CHAPTER: 1

NATURE OF FINANCIAL MANAGEMENT

Q.1. Define the scope of financial management. What role should the financial manager play in a
modern enterprise?
A.1. The scope of the financial management is to secure the capital needed by the enterprise, and
employ it in production and marketing activities, in such a way that it can generate the sufficient
returns on invested capital, with an intention to maximise the wealth of the owners.
The financial manager plays the crucial role in the modern enterprise by supporting investment
decision, financing decision, and also the profit distribution decision. He/she also helps the firm in
balancing cash inflows and cash outflows, and in turn to maintain the liquidity position of the firm.

Q.2. How does the modern financial manager differ from the traditional financial manager? Does the
modern financial manager's role differ for the large diversified firm and the small to medium size
firm?
A.2. The traditional financial manager was generally involved in the regular finance activities, e.g.,
banking operations, record keeping, management of the cash flow on an regular basis, and
informing the funds requirements to the top management, etc. But, the role of financial manager
has been enhanced in the today's environment; he/she takes an active role in financing, investment,
distribution of profits, and liquidity decisions. In addition, he/she is also involved in the custody
and safeguarding of financial and physical assets, efficient allocation of funds, etc.
The role of financial manager in case of diversified firm is more complicated in comparison with a
small and medium size firm. A diversified firm has several products and divisions and varied
financial needs. The conflicting interests of divisional managers make the work of financial
manager quite difficult in a diversified firm.

Q.3. "…the function of financial management is to review and control decisions to commit or
recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial management
is directly concerned with production, marketing and other functions within an enterprise
whenever decisions are made about the acquisition or destruction of assets" (Ezra Solomon).
Elucidate.
A.3. All functions – production, marketing etc.- require finances. The financial manager supports other
functional managers and top management to deploy the scarce resources, in such operating
activities that can generate the sufficient level of return to the firm. This gives rise to the need of
proper, efficient and effective utilisation of resources. In modern era, financial manager achieves
this by providing support for operating decisions. He also helps in planning and implementing
sound financial procedures and systems.

Q.4. What are the basic financial decisions? How do they involve risk-return trade-off?
A.4. The basic financial decisions include long-term investment decision, capital structure decision,
(i.e., financing decision), profit allocation decision (i.e., dividend distribution decision), and
liquidity decision. Each and every investment decision would yield benefits in future. To evaluate
the investment criteria, the firm will estimate the future profitability, and probable rate of return

1
 on proposed investment, and compare the same with the cut-off rate (i.e., the generally accepted
minimum level of return on investment). Because of uncertain future, investment decisions involve
risk. An investor will expect higher return from an investment if risk is high. For a lower risk
investment, the expected return will be lower. This is referred to the risk-return trade-off. The
financial decisions jointly affect the market value of shares by influencing the return and risk of the
firm.

Q.5. "The profit maximisation is not an operationally feasible criterion". Do you agree? Illustrate your
views.
A.5. The profit maximisation concept does not specify clearly whether it mean short or long-term
profit, or profit before tax or after tax. In addition, in the free economy and perfect competition,
businessmen pursue their own interests to maximise the profit by utilisation of resources in the
efficient and effective way.
Let us assume that the maximising the profit means maximising profit after tax, i.e., net profit as
reported by income statement of the business firm. It should be understood that this would not
maximise the welfare of the owners if some short-term actions were taken to improve profit. For
example, the manager may sell some of the assets and then invest funds in low-yielding assets.
The profit after taxes would go up in the short-term but the long-term profitability will suffer.

Q.6. In what ways is the wealth maximising objective superior to the profit maximisation objective?
Explain.
A.6. The wealth maximising objective means maximising the net present value, i.e., wealth of the
owner. The net wealth of the owner is the difference between the present value of its benefits and
the present value of its costs. Any action that has a positive NPV creates wealth for the owner.
The profit maximising objective tries to maximise the profit after tax, i.e., net profit, which in the
long term may reduce the net worth of the owner. (This is explained in answer no. 5). The profit
maximisation concept basically ignores the time value of money and the risk involved in firm's
activities, which are very well taken care by wealth maximisation concept.

Q.7. "The basic rationale for the objective of wealth maximisation is that it reflects the most
efficient use of society's economic resources and thus leads to a maximisation of society's
economic wealth" (Ezra Solomon). Comment critically.
A.7. The shareholder wealth will be maximised only when customers are satisfied and workers are well
paid so that they work in the interest of customers. The wealth maximisation motivates
entrepreneurs to produce goods and services by efficient allocation of resources. This in turn will
maximise the net present value of society.

Q.8. How should the finance function of an enterprise be organised? What functions do the financial
officers perform?
A.8. The finance function of a firm is generally headed by the Incharge of Finance Department, who
may be known as Director of Finance or President (Finance) or General Manager (Finance),
etc.depending on the structure and size of the firm. As the ultimate responsibility of top
management to take crucial decision for the survival of the firm and to maintain the solvency of
the firm, the head of finance department reports to the Chairman and Managing Director of the
company, and he will be one of the executive members of the Board of Directors.

2
 The finance officer will function as treasurer and controller. As a treasurer, he will look after
efficient and effective funds management, while as a controller, he will look after the operational
requirements of the firm.

Q.9. Should the titles of controller and treasurer be adopted under Indian context? Would you like to
modify their functions in view of the company practices in India? Justify your opinion.
A.9. The title of controller and treasurer is not being widely followed in India. In India, generally the
officer designated as Financial Controller performs the functions of chief accountant and
management accountant. In India, the title of the finance head is generally Finance Manager
who is involved in the management of company's funds.

Q.10. When can a conflict arise between shareholders and managers goals? How does wealth
maximisation goal take care of this conflict?
A.10. The company is a complex organisation of various interested stakeholders like owners,
employees, creditors, customers and government, etc. It should be the endeavour of the
management to reconcile the objectives of the different stakeholders. Shareholders are principals
and managers are their agents. Managers may not necessarily work in the interest of shareholders.
They may work in their self-interest and appropriate company funds in the form of higher perks
and salaries. To control managers’ actions, shareholders will have to incur monitoring costs. To
minimise the conflict, managers should be given incentives to become owners along with
shareholders (through stock options).
Since shareholders get their wealth only when the firm has created value for customers and kept
the employees satisfied, the wealth maximisation is generally in harmony with the interests of al
stakeholders. It is also consistent with the management objective of survival.

3
 CHAPTER 4

RISK AND RETURN

Q-1 What is a return? Explain the components of (total) return? Should unrealised
capital gain (or loss) be included in the calculations of returns?
A-1 Return can be defined as excess over initial investment earned over a period of
time. Return can be calculated in terms of rupee return and/or percentage return.
Return can be calculated for both real and financial assets. In case of shares, rate
of return would consist of dividend yield and capital gain yield. Note that the
unrealised capital gain (or loss) is included in the calculation of return.

Q-2 Illustrate the computation of the expected rate of return of an asset.

A-2 The expected rate of return [E (R)] is the sum of the product of each outcome
(return) and its associated probability:
Expected rate of return = Rate of return under scenario 1 ´ probability of scenario 1
+ rate of return under scenario 2 ´ probability of scenario 2 +…
+ rate of return under scenario n ´ probability of scenario n

Economic Expected Rate of

Conditions Rate of Return (%) Probability Return (%)
(1) (2) (3) (4) = (2) (4)
Growth 18.5 0.25 4.63
Expansion 10.5 0.25 2.62
Stagnation 1.0 0.25 0.25
Decline – 6.0 0.25 – 1.50
1.00 6.00

Q-3 Define holding-period return. How is it calculated?

A-3 Investors may hold their investment in shares for longer periods than for one year.
Suppose you invest Rs 1 today in a company’s share for five years. The rates of
return are 18 percent, 9 percent, 0 percent, - 10 percent and 14 percent. What is
the worth of your shares? You hold the share for five years; hence, you can
calculate the worth of your investment assuming that each year dividends from
the previous year are reinvested in shares. The worth of your investment after five
years is:

Investment worth after five years = (1 + 0.18 ) ´ (1 + 0.09 ) ´ (1 + 0.0 ) ´ (1 - 0.10 ) ´ (1 + 0.14 )
= 1.18 ´ 1.09 ´ 1.00 ´ 0.90 ´ 1.14
= Rs 1.32

Your one rupee investment has grown to Rs 1.32 at the end of five years. Thus
your total return is: 1.32 – 1 = 0.32 or 32 percent. Your total return is a five-year
holding-period return. The compound annual rate of return is as follows:

1
 Compound annual rate of return = 5 1.18 ´ 1.09 ´ 1.00 ´ 0.90 ´ 1.14 - 1
= 1.057 - 1 = 0.057 or 5.7%

Q-4 What is risk? How can risk of a security be calculated? Explain your answer with
the help of an example.
A-4 Risk of returns is the variability in rates of return. The variability of rates of return
may be defined as the extent of the deviations (or dispersion) of individual rates
of return from the average rate of return. There are two measures of this
dispersion: variance or standard deviation. Standard deviation is the square root of
variance.
The formulae calculating variance and standard deviation of historical rates of
return of a share as follows:

( )
2
1 n
s =
2
å Rt - R
n - 1 t =1

( )
2
1 n
s= s = 2
å Rt -R
n - 1 t =1
The share of Hypothetical Company Limited has the following anticipated returns
with associated probabilities:
Return (%) -20 -10 10 15 20 25
Probability 0.05 0.10 0.20 0.25 0.20 0.15
The risk, measured in terms of variance and standard deviation, is:

s 2 = ( -20 - 13) 2 ´ 0.05 + ( -10 - 13) 2 ´ 0.10 + (10 - 13) 2 ´ 0.20 + (15 - 13) 2 ´ 0.25
+ ( 20 - 13) 2 ´ 0.20 + (25 - 13) 2 ´ 0.15 + (30 - 13) 2 ´ 0.05 = 156
s = 156 = 12.49%
The expected rate of return is:
E (R ) = -20 ´ 0.05 + -10 ´ 0.10 + -10 ´ 0.20 + 15 ´ 0.25 + 20 ´ 0.20 + 25 ´ 0.15 + 30 ´ 0.05 = 13%

Q-5 What is a risk-free security? What is risk premium? How can it be estimated from
historical data?
A-5 A risk free security is a security which is free from risk of default and the
variability on its returns is the lowest. The 28-year average return on the stock
market (Sensex) is higher by 8.76 per cent in comparison with the average return
on the long-term government bonds for the same period in India. This excess
return is a compensation for the higher risk of the return on the stock market; it is
commonly referred to as risk premium.

Q-6 What is a normal distribution? How does it help to interpret standard deviation?
A-6 The normal distribution is a smooth, symmetric, continuous, bell-shaped curve.
The distribution is neither skewed nor peaked. The spread of the normal

2
distribution is characterised by the standard deviation. It is useful to notice certain
properties of a normal distribution.
· The area under the curve sums to1.
· The curve reaches its maximum at the expected value (mean) of the
distribution and one-half of the area lies on either side of the mean.
· Approximately 50 per cent of the area lies within ± 0.67 standard deviations
of the expected value; about 68 per cent of the area lies within ± 1.0 standard
deviations of the expected value; 95 per cent of the area lies within ± 1.96
standard deviation of the expected value and 99 percent of the area lies within
± 3.0 standard deviations of the expected value.

3
 CHAPTER 2

VALUE & RETURN

Q-1 ‘Generally individuals show a time preference for money.’ Give reasons for such a preference.
A-1 Individuals generally prefer possession of a given amount of cash now, rather than the same at
some future time. The main reason for the time preference or time value of money is the
availability of investment opportunities. Other reasons are uncertainty of cash flows and
preference for current consumption of goods, commodities and services.

Q-2 ‘An individual’s time preference for money may be expressed as a rate.’ Explain.
A-2 Time preference rate of money can be expressed as an interest rate. Interest rate gives money its
value, and facilitates the comparison of cash flows occurring at different time periods. The
minimum interest rate in the absence of any risk is known as risk-free rate. It is a compensation
for time. If an individual is exposed to some degree risk, he would expect a rate of return higher
than the risk-free rate from the investment compensating him for both time and risk. The rate
added to compensate risk is known as risk premium.
The interest rate permits the individual to convert different amounts offered at different time to
amounts of equivalent value in the present, i.e., a common point of reference for decision.

Q-3 Why is the consideration of time important in financial decision-making? How can time value be
adjusted? Illustrate your answer.
A-3 Most financial decisions, such as the purchase of assets or procurement of funds, affect the
firm’s cash flows in different time periods. Cash flows occurring in different time periods are not
comparable. Hence, it is required to adjust cash flows for their differences in timing and risk.
The value of cash flows to a common time point should be calculated. To maximise of owner’s
equity, it’s extremely vital to consider the timing and risk of cash flows. The choice of the risk-
adjusted discount rate (interest rate) is important for calculating the present value of cash flows.
For instance, if time preference rate is 10 per cent, it implies that an investor can accept receiving
Rs 100 if he is offered Rs 110 after one year. Rs 110 is the future value of Rs 100 today at 10%
interest rate. Thus, the individual is indifferent between Rs 100 and Rs 110 a year from now as
he/she considers these two amounts equivalent in value. You can also say that Rs 100 today is
the present value of Rs 110 after a year at 10% interest rate.

Q-4 Is the adjustment of time relatively more important for financial decisions with short-range
implications or for decisions with long-range implications? Explain.
A-4 Time value adjustment is important for both short-term and long-term decisions. If the amounts
involved are very large, time value adjustment even for a short period will have significant
implications. However, other things being same, adjustment of time is relatively more important
for financial decisions with long range implications than with short range implications. Present
value of sums far in the future will be less than present value of sums in near future.

Q-5 Explain the mechanics of calculating the present value of cash flows.
A-5 The present value of a future cash flow (inflows or outflows) is the amount of current cash that is
of equivalent value to the decision maker today. The process of determining present value of a
future payment (or receipts) or a series of future payments (or receipts) is called discounting. The
compound interest rate used for discounting cash flows is called discount rate.
1
 Present value for a lump sum amount can be worked out by using following formulae:
Fn é 1 ù
PV = = Fn ê n ú
(1 + i) n
ë (1 + i) û

The term in parentheses is the Present Value Factor (PVF, of Re. 1, which can also be traced
from the pre-calculated present value factor table).
Example: You wish to receive Rs 5,000 after five years in State Bank of India at 8% interest rate
per annum by creating a fixed deposit. How much amount will you have to invest today?
5,000 é 1 ù
PV = 5
= 5,000ê ú = 5,000 ´ 0.681 = Rs3,402
(1.08) ë (1.08)5 û

Present value of an annuity (i.e., constant and equal periodic amount for a certain number of
years) can be worked out using the following formula:
é (1 + i) n - 1ù é1 1 ù
PV = A ê ú = A ê - n ú
ë i(1 + i) û ë i i(1 + i) û
n

The term in parentheses is the present value factor of an annuity of Re.1, which is available from
PVAF table. Here, A is a constant flow each year.
Example: You will receive Rs 1,250 each year for six years. If the interest rate is 10% p.a., what
is the present value of the amounts received?

é 1 ù
= 1, 250[10 - 0.5645] = 1,250 ´ 9.4355 = Rs11,794
1
PV = 1, 250ê - 6ú
ë 0.10 0.10(1.10) û

Q-6 What happens to the present value of an annuity when the interest rate rises?
A-6 As the formulae given in A-5 above show, as the interest rate rises, the present value of a lump
sum or an annuity declines. The present value factor declines with higher interest rate, other
things remaining the same.

Q-7 What is multi-period compounding? How does it affect the annual rate of interest? Give an
example.
A-7 If the interest is paid (or received) more than once in a year, it is known as multi-period
compounding; the interest compounded more than once in a year. The actual rate of interest paid
or received is called effective rate of interest. The effective interest rate would be higher than the
nominal interest rate (since compounding is done more than once).
The effective rate of interest is calculated by using following formulae:
nm
é iù
EIR = ê1 + ú - 1
ë mû
Example: Suppose the annual interest rate is 12%. If the compounding is done annually, half
yearly and quarterly, what are the effective rates of interest? You can use the above formula. The
calculated rates are:
Annual compounding: 12%
Half-yearly Compounding: 12.36%
Quarterly Compounding: 12.55%

2
Q-8 What is an annuity due? How can you calculate the present and future values of an annuity due?
Illustrate.
A-8 A series of cash flows (i.e., receipts or payments) starting at the beginning of each period for a
specified number of periods is called an Annuity due. This implies that the first cash flow has
occurred today. The future value, i.e., compound value of an annuity due is:
FV = A (CVAFn,i) (1 + i)
For example, if you deposit Rs.1, 000 in a saving account at the beginning of the each year for 4
years to earn 6% p.a., then the future value is:
FV= 1,000(4.375) (1.06) = Rs. 4,637
Notice that 4.375 is the future value factor for an annuity of Re 1 occurring at the end of the
period.
The present value of an annuity due i:
Fn = A (PVAFn,i) (1 + i)
For example, the present value of Rs1,000 deposited in saving account at the beginning of each
year for 4 years to earn interest 6% p.a. is:
PV = 1,000 (3.170) (1.06) = Rs. 3,487
Q-9 How does discounting and compounding help in determining the sinking fund and capital
recovery?
A-9 Sinking fund is a fund which is created out of fixed payments each period to accumulate to a
future some after a specified period. For this purpose, the compound value of an annuity can be
used to calculate an annuity to be deposited to a sinking fund for ‘n’ period at ‘i’ rate of interest
to accumulate to a given sum. The equation is:
é 1 ù
A = FV ê ú = FV [SFFn,i ]
ëê CVAFn,i ûú
It means that SFFn,i is a reciprocal of compound value of an annuity factor, i.e., CVAFn,i.
Example: A company will need Rs 500,000 after seven years to redeem debentures. How much
amount should it transfer each year to accumulate a fund of Rs 500,000 after seven years if the
interest rate is 9%?
é ù
ê 1 ú é 1 ù
A = 500,000ê ú = 500,000 ê ú
ê (1.09) - 1 ú ë 9.200 û
7

êë 0.09 úû
= 500,000 ´ 0.1087 = Rs54,345
Capital recovery is the annuity of an investment for a specified time at a given rate of interest.
The present value of an annuity formula can be used to determine annual cash flow to be earned
to recover a given investment. The equation is:
é 1 ù
A = Pê ú = P[CRFn,i ]
êë PVAFn,i úû
The capital recovery factor is a reciprocal of the present value annuity factor, i.e., PVAFn,i.
Example: You have made an investment of Rs 300,000 for a period of five years. If the rate of
interest is 11%, how much cash flow should you earn each year?

3
 é ù
ê ú
ú = 300,000éê
1 1 ù
A = 300,000ê ú
ê 1 - 1 ú ë 3.700 û
êë 0.11 0.11(1.11) 5 úû
= 300,000 ´ 0.271 = Rs81,171
Q-10 Illustrate the concept of the internal rate of return.
A-10 The rate of return on an investment (based on its cash flows) is called internal rate of return
(IRR). Since IRR depends on the cash flow patterns specific or internal to a project, it’s called
internal rate of return. It is a rate where NPV is zero. Hence, IRR can be calculated manually by
trial and error.
Example: A bank offers you to deposit Rs. 1,000 today and promises to pay Rs. 1,762 at the end
of 5 years. What rate of return are you earning?
P = FV (PVF5,I ) = 1,000 = 1,762 (PVF5,I ) PVF5,i = 0.567
The PVF table shows that at 12 % column and period 5, the factor is 0.567. Hence, the internal
rate of return is 12%. You can also use the following formula (and a scientific calculator) to
calculate IRR:
1,000(1 + IRR ) 5 = 1,762
1,762
(1 + IRR ) 5 = = 1.762
1,000
IRR = 1.7621 / 5 - 1 = 0.12 or 12%
If the factor value lies between two interest percentages, then actual rate can be worked out by
using interpolation.

4
 CHAPTER 6
BETA ESTIMATION AND THE COST OF EQUITY

Q1 What is beta? How is it measured? What are the problems in beta estimation?
A1 Beta is the measure of systematic risk and it is the ratio of covariance between
market return and the security’s return to the market return variance:
cov ar j, m
bj =
s 2m
s j s m corj, m sj
= = ´ corj, m
sm ´ sm sm

Beta is also calculated by the market or index model. In the market model, we
regress returns on a security against returns of the market index. The market
model is given by the following regression equation:
R j = a + bjRm + ej
where Rj is the expected return on security j, Rm is the expected market return, a
is intercept, bj is slope of the regression and ej is the error term (with a zero mean
and constant standard deviation). The slope, bj, of the regression measures the
variability of the security’s returns relative to the market returns and it is the
security’s beta
Problems in Beta Estimation: In practice, the market portfolio is approximated by
a well-diversified share price index. We have several price indices available in
India. Notice that these indices include only shares of companies. In theory, the
market portfolio should include all risky assets – shares, bonds, gold, silver, real
estate, art objects
In computing beta by regression, we need data on returns on market index and the
security for which beta is estimated over a period of time. There is no
theoretically determined time period and time intervals for calculating beta. The
time period and the time interval may vary. The returns maybe measured on a
daily, weekly or monthly basis. One should have sufficient number of
observations over a reasonable length of time.
The return on a share and market index may be calculated as total return; that is,
dividend yield plus capital gain. In practice, one may use capital gains/loss or
price returns [i.e. Pt/Pt-1 – 1] rather total returns to estimate beta of a company’s
share. A further modification may be made in calculating the return. One may
calculate the compounded rate of return.

Q2 Do betas remain stable over time? What problem is posed by the instability of the
beta?
A2. Betas may not remain stable for a company over time even if a company stays in
the same industry. There could be several reasons for this. Over time, a company
may witness changes in its product mix, technology, competition or market share.
In India, many industrial sectors are witnessing changes in competition and

1
 market composition due to the government policy of reforms and deregulation.
This is expected to affect the betas of many companies.
Beta is an important component in the calculation of the cost of capital, which is
used as a discount rate in valuing assets and securities Instability of beta will
cause problem in determining a discount rate which is consistent over the life of
an asset.

Q3 How do you calculate the cost of equity using the CAPM framework?
A3 From the firm’s point of view, the expected rate of return from a security of
equivalent risk is the cost of equity. The expected rate of return or the cost of
equity in CAPM is given by the following equation:
R j = k e = R f + (R m - R f )b j
We need the following information to estimate a firm’s cost of equity:
1. The risk-free rate,
2. The market premium and
3. The beta of the firm’s share

Q4 What factors influence the beta of a share? Explain.

A4 Beta depends on three fundamental factors:
1. The nature of business: If a firm’s earnings are more sensitive to business
conditions, it is likely to have higher beta.
2. The operating leverage: The degree of operating leverage is defined as the
change in a company’s earnings before interest and tax due to change in sales.
Companies with higher degree of operating leverage have high betas.
3. The financial leverage: Financial leverage refers to debt in a firm’s capital
structure. Since financial leverage increases the firm’s (financial) risk, it will
increase the equity beta of the firm.

2
 CHAPTER 3

VALUATION OF BONDS & SHARES

Q-1 Explain the concept of valuation of securities? Why is the valuation concept relevant for
financial decision making purposes?
A-1 Financial assets are called securities. Risk and return are the determinants of value of a security.
The present value of flows of income in future period and the ending price of a security is known
the value of the security. The security price expected at the end of the period is difficult to
predict because a number of variables influence the security prices.
Firms raise capital by issuing securities to shareholders. Since the objective of financial
management is to maximize the shareholder value, the concept of value of securities is
important. Similarly, the cost of raising capital depends on the value of securities.

Q-2 What is a bond? Is it same as a debenture? What are the features of a bond?
A-2 A bond is a long-term debt instrument or security. Bonds are issued by the government and the
public sector companies in India. The private sector companies also issue bonds, which in India
are generally called debentures. A debenture can be secured or unsecured. The features of a bond
or debenture are as follows:
Face value Face value is called par value. A bond (debenture) is generally issued at a par value
of Rs 100 or Rs 1,000, and interest is paid on the face value.
Interest rate Interest rate is fixed and known to bondholders (debenture holders). Interest paid on
a bond/debenture is tax deductible. The interest rate is a contractual rate; it’s called a coupon rate
in USA, and coupons are detachable certificates of interest.
Maturity A bond (debenture) is generally issued for a specified period of time. It is repaid on
maturity.
Redemption value The value that a bondholder (debenture holder) will get on maturity is called
redemption, or maturity, value. A bond (debenture) may be redeemed at par or at premium (more
than par value). Redemption of a bond at discount (less than par value) will never be acceptable
by bondholders.

Q.3 Illustrate the method of valuing (i) bonds in perpetuity and (ii) bonds with maturity.
A.3 In case of a bond, the rate of interest is fixed and known to the investors. The expected cash
flows consist of annual interest payments or receipts and repayment of principal. The rate of
return expected by invertors is an appropriate capitalization rate or discount rate.
Bonds may be redeemable after a specified period (known as bond with maturity period). Bonds
in perpetuity are irredeemable bonds.
The following formula is used to determine the value of bond with maturity period.
N
INT t BN
B0 = å +
t =1 (1 + Kd ) (1 + Kd ) N
t

B 0 = [INT ´ PVAF n, i ] + B N [PVF n, i ]

Example: Rs. 1000 par value bond; maturity five years from now; rate of interest 7%; investor’s
required rate of return 8 %. The present value of the bond will be:

1
 B 0 = (70 * PVAF5,8% ) + (1000 * PVF5,8% )
= 70 * 3.993 + 1000 * 0.681 = Rs.960.51

In case of perpetual bonds, the present value is:

INT
B0 =
kd
For example, if in above example the bond will never mature then
70
B0 = = Rs 875
8%

Q-4 What is the interest rate risk? How are values of bonds affected when the market rate of interest
changes? Illustrate your answer.
A-4 There is an inverse relationship between the value of a bond and the market interest rate. The
bond value would decline when the market interest rate rises and vice-versa. For instance, the
value of 10% perpetual bond declines to Rs 667 from Rs 1,000 when market interest rate rises
from 10 percent to 15 percent, resulting in a loss of Rs 333 in value to bondholders. Interest rates
have the tendency of rising or falling in practice. Thus investors of bonds are exposed to the
interest rate risk; that is, the risk arising from the fluctuating interest rates.

Q.5 Define a yield curve. What are the reasons for an upward sloping yield curve? What is an
inverted yield curve?
A.5 Yield curve shows the relationship between the yields-to-maturity (YTM) of bonds and their
maturities. It is also called the term structure of interest rates. The upward sloping yield curve
implies that the long-term yields are higher than the short-term yields. This is the normal shape
of the yield curve, which is generally verified by historical evidence. However, many economies
in high-inflation periods have witnessed the short-term yields being higher than the long-term
yields. The inverted yield curves result when the short-term rates are higher than the long-term
rates.
There are three theories that explain the yield curve or the term structure of interest rates: (1) the
expectation theory, (2) the liquidity premium theory, and (3) the market segmentation theory.

Q-6 What is default risk and default risk premium? What is the relation between the default risk and
credit ratings of bonds (or debentures)?
A-6 Default risk is the risk that a company will default on its promised obligations to bondholders.
Bondholders can avoid the default risk by investing their funds in the government bonds instead
of the corporate bonds.
The default premium is the spread between the promised return on a corporate bond and the
return on a government bond with same maturity. The default premium will be higher for bonds
with higher chances of default.
In most countries, there are credit rating companies that rate bonds according to their safety. In
USA, Moody’s and Standard and Poor’s and others provide bond ratings. In India CRISIL,
ICRA, and CARE provide bond and other debt ratings. Debentures (bonds) with highest safety
are rated as AAA (triple A) by CRISIL. Debentures rated BBB (triple B) and above are
investment grade debentures. Debentures rated below BBB are speculative grade, and they are
also known as junk bonds or high yield bonds.

Q-7 What is the difference between the valuation of a bond and of a preference share? Illustrate.
2
A-7 Like bonds, it is relatively easy to estimate cash flows associated with preference shares. The
cash flows may include annual preference dividend and redemption value on maturity in case of
redeemable preference shares. The value of the preference share would be the sum of the present
values of dividends and the redemption value
Consider that a company has issued Rs 100 irredeemable preference share on which it pays a
dividend of Rs 9. Assume that this type of preference share is currently yielding a dividend of 11
percent. What is the value of the preference share? The preference dividend of Rs 9 is perpetuity.
Therefore, the present value of the preference share is:
PDIV 9
P0 = = = Rs 81.82
kp 0.11

Q.8 What is the meaning of term yield-to-maturity for bonds and preference shares? Is it appropriate
to talk of a yield-to-maturity on a preference share that has no specific maturity date?
A.8 When the cash flows and maturity or redemption value are known for the bond (or preference
shares), then by trial and error method, we can calculate the required rate of return. This rate is
known as yield-to-maturity (YTM) or bond’s internal rate of return.

Q.9 What is an ordinary share? What are its features? How does it differ from a preference share and
a debenture?
A.9 A share is a certificate issued to the owner acknowledging his capital contribution. An ordinary
share is without any special preference. The ordinary shareholders are the legal owners of a
company, and they assume the risk of ownership. They will get ordinary dividends only when
management (board of directors) decides to distribute profits as dividends.
The following are the features of preference and ordinary shares:
· Claims Preference shareholders have a claim on assets and income prior to ordinary
shareholders. Equity (ordinary) shareholders have a residual claim on a company’s income
and assets. They are the legal owners of the company.
· Dividend The dividend rate is fixed in the case of preference shares. Preference shares may
be issued with cumulative rights, i.e. dividend will accumulate until paid off. In the case of
equity shares neither the dividend rate is known, nor does dividend accumulate. Dividends
paid on preference and equity shares are not tax deductible.
· Redemption Both redeemable and irredeemable preference shares can be issued in
India. Redeemable preference shares have a maturity date while irredeemable preference
shares are perpetual. Equity shares have no maturity date.
· Conversion A company can issue convertible preference shares. That is, after a stated period,
such shares can be converted into ordinary shares.
As you may notice from above, the differences between ordinary shares and preference shares
are in terms of preference with regard to payment of dividend, claims on assets, and redemption.
The differences between an ordinary share and a debenture are: the holders of ordinary shares are
owners of the company and they have voting rights; the bondholders are lenders and do not have
any voting rights; they have voting rights; they are owners of residue and bear the risk of the
business; payment of dividend on ordinary shares is at the discretion of management and
dividend paid is not allowed as an expense; payment of interest to bondholders is a legal
obligation, and interest paid is tax deductible.

Q.10 Explain in detail the method of valuing an ordinary share?

A.10 Cash flows of an ordinary (or equity) share consist of the stream of dividends and terminal price
of the share. Unlike the case of a bond, cash flows of a share are not known. Thus, the risk of
3
 holding a share is higher than the risk of a bond. Consequently, equity capitalisation rate will be
higher than that of a bond. The general formula for the share valuation is as follows:
DIV1 DIV2 DIV1 + Pn
P0 = + +L+
(1 + k e ) (1 + k e )
1 2
(1 + k e ) n
As the time horizon, n, becomes very large (say, extends to infinity) the present value of future
price approaches zero. Thus the term Pn disappears from the formula, and we can use the
following equation to find the value of a share today:
n =¥

å (1 + k
DIV1
P0 = t
t =1 e)
If dividends do not grow, then capitalising earnings can determine the share value. Under no-
growth situation, earnings per share (EPS) will be equal to dividends per share (DIV) and the
present value is obtained by capitalizing earnings per share:
DIV1 EPS1
P0 = =
ke ke

In practice, dividends do grow over years. If we assume dividends to grow at a constant rate, g,
then DIV1 = DIV0 (1 + g), DIV2 = DIV1(1 + g), DIV3 = DIV2 (1 + g)..., and the share price
formula can be written as follows:
DIV1
P0 =
ke - g
This formula is useful in calculating the equity capitalisation rate (ke) when the price of the share
(P0) is known. Under the assumption of constant growth, the share value is equal to the
capitalized value of earnings plus the value of growth opportunities as shown below:
EPS1
P0 = + Vg
ke

The price of a ‘growth stock’ is not merely the capitalised value of earnings but it also includes
the present value of growth opportunities.
Given a firm’s EPS, ROE, the equity capitalisation rate, retention ratio and constant growth, the
growth opportunities can be valued as follows:

NPV1 b ´ EPS1 ( ROE - k e )

Vg = =
ke - g k e (k e - g)

Q-11 What is the perpetual growth model? What are its assumptions? Is this model applicable in a
finite case?
A-11 The present value of a share is equal to the dividend after a year, DIV1, divided by the difference
of the capitalisation rate (ke) and the growth rate (g); that is, (ke – g). Equation in the perpetual
growth model is:
DIV1
P0 =
ke - g
It is based on the following assumptions
· The capitalisation rate or the opportunity cost of capital must be greater than the growth rate,
(ke > g).

4
 · The initial dividend per share, DIV1, must be greater than zero (i.e., DIV1 > 0)..
· The relationship between ke and g is assumed to remain constant and perpetual.
This model is not applicable in a finite case.

Q.12 Why are dividends important in determining the present value of a share? How would you
account for the positive market value of company’s share which currently pays no dividend?
A.12 For shareholders in general the expected cash inflows consist only of future dividends and.
therefore, the value of an ordinary share is determined by capitalizing the future dividend stream
at an appropriate rate of discount. Secondly, shareholders doe not hold shares in perpetuity. They
finally sell shares to obtain the capital gains.
A firm paying no dividends does command positive market prices for its shares since the price
today depends on the future expectation of dividends; ultimately, shareholders will be able to
realize capital gains. The dividend capitalization model is a valid share valuation model even for
those companies which are not presently paying dividends.

Q.13 What is the difference between the expected and the required rates of return in the context of
ordinary shares? When would this difference banish?
A.13 The required rate of return (ke) will depend upon the riskiness of the share. It will be equal to the
risk-free rate of interest plus the risk-premium to account for the riskiness of the share.
DIV1
ke = + g
P0
The expected rate of return is the rate of return which an investor can expect if he / she purchases
the share at the current maker price. The expected rate of return (re) is same as the internal rate of
return on an asset.
DIV1 P - P0
re = + 1
P0 P0
Expected Dividend Expected increase in Price
re = +
Current Price Cureent Price
re = Expected Dividend yield + Expected Capital gain
When the expected rate of return is less than ke, then the selling pressure increases which brings
down the market price of share. So, through open market trading the difference between ke and re
return banishes.

Q.14 Illustrate with the help of an example, the linkage between share price and earnings. What is the
importance of price-earnings (P/E) ratio? What are its limitations?

A.14 From the view of investors, ordinary shares can be (1) growth shares or (2) income shares.
Growth shares are those which offer grater opportunity for capital gains by following high
retention policy. Income shares are those which pay higher dividends, and offers low prospect
for capital gains. The investors who want regular income would prefer to buy income shares,
while the investors who want higher return via capital gains would prefer to buy growth shares.
The linkage between share price, and earnings and dividends can be explained by following
formula used for value of ordinary shares.
DIV1 EPS1 (1 - b )
P0 = =
ke - g ke - r ´ b

5
 Here b = relation ratio; ke = opportunity cost of capital; and r = rate of return earned
The firm follows a constant policy of dividend payout of 60%, earns 20% rate of return, and its
earnings and dividends will grow perpetually at 8%. The expected EPS of next year is Rs.6.67
and the expected rate of return by investor is 12%. What would be the price of the company’s
share?
EPS1 (1 - b ) DIV1
P0 = =
k e - rb ke - g
6.67 (1 - 0.40) 4
= = = Rs.100
0.12 - (0.2 * 0.4) 0.12 - 0.08
P/E ratio is calculated as the price of share divided by earnings per share. P/E ratio is basically
the reciprocal of earnings yield (i.e., earnings-price ratio). A P/E ratio can mislead about the
performance of a share. A high P/E ratio is considered good but it could be high not because the
share price is high but because the earnings per share are quite low. P/E ratio can be manipulated
and changed by accounting policies, which may distort the fair estimation of earnings. So, it is
quite difficult to interpret EPS meaningfully and rely on EPS and P/E ratio as measure of
performance.

Q.15 What is meant by growth opportunities? How are they valued? Illustrate.
A.15 The growth opportunities are created by firm by retention of earnings (i.e., reinvestment of
retained earnings) in its operations. Retention of earnings adds value since it generates cash flows.
Given a firm’s EPS, ROE, the equity capitalisation rate, retention ratio and constant growth, the growth
opportunities can be valued as follows:
NPV1 b ´ EPS1 ( ROE - k e )
Vg = =
ke - g k e (k e - g)
We can also rewrite the formula to obtain relationship between the earnings-price ratio and capitalisation
rate as follows:
EPS1 é Vg ù
E / P ratio = = k e ê1 - ú
P0 ë P0 û
The E/P ratio will equal the capitalization rate only when growth opportunities are zero, otherwise it will
either over-estimate or under-estimate the capitalization rate.

6
 CHAPTER 5

PORTFOLIO THEORY
AND ASSETS PRICING MODELS

Q1. Illustrate the computation of the expected rate of return of an asset.

A1 The expected rate of return of individual assets can be calculated using the
following equation:
E (R x ) = (R 1 ´ P1 ) + (R 2 ´ P ) 2 + (R 3 ´ P3 ) + ..... + (R n ´ Pn )
n
E (R x ) = å R i Pi
i =1
Note that E(Rx) is the expected return on asset X, Ri is ith return and Pi is the
probability of ith return. Consider an example.

State of
Economy Probability Return (%)
A 0.10 -8
B 0.20 10
C 0.40 8
D 0.20 5
E 0.10 -4
The expected rate of return of X is the sum of the product of outcomes and their
respective probability. That is:

E (R x ) = ( -8 ´ 0.1) + (10 ´ 0.2) + (8 ´ 0.4) + (5 ´ 0.2) + ( -4 ´ 0.1) = 5%

Q2. What is risk? How can risk of a security be calculated? Explain your answer with
the help of an example.
A2 Risk of returns is the variability in rates of return. The variability of rates of return
may be defined as the extent of the deviations (or dispersion) of individual rates
of return from the average rate of return. There are two measures of this
dispersion: variance or standard deviation. Standard deviation is the square root of
variance. The formulae calculating variance and standard deviation of historical
rates of return of a share as follows:
2

å (R )
n
1
s =
2
t -R
n -1 t =1
2

å (R )
n
1
s= s = 2
-R
n -1
t
t =1

The share of Hypothetical Company Limited has the following anticipated returns
with associated probabilities:
Return (%) -20 -10 10 15 20 25
Probability 0.05 0.10 0.20 0.25 0.20 0.15
The risk, measured in terms of variance and standard deviation, is:

1
 s 2 = ( - 20 - 13 ) 2 ´ 0 . 05 + ( - 10 - 13 ) 2 ´ 0 . 10 + (10 - 13 ) 2 ´ 0 . 20 + (15 - 13 ) 2 ´ 0 . 25
+ ( 20 - 13 ) 2 ´ 0 . 20 + ( 25 - 13 ) 2 ´ 0 . 15 + ( 30 - 13 ) 2 ´ 0 . 05 = 156
s= 156 = 12 . 49 %

Q3. What is a portfolio? How is the portfolio return and risk calculated for a two-
security portfolio?
A3 A portfolio is a bundle or a combination of individual assets or securities. The
portfolio theory provides a normative approach to investors to make decisions to
invest their wealth in assets or securities under risk.1 It is based on the assumption
that investors are risk-averse
The expected rate of return on a portfolio (or simply the portfolio return) is the
weighted average of the expected rates of return on assets in the portfolio
Expected return on portfolio = weight of security X ´ exp ected return on security X
+ weight of security Y ´ expected return on security Y

E (R p ) = w ´ E (R x ) + (1 - w ) ´ E ( R y )
Note that w is the proportion of investment in asset X and (1 – w) is the remaining
investment in asset Y
The risk of a portfolio could be measured in terms of its variance or standard
deviation. The portfolio variance or standard deviation depends on the co-
movement of returns on two assets. Covariance of returns on two assets measures
their co-movement. Three steps are involved in the calculation of covariance
between two assets:
1. Determine the expected returns on assets.
2. Determine the deviation of possible returns from the expected return for each
asset.
3. Determine the sum of the product of each deviation of returns of two assets
and respective probability.
Covariance is also equal to the product of the standard deviations of the returns on
assets and their correlation. The variance of two-security portfolio is given by the
following equation:
s2p = s2x w2x + s2y w2y + 2wx w y Co varxy
= s2x w2x + s2y w2y + 2wx w y sx sy Corxy

Q4. Does diversification reduce the risk of investment? Explain with an example.
A4 Yes, diversification reduces the risk of investment. Let us consider an example
Suppose you have the following two investment opportunities: A and B:
Economic Returns (%)
Condition Probability A B
Good 0.5 40 0
Bad 0.5 0 40
The expected rate of return, variance and standard deviation of A are:

2
 E(R A ) = 0.5 ´ 40 + 0.5 ´ 0 = 20%
s 2A = 0.5(40 - 20) 2 + 0.5(0 - 20) 2 = 400
s A = 400 = 20%
Similarly, the expected rate of return, variance and standard deviation of B are:
E(R B ) = 0.5 ´ 0 + 0.5 ´ 40 = 20%
s 2B = 0.5(0 - 20) 2 + 0.5(40 - 20) 2 = 400
s B = 400 = 20%
Both investments A and B have the same expected rate of return (20 percent) and
same variance (400) and standard deviation (20 percent). Thus, they are equally
profitable and equally risky. How does combining investments A and B help an
investor? If a portfolio consisting of equal amount of A and B were constructed,
the portfolio return would be:
E (R P ) = 0.5 ´ 20 + 0.5 ´ 20 = 20%
This return is the same as the expected return from individual securities, but
without any risk. Why? If the economic conditions are good, then A would yield
40 percent return and B zero and the portfolio return will be:
E (R P ) = 0.5 ´ 40 + 0.5 ´ 0 = 20%
When economic conditions are bad, then A’s return will be zero and B’s 40
percent and the portfolio return would still remain the same:
E (R P ) = 0.5 ´ 0 + 0.5 ´ 40 = 20%
Thus, by investing equal amounts in A and B, rather than the entire amount only
in A or B, the investor is able to eliminate the risk altogether. She is assured of a
return of 20 percent with a zero standard deviation

Q5. Define systematic and unsystematic risks. Give examples of both.

A5 Systematic risk arises on account of the economy-wide uncertainties and the
tendency of individual securities to move together with changes in the market.
This part of risk cannot be reduced through diversification. It is also known as
market risk. Investors are exposed to market risk even when they hold well-
diversified portfolios of securities. The examples of systematic risk are: change in
corporate tax rate; deficit financing; restrictive credit policy etc.
Unsystematic risk arises from the unique uncertainties of individual securities. It
is also called unique risk. These uncertainties are diversifiable if a large numbers
of securities are combined to form well diversified portfolios. Uncertainties of
individual securities in a portfolio cancel out each other. Thus unsystematic risk
can be totally reduced through diversification. The examples of unsystematic risk
are: workers strike in a company; a company loses a contract; CEO of a company
dies; the company finds a cheaper source of material etc.

Q6. Explain the principle of dominance. Define the efficient portfolio and efficient
frontier.
A6 A risk-averse investor will prefer a portfolio with the highest expected return for a
given level of risk or prefer a portfolio with the lowest level of risk for a given

3
 level of expected return. In the portfolio theory, this is referred to as the principle
of dominance.
An efficient portfolio is one that has the highest expected returns for a given level
of risk. The efficient frontier is the frontier formed by the set of efficient
portfolios. All portfolios on the efficient frontier are efficient portfolios. All other
portfolios, which lie outside the efficient frontier, are inefficient portfolios.

Q7. What is the portfolio theory? Explain the assumptions and principles underlying
the portfolio theory?
A7. The portfolio theory provides a normative approach to investors to make
decisions to invest their wealth in assets or securities under risk. It is based on the
assumption that investors are risk-averse. This implies that investors hold well-
diversified portfolios instead of investing their entire wealth in a single or a few
assets. The second assumption of the portfolio theory is that the returns of assets
are normally distributed. This means that the mean (the expected value) and
variance (or standard deviation) analysis is the foundation of the portfolio
decisions. Further, we can extend the portfolio theory to derive a framework for
valuing risky assets. This framework is referred to as the capital asset pricing
model (CAPM). An alternative model for the valuation of risky assets is the
arbitrage pricing theory (APT).

Q8. What is the capital asset pricing model? Explain its assumptions and implications.
A8 The capital asset pricing model (CAPM) is a model that provides a framework to
determine the required rate of return on an asset and indicates the relationship
between return and risk of the asset. The required rate of return specified by
CAPM helps in valuing an asset. One can also compare the expected (estimated)
rate of return on an asset with its required rate of return and determine whether
the asset is fairly valued.
The most important assumptions are
1. Market efficiency The capital market efficiency implies that share prices
reflect all available information. Also, individual investors are not able to
affect the prices of securities. This means that there are large numbers of
investors holding small amount of wealth.
2. Risk aversion and mean-variance optimisation Investors are risk averse. They
evaluate a security’s return and risk in terms of the expected return and
variance or standard deviation respectively. They prefer the highest expected
returns for a given level of risk. This implies that investors are mean-variance
optimisers and they form efficient portfolios.
3. Homogeneous expectations All investors have the same expectations about the
expected returns and risks of securities.
4. Single time period All investors’ decisions are based on a single time period.
5. Risk-free rate All investors can lend and borrow at a risk-free rate of interest.
They form portfolios from publicly traded securities like shares and bonds.

4
 CAPM has the following implications:
1. Investors will always combine a risk-free asset with a market portfolio of
risky assets. They will invest in risky assets in proportion to their market
value.
2. Investors will be compensated only for that risk which they cannot diversify.
This is the market-related (systematic) risk. Beta, which is a ratio of the
covariance between the asset returns and the market returns divided by the
market variance, is the most appropriate measure of an asset’s risk.
3. Investors can expect returns from their investment according to the risk. This
implies a linear relationship between the asset’s expected return and its beta.

Q9 Explain the security market line (SML) with the help of a figure. How does it
differ from the capital market line?
A9 The expected return on a security is given by the following equation:
E(R j ) = R f + (R m - R f )b j
where Rf is the risk-free rate, Rm the market return and the measure of the
security’s systematic risk. This equation gives a line called the security market
line (SML).
The following figure shows the relationship between return and risk as measured
by beta.

E(Rj)

Security Market Line

RM

RF

beta

The SML depicts individual security risk premium as a function of security risk.
The individual security risk is measured by the security’s beta. Beta reflects the
contribution of the security to the portfolio risk.

Q10 What is beta? How is it measured? How do you calculate the expected rate of
return of a security?
A10 Beta reflects the systematic risk, which cannot be reduced. Investors can eliminate
unsystematic risk when they invest their wealth in a well-diversified market
portfolio. A beta of 1.0 indicates average level of risk while more than 1.0 means
that the security’s return fluctuates more than that of the market portfolio. A zero
beta means no risk.

5
 Beta is a ratio of the covariance of returns of a security, j, and the market
portfolio, m, to the variance of return of the market portfolio:
Cov jm s j s m Cor jm s j Cor jm
bj = = =
Varm s 2m sm
where bj is beta of the security, sj the standard deviation of return of security, sm
the standard deviation of returns of the market portfolio, s2 m the variance of
returns of the market portfolio m and Corjm the correlation coefficient between
the returns of the security j and the market portfolio m.
The expected return on a security is given by the following equation:
E(R j ) = R f + (R m - R f )b j
where Rf is the risk-free rate, Rm the market return and βj the measure of the
security’s systematic risk.

Q11 Explain the logic of the arbitrage-pricing theory (APT)? How does it compare and
contrast with CAPM?
A11 The differences of securities’ returns may not be fully explained by their betas.
The arbitrage pricing theory (APT), resulting from the limitations of CAPM,
assumes that many macro-economic factors may affect the risk of a security (or
an asset). Thus, APM is a multi-factor model to explain the return of a security.
The factors influencing security return may include industrial production, growth
in gross domestic product, the interest rate, inflation, default premium, and the
real rate of return. Price-to-book-value ratio and size have also been found to
explain to the differences in the security returns.
The fundamental logic of APT is that investors always indulge in arbitrage
whenever they find differences in the returns of assets with similar risk
characteristics.

Q12 Explain the meaning and significance of the Fama-French three-factor model.
How does it differ from CAPM?

A12 The French-Fama is a three-factor model. Three factors determine the portfolio
return: (a) Beta, (b) firm size and (c) price-to-book value. CAPM is one-factor
model and specifies that the portfolio return depend on bet alone.

6
 CHAPTER 8

CAPITAL BUDGETING DECISIONS

Q1. What is capital budgeting? Why is it significant for a firm?

A1 A capital budgeting decision may be defined as the firm’s decision to invest its
current funds most efficiently in the long-term assets in anticipation of an
expected flow of benefits over a series of years.
Investment decisions require special attention because of the following reasons.
1. They influence the firm’s growth and profitability in the long run
2. They affect the risk of the firm
3. They involve commitment of large amount of funds
4. They are irreversible, or reversible at substantial loss
5. They are among the most difficult decisions to make.

Q2. Despite its weaknesses, the payback period method is popular in practice? What
are the reasons for its popularity?
A2 Payback is considered to have the following virtues, which makes it popular in
practice.
1. Simplicity. Payback is simple to understand and easy to calculate. The
business executives consider the simplicity of method as a virtue. This is
evident from their heavy reliance on it for appraising investment proposals in
practice.
2. Cost effective. Payback method costs less than most of the sophisticated
techniques that require a lot of the analysts’ time and the use of computers.
3. Short-term effects. A company can have more favourable short-run effects on
earnings per share by setting up a shorter standard payback period. It should,
however, be remembered that this may not be a wise long-term policy as the
company may have to sacrifice its future growth for current earnings.
4. Risk shield. The risk of the project can be tackled by having a shorter standard
payback period as it may ensure guarantee against loss. A company has to
invest in many projects where the cash inflows and life expectancies are
highly uncertain. Under such circumstances, payback may become important,
not so much as a measure of profitability but as a means of establishing an
upper bound on the acceptable degree of risk.
5. Liquidity The emphasis in payback is on the early recovery of the investment.
Thus, it gives an insight into the liquidity of the project. The funds so released
can be put to other uses.

Q3. How do you calculate the accounting rate of return? What are its limitations?
A3 The accounting rate of return (or return on investment, ROI) is the ratio of the
average net operating after-tax profit (NOPAT) divided by the average
investment. The average investment would be equal to half of the original
investment if it were depreciated constantly. Alternatively, it can be found out by
dividing the total of the investment’s book values after depreciation by the life of

1
 the project. Generally, a higher ROI is considered better. For making a decision, a
cut-off rate is needed.
As a decision criterion, however, it has serious shortcoming.
1. Cash flows ignored The ARR method uses accounting profits, not cash flows,
in appraising the projects. Accounting profits are based on arbitrary
assumptions and choices and also include non-cash items. It is, therefore,
inappropriate to rely on them for measuring the acceptability of the
investment projects.
2. Time value ignored. The averaging of income ignores the time value of
money. In fact, this procedure gives more weightage to the distant receipts.
3. Arbitrary cut-off. The firm employing the ARR rule uses an arbitrary cut-off
yardstick. Generally, the yardstick is the firm’s current return on its assets
(book-value). Because of this, the growth companies earning very high rates
on their existing assets may reject profitable projects (i.e., with positive
NPVs) and the less profitable companies may accept bad projects (i.e., with
negative NPVs).

Q4. Explain the merits and demerits of the time-adjusted methods of evaluating the
investment projects.
A4 Merits:
Time value of money: Time-adjusted or discounted cash flow (DCF) techniques
recognise the time value of money—a rupee received today is worth more than a
rupee received tomorrow.
Risk: DCF techniques use the cost of capital as the discount rate, which includes a
premium for risk of the project under evaluation.
Measure of true profitability: They use all cash flows occurring over the entire life
of the project in calculating its worth. Hence, it is a measure of the project’s true
profitability.

Demerits:
In practice, it is quite difficult to obtain the estimates of cash flows due to
uncertainty. It is also difficult in practice to precisely measure the discount rate.

Q5. What is meant by the term time value of money? Which capital budgeting
methods take into consideration this concept? How is it possible for the capital
budgeting methods that do not consider the time value of money to lead to wrong
capital budgeting decisions?
A5 The time value of money is based on the premise that the value of money changes
because of investment opportunities available to investors. Hence, Rs 100 today is
not same as Rs 100 after one year. The capital budgeting methods that are based
on the time value of money are called discounted cash flow (DCF) Criteria. They
include two methods: (1) Net Present Value (NPV) and (2) Internal Rate of
Return (IRR). Profitability Index (PI), a variant of NPV method, also a DCF
technique.

2
 Non-DCF techniques are not able to differentiate between cash flows occurring in
different time periods. They not focus on value, and hence, they violate the
principle of the shareholder wealth maximisation.

Q6. Under what circumstances do the net present value and internal rate of return
methods differ? Which method would you prefer and why?
A6 The NPV and IRR methods can give conflicting ranking to mutually exclusive
projects. In the case of independent projects ranking is not important since all
profitable projects will be accepted. Ranking of projects, however, becomes
crucial in the case of mutually exclusive projects. Since the NPV and IRR rules
can give conflicting ranking to projects, one cannot remain indifferent as to the
choice of the rule. NPV method is consistent with the shareholder wealth
maximisation; hence, it should be preferred over IRR method.

Q7. What are the mutually exclusive projects? Explain the conditions when
conflicting ranking would be given by the internal rate of return and net present
value methods to such projects.
A7 Investment projects are said to be mutually exclusive when only one investment
could be accepted and others would have to be excluded. The NPV and IRR
methods can give conflicting ranking to mutually exclusive projects under the
following conditions:1
1. The cash flow pattern of the projects may differ. That is, the cash flows of one
project may increase over time, while those of others may decrease or vice-
versa.
2. The cash outlays (initial investments) of the projects may differ.
3. The projects may have different expected lives.

Q8. What is profitability index? Which is a superior ranking criterion, profitability

index or the net present value?
A8 Profitability index is the ratio of the present value of cash inflows, at the required
rate of return, to the initial cash outflow of the investment. The formula for
calculating benefit-cost ratio or profitability index is as follows:
`
PV of cash inflows PV (C t ) n Ct
PI = = =å ¸ C0
t =1 (1 + k )
t
Initial cash outlay C0

The NPV method and PI yield same accept-or-reject rules, because PI can be
greater than one only when the project’s net present value is positive. In case of
marginal projects, NPV will be zero and PI will be equal to one. But a conflict
may arise between the two methods if a choice between mutually exclusive
projects has to be made The NPV method should be preferred, except under
capital rationing. Between two mutually exclusive projects with same NPV, the
one with lower initial cost (or higher PI) will be selected

Q9. Under what conditions would the internal rate of return be a reciprocal of the
payback period?

3
A9 The reciprocal of payback will be a close approximation of the internal rate of
return if the following two conditions are satisfied:
1. The life of the project is large or at least twice the payback period.
2. The project generates equal annual cash inflows.

Q10. “The payback reciprocal has wide applicability as a meaningful approximation of

the time adjusted rate of return. But it suffers from certain major limitations.”
Explain.
A10 The payback reciprocal is a useful technique to quickly estimate the true rate of
return. But its major limitation is that every investment project dose not satisfies
the conditions on which this method is based. When the useful life of the project
is not at least twice the payback period, the payback reciprocal will always exceed
the rate of return. Similarly, it cannot be used as an approximation of the rate of
return if the project yields uneven cash inflows

Q11. Comment on the following statements:

(a) “We use payback primarily as a method of coping with risk.”

The risk of the project under payback is tackled by having a shorter standard
payback period. A company has to invest in many projects where the cash inflows
and life expectancies are highly uncertain. Under such circumstances, payback
may become important, not so much as a measure of profitability but as a means
of establishing an upper bound on the acceptable degree of risk It must be realised
that payback does not really consider risk of cash flows as it treats cash flows
occurring at different time periods as of equal importance and quality.

(b) “The virtue of the IRR rule is that it does not require the computation of the
required rate of return.”
The required rate of return does not enter in the computation of IRR. But this
information is needed in making the investment decision. The accept-or-reject
rule, using the IRR method, is to accept the project if its internal rate of return is
higher than the required rate of return or opportunity cost of capital (r > k). The
project shall be rejected if its internal rate of return is lower than the opportunity
cost of capital (r < k). The decision maker may remain indifferent if the internal
rate of return is equal to the opportunity cost of capital. So even in case of IRR
rule we require the computation of the required rate of return.”

(c) “The average accounting rate of return fails to give weight to the later cash
flows.”
The ARR method uses accounting profits, not cash flows, in appraising the
projects. Accounting profits are based on arbitrary assumptions and choices and
also include non-cash items. It is, therefore, inappropriate to rely on them for
measuring the acceptability of the investment projects. The averaging of income
ignores the time value of money. In fact, this procedure gives more weightage to
the distant receipts.

4
Q12. “Discounted payback ensures that you don’t accept an investment with negative
NPV, but it can’t stop you from rejecting projects with a positive NPV.” Illustrate
why this can happen.
A12 The discounted payback period is the number of periods taken in recovering the
investment outlay on the present value basis. The discounted payback period still
fails to consider the cash flows occurring after the payback period. Thus, it may
reject positive NPV projects.
Discounted payback illustrated: Project A involves a cash outlay of Rs 10,000 and
its discounted cash flows over its life of five years are: Rs 5,000; Rs 4,000; Rs
1,000; Rs 0 and Rs 0. The discounted payback period is 3 years. Project B also
involves a cash outlay of Rs 10,000 and its discounted cash flows over its life of
five years are: Rs 5,000; Rs 3,000; Rs 1,000; Rs 1,000 and Rs 5,000. The
discounted payback period is 4 years. On the basis of the discounted payback
period, Project A will be preferred. However, Project B generates positive NPV.

5
 CHAPTER 11

COMPLEX INVESTMENT DECISIONS

Q.1 Why should you not compare the simple NPV of the mutually exclusive projects
with different lives? What is the correct procedure to compare such projects?
A.1 The NPV of mutually exclusive projects with the same lives can be compared and
we can choose the project with highest NPV. However, the simple NPV method
fails to indicate correct choice for the difference in the projects’ lives.
The correct method to evaluate mutually exclusive projects with different lives is
by evaluating them for equal periods of time. The choice between projects with
different lives can be made by comparing their annual equivalent value (AEV).
The AEV is the NPV of an investment divided by the annuity factor given its life
and discount rate.

Q.2 Show with the help of an illustration that the annual equivalent value and the NPV
for infinite period procedures lead to same results in case of the mutually
exclusive projects with different lives.
A.2 The choice between projects with different lives should be made by evaluating
them for equal periods of time, i.e., Annual Equivalent Value (AEV) method. In
AEV method, it is assumed that each machine is replaced in the last year of its
life. The replacement chains of the machines can be assumed to extend to the
periods of time equal to least common multiple of the lives of the machines.
The same results, i.e., AEV, can be replicated at constant scale indefinitely. It
implies that an annuity is paid at the end of every n years starting from the first
period.
The AEV for specific period is calculated by using following formulae:
NPV
AEV = -------------------
Annuity Factor
The AEV for perpetuities can be calculated by using:
é (1 + k ) n ù
NPV ¥ = ( NPV n ) ê ú
ë (1 + k ) - 1 û
n

Example: Let us assume that, a machine is purchased by paying Rs 20,000, the

expected life is 3 years, and discount rate is 12%. The annual running cost of
machine is Rs. 8,000 p.a. In this case NPV of cost at 12% would be Rs. 39,200.
Hence,

39,200
AEV = = Rs.16,320
2.402

If the machine could be assumed to be replaced indefinitely, then NPV of

machine would be Rs 16,320/0.12 = Rs 136,000.
Now, if we assume that machine can be replicated at constant scale indefinitely,
then

1
 é (1.12) 3 ù
NPV = 39,200 ê ú = Rs.136,000
ë (1.12) - 1û
3

Q.3 How does the NPV rule help in determining the optimum duration of an
investment? Illustrate your answer.
A.3 On account of capital constraint, some projects can be postponed by one or two
periods. The simple rule to decide about optimum timing of an investment project
is that point of time when it maximizes the NPV. The optimum investment
(duration) timing analysis is of direct relevance in the case of tree harvesting type
problems. Suppose that we own a piece of land and are considering growing a
crop of trees, we would like to maximise the NPV of investment. The
maximisation of the investment’s NPV would depend on when we harvest trees.
The net future value of trees increases when harvesting is postponed; but the
opportunity cost of capital is incurred by not realising the value by harvesting the
trees. The NPV will be maximised when the trees are harvested at the point where
the percentage increase in value equals the opportunity cost of capital.
Suppose the net future value obtained over the years from harvesting the trees is
At and if the opportunity cost of capital is k, then the present value (PV) of the net
realisable value of trees is given by:
At
PV = = At (1 + k ) -t
(1 + k ) t
If we assume continuous compounding, the PV will be equal to:
PV = A t e -kt
Assume that At is given by the function:
A t = 3,000(1 + t )1 2
and k is equal to 10 percent. Table 1 below gives the details.

Table 1 Net Future Value Etc

Rate of
Net Future Increase Increase Present
Value in Value in Value Value
Time At DAt DAt /At PVF At ´ e–kt
t Rs Rs Rs e–kt Rs
1 4,243 – – 0.9048 3,839
2 5,196 953 0.225 0.8187 4,254
3 6,000 804 0.155 0.7408 4,445
4 6,708 708 0.118 0.6703 4,497
5 7,348 640 0.095 0.6065 4,457
6 7,937 589 0.080 0.5488 4,356

The present value is maximum when the trees are harvested in period 4. It is
noticeable that after 4 years, the rate of increase in the value of trees declines
below the opportunity cost of capital of 10 per cent.

2
 We may have to incur initial cost of planting the trees. Assume that the initial
cost, C, is Rs 4,000. The NPV will be:
NPV = A t e -kt - C = 3,000(1 + 4)1 2 (0.6703) - 4,000 = 4,497 - 4,000 = Rs 497
The NPV is highest (+ Rs 497) when the trees are harvested in 4 years.

Q.4 What are the important considerations in a replacement decision? How would you
decide when to replace equipment?
A.4 Replacement decisions should be governed by the economic and necessity
considerations. An equipment or asset should be replaced whenever a more
economic alternative is available on account of technological improvement and
reduces high operating costs.
The company should make an analysis whenever an alternative is available by
comparing the Annual Equivalent Value (AEV) of the old and new asset. The
asset is to be replaced at a point of time when AEV of new machine/asset is more
than AEV of old machine/asset.

Q.5 Define capital rationing. How would you select the investment projects under
one-period capital constraint? Would capital rationing lead to sub-optimal
investment decision?
A.5 Capital rationing refers to a situation where the firm is constrained for external or
self-imposed reasons to obtain necessary funds to invest in all investment projects
with positive NPV. Here, management has to decide to obtain that combination of
the profitable projects which yields highest NPV within the available funds.
Under the one-period constraint situation, the firm should select the portfolio of
projects which yields highest NPV per rupee of capital invested rather than to
maximize NPV in absolute term. Projects should be ranked by their profitability
index, and top-ranked projects should be undertaken until funds are exhausted.
The capital rationing leads to sub-optimal decision in case of multi period capital
constraints and project indivisibility. Number of times, it may be advisable to
accept many lower ranked smaller projects than a single large project. The
acceptance of a single large project, which may be top-ranked, excludes the
possibility of accepting small projects which may have higher total NPV.

Q.6 A finance director of a multi-crore engineering company once stated “We do not
face any capital rationing problem. The capital market is big enough to supply us
funds in various ways to finance any profitable project. We do, however, impose
budget ceiling on the capital expenditures of divisions for control purposes. But
that does not imply shortage of funds and therefore, non-acceptance of genuinely
profitable projects.” What is the finance director talking about?
A.6 Finance director is saying that they do not face any sort of External Capital
Rationing. Capital market is big and they get funds in various ways to finance any
profitable project. But they do impose ceilings on the capital expenditures of
divisions as a means of financial control. In a divisional set up, the divisional
manager may overstate their investment requirement. One way of forcing them to
carefully assess their investment opportunities and set priorities is to put upper
limit to their capital expenditures. They resort to Internal Capital Rationing for

3
 ensuring effective utilization of funds. In terms of impact, internal capital
rationing may also amount to rejecting positive NPV projects.

Q.7 Explain the limitations of the NPV and PI rules in selecting investment projects
under capital rationing.
A.7 Under the capital rationing, firm should accept all investment projects with
positive NPV in order to maximize the wealth of shareholders. The NPV rule will
not work in the following circumstances:
1. The owner-manager do not approve the idea of the public issue of shares
because of the fear of losing control of the business; or
2. The prospective investors are not convinced of the prospects of the projects;
or
3. The cut-off or minimum rate of return required by investor may be higher than
the internal rate of return of the project.
According to the PI rule those projects should be selected that give the highest
ratio of present value to initial outlay. The PI rule will not work in the following
circumstances.
1. PI rule cannot be used in multi-period constraints. In some of the projects
investment can be made in year 0 and same may require investment later on.
Some projects may require the investment in piece-meal way, i.e., in phased
manner. In such circumstances, ranking of projects is quite difficult.
2. PI rule cannot be applied thoroughly on account of project indivisibility. The
acceptance of single large project excludes the possibility of accepting small
projects which may have higher total NPV. So objective of diversification of
risks cannot be achieved by considering mutually exclusive projects or
dependent projects.

Q.8 How does mathematical programming help in the optimum choice of projects
under capital rationing? Why is not programming approach popular in practice?
A.8 The limitations of PI method in case of multi-period constraints supported
development and use of mathematical models like linear programming and integer
programming. The linear programming equations can be framed by deciding
objective functions, and also the constraints. Then the linear programming
equations can be solved with the help of computer or by using simplex method.
The LP solutions require us to accept a fraction of project. If the project is
indivisible, then we use integer programming by limiting the project either by 0
and 1. Integer programs are quite difficult to solve.
The programming approach is not popular on account of following two reasons:
1. They are costly to use, when indivisible projects are involved, and
2. These models assume that future investment opportunities are known, which
is practically not possible.

4
 CHAPTER 7

OPTIONS AND THEIR VALUATION

Q1. What is an option? What is the difference between a call option and a put option?
Illustrate your answer with the help of position diagrams.
A1 In a broad sense, an option is a claim without any liability. It is a claim contingent
upon the occurrence of certain conditions. Thus, an option is a contingent claim.
More specifically, an option is a contract that gives the holder a right, without any
obligation, to buy or sell an asset at an agreed price on or before a specified
period of time.
A call option on a share (or any asset) is a right to buy the share at an agreed
exercise (strike) price. The following diagram (see Problem 1) depicts the call
option pay-off.

4
Call Value

3
2
1
0
0 47 50 51 54
Share Price

A put option is a contract that gives the holder a right to sell a specified share (or
any other asset) at an agreed exercise price on or before a given maturity period.
The following diagram (see Problem 5) depicts the put option pay-off.

0
97 100 101 104

Q2. Show by the payoff graphs of an investor at expiration with the following
portfolios:
(i) One share and a put (long)
(ii) One share and a put (short)
(iii) One share and a call (short)
(iv) One share and two call (short)
(v) Two shares and a call (short)
(vi) A call (long) and a put (short)

1
A2 Here are two examples of pay-off graphs (for the remaining See Chapter 7 in the
book for payoff graphs).

One share and a put (short)

Value of Put to Seller

10

Value of Put
5
0
-5 60 65 70 75

-10
Share Price

A call (long) and a put (short)

Value of Portfolio of Put & Call

15
Pay-off

10

0
90 97 100 110
Share Price

Q3. Explain the difference between selling a call option and buying a put option.
Illustrate your answer.
A3 The selling of a call option (short position) means that the buyer of the call option
will have the option to exercise it. The buyer will exercise the option only when
the market price the underlying asset is higher than the exercise price. Thus, the
seller of a call option will be loser. The following example illustrates this point.

6-month call option (short): Pay-off

Exercise price, E 100
Current share price, S0 100
Share price, St 110 -10
90 0
The selling of a put option (short position) means that the buyer of the put option
will have the option to exercise it. The buyer will exercise the option only when

2
 the market price the underlying asset is less than the exercise price. Thus, the
seller of a call option will be loser. The following example illustrates this point

6-month put option (short): Pay-off

Exercise price, E 100
Current share price, S0 100
Share price at maturity, St 110 -10
90 0

Q4. Explain when a call option and a put option are in-the-money, at-the-money and
out-of-the-money.
A4 In-the-money A put or a call option is said to be in-the-money when it is
advantageous for the investor to exercise it. In the case of in-the-money call
options, the exercise price is less than the current value of the underlying asset,
while in the case of the in-the-money put options; the exercise price is higher than
the current value of the underlying asset
Out-of-the-money A put or a call option is out-of-the -money if it is not
advantageous for the investor to exercise it. In the case of the out-of-the -money
call options, the exercise price is higher than the current value of the underlying
asset, while in the case of the out-of-the -money put options, the exercise price is
lower than the current value of the underlying asset.
At-the-money When the holder of a put or a call option does not lose or gain
whether or not he exercises his option, the option is said to be at-the-money. In
the case of the out-of-the-money options the exercise price is equal to the current
value of the underlying asset

Q5. What are the factors that influence the prices of options on share? Explain how
increase in the risk-free rate and decrease in volatility can make an American put
attractive if it is exercised early?
A5 The value of an option depends on the following factors:
· Exercise price and the share (underlying asset) price
· Volatility of returns on share: The greater is the risk of the share (underlying asset),
the greater is the value of an option. As the option value cannot be less than zero, the
probability of a higher price of the share causes the option to be worth more.
· Time to expiration
· Interest rate: The exercise price is paid at the time the option is exercised. The
present value of the exercise price will depend on the interest rate. The value
of a call option will increase with the rising interest rate since the present
value of the exercise price will fall. The effect is reversed in the case of a put
option.

Q6. What will be lower and upper bounds for the price of a call option? Explain the
reasons.
A6 It is difficult to say what the price of a share at expiration will be. However, we can draw
up a probabilistic distribution of the future share prices. The call option buyer will be
utmost prepared to pay for holding the option a price equal to the value of the share.
Instead of paying more for the option, he will prefer to buy the share at present. Thus, the

3
 maximum value that an option can approach is the price of the share (the underlying
asset). This is possible only when the present value of the exercise price is zero. The
exercise price can approach to zero under two conditions: (1) the time to expiration is
very long (almost infinity) and (2) the option will not be exercised in the near future.
The minimum value of an option will be zero until share price rises above the exercise
price. At maturity, the value of the option either will be zero or the excess of the share
price over the exercise price. Most often, the value of the options will lie between upper
and lower bounds.

Q7. Why isn’t it beneficial to exercise an American call option early? Give reasons.
A7 There is always a possibility that the value of the underlying asset may increase
in the future. Hence, an American option will be exercised on maturity.

Q8. What is a protective put? What position in call option is similar to a protective
put?
A8 Put option at-the-money is called a protective put. The value of the portfolio of a
share and a put at expiration will always be greater than the value of a call at
expiration by the exercise price. The investor can also protect herself by taking a
covered position. A covered call position is an investment in a share plus the sale
of a call on that share. The position is covered because the investor holds a share
against a possible obligation to deliver the share. The total value or payoff of a
covered call at expiration is the share price minus the value (payoff) of the call.

Q9 How can a spread be created? What is a straddle? What is a strangle? Draw

payoff graphs to explain the implications of a spread, a straddle and a strangle.
A9 A spread is a combination of a put and a call with different exercise prices. A
straddle is a combined position created by the simultaneous purchase (or sale) of a
put and a call with the same expiration date and the same exercise price. A
strangle is a portfolio of a put and a call with the same expiration date but with
different exercise prices.
(Refer to the chapter in the book for graphs.)

Q10 How and why a collar is created? What are its implications for an investor?
A10 A collar involves a strategy of limiting a portfolio’s value between two bounds.
Suppose you are holding a large number of Infosys shares currently selling at Rs
4,000 per share. You can design a strategy that would let your payoff to range
within a band, irrespective of the price fluctuations in Infosys share. If you do not
want your payoff to go below Rs 3,900, you can buy a protective put with an
exercise price of Rs 3,900. Your outlay will be the premium that will be required
to pay for buying the put. You can sell a call option with an exercise price of, say,
Rs 4,100 at a premium equal to the put premium. Thus, your net outlay would be
zero. The short call limits your portfolio’s upside potential. Even if the price of
Infosys share increases beyond Rs 4,100, your payoff would not exceed Rs 4,100
because the buyer of the call will exercise his option at the share price higher than
the exercise price.

4
 4200 Payoff
4100

4000
3900

3800 Share
3700
Price
3800 3900 4000 4100 4200 4300

Q11 Explain and illustrate a one-step binomial approach to value a European option.
A 11 Suppose you own a share that has a current price of Rs 150. Its price at the end of one
year has two possibilities: either Rs 100 or Rs 300. Assume that you buy a call option on
the share with an exercise price of Rs 200. At the end of the year, you will exercise your
option if the share price is Rs 300 and the value of the option will be: Rs 300 – Rs 200 =
Rs 100. You will forgo your call option if the share price is Rs 100, and the value of
option will be zero.
Instead of buying a call option, you sell a call option on the share. You can create a
portfolio of certain number of shares (let us call it delta, D) and one call option in such a
way that there is no uncertainty of the value of portfolio at the end of one year. You can
do so if you combine a long position (buying) in the share and a short position (selling) in
the call option. Let us assume that you create a portfolio of shares and an option by
buying D (delta) shares and selling a call option. Suppose if the price goes up to Rs 300,
the buyer of the option will exercise his option and you will lose Rs 100. If the price turns
out to be Rs 100 the option buyer will not exercise his option and you do not gain or lose.
Your portfolio will be risk-less if the value of the portfolio is same whether the price of
the share increases to Rs 300 or falls to Rs 100. That is:

Difference in option values

Option delta (D ) =
Difference in share prices
100 - 0 100
= = = 0.5
300 - 100 200
The option delta is the measure of the sensitivity of the option value vis-à-vis the change
in the share price.
You will have a risk-less portfolio if you combine a long position in 0.5 shares with a
short position in one call option. If the price increases to Rs 300, the value of the
portfolio is:
0.5 ´ Rs 300 – Rs 100 = Rs 50
And if the share price falls to Rs 50, then the value of portfolio is:
0.5 ´ Rs 100 = Rs 50
The value of portfolio at the end of one year remains Rs 50 irrespective of the increase or
decrease in the share price. What is the present value of the portfolio? Since it is a risk-
less portfolio, we can use the risk-free rate as the discount rate. Suppose the risk-free rate
is 10 per cent, the present value of the portfolio is:
Rs 50
PV of portfolio = = Rs 45.45
(1.10)1

5
 Since the current price of share is Rs 150, the value of the call option can be found out as
follows:
Rs 150D - value of a call option = Rs 45.45
Rs 150 ´ 0.50 - Value of a call option = Rs 45.45
Value of a call option = Rs 75 - Rs 45.45 = Rs 29.55

Q12 What is a risk-neutral valuation approach to valuing a European option? Give an

example.
A12 We can assume that investors are risk-neutral. Therefore, for their investment in
share, they would simply expect a risk-free rate of return. In our example, the
share price could rise by 100 per cent (from Rs 150 to Rs 300) or it could fall by
33.3 per cent (from Rs 150 to Rs 100). Under these situations, a risk-neutral
investor’s return from the investment in the share is given as follows:
Expected return = (probabilit y of price increase) ´ percentage increase in price
+(1 - probabilit y of price increase) ´ percentage decrease in price = risk - free rate
= p ´ 100 + (1 - p) ´ (-33.33) = 10
p = 0.325

We can utilise this information to determine the value of the call option at the end
of the year. The call option is worth Rs 100 when the share price increases to Rs
300, and its worth is zero if the share price declines. We can thus calculate the
value of the call option at the end of one year as given below:
= 0.325  100 + (1 – 0.325)  0 = Rs 32.50
The current (present) value of the call option is = 32.5/1.1 = Rs 29.55

Q13 What are the assumptions of the Black-Scholes model for option pricing? What
are the attributes of the model?
A13 The B–S model is based on the following assumptions:
1. The rates of return on a share are log normally distributed.
2. The value of the share (the underlying asset) and the risk-free rate are constant
during the life of the option.
3. The market is efficient and there are no transaction costs and taxes.
4. There is no dividend to be paid on the share during the life of the option.
The B–S model is as follows:
C 0 = S0 N(d 1 ) - Ee - rf t N(d 2 )
where
C0 = the current value of call option
S0 = the current market value of the share
E = the exercise price
e = 2.7183, the exponential constant
rf = the risk-free rate of interest
t = the time to expiration (in years)
N(d1) = the cumulative normal probability density function

6
 d1 =
[ ]
ln (S / E) + rf + s 2 / 2 t
s t
d 2 = d1 - s t
where ln = the natural logarithm;  = the standard deviation and  2 = variance of
the continuously compounded annual return on the share.
The Black–Scholes model has two features. First, the parameters of the model,
except the share price volatility, are contained in the agreement between the
option buyer and seller. Second, in spite of its unrealistic assumptions, the model
is able to predict the true price of option reasonably well. The model is applicable
to both European and American options with a few adjustments.

Q14 Illustrate the concept of put–call parity.

A14 Suppose you buy a share (long position), buy a put (long position) and sell a call
(short). The current share price is Rs 100 and the exercise price of put and call
options is the same, that is, Rs 100. Both put and call options are European type
options and they will expire after three months. Let us further assume that there
are two possible share prices after three months: Rs 110 or Rs 90. The value of
portfolio at expiration is given in the following table.

Situation I: Share price (St) Situation II: Share price (St)

Rs110, 90,
Exercise Price (E) Rs100 Exercise Price (E) Rs100
St > E Payoff St < E Payoff
Value of share (long) St 110 St 90
at expiration
Plus: Value of put + 0 +0 + (E – St) + (100 – 90)
(long) at expiration =
[Max (E - St,, 0)] + 10
Less: Value of Call – (St – E) – (110 – 100) 0 0
(short) at expiration =
[Max (St – E), 0] – 10
Total value (payoff) St – (St – E) = 100 St + (E – St) 90 + 10 = 100
E =E

You may notice that whether share price rises or falls, the value of the portfolio at
expiration is equal to the exercise price (E). It is a risk-free portfolio since the
outcome will be the same whatever happens to the share price. The present value
of the portfolio can be calculated using a risk-free rate of return (rf). Let us
assume that the risk-free rate is 10 percent. Thus the present value of portfolio is:
PV of portfolio = S 0 + P0 - C 0 = E e - rf t
= 100e - 0.1´0.25 = 100 ´ 0.9573 = Rs 97.53
We can rewrite above Equation as follows:
S + P = C + E e - rf t

7
 This relationship is called put-call parity. We can also obtain the following
expressions from above Equation
C 0 = P0 + S 0 - E e - rf t
P = C - S + E e - rf t

Q15 What is a hedge ratio or a call option delta? How is it determined?

A15 The hedge ratio is commonly called the option’s delta.
Difference in option values
Option delta (D) =
Difference in share prices
The hedge ratio is a tool that enables us to summarize the overall exposure of
portfolios of options with various exercise prices and maturity periods. An
option’s hedge ratio is the change in the option price for an Rs 1 increase in the
share price. A call option has a positive hedge ratio and a put option has a
negative hedge ratio.
Under the Black-Scholes option valuation formula, the hedge ratio of a call option
is N (d1) and the hedge ratio for a put is N (d1) – 1. N (d) stands for the area under
the standard normal curve up to d. Therefore, the call option hedge ratio must be
positive and the put option hedge ratio is negative and of smaller absolute value
than 1.0.

Q16 Why is ordinary share an option? Explain.

A16 One distinguishing feature of ordinary share is that it has limited liability. The
limited liability feature provides an opportunity to the shareholders to default on a
debt. If a firm has incurred a debt, each time a payment is due, the shareholders
can decide to make payment or to default. If the firm’s value is more than the
payment that is due, the shareholders will make payment since they shall be left
with a positive value of their equity and keep the firm. If the payment that is due
is more than the value of the firm, the shareholders will default and let the debt-
holders keep the firm. Since the shareholders have a hidden right to default on
debt without any liability, the debt contract gives them a call option on the firm.
The debt-holders are the sellers of call option to the shareholders. The amount of
debt to be repaid is the exercise price and the maturity of debt is the time to
expiration.
There is an alternate way of looking at ordinary share as an option. The
shareholders’ option can be interpreted as a put option. The shareholders can sell
(hand-over) the firm to the debt-holders at zero exercise price if they do not want
to make the payment that is due.

8
 CHAPTER 10

CASH FLOWS FOR INVESTMENT ANALYSIS

Q1. Distinguish between profits and cash flows. Why are cash flows important in
investment decisions?
A1 Cash flow is not the same thing as profit, at least, for two reasons.
First, profit, as measured by an accountant, is based on accrual concept—revenue
(sales) is recognised when it is earned, rather than when cash is received, and
expense is recognised when it is incurred rather than when cash is paid.
Second, for computing profit, expenditures are arbitrarily divided into revenue
and capital expenditures. Revenue expenditures are entirely charged to profits
while capital expenditures are not. Capital expenditures are capitalised as assets
(investments), and depreciated over their economic life. Only annual depreciation
is charged to profit. Depreciation (DEP) is an accounting entry and does not
involve any cash flow. Thus, the measurement of profit excludes some cash flows
such as capital expenditures and includes some non-cash items such as
depreciation.
Investment decisions require information about cash flows. It is the inflow and
outflow of cash, which matters in practice. It is cash, which a firm can invest, or
pay to creditors to discharge its obligations, or distribute to shareholders as
dividends. Cash flow is a simple and objectively defined concept. It is simply the
difference between rupees received and rupees paid out.

Q2. What are incremental cash flows? Briefly explain the effects of the following on
the calculation of incremental cash flows: (a) sunk costs, (b) allocated overheads,
and (c) opportunity costs.
A2 Every investment involves a comparison of alternatives. The minimum
investment opportunity, which a company will always have, will be either to
invest or not to invest in a project. When the incremental cash flows for an
investment are calculated by comparing with a hypothetical zero-cash-flow
project, we call them absolute cash flows.
The incremental cash flows are found out by subtracting (algebraically) cash
flows of Project 1 from that of Project 2 (or vice versa). Such comparison
between two real alternatives can be called relative cash flows. The principle of
incremental cash flows assumes greater importance in the case of replacement
decisions.
Sunk costs are cash outlays incurred in the past. They are the results of past
decisions, and cannot be changed by future decisions. Since they do not influence
future decisions, they are irrelevant costs. They are unavoidable and irrecoverable
historical costs; they should simply be ignored in the investment analysis.
Since the general overheads will be incurred whether or not the new projects are
undertaken, those allocated overheads should be ignored in computing the net
cash flows of an investment. However, some of the overheads may increase

1
 because of the new project; these should be charged to the project. The
incremental cash flow rule indicates that only incremental overheads are relevant.
Opportunity costs are the expected benefits, which the company would have
derived from those resources if they were not committed to the proposed project.
It is important to note that the alternative use rule is a corollary of the incremental
cash flow rule.

Q3. A company has just tested the market for a new product. The test indicates that
the product may capture about 40 percent of the market share. It is also expected
that 25 percent of the new product’s share will be at the cost of an existing
product. The new product can be manufactured in the existing facilities, which
could also be used to meet the expected increase in one of the company’s existing
products. The company’s financial analyst argues that she would include the test
costs in the new product’s cash flows since they were incurred for testing the new
product, but would exclude the lost contribution on an existing product and the
value of the existing facilities to be used for the manufacture of the new product
because no out-of-pocket cost is incurred. Do you agree with the analyst? Why or
why not?
A3 No, test costs have already been incurred (whether project is undertaken or not,
they will not be influenced); they are sunk costs and hence, cannot be included in
the new product’s cash flows. Lost contribution on an existing product and the
value of the existing facilities to be used for the manufacture of the new product is
the opportunity cost and should be included in evaluating the new project.

Q4 How should depreciation be treated in capital budgeting? Do the depreciation

methods affect the cash flows differently? How?
A4 The computation of the after-tax cash flows requires a careful treatment of non-
cash expense items such as depreciation. Depreciation is an allocation of cost of
an asset. It involves an accounting entry and does not require any cash outflow;
the cash outflow occurred when the assets was acquired.
Depreciation, calculated as per the income tax rules, is a deductible expense for
computing taxes. In itself, it has no direct impact on cash flows, but it indirectly
influences cash flow since it reduces the firm’s tax liability. Cash outflow for
taxes saved is in fact an inflow of cash. The saving resulting from depreciation is
called depreciation tax shield.
Depreciation tax shield = Tax rate ´ Depreciation
DTS = T´ DEP
In India, for tax purpose written down value method of depreciation is allowed.
Hence, other methods will have no effect on cash flows.
Q5 In an interview with the chief executive of a motorcycle manufacturing company,
he commented: “We present our capital budgeting numbers in real terms.
Therefore, we have got to anticipate the inflation rate.” Discuss the chief
executive’s comment.
A5 The NPV rule gives correct answer to choose an investment under inflation if it is
treated consistently in cash flows and discount rate. The manufacturing company
should discount real cash flows at the real discount rate. The discount rate, being

2
 the cost of capital, is market determined and is always in nominal terms. Hence,
the company should determine the inflation rate to convert nominal cost of capital
into real cost of capita. The following equation gives the relationship between
nominal and real cost of capital:
Norminal discount rate = (1 + real discount rate)(1 + inflation rate) - 1
1 + nominal discount rate
Real discount rate = -1
1 + inflation rate

Q6. The chairman of a rubber company stated, “We don’t adjust our capital budgeting
calculations for inflation because the price and costs of the product increase by
the same rate.” Comment.
A6 What the chairman is implying is that they use real cash flows in making capital
decisions. If the real cash flows have been correctly identified and these cash
flows are discounted at real cost of capital, then the rubber company is using a
correct procedure. However, because of non-cash items like depreciation and
different inflation rates for items of revenues and expenses, it is difficult to use
real cash flow approach. It is more convenient to use nominal cash flows and
nominal discount rate in such cases.

Q7. Illustrate the distinction between real and nominal rates of return. Is this
distinction important in capital budgeting decisions? Why?
A7 The nominal discount rate is a combination of the real rate (say, K) and the
expected inflation rate (let us call it, α). This relationship, long ago recognised in
the economic theory, is called the Fisher’s effect. It may be stated as follows:
Nominal discount rate = (1 + real discount rate)(1 + inflation rate) - 1

k = (1 + K )(1 + a) - 1
In practice, it is customary to add the real rate and the expected inflation rate to
obtain the nominal required rate of return: k = K + a.
Yes, the distinction is important in capital budgeting decisions. The NPV rule
gives correct answer to choose an investment under inflation if it is treated
consistently in cash flows and discount rate. The discount rate is a market-
determined rate and therefore, includes the expected inflation rate. It is thus
generally stated in nominal terms. The cash flows should also be stated in nominal
terms to obtain an unbiased NPV. Alternatively, the real cash flows can be
discounted at the real discount rate to calculate unbiased NPV.

Q8. Why should investment decisions be separated from financing decisions?

Illustrate your answer.
A8 The firm’s weighted average cost of capital is used in evaluating investment
projects under two conditions: (1) the risk of project is the same as that of the
firm; (2) the target capital structure is same for the firm and all projects and
remains constant over years. WACC incorporates the financing effect. Hence
cash flows do not consider the financing effects. These cash flows are known as
free cash flows; they are available to service both debt and equity.

3
 CHAPTER 13

REAL OPTIONS, INVESTMENT STRATEGY AND PROCESS

Q.1 Explain the important steps in the capital budgeting process.

A.1 Capital expenditure includes all those expenditures which are expected to produce
benefits to the firm over more than one year and encompasses both tangible and
intangible assets.
The most important steps in capital budgeting process are
1. Identification, i.e., generation of investment ideas;
2. Development of forecasts of benefits and costs for each and every investment
ideas;
3. Evaluation of each and every ideas to measure whether it is profitable or not;
4. Authorization by top management or approval authority and
5. Control and monitoring, i.e. review and monitor the performance of
investment projects after completion and during their life.

Q.2 Is capital budgeting merely a question of selecting investment projects? Defend

your position.
A.2 Financial evaluation of capital expenditure proposals help to select highly
profitable projects. In practice, companies give considerable importance to
qualitative factors like market potential, possibility of technology change, trend of
government policies, etc. Judgment and intuition should definitely be used when a
choice is to be made between two or more projects, or when it involves changing
the long term strategy of the company. For routine matter, liquidity and profits
should be preferred over judgment.

Q.3 What role is played by judgment and qualitative factors in the investment
selection? Is it justifiable?
A.3 In addition to the use of the sophisticated techniques for evaluation of capital
expenditure decision, the qualitative factors like urgency, strategy and
environment play significant role.
Vision or judgment of the future, e.g., market potential, possibility of technology
change, trend of government policies, opportunities and constraints of a particular
project, etc. is very critical for the success of the firm adopting the investment
projects. A growing firm maybe able to identify profitable opportunities without
making NPV or IRR computation.

Q.4 Is there any interface between strategy and the capital budgeting system? Why
should capital budgeting be seen within a strategic perspective?
A.4 Most companies consider strategy as an important factor in capital budgeting
decision evaluation. Management should spend its time in improving the quality
of decision in the context of overall strategy, e.g., overall objective achievements
of firm. This approach provides the decision-maker with a central theme as a
guideline for effectively allocating corporate financial resources.

1
 Strategic management has emerged as a systematic approach in properly
positioning of firm in the complex environment by balancing multiple objectives,
for example, growth, competition, balance of products, total risk diversification,
and managerial capacity, etc. These reinforce the need for a strategic framework
for problem-solving under complexities and the relevance of strategic
considerations in investment planning. Capital budgeting decision involves large
investment such as acquisition of a new business or expansion in a new line of
business. Such decisions are generally handled by top management, and have
strategic importance.

Q.5 Briefly discuss the capital budgeting practices of companies in India.

A.5 In India, the investment idea generation is primarily a bottom-up process.
Generally, majority of investment proposals comes from divisional management
and plant personnel.
Indian companies use a variety of methods to encourage idea generation. The
most common methods used are: (a) management sponsored studies for project
identification; (b) formal suggestion schemes, and (c) consulting advice. In
addition, companies search investment idea by review of researches done in the
country or abroad, conducting market surveys, and deputing executives to
international trade fairs for identifying new products or technology. Companies
use arbitrary period of 5 to 10 years for forecasting cash flows on conservative
basis. Companies also do formal financial evaluation of almost three-fourths of
investment proposals. They use pay-back period criterion, and also IRR and NPV
methods for evaluation of investment proposal. Companies in India have a
tendency to equate the minimum rate with interest rate or specific cost of capital.
Indian companies do not use capital rationing theory to allocate scarce resources.
The approval of investment proposal normally lies with top management.

Q.6 What are real options? Give examples of real options. How should real option be
evaluated?
A.6 Real options are those strategic elements in investments that help creating
flexibility of operations, or that have the potential of generating profitable
opportunities in the future for the firm. Real options provide discretion to
managers to take certain investment decisions, without any obligation, for a given
price. Real options are not confined to real assets only. Patent, R&D, brands etc.
are examples of assets that have a value to the owner.
The option pricing theory provides a framework for valuing strategic investments.
The methods of valuing real options are the same as the financial options.
An investment with real option consists of two values: the value of cash flows
from the project’s assets plus the value of any future opportunity (option) arising
from holding the asset.

2
 CHAPTER 14

FINANCIAL AND OPERATING LEVERAGE

Q.1 Explain the concept of financial leverage. Show the impact of financial leverage
on the earnings per share.
A.1 The use of fixed-charges sources of funds, such as debt and preference capital,
along with owners’ equity in the capital structure is known as financial leverage
(or gearing or trading on equity). The financial leverage employed by a company
is intended to earn more on the fixed charges funds than their costs. The surplus
will increase the return on the owners’ equity.
The role of financial leverage in magnifying the return of the shareholders’ is
based on the assumptions that the fixed-charges funds (such as the loan from
financial institutions and other sources or debentures or bonds) can be obtained at
a cost lower than the firm’s rate of return on net assets. So, when the difference
between the earnings generated by assets financed by the fixed-charges funds and
costs of these funds is distributed to the shareholders, the earnings per share (EPS)
(or return on equity, ROE) increases. EPS is calculated by dividing profits after
tax (PAT) (net of preference dividend) by the number of shares outstanding.
Example:
All-equity Debt-equity
1. Investment 500,000 500,000
2. Equity capital 500,000 250,000
3. Debt capital @ 15% 0 250,000
4 EBIT 120,000 120,000
5. Less: Interest 0 37,500
6. PBT 120,000 82,500
7. Less: Taxes @ 50% 60,000 41,250
------- -------
8. PAT 60,000 41,250
9. No. of equity shares 50,000 25,000
10. EPS (5 ÷ 6) 1.20 1.65
This indicates that EPS increases as debt in introduced in the capital structure.
Q.2 Does financial leverage always increase the earnings per share? Illustrate your
answer.
Q.2 The earnings per share will increase if return on assets is higher than the interest
cost, and EPS will reduce if return on assets is lower than the interest cost. The
EPS will not be affected by the level of leverage if return on assets just equal to
the interest cost.
Example:
No Debt 50% Debt 75% Debt
(Rs.) plan (Rs.) plan (Rs.)
1. Investment 500,000 500,000 500,000
2. Equity capital 500,000 250,000 125,000
3. Debt capital @ 15% 0 250,000 375,000
4. EBIT 120,000 120,000 120,000

1
 5. Interest 0 37,500 56,250
6. PBT 120,000 82,500 63,750
7. Taxes @ 50% 60,000 41,250 31,875
8. PAT 60,000 41,250 31,875
9. No. of equity shares 50,000 25,000 12,500
10. EPS (8 ÷ 9) 1.20 1.65 2.55
11 ROI 24% 24% 24%
12 ROE 12% 16.5% 25.5%

Q.3 What is financial risk? How does it differ from business risk? How does the use
of financial leverage result in increased financial risk?
A.3 The variability of EBIT and EPS distinguish between two types of risk - operating
risk and financial risk. Operating risk or business risk can be defined as the
variability of EBIT on account of variability of sales and expenses. The
fluctuation of sales happens on account of general economic conditions, events in
related product lines, and boom or recession in industry. The variability of
expenses may include variability in prices of factors of production, technological
changes, etc.
For a given degree of variability of EBIT, the variability of EPS (or ROE)
increases with more financial leverage. The variability of EPS caused by the use
of financial leverage is called financial risk. Firms exposed to same degree of
operating risk can differ with respect to financial risk when they finance their
assets differently. A totally equity financed firm will have no financial risk. But
when debt is used, the firm adds financial risk. The operating risk is unavoidable,
while financial risk is avoidable.
Financial leverage magnifies the shareholders’ earnings. The variability of EBIT
causes EPS to fluctuate within wider ranges with debt in the capital structure.
That is, with more debt, EPS rises and falls faster than the rise and fall in EBIT.
Example:
Situation 1 Situation 2 Situation 3
Rs Rs Rs
1. EBIT 100,000 120,000 80,000
2. Less Interest 40,000 40,000 40,000
3. EBT (PBT) 60,000 80,000 40,000
4. Taxes @ 50% 30,000 40,000 20,000
5. PAT 30,000 40,000 20,000
6. No. of equity shares 50,000 50,000 50,000
7. EPS 0.60 0.80 0.40
Above example indicates that at the same level of debt-equity ratio in the capital
structure of the firm, the EPS rises by increases in EBIT, and falls by decreases in
EBIT.

Q.4 If the use of financial leverage magnifies the earnings per share under favorable
economic conditions, why companies do not employ very large amount of debt in
their capital structures?

2
A.4 Financial leverage works both ways. It accelerates EPS (and ROE) under
favorable economic conditions, but depresses EPS (and ROE) when the going are
not good for the firm. The favorable effect of the increasing financial leverage
during normal and good years is on account of the fact that the rates of return on
assets exceed the cost of debt. From, the table explained in A. 3 above, it is clear
that favorable economic condition (i.e., increase in EBIT in situation 2)
accelerated EPS, while unfavorable economic condition (i.e., decrease in EBIT in
situation 3) depressed EPS. Generally, companies do not employ very large
amount of debt on account of business risk i.e., variability in sales and expenses,
which is unpredictable with accuracy.

Q.5 What is an EBIT-EPS analysis? Illustrate your answer.

A.5 In practice, EBIT for any firm is subject to various influences on account of
fluctuations in the economic conditions, sales, expenses, etc. The EBIT-EPS
analysis helps to find out the impact of financial leverage on EPS (and ROE) for
possible fluctuations in EBIT.
Example: (A) Debt 60%, Equity 40%
Situation Situation Situation
1 (poor) 2 (Normal) 3 (Good)
1. EBIT 50,000 75,000 100,000
2. Capital Employed 500,000 500,000 500,000
3. Debt Capital @ 15% 300,000 300,000 300,000
4. Interest 45,000 45,000 45,000
5. P.B.T (1-4) 5,000 30,000 55,000
6. Taxes @ 50% 2,500 15,000 27,500
7. PAT 2,500 15,000 27,500
8. No. of equity shares 20,000 20,000 20,000
9. EPS (7 ÷ 8) 0.125 0.75 1.375
10. R.O.I (EBIT/CE) .10.0% 15.0% 20.0%

B: Assume Debt 90%, and Equity 10%

1. EBIT 50,000 75,000 100,000
2. Interest @ 15% 67,500 67,500 67,500
3. PBT (17,500) 67,500 32,500
4. Taxes @ 50% 8,750* 3,750 16,250
5. PAT (8,750) 3,750 16,250
6. No. of equity shares 5,000 5,000 5,000
7. E.P.S. (1.75) 0.75 3.25
8. R.O.I (EBIT/CE) 10.0% 15.0% 20.0%
*Assumed that losses will be set off against other profits

The above two financial plans indicate that higher financial leverage works
adversely when the firm face the unfavorable economic conditions.

Q.6 What is an indifference point in the EBIT-EPS analysis? How would you compute
it?

3
A.6 The relationship between EBIT and EPS for the alternative financial plans can be
depicted in graphical way, in the form of EBIT-EPS chart. The chart is easy to
prepare since, for any given level of financial leverage, EPS is linearly related to
EBIT. In the chart, EBIT is shown on a horizontal line and EPS on vertical line.
We can draw EBIT-EPS line for all different financial plans. The point of
intersection of all financial plans lines in short indicates the ‘Indifference point’ at
which EPS is same regardless of the level of financial leverage.
The firm wants to know the level of EBIT at which EPS would be same under two
alternative plans. It can be worked out by using following formula:
EBIT(1 - T) (EBIT - INT)(1 - T )
=
N1 N2
where N1 is the number of equity share under first plan and N2 is the number of
equity shares under second plan.
Example:
The firm is considering two financial plans, viz. an all equity plan, and a plan with
1:3 debt-equity ratio. Assume total finance need is Rs. 500,000 and debt interest
@ 10%. Using the above values, we can determine the level of EBIT at which
EPS of both plan is same. Also, assume tax rate 50% and FV of share Rs. 10.
EBIT(1 - 0.50) (EBIT - 12500)(1 - 0.50)
=
50,000 37,500
æ 37500 ö
\ 0.50EBITç ÷ = 0.50EBIT - 6250
è 50000 ø
\ 0.375EBIT - 0.50EBIT = -6,250
EBIT = 50,000
Verify: At EBIT of Rs. 50,000. The EPS of each plan:
50,000(1 - 0.50) (50,000 - 12500)(1 - 0.50)
\ =
50,000 37,500
0.50 = 0.50

Q.7 Explain the merits and demerits of the various measures of financial leverage.
A.7 The most commonly used measures of financial leverage are:
1. Debt ratio: The ratio of debt to total capital, i.e.,
D D
L1 = =
D+E V
2. Debt–equity ratio: The ratio of debt to equity, i.e.,
D
L2 =
E
3. Interest coverage: The ratio of net operating income to interest
charges,
EBIT
L3 =
Interest
The first two measures of financial leverage can be expressed either in terms of
book values or market values. The market value to financial leverage is
theoretically more appropriate because market values reflect the current attitude

4
 of investors. But it is difficult to get reliable information on market values in
practice. The market values of securities fluctuate quite frequently.
There is no difference between the first two measures of financial leverage in
operational terms. These relationships indicate that both these measures of
financial leverage will rank companies in the same order. However, the first
measure (i.e. D/V) is more specific as its value will range between zero to one.
The value of the second measure (i.e. D/E) may vary from zero to any large
number. The debt-equity ratio, as a measure of financial leverage, is more popular
in practice. There is usually an accepted industry standard to which the
company’s debt–equity ratio is compared.
The first two measures of financial leverage are also measures of capital gearing.
They are static in nature as they show the borrowing position of the company at a
point of time. These measures, thus, fail to reflect the level of financial risk,
which is inherent in the possible failure of the company to pay interest and repay
debt.
The third measure of financial leverage, commonly known as coverage ratio,
indicates the capacity of the company to meet fixed financial charges. The
reciprocal of interest coverage, that is, interest divided by EBIT, is a measure of
the firm’s income gearing. Again by comparing the company’s coverage ratio
with an accepted industry standard, investors can get an idea of financial risk.
However, this measure suffers from certain limitations. First, to determine the
company’s ability to meet fixed financial obligations; it is the cash flow
information, which is relevant, not the reported earnings. During recessionary
economic conditions, there can be wide disparity between the earnings and the net
cash flows generated from operations. Second, this ratio, when calculated on past
earnings, does not provide any guide regarding the future riskiness of the
company. Third, it is only a measure of short-term liquidity than of leverage.

Q.8 Define operating and financial leverage. How can you measure the degree of
operating and financial leverage? Illustrate with an example.
A.8 Operating leverage refers to the use of fixed costs in the operation of a firm, and it
accentuates fluctuations in the firm’s operating profit due to changes in sales.
Thus, the degree of operating leverage may be defined as the percentage change
in operating profit (EBIT) on account of change in sales.
DEBIT Sales
DOL = ´
EBIT DSales

Or
Contributi on
DOL =
EBIT
The financial leverage refers to the use of fixed charges capital like debt with
equity capital in the capital structure. The main reason for using financial leverage
is to increase the shareholders’ wealth/return.
The percentage of change in EPS occurring due to a given percentage change in
EBIT is referred to as degree of financial leverage (DFL).

5
 % Change in EPS
DFL = -------------------
% change in EBIT

DEPS EBIT
= ´
EPS DEBIT

EBIT
DFL =
EBIT - INT
For example, the expected sales volume of firm is 100,000 units. The selling price
Rs 8 per unit, the variable cost per unit Rs. 4; fixed operating charges Rs. 280,000
and fixed financial charges Rs. 50,000.

Contribution
DOL = ------------
EBIT

Sales Volume (S.P. – V.C)

= ----------------------------------------
Contribution – Fixed Operating Charges

1,00,000(8 - 4) 4,00,000
= = = 3.33
4,00,000 - 2,80,000 1,20,000

This indicates that EBIT will change by 3.33 times, for given change in sales.

EBIT
DFL =
EBIT - INT

1,20,000 1,20,000
= = = 1.71
1,20,000 - 50,000 70,000
This indicates that EPS will change by 1.71 times, for given change in EBIT.

Q.9 What is the degree of combined leverage? What do you think is the appropriate
combination of operating and financial leverage?
A.9 The degrees of operating and financial leverages can be combined to see the
effects of total leverage on EPS associated with a given change in sales. The
degree of combined leverage can be calculated as under:
% of change in EBIT % of change in EPS
DCL = ----------------------- × ---------------------
% of change in Sales % of change in EBIT
% of change in EPS
= --------------------- = DFL × DOL
% of change in Sales

6
Operating leverage and financial leverage together cause wide fluctuation in EPS
for a given change in sales. If a company employs a high level of operating
leverage and financial leverage, even a small change in the level of sales will have
dramatic effect on EPS.
The appropriate combination should be governed by the behaviour of sales. The
public utilities such as Electricity Companies can afford to combine high
operating leverage with high financial leverage since they generally have stable or
rising sales. A company whose sales fluctuate widely and erratically should avoid
use of high financial leverage since it will be exposed to a very high degree of
risk.

7
 CHAPTER 12

RISK ANALYSIS IN CAPITAL BUDGETING

Q.1 Explain the concept of risk? How can risk be measured?

A.1 Risk can be defined as variability of returns of an investment. Risk arises in
investment evaluation because we cannot make any correct prediction about the
cash flow sequence since the future events on which they depend are uncertain.
Risk can be measured by using statistical techniques to measure the variability.
Standard deviation, variance or coefficient variation can be used to measure risk.

Q.2 What are the advantages of risk-adjusted discount rate? What is the major
problem in using this approach to handle risk in capital budgeting?
A.2 The risk-adjusted discount rate is a composite rate, which allows for both time
preference and risk preference and will be the sum of the risk-free rate and risk
premium.
Risk-adjusted rate = Risk-free rate + Risk premium = kf + kr
A higher rate will be used for riskier projects and a lower rate for less risky
projects. The method is very simple, and can be easily understood. It has a great
deal of intuitive appeal for risk-averse businessman.
The constant risk-adjusted discount rate is not valid over the life span of project.
It is also quite difficult to specify risk-adjusted discount rate properly to measure
the degree of increasing risk.

Q.3 What are the advantages of using certainty-equivalent approach? Does it suffer
from any limitation?
A.3 The certainty-equivalent coefficient establishes a relationship between the certain
cash flows and the risky cash flows.

CCFt Certain net Cash flow

αt = ------- = ----------------------
NCFt Risky net cash flow

The NPV under certainty equivalent approach may be expressed as:

n
a NCFt
NPV = å t
t = 0 (1 + k f )
t

where NCFt = the forecast of net cash flow without risk-adjustment; αt = the risk
adjustment factor or certainty equivalent coefficient, and kf = risk-free rate. αt
assume a value between 0 and 1, and varies inversely with risk.
Certainty-equivalent approach explicitly recognizes the risk, but the procedure for
reducing the forecasts of cash flows is implicit. In large enterprise, the forecaster,
expecting that the reduction will be made in his forecast, as it pass through several
layers of management, may inflate them in anticipation. By focusing only on the
gloomy outcomes, chances are increased for passing by some good investments.

1
Q.4 “The certainty equivalent approach is theoretically superior to the risk-adjusted
discount rate”. Do you agree? Give reasons.
A.4 Yes, because certainty equivalent approach measures risk more accurately by
adjusting estimated cash flows and employs risk-free rate to discount the adjusted
cash flows. On the other hand, the risk-adjusted discount rate adjusts for risk by
adjusting the discount rate.
If the investor thinks that an investment may be more risky during the gestation
period, and once established, risk may reduce. In such case, the use of a constant
risk-adjusted discount rate is not valid. But the increased or decreased risks over a
period of time can easily be accounted for by changing the certainty equivalent
factors, when the certainty equivalent approach is used.

Q.5 What are the limitations of payback method as a risk handling technique? Can it
be used as a supplement to more sophisticated techniques?
A.5 The payback period is the number of years required to recover the initial outlay of
the investment. The payback period method ignores the time value of money,
ignores the cash flows occurring after the payback period, and also does not
measure the profitability of the project.
The payback period method can be used, only in case of project having special
type of risk like civil wars, introduction of new product by a competitor, and
natural disasters such as flood or fire, which will suddenly cease the entire project
altogether and be worth nothing. This method makes an allowance for risk by
focusing attention on the short term project and thereby emphasizing the liquidity
of the firm through early recovery of project.

Q.6 How can you conduct the DCF break even analysis? Why is the DCF analysis
important in risk analysis in capital budgeting?
A.6 DCF break-even means a situation where NPV is zero. The NPV of a project
depends on cash outlay, volume, price, variable costs, fixed costs, depreciation
rate, tax rate, life of the project etc. For calculating DCF break-even point, one
can take one variable and determine its minimum value at which NPV is zero.
DCF analysis is important in risk analysis since it indicates the sensitivity of the
project NPV to changes in variables. It helps to identify variables which are
critical to the project NPV.

Q.7 What is sensitivity analysis? What are its advantages and limitations?
A.7 Sensitivity analysis is a way of analyzing change in the project’s NPV (or IRR)
for a given change in one of the variables, e.g., sales volume, unit selling price,
unit variable costs, etc. It indicates how sensitive a project’s NPV (or IRR) is to
changes in particular variables. The more sensitive the NPV, the more critical is
the variable.
It has the following advantages:
1. Helps the decision maker to identify the variables which affect the cash flow
forecasts, and understand the project in totality.

2
 2. Indicates the critical variables, and helps in strengthening the ‘weak spots’ of
the projects.
3. Helps to expose inappropriate forecasts.
It has the following limitations:
1. Does not provide clear cut results.
2. Fails to focus on interrelationship between variables.

Q.8 How is the probability theory utilized in analyzing risk of investment projects?
Illustrate.
A.8 Probability may be defined as a measure of someone’s opinion about the
likelihood that an event will occur. Risk is referred to a situation where the
probability distribution of the cash flow of an investment proposal is known. The
capital budgeting decision is a forecast of future cash flows. A forecaster should
not give just one estimate, but a range of associated probability – a probability
distribution. The probability of all events to occur lies between 0 and 1.
Once the probability assignments have been made to the future cash flows, the
next step is to find out the expected net present value. It can be found out by
multiplying the monetary values of the possible events by their probabilities. The
dispersion of cash flow indicates the degree of risk. The risk can be measured by
standard deviation or variance. The standard deviation is the square root of
variance. The variance can be calculated by finding out the difference between
each event’s i.e., possible cash flow that can occur and their expected value. This
difference is squared and then multiplied by respective probability of events.
n
s 2 NCF = å ( NCFj - ENCF) 2 Pj
j=1

s NCF = s 2 NCF

Here, σ2 = variance; σ = standard deviation, NCFj = Net cash flow of jth event;
ENCF = Expected net present value; and Pj = Probability of jth event.

Q.9 Describe the decision tree approach with the help of an example. How is this
technique useful in capital budgeting?
A.9 When the sequential decision making is involved, to resolve the risk, decision tree
analysis is much useful. The decision tree provides a way to represent different
possibilities so that we can be sure that the decision we make today, take proper
account of what we can do in the future. To draw a decision tree, branches from
points marked with squares are used to denote different possible decisions, and
branches from points marked with circles denote different possible outcomes. In a
decision tree analysis, one has to work out the best decisions at the second stage
before one can choose the best first stage decision. Decision trees are valuable
because they display links between today’s and tomorrow’s decisions. Further, the
decision maker explicitly considers various assumptions underlying the decision.
For example, to construct a decision tree to build small plant or large plant
following steps are required:

3
 1. Define Investment – Here, investment proposal should be defined – e.g. to
produce a new product.
2. Identify decision alternatives – The decision alternatives should be clearly
identified, e.g., to construct small plant initially and expand it later on or to
construct large plant or construct no plant.
3. Draw a decision tree – Decision tree to be graphed indicating the decision
points, chance events and other data, e.g., relevant data such as project cash
flows, probability, and expected net present value should be located on
decision tree branches.
4. Analyze data: Analyze the data for each alternative, workout ENPV for each
alternative at each decision tree branch level, and select the best alternative.

Q.10 How can utility theory be incorporated in the capital budgeting decision to
account for the risk preferences of the decision maker?
A.10 Utility theory aims at including a decision makers’ risk preferences explicitly in to
the capital expenditure decision. The underlying principle is that an investor
prefers a higher return to a lower return, and that each successive identical
increment of money is worth less to him than the preceding one. The decision
maker’s utility function is derived to determine the decision’s utility value. A
rational decision maker would maximize his utility, by accepting the investment
project which yields maximum utility to him.
The risk-averse investors attach lower utility to increasing wealth while risk-
seeking investors attach more utility to increasing wealth. Risk neutral investors
attach same utility to increasing or decreasing wealth.
It is very difficult to derive utility function; it does not remain constant over time.
Problems are also encountered when decision is taken by a group of people.
Individuals differ in their risk preferences.

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 CHAPTER 17

DIVIDEND THEORY

Q.1 What are the essentials of Walter’s dividend model? Explain its shortcomings.
A1. Prof. J E Walter argues that the choice of dividend policies almost always affects
the value of the firm. Walter’s model is based on the following assumptions:
1. The firm finances all its investment through retained earnings;
2. The firm’s rate of return r, and its cost of capital, k, are constant;
3. The firm have 100% dividend payment or retention ratio;
4. The firm’s EPS and DPS are constant forever in determining a given value
of firm.
The market price of share is the sum total of present value of infinite stream of
constant dividend, DIV/k; and infinite stream of capital gains, [r (EPS-DPS)/k]/k.
DIV + r / k (EPS - DPS)
P=
k

According to the Walter’s model, the optimum dividend policy depends on the
relationship between r and k. If r>k, the share value will increase as the firm
retains more earnings; the price will be maximum when the firm retains 100%. If
r<k, the price will be maximum if the firm distributes 100% dividend.
The Walter’s model assumes that the firm’s investment opportunities are financed
by retained earnings only. In the long-term, r does not remain constant; it
decreases as more and more investment is made. The firm’s cost of capital also
does not remain constant; it changes directly with firm’s risk.

Q.2 What are the assumptions which underlie Gordon’s model of dividend effect?
Does dividend policy affect the value of the firm under Gordon’s model?
A.2 Gordon’s model is based on the following assumptions.
1. The firm is an all-equity firm.
2. No external financing is available for expansion.
3. Constant internal rate of return, r3 and constant cost of capital, k.
4. The firm and its stream of earnings are perpetual.
5. Corporate taxes do not exist.
6. The retention ratio, b, once decided upon, is constant.
7. The firm’s cost of capital is greater than growth rates where growth rate is
retention ration multiplied by internal rate of return, i.e., g = br.
Gordon’s model is expressed as follows:
EPS1 (1 - b)
Po =
k-g

where b is retention ratio; EPS is earnings per share; g is growth rate and it is
equal to br (retention ration multiplied by rate of return).
The Gordon model suffers from the same limitations as the Walter model.

1
Q.3 “Walter’s and Gordon’s models are essentially based on the same assumptions.
Thus, there is no basic difference between the two models.” Do you agree or not?
Why?
A.3 Yes, because both models, in short, concludes that,
1. The market value of the share increases with increase in retention ratio
when r > k.
2. The market value per share is not affected by the dividend policy when r =
k.
3. The market value per share decrease with retention if r < k.

Q.4 “According to Walter’s model the optimum payout ratio can be either zero or 100
per cent.” Explain the circumstances, when this is true.
A.4 In the case of growth firm (r > k), the market value per share, P, increases as
payout ratio declines (optimum payout ratio is zero).
In the case of declining firm (r < k), the market value per share, P, increases as
payout ratio increases (optimum payout ratio is 100%).
In the case of normal firm (r = k), the payout ratio has no effect on the market
value per share
Example:

Growth firm Normal firm Declining firm

r>k r=k r<k

Basic data r = 0.15 r = 0.10 r = 0.08

k = 0.10 k = 0.10 k = 0.10

EPS Rs. 10 Rs. 10 Rs. 10

DIV + r / k (EPS - DPS)

P=
k
Payout ratio = 0%
P= Rs. 150 P =Rs. 100 P = Rs. 80
Payout ratio = 100%
P= Rs. 100 P = Rs. 100 P = Rs. 100

Q.5 “The contention that dividends have an impact on the share price has been
characterized as the bird-in-the-hand argument.” Explain the essential of this
argument. Why this argument is considered fallacious?
A.5 According to the bird-in-the-hand argument, investors tend to behave rationally,
are risk averse and, therefore, have a preference for near dividends to future
dividends. They most certainly prefer to have their dividend today and let
tomorrow take care of itself. Further, given two companies with identical earnings
record, and prospects but one paying a larger dividend will always command
higher share price because investors prefer present to future values.
This argument is fallacious, on the contention that, if the firm does not pay any
dividend a shareholder can create a “home made dividend” by selling a part of

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 his/her shares at the fair market price in the capital market for obtaining cash.
This will not make any dilution in their wealth.

Q.6 What is Modigliani-Miller’s dividend irrelevance hypothesis? Critically evaluate

its assumptions.
A.6 M-M hypothesis of irrelevance is based on the assumptions like perfect capital
market existence, no transaction and flotation costs, no corporate taxes, no
difference in the tax rates applicable to capital gains and dividends, and risk of
uncertainty does not exist.
As per M-M, in the equilibrium, r (rate of return) will be equal to k (cost of
capital), and identical for all shares. As a result, the price of each share must
adjust so that the rate of return, which is composed of the rate of dividends and
capital gains, for every share will be equal to the discount rate. Hence, today’s
market price per share is as follows:
DIV1 + P1
Po =
(1 + k )
M-M argument implies that when the firm pays dividends, its advantage is offset
by external financing. This means that terminal value (P1) of the share declines
when dividends are paid.
Above assumptions may not always be found valid because capital markets are
not perfect, existence of flotation and transaction costs, dividend may be taxed
differently than capital gains, etc.

Q.7 “The assumptions underlying the irrelevance hypothesis of Modigliani and Miller
are unrealistic.” Explain and illustrate.
A.7 The M-M assumptions on dividend irrelevance are considered unrealistic on
account of the following reasons.
1. Investors have to pay different taxes on dividend income and capital gains.
2. The firm’s internal and external financing are not equivalent, because
flotation costs (e.g. underwriting and brokers commission, etc.) are
involved if new shares are issued.
3. The “homemade dividend” benefit cannot be fully realised by investors on
account of transaction costs (such as brokerage fee). Further, it is
inconvenient to sell the shares by investors.
4. Investors may have a desire to diversify the portfolios from the dividend
income. If firm does not distribute the dividends, then investors will be
inclined to use a higher value of k if they expect the firm to use retained
earnings for internal financing.
5. The current receipt of money in the form of dividends is considered safer
than the uncertain potential gain in future by investors, etc.

Q.8 Give arguments to support the view that dividends are relevant.
A.8 Market imperfections may make dividends relevant. Dividends are relevant
because some shareholders need a steady source of income. Some shareholders
are better off receiving dividends now rather than in the future on account of risk
of uncertainty. A tax system that treats dividends favourably than capital gains

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 can also result in high expectation by shareholders for dividend income. In India,
as per the existing law, the dividend income is non taxable, capital gains arising
within a year are taxable.

Q.9 Explain the effect of the following on the dividend policy: (i) transaction costs
and (b) agency costs.
A.9 The firm faces the choice between retaining profits for investments or paying
dividend and issuing capital for financing investments. Issuing capital involves
transaction costs such as floatation costs (e.g., preparing and issuing prospectus,
underwriting fees, brokers’ commission etc.). Thus, to avoid transactions costs,
firms may tend to retain profits and pay no dividend or low dividend.
There is information gap between managers and shareholders. Managers have
more information and therefore, they may not act n the best interests of
shareholders. Shareholders will have to incur costs – called agency costs – to
control the behaviour of managers. Paying dividends deters managers to misuse
profits and they will have to make more disclosure to raise fresh capital from
shareholders.

Q.10 What is the informational content of dividend payments? How does it affect the
share value?
A.10 It is contended that dividends are relevant because they have informational value.
The payment of dividends conveys that the company is profitable and financially
strong. It is also contended that dividends may offer tangible evidence of the
firm’s ability to generate cash, and, as a result, the dividend policy of the firm
affects the share price.
If a company follows a dividend policy of changing dividends with every cyclical
change in earnings, the market price of share may be affected little because
shareholders knew the information. A greater increase in the dividends than the
earnings may convey to the shareholders that profitable investment opportunities
of the firm are diminishing. This may depress the market price of share in spite of
an increase in dividend payments.

Q.11 What is the relationship between taxes and dividend policy? Explain by citing the
impact of different tax system.

A.11 From the tax point of view, a shareholder should prefer dividend over capital
gains on account of dividend income tax exempted, while capital gain is taxable
in India.
In most countries, different tax rates are applicable to dividends and capital gains.
On account of tax differential, some investors prefer lesser dividend income while
others prefer larger dividend income. Generally, following differential tax
systems are implemented in different countries regarding taxation of shareholders
earnings.
1. Double taxation: The shareholders’ earnings are taxed twice; first the
corporate tax is levied on profit of companies, and then dividends are
taxed as ordinary income in the hands of shareholders.

4
 2. Single taxation: The shareholders are exempt from tax on dividend
income; while earnings are taxed at the corporate level.
3. Split-rate taxation: Corporate profits are divided into retained earnings and
dividends for tax purpose. Different tax rates are applied to retained
earnings and amount distributed by way of dividend.
4. Imputation taxation: The shareholders’ earnings are not subjected to
double taxation. A company pays corporate tax on its earnings;
shareholders pay personal taxes on dividend but get full or partial tax
relief for the tax paid by the company.

Q.12 What is the argument about the tax neutrality of dividend? Illustrate your answer.

A.12 The benefits of dividend to the shareholders are that they satisfy their desire for
current income, avoid the need to sell shares and incur transaction costs etc. But
the shareholders are required to pay taxes on dividends. This involves a trade-off.
Shareholders in zero or tax brackets will prefer dividends while those in high tax
brackets will prefer capital gains.

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 CHAPTER 15

CAPITAL STRUCTURE THEORY AND POLICY

Q.1 Explain the assumptions and implications of the NI approach and the NOI
approach. Illustrate your answer with hypothetical examples.
A.1 Under the Net Income (NI) approach, the cost of debt and cost of equity are
assumed to be independent to the capital structure. The weighted average cost of
capital declines and the total value of the firm rises with increased use of
leverage.
Under the net operating income (NOI) approach, the cost of equity is assumed to
increase linearly with leverage. The weighted average cost of capital remains
constant and total value of firm also remains constant as leverage is changed.
Example:
Assume that EBIT (i.e., Net Operating Income) is Rs. 100,000. The amount of
debt employed by firm Rs. 700,000; the cost of debt 6%; and the rate of return
expected by equity shareholders 10%. ko = 8%.

NI Approach:
Rs.
NOI 100,000
Less: Interest costs 42,000
----------
Net income available to shareholders 58,000
----------
Market value of equity(S) 580,000 (58000/0.10)
Market Value of Debt (D) 700,000
-------------
Total value of firm (S+D) 1,280,000
-------------

NOI Approach:

Rs.
NOI 100,000
Market value of firm 1,250,000 (100,000/0.08)
Market value of Debt (D) 700,000
Market value of Share (S) 550,000

Now, assume that value of debt increases to Rs. 900,000

NI approach:
Rs.
NOI 100,000
Less: Interest cost 54,000 (900,000 x 6%)
---------

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 Equity Earnings 46,000
Market value of shares (S) 460,000 (46000/0.10)
Market value of debt (D) 900,000
-------------
Total value of firm 1,360,000
-------------
NOI approach:
Rs.
NOI 100,000
Market value of firm 1,250,000
Market value of debt (D) 900,000
Market value of share (S) 350,000

From the above, it is clear that as per NI approach the value of firm increases as
the use of debt increases, i.e., from Rs. 1,250,000 to Rs. 1,360,000. As per NOI
approach, the value of firm remains constant.

Q.2 Describe the traditional view on the optimum capital structure. Compare and
contrast this view with the NOI approach and the NI approach.
A.2 According to traditional approach, the cost of capital declines and the value of the
firm increases with leverage up to a prudent debt level and after reaching the
optimum level, leverage cause the cost of capital to increase and the value of the
firm to decline. The optimum capital structure occurs when the cost of capital is
minimum or the value of firm is maximum.
The NI approach indicates that the total value of firm rises with increased use of
leverage, and weighted average cost of capital declines.
The NOI approach assumes that the total value of firm remains constant as
leverage is changed, because the cost of equity increases linearly with leverage
and sets off the benefits of debt capital.
The NI approach is valid, if financing decisions have an important effect on the
value of firm. NOI approach is valid, if the financing decisions is not of great
concern, but overall cost of capital depends on business risk. Traditional approach
is based on the NI approach.

Q.3 Explain the position of M-M on the issue of an optimum capital structure,
ignoring the corporate income taxes. Use an illustration to show how home-made
leverage by an individual investor can replicate the same risk and return as
provided by the levered firm.
A.3 The Modigliani-Miller hypothesis is identical with the NOI approach. M-M
approach indicates that a firm’s market value and the cost of capital remain
invariant to the capital structure changes, i.e., any combination of debt and equity
is as good as any other. M-M hypothesis indicates that securities are traded in
perfect capital market situation, and firms can be grouped into homogeneous risk
classes. Further, it is also assumed that no corporate income taxes exist, and firms
distribute all net earnings to the shareholders.

2
 If two identical firms, except for the degree of leverage, have different market
values, arbitrage will take place to enable investors to engage in personal or
home-made leverage as against the corporate leverage to restore equilibrium in
the market.
Example:
Assume that two firms, i.e., un-leveraged firm U and leveraged firm L – have
identical expected NOI of Rs. 10,000. The value of leveraged firm is Rs. 110,000
– the value of equity shares being Rs. 60,000 and the value of debt Rs. 50,000,
and the value of un-leveraged firm is Rs. 100,000. Firm L have borrowed at the
expected rate of return of 6%. Assume that an investor, Mr. X, holds 10% of
shares of leveraged firm. How arbitrage benefits him?

Mr. X’s value of investment in firm L = Rs. 6,000 (60,000 x 10%)

Mr. X’s return from firm L
= 10% of (EBIT – INT)
= 10% (10,000 – 3,000)
= Rs. 700.
Now, Mr. X will sell his shares of firm L for Rs. 6,000, and will borrow Rs. 5,000
(Rs. 50000 × 10%) at 6% interest rate on his personal account. He will invest Rs.
11,000 to purchase shares of firm U (Rs 110,000 × 10%).
Mr. X’s return from firm U Rs.
= 10% x 11,000 = 1100
Less: Interest on personal borrowing
= 6% x 5,000 = 300
-----
Rs. 800
-----
This strategy pays to Mr. X more return at same investment. As a result of this
switching, i.e., arbitrage process, the market value of leveraged firm’s share will
decrease and that of un-leveraged firm will increase. So, equilibrium takes place
when values of both firms, i.e., U and L are identical.

Q.4 Assuming the existence of the corporate income taxes, describe M-M’s
proposition on the issue of optimum capital structure.
A.4 When the corporate taxes are assumed, firms can increase earnings of investors
through borrowing which results in interest tax shield. Under the assumption of
infinite stream of constant tax shield, the value of interest tax shield (PVINTS) is
equal to tax rate multiplied by debt (TD).
T ( k d D)
PVINTS = = TD
kd
where T is the corporate tax rate, kd is the cost of debt and D is the amount of
debt. Thus the market value of levered firm is equal to market value of un-levered
firm plus the present value of interest tax shield.

Q.5 ‘The M-M thesis is based on unrealistic assumptions.” Evaluate the reality of the
assumptions made by M-M.

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A.5 The M-M thesis is based on the assumption of perfect capital market in which
arbitrage is expected to work. The assumption that firms and individuals can
borrow and lend at the same rate of interest may not hold in practice. In reality,
firms are able to borrow at lower rates of interest than individuals. The existence
of limited liability of firms in contrast with unlimited liability of individuals
makes it incorrect to assume that ‘personal leverage’ is a perfect substitute of
‘corporate leverage’. The existence of transaction costs also interferes with the
working of arbitrage. The existence of number of institutional investors would
make it unfeasible to substitute personal leverage for corporate leverage. The
existence of corporate income tax provide the interest tax shield benefits to firm,
which results in lower cost of borrowed funds than the contractual rate of interest.

Q.6 How does the cost of equity behave with leverage under the traditional view and
the M-M position?
A.6 According to the traditional view, the rate at which shareholders’ capitalize their
net income, i.e., the cost of equity, ke remains constant up to certain level of debt,
(i.e., a certain degree of leverage). Later on, further increase in the leverage
increases the cost of equity due to the added risk (i.e., financial) and offsets the
advantage of low cost of debt, after the acceptable limit of leverage.
On the other hand, according to M-M view, the cost of equity increases with debt;
, ke, is equal to the constant average cost of capital, ko, plus a premium for the
financial risk, which is equal to debt-equity ratio times the spread between the
constant average cost of capital and the cost of debt, (ko – kd) D/E. The ke is a
linear function of leverage, measured by the market value of debt to equity, D/E.

Q.7 Consider two firms, L and U, that are identical except that L is levered where as U
is un-levered. Let Vl and Vu stand respectively, for the market value of L and U.
In a perfect market, would one expect Vu to be less or greater than or equal to Vl?
Explain.
A.7 In a perfect market Vu will be equal to Vl. If Vu is less than Vj then arbitrage
process (as suggested by M-M) will take place and value of both firms will
become equal. The arbitrage process is explained above in answer A. 3.

Q.8 “When the corporate income taxes are assumed to exist, Modigliani and Miller
and the traditional theorist agree that capital structure does affect value, so the
basic point of dispute disappears.” Do you agree? Why or Why not?
A.8 Two theories are based on different premises. Taxes or no taxes, traditional theory
is based on the assumption that leverage has three-stage effect on value of the
firm (or the firm’s cost of capital). First, there is a favourable effect on value.
Second, there is no effect. Third, as the use of leverage goes beyond certain level
(undefined level) , there is unfavourable effect. The MM theory, on the other
hand, is based on the assumption that there is a linear relationship between
leverage and financial risk. Since the advantage of leverage taken off by the
financial risk, there is no effect on value. When corporate taxes are considered,
there is a net advantage of leverage because of interest tax shield.

4
Q.9 Explain the effect of capital structure on the value of the firm when both corporate
and personal income taxes are considered?
A.9 Investors are required to pay personal taxes on the income earned by them.
Hence, from investor’s view point, taxes will include both corporate and personal
taxes. So, firms have to aim at minimizing the total taxes while deciding about
capital structure.
The advantage of interest tax shield is offset by the personal taxes paid by debt
holders on interest income. Income on account of interest is tax-exempt at
corporate level while dividend income is not. Interest income is taxed at personal
level while dividend income may largely escape personal taxes. Thus, companies
can induce tax paying investors to buy debt securities if they are offered high rate
of interest. But after a stage it will not be possible to attract investors in the high
tax brackets. This point establishes the optimum debt ratio in the economy.
Thus, the value of leveraged firm will be equal to value of un-leveraged firm plus
present value of interest tax shield benefits. The present value of interest tax
shield (PVINTS) is:
é 1 - T )(1 - Tpe) ù
PVINTS = ê1 -
(1 - Tpb) úû
D
ë
where T is corporate tax rate; Tpe is personal tax rate on equity income; Tpb is
personal tax rate on dividend income; and D is the amount of debt.

Vl = Vu + PVINTS

where Vl value of leveraged firm and Vu is value of un-leveraged firm.

Q.10 What is financial distress? How does it affect the value of firm?
A.10 The offsetting advantage of debt is grouped under the term financial distress.
Financial distress occurs when the firm finds it difficult to honour the obligations
of creditors, which may lead to insolvency also. The financial distress also
introduces inflexibility of raising funds by firm when needed. The financial
distress reduces the value of the firm, on account of insolvency costs like legal
costs, arranging the funds at higher cost of capital, etc. Hence:
Value of leveraged firm = Value of un-leveraged firm + PV of tax shield benefit –
PV of financial distress.
The costs of financial distress increases as more and more debt is introduced in
the capital structure of the firm.

Q.11 Define the capital structure. What are the elements of a capital structure? What
do you mean by an appropriate capital structure? What are the features of an
appropriate capital structure?
A.11 Capital structure refers to the mix of long term sources of funds, such as
debentures, long term debt, preference share capital and equity share capital
including reserves and surpluses.
The appropriate capital structure maximizes the long term market price per share,
also keeping in view the financial requirements of a company.
A sound or appropriate capital structure should have the following features:

5
 1. It should generate maximum returns to the shareholders.
2. There should not be the use of excessive debt to maintain long term solvency.
3. The capital structure should be flexible, to provide funds to finance its
profitable activities in future.
4. The capital structure should involve minimum risk of loss of control of the
company.

Q 12 Briefly explain the factors that influence the planning of the capital structure in
practice.
A 12 In addition to the concerns about EPS, value of firm and cash flow; the other
important considerations are as follows:
The desire to continue control over the company. For example, closely held
companies do not make issues of new shares, while widely-held companies may
make issue of new equity shares.
The firm’s willingness to venture into new profitable activities as and when
needed, then they may like to have present target debt ratio at lower end.
Restrictive covenants in loan agreements already executed.
Readiness of the investors to purchase a security in a given period of time and to
demand reasonable return.
Also, study the market conditions, and internal conditions of a company from the
view point of marketability of securities, etc.

Q 13 Explain the features and limitations of three approaches of determining a firm’s

capital structure: (a) EBIT- EPS approach, (b) valuation approach, and (c) cash
flow approach.
A 13 The EBIT-EPS approach analyzes the impact of debt on EPS. The use of fixed
cost sources of finance, such as debt and preference share capital to finance the
assets of the company, is known as financial leverage. If the assets financed with
the use of debt yield a return greater than the cost of debt, the earnings per share
also increases without an increase in the owners’ interest. The firm with high level
of the EBIT can make profitable use of the high degree of leverage to increase
return on the shareholders’ equity. The EBIT-EPS analysis does not reflect the
debt-servicing ability of the firm. This approach does not consider operating and
business risk also.
In the valuation approach, the capital structure is evaluated in terms of its effect
on the value of the firm. According to MM theory, capital structure will have
favourable effect on the value of the firm only because of the interest tax shield.
This advantage reduces because of personal taxes and financial distress caused by
leverage.
In the cash flow approach, a firm is considered prudently financed if it is able to
service its fixed charges, i.e., pay interest and principal, under any reasonably
predictable adverse conditions. At the time of planning the capital structure, the
ratio of net cash inflows of fixed charges (debt – servicing ratio) should be
examined carefully. It focuses on the liquidity and solvency of the firm over a
long-period of time.

6
Q 14 ”….the analysis of debt to equity ratios alone can be deceiving, and an analysis of
the magnitude and stability of cash flow relative to fixed changes is extremely
important in determining the appropriate capital structure-.” Give your opinion.
A 14 The cash flow analysis indicates firm’s ability to service debt obligations even
under the adverse conditions, by examining the debt-servicing ratio. It indicates
the number of times the fixed financial obligations are covered by the net cash
inflows generated by the company. The greater the coverage, the greater is the
amount of debt a company can use. The impact of debt-equity ratio should be
evaluated in terms of value, rather than EPS. It is possible for a high-growth
profitable company to suffer from cash shortage if its liquidity management is
poor. Hence, the debt capacity should be thought in terms of cash flows rather
than debt-ratios.

Q 15 What are the implications of growth opportunities for the financial leverage?
A 15 To exploit growth opportunities, a firm needs funds. Hence, firms with growth
opportunities will tend to borrow more debt in addition to utilising internal funds.

Q.16 What is meant by financial flexibility? Is a flexible capital structure costly?

A 16 Flexible capital structure means firm’s ability to adapt its capital structure to the
needs of the changing conditions. The company should be able to raise funds,
without undue delay and cost, whenever needed, to finance the profitable
investments. The financial plan of the company should be flexible enough to
change the composition of capital structure as warranted by operating needs. It is
costly on account of restrictions imposed by loan covenants, pre-maturity
repayment charges in case of retirement of loan or early redemption of
debentures, flotation costs, etc.

Q 17 What is the importance of marketability and flotation costs in the capital structure
decision of a company?
A 17 The internal conditions of a company dictate the marketability of securities in
addition to readiness of investors to purchase a security in a given period of time
and to demand reasonable return. Due to changing market sentiments, the
company has to decide whether to raise funds with an equity issue or debt issue.
Flotation cost is not very important factor influencing the capital structure of a
company. Flotation costs occur only when the funds are externally raised.
Generally, the flotation cost of debt is less than cost of equity issue. The flotation
costs can be an important consideration in deciding the size of a security issue.
Generally, the flotation costs as a percentage of funds raised will decline with
larger amount of funds.

Q 18 How do the considerations of control and size affect the capital structure decision
of the firm?
A 18 Capital structure decision is governed by desire of management to continue
control over the company. The ordinary (equity) shareholders elect the directors
of the company. This may result into dilution of control by present management
or owner. In the case of widely-held company, the shares of such company are

7
widely scattered, and by issues of new shares, there is a risk of dilution of control.
The risk of loss of control can be reduced by distribution of shares widely and in
small lots.
The closely-held small company would like to maintain control. Because of fear
of sharing control and being interfered by others, the closely held company would
like to raise debt capital instead of equity issue. To avoid the risk of loss of
control, small companies may slow down their rate of growth or issue preference
share capital or raise debt capital. A very excessive debt capital can also cause
serious liquidity problem, and render the company sick, which means complete
loss of control.
The size of company may influence its capacity and availability of funds from
different sources. A small company finds it difficult to raise long term debt or
long term loan at acceptable rate of interest and convenient terms. If small
companies are able to approach capital markets, the cost of issuing shares is
generally more than larger companies.

8
 CHAPTER 19

CAPITAL MARKET EFFICIENCY AND CAPITAL MARKETS IN INDIA

Q.1 Explain the concept of the capital market efficiency. What are the different forms
of the capital market efficiency?
A.1 Capital markets deal with financial assets or securities. Securities will be fairly
priced in the capital markets if they are efficient. Capital markets are considered
to be efficient if the prices of securities reflect the available information.
Three different forms of capital market efficiency are as under:
1. Weak form of efficiency: The security prices reflect all past information
about the price movements in the weak form of efficiency. It is not
possible for an investor to predict future security price by analyzing
historical prices, and achieve a performance (return) better than the stock
market index.
2. Semi-strong form of efficiency: In this form, security prices reflect all
publicly available information. This implies that an investor will not be
able to out-perform the market by analyzing the existing company related
or other available information. This market hypothesis implies that the
share price reflects an event or information very quickly, and, therefore, it
is not possible for an investor to beat the market using such information.
3. Strong form of efficiency: In this form of efficiency, the security prices
reflect all published and unpublished public and private information.
People with private or inside information have been able to outperform the
market.
Q.2 What is the difference between the primary market and the secondary market?
Briefly describe some significant developments in the stock markets in India.
A.2 Primary market includes new issue market for shares, debentures/bonds etc.
Secondary markets are stock exchanges facilitating trading in already issued
securities. India’s capital market includes markets for securities as well as well
developed structure of financial and investment institutions. The first stock
exchange – the Bombay Stock Exchange – was established in 1875. Now there
are 22 stock exchanges in India. The number of shareholders has increased to
about 20 million.
There are about 9000 listed companies. The market capitalization is over Rs. 100
billion, constituting about 21 per cent of the gross domestic product. Stock
exchanges in India have well developed procedures for listing, trading, settlement,
etc. They are well organized and regulated. A number of systems and rules exist
for the regulation of the stock exchanges. As a consequence of the growing
economy and the government’s policy of liberalization and deregulation, the
capital and stock markets in India have recently grown at a phenomenal rate.
Q.3 Briefly discuss the procedures for trading and settlement on the stock exchanges
in India.

1
A.3 Trading in Indian stocks is broadly categorized into two groups, i.e., specified
shares and non-specified shares. All trading is basically conducted as hand
delivery contracts, i.e., for delivery and payment within the time or on the date
stipulated when entering into the contract which shall not be more than 14 days
following the date of contract. In case of specified shares, delivery and payment
can be extended by further period of 14 days each so that the overall period does
not exceed 90 days from the date of the contract. Contract in specified shares can
be closed during the settlement period by purchase or sale, as the case may be, or
carried over to the next settlement period and only those contracts which remain
outstanding have to be performed by delivery and payment. Settlement periods
are normally two weeks long. A settlement period starts on a Friday and ends on
Thursday of the second following week. The settlement procedure includes: (1)
members submit details of his transactions for each day to the stock exchange, (2)
the details submitted by member are verified by stock exchange, (3) badla
decisions are taken by member to carry over any transaction to the next settlement
period, (4) the processing of transactions done by stock exchanges, (5) the
clearing house performs the functions of delivering securities and/or making
payments to the members.
Q.4 What developments have taken place in the capital markets in India? What are
their implications for financial managers?
A.4 The new issues market has shown phenomenal growth after the eighties. The
capital raised in a year now is about Rs. 70 billion as against Rs. 700 million in
the sixties and Rs. 900 million in the seventies. A number of companies are able
to raise substantial amount from the capital market. The corporate sector’s
dependence on the financial institutions for their funds requirements is declining
with the development of new issues market.
Financial manager can also witness new financial instruments such as convertible
securities, zero-coupon debentures, warrants, special premium notes, etc., being
issued by companies for raising capital. Yet another significant development is
the free pricing of the new issues by companies. Within the norms prescribed by
Securities and Exchange Board of India (SEBI), a company can decide the issue
price of its securities. Other significant developments include rating of securities,
investor’s protection, and mutual funds, etc.
Q5 Explain the role of merchant banking in capital markets. What is the status of
merchant banking in India?
Q.5 Merchant bankers play the role of intermediaries in the capital market in India.
They help companies in the total management of issues of securities. Therefore,
they are called issue managers. As members of stock exchange, underwriters of
new issues and book builders, they help to make market, and hence, are known as
market makers also. Merchant bankers cannot undertake the pure fund-based
activities
Service provided by merchant banking organisations in India include corporate
counselling: project counselling and pre-investment studies; capital restructuring;
credit syndication and project finance; issue management and underwriting;
portfolio management; non-resident investment; working capital finance;
acceptance credit and bill discounting; mergers, amalgamations and take-overs;

2
 venture capital; leasing finance; foreign currency finance; fixed deposit broking;
mutual funds; relief to sick industries. The merchant banking activity in India is
governed by SEBI under the SEBI (Merchant Bankers) Regulations 1992.
Q6 What are mutual funds? What are their characteristics? What are the advantages
and limitations of mutual funds?
A.6 Mutual funds provide a mechanism for collective investment. Generally they
mobilise funds from individual investors and invest the collected funds in
portfolios of securities.
There are two basic types of mutual funds: open-ended and close-ended. An
investor can buy and sell units or shares of open-ended funds at the market price
continuously. In close-ended funds, the net asset value (NAV) per share or unit is
determined based on the total value of investment. Within these two broad
categories, mutual funds may offer income funds, growth funds, balanced funds,
tax-savings funds etc. Mutual funds companies also offer index funds and hedged
funds to investors.
Mutual funds have several advantages to investors: simplicity, diversification,
professional expertise, affordability and flexibility. They do have certain
limitations as well: high brokerage, ownership risk, or no opportunity of making
extra-ordinary profit
Q7 What are index funds and hedged funds? Explain their merits and demerits?
A7 Index funds invest investors’ money in combination of securities in a general
index like Sensex or in some sector index. An index fund offers several
advantages:
A. Less expenses
B. Low research cost
C. Regular follow-up
Index funds are not without problems. They have the following limitations:
i. Index funds can never outperform the market. They may do as good or as bad
as the market does.
ii. The small investors may not be able to invest in index funds as several funds
require a large initial investment.
Hedged funds are broad based and may include foreign exchange market also. They
combine several investment strategies and try to maximize investors’ returns. A hedge
fund offers several advantages:
i. Positive returns
ii. Risk reduction
iii. Wide Choices
iv. High returns
v. Ideal investment
vi. Better diversification

3
 CHAPTER 20

LONG TERM FINANCE: SHARES, DEBENTURES AND TERM LOANS

Q.1 What is an ordinary share? How does it differ from a preference share and
debenture? Explain its most important features.
A.1 Ordinary shares (called common stocks in USA) are important securities used by
the firms to raise funds to finance their activities. Ordinary shares provide
ownership rights to ordinary shareholders. They are legal owners of the company.
As a result, they have residual claims on income and assets of the company. They
have the right to elect directors and maintain their proportionate ownership in the
company, i.e., preemptive right.
Preference shares and debentures are also important securities used by firm to
raise funds to finance their activities. Preference shareholders are also legal
owners of the company, but they have the claim over assets of the firm before the
claim of equity shares settled. They also have the right to have fixed dividend if
company decides to pay, before on equity shares.
Debentures are basically long term promissory note for raising loan capital. The
firm promises to pay interest and principal as stipulated. Debenture holders’ are
creditors of the firm, not the owner of the firm. The interest rate is fixed and
known; maturity date is also fixed and known in advance, the terms of redemption
are fixed at the time of issue of debentures. Debentures may be secured or
unsecured, while the equity shares are unsecured.
Q.2 What are the advantages and disadvantages of ordinary shares to the company?
What are the merits and demerits of the shareholders’ residual claim on income
from the investors’ point of view?
A.2 Ordinary shares represent the ownership position in a company. The shareholders
are legal owners of the company. Ordinary shares are also known as variable
income securities (the rate of dividend is not fixed and not committed). It is a
source of permanent capital.
Advantages of ordinary shares are as follows:
1. It is a permanent capital, as they do not have maturity date.
2. It increases the base of the firm, and thus increases its borrowing limits.
3. A company is not legally bound to pay dividend. When the profits are
insufficient or firm have need of funds for investment in profitable
opportunities, it can reduce or suspend payment of dividend.
Limitations of ordinary shares are as follows:
1. The control of the corporate is affected by the issuance of equity shares.
2. The exclusive use of ordinary shares as a medium of capital eliminates the
advantages likely to accrue from the policy of trading on equity.
3. Individual and institutional investor cannot purchase equity shares because of
choice or legal restrictions.
4. The excessive use of equity shares may result in over capitalization in future
when the earning capacity of the firm fails to raise up to the desired level of
equity providers.

1
 5. Ordinary shares are riskier from investors’ point of view as there is
uncertainty regarding dividend and capital gains.
The ordinary shareholders have a claim to the residual income; i.e., earnings
available for equity shareholders after satisfying all providers of funds. This
income may be split into two parts, i.e., dividends and retained earnings. Residual
income is either directly distributed in the form of dividend or indirectly in the
form of capital gains (retained earnings reinvested, enhance the earnings of the
firm in future). Dividends are payable based on discretion of company’s board of
directors. Thus, ordinary share is a risky security from the investors’ point of
view.
Q.3 What is the significance of voting rights to the ordinary shareholders? What is a
proxy? Why do proxy fights occur?
A.3 Ordinary shareholders are required to vote on a number of important matters, viz.,
election of directors, change in memorandum of association, etc. Each ordinary
share carries one right. Thus, an ordinary shareholder has votes equal to the
number of shares held by him. They may vote in person or by proxy.
A proxy is a designated person having a right to vote on behalf of shareholder at
the company’s annual general meeting. When management takeover is threatened
or some important decisions are to be taken, proxy fights – battle between rival
groups for proxy votes-occur. They particular group put all efforts to collect
proxy-votes.
Q.4 What is a right issue? What are its advantages and disadvantages from the
company’s and shareholder’s point of view?
A.4 A right issue involves selling of ordinary shares to the existing shareholders of the
company. The law in India requires that the new ordinary shares must be first
issued to the existing shareholders’ on a pro-rata basis.
The advantages of right issue are as follows:
1. The existing shareholders control is maintained through the pro-rata issue
of shares.
2. Raising of funds through right issue involves less flotation costs as
company can avoid underwriting commission and issue and promotional
expenses.
3. In case of profitable and growing company, the issue is more likely to be
successful as the subscription price is set below than current market price.
The limitations or disadvantages are:
1. The wealth of shareholders decline if they fail to exercise their voting
rights.
2. Those companies whose shareholding is concentrated in the hands of
financial institutions because of the conversion of loan into equity would
prefer public issue of shares rather than the right issues.
Q.5 Since the right issue allows the ordinary shareholders’ to purchase the shares at a
price much lower than the current market prices, why does not shareholders’
wealth increase? Illustrate your answer.
A.5 When the rights are offered for raising funds, three issues are involved: (1) the
number of rights needed to buy new shares, (2) the theoretical value of right, and
(3) the effect of rights offerings on the value of the ordinary shares outstanding.

2
 From the following illustration, it may be clear that value of a right when the
share is selling ex-rights or cum-rights, the existing shareholder does not benefit
or lose from right issue. His wealth remains unaffected when he exercises his
rights.
For example, Mr. X an investor owns 3 shares of Sunshine Co. Ltd. Current
market price is Rs. 130, so his total wealth is Rs. 390 (Rs. 130 × 3). The Sunshine
Co. has decided to issue rights for raising funds. The subscription price (issue
price) has been fixed at Rs. 75. The issue ratio has been fixed at 1:3. Hence, Mr.
X is entitled for one right share. Assume that Mr. X exercises his rights. The ex-
rights price is Rs. 116.25, as calculated below.
Price of share after right issue (So × Po) + (S × Ps)
(Ex-rights price) = --------------------
So + S
Where So is existing shares; Po is current market price; S is new shares and Ps is
subscription price.
(3 × 130) + (1 × 75)
= -------------------- = Rs. 116.25
3+1
Therefore, his total wealth is Rs. 465 (116.25 x 4). But, he has spent Rs. 75 to
obtain additional shares. So his net wealth is Rs. 390 (Rs. 465 - Rs 75).
Q.6 What is a debenture? Explain the features of a debenture.
A.6 A debenture is a long term promissory note for raising loan capital. The purchaser
of debenture is called debenture holder. Debenture holder is the creditor of the
firm.
The important features of debentures are enumerated as under:
a. It is a long term, fixed income financial security.
b. The contractual rate of interest is fixed and known. It indicates the
percentage of par value of the debentures that will be paid, non-
cumulatively – annually, semi-annually or quarterly; cumulatively – along
with principal on maturity.
c. Debentures are issued for a specific period of time, and on maturity date
redeemed by company.
d. Debenture issues may include buy-back provision. Buy-back provisions
enable the company to redeem debentures at specified price before
maturity date.
e. Debentures are either secured (by alien on company’s specific assets) or
unsecured.
f. The yield on a debenture is related to its market price; therefore, it could
be different from the coupon rate of interest. Hence,

Annual Interest
Yield = ---------------
Market Price
g. An indenture or debenture trust deed is a legal agreement between the
company issuing debentures and the debenture trustee who represents the
debenture holders.

3
Q.7 What are the pros and cons of debentures from the company’s and investors’
point of views?
A.7 Debenture has a number of advantages as long term sources of finance:
1) It involves less cost to the firm than the equity finance because investors
expect lower rate of return, and interest payments are tax-deductible.
2) Debenture issue does not cause dilution of ownership control by
company’s present management.
3) There is a certainty of finance for specified period.
4) By issuing debentures company gets an opportunity to trading on equity.
5) The debentures may be issued out of necessity. In such a situation, it may
be compelled to mortgage assets to raise funds.
6) During the periods of inflation, debenture issue benefits the company. Its
obligation of paying interest and principal which are fixed decline in real
terms.
Debentures have some limitations like.
1) A company with highly fluctuating earnings takes a great risk by issuing
debentures which may entail a great strain on its resources, and company
may face the consequences of liquidation.
2) It increases the financial leverage, which may be disadvantageous for
firms which have fluctuating sales and earnings.
3) Debentures must be paid on maturity, so it involves substantial cash
outflows at some point.
4) Debenture indenture may contain restrictive covenants which may limit
the company’s operating flexibility in future.
Q.8 Why a preference share is called a hybrid security? Do you agree that it combines
the worst features of ordinary shares and bonds?
A.8 Preference shares are hybrid securities as they include some features of both an
ordinary share and a debenture. Most preference shares in India have a cumulative
feature, requiring that all past outstanding preference dividends be paid before any
dividend to ordinary shareholders is announced. In principle, preference shares
could be redeemable, i.e., with a maturity date, or irredeemable, i.e., perpetual,
without maturity date. Like debentures, a firm can issue convertible (into equity
shares) or non-convertible preference shares.
Preference shares provide risk less leverage advantage to the equity shareholders
since preference dividend is a fixed obligation. The preference dividend is not tax
deductible. Preference shares provide more flexibility and fewer burdens to the
company.
Q.9 Explain the advantages and disadvantages of preference shares to the company.
A.9 The advantages of preference shares to the company are as follows:
1) It provides financial leverage advantage since preference dividend is a
fixed and non-committed obligation. The non-payment of preference
dividend does not threaten the life of the company.
2) It provides some financial flexibility to the company since company can
postpone dividend payment.

4
 3) The preference dividend payments are restricted to the stated amount. The
preference shareholders’ do not participate in excess profits of the
company.
4) Preference shareholders do not have any voting rights except in case
dividend arrears exist.
The following are the limitations of preference shares:
1) The preference dividend is no tax-admissible expenses as do interest on
debenture. So, it is costlier than debentures.
2) Although preference dividend can be omitted, they may have to be paid
because of their cumulative nature. Non-payments of preference dividend
adversely affect the image of the company. Thus, in future, it is quite
difficult for the company to raise funds.
Q.10 What are term loans? What are their features?
A.10 Term loans are loans for more than a year maturity. Generally, in India, they are
available for a period of 6 to 10 years. In some cases, the maturity could be as
long as 25 years. Interest on term loans is tax-deductible. Mostly, term loans are
secured through an equitable mortgage on immovable assets. Term loans secured
specifically by the assets acquired using the term loan funds, is called primary
security. Term loans are also generally secured by the company’s current and
future assets. This is called secondary or collateral security. In addition to asset
security, lender like financial institutions (FIs), add a number of restrictive
covenants (asset related, liability related, cash flow related and/or control related)
to protect itself further. FIs in India are normally insisting on the option of
converting loans into equity, and specify the repayment schedule at the time of
entering into loan agreement (in principle) with borrower.
Q.11 How does a term loan differ from a non-convertible debenture?
A.11 Non-convertible debentures (NCDs) are pure debenture (a long term promissory
note) without a feature of conversion. They are repayable on maturity. The
investor is entitled for interest and repayment of principal. Term loans are also
long term debt with a maturity of more than one year.
The term loans are obtained from banks and specially created financial
institutions (FIs) in India by private placement rather than public subscription as
is the case with NCDs. The purpose of term loans and NCDs are generally to
finance the company’s capital expenditure. Sometimes, NCDs can be issued to
finance mid-term working capital needs also.
In the case of term loans, firms directly negotiate with FIs for terms, while in case
of NCDs, the terms are decided by firms on their own by considering general
economical environment. The term loans and NCDs both can be secured by way
of mortgage on assets of the company. Term loans can be converted into equity
shares, while NCDs cannot be convertible into equity shares of preference shares.
Q.12 What is common between term loans and debentures in India? Explain the
comparative merits and demerits of both.
A.12 The term loans and debentures both represent long term debt with a maturity more
than one year. Both have contractual rate of interest. Term loans are always
secured by way of mortgage on assets of the firm, while the debentures may be

5
secured or unsecured. The interest expenses are tax-deductible expense. Both
provide the benefit of trading on equity to the shareholders.
Debenture holders do not have voting rights; therefore; debenture issue does not
cause dilution of ownership. Term loans directly do not cause dilution of
ownership, but they impose some restrictive covenants on working of the firm, so
the decision making freedom of board of directors reduces to that extent.
Debenture and term loan both result in legal obligation of payment of interest and
principal; if not paid, the lenders can force the company into liquidation. Both
increase the financial leverage, which may particularly be disadvantageous to
those firms which have fluctuating sales and earnings.

6
 CHAPTER 21

CONVERTIBLE DEBENTURES AND WARRANTS

Q.1 Define the following terms: (a) conversion price, (b) conversion value, and (c)
conversion premium.
A.1 A convertible debenture is a debenture that can be changed into a specified
number of ordinary shares at the option of the owner. It is also called hybrid
security.
The conversion price is the price paid for ordinary share at the time of conversion.
The conversion ratio is the number of ordinary shares that an investor can receive
when he/she exchanges his convertible debenture. The conversion value of a
convertible debenture is equal to the conversion ratio multiplied by the ordinary
shares market price. The difference between the convertible debenture’s market
value and higher of the conversion or NCD value (i.e., investment value of non-
convertible debenture) is called the conversion premium.

Q.2 What are the important features of a convertible security? What reasons are
generally given for issuing convertible securities?
A.2 Convertible security is either a debenture or a preference share that can be
exchanged for a stated number of ordinary shares at the option of the investor.
The most notable feature of convertible security is that it promises a fixed income
associated with security as well as chance of capital gains associated with equity
shares after the owner has exercised his conversion option.
Companies offer convertible securities to sweeten debt and thereby make it
attractive. It is a form of deferred equity financing, and provides low cost funds
during the early stage of investment project. Investors generally prefer fixed
interest convertible securities to earn a definite, fixed income with the chance of
making capital gains. The convertible securities avoid immediate dilution of the
earnings for share.

Q.3 Convertible debentures generally carry lower rates of interest than the non-
convertible debentures. If this is true, does it mean that the cost of capital on
convertible debentures is lower than on non-convertibles? Why or why not?
A.3 Yes, the cost of capital on convertible debenture is lower on non convertible
debentures. The company offers lower rate on convertibles because of the value
of the conversion feature as compared to non-convertibles. Investors generally
prefer fixed income convertibles. After the project is complete and the company’s
earnings rise, the share is likely to increase. With an in-built option to convert, the
investor are likely to make capital gains This chance of making capital gains,
tempts investors to accept lower rate of interest today.

Q.4 How is a convertible security valued? Explain your answer with the help of a
graph.
A.4 The convertible security are traded (bought and sold) in the stock market until
they are converted into equity shares. The price at which the convertible security

1
 sells is called its market value. A convertible security market value depends on
both investment and the conversion value. The difference between the convertible
debenture’s market value and the higher of the conversion or the NCD value
(investment value) is called conversion premium.

Market Conversion or
Conversion premium = Value - Investment value
---------------------------------
Conversion or Investment Value

(Refer to Figure 21.1 from the text book here.)

Above graph shows relationship between the convertible debenture’s market, investment
and conversion value and ordinary share price. The conversion value, on the other hand,
is related to the ordinary share price. It increases as the ordinary share price increases.
Typically, the market value is higher than both the investment and conversion value. The
difference between investment and conversion value lines is known as conversion
premium.

Q.5 What is a warrant? What are its characteristic features? Why are warrants issued?
A.5 A warrant is an option to buy a specified number of ordinary shares at an
indicated price during a specified period. Warrants are used by large, profitable
companies as a part of a major financing package. Warrants may also be used in
conjunction with ordinary or preference shares. The purpose is to improve the
marketability of issue.
Warrants have a number of features; few of them are explained hereunder.
1) The exercise price of a warrant is the price at which its holder can
purchase the issuing firm’s ordinary shares.
2) Exercise ratio states the number of ordinary shares that can be purchased
at the exercise price per warrant.
3) The expiration date is the date when the option to buy ordinary shares in
exchange for warrants’ expires.
4) A warrant can be either detachable (sold separately from the security to
which it was originally attached) non-detachable (cannot be sold
separately).
5) Warrants entitle to purchase ordinary shares.
Generally, following are the reasons for issuing warrants.
1) Warrants help to make the issue of equity and debentures attractive.
2) Warrants are used to ‘sweeten’ the debenture issue by giving the investors
an opportunity to participate in capital gains when the share price
appreciates.

2
 3) Warrants also provide a company an opportunity for deferred equity
financing. The company sells its ordinary shares in future at a premium by
setting exercise price higher than the prevailing share price.
4) The company to some extent is sure to obtain cash inflows in future when
investors exercise their warrants.

Q.6 Explain the difference between a convertible security and a warrant.

A.6 A convertible security and a warrant are used by large, profitable companies as a
part of a major financing package.
In the case of a convertible security and a warrant, the conversion price/exercise
price, conversion ratio/exercise ratio and conversion date/expiration date is
decided at the time of issue, to make issue more attractive.
A convertible security is converted into equity shares on conversion date, and no
cash inflows for the company occurs at that time.
In the case of warrant, the buyer, i.e., investor has an option to exercise his right
for equity or preference shares holding, and company have cash inflows on that
date.
Both a convertible security and a warrant can be used as deferred equity financing
tool, and they help in the beginning of the project, to avail the benefits of trading
on equity.

Q.7 Explain the valuation of warrants with the help of a graph.

A.7 A warrant is an option to buy a stated number of company’s ordinary shares t a
given price on or before a specified maturity date.
The theoretical value of a warrant can be found out by knowing the ordinary
share’s market price, and warrants exercise price and exercise ratio.
Warrants’ theoretical value = (Share price – Exercise price) × Exercise ratio
If the share price is less than the exercise price, then the warrant’s theoretical
value will be negative.
The difference between the warrant’s market value and its theoretical value is
called the premium.
Warrant’s market value - Warrant’s theoretical value
Premium = ------------------------------------------------------
Warrant’s theoretical value
(Refer to Figure 21.2 from the text book here.)

Q.8 What is meant by zero-interest debentures and deep-discount debentures? How is

their cost determined? Illustrate your answer.
A.8 Zero-interest debentures (ZID) or Zero-coupon bonds do not carry an explicit rate
of interest. The difference between the face value of the bond and its purchase
price is the return of the investor. For example, a company may issue a ZID of
face value Rs. 100 for Rs. 52 today for a period of 5 years. Then, the rate of
interest is 13%, calculated as under:
FV = PV (1+i)n
100 = 52 (1+i)5
By trial and error method, i = 13%.

3
Deep Discount bond or Deep-Discount debentures or zero-interest bond (DDB)
are issued at a price much lower than the face value. Thus, there is an implicit rate
of interest. For example, a bond issued at a price of Rs. 12,750 to be redeemed
after 30 years at its face value of Rs. 500,000. The implied annual rate of interest
is 13%, calculated as under:
FV = PV (1+i)n
5, 00,000 = 12,750 (1+i)30
By trial and error method, i = 13%.

4
 CHAPTER 9

THE COST OF CAPITAL

Q1. Define cost of capital? Explain its significance in financial decision-making.

A1 The project’s cost of capital is the minimum required rate of return on funds
committed to the project, which depends on the riskiness of its cash flows. The
firm’s cost of capital will be the overall, or average, required rate of return on the
aggregate of investment projects
It is a concept of vital importance in the financial decision-making. It is useful as
a standard for:
1. evaluating investment decisions,
2. designing a firm’s debt policy, and
3. appraising the financial performance of top management

Q2. What are the various concepts of cost of capital? Why should they be
distinguished in financial management?
A2 The opportunity cost is the rate of return foregone on the next best alternative
investment opportunity of comparable risk. Thus, the required rate of return on an
investment project is an opportunity cost.
In an all-equity financed firm, the equity capital of ordinary shareholders is the
only source to finance investment projects, the firm’s cost of capital is equal to
the opportunity cost of equity capital, which will depend only on the business risk
of the firm
Viewed from all investors’ point of view, the firm’s cost of capital is the rate of
return required by them for supplying capital for financing the firm’s investment
projects by purchasing various securities. It may be emphasised that the rate of
return required by all investors will be an overall rate of return - a weighted rate
of return. Thus, the firm’s cost of capital is the ‘average’ of the opportunity costs
(or required rates of return) of various securities, which have claims on the firm’s
assets. This rate reflects both the business (operating) risk and the financial risk
resulting from debt capital.
The opportunity cost of capital is given by the following formula:
C1 C2 Cn
I0 = + +L+
(1 + k ) (1 + k ) 2
(1 + k ) n
Where I0 is the capital supplied by investors in period 0 (it represents a net cash
inflow to the firm), Ct are returns expected by investors (they represent cash
outflows to the firm) and k is the required rate of return or the cost of capital.

Q3. How is the cost of debt computed? How does it differ from the cost of preference
capital?
A3 The contractual rate of interest or the coupon rate forms the basis for calculating
the cost of debt. The before-tax cost debt:
n INTt Bn
B0 = å +
t =1 (1 + k ) (1 + k d ) n
t
d

1
 The following short-cut method can also be used to calculate the before-tax cost
of debt:
1
INT+ (F - B 0 )
kd = n
1
(F + B 0 )
2
where INT is interest charges, F is face value, B0 is current value of
debenture/debt, and n is maturity of debt in years.
The before-tax cost of debt, kd, should be adjusted for the tax effect as follows:
After - tax cost of debt = k d (1 - T )
Preference shareholders bear more risk than debt-holders. In case of redeemable
preference shares, shareholders get dividends and liquidating value on maturity.
If the company does not have profits, preference shareholders may not get any
dividends. Unlike interest on debt, preference dividend is not tax deductible. The
cost of redeemable preference share:
n PDIV Pn
P0 = å t
+
t =1 (1 + k ) (1 + k p ) n
t
p

The cost of preference share is not adjusted for taxes because preference dividend
is paid after the corporate taxes have been paid.

Q4. ‘The equity capital is cost free.’ Do you agree? Give reasons.
A4 It is sometimes argued that the equity capital is free of cost. The reason for such
argument is that it is not legally binding for firms to pay dividends to ordinary
shareholders. Further, unlike the interest rate or preference dividend rate, the
equity dividend rate is not fixed. It is fallacious to assume equity capital to be free
of cost. Equity capital involves an opportunity cost. Ordinary shareholders supply
funds to the firm in the expectation of dividends and capital gains commensurate
with their risk of investment. The market value of the shares, determined by the
demand and supply forces in a well functioning capital market, reflects the return
required by ordinary shareholders. Thus, the shareholders’ required rate of return,
which equates the present value of the expected benefits with the current market
value of the share, is the cost of equity.

Q5. The basic formula to calculate the cost of equity is: (DIV1/ Po) + g. Explain its
rationale.
A5 The cost of equity is equal to the expected dividend yield (DIV1/P0) plus capital
gain rate as reflected by expected growth in dividends (g). It may be noted that
formula is based on the following assumptions:
1. The market price of the ordinary share, P0, is a function of expected dividends.
2. The dividend, DIV1, is positive (i.e. DIV1 > 0).
3. The dividends grow at a constant growth rate g, and the growth rate is equal to
the return on equity, ROE, times the retention ratio, b (i.e. g = ROE * b).
4. The dividend payout ratio [i.e. (1 – b)] is constant.

2
 The cost of equity (internal) determined by the dividend-valuation model implies
that if the firm would have distributed earnings to shareholders, they could have
invested it in the shares of the firm or in the shares of other firms of similar risk at
the current market price (P0) to earn a rate of return equal to ke. Thus, the firm
should earn a return on retained funds equal to ke to ensure growth of dividends
and share price. If a return less than ke is earned on retained earnings, the market
price of the firm’s share will fall.

Q6. Are retained earnings less expensive than the new issue of ordinary shares? Give
your views.
A6 The cost of external equity is greater than the cost of internal equity for one
reason. The selling price of the new shares may be less than the market price. In
India, the new issues of ordinary shares are generally sold at a price less than the
market price prevailing at the time of the announcement of the share issue.

Q7. What is the CAPM approach for calculating the cost of equity? What is the
difference between this approach and the constant growth approach? Which one is
better? Why?
A7 As per the CAPM, the required rate of return on equity is given by the following
relationship:
k e = R f + (R m - R f )b j
Equation requires the following three parameters to estimate a firm’s cost of
equity:
1. The risk-free rate (Rf):
2. The market risk premium (Rm – Rf):
3. The beta of the firm’s share (b):
The dividend-growth approach has limited application in practice because of its
two assumptions. First, it assumes that the dividend per share will grow at a
constant rate, g, forever. Second, the expected dividend growth rate, g, should be
less than the cost of equity, ke, to arrive at the simple growth formula
These assumptions imply that the dividend-growth approach cannot be applied to
those companies, which are not paying any dividends, or whose dividend per
share is growing at a rate higher than ke, or whose dividend policies are highly
volatile. The dividend–growth approach also fails to deal with risk directly. In
contrast, the CAPM has a wider application although it is based on restrictive
assumptions. The only condition for its use is that the company’s share is quoted
on the stock exchange. Also, all variables in the CAPM are market determined
and except the company specific share price data, they are common to all
companies. The value of beta is determined in an objective manner by using
sound statistical methods. One practical problem with the use of beta, however, is
that it does not probably remain stable over time.

Q8. ‘Debt is the cheapest source of funds.’ Explain.

A8 Debt and equity are the two main sources of funds. Debt is cheap because of two
prime reasons:

3
 1. Risk of the lenders is less as compared to equity holders so cost of debt is less,
2. Interest paid on debt is tax deductible.

Q9. How is the weighted average cost of capital calculated? What weights should be
used in its calculation?
A9 The following steps are involved for calculating the firm’s WACC:
1. Calculate the cost of specific sources of funds
2. Multiply the cost of each source by its proportion in the capital structure.
3. Add the weighted component costs to get the WACC.
In financial decision-making, the cost of capital should be calculated on an after-
tax basis. Therefore, the component costs should be the after-tax costs. If we
assume that a firm has only debt and equity in its capital structure, then the
WACC (k0) will be:
k o =k d (1 - T ) w d + k e w e
D E
k o =k d (1 - T ) + ke
D+E D+E
where k0 is the WACC, kd (1 – T) and ke are, respectively, the after-tax cost of
debt and equity, D is the amount of debt and E is the amount of equity. In a
general form, the formula for calculating WACC can be written as follows:
k 0 =k 1 w 1 + k 2 w 2 + k 3 w 3 +L
where k1, k2, … are component costs and w1, w2, … weights of various types of
capital employed by the company.
You should always use the market value weights to calculate WACC. In practice,
firms do use the book value weights. Generally, there will be difference between
the book value and market value weights, and therefore, WACC will different.
WACC, calculated using the book-value weights, will be understated if the
market value of the share is higher than the book value and vice-versa.

Q10. Distinguish between the weighted average cost of capital and the marginal cost of
capital. Which one should be used in capital budgeting and valuation of the
firm? Why?
A10 Weighted marginal cost of capital (WMCC): Marginal cost is the new or the
incremental cost of new capital (equity and debt) issued by the firm. The weighted
average cost of capital is the cost of old and new capital. In capital budgeting
decision and valuation, we consider the incremental cash flows. Hence, it
appropriate to use the marginal cost of capital as the discount rate.

Q11. ‘Marginal cost of capital is nothing but the average cost of capital.’ Explain.
A11 Marginal cost is the new or the incremental cost of new capital (equity and debt)
issued by the firm. We assume that new funds are raised at new costs according to
the firm’s target capital structure. Hence, what is commonly known as the WACC
is in fact the weighted marginal cost of capital (WMCC); that is, the weighted
average cost of new capital given the firm’s target capital structure

4
Q12. How would you apply the cost of capital concept when projects with different
risks are evaluated?
A12 A simple practical approach to incorporate risk differences in projects is to adjust
the firm’s WACC (upwards or downwards), and use the adjusted WACC to
evaluate the investment project:
Adjusted WACC = WACC ± Risk - adjustment factor

That is, a project’s cost of capital is equal to the firm’s weighted average cost of
capital plus or minus a risk adjustment factor. The risk adjustment factor would be
determined on the basis of the decision maker’s past experience and judgment
regarding the project’s risk. It should be noted that adjusting WACC for risk
differences is not theoretically a very sound method; however, this
approach is better than simply using the firm’s WACC for all projects without
regard for their risk.
Companies in practice may develop policy guidelines for incorporating the project
risk differences. One approach is to divide projects into broad risk classes, and
use different discount rates based on the decision maker’s experience. For
example, projects may be classified as:
1. Low risk projects
2. Medium risk projects
3. High risk projects.
The risk of a project depends on its operating leverage. So you can estimate a
project’s beta based on its operating leverage. You may also consider the
variability of the project’s earnings to estimate the beta.

5
 CHAPTER 22

ASSET BASED FINANCING: LEASE, HIRE PURCHASE

AND PROJECT FINANCING

Q.1 Define a lease. How does it differ from a hire purchase and instalment sale? What
are the cash flow consequences of a lease? Illustrate.
A.1 A lease is an agreement for the use of the asset for a specified rental. The owner
of the asset is called the lessor and the user the lessee. The leases are of two types,
i.e., (1) operating leases which are short term and cancellable, and (2) financial
leases which are long term non-cancellable. The most compelling reason for
leasing equipment rather than buying it is the tax advantage of depreciation which
can mutually benefit both the lessee and lessor. In India, lease can prove handy to
those firms which cannot obtain loan capital from normal sources. In the case of
lease, the company can acquire the asset without immediately paying for I;
depreciation is a deductible expenses; and lease rentals are also deductible
expenses, so it saves taxes.
Under a higher price arrangement, like in a lease, the hire purchaser is able to
avoid the payment for the purchase of the asset now, and instead pays higher
purchase instalments over a specified period and time as per agreement. The hire
purchaser becomes the owner of the asset once he has paid all instalments. Unlike
the lease, he is entitled to claim depreciation as well as the salvage value of the
acquired asset.
Hire purchase arrangements differ from instalment sale arrangement in terms of
the timing of ownership. Under hire purchase, ownership passes to the hire
purchaser on the payment of the last instalment, while under instalment sale
ownership is transferred once the agreement has been made between the buyer
and the seller.

Q.2 What are the myths and advantages of a lease?

A.2 A number of advantages, which really are myths, are claimed for a lease.
a) It is misconception about leasing that it provides 100% financing for the assets.
Most lease agreement require lease rentals in the beginning of the period. In
leasing, the firm acquires the asset and incurs the liability to make fixed
payments in future.
b) It is also myth that leasing provides off-the balance sheet financing. Leasing
affects the firm’s debt capacity; that is, its debt-servicing ability. Practically,
the contractual obligations of any form reduce the debt-servicing capacity of a
firm.
c) It is a myth that leasing absolves a firm from capital investment evaluation. It
also requires the screening of investments decision since a long term financial
commitments are to be made.
If a firm is incurring losses or making low profits, it cannot take the full
advantage of the depreciation tax shield on purchase of assets. It is, therefore,
sensible for it to let the leasing company (lessor) own the assets, take full
advantage of tax benefits, and expect that the lessor passes on at least some part of

1
 the benefits in the form of low lease rentals. So, both parties, i.e., lessee and
lessor, may stand to gain financially (of course at the cost of government which
will lose tax revenues!).
Lease is suitable, if an asset is needed for a short period. It provides the flexibility
to tailor lease payments to the lessee’s cash flow.

Q.3 Explain and illustrate the equivalent loan method of lease evaluation.
A.3 Equivalent loan amount is that amount of loan which commits a firm to exactly
the same stream of fixed obligations as does the lease liability. This case flow can
be said to “service” the lease.
The equivalent loan instalment (EIL) method consists of the following steps for
evaluation of financial lease.
1) Find out incremental cash flows from leasing.
2) Determine the amount of equivalent loan such incremental cash flows can
service.
3) Compare the equivalent loan so found with lease finance.
4) If the lease finance is more than equivalent loan, the firm should finance
the asset by leasing.
The ELI is, in fact, the present value of lease cash flows and is given by following
equation.
Equivalent loan = PV of cash flows of a lease
n
(1 - T )L t + DTS
EL = å
t =1 (1 + i(1 - T)) t
Where T is tax rate; Lt is lease instalment; DTS is depreciation tax shield and
equals T × DEP; i is interest rate and t is time period of lease.

Q.4 What is net advantage of a lease? How is it calculated?

A.4 The net advantage of leasing is equal to the purchase price of the asset (avoided)
less present value of lease flows. The formula given above (see answer to Q 3) is
used to calculate net advantage of leasing. It denotes the incremental advantage
over the net present value of buying the asset through normal financing channels.
A positive net advantage of leasing does not imply that the assets should be
acquired, it implies advantage to leasing. So, before taking decision, net present
value of asset should be assessed as an investment. It is possible that leasing may
make a financially unattractive asset investment worthwhile.

Q.5 What is the difference between equivalent loan and net advantage of lease
methods of the lease evaluation?
A.5 Financial lease involves fixed obligations in the form of lease rentals. Thus, it is
like a debt and can be evaluated that way. Given the lease rentals and tax shields,
one can find the amount of debt which this cash flow can service. This is
equivalent loan. If equivalent loan is more than the cost of the asset, it is not
worth leasing the equipment. Lease evaluation can be done by calculating the net
advantage of lease. After-tax lease rentals and tax shields may be discounted at
the after tax borrowing rate while operating costs and salvage value at the firm’s
cost of capital to find out NAL. In the following formula, we assume that the

2
 lessor will take care of the operating and maintenance expenses if the asset is least
instead of being ought.
n
(1 - T )L t + DTS t n
(1 - T)OC1 ATSVn
NAL = Ao - å +å -
t =1 [1 + i (1 + T)] t
t =1 (1 + k) (1 + k ) t

Where Ao is the purchase price of the asset avoided, DTS is the depreciation tax
shield; T is the tax rate; i is the interest rate on borrowing; Lt is the lease
instalment; OC1 is the operating cost in year t avoided; k is the after-tax cost of
capital of the firm; and ATSVn is the after-tax salvage value of the leased asset at
the end of the life, n.

Q.6 “It makes sense for companies that pay no taxes to lease from companies that do”.
Explain.
A.6 A firm that is incurring losses or making low profits, it cannot take full advantage
of the depreciation tax shield on purchase of assets. It is, therefore, sensible for it
to let the leasing company (lessor) own the asset, take full advantage of two
benefits, and passes on some benefits in the form of reduced lease rentals to the
lessee. Both the lessor and lessee will gain financially.

Q.7 What is a leveraged lease? What are its merits and demerits?
A.7 Under a leveraged lease, four parties are involved: the manufacturer of the asset,
the lender from whom the lessor borrows a substantial portion of the assets
purchase price, the lessor and the lessee. In a leveraged lease, the lessor makes
substantial borrowing, e.g., 80% of the asset’s purchase price, and provides
remaining amount. The lessor claims all tax benefits related to the ownership of
the asset. Lenders, generally the large financial institutions, provide loans on a
non-recourse basis to the lessor. Their debt is serviced exclusively out of the lease
proceeds. The lessor mortgages the asset to the lenders.
The leveraged lease creates a high degree of leverage. It is quite useful for large
capital equipment with long economic life, say, 20 years or more.

Q.8 What is the hire purchase financing? How does it differ from the lease financing?
A.8 In hire purchase financing, there are three parties: the manufacturer, the hiree and
the hirer. The hiree may be a manufacturer, or a finance company. The
manufacturer sells asset to the hiree who sells it to the hirer in exchange for the
payment to be made over a specified period of time.
The hire purchase financing have three distinctive features:
1) The owner of the asset (hiree or manufacturer) gives the possession of the
asset to the hirer on agreement.
2) The ownership will transfer to the hirer on the payment of all instalments.
3) The hirer will have the option to terminate the agreement before the
transfer of ownership of the asset.
In the case of hire purchaser, hirer is entitled to claim depreciation, while in case
of lease, lessee is not entitled to claim depreciation. Hirer can charge only interest
portion of HP payments as expenses for tax computation, while in case of lease
financing, lessee can charge the entire lease payments as expenses for tax

3
computation. On payment of all instalments as agreed, the hirer become owner of
the asset and can claim its salvage value. Lessee does not become the owner of
the asset. Therefore, he has no claim over the asset’s salvage value. In case of
lease, the asset reverts back to the lessor at the end of lease period.

4
 CHAPTER 18

DIVIDEND POLICY

Q.1 Explain the nature of the factors which influence the dividend policy of a firm.
A.1 The following factors generally influence the dividend policy of the firm.
1. Shareholders’ expectations: Shareholders’ expectation relating to
dividends or capital gains depends on their economic status, effect of
differential tax system, need for regular income, etc.
2. Firm’s financial needs: Financial needs of the company to finance the
profitable investment opportunities.
3. Legal restrictions: Legal restrictions like dividend to be paid out of
current or past profits do influence dividend policy of a firm.
4. Liquidity: The overall liquidity of a company has an effect on the
dividend decision of a firm. In the absence of sufficient cash, a firm may
be unable to pay dividends even if it has profits.
5. Firm’s financial condition: The financial condition or capability of a firm
depends on its use of borrowings and interest charges payable. A high
levered firm is expected to retain more profits and distribute less
dividends in order to strengthen its equity base.
6. Capital market accessibility: Accessibility by firm to the capital market
becomes an important factor to declare dividends. For example, a fast
growing company which has a tight liquidity position will not face any
difficulty in paying dividends if it has access to the capital markets.
7. Institutional lenders: Lenders of funds like financial institutions and
banks may generally put restrictions on dividend payments to protect
their interests when the firm is experiencing low liquidity or low
profitability, etc.

Q.2 ‘The primary purpose for which a firm exists is the payment of dividend.
Therefore, irrespective of the firm’s needs and the desires of shareholders, a firm
should follow a policy of very high dividend payout! Do you agree? Why or why
not?
A.2 This statement is not true. The primary purpose of the firm is not payment of
dividend. Rather, it is to maximise shareholders’ wealth. Paying dividend in
certain situations, may harm, rather than enhance, the shareholders’ wealth. The
MM view is that dividends are irrelevant. If we consider taxes and assume that
dividend incomes are taxed and capital gains are tax exempt, then paying
dividends will be harmful. On the contrary if capital gains are taxed and dividends
are tax exempt, then it may be in the interest of shareholders if dividends are paid.
A company having profitable growth opportunities will like to retain more and
create shareholder wealth.

Q.3 What are the factors which influence management’s decision to pay dividend of a
certain amount?

1
A.3 Dividends are paid in cash. A firm’s dividend policy has the effect of dividing its
net earnings into two parts, i.e., retained earnings and dividends. The retained
earnings provide funds to finance the long term growth. Thus, the distribution of
earnings uses the available cash of the firm. The firm which needs funds to
finance its investment opportunities will have to use external source of financing.
To safeguard the firm from approaching the capital market for external financing,
a firm may not like to distribute cash dividend. Firms with a lot of investment
opportunities do distribute some dividend because paying dividend has
information value. It provides a positive signal to investors about the future
profitability of the firm.

Q.4 What is a stable dividend policy? Why should it be followed? What can be the
consequences of changing a stable dividend policy?
A.4 Stable dividend policy means regularity in paying some dividend annually, even
though the amount of dividend may fluctuate over years, and may not be related
with earnings. Precisely, stability of dividends refers to the amount paid out
regularly. This policy should be followed, because by and large, shareholders
favour this policy and value stable dividends higher than the fluctuating ones. The
stable dividend may have a positive impact as the market price of the share. This
policy resolves uncertainty in the minds of investors about future earnings, and
satisfies the desire of many investors, such as old, retired persons, etc.
If the companies change from the stable dividend policy to an irregular or
fluctuating dividend policy, it gives an unfavourable signal to shareholders about
the stability of the firm’s operations.
Q5 How is the corporate dividend behaviour determined? Explain Linter’s model in
this regard.
A5 The firm’s dividend policy may be expressed either in terms of dividend per share
or dividend rate. According to empirical findings in India, USA and other
countries, corporate manager’s feel that current dividends depends on current
earnings, the future earnings potential as well as dividends paid in the previous
year. Further, dividends must be paid even when a company needs funds for
undertaking profitable investment projects since dividends have information
value..
Linter’s model is based on the assumptions that firms generally think in terms of
proportion of earnings to be paid out as dividend. Firms generally have target
payout ratios in view while determining change in dividends. Shareholders like a
steadily growing dividends. Thus, firms change their dividends slowly and
gradually even when there are large increases in earnings. This implies that firms
have standards regarding the speed with which they attempt to move towards the
full adjustment of payout to earnings. Linter has suggested the following formula
for change in dividends of firms in practice:
D1V1 = D1V0 + b (pEPS1 – DIV0)
where D1V1 is the expected dividend per share; D1V0 is the dividend per share of
the previous year; p is the target payment ratio; b is the speed of adjustment; and
EPS1 is the expected earnings per share in the current year.

2
Q.6 What are the different payout methods? How do shareholders react to these
methods?
A.6 Three distinct forms of dividend payout methods are (1) constant dividend per
share; (2) constant dividend payout ratio; and (3) constant dividend per share plus
extra dividend.
Constant dividend per share: The policy of a company to pay fixed amount per
share or fixed rate on paid-up capital as dividend every year, irrespective of
fluctuations in the earnings. Those investors who have dividends as the only
source of their income may prefer this method. They do not accord much
importance to the changes in the share price.
Constant payout: The ratio of dividend to earnings is known as payout ratio. With
this policy, the amount of dividend will fluctuate in direct proportion to earnings.
Internal financing with retained earnings is automatic when this policy is
followed.
Constant dividend per share plus extra dividend: The policy to pay a minimum
dividend per share with step-up feature is desirable. The small amount of dividend
is fixed to reduce the possibility of ever missing a dividend payment. The extra
dividend may be paid as an interim dividend in periods of prosperity. Certain
shareholders like this policy because of the certain cash flow in the form of the
regular dividend and the option of earning extra dividend occasionally.

Q.7 What is a bonus issue or stock dividend? What are its advantages and
disadvantages?
A.7 Bonus share means distribution of free shares to the existing shareholders. This is
known as stock dividend in the USA. This has the effect of increasing the number
of ordinary shares of the company by capitalisation of retained earnings. In India,
bonus shares cannot be issued in lieu of cash dividend. The earnings per share and
market price per share will fall proportionately to the bonus issue, but the total net
worth of the firm is not affected by the bonus issues.
Advantages
The shareholders are benefited as bonus shares are not taxable as income. They
interpret it as an indication of higher profitability of the firm. If the company is
following the constant dividend policy, then total cash dividend of the
shareholders will increase in future. Some of the shareholders can sell bonus
shares to make capital recovery.
The company is able to retain the earnings and at the same time satisfy the desires
of shareholders to receive dividend. It is the only way for firm to pay dividend
under financial difficulty and contractual restrictions, and maintain the impression
of firm in shareholders’ mind intact.
Bonus share have no effect on share value. From the company’s point of view,
they are more costly to administer than cash dividend.

Q.8 Explain a stock split? Why is it used? How does it differ from a bonus shares?
A.8 A stock (share) split is a method to increase the number of outstanding shares
through a proportional reduction in the par value of the share. A share split affects
only the par value and the number of outstanding shares, the shareholders’ total

3
 fund remains unaltered. For example, a firm’s total share capital of Rs. 10 crore
being represented by 1 crore share each having par value of Rs. 10. The firm can
split their shares two-for-one. Then after split off the number of shares will be 2
crore each having par value of Rs. 5 and total share capital will be Rs. 10 crore
only.
Stock split is done with the main purpose to reduce the market price of the share
and place it in a more popular trading range. This helps in marketability and
liquidity of the company’s shares. Generally, when the share is split, the company
seldom reduces dividend per share proportionately, so total dividends of a
shareholder increase after a stock split.
The reduction of the number of outstanding shares by increasing per share par
value is known as reverse split. This may be done, when company wants to prop
up the market price per share.
In case of both bonus share and stock split, the total net worth of firm does not
change, but number of outstanding shares increases substantially.
In case of bonus shares, the balance of the reserves and surpluses account
decreases due to a transfer to the equity capital and share premium accounts. The
par value per share remains unaffected. With a stock split, the balance of the
equity accounts does not change, but the par value per share changes.

Q.9 “Bonus shares represent simply a division of corporate pie into a large number of
pieces.” Explain.
A.9 The declaration of bonus shares is a method of capitalizing the past earnings of
the shareholders. It is a formal way of recognizing earnings of the shareholders
which they already own. It merely divides the ownership of the company into a
large number of share certificates. The ownership of shareholder does not change
by receipt of bonus share. In short, it represents simply a division of corporate pie
into a large number of pieces.

Q.10 What are the effects of bonus issue and share split on the earnings per share and
the market price of the share?
A.10 Bonus shares and stock split reduce the market price of the share reduces and it
becomes more attractive to the shareholders. The reduced market price per share,
place the company’s share in a more popular trading range. This helps in
increasing marketability and liquidity of the company’s share. The earnings per
share also reduce on account of bonus shares issue and stock split.

Q 11 What is meant by the buyback of shares? What are its effects? Is it really
beneficial to the company and shareholders?
A 11 The buyback of shares is the repurchase of its own shares by a company. In India
companies are authorized to buy back their shares. But they can not do so by
raising debt. They will use their surplus cash for doing so. Also after the buyback,
company can not issue new shares for next 12 months. There are two methods of
the share buyback in India.
1. A company can buy its shares through authorized brokers on the open market.

4
2. The company can make a tender offer, which will specify the purchase price,
the total amount, and the period within which shares will be brought back.
The purpose of the buyback is to provide companies the flexibility of improving
their EPS and share price, to defend themselves from hostile takeovers and adjust
their capital structure.
In practice, share prices may fall if the buyback results into slow growth. It may
not be effective in countering the takeover if it does not have enough surplus cash.

5
 CHAPTER 23

VENTURE CAPITAL FINANCING

Q.1 Define venture capital. Explain its characteristics.

A.1 Venture capital is risk financing available in the form of equity or quasi-equity. It
is often thought of as ‘the early stage financing of new and young enterprises
seeking to grow rapidly’. Venture capital is the investment of long term equity
finance where the venture capitalist earns his return primarily in the form of
capital gain. The assumption is that entrepreneur and venture capitalist would act
as partner.
The main characteristics are (a) It is an actual or potential equity participation
with an intention to make capital gains once enterprise becomes profitable; (b) it
is a long term, illiquid investment, not repayable on demand; and (3) it ensures
continuing participation of the venture capitalist in the management of the
entrepreneur’s business. Venture capitalist gives his marketing, technology,
planning and management skills to the new firm.

Q.2 Explain the venture financing stages. What are the methods of venture financing?
A.2 The stages of venture financing are: (a) Early stage financing includes seed
financing for supporting a concept or idea; R&D financing for product
development; start-up capital for initial production and marketing; first-stage
financing for full scale production and marketing; (b) Expansion financing
includes second stage financing for working capital and initial expansion;
development financing for facilitating public issue; bridge financing for
facilitating public issue; (c) Acquisition/buyout financing includes financing for
acquiring another firm; management buyout for enabling operating group to
acquire firm; turnaround financing for turning a sick firm/unit.
The methods of venture financing include equity, conditional loans, income notes,
participative/convertible debentures etc.

Q.3 What are the steps involved in a venture capital investment process? Explain them
briefly.
A.3 The following six steps are involved in venture capital investment process.
1) A continuous flow of deal is essential. Deals may originate in various
ways: (i) referral system, (ii) active search and (iii) intermediaries.
2) Screening: Venture capital is a service activity. In order to save time and
to select best ventures, VCFs carry out initial screening of all projects on
the basis of broad intention.
3) Due diligence: The venture capitalist, evaluate the quality of
management, (i.e., entrepreneur) before appraising the characteristics of
product, market or technology. They do preliminary as well as detailed
evaluation.
4) Risk analysis: Venture capitalists analyse product risk, market risk,
technological risk, and entrepreneurial risk in detail.

1
 5) Deal structuring: Once the venture has been evaluated as viable, the
venture capitalist and entrepreneur negotiate the terms of the deal, viz.,
the amount, the form and price of the investment. After deal structuring,
venture capitalist assumes the role of the partner and collaborator.
6) Exit: Venture capitalist play a positive role in directing the company
towards particular exit routes; i.e., through initial public offer, acquisition
by another company, purchase of shares by the promoter or by outsider.

Q.4 What is the strategic role of venture capital in developing entrepreneurship in a

country?
A.4 Venture capital financing (VCFs) in India provide different services such as
managerial consultancy, technical support and information, equity participation,
etc. Some of them, particularly those associated with the central or state level
financial institutions and nationalized banks, assist the entrepreneurs in obtaining
term loans and working capital. The supports provided by VCFs include
preparation of a business and financial plan, formulation of marketing plan and
strategy, technical advice, assistance in resource identification, recruitment,
organization structuring, etc.

Q.5 What is the need of venture capital in India? What is the status of venture capital
in India?
A.5 In India, there do exist a large number of financial institutions which provide
conventional finance to the business firms (i.e. with minimum risk; and security-
oriented and asset-based).
Because of the conservative attitude of financial institutions in India, a different
financing mechanism such as venture capital is needed to provide funds to
entrepreneurs particularly those in small scale enterprises, with new technology of
processes or methods, new product characteristics, new ideas, etc.
The concept of venture capital was formally introduced in India in 1986-87, and
the Industrial Credit and Investment of India (ICICI) started the activity in the
same year. VCFs in India can be categorized into the following four groups:
1) VCFs promoted by the central government controlled development
financial institutions.
2) VCFs promoted by state-government controlled development financial
institutions.
3) VCFs promoted by the public sector banks.
4) VCFs promoted by the foreign banks or private sector companies and
financial institutions.
In India, VCFs average investment in each venture has also increased over the
years. A steady increase in the number of projects as well as in the amount
invested by VCFs have been noticed.

Q.6 What are the possible disinvestment avenues available to venture capital firm in
India? Explain their merits and demerits.
A.6 The objective of true venture capitalist is to sell off his investment at substantial
capital gains. The disinvestment options available generally to venture capitalists

2
 are the promoter’s buyback, public issue, sale to other VCFs, sale in OTC market,
management buyouts etc.
Buyback: This is suitable in Indian condition because it keeps the ownership and
control of the promoter intact. The obvious limitation is that in a majority of cases
the market value of the shares of the venture firms would have appreciated so
much that the promoter would not be in a financial position to buy them back.
Initial Public Offerings: It improves the marketability and liquidity, better
prospects for capital gains and widely known status of the venture as well as
market control through public share participation. This public issue form of
investment can involve high transaction costs, because of the inefficiency of the
secondary market in India.
Secondary Stock Market: VCFs should be able to sell their holdings; the
investors should be able to trade shares conveniently and freely.
Q.7 Do you think tax incentives are necessary to encourage venture capital activity in
a country? Why? Make recommendations in the Indian context.
A.7 Fiscal incentives in the form of tax incentives have been found to play a central
role in the growth of venture capital in the developed countries. In India,
preferential tax treatment was available to VCFs which finance eligible
entrepreneurs. In the past, this encouraged establishment of more venture capital
firms in the private sector. Investors investing in small and medium enterprises
can be provided additional tax incentives. Investors should also be provided tax
relief if they invest in qualifying, unquoted companies or new companies.
Government should also provide tax incentives to small and medium enterprises
in the forms of capital cost allowance, deduction of R&D expenditures, tax reliefs
on profits, etc.

3
 CHAPTER 25

FINANCIAL STATEMENTS ANALYSIS

Q-1 Explain the need for financial analysis. How does the use of ratios help in financial analysis?
A-1 Financial analysis is the process of identifying the financial strength and weaknesses of the firm
by properly establishing relationships between the items of Balance Sheet and Profit and Loss
a/c. The financial analysis helps the trade creditors’ to determine the firm’s ability to meet their
claim’s within short period, helps the long-term fund providers to judge the long-term solvency,
to investors to determine the firm’s ability to meet its earnings ability and risk, and to
management for efficient and effective resource utilization.
A financial ratio is a relationship between two financial variables. The financial ratios help the
users’ to determine
a) The ability of the firm to meet its current obligations;
b) The extent to which the firm has used its long-term solvency by borrowing funds;
c) The efficiency with which the firm is utilizing its assets in generating sale revenue, and
d) The over all operating efficiency and performance of the firm.
Q-2 What do you mean by the liquidity of a firm? How can the liquidity of a firm be assessed?
A-2 Liquidity means the firm’s ability to meet its current obligations. A proper management of
liquidity ensures that firm does not suffer from lack of liquidity, and also does not have excess
liquidity. Liquidity ratios provide quick measure of liquidity. The liquidity can be assessed by
using current ratio and quick ratio. The other ratios like cash ratio, interval measure ratio and
working capital ratio can also be used.
Q-3 Is it possible for a firm to have a high current ratio and still find difficulties in paying its current
debt? Explain with illustration.
A-3 The current ratio –current assets divided by current liabilities - is a measure of the firm’s short-
term solvency. The current ratio is a test of quantity, not quality. The current liabilities are not
subject to any fall in the value, while the current assets can decline in value. The decline in value
of current assets possible if the current asset consists of doubtful and slow paying debtors or
slow-moving or/and obsolete stock of goods. Thus, a firm will high slow-paying debtors and
high slow-moving inventory will have high current ratio, but will find it difficult to service
current liabilities.
Q-4 What are the leverage or capital structure ratios? Explain the significance and limitations of the
debt-equity ratio as a measure of the firm’s solvency?
A-4 Leverage or capital stricture ratios describe relationship between debt and equity, and help to
judge the financial position of the firm. These ratios measure the proportion of outsider capital in
financing the firm’s assets, and are calculated by establishing relationships between borrowed
capital and equity capital. As a firm increases the proportion of debt, it is exposed to high degree
of financial risk. Leverage ratios are calculated to measure the financial risk and the firm’s ability
of using debt to shareholders advantage.
To know the proportion of interest bearing debt (also called funded debt) in the capital structure,
debt ratios are used. The debt-equity ratio is calculated by dividing total debt by net worth. A
high ratio means that the claims of creditors are greater than those of owners. From the point of
view of creditors, it represents high risk. It is an unsatisfactory situation from the firm’s point of
view as well since a high proportion of debt provides inflexibility to the firm’s operations and
causes payment of high interest charge. During the periods of low profits, the debt servicing will
prove to be quite burdensome to the firm.
From the shareholders’ viewpoint, the higher the debt-equity ratio, the larger the shareholders’
earnings, when the cost of debt is less than the firm is overall rate of return on investment. But
1
 under adverse conditions, debt erodes their return and in extreme situations may threaten the
solvency of the firm.
Q-5 Why are the activity ratios calculated? Do calculations of current asset turnover ratios indicate
their quality? Explain
A-5 Activity ratios are calculated to measure the firm’s efficiency in utilizing its assets in generating
sales, and are calculated by establishing relationships between sales and assets. They indicate the
speed with which assets are being converted or turned over into sales. The current assets turnover
ratios relate the current asset to sales. It indicates the quality of current assets, by comparing one
period ratio with past and projected ratios. It indicates the utilization of current assets efficiently
to maximize sales.
Q-6 How would you calculate the fixed assets turnover and the capital employed turnover ratios?
What do they imply?
A-6 If the firm would like to know the efficiency of utilizing the fixed assets, they use the fixed
turnover ratio, which is, Fixed Turnover ratio = Sales / Net Fixed Assets
To have the meaningful comparison of firm’s performance over period or with other firms, the
Gross Fixed Assets may be used instead of Net Fixed Assets in denominator of ratio.
To know the overall efficiency of the firm in utilizing the fixed assets and net current assets in
combination together, the capital employed turnover ratio may be used: Capital Employed
Turnover Ratio = Sales / Capital Employed
The capital employed is the sum total of net fixed assets and net working capital, i.e., current
assets less current liabilities.
The fixed assets turnover ratio and capital employed turnover ratio indicate the value of sale for
one rupee investment in fixed assets and capital employed (fixed assets and net current assets
together) respectively.
Q-7 Why is it necessary to calculate the profitability ratios in relation to sales? Illustrate your answer.
A-7 A firm should earn profits to survive and grow over a long period of time. The profit is the
difference between revenues and expenses over a period of time. The profitability ratios are
calculated to measure the operating efficiency of the firm in terms of profit.
The profitability ratios are to be calculated in relation to sales, because the profit is the ultimate
output of the commercial operations of the business. If the firm’s profit has to be examined from
the view point of all investors (i.e., lenders and owners), the appropriate measure is operating
profit, i.e., earnings before interest and tax.
Following are the profitability ratios in relation to sales.
i. Gross Profit Margin
GPM = (Sales-Cost of Goods Sold) / Sales
ii. Net Profit Margin
NPM = Profit after tax / Sales
iii. Modified Net Profit Margin
MNPM = [EBIT (1-T)] / Sales
Gross Profit margin indicates the management’s’ efficiency in manufacturing of the products.
Net profit margin indicates the management’s’ efficiency in manufacturing, selling,
administrating the products, and also the efficiency in utilizing the resources. This ratio is
affected by the firm’s financing policy. Modified net profit margin ratio is appropriate for a true
comparison of the operating performance of firms by ignoring the interest effect (arising from
different capital structures).
Q-8 Explain the calculation and significance of the various measures of rate of return on investment.
A-8 Rate of return on investment (ROI) is used to measure the overall operating efficiency of the firm
in managing its investments. The term investment refers to the net asset (net fixed assets plus net
current assets) or total asset or net worth plus total debt.
2
 The traditional way to measure the ROI is to divide the profit after tax (PAT) by investment. The
PAT refers to the residual income of shareholders, and investment refers to the funds supplied by
both lenders and shareholders. So, this methodology seems to be inappropriate. It is, therefore,
more appropriate to use any of the following measures to compare and evaluate the operating
efficiency.
ROI = ROTA = {EBIT (1-T)} / Total Assets
ROI = RONA = {EBIT (1-T)} / Net Assets
RONA is also known as ROCE.
Q-9 Explain the ratios which you, as an analyst, will focus your attention to in the following cases:
(a) A bank is approached by a company for a loan of Rs 50 lakh for working capital purpose.
(b) A company requests a financial institution to grant a 10 year loan of Rs 5 crore.
A-9 (a) It is extremely essential for a firm to be able to meet its current obligations as they become
due. For this purpose, the liquidity ratio will be used to measure the ability of the firm to meet its
current obligations. The ratios like current ratio, quick ratio, cash ratio, interval measure and net
working capital ratio will be used to measure the liquidity of the firm.
Also, it would be essential to measure the firm’s current debt-paying ability. This is going to be
measured by debt ratio, debt-equity ratio, fixed charge coverage ratio, etc.
(b) To grant the long-term loan, it is important to assess the firm’s financial risk and its long-term
profitability. Financial risk is assessed by calculating financial leverage or capital structure ratios.
These ratios indicate mix of funds provided by owners and lenders. These ratios are calculated
from the Balance Sheet items to determine the proportion of debt in total financing. The ratios
are: (i) debt as a proportion of capital employed, (ii) debt as a proportion of net assets, (iii) debt
as a proportion of net worth, (iv) total loan to total assets ratio.
It is also important to measure the first ability to meet interest and other fixed charges
obligations. For this purpose, interest coverage ratio and fixed charge coverage ratio will be
calculated.
Q-10 Which of the financial ratios of a company would you most likely refer to in each of the
following situations? Give reasons.
(i) The company asks you to sell material on credit.
(ii) You are thinking of investing RS. 25,000 in the company’s debentures.
(iii) You are thinking of investing RS. 25,000 in the company’s shares.
A-10 (i) Current Ratio, Quick Ratio, Cash Ratio, Average Payment Period and Working Capital
Turnover Ratio.
(ii) Total debt to Capital Employed Ratio, Interest Coverage Ratio, Fixed-charge Coverage Ratio
and Total Loan to Total Assets Ratio.
(iii) Return on Equity, Earning per shares, Dividend Pay-out Ratio, Dividend Yield, Earning
Yield, Price Earning Ratio and also Market Value to Book Value Ratio.

Q-11 What is the firm’s earning power? How are the net profit margin and the assets-turnover related?
A-11 The firm’s earning power depends on the firm’s operating performance. Basically, the ROCE or
RONA indicates the firm’s operating performance. It is always the product of the asset turnover,
gross profit and operating leverage. The operating leverage is the relationship between EBIT and
gross profit (GP).
The RONA is calculated as under:
RONA = EBIT / NA
RONA = Assets turnover ratio x gross margin x operating leverage
= (sales / NA) × (GP/ sales) × (EBIT / GP)

Q-12 What is a Dupont analysis? Explain with the help of a chart.

3
A-12 DuPont analysis traces the reasons for return on equity (ROE). Is it due to operating
performance? How much is contributed by financial leverage? The Dupont analysis chart is
shown in the text book.
ROE = RONA ´ DOL ´ DFL
PAT EBIT PAT NA
= ´ ´
NW NA EBIT NW
Sales EBIT
RONA = ´
NA Sales
Q-13 “A higher rate of return on capital employed implies that the firm is managed efficiently.’ Is this
true in every situation? What or why not?
A-13 The return on capital employed (ROCE) is equivalent to return on net assets. Net assets equal to
net fixed assets plus current assets less current liabilities. The ROCE indicates the firm’s earning
power. ROCE is also the product of the asset turnover, gross profit margin and operating
leverage. The operating leverage is the relationship between EBIT to net profit. The operating
leverage refers to the use of fixed costs in the operation of a firm. In other words, it indicates the
operating efficiency. So, it is true to say that higher ROCE indicates that firm is managed
efficiently. However, there may be situations where the operating efficiency is average but ROE
is high because of the financial leverage.
Q-14 Ratios are generally calculated from historical data. Of what use are they in assessing the firm’s
future financial condition?
A-14 Time series or trend analysis of ratios indicates the direction of change. By studying the trends of
sales and net profit, investors can restore the confidence in firm’s steady growth in earnings.
The suppliers of long-term debt are also interested in the evaluation of long-term solvency and
survival. So, they want to analysis the firm’s profitability and its ability to pay interest and repay
principal. For this purpose, they place more emphasis on firm’s projected or pro forma financial
statement than those are based on historical data.
Investors and long-term suppliers of debt concentrate on the analysis of firm’s present and future
profitability to evaluate the firm’s earning ability and risk.
Q-15 Explain the significance and limitations of the ratio analysis.
A-15 Significance: Ratio analysis is very useful to determine or evaluate the profitability of operations
of the firm, stability of profitability, the trend of profitability the efficiency in utilization of assets
of the firm, the liquidity position, capacity to raise the debt funds, cash and funds flow, etc.
When the ratios of a firm of a particular year or period are compared with past ratios of the firm,
or/and projected ratios of firm, also with industry average or competitor’s ratios, it gives more
insight to evaluate financial strength and weaknesses of the firm.
The following are the limitations of ratios:
i. It is quite difficult to find out proper basis of comparison.
ii. The cross sectional comparison becomes difficult on account for difference in situations of
two firms’ or within the same firm over the years.
iii. On account of changing value of money, the comparisons of ratios over the period become
invalid, so the interpretations become invalid.
iv. The difference in the definitions of items in the Balance Sheet and P & L statement make the
interpretation of ratios difficult.
v. The ratios are calculated at a point of time, so they are static in nature. They do not reveal
changes which have taken place between dates of two balance sheets.
vi. The ratios are calculated from past historical data and statements. For outside analyst, it
necessarily does not reflect the financial position and performance in the future.

4
 CHAPTER 26

FINANCIAL PLANNING AND STRATEGY

Q-1 What is a financial planning? How does it differ from financial forecasting?
A-1 The process of estimating the funds requirements of a firm; to finance its current and fixed assets
to meet the expected growth in business; and determining the sources of funds is called financial
planning. Financial forecasting is an integral part of financial planning. Forecasting uses past
data to estimate the future financial requirements.
Forecasts are merely estimates based on the past data; planning means what a company would
like to happen in the future, and includes necessary action plans for realizing the predetermined
intensions. Financial planning is a means for achievement of growth and profitability objectives
by making planned investment and financing decisions.
Q-2 Explain the steps involved in preparing a financial plan. What are the merits of a financial
planning?
A-2 The following steps are involved in preparing a financial plan.
(1) Analyze the firm’s past performance and establish relationships between financial variables.
(2) Analyze the firm’s strength with respect to operating characteristics like product, market
competition, production, operating risks, etc.
(3) Workout the firm’s investment needs and its capacity to generate cash flows from operations.
(4) Also workout the appropriate means to raise the external funds, based on investment and
dividend policies; and also the long-term financial health and survival plan.
Financial planning supports the management to ascertain the need of assets to sustain the higher
growth in sales, by taking proper investment and financing decision, based on long-term
projections (normally of three or five years).

Q-3 Is there a relationship between strategic planning and financial planning? Explain.
A-3 Financial planning of a company has close links with strategic planning. Strategic planning
considers all markets, including product, labour and capital, as imperfect and changing.
Strategies are developed to manage the business firm in uncertain and imperfect market
conditions and environment and exploit opportunities. The company’s strategy establishes an
effective and efficient match between its resources, opportunities and risks. Firms develop
financial plan within the overall framework of strategic plan.

Q-4 What is a financial model? Illustrate the development of a simple financial model. What are the
advantages and limitations of a financial model?
A-4 A financial planning model establishes the relationship between financial variables and targets,
and facilitates the financial forecasting and planning process. A model makes it easy for the
financial managers to prepare financial forecasts. It makes financial forecasting automatic and
saves the financial managers’ time and efforts performing a tedious activity. Financial planning
models help in examining the consequences of alternative financial strategies. A financial
planning model has three components – Inputs, Model and Output.

Q-5 What is meant by sustainable growth? Explain sustainable growth models with illustrations.
A-5 Sustainable growth may be defined as the annual percentage growth in sales that is consistent
with the firm’s financial policies (assuming no issue of fresh equity). The following model can
1
be used to determine the sustainable growth (gs) in sales:
net margin ´ retention ´ leverage
sustainabl e growth =
assets - to - sales - (net margin ´ retention ´ leverage)
The net asset to sales ratio determines the requirement of funds for investing in assets to support
a given level of sales. The requirement for funds would increase with expanding sales. The net
profit minus the dividends is an internal source of funds. Thus, the product of net profit to sales
ratio and retained profit to net profit (net margin × retention ratio) gives an idea of the funds
available internally to support the growth of the firm. Retained earnings increase the debt raising
capacity of the firm. Thus, given the target capital structure, the total funds would be equal to
retained earnings plus debt supported by the retained earnings. Net assets or capital employed
(viz. debt plus equity) to equity is a leverage measure, and is equal to one plus debt–equity ratio.
Suppose the following for a firm: PAT = Rs 100; sales = Rs 5000; dividends = Rs 400; NA=
Debt + NW (equity) = Rs 2500; NW = Rs 1250. The sustainable growth is:
100/5000 ´ 60/100 ´ 2500/1250
sustainabl e growth =
2500/5000 - (100/5000 ´ 60/100 ´ 2500/1250)
0.02 ´ 0.6 ´ 2
= = 0.05 = 5%
0.5 - (0.02 ´ 0.6 ´ 2)
A more general method of determining the sustainable growth rate in the case of multi-product
or multi-division company is to calculate the sustainable growth rate at the corporate level in
terms of growth in assets.
Sustainabl e growth = asset turnover ´ profit margin ´ income leverage
´ retention ratio ´ financial leverage
S PBIT PAT RE NA
gs = ´ ´ ´ ´
NA S PBIT PAT NW

2
 CHAPTER 27

PRINCIPLES OF WORKING CAPITAL MANAGEMENT

Q.1 Explain the concept of working capital. Are gross and net concepts of working
capital exclusive? Discuss.
A.1 Working capital signifies money required for day-to-day operations of an
organization. No business can run without the provision of adequate working
capital.
There are two concepts of working capital. Gross working capital refers to the
firm’s investment in current assets. Net working capital means the difference
between current assets and current liabilities, and therefore, represents that
position of current assets which the firm has to finance either from long term
funds or bank borrowings. Both concepts have equal significance from the
management’s view point, so they are not exclusive.
The gross working capital concept focuses attention on optimization of
investment in current assets, and effective and economical financing of current
assets. The net working capital concept is qualitative, indicates the liquidity
position of the firm and suggests the extent to which working capital needs may
be financed by permanent sources of funds.
Q.2 What is the importance of working capital for a manufacturing firm? What shall
be the repercussions if a firm has (a) paucity of working capital, (b) excess
working capital?
A.2 A manufacturing firm is required to invest in current assets for a smooth,
uninterrupted production and sales. How much a firm will invest in current assets
will depend on its operating cycle. Operating cycle is defined as the time duration
which the firm requires to manufacture and sell the product and collect cash.
Investment is current assets should be just adequate to the needs of the firm.
Excessive investment in current assets impairs the firm’s profitability, as idle
investment earns nothing. On the other hand, inadequate (i.e. paucity) amount of
working capital can threaten solvency of the firm because of its inability to meet
its current obligations.

Q.3 What is the concept of working capital cycle? What is meant by cash conversion
cycle? Why are these concepts important in working capital management? Give
an example to illustrate.
A.3 Operating cycle or working capital cycle is the time duration required to convert
inventories into production into sales into cash. Thus, working capital cycle refers
to the acquisition of resources, conversion of raw materials into work-in-process
into finished goods, conversion of finished goods into sales and collection of
sales. Larger the working capital cycle, larger the investment in current assets.
The main objective of a firm is to maximize shareholders’ wealth. One of the
major ingredients of achieving it is to maximize profit. The amount of profit
largely depends on volume of sales. In any firm, a major portion of sales is on
credit terms. There is always time gap between the day of sale and day of its
realization from customers. Realization of funds from customer will take time but

1
 the firm has to arrange money for purchase of raw materials and components, to
pay for salary, wages and other expenses. Hence, the sufficient working capital is
needed so that the flow of product from raw material stage to its completion to
finished goods is not obstructed for want of working capital. Similarly, working
capital is needed to sustain sales activity. The operating cycle can be said to be
reason of the need for working capital. So, working capital funds are required to
finance the amount blocked in the operating cycle.
Q.4 Briefly explain factors that determine the working capital needs of a firm.
A.4 The following is the description of factors which generally influence the working
capital requirements of the firm.
1. Nature of business: Service organizations do not hold any level of
inventory or the level of inventory may be very low. Hence, they require
very less amount of working capital, while the working capital
requirements of trading or manufacturing organizations are relatively very
high.
2. Volume of sales: The higher the volume of sales, the higher the
requirement of working capital.
3. The larger the manufacturing cycle, the higher is the volume working
capital needed to finance blockage of money in raw material, work-in-
progress and finished goods.
4. If the firm is following a liberal credit policy for its customers, it will
result in higher investment in receivables, leading to requirement of more
working capital.
5. During the periods when inflation rate is high, need for working capital
will also be high.
6. If the creditworthiness of an organization is good, it may manage the
business with less amount of working capital.
7. Seasonal fluctuations: During peak season, higher working capital is
needed; while during dull season, lower working capital is required.
8. If the organization’s expected growth rate is high, than working capital
requirement will be higher to sustain higher volume of sales etc.
Q.5 How is working capital affected by (a) sales, (b) technology and production
policy, and (c) inflation? Explain.
A.5 Sales: The working capital needs of a firm are related to its sales. A growing firm
may need to invest funds in fixed assets, and also to increase investment in
current assets to support enlarged scale of operations. Hence, the funds needed are
quite large.
The seasonal and cyclical fluctuations in demand for a firm’s products and
services affect the working capital requirement. In the same way, when there is an
upward swing in the economy, sales will also increase; correspondingly, the
firm’s investment in inventories, debtors, etc. will also increase.
Technology and Manufacturing Policy: A manufacturing firm has a
manufacturing cycle, so any delay in manufacturing process will result in the
accumulation of work-in-process, resulting into more funds blocked in working
capital. In order to resolve the problem of working capital, a steady production
policy needs to be implemented. But, if costs and risks of maintaining a constant

2
 production schedule are high, the firm may adopt a variable production policy,
varying its production schedules in accordance with changing demand.
If there are alternative technologies of manufacturing a product, the technological
process with the shortest manufacturing cycle may be chosen, to have lesser
amount of investment in working capital.
Inflation: Generally, inflation i.e., rising price levels will require a firm to
maintain higher amount of working capital. Same levels of current assets will
need increased investment when prices are increasing.
Q.6 Define working capital management. Why is it important to study the
management of working capital as a separate area in financial management?
A.6 Working capital management refers to the administration of all aspects of current
assets, namely cash, marketable securities, debtors and stocks and current
liabilities. There is a direct relationship between a firm’s growth and its working
capital needs. As sales grow, the firm needs to invest more in components of
working capital. So, the finance manager should be aware of such needs and
finance them quickly. Financial manager should pay special attention to the
management of current assets on a continuing basis to curtail unnecessary
investment in current assets, and in turn to manage working capital in the best
possible way to get the maximum benefit.
Q.7 Illustrate the profitability-solvency tangle in the current assets holding.
A.7 Solvency refers to the firm’s continuous ability to meet maturing obligations. To
ensure solvency, the firm should be very liquid, which means larger current assets
holdings. A liquid firm has very less risk of insolvency; it will hardly experience a
cash shortage or stock-out situation. However, there is a cost associated with
maintaining a sound liquidity position. A considerable amount of the funds will
be tied up in current assets, and to the extent this investment is idle, the firm’s
profitability will suffer.
To have higher profitability, the firm may sacrifice solvency and maintain a
relatively low level of current assets. In turn, the solvency would be threatened
and would be exposed to greater risk of cash shortage and stock-outs. The risk-
return trade-off of working capital management is illustrated below.

Firm A Firm B Firm C

Rs. Rs. Rs.

EBIT 150,000 150,000 150,000

Fixed assets 500,000 500,000 500,000
Current assets 500,000 400,000 300,000
------------------------------------------------
Total assets 1000,000 900,000 800,000
------------------------------------------------
Return on total assets
(EBIT/TA) 15.00% 16.67% 18.75%

3
 From the above illustrations, it can be concluded that firm A follows conservative
policy, provides greatest solvency, but also the lowest return on total assets
(ROTA). On the other hand, firm C follows most aggressive policy, yields highest
return but provides lowest liquidity, and thus, is very risky to the firm. Firm B
demonstrates a moderate policy.
Q.8 How would you determine the optimum level of current assets? Illustrate your
answer.
A.8 The optimum level of current assets can be determined by balancing the
profitability-solvency tangle by minimizing total cost – cost of liquidity and cost
of illiquidity. The cost of liquidity increases with the level of current assets,
through low rates of return. The cost of illiquidity is the cost of holding
insufficient current assets. This may force the firm to borrow at high rate of
interest, and/or stock out situations leads to loss of sales, etc. This is illustrated in
the following graph.

It is indicated that with the level of current assets, the cost of liquidity increases
while the cost of illiquidity decrease, and vice versa. The firm should maintain
current assets at that level where the sum of these two costs is minimized.
Q.9 Explain the costs of liquidity and illiquidity. What is the impact of these costs on
the level of current assets?
A.9 The cost of liquidity means low rates of return on assets invested. If the firm’s
level of current assets is very high, it has excessive liquidity. Its return on assets
will be low, as funds tied up in idle cash and stocks earn nothing and high levels
of debtors reduce profitability. In short, the cost of liquidity increases with the
level of current assets.
The cost of illiquidity is the cost of holding insufficient current assts. The firm
will not be in a position to honour its obligations if it carries too little cash. This
may force the firm to borrow at high rate of interest and/or to have stock-out
situations result into loss of sales. This in turn further reduces the current assets,
and vicious circle will continue, which will in turn hamper the growth of firm.

4
Q.10 “Merely increasing the level of current asset holding does not necessarily reduce
the riskiness of the firm. Rather, the composition of current assets, whether highly
liquid or highly illiquid, is the important factor to consider.” Explain your
position.
A.10 The magnitude of current assets needed is not always the same, it increases and
decreases over time. However, there is always a minimum level of current assets
which is continuously required by the firm to carry on its business operations,
which is referred to as permanent fixed working capital. The extra working
capital, i.e., variable or fluctuating or temporary working capital, needed to
support the changing production and sales activities.
Depending upon the changes in production and sales, the need for working
capital, over and above permanent working capital, will fluctuate. The temporary
working capital is created by the firm to meet liquidity requirements that will last
only temporarily.
Q.11 Explain the merit of a matching financing plan relative to a financing plan that
extensively uses (a) long-term financing, or (b) short-term financing.
A.11 When the firm follows matching approach, i.e., hedging approach, long term
financing will be used to finance fixed assets and permanent current assets and
short term financing to finance temporary or variable current assets.
As the level of fixed assets increases, the long term financing level also increases.
Under matching plan, no short term financing will be used if the firm has a fixed
current assets need only. As the level of current assets increases, the short-term
financing also increases.
Short term financing may be preferred over long term financing for two reasons,
i.e., the cost advantage and flexibility. Short term financing should generally be
less costly than long term financing.
The short term and long term financing have a leveraging effect on shareholders’
return. In India, the short term loans cost more than long-term loans. Using short
term financing to fiancé its current assets, a firm runs the risk of renewing
borrowings again and again. There is always less risk of failure when the long
term finance is used.
Q.12 Explain the risk-return trade-off of current assets financing.
A.12 According to matching approach, short term financing is used to finance
temporary or variable working capital. Under a conservative plan, the idle long
term funds can be invested in the tradable securities to conserve liquidity. Under
an aggressive policy, the firm finances a part of its permanent current assets with
short-term financing.
Theoretically, short term financing is may be less expensive than long term
financing, but, at the same time, short term financing involves a trade-off between
risk and return. This is illustrated by following example.

5
 Financing Plans
Conservative Moderate Aggressive
Rs. Rs. Rs.

Fixed Assets 300,000 300,000 300,000

Current Assets 200,000 200,000 200,000
Total Assets 500,000 500,000 500,000
Short term debt @ 12% 60,000 150,000 300,000
Long term debt @ 14% 240,000 150,000 0
-----------------------------------------------
PBIT 90,000 90,000 90,000
Interest 48,800 39,000 36,000
-----------------------------------------------
PBT 49,200 51,000 54,000
Tax @ 35% 17,220 17,850 18,900
-----------------------------------------------
PAT/Net Income 31,980 33,150 35,100
-----------------------------------------------
Return on Equity 16% 16.58% 17.55%
SF/TF 12% 30% 60%

The return on equity is highest in aggressive policy, but it is most risky as short
term financing as a ratio of total financing is maximum, and vice-versa for
conservative approach.
Q.13 Do you recommend that a firm should finance its current assets entirely with short
term financing? Explain your answer.
A.13 No, it is not advisable to use short term financing to finance its entire current
assets. The magnitude of current assets increases or decreases over time and also
with respect to level of activity. However, there is always a minimum level of
current assets which is continuously required by the firm to carry on its business
operations. This is referred as permanent working capital. The permanent working
capital to be treated as fixed assets for financing decision, and so it is advisable to
use long term funds for financing of permanent level of current assets.
If firm uses short term financing to finance its current assets entirely, then it runs
the risk of renewing borrowings again and again. This continued financing
exposes the firm to certain risks like to borrow during stringent credit, and/or to
borrow at most inconvenient terms, etc.
Q.14 What methods do you suggest for estimating working capital needs? Illustrate
your answer.
A.14 The most appropriate methods for estimating working capital needs are
enumerated hereunder:
1. Operating cycle concept: In this method, the estimates of working capital
requirements on the basis of average holding period of current assets and
relating them to costs based on company’s expectations and experiences.
This value of total current assets is known as gross working capital. From

6
 gross working capital, the expected current liabilities like sundry creditors
for raw materials, expenses, etc are deducted to find net working capital.
2. Current assets holding period method: This method is based on operating
cycle period. Here, the working capital requirement equals to gross
working capital requirement.
3. Ratio to sales method: The working capital requirements are estimated as
a ratio of sales for each component of working capital.
4. Ratio of fixed investment method: The working capital is estimated as a
percentage of fixed investment.
The above methods of estimating working capital requirements are illustrated as
under:
Rs.
Net material costs 179,200
Manufacturing overhead (other than depreciation) 628,800
Depreciation 160,000
Total Product Costs 968,000
Annual Sales 1,448,000
PBIT 480,000
Investment 1,600,000
PBDIT (PBIT + Depreciation) 640,000

Assume that raw material stock for one month; semi-finished material for one
month (based on raw material plus one half of normal conversion cost); finished
material in one month’s supply; debtors-one month sales; operating cost-one
month’s total costs; suppliers for raw material provides two months’ credit.

7
Estimation of Working Capital Requirements:
Method I: (Operating cycle approach)
Particulars Rs.
Raw material stock (179,200 ÷ 12) 14,933
Semi-finished stock:
[14,933 + (628,800 ÷ 2 ÷ 12)] 41,133
Finished goods stock (968,000 ÷ 12) 80,667
Debtors (1,448,000 ÷ 12) 120,667
Operating cash (968,000 ÷ 12) 80,667
-----------
Total current assets 338,067
Less: Current liabilities
(179,200 ÷ 12 × 2) 29,867
-----------
Net working capital requirement 308,200

Method II (Current assets holding period approach)

Working capital requirement

= Total current assets 338,067

Method III (Ratio to Sales Method)

Assume that industry’s average ratio is 30%. Therefore, working capital is 30% of
annual sales, i.e., Rs. 434,400 (30% ×1,448,000)
Method IV : Ratio of fixed investment method:
Assume 15% the average rate of fixed investment. Hence, the working capital
requirement Rs. 240,000 (i.e., 15% ×1,600,000).
All above methods are subject to error if markets are seasonal, and/or estimate is
inaccurate.
A number of factors govern the choice of methods of estimating working capital.
Therefore, each factor, for example, seasonal variations, variability in input
factors’ prices, production cycle, etc., should be given due weightage in
projecting working capital requirements.

8
 CHAPTER 16

VALUATION AND FINANCING

Q-1 What is an asset beta? How is it calculated? Assume no taxes.

A-1 We know that a portfolio consists of individual securities. Each security has its
beta, and the beta of the portfolio is the weighted average beta of individual
securities in the portfolio. Similarly, a firm has a portfolio of assets, and therefore,
the asset beta of a firm, ba is the weighted average of betas of individual assets.
Thus, asset beta is given by the following equation:
Average asset beta = beta of asset 1 ´ weight of asset 1 + beta of asset 2 ´ weight
of asset 2 +…+ beta of asset n ´ weight of asset n
b a = b1 w 1 + b 2 w 2 + × × × + b n
n
= åb w
i =1
i i

Where βa is the weighted average beta of assets, βi is the beta of ith asset and w i
is the weight of ith asset.
A firm’s assets are generally financed by debt and equity. Therefore, a firm’s
asset beta is also equal to the weighted average of the firm’s equity beta and debt
beta. Assuming no corporate tax, the beta of assets will be as follows:
Asset beta = equity beta ´ equity weight + debt beta ´ debt weight
E D
ba = be + bd
V V
where e is equity beta, d is debt beta, S is the market value of shareholders’
equity, D is the market value of debt and V is the total value of the firm (V = S +
D)

Q-2 Do the interest tax shields reduce the systematic risk? If yes how is the asset’s
beta affected by the interest tax shield?
A-2 When a firm (or project) employs fixed amount of debt, it will not fluctuate with
the value. The interest flows and tax savings are known, and they will remain tied
to debt. They remain insulated from fluctuations in the value. The interest tax
shields are as safe or risky as debt is. If debt is risk free, the interest tax shields
will also be risk free. The interest tax shields will be risky if debt is risky. Hence
the beta of the interest tax shields will be equal to the beta of debt1. When debt is
a fixed amount, and interest tax shields have same risk as debt, it is quite plausible
to discount the interest tax shields by the cost of debt.
The equality of the betas of the interest tax shields and debt under the fixed debt
assumption means that a levered firm (or project) will have lower systematic risk.
Therefore, the asset beta should be adjusted for the tax effects of debt. Hamada

1
 showed that the adjustment factors would include the corporate tax rate and the

firm’s leverage (debt ratio). The adjusted asset beta of the

levered firm will be as follows:
E D
ba = b e + bd
V - TD V - TD

Q-3 How is the equity beta determined? How is it affected by the capital structure?
A-3 We need estimate of the discount rate to determine the net present value of a
project. The discount rate depends on the project’s business risk and financial
risk. Under CAPM, the equity beta captures both the business risk and the
financial risk. Financial risk arises when the firm uses debt.
We can rewrite Equation (2) (Refer Q-1) to obtain the following equation for the
equity beta of a levered firm:
D
b e = b a + (b a - b d )
E
You can see from Equation (3) that the equity beta increases linearly with
leverage (debt-to-equity, D/E, ratio) since it adds financial risk to shareholders
The equity beta may, thus, be referred to as the levered equity beta. Financial
leverage causes variability in the return of shareholder. This adds financial risk.
As a consequence, beta of a levered firm’s equity will increase as debt is
introduced in the firm’s capital structure

Q-4 What is the asset cost of capital? How is it calculated? Is the asset cost of capital
same as the opportunity cost of capital?
A-4 Under the CAPM, the asset or opportunity cost of capital of a pure-equity
(unlevered) firm is given as follows:
Opportunity cost of capital = risk-free rate + risk premium × asset beta
k a = rf + rpba
The cost of debt and the cost of equity of a levered firm are given as follows:
Pre - tax cost of debt = k d = rf + rp b d
Cost of equity = k e = rf + rp b e
You can calculate the pre-tax weighted average cost of capital (WACC) as
follows:
E D
Pre - tax WACC = k e + kd
V V
Substituting the values for kd and ke, respectively, from Equation (5) and Equation
(6) in Equation (7), we obtain:
(
Pre - tax WACC = rf + rp b e ) VE + (rf + rp b d ) DV
æ E Dö æ E Dö
= rf ç + ÷ + rp ç b e + b d ÷
èV Vø è V Vø
æ S Dö
= rf + rp ç be + bd ÷
è V Vø
You may notice that the term within parentheses on the right hand side of
Equation (8) represents the asset beta. Hence, we can conclude that the asset or

2
 opportunity cost of capital is the same as the pre-tax WACC. Hence,
E D æ E Dö
Pre - tax WACC = k e + k d = k a = rf + rp ç b e + b d ÷ = rf + rp b a
V V è V Vø

Q-5 Using CAPM, how would you calculate the cost of equity? Show that the levered
firm’s cost of equity requires compensation for both the business risk and the
financial risk?
A-5 the cost of equity of a levered firm with risky debt as follows:
é Dù
k e = rf + rp êb a + (b a - b d ) ú
ë Eû
The shareholders of a levered firm require compensation for both business risk
and financial risk. Hence,
Cost of equity = risk-free rate + business risk premium + financial risk premium
We can rewrite Equation (10) as follows to decompose risk premium into
business risk and financial risk:
k e = r f + r p b a + r p (b a - b d )D
E
You may notice that shareholders of the levered firm demand premium equal to
rpβa for assuming the business risk and additional premium equal to rp(βa – βd)D/E
for assuming the financial risk. In the case of an unlevered firm, financial risk
premium is zero and shareholders are compensated only for the business risk.

Q-6 How is the levered firm’s cost of equity determined according to the MM
Proposition II? Is it equivalent to the cost of equity under CAPM?
A-6 Following MM’s proposition II, the levered firm’s cost of equity can be
calculated as follows:
D
k e = k a + (k a - k d )
S
Yes it is equivalent to cost of equity under CAPM.
Cost of equity = k e = rf + r p b e
Q-7 What is the logic of the MM adjusted cost of capital? Can you use it as a discount
rate for evaluating an investment project?
A-7 The concept of the adjusted cost of capital is based on the MM tax-corrected
hypothesis. Two critical assumptions are that the cash flows are perpetual and the
amount of debt is fixed. In case of the fixed debt ratio, which implies rebalancing
of debt, the adjusted cost of capital can be estimated using the Miles-Ezzell
formula as given below:
é1 + k a ù
ACC = k * = k a - Tk d D V ê ú
ë1 + k d û
This formula is same as WACC except for the last term, (1 + ka)/(1+kd). Both
WACC and the Miles-Ezzell formula assume the fixed debt ratio and debt
rebalancing.

Q-8 How do you calculate WACC? What are its assumptions? Can you use it to
evaluate an investment proposal? Is it same as the MM adjusted cost of capital?

3
A-8 WACC is calculated as the average of the cost of equity multiplied by the weight
of shareholders’ equity plus the after-tax cost of debt multiplied by the weight of
debt. Remember that WACC assumes a target capital structure based on the
market values of equity and debt. WACC is given as follows:
E D
WACC = k e + k d (1 - T )
V V
The traditional approach of investment evaluation is to use free cash flows (FCF)
and WACC. FCFs are unlevered cash flows; this is accounted for through
WACC as the discount rate. WACC is the ‘levered’ cost of capital
If the project’s risk is higher or lower than the ‘average’ risk, and/or its debt
capacity is different than the firm’s debt capacity, you cannot use the firm’s
WACC for discounting the project’s FCFs. You will have to calculate the
project’s cost of capital commensurate with its operating risk and capital
structure.
Concept of pre-tax WACC as the opportunity (or unlevered) cost of capital is
based on the MM proposition I. It assumes that financing (capital structure) does
not affect the firm’s opportunity cost of capital, ka (pre-tax WACC).

Q-9 How will you calculate a project’s WACC with its unique capital structure given
the firm’s cost of capital and capital structure data?
A-9 We could use the firm’s WACC as discount rate only for those projects that are
carbon copies of the firm. We should calculate the project’s cost of capital if its
risk or debt capacity is different
The following steps are involved in calculating the project’s cost of capital:
First, calculate the firm’s opportunity cost of capital (assuming that MM
Proposition I works).
Second, calculate the new cost of debt. The cost of debt may change if the capital
structure of the project changes
Third, calculate the project’s cost of equity, as given by MM’s Proposition II,
using the opportunity cost of capital and the project’s debt-equity ratio:
Fourth, calculate the project’s cost of capital as the after-tax weighted average
cost of debt and the cost of equity:

Q-10 How does the free cash flow and WACC approach work in the project evaluation?
What are the limitations of this approach?
A-10 The free cash flow approach adjusts the effect of the interest tax shields in the
discount rate (WACC) rather than the project’s cash follows. This approach is
based on the assumption that the capital structure (debt ratio) is constant over
time. It also assumes that the project’s and the firm’s risk and capital structures
are the same. Hence, this approach will not work if the project’s and the firm’s
risk and capital structure are different, and where the project’s capital structure is
not constant.

Q-11 Does the equity cash flow approach give the same results as the free cash flow
approach in evaluating a project? Why?
A-11 The equity cash flow (ECF) approach is similar to the FCF approach and it is
based on the same assumptions. In the ECF approach the equity cash flows, which
4
 are residual cash flows available to the equity shareholders, are discounted by the
levered cost of equity.

Q-12 What are the capital cash flows? How does the capital cash flow approach work?
How does it differ from the FCF approach?
A-12 An alternative approach, the capital cash flow (CCF) approach is much easier to
use when the project’s debt amount is fixed and the capital structure does not
remain constant. CCFs are calculated as the free cash flows plus the interest tax
shields, and they are discounted by the project’s all-equity or opportunity cost of
capital. The project’s opportunity cost of capital depends on its business risk and
is not affected by the capital structure. In the CCF approach the effect of the
interest tax shields are adjusted in the cash flows rather than the discount rate.

Q-13 What is the adjusted present value (APV) of a project? How is it calculated? What
is the difference between the CCF approach and the APV approach?
A-13 The adjusted present value (APV) approach is an alternative approach for the
project’s evaluation. It is a flexible approach that unbundles the project’s value
into several parts. It separates the operational part from the financing effects. The
base-case NPV is calculated by discounting the free cash flows at the project’s
opportunity cost of capital. The present values of the financing effects are
calculated separately using the discount rates appropriate to the risk of these
effects. For example, the interest tax shields are treated as risky as debt. Hence,
the interest tax shields are discounted at the cost of debt. APV is the sum of the
base-case NPV and the value of financing effects:
APV = Base-NPV + value of interest tax shields + value of other financing effects
APV is a useful approach in the project financing where the debt is fixed and
there are several other financing effects like issue costs, investment incentives and
special tax benefits.
The APV formula under the assumption of the perpetual cash flows and the
perpetual fixed amount of debt and without other financing effects is as follows:
FCF Tk d D
APV = +
ka kd

Q-14 What principles govern the valuation of a firm? How will you calculate the value
of the firm’s equity?
A-14 The use of the DCF techniques can be extended to value a business firm. In the
valuation of a firm a financial analyst usually assumes a constant debt ratio.
The firm can be valued using FCFs and WACC. Further, the analyst assumes a
horizon period for analysis and calculates the horizon value at the end of the
horizon period. Horizon value depends on the growth prospects of the firm after
the horizon period. Thus, the value of he firm is given as follows:
H
FCFt TVH
V=å +
t =1 (1 + WACC) t
(1 + WACC) H
The value of equity is obtained by subtracting the outstanding amount of debt
from the value of the firm. The value of equity divided by the number of
outstanding shares gives the equity value per share.

5
Q-15 Why is the calculation of the terminal value critical in determining the value of
the firm? How is the terminal value calculated?
A-15 In the case of a firm, it continuously makes investments that generate revenues
and cash flows, theoretically, forever. Therefore, the financial analyst assumes a
horizon period (H) for detailed calculations of cash flows. Financial analysts or
managers make assumption of horizon period because detailed calculations for a
long period become quite intricate. The financial analysis of such projects should
incorporate an estimate of the value of cash flows after the horizon period without
involving detailed calculations. Thus, the value of the firm is given as follows;
H
FCFt TVH
V=å +
t =1 (1 + k 0 ) t
(1 + k 0 ) H

There are many other ad hoc methods used in practice to determine terminal
value.
1. Price-earnings (P/E) ratio
2. Market-to-book value (M/B) ratio
3. Replacement cost of assets

Q-16 What is the comparative firm valuation approach? How does it work?
A-16 In the comparable companies or comparable transactions approach, key
relationships are calculated for a group of similar companies or similar
transactions as a basis for the valuation of a firm. This approach is based on the
premise that similar companies should sell for similar prices. This is a straight-
forward approach that appeals to managers and financial analysts in practice.
The following steps are involved in applying the comparative firms approach:
· Identify the comparable firms based on the criteria of similar products, size,
age, growth and profitability trends.
· For the comparable firms, calculate the firm value as a ratio of sales, EBIT,
free cash flows and market value-to-book value of assets. Sales, EBIT, free
cash flow and book value of assets are assumed as value drivers. Notice that
firm value to EBIT ratio is equivalent of price-earnings (P/E) ratio.
· Average the ratios of the comparable firms, and apply them to the sales, EBIT
and free cash flow data of the firm.

Q-17 What is the balance sheet approach to the valuation of a firm? What are its merits
and limitations?
A-17 Balance sheet or adjusted book value uses assets and liabilities information to
determine the value of the firm. Without any adjustment, the book value of equity
funds and debt funds represent the claims of investors over the firm’s assets.
Hence, the value of the firm is at least equal to the book value of its assets.
However, assets are not worth the amounts shown in the balance sheet. They are
worth more or less than the book values
Therefore, assets should be revalued to determine the value of the firm. One
approach to estimate the adjusted book values of assets is to determine their

6
current or replacement costs. It is relatively easy to find out the current costs of
current assets
A firm is not worth the current or replacement costs of its assets only. The value
of the intangible assets like brand equity, customer loyalty, or human capital
drives the value of the firm. In practice, both tangible and intangible assets should
be valued to determine the value of the firm.

7
 CHAPTER 28

RECEIVABLES MANAGEMENT AND FACTORING

Q.1 Explain the objective of credit policy? What is an optimum credit policy?
Discuss.
A.1 The objective of credit policy is to promote sales up to that point where profit is
maximized. To achieve this basic goal, the firm should manage its credit policy in
an effective manner to expand its sales, regulate and control the credit and its
management costs, and maintain debtors at an optimum level.
Optimum credit policy is the policy which maximizes the firm’s value by
minimizing total cost for a given level of revenue. The value of the firm is
maximized when the incremental rate of return (also called marginal rate of
return) of an investment is equal to the incremental cost of funds (also called
marginal cost of capital) used to finance the investment in receivables. The
incremental rate of return can be calculated as incremental operating profit
divided by the incremental investment in receivable. The incremental cost of
funds is the rate of return required by the suppliers of funds, given the risk of
investment in accounts receivable.
Q.2 Is the credit policy that maximizes expected operating profit an optimum credit
policy? Explain.
A.2 Optimum credit policy does not mean the policy that maximizes the expected
operating profit. The cost of investment should also be considered. It means the
policy that maximises the net incremental benefit, that is, difference between the
expected operating profit and the cost of capital.
Q.3 What benefits and costs are associated with the extension of credit? How should
they be combined to obtain an appropriate credit policy?
A.3 The length of time for which credit is extended to customers is called the credit
period. A firm lengthens credit period to increase its operating profit through
expected sales. However, there will be net increase in operating profit only when
the cost of extended credit period is less than the incremental operating profit.
As the firm starts loosening its credit policy, it accepts all or some of those
accounts which the firm had rejected in past. Thus, the firm will recapture lost
sales, and thus, lost contribution. In addition, new accounts may be turned to the
firm from competitors resulting into increase contribution. The opportunity costs
of lost sales declines, and opportunity benefits of new sales increases as firm
loosens the credit terms.
As the firm loosens its credit policy, the credit investigation costs, credit
monitoring costs, bad-debt losses, and collection costs increases in case of
stringent credit policy.
The optimum or appropriate credit policy is such where the firm will obtain the
maximum value for the credit policy when the incremental rate of investment in
receivable is equal to the opportunity cost of capital i.e., the incremental cost of
funds.
Q.4 What is the role of credit terms and credit standards in the credit policy of a firm?

1
A.4 Credit standards are criteria to decide to whom credit sales can be made and how
much. If the firm has soft standards and sells to almost all customers, its sales
may increase but its costs in the form of bad-debts losses and credit
administration will also increase. The firm will have to consider the impact in
terms of increase in profits and increase in costs of a change in credit standards or
any other policy variable.
Credit standards influence the quality of firm’s customers, i.e., the time taken by
customers to repay credit obligation, and the default rate. The time taken by
customers to repay debt can be determined by average collection period (ACP).
Default risk can be measured in terms of bad-debt losses ratio – the proportion of
uncollected receivable. Default risk is the likelihood that a customer will fail to
repay the credit obligation. The estimate of probability of default can be
determined by evaluating the character, i.e., willingness of customer to pay;
customer’s ability to pay and prevailing economic and other conditions. Based, on
above, firm may categorize customers into three kinds, viz., good accounts, bad
accounts and moderate accounts.
The conditions for extending credit sales are called credit terms and they include
the credit period and cash discount. Cash discounts are given for receiving
payments before than the normal credit period. All customers do not pay within
the credit period. Therefore, a firm has to make efforts to collect payments from
customers. The length of time for which credit is extended to customers is called
the credit period. A firm’s credit policy may be governed by the industry norms.
But depending on its objective, the firm can lengthen the credit period. The firm
may tighten the credit period, if customers are defaulting too frequently and bad-
debt losses are building up.
Q.5 What are the objectives of the collection policy? How should it be established?
A.5 The primary objective of collection policy is to cause increase in sales, and to
speed up the collection of dues. The collection policy should ensure prompt and
regular collection, keep down collection costs and bad debts within limits and to
maintain collection efficiency.
The collection procedure should be clearly defined in such a manner that the
responsibility to collect and the follow up should be clearly defined. This
responsibility may be entrusted to the separate credit department or accounts or
sales department. Besides the general collection policy, firm should lay-down
clear cut collection procedures for past dues or delinquent accounts.
Q.6 What shall be the effect of the following changes on the level of the firm’s
receivables?
a) Interest rate increases
b) Recession
c) Production and selling costs increases
d) The firm changes its credit term from “2/10 net 30” to “3/10 net 30”
A.6 As the interest rate increases, the total cost of production increases resulting into
more investment in receivables.
During the recession, the sales level decreases, so the investment in receivable is
supposed to reduce. But the reduction may not take place on account of delayed

2
 recovery of amount due from customers by firm. So, this may also cause the
investment in receivables to increase.
The increases in production and selling costs result to more investment in
receivables.
When company changes its terms from ‘2/10 net 30’ to ‘3/10 net 30’, this should
normally result into reduction in level of investments in receivable. But at the
same moment, more customers may be willing to avail cash discount resulting
into increase in discount costs.
Q.7 “The credit policy of a company is criticized because the bad debt losses have
increased considerably and the collection period has also increased.” Discuss
under what conditions this criticism may not be justified.
A.7 Generally it is a bad credit policy if bad debts increase and collection period also
increases. But in certain cases, once the company has recovered its fixed costs,
selling to marginal customers may be quite profitable as the contribution ratio
may be quite high. This raises the possibility of increased bad debts and high
collection policy, but at the same time high profits. The company should assess
the probability of the extent of default and the probability of higher pay-offs.
Q.8 What credit and collection procedures should be adopted in case of individual
accounts? Discuss.
A.8 In case of individual accounts, customers may be categorized in to three types
based on their creditworthiness and default risk, viz., good accounts (financially
strong); bad accounts (financially very weak, high risk customers) and marginal
accounts (customers with moderate financial health and risk).
The firm will have no difficulty in quickly deciding about the extension of credit
to good accounts, and rejecting the credit request for bad accounts. A credit
standards may be relaxed to the point where incremental returns equals to
incremental costs in case of marginal accounts, by evaluating all possibility of
bad-debts losses and collection costs.
The collection procedures should be firmly established for good accounts and bad
accounts. The collection procedures for past dues or delinquent accounts should
also be established in unambiguous terms. The marginal accounts, i.e., slow
paying permanent customers, are needed to be handled tactfully. The collection
process initiated quickly, without giving any chance to them, may antagonize
them, and the firm may lose them to competitors. In case of marginal accounts,
individual cases should be dealt with on their merits. The firm should also decide
to offer cash discount for prompt payment. For some cases, company may take
precautions by receiving pre-signed post dated cheques or approach for bills of
exchange, etc.
Q.9 How would you monitor receivables? Explain the pros and cons of various
methods.
A.9 A firm needs to continuously monitor and control its receivables to ensure the
success of collection efforts. Following are the methods to monitor and evaluate
the management of receivables.
1. Collection period method: The average collection period is calculated, and
can be compared with the firm’s stated credit period to judge the collection
efficiency. The average collection period measures the quality of receivable

3
 since it indicates the speed of their collectibility. Collection period only
provides an aggregate picture. Further, it does not provide very meaningful
information about outstanding receivable when sales variations are quite high.
2. Aging schedule: It breaks down receivables according to the length of the time
for which they have been outstanding. It helps to spot out slow-paying
customers. It also suffers from the problem of aggregation, and does not relate
receivables to sales of the same period.
3. Collection Experience Matrix: In this method, firm tries to relate receivables
to the sales of the same period. In this method, sales over a period of time are
shown horizontally and associated receivable vertically in a tabular form;
thus, a matrix is constructed. This method indicates which months’ sales
receivable are uncollected. It helps to focus efforts on the collection month-
wise.
Q.10 What is factoring? What functions does it perform?
A.10 Factoring involves an outright sale of receivables of an organization to a financial
institution or private agency, called factor. A factor specializes in management of
trade credit. Factors collect receivables and also advance cash against receivables
to solve the client firms’ liquidity problem. For providing their services, they
charge interest on advance and commission for other services.
The factor performs the following functions:
1. Factors provide financial assistance to the client by extending advance
cash against book debts.
2. Sales ledger administration and credit management services to his clients,
by maintaining the ledger of customers of clients, taking all follow-up
actions, etc. He also helps the clients and advises from the stage of credit
extension to customers to the final stage of book debt collection.
3. Protection against default in payment by debtors, by initializing legal
actions at an early time.
4. Credit collection: When individual book debts become due from the
customer, the factor undertakes all collection activity that is necessary. He
guards the interest of his client, by developing better strategy against
possible defaults by customers of his client; etc.
Q.11 Explain the features of various types of factoring.
A.11 Factors are broadly into four categories.
1. Full service non-recourse: Book debts are purchased by the factor,
assuming 100% credit risk on his account. The factor maintains the sales
ledger and accounts, takes full responsibility to recover dues from
customers of client. In the event of bad debts, he bears the loss.
2. Full service recourse factoring: In this method, client is not protected
against the risk of bad debts. The bad debts risk is borne by the company.
If the factor has advanced funds against book debts on which a customer
subsequently defaults, the client has to refund the money to the factor.
3. Bulk or agency factoring: Under this method, client continues to
administer credit and operate sales ledger. The factor financing the book
debt against bulk either on recourse or without recourse. It is a method of
financing book debts.

4
 4. Non-notification factoring: In this type of factoring, customers are not
informed about the factoring agreement. It involves the factor keeping
ledger accounts, deals with client’s customers, performs all usual
functions without a disclosure to customers that he owns the book debts.
The non-recourse or recourse factoring may be advance factoring, (the factor
advances cash against book debt to client immediately) or maturity factoring
(payment will be made by factor to client when the book debts have been
collected or matured as the case may be).
Q.12 How does factoring differ from bill discounting and short-term financing?
A.12 Bill discounting or invoice discounting consists of client drawing bills of
exchange for goods and services on buyers, and then discounting it with bank for
a charge. Factoring is like bill discounting plus specialized management of book
debt along with protection against default risk (in case of non-recourse factoring).
Bill discounting is not convenient for companies having large number of small
value customers; while factoring is convenient.
Factoring provides short term financial assistance to the client, but it differs from
short term credit in the following manner:
Factoring involve sale of book debts, and client gets advances against expected
debt collection, as and when he needs cash. Factor also undertakes the total
management of client’s book debts.

5
 CHAPTER 24

FINANCIAL STATEMENTS

Q-1 Explain the concept of “working capital flow”. Give examples of transactions that affect working capital,
and that do not affect working capital.
A-1 The working capital flow means increase or decrease in the amount of working capital on account of
effect of any transaction. There are some transactions which will not change the working capital flow. The
most of the items of Profit & Loss Account and also the business events affecting simultaneously both
current and non-current items of Balance Sheet are going to affect the working capital flow. For example,
issuance of ordinary shares for cash, purchase of machinery for cash, etc. The transactions that affect only
the current items of Balance Sheet are not going to affect the working capital flow. e.g., receipt of funds
from debtors, release of cash payment to creditors, etc.
Q-2 “Deprecation is an important source of working capital (funds)”. Do you agree? Defend your answer.
A-2 Depreciation is not a source of funds. The depreciation is added back in the profit after tax to determine
the funds from operations, because depreciation is notional entry for charging capital consumption costs
against income or revenue of firm, on account of matching concept of accountancy.
Funds mean change in cash only or change in working capital only. The depreciation is a non- cash
payment entry in the books of account, so it does not change cash. As depreciation is provided on fixed
assets, e.g., non-current assets, so it does not affect the working capital also.
Depreciation does not use cash or working capital, but it indirectly influences the flow of funds by
affecting the tax liability of the business or firm since depreciation is a deductible expense
Q-3 Explain the major sources and uses of working capital.
A-3 The major sources of working capital are as follows:
1. Net Profit from operations: The net profit as shown by P & L a/c to be adjusted for non-cash
transactions considered in P & L a/c, and also gain or loss on sale of non-current assets, etc.
2. The amount realised on account of sale of long-term investments, tangible and intangible assets.
3. Finance obtained by issuance of long-term instruments like bonds, debentures, shares; borrowing
of funds from financial institutions, banks, and non-banking finance companies, etc.
The major uses of working capital are as follows:
1. Net cash loss from operations.
2. Purchase of long-term investments, tangible and intangible assets.
3. Repayment of long-term debt like bonds, debentures, bank loans and short-term debt like
overdraft, cash credit, etc.
Q-4 Explain and illustrate the preparation of a statement of changes in working capital.
A-4 A statement of changes in working capital supports the management to reveal the way in which working
capital was obtained and used. If used for long-term planning, it provides estimates of working capital
flow and the firm’s capacity to repay long-term debt and also to determine whether or not adequate
working capital will be generated to meet firm’s expansion, diversification, modernization, etc.
The flow of working capital may be summarized as follows:
1. The net working capital increases or decreases when a transaction involves a current account and
a non-current account.
2. The net working capital remains unaffected when transaction involves only current accounts.
3. The net working capital remains unaffected when transaction involves only non-current accounts.

Q-5 What is the utility of funds flow statement in which ‘funds’ refer to ‘all financial resources’?
A-5 The ‘all financial resources’ funds flow statement is an important evaluation and planning tool. It gives a
clear picture of the causes of changes to the company’s working capital. It also indicates the financing and
investment policies followed by firms, the non-current assets acquired and the manner in which the funds
have been obtained. It also indicates the liquidity position, significant investment, repayment capacity,
etc.

1
Q-6 How can a statement of changes in cash flows be prepared? How does it differ from the statement
prepared on working capital basis?
A-6 Cash flow statement is a tool for short-term planning, and also useful to evaluate the short-term liquidity
position of a firm. Cash flow statement is prepared after considering the cash inflows and cash outflows.
Cash flow statement summarizes the causes of changes in cash position between dates of the two balance
sheets. The funds flows statement, on the other hand, focuses the attention on working capital, i.e.,
medium term liquidity; the cash flow statement focuses attention on cash, i.e., short-term liquidity.
Q-7 Explain why transactions such as depreciation expense, amortization of debenture discount and similar
internal items are neither sources nor applications of financial resources yet are treated as adjustments to
net profit.
A-7 The transactions like depreciation expenses, amortization of expenses (prepaid), etc. do not involve use of
cash or working capital. The depreciation as well as amortization of prepaid expenses simply spread the
outflows incurred earlier over the life of the assets for measuring the results of the operations. These items
are deducted from revenue of the firm to find out the net profit as per matching concept.
Q-8 How can a statement of changes in working capital or cash position be converted into a statement of
changes in financial position on ‘all financial resources’ basis? Illustrate your answer.
A-8 The statement of changes in working capital or cash position can be expanded to disclose all
those transactions which significantly influence the firm’s financial position, but do not increase
or decrease working capital or cash. For example, it is event if a company converts its debentures
of, say, Rs 300 million (Rs 30 crore) into equity shares. This is a significant event as it changes
the company’s debt-equity position. This transaction should be disclosed in the statement.
Similarly, the issuance of bonus shares (stock dividend) does not involve working capital or cash
but changes the paid-up share capital. The statement of changes in working capital or cash
position is recast to incorporate changes in all financial resources to convert into a statement of
changes in financial position on all financial resource basis.
Q-9 Is it possible for a company, with sizeable net profit, not to be in a position to pay dividends to
shareholders? Illustrate your answer.
A-9 Yes it is possible for a company with sizeable net profit not to be in a position to pay dividends to
shareholders. Payment of dividend requires cash. Company might have earned profits but profits are used
to meet the investing and financing needs of the company with no surplus cash to pay dividends.
Q-10 What is a statement of changes in financial position? How does it differ from funds flow or cash flow
statement?
A-10 The statement of changes in financial position is a more comprehensive statement incorporating all
changes; it has an analytical value as well as it is an important planning tool. It gives a clear picture of the
causes of changes in the company’s financial position with or without affecting working capital or cash
flow position. Funds flow statement helps the firm to know its liquidity position, capital expenditure
incurred, dividend paid and the extent of external financing. A projected funds or cash flow statement
guides the firm to plan the matching of inflow and outflow of funds or cash.
Q-11 What are the uses of a statement of sources and uses of working capital? When is it more appropriate to
prepare a statement of cash flow?
A-11 Uses of statement of sources and uses of working capital are as follows:
a) Indicates the liquidity position of the firm.
b) Indicates the extent of the firm’s working capital needs being met by the internally generated funds.
c) Indicates whether the firm used external sources of finances to meet its needs of funds.
d) Indicates if the firm sold any of its non-current assets, and the proceeds from such sales.
e) Indicates if the non-currents were sold for repayment of current liabilities (or long term liabilities).
f) Indicates the significant investment and financing activities of the firm, and also those which did not
involve working capital.
In the long run, the firm is interested in working capital because the items of working capital will
ultimately change into cash. But to make the payment in immediate future the firm needs cash, so for
short-term financial planning cash flow statement is needed.

2
 CHAPTER 29

INVENTORY MANAGEMENT

Q.1 Why should inventory be held? Why is inventory management important?

Explain the objectives of inventory management.
A.1 The manufacturing companies hold inventories in the form of raw materials,
work-in-process and finished goods. There are three motives for holding
inventories.
1. To facilitate smooth production and sales operation (transaction motive).
2. To guard against the risk of unpredictable changes in usage rate and delivery
time (precautionary motive).
3. To take advantage of price fluctuations (speculative motive).
Inventory management is important because inventories constitute about 60% of
current assets of public limited companies in India.
The objective of inventory management should:
1. to ensure a continuous supply of raw materials to facilitate uninterrupted
production,
2. maintain sufficient stock of raw materials in periods of short supply and
anticipate price changes,
3. maintain sufficient finished goods inventory for smooth sales operation,
and efficient customer service,
4. minimize the carrying cost and time, and
5. control investment in inventories and keep it at an optimum level.
Q.2 “There are two dangerous situations that management should usually avoid in
controlling inventories.” Identify the danger points and explain.
A.2 The excessive and inadequate inventories are two danger points within which the
firm should operate. The objective of inventory management should be to
determine and maintain optimum level of inventory investment. The optimum
level of inventory will lie between two danger points.
The excessive level of inventories consumes funds of the firm, and thus it
involves an opportunity costs. The carrying costs, such as storage expenses, etc.,
also increase in proportion of volume of inventory. This may create physical
deterioration of inventories while in storage. The inventories once purchased and
stored normally are difficult to dispose off subsequently at the same value. In
other words, the value of inventory reduces with the increasing holding period.
The inadequate investment in inventories involves the following consequences.
1. Results in frequent production interruptions.
2. It may not be possible for the company to serve the customers properly
and they may shift to competitors.
So, the aim of inventory management is to maintain sufficient inventory for the
smooth production and sales operations.
Q.3 Define the economic order quantity. How is it computed?
A.3 Economic order quantity (EOQ) is the fixed quantity of material which is ordered
when the stock comes down to a reorder level. EOQ is at the optimum level when
the total of ordering costs and carrying costs is minimum. It is the point where

1
 ordering costs equal the carrying costs. Ordering costs include costs incurred on
requisitioning, purchase ordering, transporting, receiving, inspecting and storing.
It has direct relationship with number of orders placed. Carrying cost includes
storage, insurance, taxes, clerical and staff service costs, costs of deterioration and
obsolescence, etc.
Three methods are available to determine the economic order quantity (EOQ). It
has been assumed that total amount of demand is known with certainty and usage
of materials is steady. Also, ordering cost per order and carrying cost per unit are
assumed to be constant.
1. Trial and error (T&E) approach: The inventory levels under different lot
size alternatives are worked out by preparing tables. The T&E method is a
mechanical method involving somewhat tedious computations.
2. Order formula approach:
2AO
EOQ =
C

Where, A is total requirement, O is the ordering costs and C is the carrying

costs.
3. Graphic approach: In the graphical approach, costs-carrying, ordering and
total – are plotted on vertical axis and horizontal axis is used to represent
the order size. The EOQ occurs at the point where total cost is minimum.

Q.4 “The management of inventory must meet two opposing needs.” What are they?
How is a balance brought in these two opposing needs?
A.4 The efficient inventory management helps in balancing inventory carrying costs
and stock-out costs. Excessive inventory means more carrying costs but less
stock-out situations while less inventory implies less carrying costs but more
stock-out situations.
It is difficult to predict usage and lead time accurately. If actual usage increases or
the delivery of inventory is delayed, the firm can face a problem of stock-out
which can prove to be the costly. Therefore, in order to guard against the stock-
out, the firm may maintain a safety stock, as cushion against expected increased

2
 usage and/or delayed delivery time. Thus, the re-order point (i.e. stock level when
to place order for inventory replenishment) can be increased by safety stock.
The excess inventory level will safeguard the firm against stock-out situation, but
it is also costly with respect to inventory carrying costs. Carrying costs include
storage, insurance, taxes, clerical and staff service costs, costs of deterioration etc.
The balance can be worked out between two by applying cost-benefit analysis,
and by evaluating alternative strategies of safety stock level.
Q.5 “The practical approach is determining economic order quantity is concerned with
locating a minimum cost range rather than a minimum cost point.” Explain.
A.5 The total costs of inventory may be insensitive to moderate changes in order size.
Hence, there may be range rather than an exact point of optimum quantity. To
determine this range, the order size may be changed by some percentage and the
impact on total costs may be studied. If the total costs do not change significantly,
the firm can change EOQ within the range without any significant loss.
Q.6 What are ordering and carrying costs? What is their role in inventory control?
A.6 The ordering costs includes the entire costs of acquiring raw materials. They
include costs incurred relating to requisitioning, purchase ordering, transporting,
receiving, inspecting and storing, etc. It increases in proportion to the number of
orders placed. The ordering costs decrease with increasing size of investment.
The carrying costs are incurred for maintaining a given level of inventory. It
includes storage, insurance, taxes, deterioration and obsolescence. The storage
costs comprise cost of storage space, stores handling costs, and clerical and staff
service costs incurred for store keeping, booking and accounting. Carrying costs
vary with inventory size. They decline with increase in inventory size. The
economic size of inventory would thus depend on trade-off between carrying
costs and ordering costs.
Q.7 Define safety stock. How can safety stock be computed?
A.7 In practice, there is uncertainty about the lead time and/or usage rate. Under
perfect certainty about usage rate and lead time, the re-order point (inventory at
which firm places order to replenish inventory) will be equal to:
Lead time × usage rate
Firms maintain safety stock which serves as a buffer or cushion to meet
contingencies. In that case reorder point will be equal to:
Lead time × usage rate + safety stock
Q.8 What are the costs of stock-outs? How should the costs of stock-out and the
carrying costs be balanced to obtain the optimum safety stock?
A.8 It is difficult to predict usage and lead time accurately. If actual usage increases or
the delivery of inventory is delayed, the firm can face a problem of stock-out
which can prove to be the costly. Therefore, in order to guard against the stock-
out, the firm may maintain a safety stock, as cushion against expected increased
usage and/or delayed delivery time. Thus, the re-order point (i.e. stock level when
to place order for inventory replenishment) can be increased by safety stock.
The excess inventory level will safeguard the firm against stock-out situation, but
it is also costly with respect to inventory carrying costs. Carrying costs include
storage, insurance, taxes, clerical and staff service costs, costs of deterioration etc.

3
 The balance can be worked out between two extremely by applying cost-benefit
analysis, and by evaluating alternative strategies of safety stock level.
Q.9 How is the reorder point determined? Illustrate with an example and graphically.
A.9 The re-order point is that inventory level at which an order should be placed to
replenish the inventory. To determine, the reorder point under certainty, we
should know (1) lead time, time normally taken to replenishing inventory after the
order has been placed, (2) average usage, and (3) economic order quantity. The
re-order point is calculated by:
Re-order point = Lead × average usage time
For example, if economic order quantity is 500 units; lead time is three weeks and
average usage is 50 units per week. If there is no lead time, i.e., delivery of
inventory is instantaneous, the new order will be placed at the end of 10th week
[500 units/50 units]. But, as the lead time is three weeks, the new order to be
placed at the end of 7th week, when there are 150 [50 × 3] units in stock.
Re-order print = 3 weeks × 50 units = 150 units
600
500
EOQ

400
300
200
100
0
1 2 3
Lead Time

Q.10 What is lead time? How does it affect the computation of reorder point under
certainty and uncertainty?
A.10 Lead time is the time normally taken in replenishing inventory after the order has
been placed. In the case of certainty, the usage and lead time do not fluctuate. So
reorder point is simply that level which will be maintained for consumption
during lead time.
Reorder point = Lead time × Average usage
It is difficult to predict usage and lead time accurately. So, in the uncertainty, the
firm can face a problem of stock-out which can prove to be costly for the firm.
Therefore, in order to guard against stock out, the firm may maintain safety-stock-
some minimum or buffer inventory as cushion. In such case, re-order point is
calculated as:
Reorder point = Lead time × Average usage + Safety stock
Q.11 What is a selective control of inventory? Why is it needed? Illustrate with an
example and graph the ABC analysis.
A.11 A firm, which carries a number of items in inventory which differ in value, can
follow a selective control system. The firm should, therefore, classify inventories
to identify which items should receive the most efforts in controlling. A selective
control system, such as the A-B-C analysis, (known as Always Better Control),
classifies inventories into three categories according to the consumption value of
items: A Category consists of highest value items, C category consists of lowest

4
 value items; and B category consists of high value items. Tight control may be
applied on A category of items, and relatively loose control for C category of
items.
The following steps are involved in implementing the ABC analysis.
1. Classify the items of inventories, determining the expected use in units and
the price per unit for each item.
2. Determine the total value of consumption.
3. Rank the items in accordance with total consumption value in ascending
order.
4. Compute the ratios or percentages of number of items of each item to total
units of all items, and the ratio of total value of each item to total value of all
items.
5. Combine items on the basis of their value to form three categories – A, B and
C.
Illustration:
Item Units % of Cumulative Unit Total % of Cumulative
total Price Costs Total
Rs. Rs.
1 10,000 10 } 30.40 3,04,000 38 }
2 5,000 5 } 15% 15% 51.20 2,56,000 32 } 70%
3 16,000 16 } 5.50 88,000 11 }
4 14,000 14 } 30% 45% 5.14 72,000 09 } 90%
5 30,000 30 } 1.70 51,000 6.38 }
6 15,000 15 } 55% 100% 1.50 22,500 2.81 } 100%
7 10,000 10 } 0.65 6,500 0.81 }
Total 100,000 800,000

The above table indicates that, ‘items A’ forms 15% of total items, but represents
highest value, i.e., 70%. On the other hand, ‘items C’ forms 55% of total items,
but represents only 10% of total value. ‘Item B’ occupies middle place. Thus,
highest control should be exercised on ‘Item A’ in order to maximize profitability
on its investment. In case of ‘Item C’, simple controls will be sufficient.
Q.12 Explain the steps involved in analyzing investment in inventories. Illustrate with
an example.
A.12 The analysis should involve an evaluation of the profitability of investment in
inventory. The analysis of investment in inventory should be analysed in the
following four steps:
1. Estimation of operating profit
2. Estimation of investment in inventory.
3. Estimation of rate of return on investment in inventory, and
4. Comparison of the rate of return on investment with the cost of funds.
The incremental analysis should be used to compute the value of operating
profits, investment in inventory, rate of return and cost of funds. A change in
inventory policy is desirable if the incremental rate of return exceeds the required
rate of return.

5
The expected operating profit of each inventory policy will depend on the
contribution from increased sales minus the additional carrying costs. The aim of
the firm should be to maximize operating profit in relation to investment viz.,
expected return on investment. The investment in inventory should be measured
in terms of out-of-pocket costs. The change in investment will be the sum of (1)
increased finished goods inventories, and (2) corresponding increase in other net
working capital.
The incremental rate of return (r) on investment can be calculated by using
following formula.
Incremental Operating Profit
r = -----------------------------------
Incremental Investment

If the incremental rate of return, r, is greater than required rate of return, k, then
particular inventory policy can be chosen.

6
 CHAPTER 30
CASH MANAGEMENT

Q.1 Explain the three principal motives for holding cash.

A.1 Cash is required to meet a firm’s transactions and precautionary needs. A firm
needs cash to make payments for acquisition of resources and services for the
normal conduct of business. It keeps additional funds to meet any emergency
situation. Some firms may also maintain cash for taking advantages of speculative
changes in prices of input and output.
Cash in the basic input needed to keep the business running on a continuous basis.
Cash shortage will disrupt the firm’s manufacturing operations, while excessive
cash will simply remain idle, without contributing anything towards the firm’s
profitability. So, firm should have sufficient cash, neither more nor less.
The cash for precautionary motive is the need to hold cash to meet contingencies
in the future. It provides cushion or buffer to withstand some unexpected
emergency.
Q.2 What are the advantages of cash planning? How does cash budget help in
planning the firm’s cash flows?
A.2 Cash planning is a technique to plan and control the inflow and outflow of cash.
Cash planning helps to anticipate the future cash flows and cash needs of the firm
and reduces the possibility of idle cash balances (which lowers firm’s
profitability) and cash deficits (which can cause the firm’s failure). It protects the
financial condition of the firm, and is crucial in developing the overall operating
plans of the firm.
Cash budget is the most significant device to plan for and control cash receipts
and payments. A cash budget is a summary statement of the firm’s expected cash
inflows and outflows over a projected time period. It gives information on the
timing and magnitude of expected cash flows and cash balances over the
projected period. The cash budget may differ from firm to firm. Monthly cash
budgets should be prepared by a firm whose business is affected by seasonal
variations. Daily or weekly cash budgets should be prepared for determining cash
requirements if cash flows show extreme fluctuations. Cash budgets for a longer
interval should be prepared if cash flows are relatively stable.
Q.3 Explain and illustrate the utility of cash budget.
A.3 The cash budget helps in determining the cash requirements for a pre-determined
period to run a business. One of the significant roles of the cash budget is to pin-
point when the money will be needed and when it can be repaid. This helps the
financial manager to negotiate short term financial arrangement with banks. Cash
budget also help in managing the investment of surplus cash in marketable
securities. A carefully and skillfully designed cash budget helps a firm to select
securities with appropriate maturities and reasonable risk, and maximize profit by
investing idle funds. Multi-divisional firms use cash budgets as a tool to
coordinate the flow of funds between their various divisions as well as to make
financing arrangements for these operations. Cash budget may also be useful in
determining the margins or minimum balances to be maintained with banks. It

1
 also supports to scheduling payments in connections of short-term and long-term
debt repayments as well as for capital expenditures programmes, etc.
Q.4 Illustrate with example the modus operandi of preparing a cash budget.
A.4 Two most commonly used methods of preparing a cash budget are (1) the receipts
and disbursements method, and (2) the adjusted income method.
Receipts and disbursements method: Developing a forecast for cash inflows is the
first step in preparing a cash forecast or cash budget. Three broad sources of cash
inflows can be identified: (i) operating, (ii) non-operating and (iii) financial. Cash
sales and collections from customers form the most important part of the
operating cash inflows. The operating cash inflows are reduced to the extent of
sales discounts, returns and allowances and bad debts. Non-operating cash inflows
include sale of old assets and dividend and interest income. Borrowings and
issuance of securities are external financial sources, and part of financial cash
inflows.
Next step in the preparation of cash budget is the estimate of cash outflows. Cash
outflows include
1. Operating outflows, i.e., cash purchases, payments to suppliers of materials,
advances to suppliers, wages and salaries and other operating expenses
2. Capital expenditures
3. Contractual payments
4. Repayment of loan and interest and tax payments and
5. Discretionary payments like ordinary and preference dividend.
Adjusted Income Method: This method is also known as sources and uses
approach. It is a projected cash flow statement which has three sections, i.e.,
sources of cash, uses of cash and the adjusted cash balance. It also helps in
anticipating the working capital movements. In preparing the adjusted net income
forecast items such as net income, depreciation, taxes, dividends, etc. can easily
be determined from the company’s annual operating budget. It separately takes
into account the movements in the working capital items, and thus helps to keep a
control on a firm’s working capital.
Q.5 Explain the technique that can be used to accelerate the firm’s collections.
A.5 Cash collections can be accelerated by reducing the lag or gap between the time a
customer pays bill and the time the cheque is collected and funds become
available for the firm’s use. For this purpose, a firm can use decentralized
collection system and lock-box system to speed up the collections.
A decentralized collection procedure, called concentration banking, is a system of
operating through a number of collection centres, instead of a single collection
centre centralized at the firm’s head office. The basic purpose of the decentralized
collections is to minimize the lag between the mailing time from customers to the
firm and time when the firm can make use of the firm. Decentralized mailing
system saves mailing and processing time, and thus, reduces the deposit float, and
consequently, the financing requirements.
Lock-box system: In a lock-box system, the firm establishes a number of
collection centres, considering customer locations and volume of remittances. At
each centre, the firm hires a post office box and instructs its customers to mail

2
 their remittances to the box. The firm’s local bank is given the authority to pick
up the remittances, and deposits the cheque in the firm’s account.
Q.6 What are the advantages of decentralized collection over a centralized collection?
A.6 Under the decentralized collections, the firm will have a large number of bank
accounts operated in the areas where the firm has its branches, instead of one
bank account at one place in centralized collection system.
Decentralized collection system saves mailing and processing time and, thus,
reduces the deposit float, and consequently, the financing requirements. This
system results in potential savings which should be compared with the cost of
maintaining the system.
It must be noticed that now a lot of developments and improvements have taken
place in the banking in India. Now a firm can deposit cheque anywhere and the
credit will be available immediately where the firm operates its account.
Q.7 What is a lock-box system? How does it help to reduce the cash balances?
A.7 In a lock-box system, the firm establishes a number of collection centres,
considering customer locations and volume of remittances. At each centre, the
firm hires a post office box and instructs its customers to mail their remittances to
the box. The firm’s local bank picks up the cheques and deposits in the firm’s
accounts.
The lock-box system eliminates the period between the time cheques are received
and deposited in the bank for collection by firm. The cheques are deposited
immediately and their collection process start sooner, which results into reduced
deposit floats, and may in turn reduce the cash balances.
Q.8 Distinguish between a deposit float and a payment float. What are the advantages
and dangers of “playing the float”? Explain the techniques for managing float.
A.8 The collection float means the time gap between cheques sent by customer which
are not yet collected. This time gap, i.e., delay caused by the mailing time, (the
time taken by cheque in transit), and the processing time (the time taken by the
firm in processing cheque for internal accounting purposes).
When the firm’s actual bank balance is greater than the balance shown in the
firm’s books, the difference is called disbursement or payment float.
Playing the float means to maximize the availability of funds. The difference
between the total amount of cheques drawn on a bank account and the balance
shown on the bank’s book is caused by transit and processing delays. If the
financial manager can accurately estimate the transit and processing delays time,
he or she can invest the ‘float’ during the float period to earn a return. It is a risky
game and should be played very cautiously.
Q.9 What are the objectives of a firm in controlling its disbursements? How can the
disbursements be slowed down?
A.9 Disbursements arise due to trade credit. The firm’s effective control of
disbursements can help in conserving cash and reducing the financial
requirements. The firm should make payments using credit terms to the fullest
extent. Delaying disbursements result in maximum availability of funds. For
proper control of disbursements, a centralized payment system may be
advantageous, and payments may be made from a single central account.

3
Q.10 How can the appropriate level of operating cash balance be determined? How
does uncertainty affect this problem?
A.10 The firm should maintain optimum - neither more nor less - cash balance for
transaction purposes. It may also carry additional cash as buffer or safety stock.
The amount of cash balance will depend on the risk-return trade-off.
The Baumol’s Cash Management Model provides a formal approach for
determining a firm’s cash balance under certainty. The Baumol’s model makes
these assumptions: (1) the firm is able to forecast its cash needs with certainty, (2)
cash payments occur uniformly over a period of time, (3) opportunity cost of
holding cash is known, and (4) firm will incur the same transaction cost whenever
it converts securities to cash. The optimum cash balance, C*, is obtained when the
total cost is minimum. The formula for the optimum cash balance is as follows:
2cT
C* =
k
where C* is the optimum cash balance, c is the cost per transaction, T is the total
cash needed during the year and k is the opportunity cost of holding cash balance.
The optimum cash balance will increase with increase in the transaction cost and
total funds required and decrease with the opportunity cost.

The Miller-Orr Model provides an approach for determining optimum cash

balance under uncertainty. The model allows for daily cash flow variations. As
per this model, there are upper control limits and lower control limits. The cash
balance at any point of time is not allowed to go above the upper control limit,
while it is not allowed to fall below the lower limit. In between these two levels,
there is a returning point. Once cash balances reaches to upper control limit
(UCL), the balance is reduced to returning point by investing in marketing
securities. On the other hand, when cash balances touches to lower control limit,
enough marketable securities are disposed off to restore the cash balance to
returning point.
The formula for determining the distance between upper and lower control limits
(called Z) is as follows:
(Upper Limit − Lower Limit) = (3 / 4 × Transaction Cost × Cash Flow Variance / Interest Rate)1 / 3
(
Z = 3 / 4 × cσ 2 / i )
1/ 3

We can notice from the equation that the upper and lower limits will be far off
from each other (i.e. Z will be larger) if transaction cost is higher or cash flows
show greater fluctuations. The limits will come closer as the interest rate
increases. Z is inversely related to the interest rate. It is noticeable that the upper
control limit is three times above the lower control limit and the return point lies
between the upper and the lower limits. Thus,
Upper Limit = Lower Limit + 3Z
Return Point = Lower Limit + Z
The net effect is that the firm holds the average cash balance equal to:
Average Cash Balance = Lower Limit + 4/3 Z

4
Q.11 Explain the criteria that a firm should use in choosing the short term investment
alternatives in order to invest surplus cash.
A.11 A firm can invest its excess cash in many types of securities or short-term
investment opportunities. The primary criterion in selecting a security will be its
quickest convertibility into cash. The firm should examine the basic features of
security: safety, maturity and marketability. The firm would invest in very safe
securities as the cash balance invested in them is needed in near future. The short-
term securities are preferred by the firm for the purpose of investing excess cash.
If the security can be sold quickly without loss of price, it is highly liquid or
marketable. The difference in marketability and also the default risk cause
differences in the security yields.
Q.12 Other things remaining constant, what effect would the following events have on
the average cash balance that a firm keeps for transaction purposes? Explain your
answer.
a) Increase in interest rates
b) It becomes more expensive to transfer funds from cash to securities
and vice versa.
c) The variability of net cash flow increases.
A.12 a) Increase in interest rates encourages the financial manager to review the
cash needs for transaction purpose, and to reduce the optimum cash
balance needs to earn the better yields by investing money in short-term
securities or marketable securities.
b) If the transfer of funds from cash to securities and vice-versa becomes
more expensive, then financial manager likes to have lesser total
transaction costs for conversion. This will result into increase in optimum
cash balance.
c) As the variability of cash inflows increases, so financial manager would
not like to have cash shortages, i.e., stock-out situations, so he will
maintain larger amount of optimum cash balance.

5
 CHAPTER 31

WORKING CAPITAL FINANCE

Q.1 Explain the importance of trade credit and accruals as sources of working
capital. What is the cost of these sources?
A.1 Trade credit refers to the credit that a customer gets from suppliers of goods in
normal course of business. This deferral of payments is a short term financing,
and a major source of finance. It is mostly granted on an open account basis. It
may also take the form of bills payable. It is a spontaneous source of
financing. It appears to be cost free since it does not involve explicit interest
charges. But, in practice, it involves implicit costs, i.e., via the increased price
of goods supplied to customer.
Accrued expenses represent a liability that a firm has to pay for the services
which it has already received. They represent spontaneous, interest free
sources of financing. The most important components of accruals are wages
and salaries, taxes and interest. Accrued taxes and interest also constitute
another source of financing.
Q.2 Explain the rationale of the Tandon Committee’s recommendations.
A.2 The Tandon Committee was appointed by the Reserve Bank of India in July,
1974 to suggest guidelines for the rational allocation and optimum use of bank
credit.
Bank credit is a scarce resource; hence it should be optimally used under all
circumstances. The bank credit should also be available, in addition to
industrial units, to agriculture, small-scale industry, farmers, small man and
many others. The bank funds should be utilized in most efficient way by all
sectors of the economy. The Tandon Committee, have given due weightage on
above rationale, while recommended the three methods for financing.
Q.3 Describe the important features of the Tandon Committee’s recommendations:
A.3 The important features of Tandon Committee’s recommendations are
enumerated hereunder in brief.
1) The borrower should indicate the likely demand of credit in a realistic
manner.
2) The banker should finance only the genuine production needs of the
borrower.
3) The borrower should maintain reasonable levels of inventory and
receivables; just enough to carry on his target production.
4) The working capital needs of the borrower will be partly financed by
bank; for the remaining, the borrower should depend upon his own
funds, generated internally or externally.
5) The committee has pointed out that borrower should be allowed to
hold a reasonable level of current assets, particularly inventory and
receivable. The committee have suggested norms separately for heavy
engineering, heavy seasonal, small scale industries etc.
6) The committee admitted that norms cannot be followed rigidly. It
allowed flexibility in the application of norms when a major change in
the environment justifies.
7) The committee also recommended the bifurcation of total credit into
fixed and fluctuating parts.

1
 8) They also recommended methods for calculation of maximum
permissible bank finance.
9) The committee also recommended the flow of information from
borrower to the bank on regular basis, comparing estimates and
actuals, etc.
Q.4 What are the implications of the recommendations suggested by the Tandon
Committee?
A.4 Bankers found difficulties in implementing the committee’s recommendations.
The Tandon Committee report has brought about a perspective change in the
outlook and attitude of both the bankers and their customers. The report has
also helped in bringing a financial discipline through a balanced and integrated
scheme for bank lending.
Q.5 Define commercial paper. Explain its pros and cons.
A.5 Commercial paper (CP) is a form of unsecured promissory note issued by
firms to raise short term funds. The CP are issued by companies having net
worth of Rs. 10 crore or more, and are financially sound and highest rated
companies. In addition to this, companies should have maximum permissible
bank finance of not less than Rs. 25 crore, and are listed on stock exchange.
The RBI provided that size of issue should be at least Rs. 1 crore and the size
of the each CP should not be less than Rs. 25 lakh. In India, the maturity of CP
runs between 91 to 180 days. It is expected that CP is used for short term
financing only, as an alternative to bank credit and other short term sources.
The interest rate of CP will be determined by market.
Advantages:
1) The CP is an alternative source of raising short term finance.
2) It is cheaper source of finance in comparison to bank credit.
Disadvantages or limitations:
1) As it is impersonal method, so it may not be possible to get the
maturity of CP extended.
2) It cannot be redeemed until maturity, and will have to incur interest
costs.
3) A firm facing temporary liquidity problems may not be able to raise
funds by issuing new CP etc.

2
 CHAPTER 33

DERIVATIVES FOR MANAGING FINANCIAL RISK

Q-1 What are derivatives? Why do companies hedge risk using derivatives?
A-1 A derivative is a financial instrument whose pay-offs is derived from some other
asset which is called an underlying asset. Option, an example of a derivative
security, is a more complicated derivative. There are a large number of simple
derivatives like futures or forward contracts or swaps. Derivatives are tools to
reduce a firm’s risk exposure. A firm can do away with unnecessary parts of risk
exposure and even convert exposures into quite different forms by using
derivatives. Hedging is the term used for reducing risk by using derivatives.
There are several advantages of better risk management through hedging:
• Debt capacity enhancement
• Increased focus on operations
• Isolating managerial performance
Q-2 How can options be used to hedge risk? Illustrate your answer.
A-2 An option is a right to buy or sell an asset at a specified exercise price at a
specified period of time. Option is a right and does not constitute any obligation
on the part of the buyer or seller of the option to buy or sell the underlying asset.
A foreign currency option is a handy method of reducing foreign exchange risk.
Similarly, options on interest rates and commodities are quite popular with
managers to reduce risk. Many options trade on option exchanges. However, in
practice, banks and companies strike private option deals
Let us consider an example. Suppose ONGC sells oil to Indian Petrochemical
Limited (IPCL). ONGC wants to protect itself from a potential fall in oil prices.
What should it do? It should buy a put option – a right to sell oil at a specified
exercise price at a specified time. ONGC will be able to protect itself from falling
prices and at the same time benefit from increase in the oil prices..
Q-3 Define forward and future contracts? What are the differences between forward
and future contracts?
A-3 A forward contract is an agreement between two parties to exchange an asset for
cash at a predetermined future date for a price that is specified today. Forward
contracts are flexible. They are tailor-made to suit the needs of the buyers and
sellers. You can enter into a forward contract for any goods, commodities or
assets. You can choose your delivery date for any quantity of goods or
commodities Future contracts are forwards contracts traded on organised
exchanges in standardised contract size.
It is true that future contracts are no different from forward contracts as they
serve the same purpose and operate through a contract between counterparties.
The difference is in terms of standardisation and method of operation. Futures
contracts have standardised contract size and they trade only on the organised
exchanges

1
Q-4 What is the difference between commodity futures and financial futures? What is
the relationship between spot and future prices of the financial futures?
A-4 Futures are traded in a wide variety of commodities: wheat, sugar, gold, silver,
copper, oranges, coco, oil soybean etc. Commodity prices fluctuate far and wide.
For large buyers of a commodity whose prices swing downward and upward,
there are significant cost implications. These companies reduce their risk of
upward movements in prices by hedging with commodity futures.
There are firms which do not have commodity prices exposure but they have
significant exposure of interest rates and exchange rates fluctuations. These firms
can hedge their exposure through financial futures. Financial futures, like the
commodity futures, are contracts to buy or sell financial assets at a future date at a
specified price. Financial futures, introduced for the first time in 1972 in the USA,
have become very popular. Now the trading in financial futures far exceeds
trading in commodity futures.
The relationship between the stop and the future prices will be as follows:
Futures price = Spot price (1 + rf ) t − dividend foregone
Future price Dividend foregone
Spot price = +
(1 + rf ) t (1 + rf ) t
Q-5 Consider the following two strategies. Strategy 1: Buy gold at spot price today
and hold it for six months. Strategy 2: Take a long position on the gold futures
contract expiring in six months. Lend money at risk-free interest rate that will be
equal to the futures price in six months. Show the relationship between the spot
price and the futures price.
A-5 In case of commodity futures, there is no dividend forgone. Further, the buyer of
commodity futures does not need to store commodity as delivery will be in the
future. Therefore, he avoids storage cost. Also, the buyer does not have
commodity on hand which does not give him a comfort or convenience of
meeting sudden requirements. Thus, the buyer saves storage cost but loses in
terms of convenience yield. The spot and futures prices relationship in case of
commodities futures is given as follows:
Future price Storage costs Convenience yield
Spot price = t
− +
(1 + rf ) (1 + rf ) t (1 + rf ) t
Future price  Storage costs Convenience yield 
t
= Spot price +  t
− 
(1 + rf )  (1 + rf ) (1 + rf ) t 
The difference between the present value storage costs and convenience yield is
net convenience yield (NCY). In practice, it can be inferred as the difference
between the present value of futures price and spot rice.
Q-6 Define a swap. Illustrate how interest rate swap helps to reduce risk exposure?
A-6 A swap is an agreement between two parties, called counterparties, to trade cash
flows over a period of time. Swaps arrangements are quite flexible and are useful
in many financial situations. Two most popular swaps are currency swaps and
interest-rate swaps. These two swaps can be combined when interest on loans in
two currencies are swapped.

2
 The interest rate swap allows a company to borrow capital at fixed (or floating
rate) and exchange its interest payments with interest payments at floating rate (or
fixed rate).The interest rate swaps can be used by portfolio managers and pension
fund managers to convert their bond or money market portfolios from floating
rate (or fixed rate) to synthetic fixed rate (or synthetic floating rate).
Q-7 What is a currency swap? How does currency swap reduce exposure to risk? Give
an example.
A-7 Currency swap involves an exchange of cash payments in one currency for cash
payments in another currency. Most international companies require foreign
currency for making investments abroad. These firms find difficulties in entering
new markets and raising capital at convenient terms. Currency swap is an easy
alternative for these companies to overcome this problem.
Currency swaps are a form of back-to-back loan. For example, an Indian company
wants to invest in Singapore. Suppose the government regulations restrict the
purchase of Singapore dollars for investing abroad but the company is allowed to
lend rupees abroad and borrow Singapore dollars. The company could find a
Singapore company that needs Indian rupees to invest in India. The Indian
company would borrow Singapore dollars and simultaneously lend rupees to the
Singapore company

3
 CHAPTER 32

CORPORATE RESTRUCTING, MERGERS AND ACQUISITIONS

Q1. Define and distinguish between the concepts of merger, takeover and
amalgamation. Illustrate your answer with suitable examples in the Indian
context.
A1 A merger is said to occur when two or more companies combine into one
company. One or more companies may merge with an existing company or they
may merge to form a new company. In merger, there is complete amalgamation of
the assets and liabilities as well as shareholders’ interests and businesses of the
merging companies. There is yet another mode of merger. Here one company may
purchase another company without giving proportionate ownership to the
shareholders’ of the acquired company or without continuing the business of the
acquired company. Laws in India use the term amalgamation for merger. When an
acquisition is a ‘forced’ or ‘unwilling’ acquisition, it is called a takeover.
Q2. Explain the concepts of horizontal, vertical and conglomerate merger with
examples.
A2 Horizontal merger: This is a combination of two or more firms in similar type of
production, distribution or area of business. Examples would be combining of two
book publishers or two luggage manufacturing companies to gain dominant
market share.
Vertical merger: This is a combination of two or more firms involved in different
stages of production or distribution. Joining of a TV manufacturing (assembling)
company and a TV marketing company or the joining of a spinning company and
a weaving company are examples of vertical merger. Vertical merger may take
the form of forward or backward merger. When a company combines with the
supplier of material, it is called backward merger and when it combines with the
customer, it is known as forward merger.
Conglomerate merger: This is a combination of firms engaged in unrelated lines
of business activity. A typical example is merging of different businesses like
manufacturing of cement products, fertilizers products, electronic products,
insurance investment and advertising agencies. Voltas Limited is an example of a
conglomerate company.
Q3. What are the advantages and disadvantages of mergers and takeovers?
A3 The most common motives and advantages of mergers and acquisitions are:
o Maintaining or accelerating a company’s growth, particularly when the
internal growth is constrained due to paucity of resources;
o Enhancing profitability, through cost reduction resulting from economies of
scale, operating efficiency and synergy;
o Diversifying the risk of the company, particularly when it acquires those
businesses whose income streams are not correlated;
o Reducing tax liability because of the provision of setting-off accumulated

1
 losses and unabsorbed depreciation of one company against the profits of
another;
o Limiting the severity of competition by increasing the company’s market power.
Q4. What are the important reasons for mergers and takeovers?
A4 A number of reasons are attributed for the occurrence of mergers and acquisitions.
For example, it is suggested that mergers and acquisition are intended to
o Limit competition
o Utilise under-utilised market power
o Overcome the Problem of slow growth and profitability in one’s own industry
o Achieve diversification
o Gain economies of scale and increase income with proportionately less
investment
o Establish a transnational bridgehead without excessive start-up costs to gain
access to a foreign market
o Utilise under-utilised resources—human and physical and managerial skills
o Displace existing management
o Circumvent government regulations
o Reap speculative gains attendant upon new security issue or change in P/E
ratio
o Create an image of aggressiveness and strategic opportunism, empire building
and to amass vast economic powers of the company.
Q5. Discuss in brief the legislation applicable to mergers and takeovers in India. What
are the objectives of such legislation?
A5 In India, mergers and acquisitions are regulated through the provision of the
Companies Act, 1956, the Monopolies and Restrictive Trade Practice (MRTP)
Act, 1969, the Foreign Exchange Regulation Act (FERA), 1973, the Income Tax
Act, 1961, and the Securities and Controls (Regulations) Act, 1956.1 The
Securities and Exchange Board of India (SEBI) has issued guidelines to regulate
mergers, acquisitions and takeovers.
Mergers and acquisitions may degenerate into the exploitation of shareholders,
particularly minority shareholders. They may also stifle competition and
encourage monopoly and monopolistic corporate behaviour. The objective of
these legislations is to prevent such practices.
Q6. Explain and illustrate the impact of mergers on earnings per share, market price
per share and book value per share of the acquiring company.
A6 The impact of merger depends on the exchange ratio and any synergy advantage
occurring from the merger. The following example illustrates the impact of
merger on EPS, market price of per share and book value per share. Here we
assume that there is no synergy from the merger.

2
 Before merger After merger
A B AB
PAT (Rs '000) 100 20
Equity shares ('000) 50 5
P/E ratio 20 10
EPS (Rs) 2 4
Net worth (Rs 000) 750 60
Book value per share (Rs) 15 12
(1) Exchange ratio: 1 A share: 1 B shares:
Number of shares after merger (‘000): 50 + (1 x 5) 55
PAT after merger (Rs ‘000): 100 + 20 120
EPS (Rs): 120/55 2.18
Market value per share (Rs) 40 40
Market value exchange ratio 1
Book value per share (Rs) 14.73
(2) Exchange ratio: 3 A shares: 2 B shares:
Number of shares after merger ('000): (50 + 5/2 x3) 57.5
PAT after merger with (Rs '000): (100 + 20) x 1.20 144
EPS after merger (Rs): 144/57.5 2.50
Book value per share (Rs) 14.09

Q7. When do mergers make economic sense? Explain.

A7 A merger results into an economic advantage when the combined firms are
worth more together than as separate entities. Merger benefits may result from
economies of scale, economies of vertical integration, increased efficiency, tax
shields or shared resources.

Q8. What do you mean by “tender offer”? What tactics are used by a target company
to defend itself from a hostile takeover?
A8 A tender offer is a formal offer to purchase a given number of a company’s shares
at a specific price. Tender offer can be used in two situations. First, the acquiring
company may directly approach the target company for its takeover. If the target
company does not agree, then the acquiring company may directly approach the
shareholders by means of a tender offer. Second, the tender offer may be used
without any negotiations, and it may be tantamount to a hostile takeover.
A target company in practice adopts a number of tactics to defend itself from
hostile takeover through a tender offer. These tactics include
• Divestiture
• Crown jewels
• Poison pill
• Greenmail
• White knight
• Golden parachutes
.
Q9. What do you understand by leveraged buyout and management buyout? Explain
the steps involved in the evaluation of LBO?
A9 A leveraged buy-out (LBO) is an acquisition of a company in which the acquisition

3
 is substantially financed through debt. When the managers buy their company from
its owners employing debt, the leveraged buy-out is called management buy-out
(MBO).
The evaluation of LBO transactions involves the same analysis as for mergers and
acquisitions. The DCF approach is used to value an LBO. As LBO transactions are
heavily financed by debt, the risk of lender is very high. Therefore, in most deals,
they require a stake in the ownership of the acquired firm.
Q10. What leads to the failure of a merger or acquisition? How should a company ensure
that merger or acquisition is successful?
A10 Reasons responsible for the failure of a merger or acquisition are:-
1. Excessive premium.
2. Faulty Evaluation.
3. Lack of research.
4. Failure to manage post merger integration.
A company can ensure that merger and acquisition is successful by proper
planning, search and screening, financial evaluation and most importantly, post-
merger integration.
Q11. What are the problems of post merger integration? How can integration be
achieved?
A11 Problems of post merger integration are:-
1. Deciding authority and responsibility of employees.
2. Cultural integration of the employees.
3. Skill and competencies up-gradation
4. Structural adjustments.
5. Control systems.
Peter Drucker provides the following five rules for the integration process
1. Ensure that the acquired firm has a “common core of unity” with the parent.
They should have overlapping characteristics like shared technology or
markets to exploit synergies.
2. The acquirer should think through what potential skill contribution it can
make to the acquiree.
3. The acquirer must respect the products, markets and customers of the acquired
firm.
4. The acquirer should provide appropriately skilled top management for the
acquiree with in a year.
5. The acquirer should make several cross-company promotion within a year.
Q12. What is the difference between the pooling of interest and purchase methods of
accounting for mergers? Illustrate your answer.
A12 The merger should be structured as pooling of interest. In the case of acquisition,
where the acquiring company purchases the shares of the target company, the
acquisition should be structured as a purchase.
In the pooling of interests method of accounting, the balance sheet items and the
profit and loss items of the merged firms are combined without recording the
effects of merger. This implies that asset, liabilities and other items of the
acquiring and the acquired firms are simply added at the book values without
making any adjustments. Thus, there is no revaluation of assets or creation of

4
goodwill.
Under the purchase method, the assets and liabilities of the acquiring firm after
the acquisition of the target firm may be stated at their exiting carrying amounts
or at the amounts adjusted for the purchase price paid to the target company. The
assets and liabilities after merger are generally re-valued under the purchase
method. If the acquirer pays a price greater than the fair market value of assets
and liabilities, the excess amount is shown as goodwill in the acquiring
company’s books. On the contrary, if the fair value of assets and liabilities is less
than the purchase price paid, then this difference is recorded as capital reserve

5
 CHAPTER 34

INTERNATIONAL FINANCIAL MANAGEMENT

Q1. How does financial management of an international firm differ from that of a
domestic firm?
A1 International or multinational firms operate in more than one country and their
operations involve multiple foreign currencies. Their operations are influenced by
politics and the laws of the countries where they operate. Thus, they face higher
degree of risk as compared to domestic firms. A matter of great concern for the
international firms is to analyse the implications of the changes in interest rates,
inflation rates and exchange rates on their decisions and minimise the foreign
exchange risk
Q2. What is a foreign exchange market? Who are the participants in a foreign
exchange market? What are their motivations?
A2 The foreign exchange market is the market where the currency of one country is
exchanged for the currency of another country. Most currency transactions are
channelled through the world-wide Interbank market. Interbank market is the
wholesale market in which major banks trade with each other. Foreign exchange
(Forex) market is a world-wide market of an informal network of telephone, telex,
satellite, facsimile, and computer communications between the forex market
participants which include banks, foreign exchange dealers, arbitrageurs, and
speculators.
The foreign market operators are guided by different motives when they deal in
the foreign exchange market:
• Arbitrageurs seek to earn risk-less profits by taking advantage of differences
in exchange rates among countries
• Traders operate in the foreign exchange market because exporters receive
foreign currencies which they have to convert into local currencies, and
importers make payments in foreign currencies which they purchase by
exchanging the local currency.
• Multinational firms operate in the foreign exchange market as hedgers to
protect themselves against the risk of fluctuations in the foreign exchange
rates.
• Speculators are guided purely by the profit motive.
Q3. What is a spot exchange rate? How is it different from a forward rate? How will
you calculate forward premium or discount?
A3 The spot exchange rate is the rate at which a currency can be bought or sold for
immediate delivery which is within two business days after the day of the trade.
The forward exchange rate is the rate that is currently paid for the delivery of a
currency at some future date. In terms of the volume of currency transactions, the
spot exchange market is much larger than the forward exchange market.
The forward rate may be at a premium or at a discount. Forward rate premium or
discount may be shown as an annualised percentage deviation from the spot rate.
For example, if forward dollars are more expensive than spot dollars, the dollar is
said to be trading at a premium relative to the Indian rupee.

1
 For a direct quote, the annualised forward discount or premium can be calculated
as follows:
 Spot rate - Forward rate  360
Forward premium (discount) =   × Days
 Spot rate 
For an indirect quote, the forward premium or discount can be calculated as
follows:
 Forward rate - Spot rate  360
Forward premium or discount =   × Days
 Spot rate 
Forward contracts are tailor-made according to the firm’s needs. Two parties to a forward
contract can negotiate the terms in accordance with the currency, amount,
premium/discount or any other issue.
Q4. You know the exchange rates of two countries. A third country’s exchange rate is
quoted against only the first of these countries. How can you determine the
exchange for this third country against the second country? Illustrate your answer.
A4 A cross rate is an exchange rate between the currencies of two countries that are
not quoted against each other, but are quoted against one common currency.
Currencies of many countries are not freely traded in the forex market. Therefore,
all currencies are not quoted against each other. Most currencies are, however,
quoted against the US dollar. The cross rates of currencies that are not quoted
against each other can be quoted in terms of the US dollar.
Given the exchange rates of two currencies, we can find the exchange rate for the
third currency. For example, the US dollar-Thai baht exchange rate is:
US$0.02339/Baht, and the US dollar-Indian rupee exchange rate is:
US$0.02538/INR. Suppose that INR is not quoted against Thai baht. What is the
Baht/INR exchange rate? One Indian rupee costs US$0.02538 while one baht
costs US $0.02339. Thus one Indian rupee should cost: 0.02539/0.02339 =
Baht1.085. That is:
US$0.02538 US$0.02339 US$0.02538 Baht Baht1.085
÷ = × =
INR Baht US$0.02339 INR INR

Q5. Name the four international parity conditions. Explain each one briefly.
A5 There are the following four international parity relationships:
1. Interest rate parity (IRP)
2. Purchasing power parity (PPP)
3. Forward rates and future spot rates parity
4. International Fisher effect (IFE).
Q6. What is interest rate parity? How does it work? Give an example to illustrate your
answer.
A6 Interest rate parity characterises the relationship between interest rates and
exchange rates of two countries. It states that the exchange rate of two countries
will be affected by their interest rate differential. In other words, the currency of a
high-interest-rate-country will be at a forward discount relative to the currency of

2
 a low-interest-rate-country, and vice versa. This implies that the exchange rate
(forward and spot) differential will be equal to the interest rate differential
between the two countries. That is:
Interest differential = Exchange rate (forward and spot) differential
(1 + rF ) f F / D
=
(1 + rD ) s F / D
where rF is interest rate of country F (say, the foreign country), rD is interest rate
of country D (say, domestic country), sF/D is the spot exchange rate between the
countries F and D and fF/D is the forward rate between the countries F and D.
Suppose that the interest rate on a one-year bond (rupee-denominated) in India is
14 percent while a similar bond (franc-denominated) in France pays 9 percent
interest. The spot rate for French franc is FF0.1522/INR and the 1-year forward
rate is FF0.1455/INR. If you have a choice of investment, which one should you
choose? You may notice that INR is trading at a forward discount. (Alternatively,
FF is trading at a forward premium relative to INR). Let us assume that you have
FF 1,000. If you invest FF 1,000 in France, at the end of one year, you will
receive: FF 1,000 1.09 = FF 1,090. Alternatively, you can exchange FF 1,000
for the Indian rupees at the spot rate; you will receive: FF 1,000/0.1522 = INR6,
570.30. You can invest INR 6,570.30 at 14 percent for one year. At maturity, you
will receive: INR 6,570.30 1.14 = INR 7,490.14. You can sell the Indian rupees
forward and immediately receive French franc: INR 7,490.14 0.1455 = FF
1,090. Both investments are of equal value. What you gain on the interest rate
differential, you lose on the exchange rate differential. In other words, there is a
parity between the interest rates and exchange rates, or simply interest rate parity.
Thus:
1.14 0.1522
= = 1.046
1.09 0.1455

Q7. What is the Fisher effect? How is this principle extended to international finance?
A7 We know that the nominal interest rate comprises of a real interest rate and an
expected rate of inflation. The nominal rate of interest adjusts when the inflation
rate is expected to change. The nominal interest rate will be higher when a higher
inflation rate is expected and it will be lower when a lower inflation rate is
expected. This is referred to as the Fisher effect. It is formally expressed as
follows:
(1 + nominal interest rate) = (1 + real interest rate) (1 + inflation rate)
(1 + rn ) = (1 + rr ) (1 + i )
rn = rr + i + rr i
where rn is nominal rate of interest, rr is real rate on interest, and i is the inflation
rate.
If the international capital markets are perfect, then the equivalent risk
investments in two countries should offer the same expected real rate of return.

3
 This is ensured by arbitrage. If the expected real rate of return is higher in one
country than in another, capital would flow from the second to the first country,
and investors will have opportunities to make riskless arbitrage profit. The
arbitrage activity will persist until equilibrium is established in the expected real
returns in the two countries. If the real rates of return are the same in two
countries, then, as per the Fisher effect, the nominal rates of interest in the two
countries will adjust exactly for the change in the inflation rates. In formal terms,
the international Fisher effect states that the nominal interest rate differential must
equal to the expected inflation rate differential in two countries. Thus:
Nominal interest rate differential = Expected inflation rate differential
(1 + rF ) E (1 + i F )
=
(1 + rD ) E (1 + i D )

Q8. Why should forward rate be the possible forecast of an expected future spot rate?
A8 Suppose you are an exporter who is expecting to receive the US dollars in the future, you
have two choices. You can either wait until you receive your dollars or then convert them
into rupees. You are exposed to the risk of drop in the value of dollar in the future. The
second alternative is that you fix the price of the dollar today and sell the US dollars
forward. You are thus able to avoid risk of a possible fall in the value of dollar. Suppose
you happen to be an importer who is required to make payment in the US dollars in the
future. You will do the opposite. You will buy the US dollars forward to avoid the risk of
a possible appreciation in the value of dollar in the future. If both the exporters and the
importers are in large numbers, the forward rate of US dollar relative to the Indian rupee
will be very close to the expected future spot rate. This is the expectation theory of
exchange rates.
Q9. What is the law of one price? How is it applied to international finance? Give an
example.
A9 In an efficient forex market, comprising of large number of traders having access
to information without much cost, the arbitrage activity will ensure that the
disparities in the exchange rates are eliminated. It will also ensure that the
exchange-adjusted prices of similar goods and financial assets will be equal in all
the countries. This economic behaviour is referred to as the law of one price.
Q10. Explain with the help of an example how the international Fisher effect reflects
interest parity, purchasing power parity and the expectation theory of forward
rates.
A10. Suppose the one-year interest rate is 5 percent on Swedish krona and the expected
inflation rate is 2 percent. The expected inflation rate on French franc is 6 percent.
The current spot exchange rate is FF1.063/SK (which is equal to FF1 =
SK0.9407). How much is the spot rate expected in one year? What will be the
one-year forward rate?
According to the international Fisher effect, the interest rate differential must be
equal to the inflation rate differential, and the interest rate differential provides a
forecast of the expected future spot rate. If the expectation theory of exchange rate
holds, then the forward rate should be equal to the expected future spot rate. Thus:

4
 1 + rF 1.06 E (s F / D ) f F / D
= = =
1.05 1.02 1.063 1.063
1.091 1.06 1.1047 1.1047
= = =
1.05 1.02 1.063 1.063
The interest rate on French franc is 9.1 percent; the expected future spot rate and the
forward rate are FF1.1047/SK (SK0.9052/FF).
Q11. What is foreign exchange risk? What are the implications when foreign exchange
exposure is not covered or covered partially?
A11 Foreign exchange risk is the risk that the domestic currency value of cash flows,
denominated in foreign currency, may change because of the variation in the foreign
exchange rate. Some companies do not cover their foreign exchange exposure or have a
policy of partially covering their exposure. This policy suffers from subjectivism as there
is no sound method of deciding how much to cover and how much to keep uncovered.
The firm’s risk remains unlimited in the partially covered exposure. In fact, keeping the
foreign exchange exposure totally or partially uncovered tantamount to speculation.
Q12. What is a forward cover? How does it provide a hedge against the foreign
exchange risk?
A12. Companies can take a full forward cover against its foreign exchange exposure and
entirely hedge its risk. It can contract with a bank to buy foreign currency in forward at
an agreed exchange rate. This means that irrespective of the actual exchange rate at the
end of six months, its cost will remain same. The advantage of this approach is that a
company’s management can concentrate on its operations rather than worrying about the
foreign exchange loss (or gain). Most international companies have the policy of
covering hundred percent of their foreign exchange risk.
Q13. Explain the foreign exchange option as a hedging technique. What are its pros and
cons?
A13 The foreign currency option is the right (not an obligation) to buy or sell a currency at an
agreed exchange rate (exercise price) on or before an agreed maturity period. The right to
buy is called a call option and right to sell a put option. A foreign currency option holder
will exercise his right only if it is advantageous to do so. Except for the cost of option
premium, the foreign currency option provides a unique hedging alternative; you can
avoid the loss by exercising your option and gain from the favourable change in the
exchange rate by not exercising the option.
Q14 How do money market operations provide hedging against the foreign exchange
risk?
A14 Another hedging technique is the money market operations. Company can
borrow foreign currency now, convert them into rupees at the current exchange
rate and invest in the money market in India for six months. If interest rate parity
holds, the difference in the forward rate and the spot rate is the reflection of the
differences in the interest rates in two countries. Thus company will be able to
hedge against the change in the exchange rate. The problem with the money
market alternative is that all markets are not open and all currencies are not fully
convertible. The Indian rupee is not fully convertible and there are restrictions on
the free flow of funds outside the country
Q15. How do international capital investment decisions differ from domestic capital
investment decisions? Explain the methods of evaluating international investment

5
 decisions.
A15 One factor that distinguishes the international investment decisions from the
domestic investment decisions is that cash flows are earned in foreign currency.
This fact should be considered while estimating the incremental cash flows. The
cash flows can be estimated either in the domestic currency or in the foreign
currency. The financial managers should forecast the foreign exchange rates
assuming the parity conditions. The opportunity costs should be appropriately
modified, reflecting the interest rate of the country in whose currency cash flows
are estimated. A firm, which is deciding to make investment in another country,
must vouch for the political risk in the host country. A firm’s exposure to political
risk depends on the host country’s political system, its economic conditions and
the government’s policies and actions towards foreign direct investment (FDI)
that affect the firm’s investment cash flows
Q16. What are the various alternatives available to a firm to finance its international
investments? Explain two major methods of financing international operations.
A16 Financial markets help to shift funds from the savers (lenders) to the investors
(borrowers) in exchange for a return. They allocate funds among the potential
users on the basis of the risk-return trade-off. International financial markets
transfer funds across countries. The government regulations in many countries do
not allow foreigners to access funds from those domestic financial markets.
The most important sources of international finance are: Eurocurrency loans,
Eurobonds, and American or Global Depository Receipts (ADRs or GDRs).
Q17. What is Eurocurrency market? How do Eurocurrency loans differ from
Eurobonds?
A17 Most international firms can raise funds from the Eurocurrency markets.
Eurocurrency is any freely convertible currency deposited in banks outside the
country of its origin. Depositors put their savings in banks for short periods. Thus
they hold short-term claims on banks. Banks that make Eurocurrency loans to
international companies for a long period of time use these deposits. Thus the
short-term deposits are transformed into long-term claims on borrowers. Banks
act as intermediaries between the depositors and the borrowers A borrower can
borrow in multiple currencies from the Eurocurrency market and may choose to
make payment of interest and principal in one or more currencies. The
Eurocurrency market is a very large market.
Eurobonds are bonds sold outside the country in whose currency they are
denominated. They are issued directly by borrowers to investors. For example, an
Indian company may issue US dollar-denominated bonds to investors in
Switzerland. Eurobonds may be issued in different currencies. They are known by
the currency in which they are denominated.
Q18. How does the depository receipts methods of raising funds operate? What is an
American Depository Receipt? How is it different from a Global Depository
Receipt?
A18. An indirect method of raising equity capital from foreign markets is to issue
depository receipts. A depository receipt represents number of foreign shares that
are deposited in a bank in the foreign country.

6
American Depository Receipts (ADRs) - A company issues its shares to a reputed
international financial institution in the USA that acts as a depository or the
transfer agent. The depository bundles a specified number of shares as a
depository receipt and issues them to investors in the USA. ADRs can be listed
and traded on the USA stock exchanges. The depository receives dividends from
the issuing Indian firm and then pays it to the depository receipt holders in the
USA. ADRs are denominated in US dollars and ADR investors receive dollar
equivalent dividends.
The Indian firms can also issue Global Depository Receipts (GDRs) in many
other countries. For example, GDRs allow an Indian firm (or any other foreign
firm) to raise funds from the UK, and list and trade GDRs on the London Stock
Exchange. A number of foreign countries also list their GDRs on the Luxembourg
Stock Exchange. Reliance and Grasim were the first companies to issue GDRs in
May and November 1992, respectively.

7
 CHAPTER 35

SHAREHOLDER VALUE AND CORPORATE GOVERNANCE

Q1 Describe the interface between financial policies and corporate strategy.

A1 In practice, financial policy of a company is closely linked with its corporate
strategy. A firm’s strategy establishes an effective and efficient match between its
competences and opportunities and environmental risks. It provides a mechanism
integrating the goals of its multiple constituencies. Financial policies of the firms
should be developed in context of its corporate strategy. Within the overall
framework of the firm’s strategy, there should be consistency between financial
policies—investment, debt and dividend. For example, a firm may be able to
sustain a high-growth strategy only when its investment projects generate high
profits and it follows a policy of low payout and high debt.
Q2 What is sustainable growth rate? What factors determine it?
A2 Sustainable growth may be defined as the annual percentage growth in sales that
is consistent with the firm’s financial policies (assuming no issue of fresh equity).
The following formula can be used to determine the sustainable growth (gs) in
sales:
net margin × retention × leverage
sustainable growth =
assets turnover − (net margin × retention × leverage)
PAT/S× RE/PAT× (1 + D/E)
gs =
NA/S − [PAT/S× RE/PAT× (1 + (D/E))]
p×b×l
gs =
a − ( p × b × l)
Where p = net margin = PAT/sales, b = retention ratio = retained earnings
(RE)/net profit (PAT), l = leverage = net assets (or capital employed) to equity
(net worth) = (1 + D/E), and a = asset-output ratio = net assets/sales.
The net assets to sales ratio determine the requirement of funds to be invested in assets to
support a given level of sales. The requirement for funds would increase with expanding
sales. The net profit minus the dividends is an internal source of funds. Thus, the product
of net profit to sales ratio and retained profit to net profit (net margin × retention ratio)
gives an idea of the funds available internally to support the growth of the firm. Retained
earnings increase the debt raising capacity of the firm. Thus, given the target capital
structure, the total funds would be equal to retained earnings plus debt supported by the
retained earnings [viz. pb (1 + l)]. Net assets or capital employed (viz. debt plus equity) to
equity is a leverage measure, and is equal to one plus debt–equity ratio.
Q3 What is shareholder value analysis? What relationship exists between growth,
economic profitability and the shareholder value?
A3 The value of a firm is the market value of its assets which is reflected in the
capital markets through the market values of equity and debt. Thus, shareholder
value is:
Shareholder value = Market value of the firm – Market value of debt
The market value of the shareholders’ equity is directly observable from the
capital markets. In theory, the market value should be equal the warranted

1
 economic value of the firm. The true economic value of a firm or business or
division or project or any strategy depends on the cash flows and the appropriate
discount rate (commensurate with the risk of cash flows).When the value of a firm
or a business over a planning horizon is calculated, then an estimate of the
terminal cash flows or value (TV) will also be made.
Three most commonly advocated methods of shareholder value creation are as
follows.
The first method, called the free cash flow method, uses the weighted average
cost of debt and equity (WACC) to discount free cash flows. Free cash flows are
calculated as follows:
FCF = PBIT(1 − T) + DEP ± ONCI ± ∆ NWC −CAPEX
PBIT = profit before interest and tax, T = corporate tax rate, DEP = tax
depreciation, ONCI = other non-cash items, ∆NWC = change in net working
capital (i.e. stocks plus trade debtors minus trade creditors), and CAPEX =
incremental investment
The second method calculates the economic value of a firm or business in two
parts: the economic value of unlevered firm and the economic value of the
financing effects. The value of an unlevered firm over its planning period is given
as follows:
n FCFt TVn
Vu = ∑ t
+
t =1 (1 + k )
u (1 + k u ) n
Notice that ku is the cost of capital of an unlevered firm. For the levered firm, the
second part includes the value of interest tax shield (VITS):
n ITS t
VITS = ∑
t =1 (1 + k )
d
Thus, the value of a levered firm or business is:
Value of a levered firm = Value of unlevered firm + Value of interest tax shield
We can obtain the warranted value of shareholders’ equity as the difference
between the economic value of the firm and the claims of debt holders. The value
per share (VPS) can be obtained by dividing the value of shares (E) by the
number of shares (N):
E
VPS =
N
The third method for determining the shareholder economic value is to calculate
the value of equity by discounting cash flows available to equity shareholders by
the cost of equity. The equity cash (ECF) flows will be equal to free cash flow
plus after-tax interest:
Equity cash flows = (PBIT − INT )(1 − T ) + DEP ± ONCI − ∆ NWC −CAPEX
= PBIT(1 - T) + DEP ± ONOCI - ∆NWC - CAPEX - INT(1 - T)
= FCF + INT(1 - T)
Equity cash flows are net of interest charges and investments, and, therefore, at the
corporate level they coincide with dividends. Equity cash flows reflect the expected
growth in future cash flows. At the end of the planning period (the term of investment),
the terminal or residual value of investment will have to be estimated. The economic

2
 value of equity is given by the discounted value of equity cash flows plus the present
value of terminal value.
Q4 Define MVA? How is it calculated? What are its pros and cons?
A4 In terms of market and book values of shareholder investment, shareholder value
creation (SVC) may be defined as the excess of market value over book value.
SVC is also referred to as the market value added (MVA):
Market value added = Market value – invested capital (capital employed
Market value is also referred to as the “enterprise value”. It is the total of the
firm’s market value (MV) of debt and market value of equity. MVA may also be
calculated as the difference between market value of equity and invested equity
capital. Managers must aim at earning higher MVA for shareholders
There is conceptual problem with MVA. Invested capital is at historical value.
Considering the alternative opportunities of equivalent risk, the economic value of
the invested capital would be much higher today. Yet another problem with MVA
is that it ignores cash flows received by shareholders in the form of dividends and
share buyback and cash contributed by them as additional share capital.
Q5 What is economic value added? How is it calculated?
A5 Economic value added, economic profit or residual income is defined as net
earnings (PAT) in excess of the charges (cost) for shareholders’ invested capital
(equity):
Economic value added = PAT - charges for use equity capital
= PAT - cost of equity × equity capital
In a divisionalised company, the separate information about the debt and equity
may not be available. Hence there is a popular alternative way of calculating EVA
in such situations as given below:
Economicvalue added = Net operating profit after tax - charges of invested capital
or capital employed = EVA = NOPAT - COCE
NOPAT is profit after depreciation and taxes disregarding interest on debt.
EVA can be calculated as the difference between ROCE and WACC multiplied
by invested capital or capital employed:
EVA = (ROCE - WACC) × CE
Q6 What are the advantages and disadvantages of economic value added? Is it a
superior method of performance evaluation than return on capital employed?
How?
A6 The advantages of EVA over the market-based and accounting-based measures of
value creation are as follows:
1. EVA can be calculated for divisions and even projects.
2. EVA is a measure that gauges performance over a period of time rather than at
a point of time. EVA is a flow variable and depends on the ongoing and future
operations of the firm or divisions. MVA, on the other hand, is a stock
variable.
3. EVA is not bound by the Generally Accepted Accounting Principles (GAAP).
As we discuss below, appropriate adjustment are made to calculate EVA. This
removes arbitrariness and scope for manipulations that is quite common in the
accounting-based measures.

3
 4. EVA is a measure of the firm’s economic profit. Hence, it influences and is
related to the firm’s value.

From the accounting perspective, a firm is profitable if its return on equity is

positive. However, from an economic perspective, the firm is profitable if the
return on equity exceeds the cost of equity, or return on capital employed exceeds
the over-all cost of the total capital employed.
The EVA approach uses the accounting-based net operating profit after tax while the cost
of capital is market determined. EVA are biased because they use accounting earnings
(NOPAT or PAT) which are based on arbitrary assumptions, allocations and accounting
policy changes. They also do not include changes in working capital and capital
expenditures. Therefore, the measure of EVA is not equivalent to cash flow from
operation, although with adjustments to accounting profit it comes closer to cash flows.
Q7 Define corporate governance. Describe the attributes of a good corporate
governance system.
A7 Corporate governance implies that the company would manage its affairs with
diligence, transparency, responsibility and accountability, and would maximise
shareholder wealth. Hence it is required to design systems, processes, procedures,
structures and take decisions to augment its financial performance and stakeholder
value in the long run.
Good corporate governance requires companies to adopt practices and policies
which comprise performance accountability, effective management control by the
Board of Directors, constitution of Board Committees as a part of the internal
control system, fair representation of professionally qualified, non-executive and
independent Directors on the Board, the adequate timely disclosure of information
and the prompt discharge of statutory duties. In fact, companies are needed to at
least have policies and practices in conformity with the requirements stipulated
under Clause 49 of the Listing Agreement.