SECTION B : FINANCIAL MANAGEMENT

Capital Budgeting
1. Gladiator Golf Club needs a special purpose garden cab. It has received several quotations
and has thoroughly evaluated the performance characteristics of various cabs.
(a) One quotation from Scartus Motors, is each cab cost 7,400 having a life of 8 years,
and engine is rebuilt in the fifth year. Maintenance costs of 200 per year is expected
in the first 4 years, followed by total maintenance and rebuilding cost 1,300 in the fifth
year. During the last 3 years, maintenance costs are expected to be 400 a year. At
the end of 8 years, the cab will have an estimated scrap value of 900.
(b) Another quotation invited from Chang Autos is for cab. However,
maintenance cost is expected to be is expected to increase by
150 a year through the eight year. In year 4, the engine will need to be rebuilt, and this
will cost the company 1,500 in addition to maintenance costs in that year. At the end
of 8 years, the cab will have estimated scrap value of 500.
(c) The last quotation was received from Sungsnag corporation for 4,400 a cab.
Maintenance cost in the first 4 years are expected to be 400 the first year and to
increase 100 a year. For the clubs purposes, the cab will have a life only for 4 years.
At that time, it can be traded in for new Best Cab which is expected to cost 5,200.
The estimated trade value of the old cab is 1,500. During years 5 through 8, the
second cab is expected to have maintenance costs of 500 in year and these expected
to increase by 100 each year. At the end of 8 years, the second cab is expected to
have a salvage value of 1,800.
As a finance manager of the Gladiator Club, you are required to determine
(a) Which quotation the Club should accept if cost of fund is 8%.
(b) Would your decision will change of cost of fund is 15%.
Capital Budgeting (Replacement Decision)
2. A company is trying to determine an optimal replacement policy for a piece of its equipment.
The cost of the machine is Rs.15,000 and the annual maintenance costs are Rs.1,000 in the
first year, Rs.2,000 in the second year and Rs.3,000 in the third year. Anticipated salvage
values are Rs.6,000, Rs.3,000 and Rs.0 at the end of years 1 through 3, respectively.
Assume that the company's revenues are unaffected by the replacement policy and that the
firm has a 34% tax rate, a 12% p.a. required return on this project and uses a straight-line
depreciation.
Considering the depreciation and tax effects advice the company should the equipment be
replaced every year, every second year, or every third year?

37
Working Capital Management (Cost of Commercial Paper)
3. Turbo Sales Corporation is a wholesale corporation for heavy machines, is planning for
an expansion of their activities resulting in a doubling of its sales. The finance head of
the corporation has determined it needs an additional Rs. 20 crores in short term funds to
meet finance need in the peak season roughly 6 months of the year. Mr. X, Treasury
Head of the Corporation recommended that the corporation should use commercial
papers offer to meet the finance needs.
The corporation shall have to offer 10% interest (paid in advance or discounted) plus a
sum of Rs. 1,25,000 shall be incurred to meet the floatation cost. The paper would carry
a 6 months (180 day) maturity.
Compute the effective cost of credit.
Leverage
4. Mr. Y Assistant is Finance Manager of Key Lock Co. has developed the following
analytical income statement pertaining to financial year ending 31 st March, 2008.
Financial Year 2007-08
Amount in Rs.
Sales 2,00,00,000
Variable cost 1,20,00,000
Contribution 80,00,000
Fixed Cost 50,00,000
Earning before interest & taxes 30,00,000
Interest expenses 10,00,000
Earning before taxes 20,00,000
Tax @ 50% 10,00,000
Earning after tax (EAT) 10,00,000
You as a Finance Manager are required to submit response to management of following
queries.
(1) With this data, what is the degree of operating leverage, financial leverage and
combined leverage.
(2) What is companys break even point in terms of Rupees.
(3) If in the coming year sale is likely to increase by 30%, by what per cent would
Earning Before Taxes shall increase.
(4) Prepare an analytical statement to check the accuracy of calculation computed in
(3) above.

38
Valuation of Stock
5. The current earnings of X & X Corp. are Rs. 50 a share, and it has just paid an annual
dividend of Rs. 20. The company is expected to continue to retain 60% of its earnings for
the next 3 years and that both earnings and dividends will grow at 20% a year over that
period. From year 4 onward, the payout ratio is expected to increase to 70% and the
growth rate to fall to 10 percent.
If the capitalization rate for this stock is 15 percent, calculate (a) its price, (b) its price-
earnings ratio, and (c) the present value of its growth opportunities.
Cash Management
6. Jumbo Oils Co. franchises LPG Stations in North India. All payments by franchises gas
stations for the LPG supplied is made through cheque, averaging in total Rs. 4,20,000 a
day. Presently, time between a cheque is posted by the franchise stations to company
and the company having available funds at their bank is 6 days. As Finance Manger of
the Jumbo Oils, you are required to compute:
The funds tied up in the interval of time.
Further, assuming the cost of capital as 9% you are required to comment which of the
following two plans would be better option for the company.
(a) In case company is considering a daily pick up from these stations, and deposited
the cheque already in banks. This procedure would reduce the overall delay by two
days.
However, for this purpose two cars would be needed and two additional staff shall
be hired. The cost would be Rs. 93,000 annually.
(b) Another option available for the Jumbo Oils is to avail the services of a messenger,
leading to reduction in collection period by one day. The cost of messenger
services would be Rs.10,300 annually.
Cost of Capital
7. Chaaloo Softwares Ltd. is an unlevered firm with a P/E ratio of 8.66 and has a dividend
yield of 5.5% (on the basis of ex-dividend share price). The Return on Capital Employed
is 19%. You are required to compute Cost of Equity.
8. TYC Ltd. is planning to float their debenture of the duration of 6 years for the purpose of
raising the fund. The following information is given about the proposed issue of
debentures.
Face value = Rs. 1,000
Rate of interest = 10% p.a.
Floatation Cost = 4%
Corporate tax rate = 40%

39
 Debenture is redeemable = At a premium of 2% at the end of duration.
The difference between the redemption price and the net proceeds can be written off
over the life of the debenture and the amount so written off is tax-deductible.
Compute the cost of capital of debentures.
9. The following information is given about M/s ERP Ltd.
Year 1 Year 2 Year 3
Rs. Rs. Rs.
DPS (Dividend Per Share) 25 30 30
Price per share at the beginning of the year 130 150 160

If the price per share at the beginning of the fourth year is Rs. 140, please compute the
realized yield over the period of 3 years.
Float Management
10. Tony Gray Grocers had bank balance of 10,000 on 1st December, 2008 according to
both his account and bank statement. From that day, Tony issues daily cheques for
2,500 that are cleared on the 3rd working day and deposits daily cheques of 1,800
which are realized on the 2 nd working day. What will be the amount of net float on 3 rd
December 2008?
Receivable Management
11. Tuf Limited specializes in the manufacture of a computer component. The component is
currently sold for Rs. 1,000 and its variable costs is Rs. 800 for the year ended
31.3.2008, the company sold on an average 400 components per month.
At present the company grants one month credit to its customers. The company is
thinking of extending the same to two months on account of which the following is
expected:
Increase in Sales 25%
Increase in Stock Rs. 2,00,000
Increase in Creditors Rs. 1,00,000
You are required to advise the company on whether or not to extend the credit terms if:
(a) all customers avail the extended credit period of two months and
(b) existing customers do not avail the credit terms but only the new customers avail
the same. Assume in this case the entire increase in sales is attributable to the new
customers.
The company expects a minimum return of 40% on the investment.

40
Inventory Management
12. The following data of average daily usage rates of an inventory, lead time and their
respective probabilities are available for a manufacturing unit:
Daily Usage Rate Probability Lead time (in days) Probability
(in units)
1500 0.20 20 0.40
3600 0.50 35 0.60
4500 0.30
You are required to compute:
(i) The possible usage levels at which stock-outs can occur
(ii) What will be the probability of stock-out?
Capital Structure
13. Consider the following data about two companies:
Banta Company Santa Company
No. of shares Outstanding 9,00,000 15,00,000
Market Price per share Rs.120 Rs.100
6% Debentures Rs.6,00,00,000 Nil
Profit before Tax Rs.1,80,00,000 Rs.1,80,00,000
Mr. Bhatti holds 10% of shares in Banta company. Assuming that the MM hypothesis
holds good, what shall be the gain to the Mr. Bhatti by switching from Banta Company to
Santa company.
Capital Budgeting
14. A large profit making company is considering the installation of a machine to process the
waste produced by one of its existing manufacturing process to be converted into a
marketable product. At present, the waste is removed by a contractor for disposal on
payment by the company of Rs. 50 lacs per annum for the next four years. The contract
can be terminated upon installation of the aforesaid machine on payment of a
compensation of Rs. 30 lacs before the processing operation starts. This compensation
is not allowed as deduction for tax purposes.
The machine required for carrying out the processing will cost Rs. 200 lacs to be
financed by a loan repayable in 4 equal installments commencing from the end of year 1.
The interest rate is 16% per annum. At the end of the 4 th year, the machine can be sold
for Rs. 20 lacs and the cost of dismantling and removal will be Rs. 15 lacs.
Sales and direct costs of the product emerging from waste processing for 4 years are
estimated as under:

41
 (Rs. In lacs)
Year 1 2 3 4
Sales 322 322 418 418
Material consumption 30 40 85 85
Wages 75 75 85 100
Other expenses 40 45 54 70
Factory overheads 55 60 110 145
Depreciation (as per income tax rules) 50 38 28 21
Initial stock of materials required before commencement of the processing operations is
Rs. 20 lacs at the start of year 1. The stock levels of materials to be maintained at the
end of year 1, 2 and 3 will be Rs. 55 lacs and the stocks at the end of year 4 will be nil.
The storage of materials will utilise space which would otherwise have been rented out
for Rs. 10 lacs per annum. Labour costs include wages of 40 workers, whose transfer to
this process will reduce idle time payments of Rs. 15 lacs in the year 1 and Rs. 10 lacs in
the year 2. Factory overheads include apportionment of general factory overheads
except to the extent of insurance charges of Rs. 30 lacs per annum payable on this
venture. The company charges depreciation using Written Down Value (WDV) Method.
Assume the companys tax rate is 50% and cost of capital is 15%.Ignore tax on Capital
gain/loss on the sale of machine
Present value factors for four years are as under:
Year 1 2 3 4
Present value factors 0.870 0.756 0.658 0.572
Advise the management on the desirability of installing the machine for processing the
waste. All calculations should form part of the answer.
15. What is Modified Internal Rate of Return (MIRR). Explain with the help of an example.
16. Write short note on the following:
(a) Features and Types of ADRs
(b) Explain as to how the wealth maximisation objective is superior to the profit
maximisation objective.
(c) Discuss the need for social cost benefit analysis.
(d) Basics of Debt Securitization process
17. Differentiate between the following
(a) Net Present Value and Internal Rate of Return.
(b) Deep Discount Bonds vs. Zero Coupon Bonds

42
 SUGGESTED ANSWER/HINTS

1. (a)
Particulars Period PVF Scratus Chang Sungsnag
Year @ 8%
Euros Euros Euros
Purchase Price 0 1 7,400.00 7,400.00 5,900.00 5,900.00 4,400.00 4,400.00
Maintenace Cost 1 0.926 200.00 185.20 300.00 277.80 400.00 370.40
Maintenace Cost 2 0.857 200.00 171.40 450.00 385.65 500.00 428.50
Maintenace Cost 3 0.794 200.00 158.80 600.00 476.40 600.00 476.40
Maintenace Cost* 4 0.735 200.00 147.00 2,250.00 1,653.75 4,400.00 3,234.00
Maintenace Cost** 5 0.681 1,300.00 885.30 900.00 612.90 500.00 340.50
Maintenace Cost 6 0.630 400.00 252.00 1,050.00 661.50 600.00 378.00
Maintenace Cost 7 0.584 400.00 233.60 1,200.00 700.80 700.00 408.80
Maintenace Cost 8 0.540 400.00 216.00 1,350.00 729.00 800.00 432.00
-
Scrap Value 8 0.540 -900.00 -486.00 -500.00 -270.00 1,800.00 -972.00

Total Present Value 9,163.30 11,127.80 9,496.60

Since the present value of cash outflow is least in case of Scartus's qoutation hence
it should be accepted.
* Includes rebuilding costs in case of Chang and Sungsnag.
** Includes rebuilding costs in case of Scartus.
(b)
Particulars Period PVF Scratus Chang Sungsnag
Year @
12%
Euros Euros Euros
Purchase Price 0 1 7,400.00 7,400.00 5,900.00 5,900.00 4,400.00 4,400.00
Maintenace Cost 1 0.893 200.00 178.60 300.00 267.90 400.00 357.20
Maintenace Cost 2 0.797 200.00 159.40 450.00 358.65 500.00 398.50
Maintenace Cost 3 0.712 200.00 142.40 600.00 427.20 600.00 427.20
Maintenace
Cost* 4 0.636 200.00 127.20 2,250.00 1,431.00 4,400.00 2,798.40
Maintenace
Cost** 5 0.567 1,300.00 737.10 900.00 510.30 500.00 283.50
Maintenace Cost 6 0.507 400.00 202.80 1,050.00 532.35 600.00 304.20
Maintenace Cost 7 0.452 400.00 180.80 1,200.00 542.40 700.00 316.40

43
 Maintenace Cost 8 0.404 400.00 161.60 1,350.00 545.40 800.00 323.20
Scrap Value 8 0.404 -900.00 -363.60 -500.00 -202.00 -1,800.00 -727.20

Total Present Value 8,926.30 10,313.20 8,881.40

With the higher discount rate, more distant cash outflow become less important
relative to the initial outlay. As a result, the bid with the lowest initial investment,
Sungsnag should now be accepted.
* Includes rebuilding costs in case of Chang and Sungsnag.
** Includes rebuilding costs in case of Scartus.
2. 1 year life

Maintenance costs : Rs. 1,000.

Depreciation : (Rs. 15,000 Rs. 6,000)/1 = Rs. 9,000
Reduction in taxable income : Rs. 1,000 + Rs. 9,000 = Rs. 10,000
Tax saving on account of above : 0.34 X Rs. 10,000 = Rs. 3,400
Thus the following will be cash flows:
0 year 1 year
(Rs.) (Rs.)
Maintenance costs -1,000
Tax benefit 3,400
Salvage 6,000
Cost -15,000
Total -15,000 8,400

NPV = Rs. 8,400/1.12 Rs. 15,000

= Rs. 7,500 Rs. 15,000 = -Rs.7,500
2 year life
Maintenance costs : Rs. 1,000 in year 1 and Rs. 2,000 in year 2.
Depreciation per year : (15,000 - 3,000)/2 = 6,000
Reduction in taxable income : Rs. 7,000 in year 1 and Rs. 8,000 in year 2.
Tax saving on account of above : 0.34 X Rs. 7,000 = Rs. 2,380 in year 1 and
0.34 X Rs. 8,000 = Rs. 2,720 in year 2.

44
Thus the following will be cash flows:
0 year 1 year 2 year
(Rs.) (Rs.) (Rs.)
Maintenance costs -1,000 -2,000
Tax Saving 2,380 2,720
Salvage 3,000
Cost -15,000
Total -15,000 1,380 3,720
NPV = Rs.1,380/1.12 + Rs. 3,720/1.12 Rs. 15,000
2

= Rs. 1,232 + Rs. 2,966 Rs. 15,000 = -Rs.10,802

3 year life
Maintenance costs : Rs. 1,000 in year 1, Rs. 2,000 in year 2 and
Rs. 3,000 in year 3.
Depreciation per year : Rs. 15,000/3 = Rs. 5,000
Reduction in taxable income : Rs. 6,000 in year 1, Rs. 7,000 in year 2 and
Rs. 8,000 in year 3.
Tax saving on account of above : Rs. 2,040 in year 1, Rs. 2380 in year 2 and
Rs. 2,720 in year 3.
0 year 1 year 2 year 3 year
(Rs.) (Rs.) (Rs.) (Rs.)
Maintenance costs -1,000 -2,000 -3,000
Tax Saving 2,040 2,380 2,720
Cost -15,000
Total -15,000 1,040 380 -280

NPV =Rs. 1,040/1.12 + Rs. 380/1.122 Rs. 280/1.123 Rs. 15,000

=Rs. 929 + Rs. 303 Rs. 199 Rs. 15000 = -Rs.13,967
We can now compute the annual equivalent for each proposal by using Equivalent
Annual Cost as follows:
Equivalent Annual Cost if 1 year life = -Rs. 7,500/ (0.893) = -Rs. 8400
Equivalent Annual Cost if 2 years life = -Rs. 10,802/ (1.690) = - Rs. 6392
Equivalent Annual Cost if 3 years life = -Rs. 13,967/ (2.402) = - Rs. 5815
Hence proposal 3 gives the lowest per-year operating cost.

45
3. The interest expenses:
10 180
Rs. 20,00,00,000 Rs. 1,00,00,000
100 360
The effective cost of credit shall be follows:
Rs. 1,00,00,000 Rs. 1,25,000 1

Rs. 20,00,00,000 Rs. 1,25,000 Rs. 1,00,00,000 180/360
1,01,25,000
=
9,49,37,500
= 0.1066 i.e. 10.66%.
Contribution Rs. 80,00,000
4. (1) Operating leverage 2.67 times.
EBIT Rs. 30,00,000
EBIT Rs. 30,00,000
Financial leverage 1.50 times.
EBIT I Rs. 20,00,000
Combined leverage = (2.67) (1.50) = 4.00 times.
Or
Contribution Rs. 80,00,000
4.00 times.
EBIT I Rs. 20,00,000
F
(2) Break even point sales
VC
1-
S
Rs.50,00,000
=
Rs.1,20,00,000
1
Rs.2,00,00,000
Rs.50,00,000
=
1 0.60
Rs.50,00,000
=
0.40
= Rs. 1,25,00,000
(3) The rise in Earnings Before Tax consequent upon 30% increase in sales shall be as
follows:
(30%) (4.00) = 120%.

46
 (4) Statement with 30% increase
Amount in Rs.
Sales 2,60,00,000
Variable cost 1,56,00,000
Contribution 1,04,00,000
Fixed Cost 50,00,000
EBIT 54,00,000
Interest expenses 10,00,000
Earning Before Tax 44,00,000
Tax @ 50% 22,00,000
Profit after tax (PAT) 22,00,000

As sales have increased by 30% to Rs. 2,60,00,000 from the base level of Rs.
2,00,00,000. The accuracy of result obtained in (3) above can be checked as
follows:
Rs. 44,00,000 Rs. 20,00,000 Rs. 24,00,000
120%
Rs. 20,00,000 Rs. 20,00,000
It should however be noted that since the tax rate was held constant percentage
increase in net income will also be equal to 120 per cent.
5. Div0 = Rs. 20
Rs. 20
EPS 0 Rs. 50
(1 0.60)
g1 = 0.20 Div1 = Rs. 20 1.2 = Rs. 24
g2 = 0.10 Div2 = Rs. 24 1.2 = Rs. 28.80
Div3 = Rs. 28.80 1.2 = Rs. 34.60
EPS4 = EPS (1 + g1)3 (1+ g2)
= Rs. 50 (1 + 0.20)3 (1 + 0.10)
= Rs. 50 (1.20) 3 (1.1)
= Rs. 95
Div4 = Rs. 95 (0.70) = Rs. 66.50.

47
 DIV4
P3
k e g2
Rs. 66.50
P3 Rs. 1,330.
0.15 0.10
(a) Price of share (P0)
DIV1 DIV2 DIV3 DIV4 1
P0
(1 k e) (1 k e)2
(1 k e) (k e g2 ) (1 k e)4
3

Rs. 24 Rs. 28.80 34.60 66.50 1

(1 0.15 ) (1 0.15 )2 (1 0.15 )3 (0.15 0.10 ) (1 0.15 )4

= Rs. 20.87 + Rs. 21.78 + Rs. 22.75 + Rs. 760.43 = Rs. 825.83.
P0
(b) Price Earning Ratio
Div 0
Rs.825.83
=
Rs.20
= 41.29
(c) Present Value of Growth Opportunities (PVGO)
EPS1
P0
r
EPS1 = EPS0 (1 + g1)
= Rs. 50 (1 + 0.20)
= Rs. 60.
Rs.60
PVGO = Rs. 825.83
0.15
= Rs. 825.83 Rs. 400
= Rs. 425.83

6. (i) The total amount of fund invested (tied up) in during interval period in receivables:
Rs. 4,20,000 6 days = Rs. 25,20,000
(ii) Company shall opt plan on the basis of opportunity cost (computed below) of funds
released under each of the option.

48
 (a) Daily cheque pick up:
Rs.
Opportunity cost of funds released (Rs. 4,20,000 2 days 9%) 75,600
Less: Cost of additional staff and cars (93,000)
Net saving (17,400)
(b) Services of Messengers:
Rs.
Saving of cost of funds tied up (Rs. 4,20,000 1 day 9%) 37,800
Less: Cost of services of messenger (10,300)
27,500
Hence, company should opt for services of messengers.
Market price of share
7. Price earning ratio
Earning per share (EPS)
= 8.66 (given)
Dividend Per Share (DPS) (D 0 )
Dividend yield (DY)
Market Price of Share (MPS)
= 0.055 (given)
b = Proportion of Retained Earnings
EPS DPS

EPS
DPS
1
EPS
DPS DPS Market Price of Share
Since
EPS Market Price of Share EPS
Hence = PE Ratio Dividend yield
= 8.66 0.055 = 0.4763
Thus, b = 1 0.4763
= 0.5237
As Growth Rate (g) = Rate of Return Proportion of Retained Earning
Hence, g = 0.19 0.5237
g = 0.0995

49
 D1
Cost of Equity (k e ) g
P1
or
D 0 (1 g)
g
P1
= Dividend yield (1 + g) + g
= 0.055 (1+ 0.0995) + 0.0995
= 0.055 (1.0995) + 0.0995
= 0.0605 + 0.0995
= 0.16
Ke = 16%.
8. Cost of Debt (Kd) can be computed as follows:
Net proceeds (N) = Rs. 1,000 Rs. 40 = Rs. 960.
Redeemable amount (P) = Rs. 1,000 + Rs. 20 = Rs. 1,020
Difference between Redemption price and Net Proceeds = Rs. 1,020 Rs. 960 = Rs. 60
Tax benefit for the whole life of debenture on Difference amount = Rs. 60 (1 0.40) =
Rs. 36.
Tax benefit per year = Rs. 36/6 = Rs. 6
Annual interest payment = I = Rs. 100
Duration of debentures (n) = 6 years
Tax rate (t) = 40% or 0.40
Interest (Net of tax) = Rs. 100 (1 0.40) = Rs. 60.
The cost debenture shall be as follows:
(Rs. 60 Rs.6) (Rs. 60 Rs.6) (Rs. 60 Rs.6) (Rs. 60 Rs.6) (Rs. 60 Rs.6) (Rs. 60 Rs.6) Rs. 1,020
Rs. 960
(1 kd )1 (1 kd )2 (1 kd )3 (1 kd )4 (1 kd )5 (1 kd )6 (1 kd )6

Rs. 66 Rs. 66 Rs. 66 Rs. 66 Rs. 66 Rs. 66 Rs. 1,020

Rs. 960
(1 kd )1 (1 kd )2 (1 kd )3 (1 kd )4 (1 kd )5 (1 kd )6 (1 kd )6

kd = 7.73%
or
The kd can also be calculated by using approximation formula as follows:

50
 (P N)
I n (1 t)
kd
(P N)
2
(1,020 960)
100 6 (1 0.40)

(1,020 960)
2
= 0.06666 or 6.67%.
9. The realized yield over a period of 3 years can be computed as follows:
(w1 w2 w3) 1
w1 to w3 = Wealth Ratio for the 1 3 years.
D t Pt
wt
Pt 1
Where,
Dt = Dividend to paid at end of year t.
Pt = Price of Share at end of year t.
Pt 1 = Price of Share at the beginning of year t.
Accordingly the wealth ratios for 3 years.
Rs. 25 Rs. 150
w1 1.346
Rs. 130
Rs. 30 Rs. 160
w2 1.267
Rs. 150
Rs. 30 Rs. 140
w3 1.0625
Rs. 160
Hence, the realized yield over a period of 3 years will be
(1.346 1.267 1.0625) 1 = 0.2191
or 21.91%.
10. Balance as per the Cash Book:
Day 1st December 2nd December 3rd December

Opening Balance 10,000 9,300 8,600

51
 Cheque deposited 1,800 1,800 1,800
Cheque issued 2,500 2,500 2,500
Closing Balance 9,300 8,600 7,900
Balance as per the Bank Statement:
Day 1st December 2nd December 3rd December

Opening Balance 10,000 10,000 11,800
Cheque deposited 1,800 1,800
Cheque issued 2,500
Closing Balance 10,000 11,800 11,100

Net float = 11,100 7,900 = 3,200 and positive.

11. Statement showing analysis to advise the company on
whether or not to extend the credit terms

All customers avail the Only the new

extended credit period customers avail
the extended
credit
Rs. Rs.
Profitability of additional sales
Present annual turnover
400 12 Rs. 1,000 48,00,000 48,00,000
Increase in turnover 25% 12,00,000 12,00,000
Rs. 1,000 Rs. 800
P/V ratio

100
20% 20%
Rs. 1,000
Profitability of additional sales 2,40,000 2,40,000
(increase in contribution):
20
Rs. 12,00,000 (A)
100

52
 Cost of carrying additional debtors and stock
Proposed / Additional Debtors 10,00,000 2,00,000
2 2
Rs. 60,00,000 12 Rs. 12,00,000 12

Less: Existing debtors 4,00,000 ---

1
Rs. 48,00,000 12

Additional (increase in) debtors 6,00,000 2,00,000

Investment in additional debtors 4,80,000 1,60,000
(Variable cost being 80% of sales value)
Increase in Stock 2,00,000 2,00,000
6,80,000 3,60,000
Less: Increase in Creditors 1,00,000 1,00,000
Net additional investment in working 5,80,000 2,60,000
capital
Minimum return @ 40% (B) 2,32,000 1,04,000
Excess of profits over cost of carrying 8,000 1,36,000
additional working capital @ (A B)

Advice: The above statement shows that it is profitable to extend credit period in both
cases. Hence, the company may extend credit terms. However, if only new customers
avail the extended credit period, then there will be higher profit.
12. (a) The Stock-out position will occur when the usage is likely to be above the normal
consumption and normal consumption can be found out by multiplying the weighted
average daily usage rate and expected lead time.
Hence Normal Usage during lead time = Average Daily Usage rate x Average Lead
Time
Average Daily Usage rate = 1500 x 0.20 + 3600 x 0.50 + 4500 x 0.30 = 3450 units.
Average Lead Time = 20 x 0.4 + 35 x 0.6 = 29 days
Normal Usage during lead time = 3450 x 29 = 1,00,050 units.
Hence Stock outs will occur if the usage is above 1,00,050 units.

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 (b) From the table shown below, we can infer the probability when stock-outs will occur:
Daily Usage Rate Lead Time Possible levels of
Units Probability Number of Probability Possible usage Probability
(1) (2) days (3) (4) Usage = (2) x (4)
Levels
=(1) x (3)
1500 0.2 20 0.4 30,000 0.08
35 0.6 52,500 0.12
3600 0.5 20 0.4 72,000 0.20
35 0.6 1,26,000 0.30
4500 0.3 20 0.4 90,000 0.12
35 0.6 1,57,500 0.18

When the usage levels are 1,26,000 (with probability 0.30) and 1,57,500 (with
probability 0.18) the stock out will occur.
Hence the total probability of stock-out is 0.30 + 0.18 = 0.48 i.e. 48%
13. Mr. Bhatti will dispose of his share holding in Banta Company
The amount realized by him = 90000 120 = Rs.1,08,00,000
The amount so realized by sale of shares in Banta company along with additional funds
of Rs. 60,00,000 by borrowing@ 6%, i.e. Rs.1,68,00,000 will be invested in shares of
Santa company @ Rs.100 each .i.e. 1,68,000 shares
Through the above shift, from Banta company to Santa company, Mr. Bhatti will gain as
follows:
90,000
Present Income in Banta Company = ,80,00,000 3,60,000
9,00,000
= Rs. 14,40,000
1,68,000
Proposed Income in Santa Company = 180,00,000 360,000
15,00,000
= 20,16,000 3,60,000 = Rs. 16,56,000
Increase in Income = 16,56,000 14,40,000 = Rs.2,16,000

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14. Statement of Incremental Profit
(Rs. in lacs)
Years 1 2 3 4
Sales :(A) 322 322 418 418
Material consumption 30 40 85 85
Wages 60 65 85 100
Other expenses 40 45 54 70
Factory overheads (insurance) 30 30 30 30
Loss of rent (Opportunity Cost) 10 10 10 10
Interest 32 24 16 8
Depreciation 50 38 28 21
Total cost: (B) 252 252 308 324
Incremental profit (C)=(A)-(B) 70 70 110 94
Tax (50% of (C)) 35 35 55 47
Statement of Incremental Cash Flows
(Rs. in lacs)
Years 0 1 2 3 4
Material stocks (20) (35) - - -
Compensation for contract (30) - - - -
Contract payment saved - 50 50 50 50
Tax on contract payment - (25) (25) (25) (25)
Incremental profit - 70 70 110 94
Depreciation added back - 50 38 28 21
Tax on profits - (35) (35) (55) (47)
Loan repayment - (50) (50) (50) (50)
Cash flow on sale of machinery (net) - - - - 5
Total incremental cash flows (50) 25 48 58 48
Present value factor @15% 1.00 0.870 0.756 0.658 0.572
Present value of cash flows (50) 21.75 36.288 38.164 27.456
Net present value = Rs. 123.658 Rs. 50 = 73.658 lacs.

Advice: Since the net present value of cash flows is Rs. 73.658 lacs which is positive the
management should install the machine for processing the waste.

55
 Notes:
1. Material stock increases are taken in cash flows.
2. Idle time wages have also been considered
3. Apportioned factory overheads are not relevant only insurance charges of this
project are relevant.
4. Interest calculated at 16% based on 4 equal instalments of loan repayment.
5. Sale of machinery- Net income after deducting removal expenses taken. Tax on
Capital gains ignored.
6. Saving in contract payment and income tax there on considered in the cash flows.
15. IRR implicitly assumes that positive cash flows generated are reinvested at the IRR, not
the discount (Hurdle) rate. Whereas the discount rate, not the IRR, represents the
opportunity cost of capital or Weighted Average Cost of Capital. Sometimes this in turn
makes IRR inappropriate for appraising or ranking projects. MIRR addresses this
deficiency Modified internal rate of return (MIRR) is a similar technique to IRR.
Technically, MIRR is the IRR for a project with an identical level of investment and NPV
to that being considered but with a single terminal payment. A simple example will help
explain matters.
Example
A project entails an initial investment of Rs.1,000, and offers cash returns of Rs.400,
Rs.600, and Rs.300 at the end of years one, two and three respectively. The companys
cost of capital is 10%.
Year
0 1 2 3 NPV IRR
Project cash flow (Rs.) 1,000.00 400.00 600.00 300.00
Discounted Cash Flow (Rs.) 1,000.00 363.64 495.87 225.39 84.90 14.92%
We will proceed in two stages.
Stage 1: Taking the project cash flows from the return phase (ie year one forward in this
case), compound each cash flow forward to the end of the project using the firms cost of
capital.
Year
0 1 2 3
Project cash flow (Rs.) -1,000.00 400.00 600.00 300.00
Year 1 cash flow compounded at
10% for two years (Rs.) 484.00
Year 2 cash flow compounded at
10% for one year (Rs.) 660.00
Modified cash flow (Rs.) -1,000.00 1,444.00

56
 Stage 2: Taking the total of the cash flows extended to year three, calculate the discount
rate required to set this value when discounted equal to the outlay. To do this we need to
use the following formula:
Outlay= Terminal cash flow
n
(1+MIRR)
n is the number of years of the project. We can rearrange this formula and find a solution
for this project as follows:

Terminal cash flow

MIRR = n -1
Outlay

1444
3 1 13.03%
1000

16 (a) Introduced to the financial markets in 1927, an American depositary receipt (ADR) is
a stock that trades in the United States but represents a specified number of shares
in non-US companies who want to get listed on any of the US exchanges. Each
ADR represents a certain number of regular shares of a company ADRs allow US
investors to buy shares of these companies without the costs of investing directly in
a foreign stock exchange. ADRs are issued by an approved New York bank or trust
company against the deposit of the original shares. These are deposited in a
custodial account in the US. Such receipts have to be issued in accordance with the
provisions stipulated by the SEC, USA which are very stringent. ADRs can be
traded either by trading existing ADRs or purchasing the shares in the issuers
home market and having new ADRs created, based upon availability and market
conditions. ADRs are denominated in US dollars and, pay dividends in US dollars.
These can be traded like the shares of US-based companies. The major reason for
the introduction of ADRs were the complexities involved in buying shares in foreign
countries and the difficulties associated with trading at different prices and currency
values. Normally the price of an ADR is often close to the price of the foreign stock
in its home market, adjusted for the ratio of ADRs to foreign company shares. The
process of buying new, issued ADRs goes through US brokers, Helsinki Exchanges
as well as Deutsche Bank. When transactions are made, the ADRs change hands,
not the certificates. This eliminates the actual transfer of stock certificates between
the US and foreign countries. The denomination of ADRs range between $10 and
$100 per share. However if in the home country, the shares were worth
considerably less, then each ADR would represent several real shares.
Broadly ADRs are classified in two categories Non-sponsored shares and
Sponsored Shares. The Unsponsored shares are ADRs that are traded on the over-

57
 the-counter (OTC) market. These shares have no regulatory reporting requirements
and are issued in accordance with market demand. The foreign company has no
formal agreement with a custodian bank and shares are often issued by more than
one depositary. Each depositary handles only the shares it has issued.
Unsponsored ADRs are rarely issued now days due to the hidden fees and hassles
involved in issuing them. However, there are still some companies with outstanding
unsponsored programs. Often, unsponsored program will be exchanged for Level I
depositary receipts.
Three different types of ADR issues are as follows:
Level 1 - This is the most basic and easiest type of ADR where foreign
companies either don't qualify or don't wish to have their ADR listed on an
exchange. Level 1 ADRs are found on the over-the-counter market and are an
easy and inexpensive way to gauge interest for its securities in North America.
Level 1 ADRs also have the loosest requirements from the Securities and
Exchange Commission (SEC).
Level 2 - When a foreign company wants to set up a Level 2 program, it has to
follow slightly more requirements from the SEC, e.g. to file a registration
statement with the SEC under SEC regulation. In addition to their filings, the
company is required to follow GAAP standards. Though this is a little
complicated procedure but the advantage is that not only the shares can be
listed on U.S. stock exchanges but they also get higher visibility trading
volume. These exchanges include the New York Stock Exchange (NYSE),
NASDAQ, and the American Stock Exchange (AMEX).
Level 3 Since the company is required to adhere to stricter rules that are
similar to those followed by U.S. companies, this level is most prestigious of
the three; this is when an issuer floats a public offering of ADRs on a U.S.
exchange. Level 3 ADRs are able to raise capital and gain substantial visibility
in the U.S. financial markets. Setting up a Level 3 program is equivalent to the
foreign company taking some of its shares from its home market and
depositing them to be traded in the U.S. In addition to filing requirements, any
material information given to shareholders in the home market, must be filed
with the SEC through requisite Forms.
(b) A firms financial management may often have the following as their objectives:
(i) The maximisation of firms profit.
(ii) The maximisation of firms value / wealth.
The maximisation of profit is often considered as an implied objective of a firm. To
achieve the aforesaid objective various type of financing decisions may be taken.
Options resulting into maximisation of profit may be selected by the firms decision

58
 makers. They even sometime may adopt policies yielding exorbitant profits in short
run which may prove to be unhealthy for the growth, survival and overall interests of
the firm. The profit of the firm in this case is measured in terms of its total
accounting profit available to its shareholders.
The value/wealth of a firm is defined as the market price of the firms stock. The
market price of a firms stock represents the focal judgment of all market
participants as to what the value of the particular firm is. It takes into account
present and prospective future earnings per share,the timing and risk of these
earnings, the dividend policy of the firm and many other factors that bear upon the
market price of the stock.
The value maximisation objective of a firm is superior to its profit maximisation
objective due to following reasons.
1. The value maximisation objective of a firm considers all future cash flows,
dividends, earning per share, risk of a decision etc. whereas profit
maximisation objective does not consider the effect of EPS, dividend paid or
any other returns to shareholders or the wealth of the shareholder.
2. A firm that wishes to maximise the shareholders wealth may pay regular
dividends whereas a firm with the objective of profit maximisation may refrain
from dividend payment to its shareholders.
3. Shareholders would prefer an increase in the firms wealth against its
generation of increasing flow of profits.
4. The market price of a share reflects the shareholders expected return,
considering the long-term prospects of the firm, reflects the differences in
timings of the returns, considers risk and recognizes the importance of
distribution of returns.
The maximisation of a firms value as reflected in the market price of a share is
viewed as a proper goal of a firm. The profit maximisation can be considered as a
part of the wealth maximisation strategy.
(c) 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:

59
 (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 profitability analysis.
(iv) The redistribution benefits because of project needs to be captured.
(v) The merit wants are important appraisal criteria for social cost benefit analysis.
(d) 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 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.
17 (a) NPV and IRR: NPV and IRR methods differ in the sense that the results regarding
the choice of an asset under certain circumstances are mutually contradictory under
two methods. In case of mutually exclusive investment projects, in certain
situations, they may give contradictory results such that if the NPV method finds
one proposal acceptable, IRR favours another. The different rankings given by the
NPV and IRR methods could be due to size disparity problem, time disparity
problem and unequal expected lives.

60
 The net present value is expressed in financial values whereas internal rate of
return (IRR) is expressed in percentage terms.
In the net present value cash flows are assumed to be re-invested at cost of capital
rate. In IRR reinvestment is assumed to be made at IRR rates.
(b) 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 payout during 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 Rs. 2,700 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 represent the interest to be earned by the investor on such bonds.

61