Financial Management

Suggested
Roll No.

Maximum Marks - 100

Total No. of Questions 7

Total No. of Printed Pages 4

Time Allowed 3 Hours

Marks
Attempt all questions.
Working notes should form part of the answer. Make assumptions wherever necessary.
1. After the recent earthquake, there has been a massive demand for the pre-fab
materials. Bharat & Company is considering a new project for manufacturing of prefab materials involving a capital expenditure of Rs. 600 lakh and working capital of
Rs. 150 lakh. The capacity of the plant is for an annual production of 12 lakh units
and capacity utilization during the 6-year life of the project is expected to be as
indicated below:
Year
Capacity Utilization (%)

1
33.33

2
66.67

3
90

4-6
100

The average price per unit of the product is expected to be Rs. 200 netting a
contribution of 40 percent. The annual fixed cost, excluding depreciation, are
estimated to be Rs. 480 lakh from the third year onwards; for the first and second year
it would be Rs. 240 lakh and Rs. 360 lakh respectively. The average rate of
depreciation for tax purpose is 33.33% on WDV of the capital assets. The rate of
income tax is 25%. The cost of capital is 15%.
At the end of third year, an additional investment of Rs. 100 lakh would be required
for working capital.
Expected terminal value for the fixed assets and the current assets are 10% and 100%
respectively.
20

Required:
As a financial consultant, what recommendation on the financial viability of the
project would you make to Bharat & Company on the basis of NPV, IRR and
discounted pay back criterion?
Answer a)

Calculation of Depreciation
(Rs. In lakhs)

Year
1
2
3
4
5
6

Value/WDV at the
beginning
600
400
267
178
119
79

Depreciation WDV @
33.33% on WDV
200
133
89
59
40
26

b) Calculation of effective sale proceeds of Fixed assets

Sale proceeds of fixed assets (10% of cost)
Less: Written down value
Profit on sale of fixed assets
Less: Tax on profit @25%
Effective sale proceeds (60-1.75)
c) Calculation of cash Outflows (Rs. lakh)
Initial capital expenditure
BZY

WDV at the end

400
267
178
119
79
53
(Rs. lakh)
60.00
(53.00)
7
(1.75)
58.25
600
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Add: Working capital required at the beginning

150
750
66

Add: P.V. of working capital required at the end of 3rd year

(100*0.658)
P.V. total investment

816

d) Calculation of cash inflows and the present value

Particulars
Sales unit (% capacity
utilization)
Selling price (Rs.)
Sales revenue
Less: Variable cost (60%
of Sales)
Contribution
Less: Fixed cost
EBTDA
Less: Depreciation (from
a) above)

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

400,000 800,000 1,080,000 1,200,000 1,200,000 1,200,000

200
200
200
200
200
200
(Rs. in lakh)
800
1,600
2,160
2,400
2,400
2,400
(480)
320
(240)
80

(960)
640
(360)
280

(1,296)
864
(480)
384

(1,440)
960
(480)
480

(1,440)
960
(480)
480

(1,440)
960
(480)
480

(200)

(133)

(89)

(59)

(40)

(26)

(120)

147

295

421

440

454

30

(36.75)

(73.75)

(105.25)

(110)

(113.50)

Earnings after tax

Add: Working capital
recovery (150+100)
Add: sale proceeds of
fixed assets (from (b)
above)
Add: Depreciation addback

(90)

110.25

221.25

315.75

330

340.50

250

58.25

200

133

89

59

40

26

Cash inflows

110

243.25

310.25

374.75

370

674.95

PV factor @ 15%

0.87

0.756

0.658

0.571

0.497

0.432

95.70

183.90

204.15

214

183.90

291.50

Earning before tax

Less: Tax @ 25%

Present values

Total present values of cash inflows

1173.15

i) Net present value of project =1173.15- 816 = Rs. 357.15 lakh

Recommendation: Since the project has positive NPV, it is advisable to take up the project.
ii) Calculation of IRR
Years
1
2
3
4
5
6
Cash Inflow 110
243.25
310.25
374.75
370
674.75
PVIF @ 30% 0.77 0.592
0.455
0.351
0.270
0.208
PV
84.70 144
141.16
131.54
100
140.35
(-) pv of cash outflow [816-66+(1000.455)]

TPV

741.75
795.50
(53.75)

Trial can be with any other discounting factor(DF)

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IRR=

LR +

NPV at LR
(HR-LR)
NPV at LR + NPV at HR
= 15% +

357.15
357.15+53.75
= 0.15+ (0.870.15)
= 0.15+ 0.13
0.28=28%

(30%-15%)

Recommendation:
Since, IRR is higher than the cost of capital of the company, the project is worth taking
up.
iii) Discounted pay Back period:
Years

Pv of CI (lakh)

Cumulative CI (lakh)

1
2
3
4
5
6

95.70
183.90
204.15
214
183.90
291.50

95.70
279.60
483.75
697.75
881.65
1,173.15
(816-697.75)

PBP

4 yr

Yr
183.90

= 4 yr +0.64 yr.
= 4. 64 yr.
Recommendation:
Since, the project returns its investment early within the project's life, the project
is worth taking up.
2.
a) Integration Nepal Limited has present annual sales of Rs. 40 lakh. The unit sales
price is Rs. 20. The variable cost is Rs. 12 per unit and fixed costs amount to
Rs. 5 lakh per annum. The present credit period of one month is proposed to be
extended to either 2 or 3 months whichever is more profitable. The following
additional information is available:
Credit period
Increase in sales by
% of Bad debts to sales

1 month
1%

2 months
10%
2%

3 months
30%
5%

Fixed costs will increase by Rs. 75,000 when sales will increase by 30%. The
company requires a pre-tax return on investment at 20%.
Required:
Evaluate the profitability of the proposals and recommend the company.
b) The following information pertains to Rajaram Ltd. for the year ending Ashadh
end, 2071:
(Rs. in million)
EBIT
30.00
Less: Interest on Debt (at 12%)
6.00
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PBT
Less: Tax @ 25%
PAT
Undistributed reserves

24.00
6.00
18.00
60.00

No. of outstanding shares of Rs. 10 each

EPS
Market price of the share
P/E Ratio

40 Lakh
Rs. 3.00
Rs. 30.00
10.00

The company requires Rs. 20. million for expansion which is expected to earn the
same rate as earned by the present capital employed.
If the debt to capital employed ratio is higher than 35%, the P/E ratio is expected
to decline to 8 and the cost of additional debt will rise to 14%.
Required:

(8+1=9)

i) Calculate the probable share price of Rajaram Ltd.: a) if the required amount
is raised through debt, and b) if the required amount is raised through equity
and the new share is issued at Rs. 25 per share.
ii) What option would you recommend to raise the required amount of funds to
the company?
Answer a)
A.

B.
C.

D.
E.

Evaluation of profitability for different Credit periods

Particulars
1 month
2 months
Sales
4,000,000
4,400,000
Total Costs:
2,900,000
3,140,000
Variable cost @ Rs. 12 p/u
2,400,000
2,640,000
Fixed costs
500,000
500,000
Operating Profit
1,100,000
1,260,000
Opportunity cost of Investment
48,333
104,667
in Receivables (see working
note 1)
Bad Debt
40,000
88,000
Net Benefit (B-C-D)
10,11,667
10,67,333

(Rs.)
3 months
5,200,000
3,695,000
3,120,000
575,000
1,505,000
184,750

260,000
10,60,250

Recommendation: The Credit period of 2 months should be adopted since the net benefits under this
policy are higher than those under other policies.
Working Note 1: Calculation of cost of investment in receivables:
Opportunity cost = Total cost x Collection period/360 days x Rate of return
1 month = Rs. 2,900,000 x 1/12x 20% =Rs. 48,333
2 months= Rs. 3,140,000 x 2/12x20%= Rs. 104,667
3 months=Rs. 3,695,000 x 3/12x20%= Rs. 184,750
Alternate: Students can also refer the incremental approach.
b)
Existing capital employed
Equity capital
Reserves and surplus
Debt
Existing capital employed

(40 Lakhs shares Rs. 10)

(6100/12)

Existing of Return on Capital Employed

EBIT
30
ROCE=
100
=
100
Capital Employed
150
Revised Capital Employed, whether debt or equity capital is raised
= 150+20
= Rs. 170 million
BZY

(Rs. Millions)
40.00
60.00
50.00
150.00

= 20%

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Revised EBIT, if expansion project is undertaken
= 170 20 / 100
Existing ratio of debt to capital employed
50
=
100
150

= Rs. 34 million
= 33.33%

Revised ratio of debt to total capital employed if additional debt is raised

50+20
70
=
100
=
100
= 41.18%
150+20
170
Revised ratio of debt to total capital employed if equity share capital is raised
50
50
=
100
=
100
= 29.41%
150+20
170
If the debt to capital employed ratio is higher than 35%, the P/E ratio expected to decline to 8 and raise
the cost of additional capital debt to 14%.
i) Evaluation of Finance Option and calculation of share price
(Rs. Millions)
Particulars
Option (a) Debt
Option (b) Equity
EBIT
34.00
34.00
Less: Interest on debt:
On original debt
6.00
6.00
On new debt
2.80
0.00
EBT
25.20
28.00
Less: Tax @ 25%
6.30
7.00
EAT
18.90
21.00
No. of shares (Note 1)
40 Lakhs
48 Lakhs
EPS
4.725
4.375
P/E Ratio
8
10
Market price per share
Rs. 37.8
Rs. 43.75
Note 1:
No. of new shares to be issued
= Rs. 20 million / Rs. 25 = 800,000 shares
ii) Recommendations:
Since the market price of share is higher under option (b), it is suggested to raise additional Rs. 20
million by fresh issue of 800,000 equity shares at Rs. 25 share.
3.
a) Ace One Group P. Ltd., renowned for production and marketing of "Edge" brand
leather products, has wholly owned two companies Ace P. Ltd. at Sunsari and
One P. Ltd. at Bhairahawa and are led by highly professional executive officers.
These officers are entrusted for the overall business growth of their respective
company and the Group has implemented lucrative bonus scheme that takes into
consideration the performance measure of Return on Capital Employed (ROCE).
The results of the two companies and of the group for the year ended on Ashadh
32nd, 2071 are as follows:
Ace. P. Ltd.
(Rs.' 000)

One P. Ltd.
(Rs.' 000)

Ace One
Group P. Ltd.
(Rs.' 000)

Revenue

200,000

220,000

420,000

Cost of sales

170,000

160,000

330,000

Gross profit

30,000

60,000

90,000

Administration costs

10,000

30,000

40,000

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Finance cost

10,000

10,000

Pre-tax profit

10,000

30,000

40,000

1,000,000

1,500,000

2,500,000

Accumulated depreciation

590,400

1,106,784

1,697,184

Net book value

409,600

393,216

802,816

50,000

60,000

110,000

Total Assets

459,600

453,216

912,816

Non-current borrowings

150,000

150,000

Shareholders funds

309,600

453,216

762,816

Capital and Liabilities

459,600

453,216

912,816

Non-current assets:
Original cost

Net current assets

(3+3=6)

Required:
Calculate Return on Capital Employed, Pre-Tax Profit Margin and Asset
Turnover Ratio of Ace P. Ltd. and One P. Ltd.
b) XYZ Ltd. has the following capital structure:
4,000 Equity shares of Rs. 100 each
10% Preference shares
11% Debentures

Rs. 400,000
Rs. 100,000
Rs. 500,000

The current market price of the share of XYZ Ltd. is Rs. 102. The company is
expected to declare a dividend of Rs. 10 at the end of the current year, with an
expected growth rate of 10%. The applicable tax rate is 25%.
Required:

(3+3=6)

i) Find out the cost of equity capital and the WACC.

ii) Assuming that the company can raise Rs. 300,000 12% Debentures, find out
the new cost of equity and WACC if dividend rate is increased from 10% to
12%, growth rate is reduced from 10% to 8%, and market price of the share is
reduced to Rs. 98.
c) Describe limitations of financial ratio.
Answer a)
S.
Company
No.
1.
Return on Capital Employed
Pre-Tax Profit / (Non-Current Borrowings +
Shareholders' Fund)
OR
EBIT
(Non currentBorrowing+Shareholders Fund

3
Ace P. Ltd.
= 10M/459.6M
= 2.18%

One P. Ltd.
= 30M/453.216M
= 6.62%

= 4.35%

2.

Pre-Tax Profit Margin

Pre-Tax Profit / Revenue

= 10M/200M
= 5.0%

=30M/220M
= 13.64%

3.

Asset Turnover
Revenue / Total Asset

= 200M/459.6M
= 0.435 times

= 220M/453.216M
= 0.485 times

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("M" stands for Rs. In Million)
(ii)
b)
i) Computation of Cost of Capital
Cost of Equity Capital is
D1
Ke= -----------+ g
P0
= 10/102+.10
=19.8 %
Calculation of Weighted Average Cost of Capital (WACC)

Source
Equity Capital
10% Pref. Capital
11% Debenture

Amount
400,000
100,000
500,000
1,000,000

W
0.4
0.1
0.5
1.0

C/C (after tax )

0.198
0.100
0.825

W*C/C
0.0792
0.0100
0.04125
0.13045

WACC =13.045%
ii) Computation of Cost of Capital and WACC under the New situation
Calculation of Cost of Equity, (New)

D1
Ke= -----------+ g
P0
= 12/98+.08
=20.2%
Calculation of Weighted Average Cost of Capital (New)

Source
Equity Capital
10% Pref. Capital
11% Debenture
12% Debenture

Amount
400,000
100,000
500,000
300,000
1,300,000

W
0.31
0.08
0.38
0.23
1.00

C/C ( after tax)

0.202
0.100
0.0825
0.09

W*C/C
0.0626
0.008
0.03135
0.0207
0.12157

WACC =12.157%
c) Financial ratios have following limitations:

Many large firms operate different divisions in different industries. For these companies; it is
difficult to find a meaningful set of industry-average ratios.
Inflation may badly distort a company's balance sheet. In this case, profits will also be affected.
Thus a ratio analysis of one company over time or a comparative analysis of companies of
different ages must be interpreted with judgment.
Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a
business can reduce the chance of misinterpretation. For example, a retailer's inventory may be
high in the summer in preparation for the back-to-school season. As a result, the company's
accounts payable will be high and its ROA low.
Different accounting practices can distort comparisons even within the same company, e.g.
leasing versus buying equipment, LIFO versus FIFO, etc.
It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a
historically classified growth company may be interpreted as a good sigh, but could also be seen
as a sign that the company is no longer a growth company and should command lower
valuations.
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A company may have some good and some bad ratios, making it difficult to tell if it's a good or
weak company.

4.
a) A company is considering its Working Capital Investment and Financing Policies
for the next year. Estimated fixed assets and current liabilities for the next year
are Rs. 2.60 Crores and Rs. 2.34 Crores respectively. Estimated sales and EBIT
depend on current assets investment, particularly inventories and book-debts. The
following alternative working capital policies are under consideration:
(Rs. in Crores)
Working capital policy
Investment in
Estimated
EBIT
current assets
sales
Conservative
4.50
12.30
1.23
Moderate
3.90
11.50
1.15
Aggressive
2.60
10.00
1.00
After evaluating the working capital policies, the Financial Controller of the
company has advised the adoption of the moderate working capital policy.
Further, the company is examining the following alternatives for use of long-term
and short-term borrowings for financing its assets:
(Rs. in Crores)
Financing Policy
Short-term debt
Long-term debt
Conservative
0.54
1.12
Moderate
1.00
0.66
Aggressive
1.50
0.16
Interest rate-average
12%
16%
The company will use Rs. 2.50 Crores of the equity funds. The corporate tax rate
is 25%.
(1.5+7.5=9)

Required:
i) Calculate net working capital position, under each working capital policy.
ii) Calculate net working capital position, rate of return on shareholder's equity,
and current ratio under consideration of different financing policies and
financial controller's advice.
b) The annual sales of a company is Rs. 6,000,000. Sales to variable cost ratio is 150
percent and fixed cost other than interest is Rs. 500,000 per annum. The company
has 11% Debentures of Rs. 3,000,000.

Required:
Calculate the operating, financial and combined leverage of the company.

c) What are the advantages of raising funds through issue of equity share?
2
Answer a)
i) Net Working Capital position
(Rs. Crores)
Particulars
Working Capital Policy
Conservative
Moderate
Aggressive
Current assets
4.50
3.90
2.60
Less: Current liabilities
2.34
2.34
2.34
Net working Capital position
2.16
1.56
0.26
ii) Calculation of Net WC position, ROSE and CR under different financing policy and FC's advices
(Rs. Crores)
Particulars
Financing Policy

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Fixed assets
Current assets
Total assets
Current liabilities
Short-term debt
Long-term debt
Equity capital
Total liabilities
Budgeted sales
EBIT
Less: Interest on short-term debt @ 12%
Interest on long-term debt @ 16%
EBT
Less: Tax @ 25%
EAT
(a) Net working Capital position
(Current assets-current liabilities)
(b) Rate of Return on shareholders' Equity Capital
(EAT/Equity Share Capital) 100
(c) Current ratio (Current assets/current liabilities)

Conservative
2.60
3.90
6.50
2.34
0.54
1.12
2.50
6.50
11.50
1.15
0.06
0.18
0.91
0.23
0.68
1.02

Working Note: Calculation of EBIT and EBT

Rs.
Sales
Variable costs (sales/150 x 100)
Contribution
Fixed cost
EBIT
Interest on Debenture (11% x 3,000,000)
EBT

b)

Moderate
2.60
3.90
6.50
2.34
1.00
0.66
2.50
6.50
11.50
1.15
0.12
0.11
0.92
0.23
0.69
0.56

Aggressive
2.60
3.90
6.50
2.34
1.50
0.16
2.50
6.50
11.50
1.15
0.18
0.03
0.94
0.24
0.70
0.06

27.2%

27.6%

28%

1.35

1.17

1.02

6,000,000
4,000,000
2,000,000
500,000
1,500,000
330,000
1,170,000

Operating Leverage = Contribution/ EBIT

= 2,000,000/1,500,000
= 1.333 times
Financial Leverage = EBIT/EBT
= 1,500,000/1,170,000
=1.282 times
Combined Leverage = operating leverage x financial leverage
= 1.333 x 1.282 = 1.7089 times
Or
= Contribution/EBT
= 2,000,000/1,170,000
= 1.7094 times ~1.7089 times
c)

Answer: Following are some of the advantages of raising funds by issue of equity shares:
Permanent source of finance. No liability for cash outflows associated with its
redemption.
Demonstrate financial base (Capital adequacy) of the company and helps borrowing
power of the company.
No legal obligation to pay dividends.
Can be raised further shares by making a right issue.
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5.
a) S Bank Ltd. is assessing the operational efficiency of its central cash department.
In this regard, one of the officials have come up with the suggestion to procure
sophisticated cash counting machine cum fake note detector in order to make cash
handling more effective and efficient. The quotation for the machine received
from the authorized distributor reveals cost of Rs. 35 lakhs with 3 years' warranty
and 5 years' after sales service. The useful life of the machine is 5 years and it
may be scrapped at 5% of the original cost at the end.
At the moment, the central cash department employs 4 outsourced personnel to
count, sort and stack currency notes of Rs. 1,000 and Rs. 500 denominations
manually. These employees frequently work overtime, and average monthly
overtime cost for the last three months is Rs. 25,000. The average remuneration
cost per employee engaged in the job is Rs. 22,500 per month and is entitled to
one month's Dashain Bonus. If the machine is acquired, 2 employees will be
shifted to other vacant department. The overtime costs will be entirely avoided.
The remuneration is expected to increase by 5% annually after the end of year 1
and thus there will be proportionate increment for all employee benefits.
The Bank has determined 8% as discount rate for similar investments. Tax rate for
bank is 30%.
Required:

Lay out the relevant cash flows of the investment decision.

b) An investor is seeking the price to pay for a security, whose standard deviation is
4%. The correlation coefficient for the security with the market is 0.9 and the
market standard deviation is 3.2%. The return from the government security and
the market portfolio are 6.2% and 10.8% respectively. The investor knows that,
by calculating the required return, he can then determine the price to pay for the
security.
Required:
(2.5+2.5=5)
i) What is the required return on the security?
ii) What is the price of the security, if it is paying Rs. 25 of dividend per share
and its expected growth rate is 4?
c) Pradeep's brother Sandeep has promised to give him Rs. 100,000 in cash on his
25th birthday. Today is Pradeep's 16th birthday.
(1.5+1.5+2=5)

Required: Help Sandeep with the following calculation:

i) If Sandeep wants to make annual payment into a fund after one year, how
much will each payment has to be if the fund pays 8% interest?
ii) If Sandeep decides to invest a lump sum in the fund after one year and let it
compound annually, how much will the lump sum be?
iii) If in i) above the payments are made in the beginning of the year, how much
will be the value of annuity.
(1.5+1.5+2=5)
Answer a)
Relevant cash flows:
Years
Initial Investment

(3,500,000.00)

Incremental Saving

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- Remuneration of
2 employee
- Dashain Bonus
of 2 employee

540,000.00

567,000.00

595,350.00

625,117.50

656,373.38

45,000.00

47,250.00

49,612.50

52,093.13

54,697.78

- Overtime

300,000.00

315,000.00

330,750.00

347,287.50

364,651.88

Depreciation

(665,000.00)

(665,000.00)

(665,000.00)

(665,000.00)

(665,000.00)

Annual Savings

220,000.00

264,250.00

310,712.50

359,498.13

410,723.03

Tax Cost @ 30%

66,000.00

79,275.00

93,213.75

107,849.44

123,216.91

154,000.00

184,975.00

217,498.75

251,648.69

287,506.12

Net Annual Savings

Add: Terminal
Value (5% of
Original Cost) (tax
is not attracted as
BV=SV)
Add: Non Cash
Expenses
Net Cash Flow

175,000.00

(3,500,000.00)

665,000.00

665,000.00

665,000.00

665,000.00

819,000.00

849,975.00

882,498.75

916,648.69 1,127,506.12

665,000.00

ii)
b)
i) The market sensitivity index i.e. the beta factor:

Standard deviation of an asset

0.04
= ------------------------------------------------------*CORsm = -------------*.9 = 1.125
Standard deviation of Market
0.032
Now, the expected return on the security can be ascertained with the help of CAPM equation as
follows:
Ke = Irf(Rm-Irf)
=6.2+(10.8-6.2)1.125
=11.375%
Price of security

ii)

Po =

Do (1+g)
Ke-g
25(1+0.04)
0.11375-0.04
=Rs. 352.54

c)

i. Rs. 1,00,000=A(CVAF9,0.08)= A(12.488)

Thus A=100,000/12.488= Rs. 8,007.69
ii. Rs. 100,000=P(CVF8,0.08)=P(1.8509)
Thus P=100,000/1.8509=Rs. 54,027.78
iii. This is a problem of annuity due since payment is made at the beginning of the year.
Rs. 100,000=A (CVAF9,0.08)(1.08)
Rs. 100,000=A (13.487)
A=Rs. 100,000/13.487
= Rs. 7414.55
(42.5=10)

6. Write short notes on:

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a) Modified internal rate of return
b) Private equity
c) Impact of inflation on working capital and inventory
d) Debt trap
Answer a) The Modified Internal Rate of Return (MIRR) is a financial measure of an investment's
attractiveness that attempts to obliterate the shortcomings of Internal Rate of Return. MIRR is
expected to resolve 2 issues associated with the Internal Rate of Return (IRR).
The IRR makes an assumption that interim positive cash flows are reinvested at the same rate of
return, i.e., IRR. This is usually an unrealistic scenario and a more likely situation is that the
funds will be reinvested at a rate closer to the firm's cost of capital. The IRR therefore often
gives an unduly optimistic picture of the projects under study.
Where the projects bear alternating positive and negative cash flows, there will be more than
one IRR, which leads to the confusion and ambiguity.
It is calculated as under:
MIRR

FV(positive cash flows, reinvestment rate)

-1

-PV(negative cash flows at financing rate)

OR
PV of cost = Terminal value
(1+ MIRR)n
b)

Private equity refers to the composition of equity and debt investment in the companies that are
not publicly traded on a stock exchange. It is generally made by a private equity firm, a venture
capital firm or an angel investor, each of which have their own set of goals, preferences and
investment strategies. Nonetheless, all provide working capital to a target company to nurture
expansion, new-product development, or restructuring of the companys operations, management,
or ownership.
Among the most common investment strategies in private equity are: leveraged buyouts, venture
capital, growth capital, distressed investments and mezzanine capital. In a typical leveraged
buyout transaction, a private equity firm buys majority control of an existing or mature firm. This
is distinct from a venture capital or growth capital investment, in which the investors (typically
venture capital firms or angel investors) invest in young, growing or emerging companies, and
rarely obtain majority control.
It is also often grouped into a broader category called private capital, generally used
to describe capital supporting any long-term, illiquid investment strategy.

c) Impact of inflation of working capital and Inventory

1. Due to inflation, for the same quantity of sales, the amount of Sundry Debtors and stocks will
be higher.
2. Since the value of stocks increases ( due to price increase i.e. inflation) the company will not be
able to maintain its operating capability ,unless it finds extra funds to maintain the same stock
level ( i.e. quantity)

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3. Higher value of closing stock due to inflation will lead to higher amount of profits ( in monetary
terms and not in real terms).This will cause an increase in profit related outflows like income
tax, bonus, dividends etc.
4. Thus due to inflation, the business is likely to face a condition known as technical insolvency,
unless proper planning is done to improve Real profits.
d)

Debt Trap is a situation where you add on a new debt in order to pay an existing debt.
Generally, when the firm in overleveraged all the credit sources are exhausted, firm
arrives at a situation of debt trap. It is a situation in which an entity borrows money, but
does not have enough money to make the interest payments on the loan, so it takes out
another loan--with its own interest payments--to cover the first loan's payments. They
will likely have to borrow again to pay off the second loan, creating a crippling cycle. It
is an incentive structure that lures individuals into accepting long-term debt obligations
under conditions that strongly favor the lender. Victims of debt traps are often prevented
from discharging the debt through techniques such as unusually high or variable interest
rates, changing payment plans, and unreasonably high penalties for late payments.
(42.5=10)

7. Distinguish between:
a) Growth firm and Declining firm for relevance of dividend
b) Dividend-price approach and Earning price approach to estimate cost of
equity
c) Financial distress and Insolvency
d) Business Risk and Financial risk

Answer a) According to the relevance theory of dividend, dividends are relevant and the amount of

dividend affects the value of the firm. Walter, Gorden and others propounded that dividend
decisions are relevant in influencing the value of the firm.
Growth Firm
In growth firms internal rate of return is greater than the normal rate (r>k). Therefore, r/k factor will
be greater than 1. Such firms must reinvest retained earnings since existing alternative investments
offer a lower return than the firm is able to secure. Each rupee of retained earnings will have a
weighting in Walter`s formula than a comparable rupee of dividend.
Thus, large the firm retains, higher the value of the firm. Optimum dividend payout ratio for such a
firm will be zero.
Declining Firm
Firms which earn on their investments less than the minimum rate required by investments are
designated as declining firms. The management of such firms would like to distribute its earnings to
the stockholders so that they may either spend it or invest elsewhere to earn higher return than
earned by the declining firms. Under such a situation each rupee of retained earnings will receive
lower weight than dividends and market value of the firm will tend to be maximum when it does
not retain earnings at all.
b)
In a dividend- price approach, cost of equity is calculated by dividing the current dividend by
average market price per share. This ratio expresses the cost of equity capital in relation to what
yield the company should pay to attract investors. It is calculated as:
Ke= D1/P0
Where, D1= Dividend per share in period 1
P0= Market Price per share now
Whereas earning price approach correlate the earnings of the company with the market price of
its shares. So, cost of equity shares would be based on expected rate of earning of the company.
This approach seeks to nullify the effect of changes in dividend policy.
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c) Financial Distress Vs. Insolvency
Financial distress is a situation where a firms operating cash flows are insufficient to meet its
current obligations (and so the firm must take some kind of corrective action) financial distress may
lead a firm to default on a contract, and it may involve financial restructuring between the firm, its
creditors, and its shareholders in most cases, the firm is forced to take actions that it would not have
taken if it had sufficient cash flow.
Insolvency is a term which generally means an inability to repay debts stock-based insolvency
occurs when the value of a firms assets is less than what is owed on its debt flow-based insolvency
occurs when the firms cash flows are insufficient to cover contractually required payments.
d)

Business risk refers to the risk associated with the firms operations. It is the uncertainty about
the future operating income; how well can the operating income be predicted. Business risk can
be calculated using statistical techniques such as standard deviation of the basic earning power
ratio.
Financial risk refers to the additional risk placed on the firms shareholders as a result of debt
use i.e. the additional risk a shareholder bears when a company uses debt in addition to equity
financing. Companies that issue more debt instruments would have higher financial risks than
the companies financed mostly or entirely by equity. Financial risks can be measured using
various financial ratios.

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