100% found this document useful (1 vote)
5K views63 pages

Sem 2 Question Bank (Moderated) - Financial Management

The document provides information to calculate the weighted average cost of capital (WACC) for a company. It includes details on the capital structure such as amounts of debt, preference shares, equity shares, and retained earnings. It also provides the costs of each component - the interest rate on debt, dividend rate on preference shares, and methods to calculate the cost of equity and retained earnings. Using the costs and weights based on the capital structure, the WACC is calculated. The WACC represents the average rate of return that the company is expected to pay its investors to maintain its current capital structure.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
100% found this document useful (1 vote)
5K views63 pages

Sem 2 Question Bank (Moderated) - Financial Management

The document provides information to calculate the weighted average cost of capital (WACC) for a company. It includes details on the capital structure such as amounts of debt, preference shares, equity shares, and retained earnings. It also provides the costs of each component - the interest rate on debt, dividend rate on preference shares, and methods to calculate the cost of equity and retained earnings. Using the costs and weights based on the capital structure, the WACC is calculated. The WACC represents the average rate of return that the company is expected to pay its investors to maintain its current capital structure.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 63

RTMNU MBA-II Semester CBCS (Outcome Based Education Pattern)

Course: FM – 2T1: FINANCIAL MANAGEMENT

Module 1: Introduction: Cost of Capital: Concept and Importance; Measurement of Specific


Costs – Redeemable and Irredeemable Debt, Redeemable and Irredeemable Preference
shares, Equity and Retained Earnings; Computation of Overall Cost of Capital using book
value and market value weights.

CO1: Given financial cost parameters, the future manager will be able to calculate specific
cost of capital and WACC for any specific firm.

Question1. A limited has following capital structure:

Equity share capital (200000 shares) Rs.4000000


6% Preference shares Rs.1000000
8% Debentures Rs.3000000
The market price of the company’s equity share is Rs.20. It is expected that the company will
pay a dividend of Rs.2 per share at the end of the year, which will grow at 7% for ever. The
tax rate may be taken as 50%. You are required to compute following:
1) A weighted average cost of capital based on existing capital structure.
2) The new weighted average cost of capital if the company raises an additional
Rs.2000000 debt by issuing 10% debentures. This would result in increasing the
expected dividend to Rs.3 and leave the growth rate unchanged but the price of
share will fall to Rs.15 per share.
Answer:

1) Ke = (D1/P0) + g = 2/20 + 7 = 17%


Kp = 6%
Kd = 8 (1-0.50) = 4%
WACC = (0.50*17%)+(0.125*6%)+(0.375*4%)
WACC = 10.75%
2) New Ke= ( 3/15) + 7 = 27%
Kd for additional debt = 10 (1-0.50) = 5%
WACC = (0.40*27%)+(0.10*6%)+(0.30*4%)+(0.20*5%) = 13.60%
Question 2: ABC Ltd. has the following capital structure:

S.No. Particulars Rs. In Lacs


1 Equity Capital (Rs. 10 Lacs share at par value) 100
2 12% Preference share capital 10
3 Retained Earnings 120
4 14% Non – convertible Debentures (70000 debentures at par) 70
5 14% term loan from Bank 100
Total 400
The market price per equity share is Rs. 25. The next expected dividend per share is Rs. 2 and
the DPS is expected to grow at a constant rate of 8%, The preference shares are redeemable
after 7 years at par and are currently quoted at Rs. 75 per share on the stock exchange. The
debentures are redeemable after 6 years at par and their current market quotation is Rs. 90
per share. The tax rate is 50%. Find out the weighted average cost of capital.

Solution:- Calculation the costs of various sources of finance


i. Cost of Equity = Ke= (D1/Po) + g = (2/25) + 0.08 = 0.16
ii. Cost of Retained earnings = Kr = Ke =0.16%
iii. Cost of preference shares =kp=(D+(f-p)/n)/(f+p)/2
= (12 + (100 -75)/7)/(100 + 75)/2 = 0.1780
iv. Cost of debentures = [i(1-t) + (f-p)/n]/(f+p)/2
= [14(1-.50) + (100 – 90)/6]/( 100 + 90)2 = 0.0912
v. Cost of term loans = ki = 0.14(1 – 0.5) = 0.07
Then we will calculate the weights associated with the various sources of funds:
i. We = 100/400 = 0.25
ii. Wr = 120/400 = 0.30
iii. Wp = 10/400 = 0.025
iv. Wd = 70/400 = 0.175
v. Wi = 100/400 = 0.25

Weighted average cost of capital = Weke + Wrkr + Wpkp + Wdkd + Wiki =(0.25 * 0.16) +
(0.30 * 0.16) + (0.025 * 0.1780) + (0.175 * 0.0912) + (0.25 * 0.07) = 0.1259 = 12.59%
Question 3: Ramco Ltd. wishes to raise additional finance of Rs. 10 lakhs for meeting its
investments plans. It has Rs. 2,10,000 in the forms of retained earnings available for
investment purposes. Further details are as follows:
1. Debt/Equity mix 3/7
2. Cost of Debt:
Up to Rs. 1,80,000 10% before tax
Beyond Rs.1,80,000 16% before tax
3. Earnings per share Rs. 4
4. Dividend pay out 50% of earnings
5. Expected growth rate of dividend 10%
6. Current market price per share Rs.44
7. Tax rate 50%
You are required:
a) To determine the pattern for raising additional finance.
b) To determine the post-tax average cost of additional debt.
c) To determine the cost of retained earnings and cost of equity, and
d) Compute the overall weighted average after tax cost of additional finance.

Answer:
a) Pattern of raising additional finance
Equity 70% of Rs. 10,00,000 = Rs. 7,00,000
Debt 30% of Rs. 10,00,000 = Rs. 3,00,000
The capital structure after raising additional finance:
Shareholders’ funds: Amount Total
Equity Capital 4,90,000
Retained earnings 2,10,000
Total Equity 7,00,000
Debt upto 1,80,000 1,80,000
(Interest at 10% p.a)
Debt beyond (3,00,000–1,80,000) 1,20,000
(Interest at 16% p.a.)
Total Debt 3,00,000
Total Funds 10,00,000
b) Determination of post-tax average cost of additional debt
Kd = I (1 – t)
Where,
I = Interest Rate
t = Corporate tax-rate
On Rs. 1,80,00o X 10% = 18,000
On Rs. 1,20,000 X 16% = 19,200
3,00,000 37,200

Kd = 37,200 X 100
3,00,000
= 12.4%
Post-tax average cost of additional debt = Kd = I (1 – t)
= 12.4 (1 – 0.5) = 6.2%
c) Determination of cost of retained earnings and cost of equity applying Dividend growth
model:
Ke = D1 + g
P0
Where,
Ke = Cost of equity
D1 = D0(1+ g)
D0 = Dividend Paid (i.e., 50% of EPS = 50% × Rs. 4 = Rs. 2)
g = Growth rate
P0 = Current market price per share
Then,
Ke = Rs. 2(1.1)/ Rs.44 + 0.10
= Rs. 2.2 / Rs.44 + 0.10
= 0.05 + 0.10
= 0.15 = 15%
d) Computation of overall weighted average after tax cost of additional finance
Particulars Rs Weights Cost of Funds Weighted Cost (%)
Equity 4,90,000 0.49 15% 7.35
Retained earnings 2,10,000 0.21 15% 3.15
Debt 3,00,000 0.30 6.2% 1.86
WACC 10,00,000 12.36
Question 4: A firm has the following capital structure
Source of Funds Amount Rs.
Debt 40,00,000
Preference Shares 20,00,000
Equity Shares 60,00,000
Retained Earnings 80,00,000
The debt is issued at 9% rate of interest and it’s an irredeemable debt with no floatation
costs.
The preference share carries a before tax rate of dividend @9%.
For Equity shares, the relevant details are Sale price Rs. 115 per share, flotation costs, Rs. 5
per share. The expected growth in equity dividend is 8% per year. The expected dividend at
the end of the current financial year is Rs. 11 per share
The corporate tax rate is 50 % . Calculate the current cost of weighted capital by using book
value method.

Answer:

Kd = 9 (1-0.50) = 4.5%

Kp= 9%

Rs .11
Ke = + 0.08 = 0.18 = 18%
Rs .110

Kre=Kre =18%
Method of Financing Proportion % Cost % Weighted cost
Debt 20 4.50 0.90
Preference Shares 10 9.00 0.90
Equity Shares 30 18.00 5.40
Retained Earnings 40 18.00 7.20
WACC = 13.4%
Question 5: An electric equipment manufacturing company wishes to determine the
weighted average cost of capital for evaluating capital budgeting projects. You have been
supplied with the following information:
Particulars Amount Particulars Amount
Equity Share Capital 1200000 Fixed Assets 2500000
Preference Share Capital 450000 Current Assets 1500000
Retained Earnings 450000
14% Debentures 900000
Current Liabilities 1000000
Total 4000000 Total 4000000
Additional Information:
i) 20 years 14% debentures of Rs. 2,500 face value, redeemable at 5% premium can be sold
at par with 2% floatation costs.
ii) 15% preference shares: Sale price Rs. 100 per share having 2% flotation costs.
iii) Equity shares: Sale price Rs. 115 per share, flotation costs, Rs. 5 per share.
The corporate tax rate is 35% and the expected growth in equity dividend is 8% per year. The
expected dividend at the end of the current financial year is Rs. 11 per share. Assume that
the company is satisfied with its present capital structure and intends to maintain it.

Answer:

Calculation of Specific Cost

¿
Kd = I (1−t)+(RV −NP)¿/ n (RV + NP)/2

Rs .350(1−0.35)+(Rs .2625−Rs .2450) ¿/20 ¿ /20¿


= ( Rs . 2625+ Rs .2450) ¿ = =
Rs . 227.5+ Rs .8 .75
= 0.0931
Rs .2537 .5

Rs .15
Kp = = 0.1530
Rs 100−Rs .2

Rs .11
Ke = + 0.08 = 0.18
Rs .110

Calculation of Weighted Average Cost of Capital


Source of Capital Amount Weight Specific Cost Weighted Cost
Equity Share Capital 1200000 0.40 0.18 0.072
Retained Earnings 450000 0.15 0.18 0.027
15% Preference Share Capital 450000 0.15 0.1530 0.024
14% Debenture 900000 0.30 0.0931 0.028
Total 3000000 0.151
Required WACC is 15.1%
Question 6:

The capital structure of Sunrise Ltd. comprises of 12% Debentures, 9% Preference Shares
and some equity shares of Rs.100 each in the ration of 3:2:5. The company is considering
introducing additional capital to meet the needs of expansion plans by raising 14% loan from
financial institutions. As a result of this proposal, the proportions of different above sources
would go down by 1/10, 1/15 and 1/6 respectively.

In the light of the above proposal, find out the impact on the WACC of the firm given that (i)
tax rate is 50%, (ii) expected dividend of Rs.9 at the end of the year and (iii) the growth rate
may be taken at 5%. No change is expected in dividends, growth rate, market price of the
share etc. after availing the proposed loan.

Answer:

The present WACC and the proposed WACC of the firm may be ascertained as follows:

Cost of Equity Capital = Ke = (D1 / P0) + g


= (9/100) + 0.05
= 0.14 or 14%
It has been assumed that the equity shares, preference shares and the debentures are being
traded at par
Source Present C/C Present New C/C New
Weight Weighted Weight Weighted
Cost Cost

Equity Share Capital 0.5 0.14


0.07 0.33 0.14 0.0462
Preference Share Capital 0.2 0.9
0.018 0.13 0.09 0.0126
12% Debentures 0.3 0.6
0.018 0.2 0.06 0.012
14% Loan (New) -- 0.34 0.07 0.0231
Present WACC 0.106 or New WACC 0.0939 or
10.6% 9.39%
The new WACC of the company would change from 106% (present level) to 9.39%.

Question 7:

A company has just paid a dividend of Rs.6. The dividends of the company are expected to
grow at a rate of 5%. The equity is currently quoted at market at a price of Rs.32. The
debentures are being quoted at 90%.

The other details are as follows:


Particulars Amount
Equity Capital 8,00,000
Share Premium 2,00,000
Reserves 4,00,000
Shareholder’s funds 14,00,000
14% redeemable debentures 10,00,000
Face Value of Equity and Debt assumed to be Rs.10 and Rs.100 respectively. Calculate the
Weighted Average Cost of Capital (WACC) at Market Value of weights. Ignore Taxation

Answer:

Let us work out the cost of equity and debt as follows:

D1
Ke= +g
P1
6×1.05
= +.05
32
=24 . 69 %
Cost of Equity: Ke

¿
The market value of equity =Rs.32 80,000 =25,60,000

I
Kd=
B
14
=
90
=15.55%
Cost of Debt

¿
Market value of Debt = 100000 90 = 900000

Weighted Average Cost of Capital (WACC)


Particulars Amount Weight Cost Weighted Cost
Equity 25,60,000 .74 24.69 18.76
Debt 900000 .26 15.55 4.04
Total 34,60,000 22.80%
Face Value of Equity and Debt assumed to be Rs.10 and Rs.100 respectively
Question 8. International Foods limited has following capital structure:
Particulars Book Value Rs. Market Value Rs.
Equity Capital (25000 shares of Rs.10 each) 250000 450000
13% Preference Capital (500 shares of Rs100 each) 50000 45000
Reserve and Surplus 150000 -
14% debentures of Rs.100 each) 150000 145000
600000 640000
The expected dividend per share is Rs.1.40 and the dividend per share is expected to grow at
8% forever. Preference share are redeemable after 5 years at par whereas debentures are
redeemable after 6 years at par. The tax rate for the company is 50%. You are required to
compute weighted average cost of capital for the existing capital structure using market
value as weights.

Answer:
Cost of equity Ke= (D1/P0) +g = (1.40/18) + 8% = 15.77%
Cost of Preference Capital Kp = [Pref. Div. + 1/n (RV-MP)]/(RV +MP)/2
= [13 + 1/5(100-90)] / (100+90)/2 = 15.8%
Cost of debentures Kd = [ Int (1-Tax rate) + 1/n (RV-MP)]/(RV +MP)/2
= [14 (1-0.50) +1/6(100 – 96.67)] / (100+96.67)/2 = 7.7%
WACC = (0.703125*15.77)+(0.07031*15.8%)+(0.227*7.7%) = 11.0883+1.1111 +1.745 =
13.9443%
Module 2: Leverage: Operating, Financial and Combined Leverage; EBIT-EPS Analysis;
Indifference Level of EBIT and Financial Break-even Analysis

CO-2 Given different financial options, the future manager will be able to analyse the effect
of OL and FL on EPS and recommend suitable long-term financing mix for an organization by
applying EBIT-EPS analysis, Indifference analysis and Break-even analysis to given financing
options

Question 1:

A company is contemplating to raise additional fund of Rs. 20,00,000 for setting up a project.
The company expects, EBIT of Rs. 8,00,000 from the project. Following alternative plans
are available:

(a) To raise Rs. 20,00,000 by way of equity share of Rs. 10 each

(b) To raise Rs. 10,00,000 by way of equity share @ Rs.10 and Rs. 10,00,000 by way of debt
@ 10%.

(c) To raise Rs. 6,00,000 by way of equity @ Rs.10 and rest Rs. 14,00,000 by way of
preferences shares @ 14%.

(d) To raise Rs. 6,00,000 by equity share @ Rs.10 , Rs. 6,00,000 by 10% debt, Rs. 8,00,000 by
14% Preference shares The company is in 60% tax bracket which option is best ?
Solution: EBIT-EPS Analysis
Particulars Option A Option B Option C Option D
Rs. Rs. Rs. Rs.
EBIT 8,00,000 8,00,000 8,00,000 8,00,000
(-) Interest 1,00,000 60,000
EBT 8,00,000 7,00,000 8,00,000 7,40,000
(-) Tax 4,80,000 4,20,000 4,80,000 4,44,000
EAT 3,20,000 2,80,000 3,20,000 2,96,000
(-) Pref Dividend 1,96,000 1,12,000
Earnings for Equity 3,20,000 2,80,000 1,24,000 1,84,000
shareholders
No. of equity shares 2,00,000 1,00,000 60,000 60,000
EPS = Earnings/No. of equity 1.6 2.8 2.07 3.07
shares
Option D is the best as EPS is the maximum in this case.
Question 2:
XYZ Company has currently and equity share capital of s 40 lakhs consisting of 40,000 equity
shares of Rs. 100 each. The management is planning to raise another Rs. 30 lakhs to finance
a major programme of expansion through one of the four possible financing plans. The
options are:

• Entirely through equity shares


• Rs. 15 lakhs in equity shares of Rs. 100 each and the balance in 8% debentures.
• Rs. 10 lakhs in equity shares of Rs. 100 each and the balance through long-term
borrowings at 9% interest p.a.
• Rs. 15 lakhs in equity shares of Rs. 100 each and the balance through preference
shares with 5% dividend.
The company’s EBIT will be Rs. 15 lakhs. Assuming corporate tax of 50%, Find out the EPS
and financial leverage.

Solution: Calculation of Degree of Financial Leverage (DFL)


Financial Financial Financial Financial
Particulars Plan I Plan II Plan III Plan IV
EBIT Rs. 15,00,000 Rs. 15,00,000 Rs. 15,00,000 Rs. 15,00,000

Less: Interest on debentures - 1,20,000 - -


Less: Interest on long term borrowings - - 1,80,000 -
EBT 15,00,000 13,80,000 13,20,000 15,00,000
Less: Tax @ 50% 7,50,000 6,90,000 6,60,000 7,50,000
EAT 7,50,000 6,90,000 6,60,000 7,50,000
Less: Preference Dividend - - - 75,000
Earning for Equity Shareholders 7,50,000 6,90,000 6,60,000 6,75,000
No. of Equity Shares 70,000 55,000 50,000 55,000
EPS Rs. 10.71 12.55 13.20 12.27
DFL (EBIT/EBIT-I) 1.00 1.087 1.136 1.00
Question 3:
Ceramics Ltd. has the following balance sheet and income statement
Balance Sheet as on March 31st 2019:
Assets Amount (Rs.)
Net fixed assets 10,00,000
Current assets 9,00,000
19,00,000
Liabilities
Equity capital ( Rs. 10 per share) 8,00,000
10% Debt 6,00,000
Retained earnings 3,50,000
Current liabilities 1,50,000
19,00,000

Income Statement for the year ending March 31st 2019


Particulars Amount (Rs. )
Sales 3,40,000
Operating expenses (including Rs. 60,000 1,20,000
depreciation)
EBIT 2,20,000
Less: Interest 60,000
Earnings before tax 1,60,000
Less: Taxes 56,000
Net Earnings (EAT) 1,04,000
a) Determine the degree of operating, financial and combined leverages at the current sales
level, if all operating expenses, other than depreciation, are variable costs.
b) If total assets remain at the same level, but sales (i) increase by 20 percent and (ii)
decrease by 20 percent, Compute the earnings per share at the new sales level?
Answer:
a) Calculation of Degree of operating (DOL), Financial (DFL) and Combined
leverage (DCL)

DOL = Contribution
EBIT
= Sales – Variable Expenses
EBIT
= Rs. 3,40,000 – Rs. 60,000
Rs. 2,20,000
= 1.27

DFL = EBIT
PBT
=Rs. 2,20,000
Rs.1,60,000

= 1.38

DCL = DOL×DFL
= 1.27×1.38
= 1.75

b) Earnings per share at the new sales level:


Particulars Increase by 20% Decrease by 20%

(Rs) (Rs)
Sales level 4,08,000 2,72,000
Less: Variable expenses 72,000 48,000
Less: Fixed cost 60,000 60,000
Earnings before interest and taxes 2,76,000 1,64,000
Less: Interest 60,000 60,000
Earnings before taxes 2,16,000 1,04,000
Less: Taxes 75,600 36,400
Earnings after taxes (EAT) 1,40,400 67,600
No. of equity shares 80,000 80,000
EPS 1.76 0.85
Working Notes:
1. Variable Costs = Rs. 60,000 (total cost − depreciation)
2. Variable Costs at:
Sales level, Rs. 4,08,000 = Rs. 72,000 (increase by 20%)
Sales level, Rs. 2,72,000 = Rs. 48,000 (decrease by 20%)

Question 4: The following data is available for ABC Ltd.

Particulars Amount (Rs.)

Sales 7,50,000

Variable Cost 4,20,000


Fixed Cost 60,000
Debt 4,50,000
Interest on Debt @ 9%
Equity Capital 5,50,000
Calculate ROI, Operating, financial and combined leverage. Also ascertain the level at which
EBIT will be zero.

Answer:

Return on Investment
Sales - Variable Cost - Fixed Cost

EBIT = Rs. 7, 50,000 - Rs. 4, 20,000 - Rs. 60,000 = Rs. 2, 70,000


Rs. 2, 70,000
ROI = ------------------ * 100 = 27%
Rs.10, 00,000

Operating Leverage
C Rs. 3, 30, 000
------- = - - - - - - - - - - - - - - - - - = 1.22
EBIT Rs. 2, 70, 000
Financial Leverage

EBIT Rs. 2,70,000


------- = ------------------ = 1.17
EBT Rs. 2,29,500

Combined Leverage = 1.17 * 1.22 = 1.43


Sales when EBIT will be zero
Rs. 3,30,000
P/V Ratio = ------------------ * 100 = 44%
Rs. 7,50,000

Fixed Cost = 60,000 + 40,500 = 1,00,500


Rs. 1,00,500
BEP = ------------------ = Rs.228409
44%

Question 5:

A company needs Rs. 12,00,000 for the installation of a new factory which is expected to
earn an EBIT of Rs. 2,00,000 per annum. The company has the objective of maximizing the
earnings per share. It is considering the possibility of issuing equity shares plus raising a debt
of Rs. 2,00,000 or Rs. 6,00,000 or Rs. 10,00,000. The current market price of the share is Rs.
40 and will drop to Rs. 25 if the borrowings exceed Rs. 7,50,000. The costs of borrowing are
indicated as under:

Amount of Borrowing Cost of Borrowing


Up to Rs. 2,50,000 10%
Rs. 2,50,000-6,25,000 14%
Rs. 6,25,000-10,00,000 16%
Assuming the tax rate to be 50%, find out the EPS under different options. Suggest the best
option for company.
Answer:

 Plan I II III
20000 10000
Debt 0 600000 00
10000 20000
Equity 00 600000 0
       
20000 20000
EBIT 0 200000 0
Less:iNTERE 16000
ST 20000 84000 0
18000
EBT 0 116000 40000
Less:Tax
@50% 90000 58000 20000
EAT 90000 58000 20000
No. of
Shares 25000 15000 8000
3.8666
EPS 3.6 67 2.5

50:50 Mix of debt & equity is preferred.

Question 6:

A company needs Rs.12,00,000 for the installation of a new factory which is expected to earn
an EBIT of Rs.2,00,000 per annum. The company has the objective of maximizing the
earnings per share. It is considering the possibility of issuing earnings per share. It is
considering the possibility of issuing equity shares plus raising a debt of Rs.2,00,000 or
Rs.6,00,000 or Rs.10,00,000. The current market price of the share is Rs.40 and will drop to
Rs.25 if the borrowings exceed Rs.7,50,000. The cost of borrowing are indicated as under:
Up to Rs. 2,50,000 10%
Rs.2,50,000 – Rs. 6,25,000 14%
Rs. 6,25,000 – Rs.10,00,000 16%
Assuming the tax rate to be 50%, find out the EPS under different options and suggest the
suitable plan for raising the funds.

Answer:

Plan I Plan II Plan III


Total Financing Rs. 12,00,000 Rs. 12,00,000 Rs.
-Debt Financing 2,00,000 6,00,000 12,00,000
10,00,000
Equity Financing Rs. 10,00,000 Rs. 6,00,000 Rs. 2,00,000
Issue Price 40 40 25
Number of shares required to be issued 25,000 15,000 8,000
Computation of Interest:
10% of Rs.2,00,000 Rs.20,000 -- --
14% of Rs. 6,00,000 -- Rs.84,000 --
16% of Rs.10,00,000 -- -- Rs.1,60,000
Total Interest Rs. 20,000 Rs.84,000 Rs. 1,60,000
Calculation of EPS:
EBIT Rs. 2,00,000 Rs. 2,00,000 Rs. 2,00,000
Less: Interest 20,000 84,000 1,60,000
Profit Before Tax 1,80,000 1,16,000 40,000
Less: Tax @ 50% 90,000 58,000 20,000
Profit After Tax 90,000 58,000 20,000
Number of Shares 25,000 15,000 8,000
EPS (Rs) 3.60 3.87 2.50
The EPS is highest under Plan II. The borrowings under this plan are also within the limits and
the market price would be maintained at Rs.40. Therefore, Plan II is recommended for
raising the funds.

Question 7:

The following data pertains to XLtd. and Y Ltd.for the financial year ended 31/03/2018

Particulars X Ltd. Y Ltd.


Operating Leverage 3:1 4:1
Financial Leverage 2:1 3:1
Interest Charges 24 lakhs 20 lakhs
Corporate Tax Rate 30% 30%
Variable Cost as% of sales 60% 50%
Answer

I) X Ltd.
a) Calculation of EBIT

EBIT EBIT
EBIT −Interest EBIT −24
Financial Leverage = =2 = = 2

Therefore, EBIT= 48 lakhs

b) Calculation of Contribution

Contribution Contribution
=3
EBIT 48 lakhs
Operating Leverage = =
Therefore, Contribution = 144 lakhs

c) Calculation of fixed costs

Contribution 144
Contribution-FC 144-FC
Operating Leverage = = =3

Fixed costs = 96 lakhs

d) Calculation of Sales:

% of Variable Cost =60%, hence Contribution =40% of sales

Contribution
Sales
= 40%

Sales = Contribution /40% = 144/40% = 360 lakhs

II) Y Ltd.

a) Calculation of EBIT

EBIT EBIT
EBIT −Interest EBIT −20
Financial Leverage = = =3

Therefore, EBIT= 30 lakhs

b) Calculation of Contribution .

Contribution Contribution
=4
EBIT 30 lakhs
Operating Leverage = =

Contribution = 120 lakhs

c) Calculation of fixed costs

Contribution 120
Contribution-FC 120-FC
Operating Leverage = = =4
Fixed costs = 90 lakhs

d) Calculation of Sales

% of Variable Cost =50%, hence Contribution =50% of sales

Contribution
Sales
= 50%

Sales = Contribution /50% = 120/50% = 240 lakhs


Income Statements of X and YLtd

Particulars X Ltd.(in lakhs) Y Ltd. (in lakhs)

Sales 360 240

Variable Costs 216 120

Contribution 144 120

Fixed Costs 96 90

EBIT 48 30

Less: Interest 24 20

EBT 24 10

Tax (30%) 7.2 3

PAT 16.8 7

Comments:

1. Y Ltd has higher Financial and Operating leverages, which implies that
- B has higher fixed costs to Sales ratio
- B has more debt in its capital structure
2. Contribution/ Sales ratio is more for Y Ltd, its profitability PAT/Sales is only 2.9% as
compared to 4.67% of X Ltd.
3. Hence X Ltd. has a better leverage position as compared to Y Ltd.

Q.8) X limited has a requirement of raising Rs.200000 for which following plans are
suggested:

Plan Equity Debt Preference Shares


A 100% --- ----
B 50% 50% ----
C 50% --- 50%

The before tax cost of debt and preference shares is expected to be 8% and the equity
shares of face value of Rs.10 each will be issued at a premium of Rs.10 each.
The expected EBIT of the firm is Rs.80000 and the applicable tax rate is 50%.
Find out, for each plan the EPS, the financial break-even level and indifference level of EBIT
between various plans. Also indicate if any of the plan is dominating.

Answer:
PLAN PLAN PLAN
A B C
EBIT 80000 80000 80000
Less:iNTEREST --- 8000 ---
EBT 80000 72000 80000
Less:Tax @50% 40000 36000 40000
EAT 40000 36000 40000
Less Pref. div --- --- 8000
EAEH 40000 36000 32000
No. of Shares 10000 5000 5000
EPS 4 7.20 6.40

Financial Break-even EBIT NA 8000 16000


Indifference Between AB AC BC
EBIT 16000 32000 NA
Dominating Plan Plan B
Module 3: Capital Budgeting: Concept of Capital budgeting, discounted and non-discounted
Cash Flow Techniques – NPV, IRR, PI, Discounted PBP, ARR & PBP

CO3: Given the cash-flows pertaining to a project, the future manager will be able to
estimate projects’ cash flows to distinguish between value creating and value destroying
investments using time-value intensive DCF techniques (viz. NPV, IRR, discounted payback
period, profitability index) and Non-DCF techniques (i.e. Payback Period and Average rate of
return approach)

Question 1:

1) Make a comparison between NPV and IRR methods. Which one of the two you find more
rationale and Why?
2) If the cash flows of projects X and Y are given as below, which project will you
recommend? Why?
Project Year 0 Year 1 Year 2 Year 3 NPV at 10% IRR

X -10000 2000 4000 12000 4134 26.5%

Y -10000 10000 3000 3000 3821 37.6%

Answer:
1) The process for selecting capital projects can require much thought and analysis. Many
financial evaluation methods have been employed to determine whether to accept or reject
a project. Choosing the correct method for ranking projects can be complicated when a
choice must be made between mutually exclusive projects. (When projects are mutually
exclusive, only one project can be chosen and the others must be abandoned.) The choice in
this case must be made based on the ranking of projects in order of increasing shareholder
wealth. Choices are made based on various financial evaluation methods, one of which is to
discount future net cash flows into present value terms using the cost of capital or a discount
rate. Net Present Value (NPV) and Internal Rate of Return (IRR) are the most common
methods for ranking projects in terms of the present value of future cash flows. This article
will help decision makers determine which of these two evaluation methods—NPV or IRR—is
better for evaluating mutually exclusive projects.

Net Present Value Method


The Net Present Value (NPV) Method is “a method of ranking investment proposals using the
NPV, which is equal to the present value of future net cash flows, discounted at the marginal
cost of capital.”1 The equation for NPV is as follows:
NPV= PV of Cash Inflows – PV of Cash Outflows
When NPV is positive, there are enough cash flows to pay back the project’s debt and
provide a return to shareholders. NPV is also expressed as a rupee value, which provides a
good indicator of profitability and growth in shareholder wealth.

Internal Rate of Return Method


The Internal Rate of Return (IRR) Method is “a method of ranking investment proposals using
the rate of return on an investment, calculated by finding the discount rate that equates the
present value of future cash inflows to the project’s cost” 1. It is the rate that forces NPV to
equal 0. The IRR is always expressed as a percentage. For a project to be acceptable under
the IRR method, the discount rate must exceed the project’s cost of capital, otherwise
known as the hurdle rate. An IRR less than the hurdle rate represents a cost to shareholders,
while an IRR greater than the hurdle rate represents a return on investment, increasing
shareholder wealth.

We must first analyse the reinvestment rate assumptions for each evaluation method. The
NPV method assumes that cash flows will be reinvested near or at the project’s current cost
of capital, while the IRR method assumes that the firm can reinvest cash flows at the
project’s IRR. The assumption that the firm will reinvest its cash flows at the current cost of
capital is more realistic than the assumption that cash flows can be reinvested at the
projects IRR. This is because the IRR may not reflect the true rate at which cash flows can be
reinvested.

2) NPV has an advantage over IRR when a project has non-normal cash flows. Non-normal
cash flows exist if there is a large cash outflow during or at the end of the project. The
presence of non-normal cash flows will lead to multiple IRRs. Hence, the IRR method cannot
be employed in the evaluation process. Mathematically, this problem will not occur if the
NPV method is employed. The NPV method will always lead to a singular correct accept-or-
reject decision.
In conclusion, NPV is a better method for evaluating mutually exclusive projects than the IRR
method. The NPV method employs more realistic reinvestment rate assumptions, is a
better indicator of profitability and shareholder wealth, and mathematically will return the
correct accept-or-reject decision regardless of whether the project experiences non-normal
cash flows or if differences in project size or timing of cash flows exist.

3) The reason for conflict is the pattern of cash flows and the reinvestment rate assumption
followed in NPV and IRR Methods.

4) At 10% discounting rate, project X may be preferred as it is having incremental NPV of INR
313.
Question 2:

A company is contemplating to purchase a machine. Two machines a & B are available


costing Rs. 5 Lakhs each. In comparing the profitability of machines a discounting rate of 10%
is to be used and machine is to be written off in five years by straight line method of
depreciation with nil residual value. Cash inflows after tax are expected as follows:

(Amount in Rs. Lakhs)


Year Machine A Machine B
1 1.5 0.5
2 2.0 1.5
3 2.5 2.0
4 1.5 3.0
5 1.0 2.0
Indicate which machine would be profitable using the following methods of ranking
investment proposals: (i) Pay back method (ii) Net present value method (iii)
Profitability index method and (iv) Average rate of return method
The discounting factors at 10% are

Year 1 2 3 4 5
Discounting factor 0.909 0.826 0.751 0.683 0.621

Solution:

(i) Payback period = Initial Investment/ Annual cash flows

Calculation of payback period

Machine A (Rs. In lakhs)

Year Cash Inflows Payback years required

Total Needed

1 1.50 1.50 1 year

2 2.00 2.00 1 year

3 2.50 1.50 ( 1.50/2.50)x12 = 7.2


months

5.00

Therefore payback period for Machine A = 2 years 7.2 months


Machine B

Year Cash Inflows Payback years required

Total Needed

1 0.50 0.50 1 year

2 1.50 1.50 1 year

3 2.00 2.00 1 year

4 3.00 1.00 ( 1/3)x12 = 4 months

5.00

Therefore payback period for Machine B = 3 years 4 months

(ii) Calculation of Net present Value of Cash Inflows for Machine A and Machine B
(Rs. In Lakhs)

Year Cash inflows Discount factor P.V of cash Inflows


@10%

Machine A Machine B Machine A Machine B

1 1.5 0.5 0.909 1.36 0.45

2 2.0 1.5 0.826 1.65 1.24

3 2.5 2.0 0.751 1.88 1.50

4 1.5 3.0 0.683 1.02 2.05

5 1.0 2.0 0.621 0.62 1.24

Total Present value of cash inflows 6.53 6.48

(-) Initial investment 5.00 5.00

Net present value 1.53 1.48

Rank : Machine A -1; Machine B – 2

Since Machine A has greater NPV compared to Machine B.


(iii) Calculation of Profitability Index

Particulars Machine A Machine B

Profitability index = P.V of C.I/P.V of C.O 6.53/5.00=1.306 6.48/5.00 =


1.296

Rank I II

(iv) Calculation of Average rate of return = (Average annual earning / Initial


cost)*100
(Rs. In lakhs)

Particulars Machine A Machine B

Total cash flow 8.50 9.00

(-) Depreciation for 5 years 5.00 5.00

Net earning after tax and 3.50 4.00


depreciation

Life of machine (years) 5 5

Average earning per year 0.70 0.80

Initial cost 5.00 5.00

ARR (0.70/5.00)x100 = 14% (0.50/5.00)x100= 16%

Rank II I

Suggestion: Machine B is more profitable

Question 3:

Sunshine Industries is planning to introduce a new product with a project life of 8 years. The
project, to be set up in a backward region, qualities for a one-time (at its starting) tax free
subsidy from the govt of Rs. 20,00,000. Initial equipment cost will be Rs. 1,40,00,000 and
additional equipment costing Rs. 10,00,000 will be needed at the beginning of the third year.
At the end of 8 years, the original equipment will have no resale value, but the
supplementary equipment can be sold for Rs. 1,00,000. A working capital of Rs. 15,00,000
will be needed. The sales volume over the 8 year period has been estimated as follows:
Year Units
1 80,000
2 1,20,000
3-5 3,00,000
6-8 2,00,000

A sale price of Rs. 100 per unit is expected and variable expenses will amount to 40% of sales
revenue. Fixed cash operating costs will amount to Rs. 16,00,000 per year. In addition an
extensive advertising campaign will be implemented, requiring annual outlays as follows:

Year Units
1 30,00,000
2 15,00,000
3-5 10,00,000
6-8 4,00,000

The company is subject to 50% tax rate and considers 12% to be an appropriate after-tax
cost of capital for this project. The company follows the straight line method of depreciation.
Should the project be accepted? Assume that the company does not have other incomes

Answer:
Calculation of cash Inflows : (Figures in lacs)

Year Sales Variable Fixed Advertising Depreciation Profit Tax PAT Depreciation CFAT
Cost Cost Expenses Before
Tax

1 80 32 16 30 17.50 -15.15 -- -15.50 17.50 2.00

2 120 48 16 15 17.50 23.50 4.00 4.00 17.50 21.50

3-5 300 120 16 10 19.00 135.00 67.50 67.50 19.00 86.50

6-8 200 80 16 4 19.00 81.00 40.50 40.50 19.00 59.50

As the firm has no other income, the loss of year 1 has been carried forward to year 2. So,
the tax liability of year 2 will be 50% of (Rs. 23,50,000 - Rs. 15,50,000)= Rs. 4,00,000.
Calculation of Net Present Value :

Year Out flow(Rs.) Inflow(Rs.) PVF (12%, n) PV(Rs.)

0 1,35,00,000 --- --- -1,35,00,000

1 -- 2,00,000 0.893 1,78,600

2 10,00,000 21,50,000 0.797 9,16,550

3 -- 86,50,000 0.712 61,58,880

4 -- 86,50,000 0.636 55,01,440

5 -- 86,50,000 0.567 49,04,550

6 -- 59,50,000 0.507 30,16,650

7 -- 59,50,000 0.452 26,89,400

8 -- 75,50,000 0.404 30,50,200

Net Present 1,29,16,190


Value

Since the project has an NPV of Rs. 1,29,16,190, it is acceptable.

Working Notes:

1. Cash flow for year 0 = Rs. 1,40,00,000 + Rs. 15,00,000 – Rs. 20,00,000
= Rs. 1,35,00,000
2. Cash flow for year 8:
Recovery of working capital Rs. 15,00,000
Scrap value of machine Rs. 1,00,000
Normal Inflow Rs. 59,50,000

Rs. 75,50,000
Question 4:

The following details relate to two Machines X Model & Y Model.


X Model(Rs.) Y Model (Rs.)

Cost 3,60,000 3,60,000


Estimated Life 5 years 5 years
Estimated Salvage Value 60,000 60,000
Annual Income after Tax & Depreciation:
Year I 18,000 78,000
Year II 33,000 63,000
Year III 48,000 48,000
Year IV 63,000 33,000
Year V 78,000 18,000

For X Model overhauling charges at the end of third year Rs. 1,20,000.

Depreciation has been charged at 'straight-line method . Discounting Rate is 10%. Present
Value Factor at 10% for five years are 0.909, 0.826; 0.751, 0.683 and 0.621. Suggest which
project should be accepted under Present Value Method.

CO3 Answer:
(i) Present Value of Cash Outflows

X Model (Rs.) Y Model (Rs.)

Initial Investment 3,60,000 3,60,000


Overhauling Charges (1,20,000 X .751) 90,120 -
4,50,120 3,60,000
(ii)Present Value of Cash Inflows ( X model)

Year Income after Dep Cash Present/ Present Value


Tax & dep inflow Value Factor of cash inflow
(a) (b) (c) (d=b+c) (f-dXe)
I 18,000 60,000 78,000 .909 70,902
II 33,000 60,000 93,000 .826 76,818
III 48,000 60,000 1,08,000 .751 81,108
IV 63,000 60,000 1,23,000 .683 84,009
V 78,000 60,000 1,38,000 .621 85,698
Add Present Value of Salvage (scrap) in Vth year 3,98,535
(60,000 x .621) 37,260
Total 4,35,795
Present Value of Cash inflow (Y Model)

Year Income after Dep Cash inflow Present/ Present Value


Tax & dep Value Factor of cash inflow
(a) (b) (c) (d=b+c) (f-dXe)
I 78,000 60,000 1,38,000 .909 1,25,442
II 63,000 60,000 1,23,000 .826 1,01,598
III 48,000 60,000 1,08,000 .751 81,108
IV 33,000 60,000 93,000 .683 63,519
V 18,000 60,000 78,000 .621 48,438
Add Present Value of Salvage in V th year 4,20,105
(60,000 x .621) 37,260
Total 4,57,365

Model P. V. of Inflows P. V. of Outflows Surplus / Deficit


X 4,35,795 4,50,120 - 14,325
Y 4,57,365 3,60,000 + 97,365

Question 5:

Royal Industries is considering the replacement of one of its moulding machines. The existing
machine is in good operating condition but is smaller than required if the firm is to expand its
operations. The old machine is 5 years old, has a current salvage value of Rs. 30,000 and a
remaining depreciable life of 10 years. The machine was originally purchased for Rs. 75,000
and is being depreciated at Rs. 5,000 per year for tax purposes. The new machine will cost Rs.
1,50,000 and will be depreciated on a straight line basis over 10 years, with no salvage value.
The management anticipates that, with the expanded operations, there will be need of an
additional net working capital of Rs. 30,000. The new machine will allow the firm to expand
current operations, and thereby increase revenues of Rs. 40,000, and variable operating costs
from Rs. 2,00,000 to Rs. 2,10,000. The company’s tax rate is 50% and its cost of capital is 10%.
Should the company replace its existing machine, given that the capital gain is taxable at the
same rate of tax?

Answer:
Calculation of Initial Outflow:
Particulars Rs.
Cost of Machine 1,50,000
Add: Additional Working Capital 30,000
Required 30,000
Less: Sale value of existing machine 1,50,000
10,000
Less: Tax saving @ 50% on Loss on Sale
(50,000 – 30,000)
Net Cash Outflow 1,40,000
Calculation of Annual Inflows:
Particulars Rs.
Increase in Sales Revenue 40,000
Less: Increase in Variable Cost 10,000
Increase in Contribution 30,000
Less: Tax @ 50% 15,000
Add: Tax Shield @ 50% on additional 5,000
Depreciation ( 50% of (15,000 – 5,000))
Annual CFATs 20,000
Calculation of Terminal Inflow:
Working Capital Released Rs.30,000

Calculation of Net Present Value:


Years Cash Flow (Rs) PV Factor @ Present Value (Rs)
10%
1 – 10 20,000 6.145 1,22,900
10 30,000 0.386 11,580
Present Value of Inflows 1,34,480
Less: Present Value of Cash Outflows 1,40,000
Net Present Value (5,520)
Conclusion: As the NPV of buying the new machine is negative, the firm need not replace the
existing machine.

Question 6:

Prime Ltd. is considering expansion of capacity of one of its plants at a cost of Rs.275000. The
firm’s minimum required rate of return is 14%. The following are the expected cash flows over
next 5 years and the scrap value is nil. Consider the proposal based on NPV and IRR techniques.

Year 1 2 3 4 5

Cash Flow 85000 78000 90900 65800 94200

Answer:

Year CF PVIF (14%) PV PVIF (16%) PV


1 85000 0.877 74561.4 0.862 73275.86
2 78000 0.769 60018.47 0.743 57966.71
3 90900 0.675 61354.91 0.641 58235.78
4 65800 0.592 38958.88 0.552 36340.75
5 94200 0.519 48924.53 0.476 44849.85
Total 283818.2   270669
Investment 275000   275000
NPV 8818.192   -4331.05
IRR= 14%+8818/(8818+4331) 14.67

Question 7:
A company is considering an investment proposal to install a new milling control at a cost of Rs.
50,000. The facility has a life expectancy of 5 years without any salvage value. The firm uses
SLM of depreciation and the same is used for tax purposes. The tax rate is assumed to be 35%.
The estimated cash flows before depreciation and tax (CFBDT) from the investment proposal
are as follows:-
Years 1 2 3 4 5
CFBDT (Rs.) 10,000 10,692 12,769 13,462 20,385
Compute :- (1) Payback Period ; (2) Average rate of return; (3) NPV at 10% discount rate; (4)
Profitability index at 10% discount rate.
Answer:
Years CFBDT DEP. CFAD TAX CFADT CFBDAT Cum.CFBDAT PV at PV of
(35%) 10% CFBDAT

1 10,000 10,000 NIL NIL NIL 10,000 10,000 0.909 9,090

2 10,692 10,000 692 242 450 10,450 20,450 0.826 8,632

3 12,769 10,000 2,769 969 1,800 11,800 32,250 0.751 8,862

4 13,462 10,000 3,462 1,212 2,250 12,250 44,500 0.683 8,367

5 20,385 10,000 10,385 3,635 6,750 16,750 61,250 0.621 10,401

Total Present Value 45,352

(CFBDT :- Cash flow before depreciation and tax) (CFAD = Cash flow after after depreciation)
(CFADT = Cash flow after depreciation and tax) (CFBDAT = cash flow before depreciation but
after tax)
Depreciation = Cost price – Scrap value / Number of years = 50,000 / 5 = Rs. 10,000.

1) Calculation of Payback Period :-


Rs. 44,500 are covered in 4 years. The balance of Rs. 5,500 out of initial investment will be
recovered in 5,500 / 16,750 or 0.33 year. Hence the payback period is 4.33 years.
2) Calculation of Average Rate of Return (ARR) :-
ARR = Average Annual Earning after Taxes / Average Investment
Average Annual Earning after Taxes (CFADT) = 11,250 / 5 = Rs. 2,250.
Average investment = Initial Investment + Salvage Value / 2 = Rs. 50,000 / 2 = Rs. 25,000.
ARR = 2,250 / 25,000 = 0.09 or 9%.
3) Calculation of Net present value at 10% Discount Rate
NPV = Present value of Cash Inflows – Present value of Cash Outflows
NPV = 45,352 – 50,000 = ( - ) Rs. 4,648.
4) Calculation of Profitability Index at 10% Discount Rate
PI = PV of Cash Inflows / Initial Cash Outflows = 45,352 / 50,000 = 0.907.

Question 8:
Jingle Bell company has an investment opportunity costing Rs. 1,00,000 with the following
expected cash inflow (i.e., after tax and before depreciation) :
Year Inflows PVF(10%,n) Year Inflows PVF(10%,n)
1 Rs. 15,000 0.909 6 Rs. 18,000 0.564
2 16,000 0.826 7 15,000 0.513
3 17,000 0.751 8 14,000 0.467
4 17,500 0.683 9 10,000 0.424
5 17,500 0.621 10 10,000 0.386
Using 10% the costs of capital (rate of discount) determine the (i) Net Present Value; and (ii)
Profitability Index and (iii) Internal Rate of Return
Solution:

          22%  
Inflow PVF(10%,n CFAD&
Year PV PVF (22 PV
s ) D
0.81967
1 15,000 0.909
25,000 22725 2 20491.8
0.67186 17468.4
2 16,000 0.826
26,000 21476 2 2
0.55070 14869.0
3 17,000 0.751
27,000 20277 7 9
18782. 0.45139 12413.4
4 17,500 0.683
27,500 5 9 7
17077. 0.36999 10174.9
5 17,500 0.621
27,500 5 9 8
0.30327 8491.78
6 18,000 0.564
28,000 15792 8 6
0.24858 6214.71
7 15,000 0.513
25,000 12825 9 5
0.20376 4890.26
8 14,000 0.467
24,000 11208 1 7
0.16701 3340.34
9 10,000 0.424
20,000 8480 7 7
0.13689 2737.98
10 10,000 0.386
20,000 7720 9 9
    PV of   156363   101092.
inflows 9
PV of
  less: outflows   100000   100000
      NPV 56363   1092.87
1.5636
      PI 3    
      IRR* 22.34%    
*The value of IRR can change based on the discounting rate chosen for trial and error
calculations.
Due consideration should be given to student even if the answer is near and approximate.

Question 9:

One of the two machines A and B is to be purchased. Form the following information find out
which of the two will be more profitable? The average rate of tax may be taken at 50%.
Particulars Machine A (Rs.) Machine B (Rs.)
Cost of machine 50000 80000
Machine Life 4 years 6 years
Earnings Before Tax
1st year 10000 8000
2nd year 15000 14000
3rd year 20000 25000
4th year 15000 30000
5th year --- 18000
6th year --- 13000

Solution:
Calculation for Machine A

Year EBT Tax@ 50% EAT Cash flows Cumulative


cash flows
1 10000 5000 5000 17500 17500
2 15000 7500 7500 20000 37500
3 20000 10000 10000 22500 60000
4 15000 7500 7500 20000 80000

a) Pay back period:


Investment = 50000
Recovery up to 2nd year is 37,500
Balance 12500 in 3rd year =
12500/22500 = 0.55 years i.e. 2.55
years

b) Average rate of returns:


(on original investment basis)

= Average earnings/net investment x 100


= 30000 x 4 / 50000 x 100 = 15%

Calculation for Machine B

Year EBT Tax@ 50% EAT Cash flows Cumulative


cash flows
1 8000 4000 4000 17333 17333
2 14000 7000 7000 20333 37666
3 25000 12500 12500 25833 63499
4 30000 15000 15000 28333 91832
5 18000 9000 9000 22333 141165
6 13000 6500 6500 19833 133498

a) Pay back period


Investment = Rs. 80,000
Cumulative Cash Flows shows that the recovery up to 3rd year = 63499 therefore for the
balance of Rs. 16501 will be recovered in 4th year. i.e. 16501/28333 = 0.58 year
therefore payback period is 3.58 years

b) Average rate of return (based on original investment)


= Average Profits/net investment x 100
= 54000/6 x 100
= 11.25%

Machine A is profitable in both the cases


Note: - It has been assumed that Earnings Before tax in the problem is after considering
depreciation on straight line basis.
Module 4: Given the details pertaining to elements of working capital for given level of activity,
the future manager will be able to ascertain the components of CA and CL and determine the
Gross & Net Working capital requirement of the firm.

CO4 : Given the details pertaining to elements of working capital for a given level of activity, the
future manager will be able to ascertain the components of current assets and current liabilities
and determine the gross and net operating working capital requirement.

Question 1:

Foods Limited is presently operating at 60% level producing 36,000 packets of snack
food and proposes to increase capacity utilization in the coming year by 33.3% over the
existing level of production. The following data has been supplied:

a) Unit cost structure of the product at current level Rs.


Raw material 4
Wages (Variable) 2
Overheads (variable) 2
Fixed overheads 1
Profit 1
Selling price 12
Raw materials will remain in stores for 1 month before being issued for production.
Material will remain in process for further 1 month. Suppliers grant 3 months credit
to the company.

b) Finished goods remain in godown for 2 months.


c) Debtors are allowed credit for 2 months
d) Lag in wages and overhead payment is 1 month and these expenses accrue evenly
throughout the production cycle.
e) No increase either in cost of inputs or selling price is envisaged.

Prepare a projected profitability statement and the working capital requirement at the new
level, assuming that a minimum cash balance of Rs. 19,500 has to be maintained.

Solution:
Units at 80% capacity = 36,000 x 80/60 =48,000 units
Projected Profitability Statement at 80% capacity (48,000 units)
Particulars Per annum
Sales (@12) (a) 5,76,000
Cost
Raw materials (@ Rs. 4) 1,92,000
Wages (@ Rs. 2) 96,000
Overheads (variable) (@ Rs.2) 96,000
Overheads (fixed) (36,000x Re.1) 36,000
(b) 4,20,000
Profit (a-b) 1,56,000
Computation of Working Capital requirement (at 80% capacity)
(A) Current asset Rs. Rs.
Raw material stock Rs. 1,92,000 x 1/12 16,000
WIP Stock
Raw material Rs. 1,92,000 x 1/12 16,000
Wages Rs. 96,000 x 0.5/12 4,000
Variable overheads Rs. 96,000 x 0.5/12 4,000
Fixed overheads Rs. 36,000 x 0.5/12 1,500 25,500
Finished goods stock 35,000
Sundry Debtors 96,000
Cash balance 19,500
Total (A) 1,92,000
(B)Current Liabilities
Creditors for goods Rs. 1,92,000 x 3/12 48,000
Creditors for wages Rs. 96,000 x 1/12 8,000
Creditors for expenses
Variable overhead Rs. 96,000 x 1/12 8,000
Fixed overhead Rs. 36,000 x 1/12 3,000 11,000
Total (B) 67,000
Working capital requirement (A-B) 1,25,000
Question 2: You are required to construct a statement showing the working capital required to
finance the level of activity of 18,000 units per year from the following information:-
Particulars Rs.
Raw material Per Unit 12
Direct labor Per Unit 3
Overheads per Unit 9
Total cost Per Unit 24
Profit per Unit 6
Selling price Per Unit 30
Additional Information:
1. Raw material is in stock on an average for 2 months.
2. Materials are in process on an average for half-a- month.
3. Finished goods are in stock on an average for two months.
4. Credit allowed by creditors is two months in respect of raw materials supplied.
5. Credit allowed to debtors is three months.
6. Lag in payment of wages is half month.
7. Cash on hand and at bank is expected to be Rs. 7,000.
8. You are informed that all activities are evenly spread out during the year.

Solution:
Particulars Amount Amount
A: Current Assets
1. Stock in Trade
a) Raw Materials 18,000 x 12 x 2/12 36,000
b) Work in Progress 18,000 x 18 x ½/12 13,500
c) Finished Goods 18,000 x 24 x 2/12 72,000
2. Sundry Debtors 18,000 x 30 x 3/12 1,35,000
3. Cash in Hand and at Bank 7,000
Total Current Assets 2,63,500
B: Current Liabilities
1. Sundry Creditors 18,000 x 12x 3/12 36,000
2. Wages 18,000 x 3 x ½/12 2,250
Total Current Liabilities 38,250
Estimated Net Working Capital Requirement (A-B) 2,25,250
Question 3: The management of Royal industries has called for a statement showing the
working capital needs to finance a level of activity of 1,80,000 units of output for the year. The
cost structure for the company’s product for the above-mentioned activity level is detailed
below.
Particulars Cost per unit (Rs.)
Raw Materials 20
Direct labour 5
Overheads (including depreciation of Rs. 5 per unit) 15
40
Profit 10
Selling Price 50
Additional information:-
a. Minimum desired cash balance is Rs. 20,000.
b. Raw materials are held in stock, on an average, for 2 months.
c. Finished goods remain in warehouse, on an average, for a month.
d. Suppliers of materials extend a month’s credit and debtors are provided two months credit;
cash sales are 25% of total sales.
e. There is a time lag in payment of wages of a month and half-a-month in case of overheads.
From the above data, you are required to prepare a statement showing working capital needs.
Answer:
Production and sale per month = 1,80,000 / 12 = 15000 units
Statement of Working Capital
Particulars Rs. Rs.
Current Assets
Raw material stock (15000 x 2 x Rs. 20) 6,00,000
Finished goods (15000 x 1 x Rs. 40) 6,00,000
Debtors (75% credit sale) (15000 x 75% x 2 x Rs. 50) 11,25,000
Cash 20,000
23,45,000
Less Current Liabilities
Creditors for raw material (15000 x 1 x Rs. 20) 3,00,000
Creditors for wages (15000 x 1 x Rs. 5) 75,000
Creditors for overhead (excluding depreciation) (15000 x ½ x 10) 75,000 4,50,000
Working Capital 18,95,000
Note: Depreciation is excluded while calculating overhead payable because you don’t have to
pay depreciation like other expenses.
Question 4: On 1st January, the Managing Director of Golden Pvt. Ltd. wishes to know the
amount of working capital that will be required during the year. From the following information
PREPARE the working capital requirements forecast.
Production during the previous year was 60,000 units. It is planned that this level of activity
would be maintained during the present year.
The expected ratios of the cost to selling prices are Raw materials 60%, Direct wages 10% and
Overheads 20%.
Raw materials are expected to remain in store for an average of 2 months before issue to
production.
Each unit is expected to be in process for one month, the raw materials being fed
into the pipeline immediately and the labour and overhead costs accruing evenly
during the month.
Finished goods will stay in the warehouse awaiting dispatch to customers for
approximately 3 months.
Credit allowed by creditors is 2 months from the date of delivery of raw
material. Credit allowed to debtors is 3 months from the date of dispatch.
Selling price is Rs. 5 per unit. There is a regular production and sales cycle. Wages and
overheads are paid on the 1st of each month for the previous month. The company normally
keeps cash in hand to the extent of Rs. 20,000.
Answer:
Statement of Working Capital Required:
Particulars Working (Rs.) (Rs.)
Current Assets:
Raw materials inventory 60,000 units × Rs. 5 × 60% =Rs. 1,80,000 30,000
(Per month ) : 1,80,000/12 = Rs. 15,000
(Two months) : Rs. 15,000 X 2 = Rs.
30,000
Working–in-process :
Raw materials 60,000 units × Rs. 5 × 60% =Rs. 1,80,000 15,000
(Per month ): 1,80,000/12 = Rs. 15,000
Labour costs 60,000 × Rs. 5 X 0.5/12 x 10% 1,250
Overheads 60,000 × Rs. 5 x 0.5/12 X 20% 2,500
Total work-in-process 18,750
Finished goods inventory
:
Raw materials 60,000 × Rs. 5 × 3/12 X 60% 45,000
Labour 60,000 × Rs. 5 × 3/12 X 10% 7,500
Overheads 60,000 × Rs. 5 × 3/12 X 20% 15,000
67,500
Debtors Rs. 2,70,000 × 3/12 67,500
Cash 20,000
Total Current Assets 2,03,750
Current Liabilities:
Creditors 60,000 × Rs. 5 × 2/12 X 60% 30,000
Direct wages payable 60,000 × Rs. 5 × 1/12 X 10% 2,500
Overheads payable 60,000 × Rs. 5 × 1/12 X 20% 5,000
Total Current Liabilities 37,500
Estimated working Total Current Assets - Total Current 1,66,250
capital requirements Liabilities
Working Notes:
Total Cost of Sales = RM + Wages + Overheads + Opening Finished goods inventory – Closing
finished goods inventory.
= Rs. 1,80,000 + Rs. 30,000 + Rs. 60,000 + Rs. 67,500 – Rs. 67,500
= Rs. 2,70,000.
Here it has been assumed that inventory level is uniform throughout the year, therefore
opening inventory equals closing inventory.
Question 5: A proforma cost sheet of a company provides the following particulars:

Particulars Amount per unit


Elements of cost:
Raw materials 80
Direct labour 30
Overhead 60
Total cost 170
Profit 30
Selling price 200
The following further particulars are available:
Raw materials in stock, on average, one month; Materials in process (completion stage,
50 per cent), on average, half a month; Finished goods in stock, on average, one month.
Credit allowed by suppliers is one month; Credit allowed to debtors is two months;
Average time-lag in payment of wages is 1.5 weeks and one month in overhead expenses;
one-fourth of the output is sold against cash; cash in hand and at bank is desired to be
maintained at Rs 3,65,000.
You are required to prepare a statement showing the working capital needed to finance a
level of activity of 1,04,000 units of production. You may assume that production is carried
on evenly throughout the year, and wages and overheads accrue similarly. For calculation
purposes, 4 weeks may be taken as equivalent to a month.
Answer:
Statement showing determination of net working capital
(A) Current assets:
(i) Stock of materials for 1 month: (1,04,000 x Rs 80 x 4/52) Rs 6,40,000
(ii) Work-in-progress for 0.5 month:
(a) Material (1,04,000 x Rs 80 x2/52) x 0.50 1,60,000
(b) Labour (1,04,000 x Rs 30 x 2/52) x 0.50 60,000
(c) Overheads (1,04,000 x Rs 60 x 2/52) x0.50 1,20,000
(iii) Finished goods for 1 month: (1,04,000 x Rs 170 x4/52) 13,60,000
(iv) Debtors for 2 months (78,000 x Rs 170 x8/52) 20,40,000
(v) Cash in hand and at bank 3,65,000
Total investments in current assets 47,45,000
(B) Current liabilities:
(i) Creditors, 1 month’s purchase of raw materials, (i.e. 6,40,000
1,04,000 x Rs.80 x 4/52)
(ii) Average time-lag in payment of expenses
(a) Overheads (1,04,000 x Rs 60 x 4/52) 4,80,000
(b) Labour (1,04,000 x Rs 30 x 3/104) 90,000
Total estimate of current liabilities 12,10,000
(C) Net working capital = Current assets – Current liabilities (A – B) 35,35,000
Working Notes and Assumptions
26,000 units have been sold for cash. Therefore, credit sales pertain to 78,000 units only.

Question 6: JBC Ltd sells goods on a gross profit of 25%. Depreciation is considered as a part of
cost of production. The following are the annual figures given to you
Sales (2 month’s credit) Rs. 1800000
Materials Consumed (1 month credit) Rs. 450000
Wages Paid (1 month lag in payment) Rs. 360000
Cash Manufacturing expenses (1 month lag in payment) Rs. 480000
Administrative expenses (1 month lag in payment) Rs. 120000
Sales Promotion expenses (paid quarterly in advance) Rs. 60000
The company keeps one month’s stock each of raw material and finished goods. It also keeps
Rs.100000 in cash. You are required to estimate the working capital requirements of the
company on cash cost basis, assuming 15% safety margin.
Answer:
1. Current Assets: Rs.
Cash in hand 100000
Debtors 245000
Pre-paid sales promotion expenses 15000
Inventories:
Raw materials 37500
Finished Goods 107500
TOTAL Current Assets 505000
2. Current Liabilities
Sundry creditors 37500
Outstanding Manufacturing expenses 40000
Outstanding Admin. expenses 10000
Outstanding wages 30000
TOTAL Current Liabilities 117500
NWC = CA – CL 387500
Add: 15% contingencies 58125
TOTAL WORKING CAPITAL REQUIRED 445625

Question 7: Prepare a working capital forecast for 1000000 units from the following
information:
Expected ratios of cost to selling price are
Raw materials 40%
Direct Wages 20%
Overheads 20%
Raw materials ordinarily remain in stores for 3 months before production. Every unit of
production remains in the process for 2 months and is assumed to be consisting of 100% raw
material, wages and overheads. Finished good remain in warehouse for 3 months. Credit
allowed by creditors is 4 months and credit given to debtors is 3 months from the date of
dispatch.
Estimated balance of cash to be held is Rs.200000
Lag in payment of wages is half month and Lag in payment of expenses is also half months.
Selling price is Rs.8 per unit. You are required to make a provision of 10% for contingency
(except cash). State your assumptions clearly.
Solution:
1. Current Assets: Rs.
Debtors 1600000
Inventories:
Raw materials 800000
WIP 1066667
Finished Goods 1600000
TOTAL Current Assets 5066667
2. Current Liabilities
Sundry creditors 1066667
Outstanding overheads 66666
Outstanding wages 66667
TOTAL Current Liabilities 1200000
NWC = CA – CL 3866667
Add: 10% contingencies 386667
Cash in hand 200000
TOTAL WORKING CAPITAL REQUIRED 4453334

Question 8: A company plans to manufacture and sell 400 units of washing machines per
month at a price of Rs.600 each. The ratio of cost to selling price are as follows:
Raw Materials: 30%, Packing materials 10%, Direct Labour 15% and direct expense 5%.
Fixed overheads are estimated to be Rs432000 per annum.
The inventory required to be maintained are: Raw materials 30 days, Packing material 15 days,
Finished goods 200 days and work in progress 7 days.
Other particulars are as follows:
a) Credit sales constitute 80% of the total sales.
b) Creditors allow 21 days for payment.
c) Lag in payment and overhead expenses 15 days
d) Cash requirements 12% of the net working capital
e) Assume 300 working days in a year.
Prepare a working capital requirement forecast for the next period.
Answer:
a) Selling Price and Cost Per Unit
Particulars % Amount Amount

Selling Price 600

Raw Materials 30 180


Packing Materials 10 60
Direct Labour 15 90
Direct Expenses 5 30
Fixed Expenses 432000÷4800 90
Total Cost 450
Profit 150

b) Cost of Work-in-Progress is computed by taking into account


100% Raw Materials Rs. 180
50% Labor , expenses and overheads( 50% of 90+30+90) Rs. 105
Cost of Work in Progress Rs.285

c) Forecast of Working Capital Requirements


Current Assets    
Stock:    
Raw Materials 4800×180×30/300 86400
Packing Materials 4800×60×15/300 14400
Work in Progress 4800×285×7/300 31920
Finished Goods 200×450 90000
Debtors 4800×80%×600×30/300 230400
Total Current Assets   453120
     
Current Liabilities    
Creditors for Raw Materials 4800×180×21/300 60480
Creditors for Packing Materials 4800×60×21/300 20160
Creditors for expenses 4800×30×15/300 7200
Creditors for overheads 4800×90×15/300 21600
Total Current Liabilities   109440
     
Net Working Capital (a-b)   343680
Add: Cash (12% of Net Working
capital   41242
Total Working Capital   384921.6

Question 9: X Ltd. Sells goods at a gross profit of 20%. It includes depreciation as part of cost of
production. The following figures for the 12 months ending 31 st March 2019 are given to enable
you to ascertain the requirement of working capital of the company on a cash cost basis.
In your working, you are required to assume that:
a. A safety margin of 15% will be maintained;
b. Cash is to be held to the extent of 50% current liabilities;
c. There will be no work-in-progress;
d. Tax is to be ignored
Stocks of raw materials and finished goods are kept at one month’s requirements.
Rs.
Sales at 2 months credit 27,00,000
Materials consumed (suppliers credit is for 2 months) 6,75,000
Total wages (paid at the beginning of the next month) 5,40,000
Manufacturing expenses outstanding at the end of the year(Paid one month in 60,000
arrears)
Total Administrative expenses (paid as above) 1,80,000
Sales promotion expenses paid quarterly and in advance 90,000

CO4 Answer:
A. Calculation of Manufacturing Cost – (Cash Cost only)
Particulars Rs.
Materials Consumed 6,75,000
Wages 5,40,000
Cash Manufacturing Expenses (60,000 X 12) 7,20,000
Cash Manufacturing Cost 19,35,000
B. Calculation of Cost of Sales – (Cash Cost only)
Particulars Rs.
Cash manufacturing cost (As per ‘A’ above) 19,35,000
Administrative Expenses 1,80,000
Sales Promotion Expenses 90,000
Cash Cost of Sales 22,05,000
Statement of Working Capital
Particulars Rs.
I. Current Assets:
a. Stock of Raw Materials (6,75,000/12) 56,250
b. Finished Stock (1/12 of Rs.19,35,000) 1,61,250
c. Debtors at cost of sales (22,05,000/12)2
d. Cash in Hand (50% of current liabilities) 3,67500
e. Prepaid Sales Promotion Expenses 1,16,250
22,500
Total Current Assets 7,23,750
II. Current Liabilities
a. Creditors for Goods (1/6th of materials consumed) 1,12,500
b. Outstanding Wages (5,40,000/12) 45,000
c. Outstanding Manufacturing Cost (1 month)
d. Outstanding Administrative Exp. (1 month) 60,000
15,000
Total Current Liabilities 2,32,500
Excess of Current Assets over Current Liabilities 4,91,250
Add: Safety Margin @15% 73,687
Net Working Capital on Cash Cost Basis 5,64,937
Module 5: Given the expected dividends, future price of shares, investor expectations and
funding requirements; the future manager will be able to compute the value of a share using
various dividend discount models and illustrate whether dividend is relevant for firm valuation
or not.
CO5: Given the expected dividends, future price of shares, investor expectations, and funding
requirements, the future manager will be able to compute the value of share using various
dividend discount models and illustrate whether the dividend is relevant for firm valuation or
not

Question 1: The following information is available in respect of a firm.


Capitalization Rate = 10%
Earnings per share = Rs.50
Assumed rate of return on investment may be taken at a) 12%, b) 8% or c) 10%
Show the effect of dividend policy on market price of shares applying Walter’s model when
dividend pay our ratio is i) 0% ii) 40% and iii) 100%
Solution:
According to Walter’s Model, price of share is given by
r
(E−D)
P= D ke
+
Ke Ke
Particulars a) r=12% b) r=8% c) r=10%
i) Dividend Pay out r r r
( E−D) ( E−D) ( E−D)
is 0%, therefore D ke D ke D ke
P= + P= + P= +
D=Rs.0 Ke Ke Ke Ke Ke Ke
0.12 0.08 0.10
( 50−0 ) ( 50−0 ) ( 50−0 )
0 0.10 0 0.10 0 0.10
P= + P= + P= +
0.10 0.10 0.10 0.10 0.10 0.10
P = 600 P = 400 P = 500
ii) Dividend Pay out is r r r
( E−D) ( E−D) ( E−D)
40%, therefore D ke D ke D ke
P= + P= + P= +
D=Rs.20 Ke Ke Ke Ke Ke Ke
0.12 0.08 0.10
( 50−20 ) ( 50−20 ) ( 50−20 )
20 0.10 20 0.10 20 0.10
P= + P= + P= +
0.10 0.10 0.10 0.10 0.10 0.10
P = 560 P = 440 P = 500
iiI) Dividend Pay out r r r
( E−D) ( E−D) ( E−D)
is 100%, therefore D ke D ke D ke
P= + P= + P= +
D=Rs.50 Ke Ke Ke Ke Ke Ke
0.12 0.08 0.10
( 50−50 ) ( 50−50 ) ( 50−50 )
50 0.10 50 0.10 50 0.10
P= + P= + P= +
0.10 0.10 0.10 0.10 0.10 0.10
P = 500 P = 500 P = 500
Conclusion: when,
r > k, the company should retain the profits, i.e., when r= 12%, ke= I 0%;
r is 8%, i.e., r < k, the pay-out should be high; and
r is 10%; i.e. r = k; the dividend pay-out does not affect the price of the share

Question 2:
b) The Cement Industry has been through a very trying period in the last five years and the
constraints on operations have been removed in the early part of the year. The company
hopes to improve the position in the years to come and has plans to put up an additional
plant in the neighbourhood of the present factory. Increased profits due to expansion in
capacity are expected to be 25% of the additional capital investment after meeting
interest charges but before depreciation on the additional plant installed. Shares of this
cement company are widely distributed and there is large majority of holdings in the
hands of middle-class investors whose average holding do not exceed 500 shares. The
following data is made available to you.
Last five years:
Particulars 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20
EPS (Rs.) 6.00 5.00 4.50 4.50 4.00 17.50
Cash availability per share 7.50 6.00 5.00 4.00 4.00 20.00
(Rs.)
Dividend per share (Rs.) 3.00 3.00 3.00 2.00 NIL ?
Payout ratio % 50.00 60.00 67.00 45.00 NIL ?
Average market price (face 80.00 70.00 70.00 70.00 60.00 140
value Rs. 100)
P/E ratio 13.33:1 14:1 15.6:1 15.6:1 15
Cement Company requires you to advise them w.r.t the dividend policy they have to follow for
the current year 2019-20. What recommendations would you make? Give reasons for your
answer.
Solution:
The company has a consistent track record of earnings and having a stable dividend policy. The
additional investments would fetch an expected return of 25%. The current year’s EPS is Rs.
17.50 and cash EPS is Rs. 20. The average current market price is Rs.140. The dividend pay-out
of 2017-18 is 45% and in 2018-19 is Nil. This would be due to use of retained earnings for
additional capital investment without use of external financing. This has reflected in the
increase of EPS to Rs. 17.50. The growth in earnings is likely to continue, since the company is
also planning for setting up of an additional plant in the neighbourhood of the present factory.
The savings in costs will further improve the future earning of the company. In view of the
above, the company is suggested to have a dividend pay-out ratio of 60% which requires the
cash outgo of Rs. 10.50. The cash EPS will also enable the pay-out of 60%.
Since the market price of share is increased to Rs. 140, the dividend yield works out to only
7.5% (10.50/140 x100). The company has widely distributed shareholding with a dividend
clientele of middle-class investors whose shareholding does not exceed 500 shares in the
company. The dividend payable to them many no to be tax deductible. The small investors
prefer to receive dividends periodically. The price earnings ratio of the current year is 8
(140/17.50). It is expected that the market price of share would further increase due to its
current low PE ratio. The setting up of additional plant would require raising funds from
external sources by issue of new shares. To attract the potential investors for company’s shares,
it is required to have a dividend pay-out of 60%. But a higher dividend pay-out is not suggested,
since retained earnings can be used in further expansion and growth schemes.
b) The following information is available in respect of XYZ Ltd.
Earnings per share – Rs.10
Cost of capital Ke – 0.10
Rate of return of company - 10%
Find out the market price of share as per Gordon’s model for pay-out ratios of 10%, 40%, 80%
and 100%. Comment on the results of your calculations.
Answer: As per
P = [E(1-b)]/[Ke-br]
P=[10(1-0.90)]/[0.10-0.09] = 100
P=[10(1-0.60)]/[0.10-0.06] = 100
P=[10(1-0.20)]/[0.10-0.02] = 100
P=[10(1-0)]/[0.10-0.00] = 100
Comment: If r=Ke, the dividend is irrelevant.

Question 3: Rose Ltd. has a capital of Rs. 10,00,000 in equity shares of Rs. 100 each. The shares
are currently quoted at par. The company proposes to declare a dividend of Rs. 10 per share at
the end of the current financial year. The capitalization rate for the risk class of which the
company belongs is 12%. Compute market price of the share at the end of the year, if:
1. Dividend is not declared?
2. Dividend is declared?
3. Assuming that the company pays a dividend and has net profits of Rs. 5,00,000
and makes new investments of Rs.10,00,000 during the period, how many new
shares must be issued? Use the MM model.
4. Show that the total market value of the shares at the end of the accounting year will remain
the same whether dividends are either distributed or not distributed. Also find out the
current market value of the firm under both situations.
Answer:
Given:
Cost of Equity (Ke) 12%
Number of shares in the beginning (n) 10,000
Current Market Price (P0) Rs. 100
Net Profit (E) Rs. 5,00,000
Expected Dividend Rs. 10 per share
Investment (I) Rs. 10,00,000
Computation of market price per share, when:
1. No dividend is declared:
P₀ = P1 +D1
1+Ke
100 = P1 +0
1+ 0.12
P1=112 – 0
= Rs. 112
2. Dividend is declared:
100 = P1 + 10
1+ 0.12
P1=112 – 10
= Rs. 102
3. Calculation of funds required for investment:
Earning 5,00,000
Dividend distributed 1,00,000
Fund available for investment 4,00,000
Total Investment 10,00,000
Balance Funds required 10,00,000 - 4,00,000
= Rs. 6,00,000

No. of shares = Funds required / Price of the share


= 6,00,000 / 102
= 5882.35 or 5883 Shares
Value of the firm in both cases = V = [(N+n)P1+E-I]/(1+Ke) = Rs. 1000000

Question 4: Bajaj Ltd. has 1,20,000 shares outstanding and selling at Rs. 20 each in the market.
The company hopes to make a net income of Rs. 3,50,000 during the year ended 31st March,
2009. The company is considering to pay a dividend of Rs. 2 per share at the end of the current
year. The capitalization rate for class of this company has been estimated to be 15% using MM
Dividend Valuation Model.
a) What will be the price of a share at the end of the year: (i) if dividend is paid and (ii) if
dividend is not paid?
b) How many new shares must the company issue if the dividend is paid and the company
needs Rs. 7,40,000 for an approved investment expenditure during the year?
c) Show that the total market value of the shares at the end of the accounting year will
remain the same whether dividends are either distributed or not distributed. Also find out
the current market value of the firm under both situations.

Answer:
a) Calculation of market price per share under MM Dividend Valuation Model:
P1 = P0 (1 + Ke) –D1

i. If dividend is declared:

P1 = P0 (1 + Ke) – D1

= 20 (1 + 0.15) – 2
= 20 (1.15) – 2
= Rs. 21
ii. If dividend is not declared:
P1 = P0 (1 + Ke) – D1

= 20 (1 + 0.15) – 0

= 20 (1.15)

= Rs. 23

b) Calculation of number of shares of new shares to be issued:


Particulars Dividend Dividend Not
Declared Declared
Net income (Rs.) 3,50,000 3,50,000
Less: Dividend paid 2,40,000 –
Retained earnings 1,10,000 3,50,000
New investments 7,40,000 7,40,000
Amount to be raised by issue of new shares 6,30,000 3,90,000
Market price per shares 21 23
Number of new shares to be issued 30,000 16,957

c) Calculation of value of firm:


Value of the firm in both cases = V = [(N+n)P1+E-I]/(1+Ke) = Rs. 2400000

Question 5: A company belongs to a risk-class for which the appropriate capitalization rate is
10%. It currently has outstanding 25,000 shares selling at Rs. 100 each. The firm is
contemplating the declaration of dividend of Rs. 5 per share at the end of the current financial
year. The company expects to have a net income of Rs.2.5 lakhs and a proposal for making new
investments of Rs. 5 Lakhs. Show that under the MM assumptions, the payment of dividend
does not affect the value of the firm.
Answer:
Existing Market Price per share (P0) = Rs.100
Contemplated DPS (D1) = Rs. 5
Rate of Capitalization (Ke) = 10% or 0.10
Market price as per MM approach is,
D 1 + P1
P0=
1+ k e
i. If contemplated dividends are declared, then

5+ P1
100=
1+0.10
or, P1=105

ii. If dividends are not declared, then


0+ P 1
100=
1+0.10
or, P1=110

Calculation of number of shares to be issued


Dividends Dividends
Distributed not
Distributed
Net Income Rs. 2,50,000 Rs. 2,50,000
Less: Total Dividends 1,25,000 --
Retained Earnings (A) 1,25,000 2,50,000
Investment Budget (B) 5,00,000 5,00,000
Amount to be raised by new issues (B-A) 3,75,000 2,50,000
Relevant Market Price per share 105 110
No. of new shares to be issued 3,571.4 2,272.7

Calculation of Value of the Firm


Dividends Dividends
Distributed not
Distributed
Existing No. of Shares 25,000.0 25,000.0
Add: New shares issued 3,571.4 2,272.7
Total No. of shares at the end of the year 28,571.4 27,272.7
Market Price Per Share (Rs.) 105 110
Value of the Firm (Total No. of shares X Rs. 30,00,000 Rs. 30,00,000
MPS)
Thus, the total market value of shares remains unaffected whether dividends are distributed or
not distributed at all.

Question 6: A firm has 200000 shares outstanding and is planning to declare a dividend of Rs.6
at the end of the current financial year. The present market price of the share is Rs.100. The
cost of equity capital ke, may be taken as 12%. .
Find the expected price of the share at the end of the current financial year.
Further, the company is planning to make a new investment of Rs.180000. The total profits of
the year 1 is Rs.1600000.Should the firm declare dividend or retain the profit for financing the
new project? Use MM approach.
Show that the total market value of the shares at the end of the accounting year will remain the
same whether dividends are either distributed or not distributed. Also find out the current
market value of the firm under both situations.

Answer:
a) Market Price at the end of the year if dividend is not paid:
The current price of the share is the total of dividends and expected price at the end of
year 1 discounted by the cost of equity
i.e., P0 = (D1+P1)/ 1+Ke
100 = (0+P1)/ 1+0.12
Solving this , P1=112
b) Market Price at the end of the year if dividend is paid
i.e., P0 = (D1+P1)/ 1+Ke
100 = (6+P1)/ 1+0.12
Solving this, P1=106
c) Number of shares required to be issued
Particulars If dividend is not paid If dividend is paid
Profit 1600000 1600000
Less: Dividend 0 1200000
Retained Profit 1600000 400000
New Investment 1800000 1800000
Amount to be raised through equity(New 200000 1400000
Investment minus Retained Profit)
Price of share 112 106
No of equity shares to be issued 1785.71 13207.55
Total number of shares 201785.71 213207.55
Value of the firm 22600000 22600000

Question 7: Determine the market value of the equity shares of company from following
information:
Earnings of company: Rs.500000
Dividend Paid Rs.300000
Number of shares outstanding 100000
Price-Earnings ratio 8
Rate of return on investment 15%
Are you satisfied by the current dividend policy of the firm? If not, what should be the optimal
dividend payout ratio as per Walter’s Model?
Answer:
EPS = 500000/100000=5
DPS= 300000/100000=3
Dividend payout ratio = DPS/EPS=3/5=60%
Ke=E/P=1/8=0.125 or 12.5%
MPS = EPS*P/E = 8*5=40
Or As per Walter Model
P = [5/12.5%]+ (0.15/0.125)*(8-3)/0.125
As per Walter model, when r>ke, 100% retention is recommended.
MPS at 0% payout = Rs.48.
Question8: Gordon limited has invested Rs. 500 lakhs in assets. There are 50 lakhs shares
outstanding. The par value per share is Rs. 10. It earns a rate of 15% on its investment and has a
policy of retaining 50% of earnings. If the appropriate discount rate of the company is 10%,
what is the price of its shares using the Gordon’s model? What will happen to the price of the if
the company has a dividend payout (D/P) ratio of 80% or 20%.

E(1−b)
Answer: Gordon’s Share Valuation Model: E =
Ke−br
Where,
Rate of return on investments (r) = 15% ; Cost of capital (ke) = 10%
Earning per share (E) = Net Income / Number of Outstanding Shares = 500 x 15% / 50 = 75 / 50
= 1.5
1) If Dividend payout ratio (D/P ratio) = 50%
Retention ratio (b) = 100% - 50% = 50%
Growth rate (br) = Retention ratio x Rate of return on investments = 0.50 x 0.15 = 0.075
Price of share (P) = 1.5 (1 – 0.50) / 0.10 – 0.075 = 0.75 / 0.025 = Rs. 30
Thus, Price of share (P) is Rs. 30, when D/P ratio is 50%.
2) If Dividend payout ratio (D/P ratio) = 80%
Retention ratio (b) = 100% - 80% = 20%
Growth rate (br) = Retention ratio x Rate of return on investments = 0.20 x 0.15 = 0.03
Price of share (P) = 1.5(1-0.20) / 0.10-0.03 = 1.20/0.07 = 17.14
Thus, Price of share (P) is Rs. 17.14, when D/P ratio is 80%.
3) If Dividend payout ratio (D/P ratio) = 20%
Retention ratio (b) = 100% - 20% = 80%
Growth rate (br) = Retention ratio x Rate of return on investments = 0.80 x 0.15 = 0.12
Price of share (P) = 1.5(1-0.80) / 0.10-0.12 = 0.3/-0.02 = Rs. -15
Thus, Price of share (P) is -15, when D/P ratio is 20%.
Note: ‘Ke’ and ‘r’ remain constant and will not change due to retention policies of firm and
uncertainty of earnings. If these factors and allowed to be changed, the negative share price
does not exist.

You might also like