PAPER 4 B : FINANCIAL MANAGEMENT

1.

Following is the abridged Balance Sheet of Showbiz Ltd.:

Liabilities
Share Capital
Profit
and
Loss
Account
Current Liabilities

Assets
Rs.
1,00,000 Land and Buildings
17,000 Plant
and
Machineries
40,000 Less: Depreciation

Total

Stock
Debtors
Bank
1,57,000 Total

Rs.
80,000
50,000
15,000

35,000
1,15,000

21,000
20,000
1,000

42,000
1,57,000

With the help of the additional information furnished below, you are required to prepare Trading
and Profit and Loss Account and a Balance sheet as on 31st March, 2005:
(i)

The company went in for reorganization of capital structure, with share capital remaining the
same as follows:
Share Capital
Other Shareholders Funds
5% Debentures
Trade Creditors

50%
15%
10%
25%

Debentures were issued on 1st April, interest being paid annually on 31st March.
(ii) Land and Buildings remained unchanged. Additional plant and machinery has been bought
and a further Rs. 5,000 depreciation written off.
(The total fixed assets then constituted 60% of total gross fixed and current assets.)
(iii) Working capital ratio was 8:5.
(iv) Quick assets ratio was 1:1.
(v) The debtors (four-fifth of the quick assets) to sales ratio revealed a credit period of 2
months. There were no cash sales.
(vi) Return on net worth was 10%.
(vii) Gross profit was at the rate of 15% of selling price.
(viii) Stock turnover was eight times for the year.
Ignore Taxation.
2.

The summarized Balance Sheet of Xansa Ltd. as on 31-12-2004 and 31-12-2005 are as follows:
Assets
Fixed assets at cost
Less: Depreciation
Net
Investments
Current Assets
Preliminary expenses

31-12-2004

31-12-2005

8,00,000
2,30,000
5,70,000
1,00,000
2,80,000
20,000
9,70,000

9,50,000
2,90,000
6,60,000
80,000
3,30,000
10,000
10,80,000

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Liabilities
Share Capital
Capital reserve
General reserve
Profit & Loss account
Debentures
Sundry Creditors
Tax Provision
Proposed dividend
Unpaid dividend

3,00,000

1,70,000
60,000
2,00,000
1,20,000
90,000
30,000

9,70,000

4,00,000
10,000
2,00,000
75,000
1,40,000
1,30,000
85,000
36,000
4,000
10,80,000

During 2005, the company

(a) Sold one machine for Rs. 25,000 the cost of the machine was Rs. 64,000 and depreciation
provided for it amounted to Rs. 35,000.
(b) Provided Rs. 95,000 as depreciation.
(c) Redeemed 30% of debentures at Rs. 103.
(d) Sold investments at profit and credited to capital reserve; and
(e) Decided to value the stock at cost, whereas earlier the practice was to value stock at cost
less 10%. The stock according to books on 31-12-2004 was Rs. 54,000 and stock on 31-122005 was Rs. 75,000, which was correctly valued at cost.
You are required to prepare the following statements:
(i)

Funds from Operations

(ii) Sources and application of funds and statement of changes in working capital.
(iii) Fixed assets account and loss on sale of machinery account.
3.

On 1st April, 2004 the Board of Directors of Super Ltd. wishes to know the amount of working
capital that will be required to meet the programme of activity they have planned for the year.
The following information is available:
(i)

Issued and paid-up capital Rs. 2,00,000.

(ii) 5% Debentures (secured on assets) Rs. 50,000.

(iii) Fixed assets valued at Rs. 1,25,000 on 31-12-2002.
(iv) Production during the previous year was 60,000 units, it is planned that this level of activity
should be maintained during the present year.
(v) The expected ratios of cost to selling price are raw materials 60%, direct wages 10%, and
overheads 20%.
(vi) Raw materials are expected to remain in stores for an average of two months before these
are issued for production.
(vii) Each unit of production is expected to be in process for one month.
(viii) Finished goods will stay in warehouse for approximately three months.
(ix) Creditors allow credit for 2 months from the date of delivery of raw materials.
(x) Credit allowed to debtors is 3 months from the date of dispatch.
(xi) Selling price per unit is Rs. 5.
(xii) There is a regular production and sales cycle.

25

You are required to prepare :

(a) Working capital requirement forecast; and
(b) An estimated profit and loss account and balance sheet at the end of the year.
4.

Shell Ltd. sells goods at a uniform rate of gross profit of 20% on sales including depreciation as
part of cost of production. Its annual figures are as under:
Sales (At 2 months credit)
Materials consumed (Suppliers credit 2 months)
Wages paid (Monthly at the beginning of the subsequent month)
Manufacturing expenses (Cash expenses are paid one month in arrear)
Administration expenses (Cash expenses are paid one month in arrear)
Sales promotion expenses (Paid quarterly in advance)

(Rs.)
24,00,000
6,00,000
4,80,000
6,00,000
1,50,000
75,000

The company keeps one month stock each of raw materials and finished goods. A minimum cash
balance of Rs. 80,000 is always kept. The company wants to adopt a 10% safety margin in the
maintenance of working capital. The company has no work-in-progress.
Find out the requirements of working capital of the company on cash cost basis.
5.

Zorro Limited wishes to raise additional finance of Rs. 10 lakhs for meeting its investment plans.
It has Rs. 2,10,000 in the form of retained earnings available for investment purposes. Further
details are as following:
(1)

Debt / equity mix

(2)

Cost of debt

30%/70%

Upto Rs. 1,80,000

10% (before tax)

Beyond Rs. 1,80,000

16% (before tax)

(3)

Earnings per share

Rs. 4

(4)

Dividend pay out

50% of earnings

(5)

Expected growth rate in dividend

10%

(6)

Current market price per share

Rs. 44

(7)

Tax rate

50%

You are required:

(a) To determine the pattern for raising the additional finance.
(b) To determine the post-tax average cost of additional debt.
(c) To determine the cost of retained earnings and cost of equity, and
(d) Compute the overall weighted average after tax cost of additional finance.
6.

Gamma Ltd. is considering three financing plans. The key information is as follows:
(a) Total investment to be raised Rs. 2,00,000
(b) Plans of Financing Proportion:
Plans

Equity

Debt

Preference Shares

100%

50%

50%

50%

50%

26

(c) Cost of debt

8%

Cost of preference shares

8%

(d) Tax rate

50%

(e) Equity shares of the face value of Rs. 10 each will be issued at a premium of Rs. 10 per
share.
(f)

Expected PBIT is Rs. 80,000.

You are required to determine for each plan: (i)

Earnings per share (EPS)

(ii) The financial break-even point.

(iii) Indicate if any of the plans dominate and compute the PBIT range among the plans for
indifference.
7.

XYZ Ltd. is planning its capital investment programme for next year. It has five projects all of
which give a positive NPV at the company cut-off rate of 15 percent, the investment outflows and
present values being as follows:
Project

Investment
Rs. 000
(50)
(40)
(25)
(30)
(35)

A
B
C
D
E

NPV @ 15%
Rs. 000
15.4
18.7
10.1
11.2
19.3

The company is limited to a capital spending of Rs. 1,20,000.

You are required to optimise the returns from a package of projects within the capital spending
limit. The projects are independent of each other and are divisible (i.e., part-project is possible).
8.

The following information relates to Alpha Ltd., a publishing company:

The selling price of a book is Rs. 15, and sales are made on credit through a book club and
invoiced on the last day of the month.
Variable costs of production per book are materials (Rs. 5), labour (Rs. 4), and overhead (Rs. 2)
The sales manager has forecasted the following volumes:
No. of Books

Nov

Dec

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

1,000

1,000

1,000

1,250

1,500

2,000

1,900

2,200

2,200

2,300

Customers are expected to pay as follows:

One month after the sale

40%

Two months after the sale

60%

The company produces the books two months before they are sold and the creditors for materials
are paid two months after production.
Variable overheads are paid in the month following production and are expected to increase by
25% in April; 75% of wages are paid in the month of production and 25% in the following month.
A wage increase of 12.5% will take place on 1st March.
The company is going through a restructuring and will sell one of its freehold properties in May for
Rs. 25,000, but it is also planning to buy a new printing press in May for Rs. 10,000. Depreciation
is currently Rs. 1,000 per month, and will rise to Rs. 1,500 after the purchase of the new machine.

27

The companys corporation tax (of Rs. 10,000) is due for payment in March.
The company presently has a cash balance at bank on 31 December 2004, of Rs. 1,500.
You are required to prepare a cash budget for the six months from January to June.
9.

The following table gives dividend and share price for data ABC Company.
Year

Dividend Per Share

Closing Share Price

1994

2.50

12.25

1995

2.50

14.20

1996

2.50

17.50

1997

3.00

16.75

1998

3.00

18.45

1999

3.25

22.25

2000

3.50

23.50

2001

3.50

27.75

2002

3.50

25.50

2003

3.75

27.95

2004

3.75

31.30

You are required to calculate: (i) the annual rates of return, (ii) the expected (average) rate of
return, (iii) the variance, and (iv) the standard deviation of returns.
10. A company is considering the following investment projects:
Cash Flows (Rs)
Projects

C0

C1

C2

C3

-10,000

+10,000

-10,000

+7,500

+7,500

-10,000

+2,000

+4,000

+12,000

-10,000

+10,000

+3,000

+3,000

(a) Rank the projects according to each of the following methods: (i) Payback, (ii) ARR, (iii) IRR
and (iv) NPV, assuming discount rates of 10 and 30 per cent.
(b) Assuming the projects are independent, which one should be accepted? If the projects are
mutually exclusive, which project is the best?
11. The following are the financial statements of Starfish Ltd.
Starfish Ltd.
Balance Sheets

Assets
Cash
Trade investments
Debtors
Stock

31 March
2005

(Rs.)
31 March
2004

3,49,600
1,60,000
3,05,400
2,35,200

4,83,600
4,20,000
3,08,600
1,84,600

28

Prepaid expenses
Investment in A Ltd.
Land
Buildings, net of depreciation
Machinery, net of depreciation
Total Assets
Liabilities
Creditors
Bank overdraft
Accrued expenses
Income-tax payable
Current installment due on long-term loans
Long-term loans
Debentures, net of discount
Share capital, Rs. 10 par value
Share premium
Reserves and surplus
Total Liabilities

7,600
3,00,000
14,400
24,07,200
4,43,400
42,22,800

9,200
14,400
7,13,600
4,28,200
25,62,200

1,15,200
30,000
17,400
1,93,000
40,000
1,60,000
9,60,000
6,70,000
13,40,000
6,97,200
42,22,800

1,08,400
25,000
18,400
67,400
2,00,000
6,00,000
9,50,000
4,93,000
25,62,200

Starfish Ltd.
Income Statement
for the year ended 31st March, 2005
Sales
Cost of goods sold and operating expenses including depreciation on buildings of
Rs. 26,400 and deprecation on machinery of Rs. 45,600
Operating profit
Gain on sale of trade investments
Gain on sale of machinery
Profit before taxes
Income taxes
Net profit

(Rs.)
16,92,400
11,91,200
5,01,200
25,600
7,400
5,34,200
2,09,400
3,24,800

Additional information: (i) Machinery with a net book value of Rs. 36,600 was sold during the year.
(ii) The shares of A Ltd. were acquired upon a payment of Rs. 120,000 in cash and the issuance
of 3,000 shares of Starfish Ltd. The share of Starfish Ltd. was selling for Rs. 60 a share at that
time. (iii) A new building was purchased at a cost of Rs. 17,20,000. (iv) Debentures having a
face value of Rs. 100 each were issued in January 2005, at 96. (v) The cost of trade investments
sold was Rs. 2,60,000. (vi) The company issued 4,000 shares for Rs. 2,80,000. (vii) Cash
dividends of Rs. 1.80 a share were paid on 67,000 outstanding shares.
Prepare a statement of changes in financial position on working capital basis as well as cash
basis of Starfish Ltd. for the year ended 31st March, 2005.
12. A company currently has annual sales of Rs. 5,00,000 and an average collection period of 30
days. It is considering a more liberal credit policy. If the credit period is extended, the company
expects sales and bad-debt losses to increase as follows:
Credit
policy
A

Increase in Credit
Period

Increase in Sales
(Rs.)

Bad-debt % of Total Sales

10 days

25,000

1.2

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15 days

35,000

1.5

30 days

40,000

1.8

42 days

50,000

2.2

The selling price per unit is Rs. 2. Average cost per unit at the current level of operation is Rs.
1.50 and variable cost per unit is Rs. 1.20. If the current bad-debt loss is 1 per cent of sales and
the required rate of return investment is 20 per cent, which credit policy should be undertaken?
Ignore taxes, and assume 360 days in a year.
13. A companys requirements for ten days are 6,300 units. The ordering cost per order is Rs. 10 and
the carrying cost per unit is Rs. 0.26. The following is the discount schedule applicable to the
company.
Lot size
1 -999
1,000 - 1,499
1,500 2,499
2,500 4,999
5,000 and above

Discount per unit (Rs.)

0
0.010
0.015
0.030
0.050

You are required to calculate the economic order quantity.

14. From the information and the assumption that the cash balance in hand on 1st January 2004 is
Rs. 72,500 prepare a cash budget.
Assume that 50 per cent of total sales are cash sales. Assets are to be acquired in the months of
February and April. Therefore, provisions should be made for the payment of Rs. 8,000 and Rs.
25,000 for the same. An application has been made to the bank for the grant of a loan of Rs.
30,000 and it is hoped that the loan amount will be received in the month of May.
It is anticipated that a dividend of Rs. 35,000 will be paid in June. Debtors are allowed one
months credit. Creditors for materials purchased and overheads grant one months credit. Sales
commission at 3 per cent on sales is paid to the salesman each month.
Month

January
February
March
April
May
June

Sales

Materials
Purchases

Salaries &
Wages

Production
Overheads

(Rs.)
72,000
97,000
86,000
88,600
1,02,500
1,08,700

(Rs.)
25,000
31,000
25,500
30,600
37,000
38,800

(Rs.)
10,000
12,100
10,600
25,000
22,000
23,000

(Rs.)
6,000
6,300
6,000
6,500
8,000
8,200

15. Write short notes on the following:

(a) Inter-relationship between Investment, Financing and Dividend Decisions
(b) William J. Baumal vs Miller- Orr Cash Management Model
(c) Need for Social Cost Benefit Analysis
(d) Pecking order theory of capital structure
(e) Debt Securitisation.

Office and
Selling
Overheads
(Rs.)
5,500
6,700
7,500
8,900
11,000
11,500

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SUGGESTED ANSWERS/HINTS
1.

Particulars

(Rs.)

Share capital

50%

1,00,000

Other shareholders funds

15%

30,000

5% Debentures

10%

20,000

Trade creditors

25%

50,000

100%

2,00,000

Total
Land and Buildings
Total Liabilities

Total Assets

Rs. 2,00,000

Total Assets

Fixed Assets

60% of total gross fixed assets and current assets

Rs. 2,00,000 60/100= Rs. 1,20,000

Calculation of Additions to Plant and Machinery

Total Fixed Assets
Less: Land & Buildings
Plant and machinery (after providing depreciation)
Depreciation on Machinery up to 31-3-2004
Add: Further depreciation
Total
Current Assets

= Total assets Fixed assets

= Rs. 2,00,000 Rs. 1,20,000 = Rs. 80,000

Calculation of Stock
Quick ratio:
=

Curent assets Stock

=1
Current liabilitie s

Rs. 80,000 Stock

=1
Rs. 50,000
Rs. 50,000 = Rs. 80,000- Stock
Stock

Rs. 80,000 - Rs. 50,000

Rs. 30,000

Debtors =

4/5th of Quick assets

(Rs. 80,000 30,000) 4/5

Rs. 40,000

Debtors turnover ratio

=

Debtors
365
Credit Sales

40,000 12
= 2 months
Credit Sales

= 60 days

(Rs.)
1,20,000
80,000
40,000
15,000
5,000
20,000

31

2 credit sales

4,80,000

Credit sales

4,80,000/2

2,40,000

Gross profit (15% of sales)

Rs. 2,40,00015/100 = Rs. 36,000
Return on networth (profit after tax)
Net worth =

Rs. 1,00,000 + Rs. 30,000

=

Net profit =

Rs. 1,30,000

Rs. 1,30,00010/100

Rs. 13,000

Debenture interest = Rs. 20,0005/100 = Rs. 1,000

Projected profit and loss account for the year ended 31-3-2005
To Cost of goods sold
To Gross profit
To Debentures
To Administration and other expenses
To Net profit

2,04,000 By Sales
36,000
2,40,000
1,000 By Gross Profit
22,000
13,000
36,000

2,40,000
2,40,000
36,000

36,0000

Showbiz Ltd.
Projected Balance Sheet as on 31st March, 2005
Liabilities
Share capital
Profit and loss A/c
(17,000+13,000)
5% Debentures
Current liabilities
Trade Credits

Rs. Assets
1,00,000 Fixed assets
30,000 Land and buildings
Plant & Machinery
20,000 Less: Depreciation
Current assets
50,000 Stock
Debtors
_______ Bank
2,00,000

2.

Rs.
80,000
60,000
20,000

40,000

30,000
40,000
10,000

80,000
2,00,000

Working Notes:
Fixed Assets A/c
Rs.
To Balance b/d
8,00,000 By Sale of Machinery A/c
To Cash Purchases (Balancing figure)
2,14,000 By Balance c/d
10,14,000

To Fixed Assets (original cost)

Rs.
64,000
9,50,000
10,14,000

Sale on Machinery A/c

Rs.
Rs.
64,000 By Provision for Depreciation
(provided till date)
35,000
By Cash (sales)
25,000
By Loss (P & L A/c)
4,000
64,000
64,000

32

Provision for Depreciation of Fixed Assets A/c

Rs.
35,000 By Balance b/d
2,90,000 By Profit & Loss A/c
3,25,000

To Sale of Machinery a/c

To Balance c/d

Rs.
2,30,000
95,000
3,25,000

Statement of Funds generated from Operations

(Rs.)
75,000

Profit & Loss A/c (Carried forward to B/S)

Add: Fixed Assets (loss on sales)
Depreciation
Premium on redemption of Debentures (60,0003/100)
Preliminary expenses written off
Provision for Income-tax
Proposed Dividend
Transfer to General Reserve

4,000
95,000
1,800
10,000
85,000
36,000
30,000

Less:
Profit and Loss A/c Opening Balance
Increase in Opening Stock value (54,00010/90)
Funds generated from operation

2,61,800
3,36,800

60,000
6,000

66,000
2,70,800

Funds flow Statement of Xansa Ltd. for the year ended 31-12-2005
(Rs.)
Sources of Funds:
Issue of Shares
Sale of Investments
Sale of Machinery
Funds generated from operations
Total

1,00,000
30,000
25,000
2,70,800
4,25,800

Total

2,14,000
61,800
26,000
90,000
34,000
4,25,800

Application of Funds:
Purchase of Fixed Assets
Redemption of Debentures with 3% Premium i.e., (60,000103/100)
Dividend paid for the last year (Rs. 30,000 Rs. 4,000 unpaid dividend)
Taxes paid belonging to last year
Increase in Working Capital (balancing figure)
Statement of Changes in Working Capital
Particulars
Current Assets
(including 6,000 on account
revaluation of stock)
Current Liabilities
Net Working capital
Increase in Working Capital

2004
2,86,000

2005
3,30,000

+
44,000

1,20,000
1,66,000
34,000
2,00,000

1,30,000
2,00,000
2,00,000

10,000

44,000

34,000
44,000

of

33

3.

Working Notes:
Calculation of Cost and Sales
For 60,000 units Rs.

Per unit Rs.

1,80,000

3.00

Direct Wages

30,000

0.50

Overheads

60,000

1.00

Cost of Sales

2,70,00

4.50

Profit (balancing figure)

30,000

0.50

3,00,000

5.00

Particulars
Raw Materials

Sales
Computation of Current Assets and Current Liabilities
1.

Raw Material inventory 2 months consumption

= Rs. 1,80,0002/12= Rs. 30,000

2.

Work-in-progress inventory 1 month production

Rs.
Raw material =

Rs. 1,80,000
12

= 15,000

(100%)

Direct Wages =

Rs. 30,000 50

12
100

= 1,250

(50%)

Overheads =

Rs. 60,000 50

12
100

= 2,500

= Rs. 18,750

(50%)
3.

Finished goods inventory 3 months production

= Rs. 2,70,0003/12

4.

= Rs. 67,500

Debtors 3 months Cost of Sales

= Rs. 2,70,0003/12

5.

= Rs. 67,500

Creditors 2 months raw material consumption

= Rs. 1,80,0002/12

= Rs. 30,000

Statement of Working Capital Requirement forecast

Particulars

Holding period months

Amount Rs.

Raw Materials

30,000

Work-in-Progress

18,750

Finished Goods

67,500

Debtors

67,500

Current Assets

34

Total

1,83,750

Less: Current Liabilities

30,000

Working Capital

1,53,750

Estimated Profit and Loss A/c of Super Ltd. for the year ending 31-3-2005
Rs.
Sales

(60,000 units Rs. 5)

(A)

3,00,000

Cost of Sales
Raw Material

(60% of Rs. 2,70,000)

1,80,000

Direct Wages

(10% of Rs. 2,70,000)

30,000

Overheads

(20% of Rs. 2,70,000)

60,000

Total

(B)

Gross Profit

(A) (B)

Less: Debenture Interest

(Rs. 50,0005/100)

Net Profit

2,70,000
30,000
2,500
27,500

Estimated Balance Sheet of Super Ltd. as at 31st March, 2005

Liabilities
Share Capital
Profit & Loss A/c balance

Rs. Assets

Rs.

2,00,000 Fixed Assets

8,750 Current Assets:
Raw Material

(Balancing Figure)

30,000

Profit for the year

27,500 Work-in-Progress

18,750

5% Debentures

50,000 Finished Goods

67,500

Creditors

30,000 Debtors (3 months sales)

75,000

3,16,250
4.

1,25,000

1.

3,16,250

Total Manufacturing expenses

Sales
Less: Gross profit 20%
Manufacturing cost
Less: Material
Wages
Manufacturing expenses

(Rs.)
24,00,000
4,80,000
19,20,000
6,00,000
4,80,000

2.

Cash manufacturing expenses

6,00,000

3.

Depreciation (Rs. 8,40,000 Rs. 6,00,000)

2,40,000

10,80,000
8,40,000

35

4.

Cost of Sales (Cash Expenses)

(Rs.)
Manufacturing Cost

19,20,000

Less: Depreciation

2,40,000

Cash cost of manufacture

16,80,000

Add: Administrative expenses

1,50,000

Sales promotion expenses

75,000

Total Cash Cost

5.

19,05,000

Cash in Hand

80,000
Computation of Working capital
(Rs.)

Current Assets
Debtors (Rs. 19,05,000/6)

3,17,500

Sales promotion expenses prepaid (Rs. 75,000/4)

18,750

Raw materials (Rs. 6,00,000/12)

50,000

Finished goods (Rs. 16,80,000/12)

1,40,000

Cash in hand

80,000
Total (A)

6,06,250

Current liabilities
Sundry creditors (Rs. 6,00,000/6)

1,00,000

Manufacturing expenses (Rs. 6,00,000/12)

50,000

Administrative expenses (Rs. 1,50,000/12)

12,500

Wages due (Rs. 4,80,000/12)

40,000

Working Capital

Total (B)

2,02,500

(A) - (B)

4,03,750

Add: 10% Safety margin

40,375

Working capital requirement on cash cost basis

5.

4,44,125

(a) Pattern of raising additional finance

Equity

70% of Rs. 10,00,000

= Rs. 7,00,000

Debt

30% of Rs. 10,00,000

= Rs. 3,00,000

The capital structure after raising additional finance:

Shareholders funds
Equity Capital
Retained earnings
Debt (Interest at 10% p.a.)
(Interest at 16% p.a.)

(Rs.)
(7,00,0002,10,000)
(3,00,0001,80,000)

Total Funds

4,90,000
2,10,000
1,80,000
1,20,000
10,00,000

36

(b) Determination of post-tax average cost of additional debt

KD = I (1 T)
Where,
I = Interest Rate
T = Corporate tax-rate
On Rs. 1,80,000

10% (1 0.5) =

5% or 0.05

On Rs. 1,20,000

16% (1 0.5) =

8% or 0.08

Average Cost of Debt

=

(Rs. 1,80,000 0.05) + (Rs. 1,20,000 0.08)

100 = 6.2%
Rs. 3,00,000

(c) Determination of cost of retained earnings and cost of equity applying Dividend
growth model:
KE =

D1
+g
P0

where,
KE = Cost of equity
D1 = DO(1+g)
D0 = Dividend payout (i.e., 50% earnings = 50% Rs. 4 = Rs. 2)
g = Growth rate
P0 = Current market price per share
then,

KE

Rs. 2(1.1)
+ 10%
Rs. 44

Rs. 2.2
+ 10% = 5% + 10% = 15%
Rs. 44

(d) Computation of overall weighted average after tax cost of additional finance
Particular
Equity (including retained earnings)
Debt

Rs.
7,00,000
3,00,000

Weights
0.70
0.30

Cost of funds
15%
6.2%

WACC = (Cost of Equity % Equity) + (Cost of debt % Debt)

= (15% 0.70) + (6.2% 0.30)
=
6.

(i)

10.5% + 1.86% = 12.36%.

Computation of Earnings per share (EPS)

Plans
Earnings before interest and tax (EBIT)
Less: Interest charges
Earnings before tax (EBT)
Less: Tax (@ 50%)
Earnings after tax (EAT)
Less: Preference Dividend
Earnings available for Equity shareholders
No. of Equity shares
EPS (Rs.)

A
80,000
80,000
40,000
40,000
40,000
10,000
4

B
80,000
8,000
72,000
36,000
36,000
36,000
5,000
7.20

C
80,000
80,000
40,000
40,000
8,000
32,000
5,000
6.40

37

(ii) Calculation of Financial Break-even point.

The firm will achieve its financial break-even where its earnings are able to meet its fixed
interest /preference dividend charges. Now, the financial break-even point (FBP) of three
firms can be calculated as follows:
Firm A = 0
Firm B = Rs. 8,000 (Interest charges)
Firm C = Rs. 16,000 (i.e. earnings required for payment of preference dividend is Rs.
8,000/0.5 = Rs. 16,000. The earnings required to meet both tax @ 50% and payment of
preference dividend, a total profit before interest and tax required is Rs. 16,000).
(iii) Computation of indifference point between the plans.

The indifference between two alternative methods of financing is calculated by applying the
following formula.
(EBIT I1 )(1 T ) (EBIT I 2 )(1 T )
=
E1
E2

where,
EBIT

Earning before interest and tax.

I1

Fixed charges (interest or pref. dividend) under Alternative 1

I2

Fixed charges (interest or pref. dividend) under Alternative 2

Tax rate

E1

No. of equity shares in Alternative 1

E2

No. of equity shares in Alternative 2

Now, we can calculate indifference point between different plans of financing.

I.

II.

Indifference point where EBIT of Plan A and Plan B is equal.

(EBIT 0)(1 0.5)

10,000

(EBIT 8,000)(1 0.5)

5,000

0.5 EBIT (5,000)

(0.5 EBIT 4,000) (10,000)

0.5 EBIT

EBIT 8,000

0.5 EBIT

8,000

EBIT

Rs. 16,000

Indifference point where EBIT of Plan A and Plan C is equal.

(EBIT 0)(1 0.5)

=
10,000

(EBIT 0)(1 0.5) 8,000

5,000

0.5 EBIT
10,000

0.5 EBIT - 8,000

5,000

0.25 EBIT

0.5 EBIT 8,000

0.25 EBIT

8,000

EBIT

Rs. 32,000

III. Indifference point where EBIT of Plan B and Plan C are equal.
(EBIT 8,000)(1 0.5)
5,000

(EBIT 0)(1 0.5) 8,000

5,000

0.5 EBIT 4,000

0.5 EBIT 8,000

38

There is no indifference point between the financial plans B and C.

Analysis: It can be seen that Financial Plan B dominates Plan C. Since, the financial
break-even point of the former is only Rs. 8,000 but in case of latter it is Rs. 16,000.
7.

Computation of NPVs per Rs. 1 of investment and Ranking of the projects

Project

Investment

NPV @ 15%

NPV per Rs. 1

Ranking

Rs. '000

Rs. '000

invested

(50)

15.4

0.31

(40)

18.7

0.47

(25)

10.1

0.40

(30)

11.2

0.37

(35)

19.3

0.55

Building up of a programme of projects based on their rankings

Project

Investment

NPV @ 15%

Rs. 000

Rs. 000

(35)

19.3

(40)

18.7

(25)

10.1

(20)

7.5 (2/3 of project total)

120

55.6

Thus Project A should be rejected and only two-third of Project D be undertaken. If the projects
are not divisible then other combinations can be examined as:
Investment
Rs. 000
100
105

E+B+C
E+B+D

NPV @ 15%
Rs. 000
48.1
49.2

In this case E + B + D would be preferable as it provides a higher NPV despite D ranking lower
than C.
8.

Workings:
1.

Sale receipts
Month

Nov

Dec

Jan

Feb

Mar

Apr

May

Jun

1,000

1,000

1,000

1,250

1,500

2,000

1,900

2,200

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

15,000

15,000

15,000

18,750

22,500

30,000

28,500

33,000

1 month 40%

6,000

6,000

6,000

7,500

9,000

12,000

11,400

2 month 60%

9,000

9,000

9,000

11,250

13,500

18,000

15,000

15,000

16,500

20,250

25,500

29,400

Forecast sales (S)

S15
Debtors pay:

39

2.

Payment for materials books produced two months before sale

Month

Nov

Dec

Jan

Feb

Mar

Apr

May

Jun

Qty produced (Q)

1,000

1,250

1,500

2,000

1,900

2,200

2,200

2,300

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

Materials (Q5)

5,000

6,250

7,500

10,000

9,500

11,000

11,000

11,500

5,000

6,250

7,500

10,000

9,500

11,000

Paid (2 months after)

3.

Variable overheads
Month
Qty produced (Q)

Var. overhead (Q2)

Nov

Dec

Jan

Feb

Mar

Apr

May

Jun

1,000

1,250

1,500

2,000

1,900

2,200

2,200

2,300

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

2,000

2,500

3,000

4,000

3,800
5,500

5,500

5,750

3,800

5,500

5,500

Var. overhead (Q2.50)

Paid one month later

4.

2,000

2,500

3,000

4,000

Wages payments
Dec

Jan

Feb

Mar

Apr

May

Jun

Qty produced (Q)

Month

1,250

1,500

2,000

1,900

2,200

2,200

2,300

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

Wages (Q 4)

5,000

6,000

8,000
8,550

9,900

9,900

10,350

Wages (Q 4.50)
75% this month

3,750

25% this month

4,500

6,000

6,412

7,425

7,425

7,762

1,250

1,500

2,000

2,137

2,475

2,475

5,750

7,500

8,412

9,562

9,900

10,237

Cash budget six months ended June

Receipts:
Credit sales
Premises disposal
Payments:
Materials
Var. overheads
Wages
Fixed assets
Corporation tax

Net cash flow

Balance b/f
Cumulative cash flow

Jan
Rs.

Feb
Rs.

Mar
Rs.

Apr
Rs.

May
Rs.

Jun
Rs.

15,000
15,000

15,000
15,000

16,500
16,500

20,250
20,250

25,500
25,000
50,500

29,400
29,400

5,000
2,500
5,750
13,250

6,250
3,000
7,500
16,750

7,500
4,000
8,412
10,000
29,912

10,000
3,800
9,562
23,362

9,500
5,500
9,900
10,000
34,900

11,000
5,500
10,237
26,737

1,750
1,500
3,250

(1,750)
3,250
1,500

(13,412)
1,500
(11,912)

(3,112)
(11,912)
(15,024)

15,600
(15,024)
576

2,663
576
3,239

40

9.

(i)

Annual rates of return

Year

Dividend Per Share

Closing Share Price

Annual Rates of Return (%)

1994

2.50

12.25

1995

2.50

14.20

2.50+(14.20 12.25)/12.25 = 36.33

1996

2.50

17.50

2.50+(17.50-14.20)/14.20 = 40.85

1997

3.00

16.75

3.00(16.75-17.50)/17.50 = 12.86

1998

3.00

18.45

3.00+(18.45-16.75)/16.75 = 28.06

1999

3.25

22.25

3.25+(22.25-18.45)/18.45 = 38.21

2000

3.50

23.50

3.50(23.50-22.25)/22.25 = 21.35

2001

3.50

27.75

3.50(27.75-23.50)/23.50 = 32.98

2002

3.50

25.50

3.50(25.50-27.75)/27.75 = 4.50

2003

3.75

27.95

3.75(27.95-25.50)/25.50 = 24.31

2004

3.75

31.30

3.75+(31.0-27.95)/27.95 = 25.40

(ii) Average rate of return: The arithmetic average of the annual rates of return can be taken
as:

(36.33+40.85+12.86+28.06+38.21+21.35+32.98+4.50+24.31+25.40)/10 = 26.48%.
(iii) Variance and (iv) standard deviation are calculated as shown below:
Year

Annual Rates of Returns

Annual minus Average

Rates of Return

Square of Annual minus

Average Rates of Return

1993

36.33

9.84

96.86

1994

40.85

14.36

206.22

1995

12.86

-13.63

185.71

1996

28.06

1.57

2.48

1997

38.21

11.73

137.51

1998

21.35

-5.14

26.38

1999

32.98

6.49

42.17

2000

4.50

-21.98

483.13

2001

24.31

-2.17

4.71

2002

25.40

-1.08

1.17

Sum

264.85

Average

26.48

Variance =

1 n
(R i R ) = 1186.36/(101) = 131.81
n 1 i =1

Standard deviation =
10. (a) (i)

131.81 = 11.48 .

Payback Period

Project A :

10,000/10,000 = 1 year

Project B :

10,000/7,500 = 1 1/3 years.

1186.36

41

Project C :

2 years +

Project D :

1 year.

10,000 6,000
1
= 2 years
12,000
3

(ii) ARR
Project A :

(10,000 10,000)1 / 2
=0
(10,000)1 / 2

Project B :

(15,000 10,000)1 / 2 2,500

=
= 50%
(10,000)1 / 2
5,000

Project C :

(18,000 10,000)1 / 3 2,667

=
= 53%
(10,000)1 / 2
5,000

Project D :

(16,000 10,000)1 / 3 2,000

=
= 40%
(10,000)1 / 2
5,000

Note: This net cash proceed includes recovery of investment also. Therefore, net cash
earnings are found by deducting initial investment.
(iii) IRR
Project A:

The net cash proceeds in year 1 are just equal to investment.

Therefore, r = 0%.

Project B:

This project produces an annuity of Rs. 7,500 for two years.

Therefore, the required PVAF is: 10,000/7,500 = 1.33.
This factor is found under 32% column. Therefore, r = 32%

Project C:

Since cash flows are uneven, the trial and error method will be followed.
Using 20% rate of discount the NPV is + Rs. 1,389. At 30% rate of
discount, the NPV is -Rs. 633. The true rate of return should be less
than 30%. At 27% rate of discount it is found that the NPV is -Rs. 86
and at 26% +Rs. 105. Through interpolation, we find r = 26.5%

Project D:

In this case also by using the trial and error method, it is found that at
37.6% rate of discount NPV becomes almost zero.
Therefore, r = 37.6%.

(iv) NPV
Project A:
at 10%

-10,000+10,0000.909 = -910

at 30%

-10,000+10,0000.769 = -2,310

at 10%

-10,000+7,500(0.909+0.826) = 3,013

at 30%

-10,000+7,500(0.769+0.592)= +208

at 10%

-10,000+2,0000.909+4,0000.826+12,0000.751 = +4,134

at 30%

-10,000+2,0000.769+4,0000.592+12,0000.455 =-633

at 10%

-10,000+10,0000.909+3,000(0.826+0.751) =+ 3,821

at 30%

-10,000+10,0000.769+3,000(0.592+0.4555) = + 831

Project B:

Project C:

Project D:

42

The projects are ranked as follows according to the various methods:

Ranks
Project

PB

ARR

IRR

NPV (10%)

NPV (30%)

A
B

1
2

4
2

4
2

4
3

4
2

C
D

3
1

1
3

3
1

1
2

3
1

(b) Payback and ARR are theoretically unsound method for choosing between the investment
projects. Between the two time-adjusted (DCF) investment criteria, NPV and IRR, NPV
gives consistent results. If the projects are independent (and there is no capital rationing),
either IRR or NPV can be used since the same set of projects will be accepted by any of the
methods. In the present case, except Project A all the three projects should be accepted if
the discount rate is 10%. Only Projects B and D should be undertaken if the discount rate is
30%.
If it is assumed that the projects are mutually exclusive, then under the assumption of 30%
discount rate, the choice is between B and D (A and C are unprofitable). Both criteria IRR
and NPV give the same results D is the best. Under the assumption of 10% discount rate,
ranking according to IRR and NPV conflict (except for Project A). If the IRR rule is followed,
Project D should be accepted. But the NPV rule tells that Project C is the best. The NPV
rule generally gives consistent results in conformity with the wealth maximization principle.
Therefore, Project C should be accepted following the NPV rule.

11.

Starfish Ltd.
Statement of Changes in Financial Position (Working Capital Basis) for the year ended
31st March, 2005
(Rs.)
Sources
Working capital from operations:
Net income after tax
3,24,800
Add: Depreciation
72,000
3,96,800
Less: Gain on sale of machinery
7,400
3,89,400
Sale of machinery (Rs. 36,600 + Rs. 7,400)
44,000
Debentures issued
9,60,000
Share capital issued for cash (including share premium)
2,80,000
Financial transaction not affecting working capital
Share issued in partial payment for investments in A Ltd.
1,80,000
Financial Resources Provided
18,53,400
Uses
Purchase of building
17,20,000
Purchase of machinery
97,400
Instalment currently due on long-term loans
40,000
Payment of cash dividends
1,20,600
Purchase of investments in A Ltd. for cash
1,20,000
Financial transaction not affecting working capital
Purchase of investments in A Ltd. in exchange of issue of 3000
1,80,000
shares @ Rs. 60 each
Financial Resources Applied
22,78,000
Net Decrease in Working Capital
4,24,600

43

The amount of machinery sold is found out as follows:

Machinery
Opening
balance
(given)
Purchase (plug)

Rs.
4,28,200 Sales of machinery (given)

Rs.
36,600

97,400 Depreciation (given)

Closing balance (given)
5,25,600

45,600
4,43,400
5,25,600

Starfish Ltd.
Statement of Changes in Financial Position (Cash Basis)
for the year ended 31 March, 2005
Rs.
Sources
Cash from operations:
Net income after tax
Add: Depreciation
Decrease in debtors
Decrease in prepaid expenses
Increase in creditors
Increase in income tax payable
Less: Gain on sale of machinery
Increase in stock
Decrease in accrued expenses
Sale of trade investment
Increase in bank overdraft
Sale of machinery
Debentures issued
Shares issued
Financial transaction not affecting cash
Share issued in partial payment for investments in A Ltd.
Installment currently due on long-term loans
Financial Resources Provided
Uses
Purchase of buildings
Purchase of machinery
Payment of cash dividend
Purchase of investments in A Ltd. for cash
Financial transaction not affecting cash
Purchase of investments in A Ltd. in exchange of issue of 3,000
shares @ Rs. 60 each
Installment currently due on long-term loans
Financial Resources Applied
Net Decrease in Cash

3,24,800
72,000
3,200
1,600
6,800
25,600
7,400
50,600
1,000

4,34,000

59,000
3,75,000
2,60,000
5,000
44,000
9,60,000
2,80,000
1,80,000
40,000
21,44,000
17,20,000
97,400
1,20,600
1,20,000
1,80,000
40,000
22,78,000
1,34,000

44

Notes:
1.

Funds from operations are shown in net of taxes. Alternatively, payment of tax may be
separately treated as use of funds. In that case, tax would be added to net profit.

2.

If tax shown in Profit and Loss Account is assumed to be a provision, then the amount of
cash paid for tax has to be calculated. In the present problem if this procedure is followed,
then cash paid for tax is: Rs. 1,67,400 + Rs. 2,09,400 Rs. 1,93,000 = Rs. 1,83,800.

3.

Gain on the sale of trade investments is considered an operating income.

12. The firm will maximize the shareholders value if it extends its period by additional 30 days (since
expected return is higher than required return). In fact, it can further relax credit period until its
expected return becomes 20% or net gain becomes zero.
The investment in receivables could be calculated at cost. At current level of sales, the firms
average unit cost is Rs. 1.50. Since variable cost per unit is Rs. 1.20, total fixed costs can be
found out as :
Fixed cost = Total cost Variable cost
=

Rs. 5,00,000 Rs. 1.50 Rs. 5,00,000 Rs. 1.20

Rs. 2
Rs. 2

= Rs. 3,75,000 Rs. 3,00,000 = Rs. 75,000

Increase in Credit Period
Existing

10 days

15 days

30 days

42 days

30

40

45

60

72

5,00,000

5,25,000

5,35,000

5,40,000

5,50,000

41,667

58,333

66,875

90,000

1,10,000

16,667

25,208

48,333

68,333

Credit period (days)

Annual sales

Level of receivables (at sales value) (AB)/360

Incremental
C 41,667

Required incremental profit at 20%, 0.2D

3,333

5,042

9,667

13,667

Incremental contribution on additional sales @

40%

10,000

14,000

16,000

20,000

Bad-debt losses, B% bad-debt

5,000

6,300

8,025

9,720

12,100

Incremental bad-debt losses, G 5,000

1,300

3,025

4,720

7,100

Incremental expected profit, F H

8,700

10,975

11,280

12,900

Net gain, I E

5,367

5,933

1,613

(767)

Expected return, I/D

52.2%

43.5%

23.3%

18.9%

investment

in

receivables,

Thus the total cost of different level of sales is (assuming unit price and fixed costs do not
change):

Sales

Cost

5,25,000

(5,25,000)(1.20)/2

75,000

= Rs. 3,90,000

5,35,000

(5,35,000)(1.20)/2

75,000

= Rs. 3,96,000

5,40,000

(5,40,00)(1.20)/2

75,000

= Rs. 3,99,000

5,50,000

(5,50,000)(1.20)/2

75,000

= Rs. 4,05,000

45

and level of account receivables will be:

Level of receivables

INVEST

(3,75,000)(30)/360

= Rs. 31,250

(3,90,000) (40)/360

= Rs. 43,333

12,083

(3,96,000) (45)/360

= Rs. 49,500

18,250

(3,99,000) (60)/360

= Rs. 66,500

35,250

(4,05,000) (72)/360

= Rs. 81,000

49,750

The net gain from the credit policy can be recalculated using incremental investment in accounts
receivables at cost. It would be higher now.

13. The economic order quantity without considering the discount is:
EOQ =
=

2 6,300 10
0.26
1,26,000
= 700 units (approx).
0.26

The following table is constructed to take account of the discount.

When the quantity discounts are available, the company should place four orders of 1,575 units
each, as the total cost is minimum Rs. 150.
No. of orders

10

Order size

6,300

3,150

2,100

1,575

1,260

1,050

900

787.5

700

630

Average inventory

3,150

1,575

1,050

787.5

630

525

450

393.7

350

315

Carrying cost (Rs.)

819

410

273

205

164

137

117

102

91

82

Order Cost (Rs.)

10

20

30

40

50

60

70

80

90

100

Total Cost (Rs.)

829

430

303

245

214

297

187

182

181

182

Less: Discount

315

189

95

95

63

63

Total Cost after

discount (Rs.)

514

241

208

150

151

234

187

182

181

182

Note: Discount will be available on the total quantity, 6,300 units. However, discount per unit
increases as order size increases.
14.

Cash Budget
Jan

Feb

Mar

Apr

May

June

Total

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

Rs.

36,000

48,500

43,000

44,300

51,250

54,350

2,77,400

Collections from debtors

36,000

48,500

43,000

44,300

51,250

2,23,050

Bank loan

30,000

30,000

36,000

84,500

91,500

87,300

1,25,550

1,05,600

5,30,450

25,000

31,000

25,500

30,600

37,000

1,49,100

10,000

12,100

10,600

25,000

22,000

23,000

1,02,700

6,000

6,300

6,000

6,500

8,000

32,800

5,500

6,700

7,500

8,900

11,000

39,600

2,160

2,910

2,580

2,658

3,075

3,261

16,644

Receipts
Cash sales

Total
Payments
Materials
Salaries and wages
Production overheads
Office and selling overheads
Sales commission

46

Capital expenditure

8,000

25,000

33,000

Dividend

35,000

35,000

12,160

59,510

57,180

91,658

71,075

1,17,261

4,08,844

Total
Net cash flow

23,840

24,990

34,320

(4,358)

54,475

(11,661)

1,21,606

Balance, beginning of month

72,500

96,340

1,21,330

1,55,650

1,51,292

2,05,767

1,94,106

Balance, end of month

96,340

1,21,330

1,55,650

1,51,292

2,05,767

1,94,106

3,15,712

15. (a) Inter-relationship between Investment, Financing and Dividend Decisions

The finance functions are divided into three major decisions, viz., investment, financing and
dividend decisions. It is correct to say that these decisions are inter-related because the
underlying objective of these three decisions is the same, i.e. maximisation of shareholders
wealth. Since investment, financing and dividend decisions are all interrelated, one has to
consider the joint impact of these decisions on the market price of the companys shares and
these decisions should also be solved jointly. The decision to invest in a new project needs
the finance for the investment. The financing decision, in turn, is influenced by and
influences dividend decision because retained earnings used in internal financing deprive
shareholders of their dividends. An efficient financial management can ensure optimal joint
decisions. This is possible by evaluating each decision in relation to its effect on the
shareholders wealth.
The above three decisions are briefly examined below in the light of their inter-relationship
and to see how they can help in maximising the shareholders wealth i.e. market price of the
companys shares.

Investment decision: The investment of long term funds is made after a careful assessment
of the various projects through capital budgeting and uncertainty analysis. However, only
that investment proposal is to be accepted which is expected to yield at least so much return
as is adequate to meet its cost of financing. This has an influence on the profitability of the
company and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each source of funds
involves different issues. The finance manager has to maintain a proper balance between
long-term and short-term funds. With the total volume of long-term funds, he has to ensure a
proper mix of loan funds and owners funds. The optimum financing mix will increase return
to equity shareholders and thus maximise their wealth.
Dividend decision: The finance manager is also concerned with the decision to pay or
declare dividend. HE assists the top management in deciding as to what portion of the profit
should be paid to the shareholders by way of dividends and what portion should be retained
in the business. An optimal dividend pay-out ratio maximises shareholders wealth.
The above discussion makes it clear that investment, financing and dividend decisions are
interrelated and are to be taken jointly keeping in view their joint effect on the shareholders
wealth.

(b) William J Baumal vs Miller- Orr Cash Management Model

According to William J Baumals Economic order quantity model optimum cash level is that
level of cash where the carrying costs and transactions costs are the minimum. The carrying
costs refers to the cost of holding cash, namely, the interest foregone on marketable
securities. The transaction costs refers to the cost involved in getting the marketable
securities converted into cash. This happens when the firm falls short of cash and has to
sell the securities resulting in clerical, brokerage, registration and other costs.
The optimim cash balance according to this model will be that point where these two costs
are equal. The formula for determining optimum cash balance is:

47

2U P
S

C=
Where,
C

Optimum cash balance

Annual (monthly) cash disbursements

Fixed cost per transaction

Opportunity cost of one rupee p.a. (or p.m)

Miller-Orr cash management model is a net cash flow stochastic model. This model is designed to
determine the time and size of transfers between an investment account and cash account. In this
model control limits are set for cash balances. These limits may consist of h as upper limit, z as
the return point, and zero as the lower limit.
When the cash balances reaches the upper limit, the transfer of cash equal to h-z is invested in
marketable securities account. When it touches the lower limit, a transfer from marketable
securities account to cash account is made. During the period when cash balance stays between
(h,z) and (z, o ) i.e high and low limits no transactions between cash and marketable securities
account is made. The high and low limits of cash balance are set up on the basis of fixed cost
associated with the securities transactions, the opportunity cost of holding cash and the degree of
likely fluctuations in cash balances. These limits satisfy the demands for cash at the lowest
possible total costs. The diagram given below illustrates the Miller Orr model.

(c) Need for Social Cost Benefit Analysis

Several hundred crores of rupees are committed every year to various public projects.
Analysis of such projects has to be done with reference to social costs and benefits. Since
they cannot be expected to yield an adequate commercial return on the funds employed, at
least during the short run.
Social cost benefit analysis is important for the private corporations also who have a moral
responsibility to undertake socially desirable projects.
The need for social cost benefit analysis arises due to the following:
(i)

The market prices used to measure costs & benefits in project analysis, may not
represent social values due to market imperfections.

(ii) Monetary cost benefit analysis fails to consider the external positive & negative effects
of a project.
(iii) Taxes & subsidies are transfer payments & hence irrelevant in national economic

48

profitability analysis.
The redistribution benefits because of project need to be captured.
The merit wants are important appraisal criteria for social cost benefit analysis.

(d) Pecking order Theory of Capital Structure

The pecking order theory was proposed by Donaldson in 1961. The pecking order theory
suggests that firm rely for finance, as much as they can, on internally generated funds. If
internally generated funds are not enough then they will move to additional debt finance then
equity. This is because the issue cost of internally generated funds have the lowest issue
cost and cost of new equity is the highest. Myers has suggested that the firm follows a
modified pecking order in their approach to financing. Myers has suggested asymmetric
information as a reason for heavy reliance on internal generated funds. He demonstrates
that with asymmetric information, equity shares are interpreted by the market as bad news
since managers are only motivated to issue equity share when share markets are
undeveloped. Further, the use of internal finance ensures that there is regular source of
finance which might be in line with companys expansion programme. If additional funds are
required over and above internally generated funds, then borrowings will be next alternative
in this theory.
Thus, pecking order theory rests on:
(i)

Stickly dividend policy,

(ii) A preference for internal funds,

(iii) An aversion to issue equity shares.

(e) 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
(i)

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.

(ii) The pooling function Similar loans on receivables are clubbed together to create an
underlying pool of assets. The pool is transferred in favour of Special purpose Vehicle
(SPV), which acts as a trustee for investors.
(iii) The securitisation function SPV will structure and issue securities on the basis of
asset pool. The securities carry a coupon and expected maturity which can be assetbased/mortgage based. These are generally sold to investors through merchant
bankers. Investors are pension funds, mutual funds, insurance funds.
The process of securitisation is without recourse i.e. investor bears the credit risk or risk of
default. Credit enhancement facilities like insurance, LOC & guarantees are provided.