December 20 FTFM Practice

Weighted Average Cost of Capital
What is the prediction about share price of these two entities?

CAPM Forumla
Ra = Rf+β(Rm-Rf)
Ra = Expected rate of return
Rf = Risk free rate of return
β = Risk factor
Rm = Market return
In this problem:
Rf = 6%
β = 1.25 Apple Ltd; 1.40 Banana Ltd.
Rm = 10%
Dividend = ₹64
Apple Ltd Banana Ltd
Ra = 6+1.25(10-6) = 11% Ra = 6+1.40(10-6) = 11.6%
Prediction about share price (P)
Ke = D/P Ke = D/P
= ₹64/0.11= 581.82 = 64/0.116= 551.72
Compute Weighted Average Cost of Capital (WACC) using market values as weights.
Dividend Growth Rate:
G = [EPS-DPS(1-Tax)]/Po
EPS = Earnings Per Share
DPS = Dividend Per Share
TAX = Dividend Tax Rate
Po = Issue Price Per Share
In this Problem
EPS = ₹8
DPS = ₹5
D.Tax = 10%
Po = 40%
= 8-5(1-.10)/40 = 6.25%
Cost of equity (existing):
Ke = (D1/Po)+G
D1 = Floatation cost per share
Po = Issue price per share
G = Dividend Growth Rate
In this problem
D1 =5
Po = 40%
G = 6.25% = (5/0.40)+6.25 = 12.5+6.25 = 18.75%
Equity (new issue):
Ke = (D1/t)+G
D1 = Floatation cost per share
Tax = Corporate Tax
G = Dividend Growth
In this problem
D1 =5
Po = 40-5 =35
G = 6.25%
= (5/0.35)+6.25 = 20.54
Cost of preference shares(Kp) = (Total dividends on preference shares+Dividend Tax)
Market Value of Preference shares
In this problem
Total dividends on Preference shares = ₹8,00,000x12% = ₹96,000
Dividend Tax = ₹96,000/10% = ₹9,600
Market Value of Preference shares = ₹8,50,000
Then = ₹96,000+₹9,600
₹8,50,000
= 12.42%
Cost of Debentures = Interest(1-Corporate Tax)
Interest = Cost of debentures (1-Pre-Tax Rate)
= 11%
= 11(1-.35) =7.15%
Equity capital (existing) = 60,000x₹40 = ₹24,00,000
New equity capital = ₹38,00,000-₹24,00,000 = ₹14,00,000
Preference share capital = ₹8,50,000 (given in problem)
Debentures = ₹50,00,000 (given in problem)
Source of capital Cost Market Value Total Cost
Equity capital (existing) 18.75% ₹24,00,000 ₹4,50,000
New equity capital 20.54% ₹14,00,000 ₹2,87,560
Preference share capital 12.42% ₹ 8,50,000 ₹1,05,570
Debentures 7.15% ₹50,00,000 ₹3,57,500
₹96,50,000 ₹12,00,630
Weighted Average Cost of Capital (Ko) = Total Cost
Market Value
= ₹12,00,630
₹96,50,000
= 12.44%
Calculate the cost of capital?
In this problem
Debt (Wd) = 30%
Equity (We) = 70%
Investment proposal costing less than = ₹30.00 Lakhs
Cost of raising debt and equity are follows as:
Project cost Cost of Debt Cost of Equity
Upto ₹5.00 Lakh 9% 13%
Above ₹5.00 Lakh and upto ₹20.00 Lakh 10% 14%
Above ₹20.00 Lakh and upto ₹40.00 Lakh 11% 15%
Tax Rate = 30%
Project A funds requirement = ₹8.00 Lakh
Project A funds requirement = ₹21.00 Lakh
Project A:
Cost of Project = ₹8,00,000
Debt (30% of ₹8,00,000) = ₹2,40,000
Equity (70% of ₹8,00,000 = ₹5,60,000
Kd = 10(1-0.30) = 7%
Ke =14%
WACC = KdxWd+KexWe
= (7x0.3)+(14x0.7) = 2.1+9.8 = 11.9%
Project B:
Cost of Project = ₹21,00,000
Debt (30% of ₹21,00,000) = ₹6,30,000
Equity (70% of ₹21,00,000 = ₹14,70,000
Kd = 11(1-0.30) = 7.7%
Ke =15%
WACC = KdxWd+KexWe
= (7.7x0.3)+(15x0.7) = 2.31+10.5 = 12.81%
Compute the WACC of Krishna Ltd.?
Return of security (Ke) = Rf+β(Rm-Rf)
Rf = Risk-free rate of return
Rm = Return on market portfolio
β = Beta of security
In this problem:
β = 1.5
Rf = 4%
Rm = 3.5%
= 4+1.5(3.5-1.5) = 9.25%
Kd = I(1-T)
I = Interest
T = Tax
In this problem:
Interest = 7%
Tax = 35%
= 7(1-0.35) = 4.55%
Wd = 9.25+4.55 = 13.80 = 4.55/13.80 = 0.33
We = 9.25+4.55 = 13.80 = 9.25/13.80 = 0.67
Calculation of WACC
Particulars Weight Cost WACC Cost
Equity 0.67 9.25 6.17
Debt 0.33 4.55 1.52
WACC 7.69%
Compute the weighted average cost of capital
Source of Finance Amount (₹) After Tax Cost (%)
Equity (paid-up) share capital 20,00,000 20
Retained earnings (Reserves) 40,00,000 20
Preference share capital 15,00,000 10
Debt 25,00,000 8
Total 1,00,00,000
Source Amount ₹ Propotion After Tax Cost Weighted Cost
Equity Capital 20,00,000 20.00 20.00 0.040
Retained Earnings 40,00,000 40.00 20.00 0.080
Preference share capital 15,00,000 15.00 10.00 0.015
Debt 25,00,000 25.00 8.00 0.020
Total 100,00,000 1.00 0.155
Weighted Average cost of capital 0.155 or 15.5%
Calculate the Cost of Equity
Particulars Company A Company B
Historical and expected return on equity (ROE) 16% 11%
Historical and expected dividend payout ratio 40% 40%
Beta 1.35 1.05
The expected return on the market index is 11.5% and the expected risk-free return is 5.25%.
Ke = Krf+β(Km-Krf)
Ke = Cost of Capital
Krf = Risk free rate
Km = Expected return on the market portfolio
β = Beta
Project A:
Ke = Krf+ β(Km-Krf)
Krf = 5.25
β = 1.35
Km = 11.5%
Ke = 5.25+1.35(11.5-5.25) = 5.25+8.4375 = 13.69%
Project B:
Ke = Krf+ β(Km+Krf)
Krf = 5.25
β = 1.05
Km = 11.5%
Ke = 5.25+1.05(11.5-5.25) = 5.25+6.56 = 11.81%
Compute the Weighted Average Cost of Capital
5,000 Equity shares of ₹ 100 each ₹ 5,00,000
10% Preference Shares ₹ 1,00,000
12% debentures ₹ 4,00,000
Cost of equity (Ke) = D1/Pox100+G
D1 = Declare of dividend
Po = Price of share
G = Dividend Growth Rate
In this problem:
D1 = 12%
Po = ₹120
G = 8%
= 12/120x100+8 = 18%
Cost of Preference shares (Kp) = 10%
Cost of Debentures (Kd) = D1(1-Tax)
In this problem:
D1 = 12%
Firms Tax = 40%
= 12(1-0.40) = 7.2%
Particulars Book Value Weight Cost WACC
Equity 5,00,000 0.50 18% 9.00
Preference shares 1,00,000 0.10 10% 1.00
Debentures 4,00,000 0.40 7.2% 2.88
Total 10,00,000 1.00 12.88
Calculate weighted average cost of capital using —
(i) Book value weight; and
(ii) Market value weight
Type of capital Book value (₹ in lakh) Market value (₹ in lakh) Cost of capital (%)
Debentures 4 3.8 5
Preference shares 1 1.1 8
Equity shares 6 9.0 13
Retained earnings 2 3.0 9
Total 13 16.9
Calculation of WACC using book value weights:
Source of capital Amount₹ (W) Cost (X) Weighted Cost₹(WX)
Debentures 4,00,000 0.50 20,000
Preference shares 1,00,000 0.80 8,000
Equity shares 6,00,000 0.13 78,000
Retained earnings 2,00,000 0.90 18,000
Total 13,00,000 1,24,000
ƩW = 13,00,000
ƩXW = 1,24,000
WACC = ƩXW/ ƩWx100 = (1,24,000/13,00,000)x100 = 9.54%
Calculation of WACC using market value weights:
Source of capital Amount₹ (W) Cost (X) Weighted Cost₹(WX)
Debentures 3,80,000 0.50 19,000
Preference shares 1,10,000 0.80 8,800
Equity shares 9,00,000 0.13 1,17,000
Retained earnings 3,00,000 0.90 27,000
Total 16,90,000 1,71,800
ƩW = 16,90,000
ƩXW = 1,71,800
WACC = ƩXW/ ƩWx100 = (1,71,800/16,90,000)x100 = 10.17%
Determine the cost of capital using market value as weights:
₹ Market Value (₹)
Debentures @ ₹1,000 each 15,00,000 1,100 each
Preference shares @ ₹10 each 5,00,000 12 each
Equity shares @ ₹100 each 20,00,000 200 each
TOTAL 40,00,000
Debentures carry 8% rate of interest, issued and redeemable at par with maturity period of 20 years and floating cost 4%.
Preference shares carry 10% dividend rate, issued and redeemable at par with maturity period of 15 years and floating cost
5%.
Equity dividend expected at the end of year is ₹20 per share whereas anticipated dividend growth rate is 5%. Corporate tax is
30%.
Cost of Debt:
Kd = [I(1-T)+(Rv-Sv)]/N/[(Rv+Sv)/2]
I = Interest
T = Tax
Rv = Redeemable value of debt
Sv = Net sale proceeds of debentures
N = Number years of maturity
In this problem:
I = 8%
T = 30%
Rv = ₹1,000
Sv = (₹1,000x4%)
= ₹40 = (₹1,000-₹40) = ₹960
N = 20
= [8(1-0.30)+(₹1,000-₹960)]/20/[(₹1,000+₹960)/2]
= 5.60+(₹40/20/₹980) = 5.602%
Cost of preference shares:
Kp = [I(1-T)+(Rv-Sv)]/N/[(Rv+Sv)/2]
In this problem:
I = 10%
Tax = 30%
Rv = ₹10
Sv = (₹10x5%)
= ₹0.5
= (₹10-₹0.5) = ₹9.5
N = 15
= [10(1-0.30)+ (₹10-₹0.5)]/15/[(₹10+₹0.5)/2] = 7.006%
Cost of equity:
Ke = (D1/Pox100)+G
D1 = Expected dividend
Po = Market price per share
G = Expected growth rate
In this problem:
D1 = ₹20
Po = ₹200
G = 5%
= (₹20/₹200x100)+5 = 15%
Calculation of market value:
Market value of debentures = (₹15,00,000/₹1,000)/ ₹1,100 = ₹16,50,000
Market value of preference shares = (₹5,00,000/₹10)/ ₹12 = ₹ 6,00,000
Market value of equity shares = (₹20,00,000/₹100)/ ₹200 = ₹40,00,000
Total = ₹62,50,000
Computation of Weighted Average Cost of Capital using market value as weights:
Source of capital Amount (W) Cost (X) Weighted Cost
Debentures ₹16,50,000 5.602% ₹ 92,433
Preference shares ₹ 6,00,000 7.006% ₹ 42,036
Equity shares ₹40,00,000 15.000% ₹6,00,000
ƩX ₹62,50,000 ƩXW ₹7,34,469
Ko = ƩXW/ƩX
= ₹7,34,469/₹62,50,000 = 11.75%
Calculate weighted average cost of capital at book value
No. of Equity Shares = 10,000 @ ₹7 each,
No. of debentures = ₹10,000 @ 12%
Short-term loan = ₹20,000 @10%.
Tax rate = 30%.
Assume cost of equity capital = 20%.
Calculation of cost of debentures:
Kd = I(1-T)
I = Interest
T = Tax
In this problem
I = 12
T = 30%
= 12(1-0.30) = 8.4%
Calculation of short term loan
I = 10%
T = 30%
= 10(1-0.30) = 7%
Calculation of Weighted Average Capital Cost using book values:
Source of capital Amount₹ Weight Cost WACC Cost
Equity shares 70,000 0.70 0.200 0.1400
Debentures 10,000 0.10 0.084 0.0084
Short term loan 20,000 0.20 0.007 0.0140
WACC 0.1624 or 16.24%
Compute weighted average cost of capital.
31st March, 2013: ₹
Equity shares (4,00,000 shares) 80,00,000
10% Preference shares 20,00,000
14% Debentures 60,00,000
1,60,00,000
Share of the company sells for ₹20.
Expected dividend = ₹2
Expected Growth rate = 7%
Tax rate = 30%
Ke = (D1/Po)+G
= (2/20)+0.07 = 17%
Kd = I(1-T)
= 14(1-0.30) = 9.8%
Kp = 10%
Calculation of weighted average cost of capital
Source of capital Amount₹ Cost WACC Cost₹
Equity shares 80,00,000 0.170 13,60,000
Preference shares 20,00,000 0.100 2,00,000
Debentures 60,00,000 0.098 5,88,000
Total WACC 1,60,00,000 21,48,000
WACC = (₹21,48,000/₹1,60,00,000)x100 = 13.425%
P/E Ratio
Compute the P/E ratio for the company
Net profit before tax = ₹17,50,000
Equity shares = 1,00,000 @ ₹10 each
Current market price = ₹85
Income-tax = 30%
Calculation of profit after tax:
Net Profit before tax = ₹17,50,000
Less: Income-tax = ₹ 5,25,000 (₹17,50,000x30%)
Profit after tax = ₹12,25,000
Calculation of Earnings per share = Profit after tax/No. of equity shares
= ₹12,25,000/1,00,000 = ₹12.25
P/E Ratio = Market price per share/Earnings per share
= ₹85.00/₹12.25 = ₹6.94
Income-tax = 30%
Calculation of Profit after tax:
Less: Income-Tax = ₹ 6,00,000 (₹20,00,000x30%)
= ₹14,00,000/1,50,000 = ₹9.34
= ₹75.00/₹9.34 = ₹8.03
Equity shares = 5,000 @ ₹10 each
Income-tax = 30%
Less: Income-Tax = ₹ 30,000 (₹1,00,000x30%)
Profit after tax = ₹ 70,000
Calculation of earnings per share = Profit after tax/No. of equity shares
= ₹70,000/5,000 = ₹14
= ₹40.00/₹14.00 = ₹2.85
Income-tax = 30%
Less: Income-Tax = ₹1,50,000 (₹5,00,000x30%)
= ₹3,50,000/7,000 = ₹50
= ₹60.00/₹50.00 = ₹1.20
Income-tax = 30%
Less: Income-Tax = ₹22,50,000 (₹75,00,000x30%)
= ₹43,50,000/2,50,000 = ₹17.40
= ₹90.00/₹17.40 = ₹5.17
Income-tax = 30%
Less: Income-Tax = ₹21,00,000 (₹70,00,000x30%)
= ₹49,00,000/1,50,000 = ₹32.66
= ₹75.00/₹32.66 = ₹2.29
Income-tax = 30%
Less: Income-Tax = ₹15,00,000 (₹50,00,000x30%)
= ₹35,00,000/40,000 = ₹87.50
= ₹95.00/₹87.50 = ₹1.08
Walter's model
Which of these maximise the wealth of shareholders as per Walter’s model of dividend?
The Earning per share of a company is = ₹16.
The market capitalization rate applicable to the company is = 12.5%.
Retained earnings can be employed to yield a return of = 10%.
The company is considering a payout of = 25%, 50% and 75%.
Market price per share = [DPS+R/Ke(EPS-DPS)]/Ke
DPS = Dividend per share
R = Return on investment
Ke = Capitalization rate
In this problem:
DPS = (₹16x25%); (₹16x50%); (₹16x75%)
= ₹4; ₹8; ₹12
R = 10%
Ke = 12.5%
EPS = ₹16
Dividend Pay ratio = 25%
= [₹4+(0.10/0.125)(₹16-₹4)]/0.125 = [₹4+(0.8x₹12)]/0.125= ₹108.80
= [₹8+(0.10/0.125)(₹16-₹8)]/0.125 = [₹8+(0.8x₹8)]/0.125 = ₹115.20
= [₹12+(0.10/0.125)(₹16-₹12)]/0.125 = [₹12+(0.8x₹4)]/0.125 = ₹121.60
Which of these maximise the wealth of shareholders as per Walter’s model of dividend?
The Earning per share of a company is = ₹20
The market capitalization rate applicable to the company is = 15%.
Retained earnings can be employed to yield a return of = 12.5%.
The company is considering a payout of = 30%, 60% and 90%.
In this problem:
DPS = (₹20x30%); (₹20x60%); (₹20x90%)
= ₹6; ₹12; ₹18
R = 12.5%
Ke = 15%
EPS = ₹20
= [₹6+(0.125/0.15)(₹20-₹6)]/0.15 = [₹6+(0.01875x₹14)]/0.15 = ₹41.75
= [₹12+(0.125/0.15)(₹20-₹12)]/0.15 = [₹12+(0.01875x₹8)]/0.15 = ₹81
= [₹18+(0.125/0.15)(₹20-₹18)]/0.15 = [₹18+(0.01875x₹2)]/0.15 = ₹120.50
If Walter's model is used — (a) What should be the optimum payout ratio of the firm? (b) What should be the price of a
share at this payout? (c) How shall the price of a share be affected if different payouts were employed?
In this problem:
The earnings per share of a company is = ₹10
Internal rate of return = 15%
Capitalisation rate = 12.5%
Dividend payout = 0%
= [₹0+(0.15/0.125)(₹10-₹0)]/0.125 = [₹0+1.20x₹10]/0.125 = ₹96
What would be the market value per share as per Walter’s model?
In this problem
Earnings per share = ₹5,00,000/No. of shares
= ₹5,00,000/1,00,000
= ₹5
Dividend payout ratio = 60%
No. of shares outstanding = 1,00,000
Equity capitalisation rate = 12%
Rate of return on investment = 15%
Dividend payout = (₹5,00,000x60%)= ₹3,00,000/No. of shares = ₹3,00,000/1,00,000 = ₹3
= [₹3+0.15/0.12(₹5-₹3)]/0.12 = [₹3+1.25x₹2]/0.1 = ₹45.83
You are required to calculate —(i) Market value per share as per Walter's Model.(ii) Dividend payout ratio to keep share
price at ₹40.(iii) Optimum dividend payout ratio as per Walter's Model.(iv) Market value per share at the optimum dividend
payout ratio based on Walter's Model.
No. of shares outstanding : 1 lakh
Earnings per share : ₹4
Dividend payout per share : ₹2.4
Equity capialisation rate : 12%
Rate of return on investment : 15%
= [₹2.4+0.15/0.12(₹4-₹2.4)]/0.12 = [₹2.4+1.25x₹1.6]/0.12 = ₹36.67
Which can maximise the market value of the company as per Walter’s Model.
Net profits = ₹10,00,000
Profits are retained = ₹2,50,000
Capitalization Rate = 12%.
No. of shares = 1,00,000
Dividend payout =0
Rate of Return on investment = [Retained profits/Net profits]x100
= [₹2,50,000/₹10,00,000]x100= 25%
Earnings per share = Net profits/No. of shares
= ₹10,00,000/1,00,000 = ₹10
= [₹0+0.25/0.12(₹10-₹0)]/0.12 = [₹0+(2.083x₹10)]/0.12 = ₹173.61
What should be the optimal dividend payment ratio? Use Walter’s Model.
In this problem:
Earnings of the company = ₹5,00,000
EPS = Earnings/No. of shares
= ₹5,00,000/1,00,000 = ₹5
Dividend paid = ₹3,00,000
DPS = Dividend paid/No. of shares
= ₹3,00,000/1,00,000 = ₹3
Number of shares outstanding = 1,00,000
Price-earnings ratio =8
Rate of return on investment = 15%
Ke = 1/ P/E Ratio
= 1/0.08 = 12.5%
Optimal dividend payment =0
= [₹0+0.15/0.125(₹5-₹0)]/0.125 = [₹0+1.2x₹5]/0.125 = ₹48
Indifference Point
You are required to compute indifference point
Existing Capital Structure:
20 lakh equity shares of = ₹10 each
Tax Rate = 50%
Raise additional capital of = ₹200lakh
It is evaluating two alternative financing plans:
(i) Issue of 20,00,000 equity shares of ₹ 10 each and
(ii) Issue of ₹ 200 lakh debentures carrying 14% interest.
Interest in plan (i) =0
Interest in plan (ii) = ₹2,00,00,000x14% = ₹28,00,000
No. of shares in plan (i) = Existing capital structure+Alternative plan (i)
= 20,00,000+20,00,000 = 40,00,000
No. of shares in plan (ii) = 20,00,000
Indifference point = [(X-Interest)(1-Tax rate)]/No. of shares
Indifference point under Plan (i) and Plan (ii) are equal
[(X-Interest)(1-Tax rate)]/No. of shares = [(X-Interest)(1-Tax rate)]/No. of shares
[(X-0)(1-0.50)]/40,00,000 = [(X-28,00,000)(1-0.50)]/40,00,000
X = 2X-56,00,000
X = 56,00,000
Calculate the Indifference point at which EPS would be the same by both plan.
Expansion project of = ₹100 lakh.
Tax rate = 30%.
The details of present position and different financing plans are as under.
Particulars Present position and Financial plans
Present 20 lakh equity shares and debentures of ₹50 lakh carrying interest rate 8%
Plan A Issue of Equity shares at the rate of ₹12.50 The expected Price earnings Ratio: 14
Plan B Issuance of Debentures carrying interest rate 14%. The expected Price earnings Ratio: 12
Plan A (Equity financing)
Calculation of interest on equity shares on present position = ₹50,00,000x8% = ₹4,00,000
Effective No. of equity shares = ₹20,00,000+(₹100,00,000/₹12.50) = 28,00,000
Plan A (Debt financing)
Calculation of interest on equity shares on present position = ₹50,00,000x8% = ₹4,00,000
Effective No. of debentures = (₹100,00,000x₹14) = ₹14,00,000
= ₹4,00,000+₹14,00,000 = ₹18,00,000
EPS Plan A = EPS Plan B
[(EBIT-Interest)(1-Tax)]/No. of shares = [(EBIT-Interest)(1-Tax)]/No. of shares
[(EBIT-₹4,00,000)(1-0.30)]/28,00,000 = [(EBIT-₹18,00,000)(1-0.30)]/20,00,000
[(EBIT-₹4,00,000)(0.70)]/28,00,000 = [(EBIT-₹18,00,000)(0.70)]/20,00,000
[0.70EBIT-₹2,80,000]/28,00,000 = [0.70EBIT-₹12,60,000]/20,00,000
[0.70EBIT-₹2,80,000]/28 = [0.70EBIT-₹12,60,000]/20
19.6EBIT-₹3,52,80,000 = 14EBIT-₹56,00,000
19.6EBIT-14EBIT = ₹3,52,80,000-₹56,00,000
5.6EBIT = ₹2,96,80,000
EBIT = ₹2,96,80,000/5.6
EBIT = ₹53,00,000
Net pay-off
Find out his net pay-off at the expiration of the option period, if the share price on that day happens to be 450 or 525.
Equity shares per share = ₹450
Call option for a 3-month period are available strike price = ₹485
Put option for a 3-month period are available strike price = ₹485
Call option for a 3-month period at a premium of per share = ₹15
Put option for a 3-month period at a premium of per share = ₹10
An investor wants to create a straddle position in this share.
In this problem:
Total Premium paid = ₹15+₹10 = ₹25
Share price happens to be = ₹450
Call option will not be exercised
Net pay-off = Pay off on put-Premium paid
= (₹485-₹450)-₹25 = ₹10
Share price happens to be = ₹525
Put option will not be exercised
Net pay-off = Pay off on call-Premium paid
= (₹525-₹485)-₹25 = ₹15
Foreign Currency Transactions
Calculate the expected loss, and to show how it can be hedged by a forward contract?
The payment due = 3 months
Invoice value = ¥108lakh
Spot rate = ₹66,96,000
3 months Exchange rate will decline = 10%
3 month forward rate = ¥1.48 = ₹1
In this problem
Spot rate = ¥1,08,00,000/₹66,96,000 = ¥1.613
Expected rate over 3 months period = (100%-10%) = 90% = ¥1.613x90% = ¥1.4517
Total amount required on invoice value = (¥1,08,00,000/¥1.4517) = ₹74,39,554
3 months forward rate = (¥1,08,00,000/¥1.48) = ₹72,97,297
Profit/(Loss) = Expected amount – Forward amount
= ₹7439,554-₹72,97,297 = (₹1,42,257)
Taking forward rate loss of (₹1,42,257) can be avoided.
what is the loss or gain to the customer on cancellation?
3 months forward purchase contract = SF20,000@₹74.25
Comes to bank cancellation contract = 2 Months
Spot = ₹/SF 74.30–74.35
1 month forward = ₹/SF 74.45–74.52
In this problem:
Bank to square up trade buying 1 month forward.
3 Months forwards purchase rate = ₹74.25
1 Month forward purchase rate = ₹74.52
Net effect in currency = (₹0.27)
Total payment = SF20,000x(₹0.27)
Total Profit/(Loss) = (₹5,400)
Total loss on cancellation of transaction to customer is ( ₹5,400) .
Recommend the price to be quoted in the tender by Lamuna Ltd., to American buyer.
Payment will be made in US$ = 18 months (3)
The marginal cost of producing the carpet is = ₹600 per square feet.
The tender quantity of carpet = 2,00,000 square feet
The normal mark-up on marginal cost = 25%
Spot exchange rate in Mumbai = ₹65.08-₹65.18 =1$
Expected annual inflation rate in India is = 9%
Expected annual inflation rate in US is = 3%
In this problem:
Spot Rate = ₹65.08
Annual Inflation rate in India = 1.09
Annual Inflation rate in US = 1.03
Annual = 12 months (2)
Calculation of forward rate = ₹65.08(1.09/1.03)x3/2 = ₹70.85
Cost of caret = 2,00,000x₹600 = ₹12,00,00,000
Mark-up = (₹12,00,00,000x25%) = ₹3,00,00,000
Sales value = (₹12,00,00,000+₹3,00,00,000) = ₹15,00,00,000
Current selling rate = ₹65.08
Expected selling rate = ₹70.85
Price to be quoted = ₹15,00,00,000/₹70.85 = $21,17,149
Find the expected rate of US $ in India after 1 year and 3 years from now using purchasing power parity theory.
The rate of inflation per annum in USA = 3.0%
The rate of inflation per annum India = 6.5%
The current spot rate of US $ in India is = ₹68.40
In this problem:
Spot rate = ₹68.40(1.065/1.03)x1 = ₹70.72
After 3 years = ₹68.40(1.065/1.03)x3 = ₹75.61
Advise the course of action.
Supplying goods worth = US $1,00,000
US importer and the amount is payable after = 4 months time.
The current spot rate of US $ is = ₹57.68
Rupee will appreciate next 4 months quoted at = ₹56.84
The importer accepts to pay immediately if = 2% cash discount
The current borrowing rate = 8% per annum.
In this problem:
Payment received immediately after allowing cash discount 2%
Invoice value = $1,00,000
Less: Discount 2% on ($1,00,000x2%) = $ 2,000
= $ 98,000
Spot rate = ₹57.68
Current amount ($98,000x₹57.68) = ₹56,52,640
If payment received at the end of 4 months
Rupee will appreciate next 4 months quoted at = ₹56.84
Invoice value = ₹56,84,000
Less: Opportunity cost of interest lost
($1,00,000x₹57.68x98/100x4/12) = ₹150737
Net amount = ₹55,33,263
If payment received immediately Profit/(Loss) = ₹56,52,640-₹55,33,263 = ₹1,19,377
Explore arbitrage possibility
Spot rate for US $1 = ₹66.0123
180-day forward rate for US $1 = ₹66.8190
Annualised interest rate for 6 months = 12%
Annualised interest rate for 6 months = 8%
In this problem:
Calculation of forward rate (180days) = ₹66.8190(1.012/1.08) = ₹73.03
If the spot rate on 30th September, 2013 was eventually ₹/$ = 64.17 and ¥/$ = 206.775
Is the decision to take forward cover justified?
Export value = ¥100 lakh
Spot rate = ₹/$ = 62.685
Spot rate = ¥/$ = 194.625
Forward rate = ¥/$= 206.025
Forward rate = ₹/$= 64.335
It is estimated that Yen will depreciate to 216 level and rupee to depreciate against dollar to 64.50.
The following rates appear in Foreign Exchange Market:
Spot Rate 2 Month Forward Rate
₹/1 US Dollar ₹64.00/₹64.20 ₹64.70/₹65.00
(a) How many US Dollars a Firm will have to sell to get ₹ 64.70 million after 2 months?
(b) How many rupees the firm will be required to pay to obtain US Dollar 2,00,000 in the spot market?
(c) Assuming that the firm has US Dollars 50,000, how many rupees the firm will obtain in exchange for the US Dollars?
(d) Are forward rate at premium or discount? Show the percentages also.
In this problem:
a) To sell o get ₹64.70 million after 2 months = ₹64,70,000
After 2 months forward rate to sell = ₹64.70
= ₹64,70,000/₹64.70 = $1,00,000
b) Pay to obtain in the spot market = $2,00,000
= $2,00,000x₹64.20 = $1,28,40,000
c) To sell in the market to get rupees = $50,000
= ₹32,00,000
d) Bid premium = (₹64.70-₹64.00)/₹64.00x(12/2)x100 = 6.56%
Ask premium = (₹65.00-₹64.20)/₹64.20x(12/2)x100 = 7.48%
Forward rate premiums are more higher than the spot rates
How can you take advantage of disparity in the futures and forward market?
How do you think the position would correct if on 28 October actual rate is ₹69 or ₹68 per $
Futures contract expiring to selling for = ₹68.68
Forward contract for delivery = ₹68.90
In this problem:
If accept bank offer = Forward rate-Future rate
= ₹68.90-₹68.68 = ₹0.22
At maturity spot exchange rate per $ = ₹68.00
Profit/(Loss) on future (₹68.00-₹68.68) = (₹0.68)
Profit/(Loss) on forward (₹68.90-₹68.00) = ₹0.90
Net Profit/(Loss) = ₹0.22
At maturity spot exchange rate per $ = ₹69.00
Profit/(Loss) on future (₹69.00-₹68.68) = ₹0.32
Profit/(Loss) on forward (₹68.90-₹69.00) = (₹0.10)
Net Profit/(Loss) = ₹0.22
Future market cheaper than as compared to Forward market.
You are required to calculate the expected loss if hedging is not done.
Export exposure value = ¥100 lakh
Spot rate = ₹/$ = ₹63.60
Spot rate = ¥/$ = ¥124.75
Yen will be depreciated to $ = ¥144.00
Rupee will be depreciated to $ = ₹65.00
In this problem:
Calculation of Spot rate of ¥100:
(₹/$x¥/$) = (63.60x1/124.75) = 0.5098x100 = ₹50.98
Calculation of Forward rate of ¥100:
(₹/$x¥/$) = (65.00x1/144.00) = 0.4514x100 = ₹45.14
Calculation of loss if hedging not done:
Calculation of spot rate (¥1,00,000x₹50.98) = ₹50,98,000
Calculation of forward rate (¥1,00,000x₹45.14) = ₹45,14,000
Expected Loss without forward rate = (₹5,84,000)
The importer company seeks your advice. Give your advice with reason.
Import invoice = $1,30,000.
Spot rate for = $1 : ₹48.35/₹48.36
3-month forward rate for = $1 : ₹48.81/₹48.83
The exporter has given the Indian importer two options:
(a) Pay immediately without any interest charges; or
(b) Pay after 3 months with interest @5% per annum.
The importer's bank charges 15% per annum on overdrafts.
In this problem:
a) Pay immediately without any interest charges :
Spot rate invoice amount ($1,30,000x₹48.36) = ₹62,86,800
Add: Bank charges ($1,30,000x15%/12x3x₹48.36) = ₹ 2,35,755
Total = ₹65,22,555
(b) Pay after 3 months with interest @5% per annum:
Forward rate invoice amount ($1,30,000x₹48.83) = ₹63,47,900
Add: Interest charges ($1,30,000x5%/12x3x₹48.83) = ₹ 79,349
Total = ₹64,27,249
It is advisable to make payment after 3 months company can save an amount of ₹95,306=( ₹65,22,555- ₹64,27,249).
The spot rate at the time Thai company receives payment is Baht 34.10/$
What is the cost of the forward contract (partial or full)?
(a) Does not cover its exposure. (b) Covers 60% and keeps 40% uncovered.
(c) Cover 100% exposure by entering into a forward contract.
What will be the consequences if the Thai firm:
A Thai company is expecting to receive $3 million from its customer in the US after 3 months.
The current spot exchange rate is Baht 33.75/$ and 90 days forward rate is Baht 35.35/$.
In this problem:
(a) Does not cover its exposure
Spot Rate = Baht34.10
= $30,00,000xBaht 34.10 = Baht10,23,00,000
(b) Covers 60% and keeps 40% uncovered
Covered 60% ($30,00,000x60%) = $18,00,000
90 days forward rate is = Baht35.35
= $18,00,000x Baht35.35 = Baht6,36,30,000
Uncovered 40% ($30,00,000x40%) = $12,00,000
= Baht34.10
= $12,00,000x Baht34.10 = Baht4,09,20,000
Total cost = Baht6,36,30,000+ Baht4,09,20,000 = Baht10,45,50,000
(c) Cover 100% exposure by entering into a forward contract.
90 days forward rate is = Baht 35.35
= $30,00,000xBaht 35.35 = Baht10,60,50,000
Imported 10,000 Nos. cartridges at landed cost in Mumbai, of $30 each.
They have the choice for paying for the goods immediately or in 3 months time.
They have a clean overdraft limit where 18% p.a. rate of interest is charged.
Calculate which of the following methods would be cheaper to Paper Corporation Ltd.:
(a) Pay in 3 months’ time with interest @ 15% p.a. and cover risk forward for 3 months.
(b) Settle now at a current spot rate and pay interest of the overdraft for 3 months.
The rates are as follows: ₹/$ Spot 71.25-71.55 3 month swap: 25/35.
In this problem:
(a) Pay in 3 months’ time with interest @ 15% p.a. and cover risk forward for 3 months.
Imported cartridges at landed cost = 10,000x$30 = $3,00,000
Spot rate = ₹71.25/₹71.55
Swap rate = ₹0.25/₹0.35
3 month forward rate = [₹71.25+₹0.25]/[₹71.55+₹0.35] = ₹71.50/₹71.90
3 month interest ($3,00,000x15%/12x3) = $11,250
Total exposure to be covered = $3,00,000+$11,250 = $3,11,250
Cost of exposure = $3,11,250x₹71.90 = ₹2,23,78,875
(b) Settle now at a current spot rate and pay interest of the overdraft for 3 months.
Imported cartridges at landed cost = 10,000x$30 = $3,00,000
Invoice amount in = $3,00,000x₹71.55
= ₹2,14,65,000
+Overdraft interest (₹2,14,65,000x18%/12x3) = ₹ 9,65,925
Total cost = ₹2,24,30,925
Option a) is better than option b)
The importer seeks your advice.
(i) Pay immediately without any interest charges (ii) Pay after 3 months with interest @ 5% per annum
Spot rate (₹/Singapore $) : 48.35/48.36
3-Month forward rate (₹/Singapore $) : 48.81/48.83
In this problem
(i) Pay immediately without any interest charges
Import bill for = Singapore $1,30,000.
Spot rate (₹/Singapore $) = ₹48.36
Cost of invoice = Singapore $1,30,000x₹48.36
= ₹62,86,800
+Bank charges (₹62,86,800x15%/12x3) = ₹ 2,35,755
Total cost = ₹65,22,555
(ii) Pay after 3 months with interest @ 5% per annum
Import bill for = Singapore $1,30,000.
Forward rate (₹/Singapore $) = ₹48.83
Cost of invoice = Singapore $1,30,000x₹48.83
= ₹63,47,900
+Interest charges (₹63,47,900x5%/12x3) = ₹ 79,349
Total cost = ₹64,27,249
Option (ii) is better than option (i)
2 months forward purchase contract for Euro 10,000 @ ₹74.50 per Euro
comes to bank after 1 month and requests for cancellation of the contract.
Spot 1 Euro : ₹74.60/₹74.70
1 month forward 1 Euro : ₹74.90/₹75.04
What is the loss or gain to customer on cancellation of the contract?
In this problem:
Bank to square up trade buying 1 month forward.
2 Months forwards purchase rate = ₹74.50
1 Month forward purchase rate = ₹75.04
Net effect in currency = (₹0.54)
Total payment = Euro 10,000x(₹0.54)
Total Profit/(Loss) = (₹5,400)
Total loss on cancellation of transaction to customer is ( ₹5,400)
Option-1: Pay immediately without any interest charge. Option-2: Pay after three months with interest @ 5% per annum.
Import bill for = $1,30,000
Spot rate for $1 = ₹58.35/₹58.36
3-months forward rate for $1 = ₹58.81/₹58.83
In this problem:
Option-1: Pay immediately without any interest charge.
Spot rate for $1 = ₹58.36
Value of invoice = ₹75,86,800
+Bank charges on od(₹75,86,800x15%/12/3) = ₹ 2,84,505
= ₹78,71,305
Option-2: Pay after three months with interest @ 5% per annum.
Spot rate for $1 = ₹58.83
Value of invoice = ₹76,47,900
+Interest charges (₹76,47,900x5%/12/3) = ₹ 95,599
= ₹77,43,499
Option-2 is better than Option-1
You are required to show what are the transactions the trader will execute to receive the arbitrage gain
Spot rate of = ₹/$43.30
6-Month forward rate of = ₹/$43.70
Annualised interest rate for 6 months = ($) 4%
Annualised interest rate for 6 months = (₹) 8%
If he is willing to borrow = ₹43.30 million or $1million
In this problem:
Spot rate = ₹4,33,00,000/$10,00,000 = 43.30
Interest rate differential = (₹) 8%-($) 4% = 4%
Step 1:
Borrow $10,00,000 for 6 months
Amount repayable after 6 months with interest = $10,00,000+($10,00,000x4%/12x6)
= $10,00,000+$20,000 = $10,20,000
Step 2:
Convert $10,00,000 into rupee deposited into = ₹4,33,00,000+(₹4,33,00,000x8%/12x6)
= ₹4,33,00,000+₹17,32,000 = ₹4,50,32,000
Step 3:
Convert the total amount at forward rate = ₹4,50,32,000/₹43.70 = $10,30,480.55
Net gain = $10,30,480.55-$10,20,000 = $10,480.55
Is there any arbitrage possibility?
Spot rate ($) = ₹48.0123
180 days forward rate ($) = ₹48.8190
Annualised interest rate for 6 months (₹) = 12%
Annualised interest rate for 6 months ($) = 8%
Borrow = ₹40,00,000 or $83,312
In this problem:
Spot rate = ₹40,00,000/$83,312 = ₹48.0123
Interest rate differential = (₹)12%-($)8% = 4%
Step 1:
Borrow $83,312 for 6 months
Amount repayable after 6 months with interest = $83,312+($83,312x8%/12x6)
= $83,312+$3,332.48= $86,644.48
Step 2:
Convert $83,312 into rupee deposited into = ₹40,00,000+(₹40,00,000x12%/12x6)
= ₹40,00,000+₹2,40,000 = ₹42,40,000
Step 3:
Convert the total amount at forward rate = ₹42,40,000/₹48.8190 = $86,851.43
Net gain = $86,851.43-$86,644.48 = $206.95
Advise whether the offer from Sumitomo Bank should be accepted.
Japan at a cost of = ¥2,460 lakh.
Interest rate with quarterly rests = 12% per annum
Extend credit of 90 days at = 2% per annum
Present exchange rate = ₹100 = ¥246
90 Days forward rate = ₹100 = ¥250
Commission charges for letter of credit is = 4% per 12 months.
In this problem:
Option 1: Finance import by borrowing @12% interest rate per annum:
Cost of invoice = ¥24,60,00,000
= (¥24,60,00,000/¥246)x₹100
= ₹10,00,00,000
Add: Interest (₹10,00,00,000x12%/12x3) = ₹ 30,00,000
Total cash outflow = ₹10,30,00,000
Option 2: Offer from foreign branch:
Cost of letter of credit = (¥24,60,00,000/¥246)x100x1%
= ₹10,00,000
Interest for quarter [₹10,00,000x(12/4)] = ₹ 30,000
Total = ₹10,30,000
Payment at the end 90 days:
Cost of machine = ¥24,60,00,000
Add: Interest (¥24,60,00,000x2%/12x3) = ¥ 12,30,000
Total = ¥24,72,30,000
Conversion cost = ₹100 = ¥250
= (¥24,72,30,000/¥250)x₹100 = ₹9,88,92,000
Total cost = ₹10,30,000+₹9,88,92,000 = ₹9,99,22,000
Option 2 is more better than Option 1.
Advise, whether the offer from the foreign branch should be accepted.
Machine cost = ¥2,400 lakh.
Borrow funds interest per annum with quarterly rests = 12%
Offered to extend credit of 90-days per annum = 2%
Present exchange rate: = ₹100 = ¥246
90-day forward rate: = ₹100 = ¥250
Commission charges for letter of credit is per 12 months = 4%
In this problem:
Option-1: Financing import by borrowing @12% Interest Per annum
Cost of invoice = ¥24,00,00,000
= (¥24,00,00,000/¥246)x100
= ₹ 9,75,60,975.61
+Interest charges(₹9,75,60,975.61x12%/12x3) = ₹ 29,26,829.27
Total Cash outflow = ₹10,04,87,804.88
Option 2: Offer from foreign branch:
Cost of letter of credit = (¥24,00,00,000/¥246)x100x1%
= ₹ 9,75,609.76
+Interest charges [₹9,75,609.76x(12/4)] = ₹ 29,268.30
Total cost = ₹10,04,878.05
Payment at the end of 90 days
Cost of machine = ¥24,00,00,000
Add: Interest (¥24,00,00,000x2%/12x3) = ¥ 12,00,000
Total = ¥24,12,00,000
Conversion cost = ₹100 = ¥250
= (¥24,12,00,000/¥250)x100 = ₹9,64,80,000
Total cost = ₹10,04,878.05+₹9,64,80,000 = ₹9,74,84,878.05
Option 2 is better than Option 1.
Explain whether there is any arbitrage gain possible from the quoted spot exchange rates.
Spot exchange rate = $/₹48.30
Spot exchange rate = £/₹77.52
Spot exchange rate = £/$1.6231
The arbitrageur has = $1,00,00,000
In this problem:
Conversion of $1,00,00,000x₹48.30 = ₹48,30,00,000
Conversion of ₹48,30,00,000/₹77.52 = £62,30,650.155
Conversion of £62,30,650.155x$1.6231 = $1,01,12,968.27
Arbitrage gain ($1,01,12,968.27-$1,00,00,000) = $1,12,968.27
Economic Order Quantity
Compute the optimum number of cycles required in a year
Fibre at the rate of = 5,000 metres per hour.
Fibre used by company at the rate of = 20,000 meters per day.
Cost of fibre is = ₹5 per metre.
The inventory carrying cost is = 25%
set-up costs are = ₹4,050.
Working hours per day are = 8 hou₹
Assume = 365 days in a year.
Economic order quantity (EOQ) = √(2xDxCo)/Ci
D = Annual demand
Co = Ordering cost
Ci = Cost of carrying
In this problem:
Annual demand = 20,000x365= 7,30,000 metres
Annual demand of fibre = 7,30,000/5,000 = 1,460 fibres
Ordering cost = ₹4,050
Cost of fibre = ₹5 per metre.
= 5,000x₹5= 25,000
Carrying cost = 25% of 25,000 = 6,250
= √(2x1,460x4,050)/6,250 = 43.50
You are required to — (i) Calculate the economic order quantity (EOQ); (ii) Calculate the re-order inventory level; and
(iii) If 1% quantity discount is offered by the supplier for purchases in lots of 18,000 reams or more, should the buyer accept
the proposal?
A financial literacy house buys = 72,000 reams
Special paper per annum at a cost of = ₹90 per ream.
Ordering cost per order is = ₹500
Carrying cost is = 5% per year
Normal lead time is = 20 days
Safety stock is = Nil.
Assume = 300 working days in a year.
(i) Economic order quantity (EOQ) = √(2xDxCo)/Ci
D = Annual demand
Co = Ordering cost
In this problem
D = 72,000 reams
Co = ₹500
Ci = 5% of ₹90 per ream = 4.5
= √(2x72,000x500)/4.5
= √1,60,00,000 = 4,000 reams
(ii) Re-order level = Annual usage/Normal working days in a year
Normal usage = 72,000/300 = 240 reams per day
Re-Order level = 20 days x 240 reams per day = 4,800 reams
(iii) Cost in case order size 4,000 reams
Purchase cost (72,000x₹90) = ₹64,80,000
Ordering cost (72,000/4,000)x₹500 =₹ 9,000
Carrying cost (4,000/2)x₹4.5 =₹ 9,000
Total = ₹64,98,000
Cost in case order size 18,000 reams
Purchase cost [72,000x(₹90-₹90x1%)] = ₹64,15,200
Ordering cost (72,000/18,000)x₹500 =₹ 2,000
Carrying cost (18,000/2)x(₹4.5-₹4.5x1%)] = ₹ 40,095
Total = ₹64,57,295
Cost is less in order 18,000 buyer should accept the proposal.
(a) Determine optimal order quantity.
(b) If a 3% discount is offered by the supplier for purchase in lot of 1,000 or more, should the firm accept the offer?
A firm purchases = 4,000 units per annum
Item cost at = ₹40 per unit.
Ordering cost is = ₹100 per order
Inventory carrying cost is = 12.5%.
D = Annual demand
Co = Ordering cost
In this problem:
D = 4,000
Co = ₹100
Ci = ₹40x12.5% = ₹5
= √(2x4,000x100)/5
= √1,60,000 = 400 units
(ii) Cost in case purchase of 400 units
Purchase cost (4,000x₹40) = ₹1,60,000
Ordering cost (4,000/400)x₹100 = ₹ 1,000
Carrying cost (400/2)x₹5 = ₹ 1,000
Total = ₹1,62,000
Cost in case purchase of 1,000 units
Purchase cost [4,000x(₹40-₹40x3%)] = ₹1,55,200
Ordering cost (4,000/1,000)x₹100 =₹ 400
Carrying cost [(1,000/2)x(₹5-₹5x3%)] = ₹ 2,425
Total = ₹1,58,025
Cost in case purchase of 1,000 units is cheaper than cost of 400 units. Firm can buy the offer.
(a) Economic Order Quantity
(b) Number of orders placed in a year.
1unit of finished product, of raw material is required. = 4 kg
The sales department has estimated an annual demand = 5,00,000 units
Stock position at the beginning of the year is as below:
Product X = 20,000 units
Raw material = 40,000 kgs
To place an order the company has to spent = ₹1,500
Working capital using a bank cash credit = 12%
Product X is sold at = ₹1,040 per unit
Material is purchased at = ₹150 per kgs
Annual production = Annual demand-Opening stock
= 5,00,000-20,000
= 4,80,000 units
Raw materials requirement = Annual production x Material required per unit-Opg. Stock
= (4,80,000x4)-40,000
= 18,80,000 kgs.
D = Annual demand
Co = Ordering cost
In this problem:
D = 18,80,000
Co = ₹1,500
Ci = ₹150x12% = ₹18
= √(2x18,80,000x1,500)/18
= √31,33,33,333 = 17,701 kgs
(ii) No. of orders placed in a year = 18,80,000/17,701 = 106 orders per year
Calculate the Minimum stock level, Maximum stock level, Reordering level and Average stock level from the following
information:
(1) Minimum Consumption = 100 units per day
(2) Maximum Consumption = 150 units per day
(3) Normal Consumption = 120 units per day
(4) Re-order period = 10(min)–15(max) units per day
(5) Re-order quantity = 1,500 units per day
(6) Normal re-order period = 12 days
In this problem:
3) Re-order level = Maximum consumption x Maximum Re-order period
= 150x15 = 2,250 units
2) Maximum stock level = Re-order level+Re-order quantity-(Min Consumption x Min Re-order Period)
= 2,250+1,500-(100x10) = 2,750 units
1) Minimum stock level = Re-order level-(Normal consumption x Normal Re-order period)
= 2,250-(120x12) = 810 units
4) Average stock level = [Maximum stock level+Minimum stock level]/2
= [2,750+810]/2 = 1,780 units
(a) Determine the optimal order quantity and minimum total cost including purchase cost.
(b) If a 3% discount is offered by the supplier for purchases in a lot of 1,000 or more, should the firm accept the offer?
Purchases = 2,000 units
Unit cost of = ₹20.
The ordering cost is = ₹50 per order
Inventory carrying cost is = 25%.
a) (i) Economic order quantity (EOQ) = √(2xDxCo)/Ci
D = Annual demand
Co = Ordering cost
In this problem:
D = 2,000
Co = ₹50
Ci = ₹20x25% = ₹5
= √(2x2,000x50)/5
= √40,000 = 200 units
(ii) Minimal total cost
No. of orders in lots = 2,000/200
= 10 lots
Purchase cost (2,000x₹20) = ₹40,000
Ordering cost (2,000/200)x₹50 = ₹ 500
Carrying cost (200/2)x₹5 = ₹ 500
Total cost = ₹41,000
b) if purchase in a lot 1,000 or more with 3% discount
Purchase cost [2,000x(₹20-₹20x3%)] = ₹38,800
Ordering cost (2,000/1,000)x₹50 = ₹ 100
Carrying cost (1,000/2)x(₹5-₹5x3%)] = ₹ 2,425
Firm should not accept discount offer.
Which of the following strategies being considered would you advise. (i) Place 4 orders of equal size every year
(ii) Place an order for 500 units at a time and avail a discount of 10% on the cost of items.
Annual usage = 1000 units
Ordering cost = ₹400
Carrying cost = 40%
Unit cost = ₹20
Inventory carrying cost is = 25%.
In this problem:
D = 1,000
Co = ₹400
Ci = ₹20x40%
= ₹8
(ii) Place 4 orders equal size in year
Purchase cost (1,000x₹20) = ₹20,000
Ordering cost (1,000/(1,000/4))x₹400 = ₹ 1,600
Carrying cost (250/2)x₹8 = ₹ 1,000
Total = ₹22,600
Cost in case purchase of 500 units
Purchase cost [1,000x(₹20-₹20x10%)] = ₹18,000
Ordering cost (1,000/500)x₹400 = ₹ 800
Carrying cost [(500/2)x(₹8-₹8x10%)] = ₹ 1,800
Total = ₹20,600
Cost in case of purchase of 500 units is recommended.
Calculate EOQ and number of orders needed per year.
Product-Y is sold for = ₹20 per unit.
The demand for the product = 2,000 units per month.
The cost price per unit is = ₹10.
The ordering cost is = ₹1.20 per order
Carrying cost is = 10% per annum.
D = Annual demand
Co = Ordering cost
In this problem:
D = 2,000x12 = 24,000
Co = ₹1.20
Ci = ₹10x10% = ₹1
= √(2x24,000x1.20)/1 = √57,600 = 240 units
No. of orders needed per year = 24,000/240 = 100 orders
Should the company accept the offer?
Priyanka Ltd. requires = 2,000 units annually.
The cost of the item per unit is = ₹20
Ordering cost is = ₹50 per order.
If the carrying cost is = 25% of the cost of item
Find the optimum lot size.
If the company purchases in lots of 1,000 or more units of the item, it gets a rebate of 3%.
D = Annual demand
Co = Ordering cost
In this problem:
D = 2,000
Co = ₹50
Ci = ₹20x25% = ₹5
= √(2x2,000x50)/5 = √40,000 = 200 units
No. of lot size = 2,000/200 = 10 orders
(ii) Place 10 orders equal size in year
Purchase cost (2,000x₹20) = ₹40,000
Ordering cost (2,000/(2,000/10))x₹50 = ₹ 500
Carrying cost (200/2)x₹5 = ₹ 500
Total = ₹41,000
Cost in case purchase of 1,000 units
Purchase cost [2,000x(₹20-₹20x3%)] = ₹38,800
Ordering cost (2,000/1,000)x₹50 = ₹ 100
Carrying cost [(1,000/2)x(₹5-₹5x3%)] = ₹ 2,425
Total = ₹41,325
The company should not accept the discount offer.
What advice would you offer and how much would it save for the company per year?
Pur. for its annual requirements ordering 1 month usage = 9,000 spare parts
Each spare part costs = ₹20
The ordering cost per order is = ₹15
Carrying charges are = 15% of unit cost.
D = Annual demand
Co = Ordering cost
In this problem:
D = 9,000
Co = ₹15
Ci = ₹20x15% = ₹3
= √(2x9,000x15)/3 = √90,000 = 300 units
Number of spare parts per purchase order = 9,000/12 = 750 units
Total variable cost = Ordering cost+Carrying cost
= 12x₹15+750/2x₹3 = ₹1,305
Total variable cost = Ordering cost+Carrying cost
= 9,000/300x₹15+300/2x₹3 = ₹900
Savings as per EOQ = Cost as per Current policy-Cost as per EOQ
= ₹1,305-₹900 = ₹405
As per EOQ policy company can save ₹405.
You are required to ascertain .
(i) What is the total annual cost of the existing inventory policy?
(ii) How much money would be saved by employing the economic order quantity (EOQ)?
A company buys in lot of which is a 3 months supply. = 125 boxes
The cost per box is = ₹125
Ordering cost is = ₹250
Inventory carrying cost is estimated per annum = 20% of unit value
Annual cost of existing inventory policy:
Buys lot per annum = 125x4 = 500
Purchase cost (500x₹125) = ₹62,500
Ordering cost (500/125x₹250) = ₹ 1,000
Carrying cost (125/2x₹25) = ₹ 1,562.50
Total = ₹65,062.50
D = Annual demand
Co = Ordering cost
In this problem:
D = 125x4 = 500
Co = ₹250
Ci = ₹125x20%
= ₹25
= √(2x500x125)/25 = √10,000 = 100 units
Purchase cost (500x₹125) = ₹62,500
Ordering cost (500/100x₹250) = ₹ 1,250
Carrying cost (100/2x₹25) = ₹ 1,250
Total = ₹65,000
Savings as per EOQ = Cost as per Current policy-Cost as per EOQ
= ₹65,062.50-₹65,000.00 = ₹62.50
As per EOQ policy company can save ₹62.50
You are required to comp ute the following: (i) Minimum cost order quantity (ii) Time between orders (iii) Minimum
number of back orders (iv) Maximum inventory level (v) Overall annual cost.
Unit cost = ₹200
Order cost = ₹320
Inventory carrying cost = ₹40
Back order cost (stock out cost) = ₹20
Annual demand = 2,000 units
In this problem:
(i) Minimum cost order quantity
A = 2,000
D = ₹320
C = ₹40
B = ₹20
= √[(2x200x320)/40]x(40+20/20)
= √96,000 = 309.84 or 310 units
(ii) Time between orders = Minimum order/Annual demand
= 310/2,000 = 0.155
= 0.155x12 months = 1.86 months
(iii) Minimum number of back orders = Minimum cost order quantity x Inventory carrying cost/Back
order cost+Inventory carrying cost)
= 310x40/(20+40) = 206.67 or 207 units
(iv) Maximum inventory level = Minimum cost order quantity- Minimum number of back orders
= 310-207 = 103 units
(v) Overall annual cost
Purchase cost (2,000x₹200) = ₹4,00,000.00
Ordering cost (2,000/310)x₹320 = ₹ 2,064.51
Carrying cost (207/2)x₹40/2 = ₹ 2,060.00
Total cost = ₹4,04,124.51
You are required to calculate — (i) Economic order quantity (EOQ)
(ii) If the minimum lot size to be supplied is 4,000 units, what is the extra cost, the company has to incur?
(iii) What is the minimum carrying cost, the company has to incur?
For every finished product, one unit of Component-X is required.
Laxmi Ltd. produces an auto part with a monthly demand of = 4,000 units
The product requires Component-X which is purchased at = ₹20
Holding cost is = 10% per annum
D = Annual demand
Co = Ordering cost
In this problem:
D = 4,000x12 = 48,000
Co = ₹120
Ci = ₹20x10% = ₹2
= √(2x48,000x120)/2 = √57,60,000 = 2,400 units
If lot size 2,400 units cost:
Inventory ordering cost (48,000x₹120)/2,400 = ₹2,400
Inventory carrying cost (2,400x2)/2 = ₹2,400
Total inventory holding cost = ₹2,400+₹2,400 = ₹4,800
If lot size 4,000 units cost:
Inventory ordering cost (48,000x₹120)/4,000 = ₹1,440
Inventory carrying cost (4,000x2)/2 = ₹4,000
Total inventory holding cost = ₹1,440+₹4,000 = ₹5,440
Extra cost incurred if minimum lot size 4,000 units = ₹5,440-₹4,800 = ₹640
Inventory carrying cost at the order level of 4,000 units = (Inventory size x carrying cost)/2
= (4,000x2)/2 = 4,000
Following three strategies are under consideration for the procurement: (i) Place 4 orders of equal size every year. (ii) Place
an order for 500 units at a time and avail a discount of 10% on the cost of items. (iii) Follow EOQ policy. Which of the
above strategies do you recommend? Justify your answer.
In Happy Ltd., for one of the A-class items, the following data are available:
Annual demand = 1,000 units
Ordering cost = ₹400
Holding cost = 40%
Cost per unit = ₹20
D = Annual demand
Co = Ordering cost
In this problem:
D = 1,000
Co = ₹400
Ci = ₹20x40% = ₹8
= √(2x1,000x400)/8 = √1,00,000 = 316.23 or 316 units
(i) If lot size 4 orders of equal size cost:
Purchase cost (1,000x₹20) = ₹20,000
Inventory ordering cost (1,000/250x₹400) = ₹ 1,600
Inventory carrying cost (250/2x)/₹8 = ₹ 1,000
(ii) If lot size 500 units and 10% discount cost:
Purchase cost [1,000x(₹20-₹20x10%] = ₹18,000
Inventory ordering cost (1,000/500x₹400) = ₹ 800
Inventory carrying cost (500/2)x(₹8-₹8x10%) = ₹ 1,800
(iii) If lot size 316.23 units cost:
Purchase cost (1,000x₹20) = ₹20,000
Inventory ordering cost (1,000/316.23x₹400) = ₹ 1,265
Inventory carrying cost (316.23/2)x₹8 = ₹ 1,265
Option (ii) is cheaper among 3 options.
Required — (i) Calculate the economic order quantity (EOQ) of raw materials.
(ii) Advise how frequently the orders for procurement of raw materials should be placed.
(iii) If the company proposes to rationalise placement of orders for procurement of raw materials on quarterly basis, what %
of discount in the price of raw materials should be negotiated?
Product from a raw material, which is purchased at = ₹100 per kg.
Handling cost of = ₹300+ freight of ₹325 per order.
Incremental carrying cost of inventory of raw material is = ₹.0.50 per kg. per month.
Inventory of raw material is = ₹4 per kg.
The annual production of the product is = 1,00,000 units
2 units are obtained from = 1 kg. of raw material
Annual demand = 1,00,000/2 = 50,000
Ordering cost per order = ₹300+₹325 = ₹625
Carrying cost = ₹.0.50x12+₹4 = ₹6+₹4= ₹10
D = Annual demand
Co = Ordering cost
In this problem:
D = 50,000
Co = ₹625
Ci = ₹10
= √(2x50,000x625)/10 = √62,50,000 = 2,500 Kgs.
(ii) Frequency in placing of order
Annual demand of Kgs. = 50,000
EOQ Kgs = 2,500
No. of orders placed in a year = 50,000/2500 = 20
Frequency of placing an order = 360/20 = 18 days
(iii) Incremental cost on quarterly basis:
EOQ Basis Qtly Basis
Annual usage 50,000 50,000
Size of orders 2,500 50,000/4=12,500
No. of orders 50,000/2,500= 20 50,000/12,500= 4
Cost per order ₹625 ₹625
Total ordering cost 20x₹625=₹12,500 4x₹625=₹2,500
Carrying cost per unit ₹10 ₹10
Average inventory size 2,500/2=1,250 12,500/2=6,250
Total carrying cost 1,250x₹10=₹12,500 6,250x₹10=₹62,500
Total cost ₹12,500+₹12,500=₹25,000 ₹2,500+₹62,500=₹65,000
Incremental cost ₹65,000-₹25,000 = ₹40,000
Annual purchase cost 50,000x100 = 50,00,000
If earn discount on ₹40,000 (₹40,000/50,00,000)x100=0.8%
Answer the following — (i) Calculate economic order quantity. Assume 52 weeks in a year.
(ii) Should the company accept an offer of 3% discount by the supplier who wants to supply the annual requirement of the
material in 5 equal installments?
Product which has a weekly demand of = 2,500 units.
Every finished unit of product = 5Kgs. of material
Material is purchased at = ₹104 per unit.
Carrying cost is = 10% per annum.
D = Annual demand
Co = Ordering cost
In this problem:
D = 2,500x52 = 1,30,000
Co = ₹104x5kgs. = ₹520
Ci = ₹200x10% = 20
= √(2x1,30,000x520)/20 = √67,60,000 = 2,600 units
Purchase cost of (1,30,000x₹520) = ₹6,76,00,000
Ordering cost (2,600x₹520) = ₹ 13,52,000
Carrying cost (2,600/2)x₹20 =₹ 26,000
Call and Put Option
Identify the profit or loss (ignoring dealing cost and interest) in each of the following cases :
(i) A put option with exercise price of ₹250 is bought for a premium of ₹42. The price of underlying share is ₹189 at the
expiry date. (ii) A put option with an exercise price of ₹300 is written for a premium of ₹57.
The price of the underlying share is ₹314 at the expiry date.
In this problem
(i) Profit on contract price:
Exercise price of put option = ₹250
Less: Price at expiry date = ₹189
= ₹ 61
Less: Premium = ₹ 42
Profit = ₹ 19
(ii) Exercise price = ₹300, put option is written on exercise price for a premium of ₹57.
The option will not be exercised by the investor and hence the profit earned by the company will be the premium of ₹57.
Find out his profit or loss.
An investor buys 500 shares of X Ltd. @ ₹210 per share in the cash market.
In order to hedge, he sells 300 futures of X Ltd. @ ₹195 each.
Next day, the share price and futures decline by 5% and 3% respectively.
He closes his position next day by counter-transactions.
In this problem:
Cash market:
Buying of shares 500x₹210 = ₹1,05,000
Less: Decline in share price (500x₹210-₹210x5%) = ₹ 99,750
Loss on shares = ₹ 5,250
Selling of shares 300x₹195 = ₹58,500
Less: Decline in share price (300x₹195-₹195x3%) = ₹56,745
Profit on shares = ₹ 1,755
Net Loss = ₹5,250-₹1,755
= ₹3,495
Mr. Neel holds share of AP Ltd. These shares are currently traded at ₹50. In a year’s time, it is expected that it will be either
₹40 or ₹60. Government of India bonds carry interest rate of 8% p.a. What is the value of a call option with an exercise price
of ₹52?
In this problem:
Current price of share (S0) = ₹50
Future price (S2) = ₹40
Future price (S1) = ₹60
Exercise price = ₹52
If the stock performs at 40, it will lapse at 52 and value (C0) =0
If the stock performs at 60 and the exercise price is 52,
Then call value (C1) (₹60-₹52) = ₹8
No. of calls to be bought [(S1-S2)/(C1-C0)] = [(₹60-₹40)/(₹8-₹0)] = 2.5
Spot price (S0) = Present value of lower price+Calls boughtxC0
Where C0 is value of call option today
50 = [40x1/1.08]+2.5xC0
50 = 37.04+25xC0
25C0 = 50-37.04
C0 = 12.96
C0 = 12.96/25 = 0.5184 or 5.184
The shares of Paper Power Ltd. are presently quoted in the market at the rate of ₹504 per share.
Abhay wants to play in the derivatives of Paper Power Ltd., as he holds the shares of the company. He decided to become the
call option writer.
The 3 months call options are quoted in the market at the rate of ₹505, with a premium of ₹5.
The size of option is 100 shares of Paper Power Ltd.
Work out Abhay’s net payoff, if the prices of the shares on the exercise date is between ₹490 to ₹510, with intervals of price
of ₹5.
Call option writer means the person is under obligation to sell the share at the agreed price.
3 month call option price = ₹505
Premium to be received = ₹5
Case1: If the price on the exercise date is ₹490
In this case, call option by buyer will not be exercised since call price is higher than market price.
His inflow will be (₹5x100) = ₹500
Case 2: If the price on the exercise date is ₹495
In this case, buyer of call option is neural whether to exercise the right to buy the call option or to buy from the market spot
rate. In case buyer chooses to buy from market,
then the call option writer will get the premium amount = ₹500
Case 5: If the price on the exercise date is ₹505 In this case, call option by buyer will be exercised since call price is lower
than market price.
His inflow will be premium received = 5x100
= ₹500
Difference in call option price and spot price and = (505-510)x100
= (500)
Net Inflow = Nil
Determine the intrinsic value for the buyer of an option contract, action to be taken and type of option in the following
situations:
(i) A put option, when the current value of the underlying asset is ₹1,400 and the strike price is ₹1,482.
(ii) A put option when the current value of the underlying asset is ₹950 and the strike price is ₹950.
(iii) A call option when the current value of asset is ₹1,200 and the strike price is ₹980.
(iv) A call option when the current value of underlying asset is ₹1,650 and the strike price is ₹1,700.
In this problem:
S.No. Nature Exercise Price(₹) Market Price(₹) Result Action Intrinsic Value (₹)
(i) Put 1,482 1,400 In the money Exercise 82
(ii) Put 950 950 At the money Lapse 0
(iii) Call 980 1,200 In the money Exercise 220
(iv) Call 1,700 1,650 Out of money Lapse 0
Abhay bought 1,000 shares of Panther Ltd. Panther has a beta 1.1 with the Sensex.
Each Sensex contract is equal to 50 units.
Panther now quotes at ₹100 and the Sensex futures is available at 4,500 Index points. Required:
(i) How many futures contracts Abhay will take? (ii) If the price in the spot market drops by 12%, how he will be protected?
In this problem:
Abhay bought shares of Panther Ltd = 1,000
Panther has with the Sensex = beta 1.1
Each Sensex contract is equal to = 50 units
(i) Futures to be sold = Hedge ratio x units of spot position x underlying contract
= [(1.1x1,000)/50] = 22 contracts
(ii) Panther now quotes at = ₹100
Sensex futures is available at = 4,500 Index points
Price drop = ₹100-(₹100x12%) = ₹88
Fall in index = 12/1.1= 10.91
Position in spot market = ₹12x1,000 = ₹12,000
Position in future contracts = 10.91x22x50 = ₹12,000
Gain of ₹12,000 is the same as the amount of loss ₹12,000.
The following quotes are available for 3-month options in respect of a share currently traded at ₹31:
Strike price = ₹30
Call option = ₹3
Put option = ₹2
A funds manager devises a strategy of buying a call and selling the share and a put option. Draw his profit/loss profile if it is
given that the rate of interest is 10% per annum.
What would be the profit/loss if the strategy adopted is selling a call and buying a put and a share?
In this problem:
Strategy 1: Buying a call and selling a put ad a share:
Initial cash outflow = Current trade share-Call option+Put option
= (₹31-₹3+₹2)= ₹30
Interest for = (₹30x10/(12/3) = ₹0.75
Amount grows in 3 months = ₹30+₹0.75 = ₹30.75
Net profit is = ₹30.75-= ₹30.00 = ₹0.75
Strategy 2: Buying a call and selling a put ad a share:
Initial cash outflow = Current trade share-Call option+Put option
= (₹31+₹2-₹3) = ₹30
Interest for = (₹30x10/(12/3) = ₹0.75
Amount grows in 3 months = ₹30+₹0.75 = ₹30.75
Net profit is = ₹30.75-= ₹30.00 = ₹0.75
Radha bought a 3-month call option on A Ltd.'s share with an exercise price of ₹50 at a premium of ₹4. She has also bought
a put option on the same share at an exercise price of ₹40 at a premium of ₹1.50. A's share is currently selling at ₹45.
What will be Radha's position after 3 months if the share price turns out to be ₹50 or ₹30?
In this problem:
Premium paid = ₹4+₹1.50 = ₹5.50
Profit or loss on expiration:
(a) If share price is ₹50 then neither call nor put will be exercised, entire premium will be a loss.
= Call option (0)+Put option (0)-Premium
Loss = ₹5.50
(b) If share price is ₹30 then call will lapse and put will be exercised.
Profit/loss = Call option (0) + Put option (₹40-₹30) – Premium (₹5.5)
= ₹10 - ₹5.5 = ₹4.5
Profit = ₹4.5
Trufen Ltd.’s equity shares are quoted in the BSE for physical and de-mat based delivery. The derivatives of Trufen’s shares
are in the form of option. The share is presently traded in the market at the price of ₹ 50. The following table indicates the
quoted exercise price and its related premium for call option:
Exercise Price ₹ Option premium ₹
48 6
50 4
55 5
60 7
Required to indicate for each exercise price, whether the option is At the money, Out of the money or In the money. Also
calculate the intrinsic value and time value for each exercise price.
Exercise Price ₹ Option premium ₹ Intrinsic Value ₹ Time Value ₹
48 6 50 (2)
50 4 50 0
55 5 50 5
60 7 50 10
Internet Services Ltd. is a listed company and the share prices have been volatile. An investor expects that the share price
may fall from the present level of ₹1,900 and wants to make profit by a suitable option strategy. He is short of share at a
price of ₹1,900 and wants to protect himself against any loss. The following option rates are available:
Strike Price Call Option Put Option
(₹) (₹ ) (₹ )
1,700 325 65
1,800 200 80
1,900 85 120
2,000 70 200
2,100 65 280
The investor decides to buy a call at a strike price of ₹1,800 and to write a put at a strike price of ₹2,000. Find out the profit
or loss profile of the investor if the share price on the expiration date is ₹1,600, ₹1,700, ₹1,800, ₹1,900, ₹2,000 or ₹2,100
respectively.
In this problem
Expiry date Call payoff Put payoff Net payoff
₹1,600 ___ (₹400) (₹400)
₹1,700 ___ (₹300) (₹300)
₹1,800 ___ (₹200) (₹200)
₹1,900 ₹100 (₹100) 0
₹2,000 ₹200 ____ ₹200
₹2,100 ₹300 ____ ₹300
Call pay off price starts from ₹1,800 and Put pay off from ₹2,000.
A share of Deepika Ltd. is currently selling for ₹120.
There are 2 possible prices of the share after one year — ₹132 or ₹105. Assume that risk-free rate of return is 9% per
annum. What is the value of a one-year call option (European) with an exercise price of ₹125?
In this problem:
The pay off will be equal if:
₹132-₹105 = ₹132-₹125
= ₹7/₹27
= ₹0.26
The value of portfolio after 1 year = (₹132x₹0.26)- ₹7
= ₹27.32
The current share option (S) = ₹120
The present value of call option (C) = S-C = PV of ₹27.32
= ₹120x0.26-C
= ₹31.20-₹25.05
= ₹6.15
Find out (i) hedge ratio; (ii) amount of borrowing; (iii) fair value of the call; and (iv) his cash flow position after a year.
The current market price of the equity shares of Bharat Bank Ltd. is ₹190 per share.
It may be either ₹250 or ₹140 after a year.
A call option with a strike price of ₹180 (time 1 year) is available.
The rate of interest applicable to the investor is 9%.
Rahul wants to create a order to maintain his pay off on the call option 100 shares.
In this problem:
Current market price per share = ₹190
A call option with a strike price(S) = ₹180
Expected price after a year (High) (S1) = ₹250
Expected price after a year (Low) (S2) = ₹140
Difference between strike price and expected High price(C1) = ₹250-₹180
= ₹70
(i) Hedge ratio = (C1-0)/(S1-S2) = ₹70-0/₹250-₹140
= ₹70/₹110= ₹0.64
Investor should buy 0.64 share for a call option of 1 share.
So, he should buy (100 x₹0.64) = ₹64
Out flow (₹190x₹64) = ₹12,160
(ii) Amount of borrowing (B) = S2-C2(100)/(1+r)
= ₹8,220
(iii) Fair value of call for 100 shares = S2-C2=[C(0.64x140-0)100]/1.09
=100 xΔxS–B
= 100x0.64x190-8,220 = 3,940
(iv) Cash flow position after a year: Pay off
If share price is ₹250 If share price is ₹140
Buy a call option K=₹180 100x(250-180)=7,000 Nil
Buy 64 shares and borrow (selling price of 64 shares-borrowings) 64x250=16,000 64x140=8,960
16,000-8,220=7,780
So by replicating the portfolio, the investor is able to have the same pay off of ₹7,780
Economic Value Added
Strawberry Ltd. is an established confectionary maker company. Chairman of the Strawberry has recently attended one of the
Management Development Programme in premier institution. He is willing to work out the Economic Value Added (EVA)
of the firm. He has provided to you, the following information.
You are required to calculate the EVA from the same.
1. Profit after interest and tax ₹150 lakh
2. Interest ₹25 lakh
3. Borrowing interest rate 10%
4. Owners' cost of capital 18%
5. Net worth of the company ₹300 lakh
6. Tax rate applicable 33%
7. Overall cost of capital 15%
Calculation of Net profit after tax: ₹
Profit after tax 150,00,000
Add: Interest 25,00,000
Less: Tax on interest 8,33,333
NOPAT 1,66,66,667
Cost of capital 15% of ₹300 lakh 45,00,000
EVA=NOPAT-Cost of capital (₹1,66,66,667-₹45,00,000) 1,21,66,667
Working Capital Management

You have very recently completed a professional course from the national level institute of India. You are being appointed as
an Executive Assistant of Managing Director of the newly incorporated company named as Sumati Ltd.
Sumati Ltd. is estimating to have production and sales capacity of 500 units per annum,
and would be sold at the rate of ₹17,000 per unit.
You are required to calculate the following for submission to your boss, and in turn to submit to the banking system as part
of project report.
(1) Percentage of yield on investment; (2) Percentage of profit on sales; and
(3) Rate of cash generation per annum before tax.
Following details are available for the project with an expected production of 250 units, for first year of operation:
A. Investments ₹
Land 2,00,000
Building 16,00,000
Plant and machinery 24,00,000
B. Cost of production for first year of operation
Raw material (A) 13,00,000
Raw material (B) 12,52,000
Salaries and wages 2,70,000
Repairs and maintenance on Plant cost 5%
Repairs and maintenance on Building cost 2%
Depreciation on Plant cost 7%
Depreciation on Building cost 2.5%
Administrative and other expenses 1,00,000
Steam 2,24,000
Power 12,000
Packing drums 30,000
C. Working capital requirement
Raw material stock (A) 6 months
Raw material stock (B) 3 months
Stock of finished products 1 month
Credit to customers 1 month
Credit from suppliers [only on raw material (B)] 1 month
Cash expenses 1 month
Answer: Calculation of working capital
Raw material (A) 13,00,000
Raw material (B) 12,52,000
Salary and wages 2,70,000
Repairs & Maintenance (24,00,000x5%)+(16,00,000x2%) 1,52,000
Depreciation (24,00,000x7%)+(16,00,000x2.5%) 2,08,000
Administration & Oth exps. 1,00,000
Steam 2,24,000
Power 12,000
Total 35,48,000
Cash generation per annum:
Administration & Other expenses. 1,00,000
Steam 2,24,000
Power 12,000
Repairs & Maintenance (24,00,000x5%)+(16,00,000x2%) 1,52,000
Salary and wages 2,70,000
Total 7,88,000
Current assets:
Raw material stock (A) (13,00,000/12x6) 6,50,000
Raw material stock (B) (12,52,000/12x3) 3,13,000
Stock of finished goods (35,48,000/12x1) 2,95,667
Credit to customers (250x17,000)/12x1 3,54,167
Cash expenses (7,88,000/12x1) 65,667
Total Current assets 16,78,501
Current liabilities:
Credit from suppliers (12,52,000/12x1) 1,04,333
Total Current liabilities 1,04,333
Net working capital (Current assets-Current liabilities) 15,74,168
Profit (250x1700)-35,48,000 7,02,000
Requirement of total capital:
Land 2,00,000
Building 16,00,000
Plant and machinery 24,00,000
Working capital 15,74,168
Total investment 57,74,168
i) % of yield on investment (Profit/Investment)x100 (7,02,000/57,74,168)x100 12.16%
ii) % of profit on sales (7,02,000/42,50,000)x100 16.52%
iii) Rate of cash expenses per annum before tax
Profit before tax 7,02,000
Add: Depreciation 2,08,000
Rate (9,10,000/57,74168)x100 15.76%
Calculate the working capital requirement
(i) Annual Sales ₹46.80 lakhs : 78,000 units 25% Cash Sales and balance on credit
(ii) Raw Material Cost : 60% of sales value
(iii) Labour Cost : ₹6 per unit
(iv) Variable Overheads : ₹1 per unit
(v) Fixed Overheads : ₹5,00,000 (including ₹1,10,000 as depreciation)
(vi) Budgeted stock levels : Raw Materials : 3 weeks
Work-in-progress: 1 week
(Material 100%, Labour and Overheads 50%) Finished goods: 2 weeks
(vii) Finished goods will be valued at total cost.
(viii) Debtors are allowed credit for 4 weeks.
(ix) Creditors allow 4 weeks credit.
(x) Wages are paid bimonthly i.e. by the 3rd week and by the 5th week for the 1 st & 2nd weeks and the 3rd & 4th weeks
respectively.
(xi) Time lag in payment of overheads : 2 weeks
(xii) Cash-in-hand required : ₹50,000
(xiii) It is assumed that production is carried on evenly throughout the year and wages and overheads accrue similarly.
(xiv) Calculation to be based on 52 weeks in a year.
In this problem:
Selling price per unit (₹46,80,000/78,000 Units) (1) = ₹60
Raw materials per unit (₹60x60%) (2) = ₹36
Labour cost per unit (3) =₹ 6
Variable overheads per unit (4) =₹ 1
Fixed overheads excluding depreciation (₹5,00,000-₹1,10,000)/78,000 (5) =₹ 5
Total cost excluding depreciation (2+3+4+5) = ₹48
Notes:
1. Element of cost in units/week (78000 units/52 weeks) = 1,500 units/week
Raw materials (1,500 units x 3 week) = 4,500 units
2. Work in progress (Raw material) 100% = ₹36
Labour and Overhead (50%) =₹ 6
= ₹42
3. Debtors: (78,000 unitsx0.75x4/52) = 4,500 units
4. Creditors (R.M) (78,000 unitsx4/52) = 6,000 units
Since the wages are paid bimonthly, wages due will be for = 2 weeks.
Note: No profits are ignored while calculating the working capital requirement and it is calculated on cash and cost basis.
However, it may be calculated on Total Approach basis subject to the mentoring of assumption as footnote.
Current Assets: ₹
Raw materials – 3 Weeks (4,500x₹36) 1,62,000
Work-in progress – 1 Week (1,500x₹42) 63,000
Finished goods – 2 Weeks (3,000x₹48) 1,44,000
Debtors – 4 Weeks (4,500x₹48) 2,16,000
Cash in hand 50,000
Total (A) 6,35,000
Current Liabilities ₹
Wages due – 2 Weeks (3,000x₹6) 18,000
Creditors – 4 Weeks (6,000x₹36) 2,16,000
Overheads due – 2 Weeks (3,000x₹6) 18,000
Total (B) 2,52,000
Net Working Capital (A-B) 3,83,000
Prepare working capital requirement for the company.
A company has prepared its annual budget, relevant details of which are reproduced below :
Sales (1,56,000 units) : ₹93.60 lakh (25% cash sales and balance on credit)
Raw material cost : 60% of sales value
Labour cost : ₹6 per unit
Variable overheads : ₹1 per unit
Fixed overheads : ₹10 lakh (including ₹2,20,000 as depreciation)
Budgeted stock levels : Raw materials : 3 weeks
Work-in-progress : 1 week
(Material 100%, labour and overheads 50%)
Finished goods : 2 weeks
Additional information:
— Debtors are allowed credit for 4 weeks
— Creditors allow 4 weeks credit
— Wages are paid bi-weekly, i.e., by the 3rd week and by the 5th week for the 1st & 2nd weeks and the 3rd & 4th weeks
respectively
— Lag in payment of overheads : 2 weeks
— Cash-in-hand required : ₹1,00,000
Assume 52 weeks in a year.
In this problem:
Selling price per unit (₹93,60,000/1,56,000) (1) = ₹60
Raw material cost per unit (₹60x60%) (2) = ₹36
Labour cost per unit (3) =₹ 6
Variable overhead per unit (4) =₹ 1
Fixed overhead per unit excluding depreciation (₹10,00,000-₹2,20,000)/1,56,000 (5) =₹ 5
Total cost excluding depreciation (2+3+4+5) = ₹48
Notes:
1. Elements of cost in units/weeks (1,56,000 units/52 weeks) = 3,000 units/weeks
Raw materials cost in units/weeks (3,000x3weeks) = 9,000 units
2. Work-in progress Raw materials (100%) = ₹36
Labour and overhead (6+1+5) (50%) =₹ 6
= ₹42
3. Debtors (1,56,000x75%x4/52) = 9,000 units
4. Creditors (1,56,000x4/52) =12,000 units
Since the wages are paid bimonthly, wages due will be for = 2 weeks.
Note: No profits are ignored while calculating the working capital requirement and it is calculated on cash and cost basis.
However, it may be calculated on Total Approach basis subject to the mentoring of assumption as footnote.
Current Assets ₹
Raw materials – 3 Weeks (9,000x₹36) 3,24,000
Working progress – 1 Week (3,000x₹42) 1,26,000
Finished goods – 2 Weeks (6,000x₹48) 2,88,000
Debtors – 4 Weeks (9,000x₹48) 4,32,000
Cash in hand 1,00,000
Total (A) 12,70,000
Current Liabilities ₹
Wages overdue (6,000x₹6) 36,000
Creditors – 4 Weeks (12,000x₹36) 4,32,000
Wages and overheads (6,000x₹6) 36,000
Total (B) 5,04,000
Net working capital (A-B) 7,66,000
Prepare projected statement of working capital requirements for the 2 years
Joel Ltd. is commencing a new project for manufacture of a plastic component.
The following cost information has been ascertained for annual production of 12,000 units at full capacity:
Cost Per Unit ₹
Materials 40
Direct labour and variable expenses 20
Fixed manufacturing expenses 6
Depreciation 10
Fixed administrative expenses 4
80
Selling price per unit is expected to be ₹96 and selling expenses ₹5 per unit, 80% of which is variable.
In the first 2 years of operations, production and sales are expected to be as follows:
Year Production (No. of Units) Sales (No. of Units)
1 6,000 5,000
2 9,000 8,500
Following additional information is available:
(i) Stock of materials : 2.25 months’ average consumption.
(ii) Work-in-process : Nil.
(iii) Debtors : 1 month’s average sales.
-(iv) Cash balance : ₹10,000.
(v) Creditors for supply of materials : 1 month’s average purchase during the year.
(vi) Creditors for expenses : 1 month’s average of all expenses during the year.
In this problem:
Particulars Year1 Year2
Production (Units) 6,000 9,000
Sales (Units) 5,000 8,500
₹
Sales revenue (5,000x₹96); (8,500x₹96) (A) 4,80,000 8,16,000
Cost of production (6,000x₹40); (9,000x₹40) 2,40,000 3,60,000
Direct labour and variable expenses (6,000x₹20); (9,000x₹20) 1,20,000 1,80,000
Fixed manufacturing expenses (12,000x₹6); (12,000x₹6) 72,000 72,000
Depreciation ((12,000x₹10); (12,000x₹10) 1,20,000 1,20,000
Fixed administration expenses (12,000x₹4); (12,000x₹4) 48,000 48,000
Total cost of production (1) 6,00,000 7,80,000
Add: Opening stock of finished goods (Year1:Nil); (Year2:1,000 unitsx₹10) (2) _______ 1,00,000
Cost of goods available (1+2) 6,00,000 8,80,000
Less: Closing stock of finished goods @ avg. Cost (Y1:1,000x₹100); (Y2:1,500x₹88) (1,00,000) (1,32,000)
Cost of goods sold 5,00,000 7,48,000
Add: Selling expenses – Variable ₹5x80% is ₹4 (5,000x₹4); (8,500x₹4) 20,000 34,000
Fixed selling expenses – ₹5x80% is ₹1 (12,000x₹1); (12,000x₹1) 12,000 12,000
Cost of sales (B) 5,32,000 7,94,000
Profit/(Loss) (A-B) (52,000) 22,000
Notes:
Materials consumed during the year (6,000x₹40); (9,000x₹40) 2,40,000 3,60,000
Add: Closing stock (2,40,000/12x2.25); (3,60,000/12x2.25) 45,000 67,500
2,85,000 4,27,500
Less: Opening stock (Year1:Nil); (9,000x₹5) _______ 45,000
Purchases during the year 2,85,000 3,82,500
Average purchases per month (285,000/12); (3,82,500/12) 23,750 31,875
Creditors for expenses:
Direct labour; manufacturing; administration; selling expenses for the year 2,72,000 3,46,000
Average per month (2,72,000/12); (3,46,000/12) 22,667 28,833
(iii) Projected statement of working capital requirements:
Current assets:
Stock of materials (2.25 months avg. Consumption) 45,000 67,500
Stock of finished goods 1,00,000 1,32,000
Debtors 1 month average sales (4,80,000/12); (8,16,000/12) 40,000 68,000
Cash 10,000 10,000
Total current assets (A) 1,95,000 2,77,500
Creditors for supply of materials 23,750 31,875
Creditors for expenses 22,667 28,833
Total current liabilities (B) 46,417 60,708
Working capital requirement (A-B) 1,48,583 2,16,792
Give your assessment.
Naman Ltd. currently makes all sales on credit and offers no cash discount.
It is considering a cash discount for payment within 10 days. = 2%
The firm’s current average collection period is = 60 days
Sales are = 2,00,000 units
Selling price is = ₹30 per unit
Variable cost per unit is = ₹20
Average cost per unit is at current sales volume = ₹25
It is expected that the change in credit terms will result in increase in sales to = 2,25,000 units
The average collection period will fall to = 45 days.
However, due to increased sales, increased working capital required will be = ₹1,00,000
(it does not take into account the effect on debtors).
Assuming that 50% of the total sales will be on cash discount and
20% is the required return on investment,
should the proposed discount be offered?
Assume 360 days in a year.
In this problem:
Effect of extending cash discount to customer:
Particulars ₹
Increased saes revenue (2,25,000-2,00,000x₹30) 7,50,000
Less: Variable cost (2,25,000-2,00,000x₹20) (5,00,000)
Incremental contribution 2,50,000
Add: Savings in cost due to decrease in investment in debtors (W.N1) 29,167
Less: Cost of additional capital requirement ( ₹1,00,000x0.20) (20,000)
Less: Cost involved in cash discount (0.02x2,25,000x₹30x0.5) (67,500)
Profit 1,91,667
Working notes 1:
Saving due to decrease in average collection period:
Present investment in debtors (without cash discount)=(2,00,000x25x60%) 8,33,333
Decrease in investment in debtors (with cash discount)=[(2,00,000x25)+[(25,000x20)x45]]/360 6,87,500
Decrease in investment in debtors=(₹8,33,333-₹6,87,500) 1,45,833
Savings cost=₹1,45,833x0.20 29,167
Compute the requirement of Working Capital of a company from the following information provided:
Sales for current year ₹25,00,000
There will be increase in sales by 40% in the next year
Gross Profit 20% on sale
Creditor purchase 1/4th of Cost of Goods Sold
Average collection period = 60 days Average payment period 60 days
Inventory Holding Period = 90 days (On the basis of Cost of Goods Sold)
Cash and Bank Balance 2% of Sales
(for calculation 1 year to be taken 12 × 30 = 360 days).
Answer: Calculation of net working capital
Sales ₹25,00,000
Increase in sales by 40% in next year ₹25,00,000x40%
₹10,00,000
₹25,00,000+₹10,00,000
₹35,00,000
Gross Profit ₹35,00,000x20%
₹7,00,000
Cost of goods sold/purchases ₹35,00,000-₹7,00,000
₹28,00,000
Credit purchases ₹28,00,000x1/4
₹7,00,000
Cash maintained by bank ₹35,00,000x2%
₹70,000 (i)
Debt collection period 60 days
60 (Average debtors/Credit sales)x360
Average debtors ₹35,00,000x360
₹35,00,000/360x60
₹5,83,333 (ii)
Average payment period 90 days
60 (Average creditors/Credit purchases)x360
60 (Average creditors/₹7,00,000)x360
Average creditors ₹7,00,000/360x60
₹1,16,667 (iii)
Stock holding period 90 days
90 (Average stock/COGS)x360
90 (Average stock/₹28,00,000)x360
Average stock ₹28,00,000/360x90
₹7,00,000 (iv)
Working capital requirement (i)+(ii)-(iii)+(iv)
₹70,000+₹5,83,333-₹1,16,667+₹7,00,000
₹12,36,666
From the following information provided, you are required to calculate the working capital requirement for the company.
Present your calculation in a Tabular Form.
(a) Cost per unit (₹)
Raw Material 208
Direct Labour 78
Overheads 156
Total Cost 442
Profit 78
Selling Price per unit 520
(b) (i) Raw material will be in stock on an average for one month holding.
(ii) Work in Process will comprise of 100% of material, 50% of wages and overheads for average of half a month.
(iii) Finished goods will be in stock on average of one month.
(iv) Credit allowed by suppliers of Raw Material is one month.
(v) Time lag in payment of wages is 1½ weeks.
(vi) Time lag in payment of overheads is 1 month.
(vii) Time lag in payment from Debtors is 2 months.
(viii) Cash Balance is to be maintained at a minimum of ₹ 4,80,000.
(c) Level of Activity: Production of 70,000 units per annum. It is to be assumed that production is carried on evenly
throughout the year and wages and overheads accrue similarly.
(d) Calculation to be based on 30 days a month and 52 weeks in a year.
(e) Finished goods will be valued at Total Cost.
Answer: Calculation of net working capital
Current assets: ₹
Raw material (70,000x208x30/360) 12,13,333
Work-in-progress
Raw material (70,000x208x15/360) ₹6,06,667
Direct labour (70,000x78x15/360)x50% ₹1,13,750
Overheads (70,000x78x15/360)x50% ₹2,27,500 9,47,917
Finished goods (70,000x442x30/360) 25,78,333
Debtors (70,000x520x60/360) 60,66,667
Cash balance 4,8,000
Total current assets (A) 1,12,86,250
Creditors (70,000x208x30/360) 12,13,333
Wages (70,000x78x30x1.5/52) 1,57,500
Overheads (70,000x156x30/360) 9,10,000
Total current liabilities (B) 20,83,833
Working capital (A-B) (₹1,12,86,250-₹20,83,833) 90,05,417
Note: In the above solution Debtors are calculated on selling price. Debtor can also be calculated on cost price.
Management of Rose Ltd. is contemplating the next year budget, and hence required to work out the working capital
requirements for the next year. The following information has been provided by the budget committee.
A: Estimated value for per unit of finished product
Particulars ₹ (Per Unit)
Raw materials 60
Direct wages 30
Cash based Manufacturing and administrative overhead 20
Depreciation 10
Selling and distribution overhead 10
Total cost 130
Selling price 200
Additional information provided by the concerned committee member of budget committee is as under.
(1) Expected level of activity would be 60,000 units.
(2) Raw material cost consists of the following:
Particulars ₹ per unit
Dried milk powder 40
Coco butter 18
Vanila essence 2
(3) Raw materials are purchased from different suppliers, and those suppliers are extending different credit period as
indicated hereunder:
Particulars Credit period in months
Dried milk powder 2
Coco butter ½
Vanila essence 1
(4) Product is in process for a period of ½ month. Production process requires 100% of dried milk powder and coco butter in
the beginning of the process. Vanila essence is required at a uniform and constant rate during the process.
(5) Direct wages and other overhead accrue at a uniform rate throughout production process.
(6) Past trends indicate that dried milk powder is required to be stored for 2 months period and other materials to be stored
for 1 month, before it would be given for the production process.
(7) Finished goods are kept in stock for a period of 1 month.
(8) It is estimated that ¼ of total sales would be on cash basis.
(9) The past experience also indicates that it took generally 2 months time to collect the receivables from the debto ₹ (10)
Average time-lag in payment of all overhead is 1 month and ½ month in case of labour payment.
(11) Desired cash balance to be maintained throughout the year at the level of ₹ 1 lakh.
From the above information, you are required to determine the net working capital requirement on cash basis.
Answer: Determination of net working capital
Raw material cost: ₹
a. Dried milk (₹60x₹40x2/12) 4,00,000
b. Coco butter (60,000x₹18x1/12) 90,000
c. Vanilla essence (60000x₹2x1/12) 10,000
Total raw material cost (₹4,00,000+₹90,000+₹10,000) 1 5,00,000
Work in progress:
Raw material (60,000x₹58+60,000x2x50%)x0.5/12 1,47,500
Wages and overhead (60,000x30x50%)+(60,000x20x50%)x0.5x12 62,500
Total work in progress 2 2,10,000
Finished goods: (60,000x₹110x1/12) 3 5,50,000
Debtors (60,000x120x75%x2/12) 4 9,00,000
Cash 5 1,00,000
Creditors for raw material:
a) Dried milk powder (60,000x40x2/12) 6 4,00,000
b) Coco butter (60,000x18x0.5/12) 7 45,000
c) Vanilla essence (60,000x2x1/12) 8 10,000
Wage and overhead creditors: (60,000x60x1/12) 9 3,00,000
Net working capital (Current assets-Current Liabilities) (1+2+3+4+5-6-7-8-9) 15,05,000
Calculate the Net Working Capital requirement for Vertical Ltd. from the following information:
₹ (per unit)
Raw Material 160
Direct Labour 60
Overhead 120
Total Cost 340
Profit 60
Selling Price 400
Raw material is held in stock on an average for 4 weeks.
Materials are in process on an average for 2 weeks.
Finished goods are in stock on an average for 4 weeks.
Credit allowed by supplier 4 weeks.
Credit allowed by Debtors 8 weeks.
Work in progress comprise 100% material cost & 50% conversion cost.
Lag in Payment of Wages 1½ week.
Time lag in payment of overhead expense 4 weeks.
Other information:
Cost of Sales ¼ of total sales
Cash in hand/bank ₹50,000
Expected level of production 1,04,000 units
One year is taken as 52 weeks.
Production is carried evenly throughout the year. State your assumptions, if any.
Answer: Calculation of net working capital ₹
Raw material cost of materials for the whole year (1,04,000x₹160) 1,66,40,000
Raw material requirement: Monthly consumption (4 weeks) (₹1,66,40,000/52x4) 1 12,80,000
Debtors: The average credit sales per week is (1,04,000x400/52x8x3/4) 2 48,00,000
Creditors: Suppliers allow credit of 1 month period (₹1,66,40,000/52x4) 3 12,80,000
Wages payable: (1,04,000x60/52x1 ½ ) 4 1,80,000
Overhead payable (1,04,000x120/52x4) 5 9,60,000
Work in progress:
(i) Raw materials in WIP (1,04,000x160/52x2) 6,40,000
(ii) Labour cost 1 week allowed (1.04,000x60x52x1) 1,20,000
(iii) Overhead cost 1 week allowed (1.04,000x120x52x1) 2,40,000
Finished goods inventory: 1 month cost of material (1,04,000x160/52x4) 12,80,000
Labour: (1,04,000x 60/52x4) 4,80,000
Overhead: (1,04,000x120/52x4) 9,60,000
Total finished goods 7 27,20,000
Cash 8 50,000
Current assets:
Raw materials inventory 1 12,80,000
Debtors 2 48,00,000
Work in progress 6 10,00,000
Finished goods in inventory 7 27,20,000
Cash 8 50,000
Creditors 3 12,80,000
Wages payable 4 1,80,000
Overheads payable 5 9,60,000
Himalaya Ltd. approached their banker for working capital requirement. The bank has agreed to sanction the same by
retaining margins as under:
Raw materials 18%
Work-in-progress 30%
Finished goods 20%
Debtors 10%
Following projections are available:
Estimate ₹
Annual sales 18,00,000
Cost of production 14,40,000
Raw materials purchased 9,35,000
Monthly expenditure 50,000
Anticipated opening stock of raw materials 1,80,000
Anticipated closing stock of raw materials 1,55,000
Inventory norms
Raw material 2 months
Work-in-progress 15 days
Finished goods 1 month
The firm enjoys a credit of 15 days on its purchases and allows one month credit on its supplies. On sales orders, the
company has received an advance of ₹2,50,000.
You are required to calculate — (a) Working capital required by the company; and (b) Working capital limits likely to be
approved by the banker. State your assumptions, if any.
Answer: Calculation of Working capital requirement
Calculation of working capital:
Raw materials (Opening stock+Purchases) is (9,35,000+1,80,000) 11,15,000
Less: Closing stock 1,55,000
Annual consumption 9,60,000
Monthly consumption (9,60,000/12) 80,000
Monthly sales (Annual sales/12) is (18,00,000/12) 1,50,000
Monthly cost of production (Cost of production per year/12) is (14,40,000/12) 1,20,000
Current assets:
Raw materials (80,000x2) 1,60,000
Work in progress (1,20,000/30x15) 60,000
Finished goods (1,20,000x1) 1,20,000
Sundry debtors (1,50,000x1) 1,50,000
Expenses for 50,000
Creditors (9,35,000/12)/30x15 38,958
Advance received on sales order 2,50,000
Total current liabilities 2,88,958
Net working capital required (5,40,000-2,88,958) 2,51,042
Working capital limits set by bankers:
Raw materials (1,60,000-1,60,000x18%) 1,32,200
Work in progress (60,000-60,000x30%) 42,000
Finished goods (1,20,000-1,20,000x20%) 96,000
Sundry debtors (160,000-1,60,000x10%) 1,44,000
Expenses -
Total limit likely to be approved by banker 4,14,200
A newly formed company has applied for a short-term loan to a commercial bank for financing its working capital
requirements. Projected statement of profit and loss is as follows:
Sales (20% cash) 21,00,000
Less : Cost of goods sold 15,30,000
Gross profit 5,70,000
Less : Administrative expenses 1,40,000
Selling expenses 1,30,000 2,70,000
Profit before tax (PBT) 3,00,000
Less : Tax 1,00,000
Profit after tax (PAT) 2,00,000
Cost of goods sold has been derived as follows:
Material 8,40,000
Wages and money expenses (one month arrear) 6,25,000
Depreciation 2,35,000
17,00,000
Less: Stock (10% of finished goods) 1,70,000
15,30,000
The figures given above relate only to the goods that have been finished and not to work-in-progress;
goods equal to 15% of year's production (in terms of physical units)
are in progresson an average requiring full materials and only 40% of other expenses.
The company believes in keeping 2 months consumption of material in stock.
Credit allowed to customers is 2 months.
Selling expenses and administrative expenses are 1 month in arrears
Credit allowed by supplier is 1½ months.
Add 10% to your estimated figure to cover contingencies.
You are requested by the bank to prepare an estimate of requirements of working capital for the company.
Answer: Calculation of working capital
Work in progress:
Raw material (8,40,000x15%) 1,26,000
Wages (6,25,000x15%x40%) 37,500
Raw material: (Consumed in finished goods+Consumed in WIP) (8,40,000+1,26,000) 9,66,000
Stock of material (9,66,000/12x2) 2 1,61,000
Finished goods stock (14,65,000x10%) 3 1,46,500
Debtors (Materials consumed+Wages) (8,40,000+6,25,000)x90% = 13,18,500
Add: Administration and selling expenses = 2,70,000
Before cash sales = 15,88,000
After cash sales (15,88,000x80%x2/12) 4 2,11,800
Creditors:
Raw materials consumed = Opening stock+Purchases-Closing stock
Purchases = 9,66,000+1,61,000 = 11,27,000
= 11,27,000/12x1.5 5 1,40,875
Outstanding wages (6,25,000+37,500)/12x1 6 55,028
Outstanding administration and Selling expenses. (27,000/12x1) 7 22,500
Current assets:
Work in progress 1 1,61,000
Raw material 2 1,63,000
Finished goods 3 1,46,500
Debtors 4 2,11,800
Creditors 5 140,875
Outstanding wages 6 55,208
Outstanding administration and selling expenses 7 22,500
Working capital (Current assets-Current liabilities) 4,64,217
Add: 10% for contingencies (4,64,217x10%) 46,422
Esteemed working capital 510,639
A company has prepared its annual budget, relevant details of which are reproduced below:
(i) Sales ₹46.80 lakh (25% cash sales and balance on credit): 78,000 units
(ii) Raw material cost: 60% of sales value
(iii) Labour cost: ₹6 per unit
(iv) Variable overheads: ₹1 per unit
(v) Fixed overheads: ₹5,00,000 (including ₹1,10,000 as depreciation)
(vi) Budgeted stock levels:
Raw materials: 3 weeks
Work-in-progress: 1 week (material 100%; labour and overheads 50%)
Finished goods: 2 weeks
(vii) Debtors are allowed credit: 4 weeks
(viii) Creditors allow: 4 weeks credit
(ix) Lag in payment of overheads: 2 weeks
(x) Cash in hand require: ₹50,000
(xi) Wages are paid as follows :
(a) for 1st and 2nd week : in the 3rd week
(b) for 3rd and 4th week : in the next week.
Assume one year 52 weeks.
Prepare working capital budget (requirement) for a year for the company.
Answer: Calculation of working capital.
Selling price and cost per unit ₹
Selling price 60
Raw materials (60%x60) 36
Labour 6
Variable overheads 1
Fixed overheads (3,90,000/78000) 5
Total 48
Sales per week (78,000/52) 1,500
Sales per month (1,500x4) 6,000
Sales excluding cash 25% (6,000x3/4) 4,500
Work in progress valued (36+3+3) 42
Total overhead per unit (1+5) 6
Current assets:
Raw materials (3x1,500x36) 1,62,000
Work in progress (1x1,500x42) 63,000
Finished goods (2x1,500x48) 1,44,000
Debtors (4,500x48) 2,16,000
Cash in hand 50,000
Creditors (4x1,500x36) 2,16,000
Wages (2x1,500x6) 18,000
Overheads (2x1,500x6) 18,000
Net Working capital (Current assets-Current liabilities) 3,83,000
Ashoka Ltd., a newly formed company, has applied to the commercial bank for the first time for financing its working capital
requirements. The following information is available about the projections for the current year:
Estimated level of activity: 1,04,000 completed units of production plus 4,000 units of work-in-progress.
Based on the above activity, estimated cost per unit is :
₹ per unit
Raw material 80
Direct wages 30
Overheads (exclusive of depreciation) 60
Total cost 170
Selling price 200
Raw material in stock : Average 4 weeks consumption
Work-in-progress : 50% completion stage in respect of conversion cost while materials issued at start of the processing .
Finished goods in stock : 8,000 units
. Credit allowed by suppliers : Average 4 weeks
. Credit allowed to debtors/receivables : Average 8 weeks
. Lag in payment of wages : Average 1.5 weeks
. Cash at banks is expected to be : ₹25,000
Assume that production is carried on evenly throughout the year (52 weeks) and wages and overheads accrue similarly.
All sales are on credit basis only.
Find out . (i) The net working capital required on total value method; and
(ii) The maximum permissible bank finance under second method of financing as per Tandon Committee Norms.
Answer: Calculation of net working capital:
Raw material (2,000x4x80) 6,40,000
Work in progress
(Raw materials+50% of wages+50% of overheads) (4,000x80)+(4000x30x50%)+(4,000x60x50%) 5,00,000
Finished goods (8,000x170) 13,60,000
Debtors (1,04,000-8,000)x170x 25,10,769
Raw material creditors (1,04,000+80)+(4000x80)+(2,000x4x80)x 7,13,846
Wage creditors (1,04,000x30)+(4,000x30x50%)x 91,731
Calculation of net working capital:
Raw material 6,40,000
Work in progress 5,00,000
Finished goods 13,60,000
Debtors 25,10,769
Cash 50,000
Raw material creditors 7,13,846
Wage creditors 91,731
MFBF as per Tandon committee 75% of Current assets-Current liabilities
(50,35,769x75%)-8,05,577 29,71,251
Ice Decor Ltd. sells goods at a uniform rate of gross profit of 20% on sales including depreciation as part of cost of
production. Its annual figures for the current year are as under:
Sales (at 2 months’ credit) 24,00,000
Materials consumed (suppliers’ credit 2 months) 6,00,000
Wages paid (monthly at the beginning of the subsequent month) 4,80,000
Manufacturing expenses (cash expenses are paid — 1 month in arrear) 6,00,000
Administration expenses (cash expenses are paid — 1 month in arrear) 1,50,000
Sales promotion expenses (paid quarterly in advance) 75,000
The company keeps 1 month stock each of raw materials and finished goods.
A minimum cash balance of ₹ 80,000 is always kept.
The company wants to adopt a 10% safety margin in the maintenance of working capital.
The company has no work-in-progress.
Find out the requirement of working capital of the company on cash cost basis.
Answer: Calculation of working capital:
Sales 24,00,000
Less: 2 months credit 4,80,000
Manufacturing cost 19,20,000
Less: Depreciation on cost of goods sold (24,00,000x10%) 2,40,000
16,80,000
Add: Administration expenses 1,50,000
Add: Sales promotion expenses 75, 000
Debtors 1 19,05,000
Current assets:
Raw material (6,00,000x1/12) 50,000
Finished goods (6,00,000+4,80,000+6,00,000) 1,40,000
Debtors (19,05,000/12x2) 1 3,17,500
Sales promotion prepaid (75,000/12x3) 18,750
Cash in hand 80,000
Creditors (6,00,000/12x2) 1,00,000
Manufacturing expenses (6,00,000/12x1) 50,000
Administration expenses (1,50,000/12x1) 12,500
Add: 10% safety margin (443750x10%) 44,375
Total working capital requirement 4,88,125
Income Statement
The following data relates to Ribbon Ltd.: ₹
Earnings Before Interest and Taxes (EBIT) 30,00,000
Profit after Tax 13,50,000
Operating Fixed Costs 22,50,000
Tax Rate 40%
(i) Prepare the Income Statement of Ribbon Ltd.
(ii) If the company wants to increase its profit after tax by 40%, how much should be the percentage rise in EBIT that is
required?
Answer:
Earnings before interest and taxes 30,00,000
Tax rate 40%
Earnings after tax Earnings before tax(1-Tax)
Earnings before tax Earnings after tax/(1-Tax)
Income statement:
Contribution (30,00,000+22,50,000) 52,50,000
Less: Fixed cost 22,50,000
Earnings before interest and tax 30,00,000
Less: Interest (30,00,000-22,50,000) 7,50,000
Earnings before tax 22,50,000
Less: Tax (22,50,000x40%) 9,00,000
Earnings after tax 13,50,000
(ii) % change in Earnings before tax on % change in Earnings after tax will be determined by Financial Leverage:
Degree of Financial Leverage Earnings before interest/Earnings before tax
30,00,000/22,50,000
1.33
For 1.33 increase in Earnings after tax, Earnings before tax should increase by 1%
For 40% increase in Earnings after tax, Earnings before tax should increase by 40/1.33=30%
M/s Abacus Ltd. has decided to fill up the position of finance officer. To test the analytical capacity of applicant, following
information is provided in the scanning test. You are one of the applicants for the position of finance officer. You are
required to prepare the Income Statement in the vertical format based on information given hereunder.
1. The operating leverage is 2.50.
2. The financial leverage is 3.00.
3. The earnings per share is ₹30.
4. Present market price per share is ₹225.
5. Applicable tax rate is 33.0357%.
6. Number of equity shares outstanding as of date are 20,000.
Answer:
Total number of shares 20,000
Earnings per share ₹30
Total Profit after tax (20,000x30) 6,00,000
Earnings before interest and tax 6,00,000/(1-0.330357) 8,96,000
Financial leverage Earnings Before Interest Tax/Earnings Before Tax
3 Earnings Before Interest Tax/8,96,000
Earnings Before Interest Tax (8,96,000x3) 26,88,000
Operating Leverage Contribution/Earnings Before Tax
2.5 Contribution/26,88,000
Contribution (26,88,000x2.5) 67,20,000
Fixed cost Contribution – Earnings Before Interest and Tax
67,20,000-26,88,000 40,32,000
Interest Earnings Before Interest Tax–Earnings Before Tax
26,88,000-8,96,000 17,92,000
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 20 lakh
Corporate tax rate 40%
Variable cost as percentage of sales 60%
Prepare income statement of the company.
Answer:
Financial leverage Earnings before interest tax/Profit before tax
Profit before tax (Earnings before tax – Interest)
2:1 Earnings before interest tax/(Earnings before tax-Interest)
Earnings before interest tax/Earnings before tax-interest 2/1
Earnings before interest tax/Earnings before tax-20 2/1
Earnings before interest tax 2(Earnings before interest tax–20 lakhs)
Earnings before interest tax 2Earnings before interest tax–40 lakh
2EBIT-EBIT 40 lakhs
EBIT 40 Lakhs
Operating leverage Contribution/Earnings Before Interest Tax
3:1 Contribution/40 lakhs
Contribution 40 lakhsx3
Contribution 120 lakhs
Variable cost 60% of sales
Contribution 100%-60%
Contribution 40% of sales
Contribution 120 lakhs
Hence sales (100/40)x120
Sales 300 lakhs
Computation of income statement
Sales 300
Less: Variable cost (60 of sales) (300x60%) 180
Contribution 120
Less: Fixed cost excluding interest 80
Earnings Before Interest Tax 40
Less: Interest 20
Profit Before Tax 20
Less: Corporate Tax @ 40% (20x40%) 8
Profit After Tax 12
Gordon's model
Jun 18: 3 (d) Vivu Ltd. is a reputed chemical producing company. Vivu’s shares are quoted in the market at the price of ₹
340. Roma Mutual Fund’s manager is thinking to buy the shares of Vivu. Advice the manager of Roma with respect to buy
decision through the application of Gordon model based on the following information.
(1) The expected rate of return by equity shareholders is 10%.
(2) The retention ratio is 40%.
(3) The earnings per share recorded in the recent past year is ₹ 20.
(4) The expected earnings per share for next year is ₹ 25.
(5) The internal rate of return of Vivu Ltd. is 15%.
Answer:
Gorden’s model D1/[Ke-g]
Po Market value per share beginning of the year
Ke Cost of equity share capital/Equity capitalization rate/Rate of return required by
shareholders
G Dividend per share
Earnings per share-Current year 20
Earnings per share-Next year 25
Retention ratio 40%
Dividend pay-out ratio (100%-40%) = 60%
Dividend for next year 25x60% = 15
G The retention ratio/The expected rate of return
40% /10% = 4%
Price as per Gorden’s model 15/(0.15-0.4) =15/0.11 =136
Currently the shares are over valued
The following information is collected from the annual report of Joy Ltd.:
Profit before tax ₹2.50 crore
Tax rate 40%
Retention ratio 40%
Number of outstanding shares 50,00,000
Equity capitalisation rate 12%
Rate of return on investment 15%
What should be the market price per share according to Gordon's model of dividend policy?
Answer:
Gordon’s Formula Po=E(1-b)/k-br
Po Market price per share
E Earnings per share 1,50,00,000/50,00,000 ₹3
K Cost of capital 12%
B Retention ratio 40%
R Rate of return on investment 15%
BR Growth rate (0.40x15%) 6%
Po 3(1-0.40)/(0.12-0.06) ₹30
Intrinsic Value
The share of WMZ Ltd. is at market price of ₹ 120. Put option with a strike price of ₹ 130 is priced at ₹ 15:
(i) What is the intrinsic value of option
(ii) What is the time value of option.
Answer:
Market price per share 120
Strike price 130
(i) Intrinsic value Strike price – Market price 130–120 10
(ii) Time value option 15 – 10 5
Based on the credit rating of the bonds, Rakshit has decided to apply the following discount rates for valuing bonds:
Credit Rating Discount Rate
AAA 364-day T-bill rate + 3% spread
AA AAA + 2% spread
A AAA + 3% spread
He is considering to invest in a AA rated, ₹1,000 face value bond currently selling at ₹1,025.86. The bond has five years to
maturity and the coupon rate on the bond is 15% per annum payable annually. The next interest payment is due one year
from today and the bond is redeemable at par. (Assume the 364- day T-bill rate to be 9%.)
You are required to ––
(i) Calculate the intrinsic value of the bond for Rakshit. Should he invest in the bond?
(ii) Calculate the current yield (CY) and the yield to maturity (YTM) of the bond.
(i) The appropriate discount rate for valuing the AA rated bond of Mr.Rakshit is
R = 9%+3%+2%=14%
Time Cash flow PVIF@14% PV
1 150 0.8772 131.58
2 150 0.7695 115.43
3 150 0.6750 101.25
4 150 0.5921 88.82
5 150 0.5194 597.31
1,150 EPV(CF)i.e.Po 1034.40
Intrinsic value of bond 1034.40
Since the current value is less than the market value, Mr.XYZ should buy the bond.
(ii) Current yield Coupon/Market price 150/1025.86 14.62%
The Yield o maturity (YTM) of the bond is calculated as follows:
P 150xPYIFA@15% for 4 years+1,150xPYIFA@ 15% for 5 years
150x2.855+1,150x0.4972=428.25+571.78=1,000.03
As found in sub part (i) Po@14% 1,034.40
By interpolation, YTM 14+(15-14)x1034.40-1,000.03=1,034.40-1025.86=14.2585%
Dividend Policy
XYZ Ltd. has outstanding shares 25,000
Current Market Price ₹100
It belongs to a risk class with capitalisation rate of (Ke) 20%.
The company expects to earn a net profit of during a year. ₹5,00,000
What will be the price of share if dividend is not paid?
Answer:
Net profit (25,000x100x20)=5,00,000
R (Earnings/Equity capital invested)x100
(5,00,000/(25,000x100)x100=20%
Earnings per share (EPS) (5,00,000/25,000)=20
Dividend not declared D 0
P D/Ke+[(E-DxR/Ke]/Ke
0/0.20+(20-0)x(0.20/0.20)/0.20=100
Evaluation of Proposal
A company’s capital structure consists of the following: ₹
Equity share of ₹100 each 20,00,000
Retained earnings 10,00,000
50,00,000
The company earns 12% on its employed capital. The tax rate is 50%. The company requires a sum of ₹25 lakh to finance its
expansion programme for which following alternatives are available to it:
(i) Issue 20,000 equity shares at a premium of ₹25 per share, or
(ii) Issue 10% preference shares, or
(iii) Issue 8% debentures.
It is estimated that the price earnings ratio in case of equity shares, preference shares and debentures financing would be
21.4, 17.0 and 15.7 respectively.
You are required to evaluate each proposal and recommend the best alternative.
Particulars Present Proposal-I Proposal-II Proposal-III
EBIT @12% of capital employed 6,00,000 9,00,000 9,00,000 9,00,000
Less: Interest 56,000 56,000 56,000 56,000
Less: 8% Debentures - - - 2,00,000
Profit before tax 5,44,000 8,44,000 8,44,000 6,44,000
Less: Tax @50% 2,72,000 4,22,000 4,22,000 3,22,000
Profit after tax 2,72,000 4,22,000 4,22,000 3,22,000
Preference dividend – Present 1,08,000 1,08,000 1,08,000 1,08,000
– New - - 2,50,000 -
Profit available to equity shareholders 1,64,000 3,14,000 64,000 2,14,000
Number of equity shareholders 20,000 40,000 20,000 20,000
Earnings per share (EPS) 8.20 7.85 3.20 10.70
Price Earnings Ratio - 21.40 17.00 15.70
Market price of share - 167.99 54.40 167.99
(50,00,000+25,00,000)x12%=9,00,000
Proposal-I and III have same market price of equity shares, even then Proposal-III may be opted, as the EPS is higher in this
case and would avoid interference of Debenture holders in the working of the Company.
Simplex Co. Ltd. is considering an expansion programme which is expected to cost ₹10,00,000. The company can finance
either through debt or equity. Its current financing plan is given as under:
Particulars ₹
Equity capital (50,000 shares @ ₹10 each) 5,00,000
Reserves and surplus 2,00,000
Debt (10%) 3,00,000
Total 10,00,000
The latest income statement reveals the following information :
Particulars ₹
Sales 64,00,000
Less: total costs 59,00,000
EBIT 5,00,000
Less: interest 30,000
EBT 4,70,000
Less: income-tax @ 50% 2,35,000
EAT 2,35,000
The expansion programme is expected to generate additional sales of ₹16,00,000 with a return of 15% on sales before
interest and taxes. If the expansion is financed through debt, the rate of new debt will be 12% and the price-earnings ratio
will be 4 times.
If the expansion programme is financed through equity shares, i.e., the new shares can be sold at a price of ₹40 and the
price-earnings ratio will be 5 times.
Which form of financing should the company choose, if the objective of financial management in the company is
maximisation of shareholders' wealth?
Particulars Debt Equity
Earnings before interest and tax 5,00,000+(16,00,000x15%) 7,40,000 7,40,000
Less: Interest 1,50,000 30,000
Earnings before taxes 5,90,000 7,10,000
Less: Taxes @50% 2,95,000 3,55,000
Earnings after taxes 2,95,000 3,55,000
Number of shares 50,000 75,000
Earnings per share (EAT/Number of shares) 5.90 4.73
Price earnings ratio 4 times 5 times
Market value of share 5.90x4 4,73x5
Earnings per share (P/E Ratio) 23.60 23.65
Decision: Though there is a marginal difference in the market value of shares under alternative financial plans but in view of
higher EPS (₹ 5.90) and debt equity ratio with in acceptable norm, i.e., 2.1; Financial Plan I may be accepted.
X Ltd. is considering the following two alternative financing plans:
Particulars Plan I Plan II
Equity shares @ ₹ 10 each 8,00,000 8,00,000
12% Debentures 4,00,000 —
Preference shares @ ₹ 100 each — 4,00,000
Total 12,00,000 12,00,000
The Earning Before Interest and Tax (EBIT) at indifference point between the plans is ₹4,80,000. Corporate tax rate is 30%.
Calculate the rate of dividend on preference shares.
Particulars ₹
Earnings Before Interest Tax (EBIT) 4,80,000 4,80,000
Less: Interest @12% on ₹4,00,000 48,000 -
Earnings Before Tax (EBT) 4,32,000 4,80,000
Less: Tax @30% 1,29,600 1,44,000
Earnings After Tax (EAT) 3,02,400 3,36,000
Less: Preference dividend - X
Earnings of equity shares 3,02,400 3,36,000-x
Number of equity shares 80,000 80,000
EPS of Plan I is equal to EPS of Plan II at indifference level
EPS = Earnings for Equity Shareholders/No. of equity shares 3,02,400 3,36,000-x
80,000 80,000
Rate of preference dividend 3.78% 4.20%
Business India Ltd. requires ₹12 lakh to support its increased volume of activities. Presently, its earnings before interest and
tax amount to ₹2 lakh. The General Manager (Finance) of the organisation has forwarded three proposals for meeting the
requirement of these funds:
Source of Funds Proposal-l Proposal-ll Proposal-Ill
Equity capital 10,00,000 6,00,000 2,00,000
Debt 2,00,000 6,00,000 10,00,000
Interest slab applicable to loan is as under:
Loan upto ₹2,50,000 10% p.a.
Loan from ₹2,50,001 to ₹6,25,000 14% p.a.
Loan from ₹6,25,001 to ₹10,00,000 16% p.a.
Tax rate 35%
The market price of a share of the company is ₹40 which is expected to come down to ₹25 a share, if the market borrowings
exceeds ₹7,50,000.
From among the above proposals, you are required to suggest the most profitable proposal from shareholders’ view point.
Particulars Proposal I Proposal II Proposal III
Fresh equity capital 10,00,000 6,00,000 6,00,000
Debt 2,00,000 6,00,000 10,00,000
Earnings Before Interest and Tax (EBIT) 2,00,000 2,00,000 2,00,000
Less: Interest 20,000 74,000 137,500
Earnings Before Tax(EBT) 1,80,000 1,26,000 62,500
Less: Tax @35% 63,000 44,100 21,875
Earnings after tax (EAT) 1,17,000 81,900 40,625
Number of shares 25,000 15,000 8,000
Earnings Per Share (EPS) 4.68 5.46 5.08
Plan II is the one that increases the wealth of the shareholde ₹ Hence, it is the most profitable proposal from shareholders
point of view.
Workings:
Interest under P II - (2,50,000 x 10%)+(3,50,000 x 14%) 25,000+49,000=74,000
Interest under P III - (2,50,000 x 10%)+(3,75,000 x 14%)+(3,75,000x16%) 25,000+52,500+60,000=1,37,500
Number of shares P I – 10,0,000/40 25,000
Number of shares P II – 6,0,000/40 15,000
Number of shares P III – 2,00,000/25 8,000
Three Star Co. is to decide between debt funding and equity funding for its expansion programme. Its current position is as
under:
₹
5% Debt 4,00,000
Equity capital (₹10/share) 10,00,000
Surplus 6,00,000
Total capitalisation 20,00,000
Sales 60,00,000
Less: Costs 53,80,000
Profit before interest and taxes (PBIT) 6,20,000
Less: Interest 20,000
Profit before taxes (PBT) 6,00,000
Less: Income-tax @ 33.99% 2,03,940
Profit after tax (PAT) 3,96,060
The expansion programme is estimated to cost ₹10,00,000. If it is financed through debt, the rate of interest of new debt will
be 7%. If the expansion programme is financed through fresh equity shares, the new shares can be sold netting ₹25/share.
The expansion will generate additional sales of ₹ 3,00,000 with after tax return of 5%. If the company is to follow a policy of
maximizing the market value of its shares, which form of financing should it choose and why?
(Price-earnings ratio is given to be 15.)
Particulars 7% Debt Equity
Earnings before interest and tax (EBIT) [6,20,000+(3,00,000x5%)/(1-0.3399)] 642,724 642,724
Less: Interest on old loan 20,000 20,000
Interest on fresh loan 70,000
Earnings before tax (EBT) 5,52,724 6,22,724
Income tax @33.99% 1,87,870 2,11,664
Earnings after tax (EAT) 3,64,854 4,11,060
Number of shares 1,00,000 1,40,000
Earnings per share (EPS) 3.65 2.94
PE Ratio 15 15
Market price 54.75 44.10
New number of shares: 1,00,000+(10,00,000/25) 1,40,000
The capital structure of Asha Ltd. is as under:
₹
Equity shares of ₹100 each 40,00,000
1,00,00,000
The company earns 12% on its capital. The tax rate applicable is 35%. The company requires a sum of ₹50,00,000 for which
following options are available to it :
(i) Issue of 40,000 equity shares at a premium of ₹25 per share.
(ii) Issue of 9% preference shares,
(iii) Issue of 8% debentures.
It is estimated that the P/E ratios in the cases of equity share, preference share and debenture financing would be 22.5, 18.5
and 15.2 respectively. Which of the three financing alternatives would you recommend and why?
Particulars Present Equity Preference Debentures
Earnings before interest and tax (EBIT) 12,00,000 18,00,000 18,00,000 18,00,000
Less: Interest Old 1,12,000 1,12,000 1,12,000 1,12,000
Interest New - - - 4,00,000
Earnings Before Tax (EBT) 10,88,000 16,88,000 16,88,000 12,88,000
Less: Tax @35% 3,80,800 5,90,800 5,90,800 4,50,800
Earnings after tax (EAT) 7,07,200 10,97,200 10,97,200 8,37,200
Less: Preference dividend Old 1,92,000 1,92,000 1,92,000 1,92,000
Preference dividend New - - 4,50,000 -
Profit for equity shares 515200 9,05,200 4,55,200 6,45,200
Number of equity shares 40,000 80,000 40,000 40,000
Earnings per share (EPS) 12.88 11.32 11.32 16.13
PE Ratio - 22.50 18.50 15.20
Market price per share - 254.71 210.53 245.18
(1,00,00,000+50,00,000)x12%=18,00,000
The above analysis shows that market price per share is maximum with respect to all equity financing. Hence, financing
through Equity shares is recommended.
Capital structure of Swastik Ltd. consists of the following:
Equity shares of 100 each 20,00,000
50,00,000
The company earns 12% on its capital employed. The tax rate is 35%. The company requires a sum of 25 lakh to finance its
expansion programme for which following alternatives are available to it:
(i) Issue 20,000 equity shares at a premium of 25 per share, or (ii) Issue 10% preference shares, or
(iii) Issue 8% debentures. It is estimated that the price-earnings ratio in case of equity shares, preference shares and
debentures financing would be 21.4, 17.0 and 15.7 respectively. You are required to evaluate each proposal and recommend
the best alternative.
Particulars Present Proposal-I Proposal-II Proposal-III
Earnings before interest and tax (EBIT) 6,00,000 9,00,000 9,00,000 9,00,000
Less: Interest – 7% Debentures 56,000 56,000 56,000 56,000
: Interest – 8% Debentures - - - 2,00,000
Earnings before tax 5,44,000 8,44,000 8,44,000 6,44,000
Less: Tax@35% 1,90,400 2,95,400 2,95,400 2,25,400
Earnings after tax 3,53,600 5,48,600 5,48,600 4,18,600
Less: Preference share dividend
i) 9% Preference dividend 1,08,000 1,08,000 1,08,000 1,08,000
ii) 10% Preference dividend - - 2,50,000 -
Profit available to equity shareholders 2,45,600 4,40,600 1,90,600 3,10,600
Number of equity shares 20,000 40,000 20,000 20,000
Earnings per share (EPS) 12.25 11,015 9.53 15.53
Price Earnings Ratio - 21.40 17.00 15.70
Market price per share - 235.721 162.010 243.821
Recommendation: Proposal-III to issue 8% debentures is the best alternative because in this case, EPS (Rs.15.53) and the
market price per share (Rs.243.821) is the highest.
Venkatesh Ltd. is always discarding old lines and introducing new lines of products and is considering at present three
alternative promotional plans for ushering in new products. Various combinations of prices, development expenditure and
promotional outlays are involved in these plans. High, medium and low forecast of revenues under each plan have been
formulated and their respective probabilities of occurrence have been estimated. Their budgeted revenues and probabilities
along with other relevant data are summarised as under:
(Rupees in Lakhs)
Particulars Plan-I Plan-II Plan-III
Budgeted revenue with probability:
High 30 (0.3) 24 (0.2) 50 (0.2)
Medium 20 (0.3) 20 (0.7) 25 (0.5)
Low 5 (0.4) 15 (0.1) 0 (0.3)
Variable cost as percentage of revenue 60% 75% 70%
Initial investment 25 20 24
Life in years 8 8 8
The company’s cost of capital is 12% and the income-tax rate is 40%. Investment in promotional programmes will be
amortized by the straight line method. The company will have net taxable income each year, regardless of the success or
failure of the new products.
(i) Substantiating with figures, make a detailed analysis and find out which of the promotional plans is expected to be the
most profitable?
(ii) In the worst event, which of the plans would result in maximizing the profits.
Particulars Plan I Plan II Plan III
Budget revenue weighted by probability:
High 9,00,000 4,80,000 10,00,000
Medium 6,00,000 14,00,000 12,50,000
Low 2,00,000 1,50,000 -
Expected revenue 17,00,000 20,30,000 22,50,000
Contribution 40% 25% 30%
Contribution 6,80,000 5,07,500 6,75,000
Less: Depreciation (12,5% on initial investment) 3,12,500 2,50,000 3,00,000
Earnings before Tax (EBT) 3,67,500 2,57,500 3,75,000
Less: Tax @40% 1,47,000 1,03,000 1,50,000
Profit after tax 2,20,500 1,54,500 3,00,000
Add: Depreciation 3,12,500 2,50,000 3,00,000
Average annual cash inflow 5,33,000 4,04,500 5,25,000
PV Factor @12% for 8 years 4.9676 4.9676 4.9676
Present value of cash infl0ws 26,47,731 20,09,394 26,07,990
Initial investment 25,00,000 20,00,000 24,00,000
Net present value 1,47,731 9,394 2,07,990
Profitability index 1.059 1.005 1.087
Plan III has the highest Present Value Index and also the highest NPV hence most profitable.
Low forecast 5,00,000 15,00,000 -
Contribution % 40 25 30
Contribution 2,00,000 3,75,000 -
Less: Depreciation 3,12,500 2,50,000 3,00,000
Profit/(Loss) (1,12,500) 1,25,000 3,00,000
Less: Tax @40% 45,000 50,000 (1,20,000)
Net profit/(loss) (67,500) 75,000 (1,80,000)
Add: Depreciation (12,5% on initial investment) 3,12,500 2,50,000 3,00,000
Annual cash inflow 2,45,000 3,25,000 1,20,000
PV Factor @12% for 8 years 4.9676 4.9676 4.9676
PV cash inflows 12,17,062 16,14,470 596,112
Initial outlay 25,00,000 20,00,000 24,00,000
Net present value (12,82,938) (3,85,530) (18,03,888)
On the basis of above computations, the negative NPV is the lowest in case of Plan II, hence comparatively better.
Padmavati Corporation plans to enhance assets by 50% to support the expansion plan. The management of Padmavati
Corporation has alternatives available to finance the expansion project: either a 12% debt issue or an issue of equity shares
with premium at the rate of 20%. If the expansion plan is implemented, it would result into sales of ₹8 crore. The total cost
excluding interest would be maintained at the level of 90%. The Statement of Financial Position and Income Statement of
Padmavati Corporation are reproduced hereunder.
Statement of Financial Position as on 31st December, 2018
Particulars Amount ₹
Equity and Liabilities :
10 lakh Equity shares 1,00,00,000
Assets : 2,00,00,000
Income Statement for the year ended 31st December, 2018
Particulars Amount ₹
Sales 6,00,00,000
Total cost (excluding interest) 5,40,00,000
Interest 4,40,000
Tax rate 50%
Earnings after tax 27,80,000
The market analysts, are of the view that, if the expansion is financed by debt, then Price-earnings ratio will fall from 7.50 to
5.00. You are required to calculate:
(i) Earnings per share for each alternative of financing. (ii) Market price per share for each alternative of financing.
Particulars Debt Equity
Earnings Before Interest and Tax (EBIT) 80,00,000 80,00,000
Less: Interest Old 4,40,000 4,40,000
Interest New 12,00,000 -
Earnings Before Tax (EBT) 63,60,000 75,60,000
Less: Tax @50% 31,80,000 37,80,000
Earnings After Tax (EAT) 31,80,000 37,80,000
Number of shares – Old 10,00,000 10,00,000
New - 8,33,333
Total Number of shares 10,00,000 18,33,333
Earnings Per Share (EPS)=EAT/Number of shares 3.16 2.06
Price Earnings Ratio (PE Ratio) 5 7.5
Market Price per share=EPS x PE Ratio 15.90 15.45
Calculation of new shares to be issued=1,00,00,000/12=8,33,333 shares
New interest=1,00,00,000x12%=12,00,000
Hire Purchase or Lease
Evaluate the feasibility or otherwise of a project keeping in view the following data:
(i) The nominal rate of return is 14%.
(ii) The expected rate of inflation over life is 7%.
(iii) Cash flows of the project are as under:
Year 0 1 2 3 4
Cash flows ₹ (10,000) 3,000 3,000 3,000 3,000
Also find out the real rate of return.
Year Real Cash flow Inflation adjusted cash flow Normal Cash flow PV Factor @14% PV
0 (10,000) (10,000)x(1.07)0 (10,000.00) 1.0000 (10,000.00)
1 3,000 (3,000)x(1.07)1 3,210.00 0.8772 2,815.81
2 3,000 (3,000)x(1.07)2 3434.70 0.7695 2,643.00
3 3,000 (3,000)x(1.07)3 3675.13 0.6750 2,480.71
4 3,000 (3,000)x(1.07)4 3932.39 0.5921 2,328.36
Net Present Value 267.88
The proposal may be accepted
Real Rate of Return (RRR):
Nominal Rate of Return = (1+Real Rate of Return)x(1+Inflation Rate)-1
0.14 (1+Real Rate of Return)x(1+0.07)-1
0.14 1.07+1.07RRR-1
1.07RRR 0.14-0.7
RRR 0.7/1.07=6.54%
Akshay Machines Ltd. currently manufactures 10,000 units annually on a machine which has book value of Rs.60,000 (it
was purchased for Rs. 1,20,000 six years ago). This machine is not fully depreciated for tax purposes. The manufacturing
cost per unit is as under:Rs.
Direct labour and material 24
Fixed overheads 16
It is expected that old machine can be used for indefinite period after suitable repairs at estimated cost of Rs.40,000 per
annum. On the other hand, Modern Machine Tools offers a machine with latest technology at Rs.3,00,000 after trading off
old machine for Rs.30,000. The new machine is expected to last for 10 years at the end of which its salvage value will be
Rs.20,000. However, the old machine can be sold for Rs.40,000 in open market. The projected cost per unit on the new
machine will be as under: Rs.
Direct labour and material 14
Fixed overheads 20
The fixed overheads are allocated from other departments plus depreciation on machinery. The cost of old and new
machinery will be depreciated in 10 years for tax purposes and the tax rate will be 30%. The minimum rate of return is
expected to be 10% and the annual production will stay at 10,000 units. Ignoring capital gains, advise whether new machine
should be installed or not.
Particulars Old New
Direct labour and material 24 14
Indirect variable overheads 24 24
Total 28 38
Number of units 10,000 10,000
Total cost 4,80,000 3,80,000
Annual repair 40,000 -
Depreciation 6,000 31,000
Total cost 5,26,000 4,11,000
Tax saved @30% 1,57,800 1,23,300
Add: Depreciation 6,000 31,000
Total cash savings 1,63,800 1,54,800
Net decrease in Cash flow (1,63,800-1,54,800)=9,500
Total decrease for 10 years with present value (9,500x6.145)=58,378
Present value of 20,000=(20,000x0.3855)=7,711
Total outflow over 10 years=58,378+7,711 =66,089
Initial Cash outflow =3,00,000
Net present value =3,66,089
Workings: Depreciation on new machine=(3,00,000+30,000-20,000)/10=31,000
Depreciation on old machine=(60,000/10)=6,000
The company may not replace the machine as the NPV of replacement decision is negative.
An equipment costing ₹ 4,00,000, with a life of 4 years, can be leased for 4 years for payment of ₹ 1,20,000 per year at the
end of the year. Alternatively, there is an option to borrow ₹ 4,00,000 and buy the equipment. The borrowed fund will carry
interest @ 6% payable on the outstanding balance at the close of each year. The principal borrowed sum is to be repaid in 4
equal instalments Depreciation to be considered at 25% per cent on the original cost per annum. Corporate tax to be
considered at 30% for this exercise. A fair return of 10% after tax is expected on the business. Present your choice with
comparitive analysis.
Leasing the equipment:
Year Annual Payment Tax Savings@30% Net Cash PV Factor @10% Present Value
1 1,20,000 36,000 84,000 0.9091 76,364
2 1,20,000 36,000 84,000 0.8264 69,418
3 1,20,000 36,000 84,000 0.7513 63,109
4 1,20,000 36,000 84,000 0.6830 57,372
2,66,263
Borrowing/Buying Equipment:
End Principal Annual Interest Depreciation Tax saving@30% on Net cash PV Factor Present
of borrowed payment payable interest and @ 10% Value
Year outstanding depreciation
0 4,00,000 - - - - - - -
1 3,00,000 1,24,000 24,000 1,00,000 37,200 86,800 0.9091 78,910
2 2,00,000 1,18,000 18,000 1,00,000 35,400 82,600 0.8264 68.261
3 1,00,000 1,12,000 12,000 1,00,000 33,600 78,400 0.7513 58,902
4 - 1,6,000 6,000 1,00,000 31,800 74,200 0.6830 50,679
2,56,752
Decision: As the present value of borrowing the money and buying the equipment is less than present value of leasing the
equipment, therefore the equipment should be bought from borrowed funds.
Pawan Ltd. has a machine having a balance economic life of five years, which costed ₹2,00,000 and has a book value of
₹80,000. A new machine with same capacity, costing ₹4 lakh is available in the market. One of the estimates from technical
personnel indicated, that through the acquisition of a new machine, a saving in variable cost can accrue to the extent of
₹1,40,000 per annum. The economic life of the new machine will be 5 years, and can fetch a scrap value of ₹ 40.000.
The rate of income tax would be 46% including cess, and other taxes, as envisaged. The management has fixed the soft
capital rationing at the rate of 12% per annum. If the old machine sold today, it would be result in realisation of ₹ 20,000,
and will have zero value after five years from now. For the working, you can assume no capital gain tax applicable. You can
also ignore the income tax savings on account of depreciation as well as loss on sale of existing machine.
You are required to advise the management, whether to replace the machine or not, as on date?
Particulars ₹
Net cash outlay on new machine/purchase price 4,00,000
Less: Realization from old machine 20,000
Initial investment – A 3,80,000
Cash inflows:
Annual savings in variable cost as a result of purchase of new machine 1,40,000
Less: Tax @46% 64,400
Annual savings after tax 75,600
PV cash flows annually for 5 years @12% per annum (75,600x3.6048) 2,72,523
PV of salvage (40,000x0.5674) 22,696
Total PV of Cash inflows – B 2,95,219
Net present value (NPV) (A – B) (84,781)
Hi-Fi Builders Ltd. needs to acquire the use of a crane for its construction business. The crane if purchased outright will cost
₹10,00,000. A hire-purchase and leasing company has offered the following two alternatives:
Hire-Purchase : ₹2,50,000 will be payable on signing of the agreement. Three annual installments of ₹4,00,000 will be
payable at the end of each year starting from year one. The ownership in the crane will be transferred automatically at the
end of the third year. It is assumed that the company will be able to claim depreciation on straight line basis with zero
salvage value.
Leasing : ₹20,000 will be payable towards initial service fee upon signing of the lease agreement. Annual lease rent of
₹4,32,000 is payable at the end of each year starting from the first, for a period of three years. The company is in 35% tax
bracket and its discount rate is 20%. Should it hire-purchase or lease the crane?
Option I: Hire Purchase: Computation of Interest Charges and deprecation
Year Instalments Interest Cash price Depreciation
0 2,50,000 - 2,50,000 -
1 4,00,000 2,25,000 1,75,000 3,33,333
2 4,00,000 1,50,000 2,50,000 3,33,333
3 4,00,000 75,000 3,25,000 3,33,334
Total 14,50,000 4,50,000 10,00,000 10,00,000
Total hire purchase price 14,50,000
Less: Cash price 10,00,000
Interest 4,50,000
Which is proportioned in the ratio of hire purchase price outstanding i.e. 3:2:1.
Year Instalment Tax shield @35% of Interest+Depreciation Net outflow PV Factor@20% PV of outflow
0 2,50,000 - 2,50,000 1.0000 2,50,000
1 4,00,000 1,95,417 2,04,583 0.8333 1,70,479
2 4,00,000 1,69,167 2,30,833 0.6944 1,60,290
3 4,00,000 1,42,917 2,57,083 0.5787 1,48,774
Total 7,29,543
Option II: Leasing: Calculation of cash outflows

Year Instalments Tax shield @35% on lease rental Net outflow PV factor @20% PV of outflow
0 20,000 - 20,000 1.0000 20,000
1 4,32,000 1,58,200 (4,32,000+20,000x35%) 2,73,800 0.8333 2,28,158
2 4,32,000 1,51,200 (4,32,000x35%) 2,80,800 0.6944 1,94,988
3 4,32,000 1,51,200 (4,32,000x35%) 2,80,800 0.5787 1,62,499
Total 6,05,645
The lease option implies lesser cost and, therefore, the firm should procure the crane on lease basis.
Capital Asset Pricing Model
The following data relate to two securities, A and B:
A B
Expected return 22% 17%
Beta factor () 1.5 0.7
Assume RF = 10% and RM = 18%.
Find out whether the securities, A and B are correctly priced?
The required return can be ascertained with the help of CAPM equation as follows:
Security A – Formula: RA RF+(RM-RF)β
0.10+(0.18-0.10)1.5
0.22 or 22%
This is equal to the expected return of security A. Therefore security A is correctly priced.
Security A – Formula: RA RF+(RM-RF)β
0.10+(0.18-0.10)0.7
0.156 or 15.6%
This return of 15.6% is less than the expected return of 17%. Therefore, Security B is not correctly priced. It is undervalued,
giving a return which is higher than what is required based on its level of risk.
As an investment manager you are given the following information:
Investment in Initial price Dividends Market price at Beta
equity share of (₹) (₹) the end of the year (₹)
Coil Ltd. 50 4 100 0.8
Sail Ltd. 70 4 120 0.7
Lip Ltd. 90 4 270 0.5
Govt. Bonds 2,000 280 2,010 0.99
Risk Free return may be taken at 14%.
You are required to calculate expected rate of return of each security in the portfolio using Capital Asset Pricing Model
(CAPM).
Investment in equity Initial price (P0) Dividends Market price at the Capital gains (P1-P0)
share of end of the year (P1)
Coil Ltd 50 4 100 50
Sail Ltd 70 4 120 50
Lip Ltd 90 4 270 180
Govt. Bonds 2,000 280 2,010 10
Total 2,210 292 2,500 290
Market return [(Dividends+Capital gains)/Share price at the beginning]x100
RM [(292+290)/2,210]x100 = 26.33%
Calculation of Rate of return – R RF+(RM-RF)β
Return of each equity share:
Coil Ltd 0.14+(0.2,633-0.14)0.8 0.2386 or 23.86%
Sail Ltd 0.14+(0.2,633-0.14)0.7 0.2,263 or 22.63%
Lip Ltd 0.14+(0.2,633-0.14)0.5 0.2,017 or 20.17%
Govt. Bonds 0.14+(0.2,633-0.14)0.99 0.2,621or 26.21%
The following information is available in respect of Security-X and Security-Y:
Security b Expected Rate of Return
X 1.8 22.00%
Y 1.6 20.40%
Rate of return of market portfolio is 15.3%
If risk free rate of return is 7%, are these securities correctly priced?
What would be the risk free rate of return, if they are correctly priced?
The required return can be ascertained with the help of CAPM equation as follows:
Security X – Formula: RA RF+(RM-RF)β
0.07+(0.153-0.07)1.8
0.2194 or 21.94%
This is less than the expected return of Security X i.e. 22%. Therefore, Security A is not correctly priced.
Security Y – Formula: RA RF+(RM-RF)β
0.07+(0.153-0.07)1.64
0.2028 or 20.28%
Return of 20.28% is less than the expected return of 20.40%. Therefore, Security Y is not correctly priced.
The risk free rate would
(22%-RF)/1.8 (20.40%-RF)/1.6
(0.22%-RF)x1.6 (0.2,040-RF)x1.8
0.3,520-1.6RF 0.3,672-1.8RF
2RF 0.152
RF 7.6%
So, both securities would have correctly priced if the risk free rate is 7.6%.
Your client is holding following securities as proxy of market portfolio:
Particulars of Purchase Dividends Expected Market BETA
securities Price (₹) (₹) Price after (β)
1 year (₹)
Equity shares :
Company–A 8,000 800 8,200 0.80
Company–B 10,000 800 10,500 0.70
Company–C 16,000 800 22,000 0.50
PSU bonds 34,000 3,400 32,300 1.00
Assume a risk free rate of 15%.
Calculate expected rate of return in each, using capital asset pricing model if shares are held for 1 year.
Equity shares Purchase price Dividends Expected market price after 1 year
Company–A 8,000 800 8,200
Company–B 10,000 800 10,500
Company–C 16,000 800 22,000
PSU bonds 34,000 3,400 32,300
Total 68,000 5,800 73,000
Return 73000+5,800-68,000=10,800
Return % (10,800/68,000)x100=15.882%
Calculation of Return of Security – R RF+(RM-RF)β
Return of Security – A 15+(15.882-15)0.8=15.7056%
Return of Security – B 15+(15.882-15)0.7=15.6174%
Return of Security – C 15+(15.882-15)0.5=15.4410%
Return of PSU bonds 15+(15.882-15)0.1=15.8820%
An investor is holding 1,000 shares of Horizon Ltd. Presently, the rate of dividend being paid by the company is ₹2 per share
and the share is sold at ₹25 per share.
However, several factors are likely to change during the course of the year as given below:
Existing Revised
Risk-free rate (%) 12 10
Market risk premium (%) 6 4
Beta (b) value 1.40 1.25
Expected growth rate (%) 5 9
In view of above factors, should the investor buy, hold or sell the shares and why?
Expected Rate of return on security as per CAPM Model: RF+(RF-RM)β
Existing return 0.12+(0.12-0.06)1.40=0.204 or 20.4%
Revised return 0.10+(0.10-0.04)1.25=0.175 or 17.5%
Existing share price (Po) Do(1+g)/(Ke-g)
2(1+0.05)/(0.204-0.05)=2.10/0.154=13.64%
Revised selling price 2(1+0.09)/(0.175-0.09)=2.18/0.085=25.65%
The current market price of the share is given at ₹25 per share but under equilibrium process it is expected that share price
fell to ₹ 13.64.So it is overpriced and it should be sold.
However in the revised situation, the theoretical price of a share is expected to increase to ₹ 25.65. Subject to other factors,
the investor may hold the share with a view to have capital gain in future.
During a 5 year period, the relevant results for the aggregate market are that the risk free rate (RF) is 8% and the return on
market (RM) is 14%. For that period, the results of five portfolio managers are as follows:
Portfolio Actual Average Beta (β )
Manager Return (%)
A 13 0.80
B 14 1.05
C 17 1.25
D 13 0.90
E 15 0.95
Using CAPM model, you are required to —
(i) Calculate the expected rate of return for each portfolio manager and compare the actual returns with the expected returns;
and (ii) Based upon your calculations, select the portfolio manager with the best performance.
Portfolio Manager Actual Average Return Beta (β ) Expected Return Deviation (Actual-
RP=RF+(RM-RF)β Expected)
A 13 0.80 0.08+(0.14-0.08)0.80=0.128 or 12.80 0.20
B 14 1.05 0.08+(0.14-0.08)1.05=0.143 or 14.30 (0.30)
C 17 1.25 0.08+(0.14-0.08)1.25=0.155 or 15.50 1.50
D 13 0.90 0.08+(0.14-0.08)0.90=0.134 or 13.40 (0.40)
E 15 0.95 0.08+(0.14-0.08)0.95=0.137 or 13.70 1.3
(ii)It is clearly evident from the above table that Portfolio Manager C revealed the best performance, where the actual return
was 9.7% [being (1.5/15.5) x 100] higher than the expected.
Following particulars about four corporate securities (shares) are available:
Security Today's Predicted price Expected dividend Beta
price after one year during coming year estimates
() () () (β)
A 490 580 7.0 1.4
B 180 200 7.0 1.2
C 570 640 5.0 1.0
D 220 245 6.0 0.5
Expected rate of return in the market is 14% and the risk-free rate of return is 8%. You are required to calculate for each
security —
(i) The estimated return based on the CAPM model; and
(ii) Predicted return. Also state, whether the securities are undervalued or overvalued.
Calculation of Return of Security – R RF+(RM-RF)β
Return of Security – A 0.08+(0.14-0.08)1.4=0.164 or 16.40%
Return of Security – B 0.08+(0.14-0.08)1.2=0.152 or 15.20%
Return of Security – C 0.08+(0.14-0.08)1.0=0.140 or 14.00%
Return of PSU bonds 0.08+(0.14-0.08)0.5=0.110 or 11.00%
Calculation of periodic return [(Predicted price-Current price)+(Expected dividend)/Current price]x100
Security – A [((580-490)+7)/490]x100=19.80%
Security – B [((200-180)+7)/180]x100=15.00%
Security – C [((640-570)+5)/570]x100=13.16%
Security – D [((245-220)+6)/220]x100=14.09%
Security Predicted return CAPM return Under/over valued
Security – A 19.80% 16.40% Under valued
Security – B 15.00% 15.20% Over valued
Security – C 13.16% 14.00% Over valued
Security – D 14.09% 11.00% Under valued
A Portfolio Manager has three stocks in his portfolio. Following information is available in respect of his portfolio:
Company Investment (₹) β
X Ltd. 6,00,000 1.3
Y Ltd. 3,00,000 1.4
Z Ltd. 1,00,000 0.9
Expected return on the market portfolio is 15% and the risk free rate of interest is 6%. On the basis of Capital Asset Pricing
Model (CAPM), compute the following: (i) Expected return of the portfolio; and (ii) Expected β of the portfolio.
Calculation of Return of Security – RA RF+(RM-RF)β
Return of Security – X Ltd. 0.06+(0.15-0.06)1.3=0.177
Return of Security – Y Ltd. 0.06+(0.15-0.06)1.4=0.186%
Return of Security – Z Ltd. 0.06+(0.15-0.06)0.9=0.141%
Expected rate of portfolio
Company Investment (₹) Weight (W) Β RA WxRA
X Ltd. 6,00,000 0.6 1.3 0.177 0.1062
Y Ltd. 3,00,000 0.3 1.4 0.186 0.0558
Z Ltd. 1,00,000 0.1 0.9 0.141 0.0141
10,00,000 0.1761
So the expected return of the portfolio is 0.1761 or 17.61%
Expected β of the portfolio – P 1W1+2W2+3W3=1.3x0.6+1.4x0.3+0.9x0.1=1.29
Following information is available in respect of EPS and DPS of Intelligent Ltd. for the last five years:
Year 2004 2003 2002 2001 2000
EPS ₹ 14.10 13.60 13.10 12.70 12.20
DPS ₹ 8.20 8.10 7.90 7.80 7.70
Dividends for a particular year are paid in the same calendar year. If the same dividend policy is maintained, it is expected
that the annual growth rate of earnings will be no better than the average of last four years. The risk-free rate is 6% and the
market risk premium is 4%. With reference to the market rate of return, the equity shares of the company have a β of 1.5 and
is not expected to change in near future.
The company has received a proposal from Smart Ltd. to acquire its operations by paying the value of shares.
You are required to value the equity shares of the company using (i) dividend growth model; (ii) earnings growth model; and
(iii) capital asset pricing model (CAPM).
Valuation as per dividend growth model
EPS for the year 2000 ₹12.20
EPS for the year 2004 ₹14.10
Growth rate table for 4 years ₹14.10/₹12.20=1.155
In the CVF table for 4 years, the value of 1.155 lies in between 3% and 4%. So, the growth rate, g. may be taken as 3.5%.
RA RF+(RM-RF) β
0.06+(0.10-0.06)1.5=0.12 or 12%
Now valuation as per dividend growth model: Po Do(1+g)/Ke-g
₹8.20(1+0.35)/0.12-0.35=₹99.85
Earnings growth model: Po E(1-b)/Ke-br
For the last 5 years, the company has been following a dividend payout ratio of 60% (approx). If the same dividend policy is
maintained, then retention ratio, b, is 40% and r is 12%. So,
br 0.12x0.4=4.8%
Now, Po ₹14.10(1-0.4)/0.12-0.048=8.46/0.072=₹117.50
Valuation as per CAPM: Po ₹14.10/0.12=₹117.50
Modigliani-Miller Model
Following is the data regarding two companies, Company-A and Company-B, belonging to the same risk class:
Company-A Company-B
Number of equity shares 1,00,000 2,00,000
Market price per share (₹) 15 7
10% Debentures (₹) 2,00,000 —
Profit before interest (₹) 1,20,000 1,20,000
Dividend payout ratio is 100%. Explain how under Modigliani & Miller approach, Ramesh, an investor, holding 10% of
shares in Company-A will be better off in switching his holding to Company-B.
Particulars Company-A Company-B
Profit before interest (PBI) 1,20,000 1,20,000
Less: Interest 20,000 -
Profit before tax (PBT) 1,00,000 1,20,000
Number of shares 1,00,000 2,00,000
Earnings per share (EPS) 1 0.60
Dividend per share (DPS) 1 0.60
Earning of investor (10,000x₹1) 10,000
Investor sells his 10% shares for (₹10,000x15) 1,50,000
Less: Buy 10% of the investment in Company B for (20,000 sharesx7 1,40,000
Balance money left 10,000
Income in this case:
Income on investment in Company B (20,000x0.6) 12,000
Interest earned on balance funds (10,000x10%) 1,000
Total earnings 13,000
Thus, investor will be better off in switching his holding to Company B.
Diva Ltd. has 10 lakh equity shares outstanding at the end of accounting year 2014-15. The current market price of the shares
is 150 each. The Board of directors of the company has recommended ₹8 per share as dividend. The rate of capitalisation
appropriate to the risk class to which the company belongs is 12%. Based on Modigliani-Miller approach, calculate the
market price of the share if the recommended dividend is – (a) declared; and (b) not declared.
Dividend declared – Miller-Modigliani dividend model – Po (D1+P1)/(1+Ke)
150 (8+P1)/1.12
P1 1.12x150-8=₹160
Dividend not declared – Po (D1+P1)/(1+Ke)
150 (0+P1)/1.12
P1 1.12x150=₹168
A company belongs to a risk class for which the appropriate capitalisation rate is 10%. It currently has outstanding 25,000
shares selling at ₹100 each. The company is contemplating the declaration of dividend of ₹5 per share at the end of the
current financial year. The company expects to have a net income of ₹2.5 lakh and has a proposal for making new
investments of ₹5 lakh.
You are required to show under the Modigliani and Miller (MM) assumptions, whether payment of dividend affects the value
of the company.
I Price of shares if dividend is paid
Po (D1+P1)/(1+Ke)
100 (5+P1)/(1+0.10)
P1 110-5=105
New shares to be issued – Po (m+n)x(P1-1+e)/(1+Ke)
25000x100 (m+25,000)x105-(5,00,000+2,50,000)/(1+0.10)
M 3,571 Shares
Value of firm (25,000+3,571)x105=30,00.000 (approx.)
II Price of shares if dividend is not paid
Po (D1+P1)/(1+Ke)
100 (0+P1)/(1+0.10)
P1 110-0=110
New shares to be issued – Po (m+n)x(P1-1+e)/(1+Ke)
25000x100 (m+25,000)x110-(5,00,000+2,50,000)/(1+0.10)
M 2,273 Shares
Value of firm (25,000+2,273)x110=30,00.000 (approx.)
Thus under Modigliani & Miller (mm) assumptions the payment of dividend does not affect the value of a company.
Abhishek Steel Ltd. has one lakh equity shares outstanding which are selling at ₹100 each. Its capitalisation rate is 14%. The
company is expecting ₹65 lakh income for the current year and is planning to pay dividend amounting to ₹4 lakh. The
company wants to invest in a new project which will cost ₹75 lakh. It is assumed that the Modigliani and Miller Model on
dividend policy is applicable to the company. Compute the price per share at the end of the current year and the number of
shares to be issued for financing the investment when.
(i) Dividend amounting to ₹4 lakh is paid. (ii) Dividend is not paid.
I Price of shares if dividend is paid – Po (D1+P1)/(1+ke)
Po (4+P1)/(1+0.14)
100 114-4
P1 110
Expected income 65,00,000
Less: Dividend 4,00,000
Amount available 61,00,000
Number of shares 12,727.27 or 12,728 shares
I Price of shares if dividend is not paid – Po (D1+P1)/(1+ke)
Po (0+P1)/(1+0.14)
100 P1/1.14
P1 100x1.14=114
Less; Dividend 0
P1 114
Expected income 65,00,000
Less: Dividend Nil
Amount available 65,00,000
Amount required for new project 75,00,000
Less: Income available 65,00,000
Amount required 10,00,000
Price at the end of year 1 (P1) 114
Number of shares 10,00,000/114=8,771.93 or 8,772 shares
Hence, a total of 8,772 shares need to be issued.
Rama Ltd. had 1,00,000 equity shares of Rs.10 each outstanding on 1st January, 2007. The shares are currently being quoted
at par in the market. In the wake of the removal of the dividend restraint, the company now intends to pay a dividend of Rs.2
per share for the current financial year. It belongs to a risk class whose appropriate capitalisation rate is 15%. Using
Modigliani-Miller Model and assuming no taxes, ascertain the price of the company’s shares as it is likely to prevail at the
end of the year — (i) when dividend is declared; and (ii) when no dividend is declared.
Also find out the number of new equity shares that company must issue to meet its investment needs of Rs.4 lakh assuming
that the dividend is paid and the earnings per share works out @ Rs.2.20.
(i) Price of the share, when dividend is declared – Po D1+ P1/(1+ Ke )
Po 2+P1/(1+0.15)
10 2+P1/1.15
P1 (1.15x10)-2=₹11.5-₹2=₹9.5
(ii) Price of the share, when dividend is declared – Po D1+ P1/(1+ Ke )
Po 0+P1/(1+0.15)
10 0+P1/1.15
P1 (1.15x10)-0=₹11.5-₹0=₹11.5
(iii) Number of New Equity Shares to be issued when dividend is paid: N I-(E-ND)/P1
4,00,000-(2,20,000-2,00,000)/9.5
3,80,000/9.5=40,000 shares
Thus, 40,000 new equity shares are to be issued to meet the investment requirements of the company.
Following is the data relating to Azad Ltd. and Bharat Ltd. belonging to the same risk class:
Azad Ltd. Bharat Ltd.
No. of equity shares 9,00,000 1,50,000
Market price per share ₹ 15 9
6% Debentures ₹ 8,00,000 —
Profit before interest ₹ 2,00,000 2,00,000
Dividend payout ratio 100%
Explain how under the MM approach, an investor holding 10% shares in Azad Ltd. will be better off in switching his holding
to Bharat Ltd.
Sale proceeds of 10% shares in Azad Ltd 90,000x15 13,50,000
Add: 6% debentures 8,00,000x10% 80,000
Funds available 14,30,000
Income of the investor Azad Ltd Bharat Ltd
Dividend 15,200 20,000
Less: Interest paid - 4.800
Amount after interest paid 15,200 15,200
Funds available 14,30,000
Less: Investment in Bharat Ltd 1,35,000
Funds left with the investor 12,95,000
Thus the income of the investor remains the same and at the same time he is left with Rs.12,95,000 of funds without interest.
NPV, IRR, Payback
Simon Ltd. is considering two mutually exclusive projects. Investment outlay of both the projects is ₹5 lakh and each is
expected to have a life of 5 years. Under three possible situations their annual cash flows and probabilities are as under:
Situation Probabilities Project–A Project–B
cash flow ₹ cash flow ₹
Good 0.30 6 lakh 5 lakh
Normal 0.40 4 lakh 4 lakh
Worse 0.30 2 lakh 3 lakh
If the cost of capital is 7%, which project should be accepted? Consider the risk parameter also in decision making. Explain
with workings.
Project A: Calculation of annual cash flows: Probabilities Cash flow Tot Cash flow
Good 0.30 6,00,000 1,80,000
Normal 0.40 4,00,000 1,60,000
Worse 0.30 2,00,000 60,000
Total 4,00,000
Calculation of NPV of Project – A
PV of cash outflow 5,00,000
PV of cash inflow 4,00,000x4.1=16,40,000
Net present value 16,40,000-5,00,000=11,40,000
Project B: Calculation of annual cash flows: Probabilities Cash flow Tot Cash flow
Good 0.30 5,00,000 1,50,000
Normal 0.40 4,00,000 1,60,000
Worse 0.30 3,00,000 90,000
Total 4,00,000
In this case also NPV will be same.
We need to calculate COV Project A:
Annual cash flow (X) Probabilities Cash flow-X X-X (X-X)2xP
6,00,000 0.30 1,80,000 2,00,000 12,00,00,00,000
4,00,000 0.40 1,60,000 - 12,00,00,00,000
2,00,000 0.30 60,000 2,00,000 24,00,00,00,000
Standard deviation √(x-x)2xP=√24,00,00,00,000=1,54,919.33
COV (Standard deviation /X)100
(1,54,919.33/4,00,000)x100=0.3873 or 38.73%
We need to calculate COV Project B:
Annual cash flow (X) Probabilities Cash flow-X X-X (X-X)2xP
5,00,000 0.30 1,50,000 1,00,000 3,00,00,00,000
4,00,000 0.40 1,60,000 - 3,00,00,00,000
3,00,000 0.30 90,000 1,00,000 6,00,00,00,000
Standard deviation √(x-x)2xP=√6,00,00,00,000=77,459.70
COV (Standard deviation /X)100
(77,459.70/4,00,000)x100=0.19365 or 19.37%
Since COV of project A is more, it is more riskier than Project B. Project B should be accepted.
Santra Ltd. is planning to replace an old lathe machine with a new one. The production manager has shortlisted the 2
alternative types of lathe machines, and provided the following information:
Particulars Alternative I Alternative II
Name of supplier Apple Ltd. Grapes Ltd
Cost of machine ₹ 100 lakh ₹ 50 lakh
Resultant savings in cost
Year 1 ₹ 10 lakh ₹ 20 lakh
Economical life in years 4 4
You are required to suggest which lathe machine to be purchased, by using the discounted payback period method, and
considering the applicable discount rate of 10%.
Alternative I Cash outflow 100 Lakhs
Year Saving PV Factor Savings
1 10,00,000 0.909 9,09,000
2 35,00,000 0.826 28,91,000
3 25,00,000 0.751 18,77,500
4 40,00,000 0.683 27,32,000
84,09,500
In this case, NPV is negative, since saving is lower than cash outflow
Alternative II Cash outflow 100 Lakhs
Year Saving PV Factor Savings Cumulative savings
1 20,00,000 0.909 18,18,000 18,18,000
2 20,00,000 0.826 16,52,000 34,70,000
3 20,00,000 0.751 15,02,000 49,72,000
4 20,00,000 0.683 13,60,000 63,32,000
Cash out flow 50,00,000
Discounted payback period 3+(50,00,000-49,72,000)/13,60,000
3 years and 8 days

December 20 FTFM Practice

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

December 20 FTFM Practice

Uploaded by

Copyright:

Available Formats

Weighted Average Cost of Capital

What is the prediction about share price of these two entities?

Working Capital Management

Option II: Leasing: Calculation of cash outflows

You might also like