INDEX

S.N Particulars Page No

1 Time Value Money. 1.1 - 1.13
2 Leverage. 2.1 - 2.33
3 Cost of Capital. 3.1 - 3.38
4 Capital Structure. 4.1 - 4.7
5 Capital Budgeting. 5.1 - 5.53
 Introduction
 In order to achieve the objective of the financial management i.e., the maximization of the
wealth of the shareholder, the finance manager has to take various decision. The decision,
investment decision, the financing decision and the dividend decision involve evaluation of various
alternative series of cash flow occurring over time.

 The simple reason being that one rupee of time period 1 is not comparable with one rupee of
some other time period. However, one rupee of different time periods can be made comparable
by introducing the interest factor. This interest factor is one of the crucial and exclusive
concept of the theory of finance. This concept is also known as the concept of Time Value of
Money [TVM].

 Discounted cash flow is perhaps the most important variable in financial decision making process
and estimation thereof requires the use of Time Value of Money. Money receivable in future is
less valuable than the money received today. Every individual or a firm definitely has a
preference to receive money today against the money receivable tomorrow. The obvious reason
for this preference for receiving the money today is that the rupee received today has a higher
value than the rupee receivable in future. This preference for current money as against future
money is known as the time preference for money or simply TVM. The TVM is the rate of return
which an investor can easy by reinvesting its present value.

 Compounding Technique
The compounding technique is used to find out the FV of a present money. The more frequently the
interest is compounded, the faster a FV grows. Table 1.1 shows the effect of frequent compounding
on the FV Rs.1,000 at the rate of interest 12%p.a.

TABLE 1.1: EFFECT OF MULTI-PERIOD COMPOUNDING ON THE FUTURE VALUE

Compounding Period Number of Periods (m) F.V. (Rs)

Annual 1 1,120.00
Half-Yearly 2 1,123.60
Quarterly 4 1,125.51
Monthly 12 1,126.83
Daily 365 1,127.47

Table1.1 shows that more frequently the compounding is made, the faster is the growth in the FV.
It also shows that the rate of interest is 12%p.a. but effectively it has helped earning an effective
rate of 12.36% if compounded half-yearly and at 12.55% if compounded quarterly and so on. The
rate of interest 12%p.a. is also known as the normal rate of interest and the rate of interest
12.36% or 12.55% etc. are known as the effective rate of interest

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 EFFECTIVE RATE OF INTEREST
In case, m=1 i.e., annual compounding, then re═ r i.e., the effective rate of interest is equal to the
nominal rate of interest. The effective rate of interest is very useful in financial decision making
particularly in investment decision where different optional opportunities have different
compounding intervals.

For example, a deposit of ` 10,000 is made in a bank for a period of 1 year. The bank offers two
options : (i) to receive interest at 12%p.a. compounded monthly or (ii) to receive interest at 12.25%
p.a. compounded half-yearly. Which options can be evaluated as follows :-

Solution
Option (i) :- Rate of interest 12%p.a. compounded monthly.

The effective rate of interest can be calculated with the help of equation as follows:-
( 1 + r e) ═ ( 1 + r/m)m
═ (1 + .12/12)12 ═ 1.1268

Therefore, re ═ .1268 or 12.68%

Option (ii) Rate of interest 12.25%p.a. compounded half-yearly.

The effective rate of interest can be calculated with the help of equation as follows:-
( 1 + r e) ═ ( 1 + r/m)m
═ (1 + .1225/12)2 ═ 1.1263

Therefore, re ═ .1263 or 12.63%

In this case, the normal rate of return is higher in option (ii) i.e., 12.25% but the effective rate of
interest is higher in option (i) i.e., 12.68%. Therefore, the depositor should select the option (i) i.e.,
interest at 12%p.a. compounded monthly. In this case, it illustrate two things : First, that higher
quoted rate is not necessarily the best. Second, that more the number of compounding during the
tear (instead of annual compounding), greater and significant would be the difference between the
normal quoted rate and effective rate of interest.

 Future Value Of Series Of Equal Cash Flow Or Annuity Of Cash Flows

An annuity is thus, a finite series of equal cash flows made at regular intervals. The FV of an annuity
also depends upon three variables i.e., the annual amount, the rate of interest and the time period.

Question 1
An amount of ` 50,000 is deposited today in a bank for 5 years at 14% p.a. simple interest. What will
be the accumulated amount at the end of 5 Years.

Question 2
An amount of ` 50,000 is deposited today at 14% p.a. compound annually. What is the accumulated
deposit-
1) After 3 Months
2) After 9 Months
3) After 7 Months

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Self-Practice Question 1
A students is awarded a scholarship and two options are placed before him (i) to receive Rs.100p.m.
at the end of each of next 12 months. Which option be chosen if the rate of interest is 12%p.a. ?
(Compounded Monthly)

Solution
Option I - The amount of ` 1,100 receivable now is already expressed in the present money and,
therefore, does not require any adjustment.

Option II - There is an annuity of ` 100 for a period of next 12 months. The rate of interest is
12%p.a. he position can also be expressed as an annuity of 12 periods at rate of interest 1%. On the
basis of value given in Table A-4 for PVAF(1%, 12) which is 11.255, the present value of
the annuity is ` 100 x 11.255 = ` 1,125.50.

Since, the present value in option II is higher than the present value in option I, the student should
choose the option II.

1. Discounting technique is used to find out:

(a) Terminal Value (b) Compounded Value
(c) Present Value (d) Future Value

2. The adjustment for time value of money is made through:

(a) Interest Rate (b) Inflation Rate
(c) Growth Rate (d) None of the above

Question 3
Imagine an amount of 600 standing 6 months from today. Find out PV today if discount rate 8% p.a.
compounded annually.

Question 4
An amount of 600 is standing 6 months from now, what is the PV today if discount rate is 9% p.a.
compounded monthly.

Self-Practice Question 2
Find out the present value of an investment which is expected to give a return of ` 2,500 p.a.
indefinitely and the rate of interest is 12%p.a.

Solution
Using the equation,
PV P = Annual Cash Flow/r P

= ` 2,500/.12 = ` 20,833.33

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3.Equal annual Cash Flows occurring at the end of each year for certain period is known as:
(a) Annuity (b) Perpetuity
(c) Annuity Due (d) Deferred Payment

4. Equal Annual amount occurring in the beginning of certain years are known as:
(a) Annuity (b) Perpetuity
(c) Annuity Due (d) Deferred Payment

Question 5
Redo the previous sum if discount is 9% p.a. compounded quarterly.

Question 6
What if the discount rate is 9% p.a. compounded semi annually?

Self-Practice Question 3
A finance company makes an offer to deposit a sum of ` 1,100 and then receive a return of ` 80 p.a.
perpetually. Should this offer be accepted if the rate of interest is 8%? Will the decision change if
the rate of interest is 5%?

Solution
In this case, a person should accept the offer only if the PV of the perpetuity is more than the
initial deposit of ` 1,100.

If the rate of interest is 8%, then using equation,

PV = Annual Cash Flow/r P
= 80/.08 = ` 1,000

If the rate of interest is 8%, then using equation,

PV = Annual Cash Flow/r P
= 80/.05 = ` 1,600

The offer need not be accepted at 8% rate of interest because the PV of the perpetuity is only `
1,000. It means that the depositor has to pay ` 1,100 today and will be receiving only ` 1,000 in real
terms. However, if the rate of interest reduces to 5%p.a. then the offer is acceptable as the PV of
the perpetuity now is ` 1,600 and the depositor will be benefited by ` 500 in the long run.

5. Future cash flows are converted to present values, so that these can be:
(a) Aggregated (b) Compared

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(c) Used in Decision-making annuity (d) All of the above

6. Present Value of a future cash flow would decrease if

(a) Discount Rate is reduced (b) Discount Rate is increased
(c) Time Period is decreased (d) All of the above

Question 7
We have to choose one bank out of the following three for investing our saving-
Bank A - 18% p.a. compounded monthly
Bank B - 19.2% p.a. compounded semi annually
Bank C - 20% p.a. compounded annually.

Question 8
Ascertain the compound value and compound interest of an amount of ` 75,000 at 8 % compounded
semiannually for 5 years.

Self-Practice Question 4
A bank makes an offer to deposit with it a sum of ` 16,000 and then receive a return of ` 1,800 p.a.
perpetually. Should the offer be accepted by an investor whose opportunity rate of return is 12%?
Will the decision change if his rate of return is 10%?

Solution
In this case, the PV of the perpetuity can be found as follows :-
PV = ` 1,800 ÷ 0.12
= ` 15,000

If opportunity cost is 10%, PV = ` 1,800/0.10

= ` 18,000

So, at the opportunity cost of 12% the bank offer need not be accepted. However, at 10% the offer
can be accepted.

In addition to specified perpetuities, long-term annuities can also be treated as perpetuities in

order to obtain a good approximation of the PV. The advantages of using perpetuities as
approximation to annuity value is that the present value tables are not required and the PV of a
fairly long period annuity can be easily calculated.

7. ‘Rule of 72, is a short-cut method to estimate the:

(a) Present Values (b) Compounding Effect
(c) Both (a) & (b) (d) None of the above

8. Effective Interest Rate is a factor of:

(a) Compounding Frequency (b) Basic Rate of Interest

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(c) Both (a) and (b) (d) None of the above

Question 9
Suppose you wish to withdraw 80,000 at the end of each year from a bank for 5 years- The first
withdrawal to take place 1 year from now. If interest rate is 9% p.a., what should you deposit in the
bank today?

Question 10
Akash Ltd takes a machine on lease. Lease rentals are 40000 at the end of each quarter for 5
years. If interest rate is 10% p.a. compounded quarterly, what is the PV of lease rentals?

Self-Practice Question 5
A recurring deposit of ` 100 is made in the beginning of each of next 4 year starting now @6%.
What will be total deposit at the end of 4 years?

Solution
FV = ` 100vCVAF(6%, 4) x (1x0.06)
= ` 100 x 4.375
= ` 463.75

However, it may be noted that above formula can be used only if the rate of interest is more than
the rate of growth i.e. r > g

On the basis of discussion so far, the following principles of TVM can be identified :

(i) Amount as well as timing of cash flow matter.

(ii) Monetary values should be added or subtracted only and only if all are occurring at same point
of time.
(iii) All future money value should be discounted to current date by finding out their present value.
(iv) Future value calculation compound a current cash flow to a single point of time in future.
(v) found the basis of three others given.

9. A series of Constant Cash flows occurring at regular intervals forever is known as:
(a) Growing Annuity (b) Perpetuity
(c) Growing Perpetuity (d) Annuity

10. Future Value and Present Value, both are based on:
(a) Number of Time periods (b) Interest Rate
(c) Both (a) and (b) (d) None of the above

Question 11
If lease rentals in the previous sum are payable at the beginning of each quarter, what is the PV of
rentals?

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Question 12
Mr. Yadnesh deposits 80,000 in a bank A/c today. What amount can be withdrawn at the end of
each year for 10 years? Take interest rate as 9%.

Self-Practice Question 6
Assume that a deposit is to be made at year zero into an account that will warn 8% compounded
annually. It is desired to withdraw ` 5,000 three years from now and ` 7,000 six years from now.
What is the size of the year zero deposit that will produce these future payments?

Solution
Let the initial deposit be sum of the present value of the two late withdrawals by using the present
value table:
PV = FV x PVF(r,n)
PV = ` 5,000 x PVF(8%,3)+ ` 7,000 x PVF(8%,6)
PV = ` 5,000 x PVF(0.794) + ` 7,000 x (0.630)
PV = ` 3,970 + ` 4,410
PV = ` 8,380

The amount of ` 8,380 grows to a value of ` 10,559 in three years; ` 5,000 is withdrawn then, leaving
` 5,559. This amount is left for another three years to compound to the desired amount of ` 7,000.
Therefore, an amount of ` 8,380 deposited today will result in the desired withdrawals.

11. If the Interest Rate is greater than zero, which of the following series you would prefer
to receive :-

Year 1 Year 2 Year 3 Year 4

(a) 500 400 300 200
(b) 200 300 400 500
(c) 350 350 350 350
(d) Any of the above as all are equal in total amount.

12.Time Value of Money is an important concept in finance because it takes into account:
(a) Risk (b) Time
(c) Compound Interest (d) All of the above

Question 13
If a person deposits 5,000 at the end of each year in a bank for eight year, what is the accumulated
amount at the end of 8 years, if interest rate is 7% p.a. compounded annually?

Question 14
A firm has on B/S 500 lakhs face value of debentures to be redeemed after 10 years. What amount
should be set aside at 8% p.a. in the sinking fund?

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Self-Practice Question 7
What is the present value of cash flows of ` 750 per year forever (a) at an interest rate of 8% and
(b) at an interest rate of 10%?

(Answer : (a) ` 9,375 and (b) ` 7,500)

13. Which of the following is called an

(a) Lump Sum after few years (b) A Series of Equal and Regular Amounts
(c) A Series of Unequal Amounts (d) A Series of Equal and Irregular Amounts

14. An investor wants to increase the Present Value. The rate of discount applied for should
be:
(a) Increased (b) Decreased
(c) Any of (a) and (b) (d) None of the above

Question 15
Consider a stock of P Ltd. It is no growth firm. It is expected to pay dividend of 50 at the end of
each year forever. If required rate of return is 10% p.a., what should be the share price?

Question 16
Sunil Ltd. just paid divided of 40. This is expected to grow at 5% p.a. forever. If required rate of
return is 13%, what should be the share price?

Self-Practice Question 8
Find out present value of the following:
(a) ` 1,500 receivables in 7 years a discount rate of 15%.
(b) An annuity of ` 760 starting after 1 year for 6 years at an interest rate of 12%.
(c) An annuity of ` 5,500 starting in 7 year time lasting for 6 years at a discount rate of 10%.
(d) An annuity of ` 1,000 starting immediately and lasting until 9th year at a discount rate of 20%.
(e) A perpetuity of ` 400 starting in year 3 at a discount rate of 18%.

(Answer : (a) ` 564, (b) ` 3,125, (c) ` 15,100 , (d) ` 4,837 & (e) ` 1,596.)

15.If n = 1 and Rate of Interest > zero, the following interest factor is equal to one:
(a) Present Value Factor (b) Compound Value Factor
(c) Present Value Annuity Factor (d) None of the above

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 (1 + k )
n
16. If Time is ‘n’, Rate of Interest is ‘k’ then may be called:
(a) Present Value Factor (b) Compound Value Factor
(c) Compound Value Annuity Factor (d) None of the above

Question 17
Mr. Motilal, a retired army officer, has opened an account with a reputed bank. He is required to
pay four equal annual payments of ` 15,000 each in his deposit account that pays 8% interest per
year. Find out the future value of annuity at the end of 4 years.

Question 18
Rolex Limited offers a fixed deposit scheme whereby ` 20,000 matures to ` 25,250 after two years
on a half yearly compounding basis. If the company desires to amend the scheme by compounding
interest every quarter, you are required to determine the revised maturity value?”

Self-Practice Question 9
A company has issued debentures of ` 50 lacs to be repaid after 7 years. How much should the
company invest in a sinking funds earning 12% in order to able to repay debentures?

(Answer : ` 4,95,589)

17. In a Loan Repayment Schedule, the interest amount paid each period:
(a) Remained constant (b) Increases
(c) Decreases (d) None of the above

18. Future Value of an annuity is

(a) Equal to Annuity Amount (b) Less than Annuity Amount
(c) More than total of Annuity Amount (d) None of the above

Question 19
Mr. Dayanand, an executive in an MNC, is thirty five years old. He has decide it is time to plan
seriously for his retirement. At the end of each per year until he is sixty five, he will save 10000 in
a retirement account. If the account earns 10% p.a., how much will Mr. Dayanand have saved at the
age of sixty five?

Question 20
You are Required to Calculate the Effective Annual Rate of Interest of:
1) 15% Nominal p.a. Compounded Quarterly
2) 24% Nominal p.a. Compounded Monthly

Self-Practice Question 10
What is the present worth of operating expenditure of ` 1,00,000 per year which are assumed to be
incurred continuously throughout in 8 year period if the effective annual rate of interest is 12%?

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(Answer : ` 4,96,800)

19. Concept of Future Value and Present Value are:

(a) Proportionately related (b) Inversely related
(c) Directly related (d) Not related

20. If a student is awarded scholarship receivable over next 12 months, what calculation he
should use to find out the worth of scholarship today?
(a) Present value of an amount (b) Future value of an amount
(c) Present value of an annuity (d) Future value of an annuity

Question 21
You are Required to Calculate:
1) The cost of a new mobile phone is ` 10,000. If the interest rate is 5% , how much would you have
to set aside now to provide this sum in five years ?
2) You have to pay tuition fees amounting to ` 12,000 a year at the end of each of the next six
years. If the interest rate is 8%, how much do you need to set aside today to cover these fees?
3) You have invested ` 60,476 at 8%. After paying the above tuition fees, how much would remain at
the end of six years?

Question 22
You need a sum of ` 1,00,000 at the end of 10 years. You know that the best you can do is to deposit
some lump sum amount today at 6% rate of interest or to make equal payments into a bank account,
starting a year from now on which you can earn 6% interest.

Find Out
1) What amount to be deposited today
2) What amount must be deposited annually?

Self-Practice Question 11
A firm purchases a machinery for ` 8,00,000 by making a down payment of ` 1,50,000 and remainder
in equal instalments of ` 1,50,000 for six years. What is the rate of interest to the firm?

(Answer : 10%)

21. __________ is the present value of an asset, if the annual cash inflow is ` 1,000 per
year for next 5 years and the discount rate is 15%.
(a) ` 2,500 (b) ` 3,500
(c) ` 3,352 (d) ` 2,481

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22. The effective rate of interest fort a sum of money compounded quarterly is 12.55%.
What is its nominal yield?
(a) 12.05% (b) 12.25%
(c) 12.15% (d) 12%

Question 23
You need a sum of ` 1,00,000 at the end of 10 years. You know that the best you can do to deposit
some lump sum amount today at 6% rate of interest or to make equal payments into a bank account,
starting a year from now on which you can earn 6% interest.

Find Out
1) What amount to be deposited today
2) What amount must be deposited annually?

Question 24
If we deposit 60,000 today, what will be the accumulated amount after 9 months if –
Case 1 - Interest Rate = 10% p.a. compounded annually.
Case 2 - Interest Rate = 10% p.a. compounded semi annually.
Case 3 - Interest Rate = 10% p.a. compounded quarterly.
Case 4 - Interest Rate = 9% p.a. compounded monthly.

Self-Practice Question 12
Mr. X borrows ` 1,00,000 at 8% compounded annually. Equal annual payments are to be made for 6
years. However at the time of the fourth payment, the individual elects to pay off the loan. How
much should be paid?

(Answer : ` 60,207)

23. What is the present value of annuity of ` 15,000 starting immediately (t = 0) and paying
another 5 annual instalments? Assume discounting rate of 12%.
(a) ` 85,460 (b) ` 82,500
(c) ` 75,120 (d) ` 69,702

24. A sum of ` 50,000 is invested @ 12% p.a. for 6 years. What will be the present value of
its maturity value, assuming a required rate of return of 10%?
(a) ` 86,000 (b) ` 98,700
(c) ` 55,667 (d) ` 56,504

Question 25
1) Mr Chinto borrowed ` 1,00,000 from a bank on a one-year 8% term loan, with interest
compounded quarterly. Determine the effective annual interest on the loan?

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2) Suppose Sumit has borrowed a 3-year loan of ` 10,000 at 9 per cent from his employer to buy a
motorcycle. If his employer requires three equal end-of-years repayments, then calculate the
annual instalment.

Question 26
Mr. Sahil has bought a new car and has taken a 20 month car loan of 6,00,000. The rate of interest
is 12 per cent p.a. You are required to compute the amount of monthly loan amortization for Mr.
Sahil?

Self-Practice Question 13
Ten year from now Mr. X will start receiving a pension of ` 3,000 a year. The payment will continue
for sixteen years. How much is the pension worth now, if his interest rate is 10%?

(Answer : 9,952)

25. What will be the maturity value of a sum of ` 18,000 invested today at the rate of 5%
p.a. for 10 years?
(a) ` 29,360 (b) ` 28,320
(c) ` 29,320 (d) ` 35,220

26. Given that the effective rate of interest is 9.31% p.a., what is the nominal rate of
interest p.a., if compounding is carried out quarterly?
(a) 9.25% (b) 8.5%
(c) 9% (d) 9.20%

Question 27
A person is required to pay four annual payments of ` 4,000 each in his Deposit account that pays 10
per cent interest per year. Find out the future value of annuity at the end of 4 years.

Question 28
A doctor is planning to buy an X-Ray machine for his hospital. He has two options. He can either
purchase it by making a cash payment of ` 5,00,000 or ` 6,15,000 are to be paid in six equal annual
installments. Which option do you suggest to the doctor assuming the Rate of Return is 12%?
Present Value of Annuity of ` 1 at 12% Rate of Discount for six years is 4.111.

Self-Practice Question 14
Novelty Industries is establishing a sinking fund to redeem ` 50,00,000 bond issue which matures in
15 years. How much do they have to put into the fund at the end of each year to accumulate `
50,00,000, assuming the funds are compounded at 7% annually?

(Answer : ` 1,98,973)

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 Question 29
Rohit is invested ` 2,40,000 at annual rate of interest of 10%. What is the amount after 3 years if
the compounding is done?
1) Annually
2) Semi Annually.

Self-Practice Question 15
XYZ Ltd. is creating a sinking fund to redeem its preference share capital of ` 5,00,000 issued on
01.01.2006 and maturing on 31.12.2017. The annual payments will start on 01.01.2006. The company
wants to invest equal amount every year, which will earn 12% p.a. How much is the amount of sinking
fund annuity?

(Answer : ` 18,500 p.a.)

ANSWER KEYS
1 2 3 4 5 6 7 8 9 10
(c) (a) (a) (c) (d) (b) (b) (c) (b) (c)
11 12 13 14 15 16 17 18 19 20
(a) (d) (b) (b) (d) (b) (c) (c) (b) (c)
21 22 23 24 25 26
(c) (d) (d) (c) (c) (c)

 OBJECTIVES TYPE QUESTIONS

State whether each of the following statement is True (T) or False (F)
(i) Money has no time value.
(ii) Investors do not have preference for present money.
(iii) Interest factor helps in incorporating the time value of money in financial analysis.
(iv) Time value of money is invariably considered in financial decision making.
(v) Compounding and discounting techniques are same.
(vi) Cash flow occurring at different point of time are comparable in absolute terms.
(vii) The present value of a future amount remains same irrespective of the time of occurrence
(viii) Present values and future values can be calculated only with the help of relevant mathematical
tables.
(ix) The discounting techniques help in finding out the future values of a present amount.
(x) PVF( r,n) and PVAF(r,n) are same.
(xi) Implicit rate of interest can be found with the help of compounding technique.
(xii) An annuity is an infinite series of cashflow.
(xiii)The number of cashflow in a perpetuity is known
(xiv) “A bird in hand is worth two in the bush” correctly present the concept of time value of money
(xv) Rate of interest and time period, both are requires to find out the present/future value.

Answers
(i) False (ii) False (iii) True (iv) False (v) False (vi) False (vii) False (viii) False
(ix) False (x) False (xi) True (xii) False (xiii) False (xiv) True (xv) True

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―Because some elements of operating expenses are fixed, total operating expenses
do not rise as sales revenue. (as fixed cost are included). Therefore, operating
profits rise faster than sale. In addition, non-operating expenses such as interest
payments, are also relatively fixed. Hence, net corporate profits (after interest
changes) rise even faster than operating profits. These two factors amplify the
effects of the basic business cycle. “

 Operating leverage is defined in terms of the relationship between fixed and

variable operating expenses.
 Financial leverage refers to mix of debt and equity used to finance the firms
activities. The degree of leverage can be measured in stock terms by using the ratio
of debt to equity.
 Alternatively leverage can be defined in flow terms, by using the ratio of Interest
to EBIT.

 Concept of Financial structure and capital and leverage .

 Financial structure – Mix of all funds sources that appears on liability side of B/S.
 Capital structure – Mix of all long-term sources of funds.
 The process that levels to final choice of capital structure is referred to as capital
structure planning.
 several techniques can be used to quantify the risk return characteristics of the
alternative capital structure.
 Two techniques : EBIT – EPS Analysis & Leverage
 Leverage – relationship between two interrelated variables. In simple words,
leverage is equal benefit.

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[Date] 2.1
08007978700
 EBIT Analysis .
 Earning before interest & terms.
 EBIT may be higher or lower. Thus EBIT is uncertain & such uncertainty in a firm
refers to business rise. Or operating risk.
 No matter what happens with EBIT, a fixed amount of interest must be paid to
debt investor, & residual profit varies with change in EBIT.

 Concept of leverage .
 Already seen, leverage in general refers to relationship between two interrelated
variables.
 Variable may be cost, output, sales revenue, EBIT or EPS.
 In leverage analysis, the emphasis is on the measurements of relationship between
two variables, rather than measuring these variables.
 Leverage defined as % change in one variable divided by the % change in some other
variables.
 Here, Numerator – dependent variable
Denominator – independent variable
 Thus, leverage analysis, reflects as how responsiveness is the dependent variable to
a change in the independent variable.
 Leverage = % change in dependent variable
% change in independent variable

Example, firm increased its sales promotion expenses from rupees 5000 to 6000
resulted in number of unit sold from 200 units to 300 units
Solution, % change in promotional expenses = 6000-5000 = 0.20 or 20%
5000
% change in no. of units sold = 300-200 = 0.50 or 50%
200
Leverage = 0.50 = 2.5
0.20
 It means 5 increases in no. of units sold is 2.5 times that of % increases in sales
promotion expenses.
 Point to be noted : Due to increase in expenses, units sales also increased, &
therefore benefit to firm, so, leverage = benefits.
 Alternate formulas-
1. DOL = Contribution ; 2.DFL = EBIT ; 3 DCL = Contribution
EBIT EBT EBIT

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 Here, benefit = may be

Positive Negative

Result Result

Good for business firm Risk create for business firm

 Question arises how benefit negative ?

 Sales of firm increase but the difference between cost & sale is low—generate
loss profit.

 Relationship between sales revenue, EBIT(operating

profit.),EPS .

Sales revenue – EBIT

variable cost Interest
Profit before tax
Contribution – (-)tax
fixed cost Profit after tax
EBIT. (-)preference dividend
Earning availbe for equity.
Share holders
No. of equity share
Earning per share

 Left hand side—represents. EBIT—Depends on level – sales revenue.

 Right hand side—Represents – Level of profit after tax or EPS. Depends on EBIT.
 Relationship between Sales revenue & EBIT----- Operating leverage.
 Relationship between EBIT & EPS----- Financial leverage.
 Relationship between Sales revenue & EPS ----- combined leverage.

 Operating leverage .
 Sales increases/decreases – EBIT changes.
 Operating leverage measures effect of change in sales revenue on the level of
EBIT.

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 Degree of Operating Leverage(DOL) = % change in EBIT. ( This is effect )
% change in sales revenue. (This is cause )

Case 1 present Expected Value % change.

change
Sales 2Lac 2.20lac 20000 10%
V.C (80k) 88k 8000 10%
Contri 1.2lac 1.32lac 12000 10%
-F.C (1lac) (1lac) - -
EBIT 20000 32000 12000 60%

Case I DOL= % EBIT = 60%

%sSales 10%
=6

Case 2 Present Expected Value % change.

change
Sales 2lacs 2.20lac 20000 10%
V.C 80000 88000 8000 10%
Contri 1.2lac 1.32lac 12000 10%
-F.C - - - -
EBIT 1.2lac 1.32lac 12000 10%

Case2 DOL= % EBIT = 10%

%sSales 10%
=1
Here, conclusion, that DOL=1 when fixed cost is NIL & total cost = variable cost.
 Operation leverage = benefit on profit due to inclusion of final cost.
 Alternative formula = contribution ---- Quantity (S.P-V.C)
EBIT Quantity (S.P-V.C)-F.C

 Significance of OL .
 Shows impact of change in sales on the level of operating profits of a firm.
 Firm DOL higher – experience magnified effect on EBIT for a even small change in
sales.
 Higher DOL profit or sometimes EBIT may disappear or give place to loss if sales
decline.
 A firm should operate its profit @ sufficiently higher than break even level as
chances of loss due to fluctuation in sales is minimized.
 But higher DOL should also be avoided by firm as, higher DOL- leads to higher risk
situation.

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 When there is no fix cost = DOL is 1
 Operating leverage consist both fixed & variable cost,OL is said to be high degree,
if employs greater amount of fix cost & smaller amount of variable cost

 Points to be noted .
 OL is % in EBIT as a result of % in sales
 OL arises due to fixed cost
 If F.C =0 – no OL % sales.
 Higher F.C--- higher OL—magnified change of EBIT on change sales.
 Positive DOL—means firm operating lvl > BEP & EBIT & sales are in same direction.
 Negative DOL—means firm operating lvl < BEP EBIT negative.

 Financial Leverage .
 Measure relationship between EBIT & EPS
 FL measures responsiveness of the EPS to a change in EBIT.
 Degree of financial leverage = % in EPS
% in EBIt.

OR

 Degree of financial leverage = EBIT

(EBIT- Interest)

 Incase of preference dividend

 DFL = contribution
EBIT- Interest – Pref dividend
(I-t)

 Importance of financial leverage .

 Due to financial leverage finance manager can compare the ROI of firm & lost of
debt & on these basis it can be decided that whether to have a debt financing in
capital structure or not-

 Three situation

1) ROI = Debt cost.

 Firms earning are equal cost of suppliers of funds.
 Neither nor advisable to borrow funds.
 Cannot generate surplus profit.

2) ROI< Debt capital

 Firm incur losses, if borrows funds.
 It generates unfavourable FL

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 3)ROI> Debt capital.
 Return higher than cost of financing.
 Borrow more & more debt
 Benefits indirectly to shareholders.
 As debt cost is & if higher ROI, remaining ROI (ROI – Debt) – of
shareholder.
 Favourable FL or Trading on equity.

 Points to be noted -
 FL is % in EPS as a result of 1% EBIT.
 FL emerges as result of fixed financial cost ( in form of interest Pref dividend)
 Inclusion of interest/pref dividend decided DFL.
 If fixed financial liability is 0, FL is also nor, here % EPS = % EBIT.
 Higher fixed financial cost higher the FL & larger would be the effect of change in
EBIT on the change in EPS.
 FL positive –EBIT > FBEP(financial break even point) , EPS & EBIT same direction.
 FL negative –EBIT > FBEP & - V C

 Combined leverage .
 The combine effect of operating leverage & financial leverage is known as combined
leverage.
 Product of OL & FL is known as combined leverage
 Degree of combined leverage (DCL) = DOL X DFL.
= EBIT X EPS
Sales EBIT
= EPS
Sales

OR
DCL = Contribution X EBIT
EBIT PBT
= contribution
PBT

 CL is the % EPS resulting from a 1% in sales

 Positive CL

 Sales lvl > BEP.

 EPS & sales are in same direction.

 Negative CL
 Sales level < BEP

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  EPS is negative.

 Operating break even point --- EBIT = 0

 Financial break even point --- EBT = 0
 Combined break even point ---- EPS = 0
 ROI = EBIT
Capital employed
 ROE = earning available for equity share holders
Net worth
 Net worth = ESC + reserves & surplus

 Average analysis & risk of firm .

 Operating leverage deals with business risk.
 Financial leverage deals with financial risk.
 If business risk increases & decreases the financial risk & vice versa.

 EBIT/ EPS analysis .

Indifference point / level.
 The indifference level of EBIT is one @ which the EPS under two or more capital
structure is same.
 Hence firm having some level of EPS at a given EBIT is known as indifference level
of EBIT.

 Graphical explanation .
 Plan I has higher degree of debt, however EPS is lower than plan II upto
indifference level.
 Higher degree of debt brings disadvantage to firm by lowering EPS
 Point A – EDIT of Plan I- EBIT more than – debt more – but disadvantage to firm is
less as compared to disadvantage of plan I firm
 Point B – EBIT of plan II
 Beyond indifference level EBIT, plan I show higher EPS than plan II & here higher
higher degree of debt bring higher increase in EPS
 Indifference point formula.
1) EBIT > indifference level of EBIT i.e. (EBIT) Debit is Good.
2) EBIT< indifference level of EBIT i.e. (EBIT) equity is better.
EBIT (1-t) = [EBIT- Int(1-t)]
N1 N2

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  Working capital leverage

% change ROI Current asset

% change in current asset
Total asset – change in current Asset

Business
Change in business
operations operation Business Risk.

EBIT Change in EBIT

Financial Risk.

Capital structure Effect of capital

structure.

EPS Change in EPS Total Risk.

 SUMMARY
1. Means mathematical relationship between two or more variables.
2. Variable cost which vary proportional with the change in level of output.
3. Fixed cost which remain constant in totality up to a certain level of activity.in
other words it does not change with the change in level of output.
4. Operating cost are the expenses which are related to the operation of a
business.
5. Operating fixed cost means such expenses which does not change with the
change in level of output.
6. Financing cost known as cost of finance.
7. Fixed financing cost.eg Int. on debt, preference, Int on debt company has to
pay whether there is profit or no profit.
8. In the absence of pref. dividend formula will be PAT
Net worth
 INCOME STATEMENT.
1. Higher the fixed profit, higher the DOL & vise-versa
2. No fixed cost -DOL will be 1.
3. Higher the financial cost – higher the DFL. & vise-versa.
4. No financial fixed cost – DFL-1

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 5. ROC or ROCF = EBIT
Capital employee
6. Capital employed = ESC + R + S +PSC + DEBT.
7. Return on equity (RoE) = PAT– pref. dividend.
Net worth.
8. Net worth = ESC + R + S
9. Total assets = fixed assets + Current Assets

 HOW TO REMEMBER FORMULA.

DOL DFL
DOL DFL

SALES EBIT EPS Contribution EBIT EBT

DOL DCL

 WRITE FORMULAE

 FORMULAE
1. Original formula – downward to upward.
2. Short cut formula – upward to downward.
3. If preference dividend is given then-DFL = EBIT
EBIT – interest – pref.dividend
1-t
4. if preference dividend is given then DCL = contribution
EBIT – interest- pref. dividend
1- t
where t = tax rate.
5. To convert PBT into PAT , PAT = PBT(1-t).

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6. To convert PAT into PBT, PBT = PAT
1-T
7. To convert any Pre-tax item to post tax item multiply by (1-t).
8. To convert any Post tax item to Pre tax item divide by (1-t).
9. If question requires to write interference or interpretation.
10. Always write general inferences.
11. Higher the fixed cost- higher the DOL &
12. Lower the fixed cost – lower the DFL
13. If fixed cost = 0, then DOL = 1.
14. Same for DFL.
15. Write instead of fixed cost.(interest).
16. Same for DFL.
17. Write instead of fixed cost interest, fixed cost.
18. If is operatory below BEP, leverage is negative.

Question 1 .
FL = 1.4
The firm has 14% debt of Rs 100L, Calculate EBIT.

Question 2
Turnover = 2000 Crores
PV Ratio = 30%
OFC = 120 Crores
Interest Expenses = 40 Crores
Preference Dividend = 10 Crores
Tax Rate = 40%
Calculate the Operating Leverage, Financial Leverage and Combined Leverage.

Question 3
Consider the following information for Strong Ltd:

Particulars Rs in
Lakh
EBIT 1,120
PBT 320
Fixed Cost 700

Calculate the Percentage of change in earnings per share if sales increased by 5%.

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1. Output (units) = 3,00,000 Fixed cost = Rs.3,50,000 Unit variable cost =
Rs.1.00 Interest expenses = Rs.25,000 Unit selling price = Rs.3.00 Applicable tax
rate is 35% Calculate Operating Leverage.

(A) 1.11

(B) 2.40

(C) 2.67

(D) 1.07

2. Output (units) = 3,00,000 Fixed cost = Rs.3,50,000 Unit variable cost =

Rs.1.00 Interest expenses = Rs.25,000 Unit selling price = Rs.3.00 Applicable tax

rate is 35% Calculate Financial Leverage.

(A) 1.11

(B) 2.40

(C) 2.67

(D) 1.07

3. Output (units) = 3,00,000 Fixed cost = Rs.3,50,000 Unit variable cost =

Rs.1.00 Interest expenses = Rs.25,000

Unit selling price = Rs.3.00 Applicable tax rate is 35%

Calculate Combined Leverage.

(A) 2.67

(B) 2.30

(C) 2.00

(D) 2.15

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4. If operating leverage is 2.1429 and financial leverage is 1.0699 then combined
leverage will be -

(A) 2.2927

(B) 2.0029

(C) 0.4993

(D) Data given is not sufficient

5. If combined leverage is 2 and financial leverage is 1.25 then operating leverage

will be

(A) 0.625

(B) 2.50

(C) 1.60

(D) Data given is not sufficient

6. If combined leverage is 2.2926 and operating leverage is 2.1429 then financial

leverage will be -

(A) 1.0699

(B) 0.9347

(C) 4.9128

(D) Data given is not sufficient

7. A company has sales of f 1 lakh. The variable costs are 40% of the sales while

the fixed operating costs

amount to Rs.30,000. The amount of interest on longterm debts is Rs.10,000. You

are required to calculate the combined leverage.

(A) 4

(B) 2

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(C) 3

(D) 5

8. Operating leverage is 4. This means 10% change in sales will cause -

(A) 4% change in variable cost

(B) 40% change in EPS

(C) 4% change in EBIT

(D) 40% change in EBIT

9. Financial leverage is 2.5. This means 10% change in EBIT will cause -

(A) 2.5% change in EBT

(B) 2.5% change in EPS

(C) 25% change in sales

(D) 25% change in EBT and EPS

10. Combined leverage is 3.125. This means 10% change in Sales will cause -

(A) 31.25% change in PAT

(B) 31.25% change in EPS

(C) 31.25% change in capital employed

(D) Both (A) and (B)

11. If there is a 10% increase in sale, EBIT increase by 35% and if sales
increase by 6%, taxable income will increase by 24%. Operating leverage must be
-

(A) 1.15

(B) 3.50

(C) 4.00

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(D) 2.67

Question 4

The data relating to two Companies are as given below:

Particulars Company A Company B

Equity Capital RS 6,00,000 Rs 3,50,000

You are required to Calculate the Operating Leverage, Financial Leverage and Combined
Leverage of Two Companies

Question 5

Annual sales of a company is Rs. 60,00,000. Sales to Variable Cost ratio is 150% and
Fixed Cost other than interest is Rs. 5,00,000 p.a. Company has 11% debentures of Rs.
30,00,000.

You are Required to Calculate the Operating Leverage, Financial Leverage and Combined
Leverage of the Company.

Question 6

From the following details of X Ltd. Prepare the Income Statements for the year
ended 31st December 2014:

Financial Leverage 2
Interest Rs
2,000
Operating Leverage 3
Variable Cost as a Percentage of 75%
Sales
Income Tax Rate 30%

12. If EBIT increases by 6%, taxable income increases by 6.9%. If sales increase
by 6%, taxable income will increase by 24%.

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Financial leverage must be -
(A) 1.19
(B) 1.13
(C) 1.12
(D) 1.15

13. If sales increase by 6% taxable income ie. PAT and EPS will increase by 24%.

Combined leverage must be -

(A) 3
(B) 4
(C) 5
(D) 6

14. The capital structure of a company consists of the following securities.

Rs.

10% Preference Share Capital 1,00,000

Equity Share Capital (Rs. 10 Shares) 1,00,000

12% Debenture 75,000

The amount of operating profit is Rs.69,000. The company is in 35% tax bracket.
You are required to calculate the financial leverage of the company.
(A) 1.1500
(B) 1.5466
(C) 1.1566
(D) 1.1554

15. Operating leverage is 7 and financial leverage is 2.2858. How much change in

sales will be required to bring 70% change in EBIT?

(A) 10%
(B) 70%
(C) 11.429%
(D) 30%

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16. Financial leverage = 1.5465 EBIT = Rs.1,38,000

Interest = 118,000 Tax rate = 35%.

Capital structure of the company consists of equity shares and preference shares.

Amount of Preference Dividend = Rs.

(A) Rs.19,950
(B) Rs.19,898
(C) Rs.20,000
(D) Rs.19,899

17. Total assets of Alpha Company are Rs.3,00,000. The company’s total assets

turnover ratio is 3, its fixed operating cost is Rs.1,50,000 and its variable

operating cost ratio is 50%. The income-tax rate is 50%. It also has long term

debts of Rs.1,20,000 on which interest @10% is payable. Operating, Financial &

Combined Leverages of the company are -

(A) 1.5; 1.042; 1.563 respectively

(B) 1.05; 1.42; 1.05625 respectively
(C) 1.50; 1.42; 2.13 respectively
(D) 1.55; 1.042; 1.6151 respectively

18. Contribution = Rs.4,00,000 EBIT = Rs.3,00,000

10% Debenture = Rs.6,00,000 Combined leverage = Rs.

(A) 1.63
(B) 1.66
(C) 1.68
(D) 1.62

19. Operating leverage = 2 Combined leverage = 3.5 EBIT = Rs.2,80,000 Interest

= Rs.40,000

Tax rate = 50%.

Capital structure of the company consists of equity shares and preference shares.

Amount of Preference Dividend = Rs.

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(A) Rs.39,967
(B) Rs.39,970
(C) Rs.39,000
(D) Rs.40,000

20. EBIT = Rs.4,00,000

Fixed cost = Rs.6,00,000

Interest = Rs.80,000

Combined leverage = Rs.

(A) Sufficient data is not given
(B) 3.12
(C) 3.215
(D) 3.125

21.EBIT = Rs.40,000

Variable cost = X2,40,000

Sales = Rs.4,00,000

Operating leverage = Rs.

(A) 3.5
(B) 4.125
(C) 4.0
(D) 3.125

Question 7

Following information are related to four firms of the same industry :

Firm Change in Change in Change in Earnings

Revenue Operating Income Per Share
P 27% 25% 30%
Q 25% 32% 24%
R 23% 36% 21%
S 21% 40% 23%

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 Find Out:
1) Degree of Operating Leverage
2) Degree of Combined Leverage for all the firms.

Question 8

From the following prepare Income Statement of Company A, B and C. Briefly comment
on each company’s performance:

Company A B C
Financial Leverage 3:1 2:1
Interest Rs 200 Rs 1,000
Operating Leverage 4:1 3:1
Variable Cost as a 66 2/3% 50%
Percentage to Sales
Income Tax Rate 45% 45%

Question 9

The net sales of A Ltd is Rs 30 crores. Earnings before interest and tax of the
company as a percentage of net sales is 12% The Capital employed comprises Rs 10
crores of equity Rs 2 crores of 13% Cumulative Preference Share Capital and 15%
Debentures of Rs 6 crores Income tax rate is 10%
1) Calculate the Return-on-equity for the company and indicate its segments due to the
presence of Preference Share Capital and Borrowing (Debentures).
2) Calculate the Operating Leverage of the Company given that combined leverage is 3.

22. Contribution = Rs.7,00,000 Fixed cost = Rs.2,00,000 Interest = Rs.3,00,000

Financial leverage = Rs.

(A) 2.0
(B) 1.5
(C) 2.5
(D) 1.0

23. Contribution of a firm is Rs.4,000.

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Fixed Cost:

Situation A Rs.1,000

Situation B Rs.2,000

Situation C Rs.3,000

Compute the operating leverage for the three situations.

(A) 1.33; 1.18; 1.82

(B) 1.33; 2.36; 2.86
(C) 2.86; 2.00; 3.64
(D) 1.33; 2.00; 4.00

24. EBIT of a firm is Rs.3,000.

Financial Plan Plan I Plan II Plan III

Equity Rs.5,000 Rs.7,500 Rs.2,500

Debt Rs.5,000 Rs.2,500 Rs.7,500

Cost of debt 12% 12% 12%

Compute the financial leverage for the three plans respectively.

(A) 1.33; 1.11; 1.43

(B) 1.25; 1.18; 1.43
(C) 1.66; 1.48; 1.90
(D) 1.25; 1.11; 1.43

25. Calculate Financial Leverage & EPS assuming 20% before tax rate of return on
assets. Other data:

(Rs. in Lakhs)

Particulars Solid Ltd. Sound Ltd.

Assets 100 100

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12% Debt - 50

Equity ( Rs.10 each) 100 50

Applicable tax rate firm is 50%.

Select the correct answer from the options given below:

Solid Ltd. Sound Ltd

EPS FL EPS FL

(A) 0.50 1.00 0.40 2.50

(B) 1.00 1.40 1.00 1.43

(C) 1.00 1.00 1.40 1.43

(D) 1.40 1.43 1.00 1.00

26. If the combined leverage and operating leverage figures of a company are 2.5
and 1.25 respectively, find the financial leverage and P/V ratio, given that the
equity dividend per share is Rs.2, interest payable per year is Rs.1 lakh, total
fixed cost Rs.0.5 lakh and sales Rs.10 lakhs.
(A) 3.125; 25%
(B) 2.00; 40%
(C) 2.00;25%
(D) 3.00; 40%

27. A firm has sales of Rs.75,00,000, variable cost of Rs.42,00,000 and fixed

cost of Rs.6,00,000. It has a debt of Rs.45,00,000 at 9% and equity of

Rs.55,00,000. What is the firm’s ROI?

(A) 72%
(B) 27%
(C) 32%
(D) 2396

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28. A firm has sales of Rs.75,00,000, variable cost of Rs.42,00,000 and fixed
cost of Rs.6,00,000. It has a debt of Rs.45,00,000 at 996 and equity of
Rs.55,00,000. Does it have favourable financial leverage?
(A) ROI is less than interest on loan funds and hence it has no favorable financial
leverage.
(B) ROI is equal to interest on loan fluids and hence it has favorable financial leverage.
(C) ROI is greater than interest on loan funds and hence it has favorable financial
leverage.
(D) ROI is greater than interest on loan funds and hence it has unfavorable financial
leverage.

29. A firm has sales of Rs.75,00,000, variable cost of Rs.42,00,000 and fixed
cost of Rs.6,00,000. It has a debt of Rs.45,00,000 at 996 and equity of
Rs.55,00,000.

If the firm belongs to an industry whose asset turnover is 3, does it have high or
low asset leverage?
(A) Industry asset turnover ratio is 3 whereas firm has asset turnover ratio 4 which is
high as compared to industry.
(B) Industry asset turnover ratio is 3 whereas firm has asset turnover ratio 1.75 which
is low as compared to industry.
(C) Industry asset turnover ratio is 3 whereas firm has asset turnover ratio 0.75 which
is low as compared to industry.
(D) None of the above

30. A firm has sales of Rs.75,00,000, variable cost of Rs.42,00,000 and fixed
cost of Rs.6,00,000. It has a debt of Rs.45,00,000 at 996 and equity of
Rs.55,00,000. What are the operating, financial and combined leverages of the
firm?
(A) 1.22, 1.44, 1.18
(B) 1.22, 1.12, 1.44
(C) 1.22, 1.18, 1.44
(D) 1.20,1.18,1.44

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31. A firm has sales of Rs.75,00,000, variable cost of Rs.42,00,000 and fixed

cost of Rs.6,00,000. It has a debt of Rs.45,00,000 at 996 and equity of

Rs.55,00,000. At what level of sales the EBT of the firm will be equal to zero?

(A) Rs.22,84,091
(B) Rs.10,05,000
(C) Rs.22,48,910
(D) Rs.10,50,000

32. Following data is available for A Ltd.

Financial Leverage 3:1

Interest 7 2,000

Operating Leverage 4:1

Variable cost (96 to sales) 66.6796

Income Tax Rate 4596

Contribution = Rs.

(A) Rs.6,000
(B) Rs.12,000
(C) Rs.36,000
(D) Rs.18,000

Question 10

Consider the following information for Jaguar Ltd:

Particulars Rs in Lakh
EBIT 1,120
PBT 320 Rs in
Lakh
Fixed Cost 700 Rs in
Lakh

Calculate the Percentage of change in earnings per share, if sales increased by 5%.

Question 11

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[Date] 2.22
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Consider the following information for XYZ Ltd:

Particulars Rs in
Lakh
EBIT (Earnings before 15,750
Interest and Tax)
Earnings before Tax (EBT): 7,000
Fixed Operating Costs: 1,575

Required:
Calculate Percentage change in earnings per share, if sales increase by 5%

Question 12

Suresh Limited has estimated that for a new Product its break-even point is 20,000
units if the item is sold for 14 per unit and variable cost Rs 9 per unit. Calculate the
degree of Operating leverage for sales volume 25,000 units and 30,000 units.

33. Following data is available for B Ltd.

Financial Leverage 4:1

Interest Rs.3,000

Operating Leverage 5:1

Variable cost (96 to sales) 7596

Income Tax Rate 4596

What are the sales of B Ltd.Rs.

(A) Rs.12,000
(B) Rs.20,000
(C) Rs.60,000
(D) Rs.80,000

34. Following data is available for C Ltd.

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Financial Leverage 2:1

Interest Rs.10,000

Operating Leverage 3:1

Variable cost (96 to sales) 5096

Income Tax Rate 4596

What is the sales and profit after tax (PAT) of C Ltd?

(A) Rs.1,20,000; Rs.5,500

(B) Rs.1,00,000; Rs.5,000

(C) Rs.1,50,000; Rs.6,500

(D) Rs.1,50,000; Rs.6,000

35. A Financial Analyst has gathered following data for PQR Ltd.

Change in revenue - 2796

Change in operating profit after tax = 2096

Change in operating income = 2596

What should be the operating leverage of PQR Ltd.Rs.

(A) 0.74

(B) 0.93

(C) Above 1.00

(D) 1.93

36. A Financial Analyst has gathered following data for TUV Ltd. & WXY Ltd.:

TUV WXY

Change in revenue 2396 219,

Change in operating income 3696 409j

Beta (P) 1.30 1.40

Beta (P) of market = 1.00

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[Date] 2.24
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Using the concept of operating leverage concept and beta state which company has

more risk as compared to market?

(A) TUV Ltd. is more risky

(B) WXY Ltd. is more risky
(C) TUV Ltd. & WXY Ltd. both are more risky as compared to market as there
operating leverages and betas are more than market. However, WXY Ltd. is morerisky
than market as well as TUV Ltd.
(D) TUV Ltd. & WXY Ltd. both are less risky as compared to market as there operating
leverages and betas are more than market.

37. Details of R Ltd. are given below:

Particulars Rs.in lakh

Fixed Cost (excluding interest) 2.04

Sales 30.00

12% Debentures (Rs. 100 each) 21.25

Equity share capital (Rs. 10 each) 17.00

Operating & Combined Leverage are 1.4 & 2.8 respectively. Income Tax Rate is
30%. Calculate EPS.

(A) 1.50
(B) 1.55
(C) 1.05
(D) 1.00

38. Take the data of above question and calculate P/V Ratio.

(A) 23.8%
(B) 22.8%
(C) 20.8%
(D) 24.8%

39. Take the data of above question and tell at what level of sales the earning

before tax (EBT) of the company will be equal to zero?

(A) Rs.19.00 lakh

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[Date] 2.25
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(B) Rs.19.20 lakh
(C) Rs.19.29 lakh
(D) Rs.19.92 lakh

From the following information answer next 5 questions:

The capital structure of JCPL Ltd. is as follows:

Equity Share Capital (Rs. 10 each) 8,00,000

8% Preferences Shares (Rs. 10 each) 6,25,000

10% Debenture (Rs. 100 each) 4,00,000

18,25,000

Additional Information:

Profit after tax (tax rate 30%) Rs.1,82,000

Operating expenses (including depreciation Rs.90,000) being 1.50 times of EBIT.

Equity share dividend paid 15%.

Market price per equity share Rs.20.

40. Calculate operating & financial leverage.

(A) 1.30; 1.59

(B) 1.59; 1.30
(C) 1.39; 1.50
(D) 1.50; 1.39

41. Cover for the preference and equity share of dividends = Rs.

(A) 1.10; 3.65

(B) 1.65; 1.10
(C) 1.85; 2.10
(D) 3.64; 1.10

42. Earnings Per Share (EPS) = Rs.

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[Date] 2.26
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(A) 1.56
(B) 1.65
(C) 1.91
(D) 1.19

43. Earning Yield Ratio = Rs.

(A) 8.00%
(B) 8.52%
(C) 8.25%
(D) 8.75%

Question 13

Ramdas Limited is considering the installation of a new project costing Rs 80,00,000

Expected annual sale revenue from the Projects is Rs 90,00,000 and its variable costs
are 60% of sales. Expected annual fixed cost other than interest is Rs 10,00,000
Corporate tax rate is 30 percent. The company wants to arrange the funds through
issue of 4,00,000 equity shares of Rs 10 each and 12 % debentures of Rs 40,00,000.

You are required to:

1) Calculate the operating financial and combined leverages and earnings per share
(EPS); and also
2) Determine the likely level of EBIT, if EPS is (i) Rs 4, (ii) Rs 2, (iii) 0.

Question 14

You are required to compute the operating leverages for each of the four firms P, Q, R
and S from the following price and cost data. What inferences can you draw with
respect to levels of fixed cost and the degree of operating leverage result? Assume
number of units sold is 5,000

Particulars Firms
P (Rs.) Q R (Rs.) S (Rs.)
(Rs.)
Sale Price Per Unit 20 32 50 70
Variable Cost Per 6 16 20 50
Unit
Fixed Operating Cost 80,000 40,000 2,00,000 Nil

Question 15

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[Date] 2.27
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Calculate the Degree of Operating Leverages, Degree of Financial Leverages and the
Degree of Combined Leverage for the following firms and interpret the results:

Particulars X Y Z
Output (Units) 2,50,00 1,25,000 7,50,000
0
Fixed Cost (Rs) 5,00,00 2,50,00 10,00,00
0 0 0
Unit Variable 5 2 7.50
Cost (Rs)
Unit Selling 7.50 7 10.0
Price (Rs)
Interest 75,000 25,000 -
Expense (Rs)

Question 16

You are given two financial plans of a company which has two financial situations. The
detailed information are as under:

Installed Capacity 10,000 Units

Actual Production 60% of Installed
and Sales Capacity
Selling Price Per Rs 30
Unit
Variable Cost Per Rs 20
Unit

Fixed Cost:
Situation ‘A’ = Rs 20,000
Situation ‘B’ = Rs 25,000

Capital structure of the company is as follows:

Financial Plans
Particulars AB AC
(Rs.) (Rs.)
Equity 12,000 35,000

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 Debt (Cost of 40,000 10,000
Debt 12%)
52,00 45,00
0 0

You are Required to Calculate Operating Leverage and Financial Leverage of both the
plans.

Question 17

The capital structure of MKPL Ltd. is as follows:

Equity Share Capital of Rs 10 8,00,000

Each
8% Preferences Share Capital 6,25,000
of Rs 10 Each
10% Debenture of Rs 100 Each 4,00,000
18,25,000

Additional Information:
1) Profit After Tax (Tax Rate 30%) Rs 1,82,000
2) Operating expenses (including depreciation Rs 90,000) being 1.50 times of EBIT
3) Equity share dividend paid 15%
4) Market price per equity share Rs 20.

Require to Calculate:
1) Operating Leverage and Financial Leverage
2) Cover for the Preference and Equity Share of Dividends
3) The Earning Yield and Price Earnings Ratio
4) The Net Funds Flow

44. Price earnings ratio = Rs.

(A) 12.00 times

(B) 12.12 times
(C) 12.21 times

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(D) 12.19 times

45. You are Finance Manager Big Pen Ltd. The degree of operating leverage of
your company is 5.0. The degree of financial leverage of your company is 3.0.
Your Managing Director has found that the degree of operating leverage and the
degree of financial leverage of your nearest competitor Small Pen Ltd. are 6.0 and
4.0 respectively. In his opinion, the Small Pen Ltd. is better than that Big Pen
Ltd. because of higher value of degree of leverages.

Which of the following statement is correct in relation to facts given above?

(A) High operating leverage shows higher burden of fixed cost consequently higher
business risk. As Small Pen Ltd. has higher operating leverage hence it has high
business risk as compared to Big Pen Ltd.
(B) High financial leverage shows higher burden of interest cost consequently higher
financial risk. As Small Pen Ltd. has higher financial leverage hence it has high financial
risk as compared to Big Pen Ltd.
(C) High combined leverage shows combined effect of higher burden of fixed and
interest cost consequently higher business & financial risk. As Small Pen Ltd. has higher
combined leverage hence it has high business risk & financial risk as compared to Big
Pen Ltd.
(D) All of the above

From the following information answer next 3 questions:

A simplified income statement of Abhiash Ltd. is given below.

Particulars

Sales 15,00,000

Variable cost (9,00,000)

Contribution 6,00,000

Fixed cost (2,00,000)

EBIT 4,00,000

Interest (60,000)

EBT 3,40,000

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Taxes @35% (1,19,000)

Net income 2,21,000

46. Calculate percentage increase in EBIT if sales increases by 10%.

(A) 13.61%
(B) 13.16%
(C) 13.25%
(D) 13.52%

47. Calculate percentage increase in EBT if EBIT increases by 10%.

(A) 21.21%
(B) 21.00%
(C) 21.22%
(D) 22.11%

48. Calculate percentage increase in EPS if sales increases by 10%.

(A) 28.00%
(B) 28.88%
(C) 28.44%
(D) 28.33%

From the following information answer next 5 questions:

DIGI Computers Ltd. is a manufacturer of computer systems. It has total sales of Rs.1

Crore. Its variable and fixed costs amount to Rs.60 lakhs and Rs.10 lakhs respectively.

It has borrowed Rs.60 lakhs @10% per annum and has an equity capital of Rs.75 lakhs.

49. What is company’s return on investment (ROI)Rs.

(A) 20.00%
(B) 22.00%
(C) 22.22%
(D) 20.22%

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[Date] 2.31
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50. Does it have favorable financial leverage?

(A) ROI is less than interest on loan funds and hence it has no favorable financial
leverage.
(B) ROI is equal to interest on loan funds and hence it has favorable financial leverage.
(C) ROI is greater than interest on loan funds and hence it has favorable financial
leverage.
(D) ROI is greater than interest on loan funds and hence it has unfavorable financial
leverage.

51. If the firm belongs to an industry whose asset turnover is 1, does it have

high or low asset leverage?

(A) Industry asset turnover ratio is 1 whereas firm has asset turnover ratio 2.74 which
is high as compared to industry.
(B) Industry asset turnover ratio is 1 whereas firm has asset turnover ratio 1.75 which
is low as compared to industry.
(C) Industry asset turnover ratio is 1 whereas firm has asset turnover ratio 0.74 which
is low as compared to industry.
(D) None of the above

52. What are the operating, financial and combined leverages of the firm?

(A) 1.33; 1.25; 1.67

(B) 1.33; 1.67; 1.25
(C) 1.25; 1.33; 1.67
(D) None of the above

53. If sales drop to Rs.50 lakhs, what will be the new EBIT:1

(A) Rs.20,00,000
(B) Rs.15,00,000
(C) Rs.50,00,000
(D) Rs.10,00,000

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[Date] 2.32
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54. From the following data of Abhishek Ltd., compute the operating leverage,
financial leverage, combined leverage.

EBIT 10 lakh

Profit before tax (PBT) 4 lakh

Fixed cost 6 lakh

(A) 1.6; 2.5, 4.0
(B) 2.5; 1.6; 4.0
(C) 4.0; 2.5; 1.6
(D) 4.0; 1.5; 2.5

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[Date] 2.33
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t

―Every profit seeking corporation(company) has its own risk-return characteristics. Each group
of investor in the corporation-bond holders, preferred stock holders (i.e. preference
shareholders) & common stock holders (equity shareholders)- requires a minimum rate of return
commensurate (correspondent) with the risk it accept by investing in the company/firm.‖

―From the standpoint of corporation, these groups provides the capital needed to finance the
firms’ investment. The minimum (hurdle) rate of return i.e. the corporation must earn in order
to satisfy the overall rate of return required by its investors is called the corporation’s Cost of
Capital.‖

Cost of Capital is denoted by kc/ko

Application’s of Cost of Capital .

 Application od COST OF CAPITAL in Capital budgeting; -
 It is used to discount future cash flows, to obtain their present values.

Application of Cost of Capital in capital structure .

 COST OF CAPITAL used to obtain optimized financial plan i.e. Capital structure of a firm.

Concept of Cost Capital .

 Firm needs various funds for variety of capital budgeting proposals.
 These funds produced from different types of investors i.e. preferred stock holders(Pref.
shareholder), equity shareholders (common stock holders), debt holders, depositors etc.
 Here, investor while investing will have some expectations of receiving minimum rate of return,
such return is contigent to risk perception of investor as well as risk return characteristics of
firm.
 Therefore, cost of raising funds is the minimum required rate of return of the firm i.e. COST OF

CAPITAL is the minimum return that must earn on the proposals in order to break-even.

Significance of Cost of Capital .

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[Date] 3.1
 It’s significance can be free mindly stated in terms of contribution it makes towards the
achievement of objective of maximization of wealth of share holders.
 Explanation;-If firm’s actual rate of return (IRR) exceeds its cost of capital & such return is
earned without increasing the risk characteristics of the firm, then wealth maximization goal is
merely achieved.
 Here, if return > Cost of Capital, then investor no doubt, will claim expected returns from firm.
 And the excess portion of return will be used
 For distribution among shareholders – in form of higher dividends
AND/OR
 As retained earnings i.e. reinvestment within the firm for increase in further subsequent
returns .In both situations, market price of share increases , which firmly returns in results in
increase in shareholders wealth.

Factors affecting the Cost of Capital of firm

 Risk characteristics of firm.
 Risk perception of the investor It means risk ground or figure in percentage form the investor
holds.
 Risk- free intrest rate ;-(denoted as RF)
 The interest rate on risk free or default free securities.
 E.g government securities are risk free security as chances of default in payment of interest as
well as principal amount on maturity are nil.

Two components if Risk-Free interest rate.

PURCHASING POWER
REAL INTEREST RATE.
RISK PREMIUM.
 The rate payable to lender for
 Lender lends money,i.re.
supplying funds or surrender
lend present purchasing
the funds to firm for a period
power to borrow
of time.
 While receiving, if inflation
in market, purchasing
power increase.

Business Risk .
 Risk associated with firms promise to pay interest & dividends to investor.

Unique Academy uniqueacademyforcommerce.com Prof Ashish Parikh 08007978700

[Date] 3.2
 Risk which is totally based on response of firms earning before interest & taxes (EBIT)—here
earning of firm before interest & taxes are the revenue (income) generate from sales.
 If a proposal having a high risk point , than the average risk point, then investor expectation also
rise with such effect & for that firm has to compensate to investor in addition to normal interest
rate & such compensation is known as premium on business risk.
 Business risk premium – Connected to firm – contingent to firm revenue
 Where as risk free interest –connected to external factors.

Financial Risk .
 Risk related to response of the firm’s earning per share (EPS) to variation in EBIT.
 Risk contingent to capital structure of firm.
 Higher the proportion of fixed cost securities in overall capital structure greater would be
financial risk & in such case, investor is compensated for the increased risk .This is addition of
financial risk premium over & above the business risk premium.

Other Considerations .

Liquidity .
 Higher the liquidity (i.e. conversion of current assets to cash )(other than cash) lower the
premium demand by investor.

Marketability .
 If investments are not early marketable ( not sold early) then investor would demand high
premium.

Hence Cost of Capital is defined as .

k = cost of capital.
k = IRF +b+f Irf = Risk free interest rate

b =business risk premium.

F = financial risk premium

Relation between Cost of Capital & Opportunity Cost of Investor.

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[Date] 3.3
  Opportunity cost of investor is the return foregone by the investor on the alternative investment
opportunity of the same or comparable risk. COST OF CAPITAL—IS OPPORTUNITY COST OF
SUPPLIERS OF FUND i.e. INVESTORS.
 These will rise when investor compare two investment & invest in a particular one investment,
then the other investment was opportunity for investor which he foregone.

Relation between Risk & required Rate of Return.

 Higher the risk – greater the required rate of return.
 From graph;-
 Government bonds –0% risk –no premium only interest.
 Public sector bonds—low risk—interest+ low risk premium.
 Debenture holder – moderate risk.—interest + moderate risk premium.
 Preference holders—high risk.—interest + high risk premium.
 Equity share holders—Extremly high risk—as residual interest.—
interest + extremely high risk premium.

R
I EQUITY
S SHAREHOLDERS
K
P PREFERENCE
R SHAREHOLDRES.
E
M DEBENTURE
I HOLDERS.
U
M PUBLIC
GOVT. SECTOR
SECUR BONDS.
ITES Explicit Cost & Implicit Cost.
RISK FREE INTEREST RISK
RATE Explicit Cost & Implicit Cost

EXPLICIT COST. IMPLICIT COST.

 Cost paid to uniqueacademyforcommerce.com

Unique Academy  Cost
Prof Ashish which could be 08007978700
Parikh
pref.shareholders, earned by investor if
equity shareholders, profit would be [Date]
distributed, but by 3.4
debentures.
 Taxes & Cost of Capital .
 In capital budgeting while discounting cash flows, if such cashflows are after tax i.e. CFAT,then
cost of capital should also be taken after tax basis.
 Then cost adjustment is needed for the cost of debts i.e. interest, otherwise pref.& equity are
already post tax.

Specific & overall Cost of Capital .

Cost of Capital Combine .

Cost of short-term sources. Cost of long-term sources.

But cost of capital merely measures long

term sources cost because short term
sources are temperory in nature & they
have obligation to pay the amount in short
period.

And here, combined cost (i.e.

The long term sources Overall cost of capital)is depend
have their own specific on specific cost of capital
cost.

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[Date] 3.5
Specific Costs Calculations .
s
 Cost of long term debts, bonds & debentures measures the current cost of the firm
of borrowing funds to finance the projects.

Cost of Debts Determined via .

 CURRENT LEVEL OF INTEREST- level of interest increases, cost of debt also

increases for the firm.
 THE DEFAULT RISK OF THE FIRM-default risk increases, cost of debt also
increases for the firm.
Default risk measure by bond rating higher the credit rate of firm, lower the rate &

Cost of Capital of Redeemable Debt .

Here.

I(I-t) + (RV-NP) I= interest amount

t-tax rate.
Kd = N
RV= redemption value of debenture,
(RV + NP) NP=net proceeds,
2 N=no. of years maturity of debenture.
I=i(face value) here, i= interest rate.

Cost of Capital of Irredemable Debt – Perpectual Debt.

KD = I(1-t)
NP

EXAMPLE-12.5% Debenture of face value of Rs. 100 each,floating cost 1%. Tax rate
=40%,market value=120.

CASE 1-Redeemable after 5years

I = 12.5%(100) =12.5.,NP=120-1% =118.8

12.5(1-0.40)+ (100-118.8)

Kd = 5

100+118.8

7.5 + (-3.76)
=
Kd Academy
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= [Date] 3.6
 109.4

Kd = 0.34 OR 3.41%.

Case 2- Irredeemable.
Kd = 12.5(1-0.40)

118.8

Kd = 0.063 or6.31%

Cost of Preference Share Capital .

 Differentiate preference share capital. From the Equity share capital

 Entitled to receive dividend.
 Fined rate in priority over equity share capital.
 If in case company goes for liquidation, priority to preference share capital over equity share
capital.

NOTE-NO OBLIGATION ON FIRM TO COMPLUSORILY PAY THE DIVIDEND AS

PREFEFERENCE DIVIDEND PAYABLE ONLY WHEN SUFFICIENT PROFIT AVAIBALE WITH
THE FIRM

Hence, preference holder can have priority, but cannot demand dividend.

# Preference dividend pay as appropriation of profit, unlike interest on debentures which is

charge against profit.

If firm faces consequences if paying preference dividend then .

 In case of non-payment of dividend, preference shareholder gets voting rights as per companies
act 2019.
 If affects goodwill of firm, which create difficulties in later stage.

Calculation of Cost of Capital of Preference Shares-kp.

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[Date] 3.7
Redeemable Preference shares. Irredeemable Preference shares.

D+(RV-NP) Kp = D
Kp = N NP
RV+NP
2
HERE,D= DIVIDEND.
HERE,D= DIVIDEND.
RV= REDEEMABLE VALUE. NP=NET PROCEEDS.
N= NO OF YEARS TO MATURITY.
NP= NET PROCEEDS.
NP-MV-F.

Note- if corporate divident tax (cdt) –given—replace d with d(1+cdt).

Q1.ABC LTd issues 15% preference share of the face value of rs 100each at flotation cost of
4%
Case -1 redeemable preference shares @ 10 yrs. CASE-2 irredeemable pref. shares

D+(RV-NP) Kp = D
Kp = N NP
RV+NP 15
2 96
Kp =15+(100-96) KP=0.1562 OR 15.62%
10
100+96
2

KP=0.1571 OR 15.71%

Case 3—corporate divident tax = 20% .

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[Date] 3.8
A. Redeemable Pref. Shares. B. Irredeemable Pref. Shares.

D(1+CDT) + RV-NP KP = D(1+CDT)

KP = N NP
RV + NP
2 KP = 15(1+0.20)
96.
15(1+0.20)+(100-96)
KP = 10 KP = 0.1875 OR 18.75%
100+96
2
KP = 0.1877 OR 18.77%

3 COST OF TERM LOAN—KT

KT = i( 1+t)
i=interest rate
t=tax rate.

Cost of equity share capital--- ke.

 Measurement of cost of equity share capital is most typical & conceptually a difficult exercise, as
in case of preference & debt the return from firm was known in the form of coupon rate, but in
case of equity no such rate is available as equity holders have residual interest.
 The potential investors, of equity share capital must estimate the expected stream of dividend
from the firm. These stream of dividends may be discounted to get the present value of such
stream. The rate of discount at which the expected dividends are discounted to determine their
present value is known as the cost of equity share capital.
 Hence coupon rate is not given, therefore find expectation of investors, which is denoted as Re

Methods of Calculating re.

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Here, Rf - Risk free return.
[Date] 3.9
B - Sensitivity of stock with respect
1.) Capital asset pricing method ( CAPM).
Re = RF + β(RM-RF)

CALCULATE Re

CASE 1—INTERNAL FACTOR (EQUITY)

Re = ke—floating cost absent.

CASE 2—EXTERNAL FACTOR(EQUITY).

Ke= Re
1-F F—FLOATING COST.

2.) DIVIDEND DISCOUNTING MODEL(DDM)--- GROWTH MODEL.

Re = d1 +G HERE,
Po D1= EXPECTED DIVIDEND.
Po=CURRENT MARKET PRICE.
g=PERPETUAL GROWTH RATE.
NOW’,FINDING Ke
CASE-1—INTERNAL EQUITY---Ke=Re---as floating cost absent
CASE2—EXTERNAL EQUITY ---Ke=Do + g—here,NP=NET PROCEEDS.
NP

3.) EARNING YIELD RATIO—GROWTH ABSENT.

Re=E1---HERE, E1=EARNING PER SHARE(EPS)
PO--- Po=CURRENT MARKET PRICE.
Re can be inverse of P/E RATIO
Re=1/P/E

HERE----Ke=?
IN internal equity
Re=Ke—As floating cost absent.
IN EXTERNAL EQUITY.
Ke= E1 NP=NET PROCEEDS.
NP
OR
Ke=Re
1-f
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[Date] 3.10
Calculate Overall Cost of Capital-Kc .

 The overall cost of capital is rate of return that must be earned by firm in order to satisfy the
requirements of different investors.
 Hence, overall cost of capital required minimum rate of return on assets of the firm.
 Overall cost of capital is calculated on weighted average cost of capital rather than simple
average.
 The weighted average cost of capital (WACC) defined as weighted average of the cost of
different sources.

WACC (i.e.kc) = We Ke + Wphkp + Wd Kd + WT KT.

Here, WACC - Weighted average cost of capital.

Ke - Cost of equity.

Kp - Cost of preference shares.

Kd - Cost of Debt.

Kt - Cost of Term loan.

We - Proportion of equity in capital structure.

Wp - Proportion of preference share in capital structure.

Wd - Proportion of Debt in capital structure.

Wt - Proportion of Term loan in capital structure.

Weights to Calculate overall Cost of Capital .

Book Value Weights .

 If the proportions of different sources are ascertained on the basis of the face values i.e.
accounting values (from balance sheet) called as book value weights.
 The book value weights system is not consistent with definition of the overall cost of capital
which defines that minimum rate of return needed to maintain the firm’s market value.
 Book value weights ignore the market values.

Market Value Weights .

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[Date] 3.11
 It is the proportion of each source at its market value.

Advantages of Market Value .

 Consistent to defination of overall cost of capital.

 Provides current estimate of investors required rate of return.
 Provide good estimate of cost of capital – that results in, should the firm require additional funds
from market.

Disadvantages .
 While calculating market value of equity share, it is segregated into capital (ESC) and retained
earnings (res. & surplus).
 Market values changes time to time, therefore relevancey of capital structure is not constant for
longer period.
 External factors affect market values, which indirectly influne the investment decisions as it
affects cost of capital.

While calculating book value weight – equity share includes .

Equity share capital + Reserves & Surplus .

1. While calculating market value weights – equity share includes:

Equity share capital only

Marginal cost of capital .

 Investment proposal may require funds to be raised from new internal / external sources and
results in increase in funds.
 An such situation, cost of capital of the additional funds is called the marginal cost of capital.
 If firm uses more than one source of finance in additional, then WACC is called as weighted
marginal cost of capital.
 Variables that affects WMCC :-
 Investors percieve an increase in business risk of firm.
 Financial risks changes as capital structure of firm changes.
 Increase in business risk & financial risk, increases the marginal cost of capital, which results
unviable of some proposals.

How to calculate growth .

g=b x r.
b= retained earning ratio –RER.
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[Date] 3.12
r=return on equity—ROE.

1. Rer= retained earning per share

earning per share.

2. Roe = profit after tax(pat)------ (formula for totality.)

net worth. ------------------- (esc + r&s)

= EARNING PER SHARE (Formula per share).

BOOK VALUE PER SHARE.

Intrentic value Per Share .

 Valuation of equity from investors point of view.

 Intrinsic value means should be price of the share i.e. present value of share.
IVO= D1+P1
(1+RE).
IVO = INTRENSIC VALUE
D1 = EXPECTED DIVIDEND AFTER 1 YEAR.
P1 = MARKET PRICE AFTER 1 YEAR.
RE = RETURN--- DISTOUNTING RATE.
n=NO. OF PERIOD.

Lesson round up .
 The cost of capital is the minimum required rate of return which firm must earn on its funds
in order to satisfy the expectation of its supplier of funds. If the return from capital
budgeting proposals is more than the cost of capital, then the difference will be added to
the wealth of the shareholders.

 The concept of cost of capital has a role to play in capital budgeting as well as in finalizing
the capital structure for the firm. The cost of capital depends upon the risk free interest
rate and the risk premium which depends upon the risk of the investment and the risk of the
firm.

 The cost of capital may be defined in terms of (1) Explicit cost, which the firm pays to the
supplier and (2) Implicit cost Le, the opportunity cost of the funds to the firm. The cost of
capital is calculated in after tax terms.

 Different sources of funds available to the firm may be grouped into Debt, Pref, share
capital and Retained Earnings and these sources have their specific cost of capital. However,
overall cost of capital of the firm may be ascertained as the weighted average of these
specific cost of capital.

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[Date] 3.13
 The cost of Debt and cost of Pref. share capital basically depend upon the rate of
interest/dividends and the issue/redemption values and are defined k d = Rate of Interest
(1-t) and k = Rate of Dividend.

 The cost of equity share capital, ke,is defined as k D/P 0 , or k e = Dj/Pj + g. The cost of
retained earning is lower than cost of equity as the former does no/ have any flotation
cost.The Weighted Average Cost of Capital. WACC may be ascertained by applying book
value weights market value weights of different sources of fund The WACC is denoted as ko

Question 1 .

Consider a 4 years, ZCB of FV 1000 present by trading at 690. If floating cost is 2%,
calculate the cost of ZCB to the company?
Question 2.
A firm issues a perpetual bond of FV 1000 at Rs 970.
Floating cost is Rs 10 per bond
Coupon rate on the bond is 10% and the firm’s tax rate is 35%. Find out the post tax cost of debenture.

Question 3 .
Consider a bond with the following features-
FV = 1000
Maturity = 5 Years
Coupon Rate = 12% Payable Annually
MP = 980
Floatation Cost = 2% on MP.
Bond is Redeemable at a Premium of 5% at the end of 5 year
Tax Rate =30%
Calculate Post Tax Cost of Debentures.

MCQ-1 R Ltd. has disbursed a dividend of Rs.75 on each equity share of Rs.25. The market price of share
is Rs.200. Corporate tax rate is 40%. Its cost of equity is -

(A) 30.0%
(B) 37.5%
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[Date] 3.14
(C) 35.7%
(D) 33.5%
MCQ-2 F Ltd. issued 1,00,000 equity share of Rs.100 each at a premium of Rs.20 each. Company has
incurred issue expenses of Rs.50,000. Corporate tax rate is 40%. The equity shareholders expects the
rate of dividend to 18% p.a.
Cost of equity = Rs.

(A) 15.60%
(B) 15.65%
(C) 15.06%
(D) 16.50%

MCQ-3. The equity of JPG Ltd. is traded in the market at Rs.225 each. It book value per share is Rs.100.
The dividend expected at the year end per share is Rs.45. The subsequent growth in dividends is
expected at the rate of 0.06. Calculate the cost of equity capital.

(A) 0.26
(B) 0.22
(C) 0.33
(D) 0.28
MCQ-4. Sara Ltd. has its shares having face value of Rs.25 each quoted on the stock exchange, the
current price per share is Rs.60. The gross dividends per share over the last four years have been Rs.3,
Rs.3.3, Rs.3.63 & Rs.4. Calculate cost of equity.

(A) 17.33% (B) 13.17% (C) 15.33% (D) 0.0173%

MCQ-5. F Ltd. has paid-up capital of Rs.10,00,000. Equity share of Rs.10 each and the current market
price of its equity shares is Rs.630. The dividend declared by the company during last 5 years is given
below:

Year DPS

2014 13.50

2015 15.75

2016 22.50

2017 27.00

2018 31.50

Risk free rate of interest on government securities is 9%. Ke =Rs.

(A) 45.3%
(B) 30.2%
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[Date] 3.15
(C) 28.9%
(D) 16.4%
Question 4 .
FV of in Share = 100
Dividend Rate = 12%
Maturity = 5 years
MP = 90%
Floatation Cost = 3%
CDT = 10%
Calculate cost of preference capital

Question 5 .
The following is an extract of Balance Sheet of X Itd. As on 31st Dec’15.

Particulars Amt (Rs in L)

Eq. Share Capital (10,000 eq. Share at 100 each) 10
Reserve and Surplus 190
10% Preference Capital (10,000 Share at 10 each) 10
9% Debentures (50,000 Debentures at 100 each) 50
12% Term loan 150

MP of Eq. Share = 800

MP of Preference Share = 11 (4 Years remaining to Maturity)
MP of Debenture = 108 (6 Years remaining to Maturity)
Floatation Cost of Preference Share = 1%
Floatation Cost of Debenture = 2%
CDT Rate = 10%
Corporate Tax Rate = 30%
Cost of Equity = 16%

Calculate WACC Using -

1) BV as Weights
2) MV as Weights

Question 6 .
You are required to determine the weighted average cost of capital of a firm using 1) Book- Value Weights and 2)
Market Value Weights. The following information is available for your perusal :
Present book value of the firm’s capital structure is:

Particulars Rs
Debentures of Rs 100 each 8,00,000
Preference Shares of Rs 100 each 2,00,000
Equity Shares of Rs 10 each 10,00,000
20,00,000

All these securities are traded in the capital markets. Recent prices are: Debentures @ Rs 110, Preference Shares
@Unique
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Equity Shares @ uniqueacademyforcommerce.com
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Anticipated external financing opportunities are as follows:
1) Rs 100 per Debenture Redeemable at Par : 20 Years Maturity 8% Coupon Rate, 4% Floatation Costs, Sale
Price Rs 100.
2) Rs 100 Preference Share Redeemable at Par : 15 Years Maturity, 10% Dividend Rate, 5% Floatation Costs,
Sale Price Rs 100.
3) 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 years 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%.

MCQ-6. P Ltd. has 1,50,000 equity shares of Rs.25 each and its current market value is Rs.115 each. The
before tax profit of the company for the year just ended is Rs.36,36,363. Tax rate is 34%. Cost of equity
of P Ltd. -

(A) 10.76%
(B) 12.72%
(C) 10.67%
(D) 13.48%

MCQ-7. NSZ Ltd. has equity of 15 Million and 10% debentures of 20 Million. Cost of equity is 18% and
pre-tax cost of debt is 10%. Company estimates its EBI for 7 Million. Applicable tax rate is 30%. What is
the Economic value added of NSZ Ltd.

(A) 0.088 Million

(B) 0.678 Million
(C) 0.798 Million
(D) 0.533 Million

MCQ-8. Maya Ltd. share beta factor (P) is 1.1214. Dividend paid by the company last year was Rs.3.60
per share on face value of Rs.20. The risk free rate of interest on government bonds is 7.5%. The
expected rate of return on company equity shares is 13%. What is the cost of equity (Ke) of Maya Ltd.Rs.

(A) 12.89%
(B) 13.67%
(C) 14.52%
(D) 13.03%

MCQ-9 Current market price of equity shares of Jack Ltd. is Rs.120. The company has issued
new equity shares of Rs.30 each at Rs.120 and the cost of its flotation is Rs.1.50 per share. The
gross dividends per share over the last six years have been Rs.3.15, Rs.3.3, Rs.3.48, Rs.3.63,
Rs.3.81 and Rs.4.02. It is expected to maintain the fixed dividend payout ratio in the future.
Applicable tax rate is 35%. Cost of equity of Jack Ltd. is -
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[Date] 3.17
(A) 0.856
(B) 0.0856
(C) 0.0865
(D) 0.0586

MCQ-10. Bharat Ltd. has its equity shares of Rs.10 each quoted in a stock exchange with market
price of Rs.140. A constant expected annual growth rate of 6% and a dividend of Rs.9 per share
has been paid for the last year. Calculate the cost of capital.

(A) 12.28%
(B) 12.43%
(C) 66.82%
(D) 12.81%
Question 7 .
The following information is given for Gamma Limited. You are Required to Compute the Weighted Average Cost
of Capital of the company.

1) Total Capital Employed Rs. 20,00,000

2) Debt-Equity Mix 40% 60%
3) Cost of Debt:
Upto Rs 4,80,000 10% (Before Tax)
Beyond Rs 4,80,000 16% (Before Tax)
4) Earning Per Share Rs. 6
5) Dividend Payout 50% of Earnings
6) Expected Growth Rate in Dividend 10%
7) Current Market Price Per Share Rs. 66
8) Tax Rate 50%

Question 8 .
Vishwabharati Limited has the following Book Value Capital Structure:

Equity Capital (in Shares of Rs 10 each, Fully Paid Up-At Par) Rs. 15 Crores
11% Preference Capital (in Shares of Rs 100 each, Fully Paid Up-At Par) Rs. 1 Crore
Retained Earnings Rs. 20 Crores
13.5% Debentures (of Rs 100 each) Rs. 10 Crores
15% Term Loans Rs. 12.5 Crores

The next expected Dividend on Equity Shares Per Share is Rs 3.60; the Dividend Per Share is expected to grow at
the Rate of 7%. The Market Price Per Share is Rs 40. Preference Share, Redeemable after ten years, is currently
selling at Rs 75 Per Share. Debentures, Redeemable after Six years, are selling at Rs 80 Per Debentures. The
Income Tax Rate for the company is 40%.

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[Date] 3.18
You are Required to Calculate the Weighted Average Cost of Capital using:
1) Book Value Proportions
2) Market Value Proportions

Question 9 .
You are Required to Compute the Weighted Average Cost of Capital (WACC) of Ganpati Limited considering the
given data by using:
1) Book Value Weights
2) Market Value Weights

The Capital Structure of Ganpati Limited is as under:

Particulars Rs.
Debentures (Rs 100 Per Debenture) 5,00,000
Preference Shares (Rs 100 Per Share) 5,00,000
Equity Shares (Rs 10 Per Share) 10,00,000
20,00,000

The Market Prices of these securities are:

Debentures : 105 Per Debenture
Preference Shares : 110 Per Preference Share
Equity Shares : 24 each.

Additional Information:
1) Rs 100 Per Debenture Redeemable at Par, 10% Coupon Rate, 4% Floatation Costs and 10 Years Maturity.
2) 100 Per Preference Share Redeemable at Par, 5% Coupon Rate, 2% Floatation Cost and 10 Year Maturity.
3) Equity Shares has Rs 4 Floatation Cost and Market Price Rs 24 Per Share.

The next year expected Dividend is Rs 1 with Annual Growth of 5%. The firm has practice of paying all earnings in
the form of Dividend. The Corporate Tax Rate is 50%.

Question 10 .
The R&G Company has following capital structure at 31st March, 2004, which is considered to be optimum:

Particulars Rs.
13% Debenture 3,60,000
11% Preference Share Capital 1,20,000
Equity Share Capital (2,00,000 19,20,000
Shares)

The company’s share has a Current Market Price of Rs 27.75 Per Share. The expected dividend per share in next
year is 50% of the 2004 EPS. The EPS of last 10 years is as follows. The past trends are expected to continue:
Expected to continue:

Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
EPS (Rs.) 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
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[Date] 3.19
The company can issue 14 % New Debenture. The company’s Debentures is currently Selling at Rs. 98. The New
Preference issue can be sold at a Net Price of Rs. 9.80, paying a dividend of Rs. 1.20 Per Share. The company’s
Marginal Tax Rate is 50%.
1) Calculate the After Tax (a) Cost of New Debts Preference Share Capital, (b) of Ordinary Equity, Assuming
New Equity comes from retained Earnings.
2) Calculate the Marginal Cost of Capital.
3) How much can be spent for capital investment before new ordinary share must be sold? (Assuming that
retained earnings available for the next year’s investment are 50% of 2004 earnings)
4) What will be Marginal Cost of Capital (Cost of Fund raised in excess of the amount Calculated in part 3) If
the company can sell New Ordinary Shares to Net Rs. 20 Per Share?)

The Cost of Debt and of Preference Capital is Constant.

MCQ-11. H Ltd. p is 1.8025. Dividend paid by the company last year was Rs.9 per share on face value of
Rs.30. The risk free rate is 0.61275. Risk premium is 0.0825. Calculate cost of equity capital.

(A) 21%
(B) 6.28%
(C) 14.77%
(D) 12%

MCQ-12. Rao Ltd. earns profit after tax Rs.3,96,000. Corporate tax is 0.4. Its capital structure consist of
equity shares Rs.9,60,000; 15% Term loan Rs.4,80,000. Cost of equity is 0.12. Its economic value added
is -

(A) Rs.2,66,400
(B) Rs.2,80,800
(C) Rs.2,08,800
(D) Rs.2,80,008

MCQ-13. Lava Inc.’sRs. 100 parvalue preferred stock just paid its Rs.10 per share annual dividend. The
preferred stock has a current market price of Rs.96 a share. The firm’s margined tax rate is 40 per cent,
and the firm plans to maintain its current capital structure relationship into the future. The component
cost of preferred stock to Lava Inc. would be closest to -

(A) 6.52 per cent (B) 6.25 per cent (C) 10.24 per cent (D) 10.42 per cent

MCQ-14. A financial consultant has gathered following facts for HPLC Ltd. Systematic risk of the firm is
1.1425.182 days treasury bill yield is 6%. Expected yield on market portfolio is 13%. GDP growth rate
is 9%. Sensex is 39,118. What is the cost of equity?

(A) 13.96%
(B) 14.00%
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[Date] 3.20
(C) 14.52%
(D) 18.91%

MCQ-15. An analyst has calculated economic value added < >f Rs.43,750 for Z Ltd. WACC of the company
is 11.5% and applicable tax rate is 30%. The company paid interest of Rs.1,00,000 during the year.
Total assets of the compar y are Rs.17,50,000. What is profit after tax (PAT) of the company?

(A) Rs.2,45,000
(B) Rs.1,45,000
(C) Rs.1,75,000
(D) Rs.3,15,000
Question 11 .
Sagar Ltd belongs to a risk class in which opportunity Cost of Capital is 10%. ( Value of unlevered firm). Sagar
Ltd has EBIT of 70000 and it has 8% Perpetual Debt of 2L. If Tax Rate is 30%. Answer the following questions using
M – Model –
1) Calculate the Value of Sagar Ltd.
2) Calculate the Value of Equity for Sagar Ltd.
3) Calculate Cost of Equity and Cost of Capital for Sagar Ltd.

Question 12 .
There are two firms A and B which are identical except A does not use any debt in its capital structure while B has
Rs 8,00,000, 9% Debentures in its Capitals Structure. Both the firms have Earnings Before Interest and Tax of Rs
2,60,000 p.a. and the Capitalization Rate is 10%. Assuming the Corporate Tax of 30%, Calculated the Value of these
firms according to MM Hypothesis.
Question 13 .
Shubham Ltd is an all equity financed company with a Market Value of Rs 25,00.000 and Cost of Equity = 21%.
The company wants to Buy Back Equity Shares worth Rs 5,00,000 by Issuing and Raising 15% Perpetual Debt of the
same amount. Rate of Tax may be taken as 30%. After the Capital Restructuring and Applying MM Model (With
Taxes), you are Required to Calculate:
1) Market Value of Shubham Ltd.
2) Cost of Equity .
3) Weighted Average Cost of Capital and comment on it.

MCQ-16. The beta coefficient of Zebra Ltd. is 1.16. The company has been maintaining 2.5% rate of
growth in dividends and earnings. The last dividend paid was Rs.1.20 per share. Return on government
securities is 5%. Return on market portfolio is 7%. The current market price of one share of Zebra Ltd.
is Rs.14. The earnings per share is Rs.1.95. It was decided to take cost of equity, the average for four
methods that Eire generally adopted to calculate the cost of equity in general. Average Ke = Rs.

(A) 10.33%
(B) 13.93%
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[Date] 3.21
(C) 11.29%
(D) 7.32%

MCQ-17. A Company issues Rs.50,00,000 12% Debentures of Rs.100 each. Risk premium is 8%.
Debentures are redeemable after the expiry of fixed period of 7 years. The Company is in 35% tax
bracket. Calculate the cost of debt after tax, if debentures are issued at par.

(A) 0.78
(B) 7.8%
(C) 8.7%
(D) 0.87

MCQ-18. Prsanna Ltd. issued 12% bonds of Rs.100 each at par. Corporate tax rate is 34% including
surcharge and education cess. Cost of Debt = Rs.

(A) 12%
(B) 8.42%
(C) 10%
(D) 12.48%

MCQ-19. Parag Ltd. issued 14% bonds of Rs.100 each at 98%. Corporate tax rate is 34%. Issue expense
per bond was Rs.1.5. Cost of Debt = Rs.

(A) 9.24%
(B) 9.38%
(C) 9.58%
(D) 9.12%

MCQ-20. A Company issues Rs.75,00,000 12% Debentures of Rs.100 each. Risk premium is 13.5%.
Debentures are redeemable after the expiry of fixed period of 7 years at par. The Company is in 35%
tax bracket. Calculate the cost of debt after tax, if debentures are issued at 10% discount.

(A) 9.72%
(B) 7.80%
(C) 9.27%
(D) 8.46%

Question 14 .
Alpha Limited has the following Capital Structure:

Equity Share Capital (Rs 10 each) Rs 150 lakhs

10% Debentures Rs 100 lakhs
Retained Earnings Rs 50 lakhs
Other Information :
Market Price Per Equity Share Rs 49
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[Date] 3.22
 Price-Earnings Ratio 7
Income Tax Rate 30%

Alpha Limited is considering an expansion plan and needs Rs 100 lakhs. If expansion programme is undertaken,
company feels that there will be 25 % increase in present Earnings Before Interest and Tax. The company has the
following alternatives available for raising funds required for expansion:
1) Issue Equity Shares at Rs 50 each.
2) Issue 12% Debentures for Rs 50 lakhs and for the balance, Equity Shares of Rs 50 each
3) Issue 9% Preference Shares for Rs 60 lakhs and for the balance, Equity Shares of Rs 50 each

You are Required to Advice Alpha Limited regarding the best alternative assuming Price-Earnings Ratio 7.50,7.00
and 7.25 respectively for these alternatives.
Question 15 .
Mahalaxmi Limited is setting up a project with a capital outlay of Rs 60,00,000. It has two alternatives in financing
the project cost.

Alternative (A) : 100% Equity Finance

Alternative (B) : Debt-Equity Ratio 2 : 1
The Rate of Interest Payable on the Debt is 18% p.a. The Effective Tax Rate is 40%.
Calculate the Indifference Point between the two alternative methods of financing.

Question 16 .
Kalyani Steels Limited requires Rs 5,00,000 for Construction of a New Plant. It is considering three financial plans:
1) The Company may issue 50,000 Ordinary Shares at Rs 10 Per Share.
2) 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.
3) 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.

If Kalyani Steels Limited’s Earnings Before Interest and Taxes are Rs 10,000; Rs 20,000; Rs 40,000; Rs 60,000 and
Rs 1,00,000 plans? Which alternative would you recommend for Kalyani Steels and Why?

MCQ-21. Following data is available for XYZ Ltd.: No. of debentures = Rs.5,00,000
Face value = Rs.1,000 Coupon rate = 8% Discount on issue = 1% of face value Issue expenses =
Rs.6,25,000 Term = 12 years Corporate tax rate = 25% These debentures are redeemable at premium
of Rs.14. What is cost of debt (Kd)Rs.

(A) 5.78%
(B) 5.87%
(C) 6.44%
(D) 8.32%

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[Date] 3.23
MCQ-22. Y Ltd. issues preference shares of face value Rs.500 each carrying 14% dividend and it realizes
Rs.480 per share. The shares are repayable after 12 years at 2% premium. Corporate tax rate is 25%.
Issue expense per share was Rs.2.5.

(A) 14.65%
(B) 15.82%
(C) 14.73%
(D) 14.92%

MCQ-23. PAPA Ltd. retains Rs.26,25,000 out of its current earnings. The expected rate of return to the
shareholders, if they had invested the funds elsewhere is 15%. The brokerage is 2% and the
shareholders come in 14% tax bracket. Calculate the cost of retained earnings.

(A) 12.64%
(B) 11.37%
(C) 14.80%
(D) 12.90%

MCQ-24. Chetna Fashions is expected to pay an annual dividend of Rs.0.80 a share next year. The
market price of the stock is Rs.22.40 and the growth rate is 5%. What is the firm’s cost of equity?

(A) 7.58 per cent

(B) 7.91 percent
(C) 8.24 per cent
(D) 8.57 per cent

MCQ-25. Sweet Treats common stock is currently priced at Rs.19.06 a share. The company just paid
Rs.1.15 per share as its annual dividend. The dividends have been increasing by 2.5% annually and are
expected to continue doing the same. What is this firm’s cost of equity?

(A) 8.68%
(B) 8.86%
(C) 6.18%
(D) 6.03%
Question 17 .
Company Y and Z are identical in all respect including risk factors except for Debt / Equity, company Y having
issued 10% Debentures of Rs 18 lakhs while company Z is unlevered. Both the companies earn 20% Before Interest
and Taxes on their Total Assets of Rs 30 lakhs.
Assuming a Tax Rate of 50% and Capitalization Rate of 15% from An All-Equity Company.

Compute the Value of Companies Y and Z using -

1) Net Income Approach
2) Net Operating Income Approach

Question 18 .

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[Date] 3.24
Amol Ltd. and ‘Sagar’ Ltd. are identical in every respect except Capital Structure. Amol Ltd does not Employ Debts
in its Capital Structure whereas Sagar Ltd. Employes 12% Debentures amounting to Rs 10 lakhs.

Assuming that:
1) All Assumptions of M - M Model are Met.
2) Income Tax Rate is 30%.
3) EBIT is Rs. 2,50,000.
4) The Equity Capitalizations Rate of Amol Ltd is 20%.

Calculate the Value of Both the Companies and also Find Out the Weighted Average Cost of Capital for both the
companies.

Question 19 .
A firm has a Target Debt-Equity Ratio of 2 : 1. Post Tax Cost of Debt = 12%, = 20%, What is the WACC?

Question 20 .
A firm’s Target Debt Equity Ratio = 0.5, Pre-Tax = 16%, = 20%, Tax Rate = 30%. Compute .

MCQ-26. Narendra Ltd. is planning for issue of 15% Preference Shares of Rs.100 each, redeemable at
par after 8 years. They are expected to be sold at a premium of 5%. Flotation cost is 9% of face value.
Corporate tax is 35% and corporate dividend tax is 10%. The cost of preference shares on the basis of
present value of future cash flow shall be - Use following rates for your calculations:

16% 18%

PV of Rs.1 for 1 to 8 years 4.344 4.078

PV of Rs.1 at 8th year 0.305 0.266

(A) 17.49%
(B) 16.22%
(C) 18.34%
(D) 19.20%

MCQ-27. Z Ltd. is planning for issue of 15% Debentures of Rs.100 each, redeemable at par after 5 years.
They are expected to be sold at par. Flotation cost is 10% of face value. Corporate tax is 35%. Cost of
debentures on the basis on present value of future cash flow shall be -

Use following rates for your calculations:

12% 13%

PV of Rs.1 for 1 to 5 years 3.605 3.517

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[Date] 3.25
PV of Rs.1 at 5th year 0.567 0.543

(A) 11.37%

(B) 12.57%

(C) 14.87%

(D) 12.97%

MCQ-28. Ramola Ltd. report its NOPAT Rs.25,00,000. Its capital employed and economic value added is
Rs.60,00,000 & Rs.19,00,000 respectively. What is overall cost of capital of Ramola Ltd.

(A) 10.9%
(B) 11%
(C) 10%
(D) 9.8%

MCQ-29. Mr. Investor, purchases an equity share of growing company, ATT Ltd. for Rs.210. He expects
that the ATT Ltd. to pay dividend of Rs.10.5, Rs.11.025 & Rs.11.575 in year 1, 2 & 3 respectively. He
expects to sell shares at the end of year 3 at Rs.243.10. Determine the growth rate in dividend.

(A) 4%
(B) 5%
(C) 6%
(D) 7%

MCQ-30. Mr. Lucky, purchases an equity share of growing company, XYY Ltd. for Rs.525. He expects that
the XYY Ltd. to pay dividend of Rs.26.25, Rs.27.83 & Rs.29.50 in year 1, 2 & 3 respectively. He expects to
sell shares at the end of year 3 at Rs.607.75. What is the required rate of return of Mr. Lucky on his
equity investment?

(A) 11.50%
(B) 10.50%
(C) 10.05%
(D) 11.05%
Question 21 .
Consider the following Capital Structures of X Ltd.

1000 Equity Shares of Rs 100 Each 1,00,000

Reserves and Surplus 2,00,000
Net Worth = Book Value 3,00,000
12% 500 Preference Shares @ Rs 100 Each 50,000
18%, 1000 Debentures @ 100 Each 1,00,000
20%, 5 Year Term Loan 1,50,000
CAPITAL EMPLOYED or INVESTER CAPITAL 6,00,000

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[Date] 3.26
 1) Equity Shares are presently trading at Rs 470.
2) Preference Shares are presently trading at Rs 110.
3) Debentures are presently trading at Rs 98.

Calculate weights as per Market Value and Book Value.

Question 22 .
Technomate Limited has the following Capital Structure:

9% Debentures Rs 2,75,000
11% Preference Shares Rs 2,25,000
Equity Shares (Face Value : Rs 10 Per Share) Rs 5,00,000
Rs 10,00,000

Additional Information:
1) Rs 100 Per Debenture Redeemable at Par has 2% Floatation Cost and 10 Years of Maturity. The Market Price
Per Debentures is Rs 105.
2) 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.
3) 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.
4) Corporate Income-Tax Rate is 35%.
You are Required to Calculate Weighted Average Cost of Capital (WACC) using Market Value Weights.
Question 23 .
The Capital Structure of Shamrao Limited as on 31 March, 2009 is as follows:

Particulars Rs
Equity Capital : 6,00,000 Equity Shares of Rs. 100 Each 6 crore
Reserve and Surplus 1.20 crore
12% Debenture of Rs. 100 each 1.80 crore

For the year ended 31st March, 2009 Shamrao Limited has paid Equity Dividend @ 24%. Dividend is likely to grow by
5% every year. The Market Price of Equity Share Rs 600 Per Share. Income-Tax Rate applicable to Shamrao Limited is
30%.
Required :
1) Compute the Current Weighted Average Cost of Capital.
2) The company has planned to raise a further Rs 3 crore by way of Long-Term Loan at 18% Interest. If Loan is
raised, the Market Price of Equity Share is expected to Fall to Rs 500 Per share.
What will be the New Weighted Average Cost of Capital of Shamrao Limited?
Question 24 .

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[Date] 3.27
Assume that a company is expected to pay a Dividend of Rs 5.00 Per Share this year. The company along with the
Dividend is expected to grow at a Rate of 6%. If the Current Market Price of the Share is Rs 60 Per Share, Calculate
the Estimated Cost of Equity ?

MCQ-31. Mumbai Ltd. expected to pay dividend at Rs.2 for the next year. As the company is a market
leader with good future, dividend is likely to grow by 5% every year. The equity shares are now treaded
at Rs.80 per share in the stock exchange. Tax rate applicable to the company is 50%. The capital
structure of the company also contains debt on which interest is payable @ 14%. The capital structure
has ratio of Equity & Debt 80:20. WACC = Rs.

(A) 9.40%
(B) 7.40%
(C) 8.40%
(D) 7.98%

MCQ32. Beeta Ltd. has furnished the following information:

Earnings Per Share (EPS) Rs.14

Dividend Payout Ratio 25%

Market Price Per Share Rs.140

Rate of Tax 26%

Growth rate of dividend 9%

The company wants to raise additional capital of Rs.1C lakhs including debt of Rs.4 lakhs. Cost of debt
(before tax)is 12% up toRs. 2 lakhs and 14% beyond that. Compute the marginal weighted average cost
of additional capital

(A) 11.75%
(B) 10.75%
(C) 11.57%
(D) 12.57%

MCQ-33. National Ltd. has 12,000 equity shares of Rs.100 each. Sale price is equity share Rs.115 per
share; flotation cost Rs.5 per share. Expected dividend growth rate is 5% and expected dividend at the
end of the financial year is Rs.11 per share. What is the cost of equity shares of National Ltd.Rs.

(A) 0.1133
(B) 0.1278
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[Date] 3.28
(C) 0.1475
(D) 0.15

MCQ-34. Raman Ltd. has 10% Preference Share Capital of Rs.4,50,000. Face value is Rs.10. Issue price of
preference share is Rs.100 per share; flotation cost t 2 per share. What is the cost of preference shares
to Raman Ltd.Rs.

(A) 10.20%
(B) 9.10%
(C) 12.50%
(D) 11.22%

MCQ-35 Raja Ltd. has 8% Debentures (Face value Rs.2,500) of Rs.9,00,000 which are redeemable at 5%
premium, sold at 98%, 3% flotation costs with maturity of 20 years. Corporate tax rate is 35%. The
company paid debenture interest of 60,000 out of total interest payable of 72,000. After tax cost of debt
is -

(A) 8.7%
(B) 7.7%
(C) 5.7%
(D) 6.7%
Question 25 .
Best Vision Compnay requires Rs 10,00,000 of financing and is considering two options as given under:

Options Amount of Equity Amount of Debt Before-Tax Cost of

Raised (Rs) Financing (Rs) Debt (p.a.)
A 7,00,000 3,00,000 8%
B 3,00,000 7,00,000 10%

In the first year operations, the company is expected to have Sales Revenues of Rs 5,00,000; Cost of Sales of Rs
2,00,000; and General and Administrative Expenses of Rs 1,00,000. The Tax Rate is 30%. All earnings are paid out as
Dividends at year end.

You are Required to Calculate:

1) The Weighted Average Cost of Capital under option A, if the Cost of Equity is 12%.
2) The Return on Equity and the Debt Ratio under the two options.

Question 26 .
Ganpati Limited has issued 10% Debebntures of Nominal Value of Rs 100. The Market Price is Rs 90 Ex-Interest.

You are Required to Calculate the Cost of Debentures if the Debentures are:
1)Unique
Irredeemable
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[Date] 3.29
2) Redeemable at Par After 10 Years

Question 27 .
Shubham Ltd. retains Rs 7,50,000 out of its Current Earnings. The expected Rate of Return to the Shareholders, if
they had invested the funds elsewhere is 10%. The Brokerage is 3% and the Shareholders come in 30% Tax Bracket.
Calculate the Cost of Retained Earnings.
Question 28 .
AK Limited has obtained funds from the following sources, the specific cost are also given against them:

Source of Funds Amount (Rs) Cost of Capital

Equity Shares 30,00,000 15%
Preference Shares 8,00,000 8%
Retained Earnings 12,00,000 11%
Debentures 10,00,000 9% (Before Tax)

You are Required to Calculate Weighted Average Cost of Capital. Assume that Corporate Tax Rate is 30%.

MCQ-36. Equity shares of Anuradha Ltd. are quoted in stock exchange at Rs.325 per share. New issue
priced at Rs.312.5 and flotation cost will be Rs.12.5 per share. During 5 years dividend on equity shares
have steadily grown from Rs.26.5 to Rs.35.48. Dividend at the end of current year is expected at Rs.37.5
per share. It has retained earning of Rs.30,00,000. Corporate tax is 35% and shareholders are in tax
slab of 20%. Ignore dividend tax. Calculate cost of equity and cost of retained earnings?

(A) K, = 18.50%; Kr = 14.80%

(B) K = 18.00%; Kr = 14.40%
(C) K = 17.54%; K = 14.03%
(D) Ke= 18.94%; K= 15.15%

MCQ-37. Compute the EVA with the help of following information:

Equity 10,00,000

Debt (10%) 5,00,000

Profit after tax 2,00,000

Risk-free rate of return is 7%. Beta (p) = 0.9, Market rate of return = 15%. Applicable tax rate is 40%.

(A) Rs.57,950
(B) Rs.57,590
(C) Rs.57,905
(D) Rs.59,750
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[Date] 3.30
MCQ-38. The company proposes to issue 11 year 15% debentures of Rs.500. Yield on debentures of
similar maturity and risk class is 16%; flotation cost 3% of face value. Corporate tax is 35%. Issue price
and after tax cost of debt would be -

(A) Issue price = 486.75; Kd = 12.10%

(B) Issue price = 468.75; Kd = 11.10%
(C) Issue price = 475.68; Kd = 10.10%
(D) Issue price = 457.86; Kd = 12.12%

MCQ-39 Mohan Ltd. has paid increasing dividends of Rs.0.54, Rs.0.58, Rs.0.62, Rs.0.67 and
Rs.0.72 a share over the past 4 years, respectively. Firm estimates that future increases in their
dividends will be comparable to the arithmetic. Average growth rate over these past 4 years.
The stock is currently selling for Rs.38.60 a share. The risk-free rate is 4% and the market risk
premium is 8%. What is your best estimate of cost of equity if their beta is 1.22?

(A) 14.06%
(B) 9.46%
(C) 12.97%
(D) 11.61%
MCQ-40. What is the overall (weighted average) cost of capital in the following situation? The
firm has Rs.12 million in long-term debt, Rs.2 million in preferred stock, and Rs.8 million in
common equity - all at market values. The before-tax cost for debt, preferred stock, and
common equity forms of capital are 8%, 9%, and 15%, respectively. Assume 40% tax rate.

(A) 6.40%
(B) 6.54%
(C) 8.89%
(D) 10.90%
Question 29 .
XYZ Ltd. has the following Capital Structure on October 31,2010:
Particulars Rs
Equity Share Capital 20,00,000
(2,00,000 Shares of Rs 10 each)
Reserves & Surplus 20,00,000
12% Preference Shares 10,00,000
9% Debentures 30,00,000
80,00,000

The Market Price of Equity Share is Rs 30. It is expected that the company will pay next year a Dividend of Rs 3 Per
Share, which will Grow at 7% forever. Assume 40% Income Tax Rate.
You are Required to Compute Weighted Average Cost of Capital using Market Value Weights.
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[Date] 3.31
Question 30 .
Sagar Ltd. has furnished the following information:
Earning Per Share (ESP) Rs 4
Dividend Payout Ratio Rs 25%
Market Price Per Share Rs 40
Rate of Tax 30%
Growth Rate of Dividend 8%

The company wants to raise Additional Capital of Rs 10 lakhs including Debt of Rs 4lakhs. The Cost of Debt (Before
Tax) is 10% upto Rs 2 lakhs and 15% beyond that.
Compute the After Tax Cost of Equity and Debt and the Weighted Average Cost of Capital.

Question 31 .
Rohit Ltd has the following Book-Value Capital Structure as on March 31, 2003.
Particulars Rs
Equity Share Capital (2,00,000 Shares) 40,00,000
11.5% Preference Shares 10,00,000
10% Debentures 30,00,000
80,00,000

The Equity Share of the company sells for Rs 20. It is expected that the company will pay next year a Dividend of Rs 2
Per Equity Share, which is expected to Grow at 5% p.a. forever. Assume a 35% Corporate Tax Rate.
Required:
1. Compute Weighted Average Cost of Capital (WACC) of the company based on the Exiting Capital Structure.
2. Compute the New Weighted Average Cost of Capital (WACC), if the company raised and additional Rs 20 lakhs
Debt by Issuing 12% Debentures. This would result in increasing the Expected Equity Dividend to Rs 2.40 and
Leave the Growth Rate unchanged, but the Price of Equity Share will Fall to Rs 16 Per Share.
3. Comment on the use of Weights in the Computation of Weighted Average Cost of Capital.

Question 32 .
Swapnil Limited has the following Book Value Capital Structure:
Particulars Rs.
Equity Share Capital (150 Million Shares, Rs 10 Par) 1,500 Million
Reserves and Surplus 2,250 Million
10.5% Preference Share Capital (1 Million Shares, Rs 100 Par) 100 Million
9.5% Debentures (1.5 Million Debentures, Rs 1000 Par) 1,500 Million
8.5% Term Loans from Financial Institutions 500 Million

1. The Debentures of Swapnil Limited are Redeemable after three years and are quoting at Rs 981.05 Per
Debenture. The applicable Income Tax Rate for the company is 35%.
2. The Current Market Price Per Equity Share is Rs 60. The Prevailing Default-Risk Free Interest Rate on 10-year GOI
Treasury Bonds is 5.5%. The Average Market Risk Premium is 8%. The Swapnil of the company is 1.1875.
3. The Preferred Stock of the company is Redeemable after 5 year is currently selling at Rs 98.15 Per Preference
Share.
Required:
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[Date] 3.32
1. Calculate Weighted Average Cost of Capital of the company using Market Value Weights.
2. Define the Marginal Cost of Capital Schedule for the firm if it raises Rs 750 Million for a new project. The firm
plans to have a Target Debt to Value Ratio of 20%. The beta of new project is 1.4375. The Debt Capital will be
raised through Term Loans. It will carry Interest Rate of 9.5% for the First 100 Million and 10% for the next Rs 50
Million.

MCQ-41. Equity dividend expected at the end of year is Rs.20 per share whereas anticipated
dividend growth rate is 5%. Corporate tax is 30%. Market price per share is Rs.200. What is
cost of equity?

(A) 10.5%
(B) 15%
(C) 12.9%
(D) 14%
MCQ-42. Dividend per share is Rs.15 and sell it for 1120 and floatation cost is Rs.3, then
component cost of preferred stock will be -

(A) 12.82 times (B) 0.1282 times (C) 0.1282 (D) 12.82

MCQ-43. Stock selling price is Rs.65, expected dividend is Rs.20 and cost of common stock is
42% then expected growth rate will be -

(A) 11.23%
(B) 0.01123
(C) 11.23 times
(D) 11.23
MCQ-44 . Dividend per share is Rs.18 and sell it for 1122 and floatation cost is 14, then
component cost of preferred stock will be:

(A) 15.25%
(B) 15.25 times
(C) 0.01525
(D) 15.52%
MCQ-45 . Stock selling price is Rs.45, an expected dividend is Rs.10 per share and an expected
growth rate is 8%, then cost of common stock would be:

(A) 3.02
(B) 32%
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[Date] 3.33
(C) 30.22%
(D) 32.30%

Question 33 .
The following is the Capital Structure of a Company:

Source of Capital Book Value (Rs) Market Value (Rs)

Equity Shares @ Rs 100 Each 80,00,000 1,60,00,000
9% Cumulative Preference Shares @ Rs 100 Each 20,00,000 24,00,000
11% Debentures 60,00,000 66,00,000
Retained Earnings 40,00,000 -
2,00,00,000 2,50,00,000

The Current Market Price of the Company’s Equity Share is Rs 200. For the last year the company had paid Equity
Dividend at 25% and its Dividend is likely to Grow 5% every year. The Corporate Tax Rate is 30% and Shareholders
Personal Income Tax Rate is 20%.
You are Required to Calculate:
1. Cost of Capital for each Source of Capital.
2. Average Cost of Capital on the basis of Book Value Weights.
3. Weighted Average Cost of Capital on the basis of Market Value Weights..

Question 34 .
The Capital Structure of a company as on 31st March, 2009 is as follows:

Particulars Rs
Equity Capital : 6,00,000 Equity Shares of Rs 100 each 6 Crore
Reserve and surplus 1.20 Crore
12% Debentures of Rs 100 each 1.80 Crore

For the year ended 31st March, 2009 the company has paid Equity Dividend @ 24%. Dividend is likely to Grow by 5%
every year. The Market Price of Equity Share is Rs 600 Per Share. Income-tax rate applicable to the company is 30%.
Required:
1. Compute the Current Weighted Average Cost of Capital.
2. The company has plan to raise a further Rs 3 crore by way of Long-Term Loan at 18% Interest. If Loan is raised,
the Market Price of Equity Share is Expected to Fall to Rs 500 Per Share. What will be the New Weighted Average
Cost of Capital of the Company?

Question 35 .
The Capital Structure of a company consists of Equity Shares of Rs 50 lakhs; 10% Preference Shares of Rs 10 lakhs
and 12% Debentures of Rs 30 lakhs. The Cost of Equity Capital for the Company is 14.7% and Income-Tax Rate for
this company
Unique is 30%.
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[Date] 3.34
You are Required to Calculate the Weighted Average Cost of Capital (WACC).
Question 36 .
Amit Ltd. wishes to raise Additional Finance of Rs 20 lakhs for Meeting its Investment plans. The Company has Rs
4,00,000 in the form of Retained Earnings available for Investment Purposes.
The following are the further details:
1. Debt Equity Ratio 25:75.
2. Cost of Debt at the Rate of 10% (Before Tax) upto Rs 2,00,000 and 13% (Before Tax) beyond that.
3. Earnings Per Share, Rs 12.
4. Dividend Payout 50% of Earnings.
5. Expected Growth Rate in Dividend 10%.
6. Current Market Price Per Share, Rs 60.
7. Company’s Tax Rate is 30% and Shareholder’s Personal Tax Rate is 20%
Required:
1. Calculate the Post Tax Average Cost of Additional Debt.
2. Calculate the Cost of Retained Earnings and Cost of Equity.
3. Calculate the Overall Weighted Average (After Tax) Cost of Additional Finance.

MCQ-46. Interest rate is 12% and tax savings (1-0.40) then after-tax component cost of debt
will be -
(A) 0.072 (B) 7.2 times
(C) 17.14 (D) 17.14 times
MCQ-47. Cost of common stock is 14% and bond risk premium is 9% then bond yield will be -
(A) 0.0156 (B) 0.05
(C) 0.23 (D) 0.6428
MCQ-48. Cost of common stock is 16% and bond yield is 9% then bond risk premium would be
(A) 0.07 (B) 7.0
(C) 0.0178 (D) 0.25
MCQ-49. Krishna Ltd. is currently financed with Rs.10,00,000, 796 bonds and Rs.20,00,000 of
common stock. The stock has a beta of 1.5, risk-free rate of return 496 and market risk
premium 3.596. The marginal tax rate for a company of this size is 3596. Compute the WACC of
Krishna Ltd. on book value basis?
(A) 6.8796
(B) 8.7696
(C) 9.3496
(D) 7.6896

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[Date] 3.35
MCQ-50. Apoorva Ltd. has assets of Rs.32,00,000 that have been financed as follows:
Equity shares (Rs. 100 each) 18,00,000
General reserve 3,60,000
Debt 10,40,000
For the year ended the company’s total profits before interest and taxes were Rs.6,23,000. Company
pays 896 interest on borrowed capital and the tax bracket is 4096. The market value of the equity is
Rs.150 per share. From the above, determine the weighted average cost of capital using market values
as weights.

(A) 9.0196
(B) 1096
(C) 1296
(D) 11.2396.

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[Date] 3.36
Unique Academy uniqueacademyforcommerce.com Prof Ashish Parikh 08007978700

[Date] 3.37
Self Practice Question 1
Thee expected EBIT of a firm ` 2,00,000/. It has issued Equity Share Capital with @ 10% and 6%
Debt of ` 5,00,000. Find out the Value of the Firm and Overall Cost of Capital, WACC.

Solution
EBIT ` 2,00,000
-Interest 30,000
Net Profit 1,70,00
10%
Value of Equity, E = 1,70,000 / .10 17,00,000
Value of Debt, D 5,00,000
Total Value of the Firm, V 22,00,000

WACC, EBIT / V
= 2,00,000 / 22,00,000
= .09 or 9 %
The WACC can also be calculated as follows:
WACC = [ D (D + E)] + [E / (D + E)]
= [5 / (5 + 17)] .06 + [17 / (5 + 17)].10
= .09 or 9%

can also be calculated as follows :

( ) ( )

( ) ( )

( ) ( )

( ) ( )

In the above case,

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= .09 Or 9%

1. which of the following is true for Net Income Approach?

(a) Higher Equity is Better (b) Higher Debt is Better,
(c) Debt Ratio is Irrelevant (d) None of the above.

2. In case of Net Income Approach, the Cost of Equity is:

(a) Constant (b) Increasing,
(c) Decreasing (d) None of the above.

3. In case of Net Income Approach, when the debt proportion is increased, the cost of debt :
(a) Increases (b) Decreases,
(c) Constant (d) None of the above.

4. Which of the following is true of Net Income Approach?

(a) VF = VE + VD (b) VE = VF + VD
(c) VD = VF + VE (d) VF = V - V D.E

Self Practice Question 2

Four4 firms A, B , C & D belong to same risk class. Their and are same at 20% and 12%
respectively and earn same amount of EBIT of ` 6,00,000 p.a. However, these firms differ with
respect of amount of debt financing. While Firm A is an unlevered firm (All Equity), other firms have
12% Debt of ` 5,00,000, ` 10,00,000 and ` 15,00,000 respectively. Find out their values and under
NI Approach.

Solution
Under NI Approach, the value and of these firms can be calculated as follows:

Particulars A B C D
Amount of Debt, D - ` 5,00,000 ` 10,00,000 ` 15,00,000
- 12% 12% 12%
EBIT ` 6,00,000 ` 6,00,000 ` 6,00,000 ` 6,00,000
-Interest - 60,000 1,20,000 1,80,000
PBT = PAT = NP 6,00,000 5,40,000 4,80,000 4,20,000
Cost of Equity, .20 .20 .20 .20
Value of Equity (NP / ) 30,00,000 27,00,000 24,00,000 21,00,000
+ Value of Debt D - 5,00,000 10,00,000 15,00,000
Value of Firm, V 30,00,000 32,00,000 34,00,000 36,00,000
(EBIT V) .20 .1875 .1764 .1667

The above calculation show that as the Debt increasing value of the firms are increasing.

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Conclusion
The NI Approach, through easy to understand, it is too simple to be realistic. It ignore, perhaps the
most important aspects of leverage, that the market price depends upon the risk which varies in
direct relation to the changing proportion of Debt in the Capital Structure.

5. In Net Operating Income Approach, which one of the following is constant?

(a) Cost of Equity (b) Cost of Debt
(c) WACC & (d) and

6.NOI Approach advocates that the degree of debt financing is

(a) Relevant (b) May be Relevant,
(c) Irrelevant (d) May be Irrelevant.

7. Judicious use of Leverage' is suggested by :

(a) Net Income Approach (b) Net Operating Income Approach
(c) Traditional Approach (d) All of the above.

8. Which one is true for Net Operating Income Approach?

(a) V D , = V F - V E (b) VE = VF + VD
(c) VE = VF – VD (d) VD = VF + VE

Self Practice Question 3

Four firms A, B , C & D are operating in the same competitive environment and belongs to same risk
class which has overall Cost of Capital of 20%. Firm A is an unlevered one whereas other firm have
borrowed ` 4,00,000, ` 10,00,000 and ` 16,00,000 at 15%. All the firms are earning EBIT of ` 8,00,000.
Find out their values as per NOI.

Solution

Particulars A B C D
EBIT ` 8,00,000 ` 8,00,000 ` 8,00,000 ` 8,00,000
-Interest - 60,000 1,50,000 2,40,000
PBT = PAT = NP 8,00,000 7,40,000 6,50,000 5,60,000
is Given .20 .20 .20 .20
(EBT ) ` 40,00,000 ` 40,00,000 ` 40,00,000 ` 40,00,000
- - 4,00,000 10,00,000 16,00,000
40,00,000 36,00,000 30,00,000 24,00,000
(NP ) .20 .2055 .2166 .2333

Example 3 shows that as the firm employs more and more debt, the value of the firm does not change
and remains at ` 40,00,000. However, Cost of Equity is increasing gradually from 20% to 23.33%. The

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increase in Cost of Equity has taken away the benefit of increasing debt financing keeping the overall
Cost of Capital at 20% and value of the firm at ` 40,00,000.

9. In the Traditional Approach, which one of the following remains constant?

(a) Cost of Equity (b) Cost of Debt
(c) WACC (d) None of the above.

10. In MM-Model, irrelevance of capital structure is based on :

(a) Cost of Debt and Equity (b) Arbitrage Process,
(c) Decreasing , (a) All of the above.

11. 'That there is no Corporate Tax' is assumed by :

(a) Net Income Approach (b) Net Operating Income Approach
(c) Traditional Approach (d) All of these.

12. 'That Personal Leverage can replace Corporate Leverage' is assumed by :

(a) Traditional Approach (b) MM Model,
(c) Net Income Approach (d) Net Operating Income Approach

Self Practice Question 4

A firm has a EBIT of ` 2,00,000 and belongs to a risk class of 10%. What is the Value of Cost of
Equity Capital if it employees 6% debt to the extent of 30%, 40% or 50% of the Total Capital Fund of
` 10,00,000.

Solution
The effect of changing debt proportion on the Cost of Equity Capital can be analyzed as follows:

30% Debt 40% Debt 50% Debt

EBIT ` 2,00,000 ` 2,00,000 ` 2,00,000
10% 10% 10%
Value of the Firm, V ` 20,00,000 ` 20,00,000 ` 20,00,000
Value of 6% Debt, D 3,00,000 4,00,000 5,00,000
Value of Equity, (E = V - D) 17,00,000 16,00,000 15,00,000
Net Profit (EBIT - Interest) 1,82,000 1,76,000 1,70,000
NP / E 10.7% 11% 11.33%

The of 10.7%, 11% and 11.33% can be verified for different proportion of debt by calculating
WACC , as follows:
For 30% Debt, = [D / (D + E)] + [E / (D + E)]
= [3 / (3 + 17)] .06 + [17 / (3 + 17)] .107
= 10%

For 40% Debt, = [D / (D + E)] + [E / (D + E)]

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 = [4 / (4 + 16)] .06 + [16 / (4 + 16)] .11
= 10%

For 50% Debt, = [D / (D + E)] + [E / (D + E)]

= [5 / (5 + 15)] .06 + [15 / (5 + 15)] .113
= 10%
Under NOI Approach, can also be derived as follows:
= ( )+ ( )

(D + E) = + D

E= (D + E) - D

= -

= + ( )- ( )

= + - ( )

13. Which of the following argues that the value of levered firm is higher than that of the
unlevered firm?
(a) Net Income Approach (b) Net Operating Income Approach
(c) MM Model with Taxes (d) Both (a) and (c)

14. In Traditional Approach, which one is correct?

(a) Rises Constantly (b) Decreases Constantly,
(c) Decreases Constantly (d) None of the Above.

15. Which of the following assumes constant and ?

(a) Net Income Approach (b) Net Operating Income Approach,
(c) Traditional Approach (d) MM Model.

16. Which of the following is true?

(a) Under Traditional Approach, overall cost of capital remains same
(b) Under NI Approach, overall cost of capital remains same
(c) Under NOI Approach, overall cost of capital remains same
(d) None of the Above

Self Practice Question 5

ABC Ltd. having EBIT of ` 1,50,000 is contemplating to9 redeem a part of the capital by introducing
debt financing. Presently, it is a 100% Equity firm with Equity Capitalization Rate Ke, of 16%. The firm
is to redeem the capital by introducing Debt Financing up to ` 3,00,000 i.e., 30% of Total Funds or Up

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to ` 5,00,000 i.e., 50% of Total Funds. It is expected that for the debt financing up to 30% the Rate
of Interest will be 10% and the Ke, will increase to 17%.

However, if the firm opts for 50% debt financing, then Interest will be payable at the Rate of 12%
and the Ke, will be 20%. Find out the Value of the Firm and its WACC under different Levels of Debt
Financing.

Solution
On the basis of the information given, the total funds of the firm seems to be ` 10,00,000 (Whole of
which is provided by the Equity Capital) out of which 30% or 50% i.e., ` 3,00,000 or ` 5,00,000 may be
replaced by the issue of debt bearing Interest at 10% or 12% respectively. The Value of the and its
WACC may be ascertained as follows:

0% Debt 30% Debt 50% Debt

Total Debt - ` 3,00,000 ` 5,00,000
Rate of Interest - 10% 12%
EBIT ` 1,50,000 ` 1,50,000 ` 1,50,000
- Interest - 30,000 60,000
Profit Before Tax 1,50,000 1,20,000 90,000
Equity Capitalization Rate, .16 .17 .20
Value of Equity, E 9,37,500 7,05,882 4,50,000
Value of Debt - 3,00,000 5,00,000
Total Value 9,37,500 10,05,882 9,50,000
(EBIT / Value) .16 .149 .158

17. The Traditional Approach to Value of the firm assumes that :

(a) There is no optimal capital structure.
(b) Value can be increased by judicious use of leverage,
(c) Cost of Capital and Capital structure are independent,
(d) Risk of the firm is independent of capital structure.

18. A firm has EBIT of ` 50,000. Market value of debt is ` 80,000 and overall capitalization rate is 20%. Market valu
firm under NO1 Approach is :
(a) ` 2,50,000 (b) ` 1,70,000
(c) ` 30,000 (d) ` 1,30,000

19. Which of the following is incorrect for NOI?

(a) is Constant (b) is Constant
(c) is Constant (d) & k, are constant

20. Which of the following is incorrect for value of the firm?

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(a) In the initial preposition, MM Model argues that value is independent of the financing mix.
(b) Total value of levered and unlevered firm be same otherwise arbitrage will take place
(c) Total value incorporates borrowings by firm but excludes personal borrowing
(d) Total value does not change because underlying risk does not change with financing mix.

21. Which of the following appearing in the balance sheet, generates tax advantage and hence affects the capital struct
decision ?
(a) Reserves and Surplus (b) Long-Term debt
(c) Preference Share Capital (d) Equity Share Capital.

22. In MM Model with taxes, where ‘r’ is the Interest Rate, ’D’ is the Total Debt and ‘t’ is Tax Rate, then present value of t
shields would be :
(a) r D t (b) r D
(c) D t (d) (D r) / (1 - t)

Answers
1 2 3 4 5 6 7 8 9 10 11
B A C A C C C C D B D
12 13 14 15 16 17 18 19 20 21 22
B D D A C B B C D B C

Objective Type Question

State whether each of the following statements is True (T) or False (F) .
(1) The financing decision affects the total operating profits of the firm.
(2) The equity shareholders get the residual profit of the firm.
(3) There is no difference of opinion on the relationship between capital structure and value of
the Firm.
(4) The ultimate conclusions of NI approach and the NOI approach are same.
(5) In NI approach, the is assumed to be same and constant.
(6) In NI approach, the fails as the degree of leverage is increased.
(7) In NOI approach, and are taken as constant.
(8) The NOI approach says that there is no optimal capital structure.
(9) The traditional approach says that a firm may attain an optimal capital structure.
(10) At optimal capital structure, the of the firm is highest.
(11) MM model provides a behavioral justification of NOI approach.
(12) In MM model, Personal Leverage and Corporate Leverage are considered as perfect substitute.
(13) MM model is difficult to be applied in practice.
(14) In the basic MM model, leverage does not affect the value of the firm.
(15) In the MM model, the value of the leverage firm can be found by first finding out the Value
of the Unlevered Firm.

Answers
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15)

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F T F F T T T T T F T T T T T

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 ―Many important business decisions require the selection of projects (investments
whose out lays or benefits are spread out over several periods of time
 In evaluating business proposals, it is important to weigh the expected benefits of
investment against the expenses associated with it for capital budgeting decisions
the cost and benefits are measured more appropriately by the cash flows
attributable to the investment

 Concept of capital budgeting.

 Capital budgeting decisions are related to the allocation of funds to diffrents long
term assets
 The capital budgeting decisions involves the entire process of decision making
relating to acquisition of long term assets whose returns are expecte to arise over a
period beyond 1 year.
 The obkective of capital budgeting is to select those long term investment proijects
that are expected to make max. contribution to the wealth of the share holders.

 Features & significance.( strategy based on reliable fore

casting system)
 The decision that requires the use of resources is a capital budgeting decision. Such
decisions covers all broad strategic decisions at one extreme to say
computerization of office on other end.
 Capital budgeting decision affects firms profitability, as a wrong decisions can
endanger the exitances of firm as a profitable firm.

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 The relevance and significance of capital budgeting stated as
follows

 Long term effects

a. Capital budgeting have long term effect on risk and return composition of firm
b. Via capital budgeting – commitment towards future needs of funds.( it affects
future portions & future implications.)

 Substantial commitments
a. Capital budgeting involves large commitments – results in substantial portion of
capital funds are blocked in the capital budgeting decisions.

 Irreversible decisions
a. Capital decisions are irrevertible subject to significant degree of risk.

 Affect the capacity & strength to compete

a. Firm loose competitors – f decision to mordernize is delayed or wrongly taken.
b. But time decisions – takeover minor competitor—results in monopoly positions.

 Problems & difficulties in capital budgeting

 Future uncertainly
a. Capital budgeting decisions involve long term which is uncertain.

 Time element
a. Project cost incurs immediately, however recovered in no. years. These total
returns may be more than cost incurred ( in absolute terms) , still the net benefit
cannot be ascertained unless benefits adjust for time value of money.

 Measurement problems
a. Due to launching of a product, other product of the same firm may have effect on
its revenue, or sales, but how much effect? It is unmeasurable in quantity ( as
revenue affected due to other factors)

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  Capital budgeting

Assumptions Procedure.
1. Certainty with respect of 1. Estimation of cost &
cost benefit(cost & benefit benefits of proposals
should be certain). 2. Estimation of required rate.
2. Profit motive. 3. Using capital budgeting
3. No capital rationing (zero decision criterion ( proper
scarcity of funds i.e technique of capital
unlimited funds) budgeting applied for best
selection alternatives.)

 Estimation of cost & benefits of a proposal

On basis on accounting profits.

1. Based on discretionary On the basis of cash flow.

accounting policies. 1. Describes cash movement
2. Affected by non-cash items. arising because of
3. Accounting profit expressed proposals.
in movies of diffirent time 2. Differences between A/C
period, but benefit are not profit & cashflow arise due
corporate. to non- cash items.
4. Based on accrual concepts.

From the above analysis –cashflow technique is better to valuate

cost & benefits of a proposal.

 In cash flow – cash outflow denotes – costs outflow of purchasing power.

--- cash inflow denotes – benefits – inflow of purchasing power.

 Types of cashflow
a. Original/initial cash outflow.
b. Subsequent cash inflow/ outflows.
c. Terminal cash flow.
i. Salvage value /scrape value realise on sold of asset.

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 ii. Realization of working capital.realised working capital because if notrealised the
negative net present value arises.

 Sunk cost .
a. Cost already incurred & thus has no effect om present /future decisions.
b. Irrelevant for decision, but firm has to recover it, otherwise firm cease to exit.

 Opportunity cost
a. Asking question ‗ Is there any other use of resource?
b. Futher use their & the

 Incremental approach of cash flows( relevant cash flows)

a. Cash flows are measured in incremental terms i.e those cash flows are considered,
that differ or occur as a result of undertaking / accepting the particular proposed.
b. Relevant cash flow is change ( in firm‘s future cash flows) that occurs as a direct
consequence of the decision to accept that project.
c. Changes in increments to exiting cash flows.

 Analysis of incremental cashflows

I. Stand alone principle

 The firm‘s cashflow are different from project‘s cashflows & therefore it is
cumbersome & tedious to calculate firms future cashflows with or without project.
 To avoid the situation stand alone principle applied which states,project of a firm is
itself a minifirm in the larger firm.
 Each firm has its own cost, merits & where as each project is evaluated purely on
its merits, in I to other activities of firm.

II. Co-existence with proposal

 Incremental cash flows are those which co-exist with a proposal i.e cashflow would
appear if the project is undertaken then only otherwise not.
Eg- a firm evaluated 2 projects --- project X & project Y.
Here,
Project X—requires repairs @ end of 5th of Rs1,00,000/-
Project Y – requires maintainance per annum of Rs 25000/-

If project X—selected—service contract—of Rs 25000p.a not required.

If project Y—selected—repairs--@ end of 5th years—not required.

Hence, cashflow co-exists with the project selected not other.

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III. Allocated overhead costs..
 Overhead costs—not directly related to product.
 If existing overhead cost allocated to new proposal—not incremental cost of OH.
 But if after accepting proposal – if any OH cost incurred – it is incremental
overhead cost.
 OH incremental cost calculated – break down OH – into fixed & variable cost.

IV. Product..
 Refers to sales generated by one product, which comes at expense of other
products sold by the firm.
 Phenomenon where new product introduced by a firm competes with & reduces sale
of some other existing product of the same firm.
 On one end it is -ve incremental of new product & lost cashflows/ profits from
existing product should be treated as costs, whether new product introduce ot noy
 Of cost of sales lost depends on potential of competitor of bringing
substitute.

V. Taxation & cash flows..

 Annual cash inflow, result in increase in taxable profit,so the cash flow from a
project would also affect the tax liability of firm.
 Financial management is ― All financial decisions are subservient to tax laws‖
Therefore capital budgeting—analysis is done after tax only.

VI. Depreciation, non-cash item & cashflows .

 Non-cash items are insignificant in cashflows of a project.
 As if the non-cash items effect the taxability on profit then only the non-cash
items are taken (added) in cashflow of projects.
 Here, depreciation is a non-cash item which affects tax liability on the profit.
Therefore, taken as cashflow of a project.

 Techniques of evaluation.

1) Capital budgeting involves .

 Estimation of cost & benefits of a proposal.
 Estimation of required rate of return.
 Evaluation of different proposals in order to select one.

2) Evaluation of different proposals on basis of .

 Certainty ( cashflow know are certain)

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 Un certainty.

3) Evaluation of proposal. .
 Proposal should be evaluated in terms of their economic worth of firm.
 Economic worth i.e- costof benefits of proposals of firm( cashflow)

4) Features that a capital budgeting technique should posses..

 Criterion can incorporate all cash flows associated with proposals.
 Inclusion of time value & money concept w.r.t worth of firm.
 Capable of ranking the proposal w.r.t worth.
 Objective & unambiquous -- & not subjective scope of decision maker.
 Inline to objective of max. of shareholders wealth.

Capital budgeting techniques .

Traditional or non discounting. Modern or time adjusted or discounted

cashflow.
1) Payback periods 2) accounting rate
. of return. 1) Net present value(NPV).
2) Profitability index(PI).
These are intuitively grapple with 3) Discounted payback period.
trade off between net investment & 4) Internal rate of return(IRR).
operating cash flows. 5) Modified internal rate of return.

 Traditional/ non discounting technique .

 Payback period .
a. Number of years required for the proposals cumulative cashflows to be equal to its
cash outflows.
b. Time period required to recover the initial cost of project.

 Computation of payback period .

a. Annual cashflows are equal ( annuity ) pay back period = initial investment
Annual cash inflow.
b. Annual cashflows are unequal.
 Payback period is computed on basis of cumulative cash inflows
 Eg.1.cash outflows – Rs20,000/-
Cash inflows – Rs8000/- ,Rs6000/-, Rs2000/- & Rs 2000/- over rent 5 years.

Eg.2 cash outflow – Rs18500/-

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 Cash inflow – Rs 8000/-,Rs 6000/-, Rs 4000/-, Rs 2000/- & Rs2000/- over
rent 5 years.
Here, pay back period computation=

Years Annual CIF Cumulative CIF

1 Rs 8000 8000
2 Rs 6000 14000
3 Rs 4000 18000 (till end of 3 yrs 18000
recovered)
4 Rs 2000 20000

Till end of 3 yrs- 18000 recovered. Unrecovered amt = 500

Unrecovered amount. 500

Amt recovered in next year. 2000 = 0.25

Total payback period = 3+0.25 = 3.25 years.

Pay back period …

Advantages. Disadvantages.
a. Simple & easy in both concept & a. Ignores cashflows which occurs
applications. after payback period.
b. Can be adopted by small firms. b. Ignores time value of money
c. Inalication of liquidity of firm ( ( not discount).
emphasizes earlier cash inflows.) c. Ignores salvage values.
d. Deals with risk. d. Prefers capital recovery not
Shorter pay back period-risk level low measure of profitability.
Longer pay back period-risk level high e. Covers proposal which gave
initial investment other all other
rejected.

Decision rule.
a. Payback period ( equal to target
period, proposal accept )
b. Payback period ( > target period of a
proposal, then, proposal reject)
c. Shortest the period, ranking the
proposal 1st.

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  Accounting rate of return/ average rate of return .

a. ARR based on the accounting concept of return on investment or rate of return.

b. ARR measuredly based on the accounting profit rather than the cashflows & is very
similar to the measure of rile of return on capital employed, which is generally used
to measure the overall profitability.

 Computation of ARR .

ARR = average profit after tax (PAT) AVG PAT= ∑CFAT- ∑Dep.
. investment . No. of years.

Avg invt = opening investment + closing investment

Here, investment may be- average investment—
2

OR

Initial investment.

Hint, if in question.

a. Scrap value mentioned then investment = average investment.

b. Scrap value absent then investment = initial investment.

ARR .
Drawbacks.

1) Ignores time value money.

2) Cinsiders all profit as equal to
Decision Rule of ARR.
profits earned in 1st year
3) ARR based on accounting profits 1) If pre-specified rate is less than ARR
rather than cashflows ( refer A/C of a project then Accept project.
profits v/s cashflows. 2) If pre-specified rate is greater than
4) ARR ignores life of proposal.( a ARR of project then reject the
longer life proposed have same ARR project.
as proposal of short life. 3) Multiple proposals – higher the ARR
5) Salvage value is return to project of a proposal, higher the priority of
but ARR ignores it. selection.
6) ARR fails to recognize initial
investment size required for project.

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 Modern OR Time adjusted OR Discounted cashflows

1) Net present value method – (NPV) .

 Net present value defined as sum of present values of all cash inflows less than
[have less than (-)] the sum of present values of all cash outflows associated with
proposal.
 NPV = PVCIF – PVCOF
 Here, NPV = Present value, PVCIF = Present value of cash inflows.
C IF1 + CIF2 + CIF3……..… .CIFn
(1+KC)1 (1+KC)2 (1+KC)3…..(1+Kc)n
 PVCOF = Present value of cash out flour.

 NPV –supreme criteria .

Advantages.
Properties of NPV
1) Recognize time value money.
2) Considers all cashflow i.e all 1) NPVs are additive.
outflow’s & all inflows irrespective of The NPVs of different projects can be
occurrence added to arrive at a cumulative NPV
3) based on cashflows rather than of a business.
accounting profits. 2) Intermediate cash inflows are re-
4) Discount rate i.e Kc – incorporates invested at same discount rate.
both pure return, plus premium 3) While calculating NPV, assumed that
required to set off the risk. discount rate (bc) is constant.
5) NPV represents net contribution of If discount rate change, then NPV
the proposal towards wealth of firm. computed by varying discounted
& full conformity with objective of rates.
maximization of wealth of 4) Discounted rate change due to –
shareholders a) Level of interest rate changed.
6) b) Risk characters of project may
change.
c) Financing structure may change.

 NPV decision rules .

 NPV positive = accept the project.
 NPV negative = Reject the project.
 NPV 0 = indifferent to choose may accept/ reject.

 Mutually exclusive situation .

 Accept the proposal having highest positive NPV.

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2) Profitability index (PI) .
 Benefits (in present value terms ) per rupee invested in the proposal.
 Variant of NPV technique.
 Also know as benefit cost ratio/ desireabilityfactor/present value index.
 Based on basic concept of discounting cash flow & ascertained by comparing present
value of future cash inflows with present value future cashflows.

PI = present value of cash inflow(PVCIF).

Present value of cash outflow(PVCOF)
 PI is extension of NPV, therefore merits of NPV are same of PI.

 Decision rule .
 In merterally exclusive situation – higher the PI of a proposal- 1st priority to the
proposal

 Other wise NPV v/s PI.

1. NPV – positive then, PI > 1--accept proposal.
2. NPV—negative then, PI < 1 –reject the proposal.
3. NPV—0 the, PI = 1 may accept or reject proposal.
 If NPV – PI =?

NPV +1 = PI. ( always give priority to NPV, if conflict between

NPV & PI.
Initial investment

3) Discounted payback period .

 Combo payback period & discounted cash flow technique.

 Computation of payback period under discounted concept .

 Cash inflow are equal (annuity ).
Payback = initial investment.
Present value of cash inflow
 Cash inflows are equal
Pay back period = on cumulative basis.
i.e cumulative of PVCIF
 Decision rule = lesser the payback period—better the proposal.

4) Internal rate of return (IRR) .

 IIR is same as NPV technique i.e discounting of cash flow, but the difference is in
IIR the discounting rate is unknow.

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 IRR is the actual rate of return on project ( hidden rate )
 IRR is nothing but where,
NPV = 0 ----- i.e PVCIF = PVCDF.
PI = 1 .
 Cut of – IRR = Kc
i.e IRR > Kc ----accept proposal.
iRR < Kc -----reject proposal.
IRR = Kc ------ may accept or reject proposal.
 IRR calculated by – HIT & Trial Method.

 How to calculate IRR = ? .

 Step - 1 compute extra cashflow per year –--- inflow – outflow
No. of yrs.
 Step - 2 Return on initial investment – extra cash flow per yrs.
Initial investment.
 Step – 3 multiply Step 2 solution with 1.5 ( no logic )
 Step 4 – observe cashflows.
a. If cashflows sequence favarable – assume high rate than Step 3
b. If cashflow sequence unfavourable – assume low rate than step 3

 Pull the future cashflows by that rate & final PVCIF.

 After finding present value cash inflow ( PVCIF )
If, difference between PVCIF & PVCOF is </ = 1% of PVCOF
Then, accept the finded rate i.e (V) = IRR
 Decision rule .
 Higher the IRR, better the proposal.
IRR .

Advantages.
Disadvantages.
1) Considers time value money
1) Involves complicated & trial &
concept.
error method.
2) Profit oriented concept & helps.
2) It has on implied assumption that
Selecting those proposals which
intermediate cash inflows are
one expected to earn more than
reinvested rate equal to IRR.
Kc.
3) Based towards smaller projects
3) Expressed in percentage,
which are much more likely to
compared with cut off rate (Kc)
yield high percentages of over
Hence, IRR has appeal for those
larger projects.
who want returns of proposal in %
4) To a proposal, there can ne
form.
multiple IRR which makes
4) IRR based on all cash flows, rather
complications.
than accounting profits.

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 NPV v/s IRR .
 Irr approach solves for a unique rate of return, where as NPV approach sowes for
the trade – off cash inflows & outflows. Using general required rate of return.

A. Superiority of IRR over NPV –

a) IRR gives percentage returns where as NPV gives absolute terms return.
b) For IRR availability of required rate of return is not pre- requisite, white for NPV
it must be.

B. Superiority of NPV over IRR

a) NPV shows expected increase in the wealth of the shareholders.
b) NPV gives clear cut accept reject decision rule, while IRR gives multiple results.
c) NPV of different projects is additive, whereas impossible in IRR.
d) NPV gives better ranking as compared to the IRR.

5) Modified internal Rate of return.(MIRR) .

 Assumption of re-investment rate can be over come by modifying IRR. Procedure,
such procedure is called modified internal rate of return.
 In MIRR, all cases are handled with assumption that is, intervening cashflows over
the life of project are re-invested @ a rate equal to the required rate of return,
for remaining life of project.
 The total cumulative values are discounted back to be equal the present value of
cash outflows. The rate of discount of which the P.V. of cash flow is equal to P.V. of
total cumulative cash inflows, is known as MIRR.
P.V. of cash = FV FV
Outflows. (1+r)n (1 + MIRR)n

F.V. = future value ---- P.V.(1+ r)n

r= MIRR.
n=No.of years discounting.

 Decision rule under MIRR .

a) If, MIRR > required rate of return (Kc) --- Accept the proposal.
b) If MIRR < Required rate of return (Kc) ---Reject the proposal.

 Mutually exclusive project with life disparity .

 Proposals with unequal lives.
 Assumptions-
a) Proposal are mutually exclusive.

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 b) Life disparity in project.
c) Proposal are of repetitive nature.
 An such situation, how to select the proposal ?
Solution is – calculating Annual capital charge (ACC) or
Equivalent Annual Charge ( cost) ( EAC) or
Annual benefit of the proposals.
ACC = PVCOF
or EAC (PNAF ….)
 The proposal which has lower the ACC – priority to the proposal.
 an case of Annual Benefit – higher the Annual benefit butter the proposal.

 Asset Replacement Decisions .

 A replacement decision occurs when one asset is proposed to be replacing with
another.

 Assumption while such decisions

 Economic life of the new assets is equal to remaining economic life of the existing
asset being replaced.
 for e.g. – oral asset remaining life – 8 yrs.
Here, New outset life should be – 8 yrs.

 Replacement decision involves disposal of some assets currently owned by the

firm, it involves measurement of incremental cost and benefits.

 Evaluation of Replacement Decision .

Calculating - Cost of Ne Project + Working Capital
Salvage Value (after term) of old asset
(if any)
1) Incremental Cash Inflows (after tax):- Operating cash flows of New Project
(terms)
Operating cash flows from the old
(it it was continuing)
Alternative of Calculating
Incremental CFAT - Incremental EBDIT XXX
(terms) Incremental Depreciation (XXX)
…IT XXX

 Calculate Incremental Depreciation .

Dep on New Asset XXX
Tax Dep on old Asset (XXX)

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 Incremental XXX
Dep.

 Incremental Technical inflows .

 Salvage value of new (net of tax) + Release W.C. ( LESS)
 Salvage value of old (net tax) (had it not been replaced.)

 Decision Rule .
1) NPV Technique
 Using required rate of return as obi counting rate.
 If incremental NPV – positive – accept proposal.
 If incremental NPV – negative – reject proposal – continue with old asset.

 Sensitivity Analysis
 It is identifying maximum change in components of NPV possible to remain project
acceptable.

E.g. Forecast about a proposal find NPV and sensitivity analysis of NPV @
different variables.
Initial outlay = Rs.12000 cash inflows = Rs.4500 (annual)
PVAF (14% 4) = 2.9137 Kc = 14% PVAF (14% 3 y) = 2.3216
- NPV of project = PVCIF – PVCOF
= 4500 [PVAP (14%,44)] – (12000)
= 4500 (2.9137) Rs.12000
NPV = 1112

 Sensitivity with respect to Initial outlay:-

NPV = 0
PVCIF – PVCOF = 0
PVCIF = PVCOF
4500 (2.9137) = PVCOF
PVCOF = 13111.65

 Difference between PVCOF & PVCIF .

= 13112 – 12000
= 1112
@ 1112 NPV = 0

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 or in % form – margin for initial = 1112 x 100 = 9.4%
outlay 12000
Hence @ 1112 or 9.4% of initial outlay
NPV = 0 - ………………………….

 Sensitivity with respect to Annual Cash Inflows

NPV = 0
NPV = PVCIF – PVCOF
PVCIF = PVCOF
Annual cash inflow (PVAF) = PVCOF
Annual cash flow (2.9137) = 12000
Annual cash inflow = 12000 (
2.9137
Annual cash inflow = 4118
in % form = 382 x 100
4500
= 8.5% - sensitivity of NPV
 Sensitivity with respect to Discount Rate :
NPV = 0
PVCIF = PVCOF = 0
PVCIF = PVCOF
4500 [PVAF (…., 44)] = 12000
(PVAF) = 12000
4500
(PVAF) = 2.667
(PVAF) = 2.667
PVAF = 2.667 for 4 yrs

 Hit & Trail method .

let n = 18%
1 = 2.667
4
(1+..18)
2.6900 = 2.667
which is approx.
Now, M=18%
(18% - 14%) = 4%
= 4 x 100
14
= 28.57% - NPV sensitively

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Hence now,
Sensitivity of NPV w.r.t.
1) Cas outflow = 9.4%
2) Cash inflow = 8.5%
3) Discount Rate = 28.57%
Here, Cash inflow is most sensitive i.e. 8.5% & NPV = 0 – sensitively

Question 1

Give the Cash Flow of a Project

Years 0 1 2 3
Net Cash Flow (in Lacs) (800) 300 400 500

How do we decide whether to Accept or Reject the Project given = 11.75%

Question 2

Consider a Project with Initial Investment of Rs 500 L funded as follows:

Equity = 300 L
Long Term Loan = 200 L
Interest Rate on Loan = 14%, Tax Rate = 30%, Cost of Equity = 21%,

The Project is Expected to Generate the following After Tax Cash Flows.

Years 1 2 3 4
Cash Flow 220 200 240 210

Find Out the NPV of the Project

Question 3

Consider a Project with Initial Investment of 500 lakhs. Annual Cash Flow 60 lakhs
(Perpetuity) = 12.5% , Calculate NPV.3

Question 4

Initial Investment = 600L

Life = 5 years
Kc = 15%

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NPV = 62 L
Calculate Annual Cash Flows.

Question 5

Initial Investment = 700 L

Life of the project = 8 years.
Kc = 14%
Annual Cash Flow = 150 lakhs
Calculate NPV

1. Capital budgeting is the process of identifying analyzing and selecting

investments project whose returns are expected to extend beyond -

(A) 3 years

(B) 2 years

(C) 1 year

(D) Months

2. Indifference criteria when BCR (Benefit Cost Ratio)Rs.

(A) BCR > 1

(B) BCR = 1

(C) BCR < 1

(D) None of the above

3. Criterion for IRR (Internal Rate of Return)Rs.

(A) Accept, if IRR > Cost of capital

(B) Accept, if IRR < Cost of capital

(C) Accept, if IRR = Cost of capital

(D) None of the above

4. The categories of cash flows includes -

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(A) Net initial investment

(B) Cash flow from operations after paying taxes

(C) Cash flow from terminal disposal after paying taxes

(D) All of the above

5. The concept which explains that a money received in present time is more

valuable than money received in future is classified as -

(A) Lead value of money

(B) Storage value of money

(C) Time value of money

(D) Cash value of money

6. The method which calculates the time to recoup initial investment of project in

form of expected cash flows is classified as -

(A) Net value cash flow method

(B) Payback method

(C) Single cash flow method

(D) Lean cash flows method

7. The rate of return to cover risk of investment and decrease in purchasing

power as a result of inflation is classified as -

(A) Nominal rate of return

(B) Accrual accounting rate of return

(C) Real rate of return

(D) Required rate of return

8. The payback period is multiplied to constant increase in yearly future cash

flows to calculate -

(A) Cash value of money

(B) Net initial investment

(C) Net future value

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(D) Time value of money

9. The rate of return which is made up of risk free element and business risk

element is classified as -

(A) Nominal rate of return

(B) Accrual accounting rate of return

(C) Real rate of return

(D) Required rate of return

10. The project’s expected monetary loss or monetary gain by discounting all cash

outflows and inflows using required rate of return is classified as -

(A) Net present value

(B) Net future value

(C) Net discounted value

(D) Net recorded cash value

Question 6

Consider the following project cash flows

Yea 0 1 2 3 4 5
r
NCF (80 60 100 (30 50 70
) )

Kc = 18%, Calculate NPV

Question 7

Consider the following projects

Years Net Cash Flows (Rs in Lakhs)

0 (70)
1 50

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 2 (30)
3 80
4 120

Kc = 10%, Find PI

Question 8

Year 0 1 2 3 4
NCF (800) 300 400 200 500

Calculate IRR and give us advice if cost of capital is 15%.

Question 9

Consider the following project –

Year 0 1 2 3
NCF (600) 400 300 200

Kc = 20%, Calculate IRR and advice.

Question 10

Consider the following project –

Year 0 1 2 3 4
NCF (1200) 400 500 300 700

Ke = 20%, Calculate IRR and advice.

11. A project requires initial investment of Rs.2,00,000 and estimated to

generate cash flow after tax of Rs.1,00,000, Rs.80,000, Rs.40,000, Rs.20,000

& Rs.10,000 in next 5 years. What is the payback period of the project?

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(A) 3 years and 4 months

(B) 2 years and 6 months

(C) 4 years and 2 months

(D) 2 years and 8 months

12. Y Ltd. is considering a project which requires initial investment of

Rs.6,75,000. Its cost of capital is 10%. Estimated cash flow after tax are as

follows:

Year 1 -

Year 2 1,50,000

Year 3 6,60,000

Year 4 4,20,000

Year 5 4,20,000

What is projects discounted payback period?

(A) 3 years & 7.58 months

(B) 4 years & 4.12 months

(C) 3 years & 2.32 months

(D) 4 years & 8.11 months

13. Rakesh Ltd. is considering to invest in one of four projects for which an

analyst has calculated ‘payback period reciprocal’ as 25%, 40%, 50% & 75%

respectively for Project P, Q, R & S. Which project will be selected on 'payback

period’ method of capital budgeting?

(A) Project R

(B) Project P

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(C) Project S

(D) Project Q

14. Ramsey Ltd. wants to select one of machine out of two. Data for machines

are given below:

Machine A MachineB

(?) (?)

CFAT:

Year 1 5,25,000 1,75,000

Year 2 7,00,000 5,25,000

Year 3 8,75,000 7,00,000

Year 4 5,25,000 10,50,000

Year 5 3,50,000 7,00,000

Machine has to be written off over the period of 5 years by SLM.

The company will select -

(A) Machine A because its ARR is 15% while that of Machines B is 14%

(B) Machine B because it has higher average CFAT

(C) Machine A because it has higher average CFAT

(D) Machine B because its ARR is 16% while that of Machines A is 14%

15. Following data is available for Project A whose initial investment is Rs.50,000

and salvage value after 5 years is Rs.3,750.

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Year CFATfi)

1 25,000

2 20,000

3 10,000

4 10,000

5 1,250

What is the NPV of the Project A if the Ke of the company is 10%? Ignore

taxation.

(A) Rs.5,710

(B) Rs.6,690

(C) Rs.6,800

(D) Rs.7,216

16. A Machine requires initial investment of Rs.40,000 and expected to generate

cash flow of Rs.8,400,Rs. 14,300 & Rs.32,800 in next 3 years. Applicable tax

rate is 30%

Machine A MachineB

(Rs. ) (?)

Cost 17,50,000 17,50,000

and WACC of the company is 12%. The company will select machine because -

(A) It has positive NPV of Rs.2,522

(B) It profitability index is 1.653 which is more than 1.

(C) Its IRR is between 14% to 15% which is more than WACC of the company.

(D) All of the above

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17. Profitability index of Project X is 1.20167 when its cash flow is discounted at

12%. Initial investment on project was Rs.1,50,000. This proj ect generates equal

cash flow over the five years time. How much cash flow will be generated by the

project each year?

(A) Rs.50,000

(B) Rs.40,000

(C) Rs.60,500

(D) Rs.40,897

18. LMN Corporation is considering an investment that will cost Rs.80,000 and

have a useful life of 4 years. During the first 2 years, the net incremental after-

tax cash flows are Rs.25,000 per year and for the last 2 years they are

Rs.20,000 per year. What is the payback period for this investment?

(A) 3.2 year

(B) 3.5 year

(C) 4.0 year

(D) Cannot be determined with this information.

19. Bhaskar Ltd. estimated that a proposed project’s 8-year net cash benefit will

be Rs.4,000 per year for years 1 to 8, with an additional terminal benefit of

Rs.8,000 at the end of the eighth year. Assuming that these cash inflows satisfy

exactly required rate of return of 8 percent, the project’s initial cash outflow is

closest to which of the following four possible answers?

(A) Rs.27,308

(B) Rs.25,149

(C) Rs.14,851

(D) Rs.40,000

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20. A project has the following cash inflows Rs.34,444, Rs.39,877,Rs. 25,000

&Rs. 52,800 for years 1 to 4, respectively. The initial cash outflow is

Rs.1,04,000. Which of the following four statements is correct concerning the

project internal rate of return (IRR)Rs.

(A) The IRR is less than 10%.

(B) The IRR is greater than 10%, but less than 14%.

(C) The IRR is greater than 14%, but less than 18%.

(D) The IRR is greater than or equal to 18%.

21. You must decide between two mutually exclusive projects.

Project X has cash flows of—Rs. 10,000, Rs.5,000, Rs.5,000 & Rs.5,000, for

years 0 through 3, respectively.

Project Y has cash flows of—Rs. 20,000,Rs. 10,000,Rs. 10,000 & Rs.10,000; for

years 0 through 3, respectively.

The firm has decided to assume that the appropriate cost of capital is 10% for

both projects. Which project should be chosen? Why?

(A) X; Project X‘s NPV > Project Y‘s NPV.

(B) X or Y; Makes no difference which you choose because the IRR for X is identical to

the IRR for Y and both IRRs are greater than 10%, the cost of capital

(C) Y; Project Y's NPV > Project X‘s NPV

(D) Neither X nor Y; The NPVs of both projects are negative.

22. There are two mutually exclusive projects that have different lives. Proj

ectAhasa4-year life and Project B has a 5-year life. In replacement chain

analysis, the earliest common life will occur when Project A is replicated

.................. times and Project B is replicated .................. times.

(A) 5; 4

(B) 4; 5

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(C) 20; 20

(D) Not possible to determine the answer

Question 11

For a project,
IRR = 16%
Annual cash flow = 57,500
Life = 5 years
1) Calculate initial investment.
2) It is known that if Kc goes up by 60% from its current level, NPV = 0. Calculate Kc.
3) Hence calculate NPV and PI.

Question 12

Consider the following project –

Year 0 1 2 3 4
NCF (1200) 400 500 300 700

1) Calculate IRR.
IRR = 19.67% (as calculated earlier)
2) What is the assumption taken in the calculation of IRR ?
The assumption is that the intermediate cash flow are reinvested at itself.
3) If you consider re-investment at Kc = 15%, calculate modified IRR.

Question 13

Consider a project with initial investment of Rs 500 L funded as follows.

Equity - 300 L
Long Term Loan - 200 L
Interest rate on loan =14%,
Tax Rate = 30%,
Cost of Equity = 21%,
The project is expected to generate the following after tax cash flows.

Years 1 2 3 4
Cash Flows 220 200 240 210

Find out NPV, IRR & PI.

Question 14

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Given below are the data on a capital project ‗X‘ for Theta Limited for your
consideration:

Annual Cost Saving Rs 60,000

Useful Life 4 years
Internal Rate of Return 15%
Profitability Index 1.064
Salvage Value 0

You are Required to calculate for the Project X:

1) Cost of Project
2) Payback Period
3) Cost of Capital
4) Net Present Value.

Question 15

Initial Investment = 800 L, Project Life = 5 Years, Salvage Value = 40 L. The forecast
of Cash Flow for the 5 year Period are:

Year 1 2 3 4 5
s
CFs 24 23 19 18 17
0 0 0 0 0

Calculate ARR.

23. ABC Ltd. is considering investing in a project that costs Rs.5,00,000 that will

continue for next five years. The estimated salvage value is zero, tax rate is

35%. The company uses straight line depreciation for tax purposes and the

proposed project has profit before charging depreciation of Rs.2,20,000.

Company’s cost of capital is 10%.

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What is the total present value for this project?

(A) Rs.6,74,798

(B) Rs.6,47,798

(C) Rs.6,74,987

(D) Rs.7,64,798

24. ABC Ltd. is considering investing in a project that costs Rs.5,00,000 that will

continue for next live years. The estimated salvage value is zero, tax rate is 35%.

The company uses straight line depreciation for tax purposes and the proposed

project has profit before charging depreciation of Rs.2,20,000. Company’s cost of

capital is 10%.

What is the Profitability Index of this project?

(A) 1.25

(B) 1.45

(C) 1.15

(D) 1.35

25. ABC Ltd. is considering investing in a project that costs Rs.5,00,000 that will

continue for next five years. The estimated salvage value is zero, tax rate is

35%. The company uses straight line depreciation for tax purposes and the

proposed project has profit before charging depreciation of Rs.2,20,000.

Company’s cost of capital is 10%.

What is the Payback Period of- this project?

(A) 2.52 years

(B) 2.81 years

(C) 3.24 years

(D) 4.11 years

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26. ABC Ltd. is considering investing in a project that costs Rs.5,00,000 that will

continue for next five years. The estimated salvage value is zero, tax rate is

35%. The company uses straight line depreciation for tax purposes and the

proposed project has profit before charging depreciation of Rs.2,20,000.

Company’s cost of capital is 10%.

What is the IRR of this project?

(A) Between 10% to 15%

(B) Between 10% to 20%

(C) Between 18% to 19%

(D) Between 22% to 23%

27. Machine Z purchased at year zero for Rs.5,00,000 which will be depreciated

@ 25% for 5 years on written down value basis and then will be sold at

Rs.70,000. Capital gain tax rate is 35% while corporate income tax rate is 40%.

What is the present value of cash flow of machine at 5th year if cost of capital is

12%?

(A) Rs.68,326

(B) Rs.39,690

(C) Rs.49,345

(D) Rs.87,028

28. Machine P purchased at year zero at Rs.10,00,000 which will be depreciated

@ 25% for 5 years on written down value basis and then will be sold at

Rs.1,40,000. Tax rate is 35%. Profit before depreciation at 5th year is

Rs.84,000. What is the present value of CFAT at year five if cost of capital is

12%?

(A) Rs.1,45,346

(B) Rs.1,54,643

(C) Rs.1,43,546

(D) Rs.1,54,463

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29. Net present value of Machine X is Rs.29.15 lakh. Cost of capital is 10%.

Cash flow after tax for years 1 to 5 is Rs.35 lakh, Rs.80 lakh, Rs.90 lakh, Rs.75

& Rs.20 lakh respectively. What is the purchase cost of Machine X?

(A) Not sufficient information is given.

(B) Rs.150 lakh

(C) Rs.100 lakh

(D) Rs.200 lakh

30. Following data is collected by the junior of finance department of Maya Ltd.

Project C Project D

PV @ 10% Rs. 458.30 lakh Rs. 437.52 lakh

PV @ 20% Rs. 360.90 lakh Rs. 393.52 lakh

Both project requires same investment amounting to Rs.400 lakh. Cost of capital

of Maya Ltd. is 10%.

Managing Director (MD) thinks that project D should be selected whereas Company

Secretary (CS) suggests to choose Project C. Who is Correct? Select correct

answer from the options given below.

(A) MD as NPV @ 20% of Project D is more than Project C.

(B) CS as IRR of Project C is less than Project D.

(C) MD as IRR of Project D is more than Project C.

(D) CS as NPV @ 10% of Project C is more than Project D.

Question 16

There is a 10 year project where Initial Investment = 60 Lakhs and the sum total of
after tax profit for the 10 years = 50 Lakhs. The firm has specified a hurdle ARR of
22% based on initial investment. Should the project be accepted?

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Question 17

Sagar Ltd an exiting profit-making company, is planning to introduce a new product with
a projected life of 8 years. Initial equipment cost will be Rs 120lakhs and additional
equipment costing Rs 20 lakhs will be needed at the beginning of third year.

At the end of the 8 years, the original equipment will have resale value equivalent to
the cost of removal, but the additional equipment would be sold for Rs 1 lakhs will be
needed. The 100% capacity of the plant is of 4,00,000 units per annum, but the
production and sales-volume expected are as under:

Year Capacity in Percentage

1 20
2 30
3-5 75
6-8 50

A sale price of Rs 100 per unit with a profit volume ratio of 60% is likely to be
obtained. Fixed Operating Cash Cost are likely to be Rs 16 lakhs per annum. In addition
to this the advertisement expenditure will have to be incurred as under:

Question 18

Sagar Limited is trying to decide whether to buy a machine for Rs 80,000 which will
save costs of Rs 20,000 per annum for 5 years and which will have a resale value of Rs
10,000 at the end of 5 years. If it is the company‘s policy to undertake projects only if
they are expected to yield a return of 10 percent or more, you are required to advise
Sagar Limited whether to undertake this project or not

Question 19

Ramesh Limited is considering buying a new machine which would have a useful economic
life of five years, a cost of 1,25,000 and a scrap value of 30,000, with 80 per cent of
the cost being payable at the start of the project and 20 per cent at the end of the
first year.

The machine would produce 50,000 units per annum of a new project with an estimated
selling price of 3 per unit. Direct costs would be 1.75 per unit and annual fixed costs,
including depreciation calculated on a straight- line basis, would be 40,000 per annum.
In the first year and the second year, special sales promotion expenditure, not included
in the above costs, would be incurred, amounting to Rs 10,000 and Rs 15,000
respectively.

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Evaluate the project using the NPV method of investment appraisal, assuming the
company‘s cost of capital to be 10 percent.

Question 20

An iron ore company presently extracts 1 lakhs tonnes a year

SP=1000 per ton and extraction cost = 700 per ton.
The firm is evaluating installing an equipment worth Rs 100 lakhs and putting in
additional W.W. of 10 lakhs with a view to further process 25% of the output at Rs 100
per ton Normal loss would be 20% and SP of the processed output would be 1350 per
ton.
Ke = 15%, for rate = 30%, useful life = 5 years, SV = NIL
Dep. = SLM
Check the viability of the project.

31. A company is considering whether it should spend Rs.10 lakhs on a project to

manufacture and sell a new product. Unit variable cost of the product is Rs.15. It

is expected that the new product can be sold at Rs.25 per unit. The annual fixed

costs are Rs.50,000. The project will have a life of 6 years with scrap value of

Rs.50,000 Cost of capital is 15%. The only uncertain factor is the volume of

sales. Ignore taxation. Minimum volume oi sales required to justify the project is

(A) 30,852 units

(B) 33,487 units

(C) 28,453 units

(D) 34,741 units

32. A project whose useful life is 4 years has IRR of 15% and will save cost of

Rs.1,60,000 annually. What is the project cost Le. initial investment?

(A) Rs.10,66,667

(B) Rs.4,60,000

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(C) Rs.5,32,800

(D) Rs.4,56,800

33. A professional kitchen is attempting to choose between gas and electricity for

its main heat source. Once a choice is made, the kitchen intends to keep to that

source indefinitely. Each gas oven has a net present value (NPV) of Rs.50,000

over its useful life of 5 years. Each electric oven has an NPV of 7 68,000 over its

useful life of 7 years. The cost of capital is 8%. Which should the kitchen choose

and why?

(A) Gas because its average NPV per year is highe~ than electric

(B) Electric because its NPV is higher than gas

(C) Electric because its equivalent annual benefit is higher

(D) Electric because it lasts longer than gas

34. Universe Ltd. has an investment budget of Rs.250 lakhs. The management

wants to complete the financia 1 appraisail before making the investment.

(X in lakhs)

A B

Investment required 250 225

profit before depreciation 70 60

Company follows straight line method of charging depreciation. Tax rate is 50%.

Estimate life =10 years (both projects). You will advise to select -

(A) Proj ect B, as its pay back period is less as compared to Project A

(B) Project B, as its payback period and ARR are higher than Project A.

(C) Project B, as its ARR is 10.35% whereas ARR of Project A is 10.20%

(D) Project A, as its payback period is less and ARR is higher than Project B.

35. James Co. is considering a project with an initial cost of Rs.6.2 Million. The

project will produce cash inflows of Rs.1.8 Million a year for 5 years. Firm uses

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the subjective approach to assign discount rates to projects. For this project, the

subjective adjustment is +2%. Firm has a pre-tax cost of debt of 6.7% and a

cost of equity of 9.4%. The debt-equity ratio is 0.6 and the tax rate is 35%.

What is the NPV of the project?

(A) Rs.8,11,000

(B) Rs.7,90,900

(C) Rs.7,42,060

(D) Rs.7,10,200

36. Yogesh Ltd. has to make a choice between two identical machines, in terms of

capacity, A and B. They have been designed differently, but do exactly the same

job. Machine A costs Rs.1,87,500 and will last for 3 years. It costs Rs.50,000

p.a. to run. Machine B is an economy model costing only Rs.1,25,000, but will last

for only 2 years. It costs Rs.75,000 p.a. to run. The cash flows of Machine A

and B are real cash flows. The costs are forecasted in rupees of constant

purchasing power. Ignore taxes. The opportunity cost of capital is 9%. Which

machine the Yogesh Ltd. should buy?

(A) Machine B as its present value of cash outflow is less than Machine A.

(B) Machine A as its present value of cash outflow is less than Machine B.

(C) Machine B as it is cheaper than Machine A.

(D) Machine A as its equivalent present value of cash outflow is less than Machine B.

37. The net present value of a proposed project is Rs.20,000 at a discount rate

of 5% and ( Rs.28,000) at 10%. What is the internal rate of return of the

project, to the nearest one decimal place?

(A) 7.08%

(B) 7.05%

(C) 2.03%

(D) 8.06%

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38. Monika Ltd. is considering investing in two competing projects: Delta &

Gamma. Delta has NPV of Rs.16,500 and IRR of 17%. Details of the estimated

cash flows of Gamma are as follows:

X in ‘000 Cash Flows

Year 0 (200)

Year 1 120

Year 2 60

Year 3 80

The business has a cost of capital of 10%. Which of the following combinations is

correct concerning the NPV and IRR of the two projects?

Delta Gamma

(A) Higher NPV Higher IRR

(B) Higher NPV Lower IRR

(C) Lower NPV Higher IRR

(D) Lower NPV Lower IRR

Question 21

Consider a project –
Initial Investment = 100L in plant and 40 L in WC
Sales = 1 Lakh units p.a.
Price = 120 per unit
V.C. = 60 per unit
Cash FC = 15 L per annum
Depreciation = 25% WDV
Life = 5 years
SV = Book value at the end of 5 years.
T = 40%
Kc = 12%

Calculate NPV.

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Question 22

Ganpati Limited is considering the following investment projects:

Cash Flows (Rs)

Projects C0 C1 C2 C3
A -10,000 +10,000
B -10,000 +17,500 +7,500
C -10,000 +12,000 +4,000 +12,000
D -10,000 +10,000 +3,000 +13,000

1) Rank the projects according to each of the following methods: (i) Pay back, (ii) ARR,
(iii) IRR and (iv) NPV, assuming discount rates of 10 and 30 per cent.
2) Assuming the projects ate independent, which one should be accepted? If the
projects are mutually exclusive, which project is the best?

Question 23

Consider the mutually exclusive projects –

Port Project Project

A B
NPV 40 L 110 L
Life 6 years 10 years

If Kc = 11% which project should be chosen?

Question 24

Company Rohit is forced to choose between two machines A and B. The two machines
are designed differently, but have identical capacity and do exactly the same job.
Machine A costs Rs 1,50,000 and will last for 3 years. It costs Rs 40,000 per year to
run. Machine B is an ‗economy‘ model costing only Rs 1,00,000, but will last only for 2
years, and costs Rs 60,000 per year to run. Ignore tax. Opportunity cost of capital is
10 per cent. Which machine company Amol should buy?

Question 25

Sagar Limited is considering the purchase of a new automatic machine which will carry
out same operations which are at present performed by manual labour. NM-A1 and NM-

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 A2, two alternative models are available in the market. The following details are
collected:

Machine
Particulars NM-A1 NM-A2
Cost of Machine (Rs) 20,00,000 25,00,000
Estimated working life 5 Years 5 Years
Estimated Saving in direct wages per annum 7,00,000 9,00,000
(Rs)
Estimated saving in scrap per annum (Rs) 60,000 1,00,000
Estimated additional cost of indirect 30,000 90,000
material per annum (Rs)
Estimated additional cost of indirect labour 40,000 50,000
per annum (Rs)
Estimated additional cost of repairs and 45,000 85,000
maintenance per annum (Rs)

Depreciation will be charged on a straight line method. Corporate tax rate is 30

percent and expected rate of return may be 12 percent.

You are required to evaluate the alternatives by calculating the:

1) Pay-back Period
2) Accounting (Average) Rate of Return; and
3) Profitability Index or P.V. Index (P. V. factor for Rs 1@ 12%
0.893;0.797;0.712;0.636;0567;0507)

39. A company purchases a non-current asset with a useful economic life of ten

years for Rs.12,50,000. It is expected to generate cash flows over the 10 year

period of Rs.2,50,000 p.a. before depreciation. The company charges depreciation

over the life of the asset on SLM. At the end of the period it will be sold for

Rs.2,50,000. What is the ARR for the investment (based on average profits &

average investment)Rs. Ignore Taxation.

(A) 20%

(B) 15%

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(C) 33%

(D) 25%

40. Tanishka is considering an investment in a new process. The new process will

require an increase in stocks of Rs.30,000 during the first year. There will also

be an increase in debtors outstanding of Rs.40,000 and an increase of creditors

outstanding of Rs.35,000 during the first year. The new process will use

machinery that was purchased immediately before the first year of operations at

a cost of Rs.3,00,000. The machinery is depreciated using SLM and has an

estimated life of 5 years and no residual value. During the first year, the net

operating profit before depreciation from the new process is expected to be

Rs.1,80,000. The business uses the NPV method when evaluating investment

proposals. When undertaking the NPV calculations, what would

be the estimated net cash flow during the first year of the project? (Ignore

taxation)

(A) Rs.85,000

(B) Rs.2,15,000

(C) Rs.1,45,000

(D) Rs.1,55,000

41. LW Co. has a half empty factory on which it pays Rs.5,000 p.a. If it takes

on a new project, it will have to move to a new bigger factory costing Rs.17,000

p.a. and it could rent the old factory out for Rs.3,000 p.a. until the end of the

current lease. What is the rental cost to be included in the project appraisal?

(A) Rs.14,000

(B) Rs.17,000

(C) Rs.9,000

(D) Rs.19,000

42. The one year rate of inflation is expected to be 3%. The one year money

discount rate is 6-3%. The one year real rate of discount is:

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(A) 3-3096

(B) 3-2096

(C) 9-3096

(D) 9-4996

43. The one year rate of inflation is expected to be 596. The one year real

discount rate is 1096. The one year money rate of discount is:

(A) 1096

(B) 1396

(C) 13.396

(D) 15.596

44. A company has 31 December as its accounting year end. On 1.1.2014 a new

machine costing Rs.2,00,000 is purchased. The company expects to sell the

machine on 31.12.2015 for Rs.3,50,000. The rate of corporation tax for the

company is 3096 and the same rate is applicable for capital proht/loss. Tax-

allowable depreciation is obtained at 2596 on the reducing balance basis. The

company makes sufficient profits to obtain relief for capital allowances as soon as

they arise. If the company’s cost of capital is 1596, what is the NPV?

(A) Positive Rs.32,290

(B) Negative Rs.32,290

(C) Positive Rs.1,78,445

(D) Negative Rs.1,78,445

45. A company has 31 December as its accounting year end. On 1.1.2014 a new

machine costing Rs.20,00,000 is purchased. The company expects to sell the

machine on 31.12.2015 for Rs.3,50,000. The rate of corporation tax for the

company is 3096 and the same rate is applicable for capital proht/loss. Tax-

allowable depreciation is obtained at 2596 on the reducing balance basis, and a

balancing allowance is available on disposal of the asset. The company makes

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sufficient profits to obtain relief for capital allowances as soon as they arise. If

the company’s cost of capital is 1596, what is the NPV?

(A) Negative Rs.13,48,040

(B) Negative Rs.13,44,080

(C) Positive Rs.13,48,040

(D) Positive Rs.13,44,080

46. A project has the following estimated cash inflows

Year 1: Rs.1,00,000

Year 2: Rs.1,25,000

Year 3: Rs.1,05,000

Working capital is required to be in place at the start of each year equal to 1096

of the cash inflow for that year. The cost of capital is 1096. What is the present

value of the working capital?

(A) Nil

(B) (30,036)

(C) (2,735)

(D) 33,000

47. A company has to make a choice between two machines X and Y. The two

machines are designed differently, but have identical capacity and do exactly the

same job. Machine X cost Rs.5,50,000 and will last for 3 years. It costs

Rs.1,25,000 per year to run. Machine Y is an economy model costing Rs.4,00,000,

but will last for 2 years and costs Rs.1,50,000 per year to run. These are real

cash flows. The costs are forecasted in rupees of constant purchasing power. Cost

of capital is 1296. Ignore Taxes. Which machine company should buy?

(A) Machine X

(B) Machine Y

(C) Any Machine

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(D) Any machine other than X and Y

Question 26

Pawan Ltd presently uses a machine with book value 5L, SV now = 4L, remaining life = 5
years and SV after 5 years = 50000. Its annual operating cost is 90000.
Pawan Ltd is evaluating whether to replace this machine with a new one costing 7L,
useful life = 5 years. SV at the end of 5 Years = 2L, annual operating cost = 40000.
Taking Kc as 12%, tax rate @ 40% and depreciation on the basis of SLM, Advice Pawan
Ltd.

Question 27

Rohit Ltd is evaluating whether to replace an old machine with a new one. Details
provided below

Particulars Old Mc. New Mc.

BV today - 40000 Cost today – 120000
SV today - 30000 Life – 4 years
Remaining life - 4 years SV after 4 years – 2000
SV after 4 years - 5000 Dep - SLM
Dep. SLM

The purpose of replacement is cost reduction cost reduction each year would be
45000.

Tax rate = 30%

Kc = 14%
Determine NPV of the replacement decision.

Question 28

A company wants to replace its old machine with a new automatic machine. Two models
A and B are available at the same cost of Rs 5 lakhs each. Salvage value of the old
machine is Rs 1 lakh. The utilities of the existing machine can be used if the company
purchases A.

Additional cost of utilities to be purchased in that case are Rs 1 lakh. If the company
purchases B then all the existing utilities will have to be replaced with new utilities
costing Rs 2 lakhs. The salvage Value of the old utilities will be Rs 0.20 lakhs. The
earnings after taxation are expected to be:

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 (Cash in – Flows of)
Year A Rs. B Rs. P.V. Factor @ 15%
1 1,00,000 2,00,000 0.87
2 1,50,000 2,10,000 0.76
3 1,80,000 1,80,000 0.66
4 2,00,000 1,70,000 0.57
5 1,70,000 40,000 0.50
Salvage Value at the end 5,50,000 60,000
of year

The targeted return on capital 15%. You are required to

1) Compute, for the two machines separately, net present value, discounted payback
period and desirability factor.
2) Advice which of the machines is to be selected?

Question 29

You are the financial advisor for Garmma Limited. The management has requested you
to analyse two proposed capital investment, Projects X and Y. Each project has a cost
of 10,000, and the cost of capital for each projects is 12 per cent. The expected net
cash flows in the two projects are as follows.

Yea Expected Net Cash

r Flows
Project Project
X Y
0 (10,000 (10,000
) )
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500

You are Required to:

1) Calculate each Project‘s payback period, net present value (NPV), international rate
of return (IRR), and modified international rate of return (MIRR),
2) Which project or projects should be accepted if they are independent?

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 Question 30

FH Hospital is considering 10 purchase a CT – Scan machine Presently the hospital is

outstanding the CT – Scan Machine and is earnings commission of RS 15,000 per month
(net of tax). The following details are given regarding the machine:

Particulars Rs.
Cost of CT – Scan Machine 15,00,000
Operating Cost Per Annum (Excluding Depreciation) 2,25,000
Expected Revenue Per Annum 7,90,000
Salvage Value of the Machine (After 5 Years) 3,00,000
Expected Life of the Machine 5 years

Assuming tax rate @ 30% whether it would be profitable for the hospital to purchase
the machine?

Give your recommendation under:

1) Net Present Value, Method
2) Profitability Index Method.

PV factors at 12% are given below:

48. A Ltd. is considering the purchase of a machine which will perform some

operations which are at presen t performed by workers. Machines X and Y are

altemativ e models. The following details are available for year:

Machine X Machine Y

X X

Cost of machine 1,50,000 2,40,000

Life of machine 5 years 6 years

Cost of running 7,000 11,000

Cost of material 6,000 8,000

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Savings in scrap 10,000 15,000

Cost of supervision 12,000 16,000

Savings in wages 90,000 1,20,000

Depreciation will be charged on straight line basis. Tax rate is 3096. Cost of capital is

1096. A Ltd. will select -

(A) Machine X as it has higher NPV than Machine Y

(B) Machine Y as it has higher profitability index

(C) Machine X as it has higher profitability index

(D) Machine Y as it has higher ARR than Machine X

49. ANP Ltd. is providing the following information:

Annual cost of saving Rs.48,000

Useful life 5 years

Salvage value Zero

Internal rate of return 15%

Profitability index 1.05

What is projects initial investment?

(A) Rs.1,60,900

(B) Rs.1,60,944

(C) Rs.1,60,494

(D) Rs.1,60,499

50. Using the data of above question calculate payback period.

(A) 3.35 years

(B) 3.43 years

(C) 3.53 years

(D) 3.76 years

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51. GOL Ltd. is providing the following information:

Annual cost of saving Rs.96,000

Useful life 5 years

Salvage value Zero

Internal rate of return 15%

Profitability index 1.05

What is cost of capital of GOL Ltd.Rs.

(A) 12%

(B) 13%

(C) 14%

(D) 15%

52. Using the data of above question calculate NPV.

(A) Rs.16,940

(B) Rs.16,409

(C) Rs.16,094

(D) Rs.16,904

53. In a capital rationing situation (investment limit Rs.25 lakhs), suggest the most

desirable feasible combination on the basis of the following data:

Project Initial outlay (Rs. in lakhs) NPV

A 15 6.00

B 10 4.50

C 7.5 3.60

D 6 3.00

Suggest which combination of project should be selected.

(A) A&C

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(B) B&D

(C) C&D

(D) A & B

54. S Ltd. has Rs.10,00,000 allocated for capital

budgeting purposes. Following proposals and associated profitability indexes have

been determined:

Project Amount Rs. Profitability Index

1 3,00,000 1.22

2 1,50,000 0.95

3 3,50,000 1.20

4 4,50,000 1.18

5 2,00,000 1.20

6 4,00,000 1.05

Which of the above investments should be undertaken? Assume that projects are

indivisible and there is no alternative use of the money allocated for capital budgeting

(A) 1,2 & 6

(B) 3, 4 & 5

(C) 2, 4 & 6

(D) 1, 3 & 5

Question 31

Given below are the data on a capital project ‗M‘:

Annual cash inflows Rs 60,000

Useful life 4 years
Internal rate of return 15%
Profitability index 1.064

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 Salvage value 0

You are required to calculate for this project ‘M’

1) Cost of Project
2) Pay Back Period
3) Cost of Capital
4) Net Present Value

PV factors at different rates are given below:

Discount 15% 14% 13% 12%

Factor
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

Question 32

Following are the data on a capital project being evaluated by the management of
Swapnil Ltd:

Particulars Project M
Annual cost saving Rs 40,000
Useful life 4 years
I.R.R 15%
Profitability index (PI) 1.064
NPV ?
Cost of capital ?
Cost of project ?
Payback ?
Salvage value 0

Home Work
Question 33

The PI of a different projects is shown below

Projec PI Initial

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 t Investment
A 1.2 500 Lacks
B 0.7 400 Lacks
C 1.5 300 Lacks
D 1.7 600 Lacks
E 1.1 800 Lacks

Rank the project in the descending order on the basis of NPV.

Question 34

You are required to compute the internal rate of return (IRR) of the project given
below and adviss whether the project should be accepted if the company requires a
minimum return of 17%.

Time Rs
0 (4,000)
1 1,200
2 1,410
3 1,875
4 1,150

Question 35

Given below are the data on a capital project ‗X‘ for Theta Limited for your
consideration:

Annual Cost Saving Rs 60,000

Useful Life 4 years
Internal Rate of Return 15%
Profitability Index 1.064
Salvage Value 0

You are Required to Calculate for Project X:

1) Cost of Project
2) Payback Period
3) Cost of Capital
4) Net Present Value.

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Question 36

Sagar Limited is considering to spend Rs 4,00,000 on a project to manufacture and sell

a new product. The unit variable cost of the product is Rs 6. It is expected that the
new product can be sold at Rs 10 per unit. The annual fixed cost (only cash) will be Rs
20,000. The cost of capital of the company is 15%. The only uncertain factor is the
volume of sales. To start with, the company expects to sell at least 40,000 units during
the first year, Ignore taxation.

You are Required to Calculate:

1) Net Present value of the project based on the sales expected during the first year
and on the assumption that it will continue at the same level during the remaining
years,
2) The minimum volume of sales required to justify the project.

Question 37

Saurab Electronics is considering the proposal of taking up a new project which

requires an investment of Rs 400 lakhs on machinery and other assets. The project is
expected to yield the following earnings (before depreciation and taxes) over the next
five years:

Year (Rs in
Earning Lakhs)
s
1 160
2 160
3 180
4 180
5 150

The cost of raising the additional capital is 12% and assets have to be depreciated at
20% on ‗Written Down Value‘ basis. The scrap value at the end of the five years‘ period
may be taken as zero. Income-tax applicable to the company is 50%.

You are required to calculate the net present value of the project and advise the
management to take appropriate decision. Also calculate the Internal Rate of Return of
the Project.

Note: Present value of Rs 1 at different rates of interest is as follows:

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Year 10% 12% 14% 16%
1 0.91 0.89 0.88 0.86
2 0.83 0.80 0.77 0.74
3 0.75 0.71 0.67 0.64
4 0.68 0.64 0.59 0.55
5 0.62 0.57 0.52 0.48

Question 38

A machine purchased six years back for Rs 1,50,000 has been depreciated to a book
value of Rs 90,000. It originally had a projected life of fifteen years and zero salvage
value. A new machine will cost Rs 2,50,000 and result in a reduced operating cost of Rs
30,000 per year for the next time years. The older machine could be sold for Rs
50,000. The new machine shall also be depreciated on a straight-line method on nine-
year life with salvage value of Rs 25,000.
The company‘s tax rate is 50% and cost of capital is 10%.
Determine whether the old machine should be replaced.
Given: Present Value of Re. 1 at 10% on 9th year = 0.424; and Present Value of an
annuity of Rs 1 at 10% for 8 years = 5.335.

Question 39

Beta Limited receives Rs 15,00,000 a year after taxes from an investment in an

automatic plant that has 12 more years of service life. The company‘s required rate is
12%. Beta Limited can make improvements to the plant to raise its service life to 20
years and its annual after tax cash flow to Rs 48,00,000 per year.

These investments would cost Rs 2,10,00,000. With the improvements, the plant‘s value
at the end of 12 years would rise from Rs 7,50,000 to Rs 75,00,000. Would the
improvements produce a return satisfactory to Beta Limited?

Question 40

A hospital is considering purchasing a diagnostic machine costing Rs 80,000. The

projected life of the machine is 8 years and has an expected salvage value of Rs 6,000
at the end of 8 years. The annual operating cost of the machine Rs 7,500. It is
expected to generate revenues of Rs 40,000 per year for eights years. Presently, the
hospital is outsourcing the diagnostic work and is earning commission income of Rs
12,000 per annum; net of taxes.

Required:

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Whether it would be profitable for the hospital to purchase the machine? Give your
recommendation under:
1) Net Present Value method
2) Profitability Index method.

PV factors at 10% are given below:

Year Year Year Year Year Year Year Year

1 2 3 4 5 6 7 8
0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

Question 41

Akashy Ltd is considering the purchase machine which will perform some operations
which are at present performed by workers. Machines X and Y are alternatives models.

The following details are available:

Machine X Machine Y
Particulars (Rs) (Rs)
Cost of machine 1,50,000 2,40,000
Estimated life of machine 5 years 6 years
Estimated cost of maintenance p.a. 7,000 11,000
Estimated cost of indirect 6,000 8,000
material, p.c.
Estimated saving in scrap p.a. 10,000 15,000
Estimated cost of supervision p.a. 12,000 16,000
Estimated savings in wages pa. 90,000 1,20,000

Depreciation will be charged on straight line basis. The tax rate is 30%. Evaluate the
alternatives according to :
1) Average Rate of Return Method,
2) Present Value Index Method assuming cost of being 10%. (The present value of Rs
1.00 @ 10%. p.a. for 5 years is 3.79 and for 6 years is 4.354)

Question 42

ANP Ltd. is providing the following information:

Annual cost of Rs
saving 96,000
Useful life 5 years
Salvage value Zero
Internal rate of 15%

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 return
Profitability index 1.05

Table of Discount Factor:

Discount factor Years

1 2 3 4 5 Total
15% 0.870 0.756 0.658 0.572 0.497 3.353
14% 0.877 0.769 0.675 0.592 0.519 3.432
13% 0.886 0.783 0.693 0.614 0.544 3.52

You are Required to Calculate:

1) Cost of the Project
2) Pay Back Period
3) Net Present Value of Cash Inflow
4) Cost of Capital.

Question 43

A large profit making company‘s considering the installation of a machine to process the
waste produced by one of its existing manufacturing process to be converted into
marketable product. At present , the waste is removed by a contractor for disposal on
payment by the company of Rs 50 lacs per annum for the next four years. The Contract
can be terminated upon installation of the aforesaid machine on payment of a
compensation of Rs 30 lacs before the processing operation starts. This compensation
is not allowed as deduction for tax purposes.

The machine required for carrying out the processing will cost Rs 200 lacs to be
financed by a loan repayable in 4 equal installments commencing from the end of year 1.
The interest rate is 16% per annum. At the end of the 4th year, the machine can be sold
for Rs 20 lacs and the cost of dismantling and removal will be Rs 15 lacs. Sales and
direct costs of the product emerging form waste processing for 4 years are estimated
as under:

Year 1 2 3 4
Sales 322 322 418 418
Material consumption 30 40 85 85
Wages 75 75 85 100
Other expenses 40 45 54 70
Factory overheads 55 60 110 145
Depreciation (as per income tax 50 38 28 21
rules)

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Initial stock of materials required before commencement of the processing operations
is Rs 20 lacs at the start of year1. The stock levels of materials to be maintained at
the end of year1,2 and 3 will be Rs 55 lacs and the stocks at the end of year 4 will be
nil. The storage of materials will utilise space which would otherwise have been rented
out for Rs 10 lacs per annum.

Labour costs include wages of 40 workers, whose transfer to this process will reduce
idle time payments of Rs 15 lacs in the year 1 and Rs 10 lacs in the year 2. Factory
overheads include per annum payable on this volume. The company‘s tax rate is 50%.

Present value factors for four years are as under:

Year 1 2 3 4
Present value 0.870 0.756 0.658 0.572
factors
Advise the management on the desirability of installing the machine for processing the
waste.
All calculations should from part of the answer.

Question 44

A company has to make a choice between two projects namely A and B. The initial
capital outplay of two Projects are Rs 1,35,000 and Rs 2,40,000 respectively for A and
B. There will be no scrap value at the end of the life of both the projects. The
opportunity Cost of Capital of the company is 16%.
The annual incomes are as under:

Year Project A Project Discounting Factor @

B 16%
1 - 60,000 0.862
2 30,000 84,000 0.743
3 1,32,000 96,000 0.641
4 84,000 1,02,000 0.552
5 84,000 90,000 0.476

You are Required to Calculate for each project:

1) Discounted Payback Period
2) Profitability Index
3) Net Present Value.

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