Financial Management

Assignment - A
Question 1a: Should the titles of controller and treasurer be adopted under
Indian context? Would you like to modify their functions in view of the
company practice in India? Justify your opinion?
Answer to 1a:

Controller & Treasurer are independent & they have their own Perspectives & Drivers as detailed below:

Controller Treasurer
Responsibilities include, Double entry Responsible for Liquidity management (very
accounting, financial reporting, Fraud measure, important function), Risk Management, More
detective controls, Financial restatement, focus on financial statements, follows leading
Compliance with statutory requirements like practices & responsible for the future
Rules, Accounting standards, GAAP, IFRS etc., performance of company (projects cash flows)
Controller works & forecasts the events for a Treasurer works/ forecasts the events regularly
long term. Main focus income statement (daily / weekly) focus Balance sheet & future
capital structure, capital expenditure etc.,
Ex: Cash involved event Treasurer concentrates more on cash availability
Controller looks from compliance angle (how to focus i.e. how to bring in the required cash etc,
record, what GAAP provides etc.,)

Therefore, from the above it is clear that, controller & treasurer have different roles to play. However,
majority of the Indian companies works with Financial Controller who himself takes care of the treasury
department / Portfolio.

Therefore, as far as from Indian context, it can be concluded that, controller is also responsible for treasury
jobs & there is no separate treasurer / treasury department exists

Question 1b: firm purchases a machinery for Rs. 8, 00,000 by making a down payment of Rs.1,50,000
and remainder in equal installments of Rs. 1,50,000 for six years. What is the rate of interest to the firm?

Answer to Q1b:

Particulars Ref Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Rs.
Cost of Machinery (a) 800,000
Down Payment
made by firm (b) 150,000
Financed through c = (a-
borrowings b) 650,000

Repayment in equal
instalments every d=6*15
year 0,000 900,000 150,000 150,000 150,000 150,000 150,000 150,000
(maximum of six
years)

Total interest paid e=d-

over 6 year period c 250,000

Rate of Interest
= total interest
/ total
borrowings f=e/c 38.46%
 Rate of interet g=f/6
per annum yrs 6.41%

Break of interest
cost / principal
repayment:

1) interest cost (can

be apportioned in 6:5:4:3:
the ratio of 2:1 21 6 5 4 3 2 1
no of years
repayment - i.e.
earlier the years (6+5+4+3+2
more (ratio) +1)
the interest cost &
vice versa) h 250000 71429 59524 47619 35714 23810 11905
(250,000 (250,000 (250,00 (250,00 (250,000* (250,00
*6/21) *5/21) 0*4/21) 0*3/21) 2/21) 0*1/21)

2) Principal
Outstanding
adjustment i=d-h 650000 78571 90476 102381 114286 126190 138095

Yearwise Interest
rates:
- Principal
Outstanding at year
end j 650000 571429 480952 378571 264286 138095 0
(prinicpal o/s at
year beginning -
Principal (650000- (571429- (480952 (378571 (264286- (138095
repayment) i) i) - i) - i) i) - i)

h/
princip
al o/s
RATE OF at year
INTEREST beginni
EVERY YEAR ng) 11.0% 10.4% 9.9% 9.4% 9.0% 8.6%
(h / (h / (h / (h / (h / (h /
650000) 571429) 480952) 378571) 264286) 138095)

Question 2a: Explain the mechanism of calculating the present value of

cash flows. What is annuity due? How can you calculate the present and
future values of an annuity due? Illustrate
Answer 2a:

Calculating Present Value of Cash flows:

Money has time value. For ex: Rs.1000 received today is not the same worth after a year (actually it is
less)

Present value of cash flows: It indicates the value of expected worth at current value. (Discounts the
expected cash flows at appropriate discount rate (may be 10%, 20% etc.,)
Discount rate will generally be equal to = Inflation rate + Reqd. rate of return + risk free premium rate
Details required for calculating Present Value of cash flows: Cash flows year wise, discount rate. This
technique is very useful for decision-making.
Annuity due: Uniform/ Constant/ Equal cash flows every year

Present value of annuity Future value of annuity

Worth of Lump sum consideration today which Value of fixed investment every year worth
is going to be received tomorrow tomorrow. (i.e. corpus it grows)
Computation:
Annuity * Present value annuity factor (PVAF) Annuity * Future value annuity factor (FVAF)

PVAF is calculated as = 1-[1/(1+r) to the power FVAF is calculated as = [(1+r) to the power n] - 1
n].
Illustration:

Mr. A would like to receive Rs.1000/- every Mr.X would like to grow a corpus by investment
year for 10 years from now. of Rs.10, 000 10 years from now.

It is assumed discount rate 10%, the present Rate of interest @10%, the future value annuity
value annuity factor for 10 years 10% is 6.144. factor for 10 years 10% is 1.594

Present value of annuity = 1000 * 6.144 = Future value of annuity = 10000 * 1.594=
Rs.6145/- Rs.15937/-

Question 2b: "The increase in the risk-premium of all stocks, irrespective of

their beta is the same when risk aversion increases" Comment with
practical examples

Answer 2b:

The security's beta is a function of the correlation of the security's returns with the market index returns
and the variability of the security's returns relative to the variability of the index returns.

In simple, beta measures the sensitivity of the stock with reference to broad based market index.

For instance: a beta of 1.2 for a stock would indicate that this stock is 20% riskier than the index &
similarly beta of 0.9 for a stock indicates 10% less riskier than the index.
Finally, a beta of 1.0 means, stock is as risky as the stock market index.

Therefore, the given statement is false. Expected risk-premium for stock is beta times the market risk
premium. For ex: let us assume beta = 1.2 times, market risk premium = 10%, then expected risk premium
= 10% * 1.2 times = 12%.

Question 3a: How leverage is linked with capital structure? Take example of
a MNC and analyze.
Answer to 3a:
Leverage: It is an advantage gained (it may be anything)

Leverage is linked with Capital Structure, since an organization having a optimum capital structure (where
WACC (weighted average cost of capital) is minimum) is a great leverage/ advantage both to the company
as well for the investors.

Organizations, generally have two types of risks; operating risks impact of fixed costs & variability of
EBIT & Financial risks impact of interest cost/financial charges & variability of EBT.

Example:

XYZ ltd has the following nos:

Contribution Rs.100 lacs, fixed cost Rs.25 lacs, Financial Charges/debt cost Rs.40 lacs.
 Particulars Value (Rs. In lacs)
Contribution 100
Fixed cost 25
EBIT 75
Interest cost 35
EBT 40

XYZ Ltd. has following:

Operating leverage Financial leverage

Contribution / EBIT = 100 / 75 = 1.33 EBIT / EBT = 75 / 40 = 1.87

It is always preferable to have low operating risk & high financial risk (subject to Return on capital
employed (ROCE) > Interest cost on debt funds)

We can conclude that, XYZ ltd (MNC) is having a optimum capital structure & manageable risk.

Question 3b: The following figures relate to two companies (10)

P LTD. Q LTD.
(In Rs. Lakhs)
Sales 500 1,000
Variable costs 200 300
----- --------
Contribution Fixed costs 300 700
Fixed Cost 150 400
----- --------
150 400
Interest 50 100
----- --------
Profit before tax 100 200

You are required to:

(i) Calculate the operating, financial and combined leverages for the two companies; and
Comment on the relative risk position of them

Answer 3b:

P ltd Q ltd
Particulars (in Rs. Lacs)

Sales 500 1000

Variable costs 200 300
Contibution 300 700
Fixed cost 150 400
PBIT / EBIT 150 300
Interest 50 100
Profit before Tax / EBT 100 200

Computation:

a) Opearting leverage:
= Contribution / EBIT 2.0 2.3

b) Financial leverage:
= EBIT / EBT 1.5 1.5
c) Combined leverage:
= Contirbution / EBT 3.0 3.5

Comments: Operating risk is higher Operating risk is higher than 'P' ltd
(i.e. fixed costs are high) (i.e. fixed costs are high)

Financial risk looks low Financial risk looks low

Overall risk is low as compared Overall risk is high as compared

to 'Q' ltd. to 'P' ltd.

It is always preferable to have low Operating leverage & high Financial

leverage (provided, Return on capital employed > Interest on debt funds)

Question 4a: Define various concepts of cost of capital. Explain the

procedure of calculating weighted average cost of capital.

Answer 4a:
Concepts of Cost of Capital:

a) All source of finance have its own cost. Out of long source finance, equity mode of sourcing is costlier
than debt financing because of expectation of shareholders.
b) RISK VS. COST: Equity mode of finance will have low risk but costlier as against debt funds which will
have high risk but relatively cheaper & have tax advantage thus reducing the net cost of debt.
Organizations have to effectively trade off between risk, cost & control.
c) Optimum Capital Structure: When the firm / organization has a combination of debt and equity, such
that the wealth of the firm is maximum. At this point, cost of capital is minimum & market price of a
share is maximum.

Procedure of calculating Weighted Average Cost of Capital (WACC):

It is computed by reference to proportion of each component of capital (book value or market value as
specified) as weights.

WACC = Sum [proportion of each component of capital (weights) * individual cost of capital]
Note: Tax rates needs to be adjusted in respect of debt funds.

Question 4b: The following items have been extracted from the liabilities
side of the balance sheet of XYZ Company as on 31st December 2005.
Paid up capital:
4, 00,000 equity shares of Rs each 40,00,000

Loans:
16% non-convertible debentures 20,00,000
12% institutional loans 60,00,000

Other information about the company as relevant is given below:

31st dec Dividend Earning average market price

2005 Per share per share per share
7.2 10.50 65
You are required to calculate the weighted average cost of capital, using book values as weights and
earnings/price ratio as the basis of cost of equity. Assume 9.2% tax rate
Answer 4b:

Computation of Weighted Average Cost of Capital (WACC):

Weights * Cost of
Nature of Capital Value Weights Cost of capital Capital
(basis of
bookvalues
O/S.)

a) Equity Capital 4,000,000 33% 16.15 5.38

(refer W.No.1)

b) 16% non-convertible debentures 2,000,000 17% 14.53 2.42

Interest (1-taxrate) =
16% (100%-9.2%)

c) 12% institutional loans 6,000,000 50% 10.90 5.45

Interest (1-taxrate) =
12% (100%-9.2%)

Total 12,000,000 100% 13.25

Working Note: 1

Cost of equity:

Earnings per
Price earnings approach = share /
Market price per
share

10.50 / 65 =
16.15%

Question 5a: A company has issued debentures of Rs. 50 Lakhs to be

repaid after 7 years. How much should the company invest in a sinking fund
earning 12% in order to be able to repay debentures? Show the procedure of
loan amortization and capital recovery through an example.

Answer 5a:

Debentures to be redeemed after 7 years 5,000,000

Expected rate of return - on sinking fund investment to be created 12%

Discount rate@12%, 7 yrs 0.452

Present value of expected repayment of debentures @12% 7 yrs 2,261,746

therefore, company has to invest Rs.22,61,746 @ 12% earning in Sinking fund to cover
the repayment expected 7 years from now.
 Loan Amortization Capital Recovery
A loan amortization schedule is a repayment plan that The reciprocal of Present value annuity factor
is calculated before repayment of a loan begins. (PVAF) is the capital recovery.

Amortization schedules are used for fixed interest long Below example will clarify better the meaning:
term loans such as mortgages, expenses like R& D
expenses, Purchase of Goodwill, Voluntary Retirement
payment expenses, Amalgamation expenses etc.
Procedure with Ex: Procedure with Ex: Mr.X plan to lend Rs.1 lac
today for a period of 5 years @ int.rate of 12%,
M/s.XYZ ltd has incurred a Rs.50, 00,000 as lump sum how much income Mr.X should receive each year
payment towards voluntary retirement separation to recover investment & principal back.
charges during the accounting year 2009-2010.
The result is known as capital recovery & which
XYZ ltd have planned to amortize the above expenses can be arrived by capital recovery factor.
for a period of 10 years commencing from FY.09-10
Calculation:
Therefore, the schedule of amortization for 10 year
period as follows: Present value = Annuity * PVAF @12%,5years

Rs. 500,000/- per years for 10 years Capital Recovery = Annuity * 1 /

PVAF@12%,5years

Therefore, capital recovery = 100,000 * 0.27739

= Rs.27,740 each year for 5 years.

Question 5b: A bank has offered to you an annuity of Rs. 1,800 for 10 years
if you invest Rs. 12,000 today. What is the rate of return you would earn? .

Answer 5b:

Particulars Rs.
Return expected per annum 1800
Fixed return/annuity for no of years 10
Total return expected 18000

Investment required today 12000

Nett return expected from investment 6000

Percentage of return for 10 years 50%

Percentage of return per annum 5%
 Assignment - C

Question 1: The proforma of cost-sheet of HLL provides the following data:

Cost (perunit): Rs.

Raw materials 52.0

Direct labour 19.5

Overheads 39.0

Total cost (per unit): 110.5

Profit 19.5

Selling price 130.0

The following is the additional information available:

Average raw material in stock: one month; Average materials in process: half month; Credit allowed by
suppliers: one month; Credit allowed to debtors: two months; Time lag in payment of wages: one and half
weeks; Overheads: one month. One-fourth of sales are on cash basis. Cash balance expected to be Rs.
12,000.

You are required to prepare a statement showing the working capital needed o finance a level of activity of
70,000 units of output. You may assume that production is carried on evenly throughout the year and
wages and overheads accrue similarly.

Answer 1:
Particulars Cost/unit Production = 70,000 units
cost (Rs.) for 70000 units

Raw Material 52 3640000

Direct Labour 19.5 1365000
Prime cost 5005000
Overheads 39 2730000
Total cost 110.5 7735000
Profit 19.5 1365000
Sales 130 9100000

Statement of Working Capital for HLL - 70,000 units production per year:

No of
Particulars months Computation Rs.

Current Assets: (A)

Raw material stock 1 36,40,000/12*1month 303333

Process stock - Work in progress (WIP) 0.5 50,05,000/12*0.5 months 208542
Debtors - customers 2 91,00,000*3/4 (credit sales)/12*2 1137500
Cash balance expected to maintain 12000

Total of CURRENT ASSETS - (A) 1661375

Current Liabilities: (B)

Creditors - suppliers 1 36,40,000/12*1month 303333
1.5 weeks
Wages Outstanding or 13,65,000/12*0.34 38675
0.34
month
Overheads outstanding 1 27,30,000/12*1 227500

Total of CURRENT LIABILITIES - (B) 569508

NETT WORKING CAPITAL

REQUIRED 1091867

Question 2a: Through quantitative analysis prove that PI is a better

technique than NPV in Capital Budgeting.

Answer 2a:
PI Profitability Index & NPV Net Present Value both are capital budgeting techniques.

Profitability Index (PI) Net Present Value (NPV)

PI = Present value of inflows / Present value of NPV = Present value of inflows Present
outflows value of outflows
Ideal = should be > 1 Ideal = NPV should be positive, it shows
absolute present value of tomorrows wealth
Quantitative analysis:

Present value of inflows = Rs. 200,000 Present value of inflows = Rs. 200,000
Present value of outflows = Rs. 100,000 Present value of outflows = Rs. 100,000

PI = 2 NPV = Rs.100,000

NPV technique is better than PI technique for capital budgeting decisions. NPV shows wealth at the end in
absolute amount, which will be helpful to make decisions clearly, whereas the same advantage is not
available with PI technique.

However, PI shows return over investment in times, which will be very useful for immediate decision
making.

Generally, over the years, organizations prefer NPV technique for capital budgeting decisions than PI
technique.

Question 2b: A company is considering the following investment projects:

Projects Cash Flows (Rs.)

Co C1 C2 C3

A - 10,000 + 10,000 ----- -----

B -10,000 + 7,500 + 7,500 -----
C - 10,000 + 2,000 + 4,000 + 12,000
D -10,000 + 10,000 + 3,000 + 3,000

I. according to each of the following methods: (1.) Payback, (2.) ARR, (3.) IRR, (4.) NPV assuming
discount rates of 10 and 30 percent.

II. Assuming the project is independent, which one should be accepted? If the projects are mutually
exclusive, which project is the best?
Answer 2b:
I)

Project A Project B Project C Project D

Methods
(1) Payback
@10% discount rate 1 + years 1.13 years 2.14 years 1.7 years
@30% discount rate 1 + years 1.25 years 3 + years 2.8 years
(2) Accounting rate of 100% 150% 180% 160%
return (ARR)
(3) NPV
@10% discount rate (909) 3017 4140 3824
@30% discount rate (2308) 207 (633) 833
(4) IRR 0% 32% 26% 38%

Independent project: Project with higher NPV needs to be selected, which shows wealth in absolute
value at the end of the project

Therefore, Project C needs to be accepted.

II) In case projects are mutually exclusive:

First disparity between projects needs to be resolved. NPV selects Project C whereas IRR selects Project
D, therefore, disparity exists. Since cash outflows (Rs.10, 000/-) are same for both the projects, the
disparity arisen is called as Cash flow disparity.

It can be resolved by using Incremental cash flow technique. After resolving, the right project can be
accepted.

Workings are as follows:

PROJECT A:

The following has been calculated assuming discount rates of 10%

& 30% separately:

1) Payback period: time period to recover initial investment

a) Discounted @10% b) Discounted @30%

Unrecover Unrecove
ed Discou red
Cash Discount Discounted Cash Discounted
Years discounte Years nt rate discounte
flows rate * cash flows flows cashflows
d cash * d cash
flows flows
@
@ 10%
30%

(4) = (4) = (2)

(1) (2) (3) (2) * (3) (5) (1) (2) (3) * (3) (5)

0 (10,000) 1.000 (10,000) (10,000) 0 (10,000) 1.000 (10,000) (10,000)

1 10,000 0.909 9,091 (909) 1 10,000 0.769 7,692 (2,308)

* disocunt rate computed using formule = 1 / (1+r) to the power n;
where r = disocunt rate
& n = year

Payback period = Base year + [(unrecovered disocunted cash flow of base year /
disocunted cash flows of next year) *12]

Payback period exceed 1 year, since unrecovered cash flows turns

positive only from IInd yr onwards

where base year = year in which unrecovered cash

flows turns 0 or +ve

Payback period @ 10% & 30% discount

rate = 1 + years
=1+
years

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depreciation & Tax / Initial

investment

Since no information on profits, depreciation & taxes, it is treated cash inflows

considered as profits after depreciation & taxes

therefore (10,000 (inflow) / 10,000

= (investment)) * 100

accounting rate of return = 100%; effectively 0% return

(whatever invested taken back)

4) NPV (net present value):

a) Discounted @10% b) Discounted @30%

Discounte Discounte
Cash Discoun Cash Discoun
Years d Years d
flows t rate * flows t rate *
cashflows cashflows
@ 10% @ 30%

(4) = (4) =
(1) (2) (3) (2) * (3) (1) (2) (3) (2) * (3)

(10,000
0 ) 1.000 (10,000) 0 (10,000) 1.000 (10,000)

1 10,000 0.909 9,091 1 10,000 0.769 7,692

NPV (909) NPV (2,308)

* disocunt rate computed using formule = 1 / (1+r) to the power n;

where r = disocunt rate
& n = year

3) IRR (Internal rate of return): which is the rate of

return at which NPV = 0

In project A , IRR is '0'% at which NPV =0

(i.e. there is no return from

the project)
PROJECT B:

The following has been calculated assuming discount rates of 10% &
30% separately:

1) Payback period: time period to recover initial investment

a) Discounted @10% b) Discounted @30%

Unrecover Unrecove
Discounte ed Discou red
Cash Discoun Cash Discounted
Years d discounte Years nt rate discounte
flows t rate * flows cashflows
cashflows d cash * d cash
flows flows
@
@ 10%
30%

(4) = (4) =
(1) (2) (3) (2) * (3) (5) (1) (2) (3) (2) * (3) (5)

0 (10,000) 1.000 (10,000) (10,000) 0 (10,000) 1.000 (10,000) (10,000)

1 7,500 0.909 6,818 (3,182) 1 7,500 0.769 5,769 (4,231)

2 7,500 0.826 6,198 3,017 2 7,500 0.592 4,438 207

* disocunt rate computed using formule = 1 / (1+r) to the power n;

where r = disocunt rate
& n = year

Payback period = Base year + [(unrecovered disocunted cash flow of base year /
disocunted cash flows of next year) *12]

where base year = year in which unrecovered cash

flows turns 0 or +ve

Payback period @ 10% discount rate= 1 + Payback period @ 30% discount rate=
[(3182/3017)*12] 1 + [(4231/207)*12]
=1.13 =1.25
years years

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depriciation & Tax / Initial

investment

Since no information on profits, depreciation & taxes, it is treated cash inflows

considered as profits after depreciation & taxes

therefor (15,000 (inflow) / 10,000

e= (investment)) * 100

accounting rate of return = 150%;

effectively 50% return
4) NPV (net present value):

a) Discounted @10% b) Discounted @30%

Discounte
Cash Discoun Cash Discoun Discounted
Years d Years
flows t rate * flows t rate * cashflows
cashflows
@ 10% @ 30%

(4) = (4) = (2)

(1) (2) (3) (2) * (3) (1) (2) (3) * (3)

(10,0
0 (10,000) 1.000 (10,000) 0 00) 1.000 (10,000)

1 7,500 0.909 6,818 1 7,500 0.769 5,769

2 7,500 0.826 6,198 2 7,500 0.592 4,438

NPV 3,017 NPV 207

* disocunt rate computed using formule = 1 / (1+r) to the power n;

where r = disocunt rate
& n = year

3) IRR (Internal rate of return): which is the rate of

return at which NPV = 0

For project B , IRR is calculated as below:

IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *

(L2 - L1)

where L1 = guess rate (depend on NPV, disocunted at

given required rate of return)
L2 = one more guess
rate

Relationship between discount rate and NPV:

inverse relationship:

Discount rate
goes up NPV falls
NPV goes
Discount rate comes down up

Let us assume L1 = 30% (why, because as could be seen at 30%

@ discount rate NPV is +ve
by applying the relationship,
increased disocunt rate)

Let us calculate L2 = 32%

Discounted @32%
(assumed rate)

Cash Discoun Discounte

Years
flows t rate * d
 cashflows

@ 32%

(4) =
(1) (2) (3) (2) * (3)

0 (10,000) 1.000 (10,000)

1 7,500 0.758 5,682

2 7,500 0.574 4,304

NPV (14)

therefore, IRR for Project B = 30% + [207 /(

207+14)]*32% - 30%

30% +
IRR 1.873 31.87%

PROJECT C:

The following has been calculated assuming discount rates of 10%

& 30% separately:

1) Payback period: time period to recover initial investment

a) Discounted b) Discounted
@10% @30%

Unrecover Unrecove
Disco
Discounte ed red
Cash Discoun Cash Discount unted
Years d discounte Years discounte
flows t rate * flows rate * cashf
cashflows d cash d cash
lows
flows flows
@ 10% @ 30%

(4) =
(4) = (2) *
(1) (2) (3) (2) * (3) (5) (1) (2) (3) (3) (5)

(10,0
0 (10,000) 1.000 (10,000) (10,000) 0 (10,000) 1.000 00) (10,000)

1 2,000 0.909 1,818 (8,182) 1 2,000 0.769 1,538 (8,462)

2 4,000 0.826 3,306 (4,876) 2 4,000 0.592 2,367 (6,095)

3 12,000 0.751 9,016 4,140 3 12,000 0.455 5,462 (633)

* disocunt rate computed using formule = 1 / (1+r) to the power n;

where r = disocunt rate
& n = year

Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted
cash flows of next year) *12]

where base year = year in which unrecovered cash

flows turns 0 or +ve

Payback period @ 10% discount rate= 2 + Payback period @ 30% discount rate=
[(4876/4140)*12] exceeds 3 years
=2.14 =3+
years years

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depriciation & Tax / Initial

investment

Since no information on profits, depreciation & taxes, it is treated cash inflows considered
as profits after depreciation & taxes

therefor (18,000 (inflow) / 10,000

e= (investment)) * 100

accounting rate of return = 180%;

effectively 80% return

4) NPV (net present value):

a) Discounted @10% b) Discounted @30%

Discoun
Disco
Cash Discoun Discounted Cash ted
Years Years unt
flows t rate * cash flows flows cashflo
rate *
ws
@
@ 10%
30%

(4) = (4) =
(1) (2) (3) (2) * (3) (1) (2) (3) (2) * (3)

0 (10,000) 1.000 (10,000) 0 (10,000) 1.000 (10,000)

1 2,000 0.909 1,818 1 2,000 0.769 1,538

2 4,000 0.826 3,306 2 4,000 0.592 2,367

3 12,000 0.751 9,016 3 12,000 0.455 5,462

NPV 4,140 NPV (633)

* disocunt rate computed using formule = 1 / (1+r) to the power n;

where r = disocunt rate
& n = year
3) IRR (Internal rate of return): which is the rate of
return at which NPV = 0

For project C , IRR is calculated as below:

IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *

(L2 - L1)

where L1 = guess rate (depend on NPV, disocunted at

given required rate of return)
L2 = one more guess
rate

Relationship between discount rate and NPV:

inverse relationship:

Discount rate
goes up NPV falls
NPV goes
Discount rate comes down up

Let us assume L1 = 30% (why, because as could be seen at 30% @

discount rate NPV is -ve
by applying the relationship, reduced
disocunt rate)

Let us calculate L2 = 26%

Discounted @26%
(assumed rate)

Discounte
Cash Discoun
Years d
flows t rate *
cashflows
@ 26%

(4) =
(1) (2) (3) (2) * (3)

0 (10,000) 1.000 (10,000)

1 2,000 0.794 1,587

2 4,000 0.630 2,520

3 12,000 0.500 5,999

NPV 106

therefore, IRR for Project B = 30% + [-633 /( -633-

106)]*26% - 30%

30% -
IRR 3.43 26.57

PROJECT D:

The following has been calculated assuming discount rates of 10% &
30% separately:
1) Payback period: time period to recover initial investment

a) Discounted @10% b) Discounted @30%

Unrecover Unrecove
Discou
Discounte ed red
Cash Discoun Cash Discoun nted
Years d discounte Years discounte
flows t rate * flows t rate * cashflo
cashflows d cash d cash
ws
flows flows
@ 10% @ 30%

(4)
(4) = = (2) *
(1) (2) (3) (2) * (3) (5) (1) (2) (3) (3) (5)

0 (10,000) 1.000 (10,000) (10,000) 0 (10,000) 1.000 (10,000) (10,000)

1 10,000 0.909 9,091 (909) 1 10,000 0.769 7,692 (2,308)

2 3,000 0.826 2,479 1,570 2 3,000 0.592 1,775 (533)

3 3,000 0.751 2,254 3,824 3 3,000 0.455 1,365 833

* disocunt rate computed using formule = 1 / (1+r) to the power n;

where r = disocunt rate
& n = year

Payback period = Base year + [(unrecovered disocunted cash flow of base year /
disocunted cash flows of next year) *12]

where base year = year in which unrecovered cash

flows turns 0 or +ve

Payback period @ 10% discount rate= 1 + Payback period @ 30% discount rate=
[(909/1570)*12] 2 + [(533/833)*12]
=1.7 = 2.8
years years

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depriciation & Tax / Initial

investment

Since no information on profits, depreciation & taxes, it is treated cash inflows considered as
profits after depreciation & taxes

therefor (16,000 (inflow) / 10,000

e= (investment)) * 100
accounting rate of return = 160%;
effectively 60% return

4) NPV (net present value):

a) Discounted @10% b) Discounted @30%

Discounte Disco
Cash Discoun Cash Discounted
Years d cash Years unt
flows t rate * flows cashflows
flows rate *
@
@ 10%
30%

(4) = (4) = (2)

(1) (2) (3) (2) * (3) (1) (2) (3) * (3)

0 (10,000) 1.000 (10,000) 0 (10,000) 1.000 (10,000)

1 10,000 0.909 9,091 1 10,000 0.769 7,692

2 3,000 0.826 2,479 2 3,000 0.592 1,775

3 3,000 0.751 2,254 3 3,000 0.455 1,365

NPV 3,824 NPV 833

* disocunt rate computed using formule = 1 / (1+r) to the power n;

where r = disocunt rate
& n = year

3) IRR (Internal rate of return): which is the rate of

return at which NPV = 0

For project C , IRR is calculated as below:

IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *

(L2 - L1)

where L1 = guess rate (depend on NPV, disocunted at

given required rate of return)
L2 = one more guess
rate

Relationship between discount rate and NPV:

inverse relationship:

Discount rate
goes up NPV falls
NPV goes
Discount rate comes down up

Let us assume L1 = 30% (why, because as could be seen at 30% @

discount rate NPV is+ve
by applying the relationship,
increased disocunt rate)

Let us calculate L2 = 38%

Discounted @38%
(assumed rate)

Discounte
Cash Discoun
Years d
flows t rate *
cashflows
@ 38%

(4) =
(1) (2) (3) (2) * (3)

(10,000
0 ) 1.000 (10,000)

1 10,000 0.725 7,246

2 3,000 0.525 1,575

3 3,000 0.381 1,142

NPV (37)

therefore, IRR for Project B = 30% + [833 /(

833+37)]*38% - 30%

30% +
IRR 7.66 37.66%

1) NPV (net present value): for increments cash flows

a) Discounted @10% b) Discounted @30%

Increme
ntal
Cash
Discou Discou Discounte
flows Discounted Cash
Years nt rate Years nt rate d
(project cashflows flows
* * cashflows
C
project
D)
@ @
10% 30%

(4) = (4) =
(1) (2) (3) (2) * (3) (1) (2) (3) (2) * (3)

0 0 1.000 - 0 0 1.000 -

1 (8,000) 0.909 (7,273) 1 (8,000) 0.769 (6,154)

2 1,000 0.826 826 2 1,000 0.592 592

3 9,000 0.751 6,762 3 9,000 0.455 4,096

NPV 316 NPV (1,466)

* disocunt rate computed using formule = 1 / (1+r) to the power n;

where r = disocunt rate
& n = year
3) IRR (Internal rate of return): which is the rate of
return at which NPV = 0

For project C , IRR is calculated as below:

IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *

(L2 - L1)

where L1 = guess rate (depend on NPV, disocunted at

given required rate of return)
L2 = one more guess
rate

Relationship between discount rate and NPV:

inverse relationship:

Discount rate
goes up NPV falls
NPV goes
Discount rate comes down up

Let us assume L1 = 10% (why, because as could be seen at 30% @

discount rate NPV is+ve
by applying the relationship,
increased disocunt rate)

Let us calculate L2 = 13%

Discounted @13%
(assumed rate)

Discounte
Cash Discoun
Years d
flows t rate *
cashflows
@ 13%

(4) =
(1) (2) (3) (2) * (3)

0 0 1.000 -

1 (8,000) 0.885 (7,080)

2 1,000 0.783 783

3 9,000 0.693 6,237

NPV (59)

therefore, IRR for Project B = 10% + [316 /(

316+59)]*13% - 10%

10% +
IRR 2.5 12.50%

Target return =
10%
IRR for incremental cash
flows = 12.5%
 since IRR for incremental cash flows > Target return,
select / accept Project C

Question 3a: "Firm should follow a policy of very high dividend pay-out
Taking example of two organization comment on this statement"

Answer 3a:
The statement not necessarily be true. Let us take 2 companies;

High dividend pay out company 100% payout Low dividend payout company 20% payout
a) Less retained earnings a) More retained earnings
b) Slower / lower growth rate b) Accelerated/higher growth rate
c) Lower market price c) Higher market price
d) Cost of equity (Ke) > IRR (r = rate of return d) Cost of equity (Ke) < IRR (r = rate of return
earned by company on its investment. earned by company on its investment.
e) Indicates that company is declining. e) Indicates that company is growing.

It must be noted that, dividend is a trade off between retaining money for capital expenditure and issuing
new shares.

Question 3b: An investor gains nothing from bonus share "Critically analyse
the statement through some real life situation of recent past.

Answer 3b:
The statement is false. An investor gains bonus shares at zero cost, However, the market price of the
stock will come down & over the long period, the investor definitely maximizes his wealth due to bonus
shares.

From company angle, bonus issue is only an accounting entry & it doesnt change the wealth/value of the
firm.

Recently, Bharti Airtel have issued bonus share 2:1, due to which, the investors have gained Bonus shares
at zero cost & the market have come down to the extent of bonus issue & immediately went up & investors
have cashed the bonus shares thus maximized their wealth. However, currently it is trading down due to
varied reasons.
 CASE STUDY

Ques 1: You are required to make these calculations and in the light thereof,
advise the finance manager about the suitability, or otherwise, of machine A
or machine B.

Solution:

Advise to finance manager of Brown metals ltd, to select the appropriate machine:

Particulars Machine A (Rs. In lacs) Machine B (Rs. In lacs)

1) NPV 12 14
2) Profitability index 1.48 1.35
3) Pay Back period 2 years 3 years
4) Discounted pay back period 3.18 years 3.21 years

It is advised to go in for Machine B with enhanced capacity, which will add more value to the firm.
NPV is higher in respect of Machine B as compared to Machine A & therefore machine with higher
NPV needs to be invested.

Workings are as follows:

(a) to buy machine A which is similar to the existing machine:

Cash
Unrecovered
flows Unrecovered Discount rate Discounted
Years discounted
(Rs. In cash flows * cashflows
cash flows
lacs)
@10%

(4) = (2) *
(1) (2) (3) (3) (5)

0 (25) (25) 1.000 (25) (25)

1 - (25) 0.909 - (25)

2 5 (20) 0.826 4 (21)

3 20 - 0.751 15 (6)

4 14 14 0.683 10 4

5 14 28 0.621 9 12
NPV 12

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate
& n = year

1) Net Present value = Present value of inflows - Present value of outflows = 12 (as computed above)

2) Profitability Index = Present value of inflows / present value of outflows which should be >1
37 / 25 1.48

3) Payback period = Base year + [(unrecovered cash flow of base year / cash flows of next year) *12]

where base year = year in which unrecovered cash flows turns 0 or +ve

Payback period = 2 + [(20/0)*12] = 2 years

4) Discounted Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted cash
flows of next year) *12]

where base year = year in which unrecovered cash flows turns 0 or +ve

Payback period = 3 + [(6/4)*12]

=3.18 years

(b) to go in for machine B which is more expensive & has much greater capacity:

Cash
Unrecovered
flows Unrecovered Discount rate Discounted
Years discounted
(Rs. In cash flows * cashflows
cash flows
lacs)
@10%

(4) = (2) *
(1) (2) (3) (3) (5)

0 (40) (40) 1.000 (40) (40)

1 10 (30) 0.909 9 (31)

2 14 (16) 0.826 12 (19)

3 16 - 0.751 12 (7)

4 17 17 0.683 12 4

5 15 32 0.621 9 14
NPV 14

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate
& n = year

1) Net Present value = Present value of inflows - Present value of outflows = 14 (as computed above)

2) Profitability Index = Present value of inflows / present value of outflows which should be
>1
54 / 40 1.35

3) Payback period = Base year + [(unrecovered cash flow of base year / cash flows of next year) *12]

where base year = year in which unrecovered cash flows turns 0 or +ve

Payback period = 3 + [(16/0)*12] = 3 years

4) Discounted Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted cash
flows of next year) *12]

where base year = year in which unrecovered cash flows turns 0 or +ve

Payback period = 3 + [(7/4)*12]

=3.21 years
 Assignment - C
1. The main function of a finance manager is
(a) capital budgeting
(b) capital structuring
(c) management of working capital
(d) (a),(b)and(c)
Answer (d)

2. Earning per share

(a) refers to earning of equity and preference shareholders.
(b) refers to market value per share of the company.
(c) reflects the value of the firm.
(d) refers to earnings of equity shareholders after all other obligations of the company have been met.
Answer (d)

3. If the cut off rate of a project is greater than IRR, we may

(a) accept the proposal.
(b) reject the proposal.
(c) be neutral about it.
(d) wait for the IRR to increase and match the cut off rate.
Answer (b)

4. Cost of equity share capital is

(a) equal to last dividend paid to equity shareholders.
(b) equal to rate of discount at which expected dividends are discounted to determine their PV.
(c) less than the cost of debt capital.
(d) equal to dividend expectations of equity shareholders for coming year.
Answer (b)

5. Degree of the total leverage (DTL) can be calculated by the following formula
[Given degree of operating leverage (DOL) and degree of financial leverage (DFL)]
(a) DOL + DFL
(b) DOL /DFL
(c) DFL-DOL
(d) DOL x DFL
Answer (d)

6. Risk- Return trade off implies

(a) increasing the profits of the firm through increased production
(b) not taking any loans which increase the risk of the firm
(c) taking decisions in a way which optimizes the balance between risk and return
(d) not granting credit to risky customers
Answer (c)

7. The goal of a firm should be

(a) maximization of profit
(b) maximization of earning per share
(c) maximization of value of the firm
(d) maximization of return on equity
Answer (c)

8. Current Assets minus current liabilities is equal to

(a) Gross working capital
(b) Capital employed
(c) Net worth
(d) Net working capital.
Answer (d)

9. The indifference level of EBIT is one at which

(a) EPS increases
(b) EPS remains the same
(c) EPS decreases
(d) EBIT=EPS.
Answer (d)

10. Money has time value since

(a) The value of money gets compounded as time goes by
(b) The value of money gets discounted as time goes by
(c) Money in hand today is more certain than money in future
(d) (b) and (c)
Answer (b)

11. Net working capital is

(a) excess of gross current assets over current liabilities
(b) same as net worth
(c) same as capital employed
(d) same as total assets employed
Answer (a)

12. The internal rate of return of a project is the discount rate at which NPV is
(a) positive
(b) negative
(c) zero
(d) negative minus positive
Answer (c)

13. Compounding technique is

(a) same as discounting technique
(b) slightly different from discounting technique
(c) exactly opposite of discounting technique
(d) one where interest is compounded more than once in a year.
Answer (c)

14. For determining the value of a share on the basis of P/E ratio, information is required
regarding:
(a) earning per share
(b) normal rate of return
(c) capital employed in the business
(d) contingent liabilities
Answer (a)

15. Tandon committee suggested inventory and receivable norms for

(a) 15 major industries
(b) 20 minor industries
(c) 25 major and minor industries
(d) 30 major and minor industries
Answer (c)

16. Capital structure of ABC Ltd. consists of equity share capital of Rs. 1,00,000 (10,000 share of
Rs. 10 each) and 8% debentures of Rs. 50,000 & earning before interest and tax is Rs. 20,000. The
degree of financial leverage is
(a) 1.00
(b) 1.25
(c) 2.50
(d) 2.00
Answer (b)

17. The following data is given for a company. Unit SP = Rs. 2, Variable cost/unit = Re. 0.70, Total fixed
cost- Rs. 1,00,000 Interest Charges Rs. 3,668, Output-1,00,000 units. The degree of operating leverage is
(a) 4.00
(b) 4.33
(c) 4.75
(d) 5.33
Answer (b)

18. Market price of equity share of a company is Rs. 25 and the dividend expected a year hence is Rs. 10.
The expected rate of dividend growth is 5%. The cost of equal capital to company will be
(a) 40%
(b) 45%
(c) 35%
(d) 50%
Answer (b)

19. The dilemma of "liquidity Vs profitability" arise in case of

(a) Potentially sick unit
(b) Any business organization
(c) Only public sector unites
(d) Purely trading companies
Answer (b)

20. The present value of Rs. 15000 receivable in 7 years at a discount rate of 15% is
(a) 5640
(b) 5500
(c) 5900
(d) 5940
Answer (a)

21. A bond of Rs. 1000 bearing coupon rate of 12% is redeemable at par in 10 yrs. If the required
rate of return is 10% the value of bond is
(a) 1000
(b) 1123
(c) 1140
(d) 1150
Answer (a)

22. The EPS of ABC Ltd. is Rs. 10 & cost of capital is 10%.The market price of share at return rate
of 15% and dividend pay out ratio of 40% is
(a) 100
(b) 120
(c) 130
(d) 150
Answer (a)

23. The credit term offered by a supplier is 3/10 net 60.The annualized interest cost of not availing
the cash discount is
(a) 22.58%
(b) 27.45%
(c) 37.75%
(d) 38.50%
Answer (a)

24. The costliest of long term sources of finance is

(a) Preference share capital
(b) Retained earnings
(c) Equity share capital
(d) Debentures
Answer (c)

25. Which of the following approaches advocates that the cost of equity capital & debit capital
remains the degree of leverages varies
(a) Net income approach
(b) Net operating income approach
(c) Traditional approach
(d) Modigliani-Miller approach
Answer (b) & (d)

26. Which of the following is not a feature of an optimal capital structure.

(a) Profitability
(b) Safety
(c) Flexibility
(d) Control
Answer (b)

27. While calculating weighted average cost of capital

(a) Retained earnings are excluded
(b) Bank borrowings for working capital are included
(c) Cost of issues are included
(d) Weights are based on market value or on book value
Answer (a)

28. Which of the following factors influence the capital structure of a business entity?
(a) Bargaining power with suppliers
(b) Demand for product of company
(c) Expected income
(d) Technology adopted
Answer (c)

29. According to the Walters model, a firm should have 100% dividend pay-out ratio when.
(a) r = ke
(b) r < ke
(c) r > ke
(d) g > ke
Answer (a)

30. Operating cycle can be delayed by

(a) Increase in WIP period
(b) Decrease in raw material storage period
(c) Decrease in credit payment period
(d) Both a & c above
Answer (d)

31. If net working capital is negative, it signifies that

(a) The liquidity position is not comfortable
(b) The current ratio is less then 1
(c) Long term uses are met out of short- term sources
(d) All of a, b and c above
Answer (d)

32. Which of the following models on dividend policy stresses on investors preference for the
current dividend
(a) Traditional model
(b) Walters model
(c) Gordon model
(d) MM model
Answer (d)

33. Which of the following is a technique for monitoring the status of receivables
(a) ageing schedule
(b) outstanding creditors
(c) selection matrix
(d) credit evaluation
Answer (a)

34. Average collection period is equal to

(a) 360/ Receivables Turnover Ratio
(b) Average Creditors / Sales per day
(c) Sales / Debtors
(d) Purchases / Debtors
Answer (a)

35. In IRR, the cash flows are assumed to be reinvested in the project at
(a) Internal rate of return
(b) cost of capital
(c) Marginal cost of capital
(d) risk free rate
Answer (d)

36. In a capital budgeting decision, incremental cash flow mean

(a) cash flows which are increasing.
(b) cash flows occurring over a period of time
(c) cash flows directly related to the project
(d) difference between cash inflows and outflows for each and every expenditure.
Answer (d)

37. The simple EOQ model will not hold good under which of the following conditions
(a) Stochastic demand
(b) constant unit price
(c) Zero lead time
(d) Fixed ordering costs
Answer (a)

38. The opportunity cost of capital refers to the

(a) net present value of the investment.
(b) return that is foregone by investing in a project.
(c) required investment in a project.
(d) future value of the investments cash flows.
Answer (b)

39. Which of the following factors does not influence the composition of Working Capital
requirements
(a) Nature of the business
(b) seasonality of operations
(c) availability of raw materials
(d) amount of fixed assets
Answer (d)

40. The capital structure ratio measure the

(a) Financial Risk
(b) Business Risk
(c) Market Risk
(d) operating risks
Answer (a)