Cost of Capital

CA Amit Sharma

5 COST OF CAPITAL
CHAPTER
Q.1 Effective Cost of Capital MTP May 19(2)
Annova Ltd is considering raising funds of about Rs.250 lakhs by any of two alternative methods, viz., 14%
institutional term loan and 13% non-convertible debentures. The term loan option would attract no major incidental
cost and can be ignored. The debentures would have to be issued at a discount of 2.5% and would involve cost of
issue of 2% on face value.
ADVISE the company as to the better option based on the effective cost of capital in each case. Assume a tax
rate of 50%.

Ans. Calculation of Effective Cost of Capital:

Particulars Option 1 Option 2
14% institutional Term 13% Non-convertible
loan (Rs. in Lakhs) Debentures (Rs. in lakhs)
(A) Effective capital to be raised Face value 250.00 250.00
Less: Discount Nil (6.25)
250.00 243.75
Less: Cost of issue Nil 5.00
Effective amount of capital 250.00 238.75
(B) Annual interest charges on face value of 35.0 32.50
Rs. 250 lakhs
Less: Tax benefit on interest @ 50% 17.5 16.25
17.5 16.25
(C) Effective cost of capital after tax
B 16.25
x 100 x100
A 238.75

= 7.0% = 6.81% (approx)

So, the better option is raising of funds of Rs.250 lakhs by issue of 13% Non-convertible Debenture

Q.2 Implied Rate of Return MTP May 22(1)

PRI Ltd. and SHA Ltd. are identical, however, their capital structure (in market-value terms) differs as follows:
Company Debt Equity
PRI Ltd. 60% 40%
SHA Ltd. 20% 80%

The borrowing rate for both companies is 8% in a no-tax world and capital markets are assumed to be perfect.
(a) (i) If Mr. Rhi, owns 6% of the equity shares of PRI Ltd., DETERMINE his return if the Company has
net operating income of ` 9,00,000 and the overall capitalization rate of the company (Ko) is 18%.

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(ii) CALCULATE the implied required rate of return on equity of PRI Ltd.
(b) SHA Ltd. has the same net operating income as PRI Ltd.
(i) CALCULATE the implied required equity return of SHA Ltd.
(ii) ANALYSE why does it differ from that of PRI Ltd.

Ans. Value of PRI Ltd. = NOI 9,00,000= 50,00,000

Ko 18%
(a) (i) Return on Shares of Mr. Rhi on PRI Ltd.
Particulars Amount (`)
Value of the company 50,00,000
Market value of debt (60% x ` 50,00,000) 30,00,000
Market value of shares (40% x ` 50,00,000) 20,00,000
Particulars Amount (`)
Net operating income 9,00,000
Interest on debt (8% × ` 30,00,000) 2,40,000
Earnings available to shareholders 6,60,000
Return on 6% shares (6% × ` 6,60,000) 39,600

660000
(ii) Implied required rate of return on equity of PRI Ltd. = =33%
2000000

(b) (i) Calculation of Implied rate of return of SHA Ltd.

Particulars Amount (`)

Total value of company 50,00,000
Market value of debt (20% × ` 50,00,000) 10,00,000
Market value of equity (80% × ` 50,00,000) 40,00,000
Particulars Amount (`)
Net operating income 9,00,000
Interest on debt (8% × ` 10,00,000) 80,000
Earnings available to shareholders 8,20,000
820000
Implied required rate of return on equity = = 20.5%
4000000
(ii) Implied required rate of return on equity of SHA Ltd. is lower than that of PRI Ltd. because SHA
Ltd. uses less debt in its capital structure. As the equity capitalisation is a linear function of the
debt-to-equity ratio when we use the net operating income approach, the decline in required equity
return offsets exactly the disadvantage of not employing so much in the way of “cheaper” debt
funds.

Q.3 Cost of Debt (Kd) RTP Nov 22

Bounce Ltd. evaluates all its capital projects using discounting rate of 15%. Its capital structure consists of
equity share capital, retained earnings, bank term loan and debentures redeemable at par. Rate of interest
on bank term loan is 1.5 times that of debenture. Remaining tenure of debenture and bank loan is 3 years and 5

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years respectively. Book value of equity share capital, retained earnings and bank loan is ` 10,00,000, ` 15,00,000
and ` 10,00,000 respectively. Debentures which are having book value of ` 15,00,000 are currently trading at `
97 per debenture. The ongoing P/E multiple for the shares of the company stands at 5. You are required to
CALCULATE the rate of interest on bank loan and debentures if tax rate applicable is 25%.

Ans. Let the rate of Interest on debenture be x

 Rate of Interest on loan = 1.5x
RV − NP 100 − 97
Int (1 − t ) + 100x (1 − 25) +
n 3 75x + 1
 Kd on debentures = = =
RV + NP 100 + 97 98.5
2 2
 Kd on bank loan= 1.5x (1-0.25) =1.125x
FPS 1 1 1
Ke= = = = = 0.2
MPS MPS EPS P 5
E
KY = Ke = 0.2
Computation of WACC
Capital Amount (`) Weights Cost Product
Equity 10,00,000 0.2 0.2 0.04
Reserves 15,00,000 0.3 0.2 0.06
Debentures 15,00,000 0.3 (75x+1)/98.5 (22.5x + 0.3)/98.5
Bank Loan 10,00,000 0.2 1.125x 0.225x
50,00,000 1 0.1 + 0.225x +
22.5x + 0.3
98.5

WACC = 15%
22.5x 0.3
 0.1 + 0.225x + + = 0.15
98.5 98.5
 9.85+22.1625x+22.5x+0.3=(0.15)(98.5)
 44.6625x=14.775-9.85-0.3
 44.625x-4.625
4.625
x =
44.6625
 x=10.36%
 Rate of interest on debenture=x =10.36%
Rate of interest on Bank loan=1.5x = (1.5) (10.36%) = 15.54%

Q. 4 Cost of Debt (Kd) PY Nov 20

TT Ltd. issued 20,000, 10% convertible debenture of ` 100 each with a maturity period of 5 years. At maturity
the debenture holders will have the option to convert debentures into equity shares of the company in ratio of
1:5 (5 shares for each debenture). The current market price of the equity share is ` 20 each and historically the
growth rate of the share is 4% per annum. Assuming tax rate is 25%. Compute the cost of 10% convertible
debenture using Approximation Method and Internal Rate of Return Method.PV Factor are as under:

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Year 1 2 3 4 5

PV Factor @ 15% 0.870 0.756 0.658 0.572 0.497

Ans. Determination of Redemption value:

Higher of-
(i) The cash value of debentures = `100
(ii) Value of equity shares = 5 shares × ` 20 (1+0.04)5
= 5 shares × ` 24.333
= `121.665 rounded to `121.67
`121.67 will be taken as redemption value as it is higher than the cash option and attractive to the
investors.
Calculation of Cost of 10% Convertible debenture

(i) Using Approximation Method:

(RV − NP ) 10(1 − 0.25) + (121.67 − 100)
I (1 − t ) +
n 5 7.5 + 4.334
Kd= = = =10.676%
(RV + NP ) (121.67 + 100) 110.835
2 2
(ii) Using Internal Rate of Return Method
Year Cash Discount Present Discount Present
flows factor @ Value factor @ Value
(`) 10% 15% (`)
0 100 1.000 (100.00) 1.000 (100.00)
1 to 5 7.5 3.790 28.425 3.353 25.148
5 121.67 0.621 75.557 0.497 60.470
NPV +3.982 -
14.382
NPVL 3.982
IRR= L + NPV − NPV (H − L) = 10% + 3.982 − (−14.382) (15% − 10%)
L L

=0.11084 or 11.084% (approx.)

Q.5 Cost of Debt / Equity / WACC RTP May 18

Navya Limited wishes to raise additional capital of `10 lakhs for meeting its modernisation plan. It has ` 3,00,000
in the form of retained earnings available for investments purposes. The following are the further details:

Debt/ equity mix 40%/60%

Cost of debt (before tax)
Upto ` 1,80,000 10%
Beyond ` 1,80,000 16%
Earnings per share `4
Dividend pay out `2
Expected growth rate in dividend 10%

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Current market price per share ` 44

Tax rate 50%

Required:
(i) To DETERMINE the pattern for raising the additional finance.
(ii) To CALCULATE the post-tax average cost of additional debt.
(iii) To CALCULATE the cost of retained earnings and cost of equity, and
(iv) To DETERMINE the overall weighted average cost of capital (after tax).

Ans. (i) Pattern of Raising Additional Finance

Equity = 10,00,000 × 60/100 = ` 6,00,000
Debt = 10,00,000 × 40/100 = ` 4,00,000

Capital structure after Raising Additional Finance

Sources of fund Amount(`)
Shareholder’s funds
Equity capital (6,00,000 – 3,00,000) 3,00,000
Retained earnings 3,00,000
Debt at 10% p.a. 1,80,000
Debt at 16% p.a. (4,00,000 −1,80,000) 2,20,000
Total funds 10,00,000

(ii) Post-tax Average Cost of Additional Debt

Kd=I(1-t), where ‘Kd’ is cost of debt, ‘l’ is interest and ‘t’ is tax rate.

On ‘1,80,000=10%(1-0.5)=5% or 0.05

On ‘2,20,000=16% (1-0.5)=8% or 0.08

Average Cost of Debt (Post tax) i.e.

(1,80, 000x 0.05) + (2,20, 000x 0.08)

Kd= x 100 = 6.65%
4, 00, 000
(iii) Cost of Retained Earnings and Cost of Equity applying Dividend Growth Model
D1 D(1 + g ) + g
Ke= +a or
P0
1
2(1.1) 2.2
Then, Ke= + 0.10 = + 0.10 = 0.15 or 15%
4 44
(iv) Overall Weighted Average Cost of Capital (WACC) (After Tax)
Particulars Amount (`) Weights Cost of WACC
Capital
Equity (including 6,00,000 0.60 15% 9.00
retained earnings)
Debt 4,00,000 0.40 6.65% 2.66
Total 10,00,000 1.00 11.66

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Q.6 Cost of Debt / Equity / Marginal RTP Jul 21

Indel Ltd. has the following capital structure, which is considered to be optimum as on 31st March, 2021:
Particulars (`)
14% Debentures 60,000
11% Preference shares 20,000
Equity Shares (10,000 shares) 3,20,000
4,00,00

The company share has a market price of ` 47.20. Next year dividend per share is 50% of year 2020 EPS. The
0 which is expected to continue in future.
following is the uniform trend of EPS for the preceding 10 years

Year EPS (`) Year EPS (`)

2011 2.00 2016 3.22
2012 2.20 2017 3.54
2013 2.42 2018 3.90
2014 2.66 2019 4.29
2015 2.93 2020 4.72

The company issued new debentures carrying 16% rate of interest and the current market price of debenture is
` 96. Preference shares of ` 18.50 (with annual dividend of ` 2.22 per share) were also issued. The company is in
30% tax bracket.

The company is in 30% tax bracket.

(A) CALCULATE after tax:

(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (assuming new equity from retained earnings)
(B) CALCULATE marginal cost of capital when no new shares are issued.
(C) DETERMINE the amount that can be spent for capital investment before new ordinary shares must be
sold, assuming that the retained earnings for next year’s investment is 50 percent of earnings of 2020.
(D) COMPUTE marginal cost of capital when the fund exceeds the amount calculated in assuming new equity
is issued at ` 40 per share?

Ans. (A) (i) Cost of new debt

I (1 − t ) 16(1 − 0.3)
Kd= = = 0.11667
P0 96
(ii) Cost of new preference shares
2.22
Kp = = 0.12
18.5

(iii) Cost of new equity shares

D1 2.36
Ke = +g = + 0.10
P0 47.20
Ke = 0.05 + 0.10 = 0.15

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Calculation of g when there is a uniform trend (on the basis of EPS)

EPS(2012) − EPS(2011) 2.20 − 2.00
= = 0.10 or 10%
EPS(2011) 2.00
Calculation of D1
D1 = 50% of 2020 EPS = 50% of ` 4.72 = ` 2.36

(B) Calculation of marginal cost of capital

Type of Capital Proportion Specific Cost Product
(1) (2) (3) (2) × (3) = (4)
Debentures 0.15 0.11667 0.0175
Preference Share 0.05 0.1200 0.0060
Equity Share 0.80 0.1500 0.1200

Marginal cost of capital 0.1435

(C) The company can spend the following amount without increasing marginal cost of capital and without
selling the new shares:
Retained earnings = 50% of EPS of 2020 × outstanding equity shares
= 50% of ` 4.72 × 10,000 shares = ` 23,600
The ordinary equity (Retained earnings in this case) is 80% of total capital
So, ` 23,600 = 80% of Total Capital

(D) If the company spends in excess of ` 29,500, it will have to issue new equity shares at ` 40 per share.
 The cost of new issue of equity shares will be:
D1 `2.36
Ke= +g= + 0.10 = 0.159
P0 `40
The marginal cost of capital will be:
Type of Capital Proportion Specific Cost Product
(1) (2) (3) (2) × (3) =
Debentures 0.15 0.11667 (4) 0.0175

Preference Shares 0.05 0.1200 0.0060

Equity Shares (New) 0.80 0.1590 0.1272

Marginal cost of 0.1507

capital
Q.7 Cost of Debt / Preference PY May 22
A company issues:

• 15% convertible debentures of ` 100 each at par with a maturity period of 6 years. On maturity, each
debenture will be converted into 2 equity shares of the company. The risk - free rate of return is 10%,
market risk premium is 18% and beta of the company is 1.25. The company has paid dividend of ` 12.76 per
share. Five year ago, it paid dividend of 10 per share. Flotation cost is 5% of issue amount.

• 5% preference shares of ` 100 each at premium of 10%. These shares are redeemable after 10 years at
par. Flotation cost is 6% of issue amount.

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Assuming corporate tax rate is 40%.

(i) Calculate the cost of convertible debentures using the approximation method.
(ii) Use YTM method to calculate cost of preference shares.

Year 1 2 3 4 5 6 7 8 9 10
PVIF 0.03, 0.97 0.94 0.91 0.88 0.86 0.83 0.81 0.78 0.76 0.74
t
PVIF 0.05, 1
0.95 3
0.90 5
0.86 8
0.82 3
0.78 7
0.74 3
0.711 9
0.67 6
0.64 4
0.61
t
PVIFA 2
0.97 7
1.913 4
2.82 3
3.71 4
4.58 6
5.41 6.23 7
7.02 5
7.78 4
8.53
0.03,
PVIFAt 10.95 1.85 9
2.72 7
3.54 0
4.32 7
5.07 0
5.78 0
6.46 6
7.10 0
7.72
0.05, t 2 9 3 6 9 6 6 3 8 2

Interest rate 1% 2% 3% 4% 5% 6% 7% 8% 9%
FVIF i, 5 1.051 1.104 1.159 1.217 1.27 1.33 1.40 1.46 1.53
FVIF i, 6 1.06 1.126 1.194 1.26 6
1.34 8
1.419 3
1.501 9
1.58 9
1.67
FVIF i, 7 2
1.07 1.149 1.23 5
1.316 0
1.40 1.50 1.60 7
1.714 7
1.82
2 0 7 4 6 8
Ans. (i) Calculation of Cost of Convertible Debentures:

Given that,

RF = 10% Rm-Rt = 18%

B= 1.25% D0 = 12.76

D-5 = 10 Flotation Cost = 5%

Using CAPM,

Ke = Rt+ β(Rm-Rf) = 10%+1.25(18%)

= 32.50%

Calculation of growth rate in dividend

12.76 = 10 (1+g)5

1.276 = (1+g)5

(1+5%) = 1.276……… from FV Table

g = 5%

D7 12.76(1.05)7
Price of share after 6 years = =
ke − g 0.325 − 0.5 7

12.75x1.407
P6 = = 65.28
0.275

Redemption Value of Debenture (RV) = 65.28 × 2 = 130.56 (RV)

NP = 95 n=6

(RV − NP ) 9 + 5.93
INT (1 − t ) + X 100
Kd = n X 100 = 112.78
[RV − NP ]
2
Kd = 13.24%

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(ii) Calculation of Cost of Preference Shares:

Net Proceeds = 100(1.1)-6% of 100 (1.1)

= 110-6.60

= 103.40
Redemption Value = 100

Year Cash Flows (`) PVF @ 3% PV (`) PVF @ 5% PV (`)

0 103.40 1 103.40 1 103.40
1-10 -5 8.530 -42.65 7.722 -38.61
10 -100 0.744 -74.40 0.614 -61.40
- 3.39
13.65
5% − 3%
Kp= 3%+ x 13.65 = 4.6%
[3.39 − ( −13.65)]

Q.8 Cost of Debt / Equity / WACC PY Nov 19

A Company wants to raise additional finance of ` 5 crore in the next year. The company expects to retain ` 1crore
earning next year. Further details are as follows:

(i) The amount will be raised by equity and debt in the ratio of 3: 1.

(ii) The additional issue of equity shares will result in price per share being fixed at ` 25.

(iii) The debt capital raised by way of term loan will cost 10% for the first ` 75 lakh and 12% for the next `50
lakh.

(iv) The net expected dividend on equity shares is ` 2.00 per share. The dividend is expected to grow at the
rate of 5%.

(v) Income tax rate is 25%.

You are required:

(a) To determine the amount of equity and debt for raising additional finance.

(b) To determine the post-tax average cost of additional debt.

(c) To determine the cost of retained earnings and cost of equity.

(d) To compute the overall weighted average cost of additional finance after tax .

Ans (a) Determination of the amount of equity and debt for raising additional finance:
Pattern of raising additional finance
Equity 3/4 of ` 5 Crore = ` 3.75 Crore
Debt 1/4 of ` 5 Crore = ` 1.25 Crore

The capital structure after raising additional finance:

Particulars (` Incrore)

Shareholders’ Funds
Equity Capital (3.75 – 1.00) 2.75

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Retained earnings 1.00

Debt (Interest at 10% p.a.) 0.75
(Interest at 12% p.a.) (1.25-0.75) 0.50
Total Funds 5.00

(b) Determination of post-tax average cost of additional debt

Kd = I(1-t)
Where,
I= Interest Rate
t = Corporate tax-rate
On ` 75,00,000= 10% (1 – 0.25) = 7.5% or 0.075
On ` 50,00,000= 12% (1 – 0.25) = 9% or 0.09
Average Cost of Debt
(75, 00, 000x 0.75) + (50, 00, 000x 0.09)
= x 100
1,25, 00, 000
5, 62,500 + 4,50, 000
= x 100 = 8.10%
1,25, 00, 000

(c) Determination of cost of retained earnings and cost of equity (Applying Dividend growth model):
D1
Ke= +g
P0
Where,
Ke= Cost of equity
D1= D0(1+g)
D0= Dividend paid (ie= Rs2)
g = Growth rate
P0= Current market price per share
2(1.05) 2.1
Then, Ke= + 0.05 = + 0.05 = 0.084 + 0.05 = 0.134 = 13.4%
25 25
Cost of retained earnings equals to cost of Equity i.e. 13.4%

(d) Computation of overall weighted average after tax cost of additional finance

Particular (`) Weights Cost of Weighted

funds Cost (%)
Equity (including 3,75,00,000 3/4 13.4% 10.05
retained earnings)
Debt 1,25,00,000 1/4 8.1% 2.025
WACC 5,00,00,000 12.075

Q.9 Cost of Debt / Equity MTP Nov 23(1)

ABC Company’s equity share is quoted in the market at ` 30 per share currently. The company pays a dividend of `
3 per share and the investor’s market expects a growth rate of 7% per year.

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You are required to:

(i) CALCULATE the company’s cost of equity capital.

(ii) If the company issues 10% debentures of face value of ` 100 each and realises ` 95 per debenture while the
debentures are redeemable after 10 years at a premium of 10%, CALCULATE cost of debenture using
YTM?
Assume Tax Rate to be 50%.

Ans. (i) Cost of Equity Capital (Ke):

Expected dividend per share(D1)

Ke= + Growth rate(g)
Market price per share(P0)

3x1.07
= + 0.07 = 0.177 or 17.7%
30

(ii) Cost of Debenture (Kd):

Using Present Value method (YTM)
Identification of relevant cash flows

Year Cash flows

0 Current market price (P 0) = ` 95

1 to 10 Interest net of tax [I(1-t)] = 10% of ` 100 (1 – 0.5) = ` 5

10 Redemption value (RV) = ` 100 (1.10) = ` 110

Calculation of Net Present Values (NPV) at two discount rates

Year Cash Discount factor Present Discount factor Present
flows @ 5% (L) Value (`) @ 10% (H) Value (`)
0 (`)(95) 1.000 (95.00) 1.000 (95.00)
1 to 10 5 7.722 38.61 6.145 30.725
10 110 0.614 67.54 0.386 42.46
NPV +11.15 -21.815

Calculation of IRR

NPVL
IRR = L + (H − L)
NPVL − NPVH

`11.15 `55.75
5% + (10% − 5%) = 5% + = 6.69%
`11.15 − (`−21.815) `32.965

Therefore, Kd= 6.69%

Q.10 Cost of Equity MTP May 22(1)

Following information is given for WN Ltd.:

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Earnings Rs 30 per share

Dividend Rs 9 per share

Cost of capital 15%

Internal Rate of Return on investment 20%

You are required to CALCULATE the market price per share using-
(i) Gordon’s formula

(ii) Walter’s formula

Ans. (i) As per Gordon’s Model, Price per share is computed using the formula:

E1(1 −b )
P0=
Ke −br

Where,

P0= Price per share

E1 = Earnings per share

b = Retention ratio; (1-b= Pay-out ratio)

Ke= Cost of capital

r = IRR

br = Growth rate (g)

Applying the above formula, price per share

30x 0.3 * 9
P0= = =`900
0.15 − 0.70x 0.2 0.01

9
*Dividend pay-out ratio= = 0.3 or 0.3
30

(ii) As per Walter’s Model, Price per share is computed using the formula:

r
D+ (E − D )
Price (P)= Ke
k
e

Where,

P = Market Price of the share

E = Earnings per share
D = Dividend per share
Ke= Cost of equity/ rate of capitalization/ discount rate
r = Internal rate of return/ return on investment
Applying the above formula, price per share

0.20
9+ (30 − 9)
0.15 37
P= = = 246.67
0.15 0.15

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Q.11 Cost of Debt / Equity MTP Dec 21(2)

XYZ Company’s equity share is quoted in the market at ` 25 per share currently. The company pays a dividend of `
5 per share and the investor’s market expects a growth rate of 5% per year.

You are required to:

(i) CALCULATE the company’s cost of equity capital.

(ii) If the company issues 12% debentures of face value of ` 100 each and realises ` 95 per debenture while
the debentures are redeemable after 10 years at a premium of 12%, CALCULATE cost of debenture using
YTM?

Ans. (i) Cost of Equity Capital (Ke):

Expected dividend per share(D1)

Ke= + Growthrate( g )
Marketpricepershare(P0)

5x1.05
= + 0.05 = 26%
25

(iii) Cost of Debenture (Kd): Using Present Value method (or YTM)

Identification of relevant cash flows

Year Cash flows

0 Current market price (P0) = ` 95

1 to 10 Interest net of tax [I(1-t)] = 12% of ` 100 (1 – 0.30) = `

8.40
10 Redemption value (RV) = ` 100 (1.12) = ` 112

Calculation of Net Present Values (NPV) at two discount rates

Year Cash Discount factor Present Discount factor Present

flows @ 9% (L) Value @ 10% (H) Value

0 (95) 1.0000 (95.00) 1.0000 (95.00)

1 to 10 8.40 6.4176 53.91 6.1445 51.61

10 112 0.4224 47.31 0.3855 43.18

NPV +6.22 -0.21

Calculation of IRR

NPVL
IRR= L + (H − L)
NPVL −NPVH

6.22 6.22
9% + (10% − 9%) = 9% + = 9.97%
6.22 − ( −0.21) 6.43

Therefore,Kd= 9.97%

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Q.12 Cost of Debt / Equity MTP May 21(2)

In March 2021 Tiruv Ltd.'s share was sold for Rs. 219 per share. A long-term earnings growth rate of 11.25% is
anticipated. Tiruv Ltd. is expected to pay a dividend of Rs. 5.04 per share.

(i) DETERMINE the rate of return an investor can expect to earn assuming that dividends are expected to grow
along with earnings at 11.25% per year in perpetuity?
(ii) It is expected that Tiruv Ltd. will earn about 15% on book equity and shall retain 60% of earnings. In this
case, whether there would be any change in growth rate and cost of equity? ANALYSE.

Ans. (i) According to Dividend Discount Model approach the firm’s expected or required return on equity is
computed as follows:
D1
K e= +g
P0

Where,

Ke= Cost of equity share capital

D1= Expected dividend at the end of year 1

P0= Current market price of the share.
g = Expected growth rate of dividend.
5.04
Therefore, Ke = + 0.1125 = 13.55%
219
(ii) With rate of return on retained earnings (r) of 15% and retention ratio (b) of 60%, new growth rate
will be as follows:
g = br = 0.60 x 0.15 = 0.09 or 9%
Accordingly, dividend will also get changed and to calculate this, first we shall calculate previous
retention ratio (b1) and then EPS assuming that rate of return on retained earning (r) is same.
With previous Growth Rate of 11.25% and r =15%, the retention ratio comes out to be:
0.1125 = b1 x 0.15
b1= 0.75 and payout ratio = 0.25
With 0.25 payout ratio, the EPS will be as follows:
5.04
EPS= = Rs 20.16
0.25
With new payout ratio of 40% (1 – 0.60) the new dividend will be:
D1= Rs 20.16 x 0.40 = Rs. 8.064
Accordingly new Ke will be:
8.064
Ke= + 0.09 = 12.68%
219
Q.13 Cost of Equity/ Marginal PY Nov 22

MR Ltd. is having the following capital structure, which is considered to be optimum as on 31.03.2022.

Equity share capital (50,000 shares) ` 8,00,000

12% Pref. share capital ` 50,000

15% Debentures ` 1,50,000

` 10,00,000

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The earnings per share (EPS) of the company were ` 2.50 in 2021 and the expected growth in equity dividend is
10% per year. The next year's dividend per share (DPS) is 50% of EPS of the year 202I. The current market
price per share (MPS) is ` 25.00. The 15% new debentures can be issued by the company. The company's
debentures are currently selling at ` 96 per debenture. The new 12% Pref. share can be sold at a net price of `
91.50 (face value ` 100 each). The applicable tax rate is 30%.
You are required to calculate
(a) After tax cost of
(i) New debt,
(ii) New pref. share capital and
(iii) Equity shares assuming that new equity shares come from retained earnings. (b) Marginal cost of capital,
How much can be spent for capital investment before sale of new equity shares assuming that retained
earnings for next year investment is 50% of 2021?

Ans (a) (i) After tax cost of new Debt:

I (1 − t ) 15(1 − 0.3)
Kd = =
P1 96

= 0.1094 (or) 10.94%

(ii) After tax cost of New Preference share capital:
PD  12 
Kp = =   = 0.1311 (or) 13.11%
P0  91.5 
(iii) After tax cost of Equity shares:
 D1   (2.50x 50%) 
Ke=  +g =  + 0.10

 p0   25 
=0.15 (or) 15%

(b) Marginal Cost of Capital

Type of capital Proportions Specific cost Product
Equity Shares 0.80 0.15 0.12
Preference Shares 0.05 0.1311 0.0066
Debentures 0.15 0.1094 0.0164
Marginal cost of capital 0.1430

(c) Amount that can be spend for capital investment

Retained earnings = 50% of EPS x No. of outstanding Equity shares
= 1.25 x 50,000

Proportion of equity (Retained earnings here) capital is 80% of total capital.

Therefore, ` 62,500 is 80% of total capital.

62,500
 Amount of Capital Investment= =`78,125
0.80

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Q.14 Cost of Equity/ Debt/ WACC PY July 21

Following are the information of TT Ltd.:

Particulars
Earnings per share ` 10

Dividend per share `6

Expected growth rate in Dividend 6%

Current market price per share ` 120

Tax Rate 30%

Requirement of Additional Finance ` 30 lakhs

Debt Equity Ratio (For additional finance) 2:1

Cost of Debt

0-5,00,000 10%

5,00,001 - 10,00,000 9%

Above 10,00,000 8%

Assuming that there is no Reserve and Surplus available in TT Ltd.

You are required to:
(a) Find the pattern of finance for additional requirement
(b) Calculate post tax average cost of additional debt
(c) Calculate cost of equity
(d) Calculate the overall weighted average after tax cost of additional finance.

Ans. (a) Pattern of raising additional finance

Equity 1/3 of ` 30,00,000 = ` 10,00,000
Debt 2/3 of ` 30,00,000 = ` 20,00,000
The capital structure after raising additional finance:
Particulars (`)
Shareholder’s Funds
Equity Capital 10,00,000
Debt (Interest at 10% p.a.) 5,00,000
(Interest at 9% p.a.) 5,00,000
(Interest at 8% p.a.) 10,00,000
Total Funds 30,00,00
0
(b) Determination of post-tax average cost of additional debt
Kd= I(1-t)
Where, I = Interest Rate
t = Corporate tax-rate
On First ` 5,00,000 = 10% (1 – 0.3) = 7% or 0.07
On Next ` 5,00,000 = 9% (1 – 0.3) = 6.3% or 0.063
On Next ` 10,00,000 = 8% (1 – 0.3) = 5.6% or 0.056

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(5, 00, 000x 0.07) + (5, 00, 000x 0.63) + (10, 00, 000x 0.056)
Average Cost of Debt = x 100 = 6.125%
20, 00, 000

(c) Determination of cost of equity applying Dividend growth model:

D1
Ke= +g
P0
Where,
Ke = Cost of equity
D1 = D0 (1+ g)
D0 = Dividend paid
g = Growth rate = 6%
P0 = Current market price per share = ` 120

6(1 + 0.06) 6.36

Ke = + 0.06 = + 0.06 = 0.113 or 11.3%
120 120
(d) Computation of overall weighted average after tax cost of additional finance
Particulars (`) Weights Cost of funds Weighted Cost (%)
Equity 10,00,000 1/3 11.3% 3.767
Debt 20,00,000 2/3 6.125% 4.083

WACC 30,00,000 7.85

Alternative Solution

(a) Pattern of raising additional finance

Equity 1/3 of ` 30,00,000 = ` 10,00,000
Debt 2/3 of ` 30,00,000 = ` 20,00,000

The capital structure after raising additional finance:

Particulars (`)
Shareholders’ Funds
Equity Capital 10,00,000
Debt (Interest at 8% p.a.) 20,00,000
Total Funds 30,00,000

(b) Determination of post-tax average cost of additional debt

Kd= I(1-t)

Where,
I= Interest Rate
T= Corporate tax-rate
Kd = 8%(1-0.3)= 5.6%

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(c) Determination of cost of equity applying Dividend growth model:

D1
Ke = +g
P0
Where,
Ke = Cost of equity
D1 = D0 (1+ g)
D0 = Dividend paid
g = Growth rate =6%
P0 = Current market price per share = ` 120

6(1 + 0.06) 6.36

Then, Ke = + 0.06 = + 0.06 = 0.113 or 11.3%
120 120
(d) Computation of overall weighted average after tax cost of additional finance

Particulars (`) Weights Cost of funds Weighted Cost (%)

Equity 10,00,000 1/3 11.3% 3.767
Debt 20,00,000 2/3 5.6% 3.733
WACC 30,00,000 7.50

Q.15 Cost of Retained Earn / WACC RTP Nov 23

Jason Limited is planning to raise additional finance of ` 20 lakhs for meeting its new project plans. It has `
4,20,000 in the form of retained earnings available for investment purposes. Further details are as following:

Debt / Equity Mix 30 / 70

Cost of Debt 8 % (before tax)
Upto ` 3,60,000 12 % (before
Beyond ` 3,60,000 tax)
Earnings per share `4
Dividend pay-out 50% of earnings
Current Market Price per share ` 44
Expected Growth rate in Dividend 10 %
Tax 40%

You are required:

(a) To determine the cost of retained earnings and cost of equity.
(b) To determine the post-tax average cost of additional debt.
(c) To determine the pattern for raising the additional finance, and
(d) Compute the overall weighted average after tax cost of additional finance.

Ans. (a) Cost of Equity / Retained Earnings (using dividend growth model)
D1
Ke=
P0
Where D1= Do (1 + g) = 2 (1 + .10) = 2.2
2.2
Ke= + 0.10 = 0.15 or 15 %
44

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(b) Cost of Debt (Post Tax)

Kd = I (1-t)
Upto 3,60,000 Kd = .08 (1-0.4) = 0.048
Beyond 3,60,000 = .12 (1-0.4) = 0.072
Thus, post-tax cost of additional debt = 0.048 x 3,60,000 / 6,00,000 + 0.072 x
2,40,000/ 6,00,000 = 0.0288 + 0.0288 = 0.0576 or 5.76%

(c) Pattern for Raising Additional Finance

Debt = 20,00,000 x 30% = 6,00,000
Equity = 20,00,000 x 70 % = 14,00,000
Out of this total equity amount of ` 14,00,000
Equity Shares = 14,00,000 – 4,20,000 = 9,80,000
And Retained Earnings = 4,20,000

(d) Overall Weighted Average after tax cost of additional finance

WACC = Kd x Debt Mix + Ke x Equity Mix = 0.0576 x 30% + 0.15 x 70% =0.01728+0.105 = 0.1223 or
12.23% (approx.

Q.16 WACC PY May 19

Alpha Ltd. has furnished the following information :
- Earning Per Share (EPS) `4
- Dividend payout ratio 25%
- Market price per share ` 50
- Rate of tax 30%
- Growth rate of dividend 10%
The company wants to raise additional capital of ` 10 lakhs including debt of ` 4 lakhs. The cost of debt (before
tax) is 10% up to ` 2 lakhs and 15% beyond that. Compute the after tax cost of equity and debt and also
weighted average cost of capital

Ans. (i) Cost of Equity Share Capital (Ke)

D0(1+ g ) 25% of 4 (1 + 0.10) 1.10

Ke= +g= + 0.10 = + 0.10 = 0.122 or 12.2%
P0 50 50
(ii) Cost of Debt (Kd)
Interest
Kd= x100x (1 − t )
Net Proceeds
Interest on first 2,00,000 @ 10%= 20,000
Interest on next 2,00,000 @ 15%= 30,000
50, 000
Kd= x (1 − 0.3) = 0.0875 or 8.75%
4, 00, 000
(iii) Weighted average cost of capital (WACC)
Source of Amount (` ) Weights Cost of Capital WACC (%)
capital (%)
Equity shares 6,00,000 0.60 12.20 7.32

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Debt 4,00,000 0.40 8.75 3.50

T otal 10,00,000 1.00 10.82

Alternatively Cost of Equity Share Capital (Ke) can be calculated as

D 25% of 4 1.00
Ke = +g= + 0.10 = + 0.10 = 0.120 or 12.00%
P0 50 50
Accordingly
Weighted Average Cost of Capital (WACC)
Source of Amount (` ) Weights Cost of WACC (%)
capital Capital (%)
Equity shares 6,00,000 0.60 12.00 7.20
Debt 4,00,000 0.40 8.75 3.50
T otal 10,00,000 1.00 10.70

Q.17 WACC RTP Nov 18

M/s. Navya Corporation has a capital structure of 40% debt and 60% equity. The company is presently
considering several alternative investment proposals costing less than ` 20 lakhs. The corporation always raises
the required funds without disturbing its present debt equity ratio.

The cost of raising the debt and equity are as under:

Project cost Cost of debt Cost of equity
Upto ` 2 lakhs 10% 12%
Above ` 2 lakhs & upto to ` 5 lakhs 11% 13%
Above ` 5 lakhs & upto `10 lakhs 12% 14%
Above `10 lakhs & upto ` 20 lakhs 13% 14.5%

Assuming the tax rate at 50%, CALCULATE:

(i) Cost of capital of two projects X and Y whose fund requirements are ` 6.5 lakhs and
` 14 lakhs respectively.
(ii) If a project is expected to give after tax return of 10%, DETERMINE under what conditions it would be
acceptable?
Ans. (i) Statement of Weighted Average Cost of Capital
Project cost Financing Proportion of After tax Weighted
capital cost average cost (%)
Structure (1–Tax 50%)
Upto ` 2 Lakhs Debt 0.4 10% (1 – 0.5) 0.4 × 5 = 2.0
= 5%
Equity 0.6 12% 0.6 × 12 = 7.2

9.2%

Above ` 2 lakhs Debt 0.4 11% (1 – 0.5) 0.4 × 5.5 = 2.2

& upto to ` 5 = 5.5%
Lakhs
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Equity 0.6 13% 0.6 × 13 = 7.8

10.0%
Above ` 5 lakhs Debt 0.4 12% (1 – 0.5) 0.4 × 6 = 2.4
& upto ` 10 lakhs = 6%
Equity 0.6 14% 0.6 × 14 = 8.4

10.8%
Above ` 10 lakhs Debt 0.4 13% (1 – 0.5) 0.4 × 6.5 = 2.6
& upto ` 20 lakhs = 6.5%
Equity 0.6 14.5% 0.6 × 14.5 = 8.7

11.3%

Project Fund requirement Cost of capital

X `6.5 lakhs 10.8% (from the above table)
Y `14 lakhs 11.3% (from the above table)

(ii) If a Project is expected to give after tax return of 10%, it would be acceptable provided its project cost
does not exceed ` 5 lakhs or, after tax return should be more than or at least equal to the weighted average
cost of capital.

Q.18 WACC MTP Nov 23(2)

Q Ltd. has the following capital structure at book-value as on 31st March 2022:
Particulars (`)
Equity share capital (10,00,000 shares) 4,00,00,00

12% Preference shares 0

11% Debentures 80,00,000

6,80,00,000
2,00,00,00
The equity shares of the company are sold for ` 400. It is expected
0 that the company will pay next year a
dividend of ` 20 per equity share, which is expected to grow by 5% p.a. forever. Assume a 30% corporate tax
rate.
Required:
(i) COMPUTE weighted average cost of capital (WACC) of the company based on the existing capital structure.
(ii) COMPUTE the new WACC, if the company raises an additional ` 50 lakhs debt by issuing 12% debentures.
This would result in increasing the expected equity dividend to ` 25 and leave the growth rate unchanged, but
the price of equity share will fall to ` 300 per share.

Ans. (i) Computation of Weighted Average Cost of Capital based on existing capital structure

Source of Capital Existing Weights After tax WACC (%)

Capital cost of
structure (a) capital (%) (a) × (b)
Equity share capital (W.N.1) 4,00,00,000
(`) 0.588 10.00
(b) 5.88
12% Preference share capital 80,00,000 0.118 12.00 1.42

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11% Debentures (W.N.2) 2,00,00,000 0.294 7.70 2.26

Total 6,80,00,000 1.000 9.56

Working Notes:
1. Cost of Equity Capital:
Expected dividend(D1)
Ke = + Growth( g )
Current Market Price(P0)

20
= + 0.05
400
= 10%
2. Cost of 10% Debentures
Interest(1 − t )
Kd =
Net Proceeds
22, 00, 000(1 − 0.30)
=
2, 00, 00, 000
= 0.077 or 7.7%

(ii) Computation of Weighted Average Cost of Capital based on new capital structure
Source of Capital New Capital Weights After tax WACC (%)
structure cost of
(`) (a) capital (%) (a) x (b)
Equity share capital (W.N.3) 4,00,00,000 0.548 13.33
(b) 7.30
12% Preference share capital 80,00,000 0.110 12.00 1.32
11% Debentures (W.N.2) 2,00,00,000 0.274 7.70 2.11
12% Debentures (W.N.4) 50,00,000 0.068 8.40 0.57
Total 7,30,00,000 1.000 11.30
Working Notes:

3. Cost of Equity Capital:

25
Ke = + 0.05
300
=13.33%

4. Cost of 12% Debentures

6, 00, 000(1 − 0.30)
Kd =
50, 00, 000
= 0.084 or 8.4%

Q.19 WACC MTP May 22(1)

The capital structure of a Company is given below:

Source of capital Book Value

Equity shares @ ` 100 each (`) 24,00,000

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9% Cumulative preference shares @ ` 100 each 4,00,000

11% Debentures 12,00,000

40,00,000
The company had paid equity dividend @ 25% for the last year which is likely to grow @ 5% every year. The
current market price of the company’s equity share is ` 200.
Considering corporate tax @ 30%, you are required to CALCULATE:
(i) Cost of capital for each source of capital.
(ii) Weighted average cost of capital.

Ans. (i) Calculation of Cost of Capital for each source of capital:

(a) Cost of Equity share capital:
D0 (1 + g ) 25%x100(1 + 0.05)
Ka = +g= + 0.05
Market Pr icepershare(P0) 200

26.26
= + 0.05 = 0.18125 or 18.125%
200
(b) Cost of Preference share capital (Kp)= 9%
(c) Cost of Debentures (Kd) = r (1 – t)
= 11% (1 – 0.3) = 7.7%
(ii) Weighted Average Cost of Capital

Source Amount Weights After tax Cost WACC (%)

(`) of
Capital
Equity share 24,00,000 (a)
0.60 18.125
(%) (c) = 10.875
(a)

9% Preference share 4,00,000 0.10 9.000 (b)0.900

(b)
11% Debentures 12,00,000 0.30 7.700 2.310
40,00,000 1.00 14.08
5
Q.20 WACC MTP May 21(1)
The following is the capital structure of Sharda Ltd. as on 31.12.2020:
(`)
Equity shares: 2,00,000 shares (of ` 100 each) 2,00,00,000
9% Preference Shares (of ` 100 each) 60,00,000
8% Debentures 90,00,000

The market price of the company’s share is ` 120 and it is expected that a dividend of ` 12 per share would be
declared for the year 2021. The dividend growth rate is 5% and the company is in the 30% tax bracket.
(i) CALCULATE the company’s weighted average cost of capital.
(ii) Further, in order to finance an expansion plan, the company intends to borrow a fund of ` 2 crores bearing
12% rate of interest. In this situation, WHAT will be the company’s revised weighted average cost of capital?
This financing decision is expected to increase dividend from ` 12 to ` 14 per share. However, the market price
of equity share is expected to decline from ` 120 to ` 115 per share.

In case of both (i) and (ii) above, use market value weight while calculating weighted average cost of capital

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Ans. (i) Computation of the weighted average cost of capital

Source of Market Weight After tax WACC (%)
finance Value of Cost of
capital (`) (b) capital (%) (d) = (b) × (c)
Equity share (Working
(a) note 1) 2,40,00,000 0.6154 (c)
15 9.231
[`120 × 2,00,000 shares]
9% Preference share 60,00,000 0.1538 9 1.3842
8% Debentures 90,00,000 0.2308 5.60 1.2925
3,90,00,000 1.0000 11.9077

(ii) Computation of Revised Weighted Average Cost of Capital

Source of Market Weight After tax WACC (%)
finance Value of Cost of
capital capital (%)
Equity shares (Working note 2) (`)
2,30,00,000 (b)
0.3966 (c) 17.17 (d) = (b) × (c)
6.8096
(a)
[`115 × 2,00,000 shares]
9% Preference shares 60,00,000 0.1034 9.00 0.9306
8% Debentures 90,00,000 0.1552 5.60 0.8691
12% Loan 2,00,00,000 0.3448 8.40 2.8963
5,80,00,000 1.0000 11.5056

Working Notes:
(1) Cost of Equity Shares
Ke = {Dividend Per Share (D1)/Market Price Share (P0)} + Growth Rate
= 12/120 + 0.05
= 0.15 or 15%

(2) Revised cost of equity shares (Ke) Revised Ke

= 14/115 + 0.05
= 0.1717 or 17.17%

Q.21 WACC MTP May 20

ABC Limited has the following book value capital structure:
Equity Share Capital (1 crore shares @ Rs.10 each) Rs.1,000 lakh
Reserves and Surplus Rs.2,250 lakh
9% Preference Share Capital (5 lakh shares @ Rs.100 each) Rs.500 lakh
8.5% Debentures (1.5 lakh debentures @ Rs.1,000 each) Rs.1,500 lakh
12% Term Loans from Financial Institutions Rs.500 lakh

The debentures of ABC Limited are redeemable at par after five years and are quoting at Rs.985 per debenture.
The current market price per equity share is Rs.60. The prevailing default-risk free interest rate on 10-year GOI
Treasury Bonds is 5.5%. The average market risk premium is 7%. The beta of the company is 1.85

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The preference shares of the company are redeemable at 10% premium after 5 years is currently selling at
Rs.102 per share.The applicable income tax rate for the company is 35%.
Required: CALCULATE weighted average cost of capital of the company using market value weights.

Ans. Working Notes:

(1) Computation of cost of debentures (Kd) :
(1, 000 − 985)
85(1 − 0.35) +
5 55.25 + 3
Kd= = = 0.0586 or 5.86%
(1, 000 + 985) 992.5
2
(2) Computation of cost of term loans (KT) :
=r(1-t)
0.12(1-0.35) = 0.078 or 7.8%
(3) Computation of cost of preference capital (KP) :
Pr eference Dividend+(RV-NP)/n
Kp =
(RV + NP ) / 2
(110 − 102)
9+
5 9 + 1.6
= = 0.1 or 10%
(110 + 102) 106
2
(4) Computation of cost of equity (Ke) :
= Rf + ß(Rm – Rf)
Or, = Risk free rate + (Beta × Risk premium)
= 0.055 + (1.85 0.07) = 0.1845 or 18.45%

Calculation of Weighted Average cost of capital Using market value weights

Source of Capital Market value of Weights After tax WACC (%)
capital structure cost of
(Rs. in lakh) capital (%)
Equity share capital
(1 crore shares × Rs.60 ) 6,000 0.71 18.45 13.09

9% Preference
share capital
(5 lakh shares Rs.102) 510 0.06 10.00 0.60

8.5 % Debentures
(1.5 lakh Rs.985) 1,477.5 0.17 5.86 0.99

12% Term loans 500 0.06 7.80 0.47

8,487.50 1.000 15.15

Q.22 WACC MTP Nov 18(2)

PQR Ltd. has the following capital structure on October 31, 20X8:
Sources of capital (Rs.)
Equity Share Capital (2,00,000 Shares of Rs. 10 each) 20,00,000
Reserves & Surplus 20,00,000

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12% Preference Shares 10,00,000

9% Debentures 30,00,000
80,00,000
The market price of equity share is Rs. 30. It is expected that the company will pay next year a dividend of Rs.
3 per share, which will grow at 7% forever. Assume 40% income tax rate.
You are required to COMPUTE weighted average cost of capital using market value weights.

D1 3
Ans. (i) Cost of Equity (Ke) = +g= + 0.07 = 0.1 + 0.07 = 0.17 = 17%
P0 30
(ii) Cost of Debentures (Kd) = 9 % (1-0.4) = 5.6%

Computation of Weighted Average Cost of Capital (WACC using market value weights)
Source of capital Market Weight Cost of capital WACC (%)
Value of (%)
9% Debentures 30,00,000
capital (Rs.) 0.30 5.40 1.62
12% Preference Shares 10,00,000 0.10 12.00 1.20
Equity Share Capital 60,00,000 0.60 17.00 10.20
(Rs.30 × 2,00,000 shares)
Total 1,00,00,000 1.00 13.02

Q.23 WACC MTP Nov 18(1)

PQR Ltd. has the following capital structure on October 31, 20X8:
Sources of capital (Rs.)
Equity share capital (2,00,000 shares of Rs.10 each) 20,00,000
Reserves & surplus 20,00,000
12% Preference share capital 10,00,000
9% Debentures 30,00,000
80,00,000

The market price of equity share is Rs. 30. It is expected that the company will pay next year a dividend of Rs.
3 per share, which will grow at 7% forever. Assume 40% income tax rate.
You are required to COMPUTE weighted average cost of capital using market value weights.

Ans. Workings:
D1 3
(i) Cost of Equity (Ke) = +g= + 0.07 = 0.1+0.07 = 0.17 = 17%
Po 30
(ii) Cost of Debentures (Kd) = I (1 - t) = 0.09 (1 - 0.4) = 0.054 or 5.4%

Computation of Weighted Average Cost of Capital (WACC using market value weights)
Source of capital Market Value Weight Cost of capital WACC (%)
of capital (%)
(Rs.)
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9% Debentures 30,00,000 0.30 5.40 1.62

12% Preference Shares 10,00,000 0.10 12.00 1.20
Equity Share Capital 60,00,000 0.60 17.00 10.20
(Rs. 30 × 2,00,000 shares)
Total 1,00,00,000 1.00 13.02

Q.24 WACC MTP Nov18(1)

JKL Ltd. has the following book-value capital structure as on March 31, 20X8.
(Rs.)
Equity share capital (2,00,000 shares) 40,00,000
11.5% Preference shares 10,00,000
10% Debentures 30,00,000
80,00,000

The equity shares of the company are sold at Rs. 20. It is expected that the company will pay next year a dividend
of Rs. 2 per equity share, which is expected to grow by 5% p.a. forever. Assume a 35% corporate tax rate.

Required:
(i) COMPUTE weighted average cost of capital (WACC) of the company based on the existing capital structure.

(ii) COMPUTE the new WACC, if the company raises an additional Rs. 20 lakhs debt by issuing 12% debentures.
This would result in increasing the expected equity dividend to Rs. 2.40 and leave the growth rate unchanged, but
the price of equity share will fall to Rs.16 per share.

Ans. (i) Computation of Weighted Average Cost of Capital based on existing capital structure
Existing Capital Weights After tax WACC (%)
Source of Capital structure cost of
(Rs.) capital (%)

Equity share capital (W.N.1) 40,00,000 (a)

0.500 (b) 15.00 (a) 7.500
(b)

11.5% Preference share capital 10,00,000 0.125 11.50 1.437

(W.N.2)
10% Debentures (W.N.3) 30,00,000 0.375 6.50 2.438
80,00,000 1.000 11.375
Working Notes (W.N.)
1. Cost of equity capital:
ExpectedDividend(D1 )
Ke= + Growth( g )
CurrentMarket Pr iceperShare(P0)

2
+ 0.05 = 0.15 or 15 %
20
2. Cost of preference share capital:
Annual preference share dividend(PD)
=
Netproceed sin theissueofpreferenceshare(NP )

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1,15, 000
= 0.115 or 11.5%
10, 00, 000

3. Cost of 10% Debentures:

I (1 − t ) 3, 00, 000(1 − 0.35)
= = = 0.065 or 6.5%
NP 30, 00, 000

(ii) Computation of Weighted Average Cost of Capital based on new capital structure
Source of Capital New Capital Weights After tax WACC (%)
structure cost of
(Rs.) capital (%)
(b) (a) (b)
Equity share capital (W.N. 4) 40,00,000 0.40 (a) 20.00 8.00
Preference share (W.N. 2) 10,00,000 0.10 11.50 1.15
10% Debentures (W.N. 3) 30,00,000 0.30 6.50 1.95
12% Debentures (W.N.5) 20,00,000 0.20 7.80 1.56
1,00,00,000 1.00 12.66
Working Notes (W.N.):
4. Cost of equity capital:
ExpectedDividend (D1 ) 2.40
Ke= + Growth( g ) = + 5% = 20%
CurrentMarket Pr icepershare(P0 ) 16

5. Cost of 12% Debentures

2, 40, 000(1 − 0.35)
Kd= = 0.078 or 7.8%
20, 00, 000

Q.25 WACC MTP May 18

G Limited has the following capital structure, which it considers to be optimal
Capital Structure Weightage (in %)
Debt 25
Preference Shares 15
Equity Shares 60
100
G Limited’s expected net income this year is ` 34,285.72, its established dividend payout ratio is 30 per cent, its
tax rate is 40 per cent, and investors expect earnings and dividends to grow at a constant rate of 9 per cent in
the future. It paid a dividend of ` 3.60 per share last year, and its shares currently sells at a price of ` 54 per
share.G Limited requires additional funds which it can obtain in the following ways:

• Preference Shares: New preference shares with a dividend of ` 11 can be sold to the public at a price of
`95 per share.

• Debt: Debt can be sold at an interest rate of 12 per cent. You are required to:

(i) DETERMINE the cost of each capital structure component; and

(ii) COMPUTE the weighted average cost of capital (WACC) of G Limited.

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Ans. (i) Computation of Costs of Different Components of Capital:

(a) Equity Shares:
D1 D0 (1 + g )
Ke= +g= +g
P0 P0
3.60(1.09)
= + 0.09 = 0.0727 + 0.09 = 16.27%
54
(b) Preference Shares:
Pr eference Share Dividend 11
Kp = = = 11.58%
P0 95
(c) Debt at 12%
Kd (1 – t) = 12% (1 – 0.4) = 12% × 0.6 = 7.20%.
(ii) Weighted Average Cost of Capital (WACC)

WACC = WdKd + WpKp + WeKe

WACC = 0.25 (7.2%) + 0.15 (11.58%) + 0.60 (16.27%)

= 1.8 + 1.737 + 9.762 = 13.30%.

Q.26 WACC PY Nov 22

The following is the extract of the Balance Sheet of M/s KD Ltd.:

Particulars Amount (`)
Ordinary shares (Face Value ` 10/- per share) 5,00,000
Share Premium 1,00,000
Retained Profits 6,00,000
8% Preference Shares (Face Value `25/- per share) 4,00,000
12% Debentures (Face value `100/- each) 6,00,000

22,00,000
The ordinary shares are currently priced at ` 39 ex-dividend and preference share is priced at ` 18 cum-dividend.
The debentures are selling at 120 percent ex-interest. The applicable tax rate to KD Ltd. is 30 percent. KD Ltd.'s
cost of equity has been estimated at 19 percent. Calculate the WACC (weighted average cost of capital) of KD
Ltd. on the basis of market value.

Ans. W.N. 1
Cum-dividend price of Preference shares = ` 18

Less: Dividend (8/100) x 25 =`2

 Market Price of Preference shares = ` 16
2
Kp = = 0.125 (or) 12.5%
16
 4, 00, 000 
No. of Preference shares =   = 16,000
 25 
W.N. 2
 120 
Market price of Debentures =   x 100 = Rs 120
 100 

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 12(1 − 0.3) 
Kd=   = 0.07 (or) 7%
 120 
 6, 00, 000 
No. of Debentures =   = 6,000
 100 

W.N.3
Market Price of Equity shares = Rs 39
Ke (given) = 19% or 0.19
No. of Equity shares = 5, 00, 000 = 50,000

Sources Marke Nos. Total Weight Cost of Product

t Market Capital
Value value (`)
Equity Shares 39 50,000 19,50,000
(`) 0.6664 0.19 0.1266
Preference Shares 16 16,000 2,56,000 0.0875 0.125 0.0109
Debentures 120 6,000 7,20,000 0.2461 0.07 0.0172
WACC = 0.1547
WACC = 0.1547 or 15.47%

Q.27 WACC MTP Nov 22(2)

The financial advisor of Sun Ltd is confronted with following two alternative financing plans for raising
` 10 lakhs that is needed for plant expansion and modernization
Alternative I: Issue 80% of funds with 14% Debenture [Face value (FV) ` 100] at par and redeem at a
1
premium of 10% after 10 years and balance by issuing equity shares at 33 % premium.
3
Alternative II: Raise 10% of funds required by issuing 8% Irredeemable Debentures [Face value (FV)
` 100] at par and the remaining by issuing equity shares at current market price of `125. Currently, the firm has
an Earnings per share (EPS) of ` 21
The modernization and expansion programme is expected to increase the firm’s Earnings before Interest and
Taxation (EBIT) by ` 200,000 annually.
The firm’s condensed Balance Sheet for the current year is given below:
Balance Sheet as on 31.3.2022
Liabilities Amount (`) Assets Amount (`)
Current Liabilities 5,00,000 Current Assets 16,00,000
10% Long Term Loan 15,00,000 Plant & Equipment (Net) 34,00,000
Reserves & Surplus 10,00,000
Equity Share Capital (FV: ` 100 each) 20,00,000
TOTAL 50,00,000 TOTAL 50,00,000

However, the finance advisor is concerned about the effect that issuing of debt might have on the firm. The
average debt ratio for firms in industry is 35%.He believes if this ratio is exceeded, the P/E ratio of the company
will be 7 because of the potentially greater risk.
If the firm increases its equity capital by more than 10 %, he expects the P/E ratio of the company will increase
to 8.5 irrespective of the debt ratio.

Assume Tax Rate of 25%. Assume target dividend pay-out under each alternative to be 60% for the next year
and growth rate to be 10% for the purpose of calculating Cost of Equity

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SUGGEST with reason which alternative is better on the basis of each of the below given criteria:
I. Earnings per share (EPS) & Market Price per share (MPS)
II. Financial Leverage
III. Weighted Average Cost of Capital & Marginal Cost of Capital (using Book Value weights)

Ans. Calculation of Equity Share capital and Reserves and surplus: Alternative 1:
2, 00, 000 x100
Equity Share capital = `20,00,000+ = 21,50,000
133.3333
2, 00, 000 x33.3333
Reserves= `10,00,000 + =`10,50,000
133.3333
Alternative 2:
9, 00, 000x 100
Equity Share capital = ` 20,00,000 + =`27,20,000
125
9, 00, 000x 100
Reserves= `10,00,000 + =`11,80,000
125
Capital Structure Plans
Amount in `
Capital Alternative 1 Alternative 2
Equity Share capital 21,50,000 27,20,000
Reserves and surplus 10,50,000 11,80,000
10% long term debt 15,00,000 15,00,000
14% Debentures 8,00,000 -
8% Irredeemable Debentures - 1,00,000
Total Capital Employed 55,00,000 55,00,000
Computation of Present Earnings before interest and tax (EBIT)
EPS (`) 21
No. of equity shares 20,000
Earnings for equity shareholders (I x II) (`) 4,20,000
Profit Before Tax (III/75%) (`) 5,60,000
Interest on long term loan (1500000 x 10%) (`) 1,50,000
EBIT (IV + V) (`) 7,10,000
EBIT after expansion = `7,10,000 +` 2,00,000 = `9,10,000
Evaluation of Financial Plans on the basis of EPS, MPS and Financial Leverage
Amount in `
Particulars Alternative I Alternate II
EBIT 9,10,000 9,10,000
Less: Interest: 10% on long term loan (1,50,000) (1,50,000)
14% on Debentures (1,12,000) Nil
8% on Irredeemable Debentures Nil. (8000)
PBT 6,48,000 7,52,000
Less: Tax @25% (1,62,000) (1,88,000)
PAT 4,86,000 5,64,000
No. of equity shares 21,500 27,200
EPS 22.60 20.74
Applicable P/E ratio (Working Note 1) 7 8.5
MPS (EPS X P/E ratio) 158.2 176.29
Financial Leverage EBIT/PBT 1.40 1.21

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Working Note 1
Alternative I Alternative II
Debt:
`15,00,000 +`8,00,000 23,00,000 -
`15,00,000 +`1,00,000 - 16,00,000
Total capital Employed (`) 55,00,000 55,00,000
Debt Ratio (Debt/Capital employed) =0.4182 =0.2909
=41.82% =29.09%
Change in Equity: `21,50,000-`20,00,000 1,50,000
`27,20,000-`20,00,000 7,20,000
Percentage change in equity 7.5% 36%
Applicable P/E ratio 7 8.5

Calculation of Cost of equity and various type of debt

Alternative I Alternative II
A) Cost of equity
EPS 22.60 20.74
DPS (EPS X 60%) 13.56 12.44
Growth (g) 10% 10%
Po (MPS) 158.2 176.29
Ke= Do (1 + g)/ Po 13.56 (1.1) 12.44(1.1)
158.2 176.29
=9.43% =7.76%
B) Cost of Debt:
10% long term debt 10% + (1-0.25) 10% +(1-0.25)
= 7.5% = 7.5%
14% redeemable debentures 14(1 − 0.25) + (110 − 100 / 10) nil
110 + 100 / 2
= 10.5 + 1 / 10.5
= 10.95%
8% irredeemable debenture NA 8000(1-0.25)/1,00,00 = 6%

Calculation of Weighted Average cost of capital (WACC)

Alternative 1 Alternative 2
Capital Weights Cost (%) WACC Weights Cost (%) WACC
Equity Share Capital 0.3909 9.43 3.69% 0.4945 7.76 3.84%
Reserves and Surplus 0.1909 9.43 1.80% 0.2145 7.76 1.66%
10% Long term Debt 0.2727 7.50 2.05% 0.2727 7.50 2.05%
14% Debenture 0.1455 10.95 1.59%
8% Irredeemable Debentures - 0.0182 6 0.11%
9.12% 7.66%

Calculation Marginal Cost of Capital (MACC)

Alternative 1 Alternative 2

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Amount(weight) Cost Amount (weight) Cost MACC

Capital (%) MACC (%)
Equity Share Capital ` 1,50,000(0.15) 9.43 1.41% `7,20,000(0.72) 7.76 5.59%
Reserves and Surplus ` 50,000(0.05) 9.43 0.47% `1,80,000(0.18) 7.76 1.40%
14% Debenture ` 8,00,000(0.80) 10.95 8.76% - 0.00%
8% Irredeemable
Debentures - `1,00,000(0.10) 6 0.60%
Total Capital Employed `10,00,000 10.65% `10,00,000 7.58%

Summary of solution:
Alternate I Alternate II
Earning per share (EPS) 22.60 20.74
Market price per share (MPS) 158.20 176.29
Financial leverage 1.4043 1.2101
Weighted Average cost of capital (WACC) 9.12% 7.66%
Marginal cost of capital (MACC) 10.65% 7.58%

Alternative 1 of financing will be preferred under the criteria of EPS, whereas Alternative II of financing
will be preferred under the criteria of MPS, Financial leverage, WACC and marginal cost of capital.

Q.28 WACC / Marginal MTP Nov 19

ABC Ltd. has the following capital structure which is considered to be optimum as on 31st March, 2019
(Rs.)
14% Debentures 30,00,000
11% Preference shares 10,00,000
Equity Shares (10,000 shares) 1,60,00,000
2,00,00,000

The company share has a market price of Rs. 236. Next year dividend per share is 50% of year 2019 EPS. The
following is the trend of EPS for the preceding 10 years which is expected to continue in future.
Year EPS (Rs.) Year EPS Rs.)
2010 10.00 2015 16.10
2011 11.00 2016 17.70
2012 12.10 2017 19.50
2013 13.30 2018 21.50
2014 14.60 2019 23.60
The company issued new debentures carrying 16% rate of interest and the current market price of debenture is
Rs. 96.
Preference share Rs. 9.20 (with annual dividend of Rs. 1.1 per share) were also issued. The company is in 50% tax
bracket.

(A) CALCULATE after tax:

(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (consuming new equity from retained earnings)
(B) CALCULATE marginal cost of capital when no new shares are issued.
(C) COMPUTE the amount that can be spent for capital investment before new ordinary shares must

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be sold. Assuming that retained earnings for next year’s investment are 50 percent of 2019.
(D) COMPUTE marginal cost of capital when the funds exceeds the amount calculated in (C), assuming new
equity is issued at Rs. 200 per share?

Ans (A) (i) Cost of new debt

I(1-t)
Kd =
p
16(1-0.5)
= = 0.0833
96
(ii) Cost of new preference shares
PD 1.1
Kp = = =0.12
p 9 .2
(iii) Cost of new equity shares
D
Ke = 1 + g
P

11.80
= + 0.10 + 0.05 + 0.10 = 0.15
236

Calculation of D1
D1 = 50% of 2019 EPS = 50% of 23.60 = Rs. 11.80.

(B) Calculation of marginal cost of capital

Type of Capital Proportion Specific Cost Product
(1) (2) (3) (2) × (3) = (4)
Debenture 0.15 0.0833 0.0125
Preference Share 0.05 0.12 0.0060
Equity Share 0.80 0.15 0.1200
Marginal cost of capital 0.1385

(C) The company can spend the following amount without increasing marginal cost of capital and without selling
the new shares:
Retained earnings = (0.50) (236 × 10,000) = Rs. 11,80,000
The ordinary equity (Retained earnings in this case) is 80% of total capital = 80% of Total Capital
11, 80, 000
Capital investment before issuing equity = = Rs.14,75,000
0.80
(D) If the company spends in excess of Rs.14,75,000 it will have to issue new shares.
11.80
The cost of new issue will be = + 0.10 = 0.159
200
The marginal cost of capital will be:

Type of Capital Proportion Specific Cost Product

(1) (2) (3) (2) × (3) = (4)
Debentures 0.15 0.0833 0.0125
Preference Shares 0.05 0.1200 0.0060
Equity Shares (New) 0.80 0.1590 0.1272
0.1457

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Q.29 WACC RTP Dec 21

Kalyanam Ltd. has an operating profit of ` 34,50,000 and has employed Debt which gives total Interest Charge
of ` 7,50,000. The firm has an existing Cost of Equity and Cost of Debt as 16% and 8% respectively. The firm
has a new proposal before it, which requires funds of ` 75 Lakhs and is expected to bring an additional profit of
` 14,25,000. To finance the proposal, the firm is expecting to issue an additional debt at 8% and will not be issuing
any new equity shares in the market. Assume no tax culture.
You are required to CALCULATE the Weighted Average Cost of Capital (WACC) of Kalyanam Ltd.:
(i) Before the new Proposal
(ii) After the new Proposal

Ans. Workings:
Interest
(a) Value of Debt =
cost of debt (kd )

7 , 50, 000
= = ` 93,75,000
0.08

Operating profit - Interest

(b) Value of equity capital =
Cost of equity (Ke )

34, 50, 000 − 7 , 50, 000

= = ` 1,68,75,000
0.16

(c) New Cost of equity (Ke) after proposal

Increased Operating profit - Interest on Increased debt
=
Equity capital

(34, 50, 000 + 14,25, 000) − (7 , 50, 000 + 6,00, 000)

=
1,68,75, 000

48, 75, 000 - 13,50,000 35,25, 000

= = = 0.209 or 20.9%
1, 68, 7500 1, 68, 75000

(i) Calculation of Weighted Average Cost of Capital (WACC) before the new proposal

Sources Amount (`) Weight Cost of Capital WACC

Equity 1,68,75,000 0.6429 0.160 0.1029
Debt 93,75,000 0.3571 0.080 0.0286
Total 2,62,50,000 1 0.1315 or 13.15 %

(ii) Calculation of Weighted Average Cost of Capital (WACC) after the new proposal

Sources Amount (`) Weight Cost of Capital WACC

Equity 1,68,75,000 0.5000 0.209 0.1045
Debt 1,68,75,000 0.5000 0.080 0.0400
Total 3,37,50,000 1 0.1445 or 14.45 %

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Q.30 WACC before & after Proposal RTP Maay 20

PK Ltd. has the following book-value capital structure as on March 31, 2020.

(`)

Equity share capital (10,00,000 shares) 2,00,00,000

11.5% Preference shares 60,00,000
10% Debentures 1,00,00,000
3,60,00,000
The equity shares of the company are sold for ` 200. It is expected that the company will pay next year a dividend
of ` 10 per equity share, which is expected to grow by 5% p.a. forever. Assume a 35% corporate tax rate.
Required:
(i) COMPUTE weighted average cost of capital (WACC) of the company based on the existing capital
structure.
(ii) COMPUTE the new WACC, if the company raises an additional `50 lakhs debt by issuing 12% debentures.
This would result in increasing the expected equity dividend to `12.40 and leave the growth rate
unchanged, but the price of equity share will fall to ` 160 per share.

Ans (i) Computation of Weighted Average Cost of Capital based on existing capital structure
Source of Capital Existing Weights (a) After tax cost WACC (%)
Capital of capital (%) (a) X(b)
structure (`) (b)
Equity share capital 2,00,00,000 0.555 10.00 5.55
(W.N.1)
11.5% Preference share 60,00,000 0.167 11.50 1.92
capital
10% Debentures (W.N.2) 1,00,00,000 0.278 6.50 1.81
3,60,00,000 1.000 9.28
Working Notes (W.N.):
1. Cost of equity capital:
Expected Dividend (D1 )
Ke = + Growth (g)
Current Market Priceper share (po)
10
= + 0.05
200
= 10%
2. Cost of 10% Debentures:
I (1 − t) 10,00,000(1-0.35)
= = = 0.065 or 6.5%
NP 100,00,000
(ii) Computation of Weighted Average Cost of Capital based on new capital structure

Source of Capital New Capital Weights After tax cost WACC (%)
structure (`) (b) of capital (%)(a) (a) X (b)
Equity share capital (W.N. 3) 2,00,00,000 0.488 12.75 6.10
Preference share 60,00,000 0.146 11.50 1.68
10% Debentures (W.N. 2) 1,00,00,000 0.244 6.50 1.59
12% Debentures (W.N.4) 50,00,000 0.122 7.80 0.95
4,10,00,000 1.00 10.32

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Working Notes (W.N.):

3. Cost of equity capital:
ExpectedDividend (D1 )
Ke = + Growth (g)
Current MarketPriceper share(P0 )
12.4
+ 0.05 = 0.1275 or 12.75%
160
4. Cost of 12% Debentures
6,00,000(1-0.35)
= = 0.078 or 7.8%
50,00,000
24,0000(1-0.35)
Kd = = 0.078 or 7.8%
20,00,000

Q.31 WACC before & after proposal MTP May 22(2)

Genzy Ltd. is planning to introduce a new product with a project life of 10 years. The initial equipment cost will
be ` 2.5 crores. At the end of 10 years, the equipment will have a resale value of 50 lakhs. A working capital of `
30,00,000 will be needed and it will be released at the end of the tenth year. The project will be financed with
the following capital sources.
Particulars Amount (`) Issue Price
(Market price)
Equity Share Capital of Face value ` 10 each 1,50,00,000 `30
Debentures of face value ` 100 each with a maturity of 10 years 90,00,000 `90
Preference shares of ` 100 each with a maturity of 10 years 60,00,000 `96
The existing yield on T-bills is averaging 8% p.a. The systematic risk measure for the proposed project is 1.6.
NSE NIFTY is expected to yield 14% p.a. on average for the foreseeable future. Debenture holders have been
promised a coupon of 12% and preference shareholders have been committed a dividend of 15%.

The sales volumes over 10 years have been estimated as follows:

Year 1 2 3-5 6-8 9-10
Units per year 70,000 98,000 2,10,000 2,50,000 1,20,000
A sales price of ` 300 per unit is expected and variable expenses will amount to 60% of sales revenue. Fixed
cash operating costs will amount to ` 40,00,000 per year. The loss of any year will be set off from the profits
of subsequent years.
The company is subject to a 30 per cent tax rate. The company follows straight line method of depreciation
which is to be assumed to be admissible for tax purpose also.
CALCULATE the net present value of the project for the company and advise the management to take
appropriate decision.
The PV factors are to be taken as rounded figures upto 2 decimals. Use market value weights to COMPUTE
overall cost of capital.

Ans Cost of Equity

Ke = Rf + Beta * (Rm – Rf) Ke = 8% + 1.6 * (14% - 8%)
Ke = 8% + (1.6 * 6%)
Ke = 17.6%
(RV – NP)
Int (1 − t ) +
1. Cost of Redeemable Debentures (Post-Tax) Kd = n
(RV+NP )
2

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12,00,000 * (1 – 30%) + ((1,00,00,000 – 90,00,000) / 10)

Kd =
(1,00,00,000 + 90,00,000)/ 2
Kd = 8,40,000 + 1,00,000
95,00,000
Kd = 9.89%

(RV – NP)
PD +
2. Cost of Redeemable Preference Shares Kp = n
(RV+NP )
2
Kp = 9,37,500 + 25,000
61,25,000
Kp = 15.71%

3. Weighted Average Cost of Capital (WACC) – Book Value Method

Source of Capital Market Value Weights After Tax Cost WACC
of Capital
Equity Share Capital 1,50,00,000 0.5 17.6% 0.088
Debentures 90,00,000 0.3 9.89% 0.030
Preference Share Capital 60,00,000 0.2 15.71% 0.031
3,00,00,000 1.000 0.149
WACC = 14.9%

4. Computation of CFAT
(year 1 to year 4)
Sr. Particulars / Year 1 2 3-5 6-8 9-10
No.
A Sale Price p.u. 300 300 300 300 300
Sale units 70,000 98,000 2,10,000 2,50,000 1,20,000
C Sales (A x B) 2,10,00,000 2,94,00,000 6,30,00,000 7,50,00,000 3,60,00,000
D Variable Cost p.u. 180 180 180 180 180
E Variable Cost (B x D) 1,26,00,000 1,76,40,000 3,78,00,000 4,50,00,000 2,16,00,000
F Contribution (C - E) 84,00,000 1,17,60,000 2,52,00,000 3,00,00,000 1,44,00,000
G Less: Fixed Cost 40,00,000 40,00,000 40,00,000 40,00,000 40,00,000
H PBDT (F-G) 44,00,000 77,60,000 2,12,00,000 2,60,00,000 1,04,00,000
I Less: Depreciation 20,00,000 20,00,000 20,00,000 20,00,000 20,00,000
(2,50,00,000-
50,00,000) / 10
J PBT 24,00,000 57,60,000 1,92,00,000 2,40,00,000 84,00,000
K Less: Taxes @ 30% 7,20,000 17,28,000 57,60,000 72,00,000 25,20,000
L PAT 16,80,000 40,32,000 1,34,40,000 1,68,00,000 58,80,000
M Add: Depreciation 20,00,000 20,00,000 20,00,000 20,00,000 20,00,000
N CFAT 36,80,000 60,32,000 1,54,40,000 1,88,00,000 78,80,000

5. Computation of NPV
Sr. Particulars / Year 1 2 3-5 6-8 9-10
No.

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I CFAT 36,80,000 60,32,000 1,54,40,000 1,88,00,000 78,80,000

II PVAF @ 14.9% 0.87 0.76 (0.66+0.57+ (0.43+0.38+0.33) (0.29+0.25)
0.50) = 1.73 = 1.14 = 0.54
III PV of CFATs (I x II) 32,01,600 45,84,320 2,67,11,200 2,14,32,000 42,55,200
IV Salvage + Release of 80,00,000
WC
V PVF @ 14.9% 0.25
VI PV of Salvage (IV 20,00,000
x V)
PV of Inflows = 32,01,600 + 45,84,320 + 2,67,11,200 + 2,14,32,000 + 42,55,200 + 20,00,000
PV of Inflows = 6,21,84,320
PV of Outflows = Investment + Introduction of Working Capital PV of
Outflows = 2,50,00,000 + 30,00,000
PV of Outflows = 2,80,00,000
NPV = PV of Inflows – PV of Outflows
NPV = 6,21,84,320 - 2,80,00,000
NPV = 3,41,84,320
The management should consider taking up the project as the Net Present Value of the Project is
Positive.

Q.32 WACC with Market Weights PY May 23

Capital structure of D Ltd. as on 31stMarch, 2023 is given below:

Particulars `
Equity share capital (` 10 each) 30,00,000
8% Preference share capital (` 100 each) 10,00,000
12% Debentures (` 100 each) 10,00,000
• Current market price of equity share is ` 80 per share. The company has paid dividend of
` 14.07 per share. Seven years ago, it paid dividend of ` 10 per share. Expected dividend is ` 16 per share.
• 8% Preference shares are redeemable at 6% premium after five years. Current market price per
preference share is ` 104.
• 12% debentures are redeemable at 20% premium after 10 years. Flotation cost is ` 5 per debenture.
• The company is in 40% tax bracket.
• In order to finance an expansion plan, the company intends to borrow 15% Long-term loan of ` 30,00,000
from bank. This financial decision is expected to increase dividend on equity share from ` 16 per share to
` 18 per share. However, the market price of equity share is expected to decline from ` 80 to ` 72 per
share, because investors' required rate of return is based on current market conditions.
Required:
(i) Determine the existing Weighted Average Cost of Capital (WACC) taking book value weights.
(ii) Compute Weighted Average Cost of Capital (WACC) after the expansion plan taking book value weights.
Interest Rate 1% 2% 3% 4% 5% 6% 7%
FVIFi,5 1.051 1.104 1.159 1.217 1.276 1.338 1.403
FVIFi,6 1.062 1.126 1.194 1.265 1.340 1.419 1.501
FVIFi,7 1.072 1.149 1.230 1.316 1.407 1.504 1.606

Ans (i) (a) Growth rate in Dividends

14.07 = 10 x FVIF (i,7 years)
FVIF (i,7 years) = 1.407
FVIF (5%, 7 years) = 1.407

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i = 5% So, Growth rate in dividend= 5%

(b) Cost of Equity
D1 16
Ke = +g = + 0.05
po 80
(c) Cost of Preference Shares
(RV – NP) (106-104)
PD + 8+
Kp = n = 5
(RV+NP ) (106+104 )
2 2

Kp = 8.4/105 = 8%
(d) Cost of Debt

(RV-NP) (120-95)
I(1-t ) + 12(1 - 0.4+
Kd = n = 5
(RV+NP ) ( 120+95 )
2 2
Kd = (7.2+2.5)/107.5 = 9.02% = 9.02%

Calculation of existing Weighted Average Cost of Capital (WACC)

Capital Amount (`) Weights Cost WACC
Equity Share Capital 30,00,000 0.6 25% 15.00%
Preference Share Capital 10,00,000 0.2 8% 1.60%
Debenture 10,00,000 0.2 9.02% 1.80%
50,00,000 1 18.40%
Alternative presentation
(i) Computation of existing WACC on book value weights
Source (1) Book value Weight Cost of capital Product
(`) (2) (3) (%) (4) (2) x (4)
Equity share capital 30,00,000 0.60 25 7,50,000
Preference share capital 10,00,000 0.20 8 80,000
Debentures 10,00,000 0.20 9.02 90,200
Total 50,00,000 1.00 9,20,200
WACC = (Product / Total book value) x 100 = (9,20,200 /50,00,000) x 100 = 18.4%

(ii) Cost of Long Term Debt = 15% (1-0.4) = 9%

18
Revised Ke = + 0.05 = 30%
72

Calculation of WACC after expansion taking book value weights

Capital Amount Weights Cost W.C
Equity Share Capital 30,00,000 0.3750 30% 11.25%
Preference Share Capital 10,00,000 0.1250 8% 1.00%
Debenture 10,00,000 0.1250 9.02% 1.13%
Long Term Debt 30,00,000 0.3750 9.00% 3.38%
80,00,000 1.0000 16.76%

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Alternative presentation
(i) Computation of WACC on book value weights after expansion
Source (1) Book value Weight Cost of capital Product
(`) (2) (3) (%) (4) (2) x (4)
Equity share capital 30,00,000 0.375 30 9,00,000
Preference share capital 10,00,000 0.125 8 80,000
Debentures 10,00,000 0.125 9.02 90,200
Long term loan 30,00,000 0.375 9 2,70,000
Total 80,00,000 1.00 13,40,200
WACC = (Product / Total book value) x 100 = (13,40,200 / 80,00,000) x 100 = 16.76%

Q.33 WACC PY Dec 21

Book value of capital structure of B Ltd. is as follows:

Sources Amount
12%, 6,000 Debentures @ ` 100 each ` 6,00,000
Retained earnings ` 4,50,000
4,500 Equity shares @ ` 100 each ` 4,50,000
` 15,00,000
Currently, the market value of debenture is ` 110 per debenture and equity share is ` 180 per share. The expected
rate of return to equity shareholder is 24% p.a. Company is paying tax @ 30%.

Ans Calculation of Cost of Capital of debentures ignoring market value:

Cost of Debentures (Kd)= 12 (1 - .30) = 8.40%

Computation of Weighted Average Cost of Capital based on Market Value Weights

Source of Capital Market Weights to After tax Cost WACC
Value (`) Total Capital of capital (%) (%)
Debentures (6,000 nos. × ` 110) 6,60,000 0.45(approx.) 8.40 3.78
Equity Shares (4,500 nos. × `180) 8,10,000 0.55(approx.) 24.00 13.20
14,70,000 1.00 16.98
Note: Cost of Debenture and Cost of equity considered as given without considering market value. Cost of sources
of capital can be computed based on the Market price and accordingly Weighted Average Cost of Capital can be
calculated as below:
Calculation of Cost of Capital for each source of capital considering market value of capital:
(1) Cost of Equity share capital:
Earnings 24% x100
Ke = = = 13.333%
Market Price per share 180
(2) Cost of Debentures
l(1 − t) 12(1-0.3)
(Kd) = = = 7.636%
NP 110
Computation of Weighted Average Cost of Capital based on Market Value Weights

Source of Capital Market Value Weights to Total After tax Cost WACC (%)
(`) Capital of capital (%)
Debentures (6,000 nos. × ` 110) 6,60,000 0.45(approx.) 7.636 3.44 (approx.)
Equity Shares (4,500 nos. ×` 180) 8,10,000 0.55(approx.) 13.333 7.33 (approx.)

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14,70,000 1.00 10.77(approx.)

Q.34 WACC PY Jan 21

The Capital structure of PQR Ltd. is as follows:

`
10% Debenture 3,00,000
12% Preference Shares 2,50,000
Equity Share (face value ` 10 per share) 5,00,000
10,50,000
Additional Information:
(i) ` 100 per debenture redeemable at par has 2% floatation cost & 10 years of maturity. The market price
per debenture is ` 110.
(ii) ` 100 per preference share redeemable at par has 3% floatation cost & 10 years of maturity. The market
price per preference share is ` 108.
(iii) Equity share has ` 4 floatation cost and market price per share of ` 25. The next year expected dividend
is ` 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 30%.
Required:
Calculate Weighted Average Cost of Capital (WACC) using market value weights.

Ans Workings:
D1 2
1. Cost of Equity (Ke) = +g = + 0.05 = 0.145 (approx.)
P0 −F 25 − 4

I(1-t) +
(RV-NP )
2. Cost of Debt (Kd) = n
(RV-NP )
2

10(1-0.3) +
(100-98 )
10 7 + 0.2
= = =0.073 (approx.)
(100-98 ) 99
2

PD +
(RV-NP )
3. Cost of Preference Shares (Kp) = n
(RV-NP )
2

12 +
(100-97 )
10 12 + 0.3
= = = 0.125 (approx.)
(100-97 ) 98.5
2

Calculation of WACC using market value weights

Source of capital Market Weights After tax cost WACC (Ko)

Value of capital
(`) (a) (b) (c) = (a)×(b)

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10% Debentures (` 110 × 3,000) 3,30,000 0.178 0.073 0.013

12% Preference shares (` 108 × 2,70,000 0.146 0.125 0.018
2,500)
Equity shares (` 25 × 50,000) 12,50,000 0.676 0.145 0.098
18,50,000 1.00 0.129
WACC (Ko) = 0.129 or 12.9% (approx.)

Q.35 WACC RTP Nov 19

KM Ltd. has the following capital structure on September 30, 2019:
Sources of capital (`)
Equity Share Capital (40,00,000 Shares of ` 10 each) 4,00,00,000
Reserves & Surplus 4,00,00,000
12% Preference Shares 2,00,00,000
9% Debentures 6,00,00,000
16,00,00,000

The market price of equity share is `60. It is expected that the company will pay next year a dividend of `6 per
share, which will grow at 10% forever. Assume 40% income tax rate.
You are required to COMPUTE weighted average cost of capital using market value weights.

D1 6
Ans (i) Cost of Equity (Ke) = +g= + 0.10 = 0.20 = 20%
P0 60
(ii) Cost of Debentures (Kd) = I (1 - t) = 0.09 (1 - 0.4) = 0.054 or 5.4%

Computation of Weighted Average Cost of Capital (WACC using market value weights)
Source of capital Market Value Weight Cost of WACC (%)
of capital (`) capital (%)
9% Debentures 6,00,00,000 0.1875 5.40 1.01
12% Preference Shares 2,00,00,000 0.0625 12.00 0.75
Equity Share Capital 24,00,00,000 0.7500 20.00 15.00
(`60 × 40,00,000 shares)
Total 32,00,00,000 1.00 16.76

Q.36 WACC MTP May 21(1)

CALCULATE the WACC by using Market value weights.

The capital structure of the company is as under:

(`)
Debentures (Rs.100 per debenture) 10,00,000
Preference shares (Rs.100 per share) 10,00,000
Equity shares (Rs.10 per share) 20,00,000
40,00,000
The market prices of these securities are:
Debentures Rs. 115 per debenture
Preference shares Rs. 120 per preference share
Equity shares Rs. 265 each.
Additional information:

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(1) Rs.100 per debenture redeemable at par, 10% coupon rate, 2% floatation cost, 10-year maturity.
(2) Rs.100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10 - year maturity.
(3) Equity shares have a floatation cost of Rs. 1 per share.
The next year expected dividend is Rs. 5 with an annual growth of 15%. The firm has the practice of paying
all earnings in the form of dividend.
Corporate tax rate is 30%. Use YTM method to calculate cost of debentures and preference shares.

Ans (i) Cost of Equity (Ke)

D1 Rs. 5
= +g= + 0.15 = 0.1689 or 16.89%
P0 -F Rs.265 − Re.1
(ii) Cost of Debt (Kd)
Calculation of NPV at discount rate of 5% and 7%
Year Cash flows Discount Present Discount Present Value
(Rs.) factor @ 5% Value factor @ 7% (Rs.)

0 112.7 1.000 (112.7) 1.000 (112.7)

1 to 10 7 7.722 54.05 7.024 49.17
10 100 0.614 61.40 0.508 50.80
NPV +2.75 -12.73
Calculation of IRR
2.75 2.75
IRR = 5% + (7% - 5%) = 5% + (7% - 5%) = 5.36%
2.75 − ( −12.73) 15.48
Cost of Debt (Kd) = 5.36%
(i) Cost of Preference shares (Kp)
Calculation of NPV at discount rate of 2% and 5%
Year Cashflow Discount Present Discount Present Value
(Rs.) factor@ 2% Value factor @ 5% (Rs.)
0 117.6 1.000 (117.6) 1.000 (117.6)
1 to 10 5 8.983 44.92 7.722 38.61
10 100 0.820 82.00 0.614 61.40
NPV +9.32 -17.59

Calculation of IRR 2%

9.32 9.32
(5%-2%) = 2% + = (5%-2%) = 3.04%
9.32-(-17.59) 26.91
9.32
Cost of Preference S hares (Kp) = 3.04%
9.32-(-17.59)
Calculation of WACC using market value weights
Source of capital Market Value Weights After tax WACC (Ko)
cost of
capital
(Rs.) (a) (b) (c) =(a)×(b)
10% Debentures (Rs.115× 11,50,000 0.021 0.0536 0.00113
10,000)
5% Preference shares (Rs.120× 12,00,000 0.022 0.0304 0.00067
10,000)

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Equity shares (Rs.265 × 5,30,00,000 0.957 0.1689 0.16164

2,00,000)
5,53,50,000 1.000 0.16344

WACC (Ko) = 0.16344 or 16.344%

Q.37 WACC RTP May 22

The information relating to book value (BV) and market value (MV) weights of Ex Limited is given below:

Sources Book Value (`) Market Value (`)

Equity shares 2,40,00,000 4,00,00,000
Retained earnings 60,00,000 -
Preference shares 72,00,000 67,50,000
Debentures 18,00,000 20,80,000

Additional information:
I. Equity shares are quoted at ` 130 per share and a new issue priced at ` 125 per share will be fully
subscribed; flotation costs will be ` 5 per share on face value.
II. During the previous 5 years, dividends have steadily increased from ` 10 to ` 16.105 per share. Dividend at
the end of the current year is expected to be ` 17.716 per share.
III. 15% Preference shares with face value of ` 100 would realise ` 105 per share.
IV. The company proposes to issue 11-year 15% debentures but the yield on debentures of similar maturity and
risk class is 16%; flotation cost is 2% on face value.
V. Corporate tax rate is 30%.
You are required to DETERMINE the weighted average cost of capital of Ex Limited using both the weights.

D1 17.716
Ans. (i) Cost of Equity (Ke) = +g = + 0.10*
P0 -F 125 − 5

Ke = 0.2476
*Calculation of g:
10 (1+g)5 = 10 (1+g)5 =16.105
16.105
Or, (1+g)5 = = 1.6105
10
Table (FVIF) suggests that ` 1 compounds to ` 1.6105 in 5 years at the compound rate of 10 percent.
Therefore, g is 10 per cent.
D 17.716
(ii) Cost of Retained Earnings (Kr) = 1
+g= + 0.10 = 0.2363
po
130
PD 15
(iii) Cost of Preference Shares (Kp) = = = 0.1429
P0 105
 Rv-NP   100-91.75 
I(1-t)   15(1-0.30)  
(iv) Cost of Debentures (Kd) =
 n  =  11years 
RV+NP 100 + 91.75
2 2
15x 0.70 + 0.75 11.25
= = = 0.1173
95.875 95.875

*Since yield on similar type of debentures is 16 per cent, the company would be required to offer debentures at
discount.

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Market price of debentures (approximation method) = ` 15 ÷ 0.16 = ` 93.75

Sale proceeds from debentures = ` 93.75 – ` 2 (i.e., floatation cost) = `91.75
Market value (P0) of debentures can also be found out using the present value method:

P0 = Annual Interest × PVIFA (16%, 11 years) + Redemption value × PVIF (16%,11 years)
P0 = ` 15 × 5.0287 + ` 100 × 0.1954
P0 = ` 75.4305 + ` 19.54 = ` 94.9705
Net Proceeds = ` 94.9705 – 2% of ` 100 = ` 92.9705
Accordingly, the cost of debt can be calculated

Total Cost of capital [BV weights and MV weights]

(Amount in (`) lakh)
Weights Specific Total cost
Source of capital Cost (K)
BV MV (BV × K) (MV × K)

Equity Shares 240 320** 0.2476 59.4240 79.2320

Retained Earnings 60 80** 0.2363 14.1780 18.9040

Preference Shares 72 67.50 0.1429 10.2888 9.6458

Debentures 18 20.80 0.1173 2.1114 2.4398

Total 390 488.30 86.0022 110.2216

**Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings i.e.,
240:60 or 4:1.

Weighted Average Cost of Capital (WACC):

86.0022
Using Book Value = =0.2205 or 22.05%
390
110.2216
Using Market Value = = 0.2257 or 22.57%
488.30

Q.38 WACC RTP May 19

As a financial analyst of a large electronics company, you are required to DETERMINE the weighted average cost
of capital of the company using (a) book value weights and (b) market value weights. The following information is
available for your perusal.

The Company’s present book value capital structure is:

(`)
Debentures (`100 per debenture) 8,00,000
Preference shares (`100 per share) 2,00,000
Equity shares (`10 per share) 10,00,000
20,00,000
All these securities are traded in the capital markets. Recent prices are:
Debentures, `110 per debenture, Preference shares, `120 per share, and Equity shares,
` 22 per share
Anticipated external financing opportunities are:
(i) ` 100 per debenture redeemable at par; 10 year maturity, 11 per cent coupon rate, 4 per cent flotation
costs, sale price, ` 100

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(ii) ` 100 preference share redeemable at par; 10 year maturity, 12 per cent dividend rate, 5 per cent
flotation costs, sale price, `100.
(iii) Equity shares: ` 2 per share flotation costs, sale price = ` 22.
In addition, the dividend expected on the equity share at the end of the year is ` 2 per share, the anticipated
growth rate in dividends is 7 per cent and the firm has the practice of paying all its earnings in the form of
dividends. The corporate tax rate is 35 per cent.

(RV - N P) 11(1-0.35) + (100 - 96)

Interest(1-t) + 10years
Ans. (i) Cost Debt (Kd) = N =
RV − NP 100 - 96
2 2
7.15 + 0.4
= = 0.077 or 7.70%
98

(RV − N P) (100 - 95)

PD + 12+
N 10years
(ii) Cost of Preference Shares (Kp) = =
RV − NP 100 − 95
2 2
12+0.5
= = 0.1282 or 12.82%
97.5

D 2
(iii) Cost of Equity shares (Ke) +G=
1
+ 0.07 = 0.17 or 17%
p
0
22 − 2

I – Interest, t – Tax, RV- Redeemable value, NP- Net proceeds, N- No. of years, PD- Preference
dividend, D1- Expected Dividend, P0- Price of share (net)
Using these specific costs we can calculate WACC on the basis of book value and market value weights as
follows:
(a) Weighted Average Cost of Capital (K0) based on Book value weights
Source of capital Book Weights Specific WACC (%)
value(`) cost (%)
Debentures 8,00,000 0.40 7.70 3.08
Preferences shares 2,00,000 0.10 12.82 1.28
Equity shares 10,00,000 0.50 17.00 8.50
20,00,000 1.00 12.86

(b) Weighted Average Cost of Capital (K0) based on market value weights:
Source of capital Market Weights Specific WACC (%)
value(` ) cost (%)
Debenture 8,80,000 0.265 7.70 2.04
8, 00, 000
x110
100

Preferences shares 2,40,000 0.072 12.82 0.92

2, 00, 000
x120
100
Equity shares 22,00,000 0.663 17.00 11.27

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10, 00, 000

x 22
10

33,20,000 1.000 14.23

Q.39 WACC MTP May 22(2)

The capital structure of RV Limited as on 31st March, 2022 as per its Balance Sheet is as follows:

Particulars `
Equity shares of ` 10 each 25,00,000
10% Preference shares of ` 100 each 5,00,000
Retained earnings 5,00,000
13% debentures of ` 100 each 20,00,000

The market price of equity shares is ` 50 per share. Expected dividend on equity shares is ` 3 per share. The
dividend per share is expected to grow at the rate of 8%.
Preference shares are redeemable after eight years and the current market price is ` 80 per share.
Debentures are redeemable after five years and are currently selling at ` 90 per debenture.
The tax rate applicable to the company is 35%.
CALCULATE weighted average cost of capital using:
(i) Book value proportions
(ii) Market value proportions

Ans. (i) Cost of Equity (Ke)

D1 3
+g = + 0.08 = 0.14 i.e. 14%
P 50
(ii) Cost of preference shares (Kp)
RV-NP (100 − 80)
D+ 10 +
n 8 12.5
= = = 0.1389 = 13.89%
RV+NP 100 + 80 90
2 2
(iii) Cost of debenture (Kd)
RV-NP (100 − 90)
l(1-t)+ 13(1 − 0.35) +
n 5 8.45 + 2
= = = 0.11 i.e. 11%
RV+NP 100 + 90 95
2 2
Or
 RV-NP   (100 − 90 ) 
l+ n   13+
  (1 – t)=  5  (1 – 0.35) = 0.1026 i.e. 10.26%
 RV+NP   100 + 90 
 2   
 2 

Weighted Average cost of capital (Book Value)

Amount (`) Weight (W) Cost (K) W x K
Equity shares 25,00,000 0.4546 0.14 0.0636

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Preference shares 5,00,000 0.0909 0.1389 0.0126

Retained Earnings 5,00,000 0.0909 0.14 0.0127
Debentures 20,00,000 0.3636 0.1026 0.0373
55,00,000 0.1262
Or (if Kd is 11%) the WACC = 0.1289
Thus, WACC (Book value based) = 12.62% or 12.89%

Weighted Average cost of capital (Market Value)

Amount (`) Weight (W) Cost (K) W x K
Equity shares 1,25,00,000 0.85 0.14 0.119
Preference shares 4,00,000 0.028 0.1389 0.0039
Debentures 18,00,000 0.122 0.1026 0.0125
1,47,00,000 0.1354
Or (if Kd is 11%) the WACC = 0.1363
Thus, WACC (Market value based) = 13.54% or 13.63%

Q.40 WACC RTP May 23

Amrit Corporation has the following book value capital structure:

Equity Capital (50 lakh shares of ` 10 each). ` 5,00,00000

15% Preference share (50,000 shares ` 100 each) ` 50,00,000
Retained earnings ` 4,00,00,000
Debentures 14% (2,50,000 debentures ` 100 each) ` 2,50,00,000
Term loan 13% ` 4,00,00000

The companies last year earnings per share was ` 5, and it maintains a dividend pay-out ratio of 60% and returns
on equity is 10%. The market price per share is ` 20.8. Preference share redeemable after 10 years is currently
selling for ` 90 per share. Debentures redeemable after 6 years are currently selling for ` 75 per debenture.
The income tax rate is 40%.
(a) CALCULATE the Weighted Average Cost of Capital (WACC) using market value proportions.
(b) DETERMINE the Marginal Cost of Capital (MACC) if it needs ` 5,00,00000 next year assuming the amount
will be raised by 60% equity, 20% debt and 20% retained earnings. Equity issues will fetch a net price of `
14 and cost of debt will be 13% before tax up to ` 40,00,000 and beyond ` 40,00,000 it will be 15% before
tax.

Ans. (a) Calculation of Cost of Equity

(i) D0 = ` 5x 60%
D0 = ` 3
g=bxr
= (1-0.6) x 10% = 4%
D1 = D0 x (1 + g)
= 3 x (1 + 4%)
= 3 x 1.04 = 3.12
D
Ke= 1
+g
p
0

3.12
Ke = + 0.04
20.8

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(ii) Calculation of Cost of Preference Shares

N =10 years
NP = ` 90
PD = ` 15
RV = ` 100
= PD + (RV - NP) / N
Kp = x100
(RV + N P)
15 + (100 − 90) / 10
Kp = x100
(100 + 90) /2
Kp = 16/95 x 100
Kp= 16.84%

(iii) Calculation of Cost of Debentures

N = 6 years
NP = ` 75
Interest = ` 14
RV = ` 100
T = 40%
int(1 − t) + (RV − N P) / N
Kd = x 100
(RV + NP) / 2
14 x (1 − 0.4) + (100 − 75) / 6
Kd = x 100
(100 + 75) /2
8.4 − 4.17
Kd = x 100
87.5
Kd =14.37%

(iv) Cost of Term Loan

Kd = Interest rate (1-t)
Kd = 13% (1-40%)
Kd = 7.8%
Calculation of Weighted Average Cost of Capital (WACC) (using market weights)

Capital Cost of Market Value Market Product

Capital Value (Cost x
Weights weights)
Equity 19.00% 20.8 x 50,00,000 `10,40,00,000 0.6218 11.81%
Preference 16.84% 90 x 50,000 ` 45,00,000 0.0269 0.45%
Shares
Debentures 14.37% 75 x 2,50,000 ` 1,87,50,000 0.1121 1.61%
Term Loan 7.80% ` 4,00,00,000 0.2392 1.87%
Total `16,72,50,000 1 15.74%
WACC= 15.74%

(b) Calculation of Marginal Cost of Capital (MACC)

The required capital of ` 50,000,000 will be raised as follows:

Equity = 60% of ` 50,000,000 = ` 30,000,000

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Deby = 20% of ` 50,000,000 = `10,000,000

Retained Earnings= 20% of ` 50,000,000 = ` 10,000,000

3.12
Marginal Cost of Equity = + 0.04
1.4
= 26.28%
Marginal Cost of Debt

13% of 40,00,000 +15% of 60,00,000

Cost of Debt (before tax) =
1, 00, 00, 000
5,20, 000 + 9, 00, 000
= = 14.2
1, 00, 00, 000
Cost of Debt (after tax). = 14.2% (1-t)
= 14.2% (1-0.4)
= 8.52%
Calculation of marginal cost of capital
Capital Cost of Value Weights Product (Cost
Capital x weights)
Equity 26.28% ` 3,00,00,000 0.6 15.77%
Reserves 26.28% ` 1,00,00,000 0.2 5.26%
Debt 8.52% ` 1,00,00,000 0.2 1.70%
Total ` 5,00,00,000 1 22.73%
Marginal Cost of Capital (MACC) = 22.73%

CALCULATE the WACC using the following data by using:

(a) Book value weights
(b) Market value weights

Q.41 WACC RTP Nov 20

The capital structure of the company is as under:
(a) Book value weights
(b) Market value weights
The capital structure of the company is as under:
Particulars (`)
Debentures (` 100 per debenture) 5,00,000
Preference shares (` 100 per share) 5,00,000
Equity shares (` 10 per share) 10,00,000
20,00,000
The market prices of these securities are:
Debentures ` 105 per debenture
Preference shares ` 110 per preference share
Equity shares ` 24 each.
Additional information:
(i) ` 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs, 10-year maturity.
(ii) ` 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10-year maturity.
(iii) Equity shares has ` 4 floatation cost and market price ` 24 per share.
The next year expected dividend is ` 1 with annual growth of 5%. The firm has practice of paying all
earnings in the form of dividend.

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Corporate tax rate is 30%. Use YTM method to calculate cost of debentures and preference shares.
Ans. (i) Cost of Equity (Ke)
D1
= +𝑔= v + 0.05 = 0.1 or 10%
P0-F
(ii) Cost of Debt (Kd)
Current market price (P0) – floatation cost = I(1-t) × PVAF(r,10) + RV × PVIF(r,10)
` 105 – 4% of ` 105 = ` 10 (1-0.3) × PVAF (r,10) + ` 100 × PVIF (r,10)
Calculation of NPV at discount rate of 5% and 7%
Year Cash flows Discount Present Discount Present
(`) factor @5% Value factor @7% Value (`)

0 100.8 1.000 (100.8) 1.000 (100.8)

1 to 10 7 7.722 54.05 7.024 49.17
10 100 0.614 61.40 0.508 50.80
NPV +14.65 -0.83

14.65 14.65
IRR = 5%+ (7%-5%) = 5%+ (7%-5%) = 6.89%
14.65 − ( −0.83) 15.48
Cost of Debt (Kd) = 6.89%
(iii) Cost of Preference shares (Kp)
Current market price (P0) – floatation cost = PD × PVAF(r,10) + RV × PVIF(r,10)
` 110 – 2% of ` 110 = ` 5 × PVAF (r,10) + ` 100 × PVIF (r,10)
Calculation of NPV at discount rate of 3% and 5%
Year Cash Discount Present Discount Present
flows factor @ Value factor @ Value (`)
(`) 3% 5%
0 107.8 1.000 (107.8) 1.000 (107.8)
1 to 10 5 8.530 42.65 7.722 38.61
10 100 0.744 74.40 0.614 61.40
NPV +9.25 -7.79
Calculation of IRR
9.25 9.25
=3%+ (5%-3%) = 3% (5%-3%) = 4.08%
9.25 − ( −7.79) 17.04

Cost of Preference Shares (Kp) = 4.08%

(a) Calculation of WACC using book value weights

Source of Book Value Weights After tax cost WACC (Ko)

capital of capital
(`) (a) (b) (c) = (a)×(b)
10% Debentures 5,00,000 0.25 0.0689 0.01723
5% Preference 5,00,000 0.25 0.0408 0.0102
shares
Equity shares 10,00,000 0.50 0.10 0.05000
20,00,000 1.00 0.07743
WACC (Ko) = 0.07743 or 7.74%.

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(c) Calculation of WACC using market value weights

Source of capital Market Weights After tax cost WACC (Ko)

Value of capital

(`) (a) (b) (c) = (a)×(b)

10% Debentures (` 105× 5,000) 5,25,000 0.151 0.0689 0.0104
5% Preference shares 5,50,000 0.158 0.0408 0.0064
(` 110× 5,000)
Equity shares (` 24× 1,00,000) 24,00,000 0.691 0.10 0.0691
34,75,000 1.000 0.0859
WACC (Ko) = 0.0859 or 8.59%

Q.42 WACC ICAI MAT

Gamma Limited has 5,00,000,` 1 ordinary shares whose current ex-dividend market price is ` 1.50 per share. The

company has just paid a dividend of 27 paise per share, and dividends are expected to continue at this level for

some time. If the company has no debt capital, COMPUTE the weighted average cost of capital?

Ans. Market value of equity, E = 5,00,000 shares x `1.50 = `7,50,000

Market value of debt, D = Nil

D 0.27
Cost of equity capital, Ke = =
1
= 0.18
P 1.50
0

Since there is no debt capital, WACC = Ke = 18 per cent.

Q.43 WACC ICAI MAT

The following details are provided by the GPS Limited:

(`)
Equity Share Capital 65,00,000
12% Preference Share Capital 12,00,000
15% Redeemable Debentures 20,00,000
10% Convertible Debentures 8,00,000

The cost of equity capital for the company is 16.30% and income tax rate for the company is 30%.
You are required to CALCULATE the Weighted Average Cost of Capital (WACC) of the company.

Ans. Calculation of Weighted Average Cost of Capital (WACC)

Source (`) Weight Cost of Capital WACC
after tax

Equity Capital 65,00,000 0.619 0.163 0.1009

12% Preference Capital 12,00,000 0.114 0.120 0.0137
15% RedeemableDebentures 20,00,000 0.190 0.105* 0.020
10% ConvertibleDebentures 8,00,000 0.076 0.070** 0.0053

Total 1,05,00,000 1.0000 0.1399

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* Cost of 15% Redeemable Debentures (after tax) = 15 (1 – 0.30)

= 10.5% or0.105
** Cost of 10% Convertible Debentures (after tax) = 10 (1 – 0.30)= 7% or 0.070 Weighted Average Cost of
Capital (WACC) = 0.1399 = 13.99%
(Note: In the above solution, the Cost of Debentures has been computed without considering the impact of
special features i.e. redeemability and convertibility in absence of requisite information.)

Q.44 Cost of Equity ICAI MAT

ABC Company’s equity share is quoted in the market at `25 per share currently. The company pays a dividend of
` 2 per share and the investor’s market expects a growth rate of 6% per year.
You are required to:
(i) CALCULATE the company’s cost of equity capital.
(ii) If the company issues 10% debentures of face value of `100 each and realises ` 96 per debenture while the
debentures are redeemable after12 years at a premium of 12%, CALCULATE cost of debenture using YTM?
Assume Tax Rate to be 50%.

Ans (i) Cost of Equity Capital (Ke):

Expected dividend pershare(D1 )
Ke = + Growth rate(g)
Marketprice pershare(P0 )
2 − 1.06
= + 0.06 = 0.1448 or 14.48%
25
(ii) Cost of Debenture (Kd):
Using Present Value method (YTM)

Identification of relevant cash flows

Year Cash flows
0 Current market price (P0) = ` 96
1 to 12 Interest net of tax [I(1-t)] = 10% of ` 100 (1 – 0.5) = ` 5
12 Redemption value (RV) = ` 100 (1.12) = ` 112

Calculation of Net Present Values (NPV) at two discount rates

Year Cash Discount Present Discount Present
flows(`) factor @ Value(`) factor @ Value(`)
5%(L) 10% (H)
0 (96) 1.000 (96.00) 1.000 (96.00)
1 to 12 5 8.863 44.32 6.814 34.07
12 112 0.557 62.38 0.319 35.73
NPV +10.7 -26.2

Calculation of IRR
NPVL
IRR = L+ (H-L)
NPVL − NPVH
10.7 53.5
= 5%+ (10%-5%) = 5%+ = 6.45%
10.7 − ( −26.2) 36.9
Therefore, Kd = 6.45%

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Q.45 Cost of Debt / Equity ICAI MAT

Masco Limited wishes to raise additional finance of ` 10 lakhs for meeting its investment plans. It has ` 2,10,000
in the form of retained earnings available for investment purposes. Further details are as following:
You are required to:

(1) Debt / Equity mix 3:7

(2) Cost of debt:
Upto` 1,80,000 10% (before tax)
Beyond ` 1,80,000 16% (before tax)
(3) Earnings per share `4
(4) Dividend pay out 50% of earnings
(5) Expected growth rate of dividend 10%
(6) Current market price per share ` 44
(7) Tax rate 50%
(a) DETERMINE the pattern for raising the additional finance.
(b) DETERMINE the post-tax average cost of additional debt.
(c) DETERMINE the cost of retained earnings and cost of equity.
(d) COMPUTE the overall weighted average after tax cost of additional finance.

Ans (a) Pattern for raising the additional finance:

Equity 70% of ` 10,00,000 = ` 7,00,000

Debt 30% of ` 10,00,000 = ` 3,00,000

The capital structure after raising additional finance:

(`)
Shareholders’ funds
Equity Capital (`7,00,000 –`2,10,000) 4,90,000
Retained earnings 2,10,000
Debt (Interest at 10% p.a.) 1,80,000
(Interest at 16% p.a.) (`3,00,000 –`1,80,000) 1,20,000
Total Funds 10,00,000

(b) Determination of post-tax average cost of additional debt: Kd = I (1 – t)

Where,
I = Interest Rate
t = Corporate tax-rate
On ` 1,80,000 =10% (1 – 0.5)=5% or 0.05
On ` 1,20,000 =16% (1 – 0.5)=8% or 0.08
Average Cost of Debt
(1,80, 000  0.05) + (1,20, 000  0.08)
= ×100 = 6.2%
3, 00, 000
(c) Determination of cost of retained earnings and cost of equity by applying Dividend growth model:
D D (1 + g)
Ke or Kr = 1 +g = 0 +g
po po
Where,

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D0 = Dividend paid = 50% of EPS = 50% × ` 4 = ` 2

g = Growth rate =10%
P0 = Current market price per share = `44
2 (1 + 0.10 ) 2.2
So, Ke or Kr = + 0.10 =
+ 0.10 = 0.05 + 0.10 = 0.15 or 15%
44 44
(d) Computation of overall weighted average after tax cost of additional finance:
Particulars Amount (`) Weights Cost of Weighted
funds Cost (%)

Equity(including 7,00,000 0.70 15% 10.5

retained earnings)
Debt 3,00,000 0.30 6.2% 1.86
WACC 10,00,000 12.36

Q.46 Cost of Capital ICAI MAT

DETERMINE the cost of capital of Best Luck Limited using the book value (BV) and market value (MV) weights
from the following information:
Sources Book Value (`) Market Value (`)
Equity shares 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 -
Preference shares 36,00,000 33,75,000
Debentures 9,00,000 10,40,000

Additional information:
I. Equity: Equity shares are quoted at `130 per share and a new issue priced at `125 per share will be fully
subscribed; flotation costs will be ` 5 per share.
II. Dividend: During the previous 5 years, dividends have steadily increased from ` 10.60 to ` 14.19 per share.
Dividend at the end of the current year is expected to be ` 15 per share.
III. Preference shares: 15% Preference shares with face value of ` 100 would realise`105 per share.
IV. Debentures: The company proposes to issue 11-year 15% debentures but the yield on debentures of similar
maturity and risk class is 16%; flotation cost is 2%.
V. Tax: Corporate tax rate is 35%.Ignore dividend tax.
Floatation cost would be calculated on face value.

D1 15
Ans (i) Cost of Equity (Ke) = +g +0.06 *
PO -F 125 − 5
Ke = 0.125 + 0.06 = 0.185
*Calculation of g:
` 10.6(1+g)5 = ` 14.19
14.19
Or, (1+g)5= =1.338
10.6
Table (FVIF) suggests that `1 compounds to `1.338 in 5 years at the compound rate of 6 percent.
Therefore, g is 6 per cent.

D1 15
(ii) Cost of Retained Earnings (Kr) = +g= + 0.06 = 0.18
PO 125

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PD 15
(iii) Cost of Preference Shares (Kp) = = = 0.1429
PO 105
RV-NP 100 - 91.75
l(1-t)+ 15(1 - 0.35) +
n 11years
(iv) Cost of Debentures (Kd) = =
RV+NP 100 + 91.75
n 2
15 × 0.65 + 0.75 10.5
= = = 0.1095
95.875 95.875
*Since yield on similar type of debentures is 16 per cent, the company would be required to offer debentures at
discount.
Market price of debentures (approximation method)
= ` 15 ÷ 0.16 = ` 93.75
Sale proceeds from debentures = `93.75 – ` 2 (i.e., floatation cost) = `91.75
Market value (P0) of debentures can also be found out using the present value method:
P0 = Annual Interest × PVIFA (16%, 11 years) + Redemption value × PVIF (16%, 11 years)
P0 = `15 × 5.029 + `100 × 0.195 P0 = `75.435 + `19.5 = ` 94.935
Net Proceeds = `94.935 – 2% of `100 = ` 92.935 Accordingly, the cost of debt can be calculated
Total Cost of capital [BV weights and MV weights]
(Amount in (`) lakh)

Weights Specific Total cost

Source of capital Cost (K)
BV MV (BV × K) (MV × K)

Equity Shares 120 160* 0.1850 22.2 29.6

Retained Earnings 30 40* 0.1800 5.4 7.2
Preference Shares 36 33.75 0.1429 5.14 4.82
Debentures 9 10.4 0.1095 0.986 1.139

Total 195 244.15 33.73 42.76

*Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings i.e.,
120:30 or 4:1.
Weighted Average Cost of Capital (WACC):
33.73
Using Book Value = = 0.1729 or 17.29%
195
42.76
Using Market Value = = 0.1751 or 17.51%
244.15

Q.47 Cost of Debt / Preference ICAI MAT

A company issues:
• 15% convertible debentures of ` 100 each at par with a maturity period of 6 years. On maturity, each
debenture will be converted into 2 equity shares of the company. The risk-free rate of return is 10%,
market risk premium is 18% and beta of the company is 1.25. The company has paid dividend of ` 12.76 per
share. Five years ago, it paid dividend of`10 per share. Flotation cost is 5% of issue amount.
• 5% preference shares of ` 100 each at premium of 10%. These shares are redeemable after 10 years at
par. Flotation cost is 6% of issue amount.

Assuming corporate tax rate is 40%.

(i) CALCULATE the cost of convertible debentures using the approximation method.
(ii) Use YTM method to CALCULATE cost of preference shares.

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Year 1 2 3 4 5 6 7 8 9 10

PVIF 0.03, t 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744

PVIF 0.05, t 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614

PVIFA 0.03, t 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530

PVIFA 0.05, t 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722

Interest rate 1% 2% 3% 4% 5% 6% 7% 8% 9%

FVIF i, 5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539

FVIF i, 6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677

FVIF i, 7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828

Ans (i) Calculation of Cost of Convertible Debentures:

Given that,
RF = 10%
Rm – Rf = 18%
Β = 1.25
D0 = 12.76
D5 = ` 10
Flotation Cost = 5%
Using CAPM,
Ke = Rf + β (Rm – Rf)
= 10%+1.25 (18%)
= 32.50%
Calculation of growth rate in dividend
12.76 = 10 (1+g)5
1.276 = (1+g)5
5
(1+5%) = 1.276 from FV Table
g = 5%

( )
7
D7 12.76 1.05
Price of share after 6 years = =
k-g 0.325 − 0.05
12.76  1.407
P6 =
0.275
P6 = 65.28
Redemption Value of Debenture (RV) = 65.28 × 2 = 130.56 (RV)
NP = 95
n =6
RV – NP
INT(1 – t) +
Kd = n x100
RV – NP
2
(130.56-95)
15(1 − 0.4) +
= 6 x100
(130.56-95)
2
9 + 5.93
= x100
112.78
Kd = 13.24%

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(ii) Calculation of Cost of Preference Shares:

Net Proceeds = 100 (1.1) - 6% of 100 (1.1)
= 110 - 6.60
= 103.40
Redemption Value= 100
Year Cash Flows (`) PVF @ 3% PV (`) PVF @ 5% PV (`)

0 103.40 1 103.40 1 103.40

1-10 -5 8.530 -42.65 7.722 -38.61
10 -100 0.744 -74.40 0.614 -61.40
-13.65 3.39

5% − 3%
Kp = 3% +
[3.39 − ( −13.65)]
2%
= 3% + x 13.65
17.04
Kp = 4.6021%

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6 DIVIDEND DECISIONS
CHAPTER
Q.1 Dividend Payout PY May 23
Following information are given for a company:
Earnings per share ` 10
P/E ratio 12.5
Rate of return on investment 12%
Market price per share as per Walter’s Model ` 130

You are required to calculate: (i)

Dividend payout ratio.

(ii) Market price of share at optimum dividend payout ratio.

(iii) P/E ratio, at which the dividend policy will have no effect on the price of share.

(iv) Market price of share at this P/E ratio.

(v) Market price of share using Dividend growth model.

Ans (i) The EPS of the firm is ` 10, r =12%. The P/E Ratio is given at 12.5 and the cost of capital (Ke) may be taken
as the inverse of P/E ratio. Therefore, Ke is 8% (i.e., 1/12.5). The value of the share is ` 130 which may be
equated with Walter Model as follows:
r 12%
D + (E − D ) D+ (10% − D)
ke 8%
P= or p=
Ke 8%
or [D+1.5(10-D)]/0.08=130 or
D+15-1.5D=10.4
or -0.5D=-4.6
So, D = ` 9.2
The firm has a dividend pay-out of 92% (i.e., 9.2/10).
(ii) Since the rate of return of the firm (r) is 12% and it is more than the Ke of 8%,
therefore, by distributing 92% 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 a situation, the market price would be:
12%
D+ (10% − 0)
P = 8%
8%
P = ` 187.5
So, theoretically the market price of the share can be increased by adopting a zero pay-out.

(iii) The P/E ratio at which the dividend policy will have no effect on the value of the share is such at which the
Ke would be equal to the rate of return (r) of the firm. The Ke would be 12% (= r) at the P/E ratio of
1/12%=8.33. Therefore, at the P/E ratio of 8.33, the dividend policy would have no effect on the value of the
share.
(iv) If the P/E is 8.33 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be 12% and in such a
situation ke= r and the market price, as per Walter’s model would be:

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r 12%
D+ (E − D ) 9.2 + (10% − 9.2)
ke 0.12
P = = = ` 83.33
ke 0.12
Dividend Growth Model applying growth on dividend
Ke = 8%, r = 12%, D0 = 9.2, b = 0.08
g = b.r
g = 0.08 x 0.12=0.96%
D1 = D0 (1+g) = 9.2 (1+0.0096) = ` 9.2883
D1
P= = 9.2883/(0.08 – 0.0096) = 9.2883/0.0704 = ` 131.936
(Ke − g )
Alternative
Alternatively, without applying growth on dividend
E(1 − b) 10(1 − 0.08)
P = = = ` 130.68
Ke − br 0.08 − (0.08´ 0.12)

Q.2 Dividend policy MTP May 19(1)

(a) LIST the factors determining the dividend policy of a company.

Ans (a) Factors Determining the Dividend Policy of a Company

(i) Liquidity: In order to pay dividends, a company will require access to cash. Even very profitable
companies might sometimes have difficulty in paying dividends if resources are tied up in other forms
of assets.
(ii) Repayment of debt: Dividend payout may be made difficult if debt is scheduled for repayment

(iii) Stability of Profits: Other things being equal, a company with stable profits is more likely to pay out
a higher percentage of earnings than a company with fluctuating profits.
(iv) Control: The use of retained earnings to finance new projects preserves the company’s ownership
and control. This can be advantageous in firms where the present disposition of shareholding is of
importance.
(v) Legal consideration: The legal provisions lay down boundaries within which a company can declare
dividends.
(vi) Likely effect of the declaration and quantum of dividend on market prices. (vii) Tax considerations and
(viii) Others such as dividend policies adopted by units similarly placed in the industry,
management attitude on dilution of existing control over the shares, fear of being branded as
incompetent or inefficient, conservative policy Vs non-aggressive one.
(ix) Inflation: Inflation must be taken into account when a firm establishes its dividend policy.

Q.3 Growth Model MTP May 18

A company had paid dividend of ` 2 per share last year. The estimated growth of the dividends from the company
is estimated to be 5% p.a. DETERMINE the estimated market price of the equity share if the estimated growth
rate of dividends (i) rises to 8%, and (ii) falls to 3%. Also COMPUTE the present market price of the share, given
that the required rate of return of the equity investors is 15.5%.

Ans In this case the company has paid dividend of `2 per share during the last year. The growth rate
(g) is 5%. Then, the current year dividend (D1) with the expected growth rate of 5% will be ` 2.10
D1
The share price is = Po =
Ke − g

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2.10
=
0.155 − 0.05
= ` 20
(i) In case the growth rate rises to 8% then the dividend for the current year (D1) would be ` 2.16 and market
price would be-
2.16
=
0.155 − 0.08
= ` 28.80
(ii) In case growth rate falls to 3% then the dividend for the current year (D1) would be `2.06 and market
price would be-
2.16
=
0.155 − 0.03
= `16.48

So, the market price of the share is expected to vary in response to change in expected growth rate is dividends.

Q.4 MM Approach RTP May 23

Rambo Limited Has 1,00,000 equity shares outstanding for the year 2022. The current market price of the shares
is ` 100 each. Company is planning to pay dividend of ` 10 per share. Required rate of return is 15%. Based on
Modigliani-Miller approach, calculate the market price of the share of the company when the recommended
dividend is 1) declared and 2) not declared.

How many new shares are to be issued by the company at the end of the year on the assumption that net income
for the year is ` 40 Lac and the investment budget is
` 50,00,000 when dividend is declared, or dividend is not declared.

PROOF that the market value of the company at the end of the accounting year will remain same whether
dividends are distributed or not distributed.

Ans CASE 1: Value of the firm when dividends are not paid.
Step 1: Calculate price at the end of the period
Ke = 15%, P₀ = `100, D₁ = 0
P1 + D1
Pₒ =
1 + Ke
P +0
`100 = 1
1 + 0.15
P₁ = `115

Step 2: Calculation of funds required for investment

Earning ` 40,00,000
Dividend distributed Nil
Fund available for investment ` 40,00,000
Total Investment ` 50,00,000
Balance Funds required ` 50,00,000 - ` 40,00,000 = ` 10,00,000

Step 3: Calculation of No. of shares required to be issued for balance funds

No. of shares = Funds required/P1
∆n = `10,00,000/`115

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Step 4: Calculation of value of firm nPₒ = [(n+∆n)P1-I+E]/(1+Ke)

nP₀ = [(100000+1000000/`115) `115 - `5000000 + `4000000]/(1.15)
= `1,00,00,000

CASE 2: Value of the firm when dividends are paid.

Step 1: Calculate price at the end of the period
Ke= 15%, P₀= `100, D₁= `10
P1 + D1
Pₒ =
1 + Ke
P1 + 10
`100 =
1 + 0.15
P₁ = `105
Step 2: Calculation of funds required for investment
Dividend distributed 10,00,000
Fund available for investment ` 30,00,000
Total Investment ` 50,00,000
Balance Funds required ` 50,00,000 - ` 30,00,000 = ` 20,00,000

Step 3: Calculation of No. of shares required to be issued for balance fund

No. of shares = Funds Required/P1

∆n = `2000000/`105

Step 4: Calculation of value of firm

nPₒ = [(n+∆n)P1 – I+E]/(1+Ke)
nP₀ = [(100000 + 2000000/`105) `105 – `5000000 + `4000000]/(1.15)= `1,00,00,000
Thus, it can be seen from the above calculations that the value of the firm remains
the same in either case.

Q.5 MM Approach RTP Nov 22

Ordinary shares of a listed company are currently trading at ` 10 per share with two lakh shares outstanding.
The company anticipates that its earnings for next year will be
` 5,00,000. Existing cost of capital for equity shares is 15%. The company has certain investment proposals
under discussion which will cause an additional 26,089 ordinary shares to be issued if no dividend is paid or an
additional 47,619 ordinary shares to be issued if dividend is paid.

Applying the MM hypothesis on dividend decisions, CALCULATE the amount of investment and dividend that is
under consideration by the company.

Ans P0 = ` 10 n = 2,00,000, E = ` 5,00,000

Ke = 15%, ∆n = 26,089, I = ?
P1
P0 =
1 + Ke
P1
10 =
1.5

P1 = 11.5

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I − E + nD1
∆n =
P1

I − 5, 00, 000
26,089 =
11.5

I = 8,00,024

Now,

P0 = ` 10, n = ` 2,00,000,

E = ` 5,00,000, I = 8,00,024, Ke = 15%, ∆n 47,619, D1 = ?

P1 + D1
P =
1 + Ke

P1 + D1
10 =
1.15

P1 = 11.5

I − E + nD1
∆n =
p1

I − 5, 00, 000
26,089 =
11.5

I = 8,00,024

Now,

P0 = ` 10, n = ` 2,00,000,

E = ` 5,00,000, I = 8,00,024, Ke = 15%, ∆n 47,619, D1 = ?

P1 + D1
P =
1 + ke

P1 + D1
10 =
1.5

P1 + D1 = 11.5

P1 = 11.5 - D1 ………………………… 1

I − E + nD1
∆n =
P1

8, 00, 024 − 5, 00, 000 + 2, 00, 000D1

47,619 =
P1

47,619 P1 = 2,00,000 D1 + 3,00,024

From 1,

47619 (11.5 – D1) = 2,00,000 D1 + 3,00,024

5,47,618.5 – 47,619D1 = 2,00,000D1 + 3,00,024

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2,47,594.5 = 2,00,000D1 + 47,619 D1

2,47,594.5 = 2,47,619 D1

2, 47,594.5
D1 = = 0.99 = ` 1
2, 47, 619

P1 = 11.5 – D1

P1 = 11.5 – 1

P1 = 10.5

(n + Dn)P1 −I + E
n.P0 =
1 + Ke

(2, 00, 000 + 47, 619)(10.5) − 8, 00, 024 + 5, 00, 000

1.15

n.P0 = `19,99,979 = `20,00,000

Using direct calculation,

n.P0 = 2,00,000 ×10 = ` 20,00,000

Q.6 MM Approach RTP Dec 21

Aakash Ltd. has 10 lakh equity shares outstanding at the start of the accounting year 2021.

The existing market price per share is ` 150. Expected dividend is ` 8 per share. The rate of capitalization

appropriate to the risk class to which the company belo ngs is 10%.

(i) CALCULATE the market price per share when expected dividends are: (a) declared, and (b) not declared,

based on the Miller – Modigliani approach.

(ii) CALCULATE number of shares to be issued by the company at the end of the accounting year on the

assumption that the net income for the year is ` 3 crore, investment budget is ` 6 crores, when (a) Dividends

are declared, and (b) Dividends are not declared.

(iii) PROOF that the market value of the shares at the end of the accounting year will remain unchanged

irrespective of whether (a) Dividends are declared, or (ii) Dividends are not declared.

Ans (i) Project N.

Calculation of market price per share

According to Miller – Modigliani (MM) Approach:

P1 + D1
Po =
1 + Ke

Where,

Existing market price (Po) = ` 150

Expected dividend per share (D1) =`8

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Capitalization rate (ke) = 0.10

Market price at year end (P1) = to be determined

(a) If expected dividends are declared, then

P1 + 8
` 150 =
1 + 0.10

P1 = ` 157

(b) If expected dividends are not declared, then

P1 + 0
` 150 =
1 + 0.10

P1 = ` 165

(ii) Calculation of number of shares to be issued

(a) (b)

Dividends are Dividends are not

declared (` Declared
lakh) (` lakh)
Net income 300 300

Total dividends (80) -

Retained earnings 220 300

Investment budget 600 600

Amount to be raised by new issues 380 300

Relevant market price (` per share) 157 165

No. of new shares to be issued (in lakh) 2.42 1.82

(` 380 ÷ 157; ` 300 ÷ 165)

(iii) Calculation of market value of the shares

(a) (b)
Dividends are
Dividends are
declared not
Declared
Existing shares (in lakhs) 10.00 10.00
New shares (in lakhs) 2.42 1.82
Total shares (in lakhs) 12.42 11.82
Market price per share (`) 157 165
Total market value of shares at 12.42 × 157 11.82 × 165
the end of the year (` in lakh) = 1,950 = 1,950
(approx.) (approx.)
Hence, it is proved that the total market value of shares remains unchanged irrespective of whether
dividends are declared, or not declared.

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Q.7 MM Approach MTP Nov 23(1)

ZX Ltd. has a paid-up share capital of ` 2,00,00,000, face value of ` 100 each. The current market price of the

shares is ` 100 each. The Board of Directors of the company has an agenda of meeting to pay a dividend of 50%

to its shareholders. The company expects a net income of ` 1,50,00,000 at the end of the current financial year.

Company also plans for a capital expenditure for the next financial year for a cost of ` 1,90,00,000, which can be

financed through retained earnings and issue of new equity shares.

Company’s desired rate of investment is 15%.

Required:

Following the Modigliani- Miller (MM) Hypothesis, DETERMINE value of the company when:

(i) It does not pay dividend and (ii) It does pay dividend

(n + n)P1 − I + E
Ans V1 or nP₀=
(1 + Ke )
Where,
Vf = Value of firm in the beginning of the period
n = number of shares in the beginning of the period
∆n = number of shares issued to raise the funds required
I = Amount required for investment
E = total earnings during the period
(i) Value of the ZX Ltd. when dividends are not paid.

(n + n)P1 − I + E
nPₒ =
(1 + Ke )

 40, 00, 000 

2, 00, 000    115 − Rs.1, 90, 00, 000 + 1,50, 00, 000
 115 
nPₒ=
(1 + 0.15 )
2, 70, 00, 000 − 1, 90, 00, 000 + 1,50, 00, 000
= = ` 2,00,00,000
1 + 0.5
Working notes:
1. Price of share at the end of the period (P1)

P1 + D1
Pₒ =
1 + Ke

P1 + 0
100 = or, P₁= 115
1 + 0.15
2. Calculation of funds required for investment
Earnings `1,50,00,000
Dividend distributed Nil
Fund available for investment ` 1,50,00,000
Total Investment ` 1,90,00,000
Balance Funds required ` 40,00,000
3. Calculation of no. of shares required to be issued for balance fund

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Funds required 40, 00, 000

No. of shares (∆n) = = shares
Price at end (P1 ) 115
(ii) Value of the ZX Ltd. when dividends are paid.

nPₒ =
(n + n ) P − I + E
1 + Ke
 140, 00, 000 
2, 00, 000    65 − 1, 90, 00, 000 + 1,50, 00, 000
 65 
nPₒ =
(1 + 0.15 )
2, 70, 00, 000 −1, 90, 00, 000 + 1,50, 00, 000
= = ` 2,00,00,000
(1 + 0.15 )
Working notes:

4. Price of share at the end of the period (P1)

P1 + D1
Pₒ =
1 + Ke

P2 + 50
100 = or, P₁= `65
1 + 0.15
5. Calculation of funds required for investment
Earnings ` 1,50,00,000
Dividend distributed ` 1,00,00,000
Fund available for investment ` 50,00,000
Total Investment ` 1,90,00,000
Balance Funds required ` 1,40,00,000

6. Calculation of no. of shares required to be issued for balance fund

Funds required 1, 40, 00, 000

No. of shares (∆n) = = = 2,15,385 shares(approx.)
Priceat end ( P1 ) 65
Note- As per MM-hypothesis of dividend irrelevance, value of firm remains same irrespective of
dividend paid. In the solution, there may be variation in value, which is due to rounding off error.

Q.8 MM Approach MTP May 23 (1)

Roma Nov Ltd. has a capital of `25,00,000 in equity shares of `100 each. The shares are currently quoted at `120.
The company proposes to declare a dividend of `15 per share at the end of the current financial year. The
capitalization rate for the risk class of which the company belongs is
15%. COMPUTE market price of the share at the end of the year, if
(i) Dividend is not declared.
(ii) Dividend is declared.
Assuming that the company pays the dividend and has net profits of `9,00,000 and makes new investments of
`15,00,000 during the period, CALCULATE number of new shares to be issued? Use the MM model.

Ans
Cost of Equity (Ke) 15%
Number of shares in the beginning (n) 25,000
Current Market Price (P0) 120

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Net Profit (E) 9,00,000

Expected Dividend (D1) 15
Investment (I) 15,00,000
Computation of market price per share, when:

(i) No dividend is declared:

P1 + D1
Po = P1 +D1
1 + ke
P1 + 0
`120 =
1 + 0.15
P1 = `138 – 0 = ` 138 (ii) Dividend is declared:
P + 15
`120 = 1
1 + 0.15
P1 = `138 – `15 = ` 123

Calculation of number of shares required for investment.

`
Earnings 9,00,000
Dividend distributed 3,75,000
Fund available for investment 12,75,000
Total Investment 15,00,000
Balance Funds required 15,00,000 – 12,75,000 = 2,25,000
Funds required
No. of shares =
Price at end ( P1 )
2,25, 000
= = 1,830 Shares(approx.)
123

Q.9 MM Approach MTP Dec 21(1)

M Ltd. belongs to a risk class for which the capitalization rate is 12%. It has 40,000 outstanding shares and the
current market price is ` 200. It expects a net profit of ` 5,00,000 for the year and the Board is considering
dividend of ` 10 per share.

M Ltd. requires to raise ` 10,00,000 for an approved investment expenditure. ILLUSTRATE, how the MM approach
affects the value of M Ltd. if dividends are paid or not paid.

Ans
Cost of Equity (Ke) 12%
Number of shares in the beginning (n) 40,000
Current Market Price (P0) `200
Net Profit (E) `5,00,000
Expected Dividend (D1) `10 per share
Investment (I) `10,00,000

Situation 1 – When dividends are paid Situation 2 – When dividends are not paid

P1 + D1 P1 + D1
(i) P0 = (i) P0 =
1 + ke 1 + ke

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P1 + 0 P1 + 0
200 = 200 =
1 + 0.12 1 + 0.12

P1 + 10 = 200 x 1.12 P1 + 0 = 200 x 1.12

P1 = 224 – 10 = 214 P1 = 224 – 10 = 214
(ii) Calculation of funds required (ii) Calculation of funds required
= Total Investment - (Net profit - Dividend) = Total Investment - (Net profit - Dividend)
= 10,00,000 - (5,00,000 – 4,00,000) = 10,00,000 – (5,00,000 - 0)
= 9,00,000 = 5,00,000
(iii) No. of shares required to be issued for (iii) No. of shares required to be issued for
balance fund balance fund
Funds Re quired Funds Re quired
No. of shares = No. of shares =
Price at end(P1 ) Price at end(P1 )

9, 00, 000 5, 00, 000

∆n = =4205.61 ∆n = = 2232.14
214 214

(iv) Calculation of value of firm (iv) Calculation of value of firm

V1 =
(n +n ) P1 -I +E V1 =
(n +n ) P1 -I +E
1+Ke 1+Ke
 9, 00, 000   5, 00, 000 
 40, 000 +  214 −10, 00, 000 + 5, 00, 000  40, 000 +  224 −10, 00, 000 + 5, 00, 000
 214   224 
= =
1 + 0.12 1 + 0.12
94, 60, 000 – 5, 00, 000 94, 60, 000 – 5, 00, 000
= = 80,00,000 = =80,00,000
1.12 1.12

Q.10 MM Approach MTP May 20

ZX Ltd. has a paid-up share capital of Rs.1,00,00,000, face value of Rs.100 each. The current market price of the
shares is Rs.100 each. The Board of Directors of the company has an agenda of meeting to pay a dividend of 50%
to its shareholders. The company expects a net income of Rs.75,00,000 at the end of the current financial year.
Company also plans for a capital expenditure for the next financial year for a cost of Rs.95,00,000, which can be
financed through retained earnings and issue of new equity shares.
Company’s desired rate of investment is 15%.
Required:
Following the Modigliani- Miller (MM) Hypothesis, DETERMINE value of the company when:
(i) It does not pay dividend and
(ii) It does pay dividend

(n + n)P1 − I + E
Ans V or nP₀ =
(1 + Ke )

Where,

Vf = Value of firm in the beginning of the period

n = number of shares in the beginning of the period
∆n = number of shares issued to raise the funds required
I = Amount required for investment

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E = total earnings during the period

(i) Value of the ZX Ltd. when dividends are not paid.
(n + n)P1 − I + E
nPₒ =
(1 + Ke )
 20, 00, 000 
 1, 00, 000 +  x115 − 95, 00, 000 +75, 00, 000
 115 
nPₒ =
1 + 0.15
Rs.1,35, 00, 000 − Rs.95, 00, 000 + Rs.75, 00, 000
= = Rs.1,00,00,000
(1 + 0.15)
Working notes:

1. Price of share at the end of the period (P1)

P1 + D1
Pₒ =
1 + Ke
P1 + 0
100 =
1 + 0.15
or, P₁= 115

2. Calculation of funds required for investment

Earnings Rs.75,00,000
Dividend distributed Nil
Fund available for investment Rs.75,00,000
Total Investment Rs.95,00,000
Balance Funds required Rs.20,00,000

3. Calculation of no. of shares required to be issued for balance fund

Funds Re quired 20, 00, 000

No. of shares (∆n)= = shares
Price at end(P1 ) 115
(ii) Value of the ZX Ltd. when dividends are paid.

(n + n)P1 − I + E
nPₒ =
(1 + Ke )
 70, 00, 000 
 1, 00, 000 +  x 65 − 95, 00, 000 +75, 00, 000
 65 
nP₀ =
1 + 0.15
Rs.1,35, 00, 000 − Rs.95, 00, 000 + Rs.75, 00, 000
= = Rs.1,00,00,000
(1 + 0.15)

Working notes:
4. Price of share at the end of the period (P1)
P1 + D1
Pₒ =
1 + Ke
P1 + 50
100 = or, P₁= Rs.65
1 + 0.15
5. Calculation of funds required for investment

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Earnings Rs.75,00,000
Dividend distributed Rs.50,00,000
Fund available for investment Rs.25,00,000
Total Investment Rs.95,00,000
Balance Funds required Rs.70,00,000

6. Calculation of no. of shares required to be issued for balance fund

Funds Re quired 70, 00, 000
No. of shares (∆n) = = =1,07,693 shares(approx.)
Price at end(P1 ) 65
Note- As per MM-hypothesis of dividend irrelevance, value of firm remains same irrespective of
dividend paid. In the solution, there may be variation in value, which is due to rounding off error.

Q.11 MM Approach MTP Nov 18(2)

M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000 outstanding shares and the
current market price is Rs. 100. It expects a net profit of Rs. 2,50,000 for the year and the Board is considering
dividend of Rs. 5 per share.
M Ltd. requires to raise Rs. 5,00,000 for an approved investment expenditure. ANALYSE, how the
MM approach affects the value of M Ltd. if dividends are paid or not paid.
Ans A When dividend is paid
(a) Price per share at the end of year 1
1
100 = (Rs. 5 + P 1)
1.10
110 = Rs. 5 + P1
P1 = 105
(b) Amount required to be raised from issue of new shares
Rs.5,00,000 – (Rs.2,50,000 – Rs.1,25,000)
Rs.5,00,000 – Rs.1,25,000 = Rs.3,75,000
(c) Number of additional shares to be issued
3, 75, 000 75, 000
= shares or say 3,572 shares
105 21

(d) Value of M Ltd.

(Number of shares × Expected Price per share)
i.e., (25,000 + 3,572) × Rs.105 = Rs.30,00,060
B When dividend is not paid
(a) Price per share at the end of year 1
P1
100=
1.10
P1 = 110
(b) Amount required to be raised from issue of new shares
Rs.5,00,000 – 2,50,000 = 2,50,000
(c) Number of additional shares to be issued
2,50, 000 2,50, 000
= shares or say 2,273 shares.
110 11
(d) Value of M Ltd.,

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(25,000 + 2273) × Rs.110

= Rs.30,00,030
Whether dividend is paid or not, the value remains the same.

Q.12 MM Approach MTP Nov 18(1)

RST Ltd. has a capital of Rs. 10,00,000 in equity shares of Rs. 100 each. The shares are currently quoted at par.
The company proposes to declare a dividend of Rs. 10 per share at the end of the current financial year. The
capitalization rate for the risk class of which the company belongs is
12%. COMPUTE the market price of the share at the end of the year, if
(i) a dividend is not declared?
(ii) a dividend is declared?
(iii) assuming that the company pays the dividend and has net profits of Rs.5,00,000 and makes new
investments of Rs.10,00,000 during the period, how many new shares must be issued? Use the MM model.

Ans As per MM model, the current market price of equity share is:
1
P0 = ×(D1 + P1)
1 + ke

(i) If the dividend is not declared:

1
100= x(0 + P1)
1 + 0.12
P1
100=
1.12
P1 = Rs.112

The Market price of the equity share at the end of the year would be Rs.112.

(ii) If the dividend is declared:

1
100= x(10 + P1)
1 + 0.12
P1
100= =
1.12
112 = 10 + P1
P1 = 112 – 10 = Rs.102
The market price of the equity share at the end of the year would be Rs.102.
(iii) In case the firm pays dividend of Rs.10 per share out of total profits of Rs. 5,00,000 and plans to
make new investment of Rs. 10,00,000, the number of shares to be issued may be found as follows:

Total Earnings Rs.5,00,000

- Dividends paid (1,00,000)

Retained earnings 4,00,000
Total funds required 10,00,000

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Fresh funds to be raised 6,00,000

Market price of the share 102

Number of shares to be issued (Rs.6,00,000 / 102) 5,882.35 or, the

firm would issue 5,883 shares at the rate of Rs.102

Q.13 MMP Approach & Gordan MTP May 23(2)

Rex Ltd has 20 lakh equity shares outstanding at the start of the accounting year 202 3. The existing market
price per share is ` 300. Expected dividend is ` 20 per share. The rate of capitalization appropriate to the risk
class to which the company belongs is 20%.

CALCULATE the market price per share when expected dividends are: (a) declared, and (b) not declared, based
on the Miller – Modigliani approach.

CALCULATE number of shares to be issued by the company at the end of the accounting year on the assumption
that the net income for the year is ` 5 crore; investment budget is ` 8 crores, when (a) Dividends are declared,
and (b) Dividends are not declared.

PROVE that the market value of the shares at the end of the accounting year will remain unchanged irrespective
of whether (a) Dividends are declared, or (ii) Dividends are not declared.

WHAT is the implied growth rate in dividends as per Gordon’s model, if expected dividend payment is considered
imminent?
Ans (i) Calculation of market price per share
According to Miller – Modigliani (MM) Approach:
P1 + D1
Po=
1+ke
Where,
Existing market price (Po) = ` 300
Expected dividend per share (D1) = ` 20
Capitalization rate (ke) = 0.20 Market price at year end (P1) = ?
a. If expected dividends are declared, then

300=(P1+20)/(1+0.2)
300 x 1.2 = P1+20
P1= 340

b. If expected dividends are not declared, then

300=(P1+0)/(1+0.2)
300 x 1.2 = P1
P1= 360

(ii) Calculation of number of shares to be issued

(a) (b)
Dividends are Dividends are not
declared.(` lakh) Declared (` lakh)
Net income 500 500

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Total dividends (400) -

Retained earnings 100 500
Investment budget 800 800
Amount to be raised by new issues 700 300
Relevant market price (` per share) 340 360
No. of new shares to be issued (in 2.0588 0.8333
lakh)
(` 700 ÷ 340; ` 300 ÷ 360)

(iii) Calculation of market value of the shares

(a) (b)
Particulars Dividends are Dividends are not
declared Declared
Existing shares (in lakhs) 20.00 20.00
New shares (in lakhs) 2.0588 0.8333
Total shares (in lakhs) 22.0588 20.8333
Market price per share (`) 340 360
Total market value of shares at the end of 22.0588 × 340 20.8333 × 360
the year (` in lakh) = 7,500 (approx.) = 7,500 (approx.)

Hence, it is proved that the total market value of shares remains unchanged irrespective of whether
dividends are declared, or not declared.
(iv) P0=D1/(Ke-g)

300 = 20/(0.2-g)

0.2-g = 20/300
0.2-g = 0.0667

G = 0.133333
g = 13.3333%

Q.14 Gordan’s Model RTP Nov 23

HM Ltd. is listed on Bombay Stock Exchange which is currently been evaluated by Mr. A
on certain parameters.Mr. A collated following information:
(a) The company generally gives a quarterly interim dividend. ` 2.5 per share is the last dividend declared.
(b) The company’s sales are growing by 20% on a 5-year Compounded Annual Growth Rate (CAGR) basis, however
the company expects following retention amounts against probabilities mentioned as contention is dependent
upon cash requirements for the company. Rate of return is 10% generated by the company.
Situation Prob. Retention
Ratio
A 30% 50%
B 40% 60%
C 30% 50%
(c) The current risk-free rate is 3.75% and with a beta of 1.2 company is having a risk premium of 4.25%.
You are required to help Mr. A in calculating the current market price using Gordon’s formula.

Ans Market price using Gordon’s formula

D0 (1 + g)
D (1 + g)
P0 = 0
ke − g

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D0 = 2.5×4 = 10 per share (annual)

g = br or retention ratio x rate of return
Calculation of expected retention ratio
Situation Prob. Retention Expected Retention
Ratio Ratio
A 30% 50% 0.15
B 40% 60% 0.24
C 30% 50% 0.15
Total 0.54
g = 0.54 × 0.10= 0.054 or 5.4% P0
D (1 + g)
P0 = 0
ke − g
Ke − g
10(1 + 0.054) 10.54
P0 = = = 305.51
0.0885 − 0.054 0.0345
Ke = Risk free rate + (Beta x Risk Premium)
= 3.75% + (1.2 x 4.25%) = 8.85%

Q.15 MPS Using Gordon’s Model PY Dec 21

X Ltd. is a multinational company. Current market price per share is ` 2,185. During the F.Y. 2020-21, the company
paid ` 140 as dividend per share. The company is expected to grow @ 12% p.a. for next four years, then 5% p.a.
for an indefinite period. Expected rate of return of shareholders is 18% p.a.
(i) Find out intrinsic value per share.
(ii) State whether shares are overpriced or under priced.
Year 1 2 3 4 5
Discounting Factor @ 18% 0.847 0.718 0.608 0.515 0.436

Ans As per Dividend discount model, the price of share is calculated as follows:
D1 D2 D3 D4 D (1+g) 1
P= + + + + 4 x
1
(1 + Ke) (1 + Ke)2
(1 + Ke)3
(1 + Ke) 4
(Ke-g) (1 + Ke) 4

Where,

P = Price per share

Ke = Required rate of return on equity

g = Growth rate

140x1.12 156.80 x 1.12 175.62 x1.12 196x 1.12 220.29(1 + 0.05) 1

P = + + + + x
(1 + 0.18) 1
(1 + 0.18) 2
(1 + 0.18) 3
(1 + 0.18) 4
(0.18 − 0.05) (1 + 0.18)
4

P= 132.81 + 126.10 + 119.59 + 113.45 + 916.34 = ` 1,408.29

Intrinsic value of share is ` 1,408.29 as compared to latest market price of

`2,185. Market price of share is over-priced by ` 776.71.

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Q.16 MPS using Gordon’s Model RTP May 19

The following figures are collected from the annual report of XYZ Ltd.:

Net Profit `30 lakhs

Outstanding 12% preference shares `100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

CALCULATE price per share using Gordon’s Model when dividend pay-out is (i) 25%; (ii) 50% and (iii) 100%.

Ans
` in lakhs
Net Profit 30
Less: Preference dividend 12
Earning for equity shareholders 18
Therefore earning per share 18/3 = ` 6.00
Price per share according to Gordon’s Model is calculated as follows:
E (1- b)
P0= 1
Ke-br
Here, E1 = 6, Ke = 16%
(i) When dividend pay-out is 25%
6x0.25 1.5
P0 = = = 150
0.16 − (0.75x0.2) 0.16 − 0.15
(ii) When dividend pay-out is 50%

6x0.25 3
P0 = = = 50
0.16 − (0.5x 0.2) 0.16 − 0.10

(iv) When dividend pay-out is 100%

6x1 6
P0 = = = 37.50
0.16 − (0x 0.2) 0.16

Q.17 MPS using Gordon’s Model MTP Nov 22(2)

The annual report of XYZ Ltd. provides the following information for the Financial Year 2019-20:
Particulars Amount (`)
Net Profit 78 lakhs
Outstanding 15% preference shares 120 lakhs
No. of equity shares 6 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

CALCULATE price per share using Gordon’s Model when dividend pay-out is-
(i) 30%; (ii) 50%; (iii) 100%.

Ans Price per share according to Gordon’s Model is calculated as follows:

Particulars Amount in `
Net Profit 78 lakhs

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Less:Preference dividend(120 lakhs@15%) 18 lakhs

Earnings for equity shareholders 60 lakhs
Earnings Per Share 60 lakhs/6 lakhs = ` 10.00
Price per share according to Gordon’s Model is calculated as follows:
E (1- b)
P0 = 1
Ke-br
Here, E1 = 10, Ke = 16%

(i) When dividend pay-out is 30%

10  0.30 3
P0 = = = `150
0.16 − (0.70  0.2) 0.16 − 0.14
(ii) When dividend pay-out is 50%
10  0.5 5
P0 = = = `83.33
0.16 − (0.5  0.2) 0.16 − 0.10
(iii) When dividend pay-out is 100%
10 1 10
P0 = = =` 62.5
0.16 − (0  0.2) 0.16

Q.18 MPS using Gordon’s Model MTP Nov 19

The following figures are collected from the annual report of XYZ Ltd.:

Net Profit Rs.60 lakhs

Outstanding 10% preference shares Rs.100 lakhs
No. of equity shares 5 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 14%

CALCULATE price per share using Gordon’s Model when dividend pay-out is (i) 25%; (ii) 50% and (iii) 100%.

Ans
Rs. in lakhs
Net Profit 60
Less: Preference dividend 10
Earning for equity shareholders 50
Therefore earning per share 50/5 = Rs.10.00

E1 (1- b)
P0 =
Ke-br
Here, E1 = 10, Ke = 14%, r = 20%

(i) When dividend pay-out is 25%

10x 0.25 25
P0 = = =250
0.14 − (0.75x0.2) 0.14 − 0.15
As per the Gordon’s Dividend relevance model, the Cost of equity (K e) should be greater than the growth
rate i.e. br. In this case Ke is 14% and br = 15%, hence, the equity investors would prefer capital appreciation
than dividend.

(ii) When dividend pay-out is 50

When dividend pay-out is 50%

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10x 0.5 25
P0 = = =125
0.14 − (0.5x0.2) 0.14 − 0.10
(iii) When dividend pay-out is 100%
10x 1 10
Po= = = 71.43
0.14 − (0x0.2) 0.14

Q.19 Walter Model RTP Nov 18

The earnings per share of a company is ` 10 and the rate of capitalisation applicable to it is 10 per cent. The
company has three options of paying dividend i.e. (i) 50%, (ii) 75% and (iii) 100%.
CALCULATE the market price of the share as per Walter’s model if it can earn a return of
(a) 15, (b) 10 and (c) 5 per cent on its retained earnings.

Ans Market Price (P) per share as per Walter’s Model is:

r
D+ (E - D)
Ke
P=
Ke
Where,

P = Price of Share
r = Return on investment or rate of earning
Ke = Rate of Capitalisation or Cost of Equity
Calculation of Market Price (P) under the following dividend payout ratio and earning rates:
(i) (ii) (iii)
Rate of Earning (r) DP ratio 50% DP ratio 75% DP ratio 100%

(a) 15%  0.15   0.15   0.15 

5+  (10 − 5 ) 7.5 +   (10 − 7.5 ) 10 +   (10 − 10 )
 0.10   0.10   0.10 
0.10 0.10 0.10
12.5 11.25 10
= =`125 = =`112.5 = =`100
0.10 0.10 0.10
(b) 10%  0.10   0.10   0.10 
5+  (10 − 5 ) 7.5 +   (10 − 7.5 ) 10 +   (10 − 10 )
 0.10   0.10   0.10 
0.10 0.10 0.10
10 10 10
= =`100 = =`100 = =`100
0.10 0.10 0.10
(c) 5%  0.05   0.05   0.05 
5+  (10 − 5 ) 7.5 +   (10 − 7.5 ) 10 +   (10 − 10 )
 0.10   0.10   0.10 
0.10 0.10 0.10
7.5 8.75 10
= =`75 = =`87.5 = =`100
0.10 0.10 0.10

Q.20 Walter & Gordon Model PY May 19

The following information is supplied to you :
Total Earning ` 40 Lakhs
No. of Equity Shares (of ` 100 each) 4,00,000

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Dividend Per Share `4

Cost of Capital 16%
Internal rate of return on investment 20%
Retention ratio 60%

Calculate the market price of a share of a company by using :

(i) WaIter’s Formula
(ii) Gordon's Formula

40 Lakhs
Ans Earning Per share(E) = = ` 10
4, 00, 000
Calculation of Market price per share by
r
D+ (E-D)
Ke
(i) Walter’s formula: Market Price (P) =
Ke

Where,

P = Market Price of the share.

E = Earnings per share.

D = Dividend per share.

Ke = Cost of equity/ rate of capitalization/ discount

rate.
R = Internal rate of return/ return on investment
0.20
4+(10-4)
0.16 4 +7.5
P = = = ` 71.88
0.16 0.16
(ii) Gordon’s formula: When the growth is incorporated in earnings and dividend, the present value of market
price per share (Po) is determined as follows
E (1 − b )
Gordon’s theory: Po
k − br
Where,
P0 = Present market price per
share. E = Earnings per share
b = Retention ratio (i.e. % of earnings retained)
r = Internal rate of return
(IRR) Growth rate (g) = br
10 (1 − .60) 4
Now Po = = = ` 100
16 − (.60 x .20) .04

Q.21 Walter & Gordon Model RTP Nov 20

The following information is given for QB Ltd.
Earnings per share ` 120
Dividend per share ` 36
Cost of capital 15%
Internal Rate of Return on investment 20%
CALCULATE the market price per share using
(a) Gordon’s formula (b) Walter’s formula

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Ans (a) As per Gordon’s Model, Price per share is computed using the formula:
E (1- b)
Po= 1
Ke-br
Where,
Po = Price per share
E1 = Earnings per share
b = Retention ratio; (1 - b = Pay-out ratio)
Ke = Cost of capital
r = IRR
br = Growth rate (g)
Applying the above formula, price per share
120(1 − 0.7) 36
Po= = = ` 3,600
0.15 − 0.70x 0.2 0.01
(b) As per Walter’s Model, Price per share is computed using the formula:
Price (𝐏)
Where,
P = Market Price of the share.
E = Earnings per share. D = Dividend per share.
Ke = Cost of equity/ rate of capitalization/ discount rate.
r = Internal rate of return/ return on investment
Applying the above formula, price per share
0.20
36 + (120-36)
P= 0.15
0.15
36 + 112
Or, P = = ` 986.67
0.15

Q.22 Walter & Gordon model MTP Nov 22(1)

Following information is given for WN Ltd.:
Earnings ` 30 per share
Dividend ` 9 per share
Cost of capital 15%
Internal Rate of Return on investment 20%
You are required to CALCULATE the market price per share using-
(i) Gordon’s formula (ii) Walter’s formula

Ans (i) As per Gordon’s Model, Price per share is computed using the formula:

E1 (1- b)
Po=
Ke-br
Where,
Po = Price per share
E1 = Earnings per share
b = Retention ratio; (1 - b = Pay-out ratio) Ke = Cost of capital
r = IRR
br = Growth rate (g)
Applying the above formula, price per share

30  0.3 9
Po = = = ` 900
0.15 − 0.70  0.2 0.01

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9
*Dividend pay-out ratio = = 0.3 or 30%
30
(ii) As per Walter’s Model, Price per share is computed using the formula:
r
D+ (E - D)
Ke
Price (P) =
Ke
P = Market Price of the share
E = Earnings per share
D = Dividend per share
Ke = Cost of equity/ rate of capitalization/ discount rate
r = Internal rate of return/ return on investment
Applying the above formula, price per share
0.20
9+ (30 - 9)
0.15 37
P= = = ` 246.67
0.15 0.15

Q.23 Walter & Gordon model MTP May 21(1)

The following information is given:

Dividend per share (DPS) Rs. 9

Cost of capital (Ke) 19%

Internal rate of return on investment 24%

Retention Ratio 25%

CALCULATE the market price per share by using:
(i) Walter’s formula
(ii) Gordon’s formula (Dividend Growth model)

Ans Working:

Calculation of Earnings per share (EPS):

DPS
EPS =
Dividend Payout Ratio
9
EPS = = Rs.12
1 − 0.25
Market price per share by
(i) Walter’s model:
r
D+ (E - D)
Ke
P=
Ke
0.24
9+ (12 - 9)
= 0.19
0.19
= Rs. 67.31
(ii) Gordon’s model (Dividend Growth model):
D (1- g)
Po= 1
Ke-g
Where,
Po = Present market price per share.

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g = Growth rate (br) = 0.25 × 0.24 = 0.06

b = Retention ratio
k = Cost of Capital
r = Internal rate of return (IRR)
D0 = Dividend per share
E = Earnings per share
9(1 + 0.06)
=
0.19 − 0.06
9.54
= = Rs.73.38
0.13
Alternatively,
E (1- b)
Po= 1
Ke-br
12(1- 0.25) 9
Po= = = Rs. 69.23
0.19 − 0.06 0.13

Q.24 Walter & Gordon Model MTP May 19(1)

With the help of following figures CALCULATE the market price of a share of a company by using:
(i) Walter’s formula
(ii) Dividend growth model (Gordon’s formula)
Earnings per share (EPS) Rs. 10
Dividend per share (DPS) Rs. 6
Cost of capital (k) 20%
Internal rate of return on investment 25%
Retention Ratio 60%

Ans Market price per share by

(i) Walter’s formula:
r
D+ (E - D)
Ke
P=
Ke
0.25
6+ (10 - 6)
P= 0.20
0.20
P = Rs.55
(ii) Gordon’s formula (Dividend Growth model): When the growth is incorporated in earnings and dividend, the
present value of market price per share (Po) is determined as follows:
Gordon’s theory:

E1 (1- b)
Po=
Ke-br
Where,
Po = Price per share
E1 = Earnings per share
b = Retention ratio; (1 - b = Payout ratio)
Ke = Cost of capital

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r = IRR
br = Growth rate (g)
10 (1 − 0.60 ) 4
Po = = = Rs.80
0.20 -(0.60 x 0.25) 0.05

Q.25 Optimum Payout using Walter Model RTP July 21

The following information is supplied to you:
(`)
Total Earnings 2,00,000
No. of equity shares (of ` 100 each) 20,000
Dividend paid 1,50,000
Price/ Earnings ratio 12.5

Applying Walter’s Model:

(i) ANALYSE whether the company is following an optimal dividend policy.
(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on the value of the share.
(iii) Will your decision change if the P/E ratio is 8 instead of 12.5? ANALYSE.

Ans (i) The EPS of the firm is ` 10 (i.e., ` 2,00,000/ 20,000) and r = 2,00,000/ (20,000 shares× `100) = 10%. The
P/E Ratio is given at 12.5 and the cost of capital, K e, may betaken at the inverse of P/E ratio. Therefore, Ke
is 8 (i.e., 1/12.5). The firm is distributing total dividends of ` 1,50,000 among 20,000 shares, giving a dividend
per share of` 7.50. the value of the share as per Walter’s model may be found as follows:

r 0.1
D+ (E - D) 7.5+ (10 - 7.5)
Ke 0.08
P= = =` 132.81
Ke 0.08

The firm has a dividend payout of 75% (i.e., ` 1,50,000) out of total earnings of` 2,00,000. Since, the rate
of return of the firm, r, is 10% and it is more than the K e of 8%, therefore, by distributing 75% 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 a situation, the market price would be-

0.1
0+ (10 - 0)
= 0.08 = ` 156.25
0.08

So, theoretically the market price of the share can be increased by adopting a zero payout.

(ii) The P/E ratio at which the dividend policy will have no effect on the value of the share is such at which the
Ke would be equal to the rate of return, r, of the firm. The Ke would be 10% (= r) at the P/E ratio of 10.
Therefore, at the P/E ratio of 10, the dividend policy would have no effect on the value of the share.

(iii) If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be12.5 and in such a
situation ke> r and the market price, as per Walter’s model would be:

r 0.1
D+ (E - D) 7.5+ (10 - 7.5)
Ke 0.125
P= = = ` 76
Ke 0.125

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Q.26 Optimum Payout using Walter Model RTP May 20

Following information relating to Jee Ltd. is given:

Particulars
Profit after tax ` 10,00,000
Dividend pay-out ratio 50%
Number of Equity Shares 50,000
Cost of Equity 10%
Rate of Return on Investment 12%
(i) CALCULATE market value per share as per Walter's Model?
(ii) What is the optimum dividend pay-out ratio according to Walter's Model and Market value of equity share
at that pay-out ratio?

Ans (i) Walter’s model is given by –

D + (E − D)(r / Ke )
P=
Ke
Where,
P = Market price per share,
E = Earnings per share = ` 10,00,000 ÷ 50,000 = ` 20
D = Dividend per share = 50% of 20 = ` 10 r = Return earned on investment = 12%
Ke = Cost of equity capital = 10%
22
10+ (20 - 10)x
0.10 22
P= = = ` 220
0.10 0.10
(ii) According to Walter’s model when the return on investment is more than the cost of equity capital, the price
per share increases as the dividend pay-out ratio decreases. Hence, the optimum dividend pay-out ratio in
this case is Nil. So, at a pay-out ratio of zero, the market value of the company’s share will be:

0.12
0+ (20 - 0)x
= 0.10 = 24 = ` 240
0.10 0.10

Q.27 Optimum Payout using Walter Model RTP Nov 19

The following information pertains to SD Ltd.
Earnings of the Company ` 50,00,000
Dividend Payout ratio 60%
No. of shares outstanding 10,00,000
Equity capitalization rate 12%
Rate of return on investment 15%

(i) COMPUTE the market value per share as per Walter’s model?
(ii) COMPUTE the optimum dividend payout ratio according to Walter’s model and the market value of Company’s
share at that payout ratio?

Ans (i) Walter’s model is given by

r
D+ (E - D)
Ke
P=
Ke
Where

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P = Market price per share.

E = Earnings per share = ` 5
D = Dividend per share = ` 3
R = Return earned on investment = 15% Ke = Cost of equity capital = 12%
0.15
3+ (5 - 3)
P= 0.12 = ` 45.83
0.12

(ii) According to Walter’s model when the return on investment is more than the cost of equity capital, the price
per share increases as the dividend pay-out ratio decreases. Hence, the optimum dividend pay-out ratio in
this case is nil.
So, at a pay-out ratio of zero, the market value of the company’s share will be:

0.15
0+ (5 - 0)
P= 0.12 = = `52.08
0.12
Q.28 Optimum Payout using Walter Model RTP May 18
The following information relates to Navya Ltd:
Earnings of the company ` 20,00,000
Dividend pay-out ratio 60%
No. of Shares outstanding 4,00,000
Rate of return on investment 15%
Equity capitalization rate 12%
Required:
(i) DETERMINE what would be the market value per share as per Walter’s model.
(ii) COMPUTE optimum dividend pay-out ratio according to Walter’s model and the market value of
company’s share at that pay-out ratio.

Ans Navya Ltd.

(i) Walter’s model is given by –

D + (E − D)(r / Ke )
P=
Ke

Where,
P = Market price per share,
E = Earnings per share = `20,00,000 ÷ 4,00,000 = ` 5
D = Dividend per share = 60% of 5 = ` 3
r = Return earned on investment = 15%
Ke = Cost of equity capital = 12%
0.15 0.15
3+(5-3)x 3+2x
P= 0.12 = 0.12 = ` 45.83
0.12 0.12

(ii) According to Walter’s model when the return on investment is more than the cost of equity capital, the price
per share increases as the dividend pay-out ratio decreases. Hence, the optimum dividend pay-out ratio in
this case is Nil. So, at a payout ratio of zero, the market value of the company’s share will be:-
0.15
0+(5-0)x
= 0.12 = ` 52.08
0.12

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Q.29 Optimum Payout using Walter Model MTP May 22(1)

The following figures have been extracted from the annual report of Xee Ltd.:
Net Profit ` 75 lakhs
Outstanding 12% preference shares ` 250 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

COMPUTE the approximate dividend pay-out ratio so as to keep the share price at ` 105 by using Walter’s model?

Ans
Particulars (`’ in lakhs)
Net Profit 75
Less: Preference dividend 30
Earnings for equity shareholders 45
Earnings per share 45/3 = ` 15

Let, the dividend per share be D to get share price of ` 105

r
D+ (E - D)
Ke
P=
Ke
0.20
D+ (15 - D)
105 = 0.16
0.16
0.16D+3 - 0.20D
16.8 =
0.16
0.04D = 3 – 2.688
D = 7.80
DPS 7.80
D/P ratio = x100 = ×100 = 52%
EPS 15
So, the required dividend pay-out ratio will be = 52%

Q.30 Optimum Payout using Walter Model MTP Dec 21(2)

The following information is supplied to you:
Particulars `
Total Earnings 5,00,000
Equity shares (of ` 100 each) 50,00,000
Dividend paid 3,75,000
Price/ Earnings ratio 12.5

Applying Walter’s Model:

(i) ANALYSE whether the company is following an optimal dividend policy.
(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on the value of the share.
(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5? ANALYSE.

Ans (i) The EPS of the firm is ` 10 (i.e. ` 5,00,000/ 50,000). r = 5,00,000/ 50,00,000 = 10%The P/E Ratio is given
at 12.5 and the cost of capital, Ke, may be taken at the inverseof P/E ratio. Therefore, Ke is 8 (i.e., 1/12.5).

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The firm is distributing total dividends of` 3,75,000 among 50,000 shares, giving a dividend per share of `
7.50. The value ofthe share as per Walter’s model may be found as follows:
r
D+ (E - D) 7.5+ 0.1 (10 - 7.5)
Ke 0.08
P = = = ` 132.81
Ke 0.08
The firm has a dividend payout of 75% (i.e., ` 3,75,000) out of total earnings of` 5,00,000. Since,
the rate of return of the firm, r, is 10% and it is more than the Ke of8%, therefore, by distributing 75% 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 a situation, the market price would be,
0.1
0+ (10 - 0)
= 0.08 = ` 156.25
0.08
So, theoretically, the market price of the share can be increased by adopting a zero payout.

(ii) The P/E ratio at which the dividend policy will have no effect on the value of the share is such at which the
Ke would be equal to the rate of return, r, of the firm. The Ke would be 10% (= r) at the P/E ratio of 10.
Therefore, at the P/E ratio of 10, the dividend policy would have no effect on the value of the share.

(iii) If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be12.5 and in such a
situation ke> r and the market price, as per Walter’s model would be:
r
D+ (E - D) 7.5+ 0.1 (10 - 7.5)
Ke 0.125
P= = = ` 76
Ke 0.125

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7 CASH MANAGEMENT
CHAPTER
Q.1 REORDER INVENTORY LEVEL PY May 22
A company requires 36,000 units of a product per year at cost of ` 100 per unit. Ordering cost per order is ` 250
and the carrying cost is 4.5% per year of the inventory cost. Normal lead time is 25 days and safety stock is NIL.
Assume 360 working days in a year.
(i) Calculate the Reorder Inventory Level.
(ii) Calculate the Economic Order Quantity (EOQ).
(iii) If the supplier offers 1% quantity discount for purchase in lots of 9,000 units or more, should the
company accept the proposal?

Ans. Annual Consumption = 36,000 (A)

Ordering Cost = ` 250 per order (O)
4.5
Carrying Cost =  100
100
= ` 4.5 (C) Lead Time
= 25 days

(i) Reorder Level = Lead Time × Daily Consumption

36, 000
= 25 
360
= 2,500 units

(ii) Economic Order Quantity (EOQ)

2AO 2 x 36,000 x 250
= =
C 4.5
= 2,000 units

(iii) Evaluation of Profitability of Quantity Discount Offer:

(a) When EOQ is ordered
(`)
Purchase Cost (36,000 units x ` 100) 36,00,000
Ordering Cost [(36,000 units/2,000 units) x ` 250] 4,500
Carrying Cost (2,000 units x ½ x ` 4.5) 4,500
Total Cost 36,09,000

(b) When Quantity Discount is accepted

(`)
Purchase Cost (36,000 units x ` 99*) 35,64,000
Ordering Cost [(36,000 units/9,000 units) x ` 250] 1,000
Carrying Cost (9,000 units x ½ x ` 99 x 4.5%) 20,048
Total Cost 35,85,048

*Unit Cost = `100

Less: Quantity Discount @ 1% =`1
Purchase Cost = ` 99
Advise – The total cost of inventory is lower if Quantity Discount is accepted. Hence, the company
is advised to accept the proposal.

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Q.2 Optimum Cash Balance PY Nov 22

K Ltd. has a Quarterly cash outflow of ` 9,00,000 arising uniformly during the Quarter.
The company has an Investment portfolio of Marketable Securities. It plans to meet the demands for cash by
periodically selling marketable securities. The marketable securities are generating a return of 12% p.a.
Transaction cost of converting investments to cash is ` 60. The company uses Baumol model to find out the
optimal transaction size for converting marketable securities into cash. Consider 360 days in a year.
You are required to calculate
(i) Company's average cash balance,
(ii) Number of conversions each year and
(iii) Time interval between two conversions.

Ans. (i) Computation of Average Cash balance:

Annual cash outflow (U) = 9,00,000 x 4 = ` 36,00,000
Fixed cost per transaction (P) = ` 60
12
Opportunity cost of one rupee p.a. (S) = = 0.12
100
2UP 2´36, 00, 000´60
Optimum cash balance (C) = = = ` 60,000
S 0.12

 Average Cash balance =

( 0 + 60, 000 ) = ` 30,000
2

(ii) Number of conversions p.a.

Annual cash outflow = ` 36,00,000
Optimum cash balance = ` 60,000
36, 00, 000
 No. of conversions p.a. = = 60
60, 000

(iii) Time interval between two conversions

No. of days in a year = 360
No. of conversions p.a. = 60
360
 Time interval = = 6 days
60
Q.3 Cash Budget PY Dec 21
A garment trader is preparing cash forecast for first three months of calendar year 2021.
His estimated sales for the forecasted periods are as below:

January (` '000) February (` '000) March (` '000)

Total sales 600 600 800
(i) The trader sells directly to public against cash payments and to other entities on credit. Credit sales are
expected to be four times the value of direct sales to public. He expects 15% customers to pay in the
month in which credit sales are made, 25% to pay in the next month and 58% to pay in the next to next
month. The outstanding balance is expected to be written off.
(ii) Purchases of goods are made in the month prior to sales and it amounts to 90% of sales and are made on
credit. Payments of these occur in the month after the purchase. No inventories of goods are held.
(iii) Cash balance as on 1st January, 2021 is ` 50,000.
(iv) Actual sales for the last two months of calendar year 2020 are as below:
November (` '000) December (` '000)
Total sales 640 880
You are required to prepare a monthly cash, budget for the three months from January to March, 2021

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Ans. (1) Calculation of cash and credit sales (` in thousands)

Nov. Dec. Jan. Feb. Mar.
Total Sales 640 880 600 600 800

Cash Sales (1/5 th of total 128 176 120 120 160

sales)
Credit Sales (4/5 th of total 512 704 480 480 640
(2) sales)
Calculation of Credit Sales Receipts
Month Nov. Dec. Jan. Feb. Mar.
Forecast Credit sales (Working 512.00 704.00 480.00 480.00 640.00
note 1)

Receipts:
15% in the month of sales 72.00 72.00 96.00
25% in next month 176.00 120.00 120.00
58% in next to next month 296.96 408.32 278.40
Total 544.96 600.32 494.40
Cash Budget (`ithousands)
Nov. Dec. Jan. Feb. Mar.
Opening Balance (A) 50.00 174.96 355.28
Sales 640.00 880.00 600.00 600.00 800.00
Receipts:
Cash Collection (Working note 1) 120.00 120.00 160.00
Credit Collections (Working note 2) 544.96 600.32 494.40
Total (B) 664.96 720.32 654.40
Purchases (90% of sales in the 540 540 720
prior
monthto sales)
Payments:
Payment for purchases (next month) 540 540 720
Total (C) 540 540 720
Closing balance(D) = (A + B – C) 174.96 355.28 289.68

Q.4 Monthly Cash Budget RTP Nov 22

A company was incorporated w.e.f. 1st April, 2021. Its authorised capital was ` 1,00,00,000 divided into 10 lakh
equity shares of ` 10 each. It intends to raise capital by issuing equity shares of ` 50,00,000 (fully paid) on 1st
April. Besides this, a loan of ` 6,50,000 @ 12% per annum will be obtained from a financial institution on 1st April
and further borrowings will be made at same rate of interest on the first day of the month in which borrowing is
required. All borrowings will be repaid along with interest on the expiry of one year. The company will make
payment for the following assets in April.

Particulars (`)
Plant and Machinery 10,00,000

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Land and Building 20,00,000

Furniture 5,00,000
Motor Vehicles 5,00,000
Stock of Raw Materials 5,00,000
The following further details are available:
(1) Projected Sales (April-September):
(`)
April 15,00,000
May 17,50,000
June 17,50,000
July 20,00,000
August 20,00,000
September 22,50,000
(2) Gross profit margin will be 25% on sales.
(3) The company will make credit sales only and these will be collected in the second month following sales
(4) Creditors will be paid in the first month following credit purchases. There will be credit purchases only.
(5) The company will keep minimum stock of raw materials of ` 5,00,000.
(6) Depreciation will be charged @ 10% per annum on cost on all fixed assets.
(7) Payment of miscellaneous expenses of ` 50,000 will be made in April.
(8) Wages and salaries will be ` 1,00,000 each month and will be paid on the first day of the next month.
(9) Administrative expenses of ` 50,000 per month will be paid in the month of their incurrence.
(10) No minimum cash balance is required.
You are required to PREPARE the monthly cash budget (April-September), the projected
Income Statement for the 6 months period and the projected Balance Sheet as on
30th September, 2021.

Ans.
Monthly Cash Budget (April-September) (`)
April May June July August September
Opening cash - 10,50,000 - 1,37,500 5,25,000 7,25,000
balance
A. Cash inflows
Equity shares 50,00,000 - - - - -
Loans (Refer to working 6,50,000 1,25,000 - - - -
note 1)
Receipt from
debtors - - 15,00,000 17,50,000 17,50,000 20,00,000
Total (A) 56,50,000 11,75,000 15,00,000 18,87,500 22,75,000 27,25,000
B. Cash Outflows
Plant and 10,00,000 - - - - -
Machinery
Land and Building 20,00,000 - - - - -
Furniture 5,00,000 - - - - -
Motor Vehicles 5,00,000 - - - - -
Stock of raw 5,00,000 - - - - -
materials
(Minimum stock)

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Miscellaneous 50,000 - - - - -
expenses
Payment to - 10,25,000 12,12,500 12,12,500 14,00,000 14,00,000
creditors for credit
purchases (Refer to
working note 2)
Wages and - 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
salaries
Admn. expenses 50,000 50,000 50,000 50,000 50,000 50,000
Total :(B) 46,00,000 11,75,000 13,62,500 13,62,500 15,50,000 15,50,000
Closing balance 10,50,000 - 1,37,500 5,25,000 7,25,000 11,75,000
(A)-(B)

Budgeted Income Statement for six-month period ending 30th September

Particulars (`) Particulars (`)
To Purchases 83,37,500 By Sales 1,12,50,000
To Wages and Salaries 6,00,000 By Closing stock 5,00,000
To Gross profit c/d 28,12,500
1,17,50,000 1,17,50,000
To Admn. expenses 3,00,000 By Gross profit b/d 28,12,500
To Depreciation 2,00,000

To Accrued interest on loan 45,250

To Miscellaneous expenses 50,000

To Net profit c/d 22,17,250
28,12,500 28,12,500

Projected Balance Sheet as on 30th September, 2021

Liabilities Amount (`) Assets Amount (`)
Share Capital: Fixed Assets:

Authorised Land and Building 20,00,000

capital Less: Depreciation 1,00,000 19,00,000
10,00,000 equity 1,00,00,000
Plant and 10,00,000

shares of `10 Machinery

each Less: Depreciation 50,000 9,50,000
Issued, Furniture 5,00,000
Subscribed and Less: Depreciation 25,000 4,75,000
Paid up capital
5,00,000 equity 50,00,000 Motor Vehicles 5,00,000
Shares of `10 Less: Depreciation 25,000 4,75,000 38,00,000
each

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Current Assets:
Reserve and
Surplus: Stock 5,00,000
Sundry debtors 42,50,000
Profit and Loss 22,17,250 Cash 11,75,000 59,25,000

Long-term loans 7,75,000

Current liabilities
and provisions:
Sundry creditors 15,87,500
Accrued interest 45,250
Outstanding 1,00,000 17,32,750
expenses 97,75,000 97,75,000

Working Notes:
Subsequent Borrowings Needed (`)
April May June July August September
A. Cash Inflow
Equity shares 50,00,000
Loans 6,50,000
Receipt from
debtors - - 15,00,000 17,50,000 17,50,000 20,00,000
Total (A) 56,50,000 - 15,00,000 17,50,000 17,50,000 20,00,000
B. Cash Outflow
Purchase of 40,00,000
fixed assets
Stock 5,00,000
Miscellaneous 50,000
expenses
Payment to - 10,25,000 12,12,500 12,12,500 14,00,000 14,00,000
creditors
Wages and - 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
salaries
Administrative
expenses 50,000 50,000 50,000 50,000 50,000 50,000
Total 46,00,000 11,75,000 13,62,500 13,62,500 15,50,000 15,50,000
Surplus/ (Deficit) 10,50,000 (11,75,000) 1,37,500 3,87,500 2,00,000 4,50,000
Cumulative 10,50,000 (1,25,000) 12,500 4,00,000 6,00,000 10,50,000
balance

1. There is shortage of cash in May of ` 1,25,000 which will be met by borrowings in May.
2. Payment to Creditors
Purchases = Cost of goods sold - Wages and salaries
Purchases for April = (75% of 15,00,000) - ` 1,00,000 = ` 10,25,000

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(Note: Since gross margin is 25% of sales, cost of manufacture i.e. materials plus wages and salaries should
be 75% of sales)
Hence, Purchases = Cost of manufacture minus wages and salaries of ` 1,00,000)
The creditors are paid in the first month following purchases.
Therefore, payment in May is ` 10,25,000
The same procedure will be followed for other months.
April (75% of 15,00,000) - ` 1,00,000 = ` 10,25,000
May (75% of 17,50,000) - ` 1,00,000 = ` 12,12,500
June (75% of 17,50,000) - ` 1,00,000 = ` 12,12,500
July (75% of 20,00,000) - ` 1,00,000 = ` 14,00,000
August (75% of 20,00,000) - ` 1,00,000 = ` 14,00,000
September (75% of 22,50,000) - ` 1,00,000 = ` 15,87,500
Minimum Stock ` 5,00,000
Total Purchases ` 83,37,500
3. Accrued Interest on Loan
12% interest on ` 6,50,000 for 6 months 39,000
Add: 12% interest on ` 1,25,000 for 5 months 6,250
45,250
Q.5 Cash Budget in next 3 years RTP May 22
You are given below the Profit & Loss Accounts for two years for a company:
Profit and Loss Account
Year 1 Year 2 Year 1 Year 2
(`) (`) (`) (`)
To Opening stock 32,00,000 40,00,000 By Sales 3,20,00,000 4,00,00,000
To Raw materials 1,20,00,000 1,60,00,000 By Closing 40,00,000 60,00,000
stock
To Stores 38,40,000 48,00,000 By Misc. 4,00,000 4,00,000
Income
To Manufacturing 51,20,000 64,00,000
Expenses
To Other 40,00,000 40,00,000
Expenses
To Depreciation 40,00,000 40,00,000
To Net Profit 42,40,000 72,00,000 - -
3,64,00,000 4,64,00,000 3,64,00,000 4,64,00,000
Sales are expected to be ` 4,80,00,000 in year 3.
As a result, other expenses will increase by ` 20,00,000 besides other charges. Only raw materials are in stock.
Assume sales and purchases are in cash terms and the closing stock is expected to go up by the same amount as
between year 1 and 2. You may assume that no dividend is being paid. The Company can use 75% of the cash
generated to service a loan. COMPUTE how much cash from operations will be available in year 3 for the purpose?
Ignore income tax.

Ans. Projected Profit and Loss Account for the year 3

Particulars Year 2 Year 3 Particulars Year 2 Year 3
Actual (` in Projected (` Actual (` in Projected (` in
lakhs) in lakhs) lakhs) lakhs)

To Materials consumed 140.00 168.00 By Sales 400.00 480.00

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To Stores 48.00 57.60 By Misc. 4.00 4.00

Income
To Mfg. Expenses 64.00 76.80
To Other expenses 40.00 60.00
To Depreciation 40.00 40.00
To Net profit 72.00 81.60
404.00 484.00 484.00 484.00
Cash Flow:
Particulars (` in lakhs)
Profit 81.60
Add: Depreciation 40.00
121.60
Less: Cash required for increase in stock 20.00
Net cash inflow 101.60
Available for servicing the loan: 75% of ` 1,01,60,000 or ` 76,20,000
Working Notes:
(i) Material consumed in year 1 = (32 + 120 – 40)/320 = 35%
Material consumed in year 2 = (40 + 160 – 60)/400 = 35%
35
Likely consumption in year 3 = 480× = ` 168 (lakhs)
100
(ii) Stores are 12% of sales & Manufacturing expenses are 16% of sales for both the years.
Q.6 Monthly Cash Budget MTP May 23(1)
You are given the following information:
(i) Estimated monthly Sales are as follows:
` `

January 5,50,000 June 4,40,000

February 6,60,000 July 5,50,000

March 7,70,000 August 4,40,000

April 4,40,000 September 3,30,000

May 3,30,000 October 5,50,000

(ii) Wages and Salaries are estimated to be payable as follows:

` `

April 49,500 July 55,000

May 44,000 August 49,500

June 55,000 September 49,500

(iii) Of the sales, 75% is on credit and 25% for cash. 60% of the credit sales are collected within one month
and the balance in two months. There are no bad debt losses.
(iv) Purchases amount to 75% of sales and are made and paid for in the month preceding the sales.
(v) The firm has taken a loan of `6,00,000. Interest @ 12% p.a. has to be paid quarterly in January, April and
so on.
(vi) The firm is to make payment of tax of `26,000 in July 2023.

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(vii) The firm had a cash balance of `35,000 on 1St April 2023 which is the minimum desired level of cash
balance. Any cash surplus/deficit above/below this level is made up by temporary investments/liquidation
of temporary investments or temporary borrowings at the end of each month (interest on these to be
ignored).
Required:
PREPARE monthly cash budgets for six months beginning from April, 2023 on the basis of the above
information.

Ans. Computation – Collections from Customers

Particulars Feb Mar Apr May Jun Jul Aug Sep
(`) (`) (`) (`) (`) (`) (`) (`)
Total Sales 6,60,000 7,70,000 4,40,000 3,30,000 4,40,000 5,50,000 4,40,000 3,30,000
Credit Sales
(75% of 4,95,000 5,77,500 3,30,000 2,47,500 3,30,000 4,12,500 3,30,000 2,47,500
total Sales)
Collection
(within 2,97,000 3,46,500 1,98,000 1,48,500 1,98,000 2,47,500 1,98,000
one month)
Collection
(within 1,98,000 2,31,000 1,32,000 99,000 1,32,000 1,65,000
two months)
Total
5,44,500 4,29,000 2,80,500 2,97,000 3,79,500 3,63,000
Collections

Monthly Cash Budget for Six Months: April to September 2023

Particulars April May June July August Sept.
(`) (`) (`) (`) (`) (`)
Receipts:
Opening Balance 35,000 35,000 35,000 35,000 35,000 35,000
Cash Sales 1,10,000 82,500 1,10,000 1,37,500 1,10,000 82,500
Collections from Debtors 5,44,500 4,29,000 2,80,500 2,97,000 3,79,500 3,63,000
Total Receipts (A) 6,89,500 5,46,500 4,25,500 4,69,500 5,24,500 4,80,500
Payments:
Purchases 2,47,500 3,30,000 4,12,500 3,30,000 2,47,500 4,12,500
Wages and Salaries 49,500 44,000 55,000 55,000 49,500 49,500
Interest on Loan 18,000 ----- ----- 18,000 ----- -----
Tax Payment ----- ----- ----- 26,000 ----- -----
Total Payment (B) 3,15,000 3,74,000 4,67,500 4,29,000 2,97,000 4,62,000
Minimum Cash Balance 35,000 35,000 35,000 35,000 35,000 35,000
Total Cash Required (C) 3,50,000 4,09,000 5,02,500 4,64,000 3,32,000 4,97,000
Surplus/ (Deficit) (A)-(C) 3,39,500 1,37,500 -77,000 5,500 1,92,500 -16,500
Investment/Financing:

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Total effect of (Invest)/

Financing (D) -3,39,500 -1,37,500 77,000 -5,500 -1,92,500 16,500
Closing Cash Balance (A)
+ (D) - (B) 35,000 35,000 35,000 35,000 35,000 35,000

Q.7 Monthly Cash Budget MTP May 21(1)

PREPARE monthly cash budget for the first six months of 2021 on the basis of the following information:
(i) Actual and estimated monthly sales are as follows:
Actual (Rs.) Estimated (Rs.)
October 2020 2,00,000 January 2021 60,000
November 2020 2,20,000 February 2021 80,000
December 2020 2,40,000 March 2021 1,00,000
April 2021 1,20,000
May 2021 80,000
June 2021 60,000
July 2021 1,20,000

(ii) Operating Expenses (including salary & wages) are estimated to be payable as follows:
Month (Rs.) Month (Rs.)
January 2021 22,000 April 2021 30,000
February 2021 25,000 May 2021 25,000
March 2021 30,000 June 2021 24,000

(iii) Of the sales, 75% is on credit and 25% for cash. 60% of the credit sales are collected after one month,
30% after two months and 10% after three months.
(iv) Purchases amount to 80% of sales and are made on credit and paid for in the month preceding the sales.
(v) The firm has 12% debentures of Rs.1,00,000. Interest on these has to be paid quarterly in
January, April and so on.
(vi) The firm is to make an advance payment of tax of Rs. 5,000 in April.
(vii) The firm had a cash balance of Rs. 40,000 at 31st Dec. 2020, which is the minimum desired level of cash
balance. Any cash surplus/deficit above/below this level is made up by temporary investments/liquidation
of temporary investments or temporary borrowings at the end of each month (interest on these to be
ignored).

Ans. Monthly Cash Budget for first six months of 2021

(Amount in Rs.)
Particulars Jan. Feb. Mar. April May June
Opening balance 40,000 40,000 40,000 40,000 40,000 40,000
Receipts:
Cash sales 15,000 20,000 25,000 30,000 20,000 15,000
Collection from debtors 1,72,500 97,500 67,500 67,500 82,500 70,500
Total cash available (A) 2,27,500 1,57,500 1,32,500 1,37,500 1,42,500 1,25,500
Payments:
Purchases 64,000 80,000 96,000 64,000 48,000 96,000

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Operating Expenses 22,000 25,000 30,000 30,000 25,000 24,000

Interest on debentures 3,000 - - 3,000 - -
Tax payment - - - 5,000 - -
Total payments (B) 89,000 1,05,000 1,26,000 1,02,000 73,000 1,20,000
Minimum cash balance 40,000 40,000 40,000 40,000 40,000 40,000
desired
Total cash needed (C) 1,29,000 1,45,000 1,66,000 1,42,000 1,13,000 1,60,000
Surplus/(deficit) (A - C) 98,500 12,500 (33,500) (4,500) 29,500 (34,500)
Investment/financing
Temporary Investments (98,500) (12,500) - - (29,500) -
Liquidation of temporary 33,500 4,500
investments or temporary - 34,500
borrowings
Total effect of 4,500 (29,500) 34,500
investment/financing(D) (98,500) (12,500) 33,500
Closing cash balance (A +
D - B) 40,000 40,000 40,000 40,000 40,000 40,000

Workings:
1. Collection from debtors: (Amount in Rs.)
Year 2020 Year 2021
Oct. Nov. Dec. Jan. Feb. Mar. April May June
Total sales 2,00,000 2,20,00 2,40,00 60,00 80,000 1,00,00 1,20,000 80,000 60,000
Credit sales 0 0 0 0
(75% of total
sales) 1,50,000 1,65,00 1,80,00 45,00 60,000 75,00 90,000 60,000 45,000
Collections: 0 0 0 0
One month 90,00 99,00 1,08,00 27,000 36,00 45,000 54,000 36,000
Two months 0 0
45,00 0 49,50 54,000 0
13,500 18,000 22,500 27,000
Three months 0 0
15,000 16,500 18,000 4,500 6,000 7,500
Total
collections 1,72,5 97,500 67,50 67,500 82,500 70,500
00 0
2. Payment to Creditors: (Amount in Rs.)
Year 2021
Jan Feb Mar Apr May Jun Jul
Total sales 60,000 80,000 1,00,000 1,20,000 80,000 60,000 1,20,000
Purchases 96,000
(80% of total sales) 48,000 64,000 80,000 96,000 64,000 48,000
Payment:
One month prior 64,000 80,000 96,000 64,000 48,000 96,000

Q.8 Monthly Cash Budget MTP Nov 19

You are given the following information:
(i) Estimated monthly Sales are as follows:

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(ii)
Rs. Rs.
January 1,00,000 June 80,000

February 1,20,000 July 1,00,000

March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000
(ii) Wages and Salaries are estimated to be payable as follows:
Rs. Rs.

April 9,000 July 10,000

May 8,000 August 9,000
June 10,000 September 9,000
(iii) Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are collected within one month
and the balance in two months. There are no bad debt losses.
(iv) Purchases amount to 80% of sales and are made and paid for in the month preceding the sales.
(v) The firm has taken a loan of Rs.1,20,000. Interest @ 10% p.a. has to be paid quarterly in January, April
and so on.
(vi) The firm is to make payment of tax of Rs. 5,000 in July, 2019.
(vii) The firm had a cash balance of Rs. 20,000 on 1St April, 2019 which is the minimum desired level of cash
balance. Any cash surplus/deficit above/below this level is made up by tempora ry
investments/liquidation of temporary investments or temporary borrowings at the end of each month
(interest on these to be ignored).
Required
PREPARE monthly cash budgets for six months beginning from April, 2019 on the basis of the above
information.

Ans. Computation – Collections from Debtors

Particulars Feb Mar Apr May Jun Jul Aug Sep
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Total Sales 1,20,000 1,40,000 80,000 60,000 80,000 1,00,000 80,000 60,000
Credit
Sales (80% of 96,000 1,12,000 64,000 48,000 64,000 80,000 64,000 48,000
to tal Sales)
Collectio n
(within one month) 72,000 84,000 48,000 36,000 48,000 60,000 48,000
Collectio n
24,000 28,000 16,000 12,000 16,000 20,000
(within two months)
Total Collectio ns 1,08,000 76,000 52,000 60,000 76,000 68,000
Monthly Cash Budget for Six Months: April to September, 2019
Particulars April May June July August Sept.
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Receipts:
Opening Balance 20,000 20,000 20,000 20,000 20,000 20,000
Cash Sales 16,000 12,000 16,000 20,000 16,000 12,000

100 By CA Amit Sharma

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Collections fr o m 1,08,000 76,000 52,000 60,000 76,000 68,000

Debtors
Total Receipts (A) 1,44,000 1,08,000 88,000 1,00,000 1,12,000 1,00,000
Payments:
Purchases 48,000 64,000 80,000 64,000 48,000 80,000
Wages and Salaries 9,000 8,000 10,000 10,000 9,000 9,000
Interest on Loan 3,000 ----- ----- 3,000 ----- -----
Tax Payment ----- ----- ----- 5,000 ----- -----
Total Payment (B) 60,000 72,000 90,000 82,000 57,000 89,000
Minimum Cash Bala nce 20,000 20,000 20,000 20,000 20,000 20,000
Total Cash Required (C) 80,000 92,000 1,10,000 1,02,000 77,000 1,09,000
Surplus/ (Deficit) (A)-(C) 64,000 16,000 (22,000) (2,000) 35,000 (9,000)
Investmen t/Fin ancing: Total

effect of (Invest)/ Financing

(64,000) (16,000) 22,000 2,000 (35,000) 9,000
(D)

Closing Cash Bala nce 20,000 20,000 20,000 20,000 20,000 20,000
(A) + (D) - (B)

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8 DEBTORS MANAGEMENT
CHAPTER
Q.1 Accept Factoring or Not MTP May 19(2)
Navya Ltd has annual credit sales of Rs. 45 lakhs. Credit terms are 30 days, but its management of receivables
has been poor and the average collection period is 50 days, Bad debt is 0.4 per cent of sales. A factor has offered
to take over the task of debt administration and credit checking, at an annual fee of 1 per cent of credit sales.
Navya Ltd. estimates that it would save Rs. 35,000 per year in administration costs as a result. Due to the
efficiency of the factor, the average collection period would reduce to 30 days and bad debts would be zero. The
factor would advance 80 per cent of invoiced debts at an annual interest rate of 11 per cent. Navya Ltd. is
currently financing receivables from an overdraft costing 10 per cent per year.
If occurrence of credit sales is throughout the year, COMPUTE whether the factor’s services should be accepted
or rejected. Assume 365 days in a year.

Ans
Rs.
Present level of receivables is 45 lakh× 50/365 6,16,438

In case of factor, receivables would reduce to 45 lakhs× 30/365 3,69,863

The costs of the existing policyare as follows:
Cost of financing existing receivables: 6,16,438×10% 61,644
Cost of bad debts: 45 lakhs × 0.4% 18,000
Cost of current policy 79,644
The cost under the factor are as follows:
Cost of financing new receivable through factor:
(Rs. 3,69,863 × 0.8 × 0.11) + (Rs. 3,69,863 × 0.2 × 0.10) 39,945
= (32,548 + 7,397)
Factor’s annual fee: 45 Lakhs × 0.01 45,000
Administration costs saved: (35,000)
Net cost under factor: 49,945
From the above analysis it is clear that the factor’s services are cheaper than Existing policy by Rs. 29,699
(Rs. 79,644 - Rs.49,945) per year. Hence, the services of the factor should be accepted.

Q.2 Bank Loan, Factoring, Credit RTP Dec 21

The Alliance Ltd., a Petrochemical sector company had just invested huge amount in its new expansion project.
Due to huge capital investment, the company is in need of an additional ` 1,50,000 in working capital immediately.
The Finance Manger has determined the following three feasible sources of working capital funds:
(i) Bank loan: The Company's bank will lend ` 2,00,000 at 15%. A 10% compensating balance will be required,
which otherwise would not be maintained by the company.
(ii) Trade credit: The company has been offered credit terms from its major supplier of
3/30, net 90 for purchasing raw materials worth ` 1,00,000 per month.
(iii) Factoring: A factoring firm will buy the company’s receivables of ` 2,00,000 per month, which have a collection
period of 60 days. The factor will advance up to 75 % of the face value of the receivables at 12% on an annual
basis. The factor will also charge commission of 2% on all receivables purchased. It has been estimated that
the factor’s services will save the company a credit department expense and bad debt expense of ` 1,250
and ` 1,750 per month respectively.

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On the basis of annual percentage cost, ADVISE which alternative should the company select? Assume 360 days
year.
Ans. (i) Bank loan: Since the compensating balance would not otherwise be maintained, the real annual cost of taking
bank loan would be:
15
= × 100 = 16.67% p.a.
90
(ii) Trade credit: Amount upto ` 1,50,000 can be raised within 2 months or 60 days. The real annual cost of trade
credit would be:
3 360
= x x100 = 18.56% p.a.
97 60
(iii) Factoring:
Commission charges per year = 2% x(` 2,00,000 x12) = ` 48,000
Total Savings per year = (` 1,250 + ` 1,750) x 12 = ` 36,000
Net factoring cost per year = ` 48,000 - ` 36,000 = ` 12,000
Annual Cost of Borrowing ` 1,50,000 receivables through factoring would be:
12% x 1,50, 000 + 12, 000
= x100
1,50, 000
18, 000 + 12, 000
= x100
1, 50, 000
= 20% p.a.

Advise: The company should select alternative of Bank Loan as it has the lowest annual cost i.e. 16.67% p.a.

Q.3 Bank Loan, Factoring, Credit MTP May 23(2)

Sundaram limited a plastic manufacturing company had invested enormous amount of money in a new expansion
project. Due to such a great amount of capital investment, Company needs an additional ` 2,00,00,000 in working
capital immediately. The CFO has determined the following three feasible sources of working capital funds:
Bank Loan: The company's bank will lend `2,30,00,000 at 12% per annum. However, the bank will require 15% of
the loan granted to be kept in a current account as the minimum average bal ance which otherwise would have
been just ` 50,000.
Trade Credit: A major supplier with 2/20 net 80 credit terms has approached for supply of raw material worth
`1,90,00,000 p.m.
Factoring: factoring firm will buy the companies receivables of ` 2,50,00,000 per month, which have a collection
period of 60 days. factor will advance up to 75% of the face value of the receivables at 14 percent per annum.
Factor Commission will amount to 2% on all receivables purchased. Factoring will save credit department expense
and bad debts of ` 1,75,000 p.m. and ` 2,25,000 p.m.
Based on annual percentage cost, ADVISE which alternative should the company select. Assume 360 days a year

Ans (i) Bank Loan: As the minimum average balance more than ` 50,000 need not be kept if loan is not undertaken,
the incremental money made available by bank through bank loan is` 2,30,00,000- (15% x 2,30,00,000-
` 50,000) = ` 1,96,00,000. Real annual cost of bank loan = (` 2.3 crores x 12%) / ` 1.96 crores = 14.08%.

(ii) Trade Credit: The real annual cost of trade credit will be 2/98 x 360/60 x 100 = 12.24% .
(iii) Factoring:
Commission charges per year = 2% x 2.5 crores x 12 = ` 60,00,000
Savings per year = (1,75,000+2,25,000) x 12 = ` 48,00,000
Net Factoring cost per year = ` 60,00,000 – ` 48,00,000 = `12,00,000
Annual cost of borrowing ` 2.5 crores x 75% i.e. ` 1,87,50,000 will be
(1,87,50,000 x 14% + ` 12,00,000) / 1,87,50,000 = 20.4%

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Conclusion: The company should select trade credit as a preferred mode of financing the working capital
requirement as it results in lowest cost on an annual basis.

Q.4 Change in Credit Terms PY May 23

A company has current sale of ` 12 lakhs per year. The profit-volume ratio is 20% and post-tax cost of investment
in receivables is 15%. The current credit terms are 1/10, net
50 days and average collection period is 40 days. 50% of customers in terms of sales revenue are availing cash
discount and bad debt is 2% of sales.
In order to increase sales, the company want to liberalize its existing credit terms to 2/10, net 35 days. Due to
which, expected sales will increase to ` 15 lakhs. Percentage of default in sales will remain same. Average
collection period will decrease by 10 days. 80% of customers in terms of sales revenue are expected to avail
cash discount under this proposed policy.
Tax rate is 30%.
ADVISE, should the company change its credit terms. (Assume 360 days in a year.)

Ans (i) Calculation of Cash Discount

Cash Discount = Total credit sales × % of customers who take up discount × Rate
12, 00, 000  50  0.01
Present Policy = = ` 6,000
100
Proposed Policy = 15,00,000 × 0.80 × 0.02 = ` 24,000

(ii) Opportunity Cost of Investment in Receivables

Collection period Rate of Return
Present Policy: Opportunity Cost = Total Cost × x
360 100
40 15
= 9,60,000 × x = ` 16,000
360 100
Collection period Rate of Return
Proposed Policy: = Total Cost × x
360 100
30 15
= 12,00,000 × x = ` 15,000
360 100
Statement showing Evaluation of Credit Policies
Particulars Present Proposed
Policy Policy
Credit Sales 12,00,000 15,00,000
Variable Cost @ 80%* of sales 9,60,000 12,00,000
Bad Debts @ 2% 24,000 30,000
Cash Discount 6,000 24,000
Profit before tax 2,10,000 2,46,000
Tax @ 30% 63,000 73,800
Profit after Tax 1,47,000 1,72,200
Opportunity Cost of Investment in Receivables 16,000 15,000
Net Profit 1,31,000 1,57,200

*Only relevant or variable costs are considered for calculating the opportunity costs on the funds blocked in
receivables. Since 20% is profit-volume ratio, hence the relevant costs are taken to be 80% of the respective
sales.
Advise: Proposed policy should be adopted since the net benefit is increased by
(` 1,57,200 - ` 1,31,000) = ` 26,200.

Alternative presentation using incremental approach

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`
Incremental sales (15,00,000 – 12,00,000) 3,00,000

Less: Incremental variable cost (12,00,000 – 9,60,000) 2,40,000

Less: Incremental Bad debts (30,000 – 24,000) 6,000

Less: Incremental Cash discount (24,000 – 6,000) 18,000

Increase in Profit Before Tax 36,000

Less: Tax @ 30% 10,800

Increase in Profit After Tax 25,200

Add: Savings in opportunity cost (16,000 - 15,000) 1,000

Increase in Net Profit 26,200

Advise: Proposed policy should be adopted since the net benefit is increased by
(` 1,57,200 - ` 1,31,000) = ` 26,200.

Q.5 Collection Expenses PY Jul 21

Current annual sale of SKD Ltd. is ` 360 lakhs. It's directors are of the opinion that company's current
expenditure on receivables management is too high and with a view to reduce the expenditure they are
considering following two new alternate credit policies:

Policy X Policy Y Average

collection period 1.5 months 1 month
% of default 2% 1%
Annual collection expenditure ` 12 lakh ` 20 lakh
Selling price per unit of product is ` 150. Total cost per unit is ` 120. Current credit
terms are 2 months and percentage of default is 3%.
Current annual collection expenditure is ` 8 lakh. Required rate of return on investment of
SKD Ltd. is 20%. Determine which credit policy SKD Ltd. should follow.

Ans Statement showing the Evaluation of Credit policies (Total Approach)

Particulars Present Proposed Proposed Policy

Policy Policy X(1.5 Y (1 Month)
(2 Months) Months)
` in lakhs ` in lakhs ` in lakhs
A. Expected Profit:
(a) Credit Sales* 360 360 360
(b) Total Cost other 288 288 288
than Bad Debts and collection
expenditure (360/150 x 120)
(c) Bad Debts 10.8 7.2 3.6
(360 x 0.03) (360 x 0.02) (360 x 0.01)

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(d) Collection expenditure 8 12 20

(e) Expected Profit [(a) – (b) – 53.2 52.8 48.4
(c) - (d)]
B. Opportunity Cost of 9.6 7.2 4.8
Investments in
Receivables (Working Note)
C. Net Benefits (A – B) 43.6 45.6 43.6

Recommendation: The Proposed Policy X should be followed since the net benefits under this policy are higher
as compared to other policies.
*Note: It is assumed that all sales are on credit.
Working Note:
Calculation of Opportunity Cost of Average Investments
Collection period Rate of Re turn
Opportunity Cost = Total Cost × x
12 100
2 20
Present Policy = ` 288 lakhs × x = ` 9.6 lakhs
12 100
1.5 20
Policy X = ` 288 lakhs × x = ` 7.2 lakhs
12 12
1 20
Policy X = ` 288 lakhs × x = ` 4.8 lakhs
12 100
Alternatively
Statement showing the Evaluation of Credit policies (Incremental Approach)
Particulars Present Proposed Proposed
Policy Policy X Policy Y
(2 Months) (1.5 Months) (1 Month)
` in lakhs ` in lakhs ` in lakhs
(a) Credit Sales* 360 360 360
(b) Cost of sales (360/150 x 120) 288 288 288
(c) Receivables (Refer Working Note) 48 36 24
(d) Reduction in receivables from - 12 24
present policy
(A) Savings in Opportunity Cost of - 2.4 4.8
Investment in Receivables (@ 20%)
(e) Bad Debts 10.8 7.2 3.6
(360 x 0.03) (360 x 0.02) (360 x 0.01)
(B) Reduction in bad debts from - 3.6 7.2
present policy
(f) Collection expenditure 8 12 20
(C) Increase in Collection expenditure - 4 12
from Present policy
(D) Net Benefits (A +B-C) 2 0
Recommendation: The Proposed Policy X should be followed since the net benefits under this policy are higher
as compared to other policies.
*Note: It is assumed that all sales are on credit.
Working Note:
Collection period
Calculation of Investment in Receivables=Total Cost ×
12

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2
Present Policy = ` 288 lakhs × = ` 48 lakhs
12
1.5
Policy X = ` 288 lakhs × = ` 36 lakhs
12
1
Policy Y = ` 288 lakhs × = ` 24 lakhs
12

Q.6 Credit policy PY Nov 18

MN Ltd. has a current turnover of ` 30,00,000 p.a. Cost of Sale is 80% of turnover and Bad Debts are 2%
of turnover, Cost of Sales includes 70% variable cost and 30% Fixed Cost, while company's required rate of
return is 15%. MN Ltd. currently allows 15 days credit to its customer, but it is considering increase this to
45 days credit in order to increase turnover.
It has been estimated that this change in policy will increase turnover by 20%, while Bad Debts will
increase by 1%. It is not expected that the policy change will result in an increase in fixed cost and creditors
and stock will be unchanged.
Should MN Ltd. introduce the proposed policy? (Assume 360 days year)

Ans Statement Showing Evaluation of Credit Policies

Particulars Present Policy Proposed
Policy
A. Expected Contribution
(a) Credit Sales 30,00,000 36,00,000
(b) Less: Variable Cost 16,80,000 20,16,000
(c) Contribution 13,20,000 15,84,000
(d) Less: Bad Debts 60,000 1,08,000
(e) Contribution after Bad debt [(c)-(d)] 12,60,000 14,76,000
B. Opportunity Cost of investment in 15,000 54,000
Receivables

C. Net Benefits [A-B] 12,45,000 14,22,000

D. Increase in Benefit 1,77,000
Recommendation: Proposed Policy i.e credit from 15 days to 45 days should be implemented by NM Ltd since
the net benefit under this policy are higher than those under present policy

1 Working Note:
Present Policy Propose Policy
(`) (`)
Sales 30,00,000 36,00,000
Cost of Sales (80% of sales) 24,00,000 28,80,000
Variable cost (70% of cost of sales) 16,80,000 20,16,000
2. Opportunity Costs of Average Investments

Collection period
Variable Cost × × Rate of
Return
45
Present Policy =` 24,00,000 × x15% ` 54,000
360
15
Proposed Policy = =15% ` 18,000
360

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Q.7 Credit Policy RTP May 23

River limited currently uses the credit terms of 1.5/15 net 45 days and average collection period was 30
days. The company presently having sales of ` 50,00,000 and 30% customers availing the discount. The
chances of default are currently 5%. Variable cost constitutes 65% and total cost constitute 85% of sales.
The company is planning liberalization of credit terms to 2/20 net 50 days. It is expected that sales are likely
to increase by ` 5,00,000, the default chances are 10% and average collection period will decline to 25 days.
There won't be any change in the fixed cost and 50% customers are expected to avail the discount. Tax rate
is 35%. EVALUATE this policy in comparison with the current policy and recommend whether the new policy
should be implemented. Assume cost of capital to be 10% (post tax) and 360 days in a year.

Ans Evaluation of Credit Policies

Particulars 1.5/15 net 45 2/20 net 50
A Sales `50,00,000 `55,00,000
B Variable Cost (65%) `32,50,000 `35,75,000
C Fixed Cost (20% in 1st Case) `10,00,000 `10,00,000
D Bad Debts (5% and 10%) `2,50,000 `5,50,000
E Discounts
(`5000000x30%x1.5%) `22,500 -
(`5500000x50%x2%) - `55,000
F PBT (A-B-C-D-E) `4,77,500 `3,20,000
G Tax @ 35% `1,67,125 `1,12,000
H PAT `3,10,375 `2,08,000
I Opportunity Cost
(`3250000 + `1000000) x 30/360x10%
`35,417 -
(`3575000 + `1000000) x 25/360 x 10% - `31,771
Net Benefit
`2,74,958 `1,76,229
J

The new policy leads to lower net benefit for the company. Hence it should not be implemented.

Q.8 Credit Policy RTP Nov 20

A company wants to follow a more prudent policy to improve its sales for the region which is ` 9 lakhs per
annum at present, having an average collection period of 45 days. After certain researches, the management
consultant of the company reveals the following information:
Credit Policy Increase in Increase in sales Present default
collection period anticipated
W 15 days ` 60,000 1.5%
X 30 days ` 90,000 2%
Y 45 days ` 1,50,000 3%
Z 70 days ` 2,10,000 4%

The selling price per unit is ` 3. Average cost per unit is ` 2.25 and variable costs per unit are ` 2. The current
bad debt loss is 1%. Required return on additional investment is 20%. (Assume 360 days year)
ANALYSE which of the above policies would you recommend for adoption?

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Ans A. Statement showing the Evaluation of Debtors Policies (Total Approach)

(Amount in `)
Particulars Present Proposed Proposed Proposed Proposed
Policy 45 Policy Policy Policy Policy Z
days W X Y 115 days
I. Expected Profit: 60 days 75 days 90 days
Z
(a) Credit Sales 9,00,000 9,60,000 9,90,000 10,50,000 11,10,000
(b) Total Cost other
than Bad Debts
(i) Variable Costs 6,00,000 6,40,000 6,60,000 7,00,000 7,40,000
[Sales × 2/ 3]
(ii) Fixed Costs 75,000 75,000 75,000 75,000 75,000
6,75,000 7,15,000 7,35,000 7,75,000 8,15,000
(c) Bad Debts 9,000 14,400 19,800 31,500 44,400
(d) Expected Profit 2,16,000 2,30,600 2,35,200 2,43,500 2,50,600
[(a) – (b) – (c)]
II. Opportunity Cost of 16,875 23,833 30,625 38,750 52,069
Investments in
Receivables
III. Net Benefits (I – II) 1,99,125 2,06,767 2,04,575 2,04,750 1,98,531

Recommendation: The Proposed Policy W (i.e. increase in collection period by 15 days or total 60 days)
should be adopted since the net benefits under this policy are higher as compared to other policies.

Working Notes:
(i) Calculation of Fixed Cost = [Average Cost per unit – Variable Cost per unit] × No. of Units sold
= [` 2.25 - ` 2.00] × (` 9,00,000/3)
= ` 0.25 × 3,00,000 = ` 75,000
(ii) Calculation of Opportunity Cost of Average Investments
C o lle c ti o n p er i o d R ate of R etu rn
Opportunity Cost = Total Cost x x
360 100
45 20
Present Policy = 6,75,000 × x =16,875
360 100

60 20
Policy W = 7,15,000 × x =23,833
360 100
75 20
Policy X = 7,35,000 × x = 30,625
360 100

90 20
Policy Y = 7,75,000 × x = 38,750
360 100
115 20
Policy Z = 8,15,000 × × = 52,069
360 100

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B. Another method of solving the problem is Incremental Approach. Here we assume that sales are all
credit sales. (Amount in `)
Particulars Present Proposed Proposed Proposed Proposed
Policy 45 Policy W Policy X Policy Y Policy Z
days 60 days 75 days days
90 115 days
I. Incremental Expected
Profit:
(a) Incremental Credit 0 60,000 90,000 1,50,000 2,10,000
Sales
(b) Incremental Costs
(i) Variable Costs 6,00,000 40,000 60,000 1,00,000 1,40,000
(ii) Fixed Costs 75,000 - - - -
(c) Incremental Bad Debt 9,000 5,400 10,800 22,500 35,400
Losses
(d) Incremental Expected 14,600 19,200 27,500 34,600
Profit (a – b –c)]
II. Required Return on
Incremental Investments:
(a) Cost of Credit 6,75,000 7,15,000 7,35,000 7,75,000 8,15,000
Sales
(b) Collection period 45 60 75 90 115
(c) Investment in 84,375 1,19,167 1,53,125 1,93,750 2,60,347
Receivable (a × b/360)
(d) Incremental Investment in
Receivables - 34,792 68,750 1,09,375 1,75,972

(e) Required Rate of 20 20 20 20

Return (in %)
(f) Required Return
on Incremental Investments - 6,958 13,750 21,875 35,194
(d × e)
III. Net Benefits (I – II) - 7,642 5,450 5,625 (594)
-
Recommendation: The Proposed Policy W should be adopted since the net benefits under this policy are
higher than those under other policies.
C. Another method of solving the problem is by computing the Expected Rate of Return
In c r em en tal Exp ec ted Pr o f i t
Expected Rate of Return = x100
Incremental Investment in Receivables
14, 500
For Policy W = x 100 = 41.96%
34, 792

19,200
For Policy X = x 100 = 27.93%
68, 750

27,500
For Policy Y = x 100 = 25.14%
109,375

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34, 600
For Policy Z = x 100 = 19.66%
1, 75, 972

Recommendation: The Proposed Policy W should be adopted since the Expected Rate of Return (41.96%)
is more than the Required Rate of Return (20%) and is highest among the given policies compared.

Q.9 Credit Policy RTP May 20

TM Limited, a manufacturer of colour TV sets is considering the liberalization 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 sold to
the customers in addition to other sales are as follows:
Quantity sold (No. of TV Sets)
Credit Period (Days) A B C
0 10,000 10,000 -
30 10,000 15,000 -
60 10,000 20,000 10,000
90 10,000 25,000 15,000

The selling price per TV set is `15,000. The expected contribution is 50% of the selling price. The cost of
carrying receivable averages 20% per annum.
You are required to COMPUTE the credit period to be allowed to each customer. (Assume 360 days in a year
for calculation purposes).

Ans In case of customer A, there is no increase in sales even if the credit is given. Hence comparative statement
for B & C is given below:
Particulars Customer B Customer C
1. Credit period (days) 0 30 60 90 0 30 60 90
2. Sales Units 10,000 15,000 20,000 25,000 - - 10,000 15,000
` in lakh `in lakh
3. Sales Value 1,500 2,250 3,000 3,750 - - 1,500 2,250
4. Contribution at 50% (A) 750 1,125 1,500 1,875 - - 750 1,125
5. Receivables:-
Credit Period × Sale 360 - 187.5 500 937.5 - - 250 562.5
6. Debtors at cost - 93.75 250 468.75 - - 125 281.25

7. Cost of carrying debtors - 18.75 50 93.75 - - 25 56.25

at 20% (B)
8. Excess of contributions 750 1,106.25 1,406.25 1,781.25 - - 725 1,068.75
over cost of carrying
debtors (A – B)
The excess of contribution over cost of carrying Debtors is highest in case of credit period of 90 days in
respect of both the customers B and C. Hence, credit period of 90 days should be allowed to B and C.

Q.10 Credit Policy RTP Nov 19

A regular customer of your company has approached to you for extension of credit facility for purchasing of
goods. On analysis of past performance and on the basis of information supplied, the following pattern of
payment schedule emerges:

Pattern of Payment Schedule

At the end of 30 days 20% of the bill
At the end of 60 days 30% of the bill.

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At the end of 90 days 30% of the bill.

At the end of 100 days 18% of the bill.
Non-recovery 2% of the bill.

The customer wants to enter into a firm commitment for purchase of goods of `30 lakhs in 2019, deliveries
to be made in equal quantities on the first day of each quarter in the calendar year. The price per unit of
commodity is `300 on which a profit of `10 per unit is expected to be made. It is anticipated that taking up
of this contract would mean an extra recurring expenditure of `10,000 per annum. If the opportunity cost
is 18% per annum, would you as the finance manager of the companyRECOMMEND the grant of credit to the
customer? Assume 1 year = 360 days.

Ans Statement showing the Evaluation of credit Policies

Particulars Proposed Policy`
A. Expected Profit:
(a) Credit Sales 30,00,000
(b) Total Cost
(i) Variable Costs 29,00,000
(ii) Recurring Costs 10,000
29,10,000
(c) Ba d Debts 60,000
(d) Expected Profit [(a) – (b) – (c)] 30,000
B. Opportunity Cost of Investments in Receivables 1,00,395
C. Net Benefits (A – B) (70,395)
Recommendation: The Proposed Policy should not be adopted since the net benefits under this policyare
negative
Working Note: Calculation of Opportunity Cost of Average Investments

Collection Period Rate of Return

Opportunity Cost = Total Cost x x
360 100
Particulars 20% 30% 30% 18% Total
A. Total Cost 5,82,000 8,73,000 8,73,000 5,23,800 28,51,800
B. Collection period 30/360 60/360 90/360 100/360
C. Required Rate of Return 18% 18% 18% 18%
D. Opportunity Cost 8,730 26,190 39,285 26,190 1,00,395
(A × B × C)

Q.11 Credit Policy RTP Nov 18

Tony Limited, manufacturer of Colour TV sets is considering the liberalization 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 sold to
the customers in addition to other sales are as follows:
Quantity sold (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 ` 9,000. The expected contribution is 20% of the selling price. The cost of
carrying receivable averages 20% per annum.
You are required:
(a) COMPUTE the credit period to be allowed to each customer.

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(Assume 360 days in a year for calculation purposes).

(b) DEMONSTRATE the other problems the company might face in allowing the credit period as determined
in (a) above?

Ans (a) In case of customer A, there is no increase in sales even if the credit is given. Hence comparative
statement for B & C is given below:
Particulars Customer B Customer C
1. Credit period (days) 0 30 60 90 0 30 60 90
2. Sales Units 1,000 1,500 2,000 2,500 - - 1,000 1,500
` in lakhs `in lakhs
3. Sales Value 90 135 180 225 - - 90 135
4. Contribution at 20% (A) 18 27 36 45 - - 18 27
5. Receivables:
Credit Period × Sales
360 - 11.25 30 56.25 - - 15 33.75
6. Debtors at cost i.e. - 9 24 45 - - 12 27
80% of 11.25
7. Cost of carrying - 1.8 4.8 9 - - 2.4 5.4
debtors at 20% (B)
8. Excess of contributions 18 25.2 31.2 36 - - 15.6 21.6
over cost of carrying
debtors (A – B)
The excess of contribution over cost of carrying Debtors is highest in case of credit period of 90 days in
respect of both the customers B and C. Hence, credit period of90 days should be allowed to B and C.
(b) Problem:
(i) Customer A is taking 1000 TV sets whether credit is given or not. Customer C is taking 1000 TV sets
at credit for 60 days. Hence A also may demand credit for 60 days compulsorily.
(ii) B will take 2500 TV sets at credit for 90 days whereas C would lift 1500 sets only. In such case B will
demand further relaxation in credit period i.e. B may ask for 120 days credit.

Q.12 Credit Policy MTP Nov 22(2)

Avesh Pvt. Ltd. is considering relaxing its present credit policy for accounts receivable and is in the process of
evaluating two proposed policies. Currently, the company has annual credit sales of ` 55 lakhs and accounts
receivable turnover ratio of 5 times a year. The current level of loss due to bad debts is ` 2,00,000. The company
is required to give a return of 15% on the investment in new accounts receivable. The company’s variable costs
are 75% of the selling price. Given the following information, IDENTIFY which is the better policy?
(Amount in `)
Particulars Present Policy Proposed Policy 1 Proposed Policy 2
Annual credit sales 55,00,000 65,00,000 70,00,000
Accounts receivable turnover ratio 5 times 4 times 3 times
Bad debt losses 2,00,000 3,50,000 5,00,000

Ans Statement showing the Evaluation of Accounts Receivable Policies

(Amount in `)
Particulars Present Proposed Proposed
A
Expected Profit: Policy Policy 1 Policy 2
(a) Credit Sales 55,00,000 65,00,000 70,00,000
(b) Total Cost other than Bad Debts:

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(i) Variable Costs (75%) 41,25,000 48,75,000 52,50,000

(c) Bad Debts 2,00,000 3,50,000 5,00,000

(d) Expected Profit [(a) – (b) – (c)] 11,75,000 12,75,000 12,50,000
B Opportunity Cost of Investments in Accounts 1,23,750 1,82,813 2,62,500
Receivable (Working Note) 10,51,250 10,92,187 9,87,500
C Net Benefits (A – B)
Recommendation: The Proposed Policy 1 should be adopted since the net benefits under this policy are higher
as compared to other policies.
Working Note:
Calculation of Opportunity Cost of Average Investments
Opportunity Cost = Total Cost × Collection period/12 × Rate of Return/100
Present Policy = ` 41,25,000 × 2.4/12 × 15% = `1,23,750
Proposed Policy 1 = ` 48,75,000× 3/12 × 15% = ` 1,82,813
Proposed Policy 2 = ` 52,50,000× 4/12 × 15% = ` 2,62,500

Q.13 Credit Policy MTP Nov 22(1)

GT Ltd. is taking into account the revision of its credit policy with a view to increasing its sales and profit.
Currently, all its sales are on one month credit. Other information is as follows:
Contribution 2/5th of Sales Revenue
Additional funds raising cost 20% per annum
The marketing manager of the company has given the following options along with estimates for
considerations:
Particulars Current Position Option I Option II Option III
Sales Revenue (`) 40,00,000 42,00,000 44,00,000 50,00,000
Credit period (in months) 1 1½ 2 3
Bad debts (% of sales) 2 2½ 3 5
Cost of Credit administration (`) 24,000 26,000 30,000 60,000
You are required to ADVISE the company for the best option.

Ans Statement Showing Evaluation of Credit Policies

(` in lakhs)
Current position Option I Option II Option III
Particulars (1 month) (1.5 months) (2 months) (3 months)

Sales Revenue 40,00, 42,00,000 44,00,000 50,00,000

000
Contribution @ 40% 16,00,000 16,80,000 17,60,000 20,00,000
Increase in contribution over - 80,000 1,60,000 4,00,000
Current level price (A)
Debtors = - 1  40, 00, 000 1.5  42, 00, 000 3  50, 00, 000
Average Collection period x Credit Sale 12 12 12
12
= 3,33,333.33 = 5,25,000 = 12,50,000
Increase in debtors over current 1,91,666.67 4,00,000.00 9,16,666.67
level
Cost of funds for additional − 38,333.33 80,000.00 1,83,333.33
amount of debtos @ 20% (B)

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Credit administrative cost 24,000 26,000 30,000 60,000

Increase in credit administration − 2,000 6,000 36,000
cost over present level (c)
Bad debts 80,000 1,05,000 1,32,000 2,50,000
Increase in bad debts over current − 25,000 52,000 1,70,000
levels (D)
Net gain/loss A – (B + C + D) − 14,666.67 22,000.00 10,666.67
Advise: It is suggested that the company GT Ltd. should implement Option II with a net gain of` 22,000 which
has a credit period of 2 months

Q.14 Credit Policy MTP May 21(2)

WQ Limited is considering relaxing its present credit policy and is in the process of evaluating two proposed
polices. Currently, the firm has annual credit sales of Rs . 180 lakh and Debtors turnover ratio of 4 times a year.
The current level of loss due to bad debts is Rs. 6 lakh. The firm is required to give a return of 25% on the
investment in new accounts receivables. The company’s variable costs are 60% of the selling price. Given the
following information, DETERMINE which is a better Policy?
(Amount in lakhs)
Present Proposed Policy
Policy Option I Option II
Annual credit sales (Rs.) 180 220 280
Debtors turnover ratio 4 3.2 2.4
Bad debt losses (Rs.) 6 18 38

Ans Statement showing evaluation of Credit Policies

(Amount in lakhs)
Particulars Present (Rs.) Proposed Policy (Rs.)
Option I Option II
A Expected Profit:
(a) Credit Sales 180 220 280
(b) Total Cost other than Bad Debts:
Variable Costs (60%) 108 132 168
(c) Bad Debts 6 18 38
(d) Expected Profit [(a)-(b)-(c)] 66 70 74
B Opportunity Cost of Investment in Debtors 6.75 10.31 17.5
(Refer workings)
C Net Benefits [A - B] 59.25 59.69 56.5

Recommendation: The Proposed Policy I should be adopted since the net benefits under this policy is higher than
those under other policies.

Workings:
Calculation of Opportunity Cost of Investment in Debtors
Collection Period Rate of Return
Opportunity Cost = Total Cost x x
12 100

*Collection period (in months) = 12/Debtors turnover ratio

12 / 4 25
Present Policy = Rs. 108x x = Rs. 6.75 lakhs
12 100

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12 / 3.2 25
Proposed Policy I = Rs. 132 × x = Rs. 10.31 lakhs
12 100

12 / 2.4 25
Proposed Policy II = Rs. 168 × x = Rs. 17.5 lakhs
12 100

Q.15 Credit Policy MTP Nov 18(1)

RST Limited is considering relaxing its present credit policy and is in the process of evaluating two proposed
polices. Currently, the firm has annual credit sales of Rs 225 lakhs and accounts receivable turnover ratio of 5
times a year. The current level of loss due to bad debts is Rs.7,50,000. The firm is required to give a return of
20% on the investment in new accounts receivables. The company’s variable costs are 60% of the selling price.
Given the following information, DETERMINE which is a better option?
(Amount in lakhs)
Present Policy Policy Option I Policy Option II
Annual credit sales (Rs) 225 275 350
Accounts receivable turnover ratio 5 4 3
Bad debt losses (Rs) 7.5 22.5 47.5

Ans Statement showing Evaluation of Credit Policies (Amount in lakhs)

Particulars Present Policy Proposed Proposed
(Rs.) Policy I (Rs.) Policy II(Rs.)
A Expected Profit :
(a) Credit Sales 225.00 275.00 350.00
(b) Total Cost other than Bad Debts:
Variable Costs 135.00 165.00 210.00
(c) Bad Debts 7.50 22.50 47.50
(d) Expected Profit [(a)-(b)-(c)] 82.50 87.50 92.50
B Opportunity Cost of Investment in Receivables* 5.40 8.25 14.00
C Net Benefits [A-B] 77.10 79.25 78.50
Recommendation: The Proposed Policy I should be adopted since the net benefits under this policy is higher
than those under other policies.
Working Note:
*Calculation of Opportunity Cost of Average Investments
Collection Period Rate of Return
Opportunity Cost = Total Cost x x
12 100
Present Policy = Rs.135 lakhs × 2.4/12 × 20% = Rs. 5.40 lakhs
Proposed Policy I = Rs.135 lakhs × 2.4/12 × 20% = Rs. 5.40 lakhs
Proposed Policy II =Rs. 210 lakhs × 4/12 × 20% = Rs. 14.00 lakhs

Q.16 Factoring PY Dec 21

A factoring firm has offered a company to buy its accounts receivables.
The relevant information is given below:
(i) The current average collection period for the company's debt is 80 days and ½% of debtors default. The
factor has agreed to pay over money due to the company after60 days and it will suffer all the losses of
bad debts also.
(ii) Factor will charge commission @2%.
(iii) The company spends ` 1,00,000 p.a. on administration of debtor.These are avoidable cost.
(iv) Annual credit sales are ` 90 lakhs. Total variable costs is 80% of sales. The company's cost of
borrowing is 15% per annum. Assume 365 days in a year.
Should the company enter into agreement with factoring firm?

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Ans
Particulars (`)
A. Annual Savings (Benefit) on taking Factoring Service
Cost of credit administration saved
Bad debts avoided (` 90 lakh x ½%) 1,00,000
Interest saved due to reduction in average collection period [` 90 45,000
lakh x 0.80 × 0.15 × (80 days – 60 days)/365 days] 59,178

Total 2,04,178
B. Annual Cost of Factoring to the Firm:
Factoring Commission [` 90 lakh × 2%] 1,80,000
Total 1,80,000
C. Net Annual Benefit of Factoring to the Firm (A – B) 24,178
Advice: Since savings to the firm exceeds the cost to the firm on account of factoring, therefore, the
company should enter into agreement with the factoring firm.
Q.17 Grant of Credit of Not RTP Nov 23
A regular customer of your company has approached to you for extension of credit facility for purchasing of
goods. On analysis of past performance and on the basis of information supplied, the following pattern of payment
schedule emerges:
Pattern of Payment Schedule At
the end of 30 days 20% of the bill At
the end of 60 days 30% of the bill

At the end of 90 days 30% of the bill

At the end of 100 days 18% of the bill

Non-recovery 2% of the bill

The customer wants to enter into a firm commitment for purchase of goods of ` 40 lakhs in 2022, deliveries to
be made in equal quantities on the first day of each quarter in the calendar year. The price per unit of commodity
is ` 400 on which a profit of ` 20 per unit is expected to be made. It is anticipated that taking up of this contract
would mean an extra recurring expenditure of ` 20,000 per annum. If the opportunity cost is 18% per annum,
would you as the finance manager of the company RECOMMEND the grant of credit to the customer? Assume 1
year = 360 days.

Ans Statement showing the Evaluation of credit Policies

Particulars Proposed Policy `
A. Expected Profit:
(a) Credit Sales 40,00,000
(b) Total Cost
(i) Variable Costs (` 380 x 10000 units) 38,00,000
(ii) Recurring Costs 20,000
38,20,000
(c) Bad Debts 80,000
(d) Expected Profit [(a) – (b) – (c)] 1,00,000
B. Opportunity Cost of Investments in Receivables 1,31,790
C. Net Benefits (A – B) (31,790)

Recommendation: The Proposed Policy should not be adopted since the net benefits under this policy are negative.

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Working Note: Calculation of Opportunity Cost of Average Investments

Collection Period Rate of Return
Opportunity Cost = Total Cost × x
360 100
Particulars 20% 30% 30% 18% Total

A. Total Cost 7,64,000 11,46,000 11,46,000 6,87,600 37,43,600

B. Collection period 30/360 60/360 90/360 100/360

C. Required Rate of 18% 18% 18% 18%

Return

D. Opportunity Cost 11,460 34,380 51,570 34,380 1,31,790

(A × B × C)

Q.18 Payment to Debtor MTP May 19(1)

A bank is analysing the receivables of J Ltd. in order to identify acceptable collateral for a short-term loan. The
company’s credit policy is 2/10 net 30. The bank lends 80 percent on accounts where customers are not currently
overdue and where the average payment period does not exceed 10 days past the net period. A schedule
of J Ltd.’s receivables has been prepared. ANALYSE, how much will the bank lend on pledge of receivables, if
the bank uses a 10 per cent allowance for cash discount and returns?
Account Amount Rs. Days Outstanding in days Average Payment Period
historically
74 25,000 15 20
91 9,000 45 60
107 11,500 22 24
108 2,300 9 10
114 18,000 50 45
116 29,000 16 10
123 14,000 27 48

1,08,800

Ans Analysis of the receivables of J Ltd. by the bank in order to identify acceptable collateral for a short- term
loan:
(i) The J Ltd.’s credit policy is 2/10 net 30.
The bank lends 80 per cent on accounts where customers are not currently overdue and where the average
payment period does not exceed 10 days past the net period i.e. thirty days. From the schedule of
receivables of J Ltd. Account No. 91 and Account No. 114 are currently overdue and for Account No. 123
the average payment period exceeds 40 days. Hence Account Nos. 91, 114 and 123 are eliminated.
Therefore, the selected Accounts are Account Nos. 74, 107, 108 and 116.
(ii) Statement showing the calculation of the amount which the bank will lend on a pledge of receivables if the
bank uses a 10 per cent allowances for cash discount and returns
Account No. Amount (Rs.) 90 per cent of amount (Rs.) 80% of amount (Rs.)
(a) (b) = 90% of (a) (c) = 80% of (b)
74 25,000 22,500 18,000
107 11,500 10,350 8280
108 2,300 2,070 1,656
116 29,000 26,100 20,880
Total loan amount 48,816

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9 WORKING CAPITAL
CHAPTER
Q.1 Balance Sheet & W.Cap required RTP Nov 23
Consider the following figures and ratios:
(i) Sales for the year (all credit) ` 1,05,00,000
(ii) Gross Profit ratio 35 percent
(iii) Fixed assets turnover (based on cost of goods sold) 1.5
(iv) Stock turnover (based on cost of goods sold) 6
(v) Liquid ratio 1.5:1
(vi) Current ratio 2.5:1
(vii) Receivables (Debtors) collection period 1 month
(viii) Reserves and surplus to Share capital 1:1.5
(ix) Capital gearing ratio 0.7875
(x) Fixed assets to net worth 1.3 : 1
You are required to PREPARE:
(a) Balance Sheet as on 31/3/2022 based on above details.
(b) The statement showing working capital requirement if the company wants to make a provision for
contingencies @ 14 percent of net working capital.

Ans Working Notes:

(i) Cost of Goods Sold = Sales – Gross Profit (35% of Sales)

= ` 1,05,00,000 – ` 36,75,000
= ` 68,25,000
(ii) Closing Stock = Cost of Goods Sold / Stock Turnover
68,25, 000
= = ` 11,37,500
6
(iii) Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover
68,25, 000
=
1.5
= ` 45,50,000
(iv) Current Assets:
Current Ratio = 2.5 and Liquid Ratio = 1.5
Inventories (Stock) = 2.5 – 1.5 = 1
2.5
Current Assets = Amount of Inventories (Stock) x
1
2.5
= `11,37,500 x = ` 28,43,750
1
(v) Liquid Assets (Receivables and Cash)
= Current Assets – Inventories (Stock)
= ` 28,43,750 – ` 11,37,500
= ` 17,06,250
Debtors Collection period
(vi) Receivables (Debtors) = Sales x
12
1
= `1,05,00,000x
12
= ` 8,75,000

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(vii) Cash = Liquid Assets – Receivables (Debtors)

= ` 17,06,250 – ` 8,75,000 = ` 8,31,250

Fixed Assets
(viii) Net worth =
1.3
45,50, 000
= = ` 35,00,000
1.3
(ix) Reserves and Surplus
Reserves and Share Capital = Net worth
Net worth = 1 + 1.5 = 2.5
1
Reserves and Surplus = `35,00,000 x
2.5
= ` 14,00,000
(x) Share Capital = Net worth – Reserves and Surplus
= ` 35,00,000 – ` 14,00,000
= ` 21,00,000
(xi) Current Liabilities = Current Assets/ Current Ratio
28, 43,750
= = ` 11,37,500
2.5
(xii) Long-term Debts
Capital Gearing Ratio = Long-term Debts / Equity Shareholders’ Fund
Long-term Debts = ` 35,00,000 × 0.7875 = ` 27,56,250

(a) Balance Sheet

Particulars Figures as at Figures as at
31-03-2022 (`) 31-03-2021 (`)
I. EQUITY AND
LIABILITIES

Shareholders’ funds
(a) Share capital 21,00,000 -
(b) Reserves and surplus 14,00,000 -
Non-current liabilities
(a) Long-term borrowings 27,56,250 -
Current liabilities 11,37,500 -
TOTAL 73,93,750 -
II. ASSETS
Non-current assets
Fixed assets 45,50,000 -
Current assets
Inventories 11,37,500 -
Trade receivables 8,75,000 -
Cash and cash equivalents 8,31,250 -
TOTAL 73,93,750 -
(b) Statement Showing Working Capital Requirement
Particulars (`) (`)
A. Current Assets
(i) Inventories (Stocks) 11,37,500

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(ii) Receivables (Debtors) 8,75,000

(iii) Cash in hand & at bank 8,31,250
Total Current Assets 28,43,750
B. Current Liabilities:
Total Current Liabilities
Net Working Capital (A – B) 11,37,500
17,06,250
Add: Provision for contingencies
(14% of Net Working Capital) 2,38,875
Working capital requirement 19,45,125

Q.2 Balance Sheet & W.Cap required RTP Nov 20

The following figures and ratios are related to a company:
(i) Sales for the year (all ` 90,00,000
(ii) credit) Gross Profit ratio 35 percent
(iii) Fixed assets turnover (based on cost of goods sold) 1.5
(iv) Stock turnover (based on cost of goods sold) 6
(v) Liquid ratio 1.5:1

(vi) Current ratio 2.5:1

(vii) Receivables (Debtors) collection period 1 month
(viii) Reserves and surplus to Share capital 1:1.5
(ix) Capital gearing ratio 0.7875

(x) Fixed assets to net worth 1.3 : 1

You are required to PREPARE:

(a) Balance Sheet of the company on the basis of above details.
(b) The statement showing working capital requirement, if the company wants to make a provision for
contingencies @ 15 percent of net working capital.

Ans (i) Cost of Goods Sold = Sales – Gross Profit (35% of Sales)
= ` 90,00,000 – ` 31,50,000
= ` 58,50,000
(ii) Closing Stock = Cost of Goods Sold / Stock Turnover
= ` 58,50,000/6 = ` 9,75,000
(iii) Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover
= ` 58,50,000/1.5
= ` 39,00,000
(iv) Current Assets:
Current Ratio = 2.5 and Liquid Ratio = 1.5
Inventories (Stock) = 2.5 – 1.5 = 1
Current Assets = Amount of Inventories (Stock) × 2.5/1
= ` 9,75,000 × 2.5/1 = ` 24,37,500
(v) Liquid Assets (Receivables and Cash)
= Current Assets – Inventories (Stock)
= ` 24,37,500 – ` 9,75,000
= `14,62,500

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(vi) Receivables (Debtors) = Sales × Debtors Collection period /12

= ` 90,00,000 × 1/12
= ` 7,50,000
(vii) Cash = Liquid Assets – Receivables (Debtors)
= `14,62,500 – ` 7,50,000 = ` 7,12,500
(viii) Net worth = Fixed Assets /1.3
= ` 39,00,000/1.3 = ` 30,00,000
(ix) Reserves and Surplus
Reserves and Share Capital = Net worth
Net worth = 1 + 1.5 = 2.5
Reserves and Surplus = ` 30,00,000 × 1/1.5
= ` 20,00,000
(x) Share Capital = Net worth – Reserves and Surplus
= ` 30,00,000 – ` 20,00,000
= ` 10,00,000
(xi) Current Liabilities = Current Assets/ Current Ratio
= ` 24,37,500/2.5 = ` 9,75,000
(xii) Long-term Debts
Capital Gearing Ratio = Long-term Debts / Equity Shareholders’ Fund
Long-term Debts = `30,00,000 × 0.7875 = `23,62,500

(a) Balance Sheet of the Company

Particulars Figures as at Figures as at
31-03-2020 (`) 31-03-2019 (`)
I. EQUITY AND
LIABILITIES
Shareholders’funds
(a) Share capital 10,00,000 -
(b) Reserves and surplus 20,00,000 -
Non-current liabilities
(a) Long-term borrowings 23,62,500 -
Current liabilities 9,75,000 -
TOTAL 63,37,500 -
II. ASSETS
Non-current assets
Fixed assets 39,00,000 -
Current assets
Inventories 9,75,000 -
Trade receivables 7,50,000 -
Cash and cash equivalents 7,12,500 -
TOTAL 63,37,500 -

(b) Statement Showing Working Capital Requirement

A. Current Assets (`) (`)

(i) Inventories (Stocks) 9,75,000

(ii) Receivables (Debtors) 7,50,000
(iii) Cash in hand & at bank 7,12,500

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Total Current Assets 24,37,500

B. Current Liabilities:
Total Current Liabilities 9,75,000
Net Working Capital (A – B) 14,62,500

Add: Provision for contingencies

2,19,375
(15% of Net Working Capital)
Working capital requirement 16,81,875

Q.3 Max Bank Finance PY May 22

Balance sheet of X Ltd for the year ended 31st March,2022 is given below:
( ` in lakhs)
Liabilities Amount Assets Amount
Equity Shares ` 10 each 200 Fixed Assets 500
Retained earnings 200 Raw materials 150
11% Debentures 300 W.I.P 100
Public deposits (Short-Term) 100 Finished goods 50
Trade Creditors 80 Debtors 125
Bills Payable 100 Cash/Bank 55
980 980
Calculate the amount of maximum permissible bank finance under three methods as per Tandon Committee
lending norms.

Ans The total core current assets are assumed to be ` 30 lakhs.

Current Assets = 150 + 100 + 50 + 125 + 55 = ` 480 Lakhs
Current Liabilities = 100 + 80 + 100 = ` 280 Lakhs
Maximum Permissible Banks Finance under Tandon Committee Norms:

Method I
Maximum Permissible Bank Finance = 75% of (Current Assets – Current Liabilities)
= 75% of (480 - 280)
= ` 150 Lakhs
Method II
Maximum Permissible Bank Finance = 75% of Current Assets – Current Liabilities
= 75 % of 480 – 280
= ` 80 Lakhs
Method III
Maximum Permissible Bank Finance = 75% of (Current Assets – Core Current
Assets) – Current Liabilities
= 75 % of (480 - 30) – 280
= ` 57.5 Lakhs

Q.4 Max. Bank Finance RTP May 23

Kalyan limited has provided you the following information for the year 2021-22:
By working at 60% of its capacity the company was able to generate sales of ` 72,00,000. Direct labour cost per
unit amounted to ` 20 per unit. Direct material cost per unit was 40% of the selling price per unit. Selling price
was 3 times the direct labour cost per unit. Profit margin was 25% on the total cost.For the year 2022-23, the
company makes the following estimates:

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Production and sales will increase to 90% of its capacity. Raw material per unit price will remain unchanged. Direct
expense per unit will increase by 50%. Direct labour per unit will increase by 10%. Despite the fluctuations in the
cost structure, the company wants to maintain the same profit margin on sales.
Raw materials will be in stock for one month whereas finished goods will remain in stock for two months. Production
cycle is for 2 months. Credit period allowed by suppliers is 2 months. Sales are made to three zones:
Zone Percentage of sale Mode of Credit
A 50% Credit period of 2 months
B 30% Credit period of 3 months
C 20% Cash Sales
There are no cash purchases and cash balance will be ` 1,11,000
The company plans to apply for a working capital financing from bank for the year 2022-23. ESTIMATE Net
Working Capital of the Company receivables to be taken on sales and also COMPUTE the maximum permissible
bank finance for the company using 3 criteria of Tandon Committee Norms. (Assume stock of finished goods to
be a core current asset)

Ans Cost Structure

2021-22 2022-23
Particulars Calculations P.U. Amount Calculations P.U. Amount
(p.u. X units) (p.u. X units)
Direct 40% of SP `24 `28,80,000 Same as PY `24 `43,20,000
Material
Direct Given `20 `24,00,000 20*1.1 `22 `39,60,000
labour
Direct bal. fig. `4 `4,80,000 4*1.5 `6 `10,80,000
Expenses
Total Cost SP - Profit `48 `57,60,000 `52 `93,60,000
Profit (SP/125x25) `12 `14,40,000 52*25% `13 `23,40,000
Sales 3 x Direct `60 `72,00,000 `65 `1,17,00,000
Labour p.u.
*units= `72,00,000/ `60 1,20,000/60 x90
=1,20,000 =1,80,000
Operating Cycle
Raw material holding period 1 months
Finished Goods holding period 2 months
WIP conversion period 2 months
Creditor Payment Period 2 months
Receiveable collection Period 2/3 months

Estimation of Working Capital

Particulars Calculation Amount
Current Assets
Stock of Raw Material 43,20,000 x 1/12
`3,60,000
RM cost `43,20,000
Labour cost `19,80,000
Direct Exp cost `5,40,000
Total WIP Cost `68,40,000
Stock of WIP 68,40,000 x 2/12 `11,40,000
Stock of Finished Goods 93,60,000 x 2/12 `15,60,000

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Receivables (on sales)

A 1,17,00,000 x 50% x 2/12 `9,75,000
B 1,17,00,000 x 30% x 3/12 `8,77,500
C NIL -
Cash Balance Given `1,11,000
Total Current Assets ` 50,23,500
Current Liabilities
Payables * `44,40,000 x 2/12 `7,40,000
Net Working Capital ` 42,83,500
Opening RM stock = 28,80,000 x 1/12= `2,40,000
* RM purchased = RM consumed – Opening Stock + Closing Stock
= `43,20,000 – `2,40,000 + `3,60,000 = `44,40,000
Computation of Maximum Permissible Bank Finance
Method Formula Calculation `
I 75% x (Current Assets- 75% x ( `50,23,500 - `7,40,000) `32,12,625
Current Liabilities)
I 75% x Current Assets- 75% x `50,23,500 - `7,40,000 `30,27,625
I Current Liabilities
II 75% x (Current Assets-Core 75% x ( `50,23,500- `18,57,625
I CA)- Current Liabilities `7,40,000 -
`15,60,000)

Q.5 Maximum Bank Finance MTP Nov 18(2)

A newly formed company has applied to the commercial bank for the first time for financing its working capital
requirements. The following information is available about the projections for the current year:
Estimated level of activity: 1,04,000 completed units of production plus 4,000 units of work-in progress. Based
on the above activity, estimated cost per unit is:
Raw material Rs. 80 per unit
Direct wages Rs. 30 per unit
Overheads (exclusive of depreciation) Rs. 60 per unit
Total cost Rs. 170 per unit
Selling price Rs. 200 per unit
Raw materials in stock: Average 4 weeks consumption, work-in-progress (assume 50% completion stage in respect
of conversion cost) (materials issued at the start of the processing).
Finished goods in stock 8,000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors/receivables Average 8 weeks
1
Lag in payment of wages Average1 weeks
2
Cash at banks (for smooth operation) is expected to be Rs.25,000
Assume that production is carried on evenly throughout the year (52 weeks) and wages and overheads accrue
similarly. All sales are on credit basis only.
CALCULATE
(i) Net Working Capital required;
(ii) Maximum Permissible Bank finance under first and second methods of financing as per Tandon
Committee Norms.

Ans (i) Estimate of the Requirement of Working Capital

(Rs.) (Rs.)
A. Current Assets:

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Raw material stock 6,64,615

(Refer to Working note 3)

Work in progress stock 5,00,000

(Refer to Working note 2)

Finished goods stock (Refer 13,60,000

to Working note 4) Debtors/

Receivables (Refer to 29,53,846

Working note 5) Cash and

Bank balance 25,000
55,03,461
B. Current Liabilities:
Creditors for raw 7,15,740

materials (Refer to
Working note 6) Creditors 91,731
(8,07,471)
for wages
________
(Refer to Working note 7)
46,95,990
Net Working Capital (A-B)

(ii) The maximum permissible bank finance as per Tandon Committee Norms
First Method:
75% of the net working capital financed by bank i.e. 75% of Rs.46,95,990 (Refer to (i) above)
= Rs. 35,21,993
Second Method:
(75% of Current Assets) - Current liabilities
= 75% of Rs. 55,03,461 - Rs. 8,07,471 (Refer to (i) above)
= Rs. 41,27,596 – Rs. 8,07,471
= Rs. 33,20,125
Working Notes:
1. Annual cost of production
Rs.
Raw material requirements (1,04,000 units x Rs. 80) 83,20,000
Direct wages (1,04,000 units x Rs. 30) 31,20,000
Overheads (exclusive of depreciation) (1,04,000 x Rs. 60) 62,40,000
1,76,80,000
2. Work in progress stock
Rs.
Raw material requirements (4,000 units x Rs. 80) 3,20,000
Direct wages (50% x 4,000 units x Rs. 30) 60,000
Overheads (50% x4,000 units x Rs.60) 1,20,000
5,00,000
3. Raw material stock
It is given that raw material in stock is average 4 weeks consumption. Since, the company is newly formed,
the raw material requirement for production and work in progress will be issued and consumed during the
year.Hence, the raw material consumption for the year (52 weeks) is as follows:
Rs.
For Finished goods 83,20,000
For Work in progress 3,20,000
86,40,000

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86, 40, 000

Raw material stock × 4 weeks i.e. Rs. 6,64,615
52 weeks
4. Finished goods stock

8,000 units @ Rs. 170 per unit = Rs. 13,60,000

5. Debtors for sale

Credit allowed to debtors Average 8 weeks

Credit sales for year (52 weeks) i.e. (1,04,000 units-8,000 units) 96,000 units
Selling price per unit Rs.200
Credit sales for the year (96,000 units XRs. 200) Rs. 1,92,00,000

1,92, 00, 000

Debtors × 8 weeks i.e. Rs. 29,53,846
52weeks
(Debtor can also be calculated based on Cost of goods sold)
6. Creditors for raw material:
Credit allowed by suppliers Average 4 weeks
Purchases during the year (52 weeks) i.e. Rs. 93,04,615
(Rs. 83,20,000 + Rs. 3,20,000 + Rs. 6,64,615)
(Refer to Working notes 1,2 and 3 above)
93, 04,615
Creditors × 4 weeks i.e. Rs. 7,15,740
52 weeks
7. Creditors for wages

1
Lag in payment of wages Average 1 weeks
2
Direct wages for the year (52 weeks) i.e. Rs. 31,80,000
(Rs. 31,20,000 + Rs. 60,000)
(Refer to Working notes 1 and 2 above)
31,80,000 1
Creditors Rs. X1 weeks i.e. Rs. 91,731
52weeks 2

Q.6 Net Working Capital PY May 18

Day Ltd., a newly formed company has applied to the Private Bank for the first time for financing it's
Working Capital Requirements. The following informations are available about the projections for the current
year:

Estimated Level of Activity Completed Units of Production 31200 plus unit of work
in progress 12000
Raw Material Cost ` 40 per unit
Direct Wages Cost ` 15 per unit
Overhead ` 40 per unit (inclusive of Depreciation `10 per unit)
Selling Price ` 130 per unit
Raw Material in Stock Average 30 days consumption
Work in Progress Stock Material 100% and Conversion Cost 50%
Finished Goods Stock 24000 Units
Credit Allowed by the supplier 30 days
Credit Allowed to Purchasers 60 days
Direct Wages (Lag in payment) 15 days
Expected Cash Balance ` 2,00,000

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Assume that production is carried on evenly throughout the year (360 days) and wages and overheads accrue
similarly. All sales are on the credit basis. You are required to calculate the Net Working Capital Requirement on
Cash Cost Basis.

Ans Calculation of Net Working Capital requirement:

(`) (`)
A. Current Assets:
Inventories:
Stock of Raw material 1,44,000
(Refer to Working note (iii)
Stock of Work in progress 7,50,000
(Refer to Working note (ii)
Stock of Finished goods 20,40,000
(Refer to Working note (iv)
Debtors for Sales 1,02,000
(Refer to Working note (v)
Cash 2,00,000
Gross Working Capital 32,36,000 32,36,000
B. Current Liabilities:
Creditors for Purchases 1,56,000
(Refer to Working note (vi)
Creditors for wages
(Refer to Working note (vii) 23,250
1,79,250 1,79,250
Net Working Capital (A - B) 30,56,750
Working Notes:
(i) Annual cost of production
(`)
Raw material requirements
{(31,200 × ` 40) + (12,000 x ` 40)}
17,28,000
Direct wages {(31,200 × ` 15) +(12,000 X ` 15 x 0.5)} 5,58,000
Overheads (exclusive of depreciation)
{(31,200 × ` 30) + (12,000 x ` 30 x 0.5)}
11,16,000
Gross Factory Cost 34,02,000
Less: Closing W.I.P [12,000 ( ` 40 + ` 7.5 + `15)] (7,50,000)
Cost of Goods Produced 26,52,000
Less: Closing Stock of Finished Goods
( ` 26,52,000 × 24,000/31,200)
(20,40,000)
Total Cash Cost of Sales 6,12,000

(ii) Work in progress stock

( `)
Raw material requirements (12,000 units × `40) 4,80,000
Direct wages (50% × 12,000 units × ` 15) 90,000

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Overheads (50% × 12,000 units × ` 30) 1,80,000

7,50,000
(iii) Raw material stock
It is given that raw material in stock is average 30 days consumption. Since, the company is newly
formed; the raw material requirement for production and work in progress will be issued and consumed
during the year. Hence, the raw material consumption for the year (360 days) is as follows:
( `)
For Finished goods (31,200 × ` 40) 12,48,000
For Work in progress (12,000 × ` 40) 4,80,000
17,28,000
17,28, 000
Raw material stock = × 30 days = `1,44,000
360days
(iv) Finished goods stock:

24,000 units @ ` (40+15+30) per unit = `20,40,000

60 days
(v) Debtors for sale: ` 6,12,000x = `1,02,000
360days
(vi) Creditors for raw material Purchases [Working Note (iii)]:
Annual Material Consumed ( `12,48,000 + `4,80,000) `17,28,000
Add: Closing stock of raw material ` 1,44,000
`18,72,000
18,72, 000
Credit allowed by suppliers = × 30days = ` 1,56,000
360days
(vii) Creditors for wages:
5,58, 000
Outstanding wage payment = ×15days = ` 23,250
360days

Q.7 Net Working Capital MTP May 18

A newly formed company has applied to the commercial bank for the first time for financing its working capital
requirements. The following information is available about the projections for the current year:
Estimated level of activity: 1,04,000 completed units of production plus 4,000 units of work -in-progress. Based
on the above activity, estimated cost per unit is:
Raw material `80 per unit
Direct wages `30 per unit
Overheads (exclusive of depreciation) `60 per unit
Total cost `170 per unit
Selling price `200 per unit
Raw materials in stock: Average 4 weeks consumption, work-in-progress (assume 50% completion stage in
respect of conversion cost) (materials issued at the start of the processing).
Finished goods in stock 8,000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors/receivables Average 8 weeks
1
Lag in payment of wages Average1 weeks
2
Cash at banks (for smooth operation) is expected to be `25,000Assume that production is carried on evenly
throughout the year (52 weeks) and wages and overheads accrue similarly. All sales are on credit basis only.
CALCULATE Net Working Capital.

Ans Estimate of the Requirement of Working Capital

A. Current Assets:

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( `) ( `)
Raw material stock 6,64,615
(Refer to Working note 3)
Work in progress stock 5,00,000
(Refer to Working note 2)
Finished goods stock 13,60,000
(Refer to Working note 4)
Receivables 25,10,769
(Refer to Working note 5)
Cash and Bank balance 25,000 50,60,384
B. Current Liabilities:
Payables for raw materials 7,15,740
(Refer to Working note 6)
Payables for wages 91,731 (8,07,471)
(Refer to Working note 7)
Net Working Capital (A - B) 42,52,913
Working Notes:
1. Annual cost of production

`
Raw material requirements (1,04,000 units x ` 80) 83,20,000
Direct wages (1,04,000 units x ` 30) 31,20,000
Overheads (exclusive of depreciation)(1,04,000 x ` 60) 62,40,000
1,76,80,000
2. Work in progress stock
`
Raw material requirements (4,000 units x ` 80) 3,20,000
Direct wages (50% x 4,000 units x ` 30) 60,000
Overheads (50% x 4,000 units x ` 60) 1,20,000
5,00,000
3. Raw material stock
It is given that raw material in stock is average 4 weeks’ consumption. Since, the company is newly formed,
the raw material requirement for production and work in progress will be issued and consumed during the
year.
Hence, the raw material consumption for the year (52 weeks) is as follows:

`
For Finished goods 83,20,000
For Work in progress 3,20,000
86,40,000
86, 40, 000
Raw material stock = × 4 weeks i.e. ` 6,64,615
86, 40, 000
4. Finished goods stock
8,000 units @ ` 170 per unit = `13,60,000
5. Receivables for sale
Credit allowed to debtors Average 8 weeks
Credit sales for year (52 weeks) i.e. (1,04,000 units - 8,000 units) 96,000 units
Cost per unit ` 170
Credit sales for the year (96,000 units x `170) ` 1,63,20,000

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1,63,20, 000
Receivables = × 8 weeks i.e. ` 25,10,769
52 weeks
6. Payables for raw material:
Credit allowed by suppliers Average 4 weeks
Purchases during the year (52 weeks) i.e. ` 93,04,615
( ` 83,20,000 + ` 3,20,000 + ` 6,64,615)
(Refer to Working notes 1,2 and 3 above)
93, 04,615
Payables for raw materials = × 4 weeks i.e. ` 7,15,740
52 weeks
7. Payables for wages
1
Lag in payment of wages Average1 52 weeks
2
Direct wages for the year (52 weeks) i.e. `31,80,000
( `31,20,000 + `60,000)
(Refer to Working notes 1 and 2 above)
31,80, 000 1
Payables for wages = x1 weeks i.e. ` 91,731
52 weeks 2

Q.8 Operating Cycle PY Jan 21

The following information is provided by MNP Ltd. for the year ending 31st March, 2020:
Raw Material Storage period 45 days
Work-in-Progress conversion period 20 days
Finished Goods storage period 25 days
Debt Collection period 30 days
Creditors payment period 60 days
Annual Operating Cost ` 25,00,000
(Including Depreciation of ` 2,50,000)
Assume 360 days in a year. You are required to calculate:
(i) Operating Cycle period
(ii) Number of Operating Cycle in a year.
(iii) Amount of working capital required for the company on a cost basis.
(iv) The company is a market leader in its product and it has no competitor in the market.Based on a market
survey it is planning to discontinue sales on credit and deliver products based on pre-payments in order to
reduce its working capital requirement substantially. You are required to compute the reduction in working
capital requirement in such a scenario.

Ans (i) Calculation of Operating Cycle Period:

Operating Cycle Period = R + W + F + D – C
= 45 + 20 + 25 + 30 – 60 = 60 days
(ii) Number of Operating Cycle in a Year
360 360
= = =6
Operating cycle period 60
(iii) Amount of Working Capital Required
Annual operating cost 25, 00, 000 − 2,50, 000
= =
Number of operating cycle 6
22,50, 000
= = ` 3,75,000
6
(iv) Reduction in Working Capital
Operating Cycle Period = R + W + F – C
= 45 + 20 + 25 – 60 = 30 days

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22,50, 000
Amount of Working Capital Required = x30 = ` 1,87,500
360
Reduction in Working Capital = ` 3,75,000 – ` 1,87,500 = ` 1,87,500
Note: If we use Total Cost basis, then amount of Working Capital required will be
` 4,16,666.67 (approx.) and Reduction in Working Capital will be ` 2,08,333.33 (approx.)

Q.9 Operating Cycle RTP May 18

Following information is forecasted by the Puja Limited for the year ending 31 st March,20X8:
Balance as at Balance as at
1st April, 20X7(`) 31st March,
20X8(`)
Raw Material 45,000 65,356
Work-in-progress 35,000 51,300
Finished goods 60,181 70,175
Debtors 1,12,123 1,35,000
Creditors 50,079 70,469
Annual purchases of raw material (all credit) 4,00,000
Annual cost of production 7,50,000
Annual cost of goods sold 9,15,000
Annual operating cost 9,50,000
Annual sales (all credit) 11,00,000
You may take one year as equal to 365 days.
Required:
CALCULATE
(i) Net operating cycle period.
(ii) Number of operating cycles in the year.
(iii) Amount of working capital requirement using operating cycles.

Ans Working Notes:

1. Raw Material Storage Period (R)
Average Stock of RawMaterial
= x365
Annual Consumption of RawMaterial
45, 000 + 65,356
= 2 x365
3, 79, 644
= 53 days.
Annual Consumption of Raw Material = Opening Stock + Purchases- Closing Stock
= ` 45,000 + ` 4,00,000 – ` 65,356
= ` 3,79,644

2. Work-in-Progress (WIP) Conversion Period (W)

Average Stock of WIP
WIP Conversion Period = x365
Annual Cost of Production
35,000 + 51,300
= 2 x365
7,50, 000
=21 days
3. Finished Stock Storage Period (F)
Average Stock of Finished Goods
= x365
Cost of Goods Sold

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65,178
= x365= 26 days.
9,15, 000
60,181 + 70,175
Average Stock =
2
= ` 65,178.
4. Debtors Collection Period (D)

Average Debtors
= x365
Annual Credit Sales
123,56.50
= x365
11, 00, 000
= 41 days
1,12,123 + 1
Average debtors = 35, 000 =1,23,561.50
2
5. Creditors Payment Period (C)
Average Creditors
= x365
Annual Net Credit Purchases
70, 469
= x365
4, 00, 000
= 55 days
(i) Operating Cycle Period

= R + W + F+ D - C
= 53 + 21 + 26 + 41 - 55
= 86 days
(ii) Number of Operating Cycles in the Year
365 365
= = = 4.244
Operating 86
(iii) Amount of Working Capital Required
Annual Operating Cost 9,50, 000
= = = `2,23,845.42
Number of Operating Cycles 4.244

Q.10 Operating Cycle MTP May 22(1)

Following information is forecasted by Gween Limited for the year ending 31st March, 2022:
Balance as at Balance as at
31st March, 2022 31st March, 2021
( ` in lakh) ( ` in lakh)
Raw Material 845 585
Work-in-progress 663 455
Finished goods 910 780
Receivables 1,755 1,456
Payables 923 884
Annual purchases of raw material (all credit) 5,200
Annual cost of production 5,850
Annual cost of goods sold 6,825
Annual operating cost 4,225
Annual sales (all credit) 7,605
Considering one year as equal to 365 days, CALCULATE:

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(i) Net operating cycle period.

(ii) Number of operating cycles in the year.
(iii) Amount of working capital requirement.

Ans 1. Raw Material Storage Period (R)

Average Stock of Raw Material
= x365
Annual Consumption of Raw Material
585 + 845
= 2 x365 = 53 days
4,940
Annual Consumption of Raw Material = Opening Stock + Purchases - Closing Stock
= ` 585 + ` 5,200 – ` 845 = ` 4,940 lakh
2. Work – in - Progress (WIP) Conversion Period (W)
AverageStockofWIP
= x365
AnnualCostofProduction
455 + 663
= 2 × 365 = 35 days
5,850
3. Finished Stock Storage Period (F)
Average Stock of Finished Goods
= x365
Cost of GoodsSold
780 + 910
= 2 × × 365 = 45 days.
6,825
4. Receivables (Debtors) Collection Period (D)

Average Receivables
= x365
Annual Credit Sales
14,56 + 1,755
= 2 × 365 = 77 days
7,605
5. Payables (Creditors) Payment Period (C)
Average Payablesfor materials
= x365
Annual Credit purchases
884 + 923
= 2 × 365 = 64 days
5200
(i) Net Operating Cycle Period
=R+W+F+D-C
= 53 + 35 + 45 + 77 – 64 = 146 days

(ii) Number of Operating Cycles in the Year

365 365
= = = 2.5 times
Operating Cycle Period 146
(iii) Amount of Working Capital Required
AnnualOperatingCost 4,225
= = = ` 1,690 lakh
Number ofOperatingCycles 2.5
Note: Number of days may vary due to fraction.
Q.11 Operating Cycle MTP May 20
The following information is provided by the P Ltd. for the year ending 31st March, 2020.
Raw Material storage period 52 days
Work in progress conversion period 18 days

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Finished Goods storage period 20 days

Debt Collection period 75 days
Creditors' payment period 25 days
Annual Operating Cost 45 crore
(Including depreciation of Rs.42,00,000)
(1 year = 360 days)
You are required to CALCULATE Operating Cycle period and Number of Operating Cycles in a year.

Ans Calculation of Operating Cycle Period and number of Operating Cycle in a Year
Operating Cycle Period = R + W + F + D – C
= 52 + 18 + 20 + 75 – 25 = 140 days
360
Number of Operating Cycle in a Year =
Operating Cycle Period
= 360/140 = 2.57 times

Q.12 Statement of Working Cap RTP Nov 19

Following are cost information of KG Ltd., which has commenced a new project for an annual production of
24,000 units which is the full capacity
Earnings of the Company ` 50,00,000
Dividend Payout ratio 60%
No. of shares outstanding 10,00,000
Equity capitalization rate 12%
Rate of return on investment 15%

(i) COMPUTE the market value per share as per Walter’s model?
(ii) COMPUTE the optimum dividend payout ratio according to Walter’s model and the market value of Company’s
share at that payout ratio?

Ans (i) Projected Statement of Profit / Loss

(Ignoring Taxation)
Year 1 Year 2
Production (Units) 12,000 18,000
Sales (Units) 10,000 17,000

(`) (`)
Sales revenue (A) (Sales unit × `192) 19,20,000 32,64,000
Cost of production:
Materials cost 9,60,000 14,40,000
(Units produced × `80)
Direct labour and variable expenses 4,80,000 7,20,000
(Units produced × `40)
Fixed manufacturing expenses 2,88,000 2,88,000
(Production Capacity: 24,000 units × `12)
Depreciation 4,80,000 4,80,000
(Production Capacity : 24,000 units × `20)
Fixed administration expenses 1,92,000 1,92,000
(Production Capacity : 24,000 units × `8)
Total Costs of Production 24,00,000 31,20,000
Add: Opening stock of finished goods --- 4,00,000

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(Year 1 : Nil; Year 2 : 2,000 units)

Cost of Goods available for sale 24,00,000 35,20,000
(Year 1: 12,000 units; Year 2: 20,000 units)
Less: Closing stock of finished goods at average (4,00,000) (5,28,000)
cost (year 1: 2000 units, year 2 : 3000 units)
(Cost of Production × Closing stock/ units
produced)
Cost of Goods Sold 20,00,000 29,92,000
Add: Selling expenses – Variable (Sales unit × 80,000 1,36,000
`8)
Add: Selling expenses -Fixed (24,000 units × `2) 48,000 48,000
Cost of Sales : (B) 21,28,000 31,76,000
Profit (+) / Loss (-): (A - B) (-) 2,08,000 (+) 88,000
Working Notes:
1. Calculation of creditors for supply of materials:
Year 1 ( `) Year 2 ( `)
Materials consumed during the year 9,60,000 14,40,000
Add: Closing stock (2 month’s average consumption) 1,60,000 2,40,000
11,20,000 16,80,000
Less: Opening Stock --- 1,60,000
2. Creditors for expenses:
Year 1 ( `) Year 2 ( `)
Direct labour and variable expenses 4,80,000 7,20,000
Fixed manufacturing expenses 2,88,000 2,88,000
Fixed administration expenses 1,92,000 1,92,000
Selling expenses (variable + fixed) 1,28,000 1,84,000
Total 10,88,000 13,84,000
Average per month 90,667 1,15,333
Projected Statement of Working Capital requirements
Year 1 ( `) Year 2 ( `)
Current Assets:
Inventories:
-Stock of materials 1,60,000 2,40,000
(2 month’s average consumption)
-Finished goods 4,00,000 5,28,000
Debtors (2 month’s average sales) (including profit) 3,20,000 5,44,000
Cash 1,00,000 1,00,000
Total Current Assets/ Gross working capital (A) 9,80,000 14,12,000
Current Liabilities:
Creditors for supply of materials 93,333 1,26,667
(Refer to working note 1)
Creditors for expenses 90,667 1,15,333
(Refer to working note 2)
Total Current Liabilities: (B) 1,84,000
2,42,000
Estimated Working Capital Requirements: (A-B) 7,96,000 11,70,000

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Q.13 Working Cap Requirement PY Nov 20

PK Ltd., a manufacturing company, provides the following information:
(`)
Sales 1,08,00,000
Raw Material Consumed 27,00,000
Labour Paid 21,60,000
Manufacturing Overhead (Including Depreciation for the year ` 3,60,000) 32,40,000
Administrative & Selling Overhead 10,80,000

Additional Information:
(a) Receivables are allowed 3 months' credit.
(b) Raw Material Supplier extends 3 months' credit.
(c) Lag in payment of Labour is 1 month.
(d) Manufacturing Overhead are paid one month in arrear.
(e) Administrative & Selling Overhead is paid 1 month advance.
(f) Inventory holding period of Raw Material & Finished Goods are of 3 months.
(g) Work-in-Progress is Nil.
(h) PK Ltd. sells goods at Cost plus 33⅓%.
(i) Cash Balance ` 3,00,000.
(j) Safety Margin 10%.
You are required to compute the Working Capital Requirements of PK Ltd. on Cash Cost basis.

Ans Statement showing the requirements of Working Capital (Cash Cost basis)
Particulars (`) (`)
A. Current Assets:
Inventory:
Stock of Raw material ( ` 27,00,000 × 3/12) 6,75,000
Stock of Finished goods ( ` 77,40,000 × 3/12) 19,35,000
Receivables ( ` 88,20,000 × 3/12) 22,05,000
Administrative and Selling Overhead ( ` 10,80,000 × 1/12) 90,000
Cash in Hand 3,00,000
Gross Working Capital 52,05,000 52,05,000
B. Current Liabilities:
Payables for Raw materials* ( ` 27,00,000 × 3/12) 6,75,000
Outstanding Expenses:
Wages Expenses ( ` 21,60,000 × 1/12) 1,80,000
Manufacturing Overhead ( ` 28,80,000 × 1/12) 2,40,000
Total Current Liabilities 10,95,000 10,95,000
Net Working Capital (A-B) 41,10,000
Add: Safety margin @ 10% 4,11,000
Total Working Capital requirements 45,21,000
Working Notes:
(i)
(A) Computation of Annual Cash Cost of Production (`)

Raw Material consumed 27,00,000

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Wages (Labour paid) 21,60,000

Manufacturing overhead ( ` 32,40,000 - ` 3,60,000) 28,80,000
Total cash cost of production 77,40,000

(B) Computation of Annual Cash Cost of Sales (`)

Cash cost of production as in (A) above 77,40,000

Administrative & Selling overhead 10,80,000
Total cash cost of sales 88,20,000

*Purchase of Raw material can also be calculated by adjusting Closing Stock and Opening Stock (assumed nil).
In that case Purchase will be Raw material consumed +Closing Stock -Opening Stock i.e `27,00,000 +
`6,75,000 - Nil = `33,75,000. Accordingly, Total Working Capital requirements ( ` 43,35,375) can be
calculated.

Q.14 Working Capital Requirement PY May 19

Bita Limited manufactures used in the steel industry. The following information regarding the company is given
for your consideration:
(i) Expected level of production 9000 units per annum.
(ii) Raw materials are expected to remain in store for an average of two months before issue to production.
(iii) Work-in-progress (50 percent complete as to conversion cost) will approximate to 1/2 month’s
production.
(iv) Finished goods remain in warehouse on an average for one month.
(v) Credit allowed by suppliers is one month.•
(vi) Two month's credit is normally allowed to debtors.
(vii) A minimum cash balance of ` 67,500 is expected to be maintained.
(viii) Cash sales are 75 percent less than the credit sales.
(ix) Safety margin of 20 percent to cover unforeseen contingencies.
(x) The production pattern is assumed to be even during the year.
(xi) The cost structure for Bita Limited's product is as follows:
Raw Materials 80 per unit
Direct Labour 20 per unit
Overheads (including depreciation ` 20) 80 per
unit Total Cost 180
per unit Profit 20
per unit Selling Price 200 per unit
You are required to estimate the working capital requirement of Bita limited.

Ans Statement showing Estimate of Working Capital Requirement

(Amount in `) (Amount in ` )
A. Current Assets
(i) Inventories:
 9,000 units × 80 
- Raw material inventory  x2months  1,20,000
 12months 

- Work in Progress:
 9,000 units × 20 
Raw material  x0.5months 
30,000
 12months 

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 9,000 units × 80 
Wages  x0.5months  x50%
3,750
 12months 

 9,000 units × 60 
Overheads  x0.5months  x50 11,250 45,000
 12months 

(Other than Depreciation)

Finished goods (inventory held for 1 months)
 9,000 units × 160  1,20,000
 x1months 
 12months 

(ii) Debtors (for 2 months)

 9,000 units × 160 
 x2months  ×80% or
 12months 
1,92,000

 11,52,000 
 x2months 
 12months 

(iii) Cash balance expected 67,500

Total Current assets 5,44,500
B. Current Liabilities
(i) Creditors for Raw material (1 month)
 9,000 units × 80 
 x1months  60,000
 12months 

Total current liabilities 60,000

Net working capital (A – B) 4,84,500
Add: Safety margin of 20 percent 96,900
Working capital Requirement 5,81,400

Working Notes:
1. If Credit sales is x then cash sales is x-75% of x i.e. x/4.
Or x+0.25x = ` 18,00,000
Or x= ` 14,40,000
So, credit Sales is ` 14,40,000
 14, 40, 000 
Hence, Cash cost of credit sales  x 4  = ` 11,52,000
 5 
2. It is assumed that safety margin of 20% is on net working capital.

3. No information is given regarding lag in payment of wages, hence ignored assuming it is paid regularly.

4. Debtors/Receivables is calculated based on total cost.

[If Debtors/Receivables is calculated based on sales, then debtors will be
 9, 000 units  200   14, 40, 000 
 x 2 month  x80%  x 2 month  = `2,40,000
 12 months   12 months 

Then Total Current assets will be ` 5,92,500 and accordingly Net working capital and Working capital requirement
will be ` 5,32,500aand ` 6,39,000 respectively].

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Q.15 Working Capital Requirement RTP Nov 22

Trading and Profit and Loss Account of Beat Ltd. for the year ended 31st March, 2022 is given below:
Particulars Amount(`) Amount(`) Particulars Amount(`) Amount(`)
To Opening Stock: By Sales (Credit) 1,60,00,000
- Raw Materials 14,40,000 By Closing Stock:
- Work-in- progress 4,80,000 - Raw Materials 16,00,000
- Finished Goods 20,80,000 40,00,000 - Work-inprogress 8,00,000
To Purchases (credit) 88,00,000 - Finished Goods 24,00,000 48,00,000
To Wages 24,00,000
To Production Exp. 16,00,000
To Gross Profit c/d 40,00,000
2,08,00,000 2,08,00,000
To Administration 14,00,000 By Gross Profitb/d 40,00,000
Exp.
To Selling Exp. 6,00,000
To Net Profit 20,00,000
40,00,000 40,00,000
The opening and closing payables for raw materials were ` 16,00,000 and ` 19,20,000 respectively whereas the
opening and closing balances of receivables were ` 12,00,000 and ` 16,00,000 respectively.
You are required to ASCERTAIN the working capital requirement by operating cycle method.

Ans Computation of Operating Cycle

(1) Raw Material Storage Period (R)
Average Stock of Raw Material
Raw Material Storage Period (R) =
Daily Average Consumption of Raw material
(14, 40, 000 + 16, 00, 000) / 2
= = 64.21 Days
86, 40, 000 / 365
Raw Material Consumed = Opening Stock + Purchases – Closing Stock
= ` 14,40,000+ ` 88,00,000– ` 16,00,000 = ` 86,40,000
(2) Conversion/Work-in-Process Period (W)

AverageStock of WIP
Conversion/Processing Period =
Daily Average Pr oduction
(4,80, 000 + 8, 00, 000) / 2
= = 18.96 days
1,23,20, 000 / 365
Production Cost: `
Opening Stock of WIP 4,80,000
Add: Raw Material Consumed 86,40,000
Add: Wages 24,00,000
Add: Production Expenses 16,00,000
1,31,20,000
Less: Closing Stock of WIP 8,00,000
Production Cost 1,23,20,000
(3) Finished Goods Storage Period (F)
Average Stock of Finished Goods
Finished Goods Storage Period =
Daily Average Cost of Good Sold

(20,80, 000 + 24, 00, 000) / 2

= = 68.13 Days
1,20, 00, 000 / 365

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Cost of Goods Sold `

Opening Stock of Finished Goods 20,80,000
Add: Production Cost 1,23,20,000
1,44,00,000
Less: Closing Stock of Finished Goods (24,00,000)
1,20,00,000
(4) Receivables Collection Period (D)
Average Receivables
Receivables Collection Period =
Daily averagecredit sales

(12, 00, 000 + 16, 00, 000) / 2

= = 31.94 Days
1,60, 00, 000 / 365

(5) Payables Payment Period (C)

Average Payable
Payables Payment Period =
Daily averagecredit sales

(16, 00, 000 + 19,20, 000) / 2

= = 73 Days
88, 00, 000 / 365

(6) Duration of Operating Cycle (O)

O = R+W+F+D–C
= 64.21 + 18.96 + 68.13 + 31.94 – 73
= 110.24 days
Computation of Working Capital
(i) Number of Operating Cycles per Year
= 365/Duration Operating Cycle = 365/110.24 = 3.311
(ii) Total Operating Expenses `
Total Cost of Goods sold 1,20,00,000
Add: Administration Expenses 14,00,000
Add: Selling Expenses 6,00,000
1,40,00,000
(iii) Working Capital Required
Total Operating Expenses
Working Capital Required =
Number of Operating Cycles per year

1, 40, 00, 000

= = ` 42,28,329.81
3.311

Q.16 Working Capital Requirement RTP July 21

MT Ltd. has been operating its manufacturing facilities till 31.3.202 1 on a single shift working with the following
cost structure:
Per unit (`)
Cost of Materials 24
Wages (out of which 60% variable) 20
Overheads (out of which 20% variable) 20
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Profit 8
Selling Price 72
As at 31.3.2021 with the sales of ` 17,28,000, the company held:
(`)
Stock of raw materials (at cost) 1,44,000
Work-in-progress (valued at prime cost) Finished 88,000
goods (valued at total cost) Sundry debtors 2,88,000
4,32,000
In view of increased market demand, it is proposed to double production by working an 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
overheads will continue to remain at one month.
You are required to CALCULATE the additional working capital requirements, if the policy to increase output is
implemented, to assess the impact of double shift for long term as a matter of production policy.

Ans (1) Statement of cost at single shift and double shift working
24,000 units 48,000 Units
Per unit Total Per unit Total
(`) (`) (`) (`)
Raw materials 24 5,76,000 21.6 10,36,000
Wages:
Variable 12 2,88,000 12 5,76,000
Fixed 8 1,92,000 4 1,92,000
Overheads:
Variable 4 96,000 4 1,92,000
Fixed 16 3,84,000 8 3,84,000
Total cost 64 15,36,000 49.6 23,80,800
Profit 8 1,92,000 22.4 10,75,200
Sales 72 17,28,000 72 34,56,000
Sales 17,28, 000
(2) Sales in units 2020-21 = = = 24,000 units
Unit selling price 72

(3) Stock of Raw Materials in units on 31.3.2021

Value of stock
= = 6,000 units
1, 44, 000

Cost per unit ` 24

(4) Stock of work-in-progress in units on 31.3.2021

Value of work − in − progress 88, 000
= = =2,000units
PrimeCost per unit (24+20)

(5) Stock of finished goods in units 2020-213

Value of stock 2,88, 000
= = = 4,500 units.
TotalCost per unit 64

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Comparative Statement of Working Capital Requirement

Single Shift (24,000 units) Double Shift (48,000 units)
Units Rate Amount Units Rate Amount
(`) (`) (`) (`)
Current Assets
Inventories:
Raw Materials 6,000 24 1,44,000 12,000 21.6 2,59,200
Work-in-Progress 2,000 44 88,000 2,000 37.6 75,200
Finished Goods 4,500 64 2,88,000 9,000 49.6 4,46,400
Sundry Debtors 6,000 64 3,84,000 12,000 49.6 5,95,200
Total Current Assets (A) 9,04,000 13,76,000
Current Liabilities
Creditors for Materials 4,000 24 96,000 8,000 21.6 1,72,800
Creditors for Wages 2,000 20 40,000 4,000 16 64,000
Creditors for Overheads 2,000 20 40,000 4,000 12 48,000
Total Current Liabilities (B) 1,76,000 2,84,800
Working Capital (A) – (B) 7,28,000 10,91,200
Analysis: Additional Working Capital requirement = ` 10,91,200 – ` 7,28,000 = `3,63,200, if the policy to
increase output is implemented.

Q.17 Working Capital Requirement MTP Nov23(2)

Cost sheet of X&Y Ltd. provides the following particulars:
Amount per unit (`)
Raw materials cost 260.00
Direct labour cost 125.00
Overheads cost 200.00
Total cost 585.00
Profit 75.00
Selling Price 660.00
The Company keeps raw material in stock, on an average for four weeks; work -in-progress, on an average for one
week; and finished goods in stock, on an average for two weeks.
The credit allowed by suppliers is three weeks and company allow four weeks credit to its debtors. The lag in
payment of wages is one week and lag in payment of overhead expenses is two weeks.
The Company sells one-fifth of the output against cash and maintains cash-in-hand and at bank put together at
` 2,70,000.
Required:
PREPARE a statement showing estimate of Working Capital needed to finance an activity level of
2,40,000 units of production. Assume that production is carried on evenly throughout the year, and wages and
overheads accrue similarly. Work-in-progress stock is 75% complete in all respects.

Ans Statement showing Estimate of Working Capital Needs

(Amount in `) (Amount in `)
A. Current Assets
(i) Inventories:
Raw material (4 weeks)

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 2, 40,000 units × 260  48,00,000

 x4Weeks 
 52 weeks 

WIP Inventory (1 week)

 2, 40, 000 units  585 
 x1Weeks  × 0.75
 52 weeks  20,25,000

Finished goods inventory (2 weeks)

 2, 40, 000 units  585 
 x2Weeks  54,00,000 1,22,25,000
 52 weeks 
(ii) Receivables (Debtors) (4 weeks)
 2, 40, 000 units  585  4
 x4Weeks  x
 52 weeks  5
86,40,000
(iii) Cash and bank balance 2,70,000
Total Current Assets 2,11,35,000
B. Current Liabilities:
(i) Payables (Creditors) for materials (3 weeks)
 2, 40, 000 units  125 
 x3Weeks  36,00,000
 52 weeks 
(ii) Outstanding wages (1 week)
 2, 40, 000 units  125 
 x1Weeks  5,76,923
 52 weeks 
(iii) Outstanding overheads (2 weeks)
 2, 40, 000 units  125 
 x2Weeks 
 52 weeks 
18,46,154
Total Current Liabilities 60,23,077
Net Working Capital Needs (A – B) 1,51,11,923

Q.18 Working Capital Requirement MTP Nov 23(2)

The following information is provided by the Shrishti Ltd. for the year ending 31st March 2022.
Raw Material storage period 54 days
Work in progress conversion period
20 days
Finished Goods storage period 22 days

Debt Collection period 74 days

Creditors' payment period 25 days

Annual Operating Cost 45 crore

(Including depreciation of `42,00,000)
(1 year = 360 days)
You are required to CALCULATE Operating Cycle period and Number of Operating Cycles in a year.

Ans Calculation of Operating Cycle Period and number of Operating Cycle in a Year
Operating Cycle Period = R + W + F + D – C
= 54 + 20 + 22 + 74 – 25 = 145 days

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360
Number of Operating Cycle in a Year =
Operating Cycle Period
= 360/145 = 2.48 times
Q.19 Working Capital Requirement MTP May 22(2)
The following annual figures relate to manufacturing entity:
A. Sales at one month credit 84,00,000
B. Material consumption 60% of sales value
C. Wages (paid in a lag of 15 days) 12,00,000
D. Cash Manufacturing Expenses 3,00,000
E. Administrative Expenses 2,40,000
F. Creditors extend 3 months credit for payment.
G. Cash manufacturing and administrative expenses are paid 1 months in arrear.
The company maintains stock of raw material equal to economic order quantity. The company incurs ` 100 as per
ordering cost per order and opportunity cost of capital is 15% p.a. The optimum cash balance is determined using
Baumol’s model. The bank charges ` 10 for each cash withdrawal. Finished goods are held in stock for 1 month.
The company maintains a bank balance of `12,00,000 on an average. Creditors are paid through net banking and
all other expenses are incurred in cash which is withdrawn from bank.
Assuming a 20% safety margin, you are required to ESTIMATE the amount of working capital that needs to be
invested by the Company.

Ans Statement of working capital Requirement

Particular (`) (`)
A. Current Assets
Stock of Raw Material (W.N. 2) 81,975
 1  5,45,000
Stock of finished Goods  65, 40, 000x 
 12 

 1  5,65,000
Average Receivables (at Cost)  67,80, 000x 
 12 
Bank Balance 12,00,000
Cash Balance (W.N. 3) 15,232
Gross Working Capital 24,07,207
B. Current Liabilities
 3 12,60,000
Average Creditor for materials  50, 40, 000x 
 12 

 0.5  50,000
Outstanding Wages  12, 00, 000x 
 12 

 1  25,000
Outstanding Cash Manufacturing Expenses  3,00,000x 
 12 
 1  20,000
Outstanding administrative Expenses  240, 000x 
 12 

13,55,000
Net Working Capital (A-B) 10,52,207
dd: Safety Margin @ 20% 2,10,441
Total Working Capital Requirement 12,62,648
Working Notes:

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1. Computation of annual cash Cost of Production & Sales

Material Consumed (84,00,000 × 60%) 50,40,000
Wages 12,00,000
Manufacturing expenses 3,00,000
Cash Cost of production 65,40,000
(+) Administrative Expenses 2,40,000
Cash Cost of Sales 67,80,000

2. Computation of stock of Raw Material

A = 50,40,000
B = 100
C = 0.15
2AB 2x50, 40, 000x100
EOQ = = = ` 81,975
c 0.15
3. Calculation of Cash Balance
A = 12,00,000+3,00,000+2,40,000
A = 17,40,000
B = 10
C = 0.15
2AB 2x17, 40, 000x10
Optimal Cash Balance = = = ` 15,232
c 0.15

Q.20 Working Capital Requirements MTP May 20

Cost sheet of A&R Ltd. provides the following particulars:
Amount per unit (Rs.)
Raw materials cost 200.00
Direct labour cost 75.00
Overheads cost 150.00
Total cost 425.00
Profit 75.00
Selling Price 500.00
The Company keeps raw material in stock, on an average for four weeks; work-in-progress, on an average for one
week; and finished goods in stock, on an average for two weeks.
The credit allowed by suppliers is three weeks and company allows four weeks credit to its debtors. The lag in
payment of wages is one week and lag in payment of overhead expenses is two weeks.
The Company sells one-fifth of the output against cash and maintains cash-in-hand and at bank put together at
Rs.2,50,000.
Required:
PREPARE a statement showing estimate of Working Capital needed to finance an activity level of
2,60,000 units of production. Assume that production is carried on evenly throughout the year, and wages and
overheads accrue similarly. Work-in-progress stock is 80% complete in all respects.

Ans Statement showing Estimate of Working Capital Needs

(Amount in Rs.) (Amount in Rs.)
A. Current Assets
(i) Inventories:
Raw material (4 weeks)

 2,60, 000units  Rs.200 

 x 4 weeks 
 52 weeks  40,00,000

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WIP Inventory (1 week)

 2,60, 000units  Rs.425 
 x1 weeks  × 0.8
 52 weeks  17,00,000

Finished goods inventory (2 weeks)

 2,60, 000units  Rs.425  99,50,000

 x 2 weeks  42,50,000
 52 weeks 
(ii) Receivables (Debtors) (4 weeks)
 2,60, 000units  Rs.425  4
 x 2 weeks  x
 52 weeks  5 68,00,000

(iii) Cash and bank balance 2,50,000

Total Current Assets 1,70,00,000
B. Current Liabilities:
(i) Payables (Creditors) for materials (3 weeks)

30,00,000
 2,60, 000units  Rs.200 
 x 3 weeks 
 52 weeks 

(ii) Outstanding wages (1 week)

3,75,000
 2,60, 000units  Rs.75 
 x1 weeks 
 52 weeks 

(iii) Outstanding overheads (2 weeks)

 2,60, 000units  Rs.150  15,00,000

 x 2weeks 
 52 weeks 

Total Current Liabilities 48,75,000

Net Working Capital Needs (A – B) 1,21,25,000

Q.21 Cash Cost Basis RTP July 21

While applying for financing of working capital requirements to a commercial bank, TN Industries Ltd.
projected the following information for the next year:
Cost Element Per unit ( `) Per unit ( `)
Raw materials
X 30
Y 7
Z 6 43
Direct Labour 25
Manufacturing and administration overheads (excluding 20
depreciation)

Depreciation 10
Selling overheads 15
113

Additional Information:
(a) Raw Materials are purchased from different suppliers leading to different credit period allowed as follows:
X – 2 months; Y– 1 months; Z – ½ month

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(b) Production cycle is of ½ month. Production process requires full unit of X and Y in the beginning of the
production. Z is required only to the extent of half unit in the beginning and the remaining half unit
is needed at a uniform rate during the production process.
(c) X is required to be stored for 2 months and other materials for 1 month. (d) Finished goods are held for
1 month.
(e) 25% of the total sales is on cash basis and remaining on credit basis. The credit allowed by debtors is 2
months.
(f) Average time lag in payment of all overheads is 1 months and ½ months for direct labour.
(g) Minimum cash balance of ` 8,00,000 is to be maintained.
CALCULATE the estimated working capital required by the company on cash cost basis if the budgeted level of
activity is 1,50,000 units for the next year. The company also intends to increase the estimated working capital
requirement by 10% to meet the contingencies. (You may assume that production is carried on evenly throughout
the year and direct labour and other overheads accrue similarly.)

Ans Statement showing Working Capital Requirements of TN Industries Ltd. (on cash cost basis)
Amount in( `) Amount in(`)
A. Current Assets
(i) Inventories:
Raw material
 1,50,000units  Rs.30 
x x2months 
 12 months  7,50,000
 1,50,000units  7 
y x1months 
 12 months  87,500

 1,50,000units  6 
z  x1months  75,000
 12 months 

 1,50,000units  64 
WIP  x0.5months  4,00,000
 12 months 

 1,50,000units  88 
Finished goods  x1months  11,00,000 24,12,500
 12 months 

(ii) Receivables (Debtors)

 1,50,000units  103  19,31,250
 x2months  x 0.75
 12 months 

(iii) Cash and bank balance 8,00,000

Total Current Assets 51,43,750
B. Current Liabilities:
(i) Payables (Creditors) for Raw materials

 1,50,000units  30  7,50,000
X  x2months 
 12 months 

 1,50,000units  7  87,500
Y  x1months 
 12 months 

 1,50,000units  6  37,500
Z x0.5months  8,75,000
 12 months 

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(ii) Outstanding Direct Labour

 1,50,000units  25  1,56,250
 x1months 
 12 months 

(iii) Outstanding Manufacturing and

administration overheads
2,50,000
 1,50,000units  20 
 x1months 
 12 months 

(iv) Outstanding Selling overheads

 1,50,000units  15  1,87,500
 x1months 
 12 months 

Total Current Liabilities 14,68,750

Net Working Capital Needs (A – B) 36,75,000
Add: Provision for contingencies @ 10% 3,67,500
Working capital requirement 40,42,500
Workings:
1.
(i) Computation of Cash Cost of Production Per unit ( `)
Raw Material consumed 43
Direct Labour 25
Manufacturing and administration overheads 20
Cash cost of production 88
(ii) Computation of Cash Cost of Sales Per unit ( `)
Cash cost of production as in (i) above 88
Selling overheads 15
Cash cost of sales 103
2. Calculation of cost of WIP
Particulars Per unit ( `)
Raw material (added at the beginning):
X 30
Y 7
Z ( ` 6 x 50%) 3
Cost during the year:
Z {( ` 6 x 50%) x 50%} 1.5
Direct Labour ( ` 25 x 50%) 12.5
Manufacturing and administration overheads ( ` 20 x 50%) 10
64

Q.22 Cash Cost Basis RTP May 20

Day Ltd., a newly formed company has applied to the Private Bank for the first time for financing it's Working
Capital Requirements. The following information is available about the projections for the current year:
Estimated Level of Activity Completed Units of Production 31,200 plus unit of
work in progress 12,000
Raw Material Cost ` 40 per unit
Direct Wages Cost ` 15 per unit
Overhead ` 40 per unit (inclusive of Depreciation `10 per unit)
Selling Price ` 130 per unit

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Raw Material in Stock Average 30 days consumption

Work in Progress Stock Material 100% and Conversion Cost 50%
Finished Goods Stock 24,000 Units
Credit Allowed by the supplier 30 days
Credit Allowed to Purchasers 60 days
Direct Wages (Lag in payment) 15 days
Expected Cash Balance ` 2,00,000
Assume that production is carried on evenly throughout the year (360 days) and wages and overheads accrue
similarly. All sales are on the credit basis. You are required to CALCULATE the Net Working Capital Requirement
on Cash Cost Basis.

Ans Calculation of Net Working Capital requirement:

( `) ( `)
A. Current Assets:
Inventories:
Stock of Raw material (Refer to Working note (iii) 1,44,000
Stock of Work in progress (Refer to Working note (ii) 7,50,000
Stock of Finished goods (Refer to Working note (iv) 20,40,000
Debtors for Sales(Refer to Working note (v) 1,02,000
Cash 2,00,000
Gross Working Capital 32,36,000 32,36,000
B. Current Liabilities:
Creditors for Purchases (Refer to Working note (vi) 1,56,000
Creditors for wages (Refer to Working note (vii) 23,250
1,79,250 1,79,250
Net Working Capital (A - B) 30,56,750
Working Notes:

(i) Annual cost of production

(`)
Raw material requirements
{(31,200 × ` 40) + (12,000 x ` 40)}
17,28,000
Direct wages {(31,200 × ` 15) +(12,000 X ` 15 x 0.5)} 5,58,000
Overheads (exclusive of depreciation)
{(31,200 × ` 30) + (12,000 x ` 30 x 0.5)} 11,16,000
Gross Factory Cost 34,02,000
Less: Closing W.I.P [12,000 ( ` 40 + ` 7.5 + `15)] (7,50,000)
Cost of Goods Produced 26,52,000
Less: Closing Stock of Finished Goods
( ` 26,52,000 × 24,000/31,200) (20,40,000)
Total Cash Cost of Sales* 6,12,000
[*Note: Alternatively, Total Cash Cost of Sales = (31,200 units – 24,000 units) x ( ` 40+ ` 15 + ` 30) = `
6,12,000]

(ii) Work in progress stock

(`)
Raw material requirements (12,000 units × `40) 4,80,000
Direct wages (50% × 12,000 units × ` 15) 90,000
Overheads (50% × 12,000 units × ` 30) 1,80,000

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7,50,000
(iii) Raw material stock
It is given that raw material in stock is average 30 days consumption. Since, the company is newly formed;
the raw material requirement for production and work in progress will be issued and consumed during the
year. Hence, the raw materi al consumption for the year (360 days) is as follows:
(`)
For Finished goods (31,200 × ` 40) 12,48,000
For Work in progress (12,000 × ` 40) 4,80,000
17,28,000
17,28, 000
Raw material stock = × 30 days = `1,44,000
360days
(iv) Finished goods stock:
24,000 units @ ` (40+15+30) per unit = `20,40,000
60 days
(v) Debtors for sale: ` 6,12,000x = `1,02,000
360days
(vi) Creditors for raw material Purchases [Working Note (iii)]:
Annual Material Consumed ( `12,48,000 + `4,80,000) `17,28,000
Add: Closing stock of raw material [( `17,28,000 x 30 days) / 360 days] ` 1,44,000
`18,72,000
18,72, 000
Credit allowed by suppliers = × 30days = ` 1,56,000
360days
(vii) Creditors for wages:
Outstanding wage payment = [(31,200 units x ` 15) + (12,000 units x ` 15 x .50)] x
15 days / 360 days
5,58, 000
= ×15days = ` 23,250
360days

Q.23 Working Capital Estimate RTP May 22

PQR Ltd., a company newly commencing business in the year 2021-22, provides the following projected Profit
and Loss Account:
(`) (`)
Sales 5,04,000
Cost of goods sold 3,67,200
Gross Profit 1,36,800
Administrative Expenses 33,600
Selling Expenses 31,200 64,800
Profit before tax 72,000
Provision for taxation 24,000
Profit after tax 48,000
The cost of goods sold has been arrived at as under:
Materials used 2,01,600
Wages and manufacturing Expenses 1,50,000
Depreciation 56,400
4,08,000
Less: Stock of Finished goods
(10% of goods produced not yet sold) 40,800
3,67,200
The figure given above relate only to finished goods and not to work-in-progress. Goods equal to 15% of the
year’s production (in terms of physical units) will be in process on the average requiring full materials but only
40% of the other expenses. The company believes in keeping materials equal to two months’ consumption in stock.

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All expenses will be paid one month in advance. Suppliers of materials will extend 1 -1/2 months credit. Sales will
be 20% for cash and the rest at two months’ credit. 70% of the Income tax will be paid in advance in quarterly
instalments. The company wishes to keep ` 19,200 in cash. 10% must be added to the estimated figure for
unforeseen contingencies. PREPARE an estimate of working capital.

Ans Statement showing the requirements of Working Capital

Particulars (`) (`)
A. Current Assets:
Inventory:
Stock of Raw material ( ` 2,31,840 × 2/12) 38,640
Stock of Work-in-progress (As per Working Note) 39,240
Stock of Finished goods ( ` 3,51,600 × 10/100) 35,160
Receivables (Debtors) ( `3,04,992 × 2/12) 50,832
Cash in Hand 19,200
Prepaid Expenses:
Wages & Mfg. Expenses ( ` 1,59,000 × 1/12) 13,250
Administrative expenses ( ` 33,600 × 1/12) 2,800
Selling & Distribution Expenses ( ` 31,200 × 1/12) 2,600
Advance taxes paid {(70% of ` 24,000) × 3/12} 4,200
Gross Working Capital 2,05,922 2,05,922
B. Current Liabilities:
Payables for Raw materials ( ` 2,70,480 × 1.5/12) 33,810
Provision for Taxation (Net of Advance Tax) ( ` 24,000 × 7,200
30/100)
Total Current Liabilities 41,010 41,010
C. Excess of CA over CL 1,64,912
Add: 10% for unforeseen contingencies 16,491
Net Working Capital requirements 1,81,403
Working Notes:

(i) Calculation of Stock of Work-in-progress

Particulars ( `)
Raw Material ( ` 2,01,600 × 15%) 30,240
Wages & Mfg. Expenses ( ` 1,50,000 × 15% × 40%) 9,000
Total 39,240
(ii) Calculation of Stock of Finished Goods and Cost of Sales
Particulars ( `)
Direct material Cost [ ` 2,01,600 + ` 30,240] 2,31,840
Wages & Mfg. Expenses [ ` 1,50,000 + ` 9,000] 1,59,000
Depreciation 0
Gross Factory Cost 3,90,840
Less: Closing W.I.P. (39,240)
Cost of goods produced 3,51,600
Add: Administrative Expenses 33,600
3,85,200
Less: Closing stock (35,160)
Cost of Goods Sold 3,50,040
Add: Selling and Distribution Expenses 31,200
Total Cash Cost of Sales 3,81,240

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Debtors (80% of cash cost of sales) 3,04,992

(iii) Calculation of Credit Purchase
Particulars ( `)
Raw material consumed 2,31,840
Add: Closing Stock 38,640
Less: Opening Stock -
Purchases 2,70,480

Q.24 Working Capital Estimate RTP Dec 21

The management of Trux Company Ltd. is planning to expand its business and consults you to prepare an estimated
working capital statement. The records of the company reveals the following annual information:
( `)
Sales – Domestic at one month’s credit 18,00,000
Export at three month’s credit (sales price 10% below domestic price) 8,10,000
Materials used (suppliers extend two months credit) 6,75,000
Lag in payment of wages – ½ month 5,40,000
Lag in payment of manufacturing expenses (cash) – 1 month 7,65,000
Lag in payment of Administration Expenses – 1 month 1,80,000
Selling expenses payable quarterly in advance 1,12,500
Income tax payable in four installments, of which one falls in the next 1,68,000
financial year
Rate of gross profit is 20%. Ignore work-in-progress and depreciation.
The company keeps one month’s stock of raw materials and finished goods (each) and believes in keeping
`2,50,000 available to it including the overdraft limit of ` 75,000 not yet utilized by the company.
The management is also of the opinion to make 10% margin for contingencies on computed figure.
You are required to PREPARE the estimated working capital statement for the next year.

Ans Preparation of Statement of Working Capital Requirement for Trux Company Ltd.

( `) ( `)
A. Current Assets
(i) Inventories:
Material (1 month)
 6,75, 000 
 x1 month  56,250
 12months 

Finished goods (1 month)

 21,60, 000 
 x1 month 
 12months  1,80,000 2,36,250

(ii) Receivables (Debtors)

 15,17,586 
For Domestic Sales  x1 month  1,26,466
 12months 

(iii) Prepayment of Selling expenses

 1,12,500 
 x 3 month 
 12months  28,125
(iii) Cash in hand & at bank 1,75,000
Total Current Assets 7,54,570

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B. Current Liabilities:
(i) Payables (Creditors) for materials (2
months)
 6,75, 000  1,12,500
 x 2 month 
 12months 

(ii) Outstanding wages (0.5 months)

 5, 40, 000 
 x 0.5 month 
 12months  22,500

(iii) Outstanding manufacturing expenses

 7,65,000 
 x1 month 
 12months 
63,750
(iv) Outstanding administrative expenses
 1,80,000 
 x1 month 
 12months  15,000

(v) Income tax payable 42,000

Total Current Liabilities 2,55,750
Net Working Capital (A – B) 4,98,820
Add: 10% contingency margin 49,882
Total Working Capital required 5,48,702
Working Notes:

1. Calculation of Cost of Goods Sold and Cost of Sales

Domestic ( `) Export ( `) Total ( `)
Domestic Sales 18,00,000 8,10,000 26,10,000
Less: Gross profit @ 20% on 3,60,000 90,000 4,50,000
domestic sales and 11.11% on export
sales (Working note-2)
Cost of Goods Sold 14,40,000 7,20,000 21,60,000
Add: Selling expenses (Working 77,586 34,914 1,12,500
note-3)
Cash Cost of Sales 15,17,586 7,54,914 22,72,500
2. Calculation of gross profit on Export Sales
Let domestic selling price is ` 100. Gross profit is ` 20, and then cost per unit is ` 80
Export price is 10% less than the domestic price i.e. ` 100 – (1- 0.1) = ` 90
Now, gross profit will be = ` 90 - ` 80 = ` 10
10
So, Gross profit ratio at export price will be = x100 = 11.11%
90
3. Apportionment of Selling expenses between Domestic and Exports sales:
Apportionment on the basis of sales value:
1,12, 500
Domestic Sales = x 18,00,000 = ` 77,586
26,10, 000
1,12, 500
Exports Sales = x ` 8,10,000 = ` 34,914
26,10, 000
4. Assumptions
(i) It is assumed that administrative expenses is related to production activities.
(ii) Value of opening and closing stocks are equal.

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Q.25 Working Capital Estimate MTP Nov 22(2)

PREPARE a working capital estimate to finance an activity level of 52,000 units a year (52 weeks)
based on the following data:
Raw Materials - ` 400 per unit
Direct Wages - ` 150 per unit
Overheads (Manufacturing) - `200 per unit
Overheads (Selling & Distribution) - `100perunit
Selling Price - ` 1,000 per unit, Raw materials & Finished Goods remain in stock for 4 weeks, Work in process
takes 4 weeks. Debtors are allowed 8 weeks for payment whereas creditors allow us 4 weeks.
Minimum cash balance expected is `50,000. Receivables are valued at Selling Price.

Ans
Cost Structure for 52000 units
Particulars Amount (`)
Raw Material @ ` 400P 2,08,00,000
Direct Wages @ ` 150 78,00,000
Manufacturing Overheads@ ` 200 1,04,00,000
Selling and Distribution OH@ ` 100 52,00,000
Total Cost 4,42,00,000
Sales@ `1000 5,20,00,000

Particulars Calculation Amount (`)

A. Current Assets:
Raw Material Stock 4 16,00,000
2,08,00,000 x
52
Work in Progress (78, 00, 000 + 1, 04, 00, 000 ) 4 23,00,000
2,08,00,000 + x
(WIP) Stock 2 52

Finished Goods Stock 4 34,00,000

4,42,00,000 x
52

Receivables 8 80,00,000
5,20,00,000 x
52
Cash 50,000
B. Current Liabilities: Total Current Assets 1,53,50,000
Creditors 4 16,00,000
20800000 x
52
C. Working Capital
Estimates(A-B) 1,37,50,000

Q.26 Working Capital Estimate MTP Dec 21(2)

On 01st April, 2020, the Board of Director of ABC Ltd. wish to know the amount of working capital that will be
required to meet the programme they have planned for the year. From the following information,
PREPARE a working capital requirement forecast and a forecast profit and loss account and balance sheet:
Issued share capital ` 6,00,000

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10% Debentures ` 1,00,000

Fixed Assets ` 4,50,000

Production during the previous year was 1,20,000 units; it is planned that this level of activity should be
maintained during the present year.
The expected ratios of cost to selling price are: raw materials 60%, direct wages 10% overheads 20% Raw
materials are expected to remain in store for an average of two months before issue to production.
Each unit of production is expected to be in process for one month. The time lag in wage
payment is one month.
Finished goods will stay in the warehouse awaiting dispatch to customers for approximately three months.
Credit allowed by creditors is two months from the date of delivery of raw materials. Credit given to debtors is
three months from the date of dispatch.
Selling price is ` 5 per unit.
There is a regular production and sales cycle and wages and overheads accrue evenly.

Ans Forecast Profit and Loss Account for the period 01.04.2020 to 31.03.2021
Particulars ` Particulars `
Materials consumed 3,60,000 By Sales 1,20,000 @ ` 5 6,00,000
1,20,000 @ ` 3
Direct wages : 60,000

Overheads : 1,20,000

1,20,000 @ ` 1
Gross profit c/d 60,000
6,00,000 6,00,000
Debenture interest 10,000 60,000
(10% of 1,00,000)
Net profit c/d 50,000 By gross profit b/d
60,000 60,000
Working Capital Requirement Forecast for the year 01.04.2020 to 31.03.2021
Particulars Period Total (`) Current Assets (`) Current
(Months) Liabilities(`)
Raw Work-in- Finished Debtors Creditors
materials progress goods
1.Material
In store 2 60,000
In work-in- 1 30,000
progress
In finished 3 90,000
goods
Credit to 3 90,000
debtors
9
Less : 2 60,000
Credit from
creditors
Net block 7 2,10,000
period
2. Wages:
In work-in- 1/2 2,500

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progress
In finished 3 15,000
goods
Credit to 3 15,000
debtors
6½
Less : Time 1 5,000
lag in
payment
Net block 5 ½ 27,500
period
3.Overhead
In work-in- ½ 5,000
progress
In finished 3 30,000
goods
Credit to 3 30,000
debtors
Net block 6½ 65,000
period
4.Profit
Credit to 3 15,000
debtors
Net block 3 15,000
period
Total ( `) 3,17,500 60,000 37,500 1,35,000 1,50,000 65,000

Forecast Balance Sheet as on 31.03.2021

( `) ( `)
Issued share capital 6,00,000 Fixed Assets 4,50,000
Profit and Loss A/c 50,000 Current Assets:
10% Debentures 1,00,000 Stock:
Sundry creditors 65,000 Raw materials 60,000
Bank overdraft- Work-in-progress 37,500
Balancing figure 17,500 Finished goods 1,35,000 2,32,500
Debtors 1,50,000

8,32,500 8,32,500

The Total amount of working capital, thus, stands as follows: `

Requirement as per working capital 3,17,500
Less: Bank overdraft as per balance sheet 17,500
Net requirement 3,00,000
Notes:
1. Average monthly production: 1,20,000 ÷ 12 = 10,000 units
2. Average cost per month:
Raw Material 10,000 × ( ` 5 × 0.6) = ` 30,000
Direct wages 10,000 × ( ` 5 × 0.1) = ` 5,000
Overheads 10,000 × ( ` 5 × 0.2) = ` 10,000

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3. Average profit per month: 10,000 × ( ` 5 × 0.1) = ` 5,000

4. Wages and overheads accrue evenly over the period and, hence, are assumed to be completely introduced
for half the processing time.

Q.27 Working Capital Estimate RTP May 19

A company is considering its working capital investment and financial policies for the next year. Estimated fixed
assets and current liabilities for the next year are ` 2.60 crores and ` 2.34 crores respectively. Estimated
Sales and EBIT depend on current assets investment, particularly inventories and book-debts. The
Financial Controller of the company is examining the following alternative Working Capital Policies:
Working Capital Investment in Estimated Sales EBIT
Policy Current Assets
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00
the adoption of the moderate working capital policy. The company is now examining the use of long-term and
short-term borrowings for financing its assets. The company will use ` 2.50 crores of the equity funds. The
corporate tax rate is 35%. The company is
considering the following debt alternatives.
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%
You are required to CALCULATE the following:
(i) Working Capital Investment for each policy:
(a) Net Working Capital position
(b) Rate of Return
(c) Current ratio
(ii) Financing for each policy:
(a) Net Working Capital position.
(b) Rate of Return on Shareholders’ equity.
(c) Current ratio.

Ans (i) Statement showing Working Capital Investment for each policy
Working Capital Policy
Conservative Moderate Aggressive
Current Assets: (i) 4.50 3.90 2.60
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 7.10 6.50 5.20
Current liabilities: (iv) 2.34 2.34 2.34
Net Worth: (v) = (iii) - (iv) 4.76 4.16 2.86
Total liabilities: (iv) + (v) 7.10 6.50 5.20
Estimated Sales: (vi) 12.30 11.50 10.00
EBIT: (vii) 1.23 1.15 1.00
(a) Net working capital position: (i) - 2.16 1.56 0.26
(iv)
(b) Rate of return: (vii) /(iii) 17.32% 17.69% 19.23%
(c) Current ratio: (i)/ (iv) 1.92 1.67 1.11

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(ii) Statement Showing Effect of Alternative Financing Policy

( `in crore)
Financing Policy Conservative Moderate Aggressive
Current Assets (i) 3.90 3.90 3.90
Fixed Assets (ii) 2.60 2.60 2.60
Total Assets (iii) 6.50 6.50 6.50
Current Liabilities (iv) 2.34 2.34 2.34
.Short term Debt (v) 0.54 1.00 1.50
Total current liabilities 2.88 3.34 3.84
(vi) = (iv) + (v)
Long term Debt (vii) 1.12 0.66 0.16
Equity Capital (viii) 2.50 2.50 2.50
Total liabilities (ix) = 6.50 6.50 6.50
(vi)+(vii)+(viii)
Forecasted Sales 11.50 11.50 11.50
EBIT (x) 1.15 1.15 1.15
Less: Interest on short-term 0.06 0.12 0.18
debt
(12% of `0.54) (12% of ` 1) (12% of ` 1.5)
Interest on long term debt 0.18 0.11 0.03
(16% of `1.12) (16% of `0.66) (16% of `0.16)
Earnings before tax (EBT) (xi) 0.91 0.92 0.94
Taxes @ 35% (xii) 0.32 0.32 0.33
Earnings after tax: (xiii) = (xi) – 0.59 0.60 0.61
(xii)
(a) Net Working Capital 1.02 0.56 0.06
Position: (i) - [(iv) + (v)]
(b) Rate of return on
shareholders Equity capital : 24.0% 24.4%
23.6% (xiii)/ (viii)
(c) Current Ratio (i) / (vi) 1.35 1.17 1.02

Q.28 Working Capital Estimate RTP Nov 18

A company is considering its working capital investment and financial policies for the next year. Estimated fixed
assets and current liabilities for the next year are ` 2.60 crores an ` 2.34 crores respectively. Estimated
Sales and EBIT depend on current assetsinvestment, particularly inventories and book-debts. The financial
controller of the company is examining the following alternative Working Capital Policies:
Working Capital Policy Investment in Current Assets Estimated Sales EBIT
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 policy, the Financial Controller has advised the adoption of the moderate
working capital policy. The company is now examining the use of long-term and short-term borrowings for

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financing its assets. The company will use ` 2.50 crores of the equity funds. The corporate tax rate is
35%. The company is considering the following debt alternatives.
( `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%
You are required to CALCULATE the following:
(i) Working Capital Investment for each policy:
(a) Net Working Capital position
(b) Rate of Return
(c) Current ratio
(ii) Financing for each policy:
(a) Net Working Capital position.
(b) Rate of Return on Shareholders’ equity.
(c) Current ratio.

Ans (i) Statement showing Working Capital for each policy

( ` in crores)
Working Capital Policy
Conservative Moderate Aggressive
Current Assets: (i) 4.50 3.90 2.60
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 7.10 6.50 5.20
Current liabilities: (iv) 2.34 2.34 2.34
Net Worth: (v)=(iii)-(iv) 4.76 4.16 2.86
Total liabilities: (iv)+(v) 7.10 6.50 5.20
Estimated Sales: (vi) 12.30 11.50 10.00
EBIT: (vii) 1.23 1.15 1.00
(a) Net working capital position: (i)-(iv) 2.16 1.56 0.26
(b) Rate of return: (vii)/(iii) 17.3% 17.7% 19.2%
(c) Current ratio: (i)/(iv) 1.92 1.67 1.11

(ii) Statement Showing Effect of Alternative Financing Policy

( ` in crores)
Financing Policy Conservative Moderate Aggressive
Current Assets: (i) 3.90 3.90 3.90
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 6.50 6.50 6.50
Current Liabilities: (iv) 2.34 2.34 2.34
Short term Debt: (v) 0.54 1.00 1.50
Long term Debt: (vi) 1.12 0.66 0.16
Equity Capital (vii) 2.50 2.50 2.50
Total liabilities 6.50 6.50 6.50
Forecasted Sales 11.50 11.50 11.50
EBIT: (viii) 1.15 1.15 1.15
Less: Interest short-term debt: 0.06 0.12 0.18

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(ix) (12% of ` 0.54) (12% of ` 1.00) (12% of ` 1.50)

Long term debt: (x) 0.18 0.11 0.03
(16% of ` 1.12) (16% of ` 0.66) (16% of ` 0.16)
Earning before tax: 0.91 0.92 0.94
(xi) - (ix + x)
Tax @ 35% (0.32) (0.32) (0.33)
Earning after tax: (xii) 0.59 0.60 0.61
(a) Net Working Capital 0.06
Position: (i) - [(iv)+(v)] 1.02 0.56
(b) Rate of return on 23.6% 24% 24.4%
Equity shareholders’
capital : (xii)/(vii)
(c) Current Ratio: 1.35 1.17 1.02
[(i)/(iv)+(v)]

Q.29 Working Capital Estimate RTP May 19

A proforma cost sheet of a company provides the following particulars:
Amount per unit ( `)
Raw materials cost 100.00
Direct labour cost 37.50
Overheads cost 75.00
Total cost 212.50
Profit 37.50
Selling Price 250.00
The Company keeps raw material in stock, on an average for one month; work-in-progress, on an average for one
week; and finished goods in stock, on an average for two weeks.
The credit allowed by suppliers is three weeks and company allows four weeks credit to its debtors. The lag in
payment of wages is one week and lag in payment of overhead expenses is two weeks.
The Company sells one-fifth of the output against cash and maintains cash-in-hand and at bank put together at
`37,500.
Required:
PREPARE a statement showing estimate of Working Capital needed to finance an activity level of 1,30,000
units of production. Assume that production is carried on evenly throughout the year, and wages and
overheads accrue similarly. Work-in-progress stock is 80% complete in all respects.

Ans Statement showing Estimate of Working Capital Needs

(Amount in `) (Amount in `)
A. Current Assets
(i) Inventories:
Raw material (1 month or 4 weeks)
 1,30, 000unitsx100 
 x 4 weeks 
 52 weeks  10,00,000

WIP Inventory (1 week)

 1,30, 000unitsx212.50 
 x1weeks  × 0.8
 52 weeks  4,25,000

Finished goods inventory (2 weeks)

24,87,500
10,62,500

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 1,30, 000unitsx212.50 
 x 2weeks 
 52 weeks 

(ii) Receivables (Debtors) (4 weeks)

 1,30, 000unitsx212.50  4
 x 4weeks  x
 52 weeks  5 17,00,000
37,500
(iii) Cash and bank balance
42,25,000
Total Current Assets
B. Current Liabilities:
(i) Payables (Creditors) for materials (3 weeks)
 1,30, 000unitsx100  7,50,000
 x 3weeks 
 52 weeks 

(ii) Outstanding wages (1 week)

 1,30, 000unitsx37.50  93,750
 x1weeks 
 52 weeks 

(iii) Outstanding overheads (2 weeks)

 1,30, 000unitsx75 
 x 2weeks 
 52 weeks 
3,75,000
12,18,750
Total Current Liabilities
30,06,250
Net Working Capital Needs (A – B)

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10 INVESTING DECISION
CHAPTER

Q.1 Accept Mutually Excl. Project PY May 19

Kanoria Enterprises wishes to evaluate two mutually exclusive projects X and Y.
The particulars are as under :
Project X Project Y
(`) (`)
Initial Investment 1,20,000 1,20,000
Estimated cash inflows (per annum for 8 years)
Pessimistic 26,000 12,000
Most Likely 28,000 28,000
Optimistic 36,000 52,000
The cut off rate is 14%. The discount factor at 14% are :
Year 1 2 3 4 5 6 7 8 9
Discount factor 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308

Advise management about the acceptability of projects X and Y.

Ans. The possible outcomes of Project x and Project y are as follows

Estimates Project X Project Y

Estimated PVF @ PV of NPV Estimated PVF @ PV of Cash NPV (` )
Annual Cash 14% for 8 Cash flow (` ) Annual Cash 14% for flow (` )
inflows (` ) years (` ) inflows (` ) 8 years
Pessimistic 26,000 4.639 1,20,614 614 12,000 4.639 55,668 (-64,332)
Most likely 28,000 4.639 1,29,892 9,892 28,000 4.639 1,29,892 9,892
Optimistic 36,000 4.639 2,41,228 47,004 52,000 4.639 2,41,228 1,21,228
In pessimistic situation project X will be better as it gives low but positive NPV whereas Project Y yield highly
negative NPV under this situation. In most likely situation both the project will give same result. However, in
optimistic situation Project Y will be better as it will gives very high NPV. So, project X is a risk less project
as it gives positive NPV in all the situation whereas Y is a risky project as it will result into negative NPV in
pessimistic situation and highly positive NPV in optimistic situation. So acceptability of project will largely
depend on the risk taking capacity (Risk seeking/ Risk aversion) of the management.

Q.2 NPV Method (Accept/Not) RTP May 23

Dharma Ltd, an existing profit-making company, is planning to introduce a new product with a projected life of 8
years. Initial equipment cost will be ` 240 lakhs and additional equipment costing ` 26 lakhs will be needed at the
beginning of third year. At the end of 8 years, the original equipment will have resale value equivalent to the cost
of removal, but the additional equipment would be sold for ` 2 lakhs. Working Capital of ` 25 lakhs will be needed
at the beginning of the operations. The 100% capacity of the plant is of 4,00,000 units per annum, but the
production and sales volume expected are as under:
Year Capacity (%)
1 20

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2 30
3-5 75
6-8 50

A sale price of ` 100 per unit with a profit volume ratio (contribution/sales) of 60% is likely to be obtained. Fixed
operating cash cost are likely to be ` 16 lakhs per annum. In addition to this the advertisement expenditure will
have to be incurred as under:
Year 1 2 3-5 6-8

Expenditure (` Lakhs each year) 30 15 10 4

The company is subjected to 50% tax rate and consider 12% to be an appropriate cost of capital. Straight line
method of depreciation is followed by the company. ADVISE the management on the desirability of the project.

Ans. Calculation of Cash Flow After tax

Year 1 2 3 to 5 6 to 8
A Capacity 20% 30% 75% 50%
B Units 80000 120000 300000 200000
C Contribution p.u. `60 `60 `60 `60
D Contribution `48,00,000 `72,00,000 `1,80,00,000 `1,20,00,000
E Fixed Cash Cost `16,00,000 `16,00,000 `16,00,000 `16,00,000
Depreciation
F Original Equipment `30,00,000 `30,00,000 `30,00,000 `30,00,000
(`240Lakhs/8)
G Additional Equipment -- -- `4,00,000 `4,00,000
(`24Lakhs/6)
H Advertisement `30,00,000 `15,00,000 `10,00,000 `4,00,000
Expenditure
I Profit Before Tax ` (28,00,000) `11,00,000 `1,20,00,000 `66,00,000
(D- E-F-G-H)
J Tax savings/ `14,00,000 `(5,50,000) `(60,00,000) ` (33,00,000)
(expenditure)
K Profit After Tax ` (14,00,000) `5,50,000 `60,00,000 `33,00,000
L Add: Depreciation `30,00,000 `30,00,000 `34,00,000 `34,00,000
(F+G)
M Cash Flow After Tax `16,00,000 `35,50,000 `94,00,000 `67,00,000

Calculation of NPV
Year Particula Cash Flows PV factor PV
0 Initial Investment rs ` (2,40,00,000) 1.000 ` (2,40,00,000)
0 Working Capital ` (25,00,000) 1.000 ` (25,00,000)
Introduced
1 CFAT `16,00,000 0.893 ` 14,28,800
2 CFAT ` 35,50,000 0.797 ` 28,29,350
2 Additional Equipment ` (26,00,000) 0.797 ` (20,72,200)
3 CFAT ` 94,00,000 0.712 ` 66,92,800
4 CFAT ` 94,00,000 0.636 ` 59,78,400
5 CFAT ` 94,00,000 0.567 ` 53,29,800

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6 CFAT ` 67,00,000 0.507 ` 33,96,900

7 CFAT ` 67,00,000 0.452 ` 30,28,400
8 CFAT ` 67,00,000 0.404 ` 27,06,800
8 WC Released ` 25,00,000 0.404 ` 10,10,000
8 Salvage Value ` 2,00,000 0.404 ` 80,800
Net Present Value `39,09,850
Since the NPV is positive, the proposed project should be implemented.

Q.3 NPV Method (Accept/Not) MTP Dec 21(2)

Superb Ltd. constructs customized parts for satellites to be launched by USA and Canada. The parts are
constructed in eight locations (including the central headquarter) around the world. The Finance Director, Ms.
Kuthrapali, chooses to implement video conferencing to speed up the budget process and save travel costs. She
finds that, in earlier years, the company sent two officers from each location to the central headquarter
to discuss the budget twice a year. The average travel cost per person, including air fare, hotels and meals, is `
27,000 per trip. The cost of using video conferencing is ` 8,25,000 to set up a system at each location plus ` 300
per hour average cost of telephone time to transmit signals. A total 48 hours of transmission time will be needed
to complete the budget each year. The company depreciates this type of equipment over five years by using
straight line method. An alternative approach is to travel to local rented video conferencing facilities, which can
be rented for ` 1,500 per hour plus ` 400 per hour averge cost for telephone charges. You are Senior Officer of
Finance Department. You have been asked by Ms. Kuthrapali to EVALUATE the proposal and SUGGEST
if it would be worthwhile for the company to implement video conferencing.

Ans. Option I : Cost of travel, in case Video Conferencing facility is not provided
Total Trip = No. of Locations × No. of Persons × No. of Trips per Person = 7×2×2 = 28 Trips
Total Travel Cost (including air fare, hotel accommodation and meals) (28 trips × ` 27,000 per trip) = ` 7,56,000

Option II : Video Conf.Facility is provided by Installation of Own Equipment at Different Locations

Cost of Equipment at each location (` 8,25,000 × 8 locations) = ` 66,00,000
Economic life of Machines (5 years). Annual depreciation (66,00,000/5) = ` 13,20,000
Annual transmission cost (48 hrs. transmission × 8 locations × ` 300 per hour) = ` 1,15,200
Annual cost of operation (13,20,000 + 1,15,200) = ` 14,35,200
Option III : Engaging Video Conferencing Facility on Rental Basis
Rental cost (48 hrs. × 8 location × ` 1,500 per hr) = ` 5,76,000
Telephone cost (48 hrs.× 8 locations × ` 400 per hr.) = ` 1,53,600
Total rental cost of equipment (5,76,000 + 1,53,600) = ` 7,29,600
Analysis: The annual cash outflow is minimum, if video conferencing facility is engaged on rental basis Therefore,
Option III is suggested.

Q.4 NPV Method (Accept/Not) MTP May 19(2)

(a) Prem Ltd has a maximum of Rs. 8,00,000 available to invest in new projects. Three possibilities have
emerged and the business finance manager has calculated Net present Value (NPVs) for each of the
projects as follows:

Investment Initial cash outlay Rs. NPV Rs.

Alfa (α) 5,40,000 1,00,000
Beta(β) 6,00,000 1,50,000
Gama (γ) 2,60,000 58,000
DETERMINE which investment/combination of investments should the company invest in, if we assume
that the projects can be divided?

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(b) Invest Corporation Ltd. adjusts risk through discount rates by adding various risk premiums to the risk
free rate. Depending on the resultant rate, the proposed project is judged to be a low, medium or high
risk project.
Risk level Risk free rate (%) Risk Premium (%)
Low 8 4
Medium 8 7
High 8 10
DEMONSTRATE the acceptability of the project on the basis of Risk Adjusted rate

Ans. (a) Since funds available are restricted, the normal Net Present Value (NPV) rule of accepting
investments decisions with the highest NPVs 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 Rio Ltd.
Project PV Per Rs. Rank as per PI
Alfa (α) Rs. 6,40,000 / Rs. 5,40,000 = 1.185 III

Beta (β) Rs. 7,50,000 / Rs. 6,00,000 = 1.250 I

Gama (γ) Rs. 3,18,000 / Rs. 2,60,000 = 1.223 II

Therefore Rio Ltd should invest Rs. 6,00,000 into project β (Rank I) earnings Rs. 1,50,000 and Rs.2,00,000
into project γ (Rank II) earning Rs.44,615 Rs. 2,00,000 / Rs. 2,60,000 × Rs. 58,000
So, total NPV will be Rs.1,94,615 Rs. 1,50,000 + Rs. 44,615 from Rs. 8,00,000 of investment.
(b) Calculation of Risk Adjusted rate
Risk level Risk free rate (%) Risk Premium (%) Risk adjusted rate (%)
Low 8 4 12
Medium 8 7 15
High 8 10 18
The cash flows of the project considered are as following:
Point in time (yearly intervals) 0 1 2

Cash flow (Rs. in crore) (100) 45 80

If the project is judged to be Low risk
Years 0 1 2
PV (Rs. in crore) (100) 45 80
= 63.78
1 + 0.12 = 40.18 (1 + 0.12)
2

NPV = 40.18 + 63.78 – 100 = 3.96: Accept

If the project is judged to be Medium risk
Years 0 1 2

PV (Rs. in crore) (100) 45 80

= 60.49
1 + 0.15 = 39.13 (1 + 0.15 )
2

NPV = 39.13 + 60.49 – 100 = (0.38): Reject

Years 0 1 2

PV (Rs. in crore) (100) 45 80

= 57.45
1 + 0.18 = 38.14 (1 + 0.18)
2

NPV = 38.14 + 57.45 – 100 = (4.41): Reject

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Q.5 Adjusted PV & Disc Rate PY May 18

(a) XYZ Ltd. is presently all equity financed. The directors of the company have been evaluating investment
in a project which will require ` 270 lakhs capital expenditure on new machinery. They expect the capital
investment to provide annual cash flows of ` 42 lakhs indefinitely which is net of all tax adjustments. The
discount rate which it applies to such investment decisions is 14% net.
The directors of the company believe that the current capital structure fails to take advantage of tax
benefits of debt, and propose to finance the new project with undated perpetual debt secured on the
company's assets. The company intends to issue sufficient debt to cover the cost of capital expenditure
and the after tax cost of issue.
The current annual gross rate of interest required by the market on corporate undated debt of similar risk
is 10%. The after tax costs of issue are expected to be ` 10 lakhs. Company's tax rate is 30%.
You are required to calculate:
(i) The adjusted present value of the investment,
(ii) The adjusted discount rate and
(iii) Explain the circumstances under which this adjusted discount rate may be used to evaluate future
investments.
(b) What are Masala Bonds?

Ans. (a) (i) Calculation of Adjusted Present Value of Investment (APV)

Adjusted PV = Base Case PV + PV of financing decisions associated with the project
Base Case NPV for the project:
(-) ` 270 lakhs + (` 42 lakhs / 0.14) = (-) ` 270 lakhs + ` 300 lakhs
= ` 30
Issue costs = ` 10 lakhs
Thus, the amount to be raised = ` 270 lakhs + ` 10 lakhs
= ` 280 lakhs
Annual tax relief on interest payment = ` 280 X 0.1 X 0.3
= ` 8.4 lakhs in perpetuity
The value of tax relief in perpetuity = ` 8.4 lakhs / 0.1
= ` 84 lakhs
Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on debt interest
= ` 30 lakhs – ` 10 lakhs + 84 lakhs = ` 104 lakhs

(ii) Calculation of Adjusted Discount Rate (ADR)

Annual Income / Savings required to allow an NPV to zero
Let the annual income be x.
(-) `280 lakhs X (Annual Income / 0.14) = (-) `104 lakhs
Annual Income / 0.14 = (-) ` 104 + ` 280 lakhs
Therefore, Annual income = ` 176 X 0.14 = ` 24.64 lakhs
Adjusted discount rate = (` 24.64 lakhs / `280 lakhs) X 100
= 8.8%
(iii) Useable circumstances
This ADR may be used to evaluate future investments only if the business risk of the new venture is
identical to the one being evaluated here and the project is to be financed by the same method on
the same terms. The effect on the company’s cost of capital of introducing debt into the capital
structure cannot be ignored.

(b) Masala Bond:

Masala (means spice) bond is an Indian name used for Rupee denominated bond that Indian corporate
borrowers can sell to investors in overseas markets. These bonds are issued outside India but denominated
in Indian Rupees. NTPC raised `2,000 crore via masala bonds for its capital expenditure in the year 2016.

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Q.6 Annualised Yeild PY Dec 21

Stand Ltd. is contemplating replacement of one of its machines which has become outdated and inefficient. Its
financial manager has prepared a report outlining two possible replacement machines. The details of each machine
are as follows:
Machine 1 Machine 2
Initial investment ` 12,00,000 ` 16,00,000
Estimated useful life 3 years 5 years
Residual value ` 1,20,000 ` 1,00,000
Contribution per annum ` 11,60,000 ` 12,00,000
Fixed maintenance costs per annum ` 40,000 ` 80,000
Other fixed operating costs per annum ` 7,20,000 ` 6,10,000
The maintenance costs are payable annually in advance. All other cash flows apart from the initial investment
assumed to occur at the end of each year. Depreciation has been calculated by straight line method and has been
included in other fixed operating costs. The expected cost of capital for this project is assumed as 12% p.a
Required:
(i) Which machine is more beneficial, using Annualized Equivalent Approach? Ignore tax.
(ii) Calculate the sensitivity of your recommendation in part (i) to changes in the contribution generated by
machine 1.
Year 1 2 3 4 5 6
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567 0.507
PVIFA0.12,t 0.893 1.690 2.402 3.038 3.605 4.112

Ans. Calculation of Net Cash flows

Machine 1
Other fixed operating costs (excluding depreciation) = 7,20,000–[(12,00,000–1,20,000)/3] = ` 3,60,000
Year Initial Contribution Fixed Other fixed operating Residual Value(`) Net cash
Investment (`) maintenance costs (excluding flow(`)
(`) costs(`) depreciation) (`)
0 (12,00,000) (40,000) (12,40,000)
1 11,60,000 (40,000) (3,60,000) 7,60,000
2 11,60,000 (40,000) (3,60,000) 7,60,000
3 11,60,000 (3,60,000) 1,20,000 9,20,000

Machine 2
Other fixed operating costs (excluding depreciation) = 6,10,000–[(16,00,000–1,00,000)/5] = ` 3,10,000
Year Initial Contribution Fixed maintenanc Other fixed operating Residual Net cash
0 Investment (`) costs (`) costs (excluding Value flow (`)
(`) (16,00,000) (80,000) depreciation) (`) (`) (16,80,000)
1 12,00,000 (80,000) (3,10,000) 8,10,000
2 12,00,000 (80,000) (3,10,000) 8,10,000
3 12,00,000 (80,000) (3,10,000) 8,10,000
4 12,00,000 (80,000) (3,10,000) 8,10,000
5 12,00,000 (3,10,000) 1,00,000 9,90,000

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Calculation of Net Present Value

Machine 1 Machine 2
Year 12% discount factor Net cash flow Present value (`) Net cash flow (`) Present value (`)
(`)
0 1.000 (12,40,000) (12,40,000) (16,80,000) (16,80,000)
1 0.893 7,60,000 6,78,680 8,10,000 7,23,330
2 0.797 7,60,000 6,05,720 8,10,000 6,45,570
3 0.712 9,20,000 6,55,040 8,10,000 5,76,720
4 0.636 8,10,000 5,15,160
5 0.567 9,90,000 5,61,330
NPV @ 12% 6,99,440 13,42,110
PVAF @ 12% 2.402 3.605
Equivalent Annualized Criterion 2,91,190.674 3,72,291.262
Recommendation: Machine 2 is more beneficial using Equivalent Annualized Criterion.
(ii) Calculation of sensitivity of recommendation in part (i) to changes in the contribution generated by
machine 1
Difference in Equivalent Annualized Criterion of Machines required for changing the recommendation
in part (i) = 3,72,291.262- 2,91,190.674 = ` 81,100.588
81.100.588
 Sensitivity relating to contribution = ×100 = 6.991 or 7% yearly
11.60.000.00
Alternatively,
The annualized equivalent cash flow for machine 1 is lower by ` (3,72,291.262–2,91,190.674) =
`81,100.588 than for machine 2. Therefore, it would need to increase contribution for complete 3 years
before the decision would be to invest in this machine.
Sensitivity w.r.t contribution = 81,100.588 / (11,60,000 × 2.402) x100 = 2.911%

Q.7 NPV Method (Best Option) PY Nov 22

A firm is in need of a small vehicle to make deliveries. It is intending to choose between two options. One option
is to buy a new three wheeler that would cost ` 1,50,000 and will remain in service for 10 years.
The other alternative is to buy a second hand vehicle for ` 80,000 that could remain in service for 5 years.
Thereafter the firm, can buy another second hand vehicle for ` 60,000 that will last for another 5 years.
The scrap value of the discarded vehicle will be equal to it written down value (WDV). The firm pays 30% tax and
is allowed to claim depreciation on vehicles @ 25% on WDV basis.
The cost of capital of the firm is 12%.
You are required to advise the best option.
Given:
t 1 2 3 4 5 6 7 8 9 10
PVIF (t,12%) 0.892 0.797 0.711 0.635 0.567 0.506 0.452 0.403 0.360 0.322

Ans. Selection of Investment Decision

Tax shield on Purchase of New vehicle
Year WDV Dep. @ 25% Tax shield @ 30%
1 1,50,000 37,500 11,250
2 1,12,500 28,125 8,437
3 84,375 21,094 6,328
4 63,281 15,820 4,746

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5 47,461 11,865 3,560

6 35,596 8,899 2,670
7 26,697 6,674 2,002
8 20,023 5,006 1,502
9 15,017 3,754 1,126
10 11,263 2,816 845
11 8,447 Scrap value
Tax shield on Purchase of Second hand vehicles
Year WDV Dep. @ 25% Tax shield @ 30%
1 80,000 20,000 6,000
2 60,000 15,000 4,500
3 45,000 11,250 3,375
4 33,750 8,437 2,531
5 25,313 6,328 1,898 Scrap value = ` 18,985
6 60,000 15,000 4,500
7 45,000 11,250 3,375
8 33,750 8,437 2,531
9 25,313 6,328 1,898 Scrap value = ` 14,239
10 18,985 4,746 1,424
Calculation of PV of Net outflow of New Vehicle
Year Cash OF/IF PV Factor PV of OF/IF
0 1,50,000 1 1,50,000
1 (11,250) 0.892 (10,035)
2 (8,437) 0.797 (6,724)
3 (6,328) 0.711 (4,499)
4 (4,746) 0.635 (3,014)

5 (3,560) 0.567 (2,018)

6 (2,670) 0.506 (1,351)
7 (2,002) 0.452 (905)
8 (1,502) 0.403 (605)
9 (1,126) 0.360 (405)
10 (845 + 8447) 0.322 (2,992)
PVNOF 1,17,452
Calculation of PV of Net outflow of Second hand Vehicles
Year Cash OF/IF PV Factor PV of OF/IF
0 80,000 1 80,000
1 (6,000) 0.892 (5,352)
2 (4,500) 0.797 (3,587)
3 (3,375) 0.711 (2,400)
4 (2,531) 0.635 (1,607)

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5 (60000 – 18985 – 1898) = 39,117 0.567 22,179

6 (4,500) 0.506 (2,277)
7 (3,375) 0.452 (1,525)
8 (2,531) 0.403 (1,020)
9 (1,898) 0.360 (683)
10 (1424 + 14239) = (15,663) 0.322 (5,043)
PVNOF 78,686
Advise: The PV of net outflow is low in case of buying the second hand vehicles. Therefore, it is advisable to
buy second hand vehicles.

Q.8 NPV Method (Buy M/c or not) PY Nov 22

A hospital is considering to purchase a diagnostic machine costing ` 80,000. The projected life of the machine is
8 years and has an expected salvage value of ` 6,000 at the end of 8 years. The annual operating cost of the
machine is ` 7,500. It is expected to generate revenues of ` 40,000 per year for eight years. Presently,
the hospital is outsourcing the diagnostic work and is earning commission income of ` 12,000 per annum.
Consider tax rate of 30% and Discounting Rate as 10%.
Advise:
Whether it would be profitable for the hospital to purchase the machine?
Give your recommendation as per Net Present Value method and Present Value Index method under below
mentioned two situations:
(i) If Commission income of ` 12,000 p.a. is before taxes.
(ii) If Commission income of ` 12,000 p.a. is net of taxes
Given:
t 1 2 3 4 5 6 7 8
PVIF (t, 10%) 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

Ans. Analysis of Investment Decisions

Determination of Cash inflows Situation-(i) Situation-(ii)
Commission Income Commission
before taxes Income after
taxes

Cash flow up-to 7 th year:

Sales Revenue 40,000 40,000
Less: Operating Cost (7,500) (7,500)
32,500 32,500
Less: Depreciation (80,000 – 6,000) ÷ 8 (9,250) (9,250)
Net Income 23,250 23,250
Tax @ 30% (6,975) (6,975)
Earnings after Tax (EAT) 16,275 16,275
Add: Depreciation 9,250 9,250
Cash inflow after tax per annum 25,525 25,525
Less: Loss of Commission Income (8,400) (12,000)
Net Cash inflow after tax per annum 17,125 13,525

In 8 th Year:

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Net Cash inflow after tax

Add: Salvage Value of Machine 6,000
17,125 6,000
13,525
Net Cash inflow in year 8 23,125 19,525
Calculation of Net Present Value (NPV) and Profitability Index (PI)
Particulars PV factor Situation-(i) Situation-(ii)
@10% [Commission Income [Commission Income
before taxes] after taxes]
A Present value of cash inflows (1 st 4.867 83,347.38 65,826.18
to 7 th year) (17,125 × 4.867) (13,525 × 4.867)
B Present value of cash inflow at 8 th 0.467 10,799.38 9,118.18
year (23,125 × 0.467) (19,525 × 0.467)
C PV of cash inflows 94,146.76 74,944.36
D Less: Cash Outflow 1.00 (80,000) (80,000)
E Net Present Value (NPV) 14,146.76 (5,055.64)
F PI = (C÷D) 1.18 0.94
Recommendation: The hospital may consider purchasing of diagnostic machine in situation (i) where
commission income is 12,000 before tax as NPV is positive and PI is also greater than 1. Contrary to situation
(i), in situation (ii) where the commission income is net of tax, the recommendation is reversed to not
purchase the machine as NPV is negative and PI is also less than 1.

Q.9 Buy New Machine RTP July 21

The General Manager of Merry Ltd. is considering the replacement of five -year-old equipment. The company
has to incur excessive maintenance cost of the equipment. The equipment has zero written down value. It can be
modernized at a cost of ` 1,40,000 enhancing its economic life to 5 years. The equipment could be sold for `
30,000 after 5 years. The modernization would help in material handling and in reducing labour , maintenance
& repairs costs.
The company has another alternative to buy a new machine at a cost of ` 3,50,000 with an economic life of 5
years and salvage value of ` 60,000. The new machine is expected to be more efficient in reducing costs of
material handling, labour , maintenance & repairs, etc.
The annual cost are as follows:
Existing Equipment (`) Modernization (`) New Machine (`)
Wages & Salaries 45,000 35,500 15,000
Supervision 20,000 10,000 7,000
Maintenance 25,000 5,000 2,500
Power 30,000 20,000 15,000
1,20,000 70,500 39,500
Assuming tax rate of 50% and required rate of return of 10%, should the company modernize the equipment
or buy a new machine? PV factor at 10% are as follows:
Year 1 2 3 4 5
PV factor 0.909 0.826 0.751 0.683 0.621

Ans. Workings:
Calculation of Depreciation:
140000 − 30000
On Modernized Equipment = = ` 22,000 p.a.
5 years

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350000 − 60000
On New machine = = ` 58,000 p.a.
5 years
(i) Calculation of Incremental annual cash inflows/ savings:
Particulars Existing Modernization New Machine
Equipment (`) Amount (`) Savings (`) Amount (`) Savings (`)
(1) (2) (3)=(1)-(2) (4) (5)=(1)-(4)
Wages & Salaries 45,000 35,500 9,500 15,000 30,000
Supervision 20,000 10,000 10,000 7,000 13,000
Maintenance 25,000 5,000 20,000 2,500 22,500
Power 30,000 20,000 10,000 15,000 15,000
Total 1,20,000 70,500 49,500 39,500 80,500
Less: Depreciation 22,000 58,000
(Refer Workings)
Total Savings 27,500 22,500
Less: Tax @ 50% 13,750 11,250
After Tax Savings 13,750 11,250
Add: Depreciation 22,000 58,000
Incremental 35,750 69,250
Annual
Cash Inflows
(ii) Calculation of Net Present Value (NPV)
Particulars Year Modernization (`) New Machine (`)
Initial Cash outflow (A) 0 1,40,000.00 3,50,000.00
Incremental Cash Inflows 1-5 1,35,492.50 2,62,457.50
(` 35,750 x 3.790) (` 69,250 x 3.790)
Salvage value 5 18,630.00 37,260.00
(` 30,000 x 0.621) (` 60,000 x 0.621)
PV of Cash inflows (B) 1,54,122.50 2,99,717.50
Net Present Value (B - A) 14,122.50 (50,282.50)
Advise: The company should modernize its existing equipment and not buy a new machine because NPV is
positive in modernization of equipment.

Q.10 Buy New Machine RTP Nov 20

A large profit making company is considering the installation of a machine to process the waste produced by one
of its existing manufacturing process to be converted into a marketable product. At present, the waste is
removed by a contractor for disposal on payment by the company of ` 150 lakh per annum for the next four years.
The contract can be terminated upon installation of the aforesaid machine on payment of a compensation of ` 90
lakh before the processing operation starts. This compensation is not allowed as deduction for tax purposes.
The machine required for carrying out the processing will cost ` 600 lakh to be financed by a loan repayable in 4
equal instalments commencing from end of the year 1. The interest rate is 14% per annum. At the end of the 4th
year, the machine can be sold for ` 60 lakh and the cost of dismantling and removal will be ` 45 lakh.
Sales and direct costs of the product emerging from waste processing for 4 years are estimated as under:

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(` In lakh)
Year 1 2 3 4
Sales 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory overheads 165 180 330 435
Depreciation (as per income tax rules) 150 114 84 63
Initial stock of materials required before commencement of the processing operations is `60 lakh at the start
of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be ` 165 lakh and the
stocks at the end of year 4 will be nil. The storage of materials will utilise space which would otherwise have been
rented out for ` 30 lakh per annum. Labour costs include wages of 40 workers, whose transfer to this process
will reduce idle time payments of ` 45 lakh in the year - 1 and ` 30 lakh in the year - 2. Factory overheads include
apportionment of general factory overheads except to the extent of insurance charges of ` 90 lakh per annum
payable on this venture. The company’s tax rate is 30%.
Present value factors for four years are as under:
Year 1 2 3 4
PV factors @14% 0.877 0.769 0.674 0.592

ADVISE the management on the desirability of installing the machine for processing the waste. All calculations
should form part of the answer.

Ans. Statement of Operating Profit from processing of waste (` in lakh)

Year 1 2 3 4
Sales :(A) 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 180 195 255 300
Other expenses 120 135 162 210
Factory overheads (insurance only) 90 90 90 90
Loss of rent on storage space (opportunity cost) 30 30 30 30
Interest @14% 84 63 42 21
Depreciation (as per income tax rules) 150 114 84 63
Total cost: (B) 744 747 918 969
Profit (C)=(A)-(B) 222 219 336 285
Tax (30%) 66.6 65.7 100.8 85.5
Profit after Tax (PAT) 155.4 153.3 235.2 199.5

Statement of Incremental Cash Flows (` in lakh)

Year 0 1 2 3 4
Material stock (60) (105) - - 165
Compensation for contract (90) - - - -
Contract payment saved - 150 150 150 150
Tax on contract payment - (45) (45) (45) (45)
Incremental profit - 222 219 336 285

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Depreciation added back - 150 114 84 63

Tax on profits - (66.6) (65.7) (100.8) (85.5)
Loan repayment - (150) (150) (150) (150)
Profit on sale of machinery (net) - - - - 15
Total incremental cash flows (150) 155.4 222.3 274.2 397.5
Present value factor 1.00 0.877 0.769 0.674 0.592
Present value of cash flows (150) 136.28 170.95 184.81 235.32
Net present value 577.36

Advice: Since the net present value of cash flows is ` 577.36 lakh which is positive the management should install
the machine for processing the waste.
Notes:
(i) Material stock increases are taken in cash flows.
(ii) Idle time wages have also been considered.
(iii) Apportioned factory overheads are not relevant only insurance charges of this project are relevant.
(iv) Interest calculated at 14% based on 4 equal instalments of loan repayment.
(v) Sale of machinery- Net income after deducting removal expenses taken. Tax on Capital gains ignored.
(vi) Saving in contract payment and income tax thereon considered in the cash flows.

Q.11 Buy or Rent PY May 18

Maruti Ltd. requires a plant costing ` 200 Lakhs for a period of 5 years. The company can use the plant for the
stipulated period through leasing arrangement or the requisite amount can be borrowed to buy the plant. In case
of leasing, the company received a proposal to pay annual lease rent of ` 48 Lakhs at the end of each year for a
period of 5 years.
In case of purchase, the company would have a 12%, 5 years loan to be paid in equated annual installment, each
installment becoming due in the beginning of each year. It is estimated that plant can be sold for ` 40 Lakhs at
the end of 5th year. The company uses straight line method of depreciation. Corporate tax rate is 30 %. Cost of
Capital after tax for the company is 10%.
The PVIF @ 10% and 12% for the five years are given below:
Year 1 2 3 4 5
PVIF @ 10 0.909 0.826 0.751 0.683 0.621
PVIF @ 12 0.893 0.797 0.712 0.636 0.567
You are required to advise whether the plant should be purchased or taken on lease.

Ans. Purchase Option

Loan installment = ` 200 lakhs / (1 + PVIFA 12%, 4)
= ` 200 lakhs / (1 + 3.038) = ` 49.53 lakhs
Interest payable = (` 49.53 X 5) – ` 200 lakhs = ` 47.65 lakhs
Working note:
Amortisation of Loan Installment
Year Loan amount Installment Interet Principal O/S Amount
(` In Lakhs) (`In Lakhs) (` In Lakhs) (` In Lakhs) (` In Lakhs)
0 200 49.53 0.00 49.53 150.47
1 150.47 49.53 18.06 31.47 119.00
2 119.00 49.53 14.28 35.25 83.75
3 83.75 49.53 10.05 39.48 44.27
4 44.27 49.53 *5.26 44.27 -

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5 0 0 0 0 0
Calculation of PV of outflow under Purchase Option
(` In Lakhs)
(1) (2) (3) (4) (5) (6) (7) (8)
End Debt Int. of Dep. Tax Shield Net Cash PV factors PV
Payment the o/s [(3) +(4)]x 0.3 out flows @ 10%
Principal (2) – (5)
0 49.53 0.00 0.00 0.00 49.53 1.000 49.53
1 49.53 18.06 32.00 15.02 34.51 0.909 31.37
2 49.53 14.28 32.00 13.88 35.65 0.826 29.44
3 49.53 10.05 32.00 12.61 36.92 0.751 27.72
4 49.53 *5.26 32.00 11.18 38.35 0.683 26.19
5 49.53 0 32.00 9.60 (9.60) 0.621 (5.96)
47.65 160.00 158.29
Less: PV of Salvage Value (`40 lakhs x 0.621) = 24.84
Total PV of Outflow 133.45
*Balancing Figure
Leasing Option
PV of Outflows under lease @ 10% = ` 48 lakhs x (1-0.30) x 3.790
= ` 127.34 lakhs
Decision: The plant should be taken on lease because the PV of outflows is less as compared to purchase option.

Q.12 Calculate IRR MTP Nov 23(2)

A company proposes to install a machine involving a Capital Cost of `72,00,000. The life of the machine is 5 years
and its salvage value at the end of the life is nil. The machine will produce the net operating income after
depreciation of `13,60,000 per annum. The Company’s tax rate is 35%.
The Net Present Value factors for 5 years are as under:
Discounting Rate : 14 15 16 17 18 19
Cumulative factor : 3.43 3.35 3.27 3.20 3.13 3.06
You are required to COMPUTE the internal rate of return (IRR) of the proposal.

Ans.
Computation of cash inflow per annum `

Net operating income per annum 13,60,000

Less: Tax @ 35% 4,76,000

Profit after tax 8,84,000
Add: Depreciation (`72,00,000 / 5 years)
14,40,000
Cash inflow
23,24,000

The IRR of the investment can be found as follows:

NPV = − ` 72,00,000 + ` 23,24,000 (PVAF5, r) = 0

7200000
or PVA F5 r ( Cumulative factor) = = 3.09
2324000

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Computation of Internal Rate of Return (IRR)

Discounting rate 15% 19%
Cumulative factor 3.35 3.06
Total NPV (`) 77,85,400 71,11,440
(`23,24,000  3.35) (`23,24,000  3.06)
Internal outlay (`) 72,00,000 72,00,000
Surplus (Deficit) (`) 5,85,400 (88,560)
NPV at LR
IRR = LR + × (HR -LR)
NPV at LR-NPV at HR
585400
= 15% + × (19% -15%)
585400 − ( −88560 )
= 15% +3.47 =18.47%
Note: Lower rate can be 18% or less than 18%. However, there will be no change in the final answer.

Q.13 Calculate NPV PY Nov 18

From the following details relating to a project, analyse the sensitivity of the project to changes in the Initial
Project Cost, Annual Cash Inflow and Cost of Capital :
Particulars
Initial Project Cost `2,00,00,000
Annual Cash Inflow `60,00,000
Project Life 5 years
Cost of Capital 10%
To which of the 3 factors, the project is most sensitive if the variable is adversely affected by 10 ?
Cumulative Present Value Factor for 5 years for 10% is 3.791 and for 11% is 3.696.

Ans. Calculation of NPV through Sensitivity Analysis

`
PV of cash inflows (` 60,00,000 × 3.791) 2,27,46,000
Initial Project Cost 2,00,00,000
NPV 27,46,000

Situation NPV Changes in NPV

Base(present) ` 27,46,000

If initial project cost is (` 2,27,46,000 – (2746000 − 746000 )

varied adversely by 10% ` 2,20,00,000*) 2746000

= ` 746000 =(72.83%)

If annual cash inflow is [` 54,00,000(revised (2746000 − 471400 )

varied adversely by 10% cash flow) ** × 3.791) – 2746000

(` 2,00,00,000)] = 82.83%
= ` 4,71,400

If cost of capital is varied (` 60,00,000 × 3.696)– (2746000 − 2176400 )

adversely by 10% i.e. it ` 2,00,00,000 2746000
becomes 11% = 20.76%
= ` 21,76,000

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*Revised initial project Cost = 2,00,00,000 × 110% = 2,20,00,000

**Revised Cash Flow = ` 60,00,000 x (100 – 10) % = ` 54,00,000
Conclusion: Project is most sensitive to ‘annual cash inflow’

Q.14 Calculate NPV PY May 18

A company is evaluating a project that requires initial investment of ` 60 lakhs in fixed assets and ` 12 lakhs
towards additional working capital.
The project is expected to increase annual real cash inflow before taxes by ` 24,00,000 during its life. The fixed
assets would have zero residual value at the end of life of 5 years. The company follows straight line method of
depreciation which is expected for tax purposes also. Inflation is expected to be 6% per year. For evaluating
similar projects, the company uses discounting rate of 12% in real terms. Company's tax rate is 30%.
Advise whether the company should accept the project, by calculating NPV in real terms.
PVIF (12%, 5 years) PVIF (12%, 5 years)
Year 1 0.893 Year 1 0.943
Year 2 0.797 Year 2 0.890
Year 3 0.712 Year 3 0.840
Year 4 0.636 Year 4 0.792
Year 5 0.567 Year 5 0.747

Ans. (i) Equipment’s initial cost = ` 60,00,000 + ` 12,00,000

= ` 72,00,000
(ii) Annual straight line depreciation = ` 60,00,000/5
= ` 12,00,000.
(iii) Net Annual cash flows can be calculated as follows:
= Before Tax CFs × (1 – Tc) + Tc × Depreciation (Tc = Corporate tax i.e. 30%)
= ` 24,00,000 × (1 – 0.3) + (0.3 x ` 12,00,000)
= ` 16,80,000 + ` 3,60,000 = ` 20,40,000
So, Total Present Value = PV of inflow + PV of working capital released
= (` 20,40,000 × PVIF 12%, 5 years) + (` 12,00,000 × 0.567)
= (` 20,40,000 × 3.605) + ` 6,80,400
= ` 73,54,200 + ` 6,80,400
= ` 80,34,600
So NPV = PV of Inflows – Initial Cost
= ` 80,34,600 – ` 72,00,000
= ` 8,34,600
Advice: Company should accept the project as the NPV is Positive

Q.15 Equivalent Method MTP Nov 23(1)

A new project “Ambar” requires an initial outlay of ` 4,50,000. The company uses certainty equivalent method
approach to evaluate the project. The risk-free rate is 7%. Following information is available:
Year Cash Flow After Tax (`) Certainty Equivalent Coefficient
1 1,50,000 0.90
2 2,25,000 0.80
3 1,75,000 0.58
4 1,50,000 0.56
5 70,000 0.50
PV Factor at 7%

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Year 1 2 3 4 5
PV Factor 0.935 0.873 0.816 0.763 0.713
Is investment in the project beneficial based on above information?

Ans. Calculation of Net Present Value of the Project

Year Cash Inflows After C.E. Adjusted Cash Present Value Present Value
Tax (in`) Inflows (in `) Factor (in `)
1 1,50,000 0.90 1,35,000 0.935 1,26,225
2 2,25,000 0.80 1,80,000 0.873 1,57,140
3 1,75,000 0.58 1,01,500 0.816 82,824
4 1,50,000 0.56 84,000 0.763 64,092
5 70,000 0.50 35,000 0.713 24,955
Total Present Value of Cash Inflows 4,55,236
Less: Initial Investment or Cash Outflow required for “Ambar” (4,50,000)
Net Present Value 5,236

Conclusion: As the Net Present Value of the project after considering the Certainty Equivalent factors is still
positive, it may be advised to invest in project “Ambar”.

Q.16 NPV Method (Invest Appraisal) RTP Nov 23

PQR Limited is considering buying a new machine which would have a useful economic life of five years, at a cost
of ` 40,00,000 and a scrap value of ` 5,00,000, with 80 per cent of the cost being payable at the start of the
project and 20 per cent at the end of the first year. The machine would produce 80,000 units per annum of a
new product with an estimated selling price of ` 400 per unit. Direct costs would be ` 375 per unit and annual
fixed costs, including depreciation calculated on a straight- line basis, would be ` 10,40,000 per annum.
In the first year and the second year, special sales promotion expenditure, not included in the above costs, would
be incurred, amounting to ` 1,25,000 and ` 1,75,000 respectively.
EVALUATE the project using the NPV method of investment appraisal, assuming the company’s cost of capital to
be 12 percent.

Ans. Calculation of Net Cash flows

Contribution = (400 – 375)  80,000 = ` 20,00,000
Fixed costs = 10,40,000 – [(40,00,000 – 5,00,000)/5] = ` 3,40,000
Year Capital (`) Contribution (`) Fixed costs (`) Promotion (`) Net cash flow (`)
0 (32,00,000) (32,00,000)
1 (8,00,000) 20,00,000 (3,40,000) (1,25,000) 7,35,000
2 20,00,000 (3,40,000) (1,75,000) 14,85,000
3 20,00,000 (3,40,000) 16,60,000
4 20,00,000 (3,40,000) 16,60,000
5 5,00,000 20,00,000 (3,40,000) 21,60,000
Calculation of Net Present Value
Year Net cash flow 12% discount factor Present value (`)
(`)
0 (32,00,000) 1.000 (32,00,000)
1 7,35,000 0.893 6,56,355

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2 14,85,000 0.797 11,83,545

3 16,60,000 0.712 11,81,920
4 16,60,000 0.636 10,55,760
5 21,60,000 0.567 12,24,720
21,02,30
The net present value of the project is `21,02,300. 0

Q.17 NPV Method (Invest Appraisal) RTP May 20

A company is considering the proposal of taking up a new project which requires an investment of `800 lakhs on
machinery and other assets. The project is expected to yield the following earnings (before depreciation and
taxes) over the next five years:
Year Earnings (` in lakhs)
1 320
2 320
3 360
4 360
5 300

The cost of raising the additional capital is 12% and assets have to be depreciated at 20% on written down value
basis. The scrap value at the end of the five year period may be taken as zero. Income-tax applicable to the
company is 40%.
You are required to CALCULATE the net present value of the project and advise the management to take
appropriate decision. Also CALCULATE the Internal Rate of Return of the Project.
Note: Present values of Re. 1 at different rates of interest are as follows
Year 10% 12% 14% 16% 20%
1 0.91 0.89 0.88 0.86 0.83
2 0.83 0.80 0.77 0.74 0.69
3 0.75 0.71 0.67 0.64 0.58
4 0.68 0.64 0.59 0.55 0.48
5 0.62 0.57 0.52 0.48 0.40

Ans. (i) Calculation of Net Cash Flow

(` in lakhs)
Year Profit before Depreciation (20% on WDV) PBT PAT Net cash flow
dep. and tax
(1) (2) (3) (4) (5) (3) + (5)
1 320 800  20% = 160 160 96 256
2 320 (800 − 160) 20% = 128 192 115.20 243.20
3 360 (640 − 128) 20% = 102.4 257.6 154.56 256.96
4 360 (512 − 102.4) 20% = 81.92 278.08 166.85 248.77
5 300 (409.6 − 81.92) = 327.68* −27.68 −16.61 311.07

*this is treated as a short term capital loss.

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(ii) Calculation of Net Present Value (NPV) (` in lakhs)

Year Net Cash 12% 16% 20%
Flow D.F P.V D.F P.V D.F P.V
1 256 0.89 227.84 0.86 220.16 0.83 212.48
2 243.20 0.80 194.56 0.74 179.97 0.69 167.81
3 256.96 0.71 182.44 0.64 164.45 0.58 149.03
4 248.77 0.64 159.21 0.55 136.82 0.48 119.41
5 311.07 0.57 177.31 0.48 149.31 0.40 124.43
941.36 850.71 773.16
Less: Initial Investment 800.00 800.00 800.00
NPV 141.36 50.71 -26.84
(iii) Advise: Since Net Present Value of the project at 12% = 141.36 lakhs, therefore the project should be
implemented.
(iv) Calculation of Internal Rate of Return (IRR)
50.71x4
IRR =16% +
50.71 − ( −26.84 )
2.03
= 16% + = 16% + 2.62% = 18.62%.
77.55

Q.18 NPV Method (Invest Appraisal) RTP Nov 19

MTR Limited is considering buying a new machine which would have a useful economic life of five years, at a cost
of `25,00,000 and a scrap value of `3,00,000, with 80 per cent of the cost being payable at the start of the
project and 20 per cent at the end of the first year. The machine would produce 75,000 units per annum of a
new product with an estimated sellingpriceof `300 per unit. Direct costs would be `285 per unit and annual fixed
costs, including depreciation calculated on a straight- line basis, would be `8,40,000 per annum.
In the first year and the second year, special sales promotion expenditure, not included in the above costs,
would be incurred, amounting to `1,00,000 and `1,50,000 respectively.
EVALUATE the project using the NPV method of investment appraisal, assuming the company’s cost of capital
to be 15 percent.

Ans. Calculation of Net Cash flows

Contribution = (300 – 285)  75,000 = `11,25,000
Fixed costs = 8,40,000 – [(25,00,000 – 3,00,000)/5] = `4,00,000
Year Capital (` ) Contribution (` ) Fixed costs (` ) Adverts (` ) Net cash flow (` )

0 (20,00,000) (20,00,000)

1 (5,00,000) 11,25,000 (4,00,000) (1,00,000) 1,25,000

2 11,25,000 (4,00,000) (1,50,000) 5,75,000

3 11,25,000 (4,00,000) 7,25,000

4 11,25,000 (4,00,000) 7,25,000
5 3,00,000 11,25,000 (4,00,000) 10,25,000
Calculationof Net Present Value
Year Net cash flow (` ) 12% discount factor Present value
0 (20,00,000) 1.000 (20,00,000)
(` )
1 1,25,000 0.892 1,11,500

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2 5,75,000 0.797 4,58,275

3 7,25,000 0.711 5,15,475
4 7,25,000 0.635 4,60,375
5 10,25,000 0.567 5,81,175
1,26,800
The net present value of the project is `1,26,800.

Q.19 NPV Method (Buy M/c or not) RTP May 19

BT Pathology Lab Ltd. is using an X-ray machines which reached at the end of their useful lives. Following new X-
ray machines are of two different brands with same features are available for the purchase.
Cost of Life of Maintenance Cost Rate of
Brand Machine Machine Year 1-5 Year 6-10 Year 11-15 Depreciation
XYZ `6,00,000 15 years ` 20,000 ` 28,000 ` 39,000 4%
ABC `4,50,000 10 years ` 31,000 ` 53,000 -- 6%
Residual Value of both of above machines shall be dropped by 1/3 of Purchase price in the first year and
thereafter shall be depreciated at the rate mentioned 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 first year it shall be ` 1,02,000.
• Annual Rent for the subsequent 4 years shall be ` 1,02,500.
• Annual Rent for the final 5 years shall be ` 1,09,950.
• The Rent Agreement can be terminated by BT Labs by making a payment of ` 1,00,000 as penalty. This
penalty would be reduced by ` 10,000 each year of the period of rental agreement.
You are required to:
(a) ADVISE which brand of X-ray machine should be acquired assuming that the use of machine shall be
continued for a period of 20 years.
(b) STATE which of the option is most economical if machine is likely to be used for a period of 5 years?
The cost of capital of BT Labs is 12%.

Ans. Since the life span of each machine is different and time span exceeds the useful lives of each model, we shall
use Equivalent Annual Cost method to decide which brand should be chosen.
(i) If machine is used for 20 years
Present Value (PV) of cost if machine of Brand XYZ is purchased
Period Cash Outflow (` ) PVF@12% Present Value
0 6,00,000 1.000 6,00,000
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)
7,62,927
PVAF for 1-15 years 6.811
762927
Equivalent Annual Cost = ` 1,12,014
6811
Present Value (PV) of cost if machine of Brand ABC is purchased
Period Cash Outflow (` ) PVF@12% Present Value
0 4,50,000 1.000 4,50,000

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1-5 31,000 3.605 1,11,755

6 -10 53,000 2.045 1,08,385

10 (57,000) 0.322 (18,354)

6,51,786
PVAF for 1-10 years 5.65
651786
Equivalent Annual Cost = = ` 1,15,360
5.65
Present Value (PV) of cost if machine of Brand ABC is taken on Rent
Period Cash Outflow (` ) PVF@12% Present Value
0 1,02,000 1.000 1,02,000
1-4 1,02,500 3.037 3,11,293

5-9 1,09,950 2.291 2,51,895

6,65,188
PVAF for 1-10 years = 5.65
665188
Equivalent Annual Cost = = ` 1,17,732
5.65
Decision: Since Equivalent Annual Cash Outflow is least in case of purchase of Machine of brand XYZ
the same should be purchased.
(ii) If machine is used for 5 years
(a) Scrap Value of Machine of Brand XYZ
= ` 6,00,000 – ` 2,00,000 – ` 6,00,000 × 0.04 × 4 = ` 3,04,000
(b) Scrap Value of Machine of Brand ABC
= ` 4,50,000 – ` 1,50,000 – ` 4,50,000 × 0.06 × 4 = ` 1,92,000
Present Value (PV) of cost if machine of Brand XYZ is purchased
Period Cash Outflow (` ) PVF@12% Present Value
0 6,00,000 1.000 6,00,000
1-5 20,000 3.605 72,100
5 (3,04,000) 0.567 (1,72,368)
4,99,732
Present Value (PV) of cost if machine of Brand ABC is purchased
Period Cash Outflow (` ) PVF@12% Present Value
0 4,50,000 1.000 4,50,000
1-5 31,000 3.605 1,11,755
5 (1,92,000) 0.567 (1,08,864)
4,52,891
Present Value (PV) of cost if machine of Brand ABC is taken on Rent
Period Cash Outflow (` ) PVF@12% Present Value
0 1,02,000 1.000 1,02,000
1-4 1,02,500 3.037 3,11,293

5 50,000 0.567 28,350

4,41,643
Decision: Since Cash Outflow is least in case of lease of Machine of brand ABC the same should be taken on rent.

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Q.20 Disposing Garbage Car MTP May 22(1)

A manufacturing company is presently paying a garbage disposer company ` 0.50 per kilogram to dispose-off the
waste resulting from its manufacturing operations. At normal operating capacity, the waste is about 2,00,000
kilograms per year.
After spending ` 1,20,000 on research, the company discovered that the waste could be sold for ` 5 per kilogram
if it was processed further. Additional processing would, however, require an investment of ` 12,00,000 in new
equipment, which would have an estimated life of 10 years with no salvage value. Depreciation would be calculated
by straight line method.
No change in the present selling and administrative expenses is expected e xcept for the costs incurred in
advertising ` 40,000 per year, if the new product is sold. Additional processing costs would include variable cost
of ` 2.50 per kilogram of waste put into process along with fixed cost of ` 60,000 per year (excluding
Depreciation).
There will be no losses in processing, and it is assumed that the total waste processed in a given year will be sold
in the same year. Estimates indicate that 2,00,000 kilograms of the product could be sold each year.
The management when confronted with the choice of disposing off the waste or processing it further and selling
it, seeks your ADVICE. Which alternative would you RECOMMEND? Assume that the firm's cost of capital is 15%
and it pays on an average 50% Tax on its income.
Consider Present value of Annuity of ` 1 per year @ 15% p.a. for 10 years as 5.019.

Ans. Evaluation of Alternatives:

Savings in disposing off the waste
Particulars (`)

Outflow (2,00,000 × ` 0.50) 1,00,000

Less: tax savings @ 50% 50,000

Net Outflow per year 50,000

Calculation of Annual Cash inflows in Processing of waste Material
Particulars Amount (`) Amount (`)

Sale value of waste (` 5 × 2,00,000 kilograms) 10,00,000

Less: Variable processing cost (` 2.50 × 2,00,000 kilograms) 5,00,000
Less: Fixed processing cost 60,000
Less: Advertisement cost 40,000
Less: Depreciation 1,20,000 (7,20,000)

Earnings before tax (EBT) 2,80,000

Less: Tax @ 50% (1,40,000)

Earnings after tax (EAT) 1,40,000

Add: Depreciation 1,20,000

Annual Cash inflows 2,60,000

Total Annual Benefits = Annual Cash inflows + Net savings (adjusting tax) in disposal cost
= ` 2,60,000 + ` 50,000 = ` 3,10,000
Calculation of Net Present Value
Year Particulars Amount (`)

0 Investment in new equipment (12,00,000)

1 to 10 Total Annual benefits × PVAF (10 years, 15%) 15,55,890

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Net Present Value 3,55,890

Recommendation: Processing of waste is a better option as it gives a positive Net Present Value.
Note- Research cost of ` 1,20,000 is not relevant for decision making as it is sunk cost.

Q.21 Calculate IRR MTP May 20

A company proposes to install a machine involving a Capital Cost of Rs.72,00,000. The life of the machine is 5
years and its salvage value at the end of the life is nil. The machine will produce the net operating income after
depreciation of Rs.13,60,000 per annum. The Company’s tax rate is 35%.
The Net Present Value factors for 5 years are as under:
Discounting Rate : 14 15 16 17 18 19

Cumulative factor : 3.43 3.35 3.27 3.20 3.13 3.06

You are required to COMPUTE the internal rate of return (IRR) of the proposal.

Ans.
Computation of cash inflow per annum Rs.
Net operating income per annum 13,60,000
Less: Tax @ 35% 4,76,000
Profit after tax 8,84,000

Add: Depreciation (Rs.72,00,000 / 5 years) 14,40,000

Cash inflow 23,24,000

The IRR of the investment can be found as follows:
NPV = − Rs. 72,00,000 + Rs. 23,24,000 (PVAF5, r) = 0
7200000
or PVA F5 r ( Cumulative factor) = = 3.09
2324000
Computation of Internal Rate of Return (IRR)
Discounting rate 15% 19%
Cumulative factor 3.35 3.06
Total NPV (Rs.) 77,85,400 71,11,440

(Rs.23,24,000  3.35) ( Rs.23,24,000  3.06)

Internal outlay (Rs.) 72,00,000 72,00,000
Surplus (Deficit) (Rs.) 5,85,400 (88,560)
NPV at LR
IRR = LR + ×(HR -LR)
NPV at LR - NPV at HR
585400
= 15% + ×(19% -15%)
585400 − ( −88560 )
= 15% +3.47 =18.47%

Q.22 Calculate NPV & IRR MTP May 18

You are a financial analyst of B Limited. The director of finance has asked you to analyse two capital investments
proposals, Projects X and Y. Each project has a cost of `10,000 and the cost of capital for each project is 12 per
cent. The project’s expected net cash flows are as follows:
Year Expected net cash flows
Project X (`) Project Y (`)

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0 (10,000) (10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500

(i) CALCULATE each project’s payback period, net present value (NPV) and internal rate of return (IRR).
(ii) DETERMINE, which project or projects should be accepted if they are independent?

Ans. (i) Payback Period Method

The cumulative cash flows for each project are as follows
Cumulative Cash Flows
Year Project X (`) Project Y (`)
0 (10,000) (10,000)
1 (3,500) (6,500)
2 (500) (3,000)
3 2,500 500
4 3,500 4,000
500
PaybackX = 2 + = 2.17 years.
3000
3000
PaybackY = 2 + = 2.86 years.
3500
Net Present Value (NPV)
6500 3000 3000 1000
NPVX = −` 10,000 + − − − = ` 966.01
(1.12) (1.12) (1.12) (1.12)
1 2 3 4

3500 3500 3500 3500

NPVY = −` 10,000 + − − − =  
(1.12) (1.12) (1.12) (1.12)
1 2 3 4

Internal Rate of Return (IRR)

To solve for each project’s IRR, find the discount rates that equate each NPV to zero: IRRx = 18.0%.
IRRy = 15.0%.
(ii) The following table summarizes the project rankings by each method:
Project that ranks higher
Payback X
NPV X
IRR X
Analysis: All methods rank Project X over Project Y. In addition, both projects are acceptable under the
NPV and IRR criteria. Thus, both projects should be accepted if they are independent

Q.23 MPV & PI Method PY May 22

Alpha Limited is a manufacturer of computers. It wants to introduce artificial intelligence while making computers.
The estimated annual saving from introduction of the artificial intelligence (AI) is as follows:
• reduction of five employees with annual salaries of ` 3,00,000 each
• reduction of ` 3,00,000 in production delays caused by inventory problem
• reduction in lost sales ` 2,50,000 and

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• Gain due to timely billing ` 2,00,000

The purchase price of the system for installation of artificial intelligence is ` 20,00,000 and installation
cost is ` 1,00,000. 80% of the purchase price will be paid in the year of purchase and remaining will be
paid in next year.
The estimated life of the system is 5 years and it will be depreciated on a straight -line basis. However,
the operation of the new system requires two computer specialists with annual salaries of ` 5,00,000
per person.
In addition to above, annual maintenance and operating cost for five years are as below:
(Amount in `)
Year 1 2 3 4 5
Maintenance & Operating Cost 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
Maintenance and operating cost are payable in advance.
The company's tax rate is 30% and its required rate of return is 15%.
Year 1 2 3 4 5
PVIF 0.10, t 0.909 0.826 0.751 0.683 0.621
PVIF 0.12, t 0.893 0.797 0.712 0.636 0.567

PVIF 0.15, t 0.870 0.756 0.658 0.572 0.497

Evaluate the project by using Net Present Value and Profitability Index

Ans.
Computation of Annual Cash Flow after Tax
Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Savings in Salaries 15,00,000 15,00,000 15,00,000 15,00,000 15,00,000
Reduction in 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Production Delays
Reduction in Lost 2,50,000 2,50,000 2,50,000 2,50,000 2,50,000
Sales
Gain due to Timely 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Billing
Salaryto Computer (10,00,000) (10,00,000) (10,00,000) (10,00,000) (10,00,000)
Specialist
Maintenance and (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000)
Operating Cost
(payableinadvance)
Depreciation (21 (4,20,000) (4,20,000) (4,20,000) (4,20,000) (4,20,000)
lakhs/5)
Gain Before Tax 6,30,000 6,50,000 6,70,000 6,90,000 7,10,000
Less: Tax (30%) 1,89,000 1,95,000 2,01,000 2,07,000 2,13,000
Gain After Tax 4,41,000 4,55,000 4,69,000 4,83,000 4,97,000
Add: Depreciation 4,20,000 4,20,000 4,20,000 4,20,000 4,20,000
Add: Maintenance 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
and Operating Cost
(payable in advance)

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Less: Maintenance (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000) -

and Operating Cost
(payable in advance)
Net CFAT (2,00,000) 8,81,000 8,95,000 9,09,000 9,23,000 10,37,000
Note: Annual cash flows can also be calculated Considering tax shield on depreciation & maintenance and
operating cost. There will be no change in the final cash flows after tax.
Computation of NPV
Particulars Year Cash Flows (`) PVF PV (`)
Initial Investment (80% of 20 Lacs) 0 16,00,000 1 16,00,000
Installation Expenses 0 1,00,000 1 1,00,000
Instalment of Purchase Price 1 4,00,000 0.870 3,48,000
PV of Outflows (A) 20,48,000
CFAT 0 (2,00,000) 1 (2,00,000)
CFAT 1 8,81,000 0.870 7,66,470
CFAT 2 8,95,000 0.756 6,76,620
CFAT 3 9,09,000 0.658 5,98,122
CFAT 4 9,23,000 0.572 5,27,956
CFAT 5 10,37,000 0.497 5,15,389
PV of Inflows (B) 28,84,557
NPV (B-A) 8,36,557
Profitability Index (B/A) 1.408 or 1.41
Evaluation: Since the NPV is positive (i.e. ` 8,36,557) and Profitability Index is also greater than 1 (i.e. 1.41),
Alpha Ltd. may introduce artificial intelligence (AI) while making computers.

Q.24 Calculate NPV, PI & Disc Payback PY Jan 21

A company wants to buy a machine, and two different models namely A and B are available.
Following further particulars are available:
Particulars Machine-A Machine-B
Original Cost (`) 8,00,000 6,00,000
Estimated Life in years 4 4
Salvage Value (`) 0 0
The company provides depreciation under Straight Line Method. Income tax rate applicable is 30%.
The present value of ` 1 at 12% discounting factor and net profit before depreciation and tax are as under:
Year Net Profit Before Depreciation and tax PV Factor
Machine-A Machine-B
` `
1. 2,30,000 1,75,000 0.893
2. 2,40,000 2,60,000 0.797
3. 2,20,000 3,20,000 0.712
4. 5,60,000 1,50,000 0.636

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Calculate:
1. NPV (Net Present Value)
2. Discounted pay-back period
3. PI (Profitability Index)
Suggest: Purchase of which machine is more beneficial under Discounted pay-back period method, NPV
method and PI method.

Ans. Workings:
(i) Calculation of Annual Depreciation
800000
Depreciation on Machine – A = = ` 2,00,000
4
600000
Depreciation on Machine – B = = ` 1,50,000
4
(ii) Calculation of Annual Cash Inflows
Particulars Machine-A (`)
1 2 3 4
Net Profit before Depreciation and Tax 2,30,000 2,40,000 2,20,000 5,60,000
Less: Depreciation 2,00,000 2,00,000 2,00,000 2,00,000
Profit before Tax 30,000 40,000 20,000 3,60,000
Less: Tax @ 30% 9,000 12,000 6,000 1,08,000
Profit after Tax 21,000 28,000 14,000 2,52,000
Add: Depreciation 2,00,000 2,00,000 2,00,000 2,00,000
Annual Cash Inflows 2,21,000 2,28,000 2,14,000 4,52,000

Particulars Machine-B (`)

1 2 3 4
Net Profit before Depreciation and Tax 1,75,000 2,60,000 3,20,000 1,50,000
Less: Depreciation 1,50,000 1,50,000 1,50,000 1,50,000
Profit before Tax 25,000 1,10,000 1,70,000 0
Less: Tax @ 30% 7,500 33,000 51,000 0
Profit after Tax 17,500 77,000 1,19,000 0
Add: Depreciation 1,50,000 1,50,000 1,50,000 1,50,000
Annual Cash Inflows 1,67,500 2,27,000 2,69,000 1,50,000
(iii) Calculation of PV of Cash Flows
Machine – A Machine - B
Year PV of Re 1 Cash flow PV (`) Cumulative PV Cash flow (`) PV (`) Cumulative
@ 12% (`) (`) PV (`)
1 0.893 2,21,000 1,97,353 1,97,353 1,67,500 1,49,578 1,49,578
2 0.797 2,28,000 1,81,716 3,79,069 2,27,000 1,80,919 3,30,497
3 0.712 2,14,000 1,52,368 5,31,437 2,69,000 1,91,528 5,22,025
4 0.636 4,52,000 2,87,472 8,18,909 1,50,000 95,400 6,17,425

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1. NPV (Net Present Value)

Machine – A
NPV = ` 8,18,909 - ` 8,00,000 = ` 18,909
Machine – B
NPV = ` 6,17,425 – ` 6,00,000 = ` 17,425
2. Discounted Payback Period
Machine – A
800000 − 531437
Discounted Payback Period =3+
287472
= 3 + 0.934
= 3.934 years or 3 years 11.21 months
Machine – B
600000 − 522025
Discounted Payback Period =3+
95400
= 3 + 0.817
= 3.817 years or 3 years 9.80 months
3. PI (Profitability Index)
Machine – A
818909
Profitability Index = = 1.024
800000
Machine – B
617425
Profitability Index = = 1.029
600000
Suggestion:
Method Machine - A Machine - B Suggested Machine
Net Present Value ` 18,909 ` 17,425 Machine A
Discounted Payback Period 3.934 years 3.817 years Machine B
Profitability Index 1.024 1.029 Machine B

Q.25 NPV & PI Method RTP Nov 22

K. K. M. M Hospital is considering purchasing an MRI machine. Presently , the hospital is outsourcing the work
received relating to MRI machine and is earning commission of ` 6,60,000 per annum (net of tax). The following
details are given regarding the machine:
(`)
Cost of MRI machine 90,00,000
Operating cost per annum (excluding Depreciation) 14,00,000
Expected revenue per annum 45,00,000
Salvage value of the machine (after 5 years) 10,00,000
Expected life of the machine 5 years
Assuming tax rate @ 40%, whether it would be profitable for the hospital to purchase the machine?
Give your RECOMMENDATION under:
(i) Net Present Value Method, and
(ii) Profitability Index Method.
PV factors at 10% are given below
Year 1 2 3 4 5
PV factor 0.909 0.826 0.751 0.683 0.620

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Ans. Determination of Cash inflows

Elements (`)
Sales Revenue 45,00,000
Less: Operating Cost 14,00,000
31,00,000
Less: Depreciation (90,00,000 – 10,00,000)/5 16,00,000
Net Income 15,00,000
Tax @ 40% 6,00,000
Earnings after Tax (EAT) 9,00,000
Add: Depreciation 16,00,000
Cash inflow after tax per annum 25,00,000
Less: Loss of Commission Income 6,60,000
Net Cash inflow after tax per annum 18,40,000

New Cash inflow after tax 18,40,000

Add: Salvage Value of Machine 10,00,000
Net Cash inflow in year 5 28,40,000
Calculation of Net Present Value (NPV)
Year CFAT PV Factor @10% Present Value of Cashin flows
1 to 4 18,40,000 3.169 58,30,960
5 28,40,000 0.620 17,60,800
75,91,760
Less: Cash Outflows 90,00,000
NPV (14,08,240)
Sum of discounted cash inflows 7591760
Profitability Index = = = 0.844
Present value of cash out flows 9000000
Advise: Since the net present value is negative and profitability index is also less than 1, therefore, the hospital
should not purchase the MRI machine.

Q.26 Calculate NPV, PI & Disc Payback RTP May 18

A company has to make a choice between two projects namely A and B. The initial capital outlay of two Projects
are ` 1,35,000 and ` 2,40,000 respectively for A and B. There will be no scrap value at the end of the life of both
the projects. The opportunity Cost of Capital of the company is 16%. The annual incomes are as under:

Year Project A (`) Project B (`) Discounting factor @ 16%

1 -- 60,000 0.862
2 30,000 84,000 0.743
3 1,32,000 96,000 0.641
4 84,000 1,02,000 0.552
5 84,000 90,000 0.476

Required:

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CALCULATE for each project:

(i) Discounted payback period
(ii) Profitability index
(iii) Net present value
DECIDE which of these projects should be accepted?

Ans. Working notes

1 Computation of Net Present Values of Projects
Year Cash flows Disct. Discounted Cash flow
Project A (` ) Project B (` ) factor @ Project A (`) Project B (` )
16 %
(1) (2) (3) (3)  (1) (3)  (2)
0 (1,35,000) (2,40,000) 1.000 (1,35,000) (2,40,000)
1 -- 60,000 0.862 -- 51,720
2 30,000 84,000 0.743 22,290 62,412
3 1,32,000 96,000 0.641 84,612 61,536
4 84,000 1,02,000 0.552 46,368 56,304
5 84,000 90,000 0.476 39,984 42,840
Net present value 58,254 34,812

2 Computation of Cumulative Present Values of Projects Cash inflows

Year Project A Project B
PV of cash inflows (`) Cumulative PV (`) PV of cash inflows (`) Cumulative PV (`)
1 -- -- 51,720 51,720
2 22,290 22,290 62,412 1,14,132
3 84,612 1,06,902 61,536 1,75,668
4 46,368 1,53,270 56,304 2,31,972
5 39,984 1,93,254 42,840 2,74,812

(i) Discounted payback period: (Refer to Working note 2)

Cost of Project A = ` 1,35,000
Cost of Project B = ` 2,40,000
Cumulative PV of cash inflows of Project A after 4 years = ` 1,53,270
Cumulative PV of cash inflows of Project B after 5 years = ` 2,74,812
A comparison of projects cost with their cumulative PV clearly shows that the project A’s cost will
be recovered in less than 4 years and that of project B in less than 5 years. The exact duration of
discounted payback period can be computed as follows:
Project A Project B

Excess PV of cash 18,270 34,812

Inflows over the (` 1,53,270 − ` 1,35,000) (` 2,74,812 − ` 2,40,000)
project cost (`)
Computation of 0.39 year 0.81 years
period required to (` 18,270 ÷` 46,368) (` 34,812 ÷ ` 42,840)
recover excess

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amount of cumulative
PV over project cost
(Refer to Working note 2)

Discounted payback 3.61 year 4.19 years

period (4 − 0.39) years (5 − 0.81) years

Sum of discounted cash inflows

(ii) Profitability Index(PI): =
lnitian cash outlay
193245
Profitability Index (for Project A) =
135000
274812
Profitability Index (for Project B) =
240000
(iii) Net present value(NPV) (for Project A) = ` 58,254
Net present value(NPV) (for Project B) = ` 34,812
(Refer to Working note 1)
Conclusion: As the NPV, PI of Project A is higher and Discounted Pay back is lower, therefore
Project a should be accepted.

Q.27 NPV, PI & Payback Method MTP Dec 21(1)

Sadbhavna Limited is a manufacturer of computers. It wants to introduce artificial intelligence while making
computers. It estimates that the annual savings from the artificial intelligence (AI) include a reduction of five
employees with annual salaries of ` 3,00,000 each, ` 3,00,000 from reduction in production delays caused by
inventory problem, reduction in lost sales ` 2,50,000 and ` 2,00,000 from billing issues.
The purchase price of the system for installation of artificial intelligence is ` 20,00,000 with installation cost of
` 1,00,000. The life of the system is 5 years and it will be depreciated on a straight -line basis. The salvage value
is zero which will be its market value after the end of its life of five years.
However, the operation of the new system for AI requires two computer specialists with annual salaries of `
5,00,000 per person. Also, the estimated maintenance and operating expenses of 1,50,000 is required.
The company’s tax rate is 30% and its required rate of return is 12%.
From the above information:
(i) CALCULATE the initial cash outflow and annual operating cash flow over its life of 5 years.
(ii) Further, EVALUATE the project by using Payback Period, Net Present Value and Profitability Index.
(iii) You are also REQUIRED to obtain the cash flows and NPV on the assumption that book salvage value for
depreciation purposes is ` 2,00,000 even though the machine is having no real worth in terms of its resale
value. Also, the book salvage value of ` 2,00,000 is allowed for tax purposes.
Also COMMENT on the acceptability of the project in (ii) and (iii) above.

Ans. (i) Project’s Initial Cash Outlay

Cost 20,00,000
Installation Expenses 1,00,000
Total Cash Outflow 21,00,000
Depreciation per year = 21,00,000/5 = 4,20,000
Project’s Operating Cash Flows over its 5-year life
Savings (A)
Reduction in salaries (` 3,00,000 x 5) 15,00,000
Reduction in production delays 3,00,000
Reduction in lost sales 2,50,000
Gains due to timely billing 2,00,000
22,50,000

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Costs (B)
- Depreciation 4,20,000
- Additional Specialist Cost (` 5,00,000 x 2) 10,00,000
- Maintenance Cost 1,50,000
15,70,000
Increase in Profit before tax (A – B) 6,80,000
Less: Tax @ 30% 2,04,000
Profit after tax 4,76,000
Cash Inflows = Profit after tax + Depreciation
= 4,76,000 + 4,20,000 = 8,96,000
(ii) Evaluation of the project by using NPV Method
Year Cash Inflows PVAF (12%,5y) Total PV
1-5 8,96,000 3.605 32,30,080
Less: Total Initial Cash Outflow 21,00,000
Net Present Value 11,30,080
Since NPV is positive, therefore, the project is acceptable.
Evaluation of the project by using Profitability Index Method
Profitability Index = Present Value of Cash Inflows/Present Value of Cash Outflows
= 32,30,080/21,00,000
= 1.538
Since, the profitability index is more than 1, the project is acceptable.
Calculation of the Project’s Payback*
Year Net Cash Flow Cumulative Cash Flow
1 8,96,000 8,96,000
2 8,96,000 17,92,000
3 8,96,000 26,88,000
4 8,96,000 35,84,000
5 8,96,000 44,80,000
Here, the payback period is 2 years plus a fraction of the 3rd year
So, payback period = 2 years + 3,08,000/8,96,000
= 2.34 years
* Payback period may also be solved directly as follows: 21,00,000/8,96,000 = 2.34 years
(iii) Project’s cash flows and NPV assuming that the book salvage for depreciation purpose is `2,00,000
Depreciation = (` 21,00,000 – 2,00,000)/5 = 3,80,000
Cash Inflows for the years 1 to 5 are:
Savings (calculated as earlier) 22,50,000
Less: Costs
- Depreciation 3,80,000
- Additional Specialists cost 10,00,000
- Maintenance cost 1,50,000 15,30,000
Profit before tax 7,20,000
Less: Tax @ 30% 2,16,000
Profit after tax 5,04,000
Cash Inflow (5,04,000 + 3,80,000) 8,84,000

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Calculation of NPV
It may be noted that at the end of year 5, the book value of the project would be ` 2,00,000 but its
realizable value is nil. So, the capital loss of ` 2,00,000 will result in tax savings of ` 60,000 (i.e., ` 2,00,000
x 30%), as the capital loss is available for tax purposes in view of the information given. Therefore, at the
end of year 5, there would be an additional inflow of ` 60,000. The NPV may now be calculated as follows:
Year Cash Flow (`) PVAF (12%, n) PV
1-5 8,84,000 3.605 31,86,820
5 60,000 0.567 34,020
PV of inflows 32,20,840
Outflows 21,00,000
NPV 11,20,840
As the NPV of the project is positive, the project is acceptable.

Q.28 NPV, PI & Payback Method MTP May 19(1)

X Ltd. is considering to select a machine out of two mutually exclusive machines. The company’s cost of capital is
15 per cent and corporate tax rate is 30 per cent. Other information relating to both machines is as follows:
Machine – I Machine – II
Cost of Machine Rs. 30,00,000 Rs. 40,00,000
Expected Life 10 years. 10 years.
Annual Income
(Before Tax and Depreciation) Rs. 12,50,000 Rs. 17,50,000
Depreciation is to be charged on straight line basis: You are required to CALCULATE:
(i) Discounted Pay Back Period
(ii) Net Present Value
(iii) Profitability Index
The present value factors of Re.1 @ 15% are as follows:
Year 01 02 03 04 05
PV factor @ 15% 0.870 0.756 0.658 0.572 0.497.

Ans. Working Notes:

3000000
Depreciation on Machine – I = = Rs. 3,00,000
10
4000000
Depreciation on Machine – II = = Rs. 4,00,000
10
Particulars Machine-I (Rs.) Machine – II (Rs.)

Annual Income (before T ax and Depreciation) 12,50,000 17,50,000

Less: Depreciation 3,00,000 4,00,000

Annual Income (before T ax) 9,50,000 13,50,000

Less: T ax @ 30% (2,85,000) (4,05,000)
Annual Income (after Tax) 6,65,000 9,45,000
Add: Depreciation 3,00,000 4,00,000
Annual Cash Inflows 9,65,000 13,45,000

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Year Machine – I Machine - II

PV of Re Cash flow PV Cumulative Cash flow PV Cumulative PV
1 @ 15% PV

1 0.870 9,65,000 8,39,550 8,39,550 13,45,000 11,70,150 11,70,150

2 0.756 9,65,000 7,29,540 15,69,090 13,45,000 10,16,820 21,86,970

3 0.658 9,65,000 6,34,970 22,04,060 13,45,000 8,85,010 30,71,980
4 0.572 9,65,000 5,51,980 27,56,040 13,45,000 7,69,340 38,41,320

5 0.497 9,65,000 4,79,605 32,35,645 13,45,000 6,68,465 45,09,785

(i) Discounted Payback Period
Machine – I

Discounted Payback Period = 4 +

(3000000 − 2756040 )
479605
243960
=4+ = 4 + 0.5087 = 4.5087 years or 4 years 6.10 months
479605
Machine – II

Discounted Payback Period = 4+

( 4000000 − 3841320 )
668465
158680
=4+ = 4 + 0.2374 = 4.2374 years or 4 years 2.85 months
668465
(ii) Net Present Value (NPV)
Machine – I
NPV = 32,35,645 – 30,00,000 = Rs. 2,35,645
Machine – II
NPV = 45,09,785 – 40,00,000 = Rs. 5,09,785
(iii) Profitability Index
Machine – I
3235645
Profitability Index = = 1.08
3000000

Machine – II
4509785
Profitability Index = = 1.13
4000000

Conclusion:
Method Machine - I Machine - II Rank

Discounted Payback Period 4.51 years 4.24 years II

Net Present Value Rs. .2,35,645 Rs. 5,09,785 II
Profitability Index 1.08 1.13 II

Q.29 NPV, PI & Payback Method MTP Nov 18(2)

A company has to make a choice between two projects namely A and B. The initial capital outlay of two Projects
are Rs.1,35,00,000 and Rs.2,40,00,000 respectively for A and B. There will be no scrap value at the end of the
life of both the projects. The opportunity cost of capital of the company is 16%. The annual incomes are as under:

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Year Project A Project B Discounting factor @ 16%

1 -- 60,00,000 0.862
2 30,00,000 84,00,000 0.743
3 1,32,00,000 96,00,000 0.641
4 84,00,000 1,02,00,000 0.552
5 84,00,000 90,00,000 0.476
You are required to CALCULATE for each project:
(i) Discounted payback period
(ii) Profitability index
(iii) Net present value

Ans. (1) Computation of Net Present Values of Projects (Amount in Rs. ‘000)
Year Cash flows Discount Discounted Cash flow
Project A (Rs.) Project B (Rs.) factor @ 16 % Project A (Rs.) Project B (Rs.)
(1) (2) (3) (3)  (1) (3)  (2)
0 (13,500) (24,000) 1.000 (13,500) (24,000)
1 -- 6,000 0.862 -- 5,172
2 3,000 8,400 0.743 2,229 6,241.2
3 13,200 9,600 0.641 8,461.2 6,153.6
4 8,400 10,200 0.552 4,636.8 5,630.4
5 8,400 9,000 0.476 3,998.4 4,284
Net present value 5,825.4 3,481.2
(2) Computation of Cumulative Present Values of Projects Cash inflows
(Amount in Rs. ‘000)
Project A Project B
Year PV of cash inflows (Rs.)
Cumulative PV (Rs.) PV of cash inflows (Rs.) Cumulative PV (Rs.)
1 -- -- 5,172 51,72
2 2,229 22,29 6,241.2 11,413.2
3 8,461.2 10,690.2 6,153.6 17,566.8
4 4,636.8 15,327 5,630.4 23,197.2
5 3,998.4 19,325.4 4,284 27,481.2
(i) Discounted payback period: (Refer to Working note 2)
Cost of Project A = Rs.1,35,00,000
Cost of Project B = Rs.2,40,00,000
Cumulative PV of cash inflows of Project A after 4 years = Rs.1,53,27,000
Cumulative PV of cash inflows of Project B after 5 years = Rs.2,74,81,200
A comparison of projects cost with their cumulative PV clearly shows that the project A’s cost will
be recovered in less than 4 years and that of project B in less than 5 years. The exact duration of
discounted payback period can be computed as follows :
Project A Project B
Excess PV of cash inflows 18,27,000 34,81,200
over the project cost (Rs.) (Rs.1,53,27,000 − Rs.1,35,00,000) (Rs. 2,74,81,200 − Rs.2,40,00,000)

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Computation of period 0.39 year 0.81 years

required to recover (Rs. 18,27,000 ÷ Rs.46,36,800) (Rs.34,81,200 ÷ Rs. 42,84,000)
excess amount of
cumulative PV over
project cost (Refer to
Working note 2)
Discounted payback 3.61 year 4.19 years
period (4 − 0.39) years (5 − 0.81) years
Sum of discounted cash inflows
(ii) Profitability Index: =
lnitian cash outlay
19325400
Profitability Index (for Project A) = = 1.43
13500000
27481200
Profitability Index (for Project B) = = 1.15
24000000
(iii) Net present value (for Project A) = Rs.58,25,400 (Refer to Working note 1)
Net present value (for Project B) = Rs.34,81,200

Q.30 NPV, PI & Payback Method MTP Nov 18(1)

X Limited is considering to purchase of new plant worth Rs. 80,00,000. The expected net cash flows after taxes
and before depreciation are as follows:

Year Net Cash Flows (Rs.)

1 14,00,000
2 14,00,000
3 14,00,000
4 14,00,000
5 14,00,000
6 16,00,000
7 20,00,000
8 30,00,000
9 20,00,000
10 8,00,000

The rate of cost of capital is 10%. You are required to CALCULATE

(i) Pay-back period
(ii) Net present value at 10 discount factor
(iii) Profitability index at 10 discount factor
(iv) Internal rate of return with the help of 10% and 15% discount factor
The following present value table is given for you:

Present value of Rs. 1 at Present value of Rs. 1 at

Year 10% discount rate 15% discount rate

1 .909 .870

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2 .826 .756
3 .751 .658
4 .683 .572
5 .621 .497
6 .564 .432
7 .513 .376
8 .467 .327
9 .424 .284
10 .386 .247

Ans. (i) Calculation of Pay-back Period

Cash Outlay of the Project = Rs. 80,00,000
Total Cash Inflow for the first five years = Rs. 70,00,000
Balance of cash outlay left to be paid back in the 6th year Rs. 10,00,000
Cash inflow for 6th year = 16,00,000
So the payback period is between 5th and 6th years, i.e.,
1000000
5 years + = 5.625 years or 5 years 7.5 months
600000
(ii) Calculation of Net Present Value (NPV) @10% discount rate:
Year Net Cash Inflow Present Value at Present Value (Rs.)
(Rs.) Discount Rate of 10%

(a) (b) (c) = (a) × (b)

1 14,00,000 0.909 12,72,600
2 14,00,000 0.826 11,56,400
3 14,00,000 0.751 10,51,400
4 14,00,000 0.683 9,56,200
5 14,00,000 0.621 8,69,400
6 16,00,000 0.564 9,02,400
7 20,00,000 0.513 10,26,000
8 30,00,000 0.467 14,01,000
9 20,00,000 0.424 8,48,000
10 8,00,000 0.386 3,08,800
97,92,200
Net Present Value (NPV) = Cash Outflow – Present Value of Cash Inflows
= Rs. 80,00,000 – Rs. 97,92,200 = 17,92,200

(iii) Calculation of Profitability Index @ 10% discount rate:

Present Value of Cash inflows
Profitability Index =
Cost of the investment
9792200
= = 1.224
8000000

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(iv) Calculation of Internal Rate of Return:

Net present value @ 10% interest rate factor has already been ca lculated in (ii) above, we will calculate
Net present value @15% rate factor.
Year Net Cash Inflow Present Value at Discount Present Value
(Rs.) Rate of 15% (Rs.)
(a) (b) (c) = (a)× (b)
1 14,00,000 0.870 12,18,000
2 14,00,000 0.756 10,58,400
3 14,00,000 0.658 9,21,200
4 14,00,000 0.572 8,00,800
5 14,00,000 0.497 6,95,800
6 16,00,000 0.432 6,91,200
7 20,00,000 0.376 7,52,000
8 30,00,000 0.327 9,81,000
9 20,00,000 0.284 5,68,000
10 8,00,000 0.247 1,97,600
78,84,000
Net Present Value at 15% = Rs. 78,84,000 – Rs. 80,00,000 = Rs. -1,16,000
As the net present value @ 15% discount rate is negative, hence internal rate of return falls in between
10% and 15%. The correct internal rate of return can be calculated as follows:
NPVL
IRR = L+ (H −L)
NPVL − NPVH
1792200
= 10% + (15% -10%)
1792200 − ( −116000 )
1792200
= 10% + ×5% = 14.7%
1908200
Q.31 Calculate NPV MTP May 21(2)
(a) SG Ltd. is considering a project “Z” with an initial outlay of Rs. 7,50,000 and life of 5 years. The estimates
of project are as follows:
Lower Estimates Base Upper Estimates
Sales (units) 4,500 5,000 5,500
(Rs.) (Rs.) (Rs.)
Selling Price p.u. 175 200 225
Variable cost p.u. 100 125 150
Fixed Cost 50,000 75,000 1,00,000

Depreciation included in Fixed cost is Rs. 35,000 and corporate tax is 25%.
Assuming the cost of capital as 15%, DETERMINE NPV in three scenarios i.e worst, base and best case
scenario. PV factor for 5 years at 15% are as follows:

Years 1 2 3 4 5
P.V. factor 0.870 0.756 0.658 0.572 0.497

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Ans. (i) Calculation of Yearly Cash Inflow

In worst case: High costs and Low price (Selling price) and volume(Sales units) are taken.
In best case: Low costs and High price(Selling price) and volume(Sales units) are taken.
Worst Case Base Best Case
Sales (units) (A) 4,500 5,000 5,500
(Rs.) (Rs.) (Rs.)
Selling Price p.u. 175 200 225
Less: Variable cost p.u. 150 125 100
Contribution p.u. (B) 25 75 125
Total Contribution (A x B) 1,12,500 3,75,000 6,87,500
Less: Fixed Cost 1,00,000 75,000 50,000
EBT 12,500 3,00,000 6,37,500
Less: Tax @ 25% 3,125 75,000 1,59,375
EAT 9,375 2,25,000 4,78,125
Add: Depreciation 35,000 35,000 35,000
Cash Inflow 44,375 2,60,000 5,13,125
(ii) Calculation of NPV in different scenarios
Worst Case Base Best Case
Initial outlay (A) (Rs.) 7,50,000 7,50,000 7,50,000
Cash Inflow (c) (Rs.) 44,375 2,60,000 5,13,125
Cumulative PVF @ 15% (d) 3.353 3.353 3.353
PV of Cash Inflow (B = c x d) (Rs.) 1,48,789.38 8,71,780 17,20,508.13
NPV (B - A) (Rs.) (6,01,210.62) 1,21,780 9,70,508.13

Q.32 Calculate NPV MTP Nov 19

H Ltd. is considering a new product line to supplement its range of products. It is anticipated that the new
product line will involve cash investments of Rs.70,00,000 at time 0 and Rs.1,00,00,000 in year 1. After-tax
cash inflows of Rs. 25,00,000 are expected in year 2, Rs.30,00,000 in year 3, Rs.35,00,000 in year 4 and
Rs.40,00,000 each year thereafter through year 10. Although the product line might be viable after year 10,
the company prefers to be conservative and end all calculations at that time.
(i) If the required rate of return is 15 per cent, FIND OUT the net present value of the project? Is it
acceptable?
(ii) COMPUTE NPV if the required rate of return were 10 per cent?
(iii) COMPUTE the internal rate of return?

Ans. (i)
Year Cash flow Discount Factor (15%) Present value
(Rs.) (Rs.)

0 (70,00,000) 1.000 (70,00,000)

1 (1,00,00,000) 0.870 (87,00,000)

2 25,00,000 0.756 18,90,000
3 30,00,000 0.658 19,74,000

4 35,00,000 0.572 20,02,000

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5−10 40,00,000 2.163 86,52,000

Net Present Value (11,82,000)
As the net present value is negative, the project is unacceptable.
(ii) Similarly, NPV at 10% discount rate can be computed as follows:
Year Cash flow Discount Factor (10%) Present value
(Rs.) (Rs.)
0 (70,00,000) 1.000 (70,00,000)

1 (1,00,00,000) 0.909 (90,90,000)

2 25,00,000 0.826 20,65,000

3 30,00,000 0.751 22,53,000
4 35,00,000 0.683 23,90,500

5−10 40,00,000 2.974 1,18,96,000

Net Present Value 25,14,500
Since NPV = Rs.25,14,500 is positive, hence the project would be acceptable.

NPVL
(iii) IRR = L+ (H −L)
NPVL − NPVH
2514500
= 10% + (15% −10%)
2514500 − ( − ) 1182000
= 10% + 3.4012 or 13.40%

Q.33 Calculate NPV MTP May 19(2)

Probabilities for net cash flows for 3 years of a project of Ganesh Ltd are as follows:
Year 1 Year 2 Year 3
Cash Flow (Rs.) Probability Cash Flow (Rs.) Probability Cash Flow (Rs.) Probability

2,000 0.1 2,000 0.2 2,000 0.3

4,000 0.2 4,000 0.3 4,000 0.4

6,000 0.3 6,000 0.4 6,000 0.2

8,000 0.4 8,000 0.1 8,000 0.1

CALCULATE the expected net cash flows and the present value of the expected cash flow, using 10 per cent
discount rate. Initial Investment is Rs. 10,000

Ans.
Year 1 Year 2 Year 3
Cash Flow Probability Expecte Cash Flow Probability Expected Cash Flow Probability Expecte d
(Rs.) Value (Rs.) (Rs.) Value (Rs.) (Rs.) Value (Rs.)

2,000 0.1 200 2,000 0.2 400 2,000 0.3 600

4,000 0.2 800 4,000 0.3 1200 4,000 0.4 1,600

6,000 0.3 1,800 6,000 0.4 2400 6,000 0.2 1,200

8,000 0.4 3,200 8,000 0.1 800 8,000 0.1 800

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ENCF 6,000 4,800 4,200

The present value of the expected value of cash flow at 10 per cent discount rate has been determined as
follows:
ENCF1 ENCF2 ENCF3
Present Value of cash flow = + +
(1 + K ) (1 + K ) (1 + K )
1 2 3

6000 4800 4200

= + +
(1.1) (1 + 1) (1.1)
1 2 3

= (6,000 × 0.909) + (4,800 × 0.826) + (4,200 + 0.751) = 12,573

Expected Net Present value = Present Value of cash flow - Initial Investment
= Rs. 12,573 – Rs.10,000 = Rs.2,573.

Q.34 NPV Method (Accept/Not) PY Nov 20

CK Ltd. is planning to buy a new machine. Details of which are as follows:
Cost of the Machine at the commencement ` 2,50,000
Economic Life of the Machine 8 year
Residual Value Nil
Annual Production Capacity of the Machine 1,00,000 units
Estimated Selling Price per unit `6
Estimated Variable Cost per unit `3
Estimated Annual Fixed Cost ` 1,00,000
(Excluding depreciation)
Advertisement Expenses in 1st year in addition of
annual fixed cost ` 20,000
Maintenance Expenses in 5th year in addition of
annual fixed cost ` 30,000
Cost of Capital 12%
Ignore Tax.
Analyse the above mentioned proposal using the Net Present Value Method and advice. P.V. factor @ 12% are as
under:
Year 1 2 3 4 5 6 7 8
PV Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404

Ans. Calculation of Net Cash flows

Contribution = (` 6 – ` 3)  1,00,000 units = ` 3,00,000
Fixed costs (excluding depreciation) = ` 1,00,000

Year Capital (`) Contribution (`) Fixed costs (`) Advertisement/ Net cash flow (`)
Maintenance
expenses (`)
0 (2,50,000) (2,50,000)
1 3,00,000 (1,00,000) (20,000) 1,80,000
2 3,00,000 (1,00,000) 2,00,000
3 3,00,000 (1,00,000) 2,00,000
4 3,00,000 (1,00,000) 2,00,000
5 3,00,000 (1,00,000) (30,000) 1,70,000

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6 3,00,000 (1,00,000) 2,00,000

7 3,00,000 (1,00,000) 2,00,000
8 3,00,000 (1,00,000) 2,00,000

Calculation of Net Present Value

Year Net cash flow (`) 12% discount factor Present value (`)
0 (2,50,000) 1.000 (2,50,000)
1 1,80,000 0.893 1,60,740
2 2,00,000 0.797 1,59,400
3 2,00,000 0.712 1,42,400
4 2,00,000 0.636 1,27,200
5 1,70,000 0.567 96,390
6 2,00,000 0.507 1,01,400
7 2,00,000 0.452 90,400
8 2,00,000 0.404 80,800
7,08,730
Advise: CK Ltd. should buy the new machine, as the net present value of the proposal is positive i.e ` 7,08,730.

Q.35 MPV & Payback Method PY Nov 18

PD Ltd. an existing company, is planning to introduce a new product with projected life of 8 years. Project cost
will be ` 2,40,00,000. At the end of 8 years no residual value will be realized. Working capital of ` 30,00,000
will be needed. The 100% capacity of the project is 2,00,000 units p.a. but the Production and Sales Volume is
expected are as under :
Year Number of Units
1 60,000 units
2 80,000 units
3-5 1,40,000 units
6-8 1,20,000 units
Other Information:
(i) Selling price per unit ` 200
(ii) Variable cost is 40 of sales.
(iii) Fixed cost p.a. ` 30,00,000.
(iv) In addition to these advertisement expenditure will have to be incurred as under:

Year 1 2 3-5 6-8

Expenditure (`) 50,00,000 25,00,000 10,00,000 5,00,000

(v) Income Tax is 25%.

(vi) Straight line method of depreciation is permissible for tax purpose. (vii) Cost of capital is 10%.
(viii) Assume that loss cannot be carried forward.

Year 1 2 3 4 5 6 7 8
PVF@ 10 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
Advise about the project acceptability.

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Ans. Computation of initial cash outlay(COF)

(` in lakhs)
Project Cost 240
Working Capital 30
270

Calculation of Cash Inflows(CIF):

Years 1 2 3-5 6-8
Sales in units 60,000 80,000 1,40,000 1,20,000
` ` ` `
Contribution (` 200 x 60% x No. of
Unit) 72,00,000 96,00,000 1,68,00,000 1,44,00,000

Less: Fixed cost 30,00,000 30,00,000 30,00,000 30,00,000

Less: Advertisement 50,00,000 25,00,000 10,00,000 5,00,000
Less: Depreciation (24000000/8)
= 30,00,000 30,00,000 30,00,000 30,00,000 30,00,000

Profit /(loss) (38,00,000) 11,00,000 98,00,000 79,00,000

Less: T ax @ 25% NIL 2,75,000 24,50,000 19,75,000
Profit/(Loss) after tax (38,00,000) 8,25,000 73,50,000 59,25,000
Add: Depreciation 30,00,000 30,00,000 30,00,000 30,00,000
Cash inflow (8,00,000) 38,25,000 1,03,50,000 89,25,000
(Note: Since variable cost is 40%, Contribution shall be 60% of sales)

Computation of PV of CIF
CIF PV Factor
Year ` @ 10% `

1 (8,00,000) 0.909 (7,27,200)

2 38,25,000 0.826 31,59,450
3 1,03,50,000 0.751 77,72,850
4 1,03,50,000 0.683 70,69,050
5 1,03,50,000 0.621 64,27,350
6 89,25,000 0.564 50,33,700
7 89,25,000 0.513 45,78,525
8 89,25,000
Working Capital 30,00,000 0.467 55,68,975
3,88,82,700
PV of COF 2,70,00,000
NPV 1,18,82,700
Recommendation: Accept the project in view of positive NPV.

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Q.36 NPV Method (Accept/Not) PY May 19

AT Limited is considering three projects A, B and C. The cash flows associated with the projects are
given below:
Cash flows associated with the Three Projects (`)
Project C0 C1 C2 C3 C3

A (10,000) 2,000 2,000 6,000 0

B (2,000) 0 2,000 4,000 6,000
C (10,000) 2,000 2,000 6,000 10,000
You are required to :
(a) Calculate the payback period of each of the three projects.
(b) If the cut-off period is two years, then which projects should be accepted?
(c) Projects with positive NPVs if the opportunity cost of capital is 10 percent.
(d) "Payback gives too much weight to cash flows that occur after the cut-off date". True or false?
(e) "If a firm used a single cut-off period for all projects, it is likely to accept too many short lived projects."
True or false?
P.V. Factor @ 10 %
Year 0 1 2 3 4 5
P.V. 1.000 0.909 0.826 0.751 0.683 0.621

Ans. (a) Payback Period of Projects

Projects C0 (` ) C1 (` ) C2 (` ) C3 (` ) Payback

A (10,000) 2000 2000 6,000 2,000+2,000+6,000 =10,000 i.e 3 years

B (2,000) 0 2,000 NA 0+2,000 = 2,000 i.e 2 years
C (10,000) 2000 2000 6,000 2,000+2,000+6,000 = 10,000 i.e 3 years

(b) If standard payback period is 2 years, Project B is the only acceptable project.

(c) Calculation of NPV

Year PVF Project A Project B Project C
@ Cash PV of cash Cash PV of cash Cash PV of cash
10% Flows flows Flows flows Flows flows
(` ) (` ) (` ) (` ) (` ) (` )
0 1 (10,000) (10,000) (2,000) (2,000) (10,000) (10,000)
1 0.909 2,000 1,818 0 0 2,000 1,818
2 0.826 2,000 1,652 2,000 1,652 2,000 1,652
3 0.751 6,000 4506 4,000 3004 6,000 4,506
4 0.683 0 0 6,000 4,098 10,000 6,830
NPV (-2,024) 6,754 4,806
So, Projects with positive NPV are Project B and Project C

(d) False. Payback gives no weightage to cash flows after the cut-off date.

(e) True. The payback rule ignores all cash flows after the cutoff date, meaning that future years’ cash
inflows are not considered. Thus, payback is biased towards short-term projects.

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Q.37 NPV Method (Machine Replace) RTP Nov 18

Shiv Limited is thinking of replacing its existing machine by a new machine which would cost ` 60 lakhs. The
company’s current production is 80,000 units, and is expected to increase to 1,00,000 units, if the new machine
is bought. The selling price of the product would remain unchanged at ` 200 per unit. The following is the cost
of producing one unit of product using both the existing and new machine:
Unit cost (`)
Existing Machine New Machine Difference
(80,000 units) (1,00,000 units)
Materials 75.0 63.75 (11.25)
Wages & Salaries 51.25 37.50 (13.75)
Supervision 20.0 25.0 5.0
Repairs and Maintenance 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.0 4.75
Allocated Corporate Overheads 10.0 12.50 2.50
183.25 165.50 (17.75)

The existing machine has an accounting book value of ` 1,00,000, and it has been fully depreciated for tax purpose.
It is estimated that machine will be useful for 5 years. The supplier of the new machine has offered to
accept the old machine for ` 2,50,000. However, the market price of old machine today is ` 1,50,000 and it is
expected to be ` 35,000 after 5 years. The new machine has a life of 5 years and a salvage value of ` 2,50,000
at the end of its economic life. Assume corporate Income tax rate at 40%, and depreciation is charged on straight
line basis for Income-tax purposes. Further assume that book profit is treated as ordinary income for tax
purpose. The opportunity cost of capital of the Company is 15%.
Required:
(i) ESTIMATE net present value of the replacement decision.
(ii) CALCULATE the internal rate of return of the replacement decision.
(iii) Should Company go ahead with the replacement decision? ANALYSE.
Year (t) 1 2 3 4 5
PVIF0.15t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25t 0.80 0.64 0.512 0.4096 0.3277
PVIF0.30t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35t 0.7407 0.5487 0.4064 0.3011 0.2230

Ans. (i) Net Cash Outlay of New Machine

Purchase Price ` 60,00,000
Less: Exchange value of old machine
[2,50,000 – 0.4(2,50,000 – 0)] 1,50,000
` 58,50,000
Market Value of Old Machine: The old machine could be sold for ` 1,50,000 in the market. Since the
exchange value is more than the market value, this option is not attractive. This opportunity will be lost
whether the old machine is retained or replaced. Thus, on incremental basis, it has no impact.
Depreciation base: Old machine has been fully depreciated for tax purpose.
Thus, the depreciation base of the new machine will be its original cost i.e. ` 60,00,000.

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Net Cash Flows: Unit cost includes depreciation and allocated overheads. Allocated overheads are
allocated from corporate office therefore they are irrelevant. The depreciation tax shield may be
computed separately. Excluding depreciation and allocated overheads, unit costs can be calculated. The
company will obtain additional revenue from additional 20,000 units sold.
Thus, after-tax saving, excluding depreciation, tax shield, would be
= {100,000(200 – 148) – 80,000(200 – 173)} × (1 – 0.40)
= {52,00,000 – 21,60,000} × 0.60
= ` 18,24,000
After adjusting depreciation tax shield and salvage value, net cash flows and net present value are
estimated.
Calculation of Cash flows and Project Profitability
` (‘000)
0 1 2 3 4 5
1 After-tax savings - 1824 1824 1824 1824 1824
2 Depreciation - 1150 1150 1150 1150 1150
(` 60,00,000 – 2,50,000)/5
3 Tax shield on - 460 460 460 460 460
depreciation
(Depreciation × Tax rate)
4 Net cash flows from - 2284 2284 2284 2284 2284
operations (1 + 3)*
5 Initial cost (5850)
6 Net Salvage Value - - - - - 215
7 Net Cash Flows (4+5+6) (5850) 2284 2284 2284 2284 2499
8 PVF at 15% 1.00 0.8696 0.7561 0.6575 0.5718 0.4972
9 PV (5850) 1986.166 1726.932 1501.73 1305.99 1242.50
10 NPV ` 1913.32
* Alternately Net Cash flows from operation can be calculated as follows:
Profit before depreciation and tax = ` 1,00,000 (200 -148) - 80,000 (200 -173)
= ` 52,00,000 – 21,60,000
= ` 30,40,000
So profit after depreciation and tax is ` (30,40,000 -11,50,000) × (1 - .40)
= ` 11,34,000
So profit before depreciation and after tax is :
` 11,34,000 + ` 11,50,000 (Depreciation added back) = ` 22,84,000
(ii)
` (‘000)
0 1 2 3 4 5
NCF (5850) 2284 2284 2284 2284 2499
PVF at 20% 1.00 0.8333 0.6944 0.5787 0.4823 0.4019
PV (5850) 1903.257 1586.01 1321.751 1101.57 1004.35
PV of benefits 6916.94
PVF at 30% 1.00 0.7692 0.5917 0.4550 0.3501 0.2693
PV (5850) 1756.85 1351.44 1039.22 799.63 672.98
PV of benefits 5620.12

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1066.94
IRR = 20% + 10% × = 28.23%
1296.82
(iii) Advise: The Company should go ahead with replacement project, since it is positive NPV decision.

Q.38 NPV, Payback & Disc Payback PY Nov 19

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

Ans. (i) Optimizing returns when projects are independent and divisible.
Computation of NPVs per Re. 1 of Investment and Ranking of the Projects
Project Investment (`) NPV (`) NPV per Re. 1 Ranking
invested (`)
C 40,000 20,000 0.50 1
D 1,00,000 35,000 0.35 3
E 50,000 24,000 0.48 2
F 60,000 18,000 0.30 4
Building up of a Package of Projects based on their Rankings
Project Investment (`) NPV (`)
C 40,000 20,000
E 50,000 24,000
D 10,000 3,500
(1/10 th of Project)
Total 1,00,000 47,500
The company would be well advised to invest in Projects C, E and D (1/10 th) and reject Project F to optimise
return within the amount of ` 1,00,000 available for investment.
(ii) Optimizing returns when projects are indivisible.
Package of Project Investment (`) Total NPV (`)
C and E 90,000 44,000
(40,000 + 50,000) (20,000 + 24,000)
C and F 1,00,000 38,000
(40,000 + 60,000) (20,000 + 18,000)
Only D 1,00,000 35,000
The company would be well advised to invest in Projects C and E to optimise return within the amount of `
1,00,000 available for investment.

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Q.39 NPV, Payback & Disc Payback MTP Nov 23(1)

A firm can make investment in either of the following two projects. The firm anticipates its cost of capital to be
10%. The pre-tax cash flows of the projects for five years are as follows:
Year 0 1 2 3 4 5
Project A (`) (3,00,000) 55,000 1,20,000 1,30,000 1,05,000 40,000
Project 8 (`) (3,00,000) 3,18,000 20,000 20,000 8,000 6,000

Ignore Taxation.
An amount of ` 45,000 will be spent on account of sales promotion in year 3 in case of Project A. This has not
been considered in calculation of pre-tax cash flows.
The discount factors are as under:
Year 0 1 2 3 4 5
PVF (10%) 1 0.91 0.83 0.75 0.68 0.62
You are required to calculate for each project:
(i) The payback period
(ii) The discounted payback period
(iii) Desirability factor
(iv) Net Present Value

Ans. Calculation of Present Value of cash flows

Year PV factor @ Project A Project B
10% Cash flows (`) Discounted Cash flows (`) Discounted
Cash flows Cash flows
0 1.00 (3,00,000) (3,00,000) (3,00,000) (3,00,000)
1 0.91 55,000 50,050 3,18,000 2,89,380
2 0.83 1,20,000 99,600 20,000 16,600
3 0.75 85,000(1,30,000-45,000) 63,750 20,000 15,000
4 0.68 1,05,000 71,400 8,000 5,440
5 0.62 40,000 24,800 6,000 3,720
Net Present Value 9,600 30,140
(i) The Payback period of the projects:
Project-A: The cumulative cash inflows up-to year 3 is `2,60,000 and remaining amount required to equate
the cash outflow is ` 40,000 i.e. (` 3,00,000 – ` 2,60,000) which will be recovered from year-4 cash inflow.
Hence, Payback period will be calculated as below:
40000
3 years + = 3.381 years or 3 years, 4 months, 9 days (approx.)
105000
Project-B: The cash inflow in year-1 is ` 3,18,000 and the amount required to equate the cash outflow is `
3,00,000, which can be recovered in a period less than a year. Hence, Payback period will be calculated as
below:
300000
= 0.943 years or 11 months
318000
(ii) Discounted Payback period for the projects:
Project-A: The cumulative discounted cash inflows up-to year 4 is ` 2,84,800 and remaining amount
required to equate the cash outflow is ` 15,200 i.e. (` 3,00,000 – ` 2,84,800) which will be recovered from
year-5 cash inflow. Hence, Payback period will be calculated as below:

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15200
4 years + = 4.613 years or 4 years, 2 months, and 11 days
24800
Project-B: The cash inflow in year-1 is `2,89,380 and remaining amount required to equate the cash outflow
is ` 10,620 i.e. (` 3,00,000 – ` 2,89,380) which will be recovered from year-2 cash inflow. Hence, Payback
period will be calculated as below:
10620
1 year + = 1.640 years or 1 Year, 7 months and 23 days.
16600
(iii) Desirability factor of the projects
Discounted value Cash Inflows
Desirability Factor (Profitability Index) =
Discounted value of Cash
309600
Project A = = 1.032
300000
330140
Project B = = 1.100
300000
(iv) Net Present Value (NPV) of the projects:
Please refer the above table.
Project A- ` 9,600
Project B- ` 30,140
Q.40 Purchase Machine or Not MTP May 23(2)
(a) Rambow Ltd. is contemplating purchasing machinery that would cost ` 10,00,000 plus GST @ 18% at
the beginning of year 1. Cash inflows after tax from operations have been estimated at ` 2,56,000 per
annum for 5 years. The company has two options for the smooth functioning of the machinery - one is
service, and another is replacement of parts. The company has the option to service a part of the machinery
at the end of each of the years 2 and 4 at ` 1,00,000 plus GST @ 18% for each year. In such a case, the
scrap value at the end of year 5 will be ` 76,000. However, if the company decides not to service the part,
then it will have to be replaced at the end of year 3 at ` 3,00,000 plus GST@ 18% and in this case, the
machinery will work for the 6th year also and get operational cash inflow of ` 1,86,000 for the 6th year.
It will have to be scrapped at the end of year 6 at ` 1,36,000.
Assume cost of capital at 12% and GST paid on all inputs including capital goods are eligible for input tax
credit in the same month as and when incurred.
(i) DECIDE whether the machinery should be purchased under option 1 or under option 2 or it
shouldn’t be purchased at all.
(ii) If the supplier gives a discount of ` 90,000 for purchase, WHAT would be your decision? Note:
The PV factors at 12% are:
Year 0 1 2 3 4 5 6
PV Factor 1 0.8928 0.7972 0.7118 0.6355 0.5674 0.5066

Ans. Option I: Purchase Machinery and Service Part at the end of Year 2 and 4.
Net Present value of cash flow @ 12% per annum discount rate.
NPV (in `) = - 10,00,000 + 2,56,000 x (0.8928+0.7972+0.7118+0.6355+0.5674) – (1,00,000 x 0.7972+1,00,000 x
0.6355) + (76,000 x 0.5674)
= - 10,00,000 + (2,56,000 x 3.6047) – 1,43,270+43,122.4
= - 10,00,000 + 9,22,803.2 – 1,43,270+ 43,122.4
NPV = - 1,77,344.4
Since Net Present Value is negative; therefore, this option is not to be considered.
If Supplier gives a discount of ` 90,000, then:
NPV (in `) = + 90,000 - 1,77,344.4 = -87,344.4
In this case, Net Present Value is still negative; therefore, this option may not be advisable
Option II: Purchase Machinery and Replace Part at the end of Year 2.

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NPV (in `)= - 10,00,000 + 2,56,000 x (0.8928+0.7972+0.7118+0.6355+0.5674) – (3,00,000 x 0.7118) + (1,86,000

x 0.5066+1,36,000 x 0.5066)
= - 10,00,000 + (2,56,000 x 3.6047) – 2,13,540+1,63,125.2
= - 10,00,000 + 9,22,803.2 – 2,13,540+1,63,125.2
NPV = - 1,27,611.6
Net Present Value is negative, the machinery should not be purchased.
If the Supplier gives a discount of ` 90,000, then:
NPV (in `) = 90,000 - 1,27,611.6 = - 37,611.6
In this case, Net Present Value is still negative; therefore, this option may not be advisa ble.
Decision: The Machinery should not be purchased as it will earn a negative NPV in both options of repair
and replacement.

Q.41 Purchase Machine or Not MTP May 23(1)

Yellow bells Ltd. wants to replace its old machine with new automatic machine. The old machine had been fully
depreciated for tax purpose but has a book value of `3,50,000 on 31st March 2022. The machine cannot fetch
more than `45,000 if sold in the market at present. It will have no realizable value after 10 years. The company
has been offered `1,60,000 for the old machine as a trade in on the new machine which has a price (before
allowance for trade in) of `6,50,000. The expected life of new machine is 10 years with salvage value of `63,000.
Further, the company follows straight line depreciation method but for tax purpose, wri tten down value method
depreciation @ 9% is allowed taking that this is the only machine in the block of assets.
Given below are the expected sales and costs from both old and new machine:
Old machine (`) New machine (`)
Sales 11,74,500 11,74,500
Material cost 2,61,000 1,83,063
Labour cost 1,95,750 1,59,500
Variable overhead 81,563 68,875
Fixed overhead 1,30,500 1,41,375
Depreciation 34,800 60,175
Profit Before Tax (PBT) 4,70,888 5,61,513
Tax @ 25% 1,17,722 1,40,378
Profit After Tax (PAT) 3,53,166 4,21,134
From the above information, ANALYSE whether the old machine should be replaced or not if required rate of
return is 10%? Ignore capital gain tax.
PV factors @ 10%:
Year 1 2 3 4 5 6 7 8 9 10

PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

Ans. (i) Calculation of Base for depreciation or Cost of New Machine

Particulars (`)
Purchase price of new machine 6,50,000
Less: Sale price of old machine 1,60,000
4,90,000

(iii) Calculation of Profit before tax as per books

Particulars Old machine (`) New machine (`) Difference (`)

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PBT as per books 4,70,888 5,61,513 90,625

Add: Depreciation as per books 34,800 60,175 25,375
Profit before tax and depreciation 5,05,688 6,21,688 1,16,000
(PBTD)
Calculation of Incremental NPV
PVF PBTD Dep. @ 9% PBT Tax @ 25% Cash Inflows PV of Cash
Inflows
Year @ 10% (`) (`) (`) (`) (`) (`)
1 2 3 4(2-3) (5) = (4) x (6) = (4) –(5) (7) = (6) x (1)
0.25 + (3)
1 0.909 1,16,000.00 44,100.00 71,900.00 17,975.00 98,025.00 89,104.73
2 0.826 1,16,000.00 40,131.00 75,869.00 18,967.25 97,032.75 80,149.05
3 0.751 1,16,000.00 36,519.21 79,480.79 19,870.20 96,129.80 72,193.48
4 0.683 1,16,000.00 33,232.48 82,767.52 20,691.88 95,308.12 65,095.45
5 0.621 1,16,000.00 30,241.56 85,758.44 21,439.61 94,560.39 58,722.00
6 0.564 1,16,000.00 27,519.82 88,480.18 22,120.05 93,879.95 52,948.29
7 0.513 1,16,000.00 25,043.03 90,956.97 22,739.24 93,260.76 47,842.77
8 0.467 1,16,000.00 22,789.16 93,210.84 23,302.71 92,697.29 43,289.63
9 0.424 1,16,000.00 20,738.14 95,261.86 23,815.47 92,184.53 39,086.24
10 0.386 1,16,000.00 18,871.70 97,128.30 24,282.07 91,717.93 35,403.12
5,83,834.77
Add: PV of Salvage value of new machine (` 63,000 ´ 0.386) 24,318.00
Total PV of incremental cash inflows 6,08,152.77
Less: Cost of new machine [as calculated in point(i)] 4,90,000.00
Incremental Net Present Value 1,18,152.77
Analysis: Since the Incremental NPV is positive, the old machine should be replaced.

Q.42 Purchase Machine or Not MTP Nov 22(1)

Emb ros Ltd. is planning to invest in a new product with a project life of 8 years. Initial equipment cost will be `
35 crores. Additional equipment costing ` 2.50 crores will be purchased at the end of the third year from the
cash inflow of this year. At the end of 8th year, the original equipment will have no resale value, but additional
equipment can be sold at 10% of its original cost. A working capital of ` 4 crores will be needed, and it will be
released at the end of 8th year. The project will be financed with sufficient amount of equity capital.
The sales volumes over eight years have been estimated as follows:
Year 1 2 3 4−5 6−8

Units 14,40,000 21,60,000 52,00,000 54,00,000 36,00,000

Sales price of ` 120 per unit is expected and variable expenses will amount to 60% of sales revenue. Fixed cash
operating costs will amount ` 3.60 crores per year. The loss of any year will be set off from the profits of
subsequent year. The company follows straight line method of depreciation and is subject to 30% tax rate.
Considering 12% after tax cost of capital for this project, you are required to CALCULATE the net present value
(NPV) of the project and advise the management to take appropriate decision.
PV factors @ 12% are:

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Year 1 2 3 4 5 6 7 8

.893 .797 .712 .636 .567 .507 .452 .404

Ans. Calculation of year-wise Cash Inflow (` in crores)

Year Sales VC FC Dep. Profit Tax PAT Dep. Cash

(60% of Sales Value) (@30%) inflow

1 17.28 10.368 3.6 4.375 (1.063) - (1.0630) 4.375 3.312

2 25.92 15.552 3.6 4.375 2.393 0.3990 * 1.9940 4.375 6.369

3 62.4 37.44 3.6 4.375 16.985 5.0955 11.8895 4.375 16.2645

4−5 64.8 38.88 3.6 4.825 # 17.495 5.2485 12.2465 4.825 17.0715

6−8 43.2 25.92 3.6 4.825 8.855 2.6565 6.1985 4.825 11.0235
*(30% of 2.393 – 30% of 1.063) = 0.7179 – 0.3189 = 0.3990
#4.375 + (2.50 - .25)/5 = 4.825
Calculation of Cash Outflow at the beginning
Particulars `

Cost of New Equipment 35,00,00,000

Add: Working Capital 4,00,00,000
Outflow
39,00,00,000
Calculation of NPV
Year Cash inflows (`) PV factor NPV (`)

1 3,31,20,000 .893 2,95,76,160

2 6,36,90,000 .797 5,07,60,930
3 16,26,45,000 - 2,50,00,000 = 13,76,45,000 .712 9,80,03,240
4 17,07,15,000 .636 10,85,74,740
5 17,07,15,000 .567 9,67,95,405
6 11,02,35,000 .507 5,58,89,145
7 11,02,35,000 .452 4,98,26,220
8 11,02,35,000 + 4,00,00,000 + 25,00,000 = 15,27,35,000 .404 6,17,04,940

Present Value of Inflow 55,11,30,780

Less: Out flow 39,00,00,000

Net Present Value 16,11,30,780

Advise: Since the project has a positive NPV, it may be accepted.

Q.43 Purchase Machine or Not MTP May 22(2)

Manoran jan Ltd is a News broadcasting channel having its broadcasting Centre in Mumbai. There are total 200
employees in the organisation including top management. As a part of employee benefit expenses, the company
serves tea or coffee to its employees, which is outsourced from a third -party. The company offers tea or coffee
three times a day to each of its employees. 120 employees prefer tea all three times, 40 employees prefer coffee
all three times and remaining prefer tea only once in a day. The third-party charges ` 10 for each cup of tea and
` 15 for each cup of coffee. The company works for 200 days in a year.

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Looking at the substantial amount of expenditure on tea and coffee, the finance department has proposed
to the management an installation of a master tea and coffee vending machine which will cost ` 10,00,000 with a
useful life of five years. Upon purchasing the machine, the company will have to enter into an annual maintenance
contract with the vendor, which will require a payment of ` 75,000 every year. The machine would require
electricity consumption of 500 units p.m. and current incremental cost of electricity for the company is ` 12 per
unit. Apart from these running costs, the company will have to incur the following consumables expenditure also:
(1) Packets of Coffee beans at a cost of ` 90 per packet.
(2) Packet of tea powder at a cost of ` 70 per packet.
(3) Sugar at a cost of ` 50 per Kg.
(4) Milk at a cost of ` 50 per litre.
(5) Paper cup at a cost of 20 paise per cup.
Each packet of coffee beans would produce 200 cups of coffee and same goes for tea powder packet.
Each cup of tea or coffee would consist of 10g of sugar on an average and 100 ml of milk.
The company anticipate that due to ready availability of tea and coffee through vending machines its
employees would end up consuming more tea and coffee. It estimates that the consumption will incr ease
by on an average 20% for all class of employees. Also, the paper cups consumption will be 10% more than
the actual cups served due to leakages in them.
The company is in the 25% tax bracket and has a current cost of capital at 12% per annum. Straight line
method of depreciation is allowed for the purpose of taxation. You as a financial consultant is required to
ADVISE on the feasibility of acquiring the vending machine.
PV factors @ 12%:
Year 1 2 3 4 5
PVF 0.8929 0.7972 0.7118 0.6355 0.5674

Ans. A. Computation of CFAT (Year 1 to 5)

Particulars Amount (`)
(a) Savings in existing (120 × 10 ×3) + (40 ×15 × 3) + (40 ×10 × 1) 11,60,000
Tea & Coffee charges x 200 days
(b) AMC of machine (75,000)
(c) Electricity charges 500 ×12 ×12 (72,000)
(d) Coffee Beans (W.N.) 144 × 90 (12,960)
(e) Tea Powder (W.N.) 480 × 70 (33,600)
(f) Sugar (W.N.) 1248 × 50 (62,400)
(g) Milk (W.N.) 12480 × 50 (6,24,000)
(h) Paper Cup (W.N.) 1,37,280 × 0.2 (27,456)
(i) Depreciation 10,00,000/5 (2,00,000)
Profit before Tax 52,584
(-) Tax @ 25% (13,146)
Profit after Tax 39,438
Depreciation 2,00,000
CFAT 2,39,438
B. Computation of NPV
Year Particulars CF PVF @ 12% PV
0 Cost of machine (10,00,00) 1 (10,00,000)
1-5 CFAT 2,39,438 3.6048 8,63,126

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Net Present Value (1,36,874)

Since NPV of the machine is negative, it should not be purchased.
Working Note:
Computation of Qty of consumable
No. of Tea Cups = [(120 × 3 × 200 days) + (40 × 1 × 200 days) × 1.2 = 96,000
No. of Coffee cups = 40 × 3 × 200 days × 1.2 = 28,800
28800
No. of coffee beans packet = = 144
200
96000
No. of Tea Powder Packets = = 480
200
Qty of Sugar =
( 96000 + 28800 ) X10g = 1248 kgs
1000g

Qty of Milk =
( 96000 + 28800 ) x100ml = 12,480 litres
1000ml
No. of paper cups = (96,000 + 28,800) × 1.1 = 1,37,280

Q.44 Purchase Machine or Not MTP May 21(2)

City Clap Ltd. is in the business of providing housekeeping services. There is a proposal before the company to
purchase a mechanized cleaning system for a sum of Rs. 40 lakhs. The present system of the company is to use
manual labour for the cleaning job. You are provided with the following information:

Proposed Mechanized System:

Cost of the machine Rs. 40 lakhs
Life of the machine 7 years
Depreciation (on straight line basis) 15%
Operating cost of mechanized system Rs. 20 lakhs per annum

Present system (Manual):

Manual labour 350 persons
Cost of manual labour Rs. 15,000 per person per annum
The company has an after-tax cost of fund at 10% per annum.
The applicable tax rate is 50%.

Ans. Calculation of NPV

(Rs.) (Rs.)
Cost of Manual System (Rs. 15,000 x 350) 52,50,000
Less: Cost of Mechanised System:
Operating Cost 20,00,000
Depreciation (Rs. 40,00,000 x 0.15) 6,00,000 26,00,000
Saving per annum 26,50,000
Less: Tax (50%) 13,25,000
Saving after tax 13,25,000
Add: Depreciation 6,00,000
Cash flow per annum 19,25,000
Cumulative PV Factor for 7 years @ 10% 4.867

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Present value of cash flow for 7 years 93,68,975

Less: Cost of the Machine 40,00,000
NPV 53,68,975

The mechanized cleaning system should be purchased since NPV is positive by Rs. 53,68,975.

Q.45 Purchase Machine or Not MTP May 21(1)

GG Pat hology Lab Ltd. is using 2D sonography machine which has reached the end of its useful life. The lab is
intending to upgrade along with the technology by investing in 3D sonography machine as per the choices preferred
by the patients. Following new 3D s onography machine of two different brands with same features is available in
the market:
Brand Cost of Life of Maintenance Cost (Rs.) SLM Depreciation rate (%)
machine machine Year 1-5 Year 6-10 Year 11-15
(Rs.) (Rs.)
X 15,00,000 15 50,000 70,000 98,000 6
Y 10,00,000 10 70,000 1,15,000 - 6

Residual Value of machines shall be dropped by 10% and 40% of Purchase price for Brand X and Y respectively in
the first year and thereafter shall be depreciated at the rate mentioned above on the original cost.
Alternatively, the machine of Brand Y can also be taken on rent to be returned back to the owner after use on
the following terms and conditions:
• Annual Rent shall be paid in the beginning of each year and for first year it shall be Rs. 2,24,000.
Annual Rent for the subsequent 4 years shall be Rs. 2,25,000.
• Annual Rent for the final 5 years shall be Rs. 2,70,000.
• The Rent/Agreement can be terminated by GG Labs by making a payment of Rs. 2,20,000 as penalty. This
penalty would be reduced by Rs. 22,000 each year of the period of rental agreement.
You are required to:
(i) ADVISE which brand of 3D sonography machine should be acquired assuming that the use of machine
shall be continued for a period of 20 years.
(ii) STATE which of the option is most economical if machine is likely to be used for a period of 5 years?
The cost of capital of GG Labs is 12%.
The present value factor of Rs. 1 @ 12% for different years is given as under:

Year PVF Year PVF

1 0.893 9 0.361
2 0.797 10 0.322
3 0.712 11 0.287
4 0.636 12 0.257
5 0.567 13 0.229
6 0.507 14 0.205
7 0.452 0.183
8 0.404 16 0.163

Ans. Since the life span of each machine is different and time span exceeds the useful lives of each modeI, we shall
use Equivalent Annual Cost method to decide which brand should be chosen.
(i) If machine is used for 20 years

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(a) Residual value of machine of brand X

= [Rs. 15,00,000 – (1 - 0.10)] - (Rs. 15,00,000 × 0.06 × 14) = Rs. 90,000
(b) Residual value of machine of brand Y
= [Rs. 10,00,000 – (1 - 0.40)] - (Rs. 10,00,000 × 0.06 × 9) = Rs. 60,000
Present Value (PV) of cost if machine of brand X is purchased
Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)
0 15,00,000 1.000 15,00,000
1-5 50,000 3.605 1,80,250
6-10 70,000 2.046 1,43,220
11-15 98,000 1.161 1,13,778
15 (90,000) 0.183 (16,470)
19,20,778
PVAF for 1-15 years = 6.812
1920778
Equivalent Annual Cost = = Rs. 2,81,969.76
6.812
Present Value (PV) of cost if machine of brand Y is purchased
Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)
0 10,00,000 1.000 10,00,000
1-5 70,000 3.605 2,52,350
6-10 1,15,000 2.046 2,35,290
10 (60,000) 0.322 (19,320)
14,68,320
PVAF for 1-10 years = 5.651
1468320
Equivalent Annual Cost = = Rs. 2,59,833.66
5.651
Present Value (PV) of cost if machine of brand Y is taken on rent
Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)
0 2,24,000 1.000 2,24,000
1-4 2,25,000 3.038 6,83,550
5-9 2,70,000 2.291 6,18,570
15,26,120
PVAF for 1-10 years = 5.651
1526120
Equivalent Annual Cost = = Rs. 2,70,061.94
5.651
Decision: Since Equivalent Annual Cash Outflow is least in case of purchase of Machine of brand Y
the same should be purchased.
(ii) If machine is used for 5 years
(a) Scrap value of machine of brand X
= [Rs. 15,00,000 – (1 - 0.10)] - (Rs. 15,00,000 × 0.06 × 4) = Rs. 9,90,000
(b) Scrap value of machine of brand Y
= [Rs. 10,00,000 – (1 - 0.40)] - (Rs. 10,00,000 × 0.06 × 4) = Rs. 3,60,000
Present Value (PV) of cost if machine of brand X is purchased
Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)

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0 15,00,000 1.000 15,00,000

1-5 50,000 3.605 1,80,250
5 (9,90,000) 0.567 (5,61,330)
11,18,920

Present Value (PV) of cost if machine of brand Y is purchased

Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)
0 10,00,000 1.000 10,00,000
1-5 70,000 3.605 2,52,350
5 (3,60,000) 0.567 (2,04,120)
10,48,230

Present Value (PV) of cost if machine of brand Y is taken on rent

Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)
0 2,24,000 1.000 2,24,000
1-4 2,25,000 3.038 6,83,550
5 1,10,000* 0.567 62,370
9,69,920

* [Rs. 2,20,000 - (Rs. 22,000 × 5) = Rs. 1,10,000]

Decision: Since Cash Outflow is least in case of rent of Machine of brand Y the same should be
taken on rent.
Q.46 Replace Machine using NPV RTP May 22
ABC & Co. is considering whether to replace an existing machine or to spend money on revamping it. ABC & Co.
currently pays no taxes. The replacement machine costs ` 18,00,000 now and requires maintenance of `
2,00,000 at the end of every year for eight years. At the end of eight years, it would have a salvage value of `
4,00,000 and would be sold. The existing machine requires increasing amounts of maintenance each year and its
salvage value fall each year as follows:
Year Maintenance (`) Salvage (`)
Present 0 8,00,000
1 2,00,000 5,00,000
2 4,00,000 3,00,000
3 6,00,000 2,00,000
4 8,00,000 0
The opportunity cost of capital for ABC & Co. is 15%.
REQUIRED:
When should the company replace the machine?
The following present value table is given for you:
Year Present value of ` 1 at 15% discount rate
1 0.8696
2 0.7561
3 0.6575
4 0.5718
5 0.4972
6 0.4323

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7 0.3759
8 0.3269

Ans. ABC & Co.

Equivalent Annual Cost (EAC) of new machine
(`)
(i) Cost of new machine now 18,00,000
Add: PV of annual repairs @ ` 2,00,000 per annum for 8 years
(` 2,00,000  4.4873) 8,97,460
26,97,460
Less: PV of salvage value at the end of 8 years
(` 4,00,0000.3269) 1,30,760

25,66,700
Equivalent annual cost (EAC) (` 25,66,700/4.4873) 5,71,992

PV of cost of replacing the old machine in each of 4 years

with new machine
Scenario Year Cash Flow (`) PV @ 15% PV (`)

Replace Immediately 0 (5,71,992) 1.00 (5,71,992)

0 8,00,000 1.00 8,00,000
2,28,008
Replace in one year 1 (5,71,992) 0.8696 (4,97,404)
1 (2,00,000) 0.8696 (1,73,920)
1 5,00,000 0.8696 4,34,800
(2,36,524)
Replace in two years 1 (2,00,000) 0.8696 (1,73,920)
2 (5,71,992) 0.7561 (4,32,483)
2 (4,00,000) 0.7561 (3,02,440)
2 3,00,000 0.7561 2,26,830
(6,82,013)
Replace in three years 1 (2,00,000) 0.8696 (1,73,920)
2 (4,00,000) 0.7561 (3,02,440)
3 (5,71,992) 0.6575 (3,76,085)
3 (6,00,000) 0.6575 (3,94,500)
3 2,00,000 0.6575 1,31,500
(11,15,445)
Replace in four years 1 (2,00,000) 0.8696 (1,73,920)
2 (4,00,000) 0.7561 (3,02,440)
3 (6,00,000) 0.6575 (3,94,500)
4 (5,71,992) 0.5718 (3,27,065)
4 (8,00,000) 0.5718 (4,57,440)

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(16,55,365)
Advice: The company should replace the old machine immediately because the PV of cost of replacing the old
machine with new machine is least.

Q.47 Replace Machine using NPV PY May 23

Four years ago, Z Ltd. had purchased a machine of ` 4,80,000 having estimated useful life of 8 years with zero
salvage value. Depreciation is charged using SLM method over the useful life. The company want to replace this
machine with a new machine. Details of new machine are as below:
• Cost of new machine is ` 12,00,000, Vendor of this machine is agreed to take old machine at a value of `
2,40,000. Cost of dismantling and removal of old machine will be ` 40,000. 80% of net purchase price will
be paid on spot and remaining will be paid at the end of one year.
• Depreciation will be charged @ 20% p.a. under WDV method.
• Estimated useful life of new machine is four years and it has salvage value of ` 1,00,000 at the end of year
four.
• Incremental annual sales revenue is ` 12,25,000.
• Contribution margin is 50%.
• Incremental indirect cost (excluding depreciation) is ` 1,18,750 per year.
• Additional working capital of ` 2,50,000 is required at the beginning of year and ` 3,00,000 at the beginning
of year three. Working capital at the end of year four will be nil.
• Tax rate is 30%.
• Ignore tax on capital gain.
Z Ltd. will not make any additional investment, if it yields less than 12% Advice, whether existing machine
should be replaced or not.
Year 1 2 3 4 5
PVIF0.12, t 0.893 0.797 0.712 0.636 0.567

Ans. Working Notes:

(i) Calculation of Net Initial Cash Outflow
Particulars `

Cost of New Machine 12,00,000

Less: Sale proceeds of existing machine 2,00,000
Net Purchase Price 10,00,000
Paid in year 0 8,00,000
Paid in year 1 2,00,000

(ii) Calculation of Additional Depreciation

1 2 3 4
Year ` ` ` `
Opening WDV of machine 10,00,000 8,00,000 6,40,000 5,12,000
Depreciation on new machine @ 20% 2,00,000 1,60,000 1,28,000 1,02,400
Closing WDV 8,00,000 6,40,000 5,12,000 4,09,600
Depreciation on old machine 60,000 60,000 60,000 60,000
(4,80,000/8)
Incremental depreciation 1,40,000 1,00,000 68,000 42,400

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(iii) Calculation of Annual Profit before Depreciation and Tax (PBDT)

Particulars Incremental Values (`)

Sales 12,25,000
Contribution 6,12,500
Less: Indirect Cost 1,18,750
Profit before Depreciation and Tax (PBDT) 4,93,750
Calculation of Incremental NPV
Year PVF @ PBTD (`) Incremental PBT (`) Tax @ Cash Inflows PV of Cash Inflows
12% Depreciation (`) 30% (`) (`) (`)

(1) (2) (3) (4) (5) = (4) x (6) = (4) – (5) (7) = (6) x (1)
0.30 + (3)

1 0.893 4,93,750 1,40,000 3,53,750 106,125 3,87,625 3,46,149.125

2 0.797 4,93,750 1,00,000 3,93,750 1,18,125 3,75,625 2,99,373.125

3 0.712 4,93,750 68,000 4,25,750 1,27,725 3,66,025 2,60,609.800

4 0.636 4,93,750 42,400 4,51,350 1,35,405 3,58,345 2,27,907.420

* * 11,34,039.470

Add: PV of Salvage (` 1,00,000 x 0.636) 63,600

Less: Initial Cash Outflow - Year 0 8,00,000

Year 1 (` 2,00,000 × 0.893) 1,78,600

Less: Working Capital - Year 0 2,50,000

Year 2 (` 3,00,000 × 0.797) 2,39,100

Add: Working Capital released - Year 4 (` 5,50,000 × 0.636) 3,49,800

Incremental Net Present Value 79,739.470
Since the incremental NPV is positive, existing machine should be replaced.
Alternative Presentation
Computation of Outflow for new Machine:
`
Cost of new machine 12,00,000
Replaced cost of old machine 2,40,000
Cost of removal 40,000
Net Purchase price 10,00,000
Outflow at year 0 8,00,000
Outflow at year 1 2,00,000
Computation of additional deprecation
Year 1 2 3 4
` ` ` `
Opening WDV of machine 10,00,000 8,00,000 6,40,000 5,12,000
Depreciation on new machine @ 20% 2,00,000 1,60,000 1,28,000 1,02,400
Closing WDV 8,00,000 6,40,000 5,12,000 4,09,600
Depreciation on old machine 60,000 60,000 60,000 60,000

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(4,80,000/8)
Incremental depreciation 1,40,000 1,00,000 68,000 42,400

Computation of NPV
0 1 2 3 4
Year ` ` ` ` `
1. Increase in sales revenue 12,25,000 12,25,000 12,25,000 12,25,000
2. Contribution 6,12,500 6,12,500 6,12,500 6,12,500
3. Increase in fixed cost 1,18,750 1,18,750 1,18,750 1,18,750
4. Incremental Depreciation 1,40,000 1,00,000 68,000 42,400
5. Net profit before tax 3,53,750 3,93,750 4,25,750 4,51,350
[1-(2+3+4)]
6. Net Profit after tax 2,47,625 2,75,625 2,98,025 3,15,945
(5 x 70%)
7. Add: Incremental 1,40,000 1,00,000 68,000 42,400
depreciation
8. Net Annual cash inflows 3,87,625 3,75,625 3,66,025 3,58,345
(6 + 7)

9. Release of salvage value 1,00,000

10. (investment)/disinvestment in (2,50,000) (3,00,000) 5,50,000
working capital

11. Initial cost (8,00,000) (2,00,000)

12. Total net cash flows (10,50,000) 1,87,625.0 75,625 3,66,025 10,08,345
13. Discounting Factor 1 0.893 0.797 0.712 0.636
14. Discounted cash flows (10,50,000) 1,67,549.125 60,273.125 2,60,609.800 641307.420
(12 x 13)
NPV = (1,67,549 + 60,273 + 2,60,610 + 6,41,307) - 10,50,000 = ` 79,739
Since the NPV is positive, existing machine should be replaced.

Q.48 Replace Machine using NPV PY July 21

An exis ting company has a machine which has been in operation for two years, its estimated remaining useful life
is 4 years with no residual value in the end. Its current market value is ` 3 lakhs. The management is considering
a proposal to purchase an improved model of a machine gives increase output. The details are as under:
Particulars Existing Machine New Machine
Purchase Price ` 6,00,000 ` 10,00,000
Estimated Life 6 years 4 years
Residual Value 0 0
Annual Operating days 300 300
Operating hours per day 6 6
Selling price per unit ` 10 ` 10

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Material cost per unit `2 `2

Output per hour in units 20 40
Labour cost per hour ` 20 ` 30
Fixed overhead per annum excluding depreciation ` 1,00,000 ` 60,000
Working Capital ` 1,00,000 ` 2,00,000
Income-tax rate 30% 30%
Assuming that - cost of capital is 10% and the company uses written down value of depreciation @ 20% and it
has several machines in 20% block.
Advice the management on the Replacement of Machine as per the NPV method. The discounting factors table
given below:
Discounting Factors Year 1 Year 2 Year 3 Year 4
10% 0.909 0.826 0.751 0.683

Ans. (i) Calculation of Net Initial Cash Outflows:

Particulars `
Purchase Price of new machine 10,00,000
Add: Net Working Capital 1,00,000
Less: Sale proceeds of existing machine 3,00,000
Net initial cash outflows 8,00,000

(ii) Calculation of annual Profit Before Tax and depreciation

Particulars Existing machine New Machine Differential

(1) (2) (3) (4) = (3) – (2)

Annual output 36,000 units 72,000 units 36,000 units

` ` `

(A) Sales revenue @ ` 10 per unit 3,60,000 7,20,000 3,60,000

(B) Cost of Operation

Material @ ` 2 per unit 72,000 1,44,000 72,000

Labour

Old = 1,800  ` 20 36,000

New = 1,800  ` 30 54,000 18,000

Fixed overhead excluding depreciation 1,00,000 60,000 (40,000)

Total Cost (B) 2,08,000 2,58,000 50,000

Profit Before Tax and depreciation 1,52,000 4,62,000 3,10,000

(PBTD) (A – B)

(iv) Calculation of Net Present value on replacement of machine

Year PBTD Depreciati on PBT Tax @ PAT Net cash PVF @ PV
@ 20% WDV 30% flow 10%
(1) (2) (3) (4 = 2-3) (5) (6 = 4-5) (7 = 6 + 3) (8) (9 = 7 x 8)
1 3,10,000 1,40,000 1,70,000 51,000 1,19,000 2,59,000 0.909 2,35,431.000

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2 3,10,000 1,12,000 1,98,000 59,400 1,38,600 2,50,600 0.826 2,06,995.600

3 3,10,000 89,600 2,20,400 66,120 1,54,280 2,43,880 0.751 1,83,153.880
4 3,10,000 71,680 2,38,320 71,496 1,66,824 2,38,504 0.683 1,62,898.232
7,88,478.712
Add: Release of net working capital at year end 4 (1,00,000 x 0.683) 68,300.000
Less: Initial Cash Outflow 8,00,000.000
NPV 56,778.712
Advice: Since the incremental NPV is positive, existing machine should be replaced.
Working Notes:
1. Calculation of Annual Output
Annual output = (Annual operating days x Operating hours per day) x output per hour
Existing machine = (300 x 6) x 20 = 1,800 x 20 = 36,000 units
New machine = (300 x 6) x 40 = 1,800 x 40 = 72,000 units
2. Base for incremental depreciation
Particulars `

WDV of Existing Machine

Purchase price of existing machine 6,00,000
Less: Depreciation for year 1 1,20,000
Depreciation for Year 2 96,000 2,16,000
WDV of Existing Machine (i) 3,84,000

Depreciation base of New Machine

Purchase price of new machine 10,00,000

Add: WDV of existing machine 3,84,000

Less: Sales value of existing machine 3,00,000

Depreciation base of New Machine (ii) 10,84,000
Base for incremental depreciation [(ii) – (i)] 7,00,000

(Note: The above solution have been done based on incremental approach) Alternatively, solution can
be done based on Total Approach as below:
(i) Calculation of depreciation:
Existing Machine

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

Opening balance 6,00,000 4,80,000 3,84,000 3,07,200 2,45,760 1,96,608.00

Less: Depreciation @ 20% 1,20,000 96,000 76,800 61,440 49,152 39,321.60

WDV 4,80,000 3,84,000 3,07,200 2,45,760 1,96,608 1,57,286.40

New Machine
Year 1 Year 2 Year 3 Year 4
Opening balance 10,84,000* 8,67,200 6,93,760 5,55,008.00
Less: Depreciation @ 20% 2,16,800 1,73,440 1,38,752 1,11,001.60

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WDV 8,67,200 6,93,760 5,55,008 4,44,006.40

* As the company has several machines in 20% block, the value of Existing Machine from the block
calculated as below shall be added to the new machine of ` 10,00,000:
WDV of existing machine at the beginning of the year ` 3,84,000
Less: Sale Value of Machine ` 3,00,000
WDV of existing machine in the block ` 84,000
Therefore, opening balance for depreciation of block = ` 10,00,000 + ` 84,000 = ` 10,84,000
(ii) Calculation of annual cash inflows from operation:
Particulas EXISTING MACHINE
Year 3 Year 4 Year 5 Year 6
Annual output (300 operating 36,000 units 36,000 units 36,000 units 36,000 units
Days x 6 operating hours x 20
output per hour)
` ` ` `
(A) Sales revenue @`10 per unit 3,60,000.00 3,60,000.00 3,60,000.00 3,60,000.00
(B) Less: Cost of Operation
Material @ ` 2 per unit 72,000.00 72,000.00 72,000.00 72,000.00
Labour @ ` 20 per hour for (300 x
6) hours 36,000.00 36,000.00 36,000.00 36,000.00
Fixed overhead 1,00,000.00 1,00,000.00 1,00,000.00 1,00,000.00
Depreciation 76,800.00 61,440.00 49,152.00 39,321.60
Total Cost (B) 2,84,800.00 2,69,440.00 2,57,152.00 2,47,321.60
Profit Before Tax (A – B) 75,200.00 90,560.00 1,02,848.00 1,12,678.40
Less: Tax @ 30% 22,560.00 27,168.00 30,854.40 33,803.52
Profit After Tax 52,640.00 63,392.00 71,993.60 78,874.88
Add: Depreciation 76,800.00 61,440.00 49,152.00 39,321.60
Capital 1,00,000.00
Annual Cash Inflows 1,29,440.00 1,24,832.00 1,21,145.60 2,18,196.48

Particulars NEW MACHINE

Year 1 Year 2 Year 3 Year 4
Annual output (300 operating 72,000 72,000 72,000 72,000
days x 6 operating hours x units units units units
40 output per hour)
` ` ` `
(A) Sales revenue @ `10 per 7,20,000.00 7,20,000.00 7,20,000.00 7,20,000.00
unit
(B) Less: Cost of Operation
Material @ ` 2 per unit 1,44,000.00 1,44,000.00 1,44,000.00 1,44,000.00
Labour @ ` 30 per hour for 54,000.00 54,000.00 54,000.00 54,000.00
(300 x 6) hours
Fixed overhead 60,000.00 60,000.00 60,000.00 60,000.00

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Depreciation 2,16,800.00 1,73,440.00 1,38,752.00 1,11,001.60

Total Cost (B) 4,74,800.00 4,31,440.00 3,96,752.00 3,69,001.60
Profit Before Tax (A – B) 2,45,200.00 2,88,560.00 3,23,248.00 3,50,998.40
Less: Tax @ 30% 73,560.00 86,568.00 96,974.40 1,05,299.52
Profit After Tax 1,71,640.00 2,01,992.00 2,26,273.60 2,45,698.88
Add: Depreciation 2,16,800.00 1,73,440.00 1,38,752.00 1,11,001.60
Add: Release of Working
Capital 2,00,000.00
Annual Cash Inflows 3,88,440.00 3,75,432.00 3,65,025.60 5,56,700.48

(iii) Calculation of Incremental Annual Cash Flow:

Particulars Year 1 (`) Year 2 (`) Year 3 (`) Year 4 (`)
Existing Machine (A) 1,29,440.00 1,24,832.00 1,21,145.60 2,18,196.48

New Machine (B) 3,88,440.00 3,75,432.00 3,65,025.60 5,56,700.48

Incremental Annual 2,59,000.00 2,50,600.00 2,43,880.00 3,38,504.00

Cash Flow (B – A)

(iv) Calculation of Net Present Value on replacement of machine:

Year Incremental Annual Cash Discounting factor @ Present Value of
Flow (`) (A) 10% (B) Incremental Annual Cash
Flow (`) (A x B)
1 2,59,000.00 0.909 2,35,431.000
2 2,50,600.00 0.826 2,06,995.600
3 2,43,880.00 0.751 1,83,153.880
4 3,38,504.00 0.683 2,31,198.232
Total Incremental Inflows 8,56,778.712
Less: Net Initial Cash Outflows (Working note) 8,00,000.000
Incremental NPV 56,778.712
Advice: Since the incremental NPV is positive, existing machine should be replaced.
Working Note:
Calculation of Net Initial Cash Outflows:
Particulars `
Cost of new machine 10,00,000
Less: Sale proceeds of existing machine 3,00,000
Add: incremental working capital required (` 2,00,000 – ` 1,00,000) 1,00,000
Net initial cash outflows 8,00,000

Q.49 Replace Machine using NPV RTP Dec 21

HMR Ltd. is considering replacing a manually operated old machine with a fully automatic new machine. The old
machine had been fully depreciated for tax pu rpose but has a book value of ` 2,40,000 on 31st March 2021. The
machine has begun causing problems with breakdowns and it cannot fetch more than ` 30,000 if sold in the market
at present. It will have no realizable value after 10 years. The company has been offered ` 1,00,000 for the old
machine as a trade in on the new machine which has a price (before allowance for trade in) of ` 4,50,000. The
expected life of new machine is 10 years with salvage value of ` 35,000.

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Further, the company follows straight line depreciation method but for tax purpose, written down value method
depreciation @ 7.5% is allowed taking that this is the only machine in the block of assets.
Given below are the expected sales and costs from both old and new machine:
Old machine (`) New machine (`)
Sales 8,10,000 8,10,000
Material cost 1,80,000 1,26,250
Labour cost 1,35,000 1,10,000
Variable overhead 56,250 47,500
Fixed overhead 90,000 97,500
Depreciation 24,000 41,500
PBT 3,24,750 3,87,250
Tax @ 30% 97,425 1,16,175
PAT 2,27,325 2,71,075
From the above information, ANALYSE whether the old machine should be replaced or not if required rate of
return is 10%? Ignore capital gain tax.
PV factors @ 10%:
Year 1 2 3 4 5 6 7 8 9 10
PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

Ans. Workings:
1. Calculation of Base for depreciation or Cost of New Machine
Particulars (`)
Purchase price of new machine 4,50,000
Less: Sale price of old machine 1,00,000
3,50,000
2. Calculation of Profit before tax as per books
Particulars Old machine New machine Difference
(`) (`) (`)
PBT as per books 3,24,750 3,87,250 62,500
Add: Depreciation as per books 24,000 41,500 17,500

Profit before tax and 3,48,750 4,28,750 80,000

depreciation (PBTD)

Calculation of Incremental NPV

Year PVF PBTD (`) Dep. @ PBT (`) Tax @ 30% (`) Cash Inflows PV of Cash
@ 10% 7.5% (`) (`) Inflows (`)

(1) (2) (3) (4) (5) = (4) x 0.30 (6) = (4) – (5) (7) = (6) x (1)
+ (3)
1 0.909 80,000.00 26,250.00 53,750.00 16,125.00 63,875.00 58,062.38
2 0.826 80,000.00 24,281.25 55,718.75 16,715.63 63,284.38 52,272.89
3 0.751 80,000.00 22,460.16 57,539.84 17,261.95 62,738.05 47,116.27
4 0.683 80,000.00 20,775.64 59,224.36 17,767.31 62,232.69 42,504.93
5 0.621 80,000.00 19,217.47 60,782.53 18,234.76 61,765.24 38,356.21

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6 0.564 80,000.00 17,776.16 62,223.84 18,667.15 61,332.85 34,591.73

7 0.513 80,000.00 16,442.95 63,557.05 19,067.12 60,932.88 31,258.57
8 0.467 80,000.00 15,209.73 64,790.27 19,437.08 60,562.92 28,282.88
9 0.424 80,000.00 14,069.00 65,931.00 19,779.30 60,220.70 25,533.58
10 0.386 80,000.00 13,013.82 66,986.18 20,095.85 59,904.15 23,123.00
3,81,102.44
Add: PV of Salvage value of new machine (` 35,000  0.386) 13,510.00
Total PV of incremental cash inflows 3,94,612.44
Less: Cost of new machine 3,50,000.00
Incremental Net Present Value 44,612.44
Analysis: Since the Incremental NPV is positive, the old machine should be replaced.

Q.50 Which Finance to choose RTP Nov 18

XYZ Ltd. requires an equipment costing `50,00,000; the same will be utilized over a period of 5 years. It has two
financing options in this regard:
(i) Arrangement of a loan of `50,00,000 at an interest rate of 14 percent per annum; the loan being repayable
in 5 equal year end instalments; the equipment can be sold at the end of fifth year for `5,00,000.
(ii) Leasing the equipment for a period of five years at an early rental of `16,50,000 payable at the year end.
The rate of depreciation is 15 percent on Written Down Value (WDV) basis, income tax rate is 35 percent
and discount rate is 12 percent.
ADVISE which of the financing options should XYZ Ltd. exercise and why?

Ans. Option A
The loan amount is repayable together with the interest at the rate of 14% on loan amount and is repayable in
equal instalments at the end of each year. The PVAF at the rate of 14% for 5 years is 3.432, the amount payable
will be
5000000
Annual Payment = = `14,56,876
3.432
Schedule of Debt Repayment
End of year Total Payment (`) Interest (`) Principal (`) Principal amount
outstanding (`)
1 14,56,876 7,00,000 7,56,876 42,43,124
2 14,56,876 5,94,037 8,62,839 33,80,285
3 14,56,876 4,73,240 9,83,636 23,96,649
4 14,56,876 3,35,531 11,21,345 12,75,304
5 14,56,876 1,81,572* 12,75,304 0
*Balancing Figure
Schedule of Cash Outflows: Debt Alternative (Amount in `)
End of Debt Payment Interest Depreciation Total Tax Shield Cash PV factor Present Value
year Outflows @12%

1 14,56,876 7,00,000 7,50,000 14,50,000 5,07,500 9,49,376 0.893 8,47,793

2 14,56,876 5,94,037 6,37,500 12,31,537 4,31,038 10,25,838 0.797 8,17,593
3 14,56,876 4,73,240 5,41,875 10,15,115 3,55,290 11,01,586 0.712 7,84,329

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4 14,56,876 3,35,531 4,60,594 7,96,125 2,78,644 11,78,232 0.636 7,49,356

5 14,56,876 1,81,572 3,91,505 5,73,077 2,00,577 12,56,299 0.567 7,12,322

39,11,393

Less: PV of Salvage Value (12,57,904)

26,53,489
Total present value of Outflows = ` 26,53,489

Option B
Lease Rent `16,50,000
Tax Shield (5,77,500)
Outflow 10,72,500 × 3.605 = `38,66,363
Since PV of outflows is lower in the Borrowing option, XYZ Ltd. should avail of the loan and purchase the
equipment.

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