FM Pocket Book

INDEX
Chap No. Chapter Page

1 Cost of Capital 1-11
2 Leverages 12-23
3 Capital Structure 24-40
4 Dividend Decision 41-51
5 Capital Budgeting 52-66
Risk Analysis in
6 67-72
Capital Budgeting
Financial Statement
7 73-94
Analysis
Working Capital
8 95-114
Management
Pocket Book 1 CA Ashish Kalra
www.igpinstitute.org Ph. 61355900 telegram t.me/igpinstitute

Cost of Capital 2 CA Ashish Kalra
COST OF DEBT (Kd)
(A) Cost of Irredeemable/Perpetual Debt:

Kd = I (1 – t)
NP
Where, I = Amount of Annual Interest
t = Corporate Income Tax Rate
NP = Net Proceeds
(B) Cost of Redeemable Debt:

Kd = I (1 – t) + (RV - NP)
n .
NP + RV
2
Where, RV = Redeemable Value
n = Numbers of years to maturity

COST OF DEBT USING PRESENT VALUE

METHOD [YIELD TO MATURITY (YTM)
APPROACH]
The cost of redeemable debt (Kd) is also calculated by

discounting the relevant cash flows using internal rate of
return (IRR). (The concept of IRR is discussed in the
Chapter “CAPITAL BUDGETING”). Here, YTM is the
annual return of an investment from the current date till
maturity date. So, YTM is the IRR at which PV of CASH
INFLOWS equates with the PV of CASH OUTFLOWS.
The relevant cash flows are as follows:
Year Cash Flows

CASH INFLOWS:
0 Next proceeds in case of new issue/
Current market price in case of existing
debt (NP or P0)
CASH OUTFLOWS:
1 to n Interest amount net of tax [I(1-t)]
n Redemption value (RV)

COST OF PREFERENCE SHARES (Kp)
(A) Cost of Irredeemable/Perpetual Preference Shares:

Kp = D
NP
Where, D = Amount of Annual Preference Dividends
(B) Cost of Redeemable Preference Shares:

Kp = D + (RV - NP)
n .
NP + RV
2
COST OF PREFERENCE SHARE CAPITAL

USING PRESENT VALUE METHOD [YIELD
TO MATURITY (YTM) APPROACH]
The cost of redeemable preference shares (Kp) is also

calculated by discounting the relevant cash flows using
internal rate of return (IRR). Here, YTM is the annual
return of an investment from the current date till
maturity date. So, YTM is the IRR at which PV of CASH
INFLOWS equates with the PV of CASH OUTFLOWS.

The relevant cash flows are as follows:
Year Cash Flows

CASH INFLOWS:
0 Next proceeds in case of new issue/
Current market price in case of existing
debt (NP or P0)
CASH OUTFLOWS:
1 to n Annual Preference dividends
n Redemption value (RV)
COST OF EQUITY (Ke)
1. Dividend Yield Model/Dividend Price Model:

Ke = DPS .
NP/MPS
Where, DPS = Amount of Equity Dividends per Share
MPS = Market Price per Equity Share
2. Earnings Yield Model/Earning Price Model:

Ke = EPS .
NP/MPS
Where, EPS = Earnings per Equity Share

3. Dividend Price Ratio plus Growth Method/

Dividend Growth Model:
Ke = D1 . + g
NP/P0
Where, D1 = Next Expected Dividends
= D0 (1 + g)
OR = E (1 - b)
g=bxr
D0 = Dividends just paid/Dividends paid at
the beginning of the year
E = Expected Earnings for Current Year
b = Retention ratio or 100 – Dividends Payout Ratio
P0 = Market Price of Equity Shares at beginning of year
g = Growth Rate of the Company
r = Return on Equity

4. Realised Yield Approach:

Ke (Realised Yield for 1 year) = D1 + P1 - P0
P0
Where, P1 = Market price at the end of year 1
Ke (Realised Yield for a number of years) = Discount
Rate at which amount invested in the shares by the
shareholders equals to the Present Value of Inflows
received by the investors (i.e. dividends & the actual
MPS at the time of sale).
5. Capital Asset Pricing Model (CAPM):

Ke = Rf + β [ER(m) – Rf]
Rf = Risk free Rate of Interest
β = Beta Coefficient or Market Sensitivity
ER(m) = Expected Return of Market
ER(m) – Rf = Market Risk Premium
Calculation of Beta of a Security:

β =  security x Correlation security & market
 Market

COST OF RETAINED EARNINGS (Kre)
Use same model for computing Kre as used for

computing Ke. Note that while computing Kre, only MPS
shall be taken as a denominator.
Adjustment for Personal Income-Tax, Brokerage,

Commission etc. in computation of Kre:
Kre = Ke (1 - tp) (1 - B)
Where, Ke = Required Return of Equity Shareholders
tp = Personal Tax of Shareholders
B = Brokerage Rate
WEIGHTED AVERAGE COST OF CAPITAL

(WACC) OR OVERALL COST OF CAPITAL
(Ko)
Ko = (Kd x Wd) + (Kp x Wp) + (Ke x We) + (Kre x Wre)

Note: Book Value or Market Value Weights may be
used, however Market Value Weights are preferred.

SCHEDULE OF MARGINAL COST OF CAPITAL
Step I: Determine Pattern of raising marginal funds.

Step II: Compute Cost of Capital of each segment of
all Sources of Finance.
Step III: Determine Breaking Points (or point of
exhaustion of cheaper segment of source of finance)
Breaking = Amount of Cheaper Segment of a
Point Source of Finance .
Weight of Source of Finance
Step IV: Determine Average Cost of Capital at each
Breaking Point.
Step V: Determine Overall WACC of entire Marginal
Funds.
CURRENT YIELD
Current Yield = Next Annual Interest Income x 100

Current Price or Value of
Bond/Debenture

INTRINSIC VALUE OF A BOND/

DEBENTURE
(A) Intrinsic Value of Irredeemable Bond/Debenture:

Intrinsic Value = Amount of Annual Interest Income
Required Rate of Return
(B) Intrinsic Value of Redeemable Bond/Debenture:

Intrinsic = PV of Future + PV of Redeemable
Value Interest Value
INTRINSIC VALUE OF PREFERENCE SHARES
(A) Intrinsic Value of Perpetual/Irredeemable

Preference Shares:
Intrinsic = Annual Preference Dividend
Value Receivable in perpetuity .
Required Rate of Return
(B) Intrinsic Value of Redeemable Preference Shares:

Intrinsic = P.V of Preference + Present Value
Value Dividends Receivable of
till Maturity Maturity Value

INTRINSIC VALUE OF EQUITY SHARES
(A) Constant Dividends receivable annually in

perpetuity:
Intrinsic Value/P0 = DPS
Ke
(B) Dividends growing annually at a perpetual growth

rate:
Intrinsic Value/P0 = D1 .
Ke - g
(C) Dividends growing abnormally for some years &

then normalising growth in perpetuity:
Intrinsic Value/P0 = P.V. of Dividends receivable during
Abnormal Growth Period + P.V. of Intrinsic Value of
Shares at the end of Abnormal Growth Period

Leverages 12 CA Ashish Kalra

LEVERAGES
Type of Risk Type of Leverage used to

measure risk
Operating/Business DOL
Financial DFL
Combined/Total DCL or DTL
CHART SHOWING DOL, DFL & DCL
Income Statement
Sales xxx
Less: Variable Cost (xxx)
Contribution xxx DOL
Less: Fixed Cost (xxx)
EBIT xxx
Less: Interest (xxx)
EBT xxx DCL
Less: Income tax (xxx)
EAT xxx DFL
Less: Preference dividend (xxx)
EAE xxx
No. of equity shares xxx
EPS xxx

DEGREE OF OPERATING LEVERAGE (DOL)
DOL = Contribution = % ∆ EBIT

EBIT % ∆ Sales
DEGREE OF FINANCIAL LEVERAGE (DFL)
DFL = EBIT = % ∆ EPS

EBT – Pref. Div % ∆ EBIT
(1 - t)
. DEGREE OF COMBINED LEVERAGE (DCL)/

TOTAL LEVERAGE
DCL = [DOL x DFL]

= Contribution = % ∆ EPS
EBT – Pref. Div % ∆ Sales
(1 - t)

RELATIONSHIP BETWEEN BEP &

LEVERAGES
Operating BEP & DOL

Sales DOL
• When sales is much • DOL will be slightly
higher then operating more than 1
BEP
• With the decrease in • DOL will increase
sales
• At operating BEP Sales • DOL will be infinite
• When sales is slightly • DOL will be highly
less than operating BEP negative
• Further reduction in • DOL will became
sales lower negative &
move towards 0
• At 0 Sales • DOL will be 0

Financial BEP & DFL

EBIT DFL
• When EBIT is much • DFL will be slightly
higher than financial more than 1
BEP
• With the decrease in • DFL will increase
EBIT
• At financial BEP • DFL will be infinite
• When EBIT is slightly • DFL will be highly
less than financial BEP negative
• Further reduction in • DFL will become lower
EBIT negative & move
towards 0
• At 0 EBIT • DFL will be 0

TRADING ON EQUITY: IMPACT OF

RAISING LONG TERM DEBT FUNDS
Case Financial Desired level

Leverage of D/E to
Position maximise ROE
• ROCE > Interest Favourable High level
Rate
• ROCE > Interest Unfavourable Nil or Low level
Rate
• ROCE = Interest Neutral Any Level
Rate

TRADING ON EQUITY: IMPACT OF

RAISING PREFERENCE SHARE CAPITAL
Case Position Desired level

of preference/
Equity to
maximise ROE
• Past tax ROCE > Favourable High level
Preference
dividend rate
• Post tax ROCE > Unfavourable Nil or Low level
Preference
Dividend Rate
• Post tax ROCE Neutral Any Level
= Preference
dividend rate

MARGIN OF SAFETY (MOS)
MOS (value) = Actual Sales value – Operating BEP

Sales Value
MOS (volume) = Actual Sales volume - Operating BEP
sales volume
MOS ratio = Actual sales - BEP sales x 100
Actual Sales
Or = Actual sales – BEP Sales x P/V ratio
Actual sales P/V ratio
Or = Contribution – Fixed cost
Contribution
Or = EBIT
Contribution
Or = 1
DOL
Hence, DOL = 1
MOS ratio

ANALYSIS OF DCL
Case DOL DFL Total Remarks

Risk
I Low Low Low Cannot take
advantage of Trading
on Equity.
II High High Very Very risky
High combination
III High Low Moderate Low EBIT due to high
DOL & Lesser
advantage of Trading
on equity due to low
DFL.
IV Low High Moderate Best combination as
maximum benefit of
trading on equity is
taken with moderate
total risk.

IMPACT OF FINANCIAL LEVERAGE ON

SHAREHOLDERS’ WEALTH
(I) Using ROI-ROE Analysis Framework:

ROI = EBIT x 100
Capital Employed
ROE = ROI (1 - t) + D (ROI - I)(1 - t) + {ROI(1 - t) – PD} P
E E
Where, ROI = Return on Investment
EBIT = Earnings before Interest & Tax or Net
Operating Profits
Capital Employed = Long term Debt + Shareholders’ funds

ROE = Return on Equity
D = Debt amount in capital structure
E = Equity Shareholders’ Funds in capital structure
I = Interest Rate
t = Corporate Income Tax Rate
PD = Preference Dividends Rate
P = Preference Share Capital

(II) Using ROA-ROE Analysis Framework:

ROA = NOPAT x 100
Operating Assets
ROE = ROA + D (ROA - Kd)
E
Where, NOPAT = EBIT (1 - t)
Operating Assets = Total Assets invested in the
business
Kd = Interest rate (1 - t)
FINANCIAL BEP
Financial = Interest + Preference Dividends

BEP amount on 1 – Income Tax Rate
Long term
Debts

OPERATING BEP
Operating BEP = Operating Fixed Costs

(in units) Contribution per unit
Operating BEP = Operating Fixed Costs
(in `) P/V Ratio
Where, P/V Ratio = Contribution x 100
Sales
OVERALL BEP
Overall Operating Financial

+
BEP = Fixed Costs Fixed Costs
(in units) Contribution per unit
Operating Financial
Overall +
= Fixed Costs Fixed Costs
BEP (in `)
P/V Ratio
Where, Financial Fixed Costs =
Interest on Preference Dividends
+
Long term Debts 1 – Income Tax Rate

Capital Structure 24 CA Ashish Kalra

OPTIMAL CAPITAL STRUCTURE
Optimum capital structure is one where MPS is the

maximum, if there is a tie in highest MPS, choose
capital structure having highest EPS.
Expected EPS = (Expected EBIT – I)(1 – t) – PD
N
Expected MPS = Expected EPS x P/E ratio
INDIFFERENCE POINT
(x – I) (1 – t) – PD = (x – I) (1 – t)
N1 N2
Where, x = Indifference Point EBIT
I = Interest amount on Long term Debts
t = Income Tax Rate
N1 = No. of Equity Shares in Alternative –1
N2 = No. of Equity Shares in Alternative –2
PD = Preference Dividends amount

Plan 1
Plan 2
EPS
(`) Indifference Point
Financial Point
O
EBIT (`)
Expected EBIT Better Plan

Lower Financial Break Even
< Indifference Point
Point
= Indifference Point Any one of the two plans
Lesser number of Equity
> Indifference Point
Shares

FINANCIAL BREAK – EVEN POINT
Financial Break Even Point Level of EBIT

= Interest on long term debts + Preference dividends
(1 - t)
THEORIES OF CAPITAL STRUCTURE
Net Income Net Modigliani Pecking

(NI) Operating & Miller Order
Approach Income (NOI) (MM) Theory
By David Approach Approach By
Durand By David I & II Donaldson
Durand
Traditional Approach Trade-off Theory

By Ezra Solomon Extension of MMII

COMMON EQUATIONS FOR THEORIES
VF = VD + VE = I + EBIT – I
Kd Ke
OR VF = EBIT
Ko
Where, VF = Value of Firm
VD = Value of Debt
VE = Value of Equity
I = Amount of Interest
NET INCOME (NI) APPROACH
There is a relationship between capital structure & V F.

The higher the debt-equity ratio/leverage, the better it
is. At the highest possible leverage, Ko will be the
minimum & VF will be the maximum.
Ke
Cost of
Ko
Capital
Kd
%
O
D/E Ratio/ Financial Leverage Ratio

Keu = KeL
Vu = VEu = EAE = EBIT
Keu Keu
Where, EAE = Earnings Available for Equity
Shareholders
Vu = Value of Unlevered Firm
VEu = Value of Equity of Unlevered Firm
Keu = Required Rate of Return to Equity
Shareholders of Unlevered Firm
Kou = Overall cost of capital of unlevered firm
VL = VD + VEL
VEL = EAE = (EBIT – I)
KeL KeL
KOL = EBIT
VL
Where, VL = Value of Levered Firm
KOL = Overall Cost of Capital of Levered Firm
VEL = Value of Equity of Levered Firm
KeL = Required Rate of Return of Equity
Shareholders of Levered Firm

NET OPERATING INCOME (NOI) APPROACH
There is no relationship between Capital Structure &

VF. All capital structures are optimal. Since, Ko & EBIT
are constant, hence VF also remains constant at all
levels of leverage.
Ke
Cost of
Ko
Capital %
Kd
O
VL = Vu = EBIT
Ko
KoL = Kou
VEU = VU
VEL = VL – VD
KeL = EBIT – I
VEL

TRADITIONAL APPROACH
VF increases with an increase in leverage but upto a

certain limit only. Beyond this limit, an increase in
leverage will increase its Ko & hence the VF will decline.
A Capital structure is said to be optimum at that level
of D/E Ratio where Ko is the least.
Ke
Cost of Capital %
Ko
Kd
=
Optimal Capital Structure

O D/E Ratio/ Financial Leverage Ratio
k

MM I (1958) (WITHOUT TAXATION)
Proposition I: VF is independent of level of leverage &

is determined by capitalising Net Operating Profits
with Ko.
VL = VU
VF = EBIT
Ko
VF
VD
Market
Values
VE
O =

Proposition II: KeL rises with the rise in leverage & is

the sum of Keu & Risk Premium on account of increase
in leverage which sets off completely the benefits of
introduction of less costly debt funds.
KeL = Keu + (Keu – Kd) x D
E
Ke
Ko
Cost of
Capital %
Kd
O
Proposition III: Required rate of return /cut off rate

for investment purposes is the overall capitalisation
rate (Ko) which is independent of the level of leverage.
KoL = KoU

MM II (1963)
(WITH CORPORATE TAXATION)
Proposition I: VF rises with the rise in leverage & is

determined by capitalising NOPAT with Ko.
❖ VL > VU
❖ VF = EBIT (1 - t)
❖ VL = VU + PV of Interest Tax Shield

❖ VL = VU + (Debt x t)
VF
Market Values
VD
VE
O

Proposition II: Ke of a Levered Firm (KeL) rises due to

the increase in financial risk but at a lower rate due to
the feature of corporate taxation which is saved on
account of debt.
KeL = Keu + (Keu – Kd) x D (1 – t)
E
KoL < KoU
Ke
Capital %
Cost of
Ko
Kd
O
Leverage (D/E) Ratio
Proposition III: The required rate of return/cut off

rate for investment purposes is the overall
capitalisation rate (Ko) which is no longer independent
of the level of leverage & hence Ko decreases on
account of tax savings on debt amount.
KoL < KoU

ARBITRAGE PROCESS ADVOCATED BY MM
(A) Levered to Unlevered Firm:

Step 1: Sell stake in Levered Firm at Market Price &
take personal borrowings (at Corporate Rate of
Interest) to maintain the level of Personal Leverage to
the level of Corporate Leverage.
Step 2: Invest in shares of Unlevered Firm. The
dividends income received from the Unlevered Firm will
be reduced by personal interest & the excess amount
against dividends lost in Levered Firm is Arbitrage
Gain.
(B) Unlevered Firm to Levered Firm:
Step 1: Sell stake in Unlevered Firm at Market Price
& buy shares in Levered Firm along with risk free
lending at same rate as Corporate Rate of Interest in
a manner that stake in Equity & Debt (in percentage) is
the same.
Step 2: Receive dividends from Levered Firm along
with interest on risk free lending. Compare the amount
received with the amount of dividends lost in Unlevered
Firm & the excess amount in hand is Arbitrage Gain.

THE TRADE-OFF THEORY:
TRADE OF THEORY
Optimal Debt Level
Cost of Balance Benefit of

Debt Debt
Financial Tax
Agency Cost
Distress Cost Benefit on
Interest
Direct/ Indirect/ Non -

bankruptcy Bankruptcy
Cost Cost

Maximum
value of firm
Cost of
financial
PV of distress
interest
tax shields
Value of
unlevered
firm
Debt level
Optimal debt level
PECKING ORDER THEORY
The firms rely for finance as much as they can on

internally generated funds. If not enough, then they will
move to additional debt finance. It is only when these
two sources cannot provide enough funds to satisfy
needs that the company will seek to obtain new equity
finance.

IMPACT OF CORPORATE INCOME TAX ON

NI APPROACH
Keu = KeL
Vu = VEU = EBIT (1 - t)
Keu or Kou
VEL = (EBIT – I)(1 – t)
KeL
VL = VEL + VD
KOL = EBIT(1 – t)
VL

IMPACT OF CORPORATE INCOME TAX ON

NOI APPROACH
Vu = EBIT (1 - t)
Keu/Kou
Where,
Keu = Equity Capitalisation Rate of an Unlevered Firm
Kou = Overall Cost of Capital of an Unlevered Firm
VL = Vu + (VD x t)
KOL = EBIT(1 – t)
VL
KeL = Keu + (Keu – Kd) D(1 – t)
E


Dividend Decision 42 CA Ashish Kalra
DIVIDEND POLICIES
Types of Dividend Amount of Dividends

Policy Payable
1 Constant Dividends Same amount of DPS
Per Share Policy every year
2 Constant Dividends Same percentage of
Payout Policy earnings as dividends
every year
3 Constant Dividends Same amount of DPS
Per Share with extra every year & extra
Dividends if Company DPS if EPS of Company
earns above a certain increases beyond a
level certain level
4 Constant Dividends Same % of earnings as
Payout Policy with dividends every year
minimum guaranteed subject to minimum
dividends guaranteed dividends
per share

5 Stable Steady dividends every year &

Dividends increase/ decrease in dividends
Policy only if its earnings have reached
a higher/lower permanent level
6 Residual Pay residual income in hand
Income remaining after meeting viable
Dividends Capital expenditures in hand as
Policy dividends
Ex dividend = Cum Dividend – DPS included therein
EVALUATION OF VIABLE CAPITAL

EXPENDITURE:
*If IRR of proposed project is > cost of capital of the

company = Invest
*If NPV of the proposed Project is > 0 = Invest

Theories of Dividend
RELEVANT THEORIES IRRELEVANT THEORIES
Dividend distribution Dividend distribution is

is RELEVANT for IRRELEVANT for
affecting the wealth affecting the wealth of
of shareholders shareholders
Walter James E.
Model Walter M.M.
Hypothesis
Gordon Myron J
Model Gordon
Franco Modigliani
Graham Benjamin &
& Dodd Graham & Merton Miller
Model David
Dodd
Lintner John
Model Lintner

WALTER’S MODEL
P0 = D + (r/Ke ) (E - D)
Ke
Ke = Cost of Equity = EPS = 1 .
MPS P/E Ratio
OPTIMAL DIVIDEND POLICY

r > Ke, 100% retention
r < Ke, 100% dividends payout
r = Ke, Pay & retain in any proportion
LINTNER’S MODEL
D1 = (E x D/P Ratio x Adj Rate) + D0 (1 – Adj Rate)

Earnings Adj Rate
Stable near to 1
Volatile near to 0
TRADITIONAL MODEL (GRAHAM & DODD)
P = m (D + E/3)
P = m {D + (D + R)/3} = m (4D/3) + m (R/3)

MM MODEL/IRRELEVANT THEORY
v
1. P1 = P0 (1 + Ke) – D
2. P0 = D1 + P1
1 + Ke
3. Additional No. of Equity Shares = I1 – (E - D)

to be issued at the end of year 1 P1
4. Market Capitalisation = No. of Equity x MPS

of Equity Shares Shares
5. Ke = EPS/MPS or 1/PE ratio
Market = Total no. of equity shares x

Capitalisation MPS
Free float market = (Total no. of equity shares –

capitalisation No. of equity shares held by
promoters) x MPS

DIVIDEND DISCOUNT MODEL (DDM)
Intrinsic Value = Sum of PV of Future Cash Flows

= Sum of PV of Dividends + PV of Stock Sale Price
Intrinsic = D1 + D2 + . . . + Dn + SPn .
Value (1 + Ke)1 (1 + Ke)2 (1 + Ke)n (1 + Ke)n
(A) Zero Growth Rate DDM:

Stock’s Intrinsic Value or P0 = D
Ke
(B) Constant Growth Rate DDM or Gordon Model:

Stock’s Intrinsic Value or P0 = D1 .
Ke – g
Or, P0 =
(C) Variable Growth Rate DDM:

Stock’s Intrinsic Value or P0 =
PV of dividends receivable + PV of market price at
during abnormal growth the end of the abnormal
period growth period

BUY BACK OF SHARES
Earnings Available for Equity

Expected Shareholders
=
Post Buy No. of Equity No. of
Back EPS Shares Equity
-
before Buy Share
Back bought back
Post
Expected Post
Buy Expected Post
= x Buy Back P/E
Back Buy Back EPS
Ratio
MPS
Total
No. of shares Buy Back
amount
= to be bought x Price per
required for
back share
Buy Back
(Original No. of
Market Post
equity shares –
capitalisation buy
= x No. of equity
after buy back
shares bought
back MPS
back)

Amount to be used to
No. of equity shares buyback equity shares
=
to be bought back Buyback price per
share
STOCK SPLIT & REVERSE SPLIT
(1) Stock Split:

(i) Revised Par Par Value before
Value after = Stock Split
Stock Split Stock Split Ratio
(ii) Revised No.

Old No. Stock
of Equity
= of Equity x Split
Shares after
Shares Ratio
Stock Split
(iii) Revised MPS

MPS before Stock Split
after Stock =
Split Stock Split Ratio

(2) Reverse Split/Consolidation:

(i) Revised Par Par Value
Reverse
Value after before
= x Split
Reverse Reverse
Ratio
Split Split
(ii) Revised No.

of Equity
shares after = Old No. of Equity Shares
Reverse Reverse Split Ratio
Split
(iii) Revised MPS MPS

Reverse
after before
= x Split
Reverse Reverse
Ratio
Split split

BONUS ISSUE
(i) No. of Bonus Ratio of

shares to be No. of Bonus
issued to = equity x shares
existing equity shares to be
shareholders issued
(ii) Post bonus issue = Market capitalisation

MPS of Equity shares
before bonus issue
Total No. of Equity
shares after Bonus
issue
(iii) Change in Reserves & surplus

Equity account will reduce & ESC will
=
on account of increase
bonus issue

Capital Budgeting 52 CA Ashish Kalra

PROJECT CASH FLOWS
Particulars (`)
a) Initial Cash Outflows:
Cost of New Fixed Asset(s) xxx
Add: Investment in Net Working Capital
(if any) xxx
Initial Cash Outflows xxx
b) Cash Inflows:
Operating Revenue xxx
Less: Operating Expenses excluding
depreciation (xxx)
Cash Flows Before Tax (CFBT) (1) xxx
Less: Depreciation (xxx)
Profits Before Tax (PBT) xxx
Taxes (2) xxx
Cash Flows After Tax (CFAT) (1) - (2) xxx
C) Terminal Cash Flows:
Salvage Value of asset (Net of Disposal Costs)
(Net of Capital Gains Tax Liability/ Tax Savings
on losses) xxx
Add: Recovery of Net Working Capital (if any) xxx
Terminal Year Net Cash Flows xxx

CAPITAL BUDGETING TECHNIQUES
Capital Budgeting Techniques
(I) Traditional or (II) Modern or Discounted

Non- Discounted Cash Flow Techniques
Cash Flow Techniques 1. NPV Method
1. PBP Method 2. PI Method
2. ARR Method 3. IRR Method
4. Discounted PBP Method
5. NPVI Method
6. Modified IRR
PAYBACK PERIOD (PBP) METHOD
Case I: If the anticipated Net Annual Cash Inflows

are of equal amounts against the initial investment:
Payback = Initial Investment .
Period Net Annual Cash Inflows

Case II: If the Net Annual Cash Inflows are of

unequal amounts:
Payback Period is computed by adding up the Net
Annual Cash Inflows until the total is equal to the
Initial Cash Outlay.
ACCOUNTING RATE OF RETURN (ARR)
ARR = Average PAT x 100

Initial Investment/Capital Employed
OR ARR = Average PAT x 100
Average Investment/Capital Employed
Average = ∑ PAT over the lifetime of project
PAT Project life
Average = Opening + Terminal
Capital Investment Value .
Employed 2
Where, Annual PAT = Annual CFAT - Depreciation

NET PRESENT VALUE (NPV) METHOD
NPV = PV of Cash Inflows – PV of Cash Outflows

NPV = -CF0 + CF1 + CF2 + ……… + CFn
(1 + k)° (1 + k)1 (1 + k)2 (1 + k)n
Where, CF0 = Cash outflows at Time 0 i.e. Cost of
Fixed Assets, Working Capital etc.
CFn = Cash Inflow at the end of year n
n = Life of the Project
k = Cost of Capital used as the Discount Rate
PROJECT NPV VS EQUITY NPV
Project NPV Equity NPV

1 Considers Project’s long Considers Cash
term Cash Outflows Outflows from Equity
irrespective of its funds only.
source of finance.
2 Considers Operating Considers CFAT for
CFAT plus Terminal Equity plus Terminal
Value as Cash Inflows or Value as Cash Inflows
FCFF (Free Cash Flows or FCFE (Free Cash
of Firm) Flows for Equity).

3 Discount Rate = Ko Discount Rate = Ke
4 Accept the project, if Accept the proposal, if

Project NPV  0. Equity NPV  0.
EVALUATION OF MUTUALLY EXCLUSIVE

PROPOSALS HAVING UNEQUAL LIVES
Case 1:- When only Cash Outflows are known:

Choose the proposal having Lower Equivalent Present
Value of Cash Outflows (EAPVCO)
EAPVCO = PVCO .
PVAF of years of benefit
Case 2:- When both Cash Outflows & Inflows are
known: Choose the proposal having higher Equivalent
Annual Net Present Value (EANPV)
EANPV = NPV .
PVAF of years of benefit

INTERNAL RATE OF RETURN
IRR = Discount Rate which makes the NPV of the

project under consideration = 0.
OR PI = 1 OR PVCO = PVCI
0 = -CF0 + CF1 + CF2 +……+ CFn
(1+r)0 (1+r)1 (1+r)2 (1+r)n
Where, CF0 = Cash outflows at Time 0 i.e. Cost of Fixed
Assets, Working Capital etc.
CFn = Cash Inflow at the end of year n
r = Discount Rate (IRR)
n = Life of the Project
PROJECT IRR v/s EQUITY IRR
Project IRR Equity IRR

1. Considers Project’s long Considers Cash
term Cash Outflows Outflows from Equity
irrespective of its funds only.
source of finance.
2. Considers Free Cash Considers FCFE (Free
flows of firm or FCFF as Cash Flows for Equity)
Cash Inflows. as Cash Inflows.

3. Accept the project, if Accept the proposal,

project IRR  Ko. if Equity IRR  Ke.
PROFITABILITY INDEX (PI) METHOD/

DESIRABILITY FACTOR/ BENEFIT-COST
(B/C) RATIO TECHNIQUE
PI = Present Value of Cash Inflows (PVCI)

Present Value of Cash Outflows (PVCO)
DISCOUNTED PAYBACK PERIOD

(PBP) METHOD
Discounted PBP = Period within which the PVCI

completely recovers the PVCO. Discounted PBP is
computed by calculating Cumulative PVCI till it becomes
equal to PVCO.
Appropriate discount rate = Cost of Capital of the
Firm.

NET PRESENT VALUE INDEX (NPVI)

METHOD
NPVI = NPV .
Initial Cash Outflows
MODIFIED INTERNAL RATE OF RETURN

(MIRR)/ TERMINAL RATE OF RETURN
All cash flows, apart from the Initial Investment, are

brought to the terminal value using an appropriate
discount rate (the cost of capital). This results in a
single stream of cash inflow in the terminal year. The
discount rate which equates the present value of the
terminal cash inflow to the zeroth year outflow is
called MIRR.
CF0 = [CF1 x (1+k)n-1 + CF2 x (1+k)n-2 + …… + CFn] x 1 .
(1+MIRR)n
PROJECTS WITH SYNERGIES
Choose the Combination of Projects that is expected

to yield the highest overall NPV.

TREATMENT OF SUBSIDY IN MAKING DCF

EVALUATION
(1) Subsidy receivable for installation of an

Industrial Undertaking in a SEZs or Backward Area
(BA) or Backward District: Either add subsidy
receivable in Cash Inflows or reduce it from Cash
Outflows.
(2) Subsidy for installation or purchase of an asset

(E.g. pollution control equipment): Either add subsidy
receivable in Cash Inflows or reduce receivable from
Cash Outflows. The depreciation allowed for tax
purposes is on the cost of asset purchased as reduced
by the amount of subsidy received.
(3) Export Subsidy: Add export subsidy to Sales

Revenue in order to determine CFAT as export subsidy
is a taxable income.

REPLACEMENT DECISION
Cash Outflows Cash Inflows
Incremental Incremental
Outflows Inflows
Cost of New CFAT from New

Assets xx Asset – CFAT from
Less: Scrap Old Asset xx
Value of Old Add: *Terminal
Assets today Value of New Asset
(Net of - *Terminal Value of
Capital Gain Old Asset at the end
Tax) (xx) of its useful life xx
Net Cost of xx
Replacement xx
*Terminal Value (Net of Capital gain tax, if any)

Resultant NPV > 0 Replace

=0 Replace/Continue old
<0 Continue Old
CAPITAL RATIONING
Techniques of dealing with Capital Rationing:

(I) PI Technique:
PI is useful to rank the most desirable project mix if all
the following conditions are fulfilled:
1. All Cash Outflows for all projects are at 0 period.
2. None of the projects are mutually exclusive.
3. All projects are Infinitely Divisible.
The allocation of funds is made in accordance with the
rankings given to all viable projects.
(II) NPVI Technique:
NPVI is useful to rank the most desirable project mix if
all the following conditions are fulfilled:
1. Funds are scarce today only.
2. None of the projects are mutually exclusive.
3. All projects are Infinitely Divisible.
The allocation of funds is made in accordance with the
rankings given to all viable projects.

(III) Trial and Error Method:

Make combination of project mix from the funds
available for Investment. The combination of projects
which gives highest overall NPV will be the most
desirable Project Mix.
NPV v/s IRR
In case of choice amongst mutually exclusive proposals,

NPV & IRR may give contradictory indications under
the following conditions:
1. Projects have different life expectancies.
2. Projects have different sizes of investment.
3. Projects’ cash flows differ over time.
4. Different Reinvestment Rate assumptions of
Intermediary Cash Flows as NPV method uses Cost
of Capital whereas IRR method uses IRR as the
implied Reinvestment Rate.
In case of inconsistency, the project yielding larger
NPV is preferred because cost of capital is a more
realistic reinvestment rate & IRR is a percentage but
the magnitude of cash flow is important.
Also, Multiple IRR may arise if projects have non-
conventional cash flows.
NPV v/s PI
Generally, a project offering a PI > 1 must also offer a

positive NPV. But a conflict may arise between two
methods if a choice between mutually exclusive
projects has to be made. If we have to select one
project out of two mutually exclusive projects, the NPV
should be preferred because NPV indicates the
economic contribution of the project in absolute terms.
As such a project which gives higher economic
contribution should be preferred.
This is because NPV gives ranking on the basis of
absolute value of rupees whereas PI gives ranking on the
basis of ratio. PI method is a better evaluation
technique than NPV in a situation of Capital Rationing
only.

APPLICATION OF BLOCK OF ASSETS

CONCEPT IN DCF EVALUATIONS
Block of Assets
That there are other That there are no

assets in the block of other assets in the
assets block of assets
❖ Charge normal ❖ No depreciation will be

depreciation in the charged in the last year of
last year of operation of asset (since the
operation of assets. block will cease to exist in
❖ No Capital Gain/Loss the last year) & Capital
will be computed in gain/loss = Sale Proceeds of
the last year of asset – WDV of the asset in
operation unless the the beginning of the last
Sale Proceeds year. or
exceeds the WDV of ❖ Depreciation will be charged
the Block. in the last year of operation
at normal rate & Capital
gain/loss = Sale Proceeds of
assets – WDV of asset at the
end of last years.


Risk Analysis in Capital Budgeting 68 CA Ashish Kalra
COMPUTATION OF STANDARD DEVIATION
When cash flows are dependent over time:
(NPV1 – Mean NPV)2 x Prob1 +

NPV =ඩ(NPV2 – Mean NPV)2 x Prob2 +…+
(NPVn – Mean NPV)2 x Probn
COEFFICIENT OF VARIATION
Coefficient of Variation = Standard Deviation of

Expected NPV (σ) .
Mean or Expected NPV (x̅)

SENSITIVITY ANALYSIS
Sensitivity Analysis evaluates the robustness of a

project by giving answers to "what if" type questions.
This technique provides information as to how sensitive
the estimated project parameters namely: the Project
Cost, expected Cash Inflows, the Discount rate and
the Project life, are to estimation errors. It takes care
of estimation errors by using a number of possible
outcomes in evaluating a project.
Thus, it is a technique of risk analysis which studies the
responsiveness of a criterion of merit like NPV or IRR
to variation in underlying factors like selling price,
quantity sold, returns from an Investment etc.
Sensitivity Analysis involves three steps:
1. Identification of all those variables having an
influence on the project's NPV or IRR.
2. Definition of the underlying quantitative
relationship among the variables.
3. Analysis of the impact of the changes in each of
the variables on the NPV of the project.

SCENARIO ANALYSIS
Scenario Analysis considers the probabilities of changes

in key variables and also allows decision makers to change
more than one variable at a time.
This analysis begins with base case or most likely set of
values for the input variables. Then it analyses the worst
case scenario (low unit sales, low sales price, high variable
cost and so on) and the best case scenario (high unit sales,
high sales price, low variable cost & so on). In other words,
scenario analysis answers the question “how bad could the
project look”.
Scenario analysis contains four critical components:
1. Determination of factors around which the scenarios
will be built, such as state of economy, response of
competitors on any action of the firm.
2. Determination of number of scenarios to analyse for
each factor e.g. a best case, most likely and a worst
case scenario.
3. Building of few scenarios for each factor by focusing
on critical factors.
4. Assignment of probabilities to each scenario on the
basis of macro factors e.g. exchange rates, interest
rates etc., or micro factors e.g. competitor’s reactions
etc.

NPV of various scenarios will be computed and the final

decision of acceptance / rejection is usually made by
computing Mean NPV.
CERTAINTY EQUIVALENT (CE) APPROACH
Step 1: Determine certain Cash Flows from risky cash

flows by multiplying each risky cash flow by the
appropriate CE coefficient.
Step 2: Determine Present Value of Cash Flows by
discounting the certain cash flows with Risk Free rate
of Interest.
Step 3: Thereafter the normal capital budgeting
techniques are used such as NPV and IRR.
Note: If CE coefficient is not given then we shall
compute it as follows:
CE Coefficient = Certain Cash Flows .
Risky or Expected Cash Flows

RISK ADJUSTED DISCOUNT RATE (RADR)

APPROACH
1. Compute Coefficient of Variation (CV) of the NPV of

the proposed projects and the project having higher
CV will be discounted with higher discount rate.
2. The Project having lower CE factor will be evaluated
with a higher discount rate.
3. Beta factors or Risk Index of proposed projects may
be estimated & RADR may be computed as follows:
RADR = Rf + p (Ko – Rf)
Alternatively, RADR can also be computed as follows:

RADRP = Rf + Adjustment for Firm’s Normal Risk +
Adjustment for differential risk of the project
OR, RADRP = Rf + F (Ko – Rf) + P-F (Ko – Rf)

FINANCIAL
STATEMENT ANALYSIS

Financial Statement Analysis 74 CA Ashish Kalra
PROFITABILITY RATIOS BASED ON SALES

(INCOME STATEMENT PROFITABILITY
RATIOS)
1. Cost of Goods Sold (COGS) Ratio:

COGS Ratio = Cost of Goods Sold x 100
Net Sales
Where, COGS of a Trader = Opening Stock + Net
Purchases + Direct Expenses – Closing Stock
COGS of a Manufacturer = Opening Stock of Finished
Goods + Factory Cost of Production – Closing Stock of
Finished Goods
Net Sales = Total Sales – Sales Return
2. Gross Profit (GP) Ratio or Gross Margin

Percentage:
Gross Profit Ratio = Gross Profit x 100
Net Sales
Where, Gross Profit (GP) = Net Sales – COGS
Relationship between COGS Ratio & GP Ratio:
COGS Ratio = 100 – GP Ratio
GP Ratio = 100 – COGS Ratio

3. Expense Ratio:
1. COGS ratio has been discussed above
2. Office & Admin = Office & Admin
Exp Ratio Exp. x 100
Net Sales
3. S & D = S&D
Expenses Ratio Expenses x 100
Net Sales
4. Fixed = Fixed Operating
Net Sales
5. Variable = Variable
Net Sales
4. Profit/Volume (P/V) Ratio/ Contribution/Sales

Ratio:
P/V Ratio = Contribution x 100
Sales
Where, Contribution = Sales – Variable Cost
OR = Fixed Cost + Profit - Loss

5. Operating Ratio:
Operating Ratio
= Cost of Goods Sold + Other Operating Exp. x 100
Net Sales
OR = Cost of Goods Sold ratio + Office & Admin Exp.
ratio + S & D Exp. ratio
6. Net Operating Profit Ratio:

Net Operating = Net Operating Profits or EBIT x 100
Profit Ratio Net Sales
Where, EBIT = Gross Profit – Other Operating
Expenses
OR = Net Sales – Variable cost – Fixed Cost
Relationship between Net Operating Profit Ratio &
Operating Ratio:
Net Operating Profit Ratio = (100 – Operating Ratio)
Operating Ratio = (100 – Net Operating Profit Ratio)
7. Net Profit Ratio:

Net Profit Ratio = Net Profit x 100
Net Sales
Where, Net Profit = Profits after Tax (PAT)

PROFITABILITY RATIOS BASED ON

CAPITAL & INVESTMENT
1. Return on Capital Employed or Return on

Investment:
Return on Capital = EBIT x 100
Employed Capital Employed
Where, Capital Employed = Equity Share Capital +
Reserves & Surplus + Preference Share Capital + Long
Term Debt – Fictitious Assets & Losses – Non Trade
Assets – P&L A/c (Dr.)
OR = Net Fixed Assets (including Intangible Fixed
Assets) + Net Working Capital + Trade Investments

2. Return on Equity (ROE):

(a) Return on Total Shareholder’s Funds/Net Worth:
Return on Shareholder’s = EAT x 100
Funds Ratio Shareholders’ Funds
(b) Return on Equity Shareholder’s Funds
Return on Equity = EAE x 100
Shareholder’s Equity Shareholders’ Funds
Funds Ratio
Where, Equity Shareholders’ Funds = Equity Share
Capital + Reserves & Surplus (Preferably excluding
Revaluation Reserve) – Fictitious Assets and Losses –
P&L A/c (Dr.)
Shareholders’ Funds/Net Worth/Proprietor’s Funds/
Owner’s Equity = Equity Shareholders Funds +
Preference Share Capital
3. Return on Operating Assets:

Return on Operating = NOPAT x 100
Assets Operating Assets
Where,
NOPAT = EBIT (1 – Income Tax Rate)
Operating Assets = Total Assets [excluding Fictitious
Assets & P&L A/c (Dr.)] – Non Trade Assets

4. Return on Total Assets:

Return on = Net Profit after Tax x 100
Total Assets Total Assets
Where, Total Assets = Total Assets side of Balance
Sheet (excluding Fictitious Assets)
ACTIVITY OR PERFORMANCE OR
TURNOVER RATIOS
1. Fixed Assets Turnover Ratio:

Fixed Assets = Net Sales .
Turnover Ratio Net Fixed Assets
Where, Net Fixed Assets = Gross Fixed Assets
- Accumulated Depreciation
2. Total Assets Turnover Ratio:

Total Assets = Net Sales .
Turnover Ratio Total Assets
3. Current Assets Turnover Ratio:

Current Assets = Net Sales .
Turnover Ratio Current Assets

4. Capital Turnover Ratio:

Capital = Net Sales .
Turnover Ratio Capital Employed
5. Net Working Capital Turnover Ratio:

Net Working Capital = Net Sales .
Turnover Ratio Net Working Capital
Where, Net Working Capital = Current Assets
– Current Liabilities
6. Debtors Turnover Ratio/Receivables Turnover

Ratio:
Debtors = Net Credit Sales
Turnover Ratio Debtors & B/R
Where, Net Credit Sales = Net Total Sales – Cash Sales
7. Stock or Inventory Turnover Ratio:

Inventory = Cost of Goods Sold/Cost of Sales.
Turnover Ratio Stock in Trade/Finished Goods
Note: In case COGS cannot be determined, take Sales.

8. Raw Material Turnover Ratio:

Raw Materials = Raw Materials Consumed .
Turnover Ratio Inventory of Raw Materials
Where, Raw Materials Consumed = Opening Stock of
Raw Materials + Net Purchase of Raw Materials –
Closing Stock of Raw Materials
9. Work in Progress Turnover Ratio:

Work in Progress = Net Factory Cost .
Turnover Ratio Inventory of WIP
Where, Net Factory Cost = Raw Materials Consumed +
Conversion Costs + Opening Stock of Work in Progress
– Closing Stock of Work in Progress
10. Creditors (or Accounts Payable) Turnover Ratio:

Creditors = Net Credit Purchases
Turnover Ratio Creditors & B/P
Where, Net Credit Purchases = Net Total Purchases
– Cash Purchases

11. Average Collection Period:

Average Collection Period = 360/12/ 52 .
Debtors Turnover Ratio
OR = Debtors & Bill Receivables x 360/12/52
Net Credit Sales
12. Average Inventory Conversion/Holding Period:

Average Finished Goods Conversion Period/Avg.
Stock in Trade = 360/12/52
Holding Period Stock Turnover Ratio
OR = Stock in Trade/Finished Goods x 360/12/52
Cost of Goods Sold
13. Raw Materials Inventory Conversion Period:

Raw Materials = 360/12/52 .
Conversion Period Raw Materials Turnover Ratio
OR = Stock of Raw Materials x 360/12/52
Raw Materials Consumed
14. WIP Inventory Conversion Period:

WIP Inventory = 360/12/52 .
Conversion Period WIP Turnover Ratio
OR = Stock of WIP x 360/12/52
Net Factory Cost
15. Average Payment Period:

Average Payment = 360/12/52 .
Period Creditors Turnover Ratio
OR = Creditors & Bill Payables x 360/12/52
Net Credit Purchases
COVERAGE RATIOS
1. Interest Coverage Ratio:

Interest = EBIT .
Coverage Ratio Interest on Long Term Debts
2. Preference Dividends Coverage Ratio:

Preference Dividends = EAT .
Coverage Ratio Preference Dividends
3. Equity Dividends Coverage Ratio:

Equity Dividends Coverage Ratio
= EAE OR EPS .
Equity Dividends DPS

4. Total Dividends Coverage Ratio:

Total Dividends = EAT .
Coverage Ratio Total Dividends
Total Dividends = Equity Dividends
+ Preference Dividends
5. Fixed Charges Coverage Ratio:

Fixed Charges = EBIT .
Coverage Ratio Interest on + Pref. Dividends
Long term Debt 1-t
6. Debt Service Coverage Ratio:

Debt EAT + Interest + Dep. + Other Non-cash
Service = on Long Expenditures
Coverage term Debt Like Amortisation
Ratio Interest on Long term + Installment of
Debt Principal
MARKET TEST OR MARKET STRENGTH

ANALYSIS OR INVESTOR ANALYSIS RATIOS
1. Dividends per Share (DPS):

Dividends = Dividends for Equity Shareholders
Per Share Number of Equity Shares

2. Earnings per Share (EPS):

EPS = Earnings Available for Equity Shareholders (EAE)
Number of Equity Shares
Where, EAE = EAT – Preference Dividends
3. Book Value per Share (BVPS)/Net Asset Value per

Share/Theoretical Market Price per share:
Net Asset Value = Equity Shareholders Funds
Per Share/BVPS Number of Equity Shares
4. Dividends Yield in Equity Shares:

Dividends Yield = DPS x 100
Ratio MPS
5. Earnings Yield Ratio:

Earnings Yield = EPS x 100
Ratio MPS
6. Dividends Payout Ratio:

Dividends = DPS x 100
Payout Ratio EPS
OR = 100 – Retention Ratio

7. Retention Ratio:
Retention = EPS - DPS x 100
Ratio EPS
OR = 100 - Dividends Payout Ratio
8. Price-Earnings Ratio or P/E Ratio:

P/E Ratio = MPS OR = 1 .
EPS Earnings Yield Ratio
9. Market Value to Book Value per share:

Market Value to = MPS
Book Value Ratio BVPS
LIQUIDITY/SHORT TERM SOLVENCY RATIOS
1. Current Ratio: Ideal 2:1

Current = Current Assets .
Ratio Current Liabilities
Where, Current Assets = Inventories + Prepaid
Expenses + Cash and Bank Balances + Receivables/
Debtors + Accrued Income + Short Term Loans and
Advances + Short Term Marketable Investments +
Advance Tax + Income Tax Refund Receivable

Current Liabilities = Creditors for Goods and Services +

Short Term Loans + Bank Overdraft + Cash Credit +
Outstanding Expenses + Provision for Taxation +
Proposed Dividend + Unclaimed Dividend + Short Term
Provisions + Advances from Customers + Current
maturity of long term debts
2. Acid Test/Quick/Liquidity Ratio:

Ideal 1:1
Liquid Ratio = Liquid Assets .
Current Liabilities
Where, Liquid/Quick Assets = Current Assets – Stock
– Prepaid Expenses
Alternative Approach:
Quick Ratio = Quick Assets .
Quick Liabilities
Where, Quick Liabilities = Current Liabilities – Bank
Overdraft – Cash Credit from bank & other Short Term
Loans

3. Absolute Liquidity/Cash Ratio: Ideal 0.5:1

Absolute Liquidity = Cash Reservoir .
Ratio Current Liabilities
Where, Cash Reservoir = Cash in Hand and at Bank +
Demand Deposits at Bank + Short Term Marketable
Investments
4. Defensive Interval/Cash Interval Ratio:

Defensive-Interval = Cash Reservoir + Receivables
. Ratio Projected Daily Cash Requirement
Where, Projected Daily Cash Requirement = (Operating
Cash Expenses + Interest + Income Taxes +
Dividends)/360
5. Ratio of Inventory to Working Capital:

Ideal
Inventory to Working = Inventory .
1:1
Capital Ratio Working Capital

LONG TERM SOLVENCY RATIOS
1. Debt-Equity Ratio: Ideal 2:1

Debt-Equity Ratio = Debt .
(D/E Ratio) Equity
OR = Long Term Debt Funds ..
Shareholders or Proprietors Funds or Net Worth
Where, Long Term Debt Funds = Long Term Loans
(whether Secured or Unsecured), e.g. Debentures,
Bonds, Loans from Financial Institutions
2. Debt to Total Funds Ratio/Debt Ratio:

Debt to Total Funds = Debt .
Ideal 2:3
Ratio Total Funds
OR = Debt .
Debt + Equity
Where, Total Funds = Shareholders Funds
+ Long Term Debt
3. Proprietors Funds to Total Funds Ratio/Equity Ratio:

Equity Ratio = Equity .
Ideal 1:3
Debt + Equity

4. Debt to Total Assets/Debt to Value Ratio:

Debt to Total = Debt .
Ideal 2:3
Assets Ratio Total Assets
5. Proprietary Ratio: Ideal 1:3
Proprietary Ratio = Proprietary Funds/Net Worth

Total Assets
Where, Proprietary Funds / Net Worth = Equity Share
Capital + Preference Share Capital + Reserve & Surplus
– Fictitious Assets & Losses
6. Gearing or Capital Gearing Ratio: Ideal <1
Capital = Pref. Share Capital + Long term Debts

Gearing Ratio Equity Shareholders Funds
7. Fixed Assets Ratio: Ideal <1

Fixed Assets Ratio = Net Fixed Assets
Capital Employed

8. Ratio of Current Assets to Fixed Assets:

Current Assets to = Current Assets .
Fixed Assets Ratio Net Fixed Assets
DU-PONT ANALYSIS CHART (ROI)
Return on Investment (ROI)
Net Operating Capital

Profit Ratio X Turnover Ratio
EBIT ÷ Net
Sales
Net
Sales
÷ Capital
Employed
Sales – COGS –
Office & Admin. Net
Expenses – S & D
Fixed
Assets
+ Working
Expenses Capital

DU-PONT ANALYSIS CHART (ROTA)
Return on Total Assets
Net Profit Margin X Total Assets Turnover
Net Net Net Total

Income ÷ Sales Sales ÷ Assets
Net Sales +/- Total Current

Non Operating - Costs Assets + Fixed
Assets
Surplus/Deficit
Cash,
Cost of Operating Bank & Receiv-
Goods Expenses Marketable ables
Securities
Interest Tax
Inventories Other

DU-PONT ANALYSIS CHART

(RONW OR ROE)
Return on NP Ratio
Total = EAT ÷ Sales
Assets
(ROTA) X
Return on = EAT ÷ TA Total Assets
Net Worth
X Turnover
(RONW)
= Sales ÷ TA
= PAT ÷ NW Total Assets
To Net Worth
= TA ÷ NW
Return = Net x Asset x Equity

on Net Profit Turnover Multiplier
Worth Ratio Ratio
1. Net Profit Ratio:

Net Profit Ratio = Profit After Tax
Sales

2. Assets Turnover Ratio:

Assets Turnover = Sales .
Total Assets
3. Equity Multiplier:
Equity Multiplier = Total Assets .
Shareholder’s Equity

Working
Capital
Management

Working Capital Management 96 CA Ashish Kalra
GROSS WORKING CAPITAL (GWC)
GWC = Cash in Hand + Cash at Bank + Inventories +

Debtors + Bills Receivable + Prepaid Expenses + Short
Term Investments + Short Term Loans & Advances
NET WORKING CAPITAL (NWC)
NWC = Current Assets – Current Liabilities
OPERATING CYCLE
Operating Cycle of a Trading Organisation:

Operating Cycle = S + D - C
Where, S = Stock Holding Period
D = Debtors Collection Period
C = Creditors Payment Period

Operating Cycle of Manufacturing Organisation:

Operating Cycle = R + W + F + D - C
Where, R = Raw Material Storage Period
W = Work in Progress Holding Period
F = Finished Goods Storage Period
D = Debtors Collection Period
C = Creditors Payment Period
Number of Operating Cycles = 360 days .

p.a. or Operating cycle Operating cycle period
turnover ratio in days
Average Working Capital Total Operating Costs

Requirement or Average = (excluding depreciation w/o)
Operating Cash Number of Operating
required to be Cycles p.a.
introduced for Working
Capital Purposes
Raw Materials Holding Period:

Raw Materials = Average Stock of Raw Materials x 360
Holding Period Raw Materials Consumed

Work in Progress Holding Period:

WIP Holding = Average Stock of WIP x 360
Period Net Factory Cost
Finished Goods Holding Period:

Finished Goods = Average Stock of Finished Goods x 360
Holding Period Cost of Goods Sold
Debtors Collection Period:

Debtors = Average Debtors/Receivables x 360
Collection Period Net Credit Sales
Creditors Payment Period:

Creditors = Average Creditors/Payables x 360
Payment Period Net Credit Purchases

CASH MANAGEMENT MODELS
1. William J. Baumol’s Certainty Model (1952):

OTS = 2 x A x T
C
Where, OTS = Optimum Transfer Size of cash
A = Annual or monthly Cash Disbursements
T = Fixed Costs per transaction
C = Opportunity Cost per rupee p.a. or p.m.
2. MILLER-ORR MODEL/ UNCERTAINTY MODEL

(1966):
RP = 3bσ2 1/3 + LL
4I
Where, RP = Return Point
b = Transaction Cost/ Conversion Cost
per transaction or Conversion
σ2 = Variance of daily change in expected Cash flows
or daily change in expected Cash flows
I = Daily Interest Rate
LL = Lower Limit
UL = Upper Limit

UL = 3RP – 2 x LL OR = RP + 2 x R
LL = RP – R
Where, R = 3bσ2 1/3
4I
WORKING CAPITAL INVESTMENT POLICY
Moderate/
Conservative Aggressive
Particulars Matching
Policy Policy
Policy
Amount of CA High Medium Low
Liquidity High Medium Low
Profitability Low Medium High
Risk Low Medium High

WORKING CAPITAL FINANCING POLICY
Moderate/
Conservative Aggressive
Particulars Matching
Approach Approach
Approach
(1) Short
Term Funds Low Medium High
/CL
(2) Finance Entire F.A., Entire FA Entire F.A.
out of Long Permanent & Perman- & a part of
term Funds C.A., A Part ent C.A. Permanent
of C.A.
temporary
C.A.
(3) Finance Part of Entire Entire
out of Temporary Tempo- Temporary
Short term C.A. rary C.A. C.A. & part
Funds of
Permanent
C.A.
(4) Liquidity High Medium Low
(5) Low Medium High
Profitability

(6) Best Performance in Recession Normal Boom

(7) Worst performance
Boom N.A. Recession
in
BASIC FORMAT OF CASH BUDGET
Particulars Jan. Feb. Mar.

Opening Cash Balance (A) ✓ ✓ ✓
Receipts:
Cash Sales ✓ ✓ ✓
Commission/ Dividend/ Rent/
Interest Received ✓ ✓ ✓
Cash Received from Debtors ✓ ✓ ✓
Issue of Shares
(Equity/Preference)/
Debentures ✓ ✓ ✓
Sale of F.A./ Investments ✓ ✓ ✓
Total (B) ✓ ✓ ✓

Particulars Jan. Feb. Mar.

Payments:
Suppliers of Materials ✓ ✓ ✓
Wages & Salaries ✓ ✓ ✓
Administration Overheads ✓ ✓ ✓
Production & S&D Overheads ✓ ✓ ✓
Purchase of F.A. &
Investments ✓ ✓ ✓
Redemption of Debentures/
Preference Shares ✓ ✓ ✓
Interest & Dividends Paid ✓ ✓ ✓
Total (C) ✓ ✓ ✓
Closing Cash Balance
(A)+(B)–(C) ✓ ✓ ✓

ESTIMATION OF WORKING CAPITAL

REQUIREMENT (TOTAL BASIS)
(A) Current Assets:

(I) Inventory of Raw Materials =
Raw Materials x Raw Materials Holding Period
Consumed 12/360/52
(II) Inventory of Work in Progress =
Raw Materials x WIP Holding Period x Degree of
Consumed 12/360/52 Completion
+ Conversion x WIP Holding Period x Degree of
Costs 12/360/52 Completion
If DOC is not known, assume DOC : RM = 100% & CC =
50%
(III) Inventory of Finished Goods =
Factory COGS x Finished Goods Holding Period
12/360/52
(IV) Debtors =
Net Credit Sales x Average Collection Period
12/360/52

(V) Prepaid Expenses =

Expenses for the year x Period of Pre-Payment
12/360/52
If DOC is not known, assume DOC: RM = 100% &
CC = 50%
(B) Current Liabilities:

(I) Creditors for Purchases of Raw Materials =
Net Credit Purchases x Average Payment Period
12/360/52
(II) Outstanding Expenses =
Expenses for the year x Period of Lag/Delay
12/360/52

ESTIMATION OF WORKING CAPITAL

REQUIREMENT (CASH COST BASIS)
(I) Inventory of Work in Progress =

Raw Materials x WIP Holding Period x Degree of
Consumed 12/360/52 Completion
Conversion Costs x WIP Holding Period x Degree of
excluding Dep. 12/360/52 Completion
(II) Inventory of Finished Goods =
Factory COGS x Finished Goods Holding Period
excluding Dep. 12/360/52
(III) Debtors =
Cash Cost of x Average Collection Period
Net Credit Sales 12/360/52

ESTIMATION OF ADDITIONAL WORKING

CAPITAL REQUIREMENT IN CASE OF
DOUBLE SHIFT OPERATIONS
Unless otherwise stated it will be assumed that:

1) Production & Sales (units) will be doubled.
2) Inventory of Raw Material & Finished Goods (in
units) will be doubled.
3) Fixed Cost (in total) will remain constant & Variable
Cost (per unit) will remain constant.
4) If Credit allowed to customers & credit allowed by
suppliers remains constant, then Debtors &
creditors (in units) will be doubled.
5) Inventory of WIP (in units) will remain constant.
6) Additional Working Capital requirement will be
computed on Cash Cost Basis.
AVERAGE INVESTMENT IN DEBTORS
Average = Cost of Net x ACP

Investment Credit 12 months/360 days/
in Debtors Sales 52 weeks

COST OF NET CREDIT SALES
1. Total Cost Approach: It considers the total of

Fixed Costs & Variable Costs of Credit Sales.
2. Marginal Cost Approach: It considers only the
Variable Costs & Additional Fixed Costs.
CREDIT POLICIES: LOOSENING OF CREDIT

PERIOD
Particulars Incremental Incremental

Gains Costs
Contribution Increase
Collection Costs Decrease
Bad Debts Increase
Opportunity Cost
of Investment in Increase
Debtors/WC
Fixed Costs Increase

CREDIT POLICIES: TIGHTENING OF

CREDIT PERIOD

Gains Costs
Contribution Decrease
Collection Costs Increase
Bad Debts Decrease
Opportunity Cost
of Investment in Decrease
Debtors/WC
Fixed Costs Decrease

CREDIT POLICIES: CASH DISCOUNT POLICY

Gains Costs
Contribution Increase
Collection Costs Decrease
Bad Debts Decrease
Opportunity Cost
of Investment in Decrease
Debtors/WC
Fixed Costs Increase
Cash Discount Increase
IMPLICIT ANNUAL INTEREST RATE ON

CASH DISCOUNT
Implicit Interest Rate on Cash Discount =

Cash discount on `100 x 365 / 12 x 100
`100 – Cash discount Period of
on `100 Prepayment

FLOATS
Average funds = Net Credit Sales x Days of Float

blocked in Floats 365/360 Days
FACTORING
Annual Savings on account of Factor’s Proposal:

Amount
Particulars
in (`)
Annual savings in Administration Charges xxx
Add: Savings in Bad-Debt Loss (in case of xxx
Factoring Service on non-recourse basis)
Annual Savings (A) xxx
Annual Costs on account of Factor’s Proposal:

Particulars Amount
Interest Charges p.a. xxx
Advance by Factor x Interest Rate p.a. to
the company
Add: Factor’s Commission p.a. xxx
Annual Costs (B) xxx
Net Cost p.a. (B) – (A) xxx

Computation of Advance by Factor to the Company:

Particulars Amount in (`)
Average Receivables
Credit Sales x ACP . xxx
12 /360
Less: Factoring Reserve (xxx)
Less: Factoring Commission on (xxx)
average receivables
Advance by Factor to the Company xxx
Effective Cost =
Net Cost
Advance - Advance x Interest x ACP .
by Factor by Factor Rate p.a. 12/360
to the to the
Company Company

MAXIMUM PERMISSIBLE BANK

FINANCE (MPBF) - TANDON COMMITTEE:
LENDING NORMS
Norm No. I
Current Assets ✓
Less: Current Liabilities (other than MBPF) (✓)
Net Working Capital ✓
Less: 25% thereof (✓)
MPBF ✓
Norm No. II
Current Assets ✓
Less: 25% thereof (✓)
75% of Current Assets ✓
MPBF ✓

Norm No. III

Current Assets ✓
Less: Hard-Core Current Assets (✓)
Soft-Core Current Assets ✓
Less: 25% of thereof (✓)
75% of Soft-Core Current Assets ✓
MBPF ✓
Computation of Current Ratio (CR) after Computing

MPBF with:
(1) Estimated Current Assets & Current Liabilities:
CR = Estimated Current Assets .
Estimated Other Current Liabilities + MPBF
(2) Actual Current Assets & Current Liabilities:
CR = Actual Current Assets
+ Cash receivable from MPBF .
Actual Current Liabilities + MPBF

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INDEX

Chap No. Chapter Page

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COST OF DEBT (Kd)

(A) Cost of Irredeemable/Perpetual Debt:

(B) Cost of Redeemable Debt:

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COST OF DEBT USING PRESENT VALUE

The cost of redeemable debt (Kd) is also calculated by

The relevant cash flows are as follows:

Year Cash Flows

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COST OF PREFERENCE SHARES (Kp)

(A) Cost of Irredeemable/Perpetual Preference Shares:

(B) Cost of Redeemable Preference Shares:

COST OF PREFERENCE SHARE CAPITAL

The cost of redeemable preference shares (Kp) is also

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The relevant cash flows are as follows:

Year Cash Flows

COST OF EQUITY (Ke)

1. Dividend Yield Model/Dividend Price Model:

2. Earnings Yield Model/Earning Price Model:

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3. Dividend Price Ratio plus Growth Method/

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4. Realised Yield Approach:

5. Capital Asset Pricing Model (CAPM):

Calculation of Beta of a Security:

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COST OF RETAINED EARNINGS (Kre)

Use same model for computing Kre as used for

Adjustment for Personal Income-Tax, Brokerage,

WEIGHTED AVERAGE COST OF CAPITAL

Ko = (Kd x Wd) + (Kp x Wp) + (Ke x We) + (Kre x Wre)

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SCHEDULE OF MARGINAL COST OF CAPITAL

Step I: Determine Pattern of raising marginal funds.

Current Yield = Next Annual Interest Income x 100

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INTRINSIC VALUE OF A BOND/

(A) Intrinsic Value of Irredeemable Bond/Debenture:

(B) Intrinsic Value of Redeemable Bond/Debenture:

INTRINSIC VALUE OF PREFERENCE SHARES

(A) Intrinsic Value of Perpetual/Irredeemable

Required Rate of Return

(B) Intrinsic Value of Redeemable Preference Shares:

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INTRINSIC VALUE OF EQUITY SHARES

(A) Constant Dividends receivable annually in

(B) Dividends growing annually at a perpetual growth

(C) Dividends growing abnormally for some years &

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Type of Risk Type of Leverage used to

CHART SHOWING DOL, DFL & DCL

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DEGREE OF OPERATING LEVERAGE (DOL)

DOL = Contribution = % ∆ EBIT

DEGREE OF FINANCIAL LEVERAGE (DFL)