)
Answer
Miller and Modigliani have opined that the price of equity shares of a firm depends solely on
its earnings power and is not influenced by the manner in which its earnings are split
dividend and retained earnings.
They observed `under condition of perfect capital markets, rational investors, absence of tax
discrimination dividend income and capital appreciation given the firm`s investment policy,
its dividend policy may have no influence on the market price of the shares‘. In other words,
the price of the share is not affected by the size of the dividend.
M-M‘s hypothesis of irrelevance is based on the following assumptions:
 Perfect capital markets: The firm operates in perfect capital markets where investors
behave rationally, information is freely available to all and transactions and floatation
costs do not exists. Perfect capital also implies that no investor is large enough to
affect the market price of a share.
17
 No Taxes: Taxes do not exists ; or there are no differences in the tax rates applicable
to capital gains and dividends. This means that investors value a rupee of dividend as
much as a rupee of capital gain.
 Investment policy: The firm has a fixed investment policy.
 No Risk: Risk of uncertainty does not exist. That is, investors are able to forecast
future prices and dividends with certainty, and one discount rate is appropriate for all
securities and all time periods.
Thus, r=k=k, for all t.
MM provide the following proof in support of their views. According to them, market price
of share in beginning of a year (P) is equal to present value of sum of dividend at the end of
the year (D1) and market price of the share at the end of year (P1).
Where Ke=Cost of equity capital. It is also referred as capitalization rate discount. MM

conclude that does not affect the market price of share.
Question No 4:
What are the advantages of raising funds through issue of equity share?
Answer
Following are some of the advantages of raising funds by issue of equity shares:
 Permanent source of finance. No liability for cash outflows associated with its
redemption.
 Demonstrate financial base (Capital adequacy) of the company and helps borrowing
power of the company.
 No legal obligation to pay dividends.
 Can be raised further shares by making a right issue.
Question No 5:
Discuss whether changing the capital structure of a company can lead to a reduction in its
cost of capital and hence to an increase in the value of the company. (RTP December 2014)
Answer
The value of a company can be expressed as the present value of its future cash flows,
discounted at its weighted average cost of capital (WACC). The value of a company can
therefore theoretically be maximized by minimizing its WACC. If the WACC depends on
the capital structure of a company, i.e. on the balance between debt and equity, then the
minimum WACC will arise when the capital structure is optimal.
The idea of an optimal capital structure has been debated for many years. The traditional
view of capital structure suggests that the WACC decreases as debt is introduced at low
levels of gearing, before reaching a minimum and then increasing as the cost of equity
responds to increasing financial risk.
Miller and Modigliani originally argued that the WACC is independent of a company‘s
capital structure, depending only on its business risk rather than on its financial risk. This
suggestion that it is not possible to minimize the WACC, and hence that it is not possible to
maximize the value of a company by selecting a particular capital structure, depends on the
assumption of a perfect capital market with no corporate taxation.
However, real world capital markets are not perfect and companies pay taxes on profit.
Since interest is a tax-allowable deduction in calculating taxable profit, debt is a tax-

efficient source of finance and replacing equity with debt will decrease the WACC of a
company. In the real world, therefore, increasing gearing will decrease the WACC of a
company and hence increase its value.
At high levels of gearing, the WACC of a company will increase due, for example, to
increasing bankruptcy risk. Therefore, it can be argued that use of debt in a company‘s
capital structure can reduce its WACC and increase its value, provided that gearing is kept to
an acceptable level.
Practical Questions
Question No 6:
Weather Coats Paint Ltd. has fixed operating costs of Rs. 36 million a year. Variable
operating costs are 180 per half liter of paint produced, and the average selling price is Rs.
200 per half liter.
You are required to answer the following questions with computations to support each one
of your answer.
i) What is the annual operating break-even point in half liters (QBE) and in rupees of sales
(SBE)?
ii) What would be the effect on the operating break-even point (QBE) of a simultaneous
decline to Rs. 170 per half liter in the variable operating costs and an increment of 20 per
cent in the fixed cost?
iii) Compute the degree of operating leverage (DOL) at the current sales level of 2 million
half liters.
(December 2010)( 5 Marks)
Answer
Computation of QBE and SBE
= 1,800,000 half liters
= Rs. 360,000,000 in annual sales
(ii) Effect of a Decline to Rs. 160 per half liter in the variable operating costs and an
Increase of 25 per cent in the Fixed Cost on QBE
= 1,500,000 half liters
(iii) Degree of Operating Leverage (DOL) at the current sales level of 2 Million half liters
19
= 10
Question No 7:
The capital structure of Stable Ltd. is extracted below:
(Rs. in Million)
Equity capital: 100 thousand shares of Rs.100 each 10
Reserve and surplus 12
12% preference shares: 55,000 shares of Rs. 100 each fully paid up 5.5
14% debentures of Rs. 1,000 each; 3,000 numbers 3
Long-term loan from financial institution at 12% per annum 2
32.5
The company is also availing a bank overdraft of Rs. 2 million carrying interest at 15% per
annum. The company is now drawing up its profit plan for the next year. It wants to pay
dividend to equity shareholders at 15% and keep the total dividend payout (equity as well as
preference shareholders) at 60%.
Assuming that the tax rate applicable to the company is 25%., what level of earnings (EBIT)
should the company try to achieve to meet its plan? (June 2011) ( 7 Marks)
Answer
Let ‗x‘ be the EBIT to meet the company‘s commitments.
Interest Payable Yearly
(Rs. in Million)
On debentures @ 14% on Rs. 3 million 0.42
On long term loan of Rs. 2 million @ 12% 0.24
On bank overdraft of Rs. 2 million @ 15% 0.3
0.96
Profit before tax (PBT) = EBIT – 0.96 = x – 0.96
Tax at 25% = (x – 0.96) / 4
Profit after tax (PAT) = 3 (x – 0.96) / 4
Total dividend payable
(Rs. in Million)
On preference capital of Rs. 5.5 million @ 12% 0.66
On equity capital of Rs. 10 million 1.5
2.16
Total dividend payout is limited to 60% of PAT and is also equal to Rs. 2.16.
Therefore, 3 (x – 0.0.96) /4 x 60 / 100 = 2.16
Or 3(X-0.96)/4=216/60
Or X-0.96=3.6x4/3
Or, x – 0.96 = 4.80
Or, x = 4.80 + 0.96 = 5.76

Hence, earnings before interest and tax should be Rs. 5.76 million.
Question No 8:
Following book value capital structure is available in respect of PQR Ltd.
(Rs. in million)
Equity Capital (in shares of Rs. 100 each, fully paid-up at par) 150
11% Preference Capital (in shares of Rs. 100 each, fully paid-up at par) 10
Retained Earnings 200
13.5% Debentures (of Rs. 100 each) 100
15% Term Loan 125
The next expected dividend per share on equity shares is Rs. 36 and the dividend per share is
expected to grow at the rate of 7%. The market price per share is Rs. 400.
Preference stock, redeemable after 10 years, is currently selling at Rs. 75 per share.
Debentures, redeemable after 6 years, are selling at Rs. 80 per debenture. The income tax rate
for the company is 25%.
You are required to:
i. Calculate the weighted average cost of capital using market value proportion., and
ii. Determine the weighted marginal cost of capital for the company, if it raises Rs. 100
million next year, given the following information:
 The amount will be raised by equity and debt in equal proportions.
 the company expects to retain Rs. 15 million earnings next year.
 the additional issue of equity shares will result in the net price per share being fixed at
Rs. 320.
 the debt capital raised by way of term loan will cost 15% for the first Rs. 25 million
and 16% for the next Rs. 25 million.
(June 2011)( 15 Marks)
Answer
Working Notes:
(1) Cost of Equity Capital (Ke) and Cost of Retained Earnings (Kr)
Ke = D1/P0 + g = 36/400 + 0.07 = 0.09 + 0.07 =0.16 or 16%
(2) Cost of Preference Share Capital (Kp)
= 0.1543 or 15.43%
(3) Cost of Debentures (Kd)
21
= 0.14025, say, or 14.03%
(4) Cost of Term Loan (Kt)

Kt = I (1 – t)
0.15 (1 – 0.25) = 0.15 x 0.75 = 0.1125 or 11.25%
On first Rs. 25 million Term Loan = 0.15 (1 – 0.25) = 0.1125 or 11.25%

On the next Rs. 25 million Term Loan = 0.16 (1 – 0.25) = 0.12 or 12%
(5) Cost of Fresh Equity Shares (Ke)
Ke = D1/P0 + g = 36/320 + 0.07 = 0.1825 or 18.25
(i) Calculation of Weighted Average Cost of Capital (WACC) using market value
proportion:
Market Weighted
Cost of
Source of Finance Value (Rs. cost of
Weight Capital
Millions) Capital %
Equity Capital 600 0.739 0.16 0.11824
(1.5 million shares x Rs. 400
11% Preference Capital 7.5 0.009 0.1543 0.00139
(1 lakh shares x Rs. 75)
13.5% Debentures 80 0.098 0.1403 0.01375
(1 million debentures x Rs, 80)
15% Term Loan 125 0.154 0.1125 0.01733
812.5 WACC: 0.15071
Therefore, WACC = 15.07%

Note: Retained earnings are not considered for calculating WACC since it does not
have any market value separately. The market value of equity shares reflects the value
of retained earnings as well.
(ii) Calculation of WACC of PQR Ltd. when it raises Rs. 100 million next year:
Weighted
Source of Finance Amount Weight Cost of
cost
Retained Earnings 15 0.15 0.16 0.024
Debt 15 0.15 0.1125 0.01688
Equity Shares 10 0.1 0.1825 0.01825
Debt 10 0.1 0.1125 0.01125
Equity Shares 25 0.25 0.1825 0.04563

Debt 25 0.25 0.12 0.03
100 0.14601
Therefore, WACC of raising Rs.100 million next year = 14.60%
Question No 9:
Three companies A, B and C are in the same type of business and hence have similar
operating risks. However, the capital structure of each of them is different and the following
are the details:
A B C
Equity Share Capital (Rs.) 400,000 250,000 500,000
[Face value Rs. 10 per share]
Debentures (Rs) - 100,000 250,000
[Face value per debenture Rs. 100]
Market value per share (Rs.) 15 20 12
Market value per debenture (Rs.) - 125 80
Dividend per share (Rs.) 2.7 4 2.88
Interest Rate - 10% 8%
Assume that the current levels of dividends are generally expected to continue indefinitely and
the income-tax rate at 50%.
Required:
Compute the weighted average cost of capital of each company.

Answer
Calculation of Weighted Average Cost of Capital(WACC)
Weighted
Amount (Rs.) Weights After Tax Cost
Cost
i) Cost of Capital of Shares at Market Value
A (400000×15/10) 6,00,000 1 (2.70/15) = 18% 18%
B (250000×20/10) 5,00,000 0.8 (4/20) = 20% 16%
C (500000×12/10) 6,00,000 0.75 (2.88/12) = 24% 18%
ii) Cost of capital of Debenture at Market Value

A -
(10/125) ×(1- 0.5) =
B (100000×125/100) 1,25,000 0.2
4% 0.80%
(8/80) × (1 - 0.5) =
C (250000×80/100) 2,00,000 0.25
5% 1.25%
Weighted average cost of capital

A =18% + 00% = 18%
B =16% + 0.8% = 16.8%
C =18% + 1.25% = 19.25%
Working notes:
23
Question No 10:
Exorbitant Ltd. has investigated the profitability of its assets and the cost of
its funds. The result of such an investigation has indicated that:
Current assets earn 1%, Fixed assets return 13%, Current liabilities cost 3%,
and Average long-term funds cost 10%.
The current condensed balance sheet of the company is as follows:
Amount
Liabilities Amount (Rs.) Assets
(Rs.)
Long-term funds 140,000 Fixed assets 120,000
Current liabilities 20,000 Current assets 40,000
160,000 160,000
Required:
i) Ascertain the net profitability of the firm.
ii) The company is contemplating lowering its net working capital to Rs. 14,000 by (A)
either shifting Rs. 6,000 of its current assets into fixed assets, or (B) shifting Rs. 6,000 of
its long-term funds into current liabilities. Work out the profitability for each of these
alternatives. Which do you prefer? Why?
Ascertain the effects on the net profitability, if both these alternatives are implemented
simultaneously. (December 2011) ( 9
Marks)
Answer
(i) Computation of Net profit of the Firm:
Net profit = Total profit – Total cost of financing
Total profit = Return on fixed assets + Return on current assets
Return on fixed assets = 13% of Rs.120,000 = Rs. 15,600
Return on current assets = 1% of Rs. 40,000 = Rs. 400
Total = Rs. 16,000
Total cost of financing = Cost of long-term financing + Cost of current liabilities (short-term
funds)
Cost of long-term funds = 10% of Rs. 140,000 = Rs. 14,000
Cost of current liabilities = 3% of Rs. 20,000 = Rs. 600
= Rs. 14,600
Net profit = Rs. 16,000 – Rs. 14,600 = Rs. 1,400
(ii) (A) Net profit on Shift of Rs. 6,000 of current assets into fixed assets:
Total Profit
Return on fixed assets = 13% of 126,000 = Rs. 16,380
Return on current assets = 1% of Rs. 34,000 = Rs. 340
= Rs. 16,720
Cost of financing:

As computed in (i) above Rs. 14,600
Net Profit = Rs. 16,720 – 14,600= Rs. 2,120
(B) Net profit on Shift of Rs. 6,000 of its long-term funds into current liabilities:
Total Profit = As computed in (i) above Rs. 16,000
Cost of financing:
Cost of long-term funds = 10% of Rs. 134,000 = Rs. 13,400
Cost of current liabilities = 3% of Rs. 26,000 = Rs. 780
= Rs. 14,180
The profitability of alternative (A) is more, i.e. when Rs. 6000 of current assets are shifted to
fixed assets. It is, therefore, preferable.
(iii) If both alternatives (ii) (A) and (ii) (B) are implemented simultaneously:
Total return = Rs.16,720 [as computed in (ii) (A)]
Total cost = Rs. 14,180 [as computed in (ii (B)]
Net Profit will increase.
Question No 11:
A company has 8 lakhs equity shares outstanding at the beginning of the year. The current
market price per share is Rs. 120. The board of directors of the company is contemplating to
declare a dividend of Rs. 6.40 per share. The rate of capitalization, appropriate to the risk-
class to which the company belongs, is 9.6 percent.
Required:
a) Based on M-M approach, calculate the market price of the share of the company, when
dividend is (i) declared and (ii) not declared.
b) How many new shares are to be issued by the company, if the company desires to fund
an investment budget of Rs. 320 lakhs by the end of the year, assuming net income for
the year will be Rs. 160 lakhs? (December 2014) ( 9 Marks)
Answer
i. M-M Approach of calculating share price:
P0= (P1+D1) / (1+Ke)
Where,
P0= Existing market price per share i.e. Rs. 120
P1= Market price of the share at the year end (to be determined)
D1= Contemplated dividend per share i.e. Rs. 6.40
Ke= Capitalization rate i.e. 9.6 %
Calculation of Share price when:

(i) Dividend is declared
P0= (P1+D1) / (1+Ke)
120 = (P1 + 6.4)/ (1+0.096)
P1= Rs. 125.12
(ii) Dividend is not declared

P0= (P1+D1) / (1+Ke)
120 = (P1 + 0)/ (1+0.096)
P1= Rs. 131.52
25
ii. Calculation of No. of shares to be issued:

If dividend is If dividend is not
Particulars declared declared
Nets Income (Rs. In Lakhs) 160 160
Less: Dividend (Rs. In Lakhs) 51.20 -
Retained Earnings (Rs. In Lakhs) 108.80 160
Investment budget (Rs. In Lakhs) 320 320
Amount to be raised by issue of shares (Rs. In Lakhs) 211.20 160
Market price per share (in Rs.) 125.12 131.52
No. of new shares to be issued ( in numbers) 1,68,798 1,21,655
Question 12:
KLS Limited has a total capitalization of Rs. 1,000,000 and it normally earns Rs.
100,000 before interest and taxes. The finance manager of the company wants to take
the decision regarding the capital structure. After a study of the capital market, he
gathers the following data:
Equity
Amount of Debt (Rs.) Interest rate (%) at given level of debt (%)
Capitalization Rate
- - 10
100,000 4 10.5
200,000 4 11
300,000 4.5 11.6
400,000 5 12.4
500,000 5.5 13.5
600,000 6 16
700,000 8 20
Assume that corporate taxes do not exist, and the firm always maintains its capital
structure at book values.
Required:
i) What amount of debt should be employed by the firm if the traditional approach is held
valid?
ii) If the Modigliani-Miller approach is followed, what should be the equity capitalization
rate? (December 2012)(5 Marks)
Answer
i) As per the traditional approach, optimum capital structure exists when the
weighted average cost of capital is minimum. The weighted average cost of capital
calculations at book value weights are as follows:
ke (1) We (2) kd (3) Wd (4) keWe (5) kdWd (6) k0 (7)=(5)+(6)
0.1 1 - - 0.1 - 0.1
0.105 0.9 0.04 0.1 0.0945 0.004 0.0985
0.11 0.8 0.04 0.2 0.088 0.008 0.096
0.116 0.7 0.045 0.3 0.0812 0.0135 0.0947
0.124 0.6 0.05 0.4 0.0744 0.02 0.0944
0.135 0.5 0.055 0.5 0.0675 0.0275 0.095

0.16 0.4 0.06 0.6 0.064 0.036 0.1
0.2 0.3 0,080 0.7 0.06 0.056 0.116
The company should employ debt of Rs.4,00,000 as the weighted average cost of capital
is minimum at this level of debt.
(ii) According to M-M approach, the cost of capital is a constant, and the cost of equity
increases linearly with debt. The equilibrium cost of capital is assumed to be equal to
pure equity capitalization rate, which is 10% in the present problem. The equity
capitalization rate is given by the formula:
ke = k0+ (k0-kd) x Debt/ Equity
The equity capitalization rates would be:

ke
Debt (Rs.) kd k0 (k0-kd) Debt/Equity ke
Percentage
0 - 0.1 (0.10-0.000) - 0.1 10
1,00,000 0.04 0.1 (0.10-0.040) 1,00,000/9,00,000 0.1067 10.67
2,00,000 0.04 0.1 (0.10-0.040) 2,00,000/8,00,000 0.115 11.5
3,00,000 0.045 0.1 (0.10-0.045) 3,00,000/7,00,000 0.1236 12.36
4,00,000 0.05 0.1 (0.10-0.050) 4,00,000/6,00,000 0.1333 13.33
5,00,000 0.055 0.1 (0.10-0.055) 5,00,000/5,00,000 0.145 14.5
6,00,000 0.06 0.1 (0.10-0.060) 6,00,000/4,00,000 0.16 16
7,00,000 0.08 0.1 (0.10-0.080) 7,00,000/3,00,000 0.1467 14.67
Question 13:
Phel Typewriter Ltd. and Gillis Typewriter Ltd. are identical in all respect except for capital
structure. Phel has 50 percent debt and 50 percent equity financing whereas Gillis has 20
percent debt and 80 percent equity financing, in market value terms. The borrowing rate for
both companies is 13 percent in a no-tax world and capital markets are assumed to be perfect.
The earnings of both companies are not expected to grow, and all earnings are paid out to
shareholders in the form of dividends.
Required:
i) If you own 2 percent of common stock of Phel, what would be your rupee return if the
company has net operating income of Rs. 360,000 and the overall capitalization rate of the
company is 18 percent? What is the implied equity capitalization rate?
ii) Gillis has same net operating income and overall capitalization rate as Phel. What is
the implied equity capitalization rate for Gillis? Why does it differ from Phel?
Answer
i) Phel Typewriter Ltd.
Net Operating Income(Rs.) 360,000
Overall Capitalization rate 0.18
Total Value of the firm (Rs. 360,000/0.18) 2,000,000
Market Value of debt (50%) (Rs.) 1,000,000
Market Value of stock (50%) (Rs.) 1,000,000
27
Interest on debts (13% of Rs. 1,000,000) 130,000

Earnings available to common shareholders (NOI – Interest) 230,000
Common Stock holding = 2%

Therefore, Rupee Return = 2% of earning available to shareholders = 2% × 230,000 = Rs.
4,600. Implied equity capitalization rate = Earnings available to common shareholders/
Market value of stock
= 230,000/1,000,000
= 23%
ii) Gillis Typewriter Ltd.

Net Operating Income (Rs.) 360,000
Overall Capitalization rate 0.18
Total Value of the firm(Rs. 360,000/0.18) 2,000,000
Market Value of debt (20%) (Rs.) 400,000
Market Value of stock (80%) (Rs.) 1,600,000
Interest on debts (13% of Rs. 400,000) 52,000
Earnings available to common shareholders (Rs.) (NOI – Interest) 308,000
Implied equity capitalization rate = Earnings available to common shareholders/ Market
value of stock
= 308,000/1,600,000
= 19.25%
Gillis has a lower capitalization rate than Phel because Gillis uses less debt in its capital
structure. As the equity capitalization rate is linear function of the debt-to-equity ratio when
we use the net operating income approach, the decline in the equity capitalization rate exactly
offsets the disadvantage of not employing so much in the way of cheaper debt funds.
Question 14:
Following is the capital structure of ABC Ltd. on Ashadh end, 2066:
Rs.
Equity Share Capital (of Rs. 100 each) 1,000,000
Share Premium 1,500,000
Reserves and Surplus 500,000
3,000,000
On 1 Shrawan 2066, the company made a bonus issue of 2 shares for every 5 shares held.
Mr. P had purchased 100 shares of ABC Ltd. on 1 Shrawan 2062 at the market price of Rs.
300. He sold all the shares on Ashadh end, 2068 at the market price of Rs. 450 per share
(cum-dividend). He had to pay tax @ of 5% on his dividend income and 10% on capital
gains.
Required:
If the company pays a regular dividend @ 10%, find out whether the investor P was able to
earn his required rate of return of 10% on his investments during the period, ignoring
brokerage and other transaction related costs. (Present value factors @ 10% for 1 – 6 years
are: 0.91, 0.83, 0.75, 0.68, 0.62 and 0.56 respectively).
Answer
a) Year Mr. P‘s holding in ABC Ltd. Cost(Rs.) PV (Rs.)

2062-63 to 2065-66 100 shares@ Rs. 300 30,000 10,000
2066-67 to 2067-68 100 shares + 100×(2/5)=140 shares 30,000 14,000
Calculation of Present Value of Dividend Income (Figures in Rs.)

Dividend after Present
Date Dividend @ 10% PV Factor
Tax Value
Ashadh end 2063 1,000 950 0.91 864.5
Ashadh end 2064 1,000 950 0.83 788.5
Ashadh end 2065 1,000 950 0.75 712.5
Ashadh end 2066 1,000 950 0.68 646
Ashadh end 2067 1,400 1,330 0.62 824.6
3,836.10
Rs.
Selling Price of 140 shares @ Rs. 450 per share on Ashadh end 2068: 63,000
Less: Total Cost of Purchase of Shares (100 X Rs. 300) 30,000
Capital Gain 33,000
Capital Gain Tax @ 10% 3,300
Net Gain to the Investor 29,700
Total Cash Inflow (29,700 + 30,000) 59,700
This amount is received on Ashadh end 2068, i.e. after 6 years from the date of purchase.
Present Value Factor @ 10% for 6 years 0.56
Present value of Rs. 59,700 (59,700 X 0.56) Rs. 33,432.00
Total Present Value of Inflows (33,432 + 3,836.10) Rs. 37,268.10
Less: Cash Outflow (Cost of Purchase) (Rs. 30,000.00)
Net Present Value Rs. 7,268.10
Since the net present value (gain) of the Mr. P in shares of ABC Ltd. is positive, discounting
at the rate of 10%, the investor P is getting a return on his investment at a rate in excess of
10%.
Question 15
A company wishes to find out its weighted marginal cost of capital (WMCC) based on target
capital structure proportions. The company presented the following data to you to assist the
company in determining its WMCC.
Source Proportion Range Cost
Equity share capital 50% Up to Rs. 300,000 13.00%
Rs. 300,000 – Rs. 750,000 13.30%
Rs. 750,000 and above 15.50%
Preference shares 10% Up to Rs. 100,000 9.33%
Rs. 100,000 and above 10.60%
Long term debt 40% Up to Rs. 400,000 5.68%
Rs. 400,000 – Rs. 800,000 6.50%
Rs. 800,000 and above 7.10%
Required:
29
Determine the WMCC for the company. (June 2012) ( 8 Marks)

Answer
(i) Determination of Breaking point of different sources:
Source Proportion Range Breaking Points(Rs.)
Equity share capital 0.5 Up to Rs. 300,000 300,000/0.5= 600,000
300,000 – 750,000 750,000/0.5= 1,500,000
750,000 and above -
Preference shares 0.1 Up to Rs. 100,000 100,000/0.10 = 1,000,000
100,000 and above -
Long term debt 0.4 Up to Rs. 400,000 400,000/0.4= 1000000
400,000 – 800,000 800,000/0.40 = 2,000,000
800,000 and above -
We now calculate below the WMCC for different ranges of new financing.
Range Source Proportion C/C % WMCC %

Up to Rs.600,000 Equity shares 0.50 13.00 6.50
Preference shares 0.10 9.33 0.93
Long term debt 0.40 5.68 2.27
WMCC 9.70
Rs. 600,000 – 1,000,000 Equity shares 0.50 13.30 6.65
WMCC 9.85
Rs. 1,000,000 – 1,500,000 Equity shares 0.50 13.30 6.65
WMCC 10.31
Rs. 1,500,000 – 2,000,000 Equity shares 0.50 15.50 7.75
WMCC 11.41
Rs. 2,000,000 – and above Equity shares 0.50 15.50 7.75
WMCC 11.65
Question 16
The following details of XYZ Ltd. for the year ended on Ashadh end, 2068 are given below:
Operating leverage : 1.4
Combined leverage : 2.8
Fixed cost (excluding interest) : Rs. 204 thousand
Sales : Rs. 3,000 thousand
12% Debentures of Rs. 100 each : Rs. 2,125 thousand
Equity shares capital of Rs. 100 each : Rs. 1,700 thousand

Income-tax rate : 30 per cent
Required
a. Calculate the P/V ratio and Earnings per share (EPS).
b. A 12-payment annuity of Rs. 10,000 will begin 8 years hence, i.e. the first payment
occurs at the end of 8 years. What is the present value of this annuity, if the discount rate is
14 per cent? (June 2012 )
(4+3= 7 Marks)
Answer
a. Calculation of P/V Ratio:
P/ V Ratio = Contribution / Sales X 100 Operating Leverage
= C / (C – F) X 100 1.4
=C / C -204,000
1.4 (C – 204,000) = C
1.4 C – 285,600 = C
0.4 C = 285,600
Therefore, C = 285,000/0.4
= Rs. 714,000 P/V ratio
= 714,000 /3,000,000 X 100
= 23.8%
b. Calculation of EPS:
EBT = Contribution – Fixed Cost – Interest
= 714,000 – 204,000 – 255,000
= Rs. 255,000 (Interest =Rs. 2,125,000 × 12% =Rs. 255,0000
EAT = EBT – Tax

= 255,000 – 76,500
= Rs. 178,500 (Tax = Rs. 255,000 × 30% = Rs. 76,500)
EPS = EAT / No. of Equity Shares

= 178,500/17,000
= Rs. 10.50
In the first step, we determine the value of this annuity a year before the first payment begins,
i.e. 7 years from now. This is equal to:
= Rs. 10,000 (PVIFA 14%, 12 years)
= Rs. 10,000 (5.660)
= Rs. 56,600
In the second step, the present value of the amount obtained in step 1 is found out as follows:
= Rs. 56,600 (PVIF 14%, 7 years)
= Rs. 56,600 (0.400)
= Rs. 22,640 (Approx.)
Alternatively,
Annuity amount (Rs.) = 10,000 No. of payment = 12 Discounting Rate = 14%
PVIFA at 14% for years 8-19 = 2.2621 Therefore,
PV = Rs.10,000 x 2.2640
= Rs.22,640 (Approx.)
31
Question 17
Ciron Limited has the following capital structure:
9% Debentures Rs. 275,000
11% Preference Shares Rs. 225,000
Equity Shares (face value Rs. 10 per share) Rs. 500,000
Rs. 1,000,000
Additional information:
i) Rs. 100 per debenture redeemable at par have 2% floatation cost and 10 years
of maturity. The market price per debenture is Rs. 105.
ii) Rs. 100 per preference share redeemable at par has 3% floatation cost and 10
years of maturity. The market price per preference share is Rs. 106.
iii) Equity share has Rs. 4 floatation cost and market price per share of Rs. 24. The
next year expected dividend is Rs. 2 per share with annual growth of 5%. The firm has a
practice of paying all earnings in the form of dividends.
iv) Corporate income-tax rate is 35%.
Required:
Calculate Weighted Average Cost of Capital (WACC) using market value weights.
(June 2013) ( 7.5 Marks)
Answer
Cost of Equity (Ke)
[where p0=Market price – floatation cost)
=15%
Cost of Debt (Kd)
[ ]
=6.11%
Cost of Preference Shares (Kp )
[ ]

=11.47%
Calculation of WACC using Market Value Weights
Source of Capital Market Value Weights to Total Specific Cost Total Cost
(Rs.) Capital
Debenture ( Rs.105 per debenture) 2,88,750 0.1672 0.0611 0.0102
Preference shares ( Rs.106 per 2,38,500 0.1381 0.1147 0.0158
preference shares)
Equity Shares ( Rs.24 per share) 12,00,000 0.6947 0.1500 0.1042
17,27,250 1 0.1302
WACC = 13.02%
Question 18:
Kathmandu Medical Hospital is planning to introduce a new CT scan machine which costs
Rs. 16 million. Expected annual revenue of the machine is projected to be Rs. 18 million.
Variable cost is 60% of sales and fixed costs are Rs. 2 million. The firm is planning to
finance the fund requirement by bank loan of Rs. 5 million @ 12%, by issue of
debenture of Rs. 5 million @ 8% and remaining by equity shares which will be issued at
Rs. 10 (par) per share. The taxation rate applicable to the firm is 25%.
Required:
i) Calculate operating leverage, financial leverage and combined leverage.
ii) Briefly explain the inter-linkage between leverage, profit and risk. (June 2013 )
(8 Marks)
Answer
Calculation of leverages
Particular Amount Rate Rs.
Cost of Project 16,000,000
Annual Sales 18,000,000
Variable Cost 10,800,000
Contribution 7,200,000
Fixed Cost 2,000,000
Earnings before interest and taxes 5,200,000
interest 5,000,000 12% 600,000
5,000,000 8% 400,000
Earning before tax 4,200,000
Tax 25% 1,050,000
Earning after tax 3,150,000
Operating Leverage (Cont/EBIT) 1.38
Financial Leverage (EBIT/EBT) 1.24
(DFL X
Combined Leverage 1.71
DOL)
33
ii) Interlinkage between leverage, return and risk

Leverage is a position when capital is funded largely by external sources like debt, bank
loan. The higher the livered firm, higher the profit. This is because, if the firm is funded
by debt sources, it is a cheaper source of finance as debt interest are tax deductible. But is
the firm is unlevered, i.e. funded by equity, profit will be lower as dividend to
shareholders is not tax deductible from income tax purpose. However, if the firm is too
levered, there is a risk of solvency because debt funds are repayable. The firm will be in
risk of fund at the times when debts are matured. Hence, an optimal mix of debt and equity is
required to maintain adequate profitability with solvency.
Question 19:
A company requires Rs. 1,500,000 for the installation of a new unit, which would yield an
annual EBIT of Rs. 250,000. The company‘s objective is to maximize EPS. It is considering
the possibility of raising a debt of either Rs. 300,000 or Rs. 600,000 or Rs. 900,000 plus
issuing equity shares. The current market price per share is Rs. 50 which is expected to drop
to Rs. 40 per share, if the market borrowings were to exceed Rs. 700,000. The cost of
borrowings are indicated as follows:
Level of borrowings Cost of borrowings
Up to Rs. 200,000 12% p.a
More than Rs. 200,000 to Rs. 600,000 15% p.a
More than Rs. 600,000 to Rs. 900,000 17% p.a
Required:
i) Assuming a tax rate of 50%, work out the EPS and the scheme, which you would
recommend to the company.
ii) Calculate return on capital employed under each scheme and explain the leverage
effect (December 2013) ( 8 Marks)
Answer
i) Statement showing EPS under the different schemes
Particulars Scheme I Scheme II Scheme III
Capital required (Rs.) 1,500,000 1,500,000 1,500,000
Less: Debt Content(Rs.) 300,000 600,000 900,000
Balance Equity Capital required (Rs.) 1,200,000 900,000 600,000
Market Price per Share(Rs.) 50 50 40
24,000 18,000 15,000

shares shares shares
EBIT(given) (Rs.) 250,000 250,000 250,000

Less: Interest on Debt (Rs.)
First Rs. 2,00,000 at 12% 24,000 24,000 24,000
Next up to Rs. 4,00,000 at 15% 15,000 60,000 60,000
Balance at 17% - - 51,000
Total interest cost (Rs.) 39,000 84,000 135,000
Earnings Before Tax (EBT) (Rs.) 211,000 166,000 115,000
Less: Tax at 50% (Rs.) 105,000 83,000 57,500

Earnings After Tax (EAT) (Rs.) 105,000 83,000 57,500
EPS (Rs.) 4.375 4.61 3.83
Recommendation:
EPS is maximum under Schemes II and is hence preferable, i.e., raising a debt of Rs. 600,000
and remaining from issue of equity shares.
ii) Since EBIT and capital employed are same in every scheme; i.e. ROCE =
250,000/1,500,000 = 16.67%.
Use of Debt Funds and Financial Leverage will have a favorable effect only if ROCE >
Interest Rate. ROCE is 16.67% and hence up to 15% Interest Rate, i.e. Scheme II, use of debt
will have favorable impact on EPS and ROE. However, when interest rate is higher at 17%
(i.e. in Scheme III, for Debt above Rs. 6 lakhs), Financial Leverage have negative impact and
hence EPS falls from Rs. 4.61 to Rs. 3.83.
Question 20
Koshi Traders is a growing supplier of office materials. Analysts project the following free
cash flow during the next 3 years of operation of the firm, after which free cash flow is
expected to grow at a constant 7% rate.
Year 1 2 3
Free Cash Flow (Rs. in millions) -20 30 40
The firm's weighted average cost of capital is 13%.
Required:
i) What is the terminal or horizon value of free cash flows after 3rd year?
ii) What is the value of the firm today?
iii) Suppose the company has Rs. 100 million in debt and 10 million shares of stock.
What is the price per share? (December 2013) ( 7 Marks)
Answer
i) Terminal or Horizon Value of FCF after 3rd year:
= Rs. 713.33 Million
i) Calculation of Value of the firm today

Year FCF/ Terminal value (Rs. in millions) PVIF @ 13% PV (Rs. in millions)
1 -20 0.885 -17.7
2 30 0.7831 23.493
3 40 0.6931 27.724
3 713.33 0.6931 494.41
Value of the Firm today 527.927
35
ii) Calculation of price per share

Value of Common Equity = Value of Firm today – Value of debt
= 527.927 Million-100 Million
=Rs. 427.927 Million
=Rs 42.7927
Question 21:
Himal Steels Ltd. requires Rs. 500,000 for construction of a new plant. It is considering
following three alternative financial plans:
i) The company may issue 50,000 ordinary shares at Rs. 10 per share;
ii) The company may issue 25,000 ordinary shares at Rs. 10 per share and 2,500
debentures of Rs. 100 denominations bearing a 8% rate of interest; and
iii) The company may issue 25,000 ordinary shares at Rs. 10 per share and 2,500
preference shares at Rs. 100 per share bearing a 8 % rate of dividend.
The different possible level of earnings before interest and taxes (EBIT) of Himal Steels Ltd.
are Rs. 10,000; Rs. 20,000; Rs. 40,000; Rs. 60,000 and Rs. 100,000. The applicable tax rate
is 50%.
Required:
a. Compute the earnings per share under each of the three financial plans and different
levels of EBIT.
b. Which alternative would you recommend for the company and why?
( December 2013) ( 8 marks)
Answer
i) Earnings per share under three financial plans for Himal Steel Limited
First Financial Plan- Issue of equity shares only

Particulars Rs. Rs. Rs. Rs. Rs.
EBIT 10,000 20,000 40,000 60,000 100,000
Interest 0 0 0 0 0
PBT 10,000 20,000 40,000 60,000 100,000
Taxes @50% 5,000 10,000 20,000 30,000 50,000
PAT 5,000 10,000 20,000 30,000 50,000
No of shares 50,000 50,000 50,000 50,000 50,000
EPS 0.10 0.20 0.40 0.60 1.00
Second Financial Plan- Issue of Equity Shares and Debentures

EBIT 10,000 20,000 40,000 60,000 100,000
Interest 20,000 20,000 20,000 20,000 20,000
PBT (10,000) 0 20,000 40,000 80,000

Taxes @50% (5,000) 0 10,000 20,000 40,000
PAT (5,000) 0 10,000 20,000 40,000
No of shares 25,000 25,000 25,000 25,000 25,000
EPS (0.20) 0.00 0.40 0.80 1.60
It is assumed that the company will be able to set off losses against their profit. If the
company has no profits from other operations, losses will be carried forward.
Third financial plan- Issue of Equity shares and Preference shares

EBIT 10,000 20,000 40,000 60,000 100,000
Interest 0 0 0 0 0
PBT 10,000 20,000 40,000 60,000 100,000
Taxes @50% 5,000 10,000 20,000 30,000 50,000
PAT 5,000 10,000 20,000 30,000 50,000
Preference 20,000 20,000 20,000 20,000 20,000
dividend
PAT for ordinary 0 0 0 10,000 30,000
shareholders
No of shares 25,000 25,000 25,000 25,000 25,000
EPS 0 0 0 0.40 1.20
ii) The choice of financial plan will depend upon the economic condition. If Himal Steel
Limited‘s sales are increasing, the earnings per share will be maximum under second
financial plan under favourable conditions, debt financing gives more benefit than equity or
preference capital because interest on debt is tax deductible while preference dividend is not.
Question 22:
A company belongs to a risk class for which the approximate capitalization rate is 10%. It
currently has 25,000 shares outstanding, selling at Rs. 100 each. The company is
contemplating the declaration of a dividend of Rs. 5 per share at the end of the current
financial year. It expects to have a net income of Rs. 250,000 and has a proposal for making
new investments of Rs. 500,000.
Required:
Show that under MM assumptions, the payment of dividend does not affect the
value of the firm.
Answer
A. Value of the firm, when Dividends are paid
I. Price per share at the end of year 1
37
110 = Rs.5 +P1
or P1= Rs. 105
II. Amount required to be raised from the issues of new shares

=Total required investment – (Net income – Dividend paid)
=Rs,500,000- ( Rs.250,000- Rs.125,000)= Rs.375,000
III. Number of additional shares to be issued,

=Rs. 375,000/Rs. 105
=75,000/21 shares
Where, P1 = Market price

I=Investment
E=Earnings
Now,
Value of the firms
[ ]
=2,750,000/1.10
=Rs. 2,500,000
B. Value of the firm when dividends are not paid

Price per share at the end of the year 1, Rs.100=P1/110, or P1=110
Amount required to be raised from the issue of new shares = Rs. 500,000 – Rs.
250,000
=Rs. 250,000
Number of additional share to be issued = Rs.250,000/Rs.110= 25,000/11 shares

Value of the firm
[ ]
= Rs.2,750,000/1.1
= Rs. 2,500,000
Conclusion:
Thus, whether dividends are paid or not, value of the firm remains the same under MM
assumptions. Thus, shareholders are indifferent between the retention of profits and the
payment of dividend

Question 23:
The present capital structure of the Shree Ram Mills Ltd. is as follows:
Rs. in millions
Equity shares (face value Rs. 10) 240
Reserves 360
11% Preference shares (face value Rs. 10) 120
12% Debentures (face value Rs. 100) 120
14% Term loans 360
Total 1,200
Following additional information is available:

The company's equity beta 1.06
Yield on long term treasury bonds 10%
Stock market risk premium 6%
Current ex-dividend equity share price Rs. 15
Current ex-dividend preference share price Rs. 12
Current ex-interest debenture market value Rs. 102.50
Corporate tax rate 40%
The debentures are redeemable after 3 years and interest is paid annually.
Required:
Ignore floatation costs and calculate the company's weighted average market value cost of
capital. (December 2013) (8 Marks)
Answer
Cost of Equity share capital under capital assets pricing model
Ke = Rf + β (Rm-Rf)
=0.10+1.06(0.06)
= 0.1636
=16.36%
Cost of Preference Share capital

Kp =Dp/Po
= 1.10/12
= 0.0917
= 9.17%
Cost of Redeemable Debentures (Kd)

The debentures are redeemable after 3 years and interest is paid annually. The current ex-
interest debentures market value is Rs. 102.50, which represents present value of stream of
future cash flows in the form of interest and maturity value.
Therefore, pretax cost of debenture is:
Approximate YTM ={ I +(M-V0)/n}/ (M+2V0)/3
= {12+(100-102.5)/3}/(100+2*102.5)/3
= {12-0.8333}/101.6667
= 11.1667/101.6667
39
= 0.1098 = 10.98% or 11%

= 11%
Cost of Long Term Loan (Kt)

= I(1-t) = 14%(1-0.40)
= 8.40%
Rs. in million
Equity Share Capital (Rs.240 million/Rs. 10) X15 360
11% Preference Share Capital (Rs.120 million/Rs. 10) X12 144
12% Debentures (Rs.120 million/Rs. 100) X 102.50 123
Term Loan 360
Market Value of total Capital 987
Source Market Value Weight Pre-tax cost Post-tax Weighted

Rs. In million (%) cost (%) Cost (%)
Equity Share 360 0.365 16.36 16.36 5.97

Capital
Preference Share 144 0.146 9.17 9.17 1.34
Capital
Debentures 123 0.124 11.00 6.60 0.82
Term Loan 360 0.365 14.00 8.40 3.07
WACC 11.20%
Question 24
A limited, a widely held company is considering a major expansion of its production facilities
and the following alternatives are available:
(Rs in Lakhs)
Alternatives
Share capital 50 20 10
14% Debentures - 20 15
Loan from Financial institution @ 18% p.a. - 10 25
Expected rate of return before tax @ 25%. Income Tax Rate 50%. The rate of dividend of the
company is not less than 20%. The company at present has low debt.
Which of the alternatives you would choose? ( June 2014 ) ( 4 Marks)
Answer
Evaluation of Financial Alternatives
Particulars A B C
Return on Rs. 50 Lakhs@25% 12.5 12.5 12.5
Less: interest on debentures - 2.80 2.10
Less: Interest on loan - 1.8 4.5
Taxable Profit 12.5 7.9 5.9

Less: Income Tax 50% 6.25 3.95 2.95
Profit after tax available for shareholders 6.25 3.95 2.95
Rate of return on share capital 12.5% 19.75% 29.5%
From shareholders point of view alternative C is to be chosen as it gives the highest rate of
return on share capital.
Question 25:
The Servex Company has the following capital structure on 30th June 1998:
Rs.
2,00,000 Ordinary shares 40,00,000
10% Preference shares 10,00,000
14% Debenture 30,00,000
80,00,000
The share of the company sells for Rs. 20 per share. It is expected that the company will pay
a dividend of Rs. 2 per share next year which will grow at 7 percent forever. Assume a 50
percent tax rate.
Required:
i) Compute a weighted average cost of capital based on the existing capital structure.
ii) Compute the new weighted average cost of capital if the company raises an additional Rs.
2 million debt by issuing 15 percent debentures. This would result in increasing the
expected dividend to Rs. 3 and leave the growth rate unchanged, but the price of share
will fall to Rs. 15 per share.
iii) Compute the cost of capital, if in ii) above growth rate increases to 10 percent.
(June 2014 ) ( 7 Marks)
Answer
i) WACC: Existing capital structure
After-tax Cost Weights Weighted Cost
Ordinary Shares (WN 1) 0.17 0.500 0.0850

10% Preference 0.10 0.125 0.0125
14% Debentures 0.07 0.375 0.0262
WACC 0.1237 or
12.37%
ii) WACC: New capital structure
Amount Rs. After-tax Cost Weights Weighted Cost
Ordinary Shares 4,000,000 0.27 (WN3) 0.40 0.108

10% Preference 1,000,000 0.10 0.10 0.010
14% Debentures 3,000,000 0.07 0.30 0.021
15% Debentures 2,000,000 0.075(WN4) 0.20 0.015
Weighted Average Cost of Capital 0.154 or 15.4%
iii) WACC : changed growth rate

After-tax Cost Weight Weighted Cost
Ordinary Shares 0.30 (WN5) 0.40 0.120
41
10% preference 0.10 0.10 0.010

14% Debenture 0.07 0.30 0.021
15% Debenture 0.075 0.20 0.015
Weighted Average Cost of Capital 0.166 or 16.6%
(WN1) Cost of ordinary share is: = 0.10+0.07 = 0.17
(WN2) After tax cost of debenture = 14%×(1-0.5)=7%

(WN4) After cost of debenture= 15%×(1-0.5)=7.5%
Question 26:
Calculate Operating, Financial and Combined Leverage from the following data under
situations I and II of Financial Plans A and B. Installed Capacity is for 4,000 units, whereas
actual production and sales are 75% of the capacity only. Selling Price Rs. 30 per unit and
variable cost ratio- 50% Fixed Cost under Situation I is Rs. 15,000 and under Situation II is
Rs. 20, 000.
Particulars Financial Plan A Financial Plan B

Equity Rs. 10,000 Rs. 15,000
Debt at 20% interest Rs. 10,000 Rs. 5,000
Total Rs. 20,000 Rs. 20,000
Answer
Computation of Earning before Interest & Tax(EBIT) and Earning before Tax( EBT)
Situation I Situation II Situation I Situation II
Sales Revenue Rs.90,000 Rs.90,000 Rs.90,000 Rs.90,000
(3,000units × (3,000units×Rs.30 (3,000units × (3,000units×Rs.
Rs.30) ) Rs.30) 30)
Less: Rs. Rs.45,000 Rs.45,000 Rs.45,000 Rs.45,000
Variable cost (Rs.90,000×50%) (Rs.90,000×50%) (Rs.90,000×50%) (Rs.90,000×50
%)
Contribution Rs.45,000 Rs.45,000 Rs.45,000 Rs.45,000
Less: Fixed Rs.15,000 Rs.20,000 Rs.15,000 Rs.20,000
Cost
EBIT Rs.30,000 Rs.25,000 Rs.30,000 Rs.25,000
Less: Rs.2,000 Rs.2,000 Rs.1,000 Rs.1,000
Interest on (10,000*20%) (10,000*20%) (5,000*20%) (5,000*20%)
Debt
EBT Rs.28,000 Rs.23,000 Rs.29,000 Rs.24,000
Note- Actual production and sales=4,000units× 75%=3,000 units
Computation of Operating, Financial and Combined Leverage

Situation I Situation II Situation I Situation II
Earning before Tax Rs.28,000 Rs.23,000 Rs.29,000 Rs.24,000
OL=
Contribution/EBIT
FL=
EBIT/EBT
DCL=DOL ×DFL 1.50×1.07=1.61 1.80×1.09=1.96 1.50×1.03=1.55 1.80×1.04=1.87
Question 27:
JK Ltd. has appointed you as its Finance Manager. The company wants to implement a project for
which Rs. 60 lakh is required to be raised from the market as a means of financing the project. The
following financing plans and their options are at hand:
(Rs. in lakh)
Particular Plan X Plan Y Plan Z
Option 1: Equity Shares 60 60 60
Option 2: Equity Shares 30 40 20
13% Preference Shares Nil 20 20
10% Non Convertible Debentures 30 Nil 20
Assume corporate tax rate to be 25 per cent, and the face value of all the shares and debentures to be
Rs. 100 each.
Required:
i) Calculate the indifference points and earnings per share (EPS) for each of the financing
plan.
ii) Which plan should be accepted by the company? Why? (December 2014) ( 8 Marks)
Solution
Determination of indifference point under plans X, Y, Z Let X be the EBIT in all cases.
Plan X : X(1-t)/N1 = (X-Interest)(1-t)/N2
Or,X (1-0.25)/60,000 = (X-300,000)(1-0.25)/30,000
Or, X-0.25X=2(0.75X-225,000)
Or, X-0.25X=1.5X-450,000
Or, 0.75X=Rs. 450,000
Or, X = Rs. 600,000
Plan Y : X(1-t)/N1 = [(X-Interest)(1-t)-Dp]/N2

Or, X (1-0.25)/60,000 = [X(1-0.25)-260,000]/40,000
Or, 0.75X/60,000=(0.75X-260,000)/40,000
Or, 2(0.75X)=3(0.75X-260,000)
Or, 1.50X=2.25X-780,000
Or, X = 780,000/0.75
Or, X = Rs. 1,040,000
Plan Z :X(1-t)/N1 = [(X-Interest)(1-t)-Dp]/N2

Or, X (1-0.25)/60,000 = [(X-200,000)×(1-0.25)-260,000]/20,000
Or, 0.75X/60,000=(0.75X-410,000)/20,000
Or, 0.75X=3(0.75X-410,000)
43
Or, 0.75X=2.25X-1,230,000
Or, X = Rs. 820,000
Determination of EPS under Plans X , Y and Z for options 1 and 2

Plan Plan Plan
Particulars X Y Z
1 2 1 2 1 2
EBIT 600,000 600,000 1,040,000 1,040,000 820,000 820,000

Less : Interest - 300,000 - - - 200,000
EBT 600,000 300,000 1,040,000 1,040,000 820,000 620,000
Less : Taxes @ 25% 150,000 75,000 260,000 260,000 205,000 155,000
EAT 450,000 225,000 780,000 780,000 615,000 465,000
Less: Preference Dividend - - - 260,000 - 260,000
Earnings available to
450,000 225,000 780,000 520,000 615,000 205,000
Equity holders
No. of Equity Shares 60,000 30,000 60,000 40,000 60,000 20,000
EPS 7.5 7.5 13 13 10.25 10.25
(ii) The company should adopt Plan Y since the EPS is maximum under this plan.
Question 28
Discuss about the fundamental principles governing capital structure.
Solution
The fundamental principles governing capital structure are:
(i) Cost Principle –
This principle suggests that an ideal capital structure is one that minimizes cost of capital
structure and maximizes earning per share.
(ii) Risk Principle –

This principle suggests using more proportion of common equity for financing requirement.
Use of more and more debts means higher commitment in form of interest payout. This
would lead to erosion of shareholders value in unfavorable business situation.
(iii) Control Principle –

This principle suggests to consider interest of maintain existing management and operational
control over the company. Management may wish to have control undisturbed.
(iv) Flexibility Principle –

This principle gives flexibility to the management who decides such a combination of sources
of financing which it finds easier to adjust according to changes in need of funds in future
too.
(v) Other considerations –

Besides above principles, other factors such as regulatory requirements, nature of industry,
timing of issue and competition in the industry should also be considered.

Question 29
The following information pertains to Rajaram Ltd. for the year ending Ashadh end, 2071:
(Rs. in million)
EBIT 30.00
Less: Interest on Debt (at 12%) 6.00
PBT 24.00
Less: Tax @ 25% 6.00
PAT 18.00
Undistributed reserves 60.00
No. of outstanding shares of Rs. 10 each 40 Lakh

EPS Rs. 3.00
Market price of the share Rs. 30.00
P/E Ratio 10.00
The company requires Rs. 20. million for expansion which is expected to earn the same rate
as earned by the present capital employed.
If the debt to capital employed ratio is higher than 35%, the P/E ratio is expected to decline to
8 and the cost of additional debt will rise to 14%.
Required:
i) Calculate the probable share price of Rajaram Ltd.: a) if the required amount is raised
through debt, and b) if the required amount is raised through equity and the new share is
issued at Rs. 25 per share.
ii) What option would you recommend to raise the required amount of funds to the
company?
Answer
Existing capital employed
(Rs. Millions)
Equity capital (40 Lakhs shares ×Rs. 10)
40.00
Reserves and surplus
60.00
Debt (6×100/12)
50.00
Existing capital employed
150.00
Existing of Return on Capital Employed
= 20%
Revised Capital Employed, whether debt or equity capital is raised

= 150+20
= Rs. 170 million
45
Revised EBIT, if expansion project is undertaken

= 170 × 20 / 100
= Rs. 34 million
Existing ratio of debt to capital employed
= 33.33%
Revised ratio of debt to total capital employed if additional debt is raised
= 41.18%
Revised ratio of debt to total capital employed if equity share capital is raised
= 29.41%
If the debt to capital employed ratio is higher than 35%, the P/E ratio expected to decline to 8
and raise the cost of additional capital debt to 14%.
i) Evaluation of Finance Option and calculation of share price (Rs.

Millions)
Particulars Option (a) Debt Option (b)
Equity
EBIT 34.00
34.00
Less: Interest on debt:
On original debt 6.00
6.00
On new debt 2.80
0.00
EBT 25.20
28.00
Less: Tax @ 25% 6.30
7.00
EAT 18.90
21.00
No. of shares (Note 1) 40 Lakhs 48
Lakhs

EPS 4.725
4.375
P/E Ratio 8 10
Market price per share Rs. 37.8 Rs.
43.75
Note 1:
No. of new shares to be issued = Rs. 20 million / Rs. 25 = 800,000 shares
ii) Recommendations:
Since the market price of share is higher under option (b), it is suggested to raise additional
Rs. 20 million by fresh issue of 800,000 equity shares at Rs. 25 share.
Question 30
The annual sales of a company is Rs. 6,000,000. Sales to variable cost ratio is 150 percent
and fixed cost other than interest is Rs. 500,000 per annum. The company has 11%
Debentures of Rs. 3,000,000.
Required:
Calculate the operating, financial and combined leverage of the company.
(June 2015) ( 4 marks)
Solution
Working Note: Calculation of EBIT and EBT
Rs.
Sales 6,000,000
Variable costs (sales/150 x 100) 4,000,000
Contribution 2,000,000
Fixed cost 500,000
EBIT 1,500,000
Interest on Debenture (11% x 3,000,000) 330,000
EBT 1,170,000
Operating Leverage = Contribution/ EBIT

= 2,000,000/1,500,000
= 1.333 times
Financial Leverage = EBIT/EBT

= 1,500,000/1,170,000
=1.282 times
Combined Leverage = operating leverage x financial leverage
= 1.333 x 1.282 = 1.7089 times
Or
= Contribution/EBT
= 2,000,000/1,170,000
= 1.7094 times ~1.7089 times
Question 31
Creative Security Pvt. Ltd., a trading company of fire extinguishers and security products, is
seeking working capital finance (loan collateral and inventory hypothecation) from one of the
"A" Class Licensed Financial Institutions. With bank funding, the directors of the company
would be able to withdraw temporary funds injected by them, which has remained for the last
47
12 months with stipulation of 18% interest. Nonetheless, the company desires to obtain
finance maintaining Debt- Equity Ratio after finance as 2:1 and Loan - Collateral ratio as
160% of carrying amount of Property Plant and Equipment (PPE). The extracts of financial
statements as on Kartik 30, 2072 were as under:
Statement of Financial Position as on Kartik 30, 2072
Assets Rs. Million (M)
Non-Current Assets
PPE (Opening Carrying Amount Rs. 14.9 M) 14.30
Current Assets:
Inventories 25.27
Trade and Other Receivables 9.04
Advances, Deposits and Prepayments 4.10
Cash and Cash Equivalents 1.07
Total Assets 53.78
Equity and Liability
Equity Attributable to Owners:
Share Capital (Rs. 100 per share) 6.00
Share Premium 2.00
Retained Earnings 13.49
Total Equity 21.49
Non-Current Liabilities:
Long-Term Borrowings 12.31
Current Liabilities:
Trade and Other Payables 4.23
Borrowings from Directors 14.50
Other Liabilities 1.25
Total Liabilities 32.29
Total Equity and Liabilities 53.78
Statement of Comprehensive Income for the period (Shrawan to Kartik, 2072)

Particulars Rs. Million (M)
Revenue 68.52
Cost of Sales (49.30)
Gross Profit 19.22
Operating Expenses (6.10)
Finance Costs (1.26)
Profit before Tax 11.86
Income Tax Expense (Provisioned and 100% deposited) (2.97)
Profit for the Period 8.89
Assume interest rate as 9.5% per annum payable on a quarterly basis, variable portion of cost
of sales as 80% and operating expenses as 20%, depreciation as 12% on WDV basis and tax
rate as 25%.
Required:
Calculate the degree of operating leverage, debt - equity ratio and maximum loans that can be
sought by the company.
What does the degree of operating leverage signify to the company? Present calculations for
your justification, if any.

In case the company's trade moves proportionately throughout the year and the company
repays, at the end of the year, 10% of existing long term loan outstanding with interest
accrued on all loans, what is the expected Debt Service Coverage Ratio?
(December 2015)( 12 Marks)
Answer
Refer WN 1,2 & 3
= 2.12 times
= 0.57 times
Maximum Loans that can be sought by the company

Per Debt Equity Ratio Rs. In Millions
Present Equity 21.49
Maximum Debt limit (2 times of Equity) 42.98
Existing Debt 12.31
Maximum Debt 30.67
Per Loan Collateral Ratio

Present Carry Amount of PPE 14.30
Maximum Debt limit (160% of Present Carrying Amount of PPE) 22.88
Existing Debt 12.31
Maximum Debt 10.57
Since, the lowest loan available per two criteria is Rs.10.57M, which is also lower than the
current outstanding of director's loan, the maximum debt that can be sought by the Company
is Rs.10.57M itself.
Working Notes:
1. Total Variable Costs and Fixed Cost
Components Variable (Rs. Calculation Fixed (Rs. In Calculation

In Millions) Millions)
80% of 20% of Rs.49.30 M
Cost of Sales (39.44) Rs.49.30 M (9.86)
Operating 20% of Rs.6.10 80% of Rs.6.10 M
Expenses (1.22) M (4.88)
49
Total Variable
Costs (40.66) (14.74)
2. Contribution Margin
Rs. In
Particulars Millions
Sales Revenue 68.52
Variable Cost (40.66)
Contribution Margin 27.86
3. EBIT calculation (Rs. in Millions)

Sales =68.52
VC =(40.66)
CM =27.86
FC =(14.74)
EBIT =13.12
ii) The degree of operating leverage of the Company signifies that for 100% rise in
Contribution Margin, there shall be a rise of 212% in the EBIT.
(Rs. in Millions)
Particulars 4 Months 100% Growth
Sales Revenue 68.52 137.04
Variable Cost (40.66) (81.32)
Contribution Margin 27.86 55.72
Fixed Cost (14.74) (14.74)
Earnings Before Interest and Tax 13.12 40.98
=212 %
iii) Calculation of expected Debt Service Coverage Ratio (Refer WN 4 &5)
Rs. Million
Particulars
(M)
Loans Repaid 1.23
Interest Paid 3.18
Total Repayment of Interest and Principal 4.41
Rs. Million
Particulars (M)
Profit Before Tax (Working Note 5) 36.18
Add: Depreciation (Rs. 14.9 × 12%) 1.79
Add: Finance Costs (Working Note 4) 3.18
Less: Income Tax Expenses (9.05)
Cash Profit before Interest 32.10

=7.28 times
Working Notes:
4 Annualized Finance Costs
Particulars Loan Interest Finance Cost
Outstanding Rate (Rs. In
(Rs. In Millions)
Millions)
- Existing Long Term Loan 12.31 9.5% 1.17
- New Borrowings 10.57 9.5% 0.67
- Director's Loan before New 18%
14.5 0.87
Borrowings
- Reminder of Director's Loan 3.93 18% 0.47
Total 3.18
5 Annualized Statement of Comprehensive Income
Particulars Rs. Million (M)

Revenue 205.56
Cost of Sales (147.90)
Gross Profit 57.66
Operating Expenses (18.30)
Finance Costs (Working Note 1) (3.18)
Profit before Tax 36.18
Income Tax Expense (Provisioned and 100% deposition) (9.05)
Profit for the Period 27.13
Question 32:
The equity beta of Fence Co is 0.9 and the company has issued 10 million ordinary
shares. The market value of each ordinary share is NRs.75. The company is also financed
by 7% bonds with a nominal value of NRs. 1000 per bond, which will be redeemed in seven
yearsǯ time at nominal value. The bonds have a total nominal value of NRs. 140 million.
Interest on the bonds has just been paid and the current market value of each bond is NRs.
1071.4.
The risk-free rate of return is 4% per year and the average return on the stock market is 11%
per year. The corporate tax rate is 20% per year.
Required:
Calculate the current weighted average cost of capital of Fence Co.
(RTP December 2014)
Answer
Cost of equity
The current cost of equity can be calculated using the capital asset pricing model. Equity or
market risk premium = 11 – 4 = 7%
Cost of equity = 4 + (0.9 x 7) = 4 + 6.3 = 10.3%
After-tax cost of debt
51
After-tax interest payment = 1000 x 0.07 x (1 – 0.2) = NRs. 56 per bond
5% 4% PV
Year Cash flow (NRs.) PV
discount discount (NRs.)
0 market value - 1 -1,071.40 1 -1,071.40
7-Jan interest 1,071.40
56 5.786 324.02 6.002 336.11
7 redemption 1000 0.711 711 0.76 760
-36.38 24.71
After-tax cost of debt = IRR = 4 + ((5 – 4) x 24.71)/ (24.71 + 36.38)

= 4 + 0·4
= 4·4%
Market value of equity = 10,000,000 x 750
=NRs. 750 million
Market value of Fence Co debt = 140 million x 1071.4/1000

= NRs.150 million
Total market value of company = 750 + 150

= NRs. 900 million
WACC = {(10·3 x 750) + (4·4 x 150)}/900
= 9·3%

Chapter 3: Analysis of Financial Statements
CHAPTER : 3
ANALYSIS OF FINANCIAL STATEMENTS
53
Theoretical Question
Question No 1:
Distinguish between:
a) Investing Activities and Financing Activities (June 2010)(2. 5 Marks)
Answer
The investing activities relate to the acquisition and disposal of long-term assets and other
investments not included in cash-equivalents. Their separate disclosure in Cash flow statement
is important as they represent the extent to which expenditures have been made for resources
intended to generate future income and cash flows.
The financing activities report the changes in the size and composition of the share/owner's
capital and debt of the enterprise. Their separate disclosure is useful in predicting claims on
future cash flow by providers of funds (both capital and borrowings) to the enterprise.
b) Return on equity and Return on capital employed (June 2013)(2. 5 Marks)

Answer
Return on equity (ROE) measures the rate of return on the ownership interest (shareholders'
equity) of the common stock owners. It measures a firm's efficiency at generating profits
from every unit of shareholders' equity (also known as net assets or assets minus liabilities).
ROE shows how well a company uses investment funds to generate earnings growth.
ROEs between 15% and 20% are generally considered good. Return on equity reveals
how much profit a company earned in comparison to the total amount of shareholder equity
found on the balance sheet. If you think back to lesson three, you will remember that
shareholder equity is equal to total assets minus total liabilities. It's what the shareholders
"own". Shareholder equity is a creation of accounting that represents the assets created by
the retained earnings of the business and the paid-in capital of the owners.
Return on capital employed (ROCE) is an accounting ratio used in finance, valuation, and
accounting. Return on capital employed (ROCE) is a measure of the returns that a business
is achieving from the capital employed, usually expressed in percentage terms. Capital
employed equals a company's Equity plus Non-current liabilities (or Total Assets −
Current Liabilities), in other words all the long-term funds used by the company. ROCE
indicates the efficiency and profitability of a company's capital investments. ROCE should
always be higher than the rate at which the company borrows otherwise any increase in
borrowing will reduce shareholders' earnings, and vice versa; a good ROCE is one that is
greater than the rate at which the company borrows. It can be calculated as follows:
b) Business Risk and Financial Risk (June 2011) (June 2013)(2. 5 Marks)
Business risk refers to the risk associated with the firm‘s operations. It is an unavoidable risk
because of the environment in which the firm has to operate and the business risk is
represented by the variability of earnings before interest and tax (EBIT). The variability in
turn is influenced by revenues and expenses. Revenues and expenses are affected by
demand of firm‘s products, variations in prices and proportion of fixed cost in total cost.
Whereas, financial risk refers to the additional risk placed on firm‘s shareholders as a
result of debt use in financing. Companies that issue more debt instruments would have
higher financial risk than companies financed mostly by equity. Financial risk can be
measured by ratios such as firm‘s financial leverage multiplier, total debt to assets ratio etc.

Business risk is the relative dispersion in the firm‘s expected earnings before interest and
taxes. Whereas, financial risk is the additional variability in the earnings available to the
firm‘s common stockholders and additional chance of insolvency borne by the common
stockholders caused by the use of financial leverage.
c. Funds flow statement and Cash flow statement (December 2013)( 2.5 Marks)
Answer
Funds Flow statement ascertains the changes in the financial position between two
accounting periods. It analyses the reasons for change in financial positions between two
balance sheets. It reveals the sources and application of funds. It helps to test whether
working capital has been effectively used or not.
Cash Flow statement ascertains the changes in balance of cash in hand and cash at bank
between two dates. It analyses the reasons for changes in cash and bank balance on a
particular date. It shows the inflows and outflows of cash. It is an important tool for short
term analysis. The two significant areas of analysis are cash generating efficiency and free
cash flows.
d. Horizontal analysis and Vertical analysis ( June 2014) ( 2.5 Marks)

Answer
Horizontal analysis is also known as comparative analysis. It is conducted by setting
consecutive balance sheet, income statement of statement of cash flow side by side and
reviewing changes in individual categories on year-to-year or multiyear basis. The most
important item revealed by comparative financial statement analysis is trend. The horizontal
financial statements analysis is done by restating amount of each item or group of items as a
percentage.
Vertical analysis or Vertical/ Cross-sectional/ Common size statements came from the
problems in comparing the financial statements of firms that differ in size. The vertical
analysis represents the relationship of different items of a financial statement which some
common item by expressing each item as a percentage of the common item.
 In the balance sheet, for example, the assets as well as the liabilities and equity are each
expressed as a 100% and each item in these categories is expressed as a percentage of the
respective totals.
 In the common size income statement, turnover is expressed as 100% and every item in
the income statement is expressed as a percentage of turnover.
Question No 2:
Write short notes on
a. Tools of Financial forecasting (June 2010)(2.5 Marks)
Answer
i. Days' sales method is a traditional method under which an attempt is made to calculate
the number of days sales and tie it up with the balance sheet items. As different
components of the balance sheet are forecasted in terms of days' dale, this method
measures the resources that are to be financed.
ii. Percentage of sales method is another tool of financial forecasting in which the balance
sheet items are expressed as percentage of sales. This will clearly (to some extent)
show the financial needs caused by increase in sales.
55
iii. In simple regression method, with sales forecast as starting point and based on past
relationship between sales and assets items, it is possible to construct a line of best fit
or the regression line for them. This method is used for long term forecasting.
iv. In multiple regression method, it is assumed that sales are a function of several
variables, while in simple regression method only one variable is considered.
b. Significance of Debt-equity Ratio as a Measure of Long-term Solvency.

(December 2011) (2.5 Marks)
Answer
The Debt-equity (D/E) ratio is calculated by comparing the long term debts with the total
shareholders funds. The D/E ratio throws light on the margin of safety available to the debt
providers of the firm.
If a firm with a high D/E ratio fails, then a part of the financial loss may have to be borne by
the debt providers. Thus, the greater the D/E ratio, higher would be the risk of the lenders.
From the view point of shareholders, a high D/E ratio implies that the firm is having a high
degree of financial leverage which offers the opportunity and benefit of trading on equity. In
such a case, if the rate of return of the firm is more than the cost of debt, then higher degree of
financial leverage means relatively higher return to the shareholders.
The higher D/E ratio may also have an impact on the ability of a firm to service the
debt. In addition to the payment of principal and interest on debt, such a ratio might have an
adverse impact on a firm‘s ability to pay other fixed and contractual payments in addition to
the principal and interest. On the contrary, a low D/E ratio implies a low risk to the lenders
and creditors for the firm but it will not offer the benefit of trading on equity. Therefore, a
proper balance between the proportion of debt and equity is very much essential in order to
take care of the interests of both the lenders and the shareholders and for the long term
sustainability and solvency of the firm.
Question No 3:
Answer the following, supporting the same with proper reasoning:
i. Which ratio would a rich investor interested in investing in equity shares most likely
consult while considering the financing of seasonal inventory?
ii. The credit policy of Firm ―A‖ is – A high percentage of bad-debt loss but normal
receivable turnover and credit rejection rate. What is the effect of this policy on sales and
profit?
Answer
i) While considering the financing of seasonal inventory, the rich equity investor would
be consulting the profitability ratios and ratios that provide information about risk relating to
the investment because he is mostly cautious of balancing the risk-return trade off..
ii) The effect of this policy is that the sales remain unaffected while profits decrease. This
policy indicates that the firm has poor collection policy. Accounts that are collectable are
being written off too soon. Therefore, the turnover is being maintained at the expense of
increased bad debt losses.
Question No 4:
What is the Limitations of financial ratios

( December 2013) ( 2.5 Marks) (June 2015) ( 3

Marks)
Answer
Financial ratios have following limitations:
i. Many large firms operate different divisions in different industries. For these companies,
it is difficult to find a meaningful set of industry-average ratios.
ii. Inflation may badly distort a company's balance sheet. In this case, profits will also be
affected. Thus a ratio analysis of one company over time or a comparative analysis of
companies of different ages must be interpreted with judgment.
iii. Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect
a business can reduce the chance of misinterpretation. For example, a retailer's inventory
may be high in the summer in preparation for the back-to-school season. As a result, the
company's accounts payable will be high and its ROA low.
iv. Different accounting practices can distort comparisons even within the same company,
e.g. leasing versus buying equipment, LIFO versus FIFO, etc.
v. It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a
historically classified growth company may be interpreted as a good sign, but could also
be seen as a sign that the company is no longer a growth company and should command
lower valuations.
vi. A company may have some good and some bad ratios, making it difficult to tell if it's a
good or weak company.
Question 5:
Write short note on Dividend Coverage Ratio (June 2014) (2.5 Marks)
Answer
It measures the ability to pay dividend on preference share which carry a stated rate of return.
This ratio is the ratio (expressed as X number of times) of net profits after taxes (EAT) and
the amount of preference dividend. Thus,
Dividend coverage= EAT/ Preference dividend
It can be seen that although preference dividend is fixed obligation, the earning taken into
account are after taxes. This is because, unlike debt on which interest is a charge on the
profits of the firm, the preference dividend is treated as an appropriation of profit. The ratio,
like the interest coverage ratio, reveals the safety margin available to the preference
shareholders. As a rule, the higher the coverage, the better it is from their point of view.
Question 6:
Banks and financial institutions are considered as highly leveraged institutions." Do you
agree with this statement? (December 2015) ( 3 Marks)
Answer
Banks and financial institutions are highly leveraged institutions and therefore the highly
regulated institutions in the world. The balance sheet size of any bank and financial
institution is predominantly covered by deposits and loans while the shareholders equity
covers mere 8 to 15% of the balance sheet size. The capital adequacy ratio criteria based on
the credit, market and operations risks that require the maintenance of 8 to 12% capital of
total risk weighted assets substantiate this fact.
With Such a high leverage ratio BFI are able to generate healthy profit/ROE as seen I the
market even by being within the constraints/regulation of NRB
57
Question No 7:
Explain the important ratios that would be used in each of the following situations:
 A bank is approached by a company for a loan of Rs. 50 lakhs for working capital
purpose.
 A long term creditor interested in determining whether his claim is adequately
secured.
 A shareholder who is examining his portfolio to decide whether he should hold or sell
his holdings in a company. (December 2014) ( 6 Marks)
Answer
Important Ratios used in different situations
(i) Liquidity Ratios –
Liquidity or short term solvency ratios would be used by the bank to check th e ability of the
company to repay its short-term liabilities. A Bank may use current ratio or Quick ratio to
judge short term solvency of the company. Further interest coverage ratio shall also be
analysed to ensure the interest repayment security.
(ii) Capital Structure or Leverage Ratios –

The long-term creditor would use the capital structure or leverage ratios to ensure the long
term stability and structure of the firm. A long term creditor interested in determining
whether his claim is adequately secured may use Debt-servicing coverage and interest
coverage ratio.
(iii) Profitability Ratios –

The shareholder would use the profitability ratios to measure the operational efficiency of the
company to see the final results of business operations. A shareholder may use return on
equity, earning per share and dividend per share ratios. Price earning ratio and book value per
share are also analyzed to decide whether a particular share is to sell or hold.
Question No 8:
What do you mean by Financial tapering ( December 2014) ( 2.5 Marks)
Answer
The word tapering in financial terms is increasingly being used to refer to the reduction of the
Federal Reserve's quantitative easing, or bond buying program. Tapering activities is
primarily aimed at interest rates and investors' expectations of what those rates will be in the
future. These can include conventional central bank activities, such as adjusting the discount
rate or reserve requirements, or more unconventional ones, such as quantitative easing (QE).
Central banks can employ a variety of policies to improve growth, and they must balance
short-term improvements in the economy with longer-term market expectations. If the central
bank tapers its activities too quickly, it may send the economy into a recession. If it does not
taper its activities, it may lead to high inflation.
Tapering is best known in the context of the Federal Reserve's quantitative easing program.
In reaction to the 2007 financial crisis, the Federal Reserve began to purchase assets with
long maturities to lower long-term interest rates. This activity was undertaken to entice
financial institutions to lend money, and it began when the Federal Reserve purchased
mortgage-backed securities.
Practical Questions

Question no 9:
The clients of an accounting firm wherein you are employed are concerned about the fall in
dividend from a company whose shares they hold as investment. The abridged profit and loss
account and balance sheet of the company for two years are given as follows:
Abridged P & L A/C (year ended Ashadh 31) (Rs. in lakh)
Particulars Current year Previous year
Income:
Sales and other income 19,200 15,500
Expenditure:
Operating and other expenses 15,600 11,900
Depreciation 700 650
Interest 1,850 1,750
18,150 14,300
Profit for the year 1,050 1,200
Taxes 500 200
Profit after taxes 550 1,000
Proposed dividend 200 400
Abridged Balance Sheet as on Ashadh 31 (Rs. in lakh)

Sources of funds:
Share capital (of Rs. 10 each) 4,200 2,600
Reserves and surplus 7,550 1,200
Convertible portion of
12.5% Debentures - 500
Loan funds:
Secured loans (16%) 10,100 8,700
Unsecured loans (15%) 1,000 3,300
Total 22,850 16,300
Application of funds:
Fixed Assets:
Cost 14,800 11,200
Less: Depreciation 2,700 2,000
12,100 9,20
Advances on capital A/C
& work in progress 1,000 200
Current Assets, Loans and Advances
Inventories 8,600 7,100
Sundry debtors 1,400 550
Cash and bank balances 850 680
Loans and advances 3,000 1,600
13,850 9,930
Less: Current liabilities 4,100 3,030
9,750 6,900
59
Total 22,850 16,300
Compute the following: interest cover, return on net worth, earnings per share, dividend
cover.
(June 2010)(10 Marks)
Answer
Abridged P & L A/C (year ended Ashadh 31) (Rs. in lakh)
Sales and other income 19,200 15,500

Less: Operating and other expenses 15,600 11,900
Depreciation 700 650
Earnings before interest and taxes (EBIT) 2,900 2,950
Less: Interest 1,850 1,750
1,050 1,200
Earnings before taxes 1,050 1,200
Less: Taxes 500 200
Earnings after taxes (EAT) 550 1,000
Proposed dividend (Dp) 200 400
Interest coverage ratio (EBIT/Interest) 1.57 1.69
Return on Net worth (EAT/Net worth)* 0.047 0.263
Earnings per share (EAT/no. of shares)** 1.31 3.85
Dividend cover (EAT/ Dp) 2.75 2.5
* Net worth: previous year = Rs. 3,800 (Rs. 2,600 + 1,200); current year = Rs. 11,750 (Rs. 4,200 +
7,550)
**No. of shares: previous year = 260 lakh; current year = 420 lakh.
Question No 10:
1. The following are the financial statements of PQR Ltd. for 2066/67.
Balance Sheet of PQR Ltd. as on Ashadh end 2066/67
Liabilities Amount (Rs.) Assets Amount (Rs.)

Equity Share Capital 210,000 Cash 105,000
Reserves 420,000 Debtors 525,000
Preference Share Capital 420,000 Stock 735,000
Long-term Debts 1,260,000 Fixed Assets (Net) 1,575,000
Creditors 420,000 Goodwill 210,000
Bills Payable 210,000
Outstanding Expenses 60,000
Provision for Tax 150,000
3,150,000 3,150,000

Income Statement of PQR Ltd.

for the year ending Ashadh, 2067
Rs. Rs.
Sales
Cash 420,000
Credit 1,680,000 2,100,000
Less: Expenses
Cost of Goods Sold 1,260,000
Selling, Administration and General Expenses 210,000
Depreciation 147,000
Interest on Long-term Debt 63,000 1,680,000
Profit Before Taxes 420,000
Taxes 210,000
Profit After Taxes 210,000
Less: Preference Dividend 25,500
Net Profit for Ordinary Shareholders 184,500
Add: Reserve at 1 Shrawan 2066 273,000
Profit Available to Ordinary Shareholders 457,500
Less: Dividend Paid to Equity Shareholders 37,500
Reserve at Ashadh end 2067 420,000
The ratios for the previous two years relating to the company and the industry ratios are
given below:
2064/065 2065/066 Industry

Current Ratio 2.54 2.10 2.30
Acid-test Ratio 1.10 0.96 1.20
Debtors Turnover 6.00 4.80 7.00
Stock Turnover 3.80 3.05 3.85
Long-term Debt to Total Capital 37% 42% 34%
Gross Profit Margin 38% 41% 40%
Net Profit Margin 18% 16% 15%
Return on Equity 24% 29% 19%
Return on Total Assets 7% 6.8% 8%
Tangible Assets Turnover 0.80 0.70 1.00
Interest Coverage 10 9 10
Based on the above financial statement and ratios of the company and the industry
provided above, you are required to:
a) Calculate the same ratios as provided above for 2066/067,
b) Evaluate the company‘s financial position of the company on the basis of these ratios
and past ratios of the company and the industry,
61
c) Using relevant ratios, indicate what decision would be taken in the following
situations:
i) PQR Ltd. wants to buy materials of Rs. 210,000 on a three months credit from a
domestic supplier company.
ii) PQR Ltd. wants to issue 15% debentures of Rs. 600,000 with a 10 year maturity
period.
Answer
(a) The ratios for 2066/067 for PQR Ltd. are computed as follows:
Ratio for 2066/067
1 Current Ratio 1,365,000/840,000 1.63
2 Acid-test Ratio 630,000/840,000 0.75
3 Debtors Turnover 1,680,000/525,000 3.2
4 Stock Turnover 1,260,000/735,000 1.71
Long-term Debt to Total
5 1,260,000/.2,100,000 60%
Capital
6 Gross Profit Margin 840,000/2,100,000 40%
7 Net Profit Margin 210,000/2,100,000 10%
8 Return on Equity 184,800/420,000* 44%
9 Return on Total Assets (420,000 + 63,000) (1 – 0.5)/2,940,000* 8.20%
10 Tangible Assets Turnover 2,100,000/2,940,000* 0.71
11 Interest Coverage 483,000/63,000 7.67
* Intangible assets of Rs. 210,000 excluded.
(b) Based on the ratios computed above, evaluation of the company‘s position is presented
below:
i. The liquidity position of the firm is falling which is evident from the Ratios 1 to 4
computed above.
ii. The gross profit margin is constant and matches with the industry average, but the net
profit margin ratio is declining. The two ratios together imply that the company‘s
selling and administrative expenses, depreciation and interest charges are on the rise.
iii. The decline in the net margin is partly due to rapid increase in debt (Ratio 5). This
increase also explains why the return on equity (Ratio 8) has been rising while the
return on assets is declining (Ratio 9).
iv. The decline in the net margin and the return on assets can also be attributed to the
decline in assets turnover (Ratio 10).
v. The impact of the increase in debt and overall decline in profitability are also shown by
reduction in the interest coverage (Ratio 11).
(c) Decision under Different Situations:

(i) The supplier would be more concerned with the liquidity of current assets of the
company. Therefore, Ratios 1 to 4 are more relevant to the supplier. In view of the
deteriorating liquidity position and the lengthy terms of payment, the credit may not be
granted to the company.

(ii) The company may find difficulty in selling the debentures. Already, it has a high
leverage ratio. If the debentures are issued its leverage ratio will increase to 68.89 per
cent (Rs. 1,860,000/Rs. 2,700,000) and the interest coverage ratio at the same level of
earning will decline to 4.06. In addition, the liquidity and the profitability of the
company are also declining. Therefore, it is not proper time to issue the debentures.
Question No 11:
Rock Star Company Ltd. is attempting to establish the current assets policy. Fixed Assets are
Rs. 600,000 and the company plans to maintain a 50 percent debt to Total assets ratio. The
interest rate is 10 percent on all debt. As a financial consultant, the Rock Star Company seeks
your advice on three alternatives of current asset policies: 40 %, 50%, 60% of projected sales.
The company expects to earn 15 percent before interest and taxes on sales of Rs. 3 Million.
Tax Rate applicable for the company is 40 percent. Provide your advice to the company by
showing Return on Equity under each alternative.
Answer
Given
Fixed Assets = Rs. 600,000
Debt to assets ratio = 50%
Interest on debt = 10%
EBIT = 15% of sales
Sales = Rs. 3 Million
Tax Rate (T) = 40%
Current Assets alternatives = 40 % of sales, 50% of sales, 60% of sales
Return on Equity (ROE) (%) = Required
Rock Star Company's Balance Sheet under three alternatives
Alternatives 40% of sales 50% of sales 60% of sales
Current Assets 1,200,000 1,500,000 1,800,000
Fixed Assets 600,000 600,000 600,000
Total Assets 1,800,000 2,100,000 2,400,000
Debt 900,000 1,050,000 1,200,000
Equity 900,000 1,050,000 1,200,000
Total Liabilities and 1,800,000 2,100,000 2,400,000
Equity
Computation of Interest
Total Debt (Rs.) 900,000 1,050,000 1,200,000
Total Interest( 10% of 90,000 105,000 120,000
total debt)
Rock Star Company's Income Statement under three alternatives

Alternatives 40% of sales 50% of sales 60% of sales
Sales 3,000,000 3,000,000 3,000,000
EBIT( 15%) 450,000 450,000 450,000
63
Less: Interest( 10%) 90,000 105,000 120,000
EBT 360,000 345,000 330,000
Tax( 40%) 144,000 138,000 132,000
EAT 216,000 207,000 198,000
ROE(%) 24 19.7 16.5
Question No 12:
Following are the condensed Balance Sheets of Omega Ltd. for two years and the
Statement of Profit and Loss for one year:
Balance Sheet as at end of Ashadh
(Figures in Rs. ‗000)
2069 2068
Equity Share Capital 150 110
10% Redeemable Preference Shares 10 40
Capital Redemption Reserve 10 -
General Reserve 15 10
Profit and Loss Account balance 30 20
8% Debenture with convertible option 20 40
Other Term Loans 15 30
Total 250 250
Fixed Assets less Depreciation 130 100
Long Term Investments 40 50
Working Capital 80 100
Total 250 250
Statement of Profit and Loss

for the year ended 31st Ashadh, 2069
Particular (Figures in Rs. ‗000)
Sales 600
Less: Cost of Sales -400
200
Less:
Establishment Charges 30
Selling and Distribution Expenses 60
Loss on Sale of Equipment 15
Interest Expenses 5 -110
90
Add:
Interest Income 4
Foreign Exchange Gain 10

Dividend Income 2
Damages received for loss of reputation 14 30
120
Less: Depreciation -50
70
Taxes -30
40
Dividends -15
Net profit carried to Balance Sheet 25
Chief accountant of Omega Ltd. informed that ledgers relating to debtors, creditors and
stock for both the years were seized by the income tax authorities for the purpose of
investigation and the same would not be available for at least three months. However, he
is able to furnish the following data:
(Figures in Rs. ‗000)
Ashadh end 2069 Ashadh end 2068
Dividend receivable 2 4
Interest receivable 3 2
Cash on hand and with bank 7 10
Investment maturing within two months 3 2
15 18
Interest payable 4 5
Taxes payable 6 3
10 8
Current ratio 1.5 1.4
Acid test ratio 1.1 0.8
It is also gathered that debenture-holders owning 50% of the debentures outstanding
as on Ashadh end 2068 exercised the option for conversion into equity shares during
the financial year ending on Ashadh 2069 and the same was put through. Besides, an
equipment was sold for Rs. 25,000 during the financial year 2068/69.
Required:
Prepare a cash flow statement for the financial year 2068/69 under direct method.
(December 2012)(8 Marks)
Answer:
Cash Flow Statement
(Figures in Rs.
‘000)
A. Cash Flows from Operating Activities:
Cash Receipts from customers (WN 2) 621
Cash paid to suppliers and employees (WN 3) -406
Operating expenses Paid (WN 4) -90
65
Cash generated from operations 125
Income-tax paid (WN 5) -27
Cash flow before extraordinary item 98
Add: Extraordinary items:
Foreign Exchange Gain 10
Damages for loss of reputation 14
Net cash from operating activities 122
B. Cash flows from Investing Activities:

Purchases of fixed assets (WN 6) -120
Proceeds from sale of equipment 25
Proceeds from sale of investment (50 – 40) 10
Interest received (WN 7) 3
Dividend received (WN 7) 4
Net cash used in investing activities -78
C. Cash flows from financing Activities:

Proceeds from issue of equity share capital (WN 8) 20
Redemption of Preference Share Capital -30
Repayment of term loan -15
Interest paid (WN 9) -6
Dividend paid -15
Net cash used in financing activities -46
Net decrease in cash and cash equivalents -2
Cash and cash equivalents at the beginning of the
12
period (10 + 2)
Cash and cash equivalents at the end of the period 10
Working Notes
1 Determining the value of Current Assets and Current 2068 2069
Liabilities
Current Ratio 1 1.5
Working Capital 100 80
Current Liabilities (100÷0.4) & (80÷0.5) 250 160
Current Assets (250+100) & (160+80) 350 240
Acid Test Ratio 1 1.1
Current Liabilities (as above) 250 160
Therefore, Quick Assets (QA) (CL×ATR) 200 176
Stock (CA – QA) 150 64
Other Current Assets (as given ) 18 15
(Dividend + Interest + Cash Equivalents)
Therefore, Debtors
(QA – Other Current Assets) 182 161
Therefore, Creditors
(CL – Interest payable – Taxes payable) 242 150

2 Cash Receipts from Customers

Sales (on accrual basis) 600
Add: Opening debtors (WN 1) 182 782
Less: Closing debtors (WN 1) -161
Cash Received from Customers 621
3 Cash paid to suppliers

Cost of sales 400
Add: Opening creditors (WN 1) 242
Closing stock (WN 1) 64 706
Less: Closing creditors (WN 1) 150
Opening stock (WN 1) 150 -300
406
4 Operating expenses Paid

Establishment Charges 30
Selling and Distribution expenses 60 90
5 Tax paid during the year

Tax payable in the beginning 3
Add: Provision for tax 30 33
Less: Tax payable at the end: -6
Tax paid during the year 27
6 Purchase of Fixed Assets Balance at the end 130

Add: Depreciation for current year 50
Assets sold (Book Value ) (25 + 15) 40 220
Balance at the beginning 100
Purchase of Fixed Assets during the year: 120
7 Interest and Dividend received during the year Interest Dividend
Opening Balance 2 4
Add: Accrued Income (Current Year) 4 2
6 6
Less: Closing Balance -3 -2
Received During the Year 3 4
8 Issue of Equity Share Capital for Cash

Capital at the end 150
Less: Capital issued to debenture-holders -20 130
(Conversion- 50% of 40)
67
Less: Opening Capital -110
Capital issued for Cash Interest Paid during the year
20
Balance in the beginning
9 Interest Paid during the year

Balance in the beginning 5
Add: Accrued during the year 5 10
Less: Balance at the end -4
Paid during the year 6
10 Cash and Cash Equivalents 2068 2069

Cash and Bank 10 7
Investments 2 3
12 10
11 Profit and Loss Account
Opening Balance 20
Profit for Current Year 25 45
Less: Transfer to General Reserve (15-10) 5
Transfer to Capital Redemption Reserve (10-0) 10 -15
Closing Balance 30
12. The preference share capital in the beginning and at the end was Rs. 40 and Rs. 10
thousand respectively. This redemption is backed by the issue of Equity Share Capital
of Rs. 20 thousand and transfer of Profit and Loss Account balance of Rs. 10 thousand to
Capital Redemption Reserve Account.
Question 13:
Assume that RCT Limited has owner's equity of Rs. 100,000. The ratios for the firm are as
follows:
Current Debt to total debt 0.4
Total Debt to owner's equity 0.6
Fixed Assets to owner's equity 0.6
Total assets turnover 2 times
Inventory turnover 8 times
Complete the following balance sheet:
Liabilities and Capital Amount Assets Amount
(Rs.) (Rs.)
Current Debt ........... Cash ...........
Long Term Debt ........... Inventory ...........
Total Debt ............ Total Current Assets ...........
Owners Equity ........... Fixed Assets ...........
Total Capital and Liabilities .......... Total Assets ...........
(June 2012) ( 7
Marks)

Answer
Total Debt = 0.60 X Owner's equity = 0.60X100,000 = Rs. 60,000
Fixed Assets = 0.60XOwner's equity = 0.60X100,000= Rs. 60,000
Total Capital = Total Debt + Owner's Equity = Rs. 60,000 + 100,000= Rs. 160,000
Total assets consisting of current assets and fixed assets must be equal to Rs. 160,000
(Assets= Liabilities+ Owner's equity). Fixed Assets are Rs. 60,000, therefore, current assets
should be Rs. 160,000 - 60,000 = Rs. 100,000
Sales are found as follows:

Assets turnover=Sales/Assets= 2 = Sales/Rs.160,000=2
Thus, Sales= 160,000X2
= Rs. 320,000
Inventories are found as follows:

Inventory turnover = Sales/Inventories=Rs. 320,000/Inventories=8
Thus, Inventories=320,000/8
= Rs. 40,000
Cash = Current assets - Inventories = Rs. 100,000-40,000= Rs.60,000

Current Debts =0.40XTotal debts= 0.40XRs.60,000= Rs. 24,000
Long term debts = Total Debts-Current Debts = Rs.60,000-Rs. 24,000= Rs.36,000
With all the above information, the balance sheets of RCT Ltd. would be as under:
Liabilities and Capital Amount (Rs.) Assets Amount (Rs.)

Current Debt 24,000 Cash 60,000
Long term debt 36,000 Inventory 40,000
Total Debt 60,000 Total Current Assets 100,000
Owners‘ Equity 100,000 Fixed Assets 60,000
Total Capital and Liabilities 160,000 Total Assets 160,000
Question No 14:
Following are the ratios of the business of Ganesh Traders Ltd., dealing in the
machineries, for the year ended 31st Ashadh, 2069:
Average Collection Period 3 months
Stock Turnover 1.5 times
Average Payment Period 2 months
Gross Profit Ratio 25%
Opening Receivables Rs. 600,000
Gross Profit for the year ended 31st Ashadh, 2069 amounted to Rs. 800,000. Closing stock of
the year is Rs. 20,000 above the opening stock. Closing bills receivable amounted to Rs.
50,000 and bills payable to Rs. 20,000.
Required: calculate
Sales
Sundry Debtors
69
Closing Stock
Sundry Creditors
Answer
Calculation of Total Sales
[ ]
[ ]
Net Sales = Rs.32,00,000
i) Calculation of Sundry Debtors

Average Collection Period = 3 months
Average Collection period = No of months in year/ Debtors Turnover Ratio (DTR)
3 month =12 Months/Debtors Turnover ratio (DTR)
Debtors Turnover Ratio (DTR) = 12 Months/3 Months= 4 times
Debtors Turnover Ratio (DTR) = Net Credit Sales/ Average Accounts Receivables
4 = 32, 00,000/Average Accounts Receivable
Average Accounts Receivable= Rs.32,00,000/4 =Rs.8,00,000
(Opening Receivables + Closing Receivables)/2 = Rs.8, 00,000
(Opening Receivables + Closing Receivables) = Rs.8, 00,000×2
(6,00,000 + Closing Receivables) = Rs.16, 00,000
Closing Receivables = Rs.16, 00,000-Rs.6, 00,000
=Rs.10, 00,000
Sundry Debtors = Closing Receivables- Bills Receivables
=Rs.10, 00,000-50,000
=Rs.9, 50,000
ii) Calculation of Closing Stock
Stock Turnover Ratio (STR) = 1.5 times
STR =Cost of Goods sold/ Average stock
Cost of goods sold = Sales- Gross Profit
1.5 = 24, 00,000/ Average Stock
Average Stock =24, 00,000/1.5
=Rs.16, 00,000
Average Stock = (Opening Stock +Closing Stock)/2
Rs.16, 00,000 = (Opening Stock + Closing Stock)/2
Opening Stock + Closing Stock =Rs.16, 00,000×2
Closing Stock is higher than opening stock by Rs.20, 000
Then opening Stock = (Rs.32, 00,000-Rs.20, 000)/2
Opening Stock = 31, 80,000/2=Rs.15, 90,000
Hence Closing Stock =Rs.15, 90,000+ Rs.20, 000
=Rs.16, 10,000
iii) Calculation of Sundry Creditors

Credit Purchase = Cost of goods sold+ Closing Stock- Opening Stock

=Rs.24, 00,000+Rs.16, 10,000-Rs.15, 90,000
= Rs.24, 20,000
Credit Turnover Ratio = 12 Months/ 2 months= 6 months
Credit Turnover Ratio (CTR) = Net Credit Purchase /Average Payables
Average Payables = 24, 20,000/6= Rs.4, 03,333
Creditors = Accounts Payable- Bills Payable
=Rs.403, 333-Rs.20, 000
=Rs.383, 333
Question No 15 :
You are provided with the following information of Zinc Ltd.:
Fixed assets (After writing off 30% value) Rs. 1,050,000
Fixed assets turnover ratio (on cost of sales) 2
Finished goods turnover ratio (on cost of sales) 6
Gross profit rate on sales 25%
Net profit (before interest) to sales 8%
Fixed charges cover (debenture interest 7%) 8
Debt collection period 1.5 months
Materials consumed to sales 30%
Stock of raw materials (in terms of month's consumption) 3 months
Current ratio 2.4
Quick ratio 1.0
Reserves to capital ratio 0.21
Required
Use the above information and prepare the balance sheet of Zinc Ltd.
Answer
Working Notes:
1. Calculation of cost of sales
Fixed assets turnover ratio = 2 (given)
Cost of sales/Fixed assets =2
Cost of Sales/10,50,000 =2
Cost of sales =2 X 10,50,000 = Rs. 21,00,000
2. Calculation of value of finished goods:

Inventory turnover ratio =6 (given)
Cost of Sales/Finished goods =6
Rs.21,00,000/Finished goods =6
Finished goods =21,00,000/6 = Rs. 3,50,000
3. Calculation of Sales and Gross Profit

Gross Profit ratio =25% (given)
Gross Profit/sales =25%
71
If cost of sales i.e. Rs.21,00,000 is 75%
Sales value would be 100%
Thus sales=21,00,000 X100/75 = Rs. 28,00,000
Gross Profit would be =28,00,000-21,00,000 =Rs. 7,00,000
4. Calculation of Net Profit:

Net Profit Ratio = 8% (given)
Net Profit/Sales = 8%
Net Profit/28,00,000 = 8%
Thus Net Profit =28,00,000 X 8% = Rs. 2,24,000
5. Calculation of interest charges

Interest service coverage ratio = 8 (given)
Net Profit before interest/ Interest =8
2,24,000/Interest =8
Interest =224,000/8=Rs. 28,000
6. Calculation of value of 7% Debentures:

Interest on debentures @ 7% =28,000
Thus value of debentures = 28,000X100/7 =Rs.4,00,000
7. Calculation of Debtors:
Debt collection period = 1.5 months (given)
Debtors/Sales X12 = 1.5
Debtors/28,00,000X12 = 1.5
Debtors =28,00,000X1.5/12 =Rs. 3,50,000
8. Calculation of Material consumption:

Material consumption =30% of sales (given)
=30% of Rs. 28,00,000 =Rs. 8,40,000
9. Calculation of Raw Materials stock:

Raw materials stock = 3 months of material consumption (given)
=8,40,000X3/12 =Rs. 2,10,000
10. Calculation of current assets and current liabilities:

Current ratio =2.4 (given)
Current assets/Current liabilities =2.4
Quick ratio =1 (given)
Liquid assets/Current liabilities =1
Thus value of stock =2.4-1 = 1.4
Value of stock =Finished goods + Raw materials
=3,50,000 + 2,10,000

=Rs. 5,60,000
Thus if 1.4 times is 5,60,000 then
1 times would be = 5,60,000/1.4
=4,00,000
Therefore, current liabilities =4,00,000
Current Assets =4,00,000X2.4
=Rs. 9,60,000
11. Calculation of Cash balance:

Cash balance = Current assets – stock of FG and RM and debtors
=960,000-(3,50,000+2,10,000+3,50,000) =Rs. 50,000
12. Calculation of capital and reserves:

Ratio of reserves to capital =0.21 (given)
If capital is 1
Reserves is 0.21
Net worth would be 1.21
Net worth =12,10,000
Capital is =12,10,000/1.21=Rs. 10,00,000
Reserves would be =12,10,000-10,00,000 =Rs. 2,10,000
After the above calculations, the balance sheet of Zinc Limited would be as under:
Capital and Liabilities Amount(Rs.) Assets Amount (Rs.)
Capital 10,00,000 Fixed Assets 10,50,000
Reserves 2,10,000 Current Assets
Debentures 4,00,000 Debtors 3,50,000
Current Liabilities 4,00,000 Stock (RM and FG) 5,60,000
Cash balance 50,000
20,10,000 20,10,000
Question No 16:
Using the following information, complete the Balance Sheet given below
Total Debt to Net worth :- 1:2
Total Assets Turnover :- 2
Gross Profit on Sales :- 30%
Average Collection period (assume 360 days in a year): 40 days
Inventory Turnover Ratio based on cost of goods sold and year end inventory: 3
Acid Test Ratio = 0.75
Liabilities Rs. Assets Rs.

Equity Share Capital 4,00,000 Plant and Machinery and ?
other Fixed Assets
Reserve and Surplus 6,00,000 Current Assets
Current Liabilities ? Inventory ?
73
Debtors ?
Cash ?
Total Total
(June 2013) (7 Marks)
Answer
Liabilities Rs. Assets Rs.
Equity Share Capital 400,000 Plant and Machinery and 425,000
other Fixed Assets
Reserve and Surplus 600,000 Current Assets
Current Liabilities 500,000 Inventory 700,000
Debtors 333,333
Cash 41,667
Total 15,00,000 Total 15,00,000
Working Notes
Net Worth= Equity Share Capital + Reserve and surplus
= Rs.400,000+600,000
=Rs.10,00,000
So,
Hence,
Total of Balance Sheet ( on Liabilities side)= Rs.15,00,000 ( after updating working Note 2),
so total Assets= Rs.15,00,000
So, Turnover ( i.e. sales) =Rs.15,00,000×2

=Rs.30,00,000
Cost of Goods Sold= Sales less Gross Profit

= Rs.30,00,000- 30%
= Rs.21,00,000
=Rs 3,33,333

So,
So Cash=Rs.41,667
Note: Quick Liabilities= Current Liabilities in this question, since there is no Bank Overdraft
in Balance Sheet format.
Question No 17:
Ace One Group P. Ltd., renowned for production and marketing of "Edge" brand leather
products, has wholly owned two companies Ace P. Ltd. at Sunsari and One P. Ltd. at
Bhairahawa and are led by highly professional executive officers. These officers are entrusted
for the overall business growth of their respective company and the Group has implemented
lucrative bonus scheme that takes into consideration the performance measure of Return on
Capital Employed (ROCE).
The results of the two companies and of the group for the year ended on Ashadh 32nd, 2071
are as follows:
Ace. P. Ltd. One P. Ltd. Ace One Group

(Rs.' 000) (Rs.' 000) P. Ltd.
(Rs.' 000)
Revenue 200,000 220,000 420,000
Cost of sales 170,000 160,000 330,000
Gross profit 30,000 60,000 90,000
Administration costs 10,000 30,000 40,000
Finance cost 10,000 - 10,000
Pre-tax profit 10,000 30,000 40,000
Non-current assets:
Original cost 1,000,000 1,500,000 2,500,000
Accumulated depreciation 590,400 1,106,784 1,697,184
Net book value 409,600 393,216 802,816
Net current assets 50,000 60,000 110,000
Total Assets 459,600 453,216 912,816
Non-current borrowings 150,000 - 150,000
Shareholders‘ funds 309,600 453,216 762,816
Capital and Liabilities 459,600 453,216 912,816
Required:
Calculate Return on Capital Employed, Pre-Tax Profit Margin and Asset Turnover Ratio of
Ace P. Ltd. and One P. Ltd. (June 2015) (6 marks)
Answer
S.No. Company Ace P. Ltd. One P. Ltd.
75
1. Return on Capital Employed = 10M/459.6M = 30M/453.216M
Pre-Tax Profit / (Non-Current Borrowings = 2.18% = 6.62%
+ Shareholders' Fund)
OR
EBIT
(Non current Borrowing +Shareholders = 4.35%
Fund
2. Pre-Tax Profit Margin = 10M/200M =30M/220M
Pre-Tax Profit / Revenue = 5.0% = 13.64%
3. Asset Turnover = 200M/459.6M = 220M/453.216M

Revenue / Total Asset = 0.435 times = 0.485 times
Question No 18:
MNP Limited has made plans for the year 2015-16. It is estimated that the company will
employ total assets of Rs. 25 lakh. Thirty percent of the assets would be financed by debt at
an interest rate of 9% p.a. The total direct cost for the year are estimated at Rs. 15 lakh and all
other operating expenses are estimated at Rs. 240,000. The sales revenue are estimated at Rs.
2,250,000. The tax rate is 25%.
Required: Calculate
Return on assets
Assets turnover
Return on equity
( December 2015)(7 Marks)
Answer
Calculation of net profit
Rs.
Sales revenue 2,250,000
Direct costs 1,500,000
Gross profit 750,000
Operating expenses 240,000
EBIT 510,000
Interest (9% x 7,50,000) 67,500
EBT 442,500
Taxes at 25 % 110,625
PAT 331,875
Return on Assets = EBIT (1- t) / Total Assets

= (510,000 x 0.75) / 2,500,000
=15.30 %
Alternate: EBIT/Total Assets=20.40%
Assets Turnover ratio = Sales/ assets

= 2,250,000/2,500,000
= 0.9 times
Return on Equity = PAT/Equity
= 331,875/ (2,500,000-750,000)
= 331,875/1,750,000

=18.96%
Question No 19:
SPG Ltd. has the following balances as on 1st of Shrawan 2071:
NRs.
Particulars Amount
Property, Plant & Equipment
Gross Block 1,140,000
Less: Accumulated Depreciation 399,000
Net Block 741,000
Inventory 225,000
Receivables 250,000
Cash & Bank Balance 66,500
Payables 190,000
Share Capital 570,000
The company made the following estimates for the financial year 2071-72:
The company will pay a tax-free dividend of 10% the rate of tax being 5%.
The company will acquire PPE costing NRs. 190,000 after selling one machine for NRs.
38,000 costing NRs. 95,000 and on which depreciation provided amounted to NRs. 66,500.
At the end of the year, the company will have the following balances
NRs.
Particulars Amount
Inventory 210,500
Receivables 350,000
Payables 247,000
Profit after depreciation- NRs. 114,000 104,500
Prepare the projected cash flow statement and ascertain the bank balance of SPG Ltd. as on
32 Ashad 2072 (RTP December 2014)
Answer
Projected cash flow statement of SPG Ltd. as on 32 Ashad 2072:
Net Profit After Depreciation 104,500
Adjustment
Depreciation 114,000
Gain on Sale of PPE (9,500) 104,500
209,000
Adjustment for changes in Working
Capital
(Increase)/Decrease in Inventory 14,500
(Increase)/Decrease in Receivables (100,000)
Increase/(Decrease) in Payables 57,000 (28,500)
Cash Flow From Operating Activities 180,500
77
Cash Flow From Investing Activities
Purchase of an item of PPE (190,000)
Disposal of an item of PPE 38,000
Cash Flow From Investing Activities (152,000)
Cash Flow From Financing Activities

Increase/(Decrease) in Share Capital -
Dividend Paid (60,000)
Cash Flow From Financing Activities (60,000)
Net Cash flow During the Year (31,500)
Opening Balance 66,500
Closing Balance of Cash & Cash
Equivalent 35,000
Question No 20:
The following financial information relates to VBBS Co.
Income statement extracts
Particulars 2011 2010
Revenue 14,525 10,375
Cost of sales 10,458 6,640
Profit before interest and tax 4,067 3,735
Interest 355 292
Profit before tax 3,712 3,443
Taxation 1,485 1,278
Distributable profit 2,227 2,165
Statement of financial position extracts

2011 2010
Non-current assets 15,284 14,602
Current assets
Inventory 2,149 1,092
Trade receivables 3,200 5,349 1,734 2,826
Total assets 20,633 17,428
Current liabilities
Trade payables 2,865 1,637
Overdraft 1,500 4,365 250 1,887
Equity
Ordinary shares 8,000 8,000
Reserves 4,268 12,268 3,541 11,541
Long-term liabilities
7% Bonds 4,000 4,000
Total liabilities 20,633.00 7,428.00

Average ratios for the last two years for companies with similar business operations to VBBS
Co are as follows:
Current ratio 1·7 times

Quick ratio 1·1 times
Inventory days 55 days
Trade receivables days 60 days
Trade payables days 85 days
Sales revenue/net working capital 10 times
Using suitable working capital ratios and analysis of the financial information provided,
evaluate whether VBBS Co can be described as overtrading (undercapitalized).
(RTP December 2014)
Answer
Overtrading arises when a company does not have enough long-term finance to support its
level of trading activity. There are a number of signs of overtrading, which are referred to in
the following discussion.
 Rapid increase in revenue or turnover compared to long-term finance
Revenue has increased by 40%, from NRs. 10,375,000 to NRs. 14,525,000, while long-
term finance has increased by only 4.7% (NRs. 16,268,000/NRs. 15,541,000).
 Increase in trade receivables days

A rapid increase in revenue may be due to offering more generous credit terms to
customers, in which case the trade receivables ratio would be expected to increase. Trade
receivables days have in fact increased from 61 days to 80 days, an increase of 31%. In
2010 trade receivables days were close to the average value for similar companies of 60
days, but they are now 33% more than this. While revenue has increased by 40%, trade
receivables have increased by 85% (NRs. 3,200,000/NRs. 1,734,000). It appears that VBBS
Co has offered more generous credit terms to its customers, although another explanation
could be that the company‘s customers are struggling to settle their accounts on time due a
downturn in economic activity, for example a recession, leading to an increase in overdue
payments and outstanding invoices.
 Decrease in profitability
A rapid increase in revenue may also be due to offering lower prices on products sold,
affecting gross profit margin or net profit margin. The net profit margin of VBBS Co has
decreased from 36% in 2010 to 28% in 2011. While revenue increased by 40%, profit
before interest and tax increased by only 8.9% (NRs. 4,067,000/NRs. 3,735,000). While
this decrease in profitability supports the possibility that VBBS Co has decreased selling
prices in order to increase sales volume, such a decrease in profitability may also be
caused by an increase in cost of sales or other operating costs.
 Rapid increase in current assets

The increase in trade receivables has already been discussed. Inventory increased by 97%
(NRs. 2,149,000/NRs. 1,092,000) compared to the revenue increase of 40%, indicating
perhaps that further increases in sales volume are being planned by VBBS Co. Inventory
days also increased from 60 days in 2010 to 75 days in 2011, well above the average value
for similar companies of 55 days. There has therefore been a rapid increase in current assets
79
of 89% (NRs. 5,349,000/NRs. 2,826,000), compared to the increase in long-term finance
of only 4.7%.
 An increased dependence on short-term finance

VBBS Co has certainly increased its dependence on short-term finance and this can be
shown in several ways. The sales revenue/net working capital ratio has increased from 11
times in 2010 to 15 times in 2011, compared to the average value for similar companies of
10 times. There has been a % increase in the companyǯs overdraft ȋNRs. 1,500,000/NRs.
250,000) and a 75% increase in trade payables (NRs. 2,865,000/NRs. 1,637,000).
Furthermore, trade payables days rose from 90 days in 2010 to 100 days in 2011, higher
than the average value for similar companies of 85 days. Short-term debt as a proportion of
total debt increased from 6% in 2010 (NRs. 250,000/NRs. 4,250,000) to 27% in 2011 (NRs.
1,500,000/NRs. 5,500,000). This analysis supports the view that VBBS Co is more dependent
on short-term finance in 2011 than in 2010.
 A decrease in liquidity
A key problem arising from overtrading is a decrease in liquidity and a shortage of cash. The
current ratio of VBBS Co has fallen from 1.5 times in 2010 to 1.2 times in 2011, compared to
an average value for similar companies of 1.7 times. The quick ratio or acid test ratio, which
is a more sensitive measure of liquidity, has fallen from 0.9 times in 2010 to 0.7 times in
2011, compared to an average value for similar companies of 1.1 times. There are
therefore clear indications that liquidity has fallen over the period and that VBBS Co has a
weaker liquidity position than similar companies on an average basis. However, the
current assets of the company do still exceed its current liabilities, so it does not yet have a
liquid deficit.
Overall, it can be concluded that there are several indications that VBBS Co is moving, or has
moved, into an overtrading (under capitalization) position.
Workings
Increase in revenue = 100 x (14,525 – 10,375)/10,375 = 40%
Increase in long-term finance = 100 x (16,268 – 15,541)/15,541 = 4·7%
2011 2010
Net profit margin 100 x 4,067/14,525 = 28% 100 x 3,735/10,375 = 36%
Current ratio 5,349/4,365 = 1.2 times 2,826/1,887 = 1.5 times
Quick ratio 3,200/4,365 = 0.7 times 1,734/1,887 = 0.9 times
Inventory days 365 x 2,149/10,458 = 75 days 365 x 1,092/6,640 = 60 days
Receivables days 365 x 3,200/14,525 = 80 days 365 x 1,734/10,375 = 61 days
Payables days 365 x 2,865/10,458 = 100 days 365 x 1,637/6,640 = 90 days
Net working capital 5,349 – 4,365 = NRs.984,000 2,826 – 1,887 = NRs.939,000
Sales/net working capital
14,525/984 = 15 times 10,375/939 = 11 times

Chapter 4: Valuation of Securities
CHAPTER 4
VALUATION OF SECURITIES
81
Question No 1:
a. Systematic Risk and Unsystematic Risk. (December 2010)(2.5 Marks)
Answer
Systematic risk is the variability of a security's return with that of the overall stock market.
Risks of inflation, Interest Rate Risk are example of this kind of risk. This type of risk affects
all firms in the economy and a particular firm cannot avoid it. This is also known as
Unavoidable Risk.
Unsystematic risk is the amount of a stock's variance unexplained by overall market

movements. It can be diversified away; hence it is known as Avoidable Risk. A strike may
affect only one company; a new competitor may begin to produce essentially the same
product; a technological breakthrough can make an existing product obsolete. However, by
diversification this kind of risk can be reduced and even eliminated if diversification is
efficient.
b. Yield to Call and Yield to Maturity (December 2011) (2.5 Marks)

Answer
The yield to Maturity (YTM) is the measure of a bond's rate of return that considers both the
interest income and any capital gain or loss. YTM is the bond's internal rate of return. To
calculate the Actual yield to maturity, first the approximate yield to maturity is calculated as
follows:
Where, T = Tax Rate, M = Maturity Value, n = Maturity period, Vd = Market Price of bond,
I = Interest payment on bond.
After calculating the approximate yield to maturity, interpolation shall be done by using the
two rates which are below and above the approximate rates to get the actual yield to maturity
A number of companies issue bonds with buyback or call provision. Thus, a bond can be
redeemed or called before maturity. YTC is the yield or the rate of return of a bond that may
be redeemed before maturity. The procedure for calculating the yield to call is the same as
yield to maturity. The call period would be different from the maturity period and the call or
redemption value could be different from the maturity value.
c. Over capitalization and Under capitalization (June 2013) (2.5

Marks)
Answer
Overcapitalization is a situation in which actual profits of a company are not sufficient

enough to pay interest on debentures, on loans and pay dividends on shares over a period of
time. This situation arises when the company raises more capital than required. A part of
capital always remains idle. With a result, the rate of return shows a declining trend. The
causes can be High promotion cost , Purchase of assets at higher prices, company‘s
floatation n boom period, Inadequate provision for depreciation, liberal dividend policy and
over-estimation of earnings.
Under Capitalization is the situation where exceptionally high profits are earned as compared
to other firms in the industry. An undercapitalized company situation arises when the
estimated earnings are very low as compared to actual profits. This gives rise to additional
funds, additional profits, high goodwill, high earnings and thus the return on capital
shows an increasing trend. The causes can be Low promotion costs, Purchase of assets at
deflated rates, conservative dividend policy, Floatation of company in depression stage,
High efficiency of directors, adequate provision of depreciation and large secret reserves are
maintained.
d. Yield to maturity (YTM) and Yield to call (YTC) (June 2014) (2.5
marks)
Answer
The Yield to maturity (YTM) or redemption yield of a bond or debentures, is the internal rate
of return (IRR, overall interest rate) earned by an investor who buys the bond or debenture
today at the market price, assuming that the bond will be held until maturity, and that all
coupon and principal payments will be made on schedule. Yield is to maturity is actually a
future return, as the rate at which coupon payments can be reinvested at when received is
unknown. It enables investors to compare the merits of different financial instruments.
The Yield to call (YTC) is one of the variants of YTM. It is the return if held up to call.
When bond or debenture is recallable (can be repurchased by the issuer before the maturity),
the market looks also to the Yield to Call, which is the same calculation of the YTM, but
assumes that the bond will be called, so the cash flow is shortened.
e. Dividend-price approach and Earning price approach to estimate cost of equity

(June 2015) (2.5 Marks)
Answer
In a dividend- price approach, cost of equity is calculated by dividing the current dividend by
average market price per share. This ratio expresses the cost of equity capital in relation to
what yield the company should pay to attract investors. It is calculated as:
Where, D1= Dividend per share in period 1

P0= Market Price per share now
Whereas earning price approach correlate the earnings of the company with the market price
of its shares. So, cost of equity shares would be based on expected rate of earning of the
company. This approach seeks to nullify the effect of changes in dividend policy.
f. Inflation bonds and Floating rate bonds (December 2015) ( 2.5

Marks)
83
Answer
Inflation Bonds are the bonds in which interest rate is adjusted for inflation. Thus, the
investor gets interest which is free from the effects of inflation. For example, if the interest
rate is 3 percent and the inflation rate is 6 percent, the investor will get 9 percent in total.
Floating rate bonds, as name suggests, are the bonds where the interest rate is not fixed and is
allowed to float depending upon the market conditions. This is an ideal instrument which can
be resorted to by the issuer to hedge themselves against the volatility in the interest rates.
This has become more popular as a money market instrument and being issued by the
financial institutions
Question No 2:
Write short note on
a. Perpetuities (June 2011) (2.5 Marks)
Answer
Perpetuities can be defined as a stream of equal payments expected to continue forever.
Most annuities call for payments to be made over some finite period of time, for
example, Rs1000 per year for five years. However, some annuities go for indefinitely,
or perpetually, and these are called perpetuities. The present value of perpetuities is
found as below:
PV (Perpetuities) = Payment/ Interest Rate
Most preferred stocks entitle their owners to regular, fixed dividend payments lasting
forever. These are one of the examples of ‗perpetuities‘.
b. Valuation of Compulsory Convertible Debenture (June 2012) ( 2.5 Marks)

Answer
The debenture-holders of a Compulsorily Convertible Debenture (CCD) receives interest at a
specified rate for a pre-determined period after which a part or full value of the CCD is
converted into specific number of equity shares. The cashflows resulting in the case of
valuation of CCD are;
- Periodic interest receivable from the company.
- Expected market price of the share received on conversion.
- Redemption amount, if any.
The value of a CCD is then found out by using the following formula:
where, B0 (CCD) = Value of a CCD

I = Interest amount receivable per year
ke = Required rate of return on equity component
m = Number of shares received on conversion
Pt = Share price at the time of conversion
RV = Redemption value, if any
n = Life of the debentures
kd = Rate of discount of debt.

In the case of partially convertible debentures, the annual interest before conversion and after
conversion would be different whereas in the case of fully convertible debentures, there will
not be any RV.
c. Intrinsic value of Assets (June 2012) ( 2.5 Marks)

Answer
The intrinsic value of an asset is equal to the present value of incremental future cash inflows
likely to accrue due to the acquisition of the asset, discounted at the appropriate required rate
of return. It represents the maximum price the buyer would be willing to pay for such an
asset. The principal of valuation based on the discounted cash flow approach is used in
capital budgeting decisions. In the case of business intended to be purchased, its valuation is
equivalent to the present value of incremental future cash inflows after taxes, likely to accrue
to the acquiring firm, discounted at the relevant risk adjusted discount rate, as applicable to
the acquired business. The intrinsic value indicates the maximum price at which the business
can be acquired.
Practical Questions
Question No 3:
XYZ Ltd. is foreseeing a growth rate of 12% per annum in the next 2 years. The growth rate
is likely to fall to 10% for the third year and fourth year. After that the growth rate is
expected to stabilise at 8% per annum. If the last dividend paid was Rs. 1.50 per share and
the investors' required rate of return is 16%, find out the intrinsic value per share of Z Ltd. as
of date. You may use the following table:
Years 0 1 2 3 4 5
Discounting factor at 16% 1 0.86 0.74 0.64 0.55 0.48
(June 2010) (10 Marks)

Answer
Present value of dividend stream for first 2 years:
Rs. 1.50 (1.12) x 0.86 + 1.50 (1.12)2 x 0.74
Rs. 1.68 x 0.86 + 1.88 x 0.74
Rs. 1.45 + 1.39 = 2.84 (A)
Present value of dividend stream for next 2 years:

Rs. 1.88 (1.1) x 0.64 + 1.88 (1.1)2 x 0.55
Rs. 2.07 x 0.64 + 2.28 x 0.55
Rs. 1.33 + 1.25 = 2.58 (B)
Market value of equity share at the end of 4th year computed by using the constant dividend
growth model would be:
Where D5 is dividend in the fifth year, gn is the growth rate and Ks is required rate of return.
Now, D5 = D4 (1 + gn)
85
D5 = Rs. 2.28 ( 1 + 0.08)

= Rs. 2.46
= Rs. 30.75
Present market value of P4 = 30.75 x 0.55 = Rs. 16.91 (C)
Hence the intrinsic value per share of Z Ltd. would be
A + B + C i.e. Rs. 2.84 + 2.58 + 16.91 = Rs. 22.33
Question No 4:
Fast Growing Ltd. has outstanding a Rs. 1000 face value bond with a 12% coupon rate and 3
years remaining until final maturity. Interest payments are made semi-annually.
You are required to answer the following questions with appropriate supporting computations:
i) What value should you place on this bond if your nominal annual required rate of return is
10 per cent; and
ii) Assuming a bond similar to the one described above except that is a zero-coupon, pure
discount bond, what value should you place on this bond if your nominal annual required
rate of return is 16 per cent. (Assume a semiannual compounding.
Answer
Value of Bond when kd = 10%
We have, value of a bond (V) = I/2 (PVIFA kd, 2n) + MV (PVIF kd, 2n), where
 kd is the investor‘s required rate of return
 n is the number of years and 2n is the number of semi-annual periods until maturity.
 I/2 is the periodic interest payment
 MV is the maturity value of the bond
Substituting the given values in the above formula, we get:
V = (Rs. 120/ 2) (PVIFA 0.05, 6) + Rs. 1000 (PVIF 0.05, 6)
= Rs. 60 (5.076) + Rs. 1,000 (0.746)
= Rs. 304.56 + Rs. 746
= Rs. 1,050.56.
(ii) Value of Zero Coupon Bond when kd = 16%

The value of this type of bond is found out simply by discounting the maturity value of the
bond to the present. Thus,
V = Rs. 1,000 (PVIF 0.08, 6)
= Rs. 1,000 (0.630)
= Rs. 630
Question No 5:
An investor has made investment in the equity share of Pacific Chemicals Ltd. The
capitalization rate of the company is 20 per cent and the current dividend is 25 per share.
You are required to calculate the value of the company‘s equity share if the company is
slowly sinking with an annual decline rate of 10% in the dividend. (December
2010)(4 Marks)
Answer

The value of the company‘s equity share is given by the following formula:
Ve = D1/(k – g), where D1 is the dividend in the year 1, k is the capitalization rate and g is
the growth rate in dividend.
The value of equity share in the given condition is derived as follows:

Ve = Rs. 25 (1 – 0.10)/[(0.20 – (– 0.10)]
= Rs. 25 x 0.90/0.30
= Rs. 22.50/0.30
= Rs. 75
Question No 6:
The bonds of Express Ltd. are currently selling at Rs. 130. They have 9 percent coupon rate of
interest and Rs. 100 par value. The interest is paid annually and the bonds have 20 years to
maturity.
i) Compute the Yield to Maturity (YTM) of the bond.
ii) Explain the difference between YTM and coupon rate of interest of the bond.
Answer
We have,
B = I x (PVIFAkd n) + M x (PVIF kd n)
Where,
B = Value of the Bond
I = Annual Interest Paid
n = Number of Years to Maturity
M = Par/Maturity Value
kd = Required Return on the Bond
Information given in the problem are:
B = Rs. 140
I (Annual Interest Paid) = Rs. 100 X 0.09 = Rs. 9
M (Par/Maturity Value) = Rs. 100
n = 20
kd = 9
Let us try a lower rate of 7 per cent in the formula:
B = I x (PVIFAkd, n) + M x (PVIF kd, n)
= Rs. 9 x (PVIFA 7, 20 ) + Rs. 100 x (PVIF 7, 20)
= (Rs. 9 x 10.594) + Rs. 100 x 0.258)
= Rs, 95.35 + Rs. 25.80
= Rs. 121.15.
Since Rs. 121.15 < Rs. 135, let us try still a lower rate of 6 per cent.
B = I x (PVIFAkd n) + M x (PVIF kd n)
= Rs. 9 x (PVIFA 6, 20 ) + Rs. 100 x (PVIF 6, 20)
87
= (Rs. 9 x 11.470) + Rs. 100 x 0.312)

= Rs, 103.23 + Rs. 31.20
= Rs. 134.43.
By interpolation,
= (6 + 0.33) %
= 6.33% approximately.
11) The YTM (6.33%) is below the coupon interest rate (9%) of the bond since its market
value (Rs. 130) is above its par value (Rs. 100).
ii) Explanation Ragarding the difference between YTM and Coupon Rate
Yield to maturity (YTM) is the expected rate of return on a bond if bought at its current
market price and held to maturity. It is also called the bond‘s internal rate of return (IRR).
The underlying feature of bond price is that YTM < coupon rate when a bond sells at a
premium and vice versa. Similarly, YTM = coupon rate when a bond sells at par.
In the present case, the bond is selling at a premium of Rs. 30 as compared to the par value of
Rs. 100. This is the reason for the YTM (6.33%) being lower than the coupon interest rate of
9%.
Question No 7:
Based on the credit rating of the bonds, an investor has decided to apply the following
discount rate for valuing the bonds.
Credit rating Discount rate
AAA 364-day Treasury-bill rate + 3% spread
AA AAA + 2% spread
A AAA + 3% spread
The investor is considering investing in an AA rated, Rs. 1,000 face value bond currently
selling at Rs. 1,010. The bond has five years to maturity and the coupon rate on the bond is
15% per annum payable annually. The next interest payment is due one year from today and
the bond is redeemable at par. (Assume 364-day Treasury bill rate to be 9%)
You are required to calculate:
i) Intrinsic value of the bond for the investor. Should the investor invest in the bond?
ii) Current yield (CY) and the yield to maturity (YTM) of the bond.
Answer
AA rated face value of bond = Rs. 1,000
Current selling price = Rs 1,010
Maturity period of bond = 5 years

Coupon rate of the bond = 15% per annum payable annually

Bond redeemable at par at the end of 5th year.
Net interest payment is due on year from today.
Discount rate for AA rated bond = 9% + 3% + 2% = 14%
Calculation of Present Value of Cash Inflow from Bond
(Rs.
Year-end Cash Inflow PV Factor at 14% Present Values
1 150 0.8772 131.58
2 150 0.7695 115.43
3 150 0.675 101.25
4 150 0.5921 88.82
5 1,150 0.5194 597.31
Present value of total Cash Inflow: 1,034.40
Thus, the intrinsic value of bond is Rs. 1,034.40. Since the intrinsic value of bond (Rs.
1,034.40) is more than its current market value (Rs. 1,010), it is suggested to purchase the
bond.
= 14.85%
Yield to Maturity (YTM)

P = Rs. 150 x PVIFA @ 15% for 4 years + Rs. 1,150 x PVIF at 15% for 5th year
= (150 x 2.855) + (1,150 x 0.4972 = 428 + 571.78 = 1,000.03
Present value at 14% = Rs. 1,034.40
Present value at 15% = 1,000.03
By interpolation,
= 14% + (24.40 / 34.37)
= 14.71%
Question No 8:
A 10-year, 12% semi-annual coupon bond, with a par value of Rs. 1,000 may be called in 4
years at a call price of Rs. 1,060. The bond sells for Rs. 1,100. Assume that the bond has just
been issued.
Required:
i) What is the bond‘s effective annual yield to maturity?
ii) What is the bond‘s annual current yield?
iii) What is the bond‘s capital gain or loss?
89
What is the bond‘s effective annual yield to call?

Answer
Given,
Par value (M) = Rs. 1,000
Coupon rate = 12%
Annual coupon (I) = 12% of Rs 1,000 = Rs 120
Maturity period (n) = 10 years
Call period = 4 years
Call price = Rs. 1,060
Selling price = Rs 1,100
Semi-annual compounding.
i. Calculation of bond‘s effective annual yield to maturity (YTM)

Vd = I(PVIFAkd% , n) + M(PVIFkd% , n)
So, for semiannual bond,
Rs 1,100 = I/2(PVIFAkd%/2 , n x 2) + M(PVIFkd%/2 , n x 2) ………………..(1)
= 5.16%
Now, trying at 5%,

PV = Rs 60(PVIFA5% , 20 ) + 1,000(PVIF5% , 20)
= 60 x 12.4622 + 1,000 x 0.3769 = Rs 1,124.63 > Rs 11,00
Trying at 6%,
PV = Rs 60(PVIFA6% , 20 ) + 1,000(PVIF6% , 20)

= 60 x 11.4699 + 1,000 x 0.3118 = Rs 999.99 < Rs 1,100
By interpolating,
Semiannual YTM = 5.2%
Therefore, nominal YTM = 5.2% x 2 = 10.4%
The effective annual YTM = (1 + 0.052)2 – 1 = 1.1067 – 1 = 0.1067 = 10.67%

ii. Calculation of bond‘s current yield

= Coupon payments / Price of the Bond

= 120/1,100 = 0.1091
= 10.91%
iii. Calculation of bond‘s Capital gain or loss

We have,
YTM = Current Yield + Capital Gain or Loss Yield
10.67% = 10.91% + Capital Gain or Loss Yield
Capital Gain or Loss Yield = 10.67% - 10.91% = (0.24%)
So, Capital loss is 0.24%
iv. Calculation Bond‘s Yield to Call (YTC)

We have,
Rs 1,100 = Rs 60(PVIFAkd%/2 , 2 x 4) + Rs 1,060(PVIFkd%/2 , 2 x 4)
= 5.061%
Now, trying at 5%,
PV = Rs 60(PVIFA5% , 8 ) + 1,060(PVIF5% , 8)
= 60 x 6.4632 + 1,060 x 0.6768
= Rs 1,105.20 > Rs 1,100
Trying at 6%,
PV = Rs 60(PVIFA6% , 8 ) + 1,060(PVIF6% , 8)
= 60 x 16.2098 + 1,060 x 0.6274
= Rs 1037.63 < Rs 1,100
By interpolating,
= 5.08%
Therefore, nominal YTC = 5.08% x 2 = 10.16%
The effective annual YTC = (1 + 0.0508)2 – 1 = 1.1042 – 1 = 0.1042 = 10.42%
Question No 9:
91
Albertine Ltd. has an investment opportunity available which will involve a capital
outlay in each of the next 2 years and which will produce benefits during the following 3
years. A summary of the financial implications of this investment is given below:
Year Cash Flow (Rs. ‗000) Year Cash Flow (Rs. ‗000)
1 (1,000) 4 1,300
2 (1,000) 5 3,100
3 100
Albertine Ltd. currently has 100,000 shares in issue. The dividend just paid was Rs. 15
per share. In the absence of the above investment, dividends are expected at this level
for the next 3 years, but will then demonstrate perpetual growth of 10 per cent per
annum. The company is currently all equity financed and the required rate of return of the
equity investor is estimated to be 18 per cent.
The company has a long established policy of not using any debt finance and, because
of the current depressed state of the stock market, could not, in the near future, issue
new equity. The only possible way of financing the investment is, therefore, to reduce
the dividend payments in the next 2 years. Cash received from the new investment
will all be distributed in the form of dividend. Growth in dividends at the rate of 10%
will also be maintained because of other operations.
Required:
i) Calculate the current price of share of Albertine Ltd. when investment proposal is not
accepted.
ii) Calculate the share price after the investment has been accepted using dividend
valuation model, assuming that the market knows of the dividend changes that will result
from the investment. (December, 2012)(9 Marks)
Answer
i) Current price of Share (when investment proposal is not accepted)
The current market price of the share is the present value of expected future dividends
discounted at the required rate of return, i.e. 18%.Since the company is expected to
pay a dividend of Rs. 15 for the next 3 years and thereafter, the dividend will grow at
the rate of 10%. The present market price with these parameters is ascertained as below:
Dividend per year = Rs. 15
PVAF (at 18%, 3 years) = 2.174
Therefore, PV of dividends = Rs. 15 x 2.174
= Rs. 32.61
=Rs 206.25
Present value of this amount at 18% for 3rd year = Rs. 206.25 x PVF(18%, 3)
= Rs. 206.25 X0.609
= Rs. 125.61
Present market price = Rs. 125.61 + Rs 32.61
= Rs. 158.22

ii) Current price of Share (when the investment proposal is accepted)

In first and second year the investment required of Rs.1,000,000 is financed by
reducing the old dividend rate of Rs.15 per share for 100,000 number of shares. And,
thereafter all the cash flows from new investment is distributed as additional dividend.
The present value of dividend under this situation will be as follows:
Year Old Dividend (Rs.) Change in Net Dividend PVIF @ 18% PV (Rs.)
Dividend (Rs.)
1 15 -10 (Rs.) 5 0.847 4.24
2 15 -10 5 0.718 3.59
3 15 1 16 0.609 9.74
4 (15+10% of 15) =16.5 13 29.5 0.516 15.22
5 (16.5+10% of 16.5) = 18.15 31 49.15 0.437 21.48
Total 54.27
=Rs 250
Present value of this amount at 18% for 5th year = Rs. 250 XPVF(18%, 5)
= Rs. 250 X 0.437
= Rs. 109.25
Therefore, the market price under this situation = Rs. 109.25 + Rs. 54.27
= Rs. 163.52
Question No 10:
Beta Company is contemplating conversion of 500, 14% convertible bonds of Rs. 1,000
each. Market price of the bond is Rs. 1,080. Bond indenture provides that one bond will
be exchanged for 10 shares. Price–earnings ratio before redemption is 20:1 and
anticipated price-earnings ratio after redemption is 25:1. Number of shares outstanding prior
to redemption are 10,000. EBIT amounts to Rs. 200,000. The company is in the 35% tax
bracket. Should the company convert bond into shares? Support your analytical comments
with required calculations. (June 2013) ( 4 Marks)
Answer
Particulars Pre- Post-

EBIT (Rs.) redemption
2,00,000 redemption
2,00,000
Interest @14% (Rs.) 70,000 Nil
Taxable Income (Rs.) 1,30,000 2,00,000
Less: Tax @ 35 percent (Rs.) 45,500 70,000
93
Net Income after Tax (Rs.) 84,500 1,30,000

Outstanding Shares ( Nos) 10,000 15,000
EPS (Rs.) 8.45 8.66
P/E Ratio 20:01 25:01:00
Market Price per share (Rs.)
169 216.5
(i.e. price-earnings ratio times×EPS)
Comment:
This is two-in-one benefit scheme. The company should convert the bond into shares
because both shareholders and debenture holders stand to gain. The post-redemption
market price of the equity shares would be Rs.216.50 than the pre-redemption market price
of Rs.169. Moreover the debenture holder/ bondholders would receive Rs.1, 690 in stock
(i.e. 169×10 shares, in place of receiving cash Rs.1, 080 only)
Question No 11:
The XYZ limited is contemplating a debenture issue on the following terms:
Face value = Rs. 100 per debenture
Term of maturity= 7 years
Coupon rate of Interest:
Years 1-2=8% p.a.
3-4=12% p.a.
5-7=15% p.a.
The Current market rate of interest on similar debenture is 15% p.a. The company proposes
to price the issue so as to yield a (compounded) return of 16% p.a. to the investor. Determine
the issue price. Assume the redemption on debenture at a premium of 5% (Note: The present
value interest factors at 16% p.a. for years 1 to 7 are .862, .743, .641, .552, .476, .410, and
.354 respectively). (June 2014) ( 4 marks)
Answer
The interest payments over the life of the debentures and their present values are given in the
following table:
Year Interest(Rs.) PVF@16% Present Value(Rs.)

1 8 .862 6.896
2 8 .743 5.944
3 12 .641 7.692
4 12 .552 6.624
5 15 .476 7.14
6 15 .410 6.15
7 15 .354 5.31
Total 45.756
The present value of the redemption amount of Rs. 105 (Rs.100+Rs.5)@16% p.a. is Rs.
105*.354=Rs. 37.17
Therefore, the present value of the debenture is Rs. 45.76+Rs. 37.17=Rs. 82.93. The
company should issue the debenture at this value in order to yield a return of 16% to the
investors.
Question No 12:

Consider two bonds with Rs. 1,000 face value that carry coupon rate of 8%, make annual
coupon payment and exhibit similar risk characteristics. The first bond has 5 years to
maturity whereas the second has 10 years to maturity. The appropriate discount rate for the
investment of similar risk securities is 8%.
Required:
Calculate current market price of both the bonds.
If this discount rate rises by 2 %, what will be the respective percentage price changes of the
two bonds, and why? (June 2014) ( 4 Marks)
Answer
Since the required rate of return, i.e. discount rate is equal to the coupon rate of 8%, the
current market price is equal to their face value i.e. Rs. 1000.
1st Bond
MP =Int. (PVIFA, 5 yrs) + M(PVIF, 5th yrs)
=80(8%, 5 yrs) + 1000(8%, 5th yrs)
=80×3.9927 + 1000×0.6806
=319.42 + 680.60
= Rs. 1,000.02
= Rs. 1000
2nd Bond
MP=80(8%, 10 yrs) + 1,000(8%, 10th yr)
=80×6.7101 + 1,000×0.4632
=536.81 + 463.20
=Rs. 1,000.01
= Rs. 1,000
When discount rate is increased by 2%:

New discount rate: 8+2= 10%.
Face Value 1000

Coupon 8%
Required rate of return: 10%
1st Bond
MP = Int (PVIFA 10%, 5 yrs) + M (PVIF 10%, 5th yr)
=80X 3.7908 +1000X 0.6209
=Rs. 924.16
= - 7.58%
2nd Bond
MP = Int (PVIFA 10%, 10 yrs) + M (PVIF 10%, 10th yr)
= 80X 6.1446 +1000*0.3855
=Rs. 877.07
= -12.29%
95
Therefore, change in price of second bond is greater than that of bond first because of its
longer maturity period. It is because the longer the maturity period, the higher the sensitivity
of bond price to the interest rate change.
Question No 13:
Consider from the following information:
Equity share capital (Rs.100 each) Rs. 5,000,000
Reserves and surplus Rs.500,000
15% secured loans Rs. 2,500,000
12.5% unsecured loans Rs. 1,000,000
Fixed assets Rs. 3,000,000
Investments Rs.500,000
Operating profit Rs. 2,500,000
Tax rate 25%
PE ratio 12.5
Required
Calculate the value of each equity share (December 2014) ( 5 marks)
Answer
Value= EPS × PE Ratio
Particular Rs.
Operating profit i.e. EBIT 2,500,000
Less: Interest on 15% secured loans 375,000
Interest on 12.5% unsecured loans 125,000
Profit before tax 2,000,000
Tax @ 25% 500,000
PAT 1,500,000
Number of equity shares = (Rs 5,000,000/100) = 50,000

Therefore EPS = (Rs 1,500,000/50,000) = Rs. 30
P/E Ratio is given as 12.5
Therefore,
Value of equity share =EPS×PE Ratio
= 30×12.5
=Rs.375
Question No 14:
XYZ Ltd. has the following capital structure:
4,000 Equity shares of Rs. 100 each Rs. 400,000

10% Preference shares Rs. 100,000
11% Debentures Rs. 500,000
The current market price of the share of XYZ Ltd. is Rs. 102. The company is expected to
declare a dividend of Rs. 10 at the end of the current year, with an expected growth rate of
10%. The applicable tax rate is 25%.

Required:
Find out the cost of equity capital and the WACC.
Assuming that the company can raise Rs. 300,000 12% Debentures, find out the new cost of
equity and WACC if dividend rate is increased from 10% to 12%, growth rate is reduced
from 10% to 8%, and market price of the share is reduced to Rs. 98.
(June 2015) ( 6 marks)
Answer
i) Computation of Cost of Capital
= 10/102+.10
=19.8 %
Calculation of Weighted Average Cost of Capital (WACC)
Source Amount W C/C (after tax ) W*C/C
Equity Capital 400,000 0.4 0.198 0.0792
10% Pref. Capital 100,000 0.1 0.100 0.0100
11% Debenture 500,000 0.5 0.825 0.04125
1,000,000 1.0 0.13045
WACC =13.045%
ii) Computation of Cost of Capital and WACC under the New situation
Calculation of Cost of Equity, (New)
= 12/98+.08
=20.2%
Calculation of Weighted Average Cost of Capital (New)
Source Amount W C/C ( after tax) W*C/C
Equity Capital 400,000 0.31 0.202 0.0626
10% Pref. Capital 100,000 0.08 0.100 0.008
11% Debenture 500,000 0.38 0.0825 0.03135
12% Debenture 300,000 0.23 0.09 0.0207
1,300,000 1.00 0.12157
WACC =12.157%
Question No 15:
The following information is available for your perusal:
Present book value of a firm's capital structure is: (Rs.)

Debentures of Rs. 100 each 800,000
Preference shares of Rs. 100 each 200,000
Equity shares of Rs. 10 each 1,000,000
2,000,000
All these securities are traded in the capital markets at recent prices of:
Debentures: Rs. 110, Preference shares: Rs. 120 and Equity shares: Rs. 22.
Anticipated external financing opportunities are as follows:
Rs. 100 per debenture redeemable at par: 20 years maturity, 8% coupon rate, 4% floatation
costs, sale price Rs. 100.
97
Rs. 100 preference share redeemable at par: 15 years maturity, 10% dividend rate, 5%
floatation costs, sale price Rs. 100.
Equity shares: Rs. 2 per share floatation costs, sale price Rs. 22.
In addition, the dividend expected on the equity share at the end of the year is Rs. 2 per share;
the anticipated growth rate in dividends is 5% and the firm has the practice of paying all its
earnings in the form of dividend. The corporate tax rate is 50%.
Required:
Determine the weighted average cost of capital of the firm using (i) book value weights, and
(ii) market value weights. ( December 2015) ( 9 Marks)
Answer
Calculation of Cost of Capital of Individual Components of Capital
=0.0837 or 8.37%
Cost of Debentures after tax (kd) = I(1-t)

= 8.37 (1-0.50) = 4.18%
Cost of Preference Shares
=0.1059 or 10.59%
Cost of Equity
= 0.15 or 15%
Computation of WACC based on book value weights

Book
Specific
Value Weights on Total
Cost
Source of Capital (Rs.) Total Capital Cost
Debentures (Rs. 100 each) 800,000 0.40 0.0418 0.0167
Preference Shares (Rs. 100 each) 200,000 0.10 0.1059 0.0106

Equity Shares (Rs. 10 each) 1,000,000 0.50 0.1500 0.0750

2,000,000 1.00 0.1023
Cost of Capital = 10.23%
Computation of WACC based on market value weights

Book
Specific
Value Weights on Total
Cost
Source of Capital (Rs.) Total Capital Cost
Debentures (Rs. 110 each) 880,000 0.2651 0.0418 0.01108
Preference Shares (Rs. 120 each) 240,000 0.0723 0.1059 0.00766
Equity Shares (Rs. 22 each) 2,200,000 0.6626 0.1500 0.09939
3,320,000 1.0000 0.11813
Cost of Capital = 11.81%
Question No 16:
PS Ltd. is a company that is listed on a major stock exchange. The company has
struggled to maintain profitability in the last two years due to poor economic conditions in its
home country and consequently it has decided not to pay a dividend in the current year.
However, there are now clear signs of economic recovery and PS Ltd. is optimistic that
payment of dividends can be resumed in the future. Forecast financial information relating to
the company is as follows:
Year 1 2 3
Earnings (NRs.3000) 3,000 3,600 4,300
Dividends (NRs.3000) nil 500 1,000
The company is optimistic that earnings and dividends will increase after Year 3 at a
constant annual rate of 3% per year.
PS Ltd. currently has a before-tax cost of debt of 5% per year and an equity beta of 1.6. On a
market value basis, the company is currently financed 75% by equity and 25% by debt.
During the course of the last two years, the company acted to reduce its gearing and was
able to redeem a large amount of debt. Since there are now clear signs of economic
recovery, PS Ltd. plans to raise further debt in order to modernize some of its non-current
assets and to support the expected growth in earnings. This additional debt would mean
that the capital structure of the company would change and it would be financed 60% by
equity and 40% by debt on a market value basis. The before-tax cost of debt of PS Ltd.
would increase to 6% per year and the equity beta of PS Ltd. would increase to 2.
The risk-free rate of return is 4% per year and the equity risk premium is 5% per year. In
order to stimulate economic activity the government has reduced profit tax rate for all large
companies to 20% per year.
The current average price/earnings ratio of listed companies similar to PS Ltd. is 5 times.
Required
Estimate the value of PS Ltd. using the price/earnings ratio method and discuss the usefulness
of the variables that you have used.
Calculate the current cost of equity of PS Ltd. and, using this value, calculate the value of
the company using the dividend valuation model.
99
Calculate the current weighted average after-tax cost of capital of PS Ltd. and the
weighted average after-tax cost of capital following the new debt issue, and comment on the
difference between the two values. (RTP December 2014)
Answer
Price/earnings ratio valuation
The value of the company using this valuation method is found by multiplying future
earnings by a price/earnings ratio. Using the earnings of PS Ltd. in Year 1 and the
price/earnings ratio of similar listed companies gives a value of 3,000,000 x 5= NRs.
15,000,000.
Using the current average price/earnings ratio of similar listed companies as the basis for
the valuation rests on two questionable assumptions. First, in terms of similarity, the
valuation assumes similar business operations, similar capital structures, similar earnings
growth prospects, and so on. In reality, no two companies are identical. Second, in terms of
using an average price/earnings ratio, this may derive from companies that are large and
small, successful and failing, low-geared and high-geared, and domestic or international in
terms of markets served. The calculated company value therefore has a large degree of
uncertainty attached to it.
Value of company using the dividend valuation model

The current cost of equity using the capital asset pricing model = 4 + (1.6 x 5) = 12%
Since a dividend will not be paid in Year 1, the dividend growth model cannot be applied
straight away. However, dividends after Year 3 are expected to grow at a constant annual
rate of 3% per year and so the dividend growth model can be applied to these dividends.
The present value of these dividends is a Year 3 present value, which will need discounting
back to year 0. The market value of the company can then be found by adding this to the
present value of the forecast dividends in Years2 and 3.
PV of year 2 dividend = 500,000/1.122
= NRs. 398,597
PV of year 3 dividend = 1,000,000/1.123
= NRs. 711,780
Year 3 PV of dividends after year 3 = (1,000,000 x 1.03)/ (0.12 – 0.03)

= NRs. 11,444,444
Year 0 PV of these dividends = 11,444,444/1.123
= NRs. 8,145,929
Market value from dividend valuation model = 398,597 + 711,780 + 8,145,929
= NRs. 9,256,306 or approximately NRs. 9.3 million
Current weighted average after-tax cost of capital

Current cost of equity using the capital asset pricing model = 12% After-tax cost of debt
= 5 x (1 – 0·2)
= 5 x 0·8
= 4%
Current after-tax WACC = (12 x 0·75) + (4 x 0·25) = 10% per year
Weighted average after-tax cost of capital after new debt issue
Revised cost of equity = Ke = 4 + (2·0 x 5) = 14%
Revised after-tax cost of debt = 6 x (1 – 0·2) = 6 x 0·8 = 4·8%
Revised after-tax WACC = (14 x 0·6) + (4·8 x 0·4) = 10·32% per year

Comment
The after-tax WACC has increased slightly from 10% to 10·32%. This change is a result of
the increases in the cost of equity and the after-tax cost of debt, coupled with the change
in gearing. Although the cost of equity has increased, the effect of the increase has
been reduced because the proportion of equity finance has fallen from 75% to 60% of the
long- term capital employed. Although the after-tax cost of debt has increased, the cost of
debt is less than the cost of equity and the proportion of cheaper debt finance has increased
from 25% to 40% of the long-term capital employed.
101
CHAPTER 5
CAPITAL INVESTMENT DECISION

Chapter 5: Capital Investment Decision
Question No 1:
Distinguish between
a. Floatation cost and Transaction Costs (June 2010) ( 2.5 Marks)
Answer
Floatation cost refers to the cost involved in raising capital from the market, for instance,
underwriting, commission, brokerage and other expenses. The presence of floatation costs
affects the balancing nature of internal (retained earnings) and external (dividend payments)
financing. The introduction of floatation costs implies that the net proceeds from the sale of
new shares would be less than the face value of the shares, depending upon their size.
Transaction costs refer to costs associated with the sale of securities by the shareholder
investors. In the Modigliani Miller Hypothesis, it is assumed that if dividends are not paid (or
earnings are retained), the investors desirous of current income to meet consumption need can
sell a part of their holdings without incurring any cost, like brokerage and so on. This is
obviously an unrealistic assumption. Since the sale of securities involves cost, to get current
income equivalent to the dividend, if paid, the investors would have to sell securities in
excess of income that they will receive.
b. Investment Decision and Financing Decision (December 2010)(2.5 Marks)

Investment decision refers to the capital expenditure decision. Companies lock up a large
amount of funds for future benefits as a result of the investment decision. It involves risk
and it changes the business risk complexion of a company. In addition, it brings about
changes in the composition of assets and determines the total amount of assets held by a
company. This has two important aspects: the evaluation of the profitability of the
project and measurement of cut off rate of return.
After determining the total financial requirement, a financial manager should decide
when, where from and how to raise funds to meet the financial requirement to implement
the investment decision. Funds can be raised from different sources like Short term or
Long term. Funds may be raised by issuing different instruments of debt such as bonds,
debenture, commercial papers and issuing common or preference shares. Cost of the fund
varies according to the sources. A financial manager should make appropriate mix up of
funds raised from different sources in order to minimize the overall cost of capital and
maximize the value of the firm.
c. External Capital Rationing and Internal Capital Rationing

Answer
External Capital Rationing mainly occurs on account of the imperfections in capital
markets. Imperfections may be caused be deficiencies in market information or by
rigidities of attitude that may hamper the free flow of capital. For example, A Ltd. is a
closely held company. It borrows from the financial institutions as much as it can. It still
103
has investment opportunities, which can be financed by issuing equity capital. But it
doesn't issue shares. The owners- managers do not approve the idea of the public issue of
shares because of the fear of losing control of the business.
Internal capital Rationing is caused by self- imposed restrictions by the management.
Various types of constraints may be imposed. e.g, it may be decided not to obtain
additional funds by incurring debt. This may be part of management's conservative
financial policy. Management may fix an arbitrary limit to the amount of funds to be
invested by the divisional managers. Sometimes, management may resort to capital
rationing by requiring a minimum rate of return higher than the cost of capital.
d. Capital planning and Capital rationing (December 2012 )( 2.5 Marks)

Answer:
A proper plan for a company's capital expenditures is called Capital Planning. Capital
expenditures are payments made over a period of more than one year. They are used to
acquire assets or improve the useful life of existing assets; an example of a capital
expenditure is the funding to construct a factory. Making a capital budget must
account for the potential profitability of the plans involved. Calculating the net present
value or the internal rate of return are two methods for determining a capital budget.
The act of placing restrictions on the amount of new investments or projects undertaken
by a company is called Capital Rationing. This is accomplished by imposing a higher
cost of capital for investment consideration or by setting a ceiling on the specific
sections of the budget. Companies may want to implement capital rationing in
situations where past returns of investment were lower than expected.
e. NPV and IRR (December 2013) ( 2.5 Marks)

Answer
Both NPV and IRR are techniques of capital budgeting decision. Under the NPV rule, we
discount the cash flows at a given rate which is normally the cost of capital and arrive at
NPV. Whereas, in IRR, we find a discount rate that makes NPV zero and compare this rate
with the cost of capital.
NPV is absolute measurement while IRR is a relative measurement of the project‘s worth.
NPV shows the project‘s worth in monetary term whereas IRR does in terms of rate of return
on investment. Theoretically, NPV shows how much the market value of the firm will rise if
projects are accepted and IRR shows what rate of return will the project yield if it is a
accepted. NPV assumes that cash flows are reinvested at required rate of return and IRR
assumes that they will be reinvested at project rate of return.
f. Replacement value and Market value (December 2015) (2.5 Marks)

Answer
Replacement Value is a amount that a company would be required to spend if it were to
replace its existing assets in its current condition. It is difficult to find cost of assets currently
being used by the company replacement value and is also likely to ignore the benefits of
intangibles and the utility of existing assets.
Market Value of an assets or securities is the current price at which the assets or the security
is being sold or bought in the market. Market value per share is expected to be higher than the
book value per share of profitable, growing firms. A number of factors influence the market

value per share, and therefore, it shows wide fluctuations. What is important is the long term
trend in the market value per share.
Question No 2:
Write short note on
a. Perpetuity Rate of Return (December 2010)(2.5 Marks)
Answer
Perpetuity Rate of Return - Perpetuity Rate of Return (PRR) is a conversion of
Profitability Index (PI) into a perpetuity percentage rate of return of a project. In other
words, it is PI of a project expressed in terms of the Perpetuity rate of return. So it is just
the product of PI and required rate of return from the project under consideration. It
gives the financial manager the instrument for the comparison among projects in
percentage terms. This method can be used to rank the projects of equal lives and risks.
But it is not useful to rank the mutually exclusive projects of unequal lives and different
risks.
b. Sensitivity Analysis (December 2011) ( 2.5 Marks)

Answer
The net present value or Internal Rate of Return of a project is determined by analyzing
the after tax cash flows arrived at by combining forecasts of various variables like Sales
volume, unit selling price, unit variable cost, fixed cost etc. It is difficult to arrive at an
accurate and unbiased forecast of each variable. It can't be certain about the outcome of
any of these variables. The reliability of the NPV or IRR of the project will depend on
the reliability of the forecasts of variables underlying the estimates of net cash flows. To
determine the reliability of the project's NPV or IRR, we can work out how much
difference it makes if any of these forecasts go wrong.. We can change each of the
forecasts, one at a time, to at least three values: Pessimistic, expected and optimistic. The
NPV of a project is recalculated under these different assumptions. The method of
recalculating NPV or IRR by changing each forecast is called Sensitivity Analysis.
Sensitivity Analysis is a way of analyzing change in the project's NPV or IRR for a
given change in one of the variables. It indicates how sensitive a project's NPV or IRR is
to changes in particular variables. It basically examines the sensitivity of the variables
underlying the computation of NPV or IRR rather than attempting to quantify risk. It can
be applied to any variable which is an input for the after tax cash flows. It can be
conducted with regard to volume, price, costs etc.
c. Project on Captial Rationing (June 2013) (December 2014) ( 2.5 Marks)

Answer
The capital rationing situation refers to the choice of investment proposals under financial
constraints in terms of given size of capital expenditure budget. The objective to select the
combination of projects would be the maximization of total NPV. The project selection under
capital rationing involves two stages
(i) Identification of the acceptable projects
(ii) Selection of the combination of projects.
The acceptability of projects can be based either on profitability index or IRR. The
105
method of selecting investment projects under capital rationing situation will depend upon
whether the projects are indivisible or divisible. In case the project is to be
accepted/rejected in its entirety, it is called an individual project; a divisible project, on the
other hand, can be accepted/ rejected in part.
Capital Rationing is the process hereby the limited funds available are allocated amongst the
financially viable projects which are not mutually exclusive under consideration so as to
maximize the wealth of the shareholders. Thus, capital rationing situation is said to exist if:
a) Limited funds are available for investment.
b) More than one financially viable projected which are not mutually exclusive are under
consideration
d. Profitability Index ( December 2014) ( 2.5 Marks)

Answer
Profitability index is an investment appraisal technique calculated by dividing the present
value of future cash flows of a project by the initial investment required for the project.
Profitability Index is calculated as follows:
Profitability index is actually a modification of the net present value method. While present
value is an absolute measure (i.e. it gives as the total figure for a project), the profitability
index is a relative measure (i.e. it gives as the figure as a ratio).
The decision rule is to accept a project if the profitability index is greater than 1, stay
indifferent if the profitability index is zero and don't accept a project if the profitability index
is below 1.
Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing
since it helps in ranking projects based on their per dollar return.
e. Modified Internal Rate of Return (June 2015) (2.5 Marks)

Answer
The Modified Internal Rate of Return (MIRR) is a financial measure of an investment's
attractiveness that attempts to obliterate the shortcomings of Internal Rate of Return. MIRR is
expected to resolve 2 issues associated with the Internal Rate of Return (IRR).
 The IRR makes an assumption that interim positive cash flows are reinvested at the
same rate of return, i.e., IRR. This is usually an unrealistic scenario and a more likely
situation is that the funds will be reinvested at a rate closer to the firm's cost of capital.
The IRR therefore often gives an unduly optimistic picture of the projects under
study.
 Where the projects bear alternating positive and negative cash flows, there will be
more than one IRR, which leads to the confusion and ambiguity.
It is calculated as under:

Or,
Practical Questions
Question No 3:
Growmore Ltd. is considering two projects, A and B, to undertake. The projects are mutually
exclusive and the firm can choose any one these two. There is a controversy at the top
management level of Growmore regarding the capital budgeting technique to be employed as
the basis for selection of the investment projects.
The finance director is of the view that the project with higher net present value (NPV)
should be chosen whereas the managing director strongly feels that the one with higher
internal rate of return (IRR) should be undertaken especially when the mutually exclusive
projects have the same initial outlay and length of life.
The company anticipates a cost of capital of 10% and the net after tax cash flow of the
projects (in ‗000 rupees) are as given below:
Projects _
Year A B
0 (-) 800 (-) 800
1 140 872
2 320 40
3 360 40
4 300 16
5 80 12

a) Calculate the NPV and IRR of each project;
b) Recommend, with reasons, which project should be undertaken (if either);
c) Explain the inconsistency in ranking of the two projects in the light of the remarks of the
directors; and
d) Identify the cost of capital at which your recommendation made in part (b) would be
reversed.
Following discount factors may be adopted:
Discount Year
Factor 0 1 2 3 4 5
At 10% 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209
At 15% 1.0000 0.8696 0.7561 0.6575 0.5718 0.4972
At 20% 1.0000 0.8333 0.6944 0.5787 0.4823 0.4019
107
Answer
(a) Computation of NPV and IRR:
Project A:
Discount Factors Cash Flow NPV at
Year 10% 15% 20%
10% 15% 20%
0 1.0000 1.0000 1.0000 – 800 – 800.00 – 800.00 – 800.00

1 0.9091 0.8696 0.8333 140 27.27 121.74 116.66
2 0.8264 0.7561 0.6944 320 264.45 241.95 222.21
3 0.7513 0.6575 0.5787 360 270.47 236.70 208.33
4 0.6830 0.5718 0.4823 300 204.90 171.54 144.69
5 0.6209 0.4972 0.4010 80 49.67 39.78 32.15
Total: 116.76 11.71 -75.96
Project B:
Discount Factors Cash Flow NPV at

Year 10% 15% 20%
10% 15% 20%
0 1.0000 1.0000 1.0000 – 800 – 800.00 – 800.00 – 800.00

1 0.9091 0.8696 0.8333 872 792.74 758.29 726.63
2 0.8264 0.7561 0.6944 40 33.06 30.24 27.76
3 0.7513 0.6575 0.5787 40 30.05 26.30 23.15
4 0.6830 0.5718 0.4823 16 10.93 9.15 7.72
5 0.6209 0.4972 0.4010 12 7.45 5.97 4.82
Total: 74.23 29.95 -9.82
From the above table, at 10% discount rate:
[ ]
NPV of Project A = Rs. 116,760
NPV of Project B = Rs. 74,230
Using interpolation method, IRR of individual projects are computed as follows:
Project A = 15% + [11.71/ 11.71 – (-75.96)] X 5%
= 15% + [11.71/ (11.71+ 75.96)] X 5%
= 15% + (11.71/ 87.67) X 5% = 15% + 0.67% = 15.67%
Project B = 15% + [(29.95/(29.95 + 9.82) X 5%]

= 15% + [(29.95/(39.77 + 9.82) X 5%]

= 15% + 29.95/ 39.77 X 5% = 15% + 3.77 % = 18.77%
Note: Using the rate of 10% and 20% rate for discounting, IRR derived for project A and B
will be 16.06% and 18.83% respectively.
(b) Recommendation on the Selection of Project:

Under NPV technique, project A has higher NPV (Rs. 116,760) as compared to project B
which has a NPV of Rs. 74,230. On the contrary, IRR of project B (18.77%) is much higher
than that of Project A which has an IRR of 15.67%.
The projects are mutually exclusive and conflicting rankings have occurred. In this situation,
NPV method will indicate the correct rankings due to certain limitation of IRR method as
explained under point (c). It is therefore recommended that project A should be selected for
implementation since it yields the higher NPV at a discount rate of 10%.
(c) Reasons for Inconsistency in the ranking of two Projects:

Such an inconsistency in the rankings generally occurs when the cash inflow in the project
with lower NPV is heavily loaded in the earlier years. That is exactly what has happened in
the case of Project B in the present case. Exactly, 88% of the cash inflow occurred in the first
year in this project whose NPV is lower as computed under point (a) above.
The superiority of NPV technique over the IRR method in such instances can be explained in
terms of the following factors:
(i) Percentage Returns: IRR expresses the results in percentage rather than in absolute or
monetary terms. Comparison of percentage can be misleading. For instance, an
investment of Rs. 500,000 that generates a return of 15 per cent is better than an
investment of Rs. 200,000 which yields a return of 30 per cent. If the two projects are
mutually exclusive, the first investment will yield Rs. 75,000 but the second will only
contribute Rs. 60,000 towards the profit pool of the firm. Therefore, if the objective is
to maximize the shareholders wealth, NPV is the correct measure.
(ii) Reinvestment assumptions: When NPV method is adopted, the implicit assumption is
that the cash flows generated from an investment will be reinvested at the cost of
capital. However, the IRR method assumes that all the proceeds from a project can be
reinvested to earn a return equal to the IRR of the original project. The underlying
assumption of NPV method is therefore more realistic as compared to the assumption
made in IRR method.
(d) Cost of Capital at which the Recommendation would be Reversed:

The cost of capital at which Project A would be preferred to Project B can be ascertained by
calculating the IRR on incremental investment, A – B.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Total
Particulars
(Rs. in ‗000)
Project A : Cash Flow – 800 140 320 360 300 80
Project B : Cash Flow – 800 872 40 40 16 12
109
Project (A – B) 0 –732 280 320 284 68
Discount Factor 10% 1.0000 0.9091 0.8264 0.7513 0.683 0.6209
NPV @ 10% 0 –665.46 231.39 240.42 193.97 42.22 42.54
Discount Factor 15% 1.0000 0.8696 0.7561 0.6575 0.5718 0.4972
NPV @ 15% 0 –636.55 211.71 210.40 162.39 33.81 –18.54
Using interpolation method, IRR on incremental investment
= [10% + 42.54/(42.54 + 18.24) X 5%] = 10% + 42.54/ 60.78 X 5%
= 10% + 3.5% = 13.5%
Thus, the IRR on incremental investment (A – B) is 13.5 per cent. This implies that the
decision recommended in (b) above would be reversed if the cost of capital were in excess of
13.5 per cent assuming that of the projects has a positive NPV.
Question No 4:
A plastic manufacturer has under consideration the proposal of production of high quality
plastic glasses. The necessary equipment to manufacture the glasses would cost Rs. 80,000.
Investment allowance rate on purchases of equipment is 20%. The production equipment
would last 5 years with no salvage value. The glasses can be sold at Rs. 3 each. Regardless of
the level of production, the manufacturer will incur cash costs of Rs. 25,000 each year, if the
project is undertaken. The overhead costs allocated to this new line would be Rs. 5,000. The
variable cost is estimated at Rs. 2.0 per glass. The manufacturer estimates it will sell about
75,000 glasses per year; the straight line method of depreciation will be used; the applicable
tax rate is 55%.
a) Calculate the cash outflows of the project.
b) Determine the project‘s total present value at 0, 10, 20, 30 and 40 percent discount
rate.
c) Present the net present value profile for the proposal.
d) Explore the relationship between Pay Back Reciprocal and IRR?
e) What is the basic assumption behind terminal Value Approach?
You can take the help of following PV table:
Year 10% 20% 30% 40%

1 0.909 0.833 0.769 0.714
2 0.826 0.694 0.592 0.51
3 0.751 0.579 0.455 0.364
4 0.683 0.482 0.35 0.26
5 0.621 0.402 0.269 0.186
(June 2011) ( 20 Marks)
Answer :
(i) Cash outflows:
Rs
Cost of new equipment purchases 80,000
Less: Investment Tax Credit (Rs16,000) x 55% 8,800
Net cash outflow 71,200

Cash inflows:
Rs
Sales Revenue 225,000
Less Costs:
Variable Costs 150,000
Additional Fixed Cost 25,000
Additional Depreciation 16,000
Earning Before Taxes 34,000
Less Taxes 18,700
Earning After Taxes 15,300
Add Depreciation 16,000
Cash Flow After Tax (t = 1 – 5) 31,300
(Note: Costs allocated from other departments will not be considered as they do not involve
any corresponding incremental cash outflows)
(ii) PV at different rates of discount:
Rate of discount PV factor Time (Years) CFAT Total PV
0 5 5-Jan 31,300 156,500
10 3.791 5-Jan 31,300 118,658
20 2.991 5-Jan 31,300 93,618
30 2.436 5-Jan 31,300 76,247
40 2.035 5-Jan 31,300 63,696
(iii) Net present value profile for the project:

Rate of discount NPV
0 Rs 85,300
10 47,458
20 22,418
30 5,046
40 -7,505
(iv)
The reciprocal of the pay back is a good approximation of the IRR. The pay back period
reciprocal can be applied to both annuity and mixed streams of cash flows. In case of annuity,
pay back period of the proposed investment project is determined and factor closest to the
pay back period in the year row is looked into. In case of mixed stream cash flows, average
annual cash inflow is first calculated and approximated IRR is determined with the help of
‗fake‘ pay back period.
(v)
111
Basic assumption behind the Terminal Value approach is that each cash inflow is re-invested
in another asset at a certain rate of return from the moment it is received until the termination
of the project.
Question No 5:
SC Co. is evaluating the purchase of a new machine to produce product P, which has a short
product life-cycle due to rapidly changing technology. The machine is expected to cost Rs. 1
million. Production and sales of product P are forecasted to be as follows:
Year 1 2 3 4
Production and sales (units) 35,000 53,000 75,000 36,000
The selling price of product P (in current price terms) will be Rs. 20 per unit, while the
variable cost of the product (in current price terms) will be Rs. 12 per unit. Selling price
inflation is expected to be 4% per year and variable cost inflation is expected to be 5% per
year. No increase in existing fixed costs is expected since SC Co. has spare capacity in both
space and labour terms.
Producing and selling product P will call for increased investment in working capital.
Analysis of historical levels of working capital within SC Co. indicates that at the start of
each year, investment in working capital for product P will need to be 7% of sales revenue
for that year.
SC Co. pays tax of 30% per year in the year in which the taxable profit occurs. Liability to
tax is reduced by capital allowances on machinery (tax-allowable depreciation), which SC
Co. can claim on a straight-line basis over the four-year life of the proposed investment. The
new machine is expected to have no scrap value at the end of the four-year period.
SC Co. uses a nominal (money terms) after-tax cost of capital of 12% for investment
appraisal purposes.
Required:
i. Calculate the net present value of the proposed investment in new machine for
production of product P.
ii. Calculate the internal rate of return of the proposed investment in new machine for
production of product P.
iii. Advise on the acceptability of the proposed investment in new machine for production
of product P and discuss the limitations of the evaluations that have been carried out.
Answer:
a) Calculation of net present value
Year 0 1 2 3 4
Rs. Rs. Rs. Rs. Rs.
Sales revenue (WN 1) 728,000 1,146,390 1,687,500 842,400
Variable costs (WN 2) (441,000) (701,190) (1,041,750) (524,880)

––––––––– –––––––––– ––––––––––– ––––––––

–
Contribution 287,000 445,200 645,750 317,520
Capital allowances (depreciation)
(Cost ÷ 4) (250,000) (250,000) (250,000) (250,000)
––––––––– –––––––––– ––––––––––– ––––––––
–
Taxable profit 37,000 195,200 395,750 67,520
Taxation (11,100) (58,560) (118,725) (20,256)
––––––––– –––––––––– ––––––––––– ––––––––
–
After-tax profit 25,900 136,640 277,025 47,264
Capital allowances 250,000 250,000 250,000 250,000
––––––––– –––––––––– ––––––––––– –––––––––
After-tax cash flow 275,900 386,640 527,025 297,264
Initial investment (1,000,000)

Working capital (WN 4) (50,960) (29,287) (37,878) 59,157 58,968
––––––––––– ––––––––– –––––––––– ––––––––––– ––––––
Net cash flows (1,050,960) 246,613 348,762 586,182 356,232
PVIF at 12% 1·000 0·893 0·797 0·712 0·636
––––––––––– ––––––––– –––––––––– ––––––––––– ––––––
Present values (1,050,960) 220,225 277,963 417,362 226,564
––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––
NPV = Rs. 91,154
Working Notes:
1) Sales revenue
Year 0 1 2 3 4
Selling price (Rs./unit) 20.00 20·80 21·63 22·50 23·40
(expected to increase @ 4% per year)
Sales volume (units) - 35,000 53,000 75,000 36,000
Sales revenue (Rs.) - 728,000 1,146,390 1,687,500 842,400
2) Variable costs
Year 0 1 2 3 4
Variable cost (Rs./unit) 12.00 12·60 13·23 13·89 14·58
(expected to increase @ 5% per year)
Sales volume (units) - 35,000 53,000 75,000 36,000
Variable costs (Rs.) - 441,000 701,190 1,041,750 524,880
3) Total investment in working capital

Year 0 investment = 728,000 x 0·07 = Rs. 50,960
Year 1 investment = 1,146,390 x 0·07 = Rs. 80,247
Year 2 investment = 1,687,500 x 0·07 = Rs. 118,125
Year 3 investment = 842,400 x 0·07 = Rs. 58,968
113
4) Incremental investment in working capital
Year 0 investment = 728,000 x 0·07 = (Rs.50,960))
Year 1 investment = 80,247 – 50,960 = (Rs. 29,287)
Year 2 investment = 118,125 – 80,247 = (Rs. 37,878)
Year 3 recovery = 58,968 – 118,125 = Rs. 59,157
Year 4 recovery = Rs. 58,968
(b) Calculation of internal rate of return

Year 0 1 2 3 4
Rs. Rs. Rs. Rs. Rs.
Net cash flows (1,050,960) 246,613 348,762 586,182 356,232
PVIF at 20% 1·000 0·833 0·694 0·579 0·482
––––––––––– –––––––– –––––––– –––––––– ––––––––
Present values (1,050,960) 205,429 242,041 339,399 171,704
––––––––––– –––––––– –––––––– –––––––– ––––––––
NPV at 20% = (Rs.92,387)
NPV at 12% = Rs.91,154
IRR = 12 + [(20 – 12) x 91,154/(91,154 + 92,387)] = 12 + 4 = 16%(Approx.)

(c) Acceptability of the proposed investment in new machine production of Product P
The NPV is positive. Hence, the proposed investment can be recommended on financial
grounds.
The IRR is greater than the discount rate used by SC Co for investment appraisal purposes.
Hence, the proposed investment is financially acceptable. The cash flows of the proposed
investment are conventional and so there is only one internal rate of return. Furthermore, only
one proposed investment is being considered. Therefore, there is no conflict between the
advice offered by the IRR and NPV investment appraisal methods.
Limitations of the investment evaluations
 Both the NPV and IRR evaluations are heavily dependent on the production and sales
volumes that have been forecast and so SC Co should investigate the key assumptions
underlying these forecast volumes. It is difficult to forecast the length and features of
a product‘s life cycle so there is likely to be a degree of uncertainty associated with
the forecast sales volumes. Scenario analysis may be of assistance here in providing
information on other possible outcomes to the proposed investment..
 The inflation rates for selling price per unit and variable cost per unit have been
assumed to be constant in future periods. In reality, interaction between a range of
economic and other forces influencing selling price per unit and variable cost per unit
will lead to unanticipated changes in both of these project variables. The assumption
of constant inflation rates limits the accuracy of the investment evaluations and could
be an important consideration if the investment were only marginally acceptable.
 Since no increase in fixed costs is expected because SC Co has spare capacity in both
space and labour terms, fixed costs are not relevant to the evaluation and have been
omitted. No information has been offered on whether the spare capacity exists in

future periods as well as in the current period. Since production of Product P is

expected to be more than double over three years, future capacity needs should be
assessed before a decision is made to proceed, in order to determine whether any
future incremental fixed costs may arise.
Question No 6:
South China Corporation is evaluating on investment projects for investment in new
machinery to produce a recently-developed product. The cost of the machinery, which
is payable immediately, is Rs. 1.5 million, and the scrap value of the machinery at the
end of four years is expected to be Rs. 100,000. Capital allowances (tax- allowable
depreciation) can be claimed on this investment on a 25% reducing balance basis.
Information on results from the investment has been forecast to be as follows:
Year 1 2 3 4
Sales volume (units/year) 50,000 95,000 140,000 75,000
Selling price (Rs./unit) 25 24 23 23
Variable cost (Rs./unit) 10 11 12 12· 50
Fixed costs (Rs./year) 105,000 115,000 125,000 125,000
This information must be adjusted to allow for selling price inflation of 4% per year and
variable cost inflation of 2.5% per year. Fixed costs, which are wholly attributable to
the project, have already been adjusted for inflation. South China Corporation pays
profit tax of 30% per year on one year in arrears.
South China Corporation has a nominal before-tax weighted average cost of capital of
12% and a nominal after-tax weighted average cost of capital of 7%.
Required:
Calculate the net present value of the project and comment on whether this project is
financially acceptable to South China Corporation. (December 2012)(9 Marks)
Answer
Calculation of net present value (NPV)
As nominal after-tax cash flows are to be discounted, the nominal after-tax weighted
average cost of capital of 7% must be used.
Calculation of Net Present Value (Rs.)
Particular Year 1 2 3 4 5
Sales revenue WN 1 1,300,000 2,466,200 3,621,800 2,018,250
- -
Variable costs WN 2 -512,500 -1,098,200
1,808,800 1,035,000
Contribution 787,500 1,368,000 1,813,000 983,250
Fixed costs -105,000 -115,000 -125,000 -125,000
Taxable cash flow 682,500 1,253,000 1,688,000 858,250
-
Tax liabilities -204,750 -375,900 -506,400
257,475
CA tax benefits WN 3 112,500 84,375 63,281 159,844
After-tax cash flow 682,500 1,160,750 1,396,475 415,131 -97,631
Scrap value 100,000
115
Net cash flow 682,500 1,160,750 1,396,475 515,131 -97,631
DF at 7% 0.9346 0.8734 0.8163 0.7629 0.713
Present values 637,865 1,013,800 1,139,943 392,993 -69,611
Present Value of Cash inflows = Rs.3,114,990

Cost of Machine = Rs.1,500,000
Net Present Value (NPV) = Rs.1,614,990
The project has a positive NPV of Rs. 1,614,990, so it is financially acceptable to South
China Co. However, as this is a recently-developed product, it may be appropriate to use
a project-specific discount rate that reflects the risk of the new product launch.
Working Note 1: Calculation of inflation adjusted Sales Revenue

Year 1 2 3 4
Price Inflation 100% 104% 108.16% 112.49% 116.99%
Selling price (Rs./unit) 25· 00 24· 00 23· 00 23· 00
Inflated selling price (Rs./unit) 26· 00 25· 96 25· 87 26· 91
Sales revenue (Rs./year) 1,300,000 2,466,200 3,621,800 2,018,250
Working Note 2: Calculation of inflation adjusted Variable Cost

Year 1 2 3 4
Price Inflation 100% 102.50% 105.06% 107.69% 110.38%
Variable cost (Rs./unit) 10· 00 11· 00 12· 00 12· 50
Inflated variable cost (Rs./Unit) 10· 25 11· 56 12· 92 13· 80
Variable costs (Rs./year) 512,500 1,098,200 1,808,800 1,035,000
Working Note 3: Calculation of capital allowance tax-benefits

Year 1 2 3 4
Capital Assets (Depreciation base) (Rs.) 1,500,000 1,125,000 843,750 532,812*
Depreciation Rate 0.25 0.25 0.25

Depreciation Amount (Rs.) 375,000 281,250 210,938 532,812
Tax Rate 0.3 0.3 0.3 0.3
Capital allowance tax benefits (Can be
112,500 84,375 63,281 159,844
adjusted in the year of relevant tax payable)
*Note: Capital base for 4th year = 843,750-210,938-100,000 = 532,812
Question No 7:
PQR Limited deals in mines and geological survey. It is considering the following
investment proposals for mining:
Project Cash Flows

Year 0 Year 1 Year 2 Year 3

A -10000 10000 Nil Nil
B -10000 7500 7500 Nil
C -10000 2000 4000 12000
D -10000 10000 3000 3000
Assume Discount Rate of 10 per cent.
Required:
i) Rank the projects according to each of the following methods:
 Internal Rate of Return (IRR)
 Net Present Value (NPV)
ii) Assuming the projects are independent, which one should be accepted? If the
projects are mutually exclusive, which project is the best? (December 2012) (10 Marks)
Answer
a) i) Cash Flows of Projects
Year A B C D
0 -10,000 -10,000 -10,000 -10,000
1 10,000 7,500 2,000 10,000
2 - 7,500 4,000 3,000
3 - - 12,000 3,000
Discounted Cash Flows of Projects:

Year DF at 10% A B C D
0 1 -10,000 -10,000 -10,000 -10,000
1 0.909 9,090 6,818 1,818 9,090
2 0.826 - 6,195 3,304 2,478
3 0.751 - - 9,012 2,253
NPV -910 3,013 4,134 3,821
Rank IV III I II
IRR calculations:
Project A: The net cash proceeds in year 1 is just equal to the initial investment, therefore,
IRR = 0% For Project B, C & D Trying for NPV at DF of 40%
Year DF at 40% DCF of B DCF of C DCF of D
0 1.00 -10,000 -10,000 -10,000
1 0.71 5,355 1,428 7,140
2 0.51 3,825 2,040 1,530
3 0.36 - 4,368 1,092
NPV -820 -2,164 -238
IRR (B) = LR + × (HR – LR)
117
=10 + (40-10)
=10+23.58
= 33.58% (Rank =II)
IRR (C) =10 + (40-10)
=29.69% (Rank= III)
IRR (D) =10 + (40-10)
=35.83% (Rank=I)
ii) Between, the two time-adjusted (Discounted cash flow) investment criteria, NPV
and IRR, NPV gives the consistent results. If the projects are independent, either IRR
or NPV method can be used since the same set of projects will be accepted by any of
the methods. In the present case, except Project A all the three projects should be
accepted if the discount rate is 10%. Under the assumption of 10% discount rate and
mutually exclusive projects, rankings according to IRR and NPV conflicts (except for
Project A). If we follow the IRR rule, Project D should be accepted. But the NPV rule
says that Project C is the best.
Since the NPV rule gives consistent results in conformity with the wealth
maximization principle, we would therefore accept Project C following the NPV rule.
Question No 8:
D Co. needs to increase production capacity to meet increasing demand for an existing
product, ‗Q‘, which is used in food processing. A new machine, with a useful life of four
years and a maximum output of 600,000 kgs. of Q per year, could be bought for Rs. 800,000,
payable immediately. The scrap value of the machine after four years would be Rs. 30,000.
Forecast demand of Q over the next four years is as follows:
Year 1 2 3 4
Demand (kg.) 1.4 million 1.5 million 1.6 million 1.7 million
Existing production capacity for Q is limited to one million kilograms per year, and the new
machine would only be used for catering demand additional to this. The current selling price
of Q is Rs. 8.00 per kilogram and the variable cost of materials is Rs. 5.00 per kilogram.
Other variable costs of production are Rs. 1.90 per kilogram. Fixed costs of production
associated with the new machine would be Rs. 240,000 in the first year of production,
increasing by Rs. 20,000 per year in each subsequent year of operation. D Co. pays tax one
year in arrears at an annual rate of 30% and can claim capital allowances (tax-allowable
depreciation) on a 25% reducing balance basis. The balancing allowance is claimed in the
final year of operation of new machine.
D Co. uses its after-tax weighted average cost of capital when appraising investment projects.
It has a cost of equity of 11% and a before-tax cost of debt of 8.6%. The long-term finance of
the company, on a market-value basis, consists of 80% equity and 20% debt.
Required: (June 2012)( 20 Marks)

a) Calculate the net present value of buying the new machine and advise on the acceptability
of the proposed purchase.
b) Calculate the internal rate of return of buying the new machine and advise on the
acceptability of the proposed purchase
c) What are the limitations of the investment appraisal made in (a) and (b) above? Explain
how they can be addressed.
Answer No.
a) Net present value evaluation of investment
After-tax weighted average cost of capital (%) = (11 x 0·8) + (8·6 x (1 – 0·3) x 0·2)
= 8.8 + 1.20 =10% (approx.)
(Figure in Rs.)
Year 1 2 3 4 5
Contribution 440,000 550,000 660,000 660,000 -
Fixed costs -240,000 -260,000 -280,000 -300,000 -
Taxable cash flow
290,000 380,000 360,000 -
200,000
Taxation@30% - -60,000 -87,000 -114,000 -108,000
CA tax benefits - 60,000 45,000 33,750 92,250
Scrap value 30,000
After-tax cash flows 200,000 290,000 338,000 309,750 -15,750
DF at 10% 0·909 0·826 0·751 0·683 0·621
Present values 181,800 239,540 253,838 211,559 -9,781
Rs.
Present value of benefits 876,956
Initial investment -800,000
Net present value 76,956
Advice:
The net present value is positive and so the investment is financially acceptable.
Working Note 1: Calculation of Annual contribution
Year 1 2 3 4
Excess demand (kg/yr) 400,000 500,000 600,000 700,000
New machine output (kg/yr) 400,000 500,000 600,000 600,000*
Contribution (Rs./kg) Rs. (8 – 5 –
1·1 1·1 1·1 1·1
1.9)
Contribution (Rs./yr) 440,000 550,000 660,000 660,000
*Maximum output from new machine.
Working Note 2: Capital allowance (CA) tax benefits
Year Capital allowance (Rs.) Tax benefit (Rs.)
119
1 200,000 (800,000 x 0·25) 60,000 (0·3 x 200,000)
2 150,000 (600,000 x 0·25) 45,000 (0·3 x 150,000)
3 112,500 (450,000 x 0·25) 33,750 (0·3 x 112,500)
462,500
30,000 (scrap value)
492,500
4 307,500 (by difference) 92,250 (0·3 x 307,500)
800,000
b) Internal rate of return evaluation of investment (Using trial discount factor

at 20%)
Year 1 2 3 4 5
After-tax cash flows (as in (a) above 200,000 290,000 338,000 309,750 -15,750
Discount factor at 20% 0·833 0·694 0·579 0·482 0·402
Present values 166,600 201,260 195,702 149,300 -6,332
Rs.
Present value of benefits 706,530
Initial investment -800,000
Net present value -93,470
Internal rate of return = 10 + [((20 – 10) x 76,956)/(76,956 + 93,470)] = 10 + 4·52= 14·52%

Advice:
The investment is financially acceptable since the internal rate of return is greater than
the cost of capital used for investment appraisal purposes.
c) The limitations of the above investment appraisal are:
i) Maximum output constraint of the proposed investment, which is insufficient to
address the increasing demand in year four and onwards.
ii) Uncertainty about the required additional investment to address the additional
demand in year 4 and onwards.
iii) Constant selling price and variable cost but increasing fixed cost and demand.
They can be addressed by:

i) Assumption of constant selling price and variable cost of the product.
ii) Assumption of linear increase in fixed production cost and demand of the product.
iii) Including necessary cost of additional investment required in year 4 and onward.
Question No 9:
BRT Co. has developed a new confectionery line that can be sold for Rs. 5 per box and that
is expected to have continuing popularity for many years. The finance manager of the
company proposed that the investment in the new product should be evaluated over a four
year time horizon, even though sales would continue after the fourth year on the ground that
cash flows after fourth years are too uncertain to be included in the evaluation.
The average variable and fixed costs will depend on sales volume as follows:
less than 1 1–1·9 2–2·9 3–3·9
Sales volume (boxes)
million million million million

Variable cost (Rs. per box) 2·80 3·00 3·00 3·05

Total fixed costs (Rs. in million) 1 1·8 2·8 3·8
Forecast sales volumes are as follows:
Year 1 2 3 4
Sales Volume (boxes) 0·7 million 1·6 million 2·1 million 3·0 million
The production equipment for the new confectionery line would cost Rs. 2 million and an
additional initial investment of Rs. 750,000 would be needed for working capital. Capital
allowances (tax-allowable depreciation) on a 25% reducing balance basis could be claimed
on the cost of equipment. Profit tax of 25% per year will be payable one year in arrear. A
balancing allowance would be claimed in the fourth year of operation. BRT Co. uses a
nominal after-tax cost of capital of 12% to appraise new investment projects.
Required:
a) Assuming that production only lasts for four years, calculate the net present value of
investing in the new product line using a nominal terms approach and advise on its
financial acceptability (work to the nearest Rs. 1,000).
b) Comment briefly on the proposal to use a four-year time horizon to evaluate the project,
and calculate and discuss a value that could be placed on the after-tax cash flows arising
after fourth year of operation, using a perpetuity approach. Assume, for this part of the
question only, that before-tax cash flows and profit tax are constant from year five
onwards, profit taxes are payable in the same year and that capital allowances and working
capital can be ignored. (June 2013) (20 Marks)
Answer
a) Net present value evaluation of new confectionery investment (Rs. ‗000)
Year 1 2 3 4
Sales (WN1) 3,500 8,000 10,500 15,000
Variable cost(WN2) (1,960) (4,800) (6,300) (9,150)
1,540 3,200 4,200 5,850
Fixed costs (WN3) (1,000) (1,800) (2,800) (3,800)
Taxable cash flow 540 1,400 1,400 2,050
Less: Tax@ 25% - (135) (350) (350)
Add: CA tax benefit(WN4) - 125 94 70
540 1,390 1,144 1,770
Add: Working capital released - - - 750
540 1,390 1,144 2,520
PVIF@12% 0.893 0.797 0.712 0.636
(Rs. ‗0000)
Sum of present values 4,008
Less: cost of Equipment [At year 0] =(2,000) (2,000×1.00) -2,000
WC tied up [At year 0] = (750×1.00) -750
Net present value 1,258
Advice: The proposed investment in the new product is financially acceptable, as the NPV is
positive. Working Notes:
121
1) Calculation of sales
Year 1 2 3 4
Sales volume (boxes) 700,000 1,600,000 2,100,000 3,000,000
selling price (/box) (Rs.) 5 5 5 5
Sales (/yr) Rs. ‗000 3,500 8,000 10,500 15,000
2) calculation of variable cost

Year 1 2 3 4
Variable cost per box (Rs.) 2.80 3.00 3.00 3·05
Variable cost (/yr) Rs. ‗000 1,960 4,800 6,300 9,150
3) Calculation of fixed costs

Year 1 2 3 4
Fixed costs (Rs. ‗000) 1,000 1,800 2,800 3,800
4) Calculation of Deprecation & tax benefits

Year 1 2 3 4
Capital allowance(Depn) 500,000 375,000 281,250 843,750
Tax benefit (25%) 125,000 93,750 70,312.50 210,937.50
Tax benefit (Rs. ‗000) 125 94 70 211
b) The proposal to use a four-year time horizon

The finance manager believes that cash flows are too uncertain after four years to be included
in the net present value calculation, even though sales will continue beyond four years.
While it is true that uncertainty increases with project life, cutting off the analysis after
four years will underestimate the value of the investment to the extent that cash flows after
the cut-off point are ignored. Furthermore, since the new confectionery line is expected to
be popular, cash flows after year four could be substantial, increasing the extent of the under
valuation. Artificially terminating the evaluation after four years has accelerated the recovery
of working capital and has also led to a large balancing allowance. These increased cash
flows, which arise in years four and five respectively, will overestimate the value of the
investment.
The value of cash flows after the fourth year of operation:

The approach here should be to calculate the present value of the expected future cash flows
beyond year four. If the before-tax cash flows are assumed to be constant and if the one-
year delay in tax liabilities is ignored, the year four present value of future cash flows
beyond year four can be estimated using a perpetuity approach. The year four present value
of cash flows from year five onwards will be: 2,050 x (1 – 0·25)/0·12 = 12,813 (Rs. ‗000)
The year zero present value of these cash flows = 12,813x 0·636 = 8,149 (Rs. ‗000)
Although these calculations ignore the capital allowance tax benefits (which will
decrease each year) and the incremental investment in working capital (which will
increase slightly each year), the present value of cash flows after year four is still
substantial.

Question No 10:
The Cash flows of two mutually exclusive projects are as under:
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

P (40,000) 13,000 8,000 14,000 12,000 11,000 15,000
J (20,000) 7,000 13,000 12,000 - - -
Required:
a) Estimate the net present value of the project "P" and "J" using 15% as burled rate, and
state which project should be chosen.
b) Estimate the internal rate of return of the project "P" and "J", and state which project
should be chosen.
c) Why is there a conflict in the project choice by using net present value and internal rate of
return criterion?
d) What method will you use in such a conflicting situation? Show your calculation and also
make the project choice. (December 2013) ( 20 Marks)
Answer:
a) Estimation of NPV of the projects P and J

Year Discounting factor @15% Project P Project J
Cash flow(Rs.) P.V.(Rs.) Cash flow(Rs.) P.V.(Rs.)
0 1 -40,000 -40,000 -20,000 -20,000
1 0.8696 13,000 11,305 7,000 6,087
2 0.7561 8,000 6,049 13,000 9,829
3 0.6575 14,000 9,205 12,000 7,890
4 0.5718 12,000 6,862 - -
5 0.4972 11,000 5,469 - -
6 0.4324 15,000 6,486 - -
Net Present Value 5,376 3,806
On the basis of NPV, project P is desirable.
b) Estimation of Internal Rate of Return of projects P and J:

For Project P
Average Cash Flow of Project P is as follows:
= (13,000+8,000+14,000+12,000 +11,000+15,000)/6
= Rs. 73,000/6
= Rs. 12,167
Factor to be located =40,000/12,167= 3.2876
The nearest rate of return for 3.2876 in compound value table is shown at 22%. We can use
the cash flow values for discounting at 20% by trial and error method as given in the
problem. While discounting, we get Rs.278 negative as NPV. Thus the IRR would be as
follows:
IRR for Project P = 15+[5376/ (5376+278)] x 5
=19.75%
123
For Project J
Average Cash Flow of Project J is as follows:
(7,000+13,000+12,000)/3= Rs. 32,000/3= Rs. 10,667
Factor to be located =20,000/10,667= 1.875
The nearest rate of return for 1.875 in compound value table is shown at 24%. We can use the
cash flow values for discounting at 26% by trial and error method as given in the problem.
While discounting, we get Rs. 256 negative as NPV. Thus the IRR would be as follows:
IRR for Project J = 15+ [3,806/(3,806+256)]×11

=25.31%
On the basis of IRR, project J is desirable.
c) Reason for conflict in NPV and IRR criterion: Conflict between the results of NPV and
IRR arises:
 If the project has multiple cash outflows;
 When there are mutually exclusive projects under consideration;
 When projects have unequal lives or scale of investment;
 When projects are borrowing and not lending.
 In the given case, above (b) and (c) situations apply.
The selection of project using NPV is more realistic than IRR. The wealth maximization
concept is taken into consideration in NPV method, and it is based on financial manager‘s
judgment.
d) Where there are unequal lives, unequal scale of investment, projects are mutually
exclusive and there arises the conflict in selection of projects using NPV and IRR, we can use
Equivalent Annual Value Method for project selection as follows:
Equivalent Annual Value of Project P

= NPV/Cumulative P.V. of Re.1 p.a. @15% for 6 years
= Rs. 5,376/3.7845=Rs. 1,420.
Equivalent Annual Value of Project J

= NPV/Cumulative P.V. of Re.1 p.a. @15% for 3 years
= Rs. 3,806/2.2832=Rs. 1,667
Selection of Project:
Since the Equivalent Annual Value of Project J is higher than Project P as calculated above,
we may select Project J. It will minimize risk of uncertain future.
Question No 11:
Following are the data on a capital project being evaluated by the Management of Sagun Ltd.
A Annual Cost Saving Rs. 40,000
B Useful Life 4 years
C Internal Rate of Return 15%
D Profitability Index 1.064
E Net Present Value ?
F Cost of Capital ?
G Cost of Project ?

H Payback ?
I Salvage Value Nil
Required:
Find the missing value considering the following table of discount factor only
Discount Factor 15% 14% 13% 12%
1 year 0.869 0.877 0.885 0.893
2 Year 0.756 0.769 0.783 0.797
3 Year 0.658 0.675 0.693 0.712
4 Year 0.572 0.592 0.613 0.636
2.855 2.913 2.974 3.038
(June 2014 ) ( 5 Marks)
Answer
(i) Calculation of Cost of Project
Let cost of project be x
Cost of Project at IRR 15% is equal to PV of Cash Inflow (Annual Cost Saving)
X =Rs.40, 000×2.855
=Rs.1, 14,200
(ii) Calculation of Pay Back period

Pay Back Period = Cost of Project/ Annual Cash Inflow
=Rs.1,14,200/Rs.40,000
=2.855 years
(iii) Calculation of PV of Cash Inflow

Profitability Index =PV of Cash Inflow/PV of Cash Outflow
PV of Cash Inflow = 1.064 ×Rs.1, 14,200
=1, 21,509
(iv) Calculation of Net Present Value

NPV = PV of Cash Inflow-PV of Cash Outflow
=Rs.1, 21,509-Rs.1, 14,200
=Rs.7, 309
(v) Calculation of Cost of Capital

PV of Cash Inflow = Annual Cash Inflow×PVF for 4 years at Cost of Capital
PVF for 4 years = Rs.1,21,509/Rs.40,000
=3.0378
Cost of copied = 12 %
Question No 12:
Beta Company Limited is considering replacement of its existing machine by a new machine
which is expected to cost Rs. 264,000. The new machine will have a life of five years and
will yield annual cash revenues of Rs. 568,750 and incur annual cash expenses of Rs.
295,750. The estimated salvage value of the new machine is Rs. 18,200. The existing
machine has a book value of Rs. 91,000 and can be sold for Rs. 45,500 today.
The existing machine has a remaining useful life of five years. The annual cash revenues
from this machine will be Rs. 455,000 and associated annual cash expenses will be Rs.
125
318,500. The existing machine will have a salvage value of Rs. 4,550 at the end of its useful
life.
The company is in 25% tax bracket, and writes off depreciation at 25% on written-down
value method.
The company has a target debt to total capital ratio of 15%. It has raised debt at 11% in the
past and it can raise fresh debt at 10.5%. The company plans to follow dividend discount
model to estimate the cost of equity capital. It further plans to pay a dividend of Rs. 2 per
share in the next year. The dividend per equity share of the company is expected to grow at
8% p.a. The current market price of the company's equity share is Rs. 20 per equity share.
Required:
a. Compute the weighted average cost of the capital of the company.
b. Compute the incremental cash flows for replacement decision.
c. Find out the net present value of the replacement decision.
d. Estimate the discounted payback period of the replacement decision.
e. Should the company replace the existing machine? Advise.
Answer
Computation of Weighted average cost of capital of the company (WACC)
Ke = D1/P0 + g
=2/20 + 0.08
= 0.18 = 18%
Kdt = 10.5%×(1-0.25)
= 7.875%
WACC= Kd×D/(D+E) + Ke×E/(D+E) =(7.875%×15%) + (18%× 85%) =1.18% + 15.3%

=16.48%
(b& c) Incremental cash flow and NPV of replacement decision

Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Incremental Initial Cash Outlay (WN
-207,125
1)
Incremental Revenue (WN 2) 113,750 113,750 113,750 113,750 113,750
Saving in Expenses (W.N 2) 22,750 22,750 22,750 22,750 22,750
Less: Incremental Depreciation (W.N
43,250 32,437 24,328 18,246 13,685
3)
Earnings before Tax 93,250 104,063 112,172 118,254 122,815
Less: Tax @ 25% 23,313 26,016 28,043 29,564 30,704
Earnings after Tax 69,937 78,074 84,129 88,690 92,111
Add: Incremental Depreciation 43,250 32,437 24,328 18,246 13,685
Add: Incremental salvage value
(18200-
4550) 13,650
Add: Incremental Tax Saving on Loss

on Sale(W.N 4) 6,851

Incremental cash flows -207,125 113,187 110,511 108,457 106,936 126,297

PV [email protected]% 1 0.86 0.74 0.636 0.547 0.47
Present Value -207,125 97,341 81,778 68,979 58,494 59,360
NPV 158,827
Calculation of Discounted PBP of replacement decision:
Year Cumulative PV (Rs.)

0 (158,827)
1 (109,784)
2 (28,006)
3 40,973
4 99,467
5 158,827
Discounted Payback Period
2 Years + Cumulative PV of Cash flows in 2nd Year PV of Incremental Cash flow in 3rd Year
2 years + 28,006/68,979
2.406 years or 2 Years 5 months (approx)
The company should replace the machine since the incremental NPV of the decision is
positive and discounted PBP is much lower than the life of the machine.
Working Notes:
Incremental initial cash outlay
Purchase price of new machine = Rs. 264,000
Less: Current sales price of old machine = Rs. 45,500
BSV- 91,000
CSV- 45,500
Loss 45,500
Tax Saving on due to loss (45,500*25%) =Rs 11,375
Incremental initial cash outlay = Rs. 207,125
Calculation of incremental revenue and saving in expenses
Annual Incremental revenue = Rs. 568,750– Rs. 455,000

= Rs. 113,750
Annual Saving in expenses = Rs. 318,500- Rs. 295,750
=Rs.22,750
Calculation of incremental depreciation

Depreciation of new machine Depreciation of Old machine Difference
Year
(Rs.) (Rs.) (Rs.)
1 264,000 × 25% = 66,000 91,000×25% = 22,750 43,250
127
2 198,000× 25%= 49,500 68,250 ×25%=17063 32,437
3 148,500× 25%= 37,125 51,187 × 25%=127,97 24,328
4 111,375× 25%= 27,844 38,390 × 25%=9,598 18,246
5 83,531× 25%= 20,883 28,792 × 25%= 7,198 13,685
4. Incremental loss on sale at the end of 5th year

BV of new machine = Rs. 83,531 –Rs. 20,883 = Rs. 62,648
Less : BV of old machine = Rs. 28,792 –Rs.7,198 = Rs. 21,594
Incremental book value = Rs. 41,054
Less: Incremental sales value = Rs. 18,200 –Rs. 4550 = Rs. 13,650
Incremental loss = Rs. 27,404
Tax savings @ 25% = Rs. 6,851
Question No 13:
After the recent earthquake, there has been a massive demand for the pre-fab materials.
Bharat & Company is considering a new project for manufacturing of pre-fab materials
involving a capital expenditure of Rs. 600 lakh and working capital of Rs. 150 lakh. The
capacity of the plant is for an annual production of 12 lakh units and capacity utilization
during the 6-year life of the project is expected to be as indicated below:
Year 1 2 3 4-6
Capacity Utilization (%) 33.33 66.67 90 100
The average price per unit of the product is expected to be Rs. 200 netting a contribution of
40 percent. The annual fixed cost, excluding depreciation, are estimated to be Rs. 480 lakh
from the third year onwards; for the first and second year it would be Rs. 240 lakh and Rs.
360 lakh respectively. The average rate of depreciation for tax purpose is 33.33% on WDV of
the capital assets. The rate of income tax is 25%. The cost of capital is 15%.
At the end of third year, an additional investment of Rs. 100 lakh would be required for
working capital.
Expected terminal value for the fixed assets and the current assets are 10% and 100%
respectively.
Required:
As a financial consultant, what recommendation on the financial viability of the project
would you make to Bharat & Company on the basis of NPV, IRR and discounted pay back
criterion?
(June 2015) ( 20 marks)
Answer
a) Calculation of Depreciation
(Rs. In lakhs)
Value/WDV at the Depreciation WDV @
Year beginning 33.33% on WDV WDV at the end
1 600 200 400
2 400 133 267
3 267 89 178
4 178 59 119

5 119 40 79
6 79 26 53
b) Calculation of effective sale proceeds of Fixed assets (Rs. lakh)

Sale proceeds of fixed assets (10% of cost) 60.00
Less: Written down value (53.00)
Profit on sale of fixed assets 7
Less: Tax on profit @25% (1.75)
Effective sale proceeds (60-1.75) 58.25
c) Calculation of cash Outflows (Rs. lakh)

Initial capital expenditure 600
Add: Working capital required at the beginning 150
750
Add: P.V. of working capital required at the end of 3rd year 66
(100*0.658)
P.V. total investment 816
d) Calculation of cash inflows and the present value
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Sales unit (% capacity
utilization) 400,000 800,000 1,080,000 1,200,000 1,200,000 1,200,000
Selling price (Rs.) 200 200 200 200 200 200
(Rs.
in lakh)
Sales revenue 800 1,600 2,160 2,400 2,400 2,400
Less: Variable cost (60%
of Sales) (480) (960) (1,296) (1,440) (1,440) (1,440)
Contribution 320 640 864 960 960 960
Less: Fixed cost (240) (360) (480) (480) (480) (480)
EBTDA 80 280 384 480 480 480
Less: Depreciation (from
a) above) (200) (133) (89) (59) (40) (26)
Earning before tax (120) 147 295 421 440 454
Less: Tax @ 25% 30 (36.75) (73.75) (105.25) (110) (113.50)
Earnings after tax (90) 110.25 221.25 315.75 330 340.50

Add: Working capital
recovery (150+100) - - - - - 250
Add: sale proceeds of
fixed assets (from (b)
above) - - - - - 58.25
Add: Depreciation add- 200 133 89 59 40 26
129
back
Cash inflows 110 243.25 310.25 374.75 370 674.95
PV factor @ 15% 0.87 0.756 0.658 0.571 0.497 0.432
Present values 95.70 183.90 204.15 214 183.90 291.50
Total present values of cash inflows 1173.15
i) Net present value of project =1173.15- 816 = Rs. 357.15 lakh

Recommendation: Since the project has positive NPV, it is advisable to take up the project.
ii) Calculation of IRR
Years 1 2 3 4 5 6 TPV
CashInflow 110.0 243.3 310.3 374.8 370.0 674.8 2,083.0
PVIF@30% 0.8 0.6 0.5 0.4 0.3 0.2
PV 84.7 144.0 141.2 131.5 100.0 140.4 741.8
Less:
pvofcashoutflow[816-66+(100×0.455)] 795.5
-53.75
Trial can be with any other discounting factor(DF)
= 0.15+ (0.87×0.15)
= 0.15+ 0.13
0.28=28%
Recommendation:
Since, IRR is higher than the cost of capital of the company, the project is worth taking up.
iii) Discounted pay Back period:

Years Pv of CI (lakh) Cumulative CI (lakh)
1 95.70 95.70
2 183.90 279.60
3 204.15 483.75
4 214 697.75
5 183.90 881.65
6 291.50 1,173.15

= 4 yr +0.64 yr.
= 4. 64 yr.
Recommendation:
Since, the project returns its investment early within the project's life, the project is worth
taking up.
Question No 14:
S Bank Ltd. is assessing the operational efficiency of its central cash department. In this
regard, one of the officials have come up with the suggestion to procure sophisticated cash
counting machine cum fake note detector in order to make cash handling more effective and
efficient. The quotation for the machine received from the authorized distributor reveals cost
of Rs. 35 lakhs with 3 years' warranty and 5 years' after sales service. The useful life of the
machine is 5 years and it may be scrapped at 5% of the original cost at the end.
At the moment, the central cash department employs 4 outsourced personnel to count, sort
and stack currency notes of Rs. 1,000 and Rs. 500 denominations manually. These employees
frequently work overtime, and average monthly overtime cost for the last three months is Rs.
25,000. The average remuneration cost per employee engaged in the job is Rs. 22,500 per
month and is entitled to one month's Dashain Bonus. If the machine is acquired, 2 employees
will be shifted to other vacant department. The overtime costs will be entirely avoided. The
remuneration is expected to increase by 5% annually after the end of year 1 and thus there
will be proportionate increment for all employee benefits.
The Bank has determined 8% as discount rate for similar investments. Tax rate for bank is
30%.
Required:
Lay out the relevant cash flows of the investment decision.
(June 2015) ( 5
Marks)
Answer
Relevant cash flows:
Years 0 1 2 3 4 5
Initial
Investment (3,500,000.00)
Incremental
Saving
- Remuneration
of 2 employee 540,000.00 567,000.00 595,350.00 625,117.50 656,373.38
- Dashain
Bonus of 2
employee 45,000.00 47,250.00 49,612.50 52,093.13 54,697.78
- Overtime 300,000.00 315,000.00 330,750.00 347,287.50 364,651.88
Depreciation (665,000.00) (665,000.00) (665,000.00) (665,000.00) (665,000.00)
Annual Savings 220,000.00 264,250.00 310,712.50 359,498.13 410,723.03
Tax Cost @ 30% 66,000.00 79,275.00 93,213.75 107,849.44 123,216.91
131
Net Annual
Savings 154,000.00 184,975.00 217,498.75 251,648.69 287,506.12
Add: Terminal
Value (5% of
Original Cost)
(tax is not
attracted as
BV=SV) 175,000.00
Add: Non Cash
Expenses 665,000.00 665,000.00 665,000.00 665,000.00 665,000.00
Net Cash Flow (3,500,000.00) 819,000.00 849,975.00 882,498.75 916,648.69 1,127,506.12
Question No 15:
A team of investors has recently established ‘We Care’ Hospital in Kathmandu. They plan to
buy a CT Scan Machine and are considering two different brands with similar features.
Following information is available regarding the Machines:
Cost of Life of Maintenance Cost (Rs.) Rate of

Brand Machine Machine Year 1-5 Year 6-10 Year 11-15 Depreciation
(Rs.) (SLM)
XYZ 600,000 15 years 20,000 28,000 39,000 4%
ABC 450,000 10 years 31,000 53,000 - 6%
Book value of both of machines will be dropped by 1/3rd of purchase price in the first year
and thereafter will be depreciated at the rates given in table above.
Alternatively, the machine of Brand ABC can also be taken on rent, to be returned back to the
owner after use, on the following terms and conditions:
Annual rent shall be paid in the beginning of each year and for the first year it shall be Rs.
102,000.
Annual Rent for the subsequent 4 years shall be Rs. 102,500.
Annual Rent for the final five years shall be Rs. 109,950.
Rent agreement can be terminated by the hospital by making a payment of Rs. 100,000 as
penalty. This penalty would be reduced by Rs. 10,000 each year of the period of rental
agreement.
The cost of capital of the hospital is 12%.
Required:
Advise which brand of CT-Scan Machine should be acquired assuming that the use of
machine shall be continued for a period of 20 years. Consider book value as scrap value.
Which of the option is most economical, if machine is likely to be used for a period of 5 years
only?
(June 2015) ( 20 Marks)
Answer
Since the life span of each machine is different and time span exceeds the useful lives of each
model, we should use Equivalent Annual Cost method to decide which brand should be
chosen.
If machine is used for 20 years
Present Value of cost if machine of Brand XYZ is purchased
Period Cash Outflow (Rs.) PVF @12 % Present Value
0 6,00,000 1.000 6,00,000
1-5 20,000 3.605 72,100

6-10 28,000 2.045 57,260

11-15 39,000 1.161 45,279
15 (64,000) 0.183 (11,712)
762,927
Rs. 64,000 is residual value, calculated as
=600,000-(1/3 of 600,000)-(4% of 600,000×14 yrs) = Rs. 64,000
PVAF for 15 years is 6.811
Equivalent Annual Cost (Rs.)= 762,927/6.811=Rs. 112,014
Present Value of cost if machine of Brand ABC is purchased

0 450,000 1.000 450,000
1-5 31,000 3.605 111,755
6-10 53,000 2.045 108,385
10 (57,000) 0.322 (18,354)
651,786
Rs. 57,000 is residual value, calculated as:
=450,000-(1/3 of 450,000)-(6% of 450,000×9 yrs) =Rs. 57,000
PVAF for 10 years is 5.65
Present Value of cost if machine of Brand ABC is taken on Rent
0 102,000 1.000 102,000
1-4 102,500 3.037 311,293
5-9 109,950 2.291 251,895
665,188
PVAF for 1-10 years is 5.65

Decision: Since Equivalent Annual Cash Outflow is least in case of purchase of Machine
Brand XYZ, the same should be purchased.
If machine is used for 5 years

Scrap value of Machine of Brand XYZ
=Rs. 600,000-Rs. 200,000-Rs. 600,000 x 0.04 x 4 =Rs. 304,000
Scrap value of Machine of Brand ABC
=Rs. 450,000-Rs. 150,000-Rs. 450,000 x 0.06 x 4 =Rs. 192,000
Present Value of cost if machine of Brand XYZ is purchased

0 600,000 1.000 600,000
1-5 20,000 3.605 72,100
5 (304,000) 0.567 (172,368)
499,732
Present Value of cost if machine of Brand ABC is purchased
133
0 450,000 1.000 450,000
1-5 31,000 3.605 111,755
5 (192,000) 0.567 (108,864)
452,891
Present Value of cost if machine of Brand ABC is taken on Rent

0 102,000 1.000 102,000
1-4 102,500 3.037 311,293
5 50,000 0.567 28,350
441,643
Decision: Since Cash outflow is least in case of lease of Machine of brand ABC, so same
should be taken on Rent
Question No 16:
The Board of OAP Co has decided to limit investment funds to NRs.10 million for the next
year and is preparing its capital budget. The company is considering five projects, as follows:
NRs.
Projects Initial investment Net present value
Project A 2,500,000 1,000,000

Project B 2,200,000 1,550,000
Project C 2,600,000 1,350,000
Project D 1,900,000 1,500,000
Project E 5,000,000 To be calculated
All five projects have a project life of four years. Projects A, B, C and D are divisible,
and Projects B and D are mutually exclusive. All net present values are in nominal,
after-tax terms.
Project E
This is a strategically important project, which the Board of OAP Co has decided must be
undertaken for the company to remain competitive, regardless of its financial acceptability.
Information relating to the future cash flows of this project is as follows:
Year 1 2 3 4
Sales volume (units) 12,000 13,000 10,000 10,000
Selling price (NRs./unit) 450 475 500 570
Variable cost (NRs./unit) 260 280 295 320
Fixed costs ȋNRs.ǯ000) 750 750 750 750
These forecasts are before taking account of selling price inflation of 5% per year, variable
cost inflation of 6% per year and fixed cost inflation of 3·5% per year. The fixed costs are
incremental fixed costs, which are associated with Project E. At the end of four years,
machinery from the project will be sold for scrap with a value of NRs. 400,000. Tax
allowable depreciation on the initial investment cost of Project E is available on a 25%

reducing balance basis and OAP Co pays corporate tax of 28% per year, one year in arrears.
A balancing charge or allowance is available at the end of the fourth year of operation.
OAP Co has a nominal after-tax cost of capital of 13% per year.
Required:
Calculate the nominal after-tax net present value of Project E and comment on the financial
acceptability of this project.
Calculate the maximum net present value which can be obtained from investing
the fund of NRs. 10 million, assuming here that the nominal after-tax NPV of Project E is
zero.
(RTP December 2014)
Answer
Calculation of NPV
Year 1 2 3 4 5
Sales income 5,670 6,808 5,788 6,928
Variable cost -3,307 -4,090 -3,514 -4,040
Contribution 2,363 2,718 2,274 2,888
Fixed cost -776 -803 -832 -861
Cash flow before tax 1,587 1,915 1,442 2,027
Tax at 28% -444 -536 -404 -568
Depreciation tax benefit 350 263 197 479
Cash flow after tax 1,587 1,821 1,169 1,820 -89
Scrap value 400
Net cash flow 1,587 1,821 1,169 2,220 -89
Discount at 13% 0·885 0·783 0·693 0·613 0·543
Present values 1,405 1,426 810 1,361 -48
Sum of present values 4,954

Initial investment 5,000
Net present value -46
Although the NPV of the project is negative and so financially it is not acceptable, the Board
of OAP Co has decided that it must be undertaken as it strategically important.
Workings
Year 1 2 3 4
Selling price (NRs./unit) 450 475 500 570
Inflated selling price 472·50 523·69 578·81 692·84
(NRs./unit)
Sales income ȋNRs.ǯ000/year) 5,670 6,808 5,788 6,928
Variable cost (NRs./unit) 260 280 295 320

Inflated variable cost 275·60 314·61 351·35 403·99
(NRs./unit)
Variable cost (NRs.ǯ000/year) 3,307 4,090 3,514 4,040
NRs.
135
Year Tax allowable depreciation Tax benefit
1 5,000,000 x 0·25 = 1,250,000 1,250,000 x 0·28 = 350,000
2 3,750,000 x 0·25 = 937,500 937,500 x 0·28 = 262,500
3 2,812,500 x 0·25 = 703,125 703,125 x 0·28 = 196,875
4 1,709,375* 1,709,375 x 0·28 = 478,625
*5,000,000 – 1,250,000 – 937,500 – 703,125 – 400,000 = 1,709,375
Calculation of maximum NPV

Project A B C D E
Investment 2,500 2,200 2,600 1,900 5,000
NPV 1,000 1,550 1,350 1,500 nil
PV of future cash flows 3,500 3,750 3,950 3,400 5,000
Profitability index 1.4 1.705 1.519 1.789 1
Ranking 4 3 2 1
Project E has been ranked first as it must be undertaken. Project B cannot be undertaken if
Project D is undertaken, as the two projects are mutually exclusive.
Calculation of maximum NPV
Investment NPV
Project E 5,000 nil
Project D 1,900 1,500
Project C 2,600 1,350
Project A 500 200
10,000 3,050
As Project A is divisible and only NRs. 500,000 (20%) of its NRs. 2,500,000 initial cost is
available after cumulative investment in Projects E, D and C, the NPV from the project is
NRs. 200,000 (20% of NRs. 1,000,000).
Question No 17:
Spot Co is considering how to finance the acquisition of a machine costing NRs. 750,000
with an operating life of five years. There are two financing options.
Option 1
The machine could be leased for an annual lease payment of NRs. 155,000 per year,
payable at the start of each year.
Option 2
The machine could be bought for NRs. 750,000 using a bank loan charging interest at an
annual rate of 7% per year. At the end of five years, the machine would have a scrap value of
10% of the purchase price. If the machine is bought, maintenance costs of NRs. 20,000 per
year would be incurred.
Taxation must be ignored.
Required:
Evaluate whether Spot Co should use leasing or borrowing as a source of finance, explaining
the evaluation method which you use.
(RTP December 2014)
Answer
In order to evaluate whether Spot Co should use leasing or borrowing, the present value of
the cost of leasing is compared with the present value of the cost of borrowing.

Leasing
The lease payments should be discounted using the cost of borrowing of Spot Co. Since
taxation must be ignored, the before-tax cost of borrowing must be used. The 7% interest
rate of the bank loan can be used here.
The five lease payments will begin at year 0 and the last lease payment will be at the start of
year 5,
i.e. at the end of year 4. The appropriate annuity factor to use will therefore be 4.387 (1 +
3.387). Present value of cost of leasing = 155,000 x 4.387= NRs. 679,985
Borrowing
The purchase cost and the present value of maintenance payments will be offset by the
present value of the future scrap value. The appropriate discount rate is again the before-tax
cost of borrowing of 7%.
Year Cash flow (NRs.) 7% Discount Present value

factor (NRs.)
0 Purchase (750,000) 1 (750,000)
1-5 Maintenance (20,000) 4.1 (82,000)
5 Scrap value 75,000 0.713 53,475
Present value of cost of borrowing = 750,000 + 82,000 – 53,475 = NRs. 778,525

The cheaper source of financing is leasing, since the present value of the cost of leasing
is NRs. 98,540 less than the present value of the cost of borrowing.
Question No 18:
SKL ltd. is forced to choose between two machines X & Y. the two machines are designed
differently but have identical capacity and do exactly the same job. Machine X costs NRs.
150,000 and will last for 3 years with annual operating cost of NRs. 40,000. Machine Y is an
economy model costing only NRs. 100,000, but will last only for 2 years, and costs NRs.
60,000 p.a. to operate. Opportunity cost of capital is 10%.
Advise which machine SKL ltd. should buy?
(RTP December 2014)
Answer
Machine A Machine B
Life 3 years 2 years

Initial outflows (purchase cost) 150000 100000
Annual Running Cost 40000 p.a 60000 p.a
Pv of outflows for Machine A

= 150,000
= 150,000
137
= 249,440
Pv of Outflows for Machine B
= 100,000
= 204,100
Machine A Machine B
Life 3 Years 2 Years
Pv of Outflows 249,440 204,100
Sum of PV 2.486 1.735
EAC (equal annualized year end cost) NRs 100,338 NRs 117,637
(249,440/2.486) (204,100/1.735)
Advice: SKL Ltd. shall go for machine A since it has lower equal annualized cost.

CHAPTER 6
WORKING CAPITAL MANAGEMENT AND FINANCIAL FORECASTING
139
Question No 1:
Distinguish Between
a. Recourse and Non-recourse Factoring (December 2011) ( 2.5
Marks)
Answer
In a recourse or pure factoring, the factor firm is only involved in the work of collection
of the receivables. It does not bear any risk of default by the debtors. Such a risk will
have to be invariably borne by the selling firm. Thus, in case of default by a customer,
the selling firm will have to refund the amount of advance together with charges as per
the agreement which was given by the factor to the selling firm against the receivables.
In a non-recourse factoring, the factor firm purchases the receivable of the selling firm
by paying the agreed amount (sales value less commission) to the latter. The payment
may be made immediately or after receiving from the customer buying.
The main feature of non-recourse factoring is that the risk of default by the buyer is
borne by the factor firm and the selling firm receives the sales amount. Thus, this type of
factoring will result in the purchase of receivable by the factor firm.
In non-recourse factoring, the factor also undertakes the receivables management
including evaluation of creditworthiness, thereby also assessing the risk of bad debts. In
this type of factoring, the factor firm will normally insist on discounting the seller‘s
entire book debts subject to careful examination of the debtors and their
creditworthiness. In such cases, the seller is entitled to sell to other customers not
evaluated as credit-worthy but these sales would obviously be excluded from the services
of the non-recourse factor.
b. Treasury bills and Certificate of deposits (December 2012) (2.5 Marks)

Answer
Treasury bills are sold by the government on a discount basis. As a result, the investor
does not get actual payment of interest on the Treasury bills. The return to the investor
is in the form of difference between the purchase price and face (or par) value of the
bill.
These bills are issued without the investor‘s name upon them, i.e. in the bearer form.
This feature of the treasury bills makes them easily transferable from one investor to
another. The secondary market also exists for these bills making them highly liquid. It
is also considered risk-free since it has the backing and guarantee of the government.
Certificate of deposits (CDs) are marketable receipts for funds that have been
deposited in a bank/financial institution for a specified period of time. The funds thus
deposited earn a fixed rate of interest. The denomination and the maturities is agreed
upon as per the needs and wishes of the investor.
Since the CDs are not sold at discount, the investor receives the amount deposited plus
the interest earned thereon. A secondary market also exists for the CDs. These may be
issued in the registered or bearer form. The second types of CDs are most common and
popular due to their easy transferability and liquidity.
c. Permanent working capital Vs. Variable working capital (December 2012) (2.5
Marks)
Answer
Permanent working capital is the minimum amount of gross working capital which is
always maintained in spite of the increase or decrease in the sales during the year. It
comprises of the minimum cash balance, minimum inventory level etc. If a firm does

Chapter 7: Dividend Policy
not face a seasonal cycle then it will have only a permanent working capital
requirement. Variable working capital is the amount of gross working capital that
exceeds the amount of permanent working capital at any time during the year. It is
also important for the finance manager to decide sources for financing seasonal
current assets. The variable working capital is the result of the periodic fluctuations of
the gross working capital. For example, wheat mill may have higher inventories at the
time of harvesting wheat. It causes the increase in gross working capital.
d. Investment bankers Vs. Mortgage bankers (June 2012) ( 2.5

Marks)
Answer
Investment bankers are middlemen who are involved in the sale of stocks and bonds. When a
company decides to raise funds, an investment bank comes up with the proposal to buy the
issue at wholesale and then go to sell the same to investors at retail.
Being in the business of matching users of funds with suppliers, investment bankers can sell
issues more efficiently than the issuing company. For the services provided, they receive fee
as the difference between the amounts received from the sale of securities to the public and
the amount paid to the companies.
Mortgage bankers are involved in acquiring and placing mortgages. The mortgages to the
mortgage bankers come through the individuals, businesses and builders and real estate
agents. These bankers do not hold mortgages in their own portfolios for a long time. They
usually service these for the ultimate investors. They receive fees from the ultimate investor
for the services provided to them.
e. Horizontal merger Vs. Vertical merger (June 2012) ( 2.5

Marks)
Answer
Horizontal merger takes place when two or more corporate firms dealing in similar lines of
activity combine together. Elimination or reduction in competition, putting an end to price
cutting, economies of scale in production, research and development, marketing and
management are often cited motives underlying such mergers.
Vertical merger occurs when a firm acquires firms upstream from it and/ or firms
downstream from it. In the case of an upstream merger, it extends to the suppliers of raw
materials, and to those firms that sell eventually to the consumer in the event of a
downstream merger. Thus the combination involves two or more stages of production or
distribution that are usually separate. Lower buying cost of materials, lower distribution
costs, assured supplies and market, increasing or creating barriers to entry for potential
competitors or placing them at a cost disadvantage are the chief gains accruing from such
mergers.
f. Factoring and Bills discounting (December 2015) ( 2.5 Marks)

Answer
The factoring and bills discounting are both means available for short term finance;
nevertheless they are different to each other in terms of:
Responsibility: In factoring it is the factor that usually assumes the responsibility of
collecting the bills while in bills discounting the drawer assumes the responsibility of
collecting the bills and pays the proceeds. Factoring is more associated with the management
of book debts while bill discounting is related to borrowing from commercial bank.
141
Risk of Credit: Bills discounting is always of recourse type i.e., drawer assumes the credit
risk and not the drawee bank, while factoring can be either with or without recourse. In case
of recourse, the factor does not assume credit risk and it is the company that owns receivables
assumes the credit risk.
Facility of finance: In bills discounting, there is only a provision of finance, while in
factoring, the factor provides other facilities like sales ledger maintenance, collection etc. in
addition to the finance facility.
Negotiability: The discounted bills may be re-discounted several times before they mature for
payment where as it is not possible to negotiate in case of factoring.
Accounting: Transactions in the factoring are off balance sheet items as the amount of
receivables and bank credit are not presented in the balance sheet, whereas bills discounting
are presented in the "Loans and Advances" head of the balance sheet.
g. Recourse and Non-recourse Factoring (June 2014) ( 2.5 Marks)

Answer
In a recourse or pure factoring, the factor firm is only involved in the work of collection of
the receivables. It does not bear any risk of default by the debtors. Such a risk will have to be
invariably borne by selling the firm. Thus, in case of default by a customer, the selling firm
will have to refund the amount of advanced together with charges as per the agreement which
was given by the factor to the selling firm against the receivables.
In a non-recourse factoring, the firm purchases the receivable of the selling firm by paying
the agreed amount (sales value less commission) to the latter. The payments may be made
immediately or after receiving from the customer buying.
The main feature of non-recourse factoring is that the risk of default by the buyer is borne by
the factor firm and the selling firm receives the sales amount. Thus, this type of factoring will
result in the purchase of receivable by the factor firm.
h. Clean packing credit and Packing credit against hypothecation of goods

Answer
a) Packing Credit is an advance extended by banks to an exporter for the purpose of
buying, manufacturing, processing, packing, shipping goods to overseas. If an exporter has a
firm export order placed with him by his foreign customer(buyer) or all irrevocable Letter of
Credit in his favour, he can approach a Bank for Packing Credit Facility.
Clean Packing Credit
• This facility is extended only on production of a firm export order or a letter of credit.
• There is no charge or control over raw material or finishes goods that constitute the
supply.
• The bank takes into consideration trade requirements, credit worthiness of exporter and
its margin.
• Export Credit Guarantee Corporation (ECGC) insurance cover should be obtained by the
bank.
Packing credit against hypothecation of goods
• This facility is extended only on production of a firm export order or a letter of credit.
• The goods which constitute the supply are hypothecated to the Bank as security with
stipulated margin.

• The goods shall be exported by the borrower. The Bank does not have any effective
possession of the same.
• The exporter has to submit stock statements at the time of sanction and also periodically
and for whenever there is any movement in stock.
Question No 2:
Write short note on
a. Working Capital Cycle (June 2010)(2.5Marks)
Answer
Every business undertaking requires funds for two purposes - investment in fixed assets
and investment in current assets. Funds required to invest in stock, debtors and other
current assets keep on changing shape and volume. For example, a company has some
cash in the beginning. This cash may be paid to the suppliers of raw materials, to meet
labour costs and other overheads. These three combined would generate work-in-
progress which will be converted into finished goods on the completion of the
production process. On sale, these finished goods get converted into debtors and, when
debtors pay, the firm will again have cash. The cash will again be used for financing raw
materials, work-in-progress etc. Thus there is a complete cycle when cash gets
converted into raw materials, work-in-progress, finished goods, debtors and finally
again cash. This time period is known as the working capital cycle of the firm.
b. Revolving credit agreement (December 2010)(2.5 Marks)

Answer
A revolving credit agreement is a formal commitment by a bank to lend up to a certain
amount of money to a company over a specified period of time. This type of debt is for a
short term, usually up to 3 months. The company may, however, renew or borrow
additional amount up to the limit of agreement throughout the duration of the
commitment. Although commitment can be obtained for a shorter period as well, most
revolving credit commitments are provided for 3 years.
The interest term of the revolving credit agreements are similar to but slightly higher
(usually between 0.25 to 0.50 per cent higher) than the rate at which a firm can borrow
on a short term basis under a line of credit. The banks generally charge commitment fee
usually around 0.5 per cent per annum on the difference between the amount borrowed
and the maximum limit amount.
This type of borrowing arrangement is very useful at times when the firm is not certain
about its fund requirements. The borrowing company will have flexibility in the access to
funds at the time of uncertainty and can make more definite credit arrangement when the
situation of uncertainty is resolved.
c. Factoring Services (June 2011) ( 2.5 Marks)

Answer
Factoring services - Factoring is a unique financial innovation. It is both a financial as
well as a management support to a client. It is a method of converting a non-productive,
143
inactive asset like receivable into a productive asset like cash by selling receivables to a
company that specializes in their collection and administration. Factoring is a business
involving a continuing legal relationship between a financial institution (factor) and a
business concern (client) selling goods or providing services to trade customers whereby
the factor purchases the client's account receivable and in relation thereto, controls the
credit, extended to customers and administers the sales ledger. Basically three kinds of
services fall into this: sales ledger administration and credit management, credit
collection and protection against default and bad debt losses, financial accommodation
against the assigned book debts.
d. Line of Credit with bank ( June 2012 ) ( 2.5 Marks)

Answer
A line of credit with a bank is an informal arrangement between a bank and its customers
specifying the maximum amount of credit which the bank will permit the firm to borrow at
any point of time. Normally, credit lines are established for a one-year period. The line of
credit is renewed by the bank once it receives the latest annual report and reviews the
progress of the borrower. The amount of the line of credit depends on the bank‘s assessment
of the creditworthiness and the credit needs of the borrower.
A line of credit may be adjusted upwards or downwards at the time of renewal based on the
changes in these conditions. The cash budget of a firm is an indicator of the borrower‘s short
term credit needs. The firm usually seeks a line of credit amount slightly in excess of
maximum or peak borrowing needs during the forthcoming year to give a margin of safety.
The bank may impose a ‗clean up‘ provision in a line of credit arrangement. Accordingly, the
borrower would be required to clean up the bank debt for a specified period of time during
the year. Such a cleanup period is usually one to two months.
It is, however, to be noted that a line of credit does not constitute a legal commitment on the
part of the bank to extend credit. The borrower is informed of the line of credit through a
letter indicating that the bank is willing to extend credit up to a certain amount. If the credit
worthiness of the borrower gets deteriorated during the year, the bank might not want to
extend credit or reduce the amount of credit already intimated.
e. Bridge Finance (June 2013) ( 2.5 Marks)

Answer
Bridge Finance refers, normally to loans taken by a business, usually from commercial banks
for a short period, pending disbursement of terms loan by financial institutions. Normally,
it takes time for the financial institution to finalize procedures of creation of security, tie-
up participation with other institution etc., even though a positive appraisal of project has
been made. However, once the loans are approved in principal, firms, in order not to lose
further time in starting their projects, arrange for bridge finance. Such temporary loan is
normally repaid out of the proceeds of the principal term loans. Generally the rate of
interest on bridge finance is 1% or 2% higher than on normal term loans.
f. Miller Orr Model of cash management (December 2013) ( 2.5 Marks)

Answer
The Miller and Orr model of cash management is one of the various cash management
models in operation. It is an important cash management model as well. It helps the present
day companies to manage their cash while taking into consideration the fluctuations in daily
cash flow. As per the Miller and Orr model of cash management, the companies let their cash
balance move within two limits

- the upper limit and the lower limit. The companies buy or sell the marketable securities only
if the cash balance is equal to any one of these. When the cash balance of a company touches
the upper limit, it purchases a certain number of salable securities that helps them to come
back to the desired level. If the cash balance of the company reaches the lower level, then the
company trades its salable securities and gathers enough cash to fix the problem. It is
normally assumed in such cases that the average value of the distribution of net cash flows is
zero. It is also understood that the distribution of net cash flows has a standard deviation. The
Miller and Orr model of cash management also assumes that distribution of cash flows is
normal.
g. Purpose of working capital management (December 2013) ( 2.5 Marks)

Answer
There are two important aims of the working capital management which are profitability and
solvency. A liquid firm has less risk of solvency i.e. it will hardly experience a cash shortage
or stock out situation. However there is a cost associated with maintaining a sound liquidity
position. However, to have higher profitability the firm may have to sacrifice solvency and
maintain a relatively low level of current assets. This will improve firm‘s profitability as
fewer funds will be tied up in idle current assets but its solvency would be threatened and
exposed to greater risk of cash shortage and stock out. Therefore, optimal level of working
capital need to be maintained so that profit is high and risk of solvency is low. This is also
known as risk return trade off of liquidity management.
Question No 3:
Write short note on Impact of inflation on working capital and inventory
(June 2015) ( 2.5 Marks)
Answer
Impact of inflation of working capital and Inventory
1. Due to inflation, for the same quantity of sales, the amount of Sundry Debtors and stocks
will be higher.
2. Since the value of stocks increases ( due to price increase i.e. inflation) the company will
not be able to maintain its operating capability ,unless it finds extra funds to maintain the
same stock level ( i.e. quantity)
3. Higher value of closing stock due to inflation will lead to higher amount of profits ( in
monetary terms and not in real terms).This will cause an increase in profit related
outflows like income tax, bonus, dividends etc.
4. Thus due to inflation, the business is likely to face a condition known as ―technical
insolvency‖, unless proper planning is done to improve ―Real profits‖.
Question No 4:
Discuss the relationship between the cash operating cycle and the level of investment in
working capital.
(RTP December 2014)
Answer
The cash operating cycle is the average length of time between paying trade payables and
receiving cash from trade receivables. It is the sum of the average inventory holding
period, the average production period and the average trade receivables credit period, less
the average trade payables credit period. Using working capital ratios, the cash operating
145
cycle is the sum of the inventory turnover period and the accounts receivable days, less
the accounts payable days.
The relationship between the cash operating cycle and the level of investment in working
capital is that an increase in the length of the cash operating cycle will increase the level
of investment in working capital. The length of the cash operating cycle depends on working
capital policy in relation to the level of investment in working capital, and on the nature
of the business operations of a company.
a. Working capital policy

Companies with the same business operations may have different levels of investment in
working capital as a result of adopting different working capital policies. An aggressive
policy uses lower levels of inventory and trade receivables than a conservative policy, and so
will lead to a shorter cash operating cycle. A conservative policy on the level of investment in
working capital, in contrast, with higher levels of inventory and trade receivables, will
lead to a longer cash operating cycle. The higher cost of the longer cash operating cycle
will lead to a decrease in profitability while also decreasing risk, for example the risk of
running out of inventory.
b. Nature of business operations

Companies with different business operations will have different cash operating cycles.
There may be little need for inventory, for example, in a company supplying business
services, while a company selling consumer goods may have very high levels of
inventory. Some companies may operate primarily with cash sales, especially if they sell
direct to the consumer, while other companies may have substantial levels of trade
receivables as a result of offering trade credit to other companies.
Practical Questions
Question No 5:
Zee Limited, manufacturer of Colour TV sets, are considering the liaberalisation of existing
credit terms to three of their large customers A, B and C. The credit period and likely quantity
of TV sets that will be lifted by the customers are as follows:
(Quantity lifted) (No. of TV Sets)
Credit Period (Days) A B C
0 1,000 1,000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500
The selling price per TV set is Rs. 9,000. The expected contribution is 20% of the selling
price. The cost of carrying debtors averages 20% per annum.
You are required to determine the credit period to be allowed to each customer.
(Assume 360 days in a year for calculation purposes). (June 2010)(8 Marks)
Answer
In case of customer A; there is no increase in sales as far as the credit period is concerned.
Apparently A enjoys good liquidity and the demand for TV sets in his area is limited. Hence
there is no point in allowing credit to 'A'. In case of customers 'B' and 'C' the credit period can

be determined by trading off between profitability of additional sales and the cost of carrying
additional debtors as a result of relaxation of credit period.
Profitability of additional sales on account of relaxing credit period

Customer 'B Customer 'C'
Credit period 0 30 60 90 0 30 60 90
(days) 1000 1,500 2,000 2,500 - - 1,000 1,500
Rs. lakhs Rs. lakhs

Sales 90 135 180 225 - - 90 135
Contribution at 20% 18 27 36 45 - - 18 27
Incremental
Contribution (A) - 9 9 9 - - 18 9
Debtors:
Credit period X sales - 11.25 30 56.25 - - 15
33.75
360
Incremental Debtors - 11.25 18.75 26.25 - - 15

18.75
Cost of incremental
debtors at 80% - 9 15 21 - - 12 15
Cost of carrying incremental
debtors at 20% (B) - 1.8 3 4.2 - - 2.4 3
Excess incremental contribution

over cost of carrying incremental
debtors (A - B) 7.2 6 4.8 - - 15.6 6
It is seen from the above computations that incremental contribution exceeds incremental cost
of carrying additional debtors at each credit period. Therefore, credit period to B and C
should be 90 days.
Question No 6:
Following data related to Universal Manufacturers Ltd. is made available to you.
Particulars Year 1 Year 2
Stocks:
Rs. 300,000 Rs. 405,000
Raw Materials
210,000 270,000
Work-in-process
Finished Goods 315,000 360,000
147
Purchase of Raw Materials 1,440,000 2,025,000
Cost of Goods Sold 2,100,000 2,700,000
Sales 2,400,000 3,000,000
Debtors 480,000 750,000
Creditors 240,000 270,000
You are required to compute the duration of the operating cycle for each of the two years and
comment on the increase/decrease. (Assume 360 days per year for the purpose of
computations.
Answer
Determination of Operating Cycle:
Particulars Year 1 Year 2
(i) Raw Materials Holding Period:

360 days x Stock of Raw Materials 360 x Rs. 300,000 = 75 360 x Rs. 405,000 = 72
Cost of Raw Materials Consumed* Rs. 1,440,000 Rs. 2,025,000
(* Assumed to be equivalent to purchases)
(ii) Less: Creditors Payment Period:

360 days x Creditors 360 x Rs. 240,000 = (60) 360 x Rs. 270,000 = (48)
Purchases Rs. 1,440,000 Rs. 2,025,000
(iii) Work-in-process Holding Period:

360 days x Stock of WIP . 360 x Rs. 210,000 = 36 360 x Rs. 270,000 = 36
Cost of Goods Manufactured Rs. 2,100,000 Rs. 2,700,000
(iv) Finished Goods Holding Period:

360 days x Stock of Finished Goods 360 x Rs. 315,000 = 54 360 x Rs. 36,000 = 48
Cost of Goods Sold Rs. 2,100,000 Rs. 2,700,000
(v) Debtors Collection Period:

360 days x Debtors 360 x Rs. 480,000 = 72 360 x Rs. 750,000 = 90
Credit Sales** Rs. 2,400,000 Rs. 3,000,000
(** Assumed to be equal to total sales)
Duration of Operating Cycle [Sum of (i) to (v)] 177 198
Comment on the Increase/Decrease:

The duration of the operating cycle has increased by 21 days in Year 2 as compared to Year 1.
It will necessitate more working capital in Year 2. This increase has been primarily caused by
an increase in debtors‘ collection period and decrease in creditors‘ payment period as shown in
the following table.
Increase in Debtors‘ Collection Period: 18 days
Decrease in Creditors‘ Payment Period: 12
Less: Decrease in Raw Material Holding Period: -3
Less: Decrease in Finished Goods Holding Period: -6
Net Increase in Operating Cycle: 21
Question No 7:
Progressive Manufacturers Ltd. has sales of Rs. 250 million of which 80 per cent is on credit
basis. The present credit terms of the company are ―2/15, net 45‖. At present, the average
collection period is 30 days. The proportion of sales on which customers currently take
discount is 0.50.
The firm is considering relaxing its discount terms to ―3/15, net 45‖. Such a relaxation is
expected to increase current credit sales by Rs. 10 million, reduce the average collection
period to 27 days and increase the proportion of discount sales to 0.60. The average selling
price of he company‘s product is Rs. 1,000 per unit and variable cost per unit works out to be
Rs. 800. The company is subject to a tax rate of 25 per cent and it‘s, before tax rate of
borrowings for working capital is 12 per cent.
Should the firm change its credit terms to ―3/15, net 45‖? Support your answers by calculating
the expected change in net profit (assume 360 days in a year)
Answer
Total Sales = Rs. 250 million
Credit Sales = Rs. 250 x 0.80 = Rs. 200 million
(a) Present Credit Policy:

Present credit terms are ‗2/15, net 45‘
Present average collection period = 30 days
Proportion of sales on which customers currently take discount is 0.5, or 50%.
(b) Basic revenue and cost structure applicable to both the policies:
Selling price per unit: Rs. 1,000
Variable cost per unit: Rs. 800
Contribution per unit: Rs. 200
P / V Ratio = 200/1,000 x 100 = 20%
Contribution from increased sales = Rs. 1,000,000 x 20% = Rs. 200,000
(c) Relaxed Credit Policy:

Reduction in average collection period to 27 days
Increase in proportion of discount sales to 0.60, or 60%
149
Change in the investment of Receivables
= [Rs. 200 million x 27 – 30 ] + [Rs. 10 million x 80/100 x 27/360]
360
= (-) Rs. 1.667 million + Rs. 0.60 = (-) Rs. 1.0667 million
Therefore, the reduction in receivables investment is Rs. 1.0667 million.

Saving in cost from reduction in receivables investment
= 1.0667 x 0.12 (1 – 0.25) = 0.096 million
Increase in discount cost
= [(Rs. 200 + 10) x 60/100 x 3/100] – (200 x 50/100 x 2/100)
= 3.78 – 2 = Rs. 1.78 million
Statement showing Profitability of Relaxing Credit Policy

(Rs. in million)
_______________________________________________________________
Contribution from Increased Sales 2.000
Cost savings from Reduction in the Receivables Investment 0.096
2.096
Less: Incremental Discount Cost 1.780
Incremental Profit 0.316
_______________________________________________________________________
___
The firm can increase its profits by Rs. 0.316 million by relaxing the credit policy. Therefore,
it is suggested to change the credit terms to ‗3/15, net 45‘ from the present ―2/15, net 45‖.
Question No 8:
Maya Limited is planning to change its credit policy which is expected to increase the average
collection period from one month to two months. The relaxation of credit terms is expected to
produce an increase in sales volume by 25%. Following are other relevant data:
Sales price per unit Rs.10
Profit per unit Rs.1.5
Current Sales Revenue per annum Rs. 2,400,000
Required rate of return on investment 20%
Assume that the 25% increase in sales would result additional stock of Rs. 100,000 and
additional creditors of Rs. 20,000.
Required:
Advise the company whether the credit terms should be revised in following circumstances:
i. If all the customers take longer credit terms of 2 months.
ii. If current customers do not opt for revised credit terms and only new customers opt the
revised credit terms.
Answer
The revision of credit terms is justifiable if the rate of return on the additional
investment in working capital exceeds 20%.

Extra profit from the revision

Profit Margin (1.5/10) = 15%
Increase in sales revenue = 2,400,000x25% = Rs. 600,000
Increase in profit = 600,000x15% = Rs. 90,000
Total sales revenue after revision = (2,400,000+600,000) = Rs. 3,000,000
Now, we need to calculate return on extra investment in working capital so as to assess
whether the revision of credit terms is justifiable. This is generally done by taking the figure of
debtors on the basis of cost of sales and sometimes on the basis of sales. Computations have
been done below by following both the basis.
(i) If all Debtors take two months’ Credit:
Cost of Sales
Sales Basis
Basis
Rs. Rs.
Average Debtors after the Sales Increase 425,000 500,000
(2/12 x Rs. 3,000,000 x 85%)
(2/12 x Rs. 3,000,000)
Current Average Debtors 170,000 200,000
(1/12 x Rs 2,400,000 x 85%)
(1/12 x Rs 2,400,000)
Increase in Debtors 255,000 300,000
Increase in Stocks 100,000 100,000
355,000 400,000
Increase in Creditors (20,000) (20,000)
Net Increase in Working Capital 335,000 380,000
Investment
Return on Extra Investment (Cost of Sales Basis) = 90,000/335,000 = 26.87%
Return on Extra Investment (Sales Basis) = 90,000/380,000 = 23.7%
(ii) If only the New Debtors take Two Months’ Credit:

Cost of Sales Sales Basis
Basis
Rs. Rs.
Increase in Debtors 85,000 100,000

(2/12 x Rs. 600,000 x 85%)
(2/12 x Rs. 600,000)
Increase in Stocks 100,000 100,000

Increase in Creditors (20,000) (20,000)
Net Increase in Working Capital Investment 165,000 180,000
Return on Extra Investment (Cost of Sales Basis) = 90,000/165,000 = 54.55%
151
Return on Extra Investment (Sales Basis) = 90,000/180,000 = 50%
Recommendation:
In both the cases (i) and (ii), the new credit policy appears to be worthwhile under both the
basis. Furthermore, the most of the product can also support extra sales. If the firm has high
fixed costs but low variable costs, the extra production and sales could provide a substantial
contribution at little extra cost.
Alternative Solution:
Statement of evaluation of credit policy- if all debtors take 2 months' credit
Increase/
Particulars Current New (Decrease)
Average collection period (ACP) month 1 2
ACP in year 0.0833 0.1667
Required Rate of return on investment 20%
Sales Revenue Rs. 2,400,000 3,000,000
Sales Volume (SR/ SP) unit 240,000 300,000
Selling Price/ unit Rs. 10 10
Cost of sales/ unit (SP-P) Rs. 8.50 8.50
Profit/ unit Rs. 1.50 1.50
Profit before cost of investment Rs. 360,000 450,000 90,000

(Profit x Sales unit)
Less: Cost of investment (WN 1) 34,000 101,000 67,000
Net profit 326,000 349,000 23,000

Since net profit increases by Rs.23,000 the revision in credit policy is justifiable.
Working Notes:
1. Calculation of cost of investment: Rs. Rs. Rs.
Cost of Sales 2,040,000 2,550,000

(Sales unit * CoS per unit)
Investment in debtor (CoS x ACP in yr) 170,000 425,000
Increase in Stock 100,000
Increase in Creditors (20,000)

Additional working capital investment -

80,000
(a) Cost of investment in debtors 34,000 85,000 51,000

(Investment in Debtor x required rate of
return)
(b) Cost of investment in additional WC - 16,000 16,000

(Additional WC x required rate of return)
Total cost of investment (a + b) 34,000 101,000 67,000
Statement of evaluation of credit policy- if only the new debtors take 2 months' credit
Increase/
ACP in year 0.0833 0.1667
Sales Revenue Rs. 2,400,000 3,000,000

Net profit 326,000 383,000 57,000

Working Notes:
Cost of Sales 2,040,000 2,550,000

153
Additional working capital investment - 80,000

(Investment in Debtor x required rate of
return)

Note:
If only the new debtors take 2 months credit, New total investment in debtors is calculated as
below:
Investment in debtors=
Current investment in debtor + (New CoS- Old CoS) x required rate of investment
Profit before cost of investment Rs. 360,000 450,000

Less: Cost of investment (WN 1) 34,000 101,000
Net profit 326,000 349,000
Working Notes:
1. Calculation of cost of investment: Rs. Rs.
Cost of Sales 2,040,000 2,550,000
(a) Cost of investment in debtors 34,000 85,000
(Investment in Debtor x required rate of return)

Statement of evaluation of credit policy- if only the new debtors take 2 months' credit
Increase/
ACP in year 0.0833 0.1667
Sales Revenue Rs. 2,400,000 3,000,000

Net profit 326,000 383,000 57,000
Working Notes:
Cost of Sales 2,040,000 2,550,000
155
Cost of Sales 2,040,000 2,550,000
Note:
If only the new debtors take 2 months credit, New total investment in debtors is calculated as below:
Investment in debtors=
Current investment in debtor + (New CoS- Old CoS) x required rate of investment
Question No 9:
Identify the objectives of working capital management and discuss the central
role of working capital management in financial management.
(RTP December 2014)
Answer
The objectives of working capital management are usually taken to be profitability and
liquidity. Profitability is allied to the financial objective of maximizing shareholder wealth,
while liquidity is needed in order to settle liabilities as they fall due. A company must have
sufficient cash to meet its liabilities, since otherwise it may fail. However, these two
objectives are in conflict, since liquid resources have no return or low levels of return
and hence decrease profitability. A conservative approach to working capital management
will decrease the risk of running out of cash, favoring liquidity over profitability and
decreasing risk. Conversely, an aggressive approach to working capital management will
emphasize profitability over liquidity, increasing the risk of running out of cash while
increasing profitability.
Working capital management is central to financial management for several reasons.
First, cash is the life-blood of a companyǯs business activities and without enough cash to
meet short- term liabilities, a company would fail. Second, current assets can account for
more than half of a companyǯs assets, and so must be carefully managed. Poor management
of current assets can lead to loss of profitability and decreased returns to shareholders.
Third, for SMEs current liabilities are a major source of finance and must be carefully
managed in order to ensure continuing availability of such finance
Question No 10:
As a part of the strategy to increase sales and profits, the sales manager of a fast
moving consumer goods (FMCG) company proposes to sell goods to a group of new
customers with 10% risk of non-payment. This group would require one and a half
month credit and is likely to increase sales by Rs. 100,000 per annum. Production and
selling expenses amount to 80% of sales and the income-tax rate is 50%. The company‘s
minimum required rate of return (after tax) is 25%.

Required:
i) Comment on the acceptance of the sales manager‘s proposal.
ii) Find the degree of risk of non-payment that the company should be willing to
assume if the required rate of return (after tax) were 30%.
Answer:
Evaluation of Sales Manager's proposal Rs.
Additional sales from new customers per annum 100,000
Less: Risk of non-payment @ 10% 10,000
Net Turnover 90,000
Production and selling expenses (80% of sales) 80,000
Profit before tax 10,000
Income tax @ 50% 5,000
Profit after Tax 5,000
Average Investment in Debtors:

The credit period being 1 ½ months, there will be turnover of debtors of 8 times
considering 12 month‘s year. Thus, average debtors will be Rs. 100,000 / 8 = Rs. 12,500
Cost of goods sold being 80% of sales, the average investment in debtors would be
80% of Rs. 12,500, i.e. Rs. 10,000.
Thus, the rate of return (being PAT of Rs. 5,000)
= Rs. 5,000/ 10,000 x 100/10,000 = 50%
Since the company‘s minimum rate of return is 25%, the sales manager‘s proposal should
be accepted.
Alternatively,
Cost of investment in debtor = 25% of Rs.10,000 = Rs.2,500 Increase in PAT = Rs. 5,000
Since, increase in PAT is greater than the additional cost of investment in debtor; the
Sales Manager's proposal is acceptable.
ii) Acceptable degree of risk of non-payment with the required rate of return (after tax) of
30%:
Particulars Rs.
Average investment in debtors 10,000
Required profit after tax @ 30% 3,000
Profit before tax (Grossed up by 50%) 6,000
Production and selling expenses 80,000
Required sales to achieved desired return 86,000
Additional sales 100,000
Therefore, acceptable degree of risk of non- 14,000
payment
Acceptable degree of risk (in %) 14%
Question No 11:
157
PQ Limited currently has annual sales of Rs. 500,000 and an average collection
period of 30 days. It is considering a more liberal credit policy. If the credit period is
extended, the company expects sales and bad debt losses to increase in the following
manner:
Bad
Increase debts
Increase in credit
Credit Policy in sales % of
period
(Rs.) total
Sales
A 10 days 25,000 1.2
B 15 days 35,000 1.5
C 30 days 40,000 1.8
D 42 days 50,000 2.2
The selling price per unit is Rs. 2. Average cost per unit at the current level of operation
is Rs. 1.50 and variable cost per unit is Rs. 1.20. The current bad debt loss is 1% of
the total sales and the required rate of return on investments is 20%. Ignore taxes and
assume 360 days in a year.
Required:
Recommend the credit policy to be adopted. (December 2012)(5 Marks)
Answer
The firm will maximize the shareholders value if it extends its period by additional 30
days (since expected return is higher than required return). In fact, it can further relax
credit period until its expected return becomes 20% or net gain becomes zero.
Increase in credit period
Particulars
Existing 10 days 15 days 30 days 42 days
A Credit period (days) 30 40 45 60 72
B Annual Sales (Rs.) 5,00,000 5,25,000 5,35,000 5,40,000 5,50,000
Level of receivables
C (at sales value) 41,667 58,333 66,875 90,000 1,10,000
(AXB)/360 (Rs.)
Incremental
D investment in - 16,667 25,208 48,333 68,333
E receivables (C-41,667) -
Required incremental 3,333 5,042 9,667 13,667
(Rs.)
profit at 20%
Incremental
F (0.20XD)
contribution(Rs.) (Rs.)on - 10,000 14,000 16,000 20,000
@40% (2-1.2)/2
additional
Bad debt sales
losses (BX 5,000
G 6,300 8,025 9,720 12,100
H %bad debts) (Rs.)
Incremental Bad debt - 1,300 3,025 4,720 7,100
I losses (G-5,000) (Rs.)
Incremental expected - 8,700 10,975 11,280 12,900
J profit
Net (F-H)
Gain (Rs.)
(I-E) (Rs.) - 5,367 5,933 1,613 -767
Alternatively,
The investment in receivables can be calculated at cost. At current level of sales, the
firm's average unit cost is Rs.
1.50. Since variable cost per unit is 1.20, we can find the fixed cost as follows:

Fixed Cost = Total Cost-Variable Cost

= (Rs.5,00,000) x 1.50/Rs. 2 - (Rs.5,00,000) x Rs.1.20/Rs.2
= Rs. 375,000 - Rs. 3,00,000
= Rs. 75,000
Thus, the total cost for different level of sales (assuming unit price and fixed cost do not
change):
Fixed Total
Sales (Rs.) Variable Cost (Rs.) Cost Cost
(Rs.) (Rs.)
5,25,000 5,25,000 x 1.20/2 = 315,000 75,000 3,90,000
5,35,000 5,35,000 x 1.20/2 = 321,000 75,000 3,96,000
5,40,000 5,40,000 x 1.20/2 = 324,000 75,000 3,99,000
5,50,000 5,50,000 x 1.20/2 = 330,000 75,000 4,05,000
Investment in account receivables will be:

Investment in Receivables (Rs.) Changes in Investment (Rs.)
(3,75,000) x 30/360 = 31,250 -
(3,90,000) x 40/360 = 43,333 12,083
(3,96,000) x 45/360 = 49,500 18,250
(3,99,000) x 60/360 = 66,500 35,250
(4,05,000) x 72/360 = 81,000 49,750
The net gain from the credit policy can be re-calculated using incremental investment
in accounts receivables at cost. It would be higher now.
Increase in credit period
Particulars 30 42
Existing 10 days 15 days
days days
A Credit period (days) 30 40 45 60 72
B Incremental investment in receivables - 12,083 18,250 35,250 49,750
C (Rs.)
Cost of investment at 20% (Rs.) - 2,417 3,650 7,050 9,950
D Incremental Bad debt losses (Rs.) - 1,300 3,025 4,720 7,100
Incremental contribution on additional
E sales (2-1.2)/2 (Rs.) - 10,000 14,000 16,000 20,000
@40%
F Net Gain (E-D-C) (Rs.) - 6,283 7,325 4,230 2,950
In this case, the credit policy can be extended up to 42 days.
Question No 12:
Nepal Gas Company franchise ―NP Gas‖ stations in east and west sites of Nepal. All
payments by franchises for gas product, which average Rs. 420,000 a day are by cheque.
Presently, the overall time between mailing of the cheque and the time the company has
collected or available funds at its bank is six days.
159
Required:
i) How much money is tied up in this interval of time?
ii) To reduce this delay, the company is considering daily pickups of cheques from the
stations. In all, three cars would be needed and three additional people would be hired. This
daily pick up would cost Rs. 93,000 on an annual basis and it would reduce the overall
delay by two days. Currently, the opportunity cost of funds is 9% that being the interest
rate on marketable securities. Should the company inaugurate the prick up plan? Why?
Rather than mailing cheques to its bank, the company could deliver them by messenger
service. This would reduce the overall delay by one day and would cost Rs. 10,300
annually. Should the company undertake this plan? Why?
Answer
Average daily payment by cheque= Rs. 420,000 Required time for collection of fund= 6 days
i) Cash tied up= Rs. 420,000×6 days = Rs. 2,520,000

ii) Calculation of annual net cost/benefit for pick up plan:
Opportunity cost savings = Rs. 420,000 × 2 days × 9% = Rs. 75,600
Less: Annual cost of pick up plan = (Rs. 93,000)
Net annual loss = (Rs. 17,400)
Since this option brings loss, the company should not start pick up plan.
iii) Calculation of annual net cost/benefit by employing messenger: Opportunity cost savings
(Rs. 420,000 × 1 day × 9% = Rs. 37,800
Less: Annual cost of messenger service = (Rs. 10,300)
Annual Net savings = Rs. 27,500
Since this option brings net savings to the company, this is a viable option for the company.
Question No 13:
JL Ltd. is considering the revision of its credit policy with a view to increase its sales and
profit. Currently, all its sales are on credit and the customers are given one month‘s time to
settle the dues. It has recorded a contribution of 40% on sales. It can raise additional funds at
a cost of 20% per annum. The manager of the company has given the following options along
with estimates for consideration:
Current Option Option
Particulars Option I
position II III
Sales (Rs. in millions) 20 21 22 25
Average collection period (in months) 1 1.5 2 3
Bad debts (% of sales) 2 2 .50 3 5
Cost of credit administration (Rs. in millions) 0.12 0.13 0.15 0.3
Consider debtors at cost, unless otherwise mentioned, and advise the company for the best
option to implement.
Answer
Option
Particulars Present Option I Option II
III
1 Sales 20 21 22 25
2 Variable Cost at 60% of sales 12 12.6 13.2 15

3 Contribution (1-2) 8 8.4 8.8 10

4 Cost of Debtors p.a. =Variable Cost of Sales 12 12.6 13.2 15
5 Average Collection Period (in months) 1 1.5 2 3
6 Average Debtors outstanding = (4) x (5) / 12 1 1.575 2.2 3.75
7 Interest on Average Debtors [20% on (6) ] 0.2 0.315 0.44 0.75
8 Bad Debt [20%, 2.5%, 3% & 5% of item 1] 0.4 0.525 0.66 1.25
9 Cost of Credit Administration 0.12 0.13 0.15 0.3
10 Net Benefit [(3) - (7) - (8) - (9) 7.28 7.43 7.55 7.7
Conclusion:
Option III may be chosen due to maximum Net benefit.
Question No 14:
DVD Limited is a manufacturer of DVDs. It is currently producing 50,000 DVDs annually
and all the DVDs are sold on credit basis. Currently, 80% of its working capital requirement
is financed by Nepal Bank at an interest rate of 15% p.a. Remaining working capital
requirement is financed by informal loans at 24% p.a.
Following is the costing and revenue per unit:

Rs.
Cost of raw material 40
Labor charge 15
Overhead cost 30
Cost of production 85
Selling price of DVD 105
Moreover, following working capital parameters are observed:

a) Average raw material in stock: 1 month
b) Work in progress: a half month (Completion Stage: 50%)
c) Average finished goods in stock: 1 month.
d) Credit period allowed for DVD Limited: 1 month.
e) Credit period allowed to debtors: 2 months average time
f) DVD Limited normally pays to workers and overhead only after one month of work done.
g) Average level of bank and cash balances is Rs. 50,000, in all situations.
DVD Limited is planning of scaling up its operations to the production and sales level of
100,000 units of DVD per year. It wants to finance its working capital requirement by
another bank because the other bank is ready to finance its 90% of working capital
requirement at 12% p.a. However, minimum loan of Rs. 1.5 million needs to be taken. If it
decides to scale up, raw material, labor and overhead costs are likely to increase by 10% in
incremental output. However, selling price of the DVD will come to the level of Rs. 102 per
unit, if production is increased from existing level, and will apply to all the output.
Required:
i) Assess whether DVD Limited‘s plan is considerable or not.
161
ii) Briefly explain about the sources of working capital finance, and state how firms develop
a short term financing plan. (June 2014) ( 20 Marks)
Answer:
i) Calculation of Current Income
Rs.
Gross
Particulars Output Rate
Revenue
Sales revenue 50,000 105 5,250,000
Cost of production 50,000 85 4,250,000
Gross margin 1,000,000
Less: Interest on working capital
Existing Working Capital Requirement 1,013,542 (W.N. 1)
Bank Loan Interest (on 80% of WC) 810,834 15% -121,625
Interest for Informal Loan(remaining) 202,708 24% -48,650
-170,275
Net Margin 829,725
Calculation of income in Scaled Up Production Situation Rs.

Gross
Particulars Output Rate Revenue
Sales Revenue 100,000 102 10,200,000
Cost of Production 100,000 89.25 (average) 8,925,000
Gross margin 1,275,000
Less: interest on working capital:
Total Working Capital Requirement 2,073,438 (W.N. 2)
Bank Loan Interest (90% of WC) 1,866,094 12% 223,931)
Interest for Informal Loan(remaining) 207,344 24% (49,763)

(273,694)
Net Margin 1,001,306
Since scaling up of production will result more net margin as compared to existing, the
scaling up plan is considerable.
Working Notes:
a. Calculation of Working Capital Requirement (Current Production Level)
Per
Output Unit Working
Particulars Level Cost Time Lag Capital (Rs.)
Current Assets :
Stock of Raw material 50000 40 1 month 166,667
Work in Progress:
Raw Material 50000 40 Half Month (50% Complete) 41,667
Labor Charge 50000 15 Half Month (50% Complete) 15,625
Overhead cost 50000 30 Half Month (50% Complete) 31,250
Stock of Finished 50000 85 One Month 354,167

Goods
Average Debtor 50000 85 Two Months 708,333
Cash and Bank
Balances 50,000
Less: Current
Liabilities
Average Creditors 50000 40 One Month (166,667)
Outstanding labour
charge 50000 15 One Month (62,500)
Outstanding overhead
cost 50000 30 One Month (125,000)
Total working capital requirement 1,013,542
b. Calculation of Working Capital Requirement in Scale Up situation

Per Unit Cost Incremental
Increment (existing + 10% Working
Particulars al Output of existing) Time Lag Capital(Rs.)
Current Assets:
Stock of Raw
material 50000 44 1 month 183,333
Work in Progress:
Half Month (50%
Raw Material 50000 44 Complete) 45,833
Half Month (50%
Labor Charge 50000 16.5 Complete) 17,188
Half Month (50%
Overhead Cost 50000 33 Complete) 34,375
Stock of Finished
Goods 50000 93.5 One Month 389,583
Average Debtor 50000 93.5 Two Months 779,167

Less: Current
Liabilities
Average Creditors 50000 44 One Month (183,333)

Outstanding labour
charge 50000 16.5 One Month (68,750)
Outstanding overhead
cost 50000 33 One Month (137,500)
Incremental WC 1,059,896
Total Working Capital requirement in Scale up situation 2,073,438

(existing plus incremental WC)
ii)
163
There can be broadly two types of working capital finances. One is internal source and other
is external. Trade credit, credit from employees, credit from suppliers of raw materials etc.
are those sources which are generated within the business. Besides, short term loans from
banks, commercial paper, factoring etc. are other sources of working capital finances.
Designing for the best short-term financial plan inevitably proceeds by trial and error. The
financial manager must explore the consequences of different assumptions about cash
requirements, interest rates, limits on financing from particular sources, and so on. This is
because calculation of how much short term financing is required at what time is very much
crucial as there may be various options of financings with varied cost and other impacts.
Firms are increasingly using computerized financial models to help in this process. The
financial manager should remember the key differences between the various sources of short-
term financing—for example, the differences between bank lines of credit and commercial
paper. It should also be remembered that firms often raise money on the strength of their
current assets, especially accounts receivable and inventories.
Question No 15:
In order to increase sales from their present annual level of Rs. 2, 40,000, Agni Associates is
considering a more liberal credit policy. Currently, the firm has an average collection period
of 30 days. However, it is believed that as collection Period is lengthened, sales will increase
by following amounts-
Credit Policy Increase in Average Collection Period Increase in Sales
A 15 Days Rs. 10,000
B 30 Days Rs. 15,000
C 45 Days Rs. 17,000
D 60 Days Rs. 18,000
The Variable Costs of the Firm‘s product is 60% of Sales Price.

If the Firm has pre-tax opportunity cost of 20%, which credit policy should be pursued?
(Assume a 360-Day year). (June 2014)( 7 Marks)
Answer
a) Evaluation of alternative credit policies
Particulars Present Policy A Policy B Policy C Policy D
1. Sales(given) Rs.2,40,00 Rs.2,50,00 Rs.2,55,00 Rs.2,57,00 Rs.2,58,000
0 0 0 0
2.Variable cost at 60% of Rs.1,44,00 Rs.1,50,00 Rs.1,53,00 Rs.1,54,20 Rs.1,54,800
sales 0 0 0 0
3. Contribution=(1-2) Rs.96,000 Rs.1,00,00 Rs.1,02,00 Rs.1,02,80 Rs.1,03,200
0 0 0
4. Cost of Debtors Rs.1,44,00 Rs.1,50,00 Rs.1,53,00 Rs.1,54,20 Rs.1,54,800
p.a.=Variable Cost of sales 0 0 0 0
5. Collection Period (in 30 days 45 days 60 days 75days 90 days
days)
6. Average Debtors= Rs.12,000 Rs.18,750 Rs.25,500 Rs.32,125 Rs.38,700
7. Interests on Average Rs.2,400 Rs.3,750 Rs.5,100 Rs.6,425 Rs.7,740
Debtors (20%)
8. Net Benefit =(3-7) Rs.93,600 Rs.96,250 Rs.96,900 Rs.96,375 Rs.95,460
Decision:

The Firm should select Policy B, i.e. 60 Days credit, since maximum benefit is obtained
under that policy.
Note: Alternatively, student may solve the above question under incremental approach.
Question No 16:
You are provided with the following extract of cost sheet of ABC Ltd:
Per unit (Rs.)
Raw material 50
Direct Labour 20
Overhead (including depreciation of Rs. 10) 40
Total Cost 110
Profit 20
Selling price 130
Average raw material in stock is for one month. Average material in work-in-progress is for
half month. The suppliers allow credit for one month to the company; and it also allows one
month credit to its customers. Average time lag in payment of wages and overheadsare 10
days and 30 days respectively. 25% of the sales are on cash basis. Cash balance is expected to
be Rs. 100,000. Finished goods are expected to lie in the warehouse for one month.
Production is carried on evenly throughout the year and wages and overheads accrue
accordingly.
Required:
Prepare a statement of the working capital needed to finance the level of activity of 54,000
units of output. State your assumptions, if any.
Solution
As the annual level of activity is given at 54,000 units, it means that the monthly would be
54,000/12=4,500 units. The monthly working capital requirement for this monthly turnover
can now be estimated as follows:
Estimation of Working Capital Requirement

I. Current Assets: Amount(Rs.)
Minimum Cash Balance 100,000
Inventories:
Raw Materials (4,500×Rs.50) 225,000
Work in Progress:
Materials (4,500× Rs. 50)/2 112,500
Wages 50% of (4,500× Rs. 20)/2 22,500
Overheads 50% of (4,500× Rs. 30)/2 33,750
Finished Goods (4,500× Rs.100) 450,000
Debtors(4,500× Rs.100×75%) (at cost) 337,500
Gross Working Capital 1,281,250
II. Current Liabilities:
Creditors for Materials(4500× Rs.50) 225,000
165
Creditors for Wages(4,500× Rs.20)/3 30,000
Creditors for Overheads(4,500× Rs. 30) 135,000
Total Current Liabilities 390,000
Net Working Capital (I-II) 891,250
Working Note/ Assumptions:
Note: Alternatively, student may assume debtors on selling price i.e. Rs. 130 in such a case ,
overhead needs to be calculated including depreciation i.e. at Rs. 40 while calculating WIP &
finished goods.
1. The Overheads of Rs. 40 per unit include depreciation Rs. 10 per unit, which is non-cash
item. This depreciation cost has been ignored for valuation of work-in-progress, finished
goods and debtor. The overhead cost, therefore, has been taken only at Rs. 30 per unit.
2. In the valuation of work-in-progress, the raw materials have been taken at full
requirements for 15 days; but the wages and overheads have been taken only at 50% on the
assumption that on an average all units in work in progress are 50% complete.
3. Since, the wages are paid with a time lag of 10 days, the working capital provided by
wages have been taken by dividing the monthly wages by 3 (assuming a month to consist
of 30 days)
Question No 17:
A firm is contemplating to increase its credit period from 30 days to 60 days. The average
collection period, which is at present 45 days, is expected to increase to 75 days. Due to this
change, the bad debt expenses is expected to increase from the current level of 1 percent to 3
percent of sales. Total credit sales are expected to increase from the level of 30,000 units to
34,500 units. The present average cost per unit is Rs. 8. The variable cost and sales are Rs. 6
and Rs. 10 per unit respectively. The firm expects a rate of return of 15 percent.
Required
Analyse the firm‘s Proposal to change the credit period and advise
Answer
Profit on additional sales =Rs.(10 –6) × (34,500 -30,000)units
= 4 ×Rs. 4,500
= Rs. 18,000
Average Investment in Accounts Receivable:
Present = (Total Sales Qty ×Average Cost Per Unit)/Receivable Turnover ratio
= (30,000×8) / (360/45)
= 240,000/8
= Rs.30,000
Proposed = (Existing Cost of sales + additional cost of sales)/Receivable Turnover ratio

= (2,40,000+4,500×6) / (360/75)
= 2,67,000 / 4.8

= Rs. 55,625
Additional Investment in Accounts Receivable = Rs. 55,625 – Rs. 30,000
= Rs. 25,625
Cost of additional investment in Accounts Receivable at 15% = Rs. 25,625× 15%
= Rs. 3,843.75
Additional Bad debt expenses
= (34,500×10×0.03) – (30,000×10×0.01) = 10,350 – 3,000
= Rs. 7,350
The Net Effect of Proposed increase in credit period = Additional Profit – additional expenses
= Rs. 18,000 – Rs.3,843.75 – Rs. 7,350
= Rs. 18,000 – Rs. 11,193.75 = Rs. 6,806.25
Conclusion:
The extension of credit period would result in net gain of Rs. 6,806.25, so the firm is advised
to extend credit period from 30 days to 60 days.
Question No 18:
Integration Nepal Limited has present annual sales of Rs. 40 lakh. The unit sales price is Rs.
20. The variable cost is Rs. 12 per unit and fixed costs amount to Rs. 5 lakh per annum. The
present credit period of one month is proposed to be extended to either 2 or 3 months
whichever is more profitable. The following additional information is available:
Credit period 1 month 2 months 3 months

Increase in sales by - 10% 30%
% of Bad debts to sales 1% 2% 5%
Fixed costs will increase by Rs. 75,000 when sales will increase by 30%. The company
requires a pre-tax return on investment at 20%.
Required:
Evaluate the profitability of the proposals and recommend the company.
Answer
a) Evaluation of profitability for different Credit periods (Rs.)
Particulars 1 month 2 months 3 months
A. Sales 4,000,000 4,400,000 5,200,000
Total Costs: 2,900,000 3,140,000 3,695,000
Variable cost @ Rs. 12 p/u 2,400,000 2,640,000 3,120,000
Fixed costs 500,000 500,000 575,000
B. Operating Profit 1,100,000 1,260,000 1,505,000
C. Opportunity cost of 48,333 104,667 184,750
Investment in Receivables
(see working note 1)
D. Bad Debt 40,000 88,000 260,000
E. Net Benefit (B-C-D) 10,11,667 10,67,333 10,60,250
Recommendation: The Credit period of 2 months should be adopted since the net benefits
under this policy are higher than those under other policies.
167
Working Note 1: Calculation of cost of investment in receivables:
Opportunity cost = Total cost x Collection period/360 days x Rate of return
1 month = Rs. 2,900,000 x 1/12x 20% =Rs. 48,333
2 months= Rs. 3,140,000 x 2/12x20%= Rs. 104,667
3 months=Rs. 3,695,000 x 3/12x20%= Rs. 184,750
Alternate: Students can also refer the incremental approach.
Question No 19:
A company is considering its Working Capital Investment and Financing Policies for the next
year. Estimated fixed assets and current liabilities for the next year are Rs. 2.60 Crores and
Rs. 2.34 Crores respectively. Estimated sales and EBIT depend on current assets investment,
particularly inventories and book-debts. The following alternative working capital policies
are under consideration:
(Rs. in Crores)
Working capital policy Investment in Estimated EBIT
current assets sales
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00
After evaluating the working capital policies, the Financial Controller of the company has
advised the adoption of the moderate working capital policy. Further, the company is
examining the following alternatives for use of long-term and short-term borrowings for
financing its assets:
(Rs. in Crores)
Financing Policy Short-term debt Long-term debt
Conservative 0.54 1.12
Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest rate-average 12% 16%
The company will use Rs. 2.50 Crores of the equity funds. The corporate tax rate is 25%.
Required:
i) Calculate net working capital position, under each working capital policy.
ii) Calculate net working capital position, rate of return on shareholder's equity, and
current ratio under consideration of different financing policies and financial controller's
advice. (June) 2015) ( 9 Marks)
Answer
a) i) Net Working Capital position (Rs. Crores)
Particulars Working Capital Policy
Conservative Moderate
Aggressive
Current assets 4.50 3.90 2.60
Less: Current liabilities 2.34 2.34 2.34
Net working Capital position 2.16 1.56 0.26

ii) Calculation of Net WC position, ROSE and CR under different financing policy and FC's
advices (Rs. Crores)
Particulars Financing Policy
Conservative Moderate
Aggressive
Fixed assets 2.60 2.60 2.60
Current assets 3.90 3.90 3.90
Total assets 6.50 6.50 6.50
Current liabilities 2.34 2.34 2.34
Short-term debt 0.54 1.00 1.50
Long-term debt 1.12 0.66 0.16

Equity capital 2.50 2.50 2.50
Total liabilities 6.50 6.50 6.50

Budgeted sales 11.50 11.50
11.50
EBIT 1.15 1.15 1.15
Less: Interest on short-term debt @ 12% 0.06 0.12 0.18
Interest on long-term debt @ 16% 0.18 0.11 0.03
EBT 0.91 0.92 0.94

Less: Tax @ 25% 0.23 0.23 0.24
EAT 0.68 0.69 0.70
(a) Net working Capital position 1.02 0.56 0.06
(Current assets-current liabilities)

(b) Rate of Return on shareholders' Equity Capital 27.2% 27.6% 28%
(EAT/Equity Share Capital) × 100
(c) Current ratio (Current assets/current liabilities) 1.35 1.17 1.02
Question No 20:
RPG Enterprises has been operating its manufacturing facilities till Aasadh end 2072 on a
single shift working with the following cost structure:
Per Unit (Rs.)
Cost of Material 6
Wages (out of which 40% is fixed) 5
Overheads (out of which 80% is fixed) 5
Profit 2
Selling Price 18
Sales during 2071/72 : Rs. 432,000.
As at Ashadh end 2072 the company held:
(Rs.)
169
Stock of raw materials (at cost) 36,000
Work- in- progress (valued at prime cost) 22,000
Finished goods (valued at total cost) 72,000
Sundry debtors 108,000
In view of increased market demand, it is proposed to double production by working at extra

shift. It is expected that a 10% discount will be available from suppliers of raw materials, in
view of increased volume of business. Selling price will remain the same. The credit period
allowed to customers will remain unaltered. Credit availed from suppliers will continue to
remain at the present level, i.e. 2 months. Lag in payment of wages and expenses will
continue to remain half a month.
Required:
Assess the additional working capital requirements, if the policy to increase output is
implemented.
Answer
WN. 1) Sales in Units 2071/072

WN. 1) Sales in Units 2071/072
=24 000
2) Stock of Raw Materials in Units on Ashadh end 2072
=6000 Units
3) Stock of Work-in-Progress in Units on Ashadh end 2072
=2000 Units
4) Stock of Finished Goods in Units on Ashadh end 2072

=4500 Units
5) Statement of cost at single shift and double shift working
24000 Units 48000 Units

Per Unit Total Per Unit Total
Rs. Rs. Rs. Rs.
Raw materials 6 144,000 5.4 259,200
Wages - Variables 3 72,000 3 144,000
Fixed 2 48,000 1 48,000
Overheads- Variables 1 24,000 1 48,000
Fixed 4 96,000 2 96,000
Total cost 16 384,000 12.4 5,95,200
Profit 2 48,000 5.6 268,800
18 432,000 18 864,000
Comparative Statement of Working Capital Requirement

Single Double
Shift Shift
Amount
Unit Rate Unit Rate Amount (Rs)
(Rs)
Current Assets:
Inventories -
Raw Materials 6000 6 36,000.00 12000 5.4 64,800.00
Work-in-Progress 2000 11 22,000.00 2000 9.4 18,800.00
Finished Goods 4500 16 72,000.00 9000 12.4 111,600.00
Sundry Debtors 6000 18 108,000.00 12000 18 216,000.00
Total Current Assets (A) 238,000.00 411,200.00
Current Liabilities:
Creditors for Materials 4000 6 24,000.00 8000 5.4 43,200.00
Creditors for Wages 1000 5 5,000.00 2000 4 8,000.00
Creditors for Expenses 1000 5 5,000.00 2000 3 6,000.00
Total Current Liabilities (B) 34,000.00 57,200.00
Working Capital : 204,000.00 354,000.00
(A) - (B)
Less : Profit included in
6000 2 12,000.00 12000 5.6 67,200.00
Debtors
192,000.00 286,800.00
Increase in Working Capital Requirement is (Rs. 286,800 - Rs. 192,000) Rs. 94,800
Notes:
 The quantity of materials in process will not change due to double shift working since
work started in the first shift will be completed in the second shift.
171
 The valuation of work-in-progress based on prime cost as per the policy of the
company is as under.
Single Shift Double Shift
(Rs.) (Rs.)
6 5.4
3 3
2 1
11 9.4
Question No 21:
The current assets and current liabilities of CSZ Co at the end of March 2014 are as follows:
NRs.ǯ000 NRs.ǯ000
Inventory 5,700
Trade receivables 6,575 12,275
Trade payables 2,137
Overdraft 4,682 6,819
Net current assets 5,456
For the year to end of March 2014 CSZ Co had domestic and foreign sales of NRs. 40
million, all on credit, while cost of sales was NRs.26 million. Trade payables related to both
domestic and foreign suppliers.
For the year to end of March 2015, CSZ Co has forecast that credit sales will remain at
NRs.40 million while cost of sales will fall to 60% of sales. The company expects
current assets to consist of inventory and trade receivables, and current liabilities to
consist of trade payables and the companyǯs overdraft.
CSZ Co also plans to achieve the following target working capital ratio values for the year to
the end of March 2015:
Inventory days 60 days

Trade receivables days 75 days
Trade payables days 55 days
Current ratio 1.4 times
Required:
Calculate the working capital cycle (cash collection cycle) of CSZ Co at the end of March
2014 and discuss whether a working capital cycle should be positive or negative.
Calculate the target quick ratio (acid test ratio) and the target ratio of sales to net working
capital of CSZ Co at the end of March 2015.
(RTP December 2014)
Answer

Inventory days 80 days {365 x (5,700/26,000)}
Trade receivables days 60 days {365 x (6,575/40,000)}

Trade payables days 30 days {365 x (2,137/26,000)}
Working capital cycle of CSZ Co 110 days (80 + 60 – 30)
The working cycle of CSZ Co is positive and the company pays its trade suppliers 110
days (on average) before it receives cash from its customers. This represents a financing need
as far as CSZ Co is concerned, which could be funded from a short-term or long-term source.
If the working capital cycle had been negative, CSZ Co would have been receiving cash
from its customers before it needed to pay its trade suppliers. A company, which does not
give credit to its customers, such as a supermarket chain, can have a negative working capital
cycle.
b) At the end of March 2015:

Cost of sales = 40,000,000 x 0.6 = NRs. 24,000,000
Inventory using target inventory days = 24,000,000 x 60/365 = NRs. 3,945,206
Trade receivables using target trade receivables days = 40,000,000 x 75/365 = NRs. 8,219,178
Current assets = 3,945,206 + 8,219,178 = NRs. 12,164,384
If the target current ratio is 1.4 times, current liabilities = 12,164,384/1·4 = NRs. 8,688,846
The target quick ratio (acid test ratio) = 8,219,178/8,688,846 = 0.95 times
Net current assets at the end of March 2015 = 12,164,384 – 8,688,846 = NRs. 3,475,538
Target sales/net working capital ratio = 40,000,000/3,475,538 = 11.5 times
Question No 22:
XYZ Co has annual sales revenue of NRs. million and all sales are on daysǯ credit,
although customers on average take ten days more than this to pay. Contribution represents
60% of sales and the company currently has no bad debts. Accounts receivable are
financed by an overdraft at an annual interest rate of 7%.
XYZ Co plans to offer an early settlement discount of 1.5% for payment within 15 days and
to extend the maximum credit offered to 60 days. The company expects that these
changes will increase annual credit sales by 5%, while also leading to additional
incremental costs equal to 0.5% of turnover. The discount is expected to be taken by 30%
of customers, with the remaining customers taking an average of 60 days to pay.
Required:
Evaluate whether the proposed changes in credit policy will increase the profitability of XYZ
Co. (RTP December 2014)
Answer
Current average collection period = 30 + 10 = 40 days Current accounts receivable = 6m x 40/
365 = NRs. 657,534
Average collection period under new policy = (0.3 x 15) + (0.7 x 60) = 46.5 days New level
of credit sales = NRs. 6.3 million
Accounts receivable after policy change = 6.3 x 46.5/ 365 = NRs. 802,603 Increase in
financing cost = (802,603 – 657,534) x 0.07 = NRs. 10,155
173
Amount (NRs.)
Increase in financing cost 10,155

31,500
Incremental costs
(6.3m x 0.005)
28,350
Cost of discount
(6.3m x 0.015 x 0.3)
Increase in costs 70,005
180,000
Contribution from increased sales
(6m x 0.05 x 0.6)
Net benefit of policy change 109,995
The proposed policy change will increase the profitability of XYZ Co.
Question No 23:
Entity C has monthly sales of NRs. 100,000. A factor has offered to take over the
administration of entity Cǯs trade receivables, on a non-recourse basis. It would charge a
fee of 4% of the value of invoices processed. If the factor takes over this work, entity C
would save monthly administration costs of NRs. 2,000 and would avoid bad debts, which
are 0.75% of sales. Entity C has been informed by the factor that the average collection
period will be reduced from 2 months to 1 month.
The factor will also provide finance by lending 80% of the value of unpaid invoices,
charging at an annual rate of 8% on the cash that it lends. At the moment, entity C finances
its trade receivables with bank overdraft finance at 9% per year interest.
Required
Calculate the net effect on annual profits of Entity C if the factor took over the
administration of the trade receivables and provided finance on the terms described above
(RTP December 2014)
Answer
Annual sales
= NRs. 100,000 x 12 months
= NRs. 1,200,000.
Average trade receivables without the factor

= NRs. 1,200,000 x 2 months/12 months
= NRs. 200,000
Average trade receivables with the factor

= NRs. 1,200,000 x 1 months/12 months
= NRs. 100,000
Annual Cost Amount (NRs.)

Without Factor

Administration (12 x NRs. 2000) 24,000

Bad debts (0.75 x NRs. 1,200,000) 9,000
Interest Cost of Finance (9% x NRs. 200,000) 18,000 51,000
With Factor
Fees (4% x NRs. 1,200,000) 48,000
Interest cost of finance
Factor finance (8% x 80% x NRs. 100,000) 6,400
Overdraft finance (9% x 20% x NRs. 100,000) 1,800 56,200
Net extra cost of the factor per year 5,200
175
CHAPTER 9
DIVIDEND POLICY

Question No 1:
a. Retention policy and Pay Out policy (June 2010)(2.5 Marks)
Answer
The firms resort to different dividend policies according to the situations. The firms deciding
to retain the internal accruals and deciding not to pay dividends are called retention policy.
Whereas the firms deciding to pay the dividends are called pay out policy.
The Higher retention policy will lead to lower pay out policy and vice-versa.
b. Bonus share and stock-split (December 2010)(2.5 Marks)

Answer
A bonus share is simply the payment of additional ordinary shares to the existing
shareholders. It is only a bookkeeping shift from the reserve and surplus account to the
ordinary share capital account of the company. A shareholder‘s proportional ownership in the
firms remains unchanged following the bonus issue.
Bonus shares are sometimes employed to conserve cash. Instead of increasing cash dividend
as earnings rise, a company may desire to retain a greater proportion of its earnings and
declare the issue of bonus share.
Stock split is an increase in the number of shares outstanding by a proportional reduction in

the face value of the share. The main purpose behind the stock split is to place the company‘s
share in a more popular trading range thus attracting more buyers.
In the issue of bonus share, face value of the share remains unaffected. On the other hand, a
share split causes the face value to come below the previous value.
Unless there is an increase in the earnings of the company, bonus issue will have the effect of
bring down the earnings per share. Accordingly, it will be difficult for the company to
maintain the earlier dividend per share. Similarly, it will be difficult for a company to
maintain the same cash dividend per share before and after a stock split.
Question No 2:
Write short note on Tax consideration influencing the dividend policy of the firm
(June 2010)( 2.5 Marks)
Answer
The firm's dividend policy is directed by the provisions of income-tax law. If a firm has a
large number of owners, in high tax bracket, its dividend policy may be to have higher
retention. As against this if the majority of shareholders are in lower tax bracket requiring
regular income the firm may resort to higher dividend payout, because they need current
income and the greater certainty associated with receiving the dividend now, instead of the
less certain prospect of capital gains later.
Question No 3:
Describe Walter's approach to dividend policy along with his formulation.
Answer
177
The formula given by Prof. James. E. Walter shows how the dividend policy can be used to
maximise the wealth position of the equity holders. He argues that in the long run, the share
prices reflect only the present value of the expected dividends. Retentions influence share
prices only through their effect on further dividends. The relationship between dividend and
share price can be shown on the basis of the following formula:
where,
Vc = Market value of the ordinary shares of the company
Ra = Return on internal retention i.e. the rate company earns on retained profits.
Rc = Capitalisation rate
E = Earnings per share
D = Dividend per share
Professor Walter emphasizes two factors which influence the market price of a share. The
first is the dividend per share and the second is the relationship between internal return on
retained earnings and the market expectation from that company as reflected in the
capitalisation rate. In other words, if the internal return on retained earnings is higher than the
market capitalisation rate, the value of the ordinary shares would be high even if the
dividends are low. However, if the internal return within the business is lower than what the
market expects, the value of the share would be low. In such a case, the share holders would
prefer that a higher dividend is declared so that they can utilise the funds in more profitable
opportunities elsewhere.
Question No 4:
For each of the companies described below, would you expect it to have a low, medium, or
high dividend payout ratio? Explain why?
i. A company with a large proportion of inside ownership, all of whom are high income
individuals.
ii. A growth company with an abundance of good investment opportunities.
iii. A company that has high liquidity and much unused borrowing capacity and
experiencing ordinary growth.
iv. A dividend paying company that experiences an unexpected drop in earnings from an
upward sloping trend line.
v. A company with volatile earnings and high business risk.

Answer
i. Low payout ratio. Highly taxed owners probably will want to realize their returns
through capital gains.
ii. Low payout ratio. There will be no or low residual funds.

iii. Medium or high payout ratio. There are likely to be funds left over after funding
capital expenditures. Moreover, the liquidity and access to borrowing give the
company considerable flexibility.
iv. Medium or high payout ratio. Unless the company cuts its dividend, which probably
is unlikely in the short run, its payout ratio will rise with the drop in earnings.
v. Low payout ratio. The company will probably wish to retain earnings to build its
financial strength in order to offset the business risk
Question No 5:
Discuss the weaknesses of the dividend growth model as a way of valuing a company and its
shares. (RTP December 2014)
Answer
The dividend growth model (DGM) is used widely in valuing ordinary shares and hence in
valuing companies, but there are a number of weaknesses associated with its use.
a. The future dividend growth rate

The DGM is based on the assumption that the future dividend growth rate is constant, but
experience shows that a constant dividend growth rate is, in reality, very rare. This may be
seen as less of a problem if the future dividend growth rate is regarded as an average growth
rate. Estimating the future dividend growth rate is very difficult in practice and the DGM is
very sensitive to small changes in this key variable. It is common practice to estimate the
future dividend growth rate by calculating the historical dividend growth, but the assumption
that the future will reflect the past is an easy one to challenge.
b. The cost of equity

The DGM assumes that the future cost of equity is constant, when in reality it changes
quite frequently. The cost of equity can be calculated using the capital asset pricing model,
but this model usually employs historical information, which may not reflect accurately
expectations about the future.
c. Zero dividends
It is sometimes claimed that the DGM cannot be used when no dividends are paid, but this
depends on whether dividends are expected in the future. If dividends are forecast to be
paid from a future date, the dividend growth model can be applied at that point to calculate
a share price, which can then be discounted to give the current ex dividend share price. Only
in the case where no dividends are paid and no dividends are expected to be paid will the
DGM have no application.
Question No 6:
Explain the Residual theory of dividend policy ( RTP December 2014)
Answer
The residual theory of dividend policy is that the optimal amount of dividends should be
decided as follows:
 If a company has capital investment opportunities that will have a positive NPV, it should
invest in them because they will add to the value of the company and its shares.
 The capital to invest in these projects should be obtained internally (from earnings) if
possible.
 The amount of dividends paid by a company should be the residual amount of
earnings remaining after all these available capital projects have been funded by retained
179
earnings.
 In this way, the company will maximize its total value and the market price of its shares.
A practical problem with residual theory is that annual dividends will fluctuate, depending
on the availability of worthwhile capital projects. Shareholders will therefore be unable to
predict what their dividends will be
Question No 7:
Distinguished between Growth firm and Declining firm for relevance of dividend
(June 2015)( 2.5 Marks)
Answer
According to the relevance theory of dividend, dividends are relevant and the amount of
dividend affects the value of the firm. Walter, Gorden and others propounded that dividend
decisions are relevant in influencing the value of the firm.
Growth Firm
In growth firms internal rate of return is greater than the normal rate (r>k). Therefore, r/k
factor will be greater than 1. Such firms must reinvest retained earnings since existing
alternative investments offer a lower return than the firm is able to secure. Each rupee of
retained earnings will have a weighting in Walter`s formula than a comparable rupee of
dividend.
Thus, large the firm retains, higher the value of the firm. Optimum dividend payout ratio for
such a firm will be zero.
Declining Firm
Firms which earn on their investments less than the minimum rate required by investments
are designated as declining firms. The management of such firms would like to distribute its
earnings to the stockholders so that they may either spend it or invest elsewhere to earn
higher return than earned by the declining firms. Under such a situation each rupee of
retained earnings will receive lower weight than dividends and market value of the firm will
tend to be maximum when it does not retain earnings at all.
Practical Question
Question No 8:
The following information pertains to a company:
__________________________________________________________
__
Net profit (Rs. in ‗000)
60,000
12% preference shares capital (Rs. in ‗000) 20,000
Number of equity shares outstanding (in ‗000)
60
Return on investment
20%
Equity capitalization rate
16%
_________________________________________________________
___

i. Compute the dividend payout ratio so as to keep the share price at Rs. 412.50 by using
Walter model, and
ii. Ascertain (giving reasons) the optimum payout ratio if return on investment is 16% and
equity capitalization rate is 18%. (June 2011)(6 Marks)
Answer
Calculation of Earnings per Share (EPS)
(Rs. in ‗000)
___________________________________________________________________________
___
Net Profit
6,000
Less: Preference Dividend (20,000 X 12 / 100)
2,400
Net Profit after Preference Dividend
3,600
Earnings per Share in Rs. [Rs 3,600,000/60,000]
60
___________________________________________________________________________
___
(i) Calculation of Dividend Payout Ratio:

Let dividend payout ratio be ‗x‘. The formula for share price under Walter model is::
where
P = Market price per share (Rs. 412.50 Given)

E = Earnings per share (Rs. 60 derived above)
D = Dividend per share (Rs. 60 x Given)
r = return on investment (0.20 given)
Ke = Cost of equity (0.16 Given)
Substituting the values, we get:
Or, 66 = 75 – 15 x
Or, 15 x = 75 – 66
Or, x 9/15 = 0.60, or 60%
181
Thus, the required dividend payout ratio is 60%.
(ii) Optimum Payout Ratio when Return on Investment (16%) is less than Equity
Capitalization Rate (18%)
According to Walter model, when return on investment is less than the cost of capital, the
value of the share is highest when dividend payout is maximum. It is evident that when r/Ke
is less than 1, higher dividend will maximize the value per share. Therefore, the dividend
payout should be 100% in this case.
Question No 9:
Kathmandu Wool House is a manufacturer and exporter of woolen garments to most of the
European countries and to United States of America. The business of the company is
expanding day by day and in the previous financial year, the company has registered a 25%
growth in export business.
The company is in the process of considering a new investment project. It is an all equity
financed company with 500,000 equity shares of face value of Rs. 100 per share. The current
market price of this share is Rs. 250 ex-dividend. Annual earnings are Rs. 50 per share, and
in the absence of new investment, this will remain constant in perpetuity. All earnings are
distributed at present. A new investment is available which will cost Rs. 17,500,000 in one
year‘s time and will produce annual cash inflows thereafter of Rs. 5,000,000.
Required
Analyze the effect of the new project on dividend payments and the share price of the
company (June 2012) (7 Marks)
Answer
Current Market Price of share(P) = Rs. 250
Annual Earning (D) = Rs. 50
= 50/250 X 100
= 20%
Earnings per share = Rs. 50
Total earnings = 500,000 X Rs. 50 = Rs. 25,000,000
New Project Cost = Rs. 17,500,000
Since the project is financed out of internal accruals (equity financed company), the
amount available for dividend at the end of 1st year is = 1st year earnings – project
cost
= Rs. 25,000,000 – Rs. 17,500,000

= Rs. 7,500,000
Dividend per share in 1st year:
= Rs. 7,500,000 /500,000 shares
= Rs. 15 per share
Dividend per share in 2nd year, which will remain constant in perpetuity.

= Rs. 60 per share
Since all earnings are distributed, EPS and DPS will remain the same.
The present value of new share price after the new project is taken up:
( )
= 12.50 + 250
= Rs. 262.50
It is seen that due to the investment in new project, dividend payments in 1st year will
decrease but from 2nd year onward it will increase and the share price of the company will
increase.
Question No 10:
Vikas Engineering Ltd., currently has 100,000 outstanding shares selling at Rs. 100 each.
The firm has net profit of Rs. 1,000,000 and wants to make new investments of Rs.
2,000,000 during the period. The firm is also thinking of declaring a dividend of Rs. 5 per
share at the end of the current fiscal year. The firm‘s opportunity cost of capital is 10
percent.
Required:
 What will be the price of the share at the end of the year if a dividend is not declared, and
if a dividend is declared? What will be the impact on shareholders‘ wealth?
 How many new shares must be issued when dividend is declared?
(Junes 2013) ( 8 Marks)
Answer
i) The price of the share at the end of the current fiscal year is determined as follows:
P1= P0 (1+Ke) – DIV1

The value of P, when dividend is not paid, is:
P1 = Rs 100 (1.10) - 0 = Rs 110
When dividend is paid it is:
P1 = Rs 100 (1.10) - Rs 5 = Rs 105.
It can be observed that whether dividend is paid or not the wealth of shareholders
remains the same. When the dividend is not paid the shareholder will get Rs 110 by way
of the price per share at the end of the current fiscal year. On the other hand, when
dividend is paid, the shareholder will realize Rs 105 by way of the price per share at the
end of the current fiscal year plus Rs 5 as dividend.
ii) The number of new shares to be issued by the company to finance its investments is
determined as follows:
183
mP1 = I –(E-n× DIV1)

m×105=[2,000,000 – {1,000,000 – (100,000×50}]
105m = 2,000,000 – (1,000,000 -500,000)
105m = 1,500,000
m= 1,500,000/105 =14,286 shares.
Where,
m= No. of new shares to be issued
I= Investment
N=No. of existing shares
DIV1= Dividend per share
E=earning
Question No 11:
Determine the market value of equity shares of the company from the following information
as per Walter`s Model:
Earnings of the company Rs. 5,00,000
Dividend paid Rs. 3,00,000
Number of the shares outstanding 1,00,000
Price-earnings ratio 8
Rate of return on investment 15%
Are you satisfied with the current dividend policy of the firm? If not what should be the
optimal dividend payout ratio? (June 2014) ( 6 Marks)
Answer
Price earning ratio= Market Price/EPS
8= Market Price/5
So, Market Price=Rs. 40
EPS= 500,000/100,000=Rs.5
DPS=300,000/100,000=Rs. 3
Dividend payout ratio=DPS/EPS*100

=3/5*100
=60%
As the P/E ratio is given 8, and the cost of capital (Ke) is also defined as the reciprocal of P/E
ratio, therefore the Ke may be taken as 1/8=.125 i.e.12.5%
Since, this is a growth firm having rate of return (15%) more than cost of capital(12.5%),
therefore, the company will maximize its market price if it retains its 100% of its profits. The
current market price of Rs. 40 ( based on P/E Ratio can be increased by reducing the payout
ratio. If the company opts for 100% retention (i.e. 0% payout), the market price of the share
as per Walter‘s formula should be as follows;
P=D/Ke+((r/Ke)(E-D))/Ke
=0/.125+((.15/.125)(5-0))/.125
= Rs. 48
So, the firm can increase the market price of the share up to Rs. 48 by increasing the retention
ratio to 100% or in other words, the optimal dividend payout for the firm is 0.

Question No 12:
ABC limited expects, with some degree of certainty, to generate the following profits and to
have the following capital investment during the next five years.
(Rs. in thousand)
Year 1 2 3 4 5
Net Income 5,000 4,000 2,500 2,000 1,500
Investment 2,500 2,500 3,200 4,000 5,000
The investments are financed first from the same year profit and the shortfall, if any, shall be
externally financed. The company currently has 1,000,000 equity shares and pays dividend of
Rs. 5 per share.
Required:
i. Determine dividend per share, if dividend policy is treated as a residual decision.
ii. Determine dividend per share and the amount of the external financing that will be
necessary, if a dividend payout ratio of 50% is maintained (December 2014)
( 5 Marks)
Answer
Calculation of the Dividend per share if dividend policy is treated as a residual decision
Year Profit(Rs.) Investment(Rs.) Balance(Rs.) DPS(Rs.)

1 5,000,000 2,500,000 2,500,000 2.50
2 4,000,000 2,500,000 1,500,000 1.50
3 2,500,000 3,200,000 - 0
4 2,000,000 4,000,000 - 0
5 1,500,000 5,000,000 - 0
Calculation of the Dividend per share and external financing required at 50% payout
External
Year Profit(Rs.) Dividends(Rs.) DPS(Rs.) Investment(Rs.) Financing(Rs.)
1 5,000,000 2,500,000 2.50 2,500,000 -
2 4,000,000 2,000,000 2.00 2,500,000 500,000
3 2,500,000 1,250,000 1.25 3,200,000 1,950,000
4 2,000,000 1,000,000 1.00 4,000,000 3,000,000
5 1,500,000 750,000 0.75 5,000,000 4,250,000
185
Chapter 8
OVERVIEW OF CAPITAL MARKET

Chapter 8: Overview of Capital Market
Question No 1:
Write short note on
a. Bridge Finance (June 2010) (2.5 Marks)
Answer
Bridge Finance refers, normally, to loans taken by a business, usually from commercial
banks for a short period, pending disbursement of term loans by financial institutions.
Normally, it takes time for the financial institution to finalise procedures of creation of
security, tie-up participation with other institutions etc., even though a positive appraisal
of the project has been made. However, once the loans are approved in principle, firms, in
order not to lose further time in starting their projects, arrange for bridge finance. Such
temporary loan is normally repaid out of the proceeds of the principal term loans.
Generally the rate of interest on bridge finance is 1% or 2% higher than on normal term
loans.
b. Commercial paper (June 2011) (2.5 Marks)

Answer
It is an important money market instrument in advanced countries like USA to raise short
term funds. It is a form of unsecured promissory note issued by firms to raise short term
funds. The commercial paper market in the USA is a blue-chip market where financially
sound and highest rated companies are able to issue commercial papers. The buyers of
commercial paper include banks, insurance companies, unit trusts and firms with surplus
funds to invest for a short period with minimum risk. Given this objective of the investors
in the commercial paper market, there would be demand for commercial papers of highly
creditworthy companies.
c. Debt Securitization (December 2011) ( 2.5 Marks)

Answer
It is a method of recycling of funds. It is especially beneficial to financial intermediaries
to support the lending volumes. Assets generating steady cash flows are packaged
together and against this asset pool, market securities can be issued, e.g. housing finance,
auto loans, and credit card receivables.
Process of Debt Securitisation:
(i) The origination function – A borrower seeks a loan from a bank and financial
institution. The credit worthiness of borrower is evaluated and contract is
entered into with repayment schedule structured over the life of the loan.
(ii) The pooling function – Similar loans on receivables are clubbed together to
create an underlying pool of assets. The pool is transferred in favour of
Special purpose Vehicle (SPV), which acts as a trustee for investors.
(iii) The securitisation function – SPV will structure and issue securities on the
basis of asset pool. The securities carry a coupon and expected maturity which
can be asset-based/mortgage based. These are generally sold to investors
through merchant bankers. Investors are – pension funds, mutual funds,
insurance funds.
187
The process of securitization is generally without recourse i.e. investors bear the credit
risk and issuer is under an obligation to pay to investors only if the cash flows are
received by him from the collateral. The benefits to the originator are that assets are
shifted off the balance sheet, thus giving the originator recourse to off-balance sheet
funding
d. Information Asymmetry (December 2012) ( 2.5 Marks)

Answer:
Information asymmetry deals with the study of decisions in transactions where one
party has more or better information than the other. This creates an imbalance of
power in transactions which can sometimes cause the transactions to go awry, a kind
of market failure in the worst case. Examples of this problem are adverse selection,
moral hazard, and information monopoly. Most commonly, information asymmetries
are studied in the context of principal-agent problems. Information asymmetry causes
misinforming and is essential in every communication process.
Information asymmetry models assume that at least one party to a transaction has
relevant information whereas the other(s) do not. Some asymmetric information
models can also be used in situations where at least one party can enforce, or
effectively retaliate for breaches of, certain parts of an agreement whereas the other(s)
cannot.
d. Over the counter (OTC) market (December 2012) ( 2.5

Marks)
Answer:
Over-the-counter market functions as part of the secondary market for stocks and
bonds not listed on a stock exchange. The market is composed of brokers and
dealers who stand ready to buy and sell securities at quoted prices. Most corporate
bonds and a growing number of stocks are traded over-the-counter instead of being
traded on an organized exchange.
The OTC market these days has become highly mechanized with market participants
linked together by a telecommunication network. Unlike the organized exchange, the
participants of a OTC market do not come together in a single place. A network is
maintained and price quotations are made instantaneously. In the past, most
companies preferred to list their shares on major exchanges as a matter of prestige and
necessity. This has undergone change due to the rapid development in the field of
electronics.
e. Venture Capital Financing (June 2014) ( 2.5 marks)

Answer:
Venture Capital financing refers to financing of high risk ventures promoted by new qualified
entrepreneurs who require funds to give shape to their ideas. Here, a financier (called venture
capitalist) invest in the equity or debt of an entrepreneur (promoter) undertaking who has a
potentially successful business idea but does not have desired track record or financing
backing. Generally, venture capital funding is associated with heavy initial investment
business like energy conservation, quality up gradation or with sunrise sector like information
technology.
f. Debt Securitization (June 2014) (2.5 Marks)

Answer

It is the method of recycling of funds. It is especially beneficial to financial intermediaries to

support the lending volumes. Assets generally steady cash flows are packaged together and
against this assets pool, market securities can be issued, e.g. housing finance, auto loans and
credit card receivables.
Process of Debt Securitization:
 The origination function- A borrower seeks a loan from a bank and financial institution.
The credit worthiness of borrower is evaluated and contract is entered into with
repayment schedule structured over the life of loan.
 The pooling function – Similar loans on receivables are clubbed together to create an
underlying pool of assets. The pool is transferred in favors of special purpose vehicle
(SPV), which acts as a trustee for investors.
The securitization function- SPV will structure and issued securities on the basis of assets
pool. The securities carry coupon and expected maturity which can be assets-based/mortgage
based.
g. Treasury Bills ( December 2014) ( 2.5 marks)

Answer
Treasury bills are obligation of the government. They are sold on discounted basis. The
investor does not receive an actual interest payment. The return is the difference between the
purchase price and the face (par) value of the bill.
The treasury bills are issued only in bearer form. They are purchased, therefore, without
investors' name upon them. This makes them easily transferable from one investor to another.
A very active secondary market exists for these bills. The secondary market for bills not only
makes them highly liquid but also allows purchase of bills with very short maturities. As the
bills have the full financial backing of the government, they are, for all practical purposes,
risk-free. The negligible financial risk and the high degree of liquidity make their yield lower
than those on the other marketable securities. Due to their virtually risk free nature and
because of active secondary market for them, treasury bills are one of the most popular
marketable securities even though the yield on them is lower.
h. Private equity (June 2015) ( 2.5 Marks)

Answer
Private equity refers to the composition of equity and debt investment in the companies that
are not publicly traded on a stock exchange. It is generally made by a private equity firm, a
venture capital firm or an angel investor, each of which have their own set of goals,
preferences and investment strategies. Nonetheless, all provide working capital to a target
company to nurture expansion, new-product development, or restructuring of the company‘s
operations, management, or ownership.
Among the most common investment strategies in private equity are: leveraged buyouts,
venture capital, growth capital, distressed investments and mezzanine capital. In a typical
leveraged buyout transaction, a private equity firm buys majority control of an existing or
mature firm. This is distinct from a venture capital or growth capital investment, in which the
investors (typically venture capital firms or angel investors) invest in young, growing or
emerging companies, and rarely obtain majority control.
It is also often grouped into a broader category called private capital, generally used to
describe capital supporting any long-term, illiquid investment strategy.
Question No 2:
189
a. Proxy fight and Takeover (June 2011) 2.5 Marks)
Answer
Management always solicits stockholders‘ proxies and usually gets them. However if earnings
are poor and stockholders are dissatisfied, an outside group might solicit the proxies in an
effort to overthrow management and take control of the business. This is known as proxy
fight.
Takeover is an action whereby a person or group succeeds in ousting a firm‘s management

and taking control of the company. In recent years there are cases, where attempts have been
made by one corporation to take over another by purchasing a majority of the outstanding
stock.
b. Global Depository Receipts and Euro Convertible Bonds

(June 2013) (2.5 Marks)
Answer
Global Depository Receipts (GDR) is a negotiable certificate denominated in US dollars
which represents a Non-US company‘s publically traded local currency equity shares.
GDR are created when the local currency shares of an Indian company are delivered to
Depository‘s local custodian Bank against which the Depository bank issues depository
receipts in US dollars. The GDR may be traded freely in the overseas market like any other
dollar-expressed security either on a foreign stock exchange or in the over-the-counter market
or among qualified institutional buyers.
Whereas, Euro Convertible bonds are quasi-debt securities (unsecured) which can be
converted into depository receipts or local shares. ECBs offer the investor an option to
convert the bond into equity at a fixed price after the minimum lock-in period. The price
of equity shares at the time of conversion will have a premium element. The bonds carry a
fixed rate of interest. These are bearer securities and generally the issue of such bonds
may carry two options viz. call option and put option. In the case of ECBs, the payment of
interest and the redemption of the bonds will be made by the issuer company in US dollars.
ECBs issues are listed at London or Luxemburg stock exchanges.
c. Capital market and Money Market (December 2014) ( 2.5 Marks)

Solution
Capital market and money market are two basic components of financial system. Capital
market deals with long and medium term instruments of financing while money market deals
with short term instruments. Capital market instruments are shares, debentures, mutual funds
etc. while money market instruments are interbank placement, call money, commercial
papers, treasury bills etc.
Capital market is usually classified as primary market and secondary market while there is no
such classification of money market.
Capital market participants include retail investors, institutional investors, financial

institutions, corporate houses and banks while money market participants include banks,
financial institutions, central bank and government.
Question No 3:

What is stock repurchase and why company repurchases its own stock.( June 2010)(5
Marks)
Answer
Stock repurchase is a method, in which a firm buys back shares of its own stock, thereby
decreasing shares outstanding, increasing EPS and often increasing the price of the stock.
Stock repurchases are an alternative to dividends for transmitting cash to stockholders.
Stock repurchased by the issuing firm is called Treasury Stock.
Stock price for repurchase or the equilibrium price is calculated from the following equation.
Repurchase price = S*Pc/S-n
Where,
S=Total number of shares outstanding
Pc= Current market price per share
n= Number of shares to be repurchased
Alternatively,
Repurchase price= Market price before stock repurchase/1-stock repurchase in fraction.
Reason for purchasing its own stock - If a firm has excess cash, it may repurchase its own
stock leaving fewer shares outstanding and increasing the earnings per share. Stock
repurchase may be alternative to paying cash dividends. The benefits to the shareholder are
the same under a cash dividend policy and stock repurchase. Firms also repurchase their
stock if the stock price is low. The market often sees the stock repurchases as a signal to
future prosperity. Stock repurchases may be used for employee stock options. Stock
repurchases reduces the possibility of being taken over by another firm. Stock repurchases
can be made in open market or on tender offer or on negotiation basis.
Question No 4:
Discuss the attractions of leasing as a source of both short-term and long-term finance.
(RTP December 2014)
Answer
Operating leasing can act as a source of short-term finance, while finance leasing can act as a
source of long-term finance.
Operating leasing offers a solution to the obsolescence problem, whereby rapidly aging
assets can decrease competitive advantage. Where keeping up-to-date with the latest
technology is essential for business operations, operating leasing provides equipment on
short-term contracts which can usually be cancelled without penalty to the lessee.
Operating leasing can also provide access to skilled maintenance, which might otherwise
need to be bought in by the lessee, although there will be a charge for this service.
Both operating leasing and finance leasing provide access to non-current assets in cases
where borrowing may be difficult or even not possible for a company. For example, the
company may lack assets to offer as security, or it may be seen as too risky to lend to.
Since ownership of the leased asset remains with the lessor, it can be retrieved if lease rental
payments are not forthcoming
Question No 5:
Distinguish between Money market and Capital Market (RTP December 2014)
Answer
191
The capital Market deals in financial assets. Financial Assets comprises of shares, debentures,
mutual fund etc. The capital market is also known as stock market.
Stock market and money market are two basic components of Financial system. Capital
market-deals with long and medium term instruments of financing while money market
deals with short term instruments. Some of the points of distinction between capital
market and money market are as follows:
SN Money Market Capital Market

1. There is no classification between There is a classification between primary
primary market and secondary market. market and secondary market.
2. It deals for funds of short-term It deals with funds of long-term
requirement. requirement.
3. Money market instruments include Capital Market instruments are shares and debt
interbank call money, notice money up to instruments.
three months, commercial paper, 91 days
treasury bills.
4. Money market participants are banks, Capital Market participants include retail
financial institution, Central Bank and investors, institutional investors like Mutual
Government. Funds, Financial Institution, corporate and
banks.
Question No 6:
What are the functions of debt securitization? (December 2015) ( 3 Marks)
Answer
Functions of Debt Securitization
It is a mode of financing wherein securities are issued on the basis of a package of assets
(called Asset Pool). In this method recycling funds, assets generating steady cash flows are
packaged together and against this asset pool, market securities can be issued.
 File Origination Function: A borrower seeks a loan from a lending institution (finance
company or bank). The credit worthiness of the borrower is evaluated and the loan is
sanctioned. A contract is signed between the parties, with repayment schedule spread
over the life of the loan. The lender is called the Originator, to whom the loan constitutes
an asset (receivable).
 The Pooling Function: The Originator (Lender) clubs together similar loans or
receivables, to create an underlying pool of assets. This pool is transferred in favour of a
SPV (Special Purpose Vehicle), which acts as a trustee for the investor. Once the assets
are transferred, they are held in the Originators' portfolios.
 iii) The Securitization Function: Now the SPV issues securities on the basis of
the asset pool. The securities carry a coupon and an expected maturity which can be
asset based or mortgage based. These are generally sold to investors through merchant
bankers.
Question No 7:
What are the advantages of raising funds by issuing equity shares?
( December 2015) ( 3 marks)
Solution
Following are the some of the advantages of raising funds by issue of equity shares:

 Permanent source of finance. No liability for cash outflows associated with its
redemption.
 Demonstrate financial base (Capital adequacy) of the company and helps in
borrowing power of the company.
 No legal obligation to pay dividends.
 Can be raised further shares by making a right issue.
Question No 8:
Distinguish between GDR and ADR ( December 2015) ( 2.5 Marks)
Answer
Finance can be raised by, Global Depositary Receipts (GDRs) Foreign Currency Convertible
Bonds (FCCBs) and pure debt bonds. However, GDRs and FCCB's are more popular. GDRs
do not carry voting rights and hence there is no dilution of control.
Global Depository Receipts (GDRs)
 A Depository Receipt (DR) is basically a negotiable certificate denominated in US
Dollars that represents a non- US company publicly traded local currency (Nepalese
Rupee) Equity share.
 DRs are created when the local currency shares of Nepalese company are delivered to
the depository's local custodian bank, against which the depository bank issues DRs in
US Dollars.
 These DRs may be freely traded in the overseas market like any other Dollar
denominated security through either a foreign stock exchange or through over the
Counter (OTC) market or among the restricted groups like qualified institutional
buyers.
 GDRs with warrants are more attractive than plain GDRs in view of additional value
of attached warrants.
American Depository Receipts (ADRs):

Depository Receipts issued by a company in the USA are known As ADRs. Such receipts
have to be issued in accordance with the provisions stipulated by the Securities Exchange
Commission (SEC) of the USA which is the regulatory body like the SEBON in Nepal.
Since the conditions laid down by the SEC are stringent, Nepalese companies have chosen
the indirect route to tap the vast American financial market through private placement of
GDRs listed in London and Luxembourg Stock Exchanges.
193
CHAPTER 9
INVESTMENT OPPORTUNITIES IN NEPALESE CAPITAL MARKET.

Chapter 9: Investment opportunities in Nepalese Capital Markets
Question No 1
What do you mean by reverse takeover ( December 2015) ( 2.5 Marks)
Answer
A reverse takeover or reverse merger takeover (reverse IPO) is the acquisition of a public
company by a private company so that the private company can bypass the lengthy and
complex process of going public. The transaction typically requires reorganization of
capitalization of the acquiring company.
Sometimes, it might be possible that a company continuously trades as a public company but
has no or very little assets and what remains only its internal structure and shareholders. This
type of merger is also known as "back door listing".
Reverse merger brings following benefits to acquiring private company:
 Easy capital market accessibility
 Less time consuming and less cost for becoming public
 Benefits of tax on carry forward losses of acquired company
This concept is yet to be implemented in Nepalese Capital Market as no such publicly traded
company has been acquired by the private company till date.
195

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THE INSTITUTE OF CHARTERED

The Institute of Chartered Accountants of Nepal 2

INTRODUCTION AND FUNDAMENTAL CONCEPTS OF FINANCIAL

b. Risk aversion Vs. Risk diversification ( June 2012) ( 2.5 Marks)

c. Promised Yield and Realized Yield (December 2013) ( 2.5 Marks)

The Institute of Chartered Accountants of Nepal 4

d. Risk and Uncertainty (December 2013) ( 2.5 Marks)

e. Business Risk and Financial risk (June 2015) ( 2.5 Marks)

The Institute of Chartered Accountants of Nepal 6

to bank. Preference Share Capital.

Systematic Risk Unsystematic Risk

From the given problem, we find:

The Institute of Chartered Accountants of Nepal 8

100,000 = 126,250 (PV 4, i)

3. 30 annual end of year payment of Rs. 5.5 million;

=10,000×1.267 [considering (CVF 8,3)=1.267]

The Institute of Chartered Accountants of Nepal 10

b Total interest earned = Rs. 24.18 + Rs.30.38= Rs. 54.56

ii. Rs. 100,000=P(CVF8,0.08)=P(1.8509)

Total Present Value of Annuity Due @ 10% for 10 yrs. 6.761

Annual Interest Rate = 9.50%

Interest is calculated as:

= Rs. 872.18 ('000) and so on...

The Institute of Chartered Accountants of Nepal 12

STRATEGIC FINANCE AND POLICY

c. Capital structure and Financial structure ( December 2014) ( 2.5 Marks)

The Institute of Chartered Accountants of Nepal 14

d. Financial Distress Vs. Insolvency (June 2015) ( 2.5 Marks)

Insolvency is a term which generally means an inability to repay debts stock-based

b. Direct and indirect costs associated with financial distress

c. Financial Distress (June 2012) (2.5 Marks)

d. Gearing Ratio (June 2013) ( 2.5 Marks)

e. Debt trap (June 2015) ( 2.5 Marks)

f. financial leverage (December 2015) ( 2.5 Marks)

The Institute of Chartered Accountants of Nepal 16

g. Assumptions of Capital Asset Pricing Model (CAPM)

Where Ke=Cost of equity capital. It is also referred as capitalization rate discount. MM

The Institute of Chartered Accountants of Nepal 18

= 1,800,000 half liters

= Rs. 360,000,000 in annual sales

= 1,500,000 half liters

The Institute of Chartered Accountants of Nepal 20

(2) Cost of Preference Share Capital (Kp)

= 0.14025, say, or 14.03%

(4) Cost of Term Loan (Kt)

0.15 (1 – 0.25) = 0.15 x 0.75 = 0.1125 or 11.25%

On first Rs. 25 million Term Loan = 0.15 (1 – 0.25) = 0.1125 or 11.25%

Therefore, WACC = 15.07%

The Institute of Chartered Accountants of Nepal 22

(December 2011) ( 7 Marks)

ii) Cost of capital of Debenture at Market Value

Weighted average cost of capital

The current condensed balance sheet of the company is as follows:

The Institute of Chartered Accountants of Nepal 24

Calculation of Share price when:

(ii) Dividend is not declared

ii. Calculation of No. of shares to be issued:

The Institute of Chartered Accountants of Nepal 26

ke = k0+ (k0-kd) x Debt/ Equity