FINANCIAL MANAGEMENT: AN OVERVIEW shares, debentures, long-term loans, etc. may be preferred.

If funds are
required for working capital purposes then short-term sources like bank
credit, trade credit, factoring, etc. may be used.

Introduction 2. Proper utilization of funds

Another important objective of finance function is proper utilization of funds.
The primary task of Financial Manager is to deal with funds. Management of The funds must be used in such a way that the maximum benefit is derived
funds is an important aspect of Financial Management. In a business undertaking or from them. The returns must be more than their expected cost.
in an educational institution or in a hospital or in an art society or else where
management of funds is the primary concern of the Financial Management. 3. Increasing profitability
When funds are used effectively it may lead to increase in profitability. The
Finance is regarded as the lifeblood of a business enterprise. This is because finance function must ensure availability of sufficient funds at all times.
in the modern money-oriented economy finance is one of the basic foundations of all
kinds of economic activities. Without adequate finance no business can survive or 4. Maximizing concerns value
accomplish its objectives. In general, finance may be defined as the provision of Finance function also aims at maximizing the value of the firm. Usually the
money at the time it is wanted. Thus, finance refers to making provision of money at value of the firm is determined by its profitability. The value of the firm is also
the time when it is required. influenced by other factors such as sources of funds, cost of capital, money
market conditions, etc.
Meaning of Business Finance
Organization Chart of Finance Function
Business finance is that business activity which is concerned with the
acquisition and conservation of capital funds in meeting financial needs and overall The Chief Finance Executive worked directly under the President or the
objectives of a business enterprise. In other words, it refers to the process of raising, Managing Director of the company. Besides routine work, he keeps the Board of
providing and administering of money used in a business concern. Directors informed about all the phases of business activity, including economic,
social and political developments affecting the business behavior. He also furnishes
Wheeler defines business finance as “That Business activity, which is information about the financial status of the company by reviewing it from time to
concerned with the acquisition and conservation of capital funds in meeting the time. The chief finance executive may have different officers under him to carry out
financial needs and over all objectives of business enterprise”. his functions. Broadly, his functions are divided into two: (i) Treasury Functions and
(ii) Control Functions.
In the words of Prather and Wert, “Business Finance deals primarily with
raising, administering and disbursing funds by privately owned business units An Organization Chart of Finance Function in a big organization is given
operating in non-financial fields of industry”. below.

Finance Function ORGANIZATION CHART OF FINANCE FUNCTION

BOARD OF DIRECTORS
Finance Function refers to the providing of funds needed by a business
concern on most suitable terms. In other words, it refers to the raising of funds and
PRESIDENT
their effective utilization. It does not stop only by finding out sources and raising of
funds but it also covers proper utilization of funds.

V.P. (Production) V.P. (Finance) V.P. (Sales)

Objectives of Finance Function

The main aim of finance function is to arrange adequate funds as required by Treasurer Controller
the business enterprise from time to time.
Credit Management Corporate General Accounting
The main objectives of finance function are: - Cash Management Taxes
Banking Relations Internal Audit
1. Acquiring sufficient funds Portfolio Management Budgeting
The main objective of financial function is to estimate the financial needs of
the business and then finding out suitable sources for raising them. If funds
are required for long-term investments then long term sources like issue of

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Meaning & Definition of Financial Management The following arguments are advanced against Profit Maximization: -

The term Financial Management has been defined differently by different a) The term profit is vague and it cannot be precisely defined. It means different
authors. Financial management refers to that part of the management activity, which things for different people.
is concerned with the planning, and controlling of firm’s financial resources. It deals b) Profit maximization objective ignores the time value of money and does not
with finding out various sources for raising funds and most appropriate use of such consider the magnitude and timing of earnings. It treats all earnings as equal
funds. though they occur in different periods.
c) It does not take into consideration the risk of the prospective earning stream.
Thus, financial management is considered as a subject, which deals in d) Profit maximization encourages corrupt practices to increase the profit.
planning and control of financial operations of corporate enterprises. This deals with e) The effect of dividend policy on the market price of shares is also not
the procurement of funds and their effective utilization. considered in the objective of profit maximization.
f) Profit maximization attracts cutthroat competition.
According to Solomon, “Financial Management is concerned with the efficient g) Huge amount of profit may invite government intervention.
use of an important economic resource, namely Capital Funds”.
Wealth Maximization

Objectives of Financial Management Wealth maximization refers to the increase in value of capital of the firm in
terms of market price. This increase in market price is determined by the volume of
The basic objectives of financial management can be broadly classified into capital, the capital structure, the cost of capital and rate of return to the investors.
two categories, namely: -
a) Basic Objectives How to maximize wealth?
b) Other Objectives
In order to maximize wealth, a firm should take the following steps: -
Basic Objectives 1. Avoid high level of risks
The basic objectives of financial management have been The firm should avoid such projects, which involve high profits together with
a) Profit Maximization and high risks.
b) Wealth Maximization
2. Pay Dividends
Profit Maximization Payment of regular dividends increases the firm’s reputation and
consequently the value of the firm’s shares.
Profit earning is the main aim of every economic activity. A business being an
economic institution must earn profit to cover its costs and provide funds for growth. 3. Maintain Growth in sales
No business can survive without earning profit. Profit maximization refers to The firm should have a large, stable and diversified volume of sales. This
increasing the profit of a business organization to the maximum extent possible. In protects the firm from adverse consequences of recessions, changes in
other words, it denotes the maximum profit to be earned by an organization in a customer’s preferences or fall in demand for the firm’s products on account of
given time period. other reasons.

The following arguments are advanced in favor of Profit Maximization: - 4. Maintain price of firm’s equity shares
Maximization of shareholders wealth is closely connected with the
a) When profit earning is the main aim of the business then, profit maximization maximization of the value of the firm’s equity shares. A firm can take a
should be its main objective. number of steps to maintain the value of equity shares at reasonable levels.
b) Profitability is a barometer for measuring efficiency and economic prosperity
of a business enterprise. Advantages of Wealth Maximization
c) Profits are the main sources of finance for the growth and development of a
business. a) Wealth Maximization considers the concept of time value of money.
d) A business will be able to survive under unfavorable situations like recession, b) Wealth Maximization takes care of economic welfare of the owner, which is
depression, sever competition, etc. only if it has some past earnings. reflected in the market share of a company.
e) Profitability is essential for fulfilling social needs also. c) Wealth Maximization also takes care of creditors, employees, public and
f) Profit maximization attracts the investors to invest their savings in securities management.
of the firm. d) Wealth Maximization guides the management in formulating realistic dividend
g) Profit indicates the efficient use of funds of the business concern. policy.
h) The goodwill of the firm is based on profitability

3 4
Disadvantages of Wealth Maximization 4) Dividend decision
Dividend is the portion of earning, which is distribution among the
The Wealth Maximization has been criticized on the following grounds: - shareholders. Dividend policy on the other hand determines the division of
earning between payments to shareholders and retains earnings. Formulation
a) Wealth Maximization is a prescriptive idea. The objective is not descriptive of of a proper dividend policy is one of major financial decision taken by the
what the firms actually do. finance executive.
b) The objective of wealth maximization is not necessarily socially desirable.
5) Working Capital Management
In conclusion, it can be said that the firm should follow the objective of wealth Working capital refers to the excess of current assets over current liabilities.
maximization to a extent it is viable in the context of its social responsibility and In other words, it is net current assets or net working capital. Working capital
constraints imposed by the government. is essential to maintain the smooth running of business. No business can
survive without adequate amount of working capital proper management of
Other Objectives working capital is an important area of financial management.

Besides, the above basic objectives the following are the other objectives of 6) Analysis and Interpretation of Financial Statement
financial management. The analysis and interpretation of financial statements is one of the important
tasks of a financial executive. He is expected to know the short-term, long-
1) Ensuring a fair return to a shareholder. term solvency and profitability of the concern.
2) Building up resource for growth and expansion.
3) Ensuring maximum operational efficiency by efficient and effective utilization 7) Profit planning and control
of finances. Profit planning and control is an important responsibility of a financial
4) Ensuring financial discipline in the organization. management. The profit planning and control also influence the declaration of
dividends, creation of reserves, replacement of assets, redemption of debts,
Functions of Financial Management future productions, future expansions., etc.

At present Financial Management is not restricted to raising and allocating Role of Finance Manager
funds. It also includes the study of financial institutions like stock exchange, capital
markets, etc. Some of the important functions performed by Financial Management The changed business environment has widened the role of a finance
are: - manager. The development of multi-national companies, innovation of information
technology, intense competition, etc. have increased the needs for financial planning
1) Planning the Financial Needs and control. A finance manager is expected to perform the following functions: -
The first task of a financial executive is to determine the finance needs of the
concern. The funds are needed to meet fixed assets and working capital 1) Funds Requirement Decision
needs. The requirement of fixed assets is related to the type of industry. The This is the most important function performed by the finance manager. A
working capital needs depend upon the scale of operation.. careful estimate has to be made about the total funds required for both the
fixed and working capital requirements.
2) Acquisition of Funds
After making the finance forecasting and planning, the next step will be to 2) Financing Decision
acquire funds. The finance executive must find out the various sources This is an important decision for the finance manager. It is concerned with
available for acquiring funds. These sources may be long-term or short-term. determination of the quantum of finance, the amount that can be raised from
The various long-term sources are issue of shares, debentures, long-term each source and the cost and other consequences involved.
loans from financial institutions, etc. The various short-term sources are bank
credit i.e., short-term loans, cash credit, overdraft facilities, discounting of 3) Investment Decision
bills of exchange, trade credit, factoring, lease finance, etc. This comprises decisions relating to investment in both fixed assets and
current assets. The finance manger has to evaluate different capital
3) Investment of Funds investment proposals and select the best keeping in view the overall objective
Investment decision refers to planning the deployment of available capital for of the enterprise.
the purpose of maximization the long-term profitability of the firm. It is the
firm’s decision to invest its current funds most efficiently in long-term 4) Dividend Decision
activities in anticipation of flow of future benefits over a series of year. Capital The establishment of dividend policy is another important function of finance
budgeting decisions are the most crucial and critical business decisions manager. The dividend decision involves the determination of the percentage
because the success or failure of a concern based on these decisions.

5 6
 of profits earned by the enterprise, which is to be paid to shareholders and e) To ascertain the availability of surplus funds for expenses or external
percentage of profits that should be retained as retained earnings. investments.
5) Valuation Decisions f) To ensure availability of sufficient cash for meeting expenditure, emergencies
A number of merger and consolidation take place in the present competitive and fluctuations in the level of working capital.
industrial world. A finance manager must assist the management in making g) To eliminate waste resulting from complexity of operation.
valuations. h) To prepare plans to renew or replace the existing assets.
i) To prepare policies and procedure to co-ordinate various financial operations
Apart from the above main functions, following subsidiary functions are also of the enterprise.
performed by the finance manager: -
Steps in Financial Planning
a) To ensure supply of funds to all parts of the organization
It is also the function of the finance manager to ensure supply of funds to
all parts of the organization to help in smooth operations of the activities Financial Planning involves the following steps: -
of the organization.
1) Estimating Financial Objectives
b) To evaluate Financial Performance The financial objectives of a company i.e., both short-term and long-term
The financial performance of the various units of the organization is to be objectives must be clearly and carefully prepared.
evaluated from time to time to detect any fault in the financial policy.
2) Formulating Financial Policies
c) To negotiate with Banker, Financial Institutions, etc. Financial policies are guides to all actions, which deal with procuring,
The financial executive must negotiate with Banker, Financial Institutions administering, and disbursing the funds of business firms.
and other suppliers of credit.
3) Formulating Procedures
d) To keep track of Stock Exchange The procedures are formed to ensure consistency of actions. The procedures
The financial executive must keep track of stock exchange quotations and follow the formulation of policies.
behavior of stock market prices, etc.
4) Providing for Flexibility
The financial planning should ensure flexibility in objectives, policies and
Financial Planning procedures, so as to adjust according to changing economic situations.

Finance is an important function of business. The application of planning to Principles Governing a Financial Plan
this function is Financial Planning. Financial Planning is mainly concerned with the
economical procurement of funds and profitable use of such funds. The financial plan should be prepared keeping in view the following principles.
A financial plan is a statement of estimating the amount of capital and 1) Simplicity
determining its composition. It states: - A financial plan should be simple and easily understood by everybody. A
complicated financial structure creates complications and confusions.
a) The quantum of finance is the amount needed for implementing the business
plan. 2) Clear Cut Objectives
b) The patterns of financing i.e., the form and proportion of various corporate Financial planning should be done by keeping in view the overall objectives of
securities to be issued to raise the required amount, and the company. The objectives must be clear and unambiguous.
c) The policies to be pursued for the flotation of various corporate securities.
3) Flexibility
Need for Financial Planning The financial plan should not be rigid. It should be flexible i.e., capable of
being adjusted according to the needs and circumstances. Flexibility is helpful
The need for financial planning arises to ensure the following objectives: - in making changes in plan with minimum possible delay.
a) To determine the quantum of finance to be raised.
b) To determine patterns of financing i.e., the form and proportion of various 4) Long-term View
securities. The financial plan should be formulated keeping in view the long-term needs
c) To determine policies to be pursued for the floatation of various corporate of the organization rather than finding out easiest way of obtaining the
securities. original capital.
d) To maintain liquidity throughout the year.

7 8
5) Foresight 5. Define financial management.
The financial plan should be prepared keeping in view the future requirements 6. What is profit maximization?
of capital for the business. 7. What is wealth maximization?
8. What is financial plan?
6) Liquidity 9. Mention the steps in financial plan.
Financial planning should ensure liquidity and solvency of the enterprise. 10. What is financing decision?
Adequate liquidity gives a degree of flexibility too. 11. What is investing decision?
12. What is dividend decision?
7) Contingencies 13. Explain the need for financial planning.
The financial plan should keep in view the requirements of funds for 14. How should the finance function of an enterprise be organized? What
contingencies likely to arise in future. functions are performed by the financial manager in this direction?
15. In what respect is the objective of wealth maximization superior to the profit
8) Economy maximization? Analyze.
The cost of raising the capital should be kept minimum. It should not impose 16. What are the various factors considered while drafting a financial plan for an
any unnecessary burden on the company. This is possible by having a proper industrial concern?
debt- equity mix. 17. What is financial planning? Explain the principles governing a sound financial
planning.
9) Optimum Use 18. Explain the functions of financial management.
The financial plan should provide for meeting the genuine needs of the 19. “Profit maximization is the basic goal of a Finance Manager”. Do you agree?
company. The available funds must be used effectively and efficiently. Discuss.
20. Explain the functions of a Controller and a Treasurer.

Chapter Roundup

 Business Finance refers to that business activity which is concerned with the
acquisition and conservation of capital funds in meeting the financial needs
and overall objectives of business enterprise.

 Finance function refers to the providing of funds by a business concern on

most suitable terms.

 Financial management refers to that part of management activity which is

concerned with planning and controlling of firm’s financial resources. It deals
with finding out various sources for raising funds and most appropriate use of
such funds.

 Profit maximization refers to increase in the profit of a business organization

to the maximum possible extent. In other words, it denotes the maximum
profit to be earned in an organization in a given time period.

 Wealth maximization refers to the increase in the value of capital of the firm
in terms of market price. The increase in market price is determines the value
of capital, capital structure, cost of capital and rate of return to the investors
etc..

Quick Quiz

1. Define business finance.

2. What is meant by finance function?
3. What are the objectives of financial management?
4. What is financial management?

9 10
 FINANCING DECISION
Financial Leverage
Introduction

We have already explained that the basic task of finance manager is the Growth and Stability of Sales
procurement of funds. We have also learnt that basic objective of financial
management is wealth maximization. The finance manager for the procurement of
funds is therefore required to select such a finance mix or capital structure, which
maximizes shareholders wealth. For designing the optimum capital structure he is Cost of Capital
required to select such a mix of sources of finance so that overall cost of capital is
minimum.

Financial Decision is an important decision of a financial executive. It is Nature and Size of a Firm
concerned with determination of the quantum of finance, the amount that can be

FACTORS DETERMINING THE CAPITAL STRUCTURE

raised from each sources and the cost and other consequences involved.
Flexibility
Meaning of Capital Structure

Capital structure refers to the kinds of securities and the proportionate

amounts of each security in the total capitalization of a firm. In other words, it Control
means the composition of long-term sources of funds such as debentures, long-term
loans, preference share capital and equity share capital including reserves and
surplus. In simple words, it represents the mix of different sources of long-term
funds in the total capitalization of the company. Capital Market Conditions

According to Gerestenberg “Capital structure of a company refers to the

composition or make up of its capitalization and it includes all long-term capital Purpose of Financing
resources viz. loans, reserves, shares and bonds”.

Factors determining the Capital Structure

The Period of Finance
The capital structure of a company is to be determined initially at the time of
floating the company, while determining the capital structure the following points
must be kept in view: -
Legal Requirements
1. Financial Leverage

The use of long-term debt and preference share capital along with equity Marketability
share capital is called financial leverage or trading on equity. If the firm uses
more of debts in its capital structure, increases the earning per equity share,
if the firm yields a return higher than the cost of debt. However, leverage can
operate adversely also if the rate of interest on loan is more than the Timing
expected rate of return of the firm.

2. Growth and Stability of Sales

Requirement of Investors
The capital structure of a company is also influenced by the growth and
stability of its sales. If the sales of a company are fairly stable, the company
can use more of debts in its capital structure. Stability of sales ensures easy Provision for Future
payment of interest on debt financing. Similarly, the rate of growth in sales
also affects the capital structure decision.

1 2
3. Cost of Capital 10.Legal Requirements

Cost of capital refers to the minimum return expected by its suppliers. The The finance manager has to keep in view the legal requirements while
capital structure should provide for the minimum cost of capital. While deciding about the capital structure of the company.
formulating a capital structure, an effort must be made to minimize the
overall cost of capital. 11.Marketability

4. Nature and Size of a Firm To obtain a balanced capital structure it is necessary to consider the ability of
the company to market corporate securities.
Nature and size of a firm also influences its capital structure. A concern,
which cannot provide stable earnings due to the nature of its business, will 12.Timing
have to rely mainly on equity share capital. A concern whose earnings are
stable due to the nature of its business can offer to have more of debt Closely related to flexibility is the timing for issue of securities. Proper timing
financing in its capital structure. of the security issue often brings substantial savings because of the dynamic
nature of the capital market. Intelligent management tries to anticipate the
5. Flexibility climate in capital market with a view to minimize the cost of raising funds and
also to minimize the dilution resulting from an issue of new ordinary shares.
Capital structure of a firm should be flexible i.e., it should be capable of being
adjusted according to the needs of the changing conditions. It should be 13.Requirement of Investors
possible to raise additional funds without any difficulty or delay.
Different types of securities are issued to different classes of investors
6. Control according to their requirement.

The capital structure of a company is also influenced by the policy of control. 14.Provision for Future
If the shareholders are not interested in inviting new members to enter the
company, then debt financing is preferable. If the shareholders have no While planning capital structure the provision for future requirement of capital
objection in inviting the new members to enter the company then they can is also required to be considered.
think of raising funds through equity shares.

7. Capital Market Conditions

Capital market conditions are ever changing. Sometimes there may be boom
in the market while at other times there may be depression in the market. If
the share market is in boom, it would be advisable to issue equity shares but
in case of depression the company should go for debt financing.

8. Purpose of Financing

Purpose of financing is another factor that influences the capital structure of a

firm. If funds are required for productive purposes, borrowed funds are
suitable and the company should go for issue of debentures as interest can be
paid out of the profits generated from such investments. However, if funds
are required for unproductive purposes, the company should prefer equity
share capital.

9. The Period of Finance

The period for which finance is required also affects the determination of
capital structure. Incase the funds are required for a long-term requirement
say 8 to 10 years, it will be appropriate to raise borrowed funds. However, if
funds are required more or less permanently, it will be appropriate to raise
them by the issue of equity shares.

3 4
Illustration: 1 Computation of EPS

Determine the EPS of a company, which has an Earnings Before Interest and When Earnings Before Interest and Tax is Rs. 30,000
Tax (EBIT) of Rs. 2,00,000. Its capital structure consists of the following securities. Particulars I II III
 10% Debentures Rs. 6,00,000 EBIT 30,000 30,000 30,000
 12% Preference Shares Rs. 2,00,000 Less: Interest --- --- 5,000
 Equity Shares of Rs. 100 each Rs. 5,00,000 EBT 30,000 30,000 25,000
The company is in the 50% tax bracket. Determine the percentage change in Less: Tax @ 50% 15,000 15,000 12,500
EPS associated with 25% increase and 25% decrease in EBIT. EAT 15,000 15,000 12,500
Less: Preference Dividend --- 6,000 ---
Solution: - Earnings available to Equity Share Holders 15,000 9,000 12,500

Computation of EPS EPS = Earnings available to equity share holders

25% 25% 1 0.9 1.25
Particulars Existing No. of equity shares
Increase Decrease
EBIT 2,00,000 2,50,000 1,50,000 When Earnings Before Interest and Tax is Rs. 40,000
Less: Interest 60,000 60,000 60,000 Particulars I II III
EBT 1,40,000 1,90,000 90,000 EBIT 40,000 40,000 40,000
Less: Tax @ 50% 70,000 95,000 45,000 Less: Interest --- --- 5,000
EAT 70,000 95,000 45,000 EBT 40,000 40,000 35,000
Less: Preference Dividend 24,000 24,000 24,000 Less: Tax @ 50% 20,000 20,000 17,500
Earnings available to Equity Share Holders 46,000 71,000 21,000 EAT 20,000 20,000 17,500
EPS = Earnings available to equity share Less: Preference Dividend --- 6,000 ---
holders / No. of equity shares 9.2 14.2 4.2 Earnings available to Equity Share Holders 20,000 14,000 17,500
5 x 100 -5 x 100 EPS = Earnings available to equity share holders
% increase / decrease in EPS --- 1.33 1.4 1.75
9.2 9.2 No. of equity shares
54.34% -54.34%
Illustration: 3
Illustration: 2
Penta Four Ltd., has currently an all equity share consisting of 15,000 equity
A company ltd. has a share capital of Rs. 1,00,000 divided into Equity shares shares of Rs. 100 each. The management is planning to raise another Rs. 25,00,000
of Rs. 10 each. It has major expansion programme requiring an investment of to finance a major programme of expansion and is considering three alternative
another Rs. 50,000. The management is considering the following alternatives for methods of financing:
raising this amount: - 1) To issue 25,000 Equity Shares of Rs. 100 each.
(i) Issue of 5,000 Equity shares of Rs. 10 each. 2) To issue 25,000, 8% Debentures of Rs. 100 each.
(ii) Issue of 5,000, 12% Preference Shares of Rs. 10 each. 3) To issue 25,000, 8% Preference Shares of Rs. 100 each.
(iii) Issue of 10% Debentures of Rs. 50,000.
The company’s present Earnings before Interest and Tax (EBIT) is Rs. 30,000 The company’s expected earnings before interest and taxes will be Rs.
p.a. You are required to calculate the effect of each of the above modes of financing 8,00,000. Assuming corporate tax rate is 50%. Determine the earnings per share
on the Earnings per Share (EPS) presuming (EPS) in each alternative and comment which alternative is best and why?
a) EBIT continues to be the same even after expansion.
b) EBIT increases by Rs. 10,000. Solution: -
c) Assume tax liability is 50%.
Analysis Table
Solution: - Particulars I II III
Equity Share Capital 40,00,000 15,00,000 15,00,000
Analysis Table 8% Debentures --- 25,00,000 ---
Particulars I II III 8% Preference Shares --- --- 25,00,000
Equity Share Capital 1,50,000 1,00,000 1,00,000 No. of Equity Shares 40,000 15,000 15,000
12% Preference Share capital --- 50,000 ---
10% Debentures --- --- 50,000
No. of Equity Shares 15,000 10,000 10,000

5 6
 Computation of EPS Computation of earning per equity share

Particulars I II III When earnings before interest and tax is Rs.1,20,000

EBIT 8,00,000 8,00,000 8,00,000 Particulars I II III IV
Less: Interest --- 2,00,000 --- EBIT 1,20,000 1,20,000 1,20,000 1,20,000
EBT 8,00,000 6,00,000 8,00,000 Less: Interest --- 50,000 80,000 ---
Less: Tax @ 50% 4,00,000 3,00,000 4,00,000 EBT 1,20,000 70,000 40,000 1,20,000
EAT 4,00,000 3,00,000 4,00,000 Less: Tax 60,000 35,000 20,000 60,000
Less: Preference Dividend --- --- 2,00,000 EAT 60,000 35,000 20,000 60,000
Earnings available to Equity Share Holders 4,00,000 3,00,000 2,00,000 Less: Preference Dividend --- --- --- 50,000
Earnings available to Equity Share
EPS = Earnings available to equity share holders Holders 60,000 35,000 20,000 10,000
10 20 13.33
No. of equity shares EPS = Earnings available to equity
share holders / No. of equity shares 0.3 0.233 0.2 0.067
Conclusion: - Second alternative is considered to be the best alternative because
EPS is more when compared to the other two alternatives. Computation of earning per equity share
When earnings before interest is Rs.2,40,000
Illustration: 4
Particulars I II III IV
X Ltd., capitalized with Rs. 10,00,000 divided in to 1,00,000 Equity Shares of EBIT 2,40,000 2,40,000 2,40,000 2,40,000
Rs. 10 each. The management desires to raise another Rs. 10,00,000 to finance a Less: Interest --- 50,000 80,000 ---
major expansion programme. EBT 2,40,000 1,90,000 1,60,000 2,40,000
Less: Tax 1,20,000 95,000 80,000 1,20,000
There are four possible financing plans: EAT 1,20,000 95,000 80,000 1,20,000
1) All Equity Shares Less: Preference Dividend --- --- --- 50,000
2) Rs. 5,00,000 in Equity Shares and Rs. 5,00,000 in Debentures carrying 10% Earnings available to Equity Share
interest. Holders 1,20,000 95,000 80,000 70,000
3) All debentures carrying 8% interest. EPS = Earnings available to equity
4) Rs. 5,00,000 in Equity Shares and Rs. 5,00,000 in Preference Shares carrying share holders / No. of equity shares 0.6 0.633 0.8 0.47
10% Dividend.
Illustration: 5
The existing EBIT amounts to Rs. 1,20,000 per annum.
1) You are required to calculate earnings per Equity Share under each of the Excellent Ltd., has currently Equity Share capital of Rs. 25,00,000, consisting
above four financial plans. of 25,000 shares of Rs. 100 each. The management is planning to raise another
2) Calculate the earnings per equity share, if on account of expansion the level Rs. 20,00,000 to finance a major programme of expansion through one of the four
of EBIT is doubled. possible financial plans. The options are:

Solution: - 1) All through Equity Shares.

2) Rs. 10,00,000 through Equity Shares and Rs. 10,00,000 through long-term
Analysis Table borrowings at 8% interest per annum.
3) Rs. 5,00,000 through Equity Shares and Rs. 15,00,000 through long-term
Particulars I II III IV borrowings at 9% interest per annum.
Equity Share Capital 20,00,000 15,00,000 10,00,000 15,00,000 4) Rs. 10,00,000 through Equity Shares and Rs. 10,00,000 through Preference
10% Debentures --- 5,00,000 --- --- Shares with 5% Dividend.

8% Debentures --- --- 10,00,000 --- The company’s expected earnings before interest and tax (EBIT) will be
10% Preference Share Capital --- --- --- 5,00,000 Rs. 8,00,000. Assuming a corporate tax rate of 50%, determine the earnings per
No. of Equity Shares 2,00,000 1,50,000 1,00,000 1,50,000 share in each alternative and comment, which alternative is best and why?

7 8
Solution:
Computation of earning per equity share
Analysis Table Particulars I II III IV V
Particulars I II III IV EBIT 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000
Equity Share Capital 45,00,000 35,00,000 30,00,000 35,00,000 Less: Interest --- 1,80,000 1,80,000 3,00,000 3,00,000
8% Long-term Loan --- 10,00,000 --- --- EBT 6,00,000 4,20,000 4,20,000 3,00,000 3,00,000
9% Long-term Loan --- --- 15,00,000 --- Less: Tax @ 35% 2,10,000 1,26,000 1,26,000 1,05,000 1,05,000
5% Preference Share Capital --- --- --- 10,00,000 EAT 3,90,000 2,94,000 2,94,000 2,95,000 2,95,000
No. of Equity Shares 45,000 35,000 30,000 35,000 Less: Preference Dividend --- --- 1,00,000 --- 1,00,000
Earnings available to
Computation of earning per equity share Equity Share Holders 3,90,000 2,94,000 1,94,000 2,95,000 1,95,000
Particulars I II III IV EPS = Earnings available
EBIT 8,00,000 8,00,000 8,00,000 8,00,000 to equity share holders / 7.8 8.4 7.76 11.8 13
Less: Interest --- 80,000 1,35,000 --- No. of equity shares
EBT 8,00,000 7,20,000 6,65,000 8,00,000
Less: Tax @ 50% 4,00,000 3,60,000 3,32,500 4,00,000
EAT 4,00,000 3,60,000 3,32,500 4,00,000 Illustration: 7
Less: Preference Dividend --- --- --- 50,000
Earnings available to Equity Share Firms X and Y are identical expect that Firm X is not levered while, Firm Y is
Holders 4,00,000 3,60,000 3,32,500 3,50,000 levered. The following data relate to them.
EPS = Earnings available to equity
share holders / No. of equity shares 8.89 10.3 11.1 10 Firm X Firm Y
Assets 5,00,000 5,00,000
Conclusion: - Third alternative is best because EPS is more when compared to other Debt Capital 0 2,50,000 [9% Interest]
three alternatives. Equity Share Capital 5,00,000 2,50,000
No. of Shares (50,000) (25,000)
Illustration: 6 Rate of return on assets 20% 20%

A newly established company wishes to determine an appropriate capital Calculate EPS for both the firms assuming tax rate of 50%. Will it be
structure. It can issue 12% debentures and 10% preference capital and the existing advantageous to Firm Y to raise the level of capital to 75%?
tax rate is 35%. The company requires Rs. 50,00,000.
Solution:
The possible capital structure is: Computation of earning per equity share
Plan Debenture Capital Preference Capital Equity Capital Particulars Firm X Firm Y
1. 0 0 100% EBIT 1,00,000 1,00,000
2. 30% 0 70% Less: Interest --- 22,500
3. 30% 20% 50% EBT 1,00,000 77,500
4. 50% 0 50% Less: Tax @ 50% 50,000 38,750
5. 50% 20% 30% EAT 50,000 38,750
Less: Preference Dividend --- ---
The EBIT is 12%. Calculate EPS assuming that the face value per equity share Earnings available to Equity Share Holders 50,000 38,750
is Rs. 100. EPS = Earnings available to equity share holders / No. of
1 1.55
equity shares
Solution:
Calculation of No. of Equity Shares of Firm Y
Analysis Table Assets Rs.
Particulars I II III IV V Assets 5,00,000
Equity Share Capital 50,00,000 35,00,000 25,00,000 25,00,000 15,00,000 9% Debentures 3,75,000
12% Debentures --- 15,00,000 15,00,000 25,00,000 25,00,000 Equity Share Capital 1,25,000
10% Preference --- --- 10,00,000 --- 10,00,000 No. of Equity Shares 12,500
Share Capital
No. of Equity Shares 50,000 35,000 25,000 25,000 15,000

9 10
 Computation of earning per equity share Point of Indifference
Particulars Firm Y
EBIT 1,00,000 Point of indifference refers to that EBIT level at which Earnings per Share
Less: Interest 33,750 (EPS) remains the same irrespective of the Debt and Equity mix. In other words, at
EBT 66,250 this point, the rate of return on capital employed is equal to the rate of interest on
Less: Tax @ 50% 33,125 debt. This is also known as Break even level of EBIT for alternative financial plans.
EAT 33,125 This can be calculated by using the following formula.
Less: Preference Dividend ---
Earnings available to Equity Share Holders 33,125 (X – int1) (1 – T) – PD (X – int2) (1 – T) – PD
EPS = Earnings available to equity share holders / No. of equity shares 2.65 =
S1 S2
Conclusion: - It is advantageous to Firm Y to raise the debt financing to 75%
because it increases the EPS from Rs. 1.55 to Rs. 2.65. Where X = EBIT,
int1 = Interest under first alternative
Illustration: 8 int2 = Interest under second alternative
T = Tax rate
A company needs Rs. 12,00,000 for installation of a new factory, which would PD = Preference Dividend
yield an annual EBIT of Rs. 2,00,000. The company has the objective of maximizing S1 = No. of equity shares under first alternative
the EPS. It is considering the possibility of issuing equity shares plus raising debt of S2 = No. of equity shares under second alternative
Rs. 2,00,000, or Rs. 6,00,000, or Rs. 10,00,000. The current market price per share
is Rs. 40, which is expected to drop to Rs. 25 per share. If the market borrowings Illustration: 9
were to exceed Rs. 7,50, 000. Cost of borrowings is indicated as under: -
Up to Rs. 2,50,000, @10% p.a. A project under consideration by your company requires a capital investment
Rs. 2,50,001 – Rs. 6,25,000 @ 14% p.a. of Rs. 120 lakhs. Interest on term loan is 10% per annum and tax rate is 50%.
Rs. 6,25,001 – Rs. 10,00,000 @ 16% p.a. Calculate the point of indifference for the project if the debt equity ratio insisted by
Assuming a tax rate of 50%, workout the EPS and scheme which would meet the financing agencies is 2:1. Assuming the face value per equity share is Rs. 10.
the objective of the management.
Solution: -
Solution: Analysis Table
Analysis Table
Particulars I II III Particulars I II
Equity Share Capital 10,00,000 6,00,000 2,00,000 Equity Share Capital 120 lakhs 40 lakhs
Debentures 2,00,000 6,00,000 10,00,000 10% Term-loan --- 80 lakhs
No. of Equity Shares 10,00,000 6,00,000 2,00,000 No. of Equity Shares 12 lakhs 4 lakhs
25 40 40
40,000 15,000 5,000 (X – int1) (1 – T) – PD (X – int2) (1 – T) – PD
=
Computation of EPS S1 S2
Particulars I II III
EBIT 2,00,000 2,00,000 2,00,000 (X – 0) (1 – 0.5) – 0 (X – 8) (1 – 0.5) – 0
Less: Interest 20,000 74,000 1,37,500 =
EBT 1,80,000 1,26,000 62,500 12 4
Less: Tax @ 50% 90,000 63,000 31,250
EAT 90,000 63,000 31,250 0.5 X 0.5 X – 4
Less: Preference Dividend --- --- --- =
Earnings available to Equity Share Holders 90,000 63,000 31,250 12 4

EPS = Earnings available to equity share holders 6X – 48 = 2X

2.5 4.2 6.25
No. of equity shares 4X = 48
X = 12 lakhs
Conclusion: - Third scheme maximizes EPS. Therefore, it is considered to be the
best scheme.

11 12
Illustration: 10
(X – int1) (1 – T) – PD (X – int2) (1 – T) – PD
Apple Limited has a total capitalization of Rs. 10,00,000 consisting entirely of =
equity shares of Rs. 50 each. It wishes to raise another Rs. 5,00,000 for expansion S1 S2
through one of its two possible financial plans.
(i) All equity shares of Rs. 50 each. (X – 0) (1 – 0.5) – 0 (X – 5) (1 – 0.5) – 0
(ii) All debentures carrying 9% p.a. interest. =
The present level of EBIT is Rs. 1,40,000 and income tax rate is 50%. 11 10
Calculate EBIT level at which EPS would remain the same irrespective of raising
funds through equity shares or debentures. 0.5 X 0.5 X – 2.5
=
Solution: 11 10
Analysis Table
5.5X – 27.5 = 5X
Particulars I II 5.5X – 5X = 27.5
Equity Share Capital 15,00,000 10,00,000 0.5X = 27.5
9% Debentures --- 5,00,000 X = 55 lakhs
No. of Equity Shares 30,000 20,000
Illustration: 12
(X – int1) (1 – T) – PD (X – int2) (1 – T) – PD
= ‘X’ Limited has the choice of raising an additional sum of Rs. 50,00,000 either
S1 S2 by issue of 10% debentures or by the issue of additional equity shares at Rs. 50
each. The current capitalization structure of the company consists of 1,00,000
(X – 0) (1 – 0.5) – 0 (X – 45,000) (1 – 0.5) – 0 ordinary shares and no debt. At what level of EBIT after the issue of new capital
= would EPS be the same whether the new funds has been raised either by issuing
30,000 20,000 equity shares or by rising through debentures? Assume a tax rate of 50%.

0.5 X 0.5 X – 22,500 Solution:

=
30,000 20,000 Analysis Table

15X – 675000 = 10X Particulars I II

15X – 10X = 675000 Equity Share Capital 100 lakhs 50 lakhs
5X = 675000 10% Debentures --- 50 lakhs
X = 1,35,000 No. of Equity Shares 2 lakhs 1 lakh

Illustration: 11 (X – int1) (1 – T) – PD (X – int2) (1 – T) – PD

=
A company limited has the choice for raising an additional sum of Rs. S1 S2
50,00,000 either by issue of 10% debentures or by issue of additional equity shares
at Rs. 50 each. (X – 0) (1 – 0.5) – 0 (X – 5) (1 – 0.5) – 0
The current capitalization structure of the company consists of 10,00,000 =
equity shares and no debt. At what level of EBIT after the issue of new capital would 2 1
EPS be the same whether the new funds has been raised either by issuing equity
shares or by rising through debentures? 0.5 X 0.5 X – 2.5
=
Solution: 2 1
Analysis Table
Particulars I II
Equity Share Capital 550 lakhs 500 lakhs X – 5 = 0.5X
10% Debentures --- 50 lakhs 0.5X = 5
No. of Equity Shares 11 lakhs 10 lakhs X = 10 lakhs

13 14
 CAPITAL STRUCTURE THEORIES Cost of Equity Capital

Equity and Debt Capital are the two important sources of long-term finance for a Thus, according to net income approach
firm. How much financial leverage should a firm employ? The answer is quite difficult i) The value of the firm will increase if the amount of equity is decreased by
and is based on an understanding the relationship between the financial leverage and firm issue of debentures, bonds, etc.
valuation or financial leverage and cost of capital. To understand the relationship ii) The value of firm will decrease if the amount of debt is decreased by issue
between the financial leverage and firm valuation, there are many approaches have been of additional equity shares.
propounded, some say that there exists a relationship between the two and some state that
there is no relation. The net income approach is illustrated in the following example: -

Net Income Approach Illustration 13

The essence of the net income approach is that the firm can increase its value or a) A Company’s expected annual net operating income (EBIT) is Rs. 50,000. The
lower the overall cost of capital by increasing the proportion of debt in the capital company has Rs. 2,00,000, 10% debentures. The equity capitalization rate (Ke) of
structure. The crucial assumptions of this approach are: - the company is 12.5%. Calculate the value of firm and overall cost of capital.
b) If the firm decided to raise the amount of debentures to Rs. 3,00,000, what will be
 There are no taxes. the value of the firm and overall cost of capital?
 The cost of debt capital is less than the cost of equity. c) If the firm decided to decrease the amount of debentures to Rs. 1,00,000, what
 The use of debt does not change the risk perception of investors. will be the value of the firm and overall cost of capital?

According to this approach capital structure decisions is relevant to the value of Illustration 14
the firm i.e., a change in the capital structure will lead to a corresponding change to the
overall cost of capital as well as the total value of the firm. Consider two Firms X and Y, which are identical in all respects except the degree
of leverage employed by them. The following is the financial data for these two firms.
a) If the degree of the financial leverage as measured by the ratio of debt equity is Firm X Firm Y
increased, then Net Operating Income 2,00,000 2,00,000
- the weighted average cost of capital will decline 10% Debentures --- 50,000
- the value of the firm will increase Cost of Equity 12% 12%
- the market price of equity share will increase
Calculate the value of the firms and overall cost of capital.
b) If the degree of financial leverage as measured by the ratio of debt to equity is
decreased, then Illustration 15
- the overall cost of capital will increase A Company’s expected annual net operating income (EBIT) is Rs. 1,00,000.
- the value of the firm will decrease The company has Rs. 5,00,000, 6% debentures. The equity capitalization rate
- the market price per ordinary share will decrease (Ke) of the company is 10%. Calculate the value of firm and overall cost of
capital.
b) If the firm decided to raise the amount of debentures to Rs. 7,00,000, what will be
Net Income Approach Formula
the value of the firm and overall cost of capital?
The total market value of a firm on the basis of Net income approach can be
ascertained as below Conclusion: - Thus by increasing the debt proportion in the capital structure, the
V=S+D firm is able to increase the value of the firm and lower the overall cost of capital.
Where, V = Value of a firm
S = Market value of equity
D = Market value of debt

S = Earnings available to equity share holders

15 16
Net Operating Income Approach
Illustration 16
Another theory of capital structure is the net operating income approach. This
approach is opposite to the net income approach. According to this approach, the overall (i) A company expects a net operating income of Rs. 2,00,000. It has Rs. 10,00,000; 6%
cost of capital and the value of firm will remain constant for all degrees of leverage i.e., debentures. The overall capitalization rate is 10%. Calculate the value of the firm and
any change in the degree leverage will not lead to any change in the total value of the the equity capitalization rate according to the Net Operating Income Approach.
firm and the market price of shares as well as overall cost of capital is independent of the (ii) If the debenture debt is increased to Rs. 15,00,000; What will be the effect on the
degree of leverage. value of the firm and the equity capitalization rate?

The net operating income approach is based on the following assumptions: - Solution
 The overall cost of capital (Ko) is constant for a degree of debt equity mix;
 The market capitalizes the value of the firm as whole and therefore, the split (i) Net Operating Income = Rs. 2,00,000
between debt and equity is not relevant. Overall Capitalization Rate = 10%
 The use of debt having low cost increases the risk of equity shareholders, this
result in increase in equity capitalization rate. The advantage of debt is set off Net Operating Income
Market value of the firm (V) =
exactly by the increase in the equity capitalization rate. Overall Capitalization Rate
 There are no corporate taxes.
2,00,000
Market value of the firm (V) = = 20,00,000
a) The value of the firm V = 10%
EBIT Earnings before interest and tax
OR
Ke Cost of equity capital Market Value of firm 20,00,000
Here the market value evaluates the firm as a whole and the split of capitalization Less: Market Value of debentures 10,00,000
between debt and equity is not significant. Market Value of Equity (S) 10,00,000

b) The residual value of equity S = V – D; Earnings available to Equity Share holders EBIT – Int.
Cost of Equity (Ke) = or
Where, V = Value of the firm Market Value of Equity V–D
D = Value of debt
S = Market value of equity 2,00,000 – 60,000
Cost of Equity (Ke) = = 14%
10,00,000
According to this approach, there is nothing like optimum capital structure as the
total value of the firm remains constant. However, any capital structure will be optimum (ii) If the debenture debt is increased to Rs. 15,00,000
as per net operating income approach. Market Value of firm 20,00,000

Earnings available to Equity Share holders EBIT – Int.

Cost of Equity (Ke) = or
Market Value of Equity V–D

2,00,000 – 90,000
Cost of Equity (Ke) = = 22%
5,00,000

The Traditional Approach

According to this theory, the value of firm can be increased or the overall cost of
capital can be decreased by using more of borrowed funds than equity. This is because
the cost of debt is cheaper than the cost of equity. After this stage, the value of firm or the
overall cost of capital remains more or less unchanged for moderate increase in borrowed
funds. Thus, the optimum capital structure can be reached by a proper debt equity mix.

17 18
Thereafter, the value of firm decreases and overall cost of capital increases beyond a Modigliani & Miller Approach
certain point. Thus, the Traditional Approach implies that the cost of capital is not
independent of the capital structure of the firm and that there is an optimal capital Modigliani & Miller in their paper have stated that the relationship between
structure. Leverage and Cost of Capital is explained by the net operating income approach in terms
of 3 basic propositions. They argue against the traditional approach by offering
The traditional view point on the relationship between the Leverage, Cost of behavioral justification for having the cost of capital remain constant throughout all
Capital, and Value of Firm has been explained in the following illustration. degrees of Leverage.

Illustration 17 The M & M Approach is based upon the following assumptions.

Compute the value of the firm, market value of equity and the overall cost of a) There is no corporate or personal income tax.
capital from the following details. b) Investors are assumed to be rational and behave accordingly i.e., choose a
combination of risk and return that is most advantageous to them.
Net Operating Income 3,00,000 c) There is perfect capital market, information is cost less and readily available to all
Total Investment 15,00,000 investors.
Equity Capitalization Rate d) There are no transaction costs and all securities are infinitely divisible.
(i) If the firm uses no debt 10% e) All earnings are distributed to Share Holders.
(ii) If the firm uses Rs. 6,00,000 debt 11% f) Firms can be grouped into “equivalent return” classes on the basis of their
(iii) If the firm uses Rs. 9,00,000 debt 13% business risks. All firms falling into one class have the same degree of business
risk.
Assume that Rs. 6,00,000 debt can be raised at 5% whereas Rs. 9,00,000 debt can
be raised at 6% rate of interest. M & M Approach in the absence of corporate taxes has been explained with the
following illustration. According to them, the value of an un-levered firm can be
Solution calculated as:

Computation of the Market Value of Firm, Overall Cost of Capital & Market Value Net Operating Income EBIT
Value of Un-Levered Firm (Vu) = =
of Equity Overall Capitalization Rate Ko
No Debt Rs. 6,00,00 debt Rs. 9,00,000 debt
at 5% at 6%
Net Operating Income 3,00,000 3,00,000 3,00,000 Net Operating Income EBIT
Value of Levered Firm (VL) = =
Less: Interest 30,000 54,000 Overall Capitalization Rate Ko
Earnings available to 3,00,000 2,70,000 2,46,000
Equity Share Holders Value of Levered Firm (VL) = Vu + tD
Equity Capitalization Rate 10% 11% 13%
Market Value of Shares 3,00,000 / 0.10 2,70,000 / 0.11 2,46,000 / 0.13 a
30,00,000 24,54,545 18,92,308 Where , Vu = Value of Un-Levered Firm
Market Value of Debt ---- 6,00,000 9,00,000 VL = Value of Levered Firm
Market Value of Firm 30,00,000 30,54,545 27,92,308 t = Tax Rate
Overall cost of Capital 3,00,000 / 3,00,000 / 3,00,000 / D= Debt Capital
EBIT / V 30,00,000 = 10% 30,54,545 = 27,92,308 = 10.7%
9.8 % Illustration 18

A company has earnings before Interest & Taxes of Rs. 1,25,000. It expects a
From the above table it is clear that if the firm uses debt. of Rs. 6,00,000; the
return on its investment at a rate of 12.5%. You are required to find out the total value of
value of firm increases and overall cost of capital decreases. But if more debt is used; that
the firm according to M & M Theory.
is Rs. 9,00,000 debt, and the overall cost of Capital Increases.

19 20
 Net Operating Income EBIT
Value of Un-Levered Firm (Vu) = = Chapter Roundup
Overall Capitalization Rate Ko

1,25,000  Financing decision is concerned with the determination of the quantum of

Value of Un-Levered Firm (Vu) = = 10,00,000 finance, the amount that can be raised from each source and the cost and
O.125 other consequences involved.

The value of levered and un-levered firms under the M & M Approach (Assuming that  Capital structure refers to the composition of long term sources of funds such
corporate taxes exist) can be calculated as as Debentures, Long-term Loans, Preference Share Capital and Equity Share
Capital including Reserves and Surplus.
Net Operating Income EBIT
Value of Un-Levered Firm (Vu) = = (1 – t)  Earnings per share refer to expressing the relationship between net profit
Overall Capitalization Rate Ko
available to equity shareholders and the number of equity shares.

 Point of indifference refers to that EBIT level at which Earnings Per Share
Value of Levered Firm (VL) = Vu + tD (EPS) remains the same irrespective of the Debt and Equity mix. In other
words, at this point, the rate of return on capital employed is equal to the
rate of interest on debt.
Illustration 19
There are 2 firms A & B which are exactly identical except that A does not use  The capital structure is said to be optimal capital structure when the firm has
any debt in its financing while B has Rs. 5,00,000; 5% debentures in its capital structure. selected such a combination of equity and debt so that the wealth of the firm
is maximum. At this capital structure, the cost of capital is minimum and
Both the firms having earnings before tax and the equity capitalization rate is 10%. market price per share is maximum.
Assuming the corporate tax rate of 50%, calculate the value of the firms using M & M
Approach.
Solution Quick Quiz
The market value of firm A which does not use any debt

Net Operating Income EBIT

Value of Un-Levered Firm (Vu) = = (1 – t) 1. What is Financing Decision?
Overall Capitalization Rate Ko 2. Define Capital Structure.
3. What is Optimal Capital Structure?
1,25,000 4. What is Point of Indifference?
Value of Un-Levered Firm (Vu) = x (1 – 0.5) = 6,25,000 5. Give the meaning of Earnings per Share.
0.10
6. Briefly explain the factors which influence the planning of the Capital
Structure of a Company.
The market value of firm B which uses debt financing of Rs. 5,00,000 7. The capital structure of X ltd. consists of the following securities: -
 10% Debentures Rs. 5,00,000
 12% Preference Shares Rs. 1,00,000
 Equity Shares of Rs. 100 each Rs. 4,00,000
Value of Levered Firm (VL) = Vu + tD Operating Profit (EBIT) of the company is Rs. 1,60,000 and the company is in
50% tax bracket.
(i) Determine the company’s EPS
(ii) Determine the percentage change in EPS associated with 30% increase
Value of Levered Firm (VL) = 6,25,000 + 0.5 (5,00,000) and 30% decrease in EBIT.
(iii) Determine the degree of Financial Leverage.
8. Don’t worry ltd. needs Rs. 24,00,000 for the installation of a new factory,
= 8,75,000. which would yield an annual EBIT of Rs. 5,00,000. it is considering the
possibility of issuing equity share plus raising a debt of Rs. 4,00,000, Rs.
12,00,000 and Rs. 20,00,000. The current market price of equity share is Rs.
40, which is expected to drop to Rs. 25 per share of the market borrowing
here to exceed Rs. 15,00,000 costs of borrowed capital indicated as follows.
Up to Rs. 5,00,000 12% p.a.

21 22
 Between Rs. 5,00,000 & Rs. 12,50,000 16% p.a.
Between Rs. 12,50,000 & Rs. 20,00,000 16% p.a.
Assuming the tax rate of 50%, calculate the earnings per share and indicate
the scheme that would yield maximum EPS.
9. A ltd. company has equity share capital of Rs. 5,00,000 divided into shares of
Rs. 100 each. It wishes to raise further Rs. 3,00,000 for expansion cum
modernization plans. The company plans the following financing schemes.
(a) All common stock
(b) Rs. 1,00,000 in common stock and Rs. 2,00,000 in debt at 10% per
annum.
(c) All debt at 10% per annum.
(d) Rs. 1,00,000 in common stock and Rs. 2,00,000 in preference share
capital at 8%.
The company’s existing EBIT is Rs. 1,50,000. The corporate tax rate is 50%.
Determine the earnings per share in each plan and comment on the
implication of financial leverage.
10. ‘X’ Ltd. is considering three financial plans. The key information is as follows:
(a) Total investment to be raised Rs. 2,00,000.
(b) Plans of financing proportion.
PLANS EQUITY DEBT PREFERENCE
SHARES
A 100% –– ––
B 50% 50% ––
C 50% –– 50%
(c) Cost of Debt 8%, Cost of Preference Shares 8%.
(d) Tax rate 50%.
(e) Equity shares of the face value of Rs. 10 each
(f) Expected EBIT is Rs. 80,000
Determine earnings per share for each plan.
11. It is proposed to start a business requiring a capital Rs. 10,00,000 and
assured return of 15% on investment. Calculate EPS if: -
(i) The entire capital is raised by means of Rs. 100, equity shares.
(ii) If 50% is raised from equity shares and 50% of capital is raised by
means of 10% debenture.
12. A new project under consideration by your company requires a capital
investment of Rs. 150 lakhs. Interest on term-loan is 12% and tax rate is
50%. If the debt equity ratio insisted upon by financing agencies is 2:1.
Calculate point of indifference for the project assuming that the face value of
equity share is Rs. 10 per share.
13. Wal-Mart Stores with total capitalization of Rs. 10,00,000 consisting of
entirely equity share capital has before it two choices to meet the additional
capital needs of Rs. 15,00,000.
You are required to calculate the point of indifference in each of the following
cases assuming 35% of corporate tax rate and face value of equity shares of
Rs. 100.
(i) Equity capital of Rs. 15,00,000 or Rs. 7,50,000, 10% Debenture and Rs.
7,50,000 of Equity Capital.
(ii) Equity capital of Rs. 15,00,000 or Rs. 7,50,000 equity capital and Rs.
7,50,000, 15% Preference Shares.
14. A project under consideration by a company requires a capital investment of
Rs. 75,00,000. Interest on term loan is 10% and tax rate is 50%. Calculate
the point of indifference for the project if the debt equity ratio insisted by the
financing agencies is 2:1.

23 24
 INVESTMENT DECISION Significance of Capital Budgeting

Introduction Capital Budgeting decisions are the most crucial and important business
decisions. The need, significance or importance of capital budgeting arises mainly
due to the following:
The investment and financing of funds are two crucial functions of finance
manager. The investment of funds requires a number of decisions to be taken in a a) Substantial Expenditure: - Capital budgeting decisions involve the
situation in which, funds are invested and benefits are expected over a long period. investment of substantial amount of funds. Therefore, it is necessary that the
The finance manager of a concern has to decide about the assets composition of the firm should carefully plan its investment programme so that funds are put to
firm. The assets of the firm are broadly classified into two categories namely fixed most profitable use.
assets and current assets. The aspect of taking the financial decision with regard to
fixed assets is known as investment decision or capital budgeting. b) Long-term Commitment of Funds: - Capital budgeting decisions have its
effect over a long period of time. These decisions not only affect the future
Investment decision is a long-range financial decision. This is concerned with benefits and costs of the firm but also influence the rate and direction of the
the allocation of Capital. In other words, this comprises decision relating to growth of the firm. The effects of capital budgeting decisions extend into the
investment in fixed assets. It is the most important financial decision, since the funds future.
involve cost and are available in a limited quantity to achieve the goals of
management. c) Irreversible Nature: - Capital budgeting decisions are of irreversible in
nature. Once they are taken, the firm may not be in a position to reverse
Capital Budgeting them back. This is because as it is difficult to find a buyer for the second-hand
capital items.
Capital Budgeting refers to planning the deployment of available capital for
the purpose of maximizing the long-term profitability of a firm. It is the firm’s d) Most Difficult Decision: - The capital investment decisions involve an
decision to invest its current funds most efficiently in the long-term activities in accurate assessment of future events, which infact is difficult to predict.
anticipation of flow of future benefits over a series of years. Charles T Horngreen has Further, it is quite difficult to estimate in quantitative terms all the benefits or
defined capital budgeting, as “Capital Budgeting is long-term planning for making the costs relating to a particular investment decision.
and financing proposed capital outlays”. In the words of lynch, “Capital Budgeting
consists in planning deployment of available capital for the purpose of maximizing e) Long-term effect on profits: - Capital budgeting decisions have a long-
the long-term profitability of the concern.” term effect on the profitability of a concern.

Features of Capital Budgeting Phases of Investment Decisions

Capital Budgeting decisions have the following features: - It is important for the finance manager to have an understanding of the
various stages of capital budgeting. The capital budgeting process can be divided
a) Capital Budgeting decisions involve the exchange of current funds for the into seven significant phases: -
benefits to be achieved in future.
b) The future benefits are expected to be realized over a series of years. 1. Finding Investment Opportunities: - Before investment, opportunities can
c) The funds are invested in long-term activities. be evaluated, they must first be identified. Since the long-term profitability of
d) They have a long-term effect on the profitability of the concern. most companies depends on the nature and quality of their capital
e) They generally involve huge funds. investments, locating appropriate projects is particularly important. Certain
f) The capital budgeting decisions are irreversible. capital expenditures can result from the strategic planning process.
g) They have the effect of increasing the capacity, efficiency or economy of Employees are another source of ideas and they should be encouraged to
operation of existing fixed assets. submit proposals.

2. Collect Information about Opportunities: In order to effectively evaluate

investment opportunity, the expected cash flows from project must be
estimated and the total outlay necessary to place the investment in operative
form must be determined. In addition, a plan for implementing the
opportunity must be developed and other non-financial information must be
assembled.

1 2
 3. Select Discount Rate: Before the cash flows can be evaluated, the discount capital investment plays a very significant role in forcing capital decisions on a
rate must be established. firm.

4. Financial Analysis of Cash Flows: In this phase, the techniques of capital 3. Demand Forecast: The long run forecast of demand is one of the
budgeting are applied to the estimated cash flows developed in the second determinant of investment decision. If it is found that there is a market
phase. potential for the product in the long run, the dynamic firm will have to take
decisions for capital expansion.
5. Decision: Before the final decision is made as to the selection of a particular
investment, many factors must be given consideration. The financial analysis 4. Fiscal Policy: Various tax policies of the government such as rebate on new
of cash flows is one of the most important factors, but there are other factors investment, method of allowing depreciation, tax concessions on investment
that may outweigh the most favorable cash flow. These factors social impact income etc. also have favorable influence on capital investment.
to other aspects of the company operations and long-term goals, the timing
of the cash flows, the availability of funds for investment purposes, and the 5. Cash Flows: Every firm makes a cash flow budget. Its analysis influences
impact the opportunity will have on the financial structure of the company. capital investment decisions. With its help, the firm plans the funds for
acquiring the capital asset. The budget also shows the timing of availability of
6. Project Implementation: - Once the decision has been made to invest cash flows for alternative investment proposals.
funds, more detailed plans for making the project operational are developed.
Responsibility for implementing the project is assigned and the necessary 6. Type of Management: The capital investment decisions are also influenced
steps are taken to get the project underway. The time involved in by the type of management. Whether the capital investment decision would
implementing the project naturally varies. For major expansions, where be encouraged or not depends to a large extent on the view point of the
additional facilities must be constructed, it may take several years, whereas management. If the management is modern and progressive in its outlook,
some equipment replacements can be made in a matter of days. the innovations will be encouraged.

7. Project Evaluation and Appraisal: - An important, but often omitted phase 7. Returns Expected from the Investment: In most of the cases, investment
of capital budgeting is an assessment of how effective the investment actually decisions are made in anticipation of future returns. While evaluating
is? The evaluation may be in the form of continuous monitoring of the project investment proposals, it is therefore essential for the firm to estimate future
so that corrective action can be taken. returns.

Factors Influencing Investment Decision 8. Non-Economic Factors: Sometimes, non-economic factors also influence
investment decisions, for example – an investment to improve the working
Capital Investment Decision are only concerned with the replacement of old place may result in reduction in absenteeism and improved productivity.
equipment by a new one, but also with changing technology, products, processes, Investment in a mission ensuring greater safety in operation would similarly
organization, and so on, to make the entire system more efficient. Consequently, improve production by avoiding injury to the workers.
there are a number of factors which, directly or indirectly influence a capital
investment decision. The main factors are discussed below. Techniques of Evaluation of Investment

1. Technological Change: In modern times, one often finds fast obsolescence There are many methods for evaluating capital investment proposals. In
of technology. New technology, which is relatively more efficient, takes the every method, the basic approach is to compare the benefits derived from the
place of old technology. However, in taking a decision of this type the project with the investment in the project.
management has to consider the cost of new equipment vis-à-vis the
productive efficiencies of the new as well as the old equipments. However, These methods can be broadly classified as follows: -
while evaluating the cost of the equipment the management should not take
into account, its full accounting cost but its incremental cost. Also the cost of A) Traditional methods:
new equipment is often partly offset by the salvage value of the replace 1) Payback period method and
equipment. 2) Accounting rate of return method.

2. Competitors Strategy: Many a time an investment is taken to maintain the B) Discounted cash flow methods:
competitive strength of a firm. If the competitors are installing new 1) The net present value method
equipment to expand output or to improve quality of their products, the firm 2) The internal rate of return method and
under consideration will have no alternative but to follow suit, else it will 3) The profitability index method.
perish. It is, therefore often found that the competitive strategy regarding

3 4
1. Payback Period Method Illustration: 2

The payback period method is one of the simplest and traditional methods of A project requires Rs. 2,50,000 as initial investment and it will generate an
capital investment evaluation technique. It is defined as “the initial outlet required annual cash inflow of Rs. 42,000 for eight years. What is the payback period?
divided by gross earnings”. In other words, the term payback period refers to the
time in which the project will generate the necessary cash to recover the initial Solution: -
investment. Original Investment
Payback Period =
Advantages of Payback Period Annual Cash Inflow

1) This method is easy to compute and simple to understand. 2,50,000

2) It enables quick ascertainment of degree of risk. Payback Period = = 6 years
3) It enables the firm to select a project that will yield a quick return of cash if it 42,000
is short of cash.
4) This method of project appraisal is suitable when management is risk averse Illustration: 3
or concerned with early recovery of investment, or when the industry is
subject to fast obsolescence of technology or products. ABC Company Ltd., is considering 2 alternative machines, first alternative
5) This method is of great help in those industries which are subject to rapid costs Rs. 12,000 and estimated annual cash inflow from it amounts to Rs. 4,000. Its
technological changes as it reduces the possibility of loss through economic life is 5 years. The Second alternative costs Rs. 10,000 and its estimated
obsolescence. cash inflow is also Rs. 4,000 p.a. its economic life is however, only 4 years. Advise
the management by using pay back period model.
Disadvantages of Payback Period
Solution: -
1) This method ignores the time value of money. lnitial Investment
2) It does not take into consideration the income after the payback period. Payback Period =
3) Profitable projects maybe foregone under this method, for fear of liquidity. Annual Cash Inflow

Computation of Payback Period 12,000

First alternative = = 3 years
The payback period can be calculated as follows: - 4,000

In case of constant annual cash inflows 10,000

Second alternative = = 2.5 years
If the project generates constant annual cash inflows, the payback period can 4,000
be calculated by using the following formula:
Illustration: 4
Original Investment
Payback Period = A company is considering expanding its production. It can go in either for an
Annual Cash Inflow automatic machine costing Rs. 4,48,000 with an estimated life of 6 years or an
ordinary machine costing Rs. 1,20,000 having an estimated life of 8 years. The
Illustration: 1 annual sales and costs are estimated as follows: -

A project requires an initial investment of Rs. 1,00,000 and yields annual cash Automatic Machine Ordinary Machine
inflow of Rs. 20,000 for ten years. What is the payback period? Rs. Rs.
Sales 3,00,000 3,00,000
Solution: - Costs:
Original Investment Materials 1,00,000 1,00,000
Payback Period = Labor 24,000 1,20,000
Annual Cash Inflow Variable Overheads 48,000 40,000

1,00,000 Calculate payback period and advice the management.

Payback Period = = 5 years
20,000

5 6
Solution: Solution: -
Calculation of annual cash inflow
Calculation of annual cash inflow
Automatic Ordinary
Machine Machine Old New
Rs. Rs. Machine Machine
A. Sales 3,00,000 3,00,000 Rs. Rs.
B. Variable Costs: A. Sales 60,000 90,000
Materials 1,00,000 1,00,000
Labour 24,000 1,20,000 B. Costs:
Variable Overheads 48,000 40,000 Direct Material 24,000 36,000
Total Variable Costs 1,72,000 2,60,000 Wages 6,000 10,500
Power 2,000 4,500
Annual Cash Inflow (A – B) 1,28,000 40,000 Consumable Stores 6,000 7,500
Other charges 8,000 9,000
lnitial Investment Depreciation 4,000 6,000
Payback Period = Total Cost 50,000 73,500
Annual Cash Inflow Profit before Tax (A – B) 10,000 16,500
Less: Tax @ 50% 5,000 8,250
Automatic Machine Profit after Tax 5,000 8,250
4,48,000 Add: Depreciation 4,000 6,000
Payback Period = = 3.5 years Annual Cash Inflow 9,000 14,250
1,28,000
Calculation of Payback Period
Ordinary Machine
1,20,000
Payback Period = = 3 years lnitial Investment
40,000 Payback Period =
Annual Cash Inflow
Conclusion: Ordinary machine is preferable because its payback period is
less when compared to that of Automatic machine. Old Machine

Illustration: 5 40,000
Payback Period = = 4.44 years
The directors of Alpha limited are contemplating the purchase of a new 9,000
machine, which has been in operation in the factory for the last 5 years. Ignoring
interest but considering tax at 50% of net earnings, suggest which of the two New Machine
alternatives should be preferred using payback period method. The following are the
details. 60,000
Old Machine New Machine Payback Period = = 4.21 years
Purchase Price Rs. 40,000 Rs. 60,000 14,250
Estimated life of machine 10 years 10 years
Machine running hours per annum 2,000 2,000
Conclusion: New machine is preferable because its payback period is less as
Units per hour 24 36
compared to that of Old machine.
Wages per running hour Rs. 3 Rs. 5.25
Power per annum Rs. 2,000 Rs. 4,500
Consumable stores per annum Rs. 6,000 Rs. 7,500
All other charges per annum Rs. 8,000 Rs. 9,000
Material cost per unit Re. 0.50 Re. 0.50
Selling price per unit Rs. 1.25 Rs. 1.25
You may assume that the above information regarding sales and cost of sales
will hold well throughout the economic life of each of the machines.

7 8
Illustration: 6 Illustration: 7

X Limited is considering the purchase of a new machine, which would carry Someshwar Industries Ltd. is considering the purchase of a new machine,
out some operations at present being performed by manual labour. Two alternative which would carry out some operations at present being performed by hands. The
models under consideration are A and B. Following is the information. two alternative models under consideration are camelex and shreelex.

Particulars Machine A Machine B The following information is available in respect of both models:
Cost of machines 1,50,000 2,50,000
Expected life in years 5 6 Particulars Camelex Shreelex
Cost of indirect material per annum 6,000 8,000 Cost of machines Rs. 6,00,000 Rs. 10,00,000
Estimated savings in scrap per annum 10,000 15,000 Estimated life in years 10 12
Additional cost of maintenance per annum 19,000 27,000 Estimated savings in scrap per annum Rs. 40,000 Rs. 60,000
Estimated savings in wages: Additional cost of supervision per annum Rs. 48,000 Rs. 64,000
Employees not required (Nos.) 150 200 Additional cost of maintenance per annum Rs. 28,000 Rs. 44,000
Wages per employee per annum (Rs.) 600 600 Cost of indirect materials per annum Rs. 24,000 Rs. 32,000
Estimated savings in wages:
Tax is to be regarded as 50% (Ignore depreciation for calculating Tax). Using Wages per worker per annum Rs. 2,400 Rs. 2,400
“Payback period” suggest which model should be purchased.
Number of workers not required 150 200
Solution: -
Using the method of payback period, suggest which model should be
purchased.
Calculation of Annual Cash Inflow
Solution:
Particulars Machine A Machine B
Savings in scrap 10,000 15,000 Calculation of Annual Cash Inflow: -
Estimated savings in wages 90,000 1,20,000 Particulars Camelex Shrilex
TOTAL ESTIMATED SAVINGS 1,00,000 1,35,000 A. Estimated Annual Savings Rs. Rs.
Cost of indirect material 6,000 8,000 Savings in scrap 40,000 60,000
Additional cost of maintenance 19,000 27,000 Savings in wages 3,60,000 4,80,000
TOTAL ANNUAL EXPENDITURE 25,000 35,000 Total estimated savings 4,00,000 5,40,000
E.B.T (Savings – Expenditure) 75,000 1,00,000 B. Estimated Annual Expenses
Less: Tax at 50% 37,500 50,000 Additional cost of supervision 48,000 64,000
ANNUAL CASH INFLOW 37,500 50,000 Additional cost of maintenance 28,000 44,000
Cost of indirect material 24,000 32,000
Total estimated annual expenses 1,00,000 1,40,000
Computation of Payback Period:
Annual cash inflow (A – B) 3,00,000 4,00,000
Initial Investment 1,50,000 2,50,000
Payback period = =
Annual cash inflow 37,500 50,000 Computation of Payback Period:
4 years 5 years Camele Shrilex
x
On the basis of payback period, Model A is preferable because its payback Initial Investment 6,00,000 10,00,000
period is less as compared to Model B. Payback period = =
Annual cash inflow 3,00,000 4,00,000

2 years 2.5 years

Conclusion: Model Camelex has a shorter pay back period hence, it is to be

purchased.

9 10
Concept of Cash Inflow Illustration: 9

The term cash inflow refers to earnings after tax but before depreciation Ganesh and Company is considering the purchase of a machine. Two
Cash inflow=Earnings after Tax + Depreciation. machines X and Y each costing Rs. 50,000 is available. Earnings after taxation are
This can be calculated as follows: - expected to be as under. Calculate Payback Period.

Case 1: - If profit after tax but before depreciation is given: Year Machine X Machine Y
This it is called cash inflow. Rs. Rs.
Case 2: - If profit after tax is given: 1 15,000 5,000
Cash Inflow = PAT + Depreciation. 2 20,000 15,000
Case 3: - If profit before tax is given: 3 25,000 20,000
Cash Inflow = PBT – Tax = PAT + Depreciation. 4 15,000 30,000
Case 4: - If profit before depreciation and tax is given: 5 10,000 20,000
Cash Inflow = PBDT – Depreciation = PBT – Tax = PAT + Depreciation.
Solution: -
Illustration: 8
Calculation of Payback Period
A company has an investment opportunity costing Rs. 40,000 with the Year EAT Dep. Cash Cumulative EAT Dep. Cash Cumulative
following expected net cash flows after taxes but before depreciation. (X) Inflow Cash (Y) Inflow Cash
Inflow (x) Inflow (y)
Year 1 to 5 Rs. 7,000 each year 1 15,000 10,000 25,000 25,000 5,000 10,000 15,000 15,000
Year 6 to 9 Rs. 8,000 each year 2 20,000 10,000 30,000 55,000 15,000 10,000 25,000 40,000
3 25,000 10,000 35,000 90,000 20,000 10,000 30,000 70,000
Determine the payback period. 4 15,000 10,000 25,000 1,15,000 30,000 10,000 40,000 1,10,000
5 10,000 10,000 20,000 1,35,000 20,000 10,000 30,000 1,40,000
Solution: -
Payback Period X = 1 year + (25,000 / 30,000) = 1 year and 10 months
Calculation of Payback Period
Payback Period Y = 2 years + (10,000 / 30,000) = 2 years and 4 months
Year Cash Inflow Cumulative Cash Inflow Illustration: 10
Rs. Rs.
1 7,000 7,000 A Limited Company is considering investment in a project requiring a capital
2 7,000 14,000 outlay of Rs. 2,00,000. Forecast for annual income after depreciation but before tax
3 7,000 21,000 is as follows:
4 7,000 28,000 Income after depreciation
5 7,000 35,000 Year
before tax [Rs.]
6 8,000 43,000 1 1,00,000
7 8,000 51,000 2 1,00,000
8 8,000 59,000 3 80,000
9 8,000 67,000 4 80,000
5 40,000
Payback Period = 5 years + (5,000/8,000)
= 5 years, 7 months and 13 days. Depreciation may be taken as 20% on original cost and taxation at 50% of
net income. You are required to evaluate the project by the method of payback
period.

11 12
Solution: - Illustration: 12

Calculation of Payback Period The following information is available pertaining to Machine X

Initial investment Rs. 10,00,000
Cash Inflow Cum. Required rate of return – 10%
Year EBT TAX EAT
(EAT + Dep.) Cash Inflow Cash inflows in various years
1. 1,00,000 50,000 50,000 90,000 90,000
2. 1,00,000 50,000 50,000 90,000 1,80,000 Cash Inflows
3. 80,000 40,000 40,000 80,000 2,60,000 Year
Rs.
4. 80,000 40,000 40,000 80,000 3,40,000 1 1,00,000
5. 40,000 20,000 20,000 60,000 4,00,000 2 4,00,000
3 6,00,000
Payback Period = 2 years + (20,000/80,000) 4 6,00,000
= 2 years and 3 months. 5 2,00,000

Illustration: 11 Calculate:
a) Payback period ignoring the interest factor.
A company is considering an investment proposal to install a new machine. b) Payback period taking into account the interest factor.
The machine will cost Rs. 50,000 and will have a life of 5 years and no salvage value.
The company’s tax rate is 50%. The company uses straight-line method of Solution: -
depreciation. The estimated net income before depreciation and tax from the
proposed investment proposal is as follows: 1. Calculation of Payback Period ignoring interest factor.

Year Rs. Cumulative

1 10,000 Year Cash Inflows
Cash Inflow
2 11,,000 1 1,00,000 1,00,000
3 14,,000 2 4,00,000 5,00,000
4 15,,000 3 6,00,000 11,00,000
5 25,,000 4 6,00,000 17,00,000
5 2,00,000 19,00,000
Calculate Payback Period.
Payback Period = 2 years + (5,00,000/6,00,000)
Solution: - = 2 years, and 10 months.

Calculation of Payback Period 2. Calculation of Payback Period taking interest factor into account
(Discounted payback period)
Cash Inflow Cum.
TAX at
Year EBDT Dep. EBT EAT (EAT+ dep.) Cash
50% Cash Present Value Present Cum. Present
Inflow Year
Inflows Factor Value Value
1. 10,000 10,000 0 0 0 10,000 10,000
1 1,00,000 0.909 90,900 90,900
2. 11,000 10,000 1,000 500 500 10,500 20,500
2 4,00,000 0.826 3,30,400 4,21,300
3. 14,000 10,000 4,000 2,000 2,000 12,000 32,500
3 6,00,000 0.751 4,50,600 8,71,900
4. 15,000 10,000 5,000 2,500 2,500 12,500 45,000
4 6,00,000 0.683 4,09,800 12,81,700
5. 25,000 10,000 15,000 7,500 7,500 17,500 62,500
5 2,00,000 0.621 1,24,200 14,05,900
Payback Period = 4 years + (5,000/17,500)
Discounted Payback Period = 3 years + (1,28,100/4,09,800)
= 4 years, 3 months and 13 days.
= 3 years, 3 months and 22 days.

13 14
2. Accounting Rate of Return Method 2) If the investment in working capital is given: -

Accounting rate of return means the average annual yield on the project. It is Original Investment – Scrap
one of the important methods of capital investment technique, which takes into Average Investment = + Working Capital + Scrap
account earnings over the whole life of the project. It is also known as average rate 2
of return method. Under this method, various projects are ranked on the basis of
rate of return. Illustration: 13

Advantages of Accounting Rate of Return A limited is proposing to take up a project, which requires an investment of
Rs. 1,20,000. The net income before depreciation and tax is estimated as follows: -
1) This method is easily understandable, computable and is based on readily
available accounting information. Year Rs.
2) The method takes into account the entire cash flow spread over the life of the 1 30,000
project. 2 36,000
3) This method can be easily used for comparing and ranking the projects. 3 42,000
4 48,000
Disadvantages of Accounting Rate of Return 5 60,000

1) It is based upon accounting profit and not cash flows. Depreciation is to be charged on straight-line basis. Tax rate is 50%.
2) This method also ignores the time value of money. Calculate accounting return method.
3) This method is inadequate for comparing projects of different duration.
4) Returns on investment are calculated in terms of post-tax book profits. Solution: -

Computation of Accounting Rate of Return Calculation of Average Annual Income

Accounting rate of return may be calculated as follows: - Rs.

Total profit before depreciation and tax 2,16,000
(i) Less: Total depreciation [Original Cost – Scrap] 1,20,000
Average Annual Income Total profit before tax 96,000
ARR = x 100 Less: Tax @ 50% 48,000
Original Investment Total profit after tax 48,000
(ii)
Average Annual Income 48,000
ARR = x 100 Average Annual Income = = 9,600
Average Investment 5

Average Annual Income:

Calculation of Average Investment
The term average annual income refers to average of the earnings over the
Original Investment – Scrap 1,20,000 – 0
economic life of the project. This can be calculated as follows: -
Aveg. Investment = = = 60,000
2 2
Total Profit after Tax
Average Annual Income =
Calculation of ARR
No. of Years
Average Annual Income
Average Investment:
ARR = x 100
Average Investment
The amount of average investment may be calculated in any of the following
ways: -
1) If the investment in working capital is not given: -
9,600
Original Investment – Scrap
ARR = x 100 = 16%
Average Investment =
60,000
2

15 16
Illustration: 14 Solution: -

A project requires an investment of Rs. 5,00,000 and has a scrap value of Calculation of Average Annual Income
Rs. 20,000 after five years. It is expected to yield profits after taxes during the five
years are as follows: - Rs.
Year Rs. Total profit before tax 4,00,000
1 40,000 Less: Tax @ 50% 2,00,000
2 60,000 Total profit after tax 2,00,000
3 70,000
4 50,000 Total Profit after Tax 2,00,000
5 20,000 Average Annual Income = = = 40,000
Calculate the average rate of return. Number of Years 5

Solution: - Calculation of Average Investment

Calculation of Average Annual Income Original Investment – Scrap 2,40,000 – 0

Aveg. Investment = = = 1,20,000
Total Profit after Tax 2,40,000 2 2
Average Annual Income = = = 48,000
No. of Years 5 Calculation of Average Rate of Return

Calculation of Average Investment Average Annual Income

ARR = x 100
500000-20000 Average Investment
Average investment = = 240000
2 40,000
ARR = x 100 = 33.33%
1,20,000
Calculation of Average Rate of Return
Illustration: 16
Average Annual Income
ARR = x 100 A Ltd. Co. has under consideration of the following two projects the details
Average Investment are as under: -
Particulars Project X Project Y
Investment in machinery 10,00,000 15,00,000
48,000 Working capital 5,00,000 5,00,000
ARR = x 100 = 20% Life of machinery 4 years 6 years
2,40,000 Tax rate 50% 50%
Scrap Value 10% 10%
Illustration: 15 Income before depreciation and Tax:
X Rs. Y Rs.
A limited is considering investing in a project requiring a capital outlay of 1st year 8,00,000 15,00,000
Rs. 2,40,000. Forecast of annual income after depreciation but before tax is as 2nd year 8,00,000 9,00,000
follows: - 3rd year 8,00,000 15,00,000
Year Rs. th
4 year 8,00,000 8,00,000
1 1,00,000 th
5 year 6,00,000
2 1,00,000 6th year 3,00,000
3 80,000
4 80,000 You are required to calculate the ARR and suggest which project is to be
5 40,000 preferred.
Depreciation is 20% on original cost and income tax @ 50% of net income.
Calculate the accounting rate of return.

17 18
Solution: - 3. Net Present Value
Calculation of Average Investment The NPV method is one of the discounted cash flow techniques, which
recognizes time value of money. It is considered to be the best method for
Original Investment – Scrap evaluating the capital investment projects. It is based on the assumption that cash
Average Investment = + Working Capital + Scrap flow arising at different time periods differs in value and is comparable only when
2 their present values are found out. The term NPV refers to the excess of present
value of cash inflows over the present values of cash outflows.
10,00,000 – 1,00,000
Project X = + 5,00,000 + 1,00,000 NPV= Total Present Value of Cash Inflow–Total Present Value of Cash Outflow
2
= 4,50,000 + 6,00,000 Advantages of Net Present Value
= 10,50,000
1) This method takes into account time value of money.
15,00,000 – 1,50,000 2) The whole stream of cash flows spread over the life of the project is
Project Y = + 5,00,000 + 1,50,000 considered.
2 3) Projects can be ranked according to their rate of return.
= 6,75,000 + 6,50,000 4) Makes use of the rapidly available information from accounting records.
= 13,25,000
Disadvantages of Net Present Value
Calculation of Average Annual Income
1) Method is difficult to understand.
Total Profit after Tax 2) Depends upon the knowledge of the firm’s cost of capital or discount rate.
Average Annual Income = 3) Projects with higher NPV cannot be completed as huge amount of investment
Number of Years is required.
Project X Project Y Illustration: 17
Total profit before Dep. and Tax 32,00,000 56,00,000
Less: Total Depreciation [Original Cost – Scrap] 9,00,000 13,50,000 Mahesh Electronics Company Ltd. is considering the purchase of a machine.
Total profit before Tax 23,00,000 42,50,000 Two machines P and Q each costing Rs. 50,000 is available. In comparing the
Less: Tax @ 50% 11,50,000 21,25,000 profitability of these machines a discount rate of 10% is to be used. Earnings after
Total profit after tax 11,50,000 21,25,000 taxes are expected to be as follows:

Project X = (11,50,000 / 4) = 2,87,500. Year Machine ‘P’ Machine ‘Q’

Project Y = (21,25,000 / 6) = 3,54,167. Rs. Rs.
1 15,000 5,000
Calculation of Average Rate of Return 2 20,000 15,000
3 25,000 20,000
Average Annual Income
4 15,000 30,000
ARR = x 100
5 10,000 20,000
Average Investment
The following are the present value factors at 10%.
2,87,500
Project X = x 100 = 27%
YEAR 1 2 3 4 5
10,50,000
P.V. Factors at 10% 0.909 0.826 0.751 0.683 0.621
3,54,167
Project Y = x 100 = 26% Evaluate the proposals under:
13,25,000 1. The Payback Period
2. The Accounting Rate of Return
3. The Net Present Value

19 20
Solution: - 18,000
Computation of Cash Inflows ARR (Q) = x 100 = 72%
25,000
Year Machine ‘P’ Dep. Cash Machine ‘Q’ Dep. Cash
(PAT) Inflow ‘P’ (PAT) Inflow ‘Q’ c) Calculation of Net Present Value
1 15,000 10,000 25,000 5,000 10,000 15,000 Year P.V.F @ 10% Cash Inflow P P.V of (P) Cash Inflow Q P.V of (Q)
2 20,000 10,000 30,000 15,000 10,000 25,000 1 0.909 25,000 22,725 15,000 13,635
3 25,000 10,000 35,000 20,000 10,000 30,000 2 0.826 30,000 24,780 25,000 20,650
4 15,000 10,000 25,000 30,000 10,000 40,000 3 0.751 35,000 26,285 30,000 22,530
5 10,000 10,000 20,000 20,000 10,000 30,000 4 0.683 25,000 17,075 40,000 27,320
5 0.621 20,000 12,420 30,000 18,630
Calculation of Depreciation Total P.V. of Cash Inflow 1,03,285 1,02,765
Depreciation = (Original cost – Scrap) / Life of Asset LESS: Initial Investment 50,000 50,000
P = (50,000 – 0) / 5 = 10,000. Net Present Value 53,285 52,765
Q = (50,000 – 0) / 5 = 10,000.
Illustration: 19
a) Calculation of Payback Period
Year Cash Inflow Cumulative Cash Inflow Cumulative Cash From the following information calculate the NPV of the two projects and
‘P’ Cash Inflow ‘Q’ Inflow suggest which of the two projects should be accepted assuming a discount rate of
1 25,000 25,000 15,000 15,000 10%.
2 30,000 55,000 25,000 40,000 Project X Project Y
3 35,000 90,000 30,000 70,000 Initial Investment Rs. 20,000 Rs. 30,000
4 25,000 1,15,000 40,000 1,10,000 Estimated Life 5 years 5 years
5 20,000 1,35,000 30,000 1,40,000 Scrap Value Rs. 1,000 Rs. 2,000
Payback Period (P) = 1 year + 25,000 / 30,000 = 1 year, 10 months The profit before depreciation, after taxes (cash
Payback Period (Q) = 2 years + 10,000 / 30,000 = 2 years, 4 months inflows) are as follows: -
Year X Rs. Y Rs.
b) Calculation of Accounting Rate of Return 1 5,000 20,000
2 10,000 10,000
Average Annual Income 3 10,000 5,000
ARR = x 100 4 3,000 3,000
Average Investment 5 2,000 2,000

Total Profit after Tax 85,000

The P.V. Factor @ 10% discount rate is as follows: -
Average Annual Income (P) = = = 17,000
Number of Years 5
YEAR 1 2 3 4 5
Total Profit after Tax 90,000 P.V. Factors at 10% 0.909 0.826 0.751 0.683 0.621
Average Annual Income (Q) = = = 18,000
Number of Years 5 Solution: -
Calculation of Net Present Value
Original Investment – Scrap 50,000 – 0
Avg. Investment (P) = = = 25,000 Year P.V.F @ 10% Cash Inflow X P.V of (X) Cash Inflow Y P.V of (Y)
2 2 1 0.909 5,000 4,545 20,000 18,180
2 0.826 10,000 8,260 10,000 8,260
Original Investment – Scrap 50,000 – 0 3 0.751 10,000 7,510 5,000 3,755
Avg. Investment (Q) = = = 25,000 4 0.683 3,000 2,049 3,000 2,049
2 2 5 0.621 2,000 1,242 2,000 1,242
5 0.621 1,000 621 2,000 1,242
17,000 Total P.V. of Cash Inflow 24,227 34,728
ARR (P) = x 100 = 68% LESS: Initial Investment 20,000 30,000
25,000 Net Present Value 4,227 4,728

21 22
Illustration: 20 Illustration: 21

Two competing projects, which require an equal investment of Rs. 50,000 and A firm’s cost of capital is 10%. It is considering two mutually exclusive
are expected to generate net cash flows as under: projects X and Y. The details are given below.
Project X Project Y
Year Project X Project Y Rs. Rs.
1 25,000 10,000 Investment 1,40,000 1,40,000
2 15,000 12,000 Net cash inflow
3 10,000 18,000 YEAR
4 ---- 25,000 1 20,000 1,20,000
5 12,000 8,000 2 40,000 80,000
6 6,000 4,000 3 60,000 40,000
4 90,000 20,000
The cost of the capital of the company is 10%. The following are the present 5 1,20,000 20,000
value factors at 10%. Compute:
a) Pay back period.
YEAR 1 2 3 4 5 6 b) Net present value.
P.V. Factors at 10% 0.909 0.826 0.751 0.683 0.621 0.564 c) Accounting rate of return.

Evaluate the project proposals under: P.V. Factor @ 10% for 5 years:
a) Pay back period.
b) NPV method. YEAR 1 2 3 4 5
P.V. Factor 0.909 0.826 0.751 0.683 0.621
Solution: -
Solution: -
(a) Calculation of Payback Period
a) Computation of Payback Period
Year Project X Cumulative Inflow Project Y Cumulative Inflow
1 25,000 25,000 10,000 10,000 Year Cash Inflow Cumulative Cash Inflow Cumulative Cash
2 15,000 40,000 12,000 22,000 ‘X’ Cash Inflow ‘Y’ Inflow
3 10,000 50,000 18,000 40,000 1 20,000 20,000 1,20,000 1,20,000
4 ---- 50,000 25,000 65,000 2 40,000 60,000 80,000 2,00,000
5 12,000 62,000 8,000 73,000 3 60,000 1,20,000 40,000 2,40,000
6 6,000 68,000 4,000 77,000 4 90,000 2,10,000 20,000 2,60,000
5 1,20,000 3,30,000 20,000 2,80,000
P.B.P (X) = 3 years
P.B.P (Y) = 3 years + 10,000/25,000 Pay back period (X) = 3 years + 20,000/90,000
= 3 years, 4 months and 24 days = 3 years, 2 months and 20 days
Pay back period (Y) = 1 year + 20,000/80,000
(b) Calculation of Net Present Value = 1 year and 3 months

Year Cash Inflow X P.V.F @ 10% P.V of (X) Cash Inflow Y P.V of (Y) b) Computation of Net Present Value
1 25,000 0.909 22,725 10,000 9,090
2 15,000 0.826 12,390 12,000 9,912 Year P.V Factor Cash Inflow X P.V of (X) Cash Inflow Y P.V of (Y)
3 10,000 0.751 7,510 18,000 13,518 1 0.909 20,000 18,180 1,20,000 1,09,080
4 ---- 0.683 ---- 25,000 17,075 2 0.826 40,000 33,040 80,000 66,080
5 12,000 0.621 7,452 8,000 4,968 3 0.751 60,000 45,060 40,000 30,040
6 6,000 0.564 3,384 4,000 2,256 4 0.683 90,000 61,470 20,000 13,660
Total Present Value 53,461 56,819 5 0.621 1,20,000 74,520 20,000 12,420
LESS: Initial Investment 50,000 50,000 Total P.V. of Cash inflow 2,32,270 2,31,280
Net Present Value 3,461 6,819 LESS: Initial Investment 1,40,000 1,40,000
Net Present Value 92,270 91,280

23 24
 c) Calculation of Accounting Rate of Return Solution: -

Average Annual Income (A) Calculation of Annual Cash Inflow

ARR = x 100
Average Investment Particulars Rs.
Additional Revenue 1,00,000
Calculation of Average Annual Income Less: Depreciation 80,000
Annual P.B.T 20,000
X Y Less; Tax at 40% 8,000
Total cash inflow 3,30,000 2,80,000 Annual P.A.T 12,000
LESS: Total Depreciation 1,40,000 1,40,000 Add: Depreciation 80,000
Total P A T 1,90,000 1,40,000 Annual Cash Inflow 92,000

Average Annual Income = 1,90,000/5 1,40,000/5 (B) Calculation of Net Present Value
= 38,000 28,000
Particulars Rs. Total P.V. Factor Total P.V.
Calculation of Average Investments Cash Inflow 92,000 5.651 5,19,892
Less: Initial Investment 8,00,000
Original Investment – Scrap 140000 – 0 Net Present Value – 2,80,108
Avg. Investment (X) = = = 70,000
2 2 (C) Calculation of Payback Period

Original Investment – Scrap 140000 – 0 Original Investment

Avg. Investment (Y) = = = 70,000 Payback Period =
2 2 Annual Cash Inflow

38,000 8,00,000
ARR (X) = x 100 = 54.29% Payback Period = = 8.7 years
70,000 92,000
Illustration: 23
28,000
ARR (Y) = x 100 = 40% No project is acceptable unless the yield is 10%. Cash inflows of a project
70,000 along with cash outflows are given below: -

Illustration: 22 YEAR Cash Cash Inflows

Outflows
A company is considering purchase of machinery, which costs Rs. 8,00,000 Rs. Rs.
and which has an estimated life of 10 years. This machine will generate additional 0 1,50,000 ----
Rs. 1,00,000 per year. The cost of the machine is depreciated on a straight-line and 1 30,000 20,000
has no salvage value at the end of its 10-year life. The company has a cost of capital 2 ---- 30,000
of 12 percent and a corporate tax rate of 40 percent. 3 ---- 60,000
You are required to calculate: 4 ---- 80,000
a) Annual cash inflow 5 ---- 30,000
b) The net present value and
c) The payback period The salvage value at the end of the 5th year is Rs. 40,000. Calculate the net
present value. P.V. Factor at 10% discount is as follows: -
The present value factor at 12% is as under:
Year 1 2 3 4 5
Year 1 2 3 4 5 6 7 8 9 10 P. V. Factors @ 10% 0.909 0.826 0.751 0.683 0.621
PV
0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322
Factor

25 26
Solution: -Calculation of Present Value of Cash Inflow Solution:
Year P. V. Factor Cash Inflow P. V.
1 0.909 20,000 18,180 Calculation of Cash Inflow of Proposal X
2 0.826 30,000 24,780
3 0.751 60,000 45,060 YEAR PBDT Dep. PBT Tax @ 50% PAT Cash Inflow
4 0.683 80,000 54,640 PAT + Dep.
5 0.621 30,000 18,630 1 24,000 20,000 4,000 2,000 2,000 22,000
5 0.621 40,000 24,840 2 28,000 20,000 8,000 4,000 4,000 24,000
Total P. V. of Cash Inflow 1,86,130 3 32,000 20,000 12,000 6,000 6,000 26,000
4 44,000 20,000 24,000 12,000 12,000 32,000
Calculation of Present Value of Cash Outflow
Calculation of Cash Inflow of Proposal Y
Year P. V. Factor Cash Inflow P. V.
0 1 1,50,000 1,50,000 YEAR PBDT Dep. PBT Tax @ 50% PAT Cash Inflow
1 0.909 30,000 27,270 PAT + Dep.
Total P. V. of Cash Outflow 1,77,270 1 28,000 20,000 8,000 4,000 4,000 24,000
2 32,000 20,000 12,000 6,000 6,000 26,000
Calculation of Net Present Value 3 36,000 20,000 16,000 8,000 8,000 28,000
Total Present Value of Cash Inflow 1,86,130 4 44,000 20,000 24,000 12,000 12,000 32,000
Total Present Value of Cash Outflow 1,77,270 5 40,000 20,000 20,000 10,000 10,000 30,000
Net Present Value 8,860 Calculation of Net Present Value
Year P.V Factor Cash Inflow X P.V of (X) Cash Inflow Y P.V of (Y)
Illustration: 24 1 0.909 22,000 19,998 24,000 21,816
Electrometal Private Ltd. is evaluating two mutually exclusive proposals for 2 0.826 24,000 19,824 26,000 21,476
new capital investment. The following information about the proposals is available. 3 0.751 26,000 19,526 28,000 21,028
4 0.683 32,000 21,856 32,000 21,856
Project X Project Y 5 0.621 ---- ---- 30,000 18,630
Rs. Rs. Total P.V. of Cash inflow 81,204 1,04,806
Net cash outlay 80,000 1,00,000 LESS: Initial Investment 80,000 1,00,000
Salvage value ---- ---- Net Present Value 1,204 4,806
Estimate life 4 years 5 years
Conclusion: Proposal Y is preferable because its Net Present Value is
Depreciation : Straight-line method. greater than that of Proosal X.
Cut-off discount rate : 10%
Corporate Income Tax : 50% Illustration: 25
Earnings before depreciation and Taxes:
A project involves an investment of Rs. 10,00,000 and the amount is to be
Year X Y spent as follows:
Rs. Rs. Beginning of I year Rs. 2,50,000
1 24,000 28,000 Beginning of II year Rs. 2,50,000
2 28,000 32,000 Beginning of III year Rs. 2,50,000
3 32,000 36,000 Beginning of IV year Rs. 2,50,000
4 44,000 44,000
5 ---- 40,000 The project is expected to give cash inflows as follows:

You are required to advise the company as to which proposal would be YEAR Rs.
financially viable on the basis of net present value method. 1 2,30,000
2 2,28,000
The present value of Re. 1 for 5 years @ 10% discount rate is as follows: 3 2,78,000
4 2,98,000
YEAR 1 2 3 4 5 5 2,53,000
P.V. Factor 0.909 0.826 0.751 0.683 0.621 6 1,73,000 Including scrap value

27 28
 Solution: -Calculation of Net Present Value
The cost of capital may be assumed as 12%.
Evaluate the proposal using NPV method. The discount factor @ 12% is as follows: Project Annual cash P.V. Total P.V. of Initial NPV Rank
inflow Factor cash inflow Investment
YEAR 1 2 3 4 5 6 A 25,000 5.1790 1,29,475 1,00,000 29,475 1
Discount Factor 0.893 0.797 0.712 0.635 0.567 0.507 B 20,000 4.6586 93,172 70,000 23,172 4
C 6,000 6.3345 38,007 30,000 8,007 5
Solution: - D 15,000 5.1790 77,685 50,000 27,685 2
E 12,000 6.3345 76,014 50,000 26,014 3
a. Present value of Cash Inflow
Calculation of Profitability index
Year P.V Factor @ 12% Cash Inflow P.V of Cash Inflow
1 0.893 2,30,000 2,05,390 Project Total P.V. of cash inflow Initial Investment P. I Rank
2 0.797 2,28,000 1,81,716 A 1,29,475 1,00,000 1.295 4
3 0.712 2,78,000 1,97,936 B 93,172 70,000 1.331 3
4 0.635 2,98,000 1,89,230 C 38,007 30,000 1.267 5
5 0.567 2,53,000 1,43,451 D 77,685 50,000 1.553 1
6 0.507 1,73,000 87,711 E 76,014 50,000 1.520 2
Total P.V. of Cash inflow 10,05,434
b. Present value of Cash Outflow Illustration: 27
A company is considering an investment proposal to install a new machine.
Year P.V Factor @ 12% Cash Outflow P.V of Cash Outflow The project will cost Rs. 50,000 and will have a life of 5 years and no salvage value.
0 1.000 2,50,000 2,50,000 The company’s tax rate is 50% and no investment allowance is allowed. The firm
1 0.893 2,50,000 2,23,250 uses straight-line method of deprecation. The estimated net income before
2 0.797 2,50,000 1,99,250 depreciation and tax from the proposed investment proposal are as follows:
3 0.712 2,50,000 1,78,000
Total P.V. of Cash Outflow 8,50,500 Year Net income before depreciation and Tax (Rs.)
1 10,000
Calculation of Net Present Value 2 11,000
3 14,000
Total P. V. of Cash Inflow = 10,05,434 4 15,000
Total P. V. of Cash Outflow = 8,50,500 5 25,000
Net Present Value = 1,54,934 Compute the following:
a) Pay back period.
Illustration: 26 b) Average rate of return.
c) Net present value @ 10% discount rate.
M/s Laxman and Co. has Rs. 2,00,000 to invest. The following proposals are d) Profitability index @ 10% discount rate.
under consideration. The cost of capital for the company is estimated to be 15% Following are the present value factor @ 10% per annum:
Project Initial Outlay (Rs.) Annual cash flow (Rs.) Life of project YEAR 1 2 3 4 5
A 1,00,000 25,000 10 P.V. Factor at 10% 0.909 0.826 0.751 0.683 0.621
B 70,000 20,000 08
C 30,000 6,000 20 Solution: -
D 50,000 15,000 10 1. Calculation of Pay back period
E 50,000 12,000 20 YEAR P B T D Dep. PBT Tax @ 50% PAT Cash Inflow
Rank the above projects on the basis of: PAT + Dep.
a) N P V Method 1 10,000 10,000 ---- ---- ---- 10,000
b) Profitability index Method 2 11,000 10,000 1,000 500 500 10,500
Project value of annuity of Re. 1 received in steady stream discounted @ 15% 3 14,000 10,000 4,000 2,000 2,000 12,000
08 years = 4.6586 4 15,000 10,000 5,000 2,500 2,500 12,500
10 years = 5.1790 5 25,000 10,000 15,000 7,500 7,500 17,500
20 years = 6.3345 TOTAL PAT --------------> 12,500

29 30
 Pay back period = 4 years + (5,000 / 7,500) Year Profit (Rs.)
= 4 years and 8 months. 1 5,00,000
2 8,00,000
2. Calculation of accounting rate of Return 3 10,00,000
4 6,00,000
Calculation of Average Annual Income 5 5,00,000
Total PAT 12,500
Average Annual Income = = = 2,500 Present value factor @ 12% per annum are given below:
No. of Years 5 Year 1 2 3 4 5
P.V. Factor @ 12% 0.8929 0.7972 0.7118 0.6355 0.5674
Calculation of Average Investment
Original Investment – Scrap 50,000 – 0 Ascertain the Net present value of the project.
Average Investment = = = 25,000
2 2 Solution: –

Average Annual Income 2,500 Calculation of Depreciation

ARR = x 100 = x 100 = 10%
Average Investment 25,000 Original cost – Scrap
Calculation of Net Present Value Depreciation =
Life of Asset
Year PV Factor @ 10% Cash Inflow Present Value
1 0.909 10,000 9,090 42,00,000 – 5,00,000
2 0.826 10,500 8,673 Depreciation = = 7,40,000
3 0.751 12,000 9,012 5
4 0.683 12,500 8,538
5 0.621 17,500 10,867 Calculation of Net Present Value
Total PV of Cash Inflow 46,180
Less: Initial Investment 50,000 Year PAT Depreciation Cash Inflow P.V. Factor @ P.V of
Net Present Value -3,820 PAT + Dep. 12% Cash inflow
1 5,00,000 7,40,000 12,40,000 0.8929 11,07,196
2 8,00,000 7,40,000 15,40,000 0.7972 12,27,688
Calculation of Profitability Index
3 10,00,000 7,40,000 17,40,000 0.7118 12,38,532
4 6,00,000 7,40,000 13,40,000 0.6355 8,51,570
Total Present Value of Cash Inflow
5 5,00,000 7,40,000 12,40,000 0.5674 7,03,576
Profitability Index =
6 (Scrap + Working Capital) 15,00,000 0.5674 8,51,100
Initial Investment
Total Present Value of Cash inflow 59,79,662
LESS: Initial outlay including working capital 52,00,000
46,180
[42,00,000 + 10,00,000]
Profitability Index = = 0.9236
Net Present Value 7,79,662
50,000

Illustration: 28

After conducting a survey that cost Rs. 2,00,000. Karnataka zeal Ltd. decided Illustration: 29
to undertake a project for placing a new product in the market. The company’s cut
off rate is 12%. It was estimated that the project would have a life of 5 years. The Quick Ltd. has a machine having an additional life of 5 years which costs
project would cost of Rs. 40,00,000 in plant and machinery in addition to working Rs. 1,00,000 and which has a book value of Rs. 25,000. A new machine costing
capital of Rs. 10,00,000. The scrap value of plant and machinery at the end of 5 Rs. 2,00,000 is available. Though its capacity is the same as that of old machine, it
years was estimated @ Rs. 5,00,000. After providing depreciation on straight-line will mean a saving in variable costs to the extent of Rs. 70,000 per annum. The life
basis, profits after taxes were estimated as follow: of the machine will be 5 years at the end of which it will have a scrap value of Rs.
20,000. The rate of income tax is 60% and Quick Ltd. does not make an investment,
if it yields less than 12%. The old machine, if sold, will fetch Rs. 10,000.

31 32
 Using present value method advises whether the old machine should be Solution: –
replaced or not:
P.V of Re. 1 receivable annually for 5 years @ 12% = 3.605 Calculation of N. P. V
P.V of Re. 1 receivable at the end of 5 years @ 12% = 0.567
P.V of Re. 1 receivable at the end of 1 year @ 12% = 0.893 Year P.V Factor @ 15% Cash Outflow P.V of Cash Inflow
1 0.8696 70,000 60,872
Solution: – 2 0.7561 1,00,000 75,610
Calculation of Annual Cash inflow 3 0.6575 1,30,000 85,475
Rs. Rs. 4 0.5718 90,000 51,462
Savings in variable cost 70,000 5 0.4972 15,000 7,458
LESS: Additional Depreciation 5 0.4972 45,000 22,374
Annual Depreciation on New Machine (2,00,000 – 20,000)/5 36,000 Total P.V. of Cash Inflow 3,03,251
Annual Depreciation on Old Machine (25,000 / 5) 5,000 31,000 LESS: Initial Investment 3,10,000
Annual P.B.T 39,000 Net Present Value - 6,749
LESS: Tax @ 60% 23,400
Annual P A T 15,600 Illustration: 31
ADD: Depreciation 31,000
Annual Cash inflow 46,600 From the particulars given below relating to Adarsh Ltd. you are required to
calculate:
Calculation of Net Present Value
(i) Pay back period
P. V. of Cash Inflow 46,600 X 3.605 = 1,67,993 (ii) Discounted pay back period
LESS: Initial Investment [2,00,000 – 10,000] = 1,90,000 (iii) N. P. V. and
Net Present Value = – 22,007 (iv)Profitability Index
Illustration: 30
Cost of the Project: Rs. 50,000
Metal castings Ltd. Hosur wishes to install machinery in rented premises for Cash flow after Taxes
the production of a component the demand for which is expected to last for only 5 Year Rs.
years. 1 5,000
Initial cash out lay will be: 2 20,000
3 30,000
Plant and Machinery = Rs. 2,70,000 4 30,000
Working Capital = Rs. 40,000 5 10,000
Total = Rs. 3,10,000
The cost of capital of the company is 10%
The working capital will be fully realized at the end of 5 th year. The scrap Note: Discounting factor @ 10% is
value of the plant expected to be realized at the end of 5 th year is Rs. 5,000. The Year 1 2 3 4 5
expected cash inflows from business operations are: PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621

Year Cash inflows Solution: –

1 70,000
2 1,00,000 c) Calculation of Pay back period, discounted pay back period and NPV
3 1,30,000 Year PAT Dep. PAT + Dep. P.V.F @ 10% P.V of Cash Inflow
4 90,000 Cash Inflow
5 15,000 1 5,000 10,000 15,000 0.909 13,635
2 20,000 10,000 30,000 0.826 24,780
Cost of capital is 15%. Calculate the N.P.V of the project using P.V factor @ 3 30,000 10,000 40,000 0.751 30,040
15%. 4 30,000 10,000 40,000 0.683 27,320
Year 1 2 3 4 5 5 10,000 10,000 20,000 0.621 12,420
PV Factor @ 15% 0.8696 0.7561 0.6575 0.5718 0.4972 Present Value of Cash Inflow 1,08,195
LESS: Initial Investment 50,000
Net Present Value 58,195

33 34
 4. Internal Rate of Return
a) Pay back period = 2 years + (5000 / 40,000)
= 2 years, 1 month and 15 days. Internal rate of return is the rate at which the sum of discounted cash inflows
equals to the sum of discounted cash outflows. The internal rate of return of a
b) Discounted Pay back period = 2 years + (11,585 / 30,040) project is the discount rate which makes net present value equal to zero. This is
= 2 years, 4 months and 19 days. equivalent to equating the present value of all future cash inflows to initial outlay of
the project. This rate can be calculated by using the following formula.
d) Profitability Index
C–O
Total Present Value of Cash Inflow Internal Rate of Return = A + (B – A)
Profitability Index = C–D
Initial Investment
Where, A = Discount factor @ low trial
1,08,195 B = Discount factor @ high trial
Profitability Index = = 2.164 C = Present value of cash inflow @ low trial
50,000 D = Present value of cash inflow @ high trial
O = Original investment

Advantages of Internal Rate of Return

 The IRR methods take into account the factor of time productivity of money.
 It ranks the project according to their NPV.
 Real and scientific method of appraising capital projects.
 All the cash flows in the project are considered.

Disadvantages of Internal Rate of Return

 Under rapid change of technology this may fail to provide solution. In such
cases payback period is very helpful.
 The cost of capital which is the required rate of return is difficult to
understand. It is also difficult to arrive at the IRR at the first attempt and
some trial runs may become necessary.
 May not give unique answer in all the situations.

Illustration: 32

A project is estimated to cost Rs. 16,200. It is expected to have a life of 3

years and generate cash inflows of Rs. 8,000, Rs. 7,000 and Rs. 6,000.
Calculate I R R

Present value of Rs. 1 at varying discount rate for a period of 3 years.

Year 13% 14% 15% 16%

1 0.8850 0.8772 0.8696 0.8621
2 0.7831 0.7695 0.7651 0.7432
3 0.6930 0.6750 0.6575 0.6407

35 36
Solution: – Solution: –
Calculation of Internal rate of return
Calculation of Internal Rate of Return

Year Cash Inflow P.V. Factor P.V. of P.V. Factor P.V. of

P.V.Factor P.V. of P.V.Factor P.V. of
@ 10% Cash Inflows @ 15% Cash Inflows Year Cash Inflow
@ 10% Cash Inflow @ 15% Cash Inflow
1 8,000 0.8772 7,018 0.8696 6,957
1 7,000 0.909 6,363 0.870 6,090
2 7,000 0.7695 5,386 0.7561 5,293
2 7,000 0.826 5,782 0.756 5,292
3 6,000 0.6750 4,050 0.6575 3,945
3 7,000 0.751 5,257 0.658 4,606
Total P. V of Cash Inflow 16,454 16,195
4 7,000 0.683 4,781 0.572 4,004
5 7,000 0.621 4,347 0.497 3,479
C–O
6 8,000 0.564 4,512 0.432 3,456
IRR = A + (B – A)
7 10,000 0.513 5,130 0.376 3,760
C–D
8 15,000 0.467 7,005 0.327 4,905
9 10,000 0.424 4,240 0.284 2,840
16,454 – 16,200
10 4,000 0.386 1,544 0.247 988
IRR = 14 + (15 – 14)
Total P. V of Cash Inflow 48,961 39,420
16,454 – 16,195
A = 10; B = 15; C = 48,961; D = 39,420; O = 40,000.
254
IRR = 14 + (1) = 14.98%
C–O
259
IRR = A + (B – A)
C–D
Illustration: 33
48,961 – 40,000
A company has an investment opportunity costing Rs. 40,000 with the
IRR = 10 + (15 – 10)
following Expected net Cash Inflows (i.e., after taxes and before depreciation):
48,961 – 39,420
Year Net Cash Inflows
Rs.
8,961
1 7,000
IRR = 10 + (5) = 14.70%
2 7,000
9,541
3 7,000
4 7,000
Illustration: 34
5 7,000
6 8,000
A company has to select one of the two alternative projects whose particulars
7 10,000
are given below:
8 15,000
9 10,000
PROJECT ‘A’ PROJECT ‘B’
10 4,000
Initial out lay 1,18,720 1,00,670
Determine the “Internal Rate of Return” with the help of 10% discount factor
Net cash flow:
and 15% discount factor, which is given below:
Year
Year P.V. Factor @ 10% P.V. Factor @ 15%
1 1,00,000 10,000
1 0.909 0.870 2 20,000 10,000
2 0.826 0.756 3 10,000 20,000
3 0.751 0.658 4 10,000 1,00,000
4 0.683 0.572
5 0.621 0.497
The company can arrange necessary funds at 8%. Compute the N.P.V and
6 0.564 0.432
I.R.R of each project and comment on the results. If there is any contradiction in the
7 0.513 0.376
results, state the reasons for such contradiction. How would you resolve such
8 0.467 0.327
contradiction?
9 0.424 0.284
10 0.386 0.247

37 38
 The P.V factor of Re. 1 received at the end of each year at different rates is 5. Profitability Index (PI)
given below:
Year 8% 10% 12% 14% It is the ratio of present value of future cash benefits at the required rate of
1 0.926 0.909 0.893 0.877 return to the initial cash outflow of the investment.
2 0.857 0.826 0.797 0.769
3 0.794 0.751 0.712 0.675 Total Present Value of Cash Inflow
4 0.735 0.683 0.636 0.592 Profitability Index =
Initial Investment
Solution: –
Computation of I R R of Project A Illustration: 35

Year Cash Inflow P.V.Factor P.V. of P.V.Factor P.V. of The initial cash outlay of the project is Rs. 1,00,000, and it generates cash
@ 10% Cash Inflow @ 12% Cash Inflow inflows of Rs. 40,000, Rs. 30,000, Rs. 50,000, and Rs. 20,000. Assume a 10% rate
1 1,00,000 0.909 90,900 0.893 89,300 of discount. Calculate profitability index.
2 20,000 0.826 16,520 0.797 15,940
3 10,000 0.751 7,510 0.712 7,120 Year 1 2 3 4
4 10,000 0.683 6,830 0.636 6,360 10% 0.909 0.826 0.751 0.683
Total P. V of Cash Inflow 1,21,760 1,18,720
Solution: -
A = 10; B = 12; C = 1,21,760; D = 1,18,720; O = 1,18,720. Calculation of Profitability Index

C–O Year CIF PVF 10% PV

IRR = A + (B – A) 1 40000 0.909 36360
C–D 2 30000 0.826 24780
3 50000 0.751 37550
1,21,760 – 1,18,720 4 20000 0.683 13660
IRR = 10 + (12 – 10) TPV 112350
1,21,760 – 1,18,720
Total Present Value of Cash Inflow
IRR = 10 + 2 = 12% Profitability Index =
Initial Investment
Computation of I R R of Project B
1,12,350
P.V.Factor P.V. of P.V.Factor P.V. of Profitability Index = = 1.1235
Year Cash Inflow
@ 10% Cash Inflow @ 8% Cash Inflow 1,00,000
1 10,000 0.909 9,090 0.926 9,260
2 10,000 0.826 8,260 0.857 8,570
3 20,000 0.751 15,020 0.794 15,880 Chapter Roundup
4 1,00,000 0.683 68,300 0.735 73,500
Total P. V of Cash Inflow 1,00,670 1,07,210
 Investment Decision is referred to the activity of deciding the pattern of
investment. It is a long range financial decision and deals with allocation of
A = 8; B = 10; C = 1,07,210; D = 1,00,670; O = 1,00,670.
capital. It has to show how the funds can be invested in assets which would
yield maximum return to the business concern.
C–O
IRR = A + (B – A)
 Capital Budgeting refers to planning the deployment of available capital for
C–D
the purpose of maximizing the long term profitability of a firm.
1,07,210 – 1,00,670
 The term Payback Period refers to the time in which the project will generate
IRR = 8 + (10 – 8)
the necessary cash to recover the initial investment.
1,07,210 – 1,00,670
 Average rate of return or return on investment is obtained by dividing
IRR = 8 + 2 = 10%
average annual post-tax profit by the average investment.

39 40
 14. Rahul company is considering the purchase of one of the following machines,
 Net Present Value refers to the excess of present value of future cash inflows whose relevant data are as follows: -
over the present value of cash outflows. It is considered to be the best
method for evaluating the capital investment projects. Machine X Machine Y
Estimated Life 3 years 3 years
 Internal Rate of Return is the rate at which the sum of discounted cash Capital Cost Rs. 90,000 Rs. 90,000
inflows is equal to the sum of discounted cash outflows. It is the rate at which Earnings after tax: -
the net present value of investment is zero. X Rs. Y Rs.
1st year 40,000 20,000
 Profitability Index is the ratio of present value of future cash inflows at the 2nd year 50,000 70,000
required rate of return to the initial cash outflow of the investment. 3rd year 40,000 50,000

Quick Quiz The company follows the straight-line method of depreciation; the estimated
salvage value of both the machines is zero. Show the most profitable invest
based on: -
1. What is Investing Decision?
2. Define Capital Budgeting. a) Payback Period
3. Define the term Payback Period. b) Accounting Rate of Return
4. What is Net Present Value? c) NPV and Profitability Index assuming at 10% cost of capital.
5. What is Internal Rate of Return?
6. Define Profitability Index. Note: - P.V. Factor @ 10% is as follows
7. Compare and contrast N.P.V. method with I.R.R method.
8. Critically examine the various steps involved in Capital Budgeting. YEAR 1 2 3
9. What is Capital Budgeting? Examine its need and significance. P.V. Factors at 10% 0.909 0.826 0.751
10. Critically evaluate the payback method as a method of investment appraisal.
11. A company purchased a machine at a cost of Rs. 13,00,000. Sales Revenue 15. A choice will have to be made between two competing projects proposals,
per annum is Rs. 16,00,000. Variable cost is 60% of sales. Fixed cost of which require an investment of Rs. 1,50,000 each and are expected to
Rs. 2,40,000 Tax rate 50%. Calculate pay back period. Ignore depreciation. generate net cash flow as under:
12. Find out the N P V for a project which requires an initial investment of
Rs. 50,000 and which involves a net cash inflow of Rs. 10,000 each year for 6 Year Project A Project B
years. There is no scrap value. Cost of funds is 10% of an annuity of Re. 1 for Rs. Rs.
6 years at 10% per annum is Rs. 4.355. 1 75,000 30,000
13. A company has three projects, which have a capital outlay of Rs. 1,00,000 2 45,000 36,000
each. The following is the information about cash flows: 3 30,000 54,000
4 ---- 75,000
Project C0 C1 C2 C3 C4 C5 5 36,000 24,000
1 1,00,000 40,000 45,000 30,000 25,000 25,000 6 18,000 12,000
2 1,00,000 35,000 35,000 30,000 20,000 20,000
3 1,00,000 30,000 30,000 30,000 30,000 30,000 The cost of capital of a company is 10%. The following are the project value
factor @ 10%.
You are required to rank the above projects according to each of the following
methods: YEAR 1 2 3 4 5 6
(a) Payback Period P.V. Factor 0.909 0.826 0.751 0.683 0.621 0.564
(b) Accounting Rate of Return
(c) Net Present Value Which project proposal should be chosen and why?
(d) Internal Rate of Return [assuming discount rates of 10% and 20%] Evaluate the project proposal under:
Pay back period
Present value of Re. 1 Net present value
Year 1 2 3 4 5
PV @ 10% 0.909 0.826 0.751 0.683 0.621
PV @ 20% 0.833 0.694 0.579 0.482 0.402

41 42
 16. ABC Ltd. has under consideration two mutually exclusive proposals for the WORKING CAPITAL MANAGEMENT
purchases of new equipment.

A B
Introduction
Net cash outlay 1,00,000 75,000
One of the most important areas in the day-to-day management of the firm is
Life 5 years 5 years
the management of Working Capital. Working Capital Management is the functional
Salvage Value Nil Nil
area of finance that covers all the current assets of the firm. It is concerned with
management of the level of individual current assets as well as current liabilities and
also the management of total working capital.
Profits before depreciation and taxes:
A Rs. B Rs. The term working capital refers to the capital required for day-to-day
1st year 25,000 18,000 operations of the business. It is defined as the excess of Current Assets over Current
2nd year 30,000 20,000 Liabilities and provisions. In other words, it is called “Net Current Assets or Net
3rd year 35,000 22,000 Working Capital”.
4th year 25,000 20,000
th The following table highlights the components of current assets and current
5 year 20,000 16,000
liabilities.
Using the tax rate to be 50%. Suggest the management the best alternative
using: Current Assets Current Liabilities
a) Payback Period Cash in Hand Sundry Creditors
b) NPV method @ 10% Cash at Bank Bills Payable
Bills Receivable Bank Overdraft
Note: - P.V. Factor @ 10% is as follows Sundry Debtors Outstanding Expenses
Closing Stock Incomes received in advance
YEAR 1 2 3 4 5 Prepaid Expenses Unclaimed Dividend
P.V. Factors at 10% 0.909 0.826 0.751 0.683 0.621 Outstanding Incomes Provision for Tax
Temporary Investments Proposed Dividend
17. X Ltd. wants to replace its existing stamping machine. Two machines are Advances Short-term Loans
currently available in the market. The superior stamping machine costs Rs.
50,000 and will require a cash summing expenses of Rs. 20,000 per year. The Concept of Working Capital
star machine costs Rs. 75,000 but cash running expenses are expected to be
Rs. 15,000 per year. Both the machines have a ten-year useful life with no From the point of view of time, the term working capital can be divided into
salvage value and would be depreciated on a straight-line method. two categories:

If the company pays 50% tax and wants a 10% after tax-required rate of 1) Permanent Working Capital: It refers to the Hardcore Working Capital. It is
return which machine should it purchase? The present value factors @ 10% that minimum level of investment in the current assets that is carried by the
are: business at all times to carry out minimum level of its activities. It is also known
as Fixed Working Capital.
Year 1 2 3 4 5
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621 Features of Permanent Working Capital:
a) Amount of permanent working capital remains in the business in one or
Year 6 7 8 9 10 another form.
b) There is a positive correlation between the size of the business and the
PV Factor @ 10% 0.564 0.513 0.467 0.424 0.386
amount of permanent working capital.
c) Permanent working capital should be financed from long-term funds.

2) Temporary Working Capital: It refers to that part of Working Capital, which is

required by a business over and above the Permanent Working Capital. It is also
called Variable Working Capital or Fluctuating Working Capital. The amount of
temporary working capital keeps on changing depending upon the changes in
production and sale.

43 1
 The duration of the operating cycle for the purpose of estimating working
capital is equal to the sum of the durations of each of the above said events, less the
Amt. of Working Capital
credit period allowed by suppliers.

Temporary
[Rs.]

Permanent CASH

ACCOUNTS RAW MATERIAL

Time RECEIVABLE

WORK IN PROCESS
Amt. of Working Capital

FINISHED GOODS
Temporary
[Rs.]

Permanent
Working Capital Cycle

In the form of an equation, the operating cycle process can be expressed as follows:-
Operating Cycle = R + W + F + D – C
Time
R = Raw material storage period
W = Work-in-progress holding period
Diagram: ADEQUACY OF WORKING CAPITAL F = Finished goods storage period
D = Debtors collection period
From the point of view of concept the term Working Capital can be used in C = Credit payment period
two different ways: -
The various components of operating cycle may be calculated as shown below:
1) Gross Working Capital: The gross working capital refers to investment in all
the current assets taken together. The total investments in all current assets Average stock of raw material
are known as Gross Working Capital. 1 Raw material storage period =
Average cost of raw material consumption per day
2) Net Working Capital: the term net working capital refers to the excess of
total current assets over total current liabilities. Current assets refer to those Average work-in-progress inventory
assets which can be converted in to money immediately. It may be noted that 2 Work-in-progress holding period =
the current liabilities refers to those liabilities which are payable within a Average cost of production per day
period of one year.
Average stock of finished goods
Working Capital Cycle or Operating Cycle 3 Finished goods storage period =
Average cost of goods sold per day
The working capital cycle refers to the length of time between the firms
paying cash for materials, entering into the production process, stock and the inflow Average book debts
of cash from accounts receivable. In other words, it refers to the duration of the time 4 Debtors collection period =
required to complete the following cycle of events in a manufacturing firm. It is also Average credit sales per day
called as the Operating Cycle.
Average trade creditors
a) Conversion of cash into raw materials. 5 Credit payment period =
b) Conversion of raw material into work in progress. Average credit purchases per day
c) Conversion of work in progress into finished stock.
d) Conversion of finished stock into accounts receivables through sales and
e) Conversion of account receivables into cash.

2 3
Illustration:
From the following information, calculate the operating cycle in days and amount of 5) Credit Policy
working capital employed A firm, which allows liberal credits to its customer, may enjoy higher sales but
may need more amount of working capital when compared to a firm enforcing strict
Period covered 365days credit terms. Similarly, the working capital requirements are also affected by the
Total production cost Rs.11,000 credit facilities enjoyed by the firm. A firm enjoying liberal credit facilities from its
supplier requires lower amount of working capital when compared to a firm that does
Total cost of sales Rs.12,000
not enjoy such liberal credit facilities.
Raw material consumption Rs. 4,600
Average total debtors outstanding Rs 500 6) Business Cycle
Credit sales for the year Rs.15,000 Business fluctuations lead to cyclical and seasonal changes in production and
sales and affect the working capital requirements. The business expands during the
Value of average stocks maintained period of prosperity and declines during the period of depression. Consequently,
Raw materials Rs.340 more working capital is required during the period of prosperity and less during the
period of depression.
Work-in-progress Rs 380
Finished goods Rs280 7) Fluctuation in the supply of Raw Materials
Amount given represents lakhs. If prompt and adequate supply of raw materials, spares, stores, etc. is
Solution: available, it is possible to manage with small amount of working capital. However, if
Determinants of Working Capital supply is seasonal, or chanelised through government agencies, etc., it is essential to
keep larger stocks increasing working capital requirements. This is particularly true
A large number of factors influence working capital needs of a firm. The in case of companies requiring special kind of raw materials, which is available only
following are the important factors, which determine the amount of working capital. in a particular season.

1) Nature of Industry 8) Price Level Changes

One of the important factors influencing the amount of working capital is the Inflationary trends in the economy necessitate more working capital to
nature of Industry. The term nature of Industry refers to whether a concern is a maintain the same level of activity. Generally, raising price level requires a firm to
manufacturing concern or public utility concern. The shorter the manufacturing maintain higher amount of working capital and vice versa.
process, the lower is the requirements for the working capital. This is because, in
such a case, inventories have to be maintained at a low level. Longer the 9) Profit Margin
manufacturing process the higher would be the requirements of working capital. This A high net profit margin contributes towards the working capital
is the reason why highly capital-intensive industries require a large amount of requirements. Therefore, the amount of working capital required will be less. A low
working capital to run their sophisticated and long production process. Similarly, a profit margin requires a greater amount of working capital. Infact, the net profit is a
public utility concern requires lower amount of working capital than a manufacturing source of working capital to the extent it has been earned in cash.
concern.
10) Dividend Policy
2) Size of Business The amount of profit available towards working capital needs would be
Size of business is another important factor influencing the amount of working affected by the way in which profits are appropriated. The availability of cash from
capital. The term size of business refers to the scale of operation. A large-scale operation depends upon dividend policy. Payment of dividend utilizes cash while
organization may require more amount of working capital than a small one. retaining profits acts as a source of working capital. Thus, dividend policies affect
working capital.
3) Production Policies
The Production Policy i.e., the plan for production has great influence on the 11) Abnormal Factors
amount of working capital. Production policy refers to whether the firm is capital Abnormal factors like strikes and lockouts also require additional working
intensive or labour intensive. In case of labour intensive industries the working capital. Recessionary conditions necessitate a higher amount of stock of finished
capital requirements will be more when compared to capital-intensive industries. In goods remaining in stock. Similarly, inflationary conditions necessitate more funds
such industries the requirement of long-term funds will be more than the amount of for working capital to maintain the same amount of current assets.
working capital.
12) Corporate Taxes
4) Volume of Sales The amount of taxes paid depends on taxation laws. These amounts usually
The volume of sales and size of working capital are directly related to each have to be paid in advance. Thus need for working capital varies with tax rates and
other. As the volume of sales increases there is an increase in the investment of advance tax provisions.
working capital.

4 5
Problems Associated with Excess & Inadequate Working Capital

Both the excessive and inadequate working capital positions are dangerous
from the firm’s point of view. Excess working capital results in idle funds, which do
not earn any income. Shortage of working capital intercepts production as well as
profitability.
Sources of Working Capital
Dangers of Excess of Working Capital
PERMANENT TEMPORARY
1) It results in unnecessary accumulation of inventory, thus the chances of
inventory mishandling, waste, theft and losses increase. 1) Shares. 1) Indigenous Bankers.
2) It is an indication of defective credit policy and slack collection period. 2) Debentures. 2) Trade Credit.
Consequently, higher incident of bad debts adversely affects profits.
3) Excess working capital results in idle funds, which do not earn any return for the 3) Public deposits. 3) Commercial Bank.
firm. 4) Retained earnings. 4) Installment Credit.
4) Tendencies of accumulating inventories to make speculative profits liberal and
difficult to cope with in future when the firm is unable to make speculative 5) Loans from financial institutions. 5) Advances.
profit. 6) Factoring.

Dangers of Inadequate Working Capital 7) Accrued expenses.

8) Deferred Incomes.
1) It stagnates growth and it becomes difficult for the firm to undertake profitable
project due to inadequate working capital. 9) Commercial papers.
2) It becomes difficult to implement the operating plans and achieve the firms
profit target. Permanent or Long Term Working Capital
3) Operating in efficiencies increases when the firm finds it difficult even to meet
day-to-day commitments. 1) Shares: Issue of shares is the most important source for raising the permanent
4) Lack of working capital renders the firm unable to avail of attractive credit working capital. A company can issue various types of shares such as equity
opportunities. shares, preference and deferred shares. As far as possible a company should
5) A firm looses its reputation when it is not in a position to honor its short-term raise the maximum amount of permanent capital by issue of shares.
obligations.
6) Fixed assets are not efficiently utilized for the lack of working capital funds. This 2) Debentures: A debenture is an instrument issued by the company
may result in fall in the returns on investment. acknowledging its debt to its holder. It is also an important method of rising long-
term working capital. The debenture holders are the creditors of the company. A
Sources of Working Capital fixed rate of interest is paid on debentures. The company issuing debentures
enjoys a number of benefits such as trading on equity, retention of control, tax
The working capital requirement of a concern can be classified as: benefit etc.

I. Permanent working capital requirements. 3) Public Deposits: Public deposits are the fixed deposits accepted by a business
II. Temporary working capital requirements. concern directly from the public. This source of rising working capital was very
popular in the absence of bank facility. The RBI had laid down certain limits on
The various sources for the financing of the working capital are as follows: public deposits. Non-banking concerns cannot barrow by way of public deposits
more than 25% of its paid capital and reserves.

4) Retained Earnings: Retained earnings or ploughing back of profits means the

reinvestment by concern of its surplus earnings in its business. It is an internal
source of finance and is most suitable for an establishment etc. This method of
finance is the cheapest and cost free sources of finance.

5) Loans from Financial Institution: Financial institutions like Commercial Banks,

LIC, IFCI, SFC, ICICI, IDBI etc also provide short-term, medium-term and long-
term loans. This source of finance is more suitable to meet the medium term
demands of working capital.

6 7
 invoices of its customers. Thus, a firm gets immediate payment for sales made on
Temporary Working Capital credit through factoring.
7) Accrued Expenses: Accrued expenses, which have been incurred but not yet
The main sources of temporary working capital are: paid. These simply represent a liability that a firm has to pay services already
received by it. Thus, all accrued expenses can be used as a source of short-term
1) Indigenous Bankers: Private moneylender and other country bankers used to finance.
be the main sources of finance prior to the establishment of commercial bank.
Now a day with the development of commercial banks they have lost their 8) Deferred Incomes: Deferred incomes are incomes received in advance before
monopoly. But even today some business houses have to depend upon indigenous supplying services. They represent funds received by a firm for which it has to
bankers for obtaining loans to meet their working capital requirements. supply goods or services in future. These funds increase the liquidity of a firm and
constitute an important source of short-term finance.
2) Trade Credit: Trade credit refers to the credit extended by the supplier of goods
in the normal course of business. The trade credit arrangement of a firm with its 9) Commercial Paper: Commercial paper represents unsecured promissory notes
suppliers is an important source of short-term finance. The credit worthiness of a issued by firms to raise short-term funds. It is an important money market
firm and the confidence of its supplier are the main basis of securing trade credit. instrument in advanced countries like U.S.A. Commercial paper is a cheapest
Every firm must utilize this source to the fullest extent, because this source is source of rising short-term finance as compare to the bank credit. Commercial
cost free. i.e. borrower need not pay any interest. paper is usually bought by investors including Bank, Insurance Company, Unit
Trust of India and firms to invest surplus funds for a short period.
3) Commercial Banks: Commercial banks are the most important source of short-
term capital. The different forms in which the banks normally provide loans and
advances are as follows:
a) Loans: When a bank makes an advance in lump sum against some security,
it is called a loan. In case of a loan a specified amount is sanctioned by the
bank to the customer. The entire loan amount is paid to the borrower either
in cash or by credit to his account. The borrower is required to pay interest on
the entire amount of loan from the date of sanction.
b) Cash Credit: Cash credit is an arrangement by which a bank allows his
customer to borrow money up to a certain limit against some tangible
securities. A customer can withdraw from his cash credit limit according to his
need and interest is calculated on the daily balance and not on the entire
amount.
c) Over Draft: Over draft is an arrangement by which a current account holder
is allowed to withdraw more than the balance to his credit up to a certain
limit. The interest is charged on daily over drawn balances.
d) Discounting of bill of exchange: Purchasing and discounting of bills of
exchange is the most important form in which the banks lend money without
any collateral security.

4) Installment Credit: This is another method by which the possession of goods is

taken immediately. The payment is made in installment over a predetermined
period of time. Generally interest is charged on the unpaid price but in any case, it
provides fund for some time and is used as a source of short-term working capital
by many business houses.

5) Advances: Some business houses get advances from the customers and
middlemen against order and this source is a short-term source of finance. It is a
cheap source of finance and in order to minimize their investment in working
capital the manufacturing industries prefer to take advances from their customers.

6) Factoring/Account Receivable Credit: Another method of raising short-term

finance is through account receivable or credit offered by commercial banks and
factors. A commercial bank may provide finance through discounting the bills or

8 9
Illustration: 1 Finished Goods – 4 weeks
The Board of management of Apple company Ltd. request you to prepare a Raw materials
statement showing the working capital requirements for a level of activity of 1,40,40,000 x 4/52 10,80,000
1,56,000 units of production. Labour
62,40,000 x 4/52 4,80,000
The following information is available for your calculation: Overheads
1,17,00,000 x 4/52 9,00,000
Per Unit 2) Debtors
Rs. 3,19,80,000 x 80/100 x 8/52 39,36,000
Raw-material 90 3) Cash 60,000
Direct Labour 40 Total Current Assets 84,21,000
Overheads 75
Total Cost 205 B – Current Liabilities
Profit 60 1) Creditors
Selling Price per unit 265 1,40,40,000 x 4/52 10,80,000
2) Accrued Wages
i. Raw materials are in stock, on average one month. 62,40,000 x 1.5/52 1,80,000
ii. Materials are in process, on average 2 weeks. Total Current Liabilities 12,60,000
iii. Finished goods are in stock, on average one month.
iv. Credit allowed by suppliers, one month. Working Capital Requirements (A – B) 71,61,000
v. Time lag in payment from debtors, 2 months.
vi. Lag in payment of wages, 1 ½ weeks. Illustration: 2
20% of the output is sold against cash. Cash in hand and at bank is expected
to be Rs. 60,000. It is to be assumed that production is carried on evenly The management of Vishal Ltd. has called for a statement showing the
throughout the year, wages and overheads accrue similarly and a time period working capital needed to finance a level of activity of 3,00,000 units of output for
of 4 weeks is equivalent to a month. the year. The cost structure for the company’s product, for the above-mentioned
activity level, is detailed below:
Solution: -
Statement of Cost Sheet Per Unit
Rs.
Elements of Cost Rs. Raw materials 20
Raw materials 1,40,40,000 Direct Labour 5
Direct Labour 62,40,000 Overheads 15
Overheads 1,17,00,000 Total 40
Total Cost 3,19,80,000 Profit 10
Profit 93,60,000 Selling Price per unit 50
Sales 4,13,40,000
i. Past experience indicates that raw materials are held in stock, on an average
Statement showing working capital requirements for two months.
ii. Work-in-progress (100% complete in regard to materials and 50% for labour
Components Rs. and overheads) will approximately be to half a month’s production.
A – Current Assets iii. Finished goods remain in warehouse, on an average for a month.
1) Inventory iv. Suppliers of materials extend a month’s credit.
Raw materials – 4 weeks v. Two months credit is allowed to debtors, calculation of debtors may be made
1,40,40,000 x 4/52 10,80,000 at selling price.
Work in progress – 2 weeks vi. A minimum cash balance of Rs. 25,000 is expected to be maintained.
Raw materials vii. The production pattern is assumed to be even during the year. Prepare the
1,40,40,000 x 2/52 5,40,000 statement for working capital requirements.
Labour
62,40,000 x 2/52 x 50% 1,20,000
Overheads
1,17,00,000 x 2/52 x 50% 2,25,000

10 11
Solution: - Illustration: 3

Statement of Cost Sheet A proforma cost sheet of a company provides the following particulars:

Elements of Cost Rs. Elements of Cost Per Unit

Raw materials [3,00,000 x 20] 60,00,000 Rs.
Direct Labour [3,00,000 x 5] 15,00,000 Raw materials 80
Overheads [3,00,000 x 15] 45,00,000 Direct Labour 30
Total Cost 1,20,00,000 Overheads 60
Profit [3,00,000 x 10] 30,00,000 Total Cost 170
Sales 1,50,00,000 Profit 30
Selling Price 200
Statement showing working capital requirements
The following further particulars are available:
Components Rs. Raw materials are in stock on average for one month.
A – Current Assets Materials are in process on an average for half a month.
1) Inventory Finished goods are in stock on an average for one month.
Raw materials – two months Credit allowed by suppliers is one month.
60,00,000 x 2/12 10,00,000 Credit allowed to customers is two months.
Work in progress – half a month Lag in payment of wages is 1 ½ weeks.
Raw materials Lag in payment of overhead expenses is one month.
60,00,000 x 0.5/12 2,50,000 One-fourth of the output is sold against cash.
Labour Cash in hand and at bank is expected to be Rs. 25,000.
15,00,000 x 0.5/12 x 50% 31,250
Overheads You are required to prepare a statement showing the working capital needed
45,00,000 x 0.5/12 x 50% 93,750 to finance a level of activity of 1,04,000 units of production.
Finished Goods – one month
Raw materials You may assume that production is carried on evenly throughout the year,
60,00,000 x 1/12 5,00,000 wages and overheads accrue similarly and a time period of 4 weeks is equivalent to a
Labour month.
15,00,000 x 1/12 1,25,000
Overheads Solution: -
45,00,000 x 1/12 3,75,000
2) Debtors – two months Statement of Cost Sheet
1,50,00,000 x 2/12 25,00,000
3) Cash 25,000 Elements of Cost Rs.
Total Current Assets 49,00,000 Raw materials [1,04,000 x 80] 83,20,000
Direct Labour [1,04,000 x 30] 31,20,000
B – Current Liabilities Overheads [1,04,000 x 60] 62,40,000
1) Creditors – one month Total Cost 1,76,80,000
60,00,000 x 1/12 5,00,000 Profit [1,04,000 x 30] 31,20,000
Total Current Liabilities 5,00,000 Sales 2,08,00,000

Working Capital Requirements (A – B) 44,00,000 Statement showing working capital requirements

Components Rs.
A – Current Assets
1) Inventory
Raw materials – 4 weeks
83,20,000 x 4/52 6,40,000
Work in progress – 2 weeks
Raw materials

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 83,20,000 x 2/52 3,20,000 Illustration: 4
Labour
31,20,000 x 2/52 x 50% 60,000 Solution: -
Overheads
62,40,000 x 2/52 X 50% 1,20,000 Statement showing working capital requirements
Finished Goods – 4 weeks
Raw materials Components Rs.
83,20,000 x 4/52 6,40,000 A – Current Assets
Labour 1) Inventory
31,20,000 x 4/52 2,40,000 Stock of finished goods 5,000
Overheads Stock of stores, materials, etc. 8,000
62,40,000 x 4/52 4,80,000 2) Debtors
2) Debtors – 8 weeks Inland Sales – 6 weeks credit
1,76,80,000 x 3/4 x 8/52 20,40,000 3,12,000 x 6/52 36,000
3) Cash 25,000 Export Sales 1 ½ weeks credit
Total Current Assets 45,65,000 78,000 x 1.5/52 2,250
3) Payment in Advance
B – Current Liabilities Sundry Expenses [8,000 x ¼] 2,000
1) Creditors – 4 weeks Total Current Assets 53,250
83,20,000 x 4/52 6,40,000
2) Accrued Wages – 1 ½ weeks B – Current Liabilities
31,20,000 x 1.5/52 90,000 1) Creditors [48,000 x 1.5/12] 6,000
3) Accrued Overheads – 4 weeks 2) Accrued Wages [2,60,000 x 1.5/52] 7,500
62,40,000 x 4/52 4,80,000 3) Accrued Rent, royalties, etc. [10,000 x 6/12] 5,000
4) Accrued Clerical salary [62,400 x 0.5/12] 2,600
Total Current Liabilities 12,10,000 5) Accrued Manager salary [4,800 x 0.5/12] 200
6] Accrued Miscellaneous Expenses [48,000 x 1.5/12] 6,000
Working Capital Requirements (A – B) 33,55,000 Total Current Liabilities 27,300

Working Capital Requirements (A – B) 25,950

Add: 10% towards contingences 2,595

Average amount of Working Capital Required 28,545

Illustration: 5

A proforma cost sheet of a company provides the following particulars:

Elements of Cost Per Unit

Raw materials 40%
Direct Labour 20%
Overheads 20%

The following further particulars are available:

i. It is proposed to maintain a level of activity of 2,00,000 units.
ii. Selling price is Rs. 12 per unit.
iii. Raw materials are expected to remain in stores for an average period of one
month.
iv. Materials will be in process, on averages half a month.
v. Finished goods are required to be in stock for an average period of one
month.
vi. Credit allowed to debtors is two months.
vii. Credit allowed by suppliers is one month.

14 15
 You may assume that sales and production follow a consistent pattern. You Illustration: 6
are required to prepare a statement of working capital requirements.
A proforma cost sheet of a manufacturing company provides the following
Solution: - particulars:

Statement of Cost Sheet Elements of Cost Per Unit

Rs.
Elements of Cost Rs. Raw materials 8
Raw materials [24,00,000 x 40%] 9,60,000 Direct Labour 3
Direct Labour [24,00,000 x 20%] 4,80,000 Overheads (exclusive of depreciation) 6
Overheads [24,00,000 x 20%] 4,80,000 Total cost 17
Total Cost 19,20,000
Profit 4,80,000 The following further particulars are available:
Sales [2,00,000 x 12] 24,00,000
Selling Price Rs. 20 per unit
Statement showing working capital requirements Level of activity 1,04,000 units of output per annum (52 weeks)
Raw material in stock On an average 4 weeks
Components Rs. Processing time On an average 2 weeks
A – Current Assets Finished goods in store On an average 4 weeks
1) Inventory Credit Period:
Raw materials – one month (a) Customers On an average 8 weeks
9,60,000 x 1/12 80,000 (b) Suppliers of materials On an average 4 weeks
Work in progress – half a month Lag in Payment:
Raw materials (a) Wages On an average 1 ½ weeks
9,60,000 x 0.5/12 40,000 (b) Overhead Expenses On an average 2 weeks
Labour
4,80,000 x 0.5/12 x 50% 10,000 75% of the output is sold on credit basis. Cash on hand and at bank is
Overheads expected to be Rs. 5,000.
4,80,000 x 0.5/12 x 50% 10,000 You are required to prepare a statement showing the working capital
Finished Goods – one month requirements (a) in total, and (b) as regards each constituent part of the same to
Raw materials finance a level of activity of 1,04,000 units of production per annum. You may
9,60,000 x 1/12 80,000 assume that all wages and overheads accrue evenly and are completely introduced
Labour for half the processing time, i.e., 1 week.
4,80,000 x 1/12 40,000
Overheads Solution: -
4,80,000 x 1/12 40,000
2) Debtors – two months Statement of Cost Sheet
19,20,000 x 2/12 3,20,000
Total Current Assets 6,20,000 Elements of Cost Rs.
Raw materials [1,04,000 x 8] 8,32,000
B – Current Liabilities
Direct Labour [1,04,000 x 3] 3,12,000
1) Creditors – one month
Overheads [1,04,000 x 6] 6,24,000
9,60,000 x 1/12 80,000
Total Cost 17,68,000
Total Current Liabilities 80,000
Profit [1,04,000 x 3] 3,12,000
Sales [1,04,000 x 20] 20,80,000
Working Capital Requirements (A – B) 5,40,000

16 17
Statement showing working capital requirements Illustration: 7

Components Rs. From the information given below, you are required to purpose a projected
A – Current Assets balance sheet, P&L account and then an estimate of working capital requirements.
1) Inventory a. Issued share capital – 3,00,000
Raw materials – 4 weeks 6% Debentures – 2,00,000
8,32,000 x 4/52 64,000 Fixed Assets at Cost – 2,00,000
Work in progress – 2 weeks b. The expected ratios to selling price are –
Raw materials Raw materials – 50%
8,32,000 x 2/52 32,000 Labour – 20%
Labour Overheads – 20%
3,12,000 x 2/52 x 50% 6,000 Profit – 10%
Overheads c. Raw materials are kept in stores for an average of 2 months.
6,24,000 x 2/52 x 50% 12,000 d. Finished goods remain in stock for an average period of 3 months.
Finished Goods – 4 weeks e. Production during the previous year was 1,80,000 units and it is planned to
Raw materials maintain the same in the current year also.
8,32,000 x 4/52 64,000 f. Each unit of production is expected to be in process for ½ a month (with 50%
Labour completion of labour and overheads).
3,12,000 x 4/52 24,000 g. Credit allowed to customers is 3 months and given by suppliers is 2 months.
Overheads h. Selling price is Rs. 4 per unit.
6,24,000 x 4/52 48,000 i. There is a regular production and sales cycle.
2) Debtors – 8 weeks j. Calculation of debtors may be made at selling price.
17,68,000 x 3/4 x 8/52 2,04,000
3) Cash 5,000 Solution: -
Total Current Assets 4,59,000
Calculation of Sales
B – Current Liabilities
1) Creditors – 4 weeks Sales = 1,80,000 x 4 = Rs. 7,20,000
8,32,000 x 4/52 64,000
2) Accrued Wages – 1 ½ weeks Statement of Cost Sheet
3,12,000 x 1.5/52 9,000
3) Accrued Overheads – 2 weeks Elements of Cost Rs.
6,24,000 x 2/52 24,000 Raw materials [7,20,000 x 50%] 3,60,000
Direct Labour [7,20,000 x 20%] 1,44,000
Total Current Liabilities 97,000 Overheads [7,20,000 x 20%] 1,44,000
Total Cost 6,48,000
Working Capital Requirements (A – B) 3,62,000 Profit [Bal. fig.] 72,000
Sales 7,20,000

Statement showing working capital requirements

Components Rs.
A – Current Assets
1) Inventory
Raw materials – 2 months
3,60,000 x 2/12 60,000
Work in progress – ½ month
Raw materials
3,60,000 x 0.5/12 15,000
Labour
1,44,000 x 0.5/12 x 50% 3,000
Overheads

18 19
 1,44,000 x 0.5/12 x 50% 3,000 Illustration: 8
Finished Goods – 3 months
Raw materials Prepare an estimate of working capital requirements from the information of a
3,60,000 x 3/12 90,000 Trading concern.
Labour a. Projected annual sales 1,00,000 units
1,44,000 x 3/12 36,000 b. Selling Price Rs. 8 per unit.
Overheads c. Percentage of Net Profit on Sales 25%.
1,44,000 x 3/12 36,000 d. Average Credit Period allowed to customers – 8 weeks.
2) Debtors – 3 months e. Average Credit Period allowed by suppliers – 4 weeks.
7,20,000 x 3/12 1,80,000 f. Average stock holding in terms of sales requirement 12 weeks.
3) Cash 9,000 g. Allowed 10% for contingency.
Total Current Assets 4,32,000
Solution: -
B – Current Liabilities
1) Creditors – 2 months (always on R.M.) Calculation of Sales
3,60,000 x 2/12 60,000
Sales = 1,00,000 x 8 = Rs. 8,00,000
Total Current Liabilities 60,000
Calculation of Cost
Working Capital Requirements (A – B) 3,72,000
Cost = 8,00,000 x 75% = Rs. 6,00,000
Projected P&L account for the year
Statement showing working capital requirements
Particulars Rs. Particulars Rs.
To Cost of Materials 3,60,000 By Sales 7,20,000 Components Rs.
To cost of Labour 1,44,000 A – Current Assets
To cost of Overheads 1,44,000 1) Inventory – 12 weeks
To gross profit c/d 72,000 6,00,000 x 12/52 1,38,462
7,20,000 7,20,000 2) Debtors – 8 weeks
To Interest on Debentures 6,00,000 x 8/52 92,308
(2,00,000 x 6%) 12,000 By Gross Profit b/d 72,000
Net Profit c/d 60,000 Total Current Assets 2,30,770
72,000 72,000
B – Current Liabilities
Projected Balance Sheet 1) Creditors – 4 weeks
6,00,000 x 4/52 46,154
Liabilities Rs. Assets Rs.
1. Share Capital 3,00,000 1. Fixed Assets 2,00,000 Total Current Liabilities 46,154
2. Reserves & Surplus 2. Investments ---
Net Profit 60,000 3. Current Assets Working Capital Requirements (A – B) 1,84,616
3. Secured Loans Stock of Raw Material 60,000 Add: 10% Contingency 18,462
Debentures 2,00,000 Stock of WIP 21,000 Total Working Capital 2,03,078
Outstanding Interest 12,000 Stock of Finished Goods 1,62,000
4. Unsecured Loans --- Debtors 1,80,000
5. Current Liabilities Cash at Bank (bal. fig.) 9,000
Creditors 60,000

6,32,000 6,32,000

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 ii) Finished goods are in stock, on average one month.
Chapter Roundup iii) Credit allowed by suppliers, one month.
iv) Time lag in payment from debtors, 2 months.
 al refers to that part of Working Capital, which is required by a business v) Lag in payment of wages, ½ month.
oveWorking capital is the amount of funds necessary to cover the cost of vi) Lag in payment of overhead is one month.
operating the enterprise. In other words, it is the capital required to meet day 20% of the output is sold against cash. Cash in hand and at bank is expected
to day expenses of the organization. to be Rs. 30,000. It is to be assumed that production is carried on evenly
 Permanent working capital refers to the minimum level of investment in the throughout the year.
current assets that is carried by the business at all times to carry out
minimum level of its activities. It is also known as Fixed Working Capital. Ans: Net Working Capital Rs. 26,58,000.
 Temporary working capital and above the Permanent Working Capital. It is
also called Variable Working Capital or Fluctuating Working Capital. The 10. A proforma cost sheet of a company provides the following particulars:
amount of temporary working capital keeps on changing depending upon the
changes in production and sale. Elements of Cost Per Unit
 Gross working capital refers to investment in all the current assets taken Raw materials 50%
together. The total investments in all current assets are known as Gross Direct Labour 15%
Working Capital. Overheads 15%
 Net working capital refers to the excess of total current assets over total
current liabilities. Current assets refer to those assets which can be converted The following further particulars are available:
in to money immediately. It may be noted that the current liabilities refers to a. It is proposed to maintain a level of activity of 3,00,000 units.
those liabilities which are payable within a period of one year. b. Selling price is Rs. 20 per unit.
 The working capital cycle refers to the length of time between the firms c. Raw materials are expected to remain in stores for an average period of
paying cash for materials, entering into the production process, stock and the two months.
inflow of cash from accounts receivable. It is also called as the Operating d. Materials will be in process on an average of one month (Labour and
Cycle. Overheads are assumed to be 50% completed).
e. Finished goods are required to be in stock for an average period of two
months.
Quick Quiz f. Credit allowed to debtors is two months.
g. Credit allowed by suppliers is two months.
You may assume that sales and production follow a consistent pattern. You
1. What is working capital?
are required to prepare a statement of working capital requirements.
2. Distinguish between gross working capital and net working capital.
3. What is operating cycle?
Ans: Net Working Capital Rs. 19,25,000.
4. What are the dangers of excess working capital?
5. What are the dangers of inadequate working capital?
6. What are the advantages of adequate working capital? 11. From the information given below, you are required to purpose projected
7. Explain the factors influencing the amount of working capital. balance sheet. P&L account and then an estimate of working capital
8. Explain the various sources of working capital. requirements.
Issued share capital – 15,00,000
9. The Board of directors of Ashok Engineering Company Ltd. requests you to 8% Debentures – 2,00,000
prepare a statement showing the working capital requirements forecast for a Fixed Assets at Cost – 13,00,000
level of activity of 72,000 units of production p.a. The expected ratios to selling price are –
The following information is available for your calculation: Raw materials – 40%
Labour – 20%
Particulars Per Unit Overheads – 20%
Rs. The following further particulars are available.
Raw-material 90 a. It is proposed to maintain a level of activity of 2,00,000 units.
Direct Labour 40 b. Selling price is Rs. 12 per unit.
Overheads 75 c. Raw materials are kept in stores for an average of one month.
Total Cost 205 d. Raw materials will be in process on an average of one month with 100%
Profit 60 completion of material and with 50% completion of conversion cost.
Selling Price per unit 265 e. Finished goods remain in stock for an average period of one month.
i) Raw materials are in stock, on average one month.

22 23
 f. Credit allowed to debtors is 2 months and given by suppliers is one
month.

Ans: Net Working Capital Rs. 2,00,000; Balance Sheet Rs. 22,60,000.

12. Prepare an estimate of Working Capital Requirements from the following

information of a Trading Concern.
a. Projected annual sales 1,20,000 units.
b. Selling Price Rs. 10 per unit.
c. Percentage of Net Profit on Sales 30%.
d. Average Credit Period allowed to customers – 10 weeks.
e. Average Credit Period allowed by suppliers – 5 weeks.
f. Average stock holding in terms of sales requirement 5 weeks.
g. Allowed 15% for contingency.

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