Corporate Accounting and

Financial Management
Time allowed 3hours Maximum Marks 50
Answer any 2 out of 3 (10 marks each)
1. Dhruv Itd wishes to raise additional finance of Rs 30 lakhs for meeting its
investment plans. The company has Rs 6,00,000 in the form of retained
earnings available for investment purposes. The following are further
details-
 Debt equity ratio 30:70
 Cost of debt at the rate of 11% (before tax) up to Rs 3,00,000 and
14% (before tax) beyond that.
 Earnings per share = Rs 15 and dividend payout = 70% of earnings
 Expected growth rate in dividend 10%
 Current market price per share = Rs 90
 Company's tax rate is 30% and shareholders personal tax rate is
20%
Calculate the following-
• Post tax average cost of additional debt
• cost of retained earnings and cost of equity.
• overall weighted average (after tax) cost of additional finance.
(10 MARKS)
Solution:
Loan Required = 30% of Rs. 30 lakhs Rs. 9,00,000
Interest on loan = (Rs. 3,00,000 * 11%) + (Rs. 6,00,000 * Rs. 1,17,000
14%) = Rs. 33,000 + Rs. 84,000
Kd = interest * (100% - tax rate) 9.10%
Net proceeds of issue
Ke = DPS1 + g = 15 * 70% * 110% + 10% 22.83%
MPS0 90
K0 = (Kd * Wd) + (ke * We) = (9.10% x 30%) + (22.83% x 70%) 18.711%
Note:
DPS 1 has been considered in computation of ke Alternatively, earnings
growth model may also be applied.
Alternatively, kr may be taken as post tax opportunity cost = ke (1-tp) =
22.83% x (100% - 20%) = 18.26%.

In such case, ko will be computed as under –

Component Rs % Individual WACC
Cost
Debt 9,00,000 30% Kd = 9.10% 2.73%
Retained 6,00,000 20% Kr = 18.26 3.65%
Earnings
Equity 15,00,000 50% Ke = 22.83% 11.42%
Capital
Total 30,00,000 100% WACC = 17.80%

2. A single product company sells its product at Rs.60 per unit. In 2019-20,
the company operated at a margin of safety of 40%. The fixed costs
amounted To Rs. 3,60,000 and the variable cost ratio to sales was 80%.
In 2020-21, it is estimated that the variable cost will go up by 10% and the
fixed cost will increase by 5%.
(i) FIND the selling price required to be fixed in 2020-21 to earn the
same P/V ratio as in 2019-20.
(ii) Assuming the same selling price of Rs. 60 per unit in 2020-21, Find
the number of units required to be produced and sold to earn the
same profit as in 2019-20.
(10 MARKS)
Solution:
(i) Profit earned in 2019-20:
Particular (Rs)
Total contribution (50,000 x Rs12) 6,00,000
Less: Fixed cost
Profit 3,60,000
Selling price to be fixed in 2020-21 2,40,000
Revised variable cost (Rs48 x 1.10) 52.80
Revised fixed cost (3,60,000 x 1.05) 3,78,000
PIV Ratio (same as of 2019-20) 20%
Variable cost ratio to selling price 80%

Therefore, revised selling price per unit = Rs. 52.80 ÷ 80% = Rs. 66.
(ii) No. of units to be produced and sold in 2020-21 to earn the same profit:

We know that Fixed Cost plus profit Contribution (Rs.)

Profit in 2019-20 2,40,000
Fixed cost in 2020-21 3,78,000
Desired contribution in 2020-21 6,18,000

Contribution per unit = Selling price per unit - Variable cost per unit. Rs. 60-
Rs. 52.80 - Rs. 7.20
= No. of units to be produced in 2020-21 Rs. 6,18,000+ Rs. 7.20 85,834 Units.
Workings:
1. PV ratio in 2019-20.
Particular (Rs)
Selling price per unit 60
Variable cost (80% of Selling Price) 48
Contribution 12
P/V Ratio 20%

2. No. of units sold in 2019-20.

Break even point = Fixed cost + Contribution per unit
Rs. 3,60,000+ Rs. 1230,000 units
Margin of safety is 40%. Therefore, break-even sales will be 60% of Units
sold.
No. of units sold = Break -even point in units + 60%.
30,000 60% 50,000 units
3. Ashoke Itd and Babita Itd are identical except for capital structure.
Ashoke Itd has 60% debt and 40% equity, whereas Babita Itd has 20%
 debt and 80% equity. Call % are in market-value terms). The borrowings
rate for both companies is 8% in a no-tax world, and capital markets are
assumed to be perfect.
• If X owns 3% of the equity shares of Ashoke Itd, determine his return if
the company has net operating income Rs. 4,50,000 and the overall
capitalization rate of the company is 18%. Calculate the implied
required rate of return on equity of Ashoke Itd.
• Babita Itd has the same net operating income as Ashoke Itd. Calculate
the implied required return of Babita Itd. Analyse why does it differ
from that of Ashoke Itd.
(10 MARKS)
Solution:
Net operating income approach is applicable in this case, since companies
are identical 1, capital market are perfect, no tax.
Particulars Ashoke ltd (Rs) Babita ltd (Rs)
Value of firm (F) = 4,50,000 / 18% = 4,50,000 / 18% =
EBIT /Ko 25,00,000 25,00,000
Value of debt (D) 60% = 15,00,000 20% = 5,00,000
Value of equity (F-D) 10,00,000 20,00,000
Net operating income 4,50,000 4,50,000
= EBIT
Interest on debt (8% 1,20,000 40,000
on debt in item 2)
Net income EBT for 3,30,000 4,10,000
equity holders
Implied required 33% 20.5%
equity return =

Answer any 6 out of 8 (5 marks each)

4. Consider the following information for Strong Ltd:
• EBIT= Rs 1,120 in lakhs
• PBT = Rs 320 in lakhs
• Fixed cost = Rs 700 in lakhs
Calculate the Percentage of change in earnings per share if sales increased
by 5%
 (5 MARKS)
Solution:
% change in EPS if sales increased by 5%
Contribution – fixed cost = EBIT
Contribution = fixed cost + EBIT
Contribution = 700 + 1,120

Contribution = 1,820

DCL = contribution / EBT = 1,820 L / 320L = 5.69

If sales increases by 1%, then EPS increases by 5.69%
% change in EPS = 5.69 * 5 = 28.45

5. From the following details of X Ltd. Prepare the income statement for the
year ended 31st December 2014:
• Financial Leverage = 2
• Interest = B2,000
• Operating Leverage = 3
• Variable Cost as a Percentage of Sales = 75%
• Income Tax Rate = 30%
(5 MARKS)
Solution:
Income statement
Sales (WN 3) 48,000
Less: variable cost (75% of sales) (given) (36,000)
Contribution (WN2) 12,000
Less: fixed cost (bal. fig) (8,000)
EBIT (WN 1) 4,000
Less: interest (given) (2,000)
EBT 2,000
Less: Tax (30%) (600)
1,400

6. You are given the following particulars

• Fixed cost Rs. 1,50,000
 • Variable cost Rs.15 per unit iii. Selling price is Rs. 30 per unit
Calculate:
(a) Break-even point
(b) Sales to earn a profit of Rs. 20,000
(5 MARKS)

Solution:
a) Break – even point (BEP) = fixed cost / contribution margin per unit
= Rs. 1,50,000 / Rs. 15
= Rs. 10,000 units
(Contribution per unit – sales per unit – variable cost per unit = Rs. 30 Rs. 15
b) Sales to earn a profit of Rs. 20,000
= fixed cost + desired profit / contribution per unit * selling price per unit
= Rs. 1,50,000 + Rs. 20,000 / Rs. 15 * Rs. 30
= Rs. 3,40,000

7. The capital structure of vidya Itd as on 31s march is as follows (Rs in

lakhs):
• Equity share capital 7,50,000 equity shares of Rs 100 each = 750
• Retained earnings = 250
• 13.5% preference share capital= 240
• 12.5% debenture =360
The current market price per equity share is Rs 350. The prevailing default
risk-free interest rate is 6% and rate of return on market portfolio is 15%. The
beta of the company is 1.289. The corporate tax rate is 30%. The average tax
rate of shareholders is 25% and brokerage cost is 2%, that they have to pay
while investing dividend in alternative securities. Calculate the weighted
average cost of capital on the basis of book value weights.
(5 MARKS)

Solution:
Computation of WACC (book value weights)
Components Rs. In lakhs % Individual cost WACC
Equity capital 750 46.875% Ke = Rf + β (Rm – Rf) 8.25%

= % + 1.289 (15% - 6%)

17.60%
Retained 250 15.625% 12.94% 2.02%
Earnings
Preference 240 15.000% 13.50% 2.03%
capital
Debentures 360 22.500% Kd = 12.5% * (100% - 1.97%
cop. Tax rate 30%) =
8.75%
Total 1600 100.00% 14.27%

8. A new project requires a capital outlay of 400 lakhs. The required amount
to be raised either fully by equity shares of 100 each or by equity shares
of the value of 200 lakhs and by loan of 200 lakhs at 15% interest.
Assuming a tax rate of 40%, calculate the figure of EBIT that would keep
the equity investors indifferent to the two options.
(5 MARKS)
Solution:
Option A (full equity) Option B (debt + equity)
Equity (FV100) Rs. 400 lakhs Rs. 200 lakhs
15% Debt Nil Rs. 200 lakhs
Total capital Rs. 400 lakhs Rs. 400 lakhs
No. of equity 4,00,000 2,00,000
shares

Let us assume indifference level of EBIT is Rs. X. Thus

{(𝑋 − 0 )(1 − 0.4) − 0} {(𝑋 − 30,00,000 )(1 − 0.4) − 0}
=
4,00,000 2,00,000
0.6𝑋 0.6𝑋 − 18,00,000
=
4,00,000 2,00,000
 4,00,000 0.6𝑋 − 18,00,000
0.6𝑋 = =
1 2,00,000
0.6X = 1.2X – 36,00,000
36,00,000= 1.2X – 0.6X
0.6X = 36,00,000X = Rs 60,00,000

Thus the EPS under two different financial options will be equal at 60 lakhs
EBIT Level. This can be verified as follows:

9. What is the significance of capital structure? Describe its various kinds.

(5 MARKS)
Solution:
• Capital structure means the structure or constitution or break up of
the capital employed by a firm.
• The capital employed consists of both the owners capital and the debt
capital provided by the lenders.
• According to the definition of Gesternberg, “ capital structure of a
company refers to the composition or make up of its capitalization and
it has a large proportion consisting of equity capital and includes all
the long term capital resources.”
• Type of capital structure
➢ Horizontal capital structure – In a horizontal capital structure,
the firm has zero debt components in the structure mix.
➢ Vertical capital structure – In the vertical capital structure, the
base of the structure is formed by small amount of equity share
capital.
➢ Pyramid shaped capital structure – A pyramid shaped capital
structure has a large proportion consisting of equity capital and
retained earnings.
➢ Inverted pyramid shaped capital structure – such a capital
structure has small component of equity capital, reasonable
 level of retained earnings but an ever increasing component of
debt.

10. "Retained earnings in not a cost of free source of capital", Explain. How
is the cost of retained determined?
(5 MARKS)

Solution:
• That part of earnings of a company which remains with it after
distribution of dividend among the shareholders is called as retained
earnings.
• There are commonly known as internal equity of the concern.
• There is no explicit cost of this type of profits because there is no
formal of implied obligation on the company to pay any return on this
amount.
• But it is not correct to treat them as cost free. In fact, cost of this
source of finance is its opportunity cost.
• When earnings are retained, the shareholders are forced to forge such
return.
• Hence, the expected return forged by the shareholders on foregone
dividends may be treated as the cost of retained earnings.

11. ABC Limited has the following capital structure and want to know its
Financial Break Even Point
• Equity shares (FV = 100) RS 5,00,000
• 12% Preference Shares (FV = 100) RS 5,00,000
• 10% Debentures (FV = 100) RS 10,00,000
• Tax Rate 40%
(5 MARKS)
Solution:
FBP = Interest + Preference dividend / (1-t)
1,00,000 + 6,00,000 / (1-0.40)
Rs. 11,00,000
In other words, the EPS of the firm will be zero at Rs. 11,00,000 level of EBIT.