Swapnil Patni’s Classes

CA Intermediate – Financial Management

Solve any 3 questions from the following 4 questions
Total Marks – 48

Q 1)
a) India limited requires ₹ 50,00,000 for a new plant. This plant is expected to yield earnings
before interest and taxes of ₹ 10,00,000. While deciding about the financial plan, the company
considers the objective of maximizing Earnings per share.

It has 3 alternatives to finance the project – by raising Debt of ₹ 5,00,000 or ₹ 20,00,000 or ₹

30,00,000 and the balance in each case, by issuing equity shares. The company’s share is
currently selling at ₹ 150, but it is expected to decline to ₹ 125 in case the funds are borrowed
in excess of ₹ 20,00,000. The funds can be borrowed at the rate of 9% upto ₹ 5,00,000, at 14%
over ₹ 5,00,000 and upto ₹ 20,00,000 and at 19% over ₹ 20,00,000. The tax rate applicable to
the company is 40%.

Which form of financing should the company choose? Show EPS amount upto two decimal
points. (8 Marks)
Answer –
We Know that ROCE = EBIT
Capital Employed
= 4,20,000
30,00,000
ROCE = 14.1%

Particulars Scheme I Scheme II Scheme III

Capital Employed 50,00,000 50,00,000 50,00,000

Debt 5,00,000 20,00,000 30,00,000

Equity 45,00,000 30,00,000 20,00,000
( ÷)Market Value 150 150 125
Number of Equity 30,000 20,000 16,000
EBIT 10,00,000 10,00,000 10,00,000
(-) Interest 45,000 2,55,000 4,45,000
EBT 9,55,000 7,45,000 5,55,000
(-) Tax @ 40% 3,82,000 2,98,000 2,22,000
EAT 5,73,000 4,47,000 3,33,000
(÷)Number of Equity 30,000 20,000 16,000
EPS 19.1 22.35 20.8215
Scheme- II is better Option to Opt. Focus on No. of Share & Interest with slab rate.

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b) RES Ltd. is an all equity financed company with a market value of ₹ 25,00,000 and cost of equity
(Ke) 21%. The company wants to buyback equity shares worth ₹ 5,00,000 by issuing and raising
15% perpetual debt of the same amount. Rate of tax may be taken as 30%. After the capital
restructuring and applying MM Model (with taxes), you are required to calculate:
i) Market value of RES Ltd.
ii) Cost of Equity (Ke)
iii) Weighted average cost of capital (using market weights) and comment on it. (8 Marks)
Answer –
i) Market Value of Levered a Firm = Market Value of Unlevered Firm + (Debt X Tax Rate)
= 25,00,000 + ( 5,00,000 X 30%)
= 26,50,000

ii) Cost of Eq. of new Structure = 26,50,000 – 5,00,000

= 21,50,000

iii) Cost of Equity Ke = EAT

Value of Equity
21% = EAT
25,00,0000
EAT = 5,25,000
PROFIT STATEMENT - To know EAT of New Structure

Particulars Pure Equity Debt of Equity

EBIT 7,50,000 7,50,000

(-) Interest - 75,000
EBT 7,50,000 6,75,000
(-) TAX 2,25,000 2,02,500
EAT 5,25,000 4,72,500

Calculation of New Ke = EAT

Eq. value new

= 4,72,500
21,50,000

= 21.97%
Calculation of WACC
Eq. 21,50,000 0.8113 21.97 17.82
Debt 5,00,000 0.1886 15-30% 1.9803
10.5 19.80
WACC = 19.80

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Q 2)
a) Macro Limited wishes to raise additional finance of ₹ 10 lakhs for meeting its investment plans.
It has ₹ 2,10,000 in the form of retained earnings available for investment purposes. Further
details are as following:

(1) Debt / equity mix 30% / 70%

(2) Cost of debt - Upto ₹ 1,80,000 10% (before tax)
- Beyond ₹ 1,80,000 16% (before tax)
(3) Earnings per share ₹4
(4) Dividend pay out 50% of earnings
(5) Expected growth rate in dividend 10%
(6) Current market price per share ₹ 44
(7) Tax rate 50%
You are required:
i) To determine the pattern for raising the additional finance.
ii) To determine the post-tax average cost of additional debt.
iii) To determine the cost of retained earnings and cost of equity, and
iv) overall weighted average after tax cost of additional finance. (8 Marks)

Answer –
Pattern of Raising additional Finance
Equity 70% of ₹ 10,00,000 = ₹ 7,00,000
Debt 30% of ₹ 10,00,000 = ₹ 3,00,000

The capital structure after raising additional Finance

Shareholder’s funds
Equity Capital of ( 7,00,000 - 2,10,000) 4,90,000
Retained Earnings 2,10,000
Debt (Internet at 10% P.a) 1,80,000
Debt (Internet at 16% P.a) (3,00,000 -1,80,000) 1,20,000
Total Funds 10,00,000
Calculation of Cost of Equity
Ke = D1 + g
P0
= (4 × 50% ) + 10% + 10%
44
= 2+ 10% + 10%
44
= 2.2 + 10%
44

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= 5% + 10%
= 15%

Calculation of WACC

Type Amount Weight Cost WACC

Equity 4,90,000 49% 15% 7.35%
Retained Earning 2,10,000 21% 15% 3.15%
Debt 1,80,000 5% 5% 0.9%
Debt 1,20,000 8% 8% 0.96%
12.36%

KH= Ke= (In the absence of Information)

Note - It is assumed that investor is not getting tax benefit an retained earnings.

Conclusion - If the Proposed Investment is giving higher return than 12.36% then Company
should invest.

b) Pooja Ltd. has the following book value capital structure:

Particulars Amount (₹ in cr)

Equity Capital (in shares of ₹ 10 each, fully paid up- at par) 15
11% Preference Capital (in shares of ₹ 100 each, fully paid up- at par) 1
Retained Earnings 20
13.5% Debentures (of ₹ 100 each) 10
15% Term Loans 12.5

The next expected dividend on equity shares per share is ₹ 3.60; the dividend per share is
expected to grow at the rate of 7%. The market price per share is ₹ 40.
Preference stock, redeemable after ten years, is currently selling at ₹ 75 per share.
Debentures, redeemable after six years, are selling at ₹ 80 per debenture.
The Income tax rate for the company is 40%.
Required- Calculate the current weighted average cost of capital using:
i) book value proportions; and
ii) Market value proportions. (8 Marks)

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Answer –

i) Statement showing computation of weighted average cost of capital by using Book value
proportions.

Source of finance Amount Weight Cost of capital Weighted

(Book value) (Book value (%) cost of
(₹ in crores) proportion) (b) capital (%)
(a) (c) = (a)x(b)
Equity capital 15.00 0.256 16.00 4.096
(W.N.1)
11% Preference
1.00 0.017 15.43 0.262
capital (W.N.2)

Retained earnings 20.00 0.342 16.00 5.472

(W.N.1)
13.5% Debentures 10.00 0.171 12.70 2.171
(W.N.3)
15% term loans 12.50 0.214 9.00 1.926
(W.N.4)
58.50 1.000 13.927
ii) Statement showing computation of weighted average cost of capital by using market value
proportions.

Source of finance Amount Weight Cost of Weighted

(₹ in crores) (Market value capital (%) cost of
proportions) (b) capital (%)
(a) (c) = (a) x (b)
Equity capital 60.00 0.739 16.00 11.824
(W.N.1) (1.5 crores x ₹ 40)
11%Preference 0.75 0.009 15.43 0.138
capital (W.N.2) (1 lakh x ₹ 75)
13.5% Debentures 8.00 0.098 12.70 1.245
(W.N.3) (10 lakhs x ₹ 80)
15% Term loans 12.50 0.154 9.00 1.386
(W.N.4)
81.25 1.00 14.593

[Note: Since retained earnings are treated as equity capital for purposes of calculation of cost of
specific source of finance, the market value of the ordinary shares may be taken to represent the
combined market value of equity shares and retained earnings. The separate market values of
retained earnings and ordinary shares may also be worked out by allocating to each of these a

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percentage of total market value equal to their percentage share of the total based on book
value.]

Working Notes (W.N.):

1. Cost of equity capital and retained earnings (Ke)

Ke = D1 + g
P0
Where,
Ke = Cost of equity capital
D1 = Expected dividend at the end of year 1
P0 = Current market price of equity share
g = Growth rate of dividend
Now, it is given that D1 = ₹3.60, P0 = ₹ 40 and g = 7%
Therefore, Ke = ₹ 3.60 + 0.07
₹40
Or Ke = 16%

2. Cost of preference capital (Kp)

PD+ RV – NP
Kp = n
RV + NP
2
Where,
PD = Preference dividend
RV = Redeemable value of preference shares NP = Current market price of preference share
n = Redemption period of preference shares
Now, it is given that PD = 11%, RV = ₹ 100, NP = ₹ 75 and n = 10 years
₹ 11 + ₹ 100 - ₹ 75
Therefore Kp = 10
X 100 = 15.43%
₹ 100 + ₹ 75
2
3. Cost of Debenture( Kd)

I (1- t) RV - NP
Kd = n
RV + NP
2

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Where,
I= Interest payment
t= Tax rate applicable to the company
RV= Redeemable value of debentures
NP= Current market price of debentures
n= Redemption period of debentures

Now it is given that I = 13.5, t = 40%, RV = ₹100, NP = ₹80 and n = 6 year

₹ 13.5 ( 1- 0.40) + ₹ 100 - ₹ 80

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Therefore, Kd = X 100= 12.70 %
₹ 100 + ₹ 80
2
4. Cost of Term loans (Kt)
Kt = r(1-t)
Where, r = Rate of interest on term loans
t= Tax rate applicable to the company
Now, r= 15% and t = 40%
Therefore, Kt= 15% (1 - 0.40) = 9%

Q 3)
a) Calculate the operating leverage, financial leverage and combined leverage for the following
firms and interpret the results:

P Q R
Output (units) Fixed 2,50,000 1,25,000 7,50,000
Cost (₹) 5,00,000 2,50,000 10,00,000
Unit Variable Cost (₹) 5 2 7.50
Unit Selling Price (₹) 7.50 7 10.0
Interest Expense (₹) 75,000 25,000 -
(8 Marks)

Answer –
Firms P Q R
Sale Quantity 2,50,000 Units 1,25,000 Units 7,50,000 Units
Sale Price per unit ₹ 7.50 ₹ 7.00 ₹ 10.00
Less: Variable Costs per unit (₹ 5.00) (₹ 2.00) (₹ 7.50)
Contribution per unit ₹ 2.50 ₹ 5.00 ₹ 2.50
Total Contribution ₹ 6,25,000 ₹ 6,25,000 ₹ 18,75,000
(Qty X Contribution P.u.)

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 Swapnil Patni’s Classes

Less: Fixed Costs (₹ 5,00,000) (₹ 2,50,000) (₹ 10,00,000)

EBIT ₹ 1,25,000 ₹ 3,75,000 ₹ 8,75,000
Less: Interest (₹ 75,000) (₹ 25,000) -
EBIT ₹ 50,000 ₹ 3,50,000 ₹ 8,75,000
DOL = Contribution 5.00 1.67 2.14
EBT
DFL = EBIT 2.50 1.07 1.00
EBT
DCL = DOL X DFL 12.50 1.79 2.14
Inference: Overall Risk of Firm P is the highest while that of Q is the Least.

b) Following information are related to four firms of the same industry :

Firm Change in Revenue Change in Operating Income Change in EPS

M 28% 26% 32%

N 27% 34% 26%
P 25% 38% 23%
Q 23% 43% 27%
R 25% 40% 28%

You are required to calculate –

i) Degree of Operating Leverage and
ii) Degree of Combined Leverage, of all firms (8 Marks)

Answer –
Company M N P Q R
1. Degree of Operating Leverage
Change in EBIT 26% 34% 38% 43% 40%
Change in Sales 28% 27% 25% 23% 25%
= 0.93 = 1.26 = 1.25 = 1.87 = 1.60
2. Degree of Operating Leverage
Change in EPS 32% 26% 23% 27% 28%
Change in Sales 28% 27% 25% 23% 25%
= 1.14 = 0.96 = 0.92 = 1.17 = 1.12

Q 4)
a) XYZ Ltd. requires an equipment costing ₹ 10,00,000; the same will be utilized over a period of 5
years. It has two financing options in this regard :

i) Arrangement of a loan of ₹ 10,00,000 at an interest rate of 13 percent per annum; the loan
being repayable in 5 equal year end installments; the equipment can be sold at the end of

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fifth year for ₹ 1,00,000.

ii) Leasing the equipment for a period of five years at an early rental of ₹ 3,30,000 payable at
the year end.

The rate of depreciation is 15 percent on Written Down Value (WDV) basis, income tax rate is
35 percent and discount rate is 12 percent.

Advise which of the financing options should XYZ Ltd. exercise and why? (8 Marks)

Answer –
A) Buying Option –
Given - Discount Rate = 12%
Interest Rate = 13 %
Tax Rate = 35%
Depreciation Rate = 15%

1) Step 1 – Calculation of Annual Payment

Let, amount of annual payment be X
10,00,000 = X × 3.51723
X = 10,00,000
3.51723
X = 2,84,315

Annual Payment = 2,84,315

2) Step 2 – Schedule of Debt Payment

Year Total Payment Interest Principal Principal Amount Outstanding

1 284315 1,30,000 1,54,315 8,45,685

2 284315 1,09,939 1,74,376 6,71,309
3 284315 87,270 1,97,045 4,74,264
4 284315 61,654 2,22,661 2,51,603
5 284315 32,708 2,51,603 0

3) Step 3 – Calculation of Depreciation

Year Value Depreciation WDV

1 10,00,000 1,50,000 8,50,000
2 8,50,000 1,27,500 7,22,500
3 7,22,500 1,08,375 6,14,125
4 6,14,125 92,118 5,22,007
5 5,22,007 78,301 4,43,706

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4) Step 4 – Calculation of Tax saving on Interest & Depreciation

Year Depreciation Interest Total Total Saving @35%

1 1,50,000 1,30,000 2,80,000 98,000

2 1,27,500 1,09,939 2,37,439 83,104
3 1,08,375 87,270 1,95,645 68,476
4 92,118 61,654 1,53,772 53,820
5 78,301 32,708 1,11,009 38,853

5) Step 5 – Calculation of NPV

Year CFAT Discount factor@12% DCF

1 2,84,315 – 98,000 = 1,86,315 0.8928 1,66,342
2 2,84,315 – 83,104 = 2,01,211 0.7971 1,60,385
3 2,84,315 – 68,476 = 2,15,839 0.7117 1,53,621
4 2,84,315 – 53,820 = 2,30,495 0.6355 1,46,479
5 2,84,315 – 38,853 = 2,45,462 0.5674 1,39,275
5 Pv of Salvage = (1,00,000) 0.5674 (56,740)
NPV (For Buying) 7,09,353

B) Leasing Option :-
1) Step 1 – Calculation of Tax Savings on Lease Amount
Lease Amount = 3,30,000
Tax Saving = 35% Of lease Amount
= 35% × 3,30,00

Tax Saving = 1,15,500

2) Step 2 – Calculation of NPV

Cash Flow = 3,30,000 – 1,15,500
= 2,14,500

PV @12% (for 5 years) = 2,14,500 × 3.6047

NPV = 7,73,224

Conclusion: - Company Should Opt. for Buying Option.

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b) Fair finance, a leasing company, has been approached by a prospective customer intending to
acquire a machine whose Cash Down price is ₹ 3 crores. The customer, in order to leverage his
tax position, has requested a quote for a three year lease with rentals payable at the end of
each year but in a diminishing manner such that they are in the ratio of 3: 2: 1.
Depreciation can be assumed to be on straight line basis and Fair Finance’s marginal tax rate is
35%. The target rate of return for Fair Finance on the transaction is 10%.
Required:
Calculate the lease rents to be quoted for the lease for three years. (8 Marks)

Answer –
1) Step 1 – Capital sum to be placed under lease
If Property Is Given On Lease
How Much Lease Amount will Be Expected = Cost of asset –Depreciation

Year Cash Flow Discounting Factor@10% DCF

0 3,00,00,000 Outflow 1 (3,00,00,000)

1 35,00,000 Inflow 0.9090 31,81,500
2 35,00,000 Inflow 0.8264 28,92,400
3 35,00,000 inflow 0.7513 26,29,550

2,12,96,550

2) Step 2 - If The normal annual lease rent per annum is X then Cash flow will be

Year Post-Tax Cash Flow P.v. of Post- Tax Cash flow

1 3x × (1 – 0.35) 1.95X ×(1÷1.10)=1.7727X

2 2X × (1 – 0.35) 1.3X ×(0.8264) = 1.07432
3 1X × (1 – 0.35) 0.65X ×(0.7513) = 0.488345

3.3354X

Hence 3.3354X = 212.95

X = 212.95
3.3354
= 63.8454 lakhs

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3) Step 3 - Year Wise Lease Rentals

Year Calculations Rs. in Lakhs

1 3 × 63.8454 191.54
2 2 × 63.8454 127.69
3 1 ×63.8454 63.85

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