ACADEMY OF COMMERCE

FINANCIAL MANAGEMENT
SUGGESTION FOR 2024-25

✓ Introduction to financial management

✓ Time value of money
Group A 5M X 4Q = 20 marks
✓ Capital structure
✓ Cost of capital
✓ Leverage
✓ Working capital management (sums) or theory
Group B 10M X 6Q = 60 marks ✓ Capital budgeting or theory
✓ Capital budgeting
✓ Dividend policy or theory

❖ INTRODUCTION:
 Theory:
1) Explain the inter-relation between financing decision, investing decision and dividend
decision.
2) Explain the various functions of financial management.
3) Distinguish between Profit Maximisation and Wealth Maximisation objectives of the firm.
4) Why is ‘Wealth Maximisation’ preferred over ‘Profit Maximisation’ as the goal of firm?
5) How do financial managers take financing and investment decisions?
6) Discuss the relationship between Risk and Return.
7) Discuss the main objective of Financial Management.
8) Discuss the basic components of the financial environment under which a firm has to
operate.

❖ TIME VALUE OF MONEY:

 Theory:
1) Explain the concept of time value of money with examples.
2) What is time value of money? What is its importance in long term financial decision making?
3) State the compounding and discounting techniques of time value of money.

 Numerical Problems:
1. Mrs. L intends to take a loan of Rs. 10,00,000 from a bank repayable an equal annual
instalment over a period of five years. The bank charges interest @ 10% p.a. on such loan.
How much is he required to pay in each instalment?

Answer: Rs. 2,63,797.

2. Mr. Sen estimates that he needs to withdraw Rs. 2,40,000 every year from his bank for the
next three years. He wants to know the amount of deposit he should have in his bank today
to meet the above requirement if the rate of interest is 4% p.a. [Given PVAF (4%,3) =2.775]

Answer: Rs. 6,66,000

3. Mr. X needs Rs. 1,00,000 at the end of 10 years. He has two options:

1
 ACADEMY OF COMMERCE

Option 1: Deposit some lumpsum amount today at 6% rate of interest.

Option 2: Make equal payments into bank account starting a year from now, on which he
earns 6% rate of interest.
You are required to:
(a) Find out the amount to be deposited under option 1 today.
(b) Ascertain what amount must be deposited annually into the bank account under option 2.
CVIF (6%,10) = 1.791 PVIFA (6%,10) = 7.360
CVIFA (6%, 10) = 13.181 , PVIF(6%,10) = 0.558

Answer: Amount to be deposited today: Option 1 = Rs. 55,835; Option 2 = Rs. 7,587.

4. Mr. H is offered either to receive Rs. 10,000 three years from now or Rs. 14,000 five years
from now. Which one Mr. H will accept? Assume rate of discount is 10%.
[Given: Present value of Rs. 1 at 10% are 0.751 and 0.621 for 3rd and 5th year respectively]

Answer: 1st option Rs. 7,510; 2nd option is Rs. 8,694.

5. A fixed deposit receipt has a maturity value of Rs.1,33,100. What is the amount at which the
fixed deposit has been initially purchased if compound interest rate is 10% p.a. and the
maturity period is 3 years.

Answer: Rs. 1,00,000

6. X borrows Rs. 59,36,000 from Y at a compound interest rate of 12% p.a. It is agreed that the
Loan shall be payable in two equal instalments, which shall be payable at the end of the 1st
year and 2nd year respectively. Calculate the amount of each instalments.

Answer: Rs. 35,12,426.

7. You are approached by an insurance agent to buy an annuity of Rs. 50,000 for 6 years starting
from the beginning of first year. How much you should be ready to pay now for this annuity if
you consider a discount factor of 8% per annum?

Answer: Rs. 31,500

8. Mr. X invested Rs. 50,000 at an interest of 12% p.a. for 3 years. You are required to compute
future value of investment assuming interest is compounded quarterly.

Answer: Rs. 71,288.

9. Mr. Chiko is offered the following cash inflows:

End of year: 1 2 3 4 5
Amount (Rs.) 15,000 20,000 32,000 20,000 18,000
Calculate the amount receivable by Mr. Chiko , if he wants the whole amount at the end of
4th year. [Applicable interest rate is 10% p.a. compound annually]

Answer: Rs. 1,15,727

2
 ACADEMY OF COMMERCE

10. You want to make a gift of Rs. 1,00,000 to one of your friends after 4 years from now. What
amount of money you need to invest every year starting from the beginning of the first year
so that you can get the required amount after 4 years? The normal return is 10%.

Answer: Rs. 19,589

11. Shubha invested Rs. 10,000 at an interest of 12% p.a. for 3 years. Compute Future value of
investments assuming interest is compounded quarterly. Given FVIF(3,12) = 1.4262.

Answer: Rs. 14,262.

❖ SOURCES OF CAPITAL:
 Theory:
1) Write short note on –
(a) Commercial paper
(b) Popularity of Trade Credit as a Source of Short-term Finance
(c) Public deposit
(d) Convertible debenture
2) Discuss the advantages and disadvantages of ploughing back of profit.
3) What do you mean by Finance Lease? Write its features.

❖ WORKING CAPITAL MANAGEMENT:

 Theory:
1) Write short note on –
(a) Working Capital Leverage
(b) Hard Core Current Assets
2) State the operating cycle concept of working capital.
3) What do you mean by negative working capital? What are its implication?
4) Distinguish between fixed and variable working capital of a firm.
5) Briefly discuss the relevance of liquidity and profitability in working capital management.
6) Explain how the operating cycle period can be reduced.
7) State the factors on which the duration of the cycle period depends. Explain the importance
of the cycle in Working Capital Management.
8) What is working capital forecasting? Why is such forecasting made? What factors should be
considered to forecast working capital?
9) Discuss the different strategies of financial working capital of a firm.
10) Distinguish between Permanent Working Capital and Temporary Working Capital.

 Numerical Problems:
1. From the following information prepare a statement showing the estimated Working Capital
requirements.
(i) Project annual sales - 36,000 units
(ii) Analysis of Sales: Rs. Per unit
Raw materials 6
Labour 4
Overhead 3
Profit 2

3
 ACADEMY OF COMMERCE

Selling Price 15
(iii) Additional information:
(a) Raw materials in stock - 1 month
(b) Production process - 2 months
(c) Finished goods in store - 3 months
(d) Credit allowed to debtors - 4 months
(e) Credit allowed to suppliers - 2 months
(f) Monthly wages and expenses are paid twice on 1st and 16th of each month.
(g) Production is carried on evenly during the year and expenses and wages accrue
similarly.
(h) Cash is to be kept at 10% of the net working capital.

Answer: Working Capital requirements = Rs. 3,61,667.

2. P & G Ltd. furnished below its cost and other data:

Unit Cost Rs.
Raw material 30
Direct labour 20
Overhead ?
Profit (25% on selling price) ?
Unit selling price 100
Additional information is as follows:
Average raw materials:
in Stock – 1 month
in Process – ½ month
1
Credit allowed by Suppliers – 12 months
Credit allowed to Customers – 3 months
Cash balance is assumed to be Rs. 1,00,000 and 70% of Sales are Credit Sales.
Assuming that production is carried on evenly throughout the year; you are required to
determine the Working Capital Requirement of the P&G Ltd. to achieve an output level of
1,20,000 units p.a.

Answer:
Net Working Capital = Rs. 19,62,500.
Raw material = Rs. 3,00,000; Work-in-progress = Rs. 2,62,500; Debtors = Rs. 21,00,000;
Creditors = Rs. 8,00,000.
3 1
Net Block Period (months): Raw material = 3; Direct labour = 2 4; Overhead = 24; Profit = 3.

3. A trading company’s forecast sales and other particulars are given below:
Forecast annual sales Rs. 1,30,000
Net profit on cost of sales 25%
Average credit allowed to Debtors 8 weeks
Average credit allowed to Creditors 6 weeks
Average stock carrying (to meet sales) 4 weeks
Determine forecast working capital of the company. Estimated cash on hand and at Bank Rs.
5,000.

4
 ACADEMY OF COMMERCE

Answer:
Required Working Capital: Taking Debtors at sales value = Rs. 21,000;
Taking Debtors at cost = Rs. 17,000.

4. With the following information prepare a statement showing the Working Capital required
to finance a level of activity of 10,400 units p.a.:
(i) Selling price is Rs. 5 per unit.
(ii) The expected ratios of cost to selling price are: (a) Raw materials 40%; (b) Direct
wages 10%; (c) Overhead 30%; (d) Profit 20%.
(iii) Raw materials are expected to remain in store for an average period of two months
before being issued for production and materials are in process on an average period
of six weeks.
(iv) Finished goods will stay in store approximately for six weeks before dispatch to
customers.
(v) Credit allowed to Debtors is for a period of two months.
(vi) Credit allowed by Creditors is for a period of two months.
(vii) Lag in payment of wages and overheads is for a period of two weeks.
(viii) Cash in hand and bank is expected to be Rs. 10,000.
It may be noted that production is carried on evenly during the year and wages and overheads
accrue similarly. Assume four weeks a month.

Answer:
Working capital requirement = Rs. 25,600.
Raw materials = Rs. 3,200; Direct wages = Rs. 3,600; Finished goods = 4,800; Debtors = Rs.
8,000 Creditors = Rs. 4,000.
Net block period (weeks): Raw materials = 20; Direct wages = 15; Overhead = 15; Profit = 8.

5. B Ltd. supplies you the following information: Rs.

i. Sales (at 2 months credit) 36,00,000
ii. Materials consumed (Suppliers extend 2 months credit) 9,00,000
iii. Wages paid (lag in payment – 1 month) 7,20,000
iv. Manufacturing expenses outstanding at the end of the year 80,000
(lag in payment – 1 month)
v. Total administrative expenses paid (lag in payment – 1 month) 2,40,000
vi. Sales promotion expenses paid quarterly in advance 1,20,000
The company sells its products at a gross profit of 25% counting depreciation as part of the
cost of production. It keeps one month’s stock of each of raw materials and finished goods
and a cash balance of Rs. 1,00,000.
Assuming a 20% safety margin, work out the working capital requirement of the company of
cash-cost basis. Ignore work-in-progress.

Answer:
Working capital requirement = Rs. 7,20,000.
Cash manufacturing cost = Rs. 25,80,000; Cash cost of sales = Rs. 29,40,000.

6. For a new business Mr. Bose supplied the following information:

a) The projected annual sales – Rs. 1,20,00,000.

5
 ACADEMY OF COMMERCE

b) He has estimated fixed expenses Rs. 20,000 per month and variable expenses equal to
two percent of turnover.
c) Percentage of gross profit on cost of purchase will be 25%.
d) Average expected credit period allowed to debtors – 1 month.
e) Average expected credit period from suppliers – 15 days.
f) He expects to turnover his stock 5 times in a year.
g) Average cash holding – 1 month’s expenses.
You are required to forecast his working capital requirement.

Answer:
Working capital requirement = Rs. 24,80,000.
Current assets = Rs. 29,60,000; Current liabilities = Rs. 4,80,000.

7. A manufacturing company has a capacity to produce 60,000 units p.a. The cost structure at
that capacity and selling price p.u. are given below:
Materials Rs. 5
Labour Rs. 2
Overhead Rs. 5 (60% variable; of the fixed overhead Rs. 30,000 represents depreciation)
Rs. 12
Profit Rs. 3
Selling Price Rs. 15
The other details are –
▪ Raw material storage period – 2 months; Processing time – 1 month and Finished
Goods in store – 1 month.
▪ Debtors and Creditors turnover are 6 and 12 times a year respectively.
▪ Lag in payment of overhead is ½ month.
Assuming that the company will be able to utilize 80% of its capacity – estimate the working
capital requirement on cash-cost basis.

Answer:
Working capital requirement = Rs. 1,86,500; Cash cost of sales = Rs. 5,70,000.

8. From the following information presented by a manufacturing company, estimate the

working capital requirement for the coming year:
The monthly sales volume is expected to be 40,000 units at Rs. 20 per unit. The anticipated
ratios of different elements of cost to selling price are:
Raw materials – 50%, Labour – 25%
It is estimated that budgeted overhead per week will be Rs. 20,000 including depreciation of
Rs. 5,000. Planned stock will include raw-materials for Rs. 1,50,000 and finished stock 20,000
units. Credit period allowed to debtors is 3 weeks. Credit period expected to be received from
suppliers is 2 weeks. Overhead payment will be made 1 week after incurring expenses. Wages
will be paid at the beginning of the week following the week of the work. The average
processing period of each unit will be 7 days.
Cash in hand to be maintained for contingencies is Rs. 20,000. Arrangement of bank overdraft
to the extent of Rs. 1,00,000 has been made. Assume that production is carried on evenly
throughout the year and wages and overhead accrues similarly.

6
 ACADEMY OF COMMERCE

Answer:
Net Working Capital Requirement = Rs. 8,52,500.
1 1 1
Net block period (weeks): Raw materials = 5 2; Labour 42; Overhead = 42; Profit = 3.
Raw material = Rs. 1,50,000; Work-in-progress = Rs. 1,32,500; Finished goods = Rs. 3,30,000;
Debtors = Rs. 5,85,000; Creditors = Rs. 2,65,000.

9. The following information is provided by X Ltd. for the year ended 31.3.2017:
Raw Material storage period 45 days
WIP conversion period 18 days
Finishing goods storage period 22 days
Debt collection period 30 days
Creditors payment period 55 days
Annual cash cost of operation Rs. 18 lakhs
(1 year = 360 days)
You are required to calculate:
(i) Operating cycle period
(ii) Number of operating cycle in a year.

Answer: (i) 60 days; (ii) 6.

10. From the following information presented by a manufacturing company, prepare a statement
showing working capital requirement for the coming year.
Raw materials – 40%
Labour – 30%
Budgeted overhead Rs. 32,000 per week
Overhead expenses include depreciation of Rs. 8,000 per week. Planned stock will include raw
materials for Rs. 1,92,000 and 32,000 units of finished goods.
Materials will stay in process 2 weeks
Credit allowed to debtors is 4 weeks
Credit allowed by creditors is 5 weeks.
20% of sales may be assumed to be made against cash. Cash and Bank is to be maintained at
10% of the working capital.
Assume that production is carried on evenly throughout the year and wages and overhead
accrue similarly.

Answer: Rs. 15,80,444.

❖ LEVERAGE:
 Theory:
1) Distinguish between Operating Leverage, Financial Leverage and Combined Leverage.
2) What do you understand by Operating Leverage? How would you measure it?
3) Write short note on: EBIT – EPS Analysis.
4) What is Indifference Point? Explain it in relation to EBIT – EPS Analysis.
5) Write short note on: Relation between margin of safety and degree of operating leverage.

 Numerical:

7
 ACADEMY OF COMMERCE

1. Anurup Ltd. has Equity share capital of Rs. 5,00,000 divided into shares of Rs. 100 each. It
wishes to raise Rs. 3,00,000 for expansion-cum-modernization scheme. The company plans
the following financing alternatives:
I. By issuing Equity shares of Rs. 100 each.
II. Rs. 1,00,000 by issuing Equity shares of Rs. 100 each and Rs. 2,00,000 through issue of
10% Debentures.
III. By raising loan at 10% p.a.
IV. Rs. 1,00,000 by Equity shares of Rs. 100 each and Rs. 2,00,000 by issuing 8% Preference
shares of Rs. 100 each.
You are required to suggest the best alternative giving you comment assuming that the
estimated earning before interest and taxes (EBIT) after expansion Rs. 1,50,000 and Corporate
tax rate is 35%.

Answer:
Plans I II III IV
EPS (Rs.) 12.19 14.08 15.60 13.58
Plan III should be accepted by the company.

2. Zica Ltd. provides you the following information:

Capital structure: 12% Debenture Rs. 2,00,000; 9% Preference Share Capital Rs. 3,00,000 and
4,000 Equity Shares of Rs. 100 each.
Revenue and operating cost details: Sales 3,000 units @ 600 p.u.; Variable Operating Cost p.u.
Rs. 350; Fixed Operating cost Rs. 3,20,000.
Corporate Income Tax rate and Dividend Distribution Tax rate may be assumed at 30% and
10% respectively.
Calculate DOL, DFL and DCL of Zic Ltd. Using the concept of leverage, find the percentage
change in EPS when sales increase by 10%.

Answer:
DOL = 1.74; DFL = 1.18; DCL = 2.063; EPS will be increased by 20.63%.

3. The following details of P Ltd. for the year ended 31.3.2016 are furnished:
Operating leverage – 3:1
Financial leverage – 2:1
Interest charges p.a. Rs. 20 lakhs
Corporate tax rate 50%
Variable cost as percentage on sales 60%
Prepare the Income Statement of the company.

Answer: EAT = Rs. 10

4. The selected financial data for two companies X and Y for the year ended March, 2019 are as
follows:
Particulars X Y
Variable expenses as a percentage of sales 75 50
Interest (Rs. in lakhs) 300 1,000
DOL 6 2

8
 ACADEMY OF COMMERCE

DFL 4 2
Income tax rate 0.35 0.35
a) Prepare Income Statements for X and Y.
b) Comment on the financial position of the companies.

Answer:
a) EAT of: X = Rs. 65 lakhs; Y = Rs. 650 lakhs.
b) X bears more financial risk (DFL) as compared to Y; Total risk (DCL) of X is more as
compared to Y; the ability to meet interest cost is better of Y as compared to X.

5. A multi-product company has the following costs and output data for the year 2008-09:
Product
Total
X Y Z
Sales mix 40% 35% 25%
Unit selling price (Rs.) 20 25 30
Variable cost per unit (Rs.) 10 15 18
Fixed cost (Rs.) 1,50,000
Sales (Rs.) 5,00,000
Find out break-even point of sales.

Answer: P/V ratio = 0.44; Break-even point of sales = Rs. 3,40,909.

6. The capital structure of Moon Ltd. is given below: Rs. (in Lakh)
Equity Share Capital (Rs. 10 per share) 10.00
Retained earnings 6.00
10 % Preference Share Capital 4.00
20.00
The firm has planned to undertake an expansion scheme of Rs. 10,00,000 which can be
financed (i) entirely by issue of equity shares of Rs. 10 each, or (ii) by issue of 12% Debentures
of Rs. 100 each at par.
As a result of expansion, sales and operating fixed cost will increase by 60% and 75%
respectively. The other relevant information is given below:
Sales Rs. 50,00,000
Variable Cost 60%
Operating Fixed Cost Rs. 5,00,000
Corporate Tax 40%
Calculate Leverage and EPS before and after expansion and give your opinion for taking
appropriate decision with respect to financing.

Answer:
After Expansion
Before
Equity Financing Debt Financing
Expansion
(Rs.) (Rs.)
DOL 1.33 1.38 1.38
DFL 1.05 1.03 1.09
DCL 1.397 1.421 1.504
EPS 8.60 6.775 12.83

9
 ACADEMY OF COMMERCE

7. The following information have been taken from the Income Statement of X Ltd.:
Fixed operating expenses Rs. 1,200
Fixed financial charges Rs. 600
Earning before tax Rs. 400
Calculate percentage of change in EPS, if sales increase by 10%.

Answer: EPS will be increase by 55%.

8. Relevant information about three companies are given below:

BIL PIL MIL
Annual production capacity (units) 1,00,000 1,50,000 2,50,000
Capacity utilization and sales 75% 75% 75%
Unit Selling Price (Rs.) 40 50 50
Unit Variable Cost (Rs.) 15 15 20
Fixed Cost p.a. (Rs.) 2,00,000 3,00,000 5,00,000
Equity Capital (Rs.) 5,00,000 7,00,000 10,00,000
[1,000 shares for each company]
10% Preference Share Capital (Rs.) - 50,000 1,00,000
15% Debenture (Rs.) 1,00,000 2,00,000 3,00,000
Calculate Operating Leverage, Financial Leverage, Combined Leverage and EPS of these three
companies and comment.

Answer:
BIL PIL MIL
Operating Leverage 1.12 1.08 1.10
Financial Leverage 1.009 1.01 1.01
Combined Leverage 1.13 1.09 1.11
EPS (Rs.) 830 1,798.75 2,530

9. From the following information of X Ltd. prepare the Income Statement for the year ended
31st December, 2022:
Financial Leverage :2
Interest : Rs. 2,000
Operating Leverage :3
Variable cost as a percentage of sales : 75%
Income tax rate : 30%

Answer: EBIT = Rs. 4,000; EAT = Rs. 1,400.

10. The following data have been extracted from the books of L M Ltd.:
Sales: Rs. 100 lakhs
Interest payable p.a.: Rs. 10 lakhs
Operating leverage: 1.2
Combined leverage: 2.16.
You are required to calculate:
(i) Financial leverage; (ii) Fixed cost; (iii) P/V ratio.

Answer: (i) 1.8; (ii) Rs. 4,50,000; (iii) 27%.

10
 ACADEMY OF COMMERCE

11. X Ltd. is considering two alternative financial plans. Following information relates to these
plans:
Plan-A Plan-B
Equity Share (Rs. 10 each) (Rs.) 2,00,000 1,00,000
12% Debenture (Rs.) - 1,00,000
Profit after tax (Rs.) 28,000 19,600
Price-Earning ratio 11 7.5
Which of the plans is preferable considering the wealth maximisation objective?

Answer:
Market price per share: for Plan-A = Rs. 15.40 and for Plan-B = Rs. 14.70
Plan-A is preferable.

❖ DIVIDEND POLICY:
 Theory:
1) Discuss the pros and cons of Scrip Dividend.
2) Write short note on – Gordon’s Dividend Policy Model.
3) Discuss about the different types of dividend.
4) Critically discuss Walter’s Dividend Model. To what extent are the short comings of this
model taken care of by Prof. Gordon in his dividend model?

 Numerical Problems:
1. The following information is acquired from XYZ Ltd. Net earnings – Rs. 1,00,000; Equity Capital
– 5,000 shares of Rs. 10 each, Cost of Capital – 10%, expected rate of return – (i) 9%, (ii) 10%
and (iii) 12%.
Assuming the dividend pay out ratios are 0%; 50% and 100% respectively. Determine the
effect of different dividend policies on the share price of XYZ Ltd. for the above mentioned
three alternatives levels of return using Gordon’s Model.

Answer:
Share Price:
Dividend pay out ratio
0% 50% 100%
r=9% 0 Rs. 182 Rs. 200
r=10% 0 Rs. 200 Rs. 200
r=12% 0 Rs. 250 Rs. 200

2. Z Co. Ltd. has an investment of Rs. 10,00,000 in Equity Shares of Rs. 100 each. The profitability
rate of the company is 16%. Payout ratio is 80%. Cost of Capital is 10%. What will be the price
per share as per Walter’s model? Do you consider the given pay out ratio as optimum?

Answer: Price per share is Rs. 256 at optimum payout ratio.

3. From the following information, calculate the market value of equity share of a company as
per Walter’s model:

11
 ACADEMY OF COMMERCE

Earnings after tax – Rs. 15,00,000; number of equity shares outstanding – 3,00,000; Dividend
paid – Rs. 6,00,000; Price earning ratio - 10; Rate of return on investment – 20%.
What is optimum dividend pay-out ratio in this case?

Answer:
Market value of Equity Shares = Rs. 80; Optimum dividend payout ratio is ‘0’.

4. From the following data, calculate the value of an Equity Share of each of the following three
companies according to Walter’s model when dividend pay out ratio is – (a) Nil; (b) 25% and
(c) 75%.
Companies M Ltd. L Ltd. N Ltd.
Internal rate of return (r) 15% 12% 10%
Cost of Capital (K) 12% 12% 12%
Earnings per share (E) Rs. 10 Rs. 10 Rs. 10
What conclusion would you draw from your observation?

Answer:
Value of an Equity Share:
M Ltd. L Ltd. N Ltd.
D/P ratio = Nil Rs. 104.17 Rs. 83.33 Rs. 69.44
D/P ratio = 25% Rs. 98.96 Rs. 83.33 Rs. 72.92
D/P ratio = 75% Rs. 88.54 Rs. 83.33 Rs. 79.86

5. A company has 1,00,000 equity shares of Rs. 10 each. The company expects its earnings at Rs.
6,00,000 during the next financial year and its cost of capital is 10%. Using Walter’s Model,
what dividend policy would you recommend when the rate of return on investment is
estimated at – (i) 8% and (ii) 12%?
What will be the price of each equity share if your recommendation is accepted?

Answer:
(i) When r=8%, D/P ratio = 100% and Price per share = Rs. 60.
(ii) When r=12%, D/P ratio = 0% and Price per share = Rs. 72.

6. The earning per share of a company is Rs. 8 and the rate of capitalization applicable is 10%.
The company has before it, an option of adopting (a) 50%, (b) 75% and (c) 100% dividend
payout ratio.
Compute the market price of the companies quoted share as per Gordon’s Model if the
company can earn a return of (a) 15%, (b) 10% and (c) 5%.

Answer:
Dividend pay out ratio
50% 75% 100%
r=15% Rs. 160 Rs. 96 Rs. 80
r=10% Rs. 80 Rs. 80 Rs. 80
r=5% Rs. 53.33 Rs. 68.57 Rs. 80

7. You are requested to find out the approximate dividend payment ratio as to have the share
price at Rs. 56 by using Walter Model, based on following information available for a company.

12
 ACADEMY OF COMMERCE

Net profit Rs. 50 lakhs

Outstanding 10% Preference share Rs. 80 lakhs
Number of equity shares 5 lakhs
Return on investment 15%
Cost of capital (after tax) (ke) 12%

Answer: 180%

8. Following information relating to Jee Ltd. are given:

Profit after tax Rs. 10,00,000
Dividend payout ratio 50%
Number of equity shares 50,000
Cost of equity 10%
Rate of return on investment 12%
(i) What would be the market value per share as per Walter’s Model?
(ii) What is the optimum payout rate according to Walter’s and market value of each
equity share at that payout ratio?

Answer: (i) Rs. 220; (ii) 0%, Rs. 240.

9. The following information relates to LMN Ltd.:

Earnings of the company Rs. 30,00,000
Dividend payout ratio 60%
Number of shares outstanding 5,00,000
Rate of return on investment 15%
Equity capitalized rate 13%
Required:
(i) Determine what would be the market value per share as per Walter’s model.
(ii) Compute optimum dividend payout ratio according to Walter’s model and the market
value of company’s share at that payout ratio.

Answer: (i) Rs. 48.92; (ii) 0%, Rs. 53.26.

10. From the following information calculate market price of a share of company by using: (i)
Gordon’s Model; (ii) Walter’s Model.
Total earnings : Rs. 40,00,000
No. of equity shares (of Rs. 10 each) : 4,00,000
Dividend per share : Rs. 4
Cost of capital : 16%
Internal rate of return : 20%
Retention ratio : 60%

Answer: (i) Rs. 100; (ii) Rs. 71.875.

11. The following figures are collected from the annual report of XYZ Ltd.:
Net profit Rs. 30 lakh
12% Preference share Rs. 100 lakh
Number of equity shares 3 lakh

13
 ACADEMY OF COMMERCE

Return on investment 20%

Cost of capital 16%
What should be the approximate dividend pay-out ratio so as to keep the share price at Rs.
42 using Walter’s Model?

Answer: 52%

❖ COST OF CAPITAL:
 Theory:
1) Explain the concept of cost of capital. What do you mean by marginal cost of capital? Why
should we consider marginal cost of capital rather that weighted average cost of capital
while evaluating a new project?
2) Write short note on – Capital Assets Pricing Model.
3) “retained earnings have no cost’ – is the statement justified?
4) Discuss the factors determining cost of capital.
5) Write short note on – Weighted Average Cost of Capital.

 Numerical Problems:
1. X Ltd. requires additional finance of Rs. 20 lakh for meeting its investment plans. It has Rs. 4
lakh in the form of retained earnings available for investment purposes. The following are
the further details:
(i) Debt-equity mix 40 : 60
(ii) Cost of debt: upto Rs. 4,00,000, 10% (before tax)
Beyond Rs. 4,00,000, 12% (before tax)
(iii) Earning per share Rs. 5
(iv) Dividend payout 60% of earnings
(v) Expected growth rate in dividend 5%
(vi) Current market price per share Rs. 35
(vii) Tax rate 35%
Compute the overall weighted average after tax cost of additional finance.

Answer: WACC = 11.26%

2. XYZ Ltd. has its share of Rs. 100 each quoted on the stock exchange, the current market
price per share is Rs. 240. The dividends per share over the last four years have been Rs.
12.00, Rs. 13.20, Rs. 14.50 and Rs. 16.00. Calculate the cost of equity shares.

Answer: 17.40%

3. ABC Ltd. issues 12% debentures of face value of Rs. 100 each at a discount of 3% and the
floatation cost is estimated to be 2%. The debentures are redeemable after 10 years at a
premium of 10%. Corporate tax rate is 40%. Calculate the cost of debt.

Answer: 7.90%.

14
 ACADEMY OF COMMERCE

4. Swan Ltd. has assets of Rs. 3,20,000, which have been financed with Rs. 1,04,000 of debt Rs.
1,80,000 of equity and a general reserve of Rs. 36,000. The company’s total profit after
interest and taxes for the year ended 31st March, 2013 was Rs. 27,000. It pays 8% interest on
borrowed funds and is in the 30% tax bracket. It has 1800 equity shares of Rs. 100 per share,
presently selling at a market price of Rs. 120 per share. What is the weighted average cost of
capital of Swan Ltd.

Answer: Required weighted average cost of capital = 10.2575%.

5. P. Ltd. issued Rs. 10,00,000, 11% preference shares of Rs. 100 each. The floatation cost was
@ 2% on issue price. The preference share will be redeemed at a premium of 5% after 5 years.
The tax rate applicable to the company is 30%. The corporate Dividend Tax is 10%.
Compute the cost of preference share of P. Ltd.

Answer: Cost of preference share capital = 13.3%.

6. Work out the marginal cost of capital from the following data:
Existing Capital: in lakh cost (%)
Equity 6,000 15
Preference capital 1,000 10
Debt 4,000 12
Retained earnings 1,000 18
Additional Requirement:
Equity 4,000 18
Preference capital 2,000 12
Debt 3,000 16
Retained earnings 1,000 18

Answer: Marginal cost of capital = 16.20%.

7. The capital structure of a company is given below:

Equity share capital (5,000 shares of Rs. 100 each) Rs. 5,00,000
10% Preference share (2,000 shares of Rs. 100 each) Rs. 2,00,000
12% Debentures Rs. 3,00,000
Rs. 10,00,000
Its operating profit is Rs. 2,90,000. The market price of each equity share is Rs. 250 and of each
preference share is Rs. 125.
Find the cost of each source of capital assuming:
i. Corporate tax to be 30% and
ii. Corporate dividend tax to be 10%.

Answer:
Cost of – Equity share capital = 12.46%; Preference share capital = 8.8%; Debentures = 8.4%.

8. T Ltd. has the following capital structure: (Rs. in lakhs)

Equity share capital (10 lakh shares) 100
Retained earnings 130

15
 ACADEMY OF COMMERCE

14% Debentures (70,000 debentures) 70

16% Term loan 100
400
The market price per equity share is Rs. 25. The next expected dividend per share is Rs. 2 and
is expected to grow at 8%. The debentures are redeemable after six years at par and the
current market quotation is Rs. 90 per debenture. The tax rate applicable to the firm is 50%.
You are required to compute weighted average cost of capital of the company using market
value as weights.

Answer: Weighted average cost of capital = 12.88%.

9. A company has following amount of capital with corresponding specific cost of each type:
Type of capital Book Value Market Value
(Rs.) (Rs.)
Equity Capital (25,000 shares of Rs. 10 each) 2,50,000 4,50,000
13% Preference Capital (500 shares of Rs. 100 each) 50,000 45,000
Reserve and Surplus 1,50,000 -
14% Debentures (1,500 Debentures of Rs. 100 each) 1,50,000 1,45,000
The expected dividend per share is Rs. 1.40 and the dividend per share is expected to grow at
a rate of 8% forever. Preference shares are redeemable after 5 years at par, whereas
debentures are redeemable after 6 years at par. The tax rate for the company is 50%.
You are required to compute weighted average cost of capital using market value as weight.

Answer: Weighted average cost of capital = 13.9%.

10. X & Co. has issued 12% redeemable preference shares of face value Rs. 100 for Rs. 10 lakh.
The shares are expected to be sold at 5% discount; it will also involve floatation cost of Rs. 5
per share. The shares are redeemable at a premium of 5% after 10 years. Calculate the Cost
of Capital of redeemable preference share, if the rate of tax is 50%. Ignore dividend tax.

Answer: 13.85% (approx.)

11. The capital structure and specific cost of capital (after Tax) of a company are given below:
Book value Rs./lakh After-tax cost (%)
Equity share capital (hares of Rs. 10 each) 200 18
Retained Earnings 100 18
Long-term Debt 200 6
500
The present market value of equity is Rs. 90 per share. Corporate tax rate is 40%.
1) Calculate weighted average cost of capital using:
a) book value as weights; b) market values as weights.
2) Explain the difference in weighted average costs as above.

Answer: a) 13.20% and b) 16.80%

12. Rima & Co. has issued 12% Debenture of face value Rs. 100 for Rs. 10 lakh. The debenture is
expected to be sold at 5% discount. It will also involve floatation costs of Rs. 5 per debenture.

16
 ACADEMY OF COMMERCE

The debentures are redeemable at a premium of 5% after 10 years. Calculate the cost of
debenture if the tax rate is 50%.

Answer: Before tax = 13.85% (approx.); After tax = 6.92% (approx.)

13. The capital structure and other information of a company are given below:
Amount in lakh After – tax cost of capital
(Rs.) (%)
Equity (Rs. 100 each) 100 14
Reserve and Surplus 50 ?
Debentures 200 ?
350
The market value of equity share is Rs. 300 per share. The company uses market value
weights for computing average cost of capital. The corporate tax rate is 40 percent while the
average cost of capital is 10 percent.
What is cost of reserve and surplus, and cost of debt (before tax)?

Answer: Cost of reserve and surplus =14%; Cost of debt before tax = 6.67% (approx.)

14. A Company issues 12% redeemable preference shares of Rs. 100 each at 5% premium
redeemable after 15 years at 10% premium. If the floatation cost of each share is Rs. 2, what
is the value of KP (cost of preference share) to the Company?

Answer: Without dividend tax = 11.71%; With dividend tax = 13.18%

15. A Company's share is currently quoted in the market at Rs. 20. The Company pays a dividend
of Rs. 2 per share and the investors expect a growth rate of 5% per year.
You are required to calculate (a) Cost of equity capital of the company and (b) the market
price per share, if the anticipated growth rate of dividend is 7%.

Answer: a) 15% and b) Rs. 25.

16. Y Co. Ltd. issues 10,000 12% Preference Shares of Rs. 100 each at a premium @ 10% but
redeemable at a premium @ 20% after 5 years. The Company pays underwriting commission
@5%. If tax on dividend is 12.5%, surcharge is 2.5% and education cess is 3%, calculate the
cost of Preference Share Capital.

Answer: 14.86%

17. In considering the most desirable capital structure for a company, the following estimate of
the cost of debt and equity capital (after tax) have been made at various levels of debt-equity
mix:
Debt as % of total capital employed Cost of debt (%) Cost of equity (%)
9 5 12
10 5 12
20 5 12.5
30 5.5 13

17
 ACADEMY OF COMMERCE

40 6 14
50 6.5 15.5
60 8 20
You are required to determine the optimal debt- equity mix for the company by calculating
composites cost of capital.

Answer:
Optimal Debt Equity Mix is 30% Debt and 70% Equity capital where the composite cost is least,
i.e. 10.75%.

❖ CAPITAL BUDGETING:
 Theory:
1) Distinguish between NPV & IRR.
2) Distinguish between Traditional & Discounting Pay Back Period Method.
3) State the advantages and disadvantages of Discounting Pay Back Period Method.
4) Write short note on Capital Rationing.
5) State the advantages and disadvantages of NPV Method.
6) State the advantages and disadvantages of Pay Back Period Method.
7) Discuss the factors influencing Capital Budgeting decisions.
8) Discuss the steps of Capital Budgeting.
9) Mention any 3 importance of capital budgeting. How will you take accept-reject decision
under NPV method in case of evaluation of a proposed project?
10) State the significance of Capital Budgeting decision.
11) What is Accounting Rate of Return?

 Numerical Problems:
1. Alpha Co. Ltd. is considering the purchase of a new machine for a proposed project. The
estimated sales and costs for the project are being given below:
Annual Sales: Rs. 14,00,000
Annual Costs:
– Raw materials Rs. 4,00,000
– Direct wages Rs. 3,00,000
– Variable overhead Rs. 1,00,000
Other information:
– Cost of machine Rs. 10,50,000
– Estimated scrap value Rs. 50,000
– Estimated life of machine 10 years
– Tax rate 50%
You are required to determine the pay-back period on the basis of above information.

Answer: Required pay-back period = 3 years.

2. A project requires a machine costing Rs. 5,00,000. The effective life of the machine is 5 years
and its scrap value will be Rs. 1,00,000 after 5 years. The expected annual profits including
depreciation and taxes, for the next 5 years, that can be obtained from the project are Rs.
75,000, Rs. 1,75,000, Rs. 2,00,000, Rs. 2,00,000 and Rs. 50,000 respectively. If the rate of tax

18
 ACADEMY OF COMMERCE

is 50% and depreciation is charged under fixed instalment method, calculate the ARR of the
project.

Answer: 10%.

3. A company is considering an investment project which requires an initial cash outlay of Rs.
2,50,000 on equipment. The project’s economic life is 10 years. An additional investment of
Rs. 1,00,000 would also be necessary at the end of each two years to restore the efficiency of
the equipment. The annual cash inflows which are expected from the project are as follows:
Year: 1 2 3 4 5 6 7 8 9 10
Cash
inflows: 40 55 80 90 125 150 190 200 230 250
(Rs. ‘000)
If the scrap value of the equipment is zero after 10 years and cost of capital is 20%, justify
whether the project should be accepted or not by determining the net present value.
Given: The present value factors at a discount @ 15% rate are:
Year: 1 2 3 4 5 6 7 8 9 10
PVF at
0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162
20%:

Answer: NPV = Rs. 20,020; The project should be excepted.

4. Compute the payback period for the project:

End of year 1 2 3 4 5
Book value of fixed asset 90 80 70 60 50
Profit after tax 20 22 24 26 28

Answer: 3.11 years approx.

5. A company has to select one of the two alternative projects whose particulars are given
below:
Initial Net cash flow (Rs.)
Outlay (Rs.) Y1 Y2 Y3 Y4
Project I 11.872 10,000 2,000 1,000 1,000
Project II 10,067 1,000 1,000 2,000 10,000
The company can arrange the fund at 8%. Compute the NPV and IRR of each project and
comment on the result.
The present value of Rs. 1 at different cost of capital is given below:
Year 8% 10% 12% 14%
1 .926 .909 .893 .877
2 .857 .826 .797 .770
3 .794 .751 .712 .675
4 .735 .683 .636 .592

Answer:
For project I: NPV = Rs. 631; IRR = 11.86% (approx.)
For project II: NPV = Rs. 654; IRR = 10.18%

19
 ACADEMY OF COMMERCE

6. Using the information given below compute the pay-back period under Discounted Pay-Back
Method and Comment:
Initial Outlay: Rs. 80,000
Estimated Life: 5 years
Profit after tax:
End of year 1 Rs. 6,000
2 Rs. 14,000
3 Rs. 24,000
4 Rs. 16,000
5 Nil
Depreciation has been calculated under straight Line Method. The cost of capital may be taken
at 20% p.a. and P.V. of Re. 1 at 20% p.a. is given below:
Year : 1 2 3 4 5
P.V. factor : .83 .69 .58 .48 .40

Answer: Pay-back period = 4.33 years

7. The cost of a Plant is Rs. 30,000. The expected life of the Plant is 3 years. It is expected to
generate EBDIT (Earning Before Depreciation, Interest and Tax) Rs. 13,000, Rs. 15,000, Rs.
17,000 respectively. Compute Accounting Rate of Return assuming 50% tax, and straight line
method of depreciation.

Answer: Accounting Rate of Return = 16.67%

8. From the following particulars given below calculate the Internal Rate of Return of the
projects:
i. Net Profit after-tax over the four years of the project-life:
Rs.
End of year 1 = 13,750
2 = 22,000
3 = 27,500
4 = 11,000
ii. Initial outlay: Rs. 55,000. There will be no realizable scrap value at the end of the
project life.
iii. Present value of Re. 1 receivable at the end of year 1, 2, 3 and 4 at different discount
rates:
Discount rate PV factor (Re.)
12% 0.892 0.797 0.712 0.636
13% 0.885 0.783 0.693 0.613
14% 0.877 0.770 0.675 0.592
15% 0.867 0.756 0.658 0.572

Answer:
IRR may be either 33.70%; or 33.97%; or 33.85%; or Average = 33.84%.

9. X Ltd. has been producing a chemical product by using machine Z for the last two years. Now,
the management of the company is thinking to replace this machine either by X or by Y

20
 ACADEMY OF COMMERCE

machine. The following details are furnished to you: Z X

Y
Book value (Rs.) 1,00,000 - -
Resale value now (Rs.) 1,10,000 - -
Purchase Price (Rs.) - 1,80,000 2,15,000
Annual fixed cost (including depreciation) (Rs.) 92,000 1,08,000 1,32,000
Variable running cost (including labour)
per unit (Rs.) 3 1.50 2.50
Production per hour (Unit) 8 8 12
You are also provided the following additional information:
Selling Price per unit Rs. 20
Cost of materials per unit Rs. 10
Annual operating hours 2000
Working life of each of the three machines (as from now) – 5 years.
Salvage value of machines: Z - Rs. 10,000; X - Rs. 15,000 and Y - Rs. 33.000.
The company charges depreciation using straight line method. It is anticipated that an
additional cost of Rs. 8,000 p.a. would be incurred on special advertising to sell the extra
output of machine Y.
Assume tax rate of 50% and cost of capital 10%.
The present value of Rs. 1 to be received at the end of each year at 10% is as under:
Year : 1 2 3 4 5
Present value : 0.909 0.826 0.751 0.683 0.621
Using NPV method, analyse the feasibility of the proposal and make recommendations.

Answer:
NPV of Extra Cash Inflow of Machine: X = Rs. 5,115; Y = Rs. 16,919.
The company should replace the existing machine with machine Y.

10. A company wants to replace its existing machine by Machine A, which is of similar kind or by
Machine B which is more expensive and of higher capacity, due to the increasing demand. The
available cash flow from the two machines are as follows:
Machine Immediate Cash flow Cash Inflows (in Rs. lakh) at the end of
(Rs. in lakh) 1st yr. 2nd yr. 3rd yr. 4th yr. 5th yr.
A 25 - 5 20 14 14
B 40 10 14 16 17 15
The company’s cost of capital is 10%. The finance management tries to appraise the machine
by calculating the following:
i. Net present value
ii. Profitability Index
iii. Discounted Pay Back Period
Comment on these calculations and guide the manager to select the investment.
Note: Present values of Re. 1 at 10% Discount rate are as follows:
Year : 0 1 2 3 4 5
P.V. : 1.00 0.91 0.83 0.75 0.68 0.62

Answer:

21
 ACADEMY OF COMMERCE

Methods of Appraisal Machine A Machine B Acceptability

i. NPV Rs. 12,35,000 Rs. 13,58,000 Machine B
ii. Profitability Index 1.494 1.3395 Machine A
iii. Discounted Payback Period 3.61 yr. 3.63 yr. Machine A
Machine B is more suitable to meet increasing demand.

11. Reliance Industries Ltd. has an Investment budget of Rs. 10 lakh for the current year. It has
short listed two projects X and Y. Further particulars regarding them are given below:
Project X (Rs.) Y (Rs.)
Investment Required 10,00,000 9,00,000
Average estimated cash inflows before depreciation and tax 2,40,000 2,05,000
Salvage value is assumed to be nil for both the projects after the estimated life of 10 years are
being over. The company follows straight line method of charging depreciation and tax rate is
35%. Assuming cost of capital to be 12%, find out the:
a) NPV of both the projects, and
b) IRR of both Project X and Project Y.
Given PV of an annuity of Rs. 1 for ten years at different discount rates:
Rate (%) 10 11 12 13 14 15
Annuity value for 10 6.1446 5.8992 5.6502 5.4262 5.2161 5.0188
years

Answer:
NPV of Projects: X = Rs. 79,188; Y = Rs. 30,870.
IRR of Projects: X = 13.91%; Y = 12.84%.

12. The cost of a plant is Rs. 60,000. The expected life of the plant is 3 years. It is expected to
generate EBDIT (Earning Before Depreciation, Interest and Taxes) Rs. 26,000, Rs. 30,000, Rs.
34,000 respectively.
Compute accounting rate of return assuming 30% tax and straight line method of depreciation
charges.

Answer: Accounting Rate of Return = 23.33%.

13. Compute Pay Back Period of a project of which the following details are available:
End of year 1 2 3 4 5
Book value of Fixed Assets (Rs. in lakh) 450 400 350 300 250
Profit After Tax (Rs. in lakh) 80 88 96 104 112

Answer: Pay Back Period = 3.56 years.

14. Two machines are not identical in many respects. Following are the information regarding the
two. The estimated life of both machines is five years leaving no salvage value at the end.
Cost (Rs.) Anticipated Cash flow after tax per year (Rs.)
Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5
Machine M 6,25,000 - 1,25,000 5,00,000 3,50,000 1,50,000
Machine N 10,00,000 2,50,000 3,50,000 4,00,000 4,25,000 2,00,000
The company’s cost of capital is 16%. You are required to make an appraisal of the two
machines and advise the company using (i) NPV and (ii) IRR.

22
 ACADEMY OF COMMERCE

Given: Present value of Re. 1:

End of year 16% 18% 20%
1 0.862 0.847 0.833
2 0.743 0.718 0.694
3 0.641 0.609 0.579
4 0.552 0.516 0.482
5 0.476 0.437 0.402

Answer:
NPV of Machine M: at 16% = Rs.52,975; at 18% = Rs. 15,400; at 20% = Rs. (-) 19,750.
NPV of Machine N: at 16% = Rs. 61,750; at 18% = Rs. 13,350; at 20% = Rs. (-) 32,000.
IRR of Machines: M = 18.88%; N = 18.59%.

15. Following figures relate to a new project for which a machine is to be acquired at a cost of Rs.
2,50,000 and initially Rs. 60,000 is to be invested as working capital:
Year 1 2 3 4
EBDIT (Rs.) 80,000 90,000 1,45,000 1,20,000
Depreciation (Rs.) 75,000 62,000 48,000 25,000
nd
At the beginning of 2 year, an amount of Rs. 10,000 is to be introduced as additional working
capital.
On completion of project, i.e., at the end of 4 th year, it is expected that Rs. 40,000 will be
realized from sale of scrap and working capital will be recovered in full.
Cost of capital is 12% and applicable tax rate is 30%.
Calculate NPV of the project and comment on its acceptability.
[Given the present value of Re. 1 receivable at the end of each year for 4 years at 12% p.a.
compounded annually are 0.893, 0.797, 0.712 and 0.636 respectively.]

Answer: NPV = Rs. 26,881

16. L Ltd. provides you the following information:

a) Purchase price of machine Rs. 1,73,500
b) Useful life of machine 3 years
c) Salvage value at the end of useful life Nil
d) Cost of capital 10%
e) Cash Flow After Tax (CFAT):
Year – 1 Rs. 1,00,000
Year – 2 Rs. 1,00,000
Year – 3 Rs. 80,000
Note: Present value factor @ 10% are as follows:
Year : 1 2 3
PV : 0.909 0.826 0.751
Calculate the discounted payback period.

Answer: Payback Period = 2 years.

17. X Ltd. provides the following information:

a) Annual cost saving Rs. 96,000

23
 ACADEMY OF COMMERCE

b) Useful life 5 years

c) Salvage value Rs. 0
d) Interval rate of return 15%
e) Profitability Index (PI) 1.05
You are required to calculate:
(i) Cost of the Project (ii) NPV of the Project.
PVIFA(15%,5) = 3.353

Answer:
(i) Cost of the Project = Rs. 3,21,888;
(ii) NPV of the Project = Rs. 16,094.

❖ CAPITAL STRUCTURE:
 Theory:
1) Write the features of the net income approach to capital structure theory.
2) Explain with example Earning Theory of Capitalisation.
3) What do you mean by capital structure? Mention any 3 factors that are to be considered in
determining capital structure.
4) Define high-geared, low-geared and evenly-geared capital with example.
5) “Neither Overcapitalisation nor Under-capitalisation is desirable” – Elucidate the statement.
6) Mention the cause of over-capitalisation in a company.
7) Differentiate between Overcapitalisation and Under-capitalisation.

 Numerical Problems:
1. The earning before interest and tax of Avatar Ltd. is Rs. 1,20,000. The company has Debt-
capital of Rs. 4,00,000 on which it pays interest @ 12% p.a. The equity capitalisation rate
applicable to the company is 18%.
Calculate market value and overall cost of capital of Avatar Ltd. under NI approach. Assume
there is no corporate tax.

Answer: Market value = Rs. 8,00,000; Cost of capital = Rs. 15%.

2. The following 3 firms are identical in all respect except capital structure:
Firm A Firm B Firm C
Capital structure:
Equity Capital Rs. 6,00,000 Rs. 4,00,000 Rs. 3,00,000
15% Debenture – Rs. 2,00,000 Rs. 3,00,000
Rs. 6,00,000 Rs. 6,00,000 Rs. 6,00,000
Other data:
Annual Sales Rs. 12,00,000 Rs. 12,00,000 Rs. 12,00,000
Variable Sales 75% 75% 75%
Fixed operating cost Rs. 1,20,000 Rs. 1,20,000 Rs. 1,20,000
Equity capitalisation rate 20% 20% 20%
Corporate tax Nil Nil Nil
You are required to calculate the value of the firms and overall cost of capital according to the
NI approach and comment on your result.

Answer:

24
 ACADEMY OF COMMERCE

Value of the firm: Firm A = Rs. 9,00,000; Firm B = Rs. 9,50,000; Firm C = Rs. 9,75,000.
Overall cost of capital: Firm A = 20%; Firm B = 18.95%; Firm C = Rs. 18.46%.

3. Rajdhani Ltd. has earned a profit of Rs. 4,80,000 before charging interest and tax. It has 10,000
12% Debentures of Rs. 100 each in the capital structure. The overall capitalisation rate of the
company is 6%.
Calculate the value of the firm and Equity Capitalisation rate under NOI approach.

Answer: Value of the firm = Rs. 3,60,000; Equity Capitalisation rate = 18%.

4. The net operating income of Ricki Ltd. is Rs. 2,40,000 before charging interest and tax. It has
6,000 12% debentures of Rs. 100 each. Its overall cost of capital is 16%. You are required to:
(a) Calculate the value of the firm and cost of equity capital according to the net operating
income approach.
(b) Recalculate the same, if the company –
i. Raises Rs. 3,00,000 by issuing 12% Debenture and uses the proceeds to buy-
back its equity share; and
ii. Raises Rs. 3,00,000 by issuing equity shares and uses the proceeds to redeem
12% Debentures of the same amount.
(c) Comment on the net operating income approach of the Capital structure theories from
your calculation results.

Answer: Cost of Equity: (a) 18.67%; (b) – (i) 22%; (ii) 17%

25