Index

Author & Profile 2

Preface 3

SECTION A: COST & MANAGEMENT ACCOUNTING

1. Cost and Management Accounting - Introduction 4

2. Decision Making Tools 5

3. Budgeting and Budgetary Control 15

4. Standard Costing and Variance Analysis 17

5. Learning Curve 25

SECTION B: FINANCIAL MANAGEMENT

6. Introduction to Financial Management 27

7. Tools for Financial Analysis and Planning 35

8. Working Capital Management 46

9. Cost of Capital, Capital Structure Theories, Dividend Decisions and Leverage Analysis 55

10. Capital Budgeting – Investment Decisions 81

Schedules

Time Value of Money Formulas 92

Compound Interest Tables 93

************************************************************************************************

Some matter included here is from existing publications of the author. The author reserves the right to use the material
in this workbook for his academic & professional activities, without requiring separate permission from the WIRC of
ICMAI. Due credit will be given to the publishers whenever such material is used by the author.

Images courtesy Google search. No copyright infringement intended. All copyrights acknowledged. All rights to tables,
notes & images used are owned by the respective owners &/or originators.

Disclaimer:

E&oe. Without prejudice, without recourse

ͳ
 Vidya Dhanam Sarvadhana Pradhanam

(The Wealth of Knowledge Is the Greatest Wealth)

CMA Manohar V Dansingani

Author Profile:

Registered External Expert with the European Union

Assessment Specialist for Cambridge Assessment International Education

Examination Marker for Institute and Faculty of Actuaries

Resource Person for the Institute of Cost Accountants of India

Faculty & Trainer for the Institute of Company Secretaries of India

Reviewer for Palgrave Communications

CPE Trainer for NISM (educational initiative of SEBI)

Resource Person for NCFE (promoted by RBI, SEBI, IRDAI & PFRDA)

Visiting/Guest Faculty at Premier Institutes

Facilitated two online course-packs on the Harvard Business Publishing Education website

Author of 7 books + a Workbook for Paper 20 for Final, Group IV students for the Pune Chapter of ICMAI

Online courses on Udemy have students from 39 countries & are available in 14 languages.

Free educational videos – “Funda-Mentally Simple”, on YouTube

Publications & work included in IFAC Global Knowledge Gateway, ICMAI Knowledge Bank, Portfolio Organizer, Treasury
Management, The Management Accountant.

Former (Founder President) – Pune Chapter of Institute of Management Accountants, & was a Question Writer for IMA

Awards

National Merit Scholar

Member – Million Dollar Round Table (now retired)

Gold Level Faculty at IMA Leadership Academy

Best Faculty (Final Level) ICMAI Pune

Principles

a) Vidya Dhanam Sarvadhana Pradhanam (The Wealth of Knowledge is The Greatest Wealth)

b) Good Is Not Enough…..Excellence Is The Goal

https://www.amazon.com/Manohar-Dansingani/e/B01M0HPDSY/ref=ntt_dp_epwbk_0
https://www.youtube.com/channel/UCafI20-1v7hv9cCkJVUgHFA

JRRGLVQRWHQRXJK«H[FHOOHQFHLVWKHJRDO

ʹ
 PREFACE

Dear Fellow Student

Thank You for your sincere efforts. The CMA course is both, rigorous & industry oriented.

When you qualify (soon), you will proudly boast of your academic & professional prowess!

This workbook is designed in a Q&A format, covering important concepts which are explained with suitable
illustrations & solved examples. I sincerely hope it will enable you to tackle any type of question in the examinations;
& more important, real-life situations in your professional career.

It is complementary to & not a substitute for your Study Notes. Only important & complex topics have been given
attention in this concise workbook.

May I request you to constantly increase your knowledge & to make your presence felt wherever you are, as a dedicated
professional with impeccable integrity & and unblemished ethics.

Management Accounting is a powerful tool which can make the difference between success & failure. The best project
may struggle without sound Financial Management. You must have a powerful understanding of both, to do justice to
your profession.

I am grateful to the WIRC of The Institute of Cost Accountants of India & to my students, who have taught me so
much.

Your feedback will be most appreciated. Best Wishes

0DQRKDU9'DQVLQJDQL
B.Com (Hons.), DBF, ACMA, CSSBBP, Chartered MCSI

February 2020

͵
SECTION A: COST & MANAGEMENT ACCOUNTING

1. Cost and Management Accounting - Introduction

4 :+$7,60$1$*(0(17$&&2817,1*"
:+$7,60$1$*(0(17$&&2817,1*"
$&&2817,1*"

The Association of International Certified Professional Accountants (AICPA) states that management accounting as a
practice extends to the following three areas:

• Strategic management — advancing the role of the management accountant as a strategic partner in the
organization

• Performance management — developing the practice of business decision-making and managing the
performance of the organization

• Risk management — contributing to frameworks and practices for identifying, measuring, managing and
reporting risks to the achievement of the objectives of the organization

4 +2:'2(60$1$*(0(17$&&2817,1*',))(5)520&267$&&2817,1*"
+2:'2(60$1$*(0(17$&&2817,1*',))(5)520&267$&&2817,1*"

COST ACCOUNTING MANAGEMENT ACCOUNTING

1. Cost computation, cost control & cost reduction Strategy & effective business decisions

2. Narrow scope, sub-set of management accounting Broader subject which includes cost accounting

3. Quantitative in nature Quantitative & Qualitative in nature

4. Uses historic data Use of historic data & predictive modelling

5. Statutory audit is required for large corporates No such requirement

6. Junior & mid-level staff engagement Involvement of senior management is essential

7. Can be implemented independently It requires cost & financial accounting, strategy & risk
management for effective implementation

4 :+$7$5(7+()81&7,2162)$*22'0$1$*(0(17$&&2817,1*6<67(0"
:+$7$5(7+()81&7,2162)$*22'0$1$*(0(17$&&2817,1*6<67(0"

* Provides high-quality & actionable information

* In a timely manner

* To relevant stakeholders (primarily senior management)

* With a view to analyse, interpret & control strategies for success

Ͷ
2. Decision Making Tools

4 127(210$5*,1$/&267,1*
127(210$5*,1$/&267,1*

Costs can be divided into

* Variable cost Total variable cost increases or decreases in proportion to the level of activity (cost driver). For
example, raw materials used, labour cost etc. Cost per unit remains constant, total cost changes with output.

* Fixed cost Total fixed cost remains constant for a period, or for a range of output. Rent of the factory or office is a
good example. Total cost remains unchanged, cost per unit changes with production.

* Semi-variable or semi-fixed cost Combination of fixed & variable costs. The electricity bills we receive have both, a
fixed element, & a variable element.

Cost-volume-profit (CVP) analysis analyses the effect on profit of operating, marketing & other strategic decisions;
based on the relationships between variable costs, fixed costs, selling price & the level of activity (volume). It is most
helpful in:

* Setting prices for the product or service

* Introducing a new product or service; either as an addition to the portfolio, or to replace an existing one

* Replacing an equipment

* Calculating the breakeven point

* Make or buy decisions

* Optimal product-mix

* Key factor (limiting factor) analysis

* Sensitivity analysis & Scenario analysis

CVP analysis is also used in life-cycle costing, activity-based costing (ABC), & target costing.

Important: Please do not confuse direct costs with variable costs; & indirect costs with fixed costs. Direct costs can be
fixed or variable (or semi-variable); indirect costs or overheads, likewise.

4 :+$7,67+(&2175,%87,210$5*,1"
:+$7,67+(&2175,%87,210$5*,1"

These notations will be used throughout:

Q = units sold

S = unit selling price

F = total fixed cost

V = unit variable cost

C = contribution per unit

P = operating profit

The contribution margin per unit is S – V (selling price per unit – variable cost per unit)

Total contribution is Q*C

ͷ
Contribution sales ratio (or contribution margin ratio, or profit volume ratio) is C/S

"A" Ltd. Per Unit 2018 2019

Fixed cost 50000 50000
Selling price 100
Variable cost 60
Projected sales (units) 2000 2200

C 100-60 40
C/S 40/100 40.00% or 0.40
Total S 100*2000 200000 220000 100*2200
Total V 60*2000 120000 132000 60*2200
Total C 40*2000 80000 88000 40*2200

Contribution Income Statement

"A" Ltd. 2018 2019 Change Remarks
% %
Sales 200000 100.00% 220000 100.00% 20000
Variable cos t 120000 60.00% 132000 60.00% 12000 C/S Ratio = 40%
Contribution 80000 40.00% 88000 40.00% 8000
Fixed cos t 50000 50000 0
Operating profit 30000 38000 8000 = 0.40*20000

The illustration above proves the relationship between S, V, F, & P

P = S – Total cost

P = S – (F + V), or P = S – F – V

S – V = F + P, or C = F + P

4 (;3/$,17+(%5($.(9(132,17
(;3/$,17+(%5($.(9(132,17
7+(%5($.(9(132,17

The breakeven point is the level of activity at which total revenue = total cost (zero profit/loss). Substituting in the
equation above, if profit = 0, then at breakeven point:

C=F

Breakeven point (in units) = F/Cunit

Breakeven point (in value) = F/(C/S ratio)

Using the data for “A” Ltd:

F = 50,000

C = 40

C/S = 40%

BEP (units) = 50000/40 = 1,250 units

BEP (value) = 50000/.4 = 125,000

Proof:

͸
"A" Ltd. BEP

Sales (1250 units ) 125000

Variable cos t 75000
Contribution 50000
Fixed cost 50000
Operating profit 0

Margin of Safety is the difference (in value or units) between actual/budgeted sales & the level of breakeven sales.

Higher the margin of safety, better it is for the firm; lower the breakeven point, better it is for the firm.

MoS% = Margin of Safety (rupees)/Budgeted or Actual Sales (rupees)

Greater the angle of incidence, higher is the profitability of the organization.

4   $668037,2162)0$5*,1$/&267,1*
$668037,2162)0$5*,1$/&267,1*

1. All costs can be segregated into fixed & variable components.

2. Variable cost per unit is constant irrespective of level of activity.

3. Selling price per unit is unchanged.

4. Total Fixed cost is constant.

5. Costs are only influenced by the level of output or activity.

4   ',6$'9$17$*(62)0$5*,1$/&267,1*
',6$'9$17$*(62)0$5*,1$/&267,1*

All the assumptions are inherent disadvantages of this method. Besides,

* It does not consider the time factor

* It may not be relevant for fixing long-term contracts, or for a product with a long operating cycle (e.g. ship building,
aircraft manufacture)

* Variable overheads can still be under or over absorbed in marginal costing, if the production is different from sales.

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:+$7,67+(',))(5(1&(%(7:((10$5*,1$/&267 ,1&5(0(17$/&267"

͹
Marginal cost is the change in total cost resulting from producing one additional unit. Incremental cost refers to the total
additional cost associated with a strategic decision, like expansion or product diversification etc.

4
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',67,1&7,21%(7:((10$5*,1$/&267,1* $%62537,21&267,1*

Marginal Costing (Variable Costing) Absorption Costing

(1) Marginal cost is often used in decision making process. Absorption costing is used for external reporting.
Inventories are valued at total production cost so their values
(2) Inventories are valued at variable cost of production.
are higher in absorption costing than in marginal costing.
(3) Use of marginal costing for inventory valuation is not Absorption costing can be used for inventory valuation under
allowed under accounting standards. International Accounting Standards 2.
(4) Marginal costing does not consider fixed production In absorption costing fixed factory overheads are arbitrarily
overheads for product costing so the problem of arbitrary apportioned among the cost centers which often results in
apportionment of production overheads does not arise. over or under absorption of overheads.
In absorption costing inventories are valued at total
production cost so cost of sales in a period includes same
(5) In marginal costing fixed costs are fully changed against fixed overheads incurred in the previous period (i.e., in
the relevant year profit. opening inventory) and will exclude some fixed overheads
incurred in current period but carried forward in closing
inventory as a charge against profits of future periods.
https://www.financialaccountancy.org/marginal-costing/difference-between-marginal-and-absorption-costing/

4
 S per unit 25 : V per unit 15 : F 240000 : Q 25000 units

Please find a) C per unit b) C/S Ratio c) BEP units d) BEP sales
e) Profit or Loss at current Level f) MOS (if any, at current level)

Solution

a) C per unit S-V 10

b) C/S Ratio C/S 0.4
c) BEP units F/C unit 24000
d) BEP sales F/CS Ratio 600000
e) Profit or Loss at current Level C-F 10000
f) MOS (if any, at current level) Sales - BES 25000

4
 ,17+((;$03/($%29(,)5(48,5('352),7,6 :+$76+28/'%(7+(6$/(6"

Q = (F + P)/C
Q = (240000 + 100000)/10 = 340000/10 = 34,000 units

Proof
34000 units
850000 s ales revenue
510000 total variable cos t
340000 total contribution
240000 fixed cost
100000 profit

4
 Data of two machines, A & B is provided below. What is the Point of Indifference?

Fixed cost Unit variable cost

A 200000 25

ͺ
 B 300000 15
Output is identical & can be sold at the same price.

Solution
At indifference point “Q”, total cost of Machine A = total cost of Machine B.

200000 + 25 * Q = 300000 + 15 * Q

300000-200000 = 25Q - 15Q

100000 = 10Q

Q = 10000 units

Proof: At 10,000 units

F V Total cost
A 200000 250000 450000
B 300000 150000 450000

Formula for point of indifference Q = F/ V

Difference in fixed cost/difference in variable cost per unit:

100000 / 10 = 10000 units

If projected sales are less than 10000 units, choose Machine A (lower fixed cost): if projected sales are greater
than 10000 units, choose Machine B (lower variable cost).

4
 A farmer has 600 hectares of land on which he grows apples, pears, oranges & lemons. Of this, 400 hectares
are suitable for all four fruits, & 200 hectares are suitable only for pears & oranges. Labour & other inputs are
unconstrained.

Market requirement (in boxes) of each variety

Minimum 10,000
Maximum 1,50,000

Land should be utilized for each produce in terms of complete hectares (no fractions). Relevant data is given below:
De tails Apple s Pe ars Orange s Le mons

Annual Yie ld
Boxes per hectare 400 150 100 200

Costs: $
Direct Material per hectare 1000 500 400 600

Direct Labour:
Growing per hectare 2000 1200 700 1100
Harvesting & Packing per box 7 7 9 10
Transport per box 10 10 8 19

M arke t Price pe r box 50 30 35 45

Fixed Expenses p.a. $

Growing 2,50,000
Harvesting 1,00,000
Transport 2,00,000
General Administration 3,00,000 Total 8,50,000

ͻ
Additional Information

It is possible to make the land presently suited only for pears & oranges, viable for growing apples & lemons, if certain
land development is undertaken. This would entail a capital expenditure of $15,000/ per hectare. A bank will finance
this @ 5% p.a. If this improvement is undertaken, harvesting cost of the entire crop of lemons will decrease by $2 per
box.

i) Given the constraints, please calculate area to be cultivated for each fruit to maximize profit (before land
development)

ii) Given constant basic constraints, evaluate the feasibility of land development

Solution

i) B as ic Cons traints
hectares
Land available for all four 400
Land available only for pears & oranges 200
Total 600

Market requirement (in boxes) of each variety

Minimum 10,000
Maximum 1,50,000

ii) Prioritize
D e tails Apple s Pe ars Orange s Le mons

Boxes per hectare 400 150 100 200

Cos ts : pe r he ctare $
Direct Material 1,000 500 400 600

Direct Labour:
Growing per hectare 2,000 1,200 700 1,100
Harvesting & Packing # 2,800 1,050 900 2,000
Transport # 4,000 1,500 800 3,800

Total Variable Cos ts pe r he ctare 9,800 4,250 2,800 7,500

M arke t Price pe r he ctare # 20,000 4,500 3,500 9,000

Contribution per hectare $ 10,200 250 700 1,500

R anking I IV III II
# Per box * boxes per hectare

iii) Cultivation Chart

Target boxes hectares cultivated Ensure hard rounding in excel, else it
Pears Minimum 10,000 67 will continue calculating with hidden
decimals.
Oranges 133 bal fig
200 200 hectares are suitable ONLY for pears & oranges

Lemons Minimum 10,000 50 400 hectares are suitable for all 4, but apples & lemons
have higher ranking per key factor, viz. higher
Apples 350 bal fig contribution per hectare. Hence cultivate only these 2
400 fruits in order of priority, in the balnace 400 hectares
Total 600
1,40,000 boxes of apples Ve rify that boxe s of apple s cultivate d doe s not
1,50,000 max possible violate the cons traint of maximum de mand
He nce , O.K.

ͳͲ
 iv) Cultivation Plan before Land Development If we do not know where we stand,
we have no base for comparison.
Details Apples Pears Oranges Lemons Total

Hectares (WN iii) 350 67 133 50 600

$ $
Contribution per hectare (WN ii) 10,200 250 700 1,500

Total Contribution 35,70,000 16,750 93,100 75,000 37,54,850

Fixed Expenses (given) 8,50,000

Profit 29,04,850
v) After land development, only 10,000 boxes of oranges should be produced Land development should be considered only for
Oranges is Priority III, hence minimum hectares 200 hectares. Even here, only for that area, which
Hence, land required for oranges will be 100 is surplus after cultivation of minimum market
This will release land for higher ranked produce 33 demand of the lowest priority fruits, oranges &
Currently used for oranges 133 pears. Pears is already at minimum.
vi) Land Development will cost (15,000 per hectare) 4,95,000 Land development is a capital investment.
Land Development needs to be done on 33 hectares Benefits will continue in the long-run.
Mr. Farmer has a running business.
Interest @ 5% 24,750 Relevant cost is the cost of borrowing, not the loan amount.

vii) Existing Fixed Expenses 8,50,000 The fixed cost will be increased by
Add: Interest 24,750 the element of interest.
New Fixed Expenses 8,74,750
viii) Le mons $ Change in contribution for le mons.
Current contribution per hectare 1,500
Add: Savings in harvesting
per box 2
boxes per hectare 200
Savings per hectare 400
Revise d contribution 1,900
ix) Recheck priority
Details Apple s Pears Orange s Lemons M ost important. Unchange d here.

Contribution per hectare $ 10,200 250 700 1,900

Priority I IV III II
x) Hectares under cultivation for apples
hectares Choose Priority II, lemons to cultivate
Land Released from oranges 33 land which cannot be used for apples
Land already used for apples 350
Total 383

Maximum Boxes of apples 1,50,000

Hectares Required 375

Hence, of the 33 hectares released, 25 will be used for apples

8 will be used for lemons Total for lemons 58

ͳͳ
xi) Revised Cultivation Plan Please consider only relevant costs.
In any running business, one would
Details Apples Pears Oranges Lemons Total like to recover cost of capital or cost of
borrowing: & the incremental
Hectares 375 67 100 58 600 contribution, if any, will add to the
$ $ profit (or reduce the loss)
Contribution per hectare 10,200 250 700 1,900

Total Contribution 38,25,000 16,750 70,000 1,10,200 40,21,950

Fixed Expenses 8,74,750

Estimated Profit with land development 31,47,200

Conclusion $ Extra Note
Land development is not for one single harvest.
Estimated Profit with land development 31,47,200 Relevant costs & cash flow analysis should not
Current Profit 29,04,850 be confused.

Incremental Profit with Land Development of 33 hectares 2,42,350

3/($6(*2$+($':,7+7+(352326(''(9(/230(17

4
 :+$7,65(/(9$17&267"
:+$7,65(/(9$17&267"

https://www.accaglobal.com/sg/en/student/exam-support-resources/fundamentals-exams-study-resources/f5/technical-
articles/relevant-costs.html

“Relevant costs’ can be defined as any cost relevant to a decision. A matter is relevant if there is a change in cash flow
that is caused by the decision.”

1. Sunk costs (past costs) or committed costs are not relevant

2. Re-apportionment of existing fixed costs are not relevant

3. Depreciation and book values (notional costs) are not relevant

4. Increases or decreases in cash flows caused by a project are relevant

5. Revenues forgone (given up) because of a decision are relevant

4
 681.&267

Sunk costs are expenses which have already been incurred & hence do not affect or get affected by the current
investment decision.

4
 $&&(37255(-(&7"

Mfg. Capacity 500000 units

Prodn. & s ales 400000 units
Selling Price 4 per unit
VC 1 per unit
FC 300000

Special Order Received (Accept in full, or not at all: A ll or None)

Units 250000 units
Value 750000
VC 1 per unit
Variable Modification Cos t 125000 for entire order
A dditional Capacity is available in increments of 150000 units
Cos t of additional capacity 100000

ͳʹ
Solution

Relevant

Special Order Sales Value 750000

Variable Cos t (1 * 250000 + 125000) -375000
Fixed Cos t for the
incremental capacity -100000

Relevant Incremental Income 275000 ACCEPT

Irrelevant

Normal Sales 1600000

VC on Normal Sales -400000
Fixed Cos t on Normal Capacity -300000

4
 0$.(25%8<"

In-house manufacture
Production & Sale 10000 units
Material @ 50 500000
Labour @ 25 250000
VO H @ 20 200000
FOH @ 16 160000

Buy
85 per unit
40% of labour can be saved
60% of labour will be trans ferred to
other parts in the organization

Solution

M ake Buy
Units 10000 10000
Relevant

Materials 500000
Labour (40% of 25/ is relevant) 100000
VOH 200000
Purchas e Cos t 850000
___________________________

Total Relevant Cos t 800000 850000

MAKE IN-HOUS E

Irrelevant Make Buy

Labour 60% 150000 150000
FOH 160000 160000

4
 $127(2
$127(2175$16)(535,&,1*

Transfer price is the price that one profit unit charges to another one, within the same organization (it could also be a
cross-border transfer). For example, if Audi has a separate division manufacturing engines, then the transfer price is the
price that the engine division charges the car division. Transfer prices affect the operating profit of both divisions.

ͳ͵
Objectives

a) Promote goal congruence: benefit the organization as a whole

b) Be effective: achieve objectives

c) Be efficient: utilize resources optimally

Methods

* Market-based transfer prices

* Cost-based transfer prices

* Negotiated transfer prices

(Guideline) Minimum transfer price = Incremental cost until transfer + Opportunity cost of the selling unit

This guideline holds good when there is no idle capacity in the transferring division.

If idle capacity exists, the variable cost of production would become the minimum transfer price.

ͳͶ
3. Budgeting and Budgetary Control

4
 3/($6((;3/$,1%8'*(76 %8'*(7,1*
3/($6((;3/$,1%8'*(76 %8'*(7,1*
(;3/$,1%8'*(76 %8'*(7,1*

A budget is a statement of intent. CIMA defines budgetary control as "The establishment of budgets relating the
responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted
results, either to secure by individual action the objective of that policy, or to provide a basis for its revision".

Functional budgets: depending on the “principal budget factor”

* Cash budget

* Sales budget

* Production budget (only quantities)

* Raw material and purchases budget

* Labour budget

* Capital expenditure budget

Master Budget combines all the functional budgets to present a consolidated view of projected operations & financial
implications in the forthcoming period. It also includes budgeted financial statements, cash forecast, & a financing plan.

Fixed Budget or Static or Rigid Budget is prepared for a standard or budgeted output; & it does not change.

Flexible Budget changes with output (e.g. 100% capacity, 80% capacity etc.) It recognizes the difference between fixed,
semi-fixed, & variable costs.

4
 :+$7,6=(52
:+$7,6=(52%$6('%8'*(7,1*"
%$6('%8'*(7,1*"

Typically, we prepare a budget using the available figures of the previous period & amend it according to our
expectations. For example, if volume of sales is expected to increase by 10% next year, then sales revenue will be 10%
higher than last year. However, if the selling price is expected to come down by 10% because of increased competition,
then the net change in sales revenue will be 100% * 1.1 * 0.9 = -1%

Year 0 Year 1 Change

Sales (units ) 100 110 10%
SP (unit) 10 9 -10%
Sales (value) 1000 990 -1%

With zero-based budgeting, nothing is assumed. Developed by Peter Pyhrr between 1969-1971 for Texas Instruments,
in ZBB every expense must be justified & approved for every new period. Every program or activity is broken into
decision packages, showing the associated costs of each.

Some myths about ZBB

1. ZBB simply means building your budget from zero

Reality: ZBB is a repeatable process to build a sustainable culture of cost management

2. Implementing ZBB requires cutting ‘to the bone’

Reality: The degree of cost reduction is based on the company’s top-down target

3. ZBB will overwhelm your business and prevent it from doing anything else

Reality: Initial rollout of a new ZBB program can be led by a central team and completed in four to ten months

ͳͷ
4. ZBB only focuses on SG&A

Reality: ZBB can be applied to any type of cost: capital expenditures; operating expenses; sales, general, and
administrative costs; marketing costs; variable distribution; or cost of goods sold

5. ZBB is not designed for growth-oriented companies

Reality: ZBB is successfully used by growing companies to redirect unproductive costs to more productive areas that
drive growth

(Extracts from an article, by Shaun Callaghan, Kyle Hawke, and Carey Mignerey in October 2014, “Five myths (and
realities) about zero-based budgeting“ https://www.mckinsey.com/business-functions/strategy-and-corporate-
finance/our-insights/five-myths-and-realities-about-zero-based-budgeting)

ͳ͸
4. Standard Costing and Variance Analysis

4
 67$1'$5'&2676 9$5,$1&(6
67$1'$5'&2676 9$5,$1&(6
9$5,$1&(6

Standard costs are the costs which should have been incurred in manufacturing a product, or delivering a service; at a
budgeted level of activity.

Actual costs are actually incurred, for the actual level of activity. The difference between the two is a Variance.

Imagine a customer walks into a store to purchase a computer & is told to take the machine today, but make the
payment only at the end of the year: when the actual expenses will be known & an accurate price can be fixed by the
cost accountant!

What if the customer was asked to pay 500,000/ for the computer, & to come back to collect the difference after cost
accounts were finalized? Both these methods would be disastrous for the business.

Hence, standard cost: an estimate of costs for a projected level of activity – based on past data & expectations of the
future. By its very nature, standard costing system cannot be 100% accurate. It must be assessed periodically to evaluate
variances, & to re-set standards where required.

Uses of standard cost (not exhaustive):

* Budgeting

* Inventory costing

* Overhead application

* Price setting

Variances are of two types: rate variance, & volume variance. They can apply to direct material, direct labour,
overheads, & also to items of revenue like sales.

If actual cost incurred exceeds the standard, the variance is Adverse; when actual cost is less than the standard, the
variance is Favourable

For revenues, the situation is reversed: if revenues are actually greater than budgeted, the variance is Favourable:
& if actual revenues are less than budgeted, the variance is Adverse.

4
 3/($6((;3/$,19$5,$1&($1$/<6,6
3/($6((;3/$,19$5,$1&($1$/<6,6

Variances can be studied under these heads:

* Variable cost variance

- Direct material variance

- Direct labour variance

- Variable production overhead variance

* Fixed production overhead variance

* Sales variance

ͳ͹
(https://corporatefinanceinstitute.com/resources/knowledge/accounting/variance-analysis/)

4
 0$7(5,$/&2679$5,$1&(
0$7(5,$/&2679$5,$1&(

Material Cost Variance = (SQ * SP) – (AQ * AP)

AQ = Actual Quantity

AP = Actual Price

SQ = Standard Quantity for the actual output

SP = Standard Price

ͳͺ
http://www.yourarticlelibrary.com/accounting/variances-analysis/variance-analysis-material-labour-overhead-and-
sales-variances/52883

Material Usage (or quantity) Variance = (SQ – AQ) * SP

Material usage variance = Material mix variance + Material yield variance

Material Price Variance = (SP – AP) * AQ

Reconciliation: Material Cost Variance = Material Usage Variance + Material Price Variance

4
 Product “X” requires 100 kg of material at the rate of 4 per kg. The actual consumption of material was 120
kg of Material at the rate of 4.50 per kg. Calculate Material Cost Variance.

Solution

Material cost variance = Standard cost for actual output – Actual cost

= (4*100) – (4.5*120) = 400 -540 = 140 (Adverse)

4
4 The standard material required for the production of one unit of Product A is: 50 kg @ 15 per kg. Actual
data: 400 units of Product A, Material used 22,000 kg @ 15 per kg. What is the material cost variance?

Solution

SQ for actual output = 400 units * 50 kg = 20,000 kg

Material cost variance = Standard cost for actual output – Actual cost

= (15 * 20000) - (15 * 22000) = 300000 – 330000 = 30,000 (Adverse)

4
 10 kg of raw material should be used to produce one unit of Product X. Standard cost of the material is 2 per
kg. Actual performance for one unit of Product X: 12 kg of material @ 1.80

Compute the material variances.

Solution

Material Price Variance = (SP - AP) * AQ

= (2 - 1.8) * 12

= 2.40 Favourable

Material Usage Variance = (SQ for actual output - AQ) * SP

= (10 - 12) * 2

= -4.00 Adverse

ͳͻ
Material Cost Variance = Standard cost for actual output - Actual cost

= (10 * 2) - (12 * 1.8)

= -1.60 Adverse

Proof: MCV = MPV + MUV = 2.4 - 4 = -1.60 Adverse

4
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:+$7,60$7(5,$/0,;9$5,$1&("

Material mix is the combination of inputs required for a given output. For example, the standard mix for one cup of tea
would be specific quantities of tea, milk, sugar, water, etc.

Material Mix Variance = (Revised SQ – AQ) * SP

Where RSQ = SQ *(Total quantity or weight of actual mix/Total quantity or weight of standard mix)

4
 Please calculate the Materials Mix Variance.

Material Standard Actual

1 100 units @ 10/ 130 units @ 11/
2 50 units @ 20/ 50 units @ 22/
150 180

Solution

Material Standard Actual

Quantity Rate Amount Quantity Rate Amount
1 100 10 1000 130 11 1430
2 50 20 1000 50 22 1100
150 2000 180 2530

Revised SQ 1 100*(180/150) 120

2 50*(180/150) 60

Material Mix Variance = (Revis ed SQ – AQ) * SP

1 (120-130)*10 -100 Adverse
2 (60-50)*20 200 Favourable
Material Mix Variance 100 Favourable

4
 :+$7,60$7(5,$/<,(/'9$5,$1&("

Material Yield Variance is the difference between the standard output & the actual output from the actual input.

Material Yield Variance = Standard Cost per unit * (Standard Yield for actual input – Actual Yield)

Standard Cost per unit = Cost of standard mix/Standard output

Standard Yield = Standard production * (Actual input/Standard input)

4
 Standard Input = 1000 kg, standard output (yield) = 900 kg, standard cost per kg of output = 2000

Actual input = 2000 kg, actual yield = 1900 kg. What is the material yield variance?

ʹͲ
Standard Yield for Actual Input = 900 * (2000/1000) = 1800 kg

Material Yield Variance = 2000 * (1800 -1900) = -200,000 Favourable

Even though the sign is negative, this is a favourable variance because the actual yield is greater than the standard yield.

Please remember, if actual revenue is greater than the standard that is positive for the company.

4
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/$%285&2679$5,$1&(

Labour Cost Variance = (SH * SR) – (AH * AR)

AH = Actual Hours

AR = Actual Rate

SH = Standard Hours for the actual output

SR = Standard Rate

http://www.yourarticlelibrary.com/accounting/variances-analysis/variance-analysis-material-labour-overhead-and-
sales-variances/52883

Labour Efficiency Variance = (SH – AH) * SR

Labour efficiency variance = Labour mix variance + Labour yield variance + Idle time variance

Labour Rate Variance = (SR – AR) * AH

Reconciliation: Labour Cost Variance = Labour Efficiency Variance + Labour Rate Variance

4
 Standard labour hours per unit 10

Standard rate per hour 10

Actual hours 15000

Actual production 1100

Actual wages paid 165000

Calculate the labour rate variance 

Solution

Actual rate per hour = 165000/15000 11

Labour rate variance = (SR - AR) * AH
= (10 - 11)*15000
= -15000 Adverse

ʹͳ
4
 Calculate the labour efficiency variance for the example above.

Standard hours for actual production = 1100*10 11000

Labour efficiency variance = (SH - AH) * SR
= (11000-15000)*10
= -40000 Adverse

4
 Calculate the labour cost variance & reconcile the result.

Labour Cost Variance с (SH * SR) – (AH * AR)

SH = standard hours for actual output
= (11000 * 10) - (15000 * 11)
= -55000 Adverse
Reconciliation LCV = LEV + LRV
LCV = -40000-15000 = -55000

4
 ,'/(7,0(9$5,$1&(
,'/(7,0(9$5,$1&(
9$5,$1&(

Idle time variance is always Adverse. It refers to idle time due to abnormal circumstances like breakdown, strike,
supply disruption, etc.

Idle Time variance = Idle Hours x Standard Rate per hour

Idle time will be ignored for Efficiency & Rate variances: total actual hours will be considered.

However, idle hours will be reduced when calculating Mix & Yield variances; both from the actual hours used, & for
computing revised standard hours.

4
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3/($6((;3/$,1/$%2850,;9$5,$1&(

This refers to the difference in the composition of the gang or team of labour (skilled, semi-skilled; or women, men)

Labour Mix Variance = (Revised SH – AH) * SR

Where RSH = SH * (Total hours of actual gang/total hours of standard gang or mix)

4
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3/($6((;3/$,1/$%285<,(/'9$5,$1&(
<,(/'9$5,$1&(

It is the difference between standard & actual output.

Labour Yield Variance = Standard labour cost per unit * (Standard yield for actual gang – Actual yield)

Standard Labour Cost per unit = Total cost of standard mix/Standard output

4
 3/($6(&$/&8/$7(7+(/$%2859$5,$1&(6
/($6(&$/&8/$7(7+(/$%2859$5,$1&(6

Standard Actual
Output units 500 550
Workers Hours Rate Amount Hours Rate Amount
Skilled 100 200 20000 150 220 33000
Semi-skilled 200 100 20000 150 110 16500
Unskilled 200 50 10000 200 70 14000
Total 500 100 50000 500 127 63500
Abnormal Idle Time = 10 hours for each category


ʹʹ
Solution

Direct Labour Cost Variance = Standard cost for actual output - Actual cost
Standard cost for actual output = Standard cost per unit * Actual output
= (50000/500)*550
= 55000
Direct Labou Cost Variance = 55000-63500 -8500 (A)

Direct Labour Rate Variance = AH * (SR - AR)

Skilled 150 * (200 - 220) = -3000 (A)
Semi-s killed 150 * (100 - 110) = -1500 (A)
Uns killed 200 * (50 - 70) = -4000 (A)
Direct Labour Rate Variance -8500 (A)

Direct Labour Efficiency Variance = SR * (SH for actual output - AH)

Standard hours for actual output = Actual output * (Standard hours/Standard output)
Skilled 550 * (100/500) = 110 hours
Semi-s killed 550 * (200/500) = 220 hours
Uns killed 550 * (200/500) = 220 hours
550 hours
Direct Labour Efficiency Variance
Skilled 200 * (110 - 150) = -8000 (A)
Semi-s killed 100 * (220 - 150) = 7000 (F)
Uns killed 50 * (220 - 200) = 1000 (F)
Direct Labour Efficiency Variance 0 (A)

Reconciliation 1 DLCV = DLRV + DLEV -8500 = -8500+0

Idle Time Variance = Idle hours * SR

Skilled 10 * 200 = -2000 (A )
Semi-s killed 10 * 100 = -1000 (A )
Uns killed 10 * 50 = -500 (A )
Idle Time Variance -3500 (A)

Direct Labour Mix Variance = SR * (Revised standard hours - Actual hours)

Revised standard hours = SH * (Total hours of actual gang/Total hours of standard gang)
Total hours of actual gang = 500 - 30 idle = 470 hours
Revised standard hours Skilled 100 * (470/500) = 94 hours
Semi-skilled 200 * (470/500) = 188 hours
Unskilled 200 * (470/500) = 188 hours
470 hours
Direct Labour Mix Variance
Skilled 200 * (94 - 140) = -9200 (A )
Semi-skilled 100 * (188 - 140) = 4800 (F)
Unskilled 50 * (188 - 190) = -100 (A )
-4500 (A)

Direct Labour Yield Variance = Standard labour cost per unit * (Standard yield for actual gang – Actual yield)
Standard labour cost per unit = 50000/500 = 100
Standard output for actual time = 500/500 * 470 = 470
Direct Labour Yield Variance 100 * (470 - 550)= -8000
Direct Labour Yield Variance Actual yield is higher than standard: (F) 8000 (F)

Reconciliation 2 DL Efficiency Variance = Idle Time Variance + Mix Variance + Yield Variance 0 = -3500 -4500 + 8000

ʹ͵
4
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http://www.yourarticlelibrary.com/accounting/variances-analysis/variance-analysis-material-labour-overhead-and-
sales-variances/52883

ʹͶ
5. Learning Curve

4
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:+$7,67+(/($51,1*&859( +2:,6,7,03257$17"

“The theory of the learning curve or experience1 curve is based on the simple idea that the time required to perform a
task decreases as a worker gains experience. The basic concept is that the time, or cost, of performing a task (e.g.,
producing a unit of output) decreases at a constant rate as cumulative output doubles. Learning curves are useful for
preparing cost estimates, bidding on special orders, setting labor standards, scheduling labor requirements, evaluating
labor performance, and setting incentive wage rates.” https://maaw.info/LearningCurveSummary.htm

Notes

1) Costs in learning curve can be in currency, labour hours, material etc.

2) There is no learning curve associated with overhead costs; only with recurring manufacturing or service costs.

Two theories of Learning Curve:

Cumulative Average Theory: “If there is learning in the production process, the cumulative average cost of some
doubled unit equals the cumulative average cost of the un-doubled unit times the slope of the learning curve”

Historical Facts: Described by T. P. Wright in 1936

Unit Theory: “If there is learning in the production process, the cost of some doubled unit (say, unit #100) equals the
cost of the undoubled unit (= unit #50) times the slope of the learning curve” J. R. Crawford in 1947

Defined by the equation Yx = A * xb

Where: Yx = the cost of unit x (dependent variable)

A = the theoretical cost of unit 1

x = the unit number (independent variable)

b = a constant representing the slope (slope = 2b)

 The learning rate for employees on a project is 80%. The time taken for manufacturing the first batch of 1,000
4
units is 10,000 hours. The total time and average time taken for 4 batches will be:   

Solution

Batches of 1,000 units Average time (hrs.) Total time (hrs.)

1 10,000 10,000
2 8,000 16,000
4 6,400 25,600

4
 Time for production of the first unit is 10 hours. Learning curve is 90% Show the scheduled production time
for the first 5 units.

b = ln(0.90)/ln(2) = -0.1520

Solution

ʹͷ
 b
Yx = A * x
Unit Formula Time/unit Cumulative Time
-0.152
1 10*1 10.00 10.00
-0.152
2 10*2 9.00 18.00
-0.152
3 10*3 8.46 25.39
-0.152
4 10*4 8.10 32.40
-0.152
5 10*5 7.83 39.15

We can verify from this table that:

a) The formula is accurate: time for first unit is 10 hours

b) Double of 1 is 2: hence time for 2 units with a 90% learning curve should be 10*.9 = 9 hours: for 4 should be
10*.9*.9 = 8.1 hours, which is vindicated by the table above.

c) The learning curve effect diminishes over time & will plateau out at some stage.

ʹ͸
SECTION B: FINANCIAL MANAGEMENT

6. Introduction to Financial Management

4
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:+,&+$5(7+(0$,1'(&,6,216,1),1$1&,$/0$1$*(0(17"

* Investing Decision Where to invest; which project or combination of projects should be chosen?

* Financing Decision What should be the capital structure? What combination of debt & equity?

* Distributing Decision How should the profits be distributed; how much should be retained?

4
 :+$7$5(7+()81&7,2162)),1$1&,$/0$5.(76"
:+$7$5(7+()81&7,2162)),1$1&,$/0$5.(76"

* PRICE RISK MANAGEMENT

* PRICE DISCOVERY PLATFORM

* RESOURCE ALLOCATION

* CONTRACT ENFORCEMENT

4
 %5,()127(21),1$1&,$/0$5.(76
%5,()127(21),1$1&,$/0$5.(76

* Money Market - for financial assets with original maturities of one year or less. Trading is over the
counter and is wholesale.

* Capital Market - for trading in long-term debt or equity-backed securities with maturity exceeding a year.

- Primary Market: securities are issued for the first time to raise funds for the issuer.

- Secondary Market: securities already issued are traded by owners & prospective owners. No cash
implication for the issuer.

* Derivatives Market- financial derivatives are traded.

* Commodity Market- market for commodities

* Forex Market - foreign exchange (currency) market

4
 021(<0$5.(7,167580(176
021(<0$5.(7,167580(176

Money market instruments include treasury bills, commercial paper, bankers' acceptances, deposits, certificates of
deposit, bills of exchange, repurchase agreements, and short-term asset-backed securities. The instruments may differ in
maturities, currencies & risk.

4
 &$3,7$/0$5.(7,167580(176
&$3,7$/0$5.(7,167580(176

Equity shares, preference shares, debentures, bonds, convertible debentures, convertible preference shares, securities
with warrants, secured premium notes are some of the capital market instruments. They usually carry a higher risk &
offer a higher return, relative to money market instruments.

4
 3/($6((;3/$,1*'5 $'5
3/($6((;3/$,1*'5 $'5

A Depository Receipt is a negotiable financial instrument that allows investors of any country to trade or invest in the
shares of a company in any other country. The shareholders are entitled to dividends & capital gains on that foreign
company.

American Depository Receipt (ADR): listed and traded on exchanges in the United States.

ʹ͹
Global Depository Receipt (GDR): listed and traded in non-US markets.

4
 :+$7,6)$&725,1*"
:+$7,6)$&725,1*"

“Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable (i.e.,
invoices) to a third party (called a factor) at a discount. A business will sometimes factor its receivable assets to meet its
present and immediate cash needs.

There are three parties directly involved: the factor who purchases the receivable, the one who sells the receivable, and
the debtor who has a financial liability.

If the factoring transfers the receivable "without recourse", the factor (purchaser of the receivable) must bear the loss if
the account debtor does not pay the invoice amount. If the factoring transfers the receivable "with recourse", the factor
has the right to collect the unpaid invoice amount from the transferor (seller)”

https://en.wikipedia.org/wiki/Factoring_(finance)

4
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6+257127(21 )25)$,7,1*
)25)$,7,1*

Forfaiting is a method of financing international trade that provides cash to exporters in return for selling their medium
and long-term foreign accounts receivable. The accounts are sold to a forfaiter, who is a specialized financier or bank.

4
 6+257127(21/($6,1*
6+257127(21 /($6,1*
/($6,1*

“A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the
right to use an asset for an agreed period of time.

A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title
may or may not eventually be transferred.

An operating lease is a lease other than a finance lease.” Ind AS17(4)

Initial Recognition of Finance Lease (Lessees)

“At the commencement of the lease term, lessees shall recognise finance leases as assets and liabilities in their balance
sheets at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease
payments, each determined at the inception of the lease.” Ind AS17(20)

Initial Recognition of Operating Lease (Lessees)

“Lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease term
unless another systematic basis is more representative of the time pattern of the user’s benefit.” Ind AS17(33)

4
 :+$7,66(&85,7,=$7,21"
:+$7,66(&85,7,=$7,21"

“Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages,
commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables)
and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through
securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows
collected from the underlying debt and redistributed through the capital structure of the new financing. Securities
backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of
receivables are asset-backed securities (ABS).” https://en.wikipedia.org/wiki/Securitization

ʹͺ
https://www.researchgate.net/figure/How-securitization-works_fig2_323783408

4
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7,0(9$/8(2)021(<

A rupee today is worth more than a rupee tomorrow. WHY? Money has a Time Value associated with it.

Three factors:

1) Opportunity Cost1 (Risk-free rate of return for a comparable time-period)

2) Inflation (the decrease in purchasing power of the currency in use)

3) Risk (uncertainty; chance of loss)

Today, Time T 0 Invest 10,000

For 5 years, Time T 5 Interest p.a. 12%
Time Amount (SI) Amount (CI)
0 10000 10000.00
1 11200 11200.00
2 12400 12544.00
3 13600 14049.28
4 14800 15735.19
5 16000 17623.42
(nt)
A = P*(1+rt) A = P*(1+r/n)^

A = Final Amount (FV or Future Value)

P = Principal (PV or Present Value)

r = Interest Rate

n = Frequency of Compounding

t = Number of Compounding Periods

SI = Simple Interest

CI = Compound Interest  

1
Opportunity cost is the benefit foregone by not investing in the next best available alternative: it is NOT the cost of the alternative.

ʹͻ
 

4
 7+(0$*,&2)&203281',1*

͵Ͳ
 ^nt
FV = PV* (1 +r/t)
PV 10000
r 12%
t 1
n 30
FV ?
^(3 0 * 1 )
10000* (1+0.12/1)
2 9 9 5 9 9 .2 2
Or, u s e th e co mp o u n d in teres t tab les
FV o f 1 after 30 y ears @ 12% p .a. co mp o u n d ed an n u ally .
^(3 0 )
(1 .1 2 )
2 9 .9 5 9 9 2 2
M u ltip ly th is with PV o f 10000
10000* 29.959922
2 9 9 5 9 9 .2 2

For optimal results, please use compound factors up-to four decimal places in your routine calculations.

4
 &203281',1* ',6&2817,1*
&203281',1* ',6&2817,1*

Calculation of FV given PV is called compounding. Calculation of PV given FV is discounting. In our example above,
the PV can be found by discounting 299599.22 with the factor for PV for 30 years, using 12% discount factor.

^(nt)
PV = FV/(1 +r/t)
FV 299599.22
r 12%
t 1
n 30
PV ?
^(3 0 * 1 )
299599.22/(1+.12/1)
10000
Or, u s e th e co mp o u n d in teres t tab les
PV o f 1 after 30 y ears @ 12% p .a. co mp o u n d ed an n u ally .
^(3 0 )
1 /(1 .1 2 )
0 .0 3 3 3 7 8
M u ltip ly th is with FV o f 299599.22
299599.22* 0.033378
10000

Verification is Fun:
FV factor 29.959922
PV factor 0.033378
FVIF * PVIF = 1 29.959922*0.033378
FVIF * PVIF = 1 1.0000

4
 ,03257$17127(621&203281',1*
,03257$17127(621&203281',1*
3281',1*

1. Compound Interest is Non-Additive

͵ͳ
If an investment grows by 50% in the 1st year, & then loses value by 50% in the 2nd year, the end result will not be
back to principal value.

Inves tment of 100

Year Growth Year-end Value
1 50% 150
2 -50% 75

2. The order of compounding does not matter for any given cash flow stream where interest rates are known
or projected

Inves tment of 100

Year Growth Year-end Value
1 -50% 50
2 50% 75

The final amount is the same; 1.5*.5 is the same as .5*1.5

4
 3/($6((;3/$,1$118,7,(6
3/($6((;3/$,1$118,7,(6

An annuity is a series of equal cash payments, made at equal intervals. The EMI for a home loan is an annuity: it
comprises part interest & part principal (loan repayment). At the end of the EMI term, the outstanding loan should be
zero.

Ordinary Annuity is one where the payments are made at the end of each period.

Annuity Due is an annuity where the payments are made at the beginning of each period.

PV of an ordinary annuity

PV of an annuity due

PV of an ordinary annuity * (1 + r)

FV of an ordinary annuity

FV of an annuity due

FV of an ordinary annuity * (1 + r)

͵ʹ
4
 A Fixed Deposit of 1,000,000 @ 10% compounded annually for 5 years will grow to…

Solution

^n
FV = PV * (1 + r) Table A 1.6105
1000000*(1.1)^5 or 1000000*1.6105
1610510 1610500

4
 What is the value today of 1,000,000 after 25 years if the discount rate is 10%?

Solution

^n
PV = FV/(1 + r) Table B 0.0923
1000000/(1.1)^25 or 1000000*0.0923
92296 92300

4
 You invest 100000 at the beginning of each year, starting today. Your expected return on the investment is
11% p.a. How much will you have in hand at the end of 15 years?

Solution

TABLE C 38.1899 * 100000 = 3,818,990 Or

FVIFA (1+r)^n 4.78458949

((1+r)^n-1) (1+r)^n-1 3.78458949
r (1+r)^n-1 34.405359 Ordinary Annuity
r
((1+r)^n-1) *(1+r) 38.1899 Annuity Due
r 100000 * 38.1899 = 3818990


 In the above example, if your investments were at the end of each year, would your answer have been
4
different? What is the amount?

Solution

TABLE D 34.4054 * 100000 = 3,440,540 Or

Use Factor calculated for Ordinary Annuity above, 34.40536

4
 A company promises to pay 100,000 at the end of every year for 10 years. If the discount rate is 10%, how
much is this annuity worth today?

Solution

TABLE F 6.1446 * 100000 = 614,460 Or

͵͵
PVIFA
n
1-(1/(1+r) ) (1+r)^n = 2.59374246
r 1/(1+r)^n = 0.38554329
n
1-(1/(1+r) ) = 0.61445671
n
1-(1/(1+r) ) = 6.14456711
r
A= 100000
PV of Annuity 614457

4.
 In the above example, if the payments were received at the beginning of each year, would your answer have
been different? What is the amount?

Solution

TABLE E 6.7590 * 100000 = 675,900 Or

(1+r)^n = 2.59374246
1/(1+r)^n = 0.38554329
n
1-(1/(1+r) ) = 0.61445671
n
1-(1/(1+r) ) = 6.14456711
r
Annuity Due (multiply with (1+r)) 6.75902382
A= 100000
PV of Annuity Due 675902

(Minor differences above are due to rounding & because the factors are taken up-to four decimals only)

4
 You borrow 2,000,000 for 15 years @ 14% p.a. What will be your equated annual repayment? 

Solution

Table F PVIFA is 6.1422, hence the annual repayment instalment will be 2000000 / 6.1422 = 325,616

The actual instalment will be 325,618 p.a. (minor difference because of number of decimal places)

Time Opening Interes t Total Repayment Clos ing

Loan O/S 14% Due Loan O/S
1 2000000 280000 2280000 325618 1954382
2 1954382 273613 2227995 325618 1902377
3 1902377 266333 2168710 325618 1843092
4 1843092 258033 2101125 325618 1775507
5 1775507 248571 2024078 325618 1698460
6 1698460 237784 1936245 325618 1610627
7 1610627 225488 1836114 325618 1510496
8 1510496 211470 1721966 325618 1396348
9 1396348 195489 1591837 325618 1266219
10 1266219 177271 1443489 325618 1117871
11 1117871 156502 1274373 325618 948755
12 948755 132826 1081581 325618 755963
13 755963 105835 861798 325618 536180
14 536180 75065 611245 325618 285627
15 285627 39988 325615 325615 0
Las t ins talment is adjus ted s lightly to clos e the account.

͵Ͷ
7. Tools for Financial Analysis and Planning
4
 61$3
61$36+272)),1$1&,$/5$7,26
6+272)),1$1&,$/5$7,26

LIQUIDITY RATIOS

CURRENT CURRENT ASSETS/ CURRENT LIABILITIES

Higher is better. No one size fits all; good ratio depends on the industry, the economy, & other factors

ACID TEST QUICK ASSETS / CURRENT LIABILITIES

(QUICK ASSETS = C A - INVENTORIES – PREPAID EXPENSES)

Stronger test than current ratio: higher is better.

TURNOVER RATIOS

DEBTORS TURNOVER NET CREDIT SALES / AVERAGE DEBTORS

Higher is better.

AVG COLLECTION PERIOD 360 / D T O (IN DAYS)

OR 360 * AVG DRS / NET CREDIT SALES (IN DAYS)

OR AVG DRS /AVG DAILY SALES (IN DAYS)

Lower is better.

INVENTORY T/O C O G S / AVG INVENTORY, OR NET SALES / AVG INVENTORY

Higher is better.

PROFITABILITY RATIOS

GPM G P / NET SALES

Higher is better.

NPM NP / NET SALES

Higher is better.

ASSET TURNOVER SALES / AVG ASSETS

Higher is better.

EARNING POWER E B I T / AVG TOTAL ASSETS

Higher is better.

RETURN ON EQUITY P A T / AVG EQUITY

Higher is better.

EARNINGS RATIOS

EPS P A T / NO OF SHARES

Higher is better.

͵ͷ
P E RATIO MKT PRICE OF THE SHARE / E P S

This indicates how many years it will take to recover our investment, if there is no growth, & the entire earnings are
available to shareholders either as dividend or capital appreciation. Companies with higher growth will quote at a
higher P/E multiple.

CAPITALIZATION RATE E P S / MKT PRICE OF THE SHARE

OR 1 / P E RATIO

LEVERAGE RATIOS

DEBT EQUITY DEBT / EQUITY

(DEBT = LONG TERM DEBT: EQUITY = NET WORTH

+ PREFERENCE

OR DEBT = LONG TERM DEBT + CURRENT LIAB: EQUITY = NET WORTH + PREFERENCE)

High leverage can be beneficial in good times, & can prove fatal in bad times.

DEBT ASSETS DEBT / TOTAL ASSETS

(DEBT IS SAME AS IN DEBT EQUITY RATIO)

COVERAGE RATIOS

INTEREST COVERAGE E B I T / INTEREST

Higher is better.

FIXED CHARGES COVERAGE E B D I T (BEFORE DEP, INT & TAX) & LEASE RENTALS

INT+ LEASE RENT + (LOAN REPAYMENT INSTL) + (PREF DIV)

(1-TAX RATE) (1 – TAX RATE)

Higher is better. Please note preference dividends & loan repayments are made from post-tax profits.

DEBT SERVICE COVERAGE PAT + DEP + NON CASH CHARGES + INT ON TERM LOAN

INT ON TERM LOAN + REPAYMENT OF TERM LOAN

Higher is better.

DIVIDEND RATIOS

DIVIDEND PAYOUT EQUITY DIV / EQUITY HOLDERS` EARNINGS

DIVIDEND YIELD D P S / MKT PRICE PER SHARE

LIQUIDITY: If the company has adequate cash & cash equivalents to meet all imminent payments, it is liquid

SOLVENCY: If the assets (including cash) are sufficient to pay off all liabilities, the company is solvent.

Notes

1) This is not an exhaustive list of financial ratios

2) Please remember, unless you use sense & sensibility, there is nonsense in numbers.

͵͸
4
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:+$7,67+('8321702'(/"

ROE = NPM * Total Asset Turnover * Equity Multiplier

Net Profit / Average Equity = (Net Profit / Sales) * (Sales / Average Total Assets) * (Average Total Assets / Average
Equity)

ROA = NPM * TAT

Net Profit / Average Total Assets = (Net Profit / Sales) * (Sales / Average Total Assets)

4


As sets crore Liabilities crore

Fixed As sets 300 Equity 240
Current Assets 300
Debtors 100 Long Term Loans 260
Inventory 100 Creditors 50
Cash 100 Bank O/D 50
600 600

Net Profit 140 crore

Sales 800
Opening Inventory 120

Please analyse this company with Ratio Analysis

Solution

Debt/Equity 260/240 1.08

Leverage is conservative
Current Ratio 300/100 3
Quick Ratio 200/100 2
Curent Ratio & Quick Ratio are at comfortable levels
Net Profit Margin 140/800 17.50%
Net Profit Margin is quite good, must be compared to competitors, & to historical margin
Return on Equity 140/240 58.33%
Return on Equity is excellent
Fixed As sets T/O 800/300 2.67
Total As sets T/O 800/600 1.33
Asset Turnover Ratios are fairly solid, must be compared to competitors
Inventory T/O 800/110 7.27
Inventory was held on an average for about 50 days
Debtors T/O 800/100 8
Debtors took on an average, 1.5 months to clear their dues

* Comparison must always be with historical performance, as well as with comparable peer group

* Do not compare apples to oranges: ratios of a steel company are not comparable with those of a software company.

* The state of the economy & the macro picture must be considered for meaningful analysis

* Ratio analysis is one of the tools for fundamental analysis. No single tool merits blind faith.

͵͹
4
 127(21)81'6)/2:67$7(0(17
127(21)81'6)/2:67$7(0(17

“Fund” means net working capital…viz. current assets-current liabilities. Funds Flow Statement shows all sources &
uses of Funds in the relevant period. The net result of this statement is that it shows net increase or net decrease in the
working capital employed. Another name for Funds Flow Statement is “Statement of Sources & Applications of
Funds”

Funds Flow Statement measures the:

Change in Working Capital, i.e. Change in Current Assets &/ Or Change in Current Liabilities

Sources of Funds are

i) Funds from Trading Operations

Start with the Net Profit (after depreciation & income tax but before appropriations)

ADD

Depreciation

Goodwill, Preliminary expenses, Cost of Issue of Debentures, written off during the year

Loss on sale of Fixed Assets

Loss on sale of Investments

SUBTRACT

Profit on sale of Fixed Assets

Profit on sale of Investments

Profit on Revaluation of Fixed Assets

Non-operating incomes

ii) Funds from Issue of Shares

Shares issued for cash or any other current asset will alter working capital & will be considered a source of funds.
Proceeds from shares issued against consideration of fixed assets are not a source of funds. However, such a transaction
should be disclosed in order to give a true & fair picture of the transactions. The actual amount received will be treated
as a source of funds for the period under consideration.

iii) Issue of Debentures & raising long-term loans from Financial Institutions (FIs)

Please apply the same principles as in ii) above

iv) Sale Proceeds of Long-term investments & fixed assets

The actual proceeds should be shown as a source of funds if the sale increases a current asset. However, if the sale is an
exchange of two long-term investments or fixed assets, the amount will not figure in sources of funds. A separate
disclosure is required to explain the transaction. Please remember to remove the element of profit/loss from the P&L A/c
in this calculation, since entire amount is included in sale proceeds.

v) Non-operating Incomes are also sources of funds

Applications of Funds are

i) Purchase of Fixed Assets

͵ͺ
If the amount is paid for in cash, by other current asset or by reduction in a current liability

ii) Purchase of Long-term investments

iii) Redemption of Preference Shares & Debentures

Do note, if preference shares or debentures are redeemed by issue of fresh equity, preference shares or debentures,
then it is not an application of funds. As always, in such a case, a clear disclosure is mandatory

iv) Repayments of Long-term loans

v) Payment of Dividend

vi) Payment of Income Tax

If Income tax is treated as a current liability, payment of Income Tax will not be shown as an application of
funds. However, if Income Tax is treated as an appropriation (below the line), the Provision for Income Tax will be
added to Funds from Trading Operations & the actual Tax paid will be shown as an application of funds.

4
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',))(5(1&(%(7:((1)81'6)/2: &$6+)/2:
%(7:((1)81'6)/2: &$6+)/2:

FUNDS FLOW CASH FLOW

*Changes in Working Capital Changes in Cash & Cash equivalent

*No opening & closing balances Contains both, opening & closing cash

*Records sources & applications of funds Records inflows & outflows of cash

*Net result is increase or decrease in WC Net result is increase/decrease in cash

*Is accompanied by Statement showing No such statement needed

Changes in Working Capital


4
 Please prepare for the year ended 31st March 2019:
a) Schedule of Changes in Working Capital
b) Funds Flow Statement
Systems Inc.
Balance Sheet as on 31st March 2019
Liabilities 31st March Assets 31st March
2018 2019 2018 2019

Capital 725600 748600 Goodwill (cost) 600000 600000

P&L A/c 147800 176400 Building 185000 220000
Secured Loan 120000 90000 Computers 130000 124800
Unsecured Loans 40000 68000 Debtors 120000 128000
Creditors 140000 122000 Bank 130000 120400
Cash 8400 11800

1173400 1205000 1173400 1205000



Solution

͵ͻ
 Schedule of Changes in Working Capital for the period 1/4/2018 to 31/3/2019

Account 2018 2019 Working Capital Change

Increase Decreas e

A CURRENT ASSETS

Debtors 120000 128000 8000

Bank 130000 120400 9600
Cas h 8400 11800 3400

258400 260200 11400 9600

B CURRENT LIABILITIES/PROVISIONS

Unsecured Loans 40000 68000 28000

Creditors 140000 122000 18000

180000 190000 29400 37600

Working Capital (A - B) 78400 70200

Change in WC 70200-78400 -8200 29400-37600 -8200 *

Funds Flow Statement for the Period 1/4/2018 to 31/3/2019

Particulars Amount Amount

SOURCES (INFLOW) OF FUNDS

CAPITAL 23000
P&L 28600
COMPUTERS 5200
56800

LESS: APPLICATIONS (OUTFLOW) OF FUNDS

SECURED LOANS 30000
BUILDING 35000 65000

NET CHANGE IN WORKING CAPITAL -8200 *

There is a Decrease in Net Working Capital -8200

4
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3/($6(,1',&$7(:+(7+(57+(5(,6$&+$1*(,1)81'6)/2:"

* Purchasedfurniture for cash

* Purchased furniture on credit

* Purchased machinery by issue of shares

* Bad debts written off

* Purchased short term investments for cash

Solution

ͶͲ
* Purchasedfurniture for cash Yes: cash changes (current asset changes)

* Purchased furniture on credit Yes: creditors change (current liability changes)

* Purchased machinery by issue of shares No: no change in current asset/liability

* Bad debts written off Yes: debtors change

* Purchased short term investments for cash No: no change in current assets

4
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&$6+)/2:6*(1(5$7(9$/8(3/($6((;3/$,1

Professionals are all too familiar with a situation where a company reports decent profits, but is insolvent. Cash flows
are important: they can be ploughed back for sustained growth. It is essential to bear in mind these guidelines when
appraising a new project:

• Use incremental cash flows only

• Ignore sunk costs
• All cash flows are to be considered post tax
• Exclude cost of long term funds (to avoid double-counting)
• Exclude common allocated overheads
• Remember to include opportunity cost.
Cash flows matter because

Cash Flows show the real picture

They are not so easy to manipulate

Profit may be an illusion, merely on the books

Cash Flows reflect the ability of the company to continue its active existence

The three types of cash flows are

Operating Cash Flows

Investing Cash Flows &

Financing Cash Flows

Operating Cash Flows are of paramount importance. They indicate whether the company can generate sufficient
positive cash flows from its operations. Consider two companies A & B, with identical net positive cash flows of 100
million each.

Company A Company B
( million)

Operating Cash Flow 200 -50

Investing Cash Flow -100 50
Financing Cash Flow 0 100

Net Cash Flow Generated 100 100

It is apparent that Company A has better performance, generating sufficient cash flows from operations to invest for
growth. Company B on the other hand, has to resort to asset sale & additional financing.

Ͷͳ
4
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6+257127(21',5(&7 ,1',5(&70(7+2'62)23(5$7,1*&$6+)/2:6

There are two methods of calculating operating cash flow, Direct & Indirect. The end result of both is the same, only
the steps differ.

Direct method considers actual cash paid & received during the period, which are relevant to operations.

Indirect method starts with net income, & proceeds as follows:

Net Income

Add Increase in accounts payable

Increase in taxes & expenses payable

Decrease in accounts receivable

Decrease in inventory

Depreciation

Loss on sale of assets

Subtract Increase in accounts receivable

Increase in inventory

Decrease in accounts payable

Decrease in taxes & expenses payable

Gain on sale of assets

Cash Flow From Operating Activities

4
 Net income of ABC Ltd for the year ended 31/3/2019 2,750,000
Additional Information
Depreciation provided for 1,150,000
Increase in Debtors 1,500,000
Increase in Inventory 800,000
Decrease in Creditors 1,240,000
Please find the Net Cash From Operations

Solution

Net Income 2750000

Add:
Depreciation 1150000 1150000

Balance 3900000
Less:
Increas e in Debtors 1500000
Increas e in Inventory 800000
Decrease in Creditors 1240000 3540000
Net Cash From Operations 360000

Ͷʹ
4


Celtec Ltd. has presented the following details in lakh

Particulars 2019 2018
Short Term Borrowing 201 145
Long Term Debt 310 180
Repayment of Long Term Debt 105
Dividends Paid 160
What is the Net Cash used or generated by Financing Activities?

Solution

in lakh
Particulars 2019 2018 Net Change
Short Term Borrowing 201 145 56
Total Long Term Debt Is sued 310 180 130
Repayment of Long Term Debt 105 105
Dividends Paid 160 160

Cash Flow from Financing Activities in lakh

Increas e in Short Term Borrowings 56
Increas e in Total Long Term Debt Is sued 130
Repayment of Long Term Debt -105
Dividends Paid -160
Net Cash Used in Financial Activities -79


4
 
CE Consultants' Fixed Assets A/c has increased during the year by 2,500,000
It has sold some fixed assets for a profit of 100,000
Cost of the fixed assets sold is 900,000
What are the implications?

Solution

Ͷ͵
Working Note: 1
Original Cos t of FA s old 900000
Profit on sale s hown in Profit for the year 100000

Total Sale Proceeds of FA 1000000

Working Note: 2
Fixed Assets at beginning of the year at cos t 900000
Less :
Sold during the year -900000
Balance 0

FA have increased during the year, by 2500000

Hence, clos ing balance of FA is 3400000

Since the original asset is sold, the entire closing balance comprises the new asset


a) The Profit on Sale will be removed from Operating Cas h Flow -100000
b) Total Sales Proceeds will be s hown as Pos itive Investing Cas h Flow 1000000
c) Purchase of new FA will be shown as a Negative Investing Cash Flow -3400000

4
 From the following data, please prepare a Cash Flow Statement for MN Ltd for 2019

Net Income 444000

Depreciation 20600
Sale Proceeds of Land 250000 Sold at a loss of 15000
Increas e in Debtors 100000
Decrease in Creditors 25000
Increas e in Inventory 15000
Office Purchas ed 500000
Iss ue of Debentures 250000
Fres h iss ue of Equity 150000
Dividends Paid 20000
Opening Cash 2500

Solution

ͶͶ
Cash Flows from Operations
Net Income 444000
+ Depreciation 20600
+ Los s on s ale of land 15000
- Increase in Debtors -100000
- Decrease in Creditors -25000
- Increase in Inventory -15000
Cash Provided by Operations 339600

Cash Flows from Investing Activities

+ Sale of Land 250000

- Office Purchased -500000
Cash Used in Investing Activities -250000
89600
Cash Flows from Financing Activities

+ Issue of Debentures 250000

+ Fresh issue of Equity 150000
- Dividends Paid -20000
Cash Provided by Financing Activities 380000

Increase in Cash 469600

Opening Cash 2500
Ending Cash Balance 472100

Ͷͷ
8. Working Capital Management
4
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Gross working capital = current assets. Net working capital = current assets - current liabilities. When we say working
capital, we refer to net working capital. Working capital is required to finance the routine daily operations.

Factors affecting working capital requirements

* Nature of business

* Seasonality of operations

* Production policy

* Market conditions

* Terms of supply

* Competition

* Taxes

* Dividend policy

4
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:+$7$5(
$5(7+(23(5$7,1*&<&/( 7+(&$6+&<&/("
7+(23(5$7,1*&<&/( 7+(&$6+&<&/("

* Cash Conversion Cycle = Operating Cycle - Accounts Payable Deferral Period

* Operating Cycle = Inventory conversion period + Average collection period

* Inventory conversion period = (Average inventory/COGS)*365

* Average collection period = (Average receivables/Credit sales)*365

* Accounts payable deferral period = (Average accounts payable/COGS)*365

Ͷ͸
4


Ace Co. FY 2021 projections lakh

Sales credit given two months 200
Gros s profit on sales is 20%
Material cos t s uppliers give two months credit 90
Wages paid in arrears at end of the month 40
Manufacturing expenses (cas h) outstanding for one month 2
Selling, general & administrative expenses (paid in cash) 20
Required
Raw material stock two months
Finis hed goods inventory one month
Cash balance ( lakh) 3
Safety margin 20%
What is the working capital requirement on a cash cost bas is ?


Solution

lakh
W.N.1
Sales 200
Less : Gross profit 20% 40
Manufacturing cost 160
Materials 90
W ages 40
Hence, manufacturing expenses (bal. fig. 160 - 130) 30

W.N.2
Cash manufacturing expenses (2 * 12) 24
Hence, depreciation (bal. fig. 30 - 24) 6

W.N.3
Total manufacturing cost (W.N.1) 160
Less : Depreciation (W.N.2) 6
Cash manufacturing cost 154
Add: SGA 20
Total cas h cost 174

Ͷ͹
Working Capital Required lakh
Current As sets
Debtors 2 months Total cash cost/6 = 174 / 6 29.00
Raw material 2 months Material cost/6 = 90 / 6 15.00
Finis hed goods 1 month Cash manufacturing cost / 12 = 154/12 12.83
Cash 3.00
Current Assets - A 59.83

Current Liabilities
Creditors 2 months Material cost/6 = 90 / 6 15.00
Manufacturing expenses (cas h) outstanding for 1 month 2.00
Wages outstanding 1 month 40 /12 3.33
Current Liabilities - B 20.33

Working Capital (A - B) 39.50

Add: Safety margin 20% 7.90
Working Capital Required (Cas h Cost Basis) 47.40

Notes:

1. Please do not include profit in debtors for WC requirement on a cash cost basis. If I need to invest 100 to earn
profit of 20 (sell at 120); I require cash investment of 100, not 120. There is a cost associated with borrowing & an
opportunity cost associated with own funds.

2. Please do not include profit, & SGA in finished goods.

3. Please adjust for depreciation; it is a non-cash expense.

4
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1. Credit standards

At the strictest level, the firm may sell only for cash: at the other extreme, it may extend credit to every customer.
Credit standards may be relaxed if the net result is an increase in RI2 or residual income.

RI = { S * (1 – V) - S * bn} * (1 – t) – k * I

RI change in residual income

S change in sales

V ratio of variable costs to sales

bn bad debt loss ratio due to the incremental sales

t tax rate

k post-tax cost of capital

I increased investment in debtors

I = ACP * V * ( S / 360).

ACP is the average collection period. One can use 365 in the denominator

2
RI is the net income after considering the total cost (including opportunity cost) of generating that income.

Ͷͺ
2. Credit period

RI = { S * (1 – V) - S * bn} * (1 – t) – k * I

Only I has a different connotation here

I = (ACPn – ACPo) * (S0 / 360) + V * (ACPn) * ( S / 360)

The first term on the RHS describes the incremental investment on existing sales as a result of extending the credit
period; the second term indicates the extra investment in receivables, resulting from the change in sales due to the
relaxed credit period.

3. Cash discount

RI = { S * (1 – V) - DIS} * (1 – t) + k * I

DIS is the increase in discount cost. DIS = pn * (S0 + S) * dn – (p0 * So * d0)

pn & p0 are the new & old proportions respectively, of discount sales: dn & d0 are the new & old discount percentages
respectively.

I = (ACP0 – ACPn) * (S0 / 360) - V * (ACPn) * ( S / 360)

4. Collection effort

RI = { S * (1 – V) - BD} * (1 – t) – k * I

BD is the increase in cost of bad debts. BD = bn * (S0 + S) – (b0 * S0)

I = (ACPn – ACP0) * (S0 / 360) + V * (ACPn) * ( S / 360)

4
 &5(',7(9$/8$7,21
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A robust system of credit evaluation is essential to minimize these two types of error:

Type I error Misclassification of a good customer as high credit risk

Type II error Misclassification of a bad customer as low credit risk

Type I error results in loss of sales to good customers: Type II error increases bad-debt losses due to increased risky
sales. These errors cannot be eliminated: the goal is to reduce them, using these methods.

1. Traditional Credit Analysis: “Five Cs of credit”: Character, Capacity, Capital, Collateral, & Conditions.

2. Sequential Credit Analysis: Only if character is strong will the process move to the next stage of capacity; &
so on.

3. Numerical Credit Scoring: Weights are assigned to relevant credit factors to arrive at an overall customer
rating index; & the customer is then classified as required.

4
 3/($6((;3/$,1,19(1725<0$1$*(0(17
3/($6((;3/$,1,19(1725<0$1$*(0(17

Inventory can be raw materials, work in process, in-transit, finished goods, & MRO (maintenance, repair & operation).
Inventories provide visibility & flexibility in purchasing, production scheduling, & meeting customer demands.

Cost-benefit analysis should be conducted to determine the appropriate levels of inventory.

Ͷͻ
Methods

ABC ANALYSIS

CATEGORY % OF TOTAL VALUE % OF TOTAL QTY LEVEL OF CONTROL

A 70 10 V HIGH

B 25 35 MODERATE

C 5 55 MINIMAL

VED Vital Essential Desirable

Example: The engine in a car is vital, the steering wheel is essential & air conditioning is desirable.

JIT or Just-in-Time

“On a visit to the US the management team of Toyota were inspired by, of all things, how they saw a supermarket
(Piggly Wiggly) handle their inventory. Only what was removed from the shelves by the customers was actually
replenished and ordered from suppliers. In this way shelves never became empty, nor did they end up overflowing with
excessive inventory.” https://leanmanufacturingtools.org/just-in-time-jit-production/

Benefits

* Reduction in the order to payment timeline

* Reduced inventory costs

* Less space required

* Lower handling & other costs

* Shorter lead times

* Reducing complexity in the planning process

* Sharp improvement in quality

* Enhanced productivity

* Prompt focus on problems & their quick resolution

* Employee empowerment

Optimal Order Quantity depends on the forecast of usage; the ordering cost; & the carrying cost. (Please note that
ordering includes purchase as well as production of the item.)

Economic Order Quantity (EOQ) is the order quantity that minimizes the total of (holding costs + ordering
costs) EOQ assumes that demand is constant, that each new order is delivered in full when inventory reaches zero, there
is a fixed cost for each order placed, & there is no quantity discount available.

Important:

* At EOQ the Total ordering costs = Total carrying costs.

* Neither ordering cost, nor carrying cost is at its lowest level at the EOQ: however, Total Cost is at the
minimum.

ͷͲ
Annual us age 2000 units
Order cost per order 50
Item cost 8
Carrying cost 25%
^(1/2)
EOQ = {(2 * 2000 * 50) / (8 * .25)}
316.22777
EOQ = 316 units 

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Baumol’s Model for Optimal Cash Balance

The Baumol–Tobin model was developed independently by William Baumol (1952) and James Tobin (1956). There is
a trade-off between the liquidity provided by holding money & the interest forgone by holding cash.

It calculates the optimal cash balance to be held, which minimizes total costs.

The main assumptions include: (recollect the EOQ theory)

• It is possible to forecast the demand for cash,

• There is a constant and predictable flow of cash,
• Interest rate is unchanged throughout the period when investing in securities,
• Uniform cash receipts,
• Instant cash transfers,

ͷͳ
C OPTIMAL CASH
F FIXED COST FOR TRANSACTION (INVESTING OR REDEEMING) 120
T ANNUAL CASH USAGE 1560000
k INTEREST RATE p.a. 12%

^(1/2)
C= {(2 *1560000 * 120) / .12})
C 55857 55857
Average Cash 27928.5 27928.5
Number of Trans actions 27.9284801 28
Annual Trans action Cos t 3360
Annual Opportunity Cost 3351.42
TOTAL COST (Minimum Cos t Level) 6711.42
Trans action Cos t = Opportunity Cos t at EOQ.

(The small difference between annual transaction cost & annual opportunity cost is because of rounding.)

4
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25502'(/"

This model takes into consideration the uncertainty of cash flows. There is an upper cash limit (H) & a lower cash limit
(L), as well as an optimal cash level or Return Point (Z or R). When the cash level reaches H, marketable securities are
purchased to bring cash levels back to R. When cash balance reaches L, securities are sold to bring cash back to Z or R.

ͷʹ
The lower limit, L is set by management depending upon how much risk of a cash shortfall the firm is willing to accept,
and this in turn, depends both on the access to borrowings and on the consequences of a cash shortfall.

The formulae for the Miller-Orr model are:

Note: Variance & interest rates should be expressed in daily terms. Variance = Standard Deviation2

1
ª 3Fσ º 2 3 Spread between H & L

S = 3« »
¬ 4N ¼
S
R= +L Return Point or Z, optimal level of cash

3
H =S+L High Point of Cash
(when investments will be made, to reach Return Point, Z)

4R − L
ACB = Average Cash Balance

3


ͷ͵
 

Spread 30263.31 $
^(1/3)
3*((3 * 50 * 9000000) / (4 * .000329))

Upper Limit 50263.31 $

30263.31 + 20000

Return Point 30087.77 $

(30263.31 / 3) + 20000

Average Cash 33450.36 $

Balance ( 4 * 30087.77 - 20000) / 3


ͷͶ
9. Cost of Capital, Capital Structure Theories, Dividend Decisions and
Leverage Analysis

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Cost of Capital is the weighted average of the cost of the various sources of finance used by the company.

Sources of Finance: DEBENTURES: TERM LOANS: PREFERENCE CAPITAL: EQUITY CAPITAL:

RETAINED EARNINGS

4
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:+$7,67+(&2672)'(%7"

COST OF DEBENTURES

Interest on borrowing is tax-deductible; hence it provides a tax shield to the issuer. The net cost of borrowing, post-tax
is thus lower than the coupon rate: the difference being the tax shield.

Kd = I(1-T) + (F-P)/N
(F+P)/2

• Kd = Post Tax Cost of Debenture Capital

• I = Coupon/Interest per period, per Debenture (could be yearly, half-yearly,

quarterly)

• T = Applicable Tax Rate

• F = Redemption Price per Debenture

• P = Net Amount Realized per Debenture

• N = Number of coupons till maturity

E.g. FV =100/: Interest =14% (payable annually): Amount realized =97/ Tax Rate = 50%: Term 10 yrs.:
Redemption at premium of 5/

I = 14/ T = 50% F = 105/ P = 97/ N = 10

Kd = 7.7%

If difference between the redemption price & net amount realized can be amortized over the life of the debentures and
this amount is tax deductible, the formula will be modified as follows

Kd = I(1-T) + (F-P)(1-T)/N
(F+P)/2

A more accurate measurement of cost of debt is to find the IRR; by trial & error method + interpolation.

COST OF TERM LOANS

• Kt = I(1-T)

• Kt = Cost of term loan

• I = Interest

• T = Tax rate applicable

ͷͷ
4
 :+$7$5(7+(&+$5$&7(5,67,&62)%21'6"
:+$7$5(7+(&+$5$&7(5,67,&62)%21'6"

* Interest Bearing Debt Securities

* Price changes inversely with market interest rates (as interest rates increase, price of existing bonds fall; & market
price of existing bonds rise when market interest rates fall)

* Interest is generally paid semi-annually

* Face Value or Par Value is paid out on maturity

4
 :+$7$5(7+(81'(5/<,1*$668037,216:+(1&$/&8/$7,1*<70"
:+$7$5(7+(81'(5/<,1*$668037,216:+(1&$/&8/$7,1*<70"

* No Default

* Bond Held to Maturity

* Coupons Reinvested at the YTM

4
 :+$7$5(7+(7<3(62)5,6.35(6(17,1%21'6"
:+$7$5(7+(7<3(62)5,6.35(6(17,1%21'6"

* Default Risk or Credit Risk

* Interest Rate Risk

* Market Risk

4
 +2:$5(=(52&28321%21'69$/8('"
+2:$5(=(52&28321%21'69$/8('"

Zero coupon bonds are special bonds with no periodic interest payment. They are sold at a discounted price. The
interest rate is implied by the difference between face value (FV) & issue price, given the life of the bond. (Called Deep
Discount Bonds in India)

Please consider residual life. A 10 year bond issued 5 years ago has a residual life of 5 years.

4
 3/($6((;3/$,1:,7+,//8675$7,2169$/8$7,212)&283213$<,1*%21'6
3/($6((;3/$,1:,7+,//8675$7,2169$/8$7,212)&283213$<,1*%21'6

ͷ͸
Present value of a coupon-paying bond = PV of interest payments + PV of principal

N = residual life (time to maturity)

i = market interest rate

PMT = coupon amount

FV = face value (assuming the bond is redeemed at FV)

Figure 1: Bond Price = Face Value when Coupon Rate = Market Yield

Figure 2: Bond Price < Face Value when Coupon Rate < Market Yield

ͷ͹
Figure 3: Bond Price > Face Value when Coupon Rate > Market Yield

4
 3/($6((;3/$,1&2672)35()(5(1&( &2672)(48,7<
3/($6((;3/$,1&2672)35()(5(1&( &2672)(48,7<

Note on Cost of Preference & Equity:

In case of dividend distribution tax, the net dividend outflow for the company will be

Dp * (1 + Tddt) for preference, &

De * (1 + Tddt) for equity

Where Tddt is Dividend Distribution Tax (in percentage)

COST OF PREFERENCE CAPITAL

Kp = Dp + (F-P)/N
(F+P)/2

Kp = Cost of Preference Capital

• Dp = Preference Dividend

• F = Redemption Price

• P = Net amount Realized per share

• N = Maturity Period

Notes:

1. Dividend of any kind is not tax deductible, hence does not come with a tax shield

2. If the preference shares are irredeemable, then Kp = Dp/P0 (where P0 is the current market price per share)

COST OF EQUITY CAPITAL

ͷͺ
* DIVIDEND FORECAST APPROACH

• Ke = (D1/P0) + G

• Ke = Cost of Equity Capital

• D1 = Dividend expected at end of year (or at start of next year)

• Po = Current Market Price

• G = Expected Growth Rate in Dividend

* CAPITAL ASSET PRICING MODEL APPROACH

• Ki = Rf + Bi * (Rm-Rf)

• Ki = Required Rate of Return on Security

• Rf = Risk Free Rate of Return

• Bi = Beta of Security

• Rm = Expected Return on Market Portfolio

* BOND YIELD PLUS RISK PREMIUM APPROACH

(subjective method) Yield on Long Term Bonds + Risk Premium

* EARNINGS PRICE RATIO APPROACH (INVERSE OF P/E RATIO)

E1/P0

• E1 = Expected Earnings in the next year (E0 * (1+g))

• P0 = Current Market Price per share

* COST OF EXTERNAL EQUITY

Kx = D1 +G
P0(1-F)

• Kx = Cost of External Equity

• D1 = Dividend Expected at end of year

• G = Expected Growth Rate in Dividend

• P0 = Current Market Price per share

• F = Floatation costs (as a % age of current market price)

Or K x = Ke/ (1-F)

ͷͻ
e.g. Ke (cost of retained earnings) = 18%

F = 5%

Kx = 18/0.95 = 18.95%

4
4 :+$7,67+(*25'21*52:7+02'(/"
:+$7,67+(*25'21*52:7+02'(/"

Gordon Model

P0 = ______D1______

(ke – g)

Myron Gordon stated that P0, the market price today, depended on

* Dividend payout (D1) one year later.3

* ke, the cost of equity &

* g, the constant growth rate of earnings

One can observe that this formula holds good only so long as ke > g, else, it becomes meaningless.

There are multiple stage growth models which can help to overcome this issue.

Limitations

As with all concepts, the assumptions viz. steady growth rate, constant IRR, no external financing, no taxes, & constant

retention ratio is the weaknesses. Before going ahead, let us introduce the idea of growth generated by internal

resources (retention of profits).

Retention Can Fuel Growth

Time 0 Company X Company Y

Capital (equity) 100 100

Earnings 20 20

Face Value 10 10

No. of shares 10 10

EPS 2 2

Dividend Payout 0 100%

Retention (b) 100% 0%

ROE ( r) 20% 20%

Growth (b*r) 20.0% 0.0%

3
D1 = D0 *(1+g)

͸Ͳ
Proof

Time 1 Company X Company Y

Retained Earnings 20 0

Capital (equity) 120 100

Earnings 24 20

EPS 2.4 2

Growth in EPS% 20 0

i.e. b*r

Example of Gordon Model

FV of Equity share 10

D0 2

ke 25%

g 5%

D1 2.1

P0 = D1/(ke-g)

P0 = 10.5

The Gordon Model is also used to figure out the implied required return, by rearranging the formula:

P0 = D1/(ke-g)

Hence, (D1/Po) + g = ke

4
4 :+$7,67+(:$/7(502'(/"
:+$7,67+(:$/7(502'(/"

Prof. James E. Walter believed that in the long run, share prices reflect the sum total of expected dividend streams.
Retained earnings thus, were important to the extent that they affected future dividend payouts.

It is apparent from this formula that

* Share price is inversely proportional to the cost of equity. If cost of equity increases, the price per share should

decrease

͸ͳ
* Higher the return earned by the firm on its investments, higher will be the market price. This is simple logic.

* Higher the Retained Earnings (E-D), higher will be the price. Higher retained earnings imply higher growth;

with higher dividend payouts in the future, ergo, higher price today.

A company which destroys value, viz. r < Ke, should not retain any earnings, making 100% payout

Conversely, a company which is value creating, where r > Ke, should not make any dividend payments.

Limitations

The assumptions of no external financing, no taxes, no transaction costs & constant r & ke, are its main weaknesses.

Example of Walter Model

Company A

EPS 15
Ke 10%
r 14%

Since r > Ke, the company should retain 100%

earnings

E 15
D 0
E-D (15-0) 15
Ke 10%
r 14%

P = (0/.1)+(.14/.1)*(15)/.1
P = 210
This is the value maximizing decision

Proof

Suppose a dividend of 3 per share is paid

E 15
D 3
E-D (15-3) 12
Ke 10%
r 14%

P = (3/.1)+(.14/.1)*(12)/.1
P = 198
Dividend payout reduces value


͸ʹ
4
 :+$7,67+(&$30"
:+$7,67+(&$30"

The CAPM model (1964) earned Professor Sharpe the Nobel Prize in Economic Sciences in 1990. CAPM can be

applied to an individual security or to a portfolio or to projects.

The Capital Asset Pricing Model of Sharpe & Lintner is theoretically a one-period, mean-variance theory of

equilibrium of expected return.

Assumptions of CAPM

* There are many investors; they are all price takers (they behave competitively)

* Markets are efficient & have infinite depth & breadth

* All investors have a uniform time horizon viz. one period & they all have the same information

* All assets are infinitely divisible (any fraction)

* Investors have seamless access to short-selling, unlimited securities are available for borrowing/lending,

unlimited funds are available for borrowing/lending

* Zero taxes, zero transaction costs, zero market imperfection costs

* All investors can borrow & lend funds at the risk-free rate

* Investors’ decisions are based on only two variables….expected return & risk: & they all have the same

expectations regarding distribution of returns

* Market portfolio consists of all publicly traded assets

* All investors are rational: they can & will undertake optimal diversification of their investment

portfolios on their own

The key in CAPM is the segregation of risk-components.

Sigma or standard deviation is a measure of total risk. This comprises systematic risk (or market risk, or beta, or non-

diversifiable risk) & unsystematic risk (or unique risk, or company-specific risk, or diversifiable risk)

The CAPM states that investors will be rewarded by the market only for the Beta or systematic risk because they can

& will diversify their portfolios until unsystematic risk is zero (near-zero)

͸͵
The ex-ante expected returns in equilibrium (which is the same as the required return) on capital assets will be

4
T T ='
T ä
äT ?×
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K H O H K

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'ZCPVGGZRGEVGFTGVWTPKPGSWKNKDTKWO4GSWKTGFTGVWTP
QHVJGUGEWTKV[QTRQTVHQNKQ
CPVGGZRGEVGFTGVWTPKPGSWKNKDTKWO4GSWKTGFTGVWTP
QHVJGUGEWTKV[QTRQTVHQNKQ
K

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H  4KUM
4KUMHTGGTCVGQHTGVWTP 

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T   'ZRGEVGF4GVWTPQPVJG/CTMGV2QTVHQNKQ
'ZRGEVGF4GVWTPQPVJG/CTMGV2QTVHQNKQ
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+  $GVCQTU[UVGOCVKETKUMQHVJGUGEWTKV[QTRQTVHQNKQ
$GVCQTU[UVGOCVKETKUMQHVJGUGEWTKV[QTRQTVHQNKQ

='
T ä
äT ? KUVJG4KUM
KUVJG4KUM2TGOKWOKGVJGGZVTCTGVWTPQXGTVJGTKUM
2TGOKWOKGVJGGZVTCTGVWTPQXGTVJGTKUMHTGGTCVGVJCVVJGOCTMGVKUGZRGEVGFVQ
O H

FGNKXGTVQEQORGPUCVGHQTVJGOCTMGVTKUM
TKUM
FGNKXGTVQEQORGPUCVGHQTVJGOCTMGVTKUM
TKUMHTGGKPXGUVOGPVD[FGHKPKVKQPECTTKGUPQTKUMJGPEGVJGTGKUPQ
HTGGKPXGUVOGPVD[FGHKPKVKQPECTTKGUPQTKUMJGPEGVJGTGKUPQ

TKUM
TKUMRTGOKWOCUUQEKCVGFYKVJKV
RTGOKWOCUUQEKCVGFYKVJKV

In other words, CAPM shows that there is a positive, linear relationship between the Beta & the Required

Return of an asset or a portfolio of assets. 4

Investors require a Risk Premium, or a reward for carrying risk (Not all risk, but only Beta)

Beta is the sensitivity of the stock returns, to returns on the market portfolio. Consider these statements:

Zero Risk = Risk-Free Return (Beta = 0)

Market Risk = Market Return (Beta = 1)

It follows logically, that if the systematic risk is higher than the market (Beta >1), required return will be higher,

because no one would like to take a higher risk for a given return, when there exists another investment option, offering

the same return, with lower risk.

e.g. R(f) = 8% Beta = 1.5

E(m) = 10% R(i) = ?

Using the CAPM, the Required Return is

4
While Sharpe, Lintner et al used “expected return”, as we have explained above, this is actually ex-ante, based on equilibrium & is
the “required return”, which is the term we shall use for the rest of this article. Expected Return is usually the sum of the products of
a probability distribution (of various states of nature) & the returns (given those states.)

͸Ͷ
Rf + B (Rm-Rf) = 8 + 1.5(10-8) = 11%

We can understand even intuitively, that when risk is lower, required return is lower & the CAPM substantiates this.

The asset under consideration is required to deliver a return based on its Beta (or systematic risk) vis-à-vis the market

portfolio. Greater the beta, higher would be the required return & vice-versa.

Caution: Nowhere in any rational literature will you see this equation

HIGHER RISK = HIGHER RETURN

Higher Risk does not guarantee higher return5. But any (rational) investor who accepts a higher risk, will do so only if

the returns compensate her/him for the additional risk.

4
 :+$7,67+(6(&85,7<0$5.(7/,1("
:+$7,67+(6(&85,7<0$5.(7/,1("

The SML (Security Market Line) is the graphical representation of the CAPM. It shows the relationship between

beta & required return.

Illustration: Security Market Line

The slope of the SML is the Reward to Risk Ratio: {(Rm-Rf)/ß}

In the illustration above, Rf = 6%. The Market Portfolio (ß =1) is expected to deliver 10%.
Here, Risk-premium is (10-6) = 4%
Hence, an asset or portfolio with ß =1.25 will have a required return of

Rf 6

+ ß * Risk-premium 1.25 *4 = 5

5
If such was the case, everyone would have bet their life-savings on a lame horse with no chance in a race: & come away with
windfall profits!

͸ͷ
= Rr 11

Illustration : What if Actual Price is Different from the Required Price? (SML)

Consider a security which plots above the SML. In effect, this offers a higher return for the given level of risk: if the

returns are higher (think yield also), the price must be lower, hence they are undervalued. Given the assumptions of

efficient markets & rational investors, there will be a greater demand for this security, leading to an increase in price;

& a reduction in its expected return, thus placing it finally on the SML, the market being in equilibrium.

If a security plots below the SML, it obviously delivers lower return for the same risk; ergo, its price is higher than

warranted. Rational investors will sell this investment, bringing the price down & increasing the expected returns: until

it plots on the SML. This is the simple market mechanism to ensure equilibrium.

  :5,7($6+257127(21',9(56,),&$7,212)5,6.
4

It is imperative we study risk because it can prove to be the undoing of even the best minds in Security Analysis.

The CAPM assumes that rational investors diversify the portion of risk which can be diversified & are hence rewarded

only for Beta or Market Risk. 5LVNLVWKHSUREDELOLW\RIQRWDFKLHYLQJWKHGHVLUHGUHVXOW

Total Risk = Systematic Risk + Unsystematic Risk (Total Risk = Standard Deviation)

͸͸
Illustration: Total Risk, Systematic (Non-Diversifiable) Risk, Unsystematic (Diversifiable) Risk & Diversification

From the figure four points are apparent

a) Total Risk is highest when there is no diversification

b) Beta (systematic, market, non-diversifiable) risk does not change with number of securities in the portfolio

c) Unique (market, diversifiable, unsystematic) risk can be removed with diversification6

d) Benefits of diversification become negligible beyond a point7

4
 :+$7,67+(&+$5$&7(5,67,&/,1("
:+$7,67+(&+$5$&7(5,67,&/,1("

Illustration: The Characteristic Line

The Characteristic Line relates the return on the stock (Y- axis) to the return on the market (X- axis). Note that the stock

in the illustration above has a beta <1, hence it’s required return is 8% (less than the expected market return of 10%).

6
Thus making beta = total risk for all practical purposes
7
20 to 30 stocks with low or negative correlation suffice the goal of diversification

͸͹
The slope of the characteristic line is BETA (dy/dx)

Recall that Beta of the security is defined as the covariance of the returns on the security with the returns on the market

portfolio, divided by the variance of the market portfolio.

Caution: A fairly common error: Beta of the Market is 18 but the market is not risk-free. We still have to

contend with variance or standard deviation of the market (as measures of total risk)

Understanding Beta

A high Beta by itself does not guarantee causation. For that, we must take help from:

R2 or Coefficient of Determination: is the variability in one variable which is explained by the movement of another.

R2 is a more accurate measure of CAUSATION.

R2 = r2 (square of the correlation coefficient)

If r = .9, R2 = .9*.9 =.81

Since coefficient of determination is quite high, we can rely on Beta. In this instance, 81% of the returns on the security

are explained by the index while 19% of the returns on the stock are due to reasons other than the index.

4
 (;3/$,13257)2/,2
(;3/$,13257)2/,25(78513257)2/,2%(7$ 3257)2/,267$1'$5''(9,$7,21

Portfolio Return: is the sum of the weighted averages of the returns of the individual components in the portfolio

Portfolio Beta: is the sum of the weighted averages of the betas of the individual components.

Portfolio Risk however, is not just a weighted average of the standard deviations of the individual components.

This is a two security portfolio

8
Sensitivity of returns of the market to sensitivity of returns of the market has to be 1

͸ͺ
Positive Correlation means the returns on the assets move in the same direction. Negative Correlation means the returns

on the assets move in opposite directions.

Correlation can be between -1 & +1, the signs signifying positive or negative & the value indicating the strength of

correlation between the returns on the two assets.

Standard Deviation

¦ (R − R )
T T

¦ (Rt − μ )
2 2
t
σ2 = t =1
s2 = t =1
T T −1
σ= σ 2
s= s 2

population sample

(T-1) in the denominator is to remove the sampling error.

Standard Deviation is a Measure of total risk

Correlation Coefficient

OR

͸ͻ
Where Covariance is measured as:

OR

4 3/($6('(6&5,%(:$&&
3/($6('(6&5,%(:$&&
'(6&5,%(:$&& (;3/$,1,76,03257$1&(
(;3/$,1,76,03257$1&(
(;3/$,1,76,03257$1&(

Important: Weights should be based on market value

• Ko = Wd*Kd + Wp*Kp + We*Ke + Wx*Kx

• Ko = WACC (WEIGHTED AVERAGE COST OF CAPITAL)

Wd, Wp, We, Wx are the weights of debt, preference capital, existing equity + retained earnings, & external
equity respectively, in the total capital

e.g.

SOURCE COST MV WT COST

Proportion
1 2 3 4=2*3
DEB Kd 7.50% 0.35 0.02625
PREF Kp 14% 0.25 0.035
RET EQ Ke 16% 0.3 0.048
EXT EQ Kx (F =5%) 16.84% 0.1 0.01684
Total 1.00 0.1261
WEIGHTED AVERAGE COST OF CAPITAL 12.61%

4


Price of a stock 50
Exercise price of rights share 30
Rights issue ratio 1 for 4
(one rights share entitlement for every four shares held)
What is the theoretical value of the right?

Solution

͹Ͳ
Theoretical value of the right is (S - R) / (N + 1)
S Stock price
R Rights price
N Number of shares required to be entitled to 1 rights share
(S - R) / (N + 1) (50-30) / (4+1)
Theoretical value of the right is 4

4
 

Company A
Equity crore 500
Crore shares FV 10/ 50
Reserves crore 1000
PAT crore 500
EPS per share 10
Book Value per share 30


Please show the changes if:

a) It issues Bonus shares in the ratio of 1 for 1
b) It makes a preferential allotment of shares
Ratio 1 for 2
Premium per share 20
c) It declares & pays out a dividend per share of 8
DDT 15%
d) It splits its shares (stock split) 5 for 1


Solution

Current Status
Equity crore 500
Crore s hares FV 10/ 50
Reserves crore 1000
PAT crore 500
EPS per share 10
Book Value per share 30

a) It issues Bonus shares in the ratio of 1 for 1

New s hares, 50 crore of 10/ total transfer from res erves 500 crore
Equity crore 1000
Crore shares FV 10/ 100
Reserves crore 500
PAT crore 500
EPS per share 5
Book Value per share 15


͹ͳ
b) It makes a preferential allotment of shares
Ratio 1 for 2
Premium per share 20
25 crore new shares 250 crore capital
500 crore reserves
Equity crore 750
Crore shares FV 10/ 75
Reserves crore 1500
PAT crore 500
EPS per share 6.67
Book Value per share 30
BV is unchanged because the rights offer is at 30; the same as pre-issue BV


c) It declares & pays out a dividend per s hare of 8

DDT 15%
Total payout per share 9.2 Total (crore) 460.00
including DDT
Equity crore 500
Crore shares FV 10/ 50
Reserves crore 540.00
PAT crore 500
EPS per share 10
Book Value per share 20.8


d) It s plits its s hares (stock split) 5 for 1

5 shares of 2 each, for each share of 10
Equity crore 500
Crore shares FV 2/ 250
Reserves crore 1000
PAT crore 500
EPS per share 2
Book Value per share 6
EPS & BV can be verified with initial status: multiply by 5


4
 :+$7$5(7+(7+(25,(62)&$3,7$/6758&785("
:+$7$5(7+(7+(25,(62)&$3,7$/6758&785("

The important theories of capital structure are:

1. Net Income Approach

2. Net Operating Income Approach

3. The Traditional view

4. Modigliani and Miller hypothesis

4
 3/($6((;3/$,11(7,1&20($3352$&+
3/($6((;3/$,11(7,1&20($3352$&+

According to the Net Income Approach, the cost of debt & the cost of equity of a firm remain unchanged even as
the proportion of debt & equity change. The average cost of capital rA is the weighted average cost of debt & equity.

rA = rD * (D / (D + E)) + rE * (E / (D + E))

͹ʹ
It follows that as debt is increased, overall cost of capital will come down (rD < rE), & the value of the firm will
increase.

Net Income Approach lakh

Firm 1 Firm 2
Operating income 100 100
Interest 0 20
Equity earnings 100 80
Cost of equity 10% 10%
Cost of debt 8% 8%
Market value of equity 1000 800
(100/.1) (80/.1)
Market value of debt 0 250
(0/.08) (20/.08)
Firm value 1000 1050
Average cost of capital 8%*(0/1000)+10%*(1000/1000) 8%*(250/1050)+10%*(800/1050)
Average cost of capital 10.0% 9.52%
Net Income Approach Average cost of capital decreases as debt increases, & value
of the firm increases with increased leverage

4
 3/($6((;3/$,11(723(5$7,1*,1&20($3352$&+
3/($6((;3/$,11(723(5$7,1*,1&20($3352$&+

Overall cost of capital & cost of debt are constant for all levels of debt (leverage). This implies that as more debt is
added, the cost of equity rises. Hence the cost of equity is:

rE =rA + (rA – rD) * (D/E)

Net Operating Income Approach lakh

Firm 1 Firm 2
Operating income 100 100
Overall capitalization rate 10% 10%
Firm value 1000 1000
(100/.1) (100/.1)
Interest 0 20
Equity earnings 100 80
Cost of debt 8% 8%
Market value of debt 0 250
(0/.08) (20/.08)
Market value of equity 1000 750
(1000-0) (1000-250)
Cost of equity 10.00% 10.67%
(equity capitalization rate = 100/1000 80/750
Equity earnings/Market value of equity)
Using the formula
Cost of equity rE =rA + (rA – rD) * (D/E)
.1 + (.1 - .08) * (0/1000) .1 + (.1 - .08) * (250/750)
Cost of equity 10.00% 10.67%
Net Operating Income Approach Average cost of capital & cost of debt are unchanged, value of
the firm remains the same, cost of equity increases with
increase in leverage.

͹͵
4
 :+$7,67+(75$',7,21$/9,(:2)&$3,7$/6758&785("
:+$7,67+(75$',7,21$/9,(:2)&$3,7$/6758&785("

* Cost of debt remains unchanged up to a certain level of leverage, & rises after that at an increased rate.

* Cost of equity capital is unchanged or marginally higher as leverage increases up to a certain point, & then
rises steeply beyond that.

* As a result, the overall cost of capital:

i) Decreases initially

ii) Remains unchanged for some increased leverage after that; &

iii) Rises beyond a certain level of leverage

4
 6+257127(
6+257127(217+(02',*/,$1,
217+(02',*/,$1,0,//(5+<327+(6,6
0,//(5+<327+(6,6

In 1958, Franco Modigliani9 & Merton H. Miller published a seminal paper, “THE COST OF CAPITAL,

CORPORATION FINANCE AND THE THEORY OF INVESTMENT” (The American Economic Review VOLUME

XLVIII JUNE 1958 NUMBER THREE).

Assumptions

* Perfect markets, rational investors, no taxes, no transaction costs, equivalent risk classes, investors could
replicate the firms’ leverage and borrow/lend at same rates as the firm.

Modigliani-Miller believed that,

Proposition I

“The Market Value of any firm is independent of its capital structure and is given by capitalizing its expected return

at the rate pk appropriate to its class.”

V = (S + D) = X/pk, where

V = market value of the firm

S = market value of its common shares

D = market value of the debts of the company

X = expected return on the assets owned by the company (i.e. expected profit before deduction of interest or,
Operating Income)

Hence, pk = X/V

This led to an enormously important revelation, “the average cost of capital to any firm is completely independent of

its capital structure and is equal to the capitalization rate of a pure equity stream of its class”.

If this were not so, an arbitrage10 opportunity would exist as follows:

Consider two companies, which are identical in every respect, except their capital structure:

Company X is 100% equity financed (zero financial leverage)

Company Y has $30,000 of 12% debt (market value of debt = book value)

Suppose Required return on Equity for both, X & Y is 15%

9
Franco Modigliani was an Italian-American economist and the recipient of the 1985 Nobel Memorial Prize in Economics
10
Arbitrage: simultaneous purchase & sale of the same asset, or assets with the same risk to reward profile, in different markets, at
the same time, to take advantage of a price difference.

͹Ͷ
Net Operating Income (NOI) for each firm is $10,000

Valuation of Company X $

Operating Income 10,000

Less: Interest - 0

Earnings for Equity 10,000

Required Return 15%

Hence, Market Value of Equity E/ke

= 10000/.15

= 66,667

Total Market Value (X) 66,667

Valuation of Company Y $

Operating Income 10,000

Less: Interest (12%*30,000) - 3,600

Earnings for Equity 6,400

Required Return 15%

Hence, Market Value of Equity E/ke

= 6400/.15

= 42,667

Market Value of Debt 30,000

Total Market Value (Y) 72,667

Assume an investor holds 1% of shares in Company Y, worth $426.67

Arbitrage

Initiate the arbitrage transaction

* Sell the shares of Y for $426.67

* Borrow $300 @ 12% (i.e. 1% of debt of Company Y, to replicate its capital structure)

* Buy 1% of shares in Company X, for $666.67. This results in a surplus cash flow (426.67+300-666.67 = $60)

Close out the arbitrage transaction

* Earn 15% on equity in Company X, or .15*666.67 or $100

* Pay interest @ 12% on 300 borrowed, or pay $36

* In hand, 100-36 = $ 64

Plus $60 left over (surplus cash flow)

Compare this with the original position of $426.67 in Company Y @ 15%, which would earn net $64

Obviously, the arbitrage has paid off. As more investors indulge in this process (remember the assumptions), the

market value of Company Y’s equity will decrease (more sellers), the market value of Company X’s equity will increase

͹ͷ
(more buyers), until finally, the TOTAL MARKET VALUES OF BOTH FIRMS, X & Y ARE EXACTLY THE

SAME, GIVEN THAT :

(i) THEY ARE IDENTICAL IN ALL RESPECTS, EXCEPT THEIR CAPITAL STRUCTURE, AND

(ii) BOTH EARN NOI OF $10,000

Proposition II

“The expected return on equity is equal to the expected rate of return on assets, plus a premium. The premium is
equal to the debt-equity ratio times the difference between the expected return on assets and the expected return on
debt.”

In effect, what the MM Theory states is that the market value of both, firms X & Y, should be $66,667 each.

Since Firm X is unlevered, its overall cost of capital will be equal to its required return on equity, or 15%

Firm Y has leverage, its overall cost of capital is the same @ 15%, however, the required return on equity will be
17.45%11, which can be explained as follows:

NOI 10000

Interest -3600

Available for Equity 6400

Market Value Firm 66667

Market Value Debt -30000

Market Value Equity 36667

Required Return on Equity 6400/36667

17.45%

Weighted Average Cost of Capital

Debt Equity Firm

MV 30000 36667 66667

Weight 45.00% 55.00% 100%

11
Higher Financial Leverage = Higher Risk, ergo higher required return on equity

͹͸
 Cost 12.00% 17.45%

Wt. Cost 5.40% 9.60% 15.00%

Criticisms

* Taxes are a reality: both corporate income tax & personal income tax

* Bankruptcy costs can be high

* Agency conflict is ignored

* Informational asymmetry is a reality: investors do not have the same information that managers do

* Personal leverage cannot be substituted for corporate leverage without changing the associated costs

4
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Pecking order theory starts with the fact that information is asymmetrical; managers know more about their companies
& its prospects than investors do. This affects the choice on source of funds for new projects.

There are three sources of finance, in order of preference by management:

* Internal accruals

* Debt

* Fresh issue of equity

The pecking order theory was first suggested by Donaldson in 1961; & was popularized by Myers and Majluf (1984)
where they argued that equity is a less preferred means to raise capital because when management issues new equity,
investors believe that the managers think the firm is overvalued, & are taking advantage of this over-valuation. As a
result, investors will perceive a lower value for the issue of fresh equity.

4
 6+257127(21/(9(5$*(
6+257127(21/(9(5$*(

Operating Leverage Every firm has both, fixed & variable costs. Operating leverage indicates the proportion of fixed
costs.

OL = C / OP (Contribution / Operating Profits)

High operating leverage indicates higher operating risk because of higher fixed costs. OP is nothing but C – F, hence
higher the fixed costs, higher will be the operating leverage. Higher OL results in a disproportionate change in return on
invested capital for every % rise or fall in sales.

DOL - Degree of Operating Leverage = % Change in OP / % Change in Sales

͹͹
All figures in lakh Firm A Firm B
Sales 100 100
Operating costs
Fixed 60 50
Variable 25 35
Operating profit 15 15
Contribution 75 65
Fixed cost/Total cost 70.59% 58.82%
Fixed cost/Sales 60.00% 50.00%
OL (C/OP) 5.00 4.33
Firm A has higher OL

DOL = % Change in OP for a 1% Change in Sales or Output

If sales increase by 50%, DOL 2.5 2.17
New Sales (+50%) 150 150
Operating cos ts
Fixed 60 50
Variable 37.5 52.5
Operating profit 52.5 47.5
% change in OP 250% 217%

New Sales (-50%) 50 50

Operating costs
Fixed 60 50
Variable 12.5 17.5
Operating profit -22.5 -17.5
% change in OP -250% -217%

Financial Leverage FL = OP / EBT (Operating Profit / Earnings before Tax)

It indicates how (relatively) high or low the interest cost is for the company. Higher FL results in better results for
shareholders in good times, but when the company passes through a tough phase, higher financial leverage can lead to
distress & bankruptcy. It is also known as trading on equity.

DFL - Degree of Financial Leverage = % Change in EPS / % Change in OP

DFL = EBIT

EBIT – I – {PD / (1 – T)}

EBIT Earnings before interest & taxes

I Interest

PD Preferred dividends

T Corporate tax rate

Financial Break Even Point of a company is the EBIT level at which all Fixed Costs & Interest Costs are covered. At
the financial BEP, the EPS = 0.

Combined Leverage CL = C / EBT = OL * FL

It illustrates the total risk a company carries – operating & financial. High OL & high FL is a recipe for disaster.

͹ͺ
OL signifies returns from fixed assets; FL is a measure of returns from debt financing; & CL is the combined effect of
both.

DCL - Degree of Combined Leverage = % Change in EPS / % Change in Sales

DCL$ = EBIT + FC

EBIT – I – {PD / (1 – T)}

DCLQ = Q * (P _ V)

Q * (P – V) – FC – I – {PD / (1 – T)}

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(36,1',))(5(1&(32,17

Capital Investment 2,000,000

Cost of Debt 10%
Tax Rate 40%
Equity Issue Price 25 FV 10

Alternative 1: 100% Equity, No Debt

Alternative 2: 50% Equity, 50% Debt

Solution

Alternative 1: 100% Equity, no Debt

Equity shares issued 80000 2000000
(2000000/25)
Interest 0

Alternative 2: 50% Equity, 50% Debt

Equity shares iss ued 40000 1000000
Debt 1000000
Interest 100000
(1000000*10%)


Indifference Point
This is the EBIT level at which the EPS will be the same between both the financing plans.
Let this EBIT level be "X"


Where:

X = EBIT indifference level

I1 = Interest costs under alternative 1

I2 = Interest costs under alternative 2

͹ͻ
PD = Preference dividend

T = Tax rate

S1 = Number of equity shares issued under alternative 1

S2 = Number of equity shares issued under alternative 2    

LHS {(X-0)(1-.4)-0}/80000 RHS {(X-100000)(1-.4)-0}/40000

.6X/80000 (.6X-60000)/40000
.6X/2 .6X-60000
.3X 60000
X 200000

Proof
Alternative 1: 100% Equity, no Debt Alternative 2: 50% Equity, 50% Debt
/d 200000 /d 200000
Interest 0 Interest 100000
EBT 200000 EBT 100000
Tax 80000 Tax 40000
PAT 120000 PAT 60000
Number of s hares 80000 Number of shares 40000
EPS 1.5 EPS 1.5


ͺͲ
10. Capital Budgeting – Investment Decisions
4
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Capital Budget means a list of planned capital expenditures, prepared periodically (usually, annually). Capital
expenditure is that expenditure which is incurred on resource or revenue generating plant, machinery, building etc. It is
of non-recurring nature for each item, & the benefits of this expenditure are evident over time. Capital expenditure is
most important because

a) It has long term effects

b) It is irreversible (once implemented)

c) It usually entails substantial outlays

PLANNING, ANALYSIS, SELECTION, IMPLEMENTATION & REVIEW are the phases of Capital Budgeting.

Each firm would require a thorough PROJECT ANALYSIS before it can allocate funds to any project(s). The aspects
of Project Analysis are:

MARKET ANALYSIS

TECHNICAL ANALYSIS

FINANCIAL ANALYSIS

ECONOMIC ANALYSIS

ECOLOGICAL ANALYSIS

The goal of CAPITAL BUDGETING IS IN CONSONANCE WITH THAT OF FINANCIAL MANAGEMENT:

OPTIMUM UTILIZATION OF RESOURCES & MAXIMIZATION OF VALUE AT ALL LEVELS.

Projects may be classified into:

NEW PRODUCTS OR EXPANSION

REPLACEMENT

RESEARCH & DEVELOPMENT

EXPLORATION

MISCELLANEOUS

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Projects can be appraised & compared based on cash flows & keeping in mind some parameters:

Use incremental cash flows only

Ignore sunk costs

All cash flows are to be considered post tax

Exclude cost of long term funds

Exclude common allocated overheads

ͺͳ
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COMMON METHODS OF APPRAISAL

ASSUMPTIONS

1. The risk or quality of all investment proposals under consideration is the same as that of the existing projects
of the firm.

2. Expected cash flows are realized at the end of each year.

There are four popular methods of capital budgeting

1 AVERAGE RATE OF RETURN

2 PAYBACK PERIOD

3 INTERNAL RATE OF RETURN (IRR)

4 NET PRESENT VALUE (NPV)

1 AVERAGE RATE OF RETURN

The most common formula for this is Average Income After Tax

Average Investment

e.g. post tax income 10 lakhs: Initial outlay 100 lakhs: depreciation 20 lakhs: closing balance of investment: 80 lakhs

ARR = (10/90) * 100 = 11.11%

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3$<%$&.3(5,2'

2 PAYBACK PERIOD

It is the length of time required to recover the initial cash outlay on the project. Payback Period is easy to understand &
calculate.

It has limited use because:

a) It does not consider time value of money

b) It only concerns itself with return of investment, not return on investment

c) Cash flows after the payback period are ignored

d) The threshold is arbitrary & without economic rationale

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',6&2817('3$<%$&.3(5,2'

DISCOUNTED PAY BACK PERIOD is a better measure than pay back period, but it also has limited use because:

a) It only concerns itself with return of investment, not return on investment

b) Cash flows after the payback period are ignored

c) The threshold is arbitrary & without economic rationale

4
 3/($6((;3/$,1,55:,7+$1(;$03/(
3/($6((;3/$,1,55:,7+$1(;$03/(

3 INTERNAL RATE OF RETURN

ͺ͵
IRR is a discounted cash flow method, wherein the acceptance criterion is to compare the IRR with a required rate of
return. If IRR exceeds required rate (which is usually cost of capital), the project is accepted, if not, it is rejected. The
IRR is the discount rate which makes its NPV = 0

Year Cash Flow P V @ 15% Disc PV @ 16% Disc

0 -100000 -100000 -100000
1 30000 26087 25862
2 30000 22684 22295
3 40000 26301 25626
4 45000 25729 24853
NPV 801.00 -1364.00
IRR = 15+ (801/2165) 15.37 or 15.37%

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4 NET PRESENT VALUE

All cash flows are discounted to their present values, using required rate of return. If the NPV is positive, the project
may be accepted, if negative, and then rejected. In the e g cited above, if the required rate of return (cost of capital in
most cases) is 16%, the NPV is negative & the project is rejected. If however the required rate of return is 15%, the
NPV is positive & the project is accepted.

4
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5$7(2)5(7851
5$7(2)5(7851

NPV: Net Present Value of all the cash flow streams of the company, discounted at the appropriate discount
rate or hurdle rate.

Positive NPV implies that wealth is generated for the shareholders (There is a surplus available after meeting all
costs of capital. This surplus belongs to the owners).

Profitability Index

Rules:

ͺͶ
* PI > 1, accept (NPV is positive)

* PI < 1, reject (NPV is negative)

* PI = 1, indifferent (NPV = 0)

IRR: Is that discount rate at which NPV = 0.

Had we considered 27% & 29%, the second part of the formula would have been multiplied by 2 instead of 1.
Interpolation is more accurate when the two discount factors used are closer in value.

Proof:

ͺͷ
 NPV IRR
* Expressed in currency Percentage return
* Discount rate required Not required
* NPV changes with discount rate IRR remains constant
(for a given cash flow stream)
* Acceptance Criterion
Accept if NPV is positive at a Accept if IRR is in
given discount rate excess of required rate

Disadvantages of IRR

For the cash flow stream above, NPV & IRR are calculated as shown. We know that NPV must be zero when IRR is
15.37%.

1) IRR assumes that all cash flows are reinvested in the same project, at the IRR. This is clearly a false
assumption, since this project generates only positive cash flows after the initial investment at time 0.

It is possible the cash generated could have been:

i) reinvested in another project with a different IRR

ii) used to pay out dividends

iii) used to repay debt or repurchase preference shares, & so on

2) If the cash flow changes signs more than once, & if the amount of cash flow is substantial, there may be
multiple or indeterminate IRRs.

In the example above, there are two IRRs, 10% & 0%. NPV is 0 at both. How would one evaluate these cases?

ͺ͸
Whenever there is a dispute between NPV & IRR, go with NPV

At a discount rate (hurdle rate) of 5%, NPV would be positive in this case.

Note:

* Every cash flow after time zero must be discounted, even the negative cash flows.

3) IRR rules must be reversed when we consider financing projects (below), instead of investing projects (shown
above)

This is a financing type project. The firm borrows money at time 0 & at time 1, & repays with interest at end of
period 2.

Recollect the IRR rule of acceptance: Accept if IRR is greater than discount rate (or hurdle rate or required rate).

In this case, if the discount rate was 10%, one would be tempted to reject the finance option, since IRR at 6.52% is
LESS THAN the discount rate.

NPV indicates correctly that while the market discount rate is 10%, this financing option has positive NPV, or it costs
us less than 10%, hence it creates value for shareholders.

Put in perspective, an IRR lower than the hurdle rate (in a financing project) indicates acceptance, since we pay less
than the opportunity cost of 10%, on capital borrowed.

4) IRR is biased in favour of shorter duration projects & earlier cash flows.

ͺ͹
A Ltd clearly delivers superior value addition to its shareholders (@ 25% discount rate). However, IRR would indicate
a preference for B Ltd.

MIRR

Modified Internal Rate of Return seeks to overcome the reinvestment assumption of IRR.

It considers two rates,

A reinvestment rate at which the positive cash flows generated by the business can be realistically
expected to grow, &

A discount rate (or finance rate) at which the PV of the entire stream of cash flows will be calculated.

Finance rate is 12%, NPV is positive. IRR is 15.49%. Reinvestment Rate is 15%, MIRR is 15.31%.

ͺͺ
Finance rate is 15%; NPV is positive (but changed). IRR is 15.49% (unchanged). Reinvestment Rate is 12%, MIRR is
14.19% (changed)

4
 3/($6((;3/$,1(48,9$/(17$118$/,=('139

Projects with unequal lives can be compared using EANPV.

Consider the following example:

Cost of Machine I – 75000, Life 5 years, annual operating cost 12000.

Cost of Machine II – 50000, Life 3 years, annual operating cost 20000.
Cost of Capital 12%

I II
1 Cost -75000 -50000
2 Life 5 3
3 Annual cost -12000 -20000
4 k 12% 12%
5 PVIFA(12%,5) 3.6048 2.4018
6 PV of annual costs -43257.31 6 = 3*5 -48036.63
7 NPV @ 12% -118257.31 7 = 1+6 -98036.63
8 EANPV - 32,805.73 8 = 7/5 - 40,817.45 

In this illustration, there are only negative cash flows. Hence, we must choose that project which has lower negative
value. However, the lives are unequal. NPV alone is not enough. Use Equivalent Annualized NPV. In effect, how
much would be the discounted cash flow, annually.

Machine I has the lower EANPV; hence it should be chosen over Machine II.

ͺͻ
4
4
 

Your company plans a new venture with a life of 10 years

Revenues will be 65 crore rupees in the 1st year, growing by 6% p.a.
Cost of goods sold is 30 crore in year 1, growing @ 4% p.a.
SGA 2 crore p.a.
Tax rate is 30%
Ignore working capital changes
Initial investment in property 300 crore
Depreciation SLM over 10 years
Terminal value of entire project in year 10 is 200 crore
Discount rate is 12%
Is this a good business proposal? Why?

Solution

All rupees in crore

Year Revenues COGS SG&A Dep OP Tax NOPAT Dep Operating CF Discounted Operating CF

0 -300.0000 -300.0000 

1 65.0000 -30.0000 -2.0000 -30.0000 3.0000 0.9000 2.1000 30.0000 32.1000 28.6607 139
2 68.9000 -31.2000 -2.0000 -30.0000 5.7000 1.7100 3.9900 30.0000 33.9900 27.0966
3 73.0340 -32.4480 -2.0000 -30.0000 8.5860 2.5758 6.0102 30.0000 36.0102 25.6313
4 77.4160 -33.7459 -2.0000 -30.0000 11.6701 3.5010 8.1691 30.0000 38.1691 24.2571
5 82.0610 -35.0958 -2.0000 -30.0000 14.9652 4.4896 10.4757 30.0000 40.4757 22.9670
6 86.9847 -36.4996 -2.0000 -30.0000 18.4851 5.5455 12.9396 30.0000 42.9396 21.7545
7 92.2037 -37.9596 -2.0000 -30.0000 22.2442 6.6733 15.5709 30.0000 45.5709 20.6140
8 97.7360 -39.4780 -2.0000 -30.0000 26.2580 7.8774 18.3806 30.0000 48.3806 19.5401
9 103.6001 -41.0571 -2.0000 -30.0000 30.5431 9.1629 21.3801 30.0000 51.3801 18.5282
10 109.8161 -42.6994 -2.0000 -30.0000 35.1168 10.5350 24.5817 30.0000 254.5817 81.9685
NPV is negative @ 12% Reject the project. 139 


************************************************************************************************

Thank You! Best Wishes for Your Examinations & Professional Careers.














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Images courtesy Google search. No copyright infringement intended. All copyrights acknowledged. All rights to tables,
notes & images used are owned by the respective owners &/or originators.

Disclaimer:

e&oe. Without prejudice, without recourse

Some matter included here is from existing publications of the author. The author reserves the right to use the material
in this workbook for his academic & professional activities, without requiring separate permission from the WIRC of
ICMAI. Due credit will be given to the publishers whenever such material is used by the author.

ͻͳ
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n
 FV = PV*(1+r)

 PV = FV/(1+r)n

If frequency of compounding is more than 1

nm
FV = PV*(1+r/m)

PV = FV/(1+r/m)nm

Rule of 72 (approx)
Doubling Period = 72/r
Doubling Period*r = 72

Rule of 69 (better approx)

Doubling Period = 0.35 + 69/r
(Doubling Period-0.35)*r = 69

n
FV of an Annuity = A[(1+r) -1] Annuity Due = Ordinary * (1+r)
ordinary r

PV of an Annuity = A 1-(1/(1+r)n) Annuity Due = Ordinary * (1+r)

ordinary r

PV of a Perpetuity = A/r

YTM = I + (F-P)/N
(F+P)/2

YTM = I + (F - P)/N
(.4F + .6P)

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