Financial Management - Important questions for IPCC November 2017

BASICS OF FINANCIAL MANAGEMENT

1. Discuss conflict in profit versus wealth maximization objective

Answer

Conflict in Profit versus Wealth Maximization Objective

Profit maximisation is a short–term objective and cannot be the sole objective of a company.
It is at best a limited objective. If profit is given undue importance, a number of problems can
arise like the term profit is vague, profit maximisation has to be attempted with a realisation
of risks involved, it does not take into account the time pattern of returns and as an objective
it is too narrow.

Whereas, on the other hand, wealth maximisation, is a long-term objective and means that the
company is using its resources in a good manner. If the share value is to stay high, the
company has to reduce its costs and use the resources properly. If the company follows the
goal of wealth maximisation, it means that the company will promote only those policies that
will lead to an efficient allocation of resources.

RATIO ANALYSIS

2. The assets of SONA Ltd. consist of fixed assets and current assets, while its current
liabilities comprise bank credit in the ratio of 2 : 1. You are required to prepare the
Balance Sheet of the company as on 31st March 2013 with the help of following
information:
Share Capital Rs 5,75,000

Working Capital (CA-CL) Rs 1,50,000

Gross Margin 25%
Inventory Turnover 5 times
Average Collection Period 1.5 months
Current Ratio 1.5:1
Quick Ratio 0.8: 1
Reserves & Surplus to Bank & Cash 4 times
Answer
Working Notes:

(1) Computation of Current Assets (CA) and Current Liabilities (CL)

Current Assets = Current Ratio

Current Liabilities
CA = 1.5
CL 1
∴ CA = 1.5CL
CA - CL = 1,50,000
1.5 CL- CL = 1,50,000
0.5 CL = 1,50,000
CL = 3,00,000
CA = 1.5 x 3,00,000 = 4,50,000

2. Computation of Bank Credit (BC) and Other Current Liabilities (OCL)

Other CL = 2
Bank Credit 1
BC = 2 OCL
BC + OCL = CL
2 OCL + OCL = 3,00,000
3 OCL = 3,00,000
OCL = 1,00,000
Bank Credit = 2 × 1,00,000 = 2,00,000

3.Computation of Inventory
Quick Ratio = Quick Assets
Current Liabilities
= Current Assets - Inventories
Current Liabilities
0.8 = 4,50,000 - Inventories
3,00,000
0.8 × 3,00,000 = 4,50,000 – Inventories
Inventories = 4,50,000 – 2,40,000 = 2,10,000

4. Computation of Debtors
Inventory Turnover = 5 times
Average Inventory = COGS
Inventory Turnover
COGS = 2,10,000 × 5 = 10,50,000
GP = 25%, COGS % = 75%
Sales = 10,50,000/75% = 14,00,000
Debtors = 14,00,000*1.5/12 = 175,000

5. Computation of Bank and Cash

Bank & Cash = CA - (Debtors + Inventory)
= 4,50,000 – (1,75,000 + 2,10,000)= 4,50,000 – 3,85,000 = 65,000
 6. Computation of Reserves & Surplus

Reserves & Surplus= 4

Bank & Cash

Reserves & Surplus = 4 × 65,000 = 2,60,000

Balance Sheet of SONA Ltd.

Liabilities Rs Assets Rs
Share Capital 5,75,000 Fixed Assets 6,85,000
Reserves & Surplus 2,60,000 Current Assets:
Current Liabilities: Inventories 2,10,000
Bank Credit 2,00,000 Debtors 1,75,000
Other Current Liabilities 1,00,000 Bank & Cash 65,000
11,35,000 11,35,000

3. Sohna Limited’s sales, variable costs and fixed cost amount to Rs 75,00,000, Rs 42,00,000
and Rs 6,00,000 respectively. It has borrowed Rs 45,00,000 at 9 per cent and its equity
capital totals Rs 55,00,000.
(a) What is Sohna Limited’s ROI?
(b) Does it have favourable financial leverage?
(c) If Sohna Limited belongs to an industry whose asset turnover is 3, does it have a
high or low asset leverage?
(d) If the sales drops to Rs 50,00,000, what will the new EBIT be?

Answer

(a) Computation of Sohna Limited’s ROI

ROI = EBIT/Investment

EBIT = Sales – Variable Cost – Fixed Cost

= 75 lakhs – 42 lakhs – ` 6 lakhs = 27 lakhs.

ROI = 27 lakhs/100 lakhs = 27 per cent

(b) Yes, Sohna Limited has favourable financial leverage as its ROI is higher than the interest
on debt.

(c) Asset turnover = Sales/ Total assets = 75 lakhs/100 lakhs = 0.75

The asset turnover of Sohna Limited is lower than the industry average of 3.
(d) EBIT at Sales Level of Rs 50 lakhs

Particulars Rs

Sales Revenue 50,00,000

Less: Variable Costs (50 lakhs × 0.56) 28,00,000

Less: Fixed Costs 6,00,000

EBIT 16,00,000

4. 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)
(a) 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

Profit Margin
= EBIT ÷ Sales
Return on Net Assets
(RONA)
= EBIT ÷ NA
Assets Turnover =
Sales ÷ NA
Financial Leverage
Return on Equity (Income)
(ROE) = PAT ÷ NW
= PAT ÷ E BIT

Financial Leverage
(Balance Sheet)
= NA ÷ NW

5. 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) x D/E}] (1 – t)

= [0.20 + {(0.20 – 0.10) x 0.60}] (1 – 0.40)
= [ 0.20 + 0.06] x 0.60 = 0.1560
ROE = 15.60%

TIME VALUE OF MONEY

6. Ms. A has purchased a smart phone from a shop for Rs25,000. She has paid Rs5,000 as
down payment and the rest will be paid in equated monthly instalments (EMI) for 2 years.
The interest rate charged by the bank is 14% p.a. Required:(i) Calculate the amount of
EMI and (ii) Calculate the total amount of interest payable to the bank.

Answer

Purchase price = 25,000

Loan amount = 25000-5000 = 20000

Rate of interest = 14%/12 = 1.1667% p.m

Loan = Installment*Annuity factor

20,000 = Installment*AF(1.1667,24)

20,000 = Installment*20.8277

(i) Installment =20000/20.8277 = 960.26

(ii) Total interest paid = Installments paid - loan

= 960.26*24 – 20000

= 3046.24

7. Gama Limited has borrowed Rs 1,000 to be repaid in equal installments at the end of each
of the next 3 years. The interest rate is 15 per cent. You are required to prepare an
amortisation schedule for Gama Limited.

Answer
Instalment =Loan/Annuity factor (15%,3)

= 1000/2.2832

=Rs.438
 Loan repayment schedule

Sl. Amount Outstanding Interest for Installment Amount Outstanding

No at the beginning the period repaid at the end
1 1000 150 438 712
2 712 106.8 438 381
3 381 57 438 -

CAPITAL STRUCTURE THEORIES

8. 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 of
funds such as debentures, preference share capital, equity share capital and retained earnings
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

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

Answer
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:

(i) Raising more money through issue of shares or debentures than company can employ
profitably.
(ii) Borrowing huge amount at higher rate than rate at which company can earn.
(iii) Excessive payment for the acquisition of fictitious assets such as goodwill etc.
(iv) Improper provision for depreciation, replacement of assets and distribution of dividends
at a higher rate.
(v) 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:

(i) Considerable reduction in the rate of dividend and interest payments.
(ii) Reduction in the market price of shares.
(iii) Resorting to “window dressing”.
(iv) 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)

10. X Ltd. is considering the following two alternative financing plans:

Plan - I Plan - II
Rs Rs
Equity shares of Rs 10 each 4,00,000 4,00,000
12% Debentures 2,00,000 -
Preference Shares of Rs 100 each - 2,00,000
Rs 6,00,000 Rs 6,00,000
The indifference point between the plans is ` 2,40,000. Corporate tax rate is 30%.
Calculate the rate of dividend on preference shares.

Answer

Computation of Rate of Preference Dividend

EBIT = 2,40,000
Tax rate = 30%

(EBIT- Interest) (1- Tax rate) = EBIT (1- Tax rate) -Preference Dividend
No. of Equity Shares (N1 ) No.of Equity Shares (N2 )

(2,40,000 - 24,000) (1- 0.30) = 2,40,000 (1- 0.30) -Preference Dividend

40,000 40,000

2,16,000 (1- 0.30) = 1,68,000 -Preference Dividend

1,51,200 = 1,68,000 – Preference Dividend
Preference Dividend = 1,68,000 – 1,51,200

Preference Dividend = 16,800

Rate of Dividend = Preference Dividend x 100
Preference Share Capital
= 16,800 x 100 = 8.4%
2,00,000
11. Distinguish between net income approach and net operating income approach in
capital structure theories

Answer
Difference between net income approach and net operating income approach

Point of difference Net income Approach Net operating income Approach

Brings forth the relevance of
capital structure in calculating the
Role of Capital value of firm
Structure With a judicious mixture of debt
and equity, a firm can arrive at an
optimum capital structure
Value of firm = Value of equity +
Computation Value of debt
Change in degree of leverage will
Degree of alter the overall cost of capital
Leverage and Cost (WACC) and hence the value of
of Capital: the firm.
States the irrelevance of capital
structure in calculating the value
of the firm.
Value of Equity (Residual) =
Value of firm – Value of debt
Degree of leverage of the firm is
irrelevant to the cost of capital i.e.
the cost of capital is always
constant.

12. Company XYZ is unlevered and has a cost of equity of 20 percent and a total market
value of Rs10,00,00,000. Company ABC is identical to XYZ in all respects except that it
uses debt finance in its capital structure with a market value of Rs4,00,00,000 and a cost of
10 percent. Find the market value of equity, and weighted average cost of capital if the tax
advantage of debt is 25 percent

Answer

Computation of market value of company

Market Value of levered company (ABC)
= Market value of unlevered company + Debt*Tax rate
= 10,00,00,000 + 4,00,00,000 × 0.25%
= 11,00,000

The market value of equity of company ABC

Equity = Value of firm - Debt
= 11,00,000 – 400,000
= 700,000

Weighted average Cost of capital of ABC

= Returns expected by unlevered firm/ value of levered firm *100
= 10,00,000*20%/11,00,000* 100
= 18.18%
13. The following current data are available concerning Theta Limited:
No of Share issued 10,000
Market price per share Rs20
Interest rate 12%
Tax Rate 46%
Expected EBIT Rs15,000

The company requires an additional Rs50,000 for the coming year.

You are required to determine:

Which financing option (debt or equity issue) will give higher EPS

Answer

Computation of Earnings Per Share (EPS) for the Expected EBIT

Particulars Debt(Rs) Equity(Rs)
Expected earnings before interest & tax 15,000 15,000
Less: Interest (12% of 50,000) 6,000 -
Earnings before tax (EBT) 9,000 15,000
Less: Tax (@ 46%) of EBT (9000 X 46%) 4,140 6,900
Earnings available to equity shareholder: (A) 4,860 8,100

Number of shares issued: (B) 10,000 12,500 (50000/20)+10000

Earnings per shares: (A) / (B) 0.486 0.648

Conclusion:
Earnings per share is higher when the company raises additional funds by issue of
equity shares

14. Discuss the concept of Debt-Equity or EBIT-EPS indifference point, while

determining the capital structure of a company.

Answer
Concept of Debt-Equity or EBIT-EPS Indifference Point while Determining the Capital
Structure of a Company

The determination of optimum level of debt in the capital structure of a company is a

formidable task and is a major policy decision. It ensures that the firm is able to service its
debt as well as contain its interest cost. Determination of optimum level of debt involves
equalizing between return and risk.
 EBIT – EPS analysis is a widely used tool to determine level of debt in a firm. Through
this analysis, a comparison can be drawn for various methods of financing by obtaining
indifference point. It is a point to the EBIT level at which EPS remains unchanged
irrespective of debt-equity mix.

The indifference point for the capital mix (equity share capital and debt) can be determined as
follows
(EBIT - I1) (1 – T) = (EBIT – I2) (1 – T)
E1 E2

15. Skyline Ltd. is planning an expansion programme which will require 30 crore and can
be funded through one of the following three options :

Option-1 : Issue further equity shares of 100 at par

Option-2 : Raise loans @ 15% interest
Option-3 : Issue preference shares @ 12%.

Present paid-up capital is 60 crore and average annual EBIT is 12 crore. Assume tax
rate at 30%. Post expansion EBIT is expected to be 15 crore p.a. Calculate EPS under
the three financing options indicating the alternative giving the highest return to the
equity shareholders.

Answer Rs Crs
Option 1 Option 2 Option 3
Equity shares Loan@15% Pref shares@12%
EBIT 15 15 15
Int 30*15% 0
0 4.5 0
EBT 15 10.5 15
Tax@30% 4.5 3.15 4.5
EAT 10.5 7.35 10.5
Pref share divi 30*12%
0 0 3.6
Earning to ESH 10.5 7.35 6.9
No of shares
Existing 0.6 0.6 0.6
New 0.3
Total 0.9 0.6 0.6
EPS 11.67 12.25 11.5
(Highest)
WORKING CAPITAL MANAGEMENT

16. PTX Limited is considering a change in its present credit policy. Currently it is
evaluating two policies. The company is required to give a return of 20% on the
investment in new accounts receivables. The company's variable costs are 70% of the
selling price.

Information regarding present and proposed policies is as follows:

Present Policy Policy
Policy Option 1 Option 2
Annual Credit Sales (Rs) 30,00,000 42,00,000 45,00,000
Debtors turnover ratio 4 times 3 times 2.4 times
Loss due to bad debts 3% of sales 5% of sales 6% of sales

Return on investment in new accounts receivable is based on cost of investment in

debtors. Which option would you recommend?

Answer

Statement of Evaluation of Credit Policies of PTX Limited (based on Total Cost Approach)

Present Policy Policy Option I Policy Option II

Sales Revenue 30,00,000 42,00,000 4,50,0000
Less: Variable Cost @70% 21,00,000 29,40,000 31,50,000
Contribution 9,00,000 12,60,000 13,50,000
Less: Other Relevant Costs
Bad Debt Losses (90,000) (2,10,000) (2,70,000)
Investment Cost
(VC ÷ DTR) × 20% (1,05,000) (1,96,000) (2,62,500)
Profit 7,05,000 8,54,000 8,17,500
Recommendation: PTX Limited is advised to adopt Policy Option I.

(Note: In the above solution, investment in accounts receivable is based on total cost of goods
sold on credit).

17. State the advantage of Electronic Cash Management System.

Answer

Advantages of Electronic Cash Management System

(i) Significant saving in time.
(ii) Decrease in interest costs.
(iii) Less paper work.
(iv) Greater accounting accuracy.
(v) More control over time and funds.
(vi) Supports electronic payments.
 (vii) Faster transfer of funds from one location to another, where required.
(viii) Speedy conversion of various instruments into cash.
(ix) Making available funds wherever required, whenever required.
(x) Reduction in the amount of ‘idle float’ to the maximum possible extent

18. '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 cash as it serves
both the purposes of liquidity and cash, provided choice of investment is made correctly.
As the working 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.

19. The Sales Manager of AB Limited suggests that if credit period is given for 1.5
months then sales may likely to increase by Rs. 1,20,000 per annum. Cost of sales
amounted to 90% of sales. The risk of non-payment is 5%. Income tax rate is 30%. The
expected return on investment is Rs. 3,375 (after tax). Should the company accept the
suggestion of Sales Manager?

Answer

Profitability on additional sales: Rs.

Increase in sales 1,20,000

Less: Cost of sales (90% sales) 1,08,000

Less: Bad debt losses (5% of sales) 6,000

Net profit before tax 6,000

Less: Income tax (30%) 1,800

4,200

Advise: Net profit after tax Rs. 4,200 on additional sales is higher than expected
return. Hence, proposal should be accepted.
20. A firm has a total sales of Rs. 12,00,000 and its average collection period is 90 days.
The past experience indicates that bad debt losses are 1.5% on sales. The expenditure
incurred by the firm in administering receivable collection efforts are Rs. 50,000. A factor
is prepared to buy the firm’s receivables by charging 2% commission. The factor will pay
advance on receivables to the firm at an interest rate of 16% p.a. after withholding 10% as
reserve. Calculate effective cost of factoring to the firm. Assume 360 days in a year.

Answer

Computation of Effective Cost of Factoring

Average level of Receivables = 12,00,000 * 90/360 3,00,000

Factoring Commission = 3,00,000 * 2/100 6,000

Factoring Reserve = 3,00,000 * 10/100 30,000

Amount Available for Advance = Rs. 3,00,000-(6,000+30,000) 2,64,000

Factor will deduct his interest @ 16% :-

Interest = 264000*90/360*16% = 10560

Advance to be paid = Rs. 2,64,000 – Rs. 10,560 = Rs. 2,53,440

Annual Cost of Factoring to the Firm: Rs.

Factoring Commission (Rs. 6,000 * 360/90) 24,000

Interest Charges (Rs. 10,560 *360/90) 42,240

Total 66,240

Firm’s Savings on taking Factoring Service: Rs.

Cost of Administration Saved 50,000

Cost of Bad Debts (Rs. 12,00,000 x 1.5/100) avoided 18,000

Total 68,000

Net Benefit to the Firm (Rs. 68,000 – Rs. 66,240) 1760

Effective Cost of Factoring =66240*100/253440 26.136%

Effective Cost of Factoring = 26.136%

21. MN Ltd. is commencing a new project for manufacture of electric toys. The following
cost information has been ascertained for annual production of 60,000 units at full
capacity:
Amount per unit (Rs.)
Raw materials 20
Direct labour 15
Manufacturing overheads:
Variable 15
Fixed 10 25
Selling and Distribution overheads:
Variable 3
Fixed 1 4
Total cost 64
Profit 16
Selling price 80

In the first year of operations expected production and sales are 40,000 units and
35,000 units respectively. To assess the need of working capital, the following
additional information is available:

(i) Stock of Raw materials……………………………...3 months consumption.

(ii) Credit allowable for debtors…………………………..…1½ months.
(iii) Credit allowable by creditors……………………………4 months.
(iv) Lag in payment of wages………………………………..1 month.
(v) Lag in payment of overheads…………………………..½ month.
(vi) Cash in hand and Bank is expected to be Rs. 60,000.
(vii) Provision for contingencies is required @ 10% of working capital requirement
including that provision.

You are required to prepare a projected statement of working capital requirement for
the first year of operations. Debtors are taken at cost.

Answer
Statement Showing Working Capital Requirement

A. Current Assets Rs.

Stock of Raw Materials (Rs. 8,00,000 * 3/12) 2,00,000

Stock of Finished Goods 3,25,000

Debtors at Cost (Rs. 24,40,000 * 3/24) 3,05,000

Cash and Bank 60,000

Total (A) 8,90,000

 B. Current Liabilities

Creditors for Materials (Rs. 10,00,000 * 4/12) 3,33,333

Creditors for Expenses (Rs. 13,65,000 * 1/24) 56,875

Outstanding Wages (Rs. 6,00,000 * 1/12) 50,000

Total (B) 4,40,208

Working Capital Requirement before Contingencies (A – B) 4,49,792

Add: Provision for Contingencies (Rs. 4,49,792 * 1/9) 49,977

Estimated Working Capital Requirement 4,99,769

Workings Notes:

Purchase of Raw Material during the first year Rs.

Raw Material consumed during the year 8,00,000

Add: Closing Stock of Raw Materials (3 months consumption) 2,00,000

Less: Opening Stock of Raw Material Nil

Purchases during the year 10,00,000

22. Alpha Limited sells its products on a gross profit of 20 percent on sales. The
following information is extracted from its annual accounts for the current year ended
March 31.
Rs
Sales at 3 months’ credit 40,00,000
Raw Material 12,00,000
Wages paid-average time lag 15 days 9,60,000
Manufacturing expenses paid-one month in arrears 12,00,000
Administrative expenses paid-one month in arrears 4,80,000
Sales promotion expenses-payable half-yearly in advance 2,00,000

The company enjoys one month’s credit from the suppliers of raw materials and maintains 2
months’ stock of raw materials and one and a half month’s stock of finished goods. The cash
balance is maintained at Rs1,00,000 as a precautionary measure. Assuming a 10 percent
margin, you are required to estimate the working capital(based on cost) requirements of
Alpha Limited
Answer
Statement Showing the Estimation of Working Capital Requirements of Alpha Limited

Particulars Workings Rs
(A) Current Assets :
Cash balance 1,00,000
Inventories :
Raw materials (12,00,000 * 2/12) 2,00,000
Finished goods (40,00,000 * 1.5/12) 4,00,000
Debtors (32,00,000 *3)/12 8,00,000
Prepaid sales expenses (2,00,000 * 6)/12 1,00,000
Total 16,00,000
(B) Current Liabilities
Creditors for raw material (12,00,000 * 1) /12 1,00,000
Wages (9,60,000 * 0.5) /12 40,000
Manufacturing expenses (12,00,000 * 1)/12 1,00,000
Administrative expenses (4,80,000 * 1) / 12 40,000
Total 2,80,000
(C) Net working capital (A−B) 13,20,000
Add : Margin (0.10) 1,32,000
Working Capital Requirements of Alpha
Limited 14,52,000
FUNDS FLOW STATEMENT

23. Given here is the Balance Sheet as on March 31, years 1 and 2 for Zeta Limited.

March 31, Year 1 March 31, Year 2

Rs Rs
Liabilities
Accounts Payable 20,000 18,000
Accrued expenses 2,000 4,000
Income Tax payable 1,000 1,100
Equity share capital 30,000 37,000
Retained earnings 12,650 13,650
Total 65,650 73,750
Assets
Cash 5,000 6,000
Accounts receivable 14,000 14,000
Inventory 22,000 8,000
Prepaid Insurance 200 250
Prepaid rent 150 100
Pre-paid property tax 300 400
Land 4,000 8,000
Plant & Equipment 30,000 48,000
Less: Accumulated Dep. 10,000 20,000 11,000 37,000
Total 65,650 73,750

Sales for year 2 was Rs2,10,000. Net income after tax was Rs7,000.

In arriving at net profit, items deducted from sales included,

Cost of goods sold – Rs1,65,000; Depreciation - Rs5,000; Wages and Salaries –
Rs20,000 and a gain of Rs1,000 on the sale of a plant.
The plant had a historical cost of Rs6,000, a depreciation of Rs4,000 had been
accumulated for it and it was sold for Rs3,000. This was the only asset written off
during the year. The company declared and paid Rs6,000 as dividends during the year.

You are required to prepare funds flow statement

Answer

Funds Flow Statement of Zeta Limited for the year 2

Rs
Sources of funds:
Funds from business operations(Refer to working note (i)) 11,000
Sale of Plant 3,000
Issuance of shares 7,000
Total : 21,000
Application of funds:
Purchase of Land 4,000
Purchase of Plant & Equipment (Refer to working note (ii)) 24,000
Dividend paid 6,000
Decrease in working capital (Refer to working note (iii)) 13,000
Total : 21,000
Working Notes:

(i) Funds from business operations:

Particulars Rs
Net income after taxes 7,000
Add: Depreciation 5,000
Less: Gain on sale of plant 1,000
Funds from business operations: 11,000

(ii)
Plant and Equipment Account
Particulars Rs Particulars Rs
To Balance b/d 20,000 By Cash (sale of plant) 3,000
To P & L A/c 1,000 By Depreciation 5,000
(Profit on the sale of plant) By Balance c/d 37,000
To Cash 24,000
(Purchases, balancing figure)
Total 45,000 Total 45,000
(iii)

Statement of changes in working capital

Year1 Year2
Particulars
Rs Rs
Current Assets :
Cash 5,000 6,000
Accounts receivable 14,000 14,000
Inventory 22,000 8,000
Prepaid Insurance 200 250
Prepaid Rent 150 100
Prepaid Property taxes 300 41,650 400 28,750
Less: Current Liabilities:
Accounts payable 20,000 18,000
Accrued expenses 2,000 4,000
Income tax payable 1,000 23,000 1,100 23,100

Working capital 18,650 5,650

Change in working capital 13,000 (Decrease)

LEVERAGES

24. “Financial leverage is a double edged sword” . Comment

Answer
Financial Leverage –A double edged sword

1. A “double-edged sword” has two cutting edges; in finance, a “double-edged sword”

means something that has both potential benefits and liabilities.
2. Financial leverage can multiply gains, but it also multiply losses.
3. Positive leverage
a. A business entity can leverage its revenue by buying fixed assets. This will
increase the proportion of fixed, as opposed to variable, costs, meaning that a
change in revenue will result in a larger change in operating income
b. For example, XYZ company obtains a long term debt at a rate of 12%. The
company can use the funds to earn an after-tax rate of 14%. The interest on
debt is tax deductible. If the tax rate is 40%, the after-tax interest rate would
 be 7.2% [12% × (1 – 0.4)]. The difference of 6.8% (14% – 7.2%) is, therefore,
the benefit of equity shareholders.
4. Negative Leverage
a. A negative financial leverage occurs when the assets acquired with the debts
generate a rate of return that is less than the rate of interest Negative financial
leverage is a loss for common stockholders.
b. For example in the situation above, if company makes return of 5% instead of
14%, then The difference of 2.2% (5% – 7.2%) would be loss to equity
shareholders

25. “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
26. 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

Working Notes:

Company A

(i) EBIT = 12000*5/1 = 12000

(ii) Contribution = EBIT + Fixed Cost = 15,000 + 20,000 = Rs. 35,000

(iii) Sales = Contribution + Variable cost = 35,000 + 56,000= Rs. 91,000

Company B

(i) Contribution = 40% of Sales (as Variable Cost is 60% of Sales) = 40% of 1,05,000

= Rs. 42,000

(ii) Financial Leverage = 42000/4 = 10500

(iii) Fixed Cost = Contribution – EBIT = 42,000 – 10,500 = Rs. 31,500

 Income Statements of Company A and Company B

Company A(Rs) Company B (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

27. The capital structure of the Shiva Ltd. consists of equity share capital of Rs 10,00,000
(shares of Rs 100 per value) and Rs 10,00,000 of 10% Debentures, sales increased by 20%
from 1,00,000 units to 1,20,000 units, the selling price is Rs 10 per unit: variable costs
amount to Rs 6 per unit and fixed expenses amount to Rs 2,00,000. The income-tax rate is
assumed to be 50%.

You are required to calculate the following:

(i) The percentage increase in earnings per share;
(ii) Financial leverage at 1,00,000 units and 1,20,000 units.
(iii) Operating leverage at 1,00,000 units and 1,20,000 units.
(iv) Comment on the behaviour of Operating and Financial leverages in relation to
increase in production from 1,00,000 units to 1,20,000 units.
 Answer

1,00,000 1,20,000
Particulars units units
Sales at Rs 10 per unit 10,00,000 12,00,000
Less: Variable costs at Rs 6 per unit 6,00,000 7,20,000
Contribution (C) at Rs 4 per unit 4,00,000 4,80,000
Less: Fixed expenses 2,00,000 2,00,000
Operating Profit or EBIT 2,00,000 2,80,000
Less Interest on Debentures (10% on Rs 10
Lakhs) 1,00,000 1,00,000
Profit before tax (PBT) 1,00,000 1,80,000
Less Tax at 50% 50,000 90,000
Profit after tax (PAT) or net profit 50,000 90,000
(i) Earnings per Share (EPS) [10,000 equity
shares] 5 9

% increase in EPS 9-5/5 *100 = 80%

(ii) Financial leverage EBIT/PBT 2 1.56
(iii) Operating leverage Contribution/EBIT 2 1.714

(iv) In relation to increase in Production & Sales of 1,00,000 units to 1,20,000 units (20%
increase), EPS has gone from Rs 5 to Rs 9 i.e. increased by 80%. But both the Financial
Leverage and Operating Leverage have decreased with increase in sales. Due to this
reduction, both the risks i.e. business risk & financial risks of the business are reduced.

28. Calculate the degree of operating leverage, degree of financial leverage and the
degree of combined leverage for the following firms :
N S D
Production (in units) 17,500 6,700 31,800
Fixed costs Rs 4,00,000 3,50,000 2,50,000
Interest on loan Rs 1,25,000 75,000 Nil
Selling price per unit Rs 85 130 37
Variable cost per unit Rs 38.00 42.50 12.00
Answer
Computation of Degree of Operating Leverage (DOL), Degree of Financial Leverage
(DFL) and Degree of Combined Leverage (DCL)

Firm N Firm S Firm D

Output (Units) 17,500 6,700 31,800
Selling Price/Unit 85 130 37
Sales Revenue (A) 14,87,500 8,71,000 11,76,600
Variable Cost/Unit 38.00 42.50 12.00
Less: Variable Cost (B) 6,65,000 2,84,750 3,81,600
Contribution (A-B) 8,22,500 5,86,250 7,95,000
Less: Fixed Cost 4,00,000 3,50,000 2,50,000
EBIT 4,22,500 2,36,250 5,45,000
Less: Interest on Loan 1,25,000 75,000 -
PBT 2,97,500 1,61,250 5,45,000
Operating Leverage Contribution/EBIT 1.95 2.48 1.46
Financial Leverage EBIT/EBT 1.42 1.47 1.00
Combined Leverage OL*FL 2.77 3.65 1.46

SOURCE OF FINANCE

29. State the main elements of leveraged lease.

Answer
Main Elements of Leveraged Lease
Under this lease, a third party is involved beside lessor and lessee. The lessor borrows
a part of the purchase cost (say 80%) of the asset from the third party i.e., lender. The
asset so purchased is held as security against the loan. The lender is paid off from the
lease rentals directly by the lessee and the surplus after meeting the claims of the
lender goes to the lessor. The lessor is entitled to claim depreciation allowance.

30. What is Virtual Banking? State its advantages.

Answer

Virtual banking refers to the provision of banking and related services through the use
of information technology without direct recourse to the bank by the customer.

The advantages of virtual banking services are as follows:

Lower cost of handling a transaction.
The increased speed of response to customer requirements.
The lower cost of operating branch network along with reduced staff costs leads to
cost efficiency.
 Virtual banking allows the possibility of improved and a range of services being made
available to the customer rapidly, accurately and at his convenience.

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

31. Explain the concept of Indian depository receipts.

Answer
 The concept of the depository receipt mechanism which is used to raise funds
in foreign currency has been applied in the Indian capital market through the
issue of Indian Depository Receipts (IDRs).
 Foreign companies can issue IDRs to raise funds from Indian market on the
same lines as an Indian company uses ADRs /GDRs to raise foreign capital.
 The IDRs are listed and traded in India in the same way as other Indian
securities are traded.

32. Discuss the advantages of preference share capital as an instrument of raising funds.

Answer
 No dilution in EPS on enlarged capital base.
 There is no risk of takeover as the preference shareholders do not have voting
rights.
 There is leveraging advantage as it bears a fixed charge.
 The preference dividends are fixed and pre-decided. Preference shareholders
do not participate in surplus profit as the ordinary shareholders
 Preference capital can be redeemed after a specified period.

33. Write short notes on following

a. Floating rate bonds
b. Packing credit

Answer
a. Floating rate bonds

 These are the bonds where the interest rate is not fixed and is allowed to float
depending upon the market conditions.
 These are ideal instruments which can be resorted to by the issuers to hedge
themselves against the volatility in the interest rates.
 They have become more popular as a money market instrument and have been
successfully issued by financial institutions like IDBI, ICICI etc.

b. Packing credit

 Packing credit is an advance made available by banks to an exporter.

  Any exporter, having at hand a firm export order placed with him by his
foreign buyer on an irrevocable letter of credit opened in his favour, can
approach a bank for availing of packing credit.
 An advance so taken by an exporter is required to be liquidated within 180
days from the date of its commencement by negotiation of export bills or
receipt of export proceeds in an approved manner.
 Thus Packing Credit is essentially a short-term advance

34. What is venture capital financing? State the factors which are to be considered in
financing any risky project.

Answer

Venture Capital Financing and Factors to be considered in financing any Risky

Project 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 in financing any risky project are:
(i) Quality of the management team is a very important factor to be considered. They
are required to show a high level of commitment to the project.
(ii) The technical ability of the team is also vital. They should be able to develop and
produce a new product / service.
(iii) Technical feasibility of the new product / service should be considered.
(iv) 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.
(v) A research must be carried out to ensure that there is a market for the new product.
(vi) The venture capitalist himself should have the capacity to bear risk or loss, if the
project fails.
(vii) The venture capitalist should try to establish a number of exit routes.
(viii) 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)

CAPITAL BUDGETING

35. XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The
project is to be set up in Special Economic Zone (SEZ), qualifies for one time (at starting)
tax free subsidy from the State Government of Rs. 25,00,000 on capital investment. Initial
equipment cost will be Rs. 1.75 crores. Additional equipment costing Rs. 12,50,000 will
 be purchased at the end of the third year from the cash inflow of this year. At the end of 8
years, the original equipment will have no resale value, but additional equipment can be
sold for Rs. 1,25,000. A working capital of Rs. 20,00,000 will be needed and it will be
released at the end of eighth year. The project will be financed with sufficient amount of
equity capital.

The sales volumes over eight years have been estimated as follows:
Year 1 2 3 4-5 6-8
Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000

A sales price of Rs. 120 per unit is expected and variable expenses will amount to 60%
of sales revenue. Fixed cash operating costs will amount Rs. 18,00,000 per year. The
loss of any year will be set off from the profits of subsequent two years. The company
is subject to 30 per cent tax rate and considers 12 per cent to be an appropriate after tax
cost of capital for this project. The company follows straight line method of
depreciation.

Required:
Calculate the net present value of the project and advise the management to take
appropriate decision.

Note: The PV factors at 12% are

Year 1 2 3 4 5 6 7 8
.893 .797 .712 .636 .567 .507 .452 .404

Answer
(Rs. ’000)

Cash
Year Sales VC FC Dep. Profit Tax PAT Dep. inflow
1 86.4 51.84 18 21.875 -5.315 0 0 21.875 16.56
2 129.6 77.76 18 21.875 6.65* 1.995 4.655 21.875 26.53
3 312 187.2 18 21.875 84.925 25.4775 59.4475 21.875 81.3225
4 to 5 324 194.4 18 24.125 87.475 26.2425 61.2325 24.125 85.3575
6 to 8 216 129.6 18 24.125 44.275 13.2825 30.9925 24.125 55.1175

*11.965 –(5.315) =6.65 After adjustment of loss

Cost of New Equipment 1,75,00,000

Less: Subsidy 25,00,000
Add: Working Capital 20,00,000
Outflow 1,70,00,000

Year Cash inflows DF DCF

1 16,56,000 0.893 14,78,808
2 26,53,000 0.797 21,14,441
 3 81,32,250 - 12,50,000 = 68,82,250 0.712 49,00,162
4 85,35,750 0.636 54,28,737
5 85,35,750 0.567 48,39,770
6 55,11,750 0.507 27,94,457
7 55,11,750 0.452 24,91,311
8 55,11,750 + 20,00,000 + 1,25,000 = 76,36,750 0.404 30,85,247
PV of inflows 2,71,32,933

PV of inflows 2,71,32,933
Less: Out flow 1,70,00,000
NPV 1,01,32,933

Advise: Since the project has a positive NPV, therefore, it should be accepted.

36. A Ltd. an existing profit-making company, is planning to introduce a new product

with a projected life of 8 years. Initial equipment cost will be Rs 150 lakhs and additional
equipment costing Rs 10 lakhs will be needed at the beginning of third year. At the end of
the 8 years, the original equipment will have resale value equivalent to the cost of
removal, but the additional equipment would be sold for Rs 1 lakh. For tax purpose
assume depreciation of Rs.150000 on additional equipment. Working capital of Rs 25
lakhs will be needed. The 100% capacity of the plant is of 4,00,000 units per annum, but
the production and sales-volume expected are as under:

Year Capacity in percentage

1 20
2 30
3-5 75
6-8 50

A sale price of Rs100 per unit with a profit volume ratio of 60% is likely to be obtained.
Fixed Operating Cash Costs are likely to be Rs16 lakhs per annum. In addition to this
the advertisement expenditure will have to be incurred as under:

Year 1 2 3-5 6-8

Expenditure each year (Rs in lakhs) 30 15 10 4

The company is subjected to 50% tax, straight-line method of depreciation, (permissible

for tax purposes also) and taking 12% as appropriate after tax cost of Capital, should the
project be accepted?

Answer

Computation of initial cash outlay (Rs in lakhs)

Equipment Cost 150

Working Capital 25

175
Calculation of Cash Inflows:

Years 1 2 3 to 5 6 to 8
Sales in units 80,000 1,20,000 3,00,000 2,00,000
Contribution @ Rs 60
p.u. 48,00,000 72,00,000 1,80,00,000 1,20,00,000
Fixed cost 16,00,000 16,00,000 16,00,000 16,00,000
Advertisement 30,00,000 15,00,000 10,00,000 4,00,000
Depreciation 15,00,000 15,00,000 16,50,000 16,50,000
Profit /(loss) 13,00,000) 26,00,000 1,37,50,000 83,50,000
Tax @ 50% NIL 13,00,000 68,75,000 41,75,000
Profit/(Loss) after tax 13,00,000) 13,00,000 68,75,000 41,75,000
Add: Depreciation 15,00,000 15,00,000 16,50,000 16,50,000
Cash inflow 2,00,000 28,00,000 85,25,000 58,25,000

Computation of PV of Cash Inflow

Cash Inflow PV Factor @

Year (Rs) 12% (Rs)
1 2,00,000 0.893 1,78,600
2 28,00,000 0.797 22,31,600
3 85,25,000 0.712 60,69,800
4 85,25,000 0.636 54,21,900
5 85,25,000 0.567 48,33,675
6 58,25,000 0.507 29,53,275
7 58,25,000 0.452 26,32,900
8 58,25,000 0.404 23,53,300
Working Capital 15,00,000 0.404 6,06,000
Scrap Value 1,00,000 0.404 40,400
(A) 2,73,21,450
Cash Outflow:
Initial Cash Outlay 1,75,00,000 1 1,75,00,000
Additional Investment 10,00,000 0.797 7,97,000
(B) 1,82,97,000
Net Present Value (NPV) (A)-(B) 90,24,450

Recommendation: Accept the project in view of positive NPV.

37. Beta Limited receives Rs 15,00,000 a year after taxes from an investment in an
automatic plant that has 12 more years of service life. The company’s required rate is
12%. Beta Limited can make improvements to the plant to raise its service life to 20 years
and its annual after tax cash flow to Rs 48,00,000 per year. These investments would cost
Rs 2,10,00,000. With the improvements, the plant’s value at the end of 12 years would rise
 from Rs7,50,000 to Rs75,00,000. Would the improvements produce a return satisfactory
to Beta Limited?

Answer
Calculation of the Present value of the inflows before improvements to the automatic
plant

Particulars Amount(Rs)
Income after taxes for 12 years(15,00,000 × 6.194) 92,91,000
Plant value at the end of 12 years (7,50,000 × 0.257) 1,92,750
Total present value of the inflows before improvements to the plant:
(A) 94,83,750

Calculation of the Present value of the inflows after improvement to the automatic
plant

Particulars Amount(Rs)
Income after taxes for 12 years(48,00,000 × 6.194) 2,97,31,200
Plant value at the end of 12 years (75,00,000 × 0.257) 19,27,500
Total present value of the inflows before improvements to the plant:
(A) 3,16,58,700

Differential Present value of the inflow after improvements to the automatic plant
= 3,16,58,700 (B) – 94,83,750 (A) = 2,21,74,950
Net Present value from the investments in the automatic plant
= P.V. of Cash Inflow – Cash Outflow= 2,21,74,950 – 2,10,00,000
= 11,74,950
Advice: Since the NPV is positive, the improvements produce a satisfactory return to
the firm.

38. 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 Rs 8,00,000, having useful life of three years. It costs Rs
1,30,000 per year to run. Machine 'B' is an economy model costing Rs 6,00,000, having
useful life of two years. It costs Rs 2,50,000 per year to run. The cash flows of machine 'A'
and 'B' are real cash flows. The costs are forecasted in rupees of constant purchasing
power. Ignore taxes. The opportunity cost of capital is 10%.

The present value factors at 10% are :

Year t1 t2 t3
PVIF(0.10,t) 0.9091 0.8264 0.7513
PVIFA(0.10,2) = 1.7355
PVIFA(0.10,3) = 2.4868
Which machine would you recommend the company to buy?

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):
(v) = [(ii) x (iii)] 3,23,284 4,33,875
Cash Outflow of Machines (Rs) : (vi) = (i) + (v) 11,23,284 10,33,875
Equivalent Present Value of Annual Cash Outflow
[(vi) ÷ (iii)] 4,51,698.57 5,95,721.69

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