CHARTERED ACCOUNTANCY PROFESSIONAL II

(CAP-II)

Compilation of Suggested Answers

Paper 4: Financial Management

(June 2009 - June 2019)

Education Department
The Institute of Chartered Accountants of Nepal
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© The Institute of Chartered Accountants of Nepal

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September 2019

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 Table of Content

Chapter Head Page No

Chapter 1 Time Value of Money 2
Chapter 2 Cost of Capital 10
Chapter 3 Valuation of Fixed Income Security 29
Chapter 4 Valuation of Shares 43
Chapter 5 Capital Investment Decision 54
Chapter 6 Financial Analysis 112
Chapter 7 Portfolio Management 145
Chapter 8 Working Capital Computation 174
Chapter 9 Receivable Management 195
Chapter 10 Cash Management 218
Chapter 11 Dividend Policy 229
Chapter 12 Capital Structure Management 251
Chapter 13 Interest Rate Determination 295
Chapter 14 Mutual Fund 297
Chapter 15 Other Short Notes 300

© The Institute of Chartered Accountants of Nepal 1

 CAP II Paper 4: Financial Management

Chapter 1:

Time value of Money

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 CAP II Paper 4: Financial Management

Question No. 1
Profit Maximization and Wealth Maximization Objective [December 2011] (2.5 Marks)

Answer:
The company may pursue profit maximization goal but that may not result into creation of
shareholder value. The profits will be maximized if company grows through diversification and
expansion. But all growth may not be profitable. Only that growth is profitable where
ROA > WACC or ROE > KE or Firms invest in project with positive NPV,
However, profit maximization cannot be the sole objective of a company. It is at best a limited
objective. If profit is given undue importance, a number of problems can arise like the term
profit is vague, profit maximization has to be attempted with a realization of risks involved, it
does not take into account the time pattern of returns and as an objective it is too narrow.
Whereas, on the other hand, wealth maximization, as an objective, means that the company is
using its resources in a good manner. If the share value is to stay high, the company has to
reduce its costs and use the resources properly. If the company follows the goal of wealth
maximization, it means that the company will promote only those policies that will lead to an
efficient allocation of resources.

Question No. 2
Annuities and Annuities Due [December 2012] 2.5 Marks

Answer:
The term annuity refers to any terminating stream of fixed payments over a specified period of
time. This usage is most commonly seen in discussions of finance, usually in connection with
the valuation of the stream of payments, taking into account time value of money concepts,
such as interest rate and future value.
Examples of annuities are regular deposits to a savings account, monthly home mortgage
payments, and monthly insurance payments. Annuities are classified by the frequency of
payment dates. The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at
any other interval of time.
An annuity-due is an annuity whose payments are made at the beginning of each period.
Deposits in savings, rent or lease payments, and insurance premiums are examples of annuities
due.

Question No. 3
Answer the following, supporting the same with proper reasoning: (2.5 Marks)

Whether the present value decreases at a linear rate, at an increasing rate, or at a decreasing rate
with the discount rate and why?
[June 2013]

Answer:

The present value decreases at a decreasing rate with discount rate. As the discount rate
increases, the discount factor goes on decreading. It is because the denominator of the present
value equation increases at an increasing rate with multiple of increase in period ‗n‘.

Question No. 4
Annuity and Perpetuity [June 2014] (2.5 Marks)

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 CAP II Paper 4: Financial Management

[Link] Annuity Perpetuity

1 An annuity is a stream of regular Perpetuity is a stream of payments or
periodic cash flows (either payments type of annuity that starts payments on
made or received) for a specified period fixed date and such payments continue
of time forever, i.e. perpetually. Thus, Perpetuity
is a constant stream of identical cash
flows with no end.
2 Future value of Annuity can be Perpetuity is a type of annuity which is
computed using Compounding never-ending, its sum if future value
Technique cannot be calculated
3 Examples Examples
a) Recurring Deposit installments paid a) Dividend on Irredeemable Preference
to bank. Share Capital.
b) Life insurance premium per annum b) Interest on Irredeemable Debt/Bonds.
c) Scholarships paid perpetually from an
endowment Fund, etc.

Question No. 5
A bank offers a fixed deposit scheme whereby Rs. 100,000 matures to Rs. 126,250 after years, on
half-yearly compounding basis. If the bank wishes to amend the scheme by compounding interest
every quarter, what will be the revised maturity value? (6 Marks)
[December 2011]
Answer:
Computation of Rate of Interest:
Principal = Rs. 100,000
Amount = Rs. 126,250
100,000 = 126,250
(1 + i)4
Pn = A X (PVF n, i)
100,000 = 126,250 (PV 4, i)
(PV 4, i) = 0.7921
According to the Table on Present Value Factor (PVF4, i), a PVF of 0.7921 for half-
yearly interest of 6 per cent becomes a lump sum of Re. 1. Therefore, the annual
interest rate is 2 X 0.06 = 12 per cent.
Revised maturity value, if interest is compounded quarterly:
Revised maturity value = 100,000 (1 + 12 X 1) 2 X 4 = 100,000 ( 1 + 3 )8
100 4 100
= 100,000 × (1.03) 8
= 100,000 × 1.267 [since (CVF 8, 3) = 1.267]
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 CAP II Paper 4: Financial Management

= Rs. 126,700
Therefore, the revised maturity value will be Rs. 126,700.

Question No. 6
A 12-payment annuity of Rs. 10,000 will begin 8 years hence, i.e. the first payment occurs at the
end of 8 years. What is the present value of this annuity, if the discount rate is 14 per cent?
(3 Marks)
[June 2012]
Answer:
In the first step, we determine the value of this annuity a year before the first payment begins,
i.e. 7 years from now. This is equal to:
Rs. 10,000 (PVIFA 14%, 12 years) = Rs. 10,000 (5.660) = Rs. 56,600

In the second step, the present value of the amount obtained in step 1 is found out as follows:
Rs. 56,600 (PVIF 14%, 7 years) = Rs. 56,600 (0.400) = Rs. 22,640 (Approx.)

Alternatively,
Annuity amount (Rs.) = 10,000
No. of payment = 12
Discounting Rate = 14%
PVIFA at 14% for years 8-19 = 2.2621
Therefore,
PV = Rs.10,000 x 2.2640
= Rs.22,640 (Approx.)

Question No. 7
Mohan has just own a lottery and has three award options to choose from:
[Link] receive a lump sum payment today of Rs. 61 million, or
[Link] receive 10 annual end of year payment of Rs. 9.5 million, or
[Link] receive 30 annual end of year payment of Rs. 5.5 million.
He expects to earn 8% annual return on his investment.
Required:
Recommend the best option for him. (5 Marks)
[December 2012]

Answer:
Calculation of present value of each option
1. Lump sum payment of Rs. 61 million; PV = Rs. 61 million
2. 10 annual end of year payment of Rs. 9.5 million;
PV= PMT x (PVIFA 8%, 10 years)
= Rs. 9.5 Million x 6.7101
= Rs. 63.75 Million
3. 30 annual end of year payment of Rs. 5.5 million;
PV= PMT x (PVIFA 8%, 30 years)
= Rs. 5.5 million x 11.2578
= Rs. 61.92 million

Since, option 2 provides highest present value, he should choose to receive 10 year annuity plan.

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 CAP II Paper 4: Financial Management

Question No. 8
A company offers a fixed deposit scheme whereby Rs. 10,000 matures to Rs. 12,625 after 2
years, on a half-yearly compounding basis. If the company wishes to amend the scheme by
compounding interest every quarter, what will be the revised maturity value? (3 Marks)
[June 2013]

Answer:
Computation of Revised Maturity Value
Principal = Rs. 10,000
Amount = Rs. 12,625
10,000= * +
Pn = A × (PVFn, i)
10,000 = 12,625 (PVF4, i)
0.7921 = (PVF4, i)
According to the Table on Present Value Factor (PVF4,i) of a lump sum of Re. 1, a PVF of
0.7921 for half year at interest (i) = 6 percent. Therefore, the annual interest rate is 2 ×0.06 = 12
percent.
i = 6% for half year
i = 12% for full year.
Therefore, Rate of Interest = 12% per annum

Revised Maturity Value ( )

( )

=10,000×1.267 [considering (CVF 8,3)=1.267]

Revised Maturity Value = 12,670.

Question No. 9
Madhu opened an account on Shrawan 1, 2069 with a deposit of Rs. 800. The account paid 6%
interest compounded quarterly. On Magh 1, 2069, she closed the account and added enough
additional money to invest in a 6-month time deposit for Rs. 1,000 earning 6% interest
compounded monthly.
Required: (2+2+1=5 Marks)
i) How much additional amount did Madhu invest on Magh 1?
ii) What was the maturity value of her time deposit on Shrawan 1, 2070?
iii) How much total interest was earned during the period?
(Given that (1+ i) n is 1.03022500 for, i= 1.5%, n=2, and is 1.03037751 for i=0.5% and n =6)
[December 2013]

Answer:
i) The initial investment earned interest from Shrawan to Poush, i.e. for two quarters

In this case, i=6/4=1.50%, n=2, P=Rs. 800; and

the compounded amount =800×1.03022500= Rs. 824.18
The additional amount invested on Magh 1= Rs. (1,000 - 824.18)=Rs. 175.82

ii) In this case, the time deposit earned interest compounded monthly for 6 months
Here, i =6/12=0.5%, n=6 , P=Rs. 1,000
Required maturity value = 1000×1.03037751= Rs. 1,030.38

iii) Total interest earned = Rs. 24.18 + Rs.30.38= Rs. 54.56

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 CAP II Paper 4: Financial Management

Question No. 10
A company has to make the payment of Rs. 2,000,000 on 5th of March 2015. It has some surplus
money today i.e.,4th December 2014 and it has decided to invest in a deposit of bank at 8% per
annum to meet the amount for payment. What money is required to be invested now? Take year
as 365 days. [December 2014] (2 Marks)
Answer:
Target money: Rs. 2,000,000
The amount to be invested now is in fact the present money of this targeted money. The
FVF may be ascertained as follows:
FVF = 1+ [(annual rate of interest × (Deposit period/365)]
=1+[(0.08x(90/365)]
=1.01972
Now the present value of the target amount can be ascertained as follows:
Present value = Target amount/1.01972
= Rs. 1,961,323
Note:Student may use PVF and in such case present value = Target money×PVF
the deposit of Rs. 1,961,323 at the rate of 8% for a period of 90 days will accumulate to
Rs. 2,000,000. Therefore, amount to be invested is Rs. 1,961,323

Question No. 11
Pradeep's brother Sandeep has promised to give him Rs. 100,000 in cash on his 25th birthday.
Today is Pradeep's 16th birthday.
Required: Help Sandeep with the following calculation: (1.5+1.5+2=5 Marks)
i) If Sandeep wants to make annual payment into a fund after one year, how much will each
payment has to be if the fund pays 8% interest?
ii) If Sandeep decides to invest a lump sum in the fund after one year and let it compound
annually, how much will the lump sum be?
iii) If in i) above the payments are made in the beginning of the year, how much will be the
value of annuity.
[July 2015]

Answer:
i. Rs. 1,00,000=A(CVAF9,0.08)= A(12.488)
Thus A=100,000/12.488= Rs. 8,007.69

ii. Rs. 100,000=P(CVF8,0.08)=P(1.8509)

Thus P=100,000/1.8509=Rs. 54,027.78

iii. This is a problem of annuity due since payment is made at the beginning of the year.
Rs. 100,000=A (CVAF9,0.08)(1.08)
Rs. 100,000=A (13.487)
A=Rs. 100,000/13.487
= Rs. 7414.55

Question No. 12
Mr. Liberal, an established Development Planning Consultant, was approached by the officer of
N Investment Banking Ltd. for his wealth management. Mr. Liberal is currently aged exactly 57
years and is planning to retire from his profession after the age of 60. He is currently living with
his wife and a daughter, who is settled in US. He wants to set aside some funds and let the
© The Institute of Chartered Accountants of Nepal 7
 CAP II Paper 4: Financial Management

Investment Bank manage his funds for guaranteed return from 61st year for at least 10 years for
his and his wife's living.

Mr. Liberal estimates the requirement of Rs. 120,000 per month to cover up his living from the
1st year of retirement. The officer of the Investment Bank has offered 3 schemes of which he has
chosen fixed income scheme with 0% risk and yields 10% interest per annum compounded
annually during the entire scheme period from the beginning of 61st birthday till 70th birthday
while 9.5% compounded quarterly from the beginning of deposit till the end of 60th birthday.
The proceeds by the Investment Bank are paid in lump-sums and at the beginning of every year.
Ignore management fees of Investment Bank and taxation.

Required:
What is the amount Mr. Liberal needs to deposit at the Investment Bank as of today under the
scheme? Present your calculations on Rs. in thousands. (5 Marks)
[December 2015]

Answer:

10% is the discount rate which is Mr. Liberal's yield after retirement.
Amount Mr. Liberal needs to deposit at the Investment Bank is Rs. 7,346.70 K. as below:

Total Present Value of Annuity Due @ 10%

for 10 yrs. 6.761
Rs. In '000
Annual Payment (120,000×12) 1,440.00
Total Sum at the beginning of 61st Birthday 9,735.84

Annual Interest Rate = 9.50%

Quarterly Compounded Annual Interest Rate = (1+9.5%/4)4 - 1
= 9.84%
Age Beginning Interest Closing Balance
Balance
60th 8,863.66 872.18 9,735.84
59th 8,069.61 794.05 8,863.66
58th 7,346.70 722.91 8,069.61

Interest is calculated as:

60th yr = 9735.84× 0.0984 =Rs. 872.18 ('000) and so on...

1.0984

Question No. 13
Mr. X wants to get her daughter admitted into a medical college after 15 years from now. He
will require total Rs. 2,500,000 to get admission into the college. For this, he has identified a
fund, which pays interest at 9% p.a.
Required: (5 Marks)
Determine the amount to be invested:
i) If Mr. X decides to make annual payment into the fund at the end of each year.
ii) If Mr. X decides to invest a lump sum in the fund at the end of the year.
iii) If Mr. X decides to make annual payment into the fund at the beginning of
each year.
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 CAP II Paper 4: Financial Management

[FVIF/CVF(15, 0.09) = 3.642, FVIFA/CVFA(15, 0.09) = 29.361]

[June 2017]

Answer:
(i) To get Rs. 25,00,000 after 15 years from now, Mr. X needs to deposit an amount at the
end of each year, which gets accumulated @ 9% p.a. for 15 years to become an amount
to Rs. 25,00,000.
Future Value = Annual payment x FVIFAn, I
Annual payment = future value /FVIFAn, I = 25,00,000/29.361 = Rs.85,146.96 p.a.
(ii) To get Rs. 25,00,000 after 14, one years from now. Mr. X needs to deposit a lump sum
payment to the fund which gets accumulated @ 9% p.a. for 14 years to become an
amount to Rs. 25,00,000.
Future Value = Amount x P.V Single sum factor 9% for 14 years.
Amount = 25,00,000 × 0.2992= Rs. 748,000
(iii) To get Rs. 25,00,000 after 15 years from now, Mr. X needs to deposit an amount at the
beginning of each year which gets accumulated @ 9% p.a. for 15 years to become an
amount to Rs. 25,00,000.
Future Value = Annual payment x (FVIFAn, i) x (1+i)
Annual Payment = 25,00,000/ (29.361 x 1.09) = Rs. 78, 117.68 p.a.

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 CAP II Paper 4: Financial Management

Chapter 2:

Cost of Capital

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 CAP II Paper 4: Financial Management

Question No. 1
Cost of the perpetual debt [June 2009] (2.5 Marks)

Answer:
The cost of perpetual debt is the rate of return which the lenders expect from such debt. The
coupon rate of interest or market yield on debt approximately represents the cost of debt.
Another aspect which needs mention regarding the cost of perpetual debt is that effective cost of
debt should be computed as after-tax cost not before tax. The coupon or nominal rate written in
the face of the debt document is the before cost of debt. Therefore, adjustment in the coupon rate
is essential to obtain the after tax cost of perpetual debt.
In order to compute the cost of perpetual debt, following types of data is required:
i) Net cash proceeds/inflows from the particular type of debt,
ii) Net cash outflows in terms of amount of periodic interest payment and repayment of
principal in installments or lump sum on maturity.

Since the interest paid on debt by a firm is tax deductible, it is essential that the effect cost of the
debt is obtained after considering the tax savings generated as a result of interest payment.
Another important aspect which also needs consideration is that the bonds and debentures can be
issued at (i) par, (ii) discount and (iii) premium. The coupon rate of interest needs adjustment to
ascertain the actual cost of debt.
Following two formulas are employed to determine the cost of perpetual debt:
ki = I
SV
kd = I (1 – t), where
SV
ki = Before tax cost of debt,
kd = Tax-adjusted cost of debt,
I = Annual interest payment
SV = Sale proceeds of the bond/debenture
t = Tax Rate

Question No. 2
Marginal cost of capital (December 2009) (2.5 Marks)

Answer:
The marginal cost of capital is defined as the cost of the last rupee of new capital that the firm
raises and the marginal cost rises as more and more capital is raised during a given period. A
firm‘s marginal cost of capital, also known as weighted marginal cost of capital, reflects the fact
that as the volume of total new financing increases, the costs of the various types of financing
will increase, raising the firm‘s cost of capital. Breaking points, which are found by dividing the
amount of funds available from a given financing source by its capital structure weight,
represent the level of total new financing at which the cost of one of the financing components
rises, causing an upward shift in the weighted marginal cost of capital. The weighted average
cost of capital WACC is associated with its next rupee of total new financing. The WMCC
schedule relates the WACC to each level of total new financing. It is important for capital
expenditure decisions.

Question No. 3
Perpetuities [June 2011] (2.5 Marks)

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 CAP II Paper 4: Financial Management

Answer:
Perpetuities can be defined as a stream of equal payments expected to continue for ever. Most
annuities call for payments to be made over some finite period of time, for example, Rs1000 per
year for five years. However, some annuities go for indefinitely, or perpetually, and these are
called perpetuities. The present value of perpetuities is found as below:
PV (Perpetuities) = Payment/ Interest Rate
Most preferred stocks entitle their owners to regular, fixed dividend payments lasting forever.
These are one of the examples of ‗perpetuities‘.

Question No. 4
Dividend-price approach and Earning price approach to estimate cost of equity
[July 2015] (2.5 Marks)

Answer:
In a dividend- price approach, cost of equity is calculated by dividing the current dividend by
average market price per share. This ratio expresses the cost of equity capital in relation to what
yield the company should pay to attract investors. It is calculated as:
Ke= D1/P0
Where, D1= Dividend per share in period 1
P0= Market Price per share now
Whereas earning price approach correlate the earnings of the company with the market price of
its shares. So, cost of equity shares would be based on expected rate of earning of the company.
This approach seeks to nullify the effect of changes in dividend policy.

Question No. 5
The Mike Company‘s financing plans for next year include the sale of long-term bonds
with a 10 percent coupon. The company believes it can sell the bonds at a price that
will provide a yield to maturity of 12 percent. If the marginal tax rate is 34 percent,
what is Mike‘s after tax cost of debt? (3 Marks)
(June 2009)

Answer:
Mike's after tax cost of debt can be derived as per the below formula:
After tax cost of debt = Yield to Maturity ( 1- Tax Rate)
= 12% (1- 0.34)
= 7.92%
Question No. 6
You are the financial analyst of a FMCG company based in Hetauda. The company
wishes to raise additional finance of NRs. 30 million to meet its investment plans. It
has NRs. 6.3 million in the form of retained earnings available for investment purpose.
Following further details are also available:
a) Debt-equity mix to be maintained at 30:70.
b) Cost of debt: Up to NRs. 6 million, 12 percent (before tax); Beyond NRs. 6
million, 15 per cent (before tax)
c) Earnings per share: NRs. 80
d) Dividend pay out, 50 percent of earnings
e) Expected growth rate of dividends, 20 percent
f) Current market price per share, NRs. 660
g) Tax rate, 30 percent

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 CAP II Paper 4: Financial Management

On the basis of information given above, you are required to determine/compute the following:
(4×2.5=10 Marks)
i) Pattern of raising the additional finance, assuming the company intends to maintain
the existing debt equity mix,
ii) Post tax average cost of additional debt,
iii) Cost of retained earnings and cost of equity,
iv) Overall weighted average after tax cost of additional finance.
(June 2009)

Answer:
i) Pattern of raising additional finance

Debt = 0.30 X NRs. 30 million = NRs. 9 million

Equity Funds: 0.70 X NRs. 30 million = NRs. 21 million

Statement of Debt- Equity Position

Retained Earnings NRs. 6,300,000
Equity Share Capital (Additional) NRs. 14,700,000 NRs. 21,000,000
Debt Funds (NRs. 9 million)
12% Debt NRs. 6,000,000
15% Debt NRs. 3,000,000 NRs. 9,000,000
NRs. 30,000,000

ii) Post tax average cost of additional debt

kd = Total Interest (1 – t)/9,000,000
= (NRs. 720,000 + NRs. 450,000) (1 – 0.30)/9,000,000
= 1,170,000 X 0.70/9,000,000
= 9.10 %

iii) Cost of retained earnings and cost of equity

a. Cost of equity (ke) = (D/P)+ g
= NRs. 80 (0.5) + 0.2
NRs. 660
= 26.06%

b. Cost of retained earning (kr) = Ke = 26.06 %

iv) Overall weighted average after tax cost of additional finance

ko = (ke*0.70) +(kd*0.3)
= (0.2606*0.70)+ (0.091*0.3)
= 0.1824+0.0273
= 0.2097
= 20.97%

Question No. 7
Following book value capital structure is available in respect of PQR Ltd.
(Rs. in million)
__________________________________________________________________
Equity Capital (in shares of Rs. 100 each, fully paid-up at par) 150
11% Preference Capital (in shares of Rs. 100 each, fully paid-up at par) 10
Retained Earnings 200
13.5% Debentures (of Rs. 100 each) 100
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 CAP II Paper 4: Financial Management

15% Term Loan 125

__________________________________________________________________

The next expected dividend per share on equity shares is Rs. 36 and the dividend per share is
expected to grow at the rate of 7%. The market price per share is Rs. 400.
Preference stock, redeemable after 10 years, is currently selling at Rs. 75 per share. Debentures,
redeemable after 6 years, are selling at Rs. 80 per debenture. The income tax rate for the
company is 25%.
You are required to: (8 +7=15 Marks)
b) Calculate the weighted average cost of capital using market value proportion.,
and
c) Determine the weighted marginal cost of capital for the company, if it raises
Rs. 100 million next year, given the following information:
 The amount will be raised by equity and debt in equal proportions.
 the company expects to retain Rs. 15 million earnings next year.
 the additional issue of equity shares will result in the net price per share
being fixed at Rs. 320.
 the debt capital raised by way of term loan will cost 15% for the first Rs.
25 million and 16% for the next Rs. 25 million.
[June 2011]

Answer:
Working Notes:
(1) Cost of Equity Capital (Ke) and Cost of Retained Earnings (Kr)
Ke = D1/P0 + g = 36/400 + 0.07 = 0.09 + 0.07 =0.16 or 16%

(2) Cost of Preference Share Capital (Kp)

Kp = D + (Rv – Sv) / N = 11 + (100 – 75) / 10 = 11 + 2.5 = 0.1543 or 15.43%
(Rv + Sv) /2 (100 + 75) / 2 87.5
(3) Cost of Debentures (Kd)
Kd = I + (Rv – Sv) / N (1 – t) = 13.5 + (100 – 80) / 6 (1 – 0.25) = (13.5 + 3.33) 0.75
(Rv + Sv) /2 (100 + 80) / 2 90
= 0.14025, say, or 14.03%
(4) Cost of Term Loan (Kt)
Kt = I (1 – t)
0.15 (1 – 0.25) = 0.15 x 0.75 = 0.1125 or 11.25%
On first Rs. 25 million Term Loan = 0.15 (1 – 0.25) = 0.1125 or 11.25%
On the next Rs. 25 million Term Loan = 0.16 (1 – 0.25) = 0.12 or 12%
(5) Cost of Fresh Equity Shares (Ke)
Ke = D1/P0 + g = 36/320 + 0.07 = 0.1825 or 18.25
(i) Calculation of Weighted Average Cost of Capital (WACC) using market value
proportion:
________________________________________________________________________
Source of Finance Market Value Weight Cost of Weighted cost
(Rs. Millions) Capital of Capital %
________________________________________________________________________
Equity Capital 600.00 0.739 0.1600 0.11824
(1.5 million shares x Rs. 400
11% Preference Capital
(1 lakh shares x Rs. 75) 7.50 0.009 0.1543 0,00139
© The Institute of Chartered Accountants of Nepal 14
 CAP II Paper 4: Financial Management

13.5% Debentures 80.00 0.098 0.1403 0.01375

(1 million debentures x Rs, 80)
15% Term Loan 125.00 0.154 0.1125 0.01733
812.50 WACC: 0.15071
________________________________________________________________________
Therefore, WACC = 15.07%
Note: Retained earnings are not considered for calculating WACC since it does not have
any market value separately. The market value of equity shares reflects the value of
retained earnings as well.

(ii) Calculation of WACC of PQR Ltd. when it raises Rs. 100 million next year:
________________________________________________________________________
Source of Finance Amount Weight Cost of Weighted cost
(Rs. Millions) of Capital of Capital %
________________________________________________________________________
Retained Earnings 15 0.15 0.1600 0.02400
Debt 15 0.15 0.1125 0.01688
Equity Shares 10 0.10 0.1825 0.01825
Debt 10 0.10 0.1125 0.01125
Equity Shares 25 0.25 0.1825 0.04563
Debt 25 0.25 0.1200 0.03000
100 0.14601
________________________________________________________________________
Therefore, WACC of raising Rs.100 million next year = 14.60%

Question No. 8
Three companies A, B and C are in the same type of business and hence have similar operating
risks. However, the capital structure of each of them is different and the following are the
details:
A B C
Equity Share Capital (Rs.) 400,000 250,000 500,000
[Face value Rs. 10 per share]
Debentures (Rs) - 100,000 250,000
[Face value per debenture Rs. 100]
Market value per share (Rs.) 15 20 12
Market value per debenture (Rs.) - 125 80
Dividend per share (Rs.) 2.70 4 2.88
Interest Rate - 10% 8%

Assume that the current levels of dividends are generally expected to continue indefinitely and
the income-tax rate at 50%.

Required:
Compute the weighted average cost of capital of each company. (7 Marks)
[December 2011]

Answer:
Calculation of Weighted Average Cost of Capital(WACC)

© The Institute of Chartered Accountants of Nepal 15

 CAP II Paper 4: Financial Management

Amount Weights After Tax Weighted

(Rs.) Cost Cost

i) Cost of Capital of Shares at Market Value

A (400000×15/10) 6,00,000 1.00 (2.70/15) = 18% 18%

B (250000×20/10) 5,00,000 0.80 (4/20) = 20% 16%
C (500000×12/10) 6,00,000 0.75 (2.88/12) = 24% 18%

ii) Cost of capital of Debenture at Market Value

A - - - - -
B (100000×125/100) 1,25,000 0.20 - 0.5) = 4% 0.80%
C (250000×80/100) 2,00,000 0.25 - 0.5) = 5% 1.25%

Weighted average cost of capital

A=
B=
C=
Working notes:
Weight of Share capital = MV of Share
MV of Share + MV Debenture.

Weight of Debenture = MV of Debenture

MV of Share +MV of
Debenture

Question No. 9
Ciron Limited has the following capital structure:
9% Debentures Rs. 275,000
11% Preference Shares Rs. 225,000
Equity Shares (face value Rs. 10 per share) Rs. 500,000
Rs. 1,000,000
Additional information:
i) Rs. 100 per debenture redeemable at par have 2% floatation cost and 10 years of maturity.
The market price per debenture is Rs. 105.
ii) Rs. 100 per preference share redeemable at par has 3% floatation cost and 10 years of
maturity. The market price per preference share is Rs. 106.
iii) Equity share has Rs. 4 floatation cost and market price per share of Rs. 24. The next year
expected dividend is Rs. 2 per share with annual growth of 5%. The firm has a practice of
paying all earnings in the form of dividends.
iv) Corporate income-tax rate is 35%.
Required: (7.5 Marks)
Calculate Weighted Average Cost of Capital (WACC) using market value weights.
[June 2013]

Answer:

Cost of Equity (Ke)

[where p0=Market price – floatation cost)

© The Institute of Chartered Accountants of Nepal 16

 CAP II Paper 4: Financial Management

=15%

Cost of Debt (Kd)

[ ]

=6.11%

Cost of Preference Shares (Kp )

[ ]

=11.47%

Calculation of WACC using Market Value Weights

Source of Capital Market Weights to Specific Total Cost
Value (Rs.) Total Cost
Capital
Debenture ( Rs.105 per debenture) 2,88,750 0.1672 0.0611 0.0102
Preference shares ( Rs.106 per 2,38,500 0.1381 0.1147 0.0158
preference shares)
Equity Shares ( Rs.24 per share) 12,00,000 0.6947 0.1500 0.1042
17,27,250 1 0.1302
WACC = 13.02%

Question No. 10
The present capital structure of the Shree Ram Mills Ltd. is as follows:
Rs. in millions
Equity shares (face value Rs. 10) 240
Reserves 360
11% Preference shares (face value Rs. 10) 120
12% Debentures (face value Rs. 100) 120
14% Term loans 360
Total 1,200

Following additional information is available:

The company's equity beta 1.06

© The Institute of Chartered Accountants of Nepal 17

 CAP II Paper 4: Financial Management

Yield on long term treasury bonds 10%

Stock market risk premium 6%
Current ex-dividend equity share price Rs. 15
Current ex-dividend preference share price Rs. 12
Current ex-interest debenture market value Rs. 102.50
Corporate tax rate 40%
The debentures are redeemable after 3 years and interest is paid annually.
Required: (8 Marks)
Ignore floatation costs and calculate the company's weighted average market value cost of
capital.
[December 2013]

Answer:
Cost of Equity share capital under capital assets pricing model
Ke = Rf + β (Rm-Rf)
=0.10+1.06(0.06)= 0.1636=16.36%

Cost of Preference Share capital

Kp =Dp/Po = 1.10/12= 0.0917= 9.17%

Cost of Redeemable Debentures (Kd)

The debentures are redeemable after 3 years and interest is paid annually. The current ex-interest
debentures market value is Rs. 102.50, which represents present value of stream of future cash
flows in the form of interest and maturity value.
Therefore, pretax cost of debenture is:
Approximate YTM ={ I +(M-V0)/n}/ (M+2V0)/3
= {12+(100-102.5)/3}/(100+2*102.5)/3
= {12-0.8333}/101.6667
= 11.1667/101.6667
= 0.1098 = 10.98% or 11%

Thus kd= 11%

Cost of Long Term Loan (Kt)

= I(1-t) = 14%(1-0.40)= 8.40%

Rs. in million
Equity Share Capital (Rs.240 million/Rs. 10) X15 360
11% Preference Share Capital (Rs.120 million/Rs. 10) X12 144
12% Debentures (Rs.120 million/Rs. 100) X 102.50 123
Term Loan 360
Market Value of total Capital 987

Source Market Value Weight Pre-tax cost Post-tax cost Weighted Cost
Rs. In million (%) (%) (%)
Equity Share 360 0.365 16.36 16.36 5.97
Capital
Preference 144 0.146 9.17 9.17 1.34
Share Capital
Debentures 123 0.124 11.00 6.60 0.82
Term Loan 360 0.365 14.00 8.40 3.07
WACC 11.20%

© The Institute of Chartered Accountants of Nepal 18

 CAP II Paper 4: Financial Management

Question No. 11
The Servex Company has the following capital structure on 30th June 1998:
Rs.
2,00,000 Ordinary shares 40,00,000
10% Preference shares 10,00,000
14% Debenture 30,00,000
80,00,000
The share of the company sells for Rs. 20 per share. It is expected that the company will pay a
dividend of Rs. 2 per share next year which will grow at 7 percent forever. Assume a 50 percent
tax rate.

Required: (1+3+3=7 Marks)

i) Compute a weighted average cost of capital based on the existing capital structure.
ii) Compute the new weighted average cost of capital if the company raises an additional Rs. 2
million debt by issuing 15 percent debentures. This would result in increasing the expected
dividend to Rs. 3 and leave the growth rate unchanged, but the price of share will fall to Rs.
15 per share.

iii) Compute the cost of capital, if in ii) above growth rate increases to 10 percent.
[June 2014]

Answer:
i) WACC: Existing capital structure

After-tax Cost Weights Weighted Cost

Ordinary Shares (WN 1) 0.17 0.500 0.0850

10% Preference 0.10 0.125 0.0125
14% Debentures 0.07 0.375 0.0262
WACC 0.1237 or 12.37%

ii) WACC: New capital structure

Amount Rs. After-tax Cost Weights Weighted

Cost
Ordinary Shares 4,000,000 0.27 (WN3) 0.40 0.108
10% Preference 1,000,000 0.10 0.10 0.010
14% Debentures 3,000,000 0.07 0.30 0.021
15% Debentures 2,000,000 0.075(WN4) 0.20 0.015
Weighted Average Cost of Capital 0.154 or
15.4%

iii) WACC : changed growth rate

After-tax Cost Weight Weighted Cost

Ordinary Shares 0.30 (WN5) 0.40 0.120
10% preference 0.10 0.10 0.010
14% Debenture 0.07 0.30 0.021
15% Debenture 0.075 0.20 0.015
Weighted Average Cost of Capital 0.166 or 16.6%

© The Institute of Chartered Accountants of Nepal 19

 CAP II Paper 4: Financial Management

(WN1) Cost of ordinary share is: ke= +g = +0.07 = 0.10+0.07 = 0.17

(WN2) After tax cost of debenture = 14%×(1-0.5)=7%

(WN3) Cost of ordinary share is: ke= +g = +0.07 = 0.20+0.07 = 0.27

(WN4) After cost of debenture= 15%×(1-0.5)=7.5%

(WN5) Cost of ordinary share is:ke= = +0.10 = 0.20+0.10 = 0.30

Question No. 12
XYZ Ltd. has the following capital structure:

4,000 Equity shares of Rs. 100 each Rs. 400,000

10% Preference shares Rs. 100,000
11% Debentures Rs. 500,000

The current market price of the share of XYZ Ltd. is Rs. 102. The company is expected to
declare a dividend of Rs. 10 at the end of the current year, with an expected growth rate of 10%.
The applicable tax rate is 25%.
Required: (3+3=6 Marks)
i) Find out the cost of equity capital and the WACC.
ii) Assuming that the company can raise Rs. 300,000 12% Debentures, find out the new cost of
equity and WACC if dividend rate is increased from 10% to 12%, growth rate is reduced
from 10% to 8%, and market price of the share is reduced to Rs. 98.
[July 2015]

Answer:
i) Computation of Cost of Capital
Cost of Equity Capital is
D1
Ke= -----------+ g
P0
= 10/102+.10
=19.8 %
Calculation of Weighted Average Cost of Capital (WACC)
Source Amount W C/C (after tax ) W*C/C
Equity Capital 400,000 0.4 0.198 0.0792
10% Pref. Capital 100,000 0.1 0.100 0.0100
11% Debenture 500,000 0.5 0.825 0.04125
1,000,000 1.0 0.13045
WACC =13.045%
ii) Computation of Cost of Capital and WACC under the New situation
Calculation of Cost of Equity, (New)
D1
Ke= -----------+ g
P0
= 12/98+.08
=20.2%

Calculation of Weighted Average Cost of Capital (New)

© The Institute of Chartered Accountants of Nepal 20

 CAP II Paper 4: Financial Management

Source Amount W C/C ( after tax) W*C/C

Equity Capital 400,000 0.31 0.202 0.0626
10% Pref. Capital 100,000 0.08 0.100 0.008
11% Debenture 500,000 0.38 0.0825 0.03135
12% Debenture 300,000 0.23 0.09 0.0207
1,300,000 1.00 0.12157
WACC =12.157%

Question No. 13
The following information is available for your perusal:
Present book value of a firm's capital structure is: (Rs.)
Debentures of Rs. 100 each 800,000
Preference shares of Rs. 100 each 200,000
Equity shares of Rs. 10 each 1,000,000
2,000,000
All these securities are traded in the capital markets at recent prices of:
Debentures: Rs. 110, Preference shares: Rs. 120 and Equity shares: Rs. 22.
Anticipated external financing opportunities are as follows:

i) Rs. 100 per debenture redeemable at par: 20 years maturity, 8% coupon rate, 4% floatation
costs, sale price Rs. 100.
ii) Rs. 100 preference share redeemable at par: 15 years maturity, 10% dividend rate, 5%
floatation costs, sale price Rs. 100.
iii) Equity shares: Rs. 2 per share floatation costs, sale price Rs. 22.
In addition, the dividend expected on the equity share at the end of the year is Rs. 2 per share;
the anticipated growth rate in dividends is 5% and the firm has the practice of paying all its
earnings in the form of dividend. The corporate tax rate is 50%.
Required: (12 Marks)
Determine the weighted average cost of capital of the firm using (i) book value weights, and (ii)
market value weights.
[December 2015]

Answer:
Calculation of Cost of Capital of Individual Components of Capital
(i) Cost of Debentures before tax

(100-96)
8+
20 8 + 0.20
= = = 0.0837 or 8.37%
(100+96) 98
2
Cost of Debentures after tax
= 8.37 (1-0.50) = 4.18%
Alternate: I(1-t)
(ii) Cost of Preference Shares

(100-95)
10 +
15 10 + 0.33 or
= = = 0.1059
(100+95) 97.5 10.59%
2
© The Institute of Chartered Accountants of Nepal 21
 CAP II Paper 4: Financial Management

(iii) Cost of Equity

D 2
= +g = + 0.05 = 0.15 or 15%
NP 22-2
(i) Computation of WACC based on book value weights

Book Value Weights on Specific Total

Source of Capital (Rs.) Total Capital Cost Cost
Debentures (Rs. 100 each) 800,000 0.40 0.0418 0.0167
Preference Shares (Rs. 100 each) 200,000 0.10 0.1059 0.0106
Equity Shares (Rs. 10 each) 1,000,000 0.50 0.1500 0.0750
2,000,000 1.00 0.1023
Cost of Capital = 10.23%
(ii) Computation of WACC based on market value weights

Book Value Weights on Specific Total

Source of Capital (Rs.) Total Capital Cost Cost
Debentures (Rs. 110 each) 880,000 0.2651 0.0418 0.01108
Preference Shares (Rs. 120 each) 240,000 0.0723 0.1059 0.00766
Equity Shares (Rs. 22 each) 2,200,000 0.6626 0.1500 0.09939
3,320,000 1.0000 0.11813

Cost of Capital = 11.81%

Question No. 14
The equity beta of Fence Co. is 0.9 and the company has issued 10 million ordinary shares. The
market value of each ordinary share is Rs. 7.50. The company is also financed by 7% bonds with
a nominal value of Rs. 100 per bond, which will be redeemed in seven years‘ time at nominal
value. The bonds have a total nominal value of Rs. 14 million. Interest on the bonds has just
been paid and the current market value of each bond is Rs. 107.14.

Fence Co. plans to invest in a project which is different to its existing business operations and
has identified a company, Hex Co. as the project. The equity beta of Hex Co. is 1.2 and the
company has an equity market value of Rs. 54 million. The market value of the debt of Hex Co.
is Rs. 12 million.

The risk-free rate of return is 4% per year and the average return on the stock market is 11% per
year. Both companies pay corporation tax at a rate of 20% per year.

Required: (4+4=8 Marks)

i) Calculate the current weighted average cost of capital of Fence Co.
ii) Calculate a cost of equity which could be used in appraising the new project.
[June 2017]

Answer:
i) Calculation of WACC
WACC = (Ke ×We) + (Kd × Wd )
The current cost of equity can be calculated using the capital asset pricing model.

Equity or market risk premium = market rate of return – risk free rate
=11% – 4 %
= 7%
© The Institute of Chartered Accountants of Nepal 22
 CAP II Paper 4: Financial Management

Cost of equity (Ke) = 4% + (0·9 x 7%)

= 4% + 6·3%
= 10·3%

After-tax cost of debt using trial and error:

After-tax interest payment = 100 x 0·07 x (1 – 0·2) = Rs.5·60 per bond.

Year Cash flow Rs. 5% discount PV (Rs.) 4% discount PV

(Rs.)
0 market value (107·14) 1·000 (107·14) 1·000
(107·14)
1–7 interest 5·60 5·786 32·40 6·002 33·61
7 redemption 100·00 0·711 71·10 0·760 76·00
* (3·64) 2·47
After-tax cost of debt = 4 + ((5 – 4) x 2·47)/(2·47 + 3·64)
= 4 + 0·4
= 4·4%
* OR
Kd = A.I(1-t) + CO – CI
n______
CO + CI
2
= 7(1-0.2) + 100 – 107.14
7______
100+ 107.14
2

= 5.6 – 1.02
103.57
= 4.42 %

Market value of equity = 10,000,000 x 7·50

= Rs.75,000,000

Market value of Fence Co debt = 14,000,000 x 107·14/100

= Rs.15,000,000

Total market value of company = 75,000,000 + 15,000,000

= Rs.90,000,000

WACC = ((10·3 x 75/90) + (4·4 x 15/90)

= 8.58 % +0.73 %
= 9.31 %

(ii) Since the investment project is different to business operations, its business risk is
different to that of existing operations. A cost of equity for appraising it can, therefore,
be found using the capital asset pricing model.

Ungearing Hex company equity beta

Asset beta = 1·2 x 54/(54 + (12 x 0·8))
= 1·2 x 54/63·6
= 1·019

© The Institute of Chartered Accountants of Nepal 23

 CAP II Paper 4: Financial Management

Regearing asset beta

Market value of debt = Rs.15m (calculated in part (a))
Regeared asset beta = 1·019 x (75 + (15 x 0·8))/75
= 1·019 x 87/75
= 1·182

Using the CAPM

Equity or market risk premium = 11% – 4%
= 7%

Cost of equity = 4 + (1·182 x 7)

= 4 + 8·3
= 12·3%

Question No. 15
Omni Corporation has target capital structure of 60% equity and 40% debt. The schedule of
financing cost for Omni is shown below:
Amount of New After tax Cost of Amount of New Cost of Equity
Debt (Rs. Million) Debt Equity (Rs. Million)
0-99 4.2 % 0-199 6.5%
100-199 4.6% 200-399 8.0%
200-299 5% 400-599 9.5%

Required: 7 Marks
Calculate the Break Point for Omni Corporation and also calculate WACC for
alternate level of financing in those break points.
[December 2017]

Answer:
Omni will have a break point each time a component cost of capital changes, for a total of four
break points;
Break Point debt>100mn = Rs. 100 million/0.4 = Rs. 250 Million
Break Point debt>200mn = Rs. 200 million/0.4 = Rs. 500 Million
Break Point equity>200mn = Rs. 200 million/0.6 = Rs. 333 Million
Break Point equity>400mn = Rs. 400 million/0.6 = Rs. 667 Million
Omni Corporation‘s WACC for the different break points.
WACC for Alternative level of Financing at break points
Capital (Rs. Equity Cost of Debt Cost of WACC
Million) (60%) Equity (40%) Debt
250 [ 250- 332] 150 6.5% 100 4.6% 5.74%
333 [ 333-499] 200 8.0% 133 4.6% 6.64%
500 [500-666] 300 8.0% 200 5.0% 6.80%
667 [ 667 and 400 9.5% 267 5.0% 7.70%
Above]

Question No. 16
The following is the capital structure of Simons Company Ltd. as on 31st Ashadh 2074:
© The Institute of Chartered Accountants of Nepal 24
 CAP II Paper 4: Financial Management

Rs.
Equity shares (of Rs. 100 each) 1,000,000
10% Preference Shares (of Rs. 100 each) 400,000
12% Debentures 600,000
2,000,000

The market price of the company`s share is Rs. 110 and it is expected that a dividend of Rs. 10
per share would be declared after 1 year. The dividend growth rate is 6%. The company is in the
25% tax bracket.
Required: (3+4=7 Marks)

i) Compute the weighted average cost of capital.

ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund
of Rs. 1 million bearing 14% rate of interest, what will be the company`s revised weighted
average cost of capital? This financing decision is expected to increase dividend from Rs. 10
to Rs. 12 per share. However, the market price of equity share is expected to decline from
Rs. 110 to Rs. 105 per share.
[June 2018]
Answer:
(i) Computation of the Weighted Average Cost of Capital

Source Weight(W) C/C W*C/C

Equity share 0.5 15.09% 7.55%
10% Preference share 0.2 10% 2.00%
12% Debentures 0.3 9% 2.7%
Weighted Average Cost of Capital 12.25%

ii) Computation of Revised Weighted Average Cost of Capital

Source Weight(W) C/C W*C/C

Equity share 0.333 17.43% 5.81%
10% Preference share 0.133 10% 1.33%
12% Debentures 0.200 9% 1.80%
14% Loan 0.333 10.5% 3.5%
Weighted Average Cost of Capital 12.44%

Working Notes:
1) Cost of equity shares (Ke) at present,

D1
Ke = --------------- + g = 10/110+0.06= 0.1509= 15.09%
P0

2) Revised Cost of Equity shares (Ke),

Ke = 12/105+0.06= 17.43

Question No. 17
An analyst working with McKinsey, Singapore is trying to figure out the cost of capital for a
Hydro Power Project in Nepal for his client based at USA. As the proposed investment is cross-
border, and country risk is significantly high for Nepal in comparison to USA, he wants to include
a country risk premium in his estimate of the cost of equity for the project. The analyst has
compiled the following information for his analysis;
© The Institute of Chartered Accountants of Nepal 25
 CAP II Paper 4: Financial Management

 Nepali US dollar denominated 10-Year Government Bond Yield = 8.8%

 10 Year US Treasury Bond yield = 5%
 Annualized Standard Deviation of NEPSE= 32%
 Annualized Standard Deviation of Nepali US Dollar denominated 10-Year Government
Bond= 18%
 Beta = 1.25
 Expected Market Return= 10.4%
 Risk Free Rate = 4.2%
Required: (5 Marks)
Calculate the Country Risk Premium and the Cost of Equity for the Hydro Power Project in
Nepal.
[June 2018]

Answer:
i. Calculation of Country Risk Premium
Country Risk Premium (CRP) = (Yield on Nepali bond - Yield on US Bond)×(SD of NEPSE/SD of
Nepali bond)
=[0.088-0.05]*[0.32/0.18] = 0.06756 = 6.76%

ii. Cost of Equity

KCE = RF + ß [RM – RF + CRP]
= 0.042+1.25[0.104-0.042+0.06756]
= 20.4%

Question No. 18
One of your clients has seen many references to the 'Cost of Capital' in the proposal for lending
from banks and has asked you to give him some guidance on what would be an appropriate
figure for his organization- Crisjan Ltd. The following information is available for Crisjan Ltd.:

Existing capital structure: Rs.

Issued ordinary shares (120,000) 12,000,000

Retained earnings 4,000,000

6% Preferences shares (20,000) 2,000,000

9% Debenture repayable on 2076

(Par value Rs. 1,000) 6,000,000

9% Debenture was issued in 2075 at [Link] current price is Rs. 920.A similar issue if made now
would require being at Rs. 900.

Preference shares have a par value of Rs. 100 and were originally issued at Rs. 92 per share. Its
current price is Rs. 43. A similar issue if made now would require to be at Rs. 40 per share.

The market price of an ordinary share is Rs. 700.

Rs. 6 million in dividends was paid this year which represented 75% of earnings.

Earnings are expected to grow at an annual rate of 5%.

© The Institute of Chartered Accountants of Nepal 26

 CAP II Paper 4: Financial Management

If new ordinary shares were issued now, costs incurred would represent Rs. 50 per share and a
reduction below market value of Rs. 25 per share would also be made.

Corporate tax rate is 25%.

Required: (5 Marks)

Calculate Crisjan Ltd.'s Weighted Average Cost of Capital.

[December 2018]
Answer:
a) Marginal cost (after tax) of debenture
Kd = AI(1-t) + Co- CI
n
Co+CI
2
= 90(1-0.25) + 1,000- 900
1
1000+900
2
= 17.63%

Marginal cost of Preference shares

=120,000
800,000
= 0.15
= 15%

Marginal cost of Ordinary shares

= [ 50(1+0.05)/(700-50-25)]+0.05
= 52.5/625 +0.05
= 13.4%
Weighted Average Cost of Capital:

Capital
Structure
(MV) (in Weigh Component Weight
Source of Finance million) t cost(%) ed Cost
Ordinary shares
84 13.40 12.48
120,000×700 0.9312
5.4 17.63 1.06
Debentures (9@6m) 0.0599
0.8 15 0.13
Preference shares (4@2m) 0.0089
Total 90.20 1 13.66

OR Alt Solution
Calculation of WACC(Book Value)
Sources of Finance Amount(BV) Weight(a) Cost(b) (a)×(b)
Ordinary share 120,00,000 0.50
13.40%(WN3) 6.70%
Retained Earnings 40,00,000 0.17
12.50%(WN 4) 2.125%
6% Preference Share 20,00,000 0.08 15%(WN 2) 1.20%
© The Institute of Chartered Accountants of Nepal 27
 CAP II Paper 4: Financial Management

9% Debenture 60,00,000 0.25

17.63%(WN 1) 4.408%
240,00,000 1.00 WACC 14.43%
Working Notes:
(1) Calculation of cost of Debt(kd)
Kd = AI(1-t) + Co- CI
n
Co+CI
2
= 90(1-0.25) + 1,000- 900
1
1000+900
2
= 17.63%
(2) Calculation of Cost of preference share(KP)
Kp = Pref Dividend ×100%
Net Proceeds
= 6/40×100%
= 15%
(3) Calculation of cost of Equity(ke) as per Gordon's Growth,
Ke =D1/NP + g
= 50(1+5%) + 0.05
700 -50-25
= 13.40%
(4) Calculation of cost of Retained Earnings(Kre)
Kre = D1/Po + g
= 50(1+5%) + 0.05
700
= 12.50%

© The Institute of Chartered Accountants of Nepal 28

 CAP II Paper 4: Financial Management

Chapter 3:

Valuation of Fixed Income Securities

© The Institute of Chartered Accountants of Nepal 29

 CAP II Paper 4: Financial Management

Question No. 1
Write short notes: Yield to call (YTC) and Yield to Maturity (YTM)
[June 2009] [2.5 Marks]
Answer:
The Yield to maturity (YTM) or redemption yield of a bond or debentures, is the internal rate of
return (IRR, overall interest rate) earned by an investor who buys the bond or debenture today at
the market price, assuming that the bond will be held until maturity, and that all coupon and
principal payments will be made on schedule. Yield to maturity is actually an estimation of
future return, as the rate at which coupon payments can be reinvested at when received is
unknown. It enables investors to compare the merits of different financial instruments.
The Yield to call (YTC) is one of the variants of YTM. It is the rate of return if held up to call.
When a bond or debenture is callable (can be repurchased by the issuer before the maturity), the
market looks also to the Yield to call, which is the same calculation of the YTM, but assumes
that the bond will be called, so the cash flow is shortened.

Question No. 2
Distinguish between: Nominal interest rate and effective interest rate (3 Marks)
[December 2009]

Answer:
The interest rate that is specified on an annual basis in a loan agreement or security (say, in the
case of a bond) is known as the nominal interest rate. Thus, the nominal interest rate is the
simple interest rate (without compounding) which is stated in the face of a security or a loan
agreement.
Usually, there are provisions of compounding of the interest payable on a loan or security. The
compounding may be done monthly, quarterly or semi-annually. When compounding of the
interest payable is done more than once a year, the actual annualized interest would be higher
than the nominal interest rate and it is called the effective interest rate.
The general formula for calculating effective interest rate (EIR) can be written in the following
form:
EIR = [ 1 + i/m] n x m – 1, where
i denotes the annual nominal rate of interest,
n denotes the number of year and
m denotes the number of compounding per year.
In the case of annual compounding, m = 1, in quarterly compounding m = 4, and in the case of
monthly compounding, m = 12. The formula given above can be modified to accomplish the
multi-period compounding for any number of years.

Question No. 3
Yield to Call and Yield to Maturity (2.5 Marks) [December 2011]

Answer:
The yield to Maturity (YTM) is the measure of a bond's rate of return that considers both the
interest income and any capital gain or loss. YTM is the bond's internal rate of return. To
calculate the Actual yield to maturity, first the approximate yield to maturity is calculated as
follws:
I + M – Vd
n ( 1- T)
AYTM=
© The Institute of Chartered Accountants of Nepal 30
 CAP II Paper 4: Financial Management

M + 2 * Vd
3
Where, T = Tax Rate, M = Maturity Value, n = Maturity period, Vd = Market Price of bond, I =
Interest payment on bond.
After calculating the approximate yield to maturity, interpolation shall be done by using the two
rates which are below and above the approximate rates to get the actual yield to maturity.
A number of companies issue bonds with buyback or call provision. Thus, a bond can be
redeemed or called before maturity. YTC is the yield or the rate of return of a bond that may be
redeemed before maturity. The procedure for calculating the yield to call is the same as yield to
maturity. The call period would be different from the maturity period and the call or redemption
value could be different from the maturity value.

Question No. 4
Valuation of compulsorily convertible debenture [June 2012] (2.5 Marks)

Answer:
The debenture-holders of a Compulsorily Convertible Debenture (CCD) receives interest at a
specified rate for a pre-determined period after which a part or full value of the CCD is
converted into specific number of equity shares. The cashflows resulting in the case of valuation
of CCD are;
- Periodic interest receivable from the company.
- Expected market price of the share received on conversion.
- Redemption amount, if any.
The value of a CCD is then found out by using the following formula:
n
B0 (CCD) = ∑ Ii + mPt + RV
i
i=1 (1 + kd) (1+ke)t (1+kd)n
where, B0 (CCD) = Value of a CCD
I = Interest amount receivable per year
ke = Required rate of return on equity component
m = Number of shares received on conversion
Pt = Share price at the time of conversion
RV = Redemption value, if any
n = Life of the debentures
kd = Rate of discount of debt.
In the case of partially convertible debentures, the annual interest before conversion and after
conversion would be different whereas in the case of fully convertible debentures, there will not
be any RV.

Question No. 5
Promised yield and Realized yield [December 2013] (2.5 Marks)

Answer:
Promised Yield indicates the total rate of return earned on bond if it is held to maturity. It is also
known as Yield-to-Maturity. This is the rate of return anticipated on a bond if held until the end
of its lifetime. YTM is considered a long-term bond yield expressed as an annual rate. The YTM
calculation takes into account the bond‘s current market price, par value, coupon interest rate
and time to maturity. It is also assumed that all coupon payments are reinvested at the same rate
© The Institute of Chartered Accountants of Nepal 31
 CAP II Paper 4: Financial Management

as the bond‘s current yield. YTM is a complex but accurate calculation of a bond‘s return that
helps investors to compare bonds with different maturities and coupons.
Realized Yield is the actual amount of return earned on a security investment over a period of
time. This period of time is typically the holding period which may differ from the expected
yield at maturity. The realized yield also includes the returns that have been earned from
reinvested interest, dividends and other cash distributions.

The realized yield tends to differ from the yield at maturity in scenarios where the holding
period is less than that of the maturity date. In other words, the security is settled or sold prior to
the maturity date given at the time of purchase. For example, suppose an investor purchases a
10-year bond for Rs. 1,000 that issues a 5% annual coupon. Furthermore, if the investor sells the
bond for Rs.1,000 at the end of the first year (and after receiving the first coupon payment), his
realized yield would only include the Rs. 50 coupon payment.

Question No. 6
Yield to maturity (YTM) and Yield to call (YTC) [June 2014] (2.5 Marks)

The Yield to maturity (YTM) or redemption yield of a bond or debentures, is the internal rate of
return (IRR, overall interest rate) earned by an investor who buys the bond or debenture today at
the market price, assuming that the bond will be held until maturity, and that all coupon and
principal payments will be made on schedule. Yield is to maturity is actually a future return, as
the rate at which coupon payments can be reinvested at when received is unknown. It enables
investors to compare the merits of different financial instruments.

The Yield to call (YTC) is one of the variants of YTM. It is the return if held up to call. When
bond or debenture is recallable (can be repurchased by the issuer before the maturity), the
market looks also to the Yield to Call, which is the same calculation of the YTM, but assumes
that the bond will be called, so the cash flow is shortened.

Question No. 7
Inflation bonds and Floating rate bonds [December 2015] (2.5 Marks)

Answer:
Inflation Bonds are the bonds in which interest rate is adjusted for inflation. Thus, the investor
gets interest which is free from the effects of inflation. For example, if the interest rate is 3
percent and the inflation rate is 6 percent, the investor will get 9 percent in total.
Floating rate bonds, as name suggests, are the bonds where the interest rate is not fixed and is
allowed to float depending upon the market conditions. This is an ideal instrument which can be
resorted to by the issuer to hedge themselves against the volatility in the interest rates. This has
become more popular as a money market instrument and being issued by the financial
institutions.

Question No. 8
Fast Growing Ltd. has outstanding a Rs. 1000 face value bond with a 12% coupon rate and 3
years remaining until final maturity. Interest payments are made semi-annually.
You are required to answer the following questions with appropriate supporting
computations: (2.5+1.5=4 Marks)
i) What value should you place on this bond if your nominal annual required rate of return is 10
per cent; and
ii) Assuming a bond similar to the one described above except that is a zero-coupon, pure
discount bond, what value should you place on this bond if your nominal annual required rate
of return is 16 per cent. (Assume a semiannual compounding.)
(December 2010)

© The Institute of Chartered Accountants of Nepal 32

 CAP II Paper 4: Financial Management

Answer:
(i) Value of Bond when kd = 10%

We have, value of a bond (V) = I/2 (PVIFA kd, 2n) + MV (PVIF kd, 2n), where
 kd is the investor‘s required rate of return
 n is the number of years and 2n is the number of semi-annual periods until maturity.
 I/2 is the periodic interest payment
 MV is the maturity value of the bond
Substituting the given values in the above formula, we get:
V = (Rs. 120/ 2) (PVIFA 0.05, 6) + Rs. 1000 (PVIF 0.05, 6)
= Rs. 60 (5.076) + Rs. 1,000 (0.746)
= Rs. 304.56 + Rs. 746 = Rs. 1,050.56.

(ii) Value of Zero Coupon Bond when kd = 16%

The value of this type of bond is found out simply by discounting the maturity value of the bond
to the present. Thus,
V = Rs. 1,000 (PVIF 0.08, 6) = Rs. 1,000 (0.630) = Rs. 630

Question No: 9
The bonds of Express Ltd. are currently selling at Rs. 130. They have 9 percent coupon rate of
interest and Rs. 100 par value. The interest is paid annually and the bonds have 20 years to
maturity.
You are required to: (4+2=6 Marks)
i) Compute the Yield to Maturity (YTM) of the bond.
ii) Explain the difference between YTM and coupon rate of interest of the bond.
(December 2010)

Answer:
We have,
B = I x (PVIFAkd n) + M x (PVIF kd n)
Where,
B = Value of the Bond
I = Annual Interest Paid
n = Number of Years to Maturity
M = Par/Maturity Value
kd = Required Return on the Bond

Information given in the problem are:

B = Rs. 140
I (Annual Interest Paid) = Rs. 100 X 0.09 = Rs. 9
M (Par/Maturity Value) = Rs. 100
n = 20
kd = 9

Let us try a lower rate of 7 per cent in the formula:

© The Institute of Chartered Accountants of Nepal 33
 CAP II Paper 4: Financial Management

B = I x (PVIFAkd, n) + M x (PVIF kd, n) = Rs. 9 x (PVIFA 7, 20 ) + Rs. 100 x (PVIF 7, 20)

= (Rs. 9 x 10.594) + Rs. 100 x 0.258) = Rs, 95.35 + Rs. 25.80 = Rs. 121.15.
Since Rs. 121.15 < Rs. 135, let us try still a lower rate of 6 per cent.
B = I x (PVIFAkd n) + M x (PVIF kd n) = Rs. 9 x (PVIFA 6, 20 ) + Rs. 100 x (PVIF 6, 20)
= (Rs. 9 x 11.470) + Rs. 100 x 0.312) = Rs, 103.23 + Rs. 31.20 = Rs. 134.43.

By interpolation, YTM = 6% + (134.43 – 130) % = 6% + (4.43/13.28) % = (6 + 0.33) %

(134.43– 121.15)
= 6.33% approximately.

11) The YTM (6.33%) is below the coupon interest rate (9%) of the bond since its
market value (Rs. 130) is above its par value (Rs. 100).

ii) Explanation Ragarding the difference between YTM and Coupon Rate

Yield to maturity (YTM) is the expected rate of return on a bond if bought at its current market
price and held to maturity. It is also called the bond‘s internal rate of return (IRR).
The underlying feature of bond price is that YTM < coupon rate when a bond sells at a premium
and vice versa. Similarly, YTM = coupon rate when a bond sells at par.
In the present case, the bond is selling at a premium of Rs. 30 as compared to the par value of
Rs. 100. This is the reason for the YTM (6.33%) being lower than the coupon interest rate of
9%.

Question No: 10
Based on the credit rating of the bonds, an investor has decided to apply the following discount
rate for valuing the bonds.
Credit rating Discount rate
AAA 364-day Treasury-bill rate + 3% spread
AA AAA + 2% spread
A AAA + 3% spread
The investor is considering investing in an AA rated, Rs. 1,000 face value bond currently selling
at Rs. 1,010. The bond has five years to maturity and the coupon rate on the bond is 15% per
annum payable annually. The next interest payment is due one year from today and the bond is
redeemable at par. (Assume 364-day Treasury bill rate to be 9%)
You are required to calculate: (5+3=8 Marks) (
i) Intrinsic value of the bond for the investor. Should the investor invest in the bond?
ii) Current yield (CY) and the yield to maturity (YTM) of the bond.
[June 2011]
Answer:
AA rated face value of bond = Rs. 1,000
Current selling price = Rs 1,010
Maturity period of bond = 5 years
Coupon rate of the bond = 15% per annum payable annually
Bond redeemable at par at the end of 5th year.
Net interest payment is due on year from today.

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 CAP II Paper 4: Financial Management

Discount rate for AA rated bond = 9% + 3% + 2% = 14%

Calculation of Present Value of Cash Inflow from Bond
(Rs.
___________________________________________________________________________________________________________________________________________________________
_

Year-end Cash Inflow PV Factor at 14% Present

Values
___________________________________________________________________________________________________________________________________________________________
_

1 150 0.8772 131.58

2 150 0.7695 115.43
3 150 0.6750 101.25
4 150 0.5921 88.82
5 1,150 0.5194 597.31
Present value of total Cash Inflow: 1,034.40
___________________________________________________________________________________________________________________________________________________________
_

Thus, the intrinsic value of bond is Rs. 1,034.40. Since the intrinsic value of bond (Rs. 1,034.40)
is more than its current market value (Rs. 1,010), it is suggested to purchase the bond.

Current yield = Annual Bond Interest x 100 = 150 x 100 = 14.85%

Market price 1,010
Yield to Maturity (YTM)
P = Rs. 150 x PVIFA @ 15% for 4 years + Rs. 1,150 x PVIF at 15% for 5th year
= (150 x 2.855) + (1,150 x 0.4972 = 428 + 571.78 = 1,000.03
Present value at 14% = Rs. 1,034.40
Present value at 15% = 1,000.03
By interpolation, YTM = 14 + 1,034.40 – 1,010 x 1 = 14% + (24.40 / 34.37) = 14.71%

1,034.40 – 1,000.03

Question No: 11
The beta co-efficient of security X is 1.6. The risk free rate of return is 12% and the required rate
of return is 18% on the market portfolio. If the dividend expected during the coming year is Rs.
25 and the growth rate of dividend and earnings is 8%, at what price should the security X can be
sold based on the capital asset pricing model. (5 Marks)
[June 2011]

Answer:
Expected rate of return is calculated as follows by applying CAPM formula:
E (Ri) = Rf + Bi (Rm – Rf)
= 12% + 1.6 (18% - 12%) = 12% + 9.6% = 21.6%.
Price of security X is calculated with the use of dividend growth model formula as follows:
Re = D1 / P0 + g, where
D1 = Expected dividend during the coming year

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 CAP II Paper 4: Financial Management

Re = Expected rate of return on security X

g = Growth rate of dividend
P0 = Price of security X
Substituting the values, we get:
0.216 = 25/ P0 + 0.08,
Or, 0.216 = 2.50 + 0.08 P0
P0
Or, 0.216 P0 = 25 + 0.08 P0
Or, 0.216 P0 – 0.08 P0 = 25,
Or, 0.136 P0 = 25
Or, P0 = 25 / 0.136 = Rs. 183.82.
The price at which the security X should be sold as per CAPM is Rs. 183.82.

Question No: 12
A 10-year, 12% semi-annual coupon bond, with a par value of Rs. 1,000 may be called in 4 years
at a call price of Rs. 1,060. The bond sells for Rs. 1,100. Assume that the bond has just been
issued.
Required: (4+1+1+4=10 Marks)
i) What is the bond‘s effective annual yield to maturity?
ii) What is the bond‘s annual current yield?
iii) What is the bond‘s capital gain or loss?
iv) What is the bond‘s effective annual yield to call?
[December 2011]

Answer:
Given,

Par value (M) = Rs. 1,000

Coupon rate = 12%
Annual coupon (I) = 12% of Rs 1,000 = Rs 120
Maturity period (n) = 10 years
Call period = 4 years
Call price = Rs. 1,060
Selling price = Rs 1,100
Semi-annual compounding.

i. Calculation of bond‘s effective annual yield to maturity (YTM)

Vd = I(PVIFAkd% , n) + M(PVIFkd% , n)

So, for semiannual bond,

Rs 1,100 = I/2(PVIFAkd%/2 , n x 2) + M(PVIFkd%/2 , n x 2) ………………..(1)

© The Institute of Chartered Accountants of Nepal 36

 CAP II Paper 4: Financial Management

Approximate semiannual YTM

= 5.16%
Now, trying at 5%,

PV = Rs 60(PVIFA5% , 20 ) + 1,000(PVIF5% , 20)

= 60 x 12.4622 + 1,000 x 0.3769 = Rs 1,124.63 > Rs 11,00
Trying at 6%,

PV = Rs 60(PVIFA6% , 20 ) + 1,000(PVIF6% , 20)

= 60 x 11.4699 + 1,000 x 0.3118 = Rs 999.99 < Rs 1,100

By interpolating,

Semiannual YTM = 5.2%

Therefore, nominal YTM = 5.2% x 2 = 10.4%

The effective annual YTM = (1 + 0.052)2 – 1 = 1.1067 – 1 = 0.1067 = 10.67%

ii. Calculation of bond‘s current yield

= Coupon payments / Price of the Bond
= 120/1,100 = 0.1091
= 10.91%

iii. Calculation of bond‘s Capital gain or loss

We have,

YTM = Current Yield + Capital Gain or Loss Yield

10.67% = 10.91% + Capital Gain or Loss Yield
Capital Gain or Loss Yield = 10.67% - 10.91% = (0.24%)
So, Capital loss is 0.24%
iv. Calculation Bond‘s Yield to Call (YTC)
We have,

Rs 1,100 = Rs 60(PVIFAkd%/2 , 2 x 4) + Rs 1,060(PVIFkd%/2 , 2 x 4)

Approximate semiannual YTC

© The Institute of Chartered Accountants of Nepal 37

 CAP II Paper 4: Financial Management

= 5.061%

Now, trying at 5%,

PV = Rs 60(PVIFA5% , 8 ) + 1,060(PVIF5% , 8)
= 60 x 6.4632 + 1,060 x 0.6768
= Rs 1,105.20 > Rs 1,100

Trying at 6%,

PV = Rs 60(PVIFA6% , 8 ) + 1,060(PVIF6% , 8)
= 60 x 16.2098 + 1,060 x 0.6274
= Rs 1037.63 < Rs 1,100

By interpolating,

Semiannual YTC = 5.08%

Therefore, nominal YTC = 5.08% x 2 = 10.16%

The effective annual YTC = (1 + 0.0508)2 – 1 = 1.1042 – 1 = 0.1042 =

10.42%

Question No. 13
Beta Company is contemplating conversion of 500, 14% convertible bonds of Rs. 1,000 each.
Market price of the bond is Rs. 1,080. Bond indenture provides that one bond will be exchanged
for 10 shares. Price–earnings ratio before redemption is 20:1 and anticipated price-earnings ratio
after redemption is 25:1. Number of shares outstanding prior to redemption are 10,000. EBIT
amounts to Rs. 200,000. The company is in the 35% tax bracket. Should the company convert
bond into shares? Support your analytical comments with required calculations. (4 Marks)
[June 2013]

Answer:

Particulars Pre- redemption Post-redemption

EBIT (Rs.) 2,00,000 2,00,000
Interest @14% (Rs.) 70,000 Nil
Taxable Income (Rs.) 1,30,000 2,00,000
Less: Tax @ 35 percent (Rs.) 45,500 70,000
Net Income after Tax (Rs.) 84,500 1,30,000
Outstanding Shares ( Nos) 10,000 15,000
EPS (Rs.) 8.45 8.66
P/E Ratio 20:1 25:1
Market Price per share (Rs.) 169 216.50
(i.e. price-earnings ratio times×EPS)
© The Institute of Chartered Accountants of Nepal 38
 CAP II Paper 4: Financial Management

Comment:
This is two-in-one benefit scheme. The company should convert the bond into shares
because both shareholders and debenture holders stand to gain. The post-redemption
market price of the equity shares would be Rs.216.50 than the pre-redemption market
price of Rs.169. Moreover the debenture holder/ bondholders would receive Rs.1, 690 in
stock (i.e. 169×10 shares, in place of receiving cash Rs.1, 080 only)

Question No. 14
The XYZ limited is contemplating a debenture issue on the following terms:
Face value = Rs. 100 per debenture
Term of maturity= 7 years
Coupon rate of Interest:
Years 1-2=8% p.a.
3-4=12% p.a.
5-7=15% p.a.
The Current market rate of interest on similar debenture is 15%[Link] company proposes to
price the issue so as to yield a (compounded) return of 16% p.a. to the investor. Determine the
issue price. Assume the redemption on debenture at a premium of 5% (Note: The present value
interest factors at 16% p.a. for years 1 to 7 are .862, .743, .641, .552, .476, .410, and .354
respectively). (4 Marks)
[June 2014]

Answer:
The interest payments over the life of the debentures and their present values are given in the
following table:
Year Interest(Rs.) PVF@16% Present Value(Rs.)
1 8 .862 6.896
2 8 .743 5.944
3 12 .641 7.692
4 12 .552 6.624
5 15 .476 7.14
6 15 .410 6.15
7 15 .354 5.31
Total 45.756

The present value of the redemption amount of Rs. 105 (Rs.100+Rs.5)@16% p.a. is Rs.
105*.354=Rs. 37.17
Therefore, the present value of the debenture is Rs. 45.76+Rs. 37.17=Rs. 82.93. The
company should issue the debenture at this value in order to yield a return of 16% to the
investors.

Question No. 15
Consider two bonds with Rs. 1,000 face value that carry coupon rate of 8%, make annual
coupon payment and exhibit similar risk characteristics. The first bond has 5 years to maturity
whereas the second has 10 years to maturity. The appropriate discount rate for the investment of
similar risk securities is 8%.
Required: (2+2=4 Marks)
i) Calculate current market price of both the bonds.
ii) If this discount rate rises by 2 %, what will be the respective percentage price
changes of the two bonds, and why?
[June 2014]
© The Institute of Chartered Accountants of Nepal 39
 CAP II Paper 4: Financial Management

Answer:
i) Since the required rate of return, i.e. discount rate is equal to the coupon rate of 8%, the
current market price is equal to their face value i.e. Rs. 1000.
First Bond
MP =Int. (PVIFA, 5 yrs) + M(PVIF, 5thyrs)
=80(8%, 5 yrs) + 1000(8%, 5thyrs)
=80×3.9927 + 1000×0.6806
=319.42 + 680.60
= Rs. 1,000.02 = Rs. 1000
2nd Bond
MP=80(8%, 10 yrs) + 1,000(8%, 10thyr)
=80×6.7101 + 1,000×0.4632
=536.81 + 463.20
=Rs. 1,000.01 = Rs. 1,000

ii) When discount rate is increased by 2%:

New discount rate: 8+2= 10%.

Face Value 1000

Coupon 8%
Required rate of return: 10%
First Bond
MP = Int (PVIFA 10%, 5 yrs) + M (PVIF10%, 5thyr)
=80X 3.7908 +1000X 0.6209
=Rs. 924.16
% change in price
924.16-1000
1000
= - 7.58%

Second Bond
MP = Int (PVIFA 10%, 10 yrs) + M (PVIF 10%, 10thyr)
= 80X 6.1446 +1000*0.3855
=Rs. 877.07
% change in price
= 877.07-1000
1000
= -12.29%

Therefore, change in price of second bond is greater than that of bond first because of its
longer maturity period. It is because the longer the maturity period, the higher the sensitivity
of bond price to the interest rate change.

Question No. 16
Mathura Corporation has two different bonds currently outstanding. Bond M has a face value of
Rs. 20,000 and matures in 20 years. The bond makes no payments for the first six years, then
pays Rs. 1,200 every six months over the subsequent eight years, and finally pays Rs. 1,500
every six months over the last six years. Bond N also has a face value of Rs. 20,000 and a
maturity of 20 years; it makes no coupon payments over the life of the bond. The required return
on both of these bonds is 10 percent compounded semiannually.
Required: (5 Marks)
What is the current price of Bond M and Bond N?

© The Institute of Chartered Accountants of Nepal 40

 CAP II Paper 4: Financial Management

You can use the following statistical figures:

PVIFA5%, 12 Years =8.8633 PVIFA5%, 28 Years =14.8981
PVIFA5%, 40 Years =17.1591 PVIFA5%, 40th Years=0.1420

[December 2017]

Answer:
Bond M is redeemable bond and the value of redeemable bond is discounted present value of
Interest and Principal amount over the life of the bond. Therefore the value of Bond M may be
calculated as below:
Value of Bond M = PV of Interest for First 6 Years + PV of Interest for next 8 Years + PV of
Interest for last 6 Years + PV of Redemption Value of Principal
= 0+ 1,200×[PVIFA 5%, 28 Years –PVIFA 5%, 12 Years] + 1,500×[PVIFA 5%, 40
Years –PVIFA 5%, 28 Years] + 20,000×[PVIF 5%, 40th Year]
= 0 + 1,200×[14.8981-8.8633]+ 1,500×[17.1591-14.8981]+20000×0.1420
= 7,241.76 + 3,391.50 + 2,840
= Rs. 13,473.26
Bond N is Zero Coupon Bond and the value of Zero Coupon bond is discounted present value of
Principal amount redeemed over the life of the bond. Therefore the value of Bond N may be
calculated as below:
Value of Bond N = PV of Redemption Value of Principal
= 20,000 × [PVIF5%, 40Years]
= 20,000 × 0.1420
= Rs. 2,840

Question No. 17
Suman inherited the following securities on his father‘s death:

Types of security Nos. Annual Maturity Yield %

Coupon % years
Bond A (Par value Rs. 1,000) 20 8 4 10
Bond B (Par value Rs. 1,000) 25 10 5 10
Preference Shares C (Par value 150 11 - 12
Rs. 100)
Preferences Shares D (Par 200 12 - 15
value Rs. 100)

Required: (5 Marks)
Compute the current value of Suman‘s Investment.
[December 2018]
Answer:
Value of Bond A = Interest (PVIFA 10%, 4 Years) + RV(PVIF 10%, 4th Year)
= 80*3.169+ 1000*0.683
= Rs. 936.52
Value of Bond B = Interest (PVIFA 10%, 5 Years) + RV(PVIF 10%, 5th Year)
= 100*3.79+ 1000*0.621
= Rs. 1,000
(Alternate: Since the Yield of the bond is equal to the coupon rate of the bond, the fair
value of the bond will be equal to the face value of the bond.)
© The Institute of Chartered Accountants of Nepal 41
 CAP II Paper 4: Financial Management

Value of Preference Share C =

= Rs. 11/12%=Rs. 91.67

Value of Preference Share D =

= Rs. 12/15%=Rs. 80
Calculation of Value of Investment of Suman:
Types of Security Number Value per Security Total Value
Bond A 20 936.52 18,730.04
Bond B 25 1,000 25,000
Preference Shares C 150 91.67 13,750.50
Preferences Shares D 200 80 16,000
Total value of Portfolio 73,480.54

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 CAP II Paper 4: Financial Management

Chapter 4:

Valuation of Equity Shares

© The Institute of Chartered Accountants of Nepal 43

 CAP II Paper 4: Financial Management

Question No. 1
Replacement value and Market value [December 2015] (2.5 Marks)

Answer:
Replacement Value is a amount that a company would be required to spend if it were to
replace its existing assets in its current condition. It is difficult to find cost of assets
currently being used by the company replacement value and is also likely to ignore the
benefits of intangibles and the utility of existing assets.

Market Value of an assets or securities is the current price at which the assets or the
security is being sold or bought in the market. Market value per share is expected to be
higher than the book value per share of profitable, growing firms. A number of factors
influence the market value per share, and therefore, it shows wide fluctuations. What is
important is the long term trend in the market value per share.

Question No. 2
Excess Ltd. currently pays a dividend of NRs. 40 per share and this dividend is expected to grow
at a 15 per cent annual rate for 3 years, then at a 10 per cent rate for the next 3 years, after which
it is expected to grow at a 5 percent rate forever.
What value would place on the stock if an 18 percent rate of return were required?
(6 Marks) (June 2009)

Answer:
The present value of stock is NRs.452.99. The workings are as per below:

Statement showing the Value of the Share

-----------------------------------------------------------------------------------------------------
PV Factor
End of Dividend @ 18% PV of Dividend
---------------------------------------------------------------------------------------------------------
Year 1 40 (1.15) = 46.00 0.84746 38.98
2
Year 2 40 1.15) = 52.90 0.71818 37.99
Year 3 40 (1.15)3 = 60.84 0.60863 37.03
Year 4 60.84 (1.10) = 66.92 0.51579 34.52
Year 5 60.84 (1.10)2 = 73.62 0.43711 32.18
Year 6 60.84 (1.10)3 = 80.98 0.37043 30.00
210.70
---------------------------------------------------------------------------------------------------------

Year 7 dividend = NRs. 80.98 X 1.05

= NRs. 85.03

Market Value at the end of Year 6 = NRs. 85.029/(0.18 – 0.05)

= NRs. 85.03/0.13
= NRs. 654.08

Present Value of Market Value at the end of Year 6 = 0.37043 X 654.08

= NRs. 242.29

Hence, Value of the Share = NRs. 210.70 + NRs. 242.29

= NRs. 452.99

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 CAP II Paper 4: Financial Management

Question No. 3
The following information is available in respect of the rate of return on investment (r),
capitalization rate (ke) and earnings per share (E) of Excel Ltd.
r = 12 per cent
E = NRs. 90
Determine the value of the company‘sshare under different situations as described below based
on Gordon‘s Model. (4 Marks)
________________________________________________________________
Situation D/P Ratio (1 – b) Retention Ratio (b) ke (%)
________________________________________________________________
I 10 90 20
II 20 80 20
III 40 60 15
IV 60 40 15
(June 2009)

Answer:
The value of the share of the company under different situations based on Gordon‘s
Model is as per below:
Situation Value (NRs.)
I 97.83
II 173.08
III 461.54
IV 529.41
Working Notes:
According to Gordon‘s model, we have:
P = E (1 – b)_ where
(ke – br)
P = Price of a share,
E = Earnings per share,
b = Retention ratio or percentage of earnings retained,
1 – b = D/P ratio which is the percentage of earnings distributed in the form of dividend,
ke = Capitalization rate or cost of capital
br = g = Growth rate = rate of return on investment of an all-equity firm.

Hence applying the above formula on the various situations, we have the value of share
as per below:

(a) D/P Ratio: 10%, Retention: 90%, r = 12%, br (g) = 0.9 X 0.12 = 0.108
P = 90 (1 – 0.90)_ = 90 X 0.1= 9/.092 = 97.83
(0.20 – 0.108) 0.092
(b)D/P Ratio : 20%, Retention: 80%, r = 12%, br (g) = 0.8 X 0.12 = 0.0.096
P = 90 (1 – 0.80)_ = 90 X 0.2= 18/0.104 = 173.08
(0.20 – 0.096) 0.104
(c)D/P Ratio : 40%, Retention: 60%, r = 12%, br (g) = 0.6 X 0.12 = 0.0.072
P = 90 (1 – 0.60)_ = 90 X 0.4= 36/0.078 = 461.54
(0.15 – 0.072) 0.078
(d)D/P Ratio : 60%, Retention: 40%, r = 12%, br (g) = 0.4 X 0.12 = 0.0.048
P = 90 (1 – 0.40)_ = 90 X 0.6= 54/0.102 = 529.41
(0.15 – 0.048) 0.102

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 CAP II Paper 4: Financial Management

Question No. 4
A company has a total investment of Rs. 4,000,000 in assets and 40,000 outstanding ordinary
shares at Rs. 100 per share (par value). It earns at a rate of 15 percent on its investment, and has
a consistent policy of retaining 50 percent of the earnings. If the appropriate discount rate of the
firm is 10 percent: (3+4=7 Marks)
i) Determine the price of its share using Gordon‘s model.
ii) What shall happen to the price of the shares if the company has a payout of 20 per cent
and 60 per cent respectively?
(December 2009)
Answer:

(a) Price of Share using Gordon’s model:

The share valuation model of Gordon is as follows:
P0 = DIV1 = (1 – b)EPS1 = (1 – b)rA , where
k–g k – br k – br
A denotes investment per share, which is Rs. 100 in the present case.

When the payout is 50 per cent, the price of share will be:
P0 = (1 – 0.5) 0.15 x 100 = 0.5 x 15 = 7.5/0.025 = Rs. 300
0.10 – (0.15 x 0.5) 0.10 – 0.075

(b) Price of Share at Payout of 20 and 60 percent:

(i) Payout of 20 per cent

P0 = (1 – 0.8) 0.15 x 100 = 0.2 x 15 = 3/-0.02 = Rs. -150
0.10 – (0.15 x 0.8) 0.10 – 0.12

(ii) Payout of 60 per cent:

P0 = (1 – 0.4) 0.15 x 100 = 0.6 x 15 = 9/0.04 = Rs. 225
0.10 – (0.15 x 0.4) 0.10 – 0.06

Question No: 5
An investor has made investment in the equity share of Pacific Chemicals Ltd. The capitalization
rate of the company is 20 per cent and the current dividend is 25 per share.
You are required tocalculate the value of the company‘s equity share if the company is slowly
sinking with an annual decline rate of 10% in the dividend. (3 Marks)
(December 2010)

Answer :
The value of the company‘s equity share is given by the following formula:
Ve = D1/(k – g), where D1 is the dividend in the year 1, k is the capitalization rate and g is the
growth rate in dividend.

The value of equity share in the given condition is derived as follows:

Ve = Rs. 25 (1 – 0.10)/[(0.20 – (– 0.10)] = Rs. 25 x 0.90/0.30 = Rs. 22.50/0.30 = Rs. 75

© The Institute of Chartered Accountants of Nepal 46

 CAP II Paper 4: Financial Management

Question No: 6
XYZ Ltd. is foreseeing a growth rate of 12% per annum in the next 2 years. The growth rate is
likely to fall to 10% for the third year and fourth year. After that the growth rate is expected to
stabilise at 8% per annum. If the last dividend paid was Rs. 1.50 per share and the investors'
required rate of return is 16%, find out the intrinsic value per share of Z Ltd. as of date. You
may use the following table: (10 Marks)
Years 0 1 2 3 4 5
Discounting factor at 16% 1 0.86 0.74 0.64 0.55 0.48

(June 2010)

Answer:
Present value of dividend stream for first 2 years:
Rs. 1.50 (1.12) x 0.86 + 1.50 (1.12)2 x 0.74
Rs. 1.68 x 0.86 + 1.88 x 0.74
Rs. 1.45 + 1.39 = 2.84 (A)

Present value of dividend stream for next 2 years:

Rs. 1.88 (1.1) x 0.64 + 1.88 (1.1)2 x 0.55
Rs. 2.07 x 0.64 + 2.28 x 0.55
Rs. 1.33 + 1.25 = 2.58 (B)

Market value of equity share at the end of 4th year computed by using the constant dividend
growth model would be:
P4= D5
Ks - gn
Where D5 is dividend in the fifth year, gn is the growth rate and Ks is required rate of return.
Now, D5 =D4 (1 + gn)
D5 =Rs. 2.28 ( 1 + 0.08)
=Rs. 2.46
P4 = Rs. 2.46
0.16 - 0.08
= Rs. 30.75

Present market value of P4= 30.75 x 0.55 = Rs. 16.91 (C)

Hence the intrinsic value per share of Z Ltd. would be
A + B + C i.e. Rs. 2.84 + 2.58 + 16.91 = Rs. 22.33

Question No. 7
Koshi Traders is a growing supplier of office materials. Analysts project the following free cash
flow during the next 3 years of operation of the firm, after which free cash flow is expected to
grow at a constant 7% rate.

Year 1 2 3
Free Cash Flow (Rs. in millions) -20 30 40

The firm's weighted average cost of capital is 13%.

Required: (3+2+2=7 Marks)
i) What is the terminal or horizon value of free cash flows after 3rd year?

© The Institute of Chartered Accountants of Nepal 47

 CAP II Paper 4: Financial Management

ii) What is the value of the firm today?

Suppose the company has Rs. 100 million in debt and 10 million shares of stock. What is the
price per share?
[December 2013]

Answer:
i) Terminal or Horizon Value of FCF after 3rd year:

= Free Cash flow of 3rd year(1+g)

(WACC-g)
= 40(1+0.07)
0.13- 0.07
= Rs. 713.33 Million

ii) Calculation of Value of the firm today

FCF/ Terminal value
Year (Rs. in millions) PVIF @ 13% PV (Rs. in millions)
1 -20 0.8850 (17.70)
2 30 0.7831 23.493
3 40 0.6931 27.724
3 713.33 0.6931 494.41
Value of the Firm today 527.927

iii) Calculation of price per share

Value of Common Equity = Value of Firm today – Value of debt
=527.927 Million-100 Million
=Rs. 427.927 Million

Price per share = Value of Equity

No of Equity Shares

= Rs. 427.927 Million

10 Million
Price per share = Rs. 42.7927

Question No. 8
An investor is seeking the price to pay for a security, whose standard deviation is 4%. The
correlation coefficient for the security with the market is 0.9 and the market standard deviation is
3.2%. The return from the government security and the market portfolio are 6.2% and 10.8%
respectively. The investor knows that, by calculating the required return, he can then determine
the price to pay for the security.
Required: (2.5+2.5=5 Marks)
i) What is the required return on the security?
ii) What is the price of the security, if it is paying Rs. 25 of dividend per share
and its expected growth rate is 4?
[July 2015]

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 CAP II Paper 4: Financial Management

Answer:
i) The market sensitivity index i.e. the beta factor:

Standard deviation of an asset 0.04

β= ------------------------------------------------------*CORsm = -------------*.9 = 1.125
Standard deviation of Market 0.032

Now, the expected return on the security can be ascertained with the help of CAPM equation as
follows:
Ke = Irf(Rm-Irf) β
=6.2+(10.8-6.2)×1.125

=11.375%
ii) Price of security

Do (1+g)
Po = Ke-g

25(1+0.04)
= 0.11375-0.04

=Rs. 352.54

Question No. 9
Bhardhwaj Trader Ltd. is a growing supplier of office materials. Analysts project the following
free cash flow during the next 3 years of operation of the company, after which the free cash
flow is expected to grow at a constant rate of 7%.

Year 1 2 3
Free cash flow (Rs. in millions) (20) 30 40

The firm's weighted average cost of capital is 13%.

Required: (3+2+2=7 Marks)

i) What is the terminal value of free cash flows after 3rd year?
ii) What is the value of the firm today?
iii) If the company has Rs. 100 million in debt and 10 million ordinary shares
outstanding, what is the price per share?
[June 2017]
Answer:
i) Terminal Value of Free Cash Flows after 3rd year:
Free Cash Flow of 3rd year (1+g)
= (WACC-g)

40(1+0.07)
=
0.13-0.07

= Rs. 713.33 Million

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 CAP II Paper 4: Financial Management

ii) Calculation of Value of the Firm Today

Year FCF/Terminal Value (Rs. in millions) PVIF @ 13% PV (Rs. in
millions)
1 (20) 0.8850 (17.70)
2 30 0.7831 23.493
3 40 0.6931 27.724
3 713.33 0.6931 494.41
Value of the Firm Today 527.927

iii) Calculation of Price Per Share

Value of Common
Equity = Value of Firm Today - Value of Debt

= 527.927 Million - 100 Million

= Rs. 427.927 Million

Value of Equity
Price Per Share =
No. of Equity Share

Rs. 427.927 Million

=
10 Million

= Rs. 42.7927

Question No. 10
Northern California Fruit Company‘s latest earnings are Rs. 2 per share. Earnings per share are
expected to grow at a 20 percent compounded annually for 4 years, at a 12 percent annually for the
next 4 years and at 6 percent thereafter. The dividend-pay-out ratio is expected to be 25 percent for
the first 4 years, 40 percent for the next 4 years and 50 percent thereafter. At the end of year 8, the
price -earnings ratio for the company is expected to be 8.5 times, where year 9‘s expected earnings
per share are used in the denominator.
Required: (4+4=8 Marks)
i) If the required rate of return is 14 present, what is the present market
price per share?
ii) If the present market price per share is Rs. 30, what is the stocks expected
return?
[June 2018]

Answer:

Growth Earning(Rs.) DP Ratio Dividend(Rs.)

Year 0 - 2.00 - -
Year 1 20% 2.40 25% 0.60
Year 2 20% 2.88 25% 0.72
Year 3 20% 3.46 25% 0.86
Year 4 20% 4.15 25% 1.04
Year 5 12% 4.65 40% 1.86
Year 6 12% 5.21 40% 2.08

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 CAP II Paper 4: Financial Management

Year 7 12% 5.84 40% 2.34

Year 8 12% 6.54 40% 2.62
Year 9 6% 6.93 50% 3.47

B. Price at the End of Eight Year

Given,
P8/E9 = 8.5 Times
P8 = 8.5 * E9
P8 = 58.90
Therefore, price per share at the end of year 8 ( P8) will be = Rs. 58.90
C. Calculation of Current Market Price Per Share

2.34 2.62 58.90

Rs 26.72 / Share
ii) Calculation of Stock‘s Expected Return on Market Price of Rs. 30 Per Share
2.34

2.62 58.90

The expected rate of return needs to be calculated using interpolation technique.

Therefore we need to use Hit and Trial Method at different rate.
Try at 10 % of Discount Rate

2.34 2.62 58.90

P0 = Rs. 34.87
As given market price of Rs. 30 lies in between the price per share of Rs. 32.76 and Rs.
25.25 calculated using the discount rate at 10% and 14% respectively; therefore value
can be interpolated in between 10% and 14%.
Through interpolation
Expected Rate of Return = LR X [HR-LR]
= 10% + 34.87 - 30 X [14%-10%]
34.87 - 26.72
= 10 + 4.87/8.15
= 12.39%
Therefore the expected return at current market Price of NRs 30 is
11.47%.

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 CAP II Paper 4: Financial Management

Question No. 11
SSC Ltd. is considering the immediate purchase of some, or all, of the share capital of one of two
firms- SG Ltd. and CG Ltd. Both SG and CG have one million ordinary shares issued and neither
company has any debt capital outstanding.
Both SG Ltd. and CG Ltd. are expected to pay a dividend in one year‘s time. SG's expected
dividend amounts to Rs. 30 per share and that of CG is Rs. 27 per share. Dividends will be paid
annually and are expected to increase over time. SG‘s dividends are expected to display
perpetual growth at a compound rate of 6% per annum. CG‘s dividend will grow at the annual
compound rate of 33⅓% until a dividend of Rs. 64 per share is reached in year 4. Thereafter
CG‘s dividend will remain constant.
If SSC is able to purchase all the equity capital of either company, then the reduced competition
would enable SSC to save some advertising and administrative costs which would amount to Rs.
225,000 per annum indefinitely and, in year 2, to sell some office space for Rs. 800,000. SSC
would change some operations of any company completely taken over, the details are:
SG – No dividend would be paid until year 3. Year 3 dividend would be Rs. 25 per share and
dividends would then grow at 10% per annum indefinitely.
CG – No change in total dividends in years 1 to 4, but after year 4 dividend growth would be
25% per annum compounded until year 7. Thereafter annual dividend per share would remain
constant at the year 7 amount.
An appropriate discount rate for the risk inherent in all the cash flows mentioned is 15%.
Required: (4+6=10 Marks)
i) Calculate the value per share for a minority investment in each of the companies, SG
and CG, which would provide the investor with a 15% rate of return.
ii) Calculate the maximum amount per share which SSC should consider paying for each
company in the event of a complete takeover.
[June 2019]

Answer:
i) Using the dividend valuation model, the value of ordinary shares is given by;
Vs = D0 (1+g)
Ke-g
Where D0 (1 + g) is the dividend due in one year.
Ke is the cost of equity or required return.
g is the anticipated growth in dividends.
Now,
Value per share of SG =30/(0.15-0.06)
= Rs. 333.33
The model must be modified slightly to estimate the value per share of CG as follows:
= D1/(1+Ke)1 + D2/(1+ Ke)2+ D3/(1+ Ke)3+ D4/(1+ Ke)4 × 1/ Ke
= 27/(1.15)1 + 27(1.33)/(1.15)2 +27(1.33)2/(1.15)3 +64/(1.15)3 ×1/0.15
=23.48+27.15+31.40+243.95
= Rs. 362.8
ii) Maximum price in the event of a complete take-over:
Present value of cost savings:
Administrative costs= 225,000/0.15
= Rs. 1,500,000
Sale of office space = 800,000 x 0.7562
= Rs. 604,960
Total = Rs. 2,104,960
Saving per share = Rs. 2,104,960/1,000,000 = Rs.2.10

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 CAP II Paper 4: Financial Management

Value per share of SG (with change in operations):

Vs =25/(1.15)2×1/(0.15-0.10) = Rs.378.05
Maximum price = Rs. 378.05+Rs. 2.10 = Rs. 380.15
Value per share of CG:
Vc=27/1.15+(27×1.33)/(1.15)2 +

27×(1.33)2/(1.15)3+64/(1.15)4+(64×1.25)/(1.15)5+64×(1.25)2/(1.15)6+64×(1.25)
3
/(0.15) ×(1/(1.15)6
=23.48+27.15+31.40+36.59+39.77+43.23+313.25
=Rs. 562.13
Maximum price = 562.13+2.10
=Rs. 564.23

Question No. 12
The valuation of a company has been done by an investment analyst. Based on an expected free
cash flow of Rs. 5.40 million for the following year and an expected growth rate of 9 percent, the
analyst has estimated the value of the company to be Rs. 180 million. However, he committed a
mistake of using the book values of debt and equity.
The book value weights employed by the analyst are not known, but you know that the company
has a cost of equity of 20 percent and post-tax cost of debt of 10 percent. The market value of
equity is thrice its book value, whereas the market value of its debt is nine-tenth of its book
value.
Required: [7 Marks]
Calculate the correct value of the company.
[June 2019]

Answer:

Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as

follows:
Value of Firm (V0) = FCFF1 / (Kc - gn)
Where, FCFF1 = Expected FCFF in year 1
Kc = Cost of Capital
gn = Growth rate =9%
Thus Rs. 180 m = 5.4 m / (Kc - gn)
Since, g = 9%
Kc -9% = 5.4/180
Kc = 0.03 +0.09 = 12%
Now, let X be the weight of debt and given cost of equity = 20% and cost of debt=10%,
Then 20% (1-X) + 10%X = 12%
Hence, X=0.80, so book value weight of debt was 80% and accordingly book value
weight of equity was 20%
Thus, correct weight should be 60 (thrice of book value of equity) and 72 (nine-tenth
of book value) of debt
Cost of capital = Kc= 20% (60/132) + 10% (72/132) = 14.55%
Correct value of the firm = Rs. 5.4 m / (0.1455 - 0.09) = Rs. 97.3 m

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 CAP II Paper 4: Financial Management

Chapter 5:

Capital Investment Decision

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 CAP II Paper 4: Financial Management

Question No. 1
Write short notes on: (2.5 Marks)
Perpetuity Rate of Return
(December 2010)

Answer:
Perpetuity Rate of Return - Perpetuity Rate of Return (PRR) is a conversion of Profitability
Index (PI) into a perpetuity percentage rate of return of a project. In other words, it is PI of a
project expressed in terms of the Perpetuity rate of return. So it is just the product of PI and
required rate of return from the project under consideration. It gives the financial manager the
instrument for the comparison among projects in percentage terms. This method can be used to
rank the projects of equal lives and risks. But it is not useful to rank the mutually exclusive
projects of unequal lives and different risks.

Question No. 2
External Capital Rationing and Internal Capital Rationing [December 2011] 2.5 Marks

Answer:
External Capital Rationing mainly occurs on account of the imperfections in capital markets.
Imperfections may be caused by deficiencies in market information or by rigidities of attitude
that may hamper the free flow of capital. For example, A Ltd. is a closely held company. It
borrows from the financial institutions as much as it can. It still has investment opportunities,
which can be financed by issuing equity capital. But it doesn't issue shares. The owners-
managers do not approve the idea of the public issue of shares because of the fear of losing
control of the business.

Internal capital Rationing is caused by self- imposed restrictions by the management. Various
types of constraints may be imposed. e.g, it may be decided not to obtain additional funds by
incurring debt. This may be part of management's conservative financial policy. Management
may fix an arbitrary limit to the amount of funds to be invested by the divisional managers.
Sometimes, management may resort to capital rationing by requiring a minimum rate of return
higher than the cost of capital.

Question No. 3
Sensitivity Analysis [December 2011] (2.5 Marks)
Answer:
The net present value or Internal Rate of Return of a project is determined by analyzing the after
tax cash flows arrived at by combining forecasts of various variables like Sales volume, unit
selling price, unit variable cost, fixed cost etc. It is difficult to arrive at an accurate and unbiased
forecast of each variable. It can't be certain about the outcome of any of these variables. The
reliability of the NPV or IRR of the project will depend on the reliability of the forecasts of
variables underlying the estimates of net cash flows. To determine the reliability of the project's
NPV or IRR, we can work out how much difference it makes if any of these forecasts go wrong..
We can change each of the forecasts, one at a time, to at least three values: Pessimistic, expected
and optimistic. The NPV of a project is recalculated under these different assumptions. The
method of recalculating NPV or IRR by changing each forecast is called Sensitivity Analysis.

Sensitivity Analysis is a way of analyzing change in the project's NPV or IRR for a given
change in one of the variables. It indicates how sensitive a project's NPV or IRR is to changes in
particular variables. It basically examines the sensitivity of the variables underlying the
computation of NPV or IRR rather than attempting to quantify risk. It can be applied to any
variable which is an input for the after tax cash flows. It can be conducted with regard to
volume, price, costs etc.

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 CAP II Paper 4: Financial Management

Question No. 4
Capital Planning Vs. Capital Rationing [December 2012] 2.5 Marks

Answer:
A proper plan for a company's capital expenditures is called Capital Planning. Capital
expenditures are payments made over a period of more than one year. They are used to acquire
assets or improve the useful life of existing assets; an example of a capital expenditure is the
funding to construct a factory. Making a capital budget must account for the potential
profitability of the plans involved. Calculating the net present value or the internal rate of return
are two methods for determining a capital budget.
The act of placing restrictions on the amount of new investments or projects undertaken by a
company is called Capital Rationing. This is accomplished by imposing a higher cost of capital
for investment consideration or by setting a ceiling on the specific sections of the
budget. Companies may want to implement capital rationing in situations where past returns of
investment were lower than expected.

Question No. 5
Project under capital rationing [June 2013] 2.5 Marks

Answer:
The capital rationing situation refers to the choice of investment proposals under financial
constraints in terms of given size of capital expenditure budget. The objective to select the
combination of projects would be the maximization of total NPV. The project selection under
capital rationing involves two stages
(i) Identification of the acceptable projects
(ii) Selection of the combination of projects.
The acceptability of projects can be based either on profitability index or IRR. The method of
selecting investment projects under capital rationing situation will depend upon whether the
projects are indivisible or divisible. In case the project is to be accepted/rejected in its entirety, it
is called an individual project; a divisible project, on the other hand, can be accepted/ rejected in
part.

Question No. 6
NPV and IRR yield [December 2013] 2.5 Marks
Answer:
Both NPV and IRR are techniques of capital budgeting decision. Under the NPV rule, we
discount the cash flows at a given rate which is normally the cost of capital and arrive at NPV.
Whereas, in IRR, we find a discount rate that makes NPV zero and compare this rate with the
cost of capital.
NPV is absolute measurement while IRR is a relative measurement of the project‘s worth. NPV
shows the project‘s worth in monetary term whereas IRR does in terms of rate of return on
investment. Theoretically, NPV shows how much the market value of the firm will rise if
projects are accepted and IRR shows what rate of return will the project yield if it is a accepted.
NPV assumes that cash flows are reinvested at required rate of return and IRR assumes that they
will be reinvested at project rate of return.

Question No. 7
Profitability Index [December 2014] 2.5 Marks

Answer:
Profitability index is an investment appraisal technique calculated by dividing the present
value of future cash flows of a project by the initial investment required for the project.
Profitability Index is calculated as follows:

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 CAP II Paper 4: Financial Management

Present Value of Future Cash Flows

PI =
Initial Investment Required
Profitability index is actually a modification of the net present value method. While present
value is an absolute measure (i.e. it gives as the total figure for a project), the profitability index
is a relative measure (i.e. it gives as the figure as a ratio).
The decision rule is to accept a project if the profitability index is greater than 1, stay indifferent
if the profitability index is zero and don't accept a project if the profitability index is below 1.
Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing
since it helps in ranking projects based on their per dollar return.

Question No. 8
Capital Rationing [December 2014] 2.5 Marks
Answer:
Capital Rationing is the process hereby the limited funds available are allocated amongst the
financially viable projects which are not mutually exclusive under consideration so as to
maximize the wealth of the shareholders. Thus, capital rationing situation is said to exist if:
i. Limited funds are available for investment.
ii. More than one financially viable projected which are not mutually exclusive are under
consideration.

Question No. 9
Modified internal rate of return [July 2015] 2.5 Marks

Answer:
The Modified Internal Rate of Return (MIRR) is a financial measure of an investment's
attractiveness that attempts to obliterate the shortcomings of Internal Rate of Return. MIRR is
expected to resolve 2 issues associated with the Internal Rate of Return (IRR).
 The IRR makes an assumption that interim positive cash flows are reinvested at the same
rate of return, i.e., IRR. This is usually an unrealistic scenario and a more likely situation is
that the funds will be reinvested at a rate closer to the firm's cost of capital. The IRR
therefore often gives an unduly optimistic picture of the projects under study.
 Where the projects bear alternating positive and negative cash flows, there will be more than
one IRR, which leads to the confusion and ambiguity.
It is calculated as under:

n FV(positive cash flows, reinvestment rate)

MIRR = -1
-PV(negative cash flows at financing rate)
OR
PV of cost = Terminal value
(1+ MIRR)n

Question No. 10
Conflict in project choice using PI and NPV criterion [June 2017] 2.5 Marks

Answer:
The conflict in project choice using PI and NPV criterion arises in case of mutual exclusive
projects of unequal investment size having different net present values because NPV gives
ranking on the basis of absolute amount whereas PI gives ranking on the basis of ratio. In such a
case, mutual exclusive project having highest NPV should be selected since it would increase the

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 CAP II Paper 4: Financial Management

firm‘s wealth if the project is accepted which is consistent with the wealth maximization
objective of the financial management.

Question No. 11
Sensitivity Analysis in capital budgeting [December 2017] (2.5 Marks)

Answer:
The net present value or Internal Rate of Return of a project is determined by analyzing the after
tax cash flows arrived at by combining forecasts of various variables like Sales volume, unit
selling price, unit variable cost, fixed cost etc. It is difficult to arrive at an accurate and unbiased
forecast of each variable. It can't be certain about the outcome of any of these variables. The
reliability of the NPV or IRR of the project will depend on the reliability of the forecasts of
variables underlying the estimates of net cash flows. To determine the reliability of the project's
NPV or IRR, we can work out how much difference it makes if any of these forecasts go wrong.
We can change each of the forecasts, one at a time, to at least three values: Pessimistic, expected
and optimistic. The NPV of a project is recalculated under these different assumptions. The
method of recalculating NPV or IRR by changing each forecast is called Sensitivity Analysis.

Sensitivity Analysis is a way of analyzing change in the project's NPV or IRR for a given
change in one of the variables. It indicates how sensitive a project's NPV or IRR is to changes in
particular variables. It basically examines the sensitivity of the variables underlying the
computation of NPV or IRR rather than attempting to quantify risk. It can be applied to any
variable which is an input for the after tax cash flows. It can be conducted with regard to
volume, price, costs etc.

Question No. 12
NPV and IRR [June 2018] (2.5 Marks)

Answer
Evaluation of Non-conventional investments-Both are non-equivalent as regards the
acceptance/rejection of non-conventional investments if the projects differ in their (a) expected
lives or (b) estimated cash outflows or (c) timings of cash flows.
Reinvestment Rates-IRR assumes that intermediate cash inflows are reinvested at IRR while
NPV assumes that intermediate cash inflows are reinvested at required rate of return (i.e. firm‘s
cost of capital).
Multiple/Negative Rates-IRR can yield negative rates/multiple rates under certain circumstances
while there is no such possibility under NPV method.

Question No. 13
A textile company is considering two mutually exclusive proposals, proposal I and II. Under
Proposal I, Equipment X will be purchased whereas proposal II involves the purchase of
Equipment Y. Following relevant information is available in respect of the two proposals:
-------------------------------------------------------------------------------------------------------
Proposal I Proposal II
-------------------------------------------------------------------------------------------------------
Cost Price of Equipment NRs. 1.50 million NRs. 2.50 million
Useful Life of the Equipment 5 years 5 years
Salvage Value of
Equipment at the end of its Useful Life Nil Nil
Additional Working Capital
Required due to Equipment Purchase NRs. 0.50 million NRs. 0.70 million
Sales Revenue Generated
per annum in each of the 5 years NRs. 1.60 million NRs. 2.50 million
Cash Expenses required per annum
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 CAP II Paper 4: Financial Management

in each of the 5 years NRs. 0.35 million NRs. 0.65 million

----------------------------------------------------------------------------------------------------
Both the equipments are subject to written down value method of depreciation at the rate of
25 percent. You should assume the following:
i) The company does not have any other assets in the block of 25 percent depreciation
rate other than the proposed equipment,
ii) Cost of capital of the company is 15 percent,
iii) The company is subject to 30 percent tax rate,
iv) Capital profit is chargeable to tax and capital loss is deductible from tax at
the corporate rate of tax.

On the basis of above information, you are required to: (7+7+2+4=20 Marks)
a) Compute the net present value (NPV) of Proposal I,
b) Compute NPV of Proposal II,
c) Advise the company regarding the choice of equipment,
d) Suggest the company on the condition that Equipment X will have salvage value equal to
the book value of the equipment at the end of the useful life.

(June 2009)
Answer:
a. Statement of Net Present Value of Proposal I
Particulars NRs. Working Notes
Present Value of Inflows
Sales Revenue 2,933,175 1
Tax Saving on Depreciation 248,069 2
Tax Saving on Capital Loss 53,092 3
Release of Working Capital 248,950 4
A. Sub Total 3,483,286
B. Present Value of Cash Outflows 2,000,000 5
Net Present Value (A-B) 1,483,286

b. Statement of Net Present Value of Proposal II

Particulars NRs. Working Notes
Present Value of Inflows
Sales Revenue 4,341,099 6
Tax Saving on Depreciation 413,447 7
Tax Saving on Capital Loss 88,487 8
Release of Working Capital 348,026 9
A. Sub Total 5,191,059
B. Present Value of Cash Outflows 3,200,000 10
Net Present Value (A-B) 1,991,059

c. Advice regarding the Choice of Equipment

Proposal II involving the purchase of equipment Y is recommended in view of its higher
NVP to the extent of NRs. 507,773 as compared to Proposal I. (NRs. 1,991,059 – NRs.
1,483,286).

d. Suggestion upon change in condition (Working Note 11)

NPV of Proposal I is improved from the previous level of NRs. 1,483,286 to some extent as
a result of the new assumption regarding the salvage value. However, it still falls short of the
NPV of Proposal II by NRs. 383,890 (NRs. 1,991,059 – NRs. 1,607,169). It is therefore

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 CAP II Paper 4: Financial Management

recommended that the company should make investment in Equipment Y rather than in
Equipment X.

Working Notes:
W.N. 1
Present Value of Sales Revenue: NRs.
Sales Revenue Generated: 1,600,000
Less: Cash Expenses: 350,000
Cash profit before tax: 1,250,000
Less: Taxes @ 30 per cent: 375,000
Cash Flow after Taxes: 875,000
PV Factor of Annuity for 5 Years: 3.3522
PV of Sales Revenue: 2,933,175

W.N. 2
PV of Tax Saving due to Depreciation:
Year Depreciation Tax Savings PV Factor PV of Tax Savings
(1) (2) (3) = (2) X 0.30 (4) (5) = (3) X (4)
1 NRs. 375,000 NRs. 112,500 0.86957 NRs. 97,827
2 281,250 84,375 0.75614 63,799
3 210,938 63,282 0.65752 41,609
4 158,203 47,461 0.57175 27,136
5 118,652 35,596 0.49718 17,698
1,144,043 NRs.248,069

W.N. 3
PV of Tax Savings on Capital Loss: NRs. 53,092
(NRs. 1,500,000 – 1,144,043) X 0.30 X 0.49718

W.N. 4
Release of Working Capital: NRs. 248,950
(NRs. 500,000 X 0.49718)
W.N. 5
Particulars NRs.
Cost price of Equipment: 1,500,000
Additional Working Capital: 500,000
PV of outflows 2,000,000

W.N. 6

Present Value of Sales Revenue:

Sales Revenue Generated: 2,500,000
Less: Cash Expenses: 650,000
Cash profit before tax: 1,850,000
Less: Taxes @ 30 per cent: 555,000
Cash Flow after Taxes: 1.295,000
PV Factor of Annuity for 5 Years: 3.3522
PV of Sales Revenue: 4,341,099

W.N. 7

PV of Tax Saving due to Depreciation:

Year Depreciation Tax Savings PV Factor PV of Tax Savings
(1) (2) (3) = (2) X 0.30 (4) (5) = (3) X (4)

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1 NRs. 625,000 NRs. 187,500 0.86957 NRs. 163,044

2 468,750 140,625 0.75614 106,332
3 351,563 105,469 0.65752 69,348
4 263,672 79,102 0.57175 45,227
5 197,754 59,326 0.49718 29,496
1,906,739 NRs. 413,447
W.N. 8
PV of Tax Savings on short term Capital Loss: NRs. 88,487
(NRs. 2,500,000 – 1,906,739) X 0.30 X 0.49718

W.N. 9
Release of Working Capital: NRs. 348,026
(NRs. 700,000 X 0.49718)
W.N. 10
Particulars NRs
Cost price of Equipment: 2,500,000
Additional Working Capital: 700,000
PV of Outflows: 3,200,000

W.N. 11
In case Equipment X will have salvage value equal to book value at the end of the useful life, the
computation done earlier in the case of NPV of Proposal I will require modification for:
a. Cash inflow due to salvage value, and
b. Non-occurrence of short term capital loss computed earlier.

The salvage value of the Equipment X = Purchase Cost – Accumulated Depreciation

= 1,500,000 – 1,444,043
= NRs. 355,957.

Total Present Value previously computed: NRs. 3,483,286

Less: PV of Tax Saving on Short-term Capital Loss
since there will not be any loss now: (-)53,092
Add: PV of Salvage Value (355,957 X 0.49718) 176,975
NRs. 3,607,169
Less: Cash Outflows: NRs. 2,000,000
Revised NPV of Proposal I: NRs. 1,607,169

Question No. 14
A team of entrepreneurs are considering starting a new telecom company with GSM
technology in western part of Nepal. The team carried out a study in this respect which
shows that:
 The telecom regulatory body shall grant the license to the company for a seven year
period for a lump sum fee of Rs.210 million.
 The proposed company should carry out the project by awarding a turnkey contract
of supply, delivery, installation, and commissioning of required equipment of total
400,000 line capacities for a total sum of US$ 4.5 million (exchange rate assumed to
be 1 US$ equivalent to NRs.80). Half of the contract price will be paid in advance
and the remaining half will be paid when the equipment has been installed and tested
to the satisfaction of the company.
 The equipment installation and testing process will be completed by the end of the
first year. And, the equipments will be out of date and obsolete by end of the license
period.
 Site survey should be carried out by the proposed company itself for installation of
the equipment, which will incur a cost of Rs.1,500,000 during the first year.
 The estimated line distribution and revenue details for the project are as below:
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 CAP II Paper 4: Financial Management

Particulars Year Year 2 Year 3 Year 4 Year 5

1 and
onwards
New Line Distributed 0 100,000 140,000 160,000 0
Average Revenue Per
Line Per Month (Rs.) 0 230 210 190 170

 The 50% of lines distributed each year earn revenue for 8 months in the year of
distribution on an average and the remaining 50% lines earn revenue only for 3
months in the year of distribution on an average.
 The depreciation is to be provided on straight line basis starting from the year of
operation and is assumed to be same for the purpose of taxation.
 Corporate income tax will be charged @ 25% of taxable income. If there is loss in
any year, it will be allowed to be set off against profit of coming years for taxation
purpose.
 The project will require working capital of Rs.50 million during the license period.
 The royalty payable to the government is @ 6% p.a. on gross operating revenue.
 The annual cost of service operation and maintenance is 25% of gross revenue.
 The annual administrative cost which will be incurred starting from year 1 is
assumed to be Rs.20 million. It will increase by Rs.20 million in year 2, by further
Rs.30 million in year 3 over year 2, by further Rs.30 million in year 4 over year 3,
and will remain constant thereafter.
 The proposed company‘s required rate of return will be 15%.
From the above particulars, you are required to: (6+6+8=20 Marks)
a) Prepare income statement,
b) Show calculations of capital cash outlay and cash flows of each year.
c) State, with reason and calculation of NPV and IRR, whether you would recommend
that the project be undertaken.
(December 2009)
Answer
a)
Income Statement Amount in Rupees
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Annual
Operating
Revenue - 126,500,000 413,700,000 714,400,000 816,000,000 816,000,000 816,000,000
Less:

Royalty - 7,590,000 24,822,000 42,864,000 48,960,000 48,960,000 48,960,000

Operation &
Maintenance
Cost - 31,625,000 103,425,000 178,600,000 204,000,000 204,000,000 204,000,000
Administrative
Cost 20,000,000 40,000,000 70,000,000 100,000,000 100,000,000 100,000,000 100,000,000
Amortization
of License Fee 30,000,000 30,000,000 30,000,000 30,000,000 30,000,000 30,000,000 30,000,000

Depreciation - 60,250,000 60,250,000 60,250,000 60,250,000 60,250,000 60,250,000

Total cost 50,000,000 169,465,000 288,497,000 411,714,000 443,210,000 443,210,000 443,210,000

Profit (Loss) (50,000,000) (42,965,000) 125,203,000 302,686,000 372,790,000 372,790,000 372,790,000

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 CAP II Paper 4: Financial Management

Set off of
previous year
losses - - (92,965,000) - - - -
Profit (Loss)
before tax (50,000,000) (42,965,000) 32,238,000 302,686,000 372,790,000 372,790,000 372,790,000

Taxation - - 8,059,500 75,671,500 93,197,500 93,197,500 93,197,500

Profit (Loss)
after tax (50,000,000) (42,965,000) 117,143,500 227,014,500 279,592,500 279,592,500 279,592,500

Loss to be c/f (50,000,000) (92,965,000)

Answer
b)
Calculation of CFAT Amount in Rupees
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
PBT (50,000,000) (42,965,000) 125,203,000 302,686,000 372,790,000 372,790,000 372,790,000
Tax Paid - - 8,059,500 75,671,500 93,197,500 93,197,500 93,197,500
PAT (50,000,000) (42,965,000) 117,143,500 227,014,500 279,592,500 279,592,500 279,592,500
Add back:
Amortization
of License
Fee 30,000,000 30,000,000 30,000,000 30,000,000 30,000,000 30,000,000 30,000,000
Depreciation - 60,250,000 60,250,000 60,250,000 60,250,000 60,250,000 60,250,000
(20,000,000) 47,285,000 207,393,500 317,264,500 369,842,500 369,842,500 369,842,500
Capital outlay (621,500,000)
Working
Capital
released 50,000,000
Total CFAT (641,500,000) 47,285,000 207,393,500 317,264,500 369,842,500 369,842,500 419,842,500
Capital Outlay Year 1 (Rs.)
License Fee (210,000,000)
Cost of the Equipment (360,000,000)
Survey cost (1,500,000)
Working Capital tied up (50,000,000)
Total (621,500,000)
Answer
c)
Calculation of NPV at Lower Rate
Year CFAT (Rs.) PVIF at 15% PV (Rs.)

2 47,285,000 0.8696 41,117,391

3 207,393,500 0.7561 156,810,225

4 317,264,500 0.6575 208,606,559

5 369,842,500 0.5718 211,458,650

6 369,842,500 0.4972 183,877,087

7 419,842,500 0.4323 181,509,499

983,379,410

1 (641,500,000) 1 (641,500,000)
NPV 341,875,410

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 CAP II Paper 4: Financial Management

Calculation of NPV at Higher Rate

PVIF at
Year CFAT (Rs.) PV (Rs.)
30%
2 0.7692 36,373,077
47,285,000
3 207,393,500 0.5917 122,714,734
4 0.4552 144,408,056
317,264,500
5 0.3501 129,492,140
369,842,500
6 0.2693 99,609,338
369,842,500
7 0.2072 86,981,378
419,842,500
619,578,723
1 1 (641,500,000)
(641,500,000)
NPV (21,921,277)

IRR= Lr +(NPV at Lr/ ∆PV of Inflow)* ∆r

0.15+{341,875,410 /(983,379,410-
= 619,578,723)}*(0.30-0.15)

= 0.2909
IRR= 29.09%

Since the NPV at required rate of return of 15% is positive and the IRR is greater than the
required rate of return, the project should be undertaken.

Working Notes:
(1) Calculation of Annual Operating
Revenue
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Line Distributed 0 100000 140000 160000 0
Lines in operation 0 100000 240000 400000 400000 400000 400000
Lines earning revenue 0 0 100000 240000 400000 400000 400000
for 12 months
Lines earning revenue 0 50000 70000 80000 0 0 0
for 8 months
Lines earning revenue 0 50000 70000 80000 0 0 0
for 3 months
Average Revenue Per 0 230 210 190 170 170 170
Line Per Month (Rs.)

Annual Operating 126,50 413,70 714,40 816,00 816,00

Revenue (Rs.‘000) - 0 0 0 0 0 816,000

(2) Calculation of Depreciation

Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Cost of Equipment
(Rs.‘000) 360,000
(4500*80)

Survey cost (Rs.‘000) 1,500

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 CAP II Paper 4: Financial Management

Total Cost (Rs.‘000) 361,500

Amount of
depreciation
(Rs.‘000) - 60,250 60,250 60,250 60,250 60,250 60,250

Question No: 15
Growmore Ltd. is considering two projects, A and B, to undertake. The projects are
mutually exclusive and the firm can choose any one these two. There is a controversy at the
top management level of Growmore regarding the capital budgeting technique to be
employed as the basis for selection of the investment projects.
The finance director is of the view that the project with higher net present value (NPV)
should be chosen whereas the managing director strongly feels that the one with higher
internal rate of return (IRR) should be undertaken especially when the mutually exclusive
projects have the same initial outlay and length of life.
The company anticipates a cost of capital of 10% and the net after tax cash flow of the
projects (in ‗000 rupees) are as given below:

Projects _
Year A B
0 (-) 800 (-) 800
1 140 872
2 320 40
3 360 40
4 300 16
5 80 12

You are required to: (6+3+5+6=20 Marks)

a) Calculate the NPV and IRR of each project;
b) Recommend, with reasons, which project should be undertaken (if either);
c) Explain the inconsistency in ranking of the two projects in the light of the remarks of the
directors; and
d) Identify the cost of capital at which your recommendation made in part (b) would be
reversed.
Following discount factors may be adopted:
Discount Year
Factor 0 1 2 3 4 5
At 10% 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209
At 15% 1.0000 0.8696 0.7561 0.6575 0.5718 0.4972
At 20% 1.0000 0.8333 0.6944 0.5787 0.4823 0.4019
(June 2010)

Answer:

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 CAP II Paper 4: Financial Management

(a) Computation of NPV and IRR:

Project A:

Discount Factors Cash Flow NPV at

Year 10% 15% 20%
10% 15% 20%

0 1.0000 1.0000 1.0000 – 800 – 800.00 – 800.00 – 800.00

1 0.9091 0.8696 0.8333 140 27.27 121.74 116.66
2 0.8264 0.7561 0.6944 320 264.45 241.95 222.21
3 0.7513 0.6575 0.5787 360 270.47 236.70 208.33
4 0.6830 0.5718 0.4823 300 204.90 171.54 144.69
5 0.6209 0.4972 0.4010 80 49.67 39.78 32.15
Total: 116.76 11.71 -75.96

Project B:

Discount Factors Cash Flow NPV at

Year 10% 15% 20%
10% 15% 20%

0 1.0000 1.0000 1.0000 – 800 – 800.00 – 800.00 – 800.00

1 0.9091 0.8696 0.8333 872 792.74 758.29 726.63
2 0.8264 0.7561 0.6944 40 33.06 30.24 27.76
3 0.7513 0.6575 0.5787 40 30.05 26.30 23.15
4 0.6830 0.5718 0.4823 16 10.93 9.15 7.72
5 0.6209 0.4972 0.4010 12 7.45 5.97 4.82
Total: 74.23 29.95 -9.82

From the above table, at 10% discount rate:

Formula: IRR= * +

NPV of Project A = Rs. 116,760

NPV of Project B = Rs. 74,230
Using interpolation method, IRR of individual projects are computed as follows:
Project A = 15% + [11.71/ 11.71 – (-75.96)] X 5%
= 15% + [11.71/ (11.71+ 75.96)] X 5%
= 15% + (11.71/ 87.67) X 5% = 15% + 0.67% = 15.67%
Project B = 15% + [(29.95/(29.95 + 9.82) X 5%]
= 15% + [(29.95/(39.77 + 9.82) X 5%]
= 15% + 29.95/ 39.77 X 5% = 15% + 3.77 % = 18.77%

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Note: Using the rate of 10% and 20% rate for discounting, IRR derived for project A and B will
be 16.06% and 18.83% respectively.

(b) Recommendation on the Selection of Project:

Under NPV technique, project A has higher NPV (Rs. 116,760) as compared to project B which
has a NPV of Rs. 74,230. On the contrary, IRR of project B (18.77%) is much higher than that
of Project A which has an IRR of 15.67%.
The projects are mutually exclusive and conflicting rankings have occurred. In this situation,
NPV method will indicate the correct rankings due to certain limitation of IRR method as
explained under point (c). It is therefore recommended that project A should be selected for
implementation since it yields the higher NPV at a discount rate of 10%.
(c) Reasons for Inconsistency in the ranking of two Projects:
Such an inconsistency in the rankings generally occurs when the cash inflow in the project with
lower NPV is heavily loaded in the earlier years. That is exactly what has happened in the case
of Project B in the present case. Exactly, 88% of the cash inflow occurred in the first year in this
project whose NPV is lower as computed under point (a) above.
The superiority of NPV technique over the IRR method in such instances can be explained in
terms of the following factors:
(i) Percentage Returns: IRR expresses the results in percentage rather than in absolute or
monetary terms. Comparison of percentage can be misleading. For instance, an investment
of Rs. 500,000 that generates a return of 15 per cent is better than an investment of Rs.
200,000 which yields a return of 30 per cent. If the two projects are mutually exclusive, the
first investment will yield Rs. 75,000 but the second will only contribute Rs. 60,000
towards the profit pool of the firm. Therefore, if the objective is to maximize the
shareholders wealth, NPV is the correct measure.
(ii) Reinvestment assumptions: When NPV method is adopted, the implicit assumption is that
the cash flows generated from an investment will be reinvested at the cost of capital.
However, the IRR method assumes that all the proceeds from a project can be reinvested
to earn a return equal to the IRR of the original project. The underlying assumption of
NPV method is therefore more realistic as compared to the assumption made in IRR
method.

(d) Cost of Capital at which the Recommendation would be Reversed:

The cost of capital at which Project A would be preferred to Project B can be ascertained by
calculating the IRR on incremental investment, A – B.

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Total

Particulars
(Rs. in ‘000)
Project A : Cash Flow – 800 140 320 360 300 80
Project B : Cash Flow – 800 872 40 40 16 12
Project (A – B) 0 –732 280 320 284 68
Discount Factor 10% 1.0000 0.9091 0.8264 0.7513 0.683 0.6209
NPV @ 10% 0 –665.46 231.39 240.42 193.97 42.22 42.54
Discount Factor 15% 1.0000 0.8696 0.7561 0.6575 0.5718 0.4972
NPV @ 15% 0 –636.55 211.71 210.40 162.39 33.81 –18.54

Using interpolation method, IRR on incremental investment

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 CAP II Paper 4: Financial Management

= [10% + 42.54/(42.54 + 18.24) X 5%] = 10% + 42.54/ 60.78 X 5%

= 10% + 3.5% = 13.5%
Thus, the IRR on incremental investment (A – B) is 13.5 per cent. This implies that the decision
recommended in (b) above would be reversed if the cost of capital were in excess of 13.5 per
cent assuming that of the projects has a positive NPV.

Question No. 16
A plastic manufacturer has under consideration the proposal of production of high quality plastic
glasses. The necessary equipment to manufacture the glasses would cost Rs. 80,000. Investment
allowance rate on purchases of equipment is 20%. The production equipment would last 5 years
with no salvage value. The glasses can be sold at Rs. 3 each. Regardless of the level of
production, the manufacturer will incur cash costs of Rs. 25,000 each year, if the project is
undertaken. The overhead costs allocated to this new line would be Rs. 5,000. The variable cost
is estimated at Rs. 2.0 per glass. The manufacturer estimates it will sell about 75,000 glasses per
year; the straight line method of depreciation will be used; the applicable tax rate is 55%.
a) Calculate the cash outflows of the project. (5 Marks)
b) Determine the project‘s total present value at 0, 10, 20, 30 and 40 percent discount rate.(5 Marks)
c) Present the net present value profile for the proposal. (3 Marks)
d) Explore the relationship between Pay Back Reciprocal and IRR? (5 Marks)
e) What is the basic assumption behind terminal Value Approach? (2 Marks)
[June 2011]

You can take the help of following PV table:

Year 10% 20% 30% 40%
1 0.909 0.833 0.769 0.714
2 0.826 0.694 0.592 0.510
3 0.751 0.579 0.455 0.364
4 0.683 0.482 0.350 0.260
5 0.621 0.402 0.269 0.186

Answer:
(i) Cash outflows:
Rs
Cost of new equipment 80,000
purchases
Less: Investment Tax Credit 8,800
(Rs16,000) x 55%
Net cash outflow 71,200
Cash inflows:
Rs
Sales Revenue 225,000
Less Costs:
Variable Costs 150,000
Additional Fixed Cost 25,000
Additional Depreciation 16,000
Earning Before Taxes 34,000
Less Taxes 18,700
Earning After Taxes 15,300
Add Depreciation 16,000
Cash Flow After Tax (t = 1 – 5) 31,300
(Note: Costs allocated from other departments will not be considered as they do not involve any
corresponding incremental cash outflows)

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 CAP II Paper 4: Financial Management

(ii)
PV at different rates of discount:
Rate of PV factor Time (Years) CFAT Total PV
discount
0 5.000 1-5 31,300 156,500
10 3.791 1-5 31,300 118,658
20 2.991 1-5 31,300 93,618
30 2.436 1-5 31,300 76,247
40 2.035 1-5 31,300 63,696
(iii)
Net present value profile for the project:
Rate of NPV
discount
0 Rs85,300
10 47,458
20 22,418
30 5,046
40 (7,505)

(iv)
The reciprocal of the pay back is a good approximation of the IRR. The pay back period
reciprocal can be applied to both annuity and mixed streams of cash flows. In case of annuity,
pay back period of the proposed investment project is determined and factor closest to the pay
back period in the year row is looked into. In case of mixed stream cash flows, average annual
cash inflow is first calculated and approximated IRR is determined with the help of ‗fake‘ pay
back period.
(v)
Basic assumption behind the Terminal Value approach is that each cash inflow is re-invested in
another asset at a certain rate of return from the moment it is received until the termination of the
project.

Question No. 17
SC Co. is evaluating the purchase of a new machine to produce product P, which has a short
product life-cycle due to rapidly changing technology. The machine is expected to cost Rs. 1
million. Production and sales of product P are forecasted to be as follows:

Year 1 2 3 4
Production and sales (units) 35,000 53,000 75,000 36,000

The selling price of product P (in current price terms) will be Rs. 20 per unit, while the variable
cost of the product (in current price terms) will be Rs. 12 per unit. Selling price inflation is
expected to be 4% per year and variable cost inflation is expected to be 5% per year. No increase
in existing fixed costs is expected since SC Co. has spare capacity in both space and labour
terms.

Producing and selling product P will call for increased investment in working capital. Analysis
of historical levels of working capital within SC Co. indicates that at the start of each year,
investment in working capital for product P will need to be 7% of sales revenue for that year.

SC Co. pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax is
reduced by capital allowances on machinery (tax-allowable depreciation), which SC Co. can

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 CAP II Paper 4: Financial Management

claim on a straight-line basis over the four-year life of the proposed investment. The new
machine is expected to have no scrap value at the end of the four-year period.

SC Co. uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal
purposes.

Required: (12+3+5=20 Marks)

a) Calculate the net present value of the proposed investment in new machine for production of
product P.
b) Calculate the internal rate of return of the proposed investment in new machine for
production of product P.
c) Advise on the acceptability of the proposed investment in new machine for production of
product P and discuss the limitations of the evaluations that have been carried out.
[December 2011]

Answer:
a) Calculation of net present value

Year 0 1 2 3 4
Rs. Rs. Rs. Rs. Rs.
Sales revenue (WN 1) 728,000 1,146,390 1,687,500 842,400
Variable costs (WN 2) (441,000) (701,190) (1,041,750) (524,880)
––––––––– –––––––––– ––––––––––– –––––––––
Contribution 287,000 445,200 645,750 317,520
Capital allowances (depreciation)
(Cost ÷ 4) (250,000) (250,000) (250,000) (250,000)
––––––––– –––––––––– ––––––––––– –––––––––
Taxable profit 37,000 195,200 395,750 67,520
Taxation (11,100) (58,560) (118,725) (20,256)
––––––––– –––––––––– ––––––––––– –––––––––
After-tax profit 25,900 136,640 277,025 47,264
Capital allowances 250,000 250,000 250,000 250,000
––––––––– –––––––––– ––––––––––– –––––––––
After-tax cash flow 275,900 386,640 527,025 297,264

Initial investment (1,000,000)

Working capital (WN 4) (50,960) (29,287) (37,878) 59,157 58,968
––––––––––– ––––––––– –––––––––– ––––––––––– ––––––
Net cash flows (1,050,960) 246,613 348,762 586,182 356,232
PVIF at 12% 1·000 0·893 0·797 0·712 0·636
––––––––––– ––––––––– –––––––––– ––––––––––– ––––––
Present values (1,050,960) 220,225 277,963 417,362 226,564
––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––
NPV = Rs. 91,154

Working Notes:
1) Sales revenue

Year 0 1 2 3 4
Selling price (Rs./unit) 20.00 20·80 21·63 22·50 23·40
(expected to increase @ 4% per year)
Sales volume (units) - 35,000 53,000 75,000 36,000

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 CAP II Paper 4: Financial Management

Sales revenue (Rs.) - 728,000 1,146,390 1,687,500

842,400

2) Variable costs

Year 0 1 2 3 4
Variable cost (Rs./unit) 12.00 12·60 13·23 13·89 14·58
(expected to increase @ 5% per year)
Sales volume (units) - 35,000 53,000 75,000 36,000
Variable costs (Rs.) - 441,000 701,190 1,041,750 524,880

3) Total investment in working capital

Year 0 investment = 728,000 x 0·07 = Rs. 50,960

Year 1 investment = 1,146,390 x 0·07 = Rs. 80,247
Year 2 investment = 1,687,500 x 0·07 = Rs. 118,125
Year 3 investment = 842,400 x 0·07 = Rs. 58,968

4) Incremental investment in working capital

Year 0 investment = 728,000 x 0·07 = (Rs.50,960))

Year 1 investment = 80,247 – 50,960 = (Rs. 29,287)
Year 2 investment = 118,125 – 80,247 = (Rs. 37,878)
Year 3 recovery = 58,968 – 118,125 = Rs. 59,157
Year 4 recovery = Rs. 58,968

(b) Calculation of internal rate of return

Year 0 1 2 3 4
Rs. Rs. Rs. Rs. Rs.
Net cash flows (1,050,960) 246,613 348,762 586,182 356,232
PVIF at 20% 1·000 0·833 0·694 0·579 0·482
––––––––––– –––––––– –––––––– –––––––– ––––––––
Present values (1,050,960) 205,429 242,041 339,399 171,704
––––––––––– –––––––– –––––––– –––––––– ––––––––
NPV at 20% = (Rs.92,387)
NPV at 12% = Rs.91,154

IRR = 12 + [(20 – 12) x 91,154/(91,154 + 92,387)] = 12 + 4 = 16%(Approx.)

(c) Acceptability of the proposed investment in new machine production of Product P

 The NPV is positive. Hence, the proposed investment can be recommended on financial
grounds.
 The IRR is greater than the discount rate used by SC Co for investment appraisal
purposes. Hence, the proposed investment is financially acceptable. The cash flows of
the proposed investment are conventional and so there is only one internal rate of return.
Furthermore, only one proposed investment is being considered. Therefore, there is no
conflict between the advice offered by the IRR and NPV investment appraisal methods.

Limitations of the investment evaluations

 Both the NPV and IRR evaluations are heavily dependent on the production and sales
volumes that have been forecast and so SC Co should investigate the key assumptions
underlying these forecast volumes. It is difficult to forecast the length and features of a

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 CAP II Paper 4: Financial Management

product‘s life cycle so there is likely to be a degree of uncertainty associated with the
forecast sales volumes. Scenario analysis may be of assistance here in providing information
on other possible outcomes to the proposed investment.

 The inflation rates for selling price per unit and variable cost per unit have been assumed to
be constant in future periods. In reality, interaction between a range of economic and other
forces influencing selling price per unit and variable cost per unit will lead to unanticipated
changes in both of these project variables. The assumption of constant inflation rates limits
the accuracy of the investment evaluations and could be an important consideration if the
investment were only marginally acceptable.

 Since no increase in fixed costs is expected because SC Co has spare capacity in both space
and labour terms, fixed costs are not relevant to the evaluation and have been omitted. No
information has been offered on whether the spare capacity exists in future periods as well as
in the current period. Since production of Product P is expected to be more than double over
three years, future capacity needs should be assessed before a decision is made to proceed, in
order to determine whether any future incremental fixed costs may arise.

Question No. 18
D Co. needs to increase production capacity to meet increasing demand for an existing product,
‗Q‘, which is used in food processing. A new machine, with a useful life of four years and a
maximum output of 600,000 kgs. of Q per year, could be bought for Rs. 800,000, payable
immediately. The scrap value of the machine after four years would be Rs. 30,000. Forecast
demand of Q over the next four years is as follows:

Year 1 2 3 4
Demand (kg.) 1.4 million 1.5 million 1.6 million 1.7 million

Existing production capacity for Q is limited to one million kilograms per year, and the new
machine would only be used for catering demand additional to this. The current selling price of
Q is Rs. 8.00 per kilogram and the variable cost of materials is Rs. 5.00 per kilogram. Other
variable costs of production are Rs. 1.90 per kilogram. Fixed costs of production associated with
the new machine would be Rs. 240,000 in the first year of production, increasing by Rs. 20,000
per year in each subsequent year of operation. D Co. pays tax one year in arrears at an annual
rate of 30% and can claim capital allowances (tax-allowable depreciation) on a 25% reducing
balance basis. The balancing allowance is claimed in the final year of operation of new machine.
D Co. uses its after-tax weighted average cost of capital when appraising investment projects. It
has a cost of equity of 11% and a before-tax cost of debt of 8.6%. The long-term finance of the
company, on a market-value basis, consists of 80% equity and 20% debt.

Required:
a) Calculate the net present value of buying the new machine and advise on the
acceptability of the proposed purchase. (12 Marks)
b) Calculate the internal rate of return of buying the new machine and advise on the
acceptability of the proposed purchase. (4 Marks)
c) What are the limitations of the investment appraisal made in (a) and (b) above? Explain
how they can be addressed. (4 Marks)
[June 2012]

Answer:
a) Net present value evaluation of investment
After-tax weighted average cost of capital (%) = (11 x 0·8) + (8·6 x (1 – 0·3) x 0·2)
= 8.8 + 1.20 =10% (approx.)
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 CAP II Paper 4: Financial Management

(Figure in Rs.)
Year 1 2 3 4 5

Contribution 440,000 550,000 660,000 660,000 -

Fixed costs (240,000) (260,000) (280,000) (300,000) -
––––– ––––– ––––– –––––
Taxable cash flow 200,000 290,000 380,000 360,000 -
Taxation@30% - (60,000) (87,000) (114,000) (108,000)
CA tax benefits - 60,000 45,000 33,750 92,250
Scrap value 30,000
––––– ––––– ––––– –––––
After-tax cash flows 200,000 290,000 338,000 309,750 (15,750)
DF at 10% 0·909 0·826 0·751 0·683 0·621
––––– ––––– ––––– ––––– –––––
Present values 181,800 239,540 253,838 211,559 (9,781)
––––– ––––– ––––– ––––– –––––
Rs.
Present value of benefits 876,956
Initial investment (800,000)

Net present value 76,956

Advice:
The net present value is positive and so the investment is financially acceptable.

Working Note 1: Calculation of Annual contribution

Year 1 2 3 4
Excess demand (kg/yr) 400,000 500,000 600,000 700,000
New machine output (kg/yr) 400,000 500,000 600,000 600,000*
Contribution (Rs./kg)
Rs. (8 – 5 – 1.9) 1·1 1·1 1·1 1·1
–––––––– –––––––– –––––––– ––––––––
Contribution (Rs./yr) 440,000 550,000 660,000 660,000
–––––––– –––––––– –––––––– ––––––––
*Maximum output from new machine.
Working Note 2: Capital allowance (CA) tax benefits

Year Capital allowance (Rs.) Tax benefit (Rs.)

1 200,000 (800,000 x 0·25) 60,000 (0·3 x 200,000)
2 150,000 (600,000 x 0·25) 45,000 (0·3 x 150,000)
3 112,500 (450,000 x 0·25) 33,750 (0·3 x 112,500)
––––––––
462,500
30,000 (scrap value)
––––––––
492,500
4 307,500 (by difference) 92,250 (0·3 x 307,500)
––––––––
800,000
––––––––

b) Internal rate of return evaluation of investment

(Using trial discount factor at 20%)

Year 1 2 3 4 5
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 CAP II Paper 4: Financial Management

Rs. Rs. Rs. Rs. Rs.

After-tax cash flows
(as in (a) above 200,000 290,000 338,000 309,750 (15,750)
Discount factor
at 20% 0·833 0·694 0·579 0·482 0·402
––––– ––––– ––––– ––––– –––––
Present values 166,600 201,260 195,702 149,300
(6,332)
––––– ––––– ––––– ––––– –––––

Rs.
Present value of benefits 706,530
Initial investment (800,000)

Net present value (93,470)

Internal rate of return = 10 + [((20 – 10) x 76,956)/(76,956 + 93,470)] = 10 + 4·52= 14·52%

Advice:
The investment is financially acceptable since the internal rate of return is greater than the
cost of capital used for investment appraisal purposes.

c) The limitations of the above investment appraisal are:

i) Maximum output constraint of the proposed investment, which is insufficient to
address the increasing demand in year four and onwards.
ii) Uncertainty about the required additional investment to address the additional
demand in year 4 and onwards.
iii) Constant selling price and variable cost but increasing fixed cost and demand.
They can be addressed by:
i) Assumption of constant selling price and variable cost of the product.
ii) Assumption of linear increase in fixed production cost and demand of the product.
iii) Including necessary cost of additional investment required in year 4 and onward.

Question No. 19
South China Corporation is evaluating on investment projects for investment in new machinery
to produce a recently-developed product. The cost of the machinery, which is payable
immediately, is Rs. 1.5 million, and the scrap value of the machinery at the end of four years is
expected to be Rs. 100,000. Capital allowances (tax-allowable depreciation) can be claimed on
this investment on a 25% reducing balance basis. Information on results from the investment has
been forecast to be as follows:
Year 1 2 3 4
Sales volume (units/year) 50,000 95,000 140,000 75,000
Selling price (Rs./unit) 25 24 23 23
Variable cost (Rs./unit) 10 11 12 12·50
Fixed costs (Rs./year) 105,000 115,000 125,000 125,000

This information must be adjusted to allow for selling price inflation of 4% per year and
variable cost inflation of 2.5% per year. Fixed costs, which are wholly attributable to the
project, have already been adjusted for inflation. South China Corporation pays profit tax of
30% per year on one year in arrears.
South China Corporation has a nominal before-tax weighted average cost of capital of 12% and
a nominal after-tax weighted average cost of capital of 7%.
Required:
Calculate the net present value of the project and comment on whether this project is financially
acceptable to South China Corporation. (12 Marks)
© The Institute of Chartered Accountants of Nepal 74
 CAP II Paper 4: Financial Management

[December 2012]

Answer:
Calculation of net present value (NPV)
As nominal after-tax cash flows are to be discounted, the nominal after-tax weighted average
cost of capital of 7% must be used.
Calculation of Net Present Value (Rs.)
Particular Year 1 2 3 4 5
Sales revenue WN 1 1,300,000 2,466,200 3,621,800 2,018,250
Variable costs WN 2 (512,500) (1,098,200) (1,808,800) (1,035,000)
Contribution 787,500 1,368,000 1,813,000 983,250
Fixed costs (105,000) (115,000) (125,000) (125,000)
Taxable cash 682,500 1,253,000 1,688,000 858,250
flow
Tax liabilities (204,750) (375,900) (506,400) (257,475)
CA tax benefits WN 3 112,500 84,375 63,281 159,844
After-tax cash
flow 682,500 1,160,750 1,396,475 415,131 (97,631)
Scrap value 100,000
Net cash flow 682,500 1,160,750 1,396,475 515,131 (97,631)
DF at 7% 0.9346 0.8734 0.8163 0.7629 0.7130
Present values 637,865 1,013,800 1,139,943 392,993 (69,611)

Present Value of Cash inflows = Rs.3,114,990

Cost of Machine = Rs.1,500,000
Net Present Value (NPV) = Rs.1,614,990

The project has a positive NPV of Rs. 1,614,990, so it is financially acceptable to South China
Co. However, as this is a recently-developed product, it may be appropriate to use a project-
specific discount rate that reflects the risk of the new product launch.

Working Note 1: Calculation of inflation adjusted Sales Revenue

Year 1 2 3 4
Price Inflation 104% 108.16% 112.486% 116.985%
100%
Selling price (Rs./unit) 25·00 24·00 23·00 23·00
Inflated selling price (Rs./unit) 26·00 25·96 25·87 26·91
Sales volume (units/year) 50,000 95,000 140,000 75,000
Sales revenue (Rs./year) 1,300,000 2,466,200 3,621,800 2,018,250

Working Note 2: Calculation of inflation adjusted Variable Cost

Year 1 2 3 4
Price Inflation 102.5% 105.063% 107.69% 110.382%
100%
Variable cost (Rs./unit) 10·00 11·00 12·00 12·50
Inflated variable cost (Rs./Unit) 10·25 11·56 12·92 13·80
Sales volume (units/year) 50,000 95,000 140,000 75,000
Variable costs (Rs./year) 512,500 1,098,200 1,808,800 1,035,000

Working Note 3: Calculation of capital allowance tax-benefits

Year 1 2 3 4
Capital Assets (Depreciation base) (Rs.)
1,500,000 1,125,000 843,750 532,812*

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 CAP II Paper 4: Financial Management

Depreciation Rate
0.25 0.25 0.25
Depreciation Amount (Rs.) 375,000 281,250 210,938
532,812
Tax Rate 0.30 0.30 0.30
0.30
Capital allowance tax benefits (Can be 84,375 63,281 159,844
adjusted in the year of relevant tax 112,500
payable)
*Note: Capital base for 4th year = 843,750-210,938-100,000 = 532,812

Question No. 20
PQR Limited deals in mines and geological survey. It is considering the following investment
proposals for mining:

Project Cash Flows

Year 0 Year 1 Year 2 Year 3
A -10,000 +10,000 Nil Nil
B -10,000 +7,500 +7,500 Nil
C -10,000 +2,000 +4,000 +12,000
D -10,000 +10,000 +3,000 +3,000
Assume Discount Rate of 10 per cent.
Required: (8+2=10 Marks)
i). Rank the projects according to each of the following methods: Internal Rate of Return (IRR)
Net Present Value (NPV)
ii). Assuming the projects are independent, which one should be accepted? If the projects are
mutually exclusive, which project is the best?
[December 2012]

Answer:
i) Cash Flows of Projects
Year A B C D
0 (10,000) (10,000) (10,000) (10,000)
1 10,000 7,500 2,000 10,000
2 - 7,500 4,000 3,000
3 - - 12,000 3,000

Discounted Cash Flows of Projects:

Year DF at 10% A B C D
0 1 (10,000) (10,000) (10,000) (10,000)
1 0.909 9,090 6,818 1,818 9,090
2 0.826 - 6,195 3,304 2,478
3 0.751 - - 9,012 2,253
NPV (910) 3,013 4,134 3,821
Rank IV III I II

IRR calculations:
Project A: The net cash proceeds in year 1 is just equal to the initial investment, therefore, IRR =
0%
For Project B, C & D Trying for NPV at DF of 40%
Year DF at 40% DCF of B DCF of C DCF of D
0 1 (10,000) (10,000) (10,000)
1 0.714 5,355 1,428 7,140

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 CAP II Paper 4: Financial Management

2 0.510 3,825 2,040 1,530

3 0.364 - 4,368 1,092
NPV (820) (2,164) (238)

IRR (B) = LR + × (HR – LR)

=10 + (40-10)

=10+23.58
= 33.58% (Rank =II)

IRR (C) =10 + (40-10)

=29.69% (Rank= III)

IRR (D) =10 + (40-10)

=35.83% (Rank=I)
ii) Between, the two time-adjusted (Discounted cash flow) investment criteria, NPV and IRR,
NPV gives the consistent results. If the projects are independent, either IRR or NPV method can
be used since the same set of projects will be accepted by any of the methods. In the present
case, except Project A all the three projects should be accepted if the discount rate is 10%.
Under the assumption of 10% discount rate and mutually exclusive projects, rankings according
to IRR and NPV conflicts (except for Project A). If we follow the IRR rule, Project D should be
accepted. But the NPV rule says that Project C is the best.
Since the NPV rule gives consistent results in conformity with the wealth maximization
principle, we would therefore accept Project C following the NPV rule.

Question No. 21
BRT Co. has developed a new confectionery line that can be sold for Rs. 5 per box and that is
expected to have continuing popularity for many years. The finance manager of the company
proposed that the investment in the new product should be evaluated over a four year time
horizon, even though sales would continue after the fourth year on the ground that cash flows
after fourth years are too uncertain to be included in the evaluation.
The average variable and fixed costs will depend on sales volume as follows:

less than 1 1–1·9 2–2·9 3–3·9

Sales volume (boxes)
million million million million
Variable cost (Rs. per box) 2·80 3·00 3·00 3·05
Total fixed costs (Rs. in million) 1 1·8 2·8 3·8

Forecast sales volumes are as follows:

Year 1 2 3 4
0·7 1·6 2·1 3·0
Sales Volume (boxes)
million million million million

The production equipment for the new confectionery line would cost Rs. 2 million and an
additional initial investment of Rs. 750,000 would be needed for working capital. Capital
allowances (tax-allowable depreciation) on a 25% reducing balance basis could be claimed on
the cost of equipment. Profit tax of 25% per year will be payable one year in arrear. A balancing

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 CAP II Paper 4: Financial Management

allowance would be claimed in the fourth year of operation. BRT Co. uses a nominal after-tax
cost of capital of 12% to appraise new investment projects.

Required: (12+8=20 Marks)

a) Assuming that production only lasts for four years, calculate the net present value of
investing in the new product line using a nominal terms approach and advise on its financial
acceptability (work to the nearest Rs. 1,000).
b) Comment briefly on the proposal to use a four-year time horizon to evaluate the project, and
calculate and discuss a value that could be placed on the after-tax cash flows arising after
fourth year of operation, using a perpetuity approach. Assume, for this part of the question
only, that before-tax cash flows and profit tax are constant from year five onwards, profit
taxes are payable in the same year and that capital allowances and working capital can be
ignored.
[June 2013]
Answer:
Net present value evaluation of new confectionery investment (Rs. ‗000)

Year 1 2 3 4
Sales (WN1) 3,500 8,000 10,500 15,000
Variable cost(WN2) (1,960) (4,800) (6,300) (9,150)
1,540 3,200 4,200 5,850
Fixed costs (WN3) (1,000) (1,800) (2,800) (3,800)
Taxable cash flow 540 1,400 1,400 2,050
Less: Tax@ 25% - (135) (350) (350)
Add: CA tax benefit(WN4) - 125 94 70
540 1,390 1,144 1,770
Add: Working capital released - - - 750
540 1,390 1,144 2,520
PVIF@12% 0.893 0.797 0.712 0.636
Present values 482 1,108 815 1,603
" (Rs. ‗0000)
Sum of present values 4,008
Less: cost of Equipment [At year
(2,000) (2,000×1.00)
0]= =(2,000)
WC tied up [At year 0] = (750×1.00) =(750)
Net present value 1,258

Advice: The proposed investment in the new product is financially acceptable, as the NPV is
positive.
Working Notes:
1)Calculation of sales
Year 1 2 3 4
Sales volume (boxes) 2,100,000
700,000 1,600,000 3,000,000
selling price (/box) (Rs.) 5 5 5 5
Sales (/yr) Rs. ‗000 3,500 8,000 10,500 15,000

2)calculation of variable cost

Year 1 2 3 4
Sales volume (boxes) 2,100,000
700,000 1,600,000 3,000,000
Variable cost per box (Rs.) 3.00 3.00 3·05
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 CAP II Paper 4: Financial Management

2.80
Variable cost (/yr) Rs. ‗000 1,960 4,800 6,300 9,150

3)Calculation of fixed costs

Year 1 2 3 4
Sales volume (boxes) 700,000 1,600,000 2,100,000 3,000,000
Fixed costs (Rs. ‗000) 1,000 1,800 2,800 3,800

4)Calculation of Deprecation & tax benefits

Year 1 2 3 4
Capital allowance(Depn) 500,000 375,000 281,250 843,750
Tax benefit (25%) 125,000 93,750 70,312.50 210,937.50
Tax benefit (Rs. ‗000) 125 94 70 211

b) The proposal to use a four-year time horizon

The finance manager believes that cash flows are too uncertain after four years to be included in
the net present value calculation, even though sales will continue beyond four years. While it is
true that uncertainty increases with project life, cutting off the analysis after four years will
underestimate the value of the investment to the extent that cash flows after the cut-off point are
ignored. Furthermore, since the new confectionery line is expected to be popular, cash flows
after year four could be substantial, increasing the extent of the under valuation. Artificially
terminating the evaluation after four years has accelerated the recovery of working capital and
has also led to a large balancing allowance. These increased cash flows, which arise in years
four and five respectively, will overestimate the value of the investment.

The value of cash flows after the fourth year of operation:

The approach here should be to calculate the present value of the expected future cash flows
beyond year four. If the before-tax cash flows are assumed to be constant and if the one-year
delay in tax liabilities is ignored, the year four present value of future cash flows beyond year
four can be estimated using a perpetuity approach. The year four present value of cash flows
from year five onwards will be: 2,050 x (1 – 0·25)/0·12 = 12,813 (Rs. ‗000)

The year zero present value of these cash flows = 12,813x 0·636 = 8,149 (Rs. ‗000)
Although these calculations ignore the capital allowance tax benefits (which will decrease each
year) and the incremental investment in working capital (which will increase slightly each year),
the present value of cash flows after year four is still substantial.

Question No. 22
The Cash flows of two mutually exclusive projects are as under:
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
P (40,000) 13,000 8,000 14,000 12,000 11,000 15,000
J (20,000) 7,000 13,000 12,000 - - -

Required:
(5+5+5+5=20Marks)
a) Estimate the net present value of the project "P" and "J" using 15% as burled rate, and state
which project should be chosen.
b) Estimate the internal rate of return of the project "P" and "J", and state which project should
be chosen.
c) Why is there a conflict in the project choice by using net present value and internal rate of
return criterion?

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 CAP II Paper 4: Financial Management

d) What method will you use in such a conflicting situation? Show your calculation and also
make the project choice.
[December 2013]

Answer:
a) Estimation of NPV of the projects P and J

Year Discounting Project P Project J

factor @15% Cash flow(Rs.) P.V.(Rs.) Cash flow(Rs.) P.V.(Rs.)
0 1.0000 (40,000) (40,000) (20,000) (20,000)
1 0.8696 13,000 11,305 7,000 6,087
2 0.7561 8,000 6,049 13,000 9,829
3 0.6575 14,000 9,205 12,000 7,890
4 0.5718 12,000 6,862 - -
5 0.4972 11,000 5,469 - -
6 0.4324 15,000 6,486 - -
Net Present Value 5,376 3,806

On the basis of NPV, project P is desirable.

b) Estimation of Internal Rate of Return of projects P and J:

For Project P
Average Cash Flow of Project P is as follows:
(13,000+8,000+14,000+12,000 +11,000+15,000)/6= Rs. 73,000/6= Rs. 12,167

Factor to be located =40,000/12,167= 3.2876

The nearest rate of return for 3.2876 in compound value table is shown at 22%. We can use
the cash flow values for discounting at 20% by trial and error method as given in the
problem. While discounting, we get Rs.278 negative as NPV.

Thus the IRR would be as follows:

IRR for Project P = 15+[5376/ (5376+278)] x 5=19.75%

For Project J
Average Cash Flow of Project J is as follows:
(7,000+13,000+12,000)/3= Rs. 32,000/3= Rs. 10,667

Factor to be located =20,000/10,667= 1.875

The nearest rate of return for 1.875 in compound value table is shown at 24%. We can use
the cash flow values for discounting at 26% by trial and error method as given in the
problem. While discounting, we get Rs. 256 negative as NPV.

Thus the IRR would be as follows:

IRR for Project J = 15+ [3,806/(3,806+256)]×11=25.31%

On the basis of IRR, project J is desirable.

c) Reason for conflict in NPV and IRR criterion:

Conflict between the results of NPV and IRR arises:
a) If the project has multiple cash outflows;
b) When there are mutually exclusive projects under consideration;
c) When projects have unequal lives or scale of investment;

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 CAP II Paper 4: Financial Management

d) When projects are borrowing and not lending.

In the given case, above (b) and (c) situations apply.

The selection of project using NPV is more realistic than IRR. The wealth maximization
concept is taken into consideration in NPV method, and it is based on financial manager‘s
judgment.

d) Where there are unequal lives, unequal scale of investment, projects are mutually exclusive
and there arises the conflict in selection of projects using NPV and IRR, we can use
Equivalent Annual Value Method for project selection as follows:
Equivalent Annual Value of Project P
= NPV/Cumulative P.V. of Re.1 p.a. @15% for 6 years
= Rs. 5,376/3.7845=Rs. 1,420.

Equivalent Annual Value of Project J

= NPV/Cumulative P.V. of Re.1 p.a. @15% for 3 years
= Rs. 3,806/2.2832=Rs. 1,667

Selection of Project:
Since the Equivalent Annual Value of Project J is higher than Project P as calculated above,
we may select Project J. It will minimize risk of uncertain future.

Question No. 23
a) Following are the data on a capital project being evaluated by the Management of Sagun
Ltd.
A Annual Cost Saving Rs.40,000
B Useful Life 4 years
C Internal Rate of Return 15%
D Profitability Index 1.064
E Net Present Value ?
F Cost of Capital ?
G Cost of Project ?
H Payback ?
I Salvage Value Nil

Required: (5 Marks)
Find the missing value considering the following table of discount factor only

Discount 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

[June 2014]

Answer:
(i) Calculation of Cost of Project

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Let cost of project be x

Cost of Project at IRR 15% is equal to PV of Cash Inflow (Annual Cost Saving)
X =Rs.40, 000×2.855
=Rs.1, 14,200

(ii) Calculation of Pay Back period

Pay Back Period = Cost of Project/ Annual Cash Inflow
=Rs.1,14,200/Rs.40,000
=2.855 years

(iii)Calculation of PV of Cash Inflow

Profitability Index =PV of Cash Inflow/PV of Cash Outflow
PV of Cash Inflow = 1.064 ×Rs.1, 14,200
=1, 21,509

(iv) Calculation of Net Present Value

NPV = PV of Cash Inflow-PV of Cash Outflow
=Rs.1, 21,509-Rs.1, 14,200
=Rs.7, 309

(v) Calculation of Cost of Capital

PV of Cash Inflow = Annual Cash Inflow×PVF for 4 years at Cost of Capital
PVF for 4 years = Rs.1,21,509/Rs.40,000
=3.0378
Cost of copied = 12 %

Question No. 24
Beta Company Limited is considering replacement of its existing machine by a new machine
which is expected to cost Rs. 264,000. The new machine will have a life of five years and will
yield annual cash revenues of Rs. 568,750 and incur annual cash expenses of Rs. 295,750. The
estimated salvage value of the new machine is Rs. 18,200. The existing machine has a book
value of Rs. 91,000 and can be sold for Rs. 45,500 today.
The existing machine has a remaining useful life of five years. The annual cash revenues from
this machine will be Rs. 455,000 and associated annual cash expenses will be Rs. 318,500. The
existing machine will have a salvage value of Rs. 4,550 at the end of its useful life.
The company is in 25% tax bracket, and writes off depreciation at 25% on written-down value
method.
The company has a target debt to total capital ratio of 15%. It has raised debt at 11% in the past
and it can raise fresh debt at 10.5%.
The company plans to follow dividend discount model to estimate the cost of equity capital. It
further plans to pay a dividend of Rs. 2 per share in the next year. The dividend per equity share
of the company is expected to grow at 8% p.a. The current market price of the company's equity
share is Rs. 20 per equity share.

Required: (4+8+3+4+1=20 Marks)

a) Compute the weighted average cost of the capital of the company.
b) Compute the incremental cash flows for replacement decision.
c) Find out the net present value of the replacement decision.
d) Estimate the discounted payback period of the replacement decision.
e) Should the company replace the existing machine? Advise.
[December 2014]
Answer:
a) Computation of Weightedaverage cost of capital of the company (WACC)

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Ke = D1/P0 + g
=2/20 + 0.08
= 0.18 = 18%
Kdt = 10.5%×(1-0.25)
= 7.875%

WACC= Kd×D/(D+E) + Ke×E/(D+E)

=(7.875%×15%) + (18%× 85%)
=1.18% + 15.3%
=16.48%

(b& c) Incremental cash flow and NPV of replacement decision

Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Incremental Initial Cash (207,125
Outlay (WN 1) )
Incremental Revenue (WN
2) 113,750 113,750 113,750 113,750 113,750
Saving in Expenses (W.N
2) 22,750 22,750 22,750 22,750 22,750
Less: Incremental
Depreciation (W.N 3) 43,250 32,437 24,328 18,246 13,685
Earnings before Tax 93,250 104,063 112,172 118,254 122,815
Less: Tax @ 25% 23,313 26,016 28,043 29,564 30,704
Earnings after Tax 69,937 78,074 84,129 88,690 92,111
Add: Incremental
Depreciation 43,250 32,437 24,328 18,246 13,685
Add: Incremental salvage
value (18200-4550) 13,650
Add: Incremental Tax
Saving on Loss on
Sale(W.N 4) 6,851
(207,125
Incremental cash flows ) 113,187 110,511 108,457 106,936 126,297
PV Factor@16.48% 1.00 0.860 0.740 0.636 0.547 0.470
(207,125
Present Value ) 97,341 81,778 68,979 58,494 59,360
NPV 158,827
d) Calculation of Discounted PBP of replacement decision:
Year Cumulative PV (Rs.)
0 (158,827)
1 (109,784)
2 (28,006)
3 40,973
4 99,467
5 158,827

Discounted Payback Period

= 2 Years + Cumulative PV of Cash flows in 2nd Year
PV of Incremental Cash flow in 3rd Year
= 2 years + 28,006/68,979
=2.406 years or 2 Years 5 months (approx)

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e) The company should replace the machine since the incremental NPV of the decision is
positive and discounted PBP is much lower than the life of the machine.
Working Notes:
1. Incremental initial cash outlay
Purchase price of new machine = Rs. 264,000
Less: Current sales price of old machine = Rs. 45,500
BSV- 91,000
CSV- 45,500
Loss 45,500
Tax Saving on due to loss (45,500*25%) 11,375
Incremental initial cash outlay = Rs. 207,125

2. Calculation of incremental revenue and saving in expenses

Annual Incremental revenue = Rs. 568,750 – Rs. 455,000
= Rs. 113,750
Annual Saving in expenses = Rs. 318,500 - Rs. 295,750
=Rs.22,750
3. Calculation of incremental depreciation
Year Depreciation of new machine Depreciation of Old Difference
(Rs.) machine (Rs.) (Rs.)
1 264,000 × 25% = 66,000 91,000×25% = 22,750 43,250
2 198,000× 25%= 49,500 68,250 ×25%=17063 32,437
3 148,500 × 25%= 37,125 51,187 × 25%=127,97 24,328
4 111,375 × 25%= 27,844 38,390 × 25%=9,598 18,246
5 83,531 × 25%= 20,883 28,792 × 25%= 7,198 13,685

4. Incremental loss on sale at the end of 5th year

BV of new machine = Rs. 83,531 –Rs. 20,883 = Rs. 62,648
Less : BV of old machine = Rs. 28,792 –Rs.7,198 = Rs. 21,594
Incremental book value = Rs. 41,054
Less: Incremental sales value = Rs. 18,200 –Rs. 4550 = Rs. 13,650
Incremental loss = Rs. 27,404
Tax savings @ 25% = Rs. 6,851

Question No. 25
After the recent earthquake, there has been a massive demand for the pre-fab materials. Bharat
& Company is considering a new project for manufacturing of pre-fab materials involving a
capital expenditure of Rs. 600 lakh and working capital of Rs. 150 lakh. The capacity of the
plant is for an annual production of 12 lakh units and capacity utilization during the 6-year life
of the project is expected to be as indicated below:

Year 1 2 3 4-6
Capacity Utilization (%) 33.33 66.67 90 100

The average price per unit of the product is expected to be Rs. 200 netting a contribution of 40
percent. The annual fixed cost, excluding depreciation, are estimated to be Rs. 480 lakh from the
third year onwards; for the first and second year it would be Rs. 240 lakh and Rs. 360 lakh
respectively. The average rate of depreciation for tax purpose is 33.33% on WDV of the capital
assets. The rate of income tax is 25%. The cost of capital is 15%.

At the end of third year, an additional investment of Rs. 100 lakh would be required for working
capital.

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Expected terminal value for the fixed assets and the current assets are 10% and 100%
respectively.

Required: (20 Marks)

As a financial consultant, what recommendation on the financial viability of the project would
you make to Bharat & Company on the basis of NPV, IRR and discounted pay back criterion?
[July 2015]

Answer:
a) Calculation of Depreciation
(Rs. In lakhs)
Value/WDV at the Depreciation WDV @
Year beginning 33.33% on WDV WDV at the end
1 600 200 400
2 400 133 267
3 267 89 178
4 178 59 119
5 119 40 79
6 79 26 53

b) Calculation of effective sale proceeds of Fixed assets (Rs. lakh)

Sale proceeds of fixed assets (10% of cost) 60.00
Less: Written down value (53.00)
Profit on sale of fixed assets 7
Less: Tax on profit @25% (1.75)
Effective sale proceeds (60-1.75) 58.25

c) Calculation of cash Outflows (Rs. lakh)

Initial capital expenditure 600
Add: Working capital required at the beginning 150
750
Add: P.V. of working capital required at the end of 3rd year 66
(100*0.658)
P.V. total investment 816
d) Calculation of cash inflows and the present value

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

Sales unit (% capacity
utilization) 400,000 800,000 1,080,000 1,200,000 1,200,000 1,200,000
Selling price (Rs.) 200 200 200 200 200 200
(Rs.
in lakh)
Sales revenue 800 1,600 2,160 2,400 2,400 2,400
Less: Variable cost (60%
of Sales) (480) (960) (1,296) (1,440) (1,440) (1,440)
Contribution 320 640 864 960 960 960
Less: Fixed cost (240) (360) (480) (480) (480) (480)
EBTDA 80 280 384 480 480 480
Less: Depreciation (from
a) above) (200) (133) (89) (59) (40) (26)

Earning before tax (120) 147 295 421 440 454

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 CAP II Paper 4: Financial Management

Less: Tax @ 25% 30 (36.75) (73.75) (105.25) (110) (113.50)

Earnings after tax (90) 110.25 221.25 315.75 330 340.50

Add: Working capital
recovery (150+100) - - - - - 250
Add: sale proceeds of
fixed assets (from (b)
above) - - - - - 58.25
Add: Depreciation add-
back 200 133 89 59 40 26

Cash inflows 110 243.25 310.25 374.75 370 674.95

PV factor @ 15% 0.87 0.756 0.658 0.571 0.497 0.432

Present values 95.70 183.90 204.15 214 183.90 291.50

Total present values of cash inflows 1173.15

i) Net present value of project =1173.15- 816 = Rs. 357.15 lakh

Recommendation: Since the project has positive NPV, it is advisable to take up the project.
ii) Calculation of IRR
Years 1 2 3 4 5 6
TPV
Cash Inflow 110 243.25 310.25 374.75 370 674.75
PVIF @ 30% 0.77 0.592 0.455 0.351 0.270 0.208
PV 84.70 144 141.16 131.54 100 140.35 741.75

(-) pv of cash outflow [816-66+(100×0.455)] = 795.50

(53.75)
Trial can be with any other discounting factor(DF)

IRR= LR + NPV at LR
× (HR-LR)
NPV at LR + NPV at HR

= 15% + 357.15 × (30%-15%)

357.15+53.75
= 0.15+ (0.87×0.15)
= 0.15+ 0.13
0.28=28%

Recommendation:
Since, IRR is higher than the cost of capital of the company, the project is worth taking up.

iii) Discounted pay Back period:

Years Pv of CI (lakh) Cumulative CI (lakh)

1 95.70 95.70
2 183.90 279.60
3 204.15 483.75
4 214 697.75
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 CAP II Paper 4: Financial Management

5 183.90 881.65
6 291.50 1,173.15

(816-697.75)
PBP = 4 yr + Yr
183.90

= 4 yr +0.64 yr.
= 4. 64 yr.
Recommendation:
Since, the project returns its investment early within the project's life, the project is worth taking
up.

Question No. 26
A team of investors has recently established ‘We Care’ Hospital in Kathmandu. They plan to
buy a CT Scan Machine and are considering two different brands with similar features.
Following information is available regarding the Machines:

Cost of Life of Maintenance Cost (Rs.) Rate of

Brand Machine Machine Year 1-5 Year 6-10 Year 11-15 Depreciation
(Rs.) (SLM)
XYZ 600,000 15 years 20,000 28,000 39,000 4%
ABC 450,000 10 years 31,000 53,000 - 6%

Book value of both of machines will be dropped by 1/3rd of purchase price in the first year and
thereafter will be depreciated at the rates given in table above.

Alternatively, the machine of Brand ABC 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 the first year it shall be Rs.
102,000.
 Annual Rent for the subsequent 4 years shall be Rs. 102,500.
 Annual Rent for the final five years shall be Rs. 109,950.
 Rent agreement can be terminated by the hospital by making a payment of Rs. 100,000
as penalty. This penalty would be reduced by Rs. 10,000 each year of the period of rental
agreement.
The cost of capital of the hospital is 12%.
Required: (20 Marks)
a) Advise which brand of CT-Scan Machine should be acquired assuming that the use of
machine shall be continued for a period of 20 years. Consider book value as scrap value.
b) Which of the option is most economical, if machine is likely to be used for a period of 5
years only?
[December 2015]

Answer:
Since the life span of each machine is different and time span exceeds the useful lives of each
model, we should use Equivalent Annual Cost method to decide which brand should be chosen.
(i) If machine is used for 20 years
Present Value of cost if machine of Brand XYZ is purchased

Period Cash Outflow (Rs.) PVF @12 % Present Value

0 6,00,000 1.000 6,00,000
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 CAP II Paper 4: Financial Management

1-5 20,000 3.605 72,100

6-10 28,000 2.045 57,260
11-15 39,000 1.161 45,279
15 (64,000) 0.183 (11,712)
762,927
Rs. 64,000 is residual value, calculated as
=600,000-(1/3 of 600,000)-(4% of 600,000×14 yrs) = Rs. 64,000
PVAF for 15 years is 6.811
Equivalent Annual Cost (Rs.)= 762,927/6.811=Rs. 112,014

Present Value of cost if machine of Brand ABC is purchased

Period Cash Outflow (Rs.) PVF @12 % Present Value
0 450,000 1.000 450,000
1-5 31,000 3.605 111,755
6-10 53,000 2.045 108,385
10 (57,000) 0.322 (18,354)
651,786
Rs. 57,000 is residual value, calculated as:
=450,000-(1/3 of 450,000)-(6% of 450,000×9 yrs) =Rs. 57,000
PVAF for 10 years is 5.65
Equivalent Annual Cost (Rs.)= 651,786/5.65=Rs. 115,360
Present Value of cost if machine of Brand ABC is taken on Rent
Period Cash Outflow (Rs.) PVF @12 % Present Value
0 102,000 1.000 102,000
1-4 102,500 3.037 311,293
5-9 109,950 2.291 251,895
665,188

PVAF for 1-10 years is 5.65

Equivalent Annual Cost (Rs.)= 665,188/5.65=Rs. 117,732

Decision: Since Equivalent Annual Cash Outflow is least in case of purchase of

Machine Brand XYZ, the same should be purchased.

(ii) If machine is used for 5 years

(a) Scrap value of Machine of Brand XYZ
=Rs. 600,000-Rs. 200,000-Rs. 600,000 x 0.04 x 4 =Rs. 304,000
(b) Scrap value of Machine of Brand ABC
=Rs. 450,000-Rs. 150,000-Rs. 450,000 x 0.06 x 4 =Rs. 192,000

Present Value of cost if machine of Brand XYZ is purchased

Period Cash Outflow (Rs.) PVF @12 % Present Value
0 600,000 1.000 600,000
1-5 20,000 3.605 72,100
5 (304,000) 0.567 (172,368)
499,732
Present Value of cost if machine of Brand ABC is purchased
Period Cash Outflow (Rs.) PVF @12 % Present Value
0 450,000 1.000 450,000
1-5 31,000 3.605 111,755
5 (192,000) 0.567 (108,864)
452,891

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Present Value of cost if machine of Brand ABC is taken on Rent

Period Cash Outflow (Rs.) PVF @12 % Present Value
0 102,000 1.000 102,000
1-4 102,500 3.037 311,293
5 50,000 0.567 28,350
441,643

Decision: Since Cash outflow is least in case of lease of Machine of brand ABC, so same should
be taken on Rent

Question No. 27
Mr. X, an Agricultural Engineering graduate, is planning to set up a private limited commercial
agriculture firm with registered office in Kathmandu Metropolitan City. During the initial days
of the proposed company, it will focus on cultivating and harvesting a variety of premium apples
and sell them in the ever increasing domestic market.
In order to set up his project, he has already reached agreements with the local government
authority and the local communities through a cooperative society of one of the hilly districts
suitable for farming. As such, the agreement has guaranteed minimum 25 years of lease of land
property having a total area of 800 ropanis with a rent of Rs. 2.88 crore per annum. The rent will
be paid on an annual basis with increment of 30% at the interval of every 5 years and the
plantation properties (agricultural estate and the project office) will be transferred to the
cooperative society at the end of 25th year. The rent accrual is agreed from the commercial
operation date (COD), which tentatively is proposed from 1st of Shrawan, 2073. No incentive or
residual value will be received by the proposed company at the end of project i.e. on Ashadh end
2098.
In order to operate the project successfully, you have been hired as his finance consultant and
want you to assess the information properly. From the available research data adjusted with
current inflation figures, you have been able to gather the following information in respect of
annual operating cost and capital cost:

Operating costs (Amount in Rs.)

Particulars of operating expenses Estimated annual cost Annual
growth (in
every 5 years)
Orchard Activities (Pruning and Training, Thinning,
Fertilizers, General Farm Labor, Irrigation and Electricity)
Cost of activities starting from Year 1 1,88,10,000 15%
Cost of activities starting from Year 2 14,85,000 15%
Harvesting Activities (Picking Labor, Other Labor and Hauling of Apples)
Cost of activities starting from Year 3 40,19,000 15%
Administration Expenses (except rent)
Cost of activities starting from Year 3 54,00,000 15%

Capital cost
Particulars of Capital Expenses Cost
Land Development and Ancillary Cost 5,00,00,000
Plantation Cost 12,00,00,000
Other capital investments (viz., quarters and project office set 2,00,00,000
up in leased land)

Further, you have been informed that he expects to harvest 1,500 metric tons of apples during
the 3rd year after COD, then 200 metric tons increase every year until 8th year after COD and
steady production from 9th year onwards with no further growth or decline during the entire
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 CAP II Paper 4: Financial Management

project period. In addition, he expects to fetch at least Rs.60 per kg during the first harvesting
season, i.e. on 3rd year after COD and then 15% growth after every three years adjusted with
inflation till 10th year (consider price rounding in nearest rupee).
Consider:

 tax rate as 20%;

 no tax outflows during the accumulated loss period;
 useful life of all initial investments as equivalent to the project period (lease term) and
depreciation method as SLM basis
 All assets accounted as leasehold asset and categorised under Class "E", hence no deferred
tax and temporary differences; and
 cost of capital as 10% (3 decimal places) as given below

Year 0 1 2 3 4 5 6 7 8 9 10
PV Factor @
10% 1.000 0.909 0.826 0.751 0.683 0.621 0.565 0.514 0.467 0.425 0.386

Required: (14+6=20 Marks)

a) Based on the NPV & IRR from the aforementioned information, would you suggest him to
take up this project based on the 10 years cash flow, at least from financial perspective?
Consider carrying amount of initial capital investment at the end of 10th year as its terminal
value for your computation. (Calculate in nearest thousand).

b) What three factors other than the financial should an investor look into before taking up the
project? Your answer should present factors in connection to the above apple farming case
study.
[June 2016]

Answer:
a)
Calculation of Initial Investments, Annual Depreciation and Terminal Value
Particulars Rs. In 000
Initial Investment
Land Development and Ancillary Cost 50000
Plantation Costs 120000
Other Capital Investments 20000
Total Initial Investments 190000
Useful Life of Initial Investments 25 years
Annual Depreciation 7600
Total Depreciation on 10 years 76000
Terminal Value after 10 years 114000

Year 0 1 2 3 4 5 6 7 8 9 10
Production in Tons 0 0 1500 1700 1900 2100 2300 2500 2500 2500
Price per Kg 60 60 60 69 69 69 79 79

Rs. In 000
10200 11400 15870
Sales 0 0 90000 0 0 144900 0 172500 197500 197500

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18810 18810 18810 18810 18810 21632 21632 21632 21632 21632
Orchard Activities
1485 1485 1485 1485 1485 1708 1708 1708 1708
Harvesting Activities 4019 4019 4019 4019 4019 4622 4622 4622
Administration Expenses
(except rent) 5400 5400 5400 5400 5400 6210 6210 6210

Total Costs Except Rent and

Depreciation 18810 20295 29714 29714 29714 32536 32759 34172 34172 34172
Rent 28800 28800 28800 28800 28800 37440 37440 37440 37440 37440
Depreciation 7600 7600 7600 7600 7600 7600 7600 7600 7600 7600
Total Costs 55210 56695 66114 66114 66114 77576 77799 79212 79212 79212

Profit Before Tax -55210 -56695 23886 35886 47886 67324 80901 93288 118288 118288

- - 14397
Accumulated Profit -55210 111905 -88019 52133 -4247 63077 8 237266 355554 473842

Tax 0 0 0 0 0 12615 16180 18658 23658 23658

Profit After Tax -55210 -56695 23886 35886 47886 54709 64721 74630 94630 94630
Add: Depreciation 7600 7600 7600 7600 7600 7600 7600 7600 7600 7600
Cash Profit -47610 -49095 31486 43486 55486 62309 72321 82230 102230 102230
Initial Investments -190000
Terminal Value 114000
Net Cash Flow -190000 -47610 -49095 31486 43486 55486 62309 72321 82230 102230 216230
PV Factor @ 10% 1.000 0.909 0.826 0.751 0.683 0.621 0.565 0.514 0.467 0.425 0.386
Discounted Cash Flow -190000 -43277 -40552 23646 29701 34457 35205 37173 38401 43448 83465
Net Present Value 51667

At discount rate of 10%, the project has a positive NPV of Rs.51,667K hence a much higher
discount rate (15%) is considered to compute IRR.

Net Cash Flow -190000 -47610 -49095 31486 43486 55486 62309 72321 82230 102230 216230
PV Factor @ 15% 1.000 0.870 0.757 0.658 0.572 0.497 0.432 0.376 0.327 0.284 0.247
Discounted Cash Flow -190000 -41421 -37165 20718 24874 27577 26917 27193 26889 29033 53409
Net Present Value -31976

Thus IRR shall be

= Low Rate x
= 10%+ (51,667 / (51,667 - (-31,976 ))) × 5%
= 13.09%

From the above calculation of NPV & IRR, the project can be undertaken.

b) The financial assessment of the project is indeed very important to ascertain its viability.
Nevertheless, the investors should also look into other factors such as political, social and
technological in order to determine whether these factors complement to its progression.
In addition, there is also a growing trend of examining the factors like environmental and
legal / regulatory that could influence the feasibility of the project. As far as assessment is
concerned, all these components are indispensable and interrelated.
The political factors have significant bearing in the investment of the project. These
include law and order situation, stability of the government and its policies, availability
and development of adequate infrastructures, tax regime and subsidies to the investors,
transportation facilities, adequate law for free flow of goods and services within the region
etc. Any disorder in the factors mentioned above would discourage the investors to put in

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their hard earned money as there will be severe uncertainty on economic rewards they
expect from the project.
Besides political, social factors also have important bearing on the feasibility assessment.
For instance, the proposed project is planned to be implemented in one of the hilly regions
and it is important for Mr. X to understand the behaviors, attitudes, education, population,
age group and employment status of the local community. If the district lacks youth force,
the project may find difficulty in getting workers and labors and consequently the cost of
production may shoot up making the project less attractive.
In addition to the two factors mentioned above, the technology bestows several advantages
to the investors of the present world. The process automation and the more use of
technology eventually contribute in reducing the cost of operations thereby assisting the
project to achieve the goal of long term sustainability. Again, the research and
development plays a crucial role in developing and fine tuning the product which would
lead innovating to a unique product. Like any other product researches, the apple fruit
research cannot be ignored at all.

Question No. 28
Simon Ltd. is considering five capital projects for the years 2017 and 2018. The company is
financed by equity and its cost of capital is 12%. The expected cash flows of the projects are as
follows:
(Figures in Rs.' 000)
Projects 2017 2018 2019 2020
A -70 35 35 20
B -40 -30 45 55
C -50 -60 70 80
D - -90 55 65
E -60 20 40 50

All projects are divisible i.e. size of the investment can be reduced, if necessary, in relation to
the availability of funds. None of the projects can be delayed or undertaken more than once.
Required: (10 Marks)
Which projects, Simon Ltd. should undertake if the capital funds available for the investment are
limited to Rs. 110,000 in 2017 and with no limitation in subsequent years? Use NPV, PI and
discounted PBP techniques for your analysis.
[December 2016]

Answer:
i) Computation of NPV
Rs. In ―000‖
Year PVF Project A Project B Project C Project D Project E
2017 1 -70 -70 -40 -40 -50 -50 0 0 -60 -60
2018 0.89 35 31.15 -30 -26.7 -60 -53.4 -90 -80.1 20 17.8
2019 0.8 35 28 45 36 70 56 55 44 40 32

2020 0.71 20 14.2 55 39.05 80 56.8 65 46.15 50 35.5

NPV 3.35 8.35 9.4 10.05 25.3

ii ) Calculation of Profitability Index

PV of Cash Inflows
P I = ----------------------------------
PV of Cash Outflows
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31.15+28+14.20 73.35
Project A= ------------------------- = ---------- =1.048
70 70

36+39.05 75.05
Project B= ----------------- = ---------- = 1.125
40+26.7 66.70

56+56.8 112.8
Project C= ----------------- = ---------- = 1.091
50+53.4 103.4

44+46.15 90.15
Project D= ----------------- = ---------- = 1.125
80.1 80.1

17.8+32+35.5 85.30
Project E= ----------------- = ---------- = 1.422
60 60

iii ) Calculation of discounted payback:

Rs. In ―000‖
Project A Project B Project C Project D Project E
PV PV Cum
of Cumm of m. PV of Cumm PV of Cumm PV of Cumm
Year Time CFs . CFs CFs CFs CFs . CFs CFs . CFs CFs . CFs
2017 0 -70 -70 -40 -40 -50 -50 0 0 -60 -60
31.1
2018 1 5 -38.85 -26.7 -66.7 -53.4 -103.4 -80.1 -80.1 17.8 -42.2
2019 2 28 -10.85 36 -30.7 56 -47.4 44 -36.1 32 -10.2
39.0
2020 3 14.2 3.35 5 8.35 56.8 9.4 46.15 10.05 35.5 25.3

Un-recouped Outflow
Discounted payback = Years already recouped + ----------------------------------------
PV of next year
A B C D E
=2+10850/14200 =2+30700/39050 =2+47400/56800 =2+36100/46150 =2+10200/35500
2.76 Years 2.79 Years 2.83 Years 2.78 Years 2.29 Years

Since, there is limitation of fund only in 2017, selection of the project should be made on the
basis of NPVI (Net Present Value Index)
NPV
P I = ----------------------------------
Initial Outflows
3.35
Project A= ------------------------- = 0.05
70

8.35
Project B= ----------------- = 0.21
40

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9.40
Project C= ----------------- = 0.19
50

25.30
Project E= ----------------- = 0.42
60

As per the information given, the capital funds are restricted to Rs. 110,000 in 2017. The Project
D does not require any outflow during 2017 but it is acceptable on the basis of NPV methods,
therefore, can be implemented in 2018. For other projects the capital funds of Rs. 110,000 can
be distributed on the basis of their ranking of NPVI. Therefore, the firm can adopt Project E (
Rs. 60,000), Project B (Rs. 40,000) and Part of Project C ( Rs. 10,000).

Question No. 29
ABC Ltd. is evaluating two investment projects independently with different investment
modality. Information for these projects are as follows:

Investment Analysis 1:
This is an investment in new machinery to produce a recently-developed product. The cost of the
machinery, which is payable immediately, is Rs. 1,500,000, and the scrap value of the
machinery at the end of four years, is expected to be Rs. 100,000. Depreciation for tax purpose
can be claimed on this machinery on a 25% reducing balance basis. Information on future
returns from the investment has been forecasted to be as follows:

Year 1 2 3 4
Sales volume (units/year) 50,000 95,000 140,000 75,000
Selling price (Rs./unit) 25.00 24.00 23.00 23.00
Variable cost (Rs./unit) 10.00 11.00 12.00 12.50
Fixed costs (Rs./year) 105,000 115,000 125,000 125,000

This information must be adjusted to allow for selling price inflation of 4% per year and variable
cost inflation of 2.5% per year. Fixed costs, which are wholly attributable to the project, have
already been adjusted for inflation. ABC Ltd. pays profit tax of 30% per year one year in arrears.

Investment Analysis 2:
ABC Ltd. plans to replace an existing machine and must choose between two machines.
Machine 1 has an initial cost of Rs. 200,000 and will have a scrap value of Rs. 25,000 after four
years. Machine 2 has an initial cost of Rs. 225,000 and will have a scrap value of Rs. 50,000
after three years. Annual maintenance costs of the two machines are as follows:

Year 1 2 3 4
Machine 1 (Rs./year) 25,000 29,000 32,000 35,000
Machine 2 (Rs./year) 15,000 20,000 25,000 -

Where relevant, all information relating to investment analysis 2 has already been adjusted to
include expected future inflation.

Taxation and depreciation allowances must be ignored in relation to Machine 1 and Machine 2.

Other information:

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ABC Ltd. has a nominal before-tax weighted average cost of capital of 12% and a nominal after-
tax weighted average cost of capital of 7%.

Required: (10+6+4=20 Marks)

a) Calculate the net present value of investment analysis 1 and comment on whether this
project is financially acceptable to ABC Ltd.
b) Calculate the equivalent annual costs of Machine 1 and Machine 2 in investment analysis 2,
and discuss which machine should be purchased.
c) Critically discuss the use of sensitivity analysis and probability analysis as ways of including
risk in the investment appraisal process, referring in your answer to the relative effectiveness
of each method.
[June 2017]

Answer:
(a) Calculation of net present value (NPV) of Investment Analysis 1:
As nominal after-tax cash flows are to be discounted, the nominal after-tax weighted average
cost of capital of 7% must be used.

(Rs.‘000)
Year 1 2 3 4 5
Sales revenue (WN1) 1,300 2,466 3,622 2,018
Variable costs (WN2) (513) (1,098) (1,809) (1,035)
Contribution 787 1,368 1,813 983
Fixed costs (105) (115) (125) (125)
Taxable cash flow 682 1,253 1,688 858
Tax liabilities @30% (205) (376) (506) (257)
Depreciation tax benefits (WN3) 113 84 63
160
After-tax cash flow 682 1,161 1,396 415 (97)
Scrap value - - - 100 -
Net cash flow 682 1,161 1,396 515 (97)
PVIF at 7% 0·935 0·873 0·816 0·763 0·713
Present values 638 1,014 1,139 393 (69)

Rs'.000
Present value of cash inflows 3,115
Cost of machine (1,500)
NPV 1,615

Investment 1 has a positive NPV of Rs.1,615,000, so it is financially acceptable to ABC Ltd.

Workings:
1. Sales revenue
Year 1 2 3 4

Selling price (Rs./unit) 25.00 24.00 23.00 23.00

Inflated selling price (Rs./unit)[sp×(1+i)n] 26.00 25.96 25.87 26.91
Sales volume (units/year) 50,000 95,000 140,000 75,000
Sales revenue (Rs./year) 1,300,000 2,466,200 3,621,800 2,018,250

2. Variable cost
Year 1 2 3 4

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Variable cost (Rs./unit) 10.00 11.00 12.00 12.50

Inflated variable cost (Rs./unit) [vc×(1+i)n] 10.25 11.56 12.92 13.80
Sales volume (units/year) 50,000 95,000 140,000 75,000
Variable costs (Rs./year) 512,500 1,098,200 1,808,800 1,035,000

3. Depreciation tax benefits

Year Capital allowance Tax benefit Year benefit received
1 1,500,000 x 0.25 = Rs.375,000 375,000 x 0.3 = Rs.112,500 2
2 1,125,000 x 0.25 = Rs.281,250 281,250 x 0.3 = Rs.84,375 3
3 843,750 x 0·25 = Rs.210,938 210,938 x 0.3 = Rs.63,281 4
4 Rs.532,812* 532,812 x 0.3 = Rs.159,844 5
*843,750 – 210,938 – 100,000 = Rs.532,812
Alternative calculation of net cash flow is acceptable.
(b) Calculation of equivalent annual cost for machine 1:
Since taxation and capital allowances are to be ignored, and where relevant all information
relating to project 2 has already been adjusted to include future inflation, the correct discount
rate to use here is the nominal before-tax weighted average cost of capital of 12%.

Year 0 1 2 3 4
Maintenance Costs (Rs.) - (25,000) (29,000) (32,000) (35,000)

Investment and Scrap (Rs.) (200,000) - - - 25,000

Net Cash Flow (Rs.) (200,000) (25,000) (29,000) (32,000) (10,000)
Discount at 12% 1.000 0.893 0.797 0.712 0.636
Present values (200,000) (23,325) (23,113) (22,784) (6,360)

Total present value of cash flows Rs.274,582

Cumulative present value factor 3.038
Equivalent annual cost = 274,582/3.038
= Rs.90,382
Calculation of equivalent annual cost for machine 2:
Year 0 1 2 3
Maintenance costs (Rs.) - (15,000) (20,000) (25,000)
Investment and scrap (Rs.) (225,000) - - 50,000
Net cash flow (Rs.) (225,000) (15,000) (20,000) 25,000
Discount at 12% 1.000 0.893 0.797 0.712
Present values (225,000) (13,395) (15,940) 17,800

Total present value of cash flows Rs.2,36,535

Cumulative present value factor 2·402
Equivalent annual cost = 2,36,535/2·402
= Rs.98,474

The machine with the lowest equivalent annual cost should be purchased and calculation shows
this to be Machine 1.

(c) Within the context of investment appraisal, risk relates to the variability of returns and so
it can be quantified, for example by forecasting the probabilities related to future cash
flows. From this point of view, risk can be differentiated from uncertainty, which cannot
be quantified. Uncertainty can be said to increase with project life, while risk increases
with the variability of returns.

It is commonly said that risk can be included in the investment appraisal process by
using sensitivity analysis, which determines the effect on project net present value of a

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change in individual project variables. The analysis highlights the project variable to
which the project net present value is most sensitive in relative terms. However, since
sensitivity analysis changes only one variable at a time, it ignores interrelationships
between project variables.

While sensitivity analysis can indicate the key or critical variable, it does not indicate the
likelihood of a change in the future value of this variable, i.e. sensitivity analysis does
not indicate the probability of a change in the future value of the key or critical variable.
For this reason, given the earlier comments on risk and uncertainty, it can be said that
sensitivity analysis is not a method of including risk in the investment appraisal process.

Probability analysis, as its name implies, attaches probabilities to the expected future
cash flows of an investment project and uses these to calculate the expected net present
value (ENPV). The ENPV is the average NPV that would be expected to occur if an
investment project could be repeated a large number of times. The ENPV can also be
seen as the mean or expected value of an NPV probability distribution. Given the earlier
discussion of risk and uncertainty, it is clear that probability analysis is a way of
including a consideration of risk in the investment appraisal process. It is certainly a
more effective way of considering the risk of investment projects than sensitivity
analysis.

A weakness of probability analysis, however, lies in the difficulty of estimating the

probabilities that are to be attached to expected future cash flows. While these
probabilities can be based on expert judgement and previous experience of similar
investment projects, there remains an element of subjectivity which cannot be escaped.

Question No. 30
Ganesh Enterprises needs someone to supply it with 150,000 cartons of machine screws per year
to support its manufacturing needs over the next five years, and you‘ve decided to bid on the
contract. It will cost you Rs. 780,000 to install the equipment necessary to start production; you‘ll
depreciate this cost straight-line to zero over the project‘s life. You estimate that in five years this
equipment can be salvaged for Rs. 50,000. Your fixed production costs will be Rs. 240,000 per
year, and your variable production costs will be Rs. 8.50 per carton. You also need an initial
investment in net working capital of Rs. 75,000. Your tax rate is 35 percent and you require a 16
percent return on your investment.

Required: (10 Marks)

Calculate unit bid price you should submit.
[December 2017]

Answer:
i) Initial Outlay
Cost of the Machine 780,000.00
W/C Infusion 75,000.00
855,000.00

ii) Annual Depreciation and Tax Shield

Depreciable Value 780,000.00
Life 5 Yrs
Annual Depreciation 156,000.00
Tax Shield on Annual Depreciation [Depreciation ×
Tax Rate] 54,600.00

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iii) Terminal Value

Net proceed from the Sale of Machine 32,500.00
[50,000-(50,000-0)×35%]
Release of Working Capital 75,000.00
Total Terminal Value 107,500.00

iv) Total Cash Cost Per Annum - Post Tax

Annual Variable Cost (150000×Rs.8.50) 1,275,000.00
Annual Fixed Cost 240,000.00
Total annual Cash Cost 1,515,000.00
Tax @ 35% 530,250.00
Annual Post Tax Cash Cost 984,750.00

v) Suppose SP Per Cartoon X

Annual Revenue from Sale of 150,000 Cartoon 150,000 X
Post Tax Revenue from Sale 97,500 X

vi) Net Present Value Table

Particulars Time Cash Flow PVF @ 16% Total PV
Initial Outlay 0 (855,000.00) 1.0000 (855,000.00)
Tax Shield on Annual Depreciation 1-5 54,600.00 3.2743 178,777.00
Terminal Cash Flow 5 107,500.00 0.4761 51,181.00
Post Tax Cash Cost 1-5 (984,750.00) 3.2743 (3,224,367.00)
Post Tax Revenue 1-5 97,500 X 3.2743 319,244.00 X
Net Present Value 0

Since the discount rate 16% incorporates the profit target as well, the required NPV of the Project is
Zero.

Now,
319,244.00X+51181.00+178,777.00=855,000+3,224,367.00
319,244.00X= 3,849,409.00
X= 12.06

Therefore the Bid Price per Cartoon is Rs. 12.06

Question No. 31

Consider the situation of a company, BIKE WASH, which must decide whether to replace an
existing machine. BIKE WASH currently pays no taxes. The replacement machine costs Rs. 9,000
now and requires maintenance of Rs. 1,000 at the end of every year for eight years. At the end of
eight years, the machine would be sold for Rs. 2,000 after taxes. The existing machine requires
increasing amounts of maintenance each year, and its salvage value falls each year as below:
Year Maintenance (Rs.) After tax Salvage (Rs.)

Present 0 3,000
1 1,000 2,500
2 2,000 1,500
3 3,000 1,000
4 4,000 0

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The existing machine can be sold for Rs. 3,000 now after taxes. If it is sold one year from now, the
resale price will be Rs. 2,500 after taxes, and Rs. 1,000 must be spent on maintenance during the
year to keep it running. Assume that this maintenance fee is paid at the end of the year. The
machine will last for four more years before it falls apart with zero salvage value at the end of year
4. BIKE WASH faces an opportunity cost of capital of 15 percent.

Required: (10 Marks)

Determine when BIKE WASH should replace the machine.
[December 2017]

Answer:
Our decision will be based on the comparison of the annual cost of the replacement
machine with the annual cost of the old machine.

i) Equivalent Annual Cost of New Machine

The present value of the cost of the new replacement machine is as follows;
Present Value = 9,000 + 1,000 × [PVIFA, 8 Years, 15%] – 2,000× [PVIF, 8th Year, 15%]
= 9,000 + 1,000×4.4873 – 2,000×0.3269
= Rs. 12,833.5
The Equivalent Annual Cost of new replacement machine equals:
= Present Value / 8 Year annuity factor at 15%
= 12,833.5/4.4873
= Rs. 2,860
This calculation implies that buying a replacement machine is financially equivalent to
renting this machine for Rs. 2,860 per year.

ii) Cost of Old Machine

If BIKE WASH keeps the old machine for one year, the firm must pay maintenance costs of Rs.
1,000 a year from now. BIKE WASH will receive Rs. 2,500 at the end of year if the old machine
is kept for one year but would receive Rs. 3,000 today if the old machine were sold immediately.
This reduction in sales proceeds is clearly a cost as well. Further we normally express cash flows
in terms of present value; the analysis to come is easier if we express the cash flow in terms of
its future value one year from now.

The Value for end of year 1, 2 3 and 4 will be as below;

Particulars Year-1 Year-2 Year-3 Year-4
Beginning Salvage Value [A] 3,000 2,500 1,500 1,000
Maintenance cost expressed in 1,000/1.15 2,000/1.15 3,000/1.15 4,000/1.15
term of beginning value [B] =870 =1,739 =2,609 =3,478
End Salvage value expressed in (2,500)/1.15 (1,500)/1.15 (1,000)/1.15 -
term of beginning value [C] =(2,174) =(1,304) =(870)
Net Present Value D= [A+B-C] 1,696 2,935 3,239 4,478
Future Value [D×1.15] 1,950 3,375 3,725 5,150

iii) Making the Comparison

If BIKE WASH replaces the machine immediately, we can view the annual expense as Rs. 2,860
beginning at the end of the year. This annual expense occurs forever if it replaces the new
machine every eight years.
If BIKE WASH replaces the old machine in one year, its expense from using the old machine
for that year can be viewed as Rs. 1,950 payable at the end of the year.
Therefore BIKE WASH should not replace the machine now. However, if we look into the cost
of operating old machine from 2nd year and onward, the cost is always higher than the equivalent
annual cost of new machine.
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Therefore, the old machine should be replaced after operating 1st Year.

Question No. 32
After extensive research and development, Goodweek Tires Ltd., has recently developed a new
tire, the Super Tread, and must decide whether to make the investment necessary to produce and
market it. The tire would be ideal for drivers doing a large amount of wet weather and off-road
driving in addition to normal freeway usage. The research and development costs so far have
totaled about Rs. 10 million. The Super Tread would be put on the market beginning this year,
and Goodweek expects it to stay on the market for a total of four years. Test marketing costing Rs.
5 million has shown that there is a significant market for a Super Tread-type [Link] must
initially invest Rs. 120 million in production equipment to make the Super Tread. This equipment
can be sold for Rs. 51 million at the end of four years. Goodweek intends to sell the Super Tread
to two distinct markets:
a. The original equipment manufacturer (OEM) market: The OEM market consists primarily
of the large automobile companies that buy tires for new cars. In the OEM market, the
Super Tread is expected to sell for Rs. 3,600 per tire when introduced. The variable cost to
produce each tire is Rs. 1,800 in first year of production.
b. The replacement market: The replacement market consists of all tires purchased after the
automobile has left the factory. This market allows higher margins; Goodweek expects to
sell the Super Tread for Rs. 5,900 per tire there. Variable costs are the same as in the OEM
market.
Goodweek intends to raise prices of its product in both markets at 5 percent every year as it
expects the same increase in variable costs. In addition, the Super Tread project will incur Rs.
25 million in marketing and general administration costs during the first year. This cost is
expected to increase at 4 percent in the subsequent years.

Goodweek's corporate tax rate is 25 percent. The company uses a 16 percent discount rate to
evaluate new product decisions. Automotive industry analysts expect automobile
manufacturers to produce 20,000 new cars this year and production to grow at 2.5 percent per
year thereafter. Each new car needs four tires (the spare tires are undersized and are in a
different category). Goodweek expects the Super Tread to capture 11 percent of the OEM
market. Industry analysts estimate that the replacement tire market size will be 140,000 tires
this year and that it will grow at 2 percent annually. Goodweek expects the Super Tread to
capture an 8 percent of this market share.

The appropriate depreciation schedule is as per SLM. The immediate initial working capital
requirement is Rs. 11 million. Thereafter, the net working capital requirements will be 15
percent of next year's sales. Except for the initial investment that will occur immediately,
assume all cash flows will occur at year-end.
Required: (20 Marks)
Based on net present value analysis, recommend whether investing in the project is worth
taking.
[June 2018]

Answer:

The Research & Development Cost and Test Marketing Cost incurred so far are sunk for
decision making.
A. Calculation of Initial Out Lay (Rs.)
Cost of Equipment 120,000,000
Initial W/C Infusion 11,000,000
131,000,000

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B. Calculation of Annual Depreciation (Rs.)

Cost of the Machine 120,000,000
Estimated Salvage value 51,000,000
Depreciable Value 69,000,000
Useful Life 4 Yrs
Annual Depreciation 17,250,000

C. Calculation of Sales Volume (Rs.)

1 2 3 4
OEM Market
Total Market Size for the Car 20,000 20,500 21,013 21,538
Total Number of Tires Requirement 80,000 82,000 84,052 86,152
Share of Goodweek (A) (11%) 8,800 9,020 9,246 9,477
Replacement Market
Total Market of Replacement Tires 140,000 142,800 145,656 148,569
Share of Goodweek (B) (8%) 11,200 11,424 11,652 11,886
Total Size of Sales Volume (A+B) 20,000 20,444 20,898 21,363

D. Sales Piece Per Unit and Annual Sales Value (Rs.)

1 2 3 4
OEM Market 3600 3,780 3,969 4,168
Replacement Market 5900 6,195 6,505 6,830
Sales Value OEM Market 31,680,000 34,095,600 36,697,374 39,500,136
Sales Value Replacement Market 66,080,000 70,771,680 75,796,260 81,181,380
Total Sales Value 97,760,000 10,48,67,280 112,493,634 120,681,516

E. Variable Cost Per Unit and Annual Total Variable Cost (Rs.)
1 2 3 4
Variable Cost for all market 1,800 1,890 1,985 2,085
Total Variable Cost 36,000,000 38,639,160 41,482,530 44,541,855

F. Estimation of Further Working Capital Requirement (Rs.)

Initial 1 2 3 4
Initial W/C
Requirement 11,000,000
W/C need at year end 15,730,092 16,874,045 18,102,227
Additional Infusion 4,730,092 1,143,953 1,228,182
Release of W/C 18,102,227

G. Terminal Cash Flows

Net Proceed from the sale (Rs.)
Cash Salvage Value 51,000,000
Book Salvage Value 51,000,000

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Gain/Loss -
Tax on Gain/Loss -
Net proceed from Sale 51,000,000
Release of W/C 18,102,227
Total Terminal Flow 69,102,227
(Rs.)
H. Annual CFAT Y1 Y2 Y3 Y4
Sales 97,760,000 104,867,280 112,493,634 120,681,516
Variable Cost 36,000,000 38,639,160 41,482,530 44,541,855
Marketing & Administration
Cost 25,000,000 26,000,000 27,040,000 28,121,600
Depreciation 17,250,000 17,250,000 17,250,000 17,250,000
EBT 19,510,000 22,978,120 267,21,104 30,768,061
Tax@ 25% 4,877,500 5,744,530 6,680,276 7,692,015
EAT 14,632,500 17,233,590 20,040,828 23,076,046
Add: Depreciation 17,250,000 17,250,000 17,250,000 17,250,000
CFAT 31,882,500 34,483,590 37,290,828 40,326,046
Working Capital Adjustment (4,730,092) (1,143,953) (1,228,182) -
CFAT after WC Adjustment 27,152,408 33,339,637 36,062,646 40,326,046

I. Calculation of NPV (Rs.)

PVF
Particulars Time Cash Flow @16% Total PV
Initial Outlay 0 (131,000,000) 1.00 (131,000,000)
Recurring Cash Flow 1 27,152,408 0.8621 23,408,091
2 33,339,637 0.7432 24,778,018
3 36,062,646 0.6407 23,105,337
4 40,326,046 0.5523 22,272,075
Terminal Cash Flow 4 69,102,227 0.5523 38,165,160
Net Present Value 728,681

Since the NPV of the Project is positive, it should be implemented.

Question No. 33
A company engaged in manufacture of household electrical goods has taken a strategic decision
to diversify operations and to make a major investment in facilities for the manufacture of office
equipment. The new investment is being appraised over a four-year time horizon. The
company's finance director has prepared a revenue forecast.

She predicts that it will generate Rs. 2 million operating cash flows before marketing costs in
Year 1, Rs. 14.50 million in Year 2, Rs. 15.50 million in Year 3 and Rs. 15.80 million in year 4.

Marketing costs are predicted to be Rs. 9 million in Year 1 and Rs. 2 million in each of Years 2
to 4.

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The new investment will require immediate expenditure on facilities of Rs. 30.60 million. Tax
allowable depreciation will be available on the new investment at an annual rate of 25%
reducing balance basis. It can be assumed that there will either be a balancing allowance or
charge in the final year of the appraisal. The finance director believes that the facilities will
remain viable after four years, and therefore a realisable value of Rs. 13.50 million can be
assumed at the end of the appraisal period.
The new facilities will also require an immediate initial investment in working capital of Rs. 3
million. Working capital requirements will increase every year by 5% for the next three years
and any working capital at the start of Year 4 will be assumed to be released at the end of the
appraisal period.
The company pays tax at an annual rate of 30%. Tax is payable with a year‘s time delay. Any
tax losses on the investment can be assumed to be carried forward and written off against future
profits from the investment.
The company has been considering following two choices for financing all of the Rs. 30.60
million needed for the initial investment in the facilities:
Option1: Obtaining subsidised loan from a government loan scheme, with the loan repayable at
the end of the fourth year. Issue costs of 4% of the gross finance would be payable. Interest
would be payable at a rate of 30 basis points below the risk free rate of 2.5%. In order to obtain
the benefits of the loan scheme, the company would have to fulfill various conditions, including
locating the facilities in a remote part of country where unemployment is high.

Issue costs for the subsidised loan would be paid out of available cash reserves. Issue costs are
not allowable as a tax-deductible expense.

Option 2: Issuing loan notes with interest payable at 5%, which is company's normal cost of
borrowing.

In initial discussions, the majority of the board of directors favoured using the subsidised loan.
However, the chairman argued strongly in favour of the loan notes, as, in his view, operating
costs will be lower if the company does not have to fulfill the conditions laid down by the
government. The company's finance director is sceptical, however, about whether the other
shareholders would approve the issue of loan notes on the terms suggested. The directors will
decide which method of finance to use at the next board meeting.

Assume the discount rate to be 9% to calculate present value of the cash flows.

Required: (20 Marks)

Calculate the adjusted net present value for the investment on the basis that it is financed by the
subsidized loan and conclude whether the project should be accepted or not. Show all relevant
calculations.
[December 2018]

Answer:
Calculation of NPV
(Rs. in
million)
Year 0 1 2 3 4 5
Operating cash flows 2.00 14.50 15.50 15.80 -
excluding marketing costs
Marketing costs (9.00) (2.00) (2.00) (2.00) -
Cash flow before tax (7.00) 12.50 13.50 13.80 -
Taxation (WN 1) (0.39) (3.96)

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Investment (30.60) 13.50 -

Working Capital (WN 2) (3.00) (0.15) (0.16) (0.17) 3.48 -
Cash flows (33.60) (7.15) 12.34 13.33 30.39 (3.96)
Discount Factor at 9% 1 0.917 0.841 0.771 0.707 0.648
Discounted cash flows (33.60) (6.56) 10.38 10.28 21.49 (2.57)
Net Present Value (Base (0.58)
case)
Add: Financing effect 1.57
(WN 3,4,5 & 6)
Adjusted NPV 0.99

WN 1: Taxation (Rs. in million)

Year Amount
Investment 30.60
Tax allowable Depreciation @ 25% on (7.65)
1
reducing balance
Balance 22.95
Tax allowable Depreciation @ 25% on (5.74)
2 reducing balance
Balance 17.21
Tax allowable Depreciation @ 25% on (4.30)
3 reducing balance
Balance 12.91
Balancing (gain) 0.59
4
13.50

Year 1 2 3 4
Cash flow before tax (7.00) 12.50 13.50 13.80
Tax allowable depreciation (7.65) (5.74) (4.30) 0.59
Adjusted Cash flow (14.65) 6.76 9.20 13.21
Offset of previous losses (14.65) (7.89)
Carried forward losses (14.65) (7.89)
Taxable cash flow 1.31 13.21
Tax @ 30% (0.39) (3.96)
Tax payable in Year 4 5

WN 2 : Calculation of working capital (Rs. in million)

Year 1 = 3x0.05=0.15, Year 2=(3+0.15)x0.05=0.16,
Year 3=(3+0.15+0.16)x0.05=0.17 and Year 4 = (3+0.15+0.16+0.17) =3.48

WN 3 : Issue costs
Debt: (Rs. 30.60 m/0·96) = Rs. 31.88 million
Debt issue costs: Rs. 31.88 million x 0·04 = Rs. 1.28 million
WN 4 : Tax shield on subsidised loan
Use PV of an annuity (PVA) for years 2 – 5 at 5% (assume 5% is cost of debt).
(Note: The risk-free rate of 2·5% could also be used for discounting.)
Tax shield: Rs. 30.60 million x (0·025 –0·003) x 0·3 x (4·326 – 0·952) = Rs. 0.68
million

WN 5: Subsidy Benefit
Benefit = Rs. 30.60 million x (0·05 – 0·022) x 3·543 = Rs. 3.04 million

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Tax relief lost = Rs. 30.60 million x (0·05 – 0·022) x 0·3 x (4·326 – 0·952) = Rs.
0.87 million.

WN 6: Financing side effect (Rs. in million)

Issue cost (1.28)

Tax Shield on subsidised loan 0.68
Subsidy Benefit 3.04
Tax relief lost on subsidy benefit (0.87)
Total benefit on financing side 1.57

Conclusion: If base case net present value is used, the project has a negative net present value of
Rs. 0.58 million and, on that basis it should be rejected. However, the financing side effects add
Rs. 1.57 million to the value of the project, giving a positive adjusted net present value of Rs.
0.99 million. On that basis, the project should be accepted. Further, the company should also
consider the financial implication of conditions attached to subsidized loan.

Q (1): Alternative Solution:

Calculation of Adjusted NPV for Subsidies Loan Financing

(Rs. in million)
Year 0 1 2 3 4 5
Operating cash flows excluding marketing
-
costs 2.00 14.50 15.50 15.80

Marketing costs -
(9.00) (2.00) (2.00) (2.00)
Interest cost {30.6 M*(2.5%-0.3%)}
(0.67) (0.67) (0.67) (0.67)
Cash flow before tax -
(7.67) 11.83 12.83 13.13
Taxation (WN 1)
(3.55)
Issue cost (WN 3) -
(1.28)
Sale of investment
13.50
Working Capital (WN 2) -
(3.00) (0.15) (0.16) (0.17) 3.48
Repayment of loan (30.60)
Cash flows (4.28) (7.82) 11.67 12.66 (0.49) (3.55)
Cash flows excluding interest and
repayment of loans (A) (4.28) (7.15) 12.34 13.33 30.78 (3.55)
Cash flows for interest and repayment of
loans (B) (0.67) (0.67) (0.67) (31.27)
Discount Factor at 9% (Assumed rate is
1.00 0.92 0.84 0.77 0.71 0.65
ke)( C )

Discounted cash flows(Excluding interest

and Repayment of loans) (D=A*C) (4.28) (6.56) 10.39 10.29 21.81 (2.31)

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Discount Factor at 5% (Assumed Market

1.00
cost of Debt) ( E ) 0.95 0.91 0.86 0.82 0.78
Discounted cash flows(Excluding interest
and Repayment of loans) (F=B* E) (0.64) (0.61) (0.58) (25.73)

Total Discounted Cash Flows (D+F)

(4.28) (7.20) 9.78 9.71 (3.92) (2.31)
Adjusted Net Present Value
1.78

Calculation of Adjusted NPV for Loan Financing

(Rs. in million)
Year 0 1 2 3 4 5
Operating cash flows excluding marketing
2.00 14.50 15.80 -
costs 15.50
Marketing costs -
(9.00) (2.00) (2.00) (2.00)
interest cost
(1.53) (1.53) (1.53) (1.53)
Cash flow before tax -
(8.53) 10.97 11.97 12.27
Taxation (WN 1)
(2.52)
Issue cost - -
Sale of investment
13.50
Working Capital (WN 2) -
(3.00) (0.15) (0.16) (0.17) 3.48
Repayment of loan
(30.60)
Cash flows
(3.00) (8.68) 10.81 11.80 (1.35) (2.52)
Cash flows excluding interest and
repayment of loans (A) (3.00) (7.15) 12.34 13.33 30.78 (2.52)
Cash flows for interest and repayment of
loans (B) (1.53) (1.53) (1.53) (32.13)
Discount Factor at 9% (Assumed that
0.92
given discount rate is ke)( C ) 1.00 0.84 0.77 0.71 0.65

Discounted cash flows(Excluding interest

and Repayment of loans) (D=A*C) (3.00) (6.56) 10.39 10.29 21.81 (1.64)

Discount Factor at 5% (Assumed Market

0.95
cost of Debt) ( E ) 1.00 0.91 0.86 0.82 0.78

Discounted cash flows(Excluding interest

and Repayment of loans) (F=B* E) (1.46) (1.39) (1.32) (26.43)

Total discounted Cash Flows (D+F)

(3.00) (8.02) 9.00 8.97 (4.63) (1.64)
Adjusted Net Present Value
0.69
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WN 1: Taxation (Rs. in million)

Year Amount
Investment 30.6
1 Tax allowable Depreciation @ 25% on reducing balance -7.65
Balance 22.95
Tax allowable Depreciation @ 25% on reducing balance -5.74
2
Balance 17.21
Tax allowable Depreciation @ 25% on reducing balance -4.3
3
Balance 12.91
Balancing (gain) 0.59
4
13.5

For Subsidies Loan Financing

Year 1 2 3 4
Cash flow before tax -7.6732 11.8268 12.8268 13.1268
Tax allowable depreciation -7.65 -5.74 -4.3 -0.59
Adjusted Cash flow -15.323 6.0868 8.5268 12.5368
Carried forward losses -9.2364 -0.7096 11.8272
Taxable cash flow 0 11.8272
Tax @ 30% 3.54816
Tax payable in Year 5

For Loan Financing

Year 1 2 3 4
Cash flow before tax -8.53 10.97 11.97 12.27
Tax allowable depreciation -7.65 -5.74 -4.3 -0.59
Adjusted Cash flow -16.18 5.23 7.67 11.68
Carried forward losses -10.95 -3.28 8.4
Taxable cash flow 0 8.4
Tax @ 30% 2.52
Tax payable in Year 5

WN 2 : Calculation of working capital (Rs. in million)

Year 1 = 3x0.05=0.15, Year 2=(3+0.15)x0.05=0.16,

Year 3=(3+0.15+0.16)x0.05=0.17 and Year 4 = (3+0.15+0.16+0.17) =3.48

WN 3 : Issue costs
Debt: (Rs. 30.60 m/0·96) = Rs. 31.88 million

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Debt issue costs: Rs. 31.88 million x 0·04 = Rs. 1.28

million
Conclusion: On that basis adjusted NPV as calculated above, the project with the subsidies loan
financing is having highest adjusted NPV, project with the subsidies loan financing should be
accepted. Further, the company should also consider the financial implication of conditions
attached to subsidized loan.

Question No. 34

Z Ltd. is a diversified company operating in different industries. The shares of

the company are traded in the stock exchange and currently has a market price
of Rs. 320 per share. The company‘s dividend payment over the last five years
are as follows:
Year 2018 2017 2016 2015 2014
Dividend Per Share 35 32 30 29 28
(Rs.)

The board of directors of Z Ltd. are currently considering two main investment
opportunities: one in Solar Energy and the other in the Hotel and Tourism
sector. Both projects have short lives and their associated cash flows are as
follows:
Year 1 2 3
Solar Energy (Rs. in million) 85 175 160
Hotel & Tourism (Rs. in million) 180 195 150
The investment in Solar Energy would cost Rs. 400 million while that in Hotel
and Tourism would cost Rs. 405 million.
The management of the company has identified the industry beta of Solar
Energy and Hotel and Tourism as 1.2 and 1.6 respectively. However, a research
conducted by management revealed that Z Ltd.‘s beta is 1.5. The average return
on the companies, listed on the stock exchange, is 25% and the yield on
Treasury bill is 20%. The growth rate is 5.7%.
Required: (5+5=10)
i) Compute the net present values of both projects using the
company‘s weighted average cost of capital as a discount rate.
ii) Compute the net present values using a discount rate which take into
account the risk associated with the individual projects.
[June 2019]
Answer:
(i) Computation of NPV for both projects Using WACC of company
Solar Energy
Year Cash flow (Rs. in Discount Factor PV(Rs. in
million) @17% million)
0 -400 1 -400.00
1 85 0.855 72.68
2 175 0.731 127.93
3 160 0.625 100.00
NPV (99.39)

Hotel and Tourism

Year Cash flow ([Link] Discount Factor PV ([Link]
million) @17% million)
0 -405 1 -405.00
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 CAP II Paper 4: Financial Management

1 180 0.855 153.90

2 195 0.731 142.55
3 150 0.625 93.75
(14.80)
(ii) Projects NPV using CAPM
Solar Energy
Year Cash flow ([Link] Discount Factor @ 26% PV ([Link]
million) million)
0 -400 1 -400.00
1 85 0.794 67.49
2 175 0.630 110.25
3 160 0.500 80.00
NPV (142.26)

Hotel and Tourism

Year Cash flow ([Link] Discount Factor PV ([Link]
million) @28% million)
0 -405 1 -405
1 180 0.781 140.58
2 195 0.610 118.95
3 150 0.476 71.40
NPV (74.07)
Working Notes:
1. WACC of the company, here, represents the cost of equity calculates as:
Ke = 35(1.057)/320 + 0.057

= 17.26 % (Approx)
[Link] of Capital Using CAPM (discount rate which takes into account the risk factor):
Solar Energy: Rs = Rf + B (Rm – Rf)

20% + 1.2 (25 – 20) = 20% + 6% = 26%

Hotel and Tourism:
RH = Rf + B (Rm – Rf) = 20% + 1.6 (25% - 20%)
20% + 8% = 28%
Alternate Solution

WACC can be used by taking discount factor @ 27.50% (from CAPM)

WACC (ke) = Rf + β(Rm-Rf)

= 20% + 1.5(25-20)

= 27.5%

Question No. 35
BCD Ltd. specializes in the production of ―spring table water‖ for which it has distributors both
in the Northern and Southern parts of Nepal. The consumers of the product in the East and West

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parts of Nepal are clamoring for more branches in each of these areas to enable them have this
product within their easy reach.
The Managing Director of the company formed a project team to study the feasibility of the
branch expansion project as well as its overall financial requirement. The team, after serious
meetings and deliberations, submitted its report containing the following information relating to
the branch to be opened in the Eastern part of Nepal:
 Initial investment - Rs. 350,000 with nil scrap value
 Expected life span - 10 years
 Sales volume - 20,000 units per annum
 Selling price - Rs. 20 per unit
 Direct variable cost - Rs. 15 per unit
 Fixed cost excluding depreciation - Rs. 25,000 per annum.
 IRR - 17%.
The Managing Director is concerned about the viability of the project as the IRR is close to the
company‘s hurdle rate of 15%. Therefore, he wanted you to evaluate the project very well so that
it does not run into a loss. Present value of annuity at company's hurdle rate for 10 years is
5.0188.
Required: (8+2=10 Marks)
i) Compute the sensitivity of the NPV to each of the following variables:
a. Sales price
b. Sales volume
c. Initial outlay
d. Variable cost
ii) From your calculation in (i) above, determine the two most sensitive variables and
interpret the result.
[June 2019]

Answer:
i) Calculation of NPV
Year Items NCF PVIFA@ PV
(NRs.) 15% (Rs.)
0 Initial Outlay (350,000) 1.0000 (350,000)
1 - 10 Relevant Fixed
Cost (25,000) 5.0188 (125,470)
1 - 10 Variable Cost (300,000) 5.0188 (1,505,640)
1 - 10 Sales 400,000 5.0188 2,007,520
NPV 26,410
Contribution = Sales – Variable Cost
= 400,000 – 300,000
= Rs. 100,000
PV of Contribution Rs. 100,000 x 5.0188
= Rs. 501,880
Sensitivity Analysis:
Sales Price = (NPV/ PV of Sales) x 100 =(26,410/2,007,520) x 100 = 1.32%
Sales Volume = (NPV/ PV of Contribution) x 100 = (26,410/501,880) x 100 = 5.26%
Initial Outlay = (NPV/ PV of Outlay) x 100 = (26,410/350,000) x 100 = 7.55%
Variable Cost = (NPV/ PV of Variable Cost) x 100 = (26,410/1,505,640) x 100 =
1.75%
ii) The two most sensitive variables are:
Sales price at 1.32%
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Variable Cost at 1.75%

These are derived from the sensitivity analysis workings above, as these are the two least
NPVs in terms of sensitivity.
The sales price must not fall by more than 1.32% and the variable cost must not increase
by more than 1.75%. Otherwise, the NPV starts going down.

Question No. 36
A company has a maximum of Rs. 800,000 available to invest in new projects. Three alternatives
are available and the business manager of the company has calculated net present value of each
of the alternatives as below:
Investment Initial Cash Outlay (Rs.) NPV (Rs.)
Alternative 1 540,000 100,000
Alternative 2 600,000 150,000
Alternative 3 260,000 58,000
Required: (5 Marks)
Which investment alternative should the company invest in, if the projects can be divided?
(June 2019)

Answer:
Since we have limited fund available for investment, the normal NPV rule of accepting
investment decision with the highest NPV cannot be adopted straight way. Further, as
the projects are divisible, a Profitability Index (PI) can be utilized to provide the most
beneficial combination of investment for the company.
Alternative PI Ranked as per PI
Alternative 1 640,000 / 540,000 = 1.185 III
Alternative 2 750,000 / 600,000 = 1.250 I
Alternative 3 318,000 / 260,000 = 1.223 II
Therefore, the company should invest as below:
Rs. 600,000 in alternative 2 as it has ranked first as per PI and Rs. 200,000 in alternative 3 as it
has been ranked second as per PI.

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Chapter 6:

Financial Analysis and Ratio Analysis

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Question No. 1
Du pont Equation (December 2009) (2.5 Marks)

Answer:
A Du pont shows the return on equity is affected by assets turnover, profit margin and leverage.
The Du Pont Chart was developed by Du Pont managers for evaluating performance and
analyzing ways of improving performance.
The profit margin times the total assets turnover is called the Du Pont equation. This equation
gives the rate of return on assets(ROA).

ROA = Net Profit margin* Total assets turnover

= Net Income/sales *Sales/Total assets

The ROA times the equity multiplier(total assets divided by common equity) yields the return on
equity(ROE). This equation is referred to as the Extended Du Pont Equation.
ROE= Net Income/Total Assets * Total Assets/Common Equity

Question No. 2
Significance of Debt-equity Ratio as a Measure of Long-term Solvency [December 2011]
(2.5 Marks)

Answer:
The Debt-equity (D/E) ratio is calculated by comparing the long term debts with the total
shareholders funds. The D/E ratio throws light on the margin of safety available to the debt
providers of the firm.
If a firm with a high D/E ratio fails, then a part of the financial loss may have to be borne by the
debt providers. Thus, the greater the D/E ratio, higher would be the risk of the lenders. From the
view point of shareholders, a high D/E ratio implies that the firm is having a high degree of
financial leverage which offers the opportunity and benefit of trading on equity. In such a case,
if the rate of return of the firm is more than the cost of debt, then higher degree of financial
leverage means relatively higher return to the shareholders.
The higher D/E ratio may also have an impact on the ability of a firm to service the debt. In
addition to the payment of principal and interest on debt, such a ratio might have an adverse
impact on a firm‘s ability to pay other fixed and contractual payments in addition to the
principal and interest. On the contrary, a low D/E ratio implies a low risk to the lenders and
creditors for the firm but it will not offer the benefit of trading on equity. Therefore, a proper
balance between the proportion of debt and equity is very much essential in order to take care of
the interests of both the lenders and the shareholders and for the long term sustainability and
solvency of the firm.

Question No. 3
Gearing ratio [June 2013] (2.5 Marks)

Answer:
A general term describing a financial ratio that compares some form of owner's equity (or
capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the degree
to which a firm's activities are funded by owner's funds versus creditor's funds.
The higher a company's degree of leverage, the more the company is considered risky. As for
most ratios, an acceptable level is determined by its comparison to ratios of companies in the
same industry. The best known examples of gearing ratios include the debt-to-equity ratio (total
debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity / assets), and
debt ratio (total debt / total assets).

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A company with high gearing (high leverage) is more vulnerable to downturns in the business
cycle because the company must continue to service its debt regardless of how bad sales are. A
greater proportion of equity provides a cushion and is seen as a measure of financial strength.

Question No. 4
Return on equity and Return on capital employed [June 2013] (2.5 Marks)

Answer:
Return on equity (ROE) measures the rate of return on the ownership interest (shareholders'
equity) of the common stock owners. It measures a firm's efficiency at generating profits from
every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE
shows how well a company uses investment funds to generate earnings growth. ROEs between
15% and 20% are generally considered good. Return on equity reveals how much profit a
company earned in comparison to the total amount of shareholder equity found on the balance
sheet. If you think back to lesson three, you will remember that shareholder equity is equal to
total assets minus total liabilities. It's what the shareholders "own". Shareholder equity is a
creation of accounting that represents the assets created by the retained earnings of the business
and the paid-in capital of the owners.

Return on capital employed (ROCE) is an accounting ratio used in finance, valuation, and
accounting. Return on capital employed (ROCE) is a measure of the returns that a business is
achieving from the capital employed, usually expressed in percentage terms. Capital employed
equals a company's Equity plus Non-current liabilities (or Total Assets − Current Liabilities), in
other words all the long-term funds used by the company. ROCE indicates the efficiency and
profitability of a company's capital investments. ROCE should always be higher than the rate at
which the company borrows otherwise any increase in borrowing will reduce shareholders'
earnings, and vice versa; a good ROCE is one that is greater than the rate at which the company
borrows. It can be calculated as follows:

Question No. 5
Answer the following, supporting the same with proper reasoning: (2.5 Marks)
Which ratio would a rich investor interested in investing in equity shares most likely consult
while considering the financing of seasonal inventory?
[June 2013]

Answer:
While considering the financing of seasonal inventory, the rich equity investor would be
consulting the profitability ratios and ratios that provide information about risk relating to the
investment because he is mostly cautious of balancing the risk-return trade off.

Question No. 6
Limitations of financial ratio [December 2013] (2.5 Marks)

Answer:
Financial ratios have following limitations:
i) Many large firms operate different divisions in different industries. For these companies, it is
difficult to find a meaningful set of industry-average ratios.
ii) Inflation may badly distort a company's balance sheet. In this case, profits will also be
affected. Thus a ratio analysis of one company over time or a comparative analysis of
companies of different ages must be interpreted with judgment.

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 CAP II Paper 4: Financial Management

iii) Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a
business can reduce the chance of misinterpretation. For example, a retailer's inventory may
be high in the summer in preparation for the back-to-school season. As a result, the
company's accounts payable will be high and its ROA low.
iv) Different accounting practices can distort comparisons even within the same company, e.g.
leasing versus buying equipment, LIFO versus FIFO, etc..
v) It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a
historically classified growth company may be interpreted as a good sign, but could also be
seen as a sign that the company is no longer a growth company and should command lower
valuations.
vi) A company may have some good and some bad ratios, making it difficult to tell if it's a good
or weak company.

Question No. 7
Dividend Coverage Ratio [June 2014] (2.5 Marks)
Answer:
It measures the ability to pay dividend on preference share which carry a stated rate of return.
This ratio is the ratio (expressed as X number of times) of net profits after taxes (EAT) and the
amount of preference dividend. Thus,
Dividend coverage= EAT/ Preference dividend
It can be seen that although preference dividend is fixed obligation, the earning taken into
account are after taxes. This is because, unlike debt on which interest is a charge on the profits
of the firm, the preference dividend is treated as an appropriation of profit. The ratio, like the
interest coverage ratio, reveals the safety margin available to the preference shareholders. As a
rule, the higher the coverage, the better it is from their point of view.

Question No. 8
Horizontal analysis and Vertical analysis [June 2014] (2.5 Marks)
Answer:
Horizontal analysis: This technique is also known as comparative analysis. It is conducted by
setting consecutive balance sheet, income statement of statement of cash flow side by side and
reviewing changes in individual categories on year-to-year or multiyear basis. The most
important item revealed by comparative financial statement analysis is trend. The horizontal
financial statements analysis is done by restating amount of each item or group of items as a
percentage.

Vertical analysis: Vertical/ Cross-sectional/ Common size statements came from the problems
in comparing the financial statements of firms that differ in size. The vertical analysis represents
the relationship of different items of a financial statement which some common item by
expressing each item as a percentage of the common item.

- In the balance sheet, for example, the assets as well as the liabilities and equity are each
expressed as a 100% and each item in these categories is expressed as a percentage of the
respective totals.
- In the common size income statement, turnover is expressed as 100% and every item in the
income statement is expressed as a percentage of turnover.

Question No. 9
Explain the important ratios that would be used in each of the following situations: (6 Marks)
i) A bank is approached by a company for a loan of Rs. 50 lakhs for
working capital purpose.
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 CAP II Paper 4: Financial Management

ii) A long term creditor interested in determining whether his claim is

adequately secured.
iii) A shareholder who is examining his portfolio to decide whether he
should hold or sell his holdings in a company.
[December 2014]
Answer:
Important Ratios used in different situations
(i) Liquidity Ratios –
Liquidity or short term solvency ratios would be used by the bank to check the ability of the
company to repay its short-term liabilities. A Bank may use current ratio or Quick ratio to
judge short term solvency of the company. Further interest coverage ratio shall also be
analysed to ensure the interest repayment security.
(ii) Capital Structure or Leverage Ratios –
The long-term creditor would use the capital structure or leverage ratios to ensure the long
term stability and structure of the firm. A long term creditor interested in determining
whether his claim is adequately secured may use Debt-servicing coverage and interest
coverage ratio.
(iii)Profitability Ratios –
The shareholder would use the profitability ratios tomeasure the operational efficiency of the
company to see the final results of business operations. A shareholder may use return on
equity, earning per share and dividend per share ratios. Price earning ratio and book value
per share are also analysed to decide wheather a particular share is to sell or hold.

Question No. 10
Describe limitations of financial ratio. [July 2015] (3 Marks)
Answer:
Financial ratios have following limitations:
 Many large firms operate different divisions in different industries. For these companies;
it is difficult to find a meaningful set of industry-average ratios.
 Inflation may badly distort a company's balance sheet. In this case, profits will also be
affected. Thus a ratio analysis of one company over time or a comparative analysis of
companies of different ages must be interpreted with judgment.
 Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect
a business can reduce the chance of misinterpretation. For example, a retailer's inventory
may be high in the summer in preparation for the back-to-school season. As a result, the
company's accounts payable will be high and its ROA low.
 Different accounting practices can distort comparisons even within the same company,
e.g. leasing versus buying equipment, LIFO versus FIFO, etc.
 It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a
historically classified growth company may be interpreted as a good sigh, but could also
be seen as a sign that the company is no longer a growth company and should command
lower valuations.
 A company may have some good and some bad ratios, making it difficult to tell if it's a
good or weak company.

Question No. 11
Horizontal analysis Vs. Vertical analysis [June 2016] (2.5 Marks)

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Answer:
Horizontal analysis: this technique is also known as comparative analysis. It is conducted by
setting consecutive balance sheet, income statement or cash flow side by side and reviewing
changes in individual categories on year to year or multi year basis. The most important item
revealed by comparative financial statement analysis is trend. A comparison of statements over
several years reveals direction speed & extents of a trends. The horizontal financial statement is
done by restating amount of each item or group of items as a percentage.
Vertical analysis: Vertical/Cross sectional/Common size statements came from the problems in
comparing the financial statements of firms that differ in size. The vertical analysis represents
the relationship of different items of financial statements which some common items by
expressing each item as a percentage of common item. In common size income statements, each
item is stated as percentage of net sales. The percentage of different items are computed by
dividing the absolute item by the common base (i.e. the balance sheet total or net sales as the
case may be), and multiplying by hundred.

Question No. 12
Effect of leverage on Capital Turnover and Working Capital Ratio [December 2017] (2.5
Marks)

Answer:
Effect of leverage on capital turnover and working capital ratio
An increase in sales improves the net profit ratio, raising the Return on Investment (R.O.I) to a
higher level. This however, is not possible in all situations; a rise in capital turnover is to be
supported by adequate capital base. Thus, as capital turnover ratio increases, working capital
ratio deteriorate, thus, management cannot increase its capital turnover ratio beyond a certain
limit. The main reasons for a fall in ratios showing the working capital position due to increase
in turnover ratios is that as the activity increases without a corresponding rise in working capital,
the working capital position becomes tight. As the sales increases, both current assets and
current liabilities also increase but not in proportion to current ratio. If current ratio and acid test
ratio are high, it is apparent that the capital turnover ratio can be increased without any problem.
However, it may be very risky to increase capital turnover ratio when, the working capital
position is not satisfactory.

Question No. 13
Horizontal analysis and Vertical analysis [June 2018] (2.5 Marks)

Answer:
Horizontal analysis: This technique is also known as comparative analysis. It is conducted by
setting consecutive balance sheet, income statement of statement of cash flow side by side and
reviewing changes in individual categories on year-to-year or multi year basis. The most
important item revealed by comparative financial statement analysis is trend. The horizontal
financial statements analysis is done by restating amount of each item or group of items as a
percentage.
Vertical analysis: Vertical/ Cross-sectional/ Common size statements came from the problems in
comparing the financial statements of firms that differ in size. The vertical analysis represents
the relationship of different items of financial statements with some common item by expressing
each item as a percentage of the common item. For example:
 In the balance sheet, the assets as well as the liabilities and equity are each expressed as
a 100% and each item in these categories is expressed as a percentage of the respective
totals.
 In the common size income statement, turnover is expressed as 100% and every item in
the income statement is expressed as a percentage of turn over.

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Question No. 14
Saleways Ltd. purchased a retail store in KathmanduValley and commenced the
business on Shrawan 1, 2064. Following information is also available regarding the
operations of the retail store:
Capital introduced on Shrawan 1 NRs. 2,350,000
Drawings during the year 250,000
Working Capital (current assets less current liabilities) 1,150,000
Depreciation of fixed assets during the year, based on
a rate of 20 per cent per annum on cost 150,000
Ratio of annual sales to "year-end values of
fixed assets plus working capital" 2:1
Ratio of current assets to current liabilities at the year-end 2:1
Ratio of liquid assets (cash plus debtors) to
current liabilities on year-end 5:4
Debtors at the year-end as per cent of annual sales 12
General expenses (excluding depreciation)
as per cent of annual sales 20

The current assets consist of stocks (which is unchanged throughout the year), debtors
and cash. Stocks were turned over four times during the year. The current liabilities
consisted only of creditors.

After considering all the information provided above, you are required to prepare the
following in as much details as possible: (6+6=12 Marks)
i) Trading and profit and loss account for the year ended 32 Ashadh 2065, and
ii) Balance sheet as at Ashadh end 2065.
(June 2009)
Answer:
i) Trading and P/L Accountof Saleways Ltd.
for the year ended on 32 Ashadh 2065
Debit Credit
Particulars NRs Particulars NRs
To Cost of Sales 3,450,000 By Sales 3,500,000
To Gross Profit c/d 50,000
Total 3,500,000 Total 3,500,000

To General Expenses 700,000 By Gross Profit b/f 50,000

To Depreciation 150,000 By Net Loss c/d 800,000
Total 850,000 Total 850,000

Balance Sheet of Saleways Ltd.

as at 32 Ashadh 2065
Equity and liabilities NRs Assets NRs
Opening Capital = 2,350,000 1,750,000 Property Plant & Equip 600,000
Add: Capital Intro= 450,000 Less: Depreciation
Less: Net Loss = (800,000) (750,000 -150,000)
Less: Drawings = (250,000)
Creditors 1,150,000 Current Assets
 Cash and Cash Equivalent 1,017,500
 Debtors 420,000
 Inventories 862,500
Total 2,900,000 Total 2,900,000

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Working Notes:

W.N. 1: Special Note

Only one item of current liabilities is Creditors as stated in the question. So the balancing source
of fund of NRs. 450,000 might be treated as capital introduction during the year or long term
loans. Here in solution it is shown as new capital introduction. But students may alternatively
show the balancing figure as long term loans.

W.N. 2: Determination of Current Assets and Current Liabilities

CA – CL = NRs. 1,150,000
0.5 CA – CL = 0
Subtracting equation (2) from equation (1), we get:
0.5 CA = NRs. 1,150,000, Or CA = NRs. 2,300,000
CL = NRs. 1,150,000 since there are no other current liabilities.

W.N. 3: Determination of Property, Plant & Equipment (PPE)

Depreciation @ 20 per cent = NRs. 150,000
Cost of PPE = NRs. 150,000 X 100/20 = NRs. 750,000
PPE (after Depreciation) = NRs. (750,000 – 150,000) = NRs. 600,000

W.N. 4: Determination of Sales

Sales/ (Fixed Assets + Working Capital) = 2
Or,Sales / NRs. (600,000 + 1,150,000) =2
.*.Sales = NRs. 3,500,000

W.N. 5: Determination of Liquid Assets

Liquid Ratio = LiquidAssets Or, 1.25 = LiquidAssets
Current Liabilities 1,150,000
Or, Liquid Asset = NRs. 1,437,500, which consists of cash and debtors.
(a) Debtors are 12% of annual sales = NRs. 3,500,000 X 0.12 = NRs. 420,000.
(b) Cash = NRs. 1,437,500 – NRs. 420,000 = NRs. 1,017,500.

W.N. 6: Determination of Stock

Stock = Current Assets – Liquid Assets
= NRs. 2,300,000 – NRs. 1,437,500
= NRs. 862,500

W.N. 7: Determination of Cost of Sales

Stock Turnover Ratio = Cost of Sales/Average Stock
Or, 4 = Cost of Sales/NRs. 862,500,
.*.Cost of Sales = NRs. 3,450,000

Question No. 15
The summarized accounts of New Ideas Ltd. are as follows:
Balance Sheet as at Ashadh end

Year 2 (Rs. 000) Year 1 (Rs. 000)

Fixed assets (net) 6,401 2,519
Current assets
Stock 25,426 20,231
Debtors 21,856 20,264
Balance at bank __2,917 __6,094
Total 56,600 49,108
Ordinary shares of Rs.100 5,000 5,000

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Revenue reserves 14,763 12,263

Deferred taxation 5,433 3,267
10% Debenture loans 10,000 10,000
Current liabilities
Trade creditors 18,762 16,431
Taxation 1,642 1,247
Dividends __1,000 ___900
Total 56,600 49,108

Results for the year ended Ashadh

Year 2 (Rs. 000) Year 1 (Rs. 000)
Sales 264,626 220,393
Trading profit 9,380 8,362
Interest payable 1,000 1,000
Taxation 4,380 3,642
Dividend 1,500 1,400

The following additional information is provided:

 The ordinary shares are quoted at Rs.240.
 The company requires Rs.16 million for an investment project and is considering one
of the following:
o The issue of Rs.16 million 10% debentures.
o A right issue at par.

You are required to: (6+4+5=15 Marks)

a) Calculate for both years (i) two ratios particularly significant to creditors, (ii) two
ratios particularly significant to management, and (iii) two ratios particularly
significant to shareholders. And, express a brief comment on the trend of ratios.
b) Calculate the immediate effect of the two schemes of fund raising on the gearing of
the company and comment.
c) Calculate the effect of the two schemes on the earnings per share, on the assumption
that the Year 2 profits from the existing assets will be maintained and that Rs.16
million net investments will produce profits of Rs.3.5 million before tax and interest.
The rate of tax can be assumed at 25%.
(December 2009)

Answer:
a) Year 2 Year 1
(i) Ratios significant to creditors
 Current ratio = Current assets/ Current liabilities

Year 2 (50199/21404) 2.35:1

Year 1 (46589/18578) 2.51:1
 Liquidity ratio = (Current assets-stock)/ Current liabilities

Year 2 (24773/21404) 1.16:1

Year 1 (26358/18578) 1.42:1

(ii) Ratios significant to management

 Activity ratio = Pre-tax profit/ Sales

(pre-tax profit= trading profit- interest)

Year 2 (8380/264626) 3.17%
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Year 1 (7362/220393) 3.34%

 Profitability ratio = Pre-tax profit/ Net assets

(where, net assets equals to total assets less current liabilities)

Year 2 (8380/35196) 23.8%
Year 1 (7362/30530) 24.1%

(iii) Ratios significant to shareholders

 Return on capital employed= PAT/ Shareholders‘ Fund

Year 2 (4000/19763) 20.2%

Year 1 (3720/17263) 21.6%
 Dividend cover ratio = PAT/ Dividend

Year 2 (4000/1500) 2.7:1

Year 1 (3720/1400) 2.7:1
Comments on trends of ratios:
In spite of an increase in sales of 20% and an increase in pre-tax profits of 13.8%, the
ratios mentioned show a marginally unfavourable trend between Year 1 and Year 2.

b) Effect of fund-raising schemes on gearing

Gearing = (Loan capital + Preference shares)/ Shareholders‘ Equity
Currently, Gearing = 10000/ 19763 = 50.6%
o The issue of Rs.16 million 10% debentures.
Gearing = 26000/ 19763 = 131.6%

o A rights issue at par.

Gearing = 10000/ 35763 = 28%
Comment:
The first scheme will lead to high level of gearing.

c) Effect of fund-raising schemes on EPS

EPS = PAT/ No. of shares outstanding
Current EPS = Rs.4,000,000/ 50000 = Rs.80
o The issue of Rs.16 million 10% debentures.
PAT = Trading profit - interest – tax
= (9380+3500) – (1000+1600) – {4380+25% * (3500 – 1600)}
= 12880 – 2600 – 4855
= Rs.5425 thousand
EPS = Rs.5425000/ 50000
= Rs.108.5

o A rights issue at par.

PAT = Trading profit - interest – tax
= (9380+3500) – 1000 – (4380+25% * 3500)
= 12880 – 1000 – 5255
= Rs.6625 thousand
EPS = Rs.6625000/(50000+160000)
= Rs.6625000/210000
= Rs.31.55

Question No. 16
The following are the financial statements of PQR Ltd. for 2066/67.

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Balance Sheet of PQR Ltd. as on Ashadh end 2066/67

Liabilities Amount (Rs.) Assets Amount (Rs.)

Equity Share Capital 210,000 Cash 105,000
Reserves 420,000 Debtors 525,000
Preference Share Capital 420,000 Stock 735,000
Long-term Debts 1,260,000 Fixed Assets (Net) 1,575,000
Creditors 420,000 Goodwill 210,000
Bills Payable 210,000
Outstanding Expenses 60,000
Provision for Tax 150,000
3,150,000 3,150,000

Income Statement of PQR Ltd.

for the year ending Ashadh, 2067
Rs. Rs.
Sales
Cash 420,000
Credit 1,680,000 2,100,000
Less:Expenses
Cost of Goods Sold 1,260,000
Selling, Administration and General Expenses 210,000
Depreciation 147,000
Interest on Long-term Debt 63,000 1,680,000
Profit Before Taxes 420,000
Taxes 210,000
Profit After Taxes 210,000
Less: Preference Dividend 25,500
Net Profit for Ordinary Shareholders 184,500
Add: Reserve at 1 Shrawan 2066 273,000
Profit Available to Ordinary Shareholders 457,500
Less: Dividend Paid to Equity Shareholders 37,500
Reserve at Ashadh end 2067 420,000

The ratios for the previous two years relating to the company and the industry
ratios are given below:

2064/065 2065/066 Industry

Current Ratio 2.54 2.10 2.30
Acid-test Ratio 1.10 0.96 1.20
Debtors Turnover 6.00 4.80 7.00
Stock Turnover 3.80 3.05 3.85
Long-term Debt to Total Capital 37% 42% 34%
Gross Profit Margin 38% 41% 40%
Net Profit Margin 18% 16% 15%
Return on Equity 24% 29% 19%
Return on Total Assets 7% 6.8% 8%
Tangible Assets Turnover 0.80 0.70 1.00
Interest Coverage 10 9 10

Based on the above financial statement and ratios of the company and the industry provided
above, you are required to:
f) Calculate the same ratios as provided above for 2066/067,
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g) Evaluate the company‘s financial position of the company on the basis of these ratios and
past ratios of the company and the industry,
h) Using relevant ratios, indicate what decision would be taken in the following situations:
i) PQR Ltd. wants to buy materials of Rs. 210,000 on a three months credit from a
domestic supplier company.
ii) PQR Ltd. wants to issue 15% debentures of Rs. 600,000 with a 10 year maturity
period. (11+5+4=20 Marks)
(December 2010)

Answer:
(a) The ratios for 2066/067 for PQR Ltd. are computed as follows:
__________________________________________________________________________
Computation Ratio for 2066/067
___________________________________________________________________________________________________________________________________________________________

1. Current Ratio 1,365,000/840,000 1.63

2. Acid-test Ratio 630,000/840,000 0.75
3. Debtors Turnover 1,680,000/525,000 3.20
4. Stock Turnover 1,260,000/735,000 1.71
5. Long-term Debt to Total Capital 1,260,000/.2,100,000 60%
6. Gross Profit Margin 840,000/2,100,000 40%
7. Net Profit Margin 210,000/2,100,000 10%
8. Return on Equity 184,800/420,000* 44%
9. Return on Total Assets (420,000 + 63,000) (1 – 0.5)/2,940,000* 8.2%
10. Tangible Assets Turnover 2,100,000/2,940,000* 0.71
11. Interest Coverage 483,000/63,000 7.67
___________________________________________________________________________________________________________________________________________________________
_

* Intangible assets of Rs. 210,000 excluded.

(b) Based on the ratios computed above, evaluation of the company’s position is
presented below:

i. The liquidity position of the firm is falling which is evident from the Ratios 1 to 4
computed above.
ii. The gross profit margin is constant and matches with the industry average, but the net
profit margin ratio is declining. The two ratios together imply that the company‘s
selling and administrative expenses, depreciation and interest charges are on the rise.
iii. The decline in the net margin is partly due to rapid increase in debt (Ratio 5). This
increase also explains why the return on equity (Ratio 8) has been rising while the
return on assets is declining (Ratio 9).
iv. The decline in the net margin and the return on assets can also be attributed to the
decline in assets turnover (Ratio 10).

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v. The impact of the increase in debt and overall decline in profitability are also shown by
reduction in the interest coverage (Ratio 11).

(c) Decision under Different Situations:

(i) The supplier would be more concerned with the liquidity of current assets of the
company. Therefore, Ratios 1 to 4 are more relevant to the supplier. In view of the
deteriorating liquidity position and the lengthy terms of payment, the credit may not be
granted to the company.
(ii) The company may find difficulty in selling the debentures. Already, it has a high
leverage ratio. If the debentures are issued its leverage ratio will increase to 68.89 per
cent (Rs. 1,860,000/Rs. 2,700,000) and the interest coverage ratio at the same level of
earning will decline to 4.06. In addition, the liquidity and the profitability of the
company are also declining. Therefore, it is not proper time to issue the debentures.

Question No. 17
The clients of an accounting firm wherein you are employed are concerned about the fall
individend from a company whose shares they hold as investment. The abridged profit and loss
account and balance sheet of the company for two years are given as follows:
Abridged P & L A/C (year ended Ashadh 31) (Rs. in lakh)

Particulars Current year Previous year

Income:
Sales and other income 19,200 15,500
Expenditure:
Operating and other expenses 15,600 11,900
Depreciation 700 650
Interest 1,850 1,750
18,150 14,300
Profit for the year 1,050 1,200
Taxes 500 200
Profit after taxes 550 1,000
Proposed dividend 200 400

Abridged Balance Sheet as on Ashadh 31 (Rs. in lakh)

Particulars Current year Previous year
Sources of funds:
Share capital (of Rs. 10 each) 4,200 2,600
Reserves and surplus 7,550 1,200
Convertible portion of
12.5% Debentures -- 500
Loan funds:
Secured loans (16%) 10,100 8,700
Unsecured loans (15%) 1,000 3,300
Total 22,850 16,300

Application of funds:
Fixed Assets:
Cost 14,800 11,200
Less: Depreciation 2,700 2,000
12,100 9,20
Advances on capital A/C
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 CAP II Paper 4: Financial Management

& work in progress 1,000 200

13,100 9,400

Current Assets, Loans and Advances

Inventories 8,600 7,100
Sundry debtors 1,400 550
Cash and bank balances 850 680
Loans and advances 3,000 1,600
13,850 9,930
Less: Current liabilities 4,100 3,030
9,750 6,900
Total 22,850 16,300

Compute the following: interest cover, return on net worth, earnings per share, dividend cover.
(10 Marks) (June 2010)
Answer:
Abridged P & L A/C (year ended Ashadh 31) (Rs. in lakh)

Particulars Current year Previous year

Sales and other income 19,200 15,500

Less: Operating and other expenses 15,600 11,900
Depreciation 700 650
Earnings before interest and taxes (EBIT) 2,900 2,950
Less: Interest 1,850 1,750
1,050 1,200
Earnings before taxes 1,050 1,200
Less: Taxes 500 200
Earnings after taxes (EAT) 550 1,000
Proposed dividend (Dp) 200 400
Interest coverage ratio (EBIT/Interest) 1.57 1.69
Return on Net worth (EAT/Net worth)* 0.047 0.263
Earnings per share (EAT/no. of shares)** 1.31 3.85
Dividend cover (EAT/ Dp) 2.75 2.50

* Net worth: previous year = Rs. 3,800 (Rs. 2,600 + 1,200); current year = Rs. 11,750 (Rs.
4,200 + 7,550)
**No. of shares: previous year = 260 lakh; current year = 420 lakh.

Question No. 18
Exorbitant Ltd. has investigated the profitability of its assets and the cost of its funds. The result
of such an investigation has indicated that:
Current assets earn 1%, Fixed assets return 13%, Current liabilities cost
3%, and Average long-term funds cost 10%.
The current condensed balance sheet of the company is as follows:
Liabilities Amount (Rs.) Assets Amount (Rs.)
Long-term funds 140,000 Fixed assets 120,000
Current liabilities 20,000 Current assets 40,000
160,000 160,000
Required: (3+4.5+1.5=9 Marks)
i) Ascertain the net profitability of the firm.

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ii) The company is contemplating lowering its net working capital to Rs. 14,000 by (A)
either shifting Rs. 6,000 of its current assets into fixed assets, or (B) shifting Rs.
6,000 of its long-term funds into current liabilities. Work out the profitability for each
of these alternatives. Which do you prefer? Why?
iii) Ascertain the effects on the net profitability, if both these alternatives are
implemented simultaneously.
[December 2011]

Answer:
(i) Computation of Net profit of the Firm:
Net profit = Total profit – Total cost of financing
Total profit = Return on fixed assets + Return on current assets
Return on fixed assets = 13% of Rs.120,000 = Rs. 15,600
Return on current assets = 1% of Rs. 40,000 = Rs. 400
Total Rs. 16,000

Total cost of financing = Cost of long-term financing + Cost of current liabilities (short-
term funds)
Cost of long-term funds = 10% of Rs. 140,000 = Rs. 14,000
Cost of current liabilities = 3% of Rs. 20,000 = Rs. 600
= Rs. 14,600
Net profit = Rs. 16,000 – Rs. 14,600 = Rs. 1,400

(ii) (A) Net profit on Shift of Rs. 6,000 of current assets into fixed assets:
Total Profit
Return on fixed assets = 13% of 126,000 = Rs. 16,380
Return on current assets = 1% of Rs. 34,000 = Rs. 340
Rs. 16,720
Cost of financing:
As computed in (i) above Rs. 14,600
Net Profit = Rs. 16,720 – 14,600= Rs. 2,120

(B) Net profit on Shift of Rs. 6,000 of its long-term funds into current liabilities:
Total Profit = As computed in (i) above Rs. 16,000
Cost of financing:
Cost of long-term funds = 10% of Rs. 134,000 = Rs. 13,400
Cost of current liabilities = 3% of Rs. 26,000 = Rs. 780
= Rs. 14,180
Net profit = Rs. 16,000 – Rs. 14,180 = Rs. 1,820

The profitability of alternative (A) is more, i.e. when Rs. 6000 of current assets are
shifted to fixed assets. It is, therefore, preferable.

(iii)If both alternatives (ii) (A) and (ii) (B) are implemented simultaneously:
Total return = Rs.16,720 [as computed in (ii) (A)]
Total cost = Rs. 14,180 [as computed in (ii (B)]

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Net profit = Rs. 16,720 – Rs. 14,180 = Rs. 2,540

Net Profit will increase.

Question No. 19
Assume that RCT Limited has owner's equity of Rs. 100,000. The ratios for the firm are as
follows: (7 Marks)
Current Debt to total debt 0.40
Total Debt to owner's equity 0.60
Fixed Assets to owner's equity 0.60
Total assets turnover 2 times
Inventory turnover 8 times

Required:
Complete the following balance sheet:
Liabilities and Capital Amount Assets Amount
(Rs.) (Rs.)
Current Debt ........... Cash ...........
Long Term Debt ........... Inventory ...........
Total Debt ............ Total Current Assets ...........
Owners Equity ........... Fixed Assets ...........
Total Capital and Liabilities .......... Total Assets ...........
[June 2012]

Answer:
i. Total Debt = 0.60 X Owner's equity = 0.60X100,000 = Rs. 60,000
ii. Fixed Assets = 0.60XOwner's equity = 0.60X100,000= Rs. 60,000
iii. Total Capital = Total Debt + Owner's Equity = Rs. 60,000 + 100,000= Rs. 160,000
iv. Total assets consisting of current assets and fixed assets must be equal to Rs. 160,000
(Assets= Liabilities+ Owner's equity). Fixed Assets are Rs. 60,000, therefore, current assets
should be Rs. 160,000 - 60,000 = Rs. 100,000
v. Sales are found as follows:
Assets turnover=Sales/Assets= 2 = Sales/Rs.160,000=2
Thus, Sales= 160,000X2= Rs. 320,000
vi. Inventories are found as follows:
Inventory turnover = Sales/Inventories=Rs. 320,000/Inventories=8
Thus, Inventories=320,000/8 = Rs. 40,000
vii. Cash = Current assets - Inventories = Rs. 100,000-40,000= Rs.60,000
viii. Current Debts =0.40XTotal debts= 0.40XRs.60,000= Rs. 24,000
ix. Long term debts = Total Debts-Current Debts = Rs.60,000-Rs. 24,000= Rs.36,000
x. With all the above information, the balance sheets of RCT Ltd. would be as under:

Liabilities and Capital Amount (Rs.) Assets Amount (Rs.)

Current Debt 24,000 Cash 60,000
Long term debt 36,000 Inventory 40,000
Total Debt 60,000 Total Current Assets 100,000
Owners Equity 100,000 Fixed Assets 60,000
Total Capital and Liabilities 160,000 Total Assets 160,000

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Question No 20
The following details of XYZ Ltd. for the year ended on Ashadh end, 2068 are given below:
Operating leverage : 1.4
Combined leverage : 2.8
Fixed cost (excluding interest) : Rs. 204 thousand
Sales : Rs. 3,000 thousand
12% Debentures of Rs. 100 each : Rs. 2,125 thousand
Equity shares capital of Rs. 100 each : Rs. 1,700 thousand
Income-tax rate : 30 per cent
Required:
Calculate the P/V ratio and Earnings per share (EPS). (2.5+1.5=4 Marks)
[June 2012]

Answer:
(i) Calculation of P/V Ratio:
P/ V Ratio = Contribution / Sales X 100
Operating Leverage = C / (C – F) X 100
1.4 =C / C -204,000
1.4 (C – 204,000) = C
1.4 C – 285,600 = C
0.4 C = 285,600
Therefore, C = 285,000/0.4 = Rs. 714,000
P/V ratio = 714,000 /3,000,000 X 100 = 23.8%
(ii) Calculation of EPS:
EBT = Contribution – Fixed Cost – Interest = 714,000 – 204,000 – 255,000 = Rs.
255,000
(Interest =Rs. 2,125,000 × 12% =Rs. 255,000
EAT = EBT – Tax = 255,000 – 76,500 = Rs. 178,500
(Tax = Rs. 255,000 × 30% = Rs. 76,500)
EPS = EAT / No. of Equity Shares = 178,500/17,000 = Rs. 10.50.

Question No. 21
Following are the ratios of the business of Ganesh Traders Ltd., dealing in the machineries, for
the year ended 31st Ashadh, 2069:
Average Collection Period 3 months
Stock Turnover 1.5 times
Average Payment Period 2 months
Gross Profit Ratio 25%
Opening Receivables Rs. 600,000
Gross Profit for the year ended 31st Ashadh, 2069 amounted to Rs. 800,000.
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 CAP II Paper 4: Financial Management

Closing stock of the year is Rs. 20,000 above the opening stock.
Closing bills receivable amounted to Rs. 50,000 and bills payable to Rs. 20,000.
Required: calculate (1+3+2+2=8 Marks)
i) Sales
ii) Sundry Debtors
iii) Closing Stock
iv) Sundry Creditors
[June 2013]

Answer:
i) Calculation of Total Sales
Gross Profit Ratio =* +

25 =* +

Net Sales = Rs.32,00,000

ii) Calculation of Sundry Debtors

Average Collection Period = 3 months
Average Collection period = No of months in year/ Debtors Turnover Ratio
(DTR)
3 month =12 Months/Debtors Turnover ratio (DTR)
Debtors Turnover Ratio (DTR) = 12 Months/3 Months= 4 times
Debtors Turnover Ratio (DTR) = Net Credit Sales/ Average Accounts Receivables
4 = 32, 00,000/Average Accounts Receivable

Average Accounts Receivable= Rs.32,00,000/4 =Rs.8,00,000

(Opening Receivables + Closing Receivables)/2 = Rs.8, 00,000
(Opening Receivables + Closing Receivables) = Rs.8, 00,000×2
(6,00,000 + Closing Receivables) = Rs.16, 00,000
Closing Receivables = Rs.16, 00,000-Rs.6, 00,000
=Rs.10, 00,000
Sundry Debtors = Closing Receivables- Bills Receivables
=Rs.10, 00,000-50,000
=Rs.9, 50,000
iii) Calculation of Closing Stock
Stock Turnover Ratio (STR) = 1.5 times
STR =Cost of Goods sold/ Average stock
Cost of goods sold = Sales- Gross Profit
1.5 =24, 00,000/ Average Stock
Average Stock =24, 00,000/1.5
=Rs.16, 00,000
Average Stock = (Opening Stock +Closing Stock)/2
Rs.16, 00,000 = (Opening Stock + Closing Stock)/2
Opening Stock + Closing Stock =Rs.16, 00,000×2
Closing Stock is higher than opening stock by Rs.20, 000
Then opening Stock = (Rs.32, 00,000-Rs.20, 000)/2
Opening Stock = 31, 80,000/2=Rs.15, 90,000
Hence Closing Stock =Rs.15, 90,000+ Rs.20, 000
=Rs.16, 10,000

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iv) Calculation of Sundry Creditors

Credit Purchase = Cost of goods sold+ Closing Stock- Opening Stock
=Rs.24, 00,000+Rs.16, 10,000-Rs.15, 90,000= Rs.24,
20,000
Credit Turnover Ratio = 12 Months/ 2 months= 6 months
Credit Turnover Ratio (CTR) = Net Credit Purchase /Average Payables
Average Payables = 24, 20,000/6= Rs.4, 03,333
Creditors = Accounts Payable- Bills Payable
=Rs.403, 333-Rs.20, 000
=Rs.383, 333

Question No. 22
You are provided with the following information of Zinc Ltd.:
Fixed assets (After writing off 30% value) Rs. 1,050,000
Fixed assets turnover ratio (on cost of sales) 2
Finished goods turnover ratio (on cost of sales) 6
Gross profit rate on sales 25%
Net profit (before interest) to sales 8%
Fixed charges cover (debenture interest 7%) 8
Debt collection period 1.5 months
Materials consumed to sales 30%
Stock of raw materials (in terms of month's consumption) 3 months
Current ratio 2.4
Quick ratio 1.0
Reserves to capital ratio 0.21
Required: (10 Marks)
Use the above information and prepare the balance sheet of Zinc Ltd.
[December 2013]

Answer:
Working Notes:
1. Calculation of cost of sales
Fixed assets turnover ratio = 2 (given)
Cost of sales/Fixed assets =2
Cost of Sales/10,50,000 =2
Cost of sales =2 X 10,50,000 = Rs. 21,00,000

2. Calculation of value of finished goods:

Inventory turnover ratio =6 (given)
Cost of Sales/Finished goods =6
Rs.21,00,000/Finished goods =6
Finished goods =21,00,000/6 = Rs. 3,50,000

3. Calculation of Sales and Gross Profit

Gross Profit ratio =25% (given)
Gross Profit/sales =25%
If cost of sales i.e. Rs.21,00,000 is 75%
Sales value would be 100%
Thus sales=21,00,000 X100/75 = Rs. 28,00,000
Gross Profit would be =28,00,000-21,00,000 =Rs. 7,00,000

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4. Calculation of Net Profit:

Net Profit Ratio = 8% (given)
Net Profit/Sales = 8%
Net Profit/28,00,000 = 8%
Thus Net Profit =28,00,000 X 8% = Rs. 2,24,000

5. Calculation of interest charges

Interest service coverage ratio = 8 (given)
Net Profit before interest/ Interest =8
2,24,000/Interest =8
Interest =224,000/8=Rs. 28,000

6. Calculation of value of 7% Debentures:

Interest on debentures @ 7% =28,000
Thus value of debentures = 28,000X100/7 =Rs.4,00,000

7. Calculation of Debtors:
Debt collection period = 1.5 months (given)
Debtors/Sales X12 = 1.5
Debtors/28,00,000X12 = 1.5
Debtors =28,00,000X1.5/12 =Rs. 3,50,000

8. Calculation of Material consumption:

Material consumption =30% of sales (given)
=30% of Rs. 28,00,000 =Rs. 8,40,000

9. Calculation of Raw Materials stock:

Raw materials stock = 3 months of material consumption (given)
=8,40,000X3/12 =Rs. 2,10,000

10. Calculation of current assets and current liabilities:

Current ratio =2.4 (given)
Current assets/Current liabilities =2.4
Quick ratio =1 (given)
Liquid assets/Current liabilities =1
Thus value of stock =2.4-1 = 1.4
Value of stock =Finished goods + Raw materials
=3,50,000 + 2,10,000 =Rs. 5,60,000
Thus if 1.4 times is 5,60,000 then
1 times would be = 5,60,000/1.4
=4,00,000
Therefore, current liabilities =4,00,000
Current Assets =4,00,000X2.4 =Rs. 9,60,000

11. Calculation of Cash balance:

Cash balance = Current assets – stock of FG and RM and debtors
=960,000-(3,50,000+2,10,000+3,50,000) =Rs. 50,000

12. Calculation of capital and reserves:

Ratio of reserves to capital =0.21 (given)
If capital is 1
Reserves is 0.21
Net worth would be 1.21
Net worth =12,10,000
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 CAP II Paper 4: Financial Management

Capital is =12,10,000/1.21=Rs. 10,00,000

Reserves would be =12,10,000-10,00,000 =Rs. 2,10,000

After the above calculations, the balance sheet of Zinc Limited would be as under:

Capital and Liabilities Amount(Rs.) Assets Amount (Rs.)

Capital 10,00,000 Fixed Assets 10,50,000
Reserves 2,10,000 Current Assets
Debentures 4,00,000 Debtors 3,50,000
Current Liabilities 4,00,000 Stock (RM and FG) 5,60,000
Cash balance 50,000
20,10,000 20,10,000

Question No. 23
Using the following information, complete the Balance Sheet given below
Total Debt to Net worth :- 1:2
Total Assets Turnover :- 2
Gross Profit on Sales :- 30%
Average Collection period (assume 360 days in a year):40 days
Inventory Turnover Ratio based on cost of goods sold and yearend inventory: 3
Acid Test Ratio = 0.75
Liabilities Rs. Assets Rs.
Equity Share Capital 4,00,000 Plant and Machinery and ?
other Fixed Assets
Reserve and Surplus 6,00,000 Current Assets
Current Liabilities -? Inventory ?
- Debtors ?
- Cash ?
Total Total
(7 Marks)
[June 2014]
Answer:
Liabilities Rs. Assets Rs.
Equity Share 400,000 Plant and Machinery and 425,000
Capital other Fixed Assets
Reserve and 600,000 Current Assets
Surplus
Current 500,000 - Inventory 700,000
Liabilities
- Debtors 333,333
- Cash 41,667
Total 15,00,000 Total 15,00,000

Working Notes
1) Net Worth= Equity Share Capital + Reserve and surplus=
Rs.400,000+600,000=Rs.10,00,000

2) So, Hence,

3) Total of Balance Sheet ( on Liabilities side)= Rs.15,00,000 ( after updating working Note
2), so total Assets= Rs.15,00,000

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 CAP II Paper 4: Financial Management

4) Total Assets T/O= So, Turnover ( i.e. sales)

=Rs.15,00,000×2=Rs.30,00,000
5) Cost of Goods Sold= Sales less Gross Profit= Rs.30,00,000- 30% = Rs.21,00,000
6) Debtors=Sales × =Rs.30,00,000×

7) So, Closing Inventory=

8)

So Cash=Rs.41,667
Note: Quick Liabilities= Current Liabilities in this question, since there is no Bank Overdraft in
Balance Sheet format.

Question No. 24
Ace One Group P. Ltd., renowned for production and marketing of "Edge" brand leather
products, has wholly owned two companies Ace P. Ltd. at Sunsari and One P. Ltd. at
Bhairahawa and are led by highly professional executive officers. These officers are entrusted
for the overall business growth of their respective company and the Group has implemented
lucrative bonus scheme that takes into consideration the performance measure of Return on
Capital Employed (ROCE).
The results of the two companies and of the group for the year ended on Ashadh 32nd, 2071 are
as follows:
Ace. P. Ltd. One P. Ltd. Ace One
(Rs.' 000) (Rs.' 000) Group P. Ltd.
(Rs.' 000)
Revenue 200,000 220,000 420,000
Cost of sales 170,000 160,000 330,000
Gross profit 30,000 60,000 90,000
Administration costs 10,000 30,000 40,000
Finance cost 10,000 - 10,000
Pre-tax profit 10,000 30,000 40,000
Non-current assets:
Original cost 1,000,000 1,500,000 2,500,000
Accumulated depreciation 590,400 1,106,784 1,697,184
Net book value 409,600 393,216 802,816
Net current assets 50,000 60,000 110,000
Total Assets 459,600 453,216 912,816
Non-current borrowings 150,000 - 150,000
Shareholders‘ funds 309,600 453,216 762,816
Capital and Liabilities 459,600 453,216 912,816
Required: (3+3=6 Marks)
Calculate Return on Capital Employed, Pre-Tax Profit Margin and Asset
Turnover Ratio of Ace P. Ltd. and One P. Ltd.
[July 2015]

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 CAP II Paper 4: Financial Management

Answer:
S. Company Ace P. Ltd. One P. Ltd.
No.
1. Return on Capital Employed = 10M/459.6M = 30M/453.216M
Pre-Tax Profit / (Non-Current Borrowings + = 2.18% = 6.62%
Shareholders' Fund)
OR
EBIT
(Non currentBorrowing+Shareholders Fund = 4.35%
2. Pre-Tax Profit Margin = 10M/200M =30M/220M
Pre-Tax Profit / Revenue = 5.0% = 13.64%

3. Asset Turnover = 200M/459.6M = 220M/453.216M

Revenue / Total Asset = 0.435 times = 0.485 times

("M" stands for Rs. In Million)

Question No. 25
MNP Limited has made plans for the year 2015-16. It is estimated that the company will employ
total assets of Rs. 25 lakh. Thirty percent of the assets would be financed by debt at an interest
rate of 9% p.a. The total direct cost for the year are estimated at Rs. 15 lakh and all other
operating expenses are estimated at Rs. 240,000. The sales revenue are estimated at Rs.
2,250,000. The tax rate is 25%.
Required: Calculate (3 Marks)
i) Return on assets
ii) Assets turnover
iii) Return on equity
[December 2015]

Answer:
Calculation of net profit
Rs.
Sales revenue 2,250,000
Direct costs 1,500,000
Gross profit 750,000
Operating expenses 240,000
EBIT 510,000
Interest (9% x 7,50,000) 67,500
EBT 442,500
Taxes at 25 % 110,625
PAT 331,875

(i) Return on Assets = EBIT (1- t) / Total Assets

= (510,000 x 0.75) / 2,500,000
=15.30 %
Alternate: EBIT/Total Assets=20.40%

(ii) Assets Turnover ratio = Sales/ assets

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 CAP II Paper 4: Financial Management

= 2,250,000/2,500,000 = 0.9 times

(iii) Return on Equity = PAT/Equity
= 331,875/ (2,500,000-750,000)
= 331,875/1,750,000
=18.96%

Question No. 26
Following are the financial details of two farmers Mr. M and Mr. N, who belongs to the same
area at the end of financial year 2071-72:
Income Statement
Rs. in Lakhs
M N
Gross Revenue (Value from farm 125 80
production)
Cost of Production 64 56
Gross Farm Income 61 24
Operating Expense attributable to
agriculture 24 12
Interest Expense on Agricultural Loans 4 1
Net Farm Income from Operations 33 11
Tax - -
Net Farm Income 33 11
Balance Sheet
Rs. in Lakhs
M N
Assets
Biological Asset (harvested paddy) 49 22
Non Current Asset 75 40
Current Asset 9 3
Total Assets 133 65
Previous Year Total Assets 97 48

Equity and Liabilities

Equity 63 37
Non Current Liability (full debt) 14 8
Current Liability (80% renewable debt) 56 20
Total Equity and Liabilities 133 65
The increase in total assets of Mr. M owed to increase in non current asset (80% of total assets
increment), whereas increase in total assets of Mr. N owed to increase in biological asset (75%
of total asset increment). Furthermore, the current asset of Mr. M and Mr. N grew by Rs.2 lakhs
and Rs.1 lakh respectively.
Required (2+2+4=8 Marks)
i) Calculate profit margin ratio, asset turnover and debt-equity ratio.
ii) Calculate return on equity using Du Pont formula.
iii) Analyse the ratios from calculation parts (i and ii) with reference to the information given
above and make apt suggestions. You may consider suitable assumptions / calculations and
subsidies on interest rates and insurance for your justification.
[June 2016]

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 CAP II Paper 4: Financial Management

Answer 26
i. Calculation of Profit Margin Ratio, Asset Turnover and Debt-Equity Ratio
Mr. M Mr. N
Net Farm Income (Rs. in Lakh) A 33 11
Gross Revenue (Value from farm production) (Rs. in Lakh) B 125 80
Profit Margin Ratio A/B 26.40% 13.75%

Gross Revenue (Value from farm production) (Rs. in Lakh) C 125 80

Average Farm Assets (Rs. in Lakh) D 115 56.5
Asset Turnover C/D 1.09 1.42

Debt (Full Debt + Renewable Debt) E 59 24

Equity F 63 37
Debt - Equity Ratio E/F 0.93 0.65
ii. Calculation of Return on Equity using Du Pont formula
Mr. M Mr. N

Profit Margin Ratio G 26.40% 13.75%

Asset Turnover H 1.09 1.42

Calculation of Equity Multiplier

Average Farm Assets (Rs. in Lakh) I 115 56.5
Equity J 63 37
Equity Multiplier K(I/J) 1.83 1.53

Return on Equity GHK 52.66% 29.87%

iii. The profit margin ratio of Mr. M is very strong (26.40%) vis-à-vis Mr. N who has
almost of half at 13.75%; however the asset turnover of Mr. M is lower than the Mr.
N (1.09 versus 1.42). The equity multiplier and debt equity ratio of the Mr. M is
higher than the Mr. N indicating that Mr. M has higher financial leverage ratios than
Mr. N.
As per given information, Mr. M has acquired non-current assets of Rs.28.8 lakhs
(Rs.36 lakhs  80%), whereas Mr. N has acquired non-current assets of mere Rs.3.25
lakhs (Rs.17 lakhs  25% - Rs.1 lakh). This resembles that Mr. M is expanding its
business the consequences of which may be evident in the years to come when he
uses his infrastructure at the optimum.
On the contrary, the increment of biological asset of Mr. N is Rs.12.75 lakhs (Rs.17
lakhs  75%) as against Rs.5.20 lakhs (Rs.36 lakhs  20% - Rs.2 lakhs) of Mr. M.
The inventory turnover ratio of Mr. M and Mr. N is 1.31 and 2.09 times respectively
which coupled with asset turnover ratio reflects that Mr. N had better performance
during the year and was more efficient in terms of infrastructures.
The debt equity ratio of both farmers is below 1 and therefore can be increased
ideally to the extent of 2:1 in order to improve their profitability ratios giving due
consideration to the subsidies available to the farmers on interest rates (as low as 5%
on agricultural credit) and crop insurance (50% waiver).
Considering the asset and inventory turnovers, which seem quite low assuming that
there is no seasonal storing at the end of the financial year, both need to improve
their production efficiency or price levels. In addition, they may reduce biological
assets through regular disposal thereby reducing financing and inventory handling

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 CAP II Paper 4: Financial Management

cost and also focusing to integrate the paddy farming with animal husbandry, dairy
farming, beekeeping, vegetable farming etc.
Working Note:
1. Calculation of Inventory Turnover Ratio
Cost of production 64 56
Biological Asset 49 22
Inventory Turnover 1.31 2.55

Question No. 27
The Capital structure of the company is as below:

Particulars Amount in (Rs.)

Equity share capital of Rs.10 each 8,00,000
8% preference share capital of Rs.10 each 6,25,000
10% Debenture of Rs.100 each 4,00,000
Total 18,25,000
Additional information:
Profit after tax (tax rate 30%) Rs. 1,82,000
Operating expenses (including depreciation Rs. 90,000) being 1.50 times of EBIT. Assume all
operating expenses excluding depreciation are variable.
Equity dividend paid 15%
Market price per equity share Rs.20
Required: (2+2+2+2=8 Marks)
iii) Operating and financial leverage
iv) Cover for the preference and equity share of dividends
v) The earning yield and price earnings ratio
vi) The net fund flow
[June 2016]

Answer:
Working Notes:

Net profit after tax Rs. 1,82,000

Tax @30% 78,000
Earning Before tax 2,60,000
Interest on Debenture@10% 40,000
EBIT 3,00,000
Operating Expenses 1.5 times 4,50,000
Sales 7,50,000
(i) Operating Leverage= Contribution/EBIT=(7,50,000-3,60,000)/3,00,000=1.30
times
Financial Leverage = EBIT
EBIT-Int- PD
1-Tax
= 3,00,000
3,00,000-40,000- 5,000
1-0.30

= 1.59 times

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 CAP II Paper 4: Financial Management

(ii) Preference Dividend Cover = PAT/Preference share dividend

= Rs. 1,82,000/(6,25,000 x 8%) = 3.64 times
Equity dividend cover = (PAT – Preference share dividend)/equity dividend
=(Rs.1,82,000 – 50,000)/ (8,00,000 x15%)=1.10 times
(iii) Earning yield = (EPS/ Market price) x 100 = [(1,32,000/80,000)/20] = 8.25%
Price Earning ratio = Market price/EPS = 20/1.65=12.12 times
(iv) Net Fund flow = Net profit after tax + depreciation – total dividend
= 1,82,000 + 90,000 – (50,000 + 1,20,000)
= 2,72,000 – 1,70,000
= Rs. 1,02,000

Question No. 28
The balance sheet of ABC company is given below:
(Rs. in lakh)
Liabilities Amount Assets Amount
Equity share capital 250 Fixed assets 400
General reserve 280 Investment 50
P&L A/c current year 30 Stock 460
Secured loans-long term 300 Debtors 460
Secured loans-short term 360 Cash in hand 10
Creditors 150 Miscellaneous
Other liabilities 30 expenditure (not written
off) 20
1400 1400
Additional information:
i) From the profit and loss account Rs. 90 lakhs was transferred to general
reserve during the year.
ii) Interest cost amounted to Rs. 120 lakhs.
iii) Income tax is levied at the rate of 40%
Required: Calculate (5 Marks)
(i) Debt equity ratio (ii) Current ratio (iii) Interest coverage ratio.
[December 2016]
Answer:
Current Assets Rs. 930
Current Ratio= ---------------------------- = ----------------------------= 1.72 times
Current Liabilities Rs. 540

Debt Rs. 300

Debt Equity Ratio= -------------- = -------------- = 0.56 timrs
Equity Rs. 540

EBIT Rs. 320

Interest Coverage Ratio = -------------- = -------------- = 2.67 times
Interest Rs. 120

Working Notes:
Current Assets=Stock +Debtors+ Cash = 460+460+10= 930
Current Liabilities= Short term loan+ Trade Credit + Other Liabilities= 360+150+30= 540
Debt= Term loan=300
Equity=Capital+ Reserve+ P/L-Mis. Expenses=250+280+30-20=540
EBIT=P&L A/C+ GR transfer +Interest + tax
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 CAP II Paper 4: Financial Management

=30+90+120+(30+90)×40/60=240+80=320

Question No. 29
Nepal Ltd. provides you the following information:
Gross profit ratio 40%, Net profit (after tax) ratio 12%, Operating profit ratio 30%, 15% Debt-
Equity ratio 2:1, Tax rate 50%, Shareholder‘s fund Rs. 400,000.
Required: (5 Marks)
Calculate (i) Gross profit (ii) Operating expenses (iii) Interest coverage ratio, (iv) Return on
capital employed, (v) Return on shareholders‘ funds.
[June 2017]

Answer:
15% Debt = Rs. 400,000 × 2 = Rs. 800,000
Interest on Debt = 15% × 800000 = Rs. 120,000

Assume the sales be x;

Sales X
Less: Cost of Goods Sold 0.6x
Gross Profit 0.4x
Less: operating expenses 0.1x
Operating profit @ 30% 0.3x
Less: Interest on long term debt 120,000
Profit before tax 0.3x-Rs 120,000
Less: Tax 50%(0.3x-120000)
Profit after tax 0.15x-60,000
Net profit ratio = Profit after tax/Net Sales x 100%
12% = (0.15x-60,000)/x
0.15x-0.12x = 60,000
x = 60,000/0.03
Sales = Rs. 20,00,000
Gross Profit = 40% of Rs 20,00,000
= Rs 800,000
Operating Expenses = 10% of Rs 20,00,000 = Rs 200,000
Interest coverage ratio = Profit before interest and tax/Interest on long term debt
=(0.3×2,000,000)/120,000 = 5 times
Return on Capital Employed=Profit before interest and tax/Capital employed x
100%
=30% of 20,00,000 X 100 = 50%
12,00,000
Return on Shareholders fund= Profit after interest and tax/Shareholders
fund X 100%
= Rs. 240,000/400,000 x 100 = 60%
Note:
Profit after interest and Tax = 50%[0.3x20,00,000-120,000)
=50%[600,000-120,000]
= 240,000
Question No. 30
X Co. has made plans for the next year. It is estimated that the company will employ total assets
of Rs. 8,00,000; 50 percent of the assets being financed by borrowed capital at an interest cost of
8 percent per year. The direct costs for the year are estimated at Rs. 4,80,000 and all other
operating expenses are estimated at Rs. 80,000. The goods will be sold to customer at 150
percent of the direct costs. Tax rate is 25 percent.
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 CAP II Paper 4: Financial Management

Required: Calculate: (8 Marks)

i) net profit margin
ii) return on assets
iii) assets turnover
iv) return on owners' equity
[December 2017]

Answer:
Calculation of Net profit

Particulars Amount ( Rs.)

Sales (150% of Rs. 4,80,000) 7,20,000
Direct Costs 4,80,000
Gross profit 2,40,000
Operating Expenses 80,000
Profit before interest and tax 1,60,000
Interest charges (8% of Rs.4,00,000) 32,000
Profit before tax 1,28,000
Taxes @ 25% 32,000
Net profit after tax 96,000
(i) Net profit Margin = Profit after tax/Sales=96,000/7,20,000= 13.33%
(ii) Return on Assets = (EBIT -Tax paid)/Assets= (1,60,000-32,000)/8,00,000=16% Or
EBIT/Total Assets = 20% Or PAT/Total Assets = 12%
(iii) Assets Turnover= Sales/Assets=7,20,000/8,00,000=0.9 times
(iv) Return on Equity=Net profit after tax/Equity=96,000/4,00,000=24%

Question No. 31
The net sales of A Ltd. is Rs. 30 crores. Earnings before interest and tax of the company as a
percentage of net sales are 12%. The capital employed comprises Rs. 10 crores of Equity Shares,
Rs. 2 crores of 13% Cumulative Preference Share and 15% Debentures of Rs. 6 crores. Income
tax rate is 40%.
Required: (5 Marks)
Calculate the return on equity for the company and show segment decomposition of ROE due to
the presence of Preference Share Capital and Debentures.
[December 2017]

Answer:
Calculation of Return on Equity [ROE]
[Figures in Rs. Crore]
Sales 30
Earnings Before Interest and Tax [12% of Sales] 3.6
Less: Interest [15% on NRs 6 Crore] 0.9
Earning Before Tax 2.7
Less: Tax@ 40% 1.08
Earning After Tax 1.62

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 CAP II Paper 4: Financial Management

Less: Preference Dividend 0.26

Earning for Equity Holders 1.36
Return on Equity ( 1.36/30) 13.60%

Capital Employed = Equity Share Capital + Preference Share Capital + Debt

= 10+2+6
= Rs.18 Crore
Post Tax Return on Investment = [EBIT×(1-Tax)/Capital Employed]
= [3.6×(1-0.4)/18]
= 12%
Segment Decomposition of ROE may be analyzed as below;
ROE = Post Tax ROI + [Post Tax ROI- Cost of Preference Share]×[Preference Share/Equity] +
[Post Tax ROI- Post Tax Cost of Debt]×[Debt/Equity]
= 12% + [12%-13%]×[2/10]+[12%-9%]×[6/10]
=12% -0.20% + 1.8%%
=13.60%
The negative 0.2% and Positive 1.8% is the segment of ROE caused by presence of Preference
Share Capital and Debenture in the Capital Structure.

Post Tax Cost of Debt = Coupon Rate×[1-Tax Rate]

= 15%×[1-0.40]
=9%

Question No. 32
Following are the ratios of trading activities of East West Ltd. :-
Average collection Period 3 months Opening trade receivables Rs. 600,000
Inventory turnover ratio 1.5 times Gross profit Rs. 800,000
Average payment period 2 months Opening inventory Rs. 1,590,000
Gross profit ratio 25% Closing bills receivable Rs. 50,000
Closing bills payable Rs. 20,000

All sales are made in credit.

Required: (1+3+3=7 Marks)
i) Calculate revenue from operations
ii) Calculate closing trade debtors
iii) Calculate closing inventory
[June 2018]
Answer:
i) Revenue from operations

Gross Profit Ratio = Gross Profit * 100/Revenue from operation

25 = 800,000*100/ Revenue from operation
= Rs. 3,200,000

ii) Trade debtors

Average Colletion Period = 12/Debtor turnover ratio

3 months = 12/Debtor turnover ratio
So, Debtor turnover ratio = 4 times
Debtor turnover ratio = Credit Revenue/ Average trade receivables
4 = 3200,000/ Average trade Receivables
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Average trade receivables = Rs. 800,000

(Opening + Closing Trade receivables)/2 = Rs. 800,000
600,000+Closing Receivables = 1600,000
Closing trade receivables = Rs. 1000,000
Closing trade debtors = Rs. 1000,000 – Bills receivables
= Rs. 950,000

iii) Closing inventory:

Cost of goods sold = Revenue – Gross Profit
= 3200,000-800,000
= Rs. 2,400,000
Inventory turn over ratio = Cost of Goods Sold/Average inventory
1.5 = Rs. 2,400,000/Average Inventory
Average inventory = Rs. 1,600,000
(Opening +Closing inventory)/2 = Rs. 1,600,000
Closing inventory = Rs. 1,610,000

Question No. 33
The assets of Sona Ltd. consist of fixed assets and current assets, while its ratio
of other current liabilities and bank credit comprise of 2:1.

Following information are also available:

Share capital Rs. 575,000

Working capital (CA - CL) Rs. 150,000
Gross margin 25%
Inventory turnover 5 times
Average collection period 1.5 months
Current ratio 1.5:1
Quick ratio (Quick assets/ Current liabilities.) 0.8: 1
Reserves & surplus to Bank & cash 4 times

Required: (7 Marks)

Prepare the balance sheet of the company as on 32nd Ashadh 2075.

[December 2018]
Answer:
Balance Sheet of Sona Ltd. as on 32nd Aahadh, 2075

Liabilities & Capital Amount (Rs.) Assets Amount (Rs.)

Share capital 575,000 Fixed assets (Balancing 685,000
figure)
Reserve & surplus 260,000 Current assets:
Current Liabilities: Inventories 210,000
Bank credit 100,000 Debtors 175,000
Other current liabilities 200,000 Cash & bank balance 65,000
Total 1,135,000 Total 1,135,000

Working Note:
1. Current Ratio = Current Assets/ Current Liabilities
1.5 = CA/CL
CA = 1.5CL
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Working Capital = CA – CL
150,000 = 1.5 CL – CL
0.5 CL = 150,000
CL = 150,000/0.5 = Rs. 300,000
CA= 1.5*300,000 = Rs. 450,000
2. Other Current Liabilities (OCL)/ Bank Credit (BC) = 2/1
OCL = 2 BC
Current Liabilities = OCL + BC
300,000 = 2BC + BC
BC = Rs. 100,000
OCL = Rs. 200,000

3. Quick Ratio = Quick Assets/ Current Liabilities

0.80 = (Current Assets -Stock)/CL
0.80 = (450,000 – Stock)/300,000
Stock = 450,000 – 240,000 = Rs. 210,000

4. Inventory Turnover = Cost of Goods Sold (COGS)/ Stock

5 = COGS/210,000
COGS = Rs. 1,050,000

5. Gross Profit = 25% of Sales

Gross Profit = Sales- COGS
0.25 Sales = Sales – COGS
0.75 Sales = COGS
Sales = 1,050,000/0.75 = Rs. 1,400,000
6. Debtors T.O = 12/ACP
12/1.5 =8
Debtors = Sales/ Debtors turnover = 1,400,000/8 = Rs. 175,000

7. Bank & cash = CA – Debtors – Stock

= 450,000 -175,000 – 210,000
= Rs. 65,000

8. Reserve & surplus/ Bank & cash = 4

Reserve & surplus = 4 ×Bank & cash = 4*65,000 = Rs. 260,000

Question No. 34
Following is the abridged balance sheet of Everest Co. Ltd. as at 31/03/2074:
Capital & labilities Rs. Assets Rs.
Paid up share capital 500,000 Freehold property 400,000
Profit and loss a/c 85,000 Plant & machinery 250,000
Current liabilities 200,000 (-) Depreciation 75,000 175,000
Stock 105,000
Debtor 100,000
______ Bank 5,000
785,000 785,000
The following information is also available:
i) The composition of total of the capital and liabilities side of the company‘s balance sheet as
at 32/03/2075 (the paid up share capital remaining the same as of 31/03/2074) was:
Share capital = 50% Profit & loss a/c = 15%
7% Debenture = 10% Creditors = 25%
The debenture were issued on 01/04/2074, Interest being paid on half yearly basis.

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ii) During the year ended on 32/03/2075, additional plant & machinery had been bought and a
further Rs. 25,000 depreciation written off. Freehold property remained unchanged. Total
fixed assets constituted 60% of total of Fixed assets and Current assets.
iii) Current ratio was 1.6 times and Quick ratio was 1 time.
iv) Debtor (4/5th of Quick assets) to sales ratio revealed a credit period of 2 months.
v) Gross Profit was 15% and Return on net worth was 10%. Ignore tax.
Requred: [8 Marks]
Prepare Protit & loss account and Balance sheet of the company as at
32/03/2075.
[June 2019]
Answer:

Balance sheet of Everest Co. Ltd as on 32/03/2075

Liabilities & Capital Amount(Rs.) Assets Amount(Rs.)
Share Capital 500,000 Freehold Property 400,000
Profit & Loss A/C 150,000 Plant & Machinery 300,000
7% Debenture 100,000 Less: Depreciation (100,000) 200,000
Creditors 250,000 Current Assets:
Stock 150,000
Debtors 200,000
Cash & Bank 50,000
Total 1,000,000 Total 1,000,000
Profit & Loss Account for the year ended 32/03/2075
Particulars Amount(Rs.) Particulars Amount(Rs.)
To Opening Stock 105,000 By Sales 1,200,000
To Purchase (Bal. figure) 1,065,000 By Closing Stock 150,000
To Gross Profit 180,000
1,350,000 1,350,000

To Expenses (Bal. Figure) 83,000 By Gross Profit 180,000

To Debenture Interest 7,000
To Depreciation 25,000
To Net Profit 65,000

180,000 180,000
Working Notes:
i) Total of the liabilities side = Rs. 500,000/ 0.5 = Rs. 1,000,000
ii) Profit & Loss a/c = 15% of Rs. 1,000,000 = Rs. 1,500,000
iii) 7% Debenture = 10% of Rs. 1,000,000 = Rs. 100,000
iv) Creditors = 25% of Rs. 1,000,000 = Rs. 250,000
v) Net Fixed Assets = 60% of Rs. 1,000,000 = Rs. 600,000
vi) Net Plant & Machinery = Rs. 600,000 – Rs. 400,000 = Rs. 200,000
vii) Gross Plant & Machinery = Rs. 200,000 + (Rs. 75,000 + Rs. 25,000) = Rs. 300,000
viii) Current Assets = Rs. 250,000 x 1.6 = Rs. 400,000
ix) Liquid Assets = Rs. 250,000 x 1 = Rs. 250,000
x) Stock = Rs. 400,000 – Rs. 250,000 = Rs. 150,000
xi) Debtors = Rs. 250,000/ 5 x 4 = Rs. 200,000
xii) Sales = Rs. 200,000 x 12/2 = Rs. 1200,000
xiii) Gross Profit = 15% of Rs. 1,200,000 = Rs. 180,000
xiv) Net worth = Rs. 500,000 + Rs. 150,000 = Rs. 650,000
Net Profit = 10% of Rs. 650,000 = Rs. 65,000

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Chapter 7:

Portfolio Managment

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Question No: 1
Distinguish between Systematic Risk and Unsystematic Risk (December 2010) (2.5 Marks)

Answer:
Systematic Risk and Unsystematic Risk. – Systematic risk is the variability of a security's return
with that of the overall stock market. Risks of inflation, Interest Rate Risk are example of this
kind of risk. This type of risk affects all firms in the economy and a particular firm cannot avoid
it. This is also known as Unavoidable Risk.
Unsystematic risk is the amount of a stock's variance unexplained by overall market movements.
It can be diversified away; hence it is known as Avoidable Risk. A strike may affect only one
company; a new competitor may begin to produce essentially the same product; a technological
breakthrough can make an existing product obsolete. However, by diversification this kind of
risk can be reduced and even eliminated if diversification is efficient.

Question No: 2
Explain briefly two basic principles of effective portfolio management. (7 Marks)
(June 2010)

Answer:
The two basic principles of effective portfolio management are:
i. Effective investment planning for the investment in securities by considering the following
factors.
a. Fiscal, financial and monetary policies of the Government and Central Bank.
b. Industrial and economic environment and its impact on industry prospects in terms of
prospective technological changes, competition in the market, capacity utilisation with
industry and demand prospects etc.
ii. Constant review of investment: Portfolio managers are required to review their investment
in securities on a continuous basis to indentify more profitable avenues for selling and
purchasing their investment. For this purpose, they will have to carry out the following
analysis:
a. Assessment of quality of management of the companies in which investment has already
been made or is proposed to be made.
b. Financial and trend analysis of companies' balance sheets / profit and loss accounts to
identify sound companies with optimum capital structure and better performance and to
disinvest the holding of those companies whose performance is found to be slackening.
c. The analysis of securities market and its trend is to be done on a continuous basis.

Question No: 3
Describe the term ―beta co-efficient‖ as used in the portfolio theory. Explain what does the value
of beta of 1, less than 1 and more than 1 signify. (5+2=7 Marks) [June 2011]

Answer:
Under capital asset pricing model (CAPM), the risk of an individual security can be estimated.
The market related risk, which is also called ‗systematic risk‘ is unavoidable even by
diversification of the portfolio. The systematic risk of an individual security is measured in
terms of its sensitivity to market movements which is referred to as security‘s beta.
Beta coefficient is a measure of the volatility of stock price in relation to movement in stock
index of the market. Thus, beta is the index of systematic risk. The beta factor of the market as a

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whole is 1.0. A beta of 1.0 of individual security indicates the average level of risk as compared
to the market.
Mathematically, the beta coefficient of a security is the security‘s covariance with the market
portfolio divided by the variance of the market portfolio. Symbolically,

βi = Cov im. = σi σm Cor im, where

Varm σm2
βi = Beta of an individual security
Cov im. = Covariance of returns of individual security with the market portfolio
Varm = Variance of returns of market portfolio (σm2)
Cor im = Correlation coefficient between the return s of individual security and the market
portfolio
σi = Standard deviation of returns of individual security
σm = Standard deviation of returns of market portfolio
The degree of volatility can be expressed as follows:
 If beta is 1, then it has the same level of risk profile as the market as a whole.
 If the beta is less than 1, it is not as sensitive to systematic or market risk as the average
investment.
 If beta is more than 1, it is more sensitive to the market risk than the average investment.

Question No. 4
Discrete Probability Distribution and Continuous Probability Distribution [June 2011]
(2.5 Marks)

Answer:
In case of ‗Discrete Probability Distribution‘ the number of possible outcome is limited or finite.
Suppose, if we assume that there will be only three states of economy; recession, normal or
boom, this will be the example of discrete probability distribution.
In other hand, if we assume that there will be unlimited or infinite number of possible outcomes
that will be the case of continuous probability distribution. With continuous distribution, it is
more appropriate to ask what the probability is of obtaining at least some specified rate of return
than to ask what the probability is of exactly that rate.

Question No. 5
Assumptions of Capital Asset Pricing Model (CAPM) [December 2011] (2.5 Marks)

Answer:
The capital asset pricing model (CAPM) is based upon the following assumptions:
i. The investors are basically risk averse and diversification is needed to
reduce the risk.
ii. All investors want to maximize the wealth and therefore choose a
portfolio solely on the basis of assessment of risk and return.
iii. All investors can borrow or lend an unlimited amount of funds at risk-
free rate of interest.
iv. All investors have identical estimates of risk and return of all securities.
v. All securities are perfectly divisible and liquid and there is no transaction
cost or tax.

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vi. The security market is efficient and purchases and sales by a single
investor can not affect the prices which also mean that there is perfect
competition in the market.
vii. All investors are efficiently diversified and have eliminated the
unsystematic risk. Thus, only the systematic risk is relevant in the
determination of estimated return.

Question No. 6
Asset Beta Vs. Equity Beta [June 2011] (2.5 Marks)

Answer:
Assets of a leveraged firm are financed by debt and equity. Therefore, the assets beta should be
the weighted average of the equity beta and the debt beta. For an unlevered (all equity) firm, the
asset beta and the equity beta would be the same. Debt is less risky than equity. Hence the beta
of debt will be lower than the equity beta. In case of the risk free debt, beta will be zero. For a
levered firm, the proportion of equity will be less than 1. Therefore, the beta of asset will be less
than the beta of equity.
There is also a linear relationship between the equity beta and the financial leverage. As the
financial leverage increases, the equity beta also increases. The equity beta is equal to the asset
beta if debt is zero.

Question No. 7
Risk aversion Vs. Risk diversification [June 2012] (2.5 Marks)
Answer:
Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff
rather than another bargain with a more certain, but possibly lower, expected payoff. For
example, a risk-averse investor might choose to put his or her money into a bank account
with a low but guaranteed interest rate, rather than into a stock that may have high returns,
but also has a chance of becoming worthless. An investor is said to be risk averse if he
prefers less risk to more risk, all else being equal.
Risk Diversification refers to minimization of risk which an investor may choose by investing in
various types of securities. An investor may not want to concentrate his investment in a single
risky security, as a result of which he may choose to invest in various other securities to
minimize his level of risk and harmonize his returns.

Question No: 8
Consider the following information:
Stock A, Beta >1.
Stock B, Beta =1
Stock C, Beta <1.
Required: (2+1=3 Marks)
i) Explain the relation between the above stocks and their market.
ii) Explain, if you are a risk averter, in which stock would you invest.
[December 2012]

Answer:
i) The beta factor is a measure of a stock‘s volatility in terms of market risk. Therefore,

Stock A:
Where Beta> 1, the shares are described as aggressive; they outperform the market. This means
they give a bigger return than the market when the market return is positive and a bigger loss
than the market, when the market return is negative.
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Stock B:
Where Beta= 1, the shares are described as neutral; their returns are in line with the average
return of the stock market.

Stock C:
Where Beta< 1, the shares are described as defensive; they are less risky than the market
generally.

ii) A risk averter would generally invest in those stocks which are less risky than that of
market. Therefore, Stock C would be the choice for risk averters.

Question No. 9
The Risk- Return Trade Off [December 2012] (2.5 Marks)

Answer:
This principle steps that potential return rises with an increase in risk. Low levels of uncertainty
(low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-
risk) are associated with high potential returns. According to the risk-return tradeoff,
invested money can render higher profits only if it is subject to the possibility of being lost.
Because of the risk-return trade off, you must be aware of your personal risk tolerance when
choosing investments for your portfolio. Taking on some risk is the price of achieving returns;
therefore, if you want to make money, you can't cut out all risk. The goal instead is to find an
appropriate balance - one that generates some profit, but still allows you to sleep at night.

Question No. 10
Capital Assets Pricing Model Vs. Arbitrage Pricing Model [December 2012] (2.5 Marks)
Answer:
The capital asset pricing model (CAPM) states that the return on a stock depends on whether
the stock's price follows prices in the market as a whole. CAPM is useful because it is a
statistical representation of past risk. Even though past performance is no guarantee for future
success there is a higher probability that a consistent past performer will continue to do well
over a new untested entry in the market.
Arbitrage pricing model (APM) holds that the expected return of a financial asset is largely
based on its "beta". Beta is the measure of the relationship between company related factors
which influence financial performance and the overall market in which the latter competes.
Typically a company which has a beta of one will reflect the market whereas a beta score of
0.75 means that a company will move up or down to the extent of 75 per cent of the
corresponding market movement.

Question No. 11
Security market line [June 2013] (2.5 Marks)

Answer:
Security market line (Beta function) is simply an index of Systematic Risk which cannot be
reduced by Portfolio Diversification. The slope of the SML indicates the change in excess return
of the stock over the change in excess return on the market portfolio. The Beta of the portfolio
is simply a weighted average of the individual stock Betas of the portfolio. It shows the
sensitivity of return on the stock to change in return on market portfolio.
Results of Beta Function:
 If the Beta=1.0, this implies that the excess return for the stock varies proportionally with the
excess return for the market portfolio.

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 If the Beta>1.0, this implies that the excess return for the stock varies more than
proportionally with the excess return for the market portfolio. (Aggressive)

 If the Beta<1.0, this implies that the excess return for the stock varies less than
proportionally with the excess return for the market portfolio. (Defensive).

Question No. 12
Risk and Uncertainty [December 2013] (2.5 Marks)

Answer:
In common parlan, the terms ‗Risk‘ and ‗Uncertainty‘ have synonymous meaning. However,
they differ from each other.
Risk may be defined as ―the chance of future loss that can be foreseen‖. In other word, in case
of risk an estimate can be made about the degree of happening of the loss. This is usually done
by assigning probabilities to the risk on the basis of past data and the probable trends.
Uncertainty may be defined as‖ the unforeseen chance for future loss or damages.‖ In case of
uncertainty, since the firm cannot anticipate the future loss, and hence it cannot directly deal
with it in its planning process, as is possible in the case of risk. For example, a firm can not
foresee the loss which may be due to destruction of its plant in account of earthquake.

Question No. 13
Systematic risk and Unsystematic risk [December 2014] (2.5 Marks)

Answer:
Systematic Risk Unsystematic Risk
A part of the risk that arises on account of the
A part of the risk that arises from
economy-wide uncertainties and the tendency of uncertainties which are unique to individual
individual securities to move together with securities, and which are diversifiable if
changes in the market. This part of risk cannotlarge number of securities is combined to
be reduced through diversification, and it is form well-diversified portfolios. The
called systematic or market risk. unique risks of individual securities in a
portfolio cancel out each other. This part of
Investors are exposed to market risk even when the risk can be totally reduced through
they hold well-diversified portfolios of the diversification and is called unsystematic or
securities. unique risk.

Examples of systematic risk are: Examples of unsystematic risk are:

 The Government changes the interest rate  workers declare strike in a company
policy  the R&D expert of the company
 The corporate tax rate is increased leaves
 The Government resorts to massive  a formidable competitor enters the
deficit financing market
 The inflation rate increases  the company loses a big contract in
 The Nepal Rastra bank promulgates a a bid
restrictive credit policy  the company makes a breakthrough
in process innovation
 the Government increases custom
duty on the material used by the
company
 the company is not able to obtain
adequate quantity of raw materials
from the suppliers.

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Question No. 14
Risk and Uncertainty [June 2016] (2.5 Marks)

Answer:
In common parlance, the terms Risk and Uncertainty have synonymous meaning. However, they
differ from each other. Risk may be defined as the chance of future loss that can be foreseen. In
other word, in case of risk an estimate can be made about the degree of happening of the loss.
This is usually done by assigning to the probabilities of risk on the basis of past data and the
probable trends.
Uncertainty may be defined as ―the unforeseen chance for future loss or damages.‖ In case of
uncertainty, since the firm cannot anticipate the future loss, and hence it cannot directly deal
with it in its planning process, as is possible in the case of risk. For example, a firm cannot
foresee the loss which may be due to destruction of its plant in account of earthquake.

Question No. 15
Systematic risk and Unsystematic risk [December 2016] (2.5 Marks)

Answer:
Systematic Risk: Systematic risk refers to the variability of return on stocks or portfolio
associated with changes in return on the market as a whole. It arises due to risk factors that
affect the overall market such as changes in the nations‘ economy, tax reform by the
Government or a change in the world energy situation. These are risks that affect securities
overall and, consequently, cannot be diversified away. This is the risk which is common to an
entire class of assets or liabilities. The value of investments may decline over a given time
period simply because of economic changes or other events that impact large portions of the
market. Asset allocation and diversification can protect against systematic risk because different
portions of the market tend to underperform at different times. This is also called market risk.
Unsystematic Risk Unsystematic risk refers to risk unique to a particular company or industry. It
can be avoided through diversification. This is the risk of price change due to the unique
circumstances of a specific security as opposed to the overall market. This risk can be virtually
eliminated from a portfolio through diversification.

Question No. 16
Risk and Uncertainty [June 2017] (2.5 Marks)

Answer:
In common parlance, the terms "Risk" and "Uncertainty" have synonymous meaning. However,
theydiffer from each other:
Risk may be defined as ―the chance of future loss that can be foreseen‖. In other words, in case
of
risk an estimate can be made about the degree of happening of the loss. This is usually done by
assigning probabilities to the risk on the basis of past data and the probable trends.
Whereas uncertainty may be defined as ―the unforeseen chance for future loss or damages.‖ In
case of uncertainty since the firm cannot anticipate the future loss and hence it cannot directly
deal with it in its planning process, as is possible in the case of risk

Question No. 17
Distinguish between: (June 2019, 2.5 Marks)
a) Risk aversion and Risk diversification

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Answer:
Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather
than another bargain with more certain, but possibly lower, expected payoff. For example, a risk-
averse investor might choose to put his or her money into a bank account with a low but
guaranteed interest rate, rather than into a stock that may have high returns, but also has a chance
of becoming worthless. An investor is said to be risk averse if he prefers less risk to more risk,
all else being equal.
Risk Diversification refers to minimization of risk which an investor may choose by investing in
various types of securities. An investor may not want to concentrate his investment in a single
risky security, as a result of which he may choose to invest in various other securities to
minimize his level of risk and harmonize his returns.

Question No. 18
An investor holds the following portfolio:
---------------------------------------------------------------------------------------------------
Share Beta Investment (Rs.)
---------------------------------------------------------------------------------------------------
Sigma 0.8 2,500,000
Beta 1.2 3,500,000
Alpha 1.5 4,000,000
----------------------------------------------------------------------------------------------
You are required to answer the following questions: (3+3=6 Marks)
i) What is the portfolio beta of the investor?
ii) What is the expected rate of return on the investor‘s portfolio, if the risk-free rate is
8 percent and the expected return on market portfolio is 18 percent?
(June 2009)

Answer:
i. The portfolio beta of the investor is 1.22. (W.N. 1)
ii. The expected rate of return on the investor‘s portfolio is 20.2 percent. (W.N. 2)

Working Notes
W.N.1
For given beta, the required rate of return is obtained using the following formula:

Share Investment (NRs.) Weight Beta Weight * Beta

Sigma 2,500,000 0.25 0.8 0.20
Beta 3,500,000 0.35 1.2 0.42
Alpha 4,000,000 0.40 1.5 0.60
Σ Weight * Beta = Portfolio Beta 1.22

W.N.2
We have Expected Return on Investor's Portfolio E (rp) = Rf + Bp (Rm – Rf)
Where
Rf = Risk Free Return
Bp = Portfolio Beta
Rm = Reurn on Market Portfolio

Hence,
E (rp) = 8 % + 1.22 (18 % - 8%)
= 20.2 %

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Question No. 19
a) A risky portfolio has an expected market return of 14%. What should be the proportion of
investment in risky and risk free investment of a portfolio to secure 20% expected portfolio
return, where government securities are earning 5%? (5 Marks)
b) Jessica wishes to know the expected return on her following portfolio, when the risk-free
rate is 7% and the return on market is expected to be 20%. (5 Marks)

Security Percentage of Portfolio Beta factor of Security

R 15 0.2
S 10 1.2
T 5 1.8
U 30 0.9
V 25 0.2
W 15 0.8

c) Explain the concept of an efficiency frontier. (5 Marks)

(December 2009)

Answer:
a) Expected market return on risky portfolio, E (rm) = 14%
Risk free rate of return (rf) = 5%
Expected return on total portfolio, E (rp) = 20%
Now,
E (rp) = Wm * E (rm) + (1- Wm) * rf
20% = Wm * 14% + (1- Wm) * 5%
Wm = 15/9= 1.667
Wf = 1-1.667 = -0.667
Therefore, the proportion of risky investment in the portfolio is 166.67%, and
the proportion of risk free investment is –66.67%.

b) Portfolio‘s beta (β) = 0.15*0.2+0.1*1.2+0.05*1.8+0.3*0.9+0.25*0.2+0.15*0.8

= 0.68
Now,
Expected return on the portfolio of Jessica would be
Rp = Rf+ β (Rm – Rf)
= 7% + 0.68 (20% – 7%)
= 15.84%
Therefore, Jessica‘s expected rate of return on portfolio is 15.84% .

(c) The efficiency frontier traces out the set of available portfolio combinations consistent with
risk aversion, i.e. all portfolios which maximize expected returns for a given risk or minimize
risk for a given return. The aim of any rational risk-averting investor is to locate on the
boundary, although precisely where will depend on the extent of his or her risk-aversion.

Question No. 20
Applying Capital Asset Pricing Model answer the following, the market portfolio has following
characteristics and other information are provided below:

Standard Deviation of security j 20%

Standard Deviation of market portfolio 15%
Expected Return of market portfolio 13%
Correlation between possible returns for security j and the market portfolio 0.80
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Risk Free Rate 7%

Required: (3+3+3+1=10 Marks)
i) What is the expected return of security j?
ii) What would happen to the required return if the standard deviation of security j is 30?
iii) What would happen if the correlation coefficient is 0.70?
iv) What is the functional relationship between the required return for a security and market
risk?
(December 2010)
Answer:
Given,
Standard Deviation of security j (σ j) = 20%
Standard Deviation of market Portfolio (σ m) = 15%
Expected Return of market portfolio E(R m) = 13%
Correlation between the security and market(r jm) = 0.80
Risk Free Rate(R f) = 7%
a.
Calculation of Beta
βj = r jm * σ j * σ m / σ m2
= 0.80* 20 * 15 / (15) 2
= 1.067
Required Rate of Return E(R j) = R f + [E(R m) - (R f)] βj
= 7% + [13% - 7%]1.067
= 13.40%

b.
Calculation of Beta
βj = r jm * σ j * σ m / σ m2
= 0.80* 30 * 15 / (15) 2
= 1.60
Required Rate of Return E(R j) = R f + [E(R m) - (R f)] βj
= 7% + [13% - 7%]1.6
= 16.6%
Hence the required return would increase.
c.
βj = r jm * σ j * σ m / σ m2
= 0.70* 20 * 15 / (15) 2
= 0.9333
Required Rate of Return E(R j) = R f + [E(R m) - (R f)] βj
= 7% + [13% - 7%] 0.9333
= 12.60%
Hence the required return would decrease.
d. The relationship is linear throughout and is called Security Market Line. The important point
to stress is that in market equilibrium, an expected return relationship with the market portfolio
is implied for all securities.

Question No. 21
You are evaluating a proposal to invest in two companies whose past ten years of returns are as
shown below:
Percent Returns during the Year
Company
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1 2 3 4 5 6 7 8 9 10

ABC 37 24 -7 6 18 32 -5 21 18 6

DEF 32 29 -12 1 15 30 0 18 27 10

In respect of the above companies, you are required to: (4+2.5+1.5+2=10 Marks)
i) Calculate the standard deviation of each company‘s returns,
ii) Calculate the correlation coefficient of the two company‘s returns,
iii) Determine the standard deviation of your portfolio and the average yearly return, assuming
that you had placed 50% of your money in each company‘s share, and
iv) Determine the percentage investment in each which would have resulted in the lowest risk.
(December 2010)
Answer:
(i) Standard Deviation of Returns
Average Returns of the companies are:
R ABC = (37 + 24 – 7 + 6 + 18 + 32 – 5 + 21 + 18 + 6)/10 = 15%
R DEF = (32 + 29 – 12 + 1 + 15 + 30 + 0 + 18 + 27 + 10)/10 = 15%
Standard Deviation of ABC and DEF companies are computed as shown below.
σ ABC = √ (37 – 15)2 + (24 – 15) 2 + (– 7 – 15) 2 + (6 – 15) 2 + (18 – 15) 2 + (32 – 15) 2 + (–5–15)
2
+ (21 – 15) 2 + ( 18 – 15) 2 + (6 – 15) 2
√ 10
= √ (22)2 + (9) 2 + (– 22) 2 + ( – 9) 2 + (3) 2 + (17) 2 + ( – 20) 2 + (6) 2 + ( 3) 2 + ( – 9) 2
√ 10
= √ 484 + 81 + 484 + 81 + 9 + 289 + 400 + 36 + 9 + 81 = √ 1954 = 13.98
√10 √10
σ DEF = √ (32 – 15)2 + (29 – 15) 2 + (– 12 – 15) 2 + (1–15) 2 + (15–15) 2 + (30–15) 2 +(0 – 15) 2 +
(18 – 15) 2 + ( 27 – 15) 2 + (10 – 15) 2
√ 10
= √ (17)2 + (14) 2 + (– 27) 2 + ( – 14) 2 + (0) 2 + (15) 2 + (– 15) 2 + ( 3) 2 + ( 12) 2 + (– 5) 2
√ 10
= √ 289 + 196 + 729 + 196 + 0 + 225 + 225 + 9 + 144 + 25 = √ 2038 = 14.28
√10 √10

(ii) Correlation Coefficient of Returns

Cov. ABC DEF = √ (37 – 15) (32 – 15) + (24 – 15)(29 – 15) + (– 7 – 15) (– 12 – 15) + (6 – 15) (1
– 15) + (18 – 15) (15 – 15) + (32 – 15) (30 – 15) + ( – 5 – 15)( 0 – 15) + (21 –
15) (18 – 15) + ( 18 – 15) ( 27 – 15) + (6 – 15) (10 – 15)
10
= (37 – 15) (32 – 15) + (24 – 15)(29 – 15) + (– 7 – 15) (– 12 – 15) + (6 – 15) (1 – 15)+
(18 – 15) (15 – 15) + (32 – 15) (30 – 15) + ( – 5 – 15)( 0 – 15) + (21 – 15) (18 – 15) +
( 18 – 15) ( 27 – 15) + (6 – 15) (10 – 15)
10

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= (22) (17) + (9)(14)+ (– 22) (– 27) + (– 9) (–14)+ (3) (0)+ (17) (15)+ (– 20) ( –15) + (6)
(3) + ( 3) ( 12) + ( – 9) (– 5)
10
= 374 + 126 + 594 + 126+ 0+ 255+ 300 + 18 + 36 + 45 = 1874/10 = 187.4
10
Correlation Coefficient =Cov. ABC DEF= 187.4 = 0.93
σ ABC σ DEF 13.98 x 14.28

(iii) Standard Deviation of the Portfolio and Average Yearly Return,

Assuming 50% Investment in Both the Company’s Share
σ P = √ (WABC2 σ ABC2 + W DEF2σ DEF2 + 2 WABCW DEF Correlation Coeff. σ ABC σ DEF)
= √ [(0.5)2 (13.98)2 + (0.5)2 (14.28)2 + 2 (0.5) (0.5) (13.98) (14.28) (0.93)]
= √ (48.86 + 50.97 + 92.82) = √ 192.65 = 13.88

E (RP) = 0.5 (15) + 0.5 (15) = 15%

(iv) Percentage Investment in each which

would have resulted in the Lowest Risk
Using the minimum variance equation and let W stand for ABC,
2
WABC = σ 2 – σ1 σ2 σ1,2 = (14.28) 2 – (13.98) (14.28) (0.93)
σ 12 + σ22– σ1 σ2 σ1, 2 (13.98)
2 2
+ (14.28) – 2 (13.98) (14.28) (0.93)
= 203.981 – 185.65 = 18.33 = 0.6537, Or 65.37
195.44 + 203.91 – 371.31 28.04

WDEF = 1 – 0.6537 = 0.3463, Or 34.63%

Question No: 22
As an investment manager, you are provided with the following information:

Investment in Initial Dividend Market Price Beta

Price (Rs.) at the year (Risk
(Rs.) end (Rs.) Factor)
Equity Share of ABC Cement Ltd. 20250 400 0.8
Equity Share of BCD Sugar Ltd. 20350 600 0.7
Equity Share of DEF Distillery Ltd. 20450 1,050 0.5
Government of Nepal Bonds 1,000
140 1,005 0.99
Risk-free return may be taken at 15%.
You are required to calculate: (3+4+2=9 Marks)
i) Expected rate of return on market portfolio,
ii) Expected rate of return of individual portfolio using Capital Asset Pricing Model
(CAPM),
iii) Average return of portfolio.
(December 2010)

Answer:
Investment
Investment Dividend (Rs.) Capital Gain(Rs.)
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Amount (Rs.)
Equity Share of ABC Cement Ltd. 250 20 150
Equity Share of BCD Sugar Ltd. 350 20 250
Equity Share of DEF Distillery Ltd. 450 20 600
Government of Nepal Bonds 1,000 140 5
Total: 2,050 200 1,005

(i) Expected Rate of Return on Market Portfolio :

= Dividend Earned + Capital Appreciation x 100

Initial Investment
= 200 + 1,005 x 100 = 1,205/2,050 x 100 = 58.78%
2,050

(ii) Expected rate of return of individual portfolio using Capital Asset Pricing Model
(CAPM)
Now, we can calculate the expected rate of return on individual portfolio by applying
CAPM.
E (Ri) = Rf + βi (Rm – Rf)
ABC Cement Ltd = 15 + 0.8 (58.78 – 15) = 15 + 0.8 x 43.78 = 50.02%
BCD Sugar Ltd = 15 + 0.7 (58.78 – 15) = 15 + 0.7 x 43.78 = 45.65%
DEF Distillery Ltd. = 15 + 0.5 (58.78 – 15) = 15 + 0.5 x 43.78 = 36.89%
Government of NepalBonds = 15 + 0.99 (58.78 – 15) = 15 + 0.99 x 43.78 = 58.34%

(iii) Average Return of the Portfolio:

= (50.02 + 45.65 + 36.89 + 58.34)/4 = 190.90/4 = 47.73%

Alternatively, the Average Return could also be found out on the basis of average of beta
factors of all securities in the portfolio in the following manner.
Average of Betas = (0.8 + 0.7 + 0.5 + 0.99)/4 = 2.99/4 = 0.7475

Average Return = 15 + 0.7475 (58.78 – 15) = 15 + 0.7475 x 43.78 = 15 + 32.73 = 47.73%

Question No: 23
M/s X. Ltd. has three divisions, each of approximately the same size. Its Finance Department
has estimated the rates of return for different states of nature as given. (15 Marks)

State Probability Rm Rate of Rate of Rate of

Return of Return of Return of
Division 1 Division 2 Division 3
Great 0.25 0.35 0.40 0.6 0.20
Good 0.25 0.20 0.36 0.3 0.12
Average 0.25 0.13 0.24 0.16 0.08
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Horrible 0.25 -0.08 0 -0.26 -0. 02

a) If the risk free rate is 9 %, what rate of return does the market require for each division?
b) What is the beta of the entire company?
c) If the company has 30 percent of its funds provided by riskless debt and the remainder
by equity what is the equity beta for the company?
d) Which of the divisions should be kept? Which should be spun off?
e) What will the company's beta be if the actions in part (d) are undertaken?
(June 2010)
Answer:
Calculation of the expected return of market, division1, division 2, division 3.

State Prob. Rm R1 R2 R3 pjRm pjR1 PjR2 PjR3

Great 0.25 0.35 0.40 0.6 0.20 0.0875 0.10 0.15 0.05
Good 0.25 0.20 0.36 0.3 0.12 0.05 0.09 0.075 0.03
Average 0.25 0.13 0.24 0.16 0.08 0.0325 0.06 0.04 0.02
Horrible 0.25 -0.08 0 -0.26 -0. 02 -0.02 0 -0.065 -0.005
Total 0.15 0.25 0.20 0.095

Expected Return from market E(Rm) = ∑ pjRm= 0.15 =15%

Expected Return from division 1 E(R1) = ∑ pjR1= 0.25 =25%
Expected Return from division 2 E(R2) = ∑ pjR2= 0.20 =20%
Expected Return from division 3 E(R3) = ∑ pjR3= 0.095 =9.5%
Calculation of the market variance ( cov1m, cov2m,cov3m)

State [Rm-E(Rm)]2 *Pj [R1-E(R1)][Rm- [R2-E(R2)][Rm- [R3-E(R3)][Rm-

E(Rm)] * Pj E(Rm)] * Pj E(Rm)] * Pj
Great 0.01 0.0075 0.02 0.00525
Good 0.000625 0.001375 0.00125 0.0003125
Average 0.0001 0.00005 0.0002 0.000075
Horrible 0.0132 0.014375 0.02645 0.0066125
Total 0.02395 0.023300 0.0495 0.01225

Market Variance σm2 = ∑[Rm-E(Rm)]2 * Pj = 0.02395

Covariance between division 1 and market cov1m = ∑ [R1-E(R1)][Rm-E(Rm)] * Pj =0.023300
Covariance between division 2 and market cov2m = ∑[R2-E(R2)][Rm-E(Rm)] * Pj = 0.0495
Covariance between division 3 and market cov3m = ∑[R3-E(R3)][Rm-E(Rm)] * Pj = 0.01225
Calculation of Betas
Beta of division 1 β1 = cov1m/ σm2= 0.023300/0.02395 = 0.97287

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Beta of division 2 β 2= cov2m/ σm2= 0.0495/0.02395 = 2.067

Beta of division 3 β3 = cov3m/ σm2= 0.01225/0.02395 = 0.5115

a. Required Rate of return for each division

E(Rj) = Rf + [E(Rm) – Rf] βj
E(Rj) = 9% + [15% – 9%] βj
E(R1) = 9% + [15% – 9%] 0.97287 = 14.8%
E(R2) = 9% + [15% – 9%] 2.067 = 21.4%
E(R3) = 9% + [15% – 9%] 0.5115 = 12.1%

b. The Beta of the entire company

Average beta (β) = 0.97287 + 2.067 + 0.5115/3 = 1.18614

c. The equity beta for the company

Proportion of riskless debt (Wd) = 0.3
Beta of the riskless debt (βd) =0
Proportion of equity(Ws) = 0.70
We have,
β = βdWd + βsWs
1.18614 = 0*3.3 + 0.7 * βs
βs = 1.18614/0.7 = 1.

d. Division 1 should be kept. Division 2 and division 3 spun off.

e. If the action in part(d) taken, the company's beta will be equal to division 1. So the
company's beta will be 0.97287.

Question No: 24
An investor saw an opportunity to invest in a new security with excellent growth potential. He
wants to invest more than he had, which was only Rs. 100,000. He sold another security short
with an expected rate of return of 15%. The total amount he sold was Rs. 400,000, and the total
amount he invested in the growth security, which had an expected rate of return of 30%, was Rs.
500,000. Assuming no margin requirements, what is the investor‘s expected rate of return?
(4 Marks)
[June 2011]

Answer:
Computing the portfolio weights for each security is done with the formula:
Investment in A (sold short)
Total equity investment
From the given problem, we find:
WA = - Rs, 400,000/ Rs. 100,000 = - 4.0
WB = Rs. 500,000 / Rs. 100,000 = 5.0
Rp = (- 4 x 0.15) + (5 x 0.30) = - 0.60 + 1.50 = 0.90, or 90%.

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Thus, the expected rate of return on this portfolio is 90%.

Question No: 25
The market portfolio has an expected return of 15 percent and a standard deviation of 20
percent. The standard deviation of ABC Company's stock is 25 percent and its correlation
coefficient with the market portfolio is 0.50.
Required: (2+4+1+1=8 Marks)
i) What is the beta of ABC Company's stock?
ii) What would happen to the beta if ABC Company's standard deviation were 40 percent? And,
if the correlation coefficient were 0.60?
iii) Of the total variance of the stock in the original case, what proportion is accounted for by
Systematic risk? Unsystematic risk? (The correlation coefficient squared is R-squared).
What, in general, would happen to the total variance of a portfolio if a portion of the ABC
Company stock were sold and the proceeds were invested in unrelated stocks having the same
beta? [December 2011]

Answer:
Given,
Expected Return on market portfolio, E (Rm) =15%
Standard Deviation on market portfolio,σm = 20%
Standard Deviation on ABC Company, σB = 25%
Correlation coefficient between the company & market,pBm =0.50

i) ρBm * σB * σm
The beta of ABC company (βB) =
σm2
= 0.50 * 0.25 * 0.2/ (0.2)2 = 0.625

ii) In both the instances, Beta increases which is evident from the following equation:
First, if the standard deviation of the company is 40 percent.
ρBm * σB * σm
The beta of ABC company (βB) =
σ m2
= 0.50 * 0.40 * 0.2/ (0.2)2 = 1
Second, if the correlation coefficient were 0.60.
ρBm * σB * σm
The beta of ABC company (βB) =
σ m2
= 0.60 * 0.25 * 0.2/ (0.2)2 = 0.75

iii) R- squared measures the proportion of the total variance of the dependent variable
explained by the independent variable. In our case, R squared = 0.5 * 0.5 = 0.25.
Therefore, 25 percent of the ABC Company's total variance is explained by market
movements (Systematic Risk) while unsystematic risk accounts for 75 percent of the
total variance.

iv) The more stocks with the same beta are added to a portfolio and at the same time the
ABC Company's stock is subtracted, the total variance of the portfolio declines.
Systematic risk stays the same, but unsystematic risk declines with diversification.

Question No: 26
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Stock X has an expected rate of return of 10 percent, a beta coefficient of 0.8, and a standard
deviation of expected return of 15 percent. Stock Y has an expected rate of return of 15 percent,
a beta coefficient of 1.5, and a standard deviation of expected returns of 20 percent. The risk-
free rate is 4 percent, and the market risk premium is 6 percent.
Required: (2+2+2+2=8 Marks)
i) Which stock is riskier in terms of total risk?
ii) Which stock is riskier for diversified investor?
iii) Calculate each stock‘s required rate of return. What is its significance?
iv) Calculate expected return of a portfolio that has Rs. 60,000 invested in
Stock X and Rs. 40,000 invested in Stock Y?
[December 2011]

Answer:
Given,

Stock X Stock Y

Expected rate of return 10% 15%

Beta coefficient 0.8 1.5

Standard deviation of expected return 15% 20%

Rf = 4%
Market risk Premium (MRP) = 6%
i. Total risk is measured by coefficient of variance (CV).
CV of stock X= standard deviation/Expected rate of return
CV of stock X= 0.15/0.1= 1.5
CV of stock Y= 0.2/0.15=1.3333
Since stock X has higher CV, stock X is riskier than stock Y.

ii. Which stock is riskier for diversified investor?

For diversified investor, the stock having higher Beta is more riskier. Beta measures
the risk of individual assets relative to the market portfolio. The beta of the market
portfolio is 1. Assets with beta less than 1 are called defensive assets and assets with
beta greater than 1 are called aggressive assets. Risk free assets have a beta equal to
zero. Therefore, Stock Y is riskier as it has higher beta.

iii. Calculate each stock‘s required rate of return. What is its significance?
Required rate of return= Rf +Beta × MRP

Required rate of return of X = 4%+6% × 0.8=8.8%

Required rate of return of Y= 4%+6%×1.5=13%
iv) Calculate expected return of a portfolio that has Rs 60,000 invested in
Stock X and Rs 40,000 invested in Stock Y
Expected Rate of Stock X = 10%
Expected Rate of Stock Y = 15%
Expected Rate of Portfolio = 10% 0.6 + 15% 0.4
= 6% + 6%
= 12%

Question No: 27
a) Prove that the Beta of the market portfolio is equal to 1. (4 Marks)

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b) "Nature of Business, Operating Leverage, and Financial Leverage are three

fundamental factors that determine Beta". Comment on this statement? (4 Marks)

c) Consider the following information relating to two stocks, A and B :

Year Return on A (%) Return on B (%)
2009 10 12
2010 16 18

Required:
Determine: (7 Marks)
i) The expected return on a portfolio, containing A and B in the
proportion of 40% and 60% respectively.
ii) The Standard deviation of return from each of the two stocks.
iii) The covariance of returns from the two stocks.
iv) Correlation coefficient between the returns of the two stocks.
v) The risk of a portfolio, containing A and B in the proportion of 40%
and 60% respectively.
[June 2012]
Answer:
a) Beta is a relative measure of market risk. It is the ratio of the covariance of the rate of return
to the variance of the market portfolio return.

βj = Covjm / σm2
=1
It suggests that the stock is equally risky as market risk. Hence,

βj = βm
We know,
βj = Covjm / σm2
Substituting the values βj = βm,
βm = Covmm / σm2
= ρmm * σm * σm / σm2
= ρmm
=1
The correlation of the rate of return on the market portfolio with itself must be positive and
perfect. Hence, it is proved that the Beta of the market portfolio is equal to 1.

b) The Beta is the ratio of covariance between returns on market and a security to
variance of the market returns. The variance and covariance and hence Beta depends
on three fundamental factors – the nature of business, the operating leverage and the
financial leverage.

Nature of Business – All economies go through business cycles. Firms behave

differently within a business cycle. The earnings of some companies fluctuate more
with the business cycles. Their earnings grow during the growth phase of the business
cycle and decline during the contraction phase. When we regress a company's

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earnings with the aggregate earnings of all companies in the economy, we would
obtain a sensitivity index, which we can call the company's accounting beta. The real
or the market beta is based on share market returns rather than earnings. The
accounting betas are significantly correlated with the market betas. This implies that if
a firm's earnings are more sensitive to business conditions, it is likely to have higher
beta.

Operating Leverage – It refers to the use of fixed costs. The degree of operating
leverage is defined as the change in a company's earnings before interest and tax, due
to change in sales. Since variable costs change in direct proportion of sales and fixed
costs remain constant, the variability in EBIT, when sales change is caused by fixed
costs. Higher the fixed cost, higher the variability in EBIT for a given change in sales.
Other things remaining the same, companies with higher operating leverage (because
of higher fixed costs) are more risky. Operating leverage intensifies the effect of
cyclicality on a company's earnings. As a consequence, companies with higher
degrees of operating leverage have high beta.

Financial Leverage – It refers to a debt in a firm's capital structure. Firms with debt in
the capital structure are called levered firms. The interest payments on debt are fixed
irrespective of the firm's earnings. Hence, interest charges are fixed costs of debt
financing. The fixed financial costs result in financial leverage and cause profit after
tax to vary with changes in EBIT. Since, financial leverage increases the firm's
financial risk, it will increase the equity beta of the firm.

c) (i) Expected return of the portfolio A and B, containing 40% A and 60% B
Expected Return {E (A)} = (10 + 16) / 2 = 13%
Expected Return {E (B)} = (12 + 18) / 2 = 15%
Expected Return on portfolio {Rp} = 0.4(13) + 0.6(15)
=5.2% + 9% = 14.2%

(ii) Standard deviation of return from each stock

Stock A:
Variance = 0.5 (10 – 13)² + 0.5 (16 – 13) ² = 9%
Standard deviation = √9 = 3%

Stock B:
Variance = 0.5 (12 – 15) ² + 0.5 (18 – 15) ² = 9%
Standard deviation = √9 = 3%

(iii) Covariance of return from stocks A and B

CovAB = 0.5 (10 – 13) (12 – 15) + 0.5 (16 – 13) (18 – 15) = 9%

(iv) Correlation of coefficient between the returns of the two stocks.

rAB = CovAB/ σA σB = 9 / 3*3 = 1

(v) Portfolio Risk, which contains 40% A and 60% B.

σp =
X2Aσ2A + X2Bσ2B + 2XAXB(σA σBrAB)

=
(0.4)2 (3)2 + (0.6)2 (3)2 + 2 (0.4) (0.6) (3) (3) (1)
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= 1.44 + 3.24 + 4.32

= 3%

Question No: 28
As a part of the strategy to increase sales and profits, the sales manager of a fast moving
consumer goods (FMCG) company proposes to sell goods to a group of new customers with
10% risk of non-payment. This group would require one and a half month credit and is likely to
increase sales by Rs. 100,000 per annum. Production and selling expenses amount to 80% of
sales and the income-tax rate is 50%. The company‘s minimum required rate of return (after
tax) is 25%.
Required: (3.5+3.5=7 Marks)
i) Comment on the acceptance of the sales manager‘s proposal.
ii) Find the degree of risk of non-payment that the company should be willing to assume if the
required rate of return (after tax) were 30%.
[December 2012]

Answer:
i) Evaluation of Sales Manager's proposal Rs.
Additional sales from new customers per annum 100,000
Less: Risk of non-payment @ 10% 10,000
Net Turnover 90,000
Production and selling expenses (80% of sales) 80,000
Profit before tax 10,000
Income tax @ 50% 5,000
Profit after Tax 5,000
Average Investment in Debtors:
The credit period being 1 ½ months, there will be turnover of debtors of 8 times considering 12
month‘s year.
Thus, average debtors will be Rs. 100,000 / 8 = Rs. 12,500
Cost of goods sold being 80% of sales, the average investment in debtors would be 80% of Rs.
12,500, i.e. Rs. 10,000.
Thus, the rate of return (being PAT of Rs. 5,000) =
Rs. 5,000/ 10,000 x 100/10,000 = 50%
Since the company‘s minimum rate of return is 25%, the sales manager‘s proposal should be
accepted.
Alternatively,
Cost of investment in debtor = 25% of Rs.10,000 = Rs.2,500
Increase in PAT = Rs. 5,000
Since, increase in PAT is greater than the additional cost of investment in debtor; the Sales
Manager's proposal is acceptable.

ii) Acceptable degree of risk of non-payment with the required rate of return (after tax) of 30%:
Particulars Rs.
Average investment in debtors 10,000
Required profit after tax @ 30% 3,000
Profit before tax (Grossed up by 50%) 6,000
Production and selling expenses 80,000
Required sales to achieved desired return 86,000
Additional sales 100,000
Therefore, acceptable degree of risk of non-payment 14,000
Acceptable degree of risk (in %) 14%

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Questions No. 29
P has an expected return of 22 percent and standard deviation of 40 percent. Q has an expected
return of 24 percent and standard deviation of 38 percent. P has a beta of 0.86 and that of Q is
1.24. The correlation between the returns of P and Q is 0.72. The standard deviation of the
market return is 20 percent.
Required: (2+2+2+1=7 Marks)
i) Is investing in Q better than investing in P?
ii) If you invest 30 percent in Q and 70 percent in P, what is your expected rate of
return and the portfolio standard deviation?
iii) What is the market portfolio‘s expected rate of return and how much is the
risk-free rate?
iv) What is the beta of portfolio if P‘s weight is 70 percent and Q's 30 percent?

[June 2013]

Answer:
i) P has lower return and higher standard deviation than Q. Therefore, investing in Q will
give more return with less volatility. However, investing in both will yield diversification
advantage.

(ii) Expected rate of return (rp) = 22

Portfolio standard deviation )
=√
=√
=√
=√
=0.37
=37%

i) The risk- free rate will be the same for P and Q. Their rates of return are given as follows:
rp, 22=rf +(rm-rf) 0.86
rq, 24=rf+(rm-rf) 1.24
rp-rq , -2= (rm-rf) (-0.38)
rm-rf ,-2/-0.38=5.26%
rp , 22=rf+(5.26) 0.86
rf = 17.5%
rq = 24=rf+(5.26) 1.24
rf = 17.5%
rm – 17.5 =5.26
rm = 22.76%
Market portfolio expected return (rm) = 22.76%
Risk-free rate (rf) = 17.5%
iv) pq = p p+ q q =0.86

Question No. 30
The data for the three securities A, B and C are as follows:
1.

Securities Likely Return Standard Deviation

A 16% 0.21
B 16% 0.20
C 21% 0.25

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Does anyone security dominates another? Which type of investor prefers security C?
(3 Marks)
[June 2013]

Answer:
-In case of security A and B return is equal but security B has comparatively lower
standard deviation i.e. it has lower risk, hence security B dominates security A.
-Investors who prefer high return will prefer security C irrespective of having risk i.e. high
standard deviation. He belongs to risk taking group.

Question No. 31
Calculate the market sensitivity index and the expected return on investment from the following
data: (3 Marks)
Standard deviation of an asset 2.5%
Market standard deviation 2%
Risk free rate of return 13%
Expected return on market portfolio 15%
Correlation coefficient of portfolio with market 0.8
[December 2014]

Answer:
Market sensitivity index i.e. Beta factor can be calculated as follows:
Βeta = (Standard Deviation of asset/Standard Deviation of Market) ×Correlation
Coefficient of Market
= (2.5/2)× 0.80
=1
Now, the expected return on the investment canbe ascertained with the help of CAPM
equation as follows:
R =rf+(Rm-rf)β
=13%+(15-13%)1
=15%

Question No. 32
Following is the data regarding six securities:
Securities A B C D E F
Return % 10 10 15 5 11 10
Risk (SD) % 5 6 13 5 6 7
Required: (2+4=6 Marks)
i) Which of three securities will be selected by an investor and why?
ii) Assuming perfect negative correlation, analyse whether it is preferable to
invest 80% of money in Security A and 20% in Security C or to invest 100%
of money in Security E.
[December 2014]

Answer:
i) Arranging the securities in the increasing order of risk:
Risk % Return % Security Invest
5 10 A Yes

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 CAP II Paper 4: Financial Management

5 5 D No
6 10 B No
6 11 E Yes
7 10 F No
13 15 C Yes
Securities A, E and C should be selected. The investor will try to minimize risk and
maximize return. Therefore, security A is better than D, security E is better than B and C
is better with highest return.
(ii) Calculation of overall return and overall standard deviation (Risk) when 80% in Security
A and 20% in Security C is invested.
Overall return = ReturnA×WeightA+ ReturnC×WeightC
= 10%×0.8 + 15%×0.2
=11%
Overall Variance (SD2) = (SDA× WA)2 + (SDC× WC)2 + 2× (SDA× WA) × (SDC× WC) ×rAC
SD2 = (5×0.80)2 + (13×0.20)2 + 2 ×(5×0.8) × (13×0.2) × (-1)
SD2 = 16 + 6.76 + 2 X 4 X 2.6 X (-1)
= 22.76 - 20.8
= 1.96
SD = 1.4
Summary
Alternative-1 Alternative-2
(80% in A and 20% in C) (100% in E)
SD (%) 1.4 6
Overall return (%) 11 11

Conclusion:
Since same return i.e. 11% is available from lower risk (SD) of 1.4 %, Alternative-1 is
preferable over alternative-2.

Question No. 33
The Investment Analytics Division of R Investment Bank presented the following forecast
pertaining to share price and dividend of X Bank Ltd., an "A" Class Licensed Institution, during
its regular performance review meeting for the current financial year 2072-73:

Economic Share Price (Rs.) Dividend (Rs.)

Conditions High Low Average
High Growth 350 300 325 22
Expansion 310 280 295 18
Stagnation 280 250 265 13
Decline 230 200 215 10
The Bank has recently declared dividend of Rs. 13 per share and is currently trading at Rs. 265
per share in the Nepal Stock Exchange. Due to the ongoing political stalemate and the aftermath
of recent mega earthquake, the Analytics Division has estimated higher probability for the
stagnant economic conditions and lower probability for the high growth conditions. The
probability estimates are presented as under:
Economic Conditions Probability
High Growth 10%
Expansion 20%
Stagnation 60%
Decline 10%
Required: (7 Marks)
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 CAP II Paper 4: Financial Management

Calculate and evaluate the expected rate of return and the riskiness of shares of X Bank Ltd.
[December 2015]
Answer:
Tables showing calculation of Expected Rate of Return
Table -1
Economic Share Price Dividend Expected Expected Return
Conditions High Low Average Dividend Capital Gain
Return %
1 2 3 4 5 6=5/CP 7=(4- 8=6+7
CP)/CP
High Growth 350 300 325 22 8.30% 22.64% 30.94%
Expansion 310 280 295 18 6.79% 11.32% 18.11%
Stagnation 280 250 265 13 4.91% 0% 4.91%
Decline 230 200 215 10 3.77% -18.87% -15.10%
Note: Here, current market price is considered as cost price( C P) to the investment bank.
Table -2
Economic Conditions Return Probability Expected Return
1 2 3 4=2×3
High Growth 30.94% 10% 3.09%
Expansion 18.11% 20% 3.62%
Stagnation 4.91% 60% 2.95%
Decline -15.10% 10% -1.51%
Total 8.15%
The expected return of share is 8.15%; however, the total return is anticipated to vary between
-15.10% under the adverse condition to 30.94% under the most favorable condition. The
expected return is the average return of share computed by adjusting probabilities for various
economic conditions.
The riskiness of Share is based on the following formula:
n
ơ2
= ∑ [ RI - E(R)]2 × PI
I=1
Where;
RI = Return on various economic conditions,
E(R) = Expected Rate of Return
PI = Probability of various economic conditions
Economic Return Expected Differences Square of Probability Expected
Conditions Return in Return Difference Variance
1 2 3 4=2-3
High Growth 30.94% 8.15% 22.79% 5.19% 10% 0.52%
Expansion 18.11% 8.15% 9.96% 0.99% 20% 0.19%
Stagnation 4.91% 8.15% -3.24% 0.10% 60% 0.06%
Decline -15.10% 8.15% -23.25% 5.40% 10% 0.54%
Total 1.31%

ơ2 = 1.31%
ơ
√
= 1.31% = 11.44%

The share's average dispersion is 10.89% which is considered high and therefore a risky
investment for share investors. Considering the low expected rate of return and high standard
deviation, rational investors will look into other better alternatives.

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Question No. 34
The following data relating to two securities, A and B.
A B
Expected return 22% 17%
Beta factor 1.5 0.7
Assume Risk Free Interest (Rf)=10% and Return Market (Rm)=18%. Find out whether the
securities A and B are correctly priced ? (5 Marks)
[June 2016]

Answer:
Calculation of return under CAPM
Company A=Rf+B(Rm-Rf)
=10+1.5(18-10)
=22%
Company B=Rf+B(Rm-Rf)
=10+0.7(18-10)
=15.6%

Security E(R) Expected Return Return under CAPM Position

A 22% 22% Correctly Priced
B 17% 15.6% Under Priced

The return from security A exactly equal to the calculated return under CAPM hence it is
correctly priced securities.
The return from security B is better than the return under CAPM. It indicates a favorable
position .i.e. the security is currently traded at underpriced position.

Question No. 35
The following data relat to two securities, A and B:
A B
Expected Return 22% 17%
Beta Factor 1.5 0.7
Risk Free Interest rate is 10% and Return on Market is 18%.
Required: (5 Marks)
Find out whether the securities A and B are correctly priced?
[June 2017]
Answer:
Calculation of return under CAPM
Company A=Rf+B(Rm-Rf)
=10+1.5(18-10)
=22%
Company B=Rf+B(Rm-Rf)
=10+0.7(18-10)
=15.6%

Security E(R) Expected Return Return under CAPM Position

A 22% 22% Correctly Priced
B 17% 15.6% Under Priced

The return from security A exactly equal to the calculated return under CAPM hence it is
correctly priced securities.

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The return from security B is better than the return under CAPM. It indicates a favorable
position; i.e. the security is currently traded at underpriced position.

Question No. 36
Mr. X, an investor, is seeking the price to pay for the security whose standard deviation is 5%.
The correlation coefficient for the security with the market is 0.75 and the market standard
deviation is 4%. The return from the risk-free securities is 6% and from the market portfolio is
11%. Mr. X knows that only by calculating the required rate of return, he can determine the
price to pay for the security.
Required: (5 Marks)
What is the required rate of return on the security?
[December 2017]
Answer:
Standard deviation of the security = 5%
Correlation coefficient of portfolio with market = 0.75%
Market standard deviation = 4%
Risk-free rate of return = 6%
Expected return on market portfolio = 11%

The market sensitivity index i.e. the beta factor can be calculated as follows:

Standard deviation of the security 0.05

β= ------------------------------------------------------× CORsm = -------------×.75= 0.9375
Standard deviation of Market 0.04

Now, the expected return on the investment can be ascertained with the help of CAPM
equation as follows:
Rs = Irf +(Rm-Irf) β
= 6 + (11-6)×0.9375
= 10.69%

Question No. 37
Ms. Smile currently holds two equity shares X and Y in equal proportion with the following risk
and return characteristics:
Return (RX) 24% Return (RY) 19%
σX 28% σY 23%
The returns of these securities have a positive correlation of 0.6.
Required: (3+2=5 Marks)
i) Calculate the portfolio return and risk.
ii) How much should the correlation coefficient be to bring the portfolio risk to her desired
15% level?
[June 2018]
Answer:
i) The portfolio return and risk are as under:
Portfolio Return [E(RP)] = RX × ProportionX + RY × ProportionY
= 24% × 50% + 19% × 50%
= 12% + 9.5%
= 21.5%

√
Portfolio risk [σP] = ơX2× ProportionX2 + ơY2×ProportionY2 +
2 × ơX×
ProportionX × ơY × ProportionY ×
CorrelationXY
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 CAP II Paper 4: Financial Management

= 282 × 0.502 + 232 × 0.502 + 2 × 28 × 0.50 × 23 ×

0.50 × 0.6 √
= √ 521.45 = 22.84%
ii) If Ms Smile desires the portfolio standard deviation to remain at 15%, then
correlation of equity shares X and Y shall be -0.321 as below:
152 = 282 × 0.502 + 232 × 0.502 + 2 × 28 × 0.50 × 23 × 0.50 × CorXY
225 = 328.25 + 322 CorXY
CorXY = (225 - 328.25)/322
= - 0.321

Question No. 38
As an investment manager, you are given the following information of
investments:
Investment in Initial Price Return (Rs.) Market price at Beta
(Rs.) year end (Rs.)
Cement Ltd. 25 2 (Dividend) 50 0.80
(Equity share)
Steel Ltd. (Equity 35 2 (Dividend) 60 0.70
share)
Liquor Ltd. 45 2 (Dividend) 135 0.50
(Equity share)
GON Bond. 1,000 140 (Interest) 1,005 0.99
Risk free return may be taken at 14%.
Required: (5+2=7 Marks)
i) Calculate expected rate of returns of portfolio by using CAPM.
ii) Calculate average return of the portfolio.
[December 2018]
Answer:
In the given case, market return is not given. Hence, we should calculate the market
return assuming the given securities represent the market as follows:
Investment in Market Price
Initial Price (Rs.) Return (Rs.) at year end (Rs.)
Cement Ltd 25 2 50
Steel Ltd 35 2 60
Liquor Ltd 45 2 135
GON Bond 1,000 140 1,005
Total 1,105 146 1,250
Market Return (Rm) = Closing price + Return – Opening price
Opening price
= (1250+146-1105)/1105
= 0.2633 i.e. 26.33%
Now,
i) Expected Return on Individual security
Under CAPM, expected return = Rf + (Rm – Rf)β
Cement Ltd 14% +0.8 (26.33%-14%) = 23.86%
Steel Ltd 14% +0.7 (26.33%-14%) = 22.63%
Liquor Ltd 14% +0.5 (26.33%-14%) = 20.16%

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 CAP II Paper 4: Financial Management

GON Bonds 14% +0.99 (26.33%-14%) = 26.21%

ii) Average Return of portfolio
= 23.86%×25/1105 + 22.63%×35/1105 + 20.16%×45/1105 + 26.21%×1,000/1105
= 25.80%

Question No. 39
Mr. X is to invest his funds in two securities, P & Q. The relevant information is as follows:
P Q
Expected return 12% 20%
Standard deviation 10% 18%
Coefficient of correlation ‗r‘ between P & Q = 0.15
He has decided to consider only five portfolios of P & Q as follows:
(a) All funds invested in P
(b) 50% of funds in each of P & Q
(c) 75% funds in P and 25% in Q
(d) 25% funds in P and 75% in Q
(e) All funds invested in Q
Required: [7 Marks]
i) Calculate return under different portfolios.
ii) Calculate Risk factor associated with these portfolios.
iii) Which portfolio is best for him from the risk point of view?
iv) Which portfolio is best for him from the return point of view?
[June 2019]

Answer:
Given that,
Return of P (Rp) = 12%
Return of Q (Rq) = 20%
Std Deviation of P (σp) = 10%
Std Deviation of Q (σq) = 18%
Coefficient of correlationbetween P & Q (r) = 0.15
i) Expected Return under different portfolio
Portfolio Return = Rp x Wp + Rq x Wq Return
All funds invested in P = 12% x 1 + 20% x 0 12%
50% of funds in each of P & Q = 12% x 0.50 + 20% x 0.50 16%
75% funds in P and 25% in Q = 12% x 0.75 + 20% x 0.25 14%
25% funds in P and 75% in Q = 12% x 0.25 + 20% x 0.75 18%
All funds invested in Q = 12% x 0 + 20% x 1 20%
ii) Risk Factor associated under different portfolio
Risk = √
All funds invested in P
=√
= 10%
50% of funds in each of P &Q
=√
= 10.93%
75% funds in P and 25% in Q
=√

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 CAP II Paper 4: Financial Management

= 9.31%
25% funds in P and 75% in Q
=√
= 14.09%
All funds invested in Q
=√
= 18%
iii) Portfolio of investment of 75% in P and 25% in Q is best for him from the
point of risk as this portfolio has lowest risk of 9.31%
iv) Portfolio of investment of 100% in Q is best for him from the point of
return as this portfolio has highest return of 20%

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Chapter 8:

Working capital computaion

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Question No 1: Write short notes on: (2.5 Marks)

Tools of Financial forecasting
(June 2010)

Answer:
i. Days' sales method is a traditional method under which an attempt is made to calculate the
number of days sales and tie it up with the balance sheet items. As different components of
the balance sheet are forecasted in terms of days' dale, this method measures the resources
that are to be financed.

ii. Percentage of sales method is another tool of financial forecasting in which the balance sheet
items are expressed as percentage of sales. This will clearly (to some extent) show the
financial needs caused by increase in sales.
iii. In simple regression method, with sales forecast as starting point and based on past
relationship between sales and assets items, it is possible to construct a line of best fit or the
regression line for them. This method is used for long term forecasting.
iv. In multiple regression method, it is assumed that sales are a function of several variables,
while in simple regression method only one variable is considered.

Question No. 2
Permanent working capital Vs. Variable working capital. [December 2012] (2.5 Marks)

Answer:
Permanent working capital is the minimum amount of gross working capital which is always
maintained in spite of the increase or decrease in the sales during the year. It comprises of the
minimum cash balance, minimum inventory level etc. If a firm does not face a seasonal cycle
then it will have only a permanent working capital requirement. Variable working capital is the
amount of gross working capital that exceeds the amount of permanent working capital at any
time during the year. It is also important for the finance manager to decide sources for financing
seasonal current assets. The variable working capital is the result of the periodic fluctuations of
the gross working capital. For example, wheat mill may have higher inventories at the time of
harvesting wheat. It causes the increase in gross working capital.

Question No. 3
Purpose of working capital management [December 2013] (2.5 Marks)
Answer:
There are two important aims of the working capital management which are profitability and
solvency. A liquid firm has less risk of solvency i.e. it will hardly experience a cash shortage or
stock out situation. However there is a cost associated with maintaining a sound liquidity
position. However, to have higher profitability the firm may have to sacrifice solvency and
maintain a relatively low level of current assets. This will improve firm‘s profitability as fewer
funds will be tied up in idle current assets but its solvency would be threatened and exposed to
greater risk of cash shortage and stock out. Therefore, optimal level of working capital need to
be maintained so that profit is high and risk of solvency is low. This is also known as risk return
trade off of liquidity management.

Question No: 4
Write short notes on: (2.5 Marks)
Working Capital Cycle
(June 2010)
Answers:
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Every business undertaking requires funds for two purposes - investment in fixed assets and
investment in current assets. Funds required to invest in stock, debtors and other current assets
keep on changing shape and volume. For example, a company has some cash in the beginning.
This cash may be paid to the suppliers of raw materials, to meet labour costs and other
overheads. These three combined would generate work-in-progress which will be converted into
finished goods on the completion of the production process. On sale, these finished goods get
converted into debtors and, when debtors pay, the firm will again have cash. The cash will again
be used for financing raw materials, work-in-progress etc. Thus there is a complete cycle when
cash gets converted into raw materials, work-in-progress, finished goods, debtors and finally
again cash. This time period is known as the working capital cycle of the firm.

Question No: 5
Impact of inflation on working capital and inventory. (2.5 Marks) (July 2015)
Answer:
1. Due to inflation, for the same quantity of sales, the amount of Sundry Debtors and stocks
will be higher.
2. Since the value of stocks increases ( due to price increase i.e. inflation) the company will
not be able to maintain its operating capability ,unless it finds extra funds to maintain the
same stock level ( i.e. quantity)
3. Higher value of closing stock due to inflation will lead to higher amount of profits ( in
monetary terms and not in real terms).This will cause an increase in profit related
outflows like income tax, bonus, dividends etc.
4. Thus due to inflation, the business is likely to face a condition known as ―technical
insolvency‖, unless proper planning is done to improve ―Real profits‖.

Question No: 6
Reasons for changes in working capital. [December 2016] (2.5 Marks)
Answer:
The changes in the level of working capital occur for the following 3 basic reasons:
i. Changes in Sales and operating expenses: The first factor causing a change
in the working capital requirement is a change in the sales and operating
expenses. The changes in this factor may be due to three reasons: First,
there may be a long-run trend of change. For instance, the price of a raw
material, say oil, may constantly rise, necessitating the holding of a large
inventory. The second trends would mainly affect the need for permanent
current assets. In the second place, cyclical changes in the economy leading
to ups and downs in business activity influence the level of working capital,
both permanent and temporary. The third source of change is seasonality in
sales activity. Seasonality-peaks and troughs-can be said to be the main
source of variation in the level of temporary working capital.
The change in sales and operating expenses may be either in the form of an
increase or decrease. An increase in the volume of sales is bound to be
accompanied by higher levels of cash, inventory and receivables. The
decline in sales has exactly the opposite effect a decline in the need for
working capital. A change in the operating expenses rise or fall has a
similar effect on the levels of working capital.
ii. Policy Changes: The second major cause of changes in the level of working
capital is because of policy changes initiated by the management. There is a
wide choice in the matter of current assets policy.
iii. Technological changes: Finally, technological changes can cause
significant changes in the level of working capital. If a new process
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 CAP II Paper 4: Financial Management

emerges as a result of technological developments, which shortens the

operating cycle, it reduces the need for working capital and vice versa.
Question No: 7
Permanent and Temporary working capital [June 2017] (2.5 Marks)
Answer:
It refers to a certain minimum level of current assets, which is essential for the firm to
carry on its business irrespective of the level of operations. This is the irreducible
minimum amount necessary for maintaining the circulation of the current assets. This
minimum level of investment in current assets is permanently locked up in business
and is, therefore, referred to as permanent or fixed or hardcore working capital. It is
permanent in the same way as investment in firm‘s fixed assets is. This amount of
working capital should be financed with long term funds.
Temporary Working Capital.
It refers to the amount of working capital over and above the fixed minimum amount
of working capital, which is required to meet seasonal and other temporary
requirements. It may keep on fluctuating from period to period depend upon the
several factors. It is also called fluctuating or variable or seasonal working capital.

Question No. 8
A manufacturing company sells goods at a gross profit of 25 percent. The company is
following a practice to include depreciation as part of the cost of production on a
consistent basis.

You have also been provided with the following details in respect of the costs/expenses
of the company for the 12-month period ending Ashadh 32, current year:
- Sales at 3 month‘s credit NRs. 5,400,000
- Materials consumed (Supplier‘s credit is for 3 months) : NRs. 1,350,000
- Total Wages is NRs. 1,080,000. There is a system of payment of wages twice a month. The
second wage payment of a month takes place on the last day of the month.
- Manufacturing expenses outstanding at the end of the year (cash expenses are paid one month
in arrear): NRs. 120,000
- Total administrative expenses (paid as above): NRs. 360,000
- Sales promotion expenses (paid quarterly in advance) : NRs. 180,000

On the basis of the above information,you are required to determine the working capital needs of
the company on a cash cost basis on the following assumptions: (10 Marks)
i) A safety margin of 15 percent is to be maintained.
ii) Cash is held to the extent of 60 percent of current liabilities.
iii) There will be no work-in-progress.
iv) Tax is to be ignored.
v) Finished Goods are to be valued at manufacturing costs.
vi) Stocks of raw materials and finished goods are kept at one month‘s requirement.
(June 2009)

Answer:
The company needs NRs. 1,575,500 as the working capital on a cash cost basis. The
workings of the calculation is given as per below:

Working Notes

W.N. 1

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Since the cash to be held is given to be 50 per cent of current liabilities, we would first
compute the current liabilities and then cash in hand component of the current assets.

Statement of Computation of Working Capital of a FMCG Company

(A) Current Assets:
i) Raw Materials (1,350,000/12) NRs. 112,500
ii) Finished Goods (3,870,000/12) 322,500
iii) Debtors (4,410,000 X 3/12) 1,102,500
iv) Sales Promotion Expenses (180,000 X 3/12) 45,000
v) Cash in Hand (532,500 X 0.60) 319,500
Total Current Assets: 1,902,500

(B) Current Liabilities:

i) Creditors (1,350,000 X 3/12) 337,500
ii) Manufacturing Expenses 120,000
iii) Administrative Expenses (360,000/12) 30,000
iv) Wages (1,080,000 X 1/24) 45,000
Total Current Liabilities: 532,500

(C) Net Working Capital: (A – B) 1,370,000

Add: Safety Margin: (1,370,050 X 0.15) 205,500
Working Capital Required on Cash Cost basis: NRs. 1,575,500

W.N. 2: Other Computations

Sales: NRs. 5,400,000

Less: Gross Profit Margin: NRs. 1,350,000
(5,400,000 X 0.25) ___________
Total Manufacturing Costs: 4,050,000
Less: Cost of materials consumed: 1,350,000
Less: Wages 1,080,000 2,430,000
 Manufacturing Expenses other than material and wages 1,620,000

 Cash Manufacturing Expenses: (NRs. 120,000 X 12) 1,440,000

 Depreciation (1,620,000 – 1,440,000) 180,000
 Cash Manufacturing Cost (4,050,000 – 180,000) 3,870,000
 Cash Cost of Sales (3,870,000 + 360,000 +180,000) 4,410,000

Question No: 9
Following data related to Universal Manufacturers Ltd. is made available to you.
Particulars Year 1 Year 2
Stocks:
Raw Materials Rs. 300,000 Rs. 405,000
Work-in-process 210,000 270,000
Finished Goods 315,000 360,000
Purchase of Raw Materials 1,440,000 2,025,000
Cost of Goods Sold 2,100,000 2,700,000
Sales 2,400,000 3,000,000
Debtors 480,000 750,000
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 CAP II Paper 4: Financial Management

Creditors 240,000 270,000

You are required to compute the duration of the operating cycle for each of the two years and
comment on the increase/decrease. (Assume 360 days per year for the purpose of computations.)

(8 Marks) (December 2010)

Answer:

Determination of Operating Cycle:

Particulars Year 1 Year 2

(i) Raw Materials Holding Period:

360 days x Stock of Raw Materials 360 x Rs. 300,000 = 75 360 x Rs. 405,000 = 72
Cost of Raw Materials Consumed* Rs. 1,440,000 Rs. 2,025,000
(* Assumed to be equivalent to purchases)
(ii) Less: Creditors Payment Period:
360 days x Creditors 360 x Rs. 240,000 = (60) 360 x Rs. 270,000 = (48)
Purchases Rs. 1,440,000 Rs. 2,025,000
(iii) Work-in-process Holding Period:
360 days x Stock of WIP .360 x Rs. 210,000 = 36 360 x Rs. 270,000 = 36
Cost of Goods Manufactured Rs. 2,100,000 Rs. 2,700,000
(iv) Finished Goods Holding Period:
360 days x Stock of Finished Goods360 x Rs. 315,000 = 54 360 x Rs. 36,000 = 48
Cost of Goods Sold Rs. 2,100,000 Rs. 2,700,000
(v) Debtors Collection Period:
360 days x Debtors 360 x Rs. 480,000 = 72 360 x Rs. 750,000 = 90
Credit Sales** Rs. 2,400,000 Rs. 3,000,000
(** Assumed to be equal to total sales)
Duration of Operating Cycle [Sum of (i) to (v)] 177 198

Comment on the Increase/Decrease:

The duration of the operating cycle has increased by 21 days in Year 2 as compared to Year 1. It
will necessitate more working capital in Year 2. This increase has been primarily caused by an
increase in debtors‘ collection period and decrease in creditors‘ payment period as shown in the
following table.
____________________________________________________________________________________________________________________

Increase in Debtors‘ Collection Period: 18 days

Decrease in Creditors‘ Payment Period: 12
Less: Decrease in Raw Material Holding Period: (3)
Less: Decrease in Finished Goods Holding Period: (6)
Net Increase in Operating Cycle: 21

Question No: 10

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DVDLimited is a manufacturer of DVDs. It is currently producing 50,000 DVDs

annually and all the DVDs are sold on credit basis. Currently, 80% of its working
capital requirement is financed by Nepal Bank at an interest rate of 15% p.a.
Remaining working capital requirement is financed by informal loans at 24% p.a.
Following is the costing and revenue per unit:
Rs.
Cost of raw material 40
Labor charge 15
Overhead cost 30
Cost of production 85
Selling price of DVD 105
Moreover, following working capital parameters are observed:
d) Average raw material in stock: 1 month
e) Work in progress: a half month (Completion Stage: 50%)
f) Average finished goods in stock: 1 month.
g) Credit period allowed for DVD Limited: 1 month.
h) Credit period allowed to debtors: 2 months average time
i) DVD Limited normally pays to workers and overhead only after one
month of work done.
j) Average level of bank and cash balances is Rs. 50,000, in all situations.
DVD Limited is planning of scaling up its operations to the production and sales level of
100,000 units of DVD per year. It wants to finance its working capital requirement by
another bank because the other bank is ready to finance its 90% of working capital
requirement at 12% p.a. However, minimum loan of Rs. 1.5 million needs to be taken. If it
decides to scale up, raw material, labor and overhead costs are likely to increase by 10% in
incremental output. However, selling price of the DVD will come to the level of Rs. 102 per
unit, if production is increased from existing level, and will apply to all the output.
Required: (17+3=20 Marks)
i) Assess whether DVD Limited‘s plan is considerable or not.
ii) Briefly explain about the sources of working capital finance, and state how
firms develop a short term financing plan.
[June 2014]
Answer:

i)
Calculation of Current Income
Rs.
Gross
Particulars Output Rate Revenue

Sales revenue 50,000 105 5,250,000

Cost of production 50,000 85 4,250,000

Gross margin 1,000,000

Less: Interest on working capital
Existing Working Capital
Requirement 1,013,542 (W.N. 1)

Bank Loan Interest (on 80% of WC) 810,834 15% (121,625)

Interest for Informal
Loan(remaining) 202,708 24% (48,650)
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 CAP II Paper 4: Financial Management

(170,275)

Net Margin 829,725

Calculation of income in Scaled Up Production Situation Rs.

Gross
Particulars Output Rate Revenue
Sales Revenue 100,000 102 10,200,000
Cost of Production 100,000 89.25 (average) 8,925,000
Gross margin 1,275,000
Less: interest on working capital:
Total Working Capital Requirement 2,073,438 (W.N. 2)
Bank Loan Interest (90% of WC) 1,866,094 12% 223,931)
Interest for Informal
Loan(remaining) 207,344 24%(49,763)
(273,694)
Net Margin 1,001,306
Since scaling up of production will result more net margin as compared to existing, the scaling
up plan is considerable.
Working Notes:
1. Calculation of Working Capital Requirement (Current Production Level)

Working
Output Per Unit Capital
Particulars Level Cost Time Lag (Rs.)
Current Assets :

Stock of Raw material 50000 40 1 month 166,667

Work in Progress:
Half Month (50%
Raw Material 50000 40 Complete) 41,667
Half Month (50%
Labor Charge 50000 15 Complete) 15,625
Half Month (50%
Overhead cost 50000 30 Complete) 31,250
Stock of Finished
Goods 50000 85 One Month 354,167

Average Debtor 50000 85 Two Months 708,333

Cash and Bank
Balances 50,000
Less: Current
Liabilities

Average Creditors 50000 40 One Month (166,667)

Outstanding labour
charge 50000 15 One Month (62,500)
Outstanding overhead
cost 50000 30 One Month (125,000)
Total working capital requirement 1,013,542
2. Calculation of Working Capital Requirement in Scale Up situation

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Per Unit Cost Incremental

Increment (existing + 10% Working
Particulars al Output of existing) Time Lag Capital(Rs.)
Current Assets:
Stock of Raw
material 50000 44 1 month 183,333
Work in Progress:
Half Month
(50% 45,833
Raw Material 50000 44 Complete)
Half Month
(50% 17,188
Labor Charge 50000 16.5 Complete)
Half Month
(50% 34,375
Overhead Cost 50000 33 Complete)
Stock of Finished
Goods 50000 93.5 One Month 389,583

Average Debtor 50000 93.5 Two Months 779,167

Less: Current
Liabilities

Average Creditors 50000 44 One Month (183,333)

Outstanding labour
charge 50000 16.5 One Month (68,750)
Outstanding overhead
cost 50000 33 One Month (137,500)
Incremental WC 1,059,896

Total Working Capital requirement in Scale up situation 2,073,438

(existing plus incremental WC)

ii)
There can be broadly two types of working capital finances. One is internal source and other
is external. Trade credit, credit from employees, credit from suppliers of raw materials etc.
are those sources which are generated within the business. Besides, short term loans from
banks, commercial paper, factoring etc. are other sources of working capital finances.

Designing for the best short-term financial plan inevitably proceeds by trial and error. The
financial manager must explore the consequences of different assumptions about cash
requirements, interest rates, limits on financing from particular sources, and so on. This is
because calculation of how much short term financing is required at what time is very much
crucial as there may be various options of financings with varied cost and other impacts.
Firms are increasingly using computerized financial models to help in this process. The
financial manager should remember the key differences between the various sources of
short-term financing—for example, the differences between bank lines of credit and
commercial paper. It should also be remembered that firms often raise money on the strength
of their current assets, especially accounts receivable and inventories.

Question No: 11
You are provided with the following extract of cost sheet of ABC Ltd:
Per unit (Rs.)
Raw material 50
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 CAP II Paper 4: Financial Management

Direct Labour 20
Overhead (including depreciation of Rs. 10) 40
Total Cost 110
Profit 20
Selling price 130
Average raw material in stock is for one month. Average material in work in-progress is
for half month. The suppliers allow credit for one month to the company; and it also
allows one month credit to its customers. Average time lag in payment of wages and
overheadsare 10 days and 30 days respectively. 25% of the sales are on cash basis. Cash
balance is expected to be Rs. 100,000. Finished goods are expected to lie in the
warehouse for one [Link] is carried on evenly throughout the year and wages
and overheads accrue accordingly.
Required: (7 Marks)
Prepare a statement of the working capital needed to finance the level of activity of
54,000 units of output. State your assumptions, if any.
[December 2014]

Answer:
As the annual level of activity is given at 54,000 units, it means that the monthly would
be 54,000/12=4,500 units. The monthly working capital requirement for this monthly
turnover can now be estimated as follows:
Estimation of Working Capital Requirement
I. Current Assets: Amount(Rs.)
Minimum Cash Balance 100,000
Inventories:
Raw Materials (4,500×Rs.50) 225,000
Work in Progress:
Materials (4,500× Rs. 50)/2 112,500
Wages 50% of (4,500× Rs. 20)/2 22,500
Overheads 50% of (4,500× Rs. 30)/2 33,750
Finished Goods (4,500× Rs.100) 450,000
Debtors(4,500× Rs.100×75%) (at cost) 337,500
Gross Working Capital 1,281,250

II. Current Liabilities:

Creditors for Materials(4500× Rs.50) 225,000
Creditors for Wages(4,500× Rs.20)/3 30,000
Creditors for Overheads(4,500× Rs. 30) 135,000
Total Current Liabilities 390,000
Net Working Capital (I-II) 891,250

Working Note/ Assumptions:

Note: Alternatively, student may assume debtors on selling price i.e. Rs. 130 in such a case ,
overhead needs to be calculated including depreciation i.e. at Rs. 40 while calculating WIP &
finished goods.
1. The Overheads of Rs. 40 per unit include depreciation Rs. 10 per unit, which is non-cash
item. This depreciation cost has been ignored for valuation of work-in-progress, finished
goods and debtor. The overhead cost, therefore, has been taken only at Rs. 30 per unit.
2. In the valuation of work-in-progress, the raw materials have been taken at full
requirements for 15 days; but the wages and overheads have been taken only at 50%

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on the assumption that on an average all units in work in progress are 50%
complete.
3. Since, the wages are paid with a time lag of 10 days, the working capital provided by
wages have been taken by dividing the monthly wages by 3 (assuming a month to consist
of 30 days)
Question 12
A company is considering its Working Capital Investment and Financing Policies for the next
year. Estimated fixed assets and current liabilities for the next year are Rs. 2.60 Crores and Rs.
2.34 Crores respectively. Estimated sales and EBIT depend on current assets investment,
particularly inventories and book-debts. The following alternative working capital policies are
under consideration:
(Rs. in Crores)
Working capital policy Investment in Estimated EBIT
current assets sales
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00
After evaluating the working capital policies, the Financial Controller of the company has
advised the adoption of the moderate working capital policy. Further, the company is examining
the following alternatives for use of long-term and short-term borrowings for financing its assets:
(Rs. in Crores)
Financing Policy Short-term debt Long-term
debt
Conservative 0.54 1.12
Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest rate-average 12% 16%
The company will use Rs. 2.50 Crores of the equity funds. The corporate tax rate is 25%.
Required: (1.5+7.5=9 Marks)
i) Calculate net working capital position, under each working capital policy.
ii) Calculate net working capital position, rate of return on shareholder's equity, and
current ratio under consideration of different financing policies and financial
controller's advice.
[July 2015]
Answer:

Answer: i) Net Working Capital position (Rs. Crores)

Particulars Working Capital Policy
Conservative Moderate Aggressive
Current assets 4.50 3.90 2.60
Less: Current liabilities 2.34 2.34 2.34
Net working Capital position 2.16 1.56 0.26

ii) Calculation of Net WC position, ROSE and CR under different financing policy and FC's
advices (Rs. Crores)

Particulars Financing Policy

Conservative Moderate Aggressive
Fixed assets 2.60 2.60 2.60
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 CAP II Paper 4: Financial Management

Current assets 3.90 3.90 3.90

Total assets 6.50 6.50 6.50
Current liabilities 2.34 2.34 2.34
Short-term debt 0.54 1.00 1.50
Long-term debt 1.12 0.66 0.16
Equity capital 2.50 2.50 2.50
Total liabilities 6.50 6.50 6.50
Budgeted sales 11.50 11.50 11.50

EBIT 1.15 1.15 1.15

Less: Interest on short-term debt @ 12% 0.06 0.12 0.18
Interest on long-term debt @ 16% 0.18 0.11 0.03

EBT 0.91 0.92 0.94

Less: Tax @ 25% 0.23 0.23 0.24
EAT 0.68 0.69 0.70

(a) Net working Capital position 1.02 0.56 0.06

(Current assets-current liabilities)
(b) Rate of Return on shareholders' Equity Capital 27.2% 27.6% 28%
(EAT/Equity Share Capital) × 100
(c) Current ratio (Current assets/current liabilities) 1.35 1.17 1.02

Question No: 13
RPG Enterprises has been operating its manufacturing facilities till Aasadh end
2072 on a single shift working with the following cost structure:
Per Unit (Rs.)
Cost of Material 6
Wages (out of which 40% is fixed) 5
Overheads (out of which 80% is fixed) 5
Profit 2
Selling Price 18
Sales during 2071/72 : Rs. 432,000.
As at Ashadh end 2072 the company held:
(Rs.)
Stock of raw materials (at cost) 36,000
Work- in- progress (valued at prime cost) 22,000
Finished goods (valued at total cost) 72,000
Sundry debtors 108,000
In view of increased market demand, it is proposed to double production by working at extra
shift. It is expected that a 10% discount will be available from suppliers of raw materials, in view
of increased volume of business. Selling price will remain the same. The credit period allowed to
customers will remain unaltered. Credit availed from suppliers will continue to remain at the
present level, i.e. 2 months. Lag in payment of wages and expenses will continue to remain half a
month.
Required: (12 Marks)
Assess the additional working capital requirements, if the policy to increase output is
implemented.
[December 2015]

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 CAP II Paper 4: Financial Management

Answer:

WN. 1) Sales in Units 2071/072

Sales
=
Selling price per unit
432000
= = 24000
18
2) Stock of Raw Materials in Units on Ashadh end 2072
Value of stock 36000 6000
= =
cost per unit 6 Units

3) Stock of Work-in-Progress in Units on Ashadh end 2072

Value of WIP 22000 2000
= =
prime cost per unit 11 Units

4) Stock of Finished Goods in Units on Ashadh end 2072

Value of Finished Stock 72000 4500
= =
total cost per unit 16 Units

5) Statement of cost at single shift and double shift working

` 24000 Units 48000 Units
Per Unit Total Per Unit Total
Rs. Rs. Rs. Rs.
Raw materials 6.00 144,000 5.40 259,200
Wages - Variables 3.00 72,000 3.00 144,000
Fixed 2.00 48,000 1.00 48,000
Overheads- Variables 1.00 24,000 1.00 48,000
Fixed 4.00 96,000 2.00 96,000
Total cost 16.00 384,000 12.40 5, 95,200
Profit 2.00 48,000 5.60 268,800
18.00 432,000 18.00 864,000

Comparative Statement of Working Capital Requirement

Single Shift Double Shift
Unit Rate Amount Unit Rate Amount
(Rs) (Rs)
Current Assets:
Inventories -
Raw
Materials 6000 6.00 36,000.00 12000 5.40 64,800.00
Work-in-
Progress 2000 11.00 22,000.00 2000 9.40 18,800.00
Finished
Goods 4500 16.00 72,000.00 9000 12.40 111,600.00
Sundry Debtors 6000 18.00 108,000.00 12000 18.00 216,000.00
Total Current Assets
(A) 238,000.00 411,200.00
Current Liabilities:
Creditors for
Materials 4000 6.00 24,000.00 8000 5.40 43,200.00
Creditors for Wages 1000 5.00 5,000.00 2000 4.00 8,000.00
Creditors for
Expenses 1000 5.00 5,000.00 2000 3.00 6,000.00

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 CAP II Paper 4: Financial Management

Total Current
Liabilities (B) 34,000.00 57,200.00
Working Capital :
(A) - (B) 204,000.00 354,000.00
Less : Profit included
in Debtors 6000 2.00 12,000.00 12000 5.60 67,200.00
192,000.00 286,800.00
Increase in Working Capital Requirement is (Rs. 286,800 - Rs. 192,000) Rs. 94,800
Notes:
(i) The quantity of materials in process will not change due to double shift working since work
started in the first shift will be completed in the second shift.
(ii) The valuation of work-in-progress based on prime cost as per the policy of the company is
as under.
Single Shift Double Shift
(Rs.) (Rs.)
6.00 5.40
3.00 3.00
2.00 1.00
11.00 9.40

Question No: 14
The Samriddhi Ltd. propose to raise its turnover from Rs. 6,00,000 to Rs. 8,40,000 next year and
to Rs. 9,60,000 in the succeeding year. It is expected that the purchases will go up from Rs.
1,80,000 to Rs. 2,40,000 and then to Rs. 2,70,000 in the next two years.
A steady profit of 10% on turnover is estimated over the years; and the materials, labour and
factory overheads are expected uniformly to be 30%, 20% and 30% respectively of the total cost
of goods sold.
At the end of each year the raw materials stock would amount to two months' consumption,
work-in-progress to one month's factory cost and finished goods to half a month's total cost.
There is a two months' credit period allowed to customers and received from suppliers.
The company has a policy of carrying cost equivalent to one month's requirement for payment of
labour and other overhead cost. Ignoring prepayments and accrued charges as they normally
offset each other, please work out an estimate of working capital requirement for all the three
years separately. State assumptions, if any.
(10 Marks)
[June 2016]

Answer:

a) Workings:
Particulars Year 1 Year 2 Year 3
Estimated sales 600,000 840,000 960,000
Less: Profit (@10% on sales) 60,000 84,000 96,000
Cost of goods sold (a) 540,000 756,000 864,000

Factory costs
Material cost (30% of total cost) 162,000 226,800 259,200
Labour cost (20% of total cost) 108,000 151,200 172,800
Overhead cost (30% of total cost) 162,000 226,800 259,200
(b) 432,000 604,800 691,200

Administration, selling and distribution expenses (a-b) 108,000 151,200 172,800

Purchase estimation 180,000 240,000 270,000

Estimation of Working Capital requirement
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 CAP II Paper 4: Financial Management

Particulars Year 1 Year 2 Year 3

Current Assets:
Raw material stock 2 months raw material cost 27,000 37,800 43,200

Work in Progress 1 month factory cost 36,000 50,400 57,600

Finished goods 1/2 month of cost of goods sold 22,500 31,500 36,000

Sundry debtors 2 months of credit sales 100,000 140,000 160,000

1 month of labour cost, factory
overhead, administration selling
Cash and distribution expenses 31,500 44,100 50,400
a 217,000 303,800 347,200

Current Liabilities:
Sundry Creditors 2 months of purchase estimation 30,000 40,000 45,000
b 30,000 40,000 45,000

Estimated Working Capital (a-b) 187,000 263,800 302,200

Question No: 15
The current assets and current liabilities of ABC Co. at the end of March 2016
are as follows:
Description Amount in (Rs.‗000)
Inventory 5,700
Trade receivables 6,575
Total current assets 12,275
Trade payables 2,137
Overdraft 4,682
Total current liabilities 6,819
Net current assets 5,456
For the year to end on March 2016, ABC Co. had domestic and foreign sales of
Rs. 4 crores, all on credit, while cost of sales was Rs. 2 crore 60 lakhs. Trade
payables are related to both domestic and foreign suppliers.
For the year to end on March 2017, ABC Co. has forecasted that credit sales
will remain at Rs. 4 crores while cost of sales will fall to 60% of sales. The
company expects current assets to consist of inventory and trade receivables,
and current liabilities to consist of trade payables and the company‘s overdraft.
ABC Co. also plans to achieve the following target working capital ratio for the
year to the end on March 2017:
Inventory days 60 days
Trade receivables days 75 days
Trade payables days 55 days
Current ratio 1.4 times
Assume 365 days in a year.
Required: (6+6+8=20 Marks)
d) Calculate the working capital cycle (cash collection cycle) of ABC Co. at the end of
March 2016 and discuss whether a working capital cycle should be positive or negative.
e) Calculate the target quick ratio and the target ratio of sales to net working capital of ABC
Co. at the end of March 2017.
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 CAP II Paper 4: Financial Management

f) Analyse and compare the current asset and current liability positions for March 2016 and
March 2017, and discuss how the working capital financing policy of ABC Co. would
have changed.
[December 2016]
Answer
a) Calculation of working capital cycle at the end of March 2016
Inventory days = 365 x (5,700/26,000) = 80 days
Trade receivables days = 365 x (6,575/40,000) = 60 days
Trade payables days = 365 x (2,137/26,000) = 30 days
Working capital cycle = 80 + 60 – 30 = 110 days
The working cycle of ABC Co is positive and the company pays its trade suppliers 110
days (on average) before it receives cash from its customers. This represents a financing
need as far as ABC Co is concerned, which could be funded from a short-term or long-
term source.
If the working capital cycle had been negative, ABC Co would have been receiving cash
from its customers before it needed to pay its trade suppliers. A company which does not
give credit to its customers can have a negative working capital cycle.
Even if companies might generally prefer to be paid by customers before they have to
pay their suppliers, the question of whether the working capital cycle should be positive
or negative implies that companies are able to make such a choice, but this is not usually
the case. This is because the length of the working capital cycle depends on its elements,
which are inventory days, trade receivables days and trade payables, and these elements
usually depend on the nature of the business undertaken by a company and the way that
business is conducted by its competitors. The length of the working capital cycle is
usually therefore similar between companies in the same business sector, but can differ
between business sectors.
b) Target quick ratio and sales to net working capital ratio at the end of March 2017:
Cost of sales = 40,000,000 x 0·6 = Rs. 24,000,000
Inventory using target inventory days = 24,000,000 x 60/365 = Rs. 3,945,206
Trade receivables using target trade receivables days = 40,000,000 x 75/365
= Rs. 8,219,178
Current assets = 3,945,206 + 8,219,178 = Rs. 12,164,384
If the target current ratio is 1·4 times, current liabilities = 12,164,384/1·4 = Rs.
8,688,846
The target quick ratio (acid test ratio) = 8,219,178/8,688,846 = 0·95 times
Net current assets (wc) at the end of March 2017 = 12,164,384 – 8,688,846 = Rs.
3,475,538
Target sales/net working capital ratio = 40,000,000/3,475,538 = 11.51 times
c) The current liabilities at the end of March 2017, calculated in part (b), can be divided
into trade payables and the forecast overdraft balance.
Trade payables using target trade payables days = 24,000,000 x 55/365 = Rs. 3,616,438.
The overdraft (balancing figure) = 8,688,846 – 3,616,438 = Rs. 5,072,408
Comparing current assets and current liabilities:

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 CAP II Paper 4: Financial Management

Description March 2016 March 2017

(Rs. ‗000) (Rs. ‗000)
Inventory 5,700 3,945
Trade receivables 6,575 8,219
Total Current Assets 12,275 12,164
Trade payables 2,137 3,616
Overdraft 4,682 5,072
Total Current Liabilities 6,819 8,688
Net current assets 5,456 3,476
The overdraft as a percentage of current liabilities will fall from 69% (4,682/6,819) to
58% (5,072/8,688). Even though the overdraft is expected to increase by 8.3%, current
liabilities are expected to increase by 27.4% (8,688/6,819). Most of this increase is
expected to be carried by trade payables, which will rise by 69.2% (3,616/2,137), with
trade payables days increasing from 30 days to 55 days.
At the end of March 2016, current liabilities were 56% of current assets (100 ×
6,819/12,275), suggesting that 44% of current assets were financed from a long-term
source. At the end of March 2017, current liabilities are expected to be 71% of current
assets (100 × 8,688/12,164), suggesting that 29% of current assets are financed from a
long-term source. This increasing reliance on short-term finance implies an aggressive
change in the working capital financing policy of ABC Co.

Question No: 16
A public company is commencing a new project for manufacturing of a plastic
component. The following cost information has been ascertained for annual
production of 12,000 units at full capacity:

Particulars Cost per unit (Rs.)

Materials 40
Direct labour and variable expenses 20
Fixed manufacturing expenses 6
Depreciation 10
Fixed administrative expenses 4
80
Selling price per unit is expected to be Rs. 96 and selling expenses Rs. 5 per
unit, 80% of which is variable.
In the first two years of operations, production and sales are expected to be as
follows:
Year Production (No. of units) Sales (No. of units)
1 6,000 5,000
2 9,000 8,500
Following additional information is available:
Stock of materials : 2.25 months‘ average consumption
Work in process : Nil
Debtors : 1 month‘s average sales
Cash Balance : Rs. 10,000
Creditors for supply of materials : 1 month‘s average purchase during the year
Creditors for expenses : 1 month‘s average of all expenses during the year
Required: (10 Marks)
Prepare projected profit and loss account and statement of working capital
requirement for the two years.
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 CAP II Paper 4: Financial Management

[June 2017]
Answer:
i) Projected Profit and Loss Account

Particulars Year 1 Year 2

Production (Units) 6,000 9,000
Sales (Units) 5,000 8,500
Rs. Rs.
Sales Revenue (a) (sales units × Rs. 96) 480,000 816,000

Cost of Production:
Materials (production unit× Rs.40) 240,000 360,000
Direct labour and variable expenses (@ Rs. 20 p.u.) 120,000 180,000
Fixed Manufacturing cost ( 12000 units × Rs. 6) 72,000 72,000
Depreciation ( 12000 units × Rs. 10) 120,000 120,000
Fixed administration expenses (12000 units × Rs. 4) 48,000 48,000
Cost of Production: 600,000 780,000

Add: Opening stock of finished goods ( Yr 1 nil ; Yr-

2 1000 units) (@ Rs. 600,000/6,000 units) 0 100,000
600,000 880,000

Less: Closing stock of finished goods ( Yr 1 - 1000 *

units, Yr 2 -1500 units) (@production cost per unit) 100,000 130,000
Cost of goods sold 500,000 750,000
Add: Selling expenses
- Variable @ Rs. 4 p.u. 20,000 34,000
-Fixed ( 12000 units @ Re. 1) 12,000 12,000
Cost of sales (b ) 532,000 796,000

Profit / ( Loss) (a- b) -52,000 20,000

*Alternative
Average cost method can also used
8,80,000 ×1,500
9,000+1,000
=1,32,000

ii) Calculation of Creditors for Supply of Materials

Particulars Year 1 (Rs.) Year 2 (Rs.)

Materials consumed 240,000 360,000
Add: Closing stock (2.25 month consumption) 45,000 67,500
285,000 427,500
Less: Opening Stock - 45,000
Purchases 285,000 382,500
Average purchase per month (Creditors) 23,750 31,875
iii) Calculation of creditors for Expenses

Particulars Year 1 (Rs.) Year 2 (Rs.)

Total direct labour, manufacturing,
administration and selling expenses for the 272,000 346,000
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 CAP II Paper 4: Financial Management

year

Average per month 22,667 28,833

iv ) Computation of Projected Statement of Working Capital Requirement

Particulars Year 1 (Rs.) Year 2 (Rs.)
Current Assets:
Stock of materials (2.25months' average
consumption) 45,000 67,500
Stock of Finished goods 100,000 130,000
Debtors (one month average sales) 40,000 68,000
Cash 10,000 10,000
Total (a) 195,000 275,500

Current Liabilities:
Creditors for supply of materials 23,750 31,875
Creditors for expenses 22,667 28,833
Total (b) 46,417 60,708

Estimated Working Capital (a- b) 148,583 214,792

Question No: 17
AB & Co. has applied for working capital finance from a commercial bank. The following is the
firm‘s projected profit and loss account:-
Particulars Amount (Rs.)
Sales 2,247,000
Cost of goods sold 1,637,100
Gross profit 609,900
Administrative expenses, 149,800
Selling expenses 139,100 288,900
Profit before tax 321,000
Tax provision 107,000
Profit after tax 214,000
Total cost of goods sold (COGS) is calculated as follows:
Particulars Amount (Rs.)
Material used 898,800
Wages and other manufacturing expenses 668,750
Depreciation 251,450
1,819,000
Less: Stock of finished goods (10% product not yet sold) 181,900
Cost of goods sold 1,637,100
 The figures given above relate only to the goods that have been finished, and not to
work in progress.

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 CAP II Paper 4: Financial Management


Goods equal to 15 percent of the year‘s production (in terms of physical units) are
in progress on an average requiring full material but only 40 percent of other
expenses.
 The firm has a policy of keeping two months‘ consumption of material in stock.
 All expenses are paid one month in arrears.
 Suppliers of material grant one and half months‘ credit;
 Sales are 20 percent cash while remaining sold on two months‘ credit.
 70 percent of the income tax has to be paid in advance in quarterly installments.
Required: (10 Marks)
Prepare an estimate of the working capital requirements of the firm on cash cost basis.
You may add 10 percent to your estimated figure to account for exigencies.
[June 2018]
Answer:
STATEMENT SHOWING THE REQUIREMENTS OF WORKING
CAPITAL (ON CASH COST BASIS)
Particulars Rs.
A. Current Assets:
Stock of raw material (898,800+1,34,820)×2/12 172,270
Stock of Work in Progress WN II 174,945
Stock of Finished Goods WN III 156,755
Debtors 1,359,756 x 2/12 226,626
Total Current Assets 730,796
B. Current Liabilities
Creditors for Raw Materials 1,205,890 x 1.5/12 150,736
Creditors for Wages 708,875 x 1/12 59,073
Creditors for Office and Adm. Expenses 149,800 x 1/12 12,483
Creditors for Selling & Distribution 139,100 x 1/12 11,592
Expenses
Provision for Taxation 107,000 x 30/100 32,100
Total Current Liabilities 265,984
C. Net Working Capital A-B 464,612
D. Add: Safety Margin 464,612 x 10/100 46,461
E. Required Working Capital C + D 511,073
Working Notes:
I) Calculation of raw material consumed:
Material used in Finished goods = 898,800
Materials used in WIP = 15% ×898,800 = 134,820
Raw material consumed = 898,800 + 134,820 = 1,033,620
II) CALCULATION OF STOCK OF WORK-IN-PROGRESS
Particulars Rs.
Raw Material (898,800 x 15%) 1,34,820
Wages & Manufacturing Expenses (668,750 x 0.15 x 0.40) 40,125
Total 174,945
III) CALCULATION OF STOCK OF FINISHED GOODS AND COST OF SALES
Particulars Rs.
Direct Material Cost (898,800+134820) 1,033,620

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Wages & Manufacturing Expenses (668,750+40,125) 708,875

Gross factory Cost 1,742,495
Less: Closing WIP (As per WN II) 174,945
Cost of Goods Produced 1,567,550
Less: Closing Stock (10% x 1,567,550) (156,755)
Cost of goods sold 1,410,795
Add: Office & Adm. Expenses 149,800
Add : Selling and Distribution Expenses 139,100
Total Cash cost of sales 1,699,695
Total Cash cost of Credit Sales (80% of 1,699,695) 1,359,756
OR: WN III
Valuation of Finished Goods
Raw material = 898,800×10% = 89,880
Wages and manufacturing exp.= 6,68,750×10% = 66,875
1,56,755
WN IV: Computation. Of Debtors
Debtors on sales value = ( 22,47,000×80%)×2/12 = 2,99,600
Component cost of debtors
Raw material (8,98,800 - 89,880)/22,47,000 = 36%
Wages & mgmf (6,68,750 - 66,875)/22,47,000 = 26.78%
Adm and selling exp. (1,49,800 + 1,39,100)/22,47,000 = 12.86%
Total cash cost % of Debtors = 75.6428%
Cash cost of Debtors = 2,99,600×75.6428 = 2,26,626

IV) CALCULATION OF CREDIT PURCHASES & AMOUNT OF CREDITORS

Particulars Rs.
A. Raw Material Consumed 1,033,620
B. Add: Closing Stock 172,270
C. Opening Stock Nil
D. Purchases (A+B-C) 1,205,890
E. Creditors ( 1,205,890×1.5/12) 150,736

Chapter 9:
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Receivable Management

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Question No. 1
Indicate whether the following statements are ‗True or False‘ and also support your answer with
reasons: (2.5 Marks)

-A certain firm has a credit term of 3/15, net 45 while selling goods. Here the term ‗15‘ means
discount period.
(June 2009)
Answer:
True, because if the firm pays within 15 days, it will be entitled to receive 3 percent discount.

Question No. 2
Indicate whether the following statements are ‗True or False‘ and also support your answer with
reasons: (2.5 Marks)
-Aging schedule of receivables is the maximum limit on the amount the company will
permit the firm to owe at any one point of time.
(June 2009)
Answer:
False, because aging schedule of receivables is the tabular classification of amounts
remaining to be collected. The maximum limit on the amount the company will permit
the firm to owe at any one point of time is referred to as a line of credit.

Question No. 3
Factoring services [June 2011] (2.5 Marks)
Answer:
Factoring services - Factoring is a unique financial innovation. It is both a financial as well as a
management support to a client. It is a method of converting a non productive, inactive asset like
receivable into a productive asset like cash by selling receivables to a company that specializes
in their collection and administration. Factoring is a business involving a continuing legal
relationship between a financial institution (factor) and a business concern (client) selling goods
or providing services to trade customers whereby the factor purchases the client's account
receivable and in relation thereto, controls the credit, extended to customers and administers the
sales ledger. Basically three kinds of services fall into this: sales ledger administration and credit
management, credit collection and protection against default and bad debt losses, financial
accommodation against the assigned book debts.

Question No. 4
Recourse and Non-recourse Factoring [December 2011] (2.5 Marks)
Answer:
In a recourse or pure factoring, the factor firm is only involved in the work of collection of the
receivables. It does not bear any risk of default by the debtors. Such a risk will have to be
invariably borne by the selling firm. Thus, in case of default by a customer, the selling firm will
have to refund the amount of advance together with charges as per the agreement which was
given by the factor to the selling firm against the receivables.
In a non-recourse factoring, the factor firm purchases the receivable of the selling firm by
paying the agreed amount (sales value less commission) to the latter. The payment may be made
immediately or after receiving from the customer buying.
The main feature of non-recourse factoring is that the risk of default by the buyer is borne by the
factor firm and the selling firm receives the sales amount. Thus, this type of factoring will result
in the purchase of receivable by the factor firm.

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In non-recourse factoring, the factor also undertakes the receivables management including
evaluation of creditworthiness, thereby also assessing the risk of bad debts. In this type of
factoring, the factor firm will normally insist on discounting the seller‘s entire book debts
subject to careful examination of the debtors and their creditworthiness. In such cases, the seller
is entitled to sell to other customers not evaluated as credit-worthy but these sales would
obviously be excluded from the services of the non-recourse factor.

Question No. 5
Answer the following, supporting the same with proper reasoning: (2.5 Marks)
The credit policy of Firm ―A‖ is – A high percentage of bad-debt loss but normal receivable
turnover and credit rejection rate. What is the effect of this policy on sales and profit?
[June 2013]

Answer:
The effect of this policy is that the sales remain unaffected while profits decrease. This policy
indicates that the firm has poor collection policy. Accounts that are collectable are being written
off too soon. Therefore, the turnover is being maintained at the expense of increased bad debt
losses.

Question No. 6
Recourse and Non-Recourse factoring (2.5 Marks)
[June 2014]
Answer:
In a recourse or pure factoring, the factor firm is only involved in the work of collection of the
receivables. It does not bear any risk of default by the debtors. Such a risk will have to be
invariably borne by selling the firm. Thus, in case of default by a customer, the selling firm will
have to refund the amount of advanced together with charges as per the agreement which was
given by the factor to the selling firm against the receivables.
In a non-recourse factoring, the firm purchases the receivable of the selling firm by paying the
agreed amount (sales value less commission) to the latter. The payments may be made
immediately or after receiving from the customer buying.
The main feature of non-recourse factoring is that the risk of default by the buyer is borne by the
factor firm and the selling firm receives the sales amount. Thus, this type of factoring will result
in the purchase of receivable by the factor firm.

Question No. 7
Factoring and Bills discounting (2.5 Marks)
[December 2015]

Answer:
The factoring and bills discounting are both means available for short term finance; nevertheless
they are different to each other in terms of:
Responsibility: In factoring it is the factor that usually assumes the responsibility of collecting
the bills while in bills discounting the drawer assumes the responsibility of collecting the bills
and pays the proceeds. Factoring is more associated with the management of book debts while
bill discounting is related to borrowing from commercial bank.
Risk of Credit: Bills discounting is always of recourse type i.e., drawer assumes the credit
risk and not the drawee bank, while factoring can be either with or without recourse. In
case of recourse, the factor does not assume credit risk and it is the company that owns
receivables assumes the credit risk.

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Facility of finance: In bills discounting, there is only a provision of finance, while in

factoring, the factor provides other facilities like sales ledger maintenance, collection etc.
in addition to the finance facility.
Negotiability: The discounted bills may be re-discounted several times before they mature
for payment where as it is not possible to negotiate in case of factoring.
Accounting: Transactions in the factoring are off balance sheet items as the amount of
receivables and bank credit are not presented in the balance sheet, whereas bills
discounting are presented in the "Loans and Advances" head of the balance sheet.

Question No. 8
Factoring and Bills Discounting (2.5 Marks)
[December 2017]

Answer:
The differences between Factoring and Bills discounting are as below:
 Factoring is called as "Invoice Factoring" where as Bills discounting is known
as "Invoice Discounting"
 In Factoring, the parties are known as client, factor and debtor where as in Bills
discounting, they are known as drawer, drawee and payee
 Factoring is a sort of management of book debts whereas bills discounting is a
sort of borrowing from commercial banks
 For factoring there is no specific law whereas in case of bills discounting the
negotiable instruments law is applicable

Question No. 9
Cost and benefits of factoring [June 2018] (2.5 Marks)
Answer:
The cost of factoring includes:
 Factoring commission
 Interest charged by factor on advance granted
The benefits of factoring includes:
 Saving in costs of in house credit collection department
 Saving in bad debt losses
 Saving in cost of funds invested in receivables due to reduction in average collection period
 Saving in cash discount allowed (if any)

Question No. 10
A company deals with consumer durables, having an annual turnover of NRs. 65 million, 80
percent of which are credit sales effected through a large number of dealers. The balance sales
are made through company‘s show room on cash basis. The normal period of credit allowed by
the company for sales effected through dealers is 30 days.
The company wants to expand its business substantially and there is good prospect as well.
However, the marketing manager finds that the dealers have difficult in holding more stocks due
to financial problems. He therefore proposes a change in the credit policy as follows:
(NRs. in Million)
---------------------------------------------------------------------------------------------------
Proposal Credit period Anticipated Credit Sales
---------------------------------------------------------------------------------------------------
A 45 days 65
B 60 days 75
---------------------------------------------------------------------------------------------------
- ---------

The products yield an average contribution of 20 per cent on sales.

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Fixed costs amount to NRs. 3,200,000 per annum. The company expects a pre-tax return of 25
percent on capital employed. The finance manager, after a review of the proposal, has
recommended increasing the provision for bad debts from the current 0.5 percent to 1 percent for
proposal A and 2 percent to proposal B.

Based on the above facts and information, you are required to: (9+1=10 Marks)
i) evaluate the merits of the new proposals vis-à-vis their impact on the profitability
of the company, and
ii) recommend the best policy which the company should choose.
[June 2009]
Answer:
Evaluation of Proposed Credit Policies
------------------------------------------------------------------------------------------------------------
Particulars Present Proposal A Proposal B
----------------------------------------------------------------------------------------------------------------
Sales Revenue: NRs. 52,000,000 NRs. 65,000,000 NRs. 75,000,000
Less: Variable Costs (0.80) 41,600,000 52,000,000 60,000,000
Less: Fixed Costs 3,200,000 3,200,000 3,200,000
Less: Bad Debts 260,000 650,000 1,500,000
Less: Cost of Investment in Debtors* 560,000 1,725,000 2,633,333
Profit: 6,380,000 7,425,000 7,666,667
----------------------------------------------------------------------------------------------------------------
Recommendation: Proposal B generating maximum expected profit of NRs. 7,666,667 is the
best among the three proposal and therefore recommended.

Working Notes:
Cost of Investment in Debtors
------------------------------------------------------------------------------------------------------------
Particulars Present Proposal A Proposal B
----------------------------------------------------------------------------------------------------------------
(i) Total investment in Debtors: NRs. 44,800,000 NRs. 55,200,000 NRs. 63,200,000
(Total VC + Total FC)
(ii) Debtors Turnover Ratio 12 8 6
(360 days/Average Collection Period) (360/30) (360/15) (360/60)
(iii) Average Investment in Debtors (i/ii) 3,733,333 6,900,000 10,533,333
(iv) Cost of Average Investment in Debtors: 933,333 1,725,000 2,633,333
(v X 0.25)

Question No: 11
Zee Limited, manufacturer of Colour TV sets, are considering the liaberalisation of existing
credit terms to three of their large customers A, B and C. The credit period and likely quantity
of TV sets that will be lifted by the customers are as follows:
(Quantity lifted) (No. of TV Sets)
Credit Period (Days) A B C
0 1,000 1,000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500
The selling price per TV set is Rs. 9,000. The expected contribution is 20% of the selling price.
The cost of carrying debtors averages 20% per annum.

You are required to determine the credit period to be allowed to each customer.
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 CAP II Paper 4: Financial Management

(Assume 360 days in a year for calculation purposes). (8 Marks)

(June 2010)
Answer:
In case of customer A; there is no increase in sales as far as the credit period is concerned.
Apparently A enjoys good liquidity and the demand for TV sets in his area is limited. Hence
there is no point in allowing credit to 'A'. In case of customers 'B' and 'C' the credit period can be
determined by trading off between profitability of additional sales and the cost of carrying
additional debtors as a result of relaxation of credit period.

Profitability of additional sales on account of relaxing credit period

Customer 'B Customer 'C'
Credit period 0 30 60 90 0 30 60 90

(days) 1000 1,500 2,000 2,500 - - 1,000 1,500

Rs. lakhs Rs. lakhs

Sales 90 135 180 225 - - 90 135
Contribution at 20% 18 27 36 45 - - 18 27
Incremental
Contribution (A) - 9 9 9 - - 18 9

Debtors:
Credit period X sales - 11.25 30 56.25 - - 15 33.75
360

Incremental Debtors - 11.25 18.75 26.25 - - 15 18.75

Cost of incremental
debtors at 80% - 9 15 21 - - 12 15
Cost of carrying incremental
debtors at 20% (B) - 1.8 3 4.2 - - 2.4 3

Excess incremental contribution

over cost of carrying incremental
debtors (A - B) 7.2 6 4.8 - - 15.6 6

It is seen from the above computations that incremental contribution exceeds incremental cost of
carrying additional debtors at each credit period. Therefore, credit period to B and C should be
90 days.

Question No: 12
Progressive Manufacturers Ltd. has sales of Rs. 250 million of which 80 per cent is on credit
basis. The present credit terms of the company are ―2/15, net 45‖. At present, the average
collection period is 30 days. The proportion of sales on which customers currently take
discount is 0.50.
The firm is considering relaxing its discount terms to ―3/15, net 45‖. Such a relaxation is
expected to increase current credit sales by Rs. 10 million, reduce the average collection period
to 27 days and increase the proportion of discount sales to 0.60. The average selling price of he
company‘s product is Rs. 1,000 per unit and variable cost per unit works out to be Rs. 800. The
company is subject to a tax rate of 25 per cent and it‘s, before tax rate of borrowings for
working capital is 12 per cent.
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Should the firm change its credit terms to ―3/15, net 45‖? Support your answers by calculating
the expected change in net profit (assume 360 days in a year) (8 Marks)
[June 2011]

Answer:
Total Sales = Rs. 250 million
Credit Sales = Rs. 250 x 0.80 = Rs. 200 million
(a) Present Credit Policy:
Present credit terms are ‗2/15, net 45‘
Present average collection period = 30 days
Proportion of sales on which customers currently take discount is 0.5, or 50%.
(b) Basic revenue and cost structure applicable to both the policies:
Selling price per unit: Rs. 1,000
Variable cost per unit: Rs. 800
Contribution per unit: Rs. 200

P / V Ratio = 200/1,000 x 100 = 20%

Contribution from increased sales = Rs. 1,000,000 x 20% = Rs. 200,000

(c) Relaxed Credit Policy:

Reduction in average collection period to 27 days
Increase in proportion of discount sales to 0.60, or 60%
Change in the investment of Receivables
= [Rs. 200 million x 27 – 30 ] + [Rs. 10 million x 80/100 x 27/360]
360
= (-) Rs. 1.667 million + Rs. 0.60 = (-) Rs. 1.0667 million
Therefore, the reduction in receivables investment is Rs. 1.0667 million.
Saving in cost from reduction in receivables investment
= 1.0667 x 0.12 (1 – 0.25) = 0.096 million
Increase in discount cost
= [(Rs. 200 + 10) x 60/100 x 3/100] – (200 x 50/100 x 2/100)
= 3.78 – 2 = Rs. 1.78 million

Statement showing Profitability of Relaxing Credit Policy

(Rs. in million)
___________________________________________________________________________________________________________________________________________________________

Contribution from Increased Sales 2.000

Cost savings from Reduction in the Receivables Investment 0.096

2.096
Less: Incremental Discount Cost 1.780
Incremental Profit 0.316
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___________________________________________________________________________________________________________________________________________________________

The firm can increase its profits by Rs. 0.316 million by relaxing the credit policy. Therefore, it
is suggested to change the credit terms to ‗3/15, net 45‘ from the present ―2/15, net 45‖.

Question No: 13
Maya Limited is planning to change its credit policy which is expected to increase the average
collection period from one month to two months. The relaxation of credit terms is expected to
produce an increase in sales volume by 25%. Following are other relevant data:
Sales price per unit Rs.10
Profit per unit Rs.1.5
Current Sales Revenue per annum Rs. 2,400,000
Required rate of return on investment 20%
Assume that the 25% increase in sales would result additional stock of
Rs. 100,000 and additional creditors of Rs. 20,000.
Required:
Advise the company whether the credit terms should be revised in following
circumstances: (4+3=7 Marks)
i) If all the customers take longer credit terms of 2 months.
ii) If current customers do not opt for revised credit terms and only
new customers opt the revised credit terms.
[December 2011]

Answer:

The revision of credit terms is justifiable if the rate of return on the additional investment in
working capital exceeds 20%.
Extra profit from the revision
Profit Margin (1.5/10) = 15%
Increase in sales revenue = 2,400,000x25% = Rs. 600,000
Increase in profit = 600,000x15% = Rs. 90,000
Total sales revenue after revision = (2,400,000+600,000) = Rs. 3,000,000
Now, we need to calculate return on extra investment in working capital so as to assess whether
the revision of credit terms is justifiable. This is generally done by taking the figure of debtors
on the basis of cost of sales and sometimes on the basis of sales. Computations have been done
below by following both the basis.
(i) If all Debtors take two months’ Credit:
Cost of Sales
Sales Basis Basis
Rs. Rs.
Average Debtors after the Sales Increase 425,000 500,000
(2/12 x Rs. 3,000,000 x 85%)
(2/12 x Rs. 3,000,000)
Current Average Debtors 170,000 200,000
(1/12 x Rs 2,400,000 x 85%)
(1/12 x Rs 2,400,000)
Increase in Debtors 255,000 300,000
Increase in Stocks 100,000 100,000
355,000 400,000
Increase in Creditors (20,000) (20,000)
Net Increase in Working Capital Investment 335,000 380,000
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Return on Extra Investment (Cost of Sales Basis) = 90,000/335,000 = 26.87%

Return on Extra Investment (Sales Basis) = 90,000/380,000 = 23.7%

(ii) If only the New Debtors take Two Months’ Credit:

Cost of Sales
Sales Basis Basis
Rs. Rs.
Increase in Debtors 85,000 100,000
(2/12 x Rs. 600,000 x 85%)
(2/12 x Rs. 600,000)
Increase in Stocks 100,000 100,000
Increase in Creditors (20,000) (20,000)
Net Increase in Working Capital Investment 165,000 180,000

Return on Extra Investment (Cost of Sales Basis) = 90,000/165,000 = 54.55%

Return on Extra Investment (Sales Basis) = 90,000/180,000 = 50%

Recommendation:
In both the cases (i) and (ii), the new credit policy appears to be worthwhile under
both the basis. Furthermore, the most of the product can also support extra sales. If
the firm has high fixed costs but low variable costs, the extra production and sales
could provide a substantial contribution at little extra cost.
Alternative Solution:
Statement of evaluation of credit policy- if all debtors take 2 months' credit
Increase/
Particulars Current New (Decrease)
Average collection period (ACP) month 1 2
ACP in year 0.0833 0.1667
Required Rate of return on investment 20%
Sales Revenue Rs. 2,400,000 3,000,000
Sales Volume (SR/ SP) unit 240,000 300,000
Selling Price/ unit Rs. 10 10
Cost of sales/ unit (SP-P) Rs. 8.50 8.50
Profit/ unit Rs. 1.50 1.50

Profit before cost of investment Rs. 360,000 450,000 90,000

(Profit x Sales unit)
Less: Cost of investment (WN 1) 34,000 101,000 67,000
Net profit 326,000 349,000 23,000
Since net profit increases by Rs.23,000 the revision in credit policy is justifiable.

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 CAP II Paper 4: Financial Management

Statement of evaluation of credit policy- if only the new debtors take 2 months' credit
Increase/
Particulars Current New (Decrease)
Average collection period (ACP) month 1 2
ACP in year 0.0833 0.1667
Required Rate of return on investment 20%
Sales Revenue Rs. 2,400,000 3,000,000
Sales Volume (SR/ SP) unit 240,000 300,000
Selling Price/ unit Rs. 10 10
Cost of sales/ unit (SP-P) Rs. 8.50 8.50
Profit/ unit Rs. 1.50 1.50

Profit before cost of investment Rs. 360,000 450,000 90,000

(Profit x Sales unit)
Less: Cost of investment (WN 2) 34,000 67,000 33,000
Net profit 326,000 383,000 57,000
Since net profit increases by Rs.57,000 the revision in credit policy is justifiable.

Working Notes:
1. Calculation of cost of investment: Rs. Rs. Rs.
Cost of Sales 2,040,000 2,550,000
(Sales unit * CoS per unit)
Investment in debtor (CoS x ACP in yr) 170,000 425,000
Increase in Stock 100,000
Increase in Creditors (20,000)
Additional working capital investment - 80,000
(a) Cost of investment in debtors 34,000 85,000 51,000
(Investment in Debtor x required rate of return)
(b) Cost of investment in additional WC - 16,000 16,000
(Additional WC x required rate of return)
Total cost of investment (a + b) 34,000 101,000 67,000

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2. Calculation of cost of investment: Rs. Rs. Rs.

Cost of Sales 2,040,000 2,550,000
(Sales unit * CoS per unit)
Investment in debtor (CoS x ACP in yr) 170,000 255,000
Increase in Stock 100,000
Increase in Creditors (20,000)
Additional working capital investment - 80,000
(a) Cost of investment in debtors 34,000 51,000 17,000
(Investment in Debtor x required rate of return)
(b) Cost of investment in additional WC - 16,000 16,000
(Additional WC x required rate of return)
Total cost of investment (a + b) 34,000 67,000 33,000

Note:
If only the new debtors take 2 months credit, New total investment in debtors is calculated as below:
Investment in debtors=
Current investment in debtor + (New CoS- Old CoS) x required rate of investment

Question No: 14
PQ Limited currently has annual sales of Rs. 500,000 and an average collection period of 30
days. It is considering a more liberal credit policy. If the credit period is extended, the company
expects sales and bad debt losses to increase in the following manner:
Credit Increase in credit Increase in sales Bad debts % of total
Policy period (Rs.) Sales
A 10 days 25,000 1.2
B 15 days 35,000 1.5
C 30 days 40,000 1.8
D 42 days 50,000 2.2

The selling price per unit is Rs. 2. Average cost per unit at the current level of operation is Rs.
1.50 and variable cost per unit is Rs. 1.20. The current bad debt loss is 1% of the total sales and
the required rate of return on investments is 20%. Ignore taxes and assume 360 days in a year.
Required:
Recommend the credit policy to be adopted. (8 Marks)
[December 2012]

Answer:
(a) The firm will maximize the shareholders value if it extends its period by additional 30 days (since expected
return is higher than required return). In fact, it can further relax credit period until its expected return becomes 20%
or net gain becomes zero.
Particulars Increase in credit period
Existing 10 days 15 days 30 days 42 days
A Credit period (days) 30 40 45 60 72
B Annual Sales (Rs.) 5,00,000 5,25,000 5,35,000 5,40,000 5,50,000
C Level of receivables 41,667 58,333 66,875 90,000 1,10,000
(at sales value) (AXB)/360 (Rs.)
D Incremental investment in receivables - 16,667 25,208 48,333 68,333
(C-41,667) (Rs.)
E Required incremental profit at 20% - 3,333 5,042 9,667 13,667
(0.20XD) (Rs.)
F Incremental contribution on additional sales - 10,000 14,000 16,000 20,000
@40% (2-1.2)/2 (Rs.)
G Bad debt losses (BX %bad debts) (Rs.) 5,000 6,300 8,025 9,720 12,100
H Incremental Bad debt losses - 1,300 3,025 4,720 7,100
(G-5,000) (Rs.)
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I Incremental expected profit - 8,700 10,975 11,280 12,900

(F-H) (Rs.)
J Net Gain (I-E) (Rs.) - 5,367 5,933 1,613 (767)

Alternatively,
The investment in receivables can be calculated at cost. At current level of sales, the firm's average unit cost is Rs.
1.50. Since variable cost per unit is 1.20, we can find the fixed cost as follows:

Fixed Cost = Total Cost-Variable Cost

= (Rs.5,00,000) x 1.50/Rs. 2 - (Rs.5,00,000) x Rs.1.20/Rs.2
= Rs. 375,000 - Rs. 3,00,000
= Rs. 75,000

Thus, the total cost for different level of sales (assuming unit price and fixed cost do not change):
Sales (Rs.) Variable Cost (Rs.) Fixed Cost (Rs.) Total Cost (Rs.)
5,25,000 5,25,000 x 1.20/2 = 315,000 75,000 3,90,000
5,35,000 5,35,000 x 1.20/2 = 321,000 75,000 3,96,000
5,40,000 5,40,000 x 1.20/2 = 324,000 75,000 3,99,000
5,50,000 5,50,000 x 1.20/2 = 330,000 75,000 4,05,000

Investment in account receivables will be:

Investment in Receivables (Rs.) Changes in Investment (Rs.)
(3,75,000) x 30/360 = 31,250 -
(3,90,000) x 40/360 = 43,333 12,083
(3,96,000) x 45/360 = 49,500 18,250
(3,99,000) x 60/360 = 66,500 35,250
(4,05,000) x 72/360 = 81,000 49,750

The net gain from the credit policy can be re-calculated using incremental investment in accounts receivables at
cost. It would be higher now.
Particulars Increase in credit period
Existing 10 days 15 days 30 days 42 days
A Credit period (days) 30 40 45 60 72
B Incremental investment in receivables (Rs.) - 12,083 18,250 35,250 49,750
C Cost of investment at 20% (Rs.) - 2,417 3,650 7,050 9,950
D Incremental Bad debt losses (Rs.) - 1,300 3,025 4,720 7,100
E Incremental contribution on additional sales - 10,000 14,000 16,000 20,000
@40% (2-1.2)/2 (Rs.)
F Net Gain (E-D-C) (Rs.) - 6,283 7,325 4,230 2,950
In this case, the credit policy can be extended up to 42 days.

Questions No. 15
Nepal Gas Company franchise ―NP Gas‖ stations in east and west sites of Nepal. All payments
by franchises for gas product, which average Rs. 420,000 a day are by cheque. Presently, the
overall time between mailing of the cheque and the time the company has collected or available
funds at its bank is six days.
Required: (1+3+3=7 Marks)
i) How much money is tied up in this interval of time?
ii) To reduce this delay, the company is considering daily pickups of cheques from the
stations. In all, three cars would be needed and three additional people would be
hired. This daily pick up would cost Rs. 93,000 on an annual basis and it would
reduce the overall delay by two days. Currently, the opportunity cost of funds is 9%
that being the interest rate on marketable securities. Should the company inaugurate
the prick up plan? Why?
Rather than mailing cheques to its bank, the company could deliver them by messenger service.
This would reduce the overall delay by one day and would cost Rs. 10,300 annually. Should the
company undertake this plan? Why?
[June 2013]

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Answers:
Average daily payment by cheque= Rs. 420,000
Required time for collection of fund= 6 days

i) Cash tied up= Rs. 420,000×6 days= Rs. 2,520,000

ii) Calculation of annual net cost/benefit for pick up plan:
Opportunity cost savings = Rs. 420,000 × 2 days × 9% = Rs. 75,600
Less: Annual cost of pick up plan = (Rs. 93,000)
Net annual loss = (Rs. 17,400)
Since this option brings loss, the company should not start pick up plan.

iii) Calculation of annual net cost/benefit by employing messenger:

Opportunity cost savings (Rs. 420,000 × 1 day × 9% = Rs. 37,800
Less: Annual cost of messenger service = (Rs. 10,300)
Annual Net savings =Rs. 27,500
Since this option brings net savings to the company, this is a viable
option for the company.

Question No. 16
JL Ltd. is considering the revision of its credit policy with a view to increase its sales and profit.
Currently, all its sales are on credit and the customers are given one month‘s time to settle the
dues. It has recorded a contribution of 40% on sales. It can raise additional funds at a cost of
20% per annum. The manager of the company has given the following options along with
estimates for consideration:
Particulars Current Option I Option II Option III
position
Sales (Rs. in millions) 20 21 22 25
Average collection period 1 1.50 2 3
(in months)
Bad debts (% of sales) 2 2 .50 3 5
Cost of credit administration 0.12 0.13 0.15 0.30
(Rs. in millions)

Required: (7 Marks)
Consider debtors at cost, unless otherwise mentioned, and advise the company for the best
option to implement.
[December 2013]
Answer:
(Rs. in millions)
Particulars Present Option I Option II Option III
1. Sales 20 21 22 25
2. Variable Cost at 60% of sales 12 12.6 13.2 15
3. Contribution (1-2) 8 8.4 8.8 10
4. Cost of Debtors p.a. =Variable Cost of Sales 12 12.6 13.2 15
5. Average Collection Period (in months) 1 1.5 2 3
6. Average Debtors outstanding = 1 1.575 2.20 3.75

7. Interest on Average Debtors [ ] 0.20 0.315 0.440 0.75

8. Bad Debt [ ] 0.40 0.525 0.660 1.250
9. Cost of Credit Administration 0.12 0.13 0.15 0.30
10. Net Benefit [ ] 7.28 7.43 7.55 7.70
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Conclusion:
Option III may be chosen due to maximum Net benefit.

Question No. 17
In order to increase sales from their present annual level of Rs.2, 40,000, Agni Associates is
considering a more liberal credit policy. Currently, the firm has an average collection period of
30 days. However, it is believed that as collection Period is lengthened, sales will increase by
following amounts-
Credit Policy Increase in Average Collection Period Increase in Sales
A 15 Days Rs. 10,000
B 30 Days Rs. 15,000
C 45 Days Rs. 17,000
D 60 Days Rs. 18,000
The Variable Costs of the Firm‘s product is 60% of Sales Price.
If the Firm has pre-tax opportunity cost of 20%, which credit policy should be pursued? (Assume
a 360-Day year).
(7 Marks)
[June 2014]

Answer:
Evaluation of alternative credit policies
Particulars Present Policy A Policy B Policy C Policy D
1. Sales(given) Rs.2,40,000 Rs.2,50,000 Rs.2,55,000 Rs.2,57,000 Rs.2,58,000
[Link] cost at 60% of sales Rs.1,44,000 Rs.1,50,000 Rs.1,53,000 Rs.1,54,200 Rs.1,54,800
3. Contribution=(1-2) Rs.96,000 Rs.1,00,000 Rs.1,02,000 Rs.1,02,800 Rs.1,03,200
4. Cost of Debtors Rs.1,44,000 Rs.1,50,000 Rs.1,53,000 Rs.1,54,200 Rs.1,54,800
p.a.=Variable Cost of sales
5. Collection Period (in days) 30 days 45 days 60 days 75days 90 days
6. Average Debtors= Rs.12,000 Rs.18,750 Rs.25,500 Rs.32,125 Rs.38,700
7. Interests on Average Rs.2,400 Rs.3,750 Rs.5,100 Rs.6,425 Rs.7,740
Debtors (20%)
8. Net Benefit =(3-7) Rs.93,600 Rs.96,250 Rs.96,900 Rs.96,375 Rs.95,460

Decision:
The Firm should select Policy B, i.e. 60Days credit, since maximum benefit is obtained under
that policy.

Note: Alternatively, student may solve the above question under incremental approach.

Question No. 18
A firm is contemplating to increase its credit period from 30 days to 60 days. The average
collection period, which is at present 45 days, is expected to increase to 75 days. Due to this
change, the bad debt expenses is expected to increase from the current level of 1 percent to 3
percent of sales. Total credit sales are expected to increase from the level of 30,000 units to
34,500 units. The present average cost per unit is Rs. 8. The variable cost and sales are Rs. 6 and
Rs. 10 per unit respectively. The firm expects a rate of return of 15 percent.
Required: (5 Marks)
Analyse the firm's proposal to change the credit period and advise.
[December 2014]

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Answer:
Profit on additional sales =Rs.(10 –6) × (34,500 -30,000)units
= 4 ×Rs. 4,500
= Rs. 18,000

Average Investment in Accounts Receivable:

Present = (Total Sales Qty ×Average Cost Per Unit)/Receivable Turnover ratio
= (30,000×8) / (360/45)
= 240,000/8
=Rs.30,000
Proposed = (Existing Cost of sales + additional cost of sales)/Receivable Turnover ratio
= (2,40,000+4,500×6) / (360/75)
= 2,67,000 / 4.8
= Rs. 55,625
Additional Investment in Accounts Receivable = Rs. 55,625 – Rs. 30,000
= Rs. 25,625
Cost of additional investment in Accounts Receivable at 15% = Rs. 25,625× 15%
= Rs. 3,843.75
Additional Bad debt expenses
= (34,500×10×0.03) – (30,000×10×0.01)
= 10,350 – 3,000
= Rs. 7,350
The Net Effect of Proposed increase in credit period
= Additional Profit – additional expenses
= Rs. 18,000 – Rs.3,843.75 – Rs. 7,350
= Rs. 18,000 – Rs. 11,193.75
= Rs. 6,806.25

Conclusion:
The extension of credit period would result in net gain of Rs. 6,806.25, so the firm is advised to
extend credit period from 30 days to 60 days.

Question No. 19
Integration Nepal Limited has present annual sales of Rs. 40 lakh. The unit sales price is Rs. 20.
The variable cost is Rs. 12 per unit and fixed costs amount to Rs. 5 lakh per annum. The present
credit period of one month is proposed to be extended to either 2 or 3 months whichever is more
profitable. The following additional information is available:
Credit period 1 month 2 months 3 months
Increase in sales by - 10% 30%
% of Bad debts to sales 1% 2% 5%
Fixed costs will increase by Rs. 75,000 when sales will increase by 30%. The company requires
a pre-tax return on investment at 20%.
Required: (6 Marks)
Evaluate the profitability of the proposals and recommend the company.
[July 2015]

Answer:
Evaluation of profitability for different Credit periods (Rs.)
Particulars 1 month 2 months 3 months
A. Sales 4,000,000 4,400,000 5,200,000
Total Costs: 2,900,000 3,140,000 3,695,000

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Variable cost @ Rs. 12 p/u 2,400,000 2,640,000 3,120,000

Fixed costs 500,000 500,000 575,000
B. Operating Profit 1,100,000 1,260,000 1,505,000
C. Opportunity cost of 48,333 104,667 184,750
Investment in Receivables (see
working note 1)
D. Bad Debt 40,000 88,000 260,000
E. Net Benefit (B-C-D) 10,11,667 10,67,333 10,60,250

Recommendation: The Credit period of 2 months should be adopted since the net benefits under
this policy are higher than those under other policies.
Working Note 1: Calculation of cost of investment in receivables:
Opportunity cost = Total cost x Collection period/360 days x Rate of return
1 month = Rs. 2,900,000 x 1/12x 20% =Rs. 48,333
2 months= Rs. 3,140,000 x 2/12x20%= Rs. 104,667
3 months=Rs. 3,695,000 x 3/12x20%= Rs. 184,750
Alternate: Students can also refer the incremental approach.
Question No. 20
A firm has a total sales of Rs. 200 lakhs of which 80% is on credit. It is offering credit terms of
2/40, net 120. Of the total, 50% of customers avail discounts and the balance pay in 120 days.
Past experience indicates that bad debt losses are around 1% of credit sales. The firm spends
about Rs. 2,40,000 per annum to administer its credit sales. These are avoidable as a factor is
prepared to buy the firm‘s receivables. He will charge 2% commission. He will pay advance
against receivables to the firm at an interest rate of 18 % after withholding 10% as reserve.
(5 Marks)
i) What is the effective cost of factoring? Consider year as 360 days.
ii) If bank finance for working capital is available at 14% interest,
should the firm avail of factoring service?

[June 2016]

Answer:
Total sales = Rs. 200 Lakhs
Credit Sales (80%) = Rs. 160 lakhs
Receivable for 40 days = Rs. 80 lakhs
Receivable for 120 days = Rs. 80 lakhs
Average collection period [(40x0.5) + 120x0.5)] = 80 days
Average level of receivables (Rs. 1,60,00,000x80/360)=Rs. 35,55,556
Factoring Commission= Rs. 35,55,556 x 2% = Rs.71,111
Factoring Reserve = Rs. 35,55,556 x 10% = Rs.3,55,556
Amount available for advance = Rs. 35,55,556 – (3,55,556+71,111)=Rs.31,28,889
Factor will deduct his interest at 18%,
So, interest = Rs.31,28,889 x 18% x 80/360= Rs. 1,25,156
Advance to be paid = Rs.31,28,889 – 1,25,156=Rs.30,03,733
(i) Calculation of effective cost of factoring
Annual cost of factoring to the firm:
Factoring Commission (Rs.71,111 x 360/80) = Rs. 3,20,000
Interest Charges (Rs.1,25,156 x 360/80) = Rs. 5,63,200
Sub Total Rs. 8,83,200
Firm‘s saving on using Factoring services
Cost of credit administration saved Rs. 2,40,000
Bad debts (Rs.1,60,00,000 x 1%) avoided Rs. 1,60,000

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Sub Total Rs. 4,00,000

Net Cost to the firm = Rs,8,83,200 – Rs. 4,00,00 = Rs. 4,83,200
Effective cost of factoring = Rs.4,83,200 / Rs. 30,03,733 x 100 = 16.09 %

(ii) If bank finance for working capital is available at 14%, the firm should not avail
factoring services as 14% is lower than effective cost of factoring service i.e. 16.09%

Question No. 21
The Board of Z Ltd. is seeking an improvement plan on the company‘s working capital
management. Currently, the Company has total turnover (credit sales) of Rs. 23,09,00,000 per
year and has a policy of providing 30 days credit to its customers. Per facts furnished to the
Board by the management, the average collection period is more than the prescribed limit and it
is estimated that around 1% of the turnover turn into bad that are not recoverable. The company
has around Rs. 5,07,00,000 in accounts receivables and has a cost of short-term finance at 8%
per annum.
The CFO has invited for a proposal from a factoring company, D Ltd., to manage the
receivables/sales account of the company on a with-recourse basis. Per proposal submitted to the
company, the D Ltd. has committed to use its expertise to reduce average trade receivables days
to 27 days, cutting bad debts by 60% and reducing administration costs by Rs. 15,00,000 per
year.
In addition, D Ltd. shall also advance Z Ltd. 70% of the value of invoices raised at an interest
rate of 9% per year. The D Ltd. shall charge an annual fee of 1% of credit sales.
Assume 365 days for a year.
Required: (7 Marks)
Is the factor‘s offer financially viable to Z Ltd?
[June 2016]

Answer

The offer of factor will be financially viable only if there is net benefit from the
arrangement.

Current accounts receivables 5,07,00,000

Revised accounts receivables 23,09,00,000 27/365 1,70,80,274
Reduction in receivables 3,36,19,726

Reduction in financing costs of

receivables @ 8% 3,36,19,726  8% 26,89,578
Saving in bad debts 23,09,00,000  1%  60% 13,85,400
Reduction in administration costs (given) 15,00,000
Total Savings 55,74,978

Factor's annual fee 23,09,00,000  1% 23,09,000

Increase in financing cost on 23,09,00,000  70%  (9% -
advance 8%) 16,16,300
Total Cost 39,25,300

Net Benefit from the arrangement 16,49,678

The factor‘s offer is financially viable to Z Ltd. since it saves Rs.16,49,678 annually from
the arrangement.

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Question No. 22
A new customer has approached a firm to establish new business. The customer requires 1.5
months of credit. If the proposal is accepted, the sales of the firm will go up by Rs. 240,000 per
annum. The new customer is being considered as a member of 10% risk of non-payment group.
The cost of sales amounts to 80% of sales. The tax rate is 30% and the desired
rate of return is 40% after tax.
Required: (2+5=7 Marks)
iii) What is the opportunity cost of the proposal?
iv) Should the proposal be accepted? Why?

[December 2016]

Answer:
i) Opportunity cost of the proposal is the opportunity cost of investment on
receivable which is
= (cost of sales/Receivable Turnover)×ROR
=[(240,000×0.80)/(12/1.5)]×40%
=[192,000/8]×40% = Rs. 9,600

ii) Evaluation of Credit Proposal

Description Amount (Rs.)
A Calculation of profit on additional sales
Increase in sales 240,000
Less: Cost of Sales (192,000)
EBIT 48,000
Less: Risk of non-payment (10% of Rs. 24,000
240,000)
Profit Before Tax 24,000
Tax @30% 7,200
Profit After Tax (PAT) 16,800
B Opportunity cost of Investment on 9,600
Receivable
C Net Benefit (A-B) 7,200
Decision: Since estimated PAT on additional sales ([Link].16,800) is more
than the opportunity cost of investment on receivable (i.e. Rs.9,600), the firm
should accept the offer.

Question No. 23
M/s Atlantic Company Ltd., with a turnover of Rs. 4.80 crores, is expecting growth of 25% for
coming year. Average credit period is 90 days. The past experience shows that bad debt losses
are 1.75% on sales. The company's annual administering cost for collecting receivables is Rs.
600,000. It has decided to take factoring services of a factor on terms that the factor will buy
receivables by charging 2% commission and 20% risk with recourse. The factor will pay
advance on receivables to the firm at 16% interest rate p.a. after withholding 10 % as reserve.
Required: (5 Marks)
Calculate the annualised effective cost of factoring to the firm (assume 360
days in a year).
[December 2016]

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 CAP II Paper 4: Financial Management

Answer:

Calculation of Net amount financed (Rs. in Lakh)

Expected credit sales for next year = 480 x 125% 600
Debtors on the basis of 90 days = (600 x 90/360) 150
(-) Factor reserve 10% -15
(-) Commission charged upfront @ 2% of 150 -3
(-) Interest charged upfront (16% of (150-15-3)×90/360) -5.28
Net amount financed by factor 126.72

Net periodic cost of factoring for 90 days (Rs. in Lakh)

Factoring commission 3
(+) Interest 5.28
(-) Bad Debts saved (20% of 1.75% of 600 x 90/360) -0.525
(-) Administration Expense Saved (6 x 90/360) -1.5
Net cost of factoring 6.255
Therefore, % cost of factoring for 90 days = (6.255/126.72) x100 = 4.94%
Annualized effective cost of factoring = 4.94% x 360/90 = 19.74%

Assumptions:
1. All sales are credit sales.
2. Factor will bear 20% risk of bad debts

Question No. 24
RP Ltd. has annual sales of Rs. 400 crores. It sells 80 percent of its products on a 60-day credit.
Its average collection period is 80 days. The company‘s bad debts, based on the past experience,
could be estimated as 0.9 percent of credit sales. The company‘s annual cost of administering
credit sales is 0.46875%. It is possible to avoid Rs. 4,000,000 of these costs if credit
administration is transferred by the company to a factor. The factor will charge 1.75 percent non-
recourse commission for his services. He can extend advance against receivables to the company
at an interest rate 16.5 percent after withholding 10 percent as reserve.
Required: (7 Marks)
Should the company hire services of the factors? Assume 15% Required Rate of Return and 360
days in a year.
[June 2017]
Answer:
Calculation of Factoring Commission, Interest charged and Advance Granted
Particulars Amount (Rs
in Crores)
Average Level of Receivable ( 320 X 80 )/360 71.11
Less: Factoring Commission (1.75% X 71.11) 1.24
Less: Factoring Reserve (10% of 71.11) 7.11
Eligible amount of advance 62.76
Less: Interest charged on advance (62.76 X 16.5%X80/360) 2.30
Actual amount received from factor 60.46
STATEMENT SHOWING THE EVALUATION OF FACTORING
ARRANGEMENT
Particulars Amount (Rs in
Crores)
A. Annual Benefits of Factoring to the firm:
Credit administration cost avoided 0.40
Bad Debt avoided (0.9% of 320 crores) 2.88

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 CAP II Paper 4: Financial Management

Total 3.28
B. Annual Cost of Factoring to the firm
Factoring Commission (1.24 X 360)/80 5.60
Interest Charged on advance granted 10.35
(2.3X360/80)
Total 15.95
C. Net annual cost of Factoring to the firm: 12.67
Rate of Effective cost = Net Annual Cost/Actual 20.96%
advance granted = 12.67/60.46
Or
12.67 ×100% =20.19%
*
62.76
If computed before interest it is acceptable.

Recommendation: The company should continue with its in house

credit management since its Rate of Effective Cost is less than the
cost of other sources of financing (i.e. 15%)

Working Notes:
i. Credit Sales = 400 crores x 80% = 320 crores

Question No. 25
Future Kidd Corporation presently gives credit terms of 'net 30 days'. It has Rs. 60 Million in
credit sales and its average collection period is 45 days.
To stimulate sales, the company may give credit terms of 'net 60 days'. If it does instigate these
terms, sales are expected to be increased by 15%. After the change, the average collection period
is expected to be 75 days with no difference in payment habits between old and new customers.
Variable cost is Re. 0.80 for every Re 1.00 of sales and the company's before tax required rate of
return on investment in receivables is 20%.
Required:
Should the company extend its credit period? (Assume a 360-days year) (7 Marks)

[December 2017]

Answer:
Evaluation of decision to extend credit period:
Existing Receivable Turnover= 360/45 =8 times
New Receivable Turnover = 360/75 = 4.8 times
New Sales = Rs. 60m×1.15 = Rs. 69 m
Additional Sales = Rs. 69m –Rs. 60m = Rs. 9 m
Contribution on Estimated additional Sales = 90,00,000×20/100=Rs.
18,00,000
Addl. Receivables associated with increased sales = 90,00,000/4.8 = Rs.
18,75,000
Investment in additional receivables associated with new sales =
18,75,000×80/100
= Rs.15,00,000
Receivables on present sales, on existing terms = 600,00,000/8 =75,00,000
Receivables of present sales, on new terms = 600,00,000/4.8 = 125,00,000
Investment in additional receivables associated with original sales

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 CAP II Paper 4: Financial Management

= 125,00,000-75,00,000 =
50,00,000
Total Investment in additional Receivables = 1500,000+50,00,000=65,00,000
Or
= 15,00,000+50,00,000*80%
= 15,00,000+40,00,000
= 55,00,000*20%
= 11,000
Required Return (before tax) on Addl. Investments = 65,00,000×20/100=
Rs.13,00,000

Analysis: The return on increased sales is more than the interest cost on
additional investments in debtors balances. Hence, it is recommended to extend
credit period.

Question No. 26
The Chitwan Krishi Company is planning to relax its credit policy to motivate customers to buy
on new credit terms. It is expected that the variable cost will remain 75 percent of sales. The
incremental sales are expected to be sold on credit. For the perceived increase in risk of
liberalizing the credit terms, the company requires higher return. The following table shows the
projected information:
Credit Policy Required Return on Collection New Sales (Rs.)
investment Period(days)
A 20% 40 300,000
B on
25% 45 400,000
C 32% 55 500,000
D 40% 70 600,000
Required: (5 Marks)
Which credit policy should the company pursue? Assume 360 days in a year.
[June 2018]
Answer:
Statement showing the Evaluation of Debtors Management Policies
Particulars Proposed Proposed Proposed Proposed
Policy A Policy B Policy C Policy D

A. Expected Profits
a) Credit Sales 300,000 400,000 500,000 600,000
b) Total Cost
i) Variable Cost 225,000 300,000 375,000 450,000
c) Expected profit (a)-(b) 75,000 100,000 125,000 150,000
B. Opportunity Cost of Investment in 5000 9375 18,333 35,000
Receivables (WN)
Net Benefits (a)-(b) 70,000 90,625 106,667 115,000
Recommendation: Policy D should be adopted since the net benefits under this policy is
higher than those under other policies.
Working Note: Calculation of opportunity cost of Investments in receivables.(Rs.)
Opportunity Cost = Total Cost × Collection Period/360 × Rate of Return/100
Policy A = 225,000×40/360×20% = 5,000
Policy B = 300,000×45/360×25% = 9,375

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Policy C = 375,000×55/360×32% = 18,333

Policy D = 450,000×70/360×40% = 35,000

Question No. 27
Patan Surgical P. Ltd. (PSPL) is a supplier of medical equipment. The company projects sales of
Rs. 12 million for the year ended Ashadh end 2075. PSPL‘s Board has set a strategic objective to
increase sales and reduce costs each year. In order to help achieve these objectives in the year
ended Ashadh end 2075, PSPL‘s management has put forward the following proposals:
Proposal 1: The company‘s Sales Director has estimated that if credit settlement terms were
relaxed by offering customers 90 days standard settlement terms, sales would increase by one
quarter next year, without the need to reduce prices.
Proposal 2: In a bid to achieve the Finance Department‘s cost reduction target, PSPL‘s Financial
Controller is contemplating replacing the company‘s Credit Controller, who costs Rs. 1 million
annually, and referring potentially bad debts to a factoring agency for collection. The factor has
indicated that they would charge a fixed annual fee of Rs. 980,000 for a ‗with recourse‘ factoring
service.
Further relevant details are as follows:
All sales are on credit with all debtors (except bad debts) fully observing the credit terms of 30
days. Bad debts of 1% of gross sales are currently experienced. The Sales Director expects that
this will increase to 5% if credit settlement terms are relaxed and the Credit Controller is
replaced by the factoring agency. PSPL‘s gross profit margin is 25%. PSPL is funded by a bank
overdraft, which costs 15% per annum.
Assume a 360-day year.
Required: (10 Marks)
Evaluate the profitability implications of the above two related proposals (if taken together) and
recommend.
[December 2018]

Answer:
Present Cost of Debtors:
At present the cost of debtors is Rs. 1.2325 million as follows:
Present Position Rs. in million Calculation
Sales (a) 12.00
Bad Debts @ 1% of Gross Sales (b) (0.12) (12.00 m*1%)
(12.00 m x 0.75 x
Cost of Investment in Debtors (0.1125) 30/360 x 0.15)
Cost of credit controller (d) (1.00)
Net Cost of Present Debtors
(b+c+d) (1.2325)
Proposed Cost of Debtors:
The proposed cost associated with debtors is Rs. 0.4019 million as follows:
Proposed Position Rs. in million Calculation
Sales (a) 12.00
Sales Increase 25% (b) 3.00
Revised Sales Projections (c) 15.00
Gross Profit Increase(d) 0.75 (3.00 m@25%)
Bad Debts @ 5% Gross Sales (e) (0.75) (15.00 m*5%)
(15.00 m x 0.75 x
Cost of Investment in Debtors (f) (0.4219) 90/360 x 0.15)
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 CAP II Paper 4: Financial Management

Net saving of factoring (g) 0.02 (1m-0.98m)

Net Cost of Proposal (d-e-f+g) (0.4019)
This represents an increase of Rs. 0.8306 million (i.e. 1.2325 – 0.4019)
increase in profitability.
Conclusion: The proposal to relax credit terms and to replace credit controller
with a factoring agency could be implemented, as it will improve profitability
by Rs. 0.8306 million per annum.

Question No. 28
PQR Ltd. has current sales of Rs. 1.50 million per year. Cost of sales is 75 percent of sales and
bad debts are one percent of sales. Cost of sales comprises 80 percent variable costs and 20
percent fixed costs, while the company‘s required rate of return is 12 percent. PQR Ltd. currently
allows customers 30 days credit, but is considering increasing this to 60 days in order to increase
sales. It has been estimated that this change in policy will increase sales by 15 percent and bad
debts will increase from one percent to four percent. It is expected that the policy change will not
result in an increase in fixed costs, and creditors and stock will be unchanged.
Required: [8 Marks]
Advise whether PQR Ltd. should introduce the proposed policy.
[June 2019]
Answer:

Rs. Rs.
Proposed investment in debtors = (1725000 x 60% + 1500000 x 15%) x
60/365 207,123.88
Less: Current investment in debtors = (1,500,000 x 75%) x 30/365 92,466.00
Increase in investment debtors 114,657.88
Increase in contribution = 15% x 1,500,000 x 40% 90,000.00
New level of bad debts = 1,725,000 x 4% 69,000.00
Current level of bad debts = 1,500,000 x 1% 15,000.00
Increase in bad debts (54,000.00)
Additional financing costs = 114,657.88 x 12% (13,758.87)
Savings by introducing change in policy 22,241.12
Decision
The financing policy is financially acceptable, although the savings are not significant.

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Chapter 10:

Cash Managment

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Question No. 1
Indicate whether the following statements are ‗True or False‘ and also support your answer with
reasons: (2.5 Marks)
The cash held with the purpose of future risk and contingencies is referred to as transaction
motive. (June 2009)

Answer:
False, because the cash held with the purpose of future risk and contingencies is referred to as
precautionary motive. Transaction motive refers to cash held in order to carry on the day to day
operations of the business.

Question No. 2
Stochastic model of cash management (December 2009) (2.5 Marks)
Answer:
This model assumes that cash balances randomly fluctuate between an upper limit and a lower
limit. The value of a lower limit is set by the management, the value of return point and upper
limit have been derived by Miller and Orr with a view to maintaining the total ordering and
holding costs.

Return Point (Z)= 3√3bs2/4i +Lower Limit(LL)

Upper Point = 3z-2LL

Where,
b= fixed cost per order
i= daily interest rate
s2 = variance of net the daily cash flows.

The average cash balance is obtained as follows:

ACB = 4z-LL/3

When the cash balance reaches the upper limit an amount equal to the upper limit minus the
return point is converted to marketable securities.

When the cash balance falls to lower limit, the amount converted from marketable securities to
cash is the amount represented by the return point minus lower limit.

Question No. 3
Distinguish between: (June 2019, 2.5 Marks)
William J Baumal and Miller- Orr cash management model
Answer:
According to William J Baumal‘s Economic order quantity model optimum cash level is that
level of cash where the carrying costs and transactions costs are the minimum. The carrying
costs refer to the cost of holding cash, namely, the interest foregone on marketable securities.
The transaction cost refers to the cost involved in getting the marketable securities converted
into cash. This happens when the firm falls short of cash and has to sell the securities
resulting in clerical, brokerage, registration and other costs.
The optimum cash balance according to this model will be that point where these two costs
are equal. The formula for determining optimum cash balance is:

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2UP
C = ,
S
Where
C = Optimum cash balance
U = Annual (monthly) cash disbursements
P = Fixed cost per transaction
S = Opportunity cost of one rupee p.a. (or p.m)

Miller-Orr cash management model is a net cash flow stochastic model. This model is
designed to determine the time and size of transfers between an investment account and cash
account. In this model control limits are set for cash balances. These limits may consist of h
as upper limit, z as the return point, and zero as the lower limit.
When the cash balances reach the upper limit, the transfer of cash equal to h-z is invested in
marketable securities account. When it touches the lower limit, a transfer from marketable
securities account to cash account is made. During the period when cash balance stays between
(h,z) and (z, o ) i.e high and low limits no transactions between cash and marketable securities
account is made. The high and low limits of cash balance are set up on the basis of fixed cost
associated with the securities transactions, the opportunity cost of holding cash and the degree of
likely fluctuations in cash balances. These limits satisfy the demands for cash at the lowest
possible total costs.

Question No. 4
Miller Orr Model of cash management [December 2013] (2.5 Marks)
Answer:
The Miller and Orr model of cash management is one of the various cash management models in
operation. It is an important cash management model as well. It helps the present day companies
to manage their cash while taking into consideration the fluctuations in daily cash flow. As per
the Miller and Orr model of cash management, the companies let their cash balance move within
two limits - the upper limit and the lower limit. The companies buy or sell the marketable
securities only if the cash balance is equal to any one of these. When the cash balance of a
company touches the upper limit, it purchases a certain number of salable securities that helps
them to come back to the desired level. If the cash balance of the company reaches the lower
level, then the company trades its salable securities and gathers enough cash to fix the problem.
It is normally assumed in such cases that the average value of the distribution of net cash flows
is zero. It is also understood that the distribution of net cash flows has a standard deviation. The
Miller and Orr model of cash management also assumes that distribution of cash flows is
normal.

Question No. 5
Funds flow statement and Cash flow statement yield [December 2013] (2.5 Marks)

Answer:
Funds Flow statement ascertains the changes in the financial position between two accounting
periods. It analyses the reasons for change in financial positions between two balance sheets. It
reveals the sources and application of funds. It helps to test whether working capital has been
effectively used or not.
Cash Flow statement ascertains the changes in balance of cash in hand and cash at bank between
two dates. It analyses the reasons for changes in cash and bank balance on a particular date. It
shows the inflows and outflows of cash. It is an important tool for short term analysis. The two
significant areas of analysis are cash generating efficiency and free cash flows.

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Question No. 6
Assumptions of economic lot size technique [June 2018] (2.5 Marks)

Answer:
Following are the assumptions of economic lot size technique:
 Constant Annual requirement of Cash
 Constant rate of demand of cash
 Constant Transaction costs
 Constant holding costs, and
 Zero conversion period
Question No. 7
Four kind of floats with reference to cash management [December 2018] (2.5 Marks)

Answer:
Four Kinds of Float with reference to Management of Cash are as follows:
 Billing Float: The time between the sale and the mailing of the invoice is the billing float.
 Mail Float: This is the time when a cheque is being processed by post office, messenger
service or other means of delivery.
 Cheque processing float: This is the time required for the seller to sort, record and deposit
the cheque after it has been received by the company.
 Bank processing float: This is the time from the deposit of the cheque to the crediting of
funds in the seller‘s account.

Question No. 8
Activities covered by Treasury Management [December 2018] (2.5 Marks)

Answer:
Treasury Management is concerned about the efficient management of liquidity and financial
risk in business. Main activities which are covered by Treasury Management are as follows:

(i) Cash management: Treasury management in a business organisation is concerned about

the efficient collection and repayment of cash to both insiders and to third parties.
(ii) Currency management: It manages the foreign currency risk, exchange rate risks etc. It
may advise on the currency to be used when invoicing overseas sales.
(iii) Funding management: Responsible for planning and sourcing firm‘s short, medium and
long term cash needs. It participates in capital structure, forecasting of future interest
and foreign currency rates decision-making process.
(iv) Banking: Maintains good relations with bankers and carry out initial negotiations with
them for any short term loan.
(v) Corporate finance: It advises on aspects of corporate finance including capital
structure, mergers and acquisitions.

Question No. 9
Following are the condensed Balance Sheets of Omega Ltd. for two years and the Statement of
Profit and Loss for one year:
Balance Sheet as at end of Ashadh
(Figures in Rs. ‗000)
2069 2068
Equity Share Capital 150 110
10% Redeemable Preference Shares 10 40
Capital Redemption Reserve 10 -

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General Reserve 15 10
Profit and Loss Account balance 30 20
8% Debenture with convertible option 20 40
Other Term Loans 15 30
Total 250 250
Fixed Assets less Depreciation 130 100
Long Term Investments 40 50
Working Capital 80 100
Total 250 250
Statement of Profit and Loss for the year ended 31st Ashadh, 2069
(Figures in Rs. ‗000)
Sales 600
Less: Cost of Sales (400)
200
Less:
Establishment Charges 30
Selling and Distribution Expenses 60
Loss on Sale of Equipment 15
Interest Expenses 5 (110)
90
Add:
Interest Income 4
Foreign Exchange Gain 10
Dividend Income 2
Damages received for loss of reputation 14 30
120
Less: Depreciation (50)
70
Taxes (30)
40
Dividends (15)
Net profit carried to Balance Sheet 25
Chief accountant of Omega Ltd. informed that ledgers relating to debtors, creditors and stock for
both the years were seized by the income tax authorities for the purpose of investigation and the
same would not be available for at least three months. However, he is able to furnish the
following data:
(Figures in Rs. ‗000)
Ashadh end 2069 Ashadh end 2068
Dividend receivable 2 4
Interest receivable 3 2
Cash on hand and with bank 7 10
Investment maturing within two months 3 2
15 18
Interest payable 4 5
Taxes payable 6 3
10 8
Current ratio 1.5 1.4
Acid test ratio 1.1 0.8
It is also gathered that debenture-holders owning 50% of the debentures outstanding as on
Ashadh end 2068 exercised the option for conversion into equity shares during the financial year
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ending on Ashadh 2069 and the same was put through. Besides, an equipment was sold for Rs.
25,000 during the financial year 2068/69.
Required:
Prepare a cash flow statement for the financial year 2068/69 under direct method. (20 Marks)
[December 2012]

Answer:
Cash Flow Statement
(Figures in Rs. ‗000)
Cash Flows from Operating Activities:
Cash Receipts from customers (WN 2) 621
Cash paid to suppliers and employees (WN 3) (406)
Operating expenses Paid (WN 4) (90)
Cash generated from operations 125
Income-tax paid (WN 5) (27)
Cash flow before extraordinary item 98
Add: Extraordinary items:
Foreign Exchange Gain 10
Damages for loss of reputation 14
Net cash from operating activities 122

Cash flows from Investing Activities:

Purchases of fixed assets (WN 6) (120)
Proceeds from sale of equipment 25
Proceeds from sale of investment (50 – 40) 10
Interest received (WN 7) 3
Dividend received (WN 7) 4
Net cash used in investing activities (78)

Cash flows from financing Activities

Proceeds from issue of equity share capital (WN 8) 20
Redemption of Preference Share Capital (30)
Repayment of term loan (15)
Interest paid (WN 9) (6)
Dividend paid (15)
Net cash used in financing activities (46)
Net decrease in cash and cash equivalents (2)
Cash and cash equivalents at the beginning of the period (10 + 2) 12
Cash and cash equivalents at the end of the period 10

Working Notes: (figures in Rs.'000)

Determining the value of Current Assets and Current Liabilities 2068 2069
Current Ratio 1.40 1.50
Working Capital 100 80
Current Liabilities (100÷0.4) & (80÷0.5) 250 160
Current Assets (250+100) & (160+80) 350 240
Acid Test Ratio 0.8 1.10
Current Liabilities (as above) 250 160
Therefore, Quick Assets (QA) (CL×ATR) 200 176
Stock (CA – QA) 150 64
Other Current Assets (as given ) 18 15
(Dividend + Interest + Cash Equivalents)
Therefore, Debtors 182 161
(QA – Other Current Assets)
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Therefore, Creditors 242 150

(CL – Interest payable – Taxes payable)
Cash Receipts from Customers
Sales (on accrual basis) 600
Add: Opening debtors (WN 1) 182 782
Less: Closing debtors (WN 1) - 161
Cash Received from Customers 621
Cash paid to suppliers
Cost of sales 400
Add: Opening creditors (WN 1) 242
Closing stock (WN 1) 64 706
Less: Closing creditors (WN 1) 150
Opening stock (WN 1) 150 - 300
406

Operating expenses Paid

Establishment Charges 30
Selling and Distribution expenses 60 90

Tax paid during the year

Tax payable in the beginning 3
Add: Provision for tax 30 33
Less: Tax payable at the end: -6
Tax paid during the year 27

Purchase of Fixed Assets

Balance at the end 130
Add: Depreciation for current year 50
Assets sold (Book Value ) (25 + 15) 40 220
Balance at the beginning 100
Purchase of Fixed Assets during the year: 120

Interest and Dividend received during the year

Interest Dividend
Opening Balance 2 4
Add: Accrued Income (Current Year) 4 2
6 6
Less: Closing Balance -3 -2
Received During the Year 3 4
Issue of Equity Share Capital for Cash
Capital at the end 150
Less: Capital issued to debenture-holders - 20 130
(Conversion- 50% of 40)
Less: Opening Capital - 110
Capital issued for Cash 20
Interest Paid during the year
Balance in the beginning 5
Add: Accrued during the year 5 10
Less: Balance at the end -4
Paid during the year 6

10. Cash and Cash Equivalents 2068 2069

Cash and Bank 10 7
Investments 2 3
12 10
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Profit and Loss Account

Opening Balance 20
Profit for Current Year 25 45
Less: Transfer to General Reserve (15-10) 5
Transfer to Capital Redemption Reserve (10-0) 10 - 15
Closing Balance 30

The preference share capital in the beginning and at the end was Rs. 40 and Rs. 10 thousand
respectively. This redemption is backed by the issue of Equity Share Capital of Rs. 20 thousand
and transfer of Profit and Loss Account balance of Rs. 10 thousand to Capital Redemption
Reserve Account.

Question No. 10
Guheswari Paints Ltd. having its production facilities and head office located in Biratnagar
currently follows a centralized collection system. Most of its customers are located in the cities
of terai region and KathmanduValley as well as in the remote hilly districts of Nepal.
The remittances mailed by customers take on an average 9 days to reach to central location.
Before depositing the remittances in the bank account, the company loses 2 days in processing
them. The daily average collection of the company is Rs. 750,000.
The company is thinking of establishing a lock-box system. It is expected that such a system will
reduce the mailing time by two day and processing time by one day.
Based on the above facts and information, you are required to: (3+2+3=8 Marks)
i) Determine the reduction in cash balance expected to result from the adoption of the lock-
box system.
ii) Determine the opportunity cost of the present centralized collection system if the interest
rate is assumed to be 15 per cent.
iii) Advise the company whether it should establish lock-box system if its annual cost is Rs.
250,000.
(December 2009)
Answer:
(a) The total time saved by the company by establishing the lock-box system is 3 days.

Reduction in cash balance = Time saved x daily average collection

= 3 x 750,000 = Rs. 2,250,000
(b) Opportunity cost = 15% x Rs. 2,250,000 = Rs. 337,500.
The lock-box system should be established because the opportunity cost of the present
system (Rs. 337,500) is higher than the cost of the lock-box system (Rs. 250,000) by Rs.
87,500.

Question No. 11
A Company is preparing a cash flow forecast for the three-month period from January to the end
of March. The following sales volumes have been forecasted:
December January February March April
Sales (units) 1,200 1,250 1,300 1,400 1,500
Additional Information:

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 The selling price per unit is Rs. 800 and a selling price increase of 5% will occur in
February. Sales are all on one month‘s credit.
 Production of goods for sale takes place one month before sales.
 Each unit produced requires two units of raw materials, costing Rs. 200 per unit. No raw
materials inventory is held. Raw material purchases are on one months‘ credit.
 Variable overheads and wages equal to Rs. 100 per unit are incurred during production, and
paid in the month of production.
 The opening cash balance at 1st January is expected to be Rs. 40,000.
 A long-term loan of Rs. 300,000 will be received at the beginning of March.
 A machine costing Rs. 400,000 will be purchased for cash in March.
Required: (6+2=8 Marks)
i). Calculate the cash balance at the end of each month in the three-month
period.
ii). Calculate the forecast current ratio at the end of the three-month period.
[December 2017]

Answer:
(i) Monthly Sales
Particulars December January February March April

Sales (units) 1,200 1,250 1,300 1,400 1,500

Selling price (Rs./unit) 800 800 840 840

Sales (Rs.000) 960 1,000 1,092 1,176

Purchases:
December January February March April

Production units 1,250 1,300 1,400 1,500

Raw materials (units) 2,500 2,600 2,800 3,000
(2×Production unit)
Raw materials (Rs. 000) 500 520 560 600
(@Rs.200/unit)
Variable Cost:
December January February March April

Production (units) 1,250 1,300 1,400 1,500

Variable costs (Rs.000) 125 130 140 150
(@Rs. 100/unit)

Monthly cash balances:

Particulars January (Rs. 000) February (Rs. 000) March (Rs. 000)
Cash collection from 960 1,000 1,092
Receivables
Loan 300

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Total receipts 960 1,000 1,392

Payments:
Raw materials 500 520 560
Variable costs 130 140 150
Machine 400
Total Payments 630 660 1,110
Net cash flow 330 340 282
Opening balance 40 370 710
Closing balance 370 710 992

(ii) Calculation of current ratio:

Inventory at the end of the three-month period:
This will be the finished goods for April sales of 1,500 units, which can be assumed to
be valued at the cost of production of Rs.400 per unit for materials and Rs.100 per unit
for variable overheads and wages. The value of the inventory is therefore
1,500 x 500 = Rs. 750,000.
Trade receivables at the end of the three-month period:
These will be March sales of Rs. 1,176,000.
Cash balance at the end of the three-month period:
This was forecast to be Rs. 992,000.
Trade payables at the end of the three-month period:
This will be the cash owed for March raw materials of Rs. 600,000.
Forecast current ratio
Assuming that current liabilities consist of trade payables alone:
Current ratio = (750,000 + 1,176,000 + 992,000)/600,000 = 4·9 times

Question No. 12
ABC Ltd. operates four restaurants in Eastern and Western Region of Nepal. The manager of each
restaurant transfers funds daily from the local bank to the company‘s principal bank in
Kathmandu. There are approximately 250 business days during a year in which transfers occur.
Several methods of transfer are available. A wire transfer results in immediate availability of
funds, but the local banks charge Rs. 5 per wire transfer. A transfer through an automatic clearing
house involves next-day settlement, or a 1-day delay, and costs Rs. 3 per transfer. Finally, a mail-
based depository transfer cheque arrangement costs Rs. 0.30 per transfer, and mailing times result
in a 3-day delay on average for the transfer to occur. This experience is the same for each
restaurant. The company presently uses depository transfer checks for all transfers. The restaurants
have the following daily average remittance:

Restaurant 1 Restaurant 2 Restaurant 3 Restaurant 4

Rs. 3,000 Rs. 4,600 Rs. 2,700 Rs. 5,200

Required: (4+4=8 Marks)

iii) If the opportunity cost of funds is 10 percent, which transfer procedure should be used for each
of the restaurants?
iv) If the opportunity cost of funds were 5 percent, what would be the optimal strategy?
[December 2018]
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Answer:
i) If the opportunity cost of fund is 10%
Restaurant
1 2 3 4
Option I - Wire Transfer
Annual Transfer Cost [ 250 Transfer × Rs. 5] 1,250 1,250 1,250 1,250
Cost of Fund Blocked - - - -
Total Cost under Wire Transfer 1,250 1,250 1,250 1,250
Option II - Automated Clearing House [ ACH]
Annual Transfer Cost [ 250 Transfer × Rs. 3] 750 750 750 750
Cost of Fund Blocked (Avg. remittance × 10% 300 460 270 520
Total Cost under ACH 1,050 1,210 1,020 1,270
Option III - Mail Based Transfer Cheque
Annual Transfer Cost [ 250 Transfer × Rs. 0.3] 75 75 75 75
Cost of Fund Blocked (Avg. remittance×3×10%) 900 1380 810 1560
Total Cost Under Mail based transfer system 975 1,455 885 1,635
Option Option Option Option
Preferred Transfer Method for each Restaurant III II III I

ii) If the opportunity cost of fund is 5%

Restaurant
1 2 3 4
Option I - Wire Transfer
Annual Transfer Cost [ 250 Transfer × Rs 5] 1,250 1,250 1,250 1,250
Cost of Fund Blocked - - - -
Total Cost under Wire Transfer 1,250 1,250 1,250 1,250
Option II - Automated Clearing House [ ACH]
Annual Transfer Cost [ 250 Transfer × Rs 3] 750 750 750 750
Cost of Fund Blocked (Avg. remittance × 5%) 150 230 135 260
Total Cost under ACH
900 980 885 1,010
Option III - Mail Based Transfer Cheque
Annual Transfer Cost [ 250 Transfer × Rs 0.3]
75 75 75 75
Cost of Fund Blocked (Avg. remittance ×3×5%) 450 690 405 780

Total Cost Under Mail based transfer system

525 765 480 855
Preferred Transfer Method for each Restaurant Option Option Option Option
III III III III

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Chapter 11:

Dividend Policy

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Question No. 1
Distinguish between:
Share split and reverse split (3 Marks)
(December 2009)
Answer:
Share Split: The process of reducing the paid up value of a share and increasing the number of
outstanding shares is called the share split. In the stock split, the balance in the equity share
capital account remains the same unlike in the case of bonus share in which the balances of
reserves and surpluses account decreases due to a transfer to the paid-up capital.
The earnings per share and market price per share will fall proportionately following the split of
the share. The total value of the holdings of a shareholder remains the same with a share split.
There are a number of reasons considering which the share split is carried out. Some these are:
 To make the trading in share attractive
With the reduction in paid up value per share, the market price per share comes down so that
it becomes accessible to small investors as well. This helps to make the shares of such
company more marketable and liquid.
 To signal the possibility of higher profits in the future
Often the share split are used by the top management of the company to communicate to
investors that the company is expected to earn higher level of profits in future. Expected
high profits in future forces the company management to employ share split so as to make
the shares of the company fall inside the popular trading range.
 To give higher dividends to shareholders
In general, there have not been cases of reduction of cash dividends proportionately after
share split. Often, it is found that the total dividend of the shareholders is found to have
increased after such split. It is needless to say that this will have a positive impact on the
market price of the shares of the company.

Reverse Split is employed under the situation of falling price of a company‘s share. The number
of outstanding shares is reduced following the reverse split. The paid up value per share is
increased thus bringing down the number of outstanding shares.
The reverse split is generally an indication of financial difficulty of a firm and is primarily
intended to increase the market price per share by making the per share price beyond the reach
of common investors. The reverse split is sometimes used to stop the market price of the share
below a certain limit.
Question No: 2
Distinguish between: (2.5 Marks)
Bonus share and stock-split
(December 2010)

Answer:
A bonus share is simply the payment of additional ordinary shares to the existing shareholders.
It is only a bookkeeping shift from the reserve and surplus account to the ordinary share capital
account of the company. A shareholder‘s proportional ownership in the firms remains
unchanged following the bonus issue.

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Bonus shares are sometimes employed to conserve cash. Instead of increasing cash dividend as
earnings rise, a company may desire to retain a greater proportion of its earnings and declare the
issue of bonus share.
Stock split is an increase in the number of shares outstanding by a proportional reduction in the
face value of the share. The main purpose behind the stock split is to place the company‘s share
in a more popular trading range thus attracting more buyers.
In the issue of bonus share, face value of the share remains unaffected. On the other hand, a
share split causes the face value to come below the previous value.
Unless there is an increase in the earnings of the company, bonus issue will have the effect of
bring down the earnings per share. Accordingly, it will be difficult for the company to maintain
the earlier dividend per share. Similarly, it will be difficult for a company to maintain the same
cash dividend per share before and after a stock split.

Question No: 3

Describe Walter's approach to dividend policy along with his formulation. (5 Marks)
[June 2010]
Answer:

The formula given by Prof. James. E. Walter shows how the dividend policy can be used to
maximise the wealth position of the equity holders. He argues that in the long run, the share
prices reflect only the present value of the expected dividends. Retentions influence share prices
only through their effect on further dividends. The relationship between dividend and share price
can be shown on the basis of the following formula:

Vc= D + Ra/Rc (E - D)
Rc
where,
Vc = Market value of the ordinary shares of the company
Ra = Return on internal retention i.e. the rate company earns on retained profits.
Rc = Capitalisation rate
E = Earnings per share
D = Dividend per share

Professor Walter emphasizes two factors which influence the market price of a share. The first is
the dividend per share and the second is the relationship between internal return on retained
earnings and the market expectation from that company as reflected in the capitalisation rate. In
other words, if the internal return on retained earnings is higher than the market capitalisation
rate, the value of the ordinary shares would be high even if the dividends are low. However, if
the internal return within the business is lower than what the market expects, the value of the
share would be low. In such a case, the share holders would prefer that a higher dividend is
declared so that they can utilise the funds in more profitable opportunities elsewhere.

Question 4
What is stock repurchase and why company repurchases its own stock. (5 Marks)
[June 2010]

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Answer:
Stock repurchase is a method, in which a firm buys back shares of its own stock, thereby
decreasing shares outstanding, increasing EPS and often increasing the price of the stock. Stock
repurchases are an alternative to dividends for transmitting cash to stockholders.
Stock repurchased by the issuing firm is called Treasury Stock.
Stock price for repurchase or the equilibrium price is calculated from the following equation.
Repurchase price = S*Pc/S-n
Where,
S=Total number of shares outstanding
Pc= Current market price per share
n= Number of shares to be repurchased
Alternatively,
Repurchase price= Market price before stock repurchase/1-stock repurchase in fraction.
Reason for purchasing its own stock - If a firm has excess cash, it may repurchase its own
stock leaving fewer shares outstanding and increasing the earnings per share. Stock repurchase
may be alternative to paying cash dividends. The benefits to the shareholder are the same under
a cash dividend policy and stock repurchase. Firms also repurchase their stock if the stock price
is low. The market often sees the stock repurchases as a signal to future prosperity. Stock
repurchases may be used for employee stock options. Stock repurchases reduces the possibility
of being taken over by another firm. Stock repurchases can be made in open market or on tender
offer or on negotiation basis.

Question No: 5
Write short notes on: (2.5 Marks)
Tax consideration influencing the dividend policy of the firm
(June 2010)
Answer:
The firm's dividend policy is directed by the provisions of income-tax law. If a firm has a large
number of owners, in high tax bracket, its dividend policy may be to have higher retention. As
against this if the majority of shareholders are in lower tax bracket requiring regular income the
firm may resort to higher dividend payout, because they need current income and the greater
certainty associated with receiving the dividend now, instead of the less certain prospect of
capital gains later.

Question No: 6
Distinguish between: (2.5 Marks)
Retention policy and Pay Out policy
(June 2010)

Answer:
The firms resort to different dividend policies according to the situations. The firms deciding to
retain the internal accruals and deciding not to pay dividends are called retention policy.
Whereas the firms deciding to pay the dividends are called pay out policy.
The Higher retention policy will lead to lower pay out policy and vice-versa.

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Question No: 7
For each of the companies described below, would you expect it to have a low, medium, or high
dividend payout ratio? Explain why? (5 Marks)
i) A company with a large proportion of inside ownership, all of whom are high income
individuals.
ii) A growth company with an abundance of good investment opportunities.
iii) A company that has high liquidity and much unused borrowing capacity and experiencing
ordinary growth.
iv) A dividend paying company that experiences an unexpected drop in earnings from an
upward sloping trend line.
v) A company with volatile earnings and high business risk. [December 2011]
Answer:
i. Low payout ratio. Highly taxed owners probably will want to realize their returns
through capital gains.
ii. Low payout ratio. There will be no or low residual funds.
iii. Medium or high payout ratio. There are likely to be funds left over after funding capital
expenditures. Moreover, the liquidity and access to borrowing give the company
considerable flexibility.
iv. Medium or high payout ratio. Unless the company cuts its dividend, which probably is
unlikely in the short run, its payout ratio will rise with the drop in earnings.
v. Low payout ratio. The company will probably wish to retain earnings to build its
financial strength in order to offset the business risk

Questions No. 8
Explain the Miller and Modigliani as irreverence theory of Dividend policy. (5 Marks)
(June 2014]

Answer:
i. Miller and Modigliani have opined that the price of equity shares of a firm depends
solely on its earnings power and is not influenced by the manner in which its
earnings are split dividend and retained earnings.
ii. They observed `under condition of perfect capital markets, rational investors, absence
of tax discrimination dividend income and capital appreciation given the firm`s
investment policy, its dividend policy may have no influence on the market price of
the shares‘. In other words, the price of the share is not affected by the size of the
dividend.
iii. M-M‘s hypothesis of irrelevance is based on the following assumptions:
iv. Perfect capital markets: The firm operates in perfect capital markets where
investors behave rationally, information is freely available to all and transactions and
floatation costs do not exists. Perfect capital also implies that no investor is large
enough to affect the market price of a share.
v. No Taxes: Taxes do not exists ; or there are no differences in the tax rates applicable
to capital gains and dividends. This means that investors value a rupee of dividend as
much as a rupee of capital gain.
vi. Investment policy:The firm has a fixed investment policy.
vii. No Risk:Risk of uncertainty does not exist. That is, investors are able to forcast
future prices and dividends with certainty, and one discount rate is appropriate for all
securities and all time periods.
Thus, r=k=k, for all t.
viii. MM provide the following proof in support of their views. According to them,
market price of share in beginning of a year (P) is equal to present value of sum of
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dividend at the end of the year (D1) and market price of the share at the end of year
(P1).
(D1+P1)
P0= -------------
(1+Ke)
ix. Where Ke=Cost of equity capital. It is also referred as capitalization rate discount.
MM conclude that does not affect the market price of share.

Question No. 9
Growth firm and Declining firm for relevance of dividend (2.5 Marks)
[July 2015]

Answer:
According to the relevance theory of dividend, dividends are relevant and the amount of
dividend affects the value of the firm. Walter, Gorden and others propounded that dividend
decisions are relevant in influencing the value of the firm.
Growth Firm
In growth firms internal rate of return is greater than the normal rate (r>k). Therefore, r/k factor
will be greater than 1. Such firms must reinvest retained earnings since existing alternative
investments offer a lower return than the firm is able to secure. Each rupee of retained earnings
will have a weighting in Walter`s formula than a comparable rupee of dividend.

Thus, large the firm retains, higher the value of the firm. Optimum dividend payout ratio for
such a firm will be zero.
Declining Firm
Firms which earn on their investments less than the minimum rate required by investments are
designated as declining firms. The management of such firms would like to distribute its
earnings to the stockholders so that they may either spend it or invest elsewhere to earn higher
return than earned by the declining firms. Under such a situation each rupee of retained earnings
will receive lower weight than dividends and market value of the firm will tend to be maximum
when it does not retain earnings at all.

Question 10
Reverse takeover (2.5 Marks)
[December 2015]

Answer:
A reverse takeover or reverse merger takeover (reverse IPO) is the acquisition of a public
company by a private company so that the private company can bypass the lengthy and complex
process of going public. The transaction typically requires reorganization of capitalization of the
acquiring company.
Sometimes, it might be possible that a company continuously trades as a public company but has
no or very little assets and what remains only its internal structure and shareholders. This type of
merger is also known as "back door listing".
Reverse merger brings following benefits to acquiring private company:
 Easy capital market accessibility
 Less time consuming and less cost for becoming public
 Benefits of tax on carry forward losses of acquired company
This concept is yet to be implemented in Nepalese Capital Market as no such publicly traded
company has been acquired by the private company till date.

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Question No. 11
Growth firm and Declining firm for relevance of dividend (2.5 Marks)
[June 2017]

Answer:
According to the relevance theory of dividend, dividends are relevant and the amount of dividend
affects the value of the firm. Walter, Gorden and others propounded that dividend decisions are
relevant in influencing the value of the firm.

Growth Firm

In growth firms internal rate of return is greater than the normal rate (r>k). Therefore, r/k factor
will be greater than 1. Such firms must reinvest retained earnings since existing alternative
investments offer a lower return than the firm is able to secure. Each rupee of retained earnings
will have a weighting in Walter`s formula than a comparable rupee of dividend.

Thus, large the firm retains, higher the value of the firm. Optimum dividend payout ratio for
such a firm will be zero.

Declining Firm

Firms which earn on their investments less than the minimum rate required by investments are
designated as declining firms. The management of such firms would like to distribute its
earnings to the stockholders so that they may either spend it or invest elsewhere to earn higher
return than earned by the declining firms. Under such a situation each rupee of retained earnings
will receive lower weight than dividends and market value of the firm will tend to be maximum
when it does not retain earnings at all.

Question No. 12
The earnings per share of a company is NRs. 40 and the rate of capitalization is 15 percent. The
company has an option of adopting (i) 50 and (ii) 75 per cent dividend pay out ratio.
You are required to compute the market price of the company‘s quoted shares as per Walter‘s
model if it can earn a return of (i) 20 and (ii) 15 percent on its retained earnings. (4 Marks)
[June 2009]
Answer:
Price of share if return (r) = 0.20
(i) D/P Ratio @ 50% (ii) D/P Ratio @ 75%
Price = 20 + 0.20/0.15 (40-20) Price = 30 + 0.20/0.15 (40 – 30)
0.15 0.15
= 20 + 26.66 = 30 +13.33
0.15 0.15
= NRs. 311.11 = NRs. 288.88

Price of share if return (r) = 0.15

(i) D/P Ratio 50% (ii) D/P Ratio 75%
Price = 20 + 0.15/0.15 (40-20) Price = 30 + 0.15/0.15 (40 – 30)
0.15 0.15
= 20 + 20 = 30 + 10
0.15 0.15
= NRs. 266.66 = NRs. 266.66

Question No: 13

The following information pertains to a company:

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_____________________________________________________________________________________________________________________

Net profit (Rs. in ‗000) 60,000

12% preference shares capital (Rs. in ‗000) 20,000
Number of equity shares outstanding (in ‗000) 60
Return on investment 20%
Equity capitalization rate 16%
__________________________________________________________________________________________________________________________________

You are required to: (4.5+1.5=6 Marks)

i) Compute the dividend payout ratio so as to keep the share price at Rs. 412.50
by using Walter model, and
ii) Ascertain (giving reasons) the optimum payout ratio if return on investment is 16% and
equity capitalization rate is 18%. [June 2011]

Answer
Calculation of Earnings per Share (EPS)
(Rs. in ‗000)
___________________________________________________________________________________________________________________________________________________________
_

Net Profit 6,000

Less: Preference Dividend (20,000 X 12 / 100) 2,400
Net Profit after Preference Dividend 3,600
Earnings per Share in Rs. [Rs 3,600,000/60,000] 60
___________________________________________________________________________________________________________________________________________________________
_

(i) Calculation of Dividend Payout Ratio:

Let dividend payout ratio be ‗x‘. The formula for share price under Walter model is::
P = D + r / Ke (E – D), where
Ke
P = Market price per share (Rs. 412.50 Given)
E = Earnings per share (Rs. 60 derived above)
D = Dividend per share (Rs. 60 x Given)
r = return on investment (0.20 given)
Ke = Cost of equity (0.16 Given)
Substituting the values, we get:
412.50 = 60 x + 0.20/0.16 (60 – 60 x)
0.16
Or, 412.50 = 60 x + 1.25 (60 – 60 x)
0.16
Or, 412.50 = 60 x + 75 - 75 x
0.16
Or, 66 = 75 – 15 x
Or, 15 x = 75 – 66
Or, x 9/15 = 0.60, or 60%
Thus, the required dividend payout ratio is 60%.
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(ii) Optimum Payout Ratio when Return on Investment (16%) is less than Equity
Capitalization Rate (18%)
According to Walter model, when return on investment is less than the cost of capital, the value
of the share is highest when dividend payout is maximum. It is evident that when r/Ke is less
than 1, higher dividend will maximize the value per share. Therefore, the dividend payout
should be 100% in this case.

Question No: 14
Kathmandu Wool House is a manufacturer and exporter of woolen garments to most of the
European countries and to United States of America. The business of the company is expanding
day by day and in the previous financial year, the company has registered a 25% growth in
export business.
The company is in the process of considering a new investment project. It is an all equity
financed company with 500,000 equity shares of face value of Rs. 100 per share. The current
market price of this share is Rs. 250 ex-dividend. Annual earnings are Rs. 50 per share, and in
the absence of new investment, this will remain constant in perpetuity. All earnings are
distributed at present. A new investment is available which will cost Rs. 17,500,000 in one
year‘s time and will produce annual cash inflows thereafter of Rs. 5,000,000.
Required:
Analyze the effect of the new project on dividend payments and the share price of the company.
(7 Marks) [June 2012]

Answer
a) Current Market Price of share(P) = Rs. 250
Annual Earning (D) = Rs. 50
Cost of Equity (In case of perpetuity) (Ke) = ×100
Therefore, Cost of Equity (ke)
Ke = D / P X 100 = 50/250 X 100 = 20%
Earnings per share = Rs. 50
Total earnings = 500,000 X Rs. 50 = Rs. 25,000,000
New Project Cost = Rs. 17,500,000
Since the project is financed out of internal accruals (equity financed company), the
amount available for dividend at the end of 1st year is = 1st year earnings – project cost =
Rs. 25,000,000 – Rs. 17,500,000 = Rs. 7,500,000
Dividend per share in 1st year:
= Rs. 7,500,000 /500,000 shares = Rs. 15 per share
Dividend per share in 2nd year, which will remain constant in perpetuity.
Rs. 25,000,000 + Rs. 5,000,000 = Rs. 60 per share
500,000 shares
Since all earnings are distributed, EPS and DPS will remain the same.
The present value of new share price after the new project is taken up:
P = ( Rs. 15.00 ) + ( Rs. 60 X 1 ) = 12.50 + 250 = Rs. 262.50
1.20 0.20 1.20

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It is seen that due to the investment in new project, dividend payments in 1st year will decrease
but from 2nd year onward it will increase and the share price of the company will increase.

Question No: 15
Albertine Ltd. has an investment opportunity available which will involve a capital outlay in
each of the next 2 years and which will produce benefits during the following 3 years. A
summary of the financial implications of this investment is given below:

Year Cash Flow (Rs. ‗000) Year Cash Flow (Rs. ‗000)
1 (1,000) 4 1,300
2 (1,000) 5 3,100
3 100

Albertine Ltd. currently has 100,000 shares in issue. The dividend just paid was Rs. 15 per
share. In the absence of the above investment, dividends are expected at this level for the next 3
years, but will then demonstrate perpetual growth of 10 per cent per annum. The company is
currently all equity financed and the required rate of return of the equity investor is estimated to
be 18 per cent.

The company has a long established policy of not using any debt finance and, because of the
current depressed state of the stock market, could not, in the near future, issue new equity. The
only possible way of financing the investment is, therefore, to reduce the dividend payments in
the next 2 years. Cash received from the new investment will all be distributed in the form of
dividend. Growth in dividends at the rate of 10% will also be maintained because of other
operations.

Required: (3+5=8 Marks)

i) Calculate the current price of share of Albertine Ltd. when investment proposal is not
accepted.
Calculate the share price after the investment has been accepted using dividend valuation model,
assuming that the market knows of the dividend changes that will result from the investment.
[December 2012]
Answer
i) Current price of Share (when investment proposal is not accepted)
The current market price of the share is the present value of expected future dividends
discounted at the required rate of return, i.e. 18%.Since the company is expected to pay a
dividend of Rs. 15 for the next 3 years and thereafter, the dividend will grow at the rate of 10%.
The present market price with these parameters is ascertained as below:

Dividend per year = Rs. 15

PVAF (at 18%, 3 years) = 2.174
Therefore, PV of dividends = Rs. 15 x 2.174 = Rs. 32.61
Price of share at the end of year 3 (P3) = D4 = Rs. 15 (1+0.10) = Rs. 206.25

(with perpetual growth of 10%) ke – g 0.18 – 0.10

Present value of this amount at 18% for 3rd year = Rs. 206.25 x PVF(18%, 3)
= Rs. 206.25 X0.609 = Rs. 125.61
Present market price = Rs. 125.61 + Rs 32.61 = Rs. 158.22

ii) Current price of Share (when the investment proposal is accepted)

In first and second year the investment required of Rs.1,000,000 is financed by reducing the old
dividend rate of Rs.15 per share for 100,000 number of shares. And, thereafter all the cash flows
from new investment is distributed as additional dividend.
The present value of dividend under this situation will be as follows:

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Year Old Dividend (Rs.) Change in Net PVIF PV

Dividend Dividend @ (Rs.)
(Rs.) (Rs.) 18%
1 15 -10 5 0.847 4.24
2 15 -10 5 0.718 3.59
3 15 1 16 0.609 9.74
4 (15+10% of 15) =16.5 13 29.5 0.516 15.2
5 (16.5+10% of 16.5) = 31 49.15 0.437 2
18.15 21.4
8
Total 54.2
7
Price of share at the end of year 5 (P5) = D6 = Rs. 18.15 (1 + 0.10) = Rs. 250
(with perpetual growth of 10%) ke – g 0.18 – 0.10
Present value of this amount at 18% for 5th year = Rs. 250 XPVF(18%, 5)
= Rs. 250 X 0.437 = Rs. 109.25
Therefore, the market price under this situation = Rs. 109.25 + Rs. 54.27 = Rs.
163.52

Question No. 16
Vikas Engineering Ltd., currently has 100,000 outstanding shares selling at Rs. 100 each.
The firm has net profit of Rs. 1,000,000 and wants to make new investments of Rs. 2,000,000
during the period. The firm is also thinking of declaring a dividend of Rs. 5 per share at the end
of the current fiscal year. The firm‘s opportunity cost of capital is 10 percent.
Required: (6+2=8 Marks)
ii) What will be the price of the share at the end of the year if a dividend is not declared, and if
a dividend is declared? What will be the impact on shareholders‘ wealth?
iii) How many new shares must be issued when dividend is declared?
[June 2013]
Answer:

i) The price of the share at the end of the current fiscal year is determined as follows:
P0 =
P1= P0 (1+K) – DIV1
The value of P, when dividend is not paid, is:
P1 = Rs 100 (1.10) - 0 = Rs 110
When dividend is paid it is:
P1 = Rs 100 (1.10) - Rs 5 = Rs 105.
It can be observed that whether dividend is paid or not the wealth of shareholders remains the
same. When the dividend is not paid the shareholder will get Rs 110 by way of the price per
share at the end of the current fiscal year. On the other hand, when dividend is paid, the
shareholder will realize Rs 105 by way of the price per share at the end of the current fiscal year
plus Rs 5 as dividend.

ii) The number of new shares to be issued by the company to finance its investments is
determined as follows:

mP1 = I –(E-n× DIV1)

m×105=[2,000,000 – {1,000,000 – (100,000×50}]
105m = 2,000,000 – (1,000,000 -500,000)
105m = 1,500,000
m= 1,500,000/105 =14,286 shares.
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Where,
m= No. of new shares to be issued
I= Investment
N=No. of existing shares
DIV1= Dividend per share
E=earning

Question No. 17
A company belongs to a risk class for which the approximate capitalization rate is 10%. It
currently has 25,000 shares outstanding, selling at Rs. 100 each. The company is contemplating
the declaration of a dividend of Rs. 5 per share at the end of the current financial year. It expects
to have a net income of Rs. 250,000 and has a proposal for making new investments of Rs.
500,000.
Required: 7 Marks
Show that under MM assumptions, the payment of dividend does not affect the
value of the firm.
[December 2013]

Answer:
a)
A. Value of the firm, when Dividends are paid
I. Price per share at the end of year 1

1
D1 P1
1
Rs 5 P1
1 10
110 = Rs.5 +P1 or P1= Rs. 105

II. Amount required to be raised from the issues of new shares

=Total required investment – (Net income – Dividend paid)
=Rs,500,000- ( Rs.250,000- Rs.125,000)= Rs.375,000

III. Number of additional shares to be issued,

=Rs. 375,000/Rs. 105
=75,000/21 shares
Value of the firm

Where, P1 = Market price

I=Investment
E=Earnings
Now,
Value of the firms
* +

=2,750,000/1.10

=Rs. 2,500,000

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B. Value of the firm when dividends are not paid

Price per share at the end of the year 1, Rs.100=P1/110, or P1=110
Amount required to be raised from the issue of new shares = Rs. 500,000 – Rs. 250,000
=Rs. 250,000
Number of additional share to be issued = Rs.250,000/Rs.110= 25,000/11 shares

Value of the firm

* +

= Rs.2,750,000/1.1
= Rs. 2,500,000

Conclusion:
Thus, whether dividends are paid or not, value of the firm remains the same under MM
assumptions. Thus, shareholders are indifferent between the retention of profits and the payment
of dividend

Question No. 18
Determine the market value of equity shares of the company from the following information as
per Walter`s Model:
Earnings of the company Rs. 5,00,000
Dividend paid Rs. 3,00,000
Number of the shares outstanding 1,00,000
Price-earnings ratio 8
Rate of return on investment 15%
Are you satisfied with the current dividend policy of the firm? If not what should be the optimal
dividend payout ratio? (6 Marks)
[June 2014]

Answer:
Price earning ratio= Market Price/EPS
8= Market Price/5
So, Market Price=Rs. 40
EPS= 500,000/100,000=Rs.5
DPS=300,000/100,000=Rs. 3
Dividend payout ratio=DPS/EPS*100=3/5*100=60%

Walter’s Formula
As the P/E ratio is given 8, and the cost of capital (Ke) is also defined as the reciprocal of P/E
ratio, therefore the Ke may be taken as 1/8=.125 i.e.12.5%
Since, this is a growth firm having rate of return (15%) more than cost of capital(12.5%),
therefore, the company will maximize its market price if it retains its 100% of its profits. The
current market price of Rs. 40 ( based on P/E Ratio can be increased by reducing the payout
ratio. If the company opts for 100% retention (i.e. 0% payout), the market price of the share as
per Walter‘s formula should be as follows;
P=D/Ke+((r/Ke)(E-D))/Ke
P=0/.125+((.15/.125)(5-0))/.125
= Rs. 48
So, the firm can increase the market price of the share up to Rs. 48 by increasing the retention
ratio to 100% or in other words, the optimal dividend payout for the firm is 0.

Question No. 19
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 CAP II Paper 4: Financial Management

A company has 8 lakhs equity shares outstanding at the beginning of the year. The current
market price per share is Rs. 120. The board of directors of the company is contemplating to
declare a dividend of Rs. 6.40 per share. The rate of capitalization, appropriate to the risk-class
to which the company belongs, is 9.6 percent.
Required: (4+5=9 Marks)
i) Based on M-M approach, calculate the market price of the share of the company, when
dividend is (i) declared and (ii) not declared.
ii) How many new shares are to be issued by the company, if the company desires to fund an
investment budget of Rs. 320 lakhs by the end of the year, assuming net income for the year
will be Rs. 160 lakhs? [December 2014]
Answer:
i) M-M Approach of calculating share price:
P0= (P1+D1) / (1+Ke)
Where,
P0= Existing market price per share i.e. Rs. 120
P1= Market price of the share at the year end (to be determined)
D1= Contemplated dividend per share i.e. Rs. 6.40
Ke= Capitalization rate i.e. 9.6 %

Calculation of Share price when:

(i)Dividend is declared
P0= (P1+D1) / (1+Ke)
120 = (P1 + 6.4)/ (1+0.096)
P1= Rs. 125.12
(ii)Dividend is not declared
P0= (P1+D1) / (1+Ke)
120 = (P1 + 0)/ (1+0.096)
P1= Rs. 131.52
ii. Calculation of No. of shares to be issued:
Particulars If dividend is If dividend is
declared not declared
Nets Income (Rs. In Lakhs) 160 160
Less: Dividend (Rs. In Lakhs) 51.20 -
Retained Earnings (Rs. In Lakhs) 108.80 160
Investment budget (Rs. In Lakhs) 320 320
Amount to be raised by issue of shares (Rs. In Lakhs) 211.20 160
Market price per share (in Rs.) 125.12 131.52
No. of new shares to be issued ( in numbers) 1,68,798 1,21,655

Question No. 20
ABC limited expects, with some degree of certainty, to generate the following profits and to
have the following capital investment during the next five years.
(Rs. in thousand)
Year 1 2 3 4 5
Net Income 5,000 4,000 2,500 2,000 1,500
Investment 2,500 2,500 3,200 4,000 5,000
The investments are financed first from the same year profit and the shortfall,if any, shall be
externally financed.
The company currently has 1,000,000 equity shares and pays dividend of Rs. 5 per share.
Required:
i) Determine dividend per share, if dividend policy is treated as a residual decision. (2 Marks)
ii) Determine dividend per share and the amount of the external financing that will be necessary,
if a dividend payout ratio of 50% is maintained. (3 Marks)

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[December 2014]
Answer:
Calculation of the Dividend per share if dividend policy is treated as a residual decision

Year Profit(Rs.) Investment(Rs.) Balance(Rs.) DPS(Rs.)

1 5,000,000 2,500,000 2,500,000 2.50

2 4,000,000 2,500,000 1,500,000 1.50

3 2,500,000 3,200,000 - 0

4 2,000,000 4,000,000 - 0

5 1,500,000 5,000,000 - 0
ii) Calculation of the Dividend per share and external financing required at 50% payout
External
Year Profit(Rs.) Dividends(Rs.) DPS(Rs.) Investment(Rs.) Financing(Rs.)

1 5,000,000 2,500,000 2.50 2,500,000 -

2 4,000,000 2,000,000 2.00 2,500,000 500,000

3 2,500,000 1,250,000 1.25 3,200,000 1,950,000

4 2,000,000 1,000,000 1.00 4,000,000 3,000,000

5 1,500,000 750,000 0.75 5,000,000 4,250,000

Question No. 21
Determine the market value of equity shares of the company from the following information as
per Walter`s Model:
Earnings of the company Rs. 5,00,000
Dividend paid Rs. 3,00,000
Number of the shares outstanding 1,00,000
Price-earning ratio 8
Rate of return on investment 15%
Are you satisfied with the current dividend policy of the firm? If not what should be the optimal
dividend payout ratio? (5 Marks)
[June 2016]

Answer
Price earning ratio= Market Price/EPS
8= Market Price/5
So, Market Price=Rs. 40
EPS= 500,000/100,000=Rs.5
DPS=300,000/100,000=Rs. 3
Dividend payout ratio=DPS/EPS*100=3/5*100=60%

Walter’s Formula

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As the P/E ratio is given 8, and the cost of capital (Ke) is also defined as the reciprocal of
P/E ratio, therefore the Ke may be taken as 1/8=.125 i.e.12.5%
Since, this is a growth firm having rate of return (15%) more than cost of capital(12.5%),
therefore, the company will maximize its market price if it retains its 100% of its profits. The
current market price of Rs. 40 ( based on P/E Ratio can be increased by reducing the payout
ratio. If the company opts for 100% retention (i.e. 0% payout), the market price of the share
as per Walter‘s formula should be as follows;
P=D/Ke+((r/Ke)(E-D))/Ke
P=0/.125+((.15/.125)(5-0))/.125
= Rs. 48
So, the firm can increase the market price of the share up to Rs. 48 by increasing the
retention ratio to 100% or in other words, the optimal dividend payout for the firm is 0.

Question No. 22
The following figures are collected from the annual report of XYZ Ltd.:
Net profit Rs. 30 lakhs
Outstanding 12% preference shares Rs. 100 lakhs
Number of equity shares 3 lakhs
Return on investment 20%
Cost of capital 16%
Required: (5 Marks)
What should be the approximate dividend pay-out ratio so as to keep the share price at Rs. 42 by
using Walter Model?
[December 2016]

Answer:
Rs. in lakhs
Net Profit 30
Less: Preference dividend (12% of Rs. 100 laks) 12
Earnings for equity shareholders 18
Therefore, earning per share =1,800,000/300,000 = Rs. 6.00
Let, the dividend pay-out ratio be x and so the share price will be:
P=D/Ke +(r(E-D)/Ke)/Ke (as per Walter Model)
Here D = 6x; E = Rs. 6; r = 0.20 and Ke = 0.16 and P = Rs. 42
Hence Rs. 42 = 6x/0.16+0.2(66x)/(0.16*0.16)
or Rs. 42 = 37.50x + 46.875 (1 –x)
or 9.375x = 4.875
x = 0.52
So, the required dividend payout ratio will be = 52%

Question No. 23
SE Ltd., having an equity capital of Rs. 1 billion (face value of Rs. 100 each) earned a net profit
of Rs. 15 crores during the financial year 2072/73 and is planning to make new investments of
Rs. 60 crores during the current financial year 2073/74. In line with the company's dividend
policy it has a plan of declaring dividend of Rs. 10 per share at the end of current financial year.
The firm's opportunity cost of capital is 15% and is currently traded at Rs. 100 per share.

Required: (2+2+1=5 Marks)

Considering the Modigliani and Miller's Dividend Irrelevance Theorem, what is the price of the
share at the end of the current financial year if:
i) the dividend is not declared,
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ii) the dividend is declared,

iii) How many new shares must be issued to finance its investments assuming
that dividend is declared? [December 2016]

Answer:
i. Price of the share at the end of the current financial year if the dividend is not paid is Rs.115.
P1 = P0 (1 + k) - DIV1
= 100 × (1+0.15) - 0
= 115
ii. Price of the share at the end of the current financial year if the dividend is paid is Rs.105.
P1 = P0 (1 + k) - DIV1
= 100 × (1+0.15) - 10
= 105
Where
P1 = Price at the end of the financial year
P0 = Current Price
k = Opportunity Cost of Capital
DIV1 = Dividend at the end of the financial year
iii. The value of share issued for investment is Rs.105 per share (FV and share premium).
Therefore, no. of shares to be issued:
mP1 = I - (X - nDIV1)
105m = 600,000,000 - (150,000,000 – 10,000,000 × 10)
105m = 550,000,000
m = 550,000,000/105 = 5,238,095 shares
Where
m = Required No. of New Shares
n = Existing No. of Shares
I = Investment Amount
X = Net Profit Attributable to Shareholders
DIV1 = Dividend at the end of the financial year

Question No. 24
X and Y are two fast growing companies in the engineering industry. They are close
competitors, and their asset composition, capital structure, and profitability records have been
very similar for several years. The primary difference between the companies, from a financial
management prospective, is their dividend policy. Company X tries to maintain a non-
decreasing dividend per share, while company Y maintains a constant dividend payment ratio.
Their earnings per share (EPS), dividend per share (DPS), and average share price are as
follows:
Company X (Rs.) Company Y (Rs.)
Year EPS DPS Avg. Price EPS DPS Avg. Price
1 9.30 2.00 87.50 9.50 1.90 70.00
2 7.40 2.00 67.50 7.00 1.40 45.00
3 10.50 2.00 90.00 10.25 2.10 57.50
4 12.75 2.25 110.00 12.25 2.45 100.00
5 20.00 2.50 167.00 20.25 4.05 167.50
6 16.00 2.50 170.00 17.00 3.40 160.00
7 19.00 2.50 182.00 20.00 4.00 160.00

Required: (5+3+2=10 Marks)

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iii) Determine the dividend payment ratio and price earnings ratio for both companies for all the
years.
iv) Determine the average DP ratio and PE ratio for both the companies over the period 1
through 7 years.
v) The management of company Y is puzzled as to why their share prices are lower than those
of company X, in spite of the fact that profitability of company Y is slightly better
(particularly of past three years). As a financial consultant, how would you explain the
situation?
[December 2017]

Answer:
i) Calculation of DP ratio and PE ratio of Company X
Avr.
Year EPS(Rs.) DPS(Rs.) DP ratio Price(Rs.) PE ratio
1 9.30 2.00 21.50% 87.50 9.41
2 7.40 2.00 27% 67.50 9.12
3 10.50 2.00 19.05% 90.00 8.57
4 12.75 2.25 17.64% 110.00 8.63
5 20.00 2.50 12.50% 167.50 8.38
6 16.00 2.50 15.63% 170.00 10.63
7 19.00 2.50 13.16% 182.50 9.61
94.95 15.75 875

Calculation of DP ratio and PE ratio of Company Y

Avr.
Year EPS(Rs.) DPS(Rs.) DP ratio Price(Rs.) PE ratio
1 9.50 1.90 0.20 70.00 7.37
2 7.00 1.40 0.20 45.00 6.43
3 10.25 2.10 0.20 57.50 5.61
4 12.25 2.45 0.20 100.00 8.16
5 20.25 4.05 0.20 167.50 8.27
6 17.00 3.40 0.20 160.00 9.41
7 20.00 4.00 0.20 160.00 8.00
96.50 19.30 760
ii) The average DP ratio for company X
= 15.75/ 94.95×100
=16.59 %
The average DP ratio for company Y
= 19.30/ 96.50×100
=20 %
The average PE ratio for company X
= 875/94.95
= 9.22
The average PE ratio for company Y
= 760/96.50
= 7.88
iii) Company X is following the stable dividend policy, whereas company Y is
following the stable dividend payment ratio policy. In the latter policy, sporadic
dividend payment occurs, which makes its owners very uncertain about the

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returns they can expect from their investment in the firm and, therefore,
generally depress the share prices. It is probably for this reason that company
X‘s share price is better than that of Y (during the last three years).

Question No. 25
A company has a total investment of Rs. 4,000,000 in assets and 40,000 outstanding
ordinary shares of Rs. 100 per share (par value). It earns at a rate of 15 percent on its
investment, and has a consistent policy of retaining 50 percent of the earnings. The
appropriate discount rate of the firm is 10 percent.
Required: (3+2=5 Marks)
i) Determine the price of its share using Gordon‘s model.
ii) What shall happen to the price of the shares if the company has a payout of
20 percent and 60 percent respectively?
[December 2017]

Answer:
(i) Price of Share using Gordon‘s model:

The share valuation model of Gordon is as follows:

P0 = DIV1 = (1 – b)EPS1 = (1 – b)rA , where
k–g k – br k – br
A denotes investment per share, which is Rs. 100 in the present case.
When the payout is 50 per cent, the price of share will be:
P0 = (1 – 0.5) 0.15 x 100 = 0.5 x 15 = 7.5/0.025 = Rs. 300
0.10 – (0.15 x 0.5) 0.10 – 0.075

(ii) Price of Share at Payout of 20 and 60 percent:

At Payout of 20 per cent

Ke =10%
b×r = 12%
Since br ˃ Ke as per Gordon's model price could not be computed.

At Payout of 60 per cent:

P0 = (1 – 0.4) 0.15 x 100 = 0.6 x 15 = 9/0.04 = Rs. 225

0.10 – (0.15 x 0.4) 0.10 – 0.06

Question No. 26
Horizon Enterprises is a manufacturer and exporter of woolen garments to most of the European
countries. Its business is expanding day by day, and in the previous financial year the company
has registered a 25 percent growth in export business.

The company is in the process of considering a new investment project. It is an all equity
financed company with 1,000,000 equity shares of Rs. 50 per share. The current issue price of
this share is Rs. 125 ex-dividend. Annual earnings of Rs. 25 per share, in the absence of new
investments, will remain constant in perpetuity. All earnings are distributed at present. A new
investment is available which will cost Rs. 17,500,000 in one year's time and will produce
annual cash inflows of Rs. 5,000,000 thereafter. The new investment is financed through
internal accruals.

Required: (5 Marks)

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Analyze the effect of the new investment on dividend payments and the share price.
[June 2018]
Answer:
Calculation of Cost of Equity (ke)

Ke = D/P ˣ 100
= 25/125 ˣ 100
=20%
Earnings per share = Rs. 25
Total Earnings = 1,000,000 shares @ Rs. 25 each =Rs. 25,000,000
New project cost = Rs. 17,500,000
Dividend per share in 1st year
Since the investment is financed out of internal accruals, the amount available for dividend at
the end of first year is Rs:
=1st Year's earnings - Project cost
=Rs. 25,000,000-Rs. 17,500,000
=Rs. 7,500,000
Since all the earnings are distributed, earnings per share and dividend per share are same.
Dividend per share in 1st year = Rs. 7,500,000/1,000,000 shares = Rs. 7.50
Dividend per share in 2nd year and will remain constant in perpetuity
=Rs 25,000,000+Rs. 5,000,000
1,000,000 shares
=Rs. 30 per share
The present value of new share price after the new investment is taken up
P = (Rs. 7.5/1.2) +(Rs 30/0.2 ˣ 1/1.2)
= 6.25+125
= Rs. 131.25
It is evident that the dividend payment and the price of share will increase after new
investment.

Question No. 27
SE Ltd., having an equity capital of Rs. 1 billion (face value of Rs. 100 each) earned a net profit
of Rs. 150 million during the financial year 2074/75 and is planning to make new investments of
Rs. 600 million during the current financial year 2075/76. In line with the company's dividend
policy, it has a plan of declaring dividend of Rs. 10 per share at the end of current financial year.
The firm's opportunity cost of capital is 15% and is currently traded at Rs. 100 per share.

Required: (3+2=5 Marks)

i) Considering the Modigliani and Miller's Dividend Irrelevance Theorem, what is the price of
the share at the end of the current financial year if:
 the dividend is not declared,
 the dividend is declared.
ii) How many new shares must be issued to finance its investments assuming that dividend is
declared?
[December 2018]
Answer:
i) Price of the share at the end of the current financial year if the dividend is
not paid
P1= P0 (1 + k) - DIV1

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= 100 × (1+0.15) - 0
= Rs. 115
Price of the share at the end of the current financial year if the dividend is paid
P1= P0 (1 + k) - DIV1
= 100 × (1+0.15) - 10
= Rs. 105
Where
P1= Price at the end of the financial year
P0= Current Price
k= Cost of Capital
DIV1= Dividend at the end of the financial year

ii) The value of share issued for investment is Rs.105 per share (FV and share
premium). Therefore, no. of shares to be issued:

mP1 = I - (X - nDIV1)
105m = 600 – [150– (10 × 10)]
105m = 550
m = 550 million/105 = 5,238,095 shares
Where
m = Required No. of New Shares
n = Existing No. of Shares
I = Investment Amount
X = Net Profit Attributable to Shareholders
DIV1 = Dividend at the end of the financial year

Question No. 28
A firm provides you the following information:
Total earnings = Rs. 600,000
No. of Equity share of Rs. 100 each = 40,000
Dividend Paid = Rs. 160,000
Price-Earnings (P/E) Ratio = 10
The firm is expected to maintain its rate of return on fresh investment.
Required: (3+2=5 Marks)
i) Ascertain whether the firm is following an optimal dividend policy as per Walter's
model and determine the payout ratio at which dividend policy will have no effect on
the value of the share.
ii) Will your decision change if the P/E ratio is 5 instead of 10?
Answer:
i) Rate of return on firm's investment (r) = 600,000 / (40,000 x 100) x100 =15%
Cost of Capital (Ke) = 1 / P/E ratio = 1/10 = 10%
Calculation of Payout ratio at which dividend policy will have no effect on the value
of the share:
Firm's dividend payout ratio = Rs.160,000/ Rs. 600,000 = 0.2667 or 26.67%
Rate of return of the firm (r) is 15%, which is more than its cost of capital (Ke) 10%.
Therefore, by distributing 26.67% of earnings, the firm is not following an optimal
dividend policy. The optimal dividend policy for the firm would be to pay zero
dividend and in such case, the market value of share under Walter‗s model would be
as follows:
P = ((0 + (0.15 / (0.1) x (15- 0)) / 0.1
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= Rs. 225 (Optional – Not Compulsory)

The market value of the share would increase by not paying dividend and by
retaining all the earnings of the company.
ii) Calculation of market value of share when P/E ratio is 5 instead of 10
The Ke of the firm is the inverse of P/E ratio i.e. 1/5 = 0.20. In such case Ke > r
Under the situation P/E ratio is 5, the optimum dividend policy for the company
would be 100% dividend payout at which the value of the firm would be maximum.

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Chapter 12:

Capital Structure Management

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Question No. 1
The advantage of long-term debt from company's viewpoint is that they do not participate in
superior profit and do not participate in the control of the firm. [June 2009](2.5 Marks)
Answer:
True because long-term debtholders do not participate in superior profit and do not participate in
the control of the firm. Common stockholders, however, participate in superior profit and
control of the firm.

Question No. 2
Financial distress [June 2009] (2.5 Marks)
Answer:
Financial distress refers to financial failure. Failure can be defined in several ways, and some failures
do not necessarily result in the collapse and dissolution of a firm. Failure in an economic sense
could mean that a firm is losing money – its revenues do not cover its costs. It could also mean
that its earnings rate is less than its cost of capital. A related definition would be that the present
value of cash flows of the firm is less than its obligations. In still another sense, failure occurs
when the firm‘s actual cash flows are short of its expected cash flows – its projections have not
been met. Or failure could refer to insolvency. The recent literature relates financial distress to
insolvency, distinguishing between a flow basis and a stock basis.

Question No: 3
Distinguish between Operating leverage and financial leverage [December 2010] (2.5 Marks)

Answer:
Operating leverage occurs when there is fixed operating cost associated with the production of
goods and services. Fixed operating costs are incurred with an assumption that sales volume will
produce revenues more than sufficient to cover all fixed and variable operating costs.
Fixed operating costs do not vary with the change in the volume. On the other hand, variable
operating costs vary directly with the level of output. Therefore, if volume is to change, it is the
effect of fixed operating costs which causes the profit of a firm to change.
The effect of presence of fixed operating costs (or operating leverage) is that a change in the
volume of sales will bring about more than proportional change in operating profit (or loss) of
the company.
Financing leverage is due to the use of fixed financing costs by the firm. It is employed with a
view to increase the return to ordinary shareholders. Favourable leverage occurs when the firm
used funds obtained at a fixed cost to earn more than the fixed cost of financing paid by it. If any
profit is left after paying the fixed financing costs, it belongs to the ordinary shareholders.
There is no choice for the management on the operating fixed costs. For example, a heavy
industry requires huge investment resulting in a large operating cost in the form of depreciation.
This cannot be avoided. On the other hand, financial leverage is always a choice item. Firms
need not have financing through long-term debt or preference share. They have the option to
finance their operations and capital expenditures from internal sources and through the issue of
equity shares.
Question No: 4
Distinguish between Operating Leverage and Financial Leverage. [June 2010] (2.5 Marks)
Answers:
Operating leverage results from the existence in the firm's income stream. The operating
leverage may be defined as the firm's ability to use fixed operating costs to magnify the effects

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of changes in sales on its earnings before interest and taxes. Operating leverage occurs any time
a firm has fixed costs that must be met regardless of volume.

Financial Leverage results from the presence of fixed financial charges in the firm's income
stream. Financial Leverage is concerned with the effects of changes in EBIT on the earnings
available to equity holders. It is defined as the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT on the earnings per share.

Question No: 5
Distinguish between Investing Activities and Financing Activities [June 2010] (2.5 Marks)
Answer:
The investing activities relate to the acquisition and disposal of long-term assets and other
investments not included in cash-equivalents. Their separate disclosure in Cash flow statement is
important as they represent the extent to which expenditures have been made for resources
intended to generate future income and cash flows.
The financing activities report the changes in the size and composition of the share/owner's
capital and debt of the enterprise. Their separate disclosure is useful in predicting claims on
future cash flow by providers of funds (both capital and borrowings) to the enterprise.

Question No: 6
Write short notes on: (2.5 Marks)
Direct and indirect costs associated with financial distress
(December 2010)

Answer:
Financial distress arises when a firm is not able to meet its obligations towards the payment of
interest and principal to the debt providers which can lead to bankruptcy. Direct costs of
financial distress include the costs of insolvency.
Following are the other direct costs of financial distress:
i. Long period taken in the bankruptcy cases may cause deterioration of the conditions of the
company‘s assets.
ii. Liquidation of the assets may be delayed due to conflicting interests of creditors and other
stakeholders.
iii. When the assets are sold under distress prices, they may fetch a price that is significantly
lower than their current values.
iv. Legal and administrative costs related to the bankruptcy proceedings are generally quite
high.

Question No. 7
Business Risk and Financial Risk [June 2011] (2.5 Marks)

Answer:
Business Risk is defined as the uncertainty inherent in projections of future Return on Assets
(ROA), or of Returns on Equity (ROE) if the firm uses no debt. Business risk is the single most
important determinant of capital structure. Business risk varies from one industry to another and
also among firms in given industry
Financial risk is the additional risk placed on the common stockholders as a result of using
financial leverage, which results when a firm uses fixed income securities (debt and preferred

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stock) to raise capital. Thus, it is the portion of stockholders‘ risk, over and above basic business
risk, resulting from the manner in which the firm is financed.

Question No. 8
Financial distress [June 2012] (2.5 Marks)
Answer:
Financial distress is a term used to indicate a condition when promises to creditors of a
company are broken or honored with difficulty.
• Sometimes financial distress can lead to bankruptcy.
• Financial distress is usually associated with some costs to the company; these are known as
costs of financial distress.
• This is a situation where a firm‘s operating cash flows are not sufficient to satisfy current
obligations and the firm is forced to take corrective action.
• Financial distress may lead a firm to default on a contract, and it may involve financial
restructuring between the firm, its creditors, and its equity investors.

Question No. 9
Operating breakeven point Vs. Financial breakeven point [June 2012] (2.5 Marks)
Answer:
The operating breakeven point is defined as the units of output at which total revenues are equal
to total operating costs (fixed costs plus variable costs). The operating breakeven point is
calculated as follows:
Operating BEP = Fixed Cost/ Contribution Margin.

Financial breakeven point is the situation where EBIT equals to financing cost. In this analysis,
the firms needs to just cover all of its financing costs and produce earnings per share equal to
zero. Financial Breakeven analysis can be used to help determine the impact of the firm's
financing mix on the earnings available to common stockholders.

Questions No. 10
Business Risk and Financial Risk [June 2013] (2.5 Marks)
Answer
Business risk refers to the risk associated with the firm‘s operations. It is an unavoidable risk
because of the environment in which the firm has to operate and the business risk is represented
by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced
by revenues and expenses. Revenues and expenses are affected by demand of firm‘s products,
variations in prices and proportion of fixed cost in total cost.
Whereas, financial risk refers to the additional risk placed on firm‘s shareholders as a result of
debt use in financing. Companies that issue more debt instruments would have higher financial
risk than companies financed mostly by equity. Financial risk can be measured by ratios such as
firm‘s financial leverage multiplier, total debt to assets ratio etc.

Business risk is the relative dispersion in the firm‘s expected earnings before interest and taxes.
Whereas, financial risk is the additional variability in the earnings available to the firm‘s

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common stockholders and additional chance of insolvency borne by the common stockholders
caused by the use of financial leverage.

Question No. 11
Discuss about the fundamental principles governing capital structure. [December 2014]
(4 Marks)

Answer:
The fundamental principles governing capital structure are:
(i)Cost Principle –
This principle suggests that an ideal capital structure is one that minimizes cost of capital
structure and maximizes earning per share.
(ii) Risk Principle –
This principle suggests using more proportion of common equity for financing requirement.
Use of more and more debts means higher commitment in form of interest payout. This
would lead to erosion of shareholders value in unfavorable business situation.
(iii) Control Principle –
This principle suggests to consider interest of maintain existing management and operational
control over the company. Management may wish to have control undisturbed.
(iv) Flexibility Principle –
This principle gives flexibility to the management who decides such a combination of
sources of financing which it finds easier to adjust according to changes in need of funds in
future too.
(v) Other considerations –
Besides above principles, other factors such as regulatory requirements, nature of industry,
timing of issue and competition in the industry should also be considered

Question No. 12
Capital structure and Financial structure [December 2014] (2.5 Marks)
Answer:
Capital Structure is the permanent long term financing of the company including Long term
debt, equity capital, preferential shares and retained earnings is called capital structure. It can be
also termed as a mix of long term finances used by the [Link] is the financing plan of the
company. It differs from Financial Structure which includes short term debt and accounts
payable also.

Whereas, financial Structure entails the ways the assets of the companies are financed such as
trade accounts payable, short terms borrowings as well as long term borrowings and ownership
equity. Financial structure is distinguished from capital structure where only long term debt and
equity are included. A company‘s financial structure is influenced by many factors such as
growth rate, stability of sales. It is the basic frame of references for analysis concerned with
financial leveraging decisions.

Question No. 13
What are the advantages of raising funds through issue of equity share? [July 2015] (2 Marks)

Answer:
Following are some of the advantages of raising funds by issue of equity shares:
 Permanent source of finance. No liability for cash outflows associated with its redemption.
 Demonstrate financial base (Capital adequacy) of the company and helps borrowing power
of the company.
 No legal obligation to pay dividends.
 Can be raised further shares by making a right issue.
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Question No. 14
Debt trap [July 2015] (2.5 Marks)
Answer:
Debt Trap is a situation where you add on a new debt in order to pay an existing debt. Generally,
when the firm in overleveraged all the credit sources are exhausted, firm arrives at a situation of
debt trap. It is a situation in which an entity borrows money, but does not have enough money to
make the interest payments on the loan, so it takes out another loan--with its own interest
payments--to cover the first loan's payments. They will likely have to borrow again to pay off
the second loan, creating a crippling cycle. It is an incentive structure that lures individuals into
accepting long-term debt obligations under conditions that strongly favor the lender. Victims of
debt traps are often prevented from discharging the debt through techniques such as unusually
high or variable interest rates, changing payment plans, and unreasonably high penalties for late
payments.

Question No. 15
Financial distress and Insolvency [July 2015] (2.5 Marks)
Answer:
Financial distress is a situation where a firm‘s operating cash flows are insufficient to meet its
current obligations (and so the firm must take some kind of corrective action) financial distress
may lead a firm to default on a contract, and it may involve financial restructuring between the
firm, its creditors, and its shareholders in most cases, the firm is forced to take actions that it
would not have taken if it had sufficient cash flow.
Insolvency is a term which generally means an inability to repay debts stock-based insolvency
occurs when the value of a firm‘s assets is less than what is owed on its debt flow-based
insolvency occurs when the firm‘s cash flows are insufficient to cover contractually required
payments.

Question No. 16
Business Risk and Financial risk [July 2015] (2.5 Marks)

Answer:
Business risk refers to the risk associated with the firm‘s operations. It is the uncertainty about
the future operating income; how well can the operating income be predicted. Business risk can
be calculated using statistical techniques such as standard deviation of the basic earning power
ratio.
Financial risk refers to the additional risk placed on the firm‘s shareholders as a result of debt
use i.e. the additional risk a shareholder bears when a company uses debt in addition to equity
financing. Companies that issue more debt instruments would have higher financial risks than
the companies financed mostly or entirely by equity. Financial risks can be measured using
various financial ratios.

Question No. 17
"Banks and financial institutions are considered as highly leveraged institutions." Do you agree
with this statement? [December 2015] (3 Marks)

Answer:
Banks and financial institutions are highly leveraged institutions and therefore the highly
regulated institutions in the world. The balance sheet size of any bank and financial institution is
predominantly covered by deposits and loans while the shareholders equity covers mere 8 to
15% of the balance sheet size. The capital adequacy ratio criteria based on the credit, market and
operations risks that require the maintenance of 8 to 12% capital of total risk weighted assets
substantiate this fact.

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With Such a high leverage ratio BFI are able to generate healthy profit/ROE as seen I the market
even by being within the constraints/regulation of NRB.

Question No. 18
Financial leverage [December 2015] (2.5 Marks)

Answer:
Financial Leverage may be defined as "the use of funds with a fixed cost in order to increase
earnings per share". In other words, it is the use of company funds on which it pays a limited
return. Financial leverage involves the use of funds obtained at a fixed cost in the hope of
increasing the return to common stockholders.
Degree of the financial leverage is the ratio of the percentage increase in earnings per share
(EPS) to the percentage increase in earnings before interest and taxes(EBIT).

Percentage increase in EPS

Degree of Financial leverage = ---------------------------------------
Percentage increase in EBIT
or
EBIT
Financial leverage = -------------------
EBIT-Interest

Question No. 19
Higher financial leverage is better than higher operating leverage. Comment.
[December 2016] (2.5 Marks)

Answer:
Operating leverage indicates the proportion of fixed operating charges. Higher operating
leverage indicates higher quantum of fixed operating charges. If a business firm has a lot of
fixed costs as compared to variable costs, then the firm is said to have high operating leverage.
The financial leverage indicates the proportion of fixed financial charges, in the form of interest
cost. Higher financial leverage indicates higher quantum of fixed financial charges.
The company can differ or somewhat convince the financial institution and banks, to accept the
delay in payment, which cannot be possible in the case of provider of operating activities. Hence
we can say that higher financial leverage is better than higher operating leverage.

Question No. 20
Business risk and Financial risk [December 2018] (2.5 Marks)

Answer:
Business Riskrefers to the risk associated with the firm‘s operations. It is theuncertainty about
the future operating income (EBIT), i.e. how well can the operating incomes be predicted.
Business risk can be measured by the standard deviation of the Basic Earning Power Ratio.

Financial Risk refers to the additional risk placed on the firm‘s shareholders as aresult of debt
use i.e. the additional risk a shareholder bears when a company uses debt in addition to equity
financing. Companies that issue more debt instruments would have higher financial risk than
companies financed mostly or entirely by equity.

Question No. 21
Financial distress and Insolvency [December 2018] (2.5 Marks)

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Answer:
Financial Distress is surprisingly hard to define precisely. This is true partly because of the
variety of events befalling firms under financial distress. The list of events is almost endless, but
examples are Dividend Reductions, Plant Closings, Losses, Layoffs, CEO resignations,
Plummeting stock prices and many more.

Financial distress is a situation where a firm‘s operating cash flows are not sufficient to satisfy
current obligations (such as trade credits or interest expenses) and the firm is forced to take
corrective action. Financial distress may lead a firm to default on a contract, and it may involve
financial restructuring between the firm, its creditors, and its equity investors. Usually the firm is
forced to take actions that it would not have taken if it had sufficient cash flow.

Insolvency occurs when an individual or a firm is unable to meet their financial obligations.
Accounting (Balance sheet) insolvency happens when total liabilities exceed total assets
(negative net worth).

Cash flow insolvency involves a lack of liquidity to pay debts as they fall due. A business can be
cash-flow insolvent but balance-sheet solvent if it holds market liquidity assets, particularly
against short term debt that it cannot immediately realize if called upon to do so. Conversely, a
business can have negative net assets showing on its balance sheet, making it balance-sheet
insolvent, but still be cash-flow solvent if ongoing revenue is able to meet debt obligations, and
thus avoid default: for instance, if it holds long term debt. Some large companies operate
permanently in this state.

Question No. 22
Accounting break-even and Financial break-even [June 2018] (2.5 Marks)

Answer:
Accounting break-even method is the most common form of the analysis done and one of the
easiest. It is calculated as being the number of units that need to be sold in order to produce zero
profit. More formally, the number of units required can be calculated as total fixed cost divided
by the difference between unit price and variable cost. The difference between unit price and
variable cost can be considered the profit per unit produced and sold and a business must sell
enough units to cover its fixed costs before it can become profitable.
Accounting BEP
Financial break-even is a similar concept to accounting break-even but uses very different
measurements. It is the level of earnings needed before a firm's earnings per share is equal to
zero. Here, earnings is defined as earnings before interest and taxes, or gross profit minus cost
of sales and operating expenses and earnings per share is most often defined as being earnings
divided by the number of outstanding common shares.

Financial BEP

Question No. 23
Financial restructuring [June 2019] (2.5 Marks)

Answer:
Financial restructuring is carried out internally in the firm with the consent of its
various stakeholders. Financial restructuring is a suitable mode of restructuring of
corporate firms that have incurred accumulated sizable losses for / over a number of
years. As a sequel, the share capital of such firms, in many cases, gets substantially
© The Institute of Chartered Accountants of Nepal 258
 CAP II Paper 4: Financial Management

eroded / lost; in fact, in some cases, accumulated losses over the years may be more
than share capital, causing negative net worth. Given such a dismal state of financial
affairs, a vast majority of such firms are likely to have a dubious potential for
liquidation. Can some of these Firms be revived? Financial restructuring is one such a
measure for the revival of only those firms that hold promise/prospects for better
financial performance in the years to come. To achieve the desired objective, such
firms warrant / merit a restart with a fresh balance sheet, which does not contain past
accumulated losses and fictitious assets and shows share capital at its real/true worth.

Question No. 24
Ploughing back of profits [June 2019] (2.5 Marks)
Answer:
Long-term funds may also be provided by accumulating the profits of the company and
ploughing them back into business. Such funds belong to the ordinary shareholders and
increase the net worth of the company. A public limited company must plough back a
reasonable amount of its profits each year keeping in view the legal requirements in
this regard and its own expansion plans. Such funds also entail almost no risk. Further,
control of present owners is also not diluted by retaining profits

Question No. 25
DEF Ltd. plans to expand assets by 60 percent. To finance the expansion, it has a
choice between a straight 9 percent debt issue and equity issue. Its current balance
sheet and income statement are as shown below:
Balance Sheet of DEF Ltd. as on 32 Ashadh
--------------------------------------------------------------------------------------------------
5% Debt NRs. 1,000,000 Total Assets 5,000,000
Equity Shares
(NRs. 100 per share) 2,500,000
Retained Earnings 1,500,000 ________
5,000,000
5,000,000

Income Statement for the year ended on 32 Ashadh

--------------------------------------------------------------------------------------------------
Sales NRs. 15,000,000
Total cost (excluding interest) 13,450,000
Earning before Interest and Taxes (EBIT) 1,550,000
Less: Interest on Debt 50,000
Earning before Tax (EBT) 1,500,000
Less: Taxes 450,000
Net Income 1,050,000

If the company finances the proposed expansion with debt, the rate on the incremental
debt will be 9 percent and the price/earning ratio of the equity shares will be 10. If
expansion is financed by equity, the new shares can be sold at NRs. 300 and the price
earnings ratio of all the outstanding equity shares will remain 12.

Considering all the information given above, you are required to do the following:
(8+2+2=12Marks) (June 2009)

i) Assuming that net income before interest on debt and taxes (EBIT) is 10 percent on
sales, calculate EPS at assumed sales of NRs. 10 million, NRs. 20 million and NRs.
25 million under the alternative mode of financing the expansion program (assume
no fixed costs).
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ii) Using the price/earnings ratio indicated, calculate the market value of equity share
for each sales level for both the debt and equity methods of financing.
iii) If the firm follows the policy of seeking to maximize the price of its shares, which
form of financing should be employed?

Answer:
(i) & (ii)
Computation of EPS and MPS under alternative financing plans
(Figures in NRs. ‗000)
------------------------------------------------------------------------------------------------------------
Sales Level _______________
NRs. 10 millionNRs. 20 million NRs. 25 million
DebtEquity DebtEquityDebtEquity
EBIT NRs. 1,000 Rs 1,000 NRs. 2,000 NRs. 2,000 NRs. 2,500 NRs.
2,500
Less: Interest *320 50 320 50 320 50
EBT 680 950 1,680 1,950 2,180 2,450
Less: Taxes (0.30) 204 285 504 585 654 735
EAT 476 665 1,176 1,365 1,526 1,715

Now
1. EAT 476,000665,00001,176,000 1,365,000 1,526,000 1,715,000
2. No. of Equity Shares: 25,000 35,000 25,000 35,000 25,000 35,000
3. EPS (1 / 2) 19.04 19 47.04 39 61.04 49
4. P/E Ratio 10 12 10 12 10 12
5. Market Price of Share: 190.4 228 470.4 468 610 588
------------------------------------------------------------------------------------------------------------

(iii)The answer will depend on the expected level of sales. If the sales level is at NRs. 10
million, equity form of financing should be employed as it will have better MPS. At the sales
level of NRs. 20 million and NRs. 25 million, MPS under debt form of financing is to be
preferred for higher MPS as compared to equity mode of financing.

Working Notes:
 In debt financing, the number of equity shares outstanding = 2,500,0000/100 = 25,000
 In the case of equity financing, the total number of outstanding shares will be as computed
below:
Additional equity to be raised = 0.60 X 5,000,000 = NRs. 3,000,000
Price per share at which shares can be sold: NRs. 300
Additional Number of shares = NRs. 3,000,000/NRs. 300 = 10,000
Existing Shares = 25,000
Total Number of Shares = 25,000 + 10,000 = 35,000

Question No. 26
A steel manufacturing company is planning to expand its assets by 50 percent. All financing
for this expansion will come from external sources. The expansion will generate additional
sales of Rs. 6 million with a return of 20 percent on sales before interest and taxes.
The finance department of the company has submitted the following plan for the
consideration of the Board of Directors.
Plan 1: Issue of 12.5% debentures.

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 CAP II Paper 4: Financial Management

Plan 2: Issue of 12.5% debentures for half the required amount and balance in equity shares
to be issued at 20 percent premium
Plan 3: Issue equity shares at 20 percent premium.

The Balance Sheet and Income Statement of the company as on the last day of Ashadh is as
given below.

Balance Sheet of the company as on Ashadh 2066

Liabilities Amount Assets Amount

Equity Capital (Rs. 100 per share) Rs. 8,000,000 Total Assets Rs.24,000,000
10% Debentures 6,000,000
Retained Earnings 4,000,000
Current Liabilities 6,000,000 __________
24,000,000 24,000,000

Income Statement for the year ending on Ashadh 2066

Sales Rs. 38,000,000

Operating Costs 32,000,000
Earning Before Interest and Taxes (EBIT) 6,000,000
Interest 600,000
Earning Before Tax (EBT) 5,400,000
Taxes 1,890,000
Earning After Tax (EAT) 3,510,000
Earning Per Share (EPS) 43.875

Based on the above data and information, you are required to calculate: (9+6=15 Marks)

a) Indifference points between (i) Plan 1 and 2, (ii) Plan 1 and 3, and (iii) Plan 2 and 3.

b) Expected market price of the shares in each of the situations on the assumption that
the price earnings ratio is expected to remain unchanged at 12 if plan 3 is adopted,
but is likely to drop to 9 if either plan 1 or 2 is used to finance the expansion.
(December 2009)

Answer:
Preliminary Computations:
Number of Equity Share to be issued under Plan 3 = Rs. 12,000,000/Rs. 120 = 100,000
Number of Equity Share to be issued under Plan 2 = Rs. 6,000,000/Rs. 120 = 50,000
12.5% Debentures to be issued under Plan 1 = 50% of Rs. 24,000,000 = Rs. 12,000,000.
12.5% Debentures to be issued under Plan 2 = 50% of Rs. 24,000,000 X 0.5 = Rs. 6,000,000.
(a) Indifference Point among different Finance Plans:
(i) Between Plans 1 and 2

[ (X – I1 – I2) ((1 – t) ] / N1 = [ (X – I1 – I2 ) ((1 – t) ] / N2

Where,
X = Earnings before interest and taxes (EBIT) at the indifferent point
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N1 = Number of equity shares outstanding if only equity shares are issued.

N2 = Number of equity shares outstanding if both debentures and equity shares are
issued.
I= Amount of interest on debentures
t= Corporate income tax rate

Substituting the values, we get:

[(X – 600,000 –1,500,000) 0.65] = [(X –600,000 – 750,000) 0.65]
80,000 130,000
Or, 13 (X – 2,100,000) = 8 (X – 1,350,000)
Or, 13 X – 27,300,000 = 8 X – 10,800,000
Or 5 X = 27,300,000 – 10,800,000 = 16,500,000, Therefore X = Rs. 3,300,000

(ii) Between Plans 1 and 3

[(X – 2,100,000) 0.65]= [(X – 600,000) 0.65]

80,000 180,000
Or, 18 (X – 2,100,000) = 8 (X – 600,000)
Or, 18 X – 37,800,000 = 8 X – 4,800,000
Or, 10 X = 33,000,000, Therefore X = Rs. 3,300,000

(iii) Between Plan 2 and 3

[(X –1,350,000) 0.65] = [(X – 600,000) 0.65]

130,000 180,000
Or, 18 (X-1,350,000) = 13 (X – 600,000)
Or, 18 X –24,300,000 = 13 X – 7,800,000
Or, 5 X = 16,500,000

Therefore X = Rs. 3,300,000.

(b) Determination of Market Price per Share under Various Alternative Plans:
__________________________________________________________________________
Particulars Plan 1 Plan 2 Plan 3
_____________________________________________________________________________
_________________________________________________________________________
_____

EBIT* Rs. 7,200,000 Rs. 7,200,000 Rs. 7,200,000

Less: Interest 2,100,000 1,350,000 600,000
Earning before Taxes 5,100,000 5,850,000 6,600,000
Less: Taxes (@ 35%) 1,785,000 2,047,500 2,310,000
EAT 3,315,000 3,802,500 4,290,000
Number of Equity Shares 80,000 130,000 180,000

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EPS (EAT/No. of Shares) 41.4375 29.25 23.8333

P/E Ratio 9 9 12
Expected Market Price per Share 372.94 263.25 286.00
_____________________________________________________________________________
_
* Existing EBIT Rs. 6,000,000 + EBIT on Additional Sales of Rs. 6,000,000 (0.20 X
6,000,000) = Rs. 7,200,000

Question No: 27
Rock Star Company Ltd. is attempting to establish the current assets policy. Fixed Assets are Rs.
600,000 and the company plans to maintain a 50 percent debt to Total assets ratio. The interest
rate is 10 percent on all debt. As a financial consultant, the Rock Star Company seeks your
advice on three alternatives of current asset policies: 40 %, 50%, 60% of projected sales. The
company expects to earn 15 percent before interest and taxes on sales of Rs. 3 Million. Tax Rate
applicable for the company is 40 percent. Provide your advice to the company by showing
Return on Equity under each alternative. (5 Marks)
(December 2010)
Answer:
Given
Fixed Assets = Rs. 600,000
Debt to assets ratio = 50%
Interest on debt = 10%
EBIT = 15% of sales
Sales = Rs. 3 Million
Tax Rate (T) = 40%
Current Assets alternatives = 40 % of sales, 50% of sales, 60% of sales
Return on Equity (ROE) (%) = Required

Rock Star Company's Balance Sheet under three alternatives

Alternatives 40% of sales 50% of sales 60% of sales
Current Assets 1,200,000 1,500,000 1,800,000
Fixed Assets 600,000 600,000 600,000
Total Assets 1,800,000 2,100,000 2,400,000
Debt 900,000 1,050,000 1,200,000
Equity 900,000 1,050,000 1,200,000
Total Liabilities and 1,800,000 2,100,000 2,400,000
Equity

Computation of Interest
Total Debt (Rs.) 900,000 1,050,000 1,200,000
Total Interest( 10% of 90,000 105,000 120,000
total debt)

Rock Star Company's Income Statement under three alternatives

Alternatives 40% of sales 50% of sales 60% of sales
Sales 3,000,000 3,000,000 3,000,000
EBIT( 15%) 450,000 450,000 450,000

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Less: Interest( 10%) 90,000 105,000 120,000

EBT 360,000 345,000 330,000
Tax( 40%) 144,000 138,000 132,000
EAT 216,000 207,000 198,000
ROE(%) 24 19.7 16.5

Question No 28
Weather Coats Paint Ltd. has fixed operating costs of Rs. 36 million a year. Variable operating
costs are 180 per half liter of paint produced, and the average selling price is Rs. 200 per half
liter.
You are required to answer the following questions with computations to support each one of
your answer. (2.5 + 1.5 + 1 = 5 Marks)
i) What is the annual operating break-even point in half liters (QBE) and in rupees of sales
(SBE)?
ii) What would be the effect on the operating break-even point (QBE) of a simultaneous decline
to Rs. 170 per half liter in the variable operating costs and an increment of 20 per cent in the
fixed cost?
iii) Compute the degree of operating leverage (DOL) at the current sales level of 2 million half
liters.
(December 2010)
Answer:
(i) Computation of QBE andSBE
QBE = Rs. 36 Million = Rs. 36 Million= 1,800,000 half liters
Rs. 200 – Rs. 180 Rs. 20

SBE = Rs. 36 Million = Rs. 36 Million = Rs. 36 Million = Rs. 360,000,000 in annual sales
1 – (Rs. 180/Rs. 200) 1 – 0.90 0.10

(ii) Effect of a Decline to Rs. 160 per half liter in the variable operating costs and an
Increase of 25 per cent in the Fixed Cost on QBE
QBE = Rs. 36 Million x 1.25 = Rs. 45 Million= 1,500,000 half liters
Rs. 200 – Rs. 170 Rs. 30

(iii) Degree of Operating Leverage (DOL) at the current sales level of 2 Million half
liters
DOL 2 million units = 2 Million = 2 Million = 10
(2 – 1.8) Million 0.2 Million

Question No: 29
The capital structure of Stable Ltd. is extracted below:
(Rs. in Million)
_____________________________________________________________________________________________________________________________

Equity capital: 100 thousand shares of Rs.100 each 10.0

Reserve and surplus 12.0

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12% preference shares: 55,000 shares of Rs. 100 each fully paid up 5.5
14% debentures of Rs. 1,000 each; 3,000 numbers 3.0
Long-term loan from financial institution at 12% per annum 2.0
32.5
_______________________________________________________________________________________________________________________________

The company is also availing a bank overdraft of Rs. 2 million carrying interest at 15% per
annum. The company is now drawing up its profit plan for the next year. It wants to pay
dividend to equity shareholders at 15% and keep the total dividend payout (equity as well as
preference shareholders) at 60%.
Assuming that the tax rate applicable to the company is 25%., what level of earnings (EBIT)
should the company try to achieve to meet its plan? (7 Marks)

[June 2011]

Answer:

Let ‗x‘ be the EBIT to meet the company‘s commitments.

Interest Payable Yearly
(Rs. in Million)
___________________________________________________________________________________________________________________________________________________________
_

On debentures @ 14% on Rs. 3 million

0.42
On long term loan of Rs. 2 million @ 12% 0.24
On bank overdraft of Rs. 2 million @ 15% 0.30
0.96
___________________________________________________________________________________________________________________________________________________________
_

Profit before tax (PBT) = EBIT – 0.96 = x – 0.96

Tax at 25% = (x – 0.96) / 4
Profit after tax (PAT) = 3 (x – 0.96) / 4

Total dividend payable

(Rs. in Million)
___________________________________________________________________________________________________________________________________________________________

On preference capital of Rs. 5.5 million @ 12% 0.66

On equity capital of Rs. 10 million 1.50
2.16
___________________________________________________________________________________________________________________________________________________________
_

Total dividend payout is limited to 60% of PAT and is also equal to Rs. 2.16.
Therefore, 3 (x – 0.0.96) /4 x 60 / 100 = 2.16
Or 3(X-0.96)/4=216/60
Or X-0.96=3.6x4/3
Or, x – 0.96 = 4.80
Or, x = 4.80 + 0.96 = 5.76
Hence, earnings before interest and tax should be Rs. 5.76 million.

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 CAP II Paper 4: Financial Management

Question No: 30
Phel Typewriter Ltd. and Gillis Typewriter Ltd. are identical in all respect except for capital
structure. Phel has 50 percent debt and 50 percent equity financing whereas Gillis has 20 percent
debt and 80 percent equity financing, in market value terms. The borrowing rate for both
companies is 13 percent in a no-tax world and capital markets are assumed to be perfect. The
earnings of both companies are not expected to grow, and all earnings are paid out to
shareholders in the form of dividends.

Required:

iii) If you own 2 percent of common stock of Phel, what would be your rupee return if the
company has net operating income of Rs. 360,000 and the overall capitalization rate of the
company is 18 percent? What is the implied equity capitalization rate? (4 Marks)
iv) Gillis has same net operating income and overall capitalization rate as Phel. What is the
implied equity capitalization rate for Gillis? Why does it differ from Phel? (4 Marks)
[June 2012]
Answer:

i) Phel Typewriter Ltd.

Net Operating Income(Rs.) 360,000
Overall Capitalization rate 0.18
Total Value of the firm (Rs. 360,000/0.18) 2,000,000
Market Value of debt (50%) (Rs.) 1,000,000
Market Value of stock (50%) (Rs.) 1,000,000
Interest on debts (13% of Rs. 1,000,000) 130,000
Earnings available to common shareholders 230,000
(NOI – Interest)
Common Stock holding = 2%
Therefore,
Rupee Return = 2% of earning available to shareholders
= 2% × 230,000
= Rs. 4,600.
Implied equity capitalization rate = Earnings available to common shareholders/ Market value of
stock
= 230,000/1,000,000
= 23%

ii) Gillis Typewriter Ltd.

Net Operating Income (Rs.) 360,000
Overall Capitalization rate 0.18
Total Value of the firm(Rs. 360,000/0.18) 2,000,000
Market Value of debt (20%) (Rs.) 400,000
Market Value of stock (80%) (Rs.) 1,600,000
Interest on debts (13% of Rs. 400,000) 52,000
Earnings available to common shareholders(Rs.) 308,000
(NOI – Interest)

Implied equity capitalization rate = Earnings available to common shareholders/ Market value of
stock
= 308,000/1,600,000
= 19.25%

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 CAP II Paper 4: Financial Management

Gillis has a lower capitalization rate than Phel because Gillis uses less debt in its capital
structure. As the equity capitalization rate is linear function of the debt-to-equity ratio
when we use the net operating income approach, the decline in the equity capitalization
rate exactly offsets the disadvantage of not employing so much in the way of cheaper debt
funds.

Question No: 31
Following is the capital structure of ABC Ltd. on Ashadh end, 2066:
Rs.
Equity Share Capital (of Rs. 100 each) 1,000,000
Share Premium 1,500,000
Reserves and Surplus 500,000
3,000,000
On 1 Shrawan 2066, the company made a bonus issue of 2 shares for every 5 shares held.
Mr. P had purchased 100 shares of ABC Ltd. on 1 Shrawan 2062 at the market price of Rs. 300.
He sold all the shares on Ashadh end, 2068 at the market price of Rs. 450 per share (cum-
dividend). He had to pay tax @ of 5% on his dividend income and 10% on capital gains.

Required:
If the company pays a regular dividend @ 10%, find out whether the investor P was able to earn
his required rate of return of 10% on his investments during the period, ignoring brokerage and
other transaction related costs. (Present value factors @ 10% for 1 – 6 years are: 0.91, 0.83, 0.75,
0.68, 0.62 and 0.56 respectively). (8 Marks)
[June 2012]

Answer:
b) Year Mr. P‘s holding in ABC Ltd. Cost(Rs.) PV (Rs.)
2062-63 to 2065-66 100 shares@ Rs. 300 30,000
10,000
2066-67 to 2067-68 100 shares + 100×(2/5)=140 shares 30,000
14,000

Calculation of Present Value of Dividend Income

(Figures in Rs.)
Date Dividend @ 10% Dividend after Tax PV Factor PV
Ashadh end 2063 1,000 950 0.91 864.50
Ashadh end 2064 1,000 950 0.83 788.50
Ashadh end 2065 1,000 950 0.75 712.50
Ashadh end 2066 1,000 950 0.68 646.00
Ashadh end 2067 1,400 1,330 0.62 824.60
3,836.10

Calculation of Present Value of Sale Proceeds: Rs.

Selling Price of 140 shares @ Rs. 450 per share on Ashadh end 2068: 63,000
Less: Total Cost of Purchase of Shares (100 X Rs. 300) : 30,000

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 CAP II Paper 4: Financial Management

Capital Gain : 33,000

Capital Gain Tax @ 10% : 3,300
Net Gain to the Investor : 29,700
Total Cash Inflow (29,700 + 30,000) : 59,700

This amount is received on Ashadh end 2068, i.e. after 6 years from the date of purchase.
Present Value Factor @ 10% for 6 years = 0.56
Present value of Rs. 59,700 (59,700 X 0.56) = Rs. 33,432.00
Total Present Value of Inflows (33,432 + 3,836.10) = Rs. 37,268.10
Less: Cash Outflow (Cost of Purchase) = (Rs. 30,000.00)
Net Present Value = Rs. 7,268.10
Since the net present value (gain) of the Mr. P in shares of ABC Ltd. is positive, discounting at
the rate of 10%, the investor P is getting a return on his investment at a rate in excess of 10%.

Question No: 32
A company wishes to find out its weighted marginal cost of capital (WMCC) based on target
capital structure proportions. The company presented the following data to you to assist the
company in determining its WMCC.

Source Proportion Range Cost

Equity share capital 50% Up to Rs. 300,000 13.00%
Rs. 300,000 – Rs. 750,000 13.30%
Rs. 750,000 and above 15.50%
Preference shares 10% Up to Rs. 100,000 9.33%
Rs. 100,000 and above 10.60%
Long term debt 40% Up to Rs. 400,000 5.68%
Rs. 400,000 – Rs. 800,000 6.50%
Rs. 800,000 and above 7.10%

Required:
Determine the WMCC for the company. (8 Marks)
[June 2012]

Answer:
(i) Determination of Breaking point of different sources:

Source Proportion Range Breaking Points(Rs.)

Equity share capital 0.50 Up to Rs. 300,000 300,000/0.5= 600,000
300,000 – 750,000 750,000/0.5= 1,500,000
750,000 and above -
Preference shares 0.10 Up to Rs. 100,000 100,000/0.10 = 1,000,000
100,000 and above -

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Long term debt 0.40 Up to Rs. 400,000 400,000/0.4 = 1,000,000

400,000 – 800,000 800,000/0.40 = 2,000,000
800,000 and above -

We now calculate below the WMCC for different ranges of new financing.

Range Source Proportion C/C % WMCC %

Up to Rs.600,000 Equity shares 0.50 13.00 6.50
Preference shares 0.10 9.33 0.93
Long term debt 0.40 5.68 2.27
WMCC 9.70
Rs. 600,000 – 1,000,000 Equity shares 0.50 13.30 6.65
Preference shares 0.10 9.33 0.93
Long term debt 0.40 5.68 2.27
WMCC 9.85
Rs. 1,000,000 – 1,500,000 Equity shares 0.50 13.30 6.65
Preference shares 0.10 10.60 1.06
Long term debt 0.40 6.50 2.60
WMCC 10.31
Rs. 1,500,000 – 2,000,000 Equity shares 0.50 15.50 7.75
Preference shares 0.10 10.60 1.06
Long term debt 0.40 6.50 2.60
WMCC 11.41
Rs. 2,000,000 – and above Equity shares 0.50 15.50 7.75
Preference shares 0.10 10.60 1.06
Long term debt 0.40 7.10 2.84
WMCC 11.65

Question No: 33
KLS Limited has a total capitalization of Rs. 1,000,000 and it normally earns Rs. 100,000 before
interest and taxes. The finance manager of the company wants to take the decision regarding the
capital structure. After a study of the capital market, he gathers the following data:
Equity Capitalization Rate
Amount of Debt (Rs.) Interest rate (%) at given level of debt (%)
0 - 10.00
100,000 4.0 10.50
200,000 4.0 11.00
300,000 4.5 11.60
400,000 5.0 12.40
500,000 5.5 13.50
600,000 6.0 16.00
700,000 8.0 20.00

Assume that corporate taxes do not exist, and the firm always maintains its capital structure at
book values.
Required: (4+3=7 Marks)
i). What amount of debt should be employed by the firm if the traditional approach is held
valid?
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ii). If the Modigliani-Miller approach is followed, what should be the equity capitalization rate?
[December 2012]

Answer:
(i) As per the traditional approach, optimum capital structure exists when the weighted average
cost of capital is minimum. The weighted average cost of capital calculations at book value
weights are as follows:

ke (1) We (2) kd (3) Wd (4) keWe (5) kdWd (6) k0 (7)=(5)+(6)

0.100 1.0 - - 0.1000 - 0.1000
0.105 0.9 0.040 0.1 0.0945 0.0040 0.0985
0.110 0.8 0.040 0.2 0.0880 0.0080 0.0960
0.116 0.7 0.045 0.3 0.0812 0.0135 0.0947
0.124 0.6 0.050 0.4 0.0744 0.0200 0.0944
0.135 0.5 0.055 0.5 0.0675 0.0275 0.0950
0.160 0.4 0.060 0.6 0.0640 0.0360 0.1000
0.200 0.3 0,080 0.7 0.0600 0.0560 0.1160

The company should employ debt of Rs.4,00,000 as the weighted average cost of capital is
minimum at this level of debt.

(ii) According to M-M approach, the cost of capital is a constant, and the cost of equity increases
linearly with debt. The equilibrium cost of capital is assumed to be equal to pure equity
capitalization rate, which is 10% in the present problem. The equity capitalization rate is given
by the formula:
ke = k0+ (k0-kd) x Debt/ Equity

The equity capitalization rates would be:

Debt (Rs.) kd k0 (k0-kd) Debt/Equity ke ke Percentage
0 - 0.10 (0.10-0.000) - 0.1000 10.00
1,00,000 0.040 0.10 (0.10-0.040) 1,00,000/9,00,000 0.1067 10.67
2,00,000 0.040 0.10 (0.10-0.040) 2,00,000/8,00,000 0.1150 11.50
3,00,000 0.045 0.10 (0.10-0.045) 3,00,000/7,00,000 0.1236 12.36
4,00,000 0.050 0.10 (0.10-0.050) 4,00,000/6,00,000 0.1333 13.33
5,00,000 0.055 0.10 (0.10-0.055) 5,00,000/5,00,000 0.1450 14.50
6,00,000 0.060 0.10 (0.10-0.060) 6,00,000/4,00,000 0.1600 16.00
7,00,000 0.080 0.10 (0.10-0.080) 7,00,000/3,00,000 0.1467 14.67

Question No. 34
Kathmandu Medical Hospital is planning to introduce a new CT scan machine which costs Rs.
16 million. Expected annual revenue of the machine is projected to be Rs. 18 million. Variable
cost is 60% of sales and fixed costs are Rs. 2 million. The firm is planning to finance the fund
requirement by bank loan of Rs. 5 million @ 12%, by issue of debenture of Rs. 5 million @ 8%
and remaining by equity shares which will be issued at Rs. 10 (par) per share. The taxation rate
applicable to the firm is 25%.
Required: (5+3=8 Marks)
i) Calculate operating leverage, financial leverage and combined leverage.
ii) Briefly explain the inter-linkage between leverage, profit and risk.

[June 2013]
Answer:
i) Calculation of leverages

Int Rate Rs.

Cost of Project 16,000,000
Annual Sales 18,000,000
Variable Cost 10,800,000
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 CAP II Paper 4: Financial Management

Contribution 7,200,000
Fixed Cost 2,000,000

Earnings before interest and taxes 5,200,000

interest 5,000,000 12% 600,000
5,000,000 8% 400,000
Earning before tax 4,200,000
Tax 25% 1,050,000
Earning after tax 3,150,000
Operating Leverage (Cont/EBIT) 1.38
Financial Leverage (EBIT/EBT) 1.24
Combined Leverage (DFL X DOL) 1.71

ii) Inter linkage between leverage, return and risk

Leverage is a position when capital is funded largely by external sources like debt, bank loan.
The higher the livered firm, higher the profit. This is because, if the firm is funded by debt
sources, it is a cheaper source of finance as debt interest are tax deductible. But is the firm is
unlevered, i.e. funded by equity, profit will be lower as dividend to shareholders is not tax
deductible from income tax purpose. However, if the firm is too levered, there is a risk of
solvency because debt funds are repayable. The firm will be in risk of fund at the times when
debts are matured. Hence, an optimal mix of debt and equity is required to maintain adequate
profitability with solvency.

Question No. 35
A company requires Rs. 1,500,000 for the installation of a new unit, which would yield an
annual EBIT of Rs. 250,000. The company‘s objective is to maximize EPS. It is considering the
possibility of raising a debt of either Rs. 300,000 or Rs. 600,000 or Rs. 900,000 plus issuing
equity shares. The current market price per share is Rs. 50 which is expected to drop to Rs. 40
per share, if the market borrowings were to exceed Rs. 700,000. The cost of borrowings are
indicated as follows:
Level of borrowings Cost of borrowings
Up to Rs. 200,000 12% p.a
More than Rs. 200,000 to Rs. 600,000 15% p.a
More than Rs. 600,000 to Rs. 900,000 17% p.a

Required: (5+3=8 Marks)

i) Assuming a tax rate of 50%, work out the EPS and the scheme, which you would
recommend to the company.
ii) Calculate return on capital employed under each scheme and explain the leverage effect.
[December 2013]

Answer:
i) Statement showing EPS under the different schemes

Particulars Scheme I Scheme II Scheme III

Capital required (Rs.) 1,500,000 1,500,000 1,500,000
Less: Debt Content(Rs.) 300,000 600,000 900,000
Balance Equity Capital required (Rs.) 1,200,000 900,000 600,000
Market Price per Share(Rs.) 50 50 40

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Number of Equity Shares to be issued 24,000 18,000 15,000

= shares shares shares
EBIT(given) (Rs.) 250,000 250,000 250,000
Less: Interest on Debt (Rs.)
First Rs. 2,00,000 at 12% 24,000 24,000 24,000
Next up to Rs. 4,00,000 at 15% 15,000 60,000 60,000
Balance at 17% - - 51,000
Total interest cost (Rs.) 39,000 84,000 135,000
Earnings Before Tax (EBT) (Rs.) 211,000 166,000 115,000
Less: Tax at 50% (Rs.) 105,000 83,000 57,500
Earnings After Tax (EAT) (Rs.) 105,000 83,000 57,500
EPS (Rs.) 4.375 4.61 3.83

Recommendation:
EPS is maximum under Schemes II and is hence preferable, i.e., raising a debt of Rs. 600,000
and remaining from issue of equity shares.

ii) Since EBIT and capital employed are same in every scheme; i.e. ROCE = 250,000/1,500,000
= 16.67%.

Use of Debt Funds and Financial Leverage will have a favorable effect only if ROCE > Interest
Rate. ROCE is 16.67% and hence up to 15% Interest Rate, i.e. Scheme II, use of debt will have
favorable impact on EPS and ROE. However, when interest rate is higher at 17% (i.e. in Scheme
III, for Debt above Rs. 6 lakhs), Financial Leverage have negative impact and hence EPS falls
from Rs. 4.61 to Rs. 3.83.

Questions No. 36
Himal Steels Ltd. requires Rs. 500,000 for construction of a new plant. It is considering
following three alternative financial plans:
i) The company may issue 50,000 ordinary shares at Rs. 10 per share;
ii) The company may issue 25,000 ordinary shares at Rs. 10 per share and 2,500 debentures of
Rs. 100 denominations bearing a 8% rate of interest; and
iii) The company may issue 25,000 ordinary shares at Rs. 10 per share and 2,500 preference
shares at Rs. 100 per share bearing a 8 % rate of dividend.
The different possible level of earnings before interest and taxes (EBIT) of Himal
Steels Ltd. are Rs. 10,000; Rs. 20,000; Rs. 40,000; Rs. 60,000 and Rs. 100,000.
The applicable tax rate is 50%.
Required: (6+2=8 Marks)
i. Compute the earnings per share under each of the three financial plans
and different levels of EBIT.
ii. Which alternative would you recommend for the company and why?
[December 2013]

Answer:

i) Earnings per share under three financial plans for Himal Steel Limited

First Financial Plan- Issue of equity shares only

Particulars Rs. Rs. Rs. Rs. Rs.
EBIT 10,000 20,000 40,000 60,000 100,000

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Interest 0 0 0 0 0
PBT 10,000 20,000 40,000 60,000 100,000
Taxes @50% 5,000 10,000 20,000 30,000 50,000
PAT 5,000 10,000 20,000 30,000 50,000
No of shares 50,000 50,000 50,000 50,000 50,000
EPS 0.10 0.20 0.40 0.60 1.00

Second Financial Plan- Issue of Equity Shares and Debentures

Particulars Rs. Rs. Rs. Rs. Rs.
EBIT 10,000 20,000 40,000 60,000 100,000
Interest 20,000 20,000 20,000 20,000 20,000
PBT (10,000) 0 20,000 40,000 80,000
Taxes @50% (5,000) 0 10,000 20,000 40,000
PAT (5,000) 0 10,000 20,000 40,000
No of shares 25,000 25,000 25,000 25,000 25,000
EPS (0.20) 0.00 0.40 0.80 1.60
It is assumed that the company will be able to set off losses against their profit. If the
company has no profits from other operations, losses will be carried forward.

Third financial plan- Issue of Equity shares and Preference shares

Particulars Rs. Rs. Rs. Rs. Rs.
EBIT 10,000 20,000 40,000 60,000 100,000
Interest 0 0 0 0 0
PBT 10,000 20,000 40,000 60,000 100,000
Taxes @50% 5,000 10,000 20,000 30,000 50,000
PAT 5,000 10,000 20,000 30,000 50,000
Preference 20,000 20,000 20,000 20,000 20,000
dividend
PAT for ordinary 0 0 0 10,000 30,000
shareholders
No of shares 25,000 25,000 25,000 25,000 25,000
EPS 0 0 0 0.40 1.20

ii) The choice of financial plan will depend upon the economic condition. If Himal Steel
Limited‘s sales are increasing, the earnings per share will be maximum under second
financial plan under favourable conditions, debt financing gives more benefit than equity
or preference capital because interest on debt is tax deductible while preference dividend is
not.

Question No. 37
A limited, a widely held company is considering a major expansion of its production facilities
and the following alternatives are available:
(Rs in Lakhs)
Alternatives
Share capital 50 20 10
14% Debentures - 20 15
Loan from Financial - 10 25
institution @ 18% p.a.

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Expected rate of return before tax@25%. Income Tax Rate 50%. The rate of dividend of the
company is not less than 20%. The company at present has low debt.
Which of the alternatives you would choose? (4 Marks)
[June 2014]

Answer:
Evaluation of Financial Alternatives
Particulars A B C
Return on Rs. 50 Lakhs@25% 12.5 12.5 12.5
Less: interest on debentures - 2.80 2.10
Less: Interest on loan - 1.8 4.5
Taxable Profit 12.5 7.9 5.9
Less: Income Tax 50% 6.25 3.95 2.95
Profit after tax available for shareholders 6.25 3.95 2.95
Rate of return on share capital 12.5% 19.75% 29.5%

From shareholders point of view alternative C is to be chosen as it gives the highest rate of
return on share capital.

Question No. 38
Calculate Operating, Financial and Combined Leverage from the following data under situations
I and II of Financial Plans A and [Link] Capacity is for 4,000 units, whereas actual
production and sales are 75% of the capacity [Link] Price Rs.30 per unit and variable cost
ratio- 50%Fixed Cost under Situation I is Rs. 15,000 and under Situation II is Rs.20, 000.
(8 Marks)

Particulars Financial Plan A Financial Plan B

Equity Rs. 10,000 Rs. 15,000
Debt at 20% interest Rs. 10,000 Rs. 5,000
Total Rs. 20,000 Rs. 20,000
[June 2014]
Answer:
I. Computation of Earning before Interest & Tax(EBIT) and Earning before Tax( EBT)
Particulars Financial Plan A Financial Plan B
Situation I Situation II Situation I Situation II
Sales Revenue Rs.90,000 Rs.90,000 Rs.90,000 Rs.90,000
(3,000units × s.30) (3,000units×Rs.30) (3,000units × Rs.30) (3,000units×Rs.30)
Less: Rs. Rs.45,000 Rs.45,000 Rs.45,000 Rs.45,000
Variable cost (Rs.90,000×50 (Rs.90,000×5 (Rs.90,000× (Rs.90,0
0%) 50%) 00×50%)
%)

Contribution Rs.45,000 Rs.45,000 Rs.45,000 Rs.45,000

Less: Fixed Rs.15,000 Rs.20,000 Rs.15,000 Rs.20,000
Cost
EBIT Rs.30,000 Rs.25,000 Rs.30,000 Rs.25,000
Less: Rs.2,000 Rs.2,000 Rs.1,000 Rs.1,000
Interest on (10,000*20%) (10,000*20%) (5,000*20%) (5,000*20%)

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Debt
EBT Rs.28,000 Rs.23,000 Rs.29,000 Rs.24,000

Note- Actual production and sales=4,000units× 75%=3,000 units

II. Computation of Operating, Financial and Combined Leverage
Particulars Financial Plan A Financial Plan B
Situation I Situation II Situation I Situation II
Earning before
Rs.28,000 Rs.23,000 Rs.29,000 Rs.24,000
Tax
OL=
Contribution/EBIT

FL=
EBIT/EBT

DCL=DOL ×DFL 1.50×1.07=1.61 1.80×1.09=1.96 1.50×1.03=1.55 1.80×1.04=1.87

Question No. 39
JK Ltd. has appointed you as its Finance Manager. The company wants to implement a project
for which Rs. 60 lakh is required to be raised from the market as a means of financing the
project. The following financing plans and their options are at hand:
(Rs. in lakh)
Particular Plan X Plan Y Plan Z
Option 1: Equity Shares 60 60 60
Option 2: Equity Shares 30 40 20
13% Preference Shares Nil 20 20
10% Non Convertible Debentures 30 Nil 20
Assume corporate tax rate to be 25 per cent, and the face value of all the shares and debentures to
be Rs. 100 each.
Required: (7+1=8 Marks)
i) Calculate the indifference points and earnings per share (EPS) for each of the financing
plan.
ii) Which plan should be accepted by the company? Why?
[December 2014]

Answer:
Determination of indifference point under plans X, Y, Z
Let X be the EBIT in all cases.
Plan X : X(1-t)/N1 = (X-Interest)(1-t)/N2
Or,X (1-0.25)/60,000 = (X-300,000)(1-0.25)/30,000
Or, X-0.25X=2(0.75X-225,000)
Or, X-0.25X=1.5X-450,000
Or, 0.75X=Rs. 450,000
Or, X = Rs. 600,000

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Plan Y : X(1-t)/N1 = [(X-Interest)(1-t)-Dp]/N2

Or, X (1-0.25)/60,000 = [X(1-0.25)-260,000]/40,000
Or, 0.75X/60,000=(0.75X-260,000)/40,000
Or, 2(0.75X)=3(0.75X-260,000)
Or, 1.50X=2.25X-780,000
Or, X = 780,000/0.75
Or, X = Rs. 1,040,000
Plan Z : X(1-t)/N1 = [(X-Interest)(1-t)-Dp]/N2
Or, X (1-0.25)/60,000 = [(X-200,000)×(1-0.25)-260,000]/20,000
Or, 0.75X/60,000=(0.75X-410,000)/20,000
Or, 0.75X=3(0.75X-410,000)
Or, 0.75X=2.25X-1,230,000
Or, X = Rs. 820,000
Determination of EPS under Plans X , Y and Z for options 1 and 2

Plan X Plan Y Plan Z

Particulars
1 2 1 2 1 2

EBIT 600,000 600,000 1,040,000 1,040,000 820,000 820,000

Less : Interest - 300,000 - - - 200,000

EBT 600,000 300,000 1,040,000 1,040,000 820,000 620,000

Less : Taxes @ 25% 150,000 75,000 260,000 260,000 205,000 155,000

EAT 450,000 225,000 780,000 780,000 615,000 465,000

Less: Preference
Dividend - - - 260,000 - 260,000
Earnings available to
Equity holders 450,000 225,000 780,000 520,000 615,000 205,000

No. of Equity Shares 60,000 30,000 60,000 40,000 60,000 20,000

EPS 7.50 7.50 13 13 10.25 10.25

ii) The company should adopt Plan Y since the EPS is maximum under this plan.

Question No. 40
Consider from the following information:
Equity share capital (Rs.100 each) Rs. 5,000,000
Reserves and surplus Rs.500,000
15% secured loans Rs. 2,500,000
12.5% unsecured loans Rs. 1,000,000
Fixed assets Rs. 3,000,000
Investments Rs.500,000
Operating profit Rs. 2,500,000
Tax rate 25%
PE ratio 12.5
Required: (5 Marks)
Calculate the value of each equity share.
[December 2014]

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Answer:

We have,
Value= EPS × PE Ratio
EPS calculation Rs.
Operating profit i.e. EBIT 2,500,000
Less: Interest on 15% secured loans 375,000
Interest on 12.5% unsecured loans 125,000
Profit before tax 2,000,000
Tax @ 25% 500,000
PAT 1,500,000
Number of equity shares = (Rs 5,000,000/100) = 50,000
Therefore EPS = (Rs 1,500,000/50,000) = Rs. 30
P/E Ratio is given as 12.5
Therefore,
Value of equity share =EPS×PE Ratio= 30×12.5 =Rs.375

Question No. 41
The following information pertains to Rajaram Ltd. for the year ending Ashadh end, 2071:
([Link] million)
EBIT 30.00
Less: Interest on Debt (at 12%) 6.00
PBT 24.00
Less: Tax @ 25% 6.00
PAT 18.00
Undistributed reserves 60.00
No. of outstanding shares of Rs. 10 each 40 Lakh
EPS Rs. 3.00
Market price of the share Rs. 30.00
P/E Ratio 10.00
The company requires Rs. 20. million for expansion which is expected to earn the same rate as
earned by the present capital employed.
If the debt to capital employed ratio is higher than 35%, the P/E ratio is expected to decline to 8
and the cost of additional debt will rise to 14%.
Required: (8+1=9 Marks)
i) Calculate the probable share price of Rajaram Ltd.: a) if the required amount is raised
through debt, and b) if the required amount is raised through equity and the new share is
issued at Rs. 25 per share.
ii) What option would you recommend to raise the required amount of funds to the company?

[July 2015]

Answer:
Existing capital employed
(Rs. Millions)
Equity capital (40 Lakhs shares ×Rs. 10) 40.00
Reserves and surplus 60.00
Debt (6×100/12) 50.00
Existing capital employed 150.00

Existing of Return on Capital Employed

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EBIT 30
ROCE= ×100 = ×100 = 20%
Capital Employed 150
Revised Capital Employed, whether debt or equity capital is raised
= 150+20 = Rs. 170 million
Revised EBIT, if expansion project is undertaken
= 170 × 20 / 100 = Rs. 34 million
Existing ratio of debt to capital employed
50
= ×100 = 33.33%
150

Revised ratio of debt to total capital employed if additional debt is raised

50+20 70
= ×100 = ×100 = 41.18%
150+20 170
Revised ratio of debt to total capital employed if equity share capital is raised
50 50
= ×100 = ×100 = 29.41%
150+20 170

If the debt to capital employed ratio is higher than 35%, the P/E ratio expected to decline to 8
and raise the cost of additional capital debt to 14%.
i) Evaluation of Finance Option and calculation of share price (Rs.
Millions)
Particulars Option (a) Debt Option (b)
Equity
EBIT 34.00 34.00
Less: Interest on debt:
On original debt 6.00 6.00
On new debt 2.80 0.00
EBT 25.20 28.00
Less: Tax @ 25% 6.30 7.00
EAT 18.90 21.00
No. of shares (Note 1) 40 Lakhs 48
Lakhs
EPS 4.725 4.375
P/E Ratio 8 10
Market price per share Rs. 37.8 Rs. 43.75
Note 1:
No. of new shares to be issued
= Rs. 20 million / Rs. 25 = 800,000 shares
ii) Recommendations:
Since the market price of share is higher under option (b), it is suggested to raise additional Rs.
20 million by fresh issue of 800,000 equity shares at Rs. 25 share.

Question 42
The annual sales of a company is Rs. 6,000,000. Sales to variable cost ratio is 150 percent and
fixed cost other than interest is Rs. 500,000 per annum. The company has 11% Debentures of
Rs. 3,000,000.
Required: (4 Marks)
Calculate the operating, financial and combined leverage of the company. [July 2015]

Answer:
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 CAP II Paper 4: Financial Management

Working Note: Calculation of EBIT and EBT

Rs.
Sales 6,000,000
Variable costs (sales/150 x 100) 4,000,000
Contribution 2,000,000
Fixed cost 500,000
EBIT 1,500,000
Interest on Debenture (11% x 3,000,000) 330,000
EBT 1,170,000
Operating Leverage = Contribution/ EBIT
= 2,000,000/1,500,000
= 1.333 times
Financial Leverage = EBIT/EBT
= 1,500,000/1,170,000
=1.282 times
Combined Leverage = operating leverage x financial leverage
= 1.333 x 1.282 = 1.7089 times
Or
= Contribution/EBT
= 2,000,000/1,170,000
= 1.7094 times ~1.7089 times

Question No. 43
S Bank Ltd. is assessing the operational efficiency of its central cash department. In this regard,
one of the officials have come up with the suggestion to procure sophisticated cash counting
machine cum fake note detector in order to make cash handling more effective and efficient. The
quotation for the machine received from the authorized distributor reveals cost of Rs. 35 lakhs
with 3 years' warranty and 5 years' after sales service. The useful life of the machine is 5 years
and it may be scrapped at 5% of the original cost at the end.
At the moment, the central cash department employs 4 outsourced personnel to count, sort and
stack currency notes of Rs. 1,000 and Rs. 500 denominations manually. These employees
frequently work overtime, and average monthly overtime cost for the last three months is Rs.
25,000. The average remuneration cost per employee engaged in the job is Rs. 22,500 per month
and is entitled to one month's Dashain Bonus. If the machine is acquired, 2 employees will be
shifted to other vacant department. The overtime costs will be entirely avoided. The
remuneration is expected to increase by 5% annually after the end of year 1 and thus there will
be proportionate increment for all employee benefits.
The Bank has determined 8% as discount rate for similar investments. Tax rate for bank is 30%.
Required: (5 Marks)

Lay out the relevant cash flows of the investment decision.

[July 2015]

Answer:
Relevant cash flows:

Years 0 1 2 3 4 5

Initial Investment (3,500,000.00)

Incremental Saving
- Remuneration of 540,000.00 567,000.00 595,350.00 625,117.50 656,373.38
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 CAP II Paper 4: Financial Management

2 employee
- Dashain Bonus
of 2 employee 45,000.00 47,250.00 49,612.50 52,093.13 54,697.78
- Overtime 300,000.00 315,000.00 330,750.00 347,287.50 364,651.88
Depreciation (665,000.00) (665,000.00) (665,000.00) (665,000.00) (665,000.00)
Annual Savings 220,000.00 264,250.00 310,712.50 359,498.13 410,723.03
Tax Cost @ 30% 66,000.00 79,275.00 93,213.75 107,849.44 123,216.91
Net Annual Savings 154,000.00 184,975.00 217,498.75 251,648.69 287,506.12
Add: Terminal
Value (5% of
Original Cost) (tax
is not attracted as
BV=SV) 175,000.00
Add: Non Cash
Expenses 665,000.00 665,000.00 665,000.00 665,000.00 665,000.00
Net Cash Flow (3,500,000.00) 819,000.00 849,975.00 882,498.75 916,648.69 1,127,506.12

Question No. 44
Creative Security Pvt. Ltd., a trading company of fire extinguishers and security products, is
seeking working capital finance (loan collateral and inventory hypothecation) from one of the
"A" Class Licensed Financial Institutions. With bank funding, the directors of the company
would be able to withdraw temporary funds injected by them, which has remained for the last 12
months with stipulation of 18% interest. Nonetheless, the company desires to obtain finance
maintaining Debt- Equity Ratio after finance as 2:1 and Loan - Collateral ratio as 160% of
carrying amount of Property Plant and Equipment (PPE). The extracts of financial statements as
on Kartik 30, 2072 were as under:

Statement of Financial Position as on Kartik 30, 2072

Assets Rs. Million (M)
Non-Current Assets
PPE (Opening Carrying Amount Rs. 14.9 M) 14.30
Current Assets:
Inventories 25.27
Trade and Other Receivables 9.04
Advances, Deposits and Prepayments 4.10
Cash and Cash Equivalents 1.07
Total Assets 53.78
Equity and Liability
Equity Attributable to Owners:
Share Capital (Rs. 100 per share) 6.00
Share Premium 2.00
Retained Earnings 13.49
Total Equity 21.49
Non-Current Liabilities:
Long-Term Borrowings 12.31
Current Liabilities:
Trade and Other Payables 4.23
Borrowings from Directors 14.50
Other Liabilities 1.25

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Total Liabilities 32.29

Total Equity and Liabilities 53.78
Statement of Comprehensive Income for the period (Shrawan to Kartik, 2072)
Particulars Rs. Million (M)
Revenue 68.52
Cost of Sales (49.30)
Gross Profit 19.22
Operating Expenses (6.10)
Finance Costs (1.26)
Profit before Tax 11.86
Income Tax Expense (Provisioned and 100% deposited) (2.97)
Profit for the Period 8.89
Assume interest rate as 9.5% per annum payable on a quarterly basis, variable portion of cost of
sales as 80% and operating expenses as 20%, depreciation as 12% on WDV basis and tax rate as
25%.
Required: (4+3+5=12 Marks)
i) Calculate the degree of operating leverage, debt - equity ratio and maximum loans that can
be sought by the company.
ii) What does the degree of operating leverage signify to the company? Present calculations for
your justification, if any.
iii) In case the company's trade moves proportionately throughout the year and the company
repays, at the end of the year, 10% of existing long term loan outstanding with interest
accrued on all loans, what is the expected Debt Service Coverage Ratio?

[December 2015]

Answer:
i. Refer WN 1,2 & 3
Contribution
Degree of Operating Leverage = Margin
EBIT
Rs. 27.86
= M = 2.12 times
Rs. 13.12
M
Debt
Debt Equity Ratio =
Equity

Rs. 12.31
= M = 0.57 times
Rs. 21.49
M
Maximum Loans that can be sought by the company
Per Debt Equity Ratio Rs. In Millions
Present Equity 21.49
Maximum Debt limit (2 times of Equity) 42.98
Existing Debt 12.31
Maximum Debt 30.67

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Per Loan Collateral Ratio

Present Carry Amount of PPE 14.30
Maximum Debt limit (160% of Present Carrying Amount of
PPE) 22.88
Existing Debt 12.31
Maximum Debt 10.57

Since, the lowest loan available per two criteria is Rs.10.57M, which is also
lower than the current outstanding of director's loan, the maximum debt that
can be sought by the Company is Rs.10.57M itself.
Working Notes:
1. Total Variable Costs and Fixed Cost

Components Variable (Rs. Calculation Fixed Calculation

In Millions) (Rs. In
Millions)
80% of Rs.49.30 M 20% of Rs.49.30
Cost of Sales (39.44) (9.86) M
Operating Expenses (1.22) 20% of Rs.6.10 M (4.88) 80% of Rs.6.10 M
Total Variable Costs (40.66) (14.74)

2. Contribution Margin
Rs. In
Particulars Millions
Sales Revenue 68.52
Variable Cost (40.66)
Contribution Margin 27.86

3. EBIT calculation (Rs. in Millions)

Sales =68.52
VC =(40.66)
CM =27.86
FC =(14.74)
EBIT =13.12
ii) The degree of operating leverage of the Company signifies that for 100% rise
in Contribution Margin, there shall be a rise of 212% in the EBIT.
(Rs. in Millions)
Particulars 4 Months 100% Growth
Sales Revenue 68.52 137.04
Variable Cost (40.66) (81.32)
Contribution Margin 27.86 55.72
Fixed Cost (14.74) (14.74)
Earnings Before Interest and Tax 13.12 40.98
Rs.40.98
Growth in EBIT = M -1
Rs.13.12
M
= 212%
iii) Calculation of expected Debt Service Coverage Ratio (Refer WN 4 &5)

Particulars Rs. Million (M)

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Loans Repaid 1.23

Interest Paid 3.18
Total Repayment of Interest and Principal 4.41

Particulars Rs. Million (M)

Profit Before Tax (Working Note 5) 36.18
Add: Depreciation (Rs. 14.9 × 12%) 1.79
Add: Finance Costs (Working Note 4) 3.18
Less: Income Tax Expenses (9.05)
Cash Profit before Interest 32.10

Cash Profit before interest

Debt Service Coverage Ratio (DSCR) =
Total Repayment of Interest and principal

Rs. 32.10 M
=
Rs. 4.41 M
= 7.28 times
Working Notes:

4 Annualized Finance Costs

Particulars Loan Outstanding Interest Finance Cost
(Rs. In Millions) Rate (Rs. In Millions)
- Existing Long Term Loan 12.31 9.5% 1.17
- New Borrowings 10.57 9.5% 0.67
- Director's Loan before New 18%
14.5 0.87
Borrowings
- Reminder of Director's Loan 3.93 18% 0.47
Total 3.18

5 Annualized Statement of Comprehensive Income

Particulars Rs. Million (M)
Revenue 205.56
Cost of Sales (147.90)
Gross Profit 57.66
Operating Expenses (18.30)
Finance Costs (Working Note 1) (3.18)
Profit before Tax 36.18
Income Tax Expense (Provisioned and 100% (9.05)
deposition)
Profit for the Period 27.13

Question No. 45
A company requires Rs. 25,00,000 for a new plant. This plant is expected to yield earnings
before interest and taxes of Rs. 5,00,000. While deciding about the financial plan, the company
considers the objective of maximizing earning per share. It has three alternatives to finance the
project as below:

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i) Raise debt of Rs. 2,50,000 and balance by issuing equity shares,

ii) Raise debt of Rs. 10,00,000 and balance by issuing equity shares
iii) Raise debt of Rs. 15,00,000 and balance by issuing equity shares
The company‘s share is currently selling at Rs. 150, but is expected to decline to Rs. 125 in case
the funds are borrowed in excess of Rs. 10,00,000. Assume that company can raise cash from
issue of equity at these market prices.
The funds can be borrowed at the rate of 10% up to Rs. 2,50,000, at 15% over Rs. 2,50,000 and
up to Rs. 10,00,000 and at 20% over Rs. 10,00,000. The tax arte applicable to the company is
50%.
Required: (7 Marks)
Which form of financing should the company choose?
[June 2016]

Answer:
Calculation of Earning Per Share for three alternatives to finance the project

Alternatives
I II III
Raise debt of Raise debt of Raise debt of
Particulars
Rs.2,50,000 and Rs.10,00,000 and Rs.15,00,000 and
equity of equity of equity of
Rs.22,50,000 Rs.15,00,000 Rs.10,00,000
EBIT Expected 5,00,000 5,00,000 5,00,000
Less: Interest on 25,000 1,37,500 2,37,500
Debt at rates given
in question
Earnings Before Tax 4,75,000 3,62,500 2,62,500
Less: tax at 50% 2,37,500 1,81,250 1,31,250
Earnings After Tax 2,37,500 1,81,250 1,31,250
Number of shares in 15,000 10,000 8,000
each alternative
(Equity/Market Price
per share)
Earning Per Share 15.833 18.125 16.406
The company should raise Rs.10,00,000 from debt and Rs.15,00,000 by issuing equity shares as
this alternative gives highest EPS.

Question No. 46
Calculate the value of equity share from the followings: (5 Marks)
Particulars Amount in Rs.
Equity Share Capital (Rs. 20 each) 50,00,000
Reserve and Surplus 5,00,000
15% Secured Loans 25,00,000
12.5% Unsecured Loans 10,00,000
Fixed Assets 30,00,000
Investments 5,00,000
Operating Profit 25,00,000
Tax Rate 50%
P/E Ratio 12.5
[June 2016]
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Answer:
In the given situation, the value of the share can be ascertained on the basis of earnings of
the firm and the price-earnings multiple as follows:
Value = EPS* P/E Ratio
The P/E Ratio is given and the EPS may be ascertained as follows:
Amount in Rs.
Operating Profit i.e. EBIT 2,500,000
Less: Interest on 15% secured loans 375,000
Interest on 12.5% Unsecured loans 125,000
Profit before Tax(PBT) 2,000,000
Tax@50% 1,000,000
Profit after Tax 1,000,000
Number of Equity Shares(Rs. 5000000/20) 250,000

Therefore, EPS(Rs.1000000/250000) 4.00

P/E Ratio(given) 12.5
Therefore,
Value of equity shares= EPS*P/E Ratio
=4*12.5= Rs. 50

Question No. 47
Company P and Q are identical in all respects including risk factors expect for debt/equity.
Company P has issued 10% debentures of Rs. 18 lakhs while company Q is unlevered. Both the
companies earn 20% before interest and taxes on their total assets of Rs. 30 lakhs.
Assume a tax rate of 50% and capitalization rate of 15% for all-equity company.
Required: (4+4=8 Marks)
Compute the value of P and Q using:
i) Net income approach, and
ii) Net operating income approach.
[December 2016]

Answer:
(i) Valuation Under Net Income Approach
Particulars P Q
(Amount in Rs.) (Amount in Rs.)
EBIT (20% of Rs.3,000,000) 600,000 600,000
Less: Interest (10% of Rs. 1,800,000) (180,000) -
EBT 420,000 600,000
Less: Tax @ 50% (210,000) 300,000
EAT (available to equity holders) 210,000 300,000
Value of Equity (Capitalised @ 15%) 1,400,000 2,000,000
(EAT/Capitalisation rate)
Add: value of Debt 1,800,000 -
Total value of the Company 3,200,000 2,000,000
(ii) Valuation under Net Operating Income Approach (Here, EBIT=NOI)
Particulars P Q
(Amount in Rs.) (Amount in Rs.)
Capitalisation of Earning @15% 2,000,000 2,000,000
[Rs.6,00,000 x (1-0.5)/0.15]
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Less: Value of Debt (900,000) -

((Rs.18,00,000 x (1-0.5))
Value of Equity 1,100,000 2,000,000
Add: Total Value of Debt 1,800,000 -
Total value of the Company 2,900,000 2,000,000

Question No. 48
The following information related to XL Ltd. for the year ended 31st March, 2015 are available
to you:
Particulars Amount (Rs.)
Equity Share Capital (Rs. 100 each) 2,500,000
11% Bonds (Rs.1,000 each) 1,850,000
Sales 4,200,000
Fixed cost (excluding interest) 348,000
Other Information:
Financial Leverage 1.39
Profit-Volume Ratio 25.55 %
Income Tax Rate 35%
Required: Calculate (7 Marks)
(i) Operating Leverage, (ii) Combined Leverage, and (iii) Earning per share.
[December 2016]

Answer:

Calculation of Contribution Margin

Profit – Volume Ratio = Contribution / Sales
0.2555 = Contribution / 4,200,000
Contribution = Rs. 1,073,100
(i) Operating Leverage = Contribution / (Contribution-Fixed Cost)
= 1,073,100 / (1,073,100 – 348,000)
= 1.48
(ii) Combined Leverage = Operating Leverage × Financial Leverage
= 1.48 × 1.39 = 2.06
(iii) Earnings Per Share
Number of Equity Shares = Rs. 2,500,000/100 = 25,000
Earnings Before Tax (EBT) = Contribution – Fixed Cost – Interest
= 1,073,100 – 348,000 – 203,500
= Rs. 521,600
Profit after Tax = EBT – Tax = 521,600 – 182,560 = Rs. 339,040
EPS = Rs. 339,040/25,000 = Rs.13.56

Question No. 49
Consider the following information of a manufacturing company:
Installed capacity 4,000 units
Actual production and sales 75% of the capacity
Selling price Rs. 30 per unit
Variable cost Rs. 15 per unit
Fixed cost:
Under situation I: Rs. 15,000
Under situation II: Rs. 20,000
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Capital structure:
Particulars Financial Plan
A (Rs.) B (Rs.)
Equity 10,000 15,000
20% Debt 10,000 5,000
20,000 20,000
Required: (8 Marks)
Calculate the operating leverage, financial leverage and combined leverage under situation I and
II and financial plan A and B. [June 2017]

Answer:
Operating Leverage:
Particulars Situation-I (Rs.) Situation-II (Rs.)
Sales (3,000 units@Rs.30 per unit) 90,000 90,000
Less: Variable Costs @ Rs.15 per unit (45,000) (45,000)
Contribution 45,000 45,000
Less: Fixed Cost 15,000 20,000
EBIT 30,000 25,000
Operating Leverage (Contribution/EBIT) 45,000/30,000 45,000/25,000
=1.5 =1.8
Financial Leverage:
Situation I
Plan A (Rs.) Plan B (Rs.)
EBIT 30,000 30,000
Less: Interest on Debt (2,000) (1,000)
EBT 28,000 29,000
Financial Leverage (EBIT/EBT) 30,000/28,000 30,000/29,000
= 1.07 = 1.03
Situation II
EBIT 25,000 25,000
Less: Interest on Debt (2,000) (1,000)
EBT 23,000 24,000
Financial Leverage (EBIT/EBT) 25,000/23,000 25,000/24,000
= 1.09 = 1.04
Combined Leverage:
Plan A (Rs.) Plan B (Rs.)
Situation I 1.5 x 1.07 = 1.61 1.5 x 1.03 = 1.55
Situation II 1.8 x 1.09 = 1.96 1.8 x 1.04 = 1.87

Question No. 50
TL Ltd. provides you with following figures:
Particulars Rs.
Profit before interest and tax 260,000
Less: Interest on debentures @ 12% 60,000
Profit before tax 200,000
Less: Income tax @ 50% 100,000
Profit after tax 100,000
Number of equity shares (of Rs. 10 each) 40,000
EPS (Earning per share) (Rs.) 2.50
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Market price per share (Rs.) 25

PE Ratio 10
The company has undistributed reserves of Rs. 600,000. The company needs Rs. 200,000
for expansion. This amount will earn at the same rate as funds already employed. A debt
equity ratio Debt/ (Debt+ Equity) of more than 35% will push the P/E Ratio of the
company down to 8 and raise the interest rate on additional amount borrowed to 14%.
Required: (5 Marks)
i) What will be the price of the share, if the additional fund are raised as debt?
ii) What will be the price of the share, if the amount is raised by
issuing equity shares?
[June 2017]

Answer:
Computation of existing capital and return on capital employed: -
Rs.
Equity share Capital 40,000 x 10 4,00,000
12% debentures 60 000 /12% 5,00,000
Undistributed Reserves 6,00,000
Existing Capital 15,00,000

Return on Capital employed 2,60,000/ 15,00,000 x 100%

= 17.33%
Calculation of Debt Equity Ratio
( Amount in Rs.)
Plan I (Debt Plan) Plan II (Equity Plan)
Existing Equity (Capital + 10,00,000 10,00,000
Reserve)
Additional equity - 2,00,000
Total equity (A) 10,00,000 12,00,000
Existing Debt 5,00,000 5,00,000
Additional Debt 2,00,000 -
Total Debt (B) 7,00,000 5,00,000
DE Ratio = Debt/( Debt + equity) 7 00 000/1,7000,000 500,000/(1,700,000 x
x 100 100
= 41.18% = 29.41%
Applicable P/E Ratio 8 10
Computation of probable market price of share after expansion:-
(i) ( ii ) (Rs.)
Plan I (Debt) Plan II
(Equity)
EBIT (17,00,000 x 17.33%) 2,94,610 2,94,610
2. Interest (Existing + Additional) 88,000 60,000
3. PBT (1-2) 2,06,610 2,34,610
4. Tax @ 50% 1,03,305 1,17,305

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5. PAT (3-4) 1,03,305 1,17,305

6. Preference Dividend - -
7. Equity Earnings (5-6) 1,03,305 1,17,305
8. No. of equity shares (Existing + 40,000 48,000
Additional)
9. EPS 2.58 2.44
10. P/E Ratio 8 10
11. Market Price [= EPS × P/E Ratio] 20.64 24.40

Question No. 51
A company earns profit of Rs. 300,000 per annum after meeting its interest liability of Rs.
120,000 on 12% debentures. The numbers of equity shares of Rs. 10 each are 80,000 and
retained earnings amount to Rs. 1,200,000. The company proposes to take up an expansion
scheme for which a sum of Rs. 400,000 is required. It is anticipated that, after expansion, the
company will be able to achieve the same return on investment as at present. The funds required
for expansion can be raised either through debt at the rate of 12% or by issuing equity shares at
par. The tax rate is 25%.

Required: (7+1=8 Marks)

i) Compute the earnings per share, if:
 The additional funds were raised as debt.
 The additional funds were raised by issue of equity shares.
ii) Advise the company as to which source of finance is preferable.
(June 2018)

Answer:
i)
Capital Employed Before expansion plan Rs.
Equity Shares 800,000
Debentures (Rs. 1,20,000/12)ˣ100 1,000,000
Retained Earnings 1,200,000
Total Capital Employed 3,000,000
Earnings Before the payment of Interest and Tax (EBIT)
Rs.
Profit 300,000
Interest 120,000
EBIT 420,000

Return on Investment (ROI)

ROI = (EBIT×100)/Capital Employed
= Rs. 420,000ˣ100/Rs. 3,000,000
=14%
Earnings before Interest and Tax (EBIT) After Expansion
Capital Employed after expansion = Rs. 3,400,000 (3,000,000+400,000)
Desired EBIT = 3,400,000 ˣ 14/100 = Rs. 476,000
Statement showing EPS under Present and Anticipated Expansion Scheme
Expansion Scheme
Particulars Present Situation AdditionalFunds raised as
Debt Equity

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EBIT (i) 420,000 476,000 476,000

Interest - Old Debt 120,000 120,000 120,000
Interest - New Debt 0 48,000 0
Total Interest (ii) 120,000 168,000 120,000
EBT (i)-(ii) 300,000 308,000 356,000
Less: Tax @ 25% 75,000 77,000 89,000
EAT 225,000 231,000 267,000
No. of Equity Shares 80,000 80,000 120,000
EPS 2.81 2.89 2.23
ii) If the company raises additional funds as debt the EPS would be greater. Hence, it
is suggested to raise additional funds in the form of debt.

Question No. 52
A company‘s capital structure consists of the following:

Rs. in million
Equity shares of Rs. 100 each 20
Retained earnings 10
9% Preference share 12
7% Debenture 8
50

The company is planning for an expansion. The expansion involves Rs. 25 million for which
following alternatives are available:
Issue of 200,000 equity shares at premium of Rs. 25 per share.
Issue of 10% pref. shares.
Issue of 8% debentures.

The company‘s EBIT is at the rate of 12% on its capital employed which is likely to remain
unchanged after expansion.

It is estimated that P/E ratio in the case of equity shares, preference shares and debentures
financing would be 21.4, 17 and 15.7 respectively.

Income tax rate is 50%.

Required: (5 Marks)

Which of those alternatives of financing would you recommend and why?

[December 2018]

Answer:
Statement showing evaluation of financial plan
(Rs. in million)
Particulars Under Proposed financial plans
Existing Plan I (Eq. Plan II (Pref. Plan III
Structure share) shares) (Debentures)
Earnings before 6.00 9.00 9.00 9.00
interest & tax (EBIT)
@ 12%
Less: Interest (Old) 0.56 0.56 0.56 0.56
Less: Interest (New) ---- ---- ---- 2.00
Profit before tax 5.44 8.44 8.44 6.44

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(PBT)
Less: Income tax (at 2.72 4.22 4.22 3.22
50%)
Less: Preference 1.08 1.08 1.08 1.08
dividend (Old)
Less: Preference ---- ---- 2.50 ----
dividend (New)
Profit for equity 1.64 3.14 0.64 2.14
shareholders
Number of equity 200,000 400,000 200,000 200,000
shares
EPS (Rs.) 8.20 7.85 3.20 10.70
P/E Ratio --- 21.4 17.0 15.7
Market price per --- 167.99 54.40 167.99
share
(EPS X P/E Ratio)
Conclusion: From the analysis of above three financial plans, raising of additional finance by
issue of shares and issue of debenture will maximize the market value of share. But in case of
issuing debenture the EPS of the company would be higher. If the company does not foresee any
financial risk with the issue of debenture, it is suggested to choose financial plan III.

Question No. 53
Delta Ltd. currently has an equity share capital of Rs. 1,000,000 consisting of 100,000 Equity
share of Rs. 10 each. The company is going through a major expansion plan requiring raising
funds to the tune of Rs. 600,000. To finance the expansion, the management has following
plans:
Plan-I : Issue 60,000 Equity shares of Rs. 10 each.
Plan-II: Issue 40,000 Equity shares of Rs. 10 each and the
balance through long-term borrowing at 12% interest
p.a.
Plan-III: Issue 30,000 Equity shares of Rs.10 each and 3,000
Rs.100, 9% Debentures.
Plan-IV: Issue 30,000 Equity shares of Rs. 10 each and the
balance through 6% preference shares.
The EBIT of the company is expected to be Rs. 400,000 p.a. Assume corporate tax rate of
40%.
Required: (6+2=8 Marks)
i) Calculate EPS in each of the above plans.
ii) Ascertain the degree of financial leverage in each plan and suggest the better plan.
[December 2018]
Answer:
i) Computation of EPS and Financial Leverage
Plan I Plan II Plan III Plan IV
Present Equity Shares 100,000 100,000 100,000 100,000
New Issue 60,000 40,000 30,000 30,000
No. of total equity shares 160,000 140,000 130,000 130,000
Equity share capital (Rs.) 1,600,000 1,400,000 1,300,000 1,300,000
12% Long term loan (Rs.)  200,000  
9% Debentures (Rs.)   300,000 
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6% Preference shares (Rs.)    300,000

EBIT (Rs.) 400,000 400,000 400,000 400,000
Interest on 12% Loan (Rs.)  24,000  
Interest on 9% debentures (Rs.)   27,000 
EBT (Rs.) 400,000 376,000 373,000 400,000
Less : Tax@ 40% 160,000 150,400 149,200 160,000
EAT (Rs.) 240,000 225,600 223,800 240,000
Less: Preference Dividends (Rs.)    18,000
(a) Earnings for equity shares (Rs.) 240,000 225,600 223,800 222,000
(b) No. of equity shares 160,000 140,000 130,000 130,000
(c) EPS (a  b) Rs. 1.50 1.61 1.72 1.71
ii) Computation of Financial leverage
Degree of Financial leverage-
 EBIT   EBIT  1.00 1.06 1.07 1.08
  
 EBIT  I   EBT  Or (WN. 1)
EBIT
EBT- PD
(1-t)

Comments:Since the EPS and degree of financial leverage both are highest in Plan III, the
management could accept it.
W.N 1
400000
400000-18,000 = 1.08
(1-0.40)

Question No. 54
Z Ltd. is presently financed entirely by equity shares. The current market value is Rs. 600,000. A
dividend of Rs. 120,000 has just been paid. This level of dividend is expected to be paid
indefinitely. The company is thinking of investing in a new project involving an outlay of Rs.
500,000 now and is expected to generate net cash receipts of Rs. 105,000 per annum indefinitely.
The project would be financed by issuing Rs. 500,000 debentures at the market interest rate of
18%. Ignore tax consideration.
Required: (5 Marks)
i) Calculate the value of equity shares and the gain made by the shareholders if the cost of
equity rises to 21.6% after investment in new project.
ii) Prove that weighted average cost of capital is not affected by gearing.
[June 2019]

Answer:
i) Current Cost of Equity 20%

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Statement Showing Value of Equity Holders and Gain made by them

Particulars Existing Proposed
EBIT 120,000 225,000
Less: Interest ( 18% x 500,000) - 90,000
EBT 120,000 135,000
Less: Tax - -
Earning for Equity Holders 120,000 135,000
Cost of Equity 20% 21.6%
Value of Equity 600,000 625,000
Gain made by equity holders in terms of earning - 15,000
Gain made by equity holders in terms of Value - 25,000
Value of Debt - 500,000
Value of Firm [ Value of Debt + Value of Equity] 600,000 1,125,000

ii) At present Z Limited is unleveraged firm, therefore the Cost of Equity of

the firm as well as the weighted average cost of capital of the firm is 20%
The WACC of Z Limited after infusion of Rs. 500,000 of Debt will be;
WACC [ Cost of Equity] [ Cost of Debt]

[ 21.6%] [ 18%]
= 20%
OR
Ko = EBIT/Value of firm

= 225,000/1,125,000
= 20%
Hence WACC is not affected by gearing.

Question No. 55
Honda Ltd., a producer of turbine generators, is in the following situation:
EBIT = Rs. 4 million
Tax rate = 35%
Debt outstanding = Rs. 2 million
Interest rate = 10%
Cost of equity (ke) =15%
Number of shares outstanding = 600,000
Book value per share = Rs. 10
Since Honda‘s product market is stable and the company expects no growth, all earnings
are paid out as dividends. The debt consists of perpetual bonds.
Required: 5
i) What are Honda‘s earnings per share and price per share?
ii) Honda can increase its debt by Rs. 8 million. The new debt can be used to buy
back and retire some of its shares at the current price. Its interest rate on debt will
be 12% including the existing one and its cost of equity will rise from 15% to
17%. EBIT will remain constant. Should Honda change its capital structure?
[June 2019]

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Answer:
Calculation of EPS and Current Market Price
Earnings Before Interest and Taxes 4,000,000.00
Less: Interest [2,000,000*10%] 200,000.00
Earnings Before Tax 3,800,000.00
Tax @ 35% 1,330,000.00
Profit After Tax 2,470,000.00
Number of Outstanding Shares 600,000.00
Earnings Per Share 4.12
Cost of Equity 0.15
Price Per share under Zero Growth Model ( 4.12 ÷ 0.15) 27.44
i) Additional Loan Financing 8,000,000.00
Number of Shares that can be bought back =8,000,000/27.44
291,545.00
Number of Shares Outstanding after buy back 308,455.00
Calculation of EPS and Current Market Price after Buy Back
Earnings Before Interest and Taxes 4,000,000.00
Less: Interest [10,000,000*12%] 1,200,000.00
Earnings Before Tax 2800,000.00
Tax @ 35% 980,000.00
Profit After Tax 1,820,000.00
Number of Outstanding Shares 308,455.00
Earnings Per Share 5.90
Cost of Equity 17%
Price Per share under Zero Growth Model ( 5.90 ÷ 0.17) 34.71
As the price per share increase from Rs. 27.44 to Rs. 34.71, the company should change its
capital structure.

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Chapter 13:

Interest Rate Determination

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Question No. 1
Inflation Premium [June 2011] (2.5 Marks)

Answer:
‗Inflation Premium‘ is the premium for expected inflation that investors add to the real risk free
rate of return. Inflation has a major impact on interest rates because it erodes the purchasing
power and lowers the real rate of return on investment. Investors are well aware of all this, so
when they lend money, they build in an inflation premium equal to the average inflation rate
expected over the life of the security. Therefore, if the real risk free rate is 4 percent and if
inflation is expected to be 5% (and hence inflation premium=5%) during the next year, then the
quoted rate of interest would be 9%.

Question No. 2
Write short note/ answer on: (2.5 Marks)
a) Liquidity preference theory
Answer:
The liquidity preference theory of the term structure addresses the shortcomings of the pure
expectations theory by proposing that forward rates reflect investors' expectations of future spot
rates plus a liquidity premium to compensate them for exposure to interest rate risk. Furthermore,
the theory suggests that this liquidity premium is positively related to maturity: a 25-year bond
has a larger liquidity premium than a 5-year bond. The liquidity theory says that forward rates
are biased estimates of the market's expectation of future rates because they include a liquidity
premium. Therefore, a positive-sloping yield curve may indicate that either: (1) the market
expects future interest rates to rise; or (2) that rates are expected to remain constant (or even fall),
but the addition of the liquidity premium results in a positive slope. A downward-sloping yield
curve indicates falling short term rates according to the liquidity theory.
The size of the liquidity premiums need not be constant over time. They may be larger during
periods of greater economic uncertainty, when risk aversion among investors is higher.

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Chapter 14:

Mutual Fund

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Question No. 1
Siddhartha Mutual Fund has the following assets under it on the close of
business as on:
Company No. of Shares 1st Baishakh 2073 2nd Baishakh 2073
market price per market price per
share (Rs.) share (Rs.)
HIDCL 20,000 435 445
Fewa Bikash Bank 30,000 322 360
Garima Bikash Bank 20,000 461 483
Malika Bikash Bank 60,000 525 515

Total number of units 600,000

Required: (3+5=8 Marks)

i) Calculate total Net Assets Value (NAV) and per unit NAV of the fund as on 1st
Baishakh 2073.
ii) Assume one Mr. A, submits a cheque of Rs. 3,000,000 to the Mutual Fund on 1st
Baishakh 2073 and the Fund manager of the company purchases 8,000 shares of
Fewa Bikas Bank and the balance amount is held in bank. In such a case, what would
be the position of the fund as on 1st Baishakh 2073? Also find new NAV in total and
per unit of the fund as on 2nd Baishakh, 2073.
[December 2016]

Answer:
i) NAV of fund as on 1st Baishakh 2073
= (20,000×435)+(30,000×322)+20,000×461)+(60,000×525)
= 8,700,000+9,660,000+9,220,000+31,500,000
= Rs. 59,080,000

NAV per unit =59,080,000

600,000
= Rs. 98.47

ii) The revised position of fund as on 1st Baishakh 2073 shall be as follows:
Company No. of shares 1st Baishakh 2073 market Total (Rs.)
price per share(Rs.)
HIDCL 20,000 435 8,700,000
Fewa Bikash Bank 38,000 322 12,236,000
Garima Bikash Bank 20,000 461 9,220,000
Malika Bikash Bank 60,000 525 31,500,000
Cash 424,000
62,080,000
3,000,000
Number of units of fund = 600,000+ 98.47

=630,466 units

On 2ndBaishakh, 2073, the NAV of fund will be as follows:

Company No. of shares 2nd Baishakh 2073 market Total (Rs.)
price per share(Rs.)
HIDCL 20,000 445 8,900,000
Fewa Bikash Bank 38,000 360 13,680,000
Garima Bikash Bank 20,000 483 9,660,000
Malika Bikash Bank 60,000 515 30,900,000

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Cash 424,000
NAV as on 2nd Baishakh, 2073 63,564,000

NAV/unit =Rs. 63,564,000

630,466

= Rs. 100.82

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Chapter 15:

Other Short Notes

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Question No. 1
Write short notes: 2.5 Marks
Horizontal merger and Vertical merger (June 2009)

Answer:
Horizontal Merger: A horizontal merger is a merger between two companies in the same line of
business or a merger between two competitors. Suppose, for example, Pepsi were to buy Coca-
Cola. This would be a horizontal merger. Horizontal mergers may negatively affect the
competitive situation in an industry. Therefore, they frequently run afoul of regulatory officials.
A horizontal merger often increases the degree of concentration in an industry.
Vertical Merger: A vertical merger acquires another firm that is ‗upstream‘ or ‗downstream‘. It
occurs when a supplier buys a reseller, or vice versa. The key point is that the two companies
have a buyer-seller relationship. Suppose that a jewelry retailer purchased a company that
manufactures jewelry. This would be a vertical merger. Or, suppose that a pharmaceutical
company acquired a drugstore chain.

Question No. 2
Write short notes:
Safety Stock (June 2009) 2.5 Marks

Answer:
Safety stock may be defined as the minimum additional inventory which serves as a safety
margin or cushion at times when the actual lead time and/or usage rate are more than previously
anticipated.
In the inventory management techniques, we compute economic order quantity and the reorder
point on the assumption that every thing is certain. In these models, we assume that there will be
a constant or fixed usage of inventory and that the inventory will be replenished as and when
needed. These assumptions do not, however, hold well in actual situations where uncertainties
creep up every now and then due to a number of reasons. For instance, the demand for the goods
produced by the firm may increase unexpectedly which require materials in excess quantity than
previously planned. Similarly, the receipt of inventory from the markets may be delayed due
man made and natural disaster such as strikes, floods, transportation and other problems.
When the demand for inventory increases or delivery of inventory is hindered by whatever
reasons, the firm will face a situation of shortage of inventory or stock-out. Safety stock serves
the firm better to tackle such situations or eventualities.

Question No. 3
Write short notes on:
Financial intermediaries (December 2009) (2.5 Marks)
Answer:
Financial intermediaries:
Financial intermediaries are the various financial institutions, such as pension funds, insurance
companies, banks, building societies, unit trusts and specialist investment institutions. Their role
is to accept deposits from personal and corporate savers to lend to customers via the capital and
money markets. They perform vital economic service of:
(i) Re-packaging finance: collecting small amounts of finance and re-packaging into larger
bundles for specific lending requirements (e.g. banks).
(ii) Risk-reduction: investing sums, on behalf of individuals and companies, into large, well-
diversified investment portfolios (e.g. pension funds and unit trusts).

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(iii) Liquidity transformation: bringing together short-term lenders and long-term borrowers
(e.g. building societies).
(iv) Cost reduction and advice: minimizing transaction costs and providing low-cost services to
lenders and borrowers.

Question No. 4
Write short notes on:
Revolving credit agreement (2.5 Marks)
(December 2010)

Answer:
A revolving credit agreement is a formal commitment by a bank to lend up to a certain amount
of money to a company over a specified period of time. This type of debt is for a short term,
usually up to 3 months. The company may, however, renew or borrow additional amount up to
the limit of agreement throughout the duration of the commitment. Although commitment can
be obtained for a shorter period as well, most revolving credit commitments are provided for 3
years.
The interest term of the revolving credit agreements are similar to but slightly higher (usually
between 0.25 to 0.50 per cent higher) than the rate at which a firm can borrow on a short term
basis under a line of credit. The banks generally charge commitment fee usually around 0.5 per
cent per annum on the difference between the amount borrowed and the maximum limit amount.
This type of borrowing arrangement is very useful at times when the firm is not certain about its
fund requirements. The borrowing company will have flexibility in the access to funds at the
time of uncertainty and can make more definite credit arrangement when the situation of
uncertainty is resolved.

Question No. 5
Write short notes on:
Leveraged Buyout (2.5 Marks)
(December 2010)
It is an ownership transfer consummated primarily with debt. Sometimes it is also called as
asset- based financing, the debt is secured by the assets of the enterprise involved. While some
leveraged buyouts involve the acquisition of an entire company, many involve the purchase of a
division of a company or some other subunit. Frequently the sale is to the management of the
division being sold, the company having decided that the division no longer fits its strategic
objectives. Another distinct feature is that leveraged buyouts are cash purchases, as opposed to
stock purchases. Finally the business unit involved invariably becomes a privately held as
opposed to a publicly held company.

Question No: 6
Distinguish between: Investment Decision and Financing Decision(December 2010) 2.5 Marks

Answer:
Investment decision refers to the capital expenditure decision. Companies lock up a large
amount of funds for future benefits as a result of the investment decision. It involves risk and it
changes the business risk complexion of a company. In addition, it brings about changes in the
composition of assets and determines the total amount of assets held by a company. This has two
important aspects: the evaluation of the profitability of the project and measurement of cut off
rate of return.
After determining the total financial requirement, a financial manager should decide when,
where from and how to raise funds to meet the financial requirement to implement the

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investment decision. Funds can be raised from different sources like Short term or Long term.
Funds may be raised by issuing different instruments of debt such as bonds, debenture,
commercial papers and issuing common or preference shares. Cost of the fund varies according
to the sources. A financial manager should make appropriate mix up of funds raised from
different sources in order to minimize the overall cost of capital and maximize the value of the
firm.
Question No: 7
Write short notes on: Bridge Finance (June 2010) (2.5 Marks)

Answer:

Bridge Finance refers, normally, to loans taken by a business, usually from commercial banks
for a short period, pending disbursement of term loans by financial institutions. Normally, it
takes time for the financial institution to finalise procedures of creation of security, tie-up
participation with other institutions etc., even though a positive appraisal of the project has been
made. However, once the loans are approved in principle, firms, in order not to lose further time
in starting their projects, arrange for bridge finance. Such temporary loan is normally repaid out
of the proceeds of the principal term loans. Generally the rate of interest on bridge finance is 1%
or 2% higher than on normal term loans.

Question No. 8
Commercial paper [June 2011] (2.5 Marks)

Answer:
Commercial Paper - It is an important money market instrument in advanced countries like USA
to raise short term funds. It is a form of unsecured promissory note issued by firms to raise short
term funds. The commercial paper market in the USA is a blue-chip market where financially
sound and highest rated companies are able to issue commercial papers. The buyers of
commercial paper include banks, insurance companies, unit trusts and firms with surplus funds
to invest for a short period with minimum risk. Given this objective of the investors in the
commercial paper market, there would be demand for commercial papers of highly creditworthy
companies.

Question No. 9
Proxy fight and Takeover [June 2011] (2.5 Marks)

Answer:
Management always solicits stockholders‘ proxies and usually gets them. However if earnings
are poor and stockholders are dissatisfied, an outside group might solicit the proxies in an effort
to overthrow management and take control of the business. This is known as proxy fight
Takeover is an action whereby a person or group succeeds in ousting a firm‘s management and
taking control of the company. In recent years there are cases, where attempts have been made
by one corporation to take over another by purchasing a majority of the outstanding stock.

Question No. 10
Debt Securitization [December 2011] (2.5 Marks)

Answer:
It is a method of recycling of funds. It is especially beneficial to financial intermediaries to
support the lending volumes. Assets generating steady cash flows are packaged together
and against this asset pool, market securities can be issued, e.g. housing finance, auto loans, and
credit card receivables.
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Process of Debt Securitisation:

(i) The origination function – A borrower seeks a loan from a bank and financial
institution. The credit worthiness of borrower is evaluated and contract is entered into
with repayment schedule structured over the life of the loan.
(ii) The pooling function – Similar loans on receivables are clubbed together to create an
underlying pool of assets. The pool is transferred in favour of Special purpose Vehicle
(SPV), which acts as a trustee for investors.
(iii) The securitisation function – SPV will structure and issue securities on the basis of asset
pool. The securities carry a coupon and expected maturity which can be asset-
based/mortgage based. These are generally sold to investors through merchant bankers.
Investors are – pension funds, mutual funds, insurance funds.
The process of securitization is generally without recourse i.e. investors bear the credit risk
and issuer is under an obligation to pay to investors only if the cash flows are received by
him from the collateral. The benefits to the originator are that assets are shifted off the
balance sheet, thus giving the originator recourse to off-balance sheet funding

Question No. 11
Intrinsic value of an asset [June 2012] (2.5 Marks)

Answer:
The intrinsic value of an asset is equal to the present value of incremental future cash inflows
likely to accrue due to the acquisition of the asset, discounted at the appropriate required rate of
return. It represents the maximum price the buyer would be willing to pay for such an asset. The
principal of valuation based on the discounted cash flow approach is used in capital budgeting
decisions. In the case of business intended to be purchased, its valuation is equivalent to the
present value of incremental future cash inflows after taxes, likely to accrue to the acquiring
firm, discounted at the relevant risk adjusted discount rate, as applicable to the acquired
business. The intrinsic value indicates the maximum price at which the business can be acquired.

Question No. 12
Line of credit with a bank [June 2012] (2.5 Marks)
Answer:
A line of credit with a bank is an informal arrangement between a bank and its customers
specifying the maximum amount of credit which the bank will permit the firm to borrow at any
point of time. Normally, credit lines are established for a one-year period. The line of credit is
renewed by the bank once it receives the latest annual report and reviews the progress of the
borrower. The amount of the line of credit depends on the bank‘s assessment of the
creditworthiness and the credit needs of the borrower.
A line of credit may be adjusted upwards or downwards at the time of renewal based on the
changes in these conditions. The cash budget of a firm is an indicator of the borrower‘s short
term credit needs. The firm usually seeks a line of credit amount slightly in excess of maximum
or peak borrowing needs during the forthcoming year to give a margin of safety. The bank may
impose a ‗clean up‘ provision in a line of credit arrangement. Accordingly, the borrower would
be required to clean up the bank debt for a specified period of time during the year. Such a
cleanup period is usually one to two months.
It is, however, to be noted that a line of credit does not constitute a legal commitment on the part
of the bank to extend credit. The borrower is informed of the line of credit through a letter
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indicating that the bank is willing to extend credit up to a certain amount. If the credit
worthiness of the borrower gets deteriorated during the year, the bank might not want to extend
credit or reduce the amount of credit already intimated.

Question No. 13
Investment bankers Vs. Mortgage bankers [June 2012] (2.5 Marks)
Answer:
Investment bankers are middlemen who are involved in the sale of stocks and bonds. When a
company decides to raise funds, an investment bank comes up with the proposal to buy the issue
at wholesale and then go to sell the same to investors at retail.
Being in the business of matching users of funds with suppliers, investment bankers can sell
issues more efficiently than the issuing company. For the services provided, they receive fee as
the difference between the amounts received from the sale of securities to the public and the
amount paid to the companies.
Mortgage bankers are involved in acquiring and placing mortgages. The mortgages to the
mortgage bankers come through the individuals, businesses and builders and real estate agents.
These bankers do not hold mortgages in their own portfolios for a long time. They usually
service these for the ultimate investors. They receive fees from the ultimate investor for the
services provided to them.

Question No. 14
Horizontal merger Vs. Vertical merger [June 2012] (2.5 Marks)
Answer:
Horizontal merger takes place when two or more corporate firms dealing in similar lines of
activity combine together. Elimination or reduction in competition, putting an end to price
cutting, economies of scale in production, research and development, marketing and
management are often cited motives underlying such mergers.
Vertical merger occurs when a firm acquires firms upstream from it and/ or firms downstream
from it. In the case of an upstream merger, it extends to the suppliers of raw materials, and to
those firms that sell eventually to the consumer in the event of a downstream merger. Thus the
combination involves two or more stages of production or distribution that are usually separate.
Lower buying cost of materials, lower distribution costs, assured supplies and market, increasing
or creating barriers to entry for potential competitors or placing them at a cost disadvantage are
the chief gains accruing from such mergers.

Question No. 15
Operating breakeven point Vs. Financial breakeven point [June 2012] (2.5 Marks)
Answer:
The operating breakeven point is defined as the units of output at which total revenues are equal
to total operating costs (fixed costs plus variable costs). The operating breakeven point is
calculated as follows:
Operating BEP = Fixed Cost/ Contribution Margin.

Financial breakeven point is the situation where EBIT equals to financing cost. In this analysis,
the firms needs to just cover all of its financing costs and produce earnings per share equal to
zero. Financial Breakeven analysis can be used to help determine the impact of the firm's
financing mix on the earnings available to common stockholders.

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Question No. 16
Information Asymmetry [December 2012] (2.5 Marks)

Answer:
Information asymmetry deals with the study of decisions in transactions where one party has
more or better information than the other. This creates an imbalance of power in transactions
which can sometimes cause the transactions to go awry, a kind of market failure in the worst
case. Examples of this problem are adverse selection, moral hazard, and information monopoly.
Most commonly, information asymmetries are studied in the context of principal-agent
problems. Information asymmetry causes misinforming and is essential in every communication
process.
Information asymmetry models assume that at least one party to a transaction has relevant
information whereas the other(s) do not. Some asymmetric information models can also be used
in situations where at least one party can enforce, or effectively retaliate for breaches of, certain
parts of an agreement whereas the other(s) cannot.

Question No. 17
Treasury bills and Certificate of deposits [December 2012] (2.5 Marks)

Answer:
Treasury bills are sold by the government on a discount basis. As a result, the investor does not
get actual payment of interest on the Treasury bills. The return to the investor is in the form of
difference between the purchase price and face (or par) value of the bill.
These bills are issued without the investor‘s name upon them, i.e. in the bearer form. This
feature of the treasury bills makes them easily transferable from one investor to another. The
secondary market also exists for these bills making them highly liquid. It is also considered risk-
free since it has the backing and guarantee of the government.
Certificate of deposits (CDs) are marketable receipts for funds that have been deposited in a
bank/financial institution for a specified period of time. The funds thus deposited earn a fixed
rate of interest. The denomination and the maturities is agreed upon as per the needs and wishes
of the investor.
Since the CDs are not sold at discount, the investor receives the amount deposited plus the
interest earned thereon. A secondary market also exists for the CDs. These may be issued in the
registered or bearer form. The second types of CDs are most common and popular due to their
easy transferability and liquidity.

Question No. 18
Global Depository Receipts and Euro Convertible Bonds [June 2013] (2.5 Marks)

Answer:
Global Depository Receipts (GDR) is a negotiable certificate denominated in US dollars which
represents a Non-US company‘s publically traded local currency equity shares. GDR are created
when the local currency shares of an Indian company are delivered to Depository‘s local
custodian Bank against which the Depository bank issues depository receipts in US dollars. The
GDR may be traded freely in the overseas market like any other dollar-expressed security either
on a foreign stock exchange or in the over-the-counter market or among qualified institutional
buyers.
Whereas, Euro Convertible bonds are quasi-debt securities (unsecured) which can be converted
into depository receipts or local shares. ECBs offer the investor an option to convert the bond
into equity at a fixed price after the minimum lock-in period. The price of equity shares at the

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time of conversion will have a premium element. The bonds carry a fixed rate of interest. These
are bearer securities and generally the issue of such bonds may carry two options viz. call option
and put option. In the case of ECBs, the payment of interest and the redemption of the bonds
will be made by the issuer company in US dollars. ECBs issues are listed at London or
Luxemburg stock exchanges.

Question No. 19
Debt Securitization [June 2014] (2.5 Marks)

Answer:
Debt Securitization:

It is the method of recycling of funds. It is especially beneficial to financial intermediaries to

support the lending volumes. Assets generally steady cash flows are packaged together and
against this assets pool, market securities can be issued, e.g. housing finance, auto loans and
credit card receivables.
Process of Debt Securitization:
1) The origination function- A borrower seeks a loan from a bank and financial institution.
The credit worthiness of borrower is evaluated and contract is entered into with
repayment schedule structured over the life of loan.
2) The pooling function – Similar loans on receivables are clubbed together to create an
underlying pool of assets. The pool is transferred in favors of special purpose vehicle
(SPV), which acts as a trustee for investors.
3) The securitization function- SPV will structure and issued securities on the basis of assets
pool. The securities carry coupon and expected maturity which can be assets-
based/mortgage based.
Question No. 20
Vertical Merger [June 2014] (2.5 Marks)
Answer:
A vertical merger acquires another firm that is `upstream‘ or ‗downstream‘. It occurs when a
supplier buys a reseller, or vice versa. The key point is that the two companies have a buyer-
seller relationship. Suppose that a jewelry retailer purchased a company that manufactures
jewelry. This would be the verticalmerger. Or suppose that a pharmaceutical Company acquired
a drugstore chain.

Question No. 21
Venture Capital Financing [June 2014] (2.5 Marks)
Answer:

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Venture Capital financing refers to financing of high risk ventures promoted by new qualified
entrepreneurs who require funds to give shape to their ideas. Here, a financier (called venture
capitalist) invest in the equity or debt of an entrepreneur (promoter) undertaking who has a
potentially successful business idea but does not have desired track record or financing
[Link], venture capital funding is associated with heavy initial investment business
like energy conservation, quality up gradation or with sunrise sector like information
technology.

Question No. 22
Treasury Bills [December 2014] (2.5 Marks)

Answer:
Treasury bills are obligation of the government. They are sold on discounted basis. The investor
does not receive an actual interest payment. The return is the difference between the purchase
price and the face (par) value of the bill.
The treasury bills are issued only in bearer form. They are purchased, therefore, without
investors' name upon them. This makes them easily transferable from one investor to another. A
very active secondary market exists for these bills. The secondary market for bills not only
makes them highly liquid but also allows purchase of bills with very short maturities. As the
bills have the full financial backing of the government, they are, for all practical purposes, risk-
free. The negligible financial risk and the high degree of liquidity make their yield lower than
those on the other marketable securities. Due to their virtually risk free nature and because of
active secondary market for them, treasury bills are one of the most popular marketable
securities even though the yield on them is lower.

Question No. 23
Clean packing credit and Packing credit against hypothecation of goods [December 2014] (2.5
Marks)

Answer
Packing Credit is an advance extended by banks to an exporter for the purpose of buying,
manufacturing, processing, packing, shipping goods to overseas. If an exporter has a firm export
order placed with him by his foreign customer(buyer) or all irrevocable Letter of Credit in his
favour, he can approach a Bank for Packing Credit Facility.
Clean Packing Credit
 This facility is extended only on production of a firm export order or a letter of credit.
 There is no charge or control over raw material or finishes goods that constitute the supply.
 The bank takes into consideration trade requirements, credit worthiness of exporter and its
margin.
 Export Credit Guarantee Corporation (ECGC) insurance cover should be obtained by the
bank.
Packing credit against hypothecation of goods
 This facility is extended only on production of a firm export order or a letter of credit.
 The goods which constitute the supply are hypothecated to the Bank as security with
stipulated margin.
 The goods shall be exported by the borrower. The Bank does not have any effective
possession of the same.
 The exporter has to submit stock statements at the time of sanction and also periodically and
for whenever there is any movement in stock.
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Question No. 24
Capital market and Money market [December 2014] (2.5 Marks)

Answer:
Capital market and money market are two basic components of financial system. Capital market
deals with long and medium term instruments of financing while money market deals with short
term instruments. Capital market instruments are shares, debentures, mutual funds etc. while
money market instruments are interbank placement, call money, commercial papers, treasury
bills etc.
Capital market is usually classified as primary market and secondary market while there is no
such classification of money market.
Capital market participants include retail investors, institutional investors, financial institutions,
corporate houses and banks while money market participants include banks, financial
institutions, central bank and government.

Question No. 25
Private equity [July 2015] (2.5 Marks)

Answer:
Private equity refers to the composition of equity and debt investment in the companies that are
not publicly traded on a stock exchange. It is generally made by a private equity firm, a venture
capital firm or an angel investor, each of which have their own set of goals, preferences and
investment strategies. Nonetheless, all provide working capital to a target company to nurture
expansion, new-product development, or restructuring of the company‘s operations,
management, or ownership.
Among the most common investment strategies in private equity are: leveraged buyouts, venture
capital, growth capital, distressed investments and mezzanine capital. In a typical leveraged
buyout transaction, a private equity firm buys majority control of an existing or mature firm.
This is distinct from a venture capital or growth capital investment, in which the investors
(typically venture capital firms or angel investors) invest in young, growing or emerging
companies, and rarely obtain majority control.
It is also often grouped into a broader category called private capital, generally used to describe
capital supporting any long-term, illiquid investment strategy.

Question No. 26
What are the functions of debt securitization? [December 2015] (3 Marks)

Answer:
Functions of Debt Securitization
It is a mode of financing wherein securities are issued on the basis of a package of assets (called
Asset Pool). In this method recycling funds, assets generating steady cash flows are packaged
together and against this asset pool, market securities can be issued.
i) File Origination Function: A borrower seeks a loan from a lending institution (finance
company or bank). The credit worthiness of the borrower is evaluated and the loan is
sanctioned. A contract is signed between the parties, with repayment schedule spread over
the life of the loan. The lender is called the Originator, to whom the loan constitutes an asset
(receivable).
ii) The Pooling Function: The Originator (Lender) clubs together similar loans or receivables,
to create an underlying pool of assets. This pool is transferred in favour of a SPV (Special
Purpose Vehicle), which acts as a trustee for the investor. Once the assets are transferred,
they are held in the Originators' portfolios.

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iii) The Securitization Function: Now the SPV issues securities on the basis of the asset
pool. The securities carry a coupon and an expected maturity which can be asset based or
mortgage based. These are generally sold to investors through merchant bankers.

Question No.27
What are the advantages of raising funds by issuing equity shares? [December 2015] (3 Marks)

Answer:
Following are the some of the advantages of raising funds by issue of equity shares:
 Permanent source of finance. No liability for cash outflows associated with its redemption.
 Demonstrate financial base (Capital adequacy) of the company and helps in borrowing
power of the company.
 No legal obligation to pay dividends.
 Can be raised further shares by making a right issue.

Question No. 28
Social cost benefit analysis [December 2015] (2.5 Marks)

Answer:
Social cost benefit analysis is the method of evaluating the use of public fund. It considers
monetary as well as non-monetary returns.
Large amount of public fund is committed every year for various public projects. Analysis of
such projects has to be done with reference to social costs and benefits. Such projects are not
merely considered based on commercial returns, instead considered for various social returns in
the form of employment generation, access to market, increase in life styles, access to basic
requirements such as health, education, drinking water. So, such projects are analyzed based on
what social benefits that particular project will provide. Based on such returns decision as to
whether to implement projects or not is made by the competent authorities.

Question No. 29
Financial tapering [December 2015] (2.5 Marks)

Answer:
The word tapering in financial terms is increasingly being used to refer to the reduction of the
Federal Reserve's quantitative easing, or bond buying program. Tapering activities is primarily
aimed at interest rates and investors' expectations of what those rates will be in the future. These
can include conventional central bank activities, such as adjusting the discount rate or reserve
requirements, or more unconventional ones, such as quantitative easing (QE).
Central banks can employ a variety of policies to improve growth, and they must balance short-
term improvements in the economy with longer-term market expectations. If the central bank
tapers its activities too quickly, it may send the economy into a recession. If it does not taper its
activities, it may lead to high inflation.
Tapering is best known in the context of the Federal Reserve's quantitative easing program. In
reaction to the 2007 financial crisis, the Federal Reserve began to purchase assets with long
maturities to lower long-term interest rates. This activity was undertaken to entice financial
institutions to lend money, and it began when the Federal Reserve purchased mortgage-backed
securities.

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Question No. 30
GDRs and ADRs [December 2015] (2.5 Marks)

Answer:
Finance can be raised by, Global Depositary Receipts (GDRs) Foreign Currency Convertible
Bonds (FCCBs) and pure debt bonds. However, GDRs and FCCB's are more popular. GDRs do
not carry voting rights and hence there is no dilution of control.
Global Depository Receipts (GDRs)
 A Depository Receipt (DR) is basically a negotiable certificate denominated in US Dollars
that represents a non- US company publicly traded local currency (Nepalese Rupee) Equity
share.
 DRs are created when the local currency shares of Nepalese company are delivered to the
depository's local custodian bank, against which the depository bank issues DRs in US
Dollars.
 These DRs may be freely traded in the overseas market like any other Dollar denominated
security through either a foreign stock exchange or through over the Counter (OTC) market
or among the restricted groups like qualified institutional buyers.

GDRs with warrants are more attractive than plain GDRs in view of additional value of attached
warrants.
American Depository Receipts (ADRs):
Depository Receipts issued by a company in the USA are known As ADRs. Such receipts have
to be issued in accordance with the provisions stipulated by the Securities Exchange
Commission (SEC) of the USA which is the regulatory body like the SEBON in Nepal.
Since the conditions laid down by the SEC are stringent, Nepalese companies have chosen the
indirect route to tap the vast American financial market through private placement of GDRs
listed in London and Luxembourg Stock Exchanges.

Question No. 31
Debt Securitization [June 2016] (2.5 Marks)

Answer:
Debt securitisation is a method of recycling of funds. It is especially beneficial to financial
intermediary to support the lending volumes. Assets generating steady cash flows are packaged
together and against this assets pool, market securities can be issued, e.g. housing finance, auto
loans and credit cards receivables. The process of securitization is generally without recourse i.e.
investors bear the credit risk and issuer is under an obligation to pay to investors only if the cash
flows are received by him from the collateral. The benefits to the originator are that assets are
shifted off the balance sheet, thus the originator recourse to off-balance sheet funding.

Question No. 32
Preference share and Debenture [June 2016] (2.5 Marks)

Answer:
Preference share is a special kind of share whose holders enjoy priority both as regard to the
payment of a fixed amount of dividend and also towards repayment of capital in case of winding
up of a company. Preference shares are a hybrid form of financing with some characteristics of
equity shares and some attributes of debt capital.
A debenture is a type of loan which can be raised from the public. It carries fixed percentage of
interest. Debentures are instruments for raising long term capital with a period of maturity.
Some debenture can be convertible to equity.

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Question No. 33
Financial lease and Operating lease [June 2016] (2.5 Marks)

Answer
In Financial lease, the risk and reward incident to ownership are passed on to the lessee. The
lessor only retains the legal ownership of the assets. The lessor does not bear the cost of repairs,
maintenance or operations. The lease is usually full payout.
In operating lease, the lessee is only provided the use of the assets for a certain time. Risk
incident to ownership belongs to the lessor. Usually, the lessor bears the cost of repairs,
maintenance and operations. The lease is usually non-payout.

Question No. 34
Euro convertible bonds Vs. Euro convertible zero bonds. [June 2016] (2.5 Marks)

Answer:
Euro convertible bond is a Euro bond, a debt instrument which gives the bond holders an option
to convert them into a pre determined number of equity shares of the company. Usually the price
of the equity shares at the time of conversion will have a call option (where the issuer company
has the option of calling/buying the bonds for redemption prior to the maturity date) or a put
option (which gives the holder the option to put/sell his bonds to the issuer company at a
predetermined date & price).
Euro convertible zero bonds are structured as convertible bond. No interest is payable on the
bonds. But conversion of bonds takes place on maturity at a predetermined price. Usually there
is a five years maturity period and they are treated as deferred equity issue.

Question No. 35
Clean overdraft [December 2016] (2.5 Marks)

Answer:
A clean overdraft refers to an advance by way of overdraft facility, but not backed by any
tangible securities. Hence request for clean advances are entertained only from parties which are
financially sound and reputed for their integrity. Bank has to rely upon the personal security of
the borrowers. Some factories to be considered by the banks before granting clean OD's are (a)
past operations of the party (b) turnover in the accounts (c) satisfactory dealings for considerable
period (d) reputation in the market.
As a safeguard, banks take guarantee from other persons who are credit worthy before granting
this facility. A clean advance is generally granted for a short period and must not be continued
for long.

Question No. 36
Virtual banking and its advantages [December 2016] (2.5 Marks)

Answer:
Virtual Banking refers to the provision of banking and related services through the use of
information and communication technologies (ICT) without direct resources to the bank by the
customers. The advantages of virtual banking services are as follows:
 Lower cost of handling transaction
 The increased speed of response to the customer requirements
 Lower cost of operating branch network along with reduced staff costs
 Leads to cost and service efficiency

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Question No. 37
Trading securities and Available-for-sale securities [December 2016] (2.5 Marks)

Answer:
Trading securities are those investment securities purchased with the intent to take advantage of
short-term price changes. These are classified as current assets.
Besides, available-for-sale securities are those investment securities that are purchased as a store
of wealth for the reasons like safety, to hold excess cash temporarily, or just to earn a normal
long-term return. The purchase of available-for-sale securities is then a more passive investment
than an investment in trading securities; the intent is to earn a normal return, not to make a quick
return by guessing which way the market is going. Available-for-sale securities can be classified
as current assets or long-term assets, depending on management's intent for holding them.

Question No. 38
Venture capital financing methods [June 2017] (2.5 Marks)

Answer:
Venture Capital financing refers to financing of high risk ventures promoted by new qualified
entrepreneurs who require funds to give shape to their ideas. Here, a financier (called venture
capitalist) invest in the equity or debt of an entrepreneur (promoter) undertaking who has a
potentially successful business idea but does not have desired track record or financing backing.
Generally, venture capital funding is associated with heavy initial investment business like
energy conservation, quality up gradation or with sunrise sector like information technology.

Methods of venture capital financing

i) Equity financing: The investor‘s contribution does not exceed 49% of the total equity
capital of the undertaking. Hence, the effective control and ownership remains with the
entrepreneur.
ii) Conditional Loan: A conditional loan is repayable in the form of royalty after the venture
is able to generate sales. No interest is paid on such loans. Sometimes, the entrepreneur has
a choice of paying high rate of interest instead of royalty on sales once the activity
becomes commercially sound.
iii) Income note: It is a hybrid type of finance, which combines the features of both
conventional loan and conditional loan. The entrepreneur has to pay both interest and
royalty on sales but at substantially low rates.
iv) Participating debentures: Interest on such debentures is payable at three different rates
based on the phase of operations as under.

Question No. 39
‗Loan syndication is one of the project finance services.‘ Discuss. [June 2017] (2.5 Marks)

Answer:
Loan syndication involves obtaining commitment for term loans from the financial institutions
and banks to finance the project. Basically it refers to the services rendered by merchant bankers
in arranging and procuring credit from financial institutions, banks and other lending and
investment organisation or financing the client project cost or working capital requirements.
Loan syndication is in fact a tie up of term loans from the different financial institutions. The
process of loan syndication involves various formalities such as:
i. Preparation of project details,
ii. Preparation of loan application,
iii. Selection of financial institutions for loan syndication,

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iv. Issue of sanction letter of intent from the financial institutions,

v. Compliance of terms and conditions for availing of the loan,
vi. Documentation, and
vii. Disbursement of the loan.

Question No. 40
Credit Rating [December 2017] (2.5 Marks)

Answer:
Credit rating essentially reflects the probability of timely repayment of principal and interest by
a borrower company. It indicates the risk involved in a debt instrument as well its qualities.
Higher the credit rating, greater is the probability that the borrower will make timely payment of
principal and interest and vice-versa.
It has assumed an important place in the modern and developed financial markets. It is a boon to
the companies as well as investors. It facilitates the company in raising funds in the capital
market and helps the investor to select their risk-return trade-off. By indicating credit-worthiness
of a borrower, it helps the investor in arriving at a correct and rational decision about making
investments. Credit rating system plays a vital role in investor protection. Fair and good credit
ratings motivate the public to invest their savings.
As a fee-based financial advisory service, credit rating is obviously extremely useful to the
investors, the corporate (borrowers) and banks and financial institutions. To the investors, it is
an indicator expressing the underlying credit quality of a security to be floated for in the market.
The investor is fully informed about the company as any effect of changes in business/economic
conditions on the company is evaluated and published regularly by the rating agencies. The
Corporate borrowers can raise funds at a cheaper rate with good rating. It minimizes the role of
the 'name recognition' and less known companies can also approach the market on the basis of
their rating.

Question No. 41
Agency cost of equity and debt [December 2017] (2.5 Marks)

Answer:
Agency cost refers to the cost incurred by a firm because of the problems associated with the
different interests of management and shareholder and the information asymmetry that exists
between the principal (shareholders) and the agent (management).
 Agency Cost of Equity
The agency cost of equity arises because of the difference in interests between the
shareholders and the management. As long as the management‘s interests diverge from that
of the shareholders, the shareholders will have to bear this cost. Management may be tempted
to take suboptimal decisions that may not work towards maximizing the value for the firm.
Any measures implemented to oversee and prevent this will have a cost associated with it. So,
the agency costs will include both, the cost due to the suboptimal decision, and the cost
incurred in monitoring the management to prevent them from taking these decisions.
 Agency Cost of Debt
The agency cost of debt arises because of different interests of shareholders and debt-holders.
Assume that the management is in favor of the shareholders. If so, the management can in
many ways transfer the wealth to the shareholders and leaving debt-holders empty handed.
Anticipating such activities, the debt-holders will take various preventive measures to
disallow management from doing so. The debt holders may do so in the form of higher
interest rates to protect themselves from the losses. Alternatively they may impose restrictive
covenants.
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Question No. 42
Spin Off and Carve Out [December 2017] (2.5 Marks)

Answer:
A spin-off and carve-out are different methods that a company can use to divest certain assets, a
division or a subsidiary. While the choice of a specific method by the parent company depends
on a number of factors, the ultimate objective is to increase shareholder value.
In a spin-off, the parent company distributes shares of the subsidiary that is being spun-off to its
existing shareholders on a pro rata basis, in the form of a special dividend. The parent company
typically receives no cash consideration for the spin-off. Existing shareholders benefit by now
holding shares of two separate companies after the spin-off instead of one. The spin-off is a
distinct entity from the parent company and has its own management. The parent company may
spin off 100% of the shares in its subsidiary, or it may spin off controlling interest to its
shareholders and hold a minority interest in the subsidiary.
In a carve-out, the parent company sells some or all of the shares in its subsidiary to the public
through an initial public offering (IPO). Unlike a spin-off, the parent company generally
receives a cash inflow through a carve-out. Since shares are sold to the public, a carve-out also
establishes a net set of shareholders in the subsidiary. A carve-out often precedes the full spin-
off of the subsidiary to the parent company's shareholders.

Question No. 43
Bank Overdraft and Clean Overdraft [December 2017] (2.5 Marks)

Answer:
Bank Overdraft
Bank overdraft refers to an arrangement whereby the bank allows the customers to overdraw
from the current deposit account within a specified limit. The overdraft facility is granted against
the securities of assets or personal security as in case of cash credit. Interest is charged only on
the amount actually withdrawn (i.e. debit balance) for the actual period of use (i.e., for the
period the debit balance in current deposit account remains outstanding). The cost of raising
finance by this method is the interest charged by the bank.

Clean Overdraft
Bank may entertain clean advances from those customers, which are financially, sound and
reputed for their integrity. The banks in this case rely upon the personal security of the borrower.
Banks are responsible for ensuring customer‘s credit worthiness before providing them with
clean overdraft as there is no assets securing the amount of advance. The banks normally take
guarantee from the persons whom they believe to be credit worthy.

Question No. 44
Euro Bond and Foreign Bond [December 2017] (2.5 Marks)

Answer:
Euro Bond and Foreign Bond
A Eurobond is denominated in a currency other than the home currency of the country or market
in which it is issued. These bonds are frequently grouped together by the currency in which they
are denominated, such as eurodollar or euroyen bonds. Issuance is usually handled by an
international syndicate of financial institutions on behalf of the borrower, one of which may
underwrite the bond, thus guaranteeing purchase of the entire issue. Eurobonds are issued
outside the restrictions that apply to domestic offerings. The earliest eurobonds were physically
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delivered to investors. As of 2016, they are issued electronically through a range of services,
including the Depository Trust Company (DTC) in the United States and the Certificate less
Registry for Electronic Share Transfer (CREST) in the United Kingdom. Eurobonds are usually
issued in bearer form, which makes it easier for investors to avoid regulations and taxes.
Foreign bonds, unlike Eurobonds, are issued in a single country and are usually denominated in
that country‘s currency. Often, the country in which these bonds are issued will draw
distinctions between them and bonds issued by domestic issuers—including different tax laws,
restrictions on the amount issued, and tougher disclosure rules. Foreign bonds often are
nicknamed for the country where they are issued Yankee bonds (United States), Samurai bonds
(Japan), Rembrandt bonds (the Netherlands), Bulldog bonds (Britain). Partly because of tougher
regulations and disclosure requirements, the foreign bond market hasn‘t grown in past years
with the vigor of the Eurobond market.

Question No. 45
Venture capital [June 2018] (2.5 Marks)

Answer:
Venture Capital is long term equity investments in such business which has the potentiality for
significant growth and high return on capital. The main futures of venture capital investment are:
(i) Providing finance to entrepreneurial talents;
(ii) Providing capital to persons having management skills;
(iii) Expecting a high return in the form of capital gain.
The venture capital schemes are designed to promote technological advancement and innovation
through introduction of new products, process or plants and equipment's. The activities, which
are in general needs venture capital support, are:
 Commercial production of viable new process products
 Technological up gradation including adoption of imported technology suitable to local
conditions.
 Energy conservation with innovative technology.
 Commercial exploitation of proven technology.
Thus venture capital involves in risky ventures in technology development and long gestation
technology development projects. Venture capital normally enters at the different stages in the
projects viz.
 Early Stage
Seed Capital is provided to entrepreneur for concept formulation or start-up capital for
commercial exploitation of proven product.
 Expansion Financing
Finance is provided either for major expansion of the commercial production or for working
capital support. The firm of investment takes many shapes. The most common forms are equity
purchase, conditional loans, income notes and participation debentures.

Question No. 46
Digital money and Crypto currencies [June 2018] (2.5 Marks)
Answer:
Digital money exists only in the digital form. It doesn‘t have any physical equivalent in the real
world. Nevertheless, it has all the characteristics of traditional money. Digital currencies don‘t
have geographical or political borders; transactions might be sent from any place and received at
any point in the world. Actually, digital accounts and digital wallets may be regarded as bank
deposits.
Whereas, crypto currency is an asset used as a means of exchanging. It is considered reliable
because it‘s based on cryptography. It creates and analyzes the algorithms and protocols so no
information is changed or interrupted during the conversation by third parties. Cryptocurrencies

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use Block chain and a decentralized ledger. It means that no supervisory authority controls all
the actions in the network. This comes at the expanse of all the users.
Though crypto currency is a type of digital currency, there are some fundamental differences.
Structure: Digital currencies are centralized; there is a group of people and computers that
regulates the state of the transactions in the network. Crypto currencies are decentralized, and
the regulations are made by the majority of the community.
Anonymity: In general, digital currencies require user identification. One needs to upload a photo
and some documents issued by the public authorities. Buying, investing and any other processes
with crypto currencies do not need require any of that. Nevertheless, crypto currencies are not
fully anonymous. Though the addresses don‘t contain any confidential information such as
name, residential address, etc., each transaction is registered; the senders and the receivers are
publicly known. Thus, all the transactions are tracked.
Transparency: Digital currencies are not transparent. One cannot choose the address of the
wallet and see all the money transfers. This information is confidential. Crypto currencies are
transparent. Everyone can see any transactions of any user, since all the revenue streams are
placed in a public chain.
Transaction manipulation: Digital currencies have a central authority that deals with issues. It
can cancel or freeze transactions upon the request of the participant or authorities or on
suspicion of fraud or money-laundering. Crypto currencies are regulated by the community.
Legal aspects: Most countries have some legal framework for digital currencies, but official
status for cryptocurrency is not defined. The establishment of the legal framework is only in the
process.

Question No. 47
Debt securitization [December 2018] (2.5 Marks)

Answer:
Securitization is a process in which illiquid assets are pooled into marketablesecurities that can
be sold to investors. The process leads to the creation of financial instruments that represent
ownership interest in, or are secured by a segregated income producing asset or pool of assets.
These assets are generally secured by personal or real property such as automobiles, real estate,
or equipment loans but in some cases are unsecured.
For example, a finance company has issued a large number of car loans. It desires to raise
further cash so as to be in a position to issue more loans. One way to achieve this goal is by
selling all the existing loans, however, in the absence of a liquid secondary market for individual
car loans, this may not be feasible. Instead, the company pools a large number of these loans and
sells interest in the pool to investors. This process helps the company to raise finances and get
the loans off its Balance Sheet. These finances shall help the company disburse further loans.

Question No. 48
Virtual banking and its advantage [December 2018] (2.5 Marks)
Answer:
Virtual banking refers to the provision of banking and related services through the use of
information technology without direct recourse to the bank by the customer. The advantages of
virtual banking services are as follows:
 Lower cost of handling a transaction.
 The increased speed of response to customer requirements.
 The lower cost of operating branch network along with reduced staff costs leads to cost
efficiency.
 Virtual banking allows the possibility of improved and a range of services being made
available to the customer rapidly, accurately and at his convenience.

Question No. 49
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Venture capital and Private equity [December 2018] (2.5 Marks)

Answer:
Venture capital is a risk capital and is regarded as a subset of private equity. It is generally raised
to specifically finance startups and small and medium sized private companies with strong
growth potential whereas the private equity also has component of development capital and
buyout capital that is targeted to mature businesses that are already established.
Development capital refers to the pool of capital raised to finance for expansion of businesses
while buy-out capital refers to pool of fund raised through investors and management team,
usually together with borrowed money, to buy a business from its current owners.
Effectively, therefore the private equity consists of venture capital, development capital and in
certain cases buyout capital (when buyouts are not adequately financed by banks).
The private equity is generally held in private companies or such public companies that are not
traded in stock exchanges.

Question No. 49
Repurchase agreements [June 2019] (2.5 Marks)

Answer:
A repurchase agreement is an agreement to buy any securities from a seller on the understanding
that they will be repurchased at some specified price and time in the future. However, since the
length of any repurchase agreement (or ‗repo‘) is likely to be short, a matter of months at most, it
is customary to think of repos as a form of short-term finance and therefore, logically, as being
an alternative to other money market transactions. The effect of the repo deal falls upon money
market prices and yields, it is normal to regard such repos as money market deals.
In a repo, the seller is the equivalent of the borrower and the buyer is the lender. The repurchase
price is higher than the initial sale price, and the difference in price constitutes the return to the
lender. Deals are quoted on a yield basis.
Some repo deals are genuine sales. In these circumstances, the lender owns the securities and can
sell them in the case of default. In some repo contracts, however, what is created is more strictly
a collateralized loan with securities acting as collateral while remaining in the legal ownership of
the borrower. In the case of default, the lender has only a general claim on the lender and so the
margin is likely to be greater.

Question No. 50
Distinguish between: [June 2019, 2.5 Marks]
b) Mezzanine debt and Subordinated debt
Answer:
Mezzanine debt is subordinated debt with some forms of equity enhancement attached. Regular
subordinated debt just requires the borrowing company to pay interest and principal. With
mezzanine debt, the lender has a piece of the action in the company's business. The equity kicker
in a mezzanine loan can be in the form of attached stock warrants or bonus payments to the
lender based on the valuation of the company. Warrants are used with publicly traded companies
and other forms of equity participation will be attached to the mezzanine debt of closely held
corporations.
The use of mezzanine debt provides benefits to both lenders and the borrowing company. The
company taking out the debt gets to borrow at a lower rate than it would pay on straight
subordinated debt. The lender gets the benefit of participating in the better results forecast by the
additional borrowing. If the borrower is successful in putting the newly borrowed mezzanine
financing to work, the return to the lender will be much higher than just providing a subordinated
loan.
Mezzanine debt can also be used to orchestrate the orderly transfer of ownership of a company
headed for bankruptcy. In bankruptcy, the equity shareholders are typically wiped out and lose
the ownership in the company. The equity position attached to the mezzanine debt then becomes
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the primary equity ownership in the company. This strategy allows a lender to become the owner
of a troubled company using the bankruptcy courts.

Question No. 51
Distinguish between:
a) Financial lease and Operating lease [June 2019, 2.5 Marks]

Answer:
In the case of finance lease, risk and reward incident to ownership are passed on the lessee. The
lessor only remains the legal owner of the asset. The lessee bears the risk of obsolescence. The
lease is non-cancellable by either party under it. The lessor does not bear the cost of repairs,
maintenance or operations. The lease is usually full payout.
In the case of operating lease, lessee is only provided the use of the asset for a certain time. Risk
incident to ownership belongs only to the lessor. The lessor bears the risk of obsolescence. The
lease is kept cancellable by the lessor. Usually, the lessor bears the cost of repairs, maintenance
or operations. The lease is usually non-payout.

*****

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