1. Given the data below:
Selling price per unit Rs.120, Variable cost per unit Rs.80, Fixed cost
Interest Rs.2 lakhs, Number of units sold 30,000, Calculate the three types of
2. From the following data calculate financial, operating and combined leverage.
Sales 10,000 units, Rs.25 per unit as the selling price. Variable cost Rs.5 per unit
Fixed cost Rs.30,000. Interest cost Rs.15,000. [Ap. '02]
3. A firm has sales of Rs.10,00,000, Variable cost Rs.7,00,000, fixed cost
Rs.2,00,000 and Rs.5,00,000 debt at 10% interest. What are the operating,
financial and combined leverages? [Nov. '99]
4. From the following information calculate:
Financial leverage, Operating leverage and combined leverage
Sales Rs.9,60,000, Variable cost Rs. 5,60,000, Fixed cost Rs. 2,40,000
Interest Rs.60,000, Tax Rs.50,000. [Ap. '00, Oct. '02]
5. NEKO Ltd. has a capital of Rs.50,00,000. The EBIT are Rs.10,00,000. What
would be its financial leverage [DFL]? Assuming the EBIT being Rs.7,50,000 and
Rs.12,50,000, how would the EPS be affected? Assume a tax rate of 50%. The
equity share value of Rs.10 each. [Ap. '99]
6. Total sales of a company Rs. 5,00,000, Total variable cost Rs. 3,00,000
Total fixed cost Rs.1,00,000, 6% Debenture capital is Rs.10,00,000. Find three
leverages [Oct. '00]
7. The Earnings After Tax (EAT) is Rs.61,500. Income Tax rate is 38.5%. Interest
is Rs.20,000 find out EBIT [Oct. '01, '02]
8. Calculate all 3 leverages for the following firms
Particulars P Q R
Output [Units] 3,00,000 75,000 5,00,000
Fixed cost Rs.3,50,000 Rs.7,00,000 Rs.75,000
Unit Variable cost Re.1.00 Rs.7.50 Re.0.10
Interest Expenses Rs.25,000 Rs.40,000 NIL
Unit selling price Rs.3 Rs.25 Re.0.50
9. The following details relate to X Ltd.
Selling price per unit Rs.120
Variable cost per unit Rs.70
Total fixed cost Rs.2,00,000
A] What are the operating and financial leverages when X Ltd. produces and
sells 6,000 units
B] What is the % change that will occur in the EBIT of X Ltd. if the output
increases by 5%
10. Calculate operating, financial and combined leverages under situations
where the fixed cost A] Rs.5,000 & B] Rs.10,000 and Financial plans I & II
respectively from the following data
Total assets Rs.30,000
Total assets turnover 2
Variable cost as a % of sales 60
Equity Rs.30,000 Rs.10,000
10% debentures Rs.10,000 Rs.30,000
11. Calculate all leverages under situations A,B, & C and Financial Plans I,II, & III
respectively from the following information
Installed capacity 1,200 units, Actual production and sales 800 units
Selling price per unit Rs.15, Variable cost per unit Rs.10
Fixed cost : Situation A - Rs.1,000
Situation B - Rs.2,000
Situation C - Rs.3,000
Capital structure Plan I Plan II Plan III
Equity (Rs.) 5,000 7,500 2,500
Debt (Rs.) 5,000 2,500 7,500
Cost of debt 12%
12. The capital structure of Priya Ltd. consists of Equity share capital of
Rs.10,00,000 and Rs.10,00,00 of 10% debentures. Sales increase from 1,00,000
to 1,20,000 units
The existing selling price is Rs.10 per unit
The variable cost amounted to Rs.6 per unit
Fixed cost amounted to Rs.2,00,000
The income tax rate is 50%
You are required to calculate
A] percentage increase in EPS assuming that the face value of each share is
B] degree of financial leverage at 1,00,000 and 1,20,000 units
C] degree of operating leverage at 1,00,000 and 1,20,000 units
13. ABC Ltd. provide the following data
Variable cost as % of sales 50
Degree of operating leverage 3
Degree of financial leverage 2
Tax rate 50%
Prepare the income statement
14. The following is the Balance sheet of a Company
Liabilities Rs. Assets Rs.
Equity capital [@Rs.10 per share] 60,000 Fixed assets 1,50,000
10% Long term debt 80,000 Current assets 50,000
Retained earnings 20,000
Current Liabilities 40,000
The company's total asset turnover ratio is 3
Its fixed operating costs are Rs.1,00,000
Variable operating cost ratio is 40%
The income tax rate is 50%
I] calculate all the types of leverages
II] determine the likely level of EBIT if EPS is
15. ABC Ltd. has an EBIT of Rs.1,60,000. Its capital structure consists of the
10% debentures Rs.5,00,000
12% Preference shares Rs.1,00,000
Equity shares of Rs.100 each Rs.4,00,000
The company is in the 55% tax bracket. You are required to determine
(i) The company's EPS
(ii) The percentage change in EPS associated with 30% increase and 30%
decrease in EBIT
(iii) The degree of financial leverage
WORKING CAPITAL MANAGEMENT
“ The excess of current assets over currents liabilities”
also known as circulating, revolving or fluctuating capital
Components of wc
• Gross working capital & net working capital
• Permanent working & temporary working capital
• Positive working & negative working capital
• Balance sheet working cap & cash working cap
Methods of estimating working capital.
• Conventional method-
cash inflows & cash outflows are matched together. Emphasis is on liquidity &
• Operating cycle method
It considers the production and other business operations.
It emphasis on profitability & liquidity of the firm
Factors determining WC requirements
– Nature of business 11. Growth of business
– Manufacturing cycle 12. Market conditions
– Production process 13. Supply situations
– Business cycle 14. Environment factors
– Seasonal variations
– Scale of operations
– Inventory policy
– Credit policy
– Accessibility of credit
– Business standing
Working capital management
Working capital management refers to the management of working capital with twin
objectives of Liquidity & profitability.
Working capital management establishes the best possible trade-off between the
profitability of net current assets employed and the ability to pay current liabilities as they
• Optimize investments in current assets.
• To see that the company meets its current liabilities obligations
• Manage current assets to see that the return on current assets is more than cost of
• Proper balance between current assets & current liabilities
Components of WCM
• INVENTORY MANAGEMENT
• CASH MANAGEMENT
• RECEIVABLES MANAGEGMENT
• For continuous supply for uninterrupted production
• To reduce wastage & losses
• To introduce scientific inventory management techniques
• To reduce cost of purchase & storage
• To reduce excessive or shortage of inventory
• To have uninterrupted production
• for effective utilization of store space
• To provide right material at right time, from right source & at
TOOLS OF INVENTORY MANAGEMENT
• Fixation of levels- Maximum level
2. Fixation of EOQ- √2AO÷C
• ABC analysis
• VED analysis
• FSN /FNSD analysis
• Perpetual inventory system
• Periodic inventory system
• Inventory turnover ratios
• JIT Analysis
Objectives- To make prompt cash payments
To maintain minimum cash reserve
Motives of holding cash- Transaction motive
Cash management strategies -
• Cash planning
• Managing the cash flows
• Optimum cash balance
• Investing idle cash.
• Cash planning
– It is a technique to plan for & use of cash. It involves cash forecasting and budgeting.
Cash budgets & forecasting –
Short term cash forecasting Long term cash forecasting
Methods of cash forecasting –
1. Receipt & Disbursement method
2. Adjusted net income method
2. Managing cash flows
Accelerating cash collection
• Prompt payment by customers
• Lock box system
• Concentrating banking
• Electronic fund transfer
• Decentralize collection
• Playing the Float-collection float
• Payment on last day & by drafts
• Centralisation of payments
3. Determining optimum cash balance
4. Investment in marketable securities.
Selection of securities
Determinants of accounts receivable/credit sales-
• Credit sales volume
• Credit policies
• Business terms- time period, discounts
• New products
Cost of receivables/trade credits-
• Carrying cost
• Defaulting cost
• Administration cost
Management of receivables
• Forming of credit policy
• Executing credit policy
• Formulating & executing collection policy
Credit rating-5 C’s (character, capacity, capital, collateral & condition)
Ageing schedules-it is a statement prepared to determine quality of individual debtors.
No of days, period ending, % age of debt etc.
Services-finance, maintenance of accounts, collection of data or protection against credit
Meaning of capital budgeting
Capital budgeting process
Methods of capital budgeting
The process through which different projects are evaluated is known as capital
Capital budgeting is defined “as the firm’s formal process for the acquisition and
investment of capital. It involves firm’s decisions to invest its current funds for addition,
disposition, modification and replacement of fixed assets”.
“Capital budgeting is long term planning for making and financing proposed
capital outlays”- Charles T Horngreen.
“Capital budgeting consists in planning development of available capital for the
purpose of maximising the long term profitability of the concern” – Lynch
The main features of capital budgeting are
a. potentially large anticipated benefits
b. a relatively high degree of risk
c. relatively long time period between the initial outlay and the anticipated return.
- Oster Young
Significance of capital budgeting
The success and failure of business mainly depends on how the available
resources are being utilised.
Main tool of financial management
All types of capital budgeting decisions are exposed to risk and uncertainty.
They are irreversible in nature.
Capital rationing gives sufficient scope for the financial manager to evaluate
different proposals and only viable project must be taken up for investments.
Capital budgeting offers effective control on cost of capital expenditure projects.
It helps the management to avoid over investment and under investments.
Capital budgeting process involves the following
1. Project generation: Generating the proposals for investment is the first step.
The investment proposal may fall into one of the following categories:
Proposals to add new product to the product line,
proposals to expand production capacity in existing lines
proposals to reduce the costs of the output of the existing products without
altering the scale of operation.
Sales campaining, trade fairs people in the industry, R and D institutes,
conferences and seminars will offer wide variety of innovations on capital assets for
Project Evaluation: it involves two steps
Estimation of benefits and costs: the benefits and costs are measured in terms of
cash flows. The estimation of the cash inflows and cash outflows mainly depends on
future uncertainities. The risk associated with each project must be carefully analysed
and sufficeint provision must be made for covering the different types of risks.
Selection of an appropriate criteria to judge the desirability of the project: It must
be consistent with the firm’s objective of maximising its market value. The technique of
time value of money may come as a handy tool in evaluation such proposals.
Project Selection: No standard administrative procedure can be laid down for
approving the investment proposal. The screening and selection procedures are different
from firm to firm.
Project Evaluation: Once the proposal for capital expenditure is finalised, it is
the duty of the finance manager to explore the different alternatives available for
acquiring the funds. He has to prepare capital budget. Sufficient care must be taken to
reduce the average cost of funds. He has to prepare periodical reports and must seek
prior permission from the top management. Systematic procedure should be developed
to review the performance of projects during their lifetime and after completion.
The follow up, comparison of actual performance with original estimates not only
ensures better forecasting but also helps in sharpening the techniques for improving
Factors influencing capital budgeting
Availability of funds
Structure of capital
Lending policies of financial institutions
Immediate need of the project
Economical value of the project
Trend of earnings
Methods of capital budgeting
Accounting rate of return method
Discounted cash flow methods
Net present value method
Profitability index method
Internal rate of return
Pay back period method
It refers to the period in which the project will generate the necessary cash to recover the
It does not take the effect of time value of money.
It emphasizes more on annual cash inflows, economic life of the project and original
The selection of the project is based on the earning capacity of a project.
It involves simple calcuation, selection or rejection of the project can be made easily,
results obtained is more reliable, best method for evaluating high risk projects.
It is based on principle of rule of thumb,
Does not recognize importance of time value of money,
Does not consider profitability of economic life of project,
Does not recognize pattern of cash flows,
Does not reflect all the relevant dimensions of profitability.
Accounting Rate of Return method
IT considers the earnings of the project of the economic life. This method is based on
conventional accounting concepts. The rate of return is expressed as percentage of the
earnings of the investment in a particular project. This method has been introduced to
overcome the disadvantage of pay back period. The profits under this method is
calculated as profit after depreciation and tax of the entire life of the project.
This method of ARR is not commonly accepted in assessing the profitability of
capital expenditure. Because the method does to consider the heavy cash inflow during
the project period as the earnings with be averaged. The cash flow advantage derived by
adopting different kinds of depreciation is also not considered in this method.
Accept or Reject Criterion: Under the method, all project, having Accounting Rate of
return higher than the minimum rate establishment by management will be considered
and those having ARR less than the pre-determined rate. This method ranks a Project as
number one, if it has highest ARR, and lowest rank is assigned to the project with the
It is very simple to understand and use.
This method takes into account saving over the entire economic life of the project.
Therefore, it provides a better means of comparison of project than the pay back period.
This method through the concept of "net earnings" ensures a compensation of
expected profitability of the projects and
It can readily be calculated by using the accounting data.
1. It ignores time value of money.
2. It does not consider the length of life of the projects.
3. It is not consistent with the firm's objective of maximizing the market value of
4. It ignores the fact that the profits earned can be reinvested. -
Discounted cash flow method
Time adjusted technique is an improvement over pay back method and ARR. An
investment is essentially out flow of funds aiming at fair percentage of return in future.
The presence of time as a factor in investment is fundamental for the purpose of
evaluating investment. Time is a crucial factor, because, the real value of money
fluctuates over a period of time. A rupee received today has more value than a rupee
received tomorrow. In evaluating investment projects it is important to consider the
timing of returns on investment. Discounted cash flow technique takes into account both
the interest factor and the return after the payback 'period.
Discounted cash flow technique involves the following steps:
Calculation of cash inflow and out flows over the entire life of the asset.
Discounting the cash flows by a discount factor
Aggregating the discounted cash inflows and comparing the total so obtained with
the discounted out flows.
Net present value method
It recognises the impact of time value of money. It is considered as the best method of
evaluating the capital investment proposal.
It is widely used in practice. The cash inflow to be received at different period of time
will be discounted at a particular discount rate. The present values of the cash inflow are
compared with the original investment. The difference between the two will be used for
accept or reject criteria. If the different yields (+) positive value , the proposal is selected
for invesment. If the difference shows (-) negative values, it will be rejected.
It recognizes the time value of money.
It considers the cash inflow of the entire project.
It estimates the present value of their cash inflows by using a discount rate equal to the
cost of capital.
It is consistent with the objective of maximizing the welfare of owners.
It is very difficult to find and understand the concept of cost of capital
It may not give reliable answers when dealing with alternative projects under the
conditions of unequal lives of project.
Internal Rate of Return
It is that rate at which the sum of discounted cash inflows equals the sum of discounted
cash outflows. It is the rate at which the net present value of the investment is zero.
It is the rate of discount which reduces the NPV of an investment to zero. It is called
internal rate because it depends mainly on the outlay and proceeds associated with the
project and not on any rate determined outside the investment.
Merits of IRR method
It consider the time value of money
Calculation of casot of capital is not a prerequisite for adopting IRR
IRR attempts to find the maximum rate of interest at which funds invested in the
project could be repaid out of the cash inflows arising from the project.
It is not in conflict with the concept of maximising the welfare of the equity
It considers cash inflows throughout the life of the project.
Computation of IRR is tedious and difficult to understand
Both NPV and IRR assume that the cash inflows can be reinvested at the
discounting rate in the new projects. However, reinvestment of funds at the cut off rate is
more appropriate than at the IRR.
IT may give results inconsistent with NPV method. This is especially true in case
of mutually exclusive project.
Step 1:Calculation of cash outflow
Cost of project/asset xxxx
Transportation/installation charges xxxx
Working capital xxxx
Cash outflow xxxx
Step 2: Calculation of cash inflow
Less: Cash expenses xxxx
Less: Depreciation xxxx
less: Tax xxxx
Add: Depreciation xxxx
Cash inflow p.a xxxx
Depreciation = St.Line method
PBDT – Tax is Cash inflow ( if the tax amount is given)
PATBD = Cash inflow
Cash inflow- Scrap and working capital must be added.
Step 3: Apply the different techniques
Pay back period= No. of years + Amt to recover/ total cash of next years.
ARR = Average Profits after tax/ Net investment x 100
NPV= PV of cash inflows – PV of cash outflows
Profitability index = PV of cash inflows/ PV of cash outflows
Pay back factor: Cash outflow/ Avg cash inflow p.a.
Find IRR range
PV of Cash inflows for IRR range and then calculate IRR
Factors influencing capital structure
Optimal capital structure
Point of Indifference
Types of leverages
“ Capital structure of a company refers to the composition of its capitalisation and it
includes all long term capital sources i.e., loans, reserves, shares and bonds”. –
“ the Capital structure of business can be measured by the ratio of various kinds of
permanent loan and equity capital to total capital”. - Schwarty
Factors affecting capital structure
Growth and stability
Cost of capital
Purpose of finance
Size of the company
Nature of the industry
Cost of inflation
Period of finance
Level of interest rate
Level of business activity
Availability of funds
Level of stock prices
Conditions of the capital market
Optimal capital structure
The OCM can be defined as “ that capital structure or combination of debt and equity that
leads to the maximum value of the firm”
OCM maximises the value of the company and hence the wealth of its owners and
minimise the company’s cost of capital.
the following consideration should be kept in mind while maximising the value of the
firm in achieving the goal of the optimal capital structure:
If ROI > the fixed cost of funds, the company should prefer to raise the funds
having a fixed cost, such as, debentures, Loans and PSC. It will increase EPS and MV of
If debt is used as a source of finance, the firm saves a considerable amount in
payment of tax as interest is allowed as a deductible expense in computation of tax.
It should also avoid undue financial risk attached with the use of increased debt
The Capital structure should be flexible.
Point of indifference / Range of earnings
The earnings per share, ‘equivalent point’ or ‘point of indifference’ refers to that EBIT,
level at which EPS remains the same irrespective of Different alternatives of Debt-Equity
mix. At this level of EBIT, the rate of return on capital employed is equal to the cost of
debt and this is also known as the break-even level of EBIT for alternative financial plans
CG means the ratio between the various types of securities in the capital structure of the
company. A company is said to e high-gear when it has proportionately higher/larger
issue of Debt and PS for raising the LT resources. Whereas low-gear stands for a
proportionately large issue of equity shares.
Leverage-an Increased means of accomplishing some purpose
In financial management, it is the firms ability to use fixed cost assets or funds to
increase the returns to its owners;
Financial leverage- the use of long term fixed income bearing debt and preference share
capital along with the equity share capital is called financial leverage or trading on equity
A Firm is known to have a favourable leverage if its earnings are more than what debt
would cost. On the contrary, if it does not earn as much as the debt costs then it will be
known as an unfavourable leverage.
Impact of financial leverage
When the d/f b/w the earnings from assets financed by fixed cost funds and cost of these
funds are distributed to the equity stockholders, they will get additional earnings without
increasing their own investment. Consequently, the EPS and the Rate of return on ESC
will go up.
On the contrary, if the firm acquires fixed cost funds at a higher cost than the earnings
from those assets then the EPS and return on equity capital will decrease.
Significance of financial leverage
Planning of capital structure
Limitations of FL/ trading on equity
Beneficial only to companies having stability in earnings
Increases risk and rate of interest
Restriction from financial instruments
Operating leverage results from the presence of fixed costs the help in magnifying net
operating income fluctuations flowing from small variations in revenue.
The changes in sales are related to changes in the revenue. The fixed costs do not change
with the changes in sales, any increase in sales, FC remaining the same, will magnify
OL shows the ability of a firm to use fixed operating cost to increase the effect of change
in sales and the charges in fixed operating income.
The OL affects the income which is the result of production. On the other hand,
FL is the result of financial decisions. The CL focuses attention on the entire income of
This leverage shows the relationship between a change in sales and the
corresponding variation in taxable income.
Working capital leverage
This leverage measures the sensitivity of ROI of changes in the level of current assets.
Types of Dividend policies
Factors influencing dividend policy
Forms of dividend
The term dividend refers to that part of profits of a company which is distributed by the
company among its shareholders.
It is the reward of the shareholders for investments made by them in the shares of the
Dividend policy and significance of dividend policy
It refers to the policy that the management formulates in regard to earnings for
distribution as dividends among shareholders. it determines the division of earnings
between payments to shareholders and retained earnings.
Significance of dividend policy
The firm has to balance between the growth of the company and the distribution
to the shareholders
It has a critical influence on the value of the firm
It has to also to strike a balance between the long term financing
decision( company distributing dividend in the absence of any investment opportunity)
and the wealth maximisation
The market price gets affected if dividends paid are less.
Retained earnings helps the firm to concentrate on the growth, expansion and
modernisation of the firm
To sum up, it to a large extent affects the financial structure, flow of funds,
corporate liquidity, stock prices, growth of the company and investor’s satisfaction.
Factors influencing the dividend decision
Stability of earnings
Financing policy of the firm
Liquidity of funds
Dividend policy of competitive firms
Past dividend rates
Ability to borrow
Stability of dividends/ regularity
It is the desirable policy of the management to distribute the shareholders a certain
percentage of earnings as a reward for their investment. It may not always relate to the
earnings of the company.
Constant dividend per share
Constant percentage of net earnings
Small constant dividend per share plus extra earnings
Dividend as a fixed percentage of market value
Significance of stability of dividend
Confidence among shareholders
Investors desire for current income
Institutional investor’s requirement
Stability in market prices of shares
Raising additional finances
Spreading of ownership of outstanding shares
Reduces the chances of loss of control
Market for debentures and preference shares.
Forms of Dividend
Scrip Dividend- An unusual type of dividend involving the distribution of
promissory notes that call for some type of payment at a future date.
Bond Dividend- A type of liability dividend paid in the dividend payer's bonds .
Property Dividend- A stockholder dividend paid in a form other than cash, scrip,
or the firm's own stock.
Cash Dividend- A dividend paid in cash to a company's shareholders, normally
out of the its current earnings or accumulated profits
Bonus share or Stock dividends- A dividend payment made in the form of
additional shares, rather than a cash payout.
Optional Dividend- Dividend which the shareholder can choose to take as either
cash or stock.
Objectives of stock dividend
Conservation of cash
Lower rate of dividend
Financing expansion programmes
Transferring the formal ownership of surplus and reserves to the shareholders
Widening share market
True presentation of earning capacity
Merits of Stock dividend
To the company
Maintenance of liquidity position
Satisfaction of shareholders
Economical issue of capitalisation
Remedy for under capitalisation
Widening the share for market
Finance for expansion programmes
Conservation of control
Demerits of stock dividend
To the company
Increase in the capitalisation of the company
It results in more liability
Denies other investors to shareholders
Management control not diluted it may lead to fraud
Dividend is the portion of earnings which is
Distributed among the shareholders.
Dividend policy determines the division of
Earnings between payment to shareholders
& retained earnings.
Dividend policy may be viewed as:
• Long term financing decision
• Wealth maximisation decision
Determinants of dividend policy.
• Transaction cost
• Personal taxation
• Dividend clientele
• Dividend payout ratio
• Divisible profits
• Rate of expansion
• Rate of return
• Legal provisions
• Stability of earnings
• Contractual constraints
• Cost of financing
• Degree of control
• Capital Market access
• State of economy
• Effect of trade cycles
• Policy of competitive concerns
• Constant dividend payout ratio.
• Constant dividend rate policy :- (dividend equalisation fund/reserve)
a. constant dividend per share
b. constant divided plus extra dividend
c. uniform cash dividend plus bonus shares
d. Fixed percentage of market value
Types of dividends
• Cash dividends
• Dividend warrants
• Bond dividends
• Property dividends
• Stock dividends/bonus shares
STOCK DIVIDENDS/BONUS SHARES
• Making partly paid equity shares fully paid up
• Issuing fresh equity shares to existing shares
• Conservation of cash
• Lower rate of dividends for undercapitalisation
• Financing expansion programme
• Transferring the surplus reserves
• Enhance prestige
• Widening share market
• True presentation of earning capicity.
advantages to company-
• Liquidity position
• Shareholders satisfaction
• Reduced cost of capitalisation
• Remedy for undercapitalisation
• Enhance prestige
• Widening share market
• Finance for expansion
• Conservation of control
Advantages- to investors
• Increase in their equity
• Marketability of shares is increased
• Increase in income
• Increases demand for shares
• Increase in capitalisation
• More liability of dividends
• Prevents new investors
• Control of management is diluted
• Loss of cash dividends
• Lowers the market value of share