MANAGEMENT AND CORPORATE FINANCE (Final)

A unit of Realwaves (P) Ltd
MBA CLASSES
IInd Semester
Financial Management and
Corporate Finance
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Director
(1) Financial Management and Corporate Finance
UNIT-I
Introduction to Finance & Corporate Finance: Finance & its Scope Financial Decisions, Sources
of Finance, Time Value of Money, Profit Maximization vs. Wealth Maximization, Functions of
Finance Manager in Modern Age, Corporate Finance Introduction:– Nature and Scope. Concept of
Risk and Return.
UNIT-II
Investment Decision: Concept of Opportunity Cost, Cost of Debenture, Preference and Equity
Capital, Composite Cost of Capital, Cash Flows as Profit and Components of Cash Flows, Capital
Budgeting Decisions, Calculation of NPV and IRR, Excel Application in Analyzing Projects.
UNIT-III
Financial Decision: Capital Structure, Relevance and Irrelevancy Theory, Leverage Analysis –
Financial, Operating and Combined Leverage along with its Implications, EBIT EPS Analysis, Point
of Indifference.
UNIT-IV
Dividend Relevance: Factors Affecting Dividend Policy, Forms of Dividends, Types of Dividend
Policies, Dividend Models: Walter and Gordon Model, Miller- Modigliani(MM) Hypothesis.
UNIT-V
Indian Financial System: Role of Financial Institution, Primary and Secondary Market, Lease
Financing, Venture Capital, Mutual Funds. Introduction to Derivatives.
SR NAME OF CHAPTER PAGE
NO. NO.
1 Unit-I 1
Chapter 1: Financial Accounting
2 Unit-II
Chapter 2: Time Value of Money 8
3 Unit-III
Chapter 3: Capital Budgeting 23
4 Unit-IV
Chapter 4: Operating and Financial Leverage 30
5 Unit-IV
Chapter 5: Dividend Policy 41
6 Unit-IV
Chapter 6: Lease Financing 52
7 EXAM PAPER
A unit of Realwaves (P) Ltd Financial Management
CHAPTER 1 FINANCIAL MANAGEMENT
Finance is the lifeblood of business. It is an important for trade, industry and commerce as lubricant
for wheels and blood for arteries. Finance is required for establishing developing & operating the
business efficiently. The survival & growth of a firm is possible only, if it utilizes its funds in an
optimal manner. So, it so correct to say that without adequate finance no business can survive and
without efficient financial management no business can prosper and grow. Therefore, the, success of a
business depends on proper supply of finance and its efficient management.
MEANING
Finance is the study of money management. It not only includes the act of making the money
available, but also includes its administration and control, so that the finance may be utilized in a
proper way.
BUSINESS FINANCE
Business finance can be defined, as the activity concerned with planning, raising, controlling and
administering the funds used in the business. The area of business finance comprises operations of
business firms directed towards the procurement of capital funds and their investment in various types
of assets, business finance deals with the financial planning, acquisition of funds, use and allocation of
funds and financial control.
FINANCE FUNCTION
Finance function is the process of acquiring and utilizing funds by a business. Thus, the main Finance
function is the procurement of necessary funds for the business. But, there has been a gradual change
in the nature of Finance function. In the changing scenario of modern business management of LPG
(liberalization, privatization, globalization) the Finance function has much widened. Now along with
the procurement of funds, the effective utilization & control of funds obtained is also included in
finance function. Therefore, in order to understand finance function properly, it is essential to
understand the following two approaches of finance function:
 Traditional Approach
 Modern Approach
TRADITIONAL APPROACH OF FINANCE FUNCTION

The traditional approach of financial management has limited the role of the finance manager in the
initial stages. According to this approach, the main function of finance was confined to the
procurement of funds. “The finance function was viewed as the task of providing the funds needed by
the enterprise on the terms most favourable in the light of the objectives of the business. The main
feature of this approach is raising funds.
Raising Funds: The main function of finance was to procure and manage required funds from various
sources for achieving the predetermined objectives of the enterprise.
Branches:
(1) Vidhyadhar Nagar (2) Mansarovar (3) Lal Khothi 1.1
1
MODERN APPROACH OF FINANCE FUNCTION

Finance function means activities relating to planning, procurement, control and administration of
funds used in the business. The activities like: (i) determination of capital requirements of the firm (ii)
procurement of necessary funds so that optimal capital structure can be decided. (iii) Allocation of
funds among different assets. & (iv) financial control for the effective utilization of funds are covered
under the purview of modern approach. Function of finance is not only to procure funds but their
effective utilization too. This requires the financial manager to take three important decisions i.e
financing decision, investment decision & dividend decision. These three decisions of financial
management are inter related whose net result would be the optimum utilization of funds.
Financial Management
Financing Decisions Investment Decisions Dividend Decisions
Capital Structure Working Capital Capital Expenditure Current Assets or

Decisions Financing Decisions Working Capital
(Long-term sources) (Short-term sources) Management
Cost of Capital
FINANCIAL MANAGEMENT
Financial Management is the ways & means of managing money i.e. the determination,
acquisition, allocation & utilization of financial resources usually with the aim of achieving some
particular goals or objectives.
Financial Management is the planning; organizing, directing & controlling of the procurement
& utilization of funds and safe disposal of profit to the end that individual organizational & social
objectives are accomplished.
FINANCING DECISIONS
In financing decisions, a financial manager has to decide about the amount of capital required,
proportion of debt & equity capital (capital structure) & selection of the sources of funds. The amount
of capital required is ascertained by forecasting the investment in fixed, current & intangible assets.
Capital structure is determined by the proportion of debt & equity capital in the total capital invested.
The financial manager has to maintain the optimal capital structure or the best financing mix for the
company. The capital structure would be optimal when the return to the shareholders is maximized
and the risk is minimized.
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2
INVESTMENT DECISIONS
Investment decisions pertain to the allocation of funds raised with a view to acquire assets. These
assets are of two types i.e. fixed assets and current assets. Decisions regarding investment in fixed or
long-term assets are based on the costs & benefits or returns arising from these assets. These are called
capital budgeting decisions. Decisions regarding investment in current or short-term assets are taken
keeping in view the profitability and liquidity. Finance manager should workout a strategy to obtain a
trade off between liquidity and profitability. For this, he should adopt sound techniques of current
assets management.
DIVIDEND DECISIONS
Dividend decisions pertain to allocation of income and are very important function of financial
manager. The term ‘dividend’ refers to that part of profits of a company, which is distributed by it
among its shareholders. It is the reward to shareholders for investment made by them in the share
capital of the company. Hence, the financial manager has to decide about the portion of net profits that
should be retained in the business and the portion of net profits, which should be distributed to
shareholders in the form of cash dividend. The higher rate of dividend may raise the market price of
the shares & thus maximize the wealth of shareholders. Therefore, dividend policy should be such that
it has positive impact on the wealth of the shareholders.
GOALS OR OBJECTIVES OF FINANCIAL MANAGEMENT [YEAR 2011]

(i) Profit maximization
(ii) Wealth maximization
(i) Profit maximization: The basic objective of every business enterprise is the welfare of its owners.
It can be achieved by maximization of profits. Therefore, according to this criterion, the financial
decisions (investment, financing and dividends) of a firm should be oriented to the maximization of
profits i.e., select those assets, projects and decisions, which are profitable and reject those, which are
not profitable.
(a) Test of business performance: The profit earned by any business enterprise is the result of its
production, marketing & managerial efficiency. It is the ultimate test of business performance.
(b) Main source of inspiration: It is the profit, which inspires persons or group of persons to be more
efficient than others by hard labour & competition. If the attraction of profit is over, there will be no
place of competition, in such a situation, the speed of development and progress will be at stand still.
(c) Maximum social welfare: It ensures maximum social welfare by providing maximum dividend to
shareholders, timely payment to creditors, more wages & other benefits to workers, better quality
products at cheaper rate to customers, more employment to society and maximum return to the
owners.
(d) Basis of decision-making: All strategic & tactical decisions in a business are taken keeping in
view the profit-earning objective.
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3
(ii) Wealth maximization: The wealth maximization objective is consistent with the objective of
maximizing the wealth of the owners (shareholders) by increasing the value of the firm. The
value of the firm is represented by the market price of a company’s shares. It takes into account the
present and prospective future earnings per share, the timings and the risk of these earnings, the
dividend policy of the firm and many other factors. Therefore, for the purpose of maximization of
wealth, the basic objective of a company should be to maximize the market value of its shares, because
the value of the enterprise to the shareholders increases when there is an increase in the market price
of the shares.
So, to maximize the wealth to the shareholders or market value of shares, a firm must:
 Increase the market share (growth) by new products and process developments and by
improving the quality of the products.
 Manage customers properly.
 Enhance employee capabilities and information systems.
 Avoid high levels of risk, when projects with positive or maximum net present value are
accepted, the value of the firm is maximized.
 Strike a balance between debt & equity in financing.
 Maintain a satisfactory dividend policy consistently.
FUNCTIONS OF CHIEF FINANCIAL OFFICER [YEAR 2013]

Financial manager is the executive who manages the financial matters of the business, who frame the
plans & policies regarding financial matter.
The functions of financial manager are:
(i) Estimating the amount of capital required: Required capital for (a) purchase of fixed asset (b)
meeting working capital requirement (c) modernization & expansion of business. Financial manager
makes estimates of fund required for both short term & long term.
(ii) Determining capital structure: Once the requirement of capital funds has determined, a decision
regarding the kind & proportion of sources of funds has to be taken. For this, financial manager has to
determine the proper mix of equity & debts & short term & long-term debt ratio.
(iii) Choice of source of funds: The financial manager has to decide the source from which the fund
are to be raised like: (a) equity shareholder (b) preference shareholder (c) debenture holder (d) bank &
other financial institution.
(iv) Procurement of fund: The financial manager takes steps to procure the fund required for the
business. It might require issue of prospectus, negotiation with creditors & financial institution, banks.
Procurement of fund is depending not only upon cost of raising fund but on other factors like general
market condition.
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4
(v) Utilization of fund: Financial manager invest the fund in various assets so to maximize the return
on investment. Investment decisions, management should be guided by three important principle
safety, profitability & liquidity.
(vi) Disposal of profit or surplus: Financial manager should decide:

 How much to retain for ploughing back.
 How much to distribute as dividend to shareholders.
(vii) Management of cash: Management of cash is important task of financial manager. It involves
forecasting the cash inflows & outflow to ensure that there is neither shortage nor surplus of cash with
the firm. Management of working capita funds must be available for (i) purchase of raw material (ii)
payment of wages and day-to-day expenditure.
(viii) Financial control: Evaluation of financial performance is also an important function of financial
manager. Evaluation is done by ROI. Other technique of financial control is: Ratio analysis, break-
even analysis, budget control, cost control etc.
FINANCIAL PLANNING
“Financial planning is an important part of financial management. It is the process of determining the
objectives, policies, procedures, programmes & budget to deal with financial activities of an
enterprise”
Importance of financial Plan & Policy

 Provide sound administration of financial function.
 Financial planning ensures required funds for various sources for smooth conduct of business.
 Uncertainty about the availability of fund reduces.
 Financial plan attempts to achieve a balance between the inflow & outflow of fund. Adequate
liquidity ensured through out the year.
 Financial planning serves as the basis of financial control.
Year 2013
"Sound Financial Management is a key to progress for corporations." Explain and also discuss the
importance of Financial Management.
Ans: Yes, sound financial management is a key to progress for corporations.
'Financial' means procuring sources of money supply and allocation of these sources on the basis of
forecasting monetary requirements of the business. The word 'Management' refers to planning,
organization, co-ordination and control of human activities and physical resources for achieving the
objectives of an enterprise.
Branches:
5
Thus, financial management is that part of business management which is concerned with the planning
and controlling of firm's financial resources.
Financial management refers to the management of finance. It is the effective & efficient utilization of
financial resources. It means creating a balance among financial planning, procurement of funds,;
profit administration & sources of funds.
Financial management helps the corporations by the following functions:
1) Investment Decision: The investment decision relates to the selection of assets in which funds will
be invested by a firm.
The mutual ratio between fixed and current assets affects the quantum of risk of firm. This risk affects
the cost of different sources of finance. Thus, investment decisions are mainly used in:
i) Capital Budgeting Decisions: Capital budgeting decisions are quite significant for firms because
they are concerned with such assets or projects which result in profits to the business over a long
period. Under these decisions, financial manager has to decide as to which of the different available
alternatives the best to invest in. For this purpose, expected profit accruing from that asset is evaluated
by using different techniques.
ii) Working Capital Decisions: Efficient management of working capital is also quite important for
the business because it affects profitability and liquidity of the firm. For the efficient management of
working capital, financial manager must maintain adequate balance in liquidity and profitability.
iii) Financing Decision: The second major decision involved in financial management is the financing
decision. The investment decision is broadly concerned with the asset-mix or the composition of the
assets of a firm. The concern of the financing decision is with the financing-mix or capital structure or
leverage The term capital structure refers to the proportion of debts(fixed interest sources of financing)
and equity capital (variable-dividend securities/sources of fund)The financing decision of a firm
relates to Choice of the a, proportion of these sources to finance the Investment requirements.
iv) Dividend Policy Decision: The third major decision of financial management is the decision
related dividend policy. The dividend decision should be analyzed in relation to dividend decision.
Two alternatives are available in dealing with profits of a firm: they can be distribute to the
shareholders in the firm of dividends or retained in the business which course should be followed-
dividend or retention.
v) Liquidity Decision: Liquidity decision is concerned with the management of current assets.
Basically this is Working Capital Management; Working capital Management is concerned with the
management of current assets. It is concerned with short-term survival. Short term-survival is a
prerequisite for long-term survival.
Importance of Financial Management
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6
1) Financial Planning and Control: Finance is a base for all the business activities. Business
activities should be not only harmonized but also planning determination and implementation offer
analysis of finance. All activity revolves around the finance. So finance planning and control are
important function.
2) Essence of Managerial Decision: Financial management provides a sound base to all managerial
decision management is the focal point in the process of decision making such as production, sale
Employees, Research and Development decisions are based on financial management.
3) Financial Management is a Scientific & Analysis: In the process of decision making and financial
analysis .modern mathematical techniques are used. It requires not only a feeling for the situation & an
analytical skill, but also a through knowledge of the technique and tools of financial analysis & the
knowledge to apt interpret the results.
4) Continuous Administration Function: In older times financial management was used periodically
and its importance was limited to the procurement of funds but in modern times finance is a
continuous administrative function. Its relation is with the procurement of capital, sources of funds,
capital budgeting decisions etc.
5) Centralized Nature: All business activities are centrally administered & control. All financial
decisions in business are taken at a central point. Functional areas such as marketing & production are
decentralized in the modern industrial concern, but financial co-ordination and control are achieved
through centralization.
6) Basis of a Managerial Process: Financial management is the basis of whole management process,
such as planning, co-ordination and control. According to sound financial planning all other plans are
executed & controlled.
7) Measure of Performance: Financial management deals with risk & uncertainty factors which are
directly hit by profitability & risk. Thus, financial management is needed for maintaining proper
balance in risk & uncertainty.
*****
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A unit of Realwaves (P) Ltd Time Value Of Money
CHAPTER 2 TIME VALUE OF MONEY
Q Explain the relevance of time value of money in financial decisions.

Answer:
Time value of money means that worth of a rupee received today is different from the worth of a rupee
to be received tomorrow or in future. The preference of money now, as compared to future money is
known as time preference for money.
A rupee today is more valuable than a rupee after a year due to several reasons like:-
1. Risk: There is uncertainty about the receipt of money in future
2. Inflation: In an inflationary period, a rupee today represents a greater real purchasing power than a
rupee a year later.
3. Preference for present consumption: Most of the persons & companies in general prefer current
consumption to future consumption.
4. Investment opportunities: Many person, and the companies have a preference for present money
as there are many opportunities of investment available for earing additional cash flow.
5. Capital Budgeting: While arriving at capital budgeting decisions time value of money is one of
utmost important option. In this type of decision money is invested today but return is realized over a
long period of time. Hence to arrive at a correct decision we need to consider time value of money.
FUTURE VALUE AND COMPOUNDING

Compounding is the mathematical process of calculating a future value of a payment or series of
payments. Compounding is used to find the future values (FV) of all the cash flows at the end of the
time horizon at a particular rate of interest.
Future value of a single cash flow

The future value of a single cash flow compounded annually can be calculated with the help of the
following equation:
FVn = PV (1 + r) n
Where, FVn = future value of the initial cash flow at the end of n years
PV = initial cash flow
r = annual rate of interest
n = number of years or life of investment
Illustration: 1
Mr. A invests ` 10000 in fixed deposit carrying interest @10% p.a compounding annually. You are
required to find the amount to be received by Mr. A after 5 years.
Ans: ` 16105
Illustration: 2
Mr. X makes a fixed deposit of ` 5000 in a bank which pays 8% interest compounded annually for 6
years. Find the amount to be received by Mr. X after 6 years.
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8
Ans: ` 7935
INTRA YEAR COMPOUNDING

Half- yearly, quarterly, monthly, daily, and even continuously.
mxn
FVn = PV 1 + r
m
Where, FVn = future value of the initial cash flow after ‘n’ years
r = nominal interest rate per annum
m = number of times compounding is done during a year
n = number of years for which compounding is done
Illustration: 3
Mr. A invests ` 10000 in a two year time deposit scheme of a bank which yields interest @ 6%. You
are required to find the amount receivable by Mr. A if the interest is compounded (a) half yearly, or (b)
quarterly.
Ans: (a) ` 11255 (b) ` 11265
Illustration: 4
Ascertain the compound value and compound interest of an amount of ` 75,000 at 8 percent
compounded semiannually for 5 years
Ans: Amount = 111015, CI = 36015
Illustration: 5
X is invested ` 2,40,000 at annual rate of interest of 10 percent. What is the amount after 3 years if the
compounding is done?
(i) Annually Ans: 319440
(ii) Semi-annually. Ans: 321600
FUTURE VALUE OF MULTIPLE CASH FLOWS AND DIFFERENT CASH FLOW

In many situations, it is required to find the future value of multiple cash flows or a series of payments
made at different time periods.
It finds out the future value of each of these cash flows using the appropriate future value interest
factor (FVIF).
Illustration: 6
Mr. Y invests ` 10000 today (beginning of year 1), ` 20000 at the beginning of year 2 and amount `
20000 at the beginning of year 3. How much amount will be received at the end of year 3 if the rate of
interest on such investment is 12% per annum?
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9
Ans:
Year Investment FVIF @ 12% Amount
1 10000 (1 + .12) 3 = 1.405 14050
2 20000 (1 + .12) 2 = 1.254 25080
3 20000 (1 + .12) 1 = 1.12 22400
61530
Illustration: 7
Mr. A deposits each year ` 500, ` 1000, ` 1500, ` 2000 and ` 2500 in his bank account for 5 years.
The interest rate is 5 percent. Find out the future value of his deposits at the end of the 5th year if the
amount is deposited.
(i) At the beginning of each year
(ii) At the end of each year.
Ans:
(i) Calculation of future values
Beginning of Amount Number of years Compounded Future value (`)

the year deposited ` compounded interest factor
1 2 3 4 5(2 x 4)
1 500 5 1.276 638
2 1000 4 1.216 1216
3 1500 3 1.158 1737
4 2000 2 1.103 2206
5 2500 1 1.050 2625
FV = ` 8422
(ii) Calculation of future values
End of the Amount Number of years Compounded Future value (`)

year deposited ` compounded interest factor
1 2 3 4 5(2 x 4)
1 500 4 1.216 608.00
2 1000 3 1.158 1158.00
3 1500 2 1.103 1654.50
4 2000 1 1.050 2100.00
5 2500 0 1.000 2500.00
FV = ` 8020.50
FUTURE VALUE OF AN ANNUITY

An annuity is a stream of equal annual cash flows.
The future value of an ordinary annuity for a period of n years at a rate of interest ‘r’ is given by the
following formula:
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FVAn = A (1 + r)n-1
r
Where, FVAn = Accumulation at the end of ‘n’ years

A = Amount deposited/invested at the end of every year for n years
r = Rate of interest (expressed in decimals)
n = Time horizon
Illustration: 8
Mr. A deposits ` 5000 at the end of every year for 5 years in his saving bank account. The interest rate
is 5% compounded annually. You are required to determine the accumulation in his account at the end
of 5th year.
Solution:
Calculation of annuity accumulation
End of the Amount Number of years Compounded Annuity
year deposited ` compounded interest factor accumulation
(`)
1 2 3 4 5(2 x 4)
1 5000 4 1.216 6080
2 5000 3 1.158 5790
3 5000 2 1.103 5515
4 5000 1 1.050 5250
5 5000 0 1.000 5000
27635
The above illustration can also be solved with the help of future value annuity equation as follows:
FVAn = A (1 + r)n-1
r
Now, A = ` 5000, r = 5% and n = 5

FVA 5 = ` 5000 (1 + 0.05)5-1
0.05
The expression (1 + r)n-1 is known as FVIFA.
r
FVA 5 = ` 5000 (FVIFA 5%, 5 years)

FVA 5 = ` 5000 x 5.526 = ` 27630
Illustration: 9
Mr. A decided to deposit ` 50000 per year in his provided fund (PPF) account for 14 years. What will
be the accumulated amount in his PPF account at the end of 14 years if the rate of interest is 9 percent?
Solution:
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11
The accumulated sum at the end of 14 years will be:

= ` 50000 (FVIFA 9%, 14 years)
= ` 50000 (1 + 0.09)14-1
0.09
= ` 50000 [26.019]
= ` 1300950
Illustration: 10
Mr. John is working with an MNC in Mumbai. He plans to purchase a flat in Mumbai after 5 years
when it is expected to cost him ` 25 lakh. How much should he save annually if his savings a
compound return of 12 percent?
Solution:
The future value interest factor for a 5 year annuity, given an interest rate of 12% is:
(FVIFA 12%, 5 years) = (1 + 0.12)5-1

0.12
The annual savings of Mr. John should be:
= ` 2500000
6.353
= ` 393515
Illustration: 11
A person is required to pay four equal annual payments of ` 4,000 each in his Deposit account that
pays 10 per cent interest per year. Find out the future value of annuity at the end of 4 years
Solution:
FVA = A = (1 + i)4-1
i
= ` 4000 = (1 + 0.10)4-1
0.10
= ` 4000 x 4.641
= ` 18564
Illustration: 12
A company offers a fixed deposit scheme whereby ` 10,000 matures to ` 12625 after 2 years, on a
half-yearly compounding basis. If the company wishes to amend the scheme by compounding interest
every quarter, what will be the revised maturity value?
Solution:
Computation of rate of interest and revised maturity value:
Principal = ` 10000
Amount = ` 12625
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12
10000 = 12625
(1 + i)4
Pn = A x PVF n, 1
10000 = 12625 (PVF 4, i)
0.7921 = (PVF 4, i)
According to the table on present value factor (PVF 4, i) of a lump sum of ` 1, a PVF of 0.7921 for half
year at interest (I) = 6%. Therefore, the annual interest rate is 2 x 0.06 = 12%
I = 6% for half year
I = 12% for full year
Therefore, rate of interest = 12% p.a
Revised maturity value = 10000 1 + 12 x 1 2 x 4
100 4
= 10000 1 + 3 8
100
= 10000 (1.03) 8
=10000 x 1.267 (considering (CVF8, 3) = 1.267)
Revised maturity value = 12670
PRESENT VALUE AND DISCOUNTING OF A SINGLE CASH FLOW

Discounting is the process exactly opposite to that of compounding.
Illustration: 13
Mr. A is given an opportunity to receive ` 100000 after two years, when he can earn interest of 10%
per annum on his investment. What is the amount which Mr. A should invest today so that he may be
able to receive ` 100000 after two years?
Solution:
PV = FV x PVIF r, n
PV = 100000 x PVIF 10%, 2years
PV = 100000 x .82644 = 82644.62
Illustration: 14
Find out the present value of ` 10000 received after 10years hence, if the discount rate is 8%.
Solution:
PV = FV x PVIF r, n
PV = 100000 x PVIF 8%, 10years
PV = 100000 x .463 = 4630
Illustration: 15
What is the present value of ` 1000 receivable after 6 years if the rate of discount is 10% per annum?
Ans: 565
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INTRA YEAR DISCOUNTING
Illustration: 16
Mr. A will receive ` 100000 on maturity of his investment at the end of four years. Find out the
present value of his investment if the discount rate is 12% and discounting is done (a) half yearly or
(b) quarterly.
Solution:
PV= FV x PVIF r/m, m x n
(a)When discounting is made half yearly
Now, FV = ` 100000, r = 12%, m = 2 and n = 4
PV = ` 100000 x PVIF 6%, 8
= ` 100000 x 0.627
= ` 62700
(b)When discounting is made quarterly

Now, FV = ` 100000, r = 12%, m = 4 and n = 4
PV = ` 100000 x PVIF 3%, 16
= ` 100000 x 0.623
= ` 62300
PRESENT VALUE OF MULTIPLE CASH FLOWS
Illustration: 17
Calculate the present value of the following cash flow stream if the discount rate is 14%?
Year 0 1 2 3 4 5
Cash flow (`) 5000 6000 8000 9000 8000 7000
Solution: Calculation of present value
Year Cash flow (`) PVIF 14%, n Present value
(`)
0 5000 1.000 5000
1 6000 0.877 5262
2 8000 0.769 6152
3 9000 0.675 6075
4 8000 0.592 4736
5 7000 0.519 3633
PV = ` 30858
Illustration: 18
ABC & Co. has an investment opportunity costing ` 40000 with the following expected net cash
flows:
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Year Net Cash flow (`)

1 7000
2 7000
3 7000
4 7000
5 7000
6 8000
7 10000
8 15000
9 10000
10 4000
Determine the present value assuming the rate of discount of (a) 10% and (b) 15%.
Ans: (a) 48961 (b) 39420
PRESENT VALUE OF AN ANNUITY
Leasing Loan Installment
Illustration: 19
Mr. Rohit has taken a housing loan of ` 500000 from the HDFC which is repayable in five equal
annual installments. If the loan carries a rate of interest of 12%, calculate the amount of each
installment.
Solution:
In the given case, if A is defined as the equated annual installment, we have given that
A x PVIFA 12%, 5 = ` 500000

A = ` 500000
PVIFA 12%, 5
= ` 500000 = ` 138696.26
3.605
Illustration: 20
Mr. Amit kumar is working as a finance manager in a company. He is about to retire at the age of 60.
The company offers him two post –retirement options:
(a) A lump sum payment of ` 2000000 at the time of retirement
(b) An annual payment of ` 250000 at the end of each years for 10 years.
Assuming the rate of interest of 10%, you are required to suggest a better option?
Solution:
The present value of annual payment of ` 250000 for 10 years is as under:
PVA n = A x PVIFA r, n
Now, A = ` 250000, r = 10%, n = 10
Branches:
15
PVA 10 = ` 250000 x PVIFA 10%, 10

= 250000 x 6.145 = ` 1536250
Since the lump sum payment of ` 2000000 is worth more now than the present value of annual
payment of ` 250000 for 10 years (` 1536250), Mr. Amit kumar should opt the first option
Illustration: 21
Mr. Philip has taken a 20 months car loan of ` 500000 from a finance company. The rate of interest
charged is 12% p.a. what will be the amount of monthly loan amortization?
Solution:
In this case, the rate of interest on loan amount is 12% p.a
Monthly interest = 12 percent = 1 %
12 months
PVA n = A x PVIFA r, n
A = PVA n
PVIFA r, n
= ` 500000
PVIFA 1, 20
= ` 500000
18.046
= ` 27707
Therefore, the amount of monthly loan amortization is ` 27707
Illustration: 22
Mr. X received a lump sum payment of ` 1000000 on his retirement. He deposits this amount in a
bank account which pays 10% interest. How much can Mr. X withdraw annually for a period of 15
years?
Solution:
The annual withdrawal of Mr. x will be:
= ` 1000000
PVIFA 10, 15
= ` 1000000
7.606
= ` 131475.15
*****
Branches:
16
A unit of Realwaves (P) Ltd Capital Budgeting
CHAPTER 3 CAPITAL BUDGETING
Capital budgeting is not the budgeting for raising capital from different sources of finance, but it is an
investment decision. Therefore, capital budgeting is a process relating to the long term investment of
capital funds in which future profitability of capital investment proposal is studied, comparison of
earnings with costs in relation to cost of capital is made & finally a decision is taken whether to invest
or not.
Thus, capital budgeting refers to the total process of generating, evaluating, selecting &
following up of capital expenditure alternatives.
OBJECTIVES OF CAPITAL BUDGETING

(i) Wealth maximization of shareholders: The basic objective of financial management is to
maximize the wealth of the shareholders. Therefore, the objective of capital budgeting is to select
those long-term investment projects, which are expected to make maximum contribution to the wealth
of shareholders in the long run.
(ii) Evaluation of proposal capital expenditures: With the help of capital budget, evaluation of
capital expenditures to be incurred on various assets by the firm during the budget period can be made.
This enables the top management to measure the viability of each expenditure.
(iii) Determination of priority: It means arranging various projects in order of their profitability. In
capital budgeting, the priority among various capital projects is determined so that management is able
to select most profitable project.
(iv) Analysis of past decisions: Expenditures incurred on various projects in the past are analyzed in
capital budgeting. This enables the management to known the extent to which these decisions were
correct and future policies.
PAY BACK PERIOD METHOD

This pay back period is the length of time required to recover the initial cost of the project.
(i) When annual cash inflows are equal
Pay back period = Initial Investments or I

Net annual cash inflows C
Illustration: 1
Andman ltd is considering whether to purchase some special machines. Management does not wish to
buy the machines unless their cost can be recovered in three years. The following information’s are
available:
Branches:
17
(i) Cost of the machines ` 300000

(ii) Sales revenue generated by the new machines is ` 400000
(iii) Variable cost is 60% of sales
(iv) Annual fixed costs other than depreciation are ` 15000
(v) Life of the machines is 8 years & tax rate is 50%.
Based on the criterion of three years recovery period, should the special machines are
purchased? Support your answer with a computation of pay back period required for the investment of
` 300000 to be recovered.
Ans: 3.3 years.
(ii) When annual cash inflows are unequal
Illustration: 2
A ltd company is considering investing in a project requiring a capital outlay of ` 100000. Forecasts of
annual income after depreciation but before tax is as follows:
Year 1 2 3 4 5
Amount (`) 50000 50000 40000 40000 20000
Depreciation may be taken at 20% on original cost & income tax at 50% of net income. Evaluate the
project using pay back method.
Ans: 2 ¼ years i.e 2 years 3 months.
Illustration: 3
India sweets is considering the purchase of a machine. Two machines are available in the market. A &
B, each costing ` 100000. Earnings after tax but before depreciation are expected to be as follows:
Year 1 2 3 4 5
Cash inflows: ` ` ` ` `
Machine A 25000 37500 50000 25000 12500
Machine B 12500 37500 50000 37500 25000
Evaluate the two alternatives according to pay back method.
Ans: Machine A =2 3/4 years, Machine B = 3 years.
IMPROVEMENTS IN PAY BACK PERIOD
(i) POST PAY BACK PROFITABILITY
Post pay back profitability = Total cash inflows in life + Scrap value – Initial investment.
Illustration: 4
For each of the following projects compute. (i) Pay back period (ii) Post pay back profitability
Initial outlay 100000

Annual cash inflows 20000
(After tax but before depreciation)
Branches:
18
Estimated life 8 years

Ans: (i) 5 years (ii) ` 60000
Illustration: 5
Rajendra ltd is considering the purchase of a new machine which will carry out some operations
performed by labour. A & B alternative models. From the following information you are required to
prepare a profitability statement & which will you recommend on the basis of (i) Pay back period (ii)
Post pay back profitability
Particulars Machine A Machine B

Estimated life of machine (years) 5 6
Cost of machine ` 150000 ` 250000
Addition of indirect materials 6000 8000
Estimated savings in scrap 10000 15000
Additional cost of maintenance 19000 27000
Estimated savings in direct wages:

Employees not required (number) 150 200
Wages per employee 600 600
Taxation is to be regarded as 50% of profits. Ignore depreciation for calculation of tax.
Ans: (i) Machine A = 4 years, Machine B = 5 years (ii) Machine A = 37500, Machine B = 50000
(ii) PAY BACK RECIPROCALS
Pay back reciprocals = 1 x 100

Pay back period
Now, the formula for average rate of return may be written as:
ARR =Average annual income after tax & depreciation x 100

½ (Initial investment + Salvage value)
Illustration: 6
ABC ltd is considering investing in a project that costs ` 500000. The estimated salvage value is zero;
tax rate is 35%. The company uses straight-line depreciation for tax purposes & the proposed project
has cash flows before tax (CFBT) as follows:
Year 1 2 3 4 5
CFBT (`) 100000 100000 150000 150000 250000
Determine the following (i) pay back period (ii) average rate of return.
Ans: (i) 4.18 years (ii) 13%.
Illustration: 7
XYZ Co is considering the purchase of one of the following machines; whose relevant data are as
given below:
Branches:
19
Particulars Machine X Machine Y

Estimated life 3 years 3 years
Capital cost ` 90000 ` 90000
Earnings (after tax):

Year 1 40000 20000
Year 2 50000 70000
Year 3 40000 50000
The company follows the straight-line method of depreciation; the estimated salvage value of both
types of machines is zero. Show the most profitable investment based on: (i) pay back period (ii)
average rate of return.
Ans: (i) Machine X = 1.25 yrs, Machine Y = 1.4 yrs (ii) Machine X = 96.3%, Machine Y = 103.7%.
(iii) NET PRESENT VALUE METHOD

NPV of an investment proposal may be defined as “ the sum of present value of all the cash inflows
less the sum of present values of all cash outflow associated with a proposal”
NPV = Total present value of cash inflow – Initial investment
PROFITABILITY INDEX
Profitability index is the relationship between present value of cash inflows and present value of cash
outflows. It can be calculated by using the following formula:
Profitability index = Present value of cash inflows

Present value of cash outflows
Project can be ranked on the basis of profitability index. The project is said to be viable is equal or
greater than 1
Decision criterion: Under the PI technique, the decision rule is “ Accept the proposal if PI is more
than 1 and reject the proposal if PI is less than 1”. However, if Pi is equal to 1 then the firm may be
indifferent because the present value of cash inflows is expected to be just equal to the present value of
the cash outflows.
Illustration: 8
If discount rate is 10%; find the present value of ` 1.00 received at the end of first, second and third
year.
Year 2010
Illustration: 9
A co. has two-investment proposal. The management uses net present value (NPV) method to evaluate
new investment proposals. Advice co. which proposal should be taken up by it. Depreciation is
charged at straight-line method. The cash flow before tax is given below:
Branches:
20
Year Proposal A Proposal B

1 19000 19000
2 19000 23000
3 19000 25000
4 19000 19000
Discount rate 10% 10%

Cost of project 23000 25000
Life of project 4 yr 4 yr
Salvage value 3000 5000
Tax rate 50% 50%
Ans: Proposal (A) (NPV) = 40077 – 23000 = 17077

Proposal (B) (NPV) = 45348 – 25000 = 20348
Illustration: 10
No project is acceptable unless yield is 10%. Cash inflows of a certain project along with cash
outflows are given below:
Year Cash outflow (`) Cash inflow (`)
0 150000 -
1 30000 20000
2 30000
3 60000
4 80000
5 30000
The salvage value at the end of 5th year is ` 40000.
Calculate the net present value of the project.
Year 1 2 3 4 5
Discount factor (10%) 0.909 0.826 0.751 0.683 0.621
Ans: Total value of cash outflow = 177270, Total value of cash inflow = 186130, NPV = ` 8860
(iv) INTERNAL RATE OF RETURN

This method is based on the time adjusted rate of return is internal rate of return method. It is an
important technique of evaluation of capital budgeting proposals. The IRR is defined as “ The discount
rate which gives a zero NPV” i.e. the IRR is the discount rate which will equate the present value of
cash inflows with the present value of cash outflows.
IRR = LDR + PVA – I x (HDR – LDR)

PVA – PVB
LDR = Lower discount rate
Branches:
21
HDR = Higher discount rate

PVA = PV cash inflow at LDR
PVB = PV cash inflow at HDR
I = Initial investment
PV Factor = Initial investment (Equal cash inflow)

Annual cash inflow
PV Factor = Initial investment (unequal cash inflow)
Average cash inflow
Illustration: 11
Project X and project Y costs ` 50000 and ` 25000 respectively. Their cash flows are given below.
You are required to find out the internal rate of return for each project and decide on that basis which
project is more profitable.
Year Cash inflows
Project X (`) Project Y (`)
1 5000 10000
2 15000 10000
3 30000 10000
4 20000 10000
5 10000
Ans: PV for project X = 3.125, PV for project Y = 2.5, IRR for project X = 16.39%, IRR for project Y
= 21.87%
Year 2013
Illustration: 12
Bajaj Auto Parts Ltd. is screening projects for capital expenditures. They have only Rs 1,00,000 for
investment. The following proposals have been submitted:
Project Investment (Rs) Annual Cashflow (Rs) Economic Life in Years
A 31,300 6,000 10
B 97,400 20,000 20
C 98,075 25,000 10
D 27,200 4,000 15
If cost of Capital is 20% and scrap Value of project is zero, Please recommend projects according to:
i) Payback Period Method Ans 5.21, 4.87, 3.92, 6.8 years.
ii) Rate of Return Method Ans: 18.33%, 31.06%, 30.98%, 16.07%
iii) Present Value Index Method Ans: (6148), 0, 6725, (8500)
(Given: PV Factor at 20% for 10, 15, and 20 years are 4.192, 4.675 and 4.870 respectively.)
Year 2012
Branches:
22
Illustration: 13
A firm in the business of manufacture of automobile components is considering two manually
exclusive technologies for manufacture of hydraulic brakes. Those two technologies are designated as
option A and B with project costs of Rs 1,600 lac and Rs 1,850 lac. Depending upon various features
of the product obtained from the two technologies the firm has developed a forecast of cashflows for 5
years, i.e., the life of each project. These cashflows are as below:
Year Option A Option B
1 350.00 675.00
2 475.00 575.00
3 625.00 725.00
4 575.00 350.00
5 350.00 400.00
Option A is a familiar technology and therefore the firm feels that the current cost of capital of 13% is
the appropriate discount rate. However, option B is considered riskier than the option A and therefore
firm would like to use a discount rate 15% somewhat higher that the current cost of capital. Find out
the following:
i) NPVs of the options A and B. Ans: NPV(A) 57.08 (B) 47.44
ii) IRR of the option A and B. Ans: IRR (A) 14.43% (B) 16.21%
iii) Which option would you consider with NPV rule and IRR rule?
Ans: A will prefer
Year 2011
Illustration: 14
A company is considering purchase of machinery which costs Rs 8,00,000 and which has an estimated
life of 10 years. This machine will generate additional sales of Rs 4,00,000 per year while increased
costs and maintenance will be Rs 1,00,000 per year. The cost of the machine is depreciated on a
straight line and has no salvage value at the end of its 10 years life. The company has a cost of capital
of 12 per cent and a corporate tax rate of 40 per cent.
You are required to calculate:
a) Annual Cash flow Ans: 212000
b) The Net Present Value Ans: 397800
c) Profitability Index Ans: 1.49
d) The Payback Period Ans: 3.77 years
e) Internal rate of Return Ans: 23%
Should the company purchase the new machine?
Ans: The investment is feasible under all the criteria of investment appraisal. So the company should
definitely purchase the machinery.
*****
Branches:
23
Capital Budgeting l: Principles and Techniques L0.35
PRACTICAL PROBLEMS
P.10.1 A company rs" considering an investment proposal to instal new milling
I
controls at a cost of Rs.50,000. The facility has a life expectancy of 5 years and
no salvage value. The tax rate is 35 per cent. Assume the firm uses straight line 1 Rs 10,000
I
depreciation and the same is allolt ed for tax purposes. The estimared cash flows 2 10,692
before depreciation and tax (CFBT) from the investment proposal are as follows: 3 12,769
I
Compute the following: 4 13,462
(i) Pay back period, 5 20,395
(ii) Average rate of return,
(iii) Internal rate of return,
I
(iv) Net present value at 10 per cent discount rate,

(v) Profitability index at 10 per cent discount rate.
I
Solution
Determination of cashflows after taxes (CFAT)
,,,:l:,:,rIilr. r:.:r:X'.,.,.,.l.,I.r.:.:Iu:.:i:.:.l,.;.:..:.',,:.;.:l:,i.tl.t:i:t,.,'..r.r...'',r.
.fiiGufi :2 :l,:::*::.i:::6df,l#ilii.:liiiii,i:iliiii:i,iil:i:
1 Rs 10,000 Rs 10,000 Nit Nit Nit Rs 10,000

2 10,692 10,000 Rs 692 Rs 242 Rs 45O 10,450
3 12,769 10,000 2,769 969 1,900 1 1,900
4 13,462 10,000 3,462 1,212 2,250 12,250
5 20,395 10,000 10,385 3,635 6,750 16,750
11,250 61,250
(i)
1 Rs 10,000 Rs 10,000
2 10,450 20,450
3 11,900 32,250
4 12,250 44,500
5 16,750 61,250
The recovery of the investment falls between the fourth and fifth years. Therefore, the PB is 4 years plus a fraction of the
fifth year. The fractional value = Rs 5,500 + Rs 15,750 = 0.328. Thus, rhe PB is 4.J28 years.
Average income Rs 2, 250 (Rs 1 1, 250 - 5)
(ii) Ave rage rate of return (ARR) = x 100 = x 100 - 9 per cent
Average investment Rs 25,000 (Rs 50,000 + 2)
Rs 10,000 Rs Rs 10,450 Rs 11,800 12,250 Rs 16,750

(iii) Intemal rate of retum (IRR) Rs 50,000 = (1,+r)1+ (1,+r)2f --------1- f +
(1,+rf ---1-g+rt' e+rf
The fake pay back period = 4.0816 (Rs 50,000/Rs 12,250. From Table a-4, the value closest to the fake pay back period
- years is slightly below the
of 4.A81,5 against 5 years is 4.100 against 7 per cent. Since the actual cash flow stream is the initial
average cash flow stream, the IRR is likely to be lower than 7 per cent. Let us try with 6 per cent.
1 Rs 10,000 0.943 0.935 Rs 9,430 Rs 9,350

2 10,450 0.890 0.873 9,300 9,123
3 11 ,900 0.840 0.816 9,912 9,629
4 12,250 0.792 0.763 9,702 9,347
5 16,750 o.747 0.713 12,512 11 ,942
Total PV 50,956 49.391
Less; lnitial outlay. 50,000 50,000
NPV 856 (6oe)-
The IRR is between 5 and 7 per cent. By interpolation, IRR = 5.5 per cent.
5.B
24
10.36 Financial Management
(iv) Net present value (NPV)
1 Rs 10,000 0.909 Rs 9,090

2 10,450 0.826 8,632
3 11,800 0.751 8,862
4 12,250 0.683 8,367
5 16,750 0.621 10,401
Total PV 45,352
Less: lnitial outlay 50,000
NPV (4S48)
PV of cash inflows Rs 45'352

(v) Profitabiliry index (PI) = = 0.907
PV of casir outflows Rs 50,000
P.L0.2 A project costing Rs 5,60,000 is expected to produce annual net cash benefits (CFAT) of Rs 80,000 over a period of 15
years. Estimate the internal rate of return (IRR). Also, find the pay back'period and obtain the IRR from it. How do you compare
.this IRR with the one directly estimated'/
solution ps ,r^lr" = 115'6i'ooo = 7.ooo

Rs 80,000
The factors closet to 7.000 are 7.197 at 11 per cent rate of discount and 6.811 at 1,2 per cent rate of discount against 15 years
(Table A-4). The actual IRR would be between 11 and 12 per cent.
Using interpolation, the IRR would be 0.11 + 0.005 (0.19 + 0.38) = 11.5 per cent.
IRR d€terminatlon through PB pertod The reciprocal of the PB period is a good approximation of the IRR if, (i) the life of
the proiect is at least twice the PB period, and (ii) the project generates annuity cash inflows. Accordingly, IRR would be the
reciprocal of the PB period, i.e. 1i7 = 0.1'428 = 14.28 per cent.
Comparison The two IRRs are different. But the IRR which is directly estimated is correct as at this rate of discount, NPV of
cash flow stream of the proiect would be zero. The NPV cannot be zero at 14.28 per cent. The IRR through the PR period is
only an approximate measure.
- .p.10.3 Band-Box is considering the purchase of a new wash and dry equipment in order to expand its operations. Two types
'- ,rf options arc available: a low-speed system (LSS) with a Fs 20,000 initial cos! and a high speed system (HSS) with an initial
cost of Rs 30,000. Each system has a fifteen year life and no salvage value. The net cash flows after taxes (CFAT) associated
with each investment proposal are:
ffi ,..
s A$*l.,.*$ l.lffi$Si.:..t.r .l.....l,....'l......lffi
fi
iii..i,ffi
5B#1.,...*$sffi
.......f
r'*SSJ
CFAT for years 1 through 15 Rs 4,000 Fls 6,000
\flhich speed system should be chosen by Band-Box, assuming 14 per cent cost of capital?
Solution
1-15 Rs 4,000 Rs 6,000 6.142 Rs 24,568 Rs 36,852

Less; lnitial cost 20,000 30,000
NPV 4,569 6,852
Thg high speed system should be chosen by Band-Box as its NPV is greater'
y.tp/4 ty1od. Enterprises Ltd is considering the purchase of a new computer systgm for its research and development
did[6ior,, which would cosr Rs 35 lakh. The operation and maintenance costs (excluding depreciation) aie expected to be Ps 7
lakh per annum. It is estimated that the useful life of the system would be 6 years, at the end of which the disposal value is
expected to be Rs 1 [akh.
The tangible benefis expected from the system in the form of reduction in design and draftmanship costs would be Rs 12
lakh per annum. Ttie disposal of used drawing office equipment and fumiture initiallv is anticipated to net Rs 9 lakh.
As capital expenditure in research and development, the proposal would attlact a 100 per cent write-off for tax purposes.
The gains arising from disposal of used assets may be considered tax free. The effective tax tate is 35 per cent. The average
cost of capital of the company is 12 per cent
5"1
25
l
I
value.
Capital Budgeting l: Principles and Techniques L0.37
After appropriate analysis of cash flows, advise the company of the financial viability of the proposal. Ignore tax on salvage
Solution
Assessment of financial viability of proposal (Amount in lakh of rupees)
I
lncremental cash outflows

Cost of new computer system 35
I
Less; Sale proceeds from drawing office equipment and furniture I
26
lncremental CFAT and NPV:
(a) Cost savings (years 1-6)
: Reduction in design and draftmanship costs 12
Less; Operation and maintenance costs 7
Cost savings (earnings) before taxes 5
Less: Taxes (0.35) 1.75
Earnings after taxes (CFAT) lj
(x) PV factor of annuity for 6 years (0.12) x 4.111
Total PV of cost savings 13.36 .*,r
(b) Tax savings on account of depreciation
Cost of new computer system (Rs 35 lakhs x 0.35) 12.25
(x) PV factor for year 1 x 0.892
Total PV 10^93
(c) Terminal salvage value at the end of year, 6 (Rs 1 lakh x 0.507) 0.507
(d) Gross PV of CFAT [(a) + (b) + (c)i 24.797
. Less; Cash outflows 26.000
NPV (1 .203)
Recoffinendation: Since NPV is negative, the proposal is not financially viable. -J+
r, lc
26
Capital Budgeting l: Principles and Techniques 10.39
Reommeadadoat lt is desirable for the company to construct its own consultanry centre.
Notes:
(i) Land cost does not involve any additional cash flows.
.dfii) The firm will continue to incur expenses namely, consultants' re travel and conveyance and special
ailowances, and, hence, ignored
,*
f- Pftfrff-Techtronics Ltd is considering a new project for manufacture of "'
{firh.t video games involving a capttal expenditure of Rs 600 lakh and
.*'"
working capital of Rs 150 lakh. The capacity of the plant is for an annual 1 33.33
production of 72 lakh units and capacity utilisation during the 6 year 2 66.67
working life of the project is expected to be as indicated below: 3 90
The a.veruge price per unit of the product is expected to be Rs 200 netting 4-6 100
a contribution of 40 per cent. The annual fixed costs, excluding depreciation,
are estimated to be Rs 480 lakh per annum from the third year onwards; for the first and second year, it would be Rs 240 lakh and
Rs 360 lakh respectively. The average rate of depreciltipq..fgf t45-,purp.oses,-is A33*p,55.-c.egg.o.1y[e capital 4ssets, The rate of
income tax may be taken at 35 per cent. Cost of capital is 15 per cent.
At the end of the third year, an additional investrnent of Rs 100 lakh would be required for working capital.
Terminal value for the fixed assets may be taken at 10 per cent and for the current assets at 100 per cent. For the purpose
of your calculations, the recent amendments to tax laws with regard to balancing charge may,be ignored.
Solution
Cost of capital expenditure 600.00 \ n..'

Add: Working capital required:
At the beginning of the project life 150.00
At the end of year 3, (Rs 100 x 0.658) 65.80 :
;
815.80 = 816 '
Cash inflows (CFAT) and NPV
v 800 ."' 2,400 f

-d
Sales revenue 1 ,600 2,160 2,400' 2,440-

Less; Variable costs 480 960 1,296 1,440 1,440 1,440
Less; Fixed costs 240 360 480 480 480 480
Less; Depreciation (D)
(working note 1) 200 133 89 59 4A 26
Earnings before taxes (120) 147 295 421 440 454
[ess; Taxes (0.35) (42) s1 103 147 154 159
EAT (78) 96 192 274 286 295
CFAT (EAT + D) 122@ 229 281 333 326 321
Add: Recovery of working capital 250
Add: Effective sale proceeds s8v
of fixed assets (working note 4
629
Multiplied by PV factor 0.87 0.756 0.657 0.571 0.497 0.432
Total PV(f=1-6) 106 173 185 190 162 272 1,099
Less; PV of outflows
NPV m 816
Rrcomrnendatlon; Since the NPV is positive, the project should be accepted.

@
There will be tax savings of Rs 42 lakh on the loss of Rs L20 lakh. Therefore CFAT would be - Rs 80 Lakh + Rs 42 lakh =
Rs 122 lakh.
Working notes
(1) Determination of depreciation as per written down value method
600 200
400 133
267 89
178 59
119 40
79 26
s't l
27
10.40 Financial Management
(2) Sales proceeds of fixed assets 60

down value (Rs 79
Less:'$Tritten - Rs 26) 53
-lb-;1
E
Profit on sale of tixed assets 7
Less: Taxes on profit (7 x 0.35)
:l ?
i..'
i'i
1
' .l 2.45
:
Effective sale proceeds (60 - 2.45) 57.55
s
#t P.10.8 A plastic. manufacturer has under consideration the proposal of production of high qualiry plastic glasses. The necessary
nr' I
l' .F equipment to manufacture the glasses would cost Rs 1 lakh and would last 5 years. The tax relevant rate of depreciation is 25
*'l'
}1\"
io
"1"'
per cent on written down value. There is no other asset in this block. The expected sa.lvage-value is Rs 10,000. The glasses can
-4F
9':
*-
be sold at Rs 4 each. Rggardless of the level of production, the manufacturer will incur cash cost of Rs 25,000 each year if the
proiect is undertakenffie overhead costs allocated to this new line would be Rs 5,OOQfrthe variable costs are esfimated at
n Z p.r glass. The r/anufacturer estimates it will sell about 75,000 glasses per year; tlf. ta* rate is 35 per cent. Should the
proposed equipment be purchased? Assume 20 per cent cost of capital and additional working requirement, Rs 50,000.
Solution Cash oudlows
Cost of production equipment Rs 1,00,000

Additional working capital requirement 50,000
i!
1,50,000
Determination of CFAT and NPV
Sales revenue (75,000 x 4) Rs 3,00,000 Rs 3,00,000 Rs 3,00,000 Rs 3,00,000 Rs 3,00,000

Less.' Cosfs:
Variable costs (75,000 x 2) 1 ,50,000 1,50,000 1,50,000 1,50,000 1 ,50,000
Additional fixed costs 25,000 25,000 25,000 25,000 25,000
Depreciation (D) 25,000 '19,750 14,062 10,547 Nil@
Earnings before taxes 1,00,000 1,06,250 1 ,1 0,939 1,14,453 1 ,25,000

Less.' Taxes 35,000 37,187 38,828 40,059 43,754
Earnings atter taxes (EAT) 65,000 69,063 72,110 74,394 81,250
CFAT (EAT + D) 90,000 97,913 86,172 84,941 g1 ,250
Add: Recovery of WC 50,000 -

Add: Salvage value (SV) 10,000 i,
Add: Tax benefit on short
term capital loss@@ 7,574 _,"-
1,49,924
Multiplied by PV factor 0.20 0.833 0.694 0.579 0.482 0.402
'PV (CFAT x PV factor) 74,970 60,942 49,894 40,942 59,827
Total PV(t=1-5) 236575
[ess.' Cash outflows 1,50,000
NPV 1 ,36,575
oAs the block consists of single asset, no depreciation is to be charged in the terminating year as the asset has besn
sold in the year.
o@(Rs 1,00,000
- Rs 68,359.accumulated depreciation - Rs 10,000, SV) '0.35 =Ri7,574.
Reommendatlon: The company is advised to buy the proposed equipment.
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A unit of Realwaves (P) Ltd Operating and Financial Leverage
CHAPTER 4 OPERATING AND FINANCIAL

LEVERAGE
The concept that is used to study the effects of various mix of debt & equity on the shareholders return
and risk in the capital structure of a firm is called leverage.
MEANING OF LEVERAGE
Leverage arises when the firm uses an asset or funds for which it pays a fixed cost or return. If the firm
employs an asset (land, building, machine) which has a fixed cost, it is known as ‘fixed operating cost’
and if the firm uses a source of a fund (debenture), which has fixed cost (interest), it is termed as
‘fixed financial cost’. If a firm is not required to pay any fixed cost or return, it will have no leverage.
Leverage may also be defined as relative change in profits due to change in sales. Leverage helps to
measure the effects of change in sales or profits. In other words, a small increase or decrease in sales
can increase or decrease the profits of a firm to a high extent.
OPERATING LEVERAGE
As we know the cost structure of a firm comprises two types of costs i.e. (i) fixed costs (ii) variable
costs. Fixed costs are those costs, which are not affected by the change in volume of production or
sales, whereas variable costs vary in proportion to change in volume of production or sales. When a
firm uses such an asset for which it has to pay fixed costs, then it is said that operating leverage exists
in the firm. In other words, the extent of fixed costs in operating activities of a firm determines the
operating leverage. If the fixed operating costs are more as compared to variable operating costs, the
operating leverage will be high and vice- versa. Thus, the term operating leverage refers to the
sensitivity of operating profits to changes in sales. For e.g.: if the sales increases by say 25% & the
operating profit increases by 100%, it is a case of high operating leverage. If there are no fixed costs,
there will be no operating leverage & the rate of change in operating profits will be exactly equal to
the rate of change in sales.
Operating leverage may be defined as a firm’s ability to use fixed cost assets (plant &
machinery) to magnify the effect of changes in sales on operating profits or earnings before interest &
tax (EBIT)
“Operating leverage is defined as the use of fixed operating costs to magnify a change in
profits relative to a given change in sales”
COMPUTATION OF OPERATING LEVERAGE
Contribution (Sales – Variable cost) by the operating profits

(Contribution – fixed cost)
Operating leverage = Contribution or C

Operating profits EBIT
Or
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Operating leverage = Sales – Variable cost or S – V

Contribution – Fixed costs S–V–F
Illustration: 1
A manufacturing concern produces and sells 1000 units per annum. The selling price per unit is ` 200
and the variable cost per unit is ` 70. The fixed operating costs are ` 50000. Calculate the Operating
leverage.
Ans: Operating leverage = 1.625
DEGREE OF OPERATING LEVERAGE

The degree of Operating leverage (DOL) is the ratio of the percentage change in operating profits to
percentage change in sales.
DOL = Percentage change in profits

Percentage change in sales
Or
DOL = Percentage change in EBIT
Note: when in the question, only one level of EBIT is given, the DOL can also be computed by using
the following formula:
DOL = Contribution = S – V
EBIT EBIT
Illustration: 2
X corporation has estimated that for a new product its break even point is 2000 units, if the item is sold
for ` 14 per unit, the cost accounting department has currently identified variable cost of ` 9 per unit.
Calculate the degree of operating leverage for sales volume of Rs 2500 units & 3000 units. What do
you infer from the degree of operating leverage at these sales volume.
Ans: DOL = 5
CHARACTERISTICS OF OPERATING LEVERAGE
(i) Related to assets side of balance sheet: Operating leverage implies the use of fixed assets by a
firm. As fixed assets are shown on the assets side of the balance sheet, therefore, it affects the mix of
long term or fixed assets in the balance sheet.
(ii) Related to break even point: BEP is that point of sales where all fixed costs are recovered and
there is no profit or loss at this point. The closer the level of sales (for which DOL is measured) to the
break-even point, the higher the degree of operating leverage. So, increase in BEP will increase DOL.
(iii) Business risk: Operating leverage magnifies return as well as risk. It explains the effects on profit
due to change in sales. If a firm has high operating leverage then the rate of increase in operating
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profits would be more than the rate of increase in sales. On the other hand, a slight decrease in sales
will result in a larger decrease in profits. Thus, risk increases with the increase in variability of profits.
FINANCIAL LEVERAGE
Financial leverage is related to financing activities of the firm. A firm can raise finance from the
sources, which carry fixed financial costs, & which do not involve any fixed costs. Financial leverage
arises from the presence of fixed financial costs in the income stream of the firm or due to presence of
fixed return securities in the capital structure of the company. Fixed cost/ change securities are
debentures and preference shares. The rate of interest on debt is fixed and has to be paid irrespective of
the amount of earnings.
“The firms ability to use fixed financial charges / costs to magnify the effect of changes in earnings
before interest & tax (EBIT) on firms earnings per share”. In other words, the principle of financial
leverage analyses the effects of change in EBIT on firms EPS due to the use of fixed cost bearing
sources of capital in its capital structure.
EFFECTS OF FINANCIAL LEVERAGE
(i) Effect on shareholders earnings: A company’s rate of earnings is higher than the rate of fixed
charges, financial leverage has a favourable or positive effect on earnings per share (EPS). The excess
of earnings generated by the use of fixed cost funds after meeting the cost of such funds (interest)
helps to increase the EPS or return to equity shareholders. For e.g., if a company obtains a debt at 10%
rate of interest and earns 15% on the assets financed by such debt, then there will be an increase of 5%
(15% - 10%) in earnings per share after paying the interest on debt. On the other hand, if the firm
earns only 8% on the investment of such debt, the earnings per share will decrease by 2% (10% - 8%).
(ii) Effect on Financial Risk: With the presence of financial leverage, the percentage change in
earnings per share is more than the percentage change in operating profits (EBIT). For e.g., if 10%
increase in operating profits results in 20% increase in earnings per share, then a 10% decrease in
operating profits will result in a decrease of 20% in earnings per share. Thus, with the use of financial
leverage, financial risk increases. Financial risk means the firms inability to cover the fixed financial
costs. When the firm fails to meet its obligations (payment of interest) year after year, its creditors may
demand compulsory winding up of the company. The more is the proportion of debt in a firm’s capital
structure, the greater would be the financial risk to the business. So, while using it, the debt absorbing
and debt paying capacity of the firm must be kept in view.
Example: The capital structure of a company comprises 1000, 10% debentures of ` 100 and 5000
equity shares of ` 10. Tax rate is 50%. If operating profits (EBIT) are ` 50000, ` 80000 & ` 20000.
Then the earnings per share would be:
EPS at various level of EBIT
EBIT levels
(i) (ii) (iii)
Earnings before interest & tax (EBIT) 50000 80000 20000
Less: interest 10000 10000 10000
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Earnings before taxes (EBT) 40000 70000 10000

Less: taxes (50%) 20000 35000 5000
Earnings after taxes (EAT) 20000 35000 5000
Earnings per share (EPS) 4 7 1
Percentage change in EBIT - (+) 60% (-) 60%
Percentage change in EPS - (+) 75% (-) 75%
Note: Percentage change has been calculated by dividing the current level by level (i) & multiplying it
by 100.
It is clear that from first level to second level, a 60% increase in EBIT results in an increase of
75% in EPS and at third level 60% decrease in EBIT leads to 75% decrease in EPS. This shows that
the use of fixed interest sources of funds leads to more than proportional change in EPS as a result of
change in EBIT level. Whenever a firm has fixed cost securities in the capital structure, financial
leverage is present. The greater is the amount of fixed interest sources of funds and, therefore, larger
fixed financial costs, the higher is the financial leverage.
COMPUTATION OF FINANCIAL LEVERAGE
Financial leverage = Operating Profit or Earnings Before Interest & Tax

Earnings before Tax but after Interest
Illustration: 3
Calculate the financial leverage from the following information:
Interest 5000
Sales (1000 units) 50000
Variable costs 25000
Fixed costs 15000
Ans: Financial leverage = 2
Illustration: 4 – Year 2009

A company has the following capital structure:
Equity share capital 1200000
10% preference share capital 200000
8% debentures 250000
The present EBIT is ` 100000. Calculate the financial leverage assuming that company is in
50% tax bracket.
Ans: Financial leverage = 2.5
DEGREE OF FINANCIAL LEVERAGE
Degree of Financial leverage = Percentage change in EBT

Percentage change in EBIT
Note: when only one level of profits is given in the question, the DFL can also be calculated by the
following formula:
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DFL = EBIT or EBIT

EBT EBIT - 1
Illustration: 5
A company has the following capital structure:
10000 equity shares of ` 10 each 100000
2000, 10% preference shares of ` 100 each 200000
2000, 10% debenture of ` 100 each 200000
The amount of EBIT is ` 100000. The company is in 50% tax bracket. You are required to
calculate the financial leverage of the company. What would be new financial leverage if the EBIT
increases to ` 140000 and interpret your results.
Ans: Financial leverage = 2.5, Degree of Financial leverage = 2.5
INDIFFERENCE POINT
The EBIT level at which the EPS is the same for two alternative financial plans is referred to as the
indifference point/ level.
Algebraic Approach:
Mathematically, the indifference point can be obtained by using the following symbols:
X = earnings before interest & taxes (EBIT) at the indifference point.
N1= number of equity shares outstanding if only equity shares issued.
N2 = number of equity shares outstanding if both debentures & equity shares are issued.
N3 = number of equity shares outstanding if both preference & equity shares are issued.
N4 = number of equity shares outstanding if both preference shares& debentures are issued.
I = the amount of interest on debentures.
Dp = the amount of dividend on preference shares.
t = corporate income tax rate.
Dt = tax on preference dividend.
For a new company: the indifference point can be determined by using the following equations:
(i) Equity shares versus Debentures:
X (1 – t) = (X – I) (1 – t)
N1 N2
(ii) (a) Equity shares versus Preference shares:

X (1 – t) = X (1 – t) - Dp
N1 N3
(b) Equity shares versus Preference shares with tax on Preference Dividend:
X (1 – t) = X (1 – t) – Dp (1 + Dt)
N1 N3
(iii) Equity shares versus Preference shares & Debentures:

X (1 – t) = (X – I) (1 – t) - Dp
N1 N4
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For an existing company: If the debentures are already outstanding, let us assume
I1 = interest paid on existing debt, and
I2 = interest payable on additional debt, then the indifference point would be determined by equation.
(X - I1) (1 – t) = (X - I1 - I2) (1 – t)
N1 N2
Illustration: 6
The financial manager of a company has formulated various financial plans to finance ` 3000000
required to implement various capital budgeting projects:
(i) Either equity capital of ` 3000000 or ` 1500000, 10% debentures and ` 1500000 equity;
(ii) Either equity capital of ` 3000000 or 13% preference shares of ` 1000000 and ` 2000000 equity;
(iii) Either equity capital of ` 3000000 or 13% preference shares of ` 1000000, (subject to dividend
tax of 10 percent), ` 1000000, 10% debentures and ` 1000000 equity; and
(iv) Either equity share capital of ` 2000000 and 10% debentures of ` 1000000 or 13% preference
capital of ` 1000000, 10% debentures of ` 800000, and ` 1200000 equity.
You are required to determine the indifference point for each financial plan, assuming 35%
corporate tax rate & the face value of equity shares of ` 100.
Solution: Determination of Indifference Point

(i) X (1 – t) = (X – I) (1 – t)
N1 N2
X (1 – 0.35) = (X – 150000) (1 – 0.35)
30000 15000
0.65X = 0.65X – 97500
30000 15000
0.65X = 1.3X - 195000
-0.65X = -195000
X = 195000
0.65
X= ` 300000
Confirmation table
Particulars Equity financing Equity + debt financing
EBIT 300000 300000
Less: Interest - 150000
Earning before taxes 300000 150000
Less: Taxes 105000 52500
Earnings for equity holders 195000 97500
Number of equity shares 30000 15000
EPS 6.5 6.5
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(ii) X (1 – t) = X (1 – t) - Dp
N1 N3
X (1 – 0.35) = X (1 – 0.35) – 130000
30000 20000
0.65X = 0.65X – 130000
30000 20000
X = ` 600000
Confirmation table
Particulars Equity financing Equity + preference financing
EBIT 600000 600000
Less: Taxes 210000 210000
Earning after taxes 390000 390000
Less: dividends on preference shares - 130000
EPS 13 13
(iii) X (1 – t) = (X – I) (1 – t) – Dp (1 + Dt)
N1 N4
X (1 – 0.35) = (X – 100000) (1 – 0.35) – 130000 (1 + 0.1)
30000 10000
0.65X = 0.65X – 65000 – 143000
30000 10000
X = ` 480000
Confirmation table
Particulars Equity financing Equity + pref + dividend financing
EBIT 480000 480000
Less: Interest - 100000
Earning after interest 480000 380000
Less: Taxes 168000 133000
Less: dividends including dividend
tax on preference shares - 143000
Earnings available for equity 312000 104000
holders
EPS 10.4 10.4
(iv) X (1 – t) = (X – I) (1 – t) - Dp
N1 N4
(X – 100000) (1 – 0.35) = (X – 80000) (1 – 0.35) – 130000
20000 12000
X = ` 550000
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Confirmation table
Particulars Equity + debt Equity + debt +
financing preference financing
EBIT 550000 550000
Less: Interest 100000 80000
Less: Taxes 157000 164500
Less: dividend on preference shares - 130000
EPS 14.625 14.625
On the basis of level of EBIT, which ensures identical market price for alternative financial plans, the
indifference point can be symbolically computed by equation.
P/E1 X (1 – t) = P/E2 (X – I) (1 – t) - Dp
N1 N2
Where,
P/E1 = P/E ratio of unlevered plan.
P/E2 = P/E ratio of levered plan.
Illustration: 7
Determine the indifference point at which market price of equity shares of a corporate firm will be the
same from the following data:
(i) Funds required ` 50000
(ii) Existing number of equity shares outstanding, 5000 @ ` 10 per shares
(iii) Existing 10% debt, ` 20000
(iv) Funds required can be raised either by (a) issue of 2000 equity shares, netting ` 25 per share or (b)
new 15 percent debt.
(v) The P/E ratio will be 7 times in equity alternative and 6 times in debt alternative.
(vi) Corporate tax rate, 35%
Solution:
P/E1 X (1 – t) = P/E2 (X – I) (1 – t) - Dp
N1 N2
7 (X – 2000) 0.65 = 6 (X – 9500) 0.65

7000 5000
0.65X – 1300 = 0.65X – 6175

7000 5000
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5(4.55X – 9100) = 7(3.9X x 37050)

4.55X = 213850
X = 47000
Confirmation table
Particulars 15% debt issue Equity issue
EBIT 47000 47000
Less: Interest 9500 2000
Less: Taxes 13125 15750
Earnings per share 4.875 4.18
P/E ratio (times) 6 7
Market price of the share 29.25 29.25
COMBINED OR COMPOSITE LEVERAGE

Both these leverages are closely concerned with the firm’s ability to recover its fixed costs (both
operating & financial). Thus, operating & financial leverages are combined to asset the impact of all
types of fixed costs. In case, both the leverages are combined, the result obtained will disclose the
effects of change in sales over change in tax able profit (or EPS). As such, the combined leverage may
be defined as the relationship between contribution (sales – variable costs) & the taxable income.
Combined leverage = Operating leverage x Financial leverage

Or
Combined leverage = Contribution x EBIT
EBIT EBT
Or
Combined leverage = Contribution

EBT
Illustration: 8
A company has sales of ` 1 lakh. The variable costs are 40% of the sales while the fixed operating
costs amount to ` 30000. The amount of interest on long-term debt is ` 10000.
You are required to calculate the composite leverage and illustrate its impact if sales increase by 5%.
Ans: Composite leverage = 3, Increase in % profit = 15%.
DEGREE OF COMPOSITE LEVERAGE
DCL = Degree of operating leverage x Degree of financial leverage

Or
DCL = Percentage change in EBIT x Percentage change in EPS
Percentage change in sales Percentage change in EBIT
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Or
DCL = Percentage change in EPS
In this way, combined leverage indicates the relationship between contribution (sales – variable cost)
& taxable income (EBT); whereas the degree of combined leverage (DCL) measures the percentage
change in earnings per share (EPS) due to percentage change in sales.
Illustration: 9
The capital structure of Bombay refrigeration company ltd. consist of an equity share capital of `
300000 (share of ` 10 par value) and ` 300000, 10% debentures. Sales increased by 20% from 30000
to 36000 units; the selling price is ` 10 per unit. Variable cost ` 6 per unit & fixed costs amount to `
50000. The company’s tax rate is 50%.
You are required to compute the degree of operating leverage, degree of financial leverage & degree
of combined leverage.
Ans: DOL = 1.71, DFL = 1.75, DCL = 2.99
Year 2013
Illustration: 10
A company has sales of ` 1000000; variable costs of ` 700000; fixed costs of ` 200000 & debentures
of ` 500000 at 10% interest. Calculate operating, financial & combined leverages.
Ans: OL = 3, FL = 2, CL = 6
Year 2013
Illustration: 11
The funds of shareholders of Jindal Ltd. are as follows
Rs
12% Preference Share Capital 5,00,000
Equity Share Capital @ Rs100 per Share 20,00,000
Securities Premium 2,00,000
Retained Earnings 15,00,000
42,00,000
The earnings available for equity shareholders from this period's operations are Rs 7,50,000, which
have been included as part of the Rs 15,00,000 retained earnings,
i) What is the maximum Dividend per Share (DPS) firm can pay?
ii) If the firm has Rs 3,00,000 in cash, what is the highest DPS it can pay without borrowing?
iii) Indicate what accounts, if any, will be affected if the firm pays the dividends indicated in (ii)
above?
Ans (i) DPS=75, (ii) DPS=15 iii) Accounts relating to retained earnings and cash will be affected.
Retained earnings balance will decline by 3,00,000 that is the amount of dividend paid. Cash will be
reduced to zero.
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Year 2012
Illustration: 12
The operating income of Hypothetical Ltd. amounts to Rs 1,90,000. It pays 40 per cent tax on its
income. Its capital structure consists of the following:
10% Debenture Rs 5,00,000

15% Preference Shares Rs 1,00,000
Equity Share (Rs 100 each) Rs 4,00,000
Questions:
i) Determine the firm's EPS. Ans 17.25
ii) Determine the percentage change in EPS associated with 30 per cent charge (both increase and
decrease) in EBIT. Ans (i) 30% Increase EPS = 25.8, % change = +49.57%
(ii) 30% Decrease EPS = 8.7, % change = - 49.57%
iii) Determine the degree of financial leverage at the current level of EBIT. Ans 1.6 times
iv) What additional data do you need to compute operating as well as combined leverage?
Ans The additional data required to compute the operating and combined leverage relate to sales and
variable cost.
Year 2011
Illustration: 13
Prepare income statements of the P and Q firms.
Particulars P Q
Corporate tax (%) 40 40
Interest p.a. (Rs) 12,00,000 10,00,000
Operating leverage 2 4
Financial leverage 2 2
Variable cost (%) of sales 60 50
Ans:
Particulars Rs
Sales 1,20,00,000
Less: Variable Cost 72,00,000
Contribution 48,00,000
Less: Fixed Cost 24,00,000
EBIT 24,00,000
Less: Interest 12,00,000
EBT 12,00,000
Less: Corporate Tax @ 40% 4,80,000
PAT 7,20,000
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Particulars Rs
Sales 16,00,000
Less: Variable Cost 8,00,000
Contribution 8,00,000
Less: Fixed Cost 6,00,000
EBIT 2,00,000
Less: Interest 10,00,000
EBT 10,00,000
Less: Corporate Tax @ 40% 4,00,000
PAT 6,00,000
*****
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A unit of Realwaves (P) Ltd Dividend Policy
CHAPTER 5 DIVIDEND POLICY
MEANING OF DIVIDEND & DIVIDEND POLICY

Dividend is that part of net profit which is paid in cash by the company to its shareholders after
exclusion of the retained profit.
DIVIDEND DECISIONS & DIVIDEND POLICY

Dividend decision is the determination of the percentage of earnings to be paid by the company in cash
to its shareholders as dividend and the percentage of earnings to be retained by it for financing its
long-term growth.
ESSENTIALS OF A SOUND DIVIDEND POLICY

A sound dividend policy contains the following elements:
(i) Initially lower dividend: In the beginning a company should declare dividend at low rate so that a
substantial part of the profits is available as a source of internal financing. It will strengthen the
financial position of the company. Initially lower dividends is also helpful in development and
expansion of the company. Therefore, the rate of dividend should be increased gradually as the
company prospers.
(ii) Gradual increase in dividend: With the increase in price level, the income of the company also
increases. The shareholders expect similar increase in their income. Therefore, the rate of dividend
should be increased gradually so that there, may not be any discontentment among the shareholders. If
there are super profits in any particular year, then extra dividend or interim dividend may be declared.
(iii) Stability: Stability of dividend means that there should not be too much fluctuations in the rate of
dividend. During stability, the rate of dividend is increased gradually and slowly.
STABLE OR REGULAR DIVIDEND POLICY
(a) Constant dividend per share: Under this form, a company pays a certain fixed amount per share
by way of dividend. For e.g. a company may pay ` 4 as dividend per share having a face value of ` 10.
The amount of ` 4 would be paid regularly year after year and the fluctuations in earnings will not
affect the amount of dividend. This policy is followed by those companies whose earnings are stable
for long term.
(b) Constant percentage of net earnings: According to this form, a certain percentage of net
earnings/ profits is paid by way of dividend to shareholders year after year i.e. a constant payout ratio
(DPS / EPS) is followed. For e.g., a 40% dividend payout ratio indicates that the company will
distribute 40% of its earnings to the shareholders and 60% will be retained in the business. If a
company earns ` 5 per share, the dividend amount will be ` 2 (40% of ` 5) per share.
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ADVANTAGES OF STABLE DIVIDEND POLICY

 Confidence among shareholders
 Institutional investors preference
 Stability in market price of shares
 Raising additional finance
 Market for debentures and preference shares
WALTER’S MODEL
(i) Growth firms (when r > Ke): Those firms whose internal rate of return is more than the cost of
capital (r > Ke) are called growth firms. Such firms can earn more what the investors except because
they have adequate profitable investment opportunities. These firms should have zero payout ratio and
should re- invest their entire earnings. This will maximize the market value of shares.
(ii) Declining firms (when r < Ke): Those firms whose internal rate of return is less than the cost of
capital (r < Ke) are called declining firms. Such firms do not have profitable investment opportunities
to invest their earnings. Such firms should better distribute the entire profits i.e 100% payout ratio and
let the shareholders invest their dividend income to earn higher returns.
(iii) Normal firms (when r = Ke): Those firms whose internal rate of return is equal to the cost of
capital (r = Ke) are called normal firms. In such firms, the shareholders will be indifferent whether the
firm pays dividends or retains the profits. In other words, the dividend policy of such firms does not
affect the market value of shares, because the returns to the firm from reinvesting the retained earnings
will be just equal to the return available to the shareholders on their investment of dividend income.
Thus, if r > Ke, the dividend payout ratio should be zero i.e retention of 100% profits.
If r < Ke, the dividend payout ratio should be 100% and the firm should not retain any profits.
If r = Ke, the dividend is irrelevant and dividend policy will not affect the market value of shares.
ASSUMPTIONS
The critical assumptions of Walters model are as follows:
(i) A financing is done through retained earning; external sources of funds like debt or new equity
capital are not used.
(ii) With additional investments undertaken, the firms business risk does not change. It implies that r
and K are constant.
(iii) There is no change in the key variables, namely, beginning earnings per share, E, and dividends
per share, D. the values of D and E may be changed in the model to determine results, but any given
value of E and D are assumed to remain constant in determining a given value.
(iv) The firm has perpetual (or very long) life.
FORMULA
Prof. Walter has suggested a formula to determine the market value of share, which is as under:
P = D + r (E – D) / Ke
Ke Ke
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Where,
P = market price per share
D = dividend per share
r = internal rate of return
E = earnings per share
Ke = cost of equity capital or capitalization rate.
Illustration: 1
The details regarding three companies are given below:
X ltd Y ltd Z ltd
r = 12% r = 8% r = 10%
Ke = 10% Ke = 10% Ke = 10%
E = ` 50 E = ` 50 E = ` 50
Compute the value of an equity share of each of these companies applying Walters formula when
dividend pay out ratio is (a) 0% (b) 20% (c) 40% (d) 80% (e) 100%. Comment on the conclusions
drawn.
Solution:
P = D + r (E – D) / Ke
Ke Ke
Effect of dividend policy on market price of shares.

(a) When dividend pay out ratio is 0%.
(i) For X ltd (ii) For Y ltd (iii) For Z ltd

P = 0 + .12 (50 – 0) / .10 P = 0 + .08 (50 – 0) / .10 P = 0 + .10 (50 – 0) / .10
.10 .10 .10 .10 .10 .10
= 0 + .12 (50) / .10 = 0 + .08 (50) / .10 = 0 + .10 (50) / .10
.10 .10 .10
= ` 600 = ` 400 = ` 500
(b) When dividend pay out ratio is 20%.

P = 10 + .12 (50 – 10) / .10 P = 10 + .08 (50 – 10) / .10 P = 10 + .10 (50 – 10) / .10
.10 .10 .10 .10 .10 .10
= 100 + 48 = 100 + 320 = 100 + 400
= ` 580 = ` 420 = ` 500
(c) When dividend pay out ratio is 40%.

P = 20 + .12 (50 – 20) / .10 P = 20 + .08 (50 – 20) / .10 P = 20 + .10 (50 – 20) / .10
.10 .10 .10 .10 .10 .10
= 200 + 360 = 200 + 240 = 200 + 300
= ` 560 = ` 440 = ` 500
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(d) When dividend pay out ratio is 80%.

P = 40 + .12 (50 – 40) / .10 P = 40 + .08 (50 – 40) / .10 P = 40 + .10 (50 – 40) / .10
.10 .10 .10 .10 .10 .10
= 400 + 120 = 400 + 80 = 400 + 100
= ` 520 = ` 480 = ` 500
(e) When dividend pay out ratio is 100%.

P = 50 + .12 (50 – 50) / .10 P = 50 + .08 (50 – 50) / .10 P = 50 + .10 (50 – 50) / .10
.10 .10 .10 .10 .10 .10
= 500 + 0 = 500 + 0 = 500 + 0
= ` 500 = ` 500 = ` 500
Conclusion: From the above analysis, the following conclusions are drawn:
 X ltd is a growth firm (r > Ke). The value of its shares is inversely related to dividend payout
ratios. As the dividend payout ratio increases from 0 to 100%, the market value of shares
declines from ` 600 to ` 500, when all earnings are distributed its value is lowest (` 500). In
other words, optimum payout ratio is zero.
 Y ltd is a declining firm (r < Ke). Its dividend payout ratio and the value of shares are
positively related. As payout ratio increases from 0 to 100%, the market value of the shares
also increases from ` 400 to ` 500. In this case optimum dividend policy is given by payout
ratio of 100%.
 Z ltd is a normal firm (r = Ke). The market value of its shares is constant irrespective of
dividend payout ratio. In other words, the market price is not affected whether it declares
dividend or not. It is ` 500 at all cases of dividend payment. Hence, there is no optimum
dividend policy.
Illustration: 2
Priya ltd earns ` 5 per share is capitalized at a rate of 10%and has a rate of return on investments of
18%. According the Walters formula:
(i) What should be the price per share at 25% dividend payout ratio?
(ii) Is this optimum payout ratio?
Ans: (i) ` 80 (ii) Not an optimum payout ratio.
Illustration: 3
ABC ltd was started a year back with a paid up equity capital of ` 4000000. The other details are as
under:
Earnings of the company ` 400000
Dividend paid ` 320000
Price earning ratio 12.5
Number of shares 40000
Branches:
44
You are required to find out whether the company’s dividend payout ratio is optimal, using Walters
formula.
Ans: P = ` 131.25, payout ratio 80% not optimal.
Illustration: 4
From the following information supplied to you, determine the theoretical market value of equity
shares of a company as per Walters model.
Earnings of the company ` 500000
Number of shares outstanding 100000
Price earning ratio 8
Rate of return on investment 0.15
Are you satisfied with the current dividend policy of the firm? If not, what should be the optimal
dividend payout ratio in this case?
Ans: P = ` 43.20, optimal ratio should be zero.
Illustration: 5
(i) From the following information supplied to you, ascertain whether the firms D/P ratio is optimal
according to Walter. The firm was started a year ago with an equity capital of ` 20 lakh.
Earnings of the firm ` 200000
Price earning ratio 12.5
Number of shares outstanding, 20000 @ ` 100 each. The firm is expected to maintain its current rate
of earnings on investment.
(ii) What should be the P/E ratio at which the dividend payout ratio will have no effect on the value of
the shares?
(iii) Will your decision change if the P/E ratio is 8, instead of 12.5?
Ans: (i) At 75% P = 132.81 & At 0% P = 156.25, (ii) P/E ratio of 10 times (iii) yes.
Year 2011
Illustration: 6
From the following data, determine price per share According to Walter's Model and comment
ABC XYZ
Particulars Company Company
Earnings per share Rs 10 10
Cost of Capital (%) 12 12
Return on investment (%) 15 15
Dividends per share Rs 8 5
Ans: 87.49, 93.743
GORDON’S MODEL
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45
Gordon has also proposed a dividend model that the dividend policy of the company has a direct
bearing on the market value of shares. This model is also based on the following assumptions similar
to that of Walters model.
(i) The internal rate of return (r) and the cost of capital (Ke) of the firm remains constant.
(ii) The firm operates its investment activities only through equity.
(iii) The firm has perpetual life.
Market value of a share, according to Gordon, is equal to the present value of its expected future
dividends and can be calculated as follows:
P= D or E (1 – b)
Ke – g Ke – br
Where, P = price per share

D = expected dividend per share
E = earnings per share
Ke = cost of capital or capitalization rate
b = retention ratio (1 – payout ratio) i.e. the percentage of earnings retained.
br = growth rate i.e. r.
(i) Growth firm (when r > Ke): The price per share increases as the dividend payout ratio decreases.
Thus, growth firm should distribute smaller dividends and should retain maximum earnings.
(ii) Normal firm (when r = Ke): The price per share remains unchanged and is not affected by
dividend policy. Thus, for a normal firm there is no optimum dividend payout.
(iii) Declining firm (when < Ke): The price per share increases as the dividend payout ratio increases.
Thus, the shareholders of declining firm stand to gain if the firm distributes its earnings. For such
firms, the optimum payout would be 100%.
Illustration: 7
The details regarding three companies are given below:
Growth ltd Normal ltd Declining ltd
r > Ke r = Ke r < Ke
r = 0.15 r = 0.10 r = 0.08
Ke = 0.10 Ke = 01.0 Ke = 0.10
E = ` 10 E = ` 10 E = ` 10
Find out market price of an equity share of each of these companies applying Gordon’s formula when
dividend payout ratio is (i) 40% (ii) 60% and 90%. Comment on the conclusions drawn.]
Solution: P = E (1 – b)
Ke - br
Effect of Gordon’s model on firms share price.
(i) When payout ratio is 40% and b = 60%
Branches:
46
(a) For growth ltd (r > Ke) (b) For normal ltd (r = ke) (c) For declining ltd (r < Ke)
g = br = 0.6 x 0.15 = 0.09 g = br = 0.6 x 0.10 = 0.06 g = br = 0.6 x 0.08 = 0.048
P = 10 ( 1 – 0.6) P = 10 ( 1 – 0.06) P = 10 ( 1 – 0.6)
0.10 – 0.09 0.10 – 0.06 0.10 – 0.048
= 4 = 4 = 4
0.01 0.04 0.052
= ` 400 = ` 100 = ` 77
(ii) When payout ratio is 60% and b = 40%
g = br = 0.4 x 0.15 = 0.06 g = br = 0.4 x 0.10 = 0.04 g = br = 0.4 x 0.08 = 0.032
P = 10 ( 1 – 0.4) P = 10 ( 1 – 0.04) P = 10 ( 1 – 0.4)
0.10 – 0.06 0.10 – 0.04 0.10 – 0.032
= 6 = 6 = 6
0.04 0.06 0.068
= ` 150 = ` 100 = ` 88
(iii) When payout ratio is 90% and b = 10%
g = br = 0.10 x 0.15 = 0.015 g = br = 0.10 x 0.10 = 0.01 g = br = 0.10 x 0.08 = 0.008
P = 10 ( 1 – 0.1) P = 10 ( 1 – 0.1) P = 10 ( 1 – 0.1)
0.10 – 0.015 0.10 – 0.01 0.10 – 0.008
= 9 = 9 = 9
0.085 0.09 0.092
= ` 106 = ` 100 = ` 98
Conclusions: From the above analysis, the following conclusions are drawn:
 The market value of growth ltd shares decreases from ` 400 to ` 106 due to high payout ratio.
 The market value of the shares of normal ltd will not be effected due to change in payout ratio
till the profitability of its investments and cost of capital remains equal
 The market value of the shares of declining ltd increases from ` 77 to ` 98 on account of high
payout ratio.
Illustration: 8
A company has 10% actual capitalization rate, a dividend payout of 50% and declares a dividend of `
2 per share. The normal capitalization rate in the industry to which this company belongs is 12%.
Find out the value of equity shares of the company using the Gordon model.
Ans: P = 28.58
Illustration: 9
A company has a total investment of ` 500000 in assets, and 50000 outstanding equity shares at ` 10
per share (par value). It earns a rate of 15% on its investment, and has a policy of retaining 50% of the
earnings. If the appropriate discount rate of the firm is 10%. Determine the price of its share using
Branches:
47
Gordon’s model. What shall happen to the price of the share, if the company has a payout of 80% or
20%.
Ans: D/P is 50% = ` 30, D/P is 80% = ` 17.14, D/P is 20% = (-) ` 15.
MODIGLIANI & MILLER MODEL (M – M MODEL)
Modigliani & miller says that dividend decisions and retained earning decisions do not influence the
market value of the shares i.e. dividend policy is irrelevant for valuation. M – M model is based on the
following assumptions:
 There exist a perfect capital market
 There are no floatation or transaction costs
 There are no taxes
 Future earnings are known with certainty.
A division of earnings between dividends and retained earnings has no relevance from shareholders
point of view, and the stock price is independent of such division. The model is expressed by the
formula:
P0 = D1 + P1
1 + Ke
Here,
P0 = market price per share at the beginning of the period or prevailing market price of a share.
D1 = dividend to be received at the end of the period
P1 = market price per share at the end of the period
Ke = cost of equity capital or capitalization rate
The market price of share (P1) at the end of the period can be calculated as follows by the above
formula:
P1 = P0 (1 + Ke) - D1
Issuing of new shares, Modigliani & miller approach can also be explained as follows:
nP0 = (n + m) . P1 – (I – X)
1 + Ke
Here,
n = number of shares outstanding at the beginning of the period
m = number of new shares to be issued at the end of the period
P1 = market price per share at the end of the period
I = new investment
Ke = cost of equity capital
X = new income or total net profit
No. of shares issued at the end of the period (m) can be calculated by the following formula:
m = I – (X – n D1)
P1
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48
Here,
D1 = dividend to be paid at the end of the period
Illustration: 10
Jaipur syntax ltd belongs to a risk class for which the appropriate capitalization rate is 10%. It
currently had outstanding 50000 shares of ` 10 each. The firm is contemplating the declaration of
dividend at ` 0.60 per share at the end of the current financial year. The company expects to have a net
income of ` 50000, and has a proposal for making new investments of ` 100000. Show that under the
M – M hypothesis, the payment of dividend does not effect the value of the firm.
Ans: (A) value of the firm when dividend is paid. (i) Price of share = ` 10.40 (ii) no. of shares issued
= 7700 (approx) (iii) value of the firm = ` 500000
(B) Value of the firm when dividend is not paid. (i) Price of share = ` 11 (ii) no. of shares issued =
4545 (approx) (iii) value of the firm = ` 500000
Illustration: 11
Expandent ltd had 50000 equity shares of ` 10 each outstanding on January 1. The shares are currently
being quoted at par in the market. The company now being quoted at par in the market. The company
now intends to pay a dividend of ` 2 per share for the current calendar year. It belongs to a risk class
whose appropriate capitalization rate is 15%. Using M – M model & assuming no taxes, ascertain the
price of the company’s share at it is likely to prevail at the end of the year. (a) When dividend is
declared (b) When no dividend is declared (c) Also find out the number of new equity shares that the
company must issue to meet its investment needs of ` 2 lakh, assuming a net income of ` 1.1 lakh and
also assuming that the dividend is paid.
Ans: (a) P1 = ` 9.5 (b) P1 = ` 11.5 (c) 20000 shares
Illustration: 12
The asbestos company belongs to a risk class of which the appropriate capitalization rate is 10%. It
currently has 100000 shares selling at ` 100 each. The firm is contemplating the declaration of ` 6
dividend at the end of the current fiscal year, which has just begun. Answer the following questions
based on M – M model & the assumptions of no taxes.
(a) What will be the price of the shares at the end of the year, if a dividend is not declared? What will
it be if it is declared?
(b) Assuming that the firm pays dividend, has a net income of ` 1000000 and makes new investments
of ` 2000000. During the period, how many new shares must be issued?
Ans: (a) P1 (if dividend is not paid) = ` 110, P1 (if dividend is declared) = ` 104 (b) no. of shares
issued = 15385.
*****
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49
A unit of Realwaves (P) Ltd Lease Financing
CHAPTER 6 LEASE FINANCING
LEASE FINANCING
Lease refers to a contractual between two parties whereby one (the lessor) conveys to the other (the
lessee), in return for rent, the right to use an asset for an agreed period of time. Lease is a special type
of transaction, a contractual agreement under which the owner of the asset (movable or immovable)
allows its exclusive use to another party (lessee) over a certain period of time for some consideration
(rentals).
A lease thus can be defined as “A contractual arrangement where the owner (lessor) of an asset
transfers the right to use the asset to the user (lessee) for an agreed period of time in return for rentals”.
(a) Parties to lease: There are two parties to a lease the lessor and the lessee. In a special type of lease
called leveraged lease, there is a third party, the financer, who provides the finance needed for
acquiring the asset. He is a banker to the lessor.
(b) Asset under lease: The subject matter of lease is a tangible asset, movable or immovable.
(c) Term of lease: It is the period for which the agreement of lease shall be in operation.
(d) Rentals of lease: These are the periodic (usually monthly) payments that form the consideration
for the lease transactions.
(e) Ownership separated from user: The essence of a lease agreement is that during the lease tenure,
ownership of the asset vests with the lessor & its use is allowed to the lessee. On the expiry of the
lease tenure, the asset reverts to the lessor.
TYPE OF LEASES
Lease are of following types:
(i) Financial lease: A financial lease is a contractual commitment that is non cancelable on the part of
the lessee (the user) to make a series of payments to the lessor (the owner) for the use of an asset. In
this type of lease, the lease period is usually shorter than the useful life of the asset being leased.
The lessee is responsible for maintenance, insurance and taxes payable on leased asset.
In a financial lease, lessee uses and have control over the asset without holding the title to it. The
lessee acquires most of the economic values associated with the outright ownership of the asset and
only the title deed remains with the lessor.
(ii) Operating lease: An operating lease gives to the lessee only a limited right to use the asset. Under
operating lease, lessee enjoys the right to terminate the lease at short notice without any
Branches:
50
A unit of Realwaves (P) Ltd Lease Financing
significant penalty. The responsibility of insuring and maintaining the asset in which case an operating
lease is called a ‘wet lease’. An operating lease where the lessee bears the costs of insuring and
maintaining the leased asset is called a ‘dry lease’.
 An operating lease is for a smaller period.
 The lessor is responsible for repairs, maintenance and insurance of the asset.
 An operating lease can be cancelled by the lessee prior to its expiration at a shorter notice.
 The sum of all lease payments by the lessee does not necessarily fully provide for the recovery
of the cost of the leased asset.
 The lessee is not given any uplift to purchase the asset at the end of the lease period. The lessor
has the option to lease out the asset again to another party.
 The lessor himself selects and purchases the asset & leases it out to the lessee.
 The lessor bears the risk of obsolescence and has a continued interest in the leased asset.
(iii) Leveraged lease: It is a finance lease in which the lessor borrows the majority of funds required
to purchase the leased property from a bank, financial institution or other lender. Thus, there are three
parties to the lease transaction the lessee, the lessor and the lender. This type of lease is popular in
financing of assets, which require larger capital outlays.
(iv) Sale and lease back: This is a special financing lease arrangement in which a firm (say firm X)
sells an asset to another firm (say firm Y) & simultaneously the two firms enter into a financial lease
by which firm Y leases the asset to firm X. as a result, the seller receives the purchase consideration
for the asset and also retains the use of the asset in return for periodic lease payments.
Branches:
51
I
'U'n4.-8.
?^adrceL QLr-ti
to sup ptemenf its time-

XYZ Ltd. /s considering to acqure an additional computer
share computer seryices fo ifs Clfenfs. /f has hryo oPtions-
0 To purchase the computer for Rs' 22'00'000'
(ii)Ioleasethecomputerfor.3yearsfloryule.asingCompanyforRs.5,a0,0a0
as annual/ease rent ptis-fii,if gross time-ih"u'service revenue' The
payment of Rs' 6,00,000 at the end
of
agreement also requires an add,tro nil
. the third year. Lease ,r;1 ;*- iiv,ib/e at the Year
end, and the computdr
period.
reverls io'trre /essor after the contract
TheCompanyestirnatesthatthecomputerunderreviewnowwiltbeworlh
.Rs.t-otaxns.attheendofthethirdyearForecastrevenuesare-
Rs,
Year
1
22,50,000
2 25,00,aa}
3 27,50,00Q
are
and
a,
J
52
I
,)
of the computer; repaymenls are fo be made according ta tha fotiowing

schedule: t
Principal lnterest Total

Year-end (Rs j (8s.1 (Rs/
a
I 5,A0,00a 3,52,400 9,52,0c0
Z 8,5A,000 2,72,000 11 ,22,a00
3 , 8,50, AO0 1,36,00a g, B6; ooc
The company uses the straight line method to depreQale ifs assets and pays
50% tax on ifs income.
The mana_gement of x-Yz Ltd..Approaches you,.'as a company secretary, far
advice. Which alternative would yau recommend and why?
Itote: Present value factor at g% and I6% rate sf discount:
Year 8% 16%
I 4.926 0.962
2 0.857 0.743
3 0.794 0,641
Present Value of Cash Outflows under Leasing Alternative
Fayment under lease contract fRs)

^ Tax
Shield
10% of Lumy @50% PV
, ear Lease gross SUTN
on lease cash f actor at
Net
Y
Rent revenuo payment Total
payment outflows B% Total pV
(Rs.J (Rs.) (Rs.,) (Rs ) (Rs / (Rs.) (Rs.)
1
t. 5 00,00c 2,25,000 7,25,000 3,62,500 3,62,500 0.926 3,35,675
2. 5,00,000 2,5A,0C0 7,50,000 3,75,000 3,75,000 a.857 3,21,375
3 5,00,000 2,7 5,000 6,00,000 13,75,000 6,87,500 6,97,500 0.794 5.45.975
Present Value of Cash Outftows under Buying/Borro\i/ing

Ailernative
lnstalment Pavment Tax advantaoe on
Year PV
end Principat
tnlerest Total /nlerest Depre- Net cash factor
@t 6% payment ciation outflows at 8% Total PV
(Rs ) (Rs.) (Rs.) (Rs (Rs.)
) (Rs.) (Rs )
1
I. 5,00,000 3,52,000 9,52,000 ' 1,76.000 2,00,000 4,76,000
a 0.926 4,40,776
'8,50,000 ?,72,000 11 ,22,000 1,36,OJ0 2,00,000 7,96,000 0.857 6,73,602
{
9,50,000 1 ,36,0009,96,000 69,000 2,00,000 7,1 9,000 0.794 5,70,092
Sahage value
(10,00,000) 0.794 7,94.000
18.90,470
Recommendation: Since the Present yalue
Rs'
of cash outflows under borrowing/buyinffilurnatre
8,90 ,470 is less than Present value of cash
outflow under lease arternative i.e. Rs. 12,a2,g25.
rherefcre, the company is advised to buy the
computer.
'Depreciation for 3 years (Rs.
= 22,00,000 - Rs. 10,00,000) = Rs. 12,50,c00.
discount = 16% (1 -.501 = go7o. Effective rate of interest or
rycrE Since the annual operating costs and training--costs
noi inciudeu :r tfe ca"laulations of &sh outflovys.
are sarne ,nder.both lfre aiternatives, so it is ,
Z,\
53
'lndia
ffiffi*trcr of Mahindra Electronic Corporation of beinghas been analysing
ii; i;;; poitrcy regading computers, which are now leased on a yearly
per year.
basis on rental amountinl fo Rs. 2,00,000 can be b.ou.ght
The computer
for Rs. 10,00,000. The furchase would be financed by 16% lcan repayable in 4
equal an nu al insfa/menfs.
An account of rapid technological progress in the computer industry,years it is
suggested that a'4 year economic life should be used, insfead of 10
piysicat tife. lt is estlmafed that the computer could be sold for Rs: 4,00,400 at
the end of 4 years.
The company uses the straight line method of depreciation' Corporate tax rate is
s0%.
You are required to:
(a) comment on whether the equipmentshould be bought or leased?
(b) Analyse the financial viabitity fram the point of view of ffre lessor, assuming
14% cost of caPital.
(c) Determine the minimum lebse rent at which the lessor woL't't break-even'
(d) Determine the/ease rent vr,hich wiliyield cn /RR of 16% to the lessor. ]
Prese nt value of cash o utfiatys un der Leasin g alternative
Year Lease Renf after PV factor at B% Total Present

)
1
Iaxes (Rs ) Value (Rs i
14 1,00,000 3 312 I 3,31,200\ i
Cash outflows un der Buying alternative
Year end Loan at the Loan lnteresf on Pnncipal I PinciPal

beginning lnstalment Loan Repaytnenf i oufsfa nding
of the year
\ at the end
I of the Year
1,60,000 1 ,97,398 8,02,602
1 10,00,000 3,57,398
2,28,982 5,7 3,620
2 8,02,602
2,65,619 3, U U, (.JU
3 5,7 3,620 '
3,08,00 1
4 3,08 ,00 1
.(Rs. 10,00,000 / 2.798) Present value factor of annuity of Re' 1 al16% for 4. years'
prese nt value of cash o utflow,s un der Bttyirtg a lternative
Net Cash PV factor Total PV
Tax advantage on
Outflows at B%
Paymenf Depre-
of lnferest ciation
0 926 1 87 ,421
3,57,398 80,000 75,000 2.A2,398 ,
54
2 3,57,399 64,209 75,000 2,1 8,1 g0 0.857 1,86,ggg
{
!, 3,57,399 45,990 75,00c 2,36,508 0.794 1,97 ,797
4 3,57,39E 24,699 7 5,000 2,57,699 0.735 1,89,409
Salvage value (4,00,000) 0.73s
?,94,_0rg
[^;57,606
Reommendation; lt may,be noted from the above workings that leasirfi option
is
financially superior as against buying alternative because present value
of cash
outftqrv under leasing option is lowe1.
(b) (i) Viabitity from the/esser 's point of view. aft 14%cosf or: ,rOitat
Determination of CFAT
Lease rent received 2,00,000

Less. Depreciation 1,50.000
Earning before tax
50,000
Less. faxes (S0%)
25,00q
Earning after tax
25,000
Add: Depr"eciation 1,50,000
CFAT 1,75,000
(ii) Determination of NpV
Year CFAr (Rsl PV Factor at 14% Total PV (Rs )

14 1,75,000 2.914 5,09,950
4 4,00,000 0.592 2.36.800
7,46,750
Less: Cost of computer
10.00.000
fILSSJ.LO
, ,
I (2,53,250) /
Recommendation:The proposal is not financially viable-to
the lessor.
(c) tease rent at which /essor would break even.
Rs.
Cost of computers
10,00,000
Less: PV of salvage price of computer
2,36,800
Net cost to b.e covered '
7,63,200
CFAT (Desired) (7,63 ,2A0 + 2.g 14")
2,61 ,g0B
Less: Depreciation
1,50,000.
Earning after taxes
Add: Taxes @ S0% 1 ,1 1,908
1,1J,goq
Earnirrg before tax
Add: Depreciation 2,23,816
Lease rent at which ressor wourcj break-even
'Annuity factcr at 1 4% for four years. 3,6 i
55
f
i1
*-l'-
(d) Lease rent to yieru tAX nn

1o,oo,ooo=i,
u
x
Rs.
t=1(1+ 0.16j
a,*Rs4'oo'ooo
' (i + 0.16)4
Where X = CFAT
:+Rs. 1o,oo,ooo-Rs'4'oo'ooo=i ' ,
I
(1.16)4 t?1t * 0.16)4
. Substituting (i) PV factor of annuity of Re. 1 .at 16% for 4 years is 2.798 and
(ii) PV factor of Rd. I al 16% in 4 years is 0.552.
Rs. 10,00,000 - Rs. 4,00,00C x .552 = 2.798X

I
Rs. 1 0,00,000 - Rs . 2,2A,E00 = L79BX

779209=
2.799|,
Rs. ,
V
4 - Rs. 278485
Rs.
CFAT Oesired 2,78,485
- Less. Depreciation
1 , [0_,000
Earning after taxes 1,28,485
Add. Taxes @ 50Yo
ugsqg
Earning before taxes 2,56,970
Add Depreciaticn 1 .50,0j)0
Lease Rent Desired
@
lr
l,--
It kst\ahon i)
ABC Ltd. rs considering to acquire an additional sophlsticated computer to
supplement ifs time-share compuler services to rts cilenfs. /t ias two options:
(i) To purchase the computer for Rs. 44,00,000.
(it Io /ease the computer for 3 years from a leasing company for Rs. 10,00,000
as annual /ease rlnt plus'10% of gross lime share se,vice revenud. The
agreement also requires an additional payment of Rs. 12,00,000 at the end
' of the third year. Lease rents are payable at the year end, and the computer
reverts back to fhe /essor after the contract period.
The company estimates fiaf the cc,mputer under review now will be worth Rs. 20
lakhs at the end of the third year,
/,)
Year Rs
1 45,A0,000
2 50,44,400
3 55, 0A,000
Annupl operating cosfs (excluding depreciationllease rent of computer) are

estimated al Rs, 18,A0,000 with an additional cosf cf Rs. 2,00,000 for starl-up
and training at the begjinning of the first year. fhese costs are to be borne by the
/essee. ABC Ltd. will borrow 16% interest to finance the acquisition of the B,*T
56
computer and tha rspaymenfs are to be made accarrling to the fcllowfng
sch edule: )
Year-end Pincipal (Rs ) lnterest (Rs.,) Total (Rs )

1 10,00,000 7,04,000 17,A4,A00
I
2 17,0A,000 5,44,000 22,44,0A0
3 17,00,0a0 2,72,000 19,72,000
I
The campany uses the straighi- line method

-r)
fo ddpreciate ifs assefs and pays
I
5C% tax on ifs incomE. ,.. )
',o
The management af ABC Ltd. approaches yotr, as a company Secre tary-cum_
Finance Manager, for' advicb. Which alternative would yau recommend
and
why?
I
I'lote: Present vdue faCtai at 8% and 16% rate of Cisc ount:
" Year 8% 16%

1 0.926 0. E62
2 0.857 0 743
3 0 794 4 641
;3pLtii.tr r i
Present Value of Cash Outflows uncjer Leasing
Alternative
__ !!_ ment under lease control T'l
Lease
Rent
W
I g-tt
W l, oarment
Total
-- Tax
Shie/d @
50% on
i',ler cash
ctiflcw
'.
fa
at
PV
ctor
B%
I Totat pV
I ne venue
l_ leaSe-
(Rs.) (Rs ) I rnr.,t (Rs.) (Rs.,) (Rs / (Rs.)

I U,UU,0O0 4, 50,000 4, 50, 000
I
-
10,00,0c0 5,00,000
1 7 ,25,000 7 ,25,000 0 926 6,7 1,350
15,00,000 7,50,000 50,000
-1
7, 0 857 6,42,750
.-,) 10,00,000 5,50,000 12,0a, 000 27, 50,000 13,75,00d- 13,7 5,000 0J94 1 0,91 ,750
PV 24,05, B5C
Present Value of Cash outflows under Buyingieorrowing

Alternative
', '{gar
1 /nst alment Pavr nent -__
Tax Adr.,Anlloo nn
l_-
ena Nel cash PV Tota; FV

" Principal Interest Total lnterest I orp,r-
outflow f actor
@1 6% payment I ciation at
B%
(Rs-/ (Rs ) (Rs / /Rs I (Rs ) lDn
l, \.)./
I
(Ks.l
1 10,00,000 7 ,44,000 17 ,,A4,000 3.52 000 4 ,00,000 9,52, 000- 0 926 g,B 1 ,55a_
I 17,00,900 5,44,000 22,4!,AA0 | 2,72,000 4,00,000 0 857
_1!,72,000 1 3,4 7 ,204
3 17,00,000 2,72,000 19.72.000 1 i6 nnn 4,00,c00 14,36,000 0 794 11 ,40,1 94
Salvaoe Vatue 0 794
I
I
G0,qqqqq) ,- ( 1 5,88,000)
I
PV 1 7, E0,940
3,8 )
57
I
"('XYZ Ltd is:in the business of manufacturing steel utensils. The firm is planning to diversify and add a new
productline.Thefirmeithercanbuytherequiredmachineryorgetitonlease',,.l':''
The machine can be purchased for Rs 15,00,000. It is expected to have a useful life of 5 years with a
salvage value of Rs 1,00,000 after the expiry of 5 years. The purchase can be financed by 20 per cent loan
repayable in 5 equal annual instalments (inclusive of interest) becoming. due at the end of each year.
Altematively, the machine can be taken on year-end le.ase rentals of Rs 4,50,00Q for 5,years. Advise the
company on the option it should choose. For your exercise, you may assume the following:
(i) The machine will constitute separ^te block for depreciation purposes. The company follows written
^
down value method of depreciation, the rate of depreciation being 2J per cent.
(ii) Tax rate is 35 per cent and cost of capital is 20 pef cent.
(iii) Lease rentals are to be paid at the end of the year.
(iv) Maintenance expenses estimated at Rs 30,000 per year are to be bome by the lessee.
_3,7
58
,nt
Solution
PV of Cash Outflows Under Leasing Alternative
*ffi Lease 'rent after 'taxes , [R(! -',t)J

, , fftr 4,50,00,0 (l 0.i5)1, ,,'
-
, PIffFA,,fit,'
:[2#/i:#,,
(I, * :
I,39A,'',
0,' 3.5)J,
trOffi
1-5 Rs 2,92,500 3.517 Rs 10,28,723
Borrowing/Buying Option:
Equivalent annual loan instalment - Rs 15,00,00AQi25 (PV'IFA for 5 years at 200/o r.e., 20,5) - Rs 5,01 ,505.
PV of Cash Outflows Under Buying Alternative
YeUi:endi:,LOAnt,.in;tSt
.',
ui', td i, N,e1,'eAy:hlbUtI,l PYIF at' '1, ; ',|tfu1al;;,
'Me'rE$'' ,,,,,13%1 ,,'. ,'
. :,1:,1.PV,,
fl''x ffi
T n6..,n.itff #:',
1 'F'" ,505 Rs
Rs 5,01 1 ,05,000 Rs 1,31,250 Rs 2,65,255 0.885 Rs 2,34,751
2 5,01,505 g0,gg5 99,437 3,12,173 0.783 2,44,431
3 5,0'1,505 73,969 73,828 3,53,709 0.693 2,45,120
4 5,01,505 53,656 55,37 1 3,92,478 0.613 2,40,599
5 5,01,505 29,114 41,529 4,30,963 gs4s 2,33,959
1 1,98;850
Less; PV of salvage value (Rs 1,00,000 x 0.543) -
,*9-1'3oq
[ess; PV of tax savings on short-ierm capital ]oss
(Rs 3,55,958.- Rs 1,00,000) x 0.35 = (Rs.89,585 x q$*.9) 48,645
i- ' E-t- <: 15}1!*,^iiE
-,,'-.t
Total 'qJ
o,95:9o6--.
Rroamendation
The company is advised to go for leasing as the PV of cash outflows under the leasing option is lower than
under the buylborrowing altemative.
Worklng notes
Schedule of Debt Payment
:Y;aAr,;ll Loan Laan 41, gfog;;',, ,' ;

,p;ffi "L@fu;rffiing.;r'
bfirt ,' ia*alrnent,' ol,:thiiier ,,,,t,"i,Intgtrest :' ; :
P+ih,ei l :,i'p:: 4O,' Afihi'jear.|
:r I i' ..:
;beginning'
,l :i,.;,,.,.,:,.
r',n:.!i,+:r;i (cal;.,3':';,: x ait : ial reBhyment ",, ;
(cal:: ^3"-,fo7,,.S),', ':,
.i.:$, d;ii"i.*
1 Rs 101,505 Rs 15100,000 Rs 3,00.,000 Rs 2,01,505 Rs 12,98,495
2 5,01 ,505 12\98495 2,59,,699 2,41,806 10,56,699
3 5,01,505 10,56,689 2,11,339 2,90,16f 7,66,522
4 5,01,505 7,66,522 1,53,304 3,48,201 4,19,321
5 5,01,505 4,18,321 83.1 84. 4,19,321
*Difference between the
loan instalment and loan outstanding.
Schedule of Depreciation
n;,;,rol .aafl
1 Rs 15,Q0,000 x 0.25 = Rs 3,75,000 Rs11,25,000
2 11,25,000 x 0.25'= 2,81,250 8,43,750
3 8,43,750 x 0.25 = 2,10,937 6,32,913
4 6,32,813 x 0.25 = 1,59,203 4,74,610
5 4,74$10 x 0.25 = 1,19,652 3,55,958
3, lr:
59
11,(i
'/ XYZ Builders Ltd need to acquire rhe use of a crane for their construction business, and are considering buying or
leasing a crane. The crane costs Rs 10,00,000, and is subiect to the straight line method of depreciation to a zeto salvage value
at the end of 5 yeais. In contrast, the lease rent is Rs 2,2O,OOO per year to be paid in advance each year for 5 years. XYZ
Builders Ltd can raise debt at 1.4 per cent payable in equal annual instalments, each instalment
*:"{b9}€gt$tgo_f-the year.
The company is in the 50 per cent tax bracket. Should it lease or buy the crane?
solutian
pv ofcash outflows under leasing arternative
0 Rs 2,20,000 Rs 2,20,000 1.000 Rs 2,20,000

14 2,20,000 Rs f ,fOpOO 1 ,10,000 3.387 3,72,570
5 1 ,10,000 (1 ,10,000) 0.713 (78,430)
5J4J40
3,ll
60
__roiUt at a time
Determination of interest and principal components of loan instalment
0
1
2
3
4
*Annual instalment of loan can be detennined by solving the following equation:
Loan instalment
I
4
Rs 10,00,000 :
?ol.gt4 12.914+ 1.0 (pV factor for making payment in, = 0)l
Loan instalmenr - Rs 10,00,000/3.974 -.Rs 2,55,,493
PV of cash outflows under buying alternative
Recommendatlon: The company is advised to opt for leasing as the total PV of cash outflows is lower
(R: 5J4,140) than rhar of the buying and borrowing option (Rs 5,89,902).
An industrial unit desires to acquire a diesel generating set costing Rs 20 lakh which has an economic life of 10 years at
TTT?6 tne .end of which the asset is not expected tg have any residual value. The unit is considering the altemative choices
(b) purchasing the outright by raising a loan.
of
(a) taking the machinery on lease, or asset
Lease payments (Rs 2,g5,90D are to be made in advance and the lessor requires the asset to be completely
amortised over
is useful period.
The cost of debt is worked out at 15 per cent per annum. The lender requires the loan to be re-paid in 10 equal annual
instalment becoming _&_et flS beginning of the first year. Average rate of income tax is 50 per cent. It is expected
that the
-3:
operating.o,s*o,,lffihod.Thefirmfollowsstraightlinemethodofdepreciationandthe
samr is accepted for tax purposes. As a'financial consultant, indicate what your advice will be.
Solution
3,lL
61
l-
I
I
I
I
I
Schedule of debt payment
I
,*-ffi
I
II ffiW
ao:*,i*,irdiui.E?6ld#S#${d&ffi;j
'
I ffiffi#X*
#ffif-?:;:::f,fifftrffiffiMFfl-sl$
I ffiH#SHitrXPSss
|
I 0 Rs 3,56,697* Rs 20,00,000 Rs 3,56,697 Rs 16,43,303
I r s,56,697 16,4s,sog Rs 2,62,928 93,769 15,49,s34
| 2 3,56,697 15,49,534 2,47,925 1,08,772 14,40,762
I 3 3,56,697 14,40,762 2,30,522 1,26,175 19,14,587
J + 9,56,697 1gJ45at 21o,9s4 1,46,36s 11,68,224
| 5 3,s6,697 1't,68,224 1,86,916 1,69,781 9,98,443
| 6 3,s6,697 9,98,443 1,s9,751 1,96,946 8,O1,4s7
I t s,s6,697 a,01,497 1,29,240 2,2a,4s1 s,7g,o4o
I I 3,56,697 5,73,040 91,686 2,65,011 3,08,029
|I 9 3,56,697 3,08,029 48,668 3,08,029
| *Annual instalment of loan Rs 20,00,000,/5.607,
= tlat is, 4.607 + 1.0 (rhe PV factor for making paymenr in 0 year) = Rs 3,56,697.
I
PV of cash outflows under
under buying alternative
I
I
lffiitre$$ffiffj,:,;,ijiffJxirfC0a,ta.oa'',,;;i:.141s""2,:.:.":"t",:-a,i,,',.j,j,:;,:6"'rrj,fY.g$ffi;
I ffi
1Wffi
,
I o Rs 3,s6,697 Rs 9,56,697 1.ooo Rs 3,s6,697

I
| 1 3,56,697 Rs 1,31,464 Rs 1,o0,OOo 1,zs,zss 0.926 1,1s,966

I 2 3,56,697 1,23,962 1,00,000 1,32,735 0.857 1:ts,754
| 3 3,56,697 1,1s,261 1,OO,OOO 1,41,436 0.794 1,12,300
I 4 3,56,697 1,05,167 1,00,000 1,s1,530 0.735 1,11,375
| 5 3,56,697 93,4s8 1,OO,OOO 1,63,239 0.681 1,11,166
I 6 9,s6,697 7s,B7s r,oo,ooo 1,16,822 o.6so 1,11,998
I t s,56,697 u,1zo 1,oo,ooo 1,92,ss7 0.583 1,12,272
I I 3,56,697 45,843 1,OO,OOO 2,10,854 0.540 1 ,13,86.1
I I 3,56,697 24,3U 1,00,000 2,32,363 O.sOo 1,16,181
| 10 - 1,00,000 (1 ,00,ooo) 0.463 (46,300)
I
I nmaaendadoa: The company is advised to go for leasing of diesel generating set as the PV of cash outflows under leasing
I _ - altemative is lower than that under buying altemative.
lT ll ; '/cent
+ Affa Ltd is thinking of installing a lomputer. Decide wherher the computer is to be purchased outright (rhrough l4 per
oorrowing) or to be acquired on lease rental basis. The company is in the 50 per cent tax bracket. The orher data available
|I are:
I
I Purchase of comput€r:
I
It Purchaso price: Rs 2O,OO,OOO
Annual maintenance, (to be paid in advance), Rs 50,000 per year
Expected economic usetul life, 6 years
Depreciation (for tax purposes), Straight line method
Salvage value: Rs 2,00,000
Leasing of computer:
Lease chargsg _(!o be peld in g{g1p_q}_ Be_1,50,9!0
r,iaintefinc;-pense1;-ne ilr* by ressor
Payment of Loan.' 6,year-end equal instalments of Rs 5,14;211
r" f \,
3. U
62
Soluti,on
PV of cash outflows under leasing alternative
:F#shrld:M:
Rs 2,00,000
2,00,000
*(Rs 4,50,000, lease rent in maintenance

- Rs 50,000 saving expenses).
Loan,,'il1,,tkg ,,,,,
,,be,&wniryt:t,, ; ,.
,6f itrfub:i!,e,afi
1 Rs 5,14,271 Rs 20,00,000 Rs 2,80,000 Rs 2,34,271 Rs 17,65,729

2 5,14,271 17,65,729 2,47,202 2,67,069 14,98,660
3 5,14,271 14,98,660 2,09,812 3,04,459 11,94,241
4 5,14,271 11,94,201 1,67,188 3,47,083 8,47,118
5 5,14,271 8,47 ,118 1 ,18,596 3,95,675 4,51,443
6 5,14,271 4,51,443 62,828 4,51,443
1 Rs 5,14,271 Rs 1,40,000 Rs 1,50,000 Rs 2,24,271 0.935 Rs 2,09,693

2 5,14,271 1,23,601 1,50,000 2,40,670 0.873 2,10,105
3 5,14,271 1 ,04,906 1,50,000 2,59,365 0.816 2,11,642
4 5,14,271 83,594 1 ,50,000 2,80,677 0.763 2,14,157
5 5,14,271 59,298 1 ,50,000 3,04,973 0.713 2,17,446
6 5 ,14,27 1 31,414 1 ,50,000 3,32,857 0.666 2,21,683
Present value of after-tax cash outflows 12,84,726

[ess; PV of salvage value (Rs 2,00,000 x 0.666) (1,33,200)
Net cash outflows under buying alternative 11,51,526
- fregonaendadori,; Computer should be acquired on lease basis.

Tl ABC Machine Tool Co*p"rry Lrd is considering the acquisition of a large equipment to set uP its factory in a backward
*'r' ,{ lr-
f"g-io., for Rs 12,00,000. The equipment is expected to have an economic useful life of 8 years. The equipment can be financed
either with an 8-year term loan at 14 per cent interest, repayable in equal instalments of Rs 2,58,676 per year, or by an
equivalent amount of lease rent per year. In both cases, payments are due at the end of the year. The equipment is subiect to
the straight line methocl of depreciation for tax purposes. Assuming no salvage value after the 8-year useful life and 50 per cent
tax rate, which of the financing altematives should it select?
Solution
$1
.l\
63
7
Determination of interest and principal components of loan instalment
1 Rs 2,58,676 Rs 12,00,000 Rs 1,68,000 Rs 90,676 Rs 1 1,09,324

2 2,59,676 11,09,324 1,55,305 1,03,371 10,05,953
3 2,59,676 10,05,953 1,40,933 1 ,17,943 8,88,1 1 0
4 2,59,676 8,88,110 1,24,335 1,34,341 7,53,769
5 2,59,676 7,53,769 1,05,529 1,53,149 6,00,621
6 2,59,676 6,00,621 94,097 1,74,599 4,26,032
7 2,59,676 4,26,032 59,644 1,99,032 2,27,0A0
I 2,59,676 2,27,000 31,676 2,27,000
1 Rs 2,58,676 Rs 84,000 Rs 75,000 Rs 99,676 0.935 Rs 93,197

2 2,59,676 77,652 75,000 1,06,024 0.873 92,559
3 2,59,676 70,416 75,000 3,260
1 ,1 0.816 92,420
4 2,59,676 62,167 75,000 1,21,509 0.763 92,711
5 2,59,676 52,764 75,000 1,30,912 0.713 93,340
6 2,59,676 42,043 75,000 1,41,633 0.666 94,329
7 2,59,676 29,822 75,000 1 ,53,954 0.623 95,851
8 2,59,676 15,939 75,000 1,67,939 0.582 97,682
7,52,099
*ecommendation: The borrowing (buying) alternative of financing the purchase of the large equipment should be selected.
3,[ )'
64
yq fo X tt Finance Manager of ABC Ltd, had almost decided to finance the purchase of Rs 20 lakh in new computer
'equiprnenr-'with "75 o/o long+erm debt when he was contacted by First Leasing Company Ltd. The nvmager of the leasing
company tried to convince Mr X that leasing the equipment would be more beneficial to ABC Ltd.
If . BCborrowed, the firm would be required to pay 15 per cent interest on the borrowed funds plus an annual sinking fund
payment of Rs 2,00,000. The equipmentlus an expected life of 10 years, with an anticipated salvage value of Rs 4,00,000. The
firrh uses. the straight line method of depreciation, and is in the 50 per cent tax bracket.
The leasing company is willing to lease the equipment for Rs 3,80,000 per year. Further, it was stressed that the lease
palments were fully tax deductible, while debt repayment was not.
Mr X seeks your advice before committing to lease the computer equipment. \7hat advise would you, as a financial
consultant, give to the finance managet of ABC Ltd?
Solution
PV of cash outflows under leasing alternative
1-10 Rs 1,90,000 6.710 Rs 12,74,900
J.f {
65
1 Rs 2,00,000 Rs 3,20,000 Rs 5,20,000 Rs 1,60,000 Rs 80,000..

iliirrriiililitlilil$
Rs 2,40,000 Rs
iitil:ul fil
2,80,000 0.926
irili t4,'.
Rs 2,59,280
.
2 2,00,000 2,88,000 4,99,000 1,44,000 90,000 2,24,000 2,64,000 0.g57 2,26,24g

3 2,00,000 2,56,000 4,56,000 1,2g,000 g0,000 2,08,000 2,49,000 0.794 1,96,912
4 2,00,000 2,24,000 4,24,000 1,12,000 90,000 1,92,000 2,32,000 0.735 1,70,520
5 2,00,000 1,92,000 3,92,000 96,000 90,000 1,76,000 2,16,000 0.691 1 ,47 ,096
6 2,00,000 1,60,000 3,60,000 90,000 90,000 1,60,000 2,00,000 0"630 1,26,000
7 2,00,000 1,28,000 3,29,000 64,000 90,000 1,44,000 1,94,000 0.593 1,07,272
I 2,00,000 96,000 2,96,000 49,000 90,000 1,29,000 1,69,000 0.540 90,720
I 2,00,000 64,000 2,64,000 32,000 90,000 1,12,000 1,52,000 0.500 76,000
10 2,00,000 32,000 2,32,000 16,000 e6'ooo
11 Salvage value
90,000
,i:33,333, 3 i33 ,,,33;133,
12J?,g16
* Interest is charged f the year.
* Depreciation : (Rs 20 lakh - Rs 4lakh) + 10 years : Rs 1,d0,000 x 0.50)
Recommendadon: Lease alternative is better.
ift;To
' "financial
Hypotheticar Limited is contemplating having an access to a machi
hine for a period of 5 years Discussions with various
institutions have shown that the company can have the use of rf machine for the stipulated period through leasing
arrangeinent, or the requisite amount can be borrowed at 1.4 per cent to buy the machine. The firm is in the 50 per cent tax
bracket. In case of leasing, the firm would be required to pay an annual end-of-year rent of Rs 1,20,000 for 5 years. All
maintenance, insurance and other costs are to be bome by the lessee.
In the case of purchase of the machine (which costs Rs 3,43,300, the firm would have a 14 o/o, 5-year loan, to be paid in 5
equal instalments, each instalment becoming due at the end of each year. The machine would be depreciated on a straight line
basis for tax purposes, with no salvage value.
Advise the company regarding the option it should go for, assuming lease rentals are paid (a) at the end of the year (b) in
advance.
Soluti,on
(a) PV of cash outflows under leasing alternative (year-end payment of lease rentals)
Rs 60,000 4.1 00 Rs 2,46,000

Determination of the interest and principal components of loan instalment
1 Rs 1;00,000. Rs 3,43,300 Rs 48,062 Rs 51,938 Rs 2,91 ,362

2 1,00,000 2,91,362 40,791 59,209
' 2,92,153
3 1,00,000 2,32,153 32,501 67,499 1,64,654
4 1,00,000 1,64,654 23,052 76,949 87,706
5 , 1,00,000 87,706 12,294 87,706
rDetermination of lout instabnenh Amount of loanlPMFA(L4,, = Ps
3,43,300/3.433 : Rs 1,00,000
66
7
I
PV of cash outflows after tax under buying (borrowing) alternative
1 Rs 1,00,000 Rs 24,031 Rs 34,330 Rs 41,639 0.935 Rs 38,932

2 1,00,000 20,395 34,330 45,275 0.873 39,525
3 1;00,000 16,250 34,330 49,420 0.816 40,327
4 1,00,000 11,526 34,330 54,144 0.763 41,312
5 1,00,000 6,147 34,330 59,523 0.713 42,440
m Total 2,02,536
Rqoaaeafudoa: Since the PV of cash outflows for buying,/borrowing (Rs 2,02,535) is lower than that of leasing
(Rs 2,46,000), the buying alternative is prefered.
(b) FV of cash outflows under leasing alternative, when lease rental is paid in advance
0 Rs 1,20,000 Rs 1,20,000 1.000 Rs 1,20,000

14 1,20,000 ns OO"OOO 60,000 3.387 2,03,220
5 60,000 (60,000) 0.713 (42,780)
:Rqil/o
Rrcommendatlon; Buying alternative is better.
,$*lg
67
\
IlL I Agrani Lrd. is in the business of manufacturing bearings. Some more product lines are being planned to be added to
..
. .. rhe existing s)'stem. The machinery required may be bought or may be taken on lease. The cost of machine is Rs 40,00,000
iravihg a uieful life of 5 years wittr the salvage value of Rs 8,00,000. The full purchase value of machine can be financed by 20
per cent loan repayable in five equal instalments falling due at the end of each year. Altematively, the machine can be procured
on a ! years lease, year-end lease rentals being Rs 12,00,000 per annum. The Company follows the written down value method
of depreciation at the rate of 25 per cent. Company's tax tare is 35 per cent and cost of capital is 16 per cent.
(i) Advise the company which option it should choose lease or borrow.
(ii) Assess the proposal from the lessor's point of view examining whether leasing the machine is financially viable at 14 per
. cent cost of capital (Detailed working notes should be given).
Solutian
(i) PV of cash outflows under leasing alternative
.1.l-nt'tr*#g.
PVIFA at li pef cent
fin.'iriffi
TasdX',,F8,
li#: ',
"' {2,0Ya'{l'"';:'
3 ',"'
1-5 Rs 7,80,000 3.517 Rs 27,43,260
(fi) Borrowing/Buying option

Equivalent annual loan instalment : Rs 40,00,000/2.991 (PVIFA for 5 years et 20 per cent) = Rs 73,37,345.
1 Rs 13,37,345 Rs 2,80,000 Rs 3,50,000 Rs 7,07,345 0.885 Rs 6,26,000

2 13,37,345 2,42,386 2,62,500 8,32,459 0.783 6,51 ,815
3 13,37,345 1,97 ,249 1,96,875 9,43,221 0.693 6,53,652
4 13,37,345 1,43,084 1,47,656 10,46,605 0.613 6,41,569
5 13,37,345 77,635 1,10,742 1 1,48,968 0.543 6,23,890
Total PV of cash outflows 31,9q926
Less.' PV of salvage value (Rs 8,00,000 x 0.543) 4,34,400
Less.' PV of tax savings on short-term capital loss (9,49,279 - 8,00,000) x 0.35 = (52,226 x 0.543) 28,358
NPV of cash outflows 2?,34,168
Working notes
':I4{1tn,,,, ,',, ,.'LiAfl,,At,'thg , , "., ,' -
.:'... "',.
',b '"',' :'
"'bnd"
., . : ..,t,:
'
,t i,tog qf' '

{*,tHres*
lt,
t,,,tfu,'r1gaf ,,' .""
"''
..1,
1 Rs 13,37,345 Rs 40,00,000 Rs 8,00,000 Rs 5,37,345 Rs 34,62,655

2 13,37,345 34,62,655 6,92,531 6,44,814 28,17,841
(Contd.\
j,11
68
(Contd.\
3 13,37,345 28,17,841 5,63,568 7,73,777 20,44,064
4 13,37,345 2A,44,064 4,08,813 9,28,532 1 1 ,1 5,532
5 13,37,345 1 1 ,1 5,532 2,21,813* 1 1 ,1 5,532
*Difference between loan instalment and loan outstanding.
Schedule of Depreciation
i::::r'::ir::
rt,t thbl
1 Rs 40,00,000 x 0.25 = Rs 10,00,000 Rs 30,00,000

2 30,00,000 x 0.25 = 7,50,000 22,50,000
3 22,50,000 x 0.25 = 5,62,500 16,87,500
4 16,87,500 x 0.25 = 4,21,875 12,65,625
5 12,65,625 x 0.25 = 3,16,406 9,49,219
Recommendatlon: The Company is advised to go for borrowing as the PV of cash outflows under borrowing option is
lower than under leasing alternative.
Assumption: The machine is sold after the expiry of its useful of 5 |ears; for this reason, the depreciation is charged in
5th year and there is no other asset in this block.
(ii) Determination of NPV of cash inflows
Lease rent Rs 12,00,000 Rs 12,00,000 Rs 12,00,000 Rs 12,00,000 Rs 12,00,000
[ess.' Depreciation 10,00,000 7,50,000 5,62,500 4,21,975 3,16,406

Earnings before taxes 2,00,000 4,50,000 6,37,500 ?,?g,125 8,83,594
Less: Taxes (0.35) 70,000 1,57,500 2,23,125 2,72,344 3,09,258
Earnings after taxes 1,30,000 2,92,500 4,14,375 5,05,781 5,74,336
Cash inflows after taxes 1130,000 10/2500 s/6€?5 9,27,656 8,90,742
(x) PV factor at (0.14) 0.877 0.769 0.675 0.592 0.519
Present value 9,91 ,010 9,01 ,682 6,59,391 5,49,172 4,62,295
Total PV of operating CFAT 34,63,550
Add: PV of salvage value of machine (8,00,000 x 0.519) 4,15,200
Add: PV of tax savings on short-term capital loss (52,226 x 0.519) 27,105
Gross PV 39,05,855
Less; Cost of machine 40,00,000
NPV (94,145)
Recommendation' It is not financially profitable to let out the machine on lease by the leasing Company, as NPV is negative.
Assumption: The- machine is to be sold after the expiry of 5 years. There is no other asset in the block of 25 per cent of the
lessee.
3, zo
69
,ra
l',
A
Roll No. : Total Printed Pases
' ftl
U
2M5103
rt
-
fd. B. A. (Sem. !!) (l'{air/Back) Examination, July - 2014
e
- M-2034 Financial Management
6l
Time:3 Hoursl [TotatMarks:70
[Min. Passing Marks:28
(1) TYte question. paper" is diuided in two sections.

(2) Tlwe are sections A and B. Section A contairus 6 questions out
of wh,ich the carudidate is required to attentpt any 4 questiotts.
Section B contain short case studS' / application based questions
uth,ich is compulsory,.
(3) All qu,estions are carcyirug equal marlzs.
Use of following supporting material is permitted during examination.
(Mentioned in form No. 205)
1. NIL
SECTION . A
1,1
,1" Discuss in detail the changing role of a finance manager in
v contemporary business environment. nn O R E g D L,)CAT 10 N
Puueef rvo &G+
q 9 aqcl ,qSb L
!^{
\*p7<laf,t
1-f
\.Jr
Explain the factors affecting dividend policy of a company.
7
,
tL./ _M A company produces and sells 10,000 units per annum.
The silling price per unit is Rs. 20 and the vari.able cost
per unit is 12. '-[he frxeC operating costs are Rs. 30,000.
Calcu1ate the operating leverage.
CtfT. sz-''-''':' ,* 7
(.3- !"ii'.ilf rr
2M5103r llffilllffililfillilltillilt1lililllill 1 IContd...

*2ff510Jr
l MCR€ rcucATloN
PcIru EET MORG
?{z1qsq53L
The capital structure of Raraa and cornpany is as follo*'s :
.Bs.
Retained earnings 10,00,000

9% preference shares G,s. 100 each) 5,00,000
12o/o debentures (Rs. 100 each) .......15.00.000_
50,00,000
The equity shares of the company sales for Rs. 30. It is expected
that the company wiII pay dividend of Rs. 3 per share this year.
Corporate tax rate is 35%. Assume 30% as income tax rate of
individual share holder. compute a weighted average cost of
capital 0 'ACC) of existing capital structure).
t4
(a) What are the motives and advantages of mergers and
acquisitions ?
&) Write a short note on venture capital concept.

7
-/t
,V.{r/ A manager of XYZ company is considering three projects u,hich

',n-- are not at all mutually connected and any of them independentll,
be selected. The company has necessary funds, but can not take
up more than one project. The overall cost of capital of the
company is 10% and expected cash flows from the projects are
given below :
Cash flows (Income)

ear
(Rs.)
/" *r+
I
q,1',
r.. - A 3,000 I
"?
t.oqc;1 B | 1o,ooo
';,ffi
,!
|
'i."1
" -l)L-; IJ i7.-
i C 4,(po |
You are requisted to advise the management as to which project
they should take up. Give reasons for your advice. Ose profitability
index method.) .a
12+2=14
2M5103r lfitiiljlllHtfilltffii][illntqilil[Et 2 [Contd...

(a) z Ltd,. intends to invest Rs. 1b,000 per annunl at the end.
of years 5,6, 7 and 8 at
a, annuar interest rate of 1z%. Find
out the present value of the d.eferred annuity payments.
at 9% compounded annuall5,.
)00 for , ,"rrl
M O RE 6DUCA -n O,U
" Fer
- B qr;L'lct
sECrroN
ruee r 5
nn oRE-
sqs3b
From the following information about a manufacturing company,
compute the operational cycle period and the *o.ki.rg capitai
required :
Period covered B6b days
Average total of debtors outstanding ............... Rs. Z,4l,Ag5

Raw material consumption Rs. 22,00,000
Total production cost Rs. 50,00,000
Total cost of sales Rs. 52,50,000
Sales for the year ....... ...... Rs. g0,00,000
Value of average stock maintained :
Rs. 1,62,740
Work-in-progress ...... Rs. 1,78,080
Finished goods
t4
2M5r03r ilililt]lltllil]llltl]ilillil[ililffit 3 2680

RoilNo.lqftB]/x[52 Total No of Pages: p]
CN
o
t-{
2M5103
rn
M. B. A. II Sem. (Main / Back) Exam., July-August 20ls
M-203 A Financial Management
N
=
Time: 3 Hours Maximum Marks: 70

Min. Passing Marks: 28
Instructions to Candidates :
(i) The question paper is divided in two sections.
(ii) There are sections A & B. Section A contains 6 questions out of
which the candidate is required to attempt any 4 questions.
section B contains short case study / application based question
-. ' t'\
which is compulsory. T 'L'"
(iii) All questions carry equal marks.

1. NIL 2. NIL
SECTION.A
"It is advantageous to decentralize accounting function while finance function
J Q,l should
ff il *r,;{':/.1 "r,1-rp x
be centralized." Comment.
f+ 1:gii U4)
Write shorr nores on the following
_yl :
q tS{i11.*ii j
(a) Venture Capital Jii::
(b) Global Depository Receipts (GDR)
(c) Hire Purchase
Project Financing
/@) l4x3Yz=141
y'z 1at "Cash flows at different point of time are not comparable". Comment on this
// statement.
I6l
(b) Find out the present value of Rs. 1,00,000 to be required after 4 years if the
interest rate is 6Vo P.a.
[! "' < t8l
t \j?'
[2Ms103] Page 1 of3 i
l278ol
Q. 4 The capital structure of Wye Ltd. is as under-
Rs.
2,000 6Vo debenture of Rs. 100 each (first issue) 2,00,000
1,000 77o Debenture of Rs 100 each (Second issue) 1,00,000
2,000 87o Cumulative Preference Shares of Rs.100 2,00,000

each
4,000 Equity share of Rs. 100 each 4,00,000
Retained earnings 1,00,000
The earning per share of the company in the past many years has been Rs. 15. The
shares of the company are sold in the market at book value. The company's tax rate is
50Vo and share holder's personal tax liability is 107o.
Find out the Weighted Average Cost of Capital. t14l

Q.5 Form the following information, extracted from the books of a manufacturing
company, compute the operating cycle period in days - - .-...e-a.r*!-i-?
Particulars Balance as at 31.3.13 (Rs.) Balance as at 31.3.14 (Rs.)

Raw material 1,10,000 1,50,000
Working progress 45,000 60.000
Finished goods e0,2s0 HC F L, i il u ii1.50.000
{1'756 '
Debtors l'20'ooo & d., <i tr q
Creditors 40,000 i** I' \r1 ! 36 +s,ooo
Purchase of material 7,70,000
Wages 3,30,000
Manufacturing Expenses 232,500
Administration Expenses 1,36,000
Selling and distribution 83,000
expenses
Sales - 16,42,500
(i) Purchase of material includes cash purchases of Rs.1,49,500.
(ii) All goods are sold for credit. t14l
y'e Vnut is meant by the term "leverage"? How would you compute the degree of
L-/ operating and financial leverage? Explain with suitable example. t14I
[2Ms103] Page 2 of3 127801

SECTION.B
Q.7 A Company has an investment opportunity costing Rs. 80,000 with the following
expected net cash flow after taxes and before depreciation- tl4l
Rs.
First five years 14,000 per year
6'h year F t*€{g f 0 LJ {$. 'l"t *U 16,000
''ru*
7ffvear ^
Qfttrt{4E:'*
20,000
8thyear 30,000
9th year 20,000
1Oth year 8,000
Using ll%o as the cost of capital, determine the following-

(a) Pay-back period
(b) Average rate of return
(c) Net present value at 107o discount factor.
(d) Internal rate of return with the help lOVo and t5%o discount factor.
Discount factors
@ll%o @157o
Year
I 0.909 0.870
2 0.826 0.756
3 0.751 0.658
4 0.683 0.572
5 0.621 0.497
6 0.564 0.432
7 0.513 0.376
8 0.467 0.327
9 0.424 0.284
l0 0.386 o.247
[2Ms103] Page 3 of3 l278ol

Roll No. Total fuo of pages: E
2M5103
M'B'A'IilT#' (Mai;n lBack) Exam., June-July 2016
A Financial ilIanagement

Instrutcti ons to Candidate s :
(i) The question paper is divided in two sections. ,
(ii) There are sections A & B. Section A contains 6 questions out of

which the candidate is required to attempt any 4 quistions.
Section B contains short case study / application based question
which is compulsory.
(iii) Ali questions carry equal mnrlcs.
SECTION IA
on the changing role of finance manager m contemporary business
environment. : ll41
Q. 2 Bfefty explain and illustrate the concept of time value money. u4)
Q. 3 The following information is available in respect of a firm: t t4l
' Capitalization Rate 1K; = 16
Earning per Share (E) = t 1O

Assume rate of return on investment
'
l2u5t 03l Page I of 4 [2Bool
a
r: (i) 15 (ii) 8 (iii) 10
Show the effect of dividend policy on the market price of shares using Walter's model.
Q. 4 Distiqguish between
(a) Gross Working Capital and Net working Capital 17)
(b) Production and Operating Cycle t7.l
Q. 5 From the fotlowing financial data of A industries Ltd. Calculate t14l
(a) Rate of return on original investrirent
(b) Rate of return on average investment
Particular Machine A Machine B Sr,b

Capital Outlay 3,25,000
Sales Revenue 4,00,000 cr, cerYr

-'P'\"d
Variable Cost 50% of Sziles 50Vo of Sales Ld
c$4T'' ,Dlb,_ r,:
Average Fixed Cost < 50,000 \_v , -
w\t ,*-*
#W
(Other than Depreciation)
Estimated Life
Estimated Scrap Value

8 Years 6 Years
\-{:[&.'
Additional Information :
BSde-
(i) Depreciation is-provided on Straight Line Method
(ii) Taxation is to be charged at 50Vo.
[zMs103] Page 2 of 4 [280ol

Q. 6 A ltd. has obtained data concerning the average working capital cycle of 95 days for
other companies in the same industry as under. ' ll4]

Raw Material Stock Turnover 20 Days
Credit Received 40 Days

&o
Lt@
Work in Progress Turnover 15 Days 36r
Finished goods stock Turnover 40 Days
Debtor's Collection Period 60 Days
Usrng the following data calculate the working capital cycle of A ltd.
(t in 000)
Sales 1 500. ts-rrd- g'!fu)

'st of Production 1050 cae'bH{ 7bed4 }o-|.el^
Purchases 300" ' 0#(@

Average Raw Material Stock 40 n- i- .l_)
Average Work in Progress 43
-tAF Average Finished Goods 90
Average Creditors 45
Averuge Debtors t75 t'

i
?\
1
? !
'i. l '.i
a\ \1. '',i\
;. r l}
.i
Page 3 of 4 '
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SECTION
I
-B 3
I
i
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6
';
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I
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a./ V ltd has the following capital structure on 31" March2,016' t14I
Equity Share (40000 Shares) i;'
LUVo Preference Share t"p < 5,oo,ooo l

,#' s,
F L'
.!
;. !tr*l
{-
i a-- 1
L4Vo Debenture +: l? 15,00,000
The compan5l's share is currently seU.ing at ( 20. f.{ext year's expected dividend is the
l'r\, ( i'+
< Z peikaie that will g.o* ut 6%. Thecompany is in the tax bracket at 50Vo
(i) Weighted average cost of capital of the company on the existing capital structure.
(ii) New weighted average. cost* of capital if the company raises an additional
< 10,00,000 debt by issuing .l|Vo Debenture. This will increase the existing
dividend by { I but leave growth rate unchangedand the price of share will fall
I
to t 16. ./ lo
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[2Ms 103] [2Bool

VIDEO AVAILABLE FOR
WWW.MOREEDUCATION.IN ALL PRACTICAL & THEORY SUBJECT RTU MBA CLASSES SINCE 2005
MORE EDUCATION 9829959536
JAIPUR-VIDHYADHAR NAGAR 418 MANSAROVAR PLAZA PRATAP NAGAR

VIDEO AVAILABLE FOR

VIDEO AVAILABLE FOR

VIDEO AVAILABLE FOR

VIDEO AVAILABLE FOR
Rott No. 6 O (/ * Total No of Fages= p

(Y)
c)
Exam., May r 20tB
F{ M.B.A. Ir-sem
m d#rt-t*l)
Nr-203A Financial Management
E -
N
i\Iin. Passing IVIarks: 28
Instntctions to Cantiidates :
(i) The question pape:r is divided in tw,o sections.
(ii) There are sections A & B. Section A contains 6 questions
out of which the
candidate is required to attempt any 4 questionts-. Section
B coitains short
case study / application based question ilrtrn is compulsory.
(iii) All questiory carry equal mnrks.
1. NIL 2. NIL
tru.qqp*A=,
SECTION -A
gV'ne MORE EDUCATION
profit maximisation 9829959536
is not an operationally feasible criterion.,,Do you agree?
Illushate your views.

u4)
(a) Distinguish between Nominal rate of interest and Effective
7 O) What are the steps involved in a venture capital investment

rate of interest.
process? Explain
' them briefly. [4+lo=14]
Q'3 A plastic manufacturer lras under consideration the proposal of production of high
quality plastic glasses. The necessary equipment to

manufacture the glasses would cost
< 1 lakh and would last 5 years. The tax relevant

rate of depreciation is 25 percent on
[2Ms 103] Page L of 4 [30001
G--
--Z-

VIDEO AVAILABLE FOR
WWW.MOREEDUCATION.IN ALL PRACTICAL & THEORY SUBJECT ( o)tz(L RTU MBA /' "to SINCE
,l-fCLASSES 6 2005
5..l bv
o looog
written down value. There is no other asset in this block. The expected salvage value is
manufacturer will incur cash cost of < 25,000 each year if the project is undertaken.
The overhead costs alloiated to this new line would be { 5,000. The variable costs are
estimated at72 per glass. The manufacturer estimates it will sell about 75,000 glasses
per year, the tax rate is 35 percent. Should the proposed equipment be purchased?
Assume 20 percent cost of capital and additional working capital requirement,'
<50,000. t14l
Q.4 A company has to'acquire a new car for the use of its Chief Executive Officer for 5
years. It can be acquired in either of the two ways. It can be purchased outright for
< 3,00,000 with a bank loan with 16%o interest payable annually, and the principal
repayable in fuIl at the end of the 5 years. The car will have a resale value of

< 1,00,000. Alternatively, the car could be leased for 5 years, the annrral rental being
Rs. 90,000 payable at the beginning of each year. The company pays 50 percent tax or
its income and uses the straight - line depreciation method. ll4l
.2
(a) Using the present value mcthod, evaluate the alternative proposals.
(b) Evaluate the above proposals from the point of view of the loss or, assuming:
(i) Required rate of l2Lo.
(ii) Straight line method of depreciation, and
(iii) Salvage value of Rs 1,00,000 after 5 years.
[2Mst03] Page 2 of 4 [3oool

VIDEO AVAILABLE FOR
Describe in brief the various factors which are taken into account in determining
the working capital needs of a fi.rm. [8+6=14]

,/
What are the differences between forward and futures contract.
.P
The following informatibn is provided related to the acquiring firm A Ltd. and the
target firm T Ltd. lL4l
Particulars Firm A Firm T
EAT ({Lakhs) 1,000 200
Number of shares outstanding (in lakhs) 100 50
EPS (<) 10 4
)v&d e zo
PIE ratio (Times) 10 5
z/,)5 !'!-,
lhlr*t-:
MPS (<) 100 20
,k
ru>l(o
, 1
(a), What is the swap ratio based on current market prices? ,
LtS Lo"q/
(b) What is the EPS of A Ltd after acquisition? /-t V:

/.{ ilt4illrvrfu >2?o
(c) What is the expected market price per share (MPS) of A Ltd. after acquisition,
Deterufne the market value of the merged firm
Calculate gain4oss for shareholders of the two independent companies, after
acquisition.
lzus1o3l Page 3 of4 [3000]

- -T-ry"lF::-.
VIDEO AVAILABLE FOR

i
I
SECTION-B
Cas95tudy-
-"
/-
The fotlowing facts relates to rhe Exide Indusries Lrd. (EIL):
/l
(a) Annual credit turnover in the'current financial year, ( 1200lakhs;
(b) Average collection perio d, 75 day*;
(c) Variable costruao,A3l *

(d) -
Cost of funds 0.21 per annum
\-
(e) Annual credit and Collection expenditure, Rs. 20 Lakhs of which three - fourth is
\.---
avoidable; 'L
(0 Bad debts 1 percent of sales.
The Foremost Factors Ltd. offers a factoring deal to the EIL. It

.\ ..,B* -*
t"k
'-rd.)+'.+< --h-{+-{rl&rE'-:.
charge a commission as percentasr of the value of book debts of 2 percent for

recourse factoring *d=3.:tg.eiht for non-recourse factoring. In addition, it
would charge 22 prcent per innum as discounUinterest for prepayments
(advance against uncollected and rbt due receivables) to the extent of 80 percent
gf the value of receivables. The guaranteed payment date/collection period is 60
days. 'r
What advice would you give to EIL to continue with the in-house management of
receivables or accept the factoring irrangement? u4l
[2Ms103] Page 4 of4 [30001

Roll No. 18 NFt -rxi 6 oZ TotalNoofPages: tr
2M5103
M.B.A. II - Sem. (Main & Back) Exam., May - 2019
M -203 A Financial Management

tr nstructions to Candidate s :
(i) The question paper is divided in two sec:tions.
(ii) There are sections A & B. Section A contains 6 questions out of which the
candidate is required to attempt any 4 questions. Section B contains short
case study / application based question which is compulsory.

(iii) All questions carry equal marks.
I. NIL 2. NIL
SECTION -A
Q.l.t'ln today's corporate scenario, wealth maximization objective has become more
,/
relevant". FXucidate.
l,t4l
Q/Wfite notes on the following-
(a> Venture capital finance

I4l
(
(b) Derivatives
t3l
(c) Mergers and Acquisitions
t3l
/
@) Concept of risk and return of a signal asset
t4l
[2Ms103] Page 1 of4 [1e801

UI
Q.3 (a) Explain factors affecting dividend policy decisions.
(b)Different sources of capital and methods of calculating them. t7l
XyZLtd. has given you the following estimates for calculating working capital on the
basis of net assets method and you are instructed to add l07o to your computed figure
+^ -llnrrr fnr
to allow for nnnfinoennies
contingencies. [14]
Particulars Amount for

theyear(t)
(i) Stocks of finished Products 5,000
(ii) Stocks of stores and materials 8,000
2. Average credit given:

(i) Inland debtors, 6 week's credit 3,12,000
(ii) Exports, 1.5 weeks credit 78,000
E. nverage time lag in payment of wages and other

outgoings:
(i) Wages, 1.5 weeks 2,60,000
(ii) Stocks and materials, 1.5 months 48,000
(iii) Rent and royalties, 6 months 10,000
(iv) Clerical staff, 0.5 month 62,400
(v) Manager,0.5 month 4,800
(vi) Miscellaneous expenses, 1.5 months 48,000
4. Pavment in advance:
Sundry expenses (paid quarterly in advance) 8,000
1i)
(ii) Undrawn profits on an average throughout the r 1.000
Yeaf
Calculate working capital required for the company and show your calculations'
Page? of 4 [1e801
[2Mst03]
Q.5 The selected financial data for A, B and C companies for the current year ended March
31 are as follows- t14l
Particulars A B c
Variable expenses as 66.61 75 50
percentage of sales
lnterest expenses ({ ) 200 300 1,000
Degree of operating leverage 5 6 2
a
Degree of financial leveragd J 4 2
Income tax rate 357a 35Va 357o
Prepare income statements for A, B and C companies.

{.t
Q.6 (+ If you invest ( 2,000 in a bank deposit and the bank offers you 87o interest rate
per annum compounded on quarterly basis, how much you investment value will
ttt
be after two years? trl
(b>" If you invest t 1,000 every month in a recurring deposit at llVo interest rate
compounded monthly, what will be the value your investment after one year? [4]
(c) The future value of an investment is { 10,000 after three years. Calculate its
rat
present'value if the discounted rate is 6Vo. LJJ
6 Calculate EMI of a loan amount of { 1,00,000 with interest rate of lU%a per annum
and tenure of loan is of 5 years. tll
[2Ms1o3] Page 3 of4 [1e80]

SECTION. B
Case Studv
Q'7 A company is considering an investment proposal to invest in a plant at a cost of
t 50,000' The facility has a life expectancy of 5 years and no salvage

value. The tax rate
is 357o' Assume the firm uses straight line method of depreciation and
the same is
allowed for tax purposds. The estimated cash flows before depreciation
and tax
(CFBDT) from the investment proposal are as follows:
r,r4)
Year CFBDT
I
t 10,000
2 r0,692
3 t2,769
4 13,462
5 20,395
Compute average rate of return, payback period, net present value

and internal rate of
return ofthe project ifdiscount rate is l0To.
[2Ms103] Page 4 of 4
[1e801

MANAGEMENT AND CORPORATE FINANCE (Final)

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CHAPTER 1 FINANCIAL MANAGEMENT

TRADITIONAL APPROACH OF FINANCE FUNCTION

MODERN APPROACH OF FINANCE FUNCTION

Financing Decisions Investment Decisions Dividend Decisions

Capital Structure Working Capital Capital Expenditure Current Assets or

GOALS OR OBJECTIVES OF FINANCIAL MANAGEMENT [YEAR 2011]

FUNCTIONS OF CHIEF FINANCIAL OFFICER [YEAR 2013]

The functions of financial manager are:

(vi) Disposal of profit or surplus: Financial manager should decide:

Importance of financial Plan & Policy

Ans: Yes, sound financial management is a key to progress for corporations.

Financial management helps the corporations by the following functions:

Importance of Financial Management

CHAPTER 2 TIME VALUE OF MONEY

Q Explain the relevance of time value of money in financial decisions.

FUTURE VALUE AND COMPOUNDING

Future value of a single cash flow

INTRA YEAR COMPOUNDING

FUTURE VALUE OF MULTIPLE CASH FLOWS AND DIFFERENT CASH FLOW

Beginning of Amount Number of years Compounded Future value (`)

(ii) Calculation of future values

End of the Amount Number of years Compounded Future value (`)

FUTURE VALUE OF AN ANNUITY

Where, FVAn = Accumulation at the end of ‘n’ years

Now, A = ` 5000, r = 5% and n = 5

FVA 5 = ` 5000 (FVIFA 5%, 5 years)

The accumulated sum at the end of 14 years will be:

(FVIFA 12%, 5 years) = (1 + 0.12)5-1

PRESENT VALUE AND DISCOUNTING OF A SINGLE CASH FLOW

INTRA YEAR DISCOUNTING

(b)When discounting is made quarterly

PRESENT VALUE OF MULTIPLE CASH FLOWS

Year Net Cash flow (`)

PRESENT VALUE OF AN ANNUITY

Leasing Loan Installment

A x PVIFA 12%, 5 = ` 500000

PVA 10 = ` 250000 x PVIFA 10%, 10

CHAPTER 3 CAPITAL BUDGETING

OBJECTIVES OF CAPITAL BUDGETING

PAY BACK PERIOD METHOD

(i) When annual cash inflows are equal

Pay back period = Initial Investments or I

(i) Cost of the machines ` 300000

(ii) When annual cash inflows are unequal

IMPROVEMENTS IN PAY BACK PERIOD

(i) POST PAY BACK PROFITABILITY

Initial outlay 100000

Estimated life 8 years

Particulars Machine A Machine B

Estimated savings in direct wages:

(ii) PAY BACK RECIPROCALS

Pay back reciprocals = 1 x 100

ARR =Average annual income after tax & depreciation x 100

Particulars Machine X Machine Y

Earnings (after tax):