FM PDF

Inspire Academy ( 888888 1719) Chapter 1 : LEVERAGE
1 LEVERAGE
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FM with RAJ AWATE – Amazing journey of logic and concepts ------------------------
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Types of leverage
Operating leverage Financial leverage Combined leverage
FIXED COSTS
Fixed cots
Operating fixed cost e.g. salary, Financial fixed cost e.g., interest,
insurance, rent, etc. preference dividend.
❖ OPERATING LEVERAGE :
(a) Definition: operating leverage is defined is defined as the “firm’s ability

to use fixed operating costs to magnify effects of changes in sales on its
earnings before interest and taxes.”
FM with RAJ AWATE – Amazing journey of logic and concepts

❖ FINANCIAL LEVERAGE :
(a) Meaning: financial leverage is defined as the ability of a firm to use fixed
financial charges (interest) to magnify the effect of changes in E.B.I.T/
Operating profits on the firm’s earning per share (EPS).
❖ WHEN IS A FIRM SAID TO BE FIANCIALLY FAVOURABLY

LEVERAGED :
To determine whether the degree of financial leverage is favourable or

not, the return on capital employed (ROCE) should be compared with rate
of interest on debt.
1. When ROCE greater than interest rate:

DFL is considered to be favourable or advantageous to the firm,
when it earns more on its to total investment than what is pays
towards debt capital. In other words. DFL is advantageous only if
return on capital employed (ROCE) is greater than rate of interest on
debt.
This is because shareholders gain in a situation where the company
earns a high rate of return and pays a lower rate of return to the

supplier of long term debt funds. Financial leverage in such cases is

therefore also called trading on equity.
The difference, between the return (EBIT) and the cost of the debt
funds would enhance the earnings of shareholders. Further, in case
of debt funds the interest cost also tax deductible.
2. When ROCE is less than interest rate:

Where the rate of return on investment falls below the rate of interest
the shareholders suffer because their earnings fall more sharply than
the fall in the return on investment. This is because fixed interest
costs have to be met, irrespective of the level of EBIT. In such cases,
a high DFL is disadvantageous; in fact, the use of debt funds
involving fixed commitment of interest rate on debt, DFL should be
maintained low.
3. Conclusion: DFL should be high when return on capital employed

(ROCE) is greater than interest rate on debt, if ROCE is less than
interest rate on debt, DFL should be maintained low.
❖ COMBINED LEVERAGE :
(a) Meaning: combined leverage is used to measure the total risk of a firm
i.e. operating risk and financial Risk.
(b) Explanation: effect of fixed operating costs (i.e. operating risks) is

measured by operating leverage (DOL). Effect of fixed interest charges
(i.e. financial risks) is measured by financial leverage (DFL). The
combined effect of these is measured by combined leverage (DCL).
(c) Measurement : the degree of combined leverage (DCL) is measured as

DOL × DFL
Therefore,
𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
DCL = 𝐸𝐵𝑇
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
= 𝑝𝑟𝑒𝑓.𝐷𝑖𝑣
𝐸𝐵𝐼𝑇−𝐼𝑛𝑡−
𝐼−𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
(d) Significance: DOL measures impact of change in sales on EBIT. DFL

measures the impact of change in EBIT on EPS; DCL measures the

combined impact, l.e. effect of change in sales on EPS. IF DCL is 2 times.

It implies that a 10% increase in sales will lead to 20% increase in EPS.

PROBLEMS
❖ BASIC PROBLEMS :
1. Sales 1,00,000 units @ Rs. 2 per unit

Variable cost per unit = 0.70
Fixed cost = Rs. 1,00,000
Interest = 3,668
Find
a)Degree of operating leverage
b) Degree of financial leverage
c) combined leverage
solution :
2. A firm has sales of 10, 00, 000 variable cost of Rs. 7, 00, 000 and fixed cost
of Rs. 2, 00, 000 and debt of Rs. 5, 00, 000 at 10% rate of interest. What
are the operating, financial and combined leverages? If the firm wants to
double its earnings before interest and tax (EBIT), how much of a rise in
sales would be needed on a percentage basis?
Solution :

3. A firm has sales of Rs. 50 Lakhs, Variable costs of Rs. 35 Lakhs, Fixed Cost
of Rs. 7 lakhs, 10% Debt of Rs. 30 Lakhs, and Equity Capital of Rs. 55
Lakhs. Calculate Operating and Financial leverage
Solution :
4. The following information is available for ABC& co.

EBIT Rs. 11, 20, 000
Profit before tax 3, 20, 000
Fixed costs 7, 00, 000
Calculate % change in EPS if the sales are expected to increase by 5%
Solution :

5. X Corporation has estimated that for a new product its break-even point is
2,000 units if the item is sold for Rs. 14 per unit; the cost accounting
department has currently identified variable cost of Rs. 9 per unit. Calculate
the degree of operating leverage for sales volume of 2, 500 units and 3,000
units. What do you infer from the degree of operating leverage at the sales
volumes of 2,500 units and 3, 000 units and difference if any?
Solution :
6.
Particulars A B C

66.666 75 50
Variable cost as
% of sales
200 300 1000
Interest expense
5 6 2
DOL
3 4 2
DFL
35% 35% 35%
Tax rate
Prepare income statement for the company A , B & C.
Solution :

7. Balance sheet of ABC ltd is given below :
Liability Rs. Asset Rs.
60,000 Net fixed asset 1,50,000

Equity share Current asset 50,000
capital ( Rs. 10 80,000
each) 20,000
10% long term 40,000
debt
Retained earning
Current liability
Company’s total asset turnover ratio is 3. Its fixed operating cost are Rs.
1,00,000.
Variable cost ratio is 40 %. Tax rate is 35%.
a) Calculate all type of leverage
b) Determine likely level of EBIT if EPS is i) Rs.1 ii) Rs. 3 iii)
zero

1. Match the pair

a. Operating Leverage a. EBIT / EBT
b. Financial Leverage b. DOL x DFL
c. Combined Leverage c. Contribution / EBIT
a. (a-c), (b-a), (c-b)
b. (a-b), (c-a), (b-c)
c. (c-b), (a-c), (b-b)
d. None
2. Match the pair
1. Operating Variable Cost a. Rent
2. Operating Fixed Cost b. Interest on Debentures
3. Financial fixed cost c. Material
a. (1-b), (2-c) , (3-a)
b. (1-a), (3-c), (2-b)
c. (3-b), (1-c), (2-a)
d. None
3. The Term operating Leverage is defined as ………….
a. The firm’s ability to use fixed operating cost to magnify the effect of
change in sales on its earnings before interest and taxes
b. The firm’s ability to use fixed operating cost to magnify the effect of
change in Fixed operating cost on its earnings before interest and
taxes
c. The firm’s ability to use variable operating cost to magnify the effect
of change in Fixed operating cost on its earnings before interest and
taxes
d. None.
4. What it implies if DOL is 2 times-

a. If 1% change in sales will lead to 2% change in EBIT.

b. If 2% change in sales will lead to 2% change in EBIT.
c. If 1% change in sales will lead to 1% change in EBIT.
d. All of the above.
5. If fixed cost is………………, DOL will be……………..and Vice versa.
a. Higher, Lower
b. Lower, Higher
c. Higher, Higher
d. None
6. Identify the which of the following is correct statement.
a. If fixed cost is low, the break-even point would be low hence margin
of safety and profit would be high.
b. If fixed cost is high, the break-even point would be low hence margin
of safety and profit would be high.
c. If fixed cost is low, the break-even point would be high hence margin
of safety and profit would be low.
7. The financial leverage is defined as –
a. The ability of firm to use fixed financial cost to magnify the effect of
change in EBIT on earning per shares.
b. The ability of firm to use fixed operating cost to magnify the effect of
change in EBIT on earning per shares.
c. The ability of firm to use fixed financial cost to magnify the effect of
change in EBIT on earning before tax.
8. The financial leverage occurs when company has …………… content in its
capital structure and …………… financial charges.
a. Debt, Variable
b. Equity, Fixed
c. Debt, Fixed
d. Equity, Variable
9. Identify correct statement -
a. Financial leverage is considered as indicator of financial risk.
b. Operating leverage is considered as indicator of financial risk.
c. Combined leverage is considered as indicator of financial risk.
d. all of the above
10. The following information is available for ABC & Co

EBIT= Rs. 11,20,000
PBT = 3,20,000
Fixed Costs =7,00,000

Calculate % change in EPS if the sales are expected to increase by 5%

a. 28.4375% b. 28% c. 25% d. None
11. X Corporation has estimated that for a new product its break-even point is
2000 units if the item sold for Rs. 14 per unit, the cost accounting
department has currently identified variable cost of Rs. 9 per unit. Calculate
the degree of operating leverage for sales volume of Rs. 2500 units.
a. 6 b. 4 c. 5 d. None
12. A Firm has total capital of Rs. 12 Lakhs with debt equity ratio of 2:1, its DFL
is 1.67 times.
If interest on debt is Rs. 1.2 Lakhs, find out EAT if Tax rate is 40%
a. 1.2 Lakhs b. 2.1 Lakhs c. 1 Lakhs d. None
13. The following details of Alpha Ltd for the year ended 2010 are furnished:
Financial Leverage 2:1

Operating Leverage 3:1

Interest charges per annum – Rs. 20 Lakh
Corporate tax rate - 40%
Variable cost as percentage of sales -60%
Calculate DOL, DFL & DCL.
a. DOL-6, DFL-2 & DCL- 3
b. DCL- 6, DOL-3 & DFL-2
c. DOL-3, DFL-2 & DCL-6
d. None.
14. The net sales of A Ltd is Rs. 30 Crores. Earnings before interest and tax of
the company as a percentage of net sales is 12%. The capital employed
comprises Rs. 10 crores of equity , Rs. 2 crores of 13% cumulative
preference share capital and 15% debentures of Rs. 6 crores.Income tax
rate is 40%
1) Calculate the return on equity capital.
a. 13.6% b. 14.6% c. 12% d. None


Page 1
INSPIRE Academy ( 888881719) Chapter 2 : INVENTORY MANAGEMENT 2.1
2 INVENTORY
MATERIAL
MANAGEMENT
1. WHAT IS ECONOMIC ORDER QUANTITY ( EOQ )
size of order which should be placed so that overall cost is minimum.
2 ×Annual requirement ×cost per order

EOQ = √ carrying cost p.u.p.a.
Chart :
Annual ordering cost = cost per order * Number of orders

Where, number of orders = AR / order
size
Annual carrying cost = carrying cost p.u.pa. * Average inventory

Where, average inventory = order size /2
Costing by Raj Awate – Amazing journey of logic and concept

Page 2
2. WHAT IS INVENTORY LEVEL
Reorder level
• It shows level of stock at which order must be placed.
( ROL) :
• = Maximum lead time * Maximum consumption rate

• = Safety stock + Avg lead time * Avg consumption rate
ROL
Minimum • = ROL– Avg lead time * Avg consumption rate

level
• = ROL + ROQ – Min lead time time * Min

Maximum consumption rate
level
• = (maximum level + minimum level) / 2

Average
level • = minimum level + (ROQ/2)
Danger • = emergency lead time * normal consumption

level rate

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3. TECHNIQUES OF INVENTORY CONTROL:
(i) Min-max Plan

(ii) The Two-bin System
(iii) Order Cycling System
iv) ABC Analysis
(v) Fixation of various levels
(vi) Use of Perpetual Inventory System and Continuous Verifications
4. CLASSIFICATION OF COST
(vii) Use of Control Ratios
(viii) Review of Slow and Non-moving Items
5. BILL OF MATERIAL
- A document which shows complete list of all materials & components, parts required
for a particular job including small items like nuts , bolts, screws etc is called as bill of
material
- Used for production of new product
6. BIN CARD VS STORE LEDGER
7. ABC ANALYSIS
IMPORTANT TECHNIQUE OF INVENTORY CONTROL ON SELECTIVE BASIS.

Category % in total % in total Extent of control
value quantity
A 70% 10% Constant and strict control
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B 20% 20% Need periodic review not strict as

excessive.
C 10% 70% Little control

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QUESTION 1.
A Company manufactures a special product which requires a component ‘Alpha’. The

following particulars are collected for the year 2013:
(i) Annual demand of Alpha : 8,000 units
(ii) Cost of placing an order : ` 200 per order
(iii) Cost per unit of Alpha : ` 400
(iv) Carrying cost % p.a. : 20%
Required: Compute the economic order quantity.
Solution :
QUESTION 2.
The following information relating to a type of Raw material is available:
Annual demand 2,000 units
Unit price ₹ 20.00
Ordering Cost per order ₹ 20.00
Storage Cost 2% p.a.
Interest rate 8% p.a.
Lead time Half- month
Calculate economic order quantity and total annual inventory cost of the raw material.
Solution:
2×Annual demand ×Cost per order

EOQ =√ Storage Cost per unit per annum

Page 6
Total Annual Inventory Cost
Purchasing cost
Ordering Cost
Carrying Of inventory
QUESTION 3.
KL Limited produces product 'M' which has a quarterly demand of 8,000 units. The product
requires 3 kg. quantity of material 'X' for every finished unit of product. The other information
are follows:
Cost of material 'X' : ` 20 per kg.
Cost of placing an order : ` 1,000 per order
Carrying Cost : 15% per annum of average inventory
You are required:
(i) Calculate the Economic Order Quantity for material 'X'.
Solution:
Annual demand of material ‘X’
(i) Calculation of Economic Order Quantity (EOQ) of Material ‘X’

2 × Annual Demand × Ordering Cost
EOQ = √
Carrying Cost per unit per annum

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QUESTION 4.
The following information is available in respect of a material of HLL Ltd.:

Re - order quantity 12,000 units
Lead time I 4 to 8 weeks
Maximum consumption 4,000 units per week
Normal consumption 3,000 units per week
Minimum consumption 1,550 units per week
Ascertain the following from the above information: (a) Re
- order level, (b) Minimum stock level, (C) Maximum stock
level.
QUESTION 5.
PQR Ltd., manufactures a special product, which requires ‘ZED’. The following particulars
were collected for the year 2013-14:
(i) Monthly demand of Zed : 3,000 units
(ii) Cost of placing an order : ₹ 500
(iii) Re-order period : 5 to 8 weeks
(iv) Cost per unit : ₹ 60
(v) Carrying cost p.a. : 10%
(vi) Normal usage : 500 units per week
(vii) Minimum usage : 250 units per week
(viii) Maximum usage : 750 units per week
Required:
(i) Re-order quantity.
(ii) Re-order level.
(iii) Minimum stock level.
(iv) Maximum stock level.
(v) Average stock level.
Solution:
2AO
i) Re- order quantity = √ c×i

Page 8
=
=
ii) Re- order level

= Maximum re-order period × Maximum usage
=
iii) Minimum stock level
= Re-order level – { Normal usage × Normal re- order period}
=
iv) Maximum Stock level
= Re-order level + Re- order quantity – (minimum usage × Minimum re-order
period)
=
v) Average stock level
=1/2 (Minimum stock + Maximum stock level)
=

3 DIVIDEND POLICY
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THEORIES OF DIVIDEND POLICY ----------------------
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Theories of Dividend ----------------------
Policy ----------------------
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Modigliani and ----------------------
Walter's Model Gordon's Model
Miller Approach ----------------------
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Walter’s Model Assumption: ----------------------
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1) All investment proposals of the firm are to be financed through retained earnings only and no
external finance is available to the firm.
2) The business-risk complexion of the firm remains same even after fresh investment decisions are
taken. In other words, the rate of return on investment i.e., ‘r’ and the cost of capital of the firm i.e.,
ke, are constant.
3) The firm has an infinite life.
This model considers that the investment decision and dividend decision of a firm are inter-related. A
firm should or should not pay dividends depends upon whether it has got the suitable investment
opportunities to invest the retained earnings or not.
Thus, a firm can maximize the market value of its share and the value of the firm by adopting a dividend
policy as follows:
i) If r > ke, the pay-out ratio should be zero (i.e., retention of 100% profit).
ii) If r < ke, the pay-out ratio should be 100% and the firm should not retain any profit.
iii) If r = ke, the dividend is irrelevant, and the dividend policy is not expected to affect the
market value of the share.
In order to testify the above. Walter has suggested a mathematical valuation model i.e.
Market price of Equity share :
R
𝐷+ (𝐸 − 𝐷)
P0 = Ke
𝐾𝑒
Where,
Po = Market price of Equity share.

D = Dividend per share paid by the Firm.
R = Rate of return on investment of the Firm.
Ke = Cost of Equity share capital
E = Earnings per share of the Firm.
Thus, the Walter’s formula shows that the market value of a share is the present value of the expected
stream of dividends and capital gains.
1) GORDON’S MODEL:
Meaning: Myron Gordon has also proposed a model suggesting that the dividend policy is relevant and
can affect the value of the share and that of the firm. In this model, the current ex-dividend at the amount
which shareholders expected date of return exceeds the constant growth rate of dividends.
Gordon’s Model Assumption:

This model is also based on the assumptions similar to that made in Walter’s model. However, two
additional assumptions made by this model:
1) The firm is an all equity firm, and it has no debt.

2) No external financing is used, and investment programs are financed exclusively by retained earnings.
3) The internal rate of return, r, of the firm is constant.
4) The appropriate discount rate, ke, for the firm remains constant.
5) The firm has perpetual life.
6) The retention ratio, b, once decided upon, is constant. Thus, the growth rate, g = br, is also constant.
7) The discount rate is greater than the growth rate, ke > br.
Market price of Equity share:

𝐸 (1 − b)
P0 =
𝐾𝑒 − 𝑔
Where,
Po = Market price of Equity share.

E = Earnings per share of the Firm.
B = Retention Ration (1 – Payout ratio),
R = Rate of return on Investment of the Firm.
Ke = Cost of Equity share capital, and
Br = g i.e., Growth rate of the firm.
This model shows that there is a relationship between pay-out ratio (i.e., 1 b), cost of capital Ke, rate
of return r, and the market value of the share.
2) MODIGLIANI AND MILLER APPROACH:
Meaning: The irrelevance of dividend policy for valuation of the firm has been most comprehensively
presented by Modigliani and Miller (MM). They have argued that the market price of a share is affected
by the earnings of the firm and is not influenced by the pattern of income distribution. The dividend
policy is immaterial and is of no consequence to the value of the firm.
MM Approach Assumptions: MM approach to irrelevance of dividend is based on the following

assumptions:
1) The capital markets are perfect, and the investors behave rationally.
2) All information is freely available to all the investors.
3) There is no transaction cost and no time lag.
4) Securities are divisible and can be split into any fraction.
5) There are no taxes and no flotation cost.
6) The firm has a defined investment policy and the future profits are known with certainty. The implication
is that the investment decisions are unaffected by the dividend decision and operating cash flows are
same no matter which dividend policy is adopted.
Market price of Equity share:

𝐏𝟏 = 𝑷𝟎 (𝟏 + 𝑲𝒆 ) − 𝑫
Where,
Po = Market price of Equity share today/now.
D = Dividend per share
P1 = Market price of Equity share at end of year 1
Ke = Cost of Equity share capital
RESIDUALS THEORY OF DIVIDENDS
A firm does not decide as to how much dividends be paid rather it decides as to how much profits should
be retained. The profits not required to be retained may be distributed as dividends. Therefore, dividend
decision is a passive decision. The dividends are a distribution of residual profits after retaining sufficient
profit for financing the available opportunities. Under the Residuals Theory, the firm would treat the
dividend decision in three steps:
1) Determining the level of capital expenditures which is determined by the investment opportunities.
2) Using the optimal financing mix, find out the amount of equity financing needed to support the capital
expenditure in step (i) above.
3) As the cost of retained earnings, kr is less than the cost of new equity capital, the retained earnings would
be used to meet the equity portions financing in step (ii) above. If the available profits are more than this
need, then the surplus may be distributed as dividends to shareholders. As far as the required equity
financing is in excess of the amount of profits available, no dividends would be paid to the shareholders.
1) The following information pertains to M/s XY Ltd.
Earnings of the company 5 lakhs
Dividend Pay out Ratio 60%
No. of shares outstanding 1 lakh
Equity Capitalization Rate 12%
Return on Investment 15%
What would be the market value per share as per Walter’s model?
a) 47.85 b) 45.83 c) 42.96 d) 49.77
2) By using the above question calculate what is the optimum dividend payout
ratio according to Walter’s model and the market value of Company’s share
at that payout ratio?
a) 0 %, ₹ 52.08
b) 5 %, ₹ 50.05
c) 2 %, ₹ 55.95
d) 0 %, ₹ 57.66
3) From the following particulars given in the table calculate the market share
price (for growth, normal and declining firms) using Walter’s approach to
dividend model.
4) ABC Limited is having its shares quoted in major stock exchanges. Its share
current market price after dividend distributed at the rate of 20% per annum
having a paid-up shares capital of ₹ 10 lakhs of ₹ 10 each. Annual growth rate
in dividend expected is 2%. The expected rate of return on its equity capital
is 15%. Calculate the value of ABC Limited's share based on Gordons' model.
a) ₹ 17 b) ₹ 15.69 c) ₹ 17.75 d) ₹ 16.25
5) ABC Ltd. has a capital of ₹ 10 lakhs in equity shares of ₹ 100 each. The shares
are currently quoted at par. The company proposes declaration of a dividend
of ₹ 10 per share at the end of the current financial year. The capitalisation
rate for the risk class to which the company belongs is 12%. What will be the
market price of the share at the end of the year, if dividend is not declared?
a) ₹ 112. b) ₹ 110 c) ₹ 115 d) ₹ 117
6) By using the above question calculate what will be the market price of the
share at the end of the year, if dividend is declared?
a) ₹ 102. b) ₹ 111 c) ₹ 113 d) ₹ 127
7) By using the question-assuming that the company pays the dividend and has
net profits of ₹ 5,00,000 and makes new investments of ₹ 10 lakhs during the
period, how many new shares must be issued? Use the M.M. model.
a) 5,725 shares b) 5,996 shares c) 5,226 shares d) 5,883 shares
8) With the help of following figures calculate the market price of a share of a
company by using Walter’s formula:
Earning per share (EPS) ₹ 10
Dividend per share (DPS) ₹6
Cost of capital (k) 20%
Internal rate of return on investment 25%
Retention Ratio 60%
a) ₹ 55 b) ₹ 57 c) ₹ 59 d) ₹ 53
9) With the help of above question figures calculate the market price of a share
of a company by using Dividend growth model (Gordon’s formula):
a) ₹ 75 b) ₹ 80 c) ₹ 82 d) ₹ 77
10) Calculate the Implied Growth Rate

Current Stock Price = ₹ 65
Next Year's Dividend = ₹4
Capitalization Rate = 12%
Earnings Retention Rate = 50%
a) 5.85% b) 6.65% c) 5.67% d) 7.75%
Inspire Academy ( 888888 1719) Chapter 4 : COST OF CAPITAL
4 COST OF CAPITAL
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Introduction: ------------------------
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Cost of Capital is the return expected by the providers of capital (i.e.
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shareholders, debt-holders and lenders) to the business as a compensation of
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their contribution to the total Capital.
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Cost of Capital means that rate which is paid for the use of Capital. ------------------------
When corporate uses finance from any sources it must pay additional amount ------------------------
of money besides from the principal amount, the additional money paid to the ------------------------
financers is said to be cost of capital (i.e. Interest, Dividend, etc.) ------------------------
It is also referred to as a “hurdle” rate because this is the minimum acceptable ------------------------
rate of return. ------------------------
Cost of capital is the rate of return the firm required from investment to increase ------------------------
the value of the firm in the market place. ------------------------
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Cost of capital may be defined as the cut off rate for determining future cash
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proceeds of a project and eventually deciding whether the project is worth
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undertaking or not.
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FM with RAJ AWATE – Amazing journey of logic and concepts ------------------------
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It is also the minimum rate of return that a firm must earn on its investment
which will maintain the market value of share at its current level and attract
funds.
It can be stated as the opportunity cost of an investment, i.e. the rate of return
that a company would otherwise be able to earn at the same risk level as the
investment that has been selected.
The cost of capital determines how a company can raise money may be through
a stock issue. Borrowing or a mix of the two. This is the rate of return that a firm
would receive if it invested its money someplace else with similar risk.
Features of Cost of Capital
1) Cost of Capital is not a Cost as such. It is the rate of return that a firm required
to earn from its investments.
2) It is the minimum rate of return
3) It comprises of 3 components:
a) The expected normal rate of return at Zero risk level is the rate of
Interest by Bank.
b) The premium for business risk
c) The premium for financial risk.
Importance of Cost of Capital
The cost of capital is very important in financial management and plays a

crucial role in the following areas
1) Capital budgeting decisions: Cost of capital is used for discounting cash
flows under net present value method for investment proposals. Every
investment option may have different cost of capital hence it is very
important to use the cost of capital which is relevant to the options
available. Here Internal Rate of Return (IRR) is treated as cost of capital for
evaluation of two options. So, it is very useful in capital budgeting
decisions.
2) Capital structure decisions: An optimal capital is that structure at which
the value of the firm is maximum, and cost of capital is the lowest, so cost
of capital is crucial in designing optimal capital structure.
3) Performance Appraisal: Cost of capital is used to appraise the
performance of a business. The performance of business is compared
against the cost of capital which is known as cut off rate or hurdle rate.

4) Other financial decisions: Cost of capital is also useful in making such other
financial decisions as dividend policy. Capitalization of points making the
rights issue etc.
5) Designing of optimum credit policy: While appraising the credit period to
be allowed to the customers, the cost of allowing credit period is compared
against the benefit/profit earned by providing credit to customers. Here
cost of capital is used to arrive at the present value of costs & benefits
received.
Computation of Cost of Capital
Computation of cost capital of a firm involves the following steps:

i) Computation of cost of specific sources of a capital i.e. Long Term
Debt, Preference capital, Equity and Retained earnings, and
ii) Computation of Weighted average cost of capital.
Cost of Long Term

Debt
Cost of Preference
Share Capital
Specific Source of
Finance
Methods of
Cost of Equity
calculating Cost of
Share Capital
Capital Weighted Average
Cost of Capital
(WACC)
Retained Earnings
A) Specific Source of Finance

1) Cost of Long Term Debt Capital - kd
a) Redeemable Debentures & Bonds
Cost of
Irredeemable
Debt
Cost of Long
Term Debt
Cost of
Redeemable
Debt
Meaning: External Debt do not confer ownership to the providers of finance.

They do not participate in the affairs of the company but enjoys profit before tax.
Features of Redeemable Debentures & Bonds:
a) Face Value: Debentures or Bonds are denominated with some value, this
denominated value is called face value.
b) Interest (Coupon Rate): Each debenture bears a fixed rate of interest (except
Zero Coupon Bond & Deep Discount Bond) which is payable to holders
periodically at the face value of debenture.
c) Maturity Period: Debentures or Bonds has fixed maturity period for
redemption. In case of irredeemable debentures maturity period is not
defined.
d) Redemption Value: Redemption value of Redeemable debentures or Bonds
may vary from the face value of debentures.
e) Debt may be perpetual or redeemable debt moreover, it may be issued at par,
at premium or discount interest is allowed to be deducted for computation of
tax. So adjustment for tax is required.
f) Benefit of Tax shield: Payment for interest are allowed as expenses for the
purpose of corporate tax determination. Therefore, interest expense saves the
tax liability of the company. Saving the tax liability is also known as tax shield.
Example: There are two companies A Ltd. & B Ltd. The capital of A Ltd. Is fully
financed by the shareholders whereas A Ld. uses debt fund as well. The below
is the profitability statement of both the companies:

Particulars A Ltd. B Ltd.
(₹ in lakh) (₹ in lakh)
Earning before Interest & Taxes (EBIT) (A) 100 100
Interest paid to Debenture holders (B) - (40)
Profit before Tax (PBT) C= (A-B) 100 60
Tax @ 50% (D) (50) (30)
Profit after tax (PAT) E= (C-D) 50 30
Analysis: A comparison of the two companies’ shows that the interest payment of ₹ 40
by the B Ltd. Results in a tax shield of ₹ 20 lakh (₹ 40 lakh paid as interest * 50% tax
rate). Therefore effective interest rate is ₹ 20 lakh.
b) Irredeemable Debentures: Cost of debentures which are not redeemed by

the issuer of the debenture is known is known as irredeemable debentures. Cost
of debentures not redeemable during the life time of the company.
Cost of Debt Capital can be computed as under:- denoted as (Kd)
Cost of Redeemable Debt:
(𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 × [1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 ] + [𝑅𝑉 − 𝑁𝑒𝑡 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠 ]/𝑁)/([𝑅𝑉

+ 𝑁𝑒𝑡 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠]/2)
Cost of Irredeemable Debt:
( 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 × [𝟏 − 𝒕𝒂𝒙 𝒓𝒂𝒕𝒆])/(𝑵𝒆𝒕 𝒑𝒓𝒐𝒄𝒆𝒆𝒅𝒔 𝒐𝒇 𝒊𝒔𝒔𝒖𝒆)
Where –
RV= Redeemable value of debt

N = Life of the redeemable debt.
Important Notes relevant for solving practical problems:
1. If redemption value is not given, assume redemption is at par.

2. If net proceeds are not given than assume current market price as net proceeds
because if the company raises the funds today it can raise an amount equal to
current market price.
3. If current market price is also not given, then assume face value as net proceeds.
2) Cost of Preference Share Capital (PSC) – kp
Preference share capital is paid dividend at a fixed rate. However, the dividends are
not allowed to be deducted for computation of tax. So, no adjustment for tax is
required just like debentures preference share may be perpetual or redeemable.
Hence dividend paid to preference shareholders does not reduce the tax liability of
the company. Dividend is treated as appropriation of after tax profit. Further, they
may be issued at Par, Premium or Discount. Preference share capital is categorised
as Irredeemable & Redeemable.
Cost of Irredeemable
Preference Share
Capital
Cost of Preference
Share Capital
Cost of Redeemable
Preference Share
Capital
a) Irredeemable PSC: Cost is calculated by dividing the preference dividend

with the current market price or net proceeds from the issue.
b) Redeemable PSC: Preference shares issued by company which are

redeemable on its maturity are Redeemable Preference Share Capital. Cost of
Redeemable Preference Share Capital is same as Redeemable Debentures.
Cost of preference share capital (PSC) can be computed as under: (denoted as KP)

Cost of Redeemable PSC:
(𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 + [𝑅𝑉 − 𝑁𝑒𝑡 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠 ]/𝑁)/([𝑅𝑉 + 𝑁𝑒𝑡 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠]/2)
Cost of Irredeemable PSC:
( 𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅)/(𝑵𝒆𝒕 𝒑𝒓𝒐𝒄𝒆𝒆𝒅𝒔 𝒐𝒇 𝒊𝒔𝒔𝒖𝒆)
Where –
RV = Redeemable value of preference shares
N = Life of the redeemable preference shares.
Important Notes relevant for solving practical problems:
1. If redeemable value is not given assume redemption is at par.

2. If net proceeds are not given, then assume current market price as net
proceeds because it the company raises the funds today if can raise an amount
equal to current market price.
3. If current market price is also not given, then assume face value as net
proceeds.
Example: Company issued 10,000. 10% preference share of ₹10 each, cost of
issue is ₹ 2 per share. Calculate cost of preference capital if these shares are
issued at par.
Solution:

3) COST OF EQUITY SHARE CAPITAL (ESC) - ke
Cost of equity capital (denoted by ke) represents the expectations of Equity

Shareholders from a company. It is relatively highest cost of capital, due to
relative higher risk, equity shareholders expect higher return hence the cost of
capital is also high. Based on investors behaviour and expectations, the cost
of equity capital can be determined by any of the following approaches:
Constant
Dividend Approach
Dividend Price
Approach
Dividend growth
Approach
Capital Asset Pricing
Approach
Cost of equity share
capital
Realized Yield
Approach
Constant
Earning Approach
Earning Price
Approach
Earnings growth
Approach
a) Dividend price Approach:
- This approach is also known as Dividend Valuation Model.

- It assumes that dividends influence the share price.
- It assumes that price of the share today is the present value of expected future
dividend
- This model assumes that dividends are paid at a constant rate to perpetuity.
- Here cost of equity capital is computed by dividing the current dividend by
average market price per share. This dividend price ratio expresses the cost of
equity capital in relation to what yield the company should pay to attract
investors.

i) Dividend Price Approach with Constant Dividend Method: In this approach

dividend is constant, which means there is no growth or zero growth in dividend.
The cost of equity is calculated as follows:
Ke = (D1/P0)
Where,
Ke = Cost of Equity
D1 = Annual dividend
P0= Market value of equity (ex-dividend)
Demerit:
- However, this method cannot be used to calculate cost of equity of units

suffering losses.
- It ignores the importance of retained earnings on the market price of equity
shares.
Suitability:
- This method is suitable only when the company has stable earnings and stable
dividend policy over a period of time.

ii) Dividend Price Approach with Dividend Growth Approach: Under this approach
earnings and dividends do not remain constant and the price of equity shares is also
directly influenced by the growth rate in dividends. Where earnings, dividends and
equity share price all grow at the same rate, the cost of equity is computed as
follows:
Ke = (D1/P0) + G
Where,
Ke = Cost of Equity
D1 = Expected dividend per share (D1 = D0 (1+g))
P0= Current Market price per share
G = Annual growth rate of earnings of dividend.
b) Capital Asset Pricing Model Approach (CAPM):
This model describes the linear relationship between risk and return for
securities, the risk for a security is exposed to are diversifiable and non-
diversifiable risk can be eliminated through a portfolio, consisting of large
number of well diversified securities. The non- diversifiable risk is assessed in
terms of beta coefficient (b or β) through fitting regression equation between
return of a security and the return on a market portfolio.
Thus, the cost of equity capital can be calculated under this approach as:
Ke = Rf + B (Rm - Rf)
Where,
Ke = Cost of Equity
Rf = Rate of return on security
B = Beta coefficient
Rm = Rate of return on market portfolio
(Rm - Rf) = Market Premium

Therefore, required rate of return = risk free rate + risk premium
The idea behind CAPM is that investors need to be compensated in two ways – Time
value of money and risk.
- The time value of money is represented by the risk-free rate in the formula and
compensates the investors for placing money in any investment over a period
of time.
- The other half of the formula represents risk and calculates the amount of
compensation the investor needs for taking an additional risk.
- The CAPM says that the expected return does not meet or beat the required
return, and then the investment should not be undertaken.
- The capital asset pricing approach is useful in calculating cost of equity even
when the firm is suffering losses.
c) Realized yield approach:
According to this approach, the average rate of return realized in the past few
years is historically regarded as expected return in the future. It computes the
cost of equity based on the past records of the dividend actually realised by
the equity shareholders. The yield of equity for the year is:

Y1 = (𝑫𝒕 + (𝑷𝒕 − 𝑷𝒕 − 𝟏))/(𝑷𝒕 − 𝟏)

Where,
Y1 = Yield for the year t
Dt= dividend for share at the end of the year t
Pt = price per share at the end of the year t
Pt-1= price per share at the beginning of year t.
Though this approach provides a single mechanism of calculating cost of

equity, it has unrealistic assumptions. If the earnings do not remain stable this
method is not practical.
d) Earnings / price approach:
- The advantages of this approach co- relate the earnings of the company with
the market price of its share.
- Accordingly, the cost of ordinary share capital would be based upon the
expected rate of earnings of a company.
- The argument is that each investor expects a certain amount of earnings
whether distributed or not from the company in whose shares he invests.
Example: If an investor expects that the company in which he is going to subscribe
for shares should have at least a 20% rate of earnings, the cost of ordinary share
capital can be construed on this basis. Suppose the company is expected to earn
30% the investor will be prepared to pay ₹ 150 (₹30/20 × 100) for each share
of ₹ 100. This approach is similar to the dividend price approach only it seeks to
nullify the effect of changes in the dividend policy. This approach also does not
seem to be a complete answer to the problem of determining the cost of ordinary
share since it ignores the factor of capital appreciation or depreciation in the
market value of shares.

i) Earning/Price Approach with Constant Earnings: Cost of capital is calculated

based upon the expected rate of return of the company.
Ke = (E/P)
Where,
Ke = Cost of Equity
E = Current earnings per share
P = Market share price
ii) Earning/Price Approach with Growth in Earnings:
This approach is an improvement over the earlier methods, but even this
method assume that dividend will increase at the same rate as earnings and
the equity share price is the regular of this growth as deemed by the investor.
However, in actual practice, rate of dividend is recommended by the board of
directors and shareholders cannot change it. Thus, rate of growth of dividend
subsequently depends on director’s attitude. The dividend method should
therefore be modified by substituting earnings for dividends. So, cost of equity
will be given by:
Ke = (E/P) + G
Where,
Ke = Cost of Equity
E = Current earnings per share
P= Market share price
G= Annual growth rate of earnings
The calculation of G (the growth rate) is an important factor in calculating cost

of equity capital. The past trend in earnings and dividends may be used as an
approximation to predict the future growth rate if the growth rate of dividend
is fairly stable in the past.
4) COST OF RETAINED EARNING - Ks:
Cost of retained earnings or reserve are generally taken as the same as cost of equity
this is because, if earnings are paid out as dividends without being retained and

simultaneously a rights issue is made the investors would be subscribing to the issue
based on some expected return this is taken as the indicator of the cost of reserves
or retained earnings.
There are two approaches to measure this opportunity cost one approach is by using
Discounted cash flow (DCF) method and the second approach is by using capital asset
pricing model (CAPM).
Discounted Cash Flow Approach (DCF)
Ke = (D1/P0) + G
Where,
Ke = Cost of Equity
D1 = Dividend per share
P0= Current Market price per share
G = Annual growth rate
Capital Asset Pricing Model (CAPM)
Ks = Rf + B (Rm - Rf)
Where,
Ks = Cost of equity capital
Rf = Rate of return on risk – free security
B = Beta coefficient
Rm = Rate of return on market portfolio

5) COST OF EXTERNAL EQUITY: It means cost of raising fresh equity from

the market price.
In case of growth
Ke = D1 / (P0 (1-f)) + g
Where,
Ke = Cost of Equity
f = Floatation cost
g = Growth rate
P0 = Current market price
In absence of growth
Ke = D1 / (P0 (1-f))
Where,
Ke = Cost of Equity
f = Floatation cost
P0 = Current market price
B) WEIGTED AVERAGE COST OF CAPIATL (WACC):
WACC denotes the weighted average cost of capital it is defined as the overall
cost of capital computed by reference to the proportion of each component of
capital as weights it is denoted by KO.
Hence WACC = Sum of [cost of individual components x proportion i.e. capital]
The following format may be adopted for computation of WACC:
Component Amount Proportion Individual Multiplication

or % cost
Debt (kd) W1 Kd Kd× W1
Preference capital (kp) W2 Kp Kp ×W2

Retained earnings (ke) W3 Ke Ke × W3
Equity capital (ke) W4 Ke Ke × W4
Total (ko) Ko = WACC = total of

above
The proportion or percentage of each component of capital may be determined by

reference to either book values or market values of capital.

IMPORTANCE OF WACC
The cost of weighted average method is preferred because the proportions of

various sources of funds in the capital structure are different. To be representative,
therefore cost of capital should take into account the relative proportions of
different sources of finance.
- Securities analysis employ WACC all the time when valuing and selecting
investments.
- In discounted cash flow analysis WACC is used as a hurdle rate against which to
assess return on investment capital performance.
- It also plays a key role in economic value added (EVA) calculations.
- Investors use WACC as a tool to decide whether to invest
- The WACC represents the minimum rate of return at which a company produces
value for its investors. Let’s say a company produces a return of 20% and has a
WACC of 11% by contract, if the company’s return is less than WACC the
company is shedding value which indicates that investors should put their
money elsewhere.
- Therefore WACC serves as a useful reality check for investors
Advantages of market values as weights
a. Market values are not affected by accounting policies.

b. Market values represents the opportunity
c. It is representing the present economic value of various sources of finance.
d. It is consistent with the definition of cost of capital i.e. the cost of capital is
the minimum rate of retain needed to maintain the market value of the firm.
e. Market value is the true reflection of the firm’s capital structure.
Disadvantages of market values as weight
a. Market values are not available in case of unlisted companies.

b. It is not reliable when shares are not actively traded (no purchases or sale
of share)
c. Market price fluctuates frequently and is affected by speculation.
(manipulation of share prices)
Advantages of using book values as weight

a. The data is easily available from the balance sheet data.

b. Firms set their capital structure in terms of book weights.
c. Calculations are simple
d. Less fluctuations in book value
e. Useful when market price is not available (in case of an unlisted company)
or when the shares are not activity traded
f. Many times, the investor use book value weights to do the necessary
analysis.
Disadvantages of book values as weights
a. Affected by accounting policies.

b. Does not truly represent the opportunity cost of capital
c. Does not represent the present economic values of various sources of
finance.
d. Not consistent with the definition of cost of capital.
MARGINAL COST OF CAPITAL:
- Marginal cost of capital is the cost of raising an additional rupee of capital

- It is derived when the average cost of capital is computed with marginal
weights. The weights represent the proportion of funds the firm intends to
employ
- When funds are raised in the same proportion as at present and if the
component costs remain unchanged there will be no difference between
average cost of capital and marginal cost of capital
- As the level of capital employed increases the component costs may start
increasing. In such a case both the WACC and marginal cost of capital will
increase. But marginal cost of capital will rise at a faster rate.



BASIC PROBLEMS:
1. Cost of capital means………………………… that a firm must earn on its

investment.
a. Hurdle rate
b. Minimum rate of return
c. a & b
d. None
2. Define the area where cost of capital is used to take important financial
decision-
a. Capital budgeting decision
b. Capital Structure decision
c. Designing of optimum credit policy
d. All of the above.
3. Cost of debentures not redeemable during the life time of the company is
calculated as follows-
a. Interest amount adjusted to tax liability and after that it is divided
by net proceeds of debentures issued.
b. Interest amount is not adjusted tax liability and after that it is
divided by net proceeds of debentures issued.
c. Interest amount is divided by net proceeds of debentures issued.
d. None
4. Which of the following source of funds is related to implicit cost of capital?
a. Equity share capital
b. Preference share capital
c. Debentures
d. Retained Earning
5. Cost of Capital refers to the……………..that is used in determining the present
value of the estimated future cash proceeds of the business/new project and
eventually deciding whether the business/new project is worth undertaking or
now.
a. Discount rate
b. Undiscounted rate
c. Maximum rate of return
d. None

6. Cost of equity means –

a. Which equates the present value of expected dividend with the
market share price
b. Which equates the present value of current dividend with the
market share price
c. Which equates the present value of expected future share price
d. None.
7. Marginal cost of capital means-
a. It means the cost of raising an additional rupee of capital
b. It is nothing but weighted average cost of capital
c. It is equal to cost of equity share capital
d. None
8. …………………….. does not have fixed maturity period.
a. Irredeemable debentures
b. Redeemable debentures
c. Redeemable Preference shares
d. None.
9. Which of the following cost of capital require to adjust tax?
a. Cost of equity shares
b. Cost of preference shares
c. Cost of Debentures
d. Cost of Retained earnings
10. A company issued 10000, 10% debentures of Rs. 100 each on 1.4.2017 to
be matured on 1.4.2022. the company wants to know the current cost of its
existing debt and the market price of the debentures is 80%. Compute the
cost of existing debentures assuming 35% tax rate.
a. 10.30% b. 8.87% c. 11.67% d. None
11. A company issues Rs. 10,00,000 16% irredeemable debentures of Rs. 100
each. The company is 35% tax bracket you are required to calculate the cost
of debt after tax, if debentures are issue at par.

a. 10% b. 16% c. 10.4% d. None
12. A Ltd has made an issue of debentures of Rs. 200 lakhs each debentures has
a face value of Rs. 100 and carries a rate of interest of 7% the interest is
payable annually and the debentures are redeemable at a premium of 10%
after 10 years, A ltd sells debentures at Rs. 97 per debenture and the Tax
rate is 50% what is the cost of debentures?
a. 6.61% b. 4.64% c. 7.00% d. None
13. XYZ Ltd issues 2000 10% preference shares of Rs. 100 each at Rs. 95 each.
The company proposes to redeem the preference shares at the end of 10 th
year from the date of issues. Calculate the cost preference share?
a. 11.27% b. 10.77% c. 13.34% d. None
14. If R Energy is issuing preferred stock at Rs. 100 per share, with a stated
dividend of Rs. 12 and a flotation cost of 3% then, what is the cost of
preference share?
a. 11.17% b. 12.37% c. 13.68% d. None

15. A company has paid dividend of Rs. 1 per share last year and it is expected
to grow @10% next year. Calculate the cost of equity if the market price of
Share is 55.
a. 14% b. 16% c. 12% d. None
16. ABC Ltd who is paying dividend of Rs. 5 per share and current market price
of share is Rs. 60. The dividend were expected to grow at a rate of 7.5% pa
forever what is required return using dividend discount model?
a. 14.85% b. 16.45% c. 20% d. None
17. Calculate the cost of equity capital of H Ltd whose risk free rate of return
equals 10%. The Firm’s beta equal 1.75 and the return on the market
portfolio equals to 15%
a. 15.75% b. 18.75% c. 12.65% d. None
18. ABC Company provides the following detais:

Do= Rs.4.19 Po= Rs.50 g = 5%
Calculate the cost of retained earnings.
a. 14.2% b. 13.8% c. 12.44% d. None

19. XYZ Ltd. has the following book value capital structure:
Equity Capital (in shares of ` 10 each, fully paid up- at par) 15 crores
11% Preference Capital (in shares of ` 100 each,
fully paid up- at par) 1

crore
Retained Earnings 20
crore
13.5% Debentures (of ` 100 each) 10 crores
15% Term Loans 12.5 crores
The next expected dividend on equity shares per share is Rs.3.60 the dividend per share is
expected to grow at the rate of 7%. The market price per share is Rs. 40.Preference
stock, redeemable after ten years, is currently selling at Rs.75 per share. Debentures,
redeemable after six years, are selling at Rs. 80 per debenture.The Income tax rate for the
company is 40%.Required Calculate the weighted average cost of capital using book value
proportions
a. 14.59% b. 16% c. 12% d. None

20. XYZ Ltd. has the following book value capital structure:
Equity Capital (in shares of ` 10 each, fully paid up- at par) 15

crores
11% Preference Capital (in shares of ` 100 each,
fully paid up- at par) 1 crore
Retained Earnings 20
crore
13.5% Debentures (of ` 100 each) 10 crores
15% Term Loans 12.5 crores
The next expected dividend on equity shares per share is Rs.3.60 the dividend per share is
expected to grow at the rate of 7%. The market price per share is Rs. 40.Preference
stock, redeemable after ten years, is currently selling at Rs.75 per share. Debentures,
redeemable after six years, are selling at Rs. 80 per debenture. The Income tax rate for the
company is 40%.
1) Define the weighted marginal cost of capital schedule for the company,
if it raises 10 crores next year, given the following information:
2) the amount will be raised by equity and debt in equal proportions;
3) the company expects to retain 1.5 crores earnings next year;
4) the additional issue of equity shares will result in the net price per share
being fixed at Rs.32
the debt capital raised by way of term loans will cost 15% for the first 2.5 crores and 16% for
the next 2.5 crores.
a. 13.44% b. 15% c. 16% d. None

21. JKL Ltd. has the following book-value capital structure as on March 31, 2003.
The equity share of the company sells for 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 at 5% p.a. forever.
Particulars Amount
Equity share capital (2,00,000 40,00,000
shares) 11.5% preference shares 10,00,000
10% debentures 30,00,000
80,00,000
Assume a 35% corporate tax rate.Required to Compute weighted average cost of capital
(WACC) of the company based on the existing capital structure.
a. 11.375% b. 12% c. 13% d. None

Inspire Academy ( 888888 1719) Chapter 5 : CAPITAL STRUCTURE
5 CAPITAL STRUCTURE
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Capital structure can be of various kinds as described below: ----------------------
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FM with RAJ AWATE – Amazing journey of logic and concepts ----------------------
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1) Horizontal capital structure - In a Horizontal capital structure, the firm has zero debt components in
the structure mix. The structure is quite stable. Expansion of the firm takes in a lateral manner, i.e.
through equity or retained earning only.
2) Vertical capital structure - In a vertical capital structure, the base of the structure is formed by equity
share capital. This base serves as the foundation on which the super structure of preference share
capital and debt is built. The Incremental addition in the capital structure is almost entirely in the form
of debt. Quantum of retained earnings is low and the dividend pay-out ratio is quite high.
3) Pyramid shaped capital structure - A pyramid shaped capital structure has a large proportion of
consisting of equity capital and retained earnings which have been ploughed back into the firm over a
considerably large period of time. The cost of share capital and the retained earnings of the firm is
usually lower than the cost of debt. This structure is indicating of risk averse conservative firms.
4) Inverted pyramid shaped capital structure - Such a capital structure has a small component of
equity capital, reasonable level of retained earnings but an ever-increasing component of debt. All the
increases in the capital structure in the recent past have been made through debt only.
While deciding upon the capital structure the firm has to consider the different life cycle stages
which are:
a) The Pioneering Stage

b) The Expansion Stage
c) The Stagnation/Stabilization Stage.

Different Life Cycle

Pioneering Stage
Stages
Expansion Stage
Stagnation/Stabilization
Stage
a) The Pioneering stage is one of rapid increase in demand for the products / services at the starting
stage of the life cycle of the company and the efficient companies are the one to survive. The
financial cost of borrowing is very high at this stage, due to risk perception about the company. To
survive this stage, the capital structure should orient more towards equity and avail more soft loans.
b) The Expansion stage is the next stage, during which the strong companies survive the competition
struggle and aim to expand their market share and volumes. During this stage huge investments
are made to expand production / service capacity. Requirement of funds is high during this stage.
Subject to the corporate strategy of funding projects and market conditions, the company may
raise capital at the lowest possible cost. As the earnings stabilize, the company will be in a position
to make any small variations in business, then it can seek to financially leverage itself within a pre-
fixed ceiling, by bank loans.
c) The Stabilization / stagnation stage is the last and final stage. A dynamic management will always
be on the lookout for expansion / diversification into new projects. It could again, depending on
corporate strategy, go in for green-field projects or takeover existing units, seek mergers
acquisitions and strategic alliances etc. Usually a recession in economy opens-up a vast number of
such opportunities which cash rich companies can take advantage of. In case of lack of such
opportunity, the company could reduce the financial leverage and save on interest.

CAPITAL STRUCTURE VIS-À-VIS FINANCIAL STRUCTURE :
Capital structure of a firm is different from the financial structure. We shall illustrate the difference as
under:
Sr. CAPITAL STRUCTURE FINANCIAL STRUCTURE

No.
1) Capital structure of a company refers to Financial Structure refers to the balance

types of long term financing included in the between all the company’s liabilities and its
capital equities. Financial structure thus concerns
the entire “Liability” side of the Balance
Sheet.
2) Debt, common stock, preferred stock, Financial structure on the other hands also
retained earnings and reserves. includes short term debt and accounts
payables.
3) It represents source of funding. It represents financial obligation of

company.

4) It includes both long-term & short-term It includes only long-term sources of funds.
sources of funds.
5) It means the entire liabilities side of the It means only long-term liabilities of the
balance sheet. company.
6) It will not be more important while It is one of the major determinations of the
determining the value of the firm. value of the firm.
7) Capital structure relates to long term capital Financial structure involves creation of both
deployment for creation of long term assets. long term and short-term assets.
8) Capital structure is the core element of the The financial structure of a firm is
financial structure. Capital structure can considered to be a balanced one if the
exist without the current liabilities and in amount of current liabilities is less than the
such cases, capital structure shall be equal to capital structure net of outside debt
the financial structure. But we cannot have a because in such cases the long-term capital
situation where the firm has only current is considered sufficient to pay current
liabilities and no long-term capital. liabilities in case of sudden loss of current
assets.
CAPITAL STRUCTURE THEORIES:
There are basically four theories of capital structure decision:
Theories of Capital
Structure Decision
Net Operating Modigliani and

Net Income (NI) Traditional
Income (NOI) Miller (MM)
Approach Approach
Approach Approach

1) NET INCOME APPROACH: (CAPITAL STRUCTURE MATTERS)

As suggested by Durand, this theory states that there is a relationship between capital structure and the
value of the firm and therefore, the firm can affect its value by increasing or decreasing the debt
proportion in the overall financing mix. The NI approach makes the following additional assumptions:
1. That the total capital requirement of the firm is given and remain constant.
2. That kd is less than ke
3. Both kd and ke remain constant and increase in financial leverage i.e., use of more and more debt
financing in the capital structure does not affect the risk perception of the investors.
2) NET OPERATING INCOME APPROACH: (CAPITAL STRUCTURE DOES NOT MATTER)

The Net Operating Income (NOI) approach is opposite to the NI approach. According to the NOI
approach, the market value of the firm depends upon the net operating profit or EBIT and the overall
cost of capital, WACC. The financing mix or the capital structure is irrelevant and does not affect the
value of the firm. The NOI approach makes the following assumptions:
1. The investor sees the firm as a whole and thus capitalizes the total earnings of the firm to find
the value of the firm as a whole.
2. The overall cost of capital, ko of the firm is constant and depends upon the business risk which
also is assumed to be unchanged.
3. The cost of debt, kd, is also taken as constant.
4. The use of more and more debt in the capital structure increases the risk of the shareholders
and thus results in the increase in the cost of equity capital i.e., ke. The increasing ke is such as
to completely offset the benefits of employing cheaper debt, and
5. That there is no tax.

Modigliani-Miller Approach (MM):
Modigliani-Miller (MM) Approach
MM Approach -1958: without tax MM Approach- 1963: with tax
MM MODEL WITHOUT TAXES:
1. That the firm’s capital structure is irrelevant.

2. The WACC is the same no matter what mixture of debt and equity is used to finance the firm.
3. The value of the levered firm is equal to the value of the unlevered firm, and
4. Cost of equity, ke = k0 + (ko-k) D/E. It implies that the cost of Equity raises as the firm increases
its use of debt.
MM MODEL WITH TAXES:
1. The value of the levered firm is equal to the value of unlevered firm + the present value of the
interest tax shield, i.e, VL = Vu + D (t) So, debt financing is advantageous, and it increases the
value of the firm.
2. The WACC of the firm decreases, as the firm relies more and more on debt financing.
3. The cost of Equity, ke = ko + ko – kd) (D/E) (i-t) or = k0 + (ko – k) [D (l-t)/E] where, ko is the WACC
of the unlevered firm.


1. Companies U and L are identical in every respect except that U is unlevered and L is levered. Company L has ₹
20 lakhs of 8 % debentures outstanding. Assume (i) that all the MM assumptions are met and (ii) that the tax
rate is 35%, (iii) that EBIT is ₹ 6 Lakhs and that equity-capitalization rate for U is 10%
i) What will be the values of each firm according to MM approach?

ii) Suppose V (U) = ₹ 25, 00,000 and V (L) = ₹ 35, 00,000. According to MM do they represent equilibrium
values? If not, explain the process by which equilibrium will be restored.

2. A company’s current operating income is ₹ 4 lakh. The firm has ₹ 10 Lakh of 10 % debt outstanding. Its cost of
capital is estimated to be 15%.
i) Determine the current value of the firm, using traditional approach.

ii) Calculate the overall capitalization rate as well as both types of leverage ratio – Debt-equity and debt-
value ratio
iii) The firm is considering increasing its leverage by raising an additional ₹ 5,00,000 debt and using the
proceeds to retire that amount of equity. As a result of increased financial risk, Kd is likely to go up to 12%
and Ke to 18%. Would you recommend the plan?
3.
Particulars Amount (₹)
Given Operating Income (EBIT) 50,000

Cost of Debt 10%
Outstanding Debt 2,00,000
Overall Capitalisation Rate 12.5%
a) What will the total value of firm and the equity capitalization rate?
b) If the firm increases the amount of debt from ₹ 2,00,000 to ₹ 3,00,000 and uses the proceeds of debt
to repurchases equity shares, what will be equity capitalization rate?
c) If the firm retires debt of ₹ 1,00,000 by issuing fresh equity shares of amount, what will be equity
capitalization rate?

4. A firm earns a NOI of ₹1,00,000. Its Ke is 10% and kd is 6% and the market value of debt is ₹5,00,000
a) Find the overall cost of capital and value of firm under Net Income Approach.
b) What would be the position if the value of debt is ₹700,000?
1) The term "capital structure" refers to:

a) Long-term debt, preferred stock, and common stock equity.
b) Current assets and current liabilities.
c) Total assets minus liabilities.
d) Shareholders' equity.

2) A critical assumption of the net operating income (NOI) approach to

valuation is:
a) That debt and equity levels remain unchanged.
b) That dividends increase at a constant rate.
c) That ko remains constant regardless of changes in leverage.
d) That interest expense and taxes are included in the calculation.
3) The traditional approach towards the valuation of a company assumes:
a) That the overall capitalization rate holds constant with changes in
financial leverage.
b) That there is an optimum capital structure.
c) That total risk is not altered by changes in the capital structure.
d) That markets are perfect.
4) Two firms that are virtually identical except for their capital structure are
selling in the market at different values. According to M&M
a) One will be at greater risk of bankruptcy.
b) The firm with greater financial leverage will have the higher value.
c) This proves that markets cannot be efficient.
d) This will not continue because arbitrage will eventually cause the
firms to sell at the same value.
5) A firm's degree of operating leverage (DOL) depends primarily upon its
b) Sales variability.
c) Level of fixed operating costs.
d) Closeness to its operating break-even point.
e) Debt-to-equity ratio.
6) An EBIT-EPS indifference analysis chart is used for
a) Evaluating the effects of business risk on EPS.
b) Examining EPS results for alternative financing plans at varying EBIT
levels.
c) Determining the impact of a change in sales on EBIT.
d) Showing the changes in EPS quality over time.
7) EBIT is usually the same thing as:
a) Funds provided by operations.
b) Earnings before taxes.
c) Net income.
d) Operating profit.
8) ABC Ltd’s EBIT is Rs. 5,00,000. The company has 10%, 20 lakhs debentures.
The equity capitalization rate is 16%. Calculate market value of firm.
a) Rs. 38,75,000 b) Rs. 40,00,000 c) Rs. 31,50,000 d) None

9) ABC Ltd’s EBIT is Rs. 5,00,000. The company has 10%, 20 lakhs debentures.
The equity capitalization rate is 16%. Calculate overall cost of capital.
a) 15% b) 12.90% c) 14% d) None
10) Swagat Ltd. Makes use of debt and equity capital. It has EBIT of Rs.
1,00,000. The firm has 10% debentures of Rs. 5,00,000 and the firm’s
equity capitalization rate is 15%. You are required to compute current
value of the firm.
a) Rs. 10,00,000 b) Rs. 8,33,333 c) Rs. 9,00,000 d) None
11) Swagat Ltd. Makes use of debt and equity capital. It has EBIT of Rs.
1,00,000. The firm has 10% debentures of Rs. 5,00,000 and the firm’s
equity capitalization rate is 15%. You are required to compute overall cost
of capital.
a) 14% b) 12% c) 17% d) None

6 WORKING CAPITAL MANAGEMENT
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
ESTIMATION AND CALCULATION OF WORKING CAPITAL: ----------------------
----------------------
A firm must estimate in advance as to how much net working capital will be required for the smooth operations
----------------------
of the business. Only then, it can bifurcate this requirement into permanent working capital and temporary
----------------------
working capital. This bifurcation will help in deciding the financing pattern i.e., how much working ----------------------
capital should
be financed from long term sources and how much be financed from short term sources. ----------------------
There are different approaches available to estimate the working capital requirements of a firm as----------------------
follows:
----------------------
1) Working Capital as a Percentage of Net Sales: This approach to estimate the working capital requirement is
----------------------
based on the fact that the working capital for any firm is directly related to the sales volume of ----------------------
that firm. So,
the working capital requirement is expressed as a percentage of expected sales for a particular----------------------
period. The
working capital estimation is thus, solely dependent on the sales forecast. This approach is ----------------------
based on the
assumption that higher the sales level, the greater would be the need for working capital. There are three
----------------------
steps involved in the estimation of working capital. ----------------------
a) To estimate total current assets as a % of estimated net sales. ----------------------
b) To estimate current liabilities as a % of estimated net sales, and ----------------------
c) The difference between the two above, is the net working capital as a % of net sales. ----------------------
----------------------
2) Working Capital as a Percentage of Total Assets or Fixed Assets: This approach of estimation of working
----------------------
capital requirement is based on the fact that the total assets of the firm are consisting of fixed assets and
----------------------
current assets. On the basis of past experience, a relationship between ----------------------
i) Total current assets i.e., gross working capital; or net working capital i.e., Current assets – Current
----------------------
Liabilities, and ----------------------
ii) Total fixed assets or total assets of the firm is established. ----------------------
----------------------
----------------------
----------------------
Example:
A firm is maintaining 20% of its total assets in the form of current assets and expects to have total
assets of ₹ 50,00,000 next year. Thus, the current assets of the firm would be ₹ 10,00,000 (i.e., 20% of ₹
50,00,000). In this approach, the working capital may also be estimated as a % of fixed assets.
3) Working Capital based on Operating Cycle: The concept of operating cycle, as discussed, helps determining
the time scale over which the current assets are maintained. The operating cycle for different components
of working capital gives the time for which an asset is maintained, once it is acquired. However, the concept
of operating cycle does not talk of the funds invested in maintaining these current assets. The concept of
operating cycle can definitely be used to estimate the working capital requirements for any firm. In this
approach, the working capital estimate depends upon the operating cycle of the firm. A detailed analysis is
made for each component of working capital and estimation is made for each of these components.
BANKING NORMS AND MACRO ASPECT OF WORKING CAPITAL MANAGEMENT:
Commercial banks grant working capital advances by way of cash credit limits and are the major suppliers of
working capital to trade and industry. RBI appointed study group under the chairmanship of Shri. P.L. Tandon
in August 1975. Tandon committee made certain recommendations inter alia comprising of recommendations
on norms for inventory and receivables for 15 major industries, new approach to bank lending, style of lending
credit, information system and follow up, supervision and control and norms of capital structure.
1) Norms for inventory and receivables recommended by Tandon Committee for 15 major industries,
cover about 50 per cent of industrial advances of banks. These norms were arrived at after examining
the trends reflected in the company finance studies conducted by the Reserve Bank of India and
detailed discussion with representatives and experts of the industries concerned.
2) Bank lending: The Committee introduced and concept of working capital gap. This gap arised due to
the non-coverage of the current assets by the current liabilities other than bank borrowings. A certain
portion of this gap will be filed up by the borrower’s own funds and long-term borrowings. The
Committee developed three alternatives for working out the maximum permissible level of bank
borrowings:
a) Working Capital Gap:

75% of the working capital gap will be financed by the bank i.e. Total Current Assets
Less: Current Liabilities other than Bank Borrowings.
Less: 25% of Working Capital gap from long-term sources.
b) Alternatively, the borrower has to provide for a minimum of 25% of the total current assets out
of long-term funds and the bank will provide the balance. The total current liabilities inclusive of
bank borrowings will not exceed 75% of the current assets:
Maximum Bank Borrowing permissible:
Total Current Assets
Less: 25% of current assets from long-term sources.
Less: Current liabilities other than Bank borrowings
c) The third alternative is also the same as the second one noted above except that it excludes the
permanent portion of current assets from the total current assets to be financed out of the long-
term funds, viz.
Maximum Bank Borrowing permissible=
Less: Permanent portion of current assets
Real Current Assets
Less: 25% of Real Current Assets
Thus, by following the above measures, the excessive borrowings from banks will be gradually
eliminated and the funds could be put to more productive purposes.
The above methods may be reduced to equation as under :

1st Method : PBC = 75/100 WCG
2nd Method : PBC = TCA – [(25/100 TCA) + OCL]
3rd Method : PBC = TCA – [CRA + 25/100 (TCA – CRA) + OCL]
Where,
PBC stands for Working Capital Gap
TCA stands for Total Current Assets
OCL Stands for Other Current Liabilities.
(i.e. Current Liabilities other than Bank Borrowings)
CRA stands for Amount required to finance Core Assets.
3) Style of credit: A change in the style of lending has also been suggested by the Committee so as to bifurcate
the cash credit into a loan account and demand cash credit instead of treating the entire credit limit as cash
credit for a year. This will make the credit less expensive to borrowers.
4) Information system: To monitor better credit information system in the banking industry, the committee
suggested for the borrower to submit quarterly statements in the prescribed format about its operations,
current assets and current liabilities and funds flow statements with monthly stock statements and
projected balance sheets and profit and loss account at the end of financial year.
OPERATING CYCLE CONCEPT AND APPLICATION OF QUANTITATIVE TECHNIQUES
A useful tool for managing working capital is the operating cycle.
The operating cycle analyzes the accounts receivable, inventory and accounts payable cycles in terms of
number of days.
Example:
1) Accounts receivables are analyzed by the average number of days it takes to collect an account.
2) Inventory is analyzed by the average number of days it takes to turn over the sale of a product (from the
point it comes in the store to the point it is converted to cash or an account receivable).
3) Accounts payables are analyzed by the average number of days it takes to pay a supplier invoice.
Operating/Working Capital Cycle Definition:
Working Capital cycle indicates the length of time between a company’s paying for materials, entering into
stock and receiving the cash from sales of finished goods. It can be determined by adding the number of days
required for each stage in the cycle.
Example: A company holds raw materials on an average for 60 days, it gets credit from the supplier for 15
days, production process needs 15 days, finished goods are held for 30 days and 30 days credit is extended to
debtors. The total of all these, 120 days, i.e., 60 – 15 + 15 + 30 + 30 days is the total working capital cycle.
The length of operating cycle of an enterprise is the sum of these four individual stages i.e. components of
time. The operating cycle can be calculated for a period as under:
1) Raw Materials Days

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑅𝑎𝑤 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑠𝑡𝑜𝑐𝑘
Period of raw material stock
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
Less: Period of credit 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑜𝑓 𝑟𝑎𝑤 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦
Granted by supplier
2) Period of Production 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑤𝑜𝑟𝑘 𝑖𝑛 𝑝𝑟𝑜𝑔𝑟𝑒𝑠𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑑𝑎𝑦
3) Period of turnover of Finished goods stock 𝑆𝑡𝑜𝑐𝑘 𝑜𝑓 𝑓𝑖𝑛𝑖𝑠ℎ𝑒𝑑 𝑔𝑜𝑜𝑑𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 𝑝𝑒𝑟 𝑑𝑎𝑦
4) Period of credit taken by customers 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡𝑜𝑟𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦
1) Estimation and calculation of working capital
A firm must estimate in advance as to how much net working capital will be required for the smooth operations
of the business. Only then, it can bifurcate this requirement into permanent working capital and temporary
working capital. This bifurcation will help in deciding the financing pattern i.e., how much working capital should
be financed from long term sources and how much be financed from short term sources.
There are different approaches available to estimate the working capital requirements of a firm as follows:
1) Working Capital as a Percentage of Net Sales

a) To estimate total current assets as a % of estimated net sales.
b) To estimate current liabilities as a % of estimated net sales, and
c) The difference between the two above, is the net working capital as a % of net sales.
2) Working Capital as a Percentage of Total Assets or Fixed Assets

3) Working Capital based on Operating Cycle
2) Banking norms and macro aspect of working capital management
1) Norms for inventory and receivables

2) Bank lending
a) Working Capital Gap:
75% of the working capital gap will be financed by the bank i.e. Total Current Assets
Less: 25% of Working Capital gap from long-term sources.
b) Alternatively, the borrower has to provide for a minimum of 25% of the total current assets out
of long-term funds and the bank will provide the balance. The total current liabilities inclusive of
bank borrowings will not exceed 75% of the current assets:
Maximum Bank Borrowing permissible:
Less: 25% of current assets from long-term sources.
Less: Current liabilities other than Bank borrowings
c) The third alternative is also the same as the second one noted above except that it excludes the
permanent portion of current assets from the total current assets to be financed out of the long-
term funds, viz.
Maximum Bank Borrowing permissible=
Less: Permanent portion of current assets
Real Current Assets
Less: 25% of Real Current Assets
Thus, by following the above measures, the excessive borrowings from banks will be gradually
eliminated and the funds could be put to more productive purposes.
The above methods may be reduced to equation as under :

1st Method : PBC = 75/100 WCG
2nd Method : PBC = TCA – [(25/100 TCA) + OCL]
3rd Method : PBC = TCA – [CRA + 25/100 (TCA – CRA) + OCL]
Where,
PBC stands for Working Capital Gap
TCA stands for Total Current Assets
OCL Stands for Other Current Liabilities.
(i.e. Current Liabilities other than Bank Borrowings)
CRA stands for Amount required to finance Core Assets.
3) Style of credit
4) Information system
5) Follow up
6) Norms of Capital Structure
1) From the following information of XYZ Ltd., you are required to calculate:
a. Net operating cycle period

b. Number of operating cycles in a year:
Sr. Particulars
No.
1) Raw materials inventory consumed during the year ₹6,00,000
2) Average stock of raw material ₹50,000
3) Work-in-progress inventory consumed during the year ₹5,00,000
4) Average work-in-progress inventory ₹30,000
5) Finished goods inventory consumed during the year ₹8,00,000
6) Average finished goods stock held ₹30,000
7) Average collection period from debtors 40 days
8) Average credit period availed 45 days
9) No of days in a year 360 days
Solution :
2) From the following details, prepare an estimate of the requirement working capital:
Particulars
Production 60,000 Units p.a.
Selling price per unit ₹5
Raw materials 60% of selling price
Direct wages 10% of selling price
Overheads 20% of selling price
Materials in hand 2 months requirements
Production Time 1 month
Finished goods in stores 3 months
Credit for materials 2 months
Credit allowed to customers 3 months
Average Cash Balance ₹ 20,000
Wages and overheads are paid at the beginning of the month following .In production all the required
materials are charged in the initial stage and wages and overheads accrue evenly.
3) The management of Rajesh Limited has called for a statement showing the working capital needed to finance
a level of activity of 3,00,000 units of output for the year. The cost structure for the Company’s product, for
the above-mentioned activity level, is detailed below:
Particulars Cost per unit (₹%)
Raw materials 20
Direct labour 5
Overheads 15
Total cost 40
Profit 10
Selling Price 50
Past trends indicate that raw materials are held in stock, on an average for two months.
Work-in-progress will approximate to half- a-months production. Finished goods remain in warehouse, on
an average for a month. Suppliers of material extend a month's credit.
Two months credit is normally allowed to debtors. A minimum cash balance of ₹25000 is expected to be
maintained. The production pattern is assumed to be even during the year.
Prepare the statement of working capital determination

10. A company currently has an annual turnover of ₹ 50 lakhs and an average collection period of 30 days. The
company wants to experiment with a more liberal credit policy on the ground that increase in collection
period will generate additional sales. From the following information, kindly indicate which policy the
company should adopt:
Credit policy Average collection period Annual sales (₹ In lakhs)
A 45 days 56
B 60 days 60
C 75 days 62
D 90 days 63
Variable cost is 80% of sales. Fixed Cost is ₹ 6 lakhs per annum. Required pre-tax return on investment =
20%. 1 year = 360 days.
Solution :
11. In order to increase sales from their present annual level of ₹ 2,40,000, AGNI Associates is considering a
more liberal credit policy. Currently, the firm has an average collection period of 30 days. However, it is
believed that as the collection period is lengthened, the sales will increase by the following amounts:
Credit policy Increase in Average collection period Increase in Sales (₹)
A 15 days 10,000
B 30 days 15,000
C 45 days 17,000
D 60 days 18,000
The Selling Price of the only product manufactured is Re. 1 and its variable cost is ₹ 0.60. If the firm has a
pre-tax opportunity cost of 20%, which credit policy should be pursued? (Assume a 360-day year).
12. A manufacturing firm has credit sales of ₹ 360 lakh and its average collection period is 30 days. The financial
controller estimates bad-debt losses at around 2% of credit sales. The firm spends ₹ 1,40,000 annually on
debtor’s administration. This cost comprises of telephone and internet bills along with salaries of staff
members.
A factoring firm has offered to buy the firms receivable. The factor will charge 1% commission and will pay
an advance against receivables on an interest @ 15% p.a. after withholding 10% as reserve.
What should the firm do? Assume 360 days in a year.

Solution :
1. A company currently has an annual turnover of ₹ 50 lakhs and an average collection period of 30 days. The
company wants to experiment with a more liberal credit policy on the ground that increase in collection
period will generate additional sales. From the following information, kindly indicate which policy the
company should adopt:
Credit policy Average collection period Annual sales (₹ In lakhs)
A 45 days 56
B 60 days 60
C 75 days 62
D 90 days 63
Variable cost is 80% of sales. Fixed Cost is ₹ 6 lakhs per annum. Required pre-tax return on investment =
20%. 1 year = 360 days.
Solution :
2. In order to increase sales from their present annual level of ₹ 2,40,000, AGNI Associates is considering a
more liberal credit policy. Currently, the firm has an average collection period of 30 days. However, it is
believed that as the collection period is lengthened, the sales will increase by the following amounts:
Credit policy Increase in Average collection period Increase in Sales (₹)
A 15 days 10,000
B 30 days 15,000
C 45 days 17,000
D 60 days 18,000
The Selling Price of the only product manufactured is Re. 1 and its variable cost is ₹ 0.60. If the firm has a
pre-tax opportunity cost of 20%, which credit policy should be pursued? (Assume a 360-day year).
3. A manufacturing firm has credit sales of ₹ 360 lakh and its average collection period is 30 days. The financial
controller estimates bad-debt losses at around 2% of credit sales. The firm spends ₹ 1,40,000 annually on
debtor’s administration. This cost comprises of telephone and internet bills along with salaries of staff
members.
A factoring firm has offered to buy the firms receivable. The factor will charge 1% commission and will pay
an advance against receivables on an interest @ 15% p.a. after withholding 10% as reserve.
What should the firm do? Assume 360 days in a year.

Solution :
1. ……………………………….. refer to receivables created in the course of operation of
working capital cycle
a) Sundry creditor
b) Sundry debtor
c) Current liability
d) Current asset
2. ………………………… is the important factor determining both the quantity and the quality
of accounts receivable
a) Credit policy
b) Credit analysis
c) Control over receivables
d) None of the above
3. ……………………………… is type of financial services which involves an outright sale of the
receivable of to a firm to a financial institution called as factor which in the
management of trade credit
a) Factoring services
b) Current liability
c) Current asset
4. Which of the following are the factoring services
a) Bulk factoring
b) Recourse factoring
c) Agency factoring
d) All of the above
5. The cash discount policy of the frim specify which of the following aspects
a) The rate of cash discount
b) The cash discount period
c) The net credit period
d) All the above
Page 1
Inspire Academy ( 888888 1719) Chapter 8 : Nature & Scope of Financial Management 8.1
8 Nature & Scope of Financial Management
Definition of Financial Management
Definition: Financial Management comprises the forecasting, planning, organizing, directing,

coordinating and controlling of all activities relating to acquisition and application of the financial
resources of an undertaking in keeping with its financial objective.” Raymond Chambers
Financial management “is the operational activity of a business that is responsible for obtaining and
effectively utilizing the funds necessary for efficient operations. – Joseph and Massie.
There are two basic aspects of financial management viz., procurement of funds and an effective use
of these funds to achieve business objectives.

Page 2
OBJECTIVES OF FINANCIAL MANAGEMENT
Financial management of any business firm has to set goals for itself and to interpret them in relation
to the objective of the firm.
(1) Primary Objectives (2) Other Objectives
a) Profit Maximization. a) Customer Satisfaction, i.e. value for money, quality goods,
b) Value or Wealth etc.
Maximization. b) Employee Welfare, i.e. good standard of living, giving fair
wages, etc.
c) Maintaining and improving Market Share.
d) Market Leadership in terms of products, services,
technology, management techniques, etc.
e) Good Corporate Citizenship in terms of tax remittance,
maintaining ecological balance, etc.

Page 3
Profit Maximization Wealth Maximization
Does not consider the effect of future Recognises the effect of all future cash
cash flows, dividend decisions, EPS, etc. flows, dividends, BPS, etc.
A Firm with Profit Maximization objective A Firm with Wealth Maximization

may refrain from payment of dividend to objective may pay regular dividends to its
its Shareholders. Shareholders.
Ignores time pattern of returns. Recognises the time pattern of returns.
Focus on Short-Term. Focus on Medium / Long Term
Does not consider the effect of uncertain/ Recognises the risk-return relationships.
risk.
Comparatively easy to determine the Offers no clear or specific relationship

relationship between financial decisions between financial decisions and share
and Profits market prices.
1. Focus of financial management is to address which of the financial management decision areas
a) Investment decision
b) Financing decision
c) Dividend decision
d) All of the above
2. Basic aspects of financial management are …..
a) Procurement of funds
b) Effective utilization of funds
c) Wealth maximization
d) Both a and b
3. sources of funds of business enterprises are
a) Debenture and bonds
b) Venture capital
c) Owners funds
d) All of the above
4. Equity capital are best from risk point of view for the firm because ……..

Page 4
a) They are taxes free

b) The dividend paid to them are less
c) There is no question of repayment of equity capital except when the firm is under
liquidation
d) All of the above
5. Equity Capital is usually the most expensive source of the funds because
a) The dividend expectation of shareholders are normally higher than prevalent interest rate
b) Dividend are an appropriation of profit ,not allowed as an expenses under INCOME TAX ACT
c) Both a and b
6. Debenture as a source are cheaper because
a) Debenture is free from taxes
b) Interest on debentures is paid whether or not the company makes profit
c) No question of repayment of debentures except at the time of liquation of company
d) Debenture is ownership capital
7. Debenture entail a high degree of risk since
a) They have to be repaid as per the terms of agreement
b) Interest on debentures is paid whether or not the company makes profit
c) Both a and b
8. Investment decisions are the decisions related to
a) Acquiring the optimum finance to meet financial objective and seeing that fixed and
working capital are effectively managed
b) Determining as to how much and how frequently cash can be paid out of the profits of an
organization as income for its owner /shareholder
c) Selection of assets in which funds will be invested by the firm
9. financing decisions are decisions related to …..
a) Acquiring the optimum finance to meet financial objective and seeing that fixed and working
capital are effectively managed
10. Dividend decisions are decisions related to ………
a) Acquiring the optimum finance to meet financial objective and seeing that fixed and
working Capital are effectively managed

Page 5
11. The most important goal of financial management is
a) Profit maximization
b) Matching income with expenditure
c) Using business assets effectively
d) Wealth maximization
12. To achieve wealth maximization ,the finance manager has to take careful decision in respect of
a) Investment
b) Financing
c) Dividend
d) All of the above
13.
14. For effective utilization of fixed asset finance manager would require sound knowledge of technique
of
a) capital structure
b) capital budgeting
c) working capital
d) all of the above
15. Financial management is important for an organization to carry out which of the following jobs
a) planning and funding of investment
b) monitoring expense against budgets
c) managing gains from investment
d) all of the above
16. which types funds should be procured in the business to achieve expected returns
a) the funds which have maximum cost but are best from risk point of view
b) the funds which have minimum cost but have a higher risk
c) the funds of which have minimum cost and the best from risk point of view
d) the funds which have maximum cost and higher risk
17. Which sources of funds should be selected in an organization for effective utilization of funds
a) the funds which generate income equal to the cost of procurement of the funds
b) the funds which generate income higher than the cost of procurement of funds
c) the funds which generate income lower than the cost of procurement of funds
d) as per requirement of the organization
18. Which are the non-fund based lending services provided by banks
a) guarantee

Page 6
b) letters of credit
c) both a and b
d) none of the above
19. which of the following are the disadvantages of profit maximization
a) Emphasizes the short term gains
b) Ignores risk or uncertainty
c) Ignores timing of returns
d) All of the above
20. The owner of any profit making organization looks for reward in which of the following ways
a) Drawings
b) Dividend
c) Both of the above
21. The dividend decisions includes which of the following elements
a) The amount to be paid out and the amount to be retained to support the growth of the
organization
b) The amount to be paid out
22. Financial management is all about
a) Planning and funding the investment
b) Monitoring expenses against budget
c) Managing gains from the investment
d) All of the above
23. which of the following is not an disadvantage of profit maximization
a) Offers no clear relationship between financial decisions and share price
b) Can lead to management anxiety and frustration
c) Emphasizes on short term gains
24. financial manager carry out which of the following tasks
a) taking care not to over-invest in fixed asset
b) balancing cash outflow with cash inflow
c) ensuring that there is a sufficient level of short term working capital
d) all of the above
25. which of the following are the advantages of wealth maximization
a) emphasizes the long term gains
b) recognizes risk or uncertainty
c) recognizes the timing of return
d) all of the above

Page 7
26. Measuring and maximizing shareholder wealth finance manager should follow which of the
following
a) Cash flow approach
b) Cost benefit analysis
c) Application of time value of money
d) All of the above
27. The value maximization objective is superior to its profit maximization objective due to which of
the following reasons
a) A firms that wishes to maximize the shareholders wealth may pay regular dividends wheras
a firm with an objective of profit maximization may refrain from dividend payment to the
shareholders
b) Shareholder would prefer an increase in profit of the firm against its generation of firms
wealth
28. which of the following are not the advantage of wealth maximization
a) easy to determine the link between financial decisions and profit
b) emphasizes the long term gains
c) recognizes risk or uncertainty
d) recognizes the timing of return
29. which of the following are disadvantages of profit maximization
a) Profit is must for the survival of the business
b) The term profit is vague and ambiguous
c) Essential for the growth and development of the business
d) Impact on society through factor payments
e) The term profit is vague and ambiguous
30. which of the following are the advantages of wealth maximization
a) Profit is must for the survival of the business
b) Essential for the growth and development of the business
c) Impact on society through factor payments
d) emphasizes the long term gains

Page 1
Chapter 9:Portfolio management 9.1
9. Portfolio Management
Raj Awate Mo. 8888881719 Inspire Academy, Pune

Page 2
1. Find out the expected return from the information given below-
Possible return (%) Probability
20 0.20
30 0.20
40 0.40
50 0.10
60 0.10
a) 40% b) 37% c) 50% d) None

Page 3
2. Mr. A is Interested to invest Rs. 1,00,000 in the securities market. He selected two
securities B and D for this purpose. The risk return profile of these securities are as
follows-
Security Risk ( ) Expected return (ER)
B 10% 12%
D 18% 20%
Co-efficient of correlation between B and D is 0.15
You are required to calculate the portfolio return and standard deviation as per the
information given below to be considered by A for his investment.
a) 70% investment in A
b) R- 12% & SD – 10%
c) R- 15% & SD-10%
d) R- 10% & SD – 12%
e) None

Page 4
3. Calculate value of Beta by correlation method-

Standard deviation of Stock Is 12%
Standard deviation of Market is 14%
Coefficient correlation = 0.70
a) 0.60 b) 0.78 c) 0.87 d) None
4. Consider the following information on two stock, A and B:

Page 5
Year Return A (%) Return on B (%)
2006 10 12
2007 16 18
Calculate the covariance of return from the two stocks.
a) 11% b) 10% c) 9% d) None
5. Consider the following information on two stock, A and B:

Year Return A (%) Return on B (%)
2006 10 12
2007 16 18

Page 6
Calculate the Correlation coefficient between the return of the two stocks.
a) 0 b) 1 c) 2 d) None
6. The distribution of return of security F and the market portfolio ‘p’ is given below-
Probability Return
F P
0.30 30 -10
0.40 20 20
0.30 0 30
You are required to calculate the expected return of security ‘F’ and the market
portfolio ‘P’,
a) mF- 17 & P - 14
b) F- 14 & P-17
c) P-15 & F-16
d) None

Page 7
7. The distribution of return of security F and the market portfolio ‘p’ is given below-
Probability Return
F P
0.30 30 -10
0.40 20 20
0.30 0 30
You are required to calculate the covariance between market portfolio and security.
a) -168 b) 168 c) 196 d) None

Page 8
8. Identify the example of the systematic risk given below-

a) Interest rate
b) Market Risk
c) Purchasing power Risk
d) All of the above
9. Identify the example of the unsystematic risk given below-
a) Business Risk
b) Financial Risk
c) a & b
d) None
10. Identify the correct statement given below-
a) Total risk = Systematic Risk + Market Risk
b) Total risk= Systematic Risk + Unsystematic Risk
c) Total risk= Systematic Risk - Unsystematic Risk
d) None
11. Systematic risk is also known as...................
a) Non-diversifiable risk
b) Market risk
c) a & b
d) None
12. Systematic Risk is measured in terms of .......
a) Beta
b) Co-variance
c) Standard deviation
d) None
13. ............... Risk is called as diversifiable risk and can be reduced by diversification.
a) Systematic risk
b) Unsystematic risk
c) a and b
d) None
14. ................ measures the risk premium per unit of total risk for security or portfolio of
security.
a) Sharpe Ratio
b) Treynor Ratio
c) Jensen Alpha
d) None
15. If Return of security A is 30% and security B is 25%, risk free rate of return is 8% and
standard deviation of A is 11% and that of B is 5%. Identify the which security will be
preferred as sharpe ratio.
a) A
b) B

Page 9
c) 50% in A and 50% in B

d) None
16. .................measures the risk premium per unit of systematic risk for a security or a
portfolio of security.
a) Sharpe Ratio
b) Treynor Ratio
c) Jensen Alpha
d) None
38) From the following information calculate the expected rate return of the
investment-
Market rate of return – 18%
Risk free rate of return – 15%
Standard deviation of market – 1.2
Standard deviation of portfolio- 1.5
Co-relation of co-efficient of portfolio with market- 0.75
a) 17.81% b) 16.56% c) 13.13% d) None

Page 10

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Inspire Academy ( 888888 1719) Chapter 1 : LEVERAGE

Operating leverage Financial leverage Combined leverage

(a) Definition: operating leverage is defined is defined as the “firm’s ability

FM with RAJ AWATE – Amazing journey of logic and concepts

❖ WHEN IS A FIRM SAID TO BE FIANCIALLY FAVOURABLY

To determine whether the degree of financial leverage is favourable or

1. When ROCE greater than interest rate:

FM with RAJ AWATE – Amazing journey of logic and concepts

supplier of long term debt funds. Financial leverage in such cases is

2. When ROCE is less than interest rate:

3. Conclusion: DFL should be high when return on capital employed

(b) Explanation: effect of fixed operating costs (i.e. operating risks) is

(c) Measurement : the degree of combined leverage (DCL) is measured as

(d) Significance: DOL measures impact of change in sales on EBIT. DFL

FM with RAJ AWATE – Amazing journey of logic and concepts

combined impact, l.e. effect of change in sales on EPS. IF DCL is 2 times.

FM with RAJ AWATE – Amazing journey of logic and concepts

1. Sales 1,00,000 units @ Rs. 2 per unit

FM with RAJ AWATE – Amazing journey of logic and concepts

4. The following information is available for ABC& co.

Profit before tax 3, 20, 000

Fixed costs 7, 00, 000

Calculate % change in EPS if the sales are expected to increase by 5%

FM with RAJ AWATE – Amazing journey of logic and concepts

FM with RAJ AWATE – Amazing journey of logic and concepts

Prepare income statement for the company A , B & C.

FM with RAJ AWATE – Amazing journey of logic and concepts

7. Balance sheet of ABC ltd is given below :

Liability Rs. Asset Rs.

60,000 Net fixed asset 1,50,000

FM with RAJ AWATE – Amazing journey of logic and concepts

1. Match the pair

FM with RAJ AWATE – Amazing journey of logic and concepts

a. If 1% change in sales will lead to 2% change in EBIT.

10. The following information is available for ABC & Co

FM with RAJ AWATE – Amazing journey of logic and concepts

Calculate % change in EPS if the sales are expected to increase by 5%

FM with RAJ AWATE – Amazing journey of logic and concepts

Operating Leverage 3:1

FM with RAJ AWATE – Amazing journey of logic and concepts

FM with RAJ AWATE – Amazing journey of logic and concepts

INSPIRE Academy ( 888881719) Chapter 2 : INVENTORY MANAGEMENT 2.1

1. WHAT IS ECONOMIC ORDER QUANTITY ( EOQ )

size of order which should be placed so that overall cost is minimum.

2 ×Annual requirement ×cost per order

Annual ordering cost = cost per order * Number of orders

Annual carrying cost = carrying cost p.u.pa. * Average inventory

Costing by Raj Awate – Amazing journey of logic and concept

INSPIRE Academy ( 888881719) Chapter 2 : INVENTORY MANAGEMENT 2.2

2. WHAT IS INVENTORY LEVEL

• = Maximum lead time * Maximum consumption rate

Minimum • = ROL– Avg lead time * Avg consumption rate

• = ROL + ROQ – Min lead time time * Min

• = (maximum level + minimum level) / 2

Danger • = emergency lead time * normal consumption

Costing by Raj Awate – Amazing journey of logic and concept

INSPIRE Academy ( 888881719) Chapter 2 : INVENTORY MANAGEMENT 2.3

3. TECHNIQUES OF INVENTORY CONTROL:

(i) Min-max Plan