CA INTERMEDIATE – NOV 23 ATTEMPT

FINANCIAL MANAGEMENT
SUPER REVISION (MARATHON) :- PART II
S. NO. CHAPTERS
1 INVESTMENT DECISION
2 RISK ANALYSIS IN CAPITAL BUDGETING
3 DIVIDEND DECISIONS
4 RATIO ANALYSIS
 INVESTMENT DECISIONS – CONCEPTS
1. Capital Budgeting or Investment Decisions
These are related to long term investment decisions or for fixed assets.

2. Types of Decisions
(A) Mutually Exclusive – Select one and rest all gets rejected
(B) Independent – Select any number of projects
(C) Complimentary – If main even accepted then associated events will also get accepted
(D) Replacement or Modernisation – Old assets are replaced with new assets
(E) Expansion – It is done to increase production capacity
(F) Diversification – It is aimed for introduction of new product

3. Calculation of Book Profit

Particulars Amount (`)
Operating Revenue (e.g. sales etc.) -
Less: Operating cash costs -
Profit before depreciation (or Cash flow before tax) -
Less: Depreciation -
Profit before tax -
Less: Tax -
Profit after tax -

4. Calculation of Cash Flows

Cash flows before tax = PBD
Cash flows after tax = PBD – Tax + Tax saving on loss
Cash flows after tax = PAT + Depreciation + Tax saving on loss

Cash flow after tax = Cash flow before tax (1 – t) + (Depreciation ´ t)

5. Cash flows from sale of assets

Particulars Amount (`)

Cost of Assets -
Less: Accumulated depreciation -
Book value of assets (A) -
Sale value of assets (B) -
Profit/(loss) on sale of assets (A – B) -
Tax/(tax saving) on sale (C) -
Net cash flows from sale of assets (D = B – C) -

6. Concept of Block of Assets

7. Techniques of Capital Budgeting

(A) Traditional techniques:
(1) Accounting Rate of Return (ARR)
(2) Payback period (PBP)
 (B) Modern Techniques
(1) Discounted Payback period
(2) Net Present Value (NPV)
(3) Profitability Index (PI)
(4) Internal Rate of Return (IRR)
(5) Modified Internal Rate of Return (MIRR)

8. Accounting Rate of Return or Average Rate of Return (ARR)

It is the rate of return generated on the funds invested which is based on book profits.
!"#$%&# (!)
ARR = !"#$%&# *+"#,-.#+- × 100

!"#$%&# (!)
ARR on Original investment = /$0&0+%1 *+"#,-.#+- × 100

Where,
(!)23(!)43⋯3(!)+
Average PAT = +

!*23!*43⋯3!*+
Average investment of Project =
+

/6#+0+&3718,0+&
Average investment of a year (AI) =
4

Average Investment of Project = ½(Cost of Project – Scrap value) + Scrap Value + WC

(in case of SLM)
Decision Criteria
General Rule - Maximum ARR
Mutually Exclusive – Project with maximum ARR
Independent:
Project ARR > Required ARR
Project ARR < Required ARR
Project ARR = Required ARR
9. Payback Period
It is the duration during which cost of project is recovered out of cash inflows.
78,- 89 ($8:#;-
Payback period (when CFs are equal) = !++<%1 7%,= *+918>

Payback period (when CFs are unequal)

- Calculate cumulative cash flows
- Calculate PBP
!"#$%&# !++<%1 7%,= *+918>
Payback reciprocal = *+0-0%1 0+"#,-.#+-

Decision Criteria
General Rule - Minimum PBP
Mutually Exclusive – Project with minimum PBP
Independent:
Project PBP > Required PBP
Project PBP < Required PBP
Project PBP = Required PBP

10. Time Value of Money

 Compounding Discounting

11. Discounted Payback Period

It is the duration during which cost of project is recovered from present value of cash
inflows of the project.
Step - 1) Calculate discounted cash inflows
Step – 2) Calculate discounted payback period
Decision Criteria
General Rule - Minimum Discounted PBP
Mutually Exclusive – Project with minimum Discounted PBP
Independent:
Project Discounted PBP > Required Discounted PBP
Project Discounted PBP < Required Discounted PBP
Project Discounted PBP = Required Discounted PBP
12. Net Present Value (NPV)
NPV = PV of cash inflows – PV of cash outflows = PVCI – PVCO
If life of project are different then decision will be based on equivalent annual NPV or
equivalent annual PVCO
?(@
Equivalent Annual NPV = (@!A 98$ B09#

(@7/
Equivalent Annual PVCO =
(@!A 98$ B09#

Decision Criteria
General Rule - Maximum NPV
Mutually Exclusive – Project with maximum NPV
Independent:
NPV =

13. Points to Remember (PTRs)

Unless otherwise provided, following points are to be assumed:
(a) Cost of project will be incurred at beginning of the project
(b) Working capital investment will be incurred at beginning of the project
(c) Revenue cash inflows will be at the end of the respective year
(d) 100% of working capital will be realized at end of the project
(e) Sale of assets
14. Treatment of Costs

15. Profitability Index (PI)

It is the amount of cash inflow generated for every rupee of cash outflows.
(@7*
PI = (@7/

Decision Criteria
General Rule - Maximum PI
Mutually Exclusive – Project with maximum PI
Independent:
PI =
16. Capital Rationing

17. Internal Rate of Return (IRR)

- Calculate NPV at discount rate given in question (can start with any % given in ques.)
- If NPV is +ve, increase rate to make it -ve.
- If NPV is -ve, decrease rate to make it +ve.
BC ?(@
- IRR = $% + '(BC ?(@EFC ?(@)( (*% − $% )

Decision Criteria
General Rule - Maximum IRR
Mutually Exclusive – Project with maximum IRR
Independent:
IRR =
18. NPV vs IRR
NPV is superior to IRR due to:
(a) Reinvestment rate assumption

(b) Multiple IRR can be computed with same data but it is not possible with NPV

19. Modified Internal Rate of Return (MIRR)

It is based on compounding technique.
It assumes reinvestment of intermediate cash flows at cost of capital only.
Step – 1) Calculate total compound value of intermediate cash flows at end of project

Step – 2) Initial outflow ´ (1 + r)n = Total compound value

From above equation find r which is equal to MIRR

! )8-%1 78.68<+H @%1<#

Or MIRR = - −1
*+0-0%1 8<-918>

Decision Criteria
General Rule - Maximum MIRR
Mutually Exclusive – Project with maximum MIRR
Independent:
MIRR =

20. Replacement Decisions

(a) Calculate Initial cash outflows

Particulars Amount
Cost of new assets -
(-) Sale value of old assets -

(-) Tax saving on loss on sale of old assets -

 (+) Tax payment on profit on sale of old assets -

(+) Increase in working capital -

(-) Decrease in working capital -

Cash Outflows -

(b) Calculate Incremental Revenue CFs

Particulars Amount

Increase in sales -

(+) Savings in costs -

(-) Increase in costs -

Incremental PBD -

(-) Increase in Depreciation (New – Old) -

Incremental PBT -

(-) Tax -
Incremental CFs -

(c) Calculate incremental sale of assets at end and working capital realization
(d) Calculate NPV or IRR and take decision
 INVESTMENT DECISIONS – QUESTIONS
Question – 1
CK Ltd. is planning to buy a new machine. Details of which are as follows:
Cost of the Machine at the commencement `2,50,000
Economic Life of the Machine 8 years
Residual Value Nil
Annual Production Capacity of the machine 1,00,000 units
Estimated Selling Price per unit `6
Estimated annual fixed cost (excluding depreciation) `1,00,000
Estimated variable cost per unit (excluding depreciation) `3
Advertisement expenses in 1st year in addition of annual fixed cost `20,000
th
Maintenance expenses in 5 year in addition of annual fixed cost `30,000
Cost of capital 12%
Ignore tax
Analyze the above mentioned proposal using the Net Present Value Method and advice.
PV Factor at 12% are as under:
Year 1 2 3 4 5 6 7 8
PV Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404

Solution
Statement of Present Value of Cash Flows
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Units 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Contribution 3 3 3 3 3 3 3 3
per unit (6 –
3)
Total 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Contribution
(-) Fixed 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Cost
(-) Advert. 20,000 - - - - - - -
(-) Maint. - - - - 30,000 - - -
Profit Before 1,80,000 2,00,000 2,00,000 2,00,000 1,70,000 2,00,000 2,00,000 2,00,000
Dep. or CF
PVF @ 12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404
Present 1,60,740 1,59,400 1,42,400 1,27,200 96,390 1,01,400 90,400 80,800
Value
Total Present value of cash inflows = 9,58,730 (from above table)
NPV = PVCI – PVCO = 9,58,730 – 2,50,000 = `7,08,730
It is recommended to accept the proposal as it has positive NPV.
Question – 2
You are a financial analyst of B limited. The director of finance has asked you to analyze two capital
investments proposals, Projects X and Y. Each project has a cost of `10,000 and the cost of capital
for each project is 12%. The project’s expected net cash flows are as follows:
Year Expected net cash flows
Project X (`) Project Y (`)
0 (10,000) (10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
(a) CALCULATE each project’s payback period, net present value (NPV) and internal rate of return
(IRR).
(b) DETERMINE, which project or projects should be accepted if they are independent?

Solution
(a) Computation of Payback Period
Year Project X Project Y
CF Cumulative CF Cumulative
1 6,500 6,500 3,500 3,500
2 3,000 9,500 3,500 7,000
3 3,000 12,500 3,500 10,500
4 1,000 13,500 3,500 14,000

!","""$%,&""
Payback period of Project X = 2 + ',"""
= 2.17 years
!","""$(,"""
Payback period of Project B = 2 + ',&""
= 2.86 years

Statement of NPV
Year PVF Project X Project Y
@12% CF PV CF PV
0 1 (10,000) (10,000) (10,000) (10,000)
1 0.893 6,500 5,805 3,500 3,126
2 0.797 3,000 2,391 3,500 2,790
3 0.712 3,000 2,136 3,500 2,492
4 0.636 1,000 636 3,500 2,226
NPV 968 634

Statement of NPV
Year PVF Project X Project Y
@20% CF PV CF PV
0 1 (10,000) (10,000) (10,000) (10,000)
1 0.833 6,500 5,415 3,500 2,916
 2 0.694 3,000 2,082 3,500 2,429
3 0.579 3,000 1,737 3,500 2,067
4 0.482 1,000 482 3,500 1,687
NPV (284) (901)

%)*
IRR of Project X = 12 + !%)*$($,*-)" (20 − 12) = 18.19%
)'-
IRR of Project Y = 12 + !)'-$($%"!)" (20 − 12) = 15.27%

(b) Conclusion:
Particulars Project that rank higher
Payback period Project X
NPV Project X
IRR Project X

Question – 3
GG Pathology Lab Ltd. is using 2D sonography machine which has reached the end of its useful life.
The lab is intending to upgrade along with the technology by investing in 3D sonography machine as
per the choices preferred by the patients. Following new 3D sonography machine of two different
brands with same features is available in the market:
Brand Cost of Life of Maintenance SLM
machine machine cost (`) Depreciation
(` ) (` ) rate (%)
Year 1-5 Year 6-10 Year 11-
15
X 15,00,000 15 50,000 70,000 98,000 6
Y 10,00,000 10 70,000 1,15,000 - 6
Residual value of machines shall be dropped by 10% and 40% of purchase price for Brand X and Y
respectively in the first year and thereafter shall be depreciated at the rate mentioned above on the
original cost.
Alternatively, the machine of Brand Y can also be taken on rent to be returned back to the owner after
use on the following terms and conditions:
Annual rent shall be paid in the beginning of each year and for first year it shall be `2,24,000.
Annual rent for the subsequent 4 years shall be `2,25,000.
Annual rent for the final 5 years shall be `2,70,000.
The rent agreement can be terminated by GG Labs by making a payment of `2,20,000 as penalty.
This penalty would be reduced by `22,000 each year of the period of rental agreement.
You are required to:
(i) Advise which brand of 3D sonography machine should be acquired assuming that the used of
machine shall be continued for a period of 20 years.
(ii) State which of the option is most economical if machine is likely to be used for a period of 5
years?
The cost of capital of GG Labs is 12%.
The present value factor of `1 @12% for different years is given as under:
Year PVF Year PVF
1 0.893 9 0.361
2 0.797 10 0.322
3 0.712 11 0.287
4 0.636 12 0.257
5 0.567 13 0.229
6 0.507 14 0.205
7 0.452 15 0.183
8 0.404 16 0.163

Solution
(i) Statement of Equivalent Annual Cost if Brand X is purchased
Period Cash Outflows PVF @ 12% PV (`)
0 15,00,000 1.000 15,00,000
1-5 50,000 3.605 1,80,250
6-10 70,000 2.046 1,43,220
11-15 98,000 1.161 1,13,778
15 (90,000)* 0.183 (16,470)
Total PVCO (A) 19,20,778
PVAF (1-15 year) (B) 6.812
Equivalent Annual PVCO (A÷B) 2,81,969.76
*Residual value = [15,00,000 × (1-0.10)] – (15,00,000 × 0.06 × 14) = `90,000

Statement of Equivalent Annual Cost if Brand Y is purchased

Period Cash Outflows PVF @ 12% PV (`)
0 10,00,000 1.000 10,00,000
1-5 70,000 3.605 2,52,350
6-10 1,15,000 2.046 2,35,290
10 (60,000)* 0.322 (19,320)
Total PVCO (A) 14,68,320
PVAF (1-10 year) (B) 5.651
Equivalent Annual PVCO (A÷B) 2,59,833.66
*Residual value = [10,00,000 × (1-0.40)] – (10,00,000 × 0.06 × 9) = `60,000

Statement of Equivalent Annual Cost if Brand Y is taken on rent

Period Cash Outflows PVF @ 12% PV (`)
0 2,24,000 1.000 2,24,000
1-4 2,25,000 3.038 6,83,550
5-9 2,70,000 2.291 6,18,570
Total PVCO (A) 15,26,120
PVAF (1-10 year) (B) 5.651
Equivalent Annual PVCO (A÷B) 2,70,061.94
Since equivalent annual cash outflow is lease in case of purchase of machine of brand Y the same
should be purchased.

(ii) If machine is used for 5 years.

Statement of Equivalent Annual Cost if Brand X is purchased
Period Cash Outflows PVF @ 12% PV (`)
0 15,00,000 1.000 15,00,000
1-5 50,000 3.605 1,80,250
5 (9,90,000)* 0.567 (5,61,330)
Total PVCO (A) 11,18,920
*Residual value = [15,00,000 × (1-0.10)] – (15,00,000 × 0.06 × 4) = `9,90,000

Statement of Equivalent Annual Cost if Brand Y is purchased

Period Cash Outflows PVF @ 12% PV (`)
0 10,00,000 1.000 10,00,000
1-5 70,000 3.605 2,52,350
5 (3,60,000)* 0.567 (2,04,120)
Total PVCO (A) 10,48,230
*Residual value = [10,00,000 × (1-0.40)] – (10,00,000 × 0.06 × 4) = `3,60,000

Statement of Equivalent Annual Cost if Brand Y is taken on rent

Period Cash Outflows PVF @ 12% PV (`)
0 2,24,000 1.000 2,24,000
1-4 2,25,000 3.038 6,83,550
5 1,10,000* 0.567 62,370
Total PVCO (A) 9,69,920
*Cash flow = 2,20,000 – (22,000 × 5) = `1,10,000

Since equivalent annual cash outflow is lease in case of rent of machine of brand Y the same should
be taken on rent.

Question – 4
A chemical company is presently paying an outside firm `1 per gallon to dispose off the waste material
resulting from its manufacturing operations. At normal operating capacity, the waste is about 50,000
gallons per year.

After spending `60,000 on research, the company discovered that the waste could be sold for `10 per
gallon if it was processed further. Additional processing would however, require an investment of
`6,00,000 in new equipment, which would have an estimated life of 10 years with no salvage value.
Depreciation would be calculated by straight line method.
Except for the costs incurred in advertising `20,000 per year, no change in the present selling and
administration expenses is expected, if the new product is sold. The details of additional processing
costs are as follows:
Variable – `5 per gallon of waste put into process
Fixed (excluding depreciation) – `30,000 per year

In costing the new product, general administrative overheads will be allocated at the rate of `2 per
gallon. There will be no losses in processing and it is assumed that the total waste processed in a given
year will be sold in that year. Estimates indicate that 40,000 gallons, of the product could be sold each
year. The management when confronted with the choice of disposing off the waste or processing it
further and selling it, seeks your advice. Which alternative would you recommend? Assume that the
firm’s cost of capital is 15% and it pays on an average 35% tax on its income.
Note: Present value of annuity of `1 at 15% rate of discount for 10 years is 5.019.
Solution
Statement of NPV
Particulars Amount
Sales (40,000 × 10) 4,00,000
(-) Variable cost (40,000 × 5) (2,00,000)
(-) Fixed cost (30,000)
(-) Advertisement cost (20,000)
(+) Saving in disposal cost (50,000 – 10,000) 40,000
Profit before depreciation (A) 1,90,000
(-) Depreciation (6,00,000 ÷ 10) 60,000
Profit before tax 1,30,000
(-) Tax @ 35% 45,500
Profit after tax 84,500
(+) Depreciation 60,000
Cash inflows 1,44,500
PVAF(15%, 10 years) 5.019
PVCI 7,25,246
Initial Investment – PVCO 6,00,000
NPV 1,25,246

Question – 5
A large profit making company is considering the installation of a machine to process the waste
produced by one of its existing manufacturing process to be converted into a marketable product. At
present the waste is removed by a contractor for disposal on payment by the company of `150 lakhs
per annum for the next four years. The compensation of `90 lakhs to contractor will be paid before
the processing operations starts. This compensation is not allowed as deduction for tax purposes.
The machine required for carrying out the processing will cost `600 lakhs to be financed by a loan
repayable in 4 equal installments commencing from the end to the year. The interest rate is 14% per
annum. At the end of the 4th year, the machine can be sold for `60 lakhs and the cost of dismantling
and removal will be `45 lakhs.
Sales and direct costs of the produce emerging from waste processing for 4 years are estimated as
under:
(`in lakhs)
Year 1 2 3 4
Sales 966 966 1,254 1,254
Material Consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory Overheads 165 180 330 435
Depreciation (as per income tax rules) 150 114 84 63
Initial stock of material required before commencement of the processing operation `60 lakhs at the
start of year 1. The stock levels of material to be maintained at the end of year 1, 2 and 3 will be `165
lakhs. And the stocks at the end of year 4 will be nil. The storage of materials will utilize space which
would otherwise have been rented out for `30 lakhs per annum. Labour costs include wages of 40
workers, whose transfer to this process will reduce idle time payments of `45 lakhs in year 1 and `30
lakhs in year 2. Factory overheads include apportionment of general factory overheads except to the
extent of insurance charges of `90 lakhs per annum payable on this venture. The company’s tax rate
is 30%. Present value factors for four years are as under:-
Year 1 2 3 4
PV Factor @14% 0.877 0.769 0.674 0.592
Advice the management on the desirability of installing the machine for processing the waste. All
calculation should form part of the answer.
Solution
Statement of NPV (` in lakhs)
Particulars Time PVF Amount Present Value
Compensation to contractor 0 1 90.00 90.00
Principal payment of loan 1–4 2.912 150.00 436.80
Working capital 0 1 60.00 60.00
PVCO 586.80

Cash inflows 1 0.877 305.40 267.84

2 0.769 372.30 286.30
 3 0.674 424.20 285.91
4 0.592 532.50 315.24
Cash flow from sale of assets 4 0.592 15.00 8.88
PVCI 1,164.17
NPV (PVCI – PVCO) 577.37
Since the project has positive NPV, therefore it should be accepted.
Working Note -1 Statement of Cash Flows (` in lakhs)
Particulars Year 1 Year 2 Year 3 Year 4
Sales 966 966 1,254 1,254
(-) Material consumed (90) (120) (255) (255)
(-) Wages (180) (195) (255) (300)
(-) Other expenses (120) (135) (162) (210)
(+) Saving in disposal cost 150 150 150 150
(-) Interest @14% (84) (63) (42) (21)
(-) Opportunity cost of rent (30) (30) (30) (30)
(-) Insurance (90) (90) (90) (90)
Profit before depreciation (A) 522 483 570 498
(-) Depreciation (150) (114) (84) (63)
Profit before tax 372 369 486 435
Tax @ 30% (B) 111.60 110.70 145.80 130.50
Cash Flow (A – B) 410.40 372.30 424.20 367.50
(+) Material consumed 90 120 255 255
(-) Material purchased (195) (120) (255) (90)
Net Cash Flow 305.40 372.3 424.20 532.50
Working Note- 2 Statement of Calculation of Material Purchased (` in lakhs)
Particulars Year 1 Year 2 Year 3 Year 4
Material Consumed 90 120 255 255
(+) Closing stock of material 165 165 165 -
(-) Opening stock of material (60) (165) (165) (165)
Material Purchased 195 120 255 90

Question – 6
A company has `1,00,000 available for investment and has identified the following four investments
in which to invest.
Project Investment (`) NPV (`)
C 40,000 20,000
D 1,00,000 35,000
 E 50,000 24,000
F 60,000 18,000
You are required to optimize the returns from a package of projects within the capital spending limit
if:
(a) The projects are independent of each other and are divisible
(b) The projects are not divisible

Solution
(a) Computation of NPV per `1 of investment and Ranking of Projects
Project Investment (`) NPV (`) NPV per `1 Ranking
invested (`)
C 40,000 20,000 0.50 1
D 1,00,000 35,000 0.35 3
E 50,000 24,000 0.48 2
F 60,000 18,000 0.30 4

Calculation of Package of Projects

Project Investment (`) NPV (`)
C 40,000 20,000
E 50,000 24,000
th
D (1/10 of Project) 10,000 3,500
Total 1,00,000 47,500
The company would be well advised to invest in Project C, E and D (1/10th) and reject Project F to
optimize return within the amount of `1,00,000 available for investment.

(b) Calculation of Package of Projects

Package of Project Investment (`) NPV (`)
C and E 90 000 44,000
(40,000 + 50,000) (20,000 + 24,000)
C and F 1,00,000 38,000
(40,000 + 60,000) (20,000 + 18,000)
Only D 1,00,000 35,000
The company would be well advised to invest in Projects C and E to optimize return within the amount
of `1,00,000 available for investment.

Question – 7
Given below are the data on a capital project ‘S’:
Annual cost saving `60,000
Useful life 4 years
Internal rate of return 15%
Profitability index 1.064
Salvage value 0
You are required to calculate for this project S:
(a) Cost of project
(b) Payback period
(c) Cost of capital
(d) Net Present Value
Given the following table of discount factors:
Discounting Factor 15% 14% 13% 12%
1 year 0.869 0.877 0.885 0.893
2 year 0.756 0.769 0.783 0.797
3 year 0.658 0.675 0.693 0.712
4 year 0.572 0.592 0.613 0.636
2.855 2.913 2.974 3.038
Solution
(a) Cost of Project S:
At 15% IRR,
PV of cash inflows = PV of cash outflows
Annual cash inflow × PVAF(15%, 4) = PV of cash outflows
60,000 × 2.855 = PV of cash outflows
PV of cash outflows = `1,71,300
⸫ Cost of project = `1,71,300
/012 04 5607892 !,(!,'""
(b) Payback period = :;;<=> 9=1? @;4>0A = )","""
= 2.855 years

(c) Cost of capital of Project S:

BC 04 9=1? @;4>0A1
Profitability index = BC 04 9=1? 0<24>0A1
:;;<=> 9=1? @;4>0A1×BC:E
1.064 = !,!(,'""

Annual cash inflows × PVAF = 1,82,263.20

60,000 × PVAF = 1,82,263.20
!,*,,,)'.,"
PVAF = = 3.038
)","""

Considering the data provided in questions, the PVAF are at a discount rate of 12%.
⸫Cost of capital = 12%
(d) NPV of project S = PV of cash inflows – PV of cash outflows
= (60,000 × PVAF(12%,4)) – 1,17,300 = (60,000 × 3.038) – 1,17,300
= `10,963.20

Question – 8
Calculate MIRR from the following data, if cost of capital is 9%:
 Year Cash Flows (`)
0 1,50,000
1 40,000
2 70,000
3 90,000
4 30,000
5 50,000
Solution
Statement of Compound Value
Year Cash Flows (`) CVF @ 9% CV
1 40,000 1.412 56,480
2 70,000 1.295 90,650
3 90,000 1.188 1,69,290
4 30,000 1.090 32,700
5 50,000 1.000 50,000
Total 3,99,120
! ',%%,!,"
MIRR = )!,&",""" − 1 = 21.62%

Question – 9
Shiv Limited is thinking of replacing its existing machine by a new machine which would cost `60
lakhs. The company’s current production is 80,000 units, and is expected to increase to 1,00,000 units,
if the new machine is bought. The selling price of the product would remain unchanged at `200 per
unit. The following is the cost of producing one unit of product using both the existing and new
machine:
Existing Machine New Machine Unit Cost (`)
(80,000 units) (1,00,000 units) Difference
Materials 75.0 63.75 (11.25)
Wages & Salaries 51.25 37.5 (13.75)
Supervision 20.0 25.0 5.0
Repairs & Maintenance 11.25 7.5 (3.75)
Power & Fuel 15.5 14.25 (1.25)
Depreciation 0.25 5.0 4.75
Allocated Corporate Overheads 10.0 12.5 2.5
183.25 165.5 (17.75)
The existing machine has an account book value of `1,00,000, and it has been fully depreciated for
tax purpose. It is estimated that machine will be useful for 5 years. The supplier of the new machine
has offered to accept the old machine for `2,50,000. However, the market price of old machine today
is `1,50,000 and it is expected to be `35,000 after 5 years. The new machine has a life of 5 years and
a salvage value of `2,50,000 at the end of its economic life. Assume corporate income tax rate of 40%
and depreciation is charged on straight line basis for income tax purposes. Further assume that book
profit is treated as ordinary income for tax purpose. The opportunity cost of capital of the company is
15%. Required:
(a) Estimate net present value of the replacement decision
(b) Estimate the internal rate of return of the replacement decision
(c) Should company go ahead with the replacement decision? Suggest.
Year 1 2 3 4 5
PVIF0.15,t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20,t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25,t 0.8000 0.6400 0.5120 0.4096 0.3277
PVIF0.30,t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35,t 0.7407 0.5487 0.4064 0.3011 0.2230

Solution
(a) Statement of NPV
Particulars Time PVF Amount Present Value
Cost of new machine 0 1 60,00,000 60,00,000
(-) Cash flow from sale of old assets 0 1 (1,50,000) (1,50,000)
PVCO 58,50,000

Incremental Cash flows (w.n.-1) 1-5 3.3522 22,84,000 76,56,425

Incremental cash flow from sale of asset 5 0.4972 2,29,000 1,13,859
PVCI 77,70,284
NPV (PVCI – PVCO) 19,20,284

Working Note – 1: Calculation of cash flow from sale of old assets

Book value of assets -
Less: Sale value of assets (A) 2,50,000
Profit on sale 2,50,000
Tax @ 40% (B) 1,00,000
Cash from sale of old machine (A – B) 1,50,000

Working Note – 2: Calculation of cash flow from operations

Increase in sales [(1,00,000 – 80,000) × 200] 40,00,000
Less: Increase in cost (9,60,000)
[{(63.75 + 37.5 + 25 + 7.5 + 14.25)×1,00,000} + {(75 + 51.25 + 20 + 11.25 + 15.5)×80,000}]
Incremental PBD (A) 30,40,000
)","","""$,,&","""
Less: Incremental Depreciation !* &
+ − 0" 11,50,000
Incremental PBT 18,90,000
Tax @ 40% (B) 7,56,000
Incremental cash flow from operations (A – B) 22,84,000
Working Note – 3: Incremental cash flow from sale of assets
New Existing
Cost of assets 60,00,000 -
Accumulated Depreciation 57,50,000 -
Book Value 2,50,000 -
Sale Value (A) 2,50,000 35,000
Profit - 35,000
Tax @ 40% (B) - 14,000
Cash flow from sale of assets (A – B) 2,50,000 21,000
Incremental cash flow from sale of assets = 2,50,000 – 21,000 = `2,29,000

(b) Statement of NPV

Tim PVF@20 PV PVF@30 PV
Particulars e Amount % %
Cost of new machine 0 60,00,000 1 60,00,000 1 60,00,000
(1,50,000 (1,50,000 1 (1,50,000
(-) CF from old assets 0 ) 1 ) )
PVCO 58,50,000 58,50,000

Incremental CF 1-5 22,84,000 2.9906 68,30,530 2.4355 55,62,682

Incremental CF from 92,035 0.2693 61,670
asset 5 2,29,000 0.4019
PVCI 69,22,565 56,24,352
10,72,565 (2,25,648
NPV (PVCI – PVCO) )
!",(,,&)&
IRR = 20% + !!",(,,&)&$($,,,&,)-*)" (30 − 20) = 28.26%

(c) The company should go ahead with replacement project since it has positive NPV.

Question – 10
A company wants to invest in a machinery that would cost `50,000 at the beginning of year 1. It is
estimated that the net cash inflows from operation will be `18,000 per annum for 3 years, if the
company opts to service a part of the machine at the end of year 1 at `10,000 and the scrap value at
the end of year 3 will be `12,500. However, of the company decides not to services the part, it will
have to be replaced at the end of year 2 at `15,400. But in this case, the machine will work for the 4th
year also and get operational cash inflow of `18,000 for the 4th year. It will have to be scrapped at the
end of the year 4 at `9,000. Assuming cost of capital at 10% and ignoring taxes, will you recommend
the purchase of this machine based on the net present value of its cash flows? If the supplier gives a
discount of `5,000 for purchase, what would be your decision? (The present value factors at the end
of years 0, 1, 2, 3, 4, 5 and 6 are respectively 1, 0.9091, 0.8264, 0.7513, 0.6830, 0.6290 and 0.5644).
Solution
Statement showing evaluation of mutually exclusive proposals
Particulars Time P. V. Factor Service Part Replace Part
Cash Outflows: Amoun P. V. Amoun P. V.
Cost of Machinery 0 1 t t
Service Cost 1 0.9091 50,000 50,000 50,000 50,000
(+) Replace Part 2 0.8264 10,000 9,091 ---- ----
P. V. of Cash Outflow (A) ---- ---- 15,400 12,727
Cash Inflows 59,091 62,727
Cash Inflow from Operation 1-3 2.4869
1-4 3.1699 18,000 44,764 --- ---
3 0.7513 ---- ----- 18,000 57,058
Scrap Value of Machine 4 0.6830 12,500 9,391 ---- ----
P. V. of Cash Inflows (B) ----- ------ 9,000 6,147
NPV [(B) – (A)] 54,155 63,205
(4,936) 478
Advise:- Purchase machine & Replace the part at end of second year.
(ii) If the supplier gives a discount of `5,000 on purchase of machine

Proposals Service Part Replace Part

NVP 64 5,478
Cumulative 2.4869 3,1699
Equivalent Annual NPV 25.73 1,728
Advise: Purchase machine & Replace the part at end of second year.

Question – 11
Alpha limited is a manufacturer of computers. It wants to introduce artificial intelligence while making
computers. The estimated annual saving from introduction of the artificial intelligence (AI) is as
follows:
Reduction of five employees with annual salaries of `3,00,000 each.
Reduction of `3,00,000 in production delays caused by inventory problem
Reduction in lost sales `2,50,000 and
Gain due to timely billing `2,00,000
The purchase price of the system for installation of artificial intelligence is `20,00,000 and installation
cost is `1,00,000. 80% of the purchase price will be paid in the year of purchase and remaining will
be paid in next year. The estimated life of the system is 5 years and it will be depreciated on a straight-
line basis.
However, the operation of the new system requires two computer specialists with annual salaries of
`5,00,000 per person.
In addition to above, annual maintenance and operating cost for five years are as below:
(Amount in `)
Year 1 2 3 4 5
Maintenance & Operating cost 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
Maintenance and operating cost are payable in advance.
The company’s tax rate is 30% and its required rate of return is 15%.
Year 1 2 3 4 5
PVIF0.10,t 0.909 0.826 0.751 0.683 0.621
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567
PVIF0.15,t 0.870 0.756 0.658 0.572 0.497
Evaluate the project by using Net Present Value and Profitability Index.

Solution
Calculation of Cash Flows
Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Saving in 15,00,000 15,00,000 15,00,000 15,00,000 15,00,000
Salaries
Reduction in 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
production
delays
Reduction in lost 2,50,000 2,50,000 2,50,000 2,50,000 2,50,000
sales
Gain due to 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Timely Billing
Salary to (10,00,000) (10,00,000) (10,00,000) (10,00,000) (10,00,000)
computer
specialist
Maintenance & (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000)
Operating cost
Depreciation (4,20,000) (4,20,000) (4,20,000) (4,20,000) (4,20,000)
Profit before tax 6,30,000 6,50,000 6,70,000 6,90,000 7,10,000
Less: Tax @ (1,89,000) (1,95,000) (2,01,000) (2,07,000) (2,13,000)
30%
Add: 4,20,000 4,20,000 4,20,000 4,20,000 4,20,000
Depreciation
Add: 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
Maintenance &
Operating cost
Less: (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000) -
Maintenance &
Operating cost
 Net CF (2,00,000) 8,81,000 8,95,000 9,09,000 9,23,000 10,37,000

Statement of NPV
Particulars Time PVF Amount Present Value
Initial Investment 0 1 16,00,000 16,00,000
Installation expenses 0 1 1,00,000 1,00,000
Instalment of Purchase Price 1 0.870 4,00,000 3,48,000
PVCO 20,48,000

Cash flows 0 1 (2,00,000) (2,00,000)

1 0.870 8,81,000 7,66,470
2 0.756 8,95,000 6,67,620
3 0.658 9,09,000 5,98,122
4 0.572 9,23,000 5,27,956
5 0.497 10,37,000 5,15,389
PVCI 28,84,557
NPV (PVCI – PVCO) 8,36,557
Profitability Index (PVCI PVCO) 1.41
Since, NPV is positive and Profitability index is greater than one, thus it is recommended to introduce
the system.

Question – 12
An existing company has a machine which has been in operation for two years, its estimated remaining
useful life is 4 years with no residual value in the end. Its current market value is ` 3 lakhs. The
management is considering a proposal to purchase an improved model of a machine gives increase
output. The details are as under:
Particulars Existing Machine New Machine
Purchase Price ` 6,00,000 ` 10,00,000
Estimated Life 6 years 4 years
Residual Value 0 0
Annual Operating days 300 300
Operating hours per day 6 6
Selling price per unit ` 10 ` 10
Material cost per unit `2 `2
Output per hour in units 20 40
Labour cost per hour ` 20 ` 30
Fixed overhead per annum excluding depreciation ` 1,00,000 ` 60,000
Working Capital ` 1,00,000 ` 2,00,000
Income-tax rate 30% 30%
Assuming that - cost of capital is 10% and the company uses written down value of depreciation @
20% and it has several machines in 20% block.
Advice the management on the Replacement of Machine as per the NPV method. The discounting
factors table given below:
Discounting Factors Year 1 Year 2 Year 3 Year 4
10% 0.909 0.826 0.751 0.683

Solution
Statement of NPV
Particulars Time PVF Amount Present Value
Cost of new machine 0 1 10,00,000 10,00,000
(+) Add. working cap. (2,00,000 –
1,00,000) 0 1 1,00,000 1,00,000
(-) Cash flow from sale of old assets 0 1 (3,00,000) (3,00,000)
PVCO 8,00,000

Incremental Cash flows (w.n.-1) 1 0.909 2,59,000 2,35,431

2 0.826 2,50,600 2,06,996
3 0.751 2,43,880 1,83,154
4 0.683 2,38,504 1,62,898
Incremental working capital realization 4 0.683 1,00,000 68,300
PVCI 8,56,779
NPV (PVCI – PVCO) 56,779
Since the incremental NPV is positive, thus existing machine should be replaced.

Working Note – 1: Calculation of profit before depreciation (PBD)

Particulars Existing Machine New Machine
Annual output 300 ´ 6 ´ 20 = 36,000 300 ´ 6 ´ 40 = 72,000
Sales @ `10 per unit 3,60,000 7,20,000
Less: Cost of operation
Material @`2 per unit 72,000 1,44,000
Labour 1800 ´ 20 = 36,000 1800 ´ 30 = 54,000
Fixed OHs 1,00,000 60,000
Profit before Depreciation 1,52,000 4,62,000
Thus, Annual Incremental Profit Before Depreciation = 4,62,000 – 1,52,000 = `3,10,000

Working Note – 2: Calculation of basis of depreciation

Particulars Existing After Replacement
Purchase price of existing 6,00,000 6,00,000
Less: Depreciation of Yr. 1 1,20,000 1,20,000
Less: Depreciation of Yr. 2 96,000 96,000
WDV of existing machine 3,84,000 3,84,000
Add: Purchase of new - 10,00,000
Less: Sale of existing - 3,00,000
Basis for Depreciation 3,84,000 10,84,000
Working Note – 3: Incremental cash flow from sale of assets
Particulars Year 1 Year 2 Year 3 Year 4
Incremental PBD (A) 3,10,000 3,10,000 3,10,000 3,10,000
New Depreciation 2,16,800 1,73,440 1,38,752 1,11,002
Less: Existing Depreciation 76,800 61,440 49,152 39,322
Incremental Depreciation (B) 1,40,000 1,12,000 89,600 71,680
Incremental PBT (A – B) 1,70,000 1,98,000 2,20,400 2,38,320
Tax @ 30% (C) 51,000 59,400 66,120 71,496
Incremental CFs (A – C) 2,59,000 2,50,600 2,43,880 2,38,504
 RISK ANALYSIS IN CAPITAL BUDGETING -
CONCEPTS
1. Techniques of Risk Analysis in Capital Budgeting

2. Probability Approach
Expected net cash flows = ENCF = (CF1 × Prob1) + (CF2 × Prob2) + … + (CFn × Probn)
= ∑!"#$ "# × %#
Where, CF = Cash flows
Prob. = Probability of cash flows
Ri = Cash flows
Pi = Probability of cash flows

Based on ENCF, calculate Expected NPV

Expected NPV = (ENCF1 ´ PVF1) + (ENCF2 ´ PVF2) +….+ (ENCFn ´ PVFn) – PVCO

3. Variance Analysis
σ2 = (NCF1 – ENCF)2×Prob1 + (NCF2 – ENCF)2×Prob2 +….+ (NCFn – ENCF)2×Probn
= ∑!"#$('()" − +'() )% %"
Where, σ2 = Variance in net cash flows
NCF = Net cash flows
ENCF = Expected net cash flows
Prob = P = Probability
4. Standard Deviation

σ = !(NCF! – ENCF)" × Prob! + (NCF" – ENCF)" × Prob" + ⋯ + (NCF# – ENCF)" × Prob#

= !∑#$%!(234$ − 6234)" 7$
Where, σ2 = Variance in net cash flows
NCF = Net cash flows
ENCF = Expected net cash flows
Prob = P = Probability

5. Coefficient of Variation
&'(!)(*) ,-."('"/!
Coefficient of variation = 0-(! /* 123-4'-) *-'5*!

6. Certainty Equivalent Approach

6-*'("! 6(78 9:/;7
CE Coefficient = <"7=> /* -23-4'-) 4(78 ?:/;

Certain Cash Flows = Expected Cash Flows ´ CE Coefficient

Use certain cash flows to compute NPV etc.

7. Risk Adjusted Discount Rate (RADR) Approach

Risk adjusted discount rate = Risk Free Rate + Risk Premium
Use RADR to calculate NPV etc. based on expected or given cash flows.

8. Sensitivity Analysis
It studies the impact of change in one variable at a point of time.

9. Scenario Analysis
It studies the impact of change in more than one variable at a point of time.
 RISK ANALYSIS IN CAPITAL BUDGETING -
CONCEPTS
Question – 1
Calculate variance and standard deviation on the basis of following information:
Project A Project B
Possible Cash Flows (`) Probability Cash Flow (`) Probability
event
A 80,000 0.10 2,40,000 0.10
B 1,00,000 0.20 2,00,000 0.15
C 1,20,000 0.40 1,60,000 0.50
D 1,40,000 0.20 1,20,000 0.15
E 1,60,000 0.10 80,000 0.10

Solution
Project A
Possible Net Cash Prob. Expected (X – M)2 P × (X –
Event Flow (X) (P) Value (X × P) M)2
A 80,000 0.10 8,000 160,00,00,000 16,00,00,000
B 1,00,000 0.20 20,000 40,00,00,000 8,00,00,000
C 1,20,000 0.40 48,000 0 0
D 1,40,000 0.20 28,000 40,00,00,000 8,00,00,000
E 1,60,000 0.10 16,000 160,00,00,000 16,00,00,000
ENCF 1,20,000 48,00,00,000
Mean (M) = `1,20,000
Variance = 48,00,00,0000
Standard deviation = √./0#/123 = √48,00,00,000 = 21,908.90

Project B
Possible Net Cash Prob. (P) Expected (Y – M)2 P × (Y – M)2
Event Flow (Y) Value (P × Y)
A 2,40,000 0.10 24,000 640,00,00,000 64,00,00,000
B 2,00,000 0.15 30,000 160,00,00,000 24,00,00,000
C 1,60,000 0.50 80,000 0 0
D 1,20,000 0.15 18,000 160,00,00,000 24,00,00,000
E 80,000 0.10 8,000 640,00,00,000 64,00,00,000
ENCF 1,60,000 1,76,00,00,000
Mean (M) = 1,60,000
Variance = 1,76,00,00,000
Standard deviation = √./0#/123 = √1,76,00,00,000 = 79,372.54

Question – 2
Probabilities for net cash flows for 3 years of project (Project life) are as follows:
Year 1 Year 2 Year 3
Cash Flow Probability Cash Flow Probability Cash Flow Probability
(` ) (` ) (` )
2,000 0.1 2,000 0.2 2,000 0.4
4,000 0.2 4,000 0.3 4,000 0.3
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1
Calculate the expected net cash flows. Also calculate the present value of the expected cash
flow, using 10% discount rate. Initial investment is `10,000.
Solution
Year 1 Year 2 Year 3
Cash Probability Expected Cash Probability Expected Cash Probability Expected
Flows Value Flows Value Flows Value
(` ) (` ) (` ) (`) (` ) (` )
2,000 0.1 200 2,000 0.2 400 2,000 0.3 600
4,000 0.2 800 4,000 0.3 1,200 4,000 0.4 1,600
6,000 0.3 1,800 6,000 0.4 2,400 6,000 0.2 1,200
8,000 0.4 3,200 8,000 0.1 800 8,000 0.1 800
6,000 4,800 4,200
Computation of NPV
Years Cash Flows PVF PV
1 6,000 0.909 5,454
2 4,800 0.826 3,965
3 4,200 0.751 3,154
PVCI (A) 12,573
0 10,000 1 10,000
PVCO (B) 10,000
NPV (A – B) 2,573
Question – 3
G Ltd. using certainty-equivalent approach in the evaluation of risky proposals. The following
information regarding a new project is as follows:
Year Expected Cash Flow Certainty-equivalent quotient
0 (8,00,000) 1.0
1 6,40,000 0.8
2 5,60,000 0.7
3 5,20,000 0.6
4 4,80,000 0.4
5 3,20,000 0.3
Riskless rate of interest on the government securities is 6%. DETERMINE whether the project
should be accepted?

Solution
Statement of NPV
Year Expected Certainty- Adjusted PVF @ 6% PV
Cash Flow equivalent cash flow
0 (8,00,000) 1.0 (8,00,000) 1 (8,00,000)
1 6,40,000 0.8 5,12,000 0.943 4,82,816
2 5,60,000 0.7 3,92,000 0.890 3,48,880
3 5,20,000 0.6 3,12,000 0.840 2,62,080
4 4,80,000 0.4 1,92,000 0.792 1,52,064
5 3,20,000 0.3 96,000 0.747 71,712
NPV 5,17,552
As the NPV is positive, the project should be accepted.

Question – 4
Determine the risk adjusted net present value of the following projects:
X Y Z
Net cash outlays (`) 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual Cash inflow (`) 70,000 42,000 30,000
Coefficient of variation 1.2 0.8 0.4

The company selects the risk-adjusted rate of discount on the basis of the coefficient of
variation:
 Coefficient of variation Risk-adjusted PV Factor 1 to 5 years at risk
rate of return adjusted rate of discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689

Solution
Projects Net Coefficient Risk Annual PV Discounted Net
Cash of adjusted cash Factor cash inflow Present
Outlays variation discount inflow 1-5 Value
rate years
(` ) (` ) (` ) (` )
(A) (B) (C) (D) (E) (F) (G = E × F) (H = G – B)
X 2,10,000 1.20 16% 70,000 3.274 2,29,180 19,180
Y 1,20,000 0.80 14% 42,000 3.433 1,44,186 24,186
Z 1,00,000 0.40 12% 30,000 3.605 1,08,150 8,150

Question – 5
An enterprise is investing `100 lakhs in a project. The risk-free rate of return is 7%. Risk
premium expected by the management is 7%. The life of the project is 5 years. Following are
the cash flows that are estimated over the life of the project.
Year Cash Flows (`)
1 25,00,000
2 60,00,000
3 75,00,000
4 80,00,000
5 65,00,000
CALCULATE Net Present Value of the project based on Risk free rate and also on the basis
of risks adjusted discount rate.

Solution
Risk free rate given in question is 7%. Thus, NPV at 7% is as follows:
Statement of NPV
Particulars Time PVF@7% Amount Present Value
Investment 0 1 100,00,000 100,00,000
 PVCO 100,00,000

Cash inflows 1 0.935 25,00,000 23,37,500

2 0.873 60,00,000 52,38,000
3 0.816 75,00,000 61,20,000
4 0.763 80,00,000 61,04,000
5 0.713 65,00,000 46,34,500
PVCI 244,34,000
NPV (PVCI – PVCO) 144,34,000

Risk adjusted discount rate = Risk free rate + Risk premium = 7% + 7% = 14%
Statement of NPV
Particulars Time PVF@14% Amount Present Value
Investment 0 1 100,00,000 100,00,000
PVCO 100,00,000

Cash inflows 1 0.877 25,00,000 21,92,500

2 0.769 60,00,000 46,14,000
3 0.675 75,00,000 50,62,500
4 0.592 80,00,000 47,36,000
5 0.519 65,00,000 33,73,500
PVCI 199,78,500
NPV (PVCI – PVCO) 99,78,500

Question – 6
X Ltd. is considering installation of new machine with the following details:
S. No. Particulars Figures
1 Initial Investment `1400 Crore
2 Annual unit sales 100 Crore
3 Selling price per unit `40
4 Variable cost per unit `20
5 Annual Fixed costs `500 Crore
6 Depreciation `200 Crore
7 Discount Rate 12%
8 Tax rate 30%
Consider Life of the project as 4 years with no salvage value.
Required:
(i) Compute the expected NPV of the project.
(ii) Compute the impact on the project’s NPV if change in variables is as under and also
compute which variable is having maximum impact on NPV.
 S. No. Particulars Figures
1 Unit sold per year 85 Crore
2 Selling price per unit `39
3 Variable cost per unit `22
4 Annual Fixed costs `575 crore
PV Factor at 12% are as follows:

Year 1 2 3 4
PV Factor 0.893 0.797 0.712 0.636

Solution
(i) Statement of NPV
Selling price per unit `40
Less: Variable cost per unit `20
Contribution per unit `20
Number of units 100 crores
Total Contribution `2,000 crores
Less: Fixed cost `500 crores
Profit before depreciation `1,500 crores
Less: Depreciation `200 crores
Profit before tax `1,300 crores
Less: Tax @ 30% `390 crores
Profit after tax `910 crores
Add: Deprecation `200 crores
Cash flows `1,110 crores
PVAF at 12% for 4 years 3.038
PVCI `3,372.18 crores
PVCO `1,400.00 crores
NPV `1,972.18 crores

(ii) Statement of Cash Inflows

Particulars Base Units Selling Variable Annual
Case sold per price per cost per Fixed costs
year is 85 unit is unit is is `575
crores `39 `22 crores
Selling price per unit 40 40 39 40 40
(-) Variable cost per unit 20 20 20 22 20
Contribution per unit 20 20 19 18 20
Units Sold per year 100 85 100 100 100
 (in crores)
Total Contribution (in 2,000 1,700 1,900 1,800 2,000
crores)
(-) Fixed Cost (in crores) 500 500 500 500 575
(-) Depreciation (in 200 200 200 200 200
crores)
Profit before tax 1,300 1,000 1,200 1,100 1,225
(-) Tax @30% 390 300 360 330 367.50
Profit after tax 910 700 840 770 857.50
(+) Depreciation (in 200 200 200 200 200
cores)
Cash Inflow 1,110 900 1,040 970 1,057.50
PVAF 3.038 3.038 3.038 3.038 3.038
PVCI 3,372.18 2,734.20 3,159.52 2,946.86 3,212.69
PVCO 1,400 1,400 1,400 1,400 1,400
NPV (A) 1,972.18 1,334.20 1,759.52 1,546.86 1,812.69
Change in NPV (B) - (637.98) (212.66) (425.32) (159.49)
% Change in NPV - 32.34% 10.78% 21.57% 8.09%
@
<A × 100=
From the above table it can be concluded that units sold per year has the maximum impact on
NPV and thus is the most sensitive factor to be considered.

Question – 7
SK Ltd. is considering a project with the following cash flows:
Year Cost of Plant (`) Recurring Cost (`) Savings (`)
0 10,000
1 4,000 12,000
2 5,000 14,000
The cost of capital is 9%. Measure the sensitivity of the project to changes in the levels of plant
value, running cost and savings (considering each factor at a time) such that the NPV becomes
zero. Which factor is the most sensitive to affect the acceptability of the project? The PV factor
at 9% are given below:
Year 1 2
PVF 0.917 0.842
Solution
Statement of NPV
Particulars Time PVF@9% Amount Present Value
Cost of Plant 0 1 10,000 10,000
Recurring cost 1 0.917 4,000 3,668
2 0.842 5,000 4,210
PVCO 17,878

Savings in cost 1 0.917 12,000 11,004

2 0.842 14,000 11,788
PVCI 22,792
NPV (PVCI – PVCO) 4,914
Sensitivity Analysis of different elements
(a) Cost of Plant
Increase in cost of plant that will make the project unviable = `4,914
B,D$B
% increase in cost of plant that will make the project unviable = $E,EEE × 100 = 49.14%
(b) Recurring Cost
Increase in recurring cost that will make the project unviable = `4,914
B,D$B
% increase in recurring cost that will make the project unviable = (G,HHIJB,%$E) × 100

= 62.38%
(c) Savings in Cost
Decrease in savings in cost that will make the project unviable = `4,914
B,D$B
% decrease in savings in cost that will make the project unviable = %%,LD% × 100 = 21.56%
Since % change in savings in cost is lowest, thus it is the most sensitive factor to affect the
acceptability of the project.

Question – 8
Door Ltd. is considering an investment of `4,00,000. This investment is expected to generate
substantial cash inflows over the next five years. Unfortunately, the annual cash flows from
this investment is uncertain, but the following probability distribution has been established.
Annual cash flows (`) Probability
50,000 0.30
1,00,000 0.30
1,50,000 0.40
At the end of its 5 years life, the investment is expected to have a residual value of `40,000.
The cost of capital is 5%.
(a) Calculate NPV under the three different scenarios.
(b) Calculate expected net present value
(c) Advise Door Ltd. on whether the investment is to be undertaken.
Year 1 2 3 4 5
DF @ 5% 0.952 0.907 0.864 0.823 0.784

Solution
(a) Calculation of NPV under three different scenarios
Particulars 1st Scenario 2nd Scenario 3rd Scenario
Annual Cash inflow 50,000 1,00,000 1,50,000
PVAF @ 5% 4.33 4.33 4.33
PV of cash inflow 2,16,500 4,33,000 6,49,500
PV of residual value 31,360 31,360 31,360
(40,000 × 0.784)
Total PV of cash inflow 2,47,860 4,64,360 6,80,360
(-) Initial investment 4,00,000 4,00,000 4,00,000
NPV (1,52,140) 64,360 2,80,360

(b) Calculation of expected NPV under three different scenarios

Expected annual cash inflow = (50,000 × 0.30) + (1,00,000 × 0.30) + (1,50,000 × 0.40)
= `1,05,000

Expected NPV = PV of cash inflows – PV of cash outflows

= (1,05,000 × 4.33) + (40,000 × 0.784) – 4,00,000
= `86,010

(c) Since the expected NPV of the investment is positive, the investment should be undertaken.
 DIVIDEND DECISIONS - CONCEPTS
1. Dividend
It is return to shareholders i.e. Equity and Preference

2. Basic Terms
!"#$%$& ()"%*"+*, -.# !/0%12
Earning per share (EPS) =
304+,# .- !/0%12 56"#,7

(4.0$1 .- 8%)%9,$9
Dividend per share (DPS) = 304+,# .- !/0%12 56"#,7 = EPS ´ DP Ratio

8:5
Dividend Pay-out Ratio (DP Ratio) = !:5 × 100 = 100 – Retention Ratio

Retention Ratio (b) = 100 – DP Ratio

8:5
Dividend Rate = ;"<, ="*0, × 100
8:5
Dividend Yield = >"#?,1 @#%<, @,# 76"#, × 100

!:5
Earning Yield = >"#?,1 @#%<, @,# 76"#, × 100

>:5
Price Earning Ratio (PE Ratio) = !:5
A
PE Ratio = B,

3. Dividend Policy
4. Walter Model

Market price of share (P0) = !"($%!)('/)*)

)*

Where, E = Earning per share

D = Dividend per share
Ke = Cost of equity or rate of capitalization or discount rate
r = Rate of return on investment

Position of r and Ke Company Optimum Dividend Payout Ratio

r > Ke Growth Zero
r < Ke Decline 100%
r = Ke Constant Every payout ratio is optimum

5. Dividend Discount Model

6. Zero Growth Model

($$0"* 8%)%9,$9 8
Share’s Intrinsic Value (P0) = C,/0%#, C"1, .- C,10#$ = B,

7. Constant Growth Model or Gordon Model

8A 8E(AGB,)
Market Price (P0) = B,D& = B,D&
Where, D1 = Next expected dividends or dividends payable at the end of the year
D0 = current year Dividend
Ke = cost of Equity capital or expected rate of return
G = growth rate of dividends = br
8. Variable Growth Rate Model
Price = Present value of all future benefits (i.e. dividend) from shares

9. Intrinsic Value Vs Current Value

10. Residual Theory
First use earnings for future expansion
Balance if any will be distributed among shareholders as dividend

11. Modigliani And Miller (MM) Model

:AG8A
%0 = AGB,

Where, P0 = Market price of share today

P1 = Market price of share at the end of year 1
D1 = Dividend per share at the end of year 1
Ke = Cost of equity share capital or discount rate or rate of capitalization

IAD(!D8)
Additional number of shares to be issued at the end of year 1 = ∆n = :A
Where, I1 = Amount required for investment
E = Total earnings of the company
D = Total dividend to be distributed
P1 = Market price of share at the end of year 1

($G∆K)(:A)DIG!
Current Value of Firm = No. of equity shares × MPS = (AGB,)

12. Traditional Model

!
Market Price (P) = m() + L +
Where, P = Market Price per share
D = Dividend per share
E = Earnings per share
M = Multiplier

13. Linter Model

D1 = D0 + [(EPS × Target payout) – D0] × Af
Where, D1 = Dividend in year 1 or next expected dividend
D0 = Last dear dividend
EPS = Earnings per share
Af = Adjustment factor
 DIVIDEND DECISIONS - CONCEPTS
Question – 1
The following information is supplied to you:
(`)
Total Earnings 2,00,000
No. of equity shares (of `100 each) 20,000
Dividend paid 1,50,000
Price/Earnings ratio 12.50
Applying Walter’s Model:
(i) Analyze whether the company is following an optimal dividend policy.
(ii) Compute P/E ratio at which the dividend policy will have no effect on the value of the share.
(iii) Will you decision change if the P/E ratio is 8 instead of 12.5? Analyze.

Solution
!"#$% '$()*)+, 5,77,777
EPS = -". "/ 012*#3 ,4$(0,
= 57,777
= `10 per share
8*9*:0): ;$*: <,=7,777
DPS = -". "/ 012*#3 ,4$(0,
= 57,777
= `7.50 per share
!"#$% 0$()*)+), 5,77,777
Rate of return, r = !"#$% 012*#3 9$%20 × 100 = 57,777×<77 × 100 = 10%
< <
Ke = ?/' A$#*" = <5.=7 = 0.08 = 8%

(i) At present, company pays dividend of `7.50 per share at which market price comes at:
8B('D8)((÷G0) H.=7B(<7DH.=7)(7.<7÷7.7I)
P0 = G0
= 7.7I
= `132.81
Since, r(10%) is greater than Ke(8%), thus as per Walter Model, the optimum dividend payout ratio
should be zero. Market price at zero dividend is:
8B('D8)((÷G0) 7B(<7D7)(7.<7÷7.7I)
P0 = G0
= 7.7I
= `156.25
Thus, theoretically the market price of the share can be increased by adopting a zero payout.

(ii) As per Walter Model, when r = Ke, than dividend policy will have no effect on the value of the
share price. Thus, Ke = 10% will be the required level.
< <
P/E Ratio = G0 = 7.<7 = 10

< <
(iii) If P/E ratio is 8, than Ke = ?/' A$#*"
= I = 0.125 = 12.5%
Now r(10%) is less than Ke(12.50%). As per Walter model, in such case it is advisable to distribute
maximum dividend to maximize the value of the share.
If 100% dividend is given than, price of share is:
8B('D8)((÷G0) <7B(<7D<7)(7.<7÷7.<5=)
P0 = G0
= 7.<5=
= `80
Question – 2
The following figures are collected from the annual report of XYZ Ltd.:
Net Profit `30 lakhs
Outstanding 12% Preference shares `100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%
CALCULATE price per share using Gordon’s Model when dividend pay-out is (i) 25%; (ii) 50% and
(iii) 100%.

Solution
'(<DJ)
As per Gordon’s Formula, P = G0D(J×()
'$()*)+ $9$*%$J%0 /"( 012*#3 K7,77,777D<5,77,777
Earning per share (E) = -". "/ 012*#3 ,4$(0,
= K.77.777
= `6
Cost of equity (Ke) = 16% = 0.16
Return on investment (r) = 20% = 0.20

L×7.5= <.=7
(i) When dividend pay-out ratio is 25%, P = 7.<LD(7.H=×7.57) = 7.<LD7.<= = `150

L×7.=7 K
(ii) When dividend pay-out ratio is 50%, P = 7.<LD(7.=7×7.57) = 7.<LD7.<7 = `50

L×< L
(iii) When dividend pay-out ratio is 100%, P = 7.<LD(7×7.57) = 7.<L = `37.50

Question – 3
The following figures are collected from the annual report of XYZ Ltd.:
Net Profit `30 lakhs
Outstanding 12% Preference shares `100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%
CALCULATE price per share using Gordon’s Model when dividend pay-out is (i) 25%; (ii) 50% and
(iii) 100%.

Solution
'(<DJ)
As per Gordon’s Formula, P = G0D(J×()
'$()*)+ $9$*%$J%0 /"( 012*#3 K7,77,777D<5,77,777
Earning per share (E) = -". "/ 012*#3 ,4$(0,
= K.77.777
= `6
Cost of equity (Ke) = 16% = 0.16
Return on investment (r) = 20% = 0.20

L×7.5= <.=7
(i) When dividend pay-out ratio is 25%, P = 7.<LD(7.H=×7.57) = 7.<LD7.<= = `150
 L×7.=7 K
(ii) When dividend pay-out ratio is 50%, P = 7.<LD(7.=7×7.57) = 7.<LD7.<7 = `50

L×< L
(iii) When dividend pay-out ratio is 100%, P = 7.<LD(7×7.57) = 7.<L = `37.50

Question – 4
The following figures are extracted from the annual report of RJ Ltd.:
Net Profit `50 Lakhs
Outstanding 13% preference shares `200 Lakhs
No. of Equity shares 6 Lakhs
Return on Investment 25%
Cost of Capital (Ke) 15%
You are required to compute the approximate dividend pay-out ratio by keeping the share price at `40
by using Walter’s Model.

Solution
Earning available for equity = Net Profit – Preference Dividend
= 50 lakhs – (200 lakhs × 13%) = `24 Lakhs
'$()*)+ $9$*%$J%0 /"( '12*#3 5N,77,777
Earnings per share = -". "/ '12*#3 M4$(0,
= L,77,777
= `4
8B('D8)((÷G0)
As per Walter Model, P = G0
Where,
P = Market price per share = `40
E = Earnings per share = `4
D = Dividend per share
r = Return earned on investment = 25% = 0.25
Ke = Cost of equity capital = 15% = 0.15
8B(ND8)(7.5=÷7.<=)
⸫P= 7.<=
8B(ND8)(<.LLLH)
40 = 7.<=
6 = D + 6.667 - (1.667)D
0.667D = 0.6667
D = `1
8*9*:0): ;0( ,4$(0 <
Required dividend pay-out ratio = '$()*)+ ;0( ,4$(0
× 100 = N × 100 = 25%

Question – 5
S Ltd. is foreseeing a growth rate of 12% p.a. in the next two years. The growth rate is likely to be
10% for the third and fourth year. After that the growth rate is expected to stabilize at 8% p.a. If the
last dividend was `1.50 per share and the investor’s required rate of return is 16%, determine the
current value of equity share of the company. The present value factors at 16% are as below:
 Year 1 2 3 4
PVF 0.862 0.743 0.641 0.552
Solution
Year Particulars Amount PVF @ 16% Present Value
1 Dividend 1.50×(1+0.12) = 1.68 0.862 1.45
2 Dividend 1.68×(1+0.12) = 1.88 0.743 1.40
3 Dividend 1.88×(1+0.10) = 2.07 0.641 1.33
4 Dividend 2.07×(1+0.10) = 2.28 0.552 1.24
Total 5.42
8= 5.5I(<B.7.7I)
Price at end of 4th year, P4 = G0D+ = 7.<LD7.7I
= `30.78
Current value of equity share = `5.42 + (`30.78 × 0.552) = `22.41

Question – 6
ZX Ltd. has a paid-up share capital of `1,00,00,000 face value for `100 each. The current market
price of the shares is `100 each. The Board of Directors of the company has an agenda of meeting to
pay a dividend of 50% to its shareholders. The company expects a net income of `75,00,000 at the
end of the current financial year. Company also plans for a capital expenditure for the next financial
year for a cost of `95,00,000, which can be financed through retained earnings and issue of new equity
shares. Company’s desired rate of investment is 15%.

Required:
Following the Modigilani-Miller (MM) Hypothesis, determine value of the company when:
(a) It does not pay dividend and
(b) It does pay dividend

Solution
Working Notes:
1) Market price per share = EPS × P/E = 10 × 10 = `100
As per MM Model, the price of the share (if dividend is paid):
D1 P1 =7B?<
Po = 100 = (<B7.<=) P1 = `65
(1 Ke)

2) As per MM Model, the price of the share (if dividend is not paid):
D1 P1 7B?<
Po = 100 = (<B7.<=) P1 = `115
(1 Ke)
The number of new equity shares can be found as follows:
Dividends Distributed Dividends Not Distributed
(` ) (` )
Net Income 75,00,000 75,00,000
Total Dividends (1,00,000 × 50) 50,00,000 -
Retained Earnings 25,00,000 75,00,000
Investment Budget 95,00,000 95,00,000
Amount to be raised by new issues 70,00,000 20,00,000
Relevant market Price 65 115
(` Per share)
No. of shares to be issued 1,07,692 17,391

(a) Value of ZX Ltd. when dividends are not paid

()B∆))?<DPB' [(<,77,777B<H,KR<)×<<=]DR=,77,777BH=,77,777
Value = <BG0
= (<B7.<=)
= `1,00,00,000

(b) Value of ZX Ltd. when dividends are paid

()B∆))?<DPB' [(<,77,777B<,7H,LR5)×L=]DR=,77,777BH=,77,777
Value = <BG0
= (<B7.<=)
= `1,00,00,000

Question – 7
The dividend payout ratio of S Ltd. is 40%. If the company follows traditional approach to dividend
policy with a multiplier of 9, what will be the MPS/EPS or PE Ratio of S Ltd.

Solution
As per Traditional approach, P0 = m × (D + E/3)
m = multiplier = 9
D = Dividend per share = E × 40% = 0.40 × D
P0 = Market price
P0 = m × (D + E/3)
'
P0 = 9 × $(& × 0.40) + K +
(<.57'B ')
P0 = 9 × K
P0 = 3 × 2.20 × E
?7
'
= 6.60
T?M
'?M
= 6.60
PE Ratio = 6.60

Question – 8
The target payout ratio for S Ltd. is 0.4. The dividend per share for the current year is `14. The dividend
per share in previous year was `12. The weightage given to the current year earnings is 0.60. The
number of equity shares outstanding in the company is 10,00,000. If the P/E multiple is 9, applying
Lintner Model of dividend policy to the company, compute the market capitalization of the company.

Solution
As per Linter Model, D1 = D0 + [(E × Target Payout) – D0] × AF
D1 = Next expected dividend = 14
D0 = Last paid dividend = 12
Target payout = 0.4
AF = Adjustment Factor = 0.6
⸫ 14 = 12 + [(E × 0.40) – 12] × 0.60
2 = (0.4E – 12) × 0.60
3.33 = 0.4E – 12
0.4E = 15.33
E = 38.33
⸫Earning per share = E = `38.33
PE Ratio = MPS ÷ EPS
MPS = PE Ratio × EPS = 9 × 38.33 = `344.97
Market capitalization = No. of equity shares × MPS = 10,00,000 × 344.97 = `3,449.7 lakhs
 RATIO ANALYSIS – CONCEPTS
1. Meaning of Ratio
It is a mathematical expression of the relationship between two accounting figures.

2. Ratio Analysis
Ratio analysis is the process of identifying the financial strengths and weaknesses of the
enterprise by logically establishing relationship between the items of Balance Sheet or
Income Statement or both and interpreting the results there of in order to derive
meaningful conclusions

3. Type of Ratios
The ratios may be classified on the basis of requirements of various users. The
classification is as follows:
(a) Liquidity Ratios or Short-term Solvency Ratios
(b) Long-term Solvency Ratios or Leverage Ratios
(c) Activity Ratios or Efficiency Ratios or Turnover Ratios or Performance Ratios
(d) Profitability Ratios

4. Liquidity Ratios or Short-term Solvency Ratios

These ratios are used to evaluate the firm’s short term solvency.
!"##$%& ())$&)
(a) !"##$%& ()&*+ =
!"##$%& *+,-+.+&$)
/"+01 ())$&)
(b) -"*./ ()&*+ =
!"##$%& *+,-+.+&$)

Quick Assets = Current Assets – Inventory – Prepaid Expenses + Realizable value

of inventory (if any)
!,)2 & 4,%1 4,.,%0$5 6,#1$&,-.$ 7$0"#+&+$)
(c) 012+3"&$ !)2ℎ ()&*+ =
!"##$%& *+,-+.+&$)
!,)2 & 4,%1 4,.,%0$5 !"##$%& 8%9$)&.
=
!"##$%& *+,-+.+&$)
/"+01 ())$&)
(d) 5)2*. 6$7$%2$ 8%&$#9)3 / 8%&$#9)3 ;$)2"#$ =
;,+..< !,)2 =>$#,&+%? @A>$%)$)
!,)2 & 4,%1 4,.,%0$56,#1$&,-.$ 7$0"#+&+$)5B$& C$0$+9,-.$)
=
;,+..< !,)2 =>$#,&+%? @A>$%)$)
 D$%$#,. @A>$%)$)EBF% 0,)2 @A>$%)$)
Daily Cash Operating Expenses = BF. FG H,<) +% , <$,#

(e) Net Working Capital = Current Assets – Current Liabilities (excluding short-term
bank borrowing)

5. Long Term Solvency Ratios or Leverage Ratios

These ratios are used to evaluate firm’s long term solvency.
=I%$# ! ) J"%H
(a) <="*&> ()&*+ =
B$& ())$&)
KF&,. ;$-&
(b) 6$1& ()&*+ = B$& ())$&)
*F%?E&$#L ;$-&) KF&,. ;$-&)
(c) 6$1& − <="*&> ()&*+ = 72,#$2F.H$#M) J"%H)
= 72,#$2F.H$#M) J"%H)
KF&,. ;$-&
(d) @+&)3 6$1& &+ 022$&2 ()&*+ =
KF&,. ())$&)
J"%H) 4$,#+%? J+A$H J+%,%0+,. N,<L$%&)
(e) !)A*&)3 B$)#*%C ()&*+ =
@O"+&< 72,#$2F.H$# ! ) J"%H)
N#$G$#%0$ 72,#$ !,>+&,.5;$-$%&"#$)5=&2$# -F##FI$H G"%H)
=
@O"+&< 72,#$2F.H$#M) J"%H)
N#F>#+$&,#M) J"%H
(f) D#+A#*$&)#> ()&*+ = × 100
KF&,. ())$&)
@48K
(g) 8%&$#$2& !+9$#)C$ ()&*+ =
8%&$#$)&
@(K
(h) D#$7$%.$ 6*9*H$%H !+9$#)C$ ()&*+ =
N#$G$#$%0$ ;+9+H$%H
@(@
(i) <="*&> 6*9*H$%H !+9$#)C$ ()&*+ =
@O"+&< ;+9+H$%H
@,#%+%?) ,9,+.,-.$ GF# H$-& )$#9+0$
(j) 6$1& I$#9*.$ !+9$#)C$ ()&*+ =
8%&$#$)& 5 N#+%0+>,. >F#&+F% FG +%)&,..L$%&
@48K5BF%E0,)2 =>$#,&+%? @A>$%)$)
(k) J*K$H !ℎ)#C$2 !+9$#)C$ ()&*+ =
8%&$#$)& 5 N#+%0+>,. >F#&+F% FG +%)&,..L$%&

6. Points to Remember (PTRs)

Equity Shareholder Fund / Net Worth =
 Shareholder’s Fund/ Owners Fund/ Proprietary Fund =

Capital Employed =

Total Debt or Total Outside Liabilities =

7. Activity or Efficiency or Performance or Turnover or Velocity Ratio

These ratios help in commenting on the efficiency of the enterprise in managing its assets.
B$& 7,.$)/!=D7
(a) @+&)3 022$&2 @"#%+9$# ()&*+ =
KF&,. ())$&)

B$& 7,.$)/!=D7
(b) J*K$H 022$&2 @"#%+9$# ()&*+ =
B$& J+A$H (=>$#,&+%?)())$&)

B$& 7,.$)/!=D7
(c) !)A*&)3 @"#%+9$# ()&*+ =
!,>+&,. @L>.F<$H

B$& 7,.$)/!=D7
(d) !"##$%& 022$&2 @"#%+9$# ()&*+ =
!"##$%& ())$&)

B$& 7,.$)/!=D7
(e) L+#/*%C !)A*&)3 @"#%+9$# ()&*+ =
SF#1+%? !,>+&,.

!F)& FG DFFH) 7F.H/7,.$)

(f) 8%9$%&+#> (J*%2*ℎ$H I&+./) @"#%+9$# ()&*+ = (9$#,?$ JD 7&F01

(9$#,?$ JD 7&F01
(g) 8%9$%&+#> (J*%*2ℎ$H I&+./ )O$3+.*&> =
(9$#,?$ !F)& FG DFFH) 7F.H >$# H,<

TU LF%&2) / VU I$$1) / WXV H,<)

=
7&F01 K"#%F9$# C,&+F

C,I 6,&$#+,. 7&F01

(h) 8%9$%&+#> (()P ;)&$#*)3) @"#%+9$# ()&*+ = (9$#,?$ C6 7&F01

(9$#,?$ C6 7&F01
(i) 8%9$%&+#> (J*%*2ℎ$H I&+./ )O$3+.*&> =
(9$#,?$ C6 !F%)"L$H >$# H,<

TU LF%&2) / VU I$$1) / WXV H,<)

=
8%9$%&F#< K"#%F9$# C,&+F
 !#$H+& 7,.$)
(j) ($.$*9)13$2 @"#%+9$# ()&*+ =
(9$#,?$ ,00F"%& #$0$+9,-.$)

(9$#,?$ C$0$+9,-.$)
(k) ($.$*9)13$2 O$3+.*&> =
(9$#,?$ !#$H+& 7,.$) >$# H,<

TU LF%&2) / VU I$$1) / WXV H,<)

= C$0$+9,-.$) K"#%F9$# C,&+F

!#$H+& N"#02,)$)
(l) D)>)13$2 @"#%+9$# ()&*+ = (9$#,?$ ,00F"%& >,<,-.$)

(9$#,?$ N,<,-.$)
(m) D)>)13$2 O$3+.*&> =
(9$#,?$ !#$H+& N"#02,)$) >$# H,<

TU LF%&2) / VU I$$1) / WXV H,<)

=
N,<,-.$) K"#%F9$# C,&+F

8. Points to Remember (PTRs)

- Sales will be excluding GST and net of returns if any.
- It is prefer to take average figure in denominator. If average can’t be computed then
consider closing values.

9. Profitability Ratios
These are used to measure the firm’s operating efficiency or profitability.
These are further classified in four categories:
(A) Related to Sales
(B) Related to Overall Return on Assets or Investment
(C) From Owner’s Point of View
(D) Related to Market or Valuation or Investors

10. Profitability Ratios Related to Sales

"#$%% '#$()*
(a) !"#$$ &"#'() *+)(# = +,* -./,%
× 100
B$& >#FG+& F# @(K
(b) Q$& D#+7*& ()&*+ ()7&$# &)K) = × 100
7,.$)
@4K
(c) Q$& D#+7*& ()&*+ (1$7+#$ &)K) = × 100
7,.$)
=>$#,&+%? N#FG+& F# @48K
(d) RA$#)&*%C D#+7*& ()&*+ = × 100
7,.$)
 0$%* $( "$$1% -$/1
(e) 0#$) #' !##1$ 2#31 *+)(# =
+,* -./,%
× 100
=>$#,&+%? @A>$%)$)
(f) RA$#)&*%C <KA$%2$ ()&*+ = × 100
7,.$)
!=D75=>$#,&+%? @A>$%)$)
(g) RA$#)&*%C ()&*+ = × 100
7,.$)
J+%,%0+,. @A>$%)$)
(h) J*%)%.*)3 <KA$%2$2 ()&*+ = × 100
7,.$)
(HL+%+)&#,&+F% @A>$%)$)
(i) 0HS*%*2&#)&*+% <KA$%2$2 ()&*+ = × 100
7,.$)
7$..+%? & ;+)&#+-"&+F%
(j) I & 6 <KA$%2$2 ()&*+ = × 100
7,.$)

11. Profitability Ratios related to Overall Return on Investment or Assets

B$& N#FG+& ,G&$# K,A
(a) Return on Assets (ROA) = (9$#,?$ KF&,./K,%?+-.$/J+A$H ())$&)
@48K(TE&)
= (9$#,?$ KF&,./K,%?+-.$/J+A$H ())$&)
N(K58%&$#$)&
= (9$#,?$ KF&,./K,%?+-.$/J+A$H ())$&)
@48K(TE&)
(b) Return on Net Assets (RONA) = (9$#,?$ B$& ())$&)
@48K
(c) Return on Capital Employed (ROCE) (Before Tax) = (9$#,?$ !,>+&,. @L>.F<$H × 100
@48K(TE&)
(d) Return on Capital Employed (ROCE) (After Tax) = (9$#,?$ !,>+&,. @L>.F<$H × 100
@,#%+%? GF# @O"+&< (@(@)
(e) Return on Equity (ROE) = × 100
@O"+&< 72,#$2F.H$# ! ) J"%H
@(K
(f) Return on Shareholder’s Fund = 72,#$2F.H$#! ) J"%H × 100

12. Profitability Ratios from Owner’s Point of View

@,#%+%? GF# @O"+&<
(a) Earning per Share (EPS) = BF.
FG @O"+&< 72,#$)
@O"+&< ;+9+H$%H
(b) Dividend Per Share (DPS) = BF.
FG @O"+&< 72,#$)
;N7
(c) Dividend Payout Ratio (DP Ratio) = @N7 × 100

13. Profitability Ratios related to Market or Valuation or Investors

6,#1$& N#+0$ >$# )2,#$ (6N7)
(a) Price Earning Ratio (PE Ratio) = @,#%+%? N$# 72,#$ (@N7)
 ;N7
(b) Dividend Yield Ratio = 6N7 × 100
@N7
(c) Earning Yield Ratio = 6N7 × 100
6,#1$& Y,."$ >$# )2,#$
(d) Market Value / Book Value Per share (MV / BV) =
4FF1 Y,."$ >$# )2,#$
6,#1$& 9,."$ FG $O"+&< ,%H .+,-+.+&+$)
(e) Q Ratio =
@)&+L,&$H #$>.,0$L$%& 0F)& FG ,))$&)

14. Du Pont Model

(A) Return on Capital Employed (ROCE) = Operating Profit Margin ´ Capital Turnover

(B) Return on Equity (ROE) = Net Profit Margin ´ Assets Turnover ´ Equity Multiplier
 RATIO ANALYSIS – QUESTIONS
Question – 1
The following is the Profit and loss account and Balance Sheet of KLM LLP.
Trading and Profit & loss Account
Particulars Amount (`) Particulars Amount (`)
To Opening stock 12,46,000 By Sales 1,96,56,000
To Purchases 1,56,20,000 By Closing stock 14,28,000
To Gross Profit c/d 42,18,000
2,10,84,000 2,10,84,000
To Administrative expenses 18,40,000 By Gross profit b/d 42,18,000
To Selling & Dist. exp. 7,56,000 By Interest on investment 24,600
To Interest on loan 2,60,000 By Dividend received 22,000
To Net Profit 14,08,600
42,64,600 42,64,600
Balance Sheet as on……..
Capital & Liabilities Amount (`) Assets Amount (`)
Capital 20,00,000 Plant & Machinery 24,00,000
Retained earnings 42,00,000 Building 42,00,000
General reserve 12,00,000 Furniture 12,00,000
Term loan from bank 26,00,000 Sundry receivables 13,50,000
Sundry payables 7,20,000 Inventory 14,28,000
Other liabilities 2,80,000 Cash & Bank balance 4,22,000
1,10,00,000 1,10,00,000
You are required to COMPUTE:
(a) Gross profit ratio
(b) Net Profit ratio
(c) Operating cost ratio
(d) Operating profit ratio
(e) Inventory turnover ratio
(f) Current ratio
(g) Quick ratio
(h) Interest coverage ratio
(i) Return on capital employed
(j) Debt to assets ratio

Solution
!"#$$ &"#'() ./,12,333
(a) Gross profit ratio = *+,-$
× 100 = 1,45,65,333 × 100 = 21.46%

7-) &"#'() 1.,32,533

(b) Net Profit ratio = *+,-$
× 100 = 1,45,65,333 × 100 = 7.17%
 89-"+)(:; <#$) 1,6.,=2,333>/6,45,333
(c) Operating ratio = *+,-$
× 100 = 1,45,65,333
× 100 = 91.75%
Cost of goods sold = Sales – Gross profit = 1,96,56,000 – 42,18,000 = `1,54,38,000
Operating expenses = Administrative exp. + Selling & dist. Exp.
= 18,40,000 + 7,56,000= `25,96,000

(d) Operating profit ratio = 100 – operating cost ratio = 100 – 91.75% = 8.25%

?#$) #' ;##@$ $#,@ 1,6.,=2,333

(e) Inventory turnover ratio = AB-"+;- $)#<C
= (1.,/2,333>1/,.5,333)÷/ = 11.55 times

?G""-:) +$$-)$ 1=,63,333>1.,/2,333>.,//,333 =/,33,333

(f) Current ratio = ?G""-:) ,(+H(,()(-$ = I,/3,333>/,23,333
= 13,33,333 = 3.2 times

JG(<C +$$-)$ =/,33,333K1.,/2,333

(g) Quick ratio = ?G""-:) ,(+H(,()(-$ = 13,33,333
= 1.77 times

LMNOP 7-) &"#'()>O:)-"-$) 1.,32,533>/,53,333

(h) Interest coverage ratio = O:)-"-$) = O:)-"-$)
= /,53,333
= 6.42 times

LMOP 1.,32,533>/,53,333
(i) Return on capital employed = ?+9()+, -Q9,#R-@ × 100 = 1,33,33,333
× 100 = 16.69%
Capital employed = Capital + Retained earnings + General reserve + Term loan
= 20,00,000 + 42,00,000 + 12,00,000 + 26,00,000 = `1,00,00,000

N-H) /5,33,333
(j) Debt to assets ratio = P#)+, +$$-)$ × 100 = 1,13,33,333 × 100 = 23.64%

Question – 2
Assuming the current ratio of a company is 2, STATE in each of the following cases whether the ratio
will improve or decline or will have no change:
(a) Payment of current liability
(b) Purchase of fixed assets by cash
(c) Cash collected from customers
(d) Bill receivable dishonored
(e) Issue of new shares

Solution
?G""-:) A$$-)$
Given, Current ratio = ?G""-:) S(+H(,()(-$ = 2

S. No. Situation Improve/Decline/No Reason

Change
(a) Payment of Current ratio will Let us assume CA is `2 lakhs & CL is `1
current liability improve lakhs. If payment of CL is `10,000 then
CA = 1,90,000 and CL = 90,000
 1,43,333
Current ratio = 43,333
= 2.11
Payment of current liability will reduce
the same amount in the numerator and
denominator. Hence, the ratio will
improve.
(b) Purchase of fixed Current ratio will Since the cash being a current asset
assets by cash decline converted into fixed asset, current assets
reduced, thus current ratio will fall.
(c) Cash collected Current ratio will not Cash will increase and debtors will
from customers change reduce. Hence no change in current
assets.
(d) Bills receivable Current ratio will not Bills receivable will come down and
dishonored change debtors will increase. Hence no change in
current assets.
(e) Issue of new Current ratio will As cash will increase, current assets will
shares improve increase and current ratio will increase.

Question – 3
The following accounting information and financial ratios of A&R Limited relate to the year ended
31st March, 2020:
Inventory Turnover Ratio 6 Times
Creditors Turnover Ratio 10 Times
Debtors Turnover Ratio 8 Times
Current Ratio 2.4
Gross Profit Ratio 25%
Total sales `6,00,00,000; cash sales 25% of credit sales; cash purchases `46,00,000; working capital
`56,00,000; closing inventory is `16,00,000 more than opening inventory.
You are required to calculate:
(a) Average Inventory
(b) Purchases
(c) Average Debtors
(d) Average Creditors
(e) Average Payment Period
(f) Average Collection Period
(g) Current Assets
(h) Current Liabilities

Solution
(a) Computation of Average Inventory
Gross Profit = 25% of 6,00,00,000 = `1,50,00,000
Cost of goods sold (COGS) = 6,00,00,000 - 1,50,00,000 = `4,50,00,000
Inventory Turnover Ratio = Cost of Goods sold
Average Stock
 .,63,33,333
6 = AB-"+;- *)#<C
Average stock = `75,00,000
(b) Computation of Purchases
Purchases = COGS + Increase in Stock = 4,50,00,000 + 16,00,000 = `4,66,00,000

(c) Computation of Average Debtors

Let Credit Sales be `100
Cash sales = 25% of 100 = `25
Total Sales = 100 + 25 = `125
5,33,33,333
If total sales is `6,00,00,000, then credit sales = 1/6
× 100 = `4,80,00,000
Thus, Cash Sales = `6,00,00,000 - `4,80,00,000 = `1,20,00,000
Debtors Turnover Ratio = Net Credit Sales
Average Debtors
.,23,33,333
8 = AB-"+;- N-H)#"$
Average Debtors = `60,00,000

(d) Computation of Average Creditors

Credit Purchases = Purchases — Cash Purchases
= 4,66,00,000 — 46,00,000 = `4,20,00,000
Creditors Turnover Ratio = Net Credit Sales
Average Debtors
.,/3,33,333
10 = AB-"+;- ?"-@()#"$
Average Creditors = `42,00,000

(e) Computation of Average Payment Period

Average Creditors ./,33,333
Average Payment Period = = (.,/3,33,333÷=56) = 36.5 days
Average Daily Credit Purchases
OR
Average Payment Period = 365/Creditors Turnover Ratio = 365/10 = 36.5 days

(f) Computation of Average Collection Period

Average Debtors 53,33,333
Average Collection Period = = (.,23,33,333÷=56) = 45.625 days
Average Daily Credit Sales
OR
Average collection period = 365/Debtors Turnover Ratio = 365/8 = 45.625 days

(g) Computation of Current Assets

Current Ratio = Current Assets (CA)
Current Liabilities (CL)

2.4 = CA
CL
 CL = CA/2.4
Working capital = Current Assets — Current liabilities
56,00,000 = CA – (CA/2.4)
CA = 96,00,000

(h) Computation of Current Liabilities

Current liabilities = 96,00,000 ÷ 2.4 = `40,00,000

Question – 4
With the following ratios and further information given below prepare a Trading Account, Profit and
Loss Account and Balance Sheet of ABC Company.
Fixed Assets `40,00,000
Closing stock `4,00,000
Stock turnover ratio 10
Gross profit ratio 25 percent
Net profit ratio 20 percent
Net profit to capital 1/5
Capital to total liabilities 1/2
Fixed assets to capital 5/4
Fixed assets / Total current assets 5/7

Solution
Trading and P&L Account
To Opening Stock (w.n. – 9) 80,000 By Sales (w.n. – 5) 32,00,000
To Purchases (bal. fig.) 27,20,000 By Closing Stock (given) 4,00,000
To Gross Profit (w.n. – 6) 8,00,000
36,00,000 36,00,000
To Expenses (bal. fig.) 1,60,000 By Gross Profit b/d 8,00,000
To Net Profit (w.n. – 4) 6,40,000
8,00,000 8,00,000

Balance Sheet
Capital (w.n. – 1) 32,00,000 Fixed Assets (given) 40,00,000
Other Liabilities (w.n. – 3) 64,00,000 Current Assets:
Stock (given) 4,00,000
Other CA (w.n. – 10) 52,00,000
96,00,000 96,00,000
Working Notes:
Fixed Assets 40,00,000 5
1. . Thus, Capital = `32,00,000
Capital Capital 4
Fixed Assets 40,00,000 5
2. . Thus, Total Current Assets = `56,00,000
Total Current Assets Total Current Assets 7
 Capital 32,00,000 1
3. . Thus, Other Liabilities = `64,00,000
Other liabilities Other liabilities 2
Total liabilities is taken/assumed as “External Liabilities”, i.e. excluding capital.
Net Profit Net Profit 1
4. . Thus, Net Profit = `6,40,000
Capital 32,00,000 5
Net Profit 6,40,000
5. Net Profit ratio = 20% . Thus, Sales = `32,00,000
Sales Sales
6. Gross Profit Ratio = 25%. Thus, Gross profit = 32,00,000 × 25% = `8,00,000
7. Cost of goods sold = Sales – Gross profit = 32,00,000 – 8,00,000 = `24,00,000
Cost of Goods Sold 24,00,000
8. Stock Turnover ratio = 10 .
Average Stock Average Stock
Thus, Average Stock = `2,40,000
Opening stock closing stock Opening stock 4,00,000
9. Average Stock = 2,40,000 .
2 2
Thus, Op. Stock = `80,000
10. Other Current Assets = Total Current Assets – Stock = 56,00,000 – 4,00,000 = `60,00,000

Question – 5
Following is the abridged balance Sheet of the SK Ltd. as at 31st March, 2020:
Balance Sheet
Liabilities ` Assets `
Paid up share capital 5,00,000 Free hold property 4,00,000
Profit & Loss A/c 85,000 Plant & Machinery 2,50,000
Current Liabilities 2,00,000 Less: Acc. Depreciation 75,000 1,75,000
Stock 1,05,000
Debtors 1,00,000
Bank 5,000
7,85,000 7,85,000
From the following information you are required to prepare Profit & Loss A/c (2020-21) and Balance
Sheet as at 31st March, 2021:
(a) The composition of the total of ‘liabilities’ side to the company’s Balance Sheet as at 31st March,
2021 (the paid-up capital remaining the same as at 31st March, 2020) was:
Share Capital 50%
Profit & Loss A/c 15%
10% Debentures 10%
Creditors 25%
The debentures were issued on 1st April, 2020. Interest is to be paid on 30th September, 2020 and
31st March, 2021.
(b) During the year ended on 31st March, 2021, additional Plant and Machinery had been bought and
a further `25,000 depreciation written off. Freehold property remained unchanged. The total fixed
assets then constituted 60% of total fixed and current assets.
(c) The current ratio was 1.6:1. The quick ratio was 1:1
(d) The debtors (four-fifth of the quick assets) to sales ratio revealed a credit period of two months.
(e) Gross Profit was at the rate of 15% of selling price and return on net worth as at 31st March, 2021
was 10%. Ignore taxation.
Solution
Working Notes:
(1) Particulars % Amount
Share capital 50% 5,00,000 (Because it remains same for next year)
P&L Account 15% 1,50,000 (10,00,000 × 15%)
10% Debentures 10% 1,00,000 (10,00,000 × 10%)
Creditors 25% 2,50,000 (10,00,000 × 25%)
10,00,000 (5,00,000 ÷ 50%)
(2) Interest on debenture = 1,00,000 × 10% = `10,000
(3) Total assets = Total liabilities = `10,00,000
Fixed assets = 60% × Total assets = 60% × 10,00,000 = `6,00,000
Current assets = 10,00,000 – 6,00,000 = `4,00,000
(4) Fixed assets = Freehold property + Plant & Machinery
6,00,000 = 4,00,000 + Plant & Machinery
Plant & Machinery = `2,00,000
?G""-:) A$$-)$
(5) Current ratio = ?G""-:) S(+H(,()(-$
.,33,333
1.60 = ?G""-:) S(+H(,(()(-$
Current Liabilities = `2,50,000
S(TG(@ +$$-)$
(6) Quick ratio = S(TG(@ ,(+H(,()(-$
.,33,333K*)#<C
1= /,63,333

Stock = `1,50,000
. .
(7) Debtors = 6 × Quick Assets = 6 × (4,00,000 – 1,50,000) = `2,00,000
(8) Other current assets = 4,00,000 – 1,50,000 – 2,00,000 = `50,000
AB-"+;- N-H)#"$
(9) Credit period = ?"-@() *+,-$
× 12
/,33,333
2 = ?"-@() $+,-$ × 12
Credit sales = `12,00,000
(10) Gross Profit = 15% × Sales = 15% × 12,00,000 = `1,80,000
 &"#'()
(11) Return on net worth = *U+"-U#,@-" 'G:@
13 &"#'()
133
= 6,33,333>1,63,333

Profit = `65,000

Trading and Profit and Loss Account

Particulars ` Particulars `
To Opening Stock 1,05,000 By Sales 12,00,000
To Purchases & Other exp. (Bal. fig.) 10,65,000 By Closing Stock 1,50,000
To Gross Profit c/d 1,80,00
13,50,000 13,50,000
To Depreciation 25,000 By Gross Profit b/d (Bal. fig.) 1,80,000
To Interest on Debentures 10,000
To Other exp. (Bal. fig.) 80,000
To Net profit for the year c/d 65,000
1,80,000 1,80,000
Balance Sheet
Liabilities ` Assets `
Share Capital 5,00,000 Fixed assets:
Profit & loss A/c 1,50,000 Freehold property 4,00,000
10% Debentures 1,00,000 Plant & Machinery 2,00,000 6,00,000
Creditors 2,50,000 Current assets:
Stock 1,50,000
Debtors 2,00,000
Other CA 50,000 4,00,000
10,00,000 10,00,000

Question – 6
Using the information given below, complete the Balance Sheet of PQR Private Limited:
(i) Current ratio 1.6:1
(ii) Cash and Bank balance 15% of total current assets
(iii) Debtors turnover ratio 12 times
(iv) Stock turnover (cost of goods sold) ratio 16 times
(v) Creditors turnover (cost of goods sold) ratio 10 times
(vi) Gross profit ratio 20%
(vii) Capital gearing ratio 0.6
(viii) Depreciation rate 15% on WDV
(ix) Net Fixed Assets 20% of total assets
(Assume all purchase and sales are on credit)

Balance Sheet of PQR Private Limited as at 31.03.2019

Liabilities ` Assets `
Share Capital 25,00,000 Fixed Assets
Reserve & Surplus ? Opening WDV ?
12% Long term debt ? Less: Depreciation __? ?
Current Liabilities Current Assets
Creditors ? Stock ?
Provision & outstanding Debtors ?
expenses ____? 68,50,000
Cash & Bank balance __? ?
Total ? Total ?

Solution
Balance Sheet of SK Private Limited as at 31.03.2022
Liabilities ` Assets `
Share Capital 25,00,000 Fixed Assets
Reserve & Surplus 17,81,250 Opening WDV 32,23,529
12% Long term debt 25,68,750 Less: Depreciation 4,83,529 27,40,000
Current Liabilities Current Assets
Creditors 55,89,600 Stock 34,93,500
Provision & outstanding Debtors 58,22,500
expenses 12,60,400 68,50,000
Cash & Bank balance 16,44,000 1,09,60,000
Total 1,37,00,000 Total 1,37,00,000

Working Notes:
?G""-:) A$$-)$
1) Current ratio = ?G""-:) S(+H(,()-$
?G""-:) A$$-)$
1.6 = ?G""-:) S(+H(,()(-$
Current Assets = 1.6 × Current Liabilities = 1.6 × 68,50,000 = `1,09,60,000
So, Cash and Bank balance = 15% × Current Assets = 15% × 1,09,60,000 = `16,44,000

2) Total Assets = Net fixed assets + Current assets

Total assets = 20% of total assets + 1,09,60,000
Total assets = 1,37,00,000
Net fixed assets = 20% of Total Assets = 20% × 1,09,60,000 = `27,40,000

3) Stock + Debtors = Current assets – Cash & bank = 1,09,60,000 – 16,44,000 = `93,16,000

4) Let Sales = y
?"-@() $+,-$ R
Debtors = N-H)#"$ )G":#B-" "+)(# = 1/
 *+,-$K/3% #' $+,-$ RK/3% #' R 3.23R R
Stock (on cost of goods sold) = 15
= 15
= 15
= /3
R R
1/
+ /3 = 93,16,000
y = 6,98,70,000
Sales = `6,98,70,000,
Cost of goods sold = `5,98,96,000
Stock (COGS ÷ 16) = `34,93,500
Debtors (Sales ÷ 12) = `58,22,500
Creditors (COGS ÷ 10) = `55,89,600

5) Calculation of provision of outstanding expenses = 68,50,000 – 55,89,600 = `12,60,400

6) Reserve & surplus + Long term debt = 1,37,00,000 – 68,50,000 – 25,00,000 = `43,50,000
Capital Earning Ratio = 0.6
1/% S#:; P-"Q N-H)
LTG()R *U+"- ?+9()+,>X-$-"B- & *G"9,G$
= 0.60
.=,63,333KX-$-"B- & *G"9,G$
/6,33,333>X-$-"B- & *G"9,G$
= 0.60
Reserve & Surplus = `17,81,250
12% Long term debt = `25,68,750

Question – 7
The following figures and ratios pertain to ABG Company Limited for the year ending 31st March
2016:
Annual sales (credit) `50,00,000
Gross profit ratio 28%
Fixed assets turnover ratio (based on cost of goods sold) 1.5
Stock turnover ratio (based on cost of goods sold) 6
Quick ratio 1:1
Current Ratio 1.5
Debtors collection period 45 days
Reserves & surplus to share capital 0.60:1
Capital gearing ratio 0.5
Fixed Assets to net worth 1.2:1
st
(a) Prepare the balance sheet as at 31 March 2016, based on the above information. Assume 360
days in a year.
(b) The statement showing working capital requirement, if the company wants to make a provision
for contingencies @15% of net working capital.

Solution
(a) Balance Sheet
Liabilities ` Assets `
1. Shareholder’s Funds: 1. Non-current assets:
Share capital (WN6) 12,50,000 Fixed Assets (WN 3) 24,00,000
 Reserves & surplus (WN6) 7,50,000 2. Current Assets:
2. Non-current liabilities: Stock (WN4) 6,00,000
Long-term loans (bal. fig.) 10,00,000 Debtors (WN5) 6,25,000 18,00,000
3. Current Liabilities (WN8) 12,00,000 Bank (WN9) 5,75,000
42,00,000 42,00,000

(b) Statement of Working Capital Requirement

Particulars Amount
Current Assets:
Stock 6,00,000
Debtors 6,25,000
Bank 5,75,000
18,00,000
Less: Current liabilities (12,00,000)
Working capital before contingencies provision 6,00,000
Add: Provision for contingencies @15% 90,000
Working capital after contingencies provision 6,90,000

Working notes and calculations:

1. Gross Profit ratio = 28% of sales. So Gross Profit = 28% × `50,00,000 = `14,00,000
2. Cost of goods sold (COGS) = Sales – Gross Profit = `50,00,000 – `14,00,000 = `36,00,000
COGS 36,00,000
3. Fixed Assets Turnover (based on COGS) = 1.5times
Fixed Assets Fixed Assets
Hence, Fixed Assets = `24,00,000
COGS 36,00,000
4. Stock Turnover = = 6 times
Inventory Inventory
So, inventory = `6,00,000
Note: In the absence of information, it is assumed that opening stock = closing stock = average
stock
5. Debt collection period = 45 days
45 45
So, debtors = Sales × = `50,00,000 × = `6,25,000
360 360
Fixed Assets 24,00,000
6. 1.20 So, Net worth = `20,00,000
Net Worth Net Worth
Current Assets
7. Current Ratio = = 1.5 times
Current Liabilities
So, currently assets = 1.5 x current liabilities
Quick Assets
8. Quick ratio = = 1 time
Quick Liabilities
Current Assets - Stock
So, =1
Current Liabilities
(1.5 ´ Current Assets) - Rs.6,00,000
On substitution, =1
Current Liabilities
 On solving, we get, current liabilities = `12,00,000
9. Hence, current assets = 1.5 x 12,00,000 = `18,00,000
Cash & Bank = Total CA – Debtors – Inventory = 18,00,000 – 6,00,000 – 6,25,000 = `5,75,000
Prefernce Capital Debt Nil 10,00,000
10. Verification: Capital Gearing Ratio = = = 0.5 times
Equity Shareholde rs Fund 20,00,000

Note: In the absence of information, share capital = Equity share capital only. Debt is taken from B/s
above.
Alternatively, using the capital gearing ratio, debt can be computed as balancing figure, (using equity
shareholders’ funds from WN6, and the balance sheet shall be found tallied.

Question – 8
A Limited Company’s books reveal following information: Net Income
Net Income `3,60,000
Shareholder’s Equity `4,00,000
Assets Turnover 2.5 times
Net profit margin 12%
You are required to calculate ROE (Return on Equity) of the company based on the ‘DuPont Model’.

Solution
Net Profit Margin = Net Income ÷ Revenue
0.12 = 3,60,000 ÷ Revenue
Revenue = `30,00,000

Assets turnover = Revenue ÷ Assets

2.5 = 30,00,000 ÷ Assets
Assets = `12,00,000

Equity Multiplier = Assets ÷ Shareholder’s Equity = 12,00,000 ÷ 4,00,000 = 3

Return on Equity = Net Profit Margin × Assets Turnover × Equity Multiplier

= 0.12 × 2.5 × 3 = 0.9 = 9%