Financial-Management-munotes

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ANOVERVIEW OF FI NANCIAL SYSTEM
Unit Structure :
1.1 Introduction
1.2 Definition of Finance
1.3 Indian Financial System
1.4 Financial Markets
1.5 Structure of Financial Market
1.6 Components of Financial Systems
1.7 Self Study
1.1INTRODUCTI ON
The term "finance" in our simple understanding it is perceived as
equivalent to 'Money'. We read about Money and banking in Economics,
about Monetary Theory and Practice and about "Public Finance". But
finance exactly is not money; it is the source of providing funds for a
particular activity. Thus public finance does not mean the money with
the Government, but it refers to sources of raising revenue for the
activities and functions of aGovernment. Here some of the definitions of
the word 'finance' bot ha sa source and as an activity.
1.2DEFI NITIO N& MEA NINGO FF I NANCE
Finance is defined in numerous ways by different groups of
people. Though it is difficult to give a perfect definition of Finance
following selected statements will help to deduce its broad meaning.
1.In General sense, "Finance is the management of money and other
valuables, which can be easily converted into cash."
2.According to Experts, "Finance is a simple task of providing the
necessary funds (money) required by the business of entiti es like
companies, firms, individuals and others on the terms that are most
favourable to achieve their economic objectives."
3.According to Entrepreneurs, "Finance is concerned with cash. It is
so, since, every business transaction involves cash directly or
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24.According to Academicians, "Finance is the procurement (to get,
obtain) of funds and effective (properly planned) utilization of
funds. It also deals with profits that adequately compensate for the
cost and risks borne by the business."
Alldefinitions listed above refer to finance as a source of funding
an activity. In this respect providing or securing finance by itself is a
distinct activity or function, which results in Financial Management,
Financial Services and Financial Institutions. Finance therefore represents
the resources by way funds needed for a particular activity. Thus
'finance' is only referred in relation to a proposed activity. Finance goes
with commerce, business, banking etc. Finance is also referred to as
"Funds" or "Capi tal", when referring to the financial needs of a corporate
body.
1.3INDIANFINANCIAL SYSTEM
The economic development of a nation is reflected by the
progress of the various 1 economic units, broadly classified into
corporate sector, government and house hold sector. While
performing their activities these units will be placed in a surplus
/deficit /balanced budgetary situations. There are areas or people with
surplus funds and there are those with adeficit. A financial system or
financial sector functi ons as an intermediary and facilitates the flow of
funds from the areas of surplus to the areas of deficit. A Financial
System is a composition of various institutions, markets, regulations and
laws, practices, money manager, analysts, transactions and cla ims and
liabilities.
Financial System :
The word "system", in the term "financial system", implies a set
of complex and closely connected or interlined institutions, agents,
practices, markets, transactions, claims, and liabilities in the economy.
The financial system is concerned about money,
credit and finance, the three terms are intimately related yet are somewhat
different from each other. Indian financial system consists of financial
market financial instruments and financial intermediation.
1.4FINANCIAL MARKETS
A Financial Market can be defined as the market in which financial
assets are created or transferred. As against a real transaction that
involves exchange of moneyfor real goods or services, a financial
transaction involves creation o r transfer of a financial asset Financialmunotes.in

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3Assets or Financial Instruments represents a claim to the payment of a
sum of money sometime in the future and /or periodic payment in the
form of interest or dividend.
Money Market :
The money market is a who lesale debt market for low -risk,
highly -liquid, short -term instrument. Funds are available in this market
fora period ranging from a single day up to a year. This market is
dominated mostly by government, banks and financial institutions Money
market is t hat market where short -term credit is supplied and
demanded. The major components of money market are organized
money market and unorganized money market. The unorganized
money market consists of money -lenders and indigenous bankers. The
organized money m arket consists of all banks under the control of
Reserve Bank of India, which carry out business of short -term credit (up
to one year). Individuals, industrial firms, trading firms, service agencies
and other similar business enterprises borrow short -term credit in this
market. Indian money market isnot homogeneous because of the
existence of unorganized money market, where there are differences
between interest rates, margins and securities.
Capital Market :
The capital market is designed to finance the long-term
investments. The transactions taking place in this market will be for a
period over a year. This is the other part of financial market where long
term credit is bought and sold, in other words, where capital is bought
and sold. In this capital m arket large industrial houses, corporations,
central and Is t a t eg o v e r n m e n t s ,n o n -banking financial institutions as
also commercial and developmental banks participate. Capital market
makes available long -term loans for major projects in industry,
infrastr ucture, agriculture etc. It is because of the capital market that
investment finance is made available to innovators who instigate and
sustain the process of growth and development. Stock market or share
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4Forex Market :
The Forex market deals with the multicurrency requirements,
which are met by the I exchange of currencies. Depending on the
exchange rate that is applicable, the transfer of funds takes place in this
market. This is one of the most develope d and integrated market across
the globe.
Credit Market :
Credit market is a place where banks, Financial Institutions and
NBFCs provide short, medium and long -term loans to corporate and
individuals.
1.5STRUCTURE OF FI NANCIAL MARKET
The functional cla ssification is based on the term of credit,
whether the credit supplied is short -term or long -term. Accordingly,
markets are called money markets or capital markets. The institutional
classification tells us whether the financial institutions are organized on
commercial or cooperative principles and whether they belong to the
organized or unorganized sector. The sectoral classification identifies
credit arrangements for various sectors of the economy: agriculture,
manufacturing industry, trade and others.
Financial markets are broadly sub -divided under two heads
money markets and capital markets. The former are markets in short -term
funds; the latter in long -term funds. The term money market is interpreted
more broadly to include within its folds also the notional money market
of monetary theory.
Structurally, the short -term credit market is divisible under two
sectors: organized and unorganized. The organized market comprises
the RBI and banks. It is called organized because its parts are
systematically co ordinated by the RBI. Non -bank financial institu tions
such as the LIC, the GIC and subsidiaries, the UTI also operate in this
market, but only indirectly through banks and not directly. Quasi -
government bodies and large companies may also make their short -term
surplus funds available to the market through banks.
Besides commercial banks that dominate the organized money
market, there are co operative banks. They are a part of co -operative
credit institutes that have a three -tier : structure. At the top the re are
state co -operative banks (co -operation being a state subject). At the
district level there axe central co -operative banks. At local level there are
primary credit societies and urban co -operative banks.munotes.in

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5STRUCTURE OF FINANCIAL MARKET
(ORGANIZED &U N O R G A N I S E DM A R K E T )
The whole co -operative credit system is linked with the RBI and
is dependent on it for funds. the RBI deals directly with only state co -
operative banks. For reasons of size, methods of operation and dealings
with the RBI and comm ercial banks, only state and central co -operative
banks need becounted into the organized money market; the rest (co -
operative credit societies at local level) are only loosely linked with it.
The unorganized market is large lymade up of indigenous banker sa n d
moneylenders, professional and non-professional. It is unorganized
because the activities of its parts are not systematically coordinated bythe
RBI or any other authority.
Private moneylenders operate throughout the length and breadth
of the countr y, but without any link among themselves. Indigenous
bankers are better organized on local basis, as in Bombay and
Ahmedabad. But this kind of organization is also only a loose association.
For the success of monetary and credit policy, the character of th em o n e y
market is important. The unorganized sector of the market is practically
insulated from monetary and credit controls. It is neither subject to
reserve requirements, nor capital or investment requirements. Its
dependence on the RBI or banks for fund s is very limited.
Therefore, it is not affected directly by the policy of monetary
restraint of the economy. The RBI has no control over the quality and
composition of credit in the market either. This works as an important
limitati ont ot h ew o r k i n go fm onetary policy in India. But since 1947 the
situation is rapidly changing with the fast expansion of banking in the
country and the relative shrinkage of the unorganized sector of the money
market . There are three main components of the organized sector of the
money markets. They are :
i)Inter -bank call money market
ii)Bill market, and
iii)Bank loan market
The unorganized sector also has its comparable markets. But its
call money market is very small and restricted only to the Gujarati
shroffs (one c omponent of indigenous bankers). The other two markets
are quite important. The indigenous bills are called hundies, and themunotes.in

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6hundi market is quite active. The indigenous bankers and moneylenders
are still the major source of short -term loans for the small borrower.
The main function of the money market is to provide short -term
funds to deficit spenders, whether the government or others. It does this
mainly by mobilizing short -term surpluses of both financial and non -
financial units, including state governm ents, local governments, and
quasi -government bodies. Banks performs by 'selling' deposits of
various kinds, participation Certificates and bills discounted. Then, there
are treasury bills sold 'on tap' by the RBI. The RBI itself serves as the
lender of la st resort to the market. Funds have also to be moved between
regions and from one place to another according to demand. An efficient
and well -developed system does it fast and at low cost. Also, it does not
allow regional or sectoral scarcities of funds t o emerge. The surpluses in
some centers or sectors get immediately transferred to others in short
supply. Thereby an even supply of funds and liquidity is maintained
throughout the economy. For this, banks and other constituents of
money market must have a ni n t e r -connected network of branches and
offices, rapid communication and remittance -of-funds system, and well -
trained staff.
The real economy may also have a seasonal pattern, giving rise to
seasonal ups and downs in the demand for funds. In the Indian economy
this kind of seasonality mainly arises from the seasonal character of
agriculture and some agro based industries (such as sugar) and their
large weight in the overall economy. Thus, traditionally, the Indian
money market has been facing two seasons ' busy season from October .to
April and slack season from May to September.
During the busy season the main (Kharif) crops are harvested and
marketed and sugarcane is crushed. So, th edemand for bank credit to
traders and sugar manufacturers goes up. Dur ing the slack season this
demand for funds goes down. The RBI has been following a pro seasonal
monetary policy so that any special stringency of funds does not arise
during the busy season which may hurt legitimate economic activity.
Some time with increa sed double cropping of cultivated land, hefty
increases in the output of wheat (a major rabi crop) and autumn rice,
growth of perennial industries, and Ahigher proportion of bank credit
going lo manufacturing industries, th eprevious seasonal ups and down s
in the demand fo rfunds have largely lo sttheir importance. This trend is
likely to gain in strength over time.
The capital market deals in medium -term and long -term funds.
Like money market, the capital market also is divisible into two sectors
organiz ed and unorganized. The organized sector comprises the stock
market, the RBI, banks, development banks (such as the Industrial
Development Bank of India), LIC, GIC and subsidiaries, and the U TI.
The unorganized sector is mainly made up of indigenous banke rs
and money -lenders chit funds, nidhis and similar other financialmunotes.in

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7institutions; investment companies, finance companies and hire purchase
companies; and company deposits. The role of the unorganized sector
in the capital market is of very limited importa nce.
1.6 MO NEY MARKET I NSTRUME NTS
Efficiency of financial system largely depends upon the quality
and variety of financial services provided by financial intermediaries.
The term financial services can be defined as “activities benefits and
satisfaction connected with sale of money that offers to users and
customers, financial related value.”
The money market can be denned as a market for short -term
money and financial assets that are near substitutes for money. The term
short -term means generally a per iod upto one year and near substitutes to
money is used to denote any financial asset which can be quickly
converted into money with minimum transaction cost.
Some of the important money market instruments are:
1.Call / Notice-Money Market :
Call / Not ice money is the money borrowed or lent on demand for
a very short period. When money is borrowed or lent for a day, it is
known as Call (Overnight) Money. Intervening holidays and/or
Sunday are excluded for this purpose. Thus money, borrowed on a
day and repaid on the next working day, (irrespective of number of
intervening holidays) is "Call Money". When money is borrowed or lent to
day and up to 14 days, it is "Notice Money". No collateral security is
required to cover these transactions.
2.Inter -Bank Term Money :
Inter -bank market for deposits of maturity beyond 14 days is
referred to as the term money market. The entry restrictions are the same
as those for Call/Notice Money except that, as per existing regulations,
the specified entities are not allo wed to lend beyond 14 days.
3.Treasury .Bills.
Treasury Bills are short term (up to one year) borrowing
instruments of the union government. It is an IOU of the Government. It
is a promise by the Government to pay a stated sum after expiry of the
stated period from the date of issue (14/91/182/364 days i.e. less than
one year). They are issued at a discount to the face value, and on maturity
the face value is paid to the holder. The rate of discount and the
corresponding issue price are determined at eac h auction.
4.Certificate of Deposits :
Certificates of Deposit (CDs) is a negotiable money market
instrument and issued in dematerialized form or as a Usance Promissory
Note, for funds deposited at a bank or other eligible financial institutionmunotes.in

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8for a spe cified time period. Guidelines for issue of CDs are presently
governed by various directives issued by the Reserve Bank of India, as
amended from time to time. CDs can be issued by (i) scheduled
commercial banks excluding Regional Rural Banks (RRBs) and Lo cal
Area Banks (LABs); and (ii) select all -India Financial Institutions that
have been permitted by RBI to raise short -term resources within the
umbrella limit fixed by RBI. Banks have the freedom to issue CDs
depending on their requirements. A FI may issu eC D sw i t h i nt h eo v e r a l l
umbrella limit fixed by RBI, i.e., issue of CD together with other
instruments viz., term money, term deposits, commercial papers and
intercorporate deposits should not exceed 100 per cent of its net owned
funds, as per the latest audited balance sheet.
5. Commercial Paper (CP)
Commercial Paper is a note in evidence of the debt obligation
of the issuer On issuing commercial paper the debt obligation is
transformed into an instrument Commercial Paper is thus an unsecured
promissory note privately placed with investors at a discount rate to face
value determined by market forces. Commercial Paper is freely
negotiable by endorsement and delivery. A company shall be eligible to
issue commercial paper provided -
a)the tangible net worth o ft h ec o m p a n y ,a sp e rt h el a t e s ta u d i t e d
balance sheet, is not less than `4C r o r e ;
b)the working capital (fund -based) limit of the company from the
banking system is not less than `4C r o r ea n d
c)the borrowable account of the company is classified as a Standard
Asset by the financing bank/s. The minimum maturity period of
Commercial Paper is 7 days. The minimum credit rating shall be P -2
of CRISIL or such equivalent rating by other agencies.
Capital Market Instruments :
The capital market generally consists of the following long term
period i.e., more than one year period, financial instruments; In the equity
segment Equity shares, preference shares, convertible preference shares,
non-convertible preference shares etc and in the debt segment
debentures, zero cou pon bonds, deep discount bonds etc.
Hybrid Instruments :
Hybrid instruments have both the features of equity and debenture.
This kind of instruments is called as hybrid instruments. Examples are
convertible debentures, warrants etc.
In India money mark et is regulated by Reserve bank of India and
Securities Exchange I Board of India (SEBI) regulates capital market. Capital
market consists of primary market I and secondary market. All Initial Public
Offerings comes under the primary market and I all secon dary market
transactions deals in secondary market. Secondary market refers to a market
where securities are traded after being initially offered to the public in themunotes.in

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9primary I market and/or listed on the Stock Exchange. Secondary
market comprises of equit ymarkets and the debt markets. In the
secondary market transactions BSE and NSE plays a] great role in
exchange of capital market instruments.
1.7 SELF STUDY
I.Fill in the blanks
1) The term "finance" in our simple understanding it is perceived as
equivalent to _____________________.
2) Public finance does not mean the money with the __________
3) ______________ is the management of money.
4) Finance is the procurement of ________________.
5) A _____________ system facilitates the flow of funds.
6) Financial Assets represents a claim to the payment of a sum of
___________________.
7) The money market is a wholesale _____________ market for low -
risk.
8) The capital market is designed to finance the long term ______
9) Stock market or share market is a major sub -component of
____________ market.
10) the Forex market deals with the ______________.
11) Financial markets deals with the _______________.
12) Short -term credit market is divisible into ___________ and
__________.
13) Call money market is very small and restricted only to the Gujarati
______________.
14) Efficiency of financial system largely depends upon the ______ of
financial services provided by financial intermediaries.
15) Call money is the money ____________ on demand for a very sh ort
period.
16) __________ market for deposits of maturity __________ is referred
to as the term money market.
17) Treasury Bills are short term up to ____________.
18) Certificates of Deposit is a ______________ money market
instrument.
19) __________ __ is a note in evidence of the debt obligation of the
issuer.
20) ____________ have both the features of equity and debenture.munotes.in

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10[Ans.: (1) 'Money'; (2) Government; (3) "Finance; (4) funds; (5) financial;
(6) money; (7) debt; (8) investments; (9) capital; (10) multicurrency;
(11) -money, capital; (12) o rganized, unorganized; (13) Shroffs; (14)
quality and variety; (15) borrowed or lent; (16) Inter -bank, beyond 14
days; (17) one year; (18) negotiable; (19) Com mercial Paper; (20)
Hybrid instruments ]
II.State True or False
1.The term “finance” in our simple understanding it is not
equivalent to 'Money'
2.Public finance mean the money with the Government
3.Finance is the management of money
4.Af i n a n c i a l system does not facilitates the flow of funds
5.The money mark et is a wholesale debt market for low -risk.
6.Forex market deals with the multicurrency
7.Treasury Bill' are short term up to two year
8.Hybrid instruments have only the features of debenture
9.Certificates or Deposit is a negotiable money market instrument.
10.Call mone yisthe money borrowed for a long period of time.
[Ans.: True : 3,5, 6., 9, False : 1, 2, 4, 7, 8,10.]
III.Answer the following
a)State the definition of Finance & give a detailed meaning of finance?
b)Explain the Indian Financial System with appropria te flow chart?
c)Explain the financial market with detailed classifications.
d)Give a detailed account of financial market?
e)Bring out the classification of Organised & unorganised financial
market structure?
f)State & explain the components of Indian financial s ystem?
g)Write short notes on:
i)Hybrid instrument
ii)Commercial paper
iii)Certificate of Deposit
iv)Capital Market
v)Money Market
vi)Indian Financial System
vii)Structure of Financial Market,
viii)Treasury Bill
ix)Call Notice Money Market
x)Unorga nised Money Market
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112
FINANCIAL I NTERMEDIARIES
Unit Structure :
2.1 Introduction
2.2 Types of financial intermediaries are
2.3 Financial products
2.4 Functions of financial system
2.5 Self Study
2.1 INTRODUCTIO N
The term financial intermedi ary may refer to an institution , firm or
individual who performs intermediation between two or more parties in
af i n a n c i a lc o n t e x t .T h ef i r s t party is a provider of a product or service
and the second party is aconsumer orcustome r.Financial intermediari es
are banking and non -banking institutions which transfer funds from
economic agents with surplus funds (surplus units) to economic agents
(deficit units) that would like to utilize those funds. FIs are basically two
types: Bank Financial Intermediaries ( Central banks and Commercial
banks) an dN o n -Bank Financial Intermediaries, NBFIs (insuranc e
companies, mutual trust fund ,investment companies, pensions funds,
discount houses and bureaux de change).
2.2TYPES O FF INANCIAL I NTERMEDIARIES ARE
Banks;
Credi t Unions;
Financial adviso ro rb r o k e r ;
Insurance Companies;
Life Insurance Companies;
Mutual Funds or Societies ;
Pension Funds.
The borrower who borrows money from the Financial
Intermediaries/ Institutions pays higher amount of interest than, that
receiv ed by the actual lender and the difference between the Interest paid
and Interest earned is the Financial Intermedia ries/Institutions profit.
Financial Intermediaries are broadly classified into t wo major
categories:munotes.in

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121.Fee-based or Advisory Financial Int ermediaries
2.Asset Based Financial Intermediaries.
Fee Based /Advisory Financial Intermediaries :These Financial
Intermediaries Institutions offer advisory financial services and
charge a fee according lyfortheservices rendered.
Their services includ e:
1)Issue Management 2)Underwriting
3)Portfolio Management 4)Corporate Counseling
5)Stock Broking 6)Syndicated Credit
7)Arranging Foreign Collaboration Services 8)Mergers and Acquisitions
9)Debenture Trusteeship 10)Capita lRestructuring
Asset -Based Financial Intermediaries: These Financial
Intermediaries /Institutions finance the specific requirements of their
clientele. The required infra -structure, in the form of required asset or
finance is provided for rent or interest respectively. Such c ompanies
earn their incomes from the interest spread, namely the
difference between interest paid and interest earned.
The financial institutions may be regulated by various regulatory
authorities, or may be required to disclose the qualifications of the person
to potential clients. In addition, regulatory authorities may impose specific
standards of conduct requirements on financial intermediaries when
providing services to investors.
Having designed the instrument, the issuer should then ensure
thatt h e s ef i n a n c i a l assets reach the u ltimate investor in order to garn er
the requisite amount. When the borrower of funds approaches the
financial market to raise funds ,mere is sue of securities will not suffice.
Adequate information of the issue, issuer an dt h es e c u r i t ys h o u l db e
passed on to take place. There should be a proper channel within the
financial system to ensure such transfer. To serve this purpose, financial
intermediaries came into existence. Financial intermediation in the
organized sector is conducted by a wide range of institutions
functioning under the overall surveillance of the Reserve Bank of India. In
theinitial stages, the role of the intermediary was mostly related to ensure
transfer of funds from the lender to the borrower.
Thisservice was offered by banks, FIs, brokers, and dealers.
However, as the financial system widened along with the developments
taking place in the financial markets, the scope of its operations also
widened. Some of the important intermediaries operating in t he financial
markets include; investment bankers, underwriters, stock exchanges,
registrars, depositories, custodians, portfolio managers, mutual funds,
financial advertisers financial consultants, primary dealers, satellite
dealers, self regulator y,' orga nizations, etc. Though the markets are
different, there may be a few intermediaries offering their services in
more than one market e.g. underwriter. However, the services offered by
them vary from one market to another.munotes.in

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13Intermediary Market Role
Stock Exchange Capital Market Secondary Market to
securities
Investment Banker s Capital Market, Credit
MarketCorporate advisory services,
Issue of securities
Underwriters Capital Market, Money
MarketSubscribe to unsubscribed
portion of securities
Registrars, Depositories,
CustodiansCapital Market Issue securities to the
investors on behalf of the
company and handle share
transfer activity
Primary Dealers Satellite
DealersMoney Market Market making in
government securities
Forex Dealers Forex Market Ensure exchange ink
Currencies
It is the combined working of these institutions, which enables the
financial system to function efficiently. In any economy, there are
organized systems of borrowers and lenders which are brought together
by f inancial institutions and therefore, they are known as financial
intermediaries.
In India, these financial institutions are :
1.Reserve Bank of India :
This is the apex of the financial system, established in 1934 and
nationalized in 1949. It functions as banker to the government, supplier
and controller of money and credit, maker of monetary policy and
collector of financial information and data .It controls the working of
rest of the financial systems directly or indirectly through money supply,
credi ts u p p l yb yu s i n gi n s t r u m e n t so fb a n kr a t e ,o p e nm a r k e to p e r a t i o n s ,
margins, rationing, directives etc.
2.Commercial Bank :
Commercial banks are a very important component of financial
institutions. They constitute the main supply of short -term and mediu m
term credit for domestic as well as foreign trade. Commercial banks
include nationalized banks, private commercial banks, co-operative
banks as also foreign banks, which through a network of branches make
short term and medium term finance available to c ottage, small and large
industry, trade and business as also agriculture and infrastructural
projects by mobilization of savings.
3.Financial Corporations :
After independence, financial system of India went on expanding.
In 1948, Industrial Finance Cor poration of India was established. In
1956, Industrial Credit and Investment Corporation of India established,munotes.in

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14in 1964 Industrial Development Bank of India was established, and
Industrial Reconstruction Bank of India was established in 1971, whereas
state government established State Finance Corporations. At a late stage,
Small Industries Development Ba nk of India was established. ICICI and
IDBI got converted in to banks recently.
4.Insurance Companies :
Before independence ,Private sector insurance comp anies was
formed, but then Life Insurance Corporation of India in the public
sector were established along with four subsidiaries of General
Insurance Corporation. After 1998, again private sector insurance
companies like Ba jaj-Allianz, New York Max Life I nsurance, ICICI
Prudential etc. came into being.
5. Mutual Funds :
For people ,small means it is not possible to invest in corporate
equity because of their small savings. Mutual Funds are established by
different major banks to mobilize small savings a ndchannelize the same
in industrial investment through efficient management and to minimize
risk for small investors. Unit Trust of India pioneered in this sector.
6.NABARD :
National Bank for Agricultural and Rural Development was
established in 1982 forshort term as well as long term finance for
agriculture through co -operative credit system.
7.PostOffice :
Post Offices in India run a banking unit to collect small savings
of the people and make them available for public sector investment. State
Bank of India runs a scheme for Public Provident Funds and we have
National Housing Bank also, which provides finance for construction
sector.
2.3 FI NANCIAL PRODUCTS
Financial products are classified into three main categories
depending upon their inhere nt function from the investor's perspective.
As a result of investing in one of the available types of financial
products, an investor either becomes an owner, a creditor, or gains the
right to purchase or sell a product. Some of the more popular financial
products include shares, bonds, investment funds, warrants and options.
Shares which are usually thought of as stock represent
ownership in a company. They are typically offered on public trading
markets in exchange for a certain monetary value. Investor sp a yt h e
specified price for an amount of shares in hopes that the value will
increase over time. The company selling the shares receives the funds it
needs to keep its operations afloat. Shares can also earn dividend income,
which represents a portion of the issuing company's profits that are
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15Bonds are financial products that represent a debt that the issuing
company owes to its investors. Unlike shares, the investor does not have
an ownership claim. This type of investment t ypically has a lower yield or
return than shares do, but it also carries less risk. Investors exchange cash
which is paid back by the company at a certain future date, along with
interest.
If an investor wishes to liquidate his bonds prior to the date tha t
they are scheduled to mature, they may sell them back. The value of the
bond will most likely not have reached its face value, which represents the
amount that is scheduled to bepaid back at maturity. The investor will
receive the market value of the bo nd, which may be less or more than
heoriginally paid for it. Private companies an dthe government ,both
sell bonds to the general public.
Investment funds are financial products that may consist of money
market, equity or bond funds. They do not usually invest in one particular
company or source. These funds use pooled sources of cash to purchase a
variety of stocks, bonds or very low -riskinvestments in order to diversify
and reduce risk. Depending upon an investor's financial goals, investment
funds mig ht range from high risk international shares to stable bonds with a
low rate of return similar to a savings account.
Warrants and options both consist of the option to buy and the
option to sell a financial product. The investor does not acquire ownership
or creditor status. Options are the privilege to buy or sell stock at a certain
price, whereas warrants are the privilege to buy or sell bonds. The premise
behind these types of investments is referred to as hedging, which is the
hope that the market valu e of the stock or bond will change in the way the
investor predicts.
2.4 FU NCTIO NSO FF I NANCIAL SYSTEM
Functions of Financial System are given in the diagram below.
Functio ns and Role of financial system market is given below,munotes.in

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161.Pooling of Funds
Ina financial system, the Savings of people are transferred from
households to business organizations. With these production increases
and better goods are manufactured, which increases the standard of living
of people.
2.Capital Formation
Business requir es finance. These are made available through banks,
households and different financial institutions. They mobilize savings which
leads to Capital Formation.
3.Facilitates Payment
The financial system offers convenient modes of payment for goods
and servi ces. New methods of payments like credit cards, debit cards,
cheques, etc. facilitates quick and easy transactions.
4.Provides Liquidity
In financial system, liquidity means the ability to convert into cash.
The financial market provides the investors th e opportunity to liquidate their
investments, which are in instruments like shares, debentures, bonds, etc.
Price is determined on the daily basis according to the operations of the
market force of demand and supply.
5.Short and Long Term Needs
The finan cial market ta kes into account the various needs of
different individuals and organizations. This facilitates optimum use of
finances for productive purposes.
6.Risk Function
The financial markets provide protection against life, health and
income risks .RiskManagement is an essential component of a growing
economy.
7.Better Decisions
Financial Markets provide information about the market and
various financial assets. This helps the investors to compare different
investment options and choose the bes to n e . It helps in decision making in
choosing portfolio allocations of their wealth.
8.Finances Government Needs
Government needs huge amount of money for the development
of defense infrastructure. It also requires finance for social welfare
activities , public health, education, etc. This is supplied to them byfinancial
markets.
9.Economic Development
India is a mixed economy. The Government intervenes in the
financial system to influence macro -economic variables like interest rate
or inflation. Thu s, credits can be made available to corporate at a cheaper
rate. This leads to economic development of the nation.munotes.in

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172.5SELF STUDY
I.Fill in the Blanks
1)The term financial intermediary may refer to ______________
between two or more parties in a context
2)The ______________ who borrows money from the Financial
Intermediaries / Institutions pays higher amount of interest than that
received by the ________________.
3) Financial Intermediaries / Institutions offer _________________ and
charges a fee accord ingly for the services rendered.
4) The issuer should then ensure that these financial assets reach the
ultimate _______________ inorder to _____________ the requisite
amount
5) RBI is the apex of the financial system, established in _______ and
national ized in ________________.
6) Commercial banks include nationalized banks, private
commercial banks, ____________ banks as also __________
banks .
7) Industrial Finance Corporation of India was established in ____ .
8) Industrial Credit and Investment Corporation of India were
established in _________________ .
9) Industrial Development Bank of India was established in _____.
10) Industrial Reconstruction Bank of India was established in
____________
11) Mutual Funds are established by differ ent major banks to mobilize
small _____________ and channelize the same in ____________.
12) ________________ was established in 1982 for ___________
through ______________ credit system.
13. Investors pay the specified ____________ for an amount of
shares.
14) _________ companies and the __________ both sell bonds to the
general public.
15) _________ both consist of the option to buy and the option to sell
af i n a n c i a l product.
16) In a financial system, the Savings of people are transferred from
______ ______ to____________ organizations.
17) The financial system offers convenient modes of payment for
____________ and__________.
18) The financial market provides the investors the opportunity to
______________ their ______________.munotes.in

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1819) ___________ Management is an essential component of a
___________ economy.
20) Financial Markets provide information about the __________ and
various financial __________.
[Ans.: (1) intermediation, financial; (2) borrower, actual lender; (3)
advisory financial services ; (4) investor, garner; (5) 1934,1949; (6)
cooperative, foreign; (7) 1948; (8) 1956; (9) 1964; (10) 1971; (11) savings ,
industrial investment; (12) National Bank for Agricultural and Rural
Development, agriculture, co -operative; (13) price; (14) Private,
government; (15) Warrants and options; (16) households, business; (17)
goods, services; (18) liquidate, investments; (19) Risk, growing; (20)
market, assets.]
II.State the following are True or False
1. The term financial intermediary does not refer to intermediation
between two or more parties in a financial context.
2. The borrower who borrows money from the Financial
Intermediaries/Institutions pays less amount of interest than that
received by the actual lender.
3. Financial Intermediaries / Institutions offe ra d v i s o r yf i n a n c i a l
services and charge a fee accordingly for the services rendered.
4. The issuer should then ensure that these financial assets does not
reach the investor in order to garner the requisite amount.
5. RBI is the apex of the financial system, es tablished in 1932 and
nationalized in 1936.
6. Commercial banks include nationalized banks, private
commercial banks, Cooperative banks as also foreign banks.
7. Industrial Finance Corporation of India was established in 1949.
8. Industrial Credit and Investment Corporation of India were
established in 1955.
9. Industrial Development Bank of India was established in 1964.
10.Industrial Reconstruction Bank of India was established in 1971.
11.Mutual Funds are established by different major banks to mobilize
small savings a ndchannelize the same in industrial investment.
12.National Bank for Agricultural and Rural Development was
established in 1982 for commercial purpose through co -operative
credit system.
13.Investors pay the specified price for an amount of shares.
14.Private comp anies and the government both sell bonds to the
general public.
15.Warrants and options both consist of the option to buy and the
option to sell a financial product.munotes.in

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1916.In a financial system, the Savings of people are transferred from
business organizations to business.
17.The financial system offers convenient modes of payment for
goods and services.
18.The financial market provides the borrower the opportunity to
liquidate thei rinvestments.
19.Risk Management is an essential component of a growing
economy.
20.Financial Markets provide information about the commodity
market and various immovable assets.
Ans.: [True : 3, 69,10,11,13,14,15,17,19 False : 1, 2, 4, 5, 7, 8,12, 16, 18,
20]
III.Match the following
Intermediary Market Role
Stock Exchange Capital Market Subscribe to
unsubscribed portion
of securities
Investment Banker Money Market Secondary Market to
securities
Underwriters Capital Market, Money
MarketCorporate advisory
services, Issue of
securities
Registrars,
Depositories,
CustodiansCredit M arket Issues securities to the
investors on behalf of
the company and
handle share transfer
activity
Primary Dealers
Satellite DealersCapital Market Ensure exchange ink
Currencies
Forex Dealers Forex Market Market making in
government securities
IV. Answer the following:
a)Explain the term financial intermediaries?
b)What is asset based financial intermediaries?
c)What are the different types of financial products?
d)What are the different types of financial intermediaries?
e)What are the functions of f inancial systems?
f)Explain the functions of financial systems?munotes.in

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20g)What is warrant & option?
h)What is fee based financial intermediaries?
i)Write Short notes on:
1.Role of financial system
2.Functions of financial system
3.Investment
4.Bonds
5.Shares
6.Asset Based financial intermediaries
7.Adviso ryf i n a n c i a li n t e r m e d i a r i e s
8.Warrant & Options

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213
REGULATORY FRAMEWORK OF I NDIAN
FINANCIAL SYSTEM
Unit Structure :
3.1 Introduction
3.2 Securities and Exchange Board of India (SEBI)
3.3 Objectives
3.4 SEBI Guidelines for Capital Market
3.5 SEBI reforms on Stock Exchanges
3.6 SEBI on IPO
3.7 Role of SEBI in regulating Indian Capital Market
3.8 Important steps taken by SEBI for the regulation of mutual funds
3.9 Self Study
3.1 INTRODUCTIO N
SEBI is regulator to control Indian capital market. Since its
establ ishment in 1992, it is doing hard work for protecting the interests of
Indian investors. SEBI gets education from past cheating with native
investors of India. Now, SEBI is stricter with those who commit frauds in
capital market. The role of security excha nge board of India (SEBI) in
regulating Indian capital market is very important because government of
India can only open or take decision to open new stock exchange in India
after getting advice from SEBI.
3.2 SECURITIES A ND EXCHA NGE BOARD OF I NDIA
(SEB I)
The Government has set up the Securities & Exchange Board of
India (SEBI) in April 1988. For more than three years, it had no statutory
powers. Its interim functions during the period were :
1)To collect information and advice the Government on matt ers relating
to Stock and Capital Markets.
2)Licensing and regulation of merchant banks, mutual funds etc.
3)To prepare the legal drafts for regulatory and development role of
SEBI, and
4)To perform any other functions as may be entrusted to it by th e
Government.munotes.in

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22The need for setting up independent Government agency to
regulate and develop the Stock and Capital Market in India as in many
developed countries was recognized since the Sixth Five Year Plan was
launched (1985) when some major industrial policy changes like opening
up of the economy to outside world and greater role to the Private Sector
were initiated. The rampant malpractices noticed in the Stock and Capital
Market stood in the way of infusing confidence of investors, which is
necessary for mobilization of larger quantity of funds from the public, and
helps the growth of the industry.
The malpractices were noticed in the case of companies, merchant
bankers and brokers who are all operating in the Capital Market. The need
to curb these malpractices and to promote healthy Capital Market in India
was felt. The security industry in India has to develop on the right lines for
which a competent Government agency as in U.K. (SIB) or in U.S.A.
(SEC) is needed.
Malpractices have been reported in both the primary market and
secondary market. Malpractices in the primary market are as follows :
Too many self style Investment Advisors and Consultants.
Grey Market or unofficial premiums on the new issues.
Manipulation of market prices before new issues is floated.
Delay in allotment letters or refund orders or in dispatch of share
certificates.
Delay in listing and commencement of trading in shares.
Malpractices in the Secondary Market are as follows :
Lack of transparency in the trading opera tions and prices charged to
clients.
Poor services due to delay in passing contract notes or not passing
contract notes, at all.
Delay in making payments to clients or in giving delivery of shares.
Persistence of odd lots and refusal of companies to sto p this practice of
allotting shares in odd lots.
Insider trading by agents of companies or brokers rigging and
manipulating prices.
Takeover bids to de -stabilize the management.
3.3 OBJECTIVES
The objectives of SEBI are as follows :
Investor protect ion, so that there is a steady flow of savings into the
Capital Market.
Ensuring the fair practices by the issuers of securities, namely,
companies so that they can raise resources at least cost.munotes.in

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23Promotion of efficient services by brokers, merchant banke rs and other
intermediaries so that they become competitive and professional.
Pending the legislative sanction to SEBI it carried out the functions of
supervisory and advisory body of the Government. It has initiated the
basis for control and regulation of the market, arranged for the licensing of
merchant banks, mutual funds etc. and performed the advisory functions to
the Govt. The legislation giving powers to SEBI was passed on 4thApril
1992 in the form of the securities & Exchange Board of India Act to
protect the interests of investors in securities and to promote the
development of and to regulate the securities market and for matters
connected therewith or incidental thereto.
3.4 SEBI GUIDELI NES FOR CAPITAL MARKET
Repealing of Competition Commi ssion of India (CCI) Act :
SEBI guidelines were issued after the repeal of the CCI Act
whereby the CCI guidelines became out of date. New guidelines by SEBI
were issued starting from the month of June 1992. Some CCI guidelines
were still retained, as in t he case of those for premium fixation.
Guidelines for new issues made by new companies :
They have to be issued at par. Free pricing is permitted only if the
new company is promoted by the existing company with not less than 50%
of equity.
Guidelines for new issues made by private limited companies :
New issues made by Private Limited Companies and Closely held
companies could be made by free pricing, for listing purposes if such
companies have had three years of track record of consistent profitabili ty
out of last 5 years. Not less than 20% of equity is to be offered to the
public in such cases.
Guidelines for new issues made by existing listed companies :
Public issues by existing listed companies can be made through
free pricing, if there are fur ther issues and if they are disclosed in the
prospectus. The Net Asset Value and the market price have to be
considered for the last 3 years. The companies with foreign holding
wishing to enhance the limit up to 51% will have to get the prices
approved in the general body meeting by a special resolution under Sec.
81 (A) of the Companies Act, and subject to RBI approval.
Listing of shares on the Over the Counter (OTC) :
If the new issues are made through OTC, normal guidelines will
apply if the sponsor i s not taking any share. If the shares are taken by the
sponsor, subsequent offer to the public may be made at such a price as the
sponsor may deem fit. The promoters should retain 25% quota with a lock
in period of 5 years, the sponsor should act as market maker for a period
of at least 3 years and also find another market maker for compulsorymunotes.in

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24market making. This condition was relaxed recently to encourage OTC
Listing.
Underwriting Issues :
Underwriting is optional if the issues is made to the public and
should not include reserved or preferential quota or employees quota. If
the subscription is not up to 90% of the total issue from the public
including contribution of underwriters, the public should be refunded of
their subscription within 120 days from the date of opening the issue. The
compulsory underwriting provision was also waived for smaller issues.
Composite issues :
Issues to the public by existing company can be priced differently
as compared to the rights issued to shareholders. Fully Conver tible
Debentures (FCD) & Partially Convertible Debentures (PCD). The issues
of Fully Convertible Debentures (FCDs) with a conversion period of more
than 36 months will not be permissible unless conversion is optional. In
case FCDs are convertible after 18 months, credit rating is compulsory;
credit rating is now made compulsory for all issues made to public, other
than equity. In case, the nonconvertible portion of the Partially
Convertible Debentures is to be rolled over, non -maturing debenture
holders sho uld have option to withdraw from the scheme.
New Financial Instruments :
The terms and conditions of the new instruments such as Deep
Discount Bonds, debentures with warrants and secured premium notes etc.
should be disclosed clearly so that the investo r can assess the risk and
return scenario of the instrument.
Reservation in issues :
The unreserved portion offered to public should not be less than
the minimum required for listing purposes. Preferential allotment, can be
made to promoters, companies and shareholders of those companies,
NRIs, employees and associate companies of the same group. The
allotment shall be subject to a lock in period of three years, if it is made on
firm basis, outside public issue.
Deployment of issue proceeds :
Where th e total proceeds exceed `250 crores, the company will
voluntarily disclose the arrangements made to utilize proceeds. When the
total issue proceeds exceed `500 crores, there is need for making
compulsory disclosure and for the financial institutions to mon itor the
deployment of funds, to the stock exchanges.
Minimum interval between two issues :
12 months should elapse between the public or rights issue and
bonus issue. The promoters should bring in their share of the capital
before the public issue.munotes.in

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25Employee’s stock option scheme :
The reservation for employees should not be more than 10% at
present and this quota is non -transferable for 3 years and subject to a
maximum allotment of 200 shares per employee, and the lock in was
removed later. The Lock in period for Promoters quota is 5 years and the
lock in period for preferential allotment for associates and friends is 3
years.
Bonus Shares :
Bonus issues are to be made out of free reserves, the share
premium collected in cash, Development Rebate R eserves (DRR) and
Investment Allowance Reserve. Contingent liabilities disclosed in the
audited accounts should be deducted from net profit for calculation of
residual reserves. Residual reserves after the bonus issues should be at
least 40% of the increas ed paid -up capital. 30% of the average profits
before tax for the previous 3 years should yield a rate of dividend of 10%
andthe expanded capital base. Reserves out of revaluation should not be
used for bonus payment. Bonus issues cannot be made in lieu o f
dividends, and if there are partly paid up shares, no bonus issue is
permitted. Expanded paid -up capital after bonus issue should not exceed
authorized share capital. When a company has PCD or FCD, pending
conversion, no bonus issues can be made unless t his right is kept open to
the holders of PCD and PCD falling due for conversion within 12 months.
Debentures issues :
All debentures, which have a life of more than 18 months, should
have a Development Rebate Reserve created by company out of profit.
Development Rebate Reserve should be created only for nonconvertible
portion of the debentures. Contribution to Development Rebate Reserve
should commence from the date of commercial production and when there
are profits after tax, interest and depreciation. The Development Rebate
Reserve will be considered as a part of the general reserves for payment of
the bonus issues. Development Rebate Reserve should be created and
maintained at 50% of the amount of the debentures before repayment
starts. The company sh ould have already redeemed some liability.
Development Rebate Reserve and the creation of Debenture Trust are
necessary only if the debentures have a maturity period exceeding 18
months. The Lead Institution for each issue should monitor the use of
debentu re funds either from the working capital or from the project
finance. The SEBI insists on prior licensing of debenture Trustee; Trust
deed should be ready within 6 months from the date of allotment.
By an amendment to Listing Agreement, the Companies ha ve been
asked to provide unabridged Balance Sheet to Shareholders. The
companies have to give the disposition of the funds raised in public issues
and compare the actual with targets every six months, when they present
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263.5 SE BI REFORMS O NSTOCK EXCHA NGES
The SEBI regulation of stock exchanges and their members had
started as early as February 1992 and the reforms later introduced have
been on a continuous basis. It was started with the licensing and
registration of brokers and sub -brokers in the recognized stock exchanges.
This was later extended to underwriters, portfolio managers and other
categories of players in the stock market including foreign securities firms,
Foreign Financial Institute (FFIS) Financial Investment I nstitute (FIIs),
Debenture Trustee, Collecting Bankers, etc.
The other reforms are briefly summarized below :
1)Compulsory audit and inspection of stock exchanges and their member
brokers and their accounts.
2)Transparency in the prices and brokerage charged by brokers by
showing them in their contract notes.
3)Broker accounts and client accounts are to be kept separate and clients
money is to be separately maintained in bank’s accounts and the same
to be reported to the stock exchanges.
4)Board of Directors of stock exchanges has to be reconstituted so as to
include non -brokers, public representative, and Government
representatives to the extent of 50% of the total number of members.
5)Capital adequacy norms have been laid down for members of var ious
stock exchanges separately and depending on their turnover of trade
and other factors.
6)Guidelines have been laid down for dealings of FIIs and Foreign
broker firms in the Indian stock exchanges through Indian brokers.
7)New guidelines for corpor ate members have been laid down with
limited liability of directors and opening up of their membership to
more than one stock exchange without the limiting requirement of
experience of five years in one exchange, as imposed earlier.
The term “Investor Protection” is a wide term encompassing
various measures designed to protect the investors from malpractices of
companies, brokers, merchant bankers, issue managers, Registrars of new
issue, etc. “Investors Beware” should be the watchword of all programs
for mobilization of savings for investment. As all investments have some
risk element, this risk factor should be borne in mind by the investors and
they should take all precautions to protect their interests in the first place.
If caution is made to the in vestor and if they invest in any venture without
a proper assessment of the risk, they have only to blame themselves. But if
there are malpractices by companies, brokers, etc., they have every reason
to complain. Such grievances have been increasing in num ber.munotes.in

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27The complaints of investors come from two major sources :
Against member broker of Stock Exchanges;
Against companies listed for trading on the Stock Exchanges.
Besides, there can be complaints against sub -brokers, agents,
merchant bankers, i ssue managers, etc., which cannot be entertained by
the stock exchanges as per their rules.
Complaints against Members :
Investors have complaints against brokers regarding the price,
quantity etc. at which transactions are put through, defective deliv ery or
delayed delivery, de layed payment or non -payment ., non -payment of
agreed brokerage to authorized assistants, et c. In the event of default of a
member broker, the dues of clients are also to be looked into.
Complaints against Companies :
The comp laints against companies are in the nature of non -receipt
of allotment letters, refund orders, non -receipt of dividends, interest etc.,
delay in transfer of shares and in splitting and consolidation. The clearance
of these complaints is attended to by the grievance cell by writing to the
companies, follow -up telexes, etc. and finally by warning to de -list the
companies concerned. But the clearances of these complaints are slow due
to the non -compliance or slow compliance by the companies to the
references m ade b ythe cell. The powers of the Stock Exchange are limited
to warnings and delisting of shares and as such compliance by the
companies as poor. SEBI has now powers to penalize companies violating
the listing norms.
Grievances Cell :
There is a Griev ance Cell in all Stock Exchanges, which attends to
investor complaints. Of the total, nearly 95% are against companies and
they are more difficult to settle, as many companies do not attend to the
complaints promptly despite reminders and warnings by the s tock
exchange, in view of the fact that penal powers of the Exchange are
limited. The grievance procedure in respect of complaints against
members is as follows :
1)Joint meeting of member vis -à-vis the clients for an amicable
settlement.
2)Arbitration proceedings by the committee under the by -laws.
3)Special committee appointed by the Executive Director for settlement.
4)Disciplinary proceedings including warnings, fines, penalties etc.
particularly in cases of fraud, cheating etc. by the members.
Customer’s Protection Fund :
The Customer’s Protection Fund is constituted by the Stock
Exchanges to safeguard the interests of the investor clients from default of
the stockbrokers. The Fund is financed by way of a levy on the turnover ofmunotes.in

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28members and from out of the listing fees, earmarked by the Exchanges.
The Fund is being administered by the Stock Exchange for the benefit of
the clients of the member brokers, in case of a default of a member. The
compensation of any single client is, however, limite d to Rs. 2 lakh at
present. When a member is declared a defaulter, the net assets in the hands
of the defaulter’s Committee after defraying costs, charges, expenses etc.,
relating to the realization of the assets will be used to meet the claims of
the exch ange, clearing house and then the admitted claims of the members
of the exchange against the defaulter. After meeting all these claims, if
anything is left over, the claims of the clients of the defaulting member
will be satisfied. If nothing is left over, the genuine claims of clients can
be met from the Customer’s Protection Fund. This is the same procedure
adopted by other Exchanges also where this Fund was set up.
3.6 SEBI O NINITIAL PUBLIC OFFER (IPO)
The SEBI has listed companies whose shares have to be traded and
settled in electronic book entry form 4thJanuary, 2000. The demat form of
issue of initial public offers of new issues is made compulsory. This is
made compulsory for all companies, so as to encourage demat form of
trading through electr onic book entry system. To develop the debt market,
in collaboration with the RBI, a committee was appointed, as per the SEBI
announcement early in February 2000. The SEBI also announced that
Registrars of new issues under IPO could also undertake the depo sitory
functions for those issues. Some of the Reforms in the primary market
were referred to earlier in this book. The major reforms relate to
registration and enforcement of a code of conduct on all the intermediaries
in the market, extension of regulati on to UTI along with all mutual funds
in the private and public sectors and to Money Market Mutual Funds
which were so far regulated by the RBI and enforcement of all regulations
on venture capital funds on par with all mutual funds and on FIIs and FFIs
along with the powers exercised by the RBI unde r the FEMA. Even credit
rating a gencies are brought under the Guidelines of the SEBI. New issues
under IPOs are brought compulsorily under the fold of Demat form of
allotment of new issues to 30 days and enforce d stricter surveillance on
end use of funds raised through public offer, reduced the malpractices in
the new issue market, such as price rigging and insider trading etc. The
problems of bad delivery and delays in transfer of shares odd lots etc. were
solve d by making the trading as well as transfers in demat form of
electronic book entry.
3.7 ROLE OF SEBI I NREGULATI NGINDIANCAPITAL
MARKET
1)Power to make rules for controlling stock exchange :
SEBI has power to make new rules for controlling stock e xchange
in India for example, SEBI fixed the time of trading 9 AM and 5 PM in
stock market.munotes.in

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292)To provide license to dealers and brokers :
SEBI has power to provide license to dealers and brokers of capital
market. If SEBI sees that any financial produ ct is of capital natur e, then
SEBI can also control that product and its dealers. One of themain
example is ULIPs case. SEBI said, “It is just like mutual funds and all
banks and financial and insurance companies who want to issue it must
take permission from SEBI.”
3)To stop fraud in Capital Market :
SEBI has many powers for stopping fraud in capital market. It can
ban on the trading of those brokers who are involved in fraudulent and
unfair trade practices relating to stock market. It can impose the penalties
on capital market intermediaries if they involve in insider trading.
4)To Control the Merger, Acquisition and Takeover the companies :
Many big companies in India want to create monopoly in capital
market. So, these companies buy all other c ompanies or deal in merging.
SEBI sees whether this merger or acquisition is for development of
business or to harm capital market.
5)To audit the performance of stock market :
SEBI uses his powers to audit the performance of different Indian
stock ex change for bringing transparency in the working of stock
exchanges.
6)To make new rules on carry –forward transactions :
Share trading transactions carry forward cannot exceed 25% of
broker’s total transactions 90 day limit for carry forward.
7)Tocreate relationship with Institute of chartered Accountants of
India (ICAI) :
ICAI is the authority for making new auditors of companies. SEBI
creates good relationship with ICAI for bringing more transparency in the
auditing work of company accounts be cause audited financial statements
are mirror to see the real face of company and after these investors can
decide to invest or not to invest. Moreover, investors of India can easily
trust on audited financial reports. After Satyam Scam, SEBI is
investigat ing with ICAI, whether CAs are doing their duty by ethical way
or not.
8)Introduction of derivative contracts on Volatility Index :
1)For reducing the risk of investors, SEBI has now decided to permit
Stock Exchanges to introduce derivative contracts o n Volatility Index,
subject to the condition that;
a)The underlying Volatility Index has a track record of at least one year.
b)The Exchange has in place the appropriate risk management
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302)Before introduction of such contracts, the Stock Exchanges shall
submit the following :
i)Contract specifications
ii)Position and Exercise Limits
iii)Margins
iv)The economic purpose it is intended to serve
v)Likely contribution to market development
vi)The safe guards and the risk protection mechanism adopted by the
exchange to ensure market integrity, protection of investors and
smooth and orderly trading.
vii)The infrastructure of the exchange and the surveillance system to
effectively monitor trading in suc h contracts, and
viii) Details of settlement procedure & systems.
ix)Details of back testing of the margin calculation for a period of one
year considering a call and a put option on the underlying with a
delta of 0.25 & -0.25 respectively and actual value of the
underlying.
9)To require report of Portfolio Management Activities :
1)SEBI has also power to require report of portfolio management to
check the capital market performance.
2)To educate the investors
Time to time, SEBI arranges schedul ed workshops to educate the
investors. Investor can get education through SEBI leaders by getting
up to date information.
3.8 IMPORTA NT STEPS TAKE NBY SEBI FOR THE
REGULATIO NOF MUTUAL FU NDS
1)Formation :
Certain structural changes have also been mad e in the mutual fund
industry, as part of which mutual funds are required to set up asset
management companies with fifty percent independent directors, separate
board of trustee companies, consisting of a minimum fifty percent of
independent trustees and to appoint independent custodians.
This is to ensure an arm’s length relationship between trustees,
fund ma nagers and custodians, and is a contrast with the situation
prevailing earlier in which all three functions were often performed by one
body whic h was usually the sponsor of the fund or a subsidiary of the
sponsor.
Thus, the process of forming and floating mutual funds has been
made a tripartite exercise by authorities. The trustees, the asset
management companies (AMCs) and the mutual fund sha reholders formmunotes.in

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31the three legs. SEBI guidelines provide for the trustees to maintain an
arm’s length relationship with the AMCs and do all those things that
would secure the right of investors.
With funds being managed by AMCs and custody of assets
rema ining with trustees, an element of counter -balancing of risks exists as
both can keep tabs on each other.
2)Registration :
In January, 1993 SEBI prescribed registration of mutual funds
taking into account track record of a sponsor, integrity in busine ss
transactions and financial soundness while granting permission.
This will curb excessive growth of the mutual funds and protect
investor’s interest by registering only the sound promoters with a proven
track record and financial strength. In Februar y 1993, SEBI cleared six
private sector mutual funds viz. 20thCentury Finance Corporation,
Industrial Credit & Investment Corporation of India, Tata Sons, Credit
Capital Finance Corporation, Ceat Financial Services and Apple
Industries.
3)Documents :
The offer documents of schemes launched by mutual funds and the
scheme particulars are required to be vetted by SEBI. A standard format
for mutual fund prospectuses is being formulated.
4)Code of advertisement :
Mutual funds have been required to adh ere to a code of
advertisement.
5)Assurance on returns :
SEBI has introduced a change in the Securities Control and
Regulations Act governing the mutual funds. Now the mutual funds were
prevented from giving any assurance on the land of returns they w ould be
providing. However, under pressure from the mutual funds, SEBI revised
the guidelines allowing assurances on return subject to certain conditions.
Hence, only those mutual funds which have been in the market for
at least five years are allowed to assure a maximum return of 12 percent
only, for one year. With this, SEBI, by default, allowed public sector
mutual funds an advantage against the newly set up private mutual funds.
As per basic tenets of investment, it can be justifiably argued tha t
investments in the capital market carried a certain amount of risk, and any
investor investing in the markets with an aim of making profit from capital
appreciation or otherwise, should also be prepared to bear the risks of loss.
6)Minimum corpus :
The current SEBI guidelines on mutual funds prescribe a minimum
start-up corpus of `50 Crore for an open -ended scheme, and `20 Crore
corpus for closed -ended scheme, failing which application money has to
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32The idea behind forwarding such a pr oposal to SEBI is that in the
past, the minimum corpus requirements have forced AMCs to solicit funds
from corporate bodies, thus reducing mutual funds into quasi -portfolio
management outfits. In fact, the Association of Mutual Funds in India
(AMFI) has re peatedly appealed to the regulatory authorities for scrapping
the minimum corpus requirements.
7)Institutionalization :
The efforts of SEBI have, in the last few years, been to
institutionalize the market by introducing proportionate allotment and
increasing the minimum deposit amount to `5000 etc. These efforts are to
channel the investment of individual investors into the mutual funds.
8)Investment of funds mobilized :
In November, 1992 SEBI increased the time limit from six months
to nine month s within which the mutual funds have to invest resources
raised from the latest tax saving schemes. The guideline was issued to
protect the mutual funds from the disadvantages of investing funds in the
bullish market at very high prices and suffering from poor NAV thereafter.
9)Investment in money market :
SEBI guidelines say that mutual funds can invest a maximum of 25
percent of resources mobilized into money -market instruments in the first
six months after closing the funds and a maximum of 15 perce nt of the
corpus after six months to meet short term liquidity requirements.
Private sector mutual funds, for the first time, were allowed to
invest in the call money market after this year’s budget. However, as SEBI
regulations limit their exposure to money markets, mutual funds are not
major players in the call money market. Thus, mutual funds do not have a
significant impact on the call money market.
10)Valuation of investment :
The transparent and well understood declaration or Net Asset
Values (NAVs) of mutual fund schemes is an important issue in providing
investors with information as to the performance of the fund. SEBI has
warned some mutual funds earlier of unhealthy market.
11)Inspection :
SEBI inspect mutual funds every year. A full SEBI inspection of
all the 27 mutual funds was proposed to be done by the March, 1996 to
streamline their operations and protect the investor’s interests. Mutual
funds are monitored and inspected by SEBI to ensure compliance with the
regulations.
12)Underwriting :
In July, 1994 SEBI permitted mutual funds to take up underwriting
of primary issues as a part of their investment activity. This step may
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3313)Conduct :
In September, 1994 it was cla rified by SEBI that mutual funds
shall not offer buy back schemes or assured returns to corporate investors.
The Regulations governing Mutual Funds and Portfolio Managers ensure
transparency in their functioning.
14)Voting rights :
In September, 1993 mutual funds were allowed to exercise their
voting rights. Department of Company Affairs has reportedly granted
mutual funds the right to vote as full -fledged shareholders in companies
where they have equity investments.
3.9 SELF STUDY
I.Fill in the b lanks.
1) SEBI is regulator to control Indian ________________ market.
2) SEBI is stricter with those who commit ______________ in capital
market.
3) The Government has set up the Securities & Exchange Board of India
(SEBI) in __________________.
4) The need for setting up independent Government agency to
_____________________ the _______________ Market in India.
5) The legislation giving powers to SEBI was passed on
_____________ in the form of the Securities & Exchange Board of
India.
6) Free pricin g is permitted only if the new company is promoted by the
existing company with not less than ________________.
7) Not less than ________________ is to be offered to the public.
8) The promoters should retain ______________ with a lock in period
of _____ ___________.
9) If the subscription is not up to _________________ of the total issue
from the public including contribution of ______________ the public
should be refunded of their subscription within ___________ from
the date of opening the issue.
10) The issues of Fully Convertible Debentures (FCDs) with a
conversion period of more than ________________ will not be
permissible unless conversion is __________________.
11) ________________ should elapse between the public or rights issue
and bonus issue .
12) The reservation for employees should not be more than
________________ at present and this quota is no -transferable for
________________.
13) _____________ issues are to be made out of free reserves.
14) _____________ disclosed in the audited acco unts should be deducted
from _________________.munotes.in

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3415) The ______________ will be considered as a part of the
______________ for payment of the bonus issues.
16) The SEBI insists on prior _____________ of debenture Trustees.
17) SEBI was started with the l icensing and registration of
_______________ in the recognized stock exchanges.
18) The term ________________ is a wide term encompassing various
measures designed to protect the investors.
19) SEBI has now powers to penalize companies _____________ the
listing norms.
20) The Customer’s Protection Fund is constituted by the Stock
Exchanges to safeguard the ______________ of the _______ clients
from default of the stockbrokers.
21) The compensation of any single client is, however, limited to
___________ _.
22) The SEBI has listed companies whose shares have to be traded and
settled in electronic book entry form ____________
23) SEBI has powers for stopping _____________ in capital market.
24) SEBI uses his powers to audit the performance of stock exchan ge for
bringing _______________ in the working of stock exchanges.
25) In ______________ SEBI prescribed registration of mutual funds
taking into account track record of a sponsor.
Ans : 1)Capital, 2)Frauds, 3)April 1988,
4)regulate and de velop, Stock and Capital,
5)4 April 1992, 6)50% of, equity, 7)20% of equity
8)25% quota, 5 years 9)90%, underwriters, 120 days,
10)optional, 12 months, 11)36 months, 12)10%, 3 years
13)Bonus, 14)Contingent liabilities, net pr ofit
15)Development Rebate, Reserve 16)General reserve;
17)Licensing, brokers and sub -brokers
18)“Investor Protection 19)violating
20)interests clients; 21)`2 lakh
22)4thJanuary, 2000 23)fraud
24)transparency 25)January, 1993
IIState whether the following are True or False.
1) SEBI is regulator to control Indian financial markets.
2) SEBI is stricter with those who commit loss in financial market.
3) The Government has set up the Securities & Exchange Board of In dia
(SEBI) in April 2000.
4) The need for setting up independent Government agency to regulate
and develop the Stock and Capital Market in India.
5) The Government gives powers to SEBI was passed on 4thApril, 1992
in the form of the Securities & Exchang e Board of India.munotes.in

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356) Free pricing is permitted only if the new company is promoted by the
existing company with not less than 50% of equity.
7) Not less than 50% of equity is to be offered to the public.
8) The promoters should retain 35% quota with a l ock in period of 3
years.
9) If the subscription is not up 70% of the total issue from the public
including contribution of underwriters, the public should be refunded
of their subscription within 130 days from the date of opening the
issue.
10) The issu es of Full Convertible Debentures (FCDs) with a conversion
period of more than 24 months will not be permissible unless
conversion is optional.
11) 12 months should elapse between the public or rights issue and bonus
issue.
12) The reservation for employ ee should not be more than 10% at present
and this quota is non -transferable for 3 years.
13) Bonus issues are to be made out of development reserves.
14) Reserves disclosed in the audited accounts should be deducted from
net profit.
15) The Development Rebate Reserve will be considered as a part of the
general reserve for payment of the bonus issues.
16) The SEBI insists on prior licensing of debenture Trustees.
17) SEBI was started with the licensing and registration of Companies in
the recognized st ock exchanges.
18) The term “Investor Protection” is a wide term encompassing various
measures designed to protect the investors.
19) SEBI has now powers to penalize companies violating the listing
norms.
20) The Customer’s Protection Fund is constitute d by the Stock
Exchange to safeguard the interests of the Companies from default of
the stockbrokers.
21) The compensation of any single client, is however, limited to `5 lakh.
22) The SEBI has listed companies whose share have to be traded and
settled in electronic book entry form from 4thJanuary, 2000.
23) SEBI has powers for stopping fraud in capital market.
24) SEBI uses his powers to audit the performance of stock exchange for
bringing systematic performance in the working of stock exchanges.
25) In January, 1993 SEBI prescribed registration of mutual funds taking
into account tract record of a sponsor.
Ans. True 4, 6, 11, 12, 15, 16, 18, 19, 22, 23, 25
False 1, 2, 3, 5, 7, 8, 9, 10, 13, 17, 20, 21, 24
III Answer the following :
1) Give an ove rview of Securities & Exchange Board of India?
2) Explain the functions of SEBI?
3) State 7 explain the malpractice in the primary & secondary market?munotes.in

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364) What are the objectives of SEBI?
5) State & explain the SEBI Guidelines for capital market?
6) State & explain the SEBI reforms on stock exchange?
7) What are the different sources of investor complaint?
8) What is grievance cell under SEBI?
9) Explain the role of SEBI on initial public offer?
10) What is the role of SEBI in regulating the capital market?
11) What are the important steps taken by SEBI for the regulation of
mutual fund?
12) Write Short notes on
i)Consumer protection fund
ii)Derivative contract on volatility index
iii)SEBI on Initial Public Offer
iv)Grievance Cell
v)SEBI reform so ns t o c ke x c h a n g e
vi)Overview of SEBI
IV Match the following :
Sr.
No.A Sr.
No.B
1.SEBI a.Mutual Fund
2.Legislation b.Protect investors from
malpractice
3.New issues by Private
Limited Companyc.Development Rebate
Reserve
4.Net Ass et Value d.Non transferable for 3
years
5.Promoter’s Quota e.120 days
6.Refund of public money f.5y e a r s
7.Employees State Option
Schemeg.Market price for 3 years
8.Debentures issue h.20% of equity
9.Investors Protection i.4thApril 1992
10. Code of Advertisement j.April 1988
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374
REGULATORY FRAMEWORK OF I NDIAN
FINANCIAL SYSTEM
Unit Structure :
4.1 Introduction
4.2 Role of RBI
4.3 Importance of RBI
RBI is the Issuer of Monetary Policy
RBI is the Issuer of Currency
RBI is the controller and Supervis or of Banking Syste ms
4.4 Self Study
4.1 INTRODUCTIO N
In every country there is one organization which works as the
central bank. The function of the central bank of a country is to control
and monitor the banking and financial system of the country. In India, the
Reser ve Bank of India (RBI) is the Central Bank .T h er e g u l a t o r so ft h e
Indian financial sector are the Reserve Bank of India, the Mini stryof
Finance (Income Tax Department), Foreign Exchange Dealers Association
ofIndia, Deposit Insurance and Credit Guarantee Corporation, Fixed
Income Money Market and Derivatives Association of India and the
Clearing Corporation of India Ltd. This chapter shall deal with the most
important of these regulators, the Reserve Bank of India.
4.2ROLE OF RBI AS REGULATOR
Reserve Ba nk of India is the apex monetary Institution of India. It
is also called as the central bank of the country. The Reserve Bank of
India was established on April 1, 1935 in accordance with the provisions
of the Reserve Bank of India Act, 1934. The Central Of ficeof the Reserve
Bank was initially established in Calcutta but was permanently moved to
Mumbai in 1937. The Central Office is where the Governor sits and
where policies are formulated. Though originally privately owned, since
nationalization in 1949, t he Reserve Bank is fully owned by the
Government of India.
It acts as the apex monetary authority of the country. The Central
Office is where the Governor sits and is where policies are formulated.
Though originally privately owned, since nationalization in 1949, the
Reserve Bank is fully owned by the Government of India. This actmunotes.in

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38empowers the central government, in consultatio n with the Governor of
the Bank, to issue such directions to RBI as might be considered
necessary in the public interest. A Central Board of Directors with 20
members consisting of the Governor and the Deputy Governors
governs RBI. The Governor and the deputy Governors of the Bank
areGovernment of India appointees.
The preamble of the reserve bank of India is as follows:
"...to reg ulate the issue of Bank Notes and keeping of reserves
with a view to securing monetary stability in India and generally to
operate the currency and credit system of the country to its advantage."
Thus, the basic functions of the RBI as stipulated in the Preamble
of the RBI Act are threefold: First, the RBI performs the function of
regulating the issue of bank notes (the RBI also exchanges or destroys
currency and coins not fit for circulation). In fact, by virtue of being the
sole authority for the issue of currency in the country, the RBI is
empowered to control money supply in the country; Second, the RBI
keeps reserves in order to maintain monetary stability in India; Third, the
RBI must operate the currency and credit system of India to its
advantage. In pursuance of this function, the RBI also has the
responsibility to maintain the internal and external value of the Indian
Rupee.
One of the functions the RBI performs is that it has a monopoly
with respect to the issue of currency (excluding one rupee coins and
notes which are issued by the Government of India) according to section
22 of the RBI Act. The notes are the liability of the Issue Department of
the RBI only and hence the assets of the Issue Department are also kept
separate from that of the Ba nking Department of the RBI. Such assets,
according to section 33 of the RBI Act, must consist of gold coins and
bullion, foreign securities, rupee coin, Government of India securities and
Bills of Exchange and Promissory Notes payable in India and as are
eligible for purchase by the RBI. As per amendments to the RBI Act, it
is mandated that the Issue Department of the RBI must at all times have
anaggregate value of gold bullion and foreign securities worth not less
than rupees two hundred crores of which gold coins and gold bull ion
should comprise no less than rupees hundred and fifteen crores.
Provided such minimum was maintained by the RBI the volume of
currency that can be issued by the RBI is not curtailed.
The RBI is also the regulator and supervisor of the financial system
in India . Firstly, RBI acts as a banker to both the Government of India and
the State Governments and therefore handles their current financial
transactions and also manages public debt. The RBI accepts money on
behalf of the gover nment and also makes payments for the Government.
Moreover, it acts, as a manger of foreign exchange under the Foreign
Exchange Management Act, 1999 and facilitates external trade and
payment. Secondly, it acts as a supervisor and regulator of the financia l
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39and non -banking finance companies under the guidance of the Board for
Financial Supervision which was established in 1994. It lays down broad
guidelines for banking operations wit hin the country and acts as a
banker to the scheduled banks. Commercial banks are expected to keep
deposits with the RBI and when necessary they borrow from the RBI (the
RBI functions as a lender of last resort to the commercial banks). The
RBIalso ensure s price stability within India by controlling the volume of
credit created by the commercial banks.
Lastly, the RBI also has a development role .Int h a ti tp e r f o r m s
av a r i e t yo fp r o m o t i o n a lf u n c t i o n sd i r e c t e da ts u p p o r t i n gn a t i o n a l
objectives. In pursuan ce of this function, the RBI has taken several
promotional measures such as the establishment of financial corporations
to ensure credit availability for the agricultural and industrial sector,
the promotion of the establishment of Regional Rural Banks so that
banking facilities may be available in the rural areas as well, the
establishment of the Export -Import bank in India to finance exports and
so on.
4.3IMPORTA NCE OF RBI AS REGULATORS
1)RBI is the Issuer of Monetary Policy
The RBI formulates monetar y policy twice a year. It reviews the
policy every quarter as well. The main objectives of monitoring monetary
policy are:
Inflation control
Control on bank credit
Interest rate control
The tools used for implementation of the objectives of monetary polic y
are:
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR),
Open market operations,
Different Rates such as repo rate, reverse repo rate, and bank rate.
2.RBI is the Issuer of Currency
Section 22 of the RBI Act gives authority to the RBI to issu e
currency notes. The RBI also takes action to control circulation of fake
currency.
3.RBI is the Controller and Supervisor of Banking Systems
The RBI has been assigned the role of controlling and supervising
the bank system in India. The RBI is responsi ble for controlling the
overall operations of all banks in India. These banks may be:
Public sector banks
Private sector banks
Foreign banks
Co-operative banks, or
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40The control and supervisory roles of the Reserve Bank of India is
done through the following:
a)Issue of Licence :
Under theBanking Regulation Act 1949. the RBI has been given
powers to grant licenses to commence new banking operations. The RBI
also grants, licenses to open new branches for existing banks. Under the
licensing policy, the RBI provides banking services in areas that do not
have this facility.
b)Prudential Norms :
The RBI issues guidelines for credit control and .management. The
RBI is a member of the Banking Committee on Banking Supervision
(BCBS). As such, they are responsible for implementation of international
standards of capital adequacy norms and asset classification.
c)Corporate Governance :
The RBI has power to control the appointment of the chairman and
directors of banks in India The RBI h as powers to appoint additional
directors in banks as well.
d)Know Your Customer (KYC) Norms :
To curb money laundering and prevent the use of the banking
system for financial crimes, The RBI has "Know Your Customer"
guidelines. Every bank has to ensur eK Y C norms are applied before
allowing someone to open an account.
e)Transparency Norms
Thism e a n st h a te v e r y bank has to disclose their charges for
providing services and customers have the right to know these charges.
f)Risk Management
The RBI provides guidelines to banks for taking the steps that
are necessary to mitigate risk. They do this through risk management in
Basel norms.
g)Audit and Inspection :
Theprocedure of audit and inspection is controlled by the RBI
through off -site and on-site monitoring system. On -site inspection is
done by the RBI on the basis of "CAMELS". (Capital adequacy; Asset
quality; Management; Earning; Liquidity; System andcontrol ).
h)Foreign Exchange Contro l:
The RBI plays a crucial role in foreign exchange transactions. It
does due diligence on every foreign transaction including the inflow and
outflow of foreign exchange. It takes steps to stop the fall in value of the
Indian Rupee. The RBI also takes necessary steps to control the current
account deficit. They also give support to promote export and the RBI
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41i) Development :
Being the banker of the Government of India, the RBI is
responsible for implementation of the government's policies related to
agriculture a nd rural development. The RBI also ensures the flow of
credit to other priority sectors as well .Section 54 of the RBI gives stress
on giving specialized support for rural development. Frivolity sector
lending is also in key focus area of the RBI.
The RBI plays a very important role in every aspect related to
banking and finance. Finally the control of NBFCs and others in the
financial world is also assigned with RBI The above wide -reaching
regulatory role of the RBI has placed it in a position which enabl es it to
take any actions that may be required to maintain financial stability in the
system. RBI's Report on Trend and Progress of Bunking in India states
that the combination of the RBI's role as both the monetary authority and
the regulator and supervis or of banks has worked out very well in face of
a financial crisis as many believe that the cause of the crisis was a lack of
coordination be tween separate authorities that exist for the two functions
in other nations. The Report states, "this is an arrang ement that has stood
thetest of time, has protected financial stability even in the face of some
severe onslaughts," and hence "it may be desirable to continue with the
present arrangement in the interest ofpre serving financial stability." It
further st ates, "the responsibility for financial stability cannot be
fragmented across several regulators; it has to rest unambiguously with a
single regulator, and that single regulator optimally is the central bank."
4.4 SELF STUDY
I.Fill in the Blanks
1) TheReserve Bank of India was established on ______________.
2) Reserve Bank of India Act, was enacted in the year _______.
3) The Central Office of the Reserve Bank was initially established in
___________ but was permanently moved to Mumbai in
__________.
4)A Central Board of Directors with ____________ consisting of the
_____________ and the _____________ governs RBI.
5) The RBI is also the regulator and ___________ of the financial system in
India.
6) RBI acts as a _____________ to the scheduled banks.
7)The RBI formulates ______________ policy twice a year.
8) ____________ of the RBI Act gives authority to the RBI to issue
____________ notes.
9) RBI is the _________ and Supervisor of Banking Systems.
10) RBI has been given powers to grant licenses to commence new
_____________.munotes.in

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4211) RBI is a member of the ________ on Banking Supervision.
12) The RBI has power to con trol the appointment of the
____________ of banks in India.
13) The RBI has powers to appoint additional ____________ in banks as
well.
14) The procedure of audit and inspection is controlled by the
RBI through __________ system.
15) On-site inspection is done by the RBI on the basis of ________.
[Ans.: (1) April 1, 1935; (2) 1934; (3) Calcutta , in 1937; (4) 20 members,
Governor, Deputy Governors; (5) supervisor; (6) banker; (7)
monetary; (8) Section 22 , currency, (9) Controller; (10) banking
operations; (11) Banking Committee; (12) chairman and directors;
(13) directors; (14) off -site and on -site monitoring; (15) CAMELS]
II. State w hether the following is True or False:
1.The Reserve Bank of India was established on April 1, 1939.
2.Reserve Bank of India Act, was enacted in the year 1934.
3.The Central Office of the Reserve Bank was initially established in
Mumbai but was permanently moved to Delhi in 1937.
4.A Central Board of Directors with 20 members consisting of the
Governor and the Deputy Governors governs RBI.
5.The RBI is also the regulator and supervisor of the financial market
in India.
6.RBI acts as a banker to the scheduled banks. :
7.The RBI formulates legal policy twice a year.
8.Section of the RBI Act gives authority to the RBI to issue
moratorium.
9.RBI is the Controller and Supervisor of Banking Systems.
10.RBI has been given powers to grant licenses to commence issue new
shares.
11.RBI is a member of the Banking Committee on Banking Supervision.
12.The RBI has power to control the appointment of the chairman and
directors of banks of India.
13.The RBI has no powers to appoint additional directors in banks as
well.
14.The procedure of audit and inspection is controlled by the RBI
through CAMELS monitoring system.
15.On-site inspection is done by the RBI on the basis of CAMELS.
[True: 2,4, 6, 9,11,15 False : 1, 3, 5,7, 8,10,12,13,14]munotes.in

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43III. Answer the following.
1.What i sc e n t r a lB a n k ?
2.What is the role of RBI in financial system?
3.Explain the preamble of RBI?
4.State & explain the importance of RBI?
5.What are the functions of RBI?
6.What are prudential norms?
7.Explain the concepts :
a)Foreign exchange control
b)CAMELS
c)Risk Management
d)KYC norms
e)Issue of licence
8.Write Short Notes on :
a)Overview of RBI as a regulator
b)Role of RBI
c)Functions of RBI
d)RBI as regulator & Supervision of the financial system
IV. Match the following:
Sr.No. A Sr.No. B
1. Central Office a. Banking Committee
2. Nationalization b. Monopoly
3. Members c. 1949
4. Issue of currency d. 20
5. Prudential Norms e. Mumbai

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445
TIME VALUE OF MO NEY
Unit Structure:
5.1 Introduction & Meaning of Time value of money
5.2 Formulae
5.3 Solved Problems
5.1 INTRODUCTIO N&M E A NING:
The basic idea of time value of money is that a Rs today is worth
more than a Rs tomorrow. This can be shown in many ways, many people
find it easiest to understand if they think in terms of something they
already know: food. For example having the money t oday allows you to
buy some food immediately. Alternatively you may be willing to forgo
current consumption and wait until later to purchase your food. Thus you
could lend your “food money” to another with the promise of being paid
back at some future time . Since you are passing up food today you would
demand a return sufficient to allow you to buy at least as much food in the
future that you are giving up now.
As we do not know the future this type of deal involves risks. For
example the borrower may decided to not pay you back. This is called
default risk. Or the borrower may pay you back but due to rising prices
you can no longer purchase the same amount of food as you had expected
to be able to buy. As a result of these risks (you as a lender) wou ld require
a higher interest rate to compensate for accepting the risks. However if
you ask for too high of interest rates you will not find any takers for your
loan.
5.2FORMULAE
1.Compounding vs Discounting :
Present Date Compounding Future Date
Present Cash Flows or Present
MoneyDiscounting Future Cash Flows or Future
Money
2.Simple Interest :
Simple InterestPNR,w h e r e
P = Principal Amount
N=N u m b e ro fy e a r s
R = Interest Rate per annumAmount = Principal + Interest
Hence,,AP PNR1AP NR  munotes.in

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453.Compound Interest :
Amount under
Compound
Interest
1NKPRWhere P = Principal Amount.
N=N u m b e ro fy e a r s .
K=N u m b e ro ft i m e sc o m p o u n d i n gi sd o n ep e ry e a r ,e . g .
Monthly (12), Quarterly (4), etc.
R=I n t e r e s tR a t ep e rp a y m e n t=.. 1..Interest Rate p aNumber of payment periods p a K
4.Effective Rate of Interest :
111K
EKWhere E = Effective Rate of Interest,
K=N u m b e ro ft i m e sI n t e r e s ti sp a i di nay e a r ,a n d
i= R a t e o f I n t e r e s t p e r a n n u m
5.Compounding and Future Value Formulae :
a)Future Value of a Single Cash Flow = Amount 1nR
[Amount relates to Time 0]
b)Future Value of an Annuity = Amount11nRR  
[Amount relates to n years]
Where n = number of years for which the money is invested, R=
rate of return on the investment.
6.Maturity Value of Annuity :
Maturity Value of an Annuity = Annuity Amou nt11nRR  
[Amount relates to n years]
Where n = number of years for which the money is invested, R =
rate of return on the investment.
Note : Size of the Sinking Fund Dep osit is also derived from the formula
given above, by calculating the Annuity Amount as the balancing figure.
7.Discounting and Present Value Formulae :
a)Present Value of a Single Cash Flow = Amount
1
1nR

(Amount relates to a future point of time)
b)Present Value of an Annuity = Amount
111n
nR
RR  

(Amount relates to n years)
Where n = number of years for which the money is invested, R =
rate of return on the investment.munotes.in

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468.Perpetuity Formulae :
PV of a Constant
PerpetuityCRWhere C = Cash Flow i.e. Interest, Dividend, etc. per period.
R=I n t e r e s tR a t ep e rp a y m e n tp e r i o d .
PV of a Growing
PerpetuityCRGWhere C = Cash Flow i.e. Interest, Dividend, etc. for the first period.
R=I nterest Rate per payment period.
G = Rate of growth in Cash Flows.
Note:A stream of Cash Flows at a constant rate forever is known as
Growing Perpetuity.
5.3 SOLVED PROBLEMS
1.TIME VALUE OF MO NEY
Illustration 1 : Simple Interest –Computation :
If you invest `10,000 in a Bank at Simple Interest of 7% per annum,
what will be the amount at the end of 3 years?
Here, P = Principal =
`10,000N=N u m b e ro fy e a r s=3 , R=Interest Rate
p.a. = 7% = 0.07
Simple Interest =PNR10,000 3 0.07=`2,100
Amount = Principal +
Interest=`10,000 + `2,100 =`12,100
[or] Amount = A =
P1NR  10,000 1 3 0.07   =1 0 , 0 0 0x1 . 2 1= `12,100
Illustration 2 : Simple Interest –Computation
`2,000 is deposited in a Bank for two years at Simple Interest of 6%.
How much will be the balance at the end of 2 years?
Amount12 , 0 0 0 1 2 0 . 0 6 2 , 0 0 0 1 . 1 2 2 , 2 4 0AP NR        `
Illustration 3 : Simple Interest –Rate Calculation
Find the Rate of Interest if the amount owed after 6 months is `1,050,
Borrowed Amount being `1,000.
Here, P = Principal = `1,000, N = Number of years =6,12R = Interest Rate p.a. = ?
Amount =A= 611 , 0 0 0 1 1 , 0 5 0 .12PN R R           
So,1, 05010 . 5 0 1 . 0 51, 000R  0.50 1.05 1 0.05.RSo,0.050.10 10%0.50Rmunotes.in

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47Illustration 4 : Compound Interest –Interest Calculation
Determine the Compound Interest for an Investment of `7,500 at 6%
compounded half -yearly. Given that 1NKRfor R = 0.03 and NK=
12 is 1.42576.
Amount under Compound Interest Scheme 127,500 1 0.03 7,500 1.42576 `10,693.20.
Hence , Compound Interest = `10,693.20 –`7,500 = `3,193.20
Illustration 5 : Compound Interest –Interest Calculation Determine
the Compound Amount and Compound Interest on 1,000 at 6%
compounded semi -annually for 6 years. Given that 1NKR=1.42576
for R = 3% NK=1 2 .
Here, P = Principal = `1,000,
N=N u m b e ro fy e a r s=6 ,
K = No. of time compounding = 2 p.a.
R = Interest Rate per period6%0.032
Amount under Compound Interest Scheme 1NKPR
121, 000 1 0.03 1, 000 1.42576   =`1,425.76.
Hence, Compound Interest for the 6 year period =
A–P=`1,425.76 –1,000 = `425.76.
Illustration 6 : Compound Interest –Amount Calculation `2,000 is
invested at annual rate of interest of 10%. What is the amount after 2
years if the compounding is done (a) Annually, (b) Semi -annually, (c)
Monthly, (d) Daily?
P = Principal N=No.
of yearsK RAmount 1NKPR=
(a) `2,000 2y e a r s 1p . a . 0.1022,000 1 0.10 2, 420
(b) `2,000 2y e a r s 2p . a . 0.0542,000 1 0.05 2, 431
(c) `2,000 2y e a r s12 p.a.0.008242,000 1 0.008 2, 440.58 
(d) `2,000 2y e a r s 365 p.a. 0.00027 7302,000 1 0.00027 2, 442.70 
Illustration 7 : Compound Interest -Rate Calculation
What annual Rate of Interest compounded annually doubles an
investment in 7 years? Given that 21/7=1.104090.
Here, P = Principal = ?,
N=N o .o fy e a r s=7
K = No. of times compounding = 1 p.a.
R = Interest Rate per period = R% ÷ 1 = R%munotes.in

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48Let Principal be `P. Since the investment doubles annually, the Amount =
2P.
Amount =12 .NKPR PThis means that,712PR PCanceling P on both sides, we have,712 .R
Hence,1/71 2 1.104090.R
So, R = 0.104090. Hence, Rate of Interest = 10.41%.
Illustration 8 : Compound Interest -Relevant Computations
AP e r s o no p e n e da nA c c o u n to nA p r i l2 0 1 3w i t had e p o s i to f `80,000.
The Account paid 6% Interest compounded quarterly. On October 1,
2013, he closed the account and added enough additional money to
invest in a 6 month Time Deposit for `1,00,000 earning 6%
compounded monthly.
a)How much additional amount did the person inv est on October 1?
b)What was the Maturity Value of his Time Deposit on April 1,
2014?
c)How much Total Interest was earned?
Given that 1NKRis 1.03022500 for11% ,2R NK = 2 and is
1.03.37751 for1%2R and NK = 6.
a)The Initial Investment earned interest for April -June and July -
September quarter, i.e. for 2 quar ters. In this case,
611% , 242 RN K and Compounded Amount = 80,000
2111% 8 0 , 0 0 01 . 0 3 0 2 2 5 0 02     =`82,418. So, the additional
amount invested on1st October = `1,00,000 -`82,418 = `17,582
b)The Time Deposit has earned interest compounded monthly for 2
quarters.
Here,61%, 6, 1,00,00012 2 RN K P
Required Maturity Value = 6111 , 0 0 , 0 0 0 1 %2 NKPR1, 00, 000 1.03037751  `1,03,038.
c)Total Interest Earned = 1stDeposit (82,418 -80,000)+ 2ndDeposit
(1,03,038 -1,00,000) = (2,418 +,3,038) = `5,456
2.COMPOU NDING
Illustration 9 : Maturity Value of an Annuity
Find the amount of an annuity if Payment of `500 is made annually
for 7 years at Interest rate of 14% compounded annually.munotes.in

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49Maturity Value of an Annuity = Annuity Amount11  nRRHere, Annuity Amount = `500,
n=N u m b e ro fy e a r s=7 ,
R = Rate of Interest = 14%.
Thus, Maturity Value = `50071 0.14 1500 10.73049150.14    
=`5,365.25.
Note : Value = 10.7304915 is obtained from the Future Value of Annuity
(FVA) Tables.
Illustration 10 : Maturity Value of Annuity
A person is required to pay four equal annual payment of `5,000 each
in his Deposit Account that pays 8% interest per year. Find out the
Future Value of Annuity at the end of 4 years.
Maturity Value of an Annuity = Annuity Amount11  nRRHere, Annui ty Amount = `5,000,
n=N u m b e ro fy e a r s=4 ,
R = Rate of Interest = 8%.
Thus, Maturity Value = `5,00041 0.08 15,000 4.5070.08    
=`22,535.
Note : Value = 4.507 is obtained from the Future Value of Annuity (FVA)
Tables (or) by direct calculation.
Illustration 11 : Maturity Value of an Annuity
`2,000 is invested at the end of each month in an account paying
interest 6% per year compounded monthly. W hat is the amount of
this annuity after 10thpayment? Given that101.005 1.0511
Maturity Value of an Annuity = Annuity Amount11  nRRHere, Annuity Amount = `2,000,
n=N u m b e ro fy e a r s=1 0 ,
R = Interest =0.060.005.12munotes.in

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50Thus, Maturity Value = `2,0001010 . 0 0 5 12,000 10.220.005     
=`20,440.
3.DISCOU NTING
Illustration 12 : Present Value of Future Cash Flows -Discounting -
Use of PV Factor
What is the Present Value of `1 to be received after 2 years
compounded annually at 10%?
Present Value =
1nnARHere, A= `1, R = 0.10 and N = 2. So, PV =10 . 8 2 6 4`0.83
Notes :
a)211.10= 0.8264 is obtained from the PV Tables.
b)Receiving `1 after 2 years, is as good as receiving `0.83 now.
c)if received today and invested at Compound Interest of 10% for 2
years, will lead to a Ma turity Amount of `1.
Illustration 13 : Present Value of Future Cash Flows -Discounting -
Use of PV Factor
Find the Present Value of `10,000 to be required after 5 years if the
Interest Rate be 9%. Given that51.09 1.5386
Present Value =
1nnARHere, A= `10,000, R = 0.09 and N = 5. So, PV =10,000 0.65`6,500
Notes :
a)5110.651.09 1.5386  
b)Receiving `10,000 after 5 years, is as good as receiving `6,500 now.
c)`6,500 if received today and invested to earn Compound Interest at 9%
for 5 years, will lead to a Maturity Amount of `10,000.
Illustration 14 : Present Value of Future Cash Flows -Discounting -
Use of PV Factor
Find the Present Value of `2,000 received af ter in 10 years hence, if
Discount Rate is 8%.
Present Value =
1nnARHere, A= `2,000, R = 0.08 and N = 10. So, PV =2,000 0.463`926munotes.in

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51Notes :
a)1010.4631.08is obtained from the PV Tables.
b)Receiving `2,000 after 10 years, is as good as receiving `926 now.
c)`926 if received today and invested to earn Compound Interest at 8%
for 10 years, will lead to a Maturity Amount of `2,000.
Illustration 15 : Present Value of Future Cash Flows -Discounting -
Use of PV Factor
What is the Present Value of `50,000 to be received after 10 years at
10% compounded annually?
Present Value =
1nnARHere, A= `50,000, R = 0.10 and N = 10. So, PV
=50,000 0.385543 `19,277.15
Notes :
a)1010.3855431.10is obtained from the PV Tables.
b)Receiving `50,000 after 10 years, is as good as receiving `19,277.15
now.
c)`19,277 if received today and invested to earn Compound Interest at
10% for 10 years, will lead to a Maturity Amoun to f`50,000.
Illustration 16 : Present Value of Annuity
Find out the Present Value of a 4 year annuity of `20,000 discounted
at 10%.
Present Value of an Annuity = Amount
111  
n
nR
RR
Here, Annuity Amount = `20,000,
n=N u m b e ro fy e a r s=4 ,
R = Interest =0.10.
Thus, Present Value = `20,000
4
410 . 1 0 120,000 3.16990.10 1 0.10    

=`63,398.
Illustration 17 : Annuity -Required Investment
Z plans to receive an annuity of `5,000 semi -annually for 10 years
after he retires in 18 years. Money is worth 9% compounded semi -
annually.munotes.in

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52a)How much amount is required to finance the Annuity?
b)What amount of Single Deposit made now would provide the
funds for the Annuity?
c)How much will Mr. Z receive from the Annuity?
a)Required Present Value for the 10 years annuity -
Present Value of an Annuity = Amount
111  
n
nR
RR
Here, Annuity Amount = `5,000,
n=20 10 2R = Interest = 4.5% (9%÷2)
Thus, Present Value = `5,000
20
2014 . 5 % 15, 000 13.007936540.045 1 4.5%     
`
=`65,039.68
b)To compute the amount of Single Deposit that matures to `65,039.68
in 18 years at 9% compounded semi -annually, the computation is as
under -
Present Value =
1nnARHere, A=65,039.68, R=4.5% (9 ÷2) and18 2 36.N
So, Present Value =36165,039.68 65,039.68 0.205028171.045   
=`13,334.97
c)Amount received from the Annuity = `5, 000 20installments =
`1,00,000
munotes.in

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536
CAPITAL STRUCTUREUnit Structure:6.1 Introduction
6.2 Meaning of Capital Structure
6.3 Capital Structure Theories
1)Net I ncome Approach.
2)Net Operating Income Approach.
3)Modigliani -Miller Approach (MM).
4)Traditional Approach.
6.4 Solved Problems
6.1 INTRODUCTIO N:
Capital structure is the mix of different securities to a firm’s capital.
It is a part of a company’ s financial structure. The choice of capital
structure depends upon a number of factors such as nature of business,
regularity of earnings, conditions of the financial markets and attitudes of
the investors. A capital structure will be considered appropria te if it
possesses profitability, solvency, flexibility, conservatism and control. The
capital structure of a company is to be determined initially at time of
incorporation of a company.
6.2 MEA NING OF CAPITAL STRUCTURE:
Capital structure is the mix of firm’s capital. It includes long term
sources of funds such as debentures, shares, etc. It represents the mix of
different sources of long term funds, in the capital of the company. The
term capital is used with reference to the total long term funds rais ed by a
company.
The decisions regarding the form of financing, their requirement s
and their relative proportions in the total capital of a company are known
as capital structure decisions. The company management has to take
extreme care and prudence in arriving at the proper capital structure. The
long term sources of raising capital are issue of shares, debentures or
bonds and long -term borrowings. The share is a owned capital and
debentures and bonds are borrowed capital. The capital structure of a
company is to be determined initially, at the time of formation of the
company.munotes.in

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546.3CAPITAL STRUCTURE THEORIES:
A firm has to maintain an optimum capital structure with a view to
maintain financial stability. The optimum capital structure can be obtained
when the market value per share is the maximum. Therefore, the objective
of the fir m should be taken to select a financing of debt equity mix which
will maximise the value of the firm, optimum leverage can be the mix of
debt-equity which maximises the value of a company. In order to achieve
this goal, the finance manages has to follow th e theories of capital
structure of corporate enterprises. There are four major theories which
explain the relationship between capital structure, cost of capital and value
of the firm. These are as follows:
(1) Net Income Approach.
(2) Net Operating Income Approach.
(3) Modigliani -Miller Approach (MM).
(4) Traditional Approach.
However, in order to understand this relationship, following assumptions
are made:
(1) The firm employs only two types of capital i.e. debt and equity capita l.
(2) Taxes are not considered.
(3) The firm pays its earnings in full as dividend. There is no returned
earnings.
(4) The firm’s total assets are given and there is no change in the assets.
(5)The firm’s total financing remains constant. The firm can cha nge its
capital structure by interchanging the source of finance.
(6) The operating profit is not expected to change.
(7) The business risk remains constant and it is independent of capital
structure ans financial risk.
(8) The firm has a perpetual life. I t means the business is a going concern
and it has long life.
(9) All the investors has the same subjective probability distribution of the
future expected operating profit for a given firm.
(1)NET INCOME APPROACH ( NI):
David durand, of USA, had sugges ted this approach. According to
him, capital structure decision is relevant to the valuation of the firm. It
means, a change in the capital structures causes a corresponding change in
the overall cost of capital as well as the total value of the firm.
This approach also suggests that a higher debt content in the capital
structure will result in decline in the overall cost of capital. This will cause
increase in the value of the firm and consequently in the value of equity
shares of the company. The net inc ome approach is based of the following
assumptions:munotes.in

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55(1) The cost of debt is less than cost of equity.
(2) The debt content does not change the risk perception of the investors.
Thus, the net income approach suggests that an increase in
financial leverage will lead to decline in the weighted average cost of
capital and the value of the firm as well as market price of equity shares
will increase. On the other hand, a decrease in th e financial leverage will
cause on increase in the weighted average cost of capital and a consequent
decline in the value as well as market price of equity shares.
The value of the firm on the basis of net income approach can be
ascertained as follows:
V=S+D
where,
V=Value of the firm
S=Market value of equity
D=Market value of Debt
The market value of Equity can be ascertained as follows:
SNIKewhere,
S=Market value of Equ ity
NI=Earning available to Equity shareholders
Ke=Equity capitalisation rate
Under net income approach, the value of the firm will be
maximum at a point where weighted average cost of capital is minimum.
Therefore, the theory suggests maximum possible debt-financing for
minimizing the cost of capital. The overall cost capital is determined as
follows:
EBITOverall cost of capitalValue of the firm
(2)NET OPERATI NGINCOME APPROACH ( NOI):
This approach was also suggested by Mr. David Durand. Net
operating income means earnings before interest and tax. This approach
suggests that the market value of the firm is not at all affected by the
capital structure changes. The capital structure decis ions of the firm are
irrelevant. And change in the leverage will not lead to any change in the
total value of the firm and the market price of the shares. The market value
of the firm is ascertained by capitalising the net operating income at the
overall c ost of capital (K) which is considered to be constant. The market
value a equity is ascertained by deducting the market value of the firm.munotes.in

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56The net operating approach is based on the following assumptions:
(1) The overall cost of capital (K) remains const ant for all degree of debt -
equity mix.
(2) The market capitalises the value of the firm as whole and therefore, the
split between debt and equity is not relevant.
(3) The low cost of debt increase the risk of equity shareholders. This
result in increase in equity capitalisation rate. An increase in the use of
debt is offset by an increase in the equity capitalisation rate
The value of the firm is determined as follows:EBITVK
Where, V=Value of the firm
K=Overall cost of capital
EBIT=Earning before interest and tax.
The value of equity can be determined by using the following formula:
S=V –D
S=Value of Equity
Where, V=Value of firm
D=Vale of Debt
(3) MODIG ILIA NIM I L L E RA P P R O A C H( M M ) :
Modigiliani -Miller approach provides behavioural justification for
constant overall cost of capital and total value of the firm. It does not
provide operational justification for irrelevance of the capital structure in
thevaluation of the firm. According to this approach he value of a firm is
independent of its capital structure. MM approach maintains that the
average cost of capital does not change with change in the debt -equity mix
or capital structure of the firm.
Thethree basic propositions of the MM approach are as follows:
(1) The overall cost of capital (K) and the value of the firm (V) are
independent of the capital structure. In other words K and V are
constant for all level of debt -equity mix. The total market v alue of the
firm is given by capitalising the expected net operating income (NOI)
by the rate appropriate for that risk class.
(2) The cost of equity (Ke) is equal to capitalisation rate of a pure equity
stream plus a premium for the financial risk. The fi nancial risk
increase with more debt content in the capital structure. Thus, (Ke)
increases in a manner to offset exactly the use of a less expensive
source of funds represented by debt.munotes.in

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57(3) The cut -off rate investment purpose is completely independent of the
way in which an investment is financed.
MM approach is based on the following assumptions:
(1) Capital markets are perfect. This means investors are rational and are
well informed.
(2) All the firm within the same risk class will have the same degree of
business risk.
(3) All investors have the same expectations of a firm’s net operating
income with which to evaluate the value of any firm.
According to MM approach the total investment value of a firm
depends upon its underlying profitability and risk . The operational
justification of MM approach can be explained through the functioning of
the arbitrage process. Arbitrage refers to buying assets or security at lower
price in one market and selling it at a higher price in another market. As a
result equ ilibrium is attained in different markets. For example, there are
two identical firms. One has debt in its capital structure and other is not
having the debt. Investor of the firm whose value is higher will sell their
shares buy the shares of the firm whos e value is lower. They will able to
be earn the same return at lower outlay with the same perceived risk or
lower risk. They would, therefore, be better of. The value of the levered
firm can neither be greater nor lower than that of an unlevered firm. Thus ;
there is neither advantage nor disadvantage in using debt in firm’s capital
structure.
(4) TRADITIO NAL APPROACH:
Traditional approach favours that as a result of financial leverage
up to a certain level cost of capital comes down and value of the firm
increase. However, beyond that level reserve trend emerges. Thus, the
essence of the traditional approach lies in the fact that a firm through
judicious use of debt -equity mix can increase its total value and thereby
reduce its overall cost of capital. It is because debt is a cheaper source of
funds as compared to raising money through shares because of tax
advantage. However, raising debt beyond a certain point may become a
financial risk and would result in higher equity capitalisation rate.
The princip al implication of Traditional approach is that the cost of
capital is independent on the capital structure and there is an optimal
capital structure which minimises cost of capital. At the optimal capital
structure the real marginal cost of debt and equity is the same. Before the
optimal point the real marginal cost of debt is less than real marginal cost
of debt is more than the real marginal cost of equity and beyond this point
the real marginal cost debt is more than the real marginal cost equity.
Theref ore, the firm should strive to reach the optimal capital structure and
its total valuation through a judicious use of the debt and equity capital in
capital structure. At the optimal capital structure the overall cost of capital
will be minimum ans the val ue of the firm is maximum.munotes.in

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586.4 SOLVED PROBLEMS
Problem 1 :
Vijay Ltd. has currently, an ordinary share capital of Rs. 25 lakhs,
consisting of 25,000 shares of Rs. 100 each. The management is planning
to raise another Rs. 20 lakhs to finan ce major programe of expansion
through one of four possible financing plans. The plans are
i)Entirely through ordinary shares
ii)Rs. 10 lakhs through ordinary hares and Rs. 10 lakhs long -term
borrowing at 8 percent interest per annum.
iii)Rs. 5 lakhs through ordinary shares and Rs. 15 lakhs through long term
borrowing at 9% interest per annum.
iv)Rs. 10 lakhs through ordinary shares and Rs. 10 lakhs through
preference shares with 5 percent dividend.
The company’s expected earnings before Interest and Taxes (EBIT)
will be Rs. 8 lakhs. Assuming a corporate tax rate of 50%. Determine the
earnings per share (EPS) in each alternative.
Solution :
Statement of Comparative EPS under the four possible financing
plans
(Rs. In lakhs)
(I) (II) (III) (IV)
Equity Share Capital 20.00 10.00 5.00 10.00
Preference Share Capital -- -- -- 10.00
Long Term Borrowing -- 10.00 15.00 --
Total Financing 20.00 20.00 20.00 20.00
E.B.I.T. 8.00 8.00 8.00 8.00
Less : Interest -- .80 1.35
Profit before tax (PBT) 8.00 7.20 6.65 8.00
Less : Tax @ 50% 4.00 3.60 3.325 4.00
Profit After Tax (PAT) 4.00 3.60 3.325 4.00
Less : Preference share Dividend 0.50
Funds available to Equity
shareholders4.00 3.60 3.325 3.50
No. of Equity Shares 45,000 35,000 30,000 35,000
Earnings (EPS) Per Share4,00,00045,0003, 60, 00035,0003, 32, 50030,0003,50, 00035,000=Rs. 8.89 =Rs. 10.29 =Rs. 11.08 =Rs. 10munotes.in

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59Plan III is better as the EPS is highest .
Problem 2 :
A company needs Rs. 12 lakhs for the installation of a new factory
which would yield an annual EBIT of Rs. 2,00,000. The company has the
objective of maximizing the earnings per share. It is considering the
possibility of issuing equity shares plus raising ad e b to fR s .2 , 0 0 , 0 0 0 ,R s .
6,00,000 or Rs. 10,00,000. The current market price per share is Rs. 40
which is expected to drop to Rs. 25 per share if the market
borrowings were to exceed Rs. 7,50,000/ -
Cost of bo rrowings are indicated as under :
Up to Rs. 2,50,000 10% p.a.
Between Rs. 2,50,001 and Rs. 6,25,000 14% p.a.
Between Rs. 6,25,001 and Rs. 10,00,000 16% p.a.
Assuming a tax rate of 50%, work out the EPS and the scheme
which would meet the objectiv e of the management.
Solution :
Comparative Statement of Earnings Per Share
Particulars IR s . II Rs. III Rs.
Debt 2,00,000 6,00,000 10,00,000
Equity Capital 10,00,000 6,00,000 2,00,000
Total Investment 12,00,000 12,00,000 12,00,000
No. of Equity share10,00,0004025.0006,00,0004015.0002,00,000258.000(a) E.B.I.T. 2,00,000 2,00,000 2,00,000
Less Interest on Debt
@1 0 % 20,000 25,000 25,000
@14% -- 49,000 52,500
@16% -- -- 60,000
(b) Total Interest 20,000 74,000 1,37,500
Profit Before tax (a) -(b) 1,80,000 1,26,000 62,500
Less : Tax @ 50% 90,000 63,000 31,250
Profit after tax 90,000 63,000 31,250
E.P.S.Pr
.ofit after taxNo of equity shares90.00025.0003.6063.00015.0004.2031.2508.0003.91munotes.in

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60Plan II is recommended since it gives the highest E.P.S.
Problem 3 :
From the following alternatives determine the Ideal capital
structure for the company.
I II III IV
Equity 1,00,000 75,000 50,000 25,000
Debt @ 12% -- 25,000 50,000 75,000
Total Financing 1,00,000 1,00,000 1,00,000 1,00,000
No. of Equity Shares 10,000 7,500 5,000 2,500
Profit before interest and taxes is Rs. 15,000/ -
Tax rate is 50%
Solution :
IR s . II Rs. III Rs. IV Rs.
EBIT 15,000 15,000 15,000 15,000
Less : Interest -- 3,000 6,000 9,000
Earning before tax 15,000 12,000 9,000 6,000
Less Tax @ 50% 7,500 6,000 4,500 3,000
Earning after tax 7,500 6,000 4,500 3,000
No. of shares 10,000 7,500 5,000 2,500
Earnings Per Share7.50010,0000.756.0007.5000.804.5005.0000.9030002.5001.20Problem 4 :
From the following data find out the value of each firm as per the
Modigliani and Miller approach.
Firm A Firm B Firm C
EBIT Rs. 13,00,000 Rs. 13,00,000 Rs. 13,00,000
No. of shares 3,00,000 2,50,000 2,00,000
12% Debentures Rs. 9,00,000 Rs. 10,00,000munotes.in

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61Solution :
As per M. M. Approach the valuation of the firms is as follows
Formula for M.M. Approach Firm A Firm B Firm CEarnings before interest & taxesExpected Return on Investment13.00.00012%13.00.00012%13.00.00012%Value of the firm 1,08,33,333 1,08,33,333 1,08,33,333
Problem 5 :
Calculate EPS (Earning per share) of Small Ltd. and Big Ltd.
assuming
a)20% before tax rate of return on assets.
b)10% before tax rate of return on assets.
Based on the following data.
Small Ltd. (Rs. In lakhs) Big Ltd. (Rs. In lakhs)
Assets 100 100
Debt -- 50 (12% Debenture and loan)
Equity 100 (share of Rs. 10 each) 50 (share of Rs. 10 each)
Assume a 50%. Income tax rate in both the cares. Give your
comments on the financial leverage.
Solution :
Small Ltd. Big Ltd.
20% Before
Tax Return10% Before
Tax Return20% Before
Tax Return10% Before
Tax Return
E.B.I.T. 20,00,000 10,00,000 20,00,000 10,00,000
Less : Int. and taxes -- -- 6,00,000 6,00,000
E.B.T. 20,00,000 10,00,000 14,00,000 4,00,000
Less : Tax 10,00,000 5,00,000 7,00,000 2,00,000
E.A.T. 10,00,000 5,00,000 7,00,000 2,00,000
No. of equity 10,00,000 10,00,000 5,00,000 5,00,000
Shares Re. 1.00 Re. 0.50 Rs. 1.40 Re. 0.40
Earnings per share
In the absence of Fixed charge (Interest) for Solid Ltd. There is no
financial leverage. Hence a 50% decline in its before tax rate of return is
followed by a equivalent decline is its earnings per shares. i.e. Re. 1 to Re.munotes.in

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620.50. Where as in the case of So und Ltd. there is financial feverage. Hence,
a 50 percent decline in its before tax rate value is followed by a decline of
larger proportion earnings per share from Rs. 1.40 to Re. 0.40 which is
71% less.
Problem 6 :
Omkar Ltd. planning an expansion pro gramme which will require
Rs. 30 crores and can in the founded through one of the three following
options :
a)Issue further equity shares of Rs. 100 each at par.
b)Raise loans at 15% Interest.
c)Issue preference shares at 12%.
Present paid up capi tal is Rs. 60 crores and average annual EBIT is
Rs. 12 crores. Assume I.T. rate at 50%. After the expansions. EBIT is
expected to be Rs. 15 crores per annum.
Calculate EPS under the three financing options to indicating the
alternative giving the highest return to the equity share holders.
Solution :
Statement showing EPS under three financing options
(Rs. In crores)
A
Equity Issue
Rs.B
Loan
Rs.C
Preference
share
Rs.
E.B.I.T. 15.00 15.00 15.00
Interest -- 4.5 --
E.B.T. 15.00 10.50 15.00
Tax at 50% 7.50 5.25 7.50
E.A.T. 7.50 5.25 7.50
Preference Dividend -- -- 3.60
Earnings to equity
shareholders7.50 5.25 3.90
No. of Equity Share
(Crores)0.9 0.6 0.6
Earnings per share Rs. 8.33 Rs. 8.75 Rs. 6.50
Plan B gives the highest return to the equity shareholders.
Problem 7 :
A new project under consideration require a capital outlay of Rs.
300 lakhs. The required funds can be raised either fully by equity share of
Rs. 100 each or by equity shares of the value of Rs. 200 lakhs and by loanmunotes.in

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63of Rs. 100 lakhs @ 15% interest. Assuming a tax rate of 50%. Calculate
the figures of profit before interest and tax that would keep the equity
investors indifferent to the two options. Verify your answer by calculating
the EPS.
Solution :
The equation of EPS under the two financing options are worked
as follows :
Option 1 :
Equity is Rs. 300 lakhs divided into 3,00,000 equity shares without
loan.
Therefore153PBIT OEPS
Option 2 :
Equity is Rs. 200 lakhs divided into 2,00,000 shares with the loan
of Rs. 100 lakhs @ 15% i.e. Interest is Rs. 15 lakhs.
Therefore.15 1 52PBIT RsEPS
Hence, the indif ference level of PBIT found by equating the above two
equations.0( 1 5 ) 1 5( 1 5 )32PBIT PBIT 2. 5 3 1 5 . 51.5 22.50.5 22.50.4 5 .PBIT PBIT
PBIT PBIT
PBITPBIT Rs lakhs 

Verification
Option I
Equity Funding Rs.Option 2
Equity loan financing Rs.
EBIT 45,00,000 45,00,000
Less : Interest -- 15,00,000
E.B.T. 45,00,000 30,00,000
Less : Tax 22,50,000 15,00,000
E.A.T. 22,50,000 15,00,000
No. of equity shares 3,00,000 2,00,000
Earnings Per Share Rs. 7.50 Rs. 7.50munotes.in

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64Problem 8:
Sandhya Industries Ltd. have submitted the following projections.
You are required to work out yearly Debt.
Service Coverage Ratio (DSCR)
(figure Rs. In lakhs)
Year Net Profit for
the yearInterest on Term Loan
during the yearRepayment of Term
Loan in the year
1 21.67 19.14 10.70
2 34.77 17.64 18.00
3 36.01 15.12 18.00
4 19.20 12.60 18.00
5 18.61 10.08 18.00
6 18.40 7.56 18.00
7 18.33 5.04 18.00
8 16.41 Nil 18.00
The net profit has been arrived after charging depreciation of Rs. 17.68
lakhs every year.
Solution :
The calculation of DSCR is as follows :
Years
1 2 3 4 5 6 7 8
(a) Net Profit 21.67 34.77 36.01 19.20 18.61 18.40 18.33 16.41
Depreciation 17.68 17.68 17.68 17.68 17.68 17.68 17.68 17.68
(b) Interest on Term
Loan19.14 17.64 15.12 12.60 10.08 7.56 5.04 Nil
(c) Total Cash Flow
before Interest58.49 70.09 68.81 49.48 46.37 43.64 41.05 34.09
(d) Loan Repayment 10.70 18.00 18.00 18.00 18.00 18.00 18.00 18.00
(e) Total of (b) + (d) 29.84 35.64 33.12 30.60 28.08 25.56 23.04 18.00
DSCR = (c) / (e) 1.96 1.97 2.08 1.62 1.65 1.71 1.78 1.89
Average DSCR14.661.838
Problem 9 :
The Sameer Ltd. needs Rs. 5,00,000 for commissioning of a new
plant. The following three financial plans are feasible.
i)The company may issue 50,000 equity shares of Rs. 10 per share.munotes.in

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65ii)The company may issue 25,000 equity shares at Rs. 10 per share and
2500 debentures of Rs. 100 denomination bearing an 8% rate of
interest.
iii)The company may issue 25,000 equity shares at Rs. 10 per share and
2,500 preference shares at Rs. 100 per share bearing 8% rate of
dividend.
If the Company’s earnings before interest and taxes are Rs. 10,000,
Rs. 20,000, Rs. 40,000, Rs. 60,000 and Rs. 1,00,000, what are the earnings
per share under each of the three financial plans? Which alternative would
you r ecommend and why? Assume corporate tax rate to be 50%.
Solution :
1stAlternative : 50,000 Equity shares of Rs. 10 each
(I) (II) (III) (IV) (V)
EBIT 10,000 20,000 40,000 60,000 1,00,000
Less : Tax @ 50% 5,000 10,000 20,000 30,000 50,000
EAT 5,000 10,000 20,000 30,000 50,000
No. of Shares 50,000 50,000 50,000 50,000 50,000
EPS5.00050.0000.1010.00050.0000.2020.00050.0000.4030.00050.0000.6050.00050.0001.002ndAlternative : 25000 Equity shares of Rs. 10 each and 25000 Debenture
of Rs. 100 each at 8% Interest.
(I) (II) (III) (IV) (V)
EBIT 10,000 20,000 40,000 60,000 1,00,000
Less : Interest 20,000 20,000 20,000 20,000 20,000
FBT (-)1 0 , 0 0 0 -- 20,000 40,000 80,000
Less :T a x@5 0 % -- -- 10,000 20,000 40,000
EAT (-)1 0 , 0 0 0 -- 10,000 20,000 40,000
No. of equity shares 25,00025,000 25,000 25,000 25,000
E.P.S. (-)0 . 2 00 0.40 0.80 1.60munotes.in

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663rdAlternative : 25000 Equity shares of Rs. 100 each and 2500 Preference
shares of Rs. 100 each at 8% dividend.
(I) (II) (III) (IV) (V)
EBIT 10,000 20,000 40,000 60,000 1,00,000
Less : Tax @ 50% 5,000 10,000 20,000 30,000 50,000
EAT 5,000 10,000 20,000 30,000 50,000
Less : Pref. Dividend 20,000 20,000 20,000 20,000 20,000
Earnings to equity (-)1 5 , 0 0 0 (-)1 0 , 0 0 0 Nil 10,000 30,000
Equity shares 25,000 25,000 25,000 25,000 25,000
EPS (-)0 . 6 (-)0 . 4 0 0.4 1.20
2ndAlternative is better, and gives the highest EPS in case of EBIT of Rs.
40,000 shares.
Problem 10 :
Anil. Ltd. is considering three different plans to finance its total
project costs of Rs. 100 lakhs.
There are as follows :
(Rs. In Lakhs)
Plan A Plan B Plan C
Equity (Rs. 100 per share) 50 34 25
Debt : 8% Debenture 50 66 75
100 100 100
Sales for the first three years of operations are estimated at Rs. 100
lakhs, Rs. 125 lakhs and Rs. 150 lakhs and a 10% profit before interest
and taxes forecast to be achieved. Corporate taxation to be taken at 50%.
Compute earnings per share in each of t he alternative plans of financing
for the three years.
Solution :
Statement showing Earnings per share
(Rs. In lakhs)
Plan A Plan B Plan C
1 2 3 1 2 3 1 2 3
Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
E.B.I.T. 10.00 12.50 15.00 10.00 12.50 15.00 10.00 12.50 15.00
Less Interest on
Debentures4.00 4.00 4.00 5.28 5.28 5.28 6.00 6.00 6.00
E.B.T. 6.00 8.50 11.00 4.72 7.22 7.72 4.00 6.50 9.00
Less : Tax 50% 3.00 4.25 5.50 2.36 3.61 4.80 2.00 3.25 4.50
P.A.T. 3.00 4.25 5.50 2.36 3.61 4.86 2.00 3.25 4.50
No. of shares 50,000 50,000 50,000 34,000 34,000 34,000 25,000 25,000 25,000
E.P.S. 6.00 8.50 11.00 6.94 10.62 14.29 8.00 13.00 18.00munotes.in

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67Problem 11 :
A Company capital structure consists of the following :
Plan A
Equity share of Rs. 100 each 20 Lakhs
Retained Earnings 10 Lakhs
9% Preference share 12 Lakhs
7% Debenture 8L a k h s
Total 50 Lakhs
The Company earns 12% on capital. The income tax rate is 50%.
The company requires a sum of Rs. 25 lakhs to finance expansion
programme for which following alternatives are available to it.
i)Issue of 20,000 Equity shares at a premium of Rs. 25 per shar e.
ii)Issue of 10% Preference shares.
iii)Issue of 8% Debentures.
It is estimated that the P/E ratio in the cases of equity preference
and debenture financing would be 21.4.17 and 15.7 respectively. Which of
the three financing alternatives would yo ur e c o m m e n da n dw h y ?
Solution :
Statement showing Computations of E.P.S.
Existing
PositionIssue of 20,000
Eq. Share are
at premium of
Rs. 25/ -per
shareIssue of 10%
Preference
sharesIssue of 8%
Debentures
Rs. Rs. Rs. Rs.
E.B.I.T. 6,00,000 9,00,000 9,00,000 9,00,000
Less Interest 56,000 56,000 56,000 56,000
E.B.T. 5,44,000 8,44,000 8,44,000 6,44,000
Less : Tax @ 50% 2,72,000 4,22,000 4,22,000 3,22,000
EAT 2,72,000 4,22,000 4,22,000 3,22,000
Less : Dividend on Pref.
share1,08,0001,08,000 3,58,000 1,08,000
Earnings available to equity
shareholder1,64,000 3,14,000 64,000 2,14,000
No. of equity shares 20,00040,000 20,000 20,000
Earnings per share 8.207.85 3.20 10.70
P/E Ratio -- 21.4 17 15.70
Market Price -- 167.99 54.40 167.99munotes.in

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68Problem 12 :
Satish Ltd. have Equity Share Capital of Rs. 5,00,000 (face value
Rs. 100) To meet the expenditure of an expansion programme, the
company wishes to raise Rs. 3,00,000 and is having following four
alternative sources to raise the funds :
Plan A : To have full money from equity shares :
Plan B : To have Rs. 1 Lakhs from equity and Rs. 2 Lakhs from borrowing
from the financial Institution @ 10% p.a.
Plan C : Full money from borrowing @ 10% p.a.
Plan D : Rs. 1 Lakh in equity and Rs. 2L a k h sf r o mp r e f e r e n c es h a r e sa t
8% p.a.
The company is having present earnings of Rs. 1,50,000. The
corporate tax is 50%. Suggest a suitable plan of the above four plans to
raise the required funds.
Solution
Statement showing the EPS under the f our plans
Plan A Plan B Plan C Plan D
Equity share capital 8,00,000 6,00,000 5,00,000 6,00,000
8% Pref. Share Capital -- -- -- 2,00,000
Borrowings @ 10% -- 2,00,000 3,00,000 --
8,00,000 8,00,000 8,00,000 8,00,000
E.B.I.T. 1,50,000 1,50,000 1,50,000 1,50,000
Less : Interest @ 10% 20,000 30,000
E.B.T. 1,50,000 1,30,000 1,20,000 1,50,000
Less : Tax 75,000 65,000 60,000 75,000
Less : Pref. Dividend 16,000
Earnings available to equity
shareholders75,000 65,000 60,000 59,000
No. of equity shares (Rs. 100) 8,000 6,000 5,000 6,000
Earnings per share 9.38 10.83 12.00 9.83
Plan C gives the highest EPS and therefore to be accepted.munotes.in

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69Problem 13 :
Sikandar Limited provides you the following information :
Rs.
Profit (EBIT) 2,80,000
Less : Interest on Debentures @ 10% 40,000
2,40,000
Less : Income -tax @ 50% 1,20,000
1,20,000
Number of Equity shares (Rs. 10 each) 30,000
Earnings per share (EPS) Rs. 4
Ruling Market Price Per Share Rs. 40
Price / EPS (PE) Ratio 10
The company has undistributed reserves of Rs. 7,00,000 and needs
Rs. 4,00,000 further for expansion. This investment is expected to earn the
same rate as funds already invested. You are informed that a debt equity
debtdebt equityratio higher than 32% will push the P/E ratio down to 8 and
raise the interest.
Problem 14:
A new project under consideration by your company require a
capital investment of Rs. 150 Lakhs. The required funds can be raised
either through the sale of equity shares or borrowed from financial
institution. Interest on loan is 15% and tax rate is 50%. If the debt equity
ratio insisted by the financial agencies is 2 : 1. Calculate the point of
indifference for the project.
Solution :
If Capital Investment of Rs. 150 lakhs is financed through debt;
then debt -equity ratio is required to be 2:1. Therefo re equity will be Rs.
100 lakhs and debt at 15% will be Rs. 100 lakhs. Interest will work out to
Rs. 15 lakhs.
When financed only through equity.(1 0.5)..EBITEPSNo of Eq Shares
When financed through equity and debt.(1 05)..EBIT InterestEPSNo of Eq Shares munotes.in

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70Assuming per share face value of Rs. 100 and equating the above
two equations we get,
When financed only through equity.1500000 (1 0.5)(1 0.5)
150000 500000
.5 1.5 ( 15,00,000)
.5 1.5 22,50,000
.22 ,50 ,0 0 0EBIT EBIT
EBIT EBIT
EBIT EBIT
EBIT Rs  



Verification
Particular Equity Rs. Equity + Debt Rs.
EBIT 22,50,000 22,50,000
Less : Interest -- 15,00,000
E.B.T. 22,50,000 7,50,000
Less : Tax 11,25,000 3,75,000
E.A.T. 11,25,000 3,75,000
No. of equity shares (N) (Rs. 100
each Assumed)15,00,000 5,00,000
EPSEATN11.25.0000.7515.00.0003.75.0000.755.00.000
Problem 15 :
Ganesh Ltd is contemplating conversion of 8% convertible
debentures of Rs. 1000 each. At present, it has 500 such debenture
outstanding. The market price of the debenture is Rs. 1080. The debenture
indenture provides that one debenture will be converted fo r1 0s h a r e s .T h e
price earning ratios before redemption is 20:1 and anticipated price
earning ratio after redemption is 25:1.
The number of shares outstanding prior to redemption was 10,000.
Earning before interest and taxes amounted to Rs. 20,00,000. T he
company is in the 50% tax bracket. Should the company convert its
debentures into shares?
Financing through Equity :
Sales EPS P/E Ratio Market value
4c r o r e s 1.10 5 5.50
8c r o r e s 2.14 5 10.70
10 crores 2.69 5 13.45munotes.in

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71Financing through Debt :
Sales EPS P/E Ratio Market value
4c r o r e s 1.15 4 4.60
8c r o r e s 3.15 4 12.60
10 crores 4.15 4 16.60
Problem 16:
Harsh Ltd. is considering three financing plans. The key
information is as follows :
a)Total Investment to be raised Rs. 20,00,000
b)Plan of Financing proportion.
Plan Equity Debt Preference shares
A 100% -- --
B 50% 50% --
C 50% -- 50%
c)Cost of Debt 8%
Cost of Preference shares 8%.
d)Tax rate 50%
e)Equity shares of the face value of Rs. 10 each will be issued at a
premium of Rs. 10 per share.
f)Expected PBIT is Rs. 80,000.
Determine for each Plan :
i)Earnings per share (EPS) and
ii)The financial break even point.
iii)Indicate if any of the p lans dominate and compute the PBIT range
among the plans for indifference.
Solution:
Statement showing Earnings per share :
Plans
AR s . BR s . CR s .
Profits before Interest of tax 80,000 72,000 80,000
Less : Interest 8,000
Profits before tax 80,000 80,000 80,000
Less : Tax 40,000 36,000 40,000
Profits after tax 40,000 36,000 40,000
Less : Dividend on Preference 8,000munotes.in

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72shares
Profits available to equity
shareholders40,000 36,000 32,000
No. of Equity shares 10,000 5,000 5,000
E.P.S. Rs. 4.00 Rs. 7.20 Rs. 6.40
ii) Financial Breaks even point :
Plan A : Financial Break even Point is Nil, as there is no fixed (financial)
charge.
Plan B : Financial Break even Point is Rs. 8,000; since it has to make upto
interest payment of Rs. 8000.
Plan C : Financial Break even Point is Rs. 16,000 since, it has to pay
preference dividend of Rs. 5000 after tax and therefore considering 50%
tax i.e. Rs. 8,000, the FBEP is Rs. 16,000.
iii)(a) Calculation of PBIT range of indifference between Aa n dB .
Aa n dB(a r g ) ( 1 ).PBIT Fixed ch e Tax rateNo of Share 
Since A = B, therefore
8000 .500. 5 0 / 1 0 , 0 0 05000
25,000 5000 4,00,000
25,000 4,00,00,000
16,000PBITPBIT
PBIT PBIT
PBIT
PBIT 



b)Calculation of PBIT range for indifference between A and C. arg 1 Pr .
.
10 . 5 0 % . 8 0 0 05000PBIT Fixed ch e Tax rate ef DivCNo of Shares
PBIT Nil Rs 

Since A = C
Therefore0.50 .50 .800010000 5000
.50 .16000
.32000PBIT Nil PBIT Nil Rs
PBIT PBIT Rs
PBIT Rs   

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73c)Calculation of PBIT range of indifference between B and C
Since B = C(. 8 0 0 0 ) . 5 0(0 ) ( . 5 0 ) . 8 0 0 05000 5000.50 . 4000 0.50 .8000PBIT Rs PBIT RsPBIT Rs PBIT Rs  Thus there exists difference points between B and C
The ranking order of dominant schemes are as follows
A Financial BEP Nil
B Financial BEP Rs. 8,000
C Financial BEP Rs. 16,000

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747
COST OF CAPITAL
Unit Structure :
7.1 Meaning of Cost of Capital
7.2 Cost of Equity Share of Capital
7.3 Cost of Retained earnings
7.4 Cost of Preference Share Capital
7.5 Cost of Debt/Debenture Capital
7.6 Overall Cost of Capital
7.7 Solved Problems
7.1 MEA NING OF COST OF CAPITAL
Capital is one of the most important factor for production and, like
any other factor, it has cost. The required capital obtained from various
available sources& cost of capital refers to the payment that a firm has to
make to the suppliers of capital. This includes interest payment for debt
capital (Debentures & Loan funds), dividend payment to equity and
preference shareholders etc.
The term ‘cost of capital’ means the overall cost of capital of a firm.
This ‘overall cost of capital’ consist the cost of various sources of
financing. The sources can be Equity share capital, Preference share
capital or Debt capital. Obviously, each of these sources has cost of its
own. The overall cost of capital is also called as weighted average cost of
capital. That is,
Ko = KeW1 + KrW2 + KpW3 + KdW4
where,
Ko = Overall cost of capital
Ke = Cost of equity
Kr = Cost of retained earning
Kp = Cost of preference shares
Kd = After -tax cost of debt
W1 = Proportion of equity to total capital
W2 = Proportion of retained earnings to total capital
W3 = Proportion of preference share capital to total capital
W4 = Proportion of debt to total capitalmunotes.in

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75Thus, to measure the overall cost of capital, it is necessary to determine :
1. the cost of each source of financing (equity, preference or debt), and
2. respective weights in the capital structure of the firm.
7.2 COST OF EQUITY SHARE CAPITAL
There are various methods of computing cost of equity, however,
discussed here are the important ones, viz.
i.Earning/price growth model
ii.Dividend growth model
iii.Earnings growth model
iv.Capital asset pricing m odel
Each method has its own advantages & disadvantages. In practice,
more than one method may be used to estimate the firm’s cost of capital,
When the cost of equity is computed.
i.Earnings/price model
The earnings/price ratio is calculated by dividin g the earnings per
share by the current price per share. Thus, the cost of equity (Ke) is
measured by
where,
E=Earnings per share (EPS)
P = Market Price per share (MPS)
ii.Dividend growth model
Under this model, the cost of equity is the dividend yield plus the
expected dividend growth rate. Symbolically.
where,
D = Dividend per share at the end of a period
P=M a r k e tP r i c ep e rs h a r e( M P S )
g = Dividend growth rate.
iii.Earnings growth model
This model replaces dividend by earnings in it, and the cost is
measured by the equation,
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76where,
E = Earnings per share (EPS)
P=M a r k e tP r i c ep e rs h a r e( M P S )
g = Growth rate in earnings
iv.Capital Asset Pricing Model (CAPM)
The CAPM is based on the assumption that the required rate of
return on any security equals the risk -free rate of return plus a
premium fo r risk. According to the CAPM,
R=R f+ β(Rm –Rf)
where,
R = Required rate of return on a share
Rf = Risk -free return
Rm = expected return on the market as a whole, or on an average share
value
β= Beta coefficient which measures the systematic, or u navoidable,
market risk.
7.3 COST OF RETAI NED EAR NINGS
Although these funds do not apparently cost anything, there is a
definite opportunity cost involved. The opportunity cost of retained
earnings is simply the dividend foregone by the shareholders.
7.4 COST OF PREFERE NCE SHARE CAPITAL
This dividend payable to the preference shareholders is normally
treated to be the cost of this source of finance. Thus, the cost of preference
capital (Kp) would be determined as follows:
D
Kp = 1
where,
D = Annual dividend
1 = Net proceeds of the preference share issue
The preference dividend is also paid after -tax and, hence, no adjustment
is made regarding taxes.
7.5 COST OF DEBT
The amount of interest payable is the cost of debt capital (Kd). It
should, however, be adjusted by the tax rate. As the interest payable is an
admissible deduction for computing taxable income, it would considerably
reduce the cost of debt capital. Sym bolically,
Kd = r (1 –t)munotes.in

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77where,
r = Interest rate payable
t = Marginal tax rate of the firm
7.6 OVERALL COST OF CAPITAL
The term ‘cost of capital’ is used to denote the composite or
weighted average or the overall cost of capital. When specific cost are
combine to arrive at the overall cost of capital, it is called the ‘composite’
or ‘weighed average cost of capital’. As shown earlier, the weighted
average cost of capital is computed as follows:
Ko = KeW1 + KrW2 + KpW3 + KdW4
where,
Ko = Overall cost of capital
Ke = Cost of equity
Kr = Cost of retained earnings
Kp = Cost of preference shares
Kd = After -tax cost of debt
W1 = Proportion of equity (S) to the total capital (V) =
W2 = Proportion of retained earnings (E) to the total capital
W3 = Proportion of preference share capital (P) to the total capital
and
W4 = Proportion of debt (D) to the total capital =
Computation of Overall Cost of Capital
This involves the following steps:
1. Compute specific cost of each other source capital.
2. Select appropriate ‘weight’.
3. Multiply the cost of each of the sources by the appropriate weights.
4. Divide the total cost as per (3) above by total weight to arrive at the
weighted or overall cost of capital.
It may be mentioned here that the weighted average cost of capital
may change due to:
a.a change in the cost of each component
b.a change in the relative importance of each component (i.e.
weight),
c.or a change in both.munotes.in

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787.7 SOLVED PROBLEMS
Illustrations
C.Computation of Cost of Debt
Illustration 1 : cost of Irredeemable Debt
Five years ago, Sona Limited issued 12% Irredeemable Debentures at
103, a 3 Premium to their Par Value of 100. The Current Market Price of
these Debentures is 94. If the Company pays Corporate Tax at a rate of
35%, what is the Current Cost of Debenture Capital?
Solution :()()100% 12% 100 35% 7.88.3%Pr 94 94dInterest Tax RateKNet oceeds of Issues¥- ¥ -== = =Illustration 2 : Cost of Redeemable Debt
Indebted Ltd. issued 10,000, 10% Debentures of 100 each, redeemable
in 10 years time at 10% premium. The cost of issues was 25,000. The
Company’s Income Tax Rate is 35%. Determine the Cost of Debentures,
if they were issued -(a) at par, (b) at a premium of 10%, and (c) at a
discount of 10%.
Solution :
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79Note : Cost of DebtdKwill not be equal to the Interest Rate on Debt. This
is due to the following reasons -
Expenses of Issue, i.e. differenc eb e t w e e nF a c eV a l u ea n dN e t
Proceeds,
Terms of Issue, i.e. Issue at Premium / Discount (if any),
Terms of Redemption, i.e. period and Premium payable, and
Tax-Saving Effect.
(Note : It is assumed that Premium on Redemption of Debt is not tax -
deductible.)
Illustration 3 : Cost of Redeemable Debt
A Company issued 10,000, 10% Debentures of `100 each on 1stApril,
with maturity period 5 years. The Company wants to know the Cur rent
Cost of its existing Debt and the Market Price of the Debentures is `80.
Compute the Cost of Existing Debentures assuming 35% Tax Rate.
Solution :
( ) ( )100 80100% 10 100 35%6.5 4 50.1166 11.66%100 80 90
22dRV NPInterest Tax RateNKRV NP++¥- + ¥ - ++== = = =++
B.Computation of Cost of Preference Capital
Illustration 4 : cost of Irredeemable Preference Shares
If a Company is issuing Preferred Stock at `100 per Share, with a stated
Dividend of `12, and a Floatation Cost of 3% then, what is the Cost of
Preference S hare?
Solution :
( ) ( )Pr Pr 1212.4%
Pr Pr Pr 100% 100 1 0.03peference Dividend eference Stock DividendK
Net oceeds of Issues Market ice of eferred Stock Floatation Cost== = =--
Illustration 5 : cost of Irredeemable Preference Shares
XYZ & Co. issues 2,000 10% Preference Shares of `100 each at `95 each.
Calculate the Cost of Preference Shares.
Solution :Pr 10 2,000 1010.53%Pr 95 2,000 95peference DividendKNet oceeds of Issues¥== = =¥
Illustration 6 : Cost of Redeemable Preference Shares
XYZ & Co. issues 2,000 10% Preference Shares of `100 each at `95 each.
The Company proposes to redeem the Preference Shares at the end of 10th
year from the date of issue. Calculate the Cost of Preference Shares.munotes.in

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80Solution :
100 9510 Pr1010.77%100 95
21 0pRV NPeference DividendNKRV NP- ʈ -+ + Á˜Ë¯== =++A.Computation of Cost of Equity
Illustration 7 : Cost of Equity -Dividend Price Approach
Dividend -Prayers Ltd. has a stable income and stable dividend policy.
The average annual dividend payout is ` 27 per Share (Face Value = `100).
You are required to find out -
1.Cost of Equity Capital, if Market Price in Year 1 is `150.
2.Expected Market Price in Year 2, if Cost of Equity is expected to rise
to 20%.
3.Dividend Payout required in Year 2, if the Company were to have an
expected Market Price of `160 per share, at the existing Cost of Equity.
Solution : Note : Year 0 and 1 distinction for MPS and DPS is not applied
in the solution below.
1.2718%Pr 150eDividend per share DPSKMarket ice per Share MPS== = =`
`
2.( )27 2720% ( ) , 135 : 2720%eDPSKg i v e n S o M P S N o t e D P S i s u n i f o r m a tMPS MPS=== = =````3.( )18% , 160 18% 28.80160eeDPS DPSK present K So DPSMPS=== = ¥ =```
Illustration 8 : Cost of Equity -Earnings Price Approach
Easy -Earners Ltd. has a uniform income that accrues in a four -year
business cycle. It has an average EPS of 25 (per Share of 100) over its
business cycle. You are required to find out -
1.Cost of Equity Capital, if Market P rice in Year 1 is `150.
2.Expected Market Price in Year 2, if Cost of Equity is expected to rise
to 18%.
3.EPS in Year 2, if the Company were to have an expected Market Price
of `160 per Share, at the existing cost of Equity.
Solution: Note:Year 0 and Year 1 distinction for MPS and EPS is not
applied in the solution below.munotes.in

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811.2516.67%Pr 150eEarnings per share EPSKMarket ice per Share MPS== = =`
`
2.( )25 2518% ( ) , 138.89 : 2518%eEPSK given So MPS Note EPS is uniform atMPS MPS=== = =````3.( )16.67% , 160 16.67% 26.67160eeEPS DPSKp r e s e n t K S o D P SMPS=== = ¥ =```
Illustration 9 : cost of Equity -Realised Yield Approach
Jet Ltd. is a large Company with several thousand shareholders. An
investor buys 100 shares of the Company at the beg inning of the year at a
Market Price of `225. The Par Value of each Share is `10. During the year,
the Company pays a dividend at 25%. The Price of the Share at the end of
the year is `267.50. Calculate the total return on the investment. Suppose
the Inves tor sells the shares at the end of the year, what would be the Cash
Inflows at the end of the year?
Solution :
1.()()11 0
02.50 267.50 225.0020.00%225eDPS MPS MPSKMPS+- + -== =`` `
`
2.Total Return = Dividend + Capital Gain
=()2.50 267.50 225.00+- `` `= `45 per Share, i.e. `4,500
3.Cash Inflows at the end of the year on cum -dividend sale of Shares()26,750 250 27,000Dividend +=`` `Illustrat ion 10 : Cost of Equity -CAPM Approach
Calculate the Cost of Equity Capital of H Ltd. whose Risk Free Return
equals 10%. The Firm’s Beta is 1.75 and the Return on the Market
Portfolio is 15%.
Solution : Under CAPM Approach,()10.00%ef m fKR RR b=+ - = +()1.75 15.00 10.00% 18.75%¥- =.
Illustration 11 : Cost of Equity -CAPM Approach
ABC Company provides the following details :()7%, 1.20, 6%fm fRR Rb== - =Solution : Under CAPM Approach,()7.00%ef m fKR RR b=+ - = +()1.20 6.00% 14.2%¥=.
D.Computation of Overall Cost of Capital, i.e. WACCmunotes.in

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82Illustration 12: Computation of EPS, Cost of Equity and Cost of Debt
The following is an extract from the Financial Statements of Deluxe
Ltd. (in`Lakhs)
Operating Profit 105
Less : Interest on Debentures 33
Net Operating Income before Tax 72
Less : Income Tax 36
Net Profit after Tax 36
Equity Share Capital (Shares of`10 each) 200
Reserves and Surplus 100
15% Non -Convertible Debentures (of `100 each) 220
Total Capital Employed 520
The market Price per Equity Share is 12 and per Debenture is `
93.75.
1.What is the Earnings per Share?
2.What is the Percentage Cost of Capital to the Company for the
Debenture Funds and the Equity?
Solution :
1.361.80.. 20Earnings After Tax LakhsEPSNo of Equity Shares Lakhs Shares== =``
2.1.8015%
12.00eEPSK
MPS== =`
` .
3.Cost of DebtdKmay be computed as under -
Illustration 13 :
D Limited has 5,00,000 Ordinary Shares whose Current Ex -Dividend
Market Price is 1.50 per Share. The Company has just paid a Dividend of
27 paise per Share, and Dividends are expected to continue at this level formunotes.in

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83some time. If the Company has no Debt Capital, what is the Weighted
Average Cost of Capital?
Solution :
5, 00, 000 1.50 7,50, 000. Market Value of Equity=¥ =`Market Value of Debt = Nil
270.18 18%.150eDPSKMPS== = =
Since there is no Debt Capital,
18%e WACC K ==
Illustration 14 : Computation of WACC
The Capital Structure of All -Good Ltd. is -Equity Capital 5 Lakhs,
Reserves and Surplus 2 Lakhs and Debentures 3 Lakhs. The Cost of
Capital before Tax are -(a) Equity -18% and (b) Debentures -10%. You
are require d to compute the Weighted Average Cost of Capital, assuming
a tax rate of 35%.
Solution :
Computation of WACC
Note :Reserves are taken at same Cost as Equity.
Illustration 15: Computation of WACC u sing Market Value Weights.
Newly Formed Ltd. was incorporated recently. Its Capital Structure is as
under in Market Value terms:
12% Debentures redeemable at par in 10 years time `60 Lakhs
15% Preference Shares -irredeemable `20 Lakhs
Equity Shares (320000 Shares) `80 Lakhs
The Company’s Income -Tax Rate is 35%. A study group has reported
that the required return on Equity Capital is 24% for Companies in this
line of business. You are required to compute the Company’s WACC.munotes.in

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84Solution :
Computation of WACC
Illustration 16 : Computation ofdeKKand WACC
ABC Ltd. wished to raise additional finance of `20 Lakhs for meeting its
investment plans. The Company has `4,00,000 in the form of Retained
Earnings available for investment purposes. The following are further
details -
1.Debt Equity Ratio 25:75.
2.Cost of Debt at the rate of 10% (before tax) upto 2,00,000 and 13%
(before tax) beyond that.
3.Earnings Per Share = `12.
4.Dividend Payout = 50% of Earnings.
5.Expected Growth Rate in Dividend 10%.
6.Current Market Price per Share = `60.
7.Company’s Tax Rate is 30% and Shareholder’s Personal Tax Rate is
20%.
Calculate the following -
1.Post Tax Average Cost of Additional Debt.
2.Cost of Retained Earnings and Cost of Equity.
3.Overall Weighted Average (after tax) Cost of Additional Finance.
Soluti on :
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85Note :1DPShas been considered in computation ofeK. Alternatively,
Earnings -Growth model may also be applied.
Shareholders’ Personal Tax Rate is not considered since Dividends
are exempt from Tax in their hands.
Illustration 17 : Cost of Equity using CAPM Approach and
Computation of WACC
Given below is the information concerning projects to be undertaken
by four different Companies -
Company Project Cost Debt Equity Mix
A `100 Crores `25 Crores by Equity and `75 Crores by Debt.
B `70 Crores Debt and Equity will be in equal proportion
C `200 Crores `120 Crores raised by way of Equity, and balance by
Debt.
D `50 Crores `30 Crores by Debt and balance by Equity.
The above Companies carry an Equity Beta of 1.2, 1.8, 0.90 and
2.0 respectively. If the return on Market Portfolio is 14%, Treasury Bonds
carry an Interest Rate of 8% and Pre -Tax Cost of Debt is 16%, ascertain
the appropriate Discount Rate (i.e. Cost of Ca pital) for each of the above
projects. Assume a tax rate of 30%.
Solution :
Computation of Cost of Equity (under CAPM Approach) and WACC
Note :Post Tax Cost of Debt = Interest x (100% -Tax Rate) = 16% x
(100% -30%) = 11.20%.
Illustration 18: Computation of WACC -Book Value and Market Value
Weights M 07
You are required to determine the Weighted Average Cost of Capital of a
Firm using -(a) B ook-Value Weights, and (ii) Market Value Weights. The
following information is available for your perusal :munotes.in

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861.Present Book Value of the Firm’s Capital Structure is -Debentures of
`100 each `8,00,000, Preference Shares of `100 each `2,00,000, Equity
Shares of `10 each `10,00,000.
2.All these securities are traded in the capital markets. Recent Prices are :
Debentures at `110, Preference Shares at `120 and Equity Shares at `22.
3.Ant6icipated external financing opportunities are as follows -
`100 per De benture redeemable at par : 20 years maturity 8%
Coupon Rate, 4% Floatation Costs, Sale Price `100.
`100 Preference Share redeemable at par : 15 years maturity, 10%
Dividend Rate, 5% Floatation Costs, Sale Price `100.
Equity Shares :`2 per Share Floatati on Costs, Sale Price `22.
In addition, the dividend expected on the Equity Share a t the end
of the year `2 per Share, the anticipated Growth Rate in Dividends is 5%
and the Firm has the practice of paying all its earnings in the form of
dividend. The Corporate Tax Rate is 50%.
Solution :
1.Computation of Individual Cost
a)Cost of Equity1
021 0 5 %5% 14.55%22eDPSKgMPS¥=+ = + =`
`
b)Cost of Preference Capital
Pr 2,00,000 10%10.53%Pr 2,00,000 5%peference DividendKNet oceeds Less Floating Costs¥== =`
`
c)Cost of Debt()()8,00,000 8% 100% 50% (100% )4.17%Pr 8,00,000 4%dInterest TaxKNet oceeds Less Floating Costs¥¥ - -== =`
`
2.Computation of WACC (based on Book Value Proportions)
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873.Computation of WACC (based on Market Value Proportions)
Note :In the absence of actual cost as per books, WACC is computed
based on current external financing costs.
Illustration 19: Computation of WACC -present and new Capital
Structure RTP, M 03
JKL Ltd. has the following Book -Value Capital Structure as on 31st
March -
Equity Share Capital (2,00,000 Shares) 40,00,000
11.5% Preference Shares 10,00,000
10% Debentures 30,00,000
Total 80,00,000
The Equity Shares of the Co mpany sell for 20. It is expected that
the Company will pay a Dividend of 2 per Share next year, this dividend is
expected to grow at 5% p.a. forever. Assume 35% Corporate Tax Rate.
You are required to -
1.Compute the Company’s WACC based on the existing Capital
Structure.
2.Compute the new WACC if the Company raises an additional 20
Lakhs debt by issuing 12% debentures. This would result in increasing
the expected Equity Dividend to 2.40 and leave the growth rate
unchanged, but the price of Equity Share will fall to 16 per Share.
3.Comment on the use of weights in the Computation of WACC.
Solution :
1.Computation of Individual Cost of Capital
a)()()100% 10% 100% 35% 6.50%dK Interest Tax=¥ - = ¥ - =
b)pK=Preference Dividend Rate = 11.50%
c)1
025 %5% 10.50% 5% 15.50%20eDPSKgMPS+=+ = + = + =`
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882.Computation of WACC under present Capital Structure (Book
Value We ights)
3.Computation of WACC under new capital Structure (Book Value
Weights)
Note :New Debt()()100% 12% 100% 35% 7.80%dKI n t e r e s t T a x=¥ - = ¥ - =
Revised1
02.405% 15% 5% 20.00%16.00eDPSKgMPS=+ = + = + =`
`
4.Use of Weights : Market Value weights may be preferred to Book
Value weights since they represent the Compan y’s true corporate facet.
In the evaluation of a Company’s performance, Cash Flows are
preferred to mere Book Profits, also Market Value Balance Sheet is
analysed in -depth rather than the Book Value Balance Sheet.
Illustration 20 : Computation of WACC -present and new Capital
Structure ( N99)
The following is the Capital Structure of Simons Ltd. as on 31st
December of a calendar year.
Equity Share -10,000 Shares of `100 each 10,00,000
10% Preference Shares of `100 each 4,00,000
12% Debentures 6,00,000
Total 20,00,000munotes.in

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89The Market Price of the Company’s Share is `110 and its is
expected that6 a Dividend of `10 per Share would be declared for the next
year. The Dividend Growth Rate is 6%.
1.If the Company is in the 50% tax bracket, compute its WACC.
2.For an expansion plan, the Company will borrow `10 Lakhs at 14%
rate of interest. What will be its revised WACC if this financing decision
is expected to increase dividend from `10 to `12 per Share, and the
revised Market Price of Equity Share will be `105 instead of `110?
Solution :
1.Computation of Individual Cost of Capital
a)()()100% 12% 100% 50% 6.00%dK Interest Tax=¥ - = ¥ - =
b)pK=Preference Dividend Rate = 10.00%
c)1
0106% 9.09% 6% 15.09%110eDPSKgMPS=+ = + =+ =`
`
(Note : Given that Next Year Dividend is `10)
2.Computation of WACC under present Capital Structure (Book
Value Weights)
3.Computation of WACC under new capital Structure (Book Value
Weights)
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90Note :New Debt()()100% 14% 100% 50% 7.00%dK Interest Tax=¥ - = ¥ - =
Revised1
0126% 11.43% 6% 17.43%105eDPSKgMPS=+ = + = + =`
`
Particulars A B C
Equity Share Capital (Face Value is 10) `4,00,000 `2,50,000 `5,00,000
Market Value per Share `15 `20 `12
Dividend per Share `2.70 `4.00 `2.88
Debentures (Face Value is 100) Nil `1,00,000 `2.50,000
Market Value per Debenture NA `125 `80
Interest Rate NA 10 8%
The current levels of Dividend are expected to con tinue indefinitely.
Compute each Company’s WACC, if Tax = 50%.
Illustration 21: Computation of WACC -Book Value & Market Value
Proportions -with / without tax RTPmunotes.in

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91The following information has been ex tracted from the Balance Sheet of
ABC Ltd. as on 31stDecember
Component of
CapitalEquity Share
Capital12%
Debentures18% Term
LoanTotal
Amount `In Lakhs 400 400 1,200 2,000
1.Determine the WACC of the Company. It had been paying dividends
at a consistent rate of 20% per annum.
2.What difference will it make if the Current Price of the `100 Share is
`160?
3.Determine the effect of Income Tax on WACC under both the above
situations. (Tax Rate = 40%)
Solution :
1.Computation of WACC (based on Book Value Proportions and
ignoring Tax)
Component (a) Proportion
(b)Individual Cost (c) WACC (d)
=( b )x( c )
Equity Share
Capital420()20.00%eK Dividend Rate = 4.00%
12%
Debentures42012.00%dK= 2.40%
18% Term Loan 12
2018.00%dK= 10.80%
o WACC K==17.20%
Note :
1.eK=Dividend Rate of 20% (given).
2.Book Value Proportions have considered in Column (b) above.
2.(a) Computation of WACC (based on Book Value Proportions and
ignoring Tax)
Component (a) Proportion
(b)Individual Cost (c) WACC (d)
=( b )x( c )
Equity Share
Capital420.2012.50%.160eDPS RsKMPS Rs== =2.5%
12%
Debentures42012.00%dK= 2.40%
18% Term
Loan12
2018.00%dK= 10.80%
o WACC K==15.70%munotes.in

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92Note :However, it is more appropriate to use Market Value proportions in
the above case, since the Market Price of Equity Share Capital has been
consid ered in calculatingeK. Hence WACC using Market Value
Proportions is as under -
3.Effect of Tax Rate of 35% on WACC
a)Computation of WACC with6 tax (Situation 1 above based on
Book Value Proportions)
Component (a) Proportion
(b)Individual Cost (c) WACC (d)
= (b) x (c)
Equity Share Capital420eK(Dividend Rate) = 20.00%4.00%
12% Debentures420()12.00% 100% 40% 7.20%dK=¥ - =1.44%
18% Term Loan 12
20()18.00% 100% 40% 10.80%dK=¥ - =6.48%
o WACC K==11.92%
WACC has reduced from 17.20% to 11.92%, due to tax saving effect.
b)Computation of WACC with tax (Situation 2(a) above based on
Book Value Proportions)
Component (a) Proportion
(b)Individual Cost (c) WACC (d)
= (b) x (c)
Equity Share Capital420.2012.50%.160eDPS RsKMPS Rs== =2.50%
12% Debentures420()12.00% 100% 40% 7.20%dK=¥ - =1.44%
18% Term Loan 12
20()18.00% 100% 40% 10.80%dK=¥ - =6.48%
o WACC K==11.42%
WACC has reduced from 15.70% to 10.42%, due to tax saving effect.munotes.in

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93c)Computation of WACC with tax (Situation 2(b) above based on
Book Value Proportions)
WACC has reduced from 15.35% to 10.64%, due to tax saving effect.
Illustration 22 : Computation of WACC -Book Value & Market
Value Proportions
Calculate WACC using the following data by using (a) Book Value
Weights, (b) Market Value Weights. The Capita lS t r u c t u r eo ft h e
Company is as under -
Particulars Number of Securities Amount (in `)
Debentures ( `100 per Debenture) 5,000 Debentures 5,00,000
Preference Shares ( `100 per Share) 5,000 Preference Shares 5,00,000
Equity Share ( `10 per Share) 1,00,000 Equity Shares 10,00,000
Total 20,00,000
The Market prices of these Securities are -
Debenture -`105 per Debenture, Preferences -`110 per Preference Share,
Equity -`24 each
Additional Information :
a)`100 per Debenture redeemable at par, 10% Coupan Rate, 4%
Floatation Cost, 10 year Maturity.
b)`100 per Preference Share redeemable at par, 15% Coupan Rate,
Floatation Cost, 10 year Maturity.
c)Equity Shares has `4 Floatation Cost and Market Price `24 per Share.
The next year expected dividend is `3 with annual growth of 5%. The
Firm has practice of paying all earnings in the form of Dividend.
Corporate Tax Rate is 50%.munotes.in

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94Solution :
1.Computation of Individual Cost of Capital
2.Computation of WACC based on Book Value Proportions
Component Amount Proportion Individual Cost WACC
10% Debentures `5L a k h s 25% 5.51% 1.38%
5% Preference Shares `5L a k h s 25% 15.35% 3.84%
Equity Shares `10 Lakhs 50% 20.00% 10.00%
Total `20 Lakhs 100% 15.22%
3.Computation of WACC based on Market Value Proportions
Illustration 23 : Computation of WACC
ABC Ltd. has the following capital structure which is considered to be
optimum as on 31stMarch 2014 -
Particulars Amount (in `)
14% Debentures 30,000
11% Preference Shares 10,000
Equity (10,000 Shares) 1,60,000
Total 2,00,000munotes.in

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95The Company’ s Share has a Market Price of `23.60. Next year
Dividend per Share is 50% of year 2014 EPS. The following is the
trend of EPS for the preceding 10 years which is expected to continue
in future -
Year 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
EPS (`) 1.00 1.10 1.21 1.33 1.46 1.61 1.77 1.95 2.15 2.36
The Company issued new Debentures carrying 16% rate of interest
and the Current Market Price of Debentures is `96. Preference Shares
`9.20 (with Annual Dividend of `1.1 per Share) were also issued. The
Company is in 50% tax bracket.
Required :
1.Calculate the After Tax Cost -(a) of new Debt and new Preference
Share Capital, (b) of ordinary Equity, assuming new Equity comes
from Retained Earnings.
2.Calculate the Marginal Cost of Capital when no New Shares are issued.
3.How much can be spent for Capital Investment before new ordinary
share must be sold? Assuming that retained earning available for next
year’s investment are 50% of 2014 Earnings.
4.What will be Marginal Cost of Capital when the funds exceed the
amount calculated in Part (3), assuming New Equity is issued at `20
per Share?
Solution :
1.Computation of Cost of Additional Capital (Component wise)
1.a)After Tax Cost of New Debt()()100% 16 100% 50%8.33%Pr 96dInterest Tax RateKNet oceeds of Issue¥- ¥-== =1.b)After Tax Cost of New Preference Share Capital
Pr 1.1011.96%Pr 9.20peference DividendKNet oceeds of Issue== =1.c)After Tax Cost of Ordinary Equit y
50% 2.3610% 15%23.60eDPSKgMPS¥=+ = + =2.Marginal Cost of Capital : Since the present Capital Structure is
optimum (Refer 1stsentence in the question), the additional funds will be
raised in the same ratio in order to maintain the capital. Hence, the
Marginal Cost of Capital is 15.20%, computed as under:munotes.in

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96Component ` % Individual Cost WACC
Debt 30,000 15% 8.33%dK= 1.25%
Preference Capital 10,000 5% 12.00%pK= 0.60%
Equity Capital 1,60,000 8% 15.00%eK=12.00%
Total 2,00,000 100%o WACC K==13.85%
3.Retained Earnings available for further investments = 50% of 2014
EPS.
50% 2.36 10,000 11,800 Shares=¥ ¥ =``Hence, amount to be used by way of Retained Earnings, before selling
New Ordinary Shares`11,800.
As Equity = 80% of Total Funds, the Total Capital before issuing fresh
Equity Shares11,800
80%`=1 4 , 7 5 04.Revised Marginal Cost of Capital if the Company spends in excess
of `14,750 it will have to issue New Shares :
Note : Revised Cost of Ordinary Equity
1.1810% 15.9%20eDPSKgMPS=+ = + =
Component ` % Individual Cost WACC
Debt 30,000 15% 8.33%dK= 1.25%
Preference Capital 10,000 5% 12.00%pK= 0.60%
Equity Capital 1,60,000 8% 15.90%eK=12.72%
Total 2,00,000 100%o WACC K==14.57%
Illustration 24 : Computation of WACC and Marginal WACC
XYZ Ltd. (in 40% Tax bracket) has the following Book Value Capital
Structure
Equity Capital (in Shares of `10 each, full paid -upat par) `15 Crores
11% Preference Capital (in shares of `100 each, full paid -up at par) `1C o r r e
Retained Earnings `20 Crores
13.5% Debentures (of `100 each) `10 Crores
15% Term Loans `12.5 Croresmunotes.in

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97Other Information
The next expected Dividend on Equity Shares is 3.60 per Share.
Dividends are expected to grow at 7% and the Market Price per Share
is`40.
Preference Stock, redeemable after ten years, is currently selling at
`75 per Share.
Debentures, redeemable after 6 years, are selling at `80 per
Debentures.
Required :
1.Compute the present WACC using -(a) Book Value Proportions, and
(b) Market Value Proportions.
2.Compute the Weighted Marginal Cost of Capital if the Company raises
`10 Crores next year, given the following data -
The amount will be raised by Equity and Debt in equal proportions.
The Company expects to retain `1.5 Crores earnings next year.
The additional issue of Equity Shares will result in the Net Price per
Share being fixed at `32.
Debt Capital raised by way of Term Loans will Cost 15% for the first
2.5 Crores and 16% for the next `2.5 Crores.
Solution :
1.Computation of Cost of Debt
a)Present Cost of Debentures
( ) ( )()( )100 80 Re Pr13.5 60% 100612.70%Re Pr 100 80
2 2ddemptionValue Net oceedsInterest TaxNumber of yearsKdeemptionValue Net oceedsÈ˘- -¥+ -+Í˙Î˚== =+ +
b)Present Cost of Term Loans()()100% 15% 100% 40% 9.00%.dK Interest Tax Rate=- = ¥ - =
c)Cost of Additional Debt for first `2.50 Crores =()100% 15% 60% 9.00%.Interest Tax Rate -= ¥ =
d)Cost of Additional Debt for next `2.50 Cores()100% 16% 60% 9.60%.Interest Tax Rate -= ¥ =
2.Computation of Cost of Preference Share Capital()( )100 75 Re Pr11 Pr10
15.43%Re Pr 100 75
2 2pdemptionValue Net oceedseference Dividend
Number of yearsKdeemptionValue Net oceedsÈ˘- -+ +Í˙Î˚== =+ +munotes.in

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983.Computation of Cost of Equity under Dividend + Growth
Approach
a)Present Cost of Equity
.3.607% 9% 7% 16.00%.4 0 . 0 0eDPS RsKgMPS Rs=+ = + = + =
b)Revised Cost of Equi ty
.3.607% 11.25% 7% 18.25%.32.00eDPS RsKgMPS Rs=+ = + = + =
4.Computation of Present WACC based on Book Value Proportions
Particulars Amount Proportion Individual Cost WACC
Equity Capital `15.0 Crores 15/58.5 WN 3 = 16.00% 4.10%
Preference Capital `1.0 Crore 1/58.5 WN 2 = 15.43% 0.26%
Retained Earnings `20.0 Crores 20/58.5 WN 3 = 16.00% 5.47%
Debentures `10.0 Crores 10/58.5 WN 1 = 12.70% 2.17%
Term Loans `12.5 Crores 12.5/58.5 WN 1 = 9.00% 1.92%
`58.5 Crores 100% 13.92%oK=
5.Computation of Present WACC based on Market Value
Proportions
Particulars Amount Proportion Individual Cost WACC
Equity Capital `60Crores 60/81.25 WN 3 = 16.00% 11.82%
Preference Capital `0.75Crore 0.75/81.25 WN 2 = 15.43% 0.14%
Debentures `8C r o r e s 8/81.25 WN 1 = 12.70% 1.25%
Term Loans `12.5 Crores 12.5/81.25 WN 1 = 9.00% 1.38%
`81.25Crores 100% 14.59%oK=
Note : Retained Earnings are included in Market Value of Equity Share
Capital, hence not applicable in this computation.
6.Computation of Marginal Cost of Capital
Marginal Cost of Capital is computed in different segments as under -
For the first `1.5 Crores of Equity and Debt each -since Retained
Earnings are `1.5 Crores.
For the next `1C r o r eo fD e b ta n dE q u i t ye a c h -since Cost or Debt
changes beyond `2.5 Crores Debt.
For the balance `2.5 Crores of Debt and Equity ea ch.munotes.in

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99
Illustration 25 : Computation ofeKusing WACC -Reverse Working
Backwork Ltd. has a Debt Equity Ratio of 2:1 and a WACC of 12%.
Its Debentures bear interest of 15%. Find out the cost of Equity
Capital. (Assume Tax = 35%)
Solution : Alternative 1 : Using M & M Approach :
Under M & M Approach,
( ) ( )212.00% 12.00% 9.75% 16.50%1eo odDebtKK KKEquity=+ = = + ¥ - =
.
Alternative 2 : Computation of Cost of Equity using Table Method /
Reverse Working
Note :Last column is updated first and 5.50% is computed as b alancing
figure. Thereafter,eKis the balancing figure.
Illustration 28 : Computation of Debt -Equity Ratio using WACC
Ram Ltd. has a WACC of 18.00%. Its Capital Structure co nsists of Equity
and Debt only. If the PE Ratio is 4, Interest Rate on Debt is 15%, Tax Rate
is 35%, find out the Company’s Debt -Equity Ratio.
Solution :
1.
( ) ( )11100% 15% 100% 35% 9.75% 25.00%
4deKI n t e r e s t T a x K
PE Ratio=¥ - = ¥ - = = = =munotes.in

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1002.Let Debt be D% of Total Capital. Hence, Equity = (100% -D%)
=( 1-D)
3.()()[]()()9.75% 25.00% 1 18.00%od d e e oKK W K W D D K g i v e nÈ˘ =¥+ ¥ = ¥ + ¥ -= Î˚
So,9.75% 25.00% 25.00% 18.00%DD+- =Hence,15.25%D 7.00%-= -On solving, we get,7.00%0.46 46%15.25%Do r==
Hence, Debt = 46% and Equity = 54%.
So, Debt -Equity Ratio = 46 : 54.

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1018
LEVERAGE A NALYSIS
Unit Structure
8.1Introduction & Meaning
8.2Types of Leverage
Operating Leverage
Financial Leverage
Combined L everage
8.3Solved Problems
8.1 INTRODUCTIO N& MEA NING:
The word Leverage means using borrowed money (funds) for
investment in business to maximize the profits of the
owners/Shareholders. A Business entity/firm with borrowed fund/debt
fund in its capita l structure is called Levered. A Business entity/firm with
no debt fund is said to be Unlevered. The term leverage in general refers
to relationship between two interrelated variables.
In financial analysis it represents the influence of one financial
variable over some other related financial variable. These financial
variables may be costs, output, Earning before Interest & Tax (EBIT),
Earning per Share (EPS), sales etc.
8.2 TYPES OF LEVERAGE:
1.Operating Leverage
2.Financial Leverage
3.Combined Leverage
Extract of Profit & Loss Statement (Vertical) to show Leverages:
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1021.Operating Leverage: Financial Leverage measures business risk.
Operating Leverage is the ratio of contribution and earnings before interest
& tax (EBIT). Increase or decrease in operatin g leverage is impacted due
to Existence of fixed operating cost. The firm will have higher operating
leverage if it has high fixed costs & vice versa. Higher operating leverage
will result in lower EBIT & vice versa.
1)
i.The % change in EB IT due to % change in given sales is known as
Degree of Operating leverage.
ii.Relationship: % change in EBIT = % change in Sales X D.O.L
(D.O.L =Degree of Operating Leverage)
iii.Linkage : Sales and EBIT
iv.So, Degree of Operating Leverage (D.O.L) can be calculat ed by
using following formulae.
1.)
2.)
=
Illustration
1.Contribution Rs. 25000 & EBIT Rs. 5000 Calculate D.O.L
Particulars Amount (Rs.)
Sales XXX
Less: Variable Costs (XXX)
Contribution XXX
Less: Fixed Costs (XXX)
Operating Profit/
Earnings Before
Interest & Tax (EBIT)XXX
Less: Interest (XXX)
Earnings Before Tax
(EBT)XXXCombinedLeverageOperatingLeverageFinancialLeverage
Contribution XXX
Less: Fix ed Costs (XXX)
Operating Profit/ Earnings
Before Interest & Tax (EBIT)XXX
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1032.Sales Rs. 10000 & EBIT Rs. 2000 Calculate D.O.L if sales increases to
Rs. 15,000 and EBIT Rs. 60 00.
=
%C h a n g ei nE B I T=
=
% Change in Sales =
=
D.O.L
1)Financial Leverage: Financial leverage measures financial risks.
Financial Leverage is the ratio o f Earning before interest and tax
(EBIT) & Earning before Tax (EBT). Increase or decrease in operating
leverage is impacted due to Existence of Interest Expenses. The firm
will have higher financial leverage if it has high Finance cost (interest
expenses) & vice versa
i.The % change in EPS due to % change in given EBIT is known as
Degree of Financial leverage.
ii.Relationship: % chan ge in EPS = % change in EBIT X D.F.L
iii.Linkage : EBIT and EPS
iv.So, Degree of Financial Leverage (D.F.L) can be calculated by
using following formulae.
1)
a)
(if Preference dividend is not given in Ques.)
b) D.F.L
(if Preferenc e dividend is given in Ques.)
2)
=
Illustration
1)EBIT Rs. 5000 & EBT Rs. 1000 Calculate D.F.L
Note: Preference dividend is not given in question
Earnings Before Interest & Tax
(EBIT)XXX
Less: Finance Cost (Interest Expense) (XXX)
Earnings Before Tax (EBT) XXX
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1042)EBIT Rs. 5000, EBT Rs. 1000, 10% preference share capital Rs.
3000, Tax Rate = 40% Calculate Degree of Financial Leverage
(D.F.L)
Note: Preference Dividend is given
Given: 10% preference share capital Rs. 3000 means
Pref. Dividend = Rs. 3000 X 10% = Rs. 300
D.F.L
1)EPS Rs 2 & EBIT Rs. 2000 Calculate D. F.L if EPS increases to Rs.
8a n dE B I TR s .6 0 0 0 .
=
% Change in EPS =
=
%C h a n g ei nE B I T=
=
D.F.L
2)Combined Leverage: Combined leverage measures total ri sk i.e.
business risk & financial risk. Combined Leverage is the ratio of
Contribution and Earning before tax. (EBT). Increase or decrease in
combined leverage is impacted due to existence of Total Fixed
Costs/Expenses (Operating Fixed Costs & Interest Exp enses.
Extract of Profit & Loss Statement (Vertical) to show Leverages:
i. The % change in Earning Per Share (EPS) due to % change in
given Sales is known as Degree of Combined leverage.
Relationship: % change i n EPS = % change in Sales X D.C.L
ii. Linkage : Sales and EPSParticulars Amount
(Rs.)
Sales XXX
Less: Variable Costs (XXX)
Contribution XXX
Less: Fixed Costs (XXX)
Operating Profit/ Earnings Before
Interest & Tax (EBIT)XXX
Less: Inter est (XXX)
Earnings Before Tax (EBT) XXXCombinedLeverageOperatingLeverageFinancialLeveragemunotes.in

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105iii. So, Degree of Combined Leverage (D.C.L) can be calculated by
using following formulae.
1)
a)
(if Preference dividend is not given in Ques.)
b)D.C.L
(if Preference dividend is given in Ques.)
2)
=
3)D.C.L = Degree of Operating Leverage X Degree of Financial
Leverage
8.3SOLVED PROBLEMS
Problem 1 :
The operating information of Bacchan Enterprises are as follows :
Solution :
Rs.
Sales (1000 unit sa tR s .1 0 0 ) 30,00,000
Less : Variable cost 21,00,000
Contribution (C) 9,00,000
Less : Fixed costs 3,75,000
Operating Profit (OP) or EBIT 5,25,000
Less : Interest 2,25,000
Profit before tax (PBT) 3,00,000
Operating leveragePCO
9,00,0001.715,25,000 
Financial leverage5.25.0001.753.00.000EBITPBT 
Combined leverageOP FL1.71 1.75 2.99ii)Additional sales to double EBIT :
Rs.
Present EBIT 5,25,000
Increase in EBIT (equal amount) 5,25,000
EBIT Desired 10,50,000
Add : Fixed cost 3,75,000
Contribution required 14,25,000munotes.in

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106Contribution Ratio9,00,000100 100 30%30,00,000C
S 
Therefore, Sales for contribution of Rs.14,25,00014,25,000 10030 Rs. 47,50,000Additional Sales Rs. 17,50,000
Problem 2 :
Calculate operating, financial and combined leverage under
Financial Plan X and Financial Plan Y when the fixed costs are Rs.
1,00,000 in two different situations. The information rega rding capital
structure and other data are as follows :
Rs.
Total Assets 5,00,000
Total Assets turnover based on sales 2
Variable cost as percentage of sales 60
Financial Plan
Firm X( R s . ) Y( R s . )
Equity 5,00,000 1,00,000
10% Debenture 1,00,0 00 5,00,000
solution:
Comparative statement of Leverage :
Financial Plan A B
Situation (1) (2) (1) (2)
Sales Revenue 10,00,000 10,00,000 10,00,000 10,00,000
Less : Variable Cost 6,00,000 6,00,000 6,00,000 6,00,000
Contribution (C) 4,00,000 4,00,000 4,00,000 4,00,000
Less : Fixed cost 50,000 1,00,000 50,000 1,00,000
Operating profit (EBIT) 3,50,000 3,00,000 3,50,000 3,00,000
Less : Interest 10,000 10,000 50,000 50,000
Profit before tax (PBT) 3,40,000 2,90,000 3,00,000 2,50,000
Operating Leverage :COP(EBIT)4,00,0003, 50, 0001.144,00,0003, 00, 0001.334,00,0003, 50, 0001.144,00,0003, 00, 0001.33Finance Leverage :EBITPBT3,50, 0003, 40, 0001.033, 00, 0002,90,0001.033,50, 0003, 00, 0001.163, 00, 0002,50,0001.20Combined Leverage :CPBT(AlsoCL OL FL)4,00,0003, 40, 0001.184,00,0002,90,0001.374,00,0003, 00, 0001.334,00,0002,50,0001.60munotes.in

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107Problem 3 :
Calculate operating leverage and financial leverage under
situations 1 and 2 and financial plans A and B respectively from the
following formation relating to the operation and capital structure of a
company. What are the combinations of operating and fi nancial leverage
which give highest and the least value?
Installed capacity -2000 Units
Actual production & sales -50% of installed capacity
Selling price per unit -Rs. 20
Variable cost per unit -Rs. 10
Capital Structure :
Financial Plan
Firm A( R s . ) B( R s . )
Equity 5,000 15,000
Debt. (cost of Debt. = 10%) 15,000 5,000
20,000 20,000
solution :
Actual production and sales 50% of 2000 installed capacity = 1000 units.
Contribution per unit = Rs. 10
Total contribution1000 10Rs. 10,000/ -
Comparative statement of Leverage :
Financial Plan A B
Situation (1) (2) (1) (2)
Contribution (C) 10,000 10,000 10,000 10,000
Fixed cost 4,000 5,000 4,000 5,000
Operating profit (OP) or
EBIT6,000 5,000 6,000 5,000
Less : Interest 1,500 1,500 500 500
Profit before tax (PBT) 4,500 3,500 5,500 4,500
Operating Leverage :COP10,0001.676,00010,00025,00010,0001.676,00010,00025,000Finance Leverage :EBITPBT6,0001.334,5005,0001.433,5006,0001.095,5005,0001.114,500
Combined Leverage :CPBTORCL OL FL10,0002.224,50010,0002.863,50010,0001.825,50010,0002.224,500
Highest value = 2.86 : Financial Plan A sit 2
Least value = 1.82 : Financial Plan B sit 1munotes.in

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108Problem 4:
ABC Ltd. has an average selling price of Rs. 150 per unit. Its
variable unit cost is Rs. 105 and fixed cost amount to Rs. 25 lakhs. It
finances all its assets by equity funds. It pays 35% tax on its income. XYZ
Ltd. is identical to ABC Ltd., except in respect of the pattern of financing.
The latter finances its assets 50% by equity and 50% by debt, the interest
on which amount to Rs. 3,00,000.
Determine the degree of operating financial and combined
leverages at Rs. 1,00,00,000 sales for both the firms :
Solution :
Situation ABC Ltd. XYZ Ltd.
Sales 1,05,00,000 1,05,00,000
Varia ble Cost 73,50,000 73,50,000
Contribution (C) 31,50,000 31,50,000
Less : Fixed cost 25,00,000 25,00,000
Operating profit (OP) or (EBIT) 6,50,000 6,50,000
Less : Interest -- 3,00,000
Profit before tax (PBT) 6,50,000 3,50,000
Operating Leverage :COP31,50,0004.856,50,00031,50,0004.856,50,000
Finance Leverage :EBITPBT6,50,00016,50,0006,50,0001.863,50,000
Combined Leverage :CPBT31,50,0004.856,50,00031,50,00093,50, 000ABC Ltd. is better as the CL is least.
Problem 5:
Bombay Textiles Ltd., has before it the following four methods of
financing its expansion programme :
Financial Plan
I II III IV
Equity shares of Rs. 100 each 7,50,000 5,00,000 10,00,000 2,50,000
Preference shares (of Rs. 100 each) 5,00,000 5,00,000
Debentures 7,50,000 5,00,000 -- 12,50,000
(Cost : 10%) (Cost : 11%) (Cost : 12%)
The company is in the tax bracket of 35 percent. The company has
EBIT of Rs. 2,00 ,000. Determine the degree of financial leverage of each
plan.munotes.in

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109Solution :
Financial Plan
I II III IV
EBIT 2,00,000 2,00,000 2,00,000 2,00,000
Less : Interest 75,000 55,000 -- 1,50,000
Profit before tax (PBT) 1,25,000 1,45,000 2,00,000 50,000
Financial Leverage :EBITPBT2,00,0001, 25, 0001.602,00,0001, 45, 0001.382,00,0002,00,00012,00,00050,0004Practical Questions from Professional Exams with Solutions
Question 1 :
An Income statement of SR K LTD is shown below : It is based on
an output (Sales) level of 80,000 units.
Particulars Rs.
Sales 9,60,000
Variable cost 5,60,000
Revenue before fixed costs 4,00,000
Fixed costs 2,40,000
Earning Before Interest and Tax (EBIT) 1,60,000
Interes t 60,000
Earnings before tax (EBT) 1,00,000
Tax 50,000
Net Income (Earning After Tax) 50,000
Calculate the degree of (i) operating leverage (i) financial leverage
and (iii) the combined leverages from the above data.
Solution :
i)Operating leverageContributionOperation profit or EBIT
4,00,0002.5:11,60,000 
ii)Financial leverage()()Operating profit OPProfit before tax PBT
1,60,0001.6 :11,00,000 
iii)Combined leverageContributionPBT
4,00,0004:11,00,000 
OR2.5 1.6 4:1Operating leverage Financial leverage  munotes.in

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110Question 2 :
i)Find the operating leverage from the following data :
Sales Rs. 50,000
Variable cost 60%
Fixed costs Rs. 12,000
ii)Find the financial leverage form the following data
Net Worth Rs. 25,00,000
Debt / Equity 3/1
Interest Rate 12%
Operating Profit Rs. 20,00,000
Solution :
i)Statement of Operating Profit
Particulars Rs.
Sales 50,000
Less : Variable cost 30,000
Contribution (C) 20,000
Less : Fixed costs 12,000
Operating Profit (EBIT) 8,000
Operating levera ge20,0002.58,000C
EBIT 
ii)Given net worth is 25,00,000 and
Debt Equity ratio is3125,00,000 3 75,00,000@12% .75,00,000 .9,00,00020,00,000 9,00,000 11,00,000DebtDebt Net worthEquity
Interest on Rs Rs
EBIT Interest PBT
 
  

  
Financial Leverage = / f(EBIT,PBT) = / f(20,00,000, /11,00,000) = 1.818
Question 3:
The capital structure of the Progressive corporation consists of an
ordinary share capital of Rs. 10,00,000 (shares of Rs. 100 per value) and
Rs. 10,00,000 of 10% Debentures, sales increased by 20% from 1,00,000
units to 1,20,000 units, the selling price is Rs. 10 per unit; var iable costs
amount to Rs. 6 per unit and fixed expenses amount to Rs. 2,00,000. The
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111a)You are required to calculate the following :
i)The percentage increase in earnings per share.
ii)The degree of financial le verage at 1,00,000 units and 1,20,000
units.
iii)The degree of operating leverage at 1,00,000 units and 1,20,000
units.
b)Comment on the behavior of operating and financial leverages in
relation to increase in production from 1,00,000 units to 1,20,00 0
units.
Solution :
Statement showing operating, financial leverage and EPS
Particulars 1,00,000
Units1,20,000
Units
Sales at Rs. 10 per unit 10,00,000 12,00,000
Less : Variable costs at Rs. 6 per unit 6,00,000 7,20,000
Contribution at Rs. 4 per unit 4,00,000 4,80,000
Less : Fixed expenses 2,00,000 2,00,000
Operating profit or EBIT 2,00,000 2,80,000
Less : Interest on Debentures 10% on Rs.
10 lakhs1,00,000 1,00,000
Profit before tax (PBT) 1,00,000 1,80,000
Less : Tax at 50% 50,000 90,000
Profit after tax (PAT) 50,000 90,000
(i) EPS = PAT / No of shares50,00010,000=R s .590,00010,000=R s .9
(ii) Degree of financial leverageEBITPBT2,00,0001,00,000=22,80,0001,80,000=1.56
(ii) Degree of operating leverageContributionEBIT4,00,0002,00,000=24,80,0002,80,000=1.714
b)In relation to increase in Production and Sales from 1,00,000 units to
1,20,000 units i.e. 20% increase. EPS has gone from Rs. 5 to Rs. 9 i.e.
increase by 80%. But both the financial leverage and operating
leverage have decreased consequent upon the increase in sales. Due to
reduction both risks i.e. business risk and financial risk of the business
are reduce d.
Question 4:
A firm has sales of Rs. 10,00,000, variable cost of Rs. 7,00,000
and fixed costs of Rs. 2,00,000 and debt of Rs. 5,00,000 at 10% rate of
interest. What are the operating, financial and combined leverages? If themunotes.in

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112firm wants to double up i ts earnings before interest and tax (EBIT), how
much of a rise in sales would be needed on a percentage basis?
Solution :
Statement of Operating Profit
Particulars Rs.
Sales 10,00,000
Less : Variable cost 7,00,000
Contribution (C) 3,00,000
Less : Fixed costs 2,00,000
Operating Profit or EBIT 1,00,000
Less : Interest at 10% on Rs. 5,00,000 50,000
Profit before tax (PBT) 50,000
Operating leverage3,00,00031,00,000C
OP Financial leverage1,00,000250,000OP
PBT Combined leverage32 6Statement of Sales needed to double EBIT
Operating leverage is 3 times i.e. 33.33% increase in sales volume
causes a 100% increase in operating profit or EBIT. Thus at the sales of
Rs. 13,33,333,.33, the operating profit or EBIT will become Rs. 2,00,000
i.e. double the existing one.
This is verified as follows :
Sales 13,33,333.33
Less: Variable cost (9,33,333.33)
Contribution 4,00,000.00
Less: Fixed costs (2,00,000.00)
Operating Profit 2,00,000.00
Question 5:
Calculate the degree of operating leverage, degree of financial
leverage and the degree of combined leverage for the following firms and
interpret the results :munotes.in

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113Firm Amit Babu Chandu
Output (units) 60,000 15,000 1,00,000
Fixed costs (Rs.) 7,200 14,000 1,500
Variable cost per unit (Rs.) 0.20 1.50 0.02
Interest on borrowed capital (Rs.) 4,000 8,000 Nil
Selling price per unit (Rs.) 0.60 5.00 0.10
Solution :
Firms
Firm Amit Babu Chandu
Output (Units) 60,000 15,000 1,00,000
Rs. Rs. Rs.
Sellin g Price per unit 0.60 5.00 0.10
Variable cost per unit 0.20 1.50 0.02
Contribution per unit 0.40 3.50 0.08
Total Contribution 24,000 52,500 8,000
Less : Fixed costs 7,000 14,000 1,500
EBIT or Operating Profit 17,000 38,500 6,500
Less : Interest 4,000 8,000 Nil
Profit before tax (P.B.T.) 13,000 30,500 6,500
Degree of Operating Leverage24,00017,00052,50038,5008,0006,500.. .ContributionEBIT=1.41 =1.36 =1.23
Degree of Financial Leverage17,00013,00038,50030,5006,5006,500.. ...EBITPBT=1.31 =1.26 =1.00
Degree of Combined Leverage24,00013,00052,50030,5008,0006,500..ContributionPBT=1.85 =1.72 =1.23
Comments :
Since firm Chandu has low fixed cost and no interest, it constitutes
an ideal situation. P/V ratio also is highest which is 80%. Low Operatingmunotes.in

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114leverage combined with low financial leverage will constitute an ideal
situation; whereas high operating leverage combined with high financial
leverage will constitute risky situation.
Question 6
The following are the operating results of a firm :
Sales (units) 25,000 Interests per annum Rs. 30,000
Selling price per unit Rs. 24 Tax Rate 50%
Variable cost per unit Rs. 16 No. of Equity shares 10,000
Fixed costs per annum Rs. 80,000
Compute : (i) Break -even sales, (ii) Earnings before interest and tax, (iii)
Earnings per share, (iv) Operating leverage, (v) Fi nancial leverage.
Answer :
Working Note :
1) Statement of Profit after tax
Sales 25,000 units at 24 6,00,000
Less : Variable cost2500 16(4,00,000)
Contribution 2,00,000
Less : Fixed costs (80,000)
Financial Leverage 633
Operating profit i.e. EBIT 1,20,000
Less : Interest (30,000)
PBT 90,000
Less : Tax 50% (45,000)
PAT 45,000
2) Contribution = 24 -16 Rs. 8 per unit
P.V. Ratio =8100 100 33 %24CS⅓Solution :
i)Break -even sales = F/P.V. ratio.80000 / 33 % .2,40,000Rs⅓ii)EBIT Rs. 1,20,000 (refer WN1)
iii)EPS = PAT / No. of Equity shares = Rs. 45,000/10,000 shares = Rs.
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115iv) Operating Leverage =2,00,0001.671,20,000C
EBIT 
v)Financial Leverage =1,20,0001.3390,000EBIT
PBT 
Question 7
A small indus trial Co., has a sales level of Rs. 8,40,000 with a 10%
profit margin before int. and taxes. To sustain this business, the firm
maintains a fixed assets investment of Rs. 3,00,000 and Rs. 1,50,000 as
current assets.
i)Compute the asset turnover of the f irm :
ii)What is the EBIT percent on investment?
iii)What will be the rate of return if current assets increased by Rs.
1,50,000?
iv)What will it be if current assets decreased by Rs. 75,000?
Answer
i)Total Assets =Fixed assets +Current Assets
=3,00,000 +1,50,000 =4,50,000
Sales turnover =Salestotal assets=8,40,0004,50,000=1.87
ii)EBIT = 10% of 8,40,000 = Rs. 84,000/
Percent of EBIT on investment =84,000100 18.67%4,50,000
iii)Rate of return, if current assets are increased by Rs. 1,50,000
84,000100 14%6,00,000
iv)84,000100 22.4%3,75,000
Question 8
The Net Sales of Apex Co. are Rs. 15 crores. EBIT of the
Company as a percentage of Net Sales is 12%. The Capital Employed
comprises Rs. 5 crores of eq uity, Rs. 1 crore of Cumulative Redeemable
Preference Shares bearing 13% rate of dividend and Debt Capital of Rs. 3
crores at an annual interest rate of 15%. Corporate Income Tax Rate is
40%.
Required
i)Calculate the Return on Equity (ROE) for the Comp any and indicate
its segments due to the presence of Preference Share Capital and Debt
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116ii)Calculate the Operating Leverage of the Company given that its
Combined Leverage is 3.
Answer
a) EBIT 12% of net sales i.e. 12% of 15
crores1.80
Less Interest 15% of Rs. 3 crores 0.45
PBT 1.35
Less tax at 40% 0.54
PAT 0.81
Preference Dividend 13% of 1 crore = 0.13
Profit available to Equity shareholders Rs. 0.68 crores
Profit available to Equity shareholdersROE = ×100Equity Capital
Rs. 0.68 crores= ×100=13.6%Rs. 5.00 crores
Segment of ROE due to pre ference capital = 0.002 i.e. 0.2%
Segment of ROE due to Debt = 0.018 i.e. 1.8%
b)Financial leverage = EBIT / PBT
=1 . 8 0/1 . 3 5=1 . 3 3 3 3
Combined leverage = Financial leverage ƒoperating leverage
3=1 . 3 3 3 3 ƒOperating leverage
Operating leverag e = 3/1.3333 = 2.25
Question 9
The following details of A Ltd. for the year ended 31.3.95 are
furnished :
Operating Leverage 3:1
Financial Leverage 2:1
Interest charges per annum Rs. 20 lakhs
Corporate Tax Rate 50%
Variable cost as percenta ge of sales : 60%
Prepare the Income Statement of the companymunotes.in

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117Answer
WN1:Financial leverage = 2 : 1
Financial leverage =21EBIT EBITPBT EBIT Interest 220 1EBITEBITBy cross multiplication : -
EBIT = 2 (EBIT -20)
EBIT=2( E B I T -40)
2E B I T -EBIT = 40
EBIT = Rs. 40 lakhs
2)Operating leverage = 3 : 1
Operating leverage =31ContributionEBIT340 1ContributionContribution34 0Rs. 120 lakhs
3)Variable cost is 60% of sales i .e., contribution is 40% of sales.
Hence,
Contribution 40 -Sales 100
Contribution 120 -?
12010040Rs. 300 lakhs sales
Solution
Income statement of A Ltd. for the year ended 31.3.95 (Rs. Lakhs)
Sales 300
Less : Variable cost 60% of sales 180
Contribution 40% sales (WN2) 120
Less : Fixed cost excluding interest (B/F) 80
EBIT (WN1) 40
Less : Interest 20
PBT 20
Less : Tax at 50% 10
PAT 10
Question 10
Prepare the Income statement of a firm which gives the following
details relating to its operations :
Operating Leverage =4
Financial Leverage =2
Annual interest paid =Rs. 10 Lakhs
Contribution / sales =0.4
Tax rate =40munotes.in

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118Answer
Working Note
Financial LeverageEBITPBT
2EBITEBIT Interesti.e. 2.10EBITEBIT Rs lakhs
EBIT =R s .2 0l a k h s
Operating leverageContributionEBIT
4.20ContributionRs lakhs
Contribution42 0lakhs = Rs. 80 lakhs
Contribution / Sales = 0.4 i.e. P.V. Ratio = 0.4 i.e. 40%
Variable cost ratio = 60% of sales.
Contribution 40% ………. 80 lakhs
Sales 100% ………. ?
i.e. sales = Rs. 200 lakhs
Solution
Income Statement (Rs. Lakhs)
Sales 200 EBIT 20
Less : Variable cost 60% 120 Less Interest (given) 10
Contribution 80 PBT 10
Less : Fixed overheads (B/F) 60 Less : Tax 40% 4
EBIT 20 PAT 6
Question 11
If the combined leverage and operating leverage figures of a
company are 2.5 and 1.25 respectively, find the financial levera ge and P/V
ratio, given that the equity dividend per share is Rs. 2, interest payable per
year is Rs. 1 lakh, total fixed cost Rs. 0.5 lakh and sales Rs. 10 lakhs.252.5 . .10ContributionCombined Leverage i ePBT  1251.25 . .100ContributionOperating Leverage i eEBIT  munotes.in

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119Combined Leverage Operating leverage financial leverage   2.5 1.25financial leverage 2.52.01.25Financial Leverage  20.. 2 . 0..10EBITie f i n a n c i a lL e v e r a g e iePBT  EBITFinancial LeverageEBIT Interest 
2 . ., . 2.00100EBITie E B I T R s l a k h sEBIT 
EBIT Rs. 2.00 lakhs
Less : Interest 1.00 lakhs
PBT 1.00 lakhs
EBIT 2.00 lakhs
Add : Fixe dC o s t 0.50 lakhs
Contribution 2.50 lakhs
Sales 10.00 lakhs
Variable cost 7.50 lakhs
2.50/1 0 0 1 0 0 2 5 %10.00CPV R a t i oS
Note : Reconciliation Rs. lakhs
Sales 10.00
Less : Variable cost 7.50
Contribution 2.50
Less : fixed cost 0.50
EBIT (or operating profit) 2.00
Less : interest 1.00
PBT 1.00
2.502.5100CCombined LeveragePBT (given in question)
2.501.252.00COperative LeveragePBT (given in question)
Question 12
The following financial data have been furnished by A Ltd. and B
Ltd. for the year ended 31.3.2014 :
A Ltd. BL t d .
Operating leverage 3:1 4:1munotes.in

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120Financial leverage 2:1 3:1
Interest charges per annum Rs. 12 lakhs Rs. 10 lakhs
Corporate tax rate 40% 40%
Variable cost as % of sales 60% 50%
Prepare Income statements of the two companies. Also comment
on the financial position and structure of the two companies.
Answer
For preparing Income statements, the following workings are
required :
Company A
Ltd.BL t d .EBITFinancial LeveragePBT 2:1 3:1
..12EBIT EBITieEBIT Interest EBIT lakhs  21310 1EBITEBIT lakhs
.2 4EBIT Rs lakhs.15EBIT Rs lakhsCOperating LeverageEBIT 3:1 4:124Clakhs31415 1Clakhs
C = Rs. 72 lakhs C=R s .6 0l a k h s
Variable cost to sales 60% 50%
P/v ratio 40% 50%
/Contribution Sales P v Ratio72 40%lakhs Sales60 50%lakhs Sales.180Sales Rs lakhs.120Sales Rs lakhsSolution Income Statement (Rs. Lakhs)
Particulars AL t d . B Ltd.
Sales 180 120
Less : Variable cost 60% of 180 108 60
Contribution 72 60
Less : Fixed over heads excluding
Interest (B/F) 48 45
EBIT 24 15
Less : Interest charges 12 10
PBT 12 5
Less : Tax at 40% 4.80 2
PAT 7.20 3munotes.in

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121Comments :
Financial position of A Ltd. is better than that of B Ltd. in view of
the following reasons :
1)Operatin g leverage is lower
2)Financial leverage is lower
3)Degree of Combined Leverage
A Ltd.32 6B Ltd.431 2Degree of combined leverage also is lower. That is the total risk
(business and financial) of A Lt d. is lower.
4.Interest coverage ratio is also higher. That is A Ltd. is far better to
meet the interest liability.
Interest coverage ratio =EBITInterestA Ltd. :2412lakhslakhs=2
B Ltd. :1510lakhslakhs=1 . 5
5)One disadvantage : P/v ratio of A Ltd. is lower. P/V Ratio of B Ltd. is
better.
munotes.in

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1229
WORKI NGC A P I T A LM A NAGEME NT
Unit Structure
9.1 Introduction & Meaning
9.2 Concept of Working Capital
9.3 Operating Cycle or Working Capital Cycle
9.4 Components of Operating Cycle
9.5 Solved Problems
9.1 INTRODUCTIO N& MEA NING
Any business requires minimum capital to run the day -to-day
business activities. This minimum capital is known as working capital.
The management of Working capital is one of the crucial activities of the
finance manager. working capital management is call ed short term
financial management. Short term financial management means
management of current assets and current liabilities. Current assets are
assets which can be converted into cash within an accounting year and it
includes cash, receivables, sundry d ebtors, inventory, prepaid expenses.
Current liabilities are payables within an accounting year and includes
sundry creditors, bills Payable, outstanding liabilities etc.
9.2 CO NCEPTS OF WORKI NG CAPITAL:
1.Gross working capital: Gross working capital ref ers to firm’s
investment in current assets. Current assets means receivables, sundry
debtors, stock of raw material and finished goods and work -in-
progress , cash and cash equivalents, marketable securities, prepaid
expenses etc.
2.Net working capital: Net W orking capital refers to the difference
between current assets and current liabilities. Net working capital can
be positive or negative.
a.Positive working capital: When current assets exceed current
liabilities it’s called positive working capital.
b.Negative working capital: When current liabilities exceed current
assets it’s called negative working capital.
3.Fixed working capital: A firm may have policy to maintain minimum
working capital all the time due to uncertainty involved in business,
This minimum capi tal which is required to be maintained is called as
fixed working capital.munotes.in

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1234.Fluctuating working capital: A working capital excess of fixed
working capital is known as fluctuating working capital.
9.3 OPERATI NG CYCLE OR WORKI NG CAPITAL
CYCLE:
Operating cycle means total period required
i.To convert cash into raw material
ii.To convert material into work in progress
iii.To convert work -in-progress into finished goods
iv.To convert finished goods into debtors and receivables
v.To convert receivables into cash .
Operating Cycle
9.4 COMPO NENTS OF OPERATI NG CYCLE
1.Raw material storage period
2.Work-in-progress holding period
3.Finished goods storage period
4.Debtors collection period
5.Credit period allowed by creditors.
Operating cycle = R+W+F+D -C
Illustration No. 1 Calculate operating cycle from the following:
1.Raw material storage period –1 Month
2.Work in progress holding period –1 Month
3.Finished goods storage period –2M o n t h s
4.Debtors collection period –3M o n t h s
5.Credi t period allowed by suppliers –2M o n t h s
Solution: Operating cycle = R+W+F+D -C
Operating Cycle = 1 Month + 1Month + 2Month + 3Month -2Month = 5
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124Statement Showing Estimated Working Capital Requirement -
Format
Amount Particulars Computation
(Rs.) (Rs.)
A.Current Assets:
1.Stock of Raw Material Annual Production X (Avg. Storage
Period / 12 Months /365 days/52
weeksXX
2.Stock of W -I-P XX
a.Raw Material Annual Production X( Avg. Holding
period / 12 Months /365 days/52
weeks) X 100 %*
b.Wages/ Labour cost Annual Production X( Avg. Holding
period / 12 Months /365 days/52
weeks) X 50% *
c.Mfg. Overheads Annual Production X( Avg. Holding
period / 12 Months /365 days/52
weeks) X 50% *
3.Stock of Finished Goods Annual Production X (Avg. Storage
Period / 12 Months /365 days/52
weeks)XX
4.Sundry Debtors Annual Production X (Avg.
Collection Period / 12 Months /365
days/52 weeksXX
5.Cash in Hand XX
6.Prepaid Expenses XX
Total Current
AssetsXXX
B.Current Liabilities:
1.Sundry Creditors Annual Production X (Avg. Credit
period allowed / 12 Months /365
days/52 weeksXX
2.Outstanding Expenses Annual Production X (Avg. Credit
period / 12 Months /365 days/52
weeksXX
3.Provisions XX
Total Current Liabilities (XXX)
C.Net Working Capital
(A-B)XXX
D.Safety Margin XXX
E.Total Working Capital
(C+D)
Note: * In computation of W -I-P if % degree of completion is
specified then those % to be used otherwise computation will be as
given in the format.munotes.in

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1259.5 SOLVED PROBLEMS
Problem 1 :
From the following information, you are required to estimate the
net working capital :
Cost per unit (Rs.)
Raw Material 400
Direct Labour 150
Overheads (excluding depreciation) 300
Total 850
Additional Information :
Rs. 1000 per units
Selling price 52000 units per annum
Output Average 4 weeks
Raw materials in stock Average 2 weeks
Work -in-progress (assume 50% of Completion
stage with full material consumption)
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors Average 8 weeks
Cash at bank expected to be Rs. 50,000
Assume that production is sustained at an even pace during the 52
weeks of the year. All sales are on credit basis. State any other
assumptions that you might have made while computing.
Solution :
Statement of working capital estimation
Current Assets Rs.52000 400 452Raw Material   16,00,000
Work -in-progress :
i) Raw Material 8,00,00052000 400 252   ii) Direct labour and overheads 4,50,000 12,50,000
(50% complete)52000 850 452   Finished goods52000 850 452   34,00,000munotes.in

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126Debtors52000 850 852   68,00,000
Cash at Bank 50,000
1,31,00,000
Less : Current Liabilities
Creditors 16,00,00052000 400 452   Net Working Capital 1,15,00,000
Problem 2:
A proforma cost sheet of a company provides the following
particulars :
Element of cost Amount per unit
Rs.
Raw material 80
Direct labour 30
Overheads 60
Total Cost 170
Profit 30
Selling price 200
The following further particulars are available :
Raw materials are in stock on average one month. Materials are in
process on an average half a month. Finished goods are in stock on an
average one month.
Credit allowed by suppliers is one month. Credit allowed to
debtors is two months. Lag in payment of wages is 1.5 weeks. Lag in
payment of overhead expenses is one month.
One-fourth of the output is sold against cash. Cash on hand and at
bank is expected to be Rs. 25,000.
You are required to prepare a statement showing the working
capital neede d to finance a level of activity of 1,04,000 units of
production.
You may assume that production is carried on evenly throughout
the year, wages and overheads accrue similarly and a time period of 4
weeks is equivalent to a month.munotes.in

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127Solution :
Statement of working capital requirement
Particulars Rs. Rs.
Current Assets :
Cash at bank 25,000
Stock of Raw Materials
(8000 units at Rs. 80 per unit) 6,40,000
Work -in-progress
Material for 4000 units at Rs. 80 per unit 3,20,000
Labour& Overheads equal to 2000 units at
Rs. 90 per unit1,80,000 5,00,000
Finished goods, 8000 units at Rs. 170 per
unit.13,60,000
Sundry Debtors (equivalent at cost) Sales
units 16,000
Less : Cash
Sales 4,000
12,000
Credit units -12,000 @ Rs. 170 per unit 20,40,000
Total current assets 45,65,000
Less : Current Liabilities :
Sundry creditors for 8000 units
atRs. 80 per unit. 6,40,000
Outstanding expenses
Wages (3000 units x Rs. 30) 90,000
Overheads (8000 x Rs. 60) 4,80,000 12,10,000
Net Working Capital required 33,55,000
Working notes : Sales for the year 1,04,000 units, therefore for the week
will be 1,04,000/52 = 2000 per week.
Depreciation included in overheads can not be separated because of
lack of information.
Problem 3 :
Fulch and & Co. is desirous to purchase a business and has
consulted you on one point on which you are asked to advise them is the
average amount of working capital which will be required in the first
year’s working.
You are given the following estimates and are i nstructed to add 10
percent to your computed figure to allow for contingencies.munotes.in

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128i)Average amount locked up for stocks :
Stock of finished product 5,000
Stock of stores, materials etc. 8,000
ii)Average credit given :
Inland sales -6 weeks credit 3,12,000
Export sales -1½weeks credit 78,000
iii) Lag in payment of wages and other outgoings
Wages 1 ½weeks 2,60,000
Stores, materials, etc. -1½months 48,000
Rent, Royalties -6m o n t h s 10,000
Clerical Staff -½month 62,400
Manager Salary -½month 4,800
Miscellaneous expenses -1½months 48,000
iv)Payments in advance :
Sundry expenses (paid quarterly in advance) 8,000
v)Undrawn profits on the average throughout the year 11,000
Set up your calculations for the average amount of working capital
required.
Solution :
Statement of Average Working Capital Requirements
Particulars Rs. Rs.
Current Assets :
Stock of Finished goods 5,000
Stock of stores, materials, etc. 8,000 13,000
Debtors :
Inland Sales -6 weeks sales3,12, 000 / 52 636,000
Export Sales -1 weeks sales78,000 / 52 12,250 38,250
Advance payment of expenses 2,000
Total current assets 53,250
Current liabilities :
Lag in payments :
Wages 7,500
Stores, materials, etc. 6,000
Rent, Royalties, etc. 5,000
Clerical staff 2,600
Manager’s Salary 200
Miscellaneous expenses 6,000 27,300
Net working Capital 25,950
Add : 10% for contingencies 2,595
Average working capital requirement 28,545munotes.in

Page 129

129Note :Undrawn profit has not been considered since it is a source of funds
which may or may not be used as working capital.
Problem 4 :
Deepesh Ltd., sells its products on a gross profit of 20% on sales.
The following information is extracted from its annual accounts for the
current year ended 31stDecember :
Rs.
Sales at 3 months’ credit 40,00,000
Raw material 12,00,000
Wages paid -average time lag 15 days 9,60,000
Manufacturing expenses paid -one month in arrears 12,00,000
Administrative expenses paid -one month in arrears 4,80,000
Sales promotion expenses -payable half yearly in advance 2,00,000
The company enjoys one month’s credit from the suppliers of raw
materials and maintains a 2 month’ s stock of raw materials and one -and-
half months’ stock of finished goods. The cash balance is maintained at
Rs. 1,00,000 as a precautionary measure. Assuming a 10% margin, find
out the working capital requirements of XYZ Cements Ltd.
Solution :
Stateme nt showing the determination of working capital
A)Current Assets Amount
(Rs.)
Cash balance 1,00,000
Inventories
Raw materials (Rs. 12,00,000 x 2/12) 2,00,000
Finished good :.3 ,20,000 1.512Rs 4,00,000 6,00,000
Debtors.32,00,000 312Rs 8,00,000
Prepaid sales expenses.2 ,0 0 ,0 0 0 612Rs 1,00,000
Total (A) 16,00,000munotes.in

Page 130

130B)Current Liabilities
Creditors for goods.12,00,000 112Rs 1,00,000
Wages.9 ,60,000 121 2Rs 40,000
Manufacturing expenses.12,00,000 112Rs 1,00,000
Administrative expenses.4 ,8 0 ,0 0 0 112Rs 40,000
Total (B) 2,80,000
C) Net Working Capital (A -B) 13,20,000
Add 10% margin 1,32,000
14,52,000
Working Note :
1Sales 40,00,000
Less gross profit 20% 8,00,000
Cost of production 32,00,000
Problem 5 :
The management of Diamond Ltd. has called for a statement
showing the working capital needed to finance a level of activity of
3,00,000 units of output for the year. The cost structure for the company’s
product, for the above mentioned activity level, is detailed below :
Cost per unit (Rs.)
Raw materials 20
Direct la bour 5
Overheads 15
Total cost 40
Profit 10
Selling price 50
Past trend indicate that the raw materials are held in stock, on an average,
for two months.
Work -in-progress (50% complete) will approximate to half -a-month’s
production.
Finished goods remain in warehouse, on an average, for a month.
Suppliers of materials extend a month’s credit. Two month’s credit is
normally allowed to debtors.
A minimum cash balance of Rs. 25,000 is expected to be maintained.
The production pattern is assumed to be even during the year.
Prepare the statement of working capital determination.munotes.in

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131Solution :
Statement to determine net working capital of Diamond Ltd.
Amount (Rs.)
A)Current Assets
i) Raw materials for 2 months
2 month’ s consumption
(25,000 units x 2 months x Rs. 20 per unit) 10,00,000
ii) Work -in-progress for ½month
Raw materials (12,500 units x Rs. 10) 1,25,000
Direct labour (12,500 units x Rs. 2.5) 31,250
Overhead (12,500 units x Rs. 7.5) 93,750 2,50,000
iii) Finished goods for 1 month (25,000 units x
Rs. 40)10,00,000
iv) Debtors for two months3, 00, 000 .40 212Rs20,00,000
Minimum cash balance 25,000
Total Investment in current assets 42,75,000
B)Current Liabilities
Creditors for 1 month 5,00,000
C)Net working capital (A -B) 37,75,000
Problem 6 :
The board of directors of Shrirang Engineering Company Ltd. ,
requires you to prepare a statement showing the working capital
requirements for a level of activity at 1,56,000 units of production.
The following information is available for your calculat ion.
Cost per unit (Rs.)
A)Raw materials 90
Direct labour 40
Overheads 75
Total 205
Profit 60
Selling price unit 265munotes.in

Page 132

132A) i)Raw materials are in stock, on average, for one month.
ii)Materials are in process, (50% complete) on average for 4
weeks.
iii) Finished goods are in stock, on average, for one month.
iv)Credit allowed by suppliers is one month.
v)Time lag in payment from debtors is 2 months.
vi)Average lag in payment of wages is 1 ½weeks.
vii) Average lag in payment of overheads is one month.
20% of the output is sold against cash. Cash in hand and in bank is
expected to be Rs. 60,000. It is to be assumed that production is carried
one evenly throughout the year, wages and overheads accrue similarly,
and a time period of 4 weeks is equivalent t o a month.
Solution :
Shrirang Engineering Company Ltd.
Statement showing determination of working capital
Amount (Rs.)
A)Current Assets
i) Stock of raw materials for 1 month 11,70,0001, 56, 000 .90 112Rsii) Work -in-progress for 2 weeks
a) Material 5,85,0001, 56, 000 .90 4 50%48Rs
b) Labour 2,60,0001, 56, 000 .40 4 50%48Rs
c) Overheads 4,87,5001, 56, 000 .75 4 50%48Rs
13,32,500
iii) Finished gods stock for 1 month 26,65,0001, 56, 000 .205 112Rs Total Cost iv) Debtors for 2 months (at cost)1, 24, 800 .205 212Rsv) Cash in hand and at bank 60,000
Total Current Assets (A) 94,91,500munotes.in

Page 133

133B)Current Liabilities
i)Creditors (1 month)1, 56, 000 .90 112Rs11,70,000
ii) Time lag in payment of wages1, 56, 000 .40 1.548Rs1,95,000
iii) Time lag in payment of overheads1, 56, 000 .75 112Rs9,75,000
Total current liabilities (B) 23,40,000
C)Net working capital (A -B) 71,51,500
Problem 7:
Estimate the working capital requirements from the following
annual figures by adding 5% for contingencies.
Amount (Rs.)
i) Stock of finished products and stores & materials 13,000
ii) Credit allowed :
Domestic sales -6w e e k s 3,12,000
Export sales -1½weeks 75,000
iii) Advance payment
Sundry Expenses (Quarterly Advance) 8,000
iv) Outstanding : -
Wages 1 ½weeks 2,60,000
Stores & Materials 1 ½months 48,000
iii) Rent & Royalties -6 months 10,000
Clerical staff ½month 62,400
iv) Manager ½month 4,800
Miscellaneous Expenses 1 ½months 48,000
Suggested solution :
Estimate of working capital
Rs.
Current Assets :
Inventories 13,000
Debtors
Domestic3,12, 000 65236,000
Export78,000 1.552 2,250
Advance payment of Expenses1/4 8000 2,000
Total 53,250munotes.in

Page 134

134Current Liabilities :
Outstandings
Wages2,60,000 1.552 7,500
Creditors48,000 1.512 6,000
Rent / Royalty10,000 6125,000
Clerical staff62,400242,600
Manager salary4,80024200
Miscel laneous Expenses48,000 1.512 6,000 27,300
25,950
Add 5% for contingencies 1,298
Working Capital Estimate 27,248
Problem 8:
X wishes to commence a new trading business and gives the
following information :
1)The detailed estimated sales in a year will be Rs. 12,00,000.
2)His expenses are estimated at a fixed expenses of Rs. 2,000 per month
plus a variable expense equal to 5 p ercent of his turnover.
3)He excepts to fix a sale price for each product which will be 25 percent
in excess of his cost of purchase.
4)He excepts to turnover his stock four times in the year.
5)The sales and purchases will be evenly spread throughou t the year. All
sales will be for cash, but he expects one month’s credit for purchases.
Calculate :
a)His estimated profit for the year.
b)His average working capital requirement.
Suggested solution :
a)Statement of Estimated Profit :
Rs.
Sales 12,00,000
Less : Cost of Goods sold 9,60,000
Gross Profit (25% as cost of purchase, i.e.
20% on sales)2,40,000
Less : Expenses :
Fixed2000 12 24,000
Variable (5% of Rs. 12,00,000) 60,000 84,000
Net profit 1,56,000munotes.in

Page 135

135b)Statement of Average Working Capital :
Current Assets Rs.
Stock9,60, 000 3122,40,000
Cash (assumed to be equal to monthly
expenditure)7,000
2,47,000
Less : Current Liabilities
Creditors9,60,0001280,000
Working Capital Required 1,67,000
Problem 9:
Calculate working capital from the following particulars :
Rs.
a)Annual expenses :
Wages 52,000
Stores & Material 9,600
Export 15,60011 /252   450
Prepaid Expenses1, 600352   400
10,650
Less : Current Liabilities :
Creditors for stores & materials
9, 6001.552   1,200
Creditors for expenses :
Wages52,0001.552   1,500
Office salaries112,48024   520
Rent2,000612   1,000
Office expenses9, 6001.512   1,200 4,220
Working capital required 6,430
Problem 10 :
X Ltd., sells goods at a gros s profit of 25%, not counting
depreciation as part of the cost of goods sold.munotes.in

Page 136

136The annual figures are as follows :
Domestic sales (1 month credit) 12,00,000
Export sales (3 months credit with sales price 10% below
domestic price)5,40,000
Materials used (2 months credit) 4,50,000
Manufacturing expenses paid in cash with 1 month in
arrears5,40,000
Depreciation on fixed assets 60,000
Wages paid ½month in arrears 3,60,000
Office expenses paid 1 month in arrears 1,20,000
Sales expense payable quarterly in advance 60,000
Income Tax payable in four installments of which one
falls due in the next financial year1,50,000
The company normally keeps one month’s stock of raw material
and finished goods and believing in not utilisingRs. 1,00,000 available to
it, including overdraft limit of Rs. 50,000.
Compute the working capital requirements, assuming a 15% safety
margin and ignoring work -in-progress.
Suggested solution :
Statement of working capital requirement
Current Assets Rs.
Stock of Raw Material4,50,000 11237,500
Stock of finished goods …(1)13,50,000 1121,12,500
Cash in the bank …. (ii) 50,000
Debtors :
Domestic9,00,0001275,000
Export4,50,000 3121,12,500
Prepaid Expenses 15,000
4,02,500munotes.in

Page 137

137Less : Current Liabilities
Creditors for purchases4,50,000 21275,000
Wages13, 60, 000212   15,000
Manufacturing expenses5, 40, 0001245,000
Office expenses1, 20, 0001210,000
Tax liability 37,500 1,82,500
Working Capital required 2,20,000
Working Note :
i)Domestic Sales 12,00,000
Export sales : 5,40,000
Add : 10% of Sales price i.e. 1/9thof
5,40,00060,000 6,00,000
18,00,000
Less : 25% Gross profit 4,50,000
13,50,000
Stock of finished goods in one month
13,50,0001,12, 50012
ii)Cash at Bank :
Amount available for use is Rs. 1,00,000 including Bank overdraft
limit of Rs. 50,000/ -.H e n c ec a s hi nB a n kR s .1 , 0 0 , 0 0 0 -Rs. 50,000 = Rs.
50,000.
Problem 11 :
Your company is operating at 60% capacity, producing 24,000
units per annum at the following cost price structure :
Rs. (per unit)
Raw materials 5.00
Wages 3.00
Variable Overheads 2.00
Fixed Overheads 1.00
Profit 2.00
Selling price 13.00munotes.in

Page 138

138On 31stDecember, 2015 the Current Assets and liabilities were as follows
:
Rs.
Raw materials 4000 units at cost 20,000
Work in process 1000 units at cost 8,000
Finished goods 3000 units at cost 33,000
Sundry debtors 78,000
Creditors for goods 30,000
Liability for wages 3,000
Liabilities for expenses 6,000
In view of the increased demand for the product, it has been
decided that from 1stJan. 2016, the unit should operate at 90% capacity.
You are required to ascertain the additional working capital as would be
necessary in view of additional production. The prices of materials, rate of
wages and expenses and the selling price per unit will not be changed. The
period of credit allowed to customers, credit allo wed by suppliers and also
time lag in payment of wages and expenses shall remain the same as
before. Work in process may be assumed to be 100% complete as regards
materials and 50% as regards wages and overheads.
Solution :
1)At 60% capacity production is 24,000 unit per month.
Therefore, per month production is 2000 units.
a)Raw material stock is equivalent to400022000months
b)Work -in-process1000 12000 2month
c)Finished good3000 112000 2months
d)Debtors :Rs. 78000 @ selling price of Rs. 13 per unit i.e. 6000
units sales is equivalent to 3 months sales.
e)Creditors for goods :.300006000.5RsRsunits is which equivalent to
600032000months.munotes.in

Page 139

139f)Liability for wages.30001000.RsRsunits i.e.12month
g)Liability for expenses.60002000.3Rs
Rs per unitunits.
2)Present working capital
Current Assets Rs.
Raw materials 20,000
Work -in-process 8,000
Finished goods 33,000
Debtors : (based on cost : 6,000 units x 11) 66,000
Cash in hand (assumed to equal to one month fixed
overhead) i.e. 2000 x Re. 12,000
1,29,000
Less : Current liabilities
Crs-for Goods 30,000
Liability for wages 3,000
Liability for expenses 6,000 39,000
Net working Capital 90,000
3)Fixed overheads : at 60% capacity is Re. 1 per unit i.e. total to 24000.
At 90% capacity the fixed overheads will be the same and therefore fixed
overheads per unit will be.2 4 0 0 00.6736000Rsper unit.
Therefore cost price structure at 90% capacity will be as follows :
Rs. (per unit)
Raw materials 5.00
Wages 3.00
Variable Overheads 2.00
Fixed Overheads 0.67
10.67
Profit 2.33
Selling price 13.00munotes.in

Page 140

140Statement of working capital required at 90% capacity (36000 units)
Current Assets : Rs.
Raw materials3000 2 530,000
Work -in-process
Material13000 5 7,5002
Wages and overheads13000 5.67 8,505216,005
Finished goods33000 0.672   48,015
Debto rs (based on cost)3000 3 10.67 96,030
Cash in hand (Assumed to be equivalent to one month fixed
overhead)2,000
Total (A) 1,92,050
Current Liabilities
Creditors for goods :3000 3 .5Rs 45,000
Liability for wages13000 32   4,500
Liability of expenses3000 1 2.67 8,010
Total (B) 57,570
Net working capital required (A -B) 1,34,540
Therefore additional working capital required will be (Rs. 134540 -
Rs. 90000) = Rs. 44540/ -
Problem 12:
Tiger Ltd. is a manufacturer of cement. The Annual Accounts of the
company revealed the information as follows:
1) Customers were allowed three months credit period.
2) Wages are paid after 15 days when they become due.
3) Advertising expenses are paid 6 months in advance.
4) Manufacturing expenses are paid after a month.
5) Suppliers of manufacturing items allows one month’s credit.
6) Administrative expenses are paid with an average time lag of one
month.
7) The cash balance is Rs. 50,000.
8) Finished goods are kept in stock for one and half months whereas raw
material stock is kept for two months.munotes.in

Page 141

1419) Contingency margin is 10% and other details are as follows:
(Rs. In lacs)
Sales 20.00
Raw materials 6.00
Manufacturing Expenses 6.00
Wages 4.80
Administrative Expenses 2.40
Advertising Expenses 1.00
Gross profit is 20% on sales. Estimate the working capital
requirement of the company.
Solution :
Statement of working capital Requirement
Rs.
Current Assets :
Raw materials.6212Rs lacs   1,00,000
Finished Goods19.20 312 2   2,40,000
Debtor19.70 312   4,80,000
Advertisement expenses in advance1.00 61250,000
Cash balance 50,000
Total (A) 9,20,000
Less : Current liabilities
Crs-Raw material611250,000
Outstanding -for wages4.80 112 2   20,000
M/g Exps.6.0011250,000
Admin Exps.2.4011220,000
Total (B) 1,40,000
Working capital (A) -(B) 7,80,000
Add 10% for contingency 78,000
Working Capital required 8,58,000munotes.in

Page 142

142Problem 13 :
From the following information make an assessment of working
capital required by a Lion Ltd. The firm has approached Bank A who have
agreed to sanction the working capital limits based on the data furnished
by the firm retaining margin as un der :
Raw materials : 25%
Stock in process : 33.33%
Finished goods : 25%
Bills : 20%
You are required to work out the working capital limits proposed
to be sanctioned by the bank.
Estimate for 2016 :
Monthly Sales Rs. 1,00,000
Monthly cost of production Rs. 72,000
Monthly raw materials consumption Rs. 50,000
Envisaged stocking pattern :
Raw materials :1m o n t h
Work in process :15 days
Finished goods :15 days
Whereas the firm may extend a credit of 1 month to its cu stomers,
it is hopeful of getting 15 days credit from its suppliers.
Solution :
Statement of working capital required
Current Assts Rs. % finance by bank
after marginBank finance
Raw material 50,000 75% 37,500
Work -in-process 36,000 66.67% 24,000
Finished good 36,000 75% 27,000
S. Debtors 1,00,000 80% 40,000
2,22,000munotes.in

Page 143

143Solution :
Statement of working capital
Rs.
Current Assets :
Materials4831212.00
Work -in-progress Material4814 . 0 0127.00
Expenses24 33.0012 2
Finished goods841127.00
Debtors12031230.00
(A) 56.00
Less : Current liabilities
Credition48 312 26.00
Working capital required 50.00
As per Bank norms working capital
Current Assets
Raw material (2 ½month) 10.00
Work -in-progress (1 month) 6.00
Finished goods (1 month) 7.00
Debtors : (1 ½month)
Total 38.00
Less : Current liabilities creditors (2 ½month) 10.00
Working capital as per Bank 28.00
Considering 25% of Current Assets as margin money i.e. Rs. 9.50
lakh, the permissible Bank Borrowing works out to Rs. 18.50 lacs.
Problem 14 :
Vijay Manufacturing Ltd. plans to sell 30,000 units next year. The
expected cost of goods sold is as follows :
Rs. (per unit)
Raw materials 100
Manufacturing expenses 30
Selling, administration and financial Expenses 20
Selling price 200munotes.in

Page 144

144The duration at various stages of the operating cycle is expected to be as
follows :
Raw material stage 2 months
Work -in-process stage 1 month
Finished goods stage ½month
Debtors stage 1 month
Assuming the monthly sales level of 2500 units -
i)Calculate the investment in various current assets and
ii)Estimate the gross working capital requirement if the desired cash
balance is 5% of the gross working capital requirement.
Solution :
i)Calculation of investment in various Current Assets
a)Raw material3000000212   (2 month) =R s .5 , 0 0 , 0 0 0
b)Work -in-process :3900000112   =R s .3 , 2 5 , 0 0 0
(based on total M/g cost) 1 month
c)Finished good3900000 112 2   =R s .1 , 6 2 , 5 0 0
(½month)
d)Debtors : (based on total cost)4500000112   =R s .3 , 7 5 , 0 0 0
ii)Gross working capital requirement
Rs.
Raw materials 5,00,000
Work -in-progress 3,25,000
Finished goods 1,62,500
Debtors 3,75,000
13,62,500
Cash balance (5% on gross w.c.) 71,711
i.e.1362500595   Gross Working Capital 14,34,211
munotes.in

Page 145

14510
INVENTORY MA NAGEME NT
Unit structure:
10.1 Introduction
10.2 Types of Stores
10.3 Fixation of Stock Level
10.4 The ABC Analysis
10.5 Classification and Codification
10.6 Inventory System
10.7 Material Storage Losses
10.8 Inventory Turnover Ratio
10.9 Practical Problems
10.1 INTRODUCTIO N
10.1.1 Meaning of Store and Storekeeping
Stores play a vital role in the operation of a company. Generally
un-worked material is stored and the place where it is stored is called
Store Room. It is in direct touch with the user departments in its day -to-
day activities. The chief aim of the stores is to ensure the smooth flow of
production without any i nterruption. Stores generally include raw
materials, work in progress and finished goods.
Effective storekeeping and inventory control are indispensable to
the control of material cost. Further, stores often equated directly with
money, as capital is bloc ked in inventories.
10.1.2 Purpose of Storekeeping
(1)Storekeeping helps to examine carefully all goods and materials
on receipts.
(2)It is essential to arrange for a systematic and efficient storing of
materials.
(3)Storekeeping ensure acc urate and prompt distribution of
materials to user departments as per issue requisition note.
(4)It is essential because stores often equated directly with money,
as capital is blocked in inventories.munotes.in

Page 146

14610 1 3 Functions of the Storekeeper
The store is a service department headed by the storekeeper who
holds the responsible position in the organisation of the stores department.
He is as much responsible for the articles incharge as a cashier for the
cash. Important functions of the storekeep er are given below:
(1)He must receive raw materials, components, tools, equipment
and other items and account for them properly.
(2)He must provide adequate and proper storage and preservation to
the various items.
(3)He must check, and provide proper classification and
codification of materials.
(4)Issue the materials as per material issue requisition duly signed
by an authorized person.
(5)He has to take steps to prevent leakage, theft, wastage and
deterioration.
(6) He mus t ensure good storekeeping.
(7)He should not permit any person without authorization.
(8)He should maintain proper records in order to know desired
quantities available.
(9)He must provide adequate information to the top executives for
verifications and effective d ecision making.
10.1 4 Stores Layout
In order to achieve the objectives of effective inventory control,
well planned layout of stores should be required. A planned stores layout
will facilitate easy movement of materials, good housekeeping, sufficient
space for materials handling. It ensures effective utilization of storage
space and judicious use of storage equipments. The stores department
should be equipped with shelves, racks, pallets and proper preservation
from rain, light and other such elements. An ideal location of stores
should facilitate the volume and variety of goods to be handled. In order
to bring down the transport cost it should be close to roads or railway
stations. And also as far as possible, the stores department should be near
to the receiving department. In the case of large organizations usually
stores attached to each consuming department, whereas receiving is done
centrally.
10.2 TYPES OF STORES
The types of stores depend on the size, types and policy of the
organization. Organization of stores varies from concern to concern. As
per the requirement of the firm the stores organization may be classified
into:munotes.in

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147(a)Centralized Stores.
(b)Decentralized Stores .
(c)Combination of both, i.e., Centralized Stores with Sub Stores.
a.Centralized Stores: This system is suitable to small -scale industries
where it is desirable to centralize the materials in one department.
Under this system, the store room will be most conv eniently situated
where it is near to all the departments.
Advantages of Centralized Stores
(1)Well planned layout of stores.
(2)Effective utilization of floor space.
(3)Better supervision of stores is possible.
(4)Effective material handling is possible.
(5)Lot of manual work may be eliminated.
(6)Better control is possible.
(7)Less investment is required.
(8)Ensures minimum wastages.
(9)Facilitates prompt flow of materials.
(10)Better forecasting is possible.
Disadvantages
(1)Increases transportation costs.
(2)Delay and inconvenience because of over -crowding of materials.
(3)Greater risk of loss in case of fire.
(4)Break down in transport will affect continuous flow of
production.
(5)Increases cost of materials handling.
b.Decentralized Stores: Under this system each depa rtment has its own
stores. It is suitable to large concern where there are several
departments each using a different type of material from its own
stores. In this system all the disadvantages of centralized stores can be
eliminated.
c.Combination of both: This system is also termed as imprest System
or stores control. Centralized Stores with Sub Stores is usually adopted
in large factories where departments are situated at a distance from the
central stores. In order to minimize the cost of transportation a nd
materials handling, this type of organization would be located nearer
to the receiving department. Under this system material receipts are
stored in the central stores and issues are made to the sub -stores.
Under imprest system of stores control sub sto res which are located
nearer to the central stores for the purpose of draw supplies from
central stores and issue the required quantity to production. To
maintain the stocks at the predetermined level, the sub -stores make
requisition from the central store s.munotes.in

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14810.3 FIXATIO NOF STOCK LEVEL
Material control involves physical control of materials,
preservation of stores, minimization of obsolescence and damages through
timely disposal and efficient handling. Effective stock control system
should ensure the min imization of inventory carrying cost and materials
holding cost. Level of stock is the important aspect of inventory control.
Stock level may be overstocking or under -stocking. Overstocking requires
large capital with high cost of holding. In the case of u nder-stocking,
production and overall performance of the concern as a whole will affect.
Thus, fixation of stock level is essential to maintain sufficient stock for the
smooth flow of production and sales. The following are the important
techniques usually adopted in different industries:
(a)Maximum Stock Level.
(b)Minimum Stock Level.
(c)Danger Level.
(d)Re-Order Level.
(e)Economic Ordering Quantity (EOQ).
(f)Average of Stack Level.
a.Maximum Stock Level: The maximum stock level indicates the
maximum quantity of an item should not be allowed to increase. The
maximum quantity of an item can be held in stack at any time. The
following factors can be considered while fixing the maximum stock
levels :
(1)Availab ility of capital.
(2)Availability of floor space.
(3)Cost of storage.
(4)Possibility of fluctuation of prices in raw materials.
(5)Cost of insurance.
(6)Economic order of quantity.
(7)Average rate of consumption.
(8)Re-order level and lead time.
(9)Seasonal nature of supply.
(10)Risk of obsolescence, depletion, evaporation etc.
The maximum stock level can be calculated by the following formula:
Maximum Stock Level =Re-Order Level + Re -Ordering Quantity
(Minimum Consumption x Minimum
Re-Ordering Pe riod)
b.Minimum Stock Level: Minimum stock level indicates the minimum
quantity of material to be maintained in stock. Accordingly, the
minimum quantity of an item should not be allowed to fall. The
minimum stock is also known as Safety Stock or Buffer Stoc k. The
following formula is adopted for calculation of minimum stock level :
Minimum Stock Level = Re -Order Level -(Normal Consumption x
Normal Re -Order Period)munotes.in

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149c.Danger Level: It is the stock level below the Minimum Level. This
level indicates the dang er point to affect the normal production. When
materials reach danger level, necessary steps should be taken to
restock the materials. If there is any emergency, special arrangements
should be made for fresh issue. Generally this level is fixed above the
minimum level but below the reordering level. The formula for
determination of danger level is :
Danger Level = Average Rate of Consumption x Emergency Supply
Time
d.Re-order Level: Re-order level is also termed as Ordering Level. It
indicates when to order, i.e., orders for its fresh supplies. This is the
stock level between maximum and the minimum stock levels. The re -
order stock level is fixed on the basis of economic order quanti ty, lead
time and average rate of consumption. Calculation of re -order level is
adopted by the following formula :
Re-order Level =Minimum Level + Consumption during the time to
get fresh delivery
(Or)
Re-order Level = Maximum Consumption x Maximum Re -ordering
Period
e.Economic Order Quantity (EOQ): Economic Order Quantity is one
of the important techniques used to determine the optimum quantity or
number of orders to be placed from the suppliers. The main objectives
of economic order quantity is to minimi ze the cost of ordering, cost of
carrying materials and total cost of production. Ordering costs include
cost of stationery, salaries of those engaged in receiving and
inspecting, general office and administrative expenses of purchase
departments Carrying costs are incurred on stationery, salaries, rent,
materials handling cost, interest on capital, insurance cost, risk of
obsolescence, deterioration and wastage of materials and evaporation.
Economic Order Quantity can be calculated by the following formula :
EOQ = (2AB/CS)1/2
Where EOQ = Economic Order Quantity;
A = Annual Consumption
B = Buying cost per order
C = Cost per Unit
S = Storage and Carrying cost per annum
f.Average Stock Level: Average stock level is determined on the basis
of minimum stock level and re -order quantity. This is calculated with
the help of the following formula:
Average Stock Level = Minimum Stock Level + 1/2 of Re -order
Quantity
(or)
(Minimum Level + Maximum Level)/2munotes.in

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150
Illustration: 1
From the following particulars calculate the
(a)Maximum Stock Level.
(b)Minimum Stock Level.
(c)Re-ordering Level.
(d)Average Stock Level.
(1)Normal consumption = 600 units per week.
(2)Maximum consumption = 840 units per week.
(3)Minimum consumption = 480 unit per week.
(4)Re-order quantity = 7200 units.
(5)Re-order period = 10 to 15 weeks.
(6)Normal reorder period = 12 weeks.
Solution:
Re-order Level = Maximum Consumption x Maximum Re -order Period
=840 x 15 = 12600 units
Minimum Stock Level
=Re-order Level -(Normal Consumption x Normal Re -
order Period)
=12600 -(600 x 12)
=12600 -7200 = 5400 units
Maximum Stock Level = Re -order Level + Re -order Quantity -
(Minimum Consumption x Minimum Re -order Period)
=12600 + 7200 -(480 x 10)
=19800 -4800 = 15000 units.
Average Stock Level = (Minimum Stock Level + Maximum Stock
Level)/2
= (5400 + 15000)/2
= 20400/2
= 10200 units
Illustration 2:
The following information available in respect of a material X:
Re-order quantity = 1800 units
Maximum Consumption = 450 units per week
Minimum Consumption = 150 units per week
Normal Consumption = 300 units per week
Re-order period = 3 to 5 weeks
Calculate the following:
(a)Re-order Level
(b)Minimum Stock Level
(c)Maximum Stock Levelmunotes.in

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151Solution:
(a)Re-order Level :
=Maximum Consumption x Maximum Re -order Period
=450 x 5 = 2250 units
(b) Minimum Stock Level:
=Re-order Level -(Normal Consumption x Normal Re -order
Period)
=2250 -(300 x 4)
=2250 -1200 = 1050 units.
(c)Maximum Stock Level:
=Re-order Level + Re -order Quantity -
(Minimum Consumption x Minimum Re -order
Period)
2250 +1 8 0 0 -(150 x 3)
=4050 -450 = 3600 units.
(d)Normal Re -order Period:
= (Minimum re -order period + Maximum re -order period)/2
= 3 weeks + 5 weeks /2
=4w e e k s
Illustration 3:
A company uses a particular material in a factory which is 20000
units per year. The cost per unit of material is Rs. 10. The cost of placing
one order is Rs. 100 and the inventory carrying cost 20% on ave rage
inventory. From the above information calculate Economic Order
Quantity.
Solution:
EOQ = (2AB/CS)1/2
=( 2x2 0 0 0 0 0x1 0 0 / 1 0x2 0 % )1/2
= 1,414 units
Illustration 4:
A Ltd. Co. is committed to supply 24000 bearings per annum to B
Ltd. on a steady basi s. It is estimated that it costs 10 paise as inventory
holding cost per bearing per month and that the set up cost per run of
bearing manufacture is Rs. 324.
(1)What should be the optimum run size for bearing manufacture?
(2)What would be the interval between two consecutive optimum runs?
(3)Find out the minimum inventory cost per annum.
Solution:
(1) EOQ = (2AB/CS)1/2
= (2 x 24000 x 324/10)1/2
= 3,600 unitsmunotes.in

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152(2)Number of set up per annum = Annual Production/Economic run size
= 24,000/3,600
= 6.67 times
Interval between two consecutive optimum runs = 12 x 3/20 = 1.8
months
(3)Minimum Inventory cost per year = ((24,000/3,600) x 324)) +
((3,600/2) X 1.2) =Rs. 2,160 + Rs. 2,160 = Rs. 4320
10.4 THE ABC A NALYSIS
ABC Analysis is one of the important techniques which is based
on grading the items according to the importance of materials. This
method is popularly known as Always Better Control. This is also termed
as Proportional Value Analysis -Ininventory control, this technique helps
to analyze the distribution of any characteristic by money value of
importance in order to determine its importance. Accordingly, materials
are grouped into three categories on the basis of the money value of
import ance of materials.
(1)High Value Materials -A
(2)Medium Value Materials -B
(3)Low Value Materials -C
The items, which are of high value and less than 10 per cent of the
total consumption or inventory, can be called as 'A' grouped materials. It
is required to exercise selective control and focus more attention because
of high value items. Similarly, 70 per cent of materials in total
consumption or inventory which lies 10 per cent of the inventory value
can be grouped under 'C' categories. The materials which have moderate
value that lies between the high value materials and low value materials
are grouped under 'B' category. The following table shows more
explanation about ABC Analysis:
Category Percentage to total inventoryPercentage to total
inventory cost
A Less than 10 70to80
B 10to20 15to25
C 70to80 Less than 10
Advantages of ABC Analysis
(1)Exercise selective control is possible.
(2)Focus high attention on high value items is possible.
(3)It helps to reduce the clerical efforts and costs.
(4)It facilitates better planning and improved inventory turnover.
(5)It facilitates goods storekeeping and effective materials handling.munotes.in

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15310.5 CLASSIFICATIO NAND CODIFICATIO N
In order to ensure the effective inventory control, it should be
carried out with the classification and codification of materials.
Codification is the process of representing each item by a number, the
digits of which indicate the group, the sub group, th e type and the size and
shape of the items. The codification process could be obtained by the
nature of materials in grouping all items of the same metal content say
ferrous and non -ferrous etc. The system of codification could be built by
the end use of i tems, that is, items grouped according to maintenance,
spinning, weaving, packing, foundry, machine shop etc.
Advantages of Codification
(1)Codes ensure the secrecy of materials.
(2)It is essential for mechanical accounting.
(3)Easy identification of material is possible.
(4)It ensures effective material control.
(5)It minimizes length in description of materials.
(6)Effective materials handling is possible.
(7)It helps in avoiding duplication of materials.
(8)Codification facilitates less clerical work.
(9)Cost reduction is possible.
Methods of Coding
The following are the three important Methods of Codification :
(1)Numerical Method.
(2)Alphabetical Method.
(3)Numerical Cum Alphabetical Method.
1. Numerical Method: Under this method, each number or
numerical digit is allotted to each item or material. Accordingly, each
code should uniquely indicate one item. For example, in printing press
following codes may be assigned :
Paper145
Ink 155
Gum 165
There are various u niversal decimal classification of codification
used in libraries may be indicated for identification of items.
2.Alphabetical Method: In this method alphabets or letters are used for
codification of each category of materials. Accordingly each letter or
alphabet is allotted for each item or material. For example, 'C' for
copper, 'S' for steel and so on.
3.Numerical cum Alphabetical Method: This method is done by a
combination of numerical and alphabetical method. Under this method
both numerical along with a lphabet is allotted for each item. For
example, IR 5 may indicate Ink Red of Grade 5, Steel wire 6 may be
denoted by SW 6 etc.munotes.in

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15410.6 INVENTORY SYSTEM
The chief aims of inventory control is as follows :
(1)To maintain a balanced inventory.
(2)To ensure the smooth flow of production.
(3)To keep the investment in inventory as low as possible.
Accordingly stock verification is an important aspect to ensure and
maintain a balanced inventory. The following are the two systems of stock
verification ad opted in different industries:
(1)Periodic Inventory System.
(2)Perpetual Inventory System.
(3)Continuous Stock Verification.
1.Periodic Inventory System: Under this system, quantity and value of
materials are checked and verified at the end of the accounting perio d
after having a physical verification of the units in hand.
2.Perpetual Inventory System: The Perpetual Inventory System is also
known as Automatic Inventory System. This is one of the important
methods adopted for verification inventories to know the phys ical
balances. According to ICMA London defines Perpetual Inventory
System as a method of recording stores balances after every receipt
and issue to facilitate regular checking and to obviate closing down for
stock taking.
Advantages of Perpetual Inventory System:
(1)It facilitates rigid control over stock of materials.
(2)It gives up to date details about materials in stock.
(3)Not necessary to stop production for stock taking.
(4)It assists to minimize pilferage and fraudulent practic es.
(5)It enables to reconcile the stock records and document for
accuracy.
(6)It helps to take the important decisions for corrective actions.
Perpetual Inventory Records
Perpetual Inventory represents a system of records maintained by the
organization. The r ecords are of two types, viz.:
(a)Bin Cards
(b)Stores Ledger
A constant comparison of the quantity balances of these two set of
records is made and the balances are reconciled.
a.Bin Cards: Bin Card is only quantitative record of stores receipt,
issue and balance and is kept by the Storekeeper for each item of
stores.
b.Stores Ledger: Stores ledger is both quantitative and monetary
value record of stores receipt, issue and balance an di sp r e p a r e db y
the Cost Accounting Department.munotes.in

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1553.Continuous Stock Verification : Since Verification of physical
inventory is an essential feature of a sound system of material control,
a system of continuous stock taking is introduced. Continuou s stock
taking ensures that the balances of all items of stocks are checked at
least three to four times in a year by physical verification. It avoids
long and costly procedure of closing down the stores for stock taking
on periodical basis. Stock discrepa ncies are detected on timely basis
and preventive measures can be taken. The correctness of the physical
stocks as reflected in the books is ensured and thus the monthly
accounts represent a true and fair view of the business. Continuous
Stock Verification not only serves as an essential tool of material
control but also will help in proper presentation of accounting
information to the management.
10.7 MATERIAL STORAGE LOSSES
The investment in materials constitutes a major portion of current
assets, so it is essential to exercise effective stores control. Stores control
helps to avoid losses from misappropriation, damage, deterioration etc.
Generally material storage losses arising during storage may be classified
as:
(1)Normal Loss
(2)Abnormal Loss
1.Normal Loss: Normal Losses arise during the storage of materials due
to the avoidable reasons of pilferage, theft, careless of materials
handling, clerical errors, improper storage, wrong entries etc.
2.Abnormal Loss: Abnormal Losses arise during the storag eo f
materials due to unavoidable causes of evaporation, shrinkage, bulk
losses due to accident, fire, etc.
Accounting Treatment of Normal Loss and Abnormal Loss
The following are the accounting treatment of normal and abnormal
loss of materi als arising during storage:
1.Normal Loss: (a) Inflate the issue price. (b) Charge to stores
overheads. (c) Treat it as a separate item of overheads to be recovered
as a percentage of materials consumed.
2.Abnormal Loss: Abnormal losses are directly charged to Costing
Profit and Loss Account.
3.If the loss is due to error in documentation it should be corrected
through adjustment entries.
10.8 INVENTORY TUR NOVER RATIO
Inventory Turnover Ratio may be defined as "a ratio which
measures the number of times a firm's average inventory is sold during amunotes.in

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156year." It is a ratio which is useful to measure the firm's inventory
performance. High rate of inventory turnover ratio denotes that materials
are fast moving stock . A low turnover rate indicates the locking up of
working capital in undesirable items. The Inventory turnover ratio is
calculated by the following formula:
Material Turnover Ratio = Cost of material used / Average value of
material in stock
Material Turnover in days = Days during the period / Inventory Turnover
Ratio
10.9 Practical Problems
Question 1:
The Complete Gardener is deciding on the economic order
quantity for two brands of lawn fertilizer: Super, Grow and Nature’s Own.
The foll owing information is collected:
Fertilizer
Super Grow Nature’s Own
Annual Demand 1,125 bags 1,250 bags
Relevant ordering cost per purchase order Rs. 200 Rs. 320
Annual relevant carrying cost per bag Rs. 5 Rs. 5
Required:
i)Compute EOQ for Super Grow and Nature’s Own.
ii)For the EOQ, what is the sum of the total annual relevant ordering
costs and total annual relevant carrying costs for Super Grow and
Nature’s Own?
iii)For the EOQ, Compute the number of deliveries per year for Super
Grow and Nature’s Own.
Answer :
Particulars Super Grow Nature’s Own
I.2AOEOQC22 2 5 02 0 05
=1 0 0b a g s21 2 8 01 4 0 0560
=8 0b a g s
II. Ordering cost = 2000. 100 =
20 order at Rs. 1200 =
Carrying cost1004802Total Cost24000
24000
4800012/0/80 = 16 orders at
Rs. 1400 = 22400
80/2 x 560 = 22400
44800
iii. Number of deliveries in a
year = Annual demand / EOQ =2000/100
=2 0d e l i v e r i e s1280/80 = 16 deliveriesmunotes.in

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157Question 2:
GLtd. produces a product which has a monthly demand of 4,000
units. The product requires a component X which is purchased at Rs. 20.
For every finished product, one unit of component is required. The
ordering cost is Rs. 120 per order and the holding cost i s1 0 %p . a .
You are required to calculate :
i)Economic order quantity :
ii)If the minimum lot size to be supplied is 4,000 units, what is the extra
cost, the company has to incur?
iii)What is the minimum carrying cost, the company has to incur?
Answ er:
For every finished product, one unit of component is required.
Annual consumption =4,000 1 12months = 48,000 units of
components. C = 10% of 20 = Rs. 2 per unit per annum.
i)22 4 8 , 0 0 0 1 2 02AOEOQC= 2,400 units.
ii)Ordering cost 48,000/4,000 = 12 orders at Rs. 120 1,440
Carrying cost4,000 0224,000
Total cost 5,440
In case of EOQ
Ordering cost 48,000/2,400 = 20 orders at Rs. 120 2,400
Carrying cost2,400 0222,400 4,800
Extra cost, the company has to incur : 640
iii)Minimum carrying cost :2, 400 022Rs. 2,400
Company has to incur
Question: 3
ABC Company buys in lots of 125 boxes which is a three month’s
supply. The cost per box is Rs. 125 and the o rdering cost is Rs. 250 per
order. The inventory carrying cost is estimated at 20% of unit value per
annum. You are required to ascertain :
i)What is the total annual cost of the existing inventory, policy?
ii)How much money would be saved by employing the economic order
quantity (EOQ)?munotes.in

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158Answer :
i)Buying quarterly i.e. 4 orders in a year at Rs. 250 = 1000.00
Carrying cost of average inventory
 125 020% 125 62.50 252of 1562.50
Total Annual cost of existing inventory policy Rs. 2562.50
ii)Annual Consumption =41 2 5500 boxes22 5 0 0 2 5 025
10000 100
AOEOQC
units
Ordering cost 500/100 = 5 orders at Rs. 250 = 1250.00
Carrying cost =100 02521250.00
Total cost if EOQ is followed 2500.00
Total cost at present 2562.50
Saving by employing EOQ = Rs.6 2 . 5 0
Question 4:
The quarterly production of a company’s product which has a
steady market is 20,000 units. Each unit of a product requires 0.5 kg of
raw material. The cost of placing one order for raw material is Rs. 100 and
the inventory carrying cost is Rs. 2 per annum. The lead time for
procurement of raw material is 36 days and a safety stock of 1.000 kg of
raw materials is maintained by the company the company has been able to
negotiate the following discount structure wit h the raw material supplier :
Order quantity Kgs. Discount
Rs.
Upto 6,000 Nil
6,000 -8,000 400
8,000 -16,000 2,000
16,000 -30,000 3,200
30,000 -45,000 4,000
Your are required to :
i)Calculate the re -order point taking 30 days in a month.
ii)Prepare statement showing the total cost of procurement and storage of
raw materials after considering the discount if the company elects to
place one, two, four or six orders in the year.
iii)State the number of orders which the company should place to
minimize the cost after taking EOQ also into consideration.
Answer:
i)Re-order point = lead time consumption + safety stock
Annual Production =20000 4= 80000 unitsmunotes.in

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159Annual consumption of raw materials = 80000 -0.5kg = 40000 kg
Lead time consumption =3640000 4000 .360 dayskgsdays
Reorder Point = 4000 + 1000 = 5000 kg.
ii)Statement of Total cost
No. of
ordersOrderingcost (Rs.)Each
order
qty.
(Kg.)Storage cost of average
inventory (Rs.)Total
Cost
(Rs.)Less
discountNet
Amount
(Rs.)
1100 40000 40000 0 2400002kg 40100
-4000 36100
2200 20000 20000 0 2200002kg 20200
-3200 17000
4400 10000 10000 0 2100002kg 10400
-2000 8400
6600 6667 6667 0 266672kg 7267 - 400 6867
iii)22 4 0 0 0 0 1 0 02000 .2 AOEOQ KgsC
The company should place 20 order (40000/2000 kg. EOQ) to
minimize the cost as calculated below.
Ordering cost 20 order at Rs. 100 = 2000
Carrying cost of average inventory2000 0 222000
Total cost Rs. 4000
(Minimum)
Note:The above cost of Rs. 4000 is minimum. It is also less than Rs. 6867
(after availing discount of Rs. 400). (See solution at (ii) above)
Question 5:
A firm requires 50 items every day for a machine. A fixed cost of
Rs. 50 per order is incurred for placing an order. The inventory carrying
cost per item amounts to Re. 0.02 per day. The lead period is 32 days. You
are required to compute (i) economics ord er quantity : and (ii) re -order
level.
Answer
WN:Annual consumption50 365days = 18.250 items
Inventory carrying cost per item per annum.0.02 365 .7.30Rsmunotes.in

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160Solution :
i)22 1 8 2 5 0 5 07.30AOEOQC
= 500 items
ii)Re-order level = Maximum usage per day x maximum lead time50 32days = 1,600 items
Problem 6:
A manufacturer requires 10,00,000 components for use during the
next year which is assumed to consist of 250 working days. The cost of
storing one component for one year is Rs . 4 and the cost of placing order
is Rs. 32. There must always be a safety stock equal to two working days
usage and the lead time from the supplier, which has been guaranteed will
be five working days throughout the year.
Assuming that usage takes pla ce at the end of the year and order
are placed at the of working day, you are required for :
a)Calculate the EOQ.
b)Calculate the Re -order point.
Solution:
EOQ =2AOC21 0 , 0 0 , 0 0 03 24  Where
A = 10.00.000 units
O=R s . 3 2
C=R s .4
= 4.000 Units
c)Re-order point is calculated as follows :
Re-order point = Safety Stock + (Average usage x Lead time)
Safety Stock =10,00,000 2250days
=4.000 usage x 2
=8.000 Nos.
Re-order point = 8.000 + (4.000 x 5)
=8,000 + 20,000
=28,000 Nos.
Problem 7
For the following inventory problem, find out :
a)How much should be ordered each time?
b)When should the order be placed?munotes.in

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161c)What should be the inventory level (ideally) immediately before the
material ordered is received?
Annual consumption 12,000 u nits (360 days)
Cost per unit Re. 1
Ordering cost Rs. 12 per order
Inventory carrying charge 24%
Normal lead time 15 days
Safety stock 30 days consumption
Solution:
a)EOQ =2AOC21 2 0 0 01 20.24 Where
A = 12,000 units
O=R s . 1 2
C= 24% of Rs. 1 = 0.24 per unit
= 1,096 Units
b)When should the order be placed i.e.
Re-order Level =Lead time demand + Safety stock
=15 + 30 = 45 days usage
=12,00045360
=1,500 Units.
Thus, whenever the stock in hand reaches 1,500 an order should be
placed.
c)Ideally, the stock just before the receipt of materials ordered should be
safety stock, i.e. 1,000 Units12,00030360   .
Problem 8:
Anil Company buys its annual requirement of 36,000 in s ix
instalments. Each unit cost Re. 1 and the ordering cost is Rs. 25. The
inventory carrying cost is estimated at 20% of unit value. Find the total
annual cost of the existing inventory policy. How much money can be
saved by using EOQ.munotes.in

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162Solut ion :
i) Present cost per annum Rs.
Inventory carrying cost6,000 1 20%2600
Ordering cost62 5150
750
ii) Computation of EOQ
223 6 . 0 0 02 50.20
90.00.0003.000AOEOQCUnits
A=3 6 . 0 0 0u n i t s
O=R s .2 5
C=2 0 %o fR s .1
Costs associated with EOQ :
No. of order36.000123000 Rs.
Ordering cost12 25 =3 0 0
Carrying cost =3 0 0
3000.1 20%2Rs
Total 600
Saving in cost by following EOQ (i) -(ii) = Rs. 150.
Problem 9:
A Precisio n Engineering Factory consumes 50,000 units of a
component per year. The ordering, receiving and handling costs are Rs. 3
per order while the trucking cost areRs. 12 per order. Further details are as
follows :
a)Interest cost Re. 0.06 per unit per year.
b)Deterioration and obsolescence cost Re. 0.004 per unit per year.
c)Storage cost Rs. 1000 per year for 50,000 units.
Calculate the economic order quantity.munotes.in

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163Solution :
i)EOQ =2AOCWhere A = Annual Consumption
O = Ordering cost per order
C=C a r r y i n gc o s t
A = 50,000 Units
O=R s .3+R s .1 2=R s .1 5
C=R s .0 . 0 8+0 . 0 0 4=R s .0 . 0 8 4
Therefore
EOQ =25 0 , 0 0 01 5
0.084AO25 0 , 0 0 01 51 , 0 0 084
=150,00,00,0004, 22684Units
Problem 10:
Economic Enterprises require 90,0 00 units of a certain item
annually. The cost per unit is Rs. 3, the cost per purchase was Rs. 300 and
the inventory carrying cost Rs. 6 per unit per year.
i)What is the Economic order quantity?
ii)What should the firm do if the supplier offers discount s as below viz?
Order quantity Discount %
4500 -5999 2
6000 and above 3
Solution :
i)EOQ2AOC
29 0 0 0 03 0 03, 0006Units 
ii)Calculation of optimum order size for the discount offers :
2)Is lowest, hence order quantity should be 4500 units with 2% discount.munotes.in

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164Question 11:
Calculate the economic order quantity from the following
particulars:
Name of the component Esko
Annual consumption 96,004 units
Cost of placing one order Rs. 152
Cost per unit Rs. 100
Storage and carrying cost of average stock 20%
Answer :
22 9 6 0 0 4 1 5 2120820% 100 20AOEOQ unitsCo f 
Question 12:
The annual demand for a product is 10,000 units. The unit cost is
Rs. 6 and inventory carrying cost per unit per annum is 1/3rdof the
average inventory cost. If the cost of procurement is Rs. 100, determine -
i)Economic order quantity (EOQ)
ii)Number of order per annum; and
iii)Time between two consecutive orders.
Answer :
i)22 1 0 , 0 0 0 1 0 06AOEOQCo f
21 0 , 0 0 01 0 010002
ii)No. of order per annum = 10,000/1000=10 orders.
iii)Time between two consecutive orders = 12 months/10 = 1.2 months
Question 13:
A company buys in lots of 12,500 units which is a three month’s
supply. The cost per unit is Rs. 1.20. Each order costs Rs. 45 and
inventory carrying cost is 15% of average inventory value.
Required :
i)What is the total annual cost of existing inventory policy?
ii)How much money could be saved by employing the economic order
quantity?
Answer :
i)Existing inventory policy Rs.
Ordering cost : 4 orders at Rs. 45 = 180
Carrying cost :12,500 015% 1.202=
Total annual cost of existing inventory policy = 1,305munotes.in

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165ii)Annual consumption =12,500 4quarters = 50,000 units22 5 0 , 0 0 0 4 515% 120AOEOQCo f= 5,000 units
Ordering cost: 50,000/5,000 = 10 orders at Rs. 45 = 450
Carrying cost5, 000 015% 1.202=4 5 0
Total annual cost as per EOQ = 900
Saving by employing EOQ = 1305 -900 = Rs. 405
Question 14:
Orbysol Ltd. purchases 8,000 units of a particular item per year at
an unit cost of Rs. 20, the ordering cost per order is 50 Rs. and the
inventory carrying cost is 25 percent. Find the optimal order quantity and
minimum total cost including purchase cost.
If a 3 percent discount is offered by the supplier for purchases in
lots of 1,000 or more, should the publishing house accept the proposal?
Answer :
In the case of proposals with discount, we have to work out all
three costs i.e. ordering cost, carrying cost and purchase cost with discount
and without di scount and then evaluate the proposals.
1.Without discount22 2 , 0 0 0 5 025% 20
22 , 0 0 05 02005
 AOEOQCo funitsOptimal order quantity.
In a year2,00010200orders are to be placed.
Rs.
a) Ordering cost = 10 x 50 = 500
b) Carrying cost of average inventory
200100 52=
500
1,000
c) Purchase cost 2,000 x 20 = 40,000
Minimum Total cost = 41,000munotes.in

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1662.With 3% discount
Purchase price = 20 ( -)3 %=R s .1 9 . 4 0
Carrying cost = 25% of 19.4 = Rs. 4.85
Rs.
a) Ordering cost : 2 orders in lots of 1,000 = 2 x 50 100
b)Carrying cost :1, 000500 4.852= 2,425
2,525
c) Purchase cost 2,000 x 19.40 = 38,800
Total cost = 41,325
3% discount offer need not be accepted. The discount comes to Rs.
1,200 only whereas the i ncrease in ordering cost and carrying cost would
be Rs. 1,525. The net increase in total cost would be Rs. 325. Hence the
proposal is to be rejected.
Note :If the supplier offers 4% discount, the proposal can be accepted.
Negotiation may be had with the supplier in this regard.
Question 15:
Shrikant Ltd. purchases 24,000 pieces of a component from a
Nishikant Ltd. at Rs. 500 per piece and uses them in it sa s s e m b l y
department, at a steady rate. The cost of placing an order and following it
up is Rs. 2,500. The estimated stock holding cost is approximately 1% of
the value of average stock held. The company is at present placing order
which at present very b etween an order placed every two months *i.e. six
orders p.a.) to one order per annum. Which policy would you recommend?
Answer :
Stock holding cost = C = 1% of 500 = Rs. 5.00
2AOEOQC=22 4 , 0 0 02 , 5 0 04,8995unitsmunotes.in

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167No. of order Ordering cost Carrying cost Total cost
6(4,000 pieces
each order)6 2,500 15,0004,000 051 0 , 0 0 0225,000
5(4,800 pieces
each order)52 , 5 0 01 2 , 5 0 04,800 051 2 , 0 0 0224,500
4(6,000 pieces
each order)42 , 5 0 01 0 , 0 0 06, 000 051 5 , 0 0 0225,000
3(8,000 pieces
each order)3 2,500 7,5008, 000 052 0 , 0 0 0227,500
2(12,000 pieces
each order)2 2,500 5,00012,000 053 0 , 0 0 0235,000
1(24,000 pieces)12 , 5 0 0 2 , 5 0 024,000 056 0 , 0 0 0262,500
Recommendation -5o r d e r sp e ra n n u mi sr e c o m m e n d e db e c a u s e
the total cost will be lowest at Rs. 24,500. This is never to EOQ also i.e.
4,800 pieces each order.
Question 16:
A manufacturer requires 9,600 units of a certain component
annually. This is currently purchased from a regular supplier at Rs. 50 per
unit. The cost of placing an order is Rs. 60 per order and the annual
carrying cost is Rs. 5 per piece. What is the economic order quantity
(EOQ) for placing order?
Recently, the supplier has expressed his willingness to reduce the
price to Rs. 48, if the total requirements are obtained from him in two
equal orders and to Rs. 47, if the entire quantity required is purchased in
one lot. Analyse the costs of the three o ptions and recommend the best
course.
What other factors should also be considered before the decision is
taken?munotes.in

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168Answer :
22 9 6 0 0 6 04805 AOEOQ unitsC
Cost of 3 options:
Particulars
1. EOQ Price Rs. 50 2. Price Rs. 48 3. Price Rs. 47
Purchase cost9,600 50 4,80,0009,600 48 4,60,8009,600 47 4,51, 200Ordering cost9,600 / 480 20orders
at
Rs. 60 = 1,200 2o r d e r=6 0=1 2 0 One order 60
Carrying cost :
480 051 , 2 0 024,800 051 2 , 0 0 026,600 052 4 , 0 0 02
Total cost Rs. 4,82,400 4,72,920 4,75,260
Recommendation:
The best course is to purchase at Rs. 48.
Other factors:
In this case, there are two equal orders i.e. 9,600/2=4,800 units are
to be ordered at a time.
Problem 17:
i)A factory requires 1,500 units of an item per month each costing Rs.
27. The cost per order is Rs. 150 and the inventory carrying charges work -
out to 20% of the average inventory. Find out the Economic Order
Quantity and the number of orders per year.
ii)Would you accept a 2% price discount on a minimum supply of 1, 200
Nos.? Compare the total cost in both the cases.
Solution :
i)EOQ =2AOC21 8 . 0 0 01 5 05.40 Where
A = Annual Consumption
= 1,500 x 12 = 18,000 unitsmunotes.in

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16921 8 . 0 0 01 5 0 054 O= O r d e r i n g c o s t p e r o r d e r
=R s .1 5 0p e ro r d e r .
C= C a r r y i n g c o s t
=2 0 %o fR s .2 7=5 . 4 0
=1 0 . 0 0 . 0 0 0
= 1.000 Units.
No. of orders per year
=18.000181.000UnitsOrders per annumUnits
ii)2% price discount on a minimum supply quantity of 1,200 units .
a)No. of orders per year =18.000151.200orders
b)Original price Rs. 27.00
Less : Discount 0.54
Discounted price 26.46
Statement of comparative cost
Particulars Without discount
(Rs.)With 2% discount
(Rs.)
a)Ordering cost150 18 . . 2,700ie 150 15 . . 2,250ie 
b)Inventory carrying cost1.000 27 2021 0 01.200 26.46 2021 0 0
i.e. 2.700 i.e. 3.175.20
Total (a) + (b) 5.400 5.425.20
Offer of 2% discount results in higher cost, therefore not acceptable.
munotes.in

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17011
RECEIVABLES MA NAGEME NT
Unit Structure:
11.1 Meaning & Introduction
11.2 Importance aspects of receivables Management
11.3 Purpose of Credit Policy
11.4 Evaluation of Credit Policy
11.5 Solved Problems
11.1 MEA NING&I NTRODUCTIO N:
Receivable management means managing receivables in an
effective manner so that it will maintain balance between profitability and
liquidity. Receivable means firm’s book debt receivable from debtors on
account of credit sales. Receivables management is im portant due to risk
element involve in it. Book debts arise due to credit allowed to customers.
The purpose to allow credit is to increase sales and to meet competition.
The Finance Manager has to keep optimum balance between risk and
profitability to maxi mise the total value of the firm
RECEIVABLE MA NAGEME NTINVOLVES FOLLOWI NGM A I N
COSTS:
1.Cost of financing receivables : Allowing credit to customers is like
financing customers as firm’s capital get blocked due to allowance of
credit. A firm may have to pay interest on the capital if it is a borrowed
one.
2.Cost of Collection: If customers are paying receivables within the
credit period allowed to them then there will not be any cost of
collection. But when customer’s do not pa y the receivables within the
credit period allowed to them then firm have to incur the cost for
recovery/collection of the receivables. Collection costs mainly include
legal costs.
3.Bad Debts: When customer is unable to pay his debt its called bad
debt. Ef fective receivable management can reduce the chances of bad
debts. It is said that ‘No risk, No return’ hence it becomes necessary to
firm to provide credit to customers to compete in the market and to
increase the sales.munotes.in

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17111.2 IMPORTA NT ASPECTS OF RECEIVA BLES
MANAGEME NT
1.Formulation of credit policy :
a.Credit selection : A firm can not afford to allow credit to anyone.
A firm has to evaluate credit worthiness to allow credit to
customers. Following are the points which help to evaluate credit
worthiness of t he customers.
i.Capacity : The credit will be allowed after evaluating repaying
capacity of the customer.
ii.Capital : This is another point where customer’s capital is
evaluated to know the financial strength.
iii.Collateral security : If credit is allowed to custo mer and later
he is unable to pay his debt within the credit period allowed
then how firm is going to recover the book debt from such
customer hence collateral security available to the client
becomes important to recover book debt.
iv.Character: The customer ’s ability to repay the book debts
evaluated by customer’s record of meeting past financial
obligations and past payment history.
2.Credit Terms : Credit terms are the conditions under which the firm
sells goods and services on credit to the customers. Credit terms
includes following :
a.Credit Period : credit period is time allowed to customer
within which customer has to make payment. For e.g. if cr edit
period is net 30, it means customer has to make payment within
30 days.
b.Cash Discount: Cash discount is a discount allowed to
customer for making payment within a specified period of
time. E.g. credit term ‘2/15, net 45’ means 2 % cash discount
will b e allowed if payment is made within a period of 15 days
otherwise credit period allowed is 45 days and no cash discount
will be allowed.
3.Collection policy: The firm should have effective collection policy
to avoid and reduce risk of bad debts. The collecti on policy will
cover steps to be taken and procedures to be followed when payment
is not received within the credit period allowed to customer.
11.3 PURPOSE OF CREDIT POLICY:
The purpose of having credit policy is avoid and reduce cost in
receivables. Effective credit policy will reduce the cost receivables and
will maximise the value of the firm.munotes.in

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17211.4 EVALUATIO NOF CREDIT POLICY
Evaluation of credit policy will involve estimation of following points:
a.Credit Sales
b.Cost of credit sales
c.Cash Discounts
d.Bad debts & Collection cost
e.Expected profit (Credit sales -Cost of credit sales, bad debts, collection
costs, cash discounts and other relevant cost relate dt or e c e i v a b l e )
f.Tax payable on expected profit and compute net profit after tax.
g.Computation of opportunity cost of investment in receivables.
Opportunity cost means opportunity forgone due to investment in
receivables.
Investment in account receivables =Cost of credit sales p.a. X
Average collection period(days, weeks, Months)/365 days or 52
weeks, 12 months )
Opportunity Cost = Investment in Account receivables X expected
rate of return.
h.If expected profit after tax is more than opportunity cost then only the
credit policy will be accepted.
Statement Showing Evaluation of Credit Policy (Format)
Proposed
PolicyParticulars Present
Policy
1 2
1.Expected Profit
a) Credit Sales
b) Total cost of sales
c) Bad Debts
d) Cash Discount
e) Expected Net profit before tax
[a)–b)–c)–d)]
f) Tax at %
g) Expected profit after tax (e -f)
2. Opportunity cost of investment in
receivables
3. Net Profit (1 -2)
Decision: The policy with maximum benefits should be accepted.munotes.in

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17311.5 SOLVED PROBLEMS
Problem 1 :
A firm has credit sales amounting to Rs. 60,00,000. The sales price
per unit is Rs. 50, the variable cost is Rs. 32 and the average cost per unit
is Rs. 36. The average age of accounts receivable of the firm is 60 days.
The firm wants to tighten its credit terms, as a result the sales
volume will come down to Rs. 50,00,000 and the average -age of accounts
receivable to 45 days.
Assuming a rate of return of 15%, is the proposal viable?
Solution :
Present Plan
1,20,000 units
(Rs.)Proposed Plan
1,00,000 units
(Rs.)
a) Sales (S) 60,00,000 50,00,000
Less : Variable cost (V) 38,40,000 32,00,000
Fixed costs50000 64,80,000 4,80,000
b) Total Cost 43,20,000 36,80,000
c) Investment in receivable43,20,000 6036036,80,000 45360cos .
360Total t Cr perioddays=7 , 2 0 , 0 0 0 4,60,000
d) Reduction of investment in
receivables2,60,000
e) Savings on account of returns on
reduction in investment [@15% on
(d)]39,000
f) Contribution Rs. (S -V) 21,60,000 18,00,000
g) Loss of contribution 3,60,000
h) Net Loss (e) -(g) (-)3 , 2 1 , 0 0 0
It is not recommended to go in for stricter credit terms. The existing policy
is better.
Problem 2 :
Deepak Machines Ltd., wants to relax its credit policy. It sells at
present 50,000 units at a price of Rs. 150 per unit, the variable cost is Rs.
120 per unit and the average cost per unit is Rs. 126 per unit. All the sales
are on credit, the average colle ction period being 30 days.
With the relaxation of credit policy it is expected that sales will
increase by 10% and average age of receivables to 60 days. Assuming
15% returns, should the firm relax its credit policy?munotes.in

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174Solution :
Evaluation of Credit Policies
Present Plan
(Rs.)Proposed Plan
(Rs.)
a) Sales (S) 75,00,000 50,00,000
Less : Variable cost (V) 60,00,000 32,00,000
Fixed costs50000 63,00,000 4,80,000
b) Total Cost 63,00,000 36,80,000
c) Investment in Receivable63,00,000 3036069,00,000 60360cos
360Total t Credit perioddays=5 , 2 5 , 0 0 0 =11,50,000
d) Cost of investment in receivables
(@15%)78,750 1,72,500
e) Additional cost of investment 93,750
f) Contribution (S -V) 15,00,000 16,50,000
g) Additional contribution 1,50,000
h) Net Gain (g) -(e) 56,250
The firm should relax its credit policy as there is a net gain of
Rs. 56,250.
Problem 3 :
PQR Ltd., is considering relaxing its credit policy and evaluating
two proposed policies. Currently the firm has annual credit sales of Rs. 50
lakhs and account receivable is Rs. 12,50,000. The current level of loss
due to bad debts is Rs. 1,50,000. The fi rm is required to give a return of
20% on investment in new (additional) accounts receivable. The
company’s variable costs are 70% of the selling price.
The following further information is finished :
Present Policy
(Rs.)Policy Option -I
(Rs.)Policy Option -II
(Rs.)
1) Annual credit sales 50,00,000 60,00,000 67,50,000
2) Accounts
receivable12,50,000 20,00,000 28,12,500
3) Bad Debt losses 1,50,000 3,00,000 4,50,000
You are the financial consultant of the firm. Advise the Managing
Director which option should be exercised.munotes.in

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175Solution :
Statement of evaluation of credit policies
Policy Option -I
(Rs.)Policy Option -II
(Rs.)
a) Annual credit sales 60,00,000 67,50,000
b) Increase in sales over present
sales10,00,000 17,50,000
c) Contribution on increase in
sales @ 30% [i.e. 30% of (b)]3,00,000 5,25,000
d) Increase in bad debt losses
over present bad debt losses1,50,000 3,00,000
e) Net contribution = (c)-(d) 1,50,000 2,25,000
f) Additional A/c Receivables 7,50,000 15,62,500
g) Required Return on
Investment on additional
account receivables @ 20%
i.e. 20% of (f)1,50,000 3,12,500
h) Net Gain + /
Net Loss ( -)( e )-(g)Nil (-)8 7 , 5 0 0
Option I can be exercised since required return is achieved.
Problem 4 :
A company’s present credit sales amount to Rs. 50 lakhs. Its
variable cost ratio is 60% of sales and fixed costs amount to Rs. 10 lakhs
per annum. The company proposes to relax it s present credit policy of 1
month to either 2 months or 3 months, as the case may be. The following
information are also available :
Present Policy Policy Option -IPolicy Option -II
Average age of
debtors1 month 2m o n t h s 3m o n t h s
Increase in Sales -- 20% 30%
Percentage of bad
debt1% 2.5% 5%
If the company requires a return on investment of 20% before tax,
evaluate the proposals.munotes.in

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176Solution :
Statement of evaluation of credit policies
Present Policy
(Rs.)Policy Option -
I( R s . )Policy Option -
II (Rs.)
a) Annual credit
sales50,00,000 60,00,000 65,00,0000
b) Variable cost 30,00,000 36,00,000 39,00,000
[60% of (a)]
c) Fixed cost 10,00,000 10,00,000 10,00,000
Total cost 40,00,000 46,00,000 49,00,000
d) Average
investment in
Debtors [based
on total (b) + (c)]40,00,00012=3,33,33346,00,000212=7,66,66749,00,000312=12,25,000
e) Additional
investment in
debtors4,33,334 8,91,667
f) Required return
of 20% on
investment86,667 1,78,333
g) Bad Debts. 50,000 1,50,000 3,25,000
h) Additional sales
over present sales10,00,000 15,00,000
i) Additional
contribution
[40% of (h)]4,00,000 6,00,000
j) Net contribution
[(i)-(g)]2,50,000 2,75,000
k) Net Gain / Net
Loss (j) -(f)1,63,333 96,667
Policy I is more beneficial.
Problem 5 :
Super Sports Co. dealing in sports goods, have an annual sale of
Rs. 50 lakhs and are currently extending 30 days credit to the dealers. It is
felt that sales can pick up considerably if the dealers are willing to carry
increased stocks, but the dealers have difficulty in financing their
inventory. Super Sports Co. is therefore considering shifts in credit policy.
The following information is available :
The average collection period now is 30 days.munotes.in

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177Costs :
Variable costs -80 percent o ns a l e s .
Fixed costs -Rs. 6 lakhs per annum.
Required return (pre -tax) on investment -20%
Credit Policy Average collection
PeriodAnnual Sales
(Rs. In lakhs)
A 45 days 56
B 60 days 60
C 75 days 62
D 90 days 63
Determine which policy the company should adopt.
Solution :
Existing
Credit
PolicyProposed Credit Policy
A B C D
a)Sales (Rs. In lakhs) 50.00 56.00 60.00 62.00 63.00
b)Contribution 10.00 11.20 12.00 12.40 12.60
[20% of (a)]
c)Increase in contribution 1.20 2.00 2.40 2.60
d)Average investment in
debtors (Variable Cost
+ Fixed Cost)46 50.8 54 55.6 56.4
e)Investment in Debtors
cos .360Total t Cr Period46 30360=3.8350.8 45360=6.3554 60360=955.6 75360=11.5856.4 90360=14.10
f)Additional investment
Return on investment
@2 0 %2.52
0.505.17
1.031.75
1.5510.27
2.05
Net Gain / Net Loss (c)
-(f)0.70 0.97 0.85 0.55
Policy B recommended because of highest gain.
Problem 6 :
A trader whose current sales are in the region of Rs. 6 lakhs per
annum and an averag e collection period of 30 days wants to pursue a more
liberal policy to improve sales. A study made by a management consultant
reveals the following information.munotes.in

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178Credit Policy Increase in Collection
PeriodIncrease in
SalesPayment Default
anticipated
A 10 days Rs. 30,000 1.5%
B 20 days Rs.48,000 2%
C 30 days Rs.75,000 3%
D 45 days Rs.90,000 4%
The selling price per unit is Rs. 3. Average cost per unit is Rs. 2.25
and variable cost per unit is Rs. 2.
The current bad debt loss is 1%. Required return on additional
investment is 20%. Assume 360 days a year.
Which of the above policies would you recommend for adoption?
Solution :
Existing
Credit
PolicyProposed Credit Policy
A B C D
Collection period
(days)30 40
(30+10)50
(30+20)60
(30+30)75
(30+45)
a)Sales 6,00,000 6,30,000 6,48,000 6,75,000 6,90,000
b)Costs :
Variable 4,00,000 4,20,000 4,32,000 4,50,000 4,60,000
(Rs. 2 i.e.2663%o f
sales)
Fixed cost 50,000 50,000 50,000 50,000 50,000
(25 paise at sales level
of existing 2,00,000
investment)
Total Cost 4,50,000 4,70,000 4,82,000 5,00,000 5,10,000
c) Investment in Debtors (at
cost)
cos .
360Total t Cr Perioddays450000 30360470000 40360482000 50360500000 60360510000 7536037,500 52,222 66,944 83,333 1,06,250
d) Additional Investment 14,722 29,444 45,833 68,750
e) Required Return @ 20% on
(d)2,944 5,888 9,166 13,750
f) Bad Debts Loss (%) 1% 1.5% 2% 3% 4%
%o fs a l e s( R s . ) 6,000 9,450 12,960 20,250 27,600
Increase in Bad Debt. (Rs.) 3,450 6,960 14,250 21,600
g) Contribution (Increased
sales x P/V Ratio)10,000 16,000 25,000 30,000
h) Net contribution (g) -(f) 6,550 9,040 10,750 8,400
i) Net Gain / Net Loss [(h) -
(e)]3,606 3,152 1,584 (-)5,350
Credit Policy A is recommended as it gives the highest gain.munotes.in

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179Problem 7 :
ABC Company’s present sales amount to Rs. 30 lakhs at Rs. 12 per
unit. Variable cost is Rs. 8 per unit and fixed costs amount to Rs. 2.50
lakhs per annum. Its present credit period of one month is proposed to be
extended to either 2 or 3 months, whichever appears to be more profitable.
The following estimates are made for the purpose :
Credit Policy 1 month 2 months 3m o n t h s
Increase in sales (%) -- 8% 30%
%B a dD e b tt os a l e s 1 2 6
Fixed costs will increase by Rs. 5,00,000 annually after any increase in
sales above 25% over the present level.
The company requires a pre -tax return on investment of at least
20% for the level of risk involved.
What will be the most rewarding credit policy in case of ABC
company under the above circumstances.
Solution :
Statement showing evaluation of credit policies
Particulars 1m o n t h 2m o n t h s 3m o n t h s
(Rs. In lakhs)
a) Sales 30.00 32.40 39.00
(8% Inc.) (30% Inc.)
Less variable costs 20.00 21.60 26.00
(Rs. 8 i.e.2663%o fs a l e s
Fixed cost 2.50 2.50 3.00
b) Total cost 22.50 24.10 29.00
c) Investment in Debtors
cos .12Total t Cr Periodmonths22.50 112=1 . 8 824.10 212=4 . 0 229 312=7.25
d) Additional Investment 2.14 5.37
e) Return Expected on
Additional Investment
[20% of (d)]0.43 1.07
f) Contribution 10.00 10.80 13.00
g) Additional contribution 0.80 3.00
h) Bad Debt (%) (1% (2%) (6%)
0.30 0.65 2.34
i) Increase in bad debts
losses0.35 2.04
j) Net contribution (g) -(i) 0.45 0.96
k) Net Gain / Net Loss (j) -
(e)0.02 (-)0 . 1 1
Credit Policy of 2 months is recommended.munotes.in

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180Problem 8 :
STS Ltd., which sells on credit basis has ranked its customers in
categories 1 to 5 in order of credit risk :
Category Percentage bad debts Average collection
period
1 0.0 30 days
2 1.00 45 days
3 2.00 60 days
4 5.00 90 days
5 10.00 120 days
The Company’s current credit policy is to allow unlimited credit to
firms in categories 1 to 3, limited credit to firms in category 4 and no
additional credit to firms in category 5.
As a result, orders amounting to Rs. 25,00,000 from category 4 and
Rs. 75,00,000 from category 5 customers are rejected every year. If the
STS Ltd., makes a 10% gross profit on sales and has an opportunity cost
on investment in receivables of 12%; what would be the effect on profits
of allowing full credit to all categor ies of customers? Should credit be
extended to all categories of customers?
Solution :
Statement showing the effects on profits for full credit allowed
Category 4 Category 5 Total
a) Additional sales 25.00 75.00 100.00
b) Additional contribution
(G.P. -10%)2.50 7.50 10.00
c) Bad debts losses (%)
Actual loss5%
1.2510%
7.50 8.75
d) Investment in Debtors (90% of sales) 22.50 67.50
.
360Total Investment Cr Perioddays 22.50 90360=5.6367.50 120360=22.50
e) Investment @ 12% on (d) 0.68 2.70 3.38
f) Net contribution (b) -(c) 1.25 -- 125
g) Net Gain / Net Loss (f) -(e) 0.57 (-)2 . 7 0 (-)2 . 1 3
If full credit is allowed to all the categories of customers, the
profit will lower by Rs. 2.13 lakhs.
If the credit is allowed to the categories 1 to 4 and the credit is
rejected to category 5, the profit of the Company, will be higher by
Rs. 57,000 as shown in the above workings.munotes.in

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181Problem 9 :
Vinayak Enterprises have launched an economy drive in their firm
in order to arrest the trend of declining profitability about which the firm’s
directors have been worried for quite some time. As one of the measures,
the Board of Directors has proposed to cut down the expenditure of the
credit collection Department from Rs. 45 lakhs to Rs. 37.50 lakhs per year
and also to increase the average collection period from 40 days to 60 days.
The proposal will involve a reduction in the staff strength of the
department but it is expected that the redundant employees can be
accommodated elsewhere without any financial burden whatsoever for the
firm.
The details of the present and proposed situations are as follows :
Present :
Credit sales :4,00,000 units at Rs. 75 per unit
Variable cost :Rs. 50 per unit
Fixed cost :Rs. 12.50 per unit
Total cost :Rs. 62.50 per unit
Bad Debts :1% of credit sales
Proposed :
Sales volume is expected to increase by 10%.
Bad Debts are likely to go up 3%.
Assuming that the rate of return on investment is 20% p.a. What
suggestion will you offer to the Directors?
Solution :
The proposal will have the effect of increasing the profit due to
increased sales and reduction in collection expenditure. It will als oh a v e
the effect of increasing the costs due to increase in interest on investment
and higher bad debts. The comparison of the total effects will help in
reaching the conclusion whether the proposal is beneficial.
a)Calculation of Increase in Profits d ue to increase in sales volume.
Marginal contribution =Sales price -Variable Cost.
=Rs. 75 -Rs. 50
=Rs. 25 per unit
Total contribution on Increased Volume
=40,000 units x Rs. 25 per unit
=Rs. 10,00,000
b)Increase in profits due to reduction of collection charges :
Present collection charges =Rs. 45 lakhs.
Proposed collection charges =Rs. 37.50 lakhs.
Saving in collection charges =s. 7.50 lakhs
Total Benefits (a) + (b) =Rs. 10,00,000 + Rs. 7,50,000
=Rs. 17,50,000munotes.in

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182c)Increase costs due to Interest on additional investment :
Present Average Investment :
Rs.
Variable cost4,00,000 50 2,00,00,000
Fixed cost4,00,000 12.50 50,00,000
Total cost 2,50,00,000
Debtors : 40 days
2500000040360 27,77,778
Proposed Average Investment :
Variable cost4, 40,000 50 2,20,00,000
Fixed cost 50,00,000
Total cost 2,70,00,000
Debtors : 60 days
2700000060360 45,00,000
Net Increases in Investment : 17,22,222
(45,00,000 -27,77,778)
Addl. Interest on Investment @ 20% 3,44,444
d)Increase in Costs due to increase in Bad Debts :
Rs.
Loss on Bad Debts
Present :4,00,000 . 75Rs=3 , 0 0 , 0 0 , 0 0 0@1 %3,00,000
Proposed4, 40,000 . 75Rs=3 , 3 0 , 0 0 , 0 0 0@3 %9,90,000
Addl. Loss on account of Bad Debts. 6,90,000
Total Loss (c) + (d) 10,34,444
Since the total benefits is more than the costs increased, the
proposal can be accepted.
Problem 10 :
Vishnu Trading Company desires to allow 3 percent discount for
payment made before 10thday after a credit sale. The Company’s annual
credit sales is expected to increase from 75,000 units to 1,00,000 units.munotes.in

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183The variable cost per unit is Rs. 30 and the average cost per unit is Rs. 36.
The selling price per unit Rs. 45.
The management expects that the average collection period will
come down from 30 days to 15 days. It is further expected that 50 percent
of the total sales will be on discount.
Expected rate of return on investment is 20 percent.
Should the discount facility allowed?
Present Plan
(Rs.)Proposed Plan
(Rs.)
a) Sales (S) 33,75,000 45,00,000
Less : Variable cost (V) 22,50,000 30,00,000
Fixed costs75,000 64,50,000 4,50,000
b) Total Cost 27,00,000 34,50,000
c) Investment in Debtors27,00,000 3036034,50,000 15360cos
360Total t Credit perioddays=2 , 2 5 , 0 0 0 =1,43,750
d) Reduction of investment in
Debtors81,250
e) Savings due to return of 20% on
(d) above16,250
f) Contribution (S -V) 11,25,000 15,00,000
g) Additional contribution 3,75,000
h) Cost involved in cash discount on
credit sale @ 3 percent
Total credit sales Rs. 45,00,000
50% Avail discount i.e. Rs.
2250000
3% Discount is Rs. 67,500
i) Net Gain (e) + (g) -(h) 3,23,750
Discount Policy is recommended.
Problem 11 :
The Diamond Manufacturing Company Ltd. extends on an average
credit to its customers for 60 days. It now intends to reduce the terms to 30
days by offering 2% discount for payment within 30 days. The annual
sales of the company is Rs. 1,00,00,000. The firm sells 80% of total salesmunotes.in

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184on credit basis. The sales are evenly spread over the year. The expected
rate of return is 15%.
If the company follows the discount policy of 2%, it is expected
that 60% of the customers would take the discount and the average
collection period would be reduced to 40 days.
Should the company adopt the discount policy?
Present Policy
(Rs.)Proposed Policy
(Rs.)
Total Sales 1,00,00,000 1,00,00,000
a) Credit Sales (80%) 80,00,000 80,00,000
b) Average Investments in
Receivables80,00,000 5036080,00,000 30360360Credit Sales Credit perioddays=1 1 , 1 1 , 1 1 1 =6 , 6 6 , 6 6 7
c) Reduction in Investment 4,44,444
d)Saving due to return on (c) (15%) 66,667
e) Cost of discount :
(60% of Rs. 80,00,000)
Sales on which discount will be
availed48,00,000
f) Discount @ 2% on (e) above 96,000
g) Net Loss (d) -(f) (-)2 9 , 3 3 3
Discount Policy is not recommended.
Note :
Since cost of sales information was not available, credit sales
figure have been used for working of Average Investments in Receivables.
Problem 12 :
In order to increase sales from the normal level of Rs. 24 lakhs per
annum, the Marketing Manager subm its a proposal for liberalizing credit
policy as under :
Normal sales Rs. 2.4 lakhs
Normal credit period 30 days
Proposed increase in
Credit period beyond
Normal 30 daysRelevant increase
Over normal sales
Rs.
15 days 12,000
30 days 18,000
45 day s 21,000
60 days 24,000munotes.in

Page 185

185The P/V Ratio of the company is133 %3The company expects a pre -tax return of 20% on investment.
Evaluate the above four alternatives and advise the Management. ( Assume
360 days a year.)
Solution :
Statement showing evaluation of credit policies
Particulars Present Credit Policies Options
I II III IV
Collection period (days) 30 45 60 75 90
a)Sales 2,40,000 2,52,000 2,58,000 2,61,000 2,64,000
b)Variable Costs 1,60,000 1,68,000 1,72,000 1,74,000 1,76,000
c)
Contribution133 %380,000 84,000 86,000 87,000 88,000
d)Addl. Contribution 4,000 6,000 7,000 8,000
e)Investment in receivable
:
360Cost Credit perioddays160000 30360=1 3 , 3 3 3168000 45360=2 1 , 0 0 0172000 60360=2 8 , 6 6 7174000 75360=3 6 , 2 5 0176000 90360=4 4 , 0 0 0
f)Addl. Investment in
receivables7,667 15,334 22,917 30,667
g)Return on addl.
Investment @ 20%1,533 3,067 4,583 6,133
h)Net Gain / (d) -(g) (Net
Loss)2,467 2,933 2,417 1,867
60 days credit i.e. increase by 30 days is more beneficial.
Problem 13 :
Sanjay Limited specialize in the manufacture of a computer
component. The component is currently sold for Rs. 1,000 and its variable
cost is Rs. 800. For the year ended 31.12.92, the Company sold on an
average 400 components per month.
At present the company grants one months credit to its customers.
The company is thinking of extending the same of two months on account
of which the following is expected :
Increase in sales 25%.
Increase in stocks Rs. 2,00,000.
Increase in creditors Rs. 1,00,000
You are required :
To advise the company on whether or not to extend the credit
terms if :
a)All customers avail the extended credit period of two months andmunotes.in

Page 186

186b)Only the new customers avail the two months credit. Assume in this
case that th e entire increase in sales is attributable to the new
customers.
The company expect a minimum return of 40% on the investment.
Solution:
Particulars Existing Proposal (a) Proposal (b)
All customers
Avail two
Months creditOnly new
Customers
Avail two
Months credit
a) Average credit period (days) 30 60 36
b) Sales @ Rs. 1000 each 48,00,000 60,00,000 60,00,000
c) Cost of Sales 38,40,000 48,00,000 48,00,000
d) Contribution 9,60,000 12,00,000 12,00,000
Additional contribution 2,40,000 2,40,000
e) Investment in receivables 3,20,000 8,00,000 4,80,000360Cost of sales Credit Periodf) Increase in addl. Investment
(Stock -Creditors) 1,00,000 1,00,000
g) Total addl. Investment (e) + (f) 5,80,000 2,60,00
h) Required return @ 40% of (g) 2,32,000 1,04,000
i) Net Gain (d) -(h) 8,000 1,36,000
Proposal (b) is beneficial.
Problem 14 :
As a part of the strategy to increase sales and profit, the Sal es
Manager of a company proposes to sell goods to a group of new customers
with 10% risk of non -payment. This group would require one and a half
month credit and is likely to increase sales by Rs. 1,00,000 p.a. Production
and selling expenses amount to 80% of sales and the income tax rate is
50%. The company’s minimum required rate of return (after tax) is 25%.
Should the Sales Manager’s proposal be accepted?
Also find the degree of risk of non -payment that the company
should be willing to ensure if t he required rate of return (after tax) were (i)
30%, (ii) 40% and (iii) 60%.
Suggested solution :
i)
Rs.
Additional sales from new customer 1,00,000
Less : Risk of non -payment @ 10% 10,000
Less : Production & selling expenses @ 80% 80,000
Profits before tax 10,000
Less : Tax @ 50% 5,000
Profits after tax 5,000munotes.in

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187Investment in Debtors :
Sales : Rs. 1,00,000
Cost of sales @ 80% is Rs. 80,000Debtors312 2Cost(1.5 month credit)80,000 312 2.10,000Rs 
Rate of Return :
Pr100ofit after taxInvestment
i.e.5, 000100 50%10,000
The Sales Manager’s proposal is acceptable; rate of return being
greater than 25%.
ii)Statement showing acceptable degree of risk of non -payment :
Rate or Return I3 0 %
Rs.II 40%
Rs.III 60%
Rs.
a)Average investment in debtors 10,000 10,000 10,000
b)Profit after tax (at rate of return) 3,000 4,000 6,000
c)Profit before tax
(Grossing up by 50% tax) 6,000 8,000 12,000
d)Contribution of additional sales 20,000 20,000 20,000
(sales less 80%)
e)Acceptable risk of non -payment 14,000 12,000 8,000
f)As a % of Sales 14% 12% 8%
Problem 15 :
A group of customers want to enter into a contact with you to buy
goods worth Rs. 20 lakhs during 1998. The deliveries to be made in four
equal installments quarterly. The price of the commodity is Rs. 20 per unit
on which you expect a profit of Rs. 10. Th e acceptance of this proposal
would mean an additional recurring expenditure of Rs. 10,000 p.a. on your
part.
The aging schedule of accounts receivables in respect of this group
of customers in the past was as follows :
Period Percentage of bills for W hich
payment received
At the end of 30 days 155
At the end of 60 days 25%
At the end of 90 days 40%
At the end of 100 days 20%munotes.in

Page 188

188Assuming an opportunity cost of 20% of the funds locked up in
account receivables, will it be desirable to accept the proposal?
Solution :
a)Calculation of Expected Profits from the contract :
Contribution @ 50% on contract value of Rs. 20 lakhs. (Since cost
is Rs. 10 & price of Rs. 20 per unit)
Therefore contribution is Rs. 10 lakhs
Less : Additional recurring exp enses Rs. 0.10 lakhs
Expected Profit Rs. 9.90 lakhs
b)Calculation of opportunity cost :
c)Delivers in 4 equal instalment quarterly, therefore sales in quarter is
Rs.20,00,000 4 .5,00,000RsRealisation a s per aging schedule
No. of Days Rs. Product
30 @ 15% of Rs. 5 lakhs 75,000 22,50,000
60 @ 25% of Rs. 5 lakhs 1,25,000 75,00,000
90 @ 40% of Rs. 5 lakhs 2,00,000 1,80,00,000
100 @ 20% of Rs. 5 lakhs 1,00,000 1,00,00,000
3,77,50,000
Opportunity cost of Funds blocked.
@ 20% per quarter :37750000 20.2 0 ,6 8 5365 100Rs  
Therefore for one year is42 0 , 6 8 5 . 8 2 , 7 4 0Rs There fore Net Gain = Expected Profits -Opportunity cost of funds
=9 , 9 0 , 0 0 0 -82,740 = Rs. 9,07,260
Hence proposal is acceptable.
On the basis of credit period of
1 month 2m o n t h s 3m o n t h s
Increase in sales by -- 10% 30%
% of bad debts to sales 1 2 5
Problem 16: Debtors Decision -Interest on Average Debtors
A Company currently has an annual turnover of 50 Lakhs and an
average collection period of 30 days. The Company wants to experiment
with a more liberal credit policy on the ground that increase in collection
period will generate additional sales.
From the following information, kindly indicate which policy the
Company should adopt :munotes.in

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189Credit Policy Average Collection Period Amount Sales ( `in Lakhs)
A 45 days 56
B 60 days 60
C 75 days 62
D 90 days 63
Variable Cost is 80% of Sales. Fixed Cost is `6L a k h sp e ra n n u m .
Required (pre -tax) Return on Investment is 20%. A year may be taken to
comprise of 360 days.
Solution :
Evaluation of alternative credit policies
Conclusion : The Company may choose Policy B to maximize Net
Benefit.
Problem 17: Debtors Decision -Interest on Average Debtors
In order to increase sales from their present annual level of 2,40,000, Agni
Associates is considering a more lib eral credit policy. Currently, the Firm
has an average collection period of 30 days. However, it is believed that as
Collection Period is lengthened, sales will increase by following amounts -
Credit Policy Increase in Average Collection
PeriodIncrease in Sales
A 15 days `10,000
B 30 days `15,000
C 45 days `17,000
D 60 days `18,000
The Variable Costs of the Firm’ s product in 60% of Sale Price. If the
Firm has a pre -tax opportunity cost of 20%, which credit policy
should be pursued? (Assume a 360 -day year).munotes.in

Page 190

190Decision : The Firm should select Policy B, i.e. 60 days credit, since
maximum benefit is obtained under tha t policy.
Problem 18: Debtors Decision -Interest on Average Debtors, Bad
Debts
ABC Ltd. has a present annual Sales Turnover of `40,00,00. The
unit Sale Price is `20. Variable Cost are `12 per unit and Fixed Costs
amount to `5,00,000 p.a. The present credit period of 1 month is proposed
to be extended to either 2 or 3 months whichever will be more profitable.
The following data is also made available -
Credit Period 1m o n t h 2m o n t h s 3m o n t h s
Increase in Sales -- 10% 30%
0% of Bad Debts to Sales 1 2 5
Fixed Cost will increase by 75,000 when Sales will increase by 30%. The
Company requires a pre -tax return on investment at 20%. Evaluate the
proposals and recommended best credit period for the Company.
Solution:
Conclusion : The Company can extend credit upto 2 months only, in
order to derive maximum Net Benefit.
Problem 19: Debtors Decision -Interest on Average Debtors, Bad
Debts
The current sales of Raja L td. are `250 Lakhs. It sells on terms of net 30
days and the average collection period (ACP) is 40 days. Bad Debt losses
are 3% of Sales. The cost of funds blocked in receivables is reckoned at
18%. The Variable Costs are 80% of Sales. Since the Company ha se x c e s smunotes.in

Page 191

191capacity, it can expand its sales substantially without additional Fixed
Costs. The Management is evaluating three alternative credit policies -
1.Policy A : This calls for relaxing the credit standards. It is expected to
increase sales by `40 La khs. On the new sales, ACP will be 50 days
and the Bad Debt Loss is 15%.
2.Policy B : This involves changing the terms of credit from net 30 to
net 45. this is expected to raise Sales by `15 Lakhs, lengthen the ACP
to 60 days and result in a Bad Debt Los s of 4% on the new sales.
3.Policy C : This calls for decreasing the rigour collection effort. This is
expected to push sales up by `10 Lakhs, increase the ACP to 50 days
and raise the Bad Debt Loss to 4%.
Determine the most optimum policy for the Company -Take 1 year = 360
days.
Decision : Policy A is the most paying (i.e. beneficial) policy for the
Company.
Problem 20: Credit Decision -Interest on Average Debtors, Bad Debts
A Trader, whose current sales are in the region of 6 Lakhs per annum and
an Average Collection Period of 30 days wants to pursue a more liberal
policy to improve sales. A study made by a Management Consultant
reveals the following information :
Credit
policyIncrease in
Collection periodIncrease in
SalesPercent default
anticipated
A 10 days `30,000 1.5%
B 20 days `48,000 2%
C 30 days `75,000 3%
D 45 days `90,000 4%munotes.in

Page 192

192The Selling Price per unit is 3. Average Cost per unit is 2.25 and Variable
Costs per unit are 2.
The current Bad Debt Loss is 1%. Required Return on Additional
Investment is 20%. Assume a 360 days year.
Which of the above policies would you recommend for adoption?
Note : Present Sale Quantity62,00,0003. .Lakhs
pu `
`units. Also, fixed
Costs p.u. = Total Costs 2.25 less Variable Costs 2 = `0.25 p.u. Hence,
Total Fixed Costs at present = 2,00,000 x `0.25 = `50,000, which remain
constant.
Observations :
Policy A gives maximum Net Benefit and may be chosen.
Policy B and C give Net Benefit higher than present situation, and
may be preferred in ranking.
Policy D should not be pursued at all, since the Net Benefit is
lower than the present situation.
Problem 21: Debtors Decision -Interest on Average Debt ors, Bad
Debts
XYZ Corporation is considering relaxing its present credit policy
and is in the process of evaluating two proposed policies. Currently, the
Firm has annual credit sales of `50 Lakhs and Accounts Receivable
Turnover Ratio of 4 times a year. The current level of loss due to Bad
Debts is `1,50,000. The Firm is required to give a Return of 25% on the
Investment in new Accounts Receivables. The Company’s Variable Costs
are 70% of the Selling Price. Given the following information, which is
the b etter option?munotes.in

Page 193

193Particulars Present Policy Policy Option I Policy Option II
Annual Credit Sales 50,00,000 60,00,000 67,50,000
Account Receivable
Turnover Ratio4 times 3 times 2.4 times
Bad Debt Losses 1,50,000 3,00,000 4,50,000
Solution:
Particulars Present Policy I Policy II
1. Sales `50,00,000 `60,00,000 `67,50,000
2. Variable Cost at
70% Sales`35,00,000 `42,00,000 `47,25,000
3. Contribution (1 -2) `15,00,000 `18,00,000 `20,25,000
4. Cost of Debtors p.a.
= Variable Costs =
(2 only)`35,00,000 `42,00,000 `47,25,000
5. Accounts Receivable
Turnover Ratio
(given)4 times 3 times 2.4 times
6. Average Debtors45`8,75,000 `14,00,000 `19,68,750
7. Interest on Avg
Debtors62 5 %  `2,18,750 `3,50,000 `4,92,188
8. Bad Debts `1,50,000 `3,00,000 `4,50,000
9. Net Benefits (3 -7-
8)`11,31,250 `11,50,000 `10,82,812
Observation : Option I is preferable due to maximum Net Benefit (i.e.
surplus of `18,750 over present policy).
Problem 22: Debtors Decision -Interest on Average Debtors, Bad
Debts, Collection Expenses
A Company has Sales `25,00,000. Average Collection Period is 50
days, Bad Debt losses are 5% of Sales and Collection Expenses are
`25,000. The cost of funds is 15%. The Company has 2 alternative
Collection Programmes :munotes.in

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194Particulars Programme I Programme II
Average Collection Period reduced to 40 days 30 days
Bad Debt Losses reduced to 4% of Sales 3% of Sales
Collection Expenses `50,000 `80,000
Evaluate which Programme is viable.
Particulars Present Program I Program II
1.Sales `25,00,000 `25,00,000 `25,00,000
2.Collection Period 50 days 40 days 30 days
3.
Average Debtors12365`3,42,466 `2,73,973 `2,05,479
4.Interest on Debtors at 15% `51,370 `41,096 `30,822
5.Bad Debts (5%, 4%, 3% of
Sales)`1,25,000 `1,00,000 `75,000
6.Collection Expenses `25,000 `50,000 `80,000
7.Total Expenses (4 + 5 + 6) `2,01,370 `1,91,096 `1,85,822
Conclusion : Due to least costs, Program II is most visible.
Problem 23: Evaluation of different grades of customers and credit
policies.
TheCredit Manager of Ram Ltd. is re -appraising the Company’s
credit policy. The Company sells the products on terms of net 30. Cost of
Goods Sold is 85% of Sales and Fixed Costs are further 5% of Sales. The
Company classifies its customers on a scale of 1 to 4. During the past five
years, the experience was as under -
Scale 1 2 3 4
Default as a percentage of Sales 0% 2% 10% 20%
Average Collection Period in days, for non -
defaulting accounts45 42 40 80
The average rate of interest is 15%. What conclusions do you draw about
the Company’s credit policy? What other factors should be taken into
account before changing the present policy? Discuss.munotes.in

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195Solution :
1)Evaluation of different scale of custome rs
Scale 1 2 3 4
a)Sales `100.00 `100.00 `100.00 `100.00
b)Cost of Goods Sold
(85% given)`85.00 `85.00 `85.00 `85.00
c)Contribution / Gross
Profit (a -b)`15.00 `15.00 `15.00 `15.00
d)Collection Period 45 days 42 days 40 days 80 days
e)Average Debtors365bd`10.48 `9.78 `9.32 `18.63
f)Interest on Average
Debtors15%e`1.57 `1.47 `1.40 `2.79
g)Bad Debts Nil `2.00 `10.00 `20.00
h)Net Benefit ( c -f-g) `13.43 `11.53 `3.60 Loss ( `7.79)
i)Decision / Strategy Continue
SaleContinue
SaleContinue
SaleStop Selling
Note : Since the Sales amount for each scale is not g iven specifically, the
above evaluation is made for every `100 of Sale in each category of
customer. Also, Fixed Costs of 5% of Sales are not considered relevant for
this decision.
2.Comments
a)Even though the terms are net 30, the Average Collection Period for
all categories is above 30 days. This means that the Company is very
lenient (or inefficient) in its collection policy.
b)Sales to the first 3 scales result in a Net Benefit. Hence, the Company
can continue selling to such customers. However, Sales in Scale 4
category result in a loss of 7.79 for every 100 of Sale. Hence, the
Company should stop selling to such customers. However, the
Company can continue selling to such category customer s and retain
its market share, if it can control bad debts from the present high level
of 20%, by atleast 7.80% (being the present loss)
c)Some other factors to be considered before changing the present credit
policy are -(i) effect on the various scales of customers, (ii) past
performance / experience with the customers, (iii) credit -worthiness
etc.
munotes.in

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19612
CASH MA NAGEME NT( C A S HB U D G E T )
Unit Structure :
12.1 Meaning & Introduction
12.2 Cash Management -Planning
12.3 Purposes of holding cash in business
12.4 Cash Budget
12.5 Solved Problems
12.1 MEA NING&I NTRODUCTIO N
Cash management is management of cash in efficient and in
effective manner. Organizations need to maintain cash for their daily
requirements and this level of cash has to be set after analysing operating
cycle of the particular organization. Larger the operating cycle large
amount of cash will be required and vice versa. Cash management
becomes necessary to maintain liquidity & solvency in business and to
avoid situations of additional cash and shortage of cash.
12.2 CASH MA NAGEME NT–PLANNING
Planning is required in any kind of task and in the same manner
planning of cash is required for effective cash management. In cash
planning, finance manager has to estimate future cash outflows and future
cash inflows. Cash budget is required to be prepar ed to estimate cash
outflows and cash inflows.
12.3 PURPOSES OF HOLDI NGC A S HI NBUSI NESS
Lord Keynes stated that there are 3 basic, considering the amount of cash.
1.Transaction Need: Cash is required for day -to-day requirements e.g.
purchases, payment of wages etc.
2.Speculative Need: Cash is held for taking advantage of profitable
opportunities.
3.Precautionary Need: Cash is held for providing safety against
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19712.4 CASH BUDGET
A cash budget is statement showing organization’s estimated cash
inflows and outflows for a particular time period. Cash budget statement
helps financial manager to determine future cash needs of the business
firm.
Cash Budget helps the organizations
To know the shortage/surplus of cash.
To determine the period for whic h the situation of surplus/shortage of
cash is likely to be continued.
To arrange for cash borrowings if cash shortages are expected.
To plan for financing a new project.
To plan for financing the expansion for expansion of existing.
To take advantage of c ash discount.
Format of Cash Budget
Cash Budget
April May June July Particulars
Rs. Rs. Rs. Rs.
1Opening Cash Balance: XXX XXX XXX XXX
2Add: Receipts
1.Cash Sales XXX XXX XXX XXX
2. 2.Collection from Debtors XXX XXX XXX XXX
3.Proceeds from issue of shares
&D e b e n t u r e sXXX XXX XXX XXX
4. 4.Proceeds from sale of fixed
assets.XXX XXX XXX XXX
5.Misc. Non -operating income XXX XXX XXX XXX
a.Dividend XXX XXX XXX XXX
b.Interest XXX XXX XXX XXX
3Total Cash Receipts (1+2) XXX XXX XXX XXX
4Less: Cash Payments
6.Cash purchase of material XXX XXX XXX XXX
7.Payment to suppliers of
materialsXXX XXX XXX XXX
8.Payment of wages XXX XXX XXX XXXmunotes.in

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1989.Payment of Factory, office
and admin, Selling &
distribution expensesXXX XXX XXX XXX
10.Payment for purchase of fixed
assetXXX XXX XXX XXX
11.Payment for Dividend &
Interest.XXX XXX XXX XXX
Total Cash Payments (XXX) (XXX) (XXX) (XXX)
5Net Cash Available/ Closing
balance of cash (3 -4)XXX XXX XXX XXX
12.5 SOLVED PROBLEMS
Problem 1
Prepare a cash budget for the three months ending 30thJune, 2016
from the following information of XYZ Ltd.
a)Month wise Sales / Expenses :
Month Sales Materials Wages Overheads
2016 -February 14,000 9,600 3,000 1,700
2016 -March 15,000 9,000 3,000 1,900
2016 -April 16,000 9,200 3,200 2,000
2016 -May 17,000 10,000 3,600 2,200
2016 -June 18,000 10,400 4,000 2,300
b)Terms of credit : Sales / Debtors -10% Sales are cash. 50% of Credit
Sales are collected next month and the balance in the following month.
Creditors :
Materials -2 months
Wages -¼months
Overheads -½month.
c)Cash and Bank balance on 1stApril, 2016 is expected to be Rs. 6,000.
d)Other relevant information available revels that
i)Plant & Machinery will be installed in February, 2016 at a cost of
Rs. 96,000. The repayment will be done from April, 2016 on wards
in a monthly installment of Rs. 2,000.
ii)Dividend @ 5% on Preference share capital of Rs. 2,00,000 will be
paid in June 2016.munotes.in

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199iii)Advance for the sale of vehicle amounting Rs. 9,000 is to be
received in June 2016.
iv)Dividends from investments amounting to Rs. 1,000 are expected
to be received in June, 2016.
v)Income tax (Advance) of Rs. 2,000 is to be paid in June, 2016.
Solution :
PQR Ltd. Cash Budget
(for the three months ending 30thJune 2016)
April 16 May 16 June 16
Opening balance 6,000 3,950 3,000
Sales collection 14,650 15,650 16,650
(working Note 1)
Advance for sales of 9,000
Dividends from vehicle
Investments 1,000
Total Receipts (A) 20,650 19,600 29,650
Payments :
Materials 9,600 9,000 9,200
Wages 3,150 3,500 3,900
Overheads 1,950 2,100 2,000
Plant & Machinery 2,000 2,000 2,000
Instalment
Dividend on pref. Share capital 10,000
Income tax (advance) 2,000
Total Payments (B) 16,700 16,000 29,350
Closing Balance (A) -(B) 3,950 3,000 300
Working Notes :
a)Calculation of Sales Collections :
April 16 May 16 June 16
10% Cash sales 1,600 1,700 1,800
Previous month sales
50% of 90% of same month 6,750 7,200 7,650
50% of per month sales
(remaining balance)6,300 6,750 7,200
14,650 15,650 16,650munotes.in

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200b)Calculation of wages :
April 16 May 16 June 16
¾of current month 2,400 2,700 3,000
¼of previous month 750 800 900
3,150 3,500 3,900
c)Calculation of overheads :
April 16 May 16 June 16
½of current month 1,000 1,100 1,150
½previous month 950 1,000 1,100
1,950 2,100 2,250
Problem 2:
Mr. Vinayak has given the sales forecast for January to July 2016 and
actual sales for November, December 2016 were as under. With the other
particulars given, prepare Cash Budget (cash flow statement) for five
months January -May.
Rs.
Sales November 80,000
December 70,000
January 80,000
February 1,00,000
March 80,000
April 1,00,000
May 90,000
June 1,20,000
July 1,00,000
a)Sales : 20 percent cash 80 percent credit collection in the third month
(January sales in March).
b)Variable expenses 5 percent on turnover -time lag half month.
c)Commission 5 percent on credit sales payable in the third month.munotes.in

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201d)Purchases 60 percent of the sales of the third month payment 3rdmonth
of purchases.
e)Rent and other expenses Rs. 3,000 paid every month.
f)Other payment : Fixed Assets Purchase March Rs. 50,000.
g)Taxes April Rs. 20,000.
h)Opening Cash Balance Rs. 25,000.
Solution :
Cash Budget of 2016
Particulars January February March April May
Opening balance 25,000 47,050 57,750 24,050 32,550
Receipts :
Sales : Cash 16,000 20,000 16,000 20,000 18,000
Credit 64,000 56,000 64,000 80,000 64,000
Total Receipts (A) 1,05,000 1,23,050 1,32,750 1,24,050 1,14,550
Payment :
Variable expenses 3,750 4,500 4,50 4,500 4,750
Commission at 5% of
credit sales3,200 2,800 3,200 4,000 3,200
Purchases 48,000 60,000 48,000 60,000 54,000
Rent / other expenses 3,000 3,000 3,000 3,000 3,000
Fixed Assets purchase -- -- 50,000 -- --
Taxes -- -- -- 20,000 --
Total payment (B) 57,950 70,300 1,08,700 91,500 64,950
Closing balance (A) -
(B)47,050 57,750 24,050 32,550 49,600munotes.in

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202Working Notes :
Variable Expenses :
Particulars January February March April May
½of current month (5)
i.e. 2½%2,000 2,500 2,000 2,500 2,250
½of per month
i.e. 2½%1,750 2,000 2,500 2,000 2,500
3,750 4,500 4,500 4,500 4,750
Problem 3:
The following information relates to Raghav Limited:
The selling price of a book is 15, and Sales are made on credit through a
Book Club and invoiced on the last day of the month.
Variable Costs of Production per Book are Materials ( `5), Labour ( `4),
and Overhead ( `2).
The Sales Manager has forecasted the following volumes :
Month Nov Dec Jan Feb Mar Apr May Jun Jul Aug
No. of Books 1,000 1,000 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
Customers are expected to pay as follows :
One month after the sale 40%
Two month after the sale 60%
The Company produces the Books two months before they are sold
and the Creditors for Materials are paid two months after production.
Variable Overheads are paid in the month following prod uction
and are expected to increase by 25% in April. 75% of Wages are paid in
the month of production and 25% in the following month. A Wage
Increase of 12.5% will take place on 1stMarch.
The Company is going through are structuring and will sell one o f
its Freehold Properties in May for `25,000, but it is also planning to buy a
new Printing Press in May for `10,000. depreciation is currently `1,000
per month, and will rise to `1,500 after the purchase of the New Machine.munotes.in

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203The Company’s Corporation Ta x( o f `10,000) is due for payment
in March.
The Company presently has a Cash Balance at Bank on 1stJanuary,
of 1,500.
You are required to prepare a Cash Budget for the six months from
January to June.
Solution :
1.Receipts from Customers (amounts in`000s)
2.Payments to Creditors for Materials (amounts in `000s)
(Note : Book produced two months before sale)
3.Payment of Wages (amounts in `000s)
Month Dec Jan Feb Mar Apr May Jun
Production Quantity (units) 1,250 1,500 2,000 1,900 2,200 2,200 2,300
Wages Cost at `4p u 5,000 6,000 8,000
Wages Cost at `4.5 pu 8,550 9,900 9,900 10,350
Payment :
75% this month 3,750 4,500 6,000 6,412 7,425 7,425 7,762
25% this month 1,250 1,500 2,000 2,137 2,475 2,475
Total Payment 5,750 7,500 8,412 9,562 9,900 10,237munotes.in

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2044.Payment of Variable Overheads (amounts in `000s)
Month Nov Dec Jan Feb Mar Apr May Jun
Production Quantity (units) 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
Wages Cost at `2p u 2,000 2,500 3,000 4,000 3,800
Wages Cost at `2.5 pu 5,500 5,500 5,750
Payment One Month later 2,000 2,500 3,000 4,000 3,800 5,500 5,500
5.Cash Budget for the 6 months ended 30thJune (amounts in `000s)
Particulars Jan Feb Mar Apr May Jun
A. Opening Balance 1,500 3,250 1,500 (11,912) (15,024) 576
B. Receipts
From Debtors 15,000 15,000 16,500 20,250 25,500 29,400
Sale of Freehold Property -- -- -- -- 25,500 --
Total Receipts 15,000 15,000 16,500 20,250 50,500 29,400
C. Payments
Materials 5,000 6,250 7,500 10,000 9,500 11,000
Wages 5,750 7,500 8,412 9,562 9,900 10,237
Variable Overheads 2,500 3,000 4,000 3,800 5,500 5,500
Purchase of Press Machine -- -- -- -- 10,000 --
Corpn Tax (Income Tax) -- -- 10,000 -- -- --
Total Payments 13,250 16,750 29,912 23,362 34,900 26,737
D. Closing Balance
(A + B + C)3,250 1,500 (11,912) (15,024) 576 3,239
Problem 4 :
From the information and assuming that the Cash Balance in hand
on 1stJanuary is 72,500, prepare a Cash Budget.
Assume that 50% of Tota l Sales are Cash Sales. Assets are to be
acquired in the months of February and April. Therefore, provisions
should be made for the payment of 8,000 and 25,000 for the same. An
application has been made to the grant of a Loan of 30,000 and it is hoped
thatthe Loan Amount will be received in the month of May.munotes.in

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205It is anticipated that a Dividend of 35,000 will be paid in June.
Debtors are allowed one month’s credit. Creditors for Materials purchased
and Overheads grant one month’s credit. Sales Commission a t3 %o n
Sales is paid to the Salesman each month.
The following further details are provided (amounts in `000s)
Month Sales Materials
PurchasesSalaries
&
WagesProduction
OHOffice
and
Selling
OH
January 72,000 25,000 10,000 6,000 5,500
February 97,000 31,000 12,100 6,300 6,700
March 86,000 25,500 10,600 6,000 7,500
April 88,600 30,600 25,000 6,500 8,900
May 1,02,500 37,000 22,000 8,000 11,000
June 1,08,700 38,800 23,000 8,200 11,500
Solution :
Cash Budget (amounts in `000s)
Particulars Jan Feb Mar Apr May Jun
A. Opening Balance C
&B72,500 96,340 1,21,330 1,55,650 1,51,292 2,05,767
B. Receipts
Cash Sales (50% of
Total Sales)36,000 48,500 43,000 44,300 51,250 54,350
From Debtors (50%
of previous month
Sales)-- 36,000 48,500 43,000 44,300 51,250
Bank Loan -- -- -- -- 30,000 --
Total Receipts 36,000 84,500 91,500 87,300 1,25,550 1,05,600munotes.in

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206C. Payments
Paid to Creditors (1
month delay)-- 25,000 31,000 25,500 30,600 37,000
Salaries and Wages
(paid same month)10,000 12,100 10,600 25,000 22,000 23,000Production OH(1 month delay)-- 6,000 6,300 6,000 6,500 8,000
Office & Selling OH
(1 month delay)-- 5,500 6,700 7,500 8,900 11,000
Sales Commission
(3% on same month
Sales)2,160 2,910 2,580 2,658 3,075 3,261
Capital Expenditure
(given)-- 8,000 -- 25,000 -- --
Dividend (given) -- -- -- -- --
Total Payments 12,160 59,510 57,180 91,658 71,075 1,17,251
D. Closing Balance C
&B( A+B+C )96,340 1,21,330 1,55,650 1,51,292 2,05,767 1,94,106
Problem 5 : Cash Budget for Manufacturing Firm
From the following information relating to Chandr a Ltd. you are
required to prepare a Cash Budget for the forthcoming 3 months, viz.,
May, June and July. The management wishes to maintain a Cash Balance
of`20 Lakhs at all times. Determine whether borrowing will be necessary
during the period and if so w hen and for how much. As of April 30th,t h e
Company had a Bank Balance of `20 Lakhs.
Month Actual Sales
(In Lakhs)Month Forecasted Sales
(In Lakhs)
January 50 May 70
February 50 June 80
March 60 July 100
April 60 August 100munotes.in

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207Additional Information :
1.20% of the Sales are for Cash. Credit Sales are collected as 50% in the
month of Sales, and balance equally in subsequent two months (there
is normally no Bad Debts).
2.Manufacturing Cost of Good Sold is 60% of Sales. 10% of t his cost is
Depreciation. Out of the balance 90%, 60% is paid in the previous
month, 20% in the month of sales and 10% in the subsequent month.
3.Selling and Administrative Expenses are fixed `4 Lakhs per month
plus 10% of Manufacturing Cost of Goods Sol d. All these expenses
are paid during the month of sale.
4.Interest payment : Half -yearly Interest Payments on `300 Lakhs
borrowings at 14% in January and July.
5.Dividends : `10 Lakhs Dividend is expected to be declared and paid in
July.
6.Capital E xpenditure : `40 Lakhs is expected to be invested in Plant
and Machinery in June.
7.Income Tax Payment of `20 Lakhs will be made in July.
Solution :
1.Computation of Collection from Debtors and Payment of
Manufacturing Costs ( `Lakhs)
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2082.Cash Budget ( `Lakhs)
Problem 6: Cash Budget for Manufacturing Firm
Armaan Limited is into retail business. The following information is
given for your consideration :
1.Purchase are 75% of Sales and Purchases are sold at Cost plus 33
1/3rd%.
2.Budgeted Sales, Labour Cost and expenses incurred are :
Budged Sales ( `) Labour Cost ( `)Expenses incurred ( `)
January 40,000 3,000 4,000
February 60,000 3,000 6,000
March 1,60,000 5,000 7,000
April 1,20,000 4,000 7,000
3.75% Sales are for Cash. 25% of Sales are one month’s interest -free
credit.
4.The policy of the Management is to have sufficient stock in hand at the
end of each month to meet sales demand in the next half month.
5.Creditors for Materials and Expenses are paid in the month after the
Purchases are made or the expenses incurred. Lab our is paid in full by
the end of each month.munotes.in

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2096.Expenses include a monthly depreciation charge of `2,000.
7.The Company will buy Equipment costing `18,000 cash in February
and will pay a Dividend of `20,000 in the month of March. The
opening Cash Balanc e on February is `1,000.
Prepare for the month of February and March : (a) a Profit and
Loss Account, and (b) a Cash Budget.
Solution :
1.Profit and Loss Account
Particulars February ( `)March ( `)Total ( `)
Sales 60,000 1,60,000 2,20,000
Less : Cost of Purchase (75%) 45,000 1,20,000 1,65,000
Gross Profit = 1/3rdon
Cost = 1/4thSales15,000 40,000 55,000
Less : Labour 3,000 5,000 8,000
Expenses (including
Depreciation)6,000 7,000 13,000
Net Profit 6,000 12,000 34,000
2.Cash Budget for the Months of February and March
Particulars February ( `) March ( `) Total ( `)
A. Opening Balance 1,000 (4,500) (3,500)
B. Receipts / Inflows : Sales (WN 1) 55,000 1,35,000 1,90,000
Total Receipts 55,000 1,35,000 1,90,000
C. Payments / Outflows
Trade Creditors (WN 2) 37,500 82,500 1,20,000
Expenses Creditors (WN 3) 2,000 4,000 6,000
Labour 3,000 5,000 8,000
Equipment Purchase 18,000 -- 18,000
Dividend -- 20,000 20,000
Total Payments 60,500 1,11,500 1,72,500
D. Closing Balance / (Overdraft) (4,500) 19,000 14,000munotes.in

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210Working Notes :
1.Receipts
Month Computation `
February 75% of February Sales (75% of `60,000) + 25% of January Sales
(25% of `40,000)55,000
March 75% of March Sales (75% of `1,60,000) + 25% of February Sales
(25% of `60,000)1,35,000
2.Purchases
Particulars Computation January( `)Computation February( `)
For January Sales 50% of `30,000 15,000 -- Nil
For February
Sales50% of `45,000 22,500 50% of `45,000 22,500
For March Sales -- Nil 50% of
`1,20,00060,000
Total 37,500 82,500
These purchases are paid for in February and March.
3.Expenses : Cash Expenses in January ( `4,000 -`2,000) and February
(`6,000 -`2,000) are paid for in February and March respectively.
Depreciation is not a Cash Item.
Problem 7 :
The following particulars have been obtained in respect of retail
business of Lucky Ltd., for the three months ending March, 2016.
a)Working capital as on 1stJanuary 1998 has been estimated as follows :
Rs.
Cash and bank balance 10,900
Debtors 51,400
Creditors 42,200
Outstanding expenses 4,000
Dividend due 9,700
Tax due 6,400
Stock 26,000munotes.in

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211b)Budget profit statement at the end of month.
Jan. 98
Rs.Feb.98
Rs.Mar.98
Rs.
Sales 42,000 36,000 34,000
Less : Cost of sales 32,700 28,100 26,600
Gross Profit 9,300 7,900 7,400
Less : Administrative
Selling and Distribution expenses 6,300 5,400 5,100
Net Profit before tax 3,000 2,500 2,300
c)Budgeted balance at the end of each month.
Solution :
Cash budget for Six months from January 1998 to June 1998
Jan. 98 Feb. 98 Mar. 98 Apr. 98 May 98 Jun. 98
Opening
balance10,000 77,500 1,10,250 44,500 10,875 17,775
Cash sales
Receipts
from debtors55,000 35,000 40,000 37,500 50,000 45,000
(working
note)1,51,500 1,47,750 1,17,750 1,15,875 1,23,000 1,40,625
Borrowings -- -- -- 10,000 10,000 --
(A) 2,16,500 2,60,250 2,68,000 2,07,875 1,93,875 2,03,400
Payments :
Purchases 1,12,000 1,28,000 1,20,000 1,60,000 1,44,000 96,000
(working
note 2)
Office costs 25,000 20,000 40,000 35,000 30,000 45,000
Rent 2,000 2,000 2,000 2,000 2,000 2,000
Interest on
debentures7,500 7,500
Debentures
repaid40,000
Advance tax 54,000
Interest on
borrowing100 200
(B) 1,39,000 1,50,000 2,23,500 1,97,000 1,76,100 1,90,700
Closing
balance77,500 1,10,250 14,500 10,875 17,775 12,700
(A)-(B)munotes.in

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212Working Notes :
a)Sales collection :
Jan. 98 Feb. 98 Mar. 98 Apr. 98 May 98 Jun. 98
a) Cash sales
(25%)55,000 35,000 40,000 37,500 50,000 45,000
b) Credit sales
(75%)1,65,000 1,05,000 1,20,000 1,12,500 1,50,000 1,35,000
c) (i) 25% of (b)
same month41,250 26,250 30,000 28,125 37,500 33,750
ii) 60% of
previous month
credit sales90,000 99,000 63,000 72,000 67,500 90,000
iii) 15% of 2nd
Previous month20,250 22,500 24,750 15,750 18,000 16,875
(i) + (ii) + (iii) 1,51,500 1,47,750 1,17,750 1,15,875 1,23,000 1,40,625
b)Purchases : Payment
Selling price is 25% over cost.
i.e. if the selling price is Rs. 100 cost will be Rs. 80 and profit Rs. 20.80% of all sales are purchases which are paid for in the preceding
month.Feb. 98 purchases which is 80% sales of Feb. 98 are paid in Jan. 98,
similarly purchases for other months are worked out.
Problem 8:
A newly started company wishes to prepare Cash Budget from
January 98. Prepare a Cash Budget for the first 6 months from the
following estimated revenues and expenditures :
Overheads
Month Total
sales Rs.Material
Rs.Wages
Rs.Production
Rs.Selling and
Distribution
Rs.
January 98 20,000 20,000 4,000 3,200 800
February 98 22,000 14,000 4,400 3,300 900
March 98 24,000 14,000 4,600 3,300 800
April 98 26,000 12,000 4,600 3,400 900
May 98 28,000 12,000 4,800 3,500 900
June 98 30,000 16,000 4,800 3,600 1,000munotes.in

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213Cash balance on 1stJanuary 1998 was 10,000.
A new machine is to be installed at Rs. 30,000 on credit to be
repaid by two equal installments in March and April.
Sales commission @ 5% on total sales to be paid within the month
following actual sales.
Rs. 10,000 being the amount of second call may be received in
March. Share premium amounting to Rs. 2,000 is also obtainable with 2nd
call.
Period of credit allowe d by suppliers 2 month.
Period of credit allowed to customers 1 month.
Delay in payment of overheads 1 month.
Delay in payment of wages ½month.
Assume cash sales to be 50% of total sales.
Solution :
Cash Budget
Jan. Rs. Feb. Rs. Mar.
Rs.Apr. 98 May9 8 Jun. 98
Opening balance 10,000 18,000 29,800 20,000 6,100 8,800
Receipts :
Cash sales 10,000 11,000 12,000 13,000 14,000 15,000
Collection from
debtors10,000 11,000 12,000 13,000 14,000
Share capital (2nd
call)10,000
Share premium 2,000
(A) 20,000 39,000 64,800 45,000 33,100 37,800
Payments :
Creditors 20,000 14,000 14,000 12,000
Wages
(½same month) 2,200 2,300 2,300 2,400 2,400
(½next month) 2,000 2,200 2,300 2,300 2,400
Sales commission 1,000 1,100 1,200 1,300 1,400
Production
overheads3,200 3,300 3,300 3,400 3,500
Selling and
distribution800 900 800 900 900
Overheads
Machine purchased 15,000 15,000
(B) 2,00 9,200 44,800 38,900 24,300 22,600
Closing balance 18,000 29,800 20,000 6,100 8,800 15,200
(A)-(B)munotes.in

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214Problem 9:
From the following information you are required to prepare a cash
budget for six months from January 1987 to June 1987 month by month,
showing also the cash credit facility available from Bank. Opening
overdrawn balance is Rs. 1,50,000.
Month Total
sales Rs.Material
purchase
Rs.Wages
Rs.Production
Expenses
Rs.Selling
Distribution
expenses Rs.Admin
Expenses
Rs.
January 1,44,000 50,000 20,000 12,000 8,000 3,000
February 1,94,000 62,000 24,200 12,600 10,000 3,400
March 1,72,000 51,000 21,000 12,000 11,000 4,000
April 1,77,200 61,200 50,000 13,000 13,400 4,400
May 2,05,000 74,000 44,000 16,000 17,000 5,000
June 2,17,400 77,600 46,000 16,400 18,000 5,000
Following further information is available :
a)Out of total sales 50% are cash sales and balance 50% is received in
the month following month of sale.
b)Payment for purchase of assets is to be made of Rs. 16,000 in
February, Rs. 25,000 in March and Rs. 50,000 in April.
c)Proceeds from sales of scrap are to be received in May amounting to
Rs. 6,000.
d)Dividend of Rs. 90,000 is to paid in June.
e)Sales commission is to be paid at 3% of total sales in same months in
which sales are made.
f)Suppliers for materials are pa id in the month following the month of
purchases of materials.
g)Cash credit facility granted is Rs. 2,00,000.
h)Wages are paid in the same month.
i)Creditors of production, selling and distribution and Administration
expenses are given one month’s c redit period.munotes.in

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215Solution :
Cash budget
Jan. 97 Feb. 97 Mar. 97 Apr. 97 May 97 Jun. 97
Opening
balance(1,50,000) (1,02,320) (52,340) (8,700) (17,416) 37,534
Receipts :
Cash sales 72,000 97,000 86,000 88,600 1,02,500 1,08,700
Receipts from
debtors72,000 97,000 86,000 88,600 1,02,500
Sales of scrap 6,000
(A) (78,000) 66,680 1,30,600 1,65,900 1,79,684 2,48,734
Payments :
Assets
Purchases16,000 25,000 50,000
Dividend 90,000
Sales
commission4,320 5,820 5,160 5,316 6,150 6,522
Materials 50,000 62,000 51,000 61,200 74,000
Wages 20,000 24,200 21,200 50,000 44,000 46,000
Production
expenses12,000 12,600 12,000 13,000 16,000
Selling &
Dist. Exps.8,000 10,000 11,000 13,400 17,000
Admin
Expenses3,000 3,400 4,000 4,400 5,000
(B) 24,320 1,19,020 1,39,360 1,83,316 1,42,150 2,54,522
Overdrawn
balance(1,02,320) (52,340) (8,700) (17,416) 37,534 (5,788)
(A)-(B)
Problem 10 :
From the following budgeted data of ABC Ltd., prepare cash
budget for the quarter ending 31stDecember, 1984.
Month Sales Purchases Wages Miscellaneous expenses
August 1,20,000 84,000 10,000 7,000
September 1,30,000 1,00,000 12,000 8,000
October 80,000 1,04,000 8,000 6,000
November 1,16,000 1,06,000 10,000 12,000
December 88,000 80,000 8,000 6,000munotes.in

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216Additional Information : Cash on hand on 1.10.84 : Rs. 5,000
Sales : 20% realised in the month of sale. Less discount allowed 2%,
balance realised in 2 subsequent months / equally.
Purchases : These are paid in the month following the month of supply.
Wages 25% in arrears paid in the following month.
Miscellaneou s Expenses : Paid a month in arrears.
Rent : Rs. 1000 per month paid quarterly in advance due in October.
Income Tax : Installments of Rs. 25,000 due on or before 15.12.84.
Income from Investment : Rs. 5,000 received quarterly April, July,
October, etc.
Insurance Claim : Rs. 72,936 receivable in December.
Solution :
Cash budget for the Quarter Ending 31stDecember 2016
October 94 November 94 December 94
Opening balance 5,000 5,680 (7,084)
Receipt :
Sales collection : 15,680 22,736 17,248
20% same month
(less discount 2%)
40% 1stmonth 52,000 32,000 46,400
40% 2ndmonth 48,000 52,000 32,000
Income from Investment 5,000
Insurance claim 72,936
(A) 1,25,680 1,12,416 1,61,500
Payments :
Purchases 1,00,000 1,04,000 1,06,000
Wages :
75% current month 6,000 7,500 6,000
25% next month 3,000 2,000 2,500
Miscellaneous expenses 8,000 6,000 12,000
Rent / Income Tax 3,000 25,000
(B) 1,20,000 1,19,500 1,51,500
Closing Balance (A) -(B) 5,680 (7,084) 10,000munotes.in

Page 217

217Problem 11:
Mr. Ashok Nair, the Finance Manager of Atlas Castings Ltd. is
preparing the cash budget for the first six months of 1982 on the basis of
the following information :
a)Costs and price remains unchanged
b)Out of the total sales, cash sales ar e 25%, the balance being credit,
sales, 60% of the credit sales are collected in the month after sales,
30% collected in the second month and the balance 10% in the third
month after sale. He does not expect any bad debts.
c)The Gross Profit Margin is ex pected to be 20%.
d)Actual sales and forecasted sales are as follows :
October 81 Rs. 12,00,000 March 82 Rs.8,00,000
November 81 Rs.14,00,000 April 82 Rs.12,00,000
December 81 Rs.16,00,000 May 82 Rs.12,00,000
January 82 Rs.8,00,000 June 82 Rs.8,00,000
February 82 Rs.8,00,000 July 82 Rs.10,00,000
e)Anticipated Cash Purchases, there being no credit purchases :
January 82 Rs.6,40,000 April 82 Rs.9,10,000
February 82 Rs.7,00,000 May 82 Rs.6,40,000
March 82 Rs.10,00,000 June 82 Rs.9,60,000
f)Wages and salaries to be paid in cash :
January 82 Rs.1,40,000 April 82 Rs.2,20,000
February 82 Rs.1,60,000 May 82 Rs.1,60,000
March 82 Rs.2,00,000 June 82 Rs.1,40,000
g)Interest on 20,00,000 @ 8% debentures was due on June 30, 1982
(half yearly)
h)Excise deposit due on March 31, 1982 Rs. 3,00,000.
i)Acquisition of plant and equipment planned for May 1982 Rs.
10,00,000.
j)Miscellaneous Expenses on a cash basis every month at Rs. 15,000
plus 10% of sale.munotes.in

Page 218

218k)The company will have cash balance of Rs .5 , 0 0 , 0 0 0o n3 1 . 1 2 . 8 1M r .
Ashok Nair believes that this a high level and is planning on a
continuous balance of Rs. 4,00,000.
Prepare the Cash Budget for six months to June 1982.
If additional finance is required, recommend the type of finance to
beobtained.
Solution :
Cash Budget for Six months Ending June 1997
Jan. Rs. Feb. Rs. Mar. Rs. Apr. Rs. May Rs. Jun. Rs.
Opening
balance5,00,000 9,50,000 10,20,000 2,85,000 (80,000) (9,35,000)
Receipts :
Sales
Collection13,25,000 10,25,000 8,60,000 9,00,000 10,80,000 10,70,000
(A) 18,25,000 19,75,000 18,80,000 11,85,000 10,00,000 1,35,000
Payments :
Purchases 6,40,000 7,00,000 10,00,000 9,10,000 6,40,000 9,60,000
Wages /
Salaries1,40,000 1,60,000 2,00,000 2,20,000 1,60,000 1,40,000
Interest on
Debentures10,00,000 80,000
Excise
deposit plant
/E q u i p m e n t3,00,000
Miscellaneo
us Expense95,000 95,000 95,000 1,35,000 1,35,000 95,000
(B) 8,75,000 9,55,000 15,95,000 12,65,000 19,35,000 12,75,000
Closing
balance (A)
-(B)9,50,000 10,20,000 2,85,000 (80,000) (9,35,000) (11,40,000)
a)For acquisition of plant and equipment of Rs. 10,00,000 necessary
term loan must be arranged from the bankers / financial institutions.
b)For the balance of Rs. 1,40,000, necessary overdraft facility or cash
credit can be arranged from bankers.munotes.in

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219Working Note :
Sales Collection :
Jan. Rs. Feb. Rs. Mar. Rs. Apr. Rs. May Rs. Jun. Rs.
Cash sales (25%) 2,00,000 2,00,000 2,00,000 3,00,000 3,00,000 2,00,000
Credit sales :
60% 1stmonth 7,20,000 3,60,000 3,60,000 3,60,000 5,40,000 5,40,000
30% 2ndmonth 3,15,000 3,60,000 1,80,000 1,80,000 1,80,000 2,70,000
10% 3rdmonth 90,000 1,05,000 1,20,000 60,000 60,000 60,000
13,25,000 10,25,000 8,60,000 9,00,000 10,80,000 10,70,000
b)Miscellaneous expenses :
Jan. Rs. Feb. Rs. Mar. Rs. Apr. Rs. May Rs. Jun. Rs.
Cash basis 15,000 15,000 15,000 15,000 15,000 15,000
Add 10% of Sales 80,000 80,000 80,000 1,20,000 1,20,000 80,000
95,000 95,000 95,000 1,35,000 1,35,000 95,000
Problem 12:
Shangai Co. Ltd wishes to arrange overdraft facilities with its
Bankers during the period from January to March 1992, when it will be
manufacturing mostly for stock. Prepare a Cash Budget for the above
period from the given information, indicating the exte nt of bank facilities
the company will require at the end of the cash month.
(I)
Sales Rs. Purchases Rs. Wages Rs.
November 1991 72,000 49,920 4,800
December 1991 76,800 57,600 5,600
January 1992 43,200 97,200 4,400
February 1992 69,600 98,400 4,000
March 1992 50,400 1,67,200 6,000
b)50% of credit sales are realised in the month following the Sales and
the remaining 50% in the second month following.
c)Creditors are paid in the month following the month of purchases.
d)Cash at Bank on 1.4.92 (estimated) Rs. 10,000.munotes.in

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220Solution :
ABC Co.
Cash Budget (for January to March 1992)
Particulars January Rs. February
Rs.March
Rs.
a) Estimated opening balance 10,000 21,200 (20,400)
b) Receipts from debtors 74,000 60,000 56,400
(refer working notes)
(a) + (b) 84,400 81,200 36,000
(c) Payment :
Creditors of previous month 57,600 77,200 98,400
Wages of previous month 5,600 4,400 4,000
Closing balance (a) + (b) -(c) 63,200 1,01,600 1,02,400
21,200 (-)2 0 , 4 0 0 (-)6 6 , 4 0 0
Working Notes :
a)Realisation of debtors :
Rs.
January 1981 :
50% of November sales 36,000
50% of December sales 38,400
74,400
February 1981 :
50% of December sales 38,400
50% of January sales 21,600
60,000
March 1981:
50% of January sales 21,600
50% of February sales 34,800
56,400munotes.in

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221b)It has been assumed that wages are paid on monthly basis on the first
of very next month.
Problem 13:
Arun Ltd., newly started company wishes to prepare cash budget
from January. Prepare a cash budget for the first six months from the
following estimated revenue and expenses :
Overheads
Month Total
sales Rs.Material
Rs.Wages
Rs.Production
Rs.Selling and
Distribution
Rs.
January 20,000 20,000 4,000 3,200 800
February 22,000 14,000 4,400 3,300 900
March 28,000 14,000 4,600 3,400 900
April 36,000 22,000 4,600 3,200 900
May 30,000 20,000 4,000 3,200 900
June 40,000 25,000 5,000 3,600 1,200
Cash balance on 1stJanuary was Rs. 10,000. A new machinery is
to be installed at Rs. 20,000 on credit, to be repaid by two equal
installments in March and April.
Sales commission @ 5% on total sales to be paid with a month
following actual sales.
Rs. 10,000 being the amount of 2ndcall may be received in March.
Share premium amounting to Rs. 2,000 is also obtainable with the 2ndcall.
Period of credit allowed b y suppliers 2m o n t h s
Period of credit allowed to customers 1m o n t h
Delay in payment of overheads 1m o n t h
Delay in payment of wages ½month
Assume cash sales to be 50% of total sales.munotes.in

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222Solution
Cash Budget
Jan. Rs. Feb. Rs. Mar.
Rs.Apr. Rs. May
Rs.Jun. Rs.
Opening
balance10,000 18,000 29,800 27,000 24,700 33,100
Estimated cash
receipts
Sales (cash) 10,000 11,000 14,000 18,000 15,000 20,000
Sales 10,000 11,000 14,000 18,000 15,000
(credit
collections)
Second call 10,000
Share premium 2,000
Total 20,000 39,000 66,800 59,000 57,700 68,100
Estimated
Payments :
Materials 20,000 14,000 14,000 22,000
Wages 2,000 4,200 4,500 4,600 4,300 4,500
Production
overheads3,200 3,300 3,400 3,500 3,200
Selling and
distribution800 900 900 1,000 900
Overheads
Sales
commission1,000 1,100 1,400 1,800 1,500
Purchase of
machinery10,000 10,000
Total 2,000 9,200 39,800 34,300 24,600 32,100
Closing balance 18,000 29,800 27,000 24,700 33,100 36,000munotes.in

Page 223

223Problem 14 :
Mr. Tiwari has recently set up a restaurant in a prominent shopping
complex. His business is good but because of heavy personal withdrawals,
he is facing liquidity problem. To get a better handle over his cash flows,
he requests you to prepare a cash budget for the next quarter, January
through March, for him. He has provided you with the following
information :
i)Sales are expected to be as follows. (All sales are cash sales) :
Jan. Rs. 50,000
Feb. Rs. 55,000
Mar. Rs. 60,000
ii)His estimated purchases are as follows :
Jan. Rs. 20,000
Feb. Rs. 22,000
Mar. Rs. 25,000
Payments for purchases will be made after a lag of one month.
Outstanding on account of purchases in Dec. la st are Rs. 22,000.
iii)The rent per month is Rs. 5,000 and his personal withdrawals per
month are Rs. 5,000.
iv)Salaries and other expenses payable in cash are expected to be as
follows :
Jan. Rs. 15,000
Feb. Rs. 18,000
Mar. Rs. 20,000
v)He plans to buy furniture worth Rs. 25,000 on cash payment in
February.
vi)The cash balance at present is Rs. 5,000. His target cash balance is,
however, Rs. 8,000.
What will be the surplus / deficit of cash in relation to his target
cash balance?munotes.in

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224Solution :
Cash Budget
(for the quarter January to March)
January February March
Opening balance 5,000 8,000 (10,000)
Receipts
Cash sales 50,000 55,000 60,000
(A) 55,000 63,000 50,000
Payment :
Purchases 22,000 20,000 22,000
Rent 5,000 5,000 5,000
Drawings 5,000 5,000 5,000
Salaries / Other expenses 15,000 18,000 20,000
Furniture 25,000
(B) 47,000 73,000 52,000
Closing Balance (A) -(B) 8,000 (10,000) (2,000)
Target cash balance 8,000 8,000 8,000
Surplus / (Deficit) -- 18,000 10,000
Problem 15 :
Prepare a cash budget for the quarter ending on 31stJuly 2016 on
the basis of the following information :
April May June July
Total Sales (Rs. In Lakhs) 2.00 2.50 3.00 3.50
Total Purchases (Rs. In Lakhs) 1.40 1.60 2.00 2.20
Other expenses amount to Rs. 10,000 per month plus 10% of sales
and these expenses are paid in the same month.munotes.in

Page 225

22510% of the total sales are cash sales. 50% of the credit sales are
collected in the month of sale and balance 50% in collected in the
following month. Collections from customers is subjected to 5% cash
discount if collected in the month of sale and 2.5% ca sh discount if
collected in the following month.
Creditors for purchases are paid either on a prompt or 30 days
credit basis. It is estimated that 10% of the creditors are of prompt
category.
It is the policy of the company to maintain a minimum cash
balance of Rs. 15,000. Accordingly, the actual cash balance on 1stMay
2016 was Rs. 15,000.
You can assume that any cash shortage is met by the company by
borrowing funds from its bank on temporary basis.
Solution :
Cash Budget
(for the quarter ending 31stJuly 2016)
May June July
Opening balance 15,000 57,625 1,21,562
Sales collection 2,27,500 2,77,500 3,27,500
Total Receipts (A) 2,42,500 3,35,125 4,49,062
Payments :
Discount 7,875 9,563 11,250
Expenses :
Creditors Purchase 35,000 40,000 45,000
Prompt 16,000 20,000 22,000
30 Day 1,26,000 1,44,000 1,80,000
Total payments (B) 1,84,875 2,13,563 2,58,250
Closing Balance (A) -(B) 57,625 1,21,562 1,90,812munotes.in

Page 226

226Working Notes :
a)Calculation of Sales Collections :
May June July
10% Cash sales 25,000 30,000 35,000
Credit sales :
50% of 90% of same month 1,12,500 1,35,000 1,57,500
50% of 90% of per month 90,000 1,12,500 1,35,00
2,27,500 2,77,500 3,27,500
b)Cash Discount :
5% 5,625 6,750 7,875
2-5% 2,250 2,813 3,375
7,875 9,563 11,250


munotes.in