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Question 1

What are the main responsibilities of a Chief Financial Officer of an organisation?

Answer

Responsibilities of Chief Financial Officer (CFO): The chief financial officer of an organisation plays an important role in the company’s goals, policies, and financial success. His main responsibilities include:

Financial analysis and planning: Determining the proper amount of funds to be employed in the firm.
Investment decisions: Efficient allocation of funds to specific assets.
Financial and capital structure decisions: Raisingof funds on favourable terms as possible, i.e., determining the composition of liabilities.
Management of financial resources (such as working capital).
Risk Management: Protecting assets.

Question 2

“The profit maximization is not an operationally feasible criterion.” Comment on it.

Answer

“The profit maximisation is not an operationally feasible criterion.” This statement is true because Profit maximisation can be a short-term objective for any organisation and cannot be its sole objective. Profit maximization fails to serve as an operational criterion for maximizing the owner's economic welfare. It fails to provide an operationally feasible measure for ranking alternative courses of action in terms of their economic efficiency. It suffers from the following limitations:

Vague term: The definition of the term profit is ambiguous. Does it mean short term orlong term profit? Does it refer to profit before or after tax? Total profit or profit per share?
Timing of Return: The profit maximization objective does not make distinction between returns received in different time periods. It gives no consideration to the time value of money, and values benefits received today and benefits received after a period as the same.
It ignores the risk factor.
The term maximization is also vague.

Question 3

Discuss emerging issues affecting the future role of Chief Financial Officer (CFO).

Answer

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

Regulation: Regulation requirements are increasing and CFOs have an increasingly personal stake in regulatory adherence.
Globalisation: The challenges of globalisation are creating a need for finance leaders to develop a finance function that works effectively on the global stage and that embraces diversity.
Technology: Technology is evolving very quickly, providing the potential for CFOs to reconfigure finance processes and drive business insight through ‘big data’ and analytics.
Risk: The nature of the risks that organisations face is changing, requiring more effective risk management approaches and increasingly CFOs have a role to play in ensuring an appropriate corporate ethos.
Transformation: There will be more pressure on CFOs to transform their finance functions to drive a better service to the business at zero cost impact.
Stakeholder Management: Stakeholder management and relationships will become important as increasingly CFOs become the face of the corporate brand.
Strategy: There will be a greater role to play in strategy validation and execution, because the environment is more complex and quick changing, calling on the analytical skills CFOscan bring.
Reporting: Reporting requirements will broaden and continue to be burdensome for CFOs.
Talent and Capability: A brighter spotlight will shine on talent, capability and behaviours in the top finance role.

Question 4

A company offers a Fixed deposit scheme whereby Rs10,000 matures to Rs12,625 after 2 years, on a half-yearly compounding basis. If the company wishes to amend the scheme by compounding interest every quarter, what will be the revised maturity value?

Answer

Computation of Rate of Interest and Revised Maturity Value

Principal = Rs 10,000

Amount = Rs 12,625

Question 5

X is invested Rs2,40,000 at annual rate of interest of 10 percent. What is the amount after 3 years if the compounding is done?

Annually
Semi-annually.

Answer

Computation of Future Value

Principal (P) = Rs 2,40,000
Rate of Interest (ĭ) = 10% p.a.

Time period (n)= 3 years

Amount if compounding is done:

Question 6

Why money in the future is worth less than similar money today? Give the reasons andexplain.

Answer

Money in the Future is worth less than the Similar Money Today due to several reasons:

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

Preference For Present Consumption : Most of the persons and companies in general, prefer current consumption over future consumption.

Inflation : In an inflationary period a rupee today represents a greater real purchasing power than a rupee a year hence.

Investment Opportunities : Most of the persons and companies have a preference for present money because of availabilities of opportunities of investment for earning additional cash flow.

Question 7

Discuss the financial ratios for evaluating company performance on operating efficiency and liquidity position aspects.

Answer

Financial ratios for evaluating performance on operational efficiency and liquidity position aspects are discussed as:

Operating Efficiency: Ratio analysis throws light on the degree of efficiency in the management and utilization of its assets. The various activity ratios (such as turnover ratios) measure this kind of operational efficiency. These ratios are employed to evaluate the efficiencywith which the firm manages and utilises its assets. These ratios usually indicate the frequency ofsales with respect to its assets. These assets may be capital assets or working capital or averageinventory. In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the sales revenues generated by use of its assets – total as well as its components.

Liquidity Position: With the help of ratio analysis, one can draw conclusions regarding liquidity position of a firm. The liquidity position of a firm would be satisfactory, if it is able to meet its current obligations when they become due. Inability to pay-off short-term liabilitiesaffects its credibility as well as its credit rating. Continuous default on the part of the businessleads to commercial bankruptcy. Eventually such commercial bankruptcy may lead to itssickness and dissolution. Liquidity ratios are current ratio, liquid ratio and cash to current liability ratio. These ratios are particularly useful in credit analysis by banks and other suppliers of short-term loans.

Question 8

Diagrammatically present the DU PONT CHART to calculate return on equity.

Answer

Du Pont Chart

There are three components in the calculation of return on equity using the traditional DuPont model- the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company's return on equity can be discovered and compared to its competitors.

Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier)

Question 9

Discuss the composition of Return on Equity (ROE) using the DuPont model.

Answer

Composition of Return on Equity using the DuPont Model

a) Net Profit Margin: The net profit margin is simply the after-tax profit a company generates for each rupee of revenue.

Net profit margin = Net Income ÷ Revenue

Net profit margin is a safety cushion; the lower the margin, lesser the room for error.

b) Asset Turnover: The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows:

Asset Turnover = Revenue ÷ Assets

The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset turnover.

c) Equity Multiplier: It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows:

Equity Multiplier = Assets ÷ Shareholders’ Equity.

Calculation of Return on Equity

To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.) Return on Equity = Net profit margin× Asset turnover × Equity multiplier

Question 10

Explain briefly the limitations of Financial ratios.

Answer

Limitations of Financial Ratios

The limitations of financial ratios are listed below:

Diversified product lines: Many businesses operate a large number of divisions in quite different industries. In such cases, ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons.
Financial data are badly distorted by inflation: Historical cost values may be substantially different from true values. Such distortions of financial data are also carried in the financial ratios.
Seasonal factors may also influence financial data.
To give a good shape to the popularly used financial ratios (like current ratio, debt- equity ratios, etc.): The business may make some year-end adjustments. Such window dressingcan change the character of financial ratios which would be different had there been nosuch change.
Differences in accounting policies and accounting period: It can make the accounting data of two firms non-comparable as also the accounting ratios.
There is no standard set of ratios against which a firm’s ratios can be compared:

Sometimes a firm’s ratios are compared with the industry average. But if a firm desires to be above the average, then industry average becomes a low standard. On the other hand, for a below average firm, industry averages become too high a standard to achieve.

Question 11

Explain the important ratios that would be used in each of the following situations:

A bank is approached by a company for a loan of Rs50 lakhs for working capital purposes.
A long term creditor interested in determining whether his claim is adequately secured.
A shareholder who is examining his portfolio and who is to decide whether he should hold or sell his holding in the company.
A finance manager interested to know the effectiveness with which a firm uses its available resources.

Answer

Important Ratios used in different situations

Liquidity Ratios- Here Liquidity or short-term solvency ratios would be used by the bank to check the ability of the company to pay its short-term liabilities. A bank may use Current ratio and Quick ratio to judge short terms solvency of the firm.
Capital Structure/Leverage Ratios- Here the long-term creditor would use the capital structure/leverage ratios to ensure the long term stability and structure of the firm. A long term creditors interested in the determining whether his claim is adequately secured may use Debt-service coverage and interest coverage ratio.
Profitability Ratios- The shareholder would use the profitability ratios to measure the profitability or the operational efficiency of the firm to see the final results of business operations. A shareholder may use return on equity, earning per share and dividend per share.
Activity Ratios- The finance manager would use these ratios to evaluate the efficiency with which the firm manages and utilises its assets. Some important ratios are

(a) Capital turnover ratio

(b) Current and fixed assets turnover ratio

Question 14

Using the following data, complete the Balance Sheet given below:

Gross Profits	Rs54,000
Shareholders’ Funds	Rs6,00,000
Gross Profit margin	20%
Credit sales to Total sales	80%
Total Assets turnover	0.3 times
Inventory turnover	4 times
Average collection period (a 360 daysyear)	20 days
Current ratio	1.8
Long-term Debt to Equity	40%

Balance Sheet

Liabilities Amount	(Rs)	Assets Amount	(Rs)
Creditors	………………	Cash	……………
Long-term debt	………………	Debtors	……………
Shareholders’ funds	………………	Inventory Fixed assets	…………… ……………
Answer
Gross Profits Rs 54,000
Gross Profit Margin 20%

Sales = Gross Profits / Gross Profit Margin = Rs 54,000 / 0.20 = Rs 2,70,000

Question 15

JKL Limited has the following Balance Sheets as on March 31, 2006 and March 31, 2005:

The Income Statement of the JKL Ltd. for the year ended is as follows:

Required:

i) Calculate for the year 2005-06:

a)Inventory turnover ratio

b)Financial Leverage

c) Return on Investment (ROI)

d) Return on Equity (ROE)

e) Average Collection period.

ii) Give a brief comment on the Financial Position of JKL Limited.

Answer

Ratios for the year 2005-2006

i) (a) Inventory turnover ratio

(ii)Brief Comment on the financial position of JKL Ltd.

The profitability of operations of the company are showing sharp decline due to increase in operating expenses. The financial and operating leverages are becoming adverse. The liquidity of the company is under great stress.

Question 16

ABC Limited has an average cost of debt at 10 per cent and tax rate is 40 per cent. The Financial leverage ratio for the company is 0.60. Calculate Return on Equity (ROE) if its Return on Investment (ROI) is 20 per cent.

Answer

ROE = [ROI + {(ROI – r) × D/E}] (1 – t)

= [0.20 + {(0.20 – 0.10) × 60}] (1 – 0.40)

=[ 0.20 + 0.06] × 0.60 = 0.1560

ROE = 15.60%

Question 17

The following information relates to Beta Ltd. for the year ended 31st March 2013: Net Working Capital Rs12,00,000

Fixed Assets to Proprietor’s Fund Ratio 0.75 Working Capital Turnover Ratio 5 Times Return on Equity (ROE) 15%

There is no debt capital.

You are required to calculate:

i)Proprietor’s Fund

ii) Fixed Assets

iii) Net Profit Ratio.

Answer

(i) Calculation of Proprietor’s Fund

Since Ratio of Fixed Assets to Proprietor’s Fund = 0.75

Therefore, Fixed Assets = 0.75 Proprietor’s Fund

Net Working Capital = 0.25 Proprietor’s Fund

12,00,000 = 0.25 Proprietor’s Fund

[Note: Fixed Assets may be computed alternatively by (Net Working Capital × Fixed Assets to Proprietor’s Fund Ratio) and Proprietor’s Fund by (Fixed Assets + Net Working Capital)].

Question 18

NOOR Limited provides the following information for the year ending 31st March, 2014:

Equity Share Capital	Rs25,00,000
Closing Stock	Rs6,00,000
Stock Turnover Ratio	5 times
Gross Profit Ratio	25%
Net Profit / Sale	20%
Net Profit / Capital	¼

You are required to prepare:

Trading and Profit & Loss Account for the year ending 31st March, 2014.

Answer

Working Notes:

Question 19

Distinguish between Funds Flow Statement and Cash Flow Statement.

Answer

Differentiation between Funds Flow Statement and Cash Flow Statement

Funds flow statement is based on the accrual accounting system. In case of preparation of cash flow statement all transactions affecting the cash equivalents only are taken intoconsideration.
Funds flow statement analyses the sources and applications of funds which are longtermin nature and the net increase in long-term funds will be reflected on the working capital of the firm. The Cash flow statement will only consider the increase or decrease in current assets and current liabilities in calculating the cash flow of funds from operations.
Funds flow analysis is more useful for long-range financial planning. Cash flow analysis is more useful for identifying and correcting the current liquidity problems of the firm.
Funds flow statement tallies the funds generated from various sources with various uses to which they are put. Cash flow statement tallies difference between opening balance of cash and closing balance of cash by proceeding through sources and uses.

Question 20

From the information contained in Income Statement and Balance Sheet of ‘A’ Ltd., prepare Cash Flow Statement:

Income Statement for the year ended March 31, 2006

		Rs.
Net Sales	(A)	2,52,00,000
Less:
Cash Cost of Sales		1,98,00,000
Depreciation		6,00,000
Salaries and Wages		24,00,000
Operating Expenses		8,00,000
Provision for Taxation		8,80,000
	(B)	2,44,80,000
Net Operating Profit (A – B)		7,20,000
Non-recurring Income – Profits on sale of equipment		1,20,000

		8,40,000
Retained earnings and profits brought forward		15,18,000
		23,58,000
Dividends declared and paid during the year		7,20,000
Profit and Loss Account balance as on March 31, 2006		16,38,000

Balance Sheet ason

Assets	March 31, 2005	March 31, 2006
	(Rs.)	(Rs.)
Fixed Assets:
Land	4,80,000	9,60,000
Buildings and Equipment	36,00,000	57,60,000
Current Assets:
Cash	6,00,000	7,20,000
Debtors	16,80,000	18,60,000
Stock	26,40,000	9,60,000
Advances	78,000	90,000
	90,78,000	1,03,50,000

Balance Sheet ason

Liabilities and Equity	March 31, 2005	March 31, 2006
	(Rs)	(Rs)
Share Capital	36,00,000	44,40,000
Surplus in Profit and Loss Account	15,18,000	16,38,000
Sundry Creditors	24,00,000	23,40,000
Outstanding Expenses	2,40,000	4,80,000
Income-tax payable	1,20,000	1,32,000
Accumulated Depreciation on Buildings and Equipment	12,00,000	13,20,000
	90,78,000	1,03,50,000

The original cost of equipment sold during the year 2005-06 was Rs7,20,000.

Answer

Cash Flow Statement of Company A Ltd. for the year ending March 31, 2006 Cash flows from Operating Activities

	Rs.
Net Profits before Tax and Extra-ordinary Item	16,00,000
Add: Depreciation	6,00,000
Operating Profits before Working Capital Changes	22,00,000
Increase in Debtors	(1,80,000)
Decrease in Stock	16,80,000
Increase in Advances	(12,000)
Decrease in Sundry Creditors	(60,000)
Increase in Outstanding Expenses	2,40,000
Cash Generated from Operations	38,68,000
Income tax Paid	8,68,000
Net Cash from Operations	30,00,000

Cash flows from Investment Activities

	Rs.
Purchase of Land	(4,80,000)
Purchase of Buildings and Equipment	(28,80,000)
Sale of Equipment	3,60,000
Net Cash used in Investment Activities	(30,00,000)

Cash flows from Financing Activities

		Rs.
Issue of Share Capital	8,40,000
Dividends Paid	(7,20,000)	_______
Net Cash from Financing Activities		1,20,000
Net increase in Cash and Cash Equivalents		1,20,000
Cash and Cash Equivalents at the beginning		6,00,000
Cash and Cash Equivalents at the end		7,20,000

Buildings and EquipmentAccount

	Rs		Rs
Balance b/d	36,00,000	Sale of Asset	7,20,000
Cash/Bank (purchase) (Balancingfigure)	28,80,000	Balance c/d	57,60,000 _____ _
	64,80,000		64,80,000

Accumulated Depreciation on Buildings and EquipmentAccount

	Rs			Rs
Sale of Asset		Balance b/d		12,00,000
(Accumulated depreciation)	4,80,000	Profit and (Provisional)	Loss	6,00,000
Balance c/d	13,20,000			_________
	18,00,000			18,00,000

Sale of Asset Account

	Rs
Original Cost	7,20,000
Less: Accumulated Depreciation	4,80,000
Net Cost	2,40,000
Profit on Sale of Asset	1,20,000
Sale Proceeds from Asset Sales	3,60,000

Income Tax Payable Account

Bank A/c (b/f)

Balance c/d

8,68,000

1,32,000

Balance b/d

Provision for Tax A/c

1,20,000

8,80,000

10,00,000

Question 21

The Balance Sheet of JK Limited as on 31st March, 2005 and 31st March, 2006 are given below:

Balance Sheetason (Rs’000)

Liabilities	31.03.05	31.03.06	Assets	31.03.05	31.03.0 6
Share Capital	1,440	1,920	Fixed Assets	3,840	4,560
Capital Reserve		48	Less: Depreciation	1,104	1,392
General	816	960		2,736	3,168

Liabilities	31/03/05	31/03/06	Assets	31/03/05	31/03/06
Share Capital	1,440	1,920	Fixed Assets	3,840	4,560
Capital Reserve		48	Less: Depreciation	1,104	1,392
General Reserve	816	960		2,736	3,168
Profit and Loss	288	360	Investment	480	384
Account
9% Debenture	960	672	Cash	210	312
Current Liabilities	576	624	Other Current Assets
Proposed Dividend	144	174	(including Stock)	1,134	1,272
Provision for Tax	432	408	Preliminary Expenses	96	48
Unpaid Dividend	-	18		_	_
	4,656	5,184		4,656	5,184

Additional Information:

During the year 2005-2006, Fixed Assets with a book value of Rs2,40,000 (accumulated depreciation Rs84,000) was sold forRs1,20,000.
Provided Rs4,20,000asdepreciation.
Some investments are sold at a profit of Rs48,000and Profit was credited to Capital Reserve.
It decided that stocks be valued at cost, whereas previously the practice was to value stock at cost less 10 per cent. The stock was Rs2,59,200as on 31.03.05.The stock as on31.03.06 was correctly valued atRs3,60,000.
It decided to write off Fixed Assets costing Rs60,000on which depreciation amountingtoRs48,000 has been provided.
Debentures are redeemed at Rs105. Required: Prepare a CashFlowStatement.

Answer

Cash flow Statement (31stMarch, 2006)

(A)Cashflows from OperatingActivities

Profit and Loss A/c
(3,60,000 – (2,88,000 + 28,800)		43,200
Adjustments:
Increase in General Reserve	1,44,000
Depreciation	4,20,000
Provision for Tax	4,08,000
Loss on Sale of Machine	36,000
Premium on Redemption of Debenture	14,400
Proposed Dividend	1,74,000
Preliminary Exp. w/o	48,000
Fixed Assets w/o	12,000	12,56,400
Funds from Operation		12,99,600
Increase in Sundry Current Liabilities		48,000
Increase in Current Assets
12,72,000 – (11,34,000 + 28,800)		(1,09,200)
Cash before Tax		12,38,400
Tax paid		4,32,000
Cash from Operating Activities		8,06,400

(b) Cash from Investing Activities

Purchases of fixed assets	(10,20,000)
Sale of Investment	1,44,000
Sale of Fixed Assets	1,20,000	(7,56,000)

(c) Cash from FinancingActivities

Issue of Share Capital	4,80,000
Redemption of Debenture	(3,02,400)
Dividend paid	(1,26,000)	51,600
Net increase in Cash and Cash equivalents		1,02,000
Opening Cash and Cash equivalents		2,10,000
Closing Cash		3,12,000

d) Fixed AssetsAccount

	Particulars	Rs.		Particulars	Rs.
To	Balance b/d	27,36,000	By	Cash	1,20,000
To	Purchases (Balance)	10,20,000	By	Loss on sales	36,000
			By	Depreciation	4,20,000
			By	Assets w/o	12,000
		________	By	Balance
		________	By	Balance	31,68,000
		37,56,000			37,56,000

(e)DepreciationAccount

	Particulars	Rs.		Particulars	Rs.
To	Fixed Assets (on sales)	84,000	By	Balance b/d	11,04,000
To	Fixed Assets w/o	48,000	By	Profit and Loss a/c	4,20,000
To	Balance	13,92,000			_______
		15,24,000			15,24,000

Question 22

The following are the Balance Sheets of Gama Limited for the year ending March 31, 2004 and March 31,2005:

Balance Sheet as on March, 31

		2004	2005
		Rs	Rs
Capital and Liabilities
Share Capital		6,75,000	7,87,500
General Reserves		2,25,000	2,81,250
Capital Reserve (Profit on Sale of investment)		-	11,250
Profit & Loss Account		1,12,500	2,25,000
15% Debentures		3,37,500	2,25,000
Accrued Expenses		11,250	13,500
Creditors		1,80,000	2,81,250
Provision for Dividends		33,750	38,250
Provision for Taxation		78,750	85,500
	Total	16,53,750	19,48,500
Assets
Fixed Assets		11,25,000	13,50,000
Less: Accumulated depreciation		2,25,000	2,81,250
Net Fixed Assets		9,00,000	10,68,750
Long-term Investments (at cost)		2,02,500	2,02,500

Stock (at cost)	2,25,000	3,03,750
Debtors (net of provision for doubtful debts of Rs45,000 and Rs56,250 respectively for 2004 and 2005 respectively)	2,53,125	2,75,625
Bills receivables	45,000	73,125
Prepaid Expenses	11,250	13,500
Miscellaneous Expenditure	16,875	11,250
	16,53,750	19,48,500

Additional Information:

During the year 2004-05, fixed assets with a net book value of Rs11,250 (accumulated depreciation, Rs33,750) was sold forRs9,000.
During the year 2004-05, Investments costing Rs90,000were sold, and also Investments costing Rs90,000 werepurchased.
Debentures were retired at a Premium of10%.
Tax of Rs61,875was paid for2003-04.
During the year 2004-05, bad debts of Rs15,750 were written off against the provision for Doubtful Debtaccount.
The proposed dividend for 2003-04 was paid in2004-05.

Required:

Prepare a Funds Flow Statement (Statement of changes in Financial Position on workingcapital basis) for the year ended March31,2005.

Answer

Computation of Funds from Operation

Profit and loss balance on March 31, 2005	Rs2,25,000
Add: Depreciation	90,000
Loss on Sale of Asset	2,250
Misc. Expenditure written off	5,625
Transfer to Reserves	56,250
Premium on Redemption of debentures	11,250
Provision for Dividend	38,250
Provision for Taxation	68,625
	4,97,250
Less: P/L balance on March 31, 2004	1,12,500
Funds from operations	3,84,750

Accumulated Depreciation A/c

To Fixed Asset A/c

33,750

By Bal. b/d

2,25,000

To Bal. c/d

2,81,250

By P/L A/c

(Pro (Prov. for dep.) (Bal. Fig.)

90,000

3,15,000

Fixed Assets A/c

To Bal. b/d	11,25,000	By Accumulated Depreciation A/c	33,750
		By Cash	9,000
To Bank (Purchase of Fixed Asset) (Bal. fig.)	2,70,000	By P/L (Loss on sale)	2,250
		By Bal. c/d	13,50,000
	13,95,000		13,95,000

Provision for Tax A/c

To Cash (tax paid)	61,875	By Bal. b/d	78,750
		By P/L A/c (Prov.)
To Bal. c/d	85,500	(Bal. fig.)	68,625
	1,47,375		1,47,375

Statement of Changes in Working Capital

	March 31, 2004	March 31,2005	Change in W/C
Current Assets
Stock	2,25,000	3,03,750	78,750
Debtors	2,53,125	2,75,625	22,500
Bills Receivables	45,000	73,125	28,125
Prepaid Expenses	11,250	13,500	2,250
	5,34,375	6,66,000	1,31,625	-
Less: Current liabilities
Accrued Expenses	11,250	13,500	-	2,250
Creditors	1,80,000	2,81,250	-	1,01,250
	1,91,250	2,94,750	1,31,625	1,03,500
Working Capital	3,43,125	3,71,250	-	-
Increase in Working Capital	28,125	____________	____________	28,125
Increase in Working Capital	3,71,250	3,71,250	1,31,625	1,31,625

Funds Flow Statement for the year ended March 31, 2005

Sources		Rs
	Working Capital from Operations	3,84,750
	Sale of Fixed Assets	9,000
	Sale of Investments	1,01,250
	Share Capital Issued	1,12,500
	Total Funds Provided (A)	Rs6,07,500
Uses		Rs
	Purchase of Fixed Assets	2,70,000
	Purchase of Investments	90,000
	Payment of Debentures (at a premium of 10%)	1,23,750
	Payment of Dividends	33,750
	Payment of Taxes	61,875
	Total Funds Applied (B)	5,79,375
	Increase in Working Capital (A-B)	Rs28,125

Question 23

Balance Sheets of RST Limited as on March 31, 2008 and March 31, 2009 are as under:

Liabilities	31.3.2008 Rs	31.3.2009 Rs	Assets	31.3.2008 Rs	31.3.2009 Rs
Equity Share Capital			Land & Building
(Rs10 face value per share)	10,00,000	12,00,000		6,00,000	7,00,000
General Reserve	3,50,000	2,00,000	Plant & Machinery	9,00,000	11,00,000

9% Preference Share Capital	3,00,000	5,00,000	Investments (Long- term)	2,50,000	2,50,000
Share Premium A/c	25,000	4,000	Stock	3,60,000	3,50,000
Profit & Loss A/c	2,00,000	3,00,000	Debtors	3,00,000	3,90,000
8% Debentures	3,00,000	1,00,000	Cash & Bank	1,00,000	95,000
Creditors	2,05,000	3,00,000	Prepaid Expenses	15,000	20,000
Bills Payable	45,000	81,000	Advance Tax Payment	80,000	1,05,000
Provision for Tax	70,000	1,00,000	Preliminary Expenses	40,000	35,000
Proposed Dividend	1,50,000	2,60,000		________
					_______
	26,45,000	30,45,000		26,45,000	30,45,000

Depreciationchargedonbuildingandplantandmachineryduringtheyear2008- 09 were Rs50,000 and Rs1,20,000 respectively.
During the year an old machine costing Rs1,50,000was sold for Rs32,000. Its written down value was Rs40,000on date ofsale.
Duringtheyear,incometaxfortheyear2007-08wasassessedatRs76,000.Achequeof Rs4,000 was received along with the assessment order towards refund of income tax paid in excess, by way of advance tax in earlier years.
Proposed dividend for 2007-08 was paid during the year2008-09.
9% Preference shares of Rs3,00,000, which were due for redemption, were redeemed during the year 2008-09 at a premium of 5%, out of the proceeds of fresh issue of 9% Preferenceshares.
Bonus shares were issued to the existing equity shareholders at the rate of one share for every five shares held on 31.3.2008 out of generalreserves.
Debentures werere deemed at the beginning of the year at a premium of 3%.
Interim dividend paid during the year 2008-09 wasRs50,000.

Required:

(a) Schedule of Changes in Working Capital;and Fund Flow Statement for the year ended March31,2009.

Answer

Schedule of Changes in WorkingCapital

Particulars	31.3.08	31.3.09	Effect on Working Capital
			Increase	Decrease
	Rs	Rs	Rs	Rs
Current Assets:
Stock	3,60,000	3,50,000	-	10,000
Debtors	3,00,000	3,90,000	90,000	-
Cash and Bank	1,00,000	95,000	-	5,000
Prepaid Expenses	15,000	20,000	5,000	-
Total (A)	7,75,000	8,55,000
Current Liabilities:
Creditors	2,05,000	3,00,000	-	95,000
Bills Payable	45,000	81,000	-	36,000
Total (B)	2,50,000	3,81,000
Net Working Capital (A-B)	5,25,000	4,74,000	-
Net Decrease in Working Capital	-	51,000	51,000	-

	5,25,000	5,25,000	1,46,000	1,46,000

(b) Funds Flow Statement for the year ended 31stMarch,2009

Sources of Fund	Rs
Funds from Operation	7,49,000
Issue of 9% Preference Shares	5,00,000
Sales of Plant & Machinery	32,000
Refund of Income Tax	4,000
Financial Resources Provided (A)	12,85,000
Applications of Fund	Rs.
Purchase of Land and Building	1,50,000
Purchase of Plant and Machinery	3,60,000
Redemption of Debentures	2,06,000
Redemption of Preference Shares	3,15,000
Payment of Tax	1,05,000
Payment of Interim Dividend	50,000
Payment of Dividend (2007-08)	1,50,000
Financial Resources Applied (B)	13,36,000
Net Decrease in Working Capital (A - B)	51,000

Working Notes:

Estimation of Funds from Operation

Profit and Loss A/c Balance on 31.3.2009

Add: Depreciation on Land and Building

50,000

3,00,000

Depreciation on Plant and Machinery Loss on Sale of Plant and Machinery ( 40,000 – 32,000)	1,20,000
	8,000
	5,000
	50,000

Preliminary Expenses written off (40,000 –35,000) Transfer to General Reserve Proposed Dividend Provision for Taxation Interim Dividendpaid Less: Profit and Loss A/c balance on 31.3.08 Funds from Operation	2,60,000
	1,06,000
	50,000
		6,49,000
		9,49,000
		2,00,000
		7,49,000

Plant & Machinery A/c

Rs		Rs
To Balance b/d	9,00,000	By Depreciation	1,20,000
To Bank (Purchase	3,60,000	By Bank (Sale)	32,000
(Bal. Fig.)		By P/L A/c (Loss on Sale)	8,000
		By Balance c/d	11,00,000

	12,60,000		12,60,000

Provision for TaxationA/c

Rs		Rs
To Advance tax payment A/c	76,000	By Balance b/d	70,000
To Balance c/d	1,00,000	By P/L A/c (additional provision for2007-08)	6,000
		By P/L A/c (Provision for 08-09)	1,00,000
	1,76,000		1,76,000

Advance Tax PaymentA/c

Rs		Rs
To Balance b/d	80,000	By Provision for taxation A/c	76,000
To Bank (paid for 08-09)	1,05,000	By Bank (Refund of tax)	4,000
	_______	By Balance c/d	1,05,000
	1,85000		1,85,000

8% Debentures A/c

Rs		Rs
To Bank (2,00,000 x103%) (redemption)	2,06,000	By Balance b/d	3,00,000
To Balance c/d	1,00,000	By Premium on redemption
	_______	of Debentures A/c	6,000
	3,06,000		3,06,000

9% Preference Share Capital A/c

Rs		Rs
To Bank A/c (3,00,000 x 105%) (redemption)	3,15,000	By Balance b/d	3,00,000
To Balance c/d	5,00,000	By Premium on redemption of Preference shares A/c	15,000
		By Bank (Issue)	5,00,000
	8,15,000		8,15,000

Securities Premium A/c

Rs		Rs
To Premium on redemption of debentures A/c	6,000	By Balance b/d	25,000
To Premium on redemption of preference shares A/c	15,000
To Balance c/d	4,000		______
	25,000		25,000

General Reserve A/c

Rs		Rs
To Bonus to Shareholders A/c	2,00,000	By Balance b/d	3,50,000
To Balance c/d	2,00,000	By P/L A/c (transfer) b/f	50,000
	4,00,000		4,00,000

Land and Building A/c

Rs		Rs
To Balance b/d	6,00,000	By Depreciation	50,000
To Bank (Purchase) (Bal. Fig.)	1,50,000	By Balance c/d	7,00,000
	7,50,000		7,50,000

Question 24

Balance Sheets of Star Ltd. are as under:

BalanceSheet (in lakhRs)

Liabilities	31/03/13 Rs	31/03/14 Rs	Assets	31/03/13 Rs	31/03/14 Rs
Share Capital	24.00	30.00	Plant & Machinery	15.00	21.00
Reserve	4.50	6.00	Buildings	12.00	18.00
Profit & Loss A/c	1.80	3.00	Investments	-	3.00
Debentures	-	6.00	Sundry Debtors	21.00	15.00
Provision for Taxation	2.10	3.00	Stock	6.00	12.00
Proposed Dividend	3.00	6.00	Cash in hand/Bank	6.00	6.00
Sundry Creditors	24.60	21.00
Total	60.00	75.00		60.00	75.00

With the help of following additional information, prepare Cash Flow Statement:

Depreciation on plant and machinery was charged @ 25% on its opening balance and on building @ 10% on its openingbalance.
During the year an old machine costing Rs1,50,000 (written down value Rs60,000) was sold for Rs1,05,000.
Rs1,50,000waspaidtowardsIncome-tax,duringtheyear.

Answer

Cash Flow Statement for the year ending on March 31, 2014

	Rs in lakhs	Rs in lakhs
I. Cash flows from OperatingActivities
Net profit made during the year (W.N.1)	8.70
Provision for taxation made during the year	2.40
Profit on sale of machinery	(0.60)

Adjustment for depreciation on Machinery (W.N.2)	3.75
Adjustment for depreciation on Land & Building	1.20
Operating profit before change in Working Capital	15.45
Increase in Inventory	(6.00)
Decrease in Debtors	6.00
Decrease in Creditors	(3.60)
Cash generated from operations	11.85
Income-tax paid	(1.50)
Net cash from operating activities		10.35
II. Cash flows from InvestingActivities
Purchase of Machinery	(10.20)
Sale of Machinery	1.05
Purchase of Building	(7.20)
Purchase of investments	(3.00)
		(19.35)
III. Cash flows from FinancingActivities
Issue of shares	6.00
Issue of debentures	6.00
Dividend paid	(3.00)	9.00
Net increase in cash and cash equivalent		Nil
Cash and cash equivalents at the beginning of the period		6.00
Cash and cash equivalents at the end of the period		6.00

Working Notes:

Net Profit made during the year ended 31.3.2014

	Rs in lakhs
Increase in P & L (Cr.) Balance	1.20
Add: Transfer to generalreserve	1.50
Add: Provided for proposed dividend during theyear	6.00
	8.70

(i)Plant &MachineryAccount

		Rs in lakhs			Rs in lakhs
To	Balance b/d	15.00	By	Depreciation (Bal. Fig.) [25% of 15 ]	3.75
To	P& L A/c [1.05 less 0.45 (0.60 less depreciation 0.15)]	0.60	By	Cash/Bank A/c	1.05
To	Cash/Bank (balancing fig.)	10.20	By	Balance c/d	21.00
		25.80			25.80

(ii) Provision for TaxationAccount

		Rs in lakhs			Rs in lakhs
To	Cash/Bank (Bal. Fig.)	1.50	By	Balance b/d	2.10
To	Balance c/d	3.00	By	P & L A/c	2.40
		4.50			4.50

(iii)Proposed DividendAccount

		Rs in lakhs			Rs in lakhs
To	Bank	3.00*	By	Balance b/d	3.00
To	Balance c/d	6.00	By	P & L A/c (Bal. Fig.)	6.00
		9.00			9.00

* last year’s proposed dividend assumed to be paid this year.

(iv)BuildingAccount

		Rsin lakhs			Rsin lakhs
To	Balance b/d	12.00	By	Depreciation	1.20
To	Bank A/c (Purchase)	7.20	By	Balance c/d	18.00
		19.20			19.20

Question 25

What do you understand by Weighted Average Cost ofCapital?

Answer

Weighted Average Cost of Capital

The composite or overall cost of capital of a firm is the weighted average of thecosts ofvarious sources of funds. Weights are taken in proportion of each source of funds in capital structure while making financial decisions. The weighted average cost of capital is calculatedby calculating the cost of specific source of fund and multiplying the cost of each source by its proportion in capital structure. Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm’s capital structure.That is, the after tax costof each debt and equity is calculated separately and added together to a single overallcost ofcapital.

Question 26

You are analysing the beta for ABC Computers Ltd. and have divided the company into four broad business groups, with market values and betas for each group.

Business group	Market value of equity	Unleveraged beta
Main frames	Rs100 billion	1.10
Personal Computers	Rs100 billion	1.50
Software	Rs50 billion	2.00
Printers	Rs150 billion	1.00

ABC Computers Ltd. had Rs50 billion in debt outstanding. Required:

(i) Estimate the beta for ABC Computers Ltd. as a Company.Is this beta going to be equal to the beta estimated by regressing past returns on ABC Computers stock against a market index. Why or whynot?

[Part (i) is out of syllabus and this topic is covered in Final Level paper]

(ii) If the treasury bond rate is 7.5%, estimate the cost of equity for ABC Computers Ltd. Estimate the cost of equity for each division. Which cost of equity would you use to value the printer division? The average market risk premium is 8.5%.

Answer

(i) Beta of ABCComputers

= 1.10 × 2/8 + 1.50 × 2/8 + 2 × 1/8 + 1 × 3/8 = 1.275

Beta coefficient is a measure of volatility of securities return relative to the returns of a broad based market portfolio. Hence beta measures volatility of ABC Computers stock return against broad based market portfolio. In this case we are consideringfour business groups in computer segment and not a broad based market portfolio , therefore beta calculations will not be thesame.

(ii) Cost ofequity

= rf + avmkt risk premium

= 7.5% + 1.275 × 8.5% = 18.34%

Mainframe

Personal Computers

= 7.5% + 1.10 × 8.5% =

16.85%

= 7.5% + 1.5 × 8.5% =

20.25%

Software

= 7.5% + 2 × 8.5% = 24.5%

Printers

= 7.5% + 1 × 8.5% = 16%

Advise: To value printer division, the use of 16% KE is recommended.

Question 27

Z Ltd.’s operating income (before interest and tax) is Rs9,00,000. The firm’s cost of debt is 10 per cent and currently firm employs Rs30,00,000 of debt. The overall cost of capital of firm is 12 per cent.

Required:

Calculate cost of equity.

Answer

Calculation of Cost of Equity

Question 28

ABC Ltd. wishes to raise additional finance of Rs20 lakhs for meeting its investment plans. The company has Rs4,00,000 in the form of retained earnings available for investment purposes.

The following are the further details:

Debt equity ratio 25 : 75.
Cost of debt at the rate of 10 percent (before tax) uptoRs2,00,000 and 13% (before tax) beyond that.
Earnings per share, Rs12.
Dividend payout 50% of earnings.
Expected growth rate in dividend 10%.
Current market price per share, Rs60.
Company’s tax rate is 30% and shareholder’s personal tax rate is 20%. Required:

(i) Calculate the post tax average cost of additional debt.

(ii) Calculate the cost of retained earnings and cost of equity.

(iii) Calculate the overall weighted average (after tax) cost of additional finance.

Answer

Answer
Pattern of raising capital	=	0.25 × 20,00,000
Debt	=	5,00,000
Equity	=	15,00,000
Equity fund (Rs 15,00,000)
Retained earnings	=	Rs 4,00,000
Equity (additional)	=	Rs 11,00,000
Total	=	Rs 15,00,000
Debt fund (Rs 5,00,000)
10% debt	=	Rs 2,00,000
13% debt	=	Rs 3,00,000
Total	=	Rs 5,00,000

(i) Kd = Total Interest (1 × t) / Rs5,00,000

= [20,000 + 39,000] (1 × 0.3)/ 5,00,000 or (41,300 / 5,00,000) × 100 = 8.26%

(ii) Ke = EPS × payout / mp + g = 12 (50%) / 60 ×100 + 10% 10% + 10% =20%

Kr = Ke (1 – tp) = 20(1 × 0.2) = 16%

(iii)Weighted average cost of capital

	Amount	After tax	Cost
Equity Capital	11,00,000	20.00%	2,20,000
Retained earning	4,00,000	16.00%	64,000
Debt	5,00,000	8.26%	41,300
Total	20,00,000		3,25,300

Ko = (3,25,300 / 20,00,000) ×100 = 16.27%

Question 29

Y Ltd. retains Rs7,50,000 out of its current earnings. The expected rate of return to the shareholders, if they had invested the funds elsewhere is 10%. The brokerage is 3% and the shareholders come in 30% tax bracket. Calculate the cost of retained earnings.

Answer

Computation of Cost of Retained Earnings (Kr)

Kr = k (1-TP)(1-B)

Kr = 0.10 (1- 0.30) (1-0.03)

= 0.10 (0.70) × (0.97) = 0.0679 or 6.79%

Cost of Retained Earnings = 6.79%

Question 30

PQR Ltd. has the following capital structure on October 31, 2010:

	Rs
Equity Share Capital (2,00,000 Shares of Rs10 each)	20,00,000
Reserves & Surplus	20,00,000
12% Preference Shares	10,00,000
9% Debentures	30,00,000
	80,00,000

The market price of equity share is Rs30. It is expected that the company will pay next year a dividend of Rs3 per share, which will grow at 7% forever. Assume 40% income tax rate.

You are required to compute weighted average cost of capital using market value weights.

Answer

Computation of Weighted Average Cost of Capital (WACC): Existing Capital Structure

Calculation of Cost of Equity

Question 31

Beeta Ltd. has furnished the following information:

Earning per share (ESP) Rs4
Dividend payout ratio Rs25%
Market price per share Rs40
Rate of tax 30%
Growth rate of dividend 8%

The company wants to raise additional capital of Rs10 lakhs including debt of Rs4 lakhs. The cost of debt (before tax) is 10% uptoRs2 lakhs and 15% beyond that.

Compute the after tax cost of equity and debt and the weighted average cost of capital.

Answer

(i) Cost of Equity Share Capital (Ke)

(iii)Weighted Average Cost of Capital(WACC)

Source (1)	Amount (2) In Rs	Weights (3)	Cost of Capital (4)	Weighted Average Cost (5) = (3)x(4)
Equity	6,00,000	0.6	0.105	0.063
Debt	4,00,000	0.4	0.0875	0.035
Weighted Average Cost of Capital				0.098 or 9.8%

Note: Kecan be computed alternatively taking growthrate into consideration (D0(1+g)/P0+g). The values of Keand WACC then would change accordingly as 10.7% and 9.92%respectively.]

Question 32

Discuss the major considerations in capitalstructureplanning.

Answer

Major considerations in capital structure planning

There are three major considerations, i.e. risk, cost of capital and control, which help thefinance manager in determining the proportion in which he can raise funds from various sources.

Although, three factors, i.e., risk, cost and control determine the capital structure of a particular business undertaking at a given point oftime.

Risk: The finance manager attempts to design the capital structure in such a manner, so that risk and cost are the least and the control of the existing management is diluted to the least extent. However, there are also subsidiary factors also like marketability of the issue, manoeuvrability and flexibility of the capital structure, timing of raising the funds. Risk is of two kinds, i.e., Financial risk and Business risk. Here we are concerned primarily with the financial risk. Financial risk also is of two types:

1)Risk of cashinsolvency

2) Risk of variation in the expected earnings available to equity share-holders

Cost of Capital: Cost is an important consideration in capitalstructure decisions. It isobvious that a business should be at least capable of earning enough revenue to meet its costof capital and finance its growth. Hence, along with a risk as a factor, the finance manager has toconsider the cost aspect carefully while determining the capital structure.

Control: Along with cost and risk factors, the control aspect is also an important considerationin planning the capital structure. When a company issues further equity shares, it automatically dilutes the controlling interest of the present owners. Similarly, preference shareholders can have voting rights and thereby affect the composition of the Board of Directors, in case dividends on such shares are not paid for two consecutive years. Financial institutions normally stipulate that they shall have one or more directors on the Boards. Hence, when the management agrees to raise loans from financial institutions, by implication it agrees to forego a part of its control over the company. It is obvious, therefore, that decisions concerning capital structure are taken after keeping the control factor inmind.

Question 33

Explain the assumptions of Net Operating Income approach (NOI) theory of capital structure.

Answer

Assumptions of Net Operating Income (NOI) Theory of Capital Structure

According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e.the value of the firm is independent of the capital structure of the firm.

Assumptions

The corporate income taxes do notexist.
The market capitalizes the value of the firm as whole. Thus the split between debt and equity is notimportant.
The increase in proportionof debt in capital structure leads to change in risk perception of theshareholders.
Theoverallcostofcapital(Ko)remainsconstantforalldegreesofdebtequitymix.

Question 34

Discuss financial break-even and EBIT-EPS indifference analysis.

Answer

Financial Break-even and EBIT-EPS Indifference Analysis

Financial break-even point is the minimum level of EBIT needed to satisfy all thefixedfinancial charges i.e. interest and preference dividend. It denotes the level of EBIT for which firm’s EPS equals zero. If theEBIT is less than the financial breakeven point, then the EPS will be negative but if the expected level of EBIT is more than the breakeven point, then more fixed costs financing instruments can be taken in the capital structure, otherwise, equity would bepreferred.

EBIT-EPS analysis is a vital tool for designing the optimal capital structure of a firm. The objective of this analysis is to find the EBIT level that will equate EPS regardless of the financing plan chosen.

Question 35

What is Net Operating Income (NOI) theory of capital structure? Explain the assumptions of Net Operating Income approach theory of capital structure.

Answer

Net Operating Income (NOI) Theory of Capital Structure

According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e. the value of the firm is independent of the capital structure of the firm.

Assumptions

The corporate income taxes do not exist.
The market capitalizes the value of the firm as whole. Thus the split between debt and equity is not important.
The increase in proportion of debt in capital structure leads to change in risk perception of the shareholders.
The overall cost of capital (Ko) remains constant for all degrees of debt equity mix.

Question 36

What do you mean by capital structure? State its significance in financing decision.

Answer

Concept of Capital Structure and its Significance in Financing Decision Capital structure refers to the mix of a firm’s capitalisation i.e. mix of long-term sources offunds such as debentures, preference share capital, equity share capital and retainedearnings for meeting its total capital requirement.

Significance in Financing Decision

The capital structure decisions are very important in financial management as they influence debt – equity mix which ultimately affects shareholders return and risk. These decisions help in deciding the forms of financing (which sources to be tapped), their actual requirements (amount to be funded) and their relative proportions (mix) in total capitalisation. Therefore, such a pattern of capital structure must be chosen which minimises cost of capital and maximises the owners’ return.

Question 37

What is Over-capitalisation? State its causes and consequences.

Answer

Overcapitalization and its Causes and Consequences

It is a situation where a firm has more capital than it needs or in other words assets are worth less than its issued share capital, and earnings are insufficient to pay dividend and interest.

Causes of Over Capitalization

Over-capitalisation arises due to following reasons:

Raising more money through issue of shares or debentures than company can employ profitably.
Borrowing huge amount at higher rate than rate at which company can earn.
Excessive payment for the acquisition of fictitious assets such as goodwill etc.
Improper provision for depreciation, replacement of assets and distribution of dividends at a higher rate.
Wrong estimation of earnings and capitalization.

(Note: Students may answer any two of the above reasons)

Consequences of Over-Capitalisation

Over-capitalisation results in the following consequences:

Considerable reduction in the rate of dividend and interest payments.
Reduction in the market price of shares.
Resorting to “window dressing”.
Some companies may opt for reorganization. However, sometimes the matter gets worse and the company may go into liquidation.

(Note: Students may answer any two of the above consequences)

Question 38

A Company needs Rs31,25,000 for the construction of new plant. The following three plans are feasible:

I) The Company may issue 3,12,500 equity shares at Rs10 per share.

II)The Company may issue 1,56,250 ordinary equity shares at Rs10 per share and 15,625 debentures of Rs,. 100 denomination bearing a 8% rate of interest.

III) The Company may issue 1,56,250 equity shares at Rs10 per share and 15,625 preference shares at Rs100 epr share bearing a 8% rate of dividend.

if the Company's earnings before interest and taxes are Rs62,500, Rs1,25,000, Rs2,50,000, Rs3,75,000 and Rs6,25,000, what are the earnings per share under each of three financial plans ? Assume a Corporate Income tax rate of 40%.
Which alternative would you recommend and why?
Determine the EBIT-EPS indifference points by formulae between Financing Plan I and Plan II and Plan I and Plan III.

Answer

(i) Computation of EPS under three-financial plans.

Plan I: Equity Financing

EBIT	Rs 62,500	Rs 1,25,000	Rs 2,50,000	Rs 3,75,000	Rs 6,25,000
Interest	0	0	0	0	0
EBT	Rs 62,500	Rs 1,25,000	Rs 2,50,000	Rs 3,75,000	Rs 6,25,000
Less: Taxes 40%	25,000	50,000	1,00,000	1,50,000	2,50,000
PAT	Rs 37,500	Rs 75,000	Rs 1,50,000	Rs 2,25,000	Rs 3,75,000
No. of equity shares	3,12,500	3,12,500	3,12,500	3,12,500	3,12,500
EPS	Rs 0.12	0.24	0.48	0.72	1.20

Plan II: Debt – Equity Mix

EBIT	Rs 62,500	Rs 1,25,000	Rs 2,50,000	Rs 3,75,000	Rs 6,25,000
Less: Interest	1,25,000	1,25,000	1,25,000	1,25,000	1,25,000
EBT	(62,500)	0	1,25,000	2,50,000	5,00,000
Less: Taxes 40%	25,000*	0	50,000	1,00,000	2,00,000
PAT	(37,500)	0	75,000	1,50,000	3,00,000
No. of equity shares	1,56,250	1,56,250	1,56,250	1,56,250	1,56,250
EPS	(Rs0.24 )	0	0.48	0.96	1.92

The Company will be able to set off losses against other profits. If the Company has no profits from operations, losses will be carriedforward.

PlanIII : Preference Shares – EquityMix

EBIT	Rs 62,500	Rs 1,25,000	Rs 2,50,000	Rs 3,75,000	Rs 6,25,000
Less: Interest	0	0	0	0	0
EBT	62,500	1,25,000	2,50,000	3,75,000	6,25,000
Less: Taxes (40%)	25,000	50,000	1,00,000	1,50,000	2,50,000
PAT	37,500	75,000	1,50,000	2,25,000	3,75,000
Less: Pref. dividend	1,25,000	1,25,000	1,25,000	1,25,000	1,25,000
PAT for ordinary shareholders	(87,500)	(50,000)	25,000	1,00,000	2,50,000
No.of Equity shares	1,56,250	1,56,250	1,56,250	1,56,250	1,56,250
EPS	(0.56)	(0.32)	0.16	0.64	1.60

(i) The choice of the financing plan will depend on the state of economic conditions. If the company’s sales are increasing, the EPS will be maximum under Plan II: Debt – EquityMix. Under favourable economic conditions, debt financing gives more benefit due to tax shield availability than equity or preferencefinancing.

(iii)EBIT – EPS Indifference Point : Plan I and Plan II

Question 39

The management of Z Company Ltd. wants to raise its funds from market to meet out the financial demands of its long-term projects. The company has various combinations of proposals to raise its funds.You are given the following proposals of the company:

(i)

Proposals	% of Equity	% of Debts	% of Preference shares
P	100	-	-
Q	50	50	-
R	50	-	50

ii) Cost of debt –10%

Cost of preference shares – 10%

iii) Tax rate –50%

iv) Equity shares of the face value of Rs10 each will be issued at a premium of Rs10 per share.

v) Total investment to be raised Rs40,00,000.

vi) Expected earnings before interest and tax Rs18,00,000.

From the above proposals the management wants to take advice from youfor appropriate plan after computing thefollowing:

Earnings pershare
Financialbreak-even-point

Compute the EBIT range among the plans for indifference. Also indicate ifany oftheplansdominate.

Answer

ii) Computation of Earnings per Share(EPS)

Plans	P	Q	R
	Rs	Rs	Rs
Earnings before interest & tax (EBIT)	18,00,000	18,00,000	18,00,00 0
Less: Interest charges	-	2,00,000	-
Earnings before tax (EBT)	18,00,000	16,00,000	18,00,000
Less : Tax @ 50%	9,00,000	8,00,000	9,00,000
Earnings after tax (EAT)	9,00,000	8,00,000	9,00,000
Less : Preference share dividend	-	-	2,00,000
Earnings available for equity shareholders	9,00,000	8,00,000	7,00,000
No. of shares	2,00,000	1,00,000	1,00,000
E.P.S (Rs)	4.5	8	7

(ii)Computation of Financial Break-evenPoints

Proposal‘P’ =0

Proposal‘Q’ = Rs2,00,000 (Interestcharges)

Proposal‘R’ = Earnings required for payment of preferencesharedividend i.e.

Rs2,00,000 x 0.5 (Tax Rate) = Rs4,00,000

(iii)Computation of Indifference Point between the Proposals

The indifference point

Question 40

Differentiate between Business risk and Financial risk.

Answer

Business Risk and Financial Risk

Business risk refers to the risk associated with the firm’s operations. It is an unavoidable risk because of the environment in which the firm has to operate and the business risk is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses. Revenues and expenses are affected by demand of firm’s products, variations in prices and proportion of fixed cost in total cost.

Whereas, Financial risk refers to the additional risk placed on firm’s shareholders as a result of debt use in financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly by equity. Financial risk can be measured by ratios such as firm’s financial leverage multiplier, total debt to assets ratio etc.

Question 41

“Operating risk is associated with cost structure, whereas financial risk is associated with capital structure of a business concern.” Critically examine this statement.

Answer

“Operating risk is associated with cost structure whereas financial risk is associated with capital structure of a business concern”.

Operating risk refers to the risk associated with the firm’s operations. It is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses, which are affected by demand of firm’s products, variations in prices and proportion of fixed cost in total cost. If there is no fixed cost, there would be no operating risk. Whereas financial risk refers to the additional risk placed on firm’s shareholders as a result of debt and preference shares used in the capital structure of the concern. Companies that issue more debt instruments would have higher financial risk than companies financed mostly by equity.

Question 42

From the following financial data of Company A and Company B: Prepare their Income Statements.

	Company A	Company B
	Rs	Rs
Variable Cost	56,000	60% of sales
Fixed Cost	20,000	-
Interest Expenses	12,000	9,000
Financial Leverage	5 : 1	-
Operating Leverage	-	4 : 1
Income Tax Rate	30%	30%
Sales	-	1,05,000

Answer

Income Statements of Company A and Company B

	Company A	Company B
	Rs	Rs
Sales	91,000	1,05,000
Less: Variable cost	56,000	63,000
Contribution	35,000	42,000
Less: Fixed Cost	20,000	31,500
Earnings before interest and tax (EBIT)	15,000	10,500
Less: Interest	12,000	9,000
Earnings before tax (EBT)	3,000	1,500
Less: Tax @ 30%	900	450
Earnings after tax (EAT)	2,100	1,050

Working Notes:

Company A

(i) Financial Leverage = EBIT / EBIT Interest

5 = EBIT / EBIT 12,000

Question 43

Distinguish between 'Business Risk' and 'Financial Risk'.

Answer

Business Risk and Financial Risk: Business risk refers to the risk associated with the firm’s operations. It is an unavoidable risk because of the environment in which the firm has to operate and the business risk is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses. Revenues and expenses are affected by demand of firm’s products, variations in prices and proportion of fixed cost in total cost.

Question 44

What is debt securitisation? Explain the basics of debt securitisation process.

Answer

Debt Securitisation: It is a method of recycling of funds. It is especially beneficial to financial intermediaries to support the lending volumes. Assets generating steady cash flows are packaged together and against this asset pool, market securities can be issued, e.g. housing finance, auto loans, and credit card receivables.

Process of Debt Securitisation

The origination function – A borrower seeks a loan from a finance company, bank, HDFC. The credit worthiness of borrower is evaluated and contract is entered into with repayment schedule structured over the life of the loan.
The pooling function – Similar loans on receivables are clubbed together to create an underlying pool of assets. The pool is transferred in favour of Special purpose Vehicle (SPV), which acts as a trustee for investors.
The securitisation function – SPV will structure and issue securities on the basis of asset pool. The securities carry a coupon and expected maturity which can be asset based/ mortgage based. These are generally sold to investors through merchant bankers.

Investors are – pension funds, mutual funds, insurance funds.

The process of securitization is generally without recourse i.e. investors bear the credit risk and issuer is under an obligation to pay to investors only if the cash flows are received by him from the collateral. The benefits to the originator are that assets are shifted off the balance sheet, thus giving the originator recourse to off-balance sheet funding.

Question 45

Write short notes on the following:

a) Global Depository Receipts or Euro Convertible Bonds.

b) American Depository Receipts (ADRs)

c) Bridge Finance

d) Deep Discount Bonds vs. Zero Coupon Bonds

e) Venture Capital Financing

f) Seed Capital Assistance

Answer

a) Global Depository Receipts (GDRs): It is a negotiable certificate denominated in US dollars which represents a Non-US company’s publically traded local currency equity shares. GDRs are created when the local currency shares of an Indian company are delivered to Depository’s local custodian Bank against which the Depository bank issues depository receipts in US dollars. The GDRs may be traded freely in the overseas market like any other dollar-expressed security either on a foreign stock exchange or in the over the- counter market or among qualified institutional buyers.

By issue of GDRs Indian companies are able to tap global equity market to raise foreign currency funds by way of equity. It has distinct advantage over debt as there is no repayment of the principal and service costs are lower.

(Or)

Euro Convertible Bond: Euro Convertible bonds are quasi-debt securities (unsecured) which can be converted into depository receipts or local shares. ECBs offer the investor an option to convert the bond into equity at a fixed price after the minimum lock in period. The price of equity shares at the time of conversion will have a premium element. The bonds carry a fixed rate of interest. These are bearer securities and generally the issue of such bonds may carry two options viz. call option and put option. A call option allows the company to force conversion if the market price of the shares exceeds a particular percentage of the conversion price. A put option allows the investors to get his money back before maturity. In the case of ECBs, the payment of interest and the redemption of the bonds will be made by the issuer company in US dollars. ECBs issues are listed at London or Luxemburg stock exchanges.

An issuing company desirous of raising the ECBs is required to obtain prior permission of the Department of Economic Affairs, Ministry of Finance, Government of India, Companies having 3 years of good track record will only be permitted to raise funds. The condition is not applicable in the case of projects in infrastructure sector. The proceeds of ECBs would be permitted only for following purposes:

Import of capital goods
Retiring foreign currency debts
Capitalising Indian joint venture abroad
25% of total proceedings can be used for working capital and general corporate restructuring.

The impact of such issues has been to procure for the issuing companies’ finances at very competitive rates of interest. For the country a higher debt means a forex outgo in terms of interest.

b) American Depository Receipts (ADRs): These are depository receipts issued by a company in USA and are governed by the provisions of Securities and Exchange Commission of USA. As the regulations are severe, Indian companies tap the American market through private debt placement of GDRs listed in London and Luxemburg stock exchanges. Apart from legal impediments, ADRs are costlier than Global Depository Receipts (GDRs). Legal fees are considerably high for US listing. Registration fee in USA is also substantial. Hence ADRs are less popular than GDRs.

c) Bridge Finance: Bridge finance refers, normally, to loans taken by the business, usually from commercial banks for a short period, pending disbursement of term loans by financial institutions, normally it takes time for the financial institution to finalise procedures of creation of security, tie-up participation with other institutions etc. even though a positive appraisal of the project has been made. However, once the loans are approved in principle, firms in order not to lose further time in starting their projects arrange for bridge finance. Such temporary loan is normally repaid out of the proceeds of the principal term loans. It is secured by hypothecation of moveable assets, personal guarantees and demand promissory notes. Generally rate of interest on bridge finance is higher as compared with that on term loans.

d) Deep Discount Bonds vs. Zero Coupon Bonds: Deep Discount Bonds (DDBs) are in the form of zero interest bonds. These bonds are sold at a discounted value and on maturity face value is paid to the investors. In such bonds, there is no interest payoutduring lock-in period.

IDBI was first to issue a Deep Discount Bonds (DDBs) in India in January 1992. The bond of a face value of Rs.1 lakh was sold for Rs2,700 with a maturity period of 25 years. A zero coupon bond (ZCB) does not carry any interest but it is sold by the issuing company at a discount. The difference between discounted value and maturing or face value represents the interest to be earned by the investor on such bonds.

e)Venture Capital Financing: The term venture capital refers to capital investment made in a business or industrial enterprise, which carries elements of risks and insecurity and the probability of business hazards. Capital investment may assume the form of either equity or debt or both as a derivative instrument. The risk associated with the enterprise could be so high as to entail total loss or be so insignificant as to lead to high gains.

The European Venture Capital Association describes venture capital as risk finance for entrepreneurial growth oriented companies. It is an investment for the medium or long term seeking to maximise the return.

Venture Capital, thus, implies an investment in the form of equity for high-risk projects with the expectation of higher profits. The investments are made through private placement with the expectation of risk of total loss or huge returns. High technology industry is more attractive to venture capital financing due to the high profit potential.

The main object of investing equity is to get high capital profit at saturation stage. In broad sense under venture capital financing venture capitalist makes investment to purchase debt or equity from inexperienced entrepreneurs who undertake highly risky ventures with potential of success.

f) Seed Capital Assistance: The seed capital assistance has been designed by IDBI for professionally or technically qualified entrepreneurs. All the projects eligible for financial assistance from IDBI, directly or indirectly through refinance are eligible under the scheme. The project cost should not exceed Rs2 crores and the maximum assistance under the project will be restricted to 50% of the required promoters contribution or Rs 15 lacs whichever is lower.

The seed capital Assistance is interest free but carries a security charge of one percentper annum for the first five years and an increasing rate thereafter.

Question 46

Distinguish between Operating lease and financial lease.

Answer

Difference between Financial Lease and Operating Lease

S.No.	Finance Lease	Operating Lease
1.	The risk and reward incident to ownership are passed on the lessee. The lessor only remains the legal owner of the asset.	The lessee is only provided the use of the asset for a certain time. Risk incident to ownership belongs only to the lessor.
2	The lessee bears the risk of obsolescence	The lessee is only allowed the use of asset.
3	The lease is non-cancellable by either party under it.	The lease is kept cancellable by the lessor.
4.	The lessor does not bear the cost of repairs, maintenance or operations.	Usually, the lessor bears the cost of repairs, maintenance or operations.
5.	The lease is usually full payout.	The lease is usually non-payout.

Question 47

What is venture capital financing? Discuss the factors that a venture capitalist should consider before financing any risky project.

Answer

Under Venture Capital financing, venture capitalist makes investment to purchase debt or equity from inexperienced entrepreneurs who undertake highly risky ventures with potential of success. The factors to be considered by a Venture Capitalist before financing any Risky Project are:

Quality of the management team is a very important factor to be considered. They arerequired to show a high level of commitment to the project.
The technical ability of the team is also vital. They should be able to develop and produce a new product / service.
Technical feasibility of the new product / service should be considered.
Since the risk involved in investing in the company is quite high, venture capitalists should ensure that the prospects for future profits compensate for the risk.
A research must be carried out to ensure that there is a market for the new product.
The venture capitalist himself should have the capacity to bear risk or loss, if the project fails.
The venture capitalist should try to establish a number of exist routes.
In case of companies, venture capitalist can seek for a place on the Board of Directors to have a say on all significant matters affecting the business.

(Note: Students may answer any two of the above factors.)

Question 48

Explain the concept of Multiple Internal Rate of Return.

Answer

Multiple Internal Rate of Return (MIRR)

In cases where project cash flows change signs or reverse during the life of a project for example, an initial cash outflow is followed by cash inflows and subsequently followed by a major cash outflow; there may be more than one internal rate of return (IRR). The following graph of discount rate versus net present value (NPV) may be used as an illustration:

In such situations if the cost of capital is less than the two IRRs, a decision can be made easily, however, otherwise the IRR decision rule may turn out to be misleading as the project should only be invested if the cost of capital is between IRR1 and IRR2. To understand the concept of multiple IRRs it is necessary to understand the implicit re- investment assumption in both NPV and IRR techniques.

Question 49

MNP Limited is thinking of replacing its existing machine by a new machine which would cost Rs60 lakhs. The company’s current production is Rs80,000 units, and is expected to increase to 1,00,000 units, if the new machine is bought. The selling price of the product would remain unchanged at Rs200 per unit. The following is the cost of producing one unit of product using both the existing and new machine:

			Unit cost (Rs)
	Existing Machine (80,000units)	New Machine (1,00,000units)	Difference
Materials	75.0	63.75	(11.25)
Wages & Salaries	51.25	37.50	(13.75)
Supervision	20.0	25.0	5.0
Repairs and Maintenance	11.25	7.50	(3.75)
Power and Fuel	15.50	14.25	(1.25)
Depreciation	0.25	5.0	4.75
Allocated Corporate Overheads	10.0	12.50	2.50
	183.25	165.50	(17.75)

The existing machine has an accounting book value of Rs1,00,000, and it has been fully depreciated for tax purpose. It is estimated that machine will be useful for 5 years. The supplier of the new machine has offered to accept the old machine for Rs2,50,000. However, the market price of old machine today is Rs1,50,000 and it is expected to be Rs35,000 after 5 years. The new machine has a life of 5 years and a salvage value of Rs, 2,50,000 at the end of its economic life. Assume corporate Income tax rate at 40%, and depreciation is charged on straight line basis for Income-tax purposes. Further assume that book profit is treated as ordinary income for tax purpose. The opportunity cost of capital of the Company is15%.

Required:

Estimate net present value of the replacementdecision.
Estimate the internal rate of return of the replacementdecision.
Should Company go ahead with the replacement decision?Suggest.

Year (t)	1	2	3	4	5
PVIF0.15,t	0.8696	0.7561	0.6575	0.5718	0.4972
PVIF0.20,t	0.8333	0.6944	0.5787	0.4823	0.4019
PVIF0.25,t	0.80	0.64	0.512	0.4096	0.3277
PVIF0.30,t	0.7692	0.5917	0.4552	0.3501	0.2693
PVIF0.35,t	0.7407	0.5487	0.4064	0.3011	0.2230

Answer

(i) Net Cash Outlay of New Machine

Purchase Price Rs60,00,000

Less: Exchange value of old machine[2,50,000-0.4(2,50,000-0)] 1,50,000

Rs 58,50,000

Market Value of Old Machine: The old machine could be sold for Rs1,50,000in the market. Since the exchange value is more than the market value, this option is not attractive. This opportunity will be lost whether the old machine is retained or replaced. Thus, on incremental basis, it has noimpact.

Depreciation base: Old machine has been fully depreciated for tax purpose.

Thus the depreciation base of the new machine will be its original cost i.e. Rs60,00,000.

Net Cash Flows: Unit cost includes depreciation and allocated overheads. Allocated overheads are allocations from corporate office therefore they are irrelevant. The depreciation tax shield may be computed separately. Excluding depreciation and allocated overheads, unit costs can be calculated. The company will obtain additional revenue from additional 20,000 unitssold.

Thus, after-tax saving, excluding depreciation, tax shield, would be

= {100,000(200 – 148) – 80,000(200 – 173)} ×(1 – 0.40)

= {52,00,000 – 21,60,000}×0.60

= Rs18,24,000

After adjusting depreciation tax shield and salvage value, net cash flows and net present value is estimated.

Calculation of Cash flows and Project Profitability

							Rs (‘000)
		0	1	2	3	4	5
1	After-tax savings	-	1824	1824	1824	1824	1824
2	Depreciation (Rs 60,00,000 – 2,50,000)/5	-	1150	1150	1150	1150	1150
3	Tax shield on depreciation (Depreciation × Tax rate )	-	460	460	460	460	460
4	Net cash flows from operations (1+3)	-	2284	2284	2284	2284	2284

5	Initial cost	(5850)
6	Net Salvage Value (2,50,000 –35,000)	-	-	-	-	-	215
7	Net Cash Flows (4+5+6)	(5850)	2284	2284	2284	2284	2499
8	PVF at 15%	1.00	0.8696	0.7561	0.6575	0.5718	0.4972
9	PV	(5850)	1986.166	1726.932	1501.73	1305.99	1242.50
10	NPV	Rs 1913.32

(ii)

						Rs (‘000)
	0	1	2	3	4	5
NCF	(5850)	2284	2284	2284	2284	2499
PVF at 20%	1.00	0.8333	0.6944	0.5787	0.4823	0.4019
PV	(5850)	1903.257	1586.01	1321.751	1101.57	1004.35
PV of benefits	6916.94
PVF at 30%	1.00	0.7692	0.5917	0.4550	0.3501	0.2693
PV	(5850)	1756.85	1351.44	1039.22	799.63	672.98
PV of benefits	5620.12

IRR = 20% + 10% ×1066.94 / 1296.82

= 28.23%

iii. Advise: The Company should go ahead with replacement project, since it is positive NPV decision.

Question 50

A company wants to invest in a machinery that would cost Rs50,000 at the beginning of year 1. It is estimated that the net cash inflows from operations will be Rs18,000 per annum for 3 years, if the company opts to service a part of the machine at the end of year 1 at Rs10,000. In such a case, the scrap value at the end of year 3 will be Rs12,500. However, if the company decides not to service the part, then it will have to be replaced at the end of year 2 at Rs15,400. But in this case, the machine will work for the 4th year also and get operational cash inflow of Rs18,000 for the 4th year. It will have to be scrapped at the end of year 4 at Rs9,000.

Assuming cost of capital at 10% and ignoring taxes, will you recommend the purchase of this machine based on the net present value of its cash flows?

If the supplier gives a discount of Rs5,000 for purchase, what would be your decision? (The present value factors at the end of years 0, 1, 2, 3, 4, 5 and 6 are respectively 1, 0.9091, 0.8264, 0.7513, 0.6830, 0.6209 and 0.5644).

Answer

Option I : Purchase Machinery and Service Part at the end of Year 1.

Net Present value of cash flow @ 10% per annum discount rate.

= - 50,000 + 44,762 – 12,727+ 18,441

= - 62,727+ 63,203

= +476

Net Present Value is positive, but very low as compared to the investment.

If the Supplier gives a discount of Rs5,000, then

NPV = 5,000 + 476 = 5,476

Decision: Option II is worth investing as the net present value is positive and higher as compared to Option I.

Question 51

The management of P Limited is considering selecting a machine out oftwo mutually exclusive machines. The company’s cost of capital is12 percent and corporate tax rate for the company is 30 percent.Details of the machines are as follows:

	Machine – I	Machine – II
Cost of machine	Rs 10,00,000	Rs 15,00,000
Expected life	5 years	6 years
Annual income before tax and depreciation	Rs 3,45,000	Rs 4,55,000

Depreciation is to be charged on straight line basis. You are required to:

Calculatethediscountedpay-backperiod,netpresentvalueandinternalrateofreturn for each machine.
Advise the management of P Limited as to which machine they should take up. The present value factors of Re. 1 are asfollows:

Year	1	2	3	4	5	6
At 12%	.893	.797	.712	.636	.567	.507
At 13%	.885	.783	.693	.613	.543	.480
At 14%	.877	.769	.675	.592	.519	.456
At 15%	.870	.756	.658	.572	.497	.432
At 16%	.862	.743	.641	.552	.476	.410

At 14%	.877	.769	.675	.592	.519	.456
At 15%	.870	.756	.658	.572	.497	.432
At 16%	.862	.743	.641	.552	.476	.410

Answer

(i) Computation of Discounted Payback Period, Net Present Value (NPV) and Internal Rate of Return (IRR) for TwoMachines

Calculation of Cash Inflows

	Machine –I (Rs)	Machine –II (Rs)
Annual Income before Tax and Depreciation	3,45,000	4,55,000
Less : Depreciation
Machine – I: 10,00,000 /5	2,00,000	-
Machine – II: 15,00,000 / 6	-	2,50,000
Income before Tax	1,45,000	2,05,000
Less: Tax @ 30 %	43,500	61,500
Income after Tax	1,01,500	1,43,500
Add: Depreciation	2,00,000	2,50,000
Annual Cash Inflows	3,01,500	3,93,500

		Machine – I			Machine – II
Year	P.V. of Re.1 @12%	Cash flow	P.V.	Cumulative P.V	Cash flow	P.V.	Cumulative P.V.
1	0.893	3,01,500	2,69,240	2,69,240	3,93,500	3,51,396	3,51,396
2	0.797	3,01,500	2,40,296	5,09,536	3,93,500	3,13,620	6,65,016
3	0.712	3,01,500	2,14,668	7,24,204	3,93,500	2,80,172	9,45,188
4	0.636	3,01,500	1,91,754	9,15,958	3,93,500	2,50,266	11,95,454
5	0.567	3,01,500	1,70,951	10,86,909	3,93,500	2,23,115	14,18,569
6	0.507	---	--	--	3,93,500	1,99,505	16,18,074

Advise to the Management

Ranking of Machines in terms of the Three Methods

	Machine - I	Machine - II
Discounted Payback Period	I	II
Net Present Value	II	I
Internal Rate of Return	I	II

Advise: Since Machine - I has better ranking than Machine – II, therefore, Machine – I should be selected.

Question 52

APZ Limited is considering to select a machine between two machines 'A' and 'B'. The two machines have identical capacity, do exactly the same job, but designed differently.

Machine 'A' costs Rs8,00,000, having useful life of three years. It costs Rs1,30,000 per year to run.Machine 'B' is an economy model costing Rs6,00,000, having useful life of two years. It costs Rs2,50,000 per year to run.

The cash flows of machine 'A' and 'B' are real cash flows. The costs are forecasted in rupeesof constant purchasing power. Ignoretaxes.

The opportunity cost of capital is 10%. The present value factors at 10% are:

Year	t1	t2	t3
PVIF0.10,t	0.9091	0.8264	0.7513
PVIFA0.10,2 = 1.7355
PVIFA0.10,3 = 2.4868

Which machine would you recommend the companytobuy?

Answer

Statement Showing Evaluation of Two Machines

Particulars	Machine A	Machine B
Purchase Cost (Rs) : (i)	8,00,000	6,00,000
Life of Machines (in years)	3	2
Running Cost of Machine per year (Rs) : (ii)	1,30,000	2,50,000
Cumulative PVF for 1-3 years @ 10% : (iii)	2.4868	-
Cumulative PVF for 1-2 years @ 10% : (iv)	-	1.7355
Present Value of Running Cost of Machines (Rs):	3,23,284	4,33,875
(v) = [(ii) x (iii)]
Cash Outflow of Machines (Rs) : (vi) = (i) + (v)	11,23,284	10,33,875
Equivalent Present Value of Annual Cash Outflow	4,51,698.57	5,95,721.69
[(vi) x (iii)]	Or 4,51,699	Or 5,95,722

Recommendation: APZ Limited should consider buying Machine A since its equivalent Cash outflow is less than Machine B.

Question 53

Discuss the liquidity vs. profitability issue in management of working capital.

Answer

Liquidity versus Profitability Issue in Management of Working Capital

Working capital management entails the control and monitoring of all components of working capital i.e. cash, marketable securities, debtors, creditors etc. Finance manager has to pay particular attention to the levels of current assets and their financing. To decide the level of financing of current assets, the risk return trade off must be taken into account. The level of current assets can be measured by creating a relationship between current assets and fixed assets. A firm may follow a conservative, aggressive or moderate policy.

A conservative policy means lower return and risk while an aggressive policy produces higher return and risk. The two important aims of the working capital management are profitability and solvency. A liquid firm has less risk of insolvency i.e. it will hardly experience a cash shortage or a stock out situation. However, there is a cost associated with maintaining a sound liquidity position. So, to have a higher profitability the firm may have to sacrifice solvency and maintain a relatively low level of current assets.

Question 54

A newly formed company has applied to the Commercial Bank for the first time for financing its working capital requirements. The following information is available about the projections forthe currentyear:

	Per unit
Elements of cost:	(Rs)
Raw material	40
Direct labour	15
Overhead	30
Total cost	85
Profit	15
Sales	100

Other information:

Raw material in stock: average 4 weeks consumption, Work – in progress (completion stage, 50 per cent), on an average half a month. Finished goods in stock:on anaverage, one month.

Credit allowed by suppliers is one month. Credit allowed to debtors is two months.

Average time lag in payment of wages is 1½ weeks and 4 weeks in overhead expenses. Cash in hand and at bank is desired to be maintained at Rs50,000.

All Sales are on credit basis only.

Required:

(i) Prepare statement showing estimate of working capital needed to finance an activity level of 96,000 units of production. Assume that production is carried on evenly throughout the year, and wages and overhead accrue similarly. For the calculation purpose 4 weeks may be taken as equivalent to a month and 52 weeks in a year.

(ii) From the above information calculate the maximum permissible bank finance by all the three methods for working capital as per Tandon Committee norms; assume the core current assets constitute 25% of the currentassets.

[Part (ii) is out of syllabus/removed from the syllabus of Financial Management]

Answer

Calculation of Working Capital Requirement

(A)CurrentAssets

			Rs
(i)	Stock of material for 4 weeks (96,000 × 40 × 4/52)		2,95,385
(ii)	Work in progress for ½ month or 2 weeks
	Material (96,000 × 40 × 2/52).50	73,846

			Rs
	Stock of material for 4 weeks (96,000 × 40 × 4/52)		2,95,385
	Work in progress for ½ month or 2 weeks
	Material (96,000 × 40 × 2/52).50	73,846
	Labour (96,000 × 15 × 2/52).50	27,692
	Overhead (96,000 × 30 × 2/52) .50	55,385	1,56,923
(iii)	Finished stock (96,000 × 85 × 4/52)		6,27,692
(iv)	Debtors for 2 months (96,000 × 85 × 8/52)		12,55,385
	Cash in hand or at bank		50,000
	Investment in Current Assets		23,85,385

(b) CurrentLiabilities

(i)

(ii)

Creditors for one month (96,000 × 40 × 4/52)

Average lag in payment of expenses Overheads (96,000 × 30 × 4/52)

Labour (96,000 × 15 × 3/104)

Current Liabilities

Net working capital (A – B)

2,21,538

41,538

2,95,385

2,63,076

5,58,46118,26,924

Minimum Permissible Bank Finance as per Tandon Committee

Method I : .75 (Current Assets – CurrentLiabilities)

.75 (23,85,385 – 5,58,461)

.75 (18,26,924)–5,58,461 = Rs13,70,193

Method II: .75 × Current Assets – CurrentLiabilities

.75 × 23,85,385 – 5,58,461

17,89,039 – 5,58,461 = Rs12,30,578

Method III: .75 (Current Assets – CCA) – CurrentLiabilities

.75 (23,85,385 – 5,96,346) – 5,58,461

.75 (17,89,039) – 5,58,461

13,41,779 – 5,58,461 = Rs 7,83,318

Question 55

The following figures and ratios are related to a company:

(i) Sales for the year (allcredit)	Rs 30,00,000
(ii) Gross Profitratio	25 percent
(iii) Fixed assets turnover (based on cost of goods sold)	1.5
(iv) Stock turnover (based on cost of goods sold)	6
(v) Liquidratio	1 : 1
(vi) Current ratio	1.5 : 1
(vii) Debtors collection period	2 months
(viii) Reserves and surplus to Share capital	0.6 : 1
(ix) Capital gearing ratio	0.5

(x) Fixed assets to net worth 1.20 :1

You are required to prepare:

Balance Sheet of the company on the basis ofabove details.
The statement showing working capital requirement, if the company wants to make a provision for contingencies @ 10 percent of networking capital including such provision.

Answer

(a) Preparation of Balance Sheet of a Company WorkingNotes:

1)Cost of Goods Sold=Sales–GrossProfit(=25%ofSales)

= Rs30,00,000 – Rs7,50,000

= Rs22,50,000

2) ClosingStock = Cost of Goods Sold / StockTurnover

= Rs22,50,000/6

= Rs3,75,000

3) FixedAssets = Cost of Goods Sold / Fixed Assets Turnover

= Rs22,50,000/1.5

= Rs15,00,000

4) Current Assets : Current Ratio = 1.5 and Liquid Ratio = 1 Stock = 1.5 – 1 =0.5

Current Assets = Amount of Stock x 1.5/0.5

= Rs3,75,000 x 1.5/0.5 = Rs11,25,000

5) Liquid Assets (Debtors andCash)

= Current Assets – Stock

= Rs11,25,000 – Rs3,75,000

= Rs7,50,000

6) Debtors = Sales x Debtors Collection period/12

= Rs30,00,000 x 2 /12

= Rs5,00,000

7) Cash = Liquid Assets –Debtors

= Rs7,50,000 – Rs5,00,000 = Rs2,50,000

8) Net worth = Fixed Assets/1.2

= Rs15,00,000/1.2 = Rs12,50,000

9) Reserves and Surplus

Reserves andShareCapital= 0.6 + 1 = 1.6

Reserves and Surplus = Rs12,50,000x 0.6/1.6

= Rs4,68,750

10) Share Capital = Net worth – Reserves andSurplus

= Rs12,50,000 – Rs4,68,750

= Rs7,81,250

11) Current Liabilities = Current Assets/ CurrentRatio

= Rs11,25,000/1.5 = Rs7,50,000

12) Long-termDebts

CapitalGearingRatio=Long-termDebts/Equity Share holders’Fund Long-term Debts = Rs12,50,000x 0.5 = Rs6,25,000

Balance Sheet of a Company

Liabilities	Amount (Rs)	Assets	Amount (Rs)
Equity Share Capital	7,81,250	Fixed Assets Current Assets Stock Debtors Cash	15,00,000
Reserves and Surplus	4,68,750
Long-term Debts	6,25,000		3,75,000
Current Liabilities	7,50,000		5,00,000
	________		2,50,000
	26,25,000		26,25,000

b) Statement Showing Working CapitalRequirement

A.	Current Assets
	Stock	3,75,000
	Debtors	5,00,000
	Cash	2,50,000	11,25,000
B.	Current Liabilities		7,50,000
	Working Capital before Provision (A – B)		3,75,000
Add:	Provision for Contingencies @ 10% of Working
	Capital including Provision i.e. 1/9th of Working
	Capital before Provision : 3,75,000 x 1/9		41,667
	Working Capital Requirement including Provision		4,16,667

Question 56

Explain briefly the functions of Treasury Department.

Answer

The functions of treasury department management is to ensure proper usage, storage and risk management of liquid funds so as to ensure that the organisationis able to meet its obligations, collect its receivables and also maximize the return on its investments. Towardsthis end the treasury function may be dividedinto the following:

Cash Management: The efficient collection and payment of cash both inside the organization and to third parties is the function of treasury department. Treasury normally manages surplus funds in an investmentportfolio.
Currency Management: The treasury department manages the foreign currency risk exposure of the company. It advises on the currency to be used when invoicing overseas sales. It also manages any net exchange exposures in accordance with the company policy.
Fund Management: Treasury department is responsible for planning and sourcing the company’s short, medium and long-term cash needs. It also participates in thedecisionon capital structure and forecasts future interest and foreign currencyrates.
Banking: Since short-term finance can come in the form of bank loans or throughthe sale of commercial paper in the money market, therefore, treasury department carries out negotiations with bankers and acts as the initial point of contact with them.
Corporate Finance: Treasury department is involved with both acquisition and disinvestment activities within the group. In addition, it is often responsible for investor relations.

Question 57

'Management of marketable securities is an integral part of investment of cash.' Comment.

Answer

“Management of Marketable Securities is an Integral Part of Investment of Cash”

Management of marketable securities is an integral part of investment of cashas it serves both the purposes of liquidity and cash, provided choice of investment is made correctly.As theworking capital needs are fluctuating, it is possible to invest excess funds in some short term securities, which can be liquidated when need for cash is felt. The selection of securities should be guided by three principles namely safety,maturity and marketability.

Question 58

The following details are forecasted by a company for the purpose of effective utilization andmanagement of cash:

Estimated sales and manufacturing costs:

Year and month 2010	Sales Rs	Materials Rs	Wages Rs	Overheads Rs
April	4,20,000	2,00,000	1,60,000	45,000
May	4,50,000	2,10,000	1,60,000	40,000
June	5,00,000	2,60,000	1,65,000	38,000
July	4,90,000	2,82,000	1,65,000	37,500
August	5,40,000	2,80,000	1,65,000	60,800
September	6,10,000	3,10,000	1,70,000	52,000

(i) Creditterms:

Sales – 20 percent sales are on cash, 50 percent of the credit sales are collectednext month and the balance in the followingmonth.
Credit allowed by suppliers is 2months.
Delay in payment of wages is ½ (one-half) month and of overheads is 1 (one) month.

(ii) Interest on 12 percent debentures of Rs5,00,000 is to be paid half- yearly in June and December.

(iii) Dividends on investments amounting to Rs25,000 are expected to be received in June, 2010.

(iv) A new machinery will be installed in June, 2010 at a cost of Rs4,00,000 which is payable in 20 monthly installments from July, 2010onwards.

(v) Advance income-tax, to be paid in August, 2010, is Rs15,000.

(vi) Cash balance on 1stJune, 2010 is expected to be Rs45,000 and the company wants to keepit at the end of every month around this figure. The excess cash (in multiple of thousand rupees) is being put in fixeddeposit.

You are required to prepare monthly Cash budget on the basis of above information for four months beginning fromJune,2010.

Answer

Preparation of Monthly Cash Budget

Cash Budget for four months from June, 2010 to September, 2010

Particulars

June

(Rs)

July

(Rs)

August

(Rs)

September

(Rs)

Opening Balance

Receipts:

Cash Sales

Collection from debtors

45,000

1,00,000

3,48,000

45,500

98,000

3,80,000

45,500

1,08,000

3,96,000

45,000

1,22,000

4,12,000

Dividends	25,000	-	-	-
Total (A)	5,18,000	5,23,500	5,49,500	5,79,000
Payments:
Creditors for Materials	2,00,000	2,10,000	2,60,000	2,82,000
Wages	1,62,500	1,65,000	1,65,000	1,67,500
Overheads	40,000	38,000	37,500	60,800
Instalment for Machine	-	20,000	20,000	20,000
Interest on Debentures	30,000	-	-	-
Advance Tax	-	-	15,000	-

Total (B)	4,32,500	4,33,000	4,97,500	5,30,300

Surplus (A – B)	85,500	90,500	52,000	48,700
Fixed Deposits	40,000	45,000	7,000	3,000

Closing Balance	45,500	45,500	45,000	45,700

Working Notes:

(1) Cash Sales and Collection fromDebtors:

Month	Total Sales (Rs)	Cash Sales (Rs)	Credit Sales (Rs)	Collection from Debtors
Month	Total Sales (Rs)	Cash Sales (Rs)	Credit Sales (Rs)	June (Rs)	July (Rs)	Aug.(Rs)	Sept. (Rs)
April, 2010	4,20,000	84,000	3,36,000	1,68,000	-	-	-
May, 2010	4,50,000	90,000	3,60,000	1,80,000	1,80,000	-	-
June, 2010	5,00,000	1,00,000	4,00,000	-	2,00,000	2,00,000	-
July, 2010	4,90,000	98,000	3,92,000	-	-	1,96,000	1,96,000
Aug., 2010	5,40,000	1,08,000	4,32,000	-	-	-	2,16,000
Sept., 2010	6,10,000	1,22,000	4,88,000	----	----	----	------
			Total	3,48,000	3,80,000	3,96,000	4,12,000

Payment ofWages

June = 80,000 + 82,500 = 1,62,500;

July = 82,500 + 82,500 = 1,65,000;

Aug. = 82,500 + 82,500 = 1,65,000; and

Sept.= 82,500 + 85,000 = 1,67,500.

(Note: It has been assumed that the company wants to keep minimum cash balance of Rs 45,000.)

Question 59

What are the forms ofbankcredit?

Answer

Forms of Bank Credit

Some of the forms of bank credit are:

Short Term Loans: In a loan account, the entire advance is disbursedat one time either in cash or by transfer to the current account of the borrower. It is a single advance and given against securities like shares, government securities, life insurance policies and fixed deposit receipts,etc.
Overdraft: Under this facility, customers are allowed to withdraw in excess of credit balance standing in their Current Account. A fixed limit is therefore granted to theborrower within which the borrower is allowed to overdraw hisaccount.
Clean Overdrafts: Request for clean advancesare entertained only fromparties which are financially sound and reputed for their integrity. The bank has to rely upon the personal security of theborrowers.
Cash Credits: Cash Credit is an arrangement under which a customer is allowed an advance up to certain limit against credit granted by bank. Interest is not charged on the full amount of the advance but on the amount actually availed of by him.
Advances against goods: Goods are charged to the bank either by way of pledge or by wayof hypothecation. Goods include all forms of movables which are offered to the bank assecurity.
Bills Purchased/Discounted: These advances are allowed against the security of billswhich may be clean ordocumentary. Usance bills maturing at a future date or sight are discounted by the banks for approved parties. The borrower is paid the present worth and the bank collects the full amount on maturity.
Advance against documents of title to goods: A document becomes a document of title to goods when its possession is recognisedby law or business custom as possession of the goods like bill of lading, dock warehouse keeper's certificate, railway receipt, etc. An advance against the pledge of such documents is an advance against the pledgeof goodsthemselves.
Advance against supply of bills: Advances against bills for supply of goods to government or semi-government departments against firm orders after acceptance of tenderfall under this category. It is this debt that is assigned to the bank by endorsement of supply bills and executing irrevocable power of attorney in favourof the banks for receiving the amount of supply bills from the Governmentdepartments.

(Note: Students may answer any four of the above forms of bank credit.)

Question 60

State the different types of Packing Credit.

Answer

Different Types of Packing Credit

Packing credit may be of the following types:

Clean Packing credit: This is an advance made available to an exporter only on production of a firm export order or a letter of credit without exercising any charge orcontrol over raw material or finished goods. It is a clean type of export advance. Eachproposal is weighted according to particular requirements of the trade and creditworthiness of the exporter. A suitable margin has to be maintained. Also, Export CreditGuarantee Corporation (ECGC) cover should be obtained by the bank.
Packing credit against hypothecation of goods: Export finance is made available on certain terms and conditions where the exporter has pledgeable interest and the goods are hypothecated to the bank as security with stipulated margin. At the time of utilising the advance, the exporter is required to submit alongwith the firm export order or letter of credit, relative stock statements and thereafter continue submitting them every fortnight and whenever there is any movement in stocks.
Packing credit against pledge of goods: Export finance is made available on certain terms and conditions where the exportable finished goods are pledged to the banks with approved clearing agents who will ship the same from time to time as required by the exporter. The possession of the goods so pledged lies with the bank and is kept under its lock and key.
E.C.G.C. guarantee: Any loan given to an exporter for the manufacture, processing, purchasing, or packing of goods meant for export against a firm order qualifies for the packing credit guarantee issued by Export Credit Guarantee Corporation.
Forward exchange contract: Another requirement of packing credit facility is that if the export bill is to be drawn in a foreign currency, the exporter should enter into a forward exchange contact with the bank, thereby avoiding risk involved in a possible change in the rate of exchange.

(Note: Students may answer any four of the above packing credits).