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1 RATIO ANALYSIS
CHAPTER

Q.1 All Ratios PY May 23

Following information and ratios are given in respect of AQUA Ltd. for the year ended 31st March, 2023:

Current ratio 4.0

Acid test ratio 2.5
Inventory turnover ratio (based on sales) 6
Average collection period (days) 70
Earnings per share ` 3.5
Current liabilities ` 3,10,000
Total assets turnover ratio (based on sales) 0.96
Cash ratio 0.43
Proprietary ratio 0.48
Total equity dividend ` 1,75,000
Equity dividend coverage ratio 1.60

Assume 360 days in a year.

You are required to complete Balance Sheet as on 31stMarch, 2023.
Balance Sheet as on 31stMarch, 2023.
Liabilities ` Assets `
Equity share capital (`10 per share) XXX Fixed assets XXX
Reserves & surplus XXX Inventory XXX
Long-term debt XXX Debtors XXX
Current liabilities 3,10,000 Loans & advances XXX
Cash & bank XXX
Total XXX Total XXX

Ans. (i) Current Ratio = 4

Current Assets
=4
Current Liabilities
Current Assets
=4
3,10,000
Current Assets = ` 12,40,000

(ii) Acid Test Ratio = 2.5

Current Assets - Inventory
= 2.5
Current Liabilities
12, 40, 000 - Inventory
= 2.5
3,10,000
12,40,000 – Inventory = ` 7,75,000
Inventory = ` 4,65,000

(iii) Inventory Turnover Ratio (on Sales) = 6

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Sales
=6
Inventory
Sales
=6
4,65,000
Sales = ` 27,90,000

(iv) Debtors Collection Period = 70 days

(Debtors / sales) x 360 = 70
(Debtors / 27,90,000) x 360 = 70
Debtors = ` 5,42,500

(v) Total Assets Turnover Ratio (on Sales) = 0.96

Sales
= 0.96
Total Assets
27, 90, 000
= 0.96
Total Assets
Total Assets = ` 29,06,250

(vi) Fixed Assets (FA) = Total Assets – Current Assets

= 29,06,250 – 12,40,000
Fixed Assets = ` 16,66,250

Cash
(vii) Cash Ratio = = 0.43
Current Liabilities
Cash
= 0.43
3,10,000
Cash = ` 1,33,300

Proprietary Fund
(viii) Proprietary Ratio = = 0.48
Total Assets
Proprietary Fund
= 0.48
29,06,250
Proprietary Fund = ` 13,95,000

(ix) Equity Dividend Coverage Ratio = 1.6 or

EPS 3.5
=
DPS DPS
DPS = ` 2.1875
Total Dividend
DPS =
Number of Equity Shares
1,75,000
2.1875 =
Number of Equity Shares
Number of Equity Shares = 80,000
Equity Share Capital = 80,000 x 10 = ` 8,00,000
Reserves &Surplus = 13,95,000 - 8,00,000 = ` 5,95,000

(x) Loans and Advances = Current Assets - (Inventory + Receivables + Cash & Bank)
= ` 12,40,000 - (` 4,65,000 + 5,42,500 + 1,33,300) = ` 99,200

Balance Sheet as on 31st March 2023

Liabilities ` Assets `

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Equity Share Capital (` 10 per share) 8,00,000 Fixed Assets 16,66,250

Reserves & Surplus 5,95,000 Inventory 4,65,000
Long-term debt *(B/F) 12,01,250 Receivables 5,42,500
Current Liabilities 3,10,000 Loans & Advances 99,200
Cash & Bank 1,33,300
Total 29,06,250 Total 29,06,250

Q.2 Prepare B/s PY July 21

Masco Limited has furnished the following ratios and information relating to the year ended 3 1 st March 2021:

Sales ` 75,00,000
Return on net worth 25%
Rate of income tax 50%
Share capital to reserves 6:4
Current ratio 2.5
Net profit to sales (After Income Tax) 6.50%
Inventory turnover (based on cost of goods sold) 12
Cost of goods sold ` 22,50,000
Interest on debentures ` 75,000
Receivables (includes debtors ` 1,25,000) ` 2,00,000
Payables ` 2,50,000
Bank Overdraft ` 1,50,000

You are required to:

(a) Calculate the operating expenses for the year ended 31st March, 2021.
(b) Prepare a balance sheet as on 31st March in the following format:

Liabilities ` Assets `
Share Capital Fixed Assets
Reserves and Surplus Current Assets
15% Debentures Stock
Payables Receivables
Bank Term Loan Cash

Ans. (a) Calculation of Operating Expenses for the year ended 31st March, 2021
Particulars (`)
Net Profit [@ 6.5% of Sales] Add: Income 4,87,500
Tax (@ 50%) 4,87,500
Profit Before Tax (PBT) 9,75,000
Add: Debenture Interest 75,000
Profit before interest and tax (PBIT) 10,50,000
Sales 75,00,000
Less: Cost of goods sold 22,50,000
PBIT 10,50,000 33,00,000
Operating Expenses 42,00,000

(b) Balance Sheet as on 31st March, 2021

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Liabilities ` Assets `
Share Capital 11,70,000 Fixed Assets 18,50,000
Reserve and Surplus 7,80,000 Current Assets
15% Debentures 5,00,000 Stock 1,87,500
Payables 2,50,000 Receivables 2,00,000
Bank Overdraft(or 1,50,000 Cash 6,12,500
Bank Term Loan)
28,50,000 28,50,000

Working Notes:
(i) Calculation of Share Capital and Reserves
The return on net worth is 25%. Therefore, the profit after tax of ` 4,87,500 should be equivalent to
25% of the net worth.
25
Net worth = ` 4,87,500
100
4, 87, 500 x100
Net worth = = ` 19,50,000
25
The ratio of share capital to reserves is 6:4
Share Capital = 19,50,000 x 6/10 = ` 11,70,000
Reserves = 19,50,000 x 4/10 = ` 7,80,000

(ii) Calculation of Debentures

Interest on Debentures @ 15% (as given in the balance sheet format) = ` 75,000
75, 000 x 100
Debentures = = ` 5,00,000
15

(iii) Calculation of Current Assets

Current Ratio = 2.5
Payables = ` 2,50,000
Bank overdraft = ` 1,50,000
Total Current Liabilities = ` 2,50,000 + ` 1,50,000 = ` 4,00,000
Current Assets = 2.5 x Current Liabilities = 2.5 4,00,000 = ` 10,00,000

(iv) Calculation of Fixed Assets

Particulars `
Share capital 11,70,000
Reserves 7,80,000
Debentures 5,00,000
Payables 2,50,000
Bank Overdraft 1,50,000
Total Liabilities 28,50,000
Less: Current Assets 10,00,000
Fixed Assets 18,50,000

(v) Calculation of Composition of Current Assets

Inventory Turnover = 12
Cost of goods sold
= 12
Closing stock

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22,50,000
Closing stock = = Closing stock = ` 1,87,500
12
Particulars `
Stock 1,87,500
Receivables 2,00,000
Cash (balancing figure) 6,12,500
Total Current Assets 10,00,000

Q.3 COGS PY Nov 18

The following is the information of XML Ltd. relate to the year ended 31-03-2018 : Gross Profit
20% of Sales
Net Profit 10% of Sales
Inventory Holding period 3 months
Receivable collection period 3 months
Non-Current Assets to Sales 1:4
Non-Current Assets to Current Assets 1:2
Current Ratio 2:1
Non-Current Liabilities to Current Liabilities 1:1
Share Capital to Reserve and Surplus 4:1
Non-current Assets as on 31st March, 2017 ` 50,00,000

Assume that:
(i) No change in Non-Current Assets during the year 2017-18
(ii) No depreciation charged on Non-Current Assets during the year 2017-18.
(iii) Ignoring Tax
You are required to Calculate cost of goods sold, Net profit, Inventory, Receivables and Cash for the year
ended on 31st March, 2018

Ans. Workings

Non Current Assets 1

=
Curent Assets 2
50,00,000 1
Or =
Curent Assets 2
So, Current Assets = ` 1,00,00,000

Now further,
Non Current Assets 1
=
Sales 4
50, 00, 000 1
Or =
Sales 4
So, Sales = ` 2,00,00,000

Calculation of Cost of Goods sold, Net profit, Inventory, Receivables and Cash:
(i) Cost of Goods Sold (COGS):
Cost of Goods Sold = Sales- Gross Profit
= ` 2,00,00,000 – 20% of ` 2,00,00,000
= ` 1,60,00,000

(ii) Net Profit = 10% of Sales = 10% of ` 2,00,00,000

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= ` 20,00,000

(iii) Inventory:
12 Months
Inventory Holding Period =
Inventory Turnover Ratio
Inventory Turnover Ratio = 12/ 3 = 4

COGS
4=
Average Inventory
1,60,00,000
4=
Average Inventory

Average or Closing Inventory =` 40,00,000

(iv) Receivables :
12 Months
Receivable Collection Period =
Receivables Turnover Ratio
Credit Sales
Or Receivables Turnover Ratio = 12/ 3 = 4 =
Average Accounts Receivable

2,00,00,000
Or 4 =
Average Accounts Receivable
So, Average Accounts Receivable/Receivables =` 50,00,000/-

(v) Cash:
Cash* = Current Assets* – Inventory- Receivables
Cash = ` 1,00,00,000 - ` 40,00,000 - ` 50,00,000
= ` 10,00,000
(it is assumed that no other current assets are included in the Current Asset)

Q.4 Find missing figures of B/S RTP May 23

From the following information, find out missing figures and REWRITE the balance sheet of Mukesh Enterprise.
Current Ratio = 2:1
Acid Test ratio = 3:2
Reserves and surplus = 20% of equity share capital
Long term debt = 45% of net worth Stock turnover velocity = 1.5 months Receivables turnover velocity = 2
months
You may assume closing Receivables as average Receivables. Gross profit ratio = 20%
Sales is ` 21,00,000 (25% sales are on cash basis and balance on credit basis) Closing stock is ` 40,000 more
than opening stock.
Accumulated depreciation is 1/6 of original cost of fixed assets.
Balance sheet of the company is as follows:

Liabilities (`) Assets (`)

Equity Share Capital ? Fixed Assets (Cost) ?
Reserves & Surplus ? Less: Accumulated. Depreciation ?
Long Term Loans 6,75,000 Fixed Assets (WDV) ?
Bank Overdraft 60,000 Stock ?

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Creditors ? Debtors ?
Cash ?
Total ? Total ?

Ans.
Liabilities (`) Assets (`)
Equity Share Capital 12,50,000 Fixed Assets (cost) 20,58,000
Reserves & Surplus 2,50,000 Less: Acc. Depreciation (3,43,000)
Long Term Loans 6,75,000 Fixed Assets (WDV) 17,15,000
Bank Overdraft 60,000 Stock 2,30,000
Payables 4,00,000 Receivables 2,62,500
Cash 4,27,500
Total 26,35,000 Total 26,35,000

Working Notes:
(i) Sales ` 21,00,000
Less: Gross Profit (20%) ` 4,20,000
Cost of Goods Sold (COGS) ` 16,80,000

Average Receivables
(ii) Receivables Turnover Velocity = x 12
Credit Sales
Average Receivables
2= x 12
21,00,000 x 75%
21, 00, 000 x75% x 2
Average Receivables =
12
Average Receivables = ` 2,62,500
Closing Receivables = ` 2,62,500

Average Stock
(iii) Stock Turnover Velocity = x 12
COGS
Average Stock
Or 1.5 = x 12
16,80,000
16, 80, 000 x 1.5
Or Average Stock =
12
Or Average Stock = ` 2,10,000

Opening Stock + Closing Stock

= ` 2,10, 000
2

Opening Stock + Closing Stock = ` 4,20,000…………………..(1)

Also, Closing Stock-Opening Stock = ` 40,000………………..(2)

Solving (1) and (2), we get closing stock = ` 2,30,000

Current Assets Stock + Receivables + Cash

(iv) Current Ratio = =
Current Liabilities Bank Overdraft + Creditors

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2, 30, 000 + `2, 62, 500 + Cash

Or 2 =
60,000 + Creditors

Or ` 1,20,000 + 2 Payables = ` 4,92,500 + Cash

Or 2 Payables – Cash.= ` 3,72,500

Or Cash = 2 Payables – ` 3,72,500…………………………..….(3)

Current Assests - Stock Debtor + Cash

Acid Test Ratio = =
Current Liabilities Current Liabilities

3 2, 62, 500 + Cash

Or =
2 60,000 + Creditors
Or ` 1,80,000 + 3 Payables = ` 5,25,000 + 2 Cash
Or 3 Payables – 2 Cash = ` 3,45,000 …………………… (4)
Substitute (3) in (4)
Or 3 Payables – 2(2 Payables – ` 3,72,500) = ` 3,45,000
Or 3 Payables – 4 Payables + ` 7,45,000= ` 3,45,000 (Payables) = ` 3,45,000 - ` 7,45,000
Payables = ` 4,00,000
So, Cash = 2 x ` 4,00,000 – ` 3,72,5000
Cash = ` 4,27,500

(v) Long term Debt = 45% of Net Worth Or ` 6,75,000 = 45% of Net Worth Net Worth = ` 15,00,000

(vi) Equity Share Capital (ESC) + Reserves = ` 15,00,000

Or ESC + 0.2ESC = ` 15,00,000
Or 1.2 ESC = ` 15,00,000
Equity Share Capital (ESC) = ` 12,50,000

(vii) Reserves = 0.2 x ` 12,50,000

Reserves = ` 2,50,000

(viii) Total of Liabilities=Total of Assets

Or ` 12,50,000 + ` 2,50,000 + ` 6,75,000 +` 60,000 + ` 4,00,000 + Fixes
Assets(FA) (WDV) + ` 2,30,000 + ` 2,62,000 +` 4,27,500
Or ` 26,35,000 = ` 9,20,000 + FA(WDV)
FA (WDV) =` 17,15,000
Now FA(Cost) – Depreciation = FA(WDV) Or FA(Cost) – FA(Cost)/6 = ` 17,15,000
Or 5 FA(Cost)/6 = ` 17,15,000
Or FA(Cost) = ` 17,15,000x 6/5
So, FA(Cost) = ` 20,58,000
Depreciation = ` 20,58,000/6 = ` 3,43,000

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Q.5 Prepare B/S RTP Nov 22

The following information of ASD Ltd. relate to the year ended 31st March, 2022:

Net profit 8% of sales

Raw materials consumed 20% of Cost of Goods Sold
Direct wages 10% of Cost of Goods Sold
Stock of raw materials 3 months’ usage
Stock of finished goods 6% of Cost of Goods Sold
Gross Profit 15% of Sales
Debt collection period 2 Months
(All sales are on credit)
Current ratio 2:1
Fixed assets to Current assets 13 : 11
Fixed assets to sales 1:3
Long-term loans to Current liabilities 2:1
Capital to Reserves and Surplus 1:4
You are required to PREPARE-
(a) Profit & Loss Statement of ASD Limited for the year ended 31st March, 2022 in the following format.
Particulars (`) Particulars (`)
To Direct Materials consumed ? By Sales ?
To Direct Wages ?
To Works (Overhead) ?
To Gross Profit c/d ?
? ?
To Selling and Distribution Expenses ? By Gross Profit b/d ?
To Net Profit ?
? ?

(b) Balance Sheet as on 31st March, 2022 in the following format.

Liabilities (`) Assets (`)
Share Capital ? Fixed Assets 1,30,00,000
Reserves and Surplus ? Current Assets:
Long term loans ? Stock of Raw Material ?
Current liabilities ? Stock of Finished Goods ?
Debtors ?
Cash ?
? ?

Ans. Working Notes:

(i) Calculation of Sales
Fixed Assets 1
=
Sales 3
1,30,00,000 1
= ⇒ Sales = ` 3,90,00,000
Sales 3

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(ii) Calculation of Current Assets

Fixed Assets 13
=
Current Assets 11
1,30,00,000 13
= ⇒ Current Assets = ` 1,10,00,000
Current Assets 11

(iii) Calculation of Raw Material Consumption and Direct Wages

`
Sales 3,90,00,000
Less: Gross Profit (15 % of Sales) 58,50,000
Cost of Goods sold 3,31,50,000
Raw Material Consumption (20% of Cost of Goods Sold) ` 66,30,000
Direct Wages (10% of Cost of Goods Sold)` 33,15,000

(iv) Calculation of Stock of Raw Materials (= 3 months usage)

3
= 66,30,000 x = ` 16,57,500
12

(v) Calculation of Stock of Finished Goods (= 6% of Cost of Goods Sold)

6
= 3,31,50,000 x = ` 19,89,000
100

(vi) Calculation of Current Liabilities

Current Assets
= 2
Current Liabilities
1,10,00,000
=2 ⇒ Current Liabilities = ` 55,00,000
Current Liabilities

(vii) Calculation of Debtors

Debtors
Average collection period = × 12 months
Credit Sales
Debtors
× 12 = 2 ⇒Debtors = ` 65,00,000
3,90,00,000

(viii) Calculation of Long-term Loan

Long term Loan 2
=
Current Liabilities 1
Long term Loan 2
= ⇒Long term loan = ` 1,10,00,000
55,00,000 1

(ix) Calculation of Cash Balance

`
Current assets 1,10,00,000
Less: Debtors 65,00,000
Raw materials stock 16,57,500
Finished goods stock 19,89,000 1,01,46,500

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Cash balance 8,53,500

(x) Calculation of Net worth

Fixed Assets 1,30,00,000
Current Assets 1,10,00,000
Total Assets 2,40,00,000
Less: Long term Loan 1,10,00,000
Current Liabilities 55,00,000 1,65,00,000
Net worth 75,00,000

Net worth = Share capital + Reserves = ` 75,00,000

Capital 1 1
= ⇒Share Capital = ` 75,00,000 × = ` 15,00,000
Reserves and Surplus 4 5
Reserves and Surplus = ` 75,00,000 × 5 = ` 60,00,000

Profit and Loss Statement of ASD Ltd.

for the year ended 31st March, 2022
Particulars (`) Particulars (`)
To Direct Materials 66,30,000 By Sales 3,90,00,000
consumed
To Direct Wages 33,15,000
To Works (Overhead) 2,32,05,000
(Bal. fig.)
To Gross Profit c/d 58,50,000
(15% of Sales)
3,90,00,000 3,90,00,000
To Selling and Distribution 27,30,000 By Gross Profit b/d 58,50,000
Expenses (Bal. fig.)

To Net Profit (8% of Sales) 31,20,000

58,50,000 58,50,000

Balance Sheet of ASD Ltd.

as at 31st March, 2022
Liabilities (`) Assets (`)
Share Capital 15,00,000 Fixed Assets 1,30,00,000
Reserves and Surplus 60,00,000 Current Assets:
Long term loans 1,10,00,000 Stock of Raw Material 16,57,500
Current liabilities 55,00,000 Stock of Finished Goods 19,89,000
Debtors 65,00,000
Cash 8,53,500
2,40,00,000 2,40,00,000

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Q.6 Return Ratios RTP July 21

Given below are the estimations for the next year by Niti Ltd.:
Particulars (` in crores)
Fixed Assets 5.20
Current Liabilities 4.68
Current Assets 7.80
Sales 23.00
EBIT 2.30

The company will issue equity funds of ` 5 crores in the next year. It is also considering the debt alternatives
of ` 3.32 crores for financing the assets. The company wants to adopt one of the policies given below:
(` in crores)
Financing Policy Short term debt @ 12% Long term debt @ 16% Total
Conservative 1.08 2.24 3.32
Moderate 2.00 1.32 3.32
Aggressive 3.00 0.32 3.32
Assuming corporate tax rate at 30%, CALCULATE the following for each of the financing policy:
(i) Return on total assets
(ii) Return on owner's equity
(iii) Net Working capital
(iv) Current Ratio
Also advise which Financing policy should be adopted if the company wants high returns.

Ans. (i) Return on total assets

EBIT (1 - T)
Return on total assets =
Total assets (FA + CA)
2.30 crores (1 - 0.3)
=
5.20 crores + `7.80 crores
1.61crores
= = 0.1238 or 12.38%
13 crores
(ii) Return on owner's equity
(Amount in `)
Financing policy (`)
Conservative Moderate Aggressive
Expected EBIT 2,30,00,000 2,30,00,000 2,30,00,000
Less: Interest
Short term Debt @ 12% 12,96,000 24,00,000 36,00,000
Long term Debt @ 16% 35,84,000 21,12,000 5,12,000
Earnings before tax (EBT) 1,81,20,000 1,84,88,000 1,88,88,000
Less: Tax @ 30% 54,36,000 55,46,400 56,66,400
Earnings after Tax (EAT) 1,26,84,000 1,29,41,600 1,32,21,600
Owner's Equity 5,00,00,000 5,00,00,000 5,00,00,000
Return on owner's equity = 1,26,84,000 = 1,29,41,600 = 1,32,21,600

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Net Pr ofit after taxes (EAT) 5,00,00,000 5,00,00,000 5,00,00,000

Owners'equity
= 0.2537 or = 0.2588 or = 0.2644 or
25.37% 25.88% 26.44%

(iii) Net Working capital

(` in crores)
Financing policy
Conservative Moderate Aggressive
Current Liabilities (Excluding 4.68 4.68 4.68
Short Term Debt)
Short term Debt 1.08 2.00 3.00

Total Current Liabilities 5.76 6.68 7.68

Current Assets 7.80 7.80 7.80

Net Working capital 7.80 - 5.76 7.80 - 6.68 7.80 - 7.68
= Current Assets - Current = 2.04 = 1.12 = 0.12
Liabilities

(iv) Current ratio

(` in crores)
Financing policy
Conservative Moderate Aggressive
Current Ratio 7.80 7.80 7.80
= = 1.35 = = 1.17 = = 1.02
5.76 6.68 7.68
Current Assets
=
Current Liabilities

Advise: It is advisable to adopt aggressive financial policy, if the company wants high return as the return
on owner's equity is maximum in this policy i.e. 26.44%.

Q.7 All Ratios RTP Nov 19

The following is the Profit and loss account and Balance sheet of KLM LLP.

Trading and Profit & Loss Account

Particulars Amount (` ) Particulars Amount (` )
T o Opening stock 12,46,000 By Sales 1,96,56,000
T o Purchases 1,56,20,000 By Closing stock 14,28,000
T o Gross profit c/d 42,18,000
2,10,84,000 2,10,84,000
By Gross profit b/d 42,18,000
T o Administrative expenses 18,40,000 By Interest on investment 24,600
T o Selling & distribution expenses 7,56,000 By Dividend received 22,000
T o Interest on loan 2,60,000

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T o Net profit 14,08,600

42,64,600 42,64,600

Balance Sheet as on……….

Capital & Liabilities Amount (` ) Assets Amount (` )
Capital 20,00,000 Plant & machinery 24,00,000
Retained earnings 42,00,000 Building 42,00,000
General reserve 12,00,000 Furniture 12,00,000
T erm loan from bank 26,00,000 Sundry receivables 13,50,000
Sundry Payables 7,20,000 Inventory 14,28,000
Other liabilities 2,80,000 Cash & Bank balance 4,22,000
1,10,00,000 1,10,00,000

You are required to COMPUTE:

Q.1 Gross profit ratio
(ii) Net profit ratio
(iii) Operating cost ratio
(iv) Operating profit ratio
(v) Inventory turnover ratio
(vi) Current ratio
(vii) Quick ratio
(viii) Interest coverage ratio
(ix) Return on capital employed
(x) Debt to assets ratio.

Gross profit 42,18, 000

Ans. (i) Gross profit ratio = x 100 = x `100 = 21.46%
Sales 1,96,56,000
Net profit 14, 08, 600
(ii) Net profit ratio = x 100 = x 100 = 7.17%
Sales 1,96,56,000
Operating cost
(iii) Operating ratio = x 100
Sales
Operating cost = Cost of goods sold + Operating expenses
Cost of goods sold = Sales – Gross profit
= 1,96,56,000 - 42,18,000 = 1,54,38,000
Operating expenses = Administrative expenses + Selling & distribution expenses
= 18,40,000 + 7,56,000 = 25,96,000
1,54, 38, 000 + 25, 96, 000
Therefore, Operating ratio = x 100
1,96,56,000
1, 80, 34, 000
= x 100 = 91.75%
1,96,56,000

(iv) Operating profit ratio = 100 – Operating cost ratio

= 100 – 91.75% = 8.25%

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Cost of goods sold

(v) Inventory turnover ratio =
Average stock
1,54,38,000
=
(14,28,000 + 12,46,000)
2
1, 54, 38, 000
= = 11.55 times
13,37,000

Current assets
(vi) Current ratio =
Current liablities

Current assets = Sundry receivables + Inventory + Cash & Bank balance

= 13,50,000 + 14,28,000 + 4,22,000 = 32,00,000
Current liabilities = Sundry Payables + Other liabilities
= 7,20,000 + 2,80,000 = 10,00,000
32, 00, 000
Current ratio = = 3.2 times
10,00,000

Current assets - Inventories

(vii) Quick Ratio =
Current liablities
32, 00, 000 - 14, 28, 000
= =1.77 times
10,00,000

EBIDT
(viii) Interest coverage ratio =
Interest
Net profit + Interest
=
Interest
14, 08, 600 + 2, 60, 000
= = 6.42 times
2,60,000

EBIT
(ix) Return on capital employed (ROCE) = x 100
Capital employed
Capital employed = Capital + Retained earnings + General reserve + Term loan
= 20,00,000 + 42,00,000 + 12,00,000 + 26,00,000
= 1,00,00,000

16, 68, 600

Therefore, ROCE = x 100 = 16.69%
1,00,00,000

Debts
(x) Debt to assets ratio = x 100
Total assets
26, 00, 000
= x 100 =23.64%
1,10,00,000

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Q.8 Change in current ratio RTP Nov 18

Assuming the current ratio of a Company is 2, STATE in each of the following cases whether the ratio will improve
or decline or will have no change:
(i) Payment of current liability
(ii) Purchase of fixed assets by cash
(iii) Cash collected from Customers
(iv) Bills receivable dishonoured
(v) Issue of new shares

Current Assets (CA)

Ans. Current Ratio = = 2 i.e. 2 : 1
Current Liabilities (CL)
S. Situation Improve/ Decline/ No Reason
No. Change
(i) Payment of Current Ratio will Let us assume CA is ` 2 lakhs & CL is ` 1 lakh. If
Current liability improve payment of Current Liability = `10,000 then, CA = 1,
90,000 CL = 90,000.

1, 90, 000
Current Ratio = = 2.11 : 1. When Current
90,000
Ratio is 2:1 Payment of Current liability will reduce
the same amount in the numerator and denominator.
Hence, the ratio will improve.
(ii) Purchase of Current Ratio will Since the cash being a current asset converted into
Fixed Assets by decline fixed asset, current assets reduced, thus current
cash ratio will fall.
(iii) Cash collected Current Ratio will not Cash will increase and Debtors will reduce. Hence No
from Customers change Change in Current Asset.
(iv) Bills Receivable Current Ratio will not Bills Receivable will come down and debtors will
dishonoured change increase. Hence no change in Current Assets.
(v) Issue of New Current Ratio will As Cash will increase, Current Assets will increase
Shares improve and current ratio will increase.

Q.9 Prepare B/S MTP May 22 (2)

From the following information, you are required to PREPARE a summarised Balance Sheet for
Rudra Ltd. for the year ended 31st March, 2022
Debt Equity Ratio 1:1
Current Ratio 3:1
Acid Test Ratio 8:3
Fixed Asset Turnover (on the basis of sales) 4
Stock Turnover (on the basis of sales) 6
Cash in hand 5,00,000
Stock to Debtor 1:1
Sales to Net Worth 4
Capital to Reserve 1:2
Gross Profit 20% of Cost

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COGS to Creditor 10:1

Interest for entire year is yet to be paid on Long Term loan @ 10% .

Ans. Balance Sheet of Rudra Ltd.

Liabilities Amount (`) Assets Amount (`)

Capital 10,00,000 Fixed Assets 30,00,000
Reserves 20,00,000 Current Assets:
Long Term Loan @ 10% 30,00,000 Stock in Trade 20,00,000
Current Liabilities: Debtors 20,00,000
Creditors 10,00,000 Cash 5,00,000
Other Short-term Current 2,00,000
Liability (Other STCL)
Outstanding Interest 3,00,000
75,00,000 75,00,000

Working Notes:
Let sales be ` x
Balance Sheet of Rudra Ltd.

Liabilities Amount (`) Assets Amount (`)

Capital Fixed Assets x/4
Reserves Current Assets:
Net Worth x/4 Stock in Trade x/6
Long Term Loan @ 10% x/4 Debtors x/6
Cash 5,00,000
Current liabilities:
Creditors x/12
Other Short-term Current Liability
Outstanding Interest
Total Current Liabilities x/9+5,00,000/3
Total Total

x
1 Fixed Asset Turnover = 4 =
Fixed Assets
x
Fixed Assets =
4
x
2. Stock Turnover = 6 =
Stock
x
Stock =
6
x
3. Sales to net worth = 4 =
Net worth
x
net worth =
4

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4. Debt: Equity =1:1

Long Term Loan 1
=
Net worth 1
x
Long term loan = Net worth =
4
5. Gross Profit to Cost = 20%
GP
= 20%
Sales - G P
GP
= 20%
x-GP
GP = 0.2 x – 0.2 GP
1.2 GP = 0.2 x
0.2x
GP =
1.2
GP = x/6
Cost of Goods Sold = x – x/6 = 5/6 x
6. COGS to creditors = 10:1
COGS 10
=
Creditors 1
5x
6 10
=
creditors 1
5x x
Creditors = =
60 12
Stock
7. =1
Debtor
x
Debtor = Stock =
6
8. Current Ratio =3:1
Stock + Debtors + Cash 3
=
Debtor 1
x x
+ + 5,00,000
6 6 = 3
Current Liabilities
x
+ 5,00,000
3 = CL
3
x 5,00,000
CL = +
9 3
9. CA = 3CL
 x 5,00,000 
= 3 + 
9 3 
x
CA = + 5,00,000
3
10. Net worth + Long Term Loan + Current Liability = Fixed Asset + Current Assets
x 5,00,000
x
+
x
+ + = x + x + 5,00,000
4 4 9 3 4 3

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x x x 5,00,000
+ - = 5,00,000 -
4 9 3 3
9x + 4x - 12x 15,00,000 - 5,00,000
=
36 3
x
= 10, 00, 000
36 3
= 1,20,00,000
11. Now, from above calculations, we get,
x 1,20,00,000
-> Fixed Asset = = = 30,00,000
4 4
x 1,20,00,000
-> Stock = = = 20,00,000
6 6
x 1,20,00,000
-> Debtor = = = 20,00,000
6 6
-> Net Worth =x/4 = 30,00,000
Now, Capital to Reserve is 1 : 2
Capital = ` 10,00,000
and, Reserve = ` 20,00,000
x
-> Long Term Loan = = 30,00,000
4
-> Outstanding Interest = 30,00,000×10% = 3,00,000
x 1,20,00,000
-> Creditors = = = 10,00,000
12 12
-> Current Liabilities = Creditors + Other STCL + Outstanding Interest
x 5, 00, 000
= = 10,00,000+ Other STCL + 3,00,000
9 3
1,20,00,000 5, 00, 000
= = 13,00,000+ Other STCL
9 3
15,00,000 = Other STCL + 13,00,000
Other STCL = 2,00,000

Q.10 Analyse
Decisiondecision
on basison ratio of ratio MTP
of basis DecDec
MTP 21 (2)
21 (2)

Jensen and spencer pharmaceutical is in the business of manufacturing pharmaceutical drugs including the
newly invented Covid vaccine. Due to increase in demand of Covid vaccines, the production had increased
at all time high level and the company urgently needs a loan to meet the cash and investment requirements. It
had already submitted a detailed loan proposal and project report to Expo-Impo bank, along with the financial
statements of previous three years as follows:

Statement of Profit and Loss (In ` ‘000)

2018–19 2019–20 2020–21

Sales
Cash 400 960 1,600
Credit 3,600 8,640 14,400
Total sales 4,000 9,600 16,000
Cost of goods sold 2,480 5,664 9,600
Gross profit 1,520 3,936 6,400

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Operating expenses:
General, administration, and selling expenses 160 900 2,000
Depreciation 200 800 1,320
Interest expenses (on borrowings) 120 316 680
Profit before tax (PBT) 1,040 1,920 2,400
Tax @ 30% 312 576 720
Profit after tax (PAT) 728 1,344 1,680

BALANCE SHEET (In ` ‘000)

2018–19 2019–20 2020–21
Assets
Non-Current Assets
Fixed assets (net of depreciation) 3,800 5,000 9,400
Current Assets
Cash and cash equivalents 80 200 212
Accounts receivable 600 3,000 4,200
Inventories 640 3,000 4,500
Total 5,120 11,200 18,312
Equity & Liabilities
Equity share capital (shares of ₹10 each) 2,400 3,200 4,000
Other Equity 728 2,072 3,752
Non-Current borrowings 1,472 2,472 5,000
Current liabilities 520 3,456 5,560
Total 5,120 11,200 18,312

INDUSTRY AVERAGE OF KEY RATIOS

Ratio Sector Average
Current ratio 2.30:1
Acid test ratio (quick ratio) 1.20:1
Receivable turnover ratio 7 times
Inventory turnover ratio 4.85 times
Long-term debt to total debt 24%
Debt-to-equity ratio 35%
Net profit ratio 18%
Return on total assets 10%
Interest coverage ratio (times interest earned) 10

As a loan officer of Expo-Impo Bank, you are REQUIRED to apprise the loan proposal on the basis of comparison
with industry average of key ratios considering closing balance for accounts receivable of ` 6,00,000 and
inventories of ` 6,40,000 respectively as on 31st March, 2018.

Ans. (In ` ‘000)

Ratio Formula 2018–19 2019–20 2020–21 Industry

Average
Current Ratio Current assets 1, 320 6, 200 8, 912 2.30:1
Current liabilities 520 3,456 5,560
= 2.54 = 1.80 = 1.60

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Acid test ratio Quick Assets 680 3, 200 4, 412 1.20:1

(quick ratio) Current Liabilities 520 3,456 5,560
= 1.31 = 0.93 = 0.79
Receivable Credit Sales 3,600 8,640 14,400 7 times
turnover ratio Average Accounts (600+600)/2 (600+ (3,000+
Receivable 3,000)/2 4,200)/2
=6 = 4.80 =4
Inventory COGS 2,480 5,664 9,600 4.85 times
turnover ratio Average Inventory (640+640)/2 (640+ (3,000+
3,000)/2 4,500)/2
= 3.88 = 3.11 = 2.56
Long-term debt Long term Debt × 100 1, 472 × 100 2, 472 × 100 5, 000 × 100 24%
to total debt Total Debt 1,992 5,928 10,560
= 73.90% = 41.70% = 47.35%
Debt-to- Long term Debt ×100 1, 472 × 100 2, 472 × 100 5, 000 × 100 35%
equity ratio Shareholders' Equity 3,128 5,272 7,752
= 47.06% = 46.89%
= 64.50%
Net profit Net Profit ×100 728 × 100 1, 344 × 100 1, 680 × 100 18%
ratio Sales 4,000 9,600 16,000
= 18.2% = 14%
= 10.5%
Return on Net Profit after 728 × 100 1, 344 × 100 1, 680 × 100 10%
total assets taxes ×100 5,120 11,200 18,312
Total assets = 14.22% = 12%
= 9.17%

Interest EBIT 1,160 2, 236 3, 080 10

coverage Interest 120 316 680
ratio (times = 9.67
= 7.08 = 4.53
interest
earned)

Conclusion:

In the last two years, the current ratio and quick ratio are less than the ideal ratio (2:1 and 1:1 respectively)
indicating that the company is not having enough resources to meet its current obligations. Receivables are
growing slower. Inventory turnover is slowing down as well, indicating a relative build-up in inventories or increased
investment in stock. High Long-term debt to total debt ratio and Debt to equity ratio compared to that of industry
average indicates high dependency on long term debt by the company. The net profit ratio is declining
substantially and is much lower than the industry norm. Additionally, though the Return on Total Asset(ROTA) is
near to industry average, it is declining as well. The interest coverage ratio measures how many times a company
can cover its current interest payment with its available earnings. A high interest coverage ratio means that an
enterprise can easily meet its interest obligations, however, it is declining in the case of Jensen & Spencer and
is also below the industry average indicating excessive use of debt or inefficient operations.

On overall comparison of the industry average of key ratios than that of Jensen & Spencer, the company is in
deterioration position. The company’s profitability has declined steadily over the period. However, before
jumping to the conclusion relying only on the key ratios, it is pertinent to keep in mind the industry, the company

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dealing in with i.e. manufacturing of pharmaceutical drugs. The pharmaceutical industry is one of the major
contributors to the economy and is expected to grow further. After the covid situation, people are more cautious
towards their health and are going to spend relatively more on health medicines. Thus, while analysing the loan
proposal, both the factors, financial and non-financial, needs to be kept in mind.

Q.11 All Ratios ICAI MAT

Following is the abridged Balance Sheet of Alpha Ltd.:

Liabilities ` Assets ` `
Share Capital 1,00,000 Land and Buildings 80,000
Profit and Loss Account 17,000 Plant and Machineries 50,000
Current Liabilities 40,000 Less: Depreciation 15,000 35,000
1,15,000
Stock 21,000
Receivables 20,000
Bank 1,000 42,000
Total 1,57,000 Total 1,57,000

With the help of the additional information furnished below, you are required to

PREPARE Trading and Profit & Loss Account and Balance Sheet as at 31st March, 2023:

(i) The company went in for re-organisation of capital structure, with share capital remaining the same
as follows:
Share capital 50%
Other Shareholders’ funds 15%
5% Debentures 10%
Current Liabilities 25%
Debentures were issued on 1st April, interest being paid annually on 31st March.
(ii) Land and Buildings remained unchanged. Additional plant and machinery has been bought and a further `
5,000 depreciation was written off.
(The total fixed assets then constituted 60% of total fixed and current assets.)
(iii) Working capital ratio was 8 : 5.
(iv) Quick assets ratio was 1 : 1.
(v) The receivables (four-fifth of the quick assets) to sales ratio revealed a credit period of 2 months. There
were no cash sales.
(vi) Return on net worth was 10%.
(vii) Gross profit was at the rate of 15% of selling price. (viii) Stock turnover was eight times for the year.
Ignore Taxation.

Ans.

Particulars % (` )
Share capital (given to be same) 50% 1,00,000
Other shareholders funds 15% 30,000
5% Debentures 10% 20,000

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Current Liabilities 25% 50,000

Total (1,00,000 / 50%) 100% 2,00,000

Calculation of Assets
Total liabilities = Total Assets
` 2,00,000 = Total Assets
Fixed Assets = 60% of total fixed assets and current assets
= ` 2,00,000 60/100 = ` 1,20,000
Current Assets = Total Assets – Fixed Assets
= ` 2,00,000 – ` 1,20,000 = ` 80,000

Calculation of additions to Plant & Machinery

`
Total fixed assets 1,20,000
Less: Land & Buildings 80,000
Plant and Machinery (after providing depreciation) 40,000
Less: Existing Plant & Machinery (after extra 30,000
depreciation of ₹ 5,000) i.e. 50,000 – 20,000
Addition to the Plant & Machinery 10,000

Calculation of stock
Currentassets − stock
Quick ratio: = =1
Current liabilities
`80, 000 − stock
= =1
50, 000
` 50,000 = ` 80,000 – Stock
Stock = ` 80,000 - ` 50,000
= ` 30,000

Receivables = 4/5th of quick assets

= (` 80,000 – ` 30,000) x 4/5
= ` 40,000
Receivables
Receivables turnover = × 12Months = 2 months
Credit Sales
40, 000  12
= = 2 months
Credit Sales
2×credit sales = 4,80,000
Credit sales = 4,80,000/2
= ` 2,40,000 = Total Sales (As there were no cash sales)
Gross profit = 15% of sales = ` 2,40,000 x 15/100 = ` 36,000

Return on net worth (net profit)

Net worth = ` 1,00,000 + ` 30,000
= ` 1,30,000
Net profit = ` 1,30,000 x 10/100 = ` 13,000

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Debenture interest = ` 20,000 x 5/100 = ` 1,000

Projected profit and loss account for the year ended 31st March, 2023
Particulars ` Particulars `
To cost of goods sold 2,04,000 By sales 2,40,000
To gross profit 36,000
2,40,000 2,40,000
To debenture interest 1,000 By gross profit 36,000
To administration 22,000
and other expenses
(bal. fig.)

To net profit 13,000

36,000 36,000

Projected Balance Sheet as at 31st March, 2023

Liabilities ` Assets `
Share capital 1,00,000 Fixed assets:
Profit and loss A/c 30,000 Land & buildings 80,000
(17,000+13,000) Plant & machinery 60,000
5% Debentures 20,000 Less: Depreciation 20,000 40,000
Current liabilities 50,000 Current assets
30,000
Stock
40,000
Receivables 10,000
Bank
80,000

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2 LEVERAGE
CHAPTER

Q.1 PL Statement PY Nov 22

The following information is available for SS Ltd.

Profit volume (PV) ratio 30%
Operating leverage 2.00
Financial leverage 1.50
Loan ` 1,25,000
Post-tax interest rate 5.6%
Tax rate 30%
Market Price per share (MPS) ` 140
Price Earnings Ratio (PER) 10
You are required to:
(1) Prepare the Profit-Loss statement of SS Ltd. and
(2) Find out the number of equity shares.

Ans. (1) Preparation of Profit – Loss Statement

Working Notes:
1. Post tax interest 5.60%
Tax rate 30%
Pre tax interest rate = (5.6/70) x 100 8%
Loan amount ` 1,25,000
Interest amount = 1,25,000 x 8% ` 10,000

 EBIT   EBIT   EBIT 

Financial Leverage (FL) =  =  =  
 EBT   (
 EBIT – Interest ) 
 (
 EBIT − 10, 000
 ) 

 EBIT 
1.5 =  
 (
 EBIT − 10, 000 ) 

1.5 EBIT -15000 = EBIT
1.5 EBIT – EBIT = 15,000
0.5 EBIT = 15,000
EBIT = ` 30,000
EBT = EBIT – Interest = 30,000 – 10,000 = ` 20,000

Contribution
2. Operating Leverage (OL) =
EBIT
Contribution
2 =
30, 000
Contribution = ` 60,000

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3., Fixed cost = Contribution – Profit

= 60,000 – 30,000 = ` 30,000

Contribution
4., Sales =
PV Ratio
60, 000
= = ` 2,00,000
30%

5. If PV ratio is 30%, then the variable cost is 70% on sales.

Variable cost = 2,00,000 x 70% = ` 1,40,000

Profit – Loss Statement

Particulars `
Sales 2,00,000
Less: Variable cost 1,40,000
Contribution 60000
Less: Fixed cost 30,000
EBIT 30,000
Less: Interest 10,000
EBT 20,000
Less: Tax @ 30% EAT 6,000
14,000

(2) Calculation of no. of Equity shares

Market Price per Share (MPS) = `140
Price Earnings Ratio (PER) = 10
WKT,
MPS 140
EPS = = = ` 14
PER 10
Total earnings (EAT) = ` 14,000
No. of Equity Shares = 14,000 / 14 = 1000

Q.2 % change in EPS / PL / FL / CL PY Dec 21

Information of A Ltd. is given below:

• Earnings after tax: 5% on sales
• Income tax rate: 50%
• Degree of Operating Leverage: 4 times
• 10% Debenture in capital structure: ` 3 lakhs
• Variable costs: ` 6 lakhs
Required:
(i) From the given data complete following statement:
Sales XXXX
Less: Variable costs ` 6,00,000

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Contribution XXXX
Less: Fixed costs XXXX
EBIT XXXX
Less: Interest expenses XXXX
EBT XXXX
Less: Income tax XXXX
EAT XXXX

(ii) Calculate Financial Leverage and Combined Leverage.

(iii) Calculate the percentage change in earning per share, if sales increased by 5%.

Ans. (i) Working Notes

Earning after tax (EAT) is 5% of sales
Income tax is 50%
So, EBT is 10% of Sales
Since Interest Expenses is ` 30,000
EBIT = 10% of Sales + `30,000 ……………………………. (Equation i)
Now Degree of operating leverage = 4
Contribution
So, =4
EBIT
Or, Contribution = 4 EBIT
Or, Sales – Variable Cost = 4 EBIT
Or, Sales – ` 6,00,000 = 4 EBIT ……………………………… (Equation ii)
Replacing the value of EBIT of equation (i) in Equation (ii)
We get, Sales – ` 6,00,000 = 4 (10% of Sales + ` 30,000)
Or, Sales – ` 6,00,000 = 40% of Sales + ` 1,20,000
Or, 60% of Sales = ` 7,20,000
7,20,000
So, Sales = =` 12,00,000
60%
Contribution = Sales – Variable Cost = ` 12,00,000 – ` 6,00,000 =` 6,00,000
6, 00, 000
EBIT = = ` 1,50,000
4
Fixed Cost = Contribution – EBIT = ` 6,00,000 – ` 1,50,000 = ` 4,50,000
EBT = EBIT – Interest = ` 1,50,000 – ` 30,000 = ` 1,20,000
EAT = 50% of ` 1,20,000 = ` 60,000

Income Statement
Particulars (`)
Sales 12,00,000
Less: Variable cost 6,00,000
Contribution 6,00,000
Less: Fixed cost 4,50,000
EBIT 1,50,000
Less: Interest 30,000

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EBT 1,20,000
Less: Tax (50%) 60,000
EAT 60,000

EBIT 1,50, 000

(ii) Financial Leverage = = = 1.25 times
EBT 1,20, 000
Combined Leverage = Operating Leverage × Financial Leverage
= 4 x 1.25 = 5 times
Or,
Contribution EBIT
Combined Leverage = x
EBIT EBT
Contribution 6, 00, 000
Combined Leverage = = = 5 times
EBIT 1,20, 000
(iii) Percentage Change in Earnings per share
% Change in EPS % Change in EPS
Combined Leverage = =
% change in Sales 5%
% Change in EPS = 25%
Hence, if sales increased by 5 %, EPS will be increased by 25 %.

Q.3 % change in EBIT PY Nov 20

The following data is available for Stone Ltd. : (`)
Sales 5,00,000
(-) Variable cost @ 40% 2,00,000
Contribution 3,00,000
(-) Fixed cost 2,00,000
EBIT 1,00,000
(-) Interest 25,000
Profit before tax 75,000

Using the concept of leverage, find out

(i) The percentage change in taxable income if EBIT increases by 10%.
(ii) The percentage change in EBIT if sales increases by 10%.
(iii) The percentage change in taxable income if sales increases by 10%.
Also verify the results in each of the above case.

EBIT 1, 00, 000

Ans. (i) Degree of Financial Leverage = = = 1.333 times
EBT 75, 000
So, If EBIT increases by 10% then Taxable Income (EBT) will be increased by 1.333 × 10 = 13.33% (approx.)
Verification
Particulars Amount (`)
New EBIT after 10% increase (` 1,00,000 + 10%) 1,10,000
Less: Interest 25,000
Earnings before Tax after change (EBT) 85,000
Increase in Earnings before Tax = ` 85,000 - ` 75,000 = ` 10,000

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1, 00, 000
So, percentage change in Taxable Income (EBT) = x 100 = 13.333%, hence verified
75, 000

Contribution 3, 00, 000

(ii) Degree of Operating Leverage = = = 3 times
EBIT 1, 00, 000
So, if sale is increased by 10% then EBIT will be increased by 3 × 10 = 30%

Verification
Particulars Amount (`)
New Sales after 10% increase (` 5,00,000 + 10%) 5,50,000
Less: Variable cost (40% of ` 5,50,000) 2,20,000
Contribution 3,30,000
Less: Fixed costs 2,00,000
Earnings before interest and tax after change (EBIT) 1,30,000

Increase in Earnings before interest and tax (EBIT) = ` 1,30,000 - ` 1,00,000 = ` 30,000
30, 000
So, percentage change in EBIT = x 100 = 30%, hence verified.
1, 00, 000

Contribution 3, 00, 000

(iii) Degree of Combined Leverage = = = 4 times
EBIT 75, 000
So, if sale is increased by 10% then Taxable Income (EBT) will be increased by 4 × 10 = 40%

Verification
Particulars Amount (`)
New Sales after 10% increase (` 5,00,000 + 10%) 5,50,000
Less: Variable cost (40% of ` 5,50,000) 2,20,000
Contribution 3,30,000
Less: Fixed costs 2,00,000
Earnings before interest and tax (EBIT) 1,30,000
Less: Interest 25,000
Earnings before tax after change (EBT) 1,05,000

Increase in Earnings before tax (EBT) = ` 1,05,000 - ` 75,000 = ` 30,000

30, 000
So, percentage change in Taxable Income (EBT) = x 100 = 40%, hence verified
75, 000

Q.4 EPS / FL RTP Nov 22

Debu Ltd. currently has an equity share capital of ` 1,30,00,000 consisting of 13,00,000 Equity shares. The
company is going through a major expansion plan requiring to raise funds to the tune of ` 78,00,000. To finance
the expansion the management has following plans:
Plan-I : Issue 7,80,000 Equity shares of ` 10 each.
Plan-II : Issue 5,20,000 Equity shares of ` 10 each and the balance through long-term borrowing at 12% interest
p.a.
Plan-III : Issue 3,90,000 Equity shares of ` 10 each and 39,000, 9% Debentures of ` 100 each.

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Plan-IV : Issue 3,90,000 Equity shares of ` 10 each and the balance through 6% preference shares.
EBIT of the company is expected to be ` 52,00,000 p.a.
Considering corporate tax rate @ 40%, you are required to-
(i) CALCULATE EPS in each of the above plans.
(ii) ASCERTAIN financial leverage in each plan and comment.

Ans.
Sources of Capital Plan I Plan II Plan III Plan IV
Present Equity Shares 13,00,000 13,00,000 13,00,000 13,00,000
New Issue 7,80,000 5,20,000 3,90,000 3,90,000
Equity share capital (`) 2,08,00,000 1,82,00,000 1,69,00,000 1,69,00,000
No. of Equity shares 20,80,000 18,20,000 16,90,000 16,90,000
12% Long term loan (`) − 26,00,000 − −
9% Debentures (`) − − 39,00,000 −
6% Preference Shares (`) − − − 39,00,000

Computation of EPS and Financial Leverage

Sources of Capital Plan I Plan II Plan III Plan IV
EBIT (`) 52,00,000 52,00,000 52,00,000 52,00,000
Less: Interest on 12% Loan (`) − 3,12,000 − −
Less: Interest on 9% debentures (`) − − 3,51,000 −
EBT (`) 52,00,000 48,88,000 48,49,000 52,00,000
Less: Tax@ 40% 20,80,000 19,55,200 19,39,600 20,80,000
EAT (`) 31,20,000 29,32,800 29,09,400 31,20,000
Less: Preference Dividends (`) − − − 2,34,000
(a) Net Earnings available for equity shares (`) 31,20,000 29,32,800 29,09,400 28,86,000

(b) No. of equity shares 20,80,000 18,20,000 16,90,000 16,90,000

(c) EPS (a / b) (`) 1.50 1.61 1.72 1.71
 EBIT  1.00 1.06 1.07 1.08*
Financial leverage  
 EBT 
 
 
 
EBIT
* Financial Leverage in the case of Preference dividend =  
  
 EBIT – Interest −  Dp
( ) 


 1 − t
 ( ) 

 
 
 
 52,00,000  =  52,00,000  = 1.08
  2, 34, 000    48,10, 000 
(
 52,00,000 – 0 −  ) 


(
 1 − 40  
  )

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Q.5 PL Statement RTP May 22

Company P and Q are having same earnings before tax. However, t he margin of safety of Company P is 0.20 and,
for Company Q, is 1.25 times than that of Company P. The interest expense of Company P is ` 1,50,000 and, for
Company Q, is 1/3rd less than that of Company P. Further, the financial leverage of Company P is 4 and, for
Company Q, is 75% of Company P.

Other information is given as below:

Particulars Company P Company Q

Profit volume ratio 25% 33.33%
Tax rate 45% 45%

You are required to PREPARE Income Statement for both the companies.

Ans. Income Statement

Particulars Company P (`) Company Q (`)
Sales 40,00,000 18,00,000
Less: Variable Cost 30,00,000 12,00,000
Contribution 10,00,000 6,00,000
Less: Fixed Cost 8,00,000 4,50,000
EBIT 2,00,000 1,50,000
Less: Interest 1,50,000 1,00,000
EBT 50,000 50,000
Tax (45%) 22,500 22,500
EAT 27,500 27,500

Workings:
(i) Margin of Safety
For Company P = 0.20
For Company Q = 0.20 x 1.25 = 0.25
(ii) Interest Expenses
For Company P = ` 1,50,000
For Company Q = ` 1,50,000 (1-1/3) = ` 1,00,000
(iii) Financial Leverage
For Company P = 4
For Company Q = 4 x 75% = 3
(iv) EBIT
For Company A
Financial Leverage = EBIT/(EBIT- Interest)
4 = EBIT/(EBIT- ` 1,50,000)
4EBIT – ` 6,00,000 = EBIT
3EBIT = ` 6,00,000
EBIT = ` 2,00,000
For Company B
Financial Leverage = EBIT/(EBIT - Interest)
3 = EBIT/(EBIT – ` 1,00,000)
3EBIT – ` 3,00,000 = EBIT
2EBIT EBIT = ` 3,00,000
Contribution = ` 1,50,000

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(v) For Company A

Operating Leverage
= 1/Margin of Safety
Operating Leverage = 1/0.20 = 5
5 = Contribution/EBIT
Contribution = Contribution/` 2,00,000

For Company B = ` 10,00,000

Operating Leverage
= 1/Margin of Safety
Operating Leverage = 1/0.25 = 4
4 = Contribution/EBIT
Contribution = Contribution/` 1,50,000
Sales = ` 6,00,000

(vi) For Company A

Profit Volume Ratio = 25%
Profit Volume Ratio = Contribution/Sales 100
25% = ` 10,00,000/Sales
Sales = ` 10,00,000/25%
Sales = ` 40,00,000
For Company B
Profit Volume Ratio = 33.33%
Therefore, Sales = ` 6,00,000/33.33%
Sales = ` 18,00,000

Q.6 OL & Beta theory RTP Nov 19

The following summarises the percentage changes in operating income, percentage changes in revenues, and
betas for four listed firms.
Firm Change in revenue Change in operating income Beta
A Ltd. 35% 22% 1.00
B Ltd. 24% 35% 1.65
C Ltd. 29% 26% 1.15
D Ltd. 32% 30% 1.20

Required:
(i) CALCULATE the degree of operating leverage for each of these firms. Comment also.
(ii) Use the operating leverage to EXPLAIN why these firms have different beta.

%Change in Operating income

Ans. (i) Degree of operating leverage =
%Change in Revenues
A Ltd. = 0.22 / 0.35 = 0.63
B Ltd. = 0.35 / 0.24 = 1.46
C Ltd. = 0.26 / 0.29 = 0.90
D Ltd. = 0.30 / 0.32 = 0.94
It is level specific.
(ii) High operating leverage leads to high beta. So when operating leverage is lowest i.e.
0.63, Beta is minimum (1) and when operating leverage is maximum i.e. 1.46, beta is highest i.e. 1.65

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Q.7 EPS / OL / FL / CL RTP May 19

A Company had the following Balance Sheet as on March 31, 2019:
Equity and Liabilities (` in crore) Assets (` in crore)
Equity Share Capital Fixed Assets (Net) 250
(10 crore shares of ` 10 each) 100
Reserves and Surplus 20 Current Assets 150
15% Debentures 200
Current Liabilities 80
400 400

The additional information given is as under:

Fixed Costs per annum (excluding interest) ` 80 crores
Variable operating costs ratio 65%
Total Assets turnover ratio 2.5
Income-tax rate 40%
Required:
CALCULATE the following and comment:
(i) Earnings per share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage.

Ans. Total Assets = ` 400 crores

Asset Turnover Ratio = 2.5
Hence, Total Sales = 400 x 2.5 = ` 1,000 crores

Computation of Profits after Tax (PAT)

(` in crore)
Sales 1,000
Less: Variable operating cost (65% of `1,000 crore) (650)
Contribution 350
Less: Fixed cost (other than Interest) (80)
EBIT 270
Less: Interest on debentures (15% `200 crore) (30)
EBT 240
Less: T ax 40% (96)
EAT (earnings available to equity share holders) 144

(i) Earnings per share (EPS)

144 crores
EPS = = ` 14.40
10 crore equity shares

(ii) Operating Leverage

Contribution 350
Operating leverage = = = 1.296
EBIT 270
It indicates sensitivity of earnings before interest and tax (EBIT) to change in sales at a particular level.

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(iii) Financial Leverage

270
Financial Leverage = EBIT = = 1.125
EBT 240
The financial leverage is very comfortable since the debt service obligation is small vis-à-vis EBIT.

(iv) Combined Leverage

Contribution EBIT
Combined Leverage = x EBIT
EBIT EBT

Or, Operating Leverage × Financial Leverage = 1.296 x 1.125 = 1.458

The combined leverage studies the choice of fixed cost in cost structure and choice of debt in capital
structure. It studies how sensitive the change in EPS is vis-à-vis change in sales.

Q.8 ROI / EPS / OL / FL / CL RTP Nov 18

A firm has sales of ` 75,00,000 variable cost is 56% and fixed cost is` 6,00,000. It has a debt of ` 45,00,000
at 9% and equity of ` 55,00,000. You are required to INTERPRET:
(i) The firm’s ROI?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose capital turnover is 3, does it have a high or low capital turnover?
(iv) The operating, financial and combined leverages of the firm?
(v) If the sales is increased by 10% by what percentage EBIT will increase?
(vi) At what level of sales the EBT of the firm will be equal to zero?
(vii) If EBIT increases by 20%, by what percentage EBT will increase?

Ans. Income Statement

Particulars Amount (`)
Sales 75,00,000
Less: Variable cost (56% of 75,00,000) (42,00,000)
Contribution 33,00,000
Less: Fixed costs (6,00,000)
Earnings before interest and tax (EBIT) 27,00,000
Less: Interest on debt (@ 9% on ` 45 lakhs) (4,05,000)
Earnings before tax (EBT) 22,95,000

EBIT EBIT
(i) ROI = ×100 = ×100
Capital employed Equity + Debt
27, 00, 000
= ×100 = 27%
55, 00, 000 + 45, 00, 000
(ROI is calculated on Capital Employed)

(ii) ROI = 27% and Interest on debt is 9%, hence, it has a favourable financial leverage.
NetSales
(iii) Capital Turnover =
Capital
NetSales 75, 00, 000
Or = = = 0.75
Capital 1, 00, 00, 000
Which is very low as compared to industry average of 3.

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(iv) Calculation of Operating, Financial and Combined leverages

Contribution 33, 00, 000
(a) Operating Leverage = = = 1.22 (approx)
EBIT 27, 00, 000
EBIT 27, 00, 000
(b) Financial Leverage = = = 1.18 (approx)
EBT 22, 95, 000
Contribution 33, 00, 000
(c) Combined Leverage = = = 1.44 (approx)
EBT 22, 95, 000
Or = Operating Leverage × Financial Leverage = 1.22 × 1.18 = 1.44 (approx)

(v) Operating leverage is 1.22. So if sales is increased by 10%. EBIT will be increased by 1.22 × 10 i.e. 12.20%
(approx)
(vi) Since the combined Leverage is 1.44, sales have to drop by 100/1.44 i.e. 69.44% to bring EBT to Zero
Accordingly, New Sales = ` 75,00,000 × (1-0.6944)
= ` 75,00,000 × 0.3056
= ` 22,92,000 (approx)
Hence at `22,92,000 sales level EBT of the firm will be equal to Zero.
(vii) Financial leverage is 1.18. So, if EBIT increases by 20% then EBT will increase by 1.18 × 20 = 23.6%
(approx)

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3 CAPITAL STRUCTURE
CHAPTER

Q.1 Additional capital & MPS max PY May 23

The following information pertains to CIZA Ltd.:

`
Capital Structure:
Equity share capital (` 10 8,00,000
each) Retained earnings 20,00,000
9% Preference share capital (` 100 each) 12,00,000
12% Long-term loan 10,00,000
Interest coverage 8
ratio Income tax rate 30%
Price – earnings ratio 25

The company is proposed to take up an expansion plan, which requires an additional investment of ` 34,50,000.
Due to this proposed expansion, earnings before interest and taxes of the company will increase by ` 6,15,000
per annum. The additional fund can be raised in following manner:
• By issue of equity shares at present market price, or
• By borrowing 16% Long-term loans from bank.
You are informed that Debt-equity ratio (Debt/ Shareholders' fund) in the range of 50% to 80% will bring down
the price-earnings ratio to 22 whereas; Debt-equity ratio over 80% will bring down the price-earnings ratio to
18.
Required:
Advise which option is most suitable to raise additional capital so that the Market Price per Share (MPS) is
maximized.

Ans. Working notes:

(i) Interest Coverage ratio = 8
EBIT EBIT
=8 =8
Interest 1,20, 000
So, EBIT = ` 9,60,000

(ii) Proposed Earnings Before Interest & Tax = 9,60,000 + 6,15,000 = ` 15,75,000

Option 1: Equity option

Debt = ` 10,00,000
Shareholders Fund = 8,00,000+20,00,000+12,00,000+34,50,000 = ` 74,50,000
10, 00, 000
Debt Equity ratio(Debt/Shareholders fund) = = 13.42%
74,50, 000
P/E ratio in this case will be 25 times

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Option 2: Debt option

Debt = 10,00,000+34,50,000 = ` 44,50,000
Shareholders Fund = 8,00,000+20,00,000+12,00,000 = ` 40,00,000

44,50, 000
Debt Equity ratio(Debt/Shareholders fund) = = 111.25%
40, 00, 000

Debt equity ratio has crossed the limit of 80% hence PE ratio in this case will remain at 18 times.
Number of Equity Shares to be issued = ` 34,50,000/ ` 150 = 23,000

(iii) Calculation of Earnings per Share and Market Price per share
Particulars `
Current Earnings Before Interest & Tax 9,60,000
Less: Interest 1,20,000
Earnings Before Tax 8,40,000
Less: Taxes 2,52,000
Earnings After Tax 5,88,000
Less: Preference Dividend (@9%) 1,08,000
Net earnings for Equity shareholders 4,80,000
Number of equity shares 80,000
Earnings Per Share 6
Price-earnings ratio 25
Market Price per share 150

Calculation of EPS and MPS under two financial options

Financial Options
Option I Option II
Particulars
Equity Shares 16% Long Term
Issued (`) Debt Raised (`)
Earnings before interest and Tax (EBIT) 15,75,000 15,75,000
Less: Interest on old debentures @ 12% 1,20,000 1,20,000
Less: Interest on additional loan (new) @ 16% NIL 5,52,000
on ` 34,50,000
Earnings before tax 14,55,000 9,03,000
Less: Taxes @ 30% 4,36,500 2,70,900
(EAT/Profit after tax) 10,18,500 6,32,100
Less: Preference Dividend (@9%) 1,08,000 1,08,000
Net Earnings available to Equity 9,10,500 5,24,100
shareholders
Number of Equity Shares 1,03,000 80,000
Earnings per Share (EPS) 8.84 6.55
Price/ Earnings ratio 25 18
Market price per share (MPS) 221 117.9

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Advise: Equity option has higher Market Price per Share therefore company should raise additional fund
through equity option.
Q.1
Q.2 Additional Capital & EPS max PY May 22

. The particulars relating to Raj Ltd. for the year ended 31st March, 2022 are given as follows:
Output (units at normal capacity) 1,00,000
Selling price per unit ` 40
Variable cost per unit ` 20
Fixed cost ` 10,00,000

The capital structure of the company as on 31st March, 2022 is as follows:

Particulars Amount in `
Equity share capital (1,00,000 shares of ` 10 each) 10,00,000
Reserves and surplus 5,00,000
Current liabilities 5,00,000
Total 20,00,000

Raj Ltd. has decided to undertake an expansion project to use the market potential that will involve ` 20 lakhs.
The company expects an increase in output by 50%. Fixed cost will be increased by ` 5,00,000 and variable cost
per unit will be decreased by 15%. The additional output can be sold at the existing selling price without any
adverse impact on the market.

The following alternative schemes for financing the proposed expansion program are planned:
(Amount in `)
Alternative Debt Equity Shares
1 5,00,000 Balance
2 10,00,000 Balance
3 14,00,000 Balance

Current market price per share is ` 200.

Slab wise interest rate for fund borrowed is as follows:
Fund limit Applicable interest rate
Up-to ` 5,00,000 10%
Over` 5,00,000 and up-to ` 10,00,000 15%
Over ` 10,00,000 20%

Find out which of the above-mentioned alternatives would you recommend for Raj Ltd. with reference to the
EPS, assuming a corporate tax rate is 40%?

Ans.
Alternative 1 = Raising Debt of ` 5 lakh + Equity of ` 15 lakh
Alternative 2 = Raising Debt of ` 10 lakh + Equity of ` 10 lakh
Alternative 3 = Raising Debt of ` 14 lakh + Equity of ` 6 lakh

Calculation of Earnings per share (EPS)

FINANCIAL ALTERNATIVES
Alternative 1 Alternative 2 Alternative 3

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Particulars (`) (`) (`)

Expected EBIT [W. N. (a)] 19,50,000 19,50,000 19,50,000
Less: Interest [W. N. (b)] (50,000) (1,25,000) (2,05,000)
Earnings before taxes (EBT) 19,00,000 18,25,000 17,45,000
Less: Taxes @ 40% 7,60,000 7,30,000 6,98,000
Earnings after taxes (EAT) 11,40,000 10,95,000 10,47,000
Number of shares [W. N. (d)] 1,07,500 1,05,000 1,03,000
Earnings per share (EPS) 10.60 10.43 10.17

Conclusion: Alternative 1 (i.e. Raising Debt of ` 5 lakh and Equity of ` 15 lakh) is recommended which
maximises the earnings per share.

Working Notes (W.N.):

(a) Calculation of Earnings before Interest and Tax (EBIT)

Particulars

Output (1,00,000 + 50%) (A) 1,50,000

Selling price per unit ` 40
Less: Variable cost per unit (` 20 – 15%) ` 17
Contribution per unit (B) ` 23
Total contribution (A x B) ` 34,50,000
Less: Fixed Cost (` 10,00,000 + ` 5,00,000) ` 15,00,000
EBIT ` 19,50,000

(b) Calculation of interest on Debt

Alternative (`) Total (`)

1 (` 5,00,000 x 10%) 50,000
2 (` 5,00,000 x 10%) 50,000
(` 5,00,000 x 15%) 75,000 1,25,000
3 (` 5,00,000 x 10%) 50,000
(` 5,00,000 x 15%) 75,000
(` 4,00,000 x 20%) 80,000 2,05,000

(c) Number of equity shares to be issued

Alternative 1 =
(20, 00, 000 − 5, 00, 000) =
15, 00, 000
= 7,500 shares
200 ( Market price of share ) 200

Alternative 2 =
(20, 00, 000 − 10, 00, 000) =
10, 00, 000
= 5,000 shares
200 ( Market price of share ) 200

Alternative 3 =
(20, 00, 000 − 14, 00, 000) =
6, 00, 000
= 3,000 shares
200 ( Market price of share ) 200

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(d) Calculation of total equity shares after expansion program

Alternative 1 Alternative 2 Alternative 3
Existing no. of shares 1,00,000 1,00,000 1,00,000
Add: issued under 7,500 5,000 3,000
expansion program
Total no. of equity shares 1,07,500 1,05,000 1,03,000

Q.3
Q.1 EPS / Fin. BEP / Indifference PY Nov 20
J Ltd. is considering three financing plans. The-key information is as follows:
(a) Total investment to be raised ` 4,00,000.
(b) Plans showing the Financing Proportion:

Plans Equity Debt Preference Shares

X 100% - -
Y 50% 50% -
Z 50% - 50%

(c) Cost of Debt 10%

(d) Cost of preference shares 10%
(e) Tax Rate 50%
(f) Equity shares of the face value of `10 each will be issued at a premium of ` 10 per share.
(g) Expected EBIT is ` 1,00,000.

You are required to compute the following for each plan :

(i) Earnings per share (EPS)
(ii) Financial break even point
(iii) Indifference Point between the plans and indicate if any of the plans dominate.

Ans
(i) Computation of Earnings per Share (EPS)
Plans X (`) Y (`) Z (`)
Earnings before interest & tax (EBIT) 1,00,000 1,00,000 1,00,000
Less: Interest charges (10% of ` 2,00,000) -- (20,000) --
Earnings before tax (EBT) 1,00,000 80,000 1,00,000
Less: Tax @ 50% (50,000) (40,000) (50,000)
Earnings after tax (EAT) 50,000 40,000 50,000
Less: Preference share dividend (10% of -- -- (20,000)
`2,00,000)
Earnings available for equity shareholders (A) 50,000 40,000 30,000
No. of equity shares (B) Plan X = ` 20,000 10,000 10,000
4,00,000/ ` 20
Plan Y = ` 2,00,000 / ` 20
Plan Z = ` 2,00,000 / ` 20
E.P.S (A B) 2.5 4 3
(ii) Computation of Financial Break-even Points
Financial Break-even point = Interest + Preference dividend/(1 - tax rate)
Proposal ‘X’ =0
Proposal ‘Y’ = ` 20,000 (Interest charges)

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Proposal ‘Z’ = Earnings required for payment of preference share dividend

= ` 20,000 ÷ (1- 0.5 Tax Rate) = ` 40,000
(iii) Computation of Indifference Point between the plans
Combination of Proposals

(a) Indifference point where EBIT of proposal “X” and proposal ‘Y’ is equal
(EBIT )(1 − 0.5) =
(EBIT − )(
`20, 000 1 − 0.5 )
20, 000shares 10, 000shares
0.5 EBIT = EBIT – ` 20,000
EBIT = ` 40,000

(b) Indifference point where EBIT of proposal ‘X’ and proposal ‘Z’ is equal:
(EBIT )(1 − 0.5) = ( )
EBIT 1 − 0.5 − ` 20, 000
20, 000shares 10, 000shares
0.5 EBIT = EBIT- ` 40,000
0.5 EBIT = ` 40,000
40, 000
EBIT = = ` 80,000
0.5

(c) Indifference point where EBIT of proposal ‘Y’ and proposal ‘Z’ are equal
(EBIT −` 20, 000)(1 − 0.5) = (
EBIT 1 − 0.5 ) − ` 20, 000
10, 000shares 10, 000 shares
0.5 EBIT – ` 10,000 = 0.5 EBIT – ` 20,000

There is no indifference point between proposal ‘Y’ and proposal ‘Z’

Analysis: It can be seen that financial proposal ‘Y’ dominates proposal ‘Z’, since the financial break-even-
point of the former is only ` 20,000 but in case of latter, it is ` 40,000. EPS of plan ‘Y’ is also
higher.

Q.4
Q.1 Form of Financing to choose PY Nov 18
Y Limited requires ` 50,00,000 for a new project. This project is expected to yield earnings before
interest and taxes of ` 10,00,000. While deciding about the financial plan, the company considers the objective
of maximizing earnings per' share. It has two alternatives to finance the project - by raising debt ` 5,00,000
or ` 20,00,000 and the balance, in each case, by issuing Equity Shares. The company's share is currently selling
at ` 300, but is expected to decline to ` 250 in case the funds are borrowed in excess of ` 20,00,000. The funds
can be borrowed at the rate of 12 percent upto ` 5,00,000 and at 10 percent over ` 5,00,000. The tax rate
applicable to the company is 25 percent. Which form of financing should the company choose?

Ans. Plan I = Raising Debt of Rs 5 lakh + Equity of Rs 45 lakh.

Plan II = Raising Debt of ` 20 lakh + Equity of ` 30 lakh.

Calculation of Earnings per share (EPS)

Financial Plans
Particulars Plan I Plan II
` `
Expected EBIT 10,00,000 10,00,000
Less: Interest (Working Note 1) (60,000) (2,10,000)

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Earnings before taxes 9,40,000 7,90,000

Less: T axes @ 25% (2,35,000) (1,97,500)
Earnings after taxes (EAT ) 7,05,000 5,92,500
Number of shares (Working Note 2) 15,000 10,000
Earnings per share (EPS) 47 59.25

Financing Plan II (i.e. Raising debt of ` 20 lakh and issue of equity share capital of ` 30 lakh) is the option which
maximises the earnings per share.

Working Notes:
1. Calculation of interest on Debt.
Plan I (` 5,00,000 x 12%) ` 60,000
Plan II (` 5,00,000 x 12%) ` 60,000 ` 2,10,000
(` 15,00,000 x 10%) ` 1,50,000
2. Number of equity shares to be issued

Rs. 45, 00, 000

Plan I: = 15,000 shares
(
Rs. 300 MarketPrice of share )
Rs. 30, 00, 000
Plan II: = 10,000 shares
(
Rs. 300 Market Price ofshare )
(*Alternatively, interest on Debt for Plan II can be 20,00,000 X 10% i.e. ` 2,00,000. accordingly, the
EPS for the Plan II will be `60)

Q.1
Q.5 Interest / EPS MTP Nov 22(2)
Axar Ltd. has a Sales of ` 68,00,000 with a Variable cost Ratio of 60%.

The company has fixed cost of `16,32,000. The capital of the company comprises of 12% long term debt,
`1,00,000 Preference Shares of ` 10 each carrying dividend rate of 10% and 1,50,000 equity shares.

The tax rate applicable for the company is 30%.

At current sales level, DETERMINE the Interest, EPS and amount of debt for the firm if a 25% decline in Sales
will wipe out all the EPS.

Ans. Break Even Sales = ` 6800000×0.75 = ` 51,00,000

Income Statement (Amount in `)
Original Calculation of Interest Now at present
at BEP (backward level
calculation)
Sales 68,00,000 51,00,000 68,00,000
Less: Variable Cost 40,80,000 30,60,000 40,80,000
Contribution 27,20,000 20,40,000 27,20,000
Less: Fixed Cost 16,32,000 16,32,000 16,32,000
EBIT 10,88,000 4,08,000 10,88,000
Less: Interest (EBIT-PBT) ? 3,93,714 3,93,714
PBT ? 14,286(10,000/70%) 6,94,286
Less: Tax @ 30%(or PBT-PAT) ? 4,286 2,08,286

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PAT ? 10,000(Nil+10,000) 4,86,000

Less: Preference Dividend 10,000 10,000 10,000
Earnings for Equity share holders ? Nil (at BEP) 4,76,000
Number of Equity Shares 1,50,000 1,50,000 1,50,000
EPS ? - 3.1733

So Interest=`3,93,714, EPS=`3.1733, Amount of debt=3,93,714/12%=` 32,80,950

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4 CAPITAL STRUCTURE THEORY

CHAPTER

Q.1 MM Hypothesis PY July 21

The details about two companies R Ltd. and S Ltd. having same operating risk are given below:
Particulars R Ltd. S Ltd.
Profit before interest and tax ` 10 lakhs ` 10 lakhs
Equity share capital ` 10 each ` 17 lakhs ` 50 lakhs
Long term borrowings @ 10% ` 33 lakhs -
Cost of Equity (Ke) 18% 15%

You are required to:

(1) Calculate the value of equity of both the companies on the basis of M.M. Approach without tax.
(2) Calculate the Total Value of both the companies on the basis of M.M. Approach without tax.

Ans. (1) Computation of value of equity on the basis of MM approach without tax
Particulars R Ltd. S Ltd.
(` in lakhs) (` in lakhs)
Profit before interest and taxes 10 10
Less: Interest on debt (10% × ` 33,00,000) 3.3 -
Earnings available to Equity shareholders 6.7 10
Ke 18% 15%
Value of Equity 37.222 66.667
(Earnings available to Equity shareholders/Ke)

(1) Computation of total value on the basis of MM approach without tax

Particulars R Ltd. S Ltd.
(` in lakhs) (` in lakhs)
Value of Equity (S) (as calculated above) 37.222 66.667
Debt (D) 33 -
Value of Firm (V) = S + D 70.222 66.667

Q.2 Implied equity rate of PY Jan 21

return
A Limited and B Limited are identical except for capital structures. A Ltd. has 60 per cent debt and 40 per
cent equity, whereas B Ltd. has 20 per cent debt and 80 per cent equity. (All percentages are in market-value
terms.) The borrowing rate for both companies is 8 per cent in a no-tax world, and capital markets are assumed
to be perfect.
(a) (i) If X, owns 3 per cent of the equity shares of A Ltd., determine his return i f the Company has net
operating income of ` 4,50,000 and the overall capitalization rate of the company, (Ko) is 18 percent.
(ii) Calculate the implied required rate of return on equity of A Ltd.

(b) B Ltd. has the same net operating income as A Ltd.

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(i) Calculate the implied required equity return of B Ltd.

(ii) Analyse why does it differ from that of A Ltd.
Ans. (a) Value of A Ltd. = NOI = 4, 50, 000 = 25,00,000
Ko 18%

(i) Return on Shares of X on A Ltd.

Particulars Amount (`)
Value of the company 25,00,000
Market value of debt (60% x ` 25,00,000) 15,00,000
Market value of shares (40% x ` 25,00,000) 10,00,000
Particulars Amount (`)
Net operating income 4,50,000
Interest on debt (8% × ` 15,00,000) 1,20,000
Earnings available to shareholders 3,30,000
Return on 3% shares (3% × ` 3,30,000) 9,900

3,30, 000
(ii) Implied required rate of return on equity of A Ltd. = = 33%
10, 00, 000

(b) (i) Calculation of Implied rate of return of B Ltd.

Particulars Amount (`)
Total value of company 25,00,000
Market value of debt (20% × ` 25,00,000) 5,00,000
Market value of equity (80% × ` 25,00,000) 20,00,000
Particulars Amount (`)
Net operating income 4,50,000
Interest on debt (8% × ` 5,00,000) 40,000
Earnings available to shareholders 4,10,000

4,10, 000
Implied required rate of return on equity = = 20.5%
20, 00, 000
(ii) Implied required rate of return on equity of B Ltd. is lower than that of A Ltd. because B Ltd. uses
less debt in its capital structure. As the equity capitalisation is a linear function of the debt-to-
equity ratio when we use the net operating income approach, the decline in required equity return
offsets exactly the disadvantage of not employing so much in the way of “cheaper” debt funds.

Q.3 MM Hypothesis PY Nov 18

The following data relate to two companies belonging to the same risk class :
Particulars A Ltd. B Ltd.
Expected Net Operating Income ` 18,00,000 ` 18,00,000
12% Debt ` 54,00,000 -

Equity Capitalization Rate - 18

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Required:
(a) Determine the total market value, Equity capitalization rate and weighted average cost of capital
for each company assuming no taxes as per M.M. Approach.
(b) Determine the total market value, Equity capitalization rate and weighted average cost of capital for
each company assuming 40% taxes as per M.M. Approach.

Ans. (a) Assuming no tax as per MM Approach.

Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis
Market Value of ‘B Ltd’ [Unlevered(u)]
Total Value of Unlevered Firm (Vu) = [NOI/ke] = 18,00,000/0.18 = ` 1,00,00,000
Ke of Unlevered Firm (given) = 0.18
Ko of Unlevered Firm (Same as above = ke as there is no debt) = 0.18
Market Value of ‘A Ltd’ [Levered Firm (I)]
Total Value of Levered Firm (VL) = Vu + (Debt× Nil) = ` 1,00,00,000 + (54,00,000 × nil)
= `1,00,00,000

Computation of Equity Capitalization Rate and

Weighted Average Cost of Capital (WACC)

Particulars A Ltd. B Ltd.

A. Net Operating Income (NOI) 18,00,000 18,00,000
B. Less: Interest on Debt (I) 6,48,000 -
C. Earnings of Equity Shareholders (NI) 11,52,000 18,00,000
D Overall Capitalization Rate (ko) 0.18 0.18
E T otal Value of Firm (V = NOI/ko) 1,00,00,000 1,00,00,000
F Less: Market Value of Debt 54,00,000 -
G Market Value of Equity (S) 46,00,000 1,00,00,000
H Equity Capitalization Rate [ke = NI /S] 0.2504 0.18
I Weighted Average Cost of Capital [WACC (ko)]* 0.18 0.18

ko = (ke×S/V) + (kd×D/V)

*Computation of WACC A Ltd

Component of Capital Amount Weight Cost of Capital WACC
Equity 46,00,000 0.46 0.2504 0.1152
Debt 54,00,000 0.54 0.12* 0.0648
T otal 81,60,000 0.18

*Kd = 12% (since there is no tax) WACC = 18%

(b) Assuming 40% taxes as per MM Approach

Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis
Market Value of ‘B Ltd’ [Unlevered(u)]
Total Value of unlevered Firm (Vu) = [NOI (1 - t)/ke] = 18,00,000 (1 – 0.40)] / 0.18
= `60,00,000

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Ke of unlevered Firm (given) = 0.18

Ko of unlevered Firm (Same as above = ke as there is no debt) = 0.18
Market Value of ‘A Ltd’ [Levered Firm (I)]
Total Value of Levered Firm (VL) = Vu + (Debt× Tax)
= ` 60,00,000 + (54,00,000 × 0.4)
= ` 81,60,000

Computation of Weighted Average Cost of Capital (WACC) of ‘B Ltd.’

= 18% (i.e. Ke = Ko)

Computation of Equity Capitalization Rate and

Weighted Average Cost of Capital (WACC) of a Ltd

Particulars A Ltd.
Net Operating Income (NOI) 18,00,000
Less: Interest on Debt (I) 6,48,000
Earnings Before T ax (EBT ) 11,52,000
Less: T ax @ 40% 4,60,800
Earnings for equity shareholders (NI) 6,91,200
T otal Value of Firm (V) as calculated above 81,60,000
Less: Market Value of Debt 54,00,000
Market Value of Equity (S) 27,60,000
Equity Capitalization Rate [k e = NI/S] 0.2504
Weighted Average Cost of Capital (ko)* 13.23
ko = (ke×S/V) + (kd×D/V)

*Computation of WACC A Ltd

Component of Capital Amount Weight Cost of Capital WACC
Equity 27,60,000 0.338 0.2504 0.0846
Debt 54,00,000 0.662 0.072* 0.0477
T otal 81,60,000 0.1323

*Kd= 12% (1- 0.4) = 12% × 0.6 = 7.2% WACC = 13.23%

Q.4 MM Hypothesis & Traditional RTP Jul 21

Zordon Ltd. has net operating income of ` 5,00,000 and total capitalization of ` 50,00,000 during the current
year. The company is contemplating to introduce debt financing in capital structure and has various options for
the same. The following information is available at different levels of debt value:
Debt value Interest rate Equity capitalization rate
(`) (%) (%)
0 - 10.00
5,00,000 6.0 10.50
10,00,000 6.0 11.00

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15,00,000 6.2 11.30

20,00,000 7.0 12.40
25,00,000 7.5 13.50
30,00,000 8.0 16.00

Assuming no tax and that the firm always maintains books at book values, you are REQUIRED to calculate:

(i) Amount of debt to be employed by firm as per traditional approach.

(ii) Equity capitalization rate, if MM approach is followed.

Ans. (a) Amount of debt to be employed by firm as per traditional approach

Calculation of Equity, Wd and We
Total Capital Debt Wd Equity value We
(`) (`) (`)
(a) (b) (b)/(a) (c) = (a) - (b) (c)/(a)
50,00,000 0 - 50,00,000 1.0
50,00,000 5,00,000 0.1 45,00,000 0.9
50,00,000 10,00,000 0.2 40,00,000 0.8
50,00,000 15,00,000 0.3 35,00,000 0.7
50,00,000 20,00,000 0.4 30,00,000 0.6
50,00,000 25,00,000 0.5 25,00,000 0.5
50,00,000 30,00,000 0.6 20,00,000 0.4

Statement of Weighted Average Cost of Capital (WACC)

Ke We Kd Wd Ke We KdWd Ko
(1) (2) (3) (4) (5) = (1) x (2) (6) = (3) x (4) (7) = (5) + (6)
0.100 1.0 - - 0.100 - 0.100
0.105 0.9 0.060 0.1 0.095 0.006 0.101
0.110 0.8 0.060 0.2 0.088 0.012 0.100
0.113 0.7 0.062 0.3 0.079 0.019 0.098
0.124 0.6 0.070 0.4 0.074 0.028 0.102
0.135 0.5 0.075 0.5 0.068 0.038 0.106
0.160 0.4 0.080 0.6 0.064 0.048 0.112

So, amount of Debt to be employed = ` 15,00,000 as WACC is minimum at this level of debt i.e. 9.8%.

(b) As per MM approach, cost of the capital (Ko) remains constant and cost of equity increases linearly with
debt.

Value of a firm =
Net Operating Income NOI( )
K0
5, 00, 000
` 50,00,000 =
K0
5, 00, 000
Ko = = 10%
50, 00, 000

Statement of Equity Capitalization rate (ke) under MM approach

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Debt Equity Debt/Equity Ko Kd K o - Kd Ke

(`) (`) = Ko + (Ko -
Kd) Debt Equity

(1) (2) (3) = (1)/(2) (4) (5) (6) = (4) (7) = (4) + (6) x
-(5) (3)
0 50,00,000 0 0.10 - 0.100 0.100
5,00,000 45,00,000 0.11 0.10 0.060 0.040 0.104
10,00,000 40,00,000 0.25 0.10 0.060 0.040 0.110
15,00,000 35,00,000 0.43 0.10 0.062 0.038 0.116
20,00,000 30,00,000 0.67 0.10 0.070 0.030 0.120
25,00,000 25,00,000 1.00 0.10 0.075 0.025 0.125
30,00,000 20,00,000 1.50 0.10 0.080 0.020 0.130

Q.5 Net Income & Net operating RTP May 18

Income approach
Company P and Q are identical in all respects including risk factors except for debt/equity, company P having
issued 10% debentures of ` 18 lakhs while company Q is unlevered. Both the companies earn 20% before interest
and taxes on their total assets of ` 30 lakhs.
Assuming a tax rate of 50% and capitalization rate of 15% from an all-equity company.
Required:
CALCULATE the value of companies’ P and Q using
(i) Net Income Approach and
(ii) Net Operating Income Approach.

Ans. (i) Valuation under Net Income Approach

Particulars P Amount (`) Q Amount (`)
Earnings before Interest & Tax (EBIT) 6,00,000 6,00,000
(20% of ` 30,00,000)
Less: Interest (10% of ` 18,00,000) 1,80,000
Earnings before Tax (EBT) 4,20,000 6,00,000
Less: Tax @ 50% 2,10,000 3,00,000
Earnings after Tax (EAT) 2,10,000 3,00,000
(available to equity holders)
Value of equity (capitalized @ 15%) 14,00,000 20,00,000
(2,10,000 × 100/15) (3,00,000 × 100 /15)
Add: Total Value of debt 18,00,000 Nil
Total Value of Company 32,00,000 20,00,000

(ii) Valuation of Companies under Net Operating Income Approach

Particulars P Amount (`) Q Amount (`)
Capitalisation of earnings at 15% 20,00,000 20,00,000
 (1 − 0.5) 
 
 5 
Less: Value of debt 9,00,000 Nil

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{18,00,000 (1 – 0.5)}
Value of equity 11,00,000 20,00,000
Add: Total Value of debt 18,00,000 Nil
Total Value of Company 29,00,000 20,00,000

Q.6 Traditional Theory MTP May 19(2)

The proportion and required return of debt and equity was recorded for a company with its increased
financial leverage as below:

Debt (%) Required return Equity Required Return Weighted Average Cost of
(Kd) (%) (%) (Ke) (%) Capital (WACC) (Ko)(%)

0 5 100 15 15
20 6 80 16 ?
40 7 60 18 ?
60 10 40 23 ?
80 15 20 35 ?

You are required to complete the table and IDENTIFY which capital structure is most beneficial for this
company. (Based on traditional theory, i.e., capital structure is relevant).

Ans. Computation of Weighted Average Cost of Capital (WACC) for each level of Debt-equity mix.
Debt Required Equity Required return Kd× Proportion of Weighted Average
(%) return (Kd)(%) (%) (Ke) (%) debt + Ke Proportion Cost of Capital
and equity (WACC)(Ko)(%)

0 5 100 15 0%(5%)+100%(15%) 15
2 6 80 16 20%(6%)+80%(16%) 14
0
4 7 60 18 40%(7%)+60%(18%) 13.6
0
6 10 40 23 60%(10%)+40%(23%) 15.2
0
8 15 20 35 80%(15%)+20%(35%) 19
0
The optimum mix is 40% debt and 60% equity, as this will lead to lowest WACC value i.e., 1 3.6%.

Q.7 Arbitrage Process MTP May 23(2)

Following data is available in respect of two companies having same business risk: Capital employed = ` 12,00,000,
EBIT = ` 2,40,000 and Ke = 15%

Sources Dumbo Ltd (`) Jumbo Ltd (`)

Debt (@12%) 4,00,000 Nil
Equity 8,00,000 12,00,000

An investor is holding 20% shares in the levered company. CALCULATE the increase in annual earnings of investor
if arbitrage process is undertaken.
Also EXPLAIN the arbitrage process if Ke = 20% for Dumbo Ltd instead of 15%.

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Ans. (I). Valuation of firms

Particulars Dumbo Ltd (`) Jumbo Ltd (`)
EBIT 2,40,000 2,40,000
Less: Interest on debt (12% × ` 4,00,000) 48,000 Nil
Earnings available to Equity shareholders 1,92,000 2,40,000
Ke 15% 15%
Value of Equity (S) 12,80,000 16,00,000

Debt (D) 4,00,000 Nil

Value of Firm (V) = S + D 16,80,000 16,00,000

Value of Levered company is more than that of unlevered company. Therefore, investor will sell his shares
in levered company and buy shares in unlevered company. To maintain the level of risk he will borrow
proportionate amount and invest that amount also in shares of unlevered company

(II) Investment & Borrowings

`
Sell shares in Levered company (12,80,000 x 20%) 2,56,000
Borrow money (4,00,000 x 20%) 80,000
Buy shares in Unlevered company 3,36,000

(III) Change in Return `

Income from shares in Unlevered company
(2,40,000 x 3,36,000/16,00,000) 50,400
Less: Interest on loan (80,000 x 12%) 9,600
Net Income from unlevered firm 40,800
Less: Income from Levered firm (1,92,000 x 20%) 38,400
Incremental Income due to arbitrage 2,400
Arbitrage process if Ke = 20%

(I). Valuation of firms

Particulars Dumbo Ltd (`) Jumbo Ltd (`)
EBIT 2,40,000 2,40,000
Less: Interest on debt (12% × ` 4,00,000) 48,000 Nil
Earnings available to Equity shareholders 1,92,000 2,40,000
Ke 20% 15%
Value of Equity (S) 9,60,000 16,00,000
(Earnings available to Equity shareholders/K e)
Debt (D) 4,00,000 Nil
Value of Firm (V) = S + D 13,80,000 16,00,000

Value of unlevered company is more than that of levered company. Therefore, investor will sell his shares
in unlevered company and buy proportionate shares and debt in levered company i.e. 20% share.

(II). Investment & Borrowings

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`
Sell shares in unlevered company (16,00,000 x 20%) 3,20,000
Buy shares in levered company (9,60,000 x 20%) 1,92,000
Buy Debt of levered company 1,28,000

(III). Change in Return

`
Income from shares in levered company
(1,92,000 x 20%) 38,400
Add: Interest on debt of levered (1,28,000 x 12%) 15,360
Net Income from levered firm 53,760
Less: Income from unlevered firm (2,40,000 x 20%) 48,000
Incremental Income due to arbitrage 5,760

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5 COST OF CAPITAL
CHAPTER
Q.1 Cost of Debt (Kd) RTP Nov 22

Bounce Ltd. evaluates all its capital projects using discounting rate of 15%. Its capital structure consists of
equity share capital, retained earnings, bank term loan and debentures redeemable at par. Rate of interest
on bank term loan is 1.5 times that of debenture. Remaining tenure of debenture and bank loan is 3 years and 5
years respectively. Book value of equity share capital, retained earnings and bank loan is ` 10,00,000, ` 15,00,000
and ` 10,00,000 respectively. Debentures which are having book value of ` 15,00,000 are currently trading at `
97 per debenture. The ongoing P/E multiple for the shares of the company stands at 5. You are required to
CALCULATE the rate of interest on bank loan and debentures if tax rate applicable is 25%.

Ans. Let the rate of Interest on debenture be x

 Rate of Interest on loan = 1.5x
RV − NP 100 − 97
Int(1 − t ) + 100x (1 − 25) +
n 3 75x + 1
 Kd on debentures = = =
RV + NP 100 + 97 98.5
2 2
 Kd on bank loan= 1.5x (1-0.25) =1.125x
FPS 1 1 1
Ke= = = = = 0.2
MPS MPS EPS P 5
E
KY = Ke = 0.2
Computation of WACC
Capital Amount (`) Weights Cost Product
Equity 10,00,000 0.2 0.2 0.04
Reserves 15,00,000 0.3 0.2 0.06
Debentures 15,00,000 0.3 (75x+1)/98.5 (22.5x + 0.3)/98.5
Bank Loan 10,00,000 0.2 1.125x 0.225x
50,00,000 1 0.1 + 0.225x +
22.5x + 0.3
98.5

WACC = 15%
22.5x 0.3
 0.1 + 0.225x + + = 0.15
98.5 98.5
 9.85+22.1625x+22.5x+0.3=(0.15)(98.5)
 44.6625x=14.775-9.85-0.3
 44.625x-4.625
4.625
x =  x=10.36%
44.6625
 Rate of interest on debenture=x =10.36%
Rate of interest on Bank loan=1.5x = (1.5) (10.36%) = 15.54%

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Q.3 Cost of Debt / Equity / Marginal RTP Jul 21

Indel Ltd. has the following capital structure, which is considered to be optimum as on 31st March, 2021:
Particulars (`)
14% Debentures 60,000
11% Preference shares 20,000
Equity Shares (10,000 shares) 3,20,000
4,00,00

The company share has a market price of ` 47.20. Next year dividend per share is 50% of year 2020 EPS. The
0 which is expected to continue in future.
following is the uniform trend of EPS for the preceding 10 years
Year EPS (`) Year EPS (`)
2011 2.00 2016 3.22
2012 2.20 2017 3.54
2013 2.42 2018 3.90
2014 2.66 2019 4.29
2015 2.93 2020 4.72

The company issued new debentures carrying 16% rate of interest and the current market price of debenture is
` 96. Preference shares of ` 18.50 (with annual dividend of ` 2.22 per share) were also issued. The company is in
30% tax bracket.

The company is in 30% tax bracket.

(A) CALCULATE after tax:

(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (assuming new equity from retained earnings)
(B) CALCULATE marginal cost of capital when no new shares are issued.
(C) DETERMINE the amount that can be spent for capital investment before new ordinary shares must be
sold, assuming that the retained earnings for next year’s investment is 50 percent of earnings of 2020.
(D) COMPUTE marginal cost of capital when the fund exceeds the amount calculated in assuming new equity is
issued at ` 40 per share?

Ans. (A) (i) Cost of new debt

I (1 − t ) 16(1 − 0.3)
Kd= = = 0.11667
P0 96
(ii) Cost of new preference shares
2.22
Kp = = 0.12
18.5

(iii) Cost of new equity shares

D1 2.36
Ke = +g = + 0.10
P0 47.20
Ke = 0.05 + 0.10 = 0.15
Calculation of g when there is a uniform trend (on the basis of EPS)

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EPS(2012) − EPS(2011) 2.20 − 2.00

= = 0.10 or 10%
EPS(2011) 2.00
Calculation of D1
D1 = 50% of 2020 EPS = 50% of ` 4.72 = ` 2.36

(B) Calculation of marginal cost of capital

Type of Capital Proportion Specific Cost Product
(1) (2) (3) (2) × (3) = (4)
Debentures 0.15 0.11667 0.0175
Preference Share 0.05 0.1200 0.0060
Equity Share 0.80 0.1500 0.1200

Marginal cost of capital 0.1435

(C) The company can spend the following amount without increasing marginal cost of capital and without
selling the new shares:
Retained earnings = 50% of EPS of 2020 × outstanding equity shares
= 50% of ` 4.72 × 10,000 shares = ` 23,600
The ordinary equity (Retained earnings in this case) is 80% of total capital
So, ` 23,600 = 80% of Total Capital

(D) If the company spends in excess of ` 29,500, it will have to issue new equity shares at ` 40 per share.
 The cost of new issue of equity shares will be:
D1 `2.36
Ke= +g= + 0.10 = 0.159
P0 `40
The marginal cost of capital will be:

Type of Capital Proportion Specific Cost Product

(1) (2) (3) (2) × (3) =
Debentures 0.15 0.11667 (4) 0.0175

Preference Shares 0.05 0.1200 0.0060

Equity Shares (New) 0.80 0.1590 0.1272

Marginal cost of 0.1507

capital

Q.3 Cost of Debt / Equity / WACC PY Nov 19

A Company wants to raise additional finance of ` 5 crore in the next year. The company expects to retain ` 1crore
earning next year. Further details are as follows:

(i) The amount will be raised by equity and debt in the ratio of 3: 1.

(ii) The additional issue of equity shares will result in price per share being fixed at ` 25.

(iii) The debt capital raised by way of term loan will cost 10% for the first ` 75 lakh and 12% for the next `50
lakh.

(iv) The net expected dividend on equity shares is ` 2.00 per share. The dividend is expected to grow at the

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rate of 5%.

(v) Income tax rate is 25%.

You are required:

(a) To determine the amount of equity and debt for raising additional finance.

(b) To determine the post-tax average cost of additional debt.

(c) To determine the cost of retained earnings and cost of equity.

(d) To compute the overall weighted average cost of additional finance after tax .

Ans (a) Determination of the amount of equity and debt for raising additional finance:
Pattern of raising additional finance
Equity 3/4 of ` 5 Crore = ` 3.75 Crore
Debt 1/4 of ` 5 Crore = ` 1.25 Crore
The capital structure after raising additional finance:
Particulars (` Incrore)

Shareholders’ Funds
Equity Capital (3.75 – 1.00) 2.75
Retained earnings 1.00
Debt (Interest at 10% p.a.) 0.75
(Interest at 12% p.a.) (1.25-0.75) 0.50
Total Funds 5.00
(b) Determination of post-tax average cost of additional debt
Kd = I(1-t)
Where,
I= Interest Rate
t = Corporate tax-rate
On ` 75,00,000= 10% (1 – 0.25) = 7.5% or 0.075
On ` 50,00,000= 12% (1 – 0.25) = 9% or 0.09
Average Cost of Debt
(75, 00, 000x 0.75) + (50, 00, 000x 0.09)
= x 100
1,25, 00, 000
5, 62, 500 + 4, 50, 000
= x 100 = 8.10%
1,25, 00, 000
(c) Determination of cost of retained earnings and cost of equity (Applying Dividend growth model):
D1
Ke= +g
P0
Where,
Ke= Cost of equity
D1= D0(1+g)
D0= Dividend paid (ie= Rs2)
g = Growth rate
P0= Current market price per share

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2(1.05) 2.1
Then, Ke= + 0.05 = + 0.05 = 0.084 + 0.05 = 0.134 = 13.4%
25 25
Cost of retained earnings equals to cost of Equity i.e. 13.4%
(d) Computation of overall weighted average after tax cost of additional finance

Particular (`) Weights Cost of Weighted

funds Cost (%)
Equity (including retained 3,75,00,000 3/4 13.4% 10.05
earnings)
Debt 1,25,00,000 1/4 8.1% 2.025
WACC 5,00,00,000 12.075

Q.4 WACC RTP Nov 18

M/s. Navya Corporation has a capital structure of 40% debt and 60% equity. The company is presently
considering several alternative investment proposals costing less than ` 20 lakhs. The corporation always raises
the required funds without disturbing its present debt equity ratio.

The cost of raising the debt and equity are as under:

Project cost Cost of debt Cost of equity
Upto ` 2 lakhs 10% 12%
Above ` 2 lakhs & upto to ` 5 lakhs 11% 13%
Above ` 5 lakhs & upto `10 lakhs 12% 14%
Above `10 lakhs & upto ` 20 lakhs 13% 14.5%

Assuming the tax rate at 50%, CALCULATE:

(i) Cost of capital of two projects X and Y whose fund requirements are ` 6.5 lakhs and
` 14 lakhs respectively.
(ii) If a project is expected to give after tax return of 10%, DETERMINE under what conditions it would be
acceptable?

Ans. (i) Statement of Weighted Average Cost of Capital

Project cost Financing Proportion of After tax Weighted
capital cost average cost (%)
Structure (1–Tax 50%)
Upto ` 2 Lakhs Debt 0.4 10% (1 – 0.5) 0.4 × 5 = 2.0
= 5%
Equity 0.6 12% 0.6 × 12 = 7.2

9.2%

Above ` 2 lakhs Debt 0.4 11% (1 – 0.5) 0.4 × 5.5 = 2.2

& upto to ` 5 = 5.5%
Lakhs Equity 0.6 13% 0.6 × 13 = 7.8

10.0%
Above ` 5 lakhs Debt 0.4 12% (1 – 0.5) 0.4 × 6 = 2.4

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& upto ` 10 lakhs = 6%

Equity 0.6 14% 0.6 × 14 = 8.4

10.8%
Above ` 10 lakhs Debt 0.4 13% (1 – 0.5) 0.4 × 6.5 = 2.6
& upto ` 20 lakhs = 6.5%
Equity 0.6 14.5% 0.6 × 14.5 = 8.7

11.3%

Project Fund requirement Cost of capital

X `6.5 lakhs 10.8% (from the above table)
Y `14 lakhs 11.3% (from the above table)

(ii) If a Project is expected to give after tax return of 10%, it would be acceptable provided its project cost
does not exceed ` 5 lakhs or, after tax return should be more than or at least equal to the weighted
average cost of capital.

Q.5 WACC PY Nov 22

The following is the extract of the Balance Sheet of M/s KD Ltd.:

Particulars Amount (`)
Ordinary shares (Face Value ` 10/- per share) 5,00,000
Share Premium 1,00,000
Retained Profits 6,00,000
8% Preference Shares (Face Value `25/- per share) 4,00,000
12% Debentures (Face value `100/- each) 6,00,000

22,00,000
The ordinary shares are currently priced at ` 39 ex-dividend and preference share is priced at ` 18 cum-dividend.
The debentures are selling at 120 percent ex-interest. The applicable tax rate to KD Ltd. is 30 percent. KD Ltd.'s
cost of equity has been estimated at 19 percent. Calculate the WACC (weighted average cost of capital) of KD
Ltd. on the basis of market value.

Ans. W.N. 1
Cum-dividend price of Preference shares = ` 18

Less: Dividend (8/100) x 25 =`2

 Market Price of Preference shares = ` 16
2
Kp = = 0.125 (or) 12.5%
16
 4, 00, 000 
No. of Preference shares =   = 16,000
 25 
W.N. 2
 120 
Market price of Debentures =   x 100 = Rs 120
 100 

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 12(1 − 0.3) 
Kd=   = 0.07 (or) 7%
 120 
 6, 00, 000 
No. of Debentures =   = 6,000
 100 

W.N.3
Market Price of Equity shares = Rs 39
Ke (given) = 19% or 0.19
No. of Equity shares = 5, 00, 000 = 50,000

Sources Market Nos. Total Market Weight Cost of Capital Product

Value (`) value (`)
Equity Shares 39 50,000 19,50,000 0.6664 0.19 0.1266
Preference Shares 16 16,000 2,56,000 0.0875 0.125 0.0109
Debentures 120 6,000 7,20,000 0.2461 0.07 0.0172
WACC = 0.1547
WACC = 0.1547 or 15.47%

Q.6 WACC with Market Weights PY May 23

Capital structure of D Ltd. as on 31stMarch, 2023 is given below:
Particulars `
Equity share capital (` 10 each) 30,00,000
8% Preference share capital (` 100 each) 10,00,000
12% Debentures (` 100 each) 10,00,000
• Current market price of equity share is ` 80 per share. The company has paid dividend of
` 14.07 per share. Seven years ago, it paid dividend of ` 10 per share. Expected dividend is ` 16 per share.
• 8% Preference shares are redeemable at 6% premium after five years. Current market price per
preference share is ` 104.
• 12% debentures are redeemable at 20% premium after 10 years. Flotation cost is ` 5 per debenture.
• The company is in 40% tax bracket.
• In order to finance an expansion plan, the company intends to borrow 15% Long-term loan of ` 30,00,000
from bank. This financial decision is expected to increase dividend on equity share from ` 16 per share to
` 18 per share. However, the market price of equity share is expected to decline from ` 80 to ` 72 per
share, because investors' required rate of return is based on current market conditions.
Required:
(i) Determine the existing Weighted Average Cost of Capital (WACC) taking book value weights.
(ii) Compute Weighted Average Cost of Capital (WACC) after the expansion plan taking book value weights.

Interest Rate 1% 2% 3% 4% 5% 6% 7%
FVIFi,5 1.051 1.104 1.159 1.217 1.276 1.338 1.403
FVIFi,6 1.062 1.126 1.194 1.265 1.340 1.419 1.501
FVIFi,7 1.072 1.149 1.230 1.316 1.407 1.504 1.606

Ans (i) (a) Growth rate in Dividends

14.07 = 10 x FVIF (i,7 years)
FVIF (i,7 years) = 1.407
FVIF (5%, 7 years) = 1.407

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i = 5% So, Growth rate in dividend= 5%

(b) Cost of Equity
D1 16
Ke = +g = + 0.05
po 80
(c) Cost of Preference Shares
(RV – NP) (106-104)
PD + 8+
Kp = n = 5
(RV+NP ) (106+104 )
2 2

Kp = 8.4/105 = 8%
(d) Cost of Debt

(RV-NP) (120-95)
I(1-t ) + 12(1 - 0.4+
Kd = n = 5
(RV+NP ) (120+95)
2 2
Kd = (7.2+2.5)/107.5 = 9.02% = 9.02%

Calculation of existing Weighted Average Cost of Capital (WACC)

Capital Amount (`) Weights Cost WACC
Equity Share Capital 30,00,000 0.6 25% 15.00%
Preference Share Capital 10,00,000 0.2 8% 1.60%
Debenture 10,00,000 0.2 9.02% 1.80%
50,00,000 1 18.40%
Alternative presentation
(i) Computation of existing WACC on book value weights
Source (1) Book value Weight Cost of capital Product
(`) (2) (3) (%) (4) (2) x (4)
Equity share capital 30,00,000 0.60 25 7,50,000
Preference share capital 10,00,000 0.20 8 80,000
Debentures 10,00,000 0.20 9.02 90,200
Total 50,00,000 1.00 9,20,200
WACC = (Product / Total book value) x 100 = (9,20,200 /50,00,000) x 100 = 18.4%

(ii) Cost of Long Term Debt = 15% (1-0.4) = 9%

18
Revised Ke = + 0.05 = 30%
72

Calculation of WACC after expansion taking book value weights

Capital Amount Weights Cost W.C
Equity Share Capital 30,00,000 0.3750 30% 11.25%
Preference Share Capital 10,00,000 0.1250 8% 1.00%
Debenture 10,00,000 0.1250 9.02% 1.13%
Long Term Debt 30,00,000 0.3750 9.00% 3.38%
80,00,000 1.0000 16.76%

Alternative presentation

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(i) Computation of WACC on book value weights after expansion

Source (1) Book value Weight Cost of capital Product
(`) (2) (3) (%) (4) (2) x (4)
Equity share capital 30,00,000 0.375 30 9,00,000
Preference share capital 10,00,000 0.125 8 80,000
Debentures 10,00,000 0.125 9.02 90,200
Long term loan 30,00,000 0.375 9 2,70,000
Total 80,00,000 1.00 13,40,200
WACC = (Product / Total book value) x 100 = (13,40,200 / 80,00,000) x 100 = 16.76%

Q.7 MTP Sept 24 (1)

Gitarth Limited has a current debt equity ratio of 3:7. The company is presently considering several alternative
investment proposals costing less than ` 25 lakhs. The company will always raise the funds required without
disturbing its current capital structure ratio.
The cost of raising debt and equity are as follows-
Cost of Project Kd Ke
Upto 5 lakhs 10% 12%
Above 5 lakhs & upto 10 lakhs 12% 13.5%
Above 10 lakhs & upto 20 lakhs 13% 15%
Above 20 lakhs 14% 16%

Corporate tax rate is 30%, CALCULATE:

i) Cut off rate for two Projects I & Project II whose fund requirements are 15 lakhs & ` 26 lakhs respectively.
ii) If a project is expected to give an after-tax return of 13%, determine under what conditions it would be
acceptable.
Ans. Calculation of slab wise Overall Cost of Capital
(i)
Project Cost Capital Weights Cost w x k
Source (w) (k) (%)
Upto 5 Lakhs Debt 0.3 10 3
Equity 0.7 12 8.4
Ko 11.4
Above 5 lakhs upto 10 lakhs Debt 0.3 12 3.6
Equity 0.7 13.5 9.45
Ko 13.05
Above 10 lakhs upto 20 lakhs Debt 0.3 13 3.9
Equity 0.7 15 10.5
Ko 14.4
Above 20 lakhs Debt 0.3 14 4.2
Equity 0.7 16 11.2
Ko 15.4

Cost of Raising funds for Project I

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Total Capital Ko(%) Total Cost (in `)

5,00,000 11.40 57,000
5,00,000 13.05 65,250
5,00,000 14.40 72,000
15,00,000 1,94,250

Overall COC (%) = Total Cost (in `) / Total Capital

= 1,94,250/15,00,000 * 100
= 12.95 %
Cost of Raising funds for Project II

Total Capital Ko(%) Total Cost (in `)

5,00,000 11.4 57,000

5,00,000 13.05 65,250

10,00,000 14.4 1,44,000

6,00,000 15.4 92,400

26,00,000 3,58,650

Overall COC (%) = 358650 / 2600000 * 100 = 13.79%

(ii) If any project is expected to give an after-tax return of 13%, it can be accepted only if the maximum
Overall COC (%) of that project equals 13% or less, as at 13%, project would be at break-even i.e earning
13% from the project and incurring 13% COC.
So, under that scenario, Project I can be taken as its COC is 12.95% whereas Project II can’t be taken as
its COC is 13.79%.
Maximum Value of the Project that can be taken at 13% is approx. (Using IRR technique Interpolation)
At 15 Lakhs Ko = 12.95%
At 26 Lakhs Ko = 13.79%
By interpolation, maximum value of Project at 13% will be 15 Lakhs + {(0.05 x 11)/0.84}
= 15.6548 lakhs

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6 DIVIDEND DECISIONS
CHAPTER
Q.1 Dividend Payout PY May 23
Following information are given for a company:
Earnings per share ` 10
P/E ratio 12.5
Rate of return on investment 12%
Market price per share as per Walter’s Model ` 130

You are required to calculate: (i)

Dividend payout ratio.

(ii) Market price of share at optimum dividend payout ratio.

(iii) P/E ratio, at which the dividend policy will have no effect on the price of share.

(iv) Market price of share at this P/E ratio.

(v) Market price of share using Dividend growth model.

Ans (i) The EPS of the firm is ` 10, r =12%. The P/E Ratio is given at 12.5 and the cost of capital (Ke) may be taken
as the inverse of P/E ratio. Therefore, Ke is 8% (i.e., 1/12.5). The value of the share is ` 130 which may be
equated with Walter Model as follows:
r 12%
D+ (E − D) D+ (10% − D)
ke 8%
P= or p=
Ke 8%
or [D+1.5(10-D)]/0.08=130 or
D+15-1.5D=10.4
or -0.5D=-4.6
So, D = ` 9.2
The firm has a dividend pay-out of 92% (i.e., 9.2/10).
(ii) Since the rate of return of the firm (r) is 12% and it is more than the Ke of 8%,
therefore, by distributing 92% of earnings, the firm is not following an optimal dividend
policy. The optimal dividend policy for the firm would be to pay zero dividend and in
such a situation, the market price would be:
12%
D+ (10% − 0)
P = 8%
8%
P = ` 187.5
So, theoretically the market price of the share can be increased by adopting a zero pay-out.

(iii) The P/E ratio at which the dividend policy will have no effect on the value of the share is such at which the
Ke would be equal to the rate of return (r) of the firm. The Ke would be 12% (= r) at the P/E ratio of
1/12%=8.33. Therefore, at the P/E ratio of 8.33, the dividend policy would have no effect on the value of the
share.
(iv) If the P/E is 8.33 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be 12% and in such a
situation ke= r and the market price, as per Walter’s model would be:

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r 12%
D+ (E − D) 9.2 + (10% − 9.2)
ke 0.12
P = = = ` 83.33
ke 0.12
Dividend Growth Model applying growth on dividend
Ke = 8%, r = 12%, D0 = 9.2, b = 0.08
g = b.r
g = 0.08 x 0.12=0.96%
D1 = D0 (1+g) = 9.2 (1+0.0096) = ` 9.2883
D1
P= = 9.2883/(0.08 – 0.0096) = 9.2883/0.0704 = ` 131.936
(Ke − g )

Alternative
Alternatively, without applying growth on dividend
E(1 − b) 10(1 − 0.08)
P = = = ` 130.68
Ke − br 0.08 − (0.08´ 0.12)

Q.2 MM Approach RTP Dec 21

Aakash Ltd. has 10 lakh equity shares outstanding at the start of the accounting year 2021.

The existing market price per share is ` 150. Expected dividend is ` 8 per share. The rate of capitalization

appropriate to the risk class to which the company belo ngs is 10%.

(i) CALCULATE the market price per share when expected dividends are: (a) declared, and (b) not declared,

based on the Miller – Modigliani approach.

(ii) CALCULATE number of shares to be issued by the company at the end of the accounting year on the

assumption that the net income for the year is ` 3 crore, investment budget is ` 6 crores, when (a) Dividends

are declared, and (b) Dividends are not declared.

(iii) PROOF that the market value of the shares at the end of the accounting year will remain unchanged

irrespective of whether (a) Dividends are declared, or (ii) Dividends are not declared.

Ans (i) Project N.

Calculation of market price per share

According to Miller – Modigliani (MM) Approach:

P1 + D1
Po =
1 + Ke

Where,

Existing market price (Po) = ` 150

Expected dividend per share (D1) =`8

Capitalization rate (ke) = 0.10

Market price at year end (P1) = to be determined

(a) If expected dividends are declared, then

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P1 + 8
` 150 =
1 + 0.10
P1 = ` 157

(b) If expected dividends are not declared, then

P1 + 0
` 150 =
1 + 0.10

P1 = ` 165

(ii) Calculation of number of shares to be issued

(a) (b)

Dividends are Dividends are not

declared (` Declared (` lakh)
lakh)
Net income 300 300

Total dividends (80) -

Retained earnings 220 300

Investment budget 600 600

Amount to be raised by new issues 380 300

Relevant market price (` per share) 157 165

No. of new shares to be issued (in lakh) 2.42 1.82

(` 380 ÷ 157; ` 300 ÷ 165)

(iii) Calculation of market value of the shares

(a) (b)
Dividends are Dividends are
declared not
Declared
Existing shares (in lakhs) 10.00 10.00
New shares (in lakhs) 2.42 1.82
Total shares (in lakhs) 12.42 11.82
Market price per share (`) 157 165
Total market value of shares at 12.42 × 157 11.82 × 165
the end of the year (` in lakh) = 1,950 = 1,950
(approx.) (approx.)
Hence, it is proved that the total market value of shares remains unchanged irrespective of whether
dividends are declared, or not declared.

Q.3 MPS Using Gordon’s Model PY Dec 21

X Ltd. is a multinational company. Current market price per share is ` 2,185. During the F.Y. 2020-21, the company
paid ` 140 as dividend per share. The company is expected to grow @ 12% p.a. for next four years, then 5% p.a.
for an indefinite period. Expected rate of return of shareholders is 18% p.a.
(i) Find out intrinsic value per share.
(ii) State whether shares are overpriced or under priced.

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Year 1 2 3 4 5
Discounting Factor @ 18% 0.847 0.718 0.608 0.515 0.436

Ans As per Dividend discount model, the price of share is calculated as follows:
D1 D2 D3 D4 D (1+g) 1
P= + + + + 4 x
1
(1 + Ke) (1 + Ke)2
(1 + Ke)3
(1 + Ke) 4
(Ke-g) (1 + Ke) 4
Where,

P = Price per share

Ke = Required rate of return on equity

g = Growth rate

140x1.12 156.80 x 1.12 175.62 x1.12 196x1.12 220.29(1 + 0.05) 1

P = + + + + x
(1 + 0.18) 1
(1 + 0.18)2
(1 + 0.18)3
(1 + 0.18) 4
(0.18 − 0.05) (1 + 0.18)
4

P= 132.81 + 126.10 + 119.59 + 113.45 + 916.34 = ` 1,408.29

Intrinsic value of share is ` 1,408.29 as compared to latest market price of

`2,185. Market price of share is over-priced by ` 776.71.

Q.4 Walter & Gordon Model PY May 19

The following information is supplied to you :

Total Earning ` 40 Lakhs

No. of Equity Shares (of ` 100 each) 4,00,000
Dividend Per Share `4
Cost of Capital 16%
Internal rate of return on investment 20%
Retention ratio 60%

Calculate the market price of a share of a company by using :

(i) WaIter’s Formula
(ii) Gordon's Formula

40 Lakhs
Ans Earning Per share(E) = = ` 10
4, 00, 000
Calculation of Market price per share by
r
D+ (E-D)
Ke
(i) Walter’s formula: Market Price (P) =
Ke

Where,

P = Market Price of the share.

E = Earnings per share.

D = Dividend per share.

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Ke = Cost of equity/ rate of capitalization/ discount

rate.
R = Internal rate of return/ return on investment
0.20
4+ (10-4) 4 +7.5
P = 0.16 = = ` 71.88
0.16 0.16
(ii) Gordon’s formula: When the growth is incorporated in earnings and dividend, the present value of market
price per share (Po) is determined as follows
E (1 − b )
Gordon’s theory: Po
k − br
Where,
P0 = Present market price per
share. E = Earnings per share
b = Retention ratio (i.e. % of earnings retained)
r = Internal rate of return
(IRR) Growth rate (g) = br
10 (1 − .60) 4
Now Po = = = ` 100
16 − (.60 x .20) .04

Q.5 FM Nov 23
INFO Ltd is a listed company having share capital of ` 2400 Crores of ` 5 each.
During the year 2022-23
Dividend distributed 1000%
Expected Annual growth rate in dividend 14%
Expected rate of return on its equity capital 18%
Required:
(a) Calculate price of share applying Gordon's growth Model.
(b) What will be the price of share if the Annual growth rate in dividend is only 10%?
(c) According to Gordon's growth Model, if Internal Rate of Return is 25%, then what should be the optimum
dividend payout ratio in case of growing stage of company? Comment.

Ans. (a) In the present situation, the current MPS is as follows:

P =
(
D0 1 + g )
Ke - g
Where
P = Market price per share
D0 = current year dividend
g = growth rate of dividends
Ke = cost of equity capital/ expected rate of return

P =
(
50 1 + 0.14 ) = ` 1425
0.18 - 0.14
(b) The impact of changes in growth rate to 10% on MPS will be as follows:

P =
(
50 1 + 0.10 ) = ` 687.5
0.18 - 0.10
(c) If Internal rate of return, r = 25% and Ke = 18%
As per Gordon’s model, when r > Ke, optimum dividend payout ratio is ‘Zero’. When IRR is greater than
cost of capital, the price per share increases and dividend pay- out decreases.

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Q.6 FM Nov 23
Paarath Limited had recently repurchased 20,000 equity shares at a premium of 10% to its prevailing market
price. The book value per share (after repurchasing) is ` 193.20.
Other Details of the company are as follows:
Earnings of the company (before buyback) = ` 18,00,000 Current MPS is ` 270 with a P/E Ratio of 18.
CALCULATE the Book Value per share of the company before the re- purchase.

Ans. i. No of Eq. Shares (before buyback) = Total Earnings (before buy back)/EPS
= 18,00,000/(270/18)
= 1,20,000 shares
ii. Buyback price = 270 + 10% premium = 297
iii. No of Eq. shares (after buyback) = 1,20,000 (-) 20,000 = 1,00,000 shares
iv. Total Book Value of Equity (after buyback) = 1,00,000 X 193.20
= 1,93,20,000
Now,
Total BV of Eq. (after buyback) = Total BV of Eq.(before buyback) (-)
Amt of buyback
1,93,20,000 = x (-) (20,000 X 297)
Therefore x = Total BV (before buyback)
= 2,52,60,000
BV per share (before buyback) = 2,52,60,000 / 1,20,000
= 210.50 per share

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7 CASH MANAGEMENT
CHAPTER

Q.1 Optimum Cash Balance PY Nov 22

K Ltd. has a Quarterly cash outflow of ` 9,00,000 arising uniformly during the Quarter.
The company has an Investment portfolio of Marketable Securities. It plans to meet the demands for cash by
periodically selling marketable securities. The marketable securities are generating a return of 12% p.a.
Transaction cost of converting investments to cash is ` 60. The company uses Baumol model to find out the
optimal transaction size for converting marketable securities into cash. Consider 360 days in a year.
You are required to calculate
(i) Company's average cash balance,
(ii) Number of conversions each year and
(iii) Time interval between two conversions.

Ans. (i) Computation of Average Cash balance:

Annual cash outflow (U) = 9,00,000 x 4 = ` 36,00,000
Fixed cost per transaction (P) = ` 60
12
Opportunity cost of one rupee p.a. (S) = = 0.12
100
2UP 2´36, 00, 000´60
Optimum cash balance (C) = = = ` 60,000
S 0.12

 Average Cash balance =

( 0 + 60, 000 ) = ` 30,000
2

(ii) Number of conversions p.a.

Annual cash outflow = ` 36,00,000
Optimum cash balance = ` 60,000
36, 00, 000
 No. of conversions p.a. = = 60
60, 000

(iii) Time interval between two conversions

No. of days in a year = 360
No. of conversions p.a. = 60
360
 Time interval = = 6 days
60
Q.2 Cash Budget PY Dec 21

A garment trader is preparing cash forecast for first three months of calendar year 2021.
His estimated sales for the forecasted periods are as below:

January (` '000) February (` '000) March (` '000)

Total sales 600 600 800
(i) The trader sells directly to public against cash payments and to other entities on credit. Credit sales are
expected to be four times the value of direct sales to public. He expects 15% customers to pay in the
month in which credit sales are made, 25% to pay in the next month and 58% to pay in the next to next
month. The outstanding balance is expected to be written off.

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(ii) Purchases of goods are made in the month prior to sales and it amounts to 90% of sales and are made on
credit. Payments of these occur in the month after the purchase. No inventories of goods are held.
(iii) Cash balance as on 1st January, 2021 is ` 50,000.
(iv) Actual sales for the last two months of calendar year 2020 are as below:
November (` '000) December (` '000)
Total sales 640 880

You are required to prepare a monthly cash, budget for the three months from January to March, 2021

Ans. (1) Calculation of cash and credit sales (` in thousands)

Nov. Dec. Jan. Feb. Mar.
Total Sales 640 880 600 600 800

Cash Sales (1/5 th of total 128 176 120 120 160

sales)
Credit Sales (4/5 th of total 512 704 480 480 640
(2) sales)
Calculation of Credit Sales Receipts
Month Nov. Dec. Jan. Feb. Mar.
Forecast Credit sales (Working 512.00 704.00 480.00 480.00 640.00
note 1)

Receipts:
15% in the month of sales 72.00 72.00 96.00
25% in next month 176.00 120.00 120.00
58% in next to next month 296.96 408.32 278.40
Total 544.96 600.32 494.40

Cash Budget (`ithousands)

Nov. Dec. Jan. Feb. Mar.

Opening Balance (A) 50.00 174.96 355.28
Sales 640.00 880.00 600.00 600.00 800.00
Receipts:
Cash Collection (Working note 1) 120.00 120.00 160.00
Credit Collections (Working note 2) 544.96 600.32 494.40
Total (B) 664.96 720.32 654.40
Purchases (90% of sales in the 540 540 720
prior
monthto sales)
Payments:
Payment for purchases (next month) 540 540 720
Total (C) 540 540 720
Closing balance(D) = (A + B – C) 174.96 355.28 289.68

Q.3 Monthly Cash Budget RTP Nov 22

A company was incorporated w.e.f. 1st April, 2021. Its authorised capital was ` 1,00,00,000 divided into 10 lakh
equity shares of ` 10 each. It intends to raise capital by issuing equity shares of ` 50,00,000 (fully paid) on 1st
April. Besides this, a loan of ` 6,50,000 @ 12% per annum will be obtained from a financial institution on 1st April

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and further borrowings will be made at same rate of interest on the first day of the month in which borrowing is
required. All borrowings will be repaid along with interest on the expiry of one year. The company will make
payment for the following assets in April.

Particulars (`)
Plant and Machinery 10,00,000
Land and Building 20,00,000
Furniture 5,00,000
Motor Vehicles 5,00,000
Stock of Raw Materials 5,00,000
The following further details are available:
(1) Projected Sales (April-September):
(`)
April 15,00,000
May 17,50,000
June 17,50,000
July 20,00,000
August 20,00,000
September 22,50,000
(2) Gross profit margin will be 25% on sales.
(3) The company will make credit sales only and these will be collected in the second month following sales
(4) Creditors will be paid in the first month following credit purchases. There will be credit purchases only.
(5) The company will keep minimum stock of raw materials of ` 5,00,000.
(6) Depreciation will be charged @ 10% per annum on cost on all fixed assets.
(7) Payment of miscellaneous expenses of ` 50,000 will be made in April.
(8) Wages and salaries will be ` 1,00,000 each month and will be paid on the first day of the next month.
(9) Administrative expenses of ` 50,000 per month will be paid in the month of their incurrence.
(10) No minimum cash balance is required.
You are required to PREPARE the monthly cash budget (April-September), the projected
Income Statement for the 6 months period and the projected Balance Sheet as on
30th September, 2021.

Ans.
Monthly Cash Budget (April-September) (`)
April May June July August September
Opening cash - 10,50,000 - 1,37,500 5,25,000 7,25,000
balance
A. Cash inflows
Equity shares 50,00,000 - - - - -
Loans (Refer to working 6,50,000 1,25,000 - - - -
note 1)
Receipt from
debtors - - 15,00,000 17,50,000 17,50,000 20,00,000
Total (A) 56,50,000 11,75,000 15,00,000 18,87,500 22,75,000 27,25,000
B. Cash Outflows
Plant and 10,00,000 - - - - -
Machinery

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Land and Building 20,00,000 - - - - -

Furniture 5,00,000 - - - - -
Motor Vehicles 5,00,000 - - - - -
Stock of raw 5,00,000 - - - - -
materials
(Minimum stock)
Miscellaneous 50,000 - - - - -
expenses
Payment to - 10,25,000 12,12,500 12,12,500 14,00,000 14,00,000
creditors for credit
purchases (Refer to
working note 2)
Wages and - 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
salaries
Admn. expenses 50,000 50,000 50,000 50,000 50,000 50,000
Total :(B) 46,00,000 11,75,000 13,62,500 13,62,500 15,50,000 15,50,000
Closing balance 10,50,000 - 1,37,500 5,25,000 7,25,000 11,75,000
(A)-(B)

Budgeted Income Statement for six-month period ending 30th September

Particulars (`) Particulars (`)

To Purchases 83,37,500 By Sales 1,12,50,000
To Wages and Salaries 6,00,000 By Closing stock 5,00,000
To Gross profit c/d 28,12,500
1,17,50,000 1,17,50,000
To Admn. expenses 3,00,000 By Gross profit b/d 28,12,500
To Depreciation 2,00,000

To Accrued interest on loan 45,250

To Miscellaneous expenses 50,000

To Net profit c/d 22,17,250
28,12,500 28,12,500

Projected Balance Sheet as on 30th September, 2021

Liabilities Amount (`) Assets Amount (`)

Share Capital: Fixed Assets:

Authorised Land and Building 20,00,000

capital Less: Depreciation 1,00,000 19,00,000
10,00,000 equity 1,00,00,000
Plant and 10,00,000

shares of `10 Machinery

each Less: Depreciation 50,000 9,50,000
Issued, Furniture 5,00,000

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Subscribed and Less: Depreciation 25,000 4,75,000

Paid up capital
5,00,000 equity 50,00,000 Motor Vehicles 5,00,000
Shares of `10 Less: Depreciation 25,000 4,75,000 38,00,000
each
Current Assets:
Reserve and
Surplus: Stock 5,00,000
Sundry debtors 42,50,000
Profit and Loss 22,17,250 Cash 11,75,000 59,25,000

Long-term loans 7,75,000

Current liabilities
and provisions:
Sundry creditors 15,87,500
Accrued interest 45,250
Outstanding 1,00,000 17,32,750
expenses 97,75,000 97,75,000

Working Notes:
Subsequent Borrowings Needed (`)

April May June July August September

A. Cash Inflow
Equity shares 50,00,000
Loans 6,50,000
Receipt from
debtors - - 15,00,000 17,50,000 17,50,000 20,00,000
Total (A) 56,50,000 - 15,00,000 17,50,000 17,50,000 20,00,000
B. Cash Outflow
Purchase of 40,00,000
fixed assets
Stock 5,00,000
Miscellaneous 50,000
expenses
Payment to - 10,25,000 12,12,500 12,12,500 14,00,000 14,00,000
creditors
Wages and - 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
salaries
Administrative
expenses 50,000 50,000 50,000 50,000 50,000 50,000
Total 46,00,000 11,75,000 13,62,500 13,62,500 15,50,000 15,50,000
Surplus/ (Deficit) 10,50,000 (11,75,000) 1,37,500 3,87,500 2,00,000 4,50,000
Cumulative 10,50,000 (1,25,000) 12,500 4,00,000 6,00,000 10,50,000
balance

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1. There is shortage of cash in May of ` 1,25,000 which will be met by borrowings in May.
2. Payment to Creditors
Purchases = Cost of goods sold - Wages and salaries
Purchases for April = (75% of 15,00,000) - ` 1,00,000 = ` 10,25,000
(Note: Since gross margin is 25% of sales, cost of manufacture i.e. materials plus wages and salaries should
be 75% of sales)
Hence, Purchases = Cost of manufacture minus wages and salaries of ` 1,00,000)
The creditors are paid in the first month following purchases.
Therefore, payment in May is ` 10,25,000
The same procedure will be followed for other months.
April (75% of 15,00,000) - ` 1,00,000 = ` 10,25,000
May (75% of 17,50,000) - ` 1,00,000 = ` 12,12,500
June (75% of 17,50,000) - ` 1,00,000 = ` 12,12,500
July (75% of 20,00,000) - ` 1,00,000 = ` 14,00,000
August (75% of 20,00,000) - ` 1,00,000 = ` 14,00,000
September (75% of 22,50,000) - ` 1,00,000 = ` 15,87,500
Minimum Stock ` 5,00,000
Total Purchases ` 83,37,500
3. Accrued Interest on Loan
12% interest on ` 6,50,000 for 6 months 39,000
Add: 12% interest on ` 1,25,000 for 5 months 6,250
45,250
Q.4 Cash Budget in next 3 years RTP May 22
You are given below the Profit & Loss Accounts for two years for a company:
Profit and Loss Account
Year 1 Year 2 Year 1 Year 2
(`) (`) (`) (`)
To Opening stock 32,00,000 40,00,000 By Sales 3,20,00,000 4,00,00,000
To Raw materials 1,20,00,000 1,60,00,000 By Closing 40,00,000 60,00,000
stock
To Stores 38,40,000 48,00,000 By Misc. 4,00,000 4,00,000
Income
To Manufacturing 51,20,000 64,00,000
Expenses
To Other 40,00,000 40,00,000
Expenses
To Depreciation 40,00,000 40,00,000
To Net Profit 42,40,000 72,00,000 - -
3,64,00,000 4,64,00,000 3,64,00,000 4,64,00,000
Sales are expected to be ` 4,80,00,000 in year 3.
As a result, other expenses will increase by ` 20,00,000 besides other charges. Only raw materials are in stock.
Assume sales and purchases are in cash terms and the closing stock is expected to go up by the same amount as
between year 1 and 2. You may assume that no dividend is being paid. The Company can use 75% of the cash
generated to service a loan. COMPUTE how much cash from operations will be available in year 3 for the purpose?
Ignore income tax.

Ans. Projected Profit and Loss Account for the year 3

Particulars Year 2 Year 3 Particulars Year 2 Year 3

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Actual (` in Projected (` Actual (` in Projected (` in

lakhs) in lakhs) lakhs) lakhs)
To Materials consumed 140.00 168.00 By Sales 400.00 480.00
To Stores 48.00 57.60 By Misc. 4.00 4.00
Income
To Mfg. Expenses 64.00 76.80
To Other expenses 40.00 60.00
To Depreciation 40.00 40.00
To Net profit 72.00 81.60
404.00 484.00 484.00 484.00

Cash Flow:

Particulars (` in lakhs)
Profit 81.60
Add: Depreciation 40.00
121.60
Less: Cash required for increase in stock 20.00
Net cash inflow 101.60
Available for servicing the loan: 75% of ` 1,01,60,000 or ` 76,20,000
Working Notes:
(i) Material consumed in year 1 = (32 + 120 – 40)/320 = 35%
Material consumed in year 2 = (40 + 160 – 60)/400 = 35%
35
Likely consumption in year 3 = 480× = ` 168 (lakhs)
100
(ii) Stores are 12% of sales & Manufacturing expenses are 16% of sales for both the years.

Q.5 Monthly Cash Budget MTP May 21(1)

PREPARE monthly cash budget for the first six months of 2021 on the basis of the following information:
(i) Actual and estimated monthly sales are as follows:
Actual (Rs.) Estimated (Rs.)
October 2020 2,00,000 January 2021 60,000
November 2020 2,20,000 February 2021 80,000
December 2020 2,40,000 March 2021 1,00,000
April 2021 1,20,000
May 2021 80,000
June 2021 60,000
July 2021 1,20,000

(ii) Operating Expenses (including salary & wages) are estimated to be payable as follows:

Month (Rs.) Month (Rs.)

January 2021 22,000 April 2021 30,000

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February 2021 25,000 May 2021 25,000

March 2021 30,000 June 2021 24,000

(iii) Of the sales, 75% is on credit and 25% for cash. 60% of the credit sales are collected after one month,
30% after two months and 10% after three months.
(iv) Purchases amount to 80% of sales and are made on credit and paid for in the month preceding the sales.
(v) The firm has 12% debentures of Rs.1,00,000. Interest on these has to be paid quarterly in
January, April and so on.
(vi) The firm is to make an advance payment of tax of Rs. 5,000 in April.
(vii) The firm had a cash balance of Rs. 40,000 at 31st Dec. 2020, which is the minimum desired level of cash
balance. Any cash surplus/deficit above/below this level is made up by temporary investments/liquidation
of temporary investments or temporary borrowings at the end of each month (interest on these to be
ignored).

Ans. Monthly Cash Budget for first six months of 2021

(Amount in Rs.)
Particulars Jan. Feb. Mar. April May June
Opening balance 40,000 40,000 40,000 40,000 40,000 40,000
Receipts:
Cash sales 15,000 20,000 25,000 30,000 20,000 15,000
Collection from debtors 1,72,500 97,500 67,500 67,500 82,500 70,500
Total cash available (A) 2,27,500 1,57,500 1,32,500 1,37,500 1,42,500 1,25,500
Payments:
Purchases 64,000 80,000 96,000 64,000 48,000 96,000
Operating Expenses 22,000 25,000 30,000 30,000 25,000 24,000
Interest on debentures 3,000 - - 3,000 - -
Tax payment - - - 5,000 - -
Total payments (B) 89,000 1,05,000 1,26,000 1,02,000 73,000 1,20,000
Minimum cash balance 40,000 40,000 40,000 40,000 40,000 40,000
desired
Total cash needed (C) 1,29,000 1,45,000 1,66,000 1,42,000 1,13,000 1,60,000
Surplus/(deficit) (A - C) 98,500 12,500 (33,500) (4,500) 29,500 (34,500)
Investment/financing
Temporary Investments (98,500) (12,500) - - (29,500) -
Liquidation of temporary 33,500 4,500
investments or temporary - 34,500
borrowings
Total effect of 4,500 (29,500) 34,500
investment/financing(D) (98,500) (12,500) 33,500
Closing cash balance (A +
D - B) 40,000 40,000 40,000 40,000 40,000 40,000

Workings:
1. Collection from debtors: (Amount in Rs.)

Year 2020 Year 2021

Oct. Nov. Dec. Jan. Feb. Mar. April May June
Total sales 2,00,000 2,20,00 2,40,00 60,00 80,000 1,00,00 1,20,000 80,000 60,000
0 0 0 0

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Credit sales
(75% of total
sales) 1,50,000 1,65,00 1,80,00 45,00 60,000 75,00 90,000 60,000 45,000
Collections: 0 0 0 0
One month 90,00 99,00 1,08,00 27,000 36,00 45,000 54,000 36,000
Two months 0 0
45,00 0 49,50 54,000 0
13,500 18,000 22,500 27,000
Three months 0 0
15,000 16,500 18,000 4,500 6,000 7,500
Total
collections 1,72,5 97,500 67,50 67,500 82,500 70,500
2. Payment to Creditors: 00 0 (Amount in Rs.)

Year 2021
Jan Feb Mar Apr May Jun Jul
Total sales 60,000 80,000 1,00,000 1,20,000 80,000 60,000 1,20,000
Purchases 96,000
(80% of total sales) 48,000 64,000 80,000 96,000 64,000 48,000
Payment:
One month prior 64,000 80,000 96,000 64,000 48,000 96,000

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8 DEBTORS MANAGEMENT
CHAPTER
Q.1 Accept Factoring or Not MTP May 19(2)
Navya Ltd has annual credit sales of Rs. 45 lakhs. Credit terms are 30 days, but its management of receivables
has been poor and the average collection period is 50 days, Bad debt is 0.4 per cent of sales. A factor has offered
to take over the task of debt administration and credit checking, at an annual fee of 1 per cent of credit sales.
Navya Ltd. estimates that it would save Rs. 35,000 per year in administration costs as a result. Due to the
efficiency of the factor, the average collection period would reduce to 30 days and bad debts would be zero. The
factor would advance 80 per cent of invoiced debts at an annual interest rate of 11 per cent. Navya Ltd. is
currently financing receivables from an overdraft costing 10 per cent per year.
If occurrence of credit sales is throughout the year, COMPUTE whether the factor’s services should be accepted
or rejected. Assume 365 days in a year.

Ans
Rs.
Present level of receivables is 45 lakh× 50/365 6,16,438

In case of factor, receivables would reduce to 45 lakhs× 30/365 3,69,863

The costs of the existing policyare as follows:
Cost of financing existing receivables: 6,16,438×10% 61,644
Cost of bad debts: 45 lakhs × 0.4% 18,000
Cost of current policy 79,644
The cost under the factor are as follows:
Cost of financing new receivable through factor:
(Rs. 3,69,863 × 0.8 × 0.11) + (Rs. 3,69,863 × 0.2 × 0.10) 39,945
= (32,548 + 7,397)
Factor’s annual fee: 45 Lakhs × 0.01 45,000
Administration costs saved: (35,000)
Net cost under factor: 49,945
From the above analysis it is clear that the factor’s services are cheaper than Existing policy by Rs. 29,699
(Rs. 79,644 - Rs.49,945) per year. Hence, the services of the factor should be accepted.

Q.2 Bank Loan, Factoring, Credit RTP Dec 21

The Alliance Ltd., a Petrochemical sector company had just invested huge amount in its new expansion project.
Due to huge capital investment, the company is in need of an additional ` 1,50,000 in working capital immediately.
The Finance Manger has determined the following three feasible sources of working capital funds:
(i) Bank loan: The Company's bank will lend ` 2,00,000 at 15%. A 10% compensating balance will be required,
which otherwise would not be maintained by the company.
(ii) Trade credit: The company has been offered credit terms from its major supplier of
3/30, net 90 for purchasing raw materials worth ` 1,00,000 per month.
(iii) Factoring: A factoring firm will buy the company’s receivables of ` 2,00,000 per month, which have a collection
period of 60 days. The factor will advance up to 75 % of the face value of the receivables at 12% on an annual
basis. The factor will also charge commission of 2% on all receivables purchased. It has been estimated that
the factor’s services will save the company a credit department expense and bad debt expense of ` 1,250
and ` 1,750 per month respectively.

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On the basis of annual percentage cost, ADVISE which alternative should the company select? Assume 360 days
year.

Ans. (i) Bank loan: Since the compensating balance would not otherwise be maintained, the real annual cost of taking
bank loan would be:
15
= × 100 = 16.67% p.a.
90
(ii) Trade credit: Amount upto ` 1,50,000 can be raised within 2 months or 60 days. The real annual cost of trade
credit would be:
3 360
= x x100 = 18.56% p.a.
97 60
(iii) Factoring:
Commission charges per year = 2% x(` 2,00,000 x12) = ` 48,000
Total Savings per year = (` 1,250 + ` 1,750) x 12 = ` 36,000
Net factoring cost per year = ` 48,000 - ` 36,000 = ` 12,000
Annual Cost of Borrowing ` 1,50,000 receivables through factoring would be:
12% x 1,50, 000 + 12, 000
= x100
1,50, 000
18, 000 + 12, 000
= x100
1,50, 000
= 20% p.a.

Advise: The company should select alternative of Bank Loan as it has the lowest annual cost i.e. 16.67% p.a.

Q.3 Credit Policy RTP Nov 20

A company wants to follow a more prudent policy to improve its sales for the region which is ` 9 lakhs per
annum at present, having an average collection period of 45 days. After certain researches, the management
consultant of the company reveals the following information:
Credit Policy Increase in Increase in sales Present default
collection period anticipated
W 15 days ` 60,000 1.5%
X 30 days ` 90,000 2%
Y 45 days ` 1,50,000 3%
Z 70 days ` 2,10,000 4%

The selling price per unit is ` 3. Average cost per unit is ` 2.25 and variable costs per unit are ` 2. The current
bad debt loss is 1%. Required return on additional investment is 20%. (Assume 360 days year)
ANALYSE which of the above policies would you recommend for adoption?

Ans A. Statement showing the Evaluation of Debtors Policies (Total Approach)

(Amount in `)
Particulars Present Proposed Proposed Proposed Proposed
Policy 45 Policy Policy Policy Policy Z
days W X Y 115 days
I. Expected Profit: 60 days 75 days 90 days
Z
(a) Credit Sales 9,00,000 9,60,000 9,90,000 10,50,000 11,10,000

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(b) Total Cost other

than Bad Debts
(i) Variable Costs 6,00,000 6,40,000 6,60,000 7,00,000 7,40,000
[Sales × 2/ 3]
(ii) Fixed Costs 75,000 75,000 75,000 75,000 75,000
6,75,000 7,15,000 7,35,000 7,75,000 8,15,000
(c) Bad Debts 9,000 14,400 19,800 31,500 44,400
(d) Expected Profit 2,16,000 2,30,600 2,35,200 2,43,500 2,50,600
[(a) – (b) – (c)]
II. Opportunity Cost of 16,875 23,833 30,625 38,750 52,069
Investments in
Receivables
III. Net Benefits (I – II) 1,99,125 2,06,767 2,04,575 2,04,750 1,98,531

Recommendation: The Proposed Policy W (i.e. increase in collection period by 15 days or total 60 days)
should be adopted since the net benefits under this policy are higher as compared to other policies.

Working Notes:
(i) Calculation of Fixed Cost = [Average Cost per unit – Variable Cost per unit] × No. of Units sold
= [` 2.25 - ` 2.00] × (` 9,00,000/3)
= ` 0.25 × 3,00,000 = ` 75,000
(ii) Calculation of Opportunity Cost of Average Investments

C o lle c ti o n p er i o d R ate of R etu rn

Opportunity Cost = Total Cost x x
360 100
45 20
Present Policy = 6,75,000 × x =16,875
360 100
60 20
Policy W = 7,15,000 × x =23,833
360 100
75 20
Policy X = 7,35,000 × x = 30,625
360 100
90 20
Policy Y = 7,75,000 × x = 38,750
360 100
115 20
Policy Z = 8,15,000 × × = 52,069
360 100

B. Another method of solving the problem is Incremental Approach. Here we assume that sales are all
credit sales. (Amount in `)
Particulars Present Proposed Proposed Proposed Proposed
Policy 45 Policy W Policy X Policy Y Policy Z
days 60 days 75 days days
90 115 days
I. Incremental Expected
Profit:

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(a) Incremental Credit 0 60,000 90,000 1,50,000 2,10,000

Sales
(b) Incremental Costs
(i) Variable Costs 6,00,000 40,000 60,000 1,00,000 1,40,000
(ii) Fixed Costs 75,000 - - - -
(c) Incremental Bad Debt 9,000 5,400 10,800 22,500 35,400
Losses
(d) Incremental Expected 14,600 19,200 27,500 34,600
Profit (a – b –c)]
II. Required Return on
Incremental Investments:
(a) Cost of Credit 6,75,000 7,15,000 7,35,000 7,75,000 8,15,000
Sales
(b) Collection period 45 60 75 90 115
(c) Investment in 84,375 1,19,167 1,53,125 1,93,750 2,60,347
Receivable (a × b/360)
(d) Incremental Investment in
Receivables - 34,792 68,750 1,09,375 1,75,972

(e) Required Rate of 20 20 20 20

Return (in %)
(f) Required Return
on Incremental Investments - 6,958 13,750 21,875 35,194
(d × e)
III. Net Benefits (I – II) - 7,642 5,450 5,625 (594)
-
Recommendation: The Proposed Policy W should be adopted since the net benefits under this policy are
higher than those under other policies.
C. Another method of solving the problem is by computing the Expected Rate of Return
In c r em en tal Exp ec ted Pr o f i t
Expected Rate of Return = x100
Incremental Investment in Receivables
14, 500
For Policy W = x 100 = 41.96%
34, 792

19,200
For Policy X = x 100 = 27.93%
68, 750

27,500
For Policy Y = x 100 = 25.14%
109,375

34, 600
For Policy Z = x 100 = 19.66%
1, 75, 972
Recommendation: The Proposed Policy W should be adopted since the Expected Rate of Return (41.96%)
is more than the Required Rate of Return (20%) and is highest among the given policies compared.

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Q.4 Credit Policy RTP May 20

TM Limited, a manufacturer of colour TV sets is considering the liberalization of existing credit terms to
three of their large customers A, B and C. The credit period and likely quantity of TV sets that will be sold to
the customers in addition to other sales are as follows:
Quantity sold (No. of TV Sets)
Credit Period (Days) A B C
0 10,000 10,000 -
30 10,000 15,000 -
60 10,000 20,000 10,000
90 10,000 25,000 15,000

The selling price per TV set is `15,000. The expected contribution is 50% of the selling price. The cost of
carrying receivable averages 20% per annum.
You are required to COMPUTE the credit period to be allowed to each customer. (Assume 360 days in a year
for calculation purposes).

Ans In case of customer A, there is no increase in sales even if the credit is given. Hence comparative statement
for B & C is given below:
Particulars Customer B Customer C
1. Credit period (days) 0 30 60 90 0 30 60 90
2. Sales Units 10,000 15,000 20,000 25,000 - - 10,000 15,000
` in lakh `in lakh
3. Sales Value 1,500 2,250 3,000 3,750 - - 1,500 2,250
4. Contribution at 50% (A) 750 1,125 1,500 1,875 - - 750 1,125
5. Receivables:-
Credit Period × Sale 360 - 187.5 500 937.5 - - 250 562.5
6. Debtors at cost - 93.75 250 468.75 - - 125 281.25

7. Cost of carrying debtors - 18.75 50 93.75 - - 25 56.25

at 20% (B)
8. Excess of contributions 750 1,106.25 1,406.25 1,781.25 - - 725 1,068.75
over cost of carrying
debtors (A – B)
The excess of contribution over cost of carrying Debtors is highest in case of credit period of 90 days in
respect of both the customers B and C. Hence, credit period of 90 days should be allowed to B and C.

Q.5 Credit Policy RTP Nov 19

A regular customer of your company has approached to you for extension of credit facility for purchasing of
goods. On analysis of past performance and on the basis of information supplied, the following pattern of
payment schedule emerges:

Pattern of Payment Schedule

At the end of 30 days 20% of the bill
At the end of 60 days 30% of the bill.
At the end of 90 days 30% of the bill.
At the end of 100 days 18% of the bill.
Non-recovery 2% of the bill.

The customer wants to enter into a firm commitment for purchase of goods of `30 lakhs in 2019, deliveries
to be made in equal quantities on the first day of each quarter in the calendar year. The price per unit of

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commodity is `300 on which a profit of `10 per unit is expected to be made. It is anticipated that taking up
of this contract would mean an extra recurring expenditure of `10,000 per annum. If the opportunity cost
is 18% per annum, would you as the finance manager of the company RECOMMEND the grant of credit to the
customer? Assume 1 year = 360 days.

Ans Statement showing the Evaluation of credit Policies

Particulars Proposed Policy`
A. Expected Profit:
(a) Credit Sales 30,00,000
(b) Total Cost
(i) Variable Costs 29,00,000
(ii) Recurring Costs 10,000
29,10,000
(c) Ba d Debts 60,000
(d) Expected Profit [(a) – (b) – (c)] 30,000
B. Opportunity Cost of Investments in Receivables 1,00,395
C. Net Benefits (A – B) (70,395)
Recommendation: The Proposed Policy should not be adopted since the net benefits under this policyare
negative
Working Note: Calculation of Opportunity Cost of Average Investments

Collection Period Rate of Return

Opportunity Cost = Total Cost x x
360 100
Particulars 20% 30% 30% 18% Total
A. Total Cost 5,82,000 8,73,000 8,73,000 5,23,800 28,51,800
B. Collection period 30/360 60/360 90/360 100/360
C. Required Rate of Return 18% 18% 18% 18%
D. Opportunity Cost 8,730 26,190 39,285 26,190 1,00,395
(A × B × C)

Q.6 Credit Policy MTP Nov 22(1)

GT Ltd. is taking into account the revision of its credit policy with a view to increasing its sales and profit.
Currently, all its sales are on one month credit. Other information is as follows:
Contribution 2/5th of Sales Revenue
Additional funds raising cost 20% per annum
The marketing manager of the company has given the following options along with estimates for
considerations:
Particulars Current Position Option I Option II Option III
Sales Revenue (`) 40,00,000 42,00,000 44,00,000 50,00,000
Credit period (in months) 1 1½ 2 3
Bad debts (% of sales) 2 2½ 3 5
Cost of Credit administration (`) 24,000 26,000 30,000 60,000
You are required to ADVISE the company for the best option.

Ans Statement Showing Evaluation of Credit Policies

(` in lakhs)

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Current position Option I Option II Option III

Particulars (1 month) (1.5 months) (2 months) (3 months)

Sales Revenue 40,00, 42,00,000 44,00,000 50,00,000

000
Contribution @ 40% 16,00,000 16,80,000 17,60,000 20,00,000
Increase in contribution over - 80,000 1,60,000 4,00,000
Current level price (A)
Debtors = - 1  40, 00, 000 1.5  42, 00, 000 3  50, 00, 000
Average Collection period x Credit Sale
12 12 12 12
= 3,33,333.33 = 5,25,000 = 12,50,000
Increase in debtors over current 1,91,666.67 4,00,000.00 9,16,666.67
level
Cost of funds for additional − 38,333.33 80,000.00 1,83,333.33
amount of debtos @ 20% (B)
Credit administrative cost 24,000 26,000 30,000 60,000
Increase in credit administration − 2,000 6,000 36,000
cost over present level (c)
Bad debts 80,000 1,05,000 1,32,000 2,50,000
Increase in bad debts over current − 25,000 52,000 1,70,000
levels (D)
Net gain/loss A – (B + C + D) − 14,666.67 22,000.00 10,666.67
Advise: It is suggested that the company GT Ltd. should implement Option II with a net gain of` 22,000 which
has a credit period of 2 months

Q.7 Factoring PY Dec 21

A factoring firm has offered a company to buy its accounts receivables.

The relevant information is given below:
(i) The current average collection period for the company's debt is 80 days and ½% of debtors default. The
factor has agreed to pay over money due to the company after60 days and it will suffer all the losses of
bad debts also.
(ii) Factor will charge commission @2%.
(iii) The company spends ` 1,00,000 p.a. on administration of debtor.These are avoidable cost.
(iv) Annual credit sales are ` 90 lakhs. Total variable costs is 80% of sales. The company's cost of
borrowing is 15% per annum. Assume 365 days in a year.
Should the company enter into agreement with factoring firm?
Ans
Particulars (`)
A. Annual Savings (Benefit) on taking Factoring Service
Cost of credit administration saved
Bad debts avoided (` 90 lakh x ½%) 1,00,000
Interest saved due to reduction in average collection period [` 90 45,000
lakh x 0.80 × 0.15 × (80 days – 60 days)/365 days] 59,178

Total 2,04,178
B. Annual Cost of Factoring to the Firm:
Factoring Commission [` 90 lakh × 2%] 1,80,000

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Total 1,80,000
C. Net Annual Benefit of Factoring to the Firm (A – B) 24,178

Advice: Since savings to the firm exceeds the cost to the firm on account of factoring, therefore, the
company should enter into agreement with the factoring firm.

Q.8 Payment to Debtor MTP May 19(1)

A bank is analysing the receivables of J Ltd. in order to identify acceptable collateral for a short-term loan. The
company’s credit policy is 2/10 net 30. The bank lends 80 percent on accounts where customers are not currently
overdue and where the average payment period does not exceed 10 days past the net period. A schedule
of J Ltd.’s receivables has been prepared. ANALYSE, how much will the bank lend on pledge of receivables, if
the bank uses a 10 per cent allowance for cash discount and returns?
Account Amount Rs. Days Outstanding in days Average Payment Period
historically
74 25,000 15 20
91 9,000 45 60
107 11,500 22 24
108 2,300 9 10
114 18,000 50 45
116 29,000 16 10
123 14,000 27 48

1,08,800

Ans Analysis of the receivables of J Ltd. by the bank in order to identify acceptable collateral for a short- term
loan:
(i) The J Ltd.’s credit policy is 2/10 net 30.
The bank lends 80 per cent on accounts where customers are not currently overdue and where the average
payment period does not exceed 10 days past the net period i.e. thirty days. From the schedule of
receivables of J Ltd. Account No. 91 and Account No. 114 are currently overdue and for Account No. 123
the average payment period exceeds 40 days. Hence Account Nos. 91, 114 and 123 are eliminated.
Therefore, the selected Accounts are Account Nos. 74, 107, 108 and 116.
(ii) Statement showing the calculation of the amount which the bank will lend on a pledge of receivables if the
bank uses a 10 per cent allowances for cash discount and returns

Account No. Amount (Rs.) 90 per cent of amount (Rs.) 80% of amount (Rs.)
(a) (b) = 90% of (a) (c) = 80% of (b)
74 25,000 22,500 18,000
107 11,500 10,350 8280
108 2,300 2,070 1,656
116 29,000 26,100 20,880
Total loan amount 48,816

Q.9 Factoring FM May 24

Following is the sales information in respect of Bright Ltd:
Annual Sales (90 % on credit) ` 7,50,00,000
Credit period 45 days

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Average Collection period 70 days

Bad debts 0.75%
Credit administration cost (out of which 2/5th is avoidable) ` 18,60,000
A factor firm has offered to manage the company's debtors on a non- recourse basis at a service charge of 2%.
Factor agrees to grant advance against debtors at in interest rate of 14% after withholding 20% as reserve.
Payment period guaranteed by factor is 45 days. The cost of capital of the company is 12.5%. One time redundancy
payment of ` 50,000 is required to be made to factor.
Calculate the effective cost of factoring to the company. (Assume 360 days in a year)

Ans. Evaluation of Factoring Proposal

Particulars ` `
A. Savings due to factoring
Bad Debts saved 0.75% x 7.5 crores ` 5,06,250
x 90%
Administration cost saved 18.6 lakhs x 2/5 ` 7,44,000
Interest saved due to reduction in average collection 7.5 crores x 90% ` 5,85,937.5
period x (70-45)/ 360 x 12.5%
Total ` 18,36,187.5
B. Costs of factoring:
Service charge 7.5 crores x 90% x 2% ` 13,50,000
Interest cost ` 1,15,171.875 ` 9,21,375
x 360/45
Redundancy Payment ` 50,000
Total ` 23.21,375
C. Net Annual cost to the Firm: (A-B) ` 4,85,187.5
Rate of effective cost of factoring ` 4,85,187.5/ 7.504%
` 64,66,078.125 x 100

Advice: Since the rate of effective cost of factoring is less than the existing cost of capital, therefore, the
proposal is acceptable.

Credit Sales = ` 7.5 crores x 90% = ` 6,75,00,000

Average level of receivables = ` 6.75 crores x 45/360 = ` 84,37,500
Service charge = 2% of ` 84,37,500 ` 1,68,750
Reserve = 20% of ` 84,37,500 ` 16,87,500
Total (i) ` 18,56,250
Thus, the amount available for advance is
Average level of receivables ` 84,37,500
Less: Total (i) from above ` 18,56,250
(ii) ` 65,81,250
Less: Interest @ 14% p.a. for 45 days ` 1,15,171.875
Net Amount of Advance available. ` 64,66,078.125
Note: Alternatively, if redundancy cost is taken as irrelevant for decision making, then Net Annual cost to the
Firm will be ` 4,35,187.5 and Rate of effective cost of factoring will be ` 4,35,187.5/` 64,66,078.125 x 100 =
6.730%

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If average level of receivables is considered for 70 days then the calculation can be done in following
way:
Evaluation of Factoring Proposal
Credit Sales = ` 7.5 crores X 90% = ` 6,75,00,000
Average level of receivables = ` 6.75 crores x 70/360 = ` 1,31,25,000
Service charge = 2% of ` 1,31,25,000 ` 2,62,500
Reserve = 20% of ` 1,31,25,000 ` 26,25,000
Total (i) ` 28,87,500
Thus, the amount available for advance is
Average level of receivables ` 1,31,25,000
Less: Total (i) from above ` 28,87,500
(ii) ` 1,02,37,500
Less: Interest @ 14% p.a. for 45 days ` 1,79,156.25
Net Amount of Advance available. ` 1,00,58,343.75
Note 1: Accordingly, interest cost will be ` 14,33,250 cost of factoring will be ` 28,33,250. Therefore, Rate of
effective cost of factoring is 9.913%
Note 2: Alternatively, if redundancy cost is taken as irrelevant for decision making, then Net Annual cost to
the Firm will be ` 9,47,062.5 and Rate of effective cost of factoring will be ` 9,47,062.5/ ` 1,00,58,343.75 x
100 = 9.416%.
Advice: Since the rate of effective cost of factoring is less than the existing cost of capital, therefore, the
proposal is acceptable.

Q.10 Factoring

Sukrut Limited has annual credit sales of ` 75,00,000/-. Actual credit terms are 30 days, but its management of
receivables has been poor, and the average collection period is about 60 days. Bad debt is 1 per cent of total
sales.
A factor has offered to take over the task of debt administration and credit checking, at an annual fee of 1.5
per cent of credit sales.
Sukrut Limited estimates that it would save ` 45,000 per year in administration costs as a result. Due to the
efficiency of the factor, the average collection period would come back to the original credit offered of 30
days and bad debts would come to 0.5% on recourse basis.
The factor would pay net advance of 80 percent to the company at an annual interest rate of 12 per cent after
withholding a reserve of 10%. Sukrut Limited is currently financing its receivables from an overdraft costing 10
per cent per year and will continue to finance the balance fund needed (which is not financed by factor) through
the overdraft facility.
If occurrence of credit sales is throughout the year, COMPUTE whether the factor’s services should be
accepted or rejected. Assume 360 days in a year.

Ans. Evaluation of Factoring Proposal –

PARTICULARS ` `
(A) Savings (Benefit) to the firm
Administration Cost 45,000 45,000
Bad Debts Cost (On Recourse basis)
In House – 75 lakhs X 1%
Factoring – 75 lakhs X 0.5%
Net Savings in bad debts cost (75 lakhs X 0.5%) 37,500

Cost of Carrying Debtors Cost (WN – 1) 1,06,750

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TOTAL 1,89,250
(B) Cost to the Firm:
Factor Commission [Annual credit Sales × 75 lakhs X 1.5% 1,12,500
% of Commission]
Interest Cost on Net advances (See WN – 1) 53,100
TOTAL 1,65,600
(C) Net Benefits to the Firm (A – B) 23,650

Advice: Since the savings to the firm exceed the cost due to factoring, the proposal is acceptable.
WN-1 : Calculation of Savings in Interest Cost of Carrying Debtors
(I) In house Management:
Interest Cost = Credit Sales X Avg Collection Period / 360 X Interest (%) p.a
= 75,00,000 x 60/360 x 10%
= 1,25,000
(II) If Factoring services availed: If factoring services are availed, then Sukrut Limited must raise the
funds blocked in receivables to the extent which is not funded by the factor (i.e amount of factor
reserve (+) amount of factor commission for 30 days (+) 20% of net advances)
Calculation of Net Advances to the firm -
Debtors = 75 lakhs x 30/360 = 6,25,000
(-) Factor Reserve = 10% of above = (62,500)
(-) Factor Commission = 1.5% of Debtors = (9,375)
Net Advance = 5,53,125
Advance from Factor = 5,53,125 x 80% = 4,42,500
Int cost on Advance from Factor = 4,42,500 x 12% = 53,100
Now, the amount that is not funded by the factor (6,25,000 - 4,42,500) needs to be funded by Sukrut
Limited from overdraft facility at 10%
Therefore, Int cost on Overdraft (Cost of carrying debtors)
= 1,82,500 x 10% = 18,250
Net Savings in Interest Cost of Carrying Debtors = 1,25,000 (-) 18,250 = 1,06,750

Q.11 MTP Sept 24 (1)

The financial statements of Gurunath Ltd is furnished below –
Balance Sheet as at 31st March
Particulars as at 31st March Note `
I EQUITY AND LIABILITIES:
(1) Shareholders’ Funds: 10,00,000
(2) Non–Current Liabilities: 10% Debt 6,00,000
(3) Current Liabilities 1,56,000
Total 17,56,000
II ASSETS
(1) Non–Current Assets 16,56,000
(2) Current Assets – Trade Receivables 1,00,000
Total 17,56,000

Additional Information:
1. The existing credit terms are 1/10, net 45 days and average collection period is 30 days. The current bad
debts loss is 1.5%. In order to accelerate the collection process further as also to increase sales, the

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company is contemplating liberalization of its existing credit terms to 2/10, net 45 days.
2. It is expected that sales are likely to increase by 1/3 of existing sales, bad debts increase to 2% of sales
and average collection period to decline to 20 days.
3. Credit period allowed by the supplier is 60 days. Generally, operating expenses are paid 2 months in arrears.
Total Variable expenses of the company constitute Purchases of stock in trade and operating expenses only.
4. Opportunity cost of investment in receivables is 15%. 50% and 80% of customers in terms of sales revenue
are expected to avail cash discount under existing and liberalization scheme respectively. The tax rate is
30%.
5. The Company considers only the relevant or variable costs for calculating the opportunity costs on the funds
blocked in receivables. Assume 360 days in a year and 30 days in a month.
Should the company change its credit terms?
Ans.
Particulars Result
Current liabilities 1,56,000
Total Variable expenses = Purchases & Operating Expenses 1,56,000 ÷ 60 × 360 = 9,36,000
Variable expenses % of Sales 9,36,000 ÷ 12,00,000 × 100 = 78%

Particulars Present Proposed

1 Lakh ÷ 30 × 360 12 Lakhs + 1/3rd
1. Sales
= 12,00,000 = 16,00,000
2. Variable Cost at 78%
9,36,000 12,48,000
12 Lakh × 50% × 1% 16 Lakh × 80% × 2%
3. Cash Discount
= 6,000 = 25,600
12 Lakh × 1.5% 16 Lakh × 2%
4. Bad debts
= 18,000 = 32,000
5. Profit before Tax 2,40,000 2,94,400
6. Tax @ 30% 72,000 88,320
7. Profit after Tax 1,68,000 2,06,080
8. Opportunity Cost of Invest. in
9,36,000 × 30/360 × 12,48,000 × 20/360 ×
Debtors
70% ×15% = 8,190 70% × 15% = 7,280
9. Net Benefit 1,59,810 1,98,800

Advise: Proposed policy should be adopted since the net benefit is increased by (` 1,98,800 - 1,59,810) = ` 38,990.

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9 WORKING CAPITAL
CHAPTER

Q.1 Max. Bank Finance RTP May 23

Kalyan limited has provided you the following information for the year 2021-22:
By working at 60% of its capacity the company was able to generate sales of ` 72,00,000. Direct labour cost per
unit amounted to ` 20 per unit. Direct material cost per unit was 40% of the selling price per unit. Selling price
was 3 times the direct labour cost per unit. Profit margin was 25% on the total cost.For the year 2022-23, the
company makes the following estimates:
Production and sales will increase to 90% of its capacity. Raw material per unit price will remain unchanged. Direct
expense per unit will increase by 50%. Direct labour per unit will increase by 10%. Despite the fluctuations in the
cost structure, the company wants to maintain the same profit margin on sales.
Raw materials will be in stock for one month whereas finished goods will remain in stock for two months. Production
cycle is for 2 months. Credit period allowed by suppliers is 2 months. Sales are made to three zones:
Zone Percentage of sale Mode of Credit
A 50% Credit period of 2 months
B 30% Credit period of 3 months
C 20% Cash Sales
There are no cash purchases and cash balance will be ` 1,11,000
The company plans to apply for a working capital financing from bank for the year 2022-23. ESTIMATE Net
Working Capital of the Company receivables to be taken on sales and also COMPUTE the maximum permissible
bank finance for the company using 3 criteria of Tandon Committee Norms. (Assume stock of finished goods to
be a core current asset)

Ans Cost Structure

2021-22 2022-23
Particulars Calculations P.U. Amount Calculations P.U. Amount
(p.u. X units) (p.u. X units)
Direct 40% of SP `24 `28,80,000 Same as PY `24 `43,20,000
Material
Direct Given `20 `24,00,000 20*1.1 `22 `39,60,000
labour
Direct bal. fig. `4 `4,80,000 4*1.5 `6 `10,80,000
Expenses
Total Cost SP - Profit `48 `57,60,000 `52 `93,60,000
Profit (SP/125x25) `12 `14,40,000 52*25% `13 `23,40,000
Sales 3 x Direct `60 `72,00,000 `65 `1,17,00,000
Labour p.u.
*units= `72,00,000/ `60 1,20,000/60 x90
=1,20,000 =1,80,000
Operating Cycle
Raw material holding period 1 months
Finished Goods holding period 2 months
WIP conversion period 2 months
Creditor Payment Period 2 months
Receiveable collection Period 2/3 months

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Estimation of Working Capital

Particulars Calculation Amount
Current Assets
Stock of Raw Material 43,20,000 x 1/12
`3,60,000
RM cost `43,20,000
Labour cost `19,80,000
Direct Exp cost `5,40,000
Total WIP Cost `68,40,000
Stock of WIP 68,40,000 x 2/12 `11,40,000
Stock of Finished Goods 93,60,000 x 2/12 `15,60,000
Receivables (on sales)
A 1,17,00,000 x 50% x 2/12 `9,75,000
B 1,17,00,000 x 30% x 3/12 `8,77,500
C NIL -
Cash Balance Given `1,11,000
Total Current Assets ` 50,23,500
Current Liabilities
Payables * `44,40,000 x 2/12 `7,40,000
Net Working Capital ` 42,83,500
Opening RM stock = 28,80,000 x 1/12= `2,40,000
* RM purchased = RM consumed – Opening Stock + Closing Stock
= `43,20,000 – `2,40,000 + `3,60,000 = `44,40,000
Computation of Maximum Permissible Bank Finance
Method Formula Calculation `
I 75% x (Current Assets- 75% x ( `50,23,500 - `7,40,000) `32,12,625
Current Liabilities)
I 75% x Current Assets- 75% x `50,23,500 - `7,40,000 `30,27,625
I Current Liabilities
II 75% x (Current Assets-Core 75% x ( `50,23,500- `18,57,625
I CA)- Current Liabilities `7,40,000 -
`15,60,000)

Q.2 Operating Cycle PY Jan 21

The following information is provided by MNP Ltd. for the year ending 31st March, 2020:
Raw Material Storage period 45 days
Work-in-Progress conversion period 20 days
Finished Goods storage period 25 days
Debt Collection period 30 days
Creditors payment period 60 days
Annual Operating Cost ` 25,00,000
(Including Depreciation of ` 2,50,000)
Assume 360 days in a year. You are required to calculate:
(i) Operating Cycle period
(ii) Number of Operating Cycle in a year.
(iii) Amount of working capital required for the company on a cost basis.
(iv) The company is a market leader in its product and it has no competitor in the market. Based on a market
survey it is planning to discontinue sales on credit and deliver products based on pre-payments in order to

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reduce its working capital requirement substantially. You are required to compute the reduction in working
capital requirement in such a scenario.

Ans (i) Calculation of Operating Cycle Period:

Operating Cycle Period = R + W + F + D – C
= 45 + 20 + 25 + 30 – 60 = 60 days
(ii) Number of Operating Cycle in a Year
360
= = 360 =6
Operating cycle period 60
(iii) Amount of Working Capital Required
Annual operating cost
= = 25, 00, 000 − 2,50, 000
Number of operating cycle 6

= 22,50, 000 = ` 3,75,000

6
(iv) Reduction in Working Capital
Operating Cycle Period = R + W + F – C
= 45 + 20 + 25 – 60 = 30 days
Amount of Working Capital Required = 22,50, 000 x30 = ` 1,87,500
360
Reduction in Working Capital = ` 3,75,000 – ` 1,87,500 = ` 1,87,500
Note: If we use Total Cost basis, then amount of Working Capital required will be
` 4,16,666.67 (approx.) and Reduction in Working Capital will be ` 2,08,333.33 (approx.)

Working Cap Requirement PY Nov 20

Q.3
PK Ltd., a manufacturing company, provides the following information:
(`)
Sales 1,08,00,000
Raw Material Consumed 27,00,000
Labour Paid 21,60,000
Manufacturing Overhead (Including Depreciation for the year ` 3,60,000) 32,40,000
Administrative & Selling Overhead 10,80,000

Additional Information:
(a) Receivables are allowed 3 months' credit.
(b) Raw Material Supplier extends 3 months' credit.
(c) Lag in payment of Labour is 1 month.
(d) Manufacturing Overhead are paid one month in arrear.
(e) Administrative & Selling Overhead is paid 1 month advance.
(f) Inventory holding period of Raw Material & Finished Goods are of 3 months.
(g) Work-in-Progress is Nil.
(h) PK Ltd. sells goods at Cost plus 33⅓%.
(i) Cash Balance ` 3,00,000.
(j) Safety Margin 10%.
You are required to compute the Working Capital Requirements of PK Ltd. on Cash Cost basis.

Ans Statement showing the requirements of Working Capital (Cash Cost basis)
Particulars (`) (`)
A. Current Assets:
Inventory:
Stock of Raw material ( ` 27,00,000 × 3/12) 6,75,000

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Stock of Finished goods ( ` 77,40,000 × 3/12) 19,35,000

Receivables ( ` 88,20,000 × 3/12) 22,05,000
Administrative and Selling Overhead ( ` 10,80,000 × 1/12) 90,000
Cash in Hand 3,00,000
Gross Working Capital 52,05,000 52,05,000
B. Current Liabilities:
Payables for Raw materials* ( ` 27,00,000 × 3/12) 6,75,000
Outstanding Expenses:
Wages Expenses ( ` 21,60,000 × 1/12) 1,80,000
Manufacturing Overhead ( ` 28,80,000 × 1/12) 2,40,000
Total Current Liabilities 10,95,000 10,95,000
Net Working Capital (A-B) 41,10,000
Add: Safety margin @ 10% 4,11,000
Total Working Capital requirements 45,21,000
Working Notes:
(i)
(A) Computation of Annual Cash Cost of Production (`)

Raw Material consumed 27,00,000

Wages (Labour paid) 21,60,000
Manufacturing overhead ( ` 32,40,000 - ` 3,60,000) 28,80,000
Total cash cost of production 77,40,000

(B) Computation of Annual Cash Cost of Sales (`)

Cash cost of production as in (A) above 77,40,000

Administrative & Selling overhead 10,80,000
Total cash cost of sales 88,20,000

*Purchase of Raw material can also be calculated by adjusting Closing Stock and Opening Stock (assumed nil).
In that case Purchase will be Raw material consumed +Closing Stock -Opening Stock i.e `27,00,000 +
`6,75,000 - Nil = `33,75,000. Accordingly, Total Working Capital requirements ( ` 43,35,375) can be
calculated.

Q.4 Working Capital Requirement RTP Nov 22

Trading and Profit and Loss Account of Beat Ltd. for the year ended 31st March, 2022 is given below:
Particulars Amount (`) Amount (`) Particulars Amount(`) Amount(`)
To Opening Stock: By Sales (Credit) 1,60,00,000
- Raw Materials 14,40,000 By Closing Stock:
- Work-in- progress 4,80,000 - Raw Materials 16,00,000
- Finished Goods 20,80,000 40,00,000 - Work-inprogress 8,00,000
To Purchases (credit) 88,00,000 - Finished Goods 24,00,000 48,00,000
To Wages 24,00,000
To Production Exp. 16,00,000
To Gross Profit c/d 40,00,000
2,08,00,000 2,08,00,000
To Administration 14,00,000 By Gross Profitb/d 40,00,000
Exp.

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To Selling Exp. 6,00,000

To Net Profit 20,00,000
40,00,000 40,00,000
The opening and closing payables for raw materials were ` 16,00,000 and ` 19,20,000 respectively whereas the
opening and closing balances of receivables were ` 12,00,000 and ` 16,00,000 respectively.
You are required to ASCERTAIN the working capital requirement by operating cycle method.

Ans Computation of Operating Cycle

(1) Raw Material Storage Period (R)
Average Stock of Raw Material
Raw Material Storage Period (R) =
Daily Average Consumption of Raw material
= (14, 40, 000 + 16, 00, 000) / 2 = 64.21 Days
86, 40, 000 / 365
Raw Material Consumed = Opening Stock + Purchases – Closing Stock
= ` 14,40,000+ ` 88,00,000– ` 16,00,000 = ` 86,40,000
(2) Conversion/Work-in-Process Period (W)

AverageStock of WIP
Conversion/Processing Period =
Daily Average Pr oduction
= (4,80, 000 + 8, 00, 000) / 2 = 18.96 days
1,23,20, 000 / 365
Production Cost: `
Opening Stock of WIP 4,80,000
Add: Raw Material Consumed 86,40,000
Add: Wages 24,00,000
Add: Production Expenses 16,00,000
1,31,20,000
Less: Closing Stock of WIP 8,00,000
Production Cost 1,23,20,000
(3) Finished Goods Storage Period (F)
Average Stock of Finished Goods
Finished Goods Storage Period =
Daily Average Cost of Good Sold

= (20,80, 000 + 24, 00, 000) / 2 = 68.13 Days

1,20, 00, 000 / 365

Cost of Goods Sold `

Opening Stock of Finished Goods 20,80,000
Add: Production Cost 1,23,20,000
1,44,00,000
Less: Closing Stock of Finished Goods (24,00,000)
1,20,00,000
(4) Receivables Collection Period (D)
Average Receivables
Receivables Collection Period =
Daily averagecredit sales

= (12, 00, 000 + 16, 00, 000) / 2 = 31.94 Days

1,60, 00, 000 / 365

(5) Payables Payment Period (C)

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Average Payable
Payables Payment Period =
Daily averagecredit sales

= (16, 00, 000 + 19,20, 000) / 2 = 73 Days

88, 00, 000 / 365

(6) Duration of Operating Cycle (O)

O = R+W+F+D–C
= 64.21 + 18.96 + 68.13 + 31.94 – 73
= 110.24 days
Computation of Working Capital
(i) Number of Operating Cycles per Year
= 365/Duration Operating Cycle = 365/110.24 = 3.311
(ii) Total Operating Expenses `
Total Cost of Goods sold 1,20,00,000
Add: Administration Expenses 14,00,000
Add: Selling Expenses 6,00,000
1,40,00,000
(iii) Working Capital Required
Total Operating Expenses
Working Capital Required =
Number of Operating Cycles per year

= 1, 40, 00, 000 = ` 42,28,329.81

3.311

Q.5 Working Capital Requirement RTP July 21

MT Ltd. has been operating its manufacturing facilities till 31.3.202 1 on a single shift working with the following
cost structure:
Per unit (`)
Cost of Materials 24
Wages (out of which 60% variable) 20
Overheads (out of which 20% variable) 20
64
Profit 8
Selling Price 72
As at 31.3.2021 with the sales of ` 17,28,000, the company held:
(`)
Stock of raw materials (at cost) 1,44,000
Work-in-progress (valued at prime cost) Finished 88,000
goods (valued at total cost) Sundry debtors 2,88,000
4,32,000
In view of increased market demand, it is proposed to double production by working an extra shift. It is
expected that a 10% discount will be available from suppliers of raw materials in view of increased volume of
business. Selling price will remain the same. The credit period allowed to customers will remain unaltered. Credit
availed from suppliers will continue to remain at the present level i.e. 2 months. Lag in payment of wages and
overheads will continue to remain at one month.
You are required to CALCULATE the additional working capital requirements, if the policy to increase output is
implemented, to assess the impact of double shift for long term as a matter of production policy.

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Ans (1) Statement of cost at single shift and double shift working
24,000 units 48,000 Units
Per unit Total Per unit Total
(`) (`) (`) (`)
Raw materials 24 5,76,000 21.6 10,36,000
Wages:
Variable 12 2,88,000 12 5,76,000
Fixed 8 1,92,000 4 1,92,000
Overheads:
Variable 4 96,000 4 1,92,000
Fixed 16 3,84,000 8 3,84,000
Total cost 64 15,36,000 49.6 23,80,800
Profit 8 1,92,000 22.4 10,75,200
Sales 72 17,28,000 72 34,56,000

Sales
(2) Sales in units 2020-21 = = 17,28, 000 = 24,000 units
Unit selling price 72

(3) Stock of Raw Materials in units on 31.3.2021

= Value of stock = 6,000 units

1, 44, 000

Cost per unit ` 24

(4) Stock of work-in-progress in units on 31.3.2021
Value of work − in − progress 88, 000
= = =2,000units
PrimeCost per unit (24+20)

(5) Stock of finished goods in units 2020-213

Value of stock
= = 2,88, 000 = 4,500 units.
TotalCost per unit 64

Comparative Statement of Working Capital Requirement

Single Shift (24,000 units) Double Shift (48,000 units)
Units Rate Amount Units Rate Amount
(`) (`) (`) (`)
Current Assets
Inventories:
Raw Materials 6,000 24 1,44,000 12,000 21.6 2,59,200
Work-in-Progress 2,000 44 88,000 2,000 37.6 75,200
Finished Goods 4,500 64 2,88,000 9,000 49.6 4,46,400
Sundry Debtors 6,000 64 3,84,000 12,000 49.6 5,95,200
Total Current Assets (A) 9,04,000 13,76,000
Current Liabilities
Creditors for Materials 4,000 24 96,000 8,000 21.6 1,72,800
Creditors for Wages 2,000 20 40,000 4,000 16 64,000
Creditors for Overheads 2,000 20 40,000 4,000 12 48,000
Total Current Liabilities (B) 1,76,000 2,84,800
Working Capital (A) – (B) 7,28,000 10,91,200

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Analysis: Additional Working Capital requirement = ` 10,91,200 – ` 7,28,000 = `3,63,200, if the policy to
increase output is implemented.

Q.6 Cash Cost Basis RTP July 21

While applying for financing of working capital requirements to a commercial bank, TN Industries Ltd.
projected the following information for the next year:

Cost Element Per unit ( `) Per unit ( `)

Raw materials
X 30
Y 7
Z 6 43
Direct Labour 25
Manufacturing and administration overheads (excluding 20
depreciation)

Depreciation 10
Selling overheads 15
113

Additional Information:
(a) Raw Materials are purchased from different suppliers leading to different credit period allowed as follows:
X – 2 months; Y– 1 months; Z – ½ month
(b) Production cycle is of ½ month. Production process requires full unit of X and Y in the beginning of the
production. Z is required only to the extent of half unit in the beginning and the remaining half unit
is needed at a uniform rate during the production process.
(c) X is required to be stored for 2 months and other materials for 1 month. (d) Finished goods are held for
1 month.
(e) 25% of the total sales is on cash basis and remaining on credit basis. The credit allowed by debtors is 2
months.
(f) Average time lag in payment of all overheads is 1 months and ½ months for direct labour.
(g) Minimum cash balance of ` 8,00,000 is to be maintained.
CALCULATE the estimated working capital required by the company on cash cost basis if the budgeted level of
activity is 1,50,000 units for the next year. The company also intends to increase the estimated working capital
requirement by 10% to meet the contingencies. (You may assume that production is carried on evenly throughout
the year and direct labour and other overheads accrue similarly.)

Ans Statement showing Working Capital Requirements of TN Industries Ltd. (on cash cost basis)
Amount in (`) Amount in (`)
A. Current Assets
(i) Inventories:
Raw material
 1,50,000units  Rs.30 
x x2months 
 12 months  7,50,000

 1,50,000units  7 
y x1months 
 12 months  87,500

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 1,50,000units  6 
z  x1months  75,000
 12 months 

 1,50,000units  64 
WIP  x0.5months  4,00,000
 12 months 

 1,50,000units  88 
Finished goods  x1months  11,00,000 24,12,500
 12 months 
(ii) Receivables (Debtors)
 1,50,000units  103  19,31,250
 x2months  x 0.75
 12 months 
(iii) Cash and bank balance 8,00,000
Total Current Assets 51,43,750
B. Current Liabilities:
(i) Payables (Creditors) for Raw materials

 1,50,000units  30  7,50,000
X  x2months 
 12 months 

 1,50,000units  7  87,500
Y  x1months 
 12 months 

 1,50,000units  6  37,500
Z x0.5months  8,75,000
 12 months 
(ii) Outstanding Direct Labour
 1,50,000units  25  1,56,250
 x1months 
 12 months 
(iii) Outstanding Manufacturing and
administration overheads
2,50,000
 1,50,000units  20 
 x1months 
 12 months 
(iv) Outstanding Selling overheads
 1,50,000units  15  1,87,500
 x1months 
 12 months 
Total Current Liabilities 14,68,750
Net Working Capital Needs (A – B) 36,75,000
Add: Provision for contingencies @ 10% 3,67,500
Working capital requirement 40,42,500
Workings:
1.
(i) Computation of Cash Cost of Production Per unit ( `)
Raw Material consumed 43
Direct Labour 25
Manufacturing and administration overheads 20
Cash cost of production 88
(ii) Computation of Cash Cost of Sales Per unit ( `)

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Cash cost of production as in (i) above 88

Selling overheads 15
Cash cost of sales 103
2. Calculation of cost of WIP
Particulars Per unit ( `)
Raw material (added at the beginning):
X 30
Y 7
Z ( ` 6 x 50%) 3
Cost during the year:
Z {( ` 6 x 50%) x 50%} 1.5
Direct Labour ( ` 25 x 50%) 12.5
Manufacturing and administration overheads ( ` 20 x 50%) 10
64

Q.7 Cash Cost Basis RTP May 20

Day Ltd., a newly formed company has applied to the Private Bank for the first time for financing it's Working
Capital Requirements. The following information is available about the projections for the current year:
Estimated Level of Activity Completed Units of Production 31,200 plus unit of
work in progress 12,000
Raw Material Cost ` 40 per unit
Direct Wages Cost ` 15 per unit
Overhead ` 40 per unit (inclusive of Depreciation `10 per unit)
Selling Price ` 130 per unit
Raw Material in Stock Average 30 days consumption
Work in Progress Stock Material 100% and Conversion Cost 50%
Finished Goods Stock 24,000 Units
Credit Allowed by the supplier 30 days
Credit Allowed to Purchasers 60 days
Direct Wages (Lag in payment) 15 days
Expected Cash Balance ` 2,00,000
Assume that production is carried on evenly throughout the year (360 days) and wages and overheads accrue
similarly. All sales are on the credit basis. You are required to CALCULATE the Net Working Capital Requirement
on Cash Cost Basis.

Ans Calculation of Net Working Capital requirement:

( `) ( `)
A. Current Assets:
Inventories:
Stock of Raw material (Refer to Working note (iii) 1,44,000
Stock of Work in progress (Refer to Working note (ii) 7,50,000
Stock of Finished goods (Refer to Working note (iv) 20,40,000
Debtors for Sales(Refer to Working note (v) 1,02,000
Cash 2,00,000
Gross Working Capital 32,36,000 32,36,000
B. Current Liabilities:
Creditors for Purchases (Refer to Working note (vi) 1,56,000
Creditors for wages (Refer to Working note (vii) 23,250
1,79,250 1,79,250

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Net Working Capital (A - B) 30,56,750

Working Notes:
(i) Annual cost of production
(`)
Raw material requirements
{(31,200 × ` 40) + (12,000 x ` 40)}
17,28,000
Direct wages {(31,200 × ` 15) +(12,000 X ` 15 x 0.5)} 5,58,000
Overheads (exclusive of depreciation)
{(31,200 × ` 30) + (12,000 x ` 30 x 0.5)} 11,16,000
Gross Factory Cost 34,02,000
Less: Closing W.I.P [12,000 ( ` 40 + ` 7.5 + `15)] (7,50,000)
Cost of Goods Produced 26,52,000
Less: Closing Stock of Finished Goods
( ` 26,52,000 × 24,000/31,200) (20,40,000)
Total Cash Cost of Sales* 6,12,000

[*Note: Alternatively, Total Cash Cost of Sales = (31,200 units – 24,000 units) x ( ` 40+ ` 15 + ` 30) = `
6,12,000]
(ii) Work in progress stock

(`)
Raw material requirements (12,000 units × `40) 4,80,000
Direct wages (50% × 12,000 units × ` 15) 90,000
Overheads (50% × 12,000 units × ` 30) 1,80,000
7,50,000

(iii) Raw material stock

It is given that raw material in stock is average 30 days consumption. Since, the company is newly formed;
the raw material requirement for production and work in progress will be issued and consumed during the
year. Hence, the raw materi al consumption for the year (360 days) is as follows:

(`)
For Finished goods (31,200 × ` 40) 12,48,000
For Work in progress (12,000 × ` 40) 4,80,000
17,28,000
17,28,000
Raw material stock = × 30 days = `1,44,000
360days
(iv) Finished goods stock:
24,000 units @ ` (40+15+30) per unit = `20,40,000
60 days
(v) Debtors for sale: ` 6,12,000x = `1,02,000
360days
(vi) Creditors for raw material Purchases [Working Note (iii)]:
Annual Material Consumed ( `12,48,000 + `4,80,000) `17,28,000
Add: Closing stock of raw material [( `17,28,000 x 30 days) / 360 days] ` 1,44,000
`18,72,000
18,72,000
Credit allowed by suppliers = × 30days = ` 1,56,000
360days
(vii) Creditors for wages:
Outstanding wage payment = [(31,200 units x ` 15) + (12,000 units x ` 15 x .50)] x
15 days / 360 days

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5,58, 000
= ×15days = ` 23,250
360days

Q.8 Working Capital Estimate RTP Dec 21

The management of Trux Company Ltd. is planning to expand its business and consults you to prepare an estimated
working capital statement. The records of the company reveals the following annual information:

( `)
Sales – Domestic at one month’s credit 18,00,000
Export at three month’s credit (sales price 10% below domestic price) 8,10,000
Materials used (suppliers extend two months credit) 6,75,000
Lag in payment of wages – ½ month 5,40,000
Lag in payment of manufacturing expenses (cash) – 1 month 7,65,000
Lag in payment of Administration Expenses – 1 month 1,80,000
Selling expenses payable quarterly in advance 1,12,500
Income tax payable in four installments, of which one falls in the next 1,68,000
financial year

Rate of gross profit is 20%. Ignore work-in-progress and depreciation.

The company keeps one month’s stock of raw materials and finished goods (each) and believes in keeping
`2,50,000 available to it including the overdraft limit of ` 75,000 not yet utilized by the company.
The management is also of the opinion to make 10% margin for contingencies on computed figure.
You are required to PREPARE the estimated working capital statement for the next year.

Ans Preparation of Statement of Working Capital Requirement for Trux Company Ltd.

( `) ( `)
A. Current Assets
(i) Inventories:
Material (1 month)
 6,75, 000  56,250
 x1 month 
 12months 
Finished goods (1 month)
 21,60,000 
 x1 month 
 12months  1,80,000 2,36,250

(ii) Receivables (Debtors)

 15,17,586 
For Domestic Sales  x1 month  1,26,466
 12months 
(iii) Prepayment of Selling expenses
 1,12,500 
 x 3 month 
 12months  28,125

(iii) Cash in hand & at bank 1,75,000

Total Current Assets 7,54,570
B. Current Liabilities:
(i) Payables (Creditors) for materials (2
months)
1,12,500

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 6,75,000 
 x 2 month 
 12months 
(ii) Outstanding wages (0.5 months)
 5, 40,000 
 x 0.5 month 
 12months  22,500

(iii) Outstanding manufacturing expenses

 7,65,000 
 x1 month 
 12months 
63,750
(iv) Outstanding administrative expenses
 1,80,000 
 x1 month 
 12months  15,000

(v) Income tax payable 42,000

Total Current Liabilities 2,55,750
Net Working Capital (A – B) 4,98,820
Add: 10% contingency margin 49,882
Total Working Capital required 5,48,702
Working Notes:

1. Calculation of Cost of Goods Sold and Cost of Sales

Domestic ( `) Export ( `) Total ( `)
Domestic Sales 18,00,000 8,10,000 26,10,000
Less: Gross profit @ 20% on 3,60,000 90,000 4,50,000
domestic sales and 11.11% on export
sales (Working note-2)
Cost of Goods Sold 14,40,000 7,20,000 21,60,000
Add: Selling expenses (Working 77,586 34,914 1,12,500
note-3)
Cash Cost of Sales 15,17,586 7,54,914 22,72,500
2. Calculation of gross profit on Export Sales
Let domestic selling price is ` 100. Gross profit is ` 20, and then cost per unit is ` 80
Export price is 10% less than the domestic price i.e. ` 100 – (1- 0.1) = ` 90
Now, gross profit will be = ` 90 - ` 80 = ` 10
So, Gross profit ratio at export price will be = 10 x100 = 11.11%
90
3. Apportionment of Selling expenses between Domestic and Exports sales:
Apportionment on the basis of sales value:
Domestic Sales = 1,12, 500 x 18,00,000 = ` 77,586
26,10, 000

Exports Sales = 1,12, 500 x ` 8,10,000 = ` 34,914

26,10, 000
4. Assumptions
(i) It is assumed that administrative expenses is related to production activities.
(ii) Value of opening and closing stocks are equal.

Q.9 Working Capital Estimate MTP Dec 21(2)

On 01st April, 2020, the Board of Director of ABC Ltd. wish to know the amount of working capital that will be

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required to meet the programme they have planned for the year. From the following information,
PREPARE a working capital requirement forecast and a forecast profit and loss account and balance sheet:
Issued share capital ` 6,00,000
10% Debentures ` 1,00,000
Fixed Assets ` 4,50,000
Production during the previous year was 1,20,000 units; it is planned that this level of activity should be
maintained during the present year.
The expected ratios of cost to selling price are: raw materials 60%, direct wages 10% overheads 20% Raw
materials are expected to remain in store for an average of two months before issue to production.
Each unit of production is expected to be in process for one month. The time lag in wage
payment is one month.
Finished goods will stay in the warehouse awaiting dispatch to customers for approximately three months.
Credit allowed by creditors is two months from the date of delivery of raw materials. Credit given to debtors is
three months from the date of dispatch.
Selling price is ` 5 per unit.
There is a regular production and sales cycle and wages and overheads accrue evenly.

Ans Forecast Profit and Loss Account for the period 01.04.2020 to 31.03.2021
Particulars ` Particulars `
Materials consumed 3,60,000 By Sales 1,20,000 @ ` 5 6,00,000
1,20,000 @ ` 3
Direct wages : 60,000

Overheads : 1,20,000

1,20,000 @ ` 1
Gross profit c/d 60,000
6,00,000 6,00,000
Debenture interest 10,000 60,000
(10% of 1,00,000)
Net profit c/d 50,000 By gross profit b/d
60,000 60,000
Working Capital Requirement Forecast for the year 01.04.2020 to 31.03.2021
Particulars Period Total (`) Current Assets (`) Current
(Months) Liabilities(`)
Raw Work-in- Finished Debtors Creditors
materials progress goods
1.Material
In store 2 60,000
In work-in- 1 30,000
progress
In finished 3 90,000
goods
Credit to 3 90,000
debtors
9
Less : 2 60,000
Credit from
creditors
Net block 7 2,10,000
period

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2. Wages:
In work-in- 1/2 2,500
progress
In finished 3 15,000
goods
Credit to 3 15,000
debtors
6½
Less : Time 1 5,000
lag in
payment
Net block 5 ½ 27,500
period
3.Overhead
In work-in- ½ 5,000
progress
In finished 3 30,000
goods
Credit to 3 30,000
debtors
Net block 6½ 65,000
period
4.Profit
Credit to 3 15,000
debtors
Net block 3 15,000
period
Total ( `) 3,17,500 60,000 37,500 1,35,000 1,50,000 65,000

Forecast Balance Sheet as on 31.03.2021

(`) (`)
Issued share capital 6,00,000 Fixed Assets 4,50,000
Profit and Loss A/c 50,000 Current Assets:
10% Debentures 1,00,000 Stock:
Sundry creditors 65,000 Raw materials 60,000
Bank overdraft- Work-in-progress 37,500
Balancing figure 17,500 Finished goods 1,35,000 2,32,500
Debtors 1,50,000

8,32,500 8,32,500

The Total amount of working capital, thus, stands as follows: `

Requirement as per working capital 3,17,500
Less: Bank overdraft as per balance sheet 17,500
Net requirement 3,00,000
Notes:
1. Average monthly production: 1,20,000 ÷ 12 = 10,000 units
2. Average cost per month:
Raw Material 10,000 × ( ` 5 × 0.6) = ` 30,000

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Direct wages 10,000 × ( ` 5 × 0.1) = ` 5,000

Overheads 10,000 × ( ` 5 × 0.2) = ` 10,000
3. Average profit per month: 10,000 × ( ` 5 × 0.1) = ` 5,000
4. Wages and overheads accrue evenly over the period and, hence, are assumed to be completely introduced
for half the processing time.

Q.10 Working Capital Estimate RTP May 19

A company is considering its working capital investment and financial policies for the next year. Estimated fixed
assets and current liabilities for the next year are ` 2.60 crores and ` 2.34 crores respectively. Estimated
Sales and EBIT depend on current assets investment, particularly inventories and book-debts. The
Financial Controller of the company is examining the following alternative Working Capital Policies:
Working Capital Investment in Estimated Sales EBIT
Policy Current Assets
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00
the adoption of the moderate working capital policy. The company is now examining the use of long-term and
short-term borrowings for financing its assets. The company will use ` 2.50 crores of the equity funds. The
corporate tax rate is 35%.
The company is considering the following debt alternatives.
Financing Policy Short-term Debt Long-term Debt
Conservative 0.54 1.12
Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest rate-Average 12% 16%
You are required to CALCULATE the following:
(i) Working Capital Investment for each policy:
(a) Net Working Capital position
(b) Rate of Return
(c) Current ratio
(ii) Financing for each policy:
(a) Net Working Capital position.
(b) Rate of Return on Shareholders’ equity.
(c) Current ratio.

Ans (i) Statement showing Working Capital Investment for each policy
Working Capital Policy
Conservative Moderate Aggressive
Current Assets: (i) 4.50 3.90 2.60
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 7.10 6.50 5.20
Current liabilities: (iv) 2.34 2.34 2.34
Net Worth: (v) = (iii) - (iv) 4.76 4.16 2.86
Total liabilities: (iv) + (v) 7.10 6.50 5.20
Estimated Sales: (vi) 12.30 11.50 10.00
EBIT: (vii) 1.23 1.15 1.00
(a) Net working capital position: (i) - 2.16 1.56 0.26
(iv)

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(b) Rate of return: (vii) /(iii) 17.32% 17.69% 19.23%

(c) Current ratio: (i)/ (iv) 1.92 1.67 1.11

(ii) Statement Showing Effect of Alternative Financing Policy

( `in crore)
Financing Policy Conservative Moderate Aggressive
Current Assets (i) 3.90 3.90 3.90
Fixed Assets (ii) 2.60 2.60 2.60
Total Assets (iii) 6.50 6.50 6.50
Current Liabilities (iv) 2.34 2.34 2.34
.Short term Debt (v) 0.54 1.00 1.50
Total current liabilities 2.88 3.34 3.84
(vi) = (iv) + (v)
Long term Debt (vii) 1.12 0.66 0.16
Equity Capital (viii) 2.50 2.50 2.50
Total liabilities (ix) = 6.50 6.50 6.50
(vi)+(vii)+(viii)
Forecasted Sales 11.50 11.50 11.50
EBIT (x) 1.15 1.15 1.15
Less: Interest on short-term 0.06 0.12 0.18
debt
(12% of `0.54) (12% of ` 1) (12% of ` 1.5)
Interest on long term debt 0.18 0.11 0.03
(16% of `1.12) (16% of `0.66) (16% of `0.16)
Earnings before tax (EBT) (xi) 0.91 0.92 0.94
Taxes @ 35% (xii) 0.32 0.32 0.33
Earnings after tax: (xiii) = (xi) – 0.59 0.60 0.61
(xii)
(a) Net Working Capital 1.02 0.56 0.06
Position: (i) - [(iv) + (v)]
(b) Rate of return on
shareholders Equity capital : 24.0% 24.4%
23.6% (xiii)/ (viii)
(c) Current Ratio (i) / (vi) 1.35 1.17 1.02

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10 INVESTING DECISION
CHAPTER

Q.1 NPV Method (Accept/Not) RTP May 23

Dharma 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 ` 240 lakhs and additional equipment costing ` 26 lakhs will be needed at the
beginning of third year. At the end of 8 years, the original equipment will have resale value equivalent to the cost
of removal, but the additional equipment would be sold for ` 2 lakhs. Working Capital of ` 25 lakhs will be needed
at the beginning of the operations. 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 (%)
1 20
2 30
3-5 75
6-8 50

A sale price of ` 100 per unit with a profit volume ratio (contribution/sales) of 60% is likely to be obtained. Fixed
operating cash cost are likely to be ` 16 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 (` Lakhs each year) 30 15 10 4

The company is subjected to 50% tax rate and consider 12% to be an appropriate cost of capital. Straight line
method of depreciation is followed by the company. ADVISE the management on the desirability of the project.

Ans. Calculation of Cash Flow After tax

Year 1 2 3 to 5 6 to 8
A Capacity 20% 30% 75% 50%
B Units 80000 120000 300000 200000
C Contribution p.u. `60 `60 `60 `60
D Contribution `48,00,000 `72,00,000 `1,80,00,000 `1,20,00,000
E Fixed Cash Cost `16,00,000 `16,00,000 `16,00,000 `16,00,000
Depreciation
F Original Equipment `30,00,000 `30,00,000 `30,00,000 `30,00,000
(`240Lakhs/8)
G Additional Equipment -- -- `4,00,000 `4,00,000
(`24Lakhs/6)
H Advertisement `30,00,000 `15,00,000 `10,00,000 `4,00,000
Expenditure
I Profit Before Tax ` (28,00,000) `11,00,000 `1,20,00,000 `66,00,000
(D- E-F-G-H)
J Tax savings/ `14,00,000 `(5,50,000) `(60,00,000) ` (33,00,000)
(expenditure)
K Profit After Tax ` (14,00,000) `5,50,000 `60,00,000 `33,00,000
L Add: Depreciation `30,00,000 `30,00,000 `34,00,000 `34,00,000
(F+G)

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M Cash Flow After Tax `16,00,000 `35,50,000 `94,00,000 `67,00,000

Calculation of NPV
Year Particula Cash Flows PV factor PV
0 Initial Investment rs ` (2,40,00,000) 1.000 ` (2,40,00,000)
0 Working Capital ` (25,00,000) 1.000 ` (25,00,000)
Introduced
1 CFAT `16,00,000 0.893 ` 14,28,800
2 CFAT ` 35,50,000 0.797 ` 28,29,350
2 Additional Equipment ` (26,00,000) 0.797 ` (20,72,200)
3 CFAT ` 94,00,000 0.712 ` 66,92,800
4 CFAT ` 94,00,000 0.636 ` 59,78,400
5 CFAT ` 94,00,000 0.567 ` 53,29,800
6 CFAT ` 67,00,000 0.507 ` 33,96,900
7 CFAT ` 67,00,000 0.452 ` 30,28,400
8 CFAT ` 67,00,000 0.404 ` 27,06,800
8 WC Released ` 25,00,000 0.404 ` 10,10,000
8 Salvage Value ` 2,00,000 0.404 ` 80,800
Net Present Value `39,09,850

Since the NPV is positive, the proposed project should be implemented.

Q.2 NPV Method (Accept/Not) MTP Dec 21(2)

Superb Ltd. constructs customized parts for satellites to be launched by USA and Canada. The parts are
constructed in eight locations (including the central headquarter) around the world. The Finance Director, Ms.
Kuthrapali, chooses to implement video conferencing to speed up the budget process and save travel costs. She
finds that, in earlier years, the company sent two officers from each location to the central headquarter
to discuss the budget twice a year. The average travel cost per person, including air fare, hotels and meals, is `
27,000 per trip. The cost of using video conferencing is ` 8,25,000 to set up a system at each location plus ` 300
per hour average cost of telephone time to transmit signals. A total 48 hours of transmission time will be needed
to complete the budget each year. The company depreciates this type of equipment over five years by using
straight line method. An alternative approach is to travel to local rented video conferencing facilities, which can
be rented for ` 1,500 per hour plus ` 400 per hour averge cost for telephone charges. You are Senior Officer of
Finance Department. You have been asked by Ms. Kuthrapali to EVALUATE the proposal and SUGGEST if it would
be worthwhile for the company to implement video conferencing.

Ans. Option I : Cost of travel, in case Video Conferencing facility is not provided
Total Trip = No. of Locations × No. of Persons × No. of Trips per Person = 7×2×2 = 28 Trips
Total Travel Cost (including air fare, hotel accommodation and meals) (28 trips × ` 27,000 per trip) = ` 7,56,000

Option II : Video Conf.Facility is provided by Installation of Own Equipment at Different Locations

Cost of Equipment at each location (` 8,25,000 × 8 locations) = ` 66,00,000
Economic life of Machines (5 years). Annual depreciation (66,00,000/5) = ` 13,20,000
Annual transmission cost (48 hrs. transmission × 8 locations × ` 300 per hour) = ` 1,15,200
Annual cost of operation (13,20,000 + 1,15,200) = ` 14,35,200
Option III : Engaging Video Conferencing Facility on Rental Basis
Rental cost (48 hrs. × 8 location × ` 1,500 per hr) = ` 5,76,000
Telephone cost (48 hrs.× 8 locations × ` 400 per hr.) = ` 1,53,600

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Total rental cost of equipment (5,76,000 + 1,53,600) = ` 7,29,600

Analysis: The annual cash outflow is minimum, if video conferencing facility is engaged on rental basis Therefore,
Option III is suggested.

Q.3 Adjusted PV & Disc Rate PY May 18

(a) XYZ Ltd. is presently all equity financed. The directors of the company have been evaluating investment
in a project which will require ` 270 lakhs capital expenditure on new machinery. They expect the capital
investment to provide annual cash flows of ` 42 lakhs indefinitely which is net of all tax adjustments. The
discount rate which it applies to such investment decisions is 14% net.
The directors of the company believe that the current capital structure fails to take advantage of tax
benefits of debt, and propose to finance the new project with undated perpetual debt secured on the
company's assets. The company intends to issue sufficient debt to cover the cost of capital expenditure
and the after tax cost of issue.
The current annual gross rate of interest required by the market on corporate undated debt of similar risk
is 10%. The after tax costs of issue are expected to be ` 10 lakhs. Company's tax rate is 30%.
You are required to calculate:
(i) The adjusted present value of the investment,
(ii) The adjusted discount rate and
(iii) Explain the circumstances under which this adjusted discount rate may be used to evaluate future
investments.
(b) What are Masala Bonds?

Ans. (a) (i) Calculation of Adjusted Present Value of Investment (APV)

Adjusted PV = Base Case PV + PV of financing decisions associated with the project
Base Case NPV for the project:
(-) ` 270 lakhs + (` 42 lakhs / 0.14) = (-) ` 270 lakhs + ` 300 lakhs
= ` 30
Issue costs = ` 10 lakhs
Thus, the amount to be raised = ` 270 lakhs + ` 10 lakhs
= ` 280 lakhs
Annual tax relief on interest payment = ` 280 X 0.1 X 0.3
= ` 8.4 lakhs in perpetuity
The value of tax relief in perpetuity = ` 8.4 lakhs / 0.1
= ` 84 lakhs
Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on debt interest
= ` 30 lakhs – ` 10 lakhs + 84 lakhs = ` 104 lakhs

(ii) Calculation of Adjusted Discount Rate (ADR)

Annual Income / Savings required to allow an NPV to zero
Let the annual income be x.
(-) `280 lakhs X (Annual Income / 0.14) = (-) `104 lakhs
Annual Income / 0.14 = (-) ` 104 + ` 280 lakhs
Therefore, Annual income = ` 176 X 0.14 = ` 24.64 lakhs
Adjusted discount rate = (` 24.64 lakhs / `280 lakhs) X 100
= 8.8%
(iii) Useable circumstances
This ADR may be used to evaluate future investments only if the business risk of the new venture is
identical to the one being evaluated here and the project is to be financed by the same method on
the same terms. The effect on the company’s cost of capital of introducing debt into the capital
structure cannot be ignored.

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(b) Masala Bond:

Masala (means spice) bond is an Indian name used for Rupee denominated bond that Indian corporate
borrowers can sell to investors in overseas markets. These bonds are issued outside India but denominated
in Indian Rupees. NTPC raised `2,000 crore via masala bonds for its capital expenditure in the year 2016.

Q.4 Annualised Yeild PY Dec 21

Stand Ltd. is contemplating replacement of one of its machines which has become outdated and inefficient. Its
financial manager has prepared a report outlining two possible replacement machines. The details of each machine
are as follows:
Machine 1 Machine 2
Initial investment ` 12,00,000 ` 16,00,000
Estimated useful life 3 years 5 years
Residual value ` 1,20,000 ` 1,00,000
Contribution per annum ` 11,60,000 ` 12,00,000
Fixed maintenance costs per annum ` 40,000 ` 80,000
Other fixed operating costs per annum ` 7,20,000 ` 6,10,000
The maintenance costs are payable annually in advance. All other cash flows apart from the initial investment
assumed to occur at the end of each year. Depreciation has been calculated by straight line method and has been
included in other fixed operating costs. The expected cost of capital for this project is assumed as 12% p.a
Required:
(i) Which machine is more beneficial, using Annualized Equivalent Approach? Ignore tax.
(ii) Calculate the sensitivity of your recommendation in part (i) to changes in the contribution generated by
machine 1.
Year 1 2 3 4 5 6
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567 0.507
PVIFA0.12,t 0.893 1.690 2.402 3.038 3.605 4.112

Ans. Calculation of Net Cash flows

Machine 1
Other fixed operating costs (excluding depreciation) = 7,20,000–[(12,00,000–1,20,000)/3] = ` 3,60,000
Year Initial Contribution Fixed Other fixed operating Residual Value(`) Net cash
Investment (`) maintenance costs (excluding flow(`)
(`) costs(`) depreciation) (`)
0 (12,00,000) (40,000) (12,40,000)
1 11,60,000 (40,000) (3,60,000) 7,60,000
2 11,60,000 (40,000) (3,60,000) 7,60,000
3 11,60,000 (3,60,000) 1,20,000 9,20,000

Machine 2
Other fixed operating costs (excluding depreciation) = 6,10,000–[(16,00,000–1,00,000)/5] = ` 3,10,000

Year Initial Contribution Fixed maintenanc Other fixed operating Residual Net cash
0 Investment (`) costs (`) costs (excluding Value flow (`)
(`) (16,00,000) (80,000) depreciation) (`) (`) (16,80,000)
1 12,00,000 (80,000) (3,10,000) 8,10,000

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2 12,00,000 (80,000) (3,10,000) 8,10,000

3 12,00,000 (80,000) (3,10,000) 8,10,000
4 12,00,000 (80,000) (3,10,000) 8,10,000
5 12,00,000 (3,10,000) 1,00,000 9,90,000

Calculation of Net Present Value

Machine 1 Machine 2
Year 12% discount factor Net cash flow Present value (`) Net cash flow (`) Present value (`)
(`)
0 1.000 (12,40,000) (12,40,000) (16,80,000) (16,80,000)
1 0.893 7,60,000 6,78,680 8,10,000 7,23,330
2 0.797 7,60,000 6,05,720 8,10,000 6,45,570
3 0.712 9,20,000 6,55,040 8,10,000 5,76,720
4 0.636 8,10,000 5,15,160
5 0.567 9,90,000 5,61,330
NPV @ 12% 6,99,440 13,42,110
PVAF @ 12% 2.402 3.605
Equivalent Annualized Criterion 2,91,190.674 3,72,291.262

Recommendation: Machine 2 is more beneficial using Equivalent Annualized Criterion.

(ii) Calculation of sensitivity of recommendation in part (i) to changes in the contribution generated by
machine 1
Difference in Equivalent Annualized Criterion of Machines required for changing the recommendation
in part (i) = 3,72,291.262- 2,91,190.674 = ` 81,100.588
81.100.588
 Sensitivity relating to contribution = ×100 = 6.991 or 7% yearly
11.60.000.00
Alternatively,
The annualized equivalent cash flow for machine 1 is lower by ` (3,72,291.262–2,91,190.674) =
`81,100.588 than for machine 2. Therefore, it would need to increase contribution for complete 3 years
before the decision would be to invest in this machine.
Sensitivity w.r.t contribution = 81,100.588 / (11,60,000 × 2.402) x100 = 2.911%

Q.5 NPV Method (Buy M/c or not) PY Nov 22

A hospital is considering to purchase a diagnostic machine costing ` 80,000. The projected life of the machine is
8 years and has an expected salvage value of ` 6,000 at the end of 8 years. The annual operating cost of the
machine is ` 7,500. It is expected to generate revenues of ` 40,000 per year for eight years. Presently,
the hospital is outsourcing the diagnostic work and is earning commission income of ` 12,000 per annum.
Consider tax rate of 30% and Discounting Rate as 10%.
Advise:
Whether it would be profitable for the hospital to purchase the machine?
Give your recommendation as per Net Present Value method and Present Value Index method under below
mentioned two situations:
(i) If Commission income of ` 12,000 p.a. is before taxes.
(ii) If Commission income of ` 12,000 p.a. is net of taxes
Given:
t 1 2 3 4 5 6 7 8
PVIF (t, 10%) 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

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Ans. Analysis of Investment Decisions

Determination of Cash inflows Situation-(i) Situation-(ii)
Commission Income Commission
before taxes Income after
taxes

Cash flow up-to 7 th year:

Sales Revenue 40,000 40,000
Less: Operating Cost (7,500) (7,500)
32,500 32,500
Less: Depreciation (80,000 – 6,000) ÷ 8 (9,250) (9,250)
Net Income 23,250 23,250
Tax @ 30% (6,975) (6,975)
Earnings after Tax (EAT) 16,275 16,275
Add: Depreciation 9,250 9,250
Cash inflow after tax per annum 25,525 25,525
Less: Loss of Commission Income (8,400) (12,000)
Net Cash inflow after tax per annum 17,125 13,525

In 8 th Year:
Net Cash inflow after tax
Add: Salvage Value of Machine 6,000
17,125 6,000
13,525
Net Cash inflow in year 8 23,125 19,525

Calculation of Net Present Value (NPV) and Profitability Index (PI)

Particulars PV factor Situation-(i) Situation-(ii)

@10% [Commission Income [Commission Income
before taxes] after taxes]
A Present value of cash inflows (1 st 4.867 83,347.38 65,826.18
to 7 th year) (17,125 × 4.867) (13,525 × 4.867)
B Present value of cash inflow at 8 th 0.467 10,799.38 9,118.18
year (23,125 × 0.467) (19,525 × 0.467)
C PV of cash inflows 94,146.76 74,944.36
D Less: Cash Outflow 1.00 (80,000) (80,000)
E Net Present Value (NPV) 14,146.76 (5,055.64)
F PI = (C÷D) 1.18 0.94
Recommendation: The hospital may consider purchasing of diagnostic machine in situation (i) where
commission income is 12,000 before tax as NPV is positive and PI is also greater than 1. Contrary to situation
(i), in situation (ii) where the commission income is net of tax, the recommendation is reversed to not
purchase the machine as NPV is negative and PI is also less than 1.

Q.6 Buy New Machine RTP Nov 20

A large profit making company is considering the installation of a machine to process the waste produced by one
of its existing manufacturing process to be converted into a marketable product. At present, the waste is

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removed by a contractor for disposal on payment by the company of ` 150 lakh per annum for the next four years.
The contract can be terminated upon installation of the aforesaid machine on payment of a compensation of ` 90
lakh before the processing operation starts. This compensation is not allowed as deduction for tax purposes.
The machine required for carrying out the processing will cost ` 600 lakh to be financed by a loan repayable in 4
equal instalments commencing from end of the year 1. The interest rate is 14% per annum. At the end of the 4th
year, the machine can be sold for ` 60 lakh and the cost of dismantling and removal will be ` 45 lakh.
Sales and direct costs of the product emerging from waste processing for 4 years are estimated as under:
(` In lakh)
Year 1 2 3 4
Sales 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory overheads 165 180 330 435
Depreciation (as per income tax rules) 150 114 84 63
Initial stock of materials required before commencement of the processing operations is `60 lakh at the start
of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be ` 165 lakh and the
stocks at the end of year 4 will be nil. The storage of materials will utilise space which would otherwise have been
rented out for ` 30 lakh per annum. Labour costs include wages of 40 workers, whose transfer to this process
will reduce idle time payments of ` 45 lakh in the year - 1 and ` 30 lakh in the year - 2. Factory overheads include
apportionment of general factory overheads except to the extent of insurance charges of ` 90 lakh per annum
payable on this venture. The company’s tax rate is 30%.
Present value factors for four years are as under:
Year 1 2 3 4
PV factors @14% 0.877 0.769 0.674 0.592

ADVISE the management on the desirability of installing the machine for processing the waste. All calculations
should form part of the answer.

Ans. Statement of Operating Profit from processing of waste (` in lakh)

Year 1 2 3 4
Sales :(A) 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 180 195 255 300
Other expenses 120 135 162 210
Factory overheads (insurance only) 90 90 90 90
Loss of rent on storage space (opportunity cost) 30 30 30 30
Interest @14% 84 63 42 21
Depreciation (as per income tax rules) 150 114 84 63
Total cost: (B) 744 747 918 969
Profit (C)=(A)-(B) 222 219 336 285
Tax (30%) 66.6 65.7 100.8 85.5
Profit after Tax (PAT) 155.4 153.3 235.2 199.5

Statement of Incremental Cash Flows (` in lakh)

Year 0 1 2 3 4

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Material stock (60) (105) - - 165

Compensation for contract (90) - - - -
Contract payment saved - 150 150 150 150
Tax on contract payment - (45) (45) (45) (45)
Incremental profit - 222 219 336 285
Depreciation added back - 150 114 84 63
Tax on profits - (66.6) (65.7) (100.8) (85.5)
Loan repayment - (150) (150) (150) (150)
Profit on sale of machinery (net) - - - - 15
Total incremental cash flows (150) 155.4 222.3 274.2 397.5
Present value factor 1.00 0.877 0.769 0.674 0.592
Present value of cash flows (150) 136.28 170.95 184.81 235.32
Net present value 577.36

Advice: Since the net present value of cash flows is ` 577.36 lakh which is positive the management should install
the machine for processing the waste.
Notes:
(i) Material stock increases are taken in cash flows.
(ii) Idle time wages have also been considered.
(iii) Apportioned factory overheads are not relevant only insurance charges of this project are relevant.
(iv) Interest calculated at 14% based on 4 equal instalments of loan repayment.
(v) Sale of machinery- Net income after deducting removal expenses taken. Tax on Capital gains ignored.
(vi) Saving in contract payment and income tax thereon considered in the cash flows.

Q.7 Buy or Rent PY May 18

Maruti Ltd. requires a plant costing ` 200 Lakhs for a period of 5 years. The company can use the plant for the
stipulated period through leasing arrangement or the requisite amount can be borrowed to buy the plant. In case
of leasing, the company received a proposal to pay annual lease rent of ` 48 Lakhs at the end of each year for a
period of 5 years.
In case of purchase, the company would have a 12%, 5 years loan to be paid in equated annual installment, each
installment becoming due in the beginning of each year. It is estimated that plant can be sold for ` 40 Lakhs at
the end of 5th year. The company uses straight line method of depreciation. Corporate tax rate is 30 %. Cost of
Capital after tax for the company is 10%.
The PVIF @ 10% and 12% for the five years are given below:

Year 1 2 3 4 5
PVIF @ 10 0.909 0.826 0.751 0.683 0.621
PVIF @ 12 0.893 0.797 0.712 0.636 0.567

You are required to advise whether the plant should be purchased or taken on lease.

Ans. Purchase Option

Loan installment = ` 200 lakhs / (1 + PVIFA 12%, 4)
= ` 200 lakhs / (1 + 3.038) = ` 49.53 lakhs
Interest payable = (` 49.53 X 5) – ` 200 lakhs = ` 47.65 lakhs
Working note:
Amortisation of Loan Installment

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Year Loan amount Installment Interet Principal O/S Amount

(` In Lakhs) (`In Lakhs) (` In Lakhs) (` In Lakhs) (` In Lakhs)
0 200 49.53 0.00 49.53 150.47
1 150.47 49.53 18.06 31.47 119.00
2 119.00 49.53 14.28 35.25 83.75
3 83.75 49.53 10.05 39.48 44.27
4 44.27 49.53 *5.26 44.27 -
5 0 0 0 0 0
Calculation of PV of outflow under Purchase Option
(` In Lakhs)
(1) (2) (3) (4) (5) (6) (7) (8)
End Debt Int. of Dep. Tax Shield Net Cash PV factors PV
Payment the o/s [(3) +(4)]x 0.3 out flows @ 10%
Principal (2) – (5)
0 49.53 0.00 0.00 0.00 49.53 1.000 49.53
1 49.53 18.06 32.00 15.02 34.51 0.909 31.37
2 49.53 14.28 32.00 13.88 35.65 0.826 29.44
3 49.53 10.05 32.00 12.61 36.92 0.751 27.72
4 49.53 *5.26 32.00 11.18 38.35 0.683 26.19
5 49.53 0 32.00 9.60 (9.60) 0.621 (5.96)
47.65 160.00 158.29
Less: PV of Salvage Value (`40 lakhs x 0.621) = 24.84
Total PV of Outflow 133.45
*Balancing Figure
Leasing Option
PV of Outflows under lease @ 10% = ` 48 lakhs x (1-0.30) x 3.790
= ` 127.34 lakhs
Decision: The plant should be taken on lease because the PV of outflows is less as compared to purchase option.

Q.8 Equivalent Method MTP Nov 23(1)

A new project “Ambar” requires an initial outlay of ` 4,50,000. The company uses certainty equivalent method
approach to evaluate the project. The risk-free rate is 7%. Following information is available:

Year Cash Flow After Tax (`) Certainty Equivalent Coefficient

1 1,50,000 0.90
2 2,25,000 0.80
3 1,75,000 0.58
4 1,50,000 0.56
5 70,000 0.50
PV Factor at 7%
Year 1 2 3 4 5
PV Factor 0.935 0.873 0.816 0.763 0.713

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Is investment in the project beneficial based on above information?

Ans. Calculation of Net Present Value of the Project

Year Cash Inflows After C.E. Adjusted Cash Present Value Present Value
Tax (in`) Inflows (in `) Factor (in `)
1 1,50,000 0.90 1,35,000 0.935 1,26,225
2 2,25,000 0.80 1,80,000 0.873 1,57,140
3 1,75,000 0.58 1,01,500 0.816 82,824
4 1,50,000 0.56 84,000 0.763 64,092
5 70,000 0.50 35,000 0.713 24,955
Total Present Value of Cash Inflows 4,55,236
Less: Initial Investment or Cash Outflow required for “Ambar” (4,50,000)
Net Present Value 5,236

Conclusion: As the Net Present Value of the project after considering the Certainty Equivalent factors is still
positive, it may be advised to invest in project “Ambar”.

Q.9 NPV Method (Buy M/c or not) RTP May 19

BT Pathology Lab Ltd. is using an X-ray machines which reached at the end of their useful lives. Following new X-
ray machines are of two different brands with same features are available for the purchase.

Cost of Life of Maintenance Cost Rate of

Brand Machine Machine Year 1-5 Year 6-10 Year 11-15 Depreciation
XYZ `6,00,000 15 years ` 20,000 ` 28,000 ` 39,000 4%
ABC `4,50,000 10 years ` 31,000 ` 53,000 -- 6%
Residual Value of both of above machines shall be dropped by 1/3 of Purchase price in the first year and
thereafter shall be depreciated at the rate mentioned above.
Alternatively, the machine of Brand ABC can also be taken on rent to be returned back to the owner after use
on the following terms and conditions:
• Annual Rent shall be paid in the beginning of each year and for first year it shall be ` 1,02,000.
• Annual Rent for the subsequent 4 years shall be ` 1,02,500.
• Annual Rent for the final 5 years shall be ` 1,09,950.
• The Rent Agreement can be terminated by BT Labs by making a payment of ` 1,00,000 as penalty. This
penalty would be reduced by ` 10,000 each year of the period of rental agreement.
You are required to:
(a) ADVISE which brand of X-ray machine should be acquired assuming that the use of machine shall be
continued for a period of 20 years.
(b) STATE which of the option is most economical if machine is likely to be used for a period of 5 years?
The cost of capital of BT Labs is 12%.

Ans. Since the life span of each machine is different and time span exceeds the useful lives of each model, we shall
use Equivalent Annual Cost method to decide which brand should be chosen.
(i) If machine is used for 20 years
Present Value (PV) of cost if machine of Brand XYZ is purchased
Period Cash Outflow (` ) PVF@12% Present Value

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0 6,00,000 1.000 6,00,000

1-5 20,000 3.605 72,100
6-10 28,000 2.045 57,260
11-15 39,000 1.161 45,279
15 (64,000) 0.183 (11,712)
7,62,927
PVAF for 1-15 years 6.811
762927
Equivalent Annual Cost = ` 1,12,014
6811
Present Value (PV) of cost if machine of Brand ABC is purchased
Period Cash Outflow (` ) PVF@12% Present Value
0 4,50,000 1.000 4,50,000

1-5 31,000 3.605 1,11,755

6 -10 53,000 2.045 1,08,385

10 (57,000) 0.322 (18,354)

6,51,786
PVAF for 1-10 years 5.65
651786
Equivalent Annual Cost = = ` 1,15,360
5.65
Present Value (PV) of cost if machine of Brand ABC is taken on Rent

Period Cash Outflow (` ) PVF@12% Present Value

0 1,02,000 1.000 1,02,000
1-4 1,02,500 3.037 3,11,293

5-9 1,09,950 2.291 2,51,895

6,65,188
PVAF for 1-10 years = 5.65
665188
Equivalent Annual Cost = = ` 1,17,732
5.65
Decision: Since Equivalent Annual Cash Outflow is least in case of purchase of Machine of brand XYZ the
same should be purchased.
(ii) If machine is used for 5 years
(a) Scrap Value of Machine of Brand XYZ
= ` 6,00,000 – ` 2,00,000 – ` 6,00,000 × 0.04 × 4 = ` 3,04,000
(b) Scrap Value of Machine of Brand ABC
= ` 4,50,000 – ` 1,50,000 – ` 4,50,000 × 0.06 × 4 = ` 1,92,000
Present Value (PV) of cost if machine of Brand XYZ is purchased

Period Cash Outflow (` ) PVF@12% Present Value

0 6,00,000 1.000 6,00,000
1-5 20,000 3.605 72,100
5 (3,04,000) 0.567 (1,72,368)
4,99,732
Present Value (PV) of cost if machine of Brand ABC is purchased

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Period Cash Outflow (` ) PVF@12% Present Value

0 4,50,000 1.000 4,50,000
1-5 31,000 3.605 1,11,755
5 (1,92,000) 0.567 (1,08,864)
4,52,891
Present Value (PV) of cost if machine of Brand ABC is taken on Rent

Period Cash Outflow (` ) PVF@12% Present Value

0 1,02,000 1.000 1,02,000
1-4 1,02,500 3.037 3,11,293

5 50,000 0.567 28,350

4,41,643

Decision: Since Cash Outflow is least in case of lease of Machine of brand ABC the same should be taken
on rent.

Q.10 Disposing Garbage Car MTP May 22(1)

A manufacturing company is presently paying a garbage disposer company ` 0.50 per kilogram to dispose-off the
waste resulting from its manufacturing operations. At normal operating capacity, the waste is about 2,00,000
kilograms per year.
After spending ` 1,20,000 on research, the company discovered that the waste could be sold for ` 5 per kilogram
if it was processed further. Additional processing would, however, require an investment of ` 12,00,000 in new
equipment, which would have an estimated life of 10 years with no salvage value. Depreciation would be calculated
by straight line method.
No change in the present selling and administrative expenses is expected e xcept for the costs incurred in
advertising ` 40,000 per year, if the new product is sold. Additional processing costs would include variable cost
of ` 2.50 per kilogram of waste put into process along with fixed cost of ` 60,000 per year (excluding
Depreciation).
There will be no losses in processing, and it is assumed that the total waste processed in a given year will be sold
in the same year. Estimates indicate that 2,00,000 kilograms of the product could be sold each year.
The management when confronted with the choice of disposing off the waste or processing it further and selling
it, seeks your ADVICE. Which alternative would you RECOMMEND? Assume that the firm's cost of capital is 15%
and it pays on an average 50% Tax on its income.
Consider Present value of Annuity of ` 1 per year @ 15% p.a. for 10 years as 5.019.

Ans. Evaluation of Alternatives:

Savings in disposing off the waste

Particulars (`)

Outflow (2,00,000 × ` 0.50) 1,00,000

Less: tax savings @ 50% 50,000

Net Outflow per year 50,000

Calculation of Annual Cash inflows in Processing of waste Material

Particulars Amount (`) Amount (`)

Sale value of waste (` 5 × 2,00,000 kilograms) 10,00,000

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Less: Variable processing cost (` 2.50 × 2,00,000 kilograms) 5,00,000

Less: Fixed processing cost 60,000
Less: Advertisement cost 40,000
Less: Depreciation 1,20,000 (7,20,000)

Earnings before tax (EBT) 2,80,000

Less: Tax @ 50% (1,40,000)

Earnings after tax (EAT) 1,40,000

Add: Depreciation 1,20,000

Annual Cash inflows 2,60,000

Total Annual Benefits = Annual Cash inflows + Net savings (adjusting tax) in disposal cost
= ` 2,60,000 + ` 50,000 = ` 3,10,000
Calculation of Net Present Value

Year Particulars Amount (`)

0 Investment in new equipment (12,00,000)

1 to 10 Total Annual benefits × PVAF (10 years, 15%) 15,55,890

Net Present Value

3,55,890

Recommendation: Processing of waste is a better option as it gives a positive Net Present Value.
Note- Research cost of ` 1,20,000 is not relevant for decision making as it is sunk cost.

Q.11 MPV & PI Method PY May 22

Alpha Limited is a manufacturer of computers. It wants to introduce artificial intelligence while making computers.
The estimated annual saving from introduction of the artificial intelligence (AI) is as follows:
• reduction of five employees with annual salaries of ` 3,00,000 each
• reduction of ` 3,00,000 in production delays caused by inventory problem
• reduction in lost sales ` 2,50,000 and
• Gain due to timely billing ` 2,00,000
The purchase price of the system for installation of artificial intelligence is ` 20,00,000 and installation
cost is ` 1,00,000. 80% of the purchase price will be paid in the year of purchase and remaining will be
paid in next year.
The estimated life of the system is 5 years and it will be depreciated on a straight -line basis. However,
the operation of the new system requires two computer specialists with annual salaries of ` 5,00,000
per person.
In addition to above, annual maintenance and operating cost for five years are as below:
(Amount in `)
Year 1 2 3 4 5
Maintenance & Operating Cost 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
Maintenance and operating cost are payable in advance.
The company's tax rate is 30% and its required rate of return is 15%.
Year 1 2 3 4 5
PVIF 0.10, t 0.909 0.826 0.751 0.683 0.621
PVIF 0.12, t 0.893 0.797 0.712 0.636 0.567
PVIF 0.15, t 0.870 0.756 0.658 0.572 0.497

Evaluate the project by using Net Present Value and Profitability Index

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Ans.
Computation of Annual Cash Flow after Tax
Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Savings in Salaries 15,00,000 15,00,000 15,00,000 15,00,000 15,00,000
Reduction in 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Production Delays
Reduction in Lost 2,50,000 2,50,000 2,50,000 2,50,000 2,50,000
Sales
Gain due to Timely 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Billing
Salaryto Computer (10,00,000) (10,00,000) (10,00,000) (10,00,000) (10,00,000)
Specialist
Maintenance and (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000)
Operating Cost
(payableinadvance)
Depreciation (21 (4,20,000) (4,20,000) (4,20,000) (4,20,000) (4,20,000)
lakhs/5)
Gain Before Tax 6,30,000 6,50,000 6,70,000 6,90,000 7,10,000
Less: Tax (30%) 1,89,000 1,95,000 2,01,000 2,07,000 2,13,000
Gain After Tax 4,41,000 4,55,000 4,69,000 4,83,000 4,97,000
Add: Depreciation 4,20,000 4,20,000 4,20,000 4,20,000 4,20,000
Add: Maintenance 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
and Operating Cost
(payable in advance)
Less: Maintenance (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000) -
and Operating Cost
(payable in advance)
Net CFAT (2,00,000) 8,81,000 8,95,000 9,09,000 9,23,000 10,37,000

Note: Annual cash flows can also be calculated Considering tax shield on depreciation & maintenance and
operating cost. There will be no change in the final cash flows after tax.

Computation of NPV
Particulars Year Cash Flows (`) PVF PV (`)
Initial Investment (80% of 20 Lacs) 0 16,00,000 1 16,00,000
Installation Expenses 0 1,00,000 1 1,00,000
Instalment of Purchase Price 1 4,00,000 0.870 3,48,000
PV of Outflows (A) 20,48,000
CFAT 0 (2,00,000) 1 (2,00,000)
CFAT 1 8,81,000 0.870 7,66,470
CFAT 2 8,95,000 0.756 6,76,620

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CFAT 3 9,09,000 0.658 5,98,122

CFAT 4 9,23,000 0.572 5,27,956
CFAT 5 10,37,000 0.497 5,15,389
PV of Inflows (B) 28,84,557
NPV (B-A) 8,36,557
Profitability Index (B/A) 1.408 or 1.41

Evaluation: Since the NPV is positive (i.e. ` 8,36,557) and Profitability Index is also greater than 1 (i.e. 1.41),
Alpha Ltd. may introduce artificial intelligence (AI) while making computers.

Q.12 Calculate NPV MTP May 21(2)

(a) SG Ltd. is considering a project “Z” with an initial outlay of Rs. 7,50,000 and life of 5 years. The estimates
of project are as follows:
Lower Estimates Base Upper Estimates
Sales (units) 4,500 5,000 5,500
(Rs.) (Rs.) (Rs.)
Selling Price p.u. 175 200 225
Variable cost p.u. 100 125 150
Fixed Cost 50,000 75,000 1,00,000

Depreciation included in Fixed cost is Rs. 35,000 and corporate tax is 25%.
Assuming the cost of capital as 15%, DETERMINE NPV in three scenarios i.e worst, base and best case
scenario. PV factor for 5 years at 15% are as follows:

Years 1 2 3 4 5
P.V. factor 0.870 0.756 0.658 0.572 0.497

Ans. (i) Calculation of Yearly Cash Inflow

In worst case: High costs and Low price (Selling price) and volume(Sales units) are taken.
In best case: Low costs and High price(Selling price) and volume(Sales units) are taken.
Worst Case Base Best Case
Sales (units) (A) 4,500 5,000 5,500
(Rs.) (Rs.) (Rs.)
Selling Price p.u. 175 200 225
Less: Variable cost p.u. 150 125 100
Contribution p.u. (B) 25 75 125
Total Contribution (A x B) 1,12,500 3,75,000 6,87,500
Less: Fixed Cost 1,00,000 75,000 50,000
EBT 12,500 3,00,000 6,37,500
Less: Tax @ 25% 3,125 75,000 1,59,375
EAT 9,375 2,25,000 4,78,125
Add: Depreciation 35,000 35,000 35,000
Cash Inflow 44,375 2,60,000 5,13,125

(ii) Calculation of NPV in different scenarios

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Worst Case Base Best Case

Initial outlay (A) (Rs.) 7,50,000 7,50,000 7,50,000
Cash Inflow (c) (Rs.) 44,375 2,60,000 5,13,125
Cumulative PVF @ 15% (d) 3.353 3.353 3.353
PV of Cash Inflow (B = c x d) (Rs.) 1,48,789.38 8,71,780 17,20,508.13
NPV (B - A) (Rs.) (6,01,210.62) 1,21,780 9,70,508.13

Q.13 NPV Method (Machine Replace) RTP Nov 18

Shiv Limited is thinking of replacing its existing machine by a new machine which would cost ` 60 lakhs. The
company’s current production is 80,000 units, and is expected to increase to 1,00,000 units, if the new machine
is bought. The selling price of the product would remain unchanged at ` 200 per unit. The following is the cost
of producing one unit of product using both the existing and new machine:

Unit cost (`)

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

The existing machine has an accounting book value of ` 1,00,000, and it has been fully depreciated for tax purpose.
It is estimated that machine will be useful for 5 years. The supplier of the new machine has offered to
accept the old machine for ` 2,50,000. However, the market price of old machine today is ` 1,50,000 and it is
expected to be ` 35,000 after 5 years. The new machine has a life of 5 years and a salvage value of ` 2,50,000
at the end of its economic life. Assume corporate Income tax rate at 40%, and depreciation is charged on straight
line basis for Income-tax purposes. Further assume that book profit is treated as ordinary income for tax
purpose. The opportunity cost of capital of the Company is 15%.
Required:
(i) ESTIMATE net present value of the replacement decision.
(ii) CALCULATE the internal rate of return of the replacement decision.
(iii) Should Company go ahead with the replacement decision? ANALYSE.
Year (t) 1 2 3 4 5
PVIF0.15t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25t 0.80 0.64 0.512 0.4096 0.3277
PVIF0.30t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35t 0.7407 0.5487 0.4064 0.3011 0.2230

Ans. (i) Net Cash Outlay of New Machine

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Purchase Price ` 60,00,000

Less: Exchange value of old machine
[2,50,000 – 0.4(2,50,000 – 0)] 1,50,000
` 58,50,000
Market Value of Old Machine: The old machine could be sold for ` 1,50,000 in the market. Since the
exchange value is more than the market value, this option is not attractive. This opportunity will be lost
whether the old machine is retained or replaced. Thus, on incremental basis, it has no impact.
Depreciation base: Old machine has been fully depreciated for tax purpose.
Thus, the depreciation base of the new machine will be its original cost i.e. ` 60,00,000.
Net Cash Flows: Unit cost includes depreciation and allocated overheads. Allocated overheads are
allocated from corporate office therefore they are irrelevant. The depreciation tax shield may be
computed separately. Excluding depreciation and allocated overheads, unit costs can be calculated. The
company will obtain additional revenue from additional 20,000 units sold.
Thus, after-tax saving, excluding depreciation, tax shield, would be
= {100,000(200 – 148) – 80,000(200 – 173)} × (1 – 0.40)
= {52,00,000 – 21,60,000} × 0.60
= ` 18,24,000
After adjusting depreciation tax shield and salvage value, net cash flows and net present value are
estimated.
Calculation of Cash flows and Project Profitability

` (‘000)
0 1 2 3 4 5
1 After-tax savings - 1824 1824 1824 1824 1824
2 Depreciation - 1150 1150 1150 1150 1150
(` 60,00,000 – 2,50,000)/5
3 Tax shield on - 460 460 460 460 460
depreciation
(Depreciation × Tax rate)
4 Net cash flows from - 2284 2284 2284 2284 2284
operations (1 + 3)*
5 Initial cost (5850)
6 Net Salvage Value - - - - - 215
7 Net Cash Flows (4+5+6) (5850) 2284 2284 2284 2284 2499
8 PVF at 15% 1.00 0.8696 0.7561 0.6575 0.5718 0.4972
9 PV (5850) 1986.166 1726.932 1501.73 1305.99 1242.50
10 NPV ` 1913.32

* Alternately Net Cash flows from operation can be calculated as follows:

Profit before depreciation and tax = ` 1,00,000 (200 -148) - 80,000 (200 -173)
= ` 52,00,000 – 21,60,000
= ` 30,40,000
So profit after depreciation and tax is ` (30,40,000 -11,50,000) × (1 - .40)
= ` 11,34,000
So profit before depreciation and after tax is :
` 11,34,000 + ` 11,50,000 (Depreciation added back) = ` 22,84,000
(ii)
` (‘000)

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0 1 2 3 4 5
NCF (5850) 2284 2284 2284 2284 2499
PVF at 20% 1.00 0.8333 0.6944 0.5787 0.4823 0.4019
PV (5850) 1903.257 1586.01 1321.751 1101.57 1004.35
PV of benefits 6916.94
PVF at 30% 1.00 0.7692 0.5917 0.4550 0.3501 0.2693
PV (5850) 1756.85 1351.44 1039.22 799.63 672.98
PV of benefits 5620.12
1066.94
IRR = 20% + 10% × = 28.23%
1296.82
(iii) Advise: The Company should go ahead with replacement project, since it is positive NPV decision.

Q.14 Purchase Machine or Not MTP May 23(2)

(a) Rambow Ltd. is contemplating purchasing machinery that would cost ` 10,00,000 plus GST @ 18% at
the beginning of year 1. Cash inflows after tax from operations have been estimated at ` 2,56,000 per
annum for 5 years. The company has two options for the smooth functioning of the machinery - one is
service, and another is replacement of parts. The company has the option to service a part of the machinery
at the end of each of the years 2 and 4 at ` 1,00,000 plus GST @ 18% for each year. In such a case, the
scrap value at the end of year 5 will be ` 76,000. However, if the company decides not to service the part,
then it will have to be replaced at the end of year 3 at ` 3,00,000 plus GST@ 18% and in this case, the
machinery will work for the 6th year also and get operational cash inflow of ` 1,86,000 for the 6th year.
It will have to be scrapped at the end of year 6 at ` 1,36,000.
Assume cost of capital at 12% and GST paid on all inputs including capital goods are eligible for input tax
credit in the same month as and when incurred.
(i) DECIDE whether the machinery should be purchased under option 1 or under option 2 or it
shouldn’t be purchased at all.
(ii) If the supplier gives a discount of ` 90,000 for purchase, WHAT would be your decision? Note:
The PV factors at 12% are:
Year 0 1 2 3 4 5 6
PV Factor 1 0.8928 0.7972 0.7118 0.6355 0.5674 0.5066

Ans. Option I: Purchase Machinery and Service Part at the end of Year 2 and 4.
Net Present value of cash flow @ 12% per annum discount rate.
NPV (in `) = - 10,00,000 + 2,56,000 x (0.8928+0.7972+0.7118+0.6355+0.5674) – (1,00,000 x 0.7972+1,00,000 x
0.6355) + (76,000 x 0.5674)
= - 10,00,000 + (2,56,000 x 3.6047) – 1,43,270+43,122.4
= - 10,00,000 + 9,22,803.2 – 1,43,270+ 43,122.4
NPV = - 1,77,344.4
Since Net Present Value is negative; therefore, this option is not to be considered.
If Supplier gives a discount of ` 90,000, then:
NPV (in `) = + 90,000 - 1,77,344.4 = -87,344.4
In this case, Net Present Value is still negative; therefore, this option may not be advisable
Option II: Purchase Machinery and Replace Part at the end of Year 2.
NPV (in `)= - 10,00,000 + 2,56,000 x (0.8928+0.7972+0.7118+0.6355+0.5674) – (3,00,000 x 0.7118) + (1,86,000
x 0.5066+1,36,000 x 0.5066)
= - 10,00,000 + (2,56,000 x 3.6047) – 2,13,540+1,63,125.2
= - 10,00,000 + 9,22,803.2 – 2,13,540+1,63,125.2
NPV = - 1,27,611.6

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Net Present Value is negative, the machinery should not be purchased.

If the Supplier gives a discount of ` 90,000, then:
NPV (in `) = 90,000 - 1,27,611.6 = - 37,611.6
In this case, Net Present Value is still negative; therefore, this option may not be advisa ble.
Decision: The Machinery should not be purchased as it will earn a negative NPV in both options of repair
and replacement.

Q.15 Purchase Machine or Not MTP May 23(1)

Yellow bells Ltd. wants to replace its old machine with new automatic machine. The old machine had been fully
depreciated for tax purpose but has a book value of `3,50,000 on 31st March 2022. The machine cannot fetch
more than `45,000 if sold in the market at present. It will have no realizable value after 10 years. The company
has been offered `1,60,000 for the old machine as a trade in on the new machine which has a price (before
allowance for trade in) of `6,50,000. The expected life of new machine is 10 years with salvage value of `63,000.
Further, the company follows straight line depreciation method but for tax purpose, wri tten down value method
depreciation @ 9% is allowed taking that this is the only machine in the block of assets.
Given below are the expected sales and costs from both old and new machine:

Old machine (`) New machine (`)

Sales 11,74,500 11,74,500
Material cost 2,61,000 1,83,063
Labour cost 1,95,750 1,59,500
Variable overhead 81,563 68,875
Fixed overhead 1,30,500 1,41,375
Depreciation 34,800 60,175
Profit Before Tax (PBT) 4,70,888 5,61,513
Tax @ 25% 1,17,722 1,40,378
Profit After Tax (PAT) 3,53,166 4,21,134
From the above information, ANALYSE whether the old machine should be replaced or not if required rate of
return is 10%? Ignore capital gain tax.

PV factors @ 10%:
Year 1 2 3 4 5 6 7 8 9 10

PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

Ans. (i) Calculation of Base for depreciation or Cost of New Machine

Particulars (`)
Purchase price of new machine 6,50,000
Less: Sale price of old machine 1,60,000
4,90,000

(i) Calculation of Profit before tax as per books

Particulars Old machine (`) New machine (`) Difference (`)

PBT as per books 4,70,888 5,61,513 90,625

Add: Depreciation as per books 34,800 60,175 25,375
Profit before tax and depreciation 5,05,688 6,21,688 1,16,000
(PBTD)
Calculation of Incremental NPV

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PVF PBTD Dep. @ 9% PBT Tax @ 25% Cash Inflows PV of Cash

Inflows
Year @ 10% (`) (`) (`) (`) (`) (`)
1 2 3 4(2-3) (5) = (4) x (6) = (4) –(5) (7) = (6) x (1)
0.25 + (3)
1 0.909 1,16,000.00 44,100.00 71,900.00 17,975.00 98,025.00 89,104.73
2 0.826 1,16,000.00 40,131.00 75,869.00 18,967.25 97,032.75 80,149.05
3 0.751 1,16,000.00 36,519.21 79,480.79 19,870.20 96,129.80 72,193.48
4 0.683 1,16,000.00 33,232.48 82,767.52 20,691.88 95,308.12 65,095.45
5 0.621 1,16,000.00 30,241.56 85,758.44 21,439.61 94,560.39 58,722.00
6 0.564 1,16,000.00 27,519.82 88,480.18 22,120.05 93,879.95 52,948.29
7 0.513 1,16,000.00 25,043.03 90,956.97 22,739.24 93,260.76 47,842.77
8 0.467 1,16,000.00 22,789.16 93,210.84 23,302.71 92,697.29 43,289.63
9 0.424 1,16,000.00 20,738.14 95,261.86 23,815.47 92,184.53 39,086.24
10 0.386 1,16,000.00 18,871.70 97,128.30 24,282.07 91,717.93 35,403.12
5,83,834.77
Add: PV of Salvage value of new machine (` 63,000 ´ 0.386) 24,318.00
Total PV of incremental cash inflows 6,08,152.77
Less: Cost of new machine [as calculated in point(i)] 4,90,000.00
Incremental Net Present Value 1,18,152.77
Analysis: Since the Incremental NPV is positive, the old machine should be replaced.

Q.16 Purchase Machine or Not MTP Nov 22(1)

Emb ros Ltd. is planning to invest in a new product with a project life of 8 years. Initial equipment cost will be `
35 crores. Additional equipment costing ` 2.50 crores will be purchased at the end of the third year from the
cash inflow of this year. At the end of 8th year, the original equipment will have no resale value, but additional
equipment can be sold at 10% of its original cost. A working capital of ` 4 crores will be needed, and it will be
released at the end of 8th 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 14,40,000 21,60,000 52,00,000 54,00,000 36,00,000

Sales price of ` 120 per unit is expected and variable expenses will amount to 60% of sales revenue. Fixed cash
operating costs will amount ` 3.60 crores per year. The loss of any year will be set off from the profits of
subsequent year. The company follows straight line method of depreciation and is subject to 30% tax rate.
Considering 12% after tax cost of capital for this project, you are required to CALCULATE the net present value
(NPV) of the project and advise the management to take appropriate decision.
PV factors @ 12% are:
Year 1 2 3 4 5 6 7 8

.893 .797 .712 .636 .567 .507 .452 .404

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Ans. Calculation of year-wise Cash Inflow (` in crores)

Year Sales VC FC Dep. Profit Tax PAT Dep. Cash

(60% of Sales (@30%) inflow
Value)
1 17.28 10.368 3.6 4.375 (1.063) - (1.0630) 4.375 3.312
2 25.92 15.552 3.6 4.375 2.393 0.3990 * 1.9940 4.375 6.369
3 62.4 37.44 3.6 4.375 16.985 5.0955 11.8895 4.375 16.2645
4−5 64.8 38.88 3.6 4.825 # 17.495 5.2485 12.2465 4.825 17.0715
6−8 43.2 25.92 3.6 4.825 8.855 2.6565 6.1985 4.825 11.0235

*(30% of 2.393 – 30% of 1.063) = 0.7179 – 0.3189 = 0.3990

#4.375 + (2.50 - .25)/5 = 4.825
Calculation of Cash Outflow at the beginning

Particulars `

Cost of New Equipment 35,00,00,000

Add: Working Capital 4,00,00,000
Outflow
39,00,00,000

Calculation of NPV

Year Cash inflows (`) PV factor NPV (`)

1 3,31,20,000 .893 2,95,76,160

2 6,36,90,000 .797 5,07,60,930
3 16,26,45,000 - 2,50,00,000 = 13,76,45,000 .712 9,80,03,240
4 17,07,15,000 .636 10,85,74,740
5 17,07,15,000 .567 9,67,95,405
6 11,02,35,000 .507 5,58,89,145
7 11,02,35,000 .452 4,98,26,220
8 11,02,35,000 + 4,00,00,000 + 25,00,000 = 15,27,35,000 .404 6,17,04,940

Present Value of Inflow 55,11,30,780

Less: Out flow 39,00,00,000

Net Present Value 16,11,30,780

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

Q.17 Purchase Machine or Not MTP May 22(2)

Manoran jan Ltd is a News broadcasting channel having its broadcasting Centre in Mumbai. There are total 200
employees in the organisation including top management. As a part of employee benefit expenses, the company
serves tea or coffee to its employees, which is outsourced from a third -party. The company offers tea or coffee
three times a day to each of its employees. 120 employees prefer tea all three times, 40 employees prefer coffee
all three times and remaining prefer tea only once in a day. The third-party charges ` 10 for each cup of tea and
` 15 for each cup of coffee. The company works for 200 days in a year.

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Looking at the substantial amount of expenditure on tea and coffee, the finance department has proposed
to the management an installation of a master tea and coffee vending machine which will cost ` 10,00,000 with a
useful life of five years. Upon purchasing the machine, the company will have to enter into an annual maintenance
contract with the vendor, which will require a payment of ` 75,000 every year. The machine would require
electricity consumption of 500 units p.m. and current incremental cost of electricity for the company is ` 12 per
unit. Apart from these running costs, the company will have to incur the following consumables expenditure also:
(1) Packets of Coffee beans at a cost of ` 90 per packet.
(2) Packet of tea powder at a cost of ` 70 per packet.
(3) Sugar at a cost of ` 50 per Kg.
(4) Milk at a cost of ` 50 per litre.
(5) Paper cup at a cost of 20 paise per cup.
Each packet of coffee beans would produce 200 cups of coffee and same goes for tea powder packet.
Each cup of tea or coffee would consist of 10g of sugar on an average and 100 ml of milk.
The company anticipate that due to ready availability of tea and coffee through vending machines its
employees would end up consuming more tea and coffee. It estimates that the consumption will incr ease
by on an average 20% for all class of employees. Also, the paper cups consumption will be 10% more than
the actual cups served due to leakages in them.
The company is in the 25% tax bracket and has a current cost of capital at 12% per annum. Straight line
method of depreciation is allowed for the purpose of taxation. You as a financial consultant is required to
ADVISE on the feasibility of acquiring the vending machine.
PV factors @ 12% :
Year 1 2 3 4 5
PVF 0.8929 0.7972 0.7118 0.6355 0.5674

Ans. A. Computation of CFAT (Year 1 to 5)

Particulars Amount (`)

(a) Savings in existing (120 × 10 ×3) + (40 ×15 × 3) + (40 ×10 × 1) 11,60,000
Tea & Coffee charges x 200 days
(b) AMC of machine (75,000)
(c) Electricity charges 500 ×12 ×12 (72,000)
(d) Coffee Beans (W.N.) 144 × 90 (12,960)
(e) Tea Powder (W.N.) 480 × 70 (33,600)
(f) Sugar (W.N.) 1248 × 50 (62,400)
(g) Milk (W.N.) 12480 × 50 (6,24,000)
(h) Paper Cup (W.N.) 1,37,280 × 0.2 (27,456)
(i) Depreciation 10,00,000/5 (2,00,000)
Profit before Tax 52,584
(-) Tax @ 25% (13,146)
Profit after Tax 39,438
Depreciation 2,00,000
CFAT 2,39,438

B. Computation of NPV

Year Particulars CF PVF @ 12% PV

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0 Cost of machine (10,00,00) 1 (10,00,000)

1-5 CFAT 2,39,438 3.6048 8,63,126
Net Present Value (1,36,874)

Since NPV of the machine is negative, it should not be purchased.

Working Note:
Computation of Qty of consumable
No. of Tea Cups = [(120 × 3 × 200 days) + (40 × 1 × 200 days) × 1.2 = 96,000
No. of Coffee cups = 40 × 3 × 200 days × 1.2 = 28,800
28800
No. of coffee beans packet = = 144
200
96000
No. of Tea Powder Packets = = 480
200
Qty of Sugar =
( 96000 + 28800 ) X10g = 1248 kgs
1000g

Qty of Milk =
( 96000 + 28800 ) x100ml = 12,480 litres
1000ml
No. of paper cups = (96,000 + 28,800) × 1.1 = 1,37,280

Q.18 Purchase Machine or Not MTP May 21(2)

City Clap Ltd. is in the business of providing housekeeping services. There is a proposal before the company to
purchase a mechanized cleaning system for a sum of Rs. 40 lakhs. The present system of the company is to use
manual labour for the cleaning job. You are provided with the following information:

Proposed Mechanized System:

Cost of the machine Rs. 40 lakhs
Life of the machine 7 years
Depreciation (on straight line basis) 15%
Operating cost of mechanized system Rs. 20 lakhs per annum

Present system (Manual):

Manual labour 350 persons
Cost of manual labour Rs. 15,000 per person per annum
The company has an after-tax cost of fund at 10% per annum.
The applicable tax rate is 50%.

Ans. Calculation of NPV

(Rs.) (Rs.)
Cost of Manual System (Rs. 15,000 x 350) 52,50,000
Less: Cost of Mechanised System:
Operating Cost 20,00,000
Depreciation (Rs. 40,00,000 x 0.15) 6,00,000 26,00,000
Saving per annum 26,50,000
Less: Tax (50%) 13,25,000
Saving after tax 13,25,000
Add: Depreciation 6,00,000

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Cash flow per annum 19,25,000

Cumulative PV Factor for 7 years @ 10% 4.867
Present value of cash flow for 7 years 93,68,975
Less: Cost of the Machine 40,00,000
NPV 53,68,975

The mechanized cleaning system should be purchased since NPV is positive by Rs. 53,68,975.

Q.19 Replace Machine using NPV RTP May 22

ABC & Co. is considering whether to replace an existing machine or to spend money on revamping it. ABC & Co.
currently pays no taxes. The replacement machine costs ` 18,00,000 now and requires maintenance of `
2,00,000 at the end of every year for eight years. At the end of eight years, it would have a salvage value of `
4,00,000 and would be sold. The existing machine requires increasing amounts of maintenance each year and its
salvage value fall each year as follows:
Year Maintenance (`) Salvage (`)
Present 0 8,00,000
1 2,00,000 5,00,000
2 4,00,000 3,00,000
3 6,00,000 2,00,000
4 8,00,000 0

The opportunity cost of capital for ABC & Co. is 15%.

REQUIRED:
When should the company replace the machine?
The following present value table is given for you:

Year Present value of ` 1 at 15% discount rate

1 0.8696
2 0.7561
3 0.6575
4 0.5718
5 0.4972
6 0.4323
7 0.3759
8 0.3269

Ans. ABC & Co.

Equivalent Annual Cost (EAC) of new machine
(`)
(i) Cost of new machine now 18,00,000
Add: PV of annual repairs @ ` 2,00,000 per annum for 8 years
(` 2,00,000  4.4873) 8,97,460
26,97,460
Less: PV of salvage value at the end of 8 years
(` 4,00,0000.3269) 1,30,760

25,66,700

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Equivalent annual cost (EAC) (` 25,66,700/4.4873) 5,71,992

PV of cost of replacing the old machine in each of 4 years

with new machine
Scenario Year Cash Flow (`) PV @ 15% PV (`)

Replace Immediately 0 (5,71,992) 1.00 (5,71,992)

0 8,00,000 1.00 8,00,000
2,28,008
Replace in one year 1 (5,71,992) 0.8696 (4,97,404)
1 (2,00,000) 0.8696 (1,73,920)
1 5,00,000 0.8696 4,34,800
(2,36,524)
Replace in two years 1 (2,00,000) 0.8696 (1,73,920)
2 (5,71,992) 0.7561 (4,32,483)
2 (4,00,000) 0.7561 (3,02,440)
2 3,00,000 0.7561 2,26,830
(6,82,013)
Replace in three years 1 (2,00,000) 0.8696 (1,73,920)
2 (4,00,000) 0.7561 (3,02,440)
3 (5,71,992) 0.6575 (3,76,085)
3 (6,00,000) 0.6575 (3,94,500)
3 2,00,000 0.6575 1,31,500
(11,15,445)
Replace in four years 1 (2,00,000) 0.8696 (1,73,920)
2 (4,00,000) 0.7561 (3,02,440)
3 (6,00,000) 0.6575 (3,94,500)
4 (5,71,992) 0.5718 (3,27,065)
4 (8,00,000) 0.5718 (4,57,440)
(16,55,365)

Advice: The company should replace the old machine immediately because the PV of cost of replacing the old
machine with new machine is least.

Q.20 Replace Machine using NPV PY May 23

Four years ago, Z Ltd. had purchased a machine of ` 4,80,000 having estimated useful life of 8 years with zero
salvage value. Depreciation is charged using SLM method over the useful life. The company want to replace this
machine with a new machine. Details of new machine are as below:
• Cost of new machine is ` 12,00,000, Vendor of this machine is agreed to take old machine at a value of `
2,40,000. Cost of dismantling and removal of old machine will be ` 40,000. 80% of net purchase price will
be paid on spot and remaining will be paid at the end of one year.
• Depreciation will be charged @ 20% p.a. under WDV method.

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• Estimated useful life of new machine is four years and it has salvage value of ` 1,00,000 at the end of year
four.
• Incremental annual sales revenue is ` 12,25,000.
• Contribution margin is 50%.
• Incremental indirect cost (excluding depreciation) is ` 1,18,750 per year.
• Additional working capital of ` 2,50,000 is required at the beginning of year and ` 3,00,000 at the beginning
of year three. Working capital at the end of year four will be nil.
• Tax rate is 30%.
• Ignore tax on capital gain.
Z Ltd. will not make any additional investment, if it yields less than 12% Advice, whether existing machine
should be replaced or not.
Year 1 2 3 4 5
PVIF0.12, t 0.893 0.797 0.712 0.636 0.567

Ans. Working Notes:

(i) Calculation of Net Initial Cash Outflow

Particulars `

Cost of New Machine 12,00,000

Less: Sale proceeds of existing machine 2,00,000
Net Purchase Price 10,00,000
Paid in year 0 8,00,000
Paid in year 1 2,00,000

(ii) Calculation of Additional Depreciation

1 2 3 4
Year
` ` ` `
Opening WDV of machine 10,00,000 8,00,000 6,40,000 5,12,000
Depreciation on new machine @ 20% 2,00,000 1,60,000 1,28,000 1,02,400
Closing WDV 8,00,000 6,40,000 5,12,000 4,09,600
Depreciation on old machine 60,000 60,000 60,000 60,000
(4,80,000/8)

Incremental depreciation 1,40,000 1,00,000 68,000 42,400

(iii) Calculation of Annual Profit before Depreciation and Tax (PBDT)

Particulars Incremental Values (`)

Sales 12,25,000
Contribution 6,12,500
Less: Indirect Cost 1,18,750
Profit before Depreciation and Tax (PBDT) 4,93,750

Calculation of Incremental NPV

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Year PVF @ PBTD (`) Incremental PBT (`) Tax @ Cash Inflows PV of Cash Inflows
12% Depreciation (`) 30% (`) (`) (`)

(1) (2) (3) (4) (5) = (4) x (6) = (4) – (5) (7) = (6) x (1)
0.30 + (3)

1 0.893 4,93,750 1,40,000 3,53,750 106,125 3,87,625 3,46,149.125

2 0.797 4,93,750 1,00,000 3,93,750 1,18,125 3,75,625 2,99,373.125

3 0.712 4,93,750 68,000 4,25,750 1,27,725 3,66,025 2,60,609.800

4 0.636 4,93,750 42,400 4,51,350 1,35,405 3,58,345 2,27,907.420

* * 11,34,039.470

Add: PV of Salvage (` 1,00,000 x 0.636) 63,600

Less: Initial Cash Outflow - Year 0 8,00,000

Year 1 (` 2,00,000 × 0.893) 1,78,600

Less: Working Capital - Year 0 2,50,000

Year 2 (` 3,00,000 × 0.797) 2,39,100

Add: Working Capital released - Year 4 (` 5,50,000 × 0.636) 3,49,800

Incremental Net Present Value 79,739.470

Since the incremental NPV is positive, existing machine should be replaced.
Alternative Presentation
Computation of Outflow for new Machine:

`
Cost of new machine 12,00,000
Replaced cost of old machine 2,40,000
Cost of removal 40,000
Net Purchase price 10,00,000
Outflow at year 0 8,00,000
Outflow at year 1 2,00,000

Computation of additional deprecation

Year 1 2 3 4
` ` ` `
Opening WDV of machine 10,00,000 8,00,000 6,40,000 5,12,000
Depreciation on new machine @ 20% 2,00,000 1,60,000 1,28,000 1,02,400
Closing WDV 8,00,000 6,40,000 5,12,000 4,09,600
Depreciation on old machine 60,000 60,000 60,000 60,000
(4,80,000/8)
Incremental depreciation 1,40,000 1,00,000 68,000 42,400
Computation of NPV

0 1 2 3 4
Year ` ` ` ` `

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1. Increase in sales revenue 12,25,000 12,25,000 12,25,000 12,25,000

2. Contribution 6,12,500 6,12,500 6,12,500 6,12,500
3. Increase in fixed cost 1,18,750 1,18,750 1,18,750 1,18,750
4. Incremental Depreciation 1,40,000 1,00,000 68,000 42,400
5. Net profit before tax 3,53,750 3,93,750 4,25,750 4,51,350
[1-(2+3+4)]
6. Net Profit after tax 2,47,625 2,75,625 2,98,025 3,15,945
(5 x 70%)
7. Add: Incremental 1,40,000 1,00,000 68,000 42,400
depreciation
8. Net Annual cash inflows 3,87,625 3,75,625 3,66,025 3,58,345
(6 + 7)

9. Release of salvage value 1,00,000

10. (investment)/disinvestment in (2,50,000) (3,00,000) 5,50,000
working capital

11. Initial cost (8,00,000) (2,00,000)

12. Total net cash flows (10,50,000) 1,87,625.0 75,625 3,66,025 10,08,345
13. Discounting Factor 1 0.893 0.797 0.712 0.636
14. Discounted cash flows (10,50,000) 1,67,549.125 60,273.125 2,60,609.800 641307.420
(12 x 13)

NPV = (1,67,549 + 60,273 + 2,60,610 + 6,41,307) - 10,50,000 = ` 79,739

Since the NPV is positive, existing machine should be replaced.

Q.21 Replace Machine using NPV PY July 21

An existing company has a machine which has been in operation for two years, its estimated remaining useful life
is 4 years with no residual value in the end. Its current market value is ` 3 lakhs. The management is considering
a proposal to purchase an improved model of a machine gives increase output. The details are as under:
Particulars Existing Machine New Machine
Purchase Price ` 6,00,000 ` 10,00,000
Estimated Life 6 years 4 years
Residual Value 0 0
Annual Operating days 300 300
Operating hours per day 6 6
Selling price per unit ` 10 ` 10
Material cost per unit `2 `2
Output per hour in units 20 40
Labour cost per hour ` 20 ` 30
Fixed overhead per annum excluding depreciation ` 1,00,000 ` 60,000
Working Capital ` 1,00,000 ` 2,00,000

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Income-tax rate 30% 30%

Assuming that - cost of capital is 10% and the company uses written down value of depreciation @ 20% and it
has several machines in 20% block.
Advice the management on the Replacement of Machine as per the NPV method. The discounting factors table
given below:
Discounting Factors Year 1 Year 2 Year 3 Year 4
10% 0.909 0.826 0.751 0.683

Ans. (i) Calculation of Net Initial Cash Outflows:

Particulars `
Purchase Price of new machine 10,00,000
Add: Net Working Capital 1,00,000
Less: Sale proceeds of existing machine 3,00,000
Net initial cash outflows 8,00,000

(ii) Calculation of annual Profit Before Tax and depreciation

Particulars Existing machine New Machine Differential

(1) (2) (3) (4) = (3) – (2)

Annual output 36,000 units 72,000 units 36,000 units

` ` `

(A) Sales revenue @ ` 10 per unit 3,60,000 7,20,000 3,60,000

(B) Cost of Operation

Material @ ` 2 per unit 72,000 1,44,000 72,000

Labour

Old = 1,800  ` 20 36,000

New = 1,800  ` 30 54,000 18,000

Fixed overhead excluding depreciation 1,00,000 60,000 (40,000)

Total Cost (B) 2,08,000 2,58,000 50,000

Profit Before Tax and depreciation 1,52,000 4,62,000 3,10,000

(PBTD) (A – B)

(iv) Calculation of Net Present value on replacement of machine

Year PBTD Depreciati on PBT Tax @ PAT Net cash PVF @ PV

@ 20% WDV 30% flow 10%
(1) (2) (3) (4 = 2-3) (5) (6 = 4-5) (7 = 6 + 3) (8) (9 = 7 x 8)
1 3,10,000 1,40,000 1,70,000 51,000 1,19,000 2,59,000 0.909 2,35,431.000
2 3,10,000 1,12,000 1,98,000 59,400 1,38,600 2,50,600 0.826 2,06,995.600
3 3,10,000 89,600 2,20,400 66,120 1,54,280 2,43,880 0.751 1,83,153.880
4 3,10,000 71,680 2,38,320 71,496 1,66,824 2,38,504 0.683 1,62,898.232
7,88,478.712

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Add: Release of net working capital at year end 4 (1,00,000 x 0.683) 68,300.000
Less: Initial Cash Outflow 8,00,000.000
NPV 56,778.712

Advice: Since the incremental NPV is positive, existing machine should be replaced.
Working Notes:
1. Calculation of Annual Output
Annual output = (Annual operating days x Operating hours per day) x output per hour
Existing machine = (300 x 6) x 20 = 1,800 x 20 = 36,000 units
New machine = (300 x 6) x 40 = 1,800 x 40 = 72,000 units
2. Base for incremental depreciation
Particulars `

WDV of Existing Machine

Purchase price of existing machine 6,00,000
Less: Depreciation for year 1 1,20,000
Depreciation for Year 2 96,000 2,16,000
WDV of Existing Machine (i) 3,84,000

Depreciation base of New Machine

Purchase price of new machine 10,00,000

Add: WDV of existing machine 3,84,000

Less: Sales value of existing machine 3,00,000

Depreciation base of New Machine (ii) 10,84,000
Base for incremental depreciation [(ii) – (i)] 7,00,000

(Note: The above solution have been done based on incremental approach) Alternatively, solution can
be done based on Total Approach as below:
(i) Calculation of depreciation:

Existing Machine

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Opening balance 6,00,000 4,80,000 3,84,000 3,07,200 2,45,760 1,96,608.00

Less: Depreciation @ 20% 1,20,000 96,000 76,800 61,440 49,152 39,321.60

WDV 4,80,000 3,84,000 3,07,200 2,45,760 1,96,608 1,57,286.40

New Machine
Year 1 Year 2 Year 3 Year 4
Opening balance 10,84,000* 8,67,200 6,93,760 5,55,008.00
Less: Depreciation @ 20% 2,16,800 1,73,440 1,38,752 1,11,001.60
WDV 8,67,200 6,93,760 5,55,008 4,44,006.40

* As the company has several machines in 20% block, the value of Existing Machine from the block
calculated as below shall be added to the new machine of ` 10,00,000:
WDV of existing machine at the beginning of the year ` 3,84,000
Less: Sale Value of Machine ` 3,00,000

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WDV of existing machine in the block ` 84,000

Therefore, opening balance for depreciation of block = ` 10,00,000 + ` 84,000 = ` 10,84,000

(ii) Calculation of annual cash inflows from operation:

Particulars EXISTING MACHINE

Year 3 Year 4 Year 5 Year 6
Annual output (300 operating Days 36,000 units 36,000 units 36,000 units 36,000 units
x 6 operating hours x 20 output
per hour)
` ` ` `
(A) Sales revenue @`10 per unit 3,60,000.00 3,60,000.00 3,60,000.00 3,60,000.00
(B) Less: Cost of Operation
Material @ ` 2 per unit 72,000.00 72,000.00 72,000.00 72,000.00
Labour @ ` 20 per hour for (300 x
6) hours 36,000.00 36,000.00 36,000.00 36,000.00
Fixed overhead 1,00,000.00 1,00,000.00 1,00,000.00 1,00,000.00
Depreciation 76,800.00 61,440.00 49,152.00 39,321.60
Total Cost (B) 2,84,800.00 2,69,440.00 2,57,152.00 2,47,321.60
Profit Before Tax (A – B) 75,200.00 90,560.00 1,02,848.00 1,12,678.40
Less: Tax @ 30% 22,560.00 27,168.00 30,854.40 33,803.52
Profit After Tax 52,640.00 63,392.00 71,993.60 78,874.88
Add: Depreciation 76,800.00 61,440.00 49,152.00 39,321.60
Capital 1,00,000.00
Annual Cash Inflows 1,29,440.00 1,24,832.00 1,21,145.60 2,18,196.48

Particulars NEW MACHINE

Year 1 Year 2 Year 3 Year 4
Annual output (300 operating 72,000 72,000 72,000 72,000
days x 6 operating hours x units units units units
40 output per hour)
` ` ` `
(A) Sales revenue @ `10 per 7,20,000.00 7,20,000.00 7,20,000.00 7,20,000.00
unit
(B) Less: Cost of Operation
Material @ ` 2 per unit 1,44,000.00 1,44,000.00 1,44,000.00 1,44,000.00
Labour @ ` 30 per hour for 54,000.00 54,000.00 54,000.00 54,000.00
(300 x 6) hours
Fixed overhead 60,000.00 60,000.00 60,000.00 60,000.00
Depreciation 2,16,800.00 1,73,440.00 1,38,752.00 1,11,001.60
Total Cost (B) 4,74,800.00 4,31,440.00 3,96,752.00 3,69,001.60
Profit Before Tax (A – B) 2,45,200.00 2,88,560.00 3,23,248.00 3,50,998.40
Less: Tax @ 30% 73,560.00 86,568.00 96,974.40 1,05,299.52

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Profit After Tax 1,71,640.00 2,01,992.00 2,26,273.60 2,45,698.88

Add: Depreciation 2,16,800.00 1,73,440.00 1,38,752.00 1,11,001.60
Add: Release of Working
Capital 2,00,000.00
Annual Cash Inflows 3,88,440.00 3,75,432.00 3,65,025.60 5,56,700.48

(iii) Calculation of Incremental Annual Cash Flow:

Particulars Year 1 (`) Year 2 (`) Year 3 (`) Year 4 (`)

Existing Machine (A) 1,29,440.00 1,24,832.00 1,21,145.60 2,18,196.48

New Machine (B) 3,88,440.00 3,75,432.00 3,65,025.60 5,56,700.48

Incremental Annual 2,59,000.00 2,50,600.00 2,43,880.00 3,38,504.00

Cash Flow (B – A)

(iv) Calculation of Net Present Value on replacement of machine:

Year Incremental Annual Cash Discounting factor @ Present Value of

Flow (`) (A) 10% (B) Incremental Annual Cash
Flow (`) (A x B)
1 2,59,000.00 0.909 2,35,431.000
2 2,50,600.00 0.826 2,06,995.600
3 2,43,880.00 0.751 1,83,153.880
4 3,38,504.00 0.683 2,31,198.232
Total Incremental Inflows 8,56,778.712
Less: Net Initial Cash Outflows (Working note) 8,00,000.000
Incremental NPV 56,778.712

Advice: Since the incremental NPV is positive, existing machine should be replaced.
Working Note:
Calculation of Net Initial Cash Outflows:

Particulars `
Cost of new machine 10,00,000
Less: Sale proceeds of existing machine 3,00,000
Add: incremental working capital required (` 2,00,000 – ` 1,00,000) 1,00,000
Net initial cash outflows 8,00,000

Q.22 Replace Machine using NPV RTP Dec 21

HMR Ltd. is considering replacing a manually operated old machine with a fully automatic new machine. The old
machine had been fully depreciated for tax pu rpose but has a book value of ` 2,40,000 on 31st March 2021. The
machine has begun causing problems with breakdowns and it cannot fetch more than ` 30,000 if sold in the market
at present. It will have no realizable value after 10 years. The company has been offered ` 1,00,000 for the old
machine as a trade in on the new machine which has a price (before allowance for trade in) of ` 4,50,000. The
expected life of new machine is 10 years with salvage value of ` 35,000.
Further, the company follows straight line depreciation method but for tax purpose, written down value method
depreciation @ 7.5% is allowed taking that this is the only machine in the block of assets.

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Given below are the expected sales and costs from both old and new machine:
Old machine (`) New machine (`)
Sales 8,10,000 8,10,000
Material cost 1,80,000 1,26,250
Labour cost 1,35,000 1,10,000
Variable overhead 56,250 47,500
Fixed overhead 90,000 97,500
Depreciation 24,000 41,500
PBT 3,24,750 3,87,250
Tax @ 30% 97,425 1,16,175
PAT 2,27,325 2,71,075
From the above information, ANALYSE whether the old machine should be replaced or not if required rate of
return is 10%? Ignore capital gain tax.
PV factors @ 10%:
Year 1 2 3 4 5 6 7 8 9 10
PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

Ans. Workings:
1. Calculation of Base for depreciation or Cost of New Machine

Particulars (`)
Purchase price of new machine 4,50,000
Less: Sale price of old machine 1,00,000
3,50,000
2. Calculation of Profit before tax as per books

Particulars Old machine New machine Difference

(`) (`) (`)
PBT as per books 3,24,750 3,87,250 62,500
Add: Depreciation as per books 24,000 41,500 17,500

Profit before tax and 3,48,750 4,28,750 80,000

depreciation (PBTD)

Calculation of Incremental NPV

Year PVF PBTD (`) Dep. @ PBT (`) Tax @ 30% (`) Cash Inflows PV of Cash
@ 10% 7.5% (`) (`) Inflows (`)
(1) (2) (3) (4) (5) = (4) x 0.30 (6) = (4) – (5) (7) = (6) x (1)
+ (3)
1 0.909 80,000.00 26,250.00 53,750.00 16,125.00 63,875.00 58,062.38
2 0.826 80,000.00 24,281.25 55,718.75 16,715.63 63,284.38 52,272.89
3 0.751 80,000.00 22,460.16 57,539.84 17,261.95 62,738.05 47,116.27
4 0.683 80,000.00 20,775.64 59,224.36 17,767.31 62,232.69 42,504.93
5 0.621 80,000.00 19,217.47 60,782.53 18,234.76 61,765.24 38,356.21

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6 0.564 80,000.00 17,776.16 62,223.84 18,667.15 61,332.85 34,591.73

7 0.513 80,000.00 16,442.95 63,557.05 19,067.12 60,932.88 31,258.57
8 0.467 80,000.00 15,209.73 64,790.27 19,437.08 60,562.92 28,282.88
9 0.424 80,000.00 14,069.00 65,931.00 19,779.30 60,220.70 25,533.58
10 0.386 80,000.00 13,013.82 66,986.18 20,095.85 59,904.15 23,123.00
3,81,102.44
Add: PV of Salvage value of new machine (` 35,000  0.386) 13,510.00
Total PV of incremental cash inflows 3,94,612.44
Less: Cost of new machine 3,50,000.00
Incremental Net Present Value 44,612.44
Analysis: Since the Incremental NPV is positive, the old machine should be replaced.

Q.23 MTP Sept 24

Mr. Anand is thinking of buying a Share at ` 500 whose Face Value per share is ` 100. He is expecting a bonus at
the ratio 1 : 5 at the end of the fourth year. Annual expected dividend is 20% and the same rate is expected to
be maintained on the expanded capital base. He intends to sell the Shares at the end of seventh year at an
expected price of ` 900 each. Incidental Expenses for purchase and sale of Shares are estimated to be 5% of
the Market Price. Assuming a Discount rate of 12% per annum, COMPUTE the Net Present Value from the
acquisition of the shares.

Ans. Computation of PV of Future Cash Flows

Year Nature Cash Flow DF @ 12% DCF
1 Dividends (` 100 × 20%) 20 0.893 17.86
2 Dividends (` 100 × 20%) 20 0.797 15.94
3 Dividends (` 100 × 20%) 20 0.712 14.24
4 Dividends (` 100 × 20%) 20 0.636 12.72
5 Dividends (` 100 × 1.2 × 20%) 24 0.567 13.61
6 Dividends (` 100 × 1.2 × 20%) 24 0.507 12.17
7 Dividends (` 100 × 1.2 × 20%) 24 0.452 10.85
8 Net Sale Proceeds (` 900 × 1.2 – 5%) 1,026 0.452 463.75

Present Value of Cash Inflows 561.14

0 Less: Initial Investment (` 500 + 5%) 525 1 525.00
Net Present Value 36.14

Note: At the end of Year 4, Anand will have 1.2 Share i.e. 1 Bought Share + 1/5th Bonus Share.

206 By CA Amit Sharma

Chapter - 10 Fast Cost FM by AB

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