MFA (Volume 2) by M. Asif, FCA

TABLE OF CONTENTS
(Volume – 2)
Notes + Practice Questions [by M. Asif, FCA]
Beta Version [For Classroom Use Only, NOT for Public Distribution]
Chapter No. Chapter Title Page No.
10 Sources of Finance 1
11 Cost of Finance 1
12 Identifying and Assessing Risk 1
13 Financial Risk Management 1
14 Budgeting 1
15 Working Capital Management 1
16 Introduction to Project Appraisal 1
Model Paper of CAF-6 Managerial & Financial Analysis 1
i
Grid-wise Analysis:
CAF 06: Managerial and Financial Analysis

Grid Chapters Weightage
A. Managerial Analysis 1, 2, 3, 4, 5, 6, 7, 8, 9 30 - 40
B. Financial Analysis and Risk Management 10, 11, 12, 13 30 – 40
C. Budgeting 14, 15, 16 25 - 30
100
ii
Managerial & Financial Analysis – Study Notes Chapter 10: Sources of Finance
CHAPTER 10
SOURCES OF FINANCE
ICAP Book
LO # LEARNING OBJECTIVE Reference
Chapter Paragraph #
#
LO 1 EQUITY 11 Section 2
LO 2 DEBT 11 Section 3
LO 3 ISLAMIC FINANCING 11 Section 4
LO 4 OTHER SOURCES OF FINANCE 11 Section 5

LO 5 DIRECT AND INDIRECT INVESTMENT 11 Section 6
LO 6 FACTORS TO CONSIDER BEFORE SELECTION OF SOURCE 11 Section 1
Page | 1
LO 1: EQUITY:
What is included in Equity:
Equity holder means shareholders or ultimate owner of company.
There are two types of shareholders:

1. Ordinary Shareholder
2. Preference Shareholders
Difference between Ordinary and Preference Shareholders:
Ordinary Shareholder Preference Shareholder

Rate of Dividend Variable Fixed
Payment of After payment to preference
Priority right of dividend
Dividend shareholder
Payment on After payment to preference
Priority right of repayment
Liquidation shareholder
Voting Rights Has voting rights. No voting rights.
Features of Shares:
1. Shareholders earn two types of returns i.e.
o Dividend,
o Change in share price (capital gain)
2. Cost of Equity is higher (as compared to debt), because:
o Dividend is not deductible for tax purposes.
o Risk is high in shares as compared to debt.
3. Shareholders have Pre-emptive right i.e. further shares are first offered to existing
shareholders.
4. Issuance/Floatation cost of equity is high as compared to debt.
Methods of Floatation:
Initial Public Offering (IPO):
Public Offer means shares are offered to general public. Initial Public Offer means when a company
is first time offering its shares to general public.
In an IPO:
 Offer price is decided by company and broker.
 Normally, large amount of shares is acquired by Issuing house (i.e. an investment bank)
which then offers shares to general public.
Private Placement:
Shares are not offered to general public, rather, they are offered to specific investors (usually
institutions) through brokers.
 It is a low cost method as there is no need of marketing, underwriting etc.
 It is suitable for small amount of financing.
 It is popular in Alternative Investment Market (AIM)
AIM is a sub-market of main Stock Exchange that is established to help smaller companies seeking
capital to grow.
Page | 2
Advantages of Placing: (as compared to Introduction)

 Quicker
 Cheaper
 Less disclosure of information
Disadvantages of Placing: (as compared to Introduction)

 Shares are restricted to institutional investors who may get control of company.
Introduction:
In introduction, no new shares are issued to general public. Rather, existing shares are registered
on stock exchange to increase their marketability and public trading so that company can have
better access to capital in future.
Right Issue:
Right issue means issuing new shares to existing shareholders to raise finance. A right issue of “2
for 5” means each investor holding 5 shares will be eligible to buy 2 new shares.
Bonus Issue:
Bonus issue means issuing new shares to existing shareholders without raising any finance.
Company capitalizes its reserves to issue shares. It is normally done when company is not able to
pay cash dividend.
Difference between Right Issue and Bonus Issue:

 In right Issue, cash is received by company. Therefore, assets and liabilities both increase.
 In bonus issue, cash is not received by company. There, assets are not increased. Only
reserve is capitalized.
LO 2: Debt:
Debt:
Debt means borrowing money in exchange for interest.
 Debt may be short term or long term.
 Debt may be redeemable or irredeemable.
Factors influencing choice of debt:

 Availability (some options are available only for certain companies e.g. only listed company
can make public issue of securities)
 Duration (if loan is obtained to finance a project, its repayment should match the life of
project)
 Fixed Rate or Floating Rate

Fixed rate is agreed at start. Floating rate varies during lifetime depending on market rates.
Fixed rate finance is risk-free but may be more expensive
 Security and Covenants

Borrowing power of a company may be limited due to security and covenant requirements
of lender. Security may be either:
o Fixed Charge (on specific assets e.g. land, building), or
o Floating Charge (on entire class of assets e.g. inventory, receivables, machinery)
Page | 3
Advantages and Disadvantages of Debt Financing:
Advantages Disadvantages
 No risk of variation in income
 Liquidator in case of non-
 No voting rights
payment
For Investors  Limited payment in high profits
 Secured
 High risk if unsecured
 Higher ranking of payment on
liquidation
 Security provided
 Payment even in loss or low profits
 Cheaper as tax deductible.
 Liquidator in case of non-payment
 No voting rights
For Company  Higher ranking of payment on
 Limited payment in high profit
liquidation
 Low issuance cost
 Further borrowing power reduced.
 High gearing, high risk.
Gearing is the ratio of Debt to Equity. Higher debt means higher gearing ratio. If company is highly
geared, equity finance will be a better option.
Different Types of Debt Instruments:

Commercial Paper:
These are short-term instruments (with a maturity upto 1 year).
Loan Notes:
These are long-term instruments (with a maturity upto 5 year).
Debenture:
Un-secured long-term loan.
Bond:
Secured long-term loan (with a maturity between 5 – 20 years). There are different types of Bonds
i.e.
1. Deep Discounted Bonds (Bond offered at a large discount on par value)
2. Zero Coupon Bond (Bond offered at zero interest rate. It is offered at discounted rates and
investor earn through higher redemption value)
3. Euro Bond (Bonds issued in a foreign currency. These are named after the currency in
which they are issued e.g. If a bond is issued in dollar in Pakistan, it will be called Eurodollar
Bond.)
Advantages of Zero-Coupon Bonds Disadvantages of Zero-Coupon Bonds

 Not attractive for investor, unless rate of
discount is high.
 No need to repay cash till maturity date.
 Suitable only for those investors who are
 Redemption Price is known, so better
ready to sacrifice periodic return.
planning to repay bond at maturity.
 If investor needs money back before
maturity, he will have to sell.
Page | 4
Market Value of a Debt:

Market Value of a Debt = Present Value of Interest Payments (using Annuity formula) + Present
Value of Redemption Value
Hybrids:
Hybrid is a financial instrument which has features of both Debt and Equity e.g.
 Convertible Bonds (i.e. a bond which gives holder right to convert bond into ordinary shares
on maturity at pre-decided conversion rate)
 Warrants (i.e. a bond which gives the holder right to buy ordinary shares at a set price.
Stock part can be separated from Bond)
Convertible Bonds:
How They Work:
1. Bond is issued with convertible right at agreed rate.
2. Interest is paid periodically.
3. On maturity date, holder has options either to get repayment in cash or to convert it into
ordinary shares. Holder selects option considering Share Price on maturity date.
Conversion Premium:
It is the amount by which Price of a convertible security exceeds the current market value of the
common stock into which it will be converted.
Conversion Premium = Market Price of Bond – [Market Value of Shares * Conversion Ratio]
Conversion Premium is highest in the beginning and zero on maturity.
Market Price of Convertible:

Market Price of Convertible depends on:
1. Interest Rates on Convertibles
2. Maturity Period.
3. Market Expectation of returns.
4. Conversion Value
Advantages and Disadvantages of Convertible Bonds:
 Investors can get control of company.
 Investor can evaluate and choose whether  Future dividends are not taken
For Investors
or not to go for conversion. into account in calculation.
 Possibility of higher gains in long-run
 Suitable when current share prices are
depressed.
 Reduction in control of existing
 Interest is tax-deductible.
shareholders.
For Companies  Fixed interest payments instead of
 Reduction in EPS on conversion.
dividend.
 High-gearing before conversion.
 Delayed equity. EPS not reduced
immediately.
Page | 5
Over-draft and Bank Loan:

Over-draft:
Over-draft is a short-term borrowing from bank upto an agreed limit.
 Overdrafts are repayable on demand.
 Interest is paid only when account is overdrawn.
 It is used to finance day to day operations.
Bank Loan:
Bank Loan is a medium to long term borrowing from bank. Customer borrows a fixed amount from
bank.
 Loan is repayable on maturity or in agreed installments.
 It may be immediately payable if covenants are breached.
 It can also be obtained in foreign currency.
 It is used to finance long-term projects.
Bank Loan Loan Stock (Bond)

Flexibility Terms may vary. Terms are fixed
Information is shared only with Information is shared only general
Confidentiality
bank. public.
Speed Quick Slower
Cost Low cost High issue cost
Restrictions High restrictions and monitoring Low restrictions
Financial information Periodic submission No submission required
Lease:
Finance Lease Operating Lease

Lease Term For major part of asset’s life. Short.
Risks and Rewards of Ownership Transferred to Lessee Remain with Lessor.
Insurance and Maintenance Lessee’s Responsibility. Lessor’s Responsibility.
Option to buy asset Option given to Lessee Option Not given.
Other Short-term Debt Instruments:

Certificate of Deposits (CDs):
 A certificate issued by bank acknowledging that bank has received certain money for certain
time (short-term). It will be repaid after specified term alongwith interest.
 CDs are negotiable and can be traded in money market.
Treasury Bills:
 Treasury bills are issued by Govt. to finance short-term cash requirements (usually for less
than 1 year).
 These are like bonds which are issued by Govt.
Trade Credits:
 Trade credit means delaying payments to suppliers.
Page | 6
Advantages and Disadvantages of Trade Credit:
 Material can be purchased without making
 Credit rating goes down if defaulted.
payment for 30 – 90 days.
 Additional credit is difficult to obtain.
 No interest payment (unless defaulted on
 If defaulted, interest as well as penalty may
due date)
be paid.
 Beneficial in the period of high inflation
LO 3: ISLAMIC FINANCING:
There are two important principles of Islamic Financing:
1. Riba (interest) is prohibited.
2. Speculation (gambling) is prohibited.
Islamic Financing:
1. Murabaḥa:
Murabaha means “contract for sale”. The bank buys some product (e.g. home, car, business
supplies) at the request of a customer and sells it to customer at a ‘cost plus’ price which is known
to parties and remain fixed throughout the contract. Customer makes payment on deferred basis.
Basic Features of Murabaha:

1. Product must be of some value.
2. Product must be in existence at time of contract.
3. Product must be in ownership of seller.
4. Product must be in possession of seller.
5. Price and due date must be certain.
6. Agreement should be Absolute and Certain. It should not be Contingent or Conditional on
anything.
2. Ijara:
Ijarah means "to give something on rent". The bank buys the asset which customer wants to lease,
and then leases to customer for agreed time period against periodically rental payments.
Basic Features of Ijara:

1. Lessor remains the owner of asset. Asset is returned to the lessor at end of term.
2. Risk and rewards remain with Lessor (i.e. he is responsible for repair and maintenance and
insurance).
3. Lease and Sale agreements, both should be separate and non-contingent.
4. Contract can be terminated only with mutual consent of parties.
3. Musharaka:
Musharakah is a kind of partnership where two or more parties contribute capital to a business and
divide the net profit or loss.
Profit is divided in pre-determined ratio, and loss is divided in ratio of contribution.
Page | 7
4. Mudaraba:
Mudaraba is a kind of partnership where one partner provides capital (called rab-ul-maal) and
other partner provides its expertise and management (called mudarib). Loss is borne by the capital
provider only.
There are two types of Mudaraba:

 Unrestrictive:
Working partner is free to make any lawful investment. If unlawful investment is made, he
will be responsible for whole loss.
 Restrictive:
Investor specified investment details and working partner cannot go beyond specified
investments. If unauthorized investment is made, he will be responsible for whole loss.
LO 4: OTHER SOURCES OF FINANCE:

Business Angels:
These are wealthy individuals who invest directly in a small business. Such investors usually do not
get involved in management of company.
Business Angels are a way of financing when company is in start-up phase.
Venture Capital (VC):

These are specialized institutions (e.g. investment banks) who provide capital to small business.
Organization must demonstrate to venture capitalist:

 Feasibility Report, and
 Convincing Business Plan,
 Exit-route (VC typically invest for 3 – 7 years and then realize its profit and exits its
investment).
Suitability of Venture Capital:

 Suitable for management buy-outs
 Suitable for young private companies
 May be suitable for start-ups but this is less likely.
Private Equity Funds:

These funds provide equity to operating companies that are not listed on stock exchange. Such
funds buy large share in mature business.
Such Private Funds:

 Obtain large shares in buy-out transactions, and take control of company by appointing
directors.
 Enhance value of business by removing inefficiencies (e.g. by downsizing) or increasing
growth.
 Realize the profit by selling its share.
Page | 8
Asset Securitization:
Securitization is the process of converting Existing Assets or Future Cashflows into marketable
securities.
 If existing assets are converted into marketable securities, it is called Asset-backed
securitization.
 If future cash flows are converted into marketable securities, it is called future-flows
securitization.
In an Asset Securitization:
1. Company A creates Company B (which is a separate legal entity) and then Company A
transfers some of its Asset to Company B.
2. Company B issues securities to investors showing them those assets and receives cash
against securities.
3. Cash received by Company B is transferred to Company A.
Benefits of Asset Securitization:

 Company is able to convert its non-marketable assets into marketable ones.
 If company’s credit rating is poor but asset is rated high, company is able to gain access to
high rated borrowings.
LO 5: DIRECT AND INDIRECT INVESTMENT:

Meaning of Direct and Indirect Investment:
 Direct Investment:
It means investor owns all or part of an asset. If a company invests in a foreign country (by
buying a company or extending its operations), it is called Foreign Direct Investment.
 Indirect Investment:
It means investor does not own asset, but takes risks and rewards of asset through
vehicles/intermediaries (e.g. mutual funds).
Direct Investment Indirect Investment

Financing can be divided between multiple
Divisibility Required to finance the whole project.
investors.
Liquidity Less liquid More liquid
Holding Long-term Short or Medium term.
Page | 9
LO 6: FACTORS TO CONSIDER BEFORE SELECTION OF SOURCE:

Before selection of source of finance, a company should consider following factors:
1. Amount Required:
e.g. bank may be unwilling to give large amount of loan.
2. Cost of Capital:
(e.g. cost of equity may be higher than cost of debt)
3. Duration:
For working capital requirements, short term financing is considered. For long-term
projects, long term financing is considered.
4. Flexibility:
Flexible source of financing is better e.g. Equity because it is not necessary to pay dividend
each year. However, in case of debt, it is required to pay interest each year even if company
is in loss.
5. Repayment:
Company should carefully project future cash flows to ensure it is able to pay debt/
redeemable securities on time.
6. Impact on Financial Statements:

There should be a balance between debt and equity. An imbalance may give negative
message to readers of financial statements.
Page | 10
Managerial & Financial Analysis – The Practice Kit Chapter 10: Sources of Finance
CHAPTER 10
SOURCES OF FINANCE
QUESTIONS
MULTIPLE CHOICE QUESTIONS
1 Danish Ibrahim is considering a start-up business. He has performed the feasibility of business and is very optimistic about
its future prospects. The business would require the investment of Rs. 5 million for financing capital assets and working
capital. Danish has Rs. 2 million as savings and looking for Islamic mode of financing for the remaining amount. He does not
want any interference from finance provider in making business decisions.
Danish should opt for:

(a) Murabaha
(b) Ijarah
(c) Mudaraba
(d) None of the above (01)
(ICAP, MFA –Model Paper Q.#1(vii))
2 Which TWO of the following justify that equity investment is riskier than investment in the debt capital of the same
company?
(a) Providers of debt capital have a contractual right to collect cash flows
(b) Debt capital generally provides much better return than equity investment
(c) Earnings per share can be volatile
(d) Providers of debt may ask any time to pay the debt in full (01)
(ICAP, MFA – Autumn 2022 Q.#1(iv))
3 The Islamic mode of financing in which the seller expressly mentions the cost of a commodity sold and sells it to another
person by adding mutually agreed profit is called:
(a) Ijarah
(b) Murabaha
(c) Mudaraba
(d) Musharaka (01)
(ICAP, MFA – Autumn 2022 Q.#1(vi))
4 Agha (Private) Limited (APL), a family-owned business, registered as a private company two years ago. The business has
grown exponentially and now Salman CEO, is considering to expand the business by introducing a new product. He has
developed a comprehensive business plan and is looking for source of finance for expansion. Salman is not sure regarding
the tenure the tenure for which finance would be needed as it is highly dependent on how product would perform in the
initial years.
Salman has approached a venture capitalist to finance the expansion of business. The venture capitalist would:
(a) Likely finance the project as APL has excelled in the past two years.
(b) likely finance the project as APL has a comprehensive business plan
(c) Less likely finance the project as there is no clear exit route for venture capitalist
(d) Less likely finance the project as it has only been two years since APL has registered as a private company. (1.5)
(ICAP,MFA – Spring 2022, Q.#1(i))
Page | 1
5 Furqan runs a chain of retail outlets of electronic items (items). Due to economics downturn, the demand for items has
declined significantly. Furqan is considering to sell the items on credit to customers but the wants to charge some additional
profit for allowing the customers to pay later. He is seeking the Islamic mode of financing for these transactions.
Which of the following modes of financing would be most appropriate?

(a) Mudaraba, however, Furqan would need to expressly mention the retail price of the items and the additional profit he
would charge.
(b) Murabaha, however, Furqan would need to expressly mention the cost of items and the additional profit he would
charge.
(c) Musharaka, however, Furqan would need to mutually agree the profit over the cost in the customers.
(d) Credit transactions cannot be financed through Islamic mode of financing as Furqan wants to charge profit over the
retail price. (1.5)
(ICAP,MFA – Spring 2022, Q.#1(ii))
PRACTICE QUESTIONS
Q.1 Explain the key features of the sources of finance listed below. Describe when it might be appropriate to use each of them:
(a) Equity (shares)
(b) Leases
(c) Venture capital
(d) Business angel
(e) Private equity fund
(ICAP Study Self Test Question – 1)
Q.2 (a) Distinguish between direct and indirect investment.

(b) Discuss how the liquidity and holding period for direct and indirect investment might vary
(c) Differentiate between investment and speculation
Q.3 Discuss any three advantages and three disadvantages if a project is financed through debt as against when it is financed
through equity. (03)
(ICAP, Cost Accounting – Autumn 2018 Q.#5a)
Q.4 Discuss the difference between Ijarah and conventional lease.

Q.5 Explain types of Modarba mode of Islamic financing.

Q.6 Discuss the principles of sale under Morabaha mode of Islamic financing.
Page | 2
Q.7 Agha Limited (AL), a family owned business, is considering expanding its operations. The expansion would require the
finance amounting Rs. 50 million. Agha Junaid, CEO, has proposed to finance the expansion through a bank loan as he
believes that financing through equity shares outside the family would mean sharing the decision making power in the
board meetings and AL is not ready to compromise on that.
Fauzia Agha, Finance Director, mentioned that AL’s bank is offering loan on strict terms and conditions thereby increasing
the future compliances. She has proposed that AL should finance through issue of equity shares. She believes that new
shareholders would only have stake of 10% in shareholdings of AL and therefore, have barely any say in decision making.
Required:
(a) Evaluate the proposals of CEO and Finance Director.
(b) Recommend how AL may finance the expansion. (08)
(ICAP, MFA –Model Paper Q. # 6)
Q.8 Discuss any four factors that a company may need to consider before deciding on whether to finance the expansion by
issuing new shares or convertible bonds. (04)
(ICAP, MFA – Autumn 2022 Q.# 9c)
Page | 3
SUGGESTED SOLUTIONS
SUGGESTED SOLUTIONS
MCQ # Correct Option MCQ # Correct Option MCQ # Correct Option
1 d 3 b 5 B
2 a&c 4 c
PRACTICE QUESTIONS
A.1 (a) Equity (Shares):

Equity financing involves raising money by selling shares of the company to investors. Those who purchase shares
become owners of the company and are entitled to company's profits, typically in the form of dividends.
Key features:
 No obligation to repay the amount raised (as in a loan).
 Investors have a right to share in the company's profits.
 Shareholders have a say in company decisions.
When to use:
Equity financing is typically used when a company needs a large amount of funding, and when there is a potential for high
return for investors. This is common in high-growth sectors.
(b) Leases:
Leasing involves obtaining the use of assets (like machinery, vehicles, or property) in return for regular rental payments.
The leasing company retains ownership of the asset.
Key features:
 Allows use of an asset without buying it immediately.
 Leasing expenses are generally tax-deductible.
 Leasing companies often handle maintenance and repairs.
When to use:
Leasing can be a good option when the business needs certain equipment or property but doesn't want to tie up capital in
buying them, especially when the equipment is prone to becoming obsolete quickly.
(c) Venture Capital:

Venture capital is a form of private equity financing that is provided by venture capital firms to startups and early-stage
companies that have been deemed to have high growth potential.
Key features:
 Large amounts of funding are often available.
 Venture capitalists often bring experience, strategic guidance, and networking opportunities.
 In return, venture capitalists require equity in the company, often substantial amounts.
When to use:
Venture capital is often used by startups that need a lot of capital to get off the ground and that can present a high-risk,
high-reward to the venture capitalists.
Page | 4
(d) Business Angel:

Business angels (or angel investors) are affluent individuals who provide capital for a business start-up, usually in
exchange for convertible debt or ownership equity.
Key features:
 Investors often bring their business experience and network.
 Angel investors often invest at an earlier stage than venture capitalists.
 They can offer more favorable terms than other lenders, as they are investing in the person as well as the
business.
When to use:
Business angel financing is typically used by early-stage startups that may not yet qualify for venture capital but show
promising potential.
(e) Private Equity Fund:

A private equity fund is a collective investment scheme used for making investments in various equity securities
according to one of the investment strategies associated with private equity.
Key features:
 Private equity typically involves a longer-term investment strategy with the aim of maximizing a company's
value through management improvements or strategic acquisitions.
 Private equity funds often buy out entire companies, using both their funds and borrowed money.
 They typically exit the investment after a few years by selling the company or taking it public.
When to use:
Private equity is usually employed when a company has grown to a significant size and demonstrated profitability but is
looking to get to the next level. It's also used in turnaround situations, where a company needs significant management
and operational improvements.
A.2 (a) Direct vs. Indirect Investment:

Direct investment refers to the purchase of assets or shares in a business, leading to a degree of control or influence over
the company. This can include starting a new business, buying an existing business, or taking a controlling interest in a
business.
Indirect investment, on the other hand, involves buying units in a collective investment vehicle, like a mutual fund or
exchange-traded fund (ETF), which in turn holds a portfolio of assets. The investor doesn't have control or influence over
these underlying assets.
(b) Liquidity and Holding Period:

Direct investments, such as buying a business or real estate, are generally less liquid as they cannot be sold quickly
without potentially taking a significant discount to their value. The holding period for these investments is typically
longer as these assets often take time to realize their full value.
Indirect investments, like shares in a mutual fund or ETF, are typically more liquid as they can be bought and sold on a
market quickly and easily. The holding period for these investments can be shorter, as investors can move in and out of
positions to adjust their portfolio based on market conditions.
(c) Investment vs. Speculation:

Investment involves purchasing an asset with the expectation that it will generate an acceptable rate of return over time,
typically through interest, income, or appreciation in value. Investments are made after careful analysis of the underlying
asset's value and potential for return.
Speculation, on the other hand, involves buying an asset with the hope that it will increase in price quickly, regardless of
its underlying value. Speculators aim to profit from short term price fluctuations. While potential returns can be high, so
too is the risk of loss.
Page | 5
A.3 Advantages of Debt Financing:

1. Tax Deductions:
The interest paid on debt can often be deducted from the company's taxable income, effectively reducing the
cost of the debt.
2. No Dilution of Ownership:
Debt financing does not dilute the ownership of the company's current owners or shareholders, as would be the
case with equity financing.
3. Retained Profits:
In debt financing, all profits after the debt repayment belong to the company, which is not the case in equity
financing where profits need to be shared with equity investors.
Disadvantages of Debt Financing:

1. Repayment Obligation:
Regardless of the company's financial performance, debt must be repaid according to the agreed-upon schedule.
This can put pressure on cash flow, especially in downturns.
2. Interest Payments:
Debt requires regular interest payments, which could be higher depending on the creditworthiness of the
company or the prevailing market interest rates.
3. Collateral Requirement:
Most debt financing requires some form of collateral. If the company fails to repay the loan, the lender can claim
the collateral.
Advantages of Equity Financing:

1. No Repayment Obligation:
Unlike debt, equity does not need to be repaid. This can provide a company with more financial flexibility.
2. No Interest Payments:
Equity does not require regular interest payments, which could be beneficial for companies that have volatile
cash flows.
3. Additional Resources:
Equity investors often provide more than just money. They can bring valuable industry contacts, expertise, and
credibility to the company.
Disadvantages of Equity Financing:

1. Dilution of Ownership:
Equity financing results in the dilution of current owners' stake in the company, which means sharing more of
the profits and losing some control over the company's decisions.
2. Costly:
Raising equity can be expensive, considering fees for lawyers, accountants, and investment bankers.
3. Disclosure of Information:
Companies that go for equity financing may need to disclose more information to investors, which may be used
by competitors to their advantage.
Examiners’ Comments:
Performance was good as most of the students were able to mention the advantages and disadvantages of financing a project
through debt as compared to equity.
Marking Plan:
• 0.5 mark for each advantage/disadvantage, if project is financed through debt

3.0
finance as against when it is financed through equity
.
Page | 6
A.4
Ijarah (Islamic Lease) Conventional Lease
In Ijarah, the lessor bears all the ownership risks. If
In a conventional lease, lessees may have to bear
Ownership any loss occurs that's not due to misuse or
the cost of losses or damages to the leased asset,
Risks negligence by the lessee, the lessor will bear the
depending on the lease agreement.
loss.
Under Ijarah, the lessor is generally responsible for In a conventional lease, the maintenance and
Maintenance
major maintenance and insurance of the asset, insurance responsibilities can be shifted to the
and Insurance
unless otherwise specified in the contract. lessee, depending on the terms of the agreement.
In Ijarah, the usage of the leased asset must comply
with Sharia law, and the asset must be clearly In a conventional lease, the asset can be used for
Usage of Asset specified in the contract. The lessee cannot use the any purpose agreed upon in the contract, with no
asset for activities considered Haram (prohibited) religious restrictions.
in Islam.
In a conventional lease, the lease payments may
Rental In Ijarah, the lease payments begin when the lessee begin as soon as the lease contract is signed,
Payment takes delivery of the asset and it is available for use. regardless of whether the lessee has received or
begun to use the asset.
In an Ijarah contract, there's a separate agreement
In a conventional lease, there may be an option
Purchase of (Ijarah wa-Iqtina) if the lessee wants to purchase
for the lessee to purchase the asset at the end of
Asset the asset at the end of the lease period. The
the lease period as part of the same agreement.
purchase is not a condition in the lease contract.
A.5 Restrictive Mudaraba:

In this type of Mudaraba, the provider of the funds (Rab-ul-Mal) specifies a particular business or a particular place for the
manager (Mudarib) to work. The Mudarib must adhere to these specified conditions.
Unrestrictive Mudaraba:
Here, the Rab-ul-Mal gives the Mudarib freedom to undertake whatever business he deems fit at any location. The Mudarib
has broad discretion in managing the provided funds, within the bounds of Shariah law.
A.6
1. Product must be of some value.
2. Product must be in existence at time of contract.
3. Product must be in ownership of seller.
4. Product must be in possession of seller.
5. Price and due date must be certain.
6. Agreement should be Absolute and Certain. It should not be Contingent or Conditional on anything.
A.7 (a)
Agha Junaid (CEO) Proposal:
Junaid's proposal centers on retaining control within the family business by avoiding the issuance of equity shares to
external stakeholders. Taking on debt, in the form of a bank loan, will indeed allow the family to maintain its ownership
and control. However, there are several issues with this approach:
1. Increased Financial Risk:
Borrowing increases a firm's financial risk as the company must meet its repayment obligations regardless of its
profitability. If the expansion doesn't generate the expected return, AL might have difficulty repaying the loan.
2. Interest Costs:
Borrowing money requires paying interest, which can erode profits.
3. Strict Terms and Conditions:

As Fauzia mentioned, the bank is offering the loan under strict terms and conditions. This could mean a high
interest rate, restrictive covenants, or demanding repayment terms.
Page | 7
Fauzia Agha (Finance Director) Proposal:

Fauzia proposes to issue equity shares to finance the expansion. This plan has its advantages and disadvantages:
1. No Obligation to Repay:
Unlike a loan, equity financing does not have to be repaid. This can be particularly beneficial if the company
encounters financial difficulties or if the expansion plans do not provide the expected returns.
2. No Interest Costs:
Equity financing does not incur interest costs, leaving more of the company's future earnings available to invest
back into the business.
3. Dilution of Ownership and Control:

Issuing equity shares will dilute the family's ownership. Even though the new shareholders would only have a
10% stake, they might still have some influence in decision-making, especially if they are institutional investors
with significant financial knowledge and resources.
(b) Recommendation:
The optimal source of financing will depend on AL's specific circumstances. Here are some considerations:
1. Balanced Approach:
A combination of both debt and equity could be considered. This would dilute ownership less than a full equity
issue and reduce the financial risk compared to full debt financing.
2. Alternative Debt Financing:

If the terms of the current bank loan are too onerous, AL could consider other debt financing options. This might
include a loan from a different bank, or issuing bonds.
3. Non-Traditional Equity Financing:

If AL decides to go for equity financing, it can consider strategic investors who are less likely to interfere in
operations or day-to-day management. This could include private equity investors.
A.8 Following are four factors that a company may need to consider before deciding on whether to finance the expansion by
issuing new shares or convertible bonds:
1. Cost of Capital:
The company must consider the cost of each financing method. Issuing shares might not incur any interest costs
but can dilute earnings per share, while convertible bonds require interest payments but offer the possibility of
conversion to equity in the future.
2. Dilution of Ownership:
If the company is concerned about maintaining control, they may prefer convertible bonds. While these can
potentially convert to equity, they initially allow the company to avoid the immediate dilution of ownership that
comes with issuing new shares.
3. Market Conditions:
If the equity market is bullish, it might be more advantageous to issue new shares as investors may be more willing
to invest, potentially at a premium. Conversely, in a bearish market, issuing convertible bonds might be more
attractive.
4. Financial Flexibility:
Convertible bonds offer more financial flexibility as they provide an immediate influx of cash while giving the
company the option to convert them into equity later. This can be useful if the company's financial situation or
market conditions change.
Page | 8
Managerial & Financial Analysis – Study Notes Chapter 11: Cost of Capital/Finance
CHAPTER 11
COST OF
CAPITAL / FINANCE
ICAP Book
Chapter Paragraph #
PART A: INTRODUCTION: #
LO 1 MEANING OF CAPITAL AND COST IN FINANCE 12 Section 1
LO 2 WHY COST OF CAPITAL IS CALCULATED 12 N/A
LO 3 WEIGHTED AVERAGE COST OF CAPITAL 12 Section 4
PART B: CALCULATING COST:
LO 4 COST OF BANK LOAN 12 3.2 Part
COST OF IRREDEEMABLE/PERPETUAL
LO 5 12 3.3
DEBENTURES/BONDS
LO 6 COST OF REDEEMABLE DEBENTURES/BONDS 12 3.4, 3.4
LO 7 COST OF IRREDEEMABLE PREFERENCE SHARES 12
3.5
LO 8 COST OF REDEEMABLE PREFERENCE SHARES 12
LO 9 COST OF EQUITY 12 Section 2
PART C: YIELD CURVE:
LO 10 YIELD CURVE 12 Section 5
APPENDIX
APX 1 OBJECTIVE TYPE QUESTIONS
APX 2 ANSWER KEY TO PRACTICE QUESTIONS
Page | 8
PART A – INTRODUCTION
LO 1: MEANING OF CAPITAL AND COST IN FINANCE:

Capital:
Definition of “Capital” in Finance is different from what you learnt in Accounting.
In financial management, Capital means any source of finance (whether from owner or from third
parties) which can be used to run business.
There are two types of Capital in finance i.e.

 Long-term Capital (Capital)
 Short-term Capital (Working Capital)
Long-term Capital will be discussed in this chapter. Short-term Capital will be discussed later.
Sources of Long-term Capital:
Following are different sources of Capital/Finance:

1. Bank Loan
2. Irredeemable Debentures/Bonds
3. Redeemable Debentures/Bonds (Non-Convertible, or Convertible)
4. Irredeemable Preference Shares
5. Redeemable Preference Shares
6. Equity Shares
Shares and Debentures may have Market Value (if they are traded in market). However, there is no
market price of a bank loan.
Page | 9
Cost of Each Component:
Cost means return (in %age) which should be paid to capital providers. Each source of Capital has
different cost.
Source Cost
1. Bank Loan  Interest Rate * (1 – Tax Rate)
2. Irredeemable  Interest Rate * (1 – Tax Rate)

Debentures/Bonds [Interest Rate = Interest Amount/Market Value]
3. Redeemable
 Internal Rate of Return (using after-tax interest payments)
Debentures/Bonds
4. Irredeemable
 Dividend/Market Value of Share (ex-dividend)
Preference Shares
5. Redeemable
 Internal Rate of Return (without tax adjustment)
Preference Shares
There are three methods to calculate cost of equity shares i.e.

 Capital Asset Pricing Model (CAPM)
6. Equity Shares
 Dividend Valuation without Growth
 Dividend Valuation with Growth
Notes:
 In case of Interest, Cost is calculated on after-tax basis.
 IRR is also called “Effective Rate” or “Yield to Maturity”.
Cost of Capital:
Cost of Capital of a Firm is the Weighted Average Cost of its all components of Capital (called
WACC).
WACC = [Cost of Equity * Weight] + [Cost of Debt * Weight]. + [Cost of Bank Loan * Weight]
Study Tips
1. Formula for Redeemable Securities is different from Irredeemable, because Redeemable Securities can be
issued and redeemed at Premium/Discount which may increase/decrease their cost.
2. Formula for Debentures is different from Shares because Interest is Tax-deductible but Dividend is NOT.
Page | 10
LO 2: WHY COST OF CAPITAL IS CALCULATED:

WACC is used in making Investment Decision.
To maximize shareholders’ wealth managers must make only those investments:

1. whose Return on Investment (IRR) is more than their Cost i.e.
Return on Investment (in %age) > WACC (in %age). , or
2. whose NPV (using WACC as discount factor) is positive.
LO 3: WEIGHTED AVERAGE COST OF CAPITAL:

Following is Capital Structure of a Company, alongwith its Cost. Note, how WACC is calculated.
Cost of Weighted Average

Component/Source of Finance Weight of Component
Component Cost of Component
Bank Loan (5 million) 6% 10% (i.e. 5 million / 50 million) 0.60%
Debentures (10 million) 8% 20% (i.e. 10 million / 50 million) 1.60%
Preference Shares (15 million) 10% 30% (i.e. 15 million / 50 million) 3.00%
Equity (20 million) 12% 40% (i.e. 20 million / 50 million) 4.80%
Weighted Average Cost of Capital (WACC) 10.00%
PART B – CALCULATING COST
LO 4: COST OF BANK LOAN:
Cost of Bank Loan (KD)= Rate of Interest * (1 – T)
PRACTICE QUESTION
Q. 1
Calculate the after-tax cost of debt under each of the following conditions:
(a) Interest rate of 13%, tax rate of 0%
(b) Interest rate of 13%, tax rate of 20%
(c) Interest rate of 13%, tax rate of 35%
Q. 2
A company takes out a bank loan. The bank charges interest at 10%. Tax rate is 30%.
What is the cost of this loan to company?
(ICAP CAF 06 Study Text: Chapter 12 – Example)
Page | 11
LO 5: COST OF IRREDEEMABLE/PERPETUAL DEBENTURES/BONDS:
Cost of Irredeemable Debentures (KD): = ID (1 – T)/PD
ID = Interest on Debenture in rupees.

PD = Price of Debenture in rupees.
How to Calculate Price/Value

If you are given Cost of Irredeemable Security, you can calculate its Price/ Value using same formula.
PRACTICE QUESTION
Q. 3
The coupon rate of interest on a company’s irredeemable bonds is 6% (face value: Rs. 100) and the market value of the
bonds is 103.60. The tax rate is 25%.
Required: Calculate Cost of bond.
(ICAP Book: Chapter 12 – Example)
LO 6: COST OF REDEEMABLE DEBENTURES/BONDS:

Cost of Redeemable Debentures (KD) = IRR (using after tax cash flows).
How to Calculate Internal Rate of Return (IRR):

Trial and Error Method:
1. Calculate NPV at lower rate = Cash flow at Y1 / (1+i)1 + Cash flow at Y2 / (1+i)2 + Cash flow
at Y2 / (1+i)2 + and so on …….. – Initial Market Value (e.g. 8,638 @ 8%)
2. Calculate NPV at higher rate = Same calculation as in “1” using different rate. (e.g. – 5,358 @
12%)
3. Intraplate Result
IRR = Lower Rate + NPV at lower rate /(NPV at lower rate – NPV at higher rate) * (Difference in Rates)
8% + 8,638/ (8638+5,358) * 4 % = 10.47%
Tip: Lower discount rate will increase NPV of project, and vice-versa.
Page | 12
Convertible Debentures/Bonds:
 Convertible Debentures/ are those debentures which can be converted into Shares at
maturity.
 In case of Convertible Bond, then higher of Redemption Value or Conversion Value will be
taken as Terminal value.
Point to Note:
 If a redeemable instrument is issued at par and redeemed at part, its Coupon Rate (tax adjusted) will be its cost.
[No need to calculate IRR in this situation].
PRACTICE QUESTION
Q. 4
A company has issued 12% bonds (face value: Rs. 100) that are due to be redeemed at a premium of 5% in four years’
time. The tax rate is 20% and the post-tax cost of debt is 8%.
Required: Calculate the total market value of bonds.
Q. 5
The current market value of a company’s 7% loan stock (face value: Rs. 100) is 96.25. Annual interest has just been paid.
The bonds will be redeemed at par after four years. The rate of taxation on company profits is 30%.
Required: Calculate the after-tax cost of the bonds for the company.
(Hint: Use 5% and 6% discount rates to estimate IRR).
Q. 6
The current market value of a company’s 7% convertible debenture (face value: Rs. 100) is Rs.108.70. Annual interest has
just been paid. The debenture will be convertible into equity shares in three years’ time, at a rate of 40 shares per
debenture.
The current ordinary share price is Rs.3.20 and the rate of taxation on company profits is 30%.
Required: Calculate the cost of the bonds for the company. (Hint: Use 9% and 10% discount rates to estimate IRR).
LO 7: COST OF IRREDEEMABLE PREFERENCE SHARES:
Cost of Irredeemable Preference Shares (KPS): = DPS /PPS
DPS = Dividend Per Share in rupees,

PPS= Price of share in rupees
PRACTICE QUESTION
Q. 7
Duggins Veterinary Supplies can issue perpetual preferred stock at a price of $50 a share with an annual dividend of $4.50 a
share. What is the company’s cost of preferred stock, Kps?
Page | 13
LO 8: COST OF REDEEMABLE PREFERENCE SHARES:
Cost of Redeemable Preference Shares (KPS): = Internal Rate of Return i.e. IRR
Exam Tips: Value/Price of a Redeemable Share or Debenture

Value of a Redeemable Share or Debenture is “Present Value of its Cash Flows” using Required Rate of Return.
PRACTICE QUESTION
Q. 8
A company has issued 7% Preferred Shares of Rs. 100 face value. These preference shares will be redeemed at par after
four years. Market Value of these preference shares is Rs. 96.25.
Calculate Cost of Preferred Shares.
Q. 9
A company has issued 12% Preferred Shares of Rs. 100 face value. These preference shares will be redeemed at premium
of 5% after four years. Market Value of these preference shares is Rs. 108.97.
Calculate Cost of Preferred Shares.
LO 9: COST OF EQUITY:
There are three methods to determine Cost of Equity namely:
1) Capital Asset Pricing Model
2) Dividend Valuation Model without Growth
3) Dividend Valuation Model with Growth
Capital Asset Pricing Model:

CAPM is based on the theory that expected return on equity should be based on Systematic Risk it
faces. i.e. Cost of Equity = Risk Free Rate + Premium for Systematic Risk
Symbolically,
KE = KRF + βE * [KM – KRF] .
Where:
KM = Required Rate of Return on Market
KRF = Risk Free Rate i.e. Rate on long-term Govt./Treasury Bonds
KM – KRF = Market Risk Premium
βE = Measure of systematic risk of the company (it includes both Business Risk and Financing Risk).
Page | 14
Dividend Valuation Model/DCF Model:
Model Formula
Without Growth (assuming g = 0) Ke = D0 / P0
Gordon’s Growth Model Ke = (D1 / P0) + g
Where:
P0 = Market Value or Price of Share Today (Ex. Div.)
D0 = Today’s Divided (i.e. dividend just paid, or to be paid shortly).
D1 = Expected Dividend next year. It is also calculated as D0 (1 + g) where D0 is Dividend recently
paid.
Ke = Required Rate of Return
g = growth rate. This rate can be calculated by:
 Extrapolation of Historical Growth: End Price = Start Price * (1+g)n
 Using Return on Equity (or Cost of Equity): Growth Rate (g) = ROE * Retention Rate
PRACTICE QUESTION
Q. 10
A company’s shares are currently valued at Rs.8.20 and the company is expected to pay an annual dividend of Rs.0.70 per
share for the foreseeable future.
Required: Calculate cost of equity.
Q. 11
A company’s share price is Rs.8.20. The company has just paid an annual dividend of Rs.0.70 per share, and the dividend
is expected to grow by 3.5% into the foreseeable future. The next annual dividend will be paid in one year’s time.
Required: Calculate cost of equity.
Q. 12
A company has recently paid a dividend Rs. 3 per share and the dividend is expected to grow by 5% into the foreseeable
future. The next annual dividend will be paid in one year’s time. The shareholders require an annual return of 12% from
investment in this company.
Required: Calculate market value (or Price) of each equity share.
Q. 13
A company has paid out the following dividends in recent years:
Year Dividend
20X1 100
20X2 110
20X3 120
20X4 134
20X5 148
Required: Calculate average growth rate.
Q. 14
A company has just achieved annual earnings per share of Rs.50 of which 40% has been paid in dividends and 60% has
been reinvested as retained earnings.
The company is expected to retain 60% of its earnings every year and pay out the rest as dividends. The cost of equity
capital is 8%.
Required: Calculate market value (or Price) of each equity share.
Page | 15
Q. 15
The rate of return available for investors on government bonds is 4%. The average return on market investments is 7%.
The company’s equity beta is 0.92.
Required: Calculate cost of equity using CAPM Model.
LO 10: YIELD CURVE:

Bond Valuation using Required Rate of Return:
Earlier we have learnt that:
1. Market value of a Bond can be calculating by calculating Present Value of Future Cashflows
using Required Rate of Return.
2. If Market Value is given, we can calculate its IRR using interpolation formula (i.e. higher rate
– lower rate formula).
Points to Remember:
 IRR is also known as Lenders’ Required Rate of Return, or Cost of Debt (Pre-tax), Gross Redemption Yield, or Yield
to Maturity.
Introduction to Yield Curve:

Different types of debt have different costs. Cost of debt depends on:
 Length of borrowing [Cost of long-term debt is usually high]
 Whether it is secured or unsecured [Cost of unsecured debt is usually high].
Yield Curve:
Yield Curve shows the relationship between Length of borrowing and Interest Rate. This plots the
required rates of return (Yields) against maturity.
Yields used in Yield Curve are:

 Pre-tax
 Risk-Free (e.g. yields on Govt. Bonds)
Shape of Yield Curve:

 Normal Yield Curve slopes upward/positive, because interest yields are normally higher for
longer term.
 In exceptional circumstances (when interest rates are expected to fall in future), Yield Curve
slopes downward/negative/inverse.
Positive Yield Curve Negative Yield Curve
Page | 16
Bond valuation using the yield curve:

If we are given Yield Curve (i.e. a Table of different maturity periods, and different yield rate for each maturity) and
are required to calculate Market Value of Bond, then:
Market Value = PV of cashflows using respective discount rate for each year (given in yield curve).
If we are also required to calculate Cost of Bond, then it will be calculated in usual way i.e. we can
calculate its IRR using interpolation formula (using market value as above).
Estimating the Yield Curve:

Yield Curve (i.e. Yield rate for each year) is estimated in following three steps:
1. Calculate the effective rate of return for 1-year maturity:

a. By discounting cash flows of Year 1 using Unknown rate.

a. By discounting cash flows of Year 1 with effective rate of Year 1.
b. By discounting cash flows of Year 2 using Unknown rate.

a. By discounting cash flows of Year 1 with effective rate of Year 1.
b. By discounting cash flows of Year 2 with effective rate of Year 2.
c. By discounting cash flows of Year 3 using Unknown rate.
Points to Remember:
 If you are given Yield Rates of Bonds with different maturity, you can calculate Market Value and then IRR of a
Bond.
 If you are given Coupon Rates of Bonds with different maturity, you can calculate Yield Rates for each year through
Bootstrapping (i.e. by calculating effective rate for each year step by step).
PRACTICE QUESTION
Q. 16
A company has issued a bond that will be redeemed in 4 years. The bond has a nominal interest rate of 6%.
Required:
Calculate what the market value of the bond would be if the required rate of return was 5% or 6% or 7%.
Q. 17
A company wants to issue a bond (with face value of Rs. 100) that is redeemable at par in four years and pays
interest at 6% of nominal value.
The annual spot yield curve for a bond of this class of risk is as follows:
Maturity Yield
One year 3.0%
Two years 3.5%
Three years 4.2%
Four years 5.0%
Required:
(a) Calculate the price that the bond could be sold.
(b) Use the above price to calculate the gross redemption yield of Bond (yield to maturity, cost of debt).
Page | 17
Q. 18
There are three bonds in issue for a given risk class, with face value of Rs. 100 each. All three bonds pay interest
annually in arrears and are to be redeemed for par at maturity.
Relevant information about the three bonds is as follows:

Bond Maturity Coupon rate Market value
A 1 year 6.0% 102
B 2 years 5.0% 101
C 3 years 4.0% 97
Required:
Construct the yield curve that is implied by this data.
Page | 18
APX 1: ANSWER KEY TO PRACTICE QUESTIONS:

Q. 1
(a) 13.0 %.
(b) 10.4 %.
(c) 8.45 %.
Q. 2
7%
Q. 3
The after-tax cost of the bonds is 6 (1 – 0.25)/103.60 = 0.043 or 4.3%.
Q. 4
Market Value is the Present Value of its Cash Flows i.e. Rs. 31.80 (Present Value of After tax Interest Payments) + Rs. 77.18
(Present Value of Maturity Payment) = 108.98
Q. 5
At 5% discount rate, PV is 99.66 and NPV is +3.41.
At 6% discount rate, PV is 96.18 and NPV is -0.07.
IRR using interpolation is 5.98% (approximately).
Q. 6
Cost of Bond assuming Conversion:
At 9% discount rate, PV is 111.22 (=12.40 + 98.82) and NPV is +2.52.
At 10% discount rate, PV is 108.32 (=12.19 + 96.13) and NPV is -0.38.
IRR using interpolation is 9.9% (approximately).
Cost of Bond assuming Redemption:

IRR using interpolation is 0.70% = 9% + (-19.08/-19.08+21.38) * 1%.
Hence Cost of bond of company is higher of 9.9% and 0.7% i.e. 9.9%.
Q. 7
9%.
Q. 8
NPV @ 10% = 22.19 + 68.30 = 90.49 – 96.25 = -5.76
NPV @ 8 % = 23.19 + 73.50 = 96.69 – 96.25 = +0.44
IRR = 8% + 0.44/(0.44 + 5.76) * (10% - 8% ) = 8.14%
Q. 9
NPV @ 10% = 109.46 (38.04 + 71.42) – 108.97 = + 0.49
NPV @ 15 % = 94.29 (34.26 + 60.03) – 108.97 = - 14.68
IRR = 10% + 0.49/(0.49 + 14.68) * (15% - 10% ) = 10.16
Q. 10
(0.70/8.20) = 0.085 or 8.5%.
Q. 11
= [0.70 * 1.035/8.20] + 0.035 = 0.123 or 12.3%
Q. 12
Market Value = 3 * 1.05 / (0.12 – 0.05) = 3.15/0.07 = Rs. 45
Page | 19
Q. 13
148 = 100 (1+g)^4 – 1 i.e. g = 0.103 or 10.3%
Q. 14
The current annual dividend is 40% x Rs.50 = Rs.20.
The anticipated annual growth in dividends = br = 60% × 8% = 4.8% or 0.048. the expected value per share is: d(1 +g)/re
-g = Rs.20 (1.048)/0.08 - 0.048 = Rs. 655
Q. 15
4% + 0.92 (7 – 4)% = 6.76
Q. 16
MV @ 5% = 6/(1.05)1 + 6/(1.05)2 + 6/(1.05)3 + 6/(1.05)4 + 100/(1.05)4 = 103.54
MV @ 6% = 6/(1.06)1 + 6/(1.06)2 + 6/(1.06)3 + 6/(1.06)4 + 100/(1.06)4 = 100.00
MV @ 7% = 6/(1.07)1 + 6/(1.07)2 + 6/(1.07)3 + 6/(1.07)4 + 100/(1.07)4 = 96.62
Q. 17
(a)
To calculate the price of bond using Yield Curve, we will have to calculate Present Value of cash flows using separate rate
for each year i.e.
Price = 6/1.031 + 6/1.0352 + 6/1.0423 + 106/1.054 = 103.936
(b)
To calculate gross redemption yield of Bond, we will calculate IRR taking Market Value of Bond as Rs. 103.936.
NPV @ 6% = 6/1.061 + 6/1.062 + 6/1.063 + 106/1.064 – 103.936 = – 3.936

NPV @ 5% = 6/1.051 + 6/1.052 + 6/1.053 + 106/1.054 – 103.936 = – 0.394
5% - 0.394/ (-0.394+3.936) * 1 % = 4.88%
Q. 18
To calculate Yield Curve, we will calculate Effective Rate of 1 Year Bond:

102 = 106/(1+i)1
i = 3.92%
Now, we will calculate Effective Rate of 2 Year Bond:

101 = 5/(1+0.0392)1 + 105/(1+i)2
96.189 = 105/(1+i)2
i = 4.48%
Now, we will calculate Effective Rate of 2 Year Bond:

97 = 4/(1+0.0392)1 + 4/(1+0.0448)2 + 104/(1+i)3
89.487 = 104/(1+i)3
i = 5.14%
Yield Curve:
Maturity Yield
One year 3.92%
Two years 4.48%
Three years 5.14%
Page | 20
Managerial & Financial Analysis – The Practice Book Chapter 11: Cost of Capital
CHAPTER 11
COST OF CAPITAL
QUESTIONS
1 Which of the following information is NOT required while computing cost of equity under capital assets pricing model
(CAPM)?
(a) Risk free interest rate
(b) The expected earnings
(c) The beta for the firm
(d) The expected market return (01)
(ICAP,MFA – Model Paper, Q.#1(xii))
2 Fortune Limited (FL) is in the process of issuing bonds to finance its project. It has been decided to issue bonds that are
redeemable at par (i.e. Rs. 100) in three years’ time. The bonds would carry annual interest at 10.4% payable at the end of
each year.
The annual spot yield curve for a bond of this class of risk is as follows:
Maturity 1 year 2 year 3 year 4 year
Yield 8.0% 9.5% 11.0% 12.5%
FL should issue the bonds at:

(a) an approximate discount of Re. 1 per bond
(b) an approximate discount of Rs. 5 per bond
(c) an approximate premium of Re. 1 per bond
(d) at par value (02)
(ICAP,MFA – Spring 2022, Q.#1(iv))
3 Which of the following is considered as cash flows to calculate an IRR of redeemable debt?
(a) Annual interest payment on the bond
(b) Tax relief on annual interest payments
(c) Par value of the bond, excluding any interest payable in near future
(d) Redemption amount (01)
(ICAP,MFA –Autumn 2022, Q.#1(v))
Page | 1
PRACTICE QUESTIONS
Q.1 Jamal Limited (JL) is intending to expand its existing operations and considering to issue bonds to finance the expansion.
You have been provided with the following extracts from JL’s financial statements:
Statement of Financial Position

Rs. in ‘000’
3 million ordinary shares of Rs. 100 each 300,000
Retained earnings 400,000
10% Long-term loan 650,000
The shares are quoted at Rs. 475 cum dividend. The dividend of Rs. 25 per share is due shortly.
JL has paid out following dividends during the past four years:
Year 20X1 20X2 20X3 20X4
Dividend 10 15 18 20
The loan was obtained from a bank 2 years ago and is repayable in 10 years' time. The tax rate applicable to JL is 30%.
Required:
Determine JL’s weighted average cost of capital (WACC). (06)
(ICAP, MFA – Model Paper, Q. # 9)
Q.2 Lahore Quotient (LQ) is engaged in manufacturing and selling of textile products. LQ is presently considering to expand
the business and needs finance of Rs. 50 million. The management is considering the following two options:
Option I: Issuance of new shares

Finance the entire expansion by issuing new shares. However, the new project would result in equity beta of 1.2.
Option II: Issuance of convertible bonds

Finance the entire expansion by issuing 10% convertible bonds of Rs. 1,000 each. Each bond will be converted into 3
shares at the end of year 4. The market value of each share is expected to be Rs. 400 on the date of redemption.
Following information has been extracted from the latest financial statements of LQ:
Rs. in ‘000’
1,000,000 ordinary shares (Rs. 100 each) 100,000
11% bank loan 100,000
Other information:
(i) The return on government bonds is 8% per annum, whereas, the average return on market investments is 12%
per annum. The current equity beta for LQ is 1.3.
(ii) Applicable tax rate to LQ is 30%.
(iii) The details of dividend paid during the last four years (including current year 2022) are given below:
Years 2019 2020 2021 2022
Dividend per share Rs. 10 Rs. 11 Rs. 12 Rs.14
Required:
(a) Compute LQ’s existing weighted average cost of capital. (05)
(b) Recommend whether LQ should finance the new project by issuing new shares or by issuing convertible bonds.
(06)
(ICAP,MFA –Autumn 2022, Q.#9)
Page | 2
Q.3 Zaryaab Limited (ZL) is engaged in manufacturing and selling sports goods. Following information has been extracted
from the latest financial statements of ZL:
Rs. in '000
5,000,000 ordinary shares @ Rs. 10 each 50,000
8% bank loan 25,000
Other information:
(i) Shares of ZL arc currently trading at Rs. 25 each.
(ii) The return on government bonds is 6% whereas the average return on market investments is 10%. The average
equity beta for ZL’s share is 0.9.
(iii) The tax rate applicable to ZL is 30%.
ZL is planning to set-up another factory in Peshawar for which it would need finance of Rs. 150 million for four years.
Following two financing proposals are under the consideration of ZL’s management:
(i) Issue 9% preference shares of Rs. 100 each. The preference shares would be redeemable at par at the end of 4th
year.
(ii) Issue 9% bonds of Rs. 1,000 each. The bondholders would have a right to either convert each bond into 35
ordinary shares or redeem it at a premium of 10% at the end of 4th year. The market value of ZL’s shares is
expected to increase by 7% per annum.
Required:
Recommend the financing proposal that would result in lower weighted average cost of capital (WACC). (Show necessary
computations) (10)
(ICAP, MFA – Spring 2022, Q. # 6)
Q.4 Abid Foods Limited (AFL) has issued 8,000 convertible bonds of Rs. 100 each at par value. The bonds carry mark-up at
the rate of 8% which is payable annually. Each bond may be converted into 10 ordinary shares of AFL in three years. Any
bonds not converted will be redeemed at Rs. 115 per bond.
Required:
Calculate the current market price of the bonds, if the bondholders require a return of 10% and the expected value of
AFL’s ordinary shares on the conversion day is:
(a) Rs. 12 per share (03)
(b) Rs. 10 per share (03)
(ICAP, Cost Accounting – Autumn 2016, Q.#9)
Q.5 A company’s shares are currently valued at Rs.8.20 and the company is expected to pay an annual dividend of Rs.0.70 per
share for the foreseeable future. The next annual dividend is payable in the near future and the share price of Rs.8.20 is a
cum dividend price.
Required.
Estimate the cost of equity
(ICAP Study Text, Self Test Q. # 1)
Q.6 A company’s share price is Rs.5.00. The next annual dividend will be paid in one year’s time and dividends are expected to
grow by 4% per year into the foreseeable future. The next annual dividend is expected to be Rs.0.45 per share.
Required.
Estimate the cost of equity
Page | 3
Q.7 Zimba plc is a listed all-equity financed company which makes parts for digital cameras. The company pays out all
available profits as dividends. Zimba plc has a share capital of 15 million ordinary shares. On 30 September 20X0 it
expects to pay an annual dividend of Rs. 20 per share. In the absence of any further investment the company expects the
next three annual dividend payments also to be Rs. 20p, but thereafter a 2% per annum growth rate is expected in
perpetuity. The company’s cost of equity is currently 15% per annum.
The company is considering a new investment which would require an initial outlay of Rs.500 million on 30 September
20X0. If this investment were financed by a 1 for 3 rights issue it would enable the share dividend per share to be
increased to Rs. 21 on 30 September 20X1 and all further dividends would be increased by 4% per annum. The new
investment is, however riskier than the average of existing investments, as a result of which the company’s overall cost of
equity would increase to 16% per annum were the company to remain all-equity financed.
Required.
(a) Assuming the Zimba plc remains all-equity financed and using the dividend valuation model calculate the expected ex-
dividend price per share at 30 September 20X0 if the new investment does not take place.
(b) Assuming the Zimba plc remains all-equity financed and using the dividend valuation model calculate the expected ex-
dividend price per share at 30 September 20X0 if the new investment does take place.
(c) Compare the market values with and without the investment and determine whether the new investment should be
undertaken.
Q.8 A company’s shares have a current market value of Rs.13.00. The most recent annual dividend has just been paid. This
was Rs.1.50 per share.
Required
Estimate the cost of equity in this company in each of the following circumstances:
a) Using the DVM and when the annual dividend is expected to remain Rs.1.50 into the foreseeable future.
b) Using the DVM and when the annual dividend is expected to grow by 4% each year into the foreseeable future
c) The CAPM is used, the equity beta is 1.20, the risk-free cost of capital is 5% and the expected market return is 14%.
Q.9 A company has issued 4% convertible bonds that can be converted into shares in two years’ time at the rate of 25 shares
for every Rs.100 of bonds (nominal value). It is expected that the share price in two years’ time will be Rs.4.25. If the
bonds are not converted, they will be redeemed at par after four years. The yield required by investors in these
convertibles is 6%.
What is the value of the convertible bonds?

Q.10 A company has 20 million shares each with a value of Rs.6.00, whose cost is 9%. It has debt capital with a market value of
Rs.80 million and a before-tax cost of 6%. The rate of taxation on profits is 30%.
Calculate the WACC.

Page | 4
Q.11 Educare plc is listed on the Karachi Stock Exchange. The company’s statement of financial position at 31 August 20X3
showed the following long-term financing:
Rs. m
1.2 million ordinary shares of Rs. 25 each 30
Reserves 55
85
9% loan stock 20X5 30
On 31 August 20X3 the shares were quoted at Rs. 121 cum div, with a dividend of Rs. 5.2 per share due very shortly. Over
recent years, dividends have increased at the rate of about 5% a year. This rate expected to continue in the future.
The loan stock is due to be redeemed at par on 31 August 20X5. Interest is payable annually on 31 August. The post-tax
cost of the loan stock is 5.5%.
The company’s corporation tax rate is 30%.
Required
Determine the company’s WACC at 31 August 20X3.
Q.12 International Packaging Limited (IPL) is in business of packaging material for a range of food products. Following
information has been extracted from IPL’s financial statements as on 31 December 2022:
Rs. in '000
Ordinary share capital (Rs. 10 each) 100,400
Irredeemable preference share capital (Rs. 100 each) 20,400
9% redeemable bonds (Rs. 100 each) 30,200
Additional information:
Existing businesses:
(i) IPL distributes 60% of its earnings as cash dividend. Following is the trend of its earing per share (EPS) for the
preceding six years:
For the year ended 31 December 2017 2018 2019 2020 2021 2022
EPS (Rs.) 16 19 21 24 26 28
(ii) The return on government securities is 9% per annum whereas market risk premium is 5% per annum. IPL’s current
equity beta is 1.2.
(iii) IPL pays Rs. 20 as annual dividend on each preference share every year. The current market price of preference
shares is Rs. 185 each.
(iv) 9% redeemable bonds will be redeemed on 31 December 2025 at 15% premium. The current market price of these
bonds is Rs. 110 each.
(v) Applicable tax rate is 30%.
New business:
(i) IPL is planning to setup one more packaging unit. Total cost of the project is estimated to be Rs. 45 million which will
be financed by issuing 15% redeemable preference shares of Rs. 100 each at par value. These shares will be redeemed
after 4 years at a premium of 20% above par value.
(ii) IPL estimates that, as a result of this new investment, the equity beta will increase to 1.3.
Required:
(a) Compute IPL’s weighted average cost of capital (WACC) of the existing business. (07)
(b) Calculate the impact of new business on IPL’s existing WACC. Also discuss the effect of the revised WACC on the
overall market value of the company. (05)
(ICAP, MFA – Spring 2023, Q. # 10)
Page | 5
SUGGESTED SOLUTIONS
SUGGESTED SOLUTIONS
1 b 2 a 3 c
PRACTICE QUESTIONS
A.1
Weighted
Component/Source of Market Value Cost of
Weight of Component Average Cost of
Finance (in 000) Component
Component
1,350,000
Equity (3 million * 475 - 31.6% (w-1) 67.5% (i.e. 1,350 / 2,000) 21.33%
25)
Bank Loan 650,000 7% (= 10% * 0.7) 32.5% (i.e. 650/ 2,000) 2.275%
Weighted Average Cost of Capital (WACC) 23.605%
(w-1)
g = (25/10)1/4 – 1 = 25.74% i.e. 26%.
P0 (ex dividend) = D1 / (Ke – g)
475-25 = 20 (1.26)/Ke - 0.26

Ke - 0.26 = 25.2/450
Ke = 0.316 i.e. 31.6%
A.2 Existing WACC
Component/Source of Market Value (in Weight of Weighted Average

Cost of Component
Finance million) Component Cost of Component
Ordinary Shares 1,178 13.20% 0.92 12.17%

[1 m. * 1,178 (w-1)] 0.08 + 1.3 [.12 - .08]
Bank Loan 100 7.70% 0.08 0.60%

[.11 * .7]
1278 12.77%
Page | 6

Cost of Component
Option (i)
Existing Shares 1684 12.80% 0.92 11.75%
(w-2) 0.08 + 1.2 [.12 - .08]
Bank Loan 100 7.70% 0.05 0.42%
New Shares 50 12.80% 0.03 0.35%
Revised WACC Option (i) 1834 12.52%
Component/Source of Market Value (in Cost of Weight of Weighted Average

Finance million) Component Component Cost of Component
Option (ii)
Existing WACC 1178 13.20% 0.89 11.71%
Bank Loan 100 7.70% 0.08 0.58%
Redeemable Bond 50 11.25% 0.04 0.42%
(w-1)
Revised WACC Option (ii) 1328 12.71%
Hence, Option (i) is better as it results in lower WACC.
(W-1)
Operating Cash Flow (net of
tax) 70 [1,000 * .10 * .7]
Terminal Cash Flow Higher of Redemption Value 1,000 and Conversion Value 1,200 [3 * 400]
NPV @ 10% 70/1.10^1 + 70/1.10^2 + 70/1.10^3 + 70/1.10^4 + 1,200/1.10^4 - 1,000 = + 41.51
NPV @ 12% 70/1.12^1 + 70/1.12^2 + 70/1.12^3 + 70/1.12^4 + 1,200/1.12^4 - 1,000 = - 24.76
IRR = 0.10 + 41.51/(41.51+24.76) * 0.02 = 11.25%
(a) • Many examinees were not able to correctly calculate the market value of equity.
• Some examinees used the book value of equity to calculate the WACC.
(b) • Under project finance by equity, in order to calculate WACC, a number of examinees used separate costs of equity
for the exiting equity and the newly issued equity which was incorrect.
• Under project finance by convertible debt, examinees made various mistakes while calculating the IRR. For
example, they did not apply the tax saving on interest, or/and they discounted it over 3 years instead of 4.
Page | 7
Marking Plan:
(a)
Computation of:
• WACC 1.0
• cost of equity 1.0
• market value of equity 1.5
• growth rate 1.0
• cost of debt 0.5
(b)
For project financed by shares
• Cost of equity computation 0.5
• Revised market value of equity 1.0
• WACC computation 1.0
For project financed by convertible bonds
• Determination of IRR 2.0
• WACC computation 1.0
• Conclusion 0.5
Passing Percentage:
46%
A.3
Cost of Component
Existing WACC
Ordinary Shares 125 9.60% 0.83 8.00%
[5 million shares * 25] 0.06 + 0.9 [.10 - .06]
Bank Loan 25 5.60% 0.17 0.93%

[.08 * .7]
150 8.93%

Cost of Component
Option (i)
Existing WACC 150 8.93% 0.50 4.47%

Preference Shares 150 9.00% 0.50 4.50%
Revised WACC Option (i) 300 8.97%

Cost of Component
Option (ii)
Existing WACC 150 8.93% 0.50 4.47%
Redeemable Bond 150 9.52% 0.50 4.76%
(w-1)
Revised WACC Option (ii) 300 9.23%
Hence, Option (i) is better as it results in lower WACC.
Page | 8
(W-1)
Operating Cash Flow (net of
tax) 63 [1,000 * .09 * .7]
Higher of Redemption Value 1,100 [1,000 * 1.1] and Conversion Value 1,147 [35 * 25 *
Terminal Cash Flow 1.07^4]
NPV @ 9% 63/1.09^1 + 63/1.09^2 + 63/1.09^3 + 63/1.09^4 + 1,147/1.09^4 - 1,000 = + 16.67
NPV @ 12% 63/1.12^1 + 63/1.12^2 + 63/1.12^3 + 63/1.12^4 + 1,147/1.12^4 - 1,000 = - 79.71
IRR = 0.09 + 16.67/(16.67+79.71) * 0.03 = 9.52%
• Examinees failed to determine the cost of equity by using the CAPM model.
• Some examinees assumed that return on preference shares is subject to tax deduction.
• Many examinees wasted time in determining the IRR of preference shares.
• Examinees remained confused between cash inflows and cash outflows while computing the IRR of convertible bonds.
Marking Plan:
• Market value of equity 0.5

• Cost of equity 1.0
• Cost of bank loan 0.5
• Cost of preference shares 0.5
• Determination of redemption value of convertible bonds 2.5
• Determination of WACC under each option 1.0
• Recommendation 0.5
Passing Percentage:
31%
A.4
(a) (b)
Annuity 8 (100* 8%) 8 (100* 8%)
No. of Years 3 3
Maturity Value
(higher of Redemption Price or Conversion Value) 120 115
( higher of 115 or 10 * 12) ( higher of 115 or 10 * 10)
PV @ 10% 110.05 106.3
Total Number of Shares 8,000 8,000
Market Value of Shares 880,400 850,400
This question required calculation of market value of 8% redeemable bonds when required rate of return of the bondholders
was 10% and expected value of ordinary shares on the conversion date was (a) Rs. 12 per share (b) Rs. 10 per share.
The performance was very poor. 44% of the students left this question un-attempted, while most of those who attempted it
had very little idea of the procedure to be followed. They are advised to refer to the suggested answer given on the Institute’s
website.
Marking Plan:
• Discounting of cash flows 4.0

• Determination of bonds value at higher of shares’ expected value and bonds’
2.0
redemption value
.
Page | 9
A.5 This is a question of Dividend without Growth, where D0 = 0.7 and P0 (ex dividend) = 7.5 (= 8.2 – 0.7)
P0 (ex dividend) = D0 / Ke
Ke = D0 / P0
Ke = 0.7 / 7.5 = 9.33%
A.6 This is a question of Dividend with constant Growth, where D1 = 0.45 and P0 (ex dividend) = 5.00 and g = 0.04.

(Ke – g) = D1 / P0
Ke = D1 / P0 + g
Ke = 0.45 / 5.00 + 0.04 = 13%
A.7 (a)
This is a question of Dividend with different Growth. First, we will calculate Present Value of Cashflows using Constant
Growth Model and then we will calculate Present Value of different Growth years.
Present Value of Constant Growth Period Cash Flows at end of Year 3:

P3 = D0 (1+g) / (Ke – g)
P3 = 20 (1.02)/(0.15 – 0.02) = 156.92
Present Value of all Cash Flows at Year 0:
P0 = 20/1.151 + 20/1.152 +20/1.153 + 156.92/1.153 = 148.84
(b)
This is a question of Dividend with Constant Growth, where D1 = 21, g = 0.04, Ke = 0.16
P0 = 21/ (0.16 – 0.04) = 175
(c)
No. of Shares Price per Share Market Value

Without New Investment 15,000,000 148.84 2,232,600,000
With New Investment 20,000,000 175.00 3,500,000,000
(15 + 15/3*1)
Total Increase in Market Value after Investment 1,267,400,000
Increase due to Share Issue (500,000,000)
Increase due to Profit of Project 767,400,000
A.8 (a)
This is a question of Dividend without Growth, where D0 = 1.50 and P0 (ex dividend) = 13.00
P0 (ex dividend) = D0 / Ke
Ke = D0 / P0
Ke = 1.50 / 13.00 = 11.54%
Page | 10
(b)
This is a question of Dividend with constant Growth, where D1 = 1.5 * 1.04 = 1.56, and P0 (ex dividend) = 13.00 and g =
0.04.

(Ke – g) = D1 / P0
Ke = D1 / P0 + g
Ke = 1.56 / 13.00 + 0.04 = 16%
(c)
KE = KRF + βE * [KM – KRF]
KE = 0.05 + 1.20 * [0.14 – 0.05]
KE = 0.05 + 0.108 = 15.8%
A.9 As redemption period and conversion period are different, therefore, we will calculate Present Value under both options
and higher value will be value of Convertible Bond.
Present Value if Converted = 4/1.061 + 4/1.062 + (25*4.25)/1.062 = 101.90

Present Value if Redeemed = 4/1.061 + 4/1.062 + 4/1.063 + 104/1.064 = 93.07
Therefore, Value of Convertible Bond will be Rs. 101.90.
A.10
Component/Source of Market Value (in Cost of Weight of Weighted Average Cost of
Finance million) Component Component Component
Shares 120 9.00% 0.60 5.40%

[20 m. * 6]
Debt 80 4.20% 0.40 1.68%

[6% * 0.7]
200 7.08%
A.11
Component/Source of Market Value (in Cost of Weight of Weighted Average Cost of
Finance million) Component Component Component
Shares 138.96 9.72% 0.82 7.97%

[1.2 m. * 115.8] (Working - 1)
Debt 30.44 5.50% 0.18 0.99%

(Working - 2)
169.4 8.96%
Working – 1: Cost of Equity
This is a question of Dividend with constant Growth, where D0 = 5.2 and P0 (ex dividend) = 115.8 (=121 – 5.2) and g =
0.05.

(Ke – g) = D1 / P0
Ke = D1 / P0 + g
Ke = 5.2 (1.05) / 115.8 + 0.05 = 9.72%
Page | 11
Working – 2: Market Value of Bond
Net of Tax Interest = 30 * .09 * 0.7 = 1.89 million
Present Value = 1.89/1.0551 + 31.89/1.0552 = 30.44 million
A.12 (a) Existing WACC:
Weighted
Component/Source of Weight of
Market Value (in million) Cost of Component Average Cost of
Finance Component
Component
Ordinary Shares 5,969.78 15.00% 0.99 14.82%

594.6 (W-1) * 10.04 million [9% + 1.2 * 5%]
Preference Shares 37.74 10.81% 0.01 0.07%

[185 * 0.204 million] [20/185]
9% Redeemable Bonds 33.22 7.18% 0.01 0.04%

[110 * 0.302 million] (Working - 2)
6040.74 14.93%
Working – 1: Market Value of Ordinary Shares

As dividend is growing each year, therefore we will use Dividend Growth Model.
To calculate Growth:
End Price = Start Price * (1+g)n
28 * 0.6 = 16 * 0.6 * (1+g)5
1.75 = (1+g)5
g = 11.84%
To calculate Share Price:

P0 = D0 (1 + g) / (Ke – g)
P0 = D0 (1 + g) / (Ke – g)
P0 = 16.8 (1.1184) / 0.15 – 0.1184 = 594.6
Working – 2: Cost of Bond

After tax cash flow = 100 * 0.09 * 0.7 = 6.3
NPV @ 9% = 6.3/(1.09)1 + 6.3/(1.09)2 + 121.3/(1.09)3 – 110 = – 5.25

NPV @ 6% = 6.3/(1.09)1 + 6.3/(1.09)2 + 121.3/(1.09)3 – 110 = + 3.40
6% + 3.40/(3.40+5.25) * 3 % = 7.18%
Page | 12
(b) Revised WACC:
Component/ Market Value Cost of Weight of Weighted Average

Source of Finance (in million) Component Component Cost of Component
Ordinary Shares 5,154.13 15.50% 0.98 15.16%

513.36 (W-3) * 10.04 million [9% + 1.3 * 5%]
Preference Shares 37.74 10.81% 0.01 0.08%

[185 * 0.204 million] [20/185]
9% Redeemable Bonds 33.22 7.18% 0.01 0.05%

15% Redeemable Preference Shares 45.00 18.88% 0.01 0.16%

5270.09 15.44%
Working – 3: Market Value of Ordinary Shares

P0 = D0 (1 + g) / (Ke – g)
P0 = D0 (1 + g) / (Ke – g)
P0 = 16.8 (1.1184) / 0.155 – 0.1184 = 513.36
Working – 4: Cost of Redeemable Preference Shares

Annual cash flow = 100 * 0.15 = 15
NPV @ 15% = 15/(1.15)1 + 15/(1.15)2 + 15/(1.15)3 + 135/(1.15)4 – 100 = + 11.435

NPV @ 20% = 15/(1.20)1 + 15/(1.20)2 + 15/(1.20)3 + 135/(1.20)4 – 100 = – 3.30
15% + 11.435/(11.435+3.30) * 5 % = 18.88%
Conclusion:
After new business, WACC has increased and therefore market value of company has decreased.
Page | 13
Managerial & Financial Analysis – Study Notes Chapter 12: Identifying and Assessing Risk
CHAPTER 12
IDENTIFYING AND ASSESSING RISK
ICAP Book Reference
LO # LEARNING OBJECTIVE
Chapter # Paragraph #
LO 1 TYPES OF RISKS Section 1 &

13
LO 2 RISK MANAGEMENT AND ITS BENEFTIS 3
ISO 31000: RISK MANAGEMENT FRAMEWORK

LO 3 SCOPE AND DEFINITIONS OF ISO 31000
LO 4 PRINCIPLES OF RISK MANAGEMENT FRAMEWORK
13 Section 2
LO 5 COMPONENTS OF RISK MANAGEMENT FRAMEWORK
LO 6 RISK MANAGEMENT PROCESS
APPENDIX
APX 1 OBJECTIVE TYPE QUESTIONS (ADAPTED FROM ICAP STUDY TEXT)
APX 2 SOLUTIONS TO PRACTICE QUESTIONS
Page | 1
LO 1: TYPES OF RISKS:
Risk:
Risk means uncertainty relating to future outcome of an event.
Business Risk:
A business risk is the risk that a company will not be able to achieve its objectives. Business risks
can arise from internal or external sources.
Types of Business Risks:
There are two major types of Risks:

 Pure Risk (or downside risk or Internal Control Risk or Operational Risk)
 Speculative Risk (or 2-way risk or Business Risk or Strategic Risk or Enterprise Risk)
Pure/Operational Risk Speculative/Strategic Risk

Speculative risks are those risks where the
Pure risks are those risks where the possible
possible outcomes are either a loss or a gain.
Definition outcomes are either a loss or no loss. There is no
These risks are taken with the intention of
possibility of gain.
making a profit.
Generally Controllable, because they are taken as
Control Generally uncontrollable
a result of decision.
Insurance Generally insurable. Generally not insurable.
1. Errors or negligence by staff members
2. Malfunctioning of machines which can injure
1. Investments in shares,
employees.
Examples 2. A borrowers takes loan on fixed rate, and
3. Strike by workers.
market rate changes.
4. Terrorist attack, Fire, Flood and other natural
3. launch of a new product
disaster affecting business.
Examples of Strategic and Operational Risks:

Some business decisions have both operational risks and strategic risks.
 Example 1: Implementation of a new IT System to sell goods to customers online:

o Operational Risk: There may be hardware or software fault.
o Strategic Risk: Customers will not buy goods online. Competitors may develop a
better IT system.
 Example 2: Reduction in staff providing service to customers:

o Operational Risk: Risk of errors by existing employees due to over-burden. There
may be delay in service, or unsatisfactory services.
o Strategic Risks: Company may lose customers if service is not satisfactory.
Points to Note:
 Operational risks can be managed by Operational Controls.
Page | 2
LO 2: RISK MANAGEMENT AND ITS BENEFTIS:
Benefits of adopting a Formal Risk Management Approach:
1. Increased chances of achieving objectives.

2. Proactive Management.
3. Compliance with legal requirements.
4. Awareness to identify and treat risk throughout the organization.
5. Improved controls
6. Improved Governance
7. Reliable basis for decision making
Role of Directors of a Company in Risk Management:

In Pakistan, SECP’s Code of Corporate Governance states that directors should report on Risk
Management and Compliance issues. For this purpose directors establish a Risk Management
Committee (which is a sub-committee of Board of Directors).
Responsibilities of Risk Management Committee include:

1. To identify risks,
2. To monitor and address risks
3. To report on effectiveness of risk management to Board.
Box-ticking Approach Vs. Risk-based Approach:
Box-ticking Approach:
In this approach, certain procedures are performed on every item to eliminate risk (e.g. scanning
every passenger on air-port).
Risk-based Approach:
Management assumes that some risk is unavoidable. Management looks for only those items which
have high risk, to reduce risk to acceptable level.
LO 3: SCOPE AND DEFINITIONS OF ISO 31000:
Introduction to ISO 31000:

ISO 31000 is an international standard for Risk Management that provides:
1. a set of Principles (What)
2. a Framework to help organizations develop a risk management strategy (How)
3. a description of the risk management Process. (Doing)
This standard is updated after every 5 years.

Scope
ISO 31000 provides general guidance on how to manage risk. This guidance can be applied to any
industry, any company, and at any level
Page | 3
LO 4: PRINCIPLES OF RISK MANAGEMENT FRAMEWORK:

Section 4: Principles
The principles are the foundation for managing risk and should be considered when establishing
the organization’s risk management framework and processes.
1. Integrated:
Risk management is an integral part of all organizational activities.
2. Structured and comprehensive:

A structured and comprehensive approach to risk management should be adopted.
3. Customized:
The risk management Framework and Process can be customized according to
organization’s objectives.
4. Inclusive:
All stakeholders should be involved in the risk management. This will improve awareness of
risk management.
5. Dynamic:
Risks can change due to internal and external changes in organization. Risk management
should also change accordingly.
6. Best available information:

Risk management should be based on reliable, clear and timely information.
7. Human and cultural factors:

Human and cultural factors should also be considered at each level and stage.
8. Continual improvement:
Risk management is a continuous process which is improved through learning and
experience.
LO 5: FRAMEWORK OF RISK MANAGEMENT:

Framework is a customized structure for an organization, that provides environment for risk
management process.
Risk management process is actual step-wise process for "managing" risks.
Framework
Framework development includes Integrating, Designing, Implementing, Evaluating and Improving
risk management across the organization.
Page | 4
Component Explanation
Top management should ensure:

• Customize and implement framework;
1. Leadership and • Make a policy on risk management.
Commitment • Allocate necessary resources to risk management.
• Assign authority and responsibilities at appropriate levels within
the organization.
Risk management should be integrated in every part of organization. Every

2. Integration department and everyone in the organization is responsible for managing
risk. However, it can be customized.
The next four components of framework are inter-related. This sequence of four stages is known as
Design  Implement  Evaluate  Improve.
It means designing a strategy for managing the risk according to needs of

organization. This component includes following steps:
1. Understanding the organization
2. Designing specific strategies (e.g. to set-up a risk management
3. Design
committee, to appoint risk officer)
3. Assigning roles and responsibilities
4. Allocating resources to team
5. Establishing communication and consultation between stakeholders
This means putting the plans in action. It includes:

• Setting objectives and deadlines
• Clearly defining the decision-making process
4. Implement
• Evaluating and making changes to the decision-making process
where appropriate
• Ensure that arrangements are clearly understood and practiced.
This means looking whether risk management system is working as it

should be. It includes:
5. Evaluate  Comparing performance of risk management system with goals.
 Determining whether risk management system is appropriate
or needs amendments.
This means improving risk management system on continuous basis. It

includes:
6. Improve
 taking corrective actions to remove deficiencies.
 Addressing new risks arising due to internal and external changes.
Page | 5
Example of importance of Leadership in risk management

Case:
In the 1990s, UK-based GEC was a prominent defense contractor. A shift in leadership in 1996 led to a strategic
transformation, selling defense interests and moving into the US telecommunications sector, rebranding as Marconi.
However, Marconi misjudged market dynamics leading to a collapse in the telecommunications equipment market in 2001.
The company incorrectly assumed a brief downturn, resulting in a loss of shareholder confidence and a dramatic drop in
share price from £35 billion to £800 million. Trading of its shares was suspended in July 2001 due to impending profit
warnings. The board's failure to comprehend the business risks resulted in the forced resignation of Lord Simpson. The
Marconi brand and most assets were acquired by Ericsson in 2006.
Lesson:
Leaders must not only have the vision to guide a company towards new opportunities but also the insight to understand the
potential risks associated with these strategic shifts.
Examples of Reputational Risk:

 Some years ago, the owner of a popular chain of jewellery shops in the UK criticised the quality of the goods that
were sold in his shops. The bad publicity led to a sharp fall in sales and profits. The company had to change its
name to end its association in the mind of the public with cheap, low-quality goods.
 More recently, a manufacturer of branded leisure footwear suffered damage to its reputation when it was reported
that one of its suppliers of manufactured footwear in the Far East used child labour and slave labour. Sales and
profits fell.
Examples of Legal Risk

 An example in 2006 was the decision by the US government to enforce laws against online gambling. US customers
were the main customers for on-line gambling companies based in other countries. As a result of the legal action,
the on-line gambling companies lost a large proportion of their customer base, and their profits and share prices
fell sharply.
Examples of Financial Risk

1. An oil company described one of its major risks as the risk of rising and falling oil and chemical prices due to
factors such as conflicts, political instability and natural disasters.
2. Similarly, a bank identifies risk of movements in interest rates and foreign exchange rates as market risk.
Examples of Technological Risks

1. The internet has also created risks for many retailing companies, which have had to decide whether to sell their
goods on the internet, and if so whether to shut down their traditional retail outlets.
2. A technological risk currently facing manufacturers of televisions and media companies is which format of high
definition (HD) television they should support.
3. Traditional banks were faced with the risk that if they did not develop online banking (at a high cost), non-bank
companies might enter the market and take customers away from them.
Page | 6
LO 6: RISK MANAGEMENT PROCESS:
Section 6: Risk Management Process:

Risk management process includes following activities:
 communicating and consultation
 establishing the Scope, context and criteria
 assessing, treating, monitoring, and reporting risk
 Communication means promoting awareness and understanding of

Communicating
risk.
and Consultation
 Consultation means obtaining feedback and information to support
decision-making.
 The organization should define the scope of its risk management

activities.
 The organization should establish risk management in the context
of internal and external environment in which organization
Scope, context and
operates.
criteria
 The organization should specify criteria as to how to evaluate
significance of risks, and which risks to take and which not to take.
Purpose of this step is to customize the risk management process.
Risk assessment is the overall process of risk identification, risk analysis

and risk evaluation.
 Risk Identification:
The purpose of risk identification is to identify risks that may
prevent an organization from achieving its objectives.
 Risk analysis
Risk analysis includes consideration of risk, probability, and its
impact. Risks may have:
Risk Assessment o Low Probability, Low Impact.
o Low Probability, High Impact
o High Probability, Low Impact
o High Probability, High Impact
Risk Analysis also includes consideration of existing controls and
their effectiveness.
 Risk Evaluation:
Risk evaluation involves comparing the results of the risk analysis
with the established risk criteria to determine whether Residual
Risk is tolerable or additional action is required.
Page | 7
Options for treating risk may involve one or more of the following:
• avoid risk (by discontinuing activity giving rise to risk), or remove
the risk source;
Risk Treatment • reduce the likelihood;
• reduce the consequences;
• share the risk with others (e.g. through contracts, insurance);
• retain the risk by informed decision.
Monitoring and It includes analyzing results and providing feedback. Its purpose is to
Review ensure effectiveness of risk management process.
Recording and The risk management process and its outcomes should be documented and
Reporting reported through appropriate mechanisms.
Practice Questions
Q. 1
List and briefly explain the activities in the process of risk management in view of ISO 31000.
(ICAP Study Text, Self Test Question – 1)
Page | 8
APX 1: HINTS & COMMENTS TO CONCEPT REVIEW QUESTIONS:

Q. 1
As in LO 1.
Page | 9
Managerial & Financial Analysis – The Practice Kit Chapter 12: Identifying and Assessing Risk
CHAPTER 12
IDENTIFYING AND ASSESSING RISK
QUESTIONS
1 Which of the following is NOT the step for implementation of a risk management system?
(a) Demonstrating commitment to risk management and allocating appropriate resources
(b) Developing an appropriate implementation plan including deadlines
(c) Identifying where, when and how different types of decisions are made and by whom
(d) Ensuring that the organization’s arrangements for managing risk are clearly understood and practiced
(01)
(ICAP, MFA Model Paper, Q.#1(iv))
2 HQ Group is considering entering into a business of coal extraction. The process of coal extraction is subject to strict
environmental regulations. Any mishandling could result in heavy fines. The given risk can be classified as:
(a) pure risk that cannot be reduced
(b) pure risk that can be reduced by internal controls
(c) speculative risk that cannot be reduced
(d) speculative risk that can be reduced by internal controls
. (01)
(ICAP, MFA –Spring2022, Q.#1(vii))
3 Alpha Limited is engaged in manufacturing consumer goods. The goods are manufactured in two factories and staff at head
office is mostly involved in maintenance of accounting record. The CEO has directed the management to develop a risk
management program. The management has identified various risks and classified them as high, moderate or low. Most of
the high risks pertain to factories therefore, the management has prepared a risk management program for factories. It has
a plan to train the factories’ staff to learn to manage and respond to the risk. It is also agreed that management would
proactively look for new risks at factories and continually incorporate such risks into risk management program.
Which of the following elements of Risk Management Framework: ISO 31000 is missing?
(a) Leadership and commitment
(b) Integration
(c) Implementation
(d) Evaluation (01)
(ICAP, MFA –Spring2022, Q.#1(viii))
4 Which of the following represents ‘pure risk’ for a business?

(a) Investment in a volatile share listed on Pakistan Stock Exchange
(b) Entering into a finance lease agreement at a fixed rate of interest
(c) Purchasing USD for a future payment to be made in USD
(d) Entry of a highly resourced competitor
(01)
(ICAP, MFA – Autumn 2022, Q.#1(iii))
Page | 1
PRACTICE QUESTIONS
Q.1 (a) One of the principles of ISO 31000 explains the importance of risk awareness across all levels of the organization. Discuss
how risk awareness can be embedded throughout an organization.
(b) Give examples of how risk awareness could help management in the following sectors;
(i) Health and Safety
(ii) Banking Sector
Q.2 Ventex Pvt. Limited is a company dealing in supplying IT services to clients in large manufacturing organisations that are
listed in the Fortune 500. Although their clients are satisfied with their services but due to some recent mishaps they are
questioning whether Ventex has taken sufficient risk management measures to reduce such incidents in the future. This
comes as a threat to the company’s reputation and future of the business.
In order to streamline its risk management strategy, Ventex has hired a Risk Manager. The Risk Manager has suggested the
management of Ventex to implement risk management strategies in light of a risk management framework such as ISO
31000 to formalise its risk management processes.
The management is not sure if the scope of the ISO 31000 is relevant to their organisation needs. They have called an urgent
meeting to discuss the issue.
Required:
In your opinion, what are the key takeaways about the scope of ISO 31000 standard that the Risk Manager could use in the
meeting that would give a clearer picture about the ISO 31000 standard?
Q.3 Apart from market risk, identify other broader categories of financial risks that a business is subjected to. Also identify two
strategies to manage each of the identified financial risks. (03)
(ICAP, MFA – Spring 2023, Q.# 9a)
Q.4 Azad Limited (AL) is engaged in manufacturing and selling of consumer goods. Due to on-going pandemic, some of the
customers of AL are in financial crunch. There is also news circulating that one of the major customers of AL might go
bankrupt shortly. Until now, AL has been lenient in offering credit terms to its customers to build a good relationship.
However, the management is concerned and looking for ways to mitigate such situation in future.
Required:
(i) Identify and explain the financial risk being faced by AL. (02)
(ii) Suggest and discuss the strategies that AL may adopt to manage the financial risk identified in (i) above. (04)
(ICAP, MFA – Model Paper, Q.# 10a)
Page | 2
SUGGESTED SOLUTIONS
SUGGESTED SOLUTIONS
1 A 3 B
2 b 4 d
PRACTICE QUESTIONS
A.1 (a)
1. Communication through newsletters, regular team meetings
2. Training and Education of employees all levels about the nature of risks, their potential impact, and how they can
be managed.
3. Involve employees in risk assessments and decision-making processes.
4. Leaders should demonstrate a commitment to risk management and lead by example.
5. Risk management should be embedded into the organization's day-to-day activities and decision-making
processes.
6. Recognizing and rewarding employees for actively participating in risk management activities
7. A culture should be fostered where employees feel safe to report risks
(b)
Health and Safety:
1. Identification of Hazards:
2. Preventive Measures:
3. Reducing Incidents:
4. Emergency Procedures:
Banking Sector:
1. Credit Risk Management:
2. Cybersecurity Risk Management:
3. Compliance Risk Management:
4. Market Risk Management:
A.2 Applies to all sectors and all companies:

ISO 31000 is applicable to all types of risks, regardless of the nature of the organization, and is not industry or sector-
specific.
All Activities at all level:

ISO 31000 can be applied to any and all types of objectives at all levels and areas within an organization. It can be used at a
strategic or operational level.
All types of Risks:

It can be applied to any type of risk, whatever its nature, cause or origin.
A General Framework:
The standard does not provide detailed instructions or requirements on how to manage specific risks, nor any advice
related to a specific industry or type of organisation; it consists of a general framework or guideline to be adapted.
Customizable:
ISO document advises that top leadership can customize its risk strategy for the organization as per their requirement and
circumstances — in particular, its risk profile, culture and risk appetite.
Page | 3
A.3 Credit Risk:

This is the risk that a borrower/debtor may fail to make payment of debt.
Strategies to manage credit risk:

 Setting credit limits
 Regular monitoring
 Guarantees
 Credit insurance
Liquidity Risk:
Liquidity risk is the risk that a business may not be able to meet its short-term obligations.
Strategies to manage liquidity risk:

 Standing credit lines
 Regular monitoring of working capital ratios
Many examinees were not able to identify the other categories of financial risks. Instead of identifying the categories of financial
risks, they mistakenly provided general categories of risk i.e. pure risk and speculative risk.
Marking Plan:
• 0.5 mark for defining the other financial risks 1.0

• 01 mark for identifying two risk management strategies 2.0
Passing Percentage:
68%
A.4 (i)
AL is facing Credit Risk.
Credit risk arises when a debtor fails to meet their obligations to repay his debt. In AL's case, the financial crunch of its
customers due to the ongoing pandemic, coupled with the news of one of their major customers potentially going bankrupt,
poses a significant credit risk.
(ii)
Setting Credit Limits:
Establishing a maximum amount of credit extended to a customer to prevent overexposure.
Regular Monitoring:
Periodic review of the customer's financial condition and repayment patterns.
Guarantees:
Arranging for a third party to assure the repayment of a debt in case the debtor defaults.
Credit Insurance:
Insurance policy to protect against losses from non-payment of commercial trade debt.
Page | 4
Managerial & Financial Analysis – Study Notes Chapter 13: Financial Risk Management
CHAPTER 13
FINANCIAL RISK MANAGEMENT
ICAP Book
Chapter Paragraph #
#
LO 1 INTRODUCTION TO HEDGING/DERIVATIVE MARKET
PART A: COMMODITY RATE RISK:
LO 2 COMMODITY RATE HEDGING THROUGH FORWARDS 14
2.1.3
LO 3 COMMODITY RATE HEDGING THROUGH FUTURES 14
PART B: EXCHANGE RATE RISK:
LO 4 INTRODUCTION TO EXCHANGE RATE 14
LO 5 CURRENCY RATE HEDGING THROUGH FORWARDS 14
LO 6 CURRENCY RATE HEDGING THROUGH FUTURES 14 2.1.2
LO 7 CURRENCY RATE HEDGING THROUGH OPTIONS 14
LO 8 CURRENCY RATE HEDGING THROUGH MONEY MARKET 14
PART C: INTEREST RATE RISK:
LO 9 INTEREST RATE HEDGING THROUGH FORWARDS 14
LO 10 INTEREST RATE HEDGING THROUGH FUTURES 14
2.1.1
LO 11 INTEREST RATE HEDGING THROUGH OPTIONS 14
LO 12 CALCULATING FORWARD RATE FROM SPOT RATE 14
APPENDIX
Page | 1
LO 1: INTRODUCTION TO HEDGING/DERIVATIVE MARKET:
Introduction:
A business’s days to day transactions may include:
 Sale and Purchase of Inventory
 Interest on Loan or Deposit
 Receipt and Payments in Foreign Currency (e.g. $)
These types of transactions include some risks.
Categories/Types of Risk and Strategies to manage Risk:
Category Types of Risks Strategies to Manage Risk

Commodity  Purchase price may increase, or  Forward
Price Risk  Sale price may decrease in future  Futures
 exchange rate on foreign currency  Forwards,
Exchange Rate receivable may decrease, or  Futures,
Risk  exchange rate on foreign currency payable  Options,
may increase in future  Money Market Hedge
 Interest rate on borrowing may increase,
 Forwards,
Interest Rate or
 Futures,
Risk  Interest rate on deposits may decrease in
 Options
future
Things to remember:
1. Trade Agreements are different and separate from Hedging Agreements.
2. Trade Agreements are settled through actual delivery of goods. Hedging Agreements are
settled through Price-differences.
3. Hedging becomes effective because change in market rates are adjusted through Gain/Loss
on Hedging i.e. Increase in Trade is offset by Decrease in Hedging (and vice-versa).
Page | 2
PART A – COMMODITY RATE RISK
LO 2: COMMODITY RATE HEDGING THROUGH FORWARDS:
What is a Forward Contract:
A “Forward Contract for Commodity” is a contract to buy or sell a commodity (e.g. oil, gold, or
wheat) in future (e.g. after 1 month, 3 months, or 6 months) at predetermined rate.
Forward contracts are traded in Over The Counter (OTC) market. [OTC means through a dealer
other than stock exchange]
Features of a Forward Contract:
1. There are two parties in a Forward Contract i.e. Seller and Buyer.
2. The date specified in the contract on which the trade will take place is called the maturity
date of the contract.
3. The price specified in the contract for the trade is called the delivery price in the contract.
4. Forward contracts are Customizable (as compared to Futures) i.e. parties to the contracts
decide the terms of forward contracts.
5. There is possible default risk for both parties.
Steps in Commodity Rate Hedging through Forward

1. What is to be hedged:
Sale of X units after 3 months, through Forward
2. Strategy:
Sell Total Quantity @ Rate Agreed in Forward
3. Gain /Loss on Forward:

It is Gain if company will receive more than market (on maturity).
= Total Quantity * (Agreed Rate - Market Rate)
4. Calculate Net Receipt and Effective Rate:
Receipts from Sale of Commodity @ market rate

Add: Gain on Forward
Net Receipt
Effective Rate = Net Receipts /Quantity
.
Exam Tips
Forward is a Perfect Hedging Strategy i.e. in Forward, Forward Rate is always the Effective Rate.
Page | 3
PRACTICE QUESTIONS
Q. 1
A sugar producer estimates 14.55 tons of sugar will be available for sale in three months’ time. The following are relevant
information:
(i) Sugar price in today’s market is Rs. 120,000 per ton.
(ii) Forward contract on one ton of sugar with three months to expiry is available at Rs. 130,000.
(iii) After three months, price of sugar is 115,000/ton.
Required:
Calculate net proceeds to be received by sugar producer if:
(a) Forward contract is not used by sugar producer to hedge its risk.
(b) Forward contract is used by sugar producer to hedge its risk.
(ICAP Book: Chapter 14 – Example, Amended)
LO 3: COMMODITY RATE HEDGING THROUGH FUTURES:
What is a Future Contract:
A Future Contract for Commodity is a contract to sell or buy Standard Quantity of a commodity
(e.g. oil, gold, or wheat) at predetermined rate in future (e.g. after 1 month, 3 months, or 6 months).
Futures contracts are traded on stock exchange.
Features of a Future Contract:
1. You can Sell Futures (if commodity is to be sold in in future), as well as Buy Futures (if
commodity is to be bought in in future).
2. The date on which the trade will take place is called the maturity date of the contract.
3. The price specified in the contract for the trade is called the delivery price in the contract.
4. Futures contracts are for Standardized Quantity (i.e. fraction quantity cannot be bought).
5. To manage default risk, it is marked to market through Margin Account.
Steps in Commodity Rate Hedging through Future
Sale of X units after 3 months, through Futures
2. Number of Future Contracts Required

= Total Quantity/Size of each Future
(round-off number)
3. Strategy:
Sell X Futures of 100,000 Size @ 75.5
4. Gain/(Loss) on Futures:
It is Loss if company will receive less than market (on maturity).
= No. of Futures * Size of Futures * (Agreed Rate - Market Rate)
Page | 4
Receipts from Sale of Commodity @ market rate

Less: Loss on Futures
Net Receipt
Effective Rate = Net Receipts /Quantity
.
PRACTICE QUESTIONS
Q. 2
A sugar producer estimates 14.55 tons of sugar will be available for sale in three months’ time. The following are relevant
information:
(i) Sugar price in today’s market is Rs. 120,000 per ton.
(ii) Futures contract on one ton of sugar with three months to expiry is at Rs. 130,000.
(iii) After three months, price of sugar is 115,000/ton.
Required:
Calculate net proceeds to be received by sugar producer if:
(a) Future contract is not used by sugar producer to hedge its risk.
(b) Future contract is used by sugar producer to hedge its risk.
(ICAP Book: Chapter 14 – Example, Amended)
Q. 3
A wheat trader estimates demand from her customers in next four months as 13.68 tons of wheat. The following are
relevant information:
(i) Spot price is Rs. 55,000 per ton.
(ii) Futures contract on one ton of wheat with four months to expiry is at Rs. 58,000.
Required
Compute the outcome at the end of four months if trader uses future contracts to hedge the market rate risk and price
goes to Rs. 61,000 per ton at the end of fourth month.
(ICAP Book: Chapter 14 – Self Test Question # 06)
Page | 5
PART B – EXCHANGE RATE RISK
LO 4: INTRODUCTION TO EXCHANGE RATE:
What is an Exchange Rate:

Exchange Rate is the price of a FCY in terms of local currency e.g. Rs. 200/$, or Rs. 250/£.
Direct and Indirect Exchange Rates:

Exchange Rate may be quoted either directly (preferred way) or indirectly.
 In direct quote, domestic currency is numerator e.g. Rs. 200/$.
 In indirect quote, foreign currency is numerator e.g. $0.005/Rupee
Exam Tip
Always Use/Convert Exchange Rate into Direct Quote. [Direct Rate = 1/Indirect Rate]
Buying and Selling Rate:

While quoting Exchange Rate, two types of rates are mentioned e.g. US $ exchange rate is quoted as
“Rs. 208.4 – 211.15”.
 First rate (i.e. lower rate) is called Buying Rate. It is the rate at which Bank buys $ (and we
sell).
 Second rate (i.e. higher rate) is called Selling Rate. It is the rate at which Bank sells $ (and
we buy).
Terms used in Exchange Rate Hedging:

 Spot Rate: Today’s market exchange rate.
 Forward Rate: Exchange Rate which is agreed in forward contract.
PRACTICE QUESTIONS
Q. 4
If we go to bank to buy US dollars, and bank quotes us following rate:
Rs. 203.4 – 205.65/$.
Required:
(i) What rate will be applied if we sell dollars to bank.
(ii) What rate will be applied if we buy dollars from bank.
Q. 5
A Pakistani importer has to pay $1,000 in a months time. He takes the forward rate of Rs. 210 –215/$.
Required:
At which rate importer will have to settle his liability?
Page | 6
LO 5: EXCHANGE RATE HEDGING THROUGH FORWARDS:
Forwards:
A Forward contract is a contract with a Bank to sell or buy a foreign currency (e.g. $) in future at
rate agreed today.
Steps in Exchange Rate Hedging through Forward

Receipt of $1,200,000 in 3 months, through Forward
2. Strategy:
Sell Total FCY @ Rate Agreed in Forward
3. Gain/(Loss) on Forward:
It is Gain if company will receive more than market (on maturity).
= Total FCY * (Agreed Rate - Market Rate)
Receipts from Sale of FCY @ market rate

Add: Gain on Forward
Net Receipt
Effective Rate = Net Receipts /Total FCY
.
PRACTICE QUESTIONS
Q. 6
A Pakistani importer has to pay $1,000 in a month’s time. He obtains a forward rate of $0.004444 – 0.004545 /Rupee, and
agrees on it.
If spot rate after a month is Rs. 250/$, what will be net amount which importer will be paying (in rupees)?
Page | 7
LO 6: EXCHANGE RATE HEDGING THROUGH FUTURES:

Hedging Strategy:
 Sell Futures, if FCY is receivable in future.
 Buy Futures, if FCY is payable in future.
Steps in Hedging of a FCY Receivable through Future Contract

Receipt of $1,200,000 in 3 months, through Futures

= Total FCY/Size of each Future
(round-off number)
3. Strategy:
Sell X Futures of 100,000 Size @ 75.5
It is Loss if company will receive less than market (on maturity).
No. of Futures * Size of Futures * (Agreed Rate - Market Rate)
Receipts from sale of FCY @ market rate

Less: Loss on Futures
Net Receipt
Effective Rate = Net Receipts /FCY
.
Calculation of Gain/Loss using Price Ticks:

Price Tick is the minimum change in the price of a Future or Option. It is 1% of 1% of Contract Size.
Gain/Loss (using Ticks) = No. of Futures * Number of Ticks * Tick Value
Where:
 Tick Value = Size of Future * 1% of 1%
 Number of Ticks = Change in Rate / 1% of 1%
PRACTICE QUESTIONS
Q. 7
A Pakistani company expects to receive US$1,200,000 in September, in three months’ time, and it wants to hedge its
exposure with currency futures. The current spot price is Rs.174.0000/$.
A futures contract is for $125,000. The company sells September futures at 172.2350 (i.e. Rs. 172.2350 per $1).
What will be outcome if buying rate of dollar on maturity is:

(i) 175.1350? (ii) 200 (iii) 150
Q. 8
On May 1, 202X a Pakistani company plans to hedge the market rate risk of a export receipt amounting to US$1,600,000
expected to receive on July 31,202X. The current spot price is Rs.174.0000/$.
A futures contract is for $125,000 and is available at Rs.175.5/$.
Required
Compute the outcome of hedge with future contracts if spot rate of dollar is 171.1550 on July 31, 202X.
Page | 8
LO 7: EXCHANGE RATE HEDGING THROUGH OPTIONS:
What is a “Currency Option”:

A currency option gives right to Sell or Buy Foreign currency on a specified date, at agreed
exchange rate (called Strike Rate or Exercise Price).
Types of Options:
There are two types of Options.
 Get Put Option, if FCY is receivable in future.
 Get Call Option, if FCY is payable in future.
Steps in Hedging of a FCY Receivable through Option Contract

Receipt of $20,000,000 in 4 months, through Options.
2. Option Size and Currency

$ 125,000
3. Number of Options Contracts Required

= Total FCY/Size of each Option
(round-off number)
4. Strategy:
Get Put Option of 4 Month (or nearest) expiry @Strike Rate
5. Gain on Option:
If it is Loss, don’t exercise Option. If it is Gain, exercise Option.
Gain = No. of Options * Size of Option * (Strike Rate - Market Rate)
6. Calculate Net Receipt (in LCY) and Effective Rate:
Receipts from Sale of FCY @ market rate

Add: Gain on Options
Less: Premium on Options
= Total Currency * Rate of Premium
(if Premium is in FCY, also multiply it with Spot Rate)
= Net Receipt
Effective Rate = Net Receipt/FCY
.
Exam Tips
Effective Rate on Put Options = Market Rate or Strike Rate whichever is higher – Premium Rate
Page | 9
PRACTICE QUESTIONS
Q. 9
A US company expects to pay 1 million euros to a supplier in Belgium. It is now November and the payment is due in
March.
The company wants to use currency options to hedge the exposure. Each currency option is for 125,000 euros.
Company chooses a strike price of 1.2400 (US$/€1) for the options, and that the premium for a March option at this strike
price is 3.43 US cents per euro.
Required:
Calculate total cost if US company exercises Options.
Q. 10
A US company has a net cash outflow of €300,000 in payment for clothing to be imported from Germany. The payment
date is not known exactly, but should occur in late March. On January 15, a ceiling purchase price for euros is locked in by
buying 10 calls on the euro, with a strike price of $1.58/€ and an expiration date in April.
The option premium on that date plus brokerage commissions is $.0250/€.
Required:
Calculate effective rate if on expiration date:
(a) exchange rate is $1.52/€
(b) exchange rate is $1.64/€
LO 8: EXCHANGE RATE HEDGING THROUGH MONEY MARKET:
What is a Money Market Hedging:
“To hedge FCY through borrowing and depositing money.”
Steps in Hedging of a FCY Receivable through Money Market

1. What is to be hedged
Receipt of $ 800,000 in 3 months, through Money Market Hedging.
2. Steps in Money Market Hedging:

i. Discount FCY Receivables [= FCY / 1 + (borrowing rate * period)]
ii. Borrow discounted FCY from bank.
iii. Sell FCY using Spot Rate (= buying rate or lower rate)
iv. Deposit LCY in Saving Account, and earn Interest
Principal received from selling FCY (step # iii above)

Add: Interest on Principal (step # iv above)
Net Receipt
Effective Rate = Net Receipt/FCY
.
Exam Tips
1. Spot Rate and Interest Rate are used only in Money Market Hedging.
2. In money market hedging, we don’t use money now rather we deposit it till settlement date i.e. it is
Hedging Strategy, not Financing strategy.
Page | 10
PRACTICE QUESTIONS
Q. 13
A UK company expects to receive US$800,000 in three months’ time. It wants to hedge this exposure to currency risk
using a money market hedge.
Spot three-month interest rates currently available in the money markets are:
Deposits Borrowing
US dollar 4.125% 4.250%
British pound 6.500% 6.625%
The spot exchange rate (US/£1) is 1.7770 – 1.7780.
Required:
Calculate effective exchange rate if money market hedging is used.
PART C – INTEREST RATE RISK
LO 9: INTEREST RATE HEDGING THROUGH FORWARDS:
Features of a Forward Rate Agreement (FRA):

1. Forward Rate Agreements are referred as “T1 ×T2 FRA” where T1 is the beginning period, and T2
is the ending period e.g. “Rs. 5m 3–9 FRA at 5%”
2. In FRA, only differential amount is paid.
3. In FRA interest is paid at T1 (i.e. after discounting the cash flows).
Steps in Hedging of a FCY Receivable through Money Market

Borrowing of Rs. 5,000,000 after 3 months for 6 months, through Forward
2. Strategy
Buy '3V9 FRA' for 5,000,000 @ Borrowing/Higher Interest Rate
Here, Payoff at T1 is the discounted Gain/Loss because as interest payment of FRA will be settled on
start of loan i.e.
Payoff = Loan * (Agreed Rate - Market Rate) * Period of Loan/1+(Market Rate* Period of Loan)
Interest Payment @ market rate

Less: Gain on Forward
Net Payment
Effective Rate = Net Payment/(Loan * Period)
.
Page | 11
PRACTICE QUESTIONS
Q. 14
A will need to borrow Rs.5 million in three months’ time for a period of six months. A 3 v 9 FRA for principal amount of Rs.
5 million is available at 5.40% – 5.36%.
What will be payoff to company because of this Forward if company:
(a) does not buys this FRA and at the end of month 3, six-month KIBOR is 6.25%.
(b) buys this FRA and at the end of month 3, six-month KIBOR is 6.25%.
(c) buys this FRA and at the end of month 3, six-month KIBOR is 4.75%.
Q. 15
On January 1, 202X ABC Company is planning to borrow Rs. 30 million for a period of six months starting from April 1,
202X. ABC wants to lock the rate of interest today for the planned period of borrowing.
Today the bank’s FRA rates for 3 v 9 FRAs are 5.50 – 5.47 and KIBOR is the reference rate in the contract.
(a) What should ABC do to lock the interest rate today?
(b) Calculate the future value of settlement of the FRA on April 1, 202X if:
(i) Six-month KIBOR is 6.25%.
(ii) Six-month KIBOR is 4.955%.
LO 10: INTEREST RATE HEDGING THROUGH FUTURES:
Hedging Strategy:
 Sell Futures, if amount is to be received/borrowed in future.

 Buy Futures, if amount is to be deposited in future.
Steps in Interest Rate Hedging through Future Contract

Borrowing of Rs. 8,000,000 at end of May for 3 months, through Futures

= Total Loan/Size of each Future
(round-off number)
3. Strategy:
Sell 8 Futures of 1 million Size @ 3.5%
4. Gain/(Loss) on Future:
It is Gain if company will pay less than market (on maturity).
Gain/Loss = No. of Futures * Size of Futures * (Agreed Rate - Market Rate) * Period of Loan
5. Calculate Net Payment and Effective Rate:

Less: Gain on Futures
Net Payment
Effective Rate = Net Payment/(Loan * Period of Loan)
.
Page | 12
Calculation of Gain/Loss using Price Ticks:

Price Tick is the minimum change in the price of a Future or Option. It is 1% of 1% of Contract Size.
Gain/Loss (using Ticks) = No. of Futures * Number of Price Ticks * Tick Value * Loan Period
Where:
 Number of Price Ticks = Change in Rate / 1%
 Tick Value = Size of Future * 1% of 1%
Please note that:

 Change in Interest Rate is divided by 1% (instead of 1% of 1%) because interest rate is
already in %age.
 Tick value is multiplied with Loan Period because interest is for specified period only.
Price of Future = Price of STIR Futures is quoted indirectly i.e. Price = 100 – Interest Rate. A price of
95.50 indicates Libor rate of 4.50% (100 − 95.50).
PRACTICE QUESTIONS
Q. 16
On January 1, 202X, XYZ Company plans to borrow Rs. 57 million on April 1, 202X for six months. Standard
future contract size is Rs.10 million.
The current spot KIBOR rate is 7.00% (for both three months and six months) and the current September
KIBOR futures price is the same, 93.00.
Required:
(a) How should XYZ Company hedge the interest rate risk using future contracts?
(b) Calculate the total effective borrowing cost if on April 1, 202X the three-month and six-month spot KIBOR
rate is 6.50% and the September 30, 202X futures price is also the same, 93.50 (100 – 6.5).
Q. 17
A company will need to borrow Rs. 8 million for 3 months from the end of May. It is now January.
The current spot KIBOR rate is 3.50% (for both three months and six months) and the current June KIBOR
futures price is the same, 96.50.
Suppose that in May when the company borrows Rs. 8 million, the three-month and six-month spot KIBOR
rate is 4.25% and the June futures price is the same, 95.75 (100 – 4.25).
Future Contract size is Rs. 1 million.
Required:
(a) How should Company hedge the interest rate risk using future contracts?
(b) Calculate the total effective borrowing cost.
Page | 13
LO 11: INTEREST RATE HEDGING THROUGH OPTIONS:

What is an Interest Rate Option:
An agreement with an option to pay or receive interest at an agreed rate on a Standard Principal
Amount over a standard period.
Types of Options:
 Put Option, to hedge borrowing.
 Call Option, to hedge deposits.
Steps in Interest Rate Hedging through Option Contract

Borrowing of Rs. 10,000,000 after 4 months for 3 months, through Options.

= Total Borrowing/Size of each Option
3. Strategy:
Buy Put Option to Borrow 10 million @ strike price of 4.00%
4. Gain on Option:
It is Gain if company will pay less than market (on maturity).
 Note 1: In case of Loss, option will be ignored.
 Note 2: Payoff is the discounted Gain/Loss
Gain = No. of Options * Size of Option * (Strike Rate - Market Rate) * Period of Loan/1+(Market
Rate* Period of Loan)

Less: Gain on Options (if any)
Add: Premium on Options
= Total Amount * Rate of Premium * Period of Loan
Net Payment
Effective Rate = Net Payment/(Loan * Period of Loan)
.
Exam Tips
Effective Rate on Borrowing Options = Market Rate or Strike Rate whichever is lower + Premium Rate
Exam Tips:
1. If main contract is for receipt, gain will be added and loss will be deducted.
If main contract is for payment, gain will be deducted and loss will be added.
2. If two rates are quoted as Interest rates or Exchange Rates (direct method), use lower rate
for receipts and higher rate for payment. (because bank sells at high rate and buys at low)
Page | 14
PRACTICE QUESTIONS
Q. 18
A company intends to borrow US$ 10 million in four months’ time for a period of three months, but is concerned about
the volatility of the US dollar LIBOR rate. The three-month US$ LIBOR rate is currently 3.75%, but might go up or down in
the next four months.
The company therefore takes out a borrower’s option with a strike rate of 4% for a notional three-month loan of US$10
million. [Contract size is US$10 million/option contract].
The expiry date is in four months’ time. The option premium is the equivalent of 0.5% per annum of the notional
principal.
Required:
Calculate effective rate assuming a spot LIBOR rate at the option expiry date of
(a) 6% and
(b) 3%.
Q. 19
Best Trading Limited needs to borrow US$20 million in six months’ time for a period of four months.
The four-month US$ LIBOR rate is currently 3.00%, but might go up or down in the next six months.
The borrower’s option is available at a premium of 0.2% per annum with a strike rate of 3.35% with expiry date in six
months’ time.
Assume that the company is able to borrow at the US dollar LIBOR rate.
Required:
Compute effective interest rate for Best Trading Limited, if:
(a) The three-month LIBOR rate is 3.9% at the expiry date.
(b) Three-month US dollar LIBOR rate is 3% at the expiry.
LO 12: CALCULATING FORWARD RATE FROM SPOT RATE:
If you are given Spot rate and Premium/Discount, you can calculate Forward Rate.
 If Spot Rate is “Direct Quoted”: Add Premium, Subtract Discount.
 If Spot Rate is “Indirect Quoted”: Add Discount, Subtract Premium.
After calculation of Forward Rates, use that rate for conversion which is more favorable for bank.
PRACTICE QUESTIONS
Q. 20
A UK company expects to receive US$100,000 in six months from a US customer and it wishes to hedge the exposure to
currency risk by arranging a forward contract.
The following rates are available (US$/£1):

Spot (£1) = 1.7530 - 1.7540
Six months forward premium 240 - 231
Required:
What is the amount that the company can fix its future income from the US dollars?
Page | 15
APX 2: SOLUTIONS TO PRACTICE QUESTIONS:

Q. 1
(a) If Forward contract is not used:
Commodity will be sold at market price on maturity i.e. @ Rs. 115,000/ton.
Total Receipts = 14.55 Ton * 115,000/ton = Rs. 1,673,250.
(b) If Forward contract is used:
1. Gain /Loss on Forward:

= 14.55 * (130,000 – 115,000) = 218,250
It will be a Gain as Forward Contract is favorable for sugar producer now.
Receipts from Sale of Commodity @ market rate (14.55 * 115,000) 1,673,250

Add: Gain on Forward* 218,250
Net Receipt 1,891,500
Effective Rate = [ Net Receipts / Quantity of Commodity] 130,000
* Gain and Receipt both are inflows. Therefore, this will be added.
Note: In Forward Contract, any quantity can be agreed between parties.
Q. 2
(a) If Future contract is not used, commodity will be sold at market price on maturity i.e. @ Rs. 115,000/ton.
Total Receipts = 14.55 Ton * 115,000/ton = Rs. 1,673,250
(b) If Future contract is used:

Sale of 14.55 Ton after 3 months, through Futures

= 14.55 / 1 = 14.55 i.e. 15 Future Contracts
(we rounded it off because Future Contract is available only in standard quantity of 1 Ton and not for partial quantity)
3. Strategy:
Sell 15 Futures of 1 Ton @ 130,000
15 * 1 * (130,000 – 115,000) = 225,000
It will be a Gain as Future Contract is favorable for sugar producer now.
Receipts from Sale of Commodity [14.55 * 115,000] 1,673,250

Add: Gain on Futures 225,000
Effective Rate [ Net Receipts / Quantity of Commodity] 130,464
Page | 16
Q. 3
Sale of 13.68 Ton wheat after 4 months, through Futures

= 13.68 / 1 = 13.68 i.e. 14 Future Contracts
(we rounded it off because Future Contract is available only in standard quantity of 1 Ton and not for partial quantity)
3. Strategy:
Sell 14 Futures of 1 Ton @ 58,000
14 * 1 * (58,000 – 61,000) = 42,000
It will be a Loss as Future Contract is unfavorable for wheat trader now.
Receipts from Sale of Commodity [13.68 * 61,000] 834,480

Less: Loss on Futures* (42,000)
Net Receipt 792,480
Effective Rate [ Net Receipts / Quantity of Commodity] 57,930
* Receipts is inflow, but Loss is outflow
Q. 4
(i) Bank will apply buying/lower rate i.e. Rs. 203.4/$.
(ii) Bank will apply selling/higher rate i.e. Rs. 205.65/$.
Q. 5
As importer is buying $, he will use higher rate i.e. Rs. 215/$.
If agreed today, importer will pay Rs. 2150,000 (= 215 * 1,000) and bank will give importer $1,000 after 1 month. It does
not matter whether exchange rate is Rs. 230 or Rs. 200 after one month.
Q. 6
First, we will convert exchange rate into direct method i.e. Rs. 220 – 225 (= 1/0.004545 – 1/0.004444).
[Note that after conversion to direct method, higher rate becomes lower, and lower rate becomes higher.]
As importer is buying $, bank will use selling/higher rate i.e. Rs. 225/$.
1,000 * (225 - 250) = 25,000

It will be a Gain as Forward Contract is favorable for company now.
Payment to Purchase FCY @ market rate 250,000

Less: Gain on Forward * 25,000
Net Receipt 225,000
Effective Rate [=Net Receipts /Total FCY] 225
* Payment is outflow, but Gain is inflow
Page | 17
Q. 7
Receipt of US$ 1,200,000 after 3 months, through Futures

= $ 1,200,000 / $ 125,000 = 9.6 i.e. 10 Future Contracts
(we rounded it off because Future Contract is available only in standard quantity of $ 125,000 and not for partial quantity)
3. Strategy:
Sell 10 Futures of $ 125,000 @ 172.2350
(i)
125,000 * 10 * (172.2350 – 175.1350) = 3,625,000
It will be a Loss as Future Contract is unfavorable for company now.
Receipts from Sale FCY @ market rate [1,200,000 * 175.1350] 210,162,000

Less: Loss on Futures* (3,625,000)
Effective Rate [ Net Receipts /Total FCY] 172.1142
(ii)
125,000 * 10 * (172.2350 – 200) = 34,706,250
It will be a Loss as Future Contract is unfavorable for company now.
Receipts from Sale FCY @ market rate [1,200,000 * 200] 240,000,000

Less: Loss on Futures* (34,706,250)
(iii)
125,000 * 10 * (172.2350 – 150) = 27,793,750
It will be a Gain as Future Contract is favorable for company now.
Receipts from Sale FCY @ market rate [1,200,000 * 150] 180,000,000

Add: Gain on Futures* 27,793,750
* Receipts is inflow, and Gain is also inflow
Page | 18
Q. 8

= $ 1,600,000/$ 125,000 = 12.8 i.e. 13 (rounded off)
3. Strategy:
Sell 13 Futures of 125,000 Size @ 175.5
It is Gain as company will receive more than market (on maturity).
Gain = 13 * 125,000 * (175.5 – 171.155) = 7,060,625
Gain (through Price Ticks) = Number of Futures * Number of Ticks * Tick Value * Loan Period
= 13 * 43,450 * 12.5 = 7,060,625
Receipts from sale of FCY [1,600,000 * 171.155] 273,848,000

Add: Gain on Futures 7,060,625
Effective Rate = Net Receipts /FCY 175.57
Q. 9
Payment of € 1,000,000 in March, through Options.

€ 125,000

= 1,000,000 /125,000 = 8
4. Strategy:
Get 8 Call Option @ Strike Rate $1.24/€
Payment of FCY @ market rate [1,000,000 * 1.24] 1,240,000

Less: Gain on Options N/A
Add: Premium on Options (1,000,000 * 0.0343) 34,300
= Net Payment 1,274,300
Effective Rate = Net Payment/FCY 1.2743
Q. 10
Payment of € 300,000 in March, through Options.

€ 30,000

= 10
4. Strategy:
Get 10 Call Option @ Strike Rate $1.58/€
Page | 19
5. Gain on Option:
(a) It is Loss as company will pay more than market. Don’t exercise Option.
(b) It is Gain as company will pay less than market.

Gain = 10 * 30,000 * (1.58 – 1.52) = 18,000
(a)
(b)
Payment of FCY @ market rate 456,000
492,000
Less: Gain on Options N/A (18,000)
7,500
Add: Premium on Options (300,000 * 0.0250)
7,500
= Net Payment 463,500 481,500
Effective Rate = Net Payment/FCY 1.545 1.605
Q. 13
Receipt of $ 800,000 after 3 months, through Money Market Hedging.
2. Steps in Money Market Hedging:

i. Discount US $800,000
$800,000 / 1 + (4.250% * 3/12) = $791,589
ii. Sell FCY using Spot Rate
$791,589 * 0.5624 = £445,213
iii. Deposit LCY in Saving Account, and earn Interest
Interest = £445,213 * 6.5% * 3/12 = 7,235
Principal received from selling FCY 445,213

Add: Interest on Principal 7,235
Net Receipt 452,448
Effective Rate = Net Receipt/FCY 0.5656
.
Q. 14
(a) There will be no payoff as company did not use Forward for Hedging. Company will have to pay interest on this loan
@ 6.25% for six months i.e.
Interest Payment = 5,000,000 * 6.25% * 6/12 = 156,250
(b) If company borrows this FRA, rate agreed for this borrowing will be 5.40% (i.e. higher rate as bank charges higher
rate on borrowing and less rate on deposits).
Gain/Loss on Forward:
= Loan * (Agreed Rate in FRA - Market Rate) * Period/1+(Market Rate* Period)
= 5,000,000 (5.40% - 6.25%) * 6/12 ÷ 1 + (6.25% * 6/12)
= 21,250 ÷ 1.03125
= 20,606
It is a gain as Forward Contract is favourable for us now.
(b) If company borrows this FRA, rate agreed for this borrowing will be 5.40% (i.e. higher rate as bank charges higher
rate on borrowing and less rate on deposits).
Page | 20
Gain/Loss on Forward:
= Loan * (Agreed Rate in FRA - Market Rate) * Period/1+(Market Rate* Period)
= 5,000,000 (5.40% - 4.75%) * 6/12 ÷ 1 + (4.75% * 6/12)
= 16,250 ÷ 1.02375
= 15,873
It is a loss as Forward Contract is unfavourable for us now.
Q. 15
Borrowing of Rs. 30,000,000 after 3 months for 6 months, through Forward
2. Strategy
Buy '3V9 FRA' for 30,000,000 @ 5.50%
(i) It is Gain as company will pay less than market.
Payoff = 30,000,000 * (6.25% - 5.50%) * 6/12 divided by 1+(0.0625* 6/12)
= 112,500/1.03125 = 109,091
(ii) It is Loss as company will pay more than market.

Payoff = 30,000,000 * (4.955% - 5.50%) * 6/12 divided by 1+(0.04955* 6/12)
= 81,750/1.024775 = 79,774
Q. 16
Borrowing of Rs. 57,000,000 at end of April for 6 months, through Futures

= 57,000,000/10,000,000 = 5.7 i.e. 6 (rounded-off)
3. Strategy:
Sell 6 April Futures of 10 million Size @ 7%
It is Loss as company will pay more than market (on maturity).
Loss (through Interest Rate) = 6 * 10,000,000 * (7.0% - 6.5%) * 6/12 = 150,000
Loss (through Price Ticks) = Number of Futures * Number of Ticks * Tick Value * Loan Period
= 6 * 50 * 1000 * 6/12 = 150,000
Interest Payment [57,000,000 * 6.5% * 6/12] 1,852,500

Add: Loss on Futures (150,000)
Net Payment 2,002,500
Effective Rate = Net Payment/(Loan * Period of Loan) 7.03%
Q. 17
Borrowing of Rs. 8,000,000 at end of May for 3 months, through Futures

= 8,000,000/1,000,000 = 8
3. Strategy:
Sell 8 Futures of 1 million Size @ 3.5%
Page | 21
It is Gain as company will pay less than market (on maturity).
Gain (through Interest Rate) = 8 * 1,000,000 * (4.25% - 3.50%) * 3/12 = 15,000
Gain (through Price Ticks) = Number of Futures * Number of Ticks * Tick Value * Loan Period
= 8 * 75 * 100 * 3/12 = 15,000
Interest Payment [8,000,000 * 4.25% * 3/12] 85,000

Less: Gain on Futures (15,000)
Net Payment 70,000
Q. 18
(a) (b)
Interest Payment [10,000,000 * 6% * 3/12] 150,000 75,000
Less: Gain on Options [10,000,000 * 2% * 3/12] N/A
(50,000)
Add: Premium on Options [10,000,000 * 0.5% * 3/12] 12,500
12,500
Net Payment 112,500 87,500
Effective Rate = Net Payment/(Loan * Period of Loan) 4.5% 3.5%
Q. 19
(a) The three-month LIBOR rate is 3.9% at the expiry date.
As market rate is more than strike price, therefore company will exercise this option.
Calculation of Effective Rate is:

Interest Payment @ market rate [US$20 million * 3.9% *4/12] 260,000
Less: Gain on Options [US$20 million * 3.9% - 3.35% *4/12]
(36,667)
Add: Premium on Options [US$20 million * 0.2% *4/12]
13,333
Net Payment 236,666
(b) The three-month LIBOR rate is 3.9% at the expiry date.

As market rate is less than strike price, therefore company will NOT exercise this option.
Calculation of Effective Rate is:

Interest Payment @ market rate [US$20 million * 3 % *4/12] 200,000
Add: Premium on Options [US$20 million * 0.2% *4/12]
13,333
Net Payment 213,333
Page | 22
Q. 20
Spot Rate (Indirect Quote i.e. $/£) 1.7530 1.7540
Less: Forward Points (Premium) 0.0240 0.0231
Forward Rate (Indirect Quote) 1.7290 1.7309
Forward Rate (Direct Quote i.e. £/$ ) 0.5784 0.5777
Company will receive US$100,000 * 0.5777 = £ 57,770.
Page | 23
Managerial & Financial Analysis – The Practice Kit Chapter 13: Financial Risk Management
CHAPTER 13
FINANCIAL RISK MANAGEMENT
QUESTIONS
1 A cotton producer estimates 20 tons of cotton will be available for sale in three months’ time. He gathers the following
information for the purpose of hedging using futures:
 Futures contract for one ton of cotton with three months to expiry is at Rs. 31,500.
 Producer will sell 20 futures at Rs. 31,500, as the standard contract size is one ton.
After three months, price of cotton is expected to be Rs. 32,500 per ton.
What is the cotton producer’s effective rate per ton if he decides to hedge through futures?
(a) Rs. 30,500
(b) Rs. 33,500
(c) Rs. 32,500
(d) Rs. 31,500 (02)
(ICAP, MFA – Autumn 2022, Q.#1(vii))
PRACTICE QUESTIONS
Q. 1 Shaheen Limited (SL) is engaged in manufacturing and selling textile products. SL procures the material locally which is
then manufactured and exported to customers. The management of SL is concerned over high volatility in foreign
exchange rates. The receipt of USD 50,000 from a customer is expected in three months’ time and management is
considering to hedge the foreign exchange risk.
SL’s bank has quoted the following exchange rates and annual interest rates:
USD 1
Buy Sell
Spot 178.650 179.800
1 month forward 177.745 178.795
3 months forward 177.555 178.555
Deposit % Borrowing %
USD 1.25 2.75
PKR 6.75 9.75
Required:
Determine which of the following options would be more beneficial for SL:
(a) Hedging through forward contract
(b) Hedging through money market
(c) No hedging. Assume that on the date of settlement of transaction, spot rate is USD 1 = PKR 178.15 (09)
(ICAP, CAF 06 Level – Spring 2022, Q#7)
Page | 1
Q. 2 On 1 May 202X, a Pakistani company plans to hedge the foreign exchange risk of a export receipt amounting to USD
1,600,000 expected to receive on 31 July 202X. The current spot price is Rs. 174.0/USD.
A futures contract is for USD 125,000 and is available at Rs. 175.50/ USD. The value of a tick is Rs. 12.50.
Required:
Compute the outcome of hedge with future contracts if:
(i) spot rate of dollar on 31 July 202X is USD 174.155
(ii) spot rate of dollar on 31 July 202X is USD 176.225 (05)
(ICAP, CAF 06 Level – ICAP Model Paper Q#10)
Q. 3 Assume today is 1 September 2022.
On 1 September 2022, Karachi Kites Limited (KK) plans to hedge the market rate risk of an export receipt amounting to
USD 2,000,000 which is expected to be received on 30 November 2022. The current spot price per USD is Rs. 208.
KK intends to hedge the currency risk through futures. A future contract is for USD 120,000 and is available in standard
lot size of 1 with a tick value of Rs. 12. Following future rates are available:
Future Rate Maturity Date
October future Rs. 210.5/USD 31 October 2022
November future Rs. 213.5/USD 30 November 2022
December future Rs. 215.5/USD 31 December 2022
The spot rate on 30 November 2022 is expected to be Rs. 218.5.
Required:
(a) Set up the hedge for USD receipt. (02)
(b) Compute the gain/loss in term of ticks. (02)
(c) Compute the effective exchange rate for KK. (02)
(ICAP, CAF 06 Level – Autumn 2022,Q#8)
Q. 4 Fifa Sports Limited (FSL) imports raw material from China. FSL has to pay CNY 1,000,000 in six months’ time. FSL plans to
hedge this exposure to currency risk using a money market hedge. Following information is available in this regard:
Deposit Borrowings
Interest rates
Rate per annum
In CNY (3 months) 11.35% 15.12%
In CNY (6 months) 11.71% 15.81%
In PKR (3 months) 12.12% 17.01%
In PKR (6 months) 12.90% 17.16%
PKR/CNY
Current spot exchange rate PKR 34.5
Estimated exchange rate in 3 months PKR 36.8
Estimated exchange rate in 6 months PKR 37.6
Required:
Construct money market hedge and determine the effective exchange rate. Recommend whether the hedge would be
beneficial for FSL. (06)
(ICAP, CAF 06 Level – Spring 2023, Q # 9b)
Page | 2
SUGGESTED SOLUTIONS
SUGGESTED SOLUTIONS
1 d
PRACTICE QUESTIONS
A.1 (a)
We will sell USD 50,000 to bank using 3 months forward Buy Rate (because bank will buy). Amount to be received will be
50,000 * 177.555 = 8,877,750.
(b)
Step 1: Discount FCY Receivable
50,000 / 1 + (0.0275 * 3/12) = 49658.60
Step 2: Borrow FCY and sell using spot rate

49658.60 * 178.650 = 8,871,508
Step 3: Deposit LCY in Saving Account

Interest = 8,871,508 * .0675 * 3/12 = 149,707
Principal + Interest = 8,871,508 + 149,707 = 9,021,215
(c)
We will sell USD 50,000 to bank using spot rate on date of settlement of transaction. Amount to be received will be 50,000
* 178.15 = 8,907,500.
Conclusion: Hence, Money Market Hedge is more beneficial because it will result in highest amount of receipts.
Several mistakes were noted while determining the hedging through money market. For example, in selecting the correct
borrowing rates and exchange rates.
Marking Plan:
• Hedging through forward contract 1.0

• Hedging through money market 6.5
• No hedging 1.0
• Conclusion 0.5
(b)
Passing Percentage:
73%
Page | 3
A.2

= $1,600,000/$125,000 = 12.8 i.e. 13 (rounded)
3. Strategy:
Sell 13 Futures of $125,000 Size @ 175.5
(i) It is Gain as company will receive more than market (on maturity).
= 13 * $125,000 * (175.5 – 174.155) = Rs. 2,185,625
(ii) It is Loss as company will receive less than market (on maturity).
= 13 * $125,000 * (175.5 – 176.225) = Rs. 1,178,125
(i) (ii)
Receipts from sale of FCY (1,600,000 * 174.155), (1,600,000 * 176.225) 278648000 281960000
Add: Gain on Futures 2,185,625
Less: Loss on Futures (1,178,125)
Net Receipt 280,833,625 280,781,875
Effective Rate = Net Receipts /FCY 175.52 175.49
.
A.3
Receipt of $2,000,000 in November, through Futures

= $2,000,000/$120,000 = 16.67 i.e. 17 (rounded)
3. Strategy:
Sell 17 November Futures of 120,000 Size @ Rs. 213.5
It is Loss as company will receive less than market (on maturity).
Number of Ticks = Change in Rate (i.e. 5) / 1% of 1% = 50,000
Loss = No. of Futures * Number of Price Ticks * Amount of a Price Tick

= 17 * 50,000 * 12 = 10,200,000
Receipts from sale of FCY @ market rate 437,000,000

Less: Loss on Futures (10,200,000)
Effective Rate = Net Receipts /FCY 213.4
.
Page | 4
• Some examinee did not round up the number of futures contracts to 17 considering that futures markets do not
usually allow partial contracts.
• Majority of the examines did not provide the gain / loss in terms of ricks which was one of the requirements of this
question.
• Some examinees also could not calculate the loss in rupees as they failed to correctly identify the selling and buying
rates.
Marking Plan:
(a)
• Setting up the hedge 2.0
(b)
• Computing the gain/loss in terms of ticks 2.0
(c)
• Computing the effective exchange rate 2.0
Passing Percentage:
35%
A.4 Money Market Hedge:

Step 1: Discount FCY Payable
CNY 1,000,000 / 1 + (0.1171 * 6/12) = CNY 944,689
Step 2: Amount required to Buy FCY using spot rate

CNY 944,689 * 34.5 = 32,591,770
Step 3: Borrow amount for 6 months

Interest = 32,591,770 * .1716 * 6/12 = 2,796,374
Total Payoff (Principal + Interest) = 32,591,770 + 2,796,374 = 35,388,144
Step 4: Effective Rate

Effective Rate: 35,388,144/1,000,000 = 35.39
Conclusion:
Money Market Hedging is beneficial as Total Payment after Hedging (35,388,144) is less than payment using actual rate
on date of settlement (CNY 1,000,000 * 37.6 = 37,600,000).
Some examinees chose incorrect deposit and borrowing rates when calculating the funds required. Additionally, some
examinees neglected to calculate the effective exchange rate.
Marking Plan:
• Step 1 – Compute required CNY 2.0

• Step 2 – Funds required in PKR 1.0
• Step 3 – Borrow in PKR 1.5
• Step 4 – Pay CNY and calculate effective exchange rate 1.0
• Conclusion 0.5
Passing Percentage:
68%
Page | 5
Managerial & Financial Analysis – Study Notes Chapter 14: Budgeting
CHAPTER 14
BUDGETING
ICAP Book
Chapter Paragraph #
#
LO 1 TYPES OF BUDGETS 14
PROFIT & LOSS BUDGET:
LO 2 SALES REVENUE 14
LO 3 COST OF SALES [FOR TRADING COMPANY] 14
LO 4 COST OF SALES [FOR MANUFACTURING COMPANY] 14
LO 5 BUDGETING OF OVERHEADS 14
MARGINAL COSTING AND FIFO METHOD FOR
LO 6 14
VALUATION OF INVENTORY
LO 7 LABOR EFFICIENCY/PRODUCTION EFFICIENCY 14
VALUATION OF INVENTORY AND RECONCILIATION OF
LO 8 PROFITS UNDER MARGINAL AND ABSORPTION 14
COSTING
LO 9 DEPRECIATION AND DISPOSAL OF FIXED ASSETS 14
CASH BUDGET
LO 10 CASH BUDGET 14
LO 11 SUGGESTED FORMAT OF CASH BUDGET 14
Page | 1
LO 1: TYPES OF BUDGETS:
There are two types of Budgets:
 Profit & Loss Budget (in which projected incomes and expenses are shown).
 Cash Budget (in which projected cash receipts and cash payments are shown)
Profit and Loss Budget:

Major items in P&L Budget include:
1. Sales
2. Production Budget [Material Consumed, Labor, Manufacturing Overheads]
3. Operating Expenses Budget [Operating Overheads, Depreciation & Disposal]
In P&L Budget, usually last year’s incomes and expenses are given, you have to calculate
budgeted income and expenses of next years’ using adjustments given in question.
This budget is usually prepared on aggregate basis [NOT month wise].
Cash Budget:
Major items in Cash Budget include:
1. Cash Received from Sales
2. Cash Paid for Purchases
3. Cash Paid for Labor & Overheads expenses (if manufacturing company)
4. Cash Paid for Marketing, Admin, Interest and Other expenses
This budget is usually prepared on month-wise basis.
PART B – PROFIT & LOSS BUDGET
LO 2: SALES REVENUE:
Calculation of Budgeted Sales Revenue:
Sales Revenue = Units Sold * Sale Price
 Units Sold:
Units sold may be given in the question, or you may have to calculate it using Growth Rate.
Example: If units of last year are 1,000 and there is a Growth Rate of 10%, then:
 Units of Y1 = 1,000 * 1.101 = 1,100
 Units of Y2 = 1,000 * 1.102 = 1,210 ………….., and so on.
 Sale Price:
Sale Price may be given in the question, or you may have to calculate it using Inflation Rate.
Example: If sale price of last year is Rs. 60 and there is an Inflation Rate of 5%, then:
 Price of Y1 = 60 * 1.051 = 63
 Price of Y2 = 60 * 1.052 = 66.15 ………….., and so on.
Page | 2
Further Adjustments to the Sale Revenue:

There may be further adjustments to Sales Revenue in the question e.g.
 Discount on Sale.
 More than One Products
PRACTICE QUESTION
Q. 1
XYZ Company manufactures two products STAR and BRIGHT. Forecast Sales (Units) for next month Star is 8,000 and for
Bright 2,000 units. Estimated selling price for Star and Bright is Rs. 500 and Rs. 450 per unit respectively.
Required: Calculate estimated sales revenue for next month.
(Adapted from ICAP Study Text, Example 08)
Q. 2
The marketing director of Shahid Limited has provided the following annual sales projections:
No. of units Retail price range

Men 1,200,000 Rs. 1,000 – 4,000
Women 500,000 Rs. 800 – 2,500
The previous pattern of sales indicates that 60% of units are sold at the minimum price; 10% units are sold at the
maximum price and remaining 30% at a price of Rs. 2,000 and Rs. 1,200 per footwear for men and women respectively.
Required: Calculate estimated sales revenue for next year.
(Adapted from ICAP Study Text, Self Test Question 4)
Q. 3
Rose Industries Limited (RIL) is in process of preparation of its budget for the year ending 31 March 2020. In this respect,
following information has been extracted from RIL's projected financial statements for the year ending 31 March 2019:
Rs. in million
Sales (100% credit sales) 360,000 units 2,800
Information and projections for the budget year ending 31 March 2020:
 Introduction of cash sales at 5% less than the credit sales price. This would increase the total sales volume by
30% whereas credit sales volume would reduce by 20% as some of the existing customers would shift to cash
sales.
Required: Calculate estimated sales revenue for the year ended 31 March 2020.
Q. 4
Beta (Private) Limited (BPL) deals in manufacturing and marketing of bed sheets. The management of the company is in
the phase of preparation of budget for the year 20X3-X4. BPL has production capacity of 4 million bed sheets per annum.
Currently the factory is operating at 68% of the capacity. The results for the recently concluded year are as follows:
Rs. in million
Sales 3,400
The management has planned to take following steps to increase the sale
• Increase selling price by Rs. 150 per unit.
• The sales are to be increased by 25%.
Required:
Calculate projected sales revenue for the year 20X3-X4.
Page | 3
Q. 5
Mazahir (Pakistan) Limited manufactures and sells a consumer product Zee. Salient features of the business plan for the
year ending June 30, 2011 are as under:
- Sale is budgeted at 21,000 units at the rate of Rs. 1,100 per unit.
Required: Calculate budgeted sales revenue.
Q. 6
Sadiq Limited (SL) is in the process of preparation of budget for the year ending 31 December 2018. Following are the
extracts from the statement of profit or loss for the year ended 31 December 2017:
Rs. in million
Sales (30% cash sales) 7,500
Following are the projections to be used in the preparation of the budget:

 Selling price would be reduced by 5%.
 Further, credit period offered to customers would be reduced from 45 days to 30 days. As a result, volumes of
cash and credit sales are expected to increase by 10% and 5% respectively.
Required:
Compute the budgeted Sales.
Q. 7
The following information has been extracted from the projected financial statements of Lotus Enterprises (LE) for the
year ending 30 September 2016:
Rs. in million
Sales (100% credit sales) 3,000
LE is in the process of preparing its budget for the next year. The relevant information is as under:
(i) Sale volume is projected to increase by 30%.
(ii) Introduce cash sales at a discount of 2%. It is estimated that 20% of the customers would avail the discount.
Required:
Compute the budgeted Sales.
LO 3: COST OF SALES [FOR TRADING COMPANY]:
Format:
January February March April May June
xxx xxx xxx xxx xxx xxx

Sales (given)
Opening Stock xxx xxx xxx xxx xxx xxx

Purchases (b/f) xxx xxx xxx xxx xxx xxx
Closing Stock ** xxx xxx xxx xxx xxx xxx
[50% of next period’s Sales]
Cost of Sales [75% of Sales] xxx xxx xxx xxx xxx xxx
 Example 1: Calculation of Cost of Sales.

 If Sales are 150,000 and Gross Profit Margin is 20% on Sales, then Cost of Sales is
120,000 * 0.8 = 120,000.
 If Sales are 150,000 and Gross Profit is 20% on Cost, then Cost of Sales is 150,000 /
1.2 = 125,000.
Page | 4
 Example 2: Calculation of Closing Stock

If Cost of Sales of 2024 are 150,000 and of 2025 are 200,000 and company maintains
finished goods inventory level at 50% of next month’s budgeted sales, then:
 Closing stock of finished goods in 2023 = 75,000 [=150,000 * 0.5]
 Closing stock of finished goods in 2024 = 100,000 [=200,000 * 0.5]
[Closing Stock of This Year = Opening Stock of Next Year]
Points to Note:
 If “next month” is not mentioned in question, it means closing stock will be calculated on Current Year’s Sale.
Q. 8
Queen Jewels (QJ)’s sales are made at cost plus 30%. Sales projected as under:
Sep. 2015 Oct. 2015 Nov. 2015 Dec. 2015 Jan. 2016
Sales (Rs.) 4,600,000 5,000,000 4,200,000 5,800,000 6,000,000
Required: Calculate cost of sales for each month.

Q. 9
Tennis Trading Limited (TTL) was incorporated on 1 September 2018 and would start trading from the month of October
2018. As part of planning and budgeting process, the management has developed the following estimates:
(i) Projected sales for October is Rs. 12 million. The sales would increase by Rs. 2.5 million per month till January 2019.
From February 2019 and onwards, sales would be Rs. 25 million per month.
(ii) Gross profit margin would be 30%.
(iii) TTL would maintain inventory at 80% of the projected sale of the following month, up to December 2018 and
thereafter, 85% of the projected sale of the following month.
Required:
Prepare budgeted Sales and Cost of Sales statement.
Q. 10
Smart Limited has prepared a forecast for the quarter ending December 31, 2009, which is based on the following
projections:
(i) Sales for the period October 2009 to January 2010 has been projected as under:
Rupees
October 2009 7,500,000
November 2009 9,900,000
December 2009 10,890,000
January 2010 10,000,000
The company earns a gross profit at 20% of sales. It intends to increase sales prices by 10% from November 1, 2009,
however since there would be no corresponding increase in purchase prices the gross profit percentage is projected to
increase. Effect of increase in sales price has been incorporated in the above figures.
(ii) Smart Limited follows a policy of maintaining stocks equal to projected sale of the next month.
Required:
Prepare a budgeted profit and loss statement for the quarter ending December 31, 2009.
Page | 5
Q. 11
Zinc Limited (ZL) is engaged in trading business. Following data has been extracted from ZL’s business plan for the year
ended 30 September 2012:
Sales Rs. ‘000’
Actual:
January 2012 85,000
February 2012 95, 000
Forecast:
March 2012 55,000
April 2012 60,000
May 2012 65,000
June 2012 75,000
Following information is also available:

 ZL earns a gross profit of 25% of sales and uniformly maintains stocks at 80% of the projected sale of the
following month.
Required:
Prepare a budgeted profit and loss statement for the quarter ending December 31, 2009.
LO 4: COST OF SALES [FOR MANUFACTURING COMPANY]:
Format:
Cost of Sales
- Material Consumed [Opening + Purchases - Closing]
- Labor
- FOH
Manufacturing Cost -
Add: Opening WIP
Less: Closing WIP
Cost of Goods Manufactured -
Add: Opening Finished Goods
Less: Closing Finished Goods
Cost of Goods Sold [75% of Sales] -
Usually, there two inventory levels are given in a manufacturing question i.e. Finished Good Inventory
and Material Inventory Level.
Points to Note:
 If there is no opening/closing Finished Goods, Cost of Goods Sold = Cost of Goods Manufactured.
 If there is no opening/closing Work in Process, Cost of Goods Manufactured = Manufacturing Cost.
Page | 6
Calculating Manufacturing Cost:

You can work-out Manufacturing Cost in the same way as in LO 2. Thereafter, you have to calculate
break-up of Manufacturing Cost using information given in the question.
 Example 1: Using Ratio.

Manufacturing Cost is Rs. 75,000. Ratio of direct material, direct wages and overheads is
4:3:1 respectively, then:
 Direct Material = 37,500 [75,000 * 4/8]
 Direct Labor = 28,125 [75,000 * 3/8]
 Overheads = 9,375 [75,000 * 1/8]
 Example 2: Using Rates [i.e. Growth Rate & Inflation Rate].

If last year’s sales and material consumption was Rs. 1,000 and 150 respectively. Calculate
this year’s material consumption if sales unit will increase by 10% and material price will
increase by 7%.
 Material Consumed = 150 * 1.1 * 1.07 = 176.55
 Similarly, Labor Cost and Variable Overheads will also be increased by Growth Rate
and Relevant Inflation Rate.
Exam Tip:
 Make it a habit to first adjust Growth Rate and then Inflation Rate.
 After calculation of material consumed, there is no need to calculate closing inventory of raw material, unless cash
paid to creditor is also to be calculated.
PRACTICE QUESTION
Q. 12
Double Crown Limited (DCL) is engaged in manufacturing of a product Zee. Sales projections according to DCL's business
plan for the year ending 31 December 2017, are as follows:
------------------------ Rs. in million ------------------------

May June July August
Sales 60 55 70 68
Additional information includes:

i. Goods are sold at a gross margin of 40% on sales.
ii. Ratio of direct material, direct wages and overheads is 6:3:1 respectively.
iii. Inventory levels maintained by DCL are as under:
 Direct materials: Next month’s budgeted consumption
 Finished goods: 50% of next month’s budgeted sales
Required:
i. Calculate cost of goods manufactured for the month of May, June and July.
ii. Calculate raw material purchases for the month of May and June.
Page | 7
Q. 13
Beta (Private) Limited (BPL) deals in manufacturing and marketing of bed sheets. The results for the recently concluded
year are as follows:
Rs. in million
Sales [2.72 million units] 3,400
Cost of Sales:
Material (1,493)
Labor (367)
Manufacturing overheads (635)
Other information and projection for current year is as follows:

1. The sales (units) are to be increased by 25%, and selling price to be increased by Rs. 150 per unit.
2. The raw material and labor costs are expected to increase by 5%.
3. The overall efficiency of the workforce can be increased by 15% if management allows a bonus of 20%. Further
increase in production can be achieved by hiring additional labor at Rs. 180 per unit.
4. Manufacturing overheads include depreciation of Rs. 285 million and other fixed overheads of Rs. 165 million.
5. Variable manufacturing overheads are directly proportional to the production volume of production.
6. All overheads and fixed expenses (except depreciation) will increase by 5%.
Required:
Prepare profit and loss budget for the next year.
LO 5: BUDGETING OF OVERHEADS:
There are three types of Overheads:
1. Depreciation & Gain/Loss on Disposal [Neither affected by Growth nor Inflation]
2. Fixed Cost (affected by Inflation only)
3. Variable Cost (affected by Growth + Inflation)
a. Manufacturing Cost is affected by Units Produced.
b. Manufacturing Cost is affected by Units Sold.
Exam Tip:
 All these items should always be shown in P&L as separate line item i.e. Fixed Cost should be shown separately
from Variable Cost.
 Similarly, Depreciation and Gain/Loss on Disposal should be shown separately.
LO 6: MARGINAL COSTING AND FIFO METHOD FOR VALUATION OF

INVENTORY:
Suppose a hypothetical company Rose Industries Limited uses Marginal Costing and followings
FIFO method for valuation of inventory.
This policy affects Profit and Loss in 2 ways:

1. Material Consumed.
2. Closing Stock.
Page | 8
Material Consumed:
Normally, material consumed for current year is calculated as follows:
Last year material consumed * Growth Rate (of Production) * Inflation Rate
However, if FIFO method is used, opening stock will be excluded before applying inflation rate,
because opening stock is to be used at previous year’s rates. Now, formula will be as follows:
(Last year material consumed * Growth Rate – Opening Material) * Inflation Rate + Opening Material
Exam Tip:
 Growth Rate of Sales and Production is same if Opening and Closing Finished Goods are Same.
Closing Stock:
Normally, Closing Stock of Finished Goods is calculated as follows:
Cost of Goods Manufactured/Units Manufactured * Units in Hand
However, if Marginal Costing is used, Fixed Cost will be excluded from Cost of Goods Manufactured,
because marginal cost does not include fixed cost. Now, formula will be as follows:
(Material Consumed using Current Rates + Labor + Variable Overheads) /Units Manufactured * Units in Hand
LO 7: LABOR EFFICIENCY/PRODUCTION EFFICIENCY:

What is Efficiency:
Efficiency means either:
 decrease in Cost (with same production) or
 increase in Production (with same cost).
Impact of Labor Efficiency on Budget:
 If there is increase in labor efficiency by 6%, Labor cost will decrease by 6%.
For example, if last year’s labor cost was Rs. 650 and there is increase in labor efficiency by
6% this year. Labor cost for this year will be 650 * 0.94 = 611
 If there is decrease in labor efficiency by 6%, Labor cost will increase by 6%.
For example, if last year’s labor cost was Rs. 650 and there is decrease in labor efficiency by
6% this year. Labor cost for this year will be 650 * 1.06 = 689
LO 8: VALUATION OF INVENTORY AND RECONCILIATION OF PROFITS UNDER

MARGINAL AND ABSORPTION COSTING:
Valuation of Inventory:
1. Calculate standard Cost (particularly separating Variable Rate and Fixed Rate)
2. Operating Variable Cost is Never included in value of closing stock, although it is shown in
Cost of Sales under Marginal Costing.
3. Valuation of Inventory (Marginal method) = Units in Stock * Standard Cost (excluding Fixed
FOH)
4. Valuation of Inventory (Absorption method) = Units in Stock * Standard Cost (including
Fixed FOH)
Page | 9
Reconciliation of Profit under Both Systems:
Profit under Marginal Costing XXX

Add: Fixed FOH in Closing Stock XXX
Less: Fixed FOH in Opening Stock (XXX)
Profit under Absorption Costing XXX
LO 9: DEPRECIATION AND DISPOSAL OF FIXED ASSETS:

This is a concept of Financial Accounting. Same knowledge of depreciation and disposal may also be
used in a question of Budgeting.
Calculation of Depreciation Expense:
Category Amount Rate Months Depreciation

Opening - Fully Depreciation – Disposals
Fully depreciated
Disposal
Purchased
Calculation of Disposal Account: (Exchange)
Cost of Old Asset 1,000 Acc. Dep. Of Old Assets 700

Cash paid [Exchange] 1,400 Depreciation during the year 50
Cost of New Asset [Exchange] 1,500
Loss on Disposal 150
2,400 2,400
Similarly, concept of Capital and Revenue Expenditure can also be tested in Budgeting.
PRACTICE QUESTION
Q. 14
Following are the opening balances of fixed assets as on October 1, 20X9:
 Fixed assets at cost (20% are fully depreciated): Rs. 8,000,000
Depreciation is provided @ 15% per annum on straight line basis. Depreciation is charged from date of purchase to the
date of disposal.
On October 31, 20X9 office equipment having book value of Rs. 500,000 (40% of the cost) on October 1, 20X9 would be
replaced at a cost of Rs. 2,000,000. After adjustment of trade-in allowance of Rs. 300,000 the balance would have to be
paid in cash.
Required:
Calculate Depreciation and Profit/(Loss) on disposal for the quarter ending December 31, 20X9
Page | 10
PART B – CASH BUDGET
LO 10: CASH BUDGET:

Cash Received from Sales:
If we are given month-wise Sales and “Recovery Policy”, we can calculate cash received from
Debtors.
Recovery Policy could be either in “Percentage” or in “Days”.
 Example 1: Recovery Policy in Percentage

 60% debtors are collected in 1st month after sale, remaining in 2nd month after sale.
 20% of sales is in cash. 60% of debtors are collected in 1st month after sale, remaining
(i.e. 40% of debtors) in 2nd month after sale.
 5% discount is given if debtors pay in 1st month after sales. 60% debtors are collected
in 1st month after sale, remaining in 2nd month after sale.
 Example 2: Recovery Policy in Days

 Credit period is 30 days.
o It means credit sale of January will be collected in February.
o It also means that at any month end, closing balance of debtors = Credit
Sales /360 * 30
 Credit period is 45 days.

o It means credit sale of first half of January will be collected in February, and
credit sale of second half of February will be collected in March. [This allocation
is quite surprising for some students]
o It also means that at any month end, closing balance of debtors = Credit
Sales /360 * 45
Cash Paid for Purchases:

If we are given month-wise Purchases and “Payment Policy”, we can calculate cash paid to
Creditors.
Payment Policy could be either in “Percentage” or in “Days”.
 Example 1: Payment Policy in Percentage

 All purchases of inventory would be on two months’ credit.
 10% of purchases are in cash. Remaining are paid in following month.
 Example 2: Payment Policy in Days

 Creditors are paid one month after purchase.
o It means credit purchases of January will be paid in February.
o It also means that at any month end, closing balance of creditors = Credit
Purchases /360 * 30
Page | 11
Cash Paid for Expenses:

If we are given month-wise Expenses and “Payment Policy”, we can calculate cash payments for
expenses.
Payment Policy could be:

 Salaries and Admin expenses are paid in the month in which they occur.
 Marketing expenses for January are 60,000. 50% are fixed, and 50% vary with sales volume.
Note: Depreciation will not be shown in Cash Budget.
Exam Tip:
 If Working Capital Ratios are given, these are used to calculate Closing Balances of Debtors, Creditors, Inventory
etc. Thereafter, these figures are used to calculate Cash Received/Paid during the period.
PRACTICE QUESTION
Q. 15
Zinc Limited (ZL) is engaged in trading business. Following data has been extracted from ZL’s business plan for the year
ended 30 September 20X2:
------------------------ Rs. in ‘000’ ------------------------

Sales 85,000 95,000 55,000 60,000 65,000 75,000

i. Cash sale is 20% of the total sales. ZL earns a gross profit of 25% of sales and uniformly maintains stocks at 80%
of the projected sale of the following month.
ii. 60% of the debtors are collected in the first month subsequent to sale whereas the remaining debtors are
collected in the second month following sales.
iii. Creditors are paid one month after purchases.
Required:
Calculate month-wise cash received from debtors and cash paid to creditors for the quarter ending 31 May 20XX.
Page | 12
LO 11: SUGGESTED FORMAT OF CASH BUDGET:
January February March April May

Cash Receipts from Sales:
January (20%: 48%: 32%)
February
March
April
May
Cash Paid for Purchases:

January (0%: 100%)
February
March
April
May
Expenses Paid
- Admin
- Marketing
Page | 13

Q. 1
Answer: 4,000,000 + 900,000 = 4,900,000
Q. 2
Men = 1,920 million (720 + 480 +720)
Women = 545 million (240 + 125 +180)
Q. 3
Credit Sales = [360,000 *.8] * [7,777.78]
Cash Sales = [360,000 *1.3] - 288,000] * [7,777.78 *.95]
Total Sales = Rs. 3,570 million
Q. 4
Number of Units sold in last year = 4,000,000 * 0.68 = 2,720,000
Sale Price last year = 3,400,000,000/2,720,000 = 1,250
Number of Units sold in current year = 2,720,000 * 1.25 = 3,400.000

Sale Price current year = 1,250 + 150 = 1,400
Projected Sales revenue = 3,400,000 * 1,400 = 4,760,000,000
Q. 5
Budgeted Sales Revenue = 21,000 * 1,100 = 23,100,000
Q. 6
Budgeted Cash Sales = 7,500 * .30 * .95 * 1.10 = 2,351.25
Budgeted Credit Sales = 7,500 * .70 * 0.95 * 1.05 = 5,236.875
Total Sales = 7,588,.125
Q. 7
Credit Sales = 3,000 * 1.30 * 0.80 = 3,120
Cash Sales = 3,000 * 1.30 * 0.2 * 0.98 = 764.4
Total Sales = 3,884.4
Q. 8
Answer (in 000): 3,538: 3,846: 3,231: 4,462: 4,615
Page | 14
Q. 9
September October November December January February
Sales (given) - 12,000 14,500 17,000 19,500 25,000
Opening Stock - 6,720 8,120 9,520 10,920 14,875

Add: Purchases (b/f) - 9,800 11,550 13,300 17,605 2,625
Less: Closing Stock 6,720 8,120 9,520 10,920 14,875 -
Cost of Sales (=70% of Sales) 8,400 10,150 11,900 13,650 17,500
Q. 10
October November December January
Sales (given) 7,500 9,900 10,890 10,000
Opening Stock 6,000 7,200 7,920 7,273

Add: Purchases (b/f) 7,200 7,920 7,273 x
Less: Closing Stock 7,200 7,920 7,273 x
= Cost of Sales [Sales * 8/10], [Sales * 8/11] 6,000 7,200 7,920 7,273
Q. 11
Sales (given) 85,000 95,000 55,000 60,000 65,000 75,000
Opening Stock 51,000 57,000 33,000 36,000 39,000 45,000

Purchases (b/f) 69,750 47,250 44,250 48,000 54,750 x
Closing Stock 57,000 33,000 36,000 39,000 45,000 x
Cost of Sales [Sales *0.75] 63,750 71,250 41,250 45,000 48,750 56,250
Page | 15
Q. 12
Sales (given) 60,000 55,000 70,000 68,000
Raw Material Consumed

Opening Material 20,700 22,500 24,840 12,240
Add: Purchases 22,500 24,840 12,240 x
Less: Closing Material 22,500 24,840 12,240 x
- Raw Material Consumed (M. Cost * 6/10) 20,700 22,500 24,840 12,240
- Direct Wages (M. Cost * 3/10) 10,350 11,250 12,420 6,120
- Overheads (M. Cost * 1/10) 3,450 3,750 4,140 2,040
Manufacturing Cost 34,500 37,500 41,400 20,400
Add: Opening WIP - - - -
Less: Closing WIP - - - -
Cost of Goods Manufactured 34,500 37,500 41,400 20,400
Add: Opening Finished Goods 18,000 16,500 21,000 20,400
Less: Closing Finished Goods 16,500 21,000 20,400 -
= Cost of Sales [Sales * 0.60] 36,000 33,000 42,000 40,800
Q. 13
Sales = (2.72 million * 1.25) * (1,250 + 150) = 4,760 million
Material = (1,493 * 125% * 1.05) = 1,960 million
Labor = (367 * 1.2 * 1.05) + (0.272 * 180) = 511 million
Overheads = 285 + (165 * 1.05) + (185 * 1.25 * 1.05) = 701 million
Q. 14
Depreciation (in 000)= (8,000 - 1,600 – 1,250) * 15% * 3/12 + (1,250 * 15% * 1/12) + (2,000 * .15 * 2/12) = 259
Q. 15
Purchases = March: 44, 250 & April: 48,000 & May: 54,750
Cash Received = March: 83,800 & April: 68,800 & May: 59,400
Cash Paid= March: 47,250 & April: 44,250 & May: 48,000
Page | 16
Managerial & Financial Analysis – The Practice Book Chapter 14: Budgeting
CHAPTER 14
BUDGETING
QUESTIONS
1 None.
PRACTICE QUESTIONS
Q.1 Multan Star (MS) is engaged in manufacturing and selling of a single product K-100. The management is in the process of
preparing its budgeted profit or loss statement for the year ending 31 August 2023. Following information is available in
this respect:
Information for the year ended 31 August 2022

(i) Extracts from profit or loss statement:
Rs. in ’000’
Sales 90,000
Cost of goods sold:
Material (36,000)
Labour (25,000)
Manufacturing overheads (9,000)
Gross profit 20,000
Selling and administration expenses (2,500)
Profit before tax 17,500
(ii) During the year, MS operated at 80% of its machine production capacity. It manufactured and sold 72,000 units
of K-100. Each unit of K-100 requires 3 hours of machine time.
(iii) 2.5 kg of material is required for manufacturing of each unit of K-100.
(iv) Each unit of K-100 requires three labour hours. Labour is hired under a third party contract according to which
MS has to pay for a minimum of 250,000 labour hours. However, each hour exceeding 250,000 hours would be
paid at two times of standard labour rate per hour.
(v) 20% of total manufacturing overheads are fixed. Variable manufacturing overheads are absorbed on the basis of
machine hours.
(vi) All selling and administration expenses are fixed.
(vii) There are no opening or closing stocks of raw material and finished goods.
Information and projections for the budget for the year ending 31 August 2023
(i) MS would introduce the mini version of K-100 under the name of K-50. The demand for K-50 is expected to be
25,000 units. The selling price of K-50 would be Rs. 750 each.
(ii) The introduction of K-50 would not affect the existing demand for K-100. In addition, MS has entered into a
contract with a new customer for supply of 10,000 units of K-100 at the last year’s prevailing price.
(iii) Any constraint due to production capacity would be met by reducing the production of K-100. However, any
shortfall in production of K-100 would be met by purchasing it from the market at a price of Rs. 1,200 per unit.
(iv) The selling price of K-100 (other than already contracted to supply) would increase by 12%.
(v) Each unit of K-50 would require 1 kg of material, 1.5 hours of machine and 1.5 hours of labour. The production
of K-50 would result in increase in selling and administration expenses by 20% other than the inflation.
(vi) All expenses unless otherwise specified are subject to inflation of 5%.
Required:
Prepare a budgeted profit or loss statement for the year ending 31 August 2023. (12)
(ICAP, MFA –Autumn 2022, Q.#7)
Page | 1
Q.2 Rose Industries Limited (RIL) is in process of preparation of its budget for the year ending 31 March 2020. In this respect,
following information has been extracted from RIL's projected financial statements for the year ending 31 March 2019:
Rs. in million
Sales (100% credit sales) 360,000 units 2,800
Cost of sales
• Raw material Consumed 1,120
• Variable conversion cost 280
• Fixed conversion cost (including depreciation of Rs. 24 million) 160
Operating cost
• Variable (varies with sales Volume) 190
• Fixed (including depreciation of Rs. 16 million) 45
Closing inventory
• Raw material 70
• Finished goods 40,000 units 110
Information and projections for the budget year ending 31 March 2020:
(i) The management estimates that profitability can be increased by employing the following measures:
• Introduction of cash sales at 5% less than the credit sales price. This would increase the total sales
volume by 30% whereas credit sales volume would reduce by 20% as some of the existing customers
would shift to cash sales.
• Installation of a software that would automatically generate follow-up emails to the customers and
relevant reports for the management. The software having useful life of 10 years would be operational
from 1 April 2019. The software would cost Rs. 2.5 million and its maintenance cost is estimated at Rs.
0.15 million per quarter. It is expected that as a result of the use of this software, RIL would be able to
reduce its fixed operating costs by 15%.
• As the purchases increase, RIL would negotiate with the suppliers and receive 2% trade discount.
• Cost reduction measures would be taken which would save 5% of the variable conversion and variable
operating costs.
(ii) The increase in working capital requirements would be met by arranging a running finance facility of Rs. 100
million at a mark-up of 10% per annum. It is estimated that on an average, 90% of the facility would remain
utilised during the budget year.
(iii) Effect of inflation on price of raw material and all other costs (excluding depreciation) would be 10%.
(iv) Closing raw material (in amount) and finished goods inventories (in units) would increase by 8%.
RIL uses marginal costing and follows FIFO method for valuation of inventory.
Required:
Prepare budgeted profit or loss statement for the year ending 31 March 2020. Assume that except stated otherwise, all
transactions are evenly distributed over the year (360 days). (16)
(ICAP, CAF 06 Level – Spring 2019, Q.#6)
Page | 2
Q.3 Tennis Trading Limited (TTL) was incorporated on 1 September 2018 and would start trading from the month of October
2018. As part of planning and budgeting process, the management has developed the following estimates:
(i) During the month of September 2018, TTL would pay Rs. 5 million, Rs. 2 million and Rs. 1.2 million for purchase
of a property, equipment and a motor vehicle respectively.
(ii) Projected sales for October is Rs. 12 million. The sales would increase by Rs. 2.5 million per month till January
2019. From February 2019 and onwards, sales would be Rs. 25 million per month.
(iii) Cash sales is estimated at 30% of the total sales.
(iv) Credit customers are expected to pay within one month of the sales.
(v) 80% of the credit sales would be generated by salesmen who would receive 5% commission on sales. The
commission is payable in the following month after sales.
(vi) Gross profit margin would be 30%.
(vii) TTL would maintain inventory at 80% of the projected sale of the following month, up to December 2018 and
thereafter, 85% of the projected sale of the following month. All purchases of inventories would be on two
months’ credit.
(viii) Salaries would be Rs. 1.5 million in September and Rs. 2 million per month, thereafter. Other administrative
expenses would be Rs. 1 million per month from September till January 2019 and Rs. 1.3 million per month
thereafter. Both types of expenses would be paid in the same month in which they are incurred.
(ix) An aggressive marketing scheme would be launched in September 2018. The related expenses are estimated at
Rs. 7 million. 50% of the amount would be payable in September and 50% in October 2018.
(x) Marketing expenses from October 2018 would consist of 65% variable and 35% fixed expenses. Total expenses
in October 2018 would be Rs. 2 million. All expenses would be paid in the month in which they occur.
(xi) Bank balance as of 1 September 2018 is Rs. 12 million. TTL has arranged a running finance facility from a local
bank at a mark-up of 10% per annum. The mark-up is payable at the end of each month on the closing balance.
Required:
Prepare a cash forecast (month-wise) from September 2018 to February 2019. (18)
(ICAP, CAF 06 Level – Autumn 2018, Q.#7)
Q.4 Sadiq Limited (SL) is in the process of preparation of budget for the year ending 31 December 2018. Following are the
extracts from the statement of profit or loss for the year ended 31 December 2017:
Rs. in million
Sales (30% cash sales) 7,500
Cost of goods sold (4,000)
Gross profit 3,500
Operating expenses (1,250)
Net profit before tax 2,250
Raw material inventory as on 1 January 2017 amounted to Rs. 152 million. There were no opening and closing inventories
of work in process and finished goods. SL follows FIFO method for valuation of inventories.
Following are the projections to be used in the preparation of the budget:

(i) Selling price would be reduced by 5%. Further, credit period offered to customers would be reduced from 45
days to 30 days. As a result, volumes of cash and credit sales are expected to increase by 10% and 5%
respectively.
(ii) Ratio of manufacturing cost was 5:3:2 for raw material, direct labour and factory overheads respectively.
(iii) All operating expenses and 20% of factory overheads are fixed. Total depreciation for the year 2017 amounted
to Rs. 100 million and was apportioned between manufacturing cost and operating expenses in the ratio of 7:3.
Depreciation for the next year would remain the same.
(iv) Raw material inventory would be maintained at 30 days of consumption. Up to 31 December 2017, it was
maintained at 45 days of consumption.
(v) Raw material prices and direct labour rate would increase by 10% and 6% respectively.
(vi) Impact of inflation on all other costs would be 5%.
(vii) The existing policy of payment to raw material suppliers in 30 days is to be changed to 15 days. Other costs are
to be paid in the month of incurrence.
Required:
Compute the budgeted net cash inflows/(outflows) for the year ending 31 December 2018. (Assume there are 360 days
in a year) (16)
Page | 3
Q.5 Falcon (Private) Limited (FPL) is in the process of preparing its annual budget for the next year. The available information
is as follows:
(i) Budgeted and actual production and sales for the current year:
Budgeted Actual
Units of Finished Goods
Production 25,000 23,760
Sales 24,000 22,800
(ii) Current year’s actual production cost per unit:

Rupees
Raw material input (49 kg/unit) 980
Direct labour 800
Variable production overheads 500
Fixed production overheads 400
2,680
(iii) Inventory balances:

FPL maintains the following inventory levels:
Raw material Average two months’ consumption based on budgeted production
Finished goods Average one month’s budgeted sales
Work in process (opening as 1,500 units (100% complete as to material and 60% as to conversion
well as closing) cost)
FPL follows absorption costing and uses FIFO method for valuation of inventory.
(iv) Impact of inflation:
Inflation %
Raw material and variable overheads 8
Direct labour 10
Fixed overheads (excluding depreciation) 5
(v) Sales volume would increase by 10%.

(vi) Balancing and modernisation of plant would be carried out at a cost of Rs. 20 million which would:
• increase depreciation from Rs. 5,800,000 to Rs. 7,016,800;
• reduce raw material wastages from 5% to 2% of input; and
• increase labour efficiency by 7%.
Required:
Prepare budgeted statement of cost of sales for the next year. (16)
(ICAP Study Text, Example # 09)
Page | 4
Q.6 Double Crown Limited (DCL) is engaged in manufacturing of a product Zee. Sales projections according to DCL's business
plan for the year ending 31 December 2017, are as follows:

---------------Rs. in million---------------
Sales 60 55 70 68
(i) Goods are sold at a gross margin of 40% on sales.
(ii) Ratio of direct material, direct wages and overheads is 6:3:1 respectively.
(iii) Normal loss is 5% of the units completed.
(iv) Inventory levels maintained by DCL are as under:
Direct materials Next month’s budgeted consumption
Finished goods 50% of next month’s budgeted sales
(v) 10% of all purchases are in cash. Remaining purchases are paid in the following month.
(vi) Direct wages include DCL's contribution at 5% of the direct wages, towards canteen expenses. An equal amount
is deducted from the employees’ wages. Direct wages are paid on the last day of each month. Both contributions
are paid to the canteen contractor in the following month.
(vii) Overheads for each month include depreciation on plant and machinery and factory building rent, amounting to
Rs. 0.2 million and Rs. 0.1 million respectively. The rent is paid on half yearly basis in advance on 30 June and 31
December each year.
Required:
(a) Prepare budget for material purchases, direct wages and overheads, for the month of June 2017. (10)
(b) Prepare cash payment budget for the month of June 2017. (03)
(ICAP, CAF 06 Level – Spring 2017, Q. # 4)
(ICAP’s Question Bank for CAF 06 – Q. # 1)
Q.7 The following information has been extracted from the projected financial statements of Lotus Enterprises (LE) for the
year ending 30 September 2016:
Rs. in million
Sales (100% credit sales) 3,000
Raw material consumption 900
Raw material inventory (including imports of Rs. 98 million) 158
Conversion cost: Variable 570
Fixed (including depreciation of Rs. 16 million) 40
Operating cost: Variable 730
Fixed (including depreciation of Rs. 27 million) 120
Trade creditors (local purchases) 95
Advance to suppliers for import of raw material 30
LE is in the process of preparing its budget for the next year. The relevant information is as under:
(i) Sale volume is projected to increase by 30%. In order to finance the additional working capital, the management
has decided to adopt the following measures:
• Introduce cash sales at a discount of 2%. It is estimated that 20% of the customers would avail the
discount.
• The present average collection period is 45 days. LE has decided to improve follow-ups which would
ensure collection within 40 days.
• 40% of the raw material consumed is imported which is paid in advance on placement of purchase
order. The delivery is made within 30 days after the placement of order. LE has negotiated with the
foreign suppliers and agreed that from the next year, payments would be made on receipt of the goods.
• Local purchases would be paid in 50 days.
(ii) As a result of increased production, economies of scale would reduce variable conversion cost per unit by 5%.
(iii) Due to price increases, cost of raw material and all other costs (excluding depreciation) would increase by 10%
and 8% respectively.
(iv) Average days for payment of other costs would remain the same i.e. 25 days.
(v) There is no opening and closing finished goods inventory.
Page | 5
(vi) Quantity of closing local and imported raw material as a percentage of raw material consumption would remain
the same.
(vii) LE uses FIFO method of valuation of inventory.
Required:
Prepare cash budget for the next year. (Assume that all transactions occur evenly throughout the year (360 days)
unless otherwise specified) (15)
(ICAP, CAF 06 LEVEL – Autumn 2016, Q.#1)
Q.8 Queen Jewels (QJ) deals in imitated ornaments and operates its business on-line through a web-portal. Orders are
received through the website and dispatched through a courier.
The mode of payments available to customers are as follows:
Mode of payments % of sales

Cash on delivery which is collected by the courier 60%
Advance payments through credit cards 40%
Cash collected by the courier is settled after every 7 days. The courier company’s charges are Rs. 300 per order which are
deducted on a monthly basis from the first payment due in the subsequent month. Payments through credit cards are
credited by the bank in 7 days.
High value items which represent 25% of the sales through credit cards are dispatched after 15 days of payment. All other
dispatches are made immediately and delivered on the same day.
Following further information is available:

(i) Sales are made at cost plus 30%.
(ii) Sales and sales orders are projected as under:
Sep.2015 Oct. 2015 Nov. 2015 Dec. 2015 Jan. 2016
Sales (Rs.) 4,600,000 5,000,000 4,200,000 5,800,000 6,000,000
Sales orders (Nos.) 400 450 470 490 520 i
(iii) High value items are purchased on receipt of the order. Stock level of other goods is maintained at 25% of
projected sales of the next month. 40% of all purchases are paid in the same month whereas balance is paid in
the next month.
(iv) Purchases during the month of September 2015 amounted to Rs. 3.2 million.
(v) Selling and administrative expenses are estimated at Rs. 50 million per annum and include depreciation of
tangible and amortisation of intangible assets amounting to Rs. 8 million and Rs. 2 million respectively.
(vi) Cash and bank balances as at 30 September 2015 amounted to Rs. 5.5 million.
(vii) Purchases/sales occur evenly throughout the quarter.
Required:
Prepare a cash budget of QJ for the quarter ending 31 December 2015. (Month-wise cash budget is not required) (14)
(ICAP, CAF 06 LEVEL – Autumn 2015, Q.#6)
Page | 6
Q.9 Zinc Limited (ZL) is engaged in trading business. Following data has been extracted from ZL’s business plan for the year
ended 30 September 2012:
Sales Rs. ‘000’
Actual:
January 2012 85,000
February 2012 95, 000
Forecast:
March 2012 55,000
April 2012 60,000
May 2012 65,000
June 2012 75,000

(i) Cash sale is 20% of the total sales. ZL earns a gross profit of 25% of sales and uniformly maintains stocks at 80%
of the projected sale of the following month.
(ii) 60% of the debtors are collected in the first month subsequent to sale whereas the remaining debtors are
collected in the second month following sales.
(iii) 80% of the customers deduct income tax @ 3.5% at the time of payment.
(iv) In January 2012, ZL paid Rs. 2 million as 25% advance against purchase of packing machinery. The machinery
was delivered and installed in February 2012 and was to be operated on test run for two months. 50% of the
purchase price was agreed to be paid in the month following installation and the remaining amount at the end of
test run.
(v) Creditors are paid one month after purchases.
(vi) Administrative and selling expenses are estimated at 16% and 24% of the sales respectively and are paid in the
month in which they are incurred. ZL had cash and bank balances of Rs. 100 million as at 29 February 2012.
Required:
Prepare a month-wise cash budget for the quarter ending 31 May 2012. (10)
(ICAP, CAF 06 LEVEL – Spring 2012, Q.#6)
Q.10 Following data is available from the production records of Flamingo Limited (FL) for the quarter ended 30 June 2011.
Rupees
Direct material 120,000
Direct labour @ Rs. 4 per hour 75,000
Variable overhead 70,000
Fixed overhead 45,000
The management’s projection for the quarter ended 30 September 2011 is as follows:
(i) Increase in production by 10%.
(ii) Reduction in labour hour rate by 25%.
(iii) Decrease in production efficiency by 4%.
(iv) No change in the purchase price and consumption per unit of direct material. Variable overheads are allocated to
production on the basis of direct labour hours.
Required:
Prepare a production cost budget for the quarter ended 30 September 2011. (04)
(ICAP, CAF 06 Level – Autumn 2011, Q.#3b)
Page | 7
Q.11 Mazahir (Pakistan) Limited manufactures and sells a consumer product Zee. Relevant information relating to the year
ended June 30, 2010 is as under:
Raw material per unit 5 kg at Rs. 60 per kg

Actual labour time per unit (same as budgeted) 4 hours at Rs. 75 per hour
Actual machine hours per unit (same as budgeted) 3 hours
Variable production overheads Rs. 15 per machine hour
Fixed production overheads Rs. 6 million
Annual sales 19,000 units
Annual production 18,000 units
Selling and administration overheads (70% fixed) Rs. 10 million
Salient features of the business plan for the year ending June 30, 2011 are as under:
(i) Sale is budgeted at 21,000 units at the rate of Rs. 1,100 per unit.
(ii) Cost of raw material is budgeted to increase by 4%.
(iii) A quality control consultant will be hired to check the quality of raw material. It will help improve the quality of
material procured and reduce raw material usage by 5%. Payment will be made to the consultant at Rs. 2 per kg.
(iv) The management has negotiated a new agreement with labour union whereby wages would be increased by
10%. The following measures have been planned to improve the efficiency:
• 30% of the savings in labour cost, would be paid as bonus.
• A training consultant will be hired at a cost of Rs. 300,000 per annum to improve the working
capabilities of the workers.
On account of the above measures, it is estimated that labour time will be reduced by 15%.
(v) Variable production overheads will increase by 5%.
(vi) Fixed production overheads are expected to increase at the rate of 8% on account of inflation. Fixed overheads
are allocated on the basis of machine hours.
(vii) The company has a policy of maintaining closing stock at 5% of sales. In order to avoid stock-outs, closing stock
would now be maintained at 10% of sales. The closing stocks are valued on FIFO basis.
Required:
(a) Prepare a budgeted profit and loss statement for the year ending June 30, 2011 under marginal and absorption
costing.
(b) Reconcile the profit worked out under the two methods. (20)
Q.12 Smart Limited has prepared a forecast for the quarter ending December 31, 2009, which is based on the following
projections:
(i) Sales for the period October 2009 to January 2010 has been projected as under:
Rupees
October 2009 7,500,000
November 2009 9,900,000
December 2009 10,890,000
January 2010 10,000,000
Cash sale is 20% of the total sales. The company earns a gross profit at 20% of sales. It intends to increase sales
prices by 10% from November 1, 2009, however since there would be no corresponding increase in purchase
prices the gross profit percentage is projected to increase. Effect of increase in sales price has been incorporated
in the above figures.
(ii) All debtors are allowed 45 days credit and are expected to settle promptly.
(iii) Smart Limited follows a policy of maintaining stocks equal to projected sale of the next month.
(iv) All creditors are paid in the month following delivery. 10% of all purchases are cash purchases.
(v) Marketing expenses for October are estimated at Rs. 300,000. 50% of these expenses are fixed whereas
remaining amount varies in line with the value of sales. All expenses are paid in the month in which they are
incurred.
(vi) Administration expenses paid for September were Rs. 200,000. Due to inflation, theses are expected to increase
by 2% each month.
Page | 8
(vii) Depreciation is provided @ 15% per annum on straight line basis. Depreciation is charged from date of purchase
to the date of disposal.
(viii) On October 31, 2009 office equipment having book value of Rs. 500,000 (40% of the cost) on October 1, 2009
would be replaced at a cost of Rs. 2,000,000. After adjustment of trade-in allowance of Rs. 300,000 the balance
would have to be paid in cash.
(ix) The opening balances on October 1, 2009 are projected as under:
Rupees
Cash and bank 2,500,000
Trade debts - related to September 5,600,000
Trade debts - related to August 3,000,000
Fixed assets at cost (20% are fully depreciated) 8,000,000
Required:
(a) Prepare a month-wise cash budget for the quarter ending December 31, 2009.
(b) Prepare a budgeted profit and loss statement for the quarter ending December 31, 2009. (16)
Q.13 RS Enterprises is a family concern headed by Mr. Rameez. It is engaged in manufacturing of a single product but under
two brand names i.e. A and B. Brand B is of high quality and over the past many years, the company has been charging a
60% higher price as compared to brand A. As the company has progressed, Mr. Rameez has felt the need for better
planning and control. He has compiled the following data pertaining to the year ended November 30,20X8:
Rupees Rupees
Sales 5,522,400
Production costs:
Raw materials 2,310,000
Direct labor 777,600
Overheads 630,000 3,717,600
Gross profit 1,804,800
Selling and administration expenses 800,000
Net profit 1,004,800
Product A Product B
No. of units sold 5400 3600
Labor hours required per unit 5 6
Other information is as follows:

(i) 20% of B was sold to a corporate buyer who was given a discount of 10%. The buyer has agreed to
double the purchases in 20X9 and Mr. Rameez has agreed to increase the discount to 15%.
(ii) In view of better margins in B, Mr. Rameez has decided to promote its sale at a cost of Rs. 250,000. As a
result, its sales to customers other than the corporate customer, are expected to increase by 30%.
However, the production capacity is limited. He intends to reduce the production/sale of A if necessary.
Mr. Rameez has ascertained that 90% capacity was utilized during the year ended November 30, 20X8
whereas the time required to produce one unit of B is 20% more than the time required to produce a
unit of A.
(iii) 2.4 kgs of the same raw material is used for both brands but the process of manufacturing B is slightly
complex and 10% of all raw material is wasted in the process. Wastage in processing A is 4%.
(iv) The price of raw material has remained the same for the past many years. However, the supplier has
indicated that the price will be increased by 10% with effect from March 1, 20X9.
(v) Direct labor per hour is expected to increase by 15%.
(vi) 40% of production overheads are fixed. These are expected to increase by 5%. Variable overheads per
unit of B are twice the variable overheads per unit of A. For 20X9, the effect of inflation on variable
overheads is estimated at 10%.
(vii) Selling and administration expenses (excluding the cost of promotional campaign on B) are expected to
increase by 10%.
Required:
Prepare a profit forecast statement for the year ending November 30, 20X9.
Page | 9
Q.14 The home appliances division of Umair Enterprises assembles and markets television sets. The company has a long term
agreement with a foreign supplier for the supply of electronic kits for its television sets.
Relevant details extracted from the budget for the next financial year are as follows:
Rupees
C&F value of each electronic kit 9,500
Estimated cost of import related expenses, duties etc. 900
Variable cost of local value addition for each set 3,500
Variable selling and admin expenses per set 900
Annual fixed production expenses 12,000,000
Annual fixed selling and admin expenses 9,000,000
Fixed production overheads are allocated on the basis of budgeted production which is 5,000 units.
The present supply chain is as follows:

(i) The company sells to distributors at cost of production plus 25% mark-up.
(ii) Distributors sell to wholesalers at 10% margin.
(iii) Wholesalers sell to retailers at 4% margin.
(iv) Retailers sell to consumers at retail price i.e. at 10% mark-up on their cost.
Performance of the division had not been satisfactory for the last few years. A business consulting firm was hired to
assess the situation and it has recommended the following steps:
(a) Reduce the existing supply chain by eliminating the distributors and wholesalers.
(b) Reduce the retail price by 5%.
(c) Offer sales commission to retailers at 15% of retail price.
(d) Provide after sales services.
(e) Launch advertisement campaign; expected cost of campaign would be around Rs. 5 million.
It is expected that the above steps will increase the demand by 1,500 sets. The average cost of providing after sales
service is estimated at Rs. 450 per set.
Required:
Compute the total budgeted profit:
(i) under the present situation; and
(ii) if the recommendations of the consultants are accepted and implemented.
Q.15 Cinemax Limited has recently constructed a fully equipped theatre and 3 cinema houses at a cost of Rs. 30 million. The
theatre has a capacity of 800 seats and each cinema has a capacity of 600 seats. Information and projections for the first
year of operations are as follows:
(i) Fixed administration and maintenance cost of the entire facility is Rs. 4.5 million per year.
(ii) The average cost of master print of a Hollywood film is Rs. 4 million while the cost of master print of a
Bollywood film is Rs. 6.5 million.
(iii) Two cinema houses are dedicated for Hollywood films which show the same film at the same time
while one cinema house will show Bollywood films.
(iv) Each Bollywood film is displayed for 6 weeks and the average occupancy level is 70%. Each Hollywood
film is displayed for 4 weeks and the average occupancy level is 65%. On weekdays, there are 2 shows
while on weekends (Sat and Sun), 3 shows are displayed. Ticket price has been fixed at Rs. 350.
(v) Variable cost per show is Rs. 35,000 and setup cost of each film is Rs. 500,000.
(vi) No films would be shown during 8 weeks of the year.
(vii) Theatre is rented to production houses at Rs. 60,000 per day. Each play requires setup time of 2 days
while rehearsal time needs 1 day. Each play is staged 45 times. One show is staged on weekdays
whereas two shows are staged on weekends.
(viii) There is an interval of 2 days whenever a new play is to be staged. No plays are staged during the
month of Ramadan and first 10 days of Muharram.
(ix) The construction costs of theatre and cinema houses are to be depreciated over a period of 15 years.
Assume 52 weeks in a year and 30 days in a month.
Required:
Prepare budgeted profit and loss account for the first year.
Page | 10
Q.16 Beta (Private) Limited (BPL) deals in manufacturing and marketing of bed sheets. The management of the company is in
the phase of preparation of budget for the year 20X3-X4. BPL has production capacity of 4 million bed sheets per annum.
Currently the factory is operating at 68% of the capacity. The results for the recently concluded year are as follows:
Rs. in million
Sales 3,400
Cost of goods sold
Material (1,493)
Labor (367)
Manufacturing overheads (635)
Gross profit 905
Selling expenses (60% variable) (287)
Administration expenses (100% fixed) (105)
Net profit before tax 513
Other relevant information is as under:

(i) The raw material and labor costs are expected to increase by 5%, while selling and distribution costs
will increase by 4% and 8% respectively. All overheads and fixed expenses except depreciation will
increase by 5%.
(ii) Manufacturing overheads include depreciation of Rs. 285 million and other fixed overheads of Rs. 165
million. During the year 20X3–X4 major overhaul of a machine is planned at a cost of Rs. 35 million
which will increase the remaining life from 5 to 12 years. The current book value of the machine is Rs.
40 million and it has a salvage value of Rs. 5 million. At the end of 12 years, salvage value will increase
on account of general inflation to Rs. 9 million. The company uses straight line method for depreciating
the assets.
(iii) Variable manufacturing overheads are directly proportional to the production volume of production.
(iv) Selling expenses include distribution expenses of Rs. 85 million, which are all variable
(v) Administration expenses include depreciation of Rs. 18 million. During 20X3–X4, an asset having book
value of Rs. 1.5 million will be sold at Rs. 1.8 million. No replacement will be made during the year.
Depreciation for the year 20X3-X4 would reduce to Rs. 17 million.
The management has planned to take following steps to increase the sale and improve cost efficiency:
• Increase selling price by Rs. 150 per unit.
• The sales are to be increased by 25%. To achieve this, commission on sales will be introduced
besides fixed salaries. The commission will be paid on the entire sale and the rate of
commission will be as follows:
No. of units Commission % on total sales
Less than 35,000 1.00%
35,000 – 40,000 1.25%
40,000 – 50,000 1.50%
Above 50,000 1.75%
• Currently the sales force is categorized into categories A, B and C. Number of persons in each
category is 20, 30 and 40 respectively. Previous data shows that total sales generated by each
category is same. Moreover, sales generated by each person in a particular category is also
the same. The trend is expected to continue in future.
• The overall efficiency of the workforce can be increased by 15% if management allows a
bonus of 20%. Further increase in production can be achieved by hiring additional labor at
Rs. 180 per unit.
Required:
Prepare profit and loss budget for the year 20X3–X4.
Page | 11
Q.17 Shahid Limited is engaged in manufacturing and sale of footwear. The company sells its products through company
operated retail outlets as well as through distributors. The management is in the process of preparing the budget for the
year 20X0-X1 on the basis of following information:
(i) The marketing director has provided the following annual sales projections:
No. of units Retail price range
Men 1,200,000 Rs. 1,000 – 4,000
Women 500,000 Rs. 800 – 2,500
The previous pattern of sales indicates that 60% of units are sold at the minimum price; 10% units are
sold at the maximum price and remaining 30% at a price of Rs. 2,000 and Rs. 1,200 per footwear for
men and women respectively.
(ii) It has been estimated that 30% of the units would be sold through distributors who are offered 20%
commission on retail price. The remaining 70% will be sold through company operated retail outlets.
(iii) The company operates 22 outlets all over the country. The fixed costs per outlet are Rs. 1.2 million per
month and include rent, electricity, maintenance, salaries etc.
(iv) Sales through company outlets include sales of cut size footwears which are sold at 40% below the
normal retail price and represent 5% of the total sales of the retail outlets.
(v) The company keeps a profit margin of 120% on variable cost (excluding distributors’ commission)
while calculating the retail price.
(vi) Fixed costs of the factory and head office are Rs. 45 million and Rs. 15 million per month respectively.
Required:
Prepare budgeted profit and loss account for the year 20X0 – 20X1.
Q.18 During the year ending June 30, 20X1 Abdul Habib Company Limited has planned to launch a new product which is
expected to generate a profit of Rs. 9.3 million as shown below:
Rs. in ‘000’
Sales revenue (24,000 units) 51,600
Less: cost of goods sold 37,500
Gross profit 14,100
Less: operating expenses 4,800
Net profit before tax 9,300
The following additional information is available:

i. 75% of the units would be sold on 30 days credit. Credit prices would be 10% higher than the cash price. It is
estimated that 70% of the customers will settle their account within the credit term while rest of the customers
would pay within 60 days. Bad debts have been estimated @ 2% of credit sales. All cash and credit receipts are
subject to withholding tax @ 6%.
ii. 80% of the expenses forming part of cost of goods sold are variable. These are to be paid one month in arrears.
iii. The production will require additional machinery which will be purchased on July 1, 20X0 at a cost of Rs. 60
million. The machine is expected to have a useful life of 15 years and salvage value of Rs. 7.5 million. The
company has a policy to charge depreciation on straight line basis. The depreciation on the machinery is
included in the cost of goods sold as shown above.
iv. Variable operating expenses excluding bad debts are Rs. 105 per unit. These are to be paid in the same month in
which the sale is made.
v. 50% of the fixed costs would be paid immediately when incurred while the remaining 50% would be paid 15
days in arrears.
vi. The management has decided to maintain finished goods stock of 1,000 units.
Required:
Calculate the cash requirements for the first two quarters.
Page | 12
SUGGESTED SOLUTIONS
SUGGESTED SOLUTIONS
PRACTICE QUESTIONS
A.1
Super Concepts:
 Machine Hours is Limiting Factor in the question. Therefore, we will first calculate this (in Cost of Sales)
to know how many units to produce and how many to purchase.
 Calculation of Material, Labor and Overheads is 1-step more difficult in this question, as it uses Rates and
Units to calculate Cost.
Multan Stars
Budgeted Profit and Loss Account
(in 000)
Sales (w-1) 132,050

Less: Cost of Sales
-Purchases from Market 4,500 (w-2) * 1,200 (5,400)
-Material (w-3) (45,938)
-Labor (w-4) (30,450)
-Variable Manufacturing Overheads [9,000,000*0.8/216,000*270000*1.05] (9,450)
-Fixed Manufacturing Overheads [9,000,000*0.2*1.05] (1,890)
Gross Profit 38,923
Selling & Admin expenses [2,500 * 1.2 * 1.05] (3,150)
Net Profit 35,773
w-1: Sales
Product Units Sale Price Revenue
K-100 [Special Contract] 10,000 1,250 [90,000,000/72,000] 12,500,000
K-100 [Regular] 72,000 1,400 [1,250 * 1.12] 100,800,000
K-50 25,000 750 18,750,000
132,050,000
w- 2 Purchases from Market:

Machine's Capacity is 270,000 hours [=72,000 * 3/0.8].
Production with Capacity: 25,000 units of K-50 and 77,500 units of K-100 [270,000 - 25,000 * 1.5]/3
Units of K-100 to be purchases = 4,500 [=82,000 - 77,500].
Page | 13
w- 3 Material Consumed:
Material Required [77,500 * 2.5] + [25,000 * 1] 218,750
Rate per KG [36,000,000/(72,000*2.5)] * 1.05 210
Material Consumed 45,937,500
w- 4 Labor:
Labor Hours Required [77,500 * 3] + [25,000 * 1.5] 270,000
Labor Cost for 250,000 hours 25,000,000
Rate per Hour [25,000,000/250,000] = Rs. 100
Labor Cost for additional 20,000 hours [20,000 * 100 * 2] 4,000,000
29,000,000
Inflation 1.05
Total Labor Cost 30,450,000
• Some examinees did not correctly calculate the sales value. They either applied the 12% price increase on both contracted
and other sales of K-100 or failed to apply it altogether.
• Many examinees did not calculate the production budget correctly. Most of them failed to account for the fact that K-50
required half of the machine hours as compared to K-100 and therefore arrived at incorrect internal production and external
purchase figures for K-100
• Many examinees also failed to properly account for the fact that labour was hired under a contract by which MS was bound
to pay for a minimum number of hours. This had implications on the labour rate for both minimum hours and overtime
hours.
• Some examinees did not apply the inflation anywhere in their calculations.
Marking Plan:
• Sales 2.0
• Production – units 3.0
• Material – cost 2.0
• Labour – cost 3.0
• Manufacturing overheads – cost 2.0
Passing Percentage:
35%
A.2
Super Concepts:
 In this question, Growth Rate for Sale is different from Growth Rate of Purchases (because Opening and
closing Units of finished goods are different). Be careful in using them to estimate expenses.
 Inventory is valued using FIFO method. Note treatment of Opening Raw Material in calculation of
material consumed.
 Inventory is valued using Marginal Costing. Note treatment of Fixed Cost in calculation of closing stock.
Page | 14
Rose Industries Limited

(in 000)
Sales
- Credit [360,000 *.8] * [7,777.78] 2,240,000
- Cash [360,000 *1.3] - 288,000] * [7,777.78 *.95] 1,330,000 3,570,000
Less: Cost of Sales

- Material Consumed [1,120,000/360,000*471,200 = 1,465,956]
70,000 + (1,465,956 - 70,000)*1.1*0.98 1,574,841
- Labor & FOH (Variable) [280,000/360,000 * 471,200] * 1.1 *.95 382,981
- Labor & FOH (Fixed) 24 + [136*1.1] 173,600
Manufacturing Cost 2,131,421
Add: Opening WIP 0
Less: Closing WIP 0
Cost of Goods Manufactured 2,131,421
Add: Opening Finished Goods 110,000
Less: Closing Finished Goods [1,120,000/360,000 * 1.1 * .98] + [280,000/360,000 * 1.1 * .95] * 43,200 - 179,995
Cost of Goods Sold 2,061,426 - 2,061,426
1,508,574
Operating Cost Variable [190,000/360,000* 468,000*1.1*.95] - 258,115
Operating Cost Fixed

-Depreciation [16,000 + 2,500/10] 16,250
-Other than Depreciation [45,000-16,000] * 0.85*1.1 27,115
-Maintenance [150 * 4] 600
43,965 - 43,965
Markup on running finance (100×90%×10%) - 9,000
Net Profit 1,197,494
w-1 Finished Goods Produced

Units Sold 468,000
Add: Closing Stock 43,200
Less: Opening Stock - 40,000
471,200
w-2 Raw Material Consumed

Consumed this year (1,120,000/360,000*471,200) 1,465,956
From Opening Stock 70,000
Remaining after 10% increase & 2% discount 1,504,840
1,574,840
Page | 15
w-3 Valuation of Closing Stock on FIFO/Marginal Basis
Per Unit
Raw Material (1,120,000,000/360000*1.1*.98) 3,353.78
Variable Conversion Cost (280,000,000/360000*1.1*.95) 812.78
4,166.56
No. of Units 43,200
Value of Closing Stock 179,995,200
• Students were not able to compute the sales amount correctly. In fact, credit sales could be computed by reducing the
existing sales by 20%. Secondly, cash sale could be computed by increasing the existing sales by 30% and then deducted
the revised credit sale to arrive at cash sale. Thirdly, cash sales could then be reduced by 5% being the adjustment of sale
price.
• Instead of computing the raw material consumption and variable conversion costs on the basis of budgeted production
quantity, the costs were computed in line with percentage increase in sales. Other common errors in computation of
costs were ignoring the adjustments of opening and closing finished goods inventories in the budgeted production
quantity and not following the FIFO method of valuation.
• Opening raw material was not taken into consideration in the raw material costs. Consequently, price increase and
trade discount would only be applicable on additional material to be purchased.
• Mark-up on running finance facility was computed on 100% of the running finance facility available, instead of utilized
facility of 90%.
Marking Plan:
Computation of budgeted:
• sale amount 1.5
• production quantity 1.5
• raw material consumption 3.0
• variable conversion and operating costs 4.0
• fixed conversion and operating costs 3.0
• closing finished goods using marginal costing and FIFO 3.0
Passing Percentage:
27%
Page | 16
A.3
Tennis Trading Limited
September October November December January February
Sales (given) - 12,000 14,500 17,000 19,500 25,000
Cost of Sales
(=70% of Sales) - 8,400 10,150 11,900 13,650 17,500
Less: Opening Stock
(80% of this month's COS, 85% from
January) - 6,720 8,120 9,520 10,920 14,875
Add: Closing Stock 6,720 8,120 9,520 10,920 14,875 14,875
=Purchases 6,720 9,800 11,550 13,300 17,605 17,500
Opening Balance 12,000 - 2,218 - 7,178 - 6,811 - 7,369 - 7,520

September 0 0
October (30%: 70%) - 3,600 8,400
November 4,350 10,150
December 5,100 11,900
January 5,850 13,650
February 7,500
- 3,600 12,750 15,250 17,750 21,150
Cash Paid:
Purchases (after 2 months) 6,720 9,800 11,550 13,300
Commission (Sales *70% * 80% *5% )
after 1 month 336 406 476 546
Salaries 1,500 2,000 2,000 2,000 2,000 2,000
Administrative Expenses 1,000 1,000 1,000 1,000 1,000 1,300
Aggressive Marketing Scheme 3,500 3,500
Marketing Expenses (Fixed) 700 700 700 700 700
Marketing Expenses (Variable) 1,300 1,571 1,842 2,113 2,708
Property Purchase 8,200
Mark-up (Opening + Received - Paid) *
10% /12 18 59 56 61 62 58
14,218 8,559 12,383 15,809 17,901 20,612

Closing Balance - 2,218 - 7,178 - 6,811 - 7,369 - 7,520 - 6,982
Page | 17
Sales 88,000
Less: Cost of Sales
-Opening Stock -
Add: Purchases 76,475
Less: Closing Stock - 14,875 - 61,600
Gross Profit 26,400
Commission Expense (88,000 * .028) 2,464
Salaries Expense 11,500
Admin Expenses 6,300
Aggressive Marketing Scheme 7,000
Marketing Expense (Fixed) 3,500
Marketing Expenses (Variable) 9,533
Mark-up 315
Depreciation -
Net Profit - 14,212
Budgeted Balance Sheet
Capital 12000
Loss: - 14,212 - 2,212 Property etc. 8,200
Trade Receivables 17,500
Closing Stock 14,875
Creditors 35,105
Overdraft 6,982
Commission Payable 700
40,575 40,575
This question on cash budgeting was well attempted and 51% candidates secured passing marks. However, many candidates
made simple calculation errors which were not expected at this stage. Some of the common mistakes are described below:
• Collection from credit sales were taken from October instead of November.
• Payments for purchase of inventory were computed using cost of sales instead of purchases.
• Mark-up was computed as 10% per month instead of 10% per annum.
Page | 18
Marking Plan:
Computation of:
• cash sales and credit sales 2.5
• purchases and payment to suppliers 4.0
• wages & salaries and other administrative expenses 1.0
• commission on sales 2.0
• marketing expenses (Fixed and variable) 3.0
• initial promotion and advertisement expenses 1.0
• initial capital expenditures 1.5
• net cash inflows/(outflows) and mark-up on closing balances 3.0
Passing Percentage:
51%
A.4
Sadiq Limited
2018
Cash Sales (7500*.3*.95*1.1) 2,351

Credit Sales (7500*.7*.95*1.05) 5,237
Sales (Total) 7,588
Opening Stock [4,000 * 5/10 * 45/360] 250

Add: Purchases [b/f] 2,263
Less: Closing Stock = [2,130*1.1/360 *30] - 195
Material Consumed [4,000 * 5/10 * 1.065] = 2130 (2017 Prices) 2,318
'- 250 + 1,880*1.1 = 2,318
Labor [4,000 * 3/10 * 1.065 * 1.06 ] 1,355
FOH - Depreciation 30
FOH - Other Fixed [4,000 * 2/10 *0.20 - 30] *1.05 95
FOH - Variable [4,000 * 2/10 *0.80*1.065*1.05] 716
840
= Cost of Sales 4,513

Cash Sales 2,351
Credit Sales [Opening Debtors + Credit Sales - Closing Debtors] 5,457
[5,250*45/360] + 5,237 - [5,237*30/360]
7,808
Cash Paid:
- Material [Opening Creditors + Purchases - Closing Creditors] 2,344

[174.83 + 2263.25-94.3]
- Labor 1,355
-FOH Fixed 95
-FOH Variable 716
-Operating Expenses [1,250 - 30] * 1.05 1,281
2,091
Page | 19
Calculation of Average Growth Rate:

7500 0.3 1.10 2,475.000
7500 0.7 1.05 5,512.500
7,987.500
Average Growth Rate 1.065
The overall performance in this question on cash flows was average as 42% of the candidates obtained passing marks. but
due to length of the question, many students couldn’t attempt completely, but those who did achieved passing marks.
Following mistakes were observed in this question were:
• Majority of the candidates failed to understand how to compute the impact of increase in sales volume on cost of raw
material, labour and variable factory overheads or followed very lengthy methods which resulted in loss of time
resulting in time pressure on questions attempted afterwards.
• Factory overheads were 20% of cost of sales and fixed overheads were 20% of the total overheads. Hence, variable
overheads were 16% of cost of sales. Most of the candidates did not seem to understand this point.
• Fixed cost was deducted from variable cost before bifurcating into Material Labour and Variable overhead which was
not required.
• Depreciation was not excluded for computing payment of fixed overheads and consequently failed to complete failure.
Few of the students were unable to calculate Raw material purchase of 2017.
Marking Plan:
Computation of:
• cash sales 1.0
• credit sales and collection from debtors 3.0
• purchases 4.5
• payment to suppliers 2.0
• payment to labour, factory overheads and operating expenses 5.5
Passing Percentage:
42%
Page | 20
A.5
Falcon (Private) Limited
(in 000)
Cost of Sales
Raw Material Consumed [w-3] 25,497,753
Labor [800 * 0.93* 1.10] * 25170 20,599,128
Variable Overhead [500 * 1.08] * 25170 13,591,800
Fixed Overhead [400 * 23760 - 5,800,000] *1.05 + 7,016,800] 10,906,000
Manufacturing Cost 70,594,681
Add: Opening WIP [1,500 * 49 * 20] + [1,500 * 1,700 * 0.6] 3,000,000

Less: Closing WIP [1,500 * 1,026] + [1,500 * 1,791.69 * 0.6] 3,151,521
Cost of Goods Manufactured 70,443,160
Add: Opening Finished Goods [2,000 * 2,680] 5,360,000

Less: Closing Finished Goods [2,090 * 2,817.69] 5,888,972
Cost of Goods Sold 69,914,188
W-1: Budgeted Production:

Finished Goods
Opening 2,000
Produced 25,170
Sold 25,080
Closing 2,090
W-2: Budgeted Cost:

Material [980/0.98*0.95 * 1.08] 1,026.00
Labor [800 * 0.93 * 1.10] 818.40
Variable Overheads [500 * 1.08] 540.00
Fixed Overheads [400 * 23760 - 5,800,000] *1.05 + 7,016,800] 433.29
2,817.69
W-3: Raw Material Consumed:

Total KGs consumed this year [25,170 * 49 * 0.95/0.98] 1,195,575
From Opening Material [25,000/12*2 * 49] * 20 4,083,333
From Current Year [1,195,575 - 204,167] * 20 * 1.08 21,414,420
25,497,753
Page | 21
05.99% candidates secured passing marks in this question. Common errors are discussed below:
• Opening and closing balances of raw material, WIP and finished goods were ignored.
• Change in material and labour due to the change in wastage and efficiency respectively, was not understood correctly
and various types of erroneous calculations were produced.
• 100% conversion cost was included in cost of WIP units instead of 60% conversion costs.
• Budgeted production was computed as 10% above the current year’s production instead of increasing current year’s
sale by 10% and computing production by considering the opening and closing inventory of finished goods as equivalent
to one months projected sale.
• Fixed overheads were increased by 5% (inflation) without excluding depreciation and adding the increase in
depreciation.
Marking Plan:
• Determination of:
- production units 1.5
- budgeted cost per unit 3.5
- budgeted fixed overheads 2.0
- budgeted raw material consumption 3.5
• Computation of opening work in process, manufacturing expenses and closing work
4.0
in process
• Computation of opening and closing finished goods stock 1.5
Passing Percentage:
5.99%
A.6
Double Crown Limited
Sales (given) 60,000 55,000 70,000 68,000
Cost of Sales (= 60% of Sales) 36,000 33,000 42,000 40,800
- - - -
Less: Opening Finished Goods (50% of current month's COS) 18,000 16,500 21,000 20,400
Add: Closing Finished Goods 16,500 21,000 20,400 x
= Cost of Goods Manufactured 34,500 37,500 41,400 x
Raw Material Consumed (CGM * 6/10) 20,700 22,500 24,840 x

- - -
Less: Opening Raw Material 20,700 22,500 24,840 x
Add: Closing Raw Material 22,500 24,840 x x
= Purchases 22,500 24,840 x x
- Direct Wages (CGM * 3/10) 10,350 11,250 12,420 x
- Overheads (CGM * 1/10) 3,450 3,750 4,140 x
Page | 22

Cash Paid:
Purchases for May (10%, 90%) 2,250 20,250
Purchases for June 2,484 22,356
Wages for May (95%, 5%+5%) 9,364 986

Wages for June 10,179 1,071
Overheads (excluding Depreciation & Rent) 3,150 3,450 3,840

Rent 600
14,764 37,948 27,267 -
The performance in this question on budgeting was poor as only 13% candidates could secure passing marks. The
requirement was to prepare budget for material purchases, direct wages and overheads and cash payment budget for a
month (June) which required some calculations involving previous as well as future months.
Majority of the students made some apparent errors. On the other hand, many knowledgeable candidates seemed to suffer
from lack of practice and presentation skills, as a result of which they indulged in long and repetitious computations instead
of developing a proper format which would have made the calculations much easier.
Other common mistakes were as follows:
• Normal loss was added to cost of sales although it is already included in cost of goods produced.
• Cost of sales was taken as the cost of goods manufactured i.e. opening and closing stock of finished goods were ignored.
Consequently, raw material purchases were computed incorrectly.
• Majority of the candidates were unable to calculate payment to canteen contractor correctly as they failed to realise
that since 5% contribution to canteen contractor was included in wages, amount excluding the contribution could be
calculated by dividing the gross amount by 1.05 i.e. multiplying by 100 and dividing by 105.
• While computing payment of overheads, depreciation was not excluded.
Marking Plan:
(a)
• Preparation of budget for material:
− determination of cost of sales 2.0
− determination of cost of goods manufactured 4.0
− determination of direct material purchases 2.0
• Preparation of budget for direct wages 1.0
• Preparation of budget for overheads 1.0
(b)
Cash payment budget for:
- material purchases 1.0
- direct wages 1.0
- overheads 1.0
Passing Percentage:
13%
Page | 23
A.7
Super Concepts:
 Calculation of closing local and imported raw material is an important calculation.
 FIFO calculation affects Raw Material Consumed. Absorption/Margin calculation affected Finished
Stock Valuation.
Lotus Enterprises
2018
Sales:
Cash Sales [3000 * 1.3 * 0.2 * 0.98] 764
Credit Sales [3000 * 1.3 * 0.8] 3,120
Purchases: Imports Local

Opening Stock [Given] 98 60
Add: Purchases [b/f] 542 791
Import: [98/900 * 1,268] = 138
Less: Closing Stock Local: [60/900 * 1,268] = 85 138 85
Import: [360 * 1.3 - 98 - 30] * 1.1 + 98 + 30 = 502

Material Consumed Local: [540 * 1.3 - 60] * 1.1 + 60 = 766 502 766

Cash Sales 764
Credit Sales [Opening Debtors + Credit Sales - Closing Debtors] 3,148
[3000 * 45/360] + 3120 - [3120 * 40/360]
3,913
Cash Paid:
- Material [Opening Creditors + Purchases - Closing Creditors] 1,288
Import: -30 + 542 - 0 = 512
Local: 95 + 791 - [791/360*50] = 776
-Variable Conversion Cost [Opening Payable + Expense - Closing Payable] 746.81

Expense: [570 * 1.3 * 1.08 * 0.95] = 760
[570/360*25] + 760 - [760/360*25]
-Fixed Conversion Cost Expense: [40 - 16] * 1.08 = 25.92 25.79

[24/360*25] + 25.92 - [25.92/360*25]
-Variable Operating Cost Expense: [730 * 1.3 * 1.08] = 1024.92 1,004

[730/360*25] + 1024.92 - [1024.92/360*25]
-Fixed Operating Cost Expense: [120 - 27] * 1.08 = 100.44 100

[93/360*25] + 100.44 - [100.44/360*25]
3,165
This question required preparation of cash budget. Overall performance in this question was below average. Marks were
mostly scored in the easy part of the question i.e. sales. Most of the students were unable to compute budgeted import/local
purchases correctly. Some of the common mistakes were as under:
• Instead of calculating cash and credit sales separately, many students calculated cash sales net of discount and total
sales and took the difference between the two as the credit sales.
• Majority of the students did not know how to deal with the amount of advance against imports and made numerous
types of errors.
Page | 24
• 30% growth in sales was ignored while computing closing inventory.

• Many students computed purchases and treated it as payment without adjusting opening and closing balances of trade
creditors. Similarly, some students computed raw-material consumption and treated it as purchase without considering
the opening and closing inventory balances.
• Sales growth of 30% was not considered for calculation of variable and operating costs whereas some students applied
to the fixed cost also.
• Many students did not exclude deprecation while computing cash outflows on account of fixed costs.
Marking Plan:
• Collection from cash and credit sales 4.0

• Budgeted imports and purchases of raw material 4.0
• Payments of raw material imports and purchases 2.0
• Payments for budgeted conversion and operating costs 5.0
.
A.8
Queen Jewels
Component Working Rs.
Opening Cash 5,500,000
Cash received from courier [Opening Receivables + Sales - Closing Receivables] 8,832,000
(being received 7 days after sale) [4600000*0.6*7/30] + [15000000*0.6] - [5800000*0.6*7/30]
Cash received through Credit Cards [Opening Receivables + Sales - Closing Receivables] 4,416,000
(being received 7 days after sale) (4600000*0.3*7/30) + (15000000*0.3) - (5800000*0.3*7/30)
Cash received for High Value Items (15000000*0.1) + (6000000*0.1*8/30) - (5000000*0.1*8/30) 1,526,667
(being received 8 days before sale) 14,774,667
Cash Paid:
Cash paid to Courier Company (400 + 450 + 470) * 300 396,000
Cash Paid for Purchases [w-1] 10,933,846
Cash paid for expenses [50000000-8000000-2000000]*3/12 10,000,000
21,329,846
Closing Cash (1,055,179)
Sep-15 Oct-15 Nov-15 Dec-15 Jan-16
Sales (given) 4,600,000 5,000,000 4,200,000 5,800,000 6,000,000
Opening Stock ? 865,385 726,923 1,003,846 1,038,462

Purchases (b/f) 3,200,000 3,707,692 3,507,692 4,496,154 #REF!
Closing Stock 865,385 726,923 1,003,846 1,038,462 #REF!
Cost of Sales 3,538,462 3,846,154 3,230,769 4,461,538 4,615,385
Cash Paid for Purchases 1,920,000

1,483,077 2,224,615
1,403,077 2,104,615
1,798,462
Page | 25
The overall response to this question was poor. Only few students were able to properly handle the timing of cash flows
correctly. The commonly observed errors were as follows:
• Period for collection of sales was 7 days, both in case of sales through courier as well as sales through credit card except
sale of high value items. However, collection from sales of high value items was made 8 days in advance i.e. 15 days in
advance less 7 days taken by bank to credit the amount. Most of the students failed to analyze this situation correctly
and a number of different incorrect alternatives were tried.
• Sales of the high valued items was 25% of sale through credit card i.e. 10% (25 of 40%) of total sales. Instead, many
students took it as 25% of total sales.
• While computing payment on account of purchases, most of the students correctly worked out the cost of sales for the
quarter. However, the cost of sales needed to be adjusted with opening and closing stocks to arrive at the purchases,
which were not correctly dealt with by a large number of students.
• Though it was specifically mentioned in the question that month-wise cash budget is not required, many candidates
prepared it on month by month basis and wasted precious time.
• According to the question, stock of high value items was not maintained as these were purchased on receipt of order.
Many students failed to understand this and as a result, calculated incorrect values of opening and closing stocks.
• Cost of sales was computed correctly by a number of students; however, the concept of 40% payment in current month
and 60% in subsequent month was not applied correctly by most of the candidates.
Marking Plan:
• Collection from sales 5.0

• Courier charges 1.5
• Payment for purchases 6.5
• Expenses paid 1.0
Passing Percentage:
00%
A.9
Zinc Limited
Sales (given) 85,000 95,000 55,000 60,000 65,000 75,000
Opening Stock 51,000 57,000 33,000 36,000 39,000 45,000

Purchases (b/f) 69,750 47,250 44,250 48,000 54,750 ?
Closing Stock 57,000 33,000 36,000 39,000 45,000 ?
Cost of Sales 63,750 71,250 41,250 45,000 48,750 56,250
Opening Balance 100,000 108,204 104,827 88,564

January 17,000 40,800 27,200
February 19,000 45,600 30,400
March 11,000 26,400 17,600
April 12,000 28,800 19,200
May 13,000 31,200
June 15,000
17,000 59,800 83,800 68,800 59,400 65,400
Page | 26
Cash Paid:
Purchases 69,750 47,250 44,250 48,000 54,750
Tax 476 1,674 2,346 1,926 1,663 1,831
Admin Expenses 13,600 15,200 8,800 9,600 10,400 12,000
Selling Expenses 20,400 22,800 13,200 14,400 15,600 18,000
Packing Machinery 2,000 4,000 2,000
36,476 109,424 75,596 72,176 75,663 86,581

Closing Balance 108,204 104,827 88,564 67,383
This was a routine question on cash budgeting. The performance was just average as the students seemed quite casual and
made all sorts of errors. The most common errors were in respect of calculation of tax payments. Surprisingly, many students
were unable to compute the purchases although it is a concept which is easily managed even by a Module B student.
A.10
Super Concepts:
 Production Efficiency means Labor Efficiency
 Variable Overheads are based on Labor Hours so if hours are changed, variable overheads will also
change proportionately.
Queen Jewels
Production Cost Budget
(in 000)
Direct material (120000*1.1) 132,000

Labor (75000 * 1.1 *0.75 * 1.04] 64,350
Variable Overhead (70,000 * 1.1 * 1.04] 80,080
Fixed Overhead 45,000
Manufacturing Cost 321,430
Another simple question but most of the candidates could not properly calculate the direct labour.
Page | 27
A.11
Budgeted Profit and Loss Account (Marginal Costing)
(in 000)
Sales (21000 * 1100) 23,100
Cost of Sales
Opening Stock (300 + 300 + 45 )* 950 613
Produced (22150 * 648.50) 14,364
Closing Stock (2100 * 648.50) - 1,362
13,615
Variable Selling & Admin Expenses (3000000/19000*21000) 3,316
Contribution 6,169
Fixed Cost:
Fixed Production Overhead (6000000 * 1.08) 6,480
Labor Traning Consultant 300
Fixed Selling & Admin Expenses 7,000
- 7,611
Budgeted Profit and Loss Account (Absorption Costing)

(in 000)
Sales (21000 * 1100) 23,100
Cost of Sales
Opening Stock (300 + 300 + 45 + 6000/18)* 950 929
Produced (22150 * 954.59) 21,144
Closing Stock (2100 * 954.59) - 2,005
20,069
Gross Profit 3,031
Selling and Admin Cost:

Variable Selling & Admin Expenses (3000000/19000*21000) 3,316
Fixed Selling & Admin Expenses 7,000
- 7,285
Reconciliation between Profits under Marginal & Absorption Costing

Profit under Marginal Costing - 7,611
Add: Fixed FOH in Closing Stock (306.09 * 2100) 642.79
Less: Fixed FOH in Opening Stock (6000/18) * 950 - 316.67
Profit under Absorption Costing - 7,285
Page | 28
W-1: Budgeted Production:

Finished Goods
Opening [5% of 19,000] 950
Produced [balancing figure] 22,150
Sold 21,000
Closing [10% of 21,000] 2,100
W-2: Budgeted Cost:

Material (5 * 60 * 1.04 * 0.95) 296.40
Material Inspection Cost (5 * 2 * .95) 9.50
Labor (including Bonus) (4 * 75 * 1.10 * 0.85) + (4 * 75 * 1.10 * 0.15 * 0.30) 295.35
Variable Overheads (3 * 15 * 1.05) 47.25
Budgeted Cost under Marginal Costing 648.50
Fixed Overheads (6000000 * 1.08 + 300000)/22150 306.09
Budgeted Cost under Absorption Costing 954.59
Note:
There are no opening or closing raw material or work in process.
A.12
Smart Limited
Sales (given) 7,500 9,900 10,890 10,000
Cost of Sales
(=80% of Sales) 6,000 7,200 7,920 7,273
Less: Opening Stock 6,000 7,200 7,920 7,273
Add: Closing Stock (100% of next month's COS) 7,200 7,920 7,273 x
=Purchases 7,200 7,920 7,273 x
Page | 29

Opening Balance 2,500 1,476 1,428
August 3,000
September 2,800 2,800
October (20%: 40%: 40%) 1,500 3,000 3,000
November 1,980 3,960 3,960
December 2,178 4,356
7,300 7,780 9,138 8,316
Cash Paid:
September Purchases (90%) 5,400
October Purchases (10%, 90%) 720 6,480
November 792 7,128
December 727 6,545
Marketing Expenses (fixed) 150 150 150

Marketing Expenses (variable) 150 198 218
Admin Expenses 204 208 212
Asset bought 1,700
8,324 7,828 8,435 6,545
Closing Balance 1,476 1,428 2,131 1,771
Sales 28,290
Less: Cost of Sales
-Opening Stock 6,000
Add: Purchases 22,393
Less: Closing Stock - 7,273 - 21,120
Gross Profit 7,170
Marketing Expenses (fixed) 450

Marketing Expenses (variable) 566
Admin Expenses 624
Loss/(Gain) on Disposal 184

Depreciation (8,000 - 1,600 - 1250) * .15 * 3/12 + (16) + (2,000 * .15 * 2/12) 259
Net Profit 5,087
Disposal
Cost of Old Asset 1,250 Acc. Dep. Of Old Assets 750

Cash paid 1,700 Dep. Of October 16
Cost of New Asset 2,000
Loss on Disposal 184
2,950 2,950
Page | 30
A.13
(in 000)
Sales [w - 1] 6,263,900
Cost of Sales
Raw Material Consumed [w-2] 2,716,686
Labor [w-3] 993,582
Variable Overhead [4579 * 30] + [5184 * 60] 493,251
Fixed Overhead (630000 * 0.40 * 1.05) 264,600
Gross Profit 1,795,781
Selling and Admin Expenses [800000*1.1] + 250000 1,130,000
Net Profit 665,781
W-1: Calculation of Sales Revenue:
Total
Products Quantity (Last Year) Price (Last Year) Quantity (This Year) Price (This Year) Revenue
A 5400 500 4579 500 2,289,500
B 2880 800 3744 800 2,995,200
Corporate Buyer 720 720 1440 680 979,200
6,263,900
Price of A:
5400 A + 2880 (1.6 A) + 720 (1.6 A) (0.9) = 5522400
11044.8 A = 5522400
A = 500
Quantity of A in Current Year:

Maximum Capacity = (5400*5 + 3600*6)/0.9 = 54000 hours
Hours Available for A = 54000 - (5184*6) = 22896
Units of A which can be produced = 22896/5 = 4579
W-2: Raw Material Consumed:

Last Year Rate of Raw Material = 2310000/[(5400*2.4/0.96) + (3600*2.4/0.9)] 100.00
Current Year Average Rate [100 * 3] + [110 * 9]/12 107.50
Current Year Consumption = (4579*2.4/0.96) + (5184*2.4/0.9) 25,271.50
Cost 2,716,686.25
Page | 31
W-3: Labor:
Products Quantity Labor Hours

A 4579 5
B 3744 6
Corporate Buyer 1440 6
Last Year Rate of Labor = 777600/[(5400*5) + (3600*6)] 16.00

Current Year Rate (16 * 1.15) 18.40
Current Year Hours = (4579*5)+(5184*6) 53999
993,581.60
W-3: Variable Overheads:

Variable Rate for A =
5400 (A) + 3600 (2A) = (630000*0.6)
A = 30
A.14
Budgeted Profit and Loss Account (Present Situation)
(in 000)
Sales (81500000 * 1.25) 101,875,000
Cost of Sales
Purchase Price (5000 * 9500) 47,500,000
Cost of Imports (5000 * 900) 4,500,000
Variable Cost of Local Value Addition (5000 * 3500) 17,500,000
Fixed Production Expenses 12,000,000
81,500,000
Variable Selling & Admin Expenses (5000*900) 4,500,000

Fixed Selling & Admin Expenses 9,000,000
Budgeted Profit and Loss Account (Proposed Situation)

(in 000)
Sales 6500 @ 24643.37 (W-1) 160,181,905
Cost of Sales
Purchase Price (6500 * 9500) 61,750,000
Cost of Imports (6500 * 900) 5,850,000
Variable Cost of Local Value Addition (6500 * 3500) 22,750,000
Fixed Production Expenses 12,000,000
102,350,000
Variable Selling & Admin Expenses (6500*900) 5,850,000
Page | 32
Fixed Selling & Admin Expenses 9,000,000

Sales Commission to Retailer [6500 * 24643.37 * 0.15] 24,027,286
Advertising Campaign 5,000,000
After sale service [6500 * 450] 2,925,000
W- 1: Calculation of Retail Price

-Sold to distributor [81500000/5000] * 1.25 20,375
-Price after Distributor Margin [20375/0.9] 22,638.89
-Price after Retailer Margin [22638.89/0.96] 23,582.18
-Price after Retailer Mark-up [22638.89 * 1.1] 25,940.39
Revised Price after 5% reduction [25940.39 * 0.95] 24,643.37
A.15
Cinemax Limited

Rs. in '000'
Revenue:
Revenue from sale of tickets of Bollywood Films (44 weeks * 16 * 600 * 70% * 350) 103,488
Revenue from sale of tickets of Hollywood Films (44 weeks * 16 * 600 * 65% * 350) * 2 192,192
(No. of weeks * No. of shows per week * Occupancy * Ticket Price)
Revenue from rent of theater (304 * 60,000) 18,240
Cost:
Fixed administration and maintenance cost 4,500
Depreciation (= 30 million / 15) 2,000
Cost of Bollywood Films:
Cost of Master Print of Bollywood Film (= 44 weeks/6 * 6.5) 47,667
Set-up cost of Bollywood Film (= 44 weeks/6 * 500,000) 3,667
Costs of Total Shows (Total Weeks * Shows per week * Cost per show) 24,640
(44 * 16 * 35,000)
Cost of Hollywood Films:
Cost of Master Print of Hollywood Film (= 44 weeks/4 * 4) 44,000
Set-up cost of Hollywood Film (= 44 weeks/4 * 500,000) 5,500
Costs of Total Shows (Total Weeks * Shows per week * Cost per show) 49,280
(44 * 16 * 35,000 * 2)
Net Profit 132,666
No. of days in a year 320

(360 - 30 - 10)
Interval days (@2 after every play) -16 (320 /40*2)
No. of working days of Theater 304
Old Play runs 45 times i.e. 45/9*7 = 35 days + 3 setup/rehersal days = 38 days + 2 Days interval
Page | 33
A.16
Beta Private Limited
(in 000)
Sales (w-1) 4,760,000
Less: Cost of Sales

Material (1,493 * 125% * 1.05) 1,959,563
Labor (w-1) 511,380
Manufacturing Overheads (w-4) 699,563
Commission Expense (w-3) 63,467

Selling expenses (w-5) 348,650
Admin expenses (w-6) 108,350
Gain on Disposal (1.8 - 1.5) - 300
w-1: Sales
Number of units sold in next year (4 million * 68% *1.25) 3,400,000
Sale price in next year (3,400 million /68% of 4 million) + 150 1,400
Total Revenue for next year 4,760,000,000
w- 2 Labor:
Total Cost
Cost of 100% + 15% Units [367,000 * 1.2*1.05] 462,420,000
Cost of remaining 10% capacity 272,000 48,960,000 (272,000 * 180)
[2,720,000 * 10%]
272,000 511,380,000
w- 3 Commission on Sales:
Category No. of Person Units sold Per person Sales %age of commission Amount
A 20 1,133,333 56,667 1.75% 27,766,667
B 30 1,133,333 37,778 1.25% 19,833,333
C 40 1,133,333 28,333 1.00% 15,866,667
63,466,667
w-4 Manufacturing Overheads

Variable Overheads 185 (= 635-285-165)* 1.25 * 1.05 242,812,500
Fixed Overheads (165 * 1.05) 173,250,000
Depreciation (285 - old depreciation i.e. 7 = 40-5/5 + new depreciation i.e. 5.5 = 40+35-9/12) 283,500,000
699,562,500
w-5 Selling Expenses

Fixed 114,800,000 * 1.05 120,540,000
Variable (Distribution) 85,000,000 * 1.08/2720*3400 114,750,000
Variable (Other than Distribution) 87,200,000 * 1.04 /2720*3400 113,360,000
287,000,000 348,650,000
Page | 34
w-6 Admin Expenses

Depreciation 18,000,000 - 1 million 17,000,000
Other fixed 87,000,000 * 1.05 91,350,000
105,000,000 108,350,000
A.17
Shahid Limited
Sales (W-1) 2,465,000,000

Variable Cost (Sales /2.2) 1,120,454,545
Commission to Distributors (Sales * 30% * 20%) 147,900,000
Discount on Sales (Sales * 70% * 5% * 40%) 34,510,000
Fixed Cost of Outlet (1.2 million * 22* 12) 316,800,000
Fixed Cost of Factor and Head Office (60 million * 12) 720,000,000
(W-1) Sales:
Men Women
Units Sale Price Revenue Units Sale Price Revenue
Minimum Price 720,000 1,000 720,000,000 300,000 800 240,000,000
Maximum Price 120,000 4,000 480,000,000 50,000 2,500 125,000,000
Average 360,000 2,000 720,000,000 150,000 1,200 180,000,000
1,200,000 1,920,000,000 500,000 545,000,000
Page | 35
A.18
Abdul Habib Company
July August September October November December
Cash Sales [2000 * 0.25 of 2000] 1,000 1,000 1,000 1,000 1,000 1,000
Cash Receipts from Debtors:

July [2200 * 0.75 of 2000] @ 70%: 28% 2,310 924
August 2,310 924
September 2,310 924
October 2,310 924
November 2,310
1,000 3,310 4,234 4,234 4,234 4,234
Cash Paid:
Purchase of Machinery 60,000
Tax on Cash Sales 60 60 60 60 60 60
Tax on Cash Received from Debtors 139 194 194 194 194
Variable Manufacturing Expenses 2500 2500 2500 2500 2500
[37500 *.8]/12
Fixed Manufacturing Expenses 167 333 333 333 333 333

[37500 *.2 - 3500]/12
Variable Operating Expenses 210 210 210 210 210 210

[2000 *105]
Fixed Operating Expenses 62 124 124 124 124 124

[4800 - 2520 - 792]/12
Cost of Finished Goods 1,250

[37500 * 0.8/24000*1000]
61,749 3,366 3,421 3,421 3,421 3,421
Surplus/(Shortfall) - 60,749 - 56 813 813 813 813
Let X = Cash Price, and 1.1X = Credit Price

24000 * [0.25X + 0.75 * 1.1 X] = 2150 i.e. X = 2000
Note: Bad debts are included in operating expenses.

Use month-wise cash flows because collections and payment periods are month-wise.
Page | 36
Managerial & Financial Analysis – Study Notes Chapter 15: Working Capital Management
CHAPTER 15
WORKING CAPITAL MANAGEMENT
ICAP Book
Chapter Paragraph #
PART A: WORKING CAPITAL AND ITS CALCULATION: #
LO 1 WHAT IS MEANT BY “WORKING CAPITAL” 15 1.1 – 1.4
LO 2 CASH OPERATING/CONVERSION CYCLE 15 Section 2
LO 3 TYPES OF WORKING CAPITAL AND FINANCING POLICIES 15 1.5
PART B: MANAGEMENT OF WORKING CAPITAL:
LO 4 MANAGEMENT OF RAW MATERIAL/FINISHED GOODS 15
Section 2
LO 5 MANAGEMENT OF WORK IN PROCESS 15
+
LO 6 MANAGEMENT OF DEBTORS 15 Self Test
Question 1b
LO 7 MANAGEMENT OF CREDITORS 15
PART C: OTHER CONCEPTS
LO 8 OTHER WORKING CAPITAL RATIOS 15
USE OF RATIOS TO FIND OUT FIGURES OF FINANCIAL
LO 9 15 Section 3
STATEMENTS
CALCULATING ADDITIONAL FINANCE TO INCREASE
LO 10 15
SALES

Page | 1
Past Papers' Trend Analysis [Chapter 16]
10
9
S22 A22 S23
Overview of the Chapter:

 This chapter discusses concept of Working Capital, and how to Manage it.
 In this chapter, students will learn:
 how to calculate Operating Cycle of Working Capital.
 How to reduce Operating Cycle [the lower is better].
Examinability of the Chapter: (considering latest syllabus and testing by ICAP)

Although, examiner may ask question from any topic in any way. However, based on my past experience:
 Exam question may give different working capital ratios, and may ask students to calculate amount of
working Capital.
 Exam question may also give retention ratio and may require students to calculate additional finance
needed to meet a sales target.
In-depth analysis of examinability with particular reference to Autumn 2023 attempt will be explained in class.
Page | 2
PART A – WORKING CAPITAL AND ITS CALCULATION
LO 1: WHAT IS MEANT BY “WORKING CAPITAL”:
Working Capital: (or Net-Current Assets)

Working Capital = Current Assets – Current Liabilities
Current Assets include:

 Cash,
 Inventory,
 Debtors
 Short-term Investments
 Prepayments
Current Liabilities include:

 Creditors
 Accruals
 Short-term Loans/Overdrafts
Often, Short-term loans and overdrafts are considered as means of Financing working capital, rather
than as part of working capital.
Benefits of Investing in working capital:

 Holding inventory allows to supply customers on demand.
 Selling goods on credit increases sales.
 Some cash/bank balance is necessary to meet immediate expenses.
Disadvantages of Investing in working capital:

 Funds are needed to invest in working capital.
 Working Capital costs company i.e.
Cost of Working Capital = Average Annual Investment * WACC
Objective of Working Capital Management:

Objective of working capital management is to ensure that working capital is neither excessive, nor
low.
 Excessive working capital reduces profitability.
 Low working capital reduces liquidity.
LO 2: CASH OPERATING/CONVERSION CYCLE:
Cash Operating/Conversion Cycle:

It is total number of days it takes between paying for raw material and receiving from sale of
finished goods.
Page | 3
How to Calculate Cash Operating Cycle:
Component of
Working Capital Formula to calculate Turnover Ratio (Days) Days
Raw Material (Days) Raw Material/Credit Purchases * 365 XX
WIP (Days) WIP/Cost of Sales * 365 XX
Finished Goods (Days) Finished Goods Inventory /Cost of Sales * 365 XX
Receivable (Days) Receivables /Credit Sales * 365 XX
Less: Payable (Days) Payables /Credit Purchases * 365 (XX)
Length of Operating Cycle XX

Note: Payable (days) reduce operating cycle.
Lower working capital lowers liquidity, but improves profitability (and vice-versa).
Study Tip on Calculation of Working Capital Ratios

1. These ratios can also be calculated “in times” as compared to “in days” e.g. Debtors turnover ratio (in times)
= Sales /Debtors.
2. If given in times, we can convert them into days by dividing 365 with given ratio.
3. These ratios may be compared with last year, with competitor or with industry average.
CONCEPT REVIEW QUESTION

Q. 1
The following information is available for a manufacturing company for the last two years.
Extracts from the Statement of Financial Position:
20X2 20X1
Raw Material Inventory 200,000 160,000
WIP Inventory 330,000 220,000
Finished Goods Inventory 340,000 350,000
Receivables 600,000 620,000
Payables 500,000 320,000
Extracts from the Income Statement:
20X2 20X1
Revenue 2,800,000 2,700,000
Opening Inventory 730,000 700,000

Add: Purchases 2,000,000 1,900,000
Less: Closing Inventory (870,000) (730,000)
Cost of Sales 1,860,000 1,870,000
Gross Profit 940,000 830,000
Required:
Determine the length of the cash operating cycle for 20X1 and 20X2.
Page | 4
LO 3: TYPES OF WORKING CAPITAL AND FINANCING POLICIES:
Types of Working Capital:

There are two parts/types of working capital.
Permanent working capital:

This is the minimum amount of working capital that business needs to continue to operate.
Working capital should never fall below this amount.
Fluctuating working capital:

In many businesses (particularly seasonal business), level of working capital fluctuates between
minimum and maximum levels. This is the fluctuating part of working capital.
Working Capital Financing Strategies:

1. Moderate/Matching Financing Policy:
 Fluctuating working capital is financed by  Short-term finance
 Permanent working capital (and Non-Current Assets) is financed by  Long-term
finance
2. Conservative Financing Policy: (least risky)

 Fluctuating working capital is financed by  Short-term finance + Part of Long-term
finance
 Permanent working capital (and Non-Current Assets) is financed by  Long-term
finance
3. Aggressive Financing Policy:

 Fluctuating working capital is financed by  Short-term finance
 Permanent working capital (and Non-Current Assets) is financed by  Part of
Short-term finance + Long-term finance
How to finance Permanent Working Capital

How to finance Fluctuating Working Capital
(and Non-Current Assets)
Moderate Policy Short-term Finance Long-term Finance
Conservative Policy Long-term Finance (+ Short-term) Long-term Finance
Aggressive Policy Short-term Finance Short-term Finance (+ Long-term)
Using Short-term finance over long-term finance:

Advantages:
Aggressive Financing Policy decreases liquidity but increases profitability because of.
 Lower Cost
 Flexible in size and time
Disadvantages:
 To be renewed and renegotiated frequently.
 Risky i.e. payable on demand.
Page | 5
PART B – MANAGEMENT OF WORKING CAPITAL
LO 4:MANAGEMENT OF RAW MATERIAL/FINISHED GOODS:
What if ratio is high:

A high turnover ratio (in days) indicates:
 Excessive stock is held.
Possible Strategies Effect of Strategies

Company should: Possible disadvantages of reducing the level of
 Reduce the level of inventory inventory could be:
 Stock may be out. Sales order may be
rejected, resulting in loss of profit.
 Loss of bulk discount.
What if ratio is low:

A low turnover ratio (in days) indicates:
 Inadequate stock is held which may result in stock-out or loss of bulk discount.
LO 5: MANAGEMENT OF WORK IN PROCESS:

 Production process is taking longer time.

Company should:  Investment may be required to train
 Reduce the production cycle. employees or buy new machinery.
 Employees should be controlled and motivated
to avoid delays in production process.
LO 6: MANAGEMENT OF DEBTORS:

 Customers are taking longer to pay.
 Insufficient collection procedure

Company should: Possible disadvantages of reducing credit could
 Reduce the period allowed to customers. be:
 Offer discounts to customers for early  Loss of customer and sales.
payment.  Discount may be expensive.
 Improve controls over cash collection.  Improving controls may be expensive.
Page | 6

 Customers are paying quickly.
LO 7: MANAGEMENT OF CREDITORS:

 Suppliers have relaxed credit period.
 Company is facing difficulty in making payments on timely basis.

 Suppliers have tightened credit period.
 Company is paying sooner.

Company should: Possible disadvantages of delaying payments
 Delay payment to suppliers. could be:
 Ask for discounts on early payments.  Loss of cash discounts
 Bad business relations and bad
reputation
 Loss of supplier
 Suppliers may charge higher prices

Q. 2
The working capital (or cash operating) cycle of a business is the length of time between the payment for purchased
materials and the receipt of payment from selling the goods made with the materials.
The table below gives information extracted from the annual accounts of Entity M for the past three years.
Entity M - Extracts from annual account
Year 1 Year 2 Year 3

Rs. Rs. Rs.
Raw materials 108,000 145,800 180,000
Work in progress 75,600 97,200 93,360
Finished goods 86,400 129,600 142,875
Purchases 518,400 702,000 720,000
Cost of goods sold 756,000 972,000 1,098,360
Sales 864,000 1,080,000 1,188,000
Trade receivables 172,800 259,200 297,000
Trade payables 86,400 105,300 126,000
Required
(a) calculate the length of the working capital cycle (assuming 365 days in the year); and
(b) list the actions that the management of Entity M might take to reduce the length of the cycle.
Page | 7
PART C – OTHER CONCEPTS
LO 8: OTHER WORKING CAPITAL RATIOS:
Current Ratio = Current Assets/Current Liabilities
Quick Ratio = Current Assets – Inventory / Current Liabilities
Working capital Turnover ratio = Working Capital /Sales * 365
LO 9: USE OF RATIOS TO FIND OUT FIGURES OF FINANCIAL STATEMENTS:

Ratios can also be used to find out figures in financial statements e.g. If receivable balance is Rs. 3
million and average collection period is 90 days then we can find out sales.
Debtor Turnover Ratio = Debtor/Sales * 365
Sales = Debtors/ Debtor Turnover Ratio * 365 = 3 million /90 * 365 = Rs. 12.17 million.
LO 10: CALCULATING ADDITIONAL FINANCE TO INCREASE SALES:
Formula:
Additional Finance Required = Increase in Working Capital – Profit Retained
Where:
Increase in Working Capital = Additional Sales * [Increase in Debtors + Increase in Inventory – Increase in Creditors]
Profit retained = Total Sales * Net Profit Ratio * Retention Ratio
Page | 8

Q. 3
Waseem Limited is engaged in manufacture and sale of consumer products. It’s management is in the process of
developing the sales plan for the next year. The Sales Director is of the view that the main hurdle in increasing the sales is
the availability of finance.
The summarized Balance Sheet as of November 30, 2008 is shown below:
Rs. in million
ASSETS
Fixed assets 950
Current Assets 730
1,680
LIABILITIES AND EQUITIES
Ordinary share capital 250
Retained earnings 450
700
Long term debts 465
Current liabilities 515
1,680
Following additional information is available:
(i) It has been established from the company’s past record that any increase in sales require an investment of 140%
of the additional sales amount, in inventories and accounts receivable. Further, the accounts payable of the
company also increase by 25% of the additional sales amount.
(ii) The current sales of the company is Rs. 1,100 million while the net profit after tax is 10% of sales.
(iii) It is the policy of the company to distribute 20% of its profit after tax among the shareholders of the company.
Required:
Assuming that you are the Chief Financial Officer of the company, advise the management on the following:
(a) How much additional finance would be required to achieve 20% increase in sales in the next year?
(b) What would be the maximum growth in sales that the company can achieve if:
(i) external finances are not available?
(ii) the additional financing is limited to an amount which will maintain the existing debt equity ratio? (14)
(ICAP, BFD Level – Winter 2008, Q # 2)
Page | 9
APX 1: OBJECTIVE TYPE QUESTIONS (ADAPTED FROM ICAP STUDY TEXT):

None.
APX 2: HINTS & COMMENTS TO CONCEPT REVIEW QUESTIONS:

Q. 1
20X2 20X1
Raw Material (Days) 37 days 31 days
(200,000/2,000,000 * 365) (160,000/1,900,000 * 365)
WIP (Days) 65 days 43 days
(330,000/1,860,000 * 365) (220,000/1,870,000 * 365)
Finished Goods (Days) 67 days 68 days
(340,000/1,860,000 * 365) (350,000/1,870,000 * 365)
Receivables (Days) 78 days 84 days
(600,000/2,800,000 * 365) (620,000/2,700,000 * 365)
Payables (Days) 91 days 62 days
(500,000/2,000,000 * 365) (320,000/1,900,000 * 365)
Length of Cash Operating Cycle 156 days 164 Days
Q. 2
(a)
Year 1 Year 2 Year 3
Raw Material (Days) 76 76 days 91 days
[Raw Material/Credit Purchases * 365] (108,000/518,400) (145,800/702,000 * 365) (180,000/720,000 * 365)
WIP (Days) 37 37 days 31 days
[WIP/Cost of Sales * 365] (75,600/756,000 * (97,200/972,000 * 365) (93,360/1,098,360 * 365)
365)
Finished Goods (Days) 42 49 days 47 days
[Finished Goods Inventory /Cost of Sales (86,400/756,000 * (129,600/972,000 * 365) (142,875/1,098,360 *
* 365] 365) 365)
Receivables (Days) 73 88 days 91 days
[Receivables /Credit Sales * 365] (172,800/864,000 (259,200/1,080,000 * (297,000/1,188,000 *
* 365) 365) 365)
Payables (Days) 61 55 days 64 days
[Payables /Credit Purchases * 365] (86,400/518,400 * (105,300/702,000 * 365) (126,000/720,000 * 365)
365)
Length of Cash Operating Cycle 167 Days 194 Days 197 Days
(b)
Actions To reduce Raw Material:
 Reduce the minimum and re-order level of inventory.
Actions To reduce WIP:

 Speed up/Reduce production cycle (by new technology, training)
Actions To reduce Finished Goods:

 Reduce the finished goods inventory.
Page | 10
Actions To reduce Receivables:

 Reduce credit period
 Improve collection procedures
 Offer cash discounts for early payments
Actions To reduce Payables:

 Negotiate for higher credit period.
 Delay Payments to suppliers as much as possible.
Q. 3
(a)
Increase in Working Capital = Additional Sales * [Increase in Working Capital – Increase in Creditors]
= [1,100 * 20%] * [140% – 25%]
= 253

= [1,100 * 120%] * 10% * 80%
= 105.6
Additional Finance needed = 253 – 105.6 = 147.4 million
(b)
(i)
Let Growth Rate = X, and Additional finance = 0, then:
0 = Increase in Working Capital – Profit Retained
Increase in Working Capital = [1,100 X] * [140% – 25%] = 1,265X

Profit retained = 1,100 * (1+X) * 10% * 80% = 88 + 88X
Now, solve the equation for X

0 = 1,265 X – (88 + 88 X)
0 = 1,265 X – 88 – 88 X
88 = 1,177 X
X = 7.48%
(ii)
Let Growth Rate = X, and Additional finance = Profit Retained * Debt/Equity, then:
Profit Retained * Debt/Equity = Increase in Working Capital – Profit Retained

(88 + 88X) * 465/700 = 1,265X – (88 + 88X)
58.46 + 58.46X = 1,265X – 88 – 88X
146.46 = 1,118.54X
X = 13.09%
Page | 11
Managerial & Financial Analysis – The Practice Kit Chapter 15: Working Capital Management
CHAPTER 15
WORKING CAPITAL
MANAGEMENT
QUESTIONS
1. Which of the following statements is correct about aggressive working capital funding policy?
(a) All permanent assets as well as part of the fluctuating current assets are financed by long-term funding
(b) All permanent assets as well as part of the fluctuating current assets are financed by short-term funding
(c) All fluctuating current assets as well as some of the permanent part of current assets are financed by short-term funding
(d) Only fluctuating current assets are financed by short-term funding (1.5)
(ICAP, MFA – Model Paper, Q.#1(iii))
PRACTICE QUESTIONS
Q.1 Faran Limited (FL) manufactures and sells a specialized machine. It is currently in the process of finalizing its sales plan
for 2023. According to the sales director, the main obstacle to increasing sales is the availability of working capital
finance. The finance director informed that any increase in sales would increase:
• the trade receivables by 80% of the additional sales amount;
• the inventories by 60% of the additional sales amount, and
• the made payables by 35% of the additional sales amount.
Following is the summary of FL's financial position as at 31 December 2022
Assets Rs. in million Equity and liabilities Rs. in million

Plant and machinery 950 Long term debt 165
Current liabilities:
Current assets: Trade payables 405
Inventory 500 Other payables 110
Trade receivables 300 Equity:
Cash and bank balances 30 Share capital 350
Retained earnings 450
1,780 1,780
The sales for the year ended 31 December 2022 was Rs. 2,200 million, and the net profit after tax was 15% of the sales
amount. FL distributes 25% of profit after tax as dividend to its shareholders. It is expected that profit after tax and dividend
distribution for the year 2023 will be in line with 2022.
All receipts and payments except dividend can be assumed to occur evenly throughout the year. Dividend is paid on the last
day of the financial year.
Required:
(a) Determine the amount of additional working capital finance required to achieve 25% increase in sales next year. (03)
(b) Estimate the maximum growth in sales that FL can achieve under each of the following independent assumptions:
(i) No external financing is available. (02)
(ii) Only debt financing is available to the extern that existing debt equity ratio is maintained at the end of 2023.
(04)
(ICAP, MFA – Spring 2023, Q.#8)
Page | 1
Q.2 Decor Limited (DL) is engaged in selling home decoration items. DL has provided you the following information based on
its latest management accounts:
Rs. in ’000
Average inventory 6,000
Average trade debtors 7,500
Average trade creditors 3,800
Sales 50,000
Cost of sales 35,000
The management of DL is concerned over increasing working capital requirement that is centrally managed through bank
overdraft facility. As per arrangement with the bank, DL has overdraft limit of Rs. 10 million.
For the next year, it is projected that sales and cost of sales would increase by 25% and 15% respectively. This would result
in:
• average inventory to increase by 30%
• average trade debtors to increase by 20%
• average trade creditors to increase by 10%
The CFO is of the view that DL would not be able to manage its working capital requirement within the bank overdraft limit
for next year. He has suggested that DL should take certain actions to follow industry average ratios which are given below:
Industry average ratios Number of days*

Inventory holding period 50
Trade debtors’ collection period 45
Trade creditors’ payment period 30
*Based on 365 days a year
Required:
(a) Determine the cash operating cycle for the next year. (03)
(b) Validate CFO’s view regarding management of working capital requirement if:
• DL does not follow industry average ratios
• DL follows industry average ratios (04)
(c) List down any two actions that management of DL may take to reduce the length or its cash operating cycle. Also,
mention any two risks associated with those actions of management. (03)
(ICAP, MFA – Spring 2022, Q.#8)
Page | 2
SUGGESTED SOLUTIONS
SUGGESTED SOLUTIONS
1 c
PRACTICE QUESTIONS
A.1 (a)
Increase in Working Capital = Additional Sales * [Increase in Debtors + Increase in Inventory – Increase in Creditors]
= [2,200 * 25%] * [80% + 60% – 35%]
= 577.5

= [2,200 * 125%] * 15% * 75%
= 309.375
Additional Finance needed = 577.5 – 309.375 = 268.125 million
(b)
(i)
Let Growth Rate = X, and Additional finance = 0, then:
0 = Increase in Working Capital – Profit Retained
Increase in Working Capital = [2,200 X] * [80% + 60% – 35%] = 2,310X

Profit retained = 2,200 * (1+X) * 15% * 75% = 247.5 + 247.5X

0 = 2,310 X – (247.5 + 247.5X)
0 = 2,310 X – 247.5 – 247.5X
247.5 = 2,062.5 X
X = 12%
(ii)
Let Growth Rate = X, and Additional finance = Profit Retained * Debt/Equity, then:
Profit Retained * Debt/Equity = Increase in Working Capital – Profit Retained
Increase in Working Capital = [2,200 X] * [80% + 60% – 35%] = 2,310X

Profit retained = 2,200 * (1+X) * 15% * 75% = 247.5 + 247.5X

(247.5 + 247.5X) * 465/800 = 2,310X – (247.5 + 247.5X)
143.86 + 143.56X = 2310X – 247.5 – 247.5X
391.36 = 1,918.94X
X = 20.40%
Page | 3
A.2 (a)
Cash Operating Cycle = Inventory Days + Debtors’ Days – Creditors’ Days
= [6,000 * 1.3/35,000 * 1.15] * 365+ [7,500 *1.2/ 50,000 * 1.25] * 365 – [3,800 * 1.1/35,000 * 1.15] * 365
= 70.73 Days + 52.56 Days – 37.91 Days = 85.38 Days
(b)
Working Capital Requirement if DL does not follow industry average ratios:
= [6,000 * 1.3] + [7,500 *1.2] – [3,800 * 1.1]
= 7,800 + 9,000 – 4,180 = 12,620 million
CFO is right that if DL does not follow industry average, then current overdraft limit is lower than working capital
requirements.
Working Capital Requirement if DL follows industry average ratios:

Inventory Turnover Ratio (Days) = Inventory / Sales * 365
Inventory = 50 * [35,000 * 1.15] / 365 = 5,514
Debtors = 45 * [50,000 * 1.25] / 365 = 7,705
Creditors = 30 * [35,000 * 1.15] / 365 = 3,308
Working Capital = 5,514 + 7,705 – 3,308 = 9,911
CFO is right that if DL follows industry average, then current overdraft limit is more than working capital requirements.
(c)
Actions to reduce Cash Operating Cycle Risks with Action
 Stock may be out. Sales order may be rejected, resulting
Reduce the level of inventory in loss of profit.
 Loss of bulk discount.
 Loss of cash discounts
Delay payment to suppliers.
 Bad business relations and bad reputation
• Some examinees wrongly applied the formulas for inventory days and trade creditors’ days.
• Examinees opted to offer general discussion while validating the CFO’s views. The discussion was not supported by
the numbers that could have been determined by using the given information in the case scenario.
• Actions to reduce the length of cash operating cycle were generally correct. However, the corresponding risks lacked
the substance.
Marking Plan:
(a)
• Inventory days 1.0
• Trade debtors’ days 1.0
• Trade creditors’ days 1.0
(b)
• Working capital requirement if industry average ratios are not followed 1.0
• Working capital requirement if industry average ratios are followed 3.0
(c)
• 0.5 mark for each action 1.0
• 01 mark for each risk 2.0
Passing Percentage:
54%
Page | 4
Managerial & Financial Analysis – Study Notes Chapter 16: Project Appraisal
CHAPTER 16
PROJECT APPRAISAL
ICAP Book
Chapter Paragraph #
PART A: INTRODUCTION: #
INTRODUCTION OF INVESTMENT APPRAISAL AND
LO 1 16
BASIC CALCULATIONS
Section 1
LO 2 STEPS IN INVESTMENT APPRAISAL 16 to 4
SOME FREQUENTLY TESTED ITEMS IN EXAM AND THEIR
LO 3 16
CORRECT TREATMENT
PART B: ADVANCE ADJUSTMENTS:
LO 4 EFFECT OF TAX 16 Section 5
LO 5 MISCELLANEOUS CONCEPTS 16 4.4
APPENDIX
APX 2 ANSWER KEY TO PRACTICE QUESTIONS
Page | 1
PART A – INTRODUCTION
LO 1: INTRODUCTION OF INVESTMENT APPRAISAL AND BASIC CALCULATIONS:
What is meant by Project, and Project Appraisal:

Project means a long-term asset.
Project Appraisal means calculating whether a project will be beneficial for company or not.
Methods of Project Appraisal:

There are various methods of Project Appraisal. Two most common methods are:
1. Net Present Value (NPV)

Under this method, a project is beneficial if NPV of its Cash Flows is Positive. NPV is
calculated in 1-step from Net Cashflows,
2. Internal Rate of Return (IRR)

Under this method, a project is beneficial if IRR of its Cash Flows is more than Cost of
Capital. IRR is calculated in 3-steps from Net Cashflows.
Note that Project Appraisal is based on “Cash flows” (NOT on “Profits”). Therefore, non-cash items are
ignored here.
Study Tip
You have already learnt how to calculate NPV and IRR in Chapter # 11. In this chapter, you will learn different
types of Cash Flows and how to deal them.
Method Decision Criteria Advantages Disadvantages

 Present Value concept is not easily
understood.
 It is based on Cash Flows.
 Uncertainty regarding use of Discount Rate
Net Present Value  It recognizes time value of money.
Accept if NPV > Zero  It does not consider risk and uncertainties
(NPV)  NPV measures how much amount
in estimating cash flows.
of wealth a project creates.
 It does not relate return of the project to
its cash outflows.
 It is based on Cash Flows.
 It does not measure how much wealth a
 It recognizes time value of money.
Internal Rate of project creates in absolute terms.
Accept if IRR > WACC  It is easier to evaluate a project in
Return (IRR)  It may give incorrect decision in mutually
terms of percentage.
exclusive projects.
Page | 2
Practice Questions
Q. 1
A company is considering whether to undertake an investment. The cost of capital is 10%. The initial cost of the
investment would be Rs. 50,000 and the expected annual cash flows from the project would be:
Year Revenue Cash Expense Net cash flow

1 40,000 30,000 10,000
2 55,000 35,000 20,000
3 82,000 40,000 42,000
Required:
Calculate Net Present Value of the project.
(ICAP Study Text, Example – 33)
Q. 2
A company has estimated that its cost of capital is 8.8%. It is deciding whether to invest in a project that would cost Rs.
325,000.
Net cash flows of the project for years 1 – 6 are Rs. 75,000 per year.
Required:
Q. 3
A company has estimated that its cost of capital is 8.8%. It is deciding whether to invest in a project that would cost Rs.
325,000.
Company has following cash flows pattern

Year Rs.
1 50,000
2–6 75,000
Required:
Q. 4
A business requires a minimum expected rate of return of 12% on its investments. A proposed capital investment has the
following expected cash flows.
Year Cash flow

0 (80,000)
1 20,000
2 36,000
3 30,000
4 17,000
Required:
Using Internal Rate of Return (IRR) Technique, evaluate whether project should be accepted.
Page | 3
LO 2: STEPS IN INVESTMENT APPRAISAL:
1. Use Cash Flows:

In Investment Appraisal, decisions are made on the basis of Cash Inflows and Cash Outflows. Non-
Cash items are NOT considered, and are ignored.
Examples:
 Cash paid for purchase of a fixed asset is included, but Depreciation Expense is NOT included.
 Cash received from sale of a fixed asset is included, but Profit/Loss on disposal is NOT included.
2. Use Relevant Cash Flows and Relevant Costs:

“Relevant” Cash Flows and Costs are those income or expenses which change if project is started
e.g.
 Operating Cash Flows
 Opportunity Cost
“Irrelevant” Cash Flows are income or expenses which do NOT change whether project is started
or not e.g.
 Project Feasibility Cost
 Allocated Fixed Cost.
3. Consider Timing of Cash Flows:

Considering timing, there are four types of Cash Flows. You have to carefully include each cash flow
in Relevant Year.
1. Initial Investment:
These are cash outflows which usually occur at start of project (in Year 0) e.g. cost of new
asset.
2. Operating Cash flows:

These are regular cash Inflows and Outflows which occur each year. These usually occur
from Year 1 till last year of project.
3. Terminal Cash flows:

These are Cash Flows which occur at end of project. e.g. sale proceeds from disposal of
asset, and return of working capital.
4. Working Capital Investment:

These are cash outflows which are incurred to meet working capital requirements. These
usually occur at start of project (in Year 0) e.g. investment in inventory and receivables.
However, such investment may also be incurred anytime during the project.
Page | 4
4. Put Cash flows in specified format.

Use specified format i.e. Column-wise approach for each year. Horizontal approach is NOT
recommended.
Format to calculate Cash Flows:

Cashflow Y0 Y1 Y2 Y3
Sales XXX XXX XXX
Material Costs (XXX) (XXX) (XXX)
Labor Costs (XXX) (XXX) (XXX)
Tax (XXX) (XXX) (XXX)
Initial Cost (XXX) XXX
Net Cash Flow (XXX) XXX XXX XXX
5. Use specified method of appraisal:

 Use NPV or IRR whichever method is mentioned in the question.
 NPV or IRR is calculated from final figure of Net Cash Flow of each year.
Practice Questions
Q. 5
A company is considering whether to invest in a new item of equipment costing Rs. 45,000 to make a new product. The
product would have a four-year life, and the estimated cash profits over the four-year period are as follows.
Year Rs.
1 17,000
2 25,000
3 16,000
4 4,000
The project would also need an investment in working capital of Rs. 8,000, from the beginning of Year 1.
The company uses a discount rate of 11% to evaluate its investments.
Required:
Using Internal Rate of Return (IRR) Technique, evaluate whether project should be accepted.
Page | 5
Q. 6
Ali & Co. is a medium sized medical research company, engaged in the development of new medical treatments. To date
company has invested Rs. 250,000 in the development of a new product called ‘Gravia’ which can be recovered by selling
the formula to an outsider. It is estimated that it will take further two years of development and testing before ‘Gravia’ is
approved by medical industry regulators.
The company believes that it can sell the patent for Gravia to a multinational pharmaceutical company for Rs. 1,000,000
when it has been fully developed. The directors of the Ali & co. are currently reviewing the Gravia projects as there is
some concern about the size of the required finance to complete the development work.
Following information is relevant to the projects:

 To complete the development Ali & Co. will need to acquire additional type A material expected cost Rs. 150,000
per annum over the next two years.
 Type B material will also be required. Currently there is sufficient stock of type B material to last for the two
years of the project. The material originally cost Rs. 50,000. Its replacement cost is Rs. 75,000. Instead of using it
on this project, it could immediately be sold as scrap for Rs. 20,000 It has no further alternative use.
 If it is decided to continue with Gravia project, specialist equipment will need to be purchase immediately for Rs.
100,000. This equipment could eventually be sold at the end of the project for Rs. 25,000.
 Laboratory technicians currently employed by Ali & Co. are working on Gravia project at a total annual cost of
Rs. 85,000. Currently company has no other project to use these technicians.
 Two chemists are hired for an annual salary of Rs. 20,000 each will be made redundant whenever Gravia project
ends. Redundancy payments are expected to be one full year’s salary each.
 Annual fixed overheads are 100,000 of which Rs. 60,000 are general overheads, and remaining Rs. 40,000 are
directly associated with the project.
 Interest cost on borrowed finance is Rs. 20,000 per annum.
 All cash flows occur at the end of the year unless otherwise stated.
 The discount rate used by Ali & Co. to appraise its projects is 10%.
Required:
Calculate the net present value of the project assuming that unless otherwise specified, all cash inflows/outflows would
arise at the end of year. Ignore taxation.
LO 3: SOME FREQUENTLY TESTED ITEMS IN EXAM AND THEIR CORRECT TREATMENT:
Life of Project:
 This information is used to draw columns in table (e.g. 4 years’ project means 5 columns)
 If any liability is paid in following year (e.g. tax), then additional column is also inserted at
end of project life.
Past Costs:
Past/Sunk Cost (e.g. Product Research, Due Diligence of Investment) is completely ignored because
it is not relevant.
Initial Investment:
 Initial Investment is Outflow in Year 0, and its Residual value is Inflow in last year.
 “Depreciation” and “Gain/Loss on disposal” are irrelevant in main cash flow table because
these are non-cash item, but are relevant in tax calculation table.
Page | 6
Working Capital:
 Working Capital is an Outflow in the year in which it is invested (Year 0 or later year)
 This is also an Inflow at end of Project (whether mentioned in question or not).
Bank Loan and Interest Payment:

Bank Loan and Interest Payments are completely ignored because they are financing transactions,
not investing transactions.
Existing Resources Used:

Material:
 If material is in regular use, relevant cost is its Replacement Cost.
 If material is NOT in regular use, relevant cost is higher of Disposal Value or Benefit from
alternative use is Relevant.
Labor:
 If labor is already employed having no other use, relevant cost is its Zero.
Fixed Cost:
 If fixed cost is allocated, this is irrelevant and is ignored in question.
Operating Cash Flows:

These are calculated in the same way as in topic of Budgeting i.e.
Sales Revenue:
 Inflow in each year of project.
 Calculation of Sales = Quantity * (1 + Growth)1 * Price * (1 + Inflation)1
Fixed Cost:
 Incremental Fixed Cost is Outflow in each year.
 Calculation of Fixed Cost = Fixed Cost * (1 + Inflation)1
Variable Cost:
 Outflow in each year of project.
 Calculation of Variable Cost = Quantity * (1 + Growth)1 * Per Unit Cost * (1 + Inflation)1
Opportunity Cost: [net of tax]

Opportunity Cost means benefit sacrificed for proposed Project. Examples of Opportunity Cost:
1. Loss of Rental Income
2. Decrease in Sale of Existing Product
Remember that, this opportunity cost is shown in Investment Cash Flows, but NOT in Tax Cash
flows.
Page | 7
Inflation Rates:
If inflation is applicable:
 Operating Costs are adjusted for inflation e.g. Sales, Variable Costs and Fixed Costs.
 Initial Investment, Residual Value, Working Capital are usually NOT adjusted for inflation,
unless clearly mentioned in the question.
Note: There may be single inflation rate in question for all items, or different inflation rate for different
items.
There are 3 possibilities in Exam Questions For Inflation: [& Growth]

1. All cash flows to be inflated from Year 2.
2. All cash flows to be inflated from Year 1.
3. Some cashflows to be inflated from Year 1 and some from Year 2.
Examples of Inflation in Exam Questions:

 All revenues and costs are quoted on today's rate and are expected to remain the same in the first year. Thereafter,
the estimated annual inflation of 9% would be applicable on all future revenues and costs.
 All revenues and costs are quoted on today’s rate. The estimated annual inflation of 8% would be applicable for all
revenues and costs that arise from first year and onwards.
 Impact of inflation on revenues as well as all costs would be 7%.
 Rate of inflation is estimated at 8% per annum with effect from 2nd year onward. It would affect revenues as well
as all the costs (excluding depreciation).
Practice Questions
Q. 7
A company is considering an investment in an item of equipment costing Rs. 150,000. Contribution per unit is expected to
be Rs.4 and sales are expected to be:
Year Units of sale
1 20,000
2 40,000
3 60,000
4 20,000
Fixed costs are expected to be Rs. 50,000 at today’s price levels and the equipment can be disposed of in year 4 for Rs.
10,000 at today’s price levels. The inflation rate is expected to be 6% and the money cost of capital is 15%.
Required:
Using Net Present Value (NPV) Technique, evaluate whether project should be accepted.
Q. 8
A company is considering an investment in an item of equipment costing Rs. 150,000. The equipment would be used to
make a product. The selling price of the product at today’s prices would be Rs. 10 per unit, and the variable cost per unit
(all cash costs) would be Rs. 6.
The project would have a four-year life, and sales are expected to be:
Year Units of sale

1 20,000
2 40,000
3 60,000
4 20,000
At today’s prices, it is expected that the equipment will be sold at the end of Year 4 for Rs. 10,000. There will be additional
fixed cash overheads of Rs. 50,000 each year as a result of the project, at today’s price levels.
Page | 8
The company expects prices and costs to increase due to inflation at the following annual rates:
Item Annual inflation rate
Sales 5%
Variable costs 8%
Fixed costs 8%
Equipment disposal value 6%
The company’s money cost of capital is 12%.
Required:
Q. 9
Omega Limited (OL) is the sole distributor of goods produced by ABC Limited which is a leading brand in the
international market. OL is now planning to establish a factory in collaboration with ABC Limited. The factory would be
established on a land which was purchased at a cost of Rs. 20 million in 2005. The existing market value of the land is
Rs.40 million. The cost of factory building and plant is estimated at Rs. 30 million and Rs. 100 million respectively.
The factory will produce goods which are presently supplied by ABC Limited. The sale for the first year of production is
estimated at Rs. 300 million. The existing profit margin is 20% on sales. As a result of own production, cost per unit would
decrease by 10%. The sale price and cost of production per unit (excluding depreciation) are expected to increase by 10%
and 8% respectively, each year.
Following further information is available:

• ABC Limited would assist in setting up of the factory for which it would be paid an amount of Rs. 10 million at
the time of signing the agreement. In addition, ABC Limited would be paid a royalty equal to 3% of sales.
• The factory building and installation of plant would be completed and commercial production would start one
year after signing the agreement.
• 50% of the cost of plant would be financed through a five year loan with interest payable annually at 10% per
annum. Principal would be repaid at the end of 5th year.
• A working capital injection of Rs. 15 million would be required at the commencement of commercial production.
• OL charges depreciation on factory building and plant under the straight line method.
• OL uses a five year project appraisal period. The residual value of the factory building and plant after five years
is estimated at 50% and 10% of cost respectively.
• The market value of the land after five years is estimated at Rs. 70 million.
• OL’s cost of capital is 12%.
Required:
Calculate the net present value of the project assuming that unless otherwise specified, all cash inflows/outflows would
arise at the end of year. Ignore taxation. (15)
(ICAP, Cost Accounting – Autumn 2014, Q.#3)
Page | 9
PART B: TAX CALCULATION
LO 4: EFFECT OF TAX:
If tax is applicable:
 Tax will always be calculated in a separate table below the main table of cashflows.
 Calculation of Tax payment will also include non-cash items as per Tax Rules e.g.
Tax Expense = [Operating Cash Flows – Depreciation expense – Loss on disposal of fixed
asset] * Tax Rate.
 It will be an Outflow in the same year or in following year (as mentioned in the
question).
(w-1) Calculation of Tax Payable:

Y1 Y2 Y3 Y4
Revenue – Costs 50,000 40,000 20,000 10,000
Depreciation @ 10% on WDV (26,000) (5,400) (4,860) (23,740)
Taxable Profit 24,000 34,600 15,140 (13,740)

Tax @ 32% 7,680 11,072 4,845 (4,397)
Practice Questions
Q. 10
A company is considering an investment in a non-current asset costing Rs. 80,000. The project would generate the
following cash inflows:
Year Rs.
1 50,000
2 40,000
3 20,000
4 10,000
Allowable initial allowance is 25% and normal depreciation is 10% under the reducing balance method. Tax on profits is
payable at the rate of 32%.
It is expected to have a scrap value of Rs. 20,000 at the end of year 4. The post-tax cost of capital is 9%.
Required:
LO 5: MISCELLANEOUS CONCEPTS:
Real Rate Vs. Nominal Rate:

If future cashflows are inflated (i.e. include effect of inflation), we will use Inflated/Nominal
discount rate (also called the money discount rate) to discount nominal cashflows.
The Fisher equation: (to calculate nominal rate or real rate)

1+ Nominal (or Money) Rate = (1 + Real Rate) * (1 + Inflation Rate)
Page | 10

Q. 1
Net Present Value = 10,000/(1.1)1 + 20,000/(1.1)2 +42,000/(1.1)3 – 50,000 = + 7,175
Q. 2
As inflows of the project is same from year 1 to year 6, we can use Annuity Formula to calculate present value of inflows
at start of year 1,
Present Value of Inflows at start of year 1 = R * [1 – 1/(1+i)n] /i

= 75,000 * [1 – 1/(1.088)6] /0.088 = 338,460
NPV = 338,460 – 325,000 = 13,460
Exam Tip: Start of Year 1 = Year 0
Q. 3
As inflow of the project is same from year 2 to year 6, we can use Annuity Formula to calculate present value of inflows at
start of year 2,
Present Value of Inflows at start of year 2 = R * [1 – 1/(1+i)n] /i

= 75,000 * [1 – 1/(1.088)5] /0.088 = 293,244
Present Value of Inflows at start of year 1 = [293,244 + 50,000]/1.088 = 315,482
NPV = 315,482 – 325,000 = – 9,518
Exam Tips:
Start of Year 2 = End of Year 1
As there were two different streams of cash flows, therefore, we discounted them separately.
Q. 4
PV @ 10% = 20,000/(1.1)1 + 36,000/(1.1)2 +30,000/(1.1)3 +17,000/(1.1)4 – 80,000 = + 2,085
PV @ 15 % = 20,000/(1.15)1 + 36,000/(1.15)2 +30,000/(1.15)3 +17,000/(1.15)4 – 80,000 = – 5,942
IRR = 10% + 2,085/(2,085 + 5,942) * (15% - 10% ) = 11.30%
Conclusion: Project should not be accepted as IRR is less than Required Rate of Return.
Exam Tip: To speed-up calculation, don’t use bracket with every cash flows.
Page | 11
Q. 5
Q. 5 (A company is considering …....... )
Y0 Y1 Y2 Y3 Y4
Equipment (45,000) 0
Working Capital (8,000) 8,000
Operating Cash Flow 17,000 25,000 16,000 4,000
Net Cash Flow (53,000) 17,000 25,000 16,000 12,000

Present Value @ 10% (53,000) 15,455 20,661 12,021 8,196
Net Present Value @ 10% 3,333
Present Value @ 15% (53,000) 14,783 18,904 10,520 6,861
Net Present Value @ 15% (1,933)
IRR = 10% + 3,333/ (3,333+1,933) * 5% = 13.165%
As IRR is higher than required discount rate of 11%, therefore project should be accepted.
Q. 6
Q. 6 (Ali & Co)

Y0 Y1 Y2
Value of Development Cost (250,000)
Value of Patents 1,000,000
Cost of Type A Material (150,000) (150,000)
Cost of Type B Material (20,000)
Equipment (100,000) 25,000
Two Chemists (40,000) (40,000)
(20,000 * 2) (20,000 * 2)
Redundancy Payments (40,000)
Annual Fixed Overheads (40,000) (40,000)
Net Cash Flow (370,000) (230,000) 755,000
Present Value @ 10% (370,000) (209,091) 623,967
Page | 12
Q. 7
Q. 7 (A Company)
Y0 Y1 Y2 Y3 Y4
Equipment (150,000) 12,625
(10,000 * 1.06^4)
Contribution [Actual
Growth, 6% Inflation] 84,800 179,776 285,844 100,998
(20,000 * 4 * 1.06) (40,000 * 4 * 1.062) (60,000 * 4 * 1.063) (20,000 * 4 * 1.064)
Fixed Cost [6% Inflation] (53,000) (56,180) (59,551) (63,124)

(50,000 * 1.061) (50,000 * 1.062) (50,000 * 1.063) (50,000 * 1.064)
Net Cash Flow (150,000) 31,800 123,596 226,293 50,499

Present Value @ 15% (150,000) 27,652 93,456 148,791 28,873
Net Present Value 148,773
Notes:
1. Sales and Variable Expenses vary due to TWO reasons i.e. Growth and Inflation.
2. Fixed Expenses vary due to one reason only i.e. Inflation.
Q. 8
Q. 8 (A Company)
Y0 Y1 Y2 Y3 Y4
Equipment (150,000) 12,625
(10,000 * 1.06^4)
Sales 210,000 441,000 694,575 243,101

[Actual Growth, 5% Inflation] (20,000*10*1.05) (40,000*10*1.052) (60,000*10*1.053) (20,000 * 10 * 1.05^4)
Variable Cost (129,600) (279,936) (453,496) (163,259)

[Actual Growth, 8% Inflation] (20,000*6*1.08) (40,000 *6*1.082) (60,000*6*1.083) (20,000 * 6 * 1.08^4)
Fixed Cost (54,000) (58,320) (62,986) (68,024)

[8% Inflation] (50,000*1.08) (50,000*1.082) (50,000*1.083) (50,000*1.08^4)
Net Cash Flow (150,000) 26,400 102,744 178,093 24,443

Present Value @ 12% (150,000) 23,571 81,907 126,763 15,534
Page | 13
Q. 9
Q. 9 (Omega Limited)
Y0 Y1 Y2 Y3 Y4 Y5 Y6
Value of Land (40,000,000) 70,000,000
Working Capital (15,000,000) 15,000,000
Cost of Building (10,000,000) (20,000,000) 15,000,000

Cost of Plant (100,000,000) 10,000,000
Loan & Repayment 50,000,000 (50,000,000)
Sales [No Growth, 10% Inflation] 300,000,000 330,000,000 363,000,000 399,300,000 439,230,000
(300m*1.10) (300m*1.102) (300m*1.103) (300m.*1.104)
Cost of Sales [No Growth, 8%

Inflation] (195,000,000) (210,600,000) (227,448,000) (245,643,840) (265,295,347)
(excluding (Sales * 0.8 * (195,000,000 (195,000,000 (195,000,000 (195,000,000 *
depreciation) 0.9) – 21 m. * 1.08) * 1.082) * 1.083) 1.084)
Royalty to ABC [3% of Sales] (9,000,000) (9,900,000) (10,890,000) (11,979,000) (13,176,900)
Net Cash Flow (50,000,000) (85,000,000) 96,000,000 109,500,000 124,662,000 141,677,160 220,757,753
Present
Value@12% (50,000,000) (75,892,857) 76,530,612 77,939,937 79,224,955 80,391,425 111,842,748
Net Present Value 300,036,820
Notes:
1. It is assumed that value of land is increased because of this project.
2. Interest Payment is not considered in Cash Flows as it is adjusted in Cost of Capital.
3. Depreciation is ignored because it is a non-cash item.
4. Cost of Sales includes Depreciation
A poor performance was witnessed in this question which required computation of NPV of a project. A number of errors were
observed. The most common among them are as follows:
• Majority of the students ignored the fact that installation of plant was to be completed in one year and hence the
cash flows were to be computed for Year 0 to 6. Instead, they determined cash flows for Year 0 to 5.
• A significant number of candidates did not understand the concept of Year 0 and took outflows pertaining to Year 0
in Year 1.
• Instead of its market value, cost of land was taken as outflow.
• Market value of land at the end of the period of five years was ignored.
Page | 14
Q. 10
Q. 10 (A company is considering ….)
Y0 Y1 Y2 Y3 Y4
Equipment (80,000) 20,000
Net Cash Inflows 50,000 40,000 20,000 10,000
Tax Payment (w-1) (7,680) (11,072) (4,845) 4,397

Net Cash Flow (80,000) 42,320 28,928 15,155 34,397
Present Value @ 9% (80,000) 38,826 24,348 11,703 24,368
Net Present Value 19,244
(w-1) Calculation of Tax Payable:

Y1 Y2 Y3 Y4
Revenue – Costs 50,000 40,000 20,000 10,000
Taxable Profit 24,000 34,600 15,140 (13,740)

Tax @ 32% 7,680 11,072 4,845 (4,397)
Notes:
1. Last year depreciation expense may be calculated as difference between book value and residual value.
Alternatively, this may be treated as sum of Depreciation @ 10% (4,374) and Loss on disposal (19,366).
2. Depreciation and Gain/Loss on disposal is used only in Tax Calculation.
Page | 15
Managerial & Financial Analysis – The Practice Kit Chapter 16: Project Appraisal
CHAPTER 16
PROJECT APPRAISAL
QUESTIONS
1 While evaluating the financial feasibility of a new project, the finance director concluded that the project has a positive net
present value (NPV) at the end of the project when discounted at the cost of capital of 18%. What would be the internal rate
of return (IRR) of this project?
(a) It would also be 18%
(b) It would be lower than 18%
(c) It would be higher than 18%
(d) It would depend on a number of other factors and could be higher or lower (01)
(ICAP, MFA – Spring 2023, Q.#1(xi))
PRACTICE QUESTIONS
Q.1 Cherat Mobiles (CM) produces and sells smart mobile accessories. It is planning to introduce a low-priced smart watch for
the local market. Following information has been gathered in this respect:
(i) Research and development team incurred an amount of Rs. 0.5 million on market and product research. However,
only Rs. 0.2 million was paid as an advance and the remaining amount is due for payment in two months' time.
(ii) Initial investment in the new plant for manufacturing the smart watch would be Rs. 250 million including installation
and commissioning of the plant. The plant would be partly financed through a loan of Rs. 100 million at an interest
rate of 18% per annum. The interest would be payable annually and the principal amount would have to be repaid at
the end of 5th year.
(iii) The plant would be installed in a building owned by CM which has been currently rented out at Rs. 0.5 million per
month.
(iv) CM expects to produce 3,000 watches per month. Sales volume is expected to increase by 5% per annum. Contribution
margin is estimated to be Rs. 4,000 per watch, whereas the annual fixed cost is estimated to be Rs. 58 million.
(v) Additional working capital requirements are estimated to be Rs. 15 million which would be realized at 80% of its
value at the end of 5th year. No further investment in working capital is expected during the course of the project.
(vi) The plant would be depreciated at the rate of 15% under the reducing balance method. The plant supplier has offered
to repurchase the plant for Rs. 80 million (at current prices) at the end of 5th year. CM would have to incur dismantling
costs of Rs. 1.2 million (at current prices) at the end of 5th year.
(vii) All revenues and costs are quoted on today's rate and are expected to remain the same in the first year. Thereafter,
the estimated annual inflation of 9% would be applicable on all future revenues and costs.
(viii) Applicable tax rate is 30% and tax would be payable / refundable in the year in which it arises. Dismantling costs are
allowed as an expense by the tax authorities when they are incurred.
(ix) CM's cost of capital is 20%.
Required:
By using the net present value method, recommend whether CM should launch the new smart watch. (Assume that all cash
flows arise at the end of each year unless otherwise specified) (15)
(ICAP, CAF 06 Level – Spring 2023, Q # 7)
Page | 1
Q.2 Islamabad Universe (IU) is engaged in production and sales of various consumer products. The management is in the
process of launching a new product ‘Gladiator’. You have been provided the following information in this regard:
(i) IU has outsourced the due diligence of Gladiator at the cost of Rs. 250,000 which is payable shortly.
(ii) A specialized machine costing Rs. 25 million would be needed for the production of Gladiator. The machinery
would be financed by a bank loan that would carry interest rate of 12% per annum.
(iii) The machine would be expected to produce 10,000 units in the first year of its operation. However, the production
would reduce by 10% and 15% in the second and third years respectively. At the end of third year, an overhauling
would be carried out at the cost of Rs. 2.5 million. This would result in continuation of third year’s production in
the fourth and fifth years.
(iv) The selling price and cost of goods sold (other than depreciation) of Gladiator would be Rs. 1,600 and Rs. 750 per
unit respectively.
(v) The fixed operating cost of producing Gladiator would be Rs. 1 million per annum, whereas variable operating
cost would be Rs. 100 per unit.
(vi) The machine would have an estimated useful life of five years, after which it could be scrapped for Rs. 5 million.
The machine and overhauling costs would be subject to tax depreciation of 25% on reducing balance method.
(vii) The applicable tax rate would be 30% and tax would be payable/refundable in the year in which the liability/asset
would occur.
(viii) All revenues and costs are quoted on today’s rate. The estimated annual inflation of 8% would be applicable for
all revenues and costs that arise from first year and onwards.
(ix) There are no opening or closing inventories of Gladiator in any of the five years.
Required:
Determine the discount rate at which launching of Gladiator would be financially feasible. (All cash flows occur at the end
of year unless otherwise specified) (12)
(ICAP, CAF 06 Level – Autumn 2022, Q#6)
Q.3 Comfort Wear Limited (CWL) is engaged in selling men activewear (units) through its retail outlets. The extracts from CWL’s
last year management accounts have been provided as follows:
Rs. in ‘000’
Sales (5,000 units @ Rs, 2,500J 12,500
Cost of goods sold 6,875
Gross profit 5,625
The management is considering setting up kiosks in four major shopping malls. The finance manager has gathered
following data in this regard:
(i) Kiosks will set-up at the cost of Rs. 250,000 each. Kiosks would have estimated useful life of three years,
subject to a depreciation of 40% on reducing balance method. At the end of three years, kiosks would
have no residual value.
(ii) 4,000 units would be sold through all kiosks in the first year, It is estimated that 20% customers of retail
outlets would shift to kiosks.
(iii) The past trend of retail outlets sales has revealed an average 5% increase in units’ sale each year. It is
expected to continue for both retail outlets and kiosks.
(iv) In the first year of kiosks’ sales, a discount of 15% would be offered on retail price. However, discount
would be reduced to 10% for subsequent years’ sales.
(v) The rent for each kiosk’s space would be Rs, 150,000 per annum,
(vi) The marketing campaign for kiosks would be carried out at Rs. 50,000 for the first year. However, it
would be reduced to 50% for subsequent years,
(vii) One sales person would be hired for each kiosk. He would be paid Rs. 20,000 per month in addition to
1% commission on retail price of each unit sold through kiosk.
(viii) CWL’s cost of capital is 18%,
(ix) Applicable tax rate is 30% and tax is paid in the year in which the liability arises.
(x) All revenues and costs are quoted on today’s rate that is expected to remain same in the first year.
Thereafter, the estimated annual inflation of 10% would be applicable for all future revenues and costs.
Required:
By using net present value method, recommend whether CWL should set-up kiosks. (15)
(All cash flows occur at the end of year except for cost of setting-up kiosks)
(ICAP, CAF 06 Level – Spring 2022, Q#10)
Page | 2
Q.4 Latte Limited (LL) is considering to accept a five-year proposal from Mocha Limited (ML) for supply of a product namely
K44. ML would use K44 as a raw material for its main product. Details of the proposal and related matters are summarized
as follows:
(i) Initial investment in the specialized machinery is estimated at Rs. 60 million. At the beginning of year 4, LL would
require a major overhauling on this machinery amounting to Rs. 10 million. The machinery can be disposed of at
80% of written down value at the end of project.
(ii) In year 1, LL would supply 18,000 units of K44 to ML at Rs. 5,000 per unit. The supply would increase by 5% per
annum from year 2 onward.
(iii) Variable cost is estimated at Rs. 4,000 per unit for year 1. Fixed cost associated with the proposal (other than
depreciation) is expected to be Rs. 250,000 per month, out of which Rs. 50,000 would be allocated overheads.
(iv) Impact of inflation on revenues as well as all costs would be 7%.
(v) Tax rate would be applicable at 30% and tax would be payable in the year in which liability would arise. Tax
depreciation on machinery would be allowed at the rate of 25% under reducing balance method.
(vi) The cost of capital of LL is 15%.
Assume that except stated otherwise, all cash flows would arise at the end of year.
Required:
(a) Using net present value method, advise whether LL should accept the proposal. (11)
(b) Determine the minimum discount rate at which the proposal would be acceptable to LL. (03)
Q.5 Lotus Enterprises (LE) is engaged in trading of various locally manufactured products. Hope Limited (HL), a company
incorporated outside Pakistan has offered to assist LE in establishing a manufacturing facility in Pakistan for producing its
products. LE has gathered the following information in respect of HL’s offer:
(i) The manufacturing facility will be set up on a land which was acquired by LE three years ago for Rs. 40 million.
Market value of the land at the commencement of the project is estimated at Rs. 60 million. Cost of the
manufacturing facility is estimated as under:
Rs. in million
Factory building 30
Plant including its installation 100
Other fixed assets 10
(ii) Sales for the first year of production is estimated at Rs. 500 million. It is expected that sales demand would
increase by 5% in each subsequent year.
(iii) Under the product licensing agreement, HL would be paid a royalty equal to 15% of sales.
(iv) It is expected that cost of production in the first year of production would be 75% of sales including fixed costs
and depreciation of Rs. 50 million.
(v) Additional working capital of Rs. 35 million would be required in the first year of production. Working capital
requirement would increase by Rs. 5 million each year.
(vi) Rate of inflation is estimated at 8% per annum with effect from 2nd year onward. It would affect revenues as well
as all the costs (excluding depreciation).
(vii) Factory building would be depreciated at 5% whereas plant and other fixed assets would be depreciated at 25%
using reducing balance method. It is estimated that at the end of plant’s useful life of four years:
• market value of the land would be Rs. 75 million; and
• residual value of all the assets would be equal to their carrying value.
(viii) Applicable tax rate is 30% and tax is payable in the year in which the liability arises.
(ix) LE’s cost of capital is 15%.
Required:
Compute the net present value (NPV) of the project and advise whether it would be feasible to accept HL’s offer. (Assume
that except where stated otherwise, all cash flows would arise at the end of the year) (15)
Page | 3
Q. 6 Golf Limited (GL) is engaged in the manufacturing and sale of a single product ‘Smart-X’. The existing manufacturing plant
is being operated at full capacity but the production is not sufficient to meet the growing demand of Smart-X. GL is
considering to replace it with a new Japanese plant. The production capacity of new plant would be 50% more than the
existing capacity.
To assess the viability of this decision, the following information has been gathered:
(i) The purchase and installation cost of new plant would be Rs. 500 million and Rs. 25 million respectively. The
supplier would send a team of engineers to Pakistan for final inspection of the plant before it is commissioned.
50% of the total cost of Rs. 12 million to be incurred on the visit, would be borne by GL.
(ii) As a result of installation of the new plant, fixed costs other than depreciation would increase by Rs. 30 million.
(iii) The existing plant has an estimated life of 10 years and is in use for the last 6 years. Plant’s tax carrying value is
Rs. 50 million. A machine supplier has offered to purchase the existing plant immediately at Rs. 45 million.
(iv) During the latest year, 6 million units were sold at an average selling price of Rs. 550 per unit. Variable
manufacturing cost was Rs. 450 per unit. GL expects that it can increase the sales volume by 25% in the first year
after the plant’s installation. Thereafter, the sales volume would increase by 4% per annum.
(v) The new plant would be depreciated under the straight line method. Tax depreciation is calculated on the same
basis. The residual value of the plant at the end of its useful life of 4 years is estimated at Rs. 60 million.
(vi) Applicable tax rate is 30% and tax is paid in the year in which the liability arises.
(vii) Rate of inflation is estimated at 5% per annum and would affect the revenues as well as expenses.
(viii) GL’s cost of capital is 12%.
(ix) All receipts and payments would arise at the end of the year except cost of setting up the plant which would arise
at the beginning of the year. It may be assumed that the new plant would commence operations at the start of year
1.
Required:
On the basis of internal rate of return (IRR), advise whether GL should acquire the new plant. (17)
(ICAP, CAF 06 Level – Autumn 2018, Q.#5b)
Q.7 Valika Limited (VL) plans to introduce a new product AX which would be used in hybrid cars. Following information is
available in this regard:
(i) Initial investment in the new plant including installation and commissioning is estimated at Rs. 50 million. The
plant is expected to have a useful life of four years and would have annual capacity of 200,000 units.
(ii) The demand of AX for the first year is expected to be 180,000 units which would increase by 10% per annum in
year 2 and 3. However, in year 4 the demand is expected to decline by 10%.
(iii) The contribution margin for the first year is estimated at Rs. 100 per unit which is expected to increase by 5%
each year.
(iv) The new plant would be installed at VL’s premises which are presently rented out at Rs. 1.8 million per annum. As
per the terms of rent agreement, the rent is received in advance and is subject to 7% increase per annum.
(v) Working capital of Rs. 10 million would be required at the commencement of the project. Working capital is
expected to increase by 10% each year.
(vi) The new plant would be depreciated at the rate of 25% under the reducing balance method. Tax depreciation is
to be calculated on the same basis. The residual value of the plant at the end of useful life is expected to be equal
to its carrying value.
(vii) VL’s cost of capital is 10%.
(viii) Tax rate is 30% and is paid in the year in which the tax liability arises.
Required:
On the basis of net present value, advise whether VL should invest in the above project. (Assume that except stated
otherwise, all cash flows would arise at the end of year) (17)
(ICAP, CAF 06 Level – Spring 2018, Q.#2b)
Page | 4
Q. 8 Cloudy Company Limited (CCL) manufactures and sells specialized machine X85. A newer version of the machine is gaining
popularity in the market and CCL is therefore considering to introduce a similar version i.e. D44. Detailed research in this
respect has been carried out during the last six months at a cost of Rs. 3.25 million.
The related information is as under:
(i) Initial investment in the new plant for manufacturing D44 would be Rs. 450 million including installation and
commissioning of the plant.
(ii) Sales volume of X85 in the last year was 30,000 units. It is estimated that introduction of D44 would reduce the
sale of X85 by 2,000 units every year. The contribution margin on X85 in year 1 is estimated at Rs. 5,500 per unit.
(iii) Projected production and sales of D44 are as follows:
Year 1 Year 2 Year 3 Year 4

------------------ No. of units ------------------
20,000 25,000 27,000 29,000
Estimated selling price and variable cost per unit of D44 in year 1 is estimated at Rs. 40,000 and Rs. 32,000
respectively.
(iv) Fixed costs in year 1 are estimated at Rs. 45 million. However, if the new plant is installed these costs would
increase to Rs. 75 million.
(v) Impact of inflation on selling price, variable cost and fixed cost would be 10% for both the machines/plants.
(vi) The new plant would be depreciated at the rate of 25% under the reducing balance method. Tax depreciation is
to be calculated on the same basis. The residual value of the plant at the end of its useful life of four years is
expected to be equal to its carrying value.
(vii) Applicable tax rate is 30% and tax is paid in the year in which the liability arises.
(viii) CCL’s cost of capital is 12%.
Required:
Compute internal rate of return (IRR) of the new plant and advise whether CCL should introduce D44. (Assume that all
cash flows would arise at the end of the year unless stated otherwise) (15)
Q. 9 Modern Transport Limited (MTL) is considering an investment proposal from Burraq Cab Services (BCS). As per the
proposal, MTL would provide branded cars to BCS under the following terms and conditions:
(i) BCS would pay rent of Rs. 1.8 million per annum per car to MTL. The cars would operate on a 24-hour basis. The
payment would be made at the end of year.
(ii) Cost of the drivers and maintenance cost of the car would initially be paid by BCS but would be adjusted against
car rentals payable to MTL at the end of each year.
(iii) MTL would provide a smart mobile to each driver.
MTL has estimated the following costs for deployment of a car with BCS:
Description Rupees Remarks

Estimated useful life and residual value of the car is
Car purchase price 2,000,000
4 years and Rs. 0.75 million respectively.
Car registration fee 35,000 One-time payment on registration of the car.
Mobile phone price per set 15,000 To be charged-off in the year of purchase.
To be paid at the beginning of each year. It would
Insurance premium 50,000 reduce by Rs. 5,000 each year due to decrease in
WDV of the car.
Annual salaries per driver 300,000 Would work in 8-hour shifts.
Due to ageing of cars, cost would increase by 10%
Annual maintenance cost 60,000
each year.
Page | 5
• The car would be depreciated at the rate of 25% under the reducing balance method. Tax depreciation is to be
calculated on the same basis.
• Applicable tax rate is 30% and tax is payable in the year in which the liability arises.
• Inflation is estimated at 5% per annum.
• MTL's cost of capital is 12% per annum.
Required:
Advise whether MTL should accept BCS’s proposal. (16)
Q. 10 Tropical Juices (TJ) is planning to expand its production capacity by installing a plant in a building which is owned by TJ
but has been rented out at Rs. 6 million per annum. The relevant details are as under:
(i) The cost of the building is Rs. 40 million and it is depreciated at 5% per annum.
(ii) The rent is expected to increase by 5% per annum.
(iii) Cost of the plant and its installation is estimated at Rs. 60 million. TJ depreciates plant and machinery at 25%
per annum on a straight line basis. Residual value of the plant after four years is estimated at 10% of cost.
(iv) Additional working capital of Rs. 25 million would be required on commencement of production.
(v) Selling price of the juices would be Rs. 350 per litre. Sales quantity is projected as under:
Year 1 Year 2 Year 3 Year 4

Litres 250,000 300,000 320,000 290,000
(vi) Variable cost would be Rs. 180 per litre. Fixed cost is estimated at Rs. 100 per litre based on normal capacity of
280,000 litres. Fixed cost includes yearly depreciation amounting to Rs. 16 million.
(vii) Rate of inflation is estimated at 5% per annum and would affect the revenues as well as expenses.
(viii) TJ's cost of capital is 15%.
Required:
Compute net present value (NPV) of the project and advise whether it would be feasible to expand the production capacity.
(Assume that all cash flows other than acquisition of plant and additional working capital would arise at the end of
the year) (11)
Q.11 Digital Electronics (DE) acquired a plant on 1 January 2016 under a lease arrangement on the following terms:
Lease period (commencing from 1 January 2016) 3 years

Down payment on commencement of lease Rs. 2.00 million
Lease installments payable annually in arrears Rs. 3.90 million
Amount payable on expiry of the lease term Rs. 0.89 million
On the date of acquisition, fair value of the plant was Rs. 10 million. DE depreciates its property, plant and
equipment over their useful life. The disposal price of the plant at the end of the useful life of four years is estimated
at Rs. 0.50 million.
Net cash inflows from the use of the plant are estimated as under:
Year 2016 2017 2018 2019

Amount (Rs. in million) 5.90 5.20 2.45 1.00
It may be assumed that all cash inflows arise at the end of the year.
Required:
Compute internal rate of return (IRR) and advise whether it is feasible to acquire the plant assuming that DE’s cost of capital
is 15%. (08)
Page | 6
Q.12 Sona Limited (SL) is considering investment in a joint venture. The entire cash outlay of the project is Rs. 175 million which
would require to be invested by SL immediately. The joint venture partner, Chandi Limited (CL) would provide all the
necessary technical support.
The other details of the project are estimated as follows:

(i) The project would extend over a period of four years.
(ii) Sales are estimated at Rs. 155 million per annum for the first two years and Rs. 65 million per annum during the
last two years.
(iii) Cost of sales and operating expenses excluding depreciation would be 50% and 10% of sales respectively.
(iv) CL would be entitled to share equal to 5% of sales and the remaining profit would belong to SL.
(v) At the end of the project, SL would be able to recover Rs. 100 million of the invested amount.
Assume that all cash flows other than the initial cash outlay arise annually in arrears.
Required:
Calculate the project’s internal rate of return. (09)
Q.13 Diamond Investment Limited (DIL) is considering to set-up a plant for the production of a single product X-49. The details
relating to the investment are as under:
(i) The cost of plant amounting to Rs. 160 million would be payable in advance. It includes installation and
commissioning of the plant.
(ii) Working capital of Rs. 20 million would be required at the commencement of the commercial operations.
(iii) DIL intends to sell X-49 at cost plus 25% (cost does not include depreciation on plant). Sales for the first year are
estimated at Rs. 300 million. The sales quantity would increase at 6% per annum.
(iv) The plant would be depreciated at the rate of 20% under the reducing balance method. Tax depreciation is to be
calculated on the same basis. Estimated residual value of the plant at the end of its useful life of four years would
be equal to its carrying value.
(v) Tax rate is 34% and tax is payable in the year the liability arises.
(vi) DIL’s cost of capital is 18%. All costs and prices are expected to increase at the rate of 5% per annum.
Required:
Compute the following:
(a) Net present value of the project. (12)
(b) Internal rate of return of the project. (05)
Assume that unless otherwise specified, all cash flows would arise at the end of the year.
Q.14 Larkana Fabrication Limited is considering an investment in a new machine, with a maximum output of 200,000 units per
annum, in order to manufacture a new toy.
Market research undertaken for the company indicated a link between selling price and demand, and the research agency
involved has suggested two sales strategies that could be implemented, as follows:
Strategy 1 Strategy 2
Selling price (in current price terms) Rs.8.00 per unit Rs.7.00 per unit
Sales volume in first year 100,000 units 110,000 units
Annual increase in sales volume after first year 5% 15%
The services of the market research agency have cost Rs. 75,000 and this amount has yet to be paid.
Larkana Fabrication Limited expects economies of scale to reduce the variable cost per unit as the level of production
increases.
 When below 110,000 units are produced in a year, the variable cost per unit is expected to be Rs. 3.00 (in current
price terms).
 For production between 110,000 – 119,999, the variable cost per unit is expected to be Rs. 2.95 (in current price
terms).
 For production between 120,000 – 129,999, the variable cost per unit is expected to be Rs.2.90 (in current price
terms), and so on.
Page | 7
The new machine would cost Rs. 1,600,000 and would not be expected to have any resale value at the end of its life of five
years.
Operation of the new machine will cause fixed costs to increase by Rs. 110,000 (in current price terms).
Inflation is expected to increase these costs by 4% per year. Annual inflation on the selling price and unit variable costs is
expected to be 3% per year.
The company has an average cost of capital of 10% in money (nominal) terms
Required:
(a) Identify the sales strategy which maximizes the net present value, ignore taxation.
(b) Evaluating the investment in the new machine using internal rate of return.
Q.15 Consolidated Oil wants to explore for oil near the coast of Ruritania. The Ruritanian government is prepared to grant an
exploration license for a five-year period for a fee of Rs. 300,000 per annum. The license fee is payable at the start of each
year.
To carry out the exploration work, the company will have to buy equipment now. This would cost Rs. 10,400,000, with 50%
payable immediately and the other 50% payable one year later. The company hired a specialist firm to carry out a geological
survey of the area. The survey cost Rs. 250,000 and is now due for payment.
The company’s financial accountant has prepared the following projected income statements. The forecast covers years 2-
5 when the oilfield would be operational.
Projected income statements

YEAR
2 3 4 5
Rs.‘000 Rs.‘000 Rs.‘000 Rs.‘000
Sales 7,400 8,300 9,800 5,800
Expenses:
Wages and salaries 550 580 620 520
Materials and consumables 340 360 410 370
License fee 600 300 300 300
Overheads 220 220 220 220
Depreciation 2,100 2,100 2,100 2,100
Survey cost written off 250 - - -
Interest charges 650 650 650 650
4,710 4,210 4,300 4,160
Profit 2,690 4,090 5,500 1,640
Notes
1. The license fee charge in Year 2 includes the payment that would be made at the beginning of year 1 as well as the
payment at the beginning of Year 2.
2. The overheads include an annual charge of Rs. 120,000 which represents an apportionment of head office costs.
The remainder of the overheads are directly attributable to the project.
3. The new equipment will be sold at the end of Year 5 for Rs. 2,000,000.
4. A specialized item of equipment will be needed for the project for a brief period at the end of year 2. This
equipment is currently used by the company in another long-term project. The manager of the other project has
estimated that he will have to buy machinery at a cost of Rs. 150,000 for the period the cutting tool is on loan.
5. The project will require an investment of Rs. 650,000 working capital from the end of the first year to the end of
the license period.
6. The company has a cost of capital of 10%. Ignore taxation and inflation.
Required:
Evaluate whether this project should be undertaken on the basis of Net Present Value.
(ICAP Book: Chapter 16 – Example # 36)
Page | 8
Q.16 Badger plc., a manufacturer of car accessories is considering a new product line. This project would commence at the start
of Badger plc.’s next financial year and run for four years. Badger plc.’s current year ends on 31st December 2012.
The following information relates to the project:
1. Feasibility Study:
A feasibility study costing Rs.8 million was completed earlier this year but will not be paid for until March 2013.
The study indicated that the project was technically viable.
2. Capital expenditure
If Badger plc. proceeds with the project it would need to buy new plant and machinery costing Rs.180 million to
be paid for at the start of the project. It is estimated that the new plant and machinery would be sold for Rs.25
million at the end of the project.
If Badger plc. undertakes the project it will sell an existing machine for cash at the start of the project for Rs.2
million. This machine had been scheduled for disposal at the end of 2016 for Rs.1 million.
3. Market research
Market size for the product is Rs. 1,100 million in 2012. The market is expected to grow by 2% per annum. Market
share projections should Badger plc. proceed with the project are as follows:
2013 2014 2015 2016
Market share 7% 9% 15% 15%
4. Cost data
2013 2014 2015 2016
Rs. m Rs. m Rs. m Rs. m
Purchases from main contractor 40 50 58 62
Payables (at the year-end) to main contractor 8 10 11 12
Payments to sub-contractors 6 9 8 8
Fixed overheads (total for Badger plc)

- With new line 133 110 99 90
- Without new line 120 100 90 80
5. Labor costs
At the start of the project, employees currently working in another department would be transferred to work on
the new product line. These employees currently earn Rs.3.6 million. An employee currently earning Rs. 2 million
would be promoted to work on the new line at a salary of Rs. 3 million per annum. A new employee would be
recruited to fill the vacated position.
As a direct result of introducing the new product line, employees in another department currently earning Rs. 4
million would have to be made redundant at the end of 2013 resulting in a redundancy payment of Rs. 6 million
at the end of 2014.
6. Material costs on Project

The company holds a stock of Material X which cost Rs. 6.4 million last year. There is no other use for this material.
If it is not used the company would have to dispose of it at a cost to the company of Rs. 2 million in 2013. This
would occur early in 2013.
Material Z is also in stock and will be used on the new line. It cost the company Rs. 3.5 million some years ago. The
company has no other use for it, but could sell it on the open market for Rs. 3 million early in 2013.
7. Further information
 The year-end payables are paid in the following year.
 The company’s cost of capital is a constant 10% per annum.
 It can be assumed that operating cash flows occur at the year end.
 Time 0 is 1st January 2013 (t1 is 31st December 2013 etc.)
 Ignore taxation, and inflation.
Page | 9
Q.17 Clear Co. specializes in the production of UPVC windows and doors. It is considering whether to invest in a new machine
with a capital cost of Rs. 4 million. The machine would have an expected life of five years at the end of which it would be
sold for Rs, 450,000.
If the new machine would be purchased the existing machine could either be sold immediately for Rs. 250,000 or hired out
to another company at a rental amount of Rs, 100,000 per annum, payable in advance for three years, If the machine is hired
out rather than sold it will have no residual value at the end of three years’ period. The existing machine generates annual
revenues of Rs. 8 million and its running costs are Rs, 840,000 per annum.
If the new machine is purchased revenues are expected to increase by 20%. In Addition to this, however machine running
costs are also expected to increase. Estimate have shown that, in the first year with the new machine, running costs will
increase by 18%. In every subsequent year thereafter, running costs will continue to 18% higher than each previous year’s
costs.
The company’s cost of capital is 10%. All workings should be in Rs.’000’.

Q.18 Baypack Company is considering whether to invest in a project whose details are as follows.
The project will involve the purchase of equipment costing Rs. 2,000,000. The equipment will be used to produce a range
of products for which the following estimates have been made.
Year 1 2 3 4
Rs. Rs. Rs. Rs.
Average sales price 73.55 76.03 76.68 81.86
Average variable cost 51.50 53.05 49.17 50.65
Incremental annual fixed costs Rs.1,200,000 Rs.1,200,000 Rs.1,200,000 Rs.1,200,000
Sales units 65,000 100,000 125,000 80,000
The sales prices allow for expected price increases over the period. However, cost estimates are based on current costs, and
do not allow for expected inflation in costs. Inflation is expected to be 3% per year for variable costs and 4% per year for
fixed costs. The incremental fixed costs are all cash expenditure items. Tax on profits is at the rate of 30%, and tax is payable
in the same year in which the liability arises.
Baypack Company uses a four-year project appraisal period. Residual value will be nil at the end of fourth year and straight-
line method of depreciation is used.
The company’s cost of capital for investment appraisal purposes is 10%.

Page | 10
SUGGESTED SOLUTIONS
SUGGESTED SOLUTIONS
1 c
PRACTICE QUESTIONS
A.1
Super Concepts:
 Opportunity Cost [Lost Rent] is stated net-of tax in Cash Flows, but is NOT included in tax
calculation.
A. 1 (Cherat Mobiles)
Y0 Y1 Y2 Y3 Y4 Y5
Investment Cash Flows:
Equipment & Residual Value (250,000) 112,927
Working Capital & Recovery (15,000) 12,000
Opportunity Cost: (net of tax)

-Rent Sacrificed (4,200) (4,578) (4,990) (5,439) (5,929)
[0.5 * 12 * 0.7] * [1+inflation]n
Contribution [5% Growth, 9% Inflation] 144,000 164,808 188,623 215,879 247,073
Fixed Cost [9% Inflation] (58,000) (63,220) (68,910) (75,112) (81,872)
Dismantling Cost (1,694)
Tax (14,550) (20,914) (27,786) (35,321) (43,780)

Net Cash Flow (265,000) 67,250 76,096 86,937 100,007 238,725
Present Value @ 20% (265,000) 56,042 52,845 50,311 48,229 95,938
Calculation of Tax Payable:

Y1 Y2 Y3 Y4 Y5
Profit/Cash Flow before Tax 86,000 101,588 119,713 140,767 163,508
Depreciation @ 15% on WDV (37,500) (31,875) (27,094) (23,030) (19,575)
Gain/(Loss) on disposal 0 0 0 0 2,001
Taxable Profit 48,500 69,713 92,619 117,737 145,933

Tax @ 30% 14,550 20,914 27,786 35,321 43,780
Page | 11
Notes:
1. Research cost (whether already paid or to be paid) is a past cost, hence ignored.
2. Bank Loan and Interest Payments are completely ignored because they are financing transactions, not investing
transactions.
3. Inflation started from Y2 because “Today’s rate expected to remain same in first year”.
4. In Reducing Balance Method, residual value is NOT deducted to calculate depreciation expense.
5. Dismantling cost is included in Tax calculation because question clearly states this.
• Examinees incorrectly accounted for the effect of inflation. Some applied it only from year 1, while others failed to compound
the inflation from year to year.
• Many examinees mistakenly included the loss of rental income as part of taxable income, leading to an incorrect calculation
of the tax expense.
Marking Plan:
(a)
• Working capital investment and release 1.0
• Machinery and equipment 0.5
• Loss of rental income 1.5
• Add back of depreciation and gain on disposal 1.0
• Sale value – machinery and equipment 1.5
• Discounting and NPV calculation 1.5
• Contribution margin 2.0
• Fixed cost 1.0
• Depreciation 1.0
• Gain on disposal 1.0
• Dismantling cost 1.0
• Taxation 1.0
• Conclusion 0.5
• Ignoring research and interest costs and receipt and payment of loan 0.5
Passing Percentage:
75%
A.2
A. 2 (Islamabad Universe)
Y0 Y1 Y2 Y3 Y4 Y5
Equipment & Residual Value (25,000) (3,149) 7,347
[2,500 * 1.08^3) [5,000 * 1.08^5)
Sales
17,280 16,796 15,419 16,652 17,985
[Actual Growth, 8% Inflation]
[10,000] * [10,000* 0.9] * [10,000* 0.9*0.85] * [10,000* 0.9*0.85] * [10,000* 0.9*0.85] *
[1,600*1.08] [1,600 * 1.08^2] [1,600 * 1.08^3] [1,600 * 1.08^4] [1,600 * 1.08^5]
Cost of Sales (ex. depreciation)
(8,100) (7,873) (7,228) (7,806) (8,430)
[Actual Growth, 8% Inflation]
[10,000] * [10,000* 0.9] * [10,000* 0.9*0.85] * [10,000* 0.9*0.85] * [10,000* 0.9*0.85] *
[750*1.08] [750 * 1.08^2] [750 * 1.08^3] [750 * 1.08^4] [750 * 1.08^5]
Operating Cost - Variable
(1,080) (1,050) (964) (1,041) (1,124)
[0% Growth, 8% Inflation]
[10,000] * [10,000* 0.9] * [10,000* 0.9*0.85] * [10,000* 0.9*0.85] * [10,000* 0.9*0.85] *
[100*1.08] [100 * 1.08^2] [100 * 1.08^3] [100 * 1.08^4] [100 * 1.08^5]
Operating Cost - Fixed
(1,080) (1,166) (1,260) (1,360) (1,469)
[8% Inflation]
[1,000*1.08] [1,000*1.08^2] [1,000*1.08^3] [1,000*1.08^4] [1,000*1.08^5]
Page | 12
Tax Payments (w-1) (231) (606) (736) (906) (1,211)

Net Cash Flow (25,000) 6,789 6,101 2,083 5,539 13,097
Present Value @ 10% (25,000) 6,172 5,042 1,565 3,783 8,132
Net Present Value @ 10% (306)
Present Value @ 5% (25,000) 6,466 5,534 1,799 4,557 10,262
IRR = 5% + 3,618 / (3,618+306) * 5% = 9.61%

Conclusion: At 9.61%, the launching of Gladiator would be financially feasible.
(W-1) Tax Payments:

Y1 Y2 Y3 Y4 Y5
Revenue – Costs 7,020 6,707 5,967 6,445 6,962
(Loss) on disposal (357)
7,347 – (25,000 +3,149
–20,445)
Taxable Profit 770 2,019 2,451 3,021 4,036
Tax @ 30% 231 606 736 906 1,211
Notes:
1. Loan and Interest Cost is not considered in Investment Appraisal, as they are already considered in Cost of Capital.
2. Overhauling Cost paid is not shown in Tax Calculation, because it is capitalized in cost of asset, and is depreciated.
3. Gain/Loss on disposal = Residual Value – Book Value
• Most examinees failed to account for the effect of inflation correctly. Some applied it from year 2 onwards, while some did not
compound the inflation from year to year.
• Many examinees failed to properly calculate last year’s depreciation. Instead of applying the regular written-down value
percentage, they took the entire remaining balance as tax deductible depreciation, without taking into account the scrap value.
• Some examinees failed to correctly calculate depreciation based on the reducing balance method. They deducted the
estimated scrap value from the cost of the machine to determine the depreciable value from year 1 onwards.
• Many examinees failed to ignore the due diligence cost and the interest cost on the loan.
Marking Plan:
(a)
• Sales 1.0
• Cost of goods sold 1.0
• Operating costs – variable and fixed 1.5
• Machine purchase 0.5
• Depreciation on machine and overhauling/loss on sale of machine 3.0
• Tax 0.5
• Scrap value 0.5
• IRR determination 3.0
• Ignoring due diligence and interest cost 1.0
Passing Percentage:
62%
Page | 13
A.3
Super Concepts:
 Before making a single calculation, always check for Inflation Rate and Growth Rate in
question, and carefully note the year from which Inflation/Growth is to start.
A. 3 (Comfort Wear Limited)

Y0 Y1 Y2 Y3
Equipment & Residual Value (1,000) 0

-Lost Profit on existing product (827) (955) (1,103)
[Units * Growth * Contribution * Inflation
* Tax adjustment] [1,000 * 1.05] * [1,000 * 1.05^2] * [1,000 * 1.05^3] *
[Contribution = 5,625/5,000 = 1,125] 1.125 * 0.7 [1.125 * 1.1^1] * 0.7 [1.125 * 1.1^2] * 0.7
Sales [5% Growth, 10% Inflation] 8,500 10,395 12,006

[4,000 * 2.500 * [4,000*1.05] * [4,000*1.05^2] *
0.85] [2.500 *1.1] * 0.90] [2.500 *1.1^2] * 0.90]
Cost of Sales [5% Growth, 10% Inflation] (5,500) (6,353) (7,337)

[4,000*1.05] * [4,000*1.05^2] *
[4,000 * 1.375] [1.375 *1.1] [1.375 *1.1^2]
Rent [10% Inflation] (600) (660) (726)

[150 * 4] [150 * 4 * 1.1] [150 * 4 * 1.1^2]
Marketing Campaign [10% Inflation] (50) (28) (30)

[50* 50% * 1.1] [50* 50% * 1.1^2]
Salaries [10% Inflation] (960) (1,056) (1,162)

[240 * 4] [240 * 12 * 4 * 1.1] [240 * 4 * 1.1^2]
Commission @ 1% of Retail Price (100) (116) (133)

[Sales / Discount * 1%] [Sales / Discount * 1%] [Sales / Discount * 1%]
Tax Payment [W-1] (267) (583) (677)

Net Cash Flow (1,000) 196 645 837
Present Value @ 18% (1,000) 166 464 510
Net Present Value @ 18% 139
(W-1) Tax Payments:

Y1 Y2 Y3
Revenue – Costs 1,290 2,184 2,618
Depreciation @ 40% on WDV (400) (240) (144)
(Loss) on disposal (216)
[1,000 - 784]
Taxable Profit 890 1,944 2,258
Tax @ 30% 267 583 677
Page | 14
Notes:
1. In WDV Method, rate is applied on Cost [residual value is NOT deducted].
2. Depreciation and Loss/Gain on Disposal are NOT relevant in Cash Flows, but are Tax deductible.
3. Last year’s revenue and cost rates will remain same in first year. Therefore, inflation will start from Y2.
4. Opportunity cost is shown net-of-tax and is not included in Tax Calculation.
5. Growth for Kiosk started from Year 2 because Year 1’s units sold were given in question. However, growth for
retail outlets started from Year 1 because Year 1’s units sold were not given in this case.
6. Y0 is the beginning day of Y1. [do not think that Y0 is a whole full year which comes before Y1].
• Different types of mistakes were noted in constructing the cash flows. For example, some examinees failed to apply inflation
or quantity or discount rates correctly.
• Many examinees ignored the information regarding opportunity cost of losing the sales units through retail outlets.
• Sales commission (variable component) was mostly wrongly computed.
• Some examinees ignored to consider the loss on disposal of kiosks.
Marking Plan:
(a)
• Set-up cost of Kiosks 0.5
• Revenue 1.5
• Cost of goods sold 1.5
• Gross profit lost 3.0
• Rent cost 1.0
• Marketing cost 1.0
• Staff cost 3.0
• Depreciation 0.5
• Loss on disposal 0.5
• Tax 0.5
• Adding back depreciation and loss on disposal 0.5
• Determination of NPV 1.0
Passing Percentage:
56%
A.4
Super Concepts:
 Overhauling during project-life is a Capital Asset, and should be depreciated.
 Calculation of Contribution [Instead of separate calculation of Sales and Variable Cost,
Contribution can be calculated if:
 Sales and Variable are separately given.
 Same inflation rate applies on both.
 There is no discount on Sales.
Page | 15
(a)
A. 4 (Latte Limited)
Y0 Y1 Y2 Y3 Y4 Y5
(60,000 + 10,000 -
50,137)* 80%
Contribution [5% Growth, 7% Inflation] 18,000 20,223 22,721 25,527 28,679
(18,000 * 1.05^1) * (18,000 * 1.05^2) (18,000 * 1.05^3) (18,000 * 1.05^4)
(18,000 * 1,000) (1,000 * 1.07^1) * (1,000 * 1.07^2) * (1,000 * 1.07^3) * (1,000 * 1.07^4)
Fixed Cost [7% Inflation] (2,400) (2,568) (2,748) (2,940) (3,146)

(250 - 50) * 12 (2,400 * 1.07^1) (2,400 * 1.07^2) (2,400 * 1.07^3) (2,400 * 1.07^4)
Tax (180) (1,922) (3,461) (4,127) (4,482)

Net Cash Flow (60,000) 15,420 15,734 6,512 18,459 36,942
Present Value @ 15% (60,000) 13,409 11,897 4,282 10,554 18,367
Present Value @ 10% (60,000) 14,018 13,003 4,893 12,608 22,938
(W-1) Tax Payments:

Y1 Y2 Y3 Y4 Y5
Revenue – Costs 15,600 17,655 19,973 22,586 25,533
(Loss) on disposal (3,973)
15,890 - (60,000 + 10,000 - 50,137)
Taxable Profit 600 6,405 11,535 13,758 14,939
Tax @ 30% 180 1,922 3,461 4,127 4,482
Conclusion:
Since expected NPV is negative, LL should not accept the proposal.
Notes:
1. Overhauling Cost paid is not shown in Tax Calculation, because it is capitalized in cost of asset, and is depreciated.
(b)
IRR = 10% + 7,459 / (7,459+1,492) * 5% = 14.17%
Project’s internal rate of return is 14.17%. Hence, if investors can accept 14.17% return, this project can be
accepted.
(a)
• Examinees either missed to apply the impact of increase in quantity of production and sales or the impact of inflation while
computing sales revenue and variable cost over a life of project.
• Examinees did not exclude allocated overheads while accounting for fixed cost.
• Examinees accounted for overhauling cost on machinery at the end of year 4 instead of beginning of year 4.
• Examinees did not account for depreciation on overhauling cost.
(b)
Examinees could not apply correct formula of IRR while computing the required discount rate.
Page | 16
Marking Plan:
(a)
• Year-wise computation of sales, variable costs and fixed costs (other than
4.0
depreciation) incorporating effect of inflation and volume
• Calculation of depreciation, loss on disposal and added back to profit after tax 3.0
• Cost of machine, overhauling cost and residual value 2.0
• Computation of net present value 1.5
• Conclusion 0.5
(b)
• Determination of minimum discount rate 3.0
Passing Percentage:
82%
A.5
Super Concepts:
 Market Value of Land at start and end of Project is Relevant [however, contrast its treatment
with Rental Income of Land].
 Note calculation of Variable Cost and Fixed Cost.
A. 5 (Lotus Enterprises)
Y0 Y1 Y2 Y3 Y4
Factory Building (30,000) 24,435
Plant and Other Fixed Assets (110,000) 34,805
Working Capital & Recovery (35,000) (5,000) (5,000) 45,000
- Existing Resource Used (60,000) 75,000

Sales [5% Growth, 8% Inflation] 500,000 567,000 642,978 729,137
(500,000 * 1.05^1 * (500,000 * 1.05^2 * (500,000 * 1.05^3 *
1.08^1) 1.08^2) 1.08^3)
Royalty [15% of Sales] (75,000) (85,050) (96,447) (109,371)
Cost of Sales - Fixed (ex. Dep.)

[8% Inflation] (21,000) (22,680) (24,494) (26,454)
(21,000 * 1.08^1) (21,000 * 1.08^2) (21,000 * 1.08^3)
Cost of Sales - Variable

[5% Growth, 8% Inflation] (325,000) (368,550) (417,936) (473,939)
(500,000 * 75%) – (325,000 * 1.05^1 * (325,000 * 1.05^2 * (325,000 * 1.05^3 *
50,000 1.08^1) 1.08^2) 1.08^3)
Tax Payments [W-1] (15,000) (20,601) (26,184) (31,946)
Net Cash Flow (200,000) 29,000 65,119 72,918 266,668
Present Value @ 15% (200,000) 25,217 49,239 47,944 152,468
[W-1] Tax Payments:

Y1 Y2 Y3 Y4
Revenue – Costs 79,000 90,720 104,101 119,373
Factory Depreciation @ 5% on WDV (1,500) (1,425) (1,354) (1,286)
Other Depreciation @ 25% on WDV (27,500) (20,625) (15,469) (11,602)
Taxable Profit 50,000 68,670 87,279 106,486
Tax @ 30% 15,000 20,601 26,184 31,946
Page | 17
• Variable costs were incorrectly computed by deducting the fixed costs of Rs. 50 million from each year’s total costs.
• Fixed cost was computed without deducting the depreciation.
• Amount of tax payments was computed after taking into account the working capital requirement, market value of
the land and residual value of the assets at the end of project life. In fact, these items were not subjected to tax shield.
• Recovery of working capital at the end of the tenure was not shown.
Marking Plan:
• Determination of project investment value at commencement and end of the

3.0
project
• Year-wise computation of sales, variable costs and fixed costs (other than
7.0
depreciation) incorporating effect of inflation and volume
• Calculation of depreciation and adding it back to profit after tax 3.0
• Computation of net present value 1.5
• Conclusion 0.5
Passing Percentage:
88%
Page | 18
A.6
A. 6 (Golf Limited)
Y0 Y1 Y2 Y3 Y4
(500+25+6)
Disposal of Old Equipment 45,000

-Contribution Lost of existing product (441,000) (463,050) (486,203) (510,513)
(6 m. *100 *1.05)*.7 (6 m. *100 *1.05^2)*.7 (6 m. *100 *1.05^3)*.7 (6 m. *100 *1.05^4)*.7
Contribution [5% Inflation] 787,500 859,950 939,065 1,025,459
(6 m. * 1.25) * (6 m. * 1.25 * 1.04) * (6 m. * 1.25 * 1.04^2) * (6 m. * 1.25 * 1.04^3) *
(100*1.05) (100*1.05^2) (100*1.05^3) (100*1.05^4)
Fixed Cost [5% inflation] (30,000) (31,500) (33,075) (34,729)

(30,000 * 1.05^1) (30,000 * 1.05^2) (30,000 * 1.05^3)
Tax Payments [w-1] (190,425) (213,210) (236,472) (261,894)
Net Cash Flow (486,000) 126,075 152,190 183,316 278,324
Present Value @ 10% (486,000) 114,614 125,777 137,728 190,099
Present Value @ 15% (486,000) 109,630 115,078 120,533 159,133
IRR = 10% + 82,217 / (82,217-18,374) * 5% = 16.44%
Conclusion:
Since IRR is higher than the GL's cost of capital existing plant should be replaced.
[W-1} Tax Payments:

Y1 Y2 Y3 Y4
Revenue – Cost 757,500 828,450 905,990 990,730
Depreciation @ straight line (117,750) (117,750) (117,750) (117,750)
(Loss) on disposal of old equipment (5,000)
Taxable Profit 634,750 710,700 788,240 872,981
Tax @ 30% 190,425 213,210 236,472 261,894
Notes:
1. If inflation rate for revenue and expenses is same, Contribution may directly be calculated.
2. Incremental Fixed Cost not inflated in Y1 because questions itself gave this Amount for Y1.
This question consisted of two parts. The overall performance was not satisfactory as only 26% candidates secured passing
marks. However, performance in part (a) carrying 3 marks was good as most of the students were able to mention the
advantages and disadvantages of financing a project through debt as compared to equity. Performance in part (b) was however
quite poor as a number of mistakes were observed in most of the answers. The most common mistake was that the students did
not realise that it was not mandatory for the company to purchase the new plant as the old plant was also working
satisfactorily. Hence, they needed to compare the option to continue with the existing plant with the option to purchase the
new plant by using incremental revenues and costs. Instead, they only tried to evaluate the purchase of new plant by taking the
revenues and expenses associated with the new plant without considering the existing situation.
Other common mistakes were as follows:

• IRR was not worked out and conclusion was drawn on the basis of net present value instead of IRR.
• Tax saving on loss of disposal of old plant was ignored.
Page | 19
Marking Plan:
• Calculation of:
- incremental production 3.0
- incremental contribution margin 3.0
- incremental fixed cost 1.0
- depreciation and adding back to profit after tax 1.5
- tax expense and savings 1.5
- initial investment and receipts from residual value 2.5
• Computation of net present values of cash flows 3.0
• Computation of IRR 1.0
• Conclusion 0.5
Passing Percentage:
26%
A.7
A. 7 (Valika Limited)
Y0 Y1 Y2 Y3 Y4
Working Capital & Recovery (10,000) (1,000) (1,100) (1,210) 13,310

(10,000 * 1.1) (11,000 * 1.1) (12,100 * 1.1) - (11,000 * 1.1)
Op. Cap.
-Rent Sacrificed (1,348) (1,443) (1,544) (1,652)
(1,800 * (1,800 * 1.07^2 * (1,800 * 1.07^3 * (1,800 * 1.07^4 *
1.07^1 * 0.7) 0.7) 0.7) 0.7)
Contribution 18,000 20,790 22,050 22,692
(180,000 * 100) (180,000 * 1.1)* (200,000)* (100 (196,020)*
(100 * 1.05) * 1.05^2) (100 * 1.05^3)
Tax Payments (W-1) (1,650) (3,425) (4,506) (5,225)
Net Cash Flow (61,348) 13,907 14,722 14,683 46,596
Present Value @ 10% (61,348) 12,643 12,167 11,031 31,826

Y1 Y2 Y3 Y4
Contribution 18,000 20,790 22,050 22,692
Taxable Profit 5,500 11,415 15,019 17,418
Tax @ 30% 1,650 3,425 4,506 5,225
Opinion: VL should start production of AX.
This part was very well attempted and nearly all students secured passing marks and a large number of candidates obtained
full marks. Only few mistakes were observed which are listed below:
• In year 3, production should have been restricted to 200,000. This instruction was ignored.
• Impact of rent was taken from year 1 instead of Year 0.
• Tax on rent was ignored.
• Total working capital was included in outflows in year1 to 4 instead of increase in working capital.
Page | 20
Marking Plan:
• Computation of:
- contribution margin 4.0
- depreciation and its impact 2.5
- taxation 2.0
- initial investment and residual value receipts 1.0
- incremental working capital and its recovery 2.5
- rent income lost 2.0
- net present value of cash flows 2.5
• Conclusion 0.5
Passing Percentage:
76%
A.8
Super Concepts:
 Calculation of Opportunity Cost of Lost Sales.
 Calculation of Contribution of New Product.
A. 8 (Cloudy Company Limited)
Y0 Y1 Y2 Y3 Y4
-Decrease in sale of existing
product (7,700) (16,940) (27,951) (40,995)
(2,000 * 5,500 * (4,000 * 5,500 * (6,000 * 5,500 * (8,000 * 5,500 *
0.7) 1.1^1 *0.7) 1.1^2 *0.7) 1.1^3 *0.7)
Sales [10% Inflation] 800,000 1,100,000 1,306,800 1,543,960
(25,000 * 40,000 (27,000 * 40,000 (29,000 * 40,000
(20,000 * 40,000) * 1.1^1) * 1.1^2) * 1.1^3)
Variable Cost [10% Inflation] (640,000) (880,000) (1,045,440) (1,235,168)

(25,000 * 32,000 (27,000 * 32,000 (29,000 * 32,000
(20,000 * 32,000) * 1.1^1) * 1.1^2) * 1.1^3)
Fixed Cost [10% Inflation] (30,000) (33,000) (36,300) (39,930)

(30,000,000 * (30,000,000 * (30,000,000 *
1.1^1) 1.1^2) 1.1^3)
Tax Payments [W-1] (5,250) (30,788) (48,534) (66,420)

Net Cash Flow (450,000) 117,050 139,273 148,575 303,830
Present Value @ 10% (450,000) 106,409 115,101 111,627 207,520
Present Value @ 15% (450,000) 101,783 105,310 97,691 173,716
Page | 21
IRR = 10% + 90,657 / (90,657 - 28,499) * 5% = 17.29%
Conclusion:
IRR 17.75% is higher than CCL's cost of capital (12%), therefore, CCL should introduce D44.
[W-1} Tax Payments:

Y1 Y2 Y3 Y4
Revenue – Costs 130,000 187,000 225,060 268,862
Taxable Profit 17,500 102,625 161,779 221,401
Tax @ 30% 5,250 30,788 48,534 66,420
Notes:
1. Research Cost is a sunk cost, hence not relevant.
• The figures for year 1 were given in the question. Hence, impact of inflation was to be applied from year 2 but was
incorrectly applied from year 1.
• The increase in fixed costs was ignored.
• Loss of contribution margin due to decrease in the sale of X85 was ignored.
Marking Plan:
• Determination of:
- contribution margin of new product D44 2.0
- reduction in contribution margin of existing product X85 2.0
- incremental fixed cost 1.0
- cash flows relating to tax liability including accounting/tax depreciation 3.0
- cash flows relating to initial investment and carrying value of the plant at the
2.0
end of its useful life
• Ignoring irrelevant costs 1.0
• Computation of Internal Rate of Return (IRR) 3.5
• Conclusion 0.5
Passing Percentage:
80.51%
Page | 22
A.9
A. 9 (Modern Transport Limited)
Y0 Y1 Y2 Y3 Y4
(2,000 + 35)
Sales [5% Inflation] 1,800 1,890 1,985 2,084
(1,800 * 1.05^1) (1,800 * 1.05^2) (1,800 * 1.05^3)
Cost of Mobiles (45)
(15,000 * 3)
Insurance Premium
[5% Inflation] (50) (45) (40) (35)
Salaries of Driver [5%

Inflation] (900) (945) (992) (1,042)
(300,000 * 3) (300,000 * 3) * 1.05^1 (300,000 * 3) * (300,000 * 3) *
1.05^2 1.05^3
Maintenance
[5% Inflation, 10% Increase] (60) (69) (80) (92)
(60,000 * 1.05^1 * (60,000 * 1.05^2 (60,000 * 1.05^3
1.10^1) * 1.10^2) * 1.10^3)
Tax (71) (135) (176) (242)

Net Cash Flow (2,130) 724 701 701 1,458
Present Value @ 12% (2,130) 647 559 499 926
Conclusion: The net present value is positive; therefore, the proposal should be accepted.

Y1 Y2 Y3 Y4
Sales 1,800 1,890 1,985 2,084
Cost of Mobiles (45)
Insurance Premium (50) (45) (40) (35)
Salaries (900) (945) (992) (1,042)
Maintenance (60) (69) (80) (92)
Depreciation @ 25% on WDV (509) (382) (286) (215)
Gain on disposal 106
Taxable Profit 236 449 586 806
Tax @ 30% 71 135 176 242
Notes:
1. In WDV Method, rate is applied on Cost [residual value is NOT deducted].
2. Depreciation and Loss/Gain on Disposal are NOT relevant in Cash Flows, but are Tax deductible.
3. If question is silent, Inflation does not affect Depreciation, Residual Value, Insurance.
Page | 23
In this 16 mark question, the candidates were required to evaluate an investment proposal. Average response was observed in
this question as compared to previous attempts in which students were scoring high marks in NPV based questions, as only
36% candidates secured passing marks. In many cases, simple mistakes were witnessed merely because of not reading the
question carefully. The common errors were as follows:
• Many students ignored the fact that the cars would operate on a 24 hour basis and hence the number of drivers and number
of mobiles, etc. would be three per car.
• Many students ignored inflation altogether whereas many students applied it even on the first year.
• Residual value of car was taxed instead of profit on disposal of car. Many students ignored it altogether.
• Some students wasted precious time in computing the IRR which was not required.
• Majority of the students did not understand that insurance premium would be paid from Year 0 to 3 but for tax purposes, it
would be charged in Year 1 to 4.
• Many candidates increased the car maintenance cost by 15% instead of 15.5% (1.05*1.10).
Marking Plan:
• Determination of cash flows relating to:

- initial investment including cost of cars, their residual values, registration
2.0
charges and mobile phones
- rental revenues 1.0
- salaries/meals of drivers 1.0
- maintenance cost 1.0
- insurance premium 1.0
- tax liability including tax depreciation, gain on disposal and adjustment of
7.5
insurance premium in current year and next year
• Determination of present values of cash flows 2.0
Passing Percentage:
36%
A.10
A. 10 (Tropical Juices)
Y0 Y1 Y2 Y3 Y4
Working Capital & Recovery (25,000) 25,000
-Rent Sacrificed [5% Inflation] (6,000) (6,300) (6,615) (6,946)
(6,000 * 1.05^1) (6,000 * 1.05^2) (6,000 * 1.05^3)
Sales [5% Inflation] 87,500 110,250 123,480 117,499
(250,000 * 350) (300,000 * 350 * 1.05^1) (320,000 * 350 * 1.05^2) (290,000 * 350 * 1.05^3)
Variable Cost [5% Inflation] (45,000) (56,700) (63,504) (60,428)

(250,000 * 180) (300,000 * 180 * 1.05^1) (320,000 * 180 * 1.05^2) (290,000 * 180 * 1.05^3)
Fixed Cost excl. Depreciation

[5% Inflation] (12,000) (12,600) (13,230) (13,892)
(280,000 * 100) - 16,000 (12,000,000 * 1.05^1) (12,000,000 * 1.05^2) (12,000,000 * 1.05^3)
Net Cash Flow (85,000) 24,500 34,650 40,131 67,234
Present Value @ 15% (85,000) 21,304 26,200 26,387 38,441
Conclusion:
The expansion of production facility is generating positive NPV at TJ's cost of capital of 15%. Therefore, it is feasible for TJ
to expand the production facility.
Page | 24
Notes:
1. Cost of Building is not relevant, as its opportunity cost has been taken.
2. Impact of Inflation is to be taken from Year 2 (because prices are not at today's level).
The requirement of this question was to assess feasibility for expansion of the production capacity by computing net present
value (NPV) based on the given scenario. This was a very well attempted question as 78% students were able to secure passing
marks. The errors observed were as under:
• Inflation rate of 5% was applied from year 1, instead of applying it form year 2.
• For calculation of NPV, given 15% cost of capital was adjusted to incorporate 5% inflation. As this adjusted rate of
cost of capital was applied to all the costs, it ended up in incorrect NPV.
• Loss of the building rent is an opportunity cost, but most of the students ignored it altogether.
• Many students incorrectly treated cost of building as outflow in year 0 and written down value of the building at the
end of year 4 as inflow.
• Many students computed increased fixed cost in proportion to the increase in production.
• Most of the students failed to consider the recoupment of working capital at the end of year 4.
Marking Plan:
• Up to 01 mark for each item reported in the year-wise cash flows 9.5
• Computation of net present value and advice on feasibility of expansion of the
1.5
production facility
Passing Percentage:
78%
A.11
A. 11 (Digital Electronics)
01-Jan-16 31-Dec-16 31-Dec-17 31-Dec-18 31-Dec-19

Equipment & Residual Value (2,000) (3,900) (3,900) (4,790) 500
(3,900 + 890)
Net Cash Inflow 5,900 5,200 2,450 1,000
Net Cash Flow (2,000) 2,000 1,300 (2,340) 1,500
Present Value @ 10% (2,000) 1,818 1,074 (1,758) 1,025
Present Value @ 15% (2,000) 1,739 983 (1,539) 858
IRR = 10% + 159 / (159 - 41) * 5% = 16.74%
Conclusion:
As internal rate of return (IRR) is higher than the company's cost of capital, it is advisable to acquire the plant on lease.
Notes:
1. If asset is acquired on lease, periodic lease rentals are taken as Investment Outflow instead of a single outflow at
start.
Page | 25
This question required calculation of IRR of a project and to assess whether it should be undertaken or not. It was one of the
best attempted questions as 79% of the students were able to obtain passing marks.
However, some commonly observed errors are discussed below:
• Fair value of the plant was considered as an outflow.
• Amount payable on expiry of lease term was taken as an outflow at the end of year 2019 instead of 2018.
• Disposal price of Rs. 0.5 million was ignored.
• Some of the candidates could not compute the PV factor correctly.
• Some of the candidates were unable to determine the IRR correctly due to application of incorrect formula.
• Some students started inflows from December 2017 rather than December 2016.
Marking Plan:
• Year-wise preparation of cash flows 3.0

• Discounting of the cash flows 3.0
• Computation of IRR and to suggest whether it is feasible to acquire the plant 2.0
Passing Percentage:
79%
A.12
A. 12 (Sona Limited)
Y0 Y1 Y2 Y3 Y4
Sales [No Growth, No Inflation] 155,000 155,000 65,000 65,000
Cost of Sales (77,500) (77,500) (32,500) (32,500)

(Sales * 50%) (Sales * 50%) (Sales * 50%) (Sales * 50%)
Operating Expenses (15,500) (15,500) (6,500) (6,500)

Commission to CL (7,750) (7,750) (3,250) (3,250)

Net Cash Flow (175,000) 54,250 54,250 22,750 122,750
Present Value @ 10% (175,000) 49,318 44,835 17,092 83,840
Present Value @ 15% (175,000) 47,174 41,021 14,958 70,183
IRR = 10% + 20,085 / (20,085+1,664) * 5% = 14.62%
This was an easy question and the requirement was to compute the IRR of a project. A good performance was witnessed as
more than 50% students scored full marks. However, some students lost this scoring opportunity by making the following
mistakes:
• Cost of technical support was ignored while determining the net cash flows.
• Cash flows were taken from year 2 to year 5 instead of year 1 to year 4.
• Cost of sales and operating expenses were calculated on sales net of CLs share instead of gross sales.
• Those students who obtained either both negative or both positive present values could not apply them correctly in
the formula for interpolation.
Page | 26
Marking Plan:
• Preparation of cash flows 4.5

• Discounting of the cash flows 3.0
.
A.13
A. 13 (Diamond Investment Limited)
Y0 Y1 Y2 Y3 Y4
Equipment (160,000) 65,536
(160,000 * 0.8^4)
Working Capital (20,000) 20,000
Sales 300,000 333,900 371,631 413,625

(300,000 * 1.061 * (300,000 * 1.062 * (300,000 * 1.063 *
1.051) 1.052) 1.053)
Cost of Sales (240,000) (267,120) (297,305) (330,900)

(Sales /1.25) (Sales / 1.25) (Sales / 1.25) (Sales / 1.25)
Tax Payments [W-1] (9,520) (14,001) (18,308) (22,556)

Net Cash Flow (180,000) 50,480 52,779 56,018 145,705
Present Value @ 18% (180,000) 42,780 37,905 34,095 75,153
Present Value @ 25% (180,000) 40,384 33,778 28,681 59,681
[W-1] Tax Payments:

Y1 Y2 Y3 Y4
Sales 300,000 333,900 371,631 413,625
Variable Cost (240,000) (267,120) (297,305) (330,900)
Taxable Profit 28,000 41,180 53,846 66,341
Tax @ 34% 9,520 14,001 18,308 22,556
(b) IRR = 18% + 9,932 / (9,932+17,475) * 7% = 20.54%
It was a simple question requiring computation of net present value of a project. More than 60% students were able to secure
passing marks in this question. Some of the common mistakes were as follows:
• First year sale was given. Next year’s sale should have been calculated by applying increase in volume by 6% and
increase in price by 5% separately i.e. by multiplying the previous year’s sales by 1.06 and 1.05. Many students applied
a combined increase of 11% which was incorrect.
• To find out cost of sale, the students used a number of different methods. The correct method was to divide sales by
1.25 or multiply sale by 0.80. However, many candidates computed it by multiplying sales by 0.75. Some of the
students followed the correct method for the first year but thereafter they increased it by 5% each year i.e. took the
effect of cost increase but ignored the volume increase.
• Majority of the candidates ignored the changes in working capital altogether. A number of candidates included the
increase in working capital in their calculations but ignored the recovery thereof, at the end of the project.
• Many candidates could not compute the PV factor correctly.
• A number of candidates were unable to determine the IRR correctly as they had little idea of interpolation.
Page | 27
A.14
A. 14 (Larkana) – Strategy 1
Y0 Y1 Y2 Y3 Y4 Y5

Contribution [Working below] 515 557 608 658 719
Fixed Cost [4% inflation] (114) (119) (124) (129) (134)

(110,000 * (110,000 * (110,000 * (110,000 * (110,000 *
1.041) 1.042) 1.043) 1.044) 1.045)
Net Cash Flow (1,600) 401 438 485 529 585

Present Value @ 10% (1,600) 364 362 364 362 363
Present Value @ 15% (1,600) 348 331 319 303 291
IRR = 10% + 215 / (215+8) * 5% = 14.82%
Notes:
1. Market research cost is sunk cost, hence not relevant.
Calculation of Contribution Margin:

Y1 Y2 Y3 Y4 Y5
Average Sale Price [without inflation] 8.00 8.00 8.00 8.00 8.00
Variable Cost [without inflation] (3.00) (3.00) (2.95) (2.95) (2.90)
Contribution Per Unit [without inflation] 5.00 5.00 5.05 5.05 5.10
Contribution Per Unit [3% inflation] 5.15 5.30 5.52 5.68 5.91
[Contribution * 1.031, and so on.]
Units Sold [5% Growth] 100,000 105,000 110,250 115,763 121,551
Total Contribution (in 000) 515 557 608 658 719
Page | 28
Q. 14 (Larkana) – Strategy 2
Y0 Y1 Y2 Y3 Y4 Y5

Contribution [Working below] 459 550 668 810 992
Fixed Cost [4% inflation] (114) (119) (124) (129) (134)

(110,000 * (110,000 * (110,000 * (110,000 * (110,000 *
1.04^1) 1.04^2) 1.04^3) 1.04^4) 1.04^5)
Net Cash Flow (1,600) 344 431 544 681 859

Present Value @ 10% (1,600) 313 356 409 465 533
Present Value @ 15% (1,600) 300 326 358 389 427
IRR = 10% + 476 / (476-200) * 5% = 18.62%

Y1 Y2 Y3 Y4 Y5
Average Sale Price [without inflation] 7.00 7.00 7.00 7.00 7.00
Variable Cost [without inflation] (2.95) (2.90) (2.80) (2.70) (2.55)
Contribution Per Unit [without inflation] 4.05 4.10 4.20 4.30 4.45
Contribution Per Unit [3% inflation] 4.17 4.35 4.59 4.84 5.16
[Contribution * 1.03^1]
Units Sold [15% Growth] 110,000 126,500 145,475 167,296 192,391
Total Contribution (in 000) 459 550 668 810 992
Page | 29
A.15
A. 15 (Consolidated Oil)
Y0 Y1 Y2 Y3 Y4 Y5
(10,400 * 50%)
Another Machinery bought (150)
Working Capital (650) 650

Sales - - 7,400 8,300 9,800 5,800
Wages & Salaries (550) (580) (620) (520)
Materials & Consumables (340) (360) (410) (370)
License Fee (300) (300) (300) (300) (300)
Overheads (100) (100) (100) (100)
(220-120)
Net Cash Flow (5,500) (6,150) 5,960 6,960 8,370 7,460

Present Value @ 10% (5,500) (5,591) 4,926 5,229 5,717 4,632
Conclusion:
The project has a positive NPV. The project should be undertaken because it will increase the value of the company and the
wealth of its shareholders.
Notes:
1. Survey Cost is a sunk cost, therefore not relevant.
2. Depreciation and Interest Expenses are NOT relevant in Cash Flows.
Page | 30
A.16
A. 16 (Badger)
Y0 2013 2014 2015 2016

Disposal of Existing Machine 2,000 (1,000)

78,540 103,000 175,099 178,601
(1,100 * (1,100 * 1.02^2 (1,100 * (1,100 *
Sales 1.02^1 * 7%) * 9%) 1.02^3 * 15%) 1.02^4 * 15%)
Payment to main contractor (32,000) (48,000) (57,000) (61,000) (12,000)

(Purchases - Closing + Opening) (40-8) (50-10+8) (58-11+10) (62-12+11)
Payment to sub-contractors (6,000) (9,000) (8,000) (8,000)
Fixed Overheads
(Incremental) (13,000) (10,000) (9,000) (10,000)
Increment of employee (1,000) (1,000) (1,000) (1,000)
Hiring of a new employee (2,000) (2,000) (2,000) (2,000)
Firing of employees (2,000) 4,000 4,000
(6,000 - 4000)
Material X 2,000
Material Z (3,000)
Net Cash Flow (179,000) 24,540 31,000 102,099 124,601 (12,000)

Present Value @ 10% (179,000) 22,309 25,620 76,709 85,104 (7,451)
Conclusion:
The project has a positive NPV. The project should be undertaken because it will increase the value of the company and the
wealth of its shareholders.
Notes:
1. Cost of Feasibility is a sunk cost, hence not relevant.
2. Salaries of Employees already employed, and shifted to project is not relevant.
We will first determine the Opportunity Cost of Existing Machine.

 Benefit if machine is sold immediately = Rs. 250,000
 Benefit if machine is hired out = 100,000 + 100,000/1.11 + 100,000/1.12 = 273,554
As hiring of machine is better, therefore this option will be used to evaluate project.
Page | 31
A.17
A. 17 (Clear Co.)
Y0 Y1 Y2 Y3 Y4 Y5

-Inflow received of Old Machinery 100 100 100
-Inflow sacrificed of Old Machinery (7,160) (7,160) (7,160) (7,160) (7,160)
(8,000 - 840)
Revenue 9,600 9,600 9,600 9,600 9,600
(8,000 * 1.2)
Running Cost [18% increase p.a.] (991) (1,170) (1,380) (1,629) (1,922)
(840 * 1.18)
Net Cash Flow (3,900) 1,549 1,370 1,060 811 968

Present Value @ 10% (3,900) 1,408 1,133 796 610 661
Notes:
1. Contribution from old machinery has been sacrificed because of new investment. Hence, it should be a relevant cost.
However, ICAP has not considered this in its calculation, which in my opinion is not correct.
Page | 32
A.18
A. 18 (Baypack)
As Average Sale Price and Average Variable Cost is given, hence we can calculate Contribution Margin for each year. This
will simplify our calculation.

Y1 Y2 Y3 Y4
Average Sale Price 73.55 76.03 76.68 81.86
Variable Cost [3% inflation] (53.05) (56.28) (57.97) (59.71)
(53.05 * 1.03^1) (53.05 * 1.03^2) (53.05 * 1.03^3) (53.05 * 1.03^4)
Contribution 20.51 19.75 18.71 22.15
Y0 Y1 Y2 Y3 Y4

Contribution 1,333 1,975 2,339 1,772
[Units Sold * Contribution per unit] (65,000 * 20.51) (100,000 * 19.75) (125,000 * 18.71) (80,000 * 22.15)
Fixed Cost [4% inflation] (1,248) (1,298) (1,350) (1,404)

(1,200 * 1.04^1) (1,200 * 1.04^2) (1,200 * 1.04^3) (1,200 * 1.04^4)
Tax 124 (53) (147) 40

Net Cash Flow (2,000) 210 624 842 408
Present Value @ 10% (2,000) 191 516 633 278

Y1 Y2 Y3 Y4
Contribution 1,333 1,975 2,339 1,772
Fixed Cost (1,248) (1,298) (1,350) (1,404)
Depreciation on SLM (500) (500) (500) (500)
Taxable Profit (415) 177 489 (132)

Tax @ 30% (124) 53 147 (40)
Notes:
1. ICAP Book has not included depreciation in tax calculation. Further, variable cost has not been inflated in ICAP Book
Solution.
Page | 33

MFA (Volume 2) by M. Asif, FCA

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

MFA (Volume 2) by M. Asif, FCA

Uploaded by

Copyright:

Available Formats

TABLE OF CONTENTS

Notes + Practice Questions [by M. Asif, FCA]

Chapter No. Chapter Title Page No.

Model Paper of CAF-6 Managerial & Financial Analysis 1

CAF 06: Managerial and Financial Analysis

B. Financial Analysis and Risk Management 10, 11, 12, 13 30 – 40

C. Budgeting 14, 15, 16 25 - 30

LO 3 ISLAMIC FINANCING 11 Section 4

LO 4 OTHER SOURCES OF FINANCE 11 Section 5

There are two types of shareholders:

Difference between Ordinary and Preference Shareholders:

Ordinary Shareholder Preference Shareholder

Advantages of Placing: (as compared to Introduction)

Disadvantages of Placing: (as compared to Introduction)

Difference between Right Issue and Bonus Issue:

Factors influencing choice of debt:

 Fixed Rate or Floating Rate

 Security and Covenants

Advantages and Disadvantages of Debt Financing:

Different Types of Debt Instruments:

Advantages of Zero-Coupon Bonds Disadvantages of Zero-Coupon Bonds

Market Value of a Debt:

Market Price of Convertible:

Advantages and Disadvantages of Convertible Bonds:

Over-draft and Bank Loan:

Bank Loan Loan Stock (Bond)

Finance Lease Operating Lease

Other Short-term Debt Instruments:

Advantages and Disadvantages of Trade Credit:

Basic Features of Murabaha:

Basic Features of Ijara:

There are two types of Mudaraba:

LO 4: OTHER SOURCES OF FINANCE:

Business Angels are a way of financing when company is in start-up phase.

Venture Capital (VC):

Organization must demonstrate to venture capitalist:

Suitability of Venture Capital:

Private Equity Funds:

Such Private Funds:

Benefits of Asset Securitization:

LO 5: DIRECT AND INDIRECT INVESTMENT:

Direct Investment Indirect Investment

LO 6: FACTORS TO CONSIDER BEFORE SELECTION OF SOURCE:

6. Impact on Financial Statements:

MULTIPLE CHOICE QUESTIONS

Danish should opt for:

Which of the following modes of financing would be most appropriate?

Q.2 (a) Distinguish between direct and indirect investment.

Q.4 Discuss the difference between Ijarah and conventional lease.

Q.5 Explain types of Modarba mode of Islamic financing.

MULTIPLE CHOICE QUESTIONS

A.1 (a) Equity (Shares):

(c) Venture Capital:

(d) Business Angel:

(e) Private Equity Fund:

A.2 (a) Direct vs. Indirect Investment:

(b) Liquidity and Holding Period:

(c) Investment vs. Speculation:

A.3 Advantages of Debt Financing:

Disadvantages of Debt Financing:

Advantages of Equity Financing:

Disadvantages of Equity Financing:

• 0.5 mark for each advantage/disadvantage, if project is financed through debt