Chartered Accountancy
Professional (CAP)- II
Study Material
For CAP II
Study Material
Financial
Management
Audit and
Assurance
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF NEPAL
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:
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: February, 2020
September, 2019
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Preface
This study material on the subject of ―Financial Management‖ has been exclusively designed
and developed for the students of Chartered Accountancy Professional [CAP]-II Level. It aims to
develop knowledge and understanding of financial management methods foranalyzing the
various sources of finance and capital investment opportunitiesand application of various tools
and techniques for business planning and control.
It broadly covers the chapters of Introduction and Fundamental Concepts of Financial
Management, Analysis of Financial Statements, Valuation of Securities, Capital Investment
Decision, Strategic Financial Decision, Working Capital Management and Financial Forecasting,
and Strategic Finance and Policy.
Students are requested to accustom with the syllabus of the subject and read each topic
thoroughly for understanding on the chapter. We believe this material will be of great help to the
students of CAP-II. However, they are advised to update themselves and refer recommended
text-books given in the CA Education Scheme and Syllabus along with other relevant materials
in the subject.
Last but the most, we acknowledge the efforts of CA. Sanjeev Dhakal, who has meticulously
assisted for preparation and updating this study material.
Due care
care has
has been
beentaken
takentotomake
makeevery
everychapter
chaptersimple,
simple,comprehensive
comprehensiveand
andrelevant
relevantfor
forthe
the
students.
In
case
students
need
any
clarification,
creative
feedbacks
or
suggestions
for
further
students. In case students need any clarification, creative feedbacks or suggestions for further
improvement on the material, they may be forwarded to education@ican.org.np of the
improvement on the material, they may be forwarded educationdepartment@ican.org.npto the
Institute.
Education Department.
The Institute of Chartered Accountants of Nepal
February, 2020
Education Department
The Institute of Chartered Accountants of Nepal
Syllabus
CAP-II Paper: 4 Financial Management
(One Paper - Three Hours - 100 Marks)
Level of Knowledge
Course objectives
: Working
• Develop knowledge and understanding of financial management
methods for analyzing the various sources of finance and
• Capital investment opportunities and application of various tools
and techniques for business planning and control.
Course contents
Introduction and Fundamental Concepts of Financial Management
• An overview of financial management
• Functions and objectives of financial management
Financial environment markets, institutions, and interest rates; risk and return the
basics, time value of money
Strategic Finance and Policy
• Capital structure introduction, shareholders' funds, methods of raising equity
finance, long- term debt finance
• Operating and financial gearing, gearing and the required return
• Cost of equity and debt capital, overall cost of capital
• Financial distress, signaling and agency costs.
Analysis of Financial Statements
• Overview, financial statement analysis and its precautions
• Horizontal analysis, vertical analysis, ratio analysis
• DuPont analysis, Cash flow analysis, analysis reporting
Valuation of Securities
• Fixed income securities-characteristics and valuation
• Common stock-characteristics, valuation and issuance, Hybrid securitiescharacteristics
Capital Investment Decision
• Concepts of cost of project
• Capital budgeting, evaluating cash flows, cash flow estimation
• Investment evaluation and capital rationing
Working Capital Management and Financial Forecasting
• Financial forecasting and working capital policy
• Short-term finance, management of cash and marketable securities, management of
accounts receivables, Short-term and long-term funding alternatives
Distribution Policy
• Dividend decision strategic and legal dimensions of dividend, theory of dividend
and retention policy
Overview of Capital Market
• Primary and secondary market
• Dematerialization, CDS, stock exchange, commodities exchange and regulatory
framework, mutual fund, International capital market
Investment opportunities in Nepalese Capital Market
• Key factors and indicators to be considered before making investment in capital
market
• IPO & secondary market
TABLE OF CONTENT
CHAPTER 1
Introduction & Fundamental Concepts of Financial Management
1.1 Learning Objectives
1.2 Chapter Overview
1.3 Introduction of Financial Managment
1.3.1 Overview of Financial Management
1.3.2 Meaning of Financial Management
1.3.3 Elements of Financial Management
1.3.4 Aspects of Financial Management
1.3.5 Objectives of Financial Management
1.3.6 Functions of Financial Management
1.3.7 The Financial Management Environment
1.3.8 Function of Chief Financial Officer/ Finance Manager
1.3.9 Risk, Uncertainty and Returns
1.3.10 Risk
1.3.11 Methods of Risk Management
1.3.12 Major Risk-Return Decision Areas
1.3.13 Portfolio Management Theory
1.3.15 Rate of Investments
1.3.16 Present Value of Investment
1.3.18 Annuity Payment
1.3.19 Perpetuity
CHAPTER 2
Strategic Finance Decision and Policy
2.1 Capital Finance Decision and Policy
2.1.1 Learning Objectives
2.1.2 Chapter Overview
2.1.3 Introduction
2.1.4 Capital Structure and Financial Structure
2.1.6 Optimum Capital Structure
2.1.7 Capital Structure Theories
2.1.8 Pecking Order Theory
2.1.9 Determination of Optimum Capital Structure
2.1.10 Factors Determining Capital Structure
2.1.11 Overcapitalization and Undercapitalization
2.1.12 Solutions of Knowledge Tests
2.2 Leverages
2.2.1 Learning Objectives
2.2.2 Chapter Overview
2.2.3 Introduction
2.3 Required Return and Cost of Capital
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2.3.1 Learning Objectives
2.3.2 Chapter Overview
2.3.3 Introduction
2.3.4 Importance of Cost of Capital
2.3.5 Cost of Debt Capital
2.3.6 Cost of Preference Share
2.3.7 The Cost of Equity Share Capital
2.3.8 Cost of Right Shares
2.3.9 Cost of Retained Earnings
2.3.10 Weighted Average Cost ofCapital
2.3.11 Marginal Cost of Capital (WMACC)
2.3.12 Financial Distress
2.3.13 Additional Knowledge Tests
2.3.14 Knowledge Test Answer
CHAPTER 3
Analysis of Financial Statements
3.1 Financial Statement Analysis
3.1.1 Learning Objectives
3.1.2 Chapter Overview
3.1.3 Overview of Financial Statement Analysis
3.1.4 Introduction
3.1.5 User of Financial Statements
3.1.6 Precautions in Financial Statement Analysis
3.1.7 Sources of Financial Data Analysis
3.1.8 Method of Financial Statement Analysis
3.1.9 Limitation of Financial Ratio Analysis
3.2 Ratio Analysis
3.2.1 Learning Objectives
3.2.2 Chapter Overview
3.2.3 Introduction
3.2.4 Basis of Evaluation
3.2.5 Importance of Financial Ratios
3.2.6 Limitations of Ratio Analysis
3.2.7 Types of Ratios
3.2.8 Dupont Analysis
3.3 Cash Flow Analysis
3.3.1 Learning Objectives
3.3.2 Chapter Overview
3.3.3 Introduction
3.3.4 Cash and Cash Equivalents
3.3.5 Presentation of Cash Flow Statement
3.3.6 Procedure in Preparation of Cash Flow Statement
3.3.7 Other Disclosure Requirements
3.3.8 Format of Cash Flow Statement
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CHAPTER 4
Valuation of Securities
4.1 Learning objectives
4.2 Chapter Overview
4.3 Introduction
4.4 Concept of Value
4.5 Required Rate of Return
4.6 Discount Rate
4.7 Fixed Income Securities
4.7.1 Features of a Bond / Debenture
4.7.2 Duration of Bond
4.7.3 Types of Bond/ Debenture
4.8 Preferred Stock/Preference Share
4.9 Common Stock or Equity Shares
4.9.1 Dividend Valuation Model
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CHAPTER 5
Capital Investment Decision
5.1 Learning Objectives
5.2 Chapter Overview
5.3 Introduction to Capital Budgeting
5.4 Significance of Capital Budgeting
5.5 Limitations of Capital Budgeting
5.6 Types of Capital Budgeting Decisions
5.6.1 Independent Decisions:
5.6.2 Mutually Exclusive Decisions:
5.6.3 Capital Rationing Decision
5.7 Approaches for Capital Budgeting
5.8 Comparision of the Approaches
5.9 Cashflow Approach
5.10 Cashflow Estimation
5.11 Evaluation Methology
5.12 Evaluation of Time Adjusted Methods of Appraising Investment Proposal
5.13 Reinvestment Rate Assumption
5.14 Capital Rationing
5.15 Capital Investment under Uncertainty
5.15.1 Sensitivity Analysis
5.15.2 Probability Analysis
5.16 Capital Budgeting Decision
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CHAPTER 6
Working Capital Management & Finanical Forecasting
6.1 Estimation of Working Capital
6.2 Inventory Management
6.2.1 Learning Objectives
381
381
382
411
411
6.2.2 Chapter Overview
6.2.3 Introduction
6.2.4 Objective of Inventory Management
6.2.5 Maintenance of Optimum Inventory Level
6.2.6 Economic Order Quantity
6.2.7 Reorder Level
6.3 Management of Account Receivable and Account Payable
6.3.1 Learning Objectives
6.3.2 Chapter Overview
6.3.3 Introduction
6.3.4 Meaning of Receivable
6.3.5 Objective of Maintaining Receivables
6.3.6 Cost of Maintaining Receivables
6.3.7 Objectives of Receivable Management
6.3.8 Credit Management
6.3.9 Sources of Short-Term Finance
6.3.10 Post-Shipment Finance
6.4 Management of Cash & Marketable Securities
6.4.1 Learning Objectives
6.4.2 Chapter Overview
6.4.3 Introduction of Cash Management
6.4.4 Motives for Holding Cash
6.4.5 Objectives of Cash Management
6.4.6 Cash Management Models
6.4.7 Cash Planning
6.4.8 Cash Budget
6.4.9 Cash Management: Basic Strategies
6.4.10 Cash Management Techniques/Processes
6.4.11 Marketable Securities
6.4.12 Answer of Knowledge Tests
CHAPTER 7
Dividend Decision
7.1 Learning Objectives
7.2 Chapter Overview
7.3 Introduction of Dividend Decisions
7.4 Significance of Dividend Policy
7.5 Relationship Between the Retained Earnings and Growth
7.6 Theories of Dividend Policy
7.6.1 Residual theory
7.6.2 Dividend Irrelevance Theory (MM Approach)
7.6.3 Dividend relevance Theory
7.6.4 Traditional Model
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CHAPTER 8
Overview of Capital Market
8.1 Overview of Capital Market
8.1.1 Learning Objectives
8.1.2 Chapter Overview
8.1.3 Financial Market
8.1.4 Capital Market
8.1.5 Participants in Capital Market
8.1.6 Stock Market
8.1.7 Stock Exchange
8.1.8 Dematerialization of Securities
8.1.9 Central Depository System (CDS)
8.2 Mutual Fund
8.2.1 Learning Objectives
8.2.2 Chapter Overview
8.2.3 Mutual Fund Introduction
8.2.4 Classification of mutual funds
8.2.5 Advantages of Mutual Funds
8.2.6 Disadvantages of Mutual Funds
8.2.7 Precautions While Investing in Mutual Funds
8.2.8 Evaluating Performance of Mutual Funds
8.2.9 Knowledge Test Solution
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CHAPTER 9
572
Investment Opportunities in Nepalese Capital Market
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9.1 Learning Objectives
573
9.2 Key Factors and Indicators to be considered before making Investment in Capital Market
573
9.3 Initial Public Offering (IPO)/ Primary Market
574
9.4 Glance at Major Investment Opportunities in Nepal
575
9.4.1 Energy- Hydropower, Green Energy
575
9.4.2 Agriculture
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9.4.3 Tourism
575
9.4.4 Hotel and Hospitality
576
9.4.5 Mining
576
APPENDIX
Appendix: Time Value of Money Tables
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Introduction & Fundamental Concepts of Financial Management
Chapter 1
Introduction & Fundamental Concepts of Financial Management
The Institute of Chartered Accountants of Nepal | 1
Chapter 1
Financial Management
1.1 Learning Objectives
Upon completion of this chapter student will be able to:
 Explain the nature and purpose of financial management
 Explain the function of financial management
 Identify the nature and role of capital markets
 Identify the nature and role of money markets
 Explain the role of banks and financial institutions in the operation of the money market
 Explain and differentiate risk and uncertainty
 Define portfolio management theory
 Discuss the objectives of financial management; Profit maximization vis-a-vis Wealth
maximization.
 Explain the concept of time value of money
 Calculate the future value of a sum by compounding
 Calculate the present value (PV) of a single sum using discount table
 Calculate the PV of an annuity & perpetuity using formula
 Calculate the PV of an annuity using annuity table
1.2 Chapter Overview
Introduction & Fundamental
Concept of Financial Management
Objective of
Financial
Management
Profit
Maximization
Function of
Financial
Management
Financial
Environment
Risk Uncertainty
and Returns
Wealth
Maximization
Money Market
Business Risk
Capital Market
Financial RIsk
Figure: Chapter Overview of Financial Management
2 |The Institute of Chartered Accountants of Nepal
Time Value
of Money
Introduction & Fundamental Concepts of Financial Management
1.3 Introduction of Financial Managment
1.3.1 Overview of Financial Management
Finance is regarded as the life blood of a business enterprise. This is because in the modern
money-oriented economy, finance is one of the basic foundations of all kinds of economic
activities. It is the master key which provides access to all the sources for being employed in
manufacturing and merchandising activities. It has rightly been said that business needs money
to make more money. However, it is also true that money begets more money, only when it is
properly managed. Hence, efficient management of every business enterprise is closely linked
with efficient management of its finance.
Understanding of Financial Statements from following diagram.
•Investment Appraisal
( Decide which long
term assests need to
purchase) and
working capital
requirements.
•Decision about
retention of money
/distribute as a
dividend
•Identify the sources of
finance (Debt,
preference Share,
Equity Shares)
Step
1
Step
2
Step
4
Step
3
•Calculate the cost of
capital for each
source of finance.
Figure: Stages of Financial Management- Basic Concept
The given below figure depicts the overview of the scope and functions of financial
management. It also gives the interrelation between the market value, financial decisions and
risk return trade off. The finance manager, in a bid to maximize shareholders‘ wealth, should
strive to maximize returns in relation to the given risk; he should seek courses of actions that
avoid unnecessary risks. To ensure maximum return, funds flowing in and out of the firm should
be constantly monitored to assure that they are safeguarded and properly utilized.
The Institute of Chartered Accountants of Nepal | 3
Chapter 1
Financial Management
Financial
Management
Wealth
Maximization
Financial
Decision
Financing
Decision
Return
Investment
Decision
Dividend
Decision
Risk
Figure: Overview of Financial Management
1.3.2 Meaning of Financial Management
Financial management is that managerial activity which is concerned with the planning and
controlling of the firm‘s financial resources. It is an integrated decision-making process
concerned with acquiring, financing and managing financial resources to accomplish the overall
goal of a business organization. It can also be stated as the process of planning, directing,
monitoring, organizing and controlling of the monetary resources in order to maximize the
shareholder‘s wealth. Financial managers have a major role in cash management, acquisition of
funds and in all aspects of raising and allocating capital. As far as business organizations are
concerned, the objective of financial management is to maximize the value of business.
Financial Management can also be defined as planning for the future of a business enterprise to
ensure a positive cash flow. Some experts also refer to financial management as the science of
money management. It can be defined as;
4 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
―Financial Management comprises of forecasting, planning, organizing, directing, coordinating
and controlling of all activities relating to acquisition and application of the financial resources
of an undertaking in keeping with its financial objective.”
According to Soloman, “Financial management is concerned with the efficient use of an
important economic resource, namely, Capital Funds.”
Phillippatus has given a more elaborated definition of the term financial management. According
to him ―Financial Management is concerned with the managerial decisions that result in the
acquisition and financing of short term and long-term credits for the firm.” As such it deals with
the situations that require selection of specific assets or combination of assets. The analysis of
these decisions is based on the expected inflows and outflows of funds and their effect on
managerial objectives.‖
One more definition of financial management is that “Financial management deals with
procurement of funds and their effective utilization in the business.”
Financial management can also be stated as “The management of all the processes associated
with the efficient acquisition and deployment of both short- and long-term financial resources.”
Thus, financial management is mainly concerned with the proper management of funds. The
finance manager must see that the funds are procured in a manner that the risk, cost and control
considerations are properly balanced in a given situation and there is optimum utilization of
funds.
1.3.3 Elements of Financial Management
Elements of financial management is divided into three parts;
 Investment decisions includes investment in fixed assets (called as capital budgeting).
Investment in current assets are also a part of investment decisions called as working
capital decisions. - Where to invest the money?
 Financial decisions - They relate to the raising of finance from various resources which
will depend upon decision on type of source, period of financing, cost of financing and
the returns thereby. Where to get the money from?
 Dividend decision - The finance manager has to take decision with regards to the net
profit distribution. How much to distribute amongst shareholders to keep them
satisfied?
Net profits are generally divided into two:
 Dividend for shareholders- Dividend and the rate of it has to be decided.
 Retained profits- Amount of retained profits has to be finalized which will
depend upon expansion and diversification plans of the enterprise.
1.3.4 Aspects of Financial Management
There are two basic aspects of financial management viz., procurement of funds and an effective
use of these funds to achieve business objectives.
The Institute of Chartered Accountants of Nepal | 5
Chapter 1
Financial Management
a) Procurement of Fund
Since funds can be obtained from different sources therefore their procurement is
always considered as a complex problem by business concerns.
Sources of finance for business are equity, debt, debentures, retained earnings, term
loans, working capital loans, letter of credit, euro issue, venture funding etc. These
sources of funds are used in different situations. They are classified based on time
period, ownership and control, and their source of generation. It is ideal to evaluate each
source of capital before opting for it.
Sources of Finance
Equity Share Capital
Preference Share
Capital
Retained Earnings
Debenture Bonds
Loans from Financial
Institutions
Others
Figure: Source of Finance
b) Utilization of Fund
All the funds are procured at a certain cost and after entailing a certain amount of risk. If
these funds are not utilized in the manner so that they generate an income higher than
the cost of procuring them, there is no point in running the business. Hence, it is crucial
to employ the funds properly and profitably. Some of the aspects of funds utilization
are: i.
Investment Decisions/Capital Budgeting
Investment decisions involve utilization/application of funds in the right mix of
projects and fixed assets to maximize the returns for the organization. There are
various techniques used like Net Present Value, Internal Rate of Return, and Payback
Period etc.
6 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
ii.
Working Capital Management Decisions
Working capital management is a very important day to day activity for a finance
manager. It spreads over both the broader functions i.e. procurement as well as
utilization of funds. It mainly involves management of current assets and current
liabilities and keeps the gap between two managed as per the available funds with the
organization.
1.3.5 Objectives of Financial Management
a) Profit Maximization
Traditionally, the basic objectives of financial management are the maintenance of liquid assets
and maximization of the profitability of the firm. This implies that the finance manager has to
make his decisions in a manner so that the profits of the concern are maximized. Each
alternative, therefore, is to be seen as to whether or not it gives maximum profits.
Maintenance of liquid assets means that the firm has adequate cash in hand to meet its obligation
at all times. A business firm is a profit seeking organization. Hence, profit maximization is all
well considered to be an important objective of financial management. However, the concept of
profit maximization has come under severe criticism in recent times on account of the following
reasons:
 The term profit is vague. It does not clarify what exactly it means. It conveys a different
meaning to different people. For example, profit may be in short term or long-term period; it
may be total profit or rate of profit etc.
 Profit maximization has to be attempted with a realization of risks involved. There is a
direct relationship between risk and return. Many risky propositions yield high return.
Higher the risk, higher is the possibility of profits. If profit maximization is the only goal,
then risk factor is altogether ignored. This implies that finance manager will accept highly
risky proposals also, if they give high profits. In practice, however, risk is very important
consideration and has to be balanced with the profit objective.
 Profit maximization as an objective does not take into account the time pattern of
returns. Proposal A may give a higher amount of profits as compared to proposal B, yet if
the returns begin to flow say 10 years later, proposal B may be preferred which may have
lower overall profit, but the returns flow is earlier and quicker.
 Long-run versus short run issues: In any business it is possible to boost short-term profits
as the expense of long-term profits. For example, discretionary spending on training,
advertising, repairs and research and development (R&D) may be cut. This will improve
reported profits in the short term but may impact the long-term prospect of the business.
 Profit maximization as an objective is too narrow. It fails to take into account the social
considerations as also the obligations to various interests of workers, consumers, society, as
well as ethical trade practices. If these factors are ignored, a company cannot survive for
long. Profit maximization at the cost of social and moral obligations is a short-sighted
policy.
The Institute of Chartered Accountants of Nepal | 7
Chapter 1
Financial Management
b) Wealth / value maximization
Wealth= present value of benefits-present value of costs
Wealth maximization is the concept of increasing the value of a business in order to increase the
value of the shares held by stockholders. The concept requires a company's management team to
continually search for the highest possible returns on funds invested in the business, while
mitigating any associated risk of loss. This calls for a detailed analysis of the cash flows
associated with each prospective investment, as well as constant attention to the strategic
direction of the organization.
The wealth of the shareholder is measured by the share price of the stock, which in turn is based
on the timing of return (cash Flow), their magnitude and their risk. When considering each
financial decision alternative or possible action in terms of its impact on the share price of the
company‘s stock, finance manager should accept only those action that are expected to increase
the share price. This paradigm is built upon the assumption of competitive markets in the
economy. Essentially, it is assumed that all participants who have transactions with a firm employees, suppliers, customers, lenders, etc. - are seen as willing participants in free and
competitive markets and are fully compensated at fair market prices for their services/supplies or
get fairly valued products/services for the prices they pay.
The shareholders are unique because they are residual claimants and they do not have prior
explicit or implicit claims. They can add to their wealth only after satisfying all the prior claims
of every other participant. They bear all the risk of failure and therefore it is only fair that they
get the rewards. Given these assumptions, shareholder wealth maximization is good for not only
the shareholders and but also the society because the shareholders‘ wealth comes from wealth
created by the firm after fully compensating everyone involved and the society for all the
resources used.
The share value is affected by many things. If a company is able to make good sales and build a
good name for itself, in the industry, the company‘s share value goes up. If the company makes a
risky investment, people may lose confidence in the company and the share value will come
down. So, this means that the finance manager has the power to influence decisions regarding
finances of the company. The decisions should be such that the share value does not decrease.
Thus, wealth or value maximization is the most important goal of financial management.
How do we measure the value/wealth of a firm?
According to Van Horne, ―Value of a firm is represented by the market price of the company's
common stock. The market price of a firm's stock represents the focal judgment of all market
participants as to what the value of the particular firm is. It takes into account present and
prospective future earnings per share, the timing and risk of these earnings, the dividend policy
of the firm and many other factors that bear upon the market price of the stock. The market price
serves as a performance index or report card of the firm's progress. It indicates how well
management is doing on behalf of stockholders.”
8 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
Value of Firm (V) = Number of shares (N) x Market Price of Share
Or
(V)= value of equity (Ve) + Value of debt (Vd)
c) Differentiate Profit Maximization and Wealth Maximization
The essential difference between the maximization of profits and the maximization of wealth is
that the profits focus is on short-term earnings, while the wealth focus is on increasing the
overall value of the business entity over time. These differences are substantial, as noted below:
Planning duration. Under profit maximization, the immediate increase of profits is
paramount, so management may elect not to pay for discretionary expenses, such as
advertising, research, and maintenance. Under wealth maximization, management
always pays for the discretionary expenditures.
 Risk management. Under profit maximization, management minimizes expenditures, so
it is less likely to pay for hedges that could reduce the organization's risk profile. A
wealth-focused company would work on risk mitigation, so its risk of loss is reduced.
 Pricing strategy. When management wants to maximize profits, its prices products as
high as possible in order to increase margins. A wealth-oriented company could do the
reverse, electing to reduce prices in order to build market share over the long term.
 Capacity planning. A profit-oriented business will spend just enough on its productive
capacity to handle the existing sales level and perhaps the short-term sales forecast. A
wealth-oriented business will spend more heavily on capacity in order to meet its longterm sales projections.

It should be apparent from the preceding discussion that profit maximization is a strictly shortterm approach to managing a business, which could be damaging over the long term. Wealth
maximization focuses attention on the long term, requiring a larger investment and lower shortterm profits, but with a long-term payoff that increases the value of the business.
Key Takeaway – Profit Maximization and Wealth Maximization
The company may pursue profit maximization goal but that may not result into creation of
shareholder value. The profits will be maximized if company grows through diversification
and expansion. But all growth may not be profitable. Only that growth is profitable where
ROA > WACC or ROE > KE or
Firms invest in project with positive NPV,
However, profit maximization cannot be the sole objective of a company. It is at best a
limited objective. If profit is given undue importance, a number of problems can arise like
the term profit is vague, profit maximization has to be attempted with a realization of risks
involved, it does not take into account the time pattern of returns and as an objective it is too
narrow.
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Whereas, on the other hand, wealth maximization, as an objective, means that the company
is using its resources in a good manner. If the share value is to stay high, the company has to
reduce its costs and use the resources properly. If the company follows the goal of wealth
maximization, it means that the company will promote only those policies that will lead to
an efficient allocation of resources.
1.3.6 Functions of Financial Management
To achieve wealth maximization, the finance manager has to take careful decision in respectof:
a) Decision related to investment:
These decisions determine how scarce resources in terms of funds available are committed to
projects which can range from acquiring a piece of plant to the acquisition of another company.
Funds procured from different sources have to be invested in various kinds of assets. Long term
funds are used in a project for various fixed assets and also for current assets. The investment of
funds in a project has to be made after careful assessment of the various projects through capital
budgeting. A part of long-term funds is also to be kept for financing the working capital
requirements. Asset management policies are to be laid down regarding various items of current
assets. The inventory policy would be determined by the production manager and the finance
manager keeping in view the requirement of production and the future price estimates of raw
materials and the availability of funds.
b) Financing decisions:
These decisions relate to acquiring the optimum finance to meet financial objectives and seeing
that fixed and working capital are effectively managed. The financial manager needs to possess a
good knowledge of the sources of available funds and their respective costs and needs to ensure
that the company has a sound capital structure, i.e. a proper balance between equity capital and
debt. Such managers also need to have a very clear understanding as to the difference between
profit and cash flow, bearing in mind that profit is of little avail unless the organization is
adequately supported by cash to pay for assets and sustain the working capital cycle.
Financing decisions also call for a good knowledge of evaluation of risk, e.g. excessive debt
carried high risk for an organization‘s equity because of the priority rights of the lenders. A
major area for risk-related decisions is in overseas trading, where an organization is vulnerable
to currency fluctuations, and the manager must be well aware of the various protective
procedures such as hedging (it is a strategy designed to minimize, reduce or cancel out the risk in
another investment) available to him. For example, someone who has a shop takes care of the
risk of the goods being destroyed by fire by hedging it via a fire insurance contract.
c) Dividend decisions:
These decisions relate to the determination as to how much and how frequently cash can be paid
out of the profits of an organization as income for its owners/shareholders. The owner of any
profit-making organization looks for reward for his investment in two ways, the growth of the
capital invested and the cash paid out as income; for a sole trader this income would be termed
as drawings and for a limited liability company the term is dividends.
10 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
The dividend decisions thus has two elements – the amount to be paid out and the amount to be
retained to support the growth of the organization, the latter being also a financing decision; the
level and regular growth of dividends represent a significant factor in determining a profitmaking company‘s market value, i.e. the value placed on its shares by the stock market.
All three types of decisions are interrelated, the first two pertaining to any kind of organization
while the third relates only to profit-making organizations, thus it can be seen that financial
management is of vital importance at every level of business activity, from a sole trader to the
largest multinational corporation. It is instructive to think this point through by taking the case of
the sole trader; thus he has to invest capital in a shop, fittings and equipment and in the purchase
of stock and sustaining debtors (working capital), he has to have sources of capital to finance his
investment such as his own capital and bank borrowings, and he has to make dividend decisions
to determine how much can be reasonably withdrawn from the business to ensure that it will
remain sufficiently liquid and, if desired, capable of growth.
1.3.7 The Financial Management Environment
All the businesses operate within the financial system, which consists of a financial market and
number of institutions serving business firm, individual and the regulatory bodies. When
business firm compete with each other in the product markets, they must continually interact
with the financial market. This ever-changing financial environment in which the capital is
raised became the importance to the finance manager and individual investor to know details of
their investment opportunities
The Finanicial
Environment
Financial
Institutions
Financial Markets
Financial
Securities/
Instruments
Tresury Function
Capital Market
Money Market
Figure: Overview of Financial Environment
a) Financial Markets
Financial markets represent physical location or electronic forums that facilitate the flow of
funds among investors, firms, government units and agencies. Financial markets provide the
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mechanism for allocating financial resources or funds from savers to borrowers. Individuals
make decisions as an investors, financial managers or rational decision maker. Investment
decisions involves decision-making relating to issuing and investing in stocks and bonds.
Similarly, Financial decisions in business involves decision-making relating to the efficient use
of financial resources in the production and sale of goods and services. Each financial market is
served by financial institutions that act as intermediaries.
The equity marketfacilitates the sale of equity by firms to investors or between investors. Some
financial institutions serve as intermediaries by executing transactions between willing buyers
and sellers of stock at agreed-upon prices.
The debt marketsenable firms to obtain debt financing from institutional and individual investors
or to transfer ownership of debt securities between investors. Some financial institutions serve as
intermediaries by facilitating the exchange of funds in return for debt securities at an agreedupon price.
Thus, it is quite common for one financial institution to act as the institutional investor while
another financial institution serves as the intermediary by executing the transaction that transfers
funds to a firm that needs financing. For example, Merrill Lynch (a financial institution) serves
as an intermediary in an offering of new shares by Intel (a firm in need of financing) by selling
these shares to investors, including the California Public Employees Retirement Fund (a
financial institution).
i)
The Role of Financial Markets
Within each sector of the economy (households, firms and governmental organization) there are
times when there are cash surpluses and times when there are deficits.
 In the case of surpluses, the party concerned will seek to invest/deposit/lend funds to
earn an economic return
 In the case of deficits, the party will seek to borrow funds to manage their liquidity
position.
The financial markets are mechanism where those requiring fund (deficit units) can get in touch
with those able to supply it (surplus units), i.e. allowing the buyers and sellers of finance to get
together.
ii) Types of Financial Markets
Financial markets may be divided into two parts.
a. Money Market:
The market concerned with buying and selling of short term (less than one-year original
maturity) government and corporate debt securities is called money market.
12 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
Commercial
Paper
Mutual Fund
Money
Market
Banker's
Acceptance
Certificate
of Deposit
Repurchage
Agreement
Figure: Overview of Money Markets
b.
Capital Market:
The market concerned with relatively long term (greater than one-year original maturity) debt
and equity instruments (e.g. bonds and stocks) is called capital market.
Equity
Shares
Preferenc
e Shares
Capital
Market
Bonds
Debentur
e
Figure: Overview of Capital Market
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Within the Capital and Money markets there exists both primary and secondary market.
 Primary Market:
A market where new securities are bought and sold for the first time (a ―new issues‖ market) is
called primary market. A primary market is a ―new issues‖ market. Here funds raised through
the sale of new securities flow from the ultimate savers to the ultimate investors in real assets.
This market brings together, the supply and demand; or sources and uses of new capital funds.
The main source of funds, in this market, is the domestic savings of individuals, or business.
Other sources include foreign investors and government.
A financial intermediary indirectly channels the largest part of individual‘s savings to the new
issue market, in a highly developed capital market. It is significant fact that, most individual
investors are unaware of relevant significant matters about the new issue‘s markets, and its
institutions that operate between the corporate demanders of funds and the individual investors,
and financial institutions, that supply the funds.
Figure: Primary Market-Introduction
 Secondary Market:
A market where existing (used) securities are bought and sold rather than new issues are called
secondary market. In a secondary market, existing securities are bought and sold. Transactions in
these already existing securities do not provide additional funds to the business.
The stock exchange or the secondary securities markets are basically known as secondary
market. The purpose is to help buyers and sellers to transact their business more quickly and
cheaply, than they would have been able to accomplish it all by themselves. There is significant
matter that should not be lost sight of in this context: a stock exchange typically deals in existing
securities, rather than in new issues. Therefore, its economic significance may be misunderstood.
Channeling of savings into capital formation is the primary function of the capital market; and
hence, its economic significance is to be traced to the impact it makes on the process of the
allocation of capital resources among a set of alternative uses. Since each single instance of the
purchase of an existing security, is automatically offset in exactly equal measure, by the sale of
the same security, an increase in the volume of trading in securities in the stock market does not
mean that, an increase has taken place in the economy‘s aggregate savings.
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Introduction & Fundamental Concepts of Financial Management
Only by distinguishing between the primary securities market, and the secondary securities
market, can the task of placing the capital market in the proper perspective. It is the volume of
net new issues of securities, that is used to measure an increase in savings in the form of
ownership of securities, when the economy is viewed as a whole; while transactions in existing
securities represent merely a shift among the ownership of such securities, and this invariably
cancels out in the aggregate. Similarly, additional funds are not provided for the purpose of
capital formation, through the transactions in existing securities. Only the volume of net new
issues provides additional capital to entrepreneurship and business communities.
Figure: Secondary Market- Introduction
Problems in Capital Market in Nepal
The state of affairs in the secondary market is still not good. The manner in which the stock
exchange functioned was not all satisfactory. Insider trading played havoc, with speculative
activity on a large scale, leading to stockbrokers defaulting in considerable measure. The trading
systems in place were mostly inefficient and outdated. All this led to lack of transparency in
trading operations. The risk management system in the market also failed to function
satisfactorily. Some serious faults like high rate of bad deliveries, delay in making settlements,
clubbing of settlements at times etc.; made post trade settlement procedure also seem suspect.
The methods meant to protect investors interest, did not install much confidence to the investor.
As a result, there has been clamor for measure to improve levels of transparency and efficiency
in the Nepalese capital market.
Stock Markets
A country‘s stock market is the institution that embodies many of the processes of the capital
market. Essentially, it is the market for the issued securities of public companies, government
bonds, loans issued by local authority and other publicly- owned institutions, and some
overseas stocks. A stock market assists the allocation of capital to industry, if the market
thinks highly of a company, that company‘s share will rise in value and it will be able to rise
fresh capital through the new issue market at relatively low costs.
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Financial Management
b)
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Financial Institutions
Financial institutions are that financial intermediaries that accept money from savers and use that
fund to make loans and investments in their own name. They include commercial banks, savings
institutions, Insurance companies, pension funds, finance companies and mutual funds. The flow
of funds from savers to investors in real assets can be direct; if there are financial intermediaries
in an economy the flow can also be indirect. These intermediaries come between ultimate
borrowers and lenders by transforming direct claims into indirect claims. Financial
intermediaries purchase direct (or primary) securities and in turn issue their own indirect (or
secondary) securities to the public. For example, A life insurance company purchase corporate
bonds (primary securities) and issue life insurance policies (secondary securities) to the public.
i)
a.
Types of Financial Institutions
Banks
The primary purpose of banks is to take in business deposits and to lend funds to businesses.
Banks are the most important source of funds for business firms in aggregate. Banks acquire
deposits from individuals, companies and government and in turn make loan and investments.
Besides performing a banking function, commercial banks also invest in corporate bonds and
stocks.
b.
Savings or Loans intermediaries
Savings or loans intermediaries‘ primary purpose is to take in deposits from households and to
lend funds for home and consumer loans.
c.
Credit Unions
Credit Unions are owned by depositors (share owners) who are individuals, not businesses.
Credit Unions take in funds and primarily make personal loans.
d.
Finance Companies
Non-bank firms that borrow funds to make short- and medium-term loans to higher risk
borrowers. These companies raise capital through stock issues as well as through borrowing
some of which are long term but most of it comes from commercial banks.
e.
Insurance Companies
Insurance companies whether life or non-life, receives premiums for insurance policies. This
pool of funds is used to reimburse policyholders who incur losses that are covered under the
policy.
 Life Insurers: Life insurance companies take saving in the forms of annual premium, invest
in long term securities and finally make payment to beneficiaries of the insured parties.
 Non-Life Insurers: Insure against damage to person and property (health, autos, homes,
theft, earthquake, etc.) Property and casualty insurance companies invest in municipal bonds
16 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
which offer tax exempt interest income, to a lesser extent they also invest in stocks and
bonds issued by various companies.
f.
Pension Funds
Workers and/or employers contribute funds for the pension fund to invest. The accumulated
funds are used to pay benefits at retirement. Because of the long nature of the liabilities pension
funds are able to invest in long term securities. As a result, they invest heavily in corporate
bonds and stock.
c) Financial Securities/Instruments
A financial instrument is any contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity.
The definition is wide and includes cash, deposits in other entities, trade receivables, loans to
other entities. investments in debt instruments, investments in shares and other equity
instruments.
A financial instrument may be evidence of ownership of part of something, as in stocks and
shares. Bonds, which are contractual rights to receive cash, are financial instruments.
Financial
Instruments
Primary
Equity instruments
Bonds, loans, borrowings,
Receivables & Payable,
Deposits of Cash
Derivatives
Combination
Forward & futures Financial
options Swaps Caps &
Collars, Financial Guarantee
etc.
Convertible debt,
Exchangeable debt, Dual
Currency bonds, Equity
linked notes
Figure: Types of Financial Instruments
d) Treasury Function
All treasury management activities are concerned with managing the liquidity of a business, the
importance of which to the survival and growth of a business cannot be over-emphasized.
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 The role of treasury function
a) Short-term management of resources
 Short term cash management-lending/borrowing funds as required
 Currency management
b) Long-term maximization of shareholder wealth
 Raising long-term finance, including equity strategy, management of debt capacity
and debt and equity structure.
 Investment decisions, including investment appraisal, the review of acquisitions
and divestments.
 Dividend policy
c) Risk Management
 Assessing risk exposure
 Interest rate risk management
 Hedging of foreign exchange risk
Many larger organizations will often operate a separate treasury department, separate from the
finance department. In smaller companies though, the treasury function will form part of the
responsibilities of the finance team.
1.3.8 Function of Chief Financial Officer/ Finance Manager
A chief financial officer (CFO) is the senior executive responsible for managing the financial
actions of a company. The CFO's duties include tracking cash flow and financial planning as
well as analyzing the company's financial strengths and weaknesses and proposing corrective
actions.
The CFO is similar to a treasurer or controller because they are responsible for managing the
finance and accounting divisions and for ensuring that the company‘s financial reports are
accurate and completed in a timely manner.
The primary job responsibility of the Chief Financial Officer (CFO) is to optimize the financial
performance of a company, including its reporting, liquidity, and return on investment
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Introduction & Fundamental Concepts of Financial Management
Liquidity (Treasury)
Chief
Finance
Officer
Reporting
Financial Planning
and Analysis
Fig: Role of Chief Financial Officer/Finance Manager
1.3.8.1 Reporting
Reporting takes up a lot of a CFO‘s time, and this responsibility typically resides in the
Controller‘s group. This team of professionals prepares all of the company‘s historical financial
reports required for shareholders, employees, lenders, research analysts, governments, and
regulatory bodies. This group is responsible for ensuring all reporting is prepared in an accurate
and timely manner.
1.3.8.2 Liquidity
The CFO needs to ensure the company is able to meet its financial commitments and manage
cash flow in the most efficient way. These responsibilities are usually carried out by the treasury
group, which is often smaller than the reporting team. This group is tasked with managing the
company‘s cash balance and working capital, such as accounts payable, accounts receivable, and
inventory. They also carry out the issuing of any debt, managing investments, and handle other
liquidity-related decisions.
1.3.8.3 Return on Investment
The third thing a CFO does is help earn the company earn the highest possible risk-adjusted
return on assets and return on capital (or return on equity). This is where the financial planning
and analysis – FP&A team – comes in to help the CFO forecast future cash flow of the business
and then compare actual results to what was budgeted. The FP&A team plays a critical role in
analytics and decision making in the business.
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If the company has a corporate development team, they also play a big part in creating (or
attempting to create) optimal investment returns for the business.
Key Takeaway- Role of CFO
FUNCTIONS OF A CHIEF FINANCIAL OFFICER (CFO)/ FINANCE MANAGER
The twin aspects viz procurement and effective utilization of funds are the crucial tasks, which
the CFO faces. The Chief Finance Officer is required to look into financial implications of any
decision in the firm. Thus, all decisions involving management of funds come under the
purview of finance manager. These are namely
 Estimating requirement of funds: Determining the proper amount of funds to
employ in the firm, i.e. Designating the size of the firm and its rate of growth.
 Decision regarding capital structure: Raising funds on favorable terms as possible
i.e. determining the composition of liabilities.
 Investment decisions: The efficient allocation of funds to specific assets.
 Dividend decision: The finance manager is also concerned with the decision to pay
or retain the profits earned by the company.
 Cash management: The finance manager has also to ensure that all the departments
and branches are having adequate cash balance for day to day operations of the
business. Departments or Branches which have an excess of funds have to contribute
to the central pool for use in other sections which need funds.
 Evaluating financial performance: A finance manager has to constantly review the
financial performance of the various units of the organizations.
 Financial negotiation: Finance manager should deal with the Banks, Financial
Institutions and Private Money lenders to ensure that the Borrowings is within the
authority of the company and is supported by provisions of Companies Act. He
should negotiate for the cost of debt.
 Credit Management:
 Determination of credit worthiness of customers.
 Orderly handling of collection.
 Handling cash discounts and terms of Sale for prompt payment.
1.3.9 Risk, Uncertainty and Returns
A business firm carries its operations in an environment which is not within its control. It is
exposed to all sorts of dangers both on account of internal as well as external factors. It may not
be in a position to withstand its competitors. Its products may deteriorate or become obsolete and
thus suffer a fall in their market values. Its properties may be stolen or destroyed. Its employees
may embezzle the money while its customers may fail to pay their advances on account of
bankruptcy.
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A Finance Manager has to keep all these dangers in view. He has to maintain the profitability
and liquidity of the firm keeping in view the overall objective of the firm. He has to keep himself
prepared not only to meet the planned funds requirement of the firm under ideal circumstances
but also those which may occasionally arise due to unforeseen contingencies and under most
trying conditions.
The present chapter provides an overall view of changing operating environment within which a
business firm has to function. It analyses the relationship between risk and return. It also outlines
the major areas with respect to risk and return regarding which the Finance Manager has to take
decisions for maximizing the firm's wealth.
a. Risk
Risk may be defined as "the chance of future loss that can be foreseen." In other words, in case
of risk an estimate can be made about the degree of happening of the loss. This is usually done
by assigning probabilities to the risk on the basis of past data and the probable trends.
Example 1
A firm submitted bids in respect of 200 projects during its last 10 years. Its bids were accepted in
respect of 40 such projects. It is again submitting its bid for 201st project.
On the basis of past experience, it can be said that the chances of accepting the firm's bid for the
201st project are 20%. In other words, the chances of the bid being rejected are 80%.
b. Uncertainty
Uncertainty may be defined as "the unforeseen chance for future loss or damages." In case of
uncertainty since the firm cannot anticipate the future loss and hence it cannot directly deal with
it in its planning process, as is possible in the case of risk.
Example 2
A firm cannot foresee the loss which may be due to destruction of its plant on account of natural
calamity like flood, hurricane or earthquake. In cases where occurrence of such natural calamity
can be anticipated, the firm can possibly estimate the likelihood of the loss and such loss does
not, therefore, fall in the purview of ―uncertainty‖, but will fall in the terms "Risk".
Distinction between risk and uncertainty
Risk: there area number of possible outcomes and the probability of each outcome is known.
For example, based on past experience of digging for oil in a particular area, an oil company
may estimate that they have a 60% chance of finding oil and a 40% chance of not finding oil.
Uncertainty: there are a number of possible outcomes, but the probability of each outcome is
not known.
For example, the same oil company may dig for oil in a previously unexplored area. The
company knows that it is possible for them to either find or not find oil, but it does not know
the probabilities of each of these outcomes.
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c. Return
One of the important functions of the Finance Manager is to measure return which the business
earns on account of its operations. The return represents the benefits derived by a business from
its operations. Different persons give different meanings to these benefits and hence there are
different approaches for the measurement of return. These approaches are as follows:
i)
Profit Approach
According to this approach, the return from a business is measured on the basis of the profit it
earns. However, the term profit does not have a specific meaning. According to the definition
given by accountants, the term profits is the excess of the revenues over expenses of a business
over a period, while the economists, hold a different opinion about the meaning of the term
profit. According to them, profit is the reward to the entrepreneur for bearing the risk.
However, it will be appropriate for the Finance Manager to adopt the accountant's approach
while defining the term profit. The approach is particularly useful while reporting financial
results to the shareholders, tax authorities or other stakeholders.
ii) Income Approach
The term income has a more specific and definite meaning as compared to the term profit.
Income always indicates that a precise accounting process has been followed in its computation.
Hence, income may be defined as "accounting measurement of profits".
The terms income and earnings are synonymous. There are three terms that are used for
recording income or earnings.
 Earnings before interest and Tax (EBIT): It represents to excess of the firm‘s operating
revenues over its operating expenses. It is also termed as Operating profit before interest and
Tax (OPBIT) since it represents the operating income of the business.
 Earnings before Tax (EBT): It represents the excess of the firm's total revenue and its total
expenses. The revenues include both operating and non-operating incomes. Similarly, the
expenses include both operating and non-operating/financial expenses.
 Earnings after Tax (EAT) : This represents excess of all revenues over all expenses and
taxes paid by the firm. This approach is particularly useful for the Finance Manager while
computing the profitability of two or more firms from the viewpoint of different persons
interested in the firm.
iii) Cash Flow Approach
According to this approach, the return from a business is measured in terms of the cash flows
generated by it due to operations during a particular period. As a matter of fact, some of the
business charges (e.g., depreciation, amortization of preliminary expenses, etc.) do not result in
any outflow of cash. Hence, they are added back to the accounting profits of the business to
compute the cash from operations. If the payments are larger than the revenues, the firm has a
net cash outflow.
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This approach is particularly suitable for the Finance Manager while taking capital budgeting
decisions, as explained later in the book.
iv) Ratios Approach
The term ratio means mathematical relationship between two figures. A Finance Manager uses
different accounting ratios for measuring and comparing the performance of the firm over
different time periods or of his firm with another.
In order that ratios serve as useful yardstick for comparing and measuring performance of a firm,
it is necessary that they are based on proper accounting figures and used with caution.
d. Relationship between risk and return
The rate of return required by a firm, to a great extent, depends upon the risk involved. Higher
the risk, greater is the return expected by the firm. The rate of return required by the business
consists of the components:
i) Return at Zero Risk
This refers to the expected rate of return where a project involves no risk whether business or
financial.
ii) Premium for Business Risk
The term business risk refers to the variability in operating profit (EBIT) due to change in sales.
In case of a project having more than the normal or average risk, the firm will expect a higher
rate of return than the normal rate. Hence, the return expected by the business will go up.
Similarly, if the project involves a lower degree of risk that the normal level, the return expected
by the firm will come down.
iii) Premium for Financial Risk
The term financial risk refers to the risk on account of pattern of capital structure (debt-equity
mix). A firm having higher debt content in its capital structure expects a higher rate of return as
compared to a firm which has comparatively low debt content. This is because, in the former
case, the firm requires higher operating profit to cover periodic interest payments and repayment
of principal at the time of maturity as compared to the latter.
The above three components may be put in the form of the following equation:
Rate of Return = ro +b + f
ro
= Return as Zero Risk
b
= Premium for Business Risk
f
= Premium for Financial Risk
e. General pattern of risk and return
It has generally been found while evaluating capital investment proposals that there is a direct
relationship between risk and return. A capital investment proposal involving low risk has low
return while a capital investment proposal involving higher risk has higher return.
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Financial Management
The relationship between the general pattern of risk and return from specific proposals can be
presented in the form of a chart for speedier and between decision.
Example 3
The following are the details regarding the degree of risk and return from different projects:
Risk
Project
Return (%)
A
Low
20
B
Medium
low
28
C
Medium
32
D
Medium
High
36
E
High
40
Plot the above data on a graph and show which project is most acceptable keeping in view the
risk and return involved
Solution:
Figure No. 12- Pattern of Risk-Return
The above diagram shows that projects A, B, C and E are giving returns commensurate with the
degree of risk involved, i.e. higher the risk, the greater is the return. However, project D is giving
a higher rate of return as compared medium-high degree of risk in view of the fact that it is
giving 36% return. Hence, out of these proposals, the project D is most acceptable.
f. Criteria for evaluating proposals to minimize risk
It has been stated in the preceding pages that a project giving higher rate of return involves a
higher degree of risk. While selecting a project, a firm has to keep in mind its capacity to bear
the risk. It cannot jeopardize its existence merely for seeking higher profits. It is, therefore,
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necessary for a firm to select or reject a project on the basis of risk involved. This criterion may
be fixed keeping in view the following points.
i. Select the Least Risky Proposals
According to this criterion a firm will accept only that proposal which has the least risk. For this
purpose, all proposals are arranged according to the degree of risk involved in a
descending/ascending order. The proposal having the least risk is accepted. In case two or more
proposals are to be accepted, those having minimum risk are chosen.
For example, in the Example 2, given above, project A has the least risk. Hence, the firm will
accept this proposal. However, if the firm has to accept two projects, it can select projects A and
B which have less risk as compared to the other projects.
ii. Apply Hurdle Rates
According to this criterion, the firm determines different hurdle rates for different risk levels.
The firm may decide the minimum acceptable return and any return below such minimum return
it is not going to accept the proposal. This will be clear from the following Example.
Illustration No. 1
A firm has determined the following expected rates of return keeping in view the degree of
risk involved in the proposals:
Degree of Risk
Expected Return
Low
24%
Medium Low
28%
Medium
32%
Medium High
40%
High
48%
The firm has the following proposals with it.
Degree Risk
Project
High
Medium
Expected rate of return
X
44%
Y
30%
P
20%
Q
34%
State, which of the above proposals can be accepted by the firm?
Illustration No. 1- Solution
Solution: Out of the proposals in High risk category, none of the proposals can be accepted
since they are all giving return below the required rate of return, which is 48%.
The Institute of Chartered Accountants of Nepal | 25
Chapter 1
Financial Management
Out of the Medium degree risk proposals, the firm can accept only proposal Q, which is giving
a 34% return. Proposals p has to be rejected since it is giving only 20% return as compared to
32% return required from such a category of proposals.
iii. Avoid Proposals with Fluctuating Risks
In order to minimize risk; it is necessary that those proposals which have larger fluctuation in the
returns should be avoided. For example, a proposal having fluctuations in the returns from 15%
to 20% should be preferred as compared to a project giving return from 10% to 40%.
iv. Adopt Weighted Average Approach
It will be more appropriate to adopt a weighted average approach while identifying a project on
the basis of risk and return. This involves the taking of following steps:
(a) Identification of possible future conditions.
(b) Determination of the probabilities of each possible future condition.
(c) Determination of the return under each future condition.
(d) Computing the estimated return keeping the view the probabilities as determined under (b).
(e) Computation of the weighted expected return.
These steps can be understood with the help of the following Examples.
Illustration No. 2
A firm is considering two alternative proposals for the next summer.
(i) Purchasing and selling air-conditioners.
(ii) Purchasing and selling raincoats.
The firm has limited space available in its stores. It can accommodate only one item at a time.
From the following details, you are required to identify the alternative which would be most
profitable for the firm:
Air-conditioners
Weather
Probability
(%)
Net Return
[Rs]
Hot Summer
20
60,000
Normal Summer
Cool Summer
55
25
40,000
[10,000]
100
Raincoats
Weather
Wet Summer
26 |The Institute of Chartered Accountants of Nepal
Probability
(%)
Net Return
(Rs)
20
80,000
Introduction & Fundamental Concepts of Financial Management
Normal Summer
60
30,000
Dry Summer
20
20,000
100
Illustration No. 2- Solution
Solution
(i) Statement Showing the Expected Return from Marketing Air – Conditioners
Weather
Probability
Net Return
Weighted Return
(%)
(Rs)
(Rs)
20
60,000
12,000
Normal summer
55
40,000
22,000
Cool Summer
25
(10,000)
(2,500)
Hot summer
100
31,500
(ii) Statement Showing the Expected Return from Marketing Raincoats
Weather
Probability
Net Return
Weighted Return
(%)
(Rs.)
(Rs.)
Wet Summer
Normal Summer
Dry Summer
20
80,000
16,000
60
20
30,000
20,000
18,000
4,000
100
38,000
The above calculations show that the raincoats are expected to give a return of Rs. 38,000 in
the coming season as compared to Rs. 31,500 by air-conditioners. Hence, it will be advisable
for the firm to market raincoats as compared to marketing air-conditioners in the coming
season.
Knowledge Test 1- Fresh Blossoms
Fresh Blossoms Ltd is always discarding old lines and introducing new lines of products and
is at present considering three alternative promotional plans for ushering in new products.
Various combinations of prices, development expenditures and promotional outlays are
involved in these plants. High, medium and low forecasts of revenues under each plan have
been formulated; and their respective probabilities of occurrence have been estimated. Their
budgeted revenues and probabilities along with other relevant data are summarized as under.
`Rs. In Lakhs
Plan I
Budgeted
Revenue
Plan II
Plan III
With
The Institute of Chartered Accountants of Nepal | 27
Chapter 1
Financial Management
probability
High
Medium
Low
Variable cost as % of revenue
30(30%)
24(20%)
50(20%)
20(30%)
20(70%)
25(50%)
5(40%)
15(10%)
0(30%)
60%
75%
70%
25
20
24
8
8
8
Initial investment
Life in years
The company's cost of capital is 12%; the income tax rate is 40%.
Investment in promotional programmes will be amortized by the straight time method. The
company will have net taxable income in each year. Regardless of the success or failure of the
new products. The present value of an annuity of Re. 1 at 12% for 8 years is 4.9676.
(a) Substantiating with figures make a detailed analysis and find out which of the promotional
plans is expected to be the most profitable.
(b) In the event the worst happened, which of the plans would result in maximizing profit?
Illustration No. 3
A Ltd. has a choice between three Product X, Y and Z. The following information has been
estimated.
(Profits) Rs. 000
Product
Kathmandu
Butwal
Pokhara
X
190
50
15
Y
110
200
160
Z
150
140
110
Probabilities of Profit are Kathmandu = 0.6, Butwal = 0.2, Pokhara = 0.2
(a)
Which project should be undertaken if decision is made by expected value approach?
(b)
Calculate the expected value of perfect information?
Illustration No. 3- Solution
Solution
(a)
Computation of expected Values
Product
Sector
Profit [Rs. 000]
Product X
Kathmandu
190
0.6
114
Butwal
50
0.2
10
Pokhara
15
0.2
3
28 |The Institute of Chartered Accountants of Nepal
Probability
Profit [Rs. 000]
Introduction & Fundamental Concepts of Financial Management
Expected Value (EV)
Product Y
127
Kathmandu
110
0.6
66
Butwal
200
0.2
40
Pokhara
160
0.2
32
Expected Value (EV)
Product Z
138
Kathmandu
150
0.6
90
Butwal
140
0.2
28
Pokhara
110
0.2
22
Expected Value (EV)
140
The above analysis shows that Project Z should be undertaken because it has the highest EV
of Rs. 1,40,000
(b)
Computation of Expected Value (EV) of Perfect Information
Sector
Product
Profit
Probability
Expected Value
Selected
[Rs. 000]
Kathmandu
X
190
0.6
114
Butwal
Y
200
0.2
40
Pokhara
Y
160
0.2
32
[Rs. 000]
Expected Value With perfect information
186
Hence, Expected Value of the perfect information = 186 — 140 = Rs 46
i.e. Rs. 46,000.
Knowledge Test 2- Nepal Comfort
Nepal Comfort Homes Pvt Ltd propose to install a central air-conditioning system in their city
office building. As part of the company's long-range plan, the office building is due to be
disposed of on 31st December 2017 and the company believes that whichever system is
installed, it will add some Rs. 1 lakh to the resale value at that time. Three systems—gas, oil
and solid fuel are regarded as feasible. Nepal Comfort Homes Pvt Ltd estimate that the costs
of installing and running the three systems are as follows:
(i)
Installation costs (payable at the end of each year):
Rs.
Gas
1,70,000
The Institute of Chartered Accountants of Nepal | 29
Chapter 1
Financial Management
Oil
1,50,000
Solid Fuel
1,40,000
(ii)
Annual Fuel costs (payable at the end of each year):
Annual fuel costs will depend on the severity of the weather each year and on the rate of
increase in fuel prices. At the prices expected to exist during 2015, annual fuel costs will be:
Severe Weather
Mild Weather
Rs.
Rs.
Gas
40,000
24,000
Oil
53,000
37,000
45,000
36,000
Solid Fuel
The company estimates that in each year there is a 70% chance of severe weather and a 30%
chance of mild weather. The chance of particular weather in any one year is independent of
the weather in other years.
Fuel prices during 2016 and 2017 are expected to increase at either 15% per annum
(Probability equal to 0.4) or 25% per annum 2016 will be repeated in 2017
(iii)
Maintenance costs [payable at the end of the year in which they are incurred]
Rs.
Gas
2,5000 per annum
Oil
2,000 Per annum
Solid Fuel
10,000 in 2016
All maintenance costs are fixed by contract when the system is for air-conditioning purposes.
They have a cost of capital of 20% per annum in money terms.
Required:
(a) Prepare calculations showing which central air-conditioning system should be installed,
assuming that the decision will be based on the expected present values of the costs of
each system.
(b) The discounting factors at 20% for years 1, 2 and 3 are 0.833, 0.694 and 0.579
respectively.
1.3.10 Risk
As risk is attached with every return hence calculation of only expected return is not
sufficient for decision making. Therefore, risk aspect should also be considered along with the
expected return. The most popular measure of risk is the variance or standard deviation of the
probability distribution of possible returns.
30 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
Variance is generally denoted by σ2 and is calculated by using the following formula:
𝑛𝑛
𝑖𝑖=1
[ 𝑋𝑋1 − 𝑋𝑋 2 p(Xi)]
Illustration No. 4
Calculate the risk i.e. variance or standard deviation (SD)
Possible return (%)
20
30
40
50
60
Probability
0.20
0.20
0.40
0.10
0.10
Illustration No. 4- Solution
Possible
Return
(X)
20
30
40
50
60
Probability
(P)
0.20
0.20
0.40
0.10
0.10
X*P
4.00
6.00
16.00
5.00
6.00
37.00
Deviation
(X-X̅ )
-17.00
-7.00
3.00
13.00
23.00
Square of (XX̅ )
289.00
49.00
9.00
169.00
529.00
𝑷𝑷 ∗ 𝑿𝑿 − 𝑿𝑿
𝟐𝟐
57.80
9.80
3.60
16.90
52.90
141.00
Variance = 141
Standard Deviation of the return will be the positive square root of the variance and is
generallyrepresented by σ. Accordingly, the standard deviation of return in the aboveexample
will be under root of 141 = 11.87%.
1.3.10.1 Measurement of Systematic Risk
systematic risk is the variability in security returns caused by changes in the economy
or the market and all securities are affected by such changes to some extent. Some
securities exhibit greater variability in response to market changes and some may exhibit less
response. Securities that are more sensitive to changes in factors are said to have higher
systematic risk. The average effect of a change in the economy can be represented by the
change in the stock market index. The systematic risk of a security can be measured by
relating that security‘s variability vis-à-vis variability in the stock market index. A higher
variability would indicate higher systematic risk and vice versa.
The Institute of Chartered Accountants of Nepal | 31
Chapter 1
Financial Management
Correlation Method : Using this method beta (β) can be calculated from the historical data of
returns by the following formula:
βi =
Correlation coefficient (ϒim) ∗ Ϭi ∗ Ϭm
Ϭ2 𝑚𝑚
ϒim = Correlation coefficient between the returns of the stock i and the returns of the market
index.
Ϭi = Standard deviation of returns of stock i
Ϭm = Standard deviation of returns of the market index.
Ϭ2 𝑚𝑚= Variance of the market returns
1.3.10.2 Portfolio Analysis
Portfolio Return:
For a portfolio analysis an investor first needs to specify the list of securities eligible
for selection or inclusion in the portfolio. Then he has to generate the risk-return
expectations for these securities. The expected return for the portfolio is expressed as the mean
of its rates of return over the time horizon under consideration and risk for the portfolio
is the variance or standard deviation of these rates of return around the mean return.
The expected return of a portfolio of assets is simply the weighted average of the
returns of the individual securities constituting the portfolio. The weights to be applied for
calculation of the portfolio return are the fractions of the portfolio invested in such securities.
𝒓𝒓𝒑𝒑 =
r̅p = Expected return of the portfolio.
Xi= Proportion of funds invested in security
r̅i=Expected return of security i.
n= Number of securities in the portfolio.
𝒏𝒏
𝒊𝒊=𝟏𝟏
𝑿𝑿𝑿𝑿 𝑿𝑿𝑿̅𝒊𝒊
Portfolio Risk:
As discussed earlier, the variance of return and standard deviation of return are statistical
measures that are used for measuring risk in investment. The variance of a portfolio can be
written down as the sum of 2 terms, one containing the aggregate of the weighted variances of
the constituent securities and the other containing the weighted co- variances among
different pairs of securities.
32 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
Covariance (a statistical measure) between two securities or two portfolios or a security and a
portfolio indicate how the rates of return for the two concerned entities behave relative
to each other. The covariance between two securities A and B may be calculated using the
following formula:
𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴 =
𝑅𝑅𝑅𝑅 𝑅 𝑅𝑅 𝐴𝐴 𝑅𝑅𝑅𝑅 𝑅 𝑅𝑅 𝐵𝐵
𝑁𝑁
COVAB = Covariance between x and y.
RA= Return of security x.
RB= Return of security y.
R̅ = Expected or mean return of security x.
R̅ = Expected or mean return of security y.
N = Number of observations.
The Coefficient of Correlation is expressed as:
ϒ𝐴𝐴𝐴𝐴 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
Ϭ𝐴𝐴 𝐴 𝐴𝐴𝐴
ϒAB = Coefficient of correlation between x and y.
CovAB = Covariance between A and B.
σA= Standard deviation of A.
σB = Standard deviation of B.
It may be noted on the basis of above formula the covariance can be expressed as the
product of correlation between the securities and the standard deviation of each of the
securities as shown below:
CovAB = ϒAB ∗ σA ∗ σB
is very important to note that the correlation coefficients may range from -1 to 1. A value of -1
indicates perfect negative correlation between the two securities‘ returns, while a value of +1
indicates a perfect positive correlation between them. A value of zero indicates that the
returns are independent.
The calculation of the variance (or risk) of a portfolio is not simply a weighted average of the
variances of the individual securities in the portfolio as in the calculation of the return
of portfolio. The variance of a portfolio with only two securities in it can be calculated
with the following formula:
σp2 = 𝑋𝑋12 σ12 + 𝑋𝑋22 σ22 + 2𝑋𝑋1 ∗ 𝑋𝑋2 ∗ ϒ12 ∗ σ1 ∗ σ2
The Institute of Chartered Accountants of Nepal | 33
Chapter 1
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Ϭ2 𝑝𝑝 = Portfolio variance.
x1 = Proportion of funds invested in the first security.
x2 = Proportion of funds invested in the second security (x1+x2 = 1).
Ϭ2 1= Variance of first security.
Ϭ2 2= Variance of second security.
σ1= Standard deviation of first security.
σ2= Standard deviation of second security.
ϒ12 = Correlation coefficient between the returns of the first and second securities
Perfectly Positively Correlated:
In case two securities returns are perfectly positively correlated the correlation coefficient
between these securities will be +1 and the returns of these securities then move up or
down together.
As ϒ12 = -1
σp2 = 𝑋𝑋12 σ12 + 𝑋𝑋22 σ22 + 2𝑋𝑋1 ∗ 𝑋𝑋2 ∗ ϒ12 ∗ σ1 ∗ σ2
σp2 = 𝑋𝑋12 σ12 + 𝑋𝑋22 σ22 − 2𝑋𝑋1 ∗ 𝑋𝑋2 ∗ σ1 ∗ σ2
Hence, Standard Deviation σp = X1σ1 − X2σ2
Perfectly Negatively Correlated:
In case two securities returns are perfectly positively correlated the correlation coefficient
between these securities will be -1 and the returns of these securities then move up or
down together.
As ϒ12 = 1
σp2 = 𝑋𝑋12 σ12 + 𝑋𝑋22 σ22 + 2𝑋𝑋1 ∗ 𝑋𝑋2 ∗ ϒ12 ∗ σ1 ∗ σ2
σp2 = 𝑋𝑋12 σ12 + 𝑋𝑋22 σ22 + 2𝑋𝑋1 ∗ 𝑋𝑋2 ∗ σ1 ∗ σ2
Hence, Standard Deviation σp = X1σ1 + X2σ2
Illustration No. 5
Consider the following information on two stocks, A and B:
Year
Return on A (%)
Return on B (%)
2018
10
12
2019
16
18
You are required to determine:
34 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
i.
The expected return on a portfolio containing A and B in the proportion of 40% and
60% respectively.
The Standard Deviation of return from each of the two stocks.
The covariance of returns from the two stocks.
Correlation coefficient between the returns of the two stocks.
The risk of a portfolio containing A and B in the proportion of 40% and 60%.
ii.
iii.
iv.
v.
Illustration No. 5- Solution
i.
Expected return of the portfolio A and B
E (A) = (10 + 16) / 2 = 13%
E (B) = (12 + 18) / 2 = 15%
Rp = 0.4 (13) + 0.6 (15) = 14.2%
ii.
Stock A:
Variance
Standard deviation
= 0.5 (10 – 13)² + 0.5 (16– 13) ² = 9
= √ 9=3%
Stock B:
Variance = 0.5 (12 – 15) ² + 0.5 (18– 15) ² = 9
Standard deviation = 3%
iii.
Covariance of stocks A and B
COVAB = 0.5 (10– 13) (12– 15) + 0.5 (16– 13) (18– 15) = 9
iv.
Correlation of coefficient
CORAB = COVAB/σAσB = 9/3 x 3 = 1
v.
Portfolio Risk
Since, CORAB = 1SD of the portfolio can be calculated as weighted average of
SD of individual securities
σp = 0.4 (3) + 0.6 (3) = 3%
Illustration No. 6
Following information is available on Return (%) of shares of two companies A andB :
Probabilities
Return of A
Return of B
0.05
6
8
0.2
12
18
0.5
20
28
0.2
24
34
0.05
30
44
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Chapter 1
Financial Management
(i) Compute expected return from the portfolio
(ii) If the investment in A and B is in the ratio of 70:30 what is the risk of the portfolio ?
Illustration No. 6 Solution
(i)
Expected Return and SD for Stock A and Stock B
Stock A
Return
Probability
X.P
6
0.05
0.3
12
0.2
2.4
20
0.5
24
30
d (X – 𝑿𝑿̅)
d2 = (x – 𝒙𝒙̅) 2
d2 . P
10
0.2
0.05
-13
169
8.45
49
9.8
1
1
0.5
4.8
5
25
5
1.5
11
121
6.05
-7
19
29.8
Mean = 19
SD =√29.80 = 5.46%
Stock B
Return
Probability
X.P
6
0.05
0.4
12
0.2
3.6
20
0.5
14
24
0.2
80
0.05
d (X – 𝑿𝑿̅)
d2 = (x – 𝒙𝒙̅) 2
-19
d2 . p
361
18.1
81
16.2
1
1
0.5
6.8
7
49
9.8
2.2
17
289
14.5
-9
27
59
Mean = 27
SD = √59 = 7.68%
(ii)
Risk of the portfolio at 70:30 ratio is
Probability DA
DB DA 𝒙𝒙 DB
DADB.P
0.05
-13
-19
247
12.35
0.2
-7
-9
63
12.6
0.5
1
1
1
0.5
36 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
0.2
5
7
35
7
0.05
11
17
187
9.35
41.8
CORAB = COVAB/σAσB = 41.80 / (5.46 x 7.68) = 41.80 /41.9328 = 0.9968
Ϭ𝑝𝑝 = 𝑊𝑊𝑡𝑡𝑡𝑡2 Ϭ𝐴𝐴2 + 𝑊𝑊𝑡𝑡𝑡𝑡 2 Ϭ𝐵𝐵2 + 2𝑊𝑊𝑊𝑊𝑊𝑊 ∗ 𝑊𝑊𝑊𝑊𝑊𝑊 ∗ Ϭ𝐴𝐴 ∗ Ϭ𝐵𝐵 ∗ 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
σp = 6.12
Illustration No. 7
Following is the data regarding six securities:
Securities
A
B
C
D
E
F
Return (%)
8
8
12
4
9
8
Risk (%)
4
5
12
4
5
6
Required:
i.
Which of the securities will be selected for investment?
ii.
Assuming perfect positive correlation, analyses whether it is preferable to invest 75%
of fund in security A and 25% in security C.
Illustration No. 7- Solution
i.
Security A has a return of 8% for a risk of 4%, whereas securities B and F have a
higher risk for the same rate of return. Hence security A dominates securities B and F.
For the samedegree of risk of 4% security D has only a return of 4%. Hence, this
security is also dominated by A. Securities C and E has a higher return as well as a
higher degree of risk. Hence the securities which will be selected are A, C and E.
ii.
When perfect positive correlation exists between two securities, their risk and return
can be averaged with the proportion. Hence the average value of A and C together for
a proportion of 3 : 1 for risk and return will be as follows:
Risk = 0.75×4+0.25×12 = 6%
Return 0.75×8+0.25×12 = 9%
Comparing the above average risk and return with security E, it is better to invest in E
as it has lesser risk (5%) for the same return of 9%.
The Institute of Chartered Accountants of Nepal | 37
Financial Management
Chapter 1
1.3.11 Methods of Risk Management
It has already been stated in the preceding pages that risk is inherent in business and hence there
is no escape from the risk for a businessman, however, he may face this problem with greater
confidence if he adopts a scientific approach by dealing with risk. Risk management may,
therefore, be defined as adoption of a scientific approach to the problem dealing with risk faced
by a business firm or an individual broadly, there are five methods in general for risk
management.
a. Avoidance of Risk
A business firm can avoid risk by not accepting any assignment or any transaction which
involves any type of risk whatsoever. This will naturally mean a very low volume of business
activities and losing of too many profitable activities.
b. Prevention of Risk
In case of this method, the business avoids risk by taking appropriate steps for prevention of
business risk or avoiding loss. Such steps include adoption of safety programmes, installation of
burglar alarm and extinguisher, employment of night security guard, arranging for medical care
and disposal of waste material. Etc.
c. Retention of Risk
In case of this method, the organization voluntarily accepts the risk since either the risk is
insignificant or its acceptance will be cheaper as compared to avoiding it.
d. Transfer of Risk
In case of this method, risk is transferred to some other person or organization. In other words,
under this method, a person who is subject to risk may induce another person to assume the risk,
some of the techniques used for transfer of risk are hedging sub-contracts etc.
1.3.12 Major Risk-Return Decision Areas
A Finance Manager has to choose between risk and return in every area of financial management
without endangering the liquidity of the firm. The major decision areas linked to risk and return
can be identified as follows.
i)
Financial Analysis and Control
This area is concerned with the Financial Statements i.e. Income Statement, Balance Sheet,
Funds Flow Statement, Cash Flow Statement, etc. which provide an overall view of the financial
position of the business. These statements provide the finance manager with important operating
and financial information to assess and evaluate the liquidity and financial position of the
business. He is in a position to measure risk and return associated with different areas of the
firm's activities.
ii) Budgeting and profit planning
This area is concerned with forecasting the future operating and financial performance of the
firm. He is in a position to compare alternative choices of action and select one which gives him
maximum profit with minimum risk.
38 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
iii) Capital Budgeting
This area is concerned with long-term planning for proposed capital outlays and their financing.
It includes both raising of long-term funds and their utilization. The Finance Manager with the
help of various capital budgeting techniques is in a position to predict the consequences of
accepting different investment proposals and identify those which are more profitable keeping in
view the risk and return involved.
iv) Financial planning
This area is concerned with estimating the amount of capital to be raised, determining the form
and proportionate amount of securities and laying down the policies as to the administration of
the financial plan. In order to get the maximum benefits, it is necessary that the Finance Manager
raises the funds of the right amount by right securities and at the right time.
v) Working Capital Management
This area is concerned with the problems that arise in attempting to manage the current assets,
current liabilities and the inter-relationship that exists between them. It is a crucial area for the
Finance Manager. Profitability and liquidity are the issues related to working capital
management and these two issues are balanced by risk preference. Accordingly, higher
investment in current assets may increase profitability and low investment in current assets
decreases the working capital which increases the risk but also increases the profitability.
vi) Cost of Capital
This area is concerned with determination of the rate of return the firm requires from its
investments in order to maximize the value of the firm's shares. Cost of capital determines the
minimum rate of return or cut-off point for accepting or rejecting investment in new projects.
This area is, therefore, of considerable significance for the Finance Manager.
vii) Valuation Theory
This area is concerned with valuing the firm's shares under current and potential operating
conditions. It also tries to identify the steps to be taken to increase firm's wealth.
viii) Acquisitions
This area is concerned with financial and operating impacts which a firm must consider while
deciding about the acquisition of another firm. It helps in determining the firm's value which
must be paid for acquisition of other firm's shares.
1.3.13 Portfolio Management Theory
The portfolio is a collection of investment instruments like shares, mutual funds, bonds, FDs and
other cash equivalents, etc. Portfolio management is the art of selecting the right investment
tools in the right proportion to generate optimum returns with a balance of risk from the
investment made.
In other words, a portfolio is a group of assets. The portfolio gives an opportunity to diversify
risk. Diversification of risk does not mean that there will be an elimination of risk. With every
asset, there is an attachment of two types of risk; diversifiable/unique/unexplained/unsystematic
The Institute of Chartered Accountants of Nepal | 39
Financial Management
Chapter 1
risk and undiversifiable/ market risk / explained /systematic risk. Even an optimum portfolio
cannot eliminate market risk but can only reduce or eliminate the diversifiable risk. As soon as
risk reduces, the variability of return reduces.
Best portfolio management practice runs on the principle of minimum risk and maximum return
within a given time frame. A portfolio is built based on investor‘s income, investment budget
and risk appetite keeping the expected rate of return in mind.
1.3.13.1 Objective of Portfolio Management
When the portfolio manager builds a portfolio, he should keep the following objectives in mind
based on an individual‘s expectation. The choice of one or more of these depends on the
investor‘s personal preference.







Capital Growth
Security of Principal Amount Invested
Liquidity
Marketability of Securities Invested in
Diversification of Risk
Consistent Returns
Tax Planning
1.3.13.2 Types of Portfolio Management
Portfolio Management is further of the following types:
 Active Portfolio Management: As the name suggests, in an active portfolio management
service, the portfolio managers are actively involved in buying and selling of securities to
ensure maximum profits to individuals.
 Passive Portfolio Management: In a passive portfolio management, the portfolio manager
deals with a fixed portfolio designed to match the current market scenario.
 Discretionary Portfolio management services: In Discretionary portfolio management
services, an individual authorizes a portfolio manager to take care of his financial needs on
his behalf. The individual issues money to the portfolio manager who in turn takes care of
all his investment needs, paperwork, documentation, filing and so on. In discretionary
portfolio management, the portfolio manager has full rights to take decisions on his client‘s
behalf.
 Non-Discretionary Portfolio management services: In non-discretionary portfolio
management services, the portfolio manager can merely advise the client what is good and
bad for him, but the client reserves full right to take his own decisions.
40 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
1.3.14 Time Value of Money
Most financial transactions involve a series of cash flows - regular or irregular - over a period of
time. When evaluating these cash flows the basic concept used is the time value of money. If you
are offered the choice between having Rs. 100 today and having Rs. 100 at a future date, you
will usually prefer to have Rs. 100 now. If the choice is between paying Rs. 100 now or paying
the same Rs. 100 at a future date, you will usually prefer to pay Rs. 100 later. But why is this?
Rs. 100 has the same value one year from now also. Actually, although the value is the same,
you can do much more with the money if you have it now; over the time you can earn some
interest on your money.
The time value of money (TVM) is one of the basic concepts of finance. We know that if we
deposit money in a bank account, we will receive interest. Because of this, we prefer to receive
money today rather than the same amount in the future. Money, we receive today is more
valuable to us than money received in the future by the amount of interest we can earn with the
money. This is referred to as the time value of money.
The term time value of money can be defined as ―The value derived from the use of money over
time as a result of investment and reinvestment. This term may refer to either present value or
future value calculations. The present value is the value today of an amount that would exist in
the future with a stated investment rate called the discount rate.‖ For example, with a 10%
annual discount rate, the present value today of Rs. 110 one year from now is Rs. 100.
Causes of Time Value of Money
The reason why there is time value of money is as follows:
i.
ii.
iii.
Opportunity Cost: There are alternative productive uses of money. The cost of any
decision includes the cost of the next best opportunity forgone. You can save and invest,
get interest and spend.
Inflation: It erodes the value of money.
Risk: There are always financial and non-financial risks involved.
1.3.15 Rate of Investments
The trade-off between money now and money later depends on, among other things, the rate of
interest that can be earn by investing. It impacts business finance, consumer finance and
government finance. Time value of money results from the concept of interest.
Interest rate is the cost of borrowing money as a yearly percentage. For investors, interest rate is
the rate earned on an investment as a yearly percentage.
i. Simple interest
It may be defined as ―Interest calculated as a simple percentage of the original principal
amount‖. The simple interest ‗I‘ on a principal ‗P‘ borrowed at the rate of ‗i‘ per annum for a
period of ‗t‘ years is given by:
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
The Institute of Chartered Accountants of Nepal | 41
Chapter 1
Financial Management
It must be noted that i is represented in decimals and is part of one unit. If the rate of interest is
in percent, i can be calculated by dividing it by 100.
If we add principal to the interest, we will get the total amount (A).
A= P+ I
Illustration No. 8
If you invest Rs 10,000 in a bank at simple interest of 9% per annum, what will be the amount
at the end of three years?
Illustration No. 8- Solution
Solution
Total Amount(A) = Principle (P) + Interest (i)
= P + P×i×t
= 10,000 + 10,000× 7/100×3
= 12,100
ii. Compound interest
Compound interest is the interest that accrues on a deposit or investment that uses compounding
which basically means that interest is paid both on previously earned interest and as well as on
the principal. In other words, interest due at the end of unit payment periods added to the
principal and interest on the next payment period is computed on the new principal. Naturally,
the amount calculated on the basis of compound interest rate is higher than when calculated with
the simple rate.
Compounding periods refer to the frequency with which interest is applied to the investment.
Interest may be compounded daily, weekly, monthly, semiannually, or annually. A key
relationship exists between time and interest rate. The shorter the compounding period, the
higher the effective annual interest rate (the actual rate earned on the investment after taking the
effect of compounding into account). For example, if interest is compounded daily, the
investment will grow faster than if the interest is compounded monthly or annually.
The formula for calculating the interest rate (I) is as follows:
Interest (I) =
1+ [
Nominal Return
Periods
Illustration No. 9
Company has four investment alternatives as follow:
Investment A earns 12.0 percent annually
Investment B earns 11.9 percent semiannually
Investment C earns 11.8 percent quarterly
Investment D earns 11.7 percent daily
Which investment is the best for the company?
42 |The Institute of Chartered Accountants of Nepal
]
periods – 1
Introduction & Fundamental Concepts of Financial Management
Illustration No. 9- Solution
To figure out which investment is best for the company, the effective interest rate of each
investment should be determined.
For Investment A, the effective rate would be (1 + .12 / 1)1 – 1, or 12.00 percent.
For Investment B, the effective rate would be (1 + .119 / 2)2 – 1, or 12.25 percent.
For Investment C, the effective rate would be (1 + .118 / 4)4 – 1, or 12.33 percent.
For Investment D, the effective rate would be (1 + .117 / 365)365 – 1, or 12.41 percent.
Even though Investment D has the lowest nominal return, because of compounding, it has the
highest effective interest rate. Investment D would be the best vehicle, assuming company is
lending money at this rate.
Knowledge Test 3 (compound Interest)
Determine the compound amount and compound interest on Rs. 1,000 at 6% compounded
semiannually for 6 years. Given that (1+i) n = 1.42576 for i = 3% and n = 12.
Illustration No. 10
What annual rate of interest compounded annually doubles an investment in 7 years? Given
that 21/7 = 1.104090.
Illustration No. 10 - Solution
Suppose principal of the Investment = P
Compound Amount (An) = 2P
Since, Compound Amount (An)= P(1+i) n,
2P = P(1+i)7,
Or, 2 = (1+i)7
Or, 21/721/7 = 1 + i
Or, 1.104090 = 1 + I
i.e., I = 0.10409
Required rate of interest = 10.41%
Illustration No. 11
A person opened an account on April 2016 with a deposit of Rs. 800. The account paid 6%
interest compounded quarterly. On October 1, 2016, he closed the account and added enough
additional money to invest in a 6-month Time Deposit for Rs. 1,000 earning 6% compounded
monthly.
a)
How much additional amount did the person invest on October 1?
b)
What was the maturity value of his Time Deposit on April 1, 2017?
c)
How much total interest was earned?
Given that (1+i) n is 1.03022500 for %, i = 1 ½. n = 2 and is 1.03037751 for i =1/2 % and
n =6.
The Institute of Chartered Accountants of Nepal | 43
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Illustration No. 11 - Solution
(a) The initial investment earned interests for April – June and July – September quarter, i.e.
for 2 quarters.
In this case,
Interest (i)=6/4
=1 ½%,
Period (n) = 2
Compounded amount (An) = 800{1+ 1 ½%)
= 800 × 1.03022500
= Rs. 824.18
The additional amount = Rs. (1,000 – 824.18) = Rs. 175.82
The interest earned on investment = Rs 824.18- Rs 800
= Rs 24.18
(b) In this case, the Time Deposit earned interest compounded monthly for 2 quarters.
Here, Interest (i) = 6/12
=1/2%,
Period (n) = 6,
Principal (P) =1,000
Required maturity value = 1,000 (1+1/2)6
=1,000 X 1.03037751
= Rs. 1,030.38
(c) Total interest earned = (24.18 + 30.38)
= Rs. 54.56
1.3.16 Present Value of Investment
The present value is the amount of money that represents the sum of principal and interest if
amount is required to be invested now at a certain rate compounded over a number of time
periods at a specified rate for each time period.
In the given figure, cash flows are placed directly below the tick marks, and interest
rates are shown directly above the timeline. Thus, to find the Present value of Rs
1586.90 at 8 percent interest in 6 years, the following timeline can be set up:
Time:
0
|
Cash Flow
8%
1
2
3
4
5
6
|
|
|
|
|
|
PV=?
44 |The Institute of Chartered Accountants of Nepal
Rs 1,586.90
Introduction & Fundamental Concepts of Financial Management
Finding present values is called discounting, and it is simply the reverse of compounding. The
present value (PV) equation is as follows:
𝑃𝑃𝑃𝑃 =
Where,




Or
𝐹𝐹𝐹𝐹
1 + 𝐼𝐼
𝑛𝑛
FV = the future value of the investment at the end of N years
N = the number of years in the future
I = the interest rate, or the annual interest rate or discount rate
PV = the present value, in today‘s dollars, of a sum of money you have invested or plan
to invest
𝑃𝑃𝑃𝑃 = 𝐹𝐹𝐹𝐹 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃, 𝑛𝑛
where
FV = Future value or amount;
i = interest rate per year;
n = number of periods involved in the analysis and,
PVIFi, n, the Present Value Interest Factor located at i interest rate and n years/period
Illustration No. 12
a) Find the present value of Rs 10,000 to be required after 5 years if the interest rate be 9
per cent. Given that (1.09)5 = 1.5386
b) Mr. A promises to give Mr. B Rs 500,000 in 40 years. Assuming a six percent interest
rate, what is the present value of the amount Mr. A is promising to give Mr. B in 40
years?
c) Suppose I want to be able to withdraw Rs 5,000 at the end of 5 years and withdraw Rs
6,000 at the end of 6 years, leaving a zero balance in the account after the last
withdrawal. If I can earn 5% on my balance, how much must I deposit today to satisfy
my withdrawals needs?
Illustration No. 12 - Solution
a) Here, Rate of interest (i) = 0.09,
Period (n) = 5 years,
Future Value (FV) 10,000
Required
𝑃𝑃𝑃𝑃 =
𝐹𝐹𝐹𝐹
1 + 𝐼𝐼
𝑛𝑛
The Institute of Chartered Accountants of Nepal | 45
Chapter 1
Financial Management
= 10,000 / (1.09) 5
= 10,000 / 1.5386
= Rs 6,500.
b) The present value (PV) equation is as follows:
PV = FV / (1 + I) N
PV = 500,000 / (1 +0.06)40,
= Rs 48,611
c) Future value = Rs 5000
Period (n) = 5 years
Rate of return (i) = 5 %
Present Value (PV) = FV / (1 + I) N
= 5,000 / (1 +0.05)5,
= Rs 3917.63
Future value = Rs 6000
Period (n) = 6 years
Rate of return (i) = 5 %
Present Value (PV) = FV / (1 + I) N
= 6,000 / (1 +0.05)6,
= Rs 4477.29
Total Present value of the two future values = Rs 3.917 + Rs 4477.29 = Rs 8394.92
1.3.17 Future Value of Investments
Future value (FV) refers to the amount of money an investment will grow to over
some period of time at some given interest rate. Put another way, future value is the
cash value of an investment at some time in the future.
In the given figure, cash flows are placed directly below the tick marks, and interest
rates are shown directly above the timeline. Thus, to find the future value of Rs 1000
after 6 years at 8 percent interest, the following timeline can be set up:
Time:
0
|
Cash Flow
8%
1
2
3
4
5
6
|
|
|
|
|
|
-1,000
46 |The Institute of Chartered Accountants of Nepal
FV6 =?
Introduction & Fundamental Concepts of Financial Management
Finding the future value (FV), or compounding, is the process of going from today's
values (or present values) to future amounts (or future values). It can be calculated
as
Where,




Or
𝑭𝑭𝑭𝑭 = 𝑷𝑷𝑷𝑷 𝑷 𝟏𝟏 + 𝑰𝑰
𝒏𝒏
FV = future value of the investment at the end of N periods (years)
n = number of years in the future
I = interest rate, or the annual interest (or discount) rate
PV = present value, in today‘s Rupee, of a sum of money that have already invested or plan
to invest
Where,
𝐹𝐹𝐹𝐹𝐹𝐹 = 𝑃𝑃𝑃𝑃 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹, 𝑛𝑛
PV = present value or beginning amount;
i = interest rate per year;
n = number of periods involved in the analysis.
FVIFi, n, the Future Value Interest Factor, located at i interest rate and n years/period
Illustration No. 13
A makes a deposit of Rs. 5,000 in a bank which pays 10% interest compounded annually for 6
years. You are required to find out the amount to be received after 5 years.
Illustration No. 13 - Solution
FV = PV * (1 + I) N
Now, PV = Rs. 5,000, i = 10% and n = 6 years
∴FV = Rs. 5,000 x (1 + 0.1) 6
= Rs. 5,000 × 7.716 *
= Rs. 38,580
* From table of compounded value of an annuity.
1.3.18 Annuity Payment
An annuity is a stream of regular periodic payment made or received for a specified period of
time. Most problems in financial analysis have payments made in more than one period. For
example, if a company has a 30-year mortgage and required to make 12 payments per year for 30
years, for a total of 360 payments. This kind of regular payments is called an annuity (it gets its
name from the word ―annual‖ meaning yearly – but it applies to any regular payment).
The Institute of Chartered Accountants of Nepal | 47
Chapter 1
Financial Management
If company wants to find the present value of the payments it could find the present value of
each of the 360 payments individually; however, that will take a long time. Fortunately, there is
an easier way to do this. As each of the payments of the mortgage is the same, annuity value
could be calculated.
i. Present value of an annuity
Sometimes instead of a single cash flow the cash flows of the same amount are received for a
number of years.
If the cash flow is same over the period, the present value of an annuity may be expressed as
follows:
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 = 𝑃𝑃𝑃𝑃𝑃𝑃 𝑃 𝑃
Or
Where,
1 − 1 + 𝑖𝑖
𝑟𝑟
−𝑛𝑛
𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽 𝒐𝒐𝒐𝒐 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 = 𝑷𝑷𝑷𝑷𝑷𝑷 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝒊𝒊, 𝒏𝒏
PMT= Constant periodic flow
i = Discount rate.
Illustration No. 14
a) Find out the present value of a 4-year annuity of Rs. 20,000 discounted at 10
percent.
b) What is the present value if the project instead pays cash flows that grow at a rate
10% per year for four years, starting with a cash flow of Rs 20,000 next year?
Illustration No. 14 - Solution
a) P V = Amount of annuity × Present value (r, n)
Now, i = 10%
n = 4 years
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 = 𝑃𝑃𝑃𝑃𝑃𝑃 ∗
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 = 20,000 ∗
= Rs. 63,397
1 − 1 + 𝑖𝑖
𝑟𝑟
−𝑛𝑛
1 − 1 + 0.1
0.1
−4
b) Sometimes instead of a single cash flow the cash flows of the same amount are
received for a number of years. If the cash flow is not same over the period, the
48 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
present value of an annuity (PVA) is the sum of the present values of the individual
payments.
Present value of Annuity (PVA) = PMT / (1+i) +PMT / (1+i)2 +PMT /
(1+i)3………………. +PMT/ (1+i) n
Present value of Annuity (PVA)
= PMT / (1+i) +PMT / (1+i)2 +PMT / (1+i)3. +PMT/ (1+i)4
=20000/1.10 + 20000(1.10)/1.102 + 20000(1.10)2/1.103 + 20000(1.10)3/1.104
= Rs 72,727
ii. Future value of an annuity
An annuity is a series of periodic cash flows (payments or receipts) of equal amount. The
premium payments of a life insurance policy, for example, are an annuity.
If the cash flow is same over the period, the future value of an annuity is given as:
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐹𝐹𝐹𝐹𝐹𝐹 = 𝑃𝑃𝑃𝑃𝑃𝑃 𝑃 𝑃
Or
Where,
1 + 𝑟𝑟 𝑛𝑛 − 1
𝑟𝑟
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 = 𝑃𝑃𝑃𝑃𝑃𝑃 𝑃 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑖𝑖, 𝑛𝑛
FVAn= Future value of an annuity which has duration of n years
PMT = Constant periodic flow
i = Interest rate per period
n = Duration of the annuity.
From the above equation it is clear that the future value of annuity is dependent on three
variables i.e. the annual amount, the rate of interest and the time period. If any of these variable
changes it will change the future value of the annuity. A published table is available for various
combinations of the rate of interest r and the time period n.
Illustration No. 15
A person is required to pay four equal annual payments of Rs. 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.
The Institute of Chartered Accountants of Nepal | 49
Chapter 1
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Illustration No. 15- Solution
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐹𝐹𝐹𝐹𝐹𝐹 = 𝑃𝑃𝑃𝑃𝑃𝑃 ∗
1 + 𝑟𝑟 𝑛𝑛 − 1
𝑟𝑟
= Rs. 5,000 (4.507)
= Rs. 22,535
If the cash flow is not same over the period, the Future value of an annuity (FVA) is the sum
of the future values of the individual payments.
Future value of Annuity (FVA) = PMT * (1+i) +PMT * (1+i)2 +PMT * (1+i)3……………….
+PMT * (1+i) n
60th yr. = 9735.84× 0.0984 =Rs. 872.18 ('000) and so on...
1.0984
1.3.19 Perpetuity
Perpetuity is a stream of payments or a type of annuity that starts payments on a fixed date and
such payments continue forever, or perpetually. Often preferred stock which pays a dividend is
considered as a form of perpetuity. However, one must assume that the firm does not go
bankrupt or is otherwise impeded for making timely payments. The formula for evaluating
perpetuity is relatively straight forward. It is simply the expected income stream divided by a
discount factor or market rate of interest. It reflects the expected present value of all payments.
Perpetuity is an annuity in which the periodic payments begin on a fixed date and continue
indefinitely. Fixed coupon payments on permanently invested (irredeemable) sums of money are
prime examples of perpetuities. Scholarships paid perpetually from an endowment fit the
definition of perpetuity.
The value of the perpetuity is finite because receipts that are anticipated far in the future have
extremely low present value (today's value of the future cash flows). Additionally, because the
principal is never repaid, there is no present value for the principal. The price of perpetuity is
simply the coupon amount over the appropriate discount rate or yield.
Examples of perpetuity can be local governments set aside funds so that it will be available on a
regular basis for cultural activities or a children‘s charity organization set up a fund designed to
provide a flow of regular payments indefinitely to needy children.
Therefore, what happens in perpetuity is that once the initial fund has been established the
payments will flow from the fund indefinitely which implies that these payments are nothing
more than annual interest payments.
50 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
 Calculation of multi period perpetuity
With perpetuities it is necessary to find a present value based on a series of payments that go on
forever. The formula for determining the present value of multi-period perpetuity is as follows:
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
Where:
C = the interest payment each period
i = the interest rate per payment period
𝐶𝐶
𝑖𝑖
 Calculation of growing perpetuity
A stream of cash flows that grows at a constant rate forever is known as growing perpetuity.
The formula for determining the present value of growing perpetuity is as follows:
Present Value (PV) =
C
i-g
Where:
g = the growth rate
Illustration No. 16
a) Ramesh wants to retire and receive Rs. 3,000 a month. He wants to pass this monthly
payment to future generations after his death. He can earn an interest of 8% compounded
annually. How much will he need to set aside to achieve his perpetuity goal?
b) Assuming that the discount rate is 7% per annum, how much would you pay to receive
Rs. 50, growing at 5%, annually, forever?
Illustration No. 16- Solution
a) Interest Payment each period (C) = Rs. 3,000
Rate of Interest (r) = 0.08/12 or 0.00667
Substituting these values in the above formula, we get
Rs 3,000
Present Value (PV) =
0.0067
= Rs. 4,49,775
If he wanted the payments to start today, we must increase the size of the funds to handle the
first payment. This is achieved by depositing Rs. 4,52,775 which provides the immediate
The Institute of Chartered Accountants of Nepal | 51
Chapter 1
Financial Management
payment of Rs. 3,000 and leaves Rs. 4,49,775 in the fund to provide the future Rs. 3,000
payments.
Present Value (PV) =
C
i-g
Present Value (PV) =
50
0.07 - 0.05
=
Rs 2500
52 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
Solutions of Knowledge Tests
Knowledge Test 1- Answer (Fresh Blossoms)
(a)
Statement showing profitability of different plans
Particular
(i)
Plan I
Plan II
Plan III
Rs.
Rs.
Rs.
Budgeted Revenue weighted by Profitability
High
900,000
480,000
1,000,000
Medium
600,000
1,400,000
1,250,000
Low
200,000
150,000
1,700,000
2,030,000
2,250,000
40%
25%
30%
Sales Contribution
680,000
507,500
675,000
Less: Depreciation
312,500
250,000
300,000
Profit before Tax
367,500
257,500
375,000
Less: Tax at 40%
147,000
103,000
150,000
Profit after Tax
220,500
154,500
225,000
Add: Depreciation
312,500
250,000
300,000
Average Annual Cash inflows
533,000
404,500
525,000
P.V. Factor at 12% for 8 years
4.9676
4.9676
4.9676
Present value of cash inflows
2,647,731
2,009,394
2,607,990
(iii)
Initial Investment
2,500,000
2,000,000
2,400,000
(iv)
Net Present Value (NPV)
147,731
9,394
207,990
(xi)
Profitability index (viii+ix)
1.0590
1.0050
1.0870
Expected Revenue
(ii)
Contribution as a percentage of revenue
Plan III has the highest Present Value Index and hence, it is the most profitable
(b) Computation of maximum loss under different plans
Revenue for Worst Forecast
Contribution as a percentage of revenue
Sales Contribution
Plan I
Plan II
Plan III
Rs.
Rs.
Rs.
500,000
1,500,000
Nil
40%
25%
30%
200,000
375,000
-
The Institute of Chartered Accountants of Nepal | 53
Chapter 1
Financial Management
Less: Depreciation
312,500
250,000
300,000
Profit before Tax
(112,500)
125,000
(300,000)
Less: Tax at 40%
(45,000)
50,000
(120,000)
Profit after Tax
(67,500)
75,000
(180,000)
Add: Depreciation
312,500
250,000
300,000
Average Annual Cash inflows
245,000
325,000
120,000
4.9676
4.9676
4.9676
P.V. of cash inflows
1,217,062
1,614,470
596,112
Initial Investment
2,500,000
2,000,000
2,400,000
(1,282,938)
(385,530)
(1,803,888)
P.V. factor at 12% for 8 yrs.
Net Present Value (NPV)
The above analysis shows that loss is the least under plan II in case the worst happens and
hence on this basis plan II is the best.
Knowledge Test 2- Answer (Nepal Comfort)
Solution:
i. Computation of Expected Fuel Costs
Severe Weather
Mild weather
Expected
weather
Gas
(40,000x0.70)
+
(24,000x0.30)
-
35,200
Oil
(53,000x0.70)
+
(37,000x0.30)
-
48,200
Solid Fuel
(45,000x0.70)
+
(36,000 x0.30)
-
42,300
ii. Fuel costs are expected to increase at the expected rate of
[15%x0.40] + [25%x0.60] = 21%
iii. The cash outflows of various alternatives are given below:
a. Cash Outflow on Gas System
Year
(In thousand Rupees)
0
Installation Cost
1
2
3
35.2
42.59
51.54
2.5
2.5
2.5
170
37.7
45.09
54.04
1
0.833
0.694
0.579
170
Add: Fuel Cost (Increase @ 21%)
Maintenance Costs
Gross Cash Outflows
Discount factor
54 |The Institute of Chartered Accountants of Nepal
Introduction & Fundamental Concepts of Financial Management
Discounted Cash outflows
Total present value of cash outflows
170
31.404
31.292
31.289
1
2
3
48.2
58.3
70.6
2.0
2.0
2.0
150
50.2
60.3
72.6
1
0.833
0.694
0.579
150
41.8
41.9
42.0
1
2
3
42.30
51.18
61.93
263,986
b. Cash Outflow on Oil System
Year
0
Installation Cost
150
Add: Fuel Cost (Increase @ 21%)
Maintenance Costs
Gross Cash Outflows
Discount factor
Discounted Cash outflows
Total Present Value of cash outflows
275,698
c. Cash Outflow on Solid Fuel System
Year
0
Installation Cost
140
Add: Fuel Cost (Increase @ 21%)
Maintenance Costs
Gross Cash Outflows
10
140
Discount factor
Discounted Cash outflows
Total Present Value of cash outflows
1
140
42.30
61.18
61.93
0.83
0.69
0.58
35.24
42.46
35.86
253,555
The solid fuel system has the lowest cash outflow. Hence it will be accepted.
However, the solid fuel system should only be installed if there is a saving on present airconditioning cost less the enhanced value of building.
Present Value of building enhancement = 1,00,000 x 0.579
= 57,900
Hence, Net Cost of solid fuel system
= 2,53,555 – 57,900
= 1,95,655
Thus, the system is worthwhile only when the present air-conditioning cost is greater than
Rs.1,95,655.
The Institute of Chartered Accountants of Nepal | 55
Financial Management
Knowledge Test 3- Answer (compound Interest)
Rate of Interest (i) = (6/2)
= 3%,
Period (n)
=6×2
= 12,
Principle(P)
= 1,000
Compound amount = P(1+i) n = 1,000(1+ 3%) 12
= 1,000 × 1.42576
= Rs. 1,425.76
Compound interest = 1,425.76 – 1,000
= Rs. 425.76
Or
Interest rate = (1 + 0.06 / 2)12 – 1
= 42.57 %
Compound Interest = 1000 * 42.57%
= Rs. 425.76
56 |The Institute of Chartered Accountants of Nepal
Chapter 1
Strategic Finance Decision and Policy
Chapter 2
Strategic Finance Decision and Policy
The Institute of Chartered Accountants of Nepal | 57
Chapter 2
Financial Management
2.1 Capital Finance Decision and Policy
2.1.1 Learning Objectives
Upon completion of this chapter student will be able to:
 Explain the meaning and significance of capital structure
 Analyze the point of indifference
 Discuss the various capital structure theories i.e. Net Income Approach, Traditional
Approach, Net Operating Income (NOI) Approach, Modigliani and Miller (MM)
Approach.
 Determination of optimum capital structure
 Describe the feature of optimum capital structure
 Explain the basic concept of trading on equity
 Analyzethe relationship between the performance of acompany and its impact on the
earnings of the shareholders i.e. EBIT-EPS analysis.
2.1.2 Chapter Overview
Capital Structure
Management
Theories of Capital Structures
-Net Income (NI)
-Net Operating Income (NOI)
-Modigliani-Miller (MM)
-Traditional Theories
Determination of Optimum
Capital Structure
EBIT-EPS Analysis
(Point of Indifference)
Fig: Chapter overview of Capital Structure
58 |The Institute of Chartered Accountants of Nepal
Factor Affecting Capital
Structure
Strategic Finance Decision and Policy
2.1.3 Introduction
Capital structure is the combination of capitals from different sources of finance. In other words,
it represents the mix of different sources of long-term funds (such as equity shares, preference
shares, long-term loans, retained earning etc.) in the total capitalization of the company. The
source and quantum of capital is decided on the basis of need of the company and the cost of the
capital. However, the objective of a company is to maximize the value of the company and it is
prime objective while deciding the optimal capital structure.
For example, a company has capital mix of equity shares amounting Rs. 1,00,000, debentures
amounting Rs. 1,00,000, preference shares of Rs. 1,00,000 and retained earnings of Rs. 50,000.
As the term capitalization is used for total long-term funds, total capitalization of this firm is Rs.
3, 50,000. The term capital structure is used for the mix of capitalization. In this case it will be
said that the capital structure of this firm consists of Rs. 1, 00,000 in equity shares of Rs 1 each,
Rs 100,000 in preferences shares, Rs. 1,00,000 in debentures and Rs. 50,000 in retained
earnings.
Analysis of capital structure is basically done through the ratio called, Debt Equity (D/E) ratio,
which provides insight into how risky a business‘s borrowing practices are. Usually, a company
that is heavily financed by debt has a more aggressive capital structure therefore poses greater
risk to investors.
According to Gerestenberg, “capital structure of a company refers to the composition or make
up of its capitalization and it includes all long-term capital resources viz., loans, reserves,
shares and bonds”
Hence capital structure implies the composition of funds raised from various sources broadly
classi-fied as debt and equity. It may be defined as the proportion of debt and equity in the total
capital that will remain invested in a business over a long period of time.Capital structure is
concerned with the quantitative aspect. A decision about the proportion among these types of
securities refers to the capital structure decision of an enterprise.
The Institute of Chartered Accountants of Nepal | 59
Chapter 2
Financial Management
Shareholder
Wealth
Investment
Decision
Capital
Structure
Decision
Financing
Decision
Debt + Equity
Mix Financial
Leverage
Dividend
Decision
Effect on EPS
Effect on Risk
Effect on cost
of capital
Value of Firm
Fig: Introduction of Capital Structure
2.1.4 Capital Structure and Financial Structure
The term capital structure differs from financial structure. Financial structure refers to the way
the firm's assets are financed. In other words, it includes both, long-term as well as short-term
sources of funds. Capital structure is the permanent financing of the company represented
primarily by long-term debt and shareholders' funds but excluding all short-term credit. Thus, a
company's capital structure is only a part of its financial structure.
2.1.4.1 Difference between Capital Structure and Financial Structure
Basis for
Comparison
Capital Structure
Financial Structure
Meaning
The combination of long-term
The combination of long term and shortsources of funds, which are raised
term financing represents the financial
by the business is known as Capital
structure of the company.
Structure.
Appear on
Balance Sheet
Under the head Shareholders fund
and Non-current liabilities.
Includes
Equity capital, preference capital,
Equity capital, preference capital,
retained earnings, debentures, long term
retained earnings, debentures, long
borrowings, account payable, short term
term borrowings etc.
borrowings etc.
60 |The Institute of Chartered Accountants of Nepal
The whole equities and liabilities side.
Strategic Finance Decision and Policy
Basis for
Comparison
One in another
Capital Structure
Financial Structure
The capital structure is a section of Financial structure includes capital
financial structure.
structure.
2.1.5 Patterns of Capital Structure
In case of new company, the capital structure may be of any of the following four patters.
(i)
(ii)
(iii)
(iv)
Capital structure with equity shares only;
Capital structure with both equity and preference shares;
Capital structure with equity shares and debentures; and
Capital structure with equity shares, preference shares and debentures.
The choice of an appropriate capital structure depends on a number of factors such as the nature
of the company's business, regularity of earnings, conditions of the money market, attitude of the
investor, etc. the most significant is to choose the alternative which gives the highest EPS or
rates or return on equity capital. We would like to emphasize difference of debt and equity. Debt
is a liability on which interest has to be paid irrespective of the company's profits. While equity
consists of shareholders or owners‘ funds on which proportion of the debt content in the capital
structure increases the risk and may lead to financial insolvency of the company in adverse
times.
However, raising funds through debt is cheaper as compared to equity as it is allowed as an
expense for tax purposes, resulting in higher availability of profits for shareholders. This
increases the earnings per equity share of the company which is the basic objective of a financial
manager.
2.1.5.1 EBIT-EPS Analysis
The basic objective of financial management is to design an appropriate capitalstructure which
can provide the highest earnings per share (EPS) over the company‘s expected range of earnings
before interest and taxes (EBIT).
EPS measures a company‘s performance for the shareholders whereas the EBIT measures the
coverage of interest component including shareholders return as a whole. The level of EBIT
varies from year to year and represents the success of a company‘s operations. EBIT-EPS
analysis is a vital tool for designing the optimal capital structure of a company. The objective of
this analysis is to find the EBIT level that will equate EPS regardless of the financing plan
chosen. The financial leverage affects the pattern of distribution of operating profit among
various types of investors and increases the variability of the EPS of the firm. Given a level of
EBIT, EPS will be different under different financing mix depending upon the extent of debt
financing. The effect of leverage (financial gearing-will be discussed on later chapters) on the
EPS emerges because of the existence of fixed financial charge i.e., interest on debt financial,
fixed dividend on preference share capital. The effect of fixed financial charge on the EPS
depends upon the relationship between the rate of return on assets and the rate of fixed charge. If
The Institute of Chartered Accountants of Nepal | 61
Financial Management
Chapter 2
the rate of return on assets is higher than the cost of financing, then the increasing use of fixed
charge financing (i.e., debt and preference share capital) will result in increase in the EPS. This
situation is also known as favorable financial leverage or Trading on Equity. On the other hand,
if the rate of return on assets is less than the cost of financing, then the effect may be negative
and, therefore, the increasing use of debt and preference share capital may reduce the EPS of the
firm.
The effect of the change in debt-equity mix on EPS of the company can be understood with the
help of the following Example.
Illustration No. 1
A ltd. has a share capital of Rs. 1, 00,000 divided into shares of Rs. 10 each. It has major
expansion programme requiring an investment of another Rs. 50,000. The management is
considering the following alternatives for raising this amount:
(i)
Issue of 5,000 equity shares of Rs. 10 each.
(ii)
Issue of 5,000, 12% preference shares of Rs. 10 each
(iii)
Issue of 10% debentures of Rs. 50,000.
The company's present earnings before interest and tax (EBIT) are Rs. 40,000 p.a. You are
required to calculate the effect of each of the above modes of financing on the earnings per
share (EPS) presuming:
(a)
EBIT continues to be the same even after expansion.
(b)
EBIT increases by Rs. 10,000
Illustration No. 1 Solution:
a.
When EBIT is Rs. 40,000 p.a.
Calculation of Present and Projected Earnings Per Share
Present
Particulars
Capital
Proposed Capital Structure
Structure
[All
[Equity +
Equity +
All Equity
Equity]
Pref.]
Debt
Earnings Before Interest and Tax
40,000
40,000
40,000
40,000
Less: Interest on Debenture
5,000
Earning Before Tax
40,000
40,000
40,000
35,000
Less: Tax @ 50% (assume)
20,000
20,000
20,000
17,500
Earning After Tax
20,000
20,000
20,000
17,500
Less: Pref. Dividend
6,000
Profit for Equity Shareholders
20,000
20,000
14,000
17,500
No. of Equity shares
10,000
15,000
10,000
10,000
EPS
2.00
1.33
1.40
1.75
Dilution against initial EPS of Rs.
0.67
0.60
0.25
62 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
The above table shows that dilution of earnings per share has been the least when funds have
been raised by issue of debentures.
b.
When EBIT is Rs. 50,000 p.a.
Calculation of Present and Projected Earnings Per Share
Present
Particulars
Capital
Proposed Capital Structure
Structure
All
Equity
Earnings Before Interest and Tax
[All
Equity]
40,000
[Equity+
Pref.]
50,000
50,000
Less: Interest on Debenture
Equity +
Debt
50,000
5,000
Earning Before Tax
40,000
50,000
50,000
45,000
Less: Tax @ 50% (assume)
20,000
25,000
25,000
22,500
Earning After Tax
20,000
25,000
25,000
22,500
-
-
6,000
-
Profit for Equity Shareholders
20,000
25,000
19,000
22,500
No. of Equity shares
10,000
15,000
10,000
10,000
2.00
1.67
1.90
2.25
0.33
0.10
(0.25)
Less: Pref. Dividend
EPS
Dilution against initial EPS of Rs.
The above table indicates that EPS has gone up by Re. 0.25 per share as against the present
EPS when the funds are raised by issue of debentures.
Knowledge Test 1
Goodshape Company has currently an ordinary share capital of Rs. 25 lakhs, consisting of
2.500 shares of Rs. 100 each. The management is planning to raise another Rs. 20 lakhs to
finance a major programme of expansion through one of four possible financing plans. The
options are:
(i)
Entirely through ordinary shares.
(ii) Rs. 10 lakhs through ordinary shares and Rs. 10 lakhs through long-term borrowings at
8 per cent interest per annum.
(iii) Rs. 5 lakhs through ordinary shares and Rs. 15 lakhs through long-term borrowings at 9
per cent interest per annum.
(iv) Rs. 10 lakhs through ordinary shares and Rs. 10 lakhs through preference shares with 5
per cent dividend.
The company's expected Earnings Before interest and Tax [EBIT] will be Rs. 8 lakhs.
Assuming a corporate tax rate of 50 per cent, Determine the Earnings per share [EPS] in each
alternative, and comment on the implications of financial leverage.
The Institute of Chartered Accountants of Nepal | 63
Chapter 2
Financial Management
Knowledge Test 2:
Alpha company is contemplating conversion of 500 14% convertible bonds of Rs. 1,000 each.
Market price of the bond is Rs. 1,080 Bond indenture provides that one bond will be
exchanged for 10 shares Price-earnings ratio before redemption is 20:1 and anticipated priceearnings ratio after redemption is 25: 1. Number of shares outstanding prior to redemption are
10,000. EBIT amount to Rs. 200,000. The company is in the 35% tax bracket. Should the
company convert bond into shares? Give reasons.
Knowledge Test 3:
The Balance Sheet of Smart ltd. As on Ashadh 31. 20X1 is as follows: (In lakhs of rupees)
Capital / Liabilities
Rs. Assets
Rs.
200
Fixed
Assets
500
Share Capital
140 Inventories
300
Reserves
360 Receivables
240`
Long-term Loans
200 Cash and Bank
60
Short-term Loans
120
Payables
80
Provisions
11,00
1100
Sales for the year were Rs. 600 lakhs. For the year ending on Ashadh 31. 20X2 sales are
expected to increase by 20%. The profit margin and dividend payout ratio are expected to be
4% and 50% respectively.
You are required to:
(i) Quantify the amount of external funds required.
(ii) Determine the mode of raising the funds given the following parameters:
(a) Current ratio should at least be 1.33.
(b) Ratio of fixed assets to long-term loans should be 1.5
(c) Long-term debt to equity ratio should not exceed 1.05.
(d) The funds are to be raised in the order of short-term bank borrowings. Long-term loan
and equities.
Knowledge Test 4
X Ltd. A widely held company is considering a major expansion of its production facilities
and the following alternatives are available:
Alternatives
[Rs. In Lakhs]
Share Capital
14% Debentures
18% Loan from a financial institution
64 |The Institute of Chartered Accountants of Nepal
A
50
B
20
C
10
—
—
20
10
15
25
Strategic Finance Decision and Policy
Expected rate of return before tax is 25% of capital employed. The rate of dividend of the
company is not less than 20% and tax rate of the company is 50%. The company at present has
low debt. Which of the alternatives you would choose?
2.1.5.2 Pont of Indifference
It refers to that EBIT level at which EPS remains the same irrespective of the debt-equity mix. In
other words, at this point, rate of return on capital employed is equal to the rate of interest on
debt. The indifference level of EBIT is one at which the EPS under two or more capital structure
are same.
While designing a capital structure, a firm may evaluate the effect of different financial plan on
the level of EPS for a given level of EBIT. Out of several available financial plans, the firm may
have two or more financial plans which result in same level of EPS for a given EBIT. Such a
level of EBIT at which the firm has two or more financial plans resulting in same level of EPS is
known as indifference level of EBIT. The use of financial breakeven level and the return from
alternative capital structure is called the indifference point.The EBIT is used as a dependent
variable ant eh EPS from two alternative financial plan is used as independent variable in
indifference point analysis.
Debt
Equity
Earnings
per share
Indifference Point
EBIT in NRs
If the EBIT is less than the financial breakeven point, then the EPS will be negative but if the
expected level of EBIT is more than the breakeven point, then more fixed costs financing
instruments can be taken in the capital structure, otherwise, equity would be preferred.
EBIT-EPS breakeven analysis is used for determining the appropriate amount of debt a company
might carry.
The point of indifference can be calculated with the help of the following formula:
The Institute of Chartered Accountants of Nepal | 65
Chapter 2
Financial Management
Where
EBIT
I1 =
I2 =
T
E1
E2=
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 − 𝐼𝐼1 1 − 𝑇𝑇
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 − 𝐼𝐼2 1 − 𝑇𝑇
=
𝐸𝐸1
𝐸𝐸2
=
Point of Indifference
Interest under alternative I.
Interest under alternative 2.
=
Tax Rate.
=
Number of Equity shares (or amount or equity share
Capital) under alternative1.
Number of equity shares (or amount of equity share capital) under
alternative 2.
Illustration No. 2
A new project under consideration requires a capital outlay of Rs 300 Lacfor which the funds
can either be raised by the issue of equity share of Rs 100 each or by the issue of equity share
of the value of Rs 200 lacs and by the issue of 15% loan of Rs 100 lacs. Find out the
indifference level of EBIT given the tax rate of 50%
Solution
In the financing plan I, the firm will be issuing 3 Lacs equity shares but in the financing plan
II there will be 2 Lacs equity share and a loan of Rs 100 Lac on which interest of Rs 15 lacs
would be payable. The indifferent level of EBIT may be ascertained as follows
EBIT (1- Tax)
No of Shares
EBIT (1- 0.5)
300,000
=
=
(EBIT - Interest) (1- Tax)
No of Shares
(EBIT - 1500,000) (1- 0.5)
200,000
EBIT= Rs 4,500,000
The value of EBIT in the above equation is the indifference level of EBIT and is found to be
Rs 45 Lac. At this level of EBIT, the Eps under both the plans would be same.
Knowledge Test 5
A new project under consideration by XYZ Pvt Ltd requires a capital investment of Rs. 150
lakhs. Interest on term loan is 12% and tax rate is 50%. If the debt-equity ratio insisted by the
financing agencies is 2:1. Calculate the point of indifference for the project.
Knowledge Test 6
The Evergreen Company has the choice for raising an additional sum of Rs. 50 lakhs either (i)
66 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
by the sale of 10% debentures or (ii) by issue of additional equity shares at Rs. 50 per share.
The current capitalization structure of the company consists of 10 lakh ordinary shares and no
debt. At what level of Earnings Before interest and Tax (EBIT) after the new capital is
acquired, would Earning per share (EPS) be the same whether new funds are raised either by
issuing ordinary shares or by issuing debentures? Also determine the level of EBIT at which
Uncommitted Earnings per share (UEPS) would be the same. If sinking fund obligations
amount to Rs. 5 lakhs per year. Assume a 50% tax rate. Discuss the relevance of this
calculation and also verify your results
Additional Question
Distinguish between Accounting break-even and Financial break-even
Additional Question - Solution
Accounting break-even method is the most common form of the analysis done and one of the
easiest. It is calculated as being the number of units that need to be sold in order to produce
zero profit. More formally, the number of units required can be calculated as total fixed cost
divided by the difference between unit price and variable cost. The difference between unit
price and variable cost can be considered the profit per unit produced and sold and a business
must sell enough units to cover its fixed costs before it can become profitable.
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐵𝐵𝐵𝐵𝐵𝐵 =
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑔𝑔 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑃𝑃𝑃𝑃𝑃𝑃 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈
Financial break-even is a similar concept to accounting break-even but uses very different
measurements. It is the level of earnings needed before a firm's earnings per share is equal to
zero. Here, earnings are defined as earnings before interest and taxes, or gross profit minus
cost of sales and operating expenses and earnings per share is most often defined as being
earnings divided by the number of outstanding common shares.
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝑖𝑖𝑖𝑖𝑖𝑖 𝐵𝐵𝐵𝐵𝐵𝐵 =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 + 𝑃𝑃𝑃𝑃𝑃𝑃 𝑇𝑇𝑇𝑇𝑇𝑇 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑃𝑃𝑃𝑃𝑃𝑃 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈
Illustration No. 3
A steel manufacturing company is planning to expand its assets by 50 percent. All
financing for this expansion will come from external sources. The expansion will
generate additional sales of Rs. 6 million with a return of 20 percent on sales before
interest and taxes.
The finance department of the company has submitted the following plan for the
consideration of the Board of Directors.
Plan 1: Issue of 12.5% debentures.
Plan 2: Issue of 12.5% debentures for half the required amount and balance in equity
The Institute of Chartered Accountants of Nepal | 67
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shares to be issued at 20 percent premium
Plan 3: Issue equity shares at 20 percent premium.
The Balance Sheet and Income Statement of the company as on the last day of
Ashadh is as given below.
Balance Sheet of the company as on Ashadh 2076
Liabilities
Equity Capital (Rs. 100 per share)
10% Debentures
Retained Earnings
Current Liabilities
Amount
Rs. 8,000,000
6,000,000
4,000,000
6,000,000
24,000,000
Assets
Total Assets
Amount
Rs.24,000,000
Income Statement for the year ending on Ashadh 2076
Sales
Operating Costs
Earnings Before Interest and Taxes (EBIT)
Interest
Earning Before Tax (EBT)
Taxes
Earning After Tax (EAT)
Earnings Per Share (EPS)
__________
24,000,000
Rs. 38,000,000
32,000,000
6,000,000
600,000
5,400,000
1,890,000
3,510,000
43.875
Based on the above data and information, you are required to calculate:
a) Indifference points between (i) Plan 1 and 2, (ii) Plan 1 and 3, and (iii) Plan 2 and
3.
b) Expected market price of the shares in each of the situations on the assumption
that the price earnings ratio is expected to remain unchanged at 12 if plan 3 is
adopted but is likely to drop to 9 if either plan 1 or 2 is used to finance the
expansion.
Illustration No. 3 - Solution
Solution
Preliminary Computations:
Number of Equity Share to be issued under Plan 3 = Rs. 12,000,000/Rs. 120 = 100,000
Number of Equity Share to be issued under Plan 2 = Rs. 6,000,000/Rs. 120 = 50,000
68 |The Institute of Chartered Accountants of Nepal
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Strategic Finance Decision and Policy
12.5% Debentures to be issued under Plan 1 = 50% of Rs. 24,000,000 = Rs. 12,000,000.
12.5% Debentures to be issued under Plan 2 = 50% of Rs. 24,000,000 X 0.5 = Rs. 6,000,000.
(a)
Indifference Point among different Finance Plans:
(i)
Between Plans 1 and 2
[ (X – I1 – I2) ((1 – t) ] / N1 = [ (X – I1 – I2 ) ((1 – t) ] / N2
Where,
X =
Earnings before interest and taxes (EBIT) at the indifferent point
Number of equities shares outstanding if only equity shares are issued.
N1 =
N2 = Number of equities shares outstanding if both debentures and equity shares
are issued.
I=
Amount of interest on debentures
t=
Corporate income tax rate
Substituting the values, we get:
[(X – 600,000 –1,500,000) 0.65] = [(X –600,000 – 750,000) 0.65]
80,000
130,000
Or, 13 (X – 2,100,000) = 8 (X – 1,350,000)
Or, 13 X – 27,300,000 = 8 X – 10,800,000
Or 5 X = 27,300,000 – 10,800,000 = 16,500,000, Therefore X = Rs. 3,300,000
(ii)
Between Plans 1 and 3
[(X – 2,100,000) 0.65] = [(X – 600,000) 0.65]
80,000
180,000
Or, 18 (X – 2,100,000) = 8 (X – 600,000)
Or, 18 X – 37,800,000 = 8 X – 4,800,000
Or, 10 X = 33,000,000, Therefore X = Rs. 3,300,000
(iii)
Between Plan 2 and 3
[(X –1,350,000) 0.65] =
130,000
[(X – 600,000) 0.65]
180,000
Or, 18 (X-1,350,000) = 13 (X – 600,000)
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Or, 18 X – 24,300,000 = 13 X – 7,800,000
Or, 5 X = 16,500,000
Therefore X = Rs. 3,300,000.
Answer
(b)
Determination of Market Price per Share under Various Alternative Plans:
Particulars
Plan 1
Plan 2
Plan 3
EBIT*
7,200,000
7,200,000
7,200,000
Earnings before Taxes
2,100,000
5,100,000.00
1,350,000
5,850,000.00
600,000
6,600,000.00
Less: Taxes (@ 35%)
1,785,000.00
2,047,500.00
2,310,000.00
Less: Interest
EAT
3,315,000.00
4,290,000.00
Number of Equity Shares
80,000
130,000
180,000
EPS (EAT/No. of Shares)
41.44
29.25
23.83
9
9
9
P/E Ratio
Expected Market Price per Share
*
3,802,500.00
372.94
263.25
214.50
Existing EBIT Rs. 6,000,000 + EBIT on Additional Sales of Rs. 6,000,000 (0.20 X
6,000,000) = Rs. 7,200,000
2.1.6 Optimum Capital Structure
A firm should try to maintain an optimum capital structure with a view to maintain financial
stability. The optimum capital structure is obtained when the market value per equity share is the
maximum. It may, therefore, be defined as that relationship of debt and equity securities which
maximizes the value of a company's share in the stock exchange. In case a company borrows,
and this borrowing helps in increasing the value of the company's shares in the stock exchange.
It can be said that the borrowing has helped the company in moving towards its optimum capital
structure. In case, the borrowing results in fall in market value of the company's equity share, it
can be said that the borrowing has moved the company away from its optimum capital structure.
The objective of the term should therefore be to select a financing or debt equity mix which will
lead to maximum value of the firm. The optimum capital structure and its implications have been
expressed by Ezra Solomon in the following words.
Optimum leverage can be defined as that mix of debt and equity which will maximize the market
value of a company. i.e. the aggregate value of the claims and ownership interests represented on
the credit side of the balance sheet. Further, the advantages of having an optimum financial
structure. If such an optimum does exist, is two-fold: it minimizes the company's cost of capital
which in turn increases its ability to find new wealth-creating investment opportunities, Also, by
70 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
increasing the firm's opportunity to engage its future wealth-creating investment it increases the
economy's rate of investment and growth.
Considerations
The following considerations will greatly help a finance manager in achieving his goal of
optimum capital structure.
(i) he should take advantage of favorable financial leverage, in other words, if the ROI is higher
than the fixed cost of funds, he may prefer raising funds having a fixed cost to increase the
return of equity shareholders.
(ii) he should take advantage of the leverage offered by the corporate taxes. A high corporate
income tax also provides some a form of leverage with respect to capital structure
management. The higher cost of equity financing can be avoided by use of debt which in
effect provides a form of income tax leverage to the equity shareholders. This aspect has
already been discussed in detail in the preceding pages.
(iii) He should avoid a perceived high-risk capital structure. This is because if the equity
shareholders perceive an excessive amount of debt in the capital structure of the company
the price of the equity shares will drop. The finance manager should not therefore issue
debentures or bonds whether risky or not, if the investors perceive an excessive risk and
therefore it is likely to depress the market prices of equity shares.
2.1.7 Capital Structure Theories
In order to achieve the goal of identifying an optimum debt-equity mix, it is necessary for the
finance manager to be conversant with the basic theories underlying the capital structure of
corporate enterprises. In the following pages we are reviewing these major theories and trying to
develop a unified theory of capital structure. However, it will be seen that the existence of
optimum capital structure is not accepted by all. There exist extreme views. There is a viewpoint
that strongly supports on the shareholders wealth. While according to others, the decision about
the financial structure is irrelevant as regards maximization of shareholders wealth.
Capital Structure
Relevance
Theory
Capital Structure
Theories
Capital Structure
Irrelevance
Theory
Net Income
Approach
Traditional
Approach
Net Operating
Income (NOI)
Approach
ModiglianiMiller (MM)
Approach
Fig: Capital Structure Theories
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There are four major theories/approaches explaining the relationship between capital structure,
cost of capital and value of the firm:
1. Net Incomes (NI) Approach.
2. Traditional Approach.
3. Net Operating Income (NOI) Approach.
4. Modigliani-Miller (MM) Approach, and
Assumptions
We are making the following assumptions in order to present the analysis in a simple and
intelligible manner.
(i)
The firm employs only two types of capital–debt and equity.
(ii) There are no corporate taxes. This assumption has been removed later.
(iii) The firm pays 100% of its earnings as dividend. Thus, there are no retained earnings.
(iv) The firm's total assets are given, and they do not change. In other words, the investment
decisions are assumed to be constant.
(v) The firm's total financing remains constant. The firm can change its capital structure
either by redeeming the debentures by issue of shares or by raising more debt and reduce
the equity share capital.
(vi) The Operating Earnings (EBIT) is not expected to grow.
(vii) The business risk remains constant and is independent of capital structure and financial
risks.
(viii) The firm has a perpetual life.
2.1.7.1 Net Income (NI) Approach
According to this approach, capital structure decision is relevant to the valuation of the firm. In
other words, an increase in financial leverage will lead to decline in the weighted average cost of
capital (WACC), while the value of firm as well as market price of ordinary share will
increase.Conversely, a decrease in the leverage will cause an increase in the overall cost of
capital and a consequent decline in the value as well as market price of equity shares.
Net Income approach is based on the following three assumptions:
i.
There are no corporate taxes.
ii.
The cost of debt is less than cost of equity or equity capitalization rate.
iii.
The debt content does not change the risk perception of the investor.
72 |The Institute of Chartered Accountants of Nepal
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Ke
Cost of
Capital
Ko
Kd
Degree of Leverage
From the above diagram, Ke and Kd are assumed not to change with leverage. As debt increases,
it causes weighted average cost of capital (WACC) to decrease.
The value of the firm on the basis of NI Approach can be ascertained as follows: –
V
=
S+B
V
S
B
=
=
=
Value of Firm,
Market Value of Equity.
market value of Debt.
Market value of Equity can be ascertained as follows.
Where,
S
=
S
NI
Ke
=
=
=
NI
𝐾𝐾𝐾𝐾
market value of equity,
Earnings available for equity shareholders.
Equity Capitalization Rate.
Under, NI approach, the value of the firm will be maximum at a point where weighted average
cost of capital (WACC) is minimum. Thus, the theory suggests total or maximum possible debt
financing for minimizing the cost of capital. The overall cost of capital under this approach is:
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
Overall Cost of Capital =𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉
𝑜𝑜𝑜𝑜 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
Illustration No. 4
X Ltd. is expecting an annual EBIT of Rs. 1 lakh. The company has Rs. 4.00 lakhs in 10%
debentures. The cost of equity capital or capitalization rate is 12.5% You are required to
calculate the total value of the firm also state the overall cost of capital.
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Financial Management
Illustration No. 4- Solution
Solution:
Statement Showing Value of The Firm
Particular
Earnings before interest and Tax (EBIT)
Less: Interest at 10% on Rs. 4.00 lakhs.
Earnings available for equity shareholders (NL)
Equity Capitalization Rate (Ke)
Market Value of Equity (s):
Market value of Debt (B)
Total value of the firm (S+B)
Rs.
1,00,000
40,000
60,000
12.50%
4,80,000
4,00,000
8,80,000
Calculation of Overall Cost of Capital
Overall Cost of Capital = EBIT / Value of Firm
= 100,000/ 880,000
= 11.36%
According to Net Income approach the value of the firm will increased in case the amount of
equity is decreased by issue of debentures, bonds, etc., to equity shareholders. In order to
examine effect of change in debt-equity mix in the capital structure of the firm. Let us
consider the following Example.
Knowledge Test 7
X Ltd. Is expecting an annual EBIT or Rs. 1.00 lakhs. The company has Rs. 4.00 lakhs in 10%
debentures. The equity capitalization rate is 12.5%. The company decides to raise Rs. 1.00
lakh by issue of 10% debentures and use the proceeds there of to redeem equity shares.
You are required to calculate the total value of the firm and also the overall cost of capital.
Knowledge Test 8
X Ltd. Is expecting annual EBIT of Rs.1.00 lakh. The company has Rs.4.00 lakhs in 10%
debentures. The equity capitalization rate is 12.5%. The company desires to redeem
debentures of Rs.1.00 lakh by issuing additional equity shares of Rs.1.00 lakh.
You are required to calculate the value of the firm and the overall cost of capital.
2.1.7.2 Traditional Approach
At low level of gearing:
Equity holders perceive risk as unchanged so the increase in the proportion of cheaper debt will
lower the WACC.
74 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
At higher level of gearing:
Equity holders see increased volatility of returns as debt interest must be paid first. This leads to:
 increased financial risk
 increase in Ke outweighs the extra (cheap) debt being introduced
 WACC starts to rise
At very high levels of gearing:
Serious bankruptcy risk worries equity and debt holders alike, Ke and Kd rise. WACC rises
further.
This can be shown diagrammatically:
The essence of the Traditional Approach lies in the fact that a firm through judicious use of debtequity mix can increase its total value and thereby reduce its overall cost of capital. This is
because debt is relatively a cheaper source of funds as compared to raising money through shares
because of tax advantage. However, beyond a point raising of funds through debt may become a
financial risk and would result in a higher equity capitalization rate. Thus, up to a point, the
content of debt in the capital structure will favorably affect the value of a firm. However, beyond
that point, the use of debt will adversely affect the value of the firm. At this level of debt-equity
mix, the capital structure will be optimum. At this level, the average or the composite cost of
capital will be the least. In other words, here the marginal real cost of equity will be equal to
marginal real cost (both implicit and explicit) of debt.
2.1.7.3 Net Operating Income (NOI) Approach
This approach has also been suggested by Durand This is just opposite of Net Income approach.
According to this approach, the market value of the firm is not at all affected by the capital
structure changes. The market value of the firm is ascertained by capitalizing the net operating
income at the overall cost of capital (K), which is considered to be constant. The market value of
equity is ascertained by deducting the market value of the debt from the market value of the firm.
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The Net Operating Income (NOI) approach is based on the following assumptions:
(i)
The overall cost of capital (K) remains constant for all degrees of debt –equity mix or
leverage.
(ii) The market capitalizes the value of the firm as a whole and therefore, the split between
debt and equity is not relevant.
(iii) The use of debt having low cost increases the risk of equity shareholders, this result in
increase in equity capitalization rate. Thus, the advantage of debt is set off exactly by
increase in the equity capitalization rate.
(iv) There are no corporate taxes.
According the NOI Approach, the value of a firm can be determined by the following equation:
V=
EBIT
K
Where,
V
K
= Value of firm;
= Overall Cost of Capital
As per this approach, an increase in the use of debt which is apparently cheaper is offset by an
increase in the equity capitalization rate. This happens because equity investors seek higher
compensation as they are opposed to greater risk due to the existence of fixed return securities in
the capital structure.
76 |The Institute of Chartered Accountants of Nepal
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The above diagram shows that Ko (overall cost of capital) and Kd (debt-capitalization) are
constant and Ke (cost of equity) increases with leverage.
Optimum Capital Structure
According to Net Operating Income (NOI) approach, the total value of the firm remains constant
irrespective of the debt-equity mix or the degree of leverage. The market price of equity shares
will, therefore, also not change on account of change in debt –equity mix. Hence, there is
nothing like optimum capital structure. Any capital structure will be optimum according to this
approach.
In those cases where corporate taxed presumed, theoretically there will be optimum capital
structure when there is 100% debt content. This is because with every increase in debt content
‗k‘ declines and the value of the firm go up. However, due to legal and other provisions, there
has to be a minimum equity. This means that optimum capital structure will be at a level where
there can be maximum possible debt content in the capital structure,
Illustration no. 5
XY Ltd. has an EBIT of Rs. 1 lakh. The cost of debt is 10% and the outstanding debt amounts
of Rs.4.00 lakhs. Presuming the overall capitalization rate as 12.5%, calculate the total value
of the firm and the equity capitalization rate.
Illustration No. 5- Solution
Statement Showing the Value of The Firm
Particular
Rs.
Earnings before Interest and Tax (EBIT)
100,000
Overall capitalization rate (K)
12.50%
Market Value of the Firm (V):
800,000
Total Value of Debt (B)
4,00,000
Market Value of Equity (S=V-B)
4,00,000
Equity Capitalization Rate (𝐾𝐾𝑒𝑒 ): = (EBIT –I)/ (V-B)× 100
= (1, 00,000-40,000) / (8, 00,000 -4, 00,000_) ×100
=15%
The validity of the NOI approach can be verified by calculating the Overall Capitalization
Rate
Overall Capitalization Rate (K) =
kd (B/V)+ ke(S/V)
Where,
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Financial Management
K
Kd
B
V
Ke
S
= Overall cost of capital:
=Cost of debt
=Total Debt
=Total value of the firm
=Cost of equity capital
=Market value of equity
Overall Capitalization Rate (K)
=10% (4, 00,000/8, 00,000) + 15% (4, 00,000/8, 00,000)
= 10% (1/2) + 15% (1/2)
= 50%+7.5%
= 12.5%
In case the firm raises the debt content for reducing its equity content, the total value of the
firm would remain unchanged. However, the equity capitalization rate would go up.
Knowledge Test 9
XY Ltd. has an EBIT of Rs. 1 lakh. Its cost of debt is 10% and the outstanding debt amounts
to Rs.4 lakhs. The overall capitalization rate is 12.5%. The company decides to raise a sum of
Rs. 1 lakh through debt at 10% and uses the proceeds to pay off the equity shareholders.
You are required to calculate the total value of the firm and also the equity capitalization rate.
2.1.7.4 Modigliani- Miller Approach
The Modigliani-Miller (MM) approach is similar to the Net Operating Income (NOI) approach.
In other words, according to this approach, the value of a firm is independent of its capital
structure. However, there is a basic difference between the two. The NOI approach is purely
definitional or conceptual. It does not provide operational justification for irrelevance of the
capital structure in the valuation of the firm while MM approach supports the NOI approach
providing behavioral justification for the independence of the total valuation and the cost of
capital of the firm from its capital structure. In other words, MM approach maintains that the
average cost of capital does not change with change in the debt weighed equity mix or capital
structure of the firm. It also gives operational justification for this and not merely states only a
proposition.
78 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
MM Approach -1958
without tax
Modigliani -Miller
Approach (MM)
MM Approach -1963
with tax
Fig: Modigliani-Miller Approach
A.
MM Approach without tax -1958
Assumptions:
 No Taxation
 Capital markets are perfect. This means Investors are free to buy and sell securities;
 The investors can borrow without restriction on the same terms on which the firm
can borrow;
 The investors are well informed;
 The investors behave rationally; and
 There are no transaction costs.
 Debt is risk free
MM argued that:
 As investors are rational, the required return of equity is directly proportional to the
increase in gearing. There is thus a linear relationship between Ke and gearing
(measured as D/E)
 The increase in Ke exactly offsets the benefit of the cheaper debt finance and therefore
the WACC remains constant.
 Total market value of a firm is equal to its expected net operating income divided by the
discount rate appropriate to its risk class decided by the market. Value of firm is also
unchanged.
 This can be demonstrated on the following diagram.
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Chapter 2
Conclusion


The WACC and therefore the value of the firm is unaffectedly changing in gearing
levels and gearing is irrelevant.
Implication for finance:
 Choice of finance is irrelevant to shareholder wealth: company can use any mix
of funds
Analysis
The MM view is that:
Companies which operate in the same type of business and which have similar operating risks
must have the same total value, irrespective of their capital structure.
Their view is based on the belief that the value of a company depends upon the future operating
income generated by its assets. The way in which this income is split between returns of debt
holders and returns to equity should make no difference to the total value of the firm (equity plus
debt). Thus, the total value of the firm will not change with gearing and therefore neither will its
WACC.
If the WACC is to remain constant at all levels of gearing, it follows that any benefit from the
use of cheaper debt finance must be exactly offset by the increase in cost of equity.
B. MM Approach with tax -1963
Assumption
The MM approach is subject to the following Assumptions:
1. Capital markets are perfect. This means80 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
a. Investors are free to buy and sell securities;
b. The investors can borrow without restriction on the same terms on which the firm
can borrow;
c. The investors are well informed;
d. The investors behave rationally; and
e. There are no transaction costs.
2. The firms can be classified into homogeneous risk classes. All firms within the same class
will have the same degree of business risk.
3. All investors have the same expectation of a firm‘s net operating income (EBIT) with which
to evaluate the value of any firm.
4. The dividend pay-out ratio is 100%. In other words, there are no retained earnings.
A number of practical criticisms were levelled at M&M no tax theory, but the most significant
was the assumption that there were no taxes. Since debt interest is tax-deductible the impact of
tax could not be ignored.
M&M therefore revised their theory (perfect capital market assumptions still apply):
In 196, M&M modified their model to reflect the fact that the corporate tax system gives tax
relief on interest payments.
The starting point for the theory is, as before that:
 As investors are rational, the required return of equity is directly linked to the increase
in gearing-as gearing increases, ke increases in direct proportion.
However, this is adjusted to reflect the fact that:
 Debt interest is tax deductible so the overall cost of debt to the company is lower than in
M&M -no tax.
 Lower debt costs result in less volatility in returns for the same level of gearing which
leads to lower increases in Ke.
 The increase in Ke does not offset the benefit of the cheaper debt finance and therefore
the WACC falls as gearing increases.
 Implication for Finance
 The company should use as much debt as possible. This is demonstrated in the below
diagram.
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Previously they argued that companies that differ only in their capital structure should have the
same total value of debt plus equity. This was because it was the size of firm‘s operating
earnings stream that determined its value, not the way in which it was split between returns to
debt and equity holders.
However, the corporation tax system carries a distortion under which returns to debt holder
(interest) are tax deductible to the firm, whereas returns to equity holders are not, M&M
therefore conclude that,
 geared companies have an advantage over ungeared companies, i.e. they pay less tax and
will, therefore, have a greater MV and a lower WACC.
Once again, they were able to produce a proof to support their arguments and show that as
gearing increases, the WACC steadily decreases. A levered firm should have, therefore, a greater
market value as compared to an unlevered firm. The value of the levered firm would exceed that
of the unlevered firm by an amount equal to the levered firm‘s debt multiplied by the tax rate.
This can be put in the form of the following formula:
𝑉𝑉𝑉𝑉 = 𝑉𝑉𝑉𝑉 + 𝐵𝐵𝐵𝐵
Where,
Vi
Vu
B
T
= Value of levered firm;
= Value of an unlevered firm;
= Amount of debt; and
= Tax rate
82 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
The market value of an unlevered firm will be equal to the market value of its shares.
Symbolically, Vu = S, where:
Vu
S
= Market value of an unlevered firm; and
=Market value of equity:
In other words, the value of Vu can be determined by the following equation:
Vu
= (1-T) EBT
Ke
Where
EBT
T
Ke
= Earnings before tax
= Tax rate
=Equity capitalization rate
Since in case of unlevered firm there is no debt content, earning before Tax (EBT) means
Earnings before interest and Tax (EBIT).
Arbitrage Process
The ―arbitrage process‖ is the operational justification of MM hypothesis. The term ‗Arbitrage‘
refers to an act of buying an assets or security in one market having lower price and selling it in
another market at a higher price. The consequence of such action is that the market prices of the
securities of the two firms exactly similar in all respects except in their capital structures cannot
for long remain different in different markets. Thus, arbitrage process restores equilibrium in
value of securities. This is because in case the market value of the two firms, which are equal in
all respects except their capital structures, are not equal investors of the overvalued firm would
sell their shares, borrow additional funds on personal account and invest in the undervalued firm
in order to obtain the same return on smaller investment outlay. The use of debt by the investor
for arbitrage is termed as ‗home made‘ or‘ personal leverage; this will be clear with the
following example:
Illustration no. 6
Two firms A and B are identical in all respects except that the firm A has 10%Rs.50, 000
debentures. Both the firms have the same earnings before interest and tax amounting to Rs.10,
000 the equity capitalization rate a firm A is 16% while that of firm B is 12.5%.
You are required to calculate the total market value of each of the firms and explain with an
example the working of the ‗arbitrage processes.
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Illustration no. 6- Solution
Statement Showing the Value of The Firm
Particulars
Firm A Rs.
Earnings before Interest & Tax (EBIT)
Less: Interest on Debenture
Earnings available for Equity Shareholders
Equity Capitalization Rate (ke)
Total Market Value of Equity (S):
Firm A: 5,000 / 16 ×100
Firm B: 10,000 / 12.5 ×100
Total Market Value of Debt (B)
Total Value of Firm (V)
Overall cost of Capital (k): EBIT/V:
Firm A: 10,000 / 81,250 ×100
Firm B: 50,000 / 80,000 ×100
Debt-Equity Ratio: (B/S):
Firm A: 50,000 / 81,250 ×100
10,000
5,000
5,000
16%
Firm B Rs.
10,000
10,000
12.50%
31,250
50,000
81,250
80,000
80,000
12.30%
12.50%
0.6
Working of the Arbitrage Process
The above table shows that market value of the firm A having debt content in its capital
structure is higher than the market value of the firm B which does not have any debt content in
its capital structure. According to MM Hypothesis, this situation cannot continue for long on
account of working of the arbitrage process. The investors in company B can earn a higher
return on their investment with a lower financial risk. Hence, the investors in company A will
start selling their shares and start buying shares in company B. these arbitrage transactions will
continue till company A‘s shares decline in price and B‘s shares increase in price enough to
make the total value of the two firms identical.
Illustration No. 7
Following data is available in respect of two companies having same business risk.
Capital employed = NRs 200,000 and EBIT = NRs 30,000
Sources
Levered Company
(amount in NRs)
Debt @ 10%
100,000
84 |The Institute of Chartered Accountants of Nepal
Unlevered Company
(amount in NRs)
Nil
Strategic Finance Decision and Policy
Equity
Ke
100,000
20%
200,000
12.5%
Investor is holding 15% shares in unlevered company. Calculate increase in annual earnings of
investor if he switches his holding from unlevered to levered company.
Illustration No. 7- Solution
1. Valuation of firms
Particulars
EBIT
Less Interest
Earnings available
equity
Return for equity
Value of equity
Debt
Value of Firm
for
Levered firm
30,000
10,000
20,000
Unlevered firm
30,000
Nil
30,000
20%
100,000
100,000
200,000
12.5%
240,000
Nil
240,000
Value of Unlevered company is more than that of Levered company therefore
investor will sell his shares in unlevered company and buy shares in levered
company. Market value of Debt and Equity of Levered company are in the
ratio of NRs 1,00,000 : NRs 1,00,000, i.e., 1:1. To maintain the level of risk he will
lendproportionate amount (50%) and invest balance amount (50%) in shares of
Levered company.
2. Investment and Borrowings
Sell shares in unlevered company (240,000 *15%)
Lend money (36,000*50%)
Buy shares in levered company (36,000*50%)
Total
NRs 36,000
NRs 18,000
NRs 18,000
NRs 36,000
3. Change in return
Income from shares in Levered company (18,000*20%)
Interest on money lent (18,000* 10%)
Total income after switch over
Income from unlevered firm (36000*12.5%)
Incremental Income due to arbitrage
NRs 3600
NRs 1800
NRs 5400
NRs 4500
NRs 900
Limitations of MM Hypothesis
The arbitrage process is the behavioral foundation for the MM hypothesis. However, the
arbitrage process fails to bring the desired equilibrium in the capital markets on account of the
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1. Rates of Interest are not the same for the Individuals and the Firms. The assumption
made under the MM hypothesis that the firms and individuals can borrow and lend at the
same rate of interest does not hold good in actual practice. This is because firms have the
higher credit standing as compared to the individuals on account of firm‘s holding
substantial fixed assets,
2. Homemade leverage is not Perfect Substitute for Corporate Leverage. The risk to which
an investor is exposed is not identical when the investor himself borrows proportionate to his
share in the firm‘s debt and when the firm itself borrows. As a matter of fact, the risk
exposure to the investor is greater in the former case as compared to the latter. When the
firm borrows, the liability of the investor is limited only to the extent of his proportionate
shareholding, in case the company is forced to go for its liquidation. However, when an
individual borrows, he has an unlimited liability and even his personal property can be used
for payment to his creditors.
3. Transaction Costs Involved. Buying and selling of securities involves transaction costs. It
would therefore become necessary for investor to invest a larger amount in the shares of the
unlevered /levered firms than him present investment to earn the same return.
4. Institutional Restrictions. The switching option from unlevered to levered firm and viceversa is not available to all investors, particularly, institutional investors, viz., life insurance
Corporation of Nepal, commercial banks, etc. thus, the institutional restrictions stand in the
way of smooth operation of the arbitrage process.
Illustration No. 8
Two firms A and B are identical in all respects except the degree of leverage. Firm a has 6%
debt of Rs.3.00 lacs, while firm B has no debt. Both the firms earning an EBT of Rs.1, 20,000
each. The equity capitalization rate is 10% and the corporate tax is 60%. Compute the market
value of the two firms?
Illustration No. 8- Solution
The value of Unlevered firm B can be ascertained as follows
Vu
= Profits available for Equity Shareholders
Equity Capitalization Rate
= 1, 20,000 -72,000
10%
×100
=
48,000
10
=Rs.4, 80,000
OR
Vu
= (1 –t) EBT
Ke
= (1- .6)1, 20,000
10%
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= 0.4×1, 20,000
10%
Rs.4, 80,000.
Thus, the value of firm B (unlevered) is Rs.4, 80,000.
The value of the firm A (levered) can now be ascertained as follows:
Value of Levered Firm A
Vi
=Vu +Bt
Vi
=4, 80,000+3, 00,000×.6
=4, 80,000+1, 80,000
=Rs.6, 60,000
2.1.8 Pecking Order Theory
In this approach, there is no such for an optimal capital structure through a theorized process.
Instead it is argued that firms will raise new funds in following order:
i.
ii.
iii.
Internally generated fund (internal finance)
Debt (secured, unsecured, hybrid)
New equity shares as last option
Pecking Order
Theroy
Internal Finance
(Retained
Earnings)
Debt
New equity
Fig: Pecking Order Theory
So briefly under this theory rules are
Rule 1: use internal finance first
Rule 2: Issue debt next
Rule 3: Issue of new equity shares at last
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Firms simply use all their internally generated funds first then move down the pecking order to
debt and then finally to issuing new equity, firms follow a line of least resistance that establishes
the capital structure.
Internally generated funds- i.e. retained earnings
 Already have the funds
 No issue costs
 Do not have to spend any time to collect the fund.
Debt
 Moderate issue costs
 The degree of questioning and publicity associated with debt is usually less than that of
equity shares
 Cost of fund is also low.
New Equity Shares
 Expensive issue costs
 Cost of fund is significantly high
 Extensive questioning and publicity associated with share issue
Myres has given the name ‗PECKING ORDER‘ theory as here is no well-defined debt-equity
target and there are two kind of equity internal and external. Now Debt is cheaper than both
internal and external equity because of interest. Further internal equity is less than external
equity particularly because of no transaction/issue cost, no tax etc.
2.1.9 Determination of Optimum Capital Structure
It has already been stated that at optimum capital structure, the value of an equity share is the
maximum while the average cost of capital is the minimum. The value of an equity share mainly
depends on earning per share. So long the ―Return on Investment‖ (ROI) is more than cost of
borrowings, each rupee of extra borrowing pushes up the earning per equity share which in turn
pushes up the market value of the share. It means the company can borrow till the interest rate of
the borrowings is equal to or does not exceed the return from the project. However, each extra
rupee of borrowings increases the risk and, therefore, in spite of increase in the earning per
equity share, the market value of the equity share may fall because of investors taking it as more
risky company. In some cases, in spite of increase in risk, the value of a company‘s equity shares
may increase because of investors‘ speculation on future profits.
It is almost impossible to precisely measure the fall in the market value of an equity share on
account of increase in risk due to high debt content. Market factors are highly psychological,
complex and do not follow always accepted theoretical principles since capital markets are never
perfect.
Thus, it is not possible to find out the exact debt-equity mix where the capital structure would be
optimum. A range can be determined on the basis of empirical study within which if the
company maintains its debt-equity mix, the investors will not discount its shares. For example, a
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Strategic Finance Decision and Policy
company belongs to an industry where the average debt-equity ratio is of 1:1. Empirical studies
disclosed that the investors do not discount the value of the company‘s shares so long debtequity ratio remains within 40% of the industry‘s average, i.e., between , 0.6:1 and 1.4:1.
This means that if the company maintains capital structure within this range, the value of the
equity share will not decline due to more risk perceived by the investors. In order to have the
maximum tax advantage on the interest playable, the company may maintain debt-equity ratio
near the top of the range keeping in view other factors such as profitability, solvency, flexibility,
control, etc.
The capital structure so arrived may not be optimum but would be the most reasonable under the
circumstances. Some people, therefore, refer to use the term ―appropriate or sound capital
structure‖ in place of the term ―optimum capital structure‖, the former being more a realistic
term than the latter.
Features of an appropriate Capital Structure
A capital structure will be considered to be appropriate if it possesses following features:
1. Profitability:
The capital structure of the company should be most profitable. The most profitable capital
structure is one that tends to minimize cost of financing and maximize earning per equity share.
2. Solvency:
The pattern of capital structure should be so devised as to ensure that the firm does not run the
risk of becoming insolvent. Excess use of debt threatens the solvency of the company, the debt
content should not, therefore, be such that it increases risk beyond manageable limits.
3. Flexibility:
The capital structure should be such that it can be easily maneuvered to meet the requirements of
changing conditions. Moreover, it should also be possible for the company to provide funds
whenever needed to finance its profitable activities.
4. Conservatism:
The capital structure should be conservative in the sense that the debt content in the total capital
structure does not exceed the limit which the company can bear. In other words, it should be
such as is commensurate with the company‘s ability to generate future cash flows.
5. Control:
The capital structure should be so devised that it involves minimum risk of loss of control of the
company. The above principles regarding an appropriate capital structure are as matter of fact
militant to each other. For example, rising of funds through debt is cheaper and is therefore, in
accordance with the principle of profitability, but it is risky and, therefore, goes against the
principle of solvency and conservatism. The prudent financial manager should try to have the
best out of the circumstances within which the company is operating. The relative importance of
each of the above features will also vary from company to company. For example, one company
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may give more importance to flexibility as compared to conservatisms while the other may
consider solvency to be more important than profitability. However, the fact remains that each
finance manager has to make a satisfactory compromise between the management‘s desire for
funds and the trends in the supply of funds.
2.1.10 Factors Determining Capital Structure
The capital structure of a company is to be determined initially at the time the company is
floated. Great caution is required at this stage, since the initial capital structure will have longterm implications. Of course, it is not possible to have an ideal capital structure, but the
management should set a target capital structure and the initial capital structure should be framed
and subsequent changes in the capital structure should be done keeping in view the target capital
structure. Thus, the capital structure decision is a continuous one and has to be taken whenever a
firm needs additional finances.
Following are the factors which should be kept in view while determining the capital structure of
a company:
a. Trading on Equity
A company may raise funds either by issuing the debentures or by the issue of shares.
Debentures carry a fixed rate of interest and this interest has to be paid irrespective of profits.
Preference shares are also entitled to a fixed rate of dividend, but payment of dividend depends
upon the profitability of the company. In case the rate of return (ROI) on the total capital
employed (shareholders‘ funds plus long-term borrowed funds) is more than the rate of interest
on debentures or rate of dividend on preference shares, it is said that the company is trading on
equity.
For example, the total capital employed in a company is a sum of Rs.2 lakhs. The capital
employed consists of equity shares of Rs.10 each. The company makes a profit of Rs.30, 000
every year. In such a case the company cannot pay a dividend of more than 15% on the equity
share capital. However, if the funds are raised in the following manner, and other things remain
the same, the company may be in position to pay a higher rate of return on equity shareholders‘
funds:
(a)
(b)
(c)
Rs. 1 lakh is raised by issue of debentures, carrying interest 10% p.a.
Rs. 50,000 is raised by issue of preference shares, carrying dividend at 12%;
Rs.50, 000 is raised by issue of equity shares.
In the above case out of the total profit of Rs.30,000, Rs.10,000 will be used for paying interest
while Rs.6,000. will be used for paying preference dividends. A sum of Rs.14,000 will be left for
paying dividends to the equity shareholders. Since the amount of equity capital is Rs.50,000, the
company can give a dividend of 28%. Thus, the company can pay a higher rate of dividend than
the general rate of earning on the total capital employed. This is the benefit of trading on equity.
Limitations
The trading on equity is subject to the following limitations:
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Strategic Finance Decision and Policy
(i)
(ii)
(iii)
A company can have trading on equity only when the rate of return on total capital
employed is more than the rate of interest/dividend on debentures/preference shares.
Trading on equity is beneficial only for companies which have stability in their earnings.
This is because both interest and preference dividend impose a recurring burden on the
company. In the absence of stability in profits the company will run into serious financial
difficulties in periods of trade depression.
Every rupee of extra borrowings increases the risk and hence the rate of interest expected
by the subsequent lenders goes on increasing. Thus, borrowings become costlier which
ultimately result in reducing the amount of profits available for equity shareholders.
b. Cost Principle
This principle suggests that an ideal capital structure is one that minimizes cost of capital
structure and maximizes earning per share
c. Retaining Control
The capital structure of a company is also affected by the extent to which the promoter/ existing
management of the company desire to maintain control over the affairs of the company. The
preference shareholders and debenture holders have no privilege to participate in the
management of the company. It is the equity shareholders who select the team of managerial
personnel. It is necessary, therefore, for the promoters to own majority of the equity share capital
in order to exercise effective control over the affairs of the company. The promoters or the
existing management are not interested in losing their grip over the affairs of the company and at
the same time, they need extra funds. They will, therefore, prefer preference shares or debentures
over equity shares so long they help them in retaining control over the company.
d. Risk Principle
This principle suggests using more proportion of common equity for financing requirements use
of more and more debts means higher commitment in form of interest payout. This would lead to
erosion of shareholders value in unfavorable business situation. There are two risks associated
with this principle:
(i)
(ii)
Business risk: It is an unavoidable risk because of the environment in which the
firm has to operate, and it is represented by the variability of earnings before
interest and tax (EBIT). The variability in turn is influenced by revenues and
expenses. Revenues and expenses are affected by demand of firm products,
variations in prices and proportion of fixed cost in total cost.
Financial risk: It is a risk associated with the availability of earnings per share
caused by use of financial leverage. It is the additional risk borne by the
shareholders when a firm uses debt in addition to equity financing. Generally, a firm
should neither be exposed to high degree of business risk and low degree of
financial risk or vice-versa, so that shareholders do not bear a higher risk.
e. Flexibility Principle:
By flexibility it means that the management chooses such a combination of sources of financing
which it finds easier to adjust according to changes in need of funds in future too. While debt
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could be interchanged (If the company is loaded with a debt of 18% and funds are available at
15%, it can return old debt with new debt, at a lesser interest rate), but the same option may not
be available in case of equity investment.
f. Nature of Enterprise
The nature of enterprise also to a great extent affects the capital structure of the company.
Business enterprises which have stability in their earnings, or which enjoy monopoly regarding
their products may go for debentures or preference shares since they will have adequate profits
to meet the recurring cost of interest/fixed dividend. This is true in case of public utility
concerns. On the other hand, companies which do not have this advantage should rely on equity
share capital to a greater extent for raising their funds. This is, particularly, true in case of
manufacturing enterprises.
g. Legal Requirements
The promoters of the company have also to keep in view the legal requirements while deciding
about the capital structure of the company. This is particularly true in case of banking companies
which are not allowed to issue any other type of security for raising funds except equity share
capital on account of the Banking Regulation Act.
h. Purpose of Financing
The purpose of financing also to some extent affects the capital structure of the company. In case
funds are required for some directly productive purposes. For example, purchase of new
machinery, the company can afford to raise the funds by issue of debentures. This is because the
company will have the capacity to pay interest on debentures out of the profits so earned. On the
other hand, if the funds are required for non-productive purposes, providing more welfare
facilities to the employees such as construction of school or hospital building for company‘s
employees, the company should raise the funds by issue of equity shares.
i. Period of Finance
The period for which finance is required also affects the determination of capital structure of
companies. In case, funds are required, say for 3 to 10 years, it will be appropriate to raise them
by issue of debentures rather than by issue of shares. This is because in case the funds are raises
by issue of shares, their repayment after 8 to 10 years (when they are not required) will be
subject to legal complications. Even if such funds are raised by issue of redeemable preference
shares, their redemption is also subject to certain legal restrictions. However, if the funds are
required more or less permanently, it will be appropriate to raise them by issue of equity shares
j. Market Sentiments
The market sentiments also decide the capital structure of the company. There are periods when
people want to have absolute safety. In such cases, it will be appropriate to raise funds by issue
of debentures. At other periods, people may be interested in earnings high speculative incomes:
at such times, it will be appropriate to raise funds. By issue of equity shares. Thus, if a company
wants to raise sufficient funds, it must take into account market sentiments; otherwise its issue
may not be successful.
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k. Requirement of Investors
Different types of securities are to be issued for different classes of investors. Equity shares are
best suited for bold or venturesome investors. Debentures are suited for investors who are very
cautious while preference shares are suitable for investors who are not very cautious. In order to
collect funds from different categories of investors, it will be appropriate for the companies to
issue different categories. This is particularly true when a company needs heavy funds.
l. Size of the Company
Companies which are of small size have to rely considerably upon the owners‘ funds for
financing. Such companies find it difficult to obtain long-term debt. Large companies are
generally considered to be less risky by the investors and, therefore, they can issue different
types of securities and collect their funds from different sources. They are in a better bargaining
position and can get funds from the sources of their choice.
m. Government Policy
Government policy is also an important factor in planning the company‘s capital structure. For
example, a change in the lending policy of financial institutions may mean a complete change in
the financial pattern. Similarly, by virtue of The Securities Act of Nepal, 2063 and the Rules
made there under, The Securities & Exchange Board of Nepal can also considerably affect the
capital issue policies of various companies. Besides this, the monetary and fiscal policies of the
Government also affect the capital structure decision.
n. Provision for the Future
While planning capital structure the provision for future should, also be kept in view, it will
always be safe to keep the best security to be issued in the last instead of issuing all types of
securities in one installment. In the words of Gerstendberg, ―Manager of corporate financing
operations must always think of rainy days or the emergencies. The general rule is to keep your
best security or some of your best securities till the last‖
Thus, there are many factors which are to be considered while designing an appropriate capital
structure of a company. As a matter of fact, some of them are conflicting in nature. The relative
weight age assigned to each of these factors will vary widely from company to company
depending upon the characteristics of the company, the general economic conditions and the
circumstances under which the company is operating. Companies issue debenture and preference
shares to enlarge the earnings on equity shares, while equity shares are issued to serve as a
cushion to absorb the shocks of business cycles and to afford flexibility. Of course, greater the
operating risk, the less debt the firm can use, hence in spite of the fact that the debt is cheaper the
company should use it with caution. Moreover, it should be remembered that ―Financial theory
has not developed to the point where data related to these considerations are fed at one end of a
computer and an ideal financial structure pops out of the other, Consequently, human judgment
must be used to resolve the many conflicting forces in laying plans for the types of funds to be
sought.
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2.1.11 Overcapitalization and Undercapitalization
2.1.11.1 Overcapitalization
Overcapitalization occurs when a company has issued more debt and equity than its assets are
worth. The market value of the company is less than the total capitalized value of the company.
An overcapitalized company might be paying more in interest and dividend payments than it has
the ability to sustain long-term. The heavy debt burden and associated interest payments might
be a strain on profits and reduce the amount of retained funds the company has to invest in
research and development or other projects. To escape the situation, the company may need to
reduce its debt load or buy back shares to reduce the company's dividend payments.
Restructuring the company's capital is a solution to this problem.
 Causes of Over-Capitalization:
Over-capitalization arises due to following reasons:
(i)
(ii)
(iii)
(iv)
(v)
Raising more money through issue of shares or debentures than company can employ
profitably.
Borrowing huge amount at higher rate than rate at which company can earn.
Excessive payment for the acquisition of fictitious assets such as goodwill etc.
Improper provision for depreciation, replacement of assets and distribution of
dividends at a higher rate.
Wrong estimation of earnings and capitalization.
2.1.11.2 Undercapitalization
Undercapitalization occurs when a company does not have sufficient capital to conduct normal
business operations and pay creditors. This can occur when the company is not generating
enough cash flow or is unable to access forms of financing such as debt or equity.
Undercapitalized companies also tend to choose high-cost sources of capital, such as short-term
credit, over lower-cost forms such as equity or long-term debt. Investors want to proceed with
caution if a company is undercapitalized because the chance of bankruptcy increases when a
company loses the ability to service its debts.
 Causes of Under-Capitalization:
i) Poor macroeconomic conditions that can lead to difficulty in raising funds at critical
times
ii) Failure to obtain a line of credit
iii) Funding growth with short-term capital rather than permanent capital
iv) Poor risk management, such as being uninsured or underinsured against predictable
business risks
Illustration No. 9
ABC Ltd. Has 50,000 outstanding shares. The current market price per share is NRS 100 each.
It hopes to make a net income of NRS 5,00,000 at the end of current year. The Company‘s
Board is considering a dividend of NRS 5 per share at the end of current financial year. The
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Strategic Finance Decision and Policy
company belongs to a risk class for which the capitalization rate is 10%
Show, how the M-M approach affects the value of firm if the dividends are paid or not paid.
Illustration No. 9- Solution
Solution:
a) When dividends are paid
i) Price per share at the end of year 1
100
= (5 +P1)/(1 + 0.10)
Market Price per Share (P1) = NRS 105/-.
ii) Value of firm
= D1 + P 1
1 + Ke
=50000x5+50000x105
1 + 0.10
= 250000 +5250000
1.10
= NRS 50,00,000
b) When dividend is not paid
i) Price per share at the end of year 1
100
= 1/1.1 x P1
Market Price per Share (P1) = NRS 110/ii) Value of firm
= 50000x0+50000x110
1 + 0.10
= 0 +5500000
1.10
= NRS 50,00,000/-
M.M Approach indicates that the value of the firm in both the situations will be same.
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Knowledge Test 10
M Ltd. Belongs to a risk class for which the capitalization rate is 10%. It has 25,000
outstanding shares and the current market price is NRS 100. It expects a net profit of NRS
2,50,000 for the year and the Board is considering dividend of NRS 5 per share.
M Ltd. requires to raise NRS 5,00,000 for an approved investment expenditure. Show, how
the MM approach affects the value of M Ltd If dividends are paid or not paid.
Knowledge Test 11
Summary financial information for ABC Co is given below, covering the last two years.
Income Statement (Extract)
Particulars
Revenue
Cost of sales
Salaries and wages
Other costs
Profit before interest and tax
Interest
Tax
Profit after interest and tax
Dividends payable
Current year
NRS ’000
Previous year
NRS ’000
74,521
28,256
20,027
11,489
14,749
1,553
4,347
8,849
4,800
68,000
25,772
19,562
9,160
13,506
1,863
3,726
7,917
3,100
Balance Sheet (Extract)
Particular
Shareholders‘ funds
Long term debt
Other information
Number of shares in issue (‗000)
P/E ratio (average for year)
ABC Co
Industry
96 |The Institute of Chartered Accountants of Nepal
Current year
NRS ’000
Previous year
NRS ’000
39,900
14,000
35,087
17,500
14,000
14,000
14
15.2
13
15
Strategic Finance Decision and Policy
Required
(a) Using profitability, debts, and shareholders‘ investment ratios, discuss the performance
of ABC Co over the last two years.
(b) Explain why accounting profits may not be the best measure of a company‘s
achievements.
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Chapter 2
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2.1.12 Solutions of Knowledge Tests
Knowledge Test 1- Solution
Calculation of Earnings Per Share
Additional fund
(In Rs.
Lakhs)
Proposal 1
Proposal 2
Proposal 3
Proposal 4
Ordinary
Shares
Ordinary
Shares and
Long-term
loan @ 8%
Ordinary
Shares and
Long-term
loan @ 9%
Ordinary
Shares and
Pref. Share
8.00
8.00
8.00
8.00
-
0.80
1.35
-
Earning Before Tax
8.00
7.20
6.65
8.00
Less: Tax 50%
4.00
3.60
3.33
4.00
Earning After Tax
4.00
3.60
3.33
4.00
Less Preference Share Dividend
-
-
-
0.50
Earnings available for Ordinary
Equity Share Holders
4.00
3.60
3.33
3.50
45,000
35,000
30,000
35,000
8.89
10.29
11.08
10.00
Earnings Before Interest and Tax
Less: Interest on Debenture
No. of Ordinary Shares (New
Shares plus Existing 25,000 Share)
Earnings per Share
The above analysis shows that proposal 3 gives the highest earning per share. It is on account
of the following reasons.
(i) Rate of interest on loan is fixed and independent of the profit or loss and is treated as an
expense by the income Tax authorities. Thus, the company's profit is taxed after deduction
of this interest charge.
(ii) Dividend per share is more. It will, therefore, attract shareholders for interference from
them in the management of the company.
(iii) The borrowers are not the owners; hence there will be least interference from them in the
management of the company.
98 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
Knowledge Test 2- Solution:
Calculation of Market Price of Share of Alpha Company
PreParticulars
Post- Redemption
Redemption
Earnings Before Interest and Tax
200,000
200,000
Less: Interest on Convertible Bond @ 14%
70,000
Earning Before Tax
130,000
200,000
Less: Tax @ 35 per cent
45,500
70,000
Earning After Tax
Number of Outstanding Shares (Nos.)
Earnings Per Share (Rs.)
P/E Ratio
84,500
10,000
8.45
20.1
130,000
15,000
8.67
25.1
Market Price per share [Rs.] (i.e. price-earnings
ratio times x EPS)
169.85
217.53
Comment: This is two-in-one benefits scheme. The company should convert the bond into
shares because both shareholders and debenture holders stand to gain. The post-redemption
market price of the equity shares would be Rs. 217.53 than the pre-redemption market price of
Rs. 169.85. Moreover, the debenture/bondholders would receive Rs. 1.690 in stock (i.e. 169x
10 shares, in place of receiving cash Rs. 1,080 only.
Knowledge Test 3- Solution
i. External Funds Requirement (EFR) can be computer on the basis of the factoring equation
formula.
A
L
∆S - MS1 (1 - d)
External Funds Requirement (EFR) =
[ S - S ]
Where EFR = External Funds Requirement.
A
=
Total Assets
S
=
Previous Sales
L
=
Payables and provisions
M
=
Profit margin
S1
=
Projected sales for the next year.
D
=
Dividend payout Ratio
Δs
=
Expected Increase in sales
On substituting the figures, we get the following results:
The Institute of Chartered Accountants of Nepal | 99
Chapter 2
Financial Management
External Funds Requirement (EFR) =
1100
600
[
=
=
=
ii.
(a)
Short-term Borrowing (x) will be
Existing Loans
Additional Borrowings
(c)
200
600
] * 120 - [ 0.004 * 720 * 0.5]
1.5 x 120-14.4
Rs. 180-14.4
Rs. 165.6 lakhs
Mode of raising the funds:
Short term borrowing be taken as X
Current Ratio should be 1.33.
1.33 =
(b)
-
600 ∗ 1.2
+ 𝑥𝑥
200 ∗ 1.2
1.33 =
720
+ 𝑥𝑥
240
301.35
200.00
Rs. 101.35 lakhs
Long-term Debt:
Ratio of fixed assets to long-term loans = 1.5
Let Long-term Loan be x
500𝑥𝑥1.2
= 1.5
𝑥𝑥
1.5 x = Rs. 600
Or Long-term Loan (x)
Existing Loans
Additional Loans
Equity:
External Funds
Less Additional Bank Borrowing
Additional Long-term Loans
Balance to be raised by additional equity
Rs. 400
360
Rs. 40 lakhs
165.60
101.35
40.00
141.35
24.25
Lakhs
The above computation can be verified by computing the debt-equity ratio which has not to
exceed 1.05.
Debt-equity Ratio =
Debit
Equity
100 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
400
=
224.25 + 168
=
1.02
Hence, the condition is satisfied.
Note:
Long-term Debt = 360 + 40 = 400
Equity Share Capital = 200 + 24.225 = 224.25
Reserves will also increase by 20% = 140 x 1.2 = Rs. 168 lakhs
d.
The funds are to be raised in the following order
Short term Bank Borrowings
Long-term Bank Borrowings
Equity share Capital
Total
Rs.
Rs.
101.53
40.00
24.25
165.60
Knowledge Test 4- Solution
Evaluation of Financing Alternative
Particulars
A
B
Lakhs
[Rs. In Lakhs]
C
Return on Rs. 50 lakhs @ 25%
Less: interest on Debentures
12.50
-
12.50
2.80
12.50
2.10
Interest on Loan
Taxable profit
Less: Tax @ 50%
Profit after Tax available for shareholders
12.50
6.25
6.25
1.80
7.90
3.95
3.95
4.50
5.90
2.95
2.95
12.50%
19.75%
29.50%
Rate of Return on Equity Share Capital
From shareholders point of view alternative C (highest) is to be chose.
Knowledge Test 5- Solution
In case of the project under consideration, the debt-equity ratio insisted by the financing
agencies is 2:1.
There are two alternatives available:
(i)
Raising the entire amount by issue of equity shares.
(ii) Raising Rs. 100 lakhs by way of debt and Rs. 50 lakhs by way of issue of shares. Thus,
maintaining a debt-equity ratio of 2:1
In the first case the interest amount will be zero while in the second case it will be Rs. 12
lakhs.
The Institute of Chartered Accountants of Nepal | 101
Chapter 2
Financial Management
Indifference Point
EBIT (1- Tax)
No of Shares
EBIT (1- 0.5)
150,000
=
=
(EBIT - Interest) (1- Tax)
No of Shares
(EBIT - 1200,000) (1- 0.5)
50,000
EBIT = Rs 18 Lakhs
EBIT at point of indifference is, therefore, Rs. 18 lakhs.
If EBIT is Rs. 18 lakhs, the earning on equity after tax will be 6% per annum notwithstanding
whether the capital investment is financed fully by equity or any other mix of equity and debt
provided the rate of interest on debt is 12%.
Knowledge Test 6- Solution
The level of earnings before interest and tax where the EPS will be equal under both the
alternatives can be ascertained by the following equation:
In alternative 1, debentures will be of Rs. 50 lakhs on which an interest of Rs. 5 lakhs will be
paid per annum. The number of ordinary shares will be 10 lakhs.
In alternative 2, there will be no debentures and therefore no liability for interest. But the
number of shares will be 11 lakhs since for raising Rs. 50 lakhs 1, 00,000 shares will have to
be issued. On putting the figures in the above equation.
EBIT (1- Tax)
No of Shares
=
(EBIT - Interest) (1- Tax)
No of Shares
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 1 − 0.5
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 − 𝑁𝑁𝑁𝑁𝑁𝑁 500,000 1 − 0.5
=
1,100,000
1,000,000
EBIT= Rs 50,00,000
The Value of EBIT in the above equation is the indifference level of EBIT and is found to be
Rs 50,00,000. At this level of EBIT, the EPS under both the plans would be same. In order to
find out the level of EBIT at which Uncommitted EPS would be same, the sinking fund
obligation of Rs 500,000 would also be considered and the indifferent level of EBIT in such
case would be
EBIT (1- Tax)
No of Shares
=
(EBIT - Interest) (1- Tax) - Sinking fund
102 |The Institute of Chartered Accountants of Nepal
No of Shares
Strategic Finance Decision and Policy
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 1 − 0.5
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 − 𝑁𝑁𝑁𝑁𝑁𝑁 500,000 1 − 0.5 − 500,000
=
1,100,000
1,000,000
EBIT= Rs 165,00,000
At Rs. 165 lakhs profit before interest and tax, the uncommitted earnings per share will be
equal in both the alternatives.
The above calculations help in ascertaining the level of operating profit (EBIT) beyond which
the debt alternative is beneficial because of its favorable effect on earnings per share (EPS) or
uncommitted earnings per share (UEPS). In other words, it is profitable to raise debt for
strengthening EPS or UEPS if there is likelihood that future operating profits are going to be
higher than level of EBIT as determined. On the other hand, it is advisable to issue equity
shares for raising more funds if it is expected that EBIT is going to be lower than that
calculated. The uncommitted earnings per share approach emphasize the importance of
liquidity to meet obligations regarding creation and providing for sinking funds in case the
company adopts the debt alternative. Explicit cost of the debt is low and the level of earnings
before interest and tax for earning per share equivalency point is also low. However, if
uncommitted earning per share approach is adopted the level of earnings before interest and
tax for uncommitted earning per share equivalency point debt-equity alternative will go up
significantly. Uncommitted earning per share equivalency point is significant for managerial
decision-making since it takes into account not only the explicit cost of debt but also the
commitment of resources for the repayment of debt obligations out of expected future
earnings. However, uncommitted earning per share would not have much relevance in the long
run because of redemption of debentures. The sinking fund will then become a part of the
equity shareholder's funds.
Verification
The results shown by the above equation can be verified with the help of following
calculations:
When No Sinking fund is required
Earnings before interest and Tax
Less: Interest
Earnings after interest but before Tax
Less: Tax
Earnings after Tax
Number of Outstanding Share
Earnings Per Share
Alternative I
Alternative II
55
5
50
25
55
55
28
25
10
2.50
28
11
2.50
The Institute of Chartered Accountants of Nepal | 103
Chapter 2
Financial Management
When sinking fund is required
Alternative I
Earnings before interest and Tax
Less: Interest
Earnings after interest but before Tax
Less: Tax @ 50%
Earnings after Tax
165
5
160
80
80
165
165
83
83
75
83
10
7.50
11
7.50
Earnings after Tax and sinking fund (Uncommitted
earnings)
Number of Equity shares
Earnings per share
Alternative II
Knowledge Test 7- Solution
Solution:
Statement Showing the Value of The Firm
Particular
Rs.
Earnings before Interest & Tax (EBIT)
Less: Interest at 10% on Debentures of Rs.5.00 lakhs
Earnings available for Equity Shareholders (NI)
Equity Capitalization Rate (ke)
Market Value of Equity (S):
Market Value of Debt (B)
1, 00,000
50,000
50,000
12.50%
4,00,000
5, 00,000
Total Value of Firm (S+B)
9, 00,000
Calculation of Overall cost of Capital:
Overall Cost of Capital =
EBIT / Value of Firm
=
1, 00,000 /9, 00,000
=
11.11%
The above table shows that raising of additional debt has increased the total value of the firm
and reduced the overall cost of capital structure.
Similarly, according to Net Income approach, the value of the firm will get decreased in case
the amount of debt is decreased by issuing additional equity shares. This will be clear with the
following example:
104 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
Knowledge Test 8- Solution
Solution:
Statement Showing the Value of The Firm
Particular
Earnings before Interest & Tax (EBIT)
Less: Interest at 10% on Debentures of Rs.3.00 lakhs
Earnings available for Equity Shareholders (NI)
Equity Capitalization Rate (ke)
Rs.
100,000
30,000
70,000
12.50%
Market Value of Equity (S):
Market Value of the Firm (B)
Total Value of Firm (S+B)
560,000
300,000
860,000
Calculation of Overall cost of Capital:
Overall Cost of Capital = EBIT/ Value of Firm
= 1, 00,000 / 8,60,000 ×100
= 11.6%
The above table shows that decrease in debt has reduced the overall value of the firm while
increased the overall cost of capital.
Thus, according to Net Income (NI) approach, a firm can increase or decrease its total value
(V) and decrease or increase its overall cost of capital by increasing or decreasing the debt
content or the degree of leverage in its capital structure. An increase in the value of the firm
would result in increase in the market value of its shares and vice-versa.
Knowledge Test 9- Solution
Solution:
Statement Showing the Value of The Firm
Particulars
Rs.
Earnings before Interest & Tax (EBIT)
Overall Capitalization Rate (k)
Market Value of the Firm (V): (1,00,000 /12.5) ×100
Total Value of Debt (B)
Market Value of Equity S=V-B
1,00,000
12.50%
8,00,000
5,00,000
3,00,000
Equity Capitalization Rate:
Ke = EBIT-I ×100
V-B
The Institute of Chartered Accountants of Nepal | 105
Chapter 2
Financial Management
=1,00,000-50,000 ×1000=50,000 ×100
8,00,000-50,000
3,00,000
16.67%
The overall cost of capital as per NOI approach can now be verified as follows:
Overall Cost of Capital (K)
= kd (B/V) + ke (S/V)
=10%
(5,00,000/8,00,000)
+
16.67%
Overall Cost of Capital (K)
(3,00,000/8,00,000)
= 10% (5/8) + 16.67 % (3/8)
=6.25%+6.25%
= 12.50%
According to NOI approach, the market price per share remains unaffected on account of
change in debt equity mix.
Knowledge Test-10 Solution
Answer
a. When dividend is paid
i) Price per share at the end of year 1
1(NRS 5+P1)
100 =
1.10
110 = NRS 5 + P1
P1 = 105
i) Amount required to be raised from issue of new shares
NRS 5,00,000 – (2,50,000 – 1,25,000)
NRS 5,00,000 – 1,25,000 = NRS 3,75,000
ii) Number of additional shares to be issued
3,75,000 = 75,000 shares or say 3572 shares
105
21
iii) Value of M Ltd.
(Number of shares x Expected Price per share)
i.e., (25,000 + 3,572) x NRS 105 = NRS 30,00,060
B
(i)
When dividend is not paid
price per share at the end of year 1
100 = P1.
1.10
P1 = 110
106 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
(ii)
Amount required to be raised from issue of new shares
NRS 5,00,000 – 2,50,000 = 2,50,000
(iii)
Number of additional shares to be issued
2,50,000 =
25,000 shares or say 2273 shares.
110
(iv)
11
Value of M Ltd.,
(25,000 + 2273) x NRS 110
= NRS 30,00,060
M.M Approach indicates that the value of the firm in both the situations will be same
Knowledge Test 11- Solution
Answer
a) Calculation of profitability, debts, and shareholders‘ investment ratios, discuss the
performance of ABC Co over the last two years
Ratio analysis
Current year
previous year
Return on Capital Employed
(PBIT/Long-term capital)
14,749/(39,900 + 14,000)
= 27.4%
13,506/(35,087+17,500)=
25.7%
Net profit margin
14,749/74,521 = 0.198 =
19.8%
13,506/68,000 = 0.199 =
19.9%
14,000/39,900 = 35.1%
17,500/35,087 = 49.9%
14,749/1,553 = 9.5
13,506/1,863 = 7.2
8,849/14,000 = NRS 0.63
7,917/14,000 = NRS 0.57
14.0 x 0.63 = NRS 8.82
4,800/14,000 = NRS 0.34
13.0 x 0.57 = NRS 7.41
3,100/14,000 = NRS 0.22
0.34/8.82 = 3.85%
0.22/7.41 = 2.97%
Particular
Profitability
Debt
Gearing (Debt/Equity)
Interest
coverage
(PBIT/Interest)
Shareholders’ investment
EPS
Share price (P/E x EPS)
Dividend per share
Dividend yield (DPS/Share
price)
The performance of ABC Co
A shareholder of ABC Co would probably be reasonably pleased with their performance over
these two years.
The Institute of Chartered Accountants of Nepal | 107
Financial Management
Chapter 2
i) Growth of income
The company has grown in terms of turnover and profits. Revenue has grown by 9.6%
((74,521 – 68,000)/68,000 x 100%) and return on capital employed has increased from
25.7% to 27.4%. There may be some concern over the 25.4% increase ((11,489 – 9,160)/9,160
x 100%) in other costs and more information would be needed to determine if this is a one-off
increase or a worrying long-term trend. The net profit margin is almost unchanged, showing
that the increase in ROCE is due to an increase in asset turnover. Salaries and wages have
only increased by 2.4% ((20,027 – 19,562)/19,562 x 100%) so employees may be less pleased
with the situation. Employee discontent could create problems for the business in future.
ii) Gearing
The financial risk that the shareholders are exposed to do not appear to be a problem area as
gearing has decreased from 49.9% to 35.1% and interest cover is more than sufficient. The
company may want to consider increasing gearing to invest in suitable projects and generate
further growth.
iii) Shareholder return
The shareholders‘ investment ratios all indicate that shareholders‘ wealth has increased. The
share price has increased by 19% ((8.82 – 7.41)/7.41 x 100%). The total shareholder return
is (Pl – Po + DI)/Po = (8.82 – 7.4I + 0.34)/7.41 = 23.6%. This is probably sufficient to satisfy
shareholders. The P/E ratio reflects the market‘s appraisal of the share‘s future prospects and
this has improved. It is still lower than the industry average which suggests that more growth
could be achieved.
b) Accounting profits may not be the best measure of a company‘s achievements because of
following reason.
i) Manipulation
Accounting profits can be manipulated to some extent by choices of accounting policies. For
example, the depreciation amount will depend on the basis of calculation of depreciation and
development costs can be capitalized instead of being written off to the income statement.
ii) Risk
Profit does not take account of risk. Shareholders will be very interested in the level of risk
and maximizing profits may be achieved by increasing risk to unacceptable levels.
iii) Volume of investment
Profits alone take no account of the volume of investment that it has taken to earn the profit.
Profits must be related to the volume of investment to have any real meaning.
iv) Short-term performance
Profits are reported every year (with half-year interim results for quoted companies). They are
measures of short-term historic performance, whereas a company's performance should
ideally be judged over a longer term and future prospects considered as well as past profits.
108 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
2.2 Leverages
2.2.1 Learning Objectives
Upon completion of this chapter student will be able to:
 Understand the concept of business and financial risk.

Define, calculate and explain the significance to a company‘s financial position and
financial risk of its level of the following gearing,
 Operating leverage
 financial leverage
 combined leverage
 Understand the relationship between Margin of Safety (MOS) & Operating Leverage
 Differentiate the positive and negative financial leverage.
2.2.2 Chapter Overview
Leverage
(Gearing)
Business and Financial Risk
Types of Leverages
a) Operating Leverage
b) Financial Leverage
c) Combined Leverage
Fig: Chapter Overview of Leverages
The Institute of Chartered Accountants of Nepal | 109
Financial Management
Chapter 2
2.2.3 Introduction
The general meaning given by Cambridge English dictionary is ―the action or advantage using a
lever‖.
The provenance of the word from the effect of a lever in physics, a simple machine which
amplifies the application of a comparatively small input force into a correspondingly greater
output force.
In finance, leverage (sometimes called as gearing) is any technique involving use of fixed costs
or use of debt (borrowed fund) with the expectation that the after-tax profit to equity holders
from the transaction will exceed the borrowed cost.
Gearing (i.e. Leverage) in general refers to a 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, sales revenue, Earnings Before
Interest and Tax (EBIT), Earning per share (EPS) etc. Leverage results from the use of fixed cost
assets or borrowed funds to magnify returns to the firm‘s owners. Generally, increases in
leverage result in increased return and risk, whereas decreases in leverage result in decreased
return and risk. The amount of leverage in the firm's capital structure- the mix of long-term debt
and equity maintained by the firm- can significantly affect its value by affecting return and risk.
There are three commonly used measures of leverage in financial analysis. These are:
i.
Operating Leverage- It is the relationship between Sales and EBIT and indicated
business risk.
ii.
Financial Leverage – It is the relationship between EBIT and EPS and indicates
financial risk.
iii.
Combined Leverage – It is the relationship between Sales and EPS and indicated
total risk.
2.2.3.1 Operating Leverage
Operating leverage measure the relationship between the sales revenue and the Earning Before
Income and Tax or it measure the effect of change in sales revenue on the level of Earnings
Before Income and Taxes.Operating leverage (OL) maybe defined as the uses of an asset with a
fixed cost in the expectation that sufficient revenue will be generated to cover all the fixed and
variable costs. It is the degree to which a firm uses fixed costs in its operations. The higher the
relative fixed costs (% of total costs), the higher the firm's degree of operating leverage. In firms
with high degree of operating leverage, a small change in revenues will result in a larger change
in operating income because most costs are fixed.
How the operating leverage works
Operating leverage occurs when a company has fixed costs that must be met regardless of sales
volume. When the firm has fixed costs, the percentage change in profits due to changes in sales
volume is greater than the percentage change in sales.
110 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
Illustration 1
Two firms have the following cost structure
Firm A (In NRs)
Sales
500
Variable costs
(300)
Fixed costs
(100)
EBIT
100
Firm B (In NRs)
500
(100)
(300)
100
What is the level of operating gearing in each and what would be the impact on each of a 10%
increase in sales?
Illustration 1- Answer
Operating gearing can be calculated as follows:
Firm A
Firm B
Fixed costs/variable costs
100/300=0.33
300/100=3
Firm B carries a higher operating gearing because it has higher fixed costs.
Its operating earnings will therefore be more volume-sensitive:
Firm A
Firm B
Firm A
Firm B
NRs
10% Inc
NRs
10% Inc
Sales
500
550
500
550
Variable costs
(300)
(330)
(100)
(110)
Fixed Costs
(100)
(100)
(300)
(300)
EBIT
100
120
100
140
Firm B has enjoyed an increase in EBIT of 40% whilst Firm A has had an increase of only
20%. In the same way a decrease in sales would bring about a greater fall in B‘s earnings than
in A‘s.
Operating leverage is a function of three factors:
i. Rupee amount of fixed cost,
ii. Variable contribution margin, and
iii. Volume of sales.
Operating leverage is the ratio of net operating income before fixed charges to net operating
income after fixed charges.
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 =
Where,
Q= Quantity
P= Price Per Unit
VCPU= Variable Cost Per Unit
𝑄𝑄 𝑄 𝑃𝑃 𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑄𝑄 𝑄 𝑃𝑃 𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 − 𝐹𝐹𝐹𝐹
The Institute of Chartered Accountants of Nepal | 111
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FC=Fixed Costs
Or
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀
=
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐶 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
Degree of Operating Leverage
The degree of operating leverage may be defined as percentage change in the profits resulting
from a percentage change in the sales. It can be calculated with the help of the following
formula:
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑜𝑜𝑜𝑜 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 =
% 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
% 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Operating leverage is directly proportional to business risk. More operating leverage leads
tomore business risk. The formulation of the operating leverage is static in nature and calculates
the effect on EBIT for a change in given level of Sales. If the level of sales changes, the DOL for
the new level of sales may be different.There is a relationship between leverages and Break-even
point. Both are used for profit planning. In brief the relationship between leverage, breakeven
point and fixed costs as under:
Leverage
1. Firm with low leverage
2. Firm with high leverage
Fixed Costs
1. High fixed cost
2. Lower fixed cost
Break-even point
1.Lower Break-even point
2. Higher Break-even point
Operating Leverage
1. High degree of operating leverage
2. Lower degree of
Illustration 2
A Company produces and sells 10,000 shirts. The selling price per shirt is Rs. 500. Variable
cost is Rs. 200 per shirt and fixed operating cost is Rs. 25,00,000.
(a) Calculate operating leverage.
(b) If sales are up by 10%, then what is the impact on EBIT?
Illustration 2- Solution
Solution
(a) Statement of Profitability
Particular
Sales Revenue (10,000 × 500)
Less: Variable Cost (10,000 × 200)
112 |The Institute of Chartered Accountants of Nepal
Rs.
50,00,000
20,00,000
Strategic Finance Decision and Policy
Contribution
Less: Fixed Cost
EBIT
30,00,000
25,00,000
5,00,000
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 =
=
=
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
30,00,000 / 500,000
6
(b) If the sales are up by 10%, the impact on EBIT can be identified by degree of operating
leverage
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑜𝑜𝑜𝑜 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 =
6
=
Change in EBIT/ 5,00,000
(50,00,000-55,00,000) / 50,00,000
6
=
Change in EBIT / 50,000
% 𝐶𝐶𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
% 𝐶𝐶𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Change in EBIT= 50,000* 6
=
3,00,000
% change in EBIT= 3,00,000/5,00,000 = 60 %
Above example shows the sensitivity of the firm. Due to effect of operating leverage (that is,
changes in sales result in more than proportional changes in operating profits) for each sales
increase by 10% leads to a 60% increase in operating profit. As the operating leverage is
related to the operating risk of the investments,which means that fixed cost of operations of
the enterprise. It highlights that greater the fixed cost of operations means that higher the
operating risk; which means that greater will be breakeven point and vice versa. The greater
volume of fixed cost of operations are found to be more favorable only during the occasion of
greater volume of earnings, unless otherwise the dominance of fixed cost of operations are
found to be undesirable to magnify the volume of EBIT.
Uses of Operating Leverage
 Operating leverage is one of the techniques to measure the impact of changes in sales
which lead for change in the profits of the company. If any change in the sales, it will
lead to corresponding changes in profit.
 Operating leverage helps to identify the position of fixed cost and variable cost.
 Operating leverage measures the relationship between the sales and revenue of the
company during a particular period.
The Institute of Chartered Accountants of Nepal | 113
Chapter 2
Financial Management
 Operating leverage helps to understand the level of fixed cost which is invested in the
operating expenses of business activities.
 Operating leverage describes the overall position of the fixed operating cost.
Margin of Safety and Operating Leverage
Margin of safety (MOS) may be calculated as follows:
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑆 𝑆𝑆𝑆𝑆𝑆𝑆 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
∗ 100
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Higher margin of safety indicates lower business risk and higher profit and vice versa. If we both
multiply and divide above formula with the profit volume (PV) ratio, then:
𝑀𝑀𝑀𝑀𝑀𝑀 =
𝑀𝑀𝑀𝑀𝑀𝑀 =
We know that,
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑆 𝑆𝑆𝑆𝑆𝑆𝑆 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑆 𝑆𝑆𝑆𝑆 𝑆 𝑆𝑆𝑆𝑆𝑆𝑆 𝑆 𝑆𝑆𝑆𝑆
∗
=
𝑃𝑃𝑃𝑃 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑆 𝑆𝑆𝑆𝑆
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
Further, 𝐵𝐵𝐵𝐵𝐵𝐵 =
So,𝑀𝑀𝑀𝑀𝑀𝑀 =
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝑜𝑜𝑜𝑜 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑆 𝑆𝑆𝑆𝑆 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠
𝑜𝑜𝑜𝑜 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
We Know that:
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
=
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝐷𝐷𝐷𝐷𝐷𝐷 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
Therefore, 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑜𝑜𝑜𝑜 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 =
If Margin of Safety
Rises
Falls
Business Risk
Falls
Rises
1
𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑜𝑜𝑜𝑜 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
DOL (=1/MOS)
Falls
Rises
When DOL is more than one, operating leverage exists. More is the DOL higher is operating
leverage.
114 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
Knowledge Test 1
Companies
W
Sales Price per unit
X
Y
Z
20.00
32.00
50.00
70
Variable Cost per unit
6.00
16.00
20.00
50
Fixed Operating costs
60,000.00
40,000.00
100,000.00
Nil
What calculation can you draw with respect to levels of fixed costs and the degree of
operating leverage results? Explain. Assume number of units sold is 5000.
2.2.3.2 Financial Leverage
A company has the option to finance its investments by debt and equity. The company may also
use preference capital. The rate of interest on debt is fixed irrespective of the company‘s rate of
return on assets. The company has a legal binding to pay interest on debt. The rate of preference
dividend is also fixed; but preference dividends are paid when the company earns profits. The
ordinary shareholders are entitled to the residual income. That is, earnings after interest and taxes
(less preference dividends) belong to them. The rate of the equity dividend is not fixed and
depends on the dividend policy of a company.
The use of the fixed-charges sources of funds, such as debt and preference capital along with the
owners‘ equity in the capital structure, is described as financial leverage or gearing or trading on
equity. Financial leverage (FL) maybe defined as ‗the use of funds with a fixed cost in order to
increase earnings per share.‘ In other words, it is the use of company funds on which it pays a
limited return. The fixed financial cost is nothing but the preference dividend and interest on the
fixed charge financial resources. It reveals the ability of the firm to make use of "fixed financial
charges to magnify the effects of changesin EBIT on the earnings per share". The other name of
the financial leverage is Trading on Equity, which illustrates the relationship in between the
application of the fixed charge of funds in the capital structure and Earning per share. It
measures the relationship between the EBIT and the EPS, and it reflects the effect of change in
EBIT on the level of EPS.
Financial leverage can be calculated with the help of the following formula:
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑎𝑎𝑎𝑎𝑎𝑎 𝑇𝑇𝑇𝑇𝑇𝑇
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑇𝑇𝑇𝑇𝑇𝑇
Where, EBIT= Sales- (Variable costs+ Fixed cost)
EBT = EBIT-Interest
A positive financial leverage means firm is operating at a level higher than break-even point and
EBIT and EPS moves in the same direction. Negative financial leverage indicates the firm is
operating at lower than break-even point and EPS is negative.
The Institute of Chartered Accountants of Nepal | 115
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Financial Management
How the financial leverage works
When purchasing assets, three options are available to the company for obtaining financing:
using equity, debt, and leases. Apart from equity, the rest of the options incur fixed costs that are
lower than the income that the company expects to earn from the asset. In this case, we assume
that the company uses debt to finance the asset acquisition.
Assume that Company X wants to acquire an asset that costs NRs 100,000. The company can
either use equity or debt financing.
Categories
Investment
Financed by equity
Financed by debt
Return on Investments (30%)
Interest @ 10%
Earning after interest
Earnings available for equity
Company A (opts for
all equity finance)
100,000
100,000
0
30,000
0
30,000
30%
Company B (50%
equity and 50% debt)
100,000
50,000
50,000
30,000
5,000
25000
50%
From the above table, we can observe that levered firm (which has borrowed fund) is more
profitable due to low cost borrowed fund. Also, geared firm is riskier due to fixed commitment
of finance costs.
Degree of financial leverage
Degree of financial leverage may be defined as the ratio of the percentage change in earnings per
share (EPS) to the percentage change in earnings before interest and taxes. This can be
calculated by the following formula.
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑜𝑜𝑜𝑜 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 =
% 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸
% 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
This ratio indicates that the higher of financial leverage, the more volatile earnings will be. Since
interest is usually a fixed expense, leverage magnifies returns and EPS. This is good when
operating income is rising, but it can be a problem when operating income is under pressure.
Debt financing and financial leverage offer unique advantages, but only up to a certain point,
beyond that point, debt financing may be detrimental to the firm. For example, as the use of debt
in our capital structure increases, lenders will perceive a greater financial risk for the firm. For
that reason, investor may raise the average interest rate to be paid andmay demand that certain
restrictions be placed on the corporation. Three situations may emerge as a consequence of this
comparison as follows.
116 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
a. Return on investment is equal to cost of Debt:
In this case, firm is just earning what is being paid to the supplier of the funds, so it is not
advisable to borrow the funds.
b. Return on investment is less than cost of Debt
In this case, the firm will incur losses if it employs borrowed fund, so it is also not advisable
to borrow the fund.
c.
Return on Investment is more than cost of Debt
In this case, the firm is able to earn a return on funds employed at a rate higher than the cost
of debt financing, so more and more borrowed funds are employed by the firm, the benefits
accruing to the shareholder will also increases
Analysis and Interpretation of Financial Leverage
Particulars
When EBIT is more
than fixed financial
expenses
When there is no
Debt
When EBIT is more than
fixed financial expenses
Before
After
Before
After
100,000
150,000
100,000
150,000
10,000
15,000
-
20,000
20,000
20,000
20,000
100,000
150,000
80,000
130,000
(10,000)
(5,000)
Tax @ 30%
30,000
45,000
24,000
39,000
-
-
EAT
70,000
105,000
56,000
91,000
(10,000)
(5,000)
No of Shares
10,000
10,000
10,000
10,000
10,000
10,000
7.00
10.50
5.60
9.10
(1.00)
(0.50)
EBIT
Interest
EBT
EPS
DFL
1
1.25
Before
After
-1
DFL= Change on EPS/Change in
EBIT
S. N
1
2
3
4
Situation
No Fixed Financial Cost
Higher Fixed Finance Costs
When EBIT is higher than Fixed
Financial Costs
When EBIT doesn‘t cover Fixed
Financial Costs
Result
No Financial Leverage
Higher Financial Leverage
Positive Financial Leverage
Negative Financial Leverage
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Financial Management
Illustration 2
Suppose there are two firms with the same operating leverage, business risk, and probability
distribution of EBIT and only differ with respect to their use of debt (capital structure).
Firm U
Firm L
No debt
Rs. 20,000 in assets
40% tax rate
Rs. 10,000 of 12% debt
Rs. 20,000 in assets
40% tax rate
Illustration 2 Solution
Economy
Firm U: Unleveraged
Probability
Earnings Before Interest and Tax
Less: Interest
Earning Before Tax
Less: Taxes (40%)
Earnings After Taxes
Bad
Avg.
Good
0.25
Rs.2,000
Rs. 2000
800
Rs. 1,200
0.5
Rs. 3,000
Rs. 3,000
1,200
Rs. 1,800
0.25
Rs. 4,000
Rs. 4,000
1,600
Rs. 2,400
Firm L: Leveraged
Probability
Earnings Before Interest and Tax
Less: Interest
Earning Before Tax
Less: Taxes (40%)
Earnings After Taxes
Economy
Bad
0.25
Rs. 2,000
1,200
Avg.
0.5
Rs. 3,000
1,200
Good
0.25
Rs. 4,000
1,200
Rs. 800
320
Rs. 480
Rs. 1,800
720
Rs.1080
Rs. 2,800
1,120
Rs. 1,680
Ratio comparison between leveraged and unleveraged firms
FIRM U
Basic Earning Power = (EBIT/Total Assets)
Return on Investment= (PAT/Net worth)
Time Interest Earned= (EBIT/Interest)
118 |The Institute of Chartered Accountants of Nepal
Bad
Avg.
Good
10.00%
6.00%
15.00%
9.00%
20.00%
12.00%
-
-
-
Strategic Finance Decision and Policy
FIRM L
Basic Earning Power = (EBIT/Total Assets)
Return on Investment= (PAT/Net worth)
Time Interest Earned= (EBIT/Interest)
Bad
10.00%
4.80%
1.67%
Avg.
15.00%
10.80%
2.50%
Good
20.00%
16.80%
3.30%
Thus, the effect of leverage on profitability and debt coverage can be seen from the above
example. For leverage to raise expected Return on Investment, Basic Earning Power must be
greater than cost of debt i.e. BEP >Kd because if cost of debt is greater than Basic Earning
Power , then the interest expense will be higher than the operating income produced by debtfinanced assets, so leverage will depress income. As debt increases, Time Interest Earned
decreases because Earnings Before Interest and Taxes is unaffected by debt, and interest
expense increases.
Thus, it can be concluded that the basic earning power (BEP) is unaffected by financial
leverage. Firm L has higher expected Return on Investmentbecause BEP >Kd and it has much
wider Return on Investment(and Earning Per Share) swings because of fixed interest charges.
Its higher expected return is accompanied by higher risk.
Uses of Financial Leverage
 Financial leverage helps to examine the relationship between EBIT and EPS.
 Financial leverage measures the percentage of change in taxable income to the percentage
change in EBIT.
 Financial leverage locates the correct profitable financial decision regarding capital
structure of the company.
 Financial leverage is one of the important techniques which is used to measure the fixed
financial cost (borrowed funds) with the total capital of the company.
 If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets,
the earning per share and return on equity capital will decrease and vice versa.
2.2.3.3 Combined Leverage
Combined leverage maybe defined as the potential use of fixed costs, both operating and
financial, which magnifies the effect of sales volume change on the earning per share of the firm.
Combined leverage can be calculated with the help of the following formulas:
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝑪𝑪𝑪𝑪 = 𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶 𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝑶𝑶𝑶𝑶 ∗ 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍 (𝑭𝑭𝑭𝑭)
=
Where, C= Contribution Margin
=
𝑪𝑪
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬
𝑪𝑪
𝑬𝑬𝑬𝑬𝑬𝑬
∗
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬
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Chapter 2
Financial Management
EBIT= Earnings Before Interest and Taxes
EBT= Earnings Before Taxes
Degree of combined leverage (DCL)
The percentage change in a firm‘s earning per share (EPS) results from one percent change in
sales. This is also equal to the firm‘s degree of operating leverage (DOL) times its degree of
financial leverage (DFL) at a particular level of sales.
𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝒐𝒐𝒐𝒐 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝑫𝑫𝑫𝑫𝑫𝑫
= 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝒐𝒐𝒐𝒐 𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶 𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝑫𝑫𝑫𝑫𝑫𝑫
∗ 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝒐𝒐𝒐𝒐 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 (𝑫𝑫𝑫𝑫𝑫𝑫)
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 =
DOL
Low
High
High
DFL
Low
High
Low
Low
High
% 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 % 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸
∗
% 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑛𝑛 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 % 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 =
% 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖 𝐸𝐸𝐸𝐸𝐸𝐸
% 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Comments
Lower total risk. Cannot take advantage of trading on equity
Higher total risk. Very risky combination
Moderate total risk. Not a good combination. Lower EBIT due to
higher DOL and lower advantage of trading on equity due to low
DFL
Moderate total risk. Best Combination. Higher financial risk is
balanced by lower total business risk.
Illustration 3
A firm‘s details are as under:
Sales (24,000 unit @Rs 100 per unit)
Rs. 24,00,000
Variable Cost
50%
Fixed Cost
Rs. 10,00,000
It has borrowed Rs. 10,00,000 @ 10% p.a. and its equity share capital are Rs. 10,00,000 (Rs.
100 each)
Calculate:
(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage
(d) Return on Investment
(e) If the sales increases by Rs. 6,00,000; what will the new EBIT?
120 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
Illustration 3- Solution
Solution
Calculation of Earnings after Taxes
Particular
Rs.
Sales Revenue
Less: Variable cost
Contribution Margin
Less: Fixed cost
Earnings Before Interest and Taxes
Less: Interest
24,00,000
12,00,000
12,00,000
10,00,000
2,00,000
1,00,000
Earnings Before Taxes
Less: Tax (50%)
Earnings After Taxes
No. of equity shares
1,00,000
50,000
50,000
10,000
Earnings Per share
5
1200000
(a) Operating Leverage
=
(b) Financial Leverage
=
(c) Combined Leverage
= OL × FL = 6 × 2 =
(d) Return on Investment=
20000
200000
100000
50000
1000000
=
6 times
=
2 times
× 100=
12 times.
5%
(e) If the sales are increased by Rs 600,000 then the impact of sales on EBIT can be
identified by Degree of Operating Leverage
Operating Leverage = 6
6=
Change in EBIT
0.25
Change in EBIT=1.5
Increase in EBIT = Rs. 2,00,000 × 1.5 = Rs. 3,00,000
New EBIT = 5,00,000
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Chapter 2
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Knowledge Test 2
The following details of XYZ Ltd. for the year ended on Ashadh end, 2068 are given below:
Operating leverage:
1.4
Combined leverage:
2.8
Fixed cost (excluding interest):
Rs. 204 thousand
Sales:
Rs. 3,000 thousand
12% Debentures of Rs. 100 each:
Rs. 2,125 thousand
Equity shares capital of Rs. 100 each:
Rs. 1,700 thousand
Income-tax rate:
30 per cent
Required:
Calculate the P/V ratio and Earnings per share (EPS).
Knowledge Test 3
A company requires Rs. 1,500,000 for the installation of a new unit, which would yield an
annual EBIT of Rs. 250,000. The company‘s objective is to maximize EPS. It is considering
the possibility of raising a debt of either Rs. 300,000 or Rs. 600,000 or Rs. 900,000 plus
issuing equity shares. The current market price per share is Rs. 50 which is expected to drop to
Rs. 40per share, if the market borrowings were to exceed Rs. 700,000. The cost of borrowings
is indicated as follows:
Level of borrowings
Up to Rs. 200,000
More than Rs. 200,000 to Rs. 600,000
More than Rs. 600,000 to Rs. 900,000
Cost of borrowings
12% per annum
15% per annum
17% per annum
Required:
i) Assuming a tax rate of 50%, work out the EPS and the scheme, which you would
recommend to the company.
ii) Calculate return on capital employed under each scheme and explain the leverage effect.
Knowledge Test 4
Imprerial Ltd. has the following balance sheet and income statement information
Balance Sheet as on Aashadh 31, 2076
Liabilities
Amount
in NRs
Assets
Equity Capital (NRs 10 per share)
800,000
Net Fixed Assets
10% Debt
600,000
Current Assets
122 |The Institute of Chartered Accountants of Nepal
Amount
in NRs
1,000,000
900,000
Strategic Finance Decision and Policy
Retained Earnings
350,000
Current Liabilities
150,000
1,900,000
1,900,000
Income Statement for the year ending Aashadh 31, 2076
Particulars
Amount in NRs
Sales
340,000
Operating expenses (Including NRs 60,000
depreciation)
120,000
EBIT
220,000
Less: Interest
60,000
EBT
160,000
Less Taxes @ 35%
56,000
Earnings After Taxes
104,000
a) DETERMINE the degree of operating, financial and combined leverages at the
current sales level, if all operating expenses, other than depreciation, are variable
costs.
b) If total assets remain at the same level, but sales (i) increase by 20 percent and (ii)
decrease by 20 percent, COMPUTE the earnings per share at the new sales level?
2.2.4 Solutions of Knowledge Tests
Knowledge Test -1 Solution
Companies
W
Sales Units
X
Y
Z
5,000
5,000
5,000
5,000
100,000
160,000
250,000
350,000
Less: variable costs
30,000
80,000
100,000
250,000
Contribution Margin
70,000
80,000
150,000
100,000
Less Fixed Costs
60,000
40,000
100,000
EBIT
Operating Leverage
(Contribution/EBIT)
10,000
40,000
50,000
100,000
7
2
3
1
Sales Revenue
Nil
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Chapter 2
Financial Management
The operating leverage exists only when there are fixed costs. In the case of company D, there
is no magnified effect on the EBIT due to change in sales. 20 percent increases in sales has
resulted in a 20 percent increase in EBIT. In the case of other companies, operating leverage
exists. It is maximum in company A, followed by company C and minimum in company B.
The interception of DOL of 7 is that1 per cent change in sales results in 7 per cent change in
EBIT level in the direction of the change of sales level of company A.
Knowledge Test 2-Solution
Solution:
i) Calculation of P/V Ratio:
Contribution
P/ V Ratio =
Sales
X 100
Contribution Margin
Operating Leverage =
(Contribution Margin - Fixed Cost)
C
1.4 =
(C - 204,000)
1.4 (C – 204,000) = C
1.4 C – 285,600 = C
0.4 C = 285,600
Therefore, C = 285,000/0.4 = Rs. 714,000
P/V ratio = 714,000 /3,000,000 X 100 = 23.8%
(ii) Calculation of EPS:
EBT = Contribution – Fixed Cost – Interest
= 714,000 – 204,000 – 255,000 = Rs. 255,000
(Interest =Rs. 2,125,000 × 12% =Rs. 255,000
EAT = EBT – Tax = 255,000 – 76,500 = Rs. 178,500
(Tax = Rs. 255,000 × 30% = Rs. 76,500)
Earnings Per Share=
Earning After Tax
Number of Equity Shares
= 178,500/17,000
= Rs. 10.50.
124 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
Knowledge Test 3- Solution
Solution:
i.
Statement showing EPS under the different schemes
Particulars
Scheme I
Scheme II
Capital required (Rs.)
Less: Debt Content (Rs.)
Balance Equity Capital required (Rs.)
Market Price per Share (Rs.)
Number of Equity Shares to be issued
EBIT (given) (Rs.)
Less: Interest on Debt (Rs.)
First Rs. 2,00,000 at 12%
Next up to Rs. 4,00,000 at 15%
Balance at 17%
Total interest cost (Rs.)
Earnings Before Tax (EBT) (Rs.)
Less: Tax at 50% (Rs.)
Earnings After Tax (EAT) (Rs.)
EPS (Rs.)
Scheme III
1,500,000
300,000
1,500,000
600,000
1,500,000
900,000
1,200,000
50
24000 shares
250,000
900,000
50
18000 shares
250,000
600,000
40
15000 shares
250,000
24,000
15,000
0
24,000
60,000
0
24,000
60,000
39,000
211,000
105,000
105,000
4.375
84,000
166,000
83,000
83,000
4.61
51,000
135,000
115,000
57,500
57,500
3.83
Recommendation:
EPS is maximum under Schemes II and is hence preferable, i.e., raising a debt of Rs.
600,000and remaining from issue of equity shares.
ii) Since EBIT and capital employed are same in every scheme; i.e.
ROCE = 250,000/1,500,000
= 16.67%.
Use of Debt Funds and Financial Leverage will have a favorable effect only if ROCE >
InterestRate. ROCE is 16.67% and hence up to 15% Interest Rate, i.e. Scheme II, use of debt
will havefavorable impact on EPS and ROE. However, when interest rate is higher at 17% (i.e.
in SchemeIII, for Debt above Rs. 6 lakhs), Financial Leverage have negative impact and hence
EPS falls from Rs. 4.61 to Rs. 3.83.
Knowledge Test – 4 Solution
a) Calculation of Degree of Operating (DOL), Financial (DFL) and Combined leverages
(DCL).
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑜𝑜𝑜𝑜 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 (𝐷𝐷𝐷𝐷𝐷𝐷) =
340,000 − 60,000
= 1.27
220,000
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Chapter 2
Financial Management
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑜𝑜𝑜𝑜 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 (𝐷𝐷𝐷𝐷𝐷𝐷) =
Or
220,000
= 1.38
160,000
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐷𝐷𝐷𝐷𝐷𝐷 = 𝐷𝐷𝐷𝐷𝐷𝐷 ∗ 𝐷𝐷𝐷𝐷𝐷𝐷 = 1027 ∗ 1038 = 1.75
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐷𝐷𝐷𝐷𝐷𝐷 =
(340,000 − 60,000)
= 1.75
160,000
b) Earnings per share at the new sales level
Increase by 20% NRs
Sales level
408,000
Less: Variable expenses
72,000
Less: Fixed Cost
60,000
Earnings before interest
276,000
and taxes
Less: Interest
60,000
Earnings Before taxes
216,000
(EBT)
Taxes @ 35%
75,600
Earnings after taxes
140,400
(EAT)
Number of equity share
80,000
EPS
1.76
126 |The Institute of Chartered Accountants of Nepal
Decrease by 20% NRs
272,000
48,000
60,000
164,000
60,000
104,000
36,400
67,600
80,000
0.85
Strategic Finance Decision and Policy
2.3 Required Return and Cost of Capital
2.3.1 Learning Objectives
Upon completion of this chapter student will be able to:
 explain the nature and features of different securities in relation to the risk/return tradeoff.
 explain the relative risk/return relationship of debt and equity and the effect on their
relative costs
 calculate the cost of various debt fund (irredeemable, redeemable, convertible etc.)
 calculate the cost of equity fund including retained earnings
 calculate the cost of preference shares (irredeemable, redeemable, convertible etc.)
 calculate the cost of right share.
 define and distinguish between systematic and unsystematic risk
 explain the relationship between systematic risk and return and describe the assumptions
and components of the capital asset pricing model (CAPM).
 use the CAPM to find a company‘s cost of equity.
 explain and discuss the advantage and disadvantages of the CAPM.
 calculate weighted average cost of capital and marginal cost of capital
2.3.2 Chapter Overview
Weighted Average
cost of Capital
Cost of Debt
Cost of
equity
Marginal cost of
Capital
Cost of preference
Shares
Irredeemable
Dividend
price approach
Irredeemable
Redeemable
Earning Price
approach
Redeemable
Convertible
Capital Assets
Pricing Model
Cost of retained
earnings
Fig: Chapter overview of Cost of Capital
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Chapter 2
2.3.3 Introduction
The financing decision relates to the composition of relative proportion of various sources of
finance. The financial management weighs the merits and demerits of different sources of
finance while taking the financing decision. A business can be financed from either the
shareholders‘ funds or borrowings from outside agencies. The shareholders‘ funds include equity
share capital, preference share capital and the accumulated profits whereas borrowings from
outsiders include borrowed funds like debentures and loans from financial institutions.
Borrowed Fund- The organization shall be paid the fixed interest components (may have
principal redemptions) even if in the case of loss may lead some amount of risk to the
organization. Borrowed funds involve interest and capital gain (issue on discount or/and
redeemed on premium).
Equity has no fixed commitment regarding payment of dividends or principal amount and
therefore, no risk is involved. However, cost of equity is higher than debt fund. The cost of
equity is the minimum return the shareholders would have received if they had invested
elsewhere (opportunity costs).
Both types of funds incur cost, and this is the cost of capital to the company. This means, cost of
capital is the minimum return expected by the company.
The financing decision is an important managerial decision. It influences the shareholder‘s return
and risk (shareholder wealth maximization). is required to select such a capital structure in which
expectation of investors is minimum hence shareholders‘ wealth is maximum. For that purpose,
first he needs to calculate cost of various sources of finance. In this chapter we will learn to
calculate cost of debt, cost of preference shares, cost of equity shares, cost of retained earnings
and overall cost of capital.
The cost of each source of finance to the company can be equated with the return which the
providers of finance (investors) are demanding on their investments.
This return can be expressed as a percentage (effectively, an interest rate) that can be used as the
overall measure of cost, i.e. the cost of money is the percentage return a firm needs to pay its
investors.
Market value of investments = present value of the expected future returns discounted at
the investors‘ required return.
Cost of any sources of finance is expresses in terms of percentage per annum. To calculate cost
of finance, we should identify various cash flows like,
 Inflow of amount received at the beginning
 Outflows of payment of interest, dividend, redemption amount etc.
 Inflow of tax benefit on interest or outflow of payment of dividend tax.
128 |The Institute of Chartered Accountants of Nepal
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We can identify the rate (IRR) by using trial and error method. The IRR shall be cost of capital
because, in this chapter we have initial cash inflow followed by series of cash outflows. (In
investment decisions, IRR indicates income)
Identify sources
of finance used
Equity Finance
Debt Finance
Calculate all
the costs
together, find
a weighted
average cost
Fig: Process to calculate Cost of Capital
2.3.4 Importance of Cost of Capital
 For Investment Appraisal-Estimated benefit (future cashflow) from the available
investments are discounted with the relevant cost of capital (weighted average cost of
capital). Every investment alternative may have different cost of capital hence it is very
important to use the cost of capital which is relevant to the options available.
 For Financing Decisions- If there are more than one source of finance is available,
manager can simply compare their cost of capital and choose the source which has lower
cost (with acceptable level of risk).
 Optimum Credit Policy- Opportunity cost (cost of finance) shall be analyzed while
appraising the credit period to be allowed to the customer. Cost of allowing credit period is
compared against the benefit/profit earned by providing credit to customer of segment of
customers.
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Cost of capital represents a hurdle rate that a company must overcome before it can generate
value, and it is used extensively in the capital budgeting process to determine whether a
company should proceed with a project.
2.3.5 Cost of Debt Capital
The cost of debt is the return the issuer has to offer investors to get them to hold the debt. This is
the yield to maturity of the debt. If the firm has debt outstanding, it can find its cost of debt by
looking at the yield to maturity of its bonds in the market. If the firm does not have debt
outstanding, it should look at the yield to maturity of bonds issued by similar kinds of companies
(with the idea that similar companies will have similar risk, and so the bonds will have the same
risk premium).
While calculating cost of debt, we should analyze the following factors;
a) Floatation costs: The costs of issuing the debt will increase the cost of debt.
b) Tax rate: The second factor is that interest is tax deductible, and so the use of debt shields
some of the company‘s earnings from taxation. This is a benefit of using debt, and so should
reduce its cost. If the corporate tax rate is 30%, and a firm has Rs 100,000 in interest
expenses, the cost to the companyfor financing through debt is Rs 100,000 less the Rs
30,000 value of the tax shield.
c) Issue and Redemption price- Issue and redemption prices will impact the cost of debt in
following ways,
Issue at
Par
Redemption at
Par
Discount
Par
Discount
Premium
Premium
Par
Par
Premium
Premium
Par
Discount
Discount
Cost
Cost of capital shall be coupon rate
(subject to impact of flotation costs)
Cost of capital is higher than coupon rate
Cost of capital is higher than coupon rate
Cost of capital is higher than coupon rate
Cost of capital is lower than coupon rate
Cost of capital is lower than coupon rate
Cost of capital is lower than coupon rate
The Characteristic of Debenture are as follow:
Face Value: Debenture is generally issued at its face value or commonly known as par value
of Rs 100 or Rs 1000 and interest is paid on such face value of debenture.
b. Interest rate: Interest rate or commonly known as coupon rate is generally fixed and known
to the debenture holder at the time of issue of debenture. Interest paid on debenture is tax
deductible.
c. Maturity Period: Debenture is issued for the specified period of time which is known as
maturity period and debenture is paid on its maturity.
d. Redemption value: The value that debenture holder will get on maturity is called
redemption value. It is redeemed at par or premium or discount.
a.
130 |The Institute of Chartered Accountants of Nepal
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e.
Market value: The price at which it is currently sold or bought is called the market value
which may be different from par value or redemption value. The market value (MV) of loan
notes may change daily. The main influence on the price of a loan note is the general level of
interest rates for debt at that level of risk and for the same period to maturity.
There are different types of debenture. We are discussing three types of debentures namely
irredeemable debenture, redeemable debenture and convertible debenture.
2.3.5.1 Perpetual / irredeemable Debenture:
Debenture not redeemable during the lifetime of the company. Cost of perpetual debt can be
calculated by,
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 1 − 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
𝑁𝑁𝑁𝑁𝑁𝑁 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑜𝑜𝑜𝑜 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
Net sales proceeds from sales means issue prices less issue expenses. If the issue price is not
given, then students can assume it to be equal to market price. If issue expenses are not given
simply assume it equal to zero.
Illustration 1
A company issues 10,000 10% debentures of Rs 1,00 each. Calculate the cost of debt in each
of the following case assuming corporate tax rate is 30%
a. If Debenture are issued at par with 5% flotation cost on issue price
b. If Debenture are issued at 10% premium with 5% flotation cost on issue price
c. If Debenture are issued at 10% discount with 5% flotation cost on issue price
Illustration 1 Solution
Cost of Perpetual / irredeemableDebt after tax
a.
If Debenture are issued at par with 5% flotation cost on issue price
Kd=
10(1-0.30) / 100(1-0.05)
=
7/95
=
7.4%
b. If Debenture are issued at 10% premium with 5% flotation cost on issue price
Kd=
10(1-0.30) / 100(1+0.10)(1-0.05)
=
7/104.5
=
6.7%
c.
If Debenture are issued at 10% discount with 5% flotation cost on issue price
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Financial Management
=
=
Chapter 2
Kd=
10(1-0.30) / 100(1-0.10)( 1-0.05)
7/85.5
8.2%
Knowledge Test 1
A Company has in issue 10% irredeemable debt quoted at NRs 80 ex interest. The corporation
tax rate is 30%.
a) What is the return required by the debt providers (the pre-tax cost of debt)?
b) What is the post-tax cost of debt to the company?
Knowledge Test 2
AB is a profitable, listed manufacturing company, which is considering a project to diversify
into the manufacture of computer equipment. This would involve spending NRS 220 million
on a new production plant.
It is expected that AB will continue to be financed by 60% debt and 40% equity. The debt
consists of 10% loan notes, redeemable at par after 10 years with a current market value of
NRS 90. Any new debt is expected to have the same cost of capital. AB pays tax at a rate of
30%.
Required
a)
Calculate the after-tax cost of debt of AB‘s loan notes.
2.3.5.2 Redeemable Debt:
Redeemable Debt are those debt which are redeemed after the expiry of fixed period. The cost of
Redeemable Debt may be calculated by using Approximation Method or Present Value Methods
(i) Cost of debt under Approximation Methods
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉𝑉𝑉 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
(𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 1 − 𝑇𝑇𝑇𝑇𝑇𝑇 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 +
𝑁𝑁
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 + 𝑁𝑁𝑁𝑁𝑁𝑁 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 =
2
The Company will pay interest for a number of years and then repay the principal
amount (may be on premium or discount).
 Market Price of the bond/debenture=future expected income stream from the
securities discounted at the investor‘s required rate of return.
 expected income stream will be:
 Interest paid to redemption
 The repayment principal amount.
132 |The Institute of Chartered Accountants of Nepal
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(ii) Cost of Debt under Present Value Methods
NPV =
Net Proceeds
1+kd t
−
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑡𝑡 1−𝑡𝑡
1+𝐾𝐾𝐾𝐾 𝑡𝑡
−
Redeemable Value
(1+𝐾𝐾𝐾𝐾)𝑛𝑛
Note that for the investor the purchase is effectively a zero NPV project, as the present value of
the income they receive in the future is exactly equivalent to the amount they invest today.
Hence, cost of debt is the IRR of the security (bond, debenture, etc.). We can calculate the IRR
by trial and error method.
𝐼𝐼𝐼𝐼𝐼𝐼 = 𝐿𝐿 +
Where, IRR= Internal Rate of Return
NPVL= NPV at lower rate
NPVH= NPV at higher rate
H= Higher rate
L= Lower rate
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁
∗ (𝐻𝐻𝐻𝐻𝐻)
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁
YTM or present value method is a superior method of determining cost of debt of company to
approximation method and it is also preferred in the field of finance. [Higher the difference
between the rate (H and L) we taken, lower will be the accuracy.]
Illustration 2
A company issues Rs 10,00,000, 12% debentures of Rs 100 each. The debentures are
redeemable after the expiry of fixed period of 5 years, the company is in tax rate of 40%.
Calculate the cost of debt after tax,
a. If debenture is issued at par with no flotation cost
b. If debenture is issued at par with 5% flotation cost on issue price
c. If Debenture is issued at 10% premium with 5% flotation cost on issue price
d. If debenture is issued at 10% discount with 5% flotation cost on issue price
Illustration 2- Solution
Cost of Redeemable Debt
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 − 𝑁𝑁𝑁𝑁𝑁𝑁 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
(𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 1 − 𝑇𝑇𝑇𝑇𝑇𝑇 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 +
𝑁𝑁
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 + 𝑁𝑁𝑁𝑁𝑁𝑁 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 =
2
If Debenture are issued at par with no flotation cost
Kd=
12(1-0.40) + [(100-100)/5] / (100+100)/2
=
7.2%
If Debenture are issued at par with 5% flotation cost on issue price
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Financial Management
Kd=
Chapter 2
12(1-0.40) + [(100-95)/5] / (100+95)/2
=
8.4%
If Debenture are issued at 10% premium with 5% flotation cost on issue price
Kd=
12(1-0.40) + [(100-104.5)/5] / (100+104.5)/2
=
6.16%
If Debenture are issued at 10% discount with 5% flotation cost on issue price
Kd=
12(1-0.40) + [(100-85.5)/5] / (100+85.5)/2
=
10.89%
Knowledge Test 3
A Company has in issue 12% redeemable debt with 5 years to redemption.
Redemption is at par. The current market value of the debt is NRs 107.59. The
corporation tax rate is 30%.
What is the return required by the debt providers (pre -tax cost of debt)?
2.3.5.3 Convertible Debt:
This is the type of debt security that allows the investor to choose between taking the redemption
proceeds or converting the debt security into a pre-set number of shares. The calculation of cost
of convertible debentures are very much similar to the redeemable debentures
To calculate the cost of convertible debt you should:
1) Calculate the value of the conversion option using available data
2) Compare the conversion option with the cash option. Assume all investors will choose the
option with the higher value.
3) Calculate the IRR of the flows as for redeemable debt or find the cost of debt using formula.
Illustration 3
A Company has issued convertible debenture which are due to be redeemed at a 5% premium
in five years‘ time. The coupon rate is 8% and the current MV is NRs 85. Alternatively, the
investor can choose to convert each debenture into 20 shares in five years‘ time.
The Company pays tax at 30% per annum.
The Company‘s shares are currently worth NRs 4, and their value is expected to grow at a rate
of 7% Pa.
Find the post-tax cost of convertible debt to the Company.
Illustration 3- Solution
1) Compare the redemption value (RV) with the value of the conversion option:
134 |The Institute of Chartered Accountants of Nepal
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Cash redemption value = NRs 100 * 1.05 = NRs 105
Conversion Value = 20*4*(1.07) ^5 =20*5.61=NRs 112.20
2) Select the highest of the two values as the amount to be received at Tn.
It is assumed that the investors will choose to convert the debenture and will therefore receive
NRs 112.20. In an exam question, you must assess whether conversion is likely to occur.
Hence, Redemption Value= 112.20
Market Value (Net Proceed) = 85
Number of period (N) =
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 − 𝑁𝑁𝑁𝑁𝑁𝑁 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
(𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 1 − 𝑇𝑇𝑇𝑇𝑇𝑇 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 +
𝑁𝑁
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 + 𝑁𝑁𝑁𝑁𝑁𝑁 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 =
2
= 8(1-0.3)+ (112.20-85)/5
(112.20+85)/2
= 11.19%
(You can also try IRR approach (trial and error) for your exam preparation)
You will get the answer of 11.4% approx. under IRR method.
2.3.6 Cost of Preference Share
Preference shares, more commonly referred to as preferred stock, are shares of a company‘s
stock with dividends that are paid out to shareholders before common stock dividends are issued.
If the company enters bankruptcy, preferred stockholders are entitled to be paid from company
assets before common stockholders. Most preference shares have a fixed dividend, while
common stocks generally do not. Preferred stock shareholders also typically do not hold any
voting rights, but common shareholders usually do.
As with the debt, the cost of preference share is based on the rate of return required by the firm‘s
preference stockholders, which is determined by the market price of the preference stock. Like
the debentures, preference share capital can be categorized as redeemable and irredeemable.
Accordingly cost of capital for each type will be discussed here.
There are two type of Preference share;
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Cost of Redeemable
Preference Share Capital
Cost of Preference
Shares
Cost of Irredeemable
Preference Share Capital
Fig: Cost of Preference share
2.3.6.1 Irredeemable Preference share:
Preference share not redeemable during the lifetime of the company. The cost of preference
share(Kp) may be represented as;
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝐾𝐾𝐾𝐾 =
𝐷𝐷𝐷𝐷𝐷𝐷
𝑃𝑃𝑃𝑃 1 − 𝐹𝐹
Where, DPS is the stated annual dividend,
PN is the current market price of the preference share and
F is the flotation cost of issuing share.
Note that no tax adjustments are made when calculating the component cost of preferred stock
because, unlike interest payments on debt, dividend payments on preferred stock are already
arrived after the tax adjustments which is shown below.
S.N.
1
2
3
4
5
6
7
Particulars
EBIT
Less Interest
EBT
Tax
EAT
Preference dividend
Earnings available for equity shares
Illustration 4
A company issues 10,000 10% Preference share of Rs 100 each. Calculate the cost of
preference share in each of the following cases.
a. a.If Preference share are issued at par with 5% flotation cost on issue price
b. b.If Preference share are issued at 10% premium with 5% flotation cost on issue price
c. c.If Preference share are issued at 10% discount with 5% flotation cost on issue price
136 |The Institute of Chartered Accountants of Nepal
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Illustration 4 Solution
Cost of IrredeemablePreference share
a.
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝐾𝐾𝐾𝐾 =
𝐷𝐷𝐷𝐷𝐷𝐷
𝑃𝑃𝑃𝑃 1 − 𝐹𝐹
If Preference share are issued at par with 5% flotation cost on issue price
Kp
=
10 / 100(1-0.05)
=
10.52%
b. If Preference share are issued at 10% premium with 5% flotation cost on issue price
Kp
=
10 / 100(1+0.10) (1-0.05)
=
9.56%
c.
If Preference share are issued at 10% discount with 5% flotation cost on issue price
Kp
=
10/ 100(1-0.10) (1-0.05)
=
11.69%
2.3.6.2 Redeemable Preference share:
Redeemable Preference Share are those debt which are redeemed after the expiry of fixed period.
Cost of redeemable preference share is similar to the cost of redeemable debentures with the
exception that the dividends paid to the preference shareholders are not tax deductible. The cost
of Redeemable Preference Sharemay be calculated by using Approximation Method or Present
Value Methods.
(i) Cost of Redeemable Preference Shareunder Approximation Methods
Where,
𝑅𝑅𝑅𝑅 𝑅𝑅𝑅𝑅𝑅
𝑃𝑃𝑃𝑃 +
𝑁𝑁
𝑅𝑅𝑅𝑅
+
𝑁𝑁𝑁𝑁
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 =
2
Pd= Preference dividend
RV= Redeemable Value
NP= Net Sales Proceed
N= Number of periods/years
(ii) Cost of Redeemable Preference share under Present Value Methods
Net Present Value =
Net Proceed Dividend t ) Redeemable Value
−
−
1 + Kp t
(1 + Kp)n
1 + Kp t
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Hence, cost of preference share is the IRR of the preference shares. We can calculate the IRR by
trial and error method.
𝐼𝐼𝐼𝐼𝐼𝐼 = 𝐿𝐿 +
Where, IRR= Internal Rate of Return
NPVL= NPV at lower rate
NPVH= NPV at higher rate
H= Higher rate
L= Lower rate
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁
∗ (𝐻𝐻𝐻𝐻𝐻)
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑁 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁
Illustration 5
A company issues Rs 10,00,000, 12% Preference shares of Rs 100 each. The Preference
shares are redeemable after the expiry of fixed period of 5 years, the company is in tax rate of
40%. Calculate the cost of debt after tax,
a. a.If Preference share are issued at par with no flotation cost
b. b.If Preference share are issued at par with 5% flotation cost on issue price
c. c.If Preference share are issued at 10% premium with 5% flotation cost on issue price
d. d.If Preference share are issued at 10% discount with 5% flotation cost on issue price
Illustration 5 Solution
Cost of Redeemable Preference Share can be calculated under approximation method
𝑅𝑅𝑅𝑅 − 𝑁𝑁𝑁𝑁
𝑃𝑃𝑃𝑃 +
𝑁𝑁
𝑅𝑅𝑅𝑅 + 𝑁𝑁𝑁𝑁
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 =
2
If Preference share are issued at par with no flotation cost
Kp=
12 + [(100-100)/5] / (100+100)/2
=
12%
If Preference share are issued at par with 5% flotation cost on issue price
Kp=
12 + [(100-95)/5] / (100+95)/2
=
13.33%
If Preference share are issued at 10% premium with 5% flotation cost on issue price
Kp=
12 + [(100-104.5)/5] / (100+104.5)/2
=
10.85%
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If Preference share are issued at 10% discount with 5% flotation cost on issue price
Kp=
12+ [(100-85.5)/5] / (100+85.5)/2
=
16.06%
Knowledge Test 4
XYZ Ltd. issues 2,000 10% preference shares of NRs 100 each at NRs 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 share?
2.3.7 The Cost of Equity Share Capital
In case of equity share capital, there is no commitment to pay equity dividend and it is the sole
discretion of the Board of Directors to pay or not to pay dividend or to decide at what rate the
dividend be paid to the equity shareholders. The equity shareholders are thelast claimant on the
profit of the company.The return in case of equity shares is available in the form of dividend
from the firm. Therefore, the cost of equity finance to the company is the return the investors
expect to achieve on their shares.The rate of discount at which the expected dividends are
discounted to determine theirpresent value (intrinsic value) is known as the cost of equity share
capital. The cost of equity can be estimated in following ways:
Dividend Price
Apporach
Earning Price Approach
Cost of Equity
Share Capital
Realized Yield
Approach
Capital Assets Pricing
Model (CAPM)




If the dividend is used to calculate the cost of capital - Dividend Price Approach
If the earning is used to calculate the cost of capital - Earning Price Approach
If it is difficult to forecast future earnings/dividend – Realized yield approach
While the cost of equity or expectation of investors is dependent on risk. Higher the risk
higher the expectation and vice versa. Capital Assets Pricing Model (CAPM)
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2.3.7.1 Dividend Price Approach (Dividend Valuation Model)
According to the Dividend Price Approach, the price of the share is the present value of all its
future cash dividends, where the future dividends are discounted at the required rate of return on
equity. If these dividends are constant forever the cost of common stock is derived from the
value of perpetuity. The cost of equity capital is computed by dividing the current dividend by
average market price per share.However, this method cannot be used to calculate cost of equity
of units suffering losses.
Assumptions:
 Future income stream is the dividends paid out by the company
 Dividends will be paid in perpetuity
 Dividends will be constant or growing at a fixed rate
The formula for calculating required rate of return is given below;
Where,
𝐾𝐾𝐾𝐾 =
𝐷𝐷1
𝑃𝑃0
Ke = Cost of equity
D1 = Next period dividend
P0 = Current stock price per share
This approach assumes that dividends are paid at a constant rate to perpetuity. It ignores
taxation. However, Earnings and dividends do not remain constant and the price of equity shares
is also directly influenced by the growth rate in dividends. Where earnings, dividends and equity
share price all grow at the same rate, cost of equity can be calculated as follow.
𝐾𝐾𝐾𝐾 =
𝐷𝐷1
+ 𝐺𝐺
𝑃𝑃𝑃𝑃
Where,
D1 = Next period dividend
P0 = Current Stock price per share (ex-dividend)
G = Annual growth rate of earnings of dividend.
Illustration 6
Nabin Kumar purchases and equity share of Mega Bank Ltd. Bank has paid dividend of Rs 2
per share last year. Dividends are growing at the rate of 10%. What is the required rate of
return of Nabin Kumar on his equity investment if he purchases an equity share for Rs 22?
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Illustration 6 Solution
Next period dividend (D1) = D0(1+G)
=2(1+0.10)
=2.2
Current Stock price per share (P0) = Rs 22
Annual growth rate of earnings of dividend. (G)= 10% or 0.10
According to formula
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐾𝐾𝐾𝐾 =
2.2
+ 0.10
22
=0.10 +0.10
=0.2 or 20%
=
𝐷𝐷1
+ 𝐺𝐺
𝑃𝑃0
Criticism of Dividend Price Approach
The Dividend Price Approachis criticized on the following reasons:
 P0- this can be subject to other short-term influences, such as rumored takeover bids,
which considerably distort the estimate of the cost of equity.
 The future growth pattern is impossible to predict because it will be inconsistent and
uneven.
 Due to uncertainty of future and imperfect information, only historic growth is to be used
for prediction of future growth.
 Calculation only cost of equity capital ignoring the cost of other forms of capital may not
be valid.
 The dividend growth depends on the retained earnings of the company and the growth is
difficult to assume.
2.3.7.2 Earning / Price Approach
Cost of equity share capital would be based upon the expected rate of earning of a company
whether such earning is distributed or not from the company. The advocates of this approach corelate the earnings of the company with the market price of its share. Accordingly, the cost of
ordinary share capital would be based upon the expected rate of earnings of a company. The
argument is that each investor expects a certain amount of earnings, whether distributed or not
from the company in whose shares he invests.
This approach also does not seem to be a complete answer to the problem of determining the
cost of ordinary share since,
 It ignores the factor of capital appreciation or depreciation in the market value of shares.
 It assumes that earnings per share will remain constant forever or growing at fixed rate.
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However, earnings price approach seeks to nullify the effect of changes in the dividend policy.
The cost of equity calculated by,
𝐾𝐾𝐾𝐾 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎
This method assumes that dividend will increase at the same rate as earnings, and the equity
share price is the regulator of this growth as deemed by the investor. However, in actual practice,
rate of dividend is recommended by the Board of Directors and shareholders cannot change it.
Thus, rate of growth of dividend subsequently depends on director‘s attitude. The dividend
method should, therefore, be modified by substituting earnings for dividends.
𝐾𝐾𝐾𝐾 =
𝐸𝐸
+ 𝐺𝐺
𝑃𝑃
Where,
Ke= Required rate of return of equity shareholders
E = Current earnings per share
P = Market share price
G = Annual growth rate of earnings.
Estimation of Growth Rate:
The calculation of ‗G‘ (the growth rate) is an important factor in calculating cost of equity
capital. The past trend in earnings and dividends may be used as an approximation to predict the
future growth rate if the growth rate of dividend is stable in the past.
i. The earnings retention model (Gordon‘s growth model)
Assumption:
 The higher the level of retentions in a business, the higher the potential growth ratel.
The formula is therefore:
Where,
re=accounting rate of return
b=earnings retention rate
𝑔𝑔 = 𝑏𝑏 𝑏 𝑏𝑏𝑏𝑏
Illustration 7
An equity share of the company is currently selling for Rs 60. The earning per share Rs 7.5.
The company reinvests the retained earnings at a rate of 10%. Calculate the cost of equity
share if the company dividend payout ratio is 60%
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Illustration 7 Solution
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎
𝑃𝑃0 =
+ 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺ℎ 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎
Retention ratio (b)= 1- Dividend payout ratio
= 1-0.6
=0.4
Rate of Return on equity(r) = 10%
Growth rate (g)= br
= 0.4 * 0.1
=0.04
Earnings per share at the beginning (E0) = Earnings per share (1- retention ratio)
= 7.5(1-0.4)
=4.5
Expected earnings per share at the end (E1) = E0(1+g)
=4.5(1+0.4)
=4.68
Cost of equity = 4.68 / 60 + 0.04
= 11.8%
Knowledge Test-5
A company is about to pay an ordinary dividend of NRs 16 per share. The Share Price is NRs
200. The accounting rate of return on equity is 12.5% and 20% of earnings are paid out as
dividends.
Calculate the cost of equity for the company.
ii. Average Method
It is calculated as below
Or
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝑫𝑫𝑫𝑫 = 𝑫𝑫𝑫𝑫 𝟏𝟏 + 𝒈𝒈
Where,
D0= Current Dividend
Dn = Dividend in n year ago
𝑫𝑫𝑫𝑫
𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 =
𝑫𝑫𝑫𝑫
𝟏𝟏
𝒏𝒏
𝒏𝒏
− 𝟏𝟏
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Growth rate can also be found as follows:
Step I- Divide D0 by Dn, find out the result, then refer the FVIF table,
Step II- Find out the result found at step-I in corresponding year‘s row.
Step III- See the interest rate for the corresponding column. This is the growth rate.
2.3.7.3 Realized Yield Approach
According to this approach, the average rate of return realized in the past few years is
historically regarded as ‗expected return‘ in the future. It computes cost of equity based on the
past records of dividends actually realized by the equity shareholders. The yield of equity for the
year is:
D t −P t−1
yt =
P t−1
Where,
Yt = Yield for the year t
Dt = Dividend for share for end of the year t
Pt = Price per share at the end of the year t
Pt -1 = Price per share at the beginning and at the end of the year t
Though, this approach provides a single mechanism of calculating cost of equity, it has
unrealistic assumptions. If the earnings do not remain stable, this method is not practical.
Illustration 8
Mr. Sharma had purchased a share of Zed Limited for NRs 1,000. He received dividend for a
period of five years at the rate of 10 percent. At the end of the fifth year, he sold the share of
Zed Limited for NRs 1,128. You are required to Compute the cost of equity as per realized
yield approach.
Illustration 8- Solution
We know that as per the realized yield approach, cost of equity is equal to the realized rate of
return. Therefore, it is important to compute the internal rate of return by trial and error
method. This realized rate of return is the discount rate which equates the present value of the
dividends received in the past five years plus the present value of sale price of NRs 1,128 to
the purchase price of NRs1,000. The discount rate which equalizes these two is 12 percent
approximately. Let us look at the table given for a better understanding.
Year
Dividend (NRs)
1
Sales Proceed
Discount Factor
Present Value
100
0.893
89.3
2
100
0.797
79.7
3
100
0.712
71.2
4
100
0.636
63.6
5
100
0.567
56.7
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6
1128
0.567
639.576
1000.076
Therefore, the realized rate of return may be taken as 12%. Hence cost of equity is 12%.
2.3.7.4 Capital Asset Pricing Model (CAPM)
CAPM model of calculating the cost of equity is based directly upon the risk consideration. It is
possible to find the cost of equity capital by using the mechanism of risk return trade off as given
be the capital assets pricing model. This model classifies the total risk associated with a security
into two groups
i. Unsystematic Risk (diversifiable risk)- Company/industry specific factors
This is also called company specific risk as the risk is related with the company‘s performance.
This type of risk can be reduced or eliminated by diversification of the securities portfolio.
Unsystematic risk factors don‘t affect everyone; indeed, their impact may be unique to an
individual company or restricted to a small number of companies, with some being winners and
some being losers. For example, the weather- if we have a wet summer then raincoat
manufacturers will benefit but sunglasses manufacturer will suffer.
ii. Systematic Risk (undiversifiable risk)- Market wide factors such as the state of the
economy
Undiversifiable risk is that risk which affects all thefirms at a particular point of time and hence
cannot be eliminated. The non-diversifiable risk of a security is measured in relation to a market
portfolio and is denoted by the Beta co-efficient (βi). It represents that risk which cannot be
eliminated by diversification. Therefore, contribution of a single security to the risk of a large
diversified market portfolio depends only upon its systematic risk as measured by its (β / beta
(sensitivity of a security with that of the market). Hence it can be said that the risk premium of
equity is proportional to its beta (β), that is, risk premium increases as beta/ (β increases and vice
versa. In orderto estimate the required rate of return of the equity investors, the risk associated with
the shares need to be estimated.
The CAPM argues that total risk can be divided into specific and market risk, the latter subdivided
into business and financial risk. As per CAPM, specific risk, which is also known as unsystematic
risk, can be reduced through diversification whereas market or systematic risk cannot be reduced
through diversification. Market risks can be due to regular business operations or due to the presence
of debt in the capital structure e.g. shareholders of a company, which has a high incidence of debt in
its capital structure, shall face higher risk due to a high interest payment the company shall need to
make.
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Total
Unsystematic Risk (Unique risk)
Portfolio
Systematic risk (Market Risk)
1 Security
Number of securities
Important assumptions in CAPM are:
(1)
There is an efficient market meaning existence of competitive market where Financial
securities and capital assets are bought and sold with full information of risk and return
available to all participants.
(2) There exists a rational investment goal.
(3) All assets are divisible and liquid assets.
(4) Investors are free to borrow at risk less rate of interest.
(5) Securities can be exchanged without payment of brokerage, commission or taxes and
without any transaction costs.
(6) Securities or capital assets face no bankruptcy or insolvency.
The cost of capital of equity shares as per the capital asset pricing model (CAPM) equation is:
Cost of Equity E(ri ) = Rf + ßi (E(rm) – Rf )
Therefore,
𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 𝒐𝒐𝒐𝒐 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 = 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 + 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷
Where: E(ri ) = the return from the investment Rf = the risk-free rate of return ßi = the beta value
of the investment, a measure of the systematic risk of the investment E(rm) = the return from the
market
Essentially, the required return depends on the risk of an investment where premium related to
the risk is added to the risk-free rate of return. The size of that premium is determined by the
following factor:
i. The premium the market currently gives over the risk-free rate (E(rm) - Rf).
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ii. Riskiness of the specific investment compared to the market as a whole. This is the ‗beta‘ of
the investment (ßi).
Example;
The market is giving an average return of 18%. The risk-free return is 11%. What return would
be expected from an investment having a Beta factor of 0.9.
Solution
Cost of Equity E(ri ) = Rf + ßi (E(rm) – Rf )
= 11% +0.9 (18%-11%)
=17.3 %
The formula is that of a straight-line y=a+bx, with ßi as the independent variable, Rf as the
intercept with the y axis (E(rm)-Rf) as the slope of the line, and E(r)i (the required return) as the
values being plotted on the straight line. The line itself is called the security market line (SML)
and can be drawn as:
Return
SML
Rm
Rf
ß
Understanding beta:
If an investment is riskier than average (i.e. the returns are more volatile than the average
market returns) then the ß>1.
If an investment is riskier than average (i.e. the returns are more volatile than the average
market returns) then the ß<1.
If an investment is risk free the ß=0.
Criticism of the CAPM
AS with most financial theories, there are a number of difficulties in putting them into
practice and the CAPM is no exception. Some of the problems which managers face
while using this model are as follows;
 The CAPM is a single period model. Although it can be adopted for a multi period use, the
assumptions necessary shall reduce the reliance that can be placed on the model.
 CAPM ignores transaction costs.
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 Beta value is a historical value. The use of historical values for future projections has its own
limitations. There are chances that companies change considerably over a period of time in
their capital structures and coststructures or through changes, which affect their core market.
 It is hard to accept that only market risk matters because specific risk can be diversified away.
This level of diversification of project investment is just not available to most companies.
Also, although institutional investors may be able to spread then- investments over a wide
range of shares, many individual investors may be willing to accept total risk if justified by
the likely returns. However. CAPM does not allow for irrational behavior.
 CAPM depends on an efficient investment market. However, In the context of Nepal Share
Market, due to the low volume of transactions, there is a serious question mark over market
efficiency.
 Theassumption that well-diversified portfolio is subject to systematic risk alone is also
questionable.
 Volatile companies shall use a high hurdle rate for investment decision-making. This could
lead to loss of valuable investment opportunities.
The advantages and disadvantages of CAPM
Advantages
 Provides market-based relationship between risk and return
 Focuses on systematic risk
 is useful for appraising specific projects
Disadvantages
 less useful if the investors are diversified
 ignores taxation
 actual data inputs are estimates and may be hard to obtain.
2.3.8 Cost of Right Shares
Right shares for all practical purpose are at par with the sha res Issued to new
shareholders. The Company Act, 2063 [Section 56 (8)] provides for issue of Right Shares.
Thus, existing shareholders have a pre-emptive right in the allotment of additional shares. The
cost of right shares would, therefore, be the same as the cost of new equity capital issued to the
public directly. The cost of new equity capital is the minimum rate of return management of
the company has to strive to maximize the welfare of the shareholders; it has to ensure that
minimum return on the enlarged capital which it was giving before the issue of new shares. If a
company is not able to do so, the earnings per share may be reduced and consequently
reduction of shareholders wealth. The market value of shares depends on dividend and growth
expected by the shareholders.
Thus, the cost of right shares is also -the required rate of return. It may be measured as follows:
Ks =
D1 + g
Po
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Where
Ks = Cost of Right Shares
D1 = Dividend Yield
Po
G
= Market price of the share
= Growth rate in dividend.
2.3.9 Cost of Retained Earnings
Retained earnings are the cash that company retained from the profit of the company. While this
seems like ―free‖ financing because it doesn‘t have to be raised in the market. The Company can
either keep or reinvest cash or return it to the shareholders as dividend. If the cash is reinvested,
the opportunity cost is the expected rate of return that shareholders could have obtained by
investing in the financial assets. Therefore, it is the opportunity cost of dividends forgone by
shareholders.
Cost of retained earnings is often used interchangeably with the cost of equity. However,
retained earnings are little bit cheaper than new equity financing due to cost of issuing shares. In
addition, outside investors may not have good information about the prospects of the firm, which
would make them hesitant to invest in newly issued equity.
Formula used for calculation of cost of retained earnings are same as formulas used for
calculation of cost equity.
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑀𝑀𝑀𝑀𝑀𝑀ℎ𝑜𝑜𝑜𝑜 𝐾𝐾𝐾𝐾 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑚𝑚𝑚𝑚𝑚𝑚ℎ𝑜𝑜𝑜𝑜 𝐾𝐾𝐾𝐾 =
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺ℎ 𝑀𝑀𝑀𝑀𝑀𝑀ℎ𝑜𝑜𝑜𝑜 𝐾𝐾𝐾𝐾 =
𝐷𝐷
𝑃𝑃
𝐸𝐸𝐸𝐸𝐸𝐸
𝑃𝑃
𝐷𝐷1
+ 𝐺𝐺
𝑃𝑃𝑃𝑃
But for the purpose of calculation of Ke (cost of equity): P= net proceed realized=issue price less
floatation cost. And for the purpose of calculation of Kr (cost of retained earnings): P=current
market price.
Floatation Costs:
Flotation cost is the total cost incurred by a company in offering its securities to the public. They
arise from expenses such as underwriting fees, legal fees, printing charges and registration
fees.The sum of all thesecosts is known as floatation cost.
Illustration 9
Face value of equity shares of a company is Rs.10, while current market price is Rs.200 per
share. Company is going to start a new project and is planning to finance itpartially by new
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issue and partially by retained earnings. You are required to Calculate cost of equity shares as
well as cost of retained earnings if issue price will be Rs.190 per share and floatation cost will
be Rs.5 per share. Dividend at the end of first year is expected to be Rs.10 and growth rate
will be 5%.
Illustration 9- Solution
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺ℎ 𝑀𝑀𝑀𝑀𝑀𝑀ℎ𝑜𝑜𝑜𝑜 𝐾𝐾𝐾𝐾 =
𝐷𝐷1
+ 𝐺𝐺
𝑃𝑃𝑃𝑃
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 =
10
+ 0.05
200
= 10%
10
+ 0.05
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 =
190 − 5
= 10.41%
2.3.10 Weighted Average Cost ofCapital
An entity‘s cost of capital is an average of the costs of all the finance sources within the
company weighted by the total market value (or book value) of each source.
A firm obtains capital from various sources. Due to the risk differences and the contractual
agreements between the entity and investor, the cost of capital of each source of capital differs.
The cost of capital of each source of capital is known as component, or specific, cost of capital.
The combined cost of all sources of capital is called overall, or average, cost of capital. The
component costs are combined according to the weight of each component capital to obtain the
average costs of capital. Thus, the overall cost is also called the weighted average cost of capital
(WACC).
After ascertaining the cost of each component of capital as discussed above, the average of
composite cost of all the sources of capital is to be determined. The cost of each Component of
the capital is weighted by the relative proportion of that type of funds in the capital structure.
Weights are taken to be proportioned of each source of funds in the capital structure. Then it is
called weighted average cost of capital. It is also called overall cost of capital (Ko).
When potential investment project is made, the project is assumed to be financed from the pool,
rather than from any specific fund-raising operation. If the mix of equity, debt and preference
shares within the pool of funds is assumed to remain constant overtime, the discount rate to
apply in appraising the project would be the cost of the pool of funds i.e., the WACC. The
WACC can be found by calculating the cost of each long-term source of finance weighted by the
proportions of finance used.
WACC is used as the discount rate applied to future cash flows for deriving a business‘s net
present value. WACC can be used as a hurdle rate against which to assess return on investment
capital performance.
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CIMA London defines Weighted Average Cost of Capital as the "averag e cost of
company's finance (equity, debentures, bank loans) weighted according to the proportion
each element bears to the total pool of capital weighting is usually based on marketvaluations
current yields and costs after tax.
In Summary;
The computation of the WACC involves the following steps:
Step 1: Calculate the total capital from all the sources.
Step 2: Calculate the cost of specific sources of funds e.g.: - Kd, Ke Kp, Kre
Step 3: Calculate the proportion (weight) of each sources of capital.
Step 4: Multiply the cost of each of the source by the appropriate weights.
Step 5: Compute the total weighted cost by adding the total of step 3.
Hence WACC = Sum of [Cost of Individual Components X Proportion in Capital]
The following format maybe adopted for computation of WACC
Proportion
Individual
Cost
Multiplication
Debt
W1
Kd
Kd × W 1
Preference Capital
W2
Kp
Kp × W 2
Retained Earnings
W3
Kre
Kre × W 3
Equity Capital
W4
Ke
Ke× W 4
Component
Total
Amount
Ko = WACC= Total of
above
Choice of Weights
To find an average cost (WACC), the various sources of finance must be weighted
according to the amount of each held by the company.
The weights for the sources of finance could be;
 Book value (BVs) – represents historic cost of finance
 Market value (MVs) – represent current opportunity cost of finance
(a) Book Value Weights: The weights are said to be book value weights if the proportions
of different sources are ascertained on the basis of the face values i.e., the accounting
values. The book value weights can be easily calculated by taking the relevant information
from the capital structure as given in the balance sheet of the firm.The book value weights
in calculation the firm's weighted average cost of capital assumes that new financing will
be raised using exactly the same proportion of each type of financing as the firm curr ently
has in its capital structure.
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The advantage of using book value proportions are:
 Simpler computations
 Only alternative when market data is unavailable, ineffective or unreliable .
The disadvantage of using book values proportions are:
 No relationship with present economic values, hence fallacious.
 Not consistent with the concept of the cost of capital as cost of capital is defined as
'the minimum rate of return to maintain the market value of the firm'.
(b) Market Value Weights: -The weights may also be calculated on the basis of the
market value of different sources i.e., the proportion of each source at its market value. In
order to calculate the market value weights, the firm has to find out the current market
price of the securities in each category.
The advantages of using the market value weights are.
 The market value weights are consistent with the concept of maintaining market
value in the definition of the overall cost of capital.
 The market value weights provide current estimate of the investor's required rate of
return.
 The market value weights yield good estimate of the cost of capital that would be
incurred should the firm require additional funds from the market.
The disadvantage of using market values weights are:
 Market values may not readily available, especially when the security is not a listed
one.
 Market values may be distorted by manipulative trading.
The market values are subject to charge from time to time and so the concept of optimal
capital structure in terms of market values does not remain relevant any longer.Example:
Illustration 10
The following is the capital structure of a Company:
Source of capital
Equity shares @ Rs. 100 each
9 % cumulative preference shares @ Rs.
100 each
11 % debentures
152 |The Institute of Chartered Accountants of Nepal
Book value
Rs.
80,00,000
Market value
Rs.
1,60,00,000
20,00,000
24,00,000
60,00,000
66,00,000
Strategic Finance Decision and Policy
Retained earnings
40,00,000
2,00,00,000
2,50,00,000
The current market price of the company‘s equity share is Rs. 200. For the last year the
company had paid equity dividend at 25 % and its dividend is likely to grow 5 % every
year. The corporate tax rate is 30 % and shareholders personal income tax rate is 20 %.
You are required to calculate:
1) Cost of Capital for each source of Capital
2) Weighted Average Cost of Capital on the basis of Book Value Weights
3) Weighted Average cost of Capital on the basis of Market Value Weights
Illustration 10- Solution
In order to find the weighted average cost of capital, specific cost of capital of
different sources may be calculated as follow:
a.
Cost of Equity Capital:
𝐾𝐾𝐾𝐾
𝐾𝐾𝐾𝐾
=
=3.125+5
=
=18.125%.
26.25
𝑋𝑋 100
200
b. Cost of preference capital or Kp=9%.
c.
Cost of Debentures
Kd(after tax) =r(1–T)
=11(1–0.3)
=7.7%.
d. Costof Retained Earnings:
Kr=Ke(1–Tp)
=18.125(1–0.2)
=14.5%.
i.
Calculation of Weighted Average Cost of Capital (On the basis of Book Value Weights)
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Amount (Book
Value) (Rs.)
Weights
Equity Capital
Preference Capital
Debentures
80,00,000
20,00,000
60,00,000
0.4
0.1
0.3
18.125
9
7.7
7.25
0.9
2.31
Retained earnings
40,00,000
0.2
14.5
2.9
Source
Cost of Capital
(after tax) (%)
WACC (%)
2,00,00,000
1
Hence, WACC on the basis of Book Value Weights= 13.6%
ii.
13.36
Calculation of Weighted Average Cost of Capital (On the basis of Market Value Weights)
Amount
Cost of Capital
WACC (%)
Source
(Market Value) Weights
(after tax) (%)
(Rs.)
Equity Capital
Preference Capital
Debentures
Retained earnings
1,60,00,000
24,00,000
66,00,000
0.64
0.096
0.264
2,50,00,000-
1-
18.125
9
7.7
-
14.497
Hence, WACC on the basis of Market Value Weights = 14.497 %
Knowledge Test- 6
Calculate the WACC using the following data by using:
(a) Book value weights
(b) Market value weights
The capital structure of the company is as under:
Source of Fund
Amount in NRs
Debentures (NRs 100 per debentures)
5,00,000
Preference Shares (NRs 100 per share)
5,00,000
Equity shares (NRs 10 per share)
10,00,000
20,00,000
The Market prices of these securities are:
Debentures
NRs 105 per debentures
154 |The Institute of Chartered Accountants of Nepal
11.6
0.864
2.033
Strategic Finance Decision and Policy
Preference Shares
Equity Shares
NRs 110 Per preference shares
NRs 24 each
Additional information:
1) NRs 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs, 10 year maturity.
2) NRs 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost
and 10-year maturity.
3) Equity shares has NRs 4 floatation cost and market price NRs 24 per share.The next
year expected dividend is NRs 1 with annual growth of 5%.
The firm has practice of paying all earnings in the form of dividend.Corporate tax rate
is 50%. Assume that floatation cost is to be calculated on face value.
2.3.11 Marginal Cost of Capital (WMACC)
The marginal cost of capital may be defined as the cost of raising an additional rupee of
capital. A schedule showing the relationship between additional financing and the WACC
is called the weighted marginal cost of capital. The marginal cost of capital is calculated
by taking a weighted average of the marginal costs of each component in proportion to
the respective amounts of each that the firm will raise. In short, the weighted average
cost of capital is calculated on the basis of marginal weights.
The marginal weights represent the proportion of funds the firm intends to employ. Thus,
the problem of choosing between the book value weights and the market value weights
does not arise in the case of marginal cost of capital computation.
The use of WMACC assumes that the capital structure of an entity will remain unchanged
and that any new investments will have a similar risk profile to existing investments. If a
large project is under consideration, and it would fundamentally affect the capital
structure of an entity, these assumptions would mean that WACC is no longer the
appropriate technique for investment appraisal. Use of WMACC could lead to the
acceptance of projects that reduce the entity's value. The relevant co st of capital is now
arguably the incremental cost, i.e. the marginal cost reflecting the changes in the total
cost of the capital structure before and after the introduction of the new capital.
The Schedule of WMACC can be computed as follows:
Step 1. Estimate the cost of each source of financing for various levels of its use
through an analysis of current market conditions and an assessment of the
expectations of investors and lenders. (The portion of new financing provided
by equity shares will be taken from available retained earnings until exhausted,
and then obtained through new equity financing. Since the retained earnings are
a less expensive form of equity financing than the sale of new equity shares it
should be clear that once retained earnings have been exhausted, the weighted
average cost of capital will rise with the addition of more expensive new equity
shares.)
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Step 2.
Step 3.
Step 4.
Step 5.
Determine the pattern of raising additional finance.
Identify the levels of total new financing at which the cost of new components
changes, given a capital structure.
Calculate the WACC for the various ranges of total financing between the
breaking points.
Calculate the overall WMACC.
Use of Weighted MCC for Decision Making
The Weighted MCC should be used in conjunction with the firm's available investment
opportunities in order to choose investments to be implemented. As long as a project's
internal rate of return is greater than the weighted marginal cost of new financing to be
used to finance the project, the project would be accepted.
The following variable may affect the marginal cost of capital of a specific source:
i. The investor may perceive an increase in business risk of the firm
ii. The financial risk of the firm may also change as a result of change in composition of
capital structure
iii. The increase in business and financial risk may increase the marginal cost of capital
and thus some of the proposal may become unviable.
Illustration 11
The R&G Company has following capital structure at 31st March 2019, which is considered
to be optimum:
Rs.
13% debenture
3,60,000
11% preference share capital
1,20,000
Equity share capital (2,00,000 shares)
19,20,000
The company‘sshare has a current market price of Rs. 27.75 per share. The expected
dividend per share in next year is 50 percent of the 2019 EPS. The EPS of last 10 years is as
follows. The past trends are expected to continue:
Year
2010
2011
2012
2013
EPS(Rs.)
1.00
1.120
1.254 1.405
2014
2015
2016
1.574 1.762 1.974
2017
2018
2019
2.211 2.476 2.773
The company can issue 14 percent new debenture. The company‘s debenture is currently
selling at Rs. 98. The new preference issue can be sold at a net price of Rs. 9.80, paying a
dividend of Rs. 1.20 per share. The company‘s marginal tax rate is 50%.
(i)
Calculate the after-tax cost (a) of new debts and new preference share capital, (b) of ordinary
156 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
equity, assuming new equity comes from retained earnings.
(ii) Calculate the marginal cost of capital.
(iii) How much can be spent for capital investment before new ordinary share must be sold?
Assuming that retained earnings available for next year‘s investment are 50% of 2019
earnings.
(iv) What will be marginal cost of capital (cost of fund raised in excess of the amount calculated
in part (iii))if the company can sell new ordinary shares to net Rs. 20 per share? The cost of
debt and of preference capital is constant.
Illustration 11- Solution
The existing capital structure is assumed to be optimum.
Existing Capital Structure Analysis
(i)
Type of capital
Amount (Rs)
Proportions
13% debentures
11% Preference
Equity
3,60,000
1,20,000
19,20,000
24,00,000
0.15
0.05
0.8
1
(i) Calculation of cost of capital of different sources
a After tax cost of Debt kd =
19
𝑋𝑋 1 − 0.5
98
= 0.07143
b
After tax Cost of Preference Share New Kp =
𝑐𝑐
After tax Cost of Equity Share Ke =
= 0.122449
1.3865
+ 0.12
27.75
= 0.05+ 0.12
= 0.17
(ii)
Type of capital
Debt Capital
1.20
9.80
Proportion
0.15
Specific cost
0.07143
Product
0.0107145
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Preference share
Equity Share
0.05
0.8
0.12249
0.17
Marginal Cost of Capital at
existing Capital Structure
0.0061245
0.136
0.152839 or 15.28%
(iii) The Company can spend the following amount without increasing its MCC and
without selling the new shares
Retained earnings
= 1.3865 * 200,000 = 277,300
The Ordinary equity (Retained earnings in this case) is 80% of the total capital.
Thus investment before issuing equity
277,300
𝑋𝑋 100 = 𝑅𝑅𝑅𝑅 346, 625
80
(iv) If the company spends more than Rs 346,625, it will have to issue new share. The cost of
new issue of ordinary share is
1.3865
+ 0.12 = 0.1893
Ke=
20
The marginal cost of capital of Rs 346,625
Type of capital
Debt
Preference share
Equity (new)
Marginal Cost of Capital at existing
Capital Structure
Proportion
0.15
0.05
0.8
Specific cost
0.07143
0.12249
0.1893
Product
0.0107145
0.0061245
0.15144
0.168279
16.83%
2.3.12 Financial Distress
Financial distress is defined as a condition where obligations are not met or are met with
difficulty. It is the condition in which a company or individual cannot generate revenue or
income because it is unable to meet or cannot pay its financial obligations. This is generally due
to high fixed costs, illiquid assets, or revenues sensitive to economic downturns.A major
disadvantage for a firm taking on higher levels of debt is that it increases the risk of financial
distress, and ultimately liquidation. This may have detrimental effect on both the equity and debt
holders.
Effects of Financial Distress
 The risk of incurring the costs of financial distress has a negative effect on a firm's value
which offsets the value of tax relief of increasing debt levels.
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





These costs become considerable with very high gearing. Even if a firm manages to avoid
liquidation its relationships with suppliers, customers, employees and creditors may be
seriously damaged.
Suppliers providing goods and services on credit are likely to reduce the generosity of their
terms, or even stop supplying altogether, if they believe that there is an increased chance of
the firm not being in existence in a few months' time.
Customers may develop close relationships with their suppliers and plan their own
production on the assumption of a continuance of that relationship. If there is any doubt
about the longevity of a firm, it will not be able to secure high-quality contracts. In the
consumer markets customers often need assurance that firms are sufficiently stable to deliver
on promises.
In a financial distress situation, employees may become demotivated as they sense increased
job insecurity and few prospects for advancement. The best staff will start to move to other
competitors‘ companies.
Bankers and other lenders will tend to look upon a request for further finance from a
financially distressed company with a prejudiced eye, taking a safety-first approach,and this
can continue for many years after the crisis has passed.
Management find that much of their time is spent "firefighting", dealing with day-to-day
liquidity problems and focusing on short-term cash flow rather than long-term shareholder
wealth.
The indirect costs associated with financial distress can be much more significant than the more
obvious direct costs such as paying for lawyers, accountants and for refinancing programs. Some
of these indirect and direct costs are shown in the table below:
Costs of Financial Distress
Indirect example
Direct example
 Uncertainties in customers' minds about dealing with the firm- Lost
sales, Lost Profits, Lost goodwill

Lawyers' fees
 Uncertainties in suppliers' minds about dealing with the firm - Lost
inputs, more expensive trading terms
 If assets have to be sold quickly the price may be very low


Accountants' fees
Court Fees

Management
Time
 Delays, Legal impositions, and tangles of financial reorganizations
may place restrictions on management action, interfering with the
efficient running of the business
 Management may give excessive emphasis to short term liquidity, e.g.
cut R & D and training, reduce trade credit and stock levels.
 Temptation to sell healthy businesses as this will raise the most cash
 Loss of staff morale, tendency to examine alternative employment
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 To conserve cash, lower credit terms are offered to customers, which
impacts on the marketing effort
Some Indicators of Financial Distress
As the risk of financial distress rises with the gearing ratio shareholders (and lenders) demand an
increasing return in compensation.
The important issue is at what point does the probability of financial distress so increase the cost
of equity and debt that it outweighs the benefit of the tax relief on debt?
Financial Analysis may be used to view some of the indicators of the financial distress.
Important ratios to be considered include:

Liquidity ratios

Debt management ratios

Asset utilization ratios
The ratios provide indicators on whether the firm is facing financial problems in meeting both its
current and long-term debt obligations. Other indicators are as discussed below.
Some Factors Influencing the Risk of Financial Distress Costs
The susceptibility to financial distress varies from company to company. Here are some
influences:
1. The sensitivity of the company's revenues to the general level of economic activity.
If a company is highly responsive to the ups and downs in the economy, shareholders and
lenders may perceive a greater risk of liquidation and/or distress and demand a higher return
in compensation for gearing compared with that demanded for a firm which is less sensitive
to economic events.
2. The proportion of fixed to variable costs. A firm which is highly operationally geared, and
which also takes on high borrowing, may find that equity and debt holders demand a high
return for the increased risk
3. The liquidity and marketability of the firm's assets. Some firms invest in a type of asset which
can be easily sold at a reasonably high and certain value should they go into liquidation. This
is of benefit to the financial security holders and so they may not demand such a high-risk
premium.
4. The cash-generative ability of the business. Some firms produce a high regular flow of cash
and so can reasonably accept a higher gearing level than a firm with lumpy and delayed cash
inflows.
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2.3.13 Additional Knowledge Tests
Knowledge Test-7
You are required to determine the weighted average cost of capital of a firm using (i) bookvalue
weights and (ii) market value weights. The following information is available for your perusal:
Present book value of the firm‘s capital structure is:
Rs.
Debentures of Rs. 100 each
8,00,000
Preference shares of Rs. 100 each
2,00,000
Equity shares of Rs. 10 each
10,00,000
20,00,000
All these securities are traded in the capital markets. Recent prices are:
Debentures @ Rs. 110, Preference shares @ Rs. 120 and Equity shares @ Rs. 22.
(i)
(ii)
(iii)
Anticipated external financing opportunities are as follows:
Rs. 100 per debenture redeemable at par : 20 years maturity 8% coupon rate, 4%floatation
costs, sale price Rs. 100.
Rs. 100 preference share redeemable at par : 15 years maturity, 10% dividend rate,
5%floatation costs, sale price Rs. 100.
Equity shares : Rs. 2 per share floatation costs, sale price Rs. 22.
In addition, the dividend expected on the equity share at the end of the year is Rs. 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%.
Knowledge Test-8
XY Cooperates a low-cost airline and is a listed company. By comparison to its major
competitors it is relatively small, but it has expanded significantly in recent years. The shares
are held mainly by large financial institutions.
The following are extracts from XY Co's budgeted Statement of Financial Position at 31 May
20X2.
NRS
Ordinary shares of NRS 1
Reserves
100
50
9% loan notes 20X5 (at nominal value)
200
350
Dividends have grown in the past at 3% a year, resulting in an expected dividend of NRS 1 per
share to be declared on 31 May 20X2. (Assume for simplicity that the dividend will also be
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paid on this date.) Due to expansion, dividends are expected to grow at 4% a year from 1 June
20X2 for the foreseeable future. The price per share is currently NRS 10.40 ex div, and this is
not expected to change before 31 May 20X2.
The existing loan notes are due to be redeemed at par on 31 May 20X5. The market value of
these loan notes at 1 June 20X2 is expected to be NRS 100.84 (ex-interest) per NRS 100
nominal. Interest is payable annually in arrears on 31 May and is allowable for tax purposes.
Tax is payable on profits at a rate for of 30%. Assume taxation is payable at the end of the
year in which the taxable profits arise.
The company has now decided to purchase three additional aircraft at a cost of NRS 10
million each. The board has decided that the new aircraft will be financed in full by an 8%
bank loan on 1 June 20X2.
Required
Calculate the expected weighted average cost of capital of XY Co at 31 May 20X2.
Knowledge Test-9
Following Financial data are available for PQR Ltd. for the year 2019 :
Particulars
8% debentures
10% bonds (2018)
Equity shares (NRS 10 each)
Reserves and Surplus
Total Assets
Assets Turnovers ratio
Effective interest rate
Effective tax rate
Operating margin
Dividend payout ratio
Current market Price of Share
Require rate of return of investors
(NRS in lakh)
125
50
100
300
600
1.1
8%
40%
10%
16.67%
14
15%
You are required to:
a)
b)
c)
d)
Draw income statement for the year
Calculate its sustainable growth rate
Calculate the fair price of the Company‘s share using dividend discount model, and
What is your opinion on investment in the company‘s share at current price?
162 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
Knowledge Test-10
Synergy Limited wishes to raise additional finance of NRs 10 lakhs for meeting its investment
plans. It has NRs 210,000 in the form of retained earnings available for investment purposes.
Further details are as following:
1
2
3
4
5
6
7
Debt/equity mix
Cost of Debt
Up to NRs 180,000
Beyond NRs 180,000
Earnings per share
Dividend pay out
Expected growth rate in dividend
Current market price per share
Tax rate
30%/70%
10% (before tax)
16% (before tax)
NRs 4
50% of earnings
10%
NRs 44
50%
You are required:
a)
b)
c)
d)
To determine the pattern for raising the additional finance.
To determine the post-tax average cost of additional debt.
To determine the cost of retained earnings and cost of equity, and
Compute the overall weighted average after tax cost of additional finance.
Knowledge Test - 11
A company has an issue of 12% redeemable debt with 5 years to redemption. Redemption is at
par. The current market value of the debt is NRS 107.59. The corporation tax rate is 30%.
What is the return required by the debt providers (pre-tax cost of debt)?
The Institute of Chartered Accountants of Nepal | 163
Chapter 2
Financial Management
2.3.14 Knowledge Test Answer
Knowledge Test-1 Answer
a) Pre-tax cost of debt
𝐾𝐾𝐾𝐾 =
𝐾𝐾𝐾𝐾 =
1
𝑀𝑀𝑀𝑀
10
80
Hence, Kd= 12.5%
b) Post-tax cost of debt
𝐾𝐾𝐾𝐾 1 − 𝑡𝑡 =
𝐾𝐾𝐾𝐾 1 − 𝑡𝑡 =
𝐼𝐼 1 − 𝑡𝑡
𝑀𝑀𝑀𝑀
10 1 − 0.3
80
= 0.0875 =8.75%
Note- Since this is irredeemable debt, a short-cut could be taken by multiplying the pre-tax
cost of debt by (1-t).
𝐾𝐾𝐾𝐾 1 − 𝑇𝑇 = 12.5% 1 − 0.3 = 8.75%
Knowledge Test 2- Answer
Answer
a)
After-tax cost of debt
Year
0
1–10
10
Market value
Interest (net of
tax)
Capital
repayment
Cash
flow
Discount
Factor 10%
Present
Value(NRS)
Discount
Factor 5%
PV
NRS
(90.00)
1.00
(90.00)
1.00
(90.00)
7.00
6.15
43.02
7.72
54.05
100.00
0.39
38.60
0.61
61.40
(8.39)
164 |The Institute of Chartered Accountants of Nepal
25.45
Strategic Finance Decision and Policy
By Interpolation,
The approximate cost of redeemable debt capital is, therefore:
25.45
𝑥𝑥 ( 10 − 5)
25.45 + 8.38
= 8.76 %
=5+
Knowledge Test-3 Answer
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 − 𝑁𝑁𝑁𝑁𝑁𝑁 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
(𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 +
𝑁𝑁
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉
+
𝑁𝑁𝑁𝑁𝑁𝑁
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 =
2
𝟏𝟏𝟏𝟏𝟏𝟏 − 𝟏𝟏𝟏𝟏𝟏𝟏. 𝟓𝟓𝟓𝟓
𝟓𝟓
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 = 12 +
𝟏𝟏𝟏𝟏𝟏𝟏 + 𝟏𝟏𝟏𝟏𝟏𝟏. 𝟓𝟓𝟓𝟓
𝟐𝟐
Cost of Debt = (12-1.518)/ (103.795) = 10.09%.
Or,
Timing of
cash flow
0
1-5
5
𝑰𝑰𝑰𝑰𝑰𝑰 = 𝑳𝑳 +
Particulars
Cash Flow
PV
(107.59)
DF @
5%
1
Market
Value
Interest
Payment
Capital
repayment
NPV
PV
(107.59)
DF @
15%
1
12
4.329
51.95
3.352
40.22
100
0.784
78.40
0.497
49.70
22.76
(107.59)
(17.67)
𝑵𝑵𝑵𝑵
∗ 𝑯𝑯 − 𝑳𝑳
𝑵𝑵𝑵𝑵 − 𝑵𝑵𝑵𝑵
IRR = 10.63%
Therefore, the required rate of return of investors is 10.63%.
As the linear interpolation method is used to estimate the IRR is an approximation, it does not
reconcile back to the 10.09% required return calculated under formula method.
Knowledge Test 4- Answer
The Institute of Chartered Accountants of Nepal | 165
Chapter 2
Financial Management
𝑅𝑅𝑅𝑅 − 𝑁𝑁𝑁𝑁
𝑃𝑃𝑃𝑃 +
𝑛𝑛
𝑅𝑅𝑅𝑅 + 𝑁𝑁𝑁𝑁
𝐾𝐾𝐾𝐾 =
2
100 − 95
10 +
10
100 + 95
𝐾𝐾𝐾𝐾 =
2
= 0.1077 approx.
= 10.77%
Knowledge Test 5- Answer
𝑲𝑲𝑲𝑲 = 𝑫𝑫𝑫𝑫 +
Where,
(𝟏𝟏 + 𝑮𝑮)
+ 𝑮𝑮
𝑷𝑷𝑷𝑷
P0 ex div =200-16= NRs 184
D0 =16
g=b*re
b=1-dividend payout %=1-0.2=0.8
re=12.5%
g=re*b=0.125*0.8 = 0.1
𝐾𝐾𝐾𝐾 =
16 1+0.1
184
+0.1 = 19.6
Knowledge Test- 6 Answer
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝐾𝐾𝐾𝐾 =
𝐷𝐷1
1
+ 𝑔𝑔 =
+ 0.05 = 0.1 𝑜𝑜𝑜𝑜 10%
𝑃𝑃𝑃𝑃 − 𝐹𝐹
24 − 4
𝑅𝑅𝑅𝑅 − 𝑁𝑁𝑁𝑁
100 − 96
𝑛𝑛
10
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐾𝐾𝐾𝐾 = 𝐼𝐼 1 − 𝑡𝑡 +
= 10 1 − 0.5 +
𝑅𝑅𝑅𝑅 + 𝑁𝑁𝑁𝑁
100 + 96
2
2
= 0.055 (approx.)
2
10
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑠𝑠𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎 𝐾𝐾𝐾𝐾 = 5 +
198
2
= 0.053 (approx.)
166 |The Institute of Chartered Accountants of Nepal
Strategic Finance Decision and Policy
a) Calculation of WACC using book value weights
Source of Capital
Book Value Weights
10% Debentures
5% Preference Shares
Equity Shares
500,000
500,000
1,000,000
2000,000
0.25
0.25
0.50
1.00
After tax
cost of
capital
0.055
0.053
0.10
WACC
(Ko)
After tax cost
of capital
0.055
0.053
0.10
WACC
(Ko)
0.0137
0.0132
0.0500
0.085
0.0137
0.0132
0.0500
0.0769
WACC (Ko) = 7.69%
b) Calculation of WACC using market value weights
Source of Capital
10% Debentures
5% Preference Shares
Equity Shares
Book
Value
525,000
550,000
2,400,000
3,475,000
Weights
0.151
0.158
0.691
1.00
WACC (Ko) = 8.5%
Knowledge Test- 7 Answer
(i) Computation of Weighted Average Cost of Capital based on Book Value Weights
Weights to
Book
Specific
Total
Source of Capital
Total
Value Rs.
Cost
Cost
Capital
Debentures (Rs. 100 per debenture)
8,00,000
0.4
0.0418
0.0167
Preference Shares (Rs. 100 per share) 2,00,000
0.1
0.1059
0.0106
Equity Shares (Rs. 10 per share)
10,00,000
0.5
0.15
0.075
20,00,000
1
0.1023
Cost of Capital = 10.23%
(ii) Computation of Weighted Average Cost of Capita based on Market Value Weights
Weights to
Market
Specific
Source of Capital
Total Cost
Total
Value Rs.
Cost
Capital
Debentures (Rs. 110 per debenture)
8,80,000
0.2651
0.0418
0.01108
Preference Shares (Rs. 120 per share) 2,40,000
0.0723
0.1059
0.00766
Equity Shares (Rs. 22 per share)
22,00,000
0.6626
0.15
0.09939
33,20,000
1
0.11813
Cost of Capital = 11.81%
The Institute of Chartered Accountants of Nepal | 167
Chapter 2
Financial Management
(i)
Working Notes
Determination of Specific Costs:
Cost of Debentures before tax (kd )
𝐾𝐾𝐾𝐾 =
𝑃𝑃 − 𝑁𝑁𝑁𝑁
𝑛𝑛
𝑃𝑃 + 𝑁𝑁𝑁𝑁
2
𝐼𝐼 +
Where,
I = Annual interest payment
P = Redeemable/payable value of debenture at maturity
NP = Net sale value from issue of debenture/face value expenses
8+
Kd =
100 - 96
20
(100 +96)
2
8 + 20
98
=0.836 or 8.36%
=
Cost of debenture after tax = Kd (1– t)
= 8.36 (1–.50) = 4.18%.
(ii)
Cost of Preference Shares (kp )
Kp =
Where,
D = Fixed annual dividend
P = Redeemable value of preference shares
n = Number of years to maturity.
𝐾𝐾𝐾𝐾 =
100 − 95
15
100 + 95
2
10.33
97.5
=0.1059 or 10.59%
168 |The Institute of Chartered Accountants of Nepal
P - NP
(P + NP)
2
10 +
=
D+
n
Strategic Finance Decision and Policy
(iii)
Cost of Equity (ke)
𝐾𝐾𝐾𝐾 =
Where,
D = Expected dividend per share
NP = Net proceeds per share
g = Growth expected in dividend
𝐾𝐾𝐾𝐾 =
=
=0.10 .05 .15 or 15%.
𝐷𝐷
+ 𝑔𝑔
𝑁𝑁𝑁𝑁
2
+ 0.05
22 − 2
2
+ 0.05
20
Knowledge Test- 8 Answer
a)
Cost of equity
Ke=
=
𝐷𝐷0(1+𝑔𝑔)
𝑃𝑃0
+ 𝑔𝑔\
1 𝑋𝑋 (1 + 0.04))
+ 0.04
10.40
=14%
b)
Cost of debt
Year
0
1-3
3
Cash Flow
Market value
Interest (after tax)
(I-T)
Capital repayment
K d = 5% +
Discount
Factor
5%
Discount
Factor
10%
PV
PV
(100.84)
1.00
(100.84)
1.00
(100.84)
6.30
2.49
15.67
2.72
17.15
100.00
0.75
75.10
(10.07)
0.86
86.40
2.71
2.71
𝑋𝑋 10% − 5% = 6.06%
2.71 − 10.07
Calculation of Weighted Average Cost of Capital
WACC = (Ve/ (Ve + Vd))xKe + ((Vd/(Ve +Vd))x Kd
The Institute of Chartered Accountants of Nepal | 169
Chapter 2
Financial Management
Where Ke = Cost of Equity
Kd = Cost of Debt
Ve = Value of Equity
Vd = Value of Debt
= (1,040/(1,040+201.68))x14%+ (201.68/(1,040+201.68))x6.06%
= 12.71%
Knowledge Test- 9 Sol
Knowledge Test- 9 Answer
Solution
a)
Workings:
Asset turnover ratio
Total Assets
Turnover NRS 600 lakhs x 1.1
Effective market rate
Liabilities
Interest
Operating Margin
Hence operating cost
Dividend Payout
Tax rate
= 1.1
= NRS 600
= NRS 660 lakhs
= Interest = 8%
= NRS 125 lakhs+50 lakhs = 175 lakh
= NRS 175 lakhs x 0.08 = NRS 14 lakh
= 10%
= (10 – 0.10) NRS 660 lakhs = NRS 594 lakh
= 16.67%
= 40%
Income statement
(NRS Lakhs)
Sale
Operating Exp
EBIT
Interest
EBIT
Tax @ 40%
EAT
Dividend @ 16.67%
Retained Earnings
170 |The Institute of Chartered Accountants of Nepal
660
594
66
14
52
20.8
31.2
5.2
26
Strategic Finance Decision and Policy
b)
SGR = G = ROE (1-b)
ROE = PAT and NW = NRS 300+ 100 lakh = 400 lakhs
NW
ROE = NRS 31.2 lakhs x 100 = 7.8%
NRS 400 lakhs
SGR = 0.078(1 -0.1667) = 6.5%
c)
Calculation of fair price of share using dividend discount model
P0 = D0 (1 + g)
Ke - g
Dividends =
NRS 5.2 lakhs = NRS 0.52
NRS 10 lakhs
Growth Rate = 6.5%
Hence P0 = NRS 0.52(1 + 0.065) = NRS 6.51
0.15 – 0.065
d)
Since the current market price of share is NRS 14, the share is overvalued. Hence the
investor should not invest in the company.
a)
Knowledge Test- 10 Answer
Pattern of raising additional finance
Equity 70% of NRs 10,00,000 = NRs 7,00,000
Debt 30% of NRs 10,00,000 = NRs 300,000
The capital structure after raising additional finance:
Particulars
Equity Capital (7,00,000-2,10,000)
Retained Earnings
Debt (Interest at 10% P.a.)
(Interest at 16% P.a.) (300,000-180,000)
Total Funds
b)
Amount NRs
490,000
210,000
180,000
1,20,000
10,00,000
Determination of post-tax average cost of additional debt
Kd = I (1 – t)
Where,
The Institute of Chartered Accountants of Nepal | 171
Chapter 2
Financial Management
I = Interest Rate
t = Corporate tax-rate
On NRs 1,80,000 = 10% (1 – 0.5) = 5% or 0.05
On NRs 1,20,000 = 16% (1 – 0.5) = 8% or 0.08
Average Cost of Debt
c)
=
𝑁𝑁𝑁𝑁𝑁𝑁 180,000 ∗ 0.05 + 𝑁𝑁𝑁𝑁𝑁𝑁 120,000 ∗ 0.08
= 6.2%
𝑁𝑁𝑁𝑁𝑁𝑁 300,000
Determination of post-tax average cost of additional debt
Determination of cost of retained earnings and cost of equity applying Dividend growth
model:
𝐾𝐾𝐾𝐾 =
𝐷𝐷1
+ 𝑔𝑔
𝑃𝑃0
Where Ke=Cost of equity
D1= D0(1+g)
D0= Dividend paid (i.e. 50% of EPS=50%*NRs 4= NRs 2
G=Growth rate
P0=Current market price per share
d)
Then, 𝐾𝐾𝐾𝐾 =
2 1.1
44
+ 0.1 =
2.2
44
+ 0.1 = 0.05 + 0.10 = 15%
Computation of overall weighted average after tax cost of additional finance
Particular
Amount
Weights
Cost of Funds
Weighted Costs
Equity (Including
retained earnings
700,000
0.70
15%
10.5
Debt
3,00,000
0.30
6.2%
1.86
WACC
1000,000
12.36
Knowledge Test –11- Answer
Time
0
MV
Cash flow
DF @
5%
(107.590)
1.000
172 |The Institute of Chartered Accountants of Nepal
PV
(107.590)
DF @
15%
1.000
PV
(107.590)
Strategic Finance Decision and Policy
1–5
Interest payments
12.000
4.329
51.948
3.352
40.224
5
Capital repayment
100.000
0.784
78.400
0.497
49.700
NPV
22.758
𝐼𝐼𝐼𝐼𝐼𝐼 = 5% +
(17.666)
22.76
∗ 15% − 5%
22.758 + 17.666
𝐼𝐼𝐼𝐼𝐼𝐼 = 10.63%
Therefore, the required return of investors is 10.63%. As the linear interpolation method used
to estimate the IRR is an approximation, it does not reconcile back to the 10% required return
per the illustration above.
*Assumed that par value of redeemable debt is NRs. 100.00
The Institute of Chartered Accountants of Nepal | 173
Chapter 3
Financial Management
Chapter 3
Analysis of Financial Statements
174 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
3.1 Financial Statement Analysis
3.1.1 Learning Objectives
Upon completion of this chapter student will be able to:
 Explain the components of complete set of financial statements
 Explain the precautions in financial statement analysis
 Identify the sources of financial data for analysis
 Describe the method of financial statement analysis
 Understanding of trend analysis and proportion analysis
3.1.2 Chapter Overview
Financial
Statements
Analysis
Components of
Financial
Statements
Methods of
Financial Statement
Analysis
On the basis of
Material
User of Financial
Statements
Based on Method
of Operation
External Analysis
Horizontal Analysis
Internal Analysis
Vertical Analysis
Fig: Chapter Overview of Financial Statement Analysis
The Institute of Chartered Accountants of Nepal | 175
Financial Management
Chapter 3
3.1.3 Overview of Financial Statement Analysis
Financial statement analysis involves gaining an understanding of an organization's financial
situation by reviewing its financial reports. The results can be used to make investment and
lending decisions. This review involves identifying the following items for a company's financial
statements over a series of reporting periods:
 Trends. Create trend lines for key items in the financial statements over multiple time
periods, to see how the company is performing. Typical trend lines are for revenue, the
gross margin, net profits, cash, accounts receivable, and debt.
 Proportion analysis. An array of ratios is available for discerning the relationship between
the size of various accounts in the financial statements. For example, one can calculate a
company's quick ratio to estimate its ability to pay its immediate liabilities, or its debt to
equity ratio to see if it has taken on too much debt. These analyses are frequently between
the revenues and expenses listed on the income statement and the assets, liabilities, and
equity accounts listed on the balance sheet.
3.1.4 Introduction
A business firm prepares its final accounts viz., Statement of Financial Position, Statement of
profit or loss, statement of cash flow etc. which provide useful financial information for the
purpose of decision making.
Financial statements are a structured representation of the financial position and financial
performance of an entity. John N. Nyer defines it ―Financial statements provide a summary of
the accounting of a business enterprise, the balance-sheet reflecting the assets, liabilities and
capital as on a certain data and the income statement showing the results of operations during a
certain period‖.
The objective of financial statements is to provide information about the financial position,
financial performance and cash flows of the entity that is useful to a wide range of users in
making economic decisions. It is the summary of the accounting process, which, provides useful
information to both internal and external parties. Financial statements also show the results of
the management‘s stewardship of the resources entrusted to it. A complete set of financial
statements comprises;
(a) Statement of Financial Position as at the end of the period
Statement of Financial Position is also called as balance sheet, which reflects the financial
position of the firm at the end of the financial year. Statement of Financial Position helps to
ascertain and understand the total assets, liabilities and capital of the firm. One can understand
the strength and weakness of the concern with the help of the position statement
(b) Statement of Profit or loss and other comprehensive income for that period
This statement is also called as Income statement or profit and loss account, which reflects the
operational position of the firm during a particular period. Normally it consists of one accounting
year. It determines the entire operational performance of the concern like total revenue generated
and expenses incurred for earning that revenue. Income statement helps to ascertain the gross
176 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
profit and net profit of the concern. Gross profit is determined by preparation of trading or
manufacturing a/c and net profit is determined by preparation of profit and loss account.
(c) Statement of Cash Flow for the period
Cash flow statement is a statement which shows the sources of cash inflow and uses of cash outflow of the business concern during a particular period of time. It is the statement, which
involves only short-term financial position of the business concern. Cash flow statement
provides a summary of operating, investment and financing cash flows and reconciles them with
changes in its cash and cash equivalents such as marketable securities.
(d) Statement of Change in equity for that period
It is also called as statement of retained earnings. This statement provides information about the
changes or position of owner‘s equity in the company.
However, these statements do not disclose all of the necessary and relevant information. For the
purpose of obtaining the material and relevant information necessary for ascertaining the
financial strengths and weaknesses of an enterprise, it is necessary to analyze the data depicted in
the financial statement. The financial manager has certain analytical tools which help in financial
analysis and planning. For instance, a cash flow statement is a valuable aid to a financial
manager in evaluating the inflows and outflows of cash i.e. sources and applications of cash
during particular period. In addition, ratio and trend analysis helps the manager to analyze the
past performance of the firm and to make future projections.
3.1.5 User of Financial Statements
There are a number of users of financial statement analysis. They are:
 Creditors: Anyone who has lent funds to a company is interested in its ability to pay
back the debt, and so will focus on various cash flow measures.
 Investors: Both current and prospective investors examine financial statements to learn
about a company's ability to continue issuing dividends, or to generate cash flow, or to
continue growing at its historical rate (depending upon their investment philosophies).
 Management. The company controller (Senior Management Team) prepares an ongoing
analysis of the company's financial results, particularly in relation to a number of
operational metrics that are not seen by outside entities (such as the cost per delivery,
cost per distribution channel, profit by product, and so forth).
 Regulatory authorities. If a company is publicly held, its financial statements
examined by the Securities Exchange Board of Nepal (if the company files in
Nepal), Office of Company Registrar, Nepal Rashtra Bank, Insurance Board etc. to
if its statements conform to the various accounting standards and the rules of
regulators.
are
the
see
the
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3.1.6 Precautions in Financial Statement Analysis
Financial statement information is used by both external and internal users, including investors,
creditors, managers, and regulators. These users must analyze the information in order to make
business decisions, so understanding financial statements is of great importance. Managers will
use ratio analysis to pinpoint strengths and weaknesses from which strategies and initiatives can
be formed. Funders may use ratio analysis to measure your results against other organizations or
make judgments concerning management effectiveness and mission impact
For the analysis of Financial Statement to be useful and meaningful, they must be:
 Calculated using reliable, accurate financial information.
 Calculated consistently from period to period
 Used in comparison to internal benchmarks and goals
 Used in comparison to other companies in your industry
 Viewed both at a single point in time and as an indication of broad trends and issues over
time
 Carefully interpreted in the proper context, considering there are many other important
factors and indicators involved in assessing performance.
General precaution to be taken while making a financial statement analysis are as follow
a) Standard for Comparison
Analysis have meaning only if they are compared with some standards. Usually it is
recommended that analysis of a firm based on ratio should be compared with industry average.
Even while comparing ratios with the past ratios forecast may not be correct since several factors
like market conditions, management policies etc. may affect the future operations.
The language for the statements should be same. Previously Generally Accepted Accounting
principle (GAAP) was followed. Now International Reporting Financial Standard (IFRS) [in
Nepal NFRS] is following for standard comparison.
b) Price Level Changes
Financial analysis based on accounting ratios will give misleading results if the effects of
changes in price level are not taken into account. The accounting data presented in financial
statements is assumed to remain constant. In fact, prices change over years which affect
accounting earnings. Therefore, financial statements should be adjusted as per price level
changes. For this current purchasing power and current cost accounting are quite helpful.
c) Historical Data
The financial analysis based on ratios indicate what has happened in the past because it is
calculated on the basis of historical financial statements. Analysts are more interested in future
and these ratios may not necessarily reply the firm's financial position and performance in future.
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d) Use of Ratios alone are not Adequate
Ratios are only indicators; they cannot be considered as the final regarding financial position of
the business. Other things also have to be seen. A high current ratio not necessarily mean sound
liquidity position if most of current assets comprise outdated stocks.
e) Window Dressing
Window dressing means manipulation of accounts in a way so as to conceal vital facts and
present financial statements in a way to show better position than what it actually is. In this case
financial statement analysis based on ratios cannot indicate true situation the quality of ratios
depends on accuracy of accounts.
3.1.7 Sources of Financial Data Analysis
The sources of information for financial data analysis are;
 Annual report of the organization\
 Interim financial statements
 Notes to accounts
 Statement of cash flows
 Credit and investment advisory services
3.1.8 Method of Financial Statement Analysis
According to Myres, ―Financial statement analysis is largely a study of the relationship among
the various financial factors in a business as disclosed by a single set of statements and a study of
the trend of these factors as shown in a series of statements‖.
Analysis of financial statement may be broadly classified into two important types on the basis
of material used and methods of operations.
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Types of Financial
Statement
Analysis
On the basis of
Material Used
On the basis of
Methods of
Operations
External Analysis
Internal Analysis
Horizontal
Analysis
Vertical Analysis
Fig: Type of Financial Statements Analysis
3.1.8.1 Based on Material Used
Used Based on the material used, financial statement analysis may be classified into two major
types such as External analysis and internal analysis.
A. External Analysis:
Outsiders of the business concern do normally external analyses, but they are indirectly involved
in the business concern such as investors, creditors, government organizations and other credit
agencies. External analysis is very much useful to understand the financial and operational
position of the business concern. External analysis mainly depends on the published financial
statement of the concern. This analysis provides only limited information about the business
concern.
B. Internal Analysis:
The company itself does disclose some of the valuable information to the business concern in
this type of analysis. This analysis is used to understand the operational performances of each
and every department and unit of the business concern. Internal analysis helps to take decisions
regarding achieving the goals of the business concern.
3.1.8.2 Based on Method of Operation
Based on the methods of operation, financial statement analysis may be classified into two major
types such as horizontal analysis and vertical analysis.
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Analysis of Financial Statements
A. Horizontal analysis
It is the comparison of financial information over a series of reporting period. This technique is
also known as comparative analysis. It is conducted by setting consecutive balance sheet, income
statement or statement of cash flow side-by-side and reviewing changes in individual categories
on a year-to-year or multiyear basis. The most important item revealed by comparative financial
statement analysis is trend.
A comparison of statements over several years reveals direction, speed and extent of a trend(s).
The horizontal financial statements analysis is done by restating amount of each item or group of
items as a percentage.
Such percentages are calculated by selecting a base year and assign a weight of 100 to the
amount of each item in the base year statement. Thereafter, the amounts of similar items or
groups of items in prior or subsequent financial statements are expressed as a percentage of the
base year amount. The resulting figures are called index numbers or trend ratios.
So, the horizontal analysis helps a financial analyst in establishing operation and positional trend
of the firm. The horizontal analysis may be prepared to show:
 The absolute amount of different items in monetary terms.
 The amount of periodic changes in monetary terms,
 The percentage of periodic changes to reveal the proportionate changes.
Horizontal Analysis of Income Statement
For the years ending 2018& 2019
Particulars
2019
2018
Changes in 2019 % changes in 2019
Net sales
4,00,000 5,00,000
1,00,000
+ 25%
Less: Cost of Goods Sold
3,00,000 3,75,000
75,000
+25%
Gross Profit
1,00,000 1,25,000
25,000
+25%
Less: General Expenses
10,000
10,000
Selling Expenses
15,000
20,000
5,000
+33.33%
Total Expenses
25,000
30,000
5,000
+20%
Net Profit
75,000
95,000
20,000
+26.7%
As basis of Analysis, the analyst may seek variables which seem to improve or deteriorate and
bring a challenge to the stakeholders in their various decisions. Example from the previous table
one can ask the following questions?

Why is there an increase in the stock of the company? Has the company changed its
inventory policy?
And many more question which can be elaborated by the management or which can be used as
the basis for discussions.
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B.
Vertical analysis
Vertical analysis is the proportional analysis of a financial statements, where each line on a
financial statement is listed as a percentage of another item. Vertical/Cross-sectional/Common
size statements came from the problems in comparing the financial statements of firms that differ
in size.
In the balance sheet, for example, the assets as well as the liabilities and equity are each
expressed as a 100% and each item in these categories is expressed as a percentage of the
respective totals.
 In the common size income statement, turnover is expressed as 100% and every item in the
income statement is expressed as a percentage of turnover (sales).
The Vertical Analysis represents the relationship of different items of a financial statement
which some common item by expressing each item as a percentage of the common item. In
common size income statement, each item is stated as percentage of net sales. The percentages
of different item are computed by dividing the absolute amount of that item by the common base
(i.e. the balance sheet total or the net sales as the case may be) and then multiplying by 100.

Common Size Statement (vertical analysis statement)
Particulars
Amount
Percentage
2019
2018
2019
2018
Net sales
4,00,000
5,00,000
100
100
Less: Cost of Goods Sold
3,00,000
3,75,000
75
75
Gross Profit
1,00,000
1,25,000
25
25
Less: General Expenses
10,000
10,000
2.5
2
Selling Expenses
15,000
20,000
3.75
4
Total Expenses
25,000
30,000
6.25
6
Net Profit
75,000
95,000
18.75
19
From the vertical analysis above, an analyst can compare the percentage mark-up of revenue
items and how they have been generated. The strategies may include increase/decrease of the
certain expenditure.
3.1.9 Limitation of Financial Ratio Analysis
While financial statement analysis is an excellent tool, there are several issues to be aware of that
can interfere with the interpretation of the analysis results. These issues are:

Comparability between periods. The company preparing the financial statements may have
changed the accounts in which it stores financial information, so that results may differ from
period to period. For example, an expense may appear in the cost of goods sold in one
period, and in administrative expenses in another period.
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 Comparability between companies. An analyst frequently compares the financial ratios of
different companies in order to see how they match up against each other. However, each
company may aggregate financial information differently, so that the results of their ratios
are not really comparable. This can lead an analyst to draw incorrect conclusions about the
results of a company in comparison to its competitors.
 Operational information. Financial analysis only reviews a company's financial
information, not its operational information, so you cannot see a variety of key indicators of
future performance, such as the size of the order backlog, or changes in warranty claims.
Thus, financial analysis only presents part of the total picture.
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3.2 Ratio Analysis
3.2.1 Learning Objectives
Upon completion of this chapter student will be able to:





Discuss the financial ratios and its types
Explain the meaning and usefulness of a calculated ratios.
Analysis of the ratios from the different stakeholder‘s point of view
Discuss the Du Pont analysis
State the limitation of financial ratios
3.2.2 Chapter Overview
Ratio Analysis
Importance of
Financial Ratios
Types of Financial
Ratios
Limitations of
Financial Ratios
Du-Pont Analysis
Fig: Chapter Overview of Ratio Analysis
184 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
3.2.3 Introduction
Ratio analysis is the process of comparing quantifying relationships between financial variables,
such as those variables found in the statement of financial position and statement of profit or loss
of a company.Ratio Analysis is a widely used tool of financial analysis. It is defined as the
systematic use of ratio to interpret the financial statements so that the strengths and weaknesses
of a firm as well as its historical performance and current financial condition can be determined.
The Validation of ratio analysis lies in the fact that it makes related information comparable. A
single figure by itself has no meaning but when expressed in terms of a related figure, it yields
significant inferences. When investors and analysts talk about fundamental or quantitative
analysis, they are usually referring to ratio analysis. Ratio analysis involves evaluating the
performance and financial health of a company by using data from the current and historical
financial statements.
3.2.4 Basis of Evaluation
Ratios, as shown above, are relative figures reflecting the relationship between variables. They
enable analysts to draw conclusions regarding the financial operations. The use of ratios, as a
tool of financial analysis, involves their comparison, for a single ratio like absolute figures, fails
to reveal the true position. For example, if in the case of a firm, the return on capital employed is
15 percent in a particular year, what does it indicate? Only if the figure is related to the fact that
in the preceding year the relevant return was 12 percent or 18 percent, it can be inferred whether
the profitability of the firm has declined or improved. Alternatively, if we know that the return
for the industry asa whole is 10 percent or 20 percent, the profitability of the firm in question can
be evaluated. Comparison with related facts is, therefore, the basis of ratio analysis.
Four types of comparisons are involved:
1. Time Series Analysis / Past Ratios
Past ratios are the ratios calculated from the past financial statements of the same firm. By
comparing current years ratios with past ratio, the improvement or deterioration in firm's
performance over the period can be studied. It is also known as Time Series Analysis.
2. Cross-sectional Analysis / Competitor's Ratios
Competitor‘s Ratios are ratios of some selected firms, especially the most progressive
competitor, at the same point in time. By comparing firm‘s ratios with competitor's ratios, the
firm‘s financial position in respect to competitors can be known.
3. Industry Analysis / Industry Ratios
Industry Ratios are the ratios of industry to which the firm belongs. By comparing firms‘ ratios
with industry average ratios, the firm's position vis, a vis other firms in the industry can be
understood.
4. Proforma Analysis / Projected Ratios
Projected Ratios are the ratios developed by using the projected financial statements of the firm.
The comparison of current or past ratios with future ratios indicates the firm's relative strength
and weaknesses in the past and in the future.
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3.2.5 Importance of Financial Ratios
Financial ratios and ratio analysis are key aspects within all of the following areas:





Measuring the achievement of corporate objectives
Capital budgeting decisions (for e.g. Return on capital employed)
Working capital management (current ratio, quick ratio, working capital turnover ratio)
Capital structure (gearing ratios)
Valuation of bond, equity and business
3.2.6 Limitations of Ratio Analysis
While ratios are very important tools of financial analysis, they have some limitations, such as;
 The firm can make some year-end changes to their financial statements, to improve their
ratios. Then the ratios end up being nothing but window dressing.
 Ratios ignore the price level changes due to inflation. Many ratios are calculated using
historical costs, and they overlook the changes in price level between the periods. This
does not reflect the correct financial situation.
 Accounting ratios completely ignore the qualitative aspects of the firm. They only take
into consideration the monetary aspects (quantitative)
 If the company has changed its accounting policies and procedures, this may
significantly affect financial reporting. In this case, the key financial metrics utilized in
ratio analysis are altered and the financial results recorded after the change are not
comparable to the results recorded prior to the change. It is up to the analyst to be up to
date with changes to accounting policies. Changes made are generally found in the notes
to the financial statements section.
 An analyst should be aware of seasonal factors that could potentially result in limitations
of ratio analysis. The inability to adjust the ratio analysis to the seasonality effects may
lead to false interpretations of the results from the analysis.
 There are no standard definitions of the ratios. So, firms may be using different formulas
for the ratios. One such example is Current Ratio, where some firms take into
consideration all current liabilities, but others ignore bank overdrafts from current
liabilities while calculating current ratio
 And finally, accounting ratios do not resolve any financial problems of the company.
They are a means to the end, not the actual solution.
3.2.7 Types of Ratios
Ratios can be classified into six broad groups: (i) Liquidity ratios, (ii) Capital structure/leverage
ratios, (iii) Profitability ratios and (iv) Activity/ Efficiency ratios
186 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
Types of Ratios
Liquidity Ratios
Activity/
Efficienency/
performance Ratios
Capital Structure/
leverage ratios
Profitability Ratios
Current Ratios
Capital Structure
ratio
Assets Turnover
Based on Sales of
Firms
Quick Ratios
Coverage Ratio
Capital Turnover
Based on Assets
/Investments
Working Capital
Turnover
Based on Owner's
Point of View
Cash Ratio/
Absoute Liquidity
Ratio
Defensive interval
ratio
Based on
Market/Valuation/
Fig: Types of Financial Ratios
3.2.7.1 Liquidity Ratios:
The importance of adequate liquidity in the sense of the ability of a firm to meet current/shortterm obligations when they became due for payment can hardly be overstressed. In fact, liquidity
is a prerequisite for the very survival of a firm. The short-term creditors of the firm are interested
in the short-term solvency or liquidity of a firm. But liquidity implies, from the viewpoint of
utilization of the funds of the firm that funds are idle, or they earn very little. A proper balance
between the two contradictory requirements, that is, liquidity and profitability, is required for
efficient financial management. The liquidity ratios measure the ability of a firm to meet its
short-term obligations and reflect the short-term financial strength/solvency of a firm. The ratios
which indicate the liquidity of a firm are:
1.
2.
3.
4.
5.
Net working capital
Current ratios
Acid test/quick ratios
Cash Ratio
Defensive-interval ratios and
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Liquidity Ratios
If the company suddenly finds that it is unable to renew the overdraft loan, there will be
danger of insolvency unless the company is able to turn enough of its current assets into cash
quickly.
In general, high current and quick ratios are considered ‗good‘ in that they mean that an
organization has the resources to meet its commitments as they fall due. However, it may
indicate that working capital is not being used efficiently, for example that there is too much
idle cash that should be invested to earn a return.
i. Net working Capital:
Net working capital (NWC) represents the excess of current assets over current liabilities. The
term current assets refer to assets which in the normal course of business get converted into cash
without diminution in value over a short period, usually not exceeding one year or length of
operating/cash cycle whichever is more. Current liabilities are those liabilities which required to
be paid in short periods, normally a year. Although NWC is really not a ratio, it is frequently
employed as a measure of a company‘s liquidity position. An enterprise should have sufficient
NWC in order to be able to meet the claims of the creditors and the day-to-day needs of
business. The greater is the amount of NWC, the greater is the liquidity of the firm. Accordingly,
NWC is a measure of liquidity.
 Why Net Working Capital is not the correct measure of Company‘s liquidity Position?
There is, however, no predetermined criterion as to what constitutes adequate NWC.
Requirement of NWC is based on size, nature, and economic environment of the organization.
Moreover, the size of the NWC is not an appropriate measure of the liquidity position of a firm
as shown in Table 1:
TABLE 1 Net Working Capital
Particulars
Total current assets
Totalcurrent liabilities
NWC
Company A
Company B
180,000
120,000
30,000
10,000
60,000
20,000
Of the size of NWC is a measure of liquidity, company A must be three times as liquid as
Company B. however, a deeper probe would show that this is not so. From the viewpoint of the
ability to meet its current obligations, firm B is in a better position than firm A because current
ratio of Company B is more than Company A. Another limitation of NWC, as a measure of
liquidity, is that a change in NWC does not necessarily reflect a change in the liquidity position
of a firm.
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Analysis of Financial Statements
TABLE 2 Changes in Net Working Capital
Particulars
End-year 1
End-year 2
Total current assets
100,000
200,000
Total current liabilities
25,000
100,000
NWC
75,000
100,000
Although the NWC has gone up for the firm in Table 2from Rs 75,000 to Rs 1,00,000, however,
there is, in reality, deterioration in the liquidity position as compared to year 1. In the first year,
the firm had Rs 4 of current assets for each rupee of current liabilities; but by the end of the
second year the amount of current assets for each rupee of current liabilities declined to Rs 2
only, that is by 50 percent. For these reasons, NWC is not a satisfactory measure of the liquidity
of a firm for inter-firm comparison or for trend analysis. A better indicator is the current ratio.
i. Current Ratio:
It is one of the best-known measures of short-term solvency. The current ratio is the ratio of total
current assets to total current liabilities. It is calculated by dividing current assets by current
liabilities.
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
Where,
Current Assets= Inventories+ Sundry Debtors+ Cash and Bank balances+
Receivable/Accruals+ Loans and Advances+ Disposable Investments+ Any other current assets.
Current Liabilities= Creditors (trade and bills) + Short term Loans+ Bank Overdraft+ Cash
Credit+ Outstanding Expenses + Provision for Taxation+ Proposed Dividend + Unclaimed
Dividend+ Any other current liabilities.
The current assets of a firm as already stated, represent those assets which represent those assets
which can be in the ordinary course of business, converted into cash within a short period of time
normally not exceeding one year. The current ratio for Company A and B of Table 1 are shown
in Table 3.
TABLE 3 Calculation of Current Ratio
Particulars
Company A
Company B
Current assets
Current liabilities
Rs 1,80,000
RS 1,20,000
Current Ratio
=3:2 (1.5:1)
Rs 30,000
Rs 10,000
=3:1
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Chapter 3
Validation:
The current ratio of a firm measures its short-term solvency, that is, its ability to meet short-term
obligations. As a measure of short-term/current financial liquidity, it indicates the rupees of
current assets (cash balance and its potential source of cash) available for each rupees of current
liability/obligation payable. The higher the current ratio, the larger is the amount of rupees
available per rupee of current liability, the more is the firm‘s ability to meet current obligations
and the greater is the safety of funds of short-term creditors. Thus, current ratio, in a way, is a
measure of margin of safety to the creditors.
Analysis:
In the case of company, A in the above example, the current ratio is 1.5:1. It implies that for
every one rupee of current liabilities, current assets of one-and-half rupees are available to meet
them. In other words, the current assets are one-and-half times the current liabilities. The current
ratio of 3:1 for company B signifies that current assets are three-fold its short-term obligations.
The liquidity position, as measured by the current ratio, is better in the case of Company B as
compared to Company A. this is because the safety margin in the former (200 percent) is
substantially higher than in the later (50 percent). A slight decline in the value of current assets
will adversely affect the ability of firm A to meet its obligations and, therefore, from the
viewpoint of creditors, it is a riskier venture. In contrast, there is a sufficient cushion in
Company B and even with two-thirds shrinkage in the value of its assets. It will be able to meet
its obligations in full. For the creditors the Company B is less risky/. The Analysis is: in interfirm comparison, the company with the higher current ratio has better liquidity/short-term
solvency.
It is important to note that a very high ratio of current assets to current liabilities may be
indicative of slack management practices, as it might signal excessive inventories for the current
requirements and poor credit management in terms of overextended accounts receivable. At the
same time, the firm may not be making full use of its current borrowing capacity. Therefore, a
firm should have a reasonable current ratio.
Although there is no hard and fast rule, conventionally, a current ratio of 2:1 (current assets
twice current liabilities) is considered satisfactory. The logic underlying the conventional rule is
that even with a drop-out of 50 percent (half) the value of current assets, a firm can meet its
obligations, that is, a 50 percent margin of safety is assumed to be sufficient to ward off the
worst of situations.
The firm A for our example, having a current ratio of 1.5:1 can be interpreted, on the basis of the
conventional rule, to be inadequately liquid from the point of view of its ability to always satisfy
the claims of short-term creditors. The firm B, of course, is sufficiently liquid as its current ratio
is 3:1. The rule of thumb (a current ratio of 2:1) cannot, however, this is not very meaningful
without taking into account the type of ratio expected in a similar business or within a business
sector. Any assessment of working capital ratios must take into account the nature of business
involved.
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Analysis of Financial Statements
Another factor which has a bearing on the current ratio is the nature of the industry. For instance,
public utility companies generally have a very low current ratio, as normally such companies
have very little need for current assets. The wholesale dealers, on the other hand, purchasing
goods on cash basis or on credit basis for a very short period but selling to retailers on credit
basis, require a higher current ratio. If, in our above example, firm is a public utility, its liquidity
position can be interpreted to be satisfactory even though its current ratio is less than the
conventional norm. Thus, the standard norm of current ratio (2:1) may vary from industry to
industry. However, a ratio of less than 1:1 would certainly be undesirable in any industry as at
least some safety margin is required to protect the interest of the creditors and to provide cushion
to the firm in adverse circumstances.
 Analysis of Current Ratio in terms of qualitative factors;
The limitation of current ratio arises from the fact that it is a quantitative rather than a qualitative
index of liquidity. The term quantitative refers to the fact that it takes into account the total
current assets without making any distinction between various types of current assets such as
cash, inventories and so on. A qualitative measure takes into account the proportion of various
types of current assets to the total current assets. A satisfactory measure of liquidity should
consider the liquidity of the various current assets per se. as already mentioned, while current
liabilities are fixed in the sense that they have to be paid in full in all circumstances, the current
assets are subject to shrinkage in value, for example, possibility of bad debts, realizable value of
inventory and so on. Moreover, some of the current assets are more liquids than others: cash is
the most liquid of all; receivables are more liquid than inventories, the last being the least liquid
as they have to be sold before they are converted into receivables and, then, into cash.
ii.
Acid-Test/Quick Ratio- It is often referred to as quick ratio because it is a
measurement of a firm‘s ability to convert its current assets quickly into cash in order to meet its
current liabilities. Thus, it is a measure of quick or acid liquidity.The acid-test ratio is the ratio
between quick current assets and current liabilities and is calculated by dividing the quick assets
by the current liabilities.
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
Where, Quick Assets= Current Assets- Inventories-Prepaid Expenses
Categorically, Quick Assets= Cash and Bank Balances+ Short Term Marketable Securities+
Debtors/Receivables
The term quick assets consist of only cash and near cash assets.Which means current assets
which can be converted into cash immediately or at a short notice without diminution of value.
Inventories and prepaid expenses are deducted from current assets. The exclusion of inventory is
based on the reasoning that it is not easily and readily convertible into cash. Prepaid expenses by
their very nature are not available to pay off current debts.The acid-test ratio is calculated in
Table 4.
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TABLE 4 : Calculation of Acid-Test Ratio
Cash
Debtors
Inventory
Total current assets
Rs 2,000
2,000
12,000
16,000
Total current liabilities
(i)
Current ratio
8,000
2:1
(ii)
0.5:1
Acid-test ratio
Analysis: The acid-test ratio is a rigorous measure of a firm‘s ability to service short-term
liabilities. The usefulness of the ratio lies in the fact it is widely accepted as the best available
test of the liquidity position of a firm. That the acid-test ratio is superior to the current ratio is
evident from Table 4. The current ratio of the hypothetical firm is 2:1 and can certainly be
considered satisfactory. This Analysis of the liquidity position of the firm needs modification in
the light of the quick ratio. Generally, an acid-test ratio of 1:1 is considered satisfactory as a firm
can easily meet all current claims. In the case of the hypothetical firm the quick ratio (0.5:1) is
less than the standard /norm, the satisfactory current ratio notwithstanding. The quick ratio is
more rigorous and penetrating test of the liquidity position of a firm.
iii.
Super-quick/cash ratio
𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝑎𝑎𝑎𝑎𝑎𝑎 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 + 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
This ratio is calculated by dividing super –quick assets by the current liabilities of a firm. The
super-quick current assets are cash and marketable securities. This ratio is the most rigorous and
conservative test of a firm‘s liquidity positions.
iv.
Defensive Interval Ratio
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝑎𝑎𝑎𝑎𝑎𝑎 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 + 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
If the company‘s revenue is suddenly ceased, the defensive interval would help number of days
which the company can survive for daily operating activities without the aid of additional
financing.
Projected operating expenses= Cost of goods sold- noncash expenses+ selling and distribution
expenses+ other ordinary cash expenses.
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Analysis of Financial Statements
The defensive- interval ratio measures the timespan a firm can operate on present liquid assets
(comprising cash, marketable securities and debtors) with resorting to next year‘s income
consider example given below.
Example
The projected cash operating expenditure of a firm for the year is Rs. 1,82,500. The firm has
liquid current assets amounting to Rs, 40,000. Determine the defensive-interval ratio.
Solution
Projected daily cash requirement = Rs, 1,82,500/365= Rs, 500
Defensive- interval ratio = Rs, 40,000/ Rs, 500 days = 80days
The figure of 80 days indicates that the firm has liquidity assets which can meet the operating
requirements of business for 80 days without resorting to future revenues. A higher ratio would
be favorable as it would reflect the ability of a firm to meet cash requirements for a longer period
of time. It provides safety margin to the firm in determining its ability to meet basic operational
costs. A higher ratio provides the firm with a relatively higher degree of protection and tends to
offset the weakness indication low current and acid- test ratios.
v.
Cash- flow from operations ratio
This ratio measures liquidity of a firm by comparing actual cash flows from operations (in lieu of
current and potential cash inflows from current assets such as investment and debtors) with
current liability. It is calculated as per equation given below.
𝐶𝐶𝐶𝐶𝐶𝐶ℎ − 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 =
𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
Being a cash measure, the ratio does not encounter the problems of actual convertibility of
Current Assets(such as debtors and inventory) and the need for maintaining minimum levels of
these assets. In general, higher the ratio better is a firm from the point of view of liquidity.
3.2.7.2 LEVERAGE /CAPITAL STRUCTURE RATIOS (LONG TERM SOLVENCY
RATIOS)
The solvency ratio or Leverage ratio measures the long-term stability and structure of the firm.
Capital Structure ratio is a key metric used to measure an enterprise‘s sustainability and to meet
its debt obligations. The long-term solvency ratio indicates whether a company‘s cash flow is
sufficient to meet its long-term liabilities. The lower a company's solvency ratio, the greater the
probability that it will default on its debt obligations.
Long-term lenders/creditors would judge the soundness of a firm on the basis of the long-term
financial strength measured in terms of its ability to pay the interest regularly as well as repay
the instalment of the principal on due dates or in one lump sum at the time of maturity. The
leverage or capital structure ratios may be defined as financial ratios which throw light on the
long term solvency of a firm as reflected in its ability to assure the long term lenders with (i)
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periodic payment of interest during the period of the loan and (ii) repayment of principal on
maturity or in predetermined installments at due dates.
There are thus, two aspects of the long-term solvency of a firm(i) ability to repay the principal
when due and (ii) regular payment of interest. Accordingly, there are two different, but mutually
dependent and interrelated, types of leverage ratios.
Leverage Ratios
Capital
Structure ratio
Coverage Ratio
Equity Ratio
Debt Service
Covarege Ratio
Debt Ratio
Interest
Coverage Ratio
Debt Equity
Ratio
Preference
Dividend
Coverage Ratio
Debt to Total
Assets Ratio
Fixed Charge
Coverage Ratio
Capital Gearing
Ratio
Proprietary
Ratio
Fig: Categories of Leverage or Capital Structure Ratios
Structural ratios are based on the proportions of debt and equity in the capital structure of the
firm, whereas coverage ratios are derived from the relationships between debt servicing
commitments and sources of funds for meeting these obligations.
 Capital Structure Ratios
The Capital Structure/leverage ratios may be defined as those financial ratios which measure the
long-term stability and structure of the firm. These ratios indicate the mix of funds provided by
owners and lenders and assure the lenders of the long-term funds.
194 |The Institute of Chartered Accountants of Nepal
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Various capital structure ratios are as follows;
i.
Equity Ratio
The shareholder equity ratio shows how much of the company's assets are funded by equity
shares. The lower the ratio result, the more debt a company has used to pay for its assets. It also
shows how much shareholders would receive in the event of a company-wide liquidation.:
𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 ′ 𝑠𝑠 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
This ratio indicates proportion of owner‘s fund to total fund invested in the business.
ii. Debt Ratio
The debt ratio is a financial ratio that measures the extent of a company‘s leverage. The debt
ratio is defined as the ratio of total debt to total assets, expressed as a decimal or percentage. It
can be interpreted as the proportion of a company‘s assets that are financed by debt.
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁ℎ
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝑁𝑁𝑁𝑁𝑁𝑁 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
Total outside liabilities or total debt includes short term and long term borrowing from financial
institutions, debentures, loan notes and any other interest-bearing loan.
iii. Debt-Equity Ratios:
The relationship between borrowed funds and owner‘s capital is a popular measure of the longterm financial solvency of a firm. This relationship is shown by the Debt/Equity ratios. This ratio
reflects the relative claims of creditors and shareholders against the assets of the firm.
Alternatively, this ratio indicates the relative proportions of debtand equity in financing the
assets of a firm.
One approach is to express the DE ratios in terms of the relative proportion of long-term debt
and shareholders‘ equity. Thus.
Or,
Or,
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑡𝑡𝑡𝑡 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 ′ 𝑠𝑠 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑡𝑡𝑡𝑡 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 ′ 𝑠𝑠 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
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𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑡𝑡𝑡𝑡 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 ′ 𝑠𝑠 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
Where, Shareholder‘s Equity = Equity and Preference Share Capital+ Past accumulated profits +
Capital Reserves - fictitious assets
Long Term Debt= Total outside liabilities or total debt includes short term and long term
borrowing from financial institutions, debentures, loan notes and any other interest-bearing loan.
The D/E ratio is, thus, the ratio of total outside liabilities to owners‘ total funds. In other words,
it is the ratio of the amount invested by outsiders to the amount invested by the owners of
business.
 Should current liabilities be included in the amount of debt to calculate the D/E ratio?
Current liabilities are short-term and the ability of a firm to meet such obligations is reflected in
the liquidity ratios, their amount fluctuates widely during a year and interest payments on them
are not large, they should form part of the total outside liabilities to determine the ability of a
firm to meet its long-term obligations for a number of reasons. Moreover, some current liabilities
like bank credit, which are ostensibly short-term, are renewed year after year and remain by and
large permanently in the business. Also, current liabilities have, like the long-term lenders at the
time of liquidation of the firm. Finally, the short-term creditors exercise as much, if not more,
pressure on management. The omission of current liabilities in calculating the D/E ratio would
lead to misleading results.
 Is preference share capital being the owners fund or outsider liability?
The exact treatment will depend upon the purpose for which the D/E ratio is being computed, if
the object is to examine the financial solvency of a firm in terms of its ability to avoid financial
risk, preference capital should be clubbed with equity capital. If, however, the D/E ratio is
calculated to show the effect of the use of fixed interest/dividend sources of funds on the
earnings available to the ordinary shareholder, preference capital should be clubbed with debt.
Analysis
TheD/E ratio is an important tool of financial analysis to appraise the financial structure of a
firm. It has important implications from the viewpoint of the creditors, owners and the firm
itself. The ratio reflects the relative contribution of creditors and owners of business in its
financing. A high debt equity ratio means less protection for creditors, a low ratio, on the other
hand, indicates a wider safety cushion (i.e., creditors feel the owner‘s fund can help absorb
possible losses of income and capital).For instance, D/E ratio is 1:2 implies that for every rupee
of outside liability, the firm has two rupees of owner‘s capital or the stake of the creditors is onehalf of the owners.
iv. Debt to Total Assets Ratio
Thisratio measures the proportion of total assets financed with debt and, therefore the extent of
financial leverage.
196 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
Or,
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑡𝑡𝑡𝑡 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝒕𝒕𝒕𝒕 𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 =
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨
v. Capital Gearing Ratio:
In addition to debt-equity ratio, sometimes capital gearingratio is also calculated to show the
proportion of fixed interest (dividend) bearing capital to funds belonging to equity shareholders
i.e. equity funds or net worth.
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹
𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 + 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 + 𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶 𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭
=
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 + 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 𝒂𝒂𝒂𝒂𝒂𝒂 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑺 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑺 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂
An optimal gearing ratio is primarily determined by the individual company relative to other
companies within the same industry. However, here are a few basic guidelines for good and bad
gearing ratios:
 A gearing ratio higher than 50% is typically considered highly levered or geared. As a
result, the company would be at greater financial risk, because during times of lower
profits and higher interest rates, the company would be more susceptible to loan default
and bankruptcy.
 A gearing ratio lower than 25% is typically considered low risk by both investors and
lenders.
 A gearing ratio between 25% and 50% is typically considered optimal or normal for
well-established companies.
vi. Proprietary Ratio:
The proprietary ratio (also known as the equity ratio) is the proportion of shareholders' equity to
total assets.
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
Where,
Proprietary Fund =Equity Share Capital + Preference Share Capital + Reserve and Surplus.
Total Assets excludes fictitious assets and losses.
Analysis:
The ratio focuses attention on the general financial strength of the business enterprise. The ratio
is of importance to the creditors who can find out the proportion of shareholders‘ funds in the
total assets employed in the business. If the ratio is high, this indicates that a company has a
sufficient amount of equity to support the functions of the business, and probably has room in its
The Institute of Chartered Accountants of Nepal | 197
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Financial Management
financial structure to take on additional debt, if necessary. Conversely, a low ratio indicates that
a business may be making use of too much debt or trade payables, rather than equity, to support
operations (which may place the company at risk of bankruptcy).
 Coverage Ratios
i. Interest Coverage Ratio
It is also known as ‗time-interest-earned ratio‘. Interest coverage ratio is the measure of the
adequacy of a company‘s profits relative to its interest payment on its debt. It is determined by
dividing the operating profits or earnings before interest and taxes (EBIT) by the fixed interest
charges on loans. Thus,
𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 =
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩 𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰 𝒂𝒂𝒂𝒂𝒂𝒂 𝑻𝑻𝑻𝑻𝑻𝑻
𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰
It should be noted that this ratio uses the concept of net profits before taxes because interest is
tax-deductible so that tax is calculated after paying interest on long-term loan.
The lower the interest cover, the greater the risk that profit (before interest and tax) will become
insufficient to cover interest payments. From the point of view of the lenders, the larger the
coverage, the grater is the ability of the firm to handle fixed charge liabilities and the more
assured is the payment of interest to them. However, too high a ratio may imply unused debt
capacity. In contrast, a low ratio is a danger signal that the firm is using excessive debt and
doesn‘t have the availability to offer assured payment of interest to the lenders.
Illustration No. 1
A company is currently earning an EBIT of Rs. 12 lakhs. Its present borrowings are:
11% Term loans
Rs. 40 lakhs
Working Capital:
Borrowing from Bank at 16%
Rs. 33 lakhs
Public Deposit at 12%
Rs. 15 lakhs
The sale of the company is growing and to support this company proposes to obtain an
additional bank borrowing of Rs. 25 lakhs. The increase in EBIT expected to be 20%.
Calculate the change in interest coverage ratio before and after the additional borrowing and
comment.
ii. Preferred Dividend Coverage Ratio
It measures the ability of a firm to pay dividend on preference shares which carry a stated rate of
return. This ratio is the ratio (expressed as x number of times) of net profits after taxes (EAT)
and the amount of preference dividend. Thus,
198 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 =
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝑻𝑻𝑻𝑻𝑻𝑻
𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫
Although preference dividend is a fixed obligation, the earning taken into account are after taxes.
This is because, unlike debt on which interest is a charge on the profits of the firm, the
preference dividend is treated as an appropriation of profit. The ratio, like the interest coverage
ratio, reveals the safety margin available to the preference shareholders. As a rule, the higher the
coverage, the better it is from their point of view.
Similarly, Equity Dividend Coverage Ratio can be calculated as follows,
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹
𝑵𝑵𝑵𝑵𝑵𝑵 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝑻𝑻𝑻𝑻𝑻𝑻 𝑻 𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫
=
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫
iii. Total fixed charge Coverage Ratio
While the interest coverage and preference dividend coverage ratios consider the fixed
obligations of a firm to the respective suppliers of funds, that is creditors and preference
shareholders, the total coverage ratio has a wider scope and takes into account all the committed
fixed obligations of a firm, that is, (i) interest on loan, (ii) preference dividend, (iii)lease
payments, and (iv) repayment of principal symbolically,
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹
𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄 𝐁𝐁𝐁𝐁𝐁𝐁𝐁𝐁𝐁𝐁𝐁𝐁 𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈 𝐚𝐚𝐚𝐚𝐚𝐚 𝐓𝐓𝐓𝐓𝐓𝐓 + 𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋 𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏
=
𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈 + 𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋 𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏 + 𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏 𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃 + 𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈 𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏
𝟏𝟏 𝟏𝟏𝟏𝟏𝟏𝟏𝟏
iv. Total cash flow coverage Ratio
However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate
the firm‘s ability; to meet its various financial obligations to its earnings. In fact, these payments
are met out of cash available with the firm. Accordingly, it would be more appropriate to relate
cash resources of a firm to its various fixed financial obligations. The ratio, so determined, is
referred to as total cash flow coverage ratio. Symbolically,
Total cash flow coverage=
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬+𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑+𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫+𝑵𝑵𝑵𝑵𝑵𝑵 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬
𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷+𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰+
(𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓) (𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅)
+
(𝟏𝟏𝟏𝟏𝟏)
(𝟏𝟏𝟏𝟏𝟏)
The overall ability of a firm to service outside liabilities is truly reflected in the total cash flow
coverage ratio: the higher the coverage, the better is the ability.
v.
Capital Expenditure Ratio
It measures the relationship between the firm‘s ability to generate Cash Flow from Operation and
its capital expenditure requirements. It is determined dividing Cash Flowfrom Operation by
The Institute of Chartered Accountants of Nepal | 199
Chapter 3
Financial Management
capital expenditure. The higher the ratio, the better it is. The ratio greater than one indicates that
the firm has cash to service debt as well as to make payment of dividends.
𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂 𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄 𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑 =
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬
vi.
Debt service coverage ratio (DSCR)
Lenders are interested in debt service coverage to judge the firm‘s ability to pay off current
interest and instalments.It provides the value in terms of the number of times the total debt
service obligations consisting of interest and repayment of principal in installments are covered
by the total operating funds available after the payment of taxes.
DSCR=
𝒏𝒏
𝒕𝒕=𝟏𝟏 𝑬𝑬𝑬𝑬𝑬𝑬𝒕𝒕 +𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝒕𝒕 +𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝒕𝒕 + 𝑶𝑶𝑶𝑶𝒕𝒕
𝒏𝒏 𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰
𝒕𝒕
𝒕𝒕=𝟏𝟏
The higher the ratio, the better it is. The ratio < 1, may be taken as a sign of long-term solvency
problem as it indicates that the firm does not generate enough cash internally to service debt. In
general, lending financial institutions consider 2:1 as satisfactory ratio. Consider Example given
below.
Illustration 2
Agro industries Ltd has submitted the following projections. You are required to
work out yearly debt service coverage ratio (DSCR):
(figures in Rs lakh)
Year Net profit for the year
Interest on term loan during
Repayment of term
the year
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 lakh every year.
3.2.7.3 Activity/Efficiency and Performance Ratio
These ratios indicate the efficiency with which the firm manages and utilizes its assets. In
another term they are also called ‗Assets Management Ratio‘. These ratios indicate the frequency
of sales with respect to its assets.
200 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
Activity /
Efficiency/
Performance Ratios
Capital
Assets/Total Assets
Working Capital
Total Assets
Turnover
Inventory Turnover
Fixed Assets
Turnover
Debtors Turnover
Current Assets
Turnover
Capital
Capital Turnover
Creditors Turnover
Fig: Types of Activity/Efficiency/Performance Ratios
3.2.7.4 Total Assets Turnover Ratio
The asset turnover ratio is an efficiency ratio that measures a company's ability to generate sales
from its assets by comparing net sales with average total assets. In other words, this ratio shows
how efficiently a company can use its assets to generate sales.
The total asset turnover ratio calculates net sales as a percentage of assets to show how many
sales are generated from each rupee of company assets.
Total Assets Turnover Ratio =
Sales/Cost of goods sold
Average total assets
1. Fixed Assets Turnover Ratio
It is an efficiency ratio that measures a company‘s return on their investment in property, plant,
and equipment by comparing net sales with fixed assets. In other words, it calculates how
efficiently a company is a producing sale with its machines and equipment.
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
Sales/Cost of goods sold
Average fixed assets
A high fixed assets turnover ratio indicates efficient utilization of fixed assets in generating
sales. This concept is important to investors because they want to be able to measure an
approximate return on their investment. Creditors, on the other hand, want to make sure that the
The Institute of Chartered Accountants of Nepal | 201
Chapter 3
Financial Management
company can produce enough revenues from a new piece of equipment to pay back the loan they
used to purchase it.The comparison of fixed assets turnover ratio over a period of time indicates
whether the investment in fixed assets has been judicious or not. Of course, investment in fixed
assets does not push up sales immediately but the trend of increasing sales should be visible. If
such trend is not visible or increase in sales has not been achieved after the expiry of a
reasonable time it can be very well said that increased investments in fixed assets has not been
judicious.
2. Current Assets Turnover Ratio
Current Assets Turnover Ratio indicates that the current assets are turned over in the form of
sales a greater number of times. A high current assets turnover ratio indicates the capability of
the organization to achieve maximum sales with the minimum investment in current assets.
Higher the current ratio better will be the situation
Symbolically,
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆/𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
Here, the total assets and fixed assets are net of depreciation and the assets are exclusive of
fictitious assets like debit balance of profit and loss account, deferred expenditures and so on,
The assets turnover ratio, howsoever defined, measures the efficiency of a firm in managing and
utilizing its assets. The higher the turnover ratio, the more efficient is the management and
utilization of the assets while low turnover ratios are indicative of underutilization of available
resources and presence of idle capacity.
To determine the efficiency of the ratio, it should be compared across time as well as with the
industry average. In using the assets turnover ratios one point must be carefully kept in mind.
The concept of assets/fixed assets is net of depreciation. As a result, the ratio is likely to be
higher in the case of an old and established company as compared to a new one, other things
being equal. The turnover ratio is in such cases likely to give a misleading impression regarding
the relative efficiency with which assets are being used. It should, therefore, be cautiously used.
3. Working Capital Turnover Ratio
Working capital turnover ratio is computed by dividing the cost of goods sold by net working
capital. It represents how many times the working capital has been turned over during the period.
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
202 |The Institute of Chartered Accountants of Nepal
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆/𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
Analysis of Financial Statements
Generally, a high working capital turnover ratio is better. A low ratio indicates inefficient
utilization of working capital. The ratio should be carefully interpreted because a very high
ratio may also be a sign of insufficient working capital.
Working Capital Turnover is further segregated into Inventory Turnover, Debtors Turnover,
and Creditors Turnover.
4. Inventory turnover ratio:
This ratio also known as stock turnover ratio establishes the relationship between the cost of
goods sold during the year and average inventory held during the year. The ratio indicates
whether the investment in inventory is efficiently used and whether it is within proper limits.
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
∗ 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐼
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 + 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
2
Where, Cost of goods sold =Sales-gross profit.
In case of inventory of raw material, the inventory turnover ratio is calculated using the
following formula;
𝑅𝑅𝑅𝑅𝑅𝑅 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑅𝑅𝑅𝑅𝑅𝑅 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Analysis,
The ratio indicates how fast inventory sold. A high ratio is good from the viewpoint of liquidity
and vice versa. A low ratio would sign that inventory is not used/sold/lost and stays on the shelf
or in the warehouse for a long time. This illustrated in example below.
Illustration 3
A firm has sold goods worth Rs. 300000 with a gross profit margin of 20 percent. The stock at
the beginning and the end of the year was Rs. 35000 and Rs 45000 respectively. What is the
inventory turnover ratio?
Illustration 3- Solution
Inventory Turnover Ratio=
Inventory Turnover Ratio=
Cost of Goods Sold
Average Inventory
(Rs 300,000 – Rs 60,000
(Rs 35,000 + Rs 45,000) / 2
= 6 (times per year)
The Institute of Chartered Accountants of Nepal | 203
Chapter 3
Financial Management
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
12 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀ℎ𝑠𝑠
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
12 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀ℎ𝑠𝑠
6
= 2 Months
5. Debtors turnover Ratio
The ratio indicates the speed with which money is collected from the debtors. It is computed as
follows;
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑁𝑁𝑁𝑁𝑁𝑁 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷/𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅
∗ 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 =
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
2
The ratio measures how rapidly receivables are collected. A high ratio is indicative of shorter
time-lag between credit sales and cash collection. A low ratio shows that debts are not being
collected rapidly. This is shown in example below. It measures the efficiency with which
management is managing its account receivables.
Or
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 =
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
12 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚ℎ𝑠𝑠/52 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤/360 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
Illustration 4
A firm has made credit sales of Rs. 2,40000 during the year. The outstanding amount of
debtors at the beginning and at the end of the year respectively was Rs 27,500 and Rs, 32,500.
Determine the debtor‘s turnover ratio.
Illustration 4 Answer
Solution:
Debtor Turnover Ratio =
204 |The Institute of Chartered Accountants of Nepal
Rs 240,000
(Rs 27,500 + Rs 32,500) / 2
Analysis of Financial Statements
= 8 (times per Year)
12 Months
Debtor Collection Period =
Debtor Turnover Ratio
= 1.5 times
Analysis
The average collection period measures the average number of days it takes to collect an
account receivable. This ratio is also referred to as the number of days of receivable and the
number of day‘s sales in receivables. An increase in the credit period would result in
unnecessary blockage of funds and with increased possibility of losing money due to debts
becoming bad.
A shorter collection period implies prompt payment by debtors.A longer collection period
implies too liberal and inefficient credit collection performance. The credit policy should
neither be too liberal nor too restrictive. The former will result in more blockage of funds and
bad debts while the latter will cause lower sales which will reduce profits.
6. Creditors turnover ratio:
It is a ratio between net credit purchases and the average amount of creditors outstanding during
the year. It is calculated as follows:
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑁𝑁𝑁𝑁𝑁𝑁 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶/𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
Where,
Accounts payable = trade creditors + bills payable
Net credit purchase = gross credit purchases less returns to supplies
Average creditors = average of creditors (including bills payable) outstanding at the beginning
and at the end of the year.
A low creditor‘s turnover ratio reflects liberal credit terms granted by suppliers,while a high ratio
shows that accounts are settled rapidly.
Or,
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 /𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 =
=
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎
12 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀ℎ𝑠𝑠/52 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊/360 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
The Institute of Chartered Accountants of Nepal | 205
Chapter 3
Financial Management
Analysis
The creditors turnover ratio and the creditors payment period indicate about the promptness or
otherwise in making payment for credit purchases. A higher creditors turnover ratio or a lower
creditors payment period signifies that the creditors are being paid promptly thus enhancing
the creditworthiness of the company. However, a very favorable ratio to this effect also shows
that the business is not taking full advantage of credit facilities which can be allowed by the
creditors.
Illustration 5
The firm of examples above has made credit purchases of Rs, 1,80000. the amount payable to
the creditors at the beginning and the end of the year is Rs. 42,500 and Rs,47,500 respectively.
Find out the creditor‘s turnover ratio.
Illustration 5 Answer
Creditor Turnover Ratio =
Rs 180,000
(42,500 + 47,500) / 2
= 4 Times a year
Creditors Payment Ratio =
12 Months
Creditor Turnover Ratio
= 3 Months
Cash Operating Cycle
The cash operating cycle reflects a firm‘s investment in working capital as it moves through
the production process towards sales. The investment in working capital gradually increases,
first being only in raw material, but then in labor and overheads as production progresses. This
investment must be maintained throughout the production process, the holding period for
finished goods and up to the final collection of cash from trade receivable.
Calculation of the cash operating cycle:
For manufacturing business, the cash operating cycle is calculated as;
Raw material holding period
Less Payable payment period
WIP holding period
Finished goods holding period
Receivable holding period
206 |The Institute of Chartered Accountants of Nepal
xx
(xx)
xx
xx
xx
XX
Analysis of Financial Statements
The summing up of the three turnover ratios (known as a cash cycle) has a bearing on the
liquidity of a firm. The cash cycle captures the interrelationship of sales, collections from debtors
and payment to creditors. The combined effect of the three turnover ratios is summarized below.
Inventory holding period
Add: debtor‘s collection period
Less: creditors‘ payment period
2 months
+ 1.5 months
-3 months
----------0.5
-----------
As a rule, the shorter is the cash cycle. The better are the liquidity ratios as measured above and
vice versa.
3. Capital Turnover Ratio
Capital Turnover Ratio indicates the efficiency of the organization with which the capital
employed is being utilized. A high capital turnover ratio indicates the capability of the
organization to achieve maximum sales with minimum amount of capital employed. Higher the
capital turnover ratio better will be the situation
Capital Turnover Ratio =
Sales/Cost of goods sold
Average capital Employed
Analysis,
This ratio indicates the firm‘s ability of generating sales/ Cost of Goods Sold per rupee of
long-term investment. The higher the ratio, the more efficient is the utilization of owner‘s and
long-term creditors‘ funds.
Notes for calculating Activity/ Efficiency and Performance Ratio
 Only selling & distribution expenses differentiate Cost of Goods Sold (COGS) and
Cost of Sales (COS) in its absence, COGS will be equal to sales.
 We can consider Cost of Goods Sold/ Cost of Sales to calculate turnover ratios
eliminating profit part.
 Average of Total Assets/ Fixed Assets/ Current Assets/ Net Assets/ Working Capital/
also can be taken in calculating the above ratios. In fact, when average figures of total
assets, net assets, capital employed, shareholders‘ fund etc. are available it may be
preferred to calculate ratios by using this information.
3.2.7.5 Profitability Ratio
The profitability ratios measure the profitability or the operational efficiency of the firm. These
ratios reflect the final results of business operations. The results of the firm can be evaluated in
terms of its earnings with reference to a given level of assets or sales or owner‘s interest etc.
Therefore, the profitability ratios are broadly classified in four categories:
The Institute of Chartered Accountants of Nepal | 207
Chapter 3
Financial Management
Profitability
Ratios
Overall return
on Investments
Based on Sales
Owners Point of
View
Market/
Valuation/
Investors
Gross Profit
Return on
Investment
Earning Per
Share
Price Earning
Ratio
Operating Profit
Return on
Equity
Dividend per
Share
Dividend and
Earning Yield
Net Profit
Retun on
Capital
Employed
Dividend
Payout Ratio
Market Value/
Book Value Per
Share
Expenses Ratios
Return on
Assets
Total
Shareholder
Return
Fig: Types of Profitability Ratios
I.
Profitability Ratios based on Sales of Firm
a) Gross Profit Ratio
The gross profit margin (gross margin) measures the profit a company makes from its cost of
goods sold (cost of sales). This ratio measures how efficiently management uses labor and raw
materials in the production process, and it is calculated as follows
Gross Profit Ratio =
Gross profit
× 100
Sales
Analysis of Gross Profit Ratio
This ratio is used to compare departmental profitability or product profitability. Gross profit
margin depends on the relationship between price/ sales, volume and costs. A high Gross
Profit Margin is a favorable sign of good management.It also helps in ascertaining whether the
average percentage of mark-up on the goods is maintained.
Operating Profit Ratio
208 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
The operating profit margin (operating margin) compares a company‘s operating income
(earnings before interest and taxes, or EBIT) to sales. It indicates how successful management
has been in generating income from operating the business.
Or,
Operating Profit Ratio =
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
Operating Profit
× 100
Sales
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑎𝑎𝑎𝑎𝑎𝑎 𝑇𝑇𝑇𝑇𝑇𝑇 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
∗ 100
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Where,
Operating Profit = Sales-Cost of Sales
Analysis of Operating Profit Ratio
Operating profit ratio measures the percentage of each sale in rupees that remains after the
payment of all costs and expenses except for interest and taxes. This ratio is followed closely
by analysts because it focuses on operating results. Operating profit is often referred to as
earnings before interest and taxes or EBIT.
b) Net Profit Ratio
Net profit is profit that is generated from all phases of the business, including interest and taxes.
This is the ―bottom line‖ that draws most of the attention in discussions of a company‘s
profitability. The net profit margin (net margin) compares net income to sales, such that it
measures overall profitability of the business
Or,
Or
Net Profit Ratio =
𝑁𝑁𝑁𝑁𝑁𝑁 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
Net Profit
∗ 100
Sales
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇
∗ 100
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
∗ 100
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Analysis
A consistently high net margin is often indicative of a company with one or more competitive
advantages. Furthermore, a high net margin provides a company with a cushion during
downturns in its business.
c) Expenses Ratio:
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Chapter 3
Financial Management
Based on different concepts of expenses it can be expresses in different variants as
below:
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
∗ 100
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑒𝑒𝑒𝑒𝑒𝑒. +𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 & 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒𝑒𝑒
∗ 100
=
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
II.
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 + 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
∗ 100
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
∗ 100
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Profitability Ratios Required for Analysis from Owner‘s Point of View
a) Earnings per Share:
Earnings per share is calculated in order to indicate each shareholder‘s proportionate share in the
company‘s earnings. Earnings per share information is useful in evaluating the return on
investment and risk of a company. Earnings per share can be used to predict future cash flows
per share, to compare intercompany performance using the price/earnings ratio.
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑓𝑓𝑓𝑓𝑓𝑓 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
Where, Earning available for equity shareholders= Earnings after tax-preference dividend
Basic and Diluted Earnings Per Shares
When a corporation has a complex capital structure, basic earnings per share and diluted
earnings per share are reported on the face of the income statement. A complex capital
structure includes potential common shares that can be used by the holder to acquire common
stock. Potential common shares include stock options and warrants, convertible preferred
stocks and bonds, participating securities and other contingent shares. In such case, diluted
earnings per share shows the earnings per share after including all potential common shares
that would reduce earnings per share. When a corporation has dilutive effect on earning for
that period, due to inclusion of a potential common share, Dilutive Earning per share is
calculated
b) Dividend per Share:
210 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
Earnings per share as stated above reflects the profitability of a firm per share; it does not reflect
how much profit is paid as dividend and how much is retained by the business. Dividend per
share ratio indicates the amount of profit distributed to shareholders per share. It is calculated as:
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑡𝑡𝑡𝑡 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
c) Dividend payout ratio:
This ratio measures the dividend paid in relation to net earnings. It is determined to see to how
much extent earnings per share have been retained by the management for the business.
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 (𝐷𝐷𝐷𝐷𝐷𝐷)
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 (𝐸𝐸𝐸𝐸𝐸𝐸)
d) Total Shareholder Return (TSR):
This measures the returns to the investor by taking account of
 Dividend Income
 Capital Appreciation
𝑇𝑇𝑇𝑇𝑇𝑇 =
𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑎𝑎𝑎𝑎 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Further analysis of Total Shareholder Return (TSR)
Probably the best measure of returns to equity, TSR takes account of the dividend income paid
to shareholders and the capital growth of the shares.
The TSR from an investment can easily be compared between companies or benchmarked
against industry or market returns without having to worry about differences in size of the
businesses.
The actual return received by the investor will depend on the shareholder‘s marginal rate of
income tax and the capital gain tax suffered on any realized capital gain. Whether the
shareholders prefer high dividend income or high capital gains will therefore depend on their
tax position.
3.2.7.6 Profitability Ratios Related to Market/ Valuation/ Investors
These ratios involve measures that consider the market value of the company‘s shares.
a) Price Earnings Ratio:
The price earnings ratio indicates the expectation of equity investors about the earnings of the
firm. It relates earnings to market price and is generally taken as a summary measure of growth
potential of an investment, risk characteristics, shareholders orientation, corporate image and
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degree of liquidity. Simply, it expresses the amount the shareholders are prepared to pay for the
share as a multiple of current earnings.
It is calculated as:
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
A high PE ratio indicates that investors perceive the firm‘s earnings to be high quality-usually a
mixture of high growth and/or lower risk expectations.
This is the basic measure of a Company‘s performance from the market‘s point of view.
Investors estimate a share‘s value as the amount they are willing to pay for each unit of
earnings.
Broadly, a high price-earnings ratio means the market believes that the company has strong
future growth prospects. A low price-earnings ratio generally means the market has low
earnings growth expectations for the firm or there is high risk or uncertainty of the firm
actually achieving growth.
b) Dividend and Earning yield
This provides a direct measure of the wealth received by the (ordinary) shareholder. It is the
annual dividend per share expressed as an annual rate of return on the share price.
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 (𝐷𝐷𝐷𝐷𝐷𝐷)
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 (𝑀𝑀𝑀𝑀𝑀𝑀)
This ratio indicates return on investment; this may be on average investment or closing
investment. Dividend (%) indicates return on paid up value of shares. But yield (%) is the
indicator of true return in which share capital is taken at its market value.
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 (𝐸𝐸𝐸𝐸𝐸𝐸)
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 (𝑀𝑀𝑀𝑀𝑀𝑀)
Earning yield ratio is the inverse of PE ratio. Therefore,
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌 =
1
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
c) Market Value/Book Value Per share
It provides evaluation of how investors view the company‘s past and future performance.
=
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎
=
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁ℎ/ 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎
d) Average Yield on Share Price
212 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
Average Yield On Share Price =
Dividend
× 100
Average Share Price
Average Yield On Share Price =
Dividend
× 100
Closing Share Price
Or
This ratio indicates return on investment; this may be on average investment or closing
investment. Dividend (%) indicates return on paid up value of shares. But yield (%) is the
indicator of true return in which share capital is taken at its market value.
Profitability Ratios based on Assets/Investments:
b) Return on Equity (ROE):
Return on Equity measures the profitability of equity funds invested in the firm. This ratio
reveals how profitability of the owner‘s funds have been utilized by the firm. This ratio is
computed as:
𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇
𝑁𝑁𝑁𝑁𝑁𝑁 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊ℎ
Where, Profit After Tax means earnings available for equity shareholders and Net worth means
ordinary Share Capital + Reserves.
Return on equity is one of the most important indicators of a firm‘s profitability and potential
growth. It is useful for comparing the profitability of a company with other firms in the same
industry.
c) Return on Capital Employed/Return on Investment:
ROI is the most important ratio of all. It is the percentage of return on funds invested in the
business by its owners. In short, this ratio tells the owner whether or not all the effort put into the
business has been worthwhile. The ROI is calculated as follows:
Or,
Or,
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑇𝑇𝑇𝑇𝑇𝑇 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
∗ 100
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 1 − 𝑡𝑡
∗ 100
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
The Institute of Chartered Accountants of Nepal | 213
Chapter 3
Financial Management
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑁𝑁𝑁𝑁𝑁𝑁 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇 + 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
∗ 100
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
Capital Employed = Total Assets-Current Liabilities
(Equity Share Capital + Reserve and Surplus + Pref. Share Capital + Debentures and other
long-term loan - Misc. expenditure and losses - Non-trade Investments.)
(Intangible assets (assets which have no physical existence like goodwill, patents and
trademarks) should be included in the capital employed. But no fictitious asset should be
included within capital employed.)
d) Return on Investment
Return on Investment is a performance measure used to evaluate the efficiency of an investment
or to compare the efficiency of a number of different investments. To calculate ROI, the benefit
(return) of an investment is divided by the cost of the investment; the result is expressed as a
percentage or a ratio. The return on investment formula:
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅/𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃/𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
∗ 100
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
∗
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑅𝑅𝑅𝑅𝑅𝑅 = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
ROI can be improved either by improving operating profit ratio or capital turnover or by both.
e) Return on Assets (ROA):
The profitability ratio is measured in terms of relationship between net profits and assets
employed to earn that profit.Return on assets, commonly referred to as ROA, is a measurement
of management performance. ROA tells the investor how well a company uses its assets to
generate income. A higher ROA denotes a higher level of management performance. The ROA
may be measured as follows:
Or
Or
Return on Assets =
Return on Assets =
214 |The Institute of Chartered Accountants of Nepal
Net profit after taxes
Average Total Assets
Net profit after taxes
Average Tangible Assets
Analysis of Financial Statements
Return on Assets =
Net profit after taxes
Average Fixed Assets
3.2.8 Dupont Analysis
A finance executive at E.I. Du Pont de Nemours and Co., of Wilmington, Delaware, created the
DuPont system of financial analysis in 1919. That system is used around the world today and
serves as the basis of components that make up return on equity.
DuPont analysis, a common form of financial statement analysis, decomposes return on net
operating assets into two multiplicative components: profit margin and asset turnover.
The Du Pont analysis computes the ROE as the product of margin, turnover, and leverages given
below
Return on Equity = (Net Profit Margin) X (Asset Turnover) X (Equity Multiplier)
The equity multiplier, as shown below, is a measure of the firm‘s leverage. TheDu Pont
relationship can be rewrite using the ratio formulas as follows:
𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑁𝑁𝑁𝑁𝑁𝑁 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
∗
∗
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
Return on Equity
Return on Net
Assets (ROA)
Financial
Leverage
Net Profit
Margin
Equity
Multiplier
Assets Turnover
Fig: Du Pont Chart
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Chapter 3
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Composition of Return on Equity using the DuPont Model
There are three components in the calculation of return on equity using the traditional DuPont
model- the net profit margin, asset turnover, and the equity multiplier. By examining each input
individually, the sources of a company‘s return on equity can be discovered and compared to its
competitors.
i. Net Profit Margin:The net profit margin is simply the after-tax profit a company generates
for each rupee of revenue. Net profit margins vary across industries, making it important to
compare a potential investment against its competitors. Although the general rule-of-thumb
is that a higher net profit margin is preferable, it is not uncommon for management to
purposely lower the net profit margin in a bid to attract higher sales.
𝑁𝑁𝑁𝑁𝑁𝑁 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 =
𝑁𝑁𝑁𝑁𝑁𝑁 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
ii. Asset Turnover:The asset turnover ratio is a measure of how effectively a company converts
its assets into sales. It is calculated as follows:
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 =
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the
net profit margin, the lower the asset turnover. The result is that the investor can compare
companies using different models (low-profit, high-volume vs. high-profit, low-volume) and
determine which one is the more attractive business.
iii. Equity Multiplier:It is possible for a company with terrible sales and margins to take on
excessive debt and artificially increase its return on equity. The equity multiplier, a measure
of financial leverage, allows the investor to see what portion of the return on equity is the
result of debt. The equity multiplier is calculated as follows:
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 ′ 𝑠𝑠 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
Illustration 6
ABC Company‘s details are as under:
Revenue: NRs. 29,261; Net Income: NRs. 4,212; Assets: NRs. 27,987; Shareholders. Equity:
Rs. 13,572.
Calculate
i) Return on equity.
ii). Return on equity if all the assets were all financed by equity only
216 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
Illustration 6 Answer
i) Net Profit Margin = Net Income (Rs. 4,212) ÷ Revenue (Rs. 29,261)
= 0.1439, or 14.39%
Asset Turnover = Revenue (Rs. 29,261) ÷ Assets (Rs. 27,987)
= 1.0455
Equity Multiplier = Assets (Rs. 27,987) ÷ Shareholders. Equity (Rs. 13,572)
= 2.0621
Finally, we multiply the three components together to calculate the return on equity:
Return on Equity= (0.1439) x (1.0455) x (2.0621)
= 0.3102, or 31.02%
ii) Calculation of Return on equity if all the assets were all financed by Equity Only
Equity Multiplier = Assets (Rs. 27,987) ÷ Shareholders. Equity (Rs. 27,987)
=1
Return on Equity= (0.1439) x (1.0455) x 1
= 0.1504, or 15.04%
Analysis:A 31.02% return on equity is good in any industry. Yet, if you were to leave out the
equity multiplier to see how much company would earn if it were completely debt-free, you
will see that the ROE drops to 15.04%. In other words, 15.04% of the return on equity was
due to profit margins and sales, while (31.02% -15.04%) = 15.96% was due to returns earned
on the debt at work in the business. If you found a company at a comparable valuation with
the same return on equity yet a higher percentage arose from internally generated sales, it
would be more attractive.
3.2.8.1 Ratios in Different Sectors
A. Ratios used in Hotel Industry
The variety of ratios used by hotel industry which are:
 Room Occupancy Ratio
 Bed Occupancy Ratio
 Double Occupancy Ratio
 Seat Occupancy Ratios etc.
B. Ratios used in transport industry:
The following important ratios are used in transport industry:
 Passenger Kilometer
 Seat occupancy Ratios
 Operating cost per kilometer
C. Telecom Industry:
The following important ratios are used in telecom Industry.
 Average duration of the outgoing call
 Number of outgoing calls per connection
 Revenue per customer
The Institute of Chartered Accountants of Nepal | 217
Chapter 3
Financial Management
Category
Liquidity
Ratio
Type of Ratio
Current Ratio
Formula
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
Quick Ratio
Superquick/cash
ratio
Defensive
Interval Ratio
Leverage
/Capital
Structure
Ratios
Cash- flow
from
operations
ratio
Equity Ratio
Debt Ratio
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 − 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐶𝐶𝐶𝐶𝐶𝐶𝑕𝑕 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐶𝐶𝐶𝐶𝐶𝐶𝑕𝑕 𝑎𝑎𝑎𝑎𝑎𝑎 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 + 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝐶𝐶𝐶𝐶𝐶𝐶𝑕𝑕 𝑎𝑎𝑎𝑎𝑎𝑎 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 + 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
=
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐶𝐶𝐶𝐶𝐶𝐶𝑕𝑕 − 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 =
𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑕𝑕𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
Debt to Total
Assets Ratio
Capital
Gearing Ratio
Proprietary
Ratio
𝐶𝐶𝐶𝐶𝐶𝐶𝑕𝑕 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑕𝑕𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑟𝑟 ′ 𝑠𝑠 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑕𝑕
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
Debt-Equity
Ratios
𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝐷𝐷𝐷𝐷𝐷𝐷𝑡𝑡 𝑡𝑡𝑡𝑡 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝑁𝑁𝑁𝑁𝑁𝑁 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑕𝑕𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑟𝑟 ′ 𝑠𝑠 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑡𝑡𝑡𝑡 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝒕𝒕𝒕𝒕 𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 =
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮𝑮 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹
𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 + 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 + 𝑶𝑶𝑶𝑶𝑶𝑶𝒆𝒆𝒆𝒆 𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭
=
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 + 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 𝒂𝒂𝒂𝒂𝒂𝒂 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 − 𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 − 𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇 𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
218 |The Institute of Chartered Accountants of Nepal
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
Analysis of Financial Statements
Interest
Coverage
Ratio
Preferred
Dividend
Coverage
Ratio
Equity
Dividend
Coverage
Ratio
Total
fixed
charge
Coverage
Ratio
Total
cash
flow coverage
Ratio
Capital
Expenditure
Ratio
Activity/
Efficiency
and
Performance
Ratio
Debt service
coverage ratio
(DSCR)
Total Assets
Turnover
Ratio
Fixed Assets
Turnover
Ratio
Current
Assets
Turnover
Ratio
Working
Capital
Turnover
Ratio
Inventory
turnover ratio:
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑎𝑎𝑎𝑎𝑎𝑎 𝑇𝑇𝑇𝑇𝑇𝑇
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 =
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝑻𝑻𝑻𝑻𝑻𝑻
𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹
𝑵𝑵𝑵𝑵𝑵𝑵 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝑻𝑻𝑻𝑻𝒙𝒙 − 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫
=
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹
𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄 𝐁𝐁𝐁𝐁𝐁𝐁𝐁𝐁𝐁𝐁𝐁𝐁 𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈 𝐚𝐚𝐚𝐚𝐚𝐚 𝐓𝐓𝐓𝐓𝐓𝐓 + 𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋 𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏
=
𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈 + 𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋 𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏 + 𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏 𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃𝐃 + 𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈 𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏
𝟏𝟏 − 𝐓𝐓𝐓𝐓𝐓𝐓
Total cash flow
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬+𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑+𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫+𝑵𝑵𝑵𝑵𝑵𝑵 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬
coverage=
(𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓) (𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅)
𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷+𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰+
(𝟏𝟏−𝒕𝒕)
𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂 𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄𝐄 𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑 =
DSCR=
+
(𝟏𝟏−𝒕𝒕)
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬
𝒏𝒏
𝒕𝒕=𝟏𝟏 𝑬𝑬𝑬𝑬𝑬𝑬𝒕𝒕 +𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝒕𝒕 +𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝒕𝒕 + 𝑶𝑶𝑶𝑶𝒕𝒕
𝒏𝒏 𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰
𝒕𝒕
𝒕𝒕=𝟏𝟏
Total Assets Turnover Ratio =
Sales/Cost of goods sold
Average total assets
Sales
of goods sold
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = Cost
Average fixed assets
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆/𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆/𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑅𝑅𝑅𝑅𝑅𝑅 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝑅𝑅𝑅𝑅𝑅𝑅 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
=
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
The Institute of Chartered Accountants of Nepal | 219
Chapter 3
Financial Management
Debtors
turnover
Ratio
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
Creditors
turnover ratio
Capital
Turnover
Ratio
Profitability
Ratio
Gross
Ratio
Profit
Operating
Profit Ratio
Net
Ratio
Profit
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
=
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
=
𝑁𝑁𝑁𝑁𝑁𝑁 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎
𝐴𝐴𝐴𝐴𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶/𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 /𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
=
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎
Capital Turnover Ratio =
Sales/Cost of goods sold
Average capital Employed
Gross Profit Ratio =
Operating Profit Ratio =
Net Profit Ratio =
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
Expenses
Ratio:
Earnings per
Share:
𝑁𝑁𝑁𝑁𝑁𝑁 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 ∗
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
Gross profit
× 100
Sales
Operating Profit
× 100
Sales
Net Profit
∗ 100
Sales
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
∗ 100
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
∗ 100
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑒𝑒𝑒𝑒𝑒𝑒. +𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 & 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑕𝑕𝑒𝑒𝑒𝑒𝑒𝑒
∗ 100
=
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎 =
220 |The Institute of Chartered Accountants of Nepal
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑓𝑓𝑓𝑓𝑓𝑓 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑕𝑕𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
Analysis of Financial Statements
Dividend per
Share
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎
=
Dividend
payout ratio
Total
Shareholder
Return (TSR)
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑡𝑡𝑡𝑡 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑕𝑕𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑇𝑇𝑇𝑇𝑇𝑇 =
Price
Earnings
Ratio
𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐶𝐶𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑎𝑎𝑎𝑎 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 − 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
Dividend and
Earning yield
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌 =
Market
Value/Book
Value
Per
share
Average
Yield
on
Share Price
Return
on
Equity (ROE)
Return
on
Capital
Employed/Ret
urn
on
Investment:
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎 (𝐷𝐷𝐷𝐷𝐷𝐷)
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎 (𝐸𝐸𝐸𝐸𝐸𝐸)
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎 (𝐷𝐷𝐷𝐷𝐷𝐷)
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎 (𝑀𝑀𝑀𝑀𝑀𝑀)
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎 (𝐸𝐸𝐸𝐸𝐸𝐸)
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎 (𝑀𝑀𝑀𝑀𝑀𝑀)
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌 =
=
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
1
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
=
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑃𝑃𝑒𝑒𝑒𝑒 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑕𝑕/ 𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
Average Yield On Share Price =
Average Yield On Share Price =
𝑅𝑅𝑅𝑅𝑅𝑅 =
Dividend
× 100
Average Share Price
Dividend
× 100
Closing Share Price
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇
𝑁𝑁𝑁𝑁𝑁𝑁 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑕𝑕
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
=
∗ 100
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑇𝑇𝑇𝑇𝑇𝑇 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 1 − 𝑡𝑡
∗ 100
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
The Institute of Chartered Accountants of Nepal | 221
Chapter 3
Financial Management
Return
on
Investment
(ROI)
Return
Assets
(ROA):
DU-PONT
Analysis
on
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅/𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃/𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
∗ 100
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑅𝑅𝑅𝑅𝑅𝑅 =
Return on Assets =
Return on Assets =
𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
∗
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
Net profit after taxes
Average Total Assets
Net profit after taxes
Average Tangible Assets
𝑁𝑁𝑁𝑁𝑁𝑁 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
∗
∗
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎𝑕𝑕𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
222 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
Knowledge Test 1
Following is the Profit and Loss Account and Balance Sheet of PKJ Ltd. Redraft them for the
purpose of analysis and calculate the following ratios:
1)
Gross Profit Ratio
2)
Overall Profitability Ratio
3)
Current Ratio
4)
Debt-Equity Ratio
5)
Stock-Turnover Ratio
6)
Finished goods Turnover Ratio
7)
Liquidity ratio
Profit or Loss A/c
Particulars
Amount in NRs
Opening stock of finished
goods
100,000.00
Opening stock of raw
material
Particulars
Sales
Amount in NRs
1,000,000.00
50,000.00
Closing stock of
raw material
150,000.00
Purchase of raw material
300,000.00
Closing stock of
finished goods
100,000.00
Direct wages
200,000.00
Profit on sale of
shares
50,000.00
Manufacturing Exp
100,000.00
Administration Exp
50,000.00
Selling & distribution Exp
50,000.00
Loss on sale of Plant
55,000.00
Interest on debentures
10,000.00
Net Profit
385,000.00
1,300,000.00
1,300,000.00
Balance Sheet
Liabilities
Equity share capital
Amount(NRs)
Assets
1,00,000 Fixed assets
Amount (NRs)
2,50,000
The Institute of Chartered Accountants of Nepal | 223
Chapter 3
Financial Management
Preference share capital
1,00,000 Stock of raw material
1,50,000
Reserves
1,00,000 Stock of finished goods
1,00,000
Debentures
2,00,000 Bank balance
Sundry Creditors
1,00,000 Debtors
Bills Payable
50,000
1,00,000
50,000
6,50,000
6,50,000
Knowledge Test 2
A company has a profit margin of 20% and asset turnover of 3 times. What is the company‘s
return on investment? How will this return on investment vary if,
(i)
Profit margin is increased by 5%
(ii)
Asset turnover is decreased to 2 times
(iii) Profit margin is decreased by 5% and asset turnover is increase to 4 times
Knowledge Test 3
With the help of the following information complete the Balance Sheet of PKJ Ltd.
Equity share capital
NRs 1,00,000
The relevant ratios of the company are as follows:
Current debt to total debt
40
Total debt to owner‘s equity
60
Fixed assets to owner‘s equity
60
Total assets turnover
2 Times
Inventory turnover
8 Times
Knowledge Test 4
Using the following data, prepare the Balance Sheet:
Gross profits
NRs 54,000
Shareholders‘ Funds
NRs 6,00,000
Gross Profit Margin
20%
224 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
Credit Sales to Total Sales
80%
Total Assets turnover
0.3 times
Inventory turnover
4 times
Average collection period (360 days year)
20 days
Current ratio
1.8
Long-term Debt to Equity
40%
Knowledge Test 5
ABC Limited has made plans for the next year 2019-2020. It is estimated that the company
will employ total assets of NRs25,00,000; 30% of assets being financed by debt at an interest
cost of 9% p.a. The direct costs for the year are estimated at NRs15,00,000 and all other
operating expenses are estimated at NRs2,40,000.
The sales revenue is estimated at NRs22,50,000. Tax rate is assumed to be 40%.
Required to calculate:
(a) Net profit margin
(b) Return on Assets
(c) Asset turnover (d) Return on equity
Knowledge Test 1- Solution
PKJ Ltd.
Income Statement
Sales
1,000,000
(-) Cost of goods sold:
Raw material consumed (50,000 + 3,00,000 – 1,50,000)
2,00,000
Wages
2,00,000
Manufacturing expenses
1,00,000
Cost of production
5,00,000
(+) Opening stock of finished goods
1,00,000
(-) Closing stock of finished goods
Gross profit
(1,00,000)
(5,00,000)
5,00,000
The Institute of Chartered Accountants of Nepal | 225
Chapter 3
Financial Management
(-) Operating expenses:
Administrative expenses
50,000
Selling and distribution
50,000
Operating profit
(1,00,000)
4,00,000
(+) Non-operating income (Profit on Sale of Shares)
50,000
(-) Loss on sale of plant
(55,000)
EBIT
3,95,000
(-) Interest
(10,000)
EBT / Net Profit
3,85,000
Position Statement
NRs
Bank
50,000
Debtors
1,00,000
Liquid Assets
1,50,000
(+) Stock (R.M.+F.G.)
2,50,000
Current Assets
4,00,000
(-) Current liabilities (S.C.B.P.)
(1,50,000)
Working capital
2,50,000
(+) Fixed assets
2,50,000
Capital employed in business
5,00,000
(-) External liabilities
Shareholders‘ funds
(-) Preference share capital
Equity share capital
226 |The Institute of Chartered Accountants of Nepal
(2,00,000)
3,00,000
(1,00,000)
2,00,000
Analysis of Financial Statements
Represented by
Equity share capital
1,00,000
(+) Reserves
1,00,000
2,00,000
1. 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
2. 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
3. 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
∗ 100 =
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
4. 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐸𝐸𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
=
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
5. 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
500,000
1000000
400,000
150,000
=
=
= 50%
400,000
500,000
= 2.67%
200,000
500,000
= 0.4
𝑅𝑅𝑅𝑅𝑅𝑅 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑜𝑜𝑜𝑜 𝑅𝑅𝑅𝑅𝑅𝑅 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝑔𝑔𝑔𝑔 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑜𝑜𝑜𝑜 𝑅𝑅𝑅𝑅𝑅𝑅 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 =
6. 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
=
150,000
150,000
=1
=
= 80%
200,000
100,000
=2
50,000 + 150,000
2
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 − 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 − 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 − 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 − 𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
Knowledge Test 2- Solution
Solution:
Net profit ratio
= 20% (given)
Assets turnover ratio
= 3 times (given)
Return on Investment (ROI)
= Net Profit ratio x Assets turnover ratio
= 20% × 3 times = 60%
(i) If net profit ratio is increased by 5%:
Then Revised Net Profit Ratio = 20 + 5 = 25%
Asset Turnover Ratio (as before) = 3 times
The Institute of Chartered Accountants of Nepal | 227
Chapter 3
Financial Management
∴ ROI = 25 % x 3 times = 75%
(ii) If assets turnover ratio is decreased to 2 times:
NP Ratio (as before) = 20%
Revised Asset Turnover Ratio = 2 times
∴ ROI = 20% × 2 times = 40%
(iii) If net profit ratio falls by 5% and assets turnover ratio raises to 4 times:
Then Revised NP Ratio = 20 - 5 = 15%
Revised Asset Turnover Ratio = 4 times
∴ ROI = 15% x 4 = 60%
Knowledge Test 3- Solution
Liabilities
Owners‘ equity
In the Books of PKJ Ltd.
Balance Sheet
Amount (NRs) Assets
Amount (NRs)
1,00,000 Fixed Assets
60,000
Current debt
24,000 Cash
60,000
Long term debt
36,000 Inventory
40,000
1,60,000
1,60,000
Working Notes:
1.
Fixed assets = 0.60 x Owners equity = 0.60 x NRs 1,00,000 = NRs 60,000.
2.
Total debt = 0.60 x Owners equity = 0.60 x NRs 1,00,000 = NRs 60,000.
3.
Total assets consisting of fixed assets and current assets must be equal to NRs 1,60,000
(Assets = Liabilities + Owners equity). Since fixed assets are ` 60,000 hence, current
assets should be NRs 1,00,000.
4.
Total equity = Total debt + Owners equity = NRs 60,000 + NRs 1,00,000 = NRs
1,60,000.
5.
Total assets turnover = 2 Times; Inventory turnover = 8 Times. Therefore,
Inventory/Total assets = 2/8 = 1/4; Total assets = NRs 1,60,000. Therefore, Inventory =
1,60,000 / 4 = 40,000.
228 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
6.
Cash = NRs 1,00,000 – NRs 40,000 = NRs 60,000.
Knowledge Test 4- Solution
Liabilities
Balance Sheet
Amount (NRs)
Creditors (bal. Fig.)
Assets
Amount (NRs)
60,000 Cash
42,000
Long Term Debts
2,40,000 Debtors
12,000
Share Holders Fund
6,00,000 Inventory
54,000
Fixed Assets (bal. fig).
9,00,000
7,92,000
9,00,000
Working Notes:
1.
Gross Profit:
GP Margin
2.
GP
= NRs 54,000
Sales
= 54,000/20% = NRs 2,70,000
Credit Sales:
Credit Sales
= 2,70,000 × 80%
3.
= 80% of Total Sales
= NRs 2,16,000
Total Assets:
Total Assets Turnover
Total Assets
4.
= 20%
= Sales / Total Assets = 0.3 Times
= 2,70,000 / 0.3
= NRs 9,00,000
Inventory Turnover:
Inventory Turnover
= Cost of Goods Sold / Inventory × 100
= 2,70,000 – 54,000/Inventory
=
2,16,000/4
= NRs 54,000
The Institute of Chartered Accountants of Nepal | 229
Chapter 3
Financial Management
5.
Debtors:
Debtors
6.
= Credit Sales × 20 / 360 days =NRs 12,000
Creditors:
Total Assets
= 9,00,000
Total of Balance Sheet = 9,00,000
Now, Long Term Debt
= Long Term Debt / Equity = 40%
Long Term Debt
= 40% of equity
= 6,00,000 × 40%
= NRs 2,40,000
Now Balancing figure of Liability side is creditors
= 9,00,000 - 6,00,000 (Equity) - 2,40,000 (Long Term Debt)
= `60,000
Creditors = NRs60,000
7.
Current Ratio – Cash:
Current ratio = Current Assets / Current Liabilities
1.8 = Debtors + Inventory + Cash / Creditors
1.8 = 12,000 + 54,000 + Cash / 60,000
1,08,000 = 66,000 + Cash
Cash = NRs42,000
8.
Fixed Assets:
Balancing figure on Assets Side is Fixed Assets.
9.
Sales
COGS = Sales - G.P.
COGS = NRs2,70,000 - 54,000 = NRs 2,16,000
Knowledge Test 5 Solution
The net profit is computed as follows:
230 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
(NRS)
Particulars
Sales Revenue
22,50,000
Less: Direct Costs
15,00,000
Gross Profits
7,50,000
Less: Operating Expense
2,40,000
EBIT
5,10,000
Less: Interest (9% x 7,50,000)
67,500
EBT
4,42,500
Less: Taxes (@ 40%)
1,77,000
PAT
2,65,500
(a) Net Profit Margin
Net Profit Margin
= EBIT (1-t) / Sales x 100
= 5,10,000 x (1 – 0.4) / 22,50,000 = 13.6%
(b) Return on Assets (ROA)
ROA
= EBIT (1-t) / Total Assets
= 5,10,000 (1 – 0.4) / 25,00,000
= 3,06,000 / 25,00,000
= 0.1224
= 12.24%
(c) Asset Turnover
Asset Turnover
= Sales / Assets
= 22,50,000 / 25,00,000
= 0.9
(d) Return on Equity (ROE)
ROE
= PAT / Equity
= 2,65,500 / 17,50,000
= 15.17%
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3.3 Cash Flow Analysis
3.3.1 Learning Objectives
Upon completion of this chapter student will be able to:
 Know the meaning of cash flow statements and understand the sources and
applications of cash.
 understand the operating, investing and financing cashflows
 define terminology of cash and cash equivalents
 able to segregate cash and non-cash transactions
 understand the disclosure requirements.
 Understand the difference between cash flow statements and funds flow statements.
3.3.2 Chapter Overview
Cash flow
statements
NAS 7 and
Disclosure
requirements
Cash from operating
activities
Cash from investing
activities
Financing activities
Fig: Chapter Overview of Cash Flow Statements
232 |The Institute of Chartered Accountants of Nepal
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3.3.3 Introduction
A cash flow statement is a statement which discloses the changes in cash position between the
two periods. The cash flow statement outlines the reasons for such inflows or outflows of cash.
The cash flow statement is an important planning tool in the hands of management. This helps
the management in formulating plans for immediate future cash needs. A projected cash flow
statement or a Cash Budget will help the management in estimating as to how much cash will be
available at a particular point of time to meet obligations like payment to trade creditors,
repayment of cash loans, dividends, etc. A proper planning of the cash resources will enable the
management to make available sufficient cash whenever needed and invest surplus cash, if any
in productive and profitable opportunities.
The term cash comprises cash on hand, demand deposits with the banks and includes cash
equivalents. Due to various limitations of Funds flow statements, the cash flow statement has
gained prominence and is used by the management as an important tool of financial analysis,
planning and management.
3.3.3.1 Utility of cash flow analysis
A cash flow statement is useful for short-term planning. A business enterprise needs sufficient
cash to meet its various obligations in the near future such as payment for purchase of fixed
assets, payment of debts maturing in the near future, expenses of the business, etc. Some of the
advantages are given below;
 Helps in efficient cash management: It helps to determine how much cash will be
available at a particular point of time to meet obligations like purchase of capital
expenditure, payment to trade creditors, repayment of cash loans, dividends, etc. This
helps to provide information about the liquidity and solvency information of an
enterprise.
 Helps in internal financial management:A proper planning of the cash resources
will enable the management to make available sufficient cash whenever needed and
invest surplus cash, if any in productive and profitable opportunities.
 Discloses the movements of cash: Cash inflow and cash outflow are clearly shown.
 Historical versus Future Estimates: Historical cash flow information is often used
as an indicator of the amount, timing and certainty of future cash flows.
 Discloses the success or failure of cash planning:It helps in determining how
efficiently the cash is being managed by the management of the business.
 Comparison Between Two Enterprises: Cash flow information is useful in
assessing the ability of the enterprise to generate cash and cash equivalents and
enables users to develop models to assess and compare the present value of the future
cash flows of different enterprises
 Analysis of Profitability vis-à-vis Net Cash Flow: It is also useful in examining the
relationship between profitability and net cash flow.
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Financial Management
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3.3.3.2 Limitations of cash flow analysis
Cash flow analysis is a useful tool of financial analysis. However, it has its own limitations.
These limitations are as under:
a) Fails to Present Net Income:
Cash Flow Statement actually fails to present the net income of a firm for a period since it does
not consider non-cash items which can easily be ascertained by an Income Statement. It can be
used as a supplement to Income Statement.
b) Fails to Assess the Liquidity and Solvency Position:
Practically, cash flow statement does not help to assess liquidity or solvency position of a firm.
Proper liquidity position cannot be assessed from the cash flow statement which presents only
the cash position at the end of the period. It only helps how much amount of obligation can be
met, i.e. Cash Flow Statement does not represent the real liquidity position.
c) Neither a Substitute of Funds Flow Statement nor Income Statement:
Cash Flow Statement is neither a substitute of Funds Flow Statement nor a substitute of Income
Statement. The functions which are performed by a Funds Flow Statement of Income statement
cannot be done by a Cash Flow Statement.
d) Not to Assess Profitability:
Practically, cash flows from operation does not help to assess profitability of a firm since it
neither considers the costs nor revenues.
e) Does not Assess Future Cash Flows:
Since Cash Flow Statement is prepared on the basis of historical cost and, as such, it does not
help to know the future/projected cash flows.
f) Inter-Industry Comparison Not Possible:
Since Cash Flow Statement does not measure the economic efficiency of a firm in comparison
with other inter-industry comparison is not possible, e.g. a firm having less capital investment
will have less cash flow than the firm which has more capital investment having a higher cash
flow.
3.3.3.3 Benefits of cash flow information
A cash flow statement, when used in conjunction with the other financial statements, provides
information that enables users to evaluate the changes in net assets of an enterprise, its financial
structure (including its liquidity and solvency) and its ability to affect the amounts and timing of
cash flows in order to adapt to changing circumstances and opportunities.
Cash flow information is useful in assessing the ability of the enterprise to generate cash and
cash equivalents and enables users to develop models to assess and compare the present value of
the future cash flows of different enterprises. It also enhances the comparability of the reporting
of operating performance by different enterprises because it eliminates the effects of using
different accounting treatments for the same transactions and events.
234 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
Historical cash flow information is often used as an indicator of the amount, timing and certainty
of future cash flows. It is also useful in checking the accuracy of past assessments of future cash
flows and in examining the relationship between profitability and net cash flow and the impact
of changing prices.
3.3.3.4 Terminology of Cash Flow Statement
NAS-7 has defined the following terms as follows:
a) Cash comprises cash on hand and demand deposits with banks.
b) Cash equivalents are short term highly liquid investments that are readily convertible into
known amounts of cash and which are subject to an insignificant risk of changes in value.
c) Cash flows are inflows and outflows of cash and cash equivalents.
d) Operating activities are the principal revenue-producing activities of the enterprise and other
activities that are notinvesting or financing activities.
e) Investing activities are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents.
f) Financing activities are activities that result in changes in the size and composition of the
contributed equity and borrowings of the entity.
3.3.4 Cash and Cash Equivalents
Cash equivalents are held for the purpose of meeting short-term cash commitments rather than
for investment or other purposes. For an investment to qualify as a cash equivalent it must be
readily convertible to a known amount of cash and be subject to an insignificant risk of changes
in value. Therefore, an investment normally qualifies as a cash equivalent only when it has a
short maturity of, say, three months or less from the date of acquisition. Equity investments are
excluded from cash equivalents unless they are, in substance, cash equivalents, for example in
the case of preferred shares acquired within a short period of their maturity and with a specified
redemption date.
Bank borrowings are generally considered to be financing activities. However, bank overdrafts
which are repayable on demand form an integral part of an entity‘s cash management. In these
circumstances, bank overdrafts are included as a component of cash and cash equivalents. A
characteristic of such banking arrangements is that the bank balance often fluctuates from being
positive to overdrawn.
Cash flows exclude movements between items that constitute cash or cash equivalents because
these components are part of the cash management of an entity rather than part of its operating,
investing and financing activities. Cash management includes the investment of excess cash in
cash equivalents.
3.3.5 Presentation of Cash Flow Statement
The cash flow statement shall report cash flows during the period classified into following
categories.
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Financial Management
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Cash flow from Operating Activities
Cash flow from Investing Activities
Cash Flow from Financing Activities
An entity presents its cash flows from operating, investing and financing activities in a manner
which is most appropriate to its business. Classification by activity provides information that
allows users to assess the impact of those activities on the financial position of the entity and the
amount of its cash and cash equivalents. This information may also be used to evaluate the
relationship among those activities.
A single transaction may include cash flows that are classified differently. For example, when
the cash repayment of a loan includes both interest and capital, the interest element may be
classified as an operating activity and the capital element is classified as a financing activity.
3.3.5.1 Operating Activities
The amount of cash flows arising from operating activities is a key indicator of the extent to
which the operations of the entity have generated sufficient cash flows to repay loans, maintain
the operating capability of the entity, pay dividends and make new investments without recourse
to external sources of financing. Information about the specific components of historical
operating cash flows is useful, in conjunction with other information, in forecasting future
operating cash flows.
Cash flows from operating activities are primarily derived from the principal revenue-producing
activities of the entity. Therefore, they generally result from the transactions and other events
that enter into the determination of profit or loss. Examples of cash flows from operating
activities are:
i. cash receipts from the sale of goods and the rendering of services;
ii. cash receipts from royalties, fees, commissions and other revenue;
iii. cash payments to suppliers for goods and services;
iv. cash payments to and on behalf of employees;
v. cash receipts and cash payments of an insurance entity for premiums and claims, annuities
and other policy benefits;
vi. cash payments or refunds of income taxes unless they can be specifically identified with
financing and investing activities; and
vii. cash receipts and payments from contracts held for dealing or trading purposes.
Some transactions, such as the sale of an item of plant, may give rise to a gain or loss which is
included in the determination of profit or loss. However, the cash flows relating to such
transactions are cash flows from investing activities. However, cash payments to manufacture or
236 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
acquire assets held for rental to others and subsequently held for sale are cash flow cash flows
from operating activities.
An entity may hold securities and loans for dealing or trading purposes, in which case they are
similar to inventory acquired specifically for resale. Therefore, cash flows arising from the
purchase and sale of dealing or trading securities are classified as operating activities. Similarly,
cash advances and loans made by financial institutions are usually classified as operating
activities since they relate to the main revenue-producing activity of that entity.
3.3.5.2 Investing Activities
The separate disclosure of cash flows arising from investing activities is important because the
cash flows represent the extent to which expenditures have been made for resources intended to
generate future income and cash flows. Examples of cash flows arising from investing activities
are:
a) cash payments to acquire property, plant and equipment, intangibles and other long-term
assets. These payments include those relating to capitalized development costs and selfconstructed property, plant and equipment;
b) cash receipts from sales of property, plant and equipment, intangibles and other long-term
assets;
c) cash payments to acquire equity or debt instruments of other entities and interests in joint
ventures (other than payments for those instruments considered to be cash equivalents or
those held for dealing or trading purposes);
d) cash receipts from sales of equity or debt instruments of other entities and interests in joint
ventures (other than receipts for those instruments considered to be cash equivalents and
those held for dealing or trading purposes);
e) cash advances and loans made to other parties (other than advances and loans made by a
financial institution);
f) cash receipts from the repayment of advances and loans made to other parties (other than
advances and loans of a financial institution);
g) cash payments for futures contracts, forward contracts, option contracts and swap contracts
except when the contracts are held for dealing or trading purposes, or the payments are
classified as financing activities; and cash receipts from futures contracts, forward contracts,
option contracts and swap contracts except when the contracts are held for dealing or trading
purposes, or the receipts are classified as financing activities. When a contract is accounted
for as a hedge of an identifiable position, the cash flows of the contract are classified in the
same manner as the cash flows of the position being hedged.
3.3.5.3 Financing Activities
The separate disclosure of cash flows arising from financing activities is important because it is
useful in predicting claims on future cash flows by providers of capital to the entity. Examples of
cash flows arising from financing activities are:
a) cash proceeds from issuing shares or other equity instruments;
b) cash payments to owners to acquire or redeem the entity‘s shares;
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Financial Management
Chapter 3
c) cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or
long-term borrowings;
d) cash repayments of amounts borrowed; and
e) cash payments by a lessee for the reduction of the outstanding liability relating to a finance
lease.
 Interest and Dividends
Cash flows from interest and dividends received and paid shall each be disclosed separately.
Each shall be classified in a consistent manner from period to period as either operating,
investing or financing activities.
The total amount of interest paid during a period is disclosed in the cash flow statement whether
it has been recognized as an expense in the income statement or capitalized in accordance with
the allowed alternative treatment in NAS 23 Borrowing Costs.
Interest paid and interest and dividends received are usually classified as operating cash flows
for a financial institution. However, there is no consensus on the classification of these cash
flows for other entities. Interest paid and interest and dividends received may be classified as
operating cash flows because they enter into the determination of profit or loss. Alternatively,
interest paid, and interest and dividends received may be classified as financing cash flows and
investing cash flows respectively, because they are costs of obtaining financial resources or
returns on investments.
Dividends paid may be classified as a financing cash flow because they are a cost of obtaining
financial resources. Alternatively, dividends paid may be classified as a component of cash flows
from operating activities in order to assist users to determine the ability of an entity to pay
dividends out of operating cash flows.
 Taxes on Income
Cash flows arising from taxes on income shall be separately disclosed and shall be classified as
cash flows from operating activities unless they can be specifically identified with financing and
investing activities.
Taxes on income arise on transactions that give rise to cash flows that are classified as operating,
investing or financing activities in a cash flow statement. While tax expense may be readily
identifiable with investing or financing activities, the related tax cash flows are often
impracticable to identify and may arise in a different period from the cash flows of the
underlying transaction. Therefore, taxes paid are usually classified as cash flows from operating
activities. However, when it is practicable to identify the tax cash flow with an individual
transaction that gives rise to cash flows that are classified as investing or financing activities the
tax cash flow is classified as an investing or financing activity as appropriate. When tax cash
flows are allocated over more than one class of activity, the total amount of taxes paid is
disclosed.
238 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
 Investments in Subsidiaries, Associates and Joint Ventures
When accounting for an investment in an associate or a subsidiary accounted for by use of the
equity or cost method, an investor restricts its reporting in the cash flow statement to the cash
flows between itself and the investee, for example, to dividends and advances.
An entity which reports its interest in a jointly controlled entity using proportionate
consolidation, includes in its consolidated cash flow statement its proportionate share of the
jointly controlled entity‘s cash flows. An entity which reports such an interest using the equity
method includes in its cash flow statement the cash flows in respect of its investments in the
jointly controlled entity, and distributions and other payments or receipts between it and the
jointly controlled entity.
 Acquisitions and disposals of subsidiaries and other business units
The aggregate cash flows arising from acquisitions and from disposals of subsidiaries or other
business units shall be presented separately and classified as investing activities.
An entity shall disclose, in aggregate, in respect of both acquisitions and disposals of subsidiaries
or other business units during the period each of the following:
a)
b)
c)
d)
the total purchase or disposal consideration;
the portion of the purchase or disposal consideration discharged by means of cash and
cash equivalents;
the amount of cash and cash equivalents in the subsidiary or business unit acquired or
disposed of; and
the amount of the assets and liabilities other than cash or cash equivalents in the subsidiary
or business unit acquired or disposed of, summarized by each major category.
The separate presentation of the cash flow effects of acquisitions and disposals of subsidiaries
and other business units as single line items, together with the separate disclosure of the amounts
of assets and liabilities acquired or disposed of, helps to distinguish those cash flows from the
cash flows arising from the other operating, investing and financing activities. The cash flow
effects of disposals are not deducted from those of acquisitions.
The aggregate amount of the cash paid or received as purchase or sale consideration is reported
in the cash flow statement net of cash and cash equivalents acquired or disposed of.
 Non-Cash Transactions
Investing and financing transactions that do not require the use of cash or cash equivalents shall
be excluded from a cash flow statement. Such transactions shall be disclosed elsewhere in the
financial statements in a way that provides all the relevant information about these investing and
financing activities.
Many investing and financing activities do not have a direct impact on current cash flows
although they do affect the capital and asset structure of an entity. The exclusion of non-cash
transactions from the cash flow statement is consistent with the objective of a cash flow
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Financial Management
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statement as these items do not involve cash flows in the current period. Examples of non-cash
transactions are:
 the acquisition of assets either by assuming directly related liabilities or by means of a
finance lease;
 the acquisition of an entity by means of an equity issue; and
 the conversion of debt to equity.
3.3.6 Procedure in Preparation of Cash Flow Statement
The procedure used for the preparation of cash flow statement is as follows:
Calculation of net increase or decrease in cash and cash equivalents accounts:The difference
between cash and cash equivalents for the period may be computed by comparing these accounts
given in the comparative balance sheets. The results will be cash receipts and payments during
the period responsible for the increase or decrease in cash and cash equivalent items.
Calculation of the net cash provided or used by operating activities:It is by the analysis of
Profit and Loss Account, Comparative Balance Sheet and selected additional information.
Calculation of the net cash provided or used by investing and financing activities:All other
changes in the Balance sheet items must be analyzed considering the additional information and
effect on cash may be grouped under the investing and financing activities.
Preparation of a Cash Flow Statement: It may be prepared by classifying all cash inflows and
outflows in terms of operating, investing and financing activities. The net cash flow provided or
used in each of these three activities may be highlighted. Ensure that the aggregate of net cash
flows from operating, investing and financing activities is equal to net increase or decrease in
cash and cash equivalents.
Report any significant investing financing transactions that did not involve cash or cash
equivalents in a separate schedule to the Cash Flow Statement.
Reporting of Cash Flow from Operating Activities
An entity shall report its cash flows from operating activities using either:
a) the direct method, whereby major classes of gross cash receipts and gross cash payments are
disclosed; or
b) the indirect method whereby profits, or loss is adjusted for the effects of transactions of a
non-cash nature, any deferrals or accruals of past or future operating cash receipts or
payments, and items of income or expense associated with investing or financing cash flows.
The indirect method is also called reconciliation method as it involves reconciliation of net profit
or loss as given in the Profit and Loss Account and the net cash flow from operating activities as
shown in the Cash Flow Statement. In other words, net profit or losses adjusted for non-cash and
non-operating items
240 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
Entities are encouraged to report cash flows from operating activities using the direct method.
The direct method provides information which may be useful in estimating future cash flows and
which is not available under the indirect method. Under the direct method, information about
major classes of gross cash receipts and gross cash payments may be obtained either:
a) from the accounting records of the entity; or
b) by adjusting sales, cost of sales (interest and similar income and interest expense and similar
charges for a financial institution) and other items in the income statement for:
i.
changes during the period in inventories and operating receivables and payables;
ii.
other non-cash items; and
iii.
other items for which the cash effects are investing or financing cash flows.
Under the indirect method, the cash flow from operating activities is determined by adjusting net
profit or loss for the effects of:
i.
changes during the period in inventories and operating receivables and payables;
ii.
non-cash items such as depreciation, provisions, deferred taxes, unrealized foreign
currency gains and losses, undistributed profits of associates, and minority interests;
and
iii.
all other items for which the cash effects are investing or financing cash flows.
Alternatively, the net cash flow from operating activities may be presented under the indirect
method by showing the revenues and expenses disclosed in the income statement and the
changes during the period in inventories and operating receivables and payables.
3.3.7 Other Disclosure Requirements
If any significant cash and cash equivalent balances held by the enterprise are not available for
use by it, it should be disclosed in the cash flow statement. For example, cash held by the
overseas branch which is not available for use by the enterprise due to exchange control
regulations or due to other legal restrictions.
Any additional information to understand the financial position and liquidity position of an
enterprise should be disclosed. For example:
The amount of undrawn borrowing facilities that may be available for future operating activities
and to settlement of capital commitments, indicating any restrictions on the use of these
facilities; and
The aggregate amount of cash flows that represent increases in operating capacity separately
from those cash flows that are required to maintain operating capacity.
A reconciliation of cash and cash equivalents given in its cash flow statement with equivalent
items reported in the Balance Sheet.
An enterprise should disclose the policy which it adopts in determining the composition of cash
and cash equivalent.
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The effect of any change in the policy for determining components of cash and cash equivalents
should be reported in accordance with NAS 8, ‗‖ Accounting Policies, Change in Accounting
Estimates and Error‖.
3.3.8 Format of Cash Flow Statement
NAS 7 has not provided any specific format for the preparation of cash flow statements, but a
general idea can be had from the Example given in the appendix to the Accounting Standard.
There seems to be flexibility in the presentation of cash flow statements. However, a widely
accepted format under direct method and indirect method is given below:
Cash Flow Statement (Direct Method)
Rs.
Particular
Cash Flow from Operating Activities
Cash receipts from customers
xxx
Cash paid to suppliers and employees
(xxx)
Cash generated from operations
xxx
Income tax paid
(xxx)
Net cash from Operating Activities
(a)
xxx
Cash Flows from Investing Activities
Purchase of fixed assets
(xxx)
Proceeds from sale of equipment
xxx
Interest received
xxx
Dividend received
xxx
Net cash from investing Activities
(b)
xxx
Cash Flows from Financing Activities
Proceeds from issuance of share capital
xxx
Proceeds from long-term borrowings
xxx
Repayments of long-term borrowings
(xxx)
Interest paid
(xxx)
Dividend paid
(xxx)
Net cash from Financing Activities
Net increase (decrease) in Cash and Cash Equivalent (a+b+c)
242 |The Institute of Chartered Accountants of Nepal
(c)
xxx
xxx
Analysis of Financial Statements
Cash and Cash Equivalents at beginning of period
xxx
Cash and Cash Equivalent at end of period
xxx
Cash Flow Statement (Indirect Method) (Rs.)
Rs.
Particular
Cash Flow from Operating Activities
Net profit before tax and extraordinary items
Adjustments for:
- Depreciation
- Foreign exchange
- Investments
- Gain or loss on sale of fixed assets
- Interest/dividend
Operating profit before working capital changes
Adjustments for:
- Trade and other receivables
- Inventories
- Trade payable
Cash generation from operations
- Interest paid
- Direct Taxes
Cash before extraordinary items
Deferred revenue
Net cash from Operating Activities
Cash Flow from Investing Activities
Purchase of fixed assets
Sale of fixed assets
Purchase of investments
Interest received
Dividend received
Loans to subsidiaries
Net cash from Investing Activities
xxx
xxx
xxx
xxx
(xxx)
xxx
xxx
(a)
xxx
(xxx)
xxx
xxx
(xxx)
(xxx)
xxx
xxx
xxx
(b)
(xxx)
xxx
xxx
(xxx)
xxx
xxx
xxx
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Cash Flow from Financing Activities
Proceeds from issue of share capital
Proceeds from long term borrowings
xxx
xxx
Repayment to finance/lease liabilities
Dividend paid
Net cash from Financing Activities
Net increase (decrease) in Cash and Cash Equivalents (a+b+c)
Cash and Cash Equivalents at the beginning of the year
(xxx)
(xxx)
xxx
xxx
xxx
Cash and Cash Equivalents at the end of the year
(c)
xxx
Illustration No. 1
The following additional information is also relevant for the preparation of the statements of
cash flows;

all of the shares of a subsidiary were acquired for 590. The fair values of assets acquired,
and liabilities assumed were as follows:
Inventories
100
Accounts receivable
100
Cash
40
Property, plant and equipment
650
Trade payables
100
Long-term debt
200

250 was raised from the issue of share capital and a further
250 were raised from long-term borrowings.

interest expense was 400 of which 170 was paid during the period. Also 100 relating to
interest expense of the prior period were paid during the period.

dividends paid were 1,200.
the liability for tax at the beginning and end of the period was 1,000 and 400

respectively. During the period, a further 200 tax was provided for. Withholding tax on
dividends received amounted to 100.

during the period, the group acquired property, plant and equipment with an aggregate
cost of 1,250 of which 900 was acquired by means of finance leases. Cash payments of
350 were made to purchase property, plant and equipment.

plant with original cost of 80 and accumulated depreciation of 60 was sold for 20.

accounts receivable as at end of 2076 include 100 of interest receivable.
Consolidated income statement for the period ended 2076
Sales
Cost of sales
Gross profit
244 |The Institute of Chartered Accountants of Nepal
30,650.00
(26,000.00)
4,650.00
Analysis of Financial Statements
Depreciation
Administrative and selling expenses
Interest expense
Investment income
Foreign exchange loss
Profit before taxation
Taxes on income
Profit
(450.00)
(910.00)
(400.00)
500.00
(40.00)
3,350.00
(300.00)
3,050.00
Consolidated Balance Sheet as at end of 2076
2076
2075
230.00
1,900.00
1,000.00
2,500.00
160.00
1,200.00
1,950.00
2,500.00
3,730.00
(1,450.00)
2,280.00
1,910.00
(1,060.00)
850.00
Total assets
7,910.00
6,660.00
Liabilities
Trade payables
Interest payable
Income taxes payable
Long term debt
Total liabilities
250.00
230.00
400.00
2,300.00
3,180.00
1,890.00
100.00
1,000.00
1,040.00
4,030.00
Shareholders‘ Equity
Share capital
Retained earnings
Total shareholders‘ equity
Total liabilities and shareholders‘ equity
1,500.00
3,230.00
4,730.00
7,910.00
1,250.00
1,380.00
2,630.00
6,660.00
Particulars
Assets
Cash and cash equivalents
Accounts receivable
Inventory
Portfolio investments
Property, plant and equipment at cost
Accumulated depreciation
Property, plant and equipment net
(Note: The format is adopted from IAS. The reporting entities may alter certain line
items if so, required by the form prescribed by regulating authorities.)
Prepare the cash flow statement under Direct Method and Indirect Method
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Illustration No. 1 Solution
i. Direct method cash flow statement
Particular
Cash Flows from operating activities
Cash receipts from customers
Cash paid to suppliers and employees
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
2,002
30,150
(27,600)
2,550
(270)
(900)
1,380
Cash flows from investing activities
Acquisition of subsidiary X, net of cash acquired (Note A)
Purchase of property, plant and equipment (Note B)
Proceeds from sale of equipment
(550)
(350)
20
Interest received
Dividends received
Net cash used in investing activities
200
200
(480)
Cash flows from financing activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Payment of finance lease liabilities
Dividends paid*
Net cash used in financing activities
250
250
(90)
(1,200)
(790)
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period (Note C)
110
120
Cash and cash equivalents at end of period (Note C)
230
*This could also be shown as an operating cash flow
ii. Indirect method cash flow statement
Particular
Cash flows from operating activities
246 |The Institute of Chartered Accountants of Nepal
2,002
Analysis of Financial Statements
Net profit before taxation, and extraordinary item
Adjustment for:
3,350
Depreciation
Foreign exchange loss
Investment income
Interest expense
450
40
(500)
400
Operating profit before working capital changes
Increase in trade and other receivables
Decrease in inventories
Decrease in trade payables
3,740
(500)
1,050
(1,740)
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
2,550
(270)
(900)
1,380
Cash flows from investing activities
Acquisition of subsidiary X, net of cash acquired (Note A)
Purchase of property, plant and equipment (Note B)
Proceeds from sale of equipment
Interest received
Dividends received
Net cash used in investing activities
(550)
(350)
20
200
200
(480)
Cash flows from financing activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
250
250
Payment of finance lease liabilities
Dividends paid*
Net cash used in financing activities
(90)
(1,200)
(790)
Net cash used in financing activities
(790)
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period (Note C)
Cash and cash equivalents at end of period (Note C)
*This could also be shown as an operating cash flow
110
120
230
The Institute of Chartered Accountants of Nepal | 247
Chapter 3
Financial Management
Notes to the Cash Flow Statement (direct method and indirect method)
A. Acquisition of subsidiary
During the period the group acquired subsidiary X. The fair value of assets acquired, and
liabilities assumed were as follows:
Particulars
Amount
Cash
40.00
Inventories
100.00
Accounts receivable
100.00
Property, plant and equipment
650.00
Trade payables
(100.00)
Long-term debt
(200.00)
Total purchase price
Less: Cash of X
590.00
(40.00)
Cash flow on acquisition net of cash
acquired
550.00
B. Property, plant and equipment
During the period, the Group acquired property, plant and equipment with an aggregate cost of
1,250 of which 900 was acquired by means of finance leases. Cash payments of 350 were
made to purchase property, plant and equipment.
C. Cash and cash equivalents
Cash and cash equivalents consist of cash on hand and balance with banks, and investments in
money market instruments. Cash and cash equivalents included in the cash flow statement
comprise the following balance sheet amounts:
2076
2075
Cash and cash equivalents as previously reported
230.00
160.00
Effect of exchange rate changes
230.00
(40.00)
Cash and cash equivalents as restated
120.00
Cash and cash equivalents at the end of the period include deposits with banks of 100 held by a
subsidiary which are not freely remissible to the holding company because of currency
exchange restrictions. The Group has undrawn borrowing facilities of 2,000 of which 700 may
be used only for future expansion.
Alternative Presentation
(Indirect method)
As an alternative, in an indirect method cash flow statement, operating profit before working
248 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
capital changes is sometimes presented as follows:
Particulars
Revenue excluding investment income
Amount
30,650.00
Operating expense excluding depreciation
(26,910.00)
Operating profit before working capital changes
3,740.00
Knowledge test 1
Liabilities
32.03.75
Share Capital
31.03.76
1,440
Assets
1,920 Fixed Assets
48 Less: Depreciation
32.03.75 31.03.76
3,840
4,560
1,104
1,392
2,736
3,168
Capital Reserve
-
General Reserve
816
960 Net Fixed Asset
Profit and Loss A/c
288
360 Investment
480
384
9% Debenture
960
672 Cash
210
312
Current Liabilities
576
624 Other Current Assets
Proposed Dividend
144
174 (including Stock)
1,134
1,272
Provision for Tax
432
408 Preliminary Expenses
96
48
Unpaid Dividend
-
18
4,656
5,184
4,656
5,184
Additional Information:
1.
During the year 2075-2076, Fixed Assets with a book value of NRs 2,40,000
(accumulated depreciation NRs 84,000) was sold for NRs 1,20,000.
2.
Provided NRs 4,20,000 as depreciation.
3.
Some investments are sold at a profit of NRs 48,000 and profit was credited to Capital
Reserve.
4.
It decided that stocks be valued at cost, whereas previously the practice was to value
stock at cost less 10 per cent. The stock was NRs 2,59,200 as on 31.03.2075. The stock as
on 31.03.2076 was correctly valued at NRs 3,60,000.
5.
It decided to write off Fixed Assets costing NRs 60,000 on which depreciation amounting
to NRs 48,000 has been provided.
6.
Debentures are redeemed at NRs 105.
The Institute of Chartered Accountants of Nepal | 249
Chapter 3
Financial Management
Required:
Prepare a Cash Flow Statement
Knowledge test 2
Balance Sheets of a company as on Aashadh 32, 2075, and Aashadh 31, 2076 were as follows:
(Amount i
Liabilities
Equity share
capital
31.03.2075
31.03.2076
10,00,000
10,00,000
Assets
31.03.2075
31.03.2076
Goodwill
1,00,000
80,000
8% Pref. Share
capital
2,00,000
3,00,000 Land and
Building
7,00,000
6,50,000
General Reserve
1,20,000
1,45,000 Plant and
Machinery
6,00,000
6,60,000
2,40,000
2,20,000
Securities
Premium
-
25,000 Investments
(non-trading)
Profit & Loss
A/c.
2,10,000
3,00,000 Stock
4,00,000
3,85,000
11% Debentures
5,00,000
3,00,000 Debtors
2,88,000
4,15,000
Creditors
1,85,000
2,15,000 Cash and Bank
88,000
93,000
1,05,000 Prepaid
Expenses
15,000
11,000
-
20,000
Provision for tax
Proposed
Dividend
80,000
1,36,000
24,31,000
Additional Information:
1,44,000 Premium on
Redemption of
debenture
25,34,000
24,31,000
25,34,000
Investments were sold during the year at a profit of NRs15,000.
During the year an old machine costing NRs80,000 was sold for NRs36,000. Its written
down value was NRs45,000.
3. Depreciation charged on Plant and Machinery @ 20% on the opening balance.
4. There was no purchase or sale of Land and Building.
5. Provision for tax made during the year was NRs96,000.
6. Preference shares were issued for consideration of cash during the year.
You are required to prepare:
1.
2.
a.
Cash Flow Statement as per NAS-7.
250 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
Additional Questions 1
2. The condensed balance sheets of X Ltd. and Y Ltd. as on 31.03.2075 and the condensed
Consolidated Balance Sheet of X Ltd. as on 31.03.2076 are as follows:
Land
Building
Machinery
Current Assets
Deposit on purchase of shares of Y Ltd.
Total
Issued share capital: 5,000 equity
shares of Rs. 100 each
6% Preference shares (Rs. 100 each)
Equity shares of Rs. 100 each
Profit & loss account
Minority Interest in Y Ltd.
Long-term Debt:
7% Debentures (due on 31.6.2076)
8% Debentures (issued on 1.7.2076)
Current liabilities – Creditors
Provision for Depreciation:
Building
Machinery
Total
X Ltd. (Rs.)
31.03.2076
400,000
423,000
975,000
2,217,000
Nil
4,015,000
X Ltd. (Rs.)
31.03.2075
75,000
345,000
650,000
1,061,000
50,000
2,181,000
Y Ltd. (Rs.)
31.03.2075
575,000
128,000
550,000
1,125,000
Nil
2,378,000
500,000
250,000
500,000
498,000
187,000
500,000
1,605,000
135,000
340,000
4,015,000
500,000
250,000
120,000
500,000
450,000
746,000
964,000
75,000
110,000
2,181,000
69,000
275,000
2,378,000
The following additional information for the year 2076 is available:
a) X Ltd. owns 4,000 equity shares of Y Ltd. These shares were acquired on 1.1.2076 for Rs.
550,000.
b) Land cost Rs. 250,000 owned by Y Ltd. was sold for Rs. 275,000.
c) Sales of fixed assets of X Ltd. were as follows:
Building costing Rs. 50,000, accumulated depreciation Rs. 29,000 was sold for Rs.
31,000. Machinery costing Rs. 250,000, accumulated depreciation Rs.125, 000 was sold
for Rs. 100,000.
d) X Ltd. issued 2,500 preference shares at par and the dividend on these shares was paid for
the full year.
e) Goodwill on consolidation has been charged to consolidated P & L account.
f) Y Ltd. paid Rs. 100,000 dividends on its equity shares for the year 2075.
g) Y Ltd. is the only subsidiary of X Ltd.
The Institute of Chartered Accountants of Nepal | 251
Chapter 3
Financial Management
Prepare consolidated Cash Flow Statement for the year 2076.
3. XYZ Ltd. Company‘s Comparative Balance Sheet for 2076 and the Company‘s Income
Statement for the year are as follows:
Additional Question No. 2
The following is the income statement XYZ Company for the year 2076:
Particulars
Amount
in NRs
Sales
Amount in
NRs
162,700.00
Add.:EquityinABCCompany‘searnings
6,000.00
168,700.00
Expenses
Costofgoodssold
89,300.00
Salaries
34,400.00
Depreciation
7,450.00
Insurance
500.00
Researchanddevelopment
1,250.00
Patentamortization
900.00
Interest
10,650.00
Baddebts
2,050.00
Incometax:
Current
6,600.00
Deferred
1,550.00
Totalexpenses
Netincome
8,150.00
154,650.00
14,050.00
Additional information‘s are:
(i) 70% of gross revenue from sales was on credit.
(ii) Merchandise purchases amounting to Rs. 92,000 were on credit.
(iii) Salaries payable totaled Rs. 1,600 at the end of the year.
252 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
(iv)
(v)
(vi)
(vii)
Amortization of premium on bonds payable was Rs. 1,350.
No dividends were received from the other company.
XYZ Company declared cash dividend of Rs. 4,000.
Changes in Current Assets and Current Liabilities were as follows:
Increase(Decrease)
Rs.
Cash
Marketable securities
Accounts receivable
Allowance for bad debt
Inventory
Prepaid insurance
Accounts payable (for merchandise)
Salaries payable
Dividends payable
500
1,600
(7,150)
(1,900)
2,700
700
5,650
(2,050)
(3,000)
Prepare a statement showing the amount of cash flow from operations.
Additional Question No.3
From the information contained in Income Statement and Balance Sheet of ‗A‘ Ltd., prepare
Cash Flow Statement:
Income Statement for the year ended Aashadh 31, 2076
Rs.
Net Sales
(A)
2,52,00,000
Less:
Cash Cost of Sales
1,98,00,000
Depreciation
6,00,000
Salaries and Wages
24,00,000
Operating Expenses
8,00,000
Provision for Taxation
8,80,000
(B)
2,44,80,000
Net Operating Profit (A – B)
7,20,000
Non-recurring Income – Profits on sale of equipment
1,20,000
8,40,000
Retained earnings and profits brought forward
15,18,000
The Institute of Chartered Accountants of Nepal | 253
Chapter 3
Financial Management
23,58,000
Dividends declared and paid during the year
7,20,000
16,38,000
Profit and Loss Account balance as on Aashadh 31,
2076
Balance Sheet as on
Assets
Aashadh 32, 2075
Aashadh
2075
(Rs.)
(Rs.)
31,
Fixed Assets:
Land
4,80,000
9,60,000
36,00,000
57,60,000
6,00,000
7,20,000
Debtors
16,80,000
18,60,000
Stock
26,40,000
9,60,000
78,000
90,000
90,78,000
1,03,50,000
Share Capital
36,00,000
44,40,000
Surplus in Profit and Loss Account
15,18,000
16,38,000
Sundry Creditors
24,00,000
23,40,000
Outstanding Expenses
2,40,000
4,80,000
Income-tax payable
1,20,000
1,32,000
12,00,000
13,20,000
90,78,000
1,03,50,000
Buildings and Equipment
Current Assets:
Cash
Advances
Liabilities and Equity
Accumulated Depreciation
on Buildings and Equipment
The original cost of equipment sold during the year 2075-76 was Rs. 7,20,000.
Additional Question No.4
Sweet Bakery has the following balances as on 1stShrawan 2075:
Amount in NRs.
Fixed Assets
11,40,000
Less; Depreciation
3,99,000
254 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
7,41,000
Stocks and Debtors
4,75,000
Bank Balance
66,500
Creditors
1,14,000
Bills payable
76,000
Capital (Shares of Rs. 100 each)
5,70,000
The Company made the following estimates for financial year 2075-76:
i.
The company will pay a free of tax dividend of 10% the rate of tax being 25%.
ii.
The company will acquire fixed assets costing Rs.1,90,000 after selling one
machine for Rs. 38,000 costing Rs. 95,000 and on which depreciation provided
amounted to Rs. 66,500.
iii.
Stocks and Debtors, Creditors and Bills payables at the end of financial year are
expected to be Rs. 5,60,500, Rs. 1,48,200 and Rs. 98,800 respectively.
iv.
The profit would be Rs. 1,04,500 after depreciation of Rs. 1,14,000.
Prepare the projected cash flow statement and ascertain the bank balance of X Ltd. at the
end of Financial year 2075-76.
Knowledge Test 1- Solution
Solution:
Cash Flow Statement (as on 31st Aashadh 2076)
Amount in
NRs
Amount in
NRs
Amount in
NRs
1. Cash flows from Operating Activities
Profit and Loss A/c [3,60,000 -(2,88,000 +
28,800)]
43,200
Adjustments:
Increase in General Reserve
1,44,000
Depreciation
4,20,000
Provision for Tax
4,08,000
Loss on Sale of Machine
36,000
Premium on Redemption of debenture
14,400
Proposed Dividend
1,74,000
The Institute of Chartered Accountants of Nepal | 255
Chapter 3
Financial Management
Preliminary Exp written off
48,000
Fixed Assets written off
12,000
12,56,400
Funds from operation
12,99,600
Increase in Sundry Creditors
48,000
Increase in Current Assets [12,72,000 (11,34,000 + 28,800)]
(1,09,200)
Cash before Tax
12,38,400
Tax paid
4,32,000
Net Cash from operating activities
8,06,400
2. Cash from Investing Activities
Purchase of fixed assets
(10,20,000)
Sale of Investment
1,44,000
Sale of Fixed Assets
1,20,000
(7,56,000)
3. Cash from Financing Activities
Issue of Share Capital
4,80,000
Redemption of Debenture
(3,02,400)
Dividend paid
(1,26,000)
51,600
Net increase in Cash and Cash equivalents
1,02,000
Opening Cash and Cash equivalents
2,10,000
Closing Cash
3,12,000
Working Notes:
Fixed Assets Account
Dr.
Particulars
Amount in
NRs
Particulars
Amount in
NRs
To Balance b/d
27,36,000 By Cash
To Purchases (balancing
figure)
10,20,000 By Loss on sales
36,000
By Depreciation
4,20,000
256 |The Institute of Chartered Accountants of Nepal
1,20,000
Analysis of Financial Statements
By Assets written off
12,000
By Balance c/d
31,68,000
37,56,000
37,56,000
Depreciation Account
Dr.
Particulars
Amount in
NRs
Particulars
To Fixed Assets (on sales)
84,000 By Balance b/d
To Fixed Assets w/o
48,000 By Profit and Loss, A/c
To Balance c/d
Amount in
NRs
11,04,000
4,20,000
13,92,000
15,24,000
15,24,000
Knowledge Test 2- Solution
Cash Flow Statement for the year ending 31st Aashadh, 2076
Particulars
A
Amount
NRs
in Amount
NRs
Cash flow from Operating Activities
Profit and Loss A/c as on 31.3.2016
3,00,000
Less: Profit and Loss A/c as on 31.3.2015
2,10,000
90,000
Add: Transfer to General Reserve
25,000
Provision for Tax
96,000
Proposed Dividend
1,44,000
Profit before Tax
2,65,000
3,55,000
Adjustment for Depreciation
Land and Building
Plant and Machinery
Profit on Sale of Investments
Loss on Sale of Plant and Machinery
Goodwill written off
50,000
1,20,000
1,70,000
(15,000)
9,000
20,000
The Institute of Chartered Accountants of Nepal | 257
Chapter 3
Financial Management
Interest on Debenture
33,000
Operating Profit before Working Capital changes
5,72,000
Adjustment for Working Capital changes:
Decrease in Prepaid Expenses
Decrease in Stock
15,000
Increase in Debtors
(1,27,000)
Increase in Creditors
B
C
4,000
30,000
Cash generated from Operations
4,94,000
Income tax paid
(71,000)
Net Cash Inflow from Operating Activities (a)
4,23,000
Cash flow from Investing Activities
Sale of Investment
35,000
Sale of Plant and Machinery
36,000
Purchase of Plant and Machinery
(2,25,000)
Net Cash Outflow from Investing Activities (b)
(1,54,000)
Cash flow from Financing Activities
Issue of Preference Shares
Premium received on issue of securities
1,00,000
25,000
Redemption of Debentures at a premium
(2,20,000)
Dividend paid
(1,36,000)
Interest paid to Debenture holders
Net Cash outflow from Financing Activities (c)
Net increase in Cash and Cash Equivalents during the
year (a+b+c)
(33,000)
(2,64,000)
5,000
Cash and Cash Equivalents at the beginning of the year
88,000
Cash and Cash Equivalents at the end of the year.
93,000
Working Notes:
Provision for the Tax Account
258 |The Institute of Chartered Accountants of Nepal
Analysis of Financial Statements
Dr.
Particulars
Amount
(NRs)
Particulars
Amount
(NRs)
To Bank (paid)
71,000
By Balance b/d
80,000
To Balance c/d
1,05,000
By Profit and Loss, A/c
96,000
1,76,000
1,76,000
Investment Account
Dr.
Particulars
To Balance b/d
Amount
(NRs)
2,40,000
To profit and loss (profit on sale) 15,000
Particulars
Amount
(NRs)
By balance (bal fig)
35,000
By balance c/d
2,20,000
2,55,000
2,55,000
Plant & Machinery Account
Dr.
Particulars
Amount
(NRS)
Particulars
To Balance b/d
6,00,000
By Bank (sale)
To Bank A/c (Purchase)
2,25,000
By Profit and Loss, A/c
(loss on sale)
8,25,000
Amount
(NRs)
36,000
9,000
By Depreciation
1,20,000
By Balance c/d
6,60,000
8,25,000
Note:
In this question, the date of redemption of debentures is not mentioned. So, it is assumed that
the debentures are redeemed at the beginning of the year.
The Institute of Chartered Accountants of Nepal | 259
Chapter 4
Financial Management
Chapter 4
Valuation of Securities
260 |The Institute of Chartered Accountants of Nepal
Valuation of Securities
4.1 Learning objectives
Upon completion of this chapter student will be able to:





Understand the valuation of fixed income securities (bond, debenture etc.)
Explain the types of fixed income securities.
Calculate the present value of preference shares.
Calculate the valuation of equity shares.
Analyze the valuation of equity shares where there is no dividend.
4.2 Chapter Overview
Valuation of
Securities
Valuation of
Fixed Income
Securities
Redeemable
Bond
Perpetual Bond
Preference
Shares
Equity Shares
Dividend
Valuation
Model
Holding Period
1 year
Multi Period
Holding Period
Zero Growth
Dividend
Constant
Growth
Dividend
Variable
Growth
Dividend
Fig: Chapter Overview of Valuation of Securities
The Institute of Chartered Accountants of Nepal | 261
Financial Management
Chapter 4
4.3 Introduction
The definition of an investment is a fund commitment to obtain a return that would pay off the
investor for the time during which the funds are invested or locked, for the expected rate
ofinflation over the investment horizon, and for the uncertainty involved. Most investments are
expected to have cash flows and a stated market price (e.g., common stock), and one must
estimate a value for the investment to determine if its current market price is consistent with his
estimated intrinsic value. Investment returns can take many forms, including earnings, cash
flows, dividends, interest payments, or capital gains (increases in value) during an investment
horizon.
Knowing what an asset is worth and what determines its value is a pre-requisite for
making intelligent decisions while choosing investments for a portfolio or in deciding an
appropriate price to pay or receive in a business takeover and in making investment, financing
and dividend choices when running a business. We can make reasonable estimates of value for
most assets, and that the fundamental principles determining the values of all types of assets
whether real or financial, are the same. While some assets are easier to value than others, for
different assets, the details of valuation and the uncertainty associated with value estimates may
vary. However, the core principles of valuation always remain the same.
4.4 Concept of Value
There are many other concepts of value, used for different purpose. They are given below.
 Books value Book value is an accounting concept. Assets are recorded at historical cost, and
they are depreciated over years. Book value may include intangible assets at acquisition cost
minus amortized value. The book value of the debt is started at the outstanding amount. The
different between the book values of assets and liabilities is equal to shareholders‘ funds or
net worth. Book value per share is determined as net worth divided by the number of shares
outstanding terms of its potential benefits.
 Replacement value Replacement value is the amount that a company would be required to
spend if it were to replace its existing assets in the current condition. It is difficult to find
cost of assets currently being used by the company replacement value is also likely to ignore
the benefits of intangibles and the utility of existing assets.
 Liquidation value Liquidation value is the amount that a company could realize if it sold its
assets, after having terminated its business., Liquidation value is generally a minimum value
which a company might accepts if it sold its business.
 Going concern value Going concern value is the amount that a company could realize if it
sold its business as an operating business. Going concern value would always be higher than
the liquidation value, the difference accounted for the usefulness of assetsand value of
intangibles.
 Market value Market value of an assets or securities is the current price at which the assets
or the security is being sold or bought in the market. Market value per share is expected to
be higher than the book value per share of profitable, growing firms. A number of factors
influence the market value per share, and therefore, it shows wide fluctuations. What is
important is the long-term trend in the market value per share. In ideal situation, where the
262 |The Institute of Chartered Accountants of Nepal
Valuation of Securities
capital markets are efficient and in equilibrium, market should be equal to percent (or
intrinsic) value of a share.
4.5 Required Rate of Return
The required rate of return is the minimum return an investor expects to achieve by investing in a
project. An investor typically sets the required rate of return by adding a risk premium to the
interest percentage that could be gained by investing excess funds in a risk-free investment. The
required rate of return is influenced by the following factors:
 Risk of the investment. A company or investor may insist on a higher required rate of return
for what is perceived to be a risky investment, or a lower return on a correspondingly lowerrisk investment. Some entities will even invest funds in negative-return government bonds if
the bonds are perceived to be very secure.
 Liquidity of the investment. If an investment cannot return funds for a number of years, this
effectively increases the risk of the investment, which in turn increases the required rate of
return.
 Inflation. The required rate of return must be layered on top of the expected inflation rate.
Thus, a high expected inflation rate will drastically increase the required rate of return.
The required rate of return is useful as a benchmark or threshold, below which possible projects
and investments are discarded. Thus, it can be an excellent tool for sorting through a variety of
investment options. However, management might deliberately opt to ignore this metric and
invest heavily in an area considered to be of long-term strategic importance to the business; in
this case, the expectation is that the required rate of return will indeed be met, but at a point well
in the future.
The required rate of return is not the same as the cost of capital of a business. The cost of capital
is the cost that a business incurs in exchange for the use of the debt, preferred stock, and
common stock given to it by lenders and investors. The cost of capital represents the lowest rate
of return at which a business should invest funds, since any return below that level would
represent a negative return on its debt and equity. The required rate of return should never be
lower than the cost of capital, and it could be substantially higher.
4.6 Discount Rate
Discount rate is the rate of return used to discount future cash flows back to their present value.
This rate is often a company‘s Weighted Average Cost of Capital (WACC), required rate of
return, or the hurdle rate investors expect to earn relative to the risk of the investment.
4.7 Fixed Income Securities
4.7.1 Features of a Bond / Debenture
 Face value Face value is called par value. A bond/debenture is generally issued at a par
value of Rs.100 or Rs.1,000; an interest is paid on face value.
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 Coupon rate (Interest rate)Interest rate is fixed and known to bondholders/debenture
holders. Interest paid on a bond/debenture is tax deductible. The interest rate is also called
coupon rate. It is a rate mentioned on the certificate (coupon).
 Maturity A bond/debenture is issued for a specified period of time. It is repaid on maturity.
 Redemption value the value which a bondholder/debenture holder will get on maturity is
called redemption value. A bond/debenture may be redeemed at par or at premium (more
than par value) or at discount (less than par value)
 Market value A bond/debenture may be traded in a stock exchange. The price at which it is
different from par value or redemption value.
4.7.2 Duration of Bond
Duration of bond is the average time taken by an investor to collect his/her investment. If an
investor receives a part of his/her investment over the time on specific intervals before maturity,
the investment will offer the duration which would be lesser than the maturity of the instrument.
Higher the coupon rate, lesser would be the duration.It measures how quickly a bond will repay
its true cost. The longer the time it takes the greater exposure of risk of changes in the interest.
Macaulay duration and modified duration are chiefly used to calculate the durations of bonds.
The Macaulay duration calculates the weighted average time before a bondholder would receive
the bond's cash flows. Conversely, modified duration measures the price sensitivity of a bond
when there is a change in the yield to maturity.
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 =
where:
C=periodic coupon payment
y=periodic yield
M=the bond‘s maturity value
n=duration of bond in periods
𝑛𝑛
𝑛𝑛𝑛𝑛𝑛
𝑇𝑇 𝑇 𝑇𝑇
+
𝑡𝑡 = 1 1 + 𝑦𝑦 𝑡𝑡
1 + 𝑦𝑦 𝑛𝑛
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
The modified duration is an adjusted version of the Macaulay duration, which accounts for
changing yield to maturities. The formula for the modified duration is the value of the Macaulay
duration divided by 1, plus the yield to maturity, divided by the number of coupon periods per
year. The modified duration determines the changes in a bond's duration and price for each
percentage change in the yield to maturity.
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 =
264 |The Institute of Chartered Accountants of Nepal
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝑌𝑌𝑌𝑌𝑌𝑌
1+
𝑛𝑛
Valuation of Securities
4.7.3 Types of Bond/ Debenture
Redeemable
Bond
Types of
Bonds
Irredeemable
Bond
Coupon
Bond
Zero Coupon
Bond
Fig: Types of Bond/Debenture
4.7.3.1 Bond with a maturity period (Redeemable Bond)
A bond or debenture may be issued for a specified period of time. When a bond or a debenture
has a finite maturity, to determine its present value, we shall consider annual interest payments
plus its terminal, or maturity, value. Using the present value concept, the discounted value of
these flows will be calculated. By comparing the present value of a bond with its current market
value, it can be determined whether the bond is overvalued or undervalued.
The following formula can be used to determine the value of a bond
𝐵𝐵0 =
𝐼𝐼𝐼𝐼𝐼𝐼1
𝐼𝐼𝐼𝐼𝐼𝐼2
+
1 + 𝐾𝐾𝑑𝑑
1 + 𝐾𝐾𝑑𝑑
2
+
Where
𝐵𝐵0 = present value of a bond/debenture
𝐼𝐼𝐼𝐼𝐼𝐼1 = amount of interest in period t
𝐾𝐾𝑑𝑑 = required rate of return
𝐵𝐵𝑛𝑛 = terminal or maturity value in period n
n = number of years to maturity.
𝐼𝐼𝐼𝐼𝐼𝐼3
1 + 𝐾𝐾𝑑𝑑
3
+ …………………+
𝐼𝐼𝐼𝐼𝐼𝐼𝑛𝑛 + 𝐵𝐵𝑛𝑛
1 + 𝐾𝐾𝑑𝑑 𝑛𝑛
Bond Valuation- Key Point
1. The bond price can be summarized as the sum of the present value of the par value
repaid at maturity and the present value of coupon payments.
2. A typical bond makes coupon payments at fixed intervals during the life of it and a
final repayment of par value at maturity. Together with coupon payments, the par
value at maturity is discounted back to the time of purchase to calculate the bond
price.
3. The interest rate used to discount future cash flows of a financial instrument; the
annual interest rate used to decrease the amounts of future cash flow to yield their
present value.
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Illustration No. 1
Suppose an investor is considering the purchase of a five-year, Rs 1,000 par value bond,
bearing a nominal (coupon) rate of interest of 7 per cent. The investor's required rate of return
is 8 percent. What should he be willing to pay now to purchase the bond if it matures at par?
The investor will receive cash Rs. 70 as interest each year for 5 years and Rs.1000 on maturity
(i.e. at the end of the fifth year).
Using the approximation method, find the present value of the bond (B0).
Illustration No. 1- Solution
𝐵𝐵0 =
= Rs 960.51
70
70
+
1.80
1.80
2
+
70
1.80
3
+
70
1.80
4
+
70
1.80
5
+
1000
1.80 5
It may be observed that Rs. 70 is an annuity for 5 years and Rs. 1,000 is received as a lump
sum at the end of the fifth year.
Using he present value tables; the present value of bond is:
B0
Rs. 70 *3.993+Rs 1,000*0.681
= Rs.279.51 +Rs.681
= Rs 960.51
=
This implies that Rs.1, 000 bonds are worth Rs 960.51 today if the required rate of return is 8
percent. The investor would not be willing to pay more than Rs. 960.51 for bond today. Note
that Rs. 960.51 is a composite of the present value of interest value of interest payments,
Rs279.51 and the present value of the maturity value, Rs 681.
A bond or debenture may be amortized every year. In that case, the principal will decline with
annual payments and interest will be calculated on the outstanding amount.
Illustration No. 2
The government is proposing to sell a 5-years bond of Rs 1,000 at 8 percent rate of interest per
annum. The bond amount will be amortized equally over its life. If an investor has a minimum
required rate of return of 7 percent, what is the bond's present value for him?
Knowledge Test -1
A NRs 1,000 par value bond bearing a coupon rate of 14 per cent matures after 5 years, the
required rate of return on this bond is 13 per cent. Calculate the value of the bond.
Behavioral analysis of Bond
Required rate of return > Coupon Rate
Required rate of return < Coupon Rate
Required rate of return = Coupon Rate
266 |The Institute of Chartered Accountants of Nepal
Bonds sells at discount
Bonds sells at premium
Bonds sells at par
Valuation of Securities
Semi-annual interest Payment
In practice, it is quite common to pay interest on bonds/debentures semi-annual. The formula for
bond valuation can be modified in terms of half -yearly interest payments and compounding
periods as given below:
𝐵𝐵0 =
Where,
INT= Coupon Interest
Kd = Cost of Debt
Bn= Maturity value of Bond
2𝑛𝑛
𝑡𝑡=1
1
𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡
2
𝐾𝐾
1 + 2𝑑𝑑
𝑡𝑡
+
𝐵𝐵𝑛𝑛
𝐾𝐾
1 + 2𝑑𝑑
2𝑛𝑛
Or Simply,
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 = 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐼 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼, 𝑛𝑛 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
𝐾𝐾𝐾𝐾
𝐾𝐾𝐾𝐾
+ 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 2𝑛𝑛 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
2
2
Where,
n period= number of period (if semiannual, then n= duration of bond*2)
Kd= Cost of debt
Illustration No. 3
A 10-year bond of Rs 1,000 has an annual rate of interest of 12 percent. The interest is paid
half-yearly. If the required rate of return is 16 percent, what is the value of the bond?
Illustration No. 3- Solution
𝐵𝐵0 =
=
2𝑛𝑛
𝑡𝑡=1
2×10
𝑡𝑡=1
1
2 𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡
𝐾𝐾
1 + 2𝑑𝑑
𝑡𝑡
1
2 120
0.16
1+ 2
+
1
𝐵𝐵𝑛𝑛
𝐾𝐾
1 + 2𝑑𝑑
+
2𝑛𝑛
1000
0.16
1+ 2
2×10
= 60×9.818 + 1000× 0.215
= Rs. 804.08
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4.7.3.2 Perpetual Bonds
Bonds or Debenture which will never mature are known as perpetual bonds. Perpetual bonds or
debentures are rarely found in practice. After the Nepoleonic War, England issued these types of
bonds to pay off many smaller issued that had been floated in prior years to pay for the war. In
case of the perpetual Bonds, as there is no maturity, or terminal value. The value of the bonds
would simply be discounted value of the infinite stream of interest flows.
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐵𝐵0 =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝐾𝐾𝐾𝐾
Bond Maturity and Interest Rate Risk
The value of a bond depends upon the interest rate. As interest rate changes, the value of bonds
also varies. There is an inverse relationship between the value of a bond and the interest rate.
The value will decline when the interest rate rises and vice-versa. For instance, the value of 5year bond in the example comes down to Rs.960.51 from Rs. 1,000 when interest rate is assumed
to rise from 7 percent to 8 percent, resulting in a loss of Rs. 39.49 to the bond holder. Interest
rates have the tendency of rising or falling in practice. Thus, investors investing their funds in
bonds are exposed to risk from increasing or falling interest rates.
The intensity of interest rate risk would be higher on bonds with long maturity than those in
short periods. This point can be verified by examining table given below where value of 5 year,
10-year bonds (coupon rate 7 percent and maturity value of Rs. 1,000) and a perpetual bond are
given. These values are also plotted in chart. At 7 percent interest rate, values of all three bonds
are same, Rs.1, 000. when interest rate rises to say, 8 percent 5 -year bond falls to Rs.961, 10year bond to Rs.933 and perpetual bond still further to Rs. 875. Similarly, the value of long-term
bond will fluctuate (increase) more when rates fall below 7 percent. The differential value
response to interest rates changes between short term and long-term bond will always be true.
Thus, two bonds of same quality (in terms of the risk of default) would have different exposure
to interest rate risk - the one with longer maturity is exposed to greater degree of risk from
increasing interest rates.
Interest rate (%)
4
5
6
7
8
9
10
Value of 5-year bond
(Rs)
1,134
1,087
1,042
1,000
961
922
886
268 |The Institute of Chartered Accountants of Nepal
Value of 10-Year bond
(Rs)
1,244
1,155
1,073
1,000
933
871
816
Value of perpetual
bond (Rs.)
1,750
1,400
1,167
1,000
875
778
700
Valuation of Securities
2000
Value of bond
1800
Interest rate (%)
1600
1400
Value of 5-year bond
(Rs)
1200
1000
Value of 10-Year bond
(Rs)
800
600
400
Value of perpetual
bond (Rs.)
200
0
1
2
3
4
5
6
7
Interest Rate
Yield to maturity
We have so far assumed that the bond's required rate of return is given for calculating its value.
We may be required to calculate the required rate of return when the bond's price and cash flows
are known. This rate is also known as yield to maturity (YTM) of bond's internal rate of return.
Example:
Suppose that the market price of a bond is Rs 883.40 (face value being Rs.1,000). The bond will
pay interest at 6 percent per annum for 5 year, after which be retired at par. The bond's yield to
maturity is given a follow:
Kd =YTM
883.4 =
60
(1 + 𝐾𝐾𝑑𝑑)
1
+
60
(1 + 𝐾𝐾𝑑𝑑)
2
+
60
(1 + 𝐾𝐾𝑑𝑑)
3
+
60
(1 + 𝐾𝐾𝑑𝑑)
4
+
60
(1 + 𝐾𝐾𝑑𝑑) 5
=10 %(by interpolation method) [detailed discussion of interpolation method will be on
chapter capital investment decisions)
4.7.3.3 Zero Coupon Bond
As name indicates these bonds do not pay interest during the life of the bonds. Instead, zero
coupon bonds are issued at discounted price to their face value, which is the amount a bond will
be worth when it matures or comes due. When a zero-coupon bond matures, the investor will
receive one lump sum (face value) equal to the initial investment plus interest that has been
accrued on the investment made. The maturity dates on zero coupon bonds are usually long term.
These maturity dates allow an investor for a long-range planning. Zero coupon bonds issued by
banks, government and private sector companies. However, bonds issued by corporate sector
carry a potentially higher degree of risk, depending on the financial strength of the issuer and
longer maturity period, but they also provide an opportunity to achieve a higher return.
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4.7.3.4 Convertible Debentures
Convertible Debentures are those debentures which are converted in equity shares after certain
period of time. The equity shares for each convertible debenture are called Conversion Ratio and
price paid for the equity share is called ‗Conversion Price‘.
Further, conversion value of debenture is equal to Price per Equity Share x Converted No. of
Shares per Debenture.
Illustration No. 4
Everest Ltd. has issued convertible debentures with coupon rate 12%. Each debenture has an
option to convert to 20 equity shares at any time until the date of maturity. Debentures will be
redeemed at NRs 100 on maturity of 5 years. An investor generally requires a rate of return of
8% p.a. on a 5-year security. As an investor when will you exercise conversion for given
market prices of the equity share of (i) NRs 4, (ii) NRs 5 and (iii) NRs 6.
Cumulative PV factor for 8% for 5 years: 3.993
PV factors for 8% for year 5: 0.681
Illustration No. 4- Solution
If Debentures are not converted its value is as under: PV @ 8%
Interest- NRs 12 for 5 years
3.993
th
Redemption – NRs 100 in 5
0.681
year
NRs
47.916
68.100
116.016
Value of equity Shares
Market Price
No.
Total
NRs 4
20
NRs 80
NRs 5
20
NRs 100
NRs 6
20
NRs 120
Hence, unless the market price is NRs 6 conversion should not be exercised
4.8 Preferred Stock/Preference Share
Present value of preference shares
Preference shareholders have preference right over payment of dividend and settlement of
principal amount upon liquidation, over common shareholders. A preference share can be
irredeemable or redeemable. Redeemable preference shares have a fixed maturity date and
irredeemable preference shares have perpetual life with only dividend payments periodically
upon profit availability. Preference shares can also be cumulative and non-cumulative. . Like
bonds, it is relatively easy to estimate the cash outflows associated with preference shares.
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Valuation of Securities
Basically, the value of preference share is the present value of all the future expected dividend
payments and the maturity value, discounted at the required return on preference shares.
Formula,
Or
𝑃𝑃𝑜𝑜 =
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃1
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃2
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑛𝑛 + 𝑝𝑝𝑛𝑛
+
+⋯+
1
2
(1 + 𝐾𝐾𝑝𝑝 )
(1 + 𝐾𝐾𝑝𝑝 )
(1 + 𝐾𝐾𝑝𝑝 )𝑛𝑛
𝑝𝑝𝑜𝑜 =
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑡𝑡
𝑃𝑃𝑛𝑛
𝑛𝑛
𝑡𝑡=1 (1+ 𝐾𝐾 )𝑡𝑡 + (1+𝐾𝐾 )𝑛𝑛
𝑝𝑝
𝑝𝑝
Where 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑡𝑡 is the preference dividend per share in period t, ke is the required rate of return on
preference share and pn the value of the preference share on maturity
Features of Preference and Equity Shares
 Claims Preference shareholders have a claim on assets and income prior to ordinary
shareholders. Equity (ordinary) shareholders have a residual claim on a company's income
and assets. They are the legal owners of the company.
 Dividend the dividend rate is fixed in the case of preference shares. Preference shares may
be issue with cumulative rights, i.e. dividend will accumulate until paid off. In the case of
equity share neither the dividend rate is known, nor does dividend accumulate. Dividend
paid on preference and equity shares have no maturity date.
 Redemption Both redeemable and irredeemable preference share can be issued in Nepal.
Redeemable preference shares have no maturity date.
 Conversion A company can issue convertible preference shares. That is, after a stated
period, such shares can be converted into ordinary shares.
Illustration No. 5
A company has a Rs 100 irredeemable preference share on which it pays a dividend of Rs
9. Assume that this type of a preference share is currently yielding a dividend of 11 per
cent. What is the value of preference share?
Illustration No. 5- Solution
The present value of the preference share will be:
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝑎𝑎 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑠𝑠𝑕𝑕𝑎𝑎𝑎𝑎𝑎𝑎 =
= Rs 81.82
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑘𝑘𝑝𝑝
9
=
0.11
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Financial Management
= 0.11 or 11 %
The rate 𝑘𝑘𝑝𝑝 is the preference share's yield to maturity. For a preference share with
maturity, 𝑘𝑘𝑝𝑝 can be found out by trial and error.
Illustration No. 6
Let us assume the face value of the preference share is NRs 500 and the stated dividend rate is
12%. The shares are redeemable after 5 years period. Calculate the value of preference shares
if the required rate of return is 13%.
Illustration No. 6- Solution
Annual dividend = 500 x 12% = NRs 60
Year
Cash Flow (Amount in NRs)
1
2
3
4
5
60
60
60
60
560
Value of Preference Shares
Discounted Factor @
13%
0.885
0.783
0.693
0.613
0.543
Value of Preference
Shares
53.1
46.98
41.58
36.78
304.08
482.52
The value of preference share is NRs 482.52.
The value is lower than face value due to the rate of dividend is lower than required rate of
return.
4.9 Common Stock or Equity Shares
When an investor buys a share of common stock, it is reasonable to expect that what an investor
is willing to pay for the share reflects what he expects to receive from it. What he expects to
receive are future cash flows in the form of dividends and the capital appreciation of the stock
when it is sold. The value of a share of stock should be equal to the present value of all the future
cash flows that an investor expects to receive from that share. Since common stock never
matures, today's value is the present value of an infinite stream of cash flows. And, common
stock dividends are not fixed, as in the case of preferred stock. Not knowing the amount of the
dividends or even if there will be future dividends makes it difficult to determine the value of
common stock.
4.9.1 Dividend Valuation Model
The value of a share today is a function of cash inflows expected by investors and risk
associated with those cash inflows. Cash inflows expected from an equity share will consist
of dividends expected to be received by the owner while holding the share and the price
which he expects to obtain when the share is sold.The price which the owner is expected to
272 |The Institute of Chartered Accountants of Nepal
Valuation of Securities
receive when the share is sold will include the original investment plus a capital gain (or
minus a capital loss).
It is normally found that a shareholder does not hold the share in perpetuity.He holds the
share for some time, receives the dividends and finally sells it to obtain capital gains.But
when he sells the share, the buyer is also simply purchasing a stream of further dividend.
The ultimate conculsion is that, for shareholders in general, the expected cash inflows
consist only of future dividends and, therefore, the value of an ordinary share is determined
by capitalising the future dividend stream at an appropriate rate of discount. The value of a
share is the present value of its future stream of dividends.
The specific purpose of the dividend growth model valuation is to estimate the fair value of an
equity. Once this fair value is calculated, investors can compare the fair value with the current
share or unit price to determine whether a particular equity is overvalued or undervalued. Based
on this comparison, investors can decide which equities to buy and sell to optimize their
portfolio‘s total returns.
Assumptions of Dividend Valuation Model:
1. Dividend to be paid annually.
2. Payment of first dividend shall occur at the end of first year.
3. Sale of equity shares occur at the end of the first year and that to at ex-dividend price.
a. Single Period Valuation
The value of the share today, (P 0), will be determined as the persent value of the expected
dividend per share at the end of the first year, (DIV 1),plus the present value of the expected
price of the share after a year, (P1). thus,
P0 =
D1 + p1
1 + ke
… … … … … … … … … . 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 1
above equation gives the 'fair' or 'reasonable' price of the share as it reflect the persent value
of the share.
Illustration No. 7
Share of X Ltd. is expected to be sold at Rs. 36 with a dividend of Rs. 6 after one year. If
required rate of return is 20% then what will be the share price.
Illustration No. 7- Solution
The expected share price shall be computed as follow:
𝑃𝑃0 =
6 + 36
1 + 0.20
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Financial Management
𝑃𝑃0 =
42
1.2
= NRs 35.
An investor can thus, represent his expectation with regard to future share price in terms of
expected growth.If the share price is expected to grow at g percent, then we can write (P1)
as follows:
Price of a Share P1 = p0 1 + g … … … … … … … … … … … … . . Equation 2
Simplifying Equation 1 and 2 , we obtain current price of a share as :
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑎𝑎𝑎𝑎 𝑡𝑡ℎ𝑒𝑒 𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 0 (𝑃𝑃0 ) =
𝐷𝐷1(1 + 𝑔𝑔)
𝐾𝐾𝑒𝑒 − 𝑔𝑔
The present value of a share is determined by its expected dividend divided by the difference
of the shareholder capitalisation,or required,rate of return (ke) and growth rate (g) in the
share value
Illustration No. 8
Lets us assume that an investor intends to buy a share and will hold it for one year. He
expects the share to pay a dividend of Rs 2 next year,and would sell the share at an
expected price of Rs 21 at the end of the year.If the investor's required rate of return (Ke)is
15 per cent, how much should he pay for the share today?
Illustration No. 8- Solution
Using Equation ,the value of the share in the example is as follows:
𝑃𝑃0 =
2 + 21
1.15
= Rs 20
The investor would buy the share if the actual price is less than Rs 20 –the face value of
the share.In a well functionimg capital market 'there ought not to be any difference
between the persent value and market value of the share. Investors would have full
information and it would be reflected in the market price of the share in a well
functioning market.
In the example, if the investor would have expected the share price to grow at 5 per
cent,the value of the share today using Equation will be :
274 |The Institute of Chartered Accountants of Nepal
Valuation of Securities
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑎𝑎𝑎𝑎 𝑡𝑡ℎ𝑒𝑒 𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 0 (𝑃𝑃0 ) =
= Rs 20
2
0.15 − 0.05
b. Multi – Period Valuation
Zero
Growth
Valuation
based on
Multi
Holding
Period
Constant
Growth
Variable
growth
Zero Growth : It is also called as constant dividend, as dividend amount remains same over
the infinite period. The value of equity can be found as follows:
𝑃𝑃0 =
𝐷𝐷
𝐾𝐾𝐾𝐾
Constant Growth : According to constant growth, it is assumed that the growth of dividend is
constant over infinite period. Constant Dividend assumption is quite unrealistic
assumption. The value of equity shared can be found by using following formula:
𝑃𝑃0 =
𝐷𝐷0 1 + 𝐺𝐺
𝐾𝐾𝐾𝐾 − 𝑔𝑔
Growth in Dividends
Dividends do not remain constant. Earnings and dividend of most companies grow over
time, at least, because of their retention policies. Historical evidences indicate that most
companies have been retaning a substantial portion of their earning (about 50 per cent )
for reinvestment in the business. This policy would increase the common shareholder's
equity as well as the firm's future earning. If the number of shares do not change, this
policy should tend to increase earning per share, and consequently, it should produce an
expanding stream of dividends per share.
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Variable Growth Rate:
Accordingly, valuation of equity shares can be done based on variable growth in dividends.
Multiple growth rate is used to calculate the price of equity. However, it should be noted that one
growth rate shall be assumed to be for infinity only then we can find value of equity shares.
The dividends of a company may not grow at a constant rate indefinitely. There are
companies whose dividends grow at a super - normal growth rate during the periods when
they are experiencing very high demand for their products. Afterwards, the dividend may
grow at a normal rate when the demand reaches the normal level.
Where,
𝑃𝑃0 =
𝐷𝐷0 1 + 𝑔𝑔1
𝐷𝐷0 1 + 𝑔𝑔1 2
𝐷𝐷0 1 + 𝑔𝑔 𝑛𝑛
𝑃𝑃𝑃𝑃
+
+
⋯
…
…
…
…
…
+
1
2
𝑛𝑛
1 + 𝐾𝐾𝐾𝐾
1 + 𝐾𝐾𝐾𝐾
1 + 𝐾𝐾𝐾𝐾
1 + 𝑘𝑘𝑘𝑘
𝑃𝑃𝑃𝑃 =
𝑛𝑛
𝐷𝐷1 1 + 𝑔𝑔2
𝐾𝐾𝐾𝐾 − 𝑔𝑔2
D0 = Dividend per share
g1 = super growth rate
g2 = normal growth rate
Pn = Price of share at the end of Super Growth i.e. beginning of Normal Growth Period
Ke = required rate of return
Supernormal Growth
Equation will become:
𝑝𝑝0 =
𝑛𝑛
𝑡𝑡=1
𝐷𝐷𝐷𝐷𝐷𝐷0 1 + 𝑔𝑔𝑠𝑠
1 + 𝑘𝑘𝑒𝑒 𝑡𝑡
𝑡𝑡
∞
+
𝑡𝑡=𝑛𝑛+1
𝐷𝐷𝐷𝐷𝐷𝐷𝑛𝑛 1 + 𝑔𝑔𝑛𝑛 1−𝑛𝑛
1 + 𝑘𝑘𝑒𝑒 𝑡𝑡
Illustration No. 9
Shyam & Co. has declared and paid annual dividend of NRs 4 per share. It is expected the
dividend will grow @ 20% for the next two years and 10% thereafter. The required rate of
return of equity investors is 15%. Compute the current price at which equity shares should
sell. Note: Present Value Interest Factor (PVIF) @ 15%:
For year 1 = 0.8696;
For year 2 = 0.7561
Illustration No. 9- Solution
D0 = NRs 4
D1 = NRs 4*(1.20) = NRs 4.80
D2 = NRS 4*(1.20)^2 = NRs 5.76
D3 = NRs 4 *(1.20)2 *(1.10) = NRs 6.336
276 |The Institute of Chartered Accountants of Nepal
Valuation of Securities
𝑃𝑃0 =
𝑃𝑃𝑃𝑃 =
𝑃𝑃𝑃𝑃 =
𝑃𝑃0 =
𝐷𝐷1
𝐷𝐷2
+
1 + 𝑘𝑘𝑘𝑘
1 + 𝐾𝐾𝐾𝐾
𝐷𝐷3
𝑘𝑘𝑘𝑘 − 𝑔𝑔
2
𝑃𝑃𝑃𝑃
1 + 𝑘𝑘𝑘𝑘
+
6.336
= 126.72
0.15 − 0.10
4.80
5.76
+
1 + 0.15
1 + 0.15
2
+
2
126.72
1 + 0.15
2
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 4.80 ∗ 0.8696 + 5.76 ∗ 0.7561 + 126.72 ∗ 0.7561
Price = NRs 104.34
If a totally equity financed firm retains a constant proportion of its annual earning
(say,ROE),then it can be shown that the dividends will grow at a constant rate equal to the
product of retention ratio and return on equity.
Growth = Retention ratio × Return on equity
g = b × ROE
Earnings Capitalisation
The dividend capitalisation model,discussed so far, is the basic share valuation
model.However, under two case,the value of the share can be determined by capitalising the
expected earning ;

when the firm pays out 100 per cent dividends;that is,it does not retain any earnings;

when the firm's return on equity (ROE) is equal to its opportunity cost of capital (ke).
The first case in which the earnings capitalisation model may be employed is the one when
the earning of the firm are stable.The earning will not grow if the firm does not retain the
earnings (and also does not employ any debt).Thus,if the retention rate ,b, is zero, the
growth rate,g, would also be equal to zero and DIV1 would be equal to EPS 1.Under these
conditions,the value of the share will be equal to the expected earnings per share divided by
the equity canditions,the value of the share will be equal to the expected ea9rnings per share
divided by the equity capitalisation rate. Since DIV1=EPS (1-b) and g=rb(where r is equal to
ROE),we can write formula for share valuation as follows:
𝑝𝑝0 =
𝐸𝐸𝐸𝐸𝐸𝐸1 1 − 𝑏𝑏
𝑘𝑘𝑒𝑒 − 𝑟𝑟𝑟𝑟
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Chapter 4
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Knowledge Test 2
D Ltd is foreseeing a growth rate of 12 % p.a for next two years. The growth rate is likely to
increase to 10% for the next two years. After that the growth rate is expected to continue at
8% p.a. The company paid a dividend of Rs 1.5 per share last year. Investor‘s required rate of
return is 16%. Determine the current value of equity share of the company.
Knowledge Test 3
A Ltd. has an investment opportunity available which will involve a capital outlay in each of
thenext 2 years and which will produce benefits during the following 3 years. A summary of
the financial implicationsof this investment is given below:
Year
Cash Flow (Rs. ‗000)
Year Cash Flow (Rs. ‗000)
1
-1,000
4
1,300
2
-1,000
5
3,100
3
100
A Ltd. currently has 100,000 shares in issue. The dividend just paid was Rs. 15 per share. In
the absence ofthe above investment, dividends are expected at this level for the next 3 years
but will then demonstrate perpetualgrowth of 10 per cent per annum. The company is
currently all equity financed and the required rate of return of theequity investor is estimated
to be 18 per cent.
The company has a long-established policy of not using any debt finance and, because of the
current depressedstate of the stock market, could not, in the near future, issue new equity. The
only possible way of financing theinvestment is, therefore, to reduce the dividend payments in
the next 2 years. Cash received from the new investment will all be distributed in the form of
dividend. Growth in dividends at the rate of 10% will also bemaintained because of other
operations.
i) Calculate the current price of share of ALtd. when investment proposal is not accepted.
ii) Calculate the share price after the investment has been accepted using dividend valuation
model, assuming thatthe market knows of the dividend changes that will result from the
investment.
278 |The Institute of Chartered Accountants of Nepal
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Knowledge Test 1- Answer
The value of the bond is
V = NRs 140(PVIFA13%, 5yrs) + NRs 1,000(PVIF13%,5yrs)
= NRs 140(3.517) + NRs 1,000(0.543) = NRs 1,035.4
Knowledge Test 2- Solution
Solution
Current value of equity shares in t0 = (PV of dividend payment during the year (1-4) + ( PV of
Expected market price at the end of the year 4)
Calculation of Present Value of Dividend Payment
Year
Dividend
PV. Factor @ 16%
Total PV of Dividend
1
D1= 1.50 (1+0.12) = 1.68
0.862
1.448
2
D2= 1.68 (1+ 0.12) = 1.88
0.743
1.397
3
D3 = 1.88 (1+ 0.10) =2.07
0.641
1.327
4
D4=2.07 (1+0.10) = 2.28
0.552
1.259
5.431
Calculation of Expected Market price at the end of year 4
𝑃𝑃4 =
=
=
𝐷𝐷5
𝐾𝐾𝑒𝑒 − 𝑔𝑔
𝐷𝐷4 (1 + 𝑔𝑔)
𝐾𝐾𝑒𝑒 − 𝑔𝑔
2.28(1 + 0.08)
0.16 − 0.08
= NRs 30.78
Present Value of Market price of share (P4) = P4 x PV factor
= Rs 30.78 x 0.552
= Rs 16.99
Market price in P0 = PV of dividend + PV of Market price of share (p4)
=Rs 5.431 + Rs 16.99
=Rs 22.421
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Chapter 4
Financial Management
Knowledge Test 3- Solution
(i) Current price of Share (when investment proposal is not accepted)
The current market price of the share is the present value of expected future dividends
discounted at the requiredrate of return, i.e. 18%.Since the company is expected to pay a
dividend of Rs. 15 for the next 3 years andthereafter, the dividend will grow at the rate of
10%.
The present market price with these parameters is ascertainedas below:
Dividend per year
= Rs. 15
PVAF (at 18%, 3 years)
= 2.174
Therefore, PV of dividends
= Rs. 15 x 2.174
= Rs. 32.61
Price of share at the end of year 3 (P3) with perpetual growth of 10%
𝐷𝐷4
𝑃𝑃3 =
𝐾𝐾𝑒𝑒 − 𝑔𝑔
=
15 (1 + 0.10)
0.18 − 0.10
= Rs. 206.25
Present value of this amount at 18% for 3rd year = Rs. 206.25 * PVIF(18%, 3)
= Rs. 206.25 * 0.609
= Rs. 125.61
Present market price
= Rs. 125.61 + Rs 32.61
= Rs. 158.22
ii) Current price of Share (when the investment proposal is accepted)
In first and second year the investment required of Rs.1,000,000 is financed by reducing the
old dividend rate of Rs.15 per share for 100,000 number of shares. And, thereafter all the cash
flows from new investment is distributed as additional dividend.
The present value of dividend under this situation will be as follows:
Year
1
2
3
4
5
Old Dividend (Rs)
Change in
Dividend
(Rs)
Net Dividend
(Rs)
PVIF @
18%
PV (Rs)
-10
-10
1
13
31
5
5
16
29.5
49.15
0.847
0.718
0.609
0.516
0.437
4.24
3.59
9.74
15.22
21.48
15
15
15
(15 + 10% of 16) = 16.5
(16.5 + 10 % of 16.5) = 18.15
54.27
280 |The Institute of Chartered Accountants of Nepal
Valuation of Securities
Price of share at the end of year 5 (P5) with perpetual growth of 10%
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑎𝑎𝑎𝑎 𝑡𝑡ℎ𝑒𝑒 𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 5 (𝑃𝑃5 ) =
=
18.15 (1 + 0.10)
0.18 − 0.10
𝐷𝐷6
𝐾𝐾𝑒𝑒 − 𝑔𝑔
=Rs 250
Present value of this amount at 18% for 5th year
= Rs. 250 * PVIF(18%, 5)
= Rs. 250 * 0.437
= Rs. 109.25
Therefore, the market price under this situation
= Rs. 109.25 + Rs. 54.27
= Rs. 163.52
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Chapter 5
Financial Management
Chapter 5
Capital Investment Decision
282 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
5.1 Learning Objectives
Upon completion of this chapter student will be able to:











Explain the importance and purpose of capital budgeting
Explain the concept of relevant cash flow.
State the conventional and non-conventional cash flows.
Discuss the investment decision under traditional approach (which doesn‘t consider
time value of money) like payback period and return on capital employed
Discuss the various investment appraisal techniques like NPV, IRR, modified internal
rate of return (MIRR), discounted payback period (DPBP)
Explain the impact of tax on discounted cash flow technique
Define the terminal cash flows under modified internal rate of return
Analyze the advantages and disadvantages of the investment appraisal technique.
State the capital rationing under capital expenditure
Define and distinguish the divisible and non-divisible projects under capital rationing
Define sensitivity analysis and discuss its usefulness in investment appraisal
5.2 Chapter Overview
Capital Investment
Decision
Evaluation
Technique
Traditional
Technique
Return on Capital
Employed (Average
Rate of Return)
Capital Rationing
Discounted Cash
Flow technique
Sensitivity Analysis
Discounted Pay
Back Period
Payback Period
Net Present Value
Internal Rate of
Return
Fig: Chapter Overview of Capital Investment Decision
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Chapter 5
5.3 Introduction to Capital Budgeting
Capital Budgeting is the planning process whereby organization evaluates whether any
expenditure on capital items is beneficial for organization. These benefits may be either in the
form of increased revenues or reduced costs.
It includes the decision regarding addition, disposition, modification and replacement of fixed
assets. However, the broad form of Capital Budgeting decision includes investment decisions as
well which covers the decision regarding feasibility of investment projects as well which is
called investment decisions.
The term Capital Budgeting is used interchangeably with capital expenditure decision and longterm investment decision. Capital Budgeting involves:
 Identification of investment projects and capital expenditures suitable as per the needs
and objectives of the organization.
 Evaluation of the proposals using the evaluation methodology and techniques.
 Selection of the proposal which maximizes return or minimizes the cost.
5.4 Significance of Capital Budgeting
In the modern economic world, capital budgeting is crucial in each and every small and longterm investment decisions for the sustainability and successful operation of the business:








Essential tool for financial management.
Supports finance managers to evaluate different projects.
Provides an opportunity to grab investment opportunities.
Helps in exposing the risk and uncertainty of different projects.
Provides a bird eye view on sustainability of the projects.
Provides a way for effective control on expenditure on projects.
Helps in maximization of return at minimal cost.
Protects from the risk of over or under investing.
5.5 Limitations of Capital Budgeting
Capital expenditure decisions are of considerable significance as the future success and growth
of the firm depends heavily on them. But they are beset with a number of limitations:
 Considerable time is required to obtain benefit from these decisions.
 Decisions are long term and majorly irreversible in nature.
 Techniques used for budgeting are mainly on assumption basis. Hence, there is chance
of making wrong decisions.
 Wrong decision affects long term durability.
 Availability of skilled professional for making the decisions is not easy.
 Expensive exercise.
284 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
5.6 Types of Capital Budgeting Decisions
An organization may encounter with a situation to make following types of Capital Budgeting
decisions:
5.6.1 Independent Decisions:
Independent decisions of Capital Budgeting are based on designated return. The proposals which
provide minimum return on investment are accepted and the rest are rejected. Therefore, these
sorts of decisions are also called Accept-Reject decisions. If the proposal is accepted, the
organization shall invest in it else the organization does not invest in it. Decisions on
Independent proposals do not depend upon each other. There is chance of selection of one or all
proposals or rejection of one or all proposals.
5.6.2 Mutually Exclusive Decisions:
Mutually Exclusive decisions on Capital Budgeting refer to the decisions made on such
proposals where acceptance of one proposal results in the automatic rejection of the other
proposal. In other words, one can be rejected and the other can be accepted. The alternatives are
mutually exclusive and only one may be chosen.
5.6.3 Capital Rationing Decision
Capital rationing decisions on capital budgeting are used in the situation where the organization
has limited funds for investment. The criteria of both rate of return and availability of funds are
considered for making these types of decisions. The proposal yielding high rate of return but
within the available fund are selected.
Example No. 1
Suppose an organization has option to invest in a construction project. There are four projects
currently in operation. The organization has expected minimum 11% return from the projects.
And has limited its expected cost to Rs. 15 Lakhs
Project A:
 Cost of Investment – Rs. 10 Lakhs
 Return of project – 10%
Project B:
 Cost of Investment – Rs. 12 Lakhs
 Return of project – 11%
Project C:
 Cost of Investment – Rs. 14 Lakhs
 Return of project – 13%
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Chapter 5
Financial Management
Project D:
 Cost of Investment – Rs. 16 Lakhs
 Return of project – 14%
Under Independent Decision: Project B, Project C and Project D have chance of being
selected.
Under Mutually Exclusive Decision: Only Project D shall be selected.
Under Capital Rationing Decision: Project C shall be selected.
5.7 Approaches for Capital Budgeting
Capital budgeting is concerned with investment decisions which yield return over a period of
time in future. The foremost requirement for evaluation of any capital investment proposal is to
estimate the future benefits accruing from the investment proposal. Theoretically, two alternative
criteria are available to evaluate the benefits:
 Accounting Profit Approach, and
 Cash Flows Approach.
Non- Cash Income/Expense are adjusted from Accounting Profit to get the cash flows. Noncash expenses are added back, and Non-cash incomes are deducted.
Accounting
Profit
Non- cash
Income/Expenses
Cash Flows
The cash flow approach of measuring future benefits of a project is superior to the accounting
approach as cash flows are theoretically better measures of the net economic benefits of costs
associated with a proposed project.
5.8 Comparision of the Approaches
The comparison of these approaches can be outlined under the below headings:
5.8.1 Availability of Funds for Investment and Reinvestment.
The organization needs cash for initial investment (outflows), and the return received on cash
from the investment on periodic intervals (inflows) can also be reinvested. The capital budgeting
needs to consider this fact to find out whether future economic inflows are sufficiently large to
warrant the initial investment. Cash flow approach considers this fact
In the accounting approach, the initial cost of the investment is allocated over its economic
286 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
useful life in the nature of depreciation rather than at the time when costs are actually incurred.
The accounting treatment clearly does not reflect the original need for cash at the time of inflows
and outflows in later years.
The difference between the cash flow approach and the accounting profit approach is depicted in
below table.
A Comparison of Cash Flow and Accounting Profit Approaches
Accounting
approach
Revenues
(-) Operating expenses:
Cash expenses
Depreciation
Cash flow approach
1,000
500
300
1,000
500
(800)
-
(500)
Earnings before tax
Less: Taxes (0.35)
200
(70)
500
(70)
Net earnings after taxes / Cash flow
130
430
Above table shows that the accounting profits amounting to Rs 130 are less than the cash flow
(Rs 430). This difference can be attributed to the depreciation charge of Rs 300. The cash
available with the firm is Rs 430. This can be utilized for further investment. The accounting
approach indicates that only Rs 130 is available and hence gives only a partial picture of the
tangible benefits available. Clearly, such an approach does not bring out the total benefits of the
project available for reinvesting.
5.8.2 Accounting Ambiguities
The use of cash flows avoids accounting ambiguities. Though various accounting methods are
used, the calculation will show only one set of cash flows associated with the project.
But in accounting approach, different net incomes will be arrived under different accounting
procedures. There are various accounting principles and procedures for calculation of net
income. Valuation of inventory, allocation of costs, calculation of depreciation and amortization
of various expenses can involve different methods.
5.8.3 Time Value of Money
The cash flow approach takes cognizance of the time value of money whereas the accounting
approach ignores it.
Under the usual accounting practice, revenue is recognized as being generated when the product
is sold, not when the cash is collected from the sale; revenue may remain a paper figure for
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Chapter 5
months or years before payment of the invoice is received. Expenditure, too, is recognized as
being made when incurred and not when the actual payment is made. Depreciation is deducted
from the gross revenues to determine the before-tax earnings. Such a procedure ignores the
increased flow of funds potentially available for other uses
Profit Vs Cash Flows
Cash flows are better measure of the suitability of a capital investment because;
 Cash is what ultimately counts- profits are only a guide to cash availability: they
cannot actually be spent
 Profit measurement is subjective- the time period in which income and expenses are
recorded, and so on, are a matter of judgement.
 Cash is used to pay dividends – dividends are the ultimate method of transferring
wealth to equity shareholders
5.9 Cashflow Approach
5.9.1 Cashflow and Relevant Costs
For all methods (except ROCE / ARR), only relevant cash flows should be considered.
These are;
 Future costs
 Incremental costs
 Cash-based costs
 Opportunity costs
Ignore:
 Sunk costs
 Committed costs
 Non-cash items
 Allocated costs
Costs
Sunk costs
Committed
costs
Non-cash items
Allocated
overhead
Remarks
Cost that have already incurred are not relevant to the current decision.
The money that has been already spent cannot be recovered and so it is not
relevant.
Cost that will be incurred anyway, whether or not a capital project goahead cannot be relevant to the decision about investing in the project.
Non-cash items of costs never be relevant to investment decision.
Depreciation charge on non-current assets are relevant costs.
allocated overheads are charged based on some rational basis such as
machine hour, labor hour, direct material consumption etc. Since,
288 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
Opportunity
costs
expenditures already incurred are allocated to new proposal; they should
not be considered as cash flows
Opportunity costs are the cash flows in relation to the next best alternative,
E.g. if a machine that was to be sold is used on a project, the lost value is
an opportunity cost and is relevant.
5.9.2 Cash Flow Pattern
Cash flow pattern associated with capital investment projects can be classified as conventional or
non-conventional.

Conventional Cash Flows Pattern
The cash flow pattern in which direction of cash flows change only once over the time period is
called conventional cash flows pattern. They consist of an initial cash outflow followed by a
series of cash inflows. Most of the capital expenditure decisions display this pattern of cash flow.
This pattern can be explained by mathematical notation as -,+,+,+,+,+,+.
To illustrate, the firm may spend Rs 1,500 in time period zero and as a result may expect to
receive Rs 300 cash inflow at the end of each year for the next 8 years. The conventional cash
flow pattern is diagrammed given below:
Year
0
Cash inflows
Cash outflows

1
2
3
4
5
6
7
300
300
300
300
300
300
300
(1,500)
Non-Conventional Cash Flows Pattern
Non-Conventional Cash Flows refer to the cash flow pattern in which direction of cash flows
change more than once over the time period. An initial cash outflow is not followed by a
series of inflows, there will be other cash outflow in the intervals. A classic example of such
cash flow patterns is that of the purchase of an asset that generates cash inflows for a period of
years, is overhauled, and again generates a stream of cash inflows for a number of years. This
pattern can be explained by mathematical notation as -, +, +, +, -, +, +, -.
To illustrate, a machine purchased for Rs 1,000 generates cash inflows of Rs 250 each for five
years. In the sixth year, an outflow of Rs 400 is required to overhaul the machine, after which it
generates cash inflows of Rs 250 for four years. Such a non-conventional pattern of cash flows is
given below:
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Year
0
Cash inflows
Cash outflows
1
2
3
4
5
6
7
8
9
10
250
250
250
250
250
250
250
250
250
250
-1,000
-400
5.10 Cashflow Estimation
When evaluating a capital budgeting project, estimation of the future after-tax cash flows from
the asset is required to be made. Estimation of future cash flows requires to be carried out with
the correct assumptions and forecasts. Incorrect forecasts could cause the firm to either accept
projects that actually are unacceptable or reject projects that actually are acceptable.
There are certain ingredients of cash flow estimations.
Initial
investment
Ingredients
Incremental cash
flows
Indirect
expenses effect
Depreciation
effect
Other projects
effect
Tax effect
Working capital
effect
5.10.1 Initial Investment Outflow
It includes cash flows that occur only at the beginning of the project‘s life. Cash flows included
in this category are:
 Purchase price of the asset
 Shipping and installation costs
 The cash flows associated with disposal of the old asset if that asset is being replaced
 Taxes
 Changes in net working capital
 And any other up-front cash flows associated with a capital budgeting project.
The item Changes in net working capital refers to the fact that in many cases inventory or other
working capital accounts are affected when a new machine is purchased and added to the firm or
290 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
when an old machine is replaced by a new. In some cases inventory will increase, which means
there will be an additional cash outflow associated with purchasing the additional inventory, and
in other cases inventory will decrease, which means there will be a cash inflow associated with
purchasing the asset because inventory can be sold until the new, lower level of inventory is
attained.
5.10.2 Incremental Operating Cash Flows
These cash flows are the changes in cash flows that are sustained throughout the life of the asset.
Cash flows included in this category are:
 Permanent changes in cash sales
 Change in salaries, costs of raw materials
 Other cash operating revenues and expenses that change because the asset is purchased.
5.10.3 Effect ofIndirect Expenses
Another factor which merits special consideration in estimating cash flows is the effect of
overheads. The indirect expenses/overheads are allocated to the different products on the basis of
wages paid, materials used, floor space occupied or some other similar common factor. If the
amount of overheads changes as a result of the investment decision, it should be taken into
consideration. If, however, overheads do not change as a result of the investment decision, they
are not relevant (It is not incremental).
A company allocates overheads on the basis of the floor space used. Assume it intends to replace
an old machine by a new one. Further assume that the new machine would occupy less space so
that there would be a reduction in the overhead charged to it. Since there is no effect on cash
flows, a change in the overhead is not relevant to the cash flow streams of the machine being
acquired. But if the surplus space is used for an alternative use, and if any cash flow is generated,
it will be relevant to the calculations.
5.10.4 Effect of Depreciation
As the depreciation is noncash expenditure and itself does not affect the cash flow, however we
must consider tax benefit/ shield from depreciation while computing the cash flow of the project.
Since this benefit reduces cash outflow for taxes, it is considered as cash inflow. To understand
how depreciation acts as tax shield let us consider following example.
Example No. 2
Shyam Ltd, manufactures electronic fitted in desert coolers. It has an annual turnover of 30
Crores and cash expense to generate this much of sale is 25 Crores. Suppose applicable tax
rate is 30% and depreciation is 1.5 Cr per annum. The table below is showing tax shield due to
the deprecation under two scenarios i.e. with and without depreciation.
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Amount in Crore
Particulars
No depreciation is charged
Total Sales
Less: Cost of Goods Sold
Gross Profit
Less: Depreciation
Profit before tax
Tax @ 30%
Profit after tax
Add: Depreciation*
Cash flow
Depreciation is charged
30
-25
5
0
5
1.5
3.5
0
3.5
30
-25
5
1.5
3.5
1.05
2.45
1.5
3.95
* Being Non-Cash expenditure depreciation has been added back while calculating the cash
flow.
As we can see in the above table that due to depreciation under second scenario a tax saving of
0.45 Crore (1.5-1.05) was made. This is called tax shield/benefit. The tax shield on
depreciation is considered while estimating the cash flows.
Block of Assets and Depreciation
Taxable income is calculated as per the provisions of Income Tax of the country. The treatment
of deprecation is based on the concept of ―Block of Assets‖, which means a group of assets
falling within a particular class of assets. This class of assets can be building, machinery,
furniture, vehicle etc. in respect of which depreciation is charged at same rate. The treatment of
tax depends on the fact whether block of asset consist of one asset or several assets. To
understand the concept of block of asset let us discuss an example.
Suppose A Ltd. acquired new machinery for NRs 1,00,000 depreciable at 20% as per Written
Down Value (WDV) method. The machine has an expected life of 5 years with salvage value of
NRs 10,000. The treatment of Depreciation/ loss on sale of machinery in the 5th year in two
cases shall be as follows:
Depreciation calculation for 5 years is calculated below;
Particulars
Purchase of Machinery
Less: Depreciation for 1st year @20%
WDV at the end of year 1
Less: Depreciation for 2nd year @20%
WDV at the end of year 2
292 |The Institute of Chartered Accountants of Nepal
Amount in NRs
100,000
20,000
80,000
16,000
64,000
Capital Investment Decision
Less: Depreciation for 3rd year @20%
WDV at the end of year 3
Less: Depreciation for 4th year @20%
WDV at the end of year 4
12,800
51,200
10,240
40,960
i) Case 1:There is no other asset in the Block:When there is one asset in the block and
block shall cease to exist at the end of 5th year no deprecation shall be charged in this year
and tax benefit/loss or gain on sale of machinery shall be calculated as follows:
Particulars
WDV at the end of year 4
Less: Salvage value
Loss on sale of machinery
Tax Benefit @ 25% (assumed)
Amount in NRs
40,960
10,000
30,960
7,740
ii) Case 2:More than one asset exists in the Block:When more than one asset exists in the
block and deprecation shall be charged in the terminal year (5th year) in which asset is sold.
The WDV on which depreciation be charged shall be calculated by deducting sale value
from the WDV in the beginning of the year.
Tax benefit on Depreciation shall be calculated as follows:
Particulars
Amount in NRs
WDV at the end of year 4
40,960
Less: Salvage value
10,000
Written down value
30,960
Depreciation @ 20%
6,192
Tax Benefit @ 25% (assumed)
1,548
5.10.5 Tax Effect
It has been already observed that cash flows to be considered for purposes of capital budgeting
are net of taxes. Operating cash flows and profit before tax are subject to change because of
change in capital investment which in turn causes change in tax.
Special consideration needs to be given to tax effects on cash flows if the firm is incurring losses
and, therefore, paying no taxes. The tax laws permit carrying losses forward to be set off against
future income. In such cases, the benefits of tax savings would accrue in future years.
Illustration No. 1
XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The project is
to be set up in Special Economic Zone (SEZ), qualifies for one-time (at starting) tax free
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subsidy from the State Government of Rs. 25 lakhs on capital investment. Initial equipment
cost will be Rs 1.75 crores. Additional equipment costing Rs 12.50 lakhs will be purchased at
the end of the third year from the cash inflow of this year. At the end of 8 years, the original
equipment will have no resale value, but additional equipment can be sold for Rs 1.25 lakhs. A
working capital of Rs 20 lakhs will be needed and it will be released at the end of 8th year. The
project will be financed with sufficient amount of equity capital.
The sales volumes over eight years have been estimated as follows:
Year
1
Units
72,000
2
1,08,000
3
2,60,000
4-5
6-8
2,70,000
1,80,000
A sales price of Rs 120 per unit is expected and variable expenses will amount to 60% of sales
revenue. Fixed cash operating costs will amount Rs 18 lakhs per year. The loss of any year
will be set off from the profits of subsequent two years. The company is subject to 30 per cent
tax rate and considers 12 per cent to be an appropriate after-tax cost of capital for this project.
The company follows straight line method of depreciation.
Require:
Calculate the amount of cash inflows after tax and cash outflows:
Illustration No. 1- Solution
Solution
Calculation of Cash Inflow After Tax
Year
1
2
Sales
86.4
129.6
Less: Variable cost
51.84
77.76
Less: Fixed Cost
18
18
Profit Before Depreciation and Tax
16.56
33.84
Less: Depreciation
21.875
21.875
Net Profit After depreciation
-5.315
11.965
Less: Adjustment of Previous year
Losses
-5.315
Net profit After Depreciation and
Loss
-5.315
6.65
Less: Tax
0
1.995
Net Profit After Tax
-5.315
4.655
294 |The Institute of Chartered Accountants of Nepal
3
312
187.2
18
106.8
21.875
84.925
(In ‗000)
4-5
6-8
324
216
194.4
129.6
18
18
111.6
68.4
24.125
24.125
87.475
44.275
-
-
-
84.925
25.4775
59.4475
87.475
26.2425
61.2325
44.275
13.2825
30.9925
Capital Investment Decision
Add: Depreciation
Cash Flow After Tax
Calculation of Cash Outflow
Particular
Cost of New Equipment
Less: Subsidy
Add: Working Capital
Outflow
21.875
16.56
21.875
26.53
21.875
81.3225
24.125
85.3575
24.125
55.1175
Amount
17,500,000
2,500,000
2,000,000
17,000,000
5.10.6 Effect onOther Projects
Cash flow effects of the other existing project must be taken into consideration if it is not
economically independent. For instance, if a company is considering the production of a new
product which competes with the existing products in the product line, it is likely that as a result
of the new proposal, the cash flows related to the old product will be affected.
Assume that there is a decline of Rs 5,000 in the actual flow from the existing product. This
should be taken into consideration while estimating the cash streams from the new proposal. In
operational terms, the cash flow from the new product should be reduced by Rs 5,000. This is in
conformity with the general rule of the incremental cash flows which involves identifying
changes in cash flows as a result of undertaking the project being evaluated.
5.10.7 Effect ofWorking Capital
Working capital constitutes another important ingredient of the cash flow stream which is
directly related to an investment proposal. The term working capital is used here in net sense,
that is, current assets minus current liabilities (net working capital).
If an investment is expected to increase sales, it is likely that there will be an increase in current
assets in the form of accounts receivable, inventory and cash. But part of this increase in current
assets will be offset by an increase in current liabilities in the form of increased accounts and
notes payable. Obviously, the sum equivalent to the difference between these additional current
assets and current liabilities will be needed to carry out the investment proposal.
The increased working capital forms part of the initial cash outflow. Further decrease in working
capital shall reduce the amount of initial cash outflow. The additional net working capital will,
however, be returned to the firm at the end of the project's life. Therefore, the recovery of
working capital becomes part of the cash inflow stream in the terminal (last) year. However,
working capital added in the initial investment and the one subsequently recovered do not
balance out each other due to the time value of money.
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The increase in the working capital may not only be in the zero-time period, that is, at the time of
initial investment. There can be continuous increase in the working capital as sales increase in
later years. This increase in working capital should be considered as cash outflow of the year in
which additional working capital is required.
Important rules for working capital impact on investment appraisal
Investment in a new project often requires an additional investment in working capital. i.e. the
difference between short term assets and liabilities.
 Initial investment is a cash outflow at the start of the project.
 If the investment is increased during the project, the increase is a relevant cash flow.
 If the investment is decreased during the project, the decrease is a relevant cash flow
 At the end of the project all the working capital is released and treated as a cash
inflow.
Illustration No. 2
A company expects sales for a new project to be NRs 225,000 in the first year growing at 5%
pa. The project is expected to last for 4 years. Working capital equal to 10% of annual sales is
required and needs to be placed at the start of each year.
Calculate the working capital flows for incorporation into the NPV calculation.
Illustration No. 2 solution
Particulars
Sales in NRS
Working Capital
Relevant cash flow
T0
(22,500)
(22,500)
T1
225,000
(23,625)
(1,125)
T2
236,250
(24,806)
(1,181)
T3
248,063
(26,046)
(1,241)
T4
260,466
26,046
5.11 Evaluation Methology
The methods of appraising capital expenditure proposals can be classified into two broad
categories:
1. Non-Financial Feasibility
2. Financial Feasibility.
Same can be broadly categories as follows;
296 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
Evaluation
Technequ
e
Non
Financial
Feasibility
Financial
Feasibility
Time
adjusted
Approach
Traditiona
l approach
Average
Rate of
Return
Pay Back
Period
Discounte
d Pay
back
period
Net
Present
Valaue
Internal
Rate of
Return
Market
Feasibility
Modified
internal
rate of
return
Technical
Feasibility
Net
Terminal
Value
Method
Profitabili
ty Index
5.11.1 Non-Financial Feasibility:
A few researchers have thrown some light on the non-financial aspects of capital budgeting. For
instance, Shimin (1995) in his study of 115 CFOs found that non-financial techniques play a
considerable role in project evaluation. Similarly, Petty, Scott and Bird (1975) reported that 77
percent of the firms replied that although quantitative influences are dominant, qualitative factors
also influence the investment decision. They also found that the most important qualitative factor
affecting investment decision. Broadly, non-financial criteria for project evaluation can be
classified as;
A. Market feasibility:
Products having high sales potential are less risky to invest in. For conducting the
market feasibility study, the salability of proposed products is important. Indicators of
buyer‘s behavior in response to a new product have to be taken into the account.
Broadly, below mentioned points need to be considered while conducting market
feasibility.




Economic indicator
Demand Estimation
Market potential of proposed products.
Supply Chain Management
B. Technical Feasibility:
Technical feasibility analysis of a project can vary with the size and complexity involve
in setting up the project. Establishing the large-scale project for manufacturing the
products will require an analyst to evaluate the various technical aspect such as;
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





Environmental Impact Analysis
Utility (Water, Electricity, power (Back Up) availability.
Ease of technology absorption.
The technical speciation of plant and equipment.
Scale of operation and line balancing.
Technical obsolescence possibility.
5.11.2 Financial Feasibility
Financial feasibility focuses on analysis of financial aspects such as:
 Cost of project
 Projected cash flows
 Return from the project
5.11.2.1 TRADITIONAL TECHNIQUES
Traditional techniques of financial feasibility have been discussed below:

AVERAGE RATE OF RETURN (RETURN ON CAPITAL EMPLOYED)
The average rate of return (ARR) method of evaluating proposed capital expenditure is also
known as the accounting rate of return method. It is based upon accounting information rather
than cash flows. There is no unanimity regarding the definition of the rate of return. There are a
number of alternative methods for calculating the ARR. The most common usage of the average
rate of return (ARR) expresses it as follows:
Or,
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝐴𝐴𝐴𝐴𝐴𝐴 =
𝐴𝐴𝐴𝐴𝐴𝐴 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑎𝑎𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
∗ 100
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑎𝑎𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
∗ 100
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
The average profits after taxes are determined as
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐸 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐸 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
The average investment is determined averaging the amount of fund remained blocked during
the life of the project under consideration.
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Capital Investment Decision
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 + 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉
2
Illustration No. 3
Initial investment (purchase of machine) = Rs 11,000,
Salvage value,
= Rs 1,000,
Working capital,
= Rs 2,000,
Service life (years)
= 5 years
The straight-line method of depreciation is adopted
Annual depreciation = Cost of Machine – Salvage Value
Life
= Rs.11, 000 – Rs.1, 000
5 Years
= Rs.2, 000
Working
Capital
Average investment on Fixed Asset
Beginning of the
End of
average
year
Depreciation the year
Investment
1
2,000
11,000
2,000
9,000
10,000
2
2,000
9,000
2,000
7,000
8,000
3
2,000
7,000
2,000
5,000
6,000
4
2,000
5,000
2,000
3,000
4,000
5
Average
value
2,000
3,000
2,000
1,000
2,000
Year
2,000
6,000
Hence average investment on project = Average Investment on Working Capital + Average
Investment on Fixed asset
= Rs. 2,000 + Rs. 6,000
= Rs.8, 000
Or directly,
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑜𝑜𝑜𝑜 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 + 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉
2
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𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 =
Illustration No. 4
Particular
11000 + 1000
= 𝑁𝑁𝑁𝑁𝑁𝑁 6,000
2
Machine A
Cost of Machine
Annual estimated income after depreciation and income tax:
1
2
3
4
5
Rs 56,125
Rs 56,125
3,375
11,375
5,375
7,375
9,375
11,375
9,375
7,375
5,375
3,375
5
5
3,000
3,000
Estimated life (years)
Estimated salvage value
Machine B
If the depreciation has been charged on straight line basis calculate the Average Rate of Return
Illustration No. 4- Solution
i.
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝐴𝐴𝐴𝐴𝐴𝐴 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑎𝑎𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
∗ 100
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
Calculation of Average income
Year
Machine A
Machine B
1
3,375
11,375
2
5,375
9,375
3
7,375
7,375
4
9,375
5,375
5
11,375
3,375
Total Income of Five Year
36,875
36,875
5
5
7,375
7,375
Estimated life (years)
Average Income (Total Income / Estimate Life)
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Capital Investment Decision
ii.
Calculation of Average Investment
Year
Machine A
Machine B
Cost of Machine
Rs 56,125
Rs 56,125
Estimated salvage value
Rs 3,000
Average Investment Value
=
Rs 3,000
56,125 + 3000
=
2
=Rs 29,562.50
iii.
ARR
56,125 + 3000
2
=Rs 29,562.50
Calculation of Average Rate of Return
Machine A
Machine B
= 7,375/29,562,50 X 100
= 7,375/29,562,50 X 100
= 24.9 per cent
= 24.9 per cent
In addition to the above, there are other approaches to calculate the average rate of return
(ARR). One approach, which is a variation of the above, involves using original rather than
the average cost of the project. In the case of this alternative approach, the ARR for both the
machines would be 13.1 per cent (Rs 7,375 / Rs 56,125).
Decision:
A project would qualify to be accepted if the actual ARR is higher than the minimum desired
ARR. Otherwise; it is liable to be rejected. Alternatively, the ranking method can be used to
select or reject proposals. Thus, the alternative proposals under consideration may be arranged in
the descending order of magnitude, starting with the proposal with the highest ARR and ending
with the proposal having the lowest ARR. Obviously, projects having higher ARR would be
preferred to projects with lower ARR.
Knowledge Test 1
A project costs Rs. 5, 00,000 and has a scrap value of 1,00,000 after 5 years. The net profit
before depreciation and taxes for the five years period are expected to be Rs. 1, 00,000. Rs. 1,
20,000. Rs. 1,40,000, Rs. 1, 60,000 and Rs. 2,00,000. You are required to calculate the
Accounting Rate of Return, assuming 50% rate of tax and depreciation on straight line
method.
Advantages and Disadvantages of Average Rate of Return
Advantages of Average Rate of Return:
 Simplicity- being based on widely reported measures of return (profits) and assets
(statement of financial position values), it is easily understood and easily calculated.
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 It uses readily available data and does not require any special procedure to generate the
data.
 ARR evaluate the performance on the operating result of an investment.
 This method considered all net income over the entire life of the project and provides
the measures of investment profitability.
Disadvantages of Average Rate of Return:
 The ARR criterion of measuring the worth of investment does not differentiate
between the sizes of the investment required for each project. Competing investment
proposals may have the same ARR, but may require different average investments, as
shown in Table below. The ARR method, in such a situation, will leave the firm in an
indeterminate position.
For example;
Machine
Average annual earning
Average investment
ARR (per cent)
A
B
C
Rs 6,000
Rs 2,000
Rs 4,000
Rs 30,000
Rs 10,000
Rs 20,000
20%
20%
20%
 Secondly, this method does not take into consideration any benefits which can accrue
to the firm from the sale or abandonment of equipment which is replaced by the
new investment. The `new' investment, from the point of view of correct financial
decision making, should be measured in terms of incremental cash outflows due to new
investments, that is, new investment minus sale proceeds of the existing equipment tax
adjustment. But the ARR method does not make any adjustment in this regard to
determine the level of average investments. Investments in fixed assets are determined at
their acquisition cost.
 No account is taken of project life.
 No account is taken of timing of cash flow (doesn‘t consider time value of money)
 It doesn‘t measure absolute gain.
For these reasons, the ARR leaves much to be desired as a method for project selection.
 PAY BACK METHOD
The payback method (PB) is the second traditional method of capital budgeting. It is the simplest
and, perhaps, the most widely employed, quantitative method for appraising capital expenditure
decisions. This method answers the question: How many years will it take for the cash benefits
to pay the original cost of an investment, normally disregarding salvage value? Cash benefits
here represent CFAT ignoring interest payment. Thus, the pay back method (PB) measures the
number of years required for the CFAT to pay back the original outlay required in an investment
proposal.
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Calculation of Pay-back Period:
Pay-back period can be calculated into the following two different situations:
(a) In the case of constant annual cash inflows.
This method can be applied when the cash flow stream is in the nature of annuity for each year
of the project's life, that is, CFAT are uniform. In such a situation, the initial cost of the
investment is divided by the constant annual cash flow:
Cash Outlay (Initial Investment)
Pay-Back Period =
Constant Annual Cash Inflow
Illustration No. 5
A project requires initial investment of Rs. 40,000 and it will generate an annual cash inflow
of Rs. 8,000 for 10 years. You are required to find out pay-back period.
Illustration No. 5 Solution
Pay-Back Period =
=
= 5 𝑦𝑦𝑒𝑒𝑎𝑎𝑟𝑟𝑠𝑠
Cash Outlay (Initial Investment)
Constant Annual Cash Flow
𝑅𝑅𝑠𝑠.40,000
𝑅𝑅𝑠𝑠 8,000
(b) In the case of Uneven or Unequal Cash Inflows:
The second method is used when a project's cash flows are not uniform (mixed stream) but vary
from year to year. In such a situation, Pay-Back is calculated by the process of cumulating cash
flows till the time when cumulative cash flows become equal to the original investment outlay.
Illustration No. 6
From the following information you are required to calculate pay-back period:
Year
Particular
Initial Investment
Cash Inflow During the Period
Machine A
Rs 56,125
Machine B
Rs 56,125
1
2
3
4
Rs 14,000
16,000
18,000
20,000
Rs 22,000
20,000
18,000
16,000
5
25,000
17,000
0
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Illustration No. 6- Solution
Calculation of Payback Period
Machine A
Year
Cumulative
CFAT
Annual CFAT
Machine B
Annual CFAT
Cumulative
CFAT
1
2
Rs 14,000
16,000
Rs 14,000
30,000
Rs 22,000
20,000
Rs 22,000
42,000
3
18,000
48,000
18,000
60,000
4
20,000
68,000
16,000
76,000
5
25,000
93,000
17,000
93,000
In case of Machine A
The above table shows that at the end of 4th years the cumulative cash inflows exceeds the
investment of Rs 56,125 Thus the pay-back period is as follows:
Pay-back Period = 3 +
56,125-48,000
20000
= 3.406 years.
In case of Machine B
At the end of 3rd years the cumulative cash inflows exceed the investment of Rs 56,125 Thus
the pay-back period is as follows:
Pay-back Period = 2 +
56,125 - 42,000
18000
= 2.785 years
Decision Rule:
One application of this technique is to compare the actual pay back with a predetermined pay
back, that is, the pay back set up by the management in terms of the maximum period during
which the initial investment must be recovered. If the actual payback period is less than the
predetermined pay back, the project would be accepted; if not, it would be rejected.
Alternatively, the pay back can be used as a ranking method. When mutually exclusive projects
are under consideration, they may be ranked according to the length of the payback period. Thus,
304 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
the project having the shortest pay back may be assigned rank one, followed in that order so that
the project with the longest pay back would be ranked last. Obviously, projects with shorter
payback period will be selected.
Advantage and Disadvantage of Payback Period:
Advantage of Payback Period
 It is easy to calculate and simple to understand.
 The pay back method is an improvement over the ARR approach. Its superiority arises
due to the fact that it is based on cash flow analysis.
 The length of payback period can also serve as an estimate of project risk. The longer
the payback period, the risker the project as long-term prediction are less reliable.
Disadvantage of Payback Period:
The pay back approach, however, suffers from serious limitations. Its major shortcomings are as
follows:
 The first major shortcoming of the pay back method is that it completely ignores all cash
inflows after the payback period. This can be very misleading in capital budgeting
evaluations.
 It ignores project profitability
 Ignores the cashflows after the payback period. Detail calculation is shown in below
table.
Calculation of Pay Back Period
Particulars
Project X
Project Y
Total cost of the Project
Cash inflows (CFAT)
Year 1
2
3
4
5
Rs 15,000
Rs 15,000
5,000
6,000
4,000
-
4,000
5,000
6,000
6,000
3,000
6
-
3,000
Payback period (Years)
3
3
In fact, the project differs widely in respect of cash inflows generated after the payback period.
The cash flow for project X stops at the end of the third year, while that of Y continues up to the
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sixth year, Obviously, the firm would prefer project Y because it makes available to the firm
cash inflows of Rs 12,000, in years 4 through 6, whereas project X does not yield any cash
inflow after the third year. Under the pay back method, however, both the projects would be
given equal ranking, which is apparently incorrect. Therefore, it cannot be regarded as a measure
of profitability. Its failure lies in the fact that it does not consider the total benefits accruing from
the project.
 In other words, to the extent the pay back method fails to consider the pattern of cash
inflows, it ignores the time value of money.
Below table shows that both the projects A and B have (i) the same cash outlays in the zero-time
period; (ii) the same total cash inflows of Rs 15,000; and (iii) the same payback period of 3
years. But project A would be acceptable to the firm because it returns cash earlier than project
B, enabling A to repay a loan or reinvest it and earn a return. A possible solution to this problem
is provided by determining the payback period of discounted cash flows. This is illustrated in the
subsequent section of this chapter.
Particular
Cash flows of Projects
Project A
Total cost of the project
Project B
Rs 15,000
Rs 15,000
Year 1
10,000
1,000
Year 2
4,000
4,000
Year 3
1,000
10,000
Cash inflows (CFAT)
 Another drawback of the pay back method is that it does not take into consideration the
entire life of the project during which cash flows are generated. As a result, projects
with large cash inflows in the latter span of their lives may be rejected. In favor of less
profitable projects which happen to generate a larger proportion of their cash inflows in
the earlier part of their lives. Table presents the comparison of two such projects. On the
basis of the pay back criterion, project A will be adjudged superior to project B.
Calculation of Payback Period
Project A
Project B
Total cost of the project
Rs 40,000
Rs 40,000
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Capital Investment Decision
Cash inflows (CFAT)
Years, 1
2
14,000
10,000
16,000
10,000
3
4
5
6
10,000
4,000
2,000
1,000
10,000
10,000
12,000
16,000
7
Nil
17,000
3
4
Payback period (years)
It is quite evident just from a casual inspection that project B is more profitable than project A,
since the cash inflows of the Project B amount to Rs 45,000 after the expiry of the payback
period and the cash flows of: the Project A beyond the payback period are only Rs 7,000.
Situations where the Pay Back Period Method is more appropriate.
The above weaknesses notwithstanding, the pay back method can be gainfully employed under
certain circumstances such as;
 In the first place, where the long-term outlook, say in excess of three years, is extremely
hazy, the pay back method may be useful. In a politically unstable country, for instance,
a quick return to recover the investment is the primary goal, and subsequent profits are
almost unexpected surprises.
 Likewise, this method be very appropriate for firms suffering from liquidity crisis. A
firm with limited liquid assets and no ability to raise additional funds, which
nevertheless wishes to undertake capital projects in the hope of easing the crisis, might
use pay back as a selection criterion because it emphasizes quick recovery of the firm's
original outlay and little impairment of the already critical liquidity situation.
 Thirdly, the payback method is beneficial in taking capital budgeting decisions which
lay more emphasis on short run earning performance rather than its long-term growth.
The payback period is a measure of liquidity of investments rather than their
profitability. Thus, the payback period should more appropriately be treated as a
constraint to be satisfied than as a profitability measure to be maximized."
 Finally, the payback period is useful, apart from measuring liquidity, in making
calculations in certain situations. For instance, the internal rate of return can be
computed easily from the payback period. The pay back method is a good
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approximation of the internal rate of return which otherwise requires a trial and error
approach.
To conclude the demerits of the traditional methods of appraising capital investment decisions,
there are two major drawbacks of these techniques. They do not consider the total benefits in
terms of
(i)
the magnitude and
(ii)
The timing of cash flows.
For these reasons, the traditional methods are unsatisfactory as capital budgeting decision
criteria. The two essential ingredients of a theoretically sound appraisal method, therefore, are
that (i) it should be based on a consideration of the total cash stream, and (ii) it should
consider the time value of money as reflected in both the magnitude and the timing of expected
cash flows in each period of a project's life. The time-adjusted (also known as discounted cash
flow) techniques satisfy these requirements and, to that extent, provide a more objective basis for
selecting and evaluating investment projects.
5.11.2.2 TIME ADJUSTED (TA) / DISCOUNTED CASHFLOW (DCF) TECHNIQUES
Discounted cash flow is a method of capital investment appraisal techniques which take into
consideration the time value of money while evaluating the costs and benefits of a project. In one
form or another, all these methods require cash flows to be discounted at a certain rate, that is,
the cost of capital. The cost of capital (K) is the minimum discount rate earned on a project that
leaves the market value unchanged.
The second commendable feature of these techniques is that they take into account all benefits
and costs occurring during the entire life of the project.
A.
DISCOUNTED PAY-BACK PERIOD
The present value or the discounted cash flow procedure recognizes that cash flow streams at
different time periods differ in value and can be compared only when they are expressed in terms
of a common denominator, that is, present values. It, thus, takes into account the time value of
money. In this method, all cash flows are expressed in terms of their present values.
Illustration No. 7
From the following information you are required to calculate Discounted Pay-back period:
Year
0
Particular
Initial Investment
Cash Inflow During the Period
308 |The Institute of Chartered Accountants of Nepal
Machine A
Rs 56,125
Machine B
Rs 56,125
Capital Investment Decision
1
2
3
4
Rs 14,000
16,000
18,000
20,000
Rs 22,000
20,000
18,000
16,000
5
25,000
17,000
Illustration No. 7- Solution
Calculations of Present Value of CFAT
Machine A
Ye
ar
Machine B
CFAT
PV
factor
(0.10)
Present
value
of
CFAT
Cumulative
PV of
CFAT
12,726
22,000
0.909
19,998
19,998
13,216
25,942
20,000
0.826
16,520
36,518
0.751
13,518
39,460
18,000
0.751
13,518
50,036
20,000
0.683
13,660
53,120
16,000
0.683
10,928
60,964
25,000
0.621
15,525
68,645
17,000
0.621
10,557
71,521
CFAT
PV
factor
(0.10)
Present
value of
CFAT
Cumulative
PV of CFAT
1
14,000
0.909
12,726
2
16,000
0.826
3
18,000
4
5
In case of Machine A
The above table shows that at the end of 4th years the cumulative cash inflows exceeds the
investment of Rs 56,125 Thus the pay-back period is as follows:
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃 − 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 4 +
= 4.2 years.
56,125 − 53,120
15,525
In case of Machine B
At the end of 3rd years the cumulative cash inflows exceed the investment of Rs 56,125 Thus
the pay-back period is as follows:
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃 − 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 3 +
56,125 − 50,036
10,928
= 3.55 years
The PV of CFAT now can be used to determine the `discounted' payback period. It is
determined on the basis of discounted present value of CFAT vis-a-vis unadjusted cash flows
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Financial Management
used in the `simple' pay back method. The relevant values of the `discounted' payback period
are 4.2 and 3.55 years for Machines A and B respectively
Solution:
B.
NET PRESENT VALUE (NPV) METHOD
The net present value technique is a discounted cash flow method that considers the time value
of money in evaluating capital investments. An investment has cash flows throughout its life,
and it is assumed that a rupee of cash flow in the early years of an investment is worth
more than a rupee of cash flow in a later year. The net present value method uses a specified
discount rate to bring all subsequent net cash inflows after the initial investment to their present
values (the time of the initial investment or year 0).
An organization may establish a minimum rate of return that all capital projects must meet; this
minimum could be based on an industry average or the cost of other investment opportunities.
Many organizations choose to use the cost of capital as the desired rate of return; the cost of
capital is the cost that an organization has incurred in raising funds or expects to incur in raising
the funds needed for an investment.
The overall cost of capital of a firm is a proportionate average of the costs of the various
components of the firm‘s financing. A firm obtains funds by issuing preferred or common stock;
borrowing money using various forms of debt such a notes, loans, or bonds; or retaining
earnings. The costs to the firm are the returns demanded by debt and equity investors through
which the firm raises the funds.
The net present value of a project is the amount, in current rupees, the investment earns after
yielding the desired rate of return in each period.
Net Present Value = Present Value of Net Cash Flow - Total Net Initial Investment.
It can be express as below,
𝑵𝑵𝑵𝑵𝑵𝑵 =
𝑪𝑪𝑪𝑪
𝑪𝑪𝑪𝑪
+
𝟏𝟏 + 𝑲𝑲
𝟏𝟏 + 𝒌𝒌
𝟐𝟐
+
Where,
C = Cash flow of various year (cash inflows)
k= Discount rate
n= Life of the project
I = investment (Cash outflows)
𝑪𝑪𝑪𝑪
𝟏𝟏 + 𝒌𝒌
𝟑𝟑
+ ⋯……….+
𝑪𝑪𝑪𝑪
𝟏𝟏 + 𝒌𝒌
𝒏𝒏
− 𝑰𝑰
Decision Rule
 If NPV is positive - the project is financially viable
 If the NPV is zero – the project breaks even
 If NPV is negative – the project is not financially viable
 If the company has two or more mutually exclusive projects under consideration it
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Capital Investment Decision
should use choose the one with highest NPV
 The NPV gives the impact of the project on shareholder wealth.
If the present value of cash inflows is more than the present value of cash outflows, it would be
accepted. If not, it would be rejected. (simply, if NPV is positive, then the project is accepted
otherwise project is rejected)
Assumptions on discounting
Unless the examiner tells you otherwise, the following assumptions are made about cash flows
when calculating the net present value;
 All cash flows occur at the start of year T0
 Initial investment occurs at T0
 Other cash flows start one year after that (T1)
Illustration No. 8
Compute the net present value for a project with a net investment of Rs. 1, 00,000 and the
following cash flows if the company‘s cost of capital is 10%? Net cash flows for year one is
Rs. 55,000; for year two is Rs. 80,000 and for year three is Rs. 15,000. [PVIF @ 10% for three
years is 0.909, 0.826 and 0.751]
Illustration No. 8- Solution
Calculation of Net Present Value
Year
Net Cash Flows
PVIF @ 10%
1
2
55,000
80,000
0.909
0.826
Discounted Cash
Flows
49,995
66,080
3
15,000
0.751
11,265
Total Discounted Cash Flows
Less: Net Investment
1,27,340
1,00,000
Net Present Value
27,340
Recommendation:Since the net present value of the project is positive, the company should
accept the project.
Illustration No. 9
ABC Ltd is a small company that is currently analyzing capital expenditure proposals for the
purchase of equipment; the company uses the net present value technique to evaluate projects.
The capital budget is limited to 500,000 which ABC Ltd believes is the maximum capital it
can raise. The initial investment and projected net cash flows for each project are shown
below. The cost of capital of ABC Ltd is 12%. You are required to compute the NPV of the
different projects.
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Project A
Project B
Project C
Project D
Initial Investment
Project Cash Inflows
Year
1
2
3
4
200,000
190,000
250,000
210,000
50,000
50,000
50,000
50,000
40,000
50,000
70,000
75,000
75,000
75,000
60,000
80,000
75,000
75,000
60,000
40,000
5
50,000
75,000
100,000
20,000
Illustration No. 9- Solution
Period
1
2
3
Calculation of net present value:
Present
value
Project A Project B
factor
0.893
44,650
35,720
0.797
39,850
39,850
0.712
35,600
49,840
4
5
Total Present value of cash
inflows
Less: Initial investment
0.636
0.567
Net present value
Project C
Project D
66,975
59,775
42,720
66,975
59,775
42,720
31,800
28,350
47,700
42,525
50,880
56,700
25,440
11,340
180,250
215,635
277,050
206,250
200,000
190,000
250,000
210,000
-19,750
25,635
27,050
-3,750
Evaluation of Net Present Value
The present value method including the NPV variation possesses several merits. The first, and
probably the most significant, advantage is that it explicitly recognizes the time value of
money.
 From the above illustration, total cash inflows (CFAT) pertaining to the two machines (A
and B) are equal. But the present value as well as the NPV is different. This is primarily
because of the differences in the pattern of the cash streams. The magnitude of CFAT in the
case of machine A is lower in the earlier years as compared to the machine B while it is
greater in the latter years. Because of larger inflows in the first two years, the NPV of
machine B is larger than that of machine A. The need for recognizing the time value of
money is, thus, satisfied by this method.
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Capital Investment Decision
 Secondly, it also fulfills the second attribute of a sound method of appraisal in that it
considers the total benefits arising out of the proposal over its lifetime.
 Thirdly, a changing discount rate can be built into the NPV calculations by altering the
denominator. This feature becomes important as this rate normally changes because the
longer the time span, the lower is the value of money and the higher is the discount rate.
 Fourthly, this method is particularly useful for the selection of mutually exclusive projects.
This aspect will be discussed in detail in the latter part of the chapter, where it is shown that
for mutually exclusive choice problems, the NPV method is the best decision-criterion.
 Finally, this method of asset selection is instrumental in achieving the objective of financial
management which is the maximization of the shareholders' wealth. The rationale behind
this contention is the effect on the market price of shares as a result of the acceptance of a
proposal having present value exceeding the initial outlay or, as a variation having NPV
greater than zero.
The market price of the shares will be affected by the relative force of what the investors expect
and what actual return is earned on the funds. The discount rate that is used to convert benefits
into present values is the minimum rate or the rate of interest is that when the present values of
cash inflows is equal to the initial outlay or when the NPV = 0, the return on investment just
equals the expected or required rate by investors.
There would, therefore, be no change in the market price of shares. When the present value
exceeds the outlay or the NPV > 0, the return would be higher than expected by the investors. It
would, therefore, lead to an increase in share prices. The present value method is, thus, logically
consistent with the goal of maximizing shareholders' wealth in terms of maximizing the market
price of the shares.
In brief, the present value method is a theoretically correct technique for the selection of
investment projects. Nevertheless, it has certain limitations also.
The second, and a more serious problem associated with the present value method, involves the
calculation of the required rate of return to discount the cash flows. The discount rate is the most
important element used in the calculation of the present values because different discount rates
will give different present values. The relative desirability of a proposal will change with a
change in the discount rate.
 Advantages and Disadvantages of using NPV
Advantages:
Theoretically, NPV method of investment appraisal is superior to all others. This is because;
 consider the time value of money
 it is based on cash flows not profit
 considers the whole life of the project
 should lead to maximization of shareholders wealth
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Chapter 5
Disadvantages:
 Difficult to calculate. To understand the meaning of NPV calculated requires an
understanding of discounting.
 It requires knowledge of cost of capital
Illustration No 10
For instance, for a proposal involving an initial outlay of Rs 9,000, having annuity of Rs
2,800 for 5 years, the net present values for different required rates of return are given below,
Net Present Value with Different Discount Rates
Discount rate (percent)
Net present Value
Zero
Rs 5,000.00
4
3,465.00
8
2,179.50
10
1,614.00
12
1,093.50
16
168.00
20
(626.50)
The importance of the discount rate is, thus, obvious. But the calculation of the required rate
of return presents serious problems. The cost of capital is generally the basis of the discount
rate. The calculation of the cost of capital is very complicated. In fact, there is a difference
of opinion even regarding the exact method of calculating it.
 Another shortcoming of the present value method is that it is an absolute measure.
Prima facie between two projects, this method will favor the project which has higher
present value (or NPV). But it is likely that this project may also involve a larger
initial outlay. Thus, in case of projects involving different outlays, the present value
method may not give dependable results.
 Finally, the present value method may also not give satisfactory results in the case of
two projects having different effective lives. In general, the project with a shorter
economic life would be preferable, other things being equal. A project which has a
higher present value may also have a larger economic life so that the funds will
remain invested for a longer period, while the alternative proposal may have shorter
life but smaller present value. In such situations,' the present value method may not
reflect the true worth of the alternative proposals.
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Capital Investment Decision
C.
INTERNAL RATE OF RETURN (IRR) METHOD
The third discounted cash flow (DCF) or time-adjusted method for appraising capital investment
decisions is the internal rate of return (IRR) method. This technique is also known as yield on
investment, marginal efficiency of capital, marginal productivity of capital, rate of return, and
time-adjusted rate of return and so on. Internal Rate of Return is the rate of interest at which
the present value of expected cash inflows from a project equals the present value of
expected cash outflows of the project.
The internal rate of return is usually the rate of return that a project earns. It is defined as the
discount rate (r) which equates the aggregate present value of the net cash inflows (CFAT) with
the aggregate present value of cash outflows of a project. In other words, it is that rate which
gives the project NPV of zero.
Decision Rule:
 Project should be accepted if the IRR is greater than Cost of capital
If IRR>Ko
Project is accepted
If IRR<Ko
Project is rejected
If IRR = Ko
Project is at break even
Computation of IRR
The procedure will depend on whether the cash flows are annuity or mixed stream.
a) In the case of constant annual cash inflows (Annuity).
The following steps are taken in determining IRR for an annuity.
 Determine the payback period of the proposed investment.
Cash outlay (or) initial investment
Payback period =
Cash inflow
 In the Table of Present Value of an Annuity Factor, find the two-present value of Annuity
Factor within which the payback period lies
 From the top row of the table, note interest rate (r) corresponding to these above Present
Values
 Determine actual IRR by interpolation. This can be done either directly or indirectly by
finding present values of annuity
𝐼𝐼𝐼𝐼𝐼𝐼 = 𝐿𝐿𝐿𝐿 +
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑎𝑎𝑎𝑎 𝐿𝐿𝐿𝐿 𝐿 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑎𝑎𝑎𝑎 𝐿𝐿𝐿𝐿 𝐿 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑎𝑎𝑎𝑎 ℎ𝑖𝑖𝑖𝑖ℎ𝑒𝑒𝑒𝑒 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
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NPV
NRS
IRR Calculated using interpolation
Discount rate
NPV True IRR
Illustration No. 11
A project costs Rs.36,000 and is expected to generate cash inflows of Rs.11,200 annually for 5
years. Calculate the IRR of the project.
Illustration No. 11- Solution
(1) The payback period
= Rs 36,000/Rs 11,200
= 3.214
(2) In the Table Present Value of An Annuity, discount factors closest to 3.214 for 5 years are
3.274 (16 per cent rate of interest) and 3.199 (17 per cent rate of interest). The actual value of
IRR which lies between 16 % and 17 % can, now, be determined using above Equations.
Substituting the values in Equation we get:
IRR =
16 +
3.274 - 3.214
3.272 -3.199
= 16.8%
In the case of Mixed Stream of Cash Flows.
In a mixed stream of cash flows, the inflows in various years are uneven or unequal. One way to
simplify the process is to use `fake annuity' as a starting point1'- The following procedure is a
useful guide to calculating IRR:
316 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
1.
Determine `fake payback period' as follow
Cash outlay (or) initial investment
Fake Payback period =
Average Annual Cash inflow
where, Average Annual Cash inflow = Total cash Inflow / Life of Project
2.
Look for the factor, in Present Value of Annuity Table, closest to the fake pay back
value in the same manner as in the case of annuity. The result will be a rough
approximation of the IRR, based on the assumption that the mixed stream is an annuity
(fake annuity).
Adjust subjectively the IRR obtained in step 3 by comparing the pattern of average
annual cash inflows to the actual mixed stream of cash flows. If the -actual cash flows
stream happens to be higher in the initial years of the project's life than the average
stream, adjust the IRR a few percentage points upward. The reason is obvious as the
greater recovery of funds in the earlier years is likely to give a higher yield rate (IRR).
Conversely, if in the early years the actual cash inflows are below the average, adjust the
IRR a few percentage points downward. If the average cash flows pattern seems fairly
close to the actual pattern, no adjustment is to be made.
Find out the present value of the mixed cash flows, taking the IRR as the discount rate
as estimated in step 4.
Calculate the PV, using the discount rate. If the PV of CFAT equals the initial outlay,
that is, NPV is zero, it is the IRR. Otherwise, repeat step 4. Stop, once two consecutive
discount rates that cause the NPV to be positive and negative, respectively have been
calculated. Whichever of these two rates causes the NPV to be closest to zero is the IRR
to the nearest 1 per cent.
The actual value can be ascertained by the method of interpolation as in the case of an
annuity.
3.
4.
5.
6.
𝐼𝐼𝐼𝐼𝐼𝐼 = 𝐿𝐿𝐿𝐿 +
Where, LR = Lower Rate
HR = Higher Rate
𝑁𝑁𝑁𝑁𝑁𝑁 𝑎𝑎𝑎𝑎 𝐿𝐿𝐿𝐿
∗ (𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻)
𝑁𝑁𝑁𝑁𝑁𝑁 𝑎𝑎𝑎𝑎 𝐿𝐿𝐿𝐿 𝐿 𝐿𝐿𝐿𝐿𝐿𝐿 𝑎𝑎𝑎𝑎 𝐻𝐻𝐻𝐻
Alternate methodology for IRR calculation
 Calculate the NPV at cost of capital
 If the cost NPV is positive, then increase the rate to higher side or vice versa
 Calculate two NPV for the project. There shall be positive NPV at lower rate and
negative NPV at higher rate.
 Use the formula to find the IRR.
Illustration No. 12
From the following information you are required to calculate Internal Rate of Return:
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Year
Particular
Machine A
Machine B
0
Initial Investment
Cash Inflow During the Period
Rs 56,125
Rs 56,125
1
2
Rs 14,000
16,000
Rs 22,000
20,000
3
18,000
18,000
4
20,000
16,000
5
25,000
17,000
Illustration No. 12 - Solution
Solution
1. Average Annual Cash inflow = Rs 93,000 / 5 years
= Rs 18,600
2.
Fake Payback period = Initial Outlay / Average Annual Cash Inflow
=Rs 56,125 / Rs 18,600
= 3.017 years.
In the Table Present Value of An Annuity, the factor closest to 3.017 for 5 years is 2.991
for a rate of 20 per cent.
Since the actual cash flows in the earlier years are greater than the average cash flows of
Rs 18,600 in machine B, a subjective increase of, say, 1 per cent is made. This makes an
estimated rate of IRR 21 per cent for machine B. In the case of machine, A, since cash
inflows in the initial years are smaller than the average cash flows, a subjective decrease
of, say, 2 per cent is made. This makes the estimated IRR rate 18 per cent for machine A.
Using the PV factors for 21 per cent (Machine B) and 18 per cent (Machine A) from
Present Value of Annuity Table for years 1-5, the PVs are calculated as below
3.
4.
5.
Calculation of Net Present Value
Year
1
2
3
4
CFAT
14,000
16,000
18,000
20,000
Machine
A
PV factor
(0.18)
0.847
0.718
0.609
0.516
318 |The Institute of Chartered Accountants of Nepal
Machine B
Total PV
CFAT
PV factor
(0.21)
Total PV
11,858
11,488
10,962
10,320
22,000
20,000
18,000
16,000
0.826
0.683
0.564
0.467
18,172
13,660
10,152
7,472
Capital Investment Decision
5
PV of cash inflows
25,000
0.437
10,925
55,553
17,000
0.386
6,562
56,018
Less initial outlay
56,125
56,125
Net present value
(572)
(107)
6. Since the NPV is negative for both the machines, the discount rate should be subsequently
lowered. In the case of machine, A, the difference is of Rs 572 whereas in machine B the
difference is Rs 107. Therefore, in the former case the discount rate is lowered by 1 per
cent in both the cases. As a result, the new discount rate would be 17 per cent for A and
20 per cent for B.
7. The calculations given below shows that the NPV at discount rate of 17 per cent is Rs.853
for machine A and Rs 1,049 for machine B at 20 per cent discount.
Calculation of Net Present Value
Machine
A
PV factor
(0.17)
Machine B
Total
PV
Year
CFAT
1
2
3
4
14,000
16,000
18,000
20,000
0.855
0.731
0.624
0.534
11,970
11,696
11,232
10,680
5
PV of cash inflows
Less initial outlay
25,000
0.456
11,400
56,978
56,125
Net present value
853
CFAT
22,00
0
20,00
0
18,00
0
16,00
0
17,00
0
PV factor
(0.20) PV
Total
0.833
0.694
0.579
0.484
18,326
13,880
10,422
7,744
0.442
7,514
57,886
56,125
1,761
(a) For Machine A:
Since 17 per cent and 18 per cent are consecutive discount rates that give positive and
negative net present values, interpolation method can be applied to find the actual IRR which
will be between 17 and 18 per cent.
IRR =
17 +
853
853-(-572)
X (18-17)
= 17.6%
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(b) For Machine B:
Since 20 % and 21% are consecutive discount rates that give positive and negative net present
values, interpolation method can be applied to find the actual IRR which will be between 20 %
and 21%.
IRR =
20 +
1761
1761-(-107)
X (21-20)
= 20.9%
Evaluation of IRR
 The IRR method is a theoretically correct technique to evaluate capital ' expenditure
decisions. It has the advantages which are offered by the NPV criterion such as: (i) it
considers the time value of money, and (ii) it takes into account the total cash inflows and
outflows.
 In addition, the IRR is easier to understand. Business executives and non-technical people
understand the concept of IRR much more readily than they understand the concept of NPV.
They may not be following the definition of IRR in terms of the equation, but they are well
aware of its usual meaning in terms of the Total PV rate of return on investment.
 For instance, business executives will understand the investment proposal in a better way if
told that IRR of machine B is 21 per cent and cost of capital is 10 per cent instead of saying
that the NPV of machine B is 15,396.
 Another merit of IRR is that it does not use the concept of the required rate of return/the cost
of capital. It itself provides a rate of return which is indicative of the profitability of the
proposal. The cost of capital of course, enters the calculations later on.
 Finally, it is consistent with the overall objective of maximizing shareholders' wealth.
According to as a decision-criterion, the acceptance or otherwise of a project is based on a
comparison of the IRR powered. In expected by the investors, the share prices will remain
unchanged. Since, with IRR, only such projects are accepted as have IRR > required rate,
the share prices will tend to rise. This will naturally lead to the maximization of
shareholders' wealth.
Limitation of Internal Rate of Return
This aspect also has been discussed in detail later in this chapter.
Under the IRR method, it is assumed that all intermediate cash flows are reinvested at the IRR.
In our example, the IRR rates for machines A and B are 17.6 per cent and 20.9 per cent
respectively. In operational terms, 17.6 per cent IRR signifies that all cash inflows of machine A
can be reinvested at 17.6 per cent whereas that of B at 20.9 per cent.
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Capital Investment Decision
Moreover, it is not safe to assume always that intermediate cash flows from the project will be
reinvested at all. A portion of cash inflows may be paid out as dividends. Likewise, a portion of
it may be tied up in current assets such as stocks, debtors or cash.
 Advantages and Disadvantages of IRR
Advantages:
a) Considers the time value of money
b) Is a relative measurement and therefore easily understood
c) Uses cash flow not profits
d) Considers the whole life of projects
e) Means a firm selecting projects where the IRR exceeds the cost of capital should
increase shareholder‘s wealth.
Disadvantages:
a) It involves tedious calculations. As shown above, it generally involves complicated
problems.
b) It produces multiple rates which can be confusing. This aspect is further developed
later in this chapter.
c) In evaluating mutually exclusive proposals, the project with the highest IRR would be
picked up to the exclusion of all others. However, in practice, it may not turn out to be
the one which is the most.
d) Non- conventional cash flows may give rise to multiple IRRs which means the
interpolation method can‘t be used.
Interpretation- Multiple IRR
Non- conventional cash flows may give rise to no IRR or multiple IRRs. For example, a
project with an outflow at T0 and T2 but income at T0 could depending on the size of the
cash flows.
Non-conventional cash flows showing multiple IRR
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Difference between NPV and IRR
Basis for Comparison
Expressed in
NPV
The total of all the present
values of cash flows (both
positive and negative) of a
project is known as Net
Present Value or NPV.
Absolute terms
What it represents?
Surplus from the project
Decision Making
It makes decision making
easy.
Percentage terms
Point of no profit no loss
(Breakeven point)
It does not help in decision
making
Cost of capital rate
Internal rate of return
Will not affect NPV
Will show
multiple IRR
Meaning
Rate for reinvestment of
intermediate cash flows
Variation in the cash
outflow timing
D.
IRR
IRR is described as a rate at
which the sum of discounted
cash
inflows
equates
discounted cash outflows.
negative
or
MODIFIED INTRNAL RATE OF RETURN
Despite NPV's conceptual superiority, managers seem to prefer IRR over NPV because IRR is
intuitively more appealing as it is a percentage measure. The modified IRR or MIRR overcomes
the shortcomings of the regular IRR. It represents the rate of return that equates the present value
of a project‘s cash outflows with the present value of its cash inflows, which are stated in terms
of rupee at the end of the project‘s life. MIRR is computed as follows,
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 =
1 + 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑛𝑛
(The details of computation of terminal value has been discussed in point number E)
Comparison between IRR and MIRR
Basis for
Comparison
IRR
MIRR
Meaning
IRR is the discount amount for
investment that corresponds between
initial capital outlay and the present
value of predicted cash flows.
MIRR is the price in the
investment plan that equalizes
the latest value of cash inflow to
the first cash outflow.
What is it?
Net Present Value is equivalent to zero
Net Present Value is equivalent
to the outflow.
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Capital Investment Decision
Prediction
Project cash flows are reinvested at the
project's own IRR
Project cash flows are reinvested
at the cost of capital.
Precision
Low
Comparatively high
Multiple IRR
Multiple IRR may be arisen.
The problem of multiple rates
does not exist with MIRR.
Thus, MIRR is a distinct improvement over the regular IRR but following matter need to be
taken into consideration:
i.
If the mutually exclusive projects are of the same size, NPV and MIRR lead to the same
decision irrespective of variations in life.
ii.
If the mutually exclusive projects differ in size, there may be a possibility of conflict
between NPV and IRR. MIRR is better than the regular IRR in measuring true rate of
return. However, for choosing among mutually exclusive projects of different size, NPV
is a better alternative in measuring the contribution of each project to the value of the
firm
Illustration No. 13
Cash flow of the two projects are given below
Cash Flows
Year
Project A
Project B
0
-7,000
-8,000
1
2,000
6,000
2
1,000
3,000
3
5,000
1,000
4
3,000
500
Calculate the modified rate of Return if cost of capital is 15%
Illustration No. 13- Solution
Solution
Calculation of Modified rate of return on Project A
7,000 =
2000(1.15)3 + 1000(1.15)2 + 5000(1.15)1 + 3000(1.15)0
(1+MIRRA)
7,000=
13,114.25
(1+MIRRA)
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MIRRA = 16.99
Calculation of Modified rate of return on Project B
8,000 =
6000(1.15)3 + 3000(1.15)2 + 1000(1.15)1 + 500(1.15)0
(1+MIRRB)
8,000=
14,742.75
(1+MIRRB)
MIRRB= 16.51
E.
TERMINAL VALUE METHOD
The terminal value method is an improvement over the net present value method of making
capital investment decisions. Under this method, it is assumed that each of the future cash flows
is immediately reinvested in another project at a certain (hurdle) rate of return until the
termination of the project. In other words, the net cash flows and outlays are compounded
forward rather than discounting them backward as followed in net present value (NPV) method
Accept-reject Criteria:
In case of a single project, the project is accepted if the present value of the total of the
compounded reinvested cash inflows is greater than the present value of the outlays, otherwise it
is rejected. In case of mutually exclusive projects, the project with higher present value of the
total of the compounded cash flows is accepted.
PVTS > PVO = Accept the Project
PVTS < PVO = Reject the Project
The firm would be indifferent if both the values are equal.
Illustration No. 14
Original outlay: Rs 10,000
Life of the project:
5 years
Cash inflows:
Rs 4,000 each for 5 years
Cost of capital (k):
10 per cent
Expected interest rates at which cash inflows will be reinvested:
Year-end
Per cent
1
2
6
6
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Capital Investment Decision
3
4
5
8
8
8
Illustration No. 14- Solution
We would reinvest Rs 4,000 received at the end of the year 1 for 4 years at the rate of 6 per
cent. The cash inflows in year 2 will be re-invested for 3 years at 6 per cent, the cash inflows
of year 3 for 2 years and so on. There will be no reinvestment of cash inflows received at the
end of the fifth year. The total sum of these compounded cash inflows is then discounted back
for 5 years at 10 per cent and compared with the present value of the cash outlays, that is, Rs
10,000 (in this case).
Calculation of Present Value of Terminal Sum
1
2
3
4
Rs 4,000
4,000
4,000
4,000
6
6
8
8
4
3
2
1
1.262
1.191
1.166
1.08
Total
compounded
sum
Rs 5,048
4,764
4,664
4,320
5
4,000
8
0
1
4,000
Year
Cash inflows
Rate of
interest
Years for
investment
Compounding
factor
Total Present Value of Terminal Sum
22,796
Now, we have to find out the present value of Rs 22,796. The discount rate would be the cost
of capital, k (0.10). The sum of Rs.22,796 would be received at the end of year 5. Its present
value = Rs 22,796 x 0.621 = Rs 14,156.3.
Thus, since the PVTS of Rs 14,156.3.1 exceeds the original outlay of Rs 10,000, we would
accept the assumed project under the TV criterion.
A variation of the terminal value method (TV) is the net terminal value (NTV). Symbolically
it can be represented as NTV = (PVTS - PVO). If the NTV is positive, accept the project, if
the NTV is negative, reject the project. In the above example, the NTV is positive. Its value is
Rs 4,156.31. Therefore, the project is acceptable.
The NTV method is similar to NPV method, with the difference that while in the former,
values are compounded, in the latter, they are discounted. Both the methods will give the same
results provided of course the same figures have been discounted as have been compounded
and the same interest rate (rates) is used for both discounting and compounding.
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Financial Management
Chapter 5
Knowledge Test 2
The following information relates to the project:
Initial Outlay
NRs 20,000
Life of the project
4 years
Cash inflows
NRs 10,000 pa
Cost of capital
12%
Expected interest or hurdle rate at which inflows
will be reinvested after end of year:
1
7%
2
7%
3
9%
4
9%
You are required to analyze the feasibility of the project using terminal value method.
Advantages of Net Terminal Value (or TV) method
i. These methods explicitly incorporate the assumption about how the cash inflows are
reinvested once they are received and avoid any influence of the cost of capital on the cash
inflow stream itself.
ii. It is mathematically easier, making simple the process of evaluating the investment worth
of alternative capital projects.
iii. This method would be easier to understand for business executives who are not trained in
accountancy or economics than NPV for IRR, as the `compounding technique', appeals
more than `discounting'.
iv. It is better suited to cash budgeting requirements. The NPV computation despite being a
cash flow approach does not explicitly show all the cash inflows. It does not consider cash
inflows in respect of interest earnings.
Disadvantages:
i.
The major practical problem of this method lies in projecting the future rates of interest at
which the intermediate cash inflows received will be reinvested.
F.
PROFITABILITY INDEX (PI) OR BENEFIT-COST RATIO (B/C RATIO)
The Profitability Index (PI) measures the ratio between the present value of future cash flows
and the initial investment. The index is a useful tool for ranking investment projects and
measures the present value of returns per rupee invested. The Profitability Index is also known as
the Profit Investment Ratio (PIR) or the Value Investment Ratio (VIR).
A major shortcoming of the NPV method is that, being an absolute measure, it is not a reliable
method to evaluate projects requiring different initial investments. The PI method provides a
solution to this kind of problem. It is, in other words, a relative measure. It may be defined as the
326 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
ratio which is obtained by dividing the present value of future cash inflows by the present value
of cash outlays.
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 =
Or,
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 =
Accept-Reject Criteria
When PI=1
When PI>1
When PI<1
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
𝑁𝑁𝑁𝑁𝑁𝑁 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 + 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
Indifferent to the project
Project is accepted
Project is rejected
The higher the profitability index, the more attractive the investment.
Illustration No. 15
Company A Consider two projects. Project A requires an initial investment of NRs 1,500,000
and project B requires an initial investment of NRs 3,000,000. Cost of capital of Project A is
10% and appropriate cost of capital for project B is 13%.
Year
1
2
3
4
5
6
7
Cash inflow Project A
150,000
300,000
500,000
200,000
600,000
500,000
100,000
Cash Inflow Project B
100,000
500,000
1,000,000
1,500,000
200,000
500,000
1,000,000
Using the profitability index method, which project should the company undertake?
Illustration No. 15- Solution
Calculation of present value of cash inflow of both the project
Year
Cash
inflow
Discounting
factor
@
Present Value
of
Cash
Cash
Inflow
Discounting
factor
@
Present
Value of
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Chapter 5
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1
2
3
4
5
6
7
Project
A
150,000
300,000
500,000
200,000
600,000
500,000
100,000
10%
0.909
0.826
0.751
0.683
0.621
0.564
0.513
inflows
136,363.64
247,933.88
375,657.40
136,602.69
372,552.79
282,236.97
51,315.81
Project B
100,000
500,000
1,000,000
1,500,000
200,000
500,000
1,000,000
10%
0.885
0.783
0.693
0.613
0.543
0.480
0.425
1,602,663.18
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑓𝑓𝑓𝑓𝑓𝑓 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐴𝐴 =
Cash
inflows
88,495.58
391,573.34
693,050.16
919,978.09
108,551.99
240,159.26
425,060.64
2,866,869.
07
1,602,663.18
= 1.068
1,500,000
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑓𝑓𝑓𝑓𝑓𝑓 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐵𝐵 =
2,866,869.07
= 0.96
3,000,000
Since the PI for project A is greater than 1, project A is accepted.
Though it is common to define PI as the ratio of the PV of the cash inflows divided by the PV
of cash outflows, the PI may also be measured on the basis of the net benefits of a project
against its current cash outlay rather than measure its gross benefits against its total cost over
the life of the project. This aspect becomes very important in situations of capital rationing. In
such a situation, the decision rule would be to accept the project if the PI is positive and reject
the project if it is negative.
Summary of decision criteria of capital Budgeting decision:
Techniques
NonDiscounted
Pay Back
For Independent Project
(i)
When Payback period ≤
Maximum Acceptable Payback
period: Accepted
328 |The Institute of Chartered Accountants of Nepal
For
Mutually
Exclusive
Projects
Project with least
Payback period
should be selected
Capital Investment Decision
(ii)
When Payback period ≥
Maximum Acceptable Payback
period: Rejected
Accounting
Rate of Return
(ARR)
(i) When ARR≥ Minimum
acceptable rate of return: Accepted
Project with the
maximum ARR
should be selected
(ii) When ARR ≤ Minimum
Acceptable Rate of Return: Rejected
Net Present
Value (NPV)
(i) When NPV > 0: Accepted
(ii) When NPV < 0: Rejected
(i) When PI > 1: Accepted
Discounted
Profitability
Index (PI)
Internal Rate
of Return
(IRR)
(ii) When PI<1: Rejected
(i)
When IRR >K: Accepted
(ii) When IRR <K: Rejected
Project with the
highest positive
NPV should be
selected
When Net Present
Value is same
project with Highest
PI should be
selected
Project with the
maximum IRR
should be selected
Where, K denoted as cost of capital.
5.12 Evaluation of Time Adjusted Methods of Appraising Investment Proposal
The discussions in the preceding sections have explained the various time-adjusted methods of
appraising investment projects. We now propose to present a comparative view of these
methods. First, the two widely used methods-NPV and IRR-are compared to evaluate their
relative suitability. We subsequently compare NPV with PI.
i. Comparison between NPV and IRR Methods
The NPV and IRR methods are similar in certain respects. For instance, in certain situations,
they would give the same accept-reject decision. But they also differ in the sense that the results
regarding the choice of an asset are under certain circumstances mutually contradictory. The
comparison of these methods, therefore, involves a discussion of (i) the similarities between the
methods, and (ii) their differences, as also the factors which are likely to cause differences.
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Same Decisions of NPVand IRR Methods: Independent Project
 Both the net present value and the internal rate of return methods are discounted cash
flow methods which mean that they consider the time value of money.
 Both the techniques consider all cash flows over the expected useful life of the
investment.
 Independent investment proposals which do not compete with one another and which
may be either accepted or rejected based on a minimum required rate of return. Under
these circumstances, both methods gave same results.
 Under Conventional investment proposals (which involve cash outflows or outlays in
the initial period followed by a series of cash inflows),both methods gave same results
under these circumstances.
Conflicting Decision of NPV and IRR Methods: Mutually Exclusive Project
Thus, in the case of independent conventional investments, the NPV and IRR methods will give
concurrent results. However, in certain situations they will give contradictory results such that if
the NPV method finds one proposal acceptable, IRR favors another. This is so in the case of
mutually exclusive investment projects. The mutual exclusiveness of the investment projects
may be of two types:
i.
ii.
Technical exclusiveness: The term technical exclusiveness refers to alternatives having
different profitability and the selection of that alternative which is the most profitable.
Thus, in the case of a purchase or lease decision the more profitable out of the two will
be selected
Financial exclusiveness. If there are resource constraints, a firm will be forced to select
that project which is the most profitable rather than accept all projects which exceed a
minimum acceptable level. The exclusiveness due to limited funds is popularly known
as capital rationing.
The different ranking given by the NPV and IRR methods can be illustrated under the following
heads:
a. Size-Disparity Problem
This arises when the initial investment in projects under consideration, that is, mutually
exclusive projects, is different. The cash outlay of some projects is larger than that of others. In
such a situation, the NPV and IRR will give a different ranking.
Illustration No. 16
Another condition under contradictory ranking to the projects under NPV and IRR, is when
the cash outlays are of different sizes.
330 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
Project
Cash flows
NPV @ 10%
IRR of
project
C0
C1
A
-1,000
1500
364
50%
B
-1,00,000
120,000
9091
20%
A-B
-99,000
118,500
8727
19.7%
the
As the IRR gives ambiguous results, NPV of project-B is high, it should be accepted. The
same results will be obtained if we calculate the IRR on the incremental investment. The
incremental investment of Rs. 99,000 will generate cash inflow of Rs. 1,18,500 after a year.
Thus, the return on the incremental investment Is 19.7%, which is in excess of the 10%
required rate of return. We should Therefore prefer project-B to project-A.
This recommendation is consistent with the goal of the firm of maximizing shareholders' wealth.
When faced with mutually exclusive projects, each having a positive NPV, the one with the
largest NPV will have the most beneficial effect on shareholders wealth. Since the selection
criterion under the NPV method is to pick up the project with the largest NPV, the NPV is the
best operational criterion. As long as the firm accepts the mutually exclusive investment
proposal with the largest NPV, it will be acting consistently with the goal of maximizing
shareholders' wealth. This is because the project with the largest NPV will cause the share price
and shareholders' wealth to increase more than any of the other projects.
Incremental Approach
The conflict between the NPV and IRR in the above situation can be resolved by modifying the
IRR so that it is based on incremental analysis. According to the incremental approach, when the
IRR of two mutually exclusive projects whose initial outlays are different exceeds the required
rate of return, the IRR of the incremental outlay of the project requiring a bigger initial
investment should be calculated. This involves the following steps:
i. Find out the differential cash flows between the two proposals.
ii. Calculate the IRR of the incremental cash flows.
iii. If the IRR of the differential cash flows exceeds the required rate of return, the project having
greater investment outlays should be selected, otherwise it should be rejected.
The logic behind the incremental approach is that the firm would get the profits promised by the
project involving smaller outlay plus a profit on the incremental outlay. In general, projects
requiring larger outlay would be more profitable if IRR on differential cash outlays exceeds the
required rate or return. The modified IRR for mutually exclusive proposals involving sizedisparity problem would provide an accept-reject decision identical to that given by the NPV
method.
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Illustration No. 17
Project
M
N
C0
(1,680)
(1,680)
Cash flows
C1
C2
1400
700
140
840
Incremental Approach
Project
Cash flows
C0
C1
C2
M-N
0
-1260
140
@
C3
140
1510
NPV
9%
301
321
IRR of the
project
23%
17%
@
C3
1370
NPV
9%
20
IRR of the
project
10%
Project N is better than M despite its lower IRR because it offers all benefits that project M
offers plus the opportunity of an incremental investment at 10% a rate higher than the required
rate of return of 9%. It may be noticed that the NPV of the incremental flows is the difference
of the NPV of the project N over that of project M; this is so because of the value additively
principle. The incremental approach is a satisfactory way of salvaging the IRR rule. But the
series of incremental cash flows may result in negative and positive cash flows. This would
result in multiple rates of return and ultimately the NPV method will have to be used.
b. Time-disparity Problem
The mutually exclusive proposals may differ on the basis of the pattern of cash flows generated,
although their initial investments may be the same. This may be called the time-disparity
problem. The time-disparity problem may be defined as the conflict in ranking of proposals by
the NPV and IRR methods which have different patterns of cash inflows. In such a situation, like
the size-disparity problem, the NPV method would give results superior to the IRR method.
Illustration No. 18
The most commonly found condition for the conflict between the NPV and IRR methods is
the difference in the timing of cash flows. Let us consider the following two Projects, M and
N.
Project
M
N
C0
(1,680)
(1,680)
C1
1400
140
Cash flows
C2
700
840
332 |The Institute of Chartered Accountants of Nepal
C3
140
1510
NPV
9%
301
321
@
IRR of the
project
23%
17%
Capital Investment Decision
Which project should we choose between projects M and N? Both projects generate positive
NPV at 9% cost of capital. Therefore, both are profitable. But project N is better since it has a
higher NPV. The IRR rule indicates that we should choose project N, as it has higher IRR. If
we choose project-N following the NPV rule, we shall be richer by an additional value of Rs
20. Should we have the satisfaction of earning a higher rate of return, or should we like to be
richer? The NPV rule is consistent with the objective of maximizing wealth. When we have to
choose between mutually exclusive projects, the easiest procedure is to compare the NPVs of
the projects and choose the one with the larger NPV.
Under the time-disparity problem it is the cost of capital which will determine the ranking of
projects. Both the methods give identical prescription. But it does not imply that the IRR is
superior to the NPV method, as the NPV is giving the same ranking as the IRR. In the event of
conflicting rankings, the firm should rely on the rankings given by the NPV method.
c.
Projects with Unequal Lives
Difference in the life spans of two mutually exclusive projects can also give rise to the conflict
between the NPV and IRR rules. To illustrate, let us consider two mutually exclusive projects X
and Y of significantly different expected lives.
Illustration No. 19
Project
Cash flows
C0
X
-10,000
Y
-10,000
NPV @
10%
C1
C2
C3
C4
C5
12,000.00
-
-
-
-
909.00
-
-
-
-
20,120.00
2,493.00
IRR of
the
project
20%
15%
Thus, two methods rank the projects differently. The NPV rule can be used to choose
between the projects since it is always consistent with the wealth Maximization principle.
Thus, project-Y should be preferred since it has higher NPV. However, in case of
mutually exclusive Projects havingunequal lives, ‗Annualized NPV‘criterion should be
used and the project having higher Annualized NPV(based on Cash Inflows) or lower
Annualized NPV(based on Cash Outflows) should be selected. Annualized NPV can be
calculated by NPV divided by cumulative present value of rupee per annum @cost of
capital for the project or Present value of annuity @cost of capital and no. of years.
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The conflict in the ranking by the two methods in such cases may be resolved by adopting a
modified procedure i.e.
i. Replacement Chain (Common Life) Method
ii. Equivalent annual value/cost approach.
i.
Replacement Chain (Common Life) Method or Time Horizon Approach
According to this approach, in order to have valid comparisons between the projects, they
must be compared over the same period. The comparison may, thus, extend over multiples
of the lives of each project. Thus, if the service life of one project is 3 years and of another
4 years, the comparison must be over a 12-year period with replacements occurring for
each project
Illustration No. 20
Project A
Initial outlay
Cash inflows after taxes
1
Project B
Rs 10,000
Rs 20,000
8,000
8,000
7,000
Nil
Nil
2
9,000
7,000
6,000
4
10%
10%
2
3
4
Service life (years)
Required rate of return
Illustration No. 20- Solution
Project A
Year
Cash flows
PV factor
Total present Value
0
1
Rs 10,000
8,000
1.000
0.909
(Rs 10,000)
7,272
2
7,000
0.826
5,782
0.826
0.751
0.683
(8,260)
6,008
4,781
5583
3
3
4
NPV
(10,000)
8,000
7,000
a
334 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
Project B
Year
0
1
2
3
Cash flows
Rs 20,000
8,000
9,000
7,000
PV factor
1.000
0.909
0.826
0.751
Total present value
Rs 20,000
7,272
7,434
5,257
4
6,000
0.683
4,098
Net present value
4,061
Decision
Project A should be preferred to project B because of its larger NPV. If we had compared the
two projects without incorporating the consequences of replacing the machine at the end of
year 2, the decision would have been the reverse, because the net present value of project A
then would be Rs 3,054 [Rs 7,272 + Rs 5,782 - Rs 10,000].
The implicit assumption of this approach is that the investment which is being replaced will
produce cash flows of a similar pattern in future as it has done in the past.
ii. Equivalent Annual Value Approach
According to this method, equivalent annual value/cost of all mutually exclusive investment
projects under consideration is determined. The equivalent annual net present value (EAB) is
determined by dividing the NPV of cash flows of the project by the annuity factor
corresponding to the life of the project at the given cost of capital. The decision criterion, in
the case of revenue-expanding proposals, is the maximization of EAB and minimization of
cost (EAC) in the case of cost-reduction proposals.
Equivalent Annual Benefit
The equivalent annual benefit (EAB) is the annual annuity with the same value as the net
present value of an investment project.
It can be calculated using as similar formula to that used for the equivalent annual cost:
𝑬𝑬𝑬𝑬𝑬𝑬 =
𝑵𝑵𝑵𝑵𝑵𝑵 𝒐𝒐𝒐𝒐 𝒕𝒕𝒕𝒕𝒕𝒕 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷
𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭
Calculating the EAB is particularly useful when trying to compare projects with unequal lives.
The project with the highest EAB would be preferred.
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Equivalent Annual Cost
𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 =
𝑷𝑷𝑷𝑷 𝒐𝒐𝒐𝒐 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄
𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭
Illustration No. 21
A firm is considering buying one of the following two mutually exclusive investment projects:
Project A: Buy a machine that requires an initial investment outlay of Rs 1,00,000 and will
generate the CFAT of Rs 30,000 per year for 5 years.
Project B: Buy a machine that requires an initial investment outlay of Rs 1,25,000 and will
generate the CFAT of Rs 27,000 per year for 8 years.
Which project should be undertaken by the firm? Assume 10 per cent as cost of capital.
Illustration No. 21- Solution
Solution
Determination of NPV of project A and B
Project
Years
CFAT
PV factor (0.10)
Total PV
NPV
A
1-5
Rs 30,000
3.791
Rs1,13,730
Rs 13,730
B
1-8
27,000
5.335
1,44,045
19,045
Equivalent Annual Net Present Value EAB
𝑁𝑁𝑁𝑁𝑁𝑁 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝑡𝑡ℎ𝑒𝑒 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
=
PV of Annuity corresponding to life of the Project at given cost of Capital
𝐸𝐸𝐸𝐸𝐸𝐸 𝐴𝐴 =
𝐸𝐸𝐸𝐸𝐸𝐸 𝐵𝐵 =
𝑁𝑁𝑁𝑁𝑁𝑁 13,730
= 𝑁𝑁𝑁𝑁𝑁𝑁 3,621.74
3.791
𝑁𝑁𝑁𝑁𝑁𝑁 19,045
= 𝑁𝑁𝑁𝑁𝑁𝑁 3,569.82
5.335
On the basis of NPV criterion, Project B is preferred. However, on the basis of EAB, project A
becomes more desirable with higher EAB. In fact, acceptance of project A would be a right
decision.
Knowledge Test 3
A firm is considering installing a large stamping machine. Two machines currently being
336 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
marketed will do the job satisfactorily. Machine A costs Rs 50,000 and will require cash
running expenses of Rs 15,000 per year. It has a useful life of 6 years and is expected to yield
Rs 2,000 salvage value at the end of its useful life. Machine B costs Rs 65,000 but cash
running expenses are expected to be Rs 12,000. This machine is expected to have a useful life
of 10 years with salvage value of Rs 5,000. Assume both the machines would be depreciated
on straight line basis for tax purposes.
If the corporate tax rate is 35 per cent and cost of capital is 10 per cent, which machine should
be selected:
5.13 Reinvestment Rate Assumption
The preceding discussions have revealed that in the case of mutually exclusive projects, the NPV
and IRR methods would rank projects differently, where
(a) the projects have different cash outlays initially,
(b) the pattern of cash inflows is different, and
(c) the service lives of the projects are unequal.
It has also been found that the ranking given by the NPV method in such cases is theoretically
more correct. The conflict between these two methods is mainly due to different assumptions
with regard to the reinvestment rate on funds released from the proposal.
The assumption underlying the IRR method seems to be incorrect and deficient. The IRR
criterion implicitly assumes that the cash flow generated by the projects will be reinvested at the
internal rate of return, that is, the same rate as the proposal itself offers. With the NPV method,
the assumption is that the funds released can be reinvested at a rate equal to the cost of capital,
that is, the required rate of return.
The crucial factor is which assumption is correct? The assumption of the NPV method is
considered to be superior theoretically because it has the virtue of having a rate which can
consistently be applied to all investment proposals. Moreover, the rate of return (k) represents an
opportunity rate of investment. In contrast to the NPV method, the IRR method assumes a high
reinvestment rate for investment proposals having a high IRR and a low investment rate for
investment proposals having a low IRR. The implicit reinvestment rate will differ depending
upon the cash flow stream for each investment proposal.
Obviously, under the IRR method, there can be as many rates of reinvestment as there are
investment proposals to be evaluated unless some investment proposals turn out to have an IRR
which is equal to that of some other project(s).
The superficiality of the reinvestment rate under the IRR method can be demonstrated by
comparing the following two investment projects.
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Illustration No. 22
Project
Initial investment
A
B
Rs 100
100
Cash inflows
Year 1
Year 2
Rs 200
Rs 400
Under the IRR method, both projects have a rate of return of 100 per cent. If Rs 100 were
invested for one year at 100 per cent, it would grow to Rs 200, and if invested for two years, to
Rs 400. Since both the projects have the same IRR, the firm should be indifferent regarding
their acceptability, if only one of two projects are to be picked up as both the projects are
equally profitable. For this to be true, it is necessary that Rs 200 received at the end of year 1
in case of project A should be equal to Rs 400 at the end of year 2. In order to achieve this, it
necessarily follows that the firm must be able to reinvest the first year's earnings at 100 per
cent. If not, it would be unable to transform Rs 200 at the end of the first year into Rs 400 at
the end of the second. And if it cannot transform Rs 200 into Rs 400 in a year's time, the two
projects A and B cannot be ranked equal. There is no reason to believe that a firm can find
other investment opportunities at precisely the required rate.
In contrast, the present value method does not pose any problem. Let us calculate the present
value of above example, assuming cost of capital (k) as 10 per cent.
Year
1
2
Project A
Project B
Cashflows PV factor Total PV
Cashflows
Rs 200
0
0
Rs 400
0.909
-
Less initial outlay
Rs 181.80
—
181.80
100.00
Net present value
81.80
PV factor
—
0.826
Total PV
—
330.40
330.40
330.40
100.00
230.40
The PV method indicates that project B is preferable to project A as its net present value is
greater. The reinvestment rate in the PV method seems more realistic and reasonable. It
assumes that earnings are reinvested at the same rate as the market cost of capital.
However, the IRR can be modified assuming the cost of capital to be the reinvestment rate.
The intermediate cash inflows will be compounded by using the cost of capital. The
compounded sum so arrived at and the initial cost outflows can be used as the basis of
determining the IRR. The limitation of IRR arising out of the inconsistency in the
reinvestment rate assumption can be obviated through the modified approach.
Thus, the assumption regarding the reinvestment rate of the cash inflows generated at the
intermediate stage is theoretically more correct in the case of NPV as compared to the IRR.
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Capital Investment Decision
This is mainly because the rate is a consistent figure for the NPV, but it can widely vary for
the IRR according to the cash flow pattens.
 Computational Problems
Apart from inconsistency in the application of the reinvestment rate, the IRR method also suffers
from computational problems. These may be discussed with reference to two aspects.
i. Computation in conventional cash flows
It has been shown while computing the IRR that the calculation of the IRR involves a trial-anderror procedure as a result of which complicated computation has to be done. In conventional
proposals having a constant cash inflow stream (i.e. annuity) the computation, is not so tedious.
But when the cash inflows are unequal over the years, laborious calculations are involved. The
calculation of the NPV, on the other hand, is relatively simple and presents no special problems.
ii. Computationin non-conventional flows
The problem of computation of IRR gets accentuated when cash flow patterns are nonconventional. The complications in such cases are (a) that the IRR is indeterminate, and (b) there
may be multiple IRRs.
a. Indeterminate IRR
For the following pattern of cash flows of an investment proposal, the IRR cannot be
determined.
Example 19
CO0
= Rs 1
CFAT1 = 2
CO2
= 2
Where subscripts 0, 1, 2 refer to respective time periods, CFAT = cash inflows, CO = cash
outflows
The required equation to solve the IRR is:
2
1+ 1+r 2 =
2
1+r
Which leads to r2 = -1
Clearly, the value of IRR is indeterminate. On the other hand, the NPV of this project, given k as
10 per cent, can be easily ascertained. This would be negative (Rs -0.834), as shown below:
Year
0
Cash flows
Rs (1)
PV factor
1.000
Total present value
Rs 1.000
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Financial Management
1
2
+2
(2)
0.909
0.826
1.818
(1.652)
(0.834)
b. Multiple Rates of IRR
Another serious computational deficiency of IRR method is that it can yield multiple internal
rates of return.
Example 20
Initial cost
Year 0
(Rs 20,000)
Net cash flow
1
90,000
Net cash flow
2
(80,000)
The required equation is: Rs. 20,000=
90,000
1+r
=
Rs .80,000
1+r
2
9
Let (1+r) be = x and divide both sides of equation by Rs 10,000, 2= X
8
X2
=0
Multiplying by X2, we can transform the equation into the quadratic form.
2X2 – 9X + 8 = 0
Such an equation with a variable to the second power has 2 roots which can be identified as:
X=
Where
−b± b 2 −4ac
2a
a= coefficient of the variable raised to the second power
b= coefficient of the variable raised to the first power
c = constant or coefficient of the variable raised to the zero power
Substituting the values for a, b, and c into the quadratic formula produces value for X of 1.21.
Since X= (1 + r), the internal rates for this project are 21.9 and 228 per cent.
Thus, the project yields a dual IRR. This kind of problem does not arise when the NPV method
is used. The problem with the IRR is that if two rates of return make the present value of the
project zero, (21.9 and 228 per cent respectively in our example), which rate should be used for
decision-making purposes?
ii. Comparison between Net Present Value v. Profitability Index
In most situations, the NPV and PI, as investment criteria, provide the same accept and reject
decision, because both the methods are closely related to each other. Under the PI method, the
340 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
investment proposal will be acceptable if the PI is greater than one; it will be greater than one
only when the proposal has a positive net present value. Likewise, PI will be less than one when
the investment proposal has negative net present value under the NPV method. However, while
evaluating mutually exclusive investment proposals, these methods may give different rankings.
Illustration No. 23
Year
Project A
Project B
0
1
2
Present value of cash inflow (0.10)
Net Present Value
(Rs 50,000)
40,000
40,000
69,440
19,440
69440 / 50000
=1.39
(Rs 35,000)
30,000
30,000
52,080
17,080
52080 / 35000
= 1.49
Profitability Index
Thus, project A is acceptable under the NPV method, while project B under the PI method.
Which project should the firm accept? The NPV technique is superior and so project A should
be accepted. The reasons for the superiority of NPV method are the same as given in
comparing NPV and IRR techniques. The best project is the one which adds the most, among
available alternatives, to the shareholders' wealth. The NPV method, by its very definition,
will always select such projects. Therefore, the NPV method gives a better mutually exclusive
choice than PI the NPV method guarantees the choice of the best alternative.
5.14 Capital Rationing
Project Selection Under Capital Rationing
Shareholder wealth is maximized if a company undertakes all possible positive NPV projects.
The capital rationing situation refers to the choice of investment proposals under financial
constraints in terms of a given size of capital expenditure budget. The objective to select the
combination of projects would be the maximization of the total NPV. The project selection under
capital rationing involves two stages:
(i)
identification of the acceptable projects.
(ii)
selection of the combination of projects.
The acceptability of projects can be based either on profitability index or IRR. The method of
selecting investment or projects under capital rationing situation will depend upon whether the
projects are indivisible or divisible. In case the project is to be accepted/rejected in its entirety, it
is called an indivisible project; on the other hand, divisible project can be accepted/rejected in
part.
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Financial Management
Concept of Hard capital rationing and Soft Capital Rationing
Hard Capital Rationing: - limit on sources of fund is due to external environment such as
lending institutes, government etc.
Soft Capital Rationing: - It is due to impose limitation by own management. It is due to
internal environment of the company.
Illustration No. 24
A company has Rs 7 crore available for investment. It has evaluated its options and has found
that only 4 investment projects given below have positive NPV. All these investments are
divisible. Advise the management which investment(s)/projectsitshouldselect.
Project
Initial investment (Rs crore)
NPV (Rs crore)
PI
X
3.00
0.60
1.20
Y
2.00
0.50
1.25
Z
2.50
1.50.
1.60
W
6.00
1.80
1.30
Illustration No. 24 - Solution
Ranking of the Projects in Descending Order of Profitability Index
Project and (rank)
Investment outlay (Rs crore)
Profitability index
NPV (Rs crore)
Z (1)
2.50
1.60
1.50
W (2)
6.00
1.30
1.80
Y (3)
2.00
1.25
0.50
X (4)
3.00
1.20
0.60
Accept Project Z in full and W in part (Rs 4,50,000) as it will maximize the NPV. A similar
kind of exercise can be done using the IRR instead of the PI.
Illustration No. 25
A company working against a self-imposed capital budgeting constraint of Rs 70 crore is
trying to decide which of the following investment proposals should be undertaken by it. All
these investment indivisible as well as independent. The list of investments along with the
investment required and the NPV of the projected cash flows are given as below:
Project
A
B
C
D
E
Initial investment (Rs crore)
10
24
32
22
18
Which investment should be acquired by the company?
342 |The Institute of Chartered Accountants of Nepal
NPV (Rs crore)
6
18
20
30
20
Capital Investment Decision
Illustration No. 25- Solution
Given,
A
B
C
D
10
24
32
22
6
18
20
30
PV of Cash
inflow
16
42
52
52
E
18
20
38
Project Initial investment (Rs crore) NPV (Rs crore)
PI
Rank
1.6
1.75
1.625
2.36
V
III
IV
I
2.11
II
NPV from investments D, E and B is Rs 68 crore with Rs 64 crore utilized leaving Rs 6 crore
to be invested in some other investment outlet. No other investment package would yield an
NPV of this amount. The company is advised to invest in D, E and B projects.
5.15 Capital Investment under Uncertainty
It was assumed that those investment proposals did not involve any kind of risk, i.e., whatever
the proposal is undertaken, there would not be any change in the business risk which are
apprehended by the suppliers of capital. Practically, in real world situation, this seldom happens.
We know that decisions are taken on the basis of forecast which again depends on future events
whose happenings cannot be anticipated/predicted with absolute cer-tainly due to some factors,
e.g., economic, social, political etc. That is why question of risk and uncertainty appear before
the business world although it varies from one investment proposal to another.
Therefore, while evaluating investment proposals care should be taken about the effect that their
acceptance may have on the firm‘s business risk as apprehended by the creditors and/or
investors. As such, the firm should always prefer a less risky investment proposal than a riskier
one.The riskiness of an investment proposal may be defined as the variability of its possible
terms, i.e., the variability which may likely be occurred in the future returns from the project
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Chapter 5
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Capital
Investment
under
Uncertainty
Uncertainty
Sensitivity
Analysis
Risk
Expected
Values
Other
Methods
Simulation
Adjusted
Payback
Risk Adjusted
Discount rate
Fig: Capital Investment Decision under Uncertainty
We now understand the concept of Risk and Uncertainty
 Risk
It involves situations in which the probabilities of a particular event which occurs are known,
i.e., chance of future loss can be foreseen.
 Uncertainty
The probabilities of a particular event which occurs are not known i.e., the future loss cannot be
foreseen. The basic difference between risk and uncertainty is that variability is less in case of
risk whereas it is more in case of uncertainty although both the terms are used here
interchangeably.
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Capital Investment Decision
Basis for Comparison
Risk
Uncertainty
Meaning
The probability of winning
or losing something worthy
is known as risk.
Uncertainty implies a situation
where the future events are not
known.
Ascertainment
It can be measured
It cannot be measured.
Outcome
Chances of outcomes are
known.
The outcome is unknown.
Control
Controllable
Uncontrollable
Minimization
Yes
No
Probabilities
Assigned
Not assigned
5.15.1 Sensitivity Analysis
Sensitivity analysis helps a business estimate what will happen to the project if the assumptions
and estimates turn out to be unreliable. Sensitivity analysis involves changing the assumptions or
estimates in a calculation to see the impact on the project's finances. In this way, it prepares the
business's managers in case the project doesn't generate the expected results, so they can better
analyze the project before making an investment.
 For example, what if demand fell by 10% compared to our original forecasts? Would the
project still viable?
 Ideally, we want to know how much demand could fall before the project should be
rejected or, equivalently, the breakeven demand that gives an NPV of zero. We could
then assess the likelihood of forecast demand being that low.
Calculation of Sensitivity
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 =
𝑁𝑁𝑁𝑁𝑁𝑁
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐ℎ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
Lower the sensitivity margin, the more sensitive the decision to the particular parameter being
considered, i.e. small changes in the estimate could change the project decision from accept to
reject.
Illustration No. 26
An investment of NRs 40,000 today is expected to give rise to annual contribution of NRs
25,000. This is based on selling one product with a sales volume of 10,000 units, selling price
of NRs 12.5 and variable cost per unit of NRs 10. Annual fixed cost of NRs 10,000 will be
incurred for the next four years; the discount is 10%.
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Required:
a) Calculate the NPV of the investment
b) Calculate the sensitivity of your calculation to the following:






Initial investment
Selling price per unit
Variable cost per unit
Fixed costs
Sales volume
Discount rate
Illustration No. 26- Solution
a)
Time
Narrative
0
Investment
1-4
Contributions
1-4
Fixed Costs
NPV
Cash flows
(40,000)
25,000
(10,000)
Therefore, the decision should be to accept the investment
b)
i) Sensitivity to initial investment
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑡𝑡𝑡𝑡 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 =
DF
1
3.170
3.170
PV
(40,000)
79,250
(31,700)
7,550
7,550
= 18.9%
40,000
ii) Sensitivity to selling price per unit
If selling price changes, the revenue will change, so the relevant cash flow will be
revenue
PV of revenue = NRs 12.50 * 10,000* 3.170 = NRs 396,250
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑤𝑤𝑤𝑤𝑤𝑤ℎ 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 =
7,550
∗ 100 = 1.9 %
396,250
iii) Sensitivity to variable cost per unit
If the variable cost per unit changes, the total variable cost will change, so the
relevant cash flow will be total variable cost
PV of total variable cost = NRs 10*10,000*3.170 = 317,000
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𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑖𝑖𝑖𝑖𝑖𝑖 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑤𝑤𝑤𝑤𝑤𝑤ℎ 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 =
iv) Sensitivity to fixed costs
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑤𝑤𝑤𝑤𝑤𝑤ℎ 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 =
7,550
∗ 100 = 2.4 %
317,000
7550
∗ 100 = 23.8%
10,000 ∗ 3.170
v) Sensitivity to sales volume
As sales volume affects both sales revenue and variable costs, being asked to find
‗the sensitivity to sales volume is the same as sensitivity to contribution.
PV of contribution = (12.50-10) *10,000*3.170 = 79,250
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 =
7,550
= 9.5%
79,250
vi) Sensitivity to discount rate
To calculate the sensitivity to the discount rate, it is necessary to find the rate at
which the project NPV is zero, i.e. the internal rate of return (ITT) of the project.
Time
0
1-4
Cash flow
(40,000)
15,000
DF %
1
2.667
PV
(40,000)
40,000
0
From table, at four years, the closest annuity rate is 2.667 occurs at approximately
18%. This is therefore the breakeven discount rate, i.e. the IRR.
The sensitivity is therefore (18-10)/10*100 = 80%. i.e. the cost of capital would
have to rise by 80% before the NPV falls to zero.
Advantages and Disadvantages of Sensitivity Analysis
Advantages:
 Simple to calculate
 Identifies critical estimates
Disadvantages:
 Assumes variables changes independently for each other
 Doesn‘t assess the likelihood of a variable changes.
 Doesn‘t directly identify a correct decision.
The Institute of Chartered Accountants of Nepal | 347
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5.15.2 Probability Analysis
When there are several possible outcomes for a decision and probabilities can be assigned to
each, a probability distribution of expected cash flows can often be estimated, recognizing there
are several possible outcomes, not just one. This could then be used to:
1) Calculate an expected value (EV)
2) Measure risk by:
a) Calculate the worst possible outcome and its profitability;
b) Calculating the probability that the project will fail (for example, that a negative
NPV will result);
c) Assessing the standard deviation of the outcomes.
 The expected value is the weighted average of all the possible outcomes, with the
weightings based on the probability estimates
 The standard deviation is a statistical measure of the variability of a distribution around
its mean (i.e. it measures the dispersion of possible outcomes about the EV). The
smaller the distribution, lower this measure will be. It is a measure of risk- the wider the
dispersion the riskier the situation.
Calculate the Expected Values
The formula for calculating an Expected Value is;
Where, P= the probability of an outcome
x = the value of an outcome
𝐸𝐸𝐸𝐸 =
𝑝𝑝𝑝𝑝
Illustration No. 27
A firm has to choose three mutually exclusive projects, the outcomes of which depend on the
state of the economy. The following estimates have been made:
State of economy
Probability
Project A
Project B
Project C
Recession
0.5
NPV (amount in
NRS)
100
0
180
Stable
0.4
NPV (amount
NRS)
200
500
190
in
Growing
0.1
NPV (amount
NRS)
1400
600
200
Determine which project should be selected on the basis of expected market values.
348 |The Institute of Chartered Accountants of Nepal
in
Capital Investment Decision
Illustration No. 27- Solution
Particulars
Probability
Recession
Stable
Growing
0.5
0.4
0.1
Project A
NPV
100
200
1,400
Project B
NPV
0
500
600
Project C
NPV
180
190
200
EV of
A
50
80
140
270
EV of
B
0
200
60
260
EV of
C
90
67
20
186
On the basis of expected values, project A should be selected.
However, it should be noted that project A is also the riskiest option as it has the widest range
of potential outcomes.
Knowledge Test 4
Ashwin Co is considering an investment of NRs 460,000 in a non-current asset expected to
generate substantial cash inflows over the next five years. Unfortunately, the annual cash
flows from this investment are uncertain, but the following probability distribution has been
established.
Annual Cash flow (amount in NRs)
Probability
50,000
0.3
100,000
0.5
150,000
0.2
At the end of its five-year life, the asset is expected to sell for NRs 40,000. The cost of capital
is 5%
Should the investment be undertaken?
Strengths and Weaknesses of Expected Values
Strengths:
 Deals with multiple outcomes
 Quantifies probabilities
 Relatively simple calculation
 Assets decision making
Weaknesses:
 Subjective probabilities
 Ignores variability of payoffs
 Risk neutral decision i.e. ignores investor‘s attitude to risk.
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5.16 Capital Budgeting Decision
The rationale underlying the capital budgeting decision is to evaluate the long-term investment
proposal. This will enable the firm to achieve its objective of maximizing profits either by way
of increased revenues or cost reductions. Thus, a firm must replace worn and obsolete plants and
machinery, acquire fixed assets for current and new products and make strategic investment
decisions which will increase the value of shareholder wealth. Capital budgeting decision can be
of two types: (i) those which expand revenues, and (ii) those which reduce costs.
I. Capital Budgeting Decision Affecting Revenues
Such investment decisions are expected to bring in additional revenue, thereby raising the size
of the firm's total revenue. They can be the result of either expansion of present operations or the
development of new product lines. Both types of investment decisions involve acquisition of
new fixed assets and are income-expansionary in nature in the case of manufacturing firms.
Illustration No. 28
Example 24
Bharat & Company is considering a new project for manufacturing of prefab materials
involving a capital expenditure of Rs. 600 lakh and working capital of Rs. 150 lakhs. The
capacity of the plant is for an annual production of 12 lakh units and capacity utilization
during the 6-year life of the project is expected to be as indicated below:
Year
Capacity Utilization (%)
1
33.33
2
66.67
3
90
4-6
100
The average price per unit of the product is expected to be Rs. 200 netting a contribution of
40 percent. The annual fixed cost, excluding depreciation, are estimated to be Rs. 480 lakhs
from the third year onwards; for the first and second year it would be Rs. 240 lakh and Rs.
360 lakhs respectively. The average rate of depreciation for tax purpose is 33.33% on WDV
of the capital assets. The rate of income tax is 25%. The cost of capital is 15%.
At the end of third year, an additional investment of Rs. 100 lakhs would be required for
working capital.
Expected terminal value for the fixed assets and the current assets are 10% and 100%
respectively.
Required:
As a financial consultant, what recommendation on the financial viability of the project
would you make to Bharat & Company on the basis of NPV, IRR and discounted pay back
criterion?
350 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
Illustration No. 28- Solution
Calculation of Depreciation
Year
1
2
3
4
5
6
(Rs. In lakhs)
Value/WDV at the
beginning
600
400
267
178
119
79
Depreciation WDV @
33.33% on WDV
200
133
89
59
40
26
WDV at the end
400
267
178
119
79
53
b) Calculation of effective sale proceeds of Fixed assets
Sale proceeds of fixed assets (10% of cost)
Less: Written down value
Profit on sale of fixed assets
Less: Tax on profit @25%
Effective sale proceeds (60-1.75)
(Rs. lakh)
60.00
(53.00)
7
(1.75)
58.25
c) Calculation of cash Outflows (Rs. lakh)
Initial capital expenditure
Add: Working capital required at the beginning
600
150
750
66
Add: P.V. of working capital required at the end of 3rd year
(100*0.658)
P.V. total investment
816
d) Calculation of cash inflows and the present value
Particulars
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Sales unit (% capacity
utilization)
400,000
800,000
1,080,000
1,200,000
1,200,000
1,200,000
200
200
200
200
200
200
Selling price (Rs.)
(Rs. in lakh)
Sales revenue
Less: Variable cost
(60% of Sales)
Contribution
Less: Fixed cost
800
1,600
2,160
2,400
2,400
2,400
(480)
(960)
(1,296)
(1,440)
(1,440)
(1,440)
320
640
864
960
960
960
(240)
(360)
(480)
(480)
(480)
(480)
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Chapter 5
Financial Management
EBTDA
80
280
384
480
480
480
Less: Depreciation
(from a) above)
(200)
(133)
(89)
(59)
(40)
(26)
Earning before tax
(120)
147
295
421
440
454
Less: Tax @ 25%
30
(36.75)
(73.75)
(105.25)
(110)
(113.50)
Earnings after tax
(90)
110.25
221.25
315.75
330
340.50
Add: Working capital
recovery (150+100)
-
-
-
-
-
250
Add: sale proceeds of
fixed assets (from (b)
above)
-
-
-
-
-
58.25
Add: Depreciation addback
200
133
89
59
40
26
Cash inflows
110
243.25
310.25
374.75
370
674.95
PV factor @ 15%
0.87
0.756
0.658
0.571
0.497
0.432
Present values
95.70
183.90
204.15
214
183.90
291.50
Total present values of cash inflows
1173.15
i) Net present value of project =1173.15- 816 = Rs. 357.15 lakh
Recommendation: Since the project has positive NPV, it is advisable to take up the project.
ii) Calculation of IRR
Years
1
2
3
4
5
6
Cash Inflow
110
243.25
310.25
374.75
370
674.75
PVIF @ 30%
0.77
0.592
0.455
0.351
0.27
0.208
PV
84.7
144
141.16
131.54
100
140.35
(-) PV of cash outflow [816-66+(100×0.455)]
TPV
741.75
795.5
-53.75
Trial can be with any other discounting factor (DF)
𝑰𝑰𝑰𝑰𝑰𝑰 = 𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 +
𝑵𝑵𝑵𝑵𝑵𝑵 𝒂𝒂𝒂𝒂 𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹
∗ 𝑯𝑯𝑯𝑯 − 𝑳𝑳𝑳𝑳
𝑵𝑵𝑵𝑵𝑵𝑵 𝒂𝒂𝒂𝒂 𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 − 𝑵𝑵𝑵𝑵𝑵𝑵 𝒂𝒂𝒂𝒂 𝒉𝒉𝒉𝒉𝒉𝒉𝒉𝒉𝒉𝒉𝒉𝒉 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹
352 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
= 15% +
357.15
×
(30%-15%)
357.15+53.75
= 0.15+ (0.87×0.15)
= 0.15+ 0.13
= 0.28
=28%
Recommendation:
Since, IRR is higher than the cost of capital of the company, the project is worth taking up.
iii) Discounted pay Back period:
Years
PV of CI (lakh)
1
2
3
4
5
6
95.70
183.90
204.15
214
183.90
291.50
PBP
=
4 yr.
+
Cumulative CI (lakh)
95.70
279.60
483.75
697.75
881.65
1,173.15
(816-697.75)
183.90
Yr.
= 4 yr. +0.64 yr.
= 4. 64 yr.
Recommendation:
Since, the project returns its investment early within the project's life, the project is worth
taking up.
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Chapter 5
Financial Management
ii. Capital Budgeting Decision Reducing Costs
Such decisions, by reducing costs, add to the total earnings of the firm. A classic example of
such investment decisions are the replacement proposals when an asset wears out or becomes
outdated. The firm must decide whether to continue with the existing assets or replace them. The
firm evaluates the benefits from the new machine in terms of lower operating cost and the outlay
that would be needed to replace the machine. An expenditure on a new machine may be quite
justifiable in the light of the total cost savings that result.
Illustration No. 29
Royal Industries Ltd. is considering the replacement of one of its molding machines. The
existing machine' is in good operating condition but is smaller than required if the firm is to
expand its operations. It is 4 years old, has a current salvage value of Rs 2,00,000 and a
remaining life of 6 years. The machine was initially purchased for Rs 10 lakh and is being
depreciated at 25 per cent on the basis of written down value method.
The new machine will cost Rs 15 lakh and will be subject to the same method as well as the
same rate of depreciation. It is expected to have a useful life of 6 years, salvage value of Rs
1,50,000 at the sixth-year end. The management anticipates that with the expanded operations,
there will be a need of an additional net working capital of Rs 1 lakh.
The new machine will allow the firm to expand current operations and thereby increase annual
revenues by Rs 5,00,000; variable cost to volume ratio is 30 per cent. Fixed costs (excluding
depreciation) are likely to remain unchanged.
The corporate tax rate is 35 per cent. Its cost of capital is 10 per cent. The company has
several machines in the block of 25 per cent depreciation.
Should the company replace its existing machine? What course of action would you suggest, if
there is no salvage value?
Illustration No. 29- Solution
Solution
(a) Cash outflows (incremental):
Cost of the new machine
Rs15,00,000
Add additional working capital
1,00,000
Less sale value of existing machine
2,00,000
14,00,000
(b) Determination of Incremental CFAT (Operating)
Year Incremental Incremental Taxable
Taxes
354 |The Institute of Chartered Accountants of Nepal
EAT
CFAT
Capital Investment Decision
contribution depreciation
1
1
2
3
4
5
6
2
Rs 3,50,000
3,50,000
3,50,000
3,50,000
3,50,000
3,50,000
3
Rs 3,25,000
2,43,750
1,82,813
1,37,109
1,02,832
39,624
income
(0.35)
4
Rs 25,000
1,06,250
1,67,187
2,12,891
2,47,168
3,10,376
5
Rs 8,750
37,188
58,515
74,512
86,509
1,08,632
[Col.4 - Col.5]
6
Rs 16,250
69,062
1,08,672
1,38,379
1,60,659
2,01,744
[Col.6 +Col.3]
7
Rs 3,41,250
3,12,812
2,91,485
2,75,488
2,63,491
2,41,368
(c) Determination of NPV (Salvage Value = Rs 1.50 lakh)
Year
1
2
3
4
5
6
6 Salvage value
6 Recovery of working capital
Gross present value
Initial Investment
CFAT
PV factor (0.10)
3,41,250
3,12,812
2,91,483
2,75,488
2,63,491
2,41,368
1,50,000
1,00,000
Net present Value
0.909
0.826
0.751
0.683
0.621
0.564
0.564
0.564
Total PV
3,10,196
2,58,383
2,18,904
1,88,158
1,63,628
1,36,132
84,600
56,400
14,16,400
14,00,000
16,400
Recommendation: Since the NPV is positive, the company is advised to replace the existing
machine. The NPV is likely to be higher as tax advantage will accrue on the eligible
depreciation of Rs 1, 18,872 (Rs 3,08,496 – RS 1,50,000 – Rs 39,624) in the future years.
Working note
1. Calculation of Incremental Revenue
Rs 5,00,000 - [Rs 5,00,000 x 0.30, variable cost to value (VN) ratio] = Rs 3,50,000
2. Calculation of Incremental Depreciation
Year
1
2
3
4
Asset Cost Base
Depreciation (25% on WDV)
Rs 13,00,000
9,75,000
7,31,250
5,48,437
Rs 3,25,000
2,43,750
1,82,813
1,37,109
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*
5
4,11,328
1,02,832
6
3,08,496
39,624*
0.25X(Rs 3,08,496 – Rs 4,66,992) = Rs 39,624
(i) Written down value (WDV) of existing machine at the beginning of the year 5
Initial cost of machine
Rs 10,00,000
Less depreciation @ 25% in year 1
2,50,000
WDV at beginning of year 2
7,50,000
Less depreciation @ 25% on WDV
187,500
WDV at beginning of year 3
5,62,500
Less depreciation @ 25% on WDV
1,40,625
WDV at beginning of year 4
4,21,875
Less depreciation @ 25% on WDV
1,05,475
WDV at beginning of year 5
3,16,406
(ii) Depreciation base of new machine
WDV of existing machine
Add cost of the new machine
Less sale proceeds of existing machine
3,16,406
15,00,000
2, 00,000
(iii) Base for incremental depreciation
Depreciation base of a new machine
Less depreciation base of an existing machine
16,16,406
3, 16,406
(ii) Calculation of Net Present Value of machine if there is no Salvage Value
a. For the first 5 years, depreciation will remain unchanged. In the sixth year, it will be =
Rs 3,08,496 x 0.25 = Rs 77,124.
b. Operating CFAT for years 1-5 will remain unchanged.
CFAT for year 6 would be:
Particular
Amount
Incremental contribution
Less incremental depreciation
Taxable income
350,000
77,124
272,876
Less taxes (0.35)
EAT
Add depreciation
CFAT
95,507
177,369
77,124
254,493
356 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
c. Calculation of NPV
Year
CFAT
1
2
3
4
5
6 Operating CFAT (6th year)
6 Recovery of working capital
PV factor (0.10)
341,250
312,812
291,483
275,488
263,491
Total PV
0.909
0.826
0.751
0.683
0.621
0.564
0.564
254,493
100,000
310,196
258,383
218,904
188,158
163,628
143,534
56,400
Gross present value
Initial Investment
1,339,203
1,400,000
Net present Value
(60,797)
Recommendation: Since the NPV is negative, the existing machine should not be replaced.
A fundamental difference between the above two categories of investment decision lies in the
fact that cost-reduction investment decisions are subject to less uncertainty in comparison to the
revenue-affecting investment decisions. This is so because the firm has a better `feel' for
potential cost savings as it can examine past production and cost data. However, it is difficult to
precisely estimate the revenues and costs resulting from a new product line, particularly when
the firm knows relatively little about the same.
Knowledge Test 5
A company is considering a proposal to install a machine. The cash flows are as follows: Particulars
Machine A (amount in
NRS)
Year 0
1st yr.
2nd yr.
3rd yr.
4th yr.
5th yr.
45
10
14
16
17
15
The Company‘s cost of capital is 10%. You are required to make these calculations.
(1) Net Present Value;
(2) Profitability Index;
(3) Payback Period;
(4) Discounted Payback Period;
(5) IRR.
Note: - Present Values of Re. 1 at 10% discount rate are as follows:
The Institute of Chartered Accountants of Nepal | 357
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Financial Management
Year
0
1
2
3
4
5
P.V.
1
0.909
0.826
0.751
0.683
0.621
Knowledge Test 6
Project M
Annual cost saving
Useful life
Rs. 40,000
4 years
IRR
15%
Profitability Index (P.I.)
1.064
NPV
?
Cost of capital
?
Cost of Project
?
Payback
?
Salvage value
0
Find the missing values considering the following table of discount factor only:
Discount factor
15%
14%
13%
12%
1 year
0.869
0.877
0.885
0.893
2 year
0.756
0.769
0.783
0.797
3 year
0.658
0.675
0.693
0.712
4 year
0.572
0.592
0.613
0.636
Annuity
2.855
2.913
2.974
3.038
Knowledge Test 7
A company is evaluating three investment situations
(1) Produce a new line of aluminum skillets,
(2) Expand its existing cooker line to include several new sizes, and
(3) Develop a new higher-quality line of cookers. If only the project in question is
undertaken, the expected present values and the amounts of investment required are
Project
Investment Required
Present Value of Future Cash Flow
1
2
200,000
115,000
290,000
185,000
3
270,000
400,000
358 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
If projects 1 and 2 jointly undertaken, there will be no economies, the investments required,
and present values will simply be the sum of the parts. With projects 1 and 3, economies are
possible in investment because one of the machines acquired can be used in both production
processes. The total investment required for projects 1 and 3 combined is Rs 440,000. If
projects 2 and 3 are undertaken, there are economies to be achieved in marketing and
producing the products but not in investment. The expected present value of future cash flows
for projects 2 and 3 is Rs 620,000. If all three projects are undertaken simultaneously, the
economies noted will still hold. However, a Rs 125,000 extension on the plant will be
necessary, as space is not available for all three projects. Which project or projects should be
chosen?
Knowledge Test 8
A company is considering which of two mutually exclusive projects it should undertake. The
Finance Director thinks that the project with the higher NPV should be chosen whereas the
Managing Director thinks the one with the higher IRR should be undertaken especially as both
projects have the same initial outlay and length of life. The company anticipates a cost capital
of 10% and the net after tax cash flows of the projects are as follows:
(cash Flows Figs 000)
Year
0
1
2
3
4
5
Project X
-200
35
80
90
75
20
Project Y
Required: -
-200
218
10
10
4
3
(a)
(b)
(c)
Calculate the NPV and IRR of each project.
State, with reasons, which project you would recommend]
Explain the inconsistency in the ranking of the two projects.
The discount factors are follows:
Year
Discount Factors
Discount Factors
-10%
0
1
1
0.91
2
0.83
3
0.75
4
0.68
5
0,62
-20%
1
0.83
0.69
0.58
0.48
0.41
Knowledge Test 9
A theatre with some surplus accommodation proposes to extend its catering facilities to
provide light meals to its patrons.
The Management Board is prepared to make initial funds available to cover capital cost. It
requires that these be repaid over a period of five years at a rate of interest of 14% and
discounting factors at this interest rate are indicated below:
The Institute of Chartered Accountants of Nepal | 359
Chapter 5
Financial Management
Year
0
Discounting factor
1
1
2
0.88
3
0.77
4
0.67
5
0.59
0.52
The capital costs are estimated at Rs. 60,000 for equipment that will have a life of five years
and no residual value. Running costs of staff, etc., will be Rs. 20,000 in the year, increasing by
Rs. 2,000 in each subsequent year. The board proposes to charge Rs. 5,000 per annum for
lighting heating and other property expenses and wants a nominal Rs. 2,500 per annum to
cover any unforeseen contingencies. Apart from this, the Board is not looking for any profit,
as such, from the extension of these facilities, because it believes that this will enable more
theatre seats to be sold. It is proposed that costs should be recovered by setting prices for the
food at double the direct costs.
It is not expected that the full sales level will be reached until year 3. The proportions of the
level estimated to be reached in years 1 and 2 are 35% and 65% respectively.
You are required to: Calculate the sales that need to be achieved in each of the five years to
meet the Board‘s targets, Ignore taxation and inflation.
Knowledge Test 10
An iron ore company is considering investing in a new processing facility. The company
extracts ore from an open pit mine. During a year, 1,00,000 tons of ore is extracted. If the
output from the extraction process is sold immediately upon removal of dirt, rocks and other
impurities, a price of Rs 1,000 per ton of ore can be obtained. The company has estimated that
its extraction costs amount to 70 per cent of the net realizable value of the ore.
As an alternative to selling all the ore at Rs 1,000 per ton, it is possible to process further 25
per cent of the output. The additional cash cost of further processing would be Rs 100 per ton.
The proposed ore would yield 80 per cent final output and can be sold at Rs 1,600 per ton.
For additional processing, the company would have to install equipment costing Rs.1001akh.
The equipment is subject to 25 per cent depreciation per annum on reducing balance (WDV)
basis/method. It is expected to have useful life of 5 years. Additional working capital
requirement is estimated at Rs. 10 lakhs. The company's cut-off rate for such investments is 15
per cent. Corporate tax rate is 35 per cent.
Assuming there is no other plant and machinery subject to 25 per cent depreciation, should the
company install the equipment if (a) the expected salvage is Rs 10 lakh and (b) there would be
no salvage value at the end of year 5.
Knowledge Test 11
For the company in Knowledge Test 10 , assume there are other plants and machinery subject to
25 per cent depreciation (i.e. in the same block of assets). What course of action should the
company choose?
360 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
Knowledge Test 12
A company is considering two mutually exclusive proposals, X and Y.
Proposal X will require the purchase of machine X, for Rs 1,50,000 with no salvage value but
an increase in the level of working capital to the tune of Rs 50,000 over its life. The project
will generate additional sales of Rs 1,30,000 and require cash expenses of Rs 30,000 in each
of the 5 years of its life.
Proposal Y will require the purchase of machine Y for Rs 2,50,000 with no salvage value and
additional working capital of Rs 70,000. The project is expected to generate additional sales of
Rs 2,00,000 with cash expenses aggregating Rs 50,000.
Both the machines are subject to written down value method of depreciation at the rate of 25
per cent. Assuming the company does not have any other asset in the block of 25 per cent; has
12'per cent cost of capital and is subject to 35 per cent tax, advice which machine it should
purchase?
What course of action would you suggest if Machine X and Machine Y have salvage values of
Rs 10,000 and Rs 25,000 respectively?
Chapter Summary:
 Capital budgeting is the process of evaluating and selecting long-term investments that are
in line with the goal of investor‘s wealth maximization.
 The capital budgeting decisions are important, crucial and critical business decisions due
to substantial expenditure involved; long period for the recovery of benefits; irreversibility
of decisions and the complexity involved in capital investment decisions.
 One of the most important tasks in capital budgeting is estimating future cash flows for a
project. The final decision we make at the end of the capital budgeting process is no better
than the accuracy of our cash-flow estimates.
 Tax payments like other payments must be properly deducted in deriving the cash flows.
That is, cash flows must be defined in post-tax terms.
 There are a number of capital budgeting techniques available for appraisal of investment
proposals and can be classified as traditional (non-discounted) and time-adjusted
(discounted).
 The most common traditional capital budgeting techniques are Payback Period and
Accounting (Book) Rate of Return.
 Payback Period
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡𝑡 𝑐𝑐𝑐𝑐𝑐𝑐ℎ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓
 Average Rate of Return or Return on Capital Employed
The Institute of Chartered Accountants of Nepal | 361
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𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑎𝑎𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
∗ 100
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝐴𝐴𝐴𝐴𝐴𝐴 =
 Net Present Value Technique (NPV):
𝑁𝑁𝑁𝑁𝑁𝑁 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉
= 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
− 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
 Profitability Index
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 =
 Interpolation for IRR Calculation
𝐼𝐼𝐼𝐼𝐼𝐼 = 𝐿𝐿𝐿𝐿 +
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
𝑁𝑁𝑁𝑁𝑁𝑁 𝑎𝑎𝑎𝑎 𝐿𝐿𝐿𝐿
∗ (𝐻𝐻𝐻𝐻 − 𝐿𝐿𝐿𝐿)
𝑁𝑁𝑁𝑁𝑁𝑁 𝑎𝑎𝑎𝑎 𝐿𝐿𝐿𝐿 − 𝑁𝑁𝑁𝑁𝑁𝑁 𝑎𝑎𝑎𝑎 𝐻𝐻𝐻𝐻
 Modified Internal Rate of Return (MIRR): All cash flows, apart from the initial
investment, are brought to the terminal value using an appropriate discount rate (usually
the Cost of Capital).
362 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
Knowledge Test 1- Answer
Solution
Calculation of Accounting Rate of Return
Years
1
Net Income before
Depreciation and
Taxes
Less: Depreciation
{5,00,000-1,00,00) /5}
Net Profit before
Taxes
Less: Taxes @ 50%
Net Profit After Tax
2
3
4
5
1,00,000
1,20,000
1,40,000
1,60,000
2,00,000
1,44,000
80,000
80,000
80,000
80,000
80,000
80,000
20,000
40,000
60,000
80,000
1,20,000
64,000
10,000
20,000
30,000
40,000
60,000
32,000
10,000
20,000
30,000
40,000
60,000
32,000
Average Annual Profits - Depreciation and Taxes
Average Investment
ARR =
Average
X 100
Average Annual Profits after Depreciation and Taxes = Rs. 32,000
Average Investments
Original Investments - Scrap Value
2
=
5,00,000 +1,00,000
2
= Rs 3,00,000
=
Average Rate of Return
=
32,000
3,00,000
X 100
= 10.67 %
Knowledge Test 2- Answer
Calculation of Compounded value of cash inflows
Year
1
2
Cash
inflows
10,000
10,000
Rate of
interest
7%
7%
Year of
investment
3
2
Compounding
factors
1.225
1.145
Compounded
values
12,250
11,450
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Chapter 5
Financial Management
3
4
10,000
10,000
9%
9%
1
0
1.090
1
10,900
10,000
44,600
Present value of the total of the compounded reinvested cash inflows,
𝑃𝑃𝑃𝑃 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐ℎ 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
1 + 𝑘𝑘 4
𝑃𝑃𝑃𝑃 =
44600
1 + 0.12
4
𝑃𝑃𝑃𝑃 = 28,366
As the present value of the compounded reinvested cash flows of NRs 28,366 is greater than
the original cash outlay of NRs 20,000.
Knowledge Test 3- Answer
PV
factor
(0.10)
Costs
Initial cost
(Operating cost):
1-6 years (A)
1-10 years (B)
Less salvage value:
6th year (A)
10th year (B)
Present value of total
costs
Divided by annuity
PV factor for 10 per
cent corresponding to
the life of the project
(capital
recovery
Equivalent annual cost
factor)
(EAC)
Machine
A 50,000
Adjusted PV
Machine
A 50,000
Machine B
65,000
1.000
30,267
5,700
4.355
6.145
5,000
0.564
0.386
1,128
-
1,930
79,139.25
98,096.50
4.355
6.145
18,172
15,964
6,950
2,000
Machine B
65,000
35,027
Recommendation: Since Machine B has a lower equivalent annual cost, it is preferred
investment.
364 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
Working notes
1. Determination of operating costs:
Machine A
Machine B
Cash running cost
Less tax shield @35 per cent (assuming profitable operations)
Less tax advantage on depreciation charged every year
Machine A (Rs 8000 x 0.35)
Rs 15,000
5,250
Rs 12,000
4,200
2,800
-
Machine B (Rs 6,000 x 0.35)
-
2,100
Effective operating cash outflows
6,950
5,700
Knowledge Test 4- Answer
Expected annual cash flows are:
Annual Cash flow (x)
50,000
100,000
150,000
Expected Values
NPV Calculation
Time
0
1-5
5
NPV
Project NPV (p)
0.3
0.5
0.2
Cash flows
(460,000)
95,000
40,000
DF @ 5%
1.00
4.329
0.784
P*x
15,000
50,000
30,000
95,000
PV
(460,000)
411,255
31,360
(17,385)
As the expected NPV is negative, the project should not be undertaken.
Knowledge Test – 5 Answer
Answer
(1)
Calculation of P.V. of Inflows of 10% cost of capital
Year
Present Value factor @10%
inflows
present value
1
0.909
10
9.090
2
0.826
14
11.564
3
0.751
16
12.016
4
0.683
17
11.611
5
0.621
15
9.315
NPV
53.596
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Chapter 5
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NPV = P.V. of Inflows – PV. Of Outflows
= 53.596 – 45 = 8.596
(2)
(3)
Calculation of Profitability Index
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 =
Calculation of Payback period
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
Year
Inflows
Cumulative Inflows
1
10
10
2
14
24
3
16
40
4
17
57
5
15
72
The amount invested is 45 It is recovered talk between year 3 & 4.
Pay back = 3+(45 – 40) = 3.294 year.
17
(4)
Discounted payback period
Year
1
P.V.% of Inflows
9.09
Cumulative present value
9.09
2
11.564
20.654
3
12.016
32.67
4
11.611
44.28
5
9.315
53.2
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 4 +
45 − 44.28
9.315
= 4.077 years
(5)
Calculation of IRR: The NPV at cost of capital is positive ( +8.596) Hence a high rate is use for finding
negative N.P.V ( say 20% rate)
366 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
Calculation of P.V Inflows at 20%
Year
P.V.f. @20%
Inflows
present value
1
0.833
10
8.33
2
0.694
14
9.716
3
0.579
16
9.264
4
0.482
17
8.194
5
0.902
15
6.03
41.534
N.P.V = 41.534 – 45 = - 3.466
IRR =
Low rate +
NPV at Low rate
(NPV at Low rate – NPV High rate)
= 10 +
x (Diff in rates)
8.596
∗ 20 − 10
8.596 + 3.466
= 17.127 %
Knowledge Test – 6 Answer
Annual cash saving = Annual Cash Inflows = 40,000
When IRR discount rate is used
P.V of Inflows = P.V of outflows
Annual Inflows x sum of Present Value Factor @ IRR = Outflows
40,000 x 2.855= 114200
Cost of Project (outflow) = 114200
(ii)
P.I. = P.V of Inflow ( at cost of cap. dis. Rate)
Outflow
1.064 = P.V of Inflow
114,200
P.V of Inflows = 114,200 x 1.064
=121,509 (approx.)
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NPV
= P.V of Inflows – outflow
= (at cost of cap. dis. rate)
= 121,509-114,200
= 7,309
P.V of Inflow (at cost of cap dis rate) = Annual x sum of Present value factor Inflows at cost
of cap
121,509 = 40,000 x sum of present value factor
Sum of Present Value Factor = 3,038 (Approx.)
So, cost of cap = 12% (from given table)
Calculation of Payback Period
Year
Inflows
Commutative Inflows
1
40,000
40,000
2
40,000
80,000
3
40,000
120,000
4
40,000
160,000
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 2 +
= 2.85 Yrs.
Note
114,200 − 80,000
120,000 − 80,000
Since annual Inflows are equal, we may get
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
=
114,200
40,000
=2.855
368 |The Institute of Chartered Accountants of Nepal
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
Capital Investment Decision
Knowledge Test 7 - Answer
Solution
Profit (s)
P.V of Inflow
Outflow
Net Present Value
1
2
3
290,000
185,000
400,000
200,000
115,000
270,000
90,000
70,000
130,000
1&2
290,000
185,000
200,000
115,000
160,000
2&3
620,000
385,000
235,000
3&1
690,000
440,000
250,000
1&2&3
290,000
115,000
620,000
440,000
125,000
230,000
Advice:- Project combination 3 & 1 should be selected.
Knowledge Test 8 - Answer
(a)
Normally NPV is calculated using cost of capital as discounting factor @ 10%
Particular
Initial Outflow
Inflows
time
P.V. f
0
1
2
3
4
5
1
0.91
0.83
0.75
0.68
0.62
Project
X
cashflow
-200
35
80
90
75
20
Project Y
Present
Value
-200
31.85
66.4
67.5
51
12.4
NPV
29.15
Calculation of Net Present Value using 20% discount rate
cashflow
-200
218
10
10
4
3
Present
Value
-200
0.28
8.3
7.5
2.72
1 .86
18.76
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Project X
Project Y
Particular
time
P.V .f
Amt
Present
Value
Amt
Present
Value
Initial Outflow
Inflows
0
1
2
3
4
1
0.83
0.69
0.58
0.48
-200
35
80
90
75
-200
29.05
55.2
52.2
36
-200
218
10
10
4
-200
180
6.9
5.8
1.92
5
0.41
20
8.2
3
1 .23
NPV
IRR =
IRR (X) =
-19.35
-3.21
NPV at Low rate
Low rate +
x (Diff in rates)
(NPV at Low rate – NPV High rate)
29.15
10 +
29.15 – (-19.35)
X (20-10)
= 16.01%
IRR (Y) =
18.76
10 +
18.76 – (-3.21)
X (20-10)
= 18.54%
Summary
NPV
Amt
Rank
IRR
Amt
Rank
Project x
29.15
I
16.01
II
Project y
18.76
II
18.54
I
(b)
The Rank based on NPV & IRR is different. NPV means present value of surplus left
after meeting all cost of fund. It can be used to know the addition in ousting wealth (In
absolute amount) whereas IRR (available rate of return) informs average available rate of
return over profit life.
Secondly, the calculation of NPV used cost of capital as discount rate .It is the rate of return in
general. The calculation of IRR was the project specific rate of return as discount rate. It
370 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
assumes that the cash Inflow over the project life generates this same rate of return. It is not
always true hence NPV is considered best selection criteria for mutually exclusive project. In
this case project x with high NPV is selected (although it has low rate)
Reason for inconsistency in Ranking
(a)
Diff in Amt of total Inflows
Project x = 35+80+90+75+20 = 300
Project y = 218+10+10+4+3 = 245
In this case the project which has higher total Inflows, but same initial outflows provide better
NPV hence NPV for project x is more.
(b)
Difference in pattern of Inflows:A Project which provides high inflows during initial period and low inflow later on has better
IRR. Project Y has quite high inflows during initial period hence is has high IRR.
(c)
Difference assumption for calculation of NPV/ IRR;- NPV is calculated using cost of
capital discount rate this calculation assumes that the Inflows from project over product life
when reinvested for balance period they generate rate of return equal to cost of capital . It is
true.
The calculation of IRR assumes that the cash flows can be reinvested at IRR rate for
remaining life of project. It is not always true.
Knowledge Test 9- Answer
Answer
Board is planning to recover the cost only. it is not looking for any profit. It means NPV =0
(i)
First year; indirect cost
= 20000+5000+2500 = 27500
(Running cost) (Heating, lighting) (Contingency)
It will increase 2000 each year
Calculation of P.V of Indirect cost
Year
P.V.f
Indirect cost
Present value
1
0.88
27,500.00
24,200.00
2
0.77
29,500.00
22,715.00
3
0.67
31,500.00
21,105.00
4
0.59
33,500.00
19,765.00
5
0.52
35,500.00
18,460.00
106,245.00
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(ii)
Calculation of P.V of Sales Value
Calculation of P.V of Indirect cost
Year
P.V.f
Sales
Present value
1
0.88
0.35x
0.308x
2
0.77
0.65x
0.5005x
3
0.67
x
67x
4
0.59
x
59x
5
0.52
x
52x
2.5885 x
(iii)
Sales price is set at double of direct cost of food
P.V of direct cost
= ½ x P.V of sale
= ½ x 2.5885x = 1.29425x
N.P.V = [present value of sales– P.V of direct cost – P.V of indirect cost] – initial outflow
0 = 2.5885 x – 1.29425 x-106245-60000
1.29425x = 166245
X = 166245
1.29425
Sales Value
Year 1
2 – 12
3 to 5
= 128449
128499x.35 = 44957
8449x.65 = 83492
128449 x 1 = 128,449 Per annum
Knowledge Test 10 Answer
Solution
Financial Evaluation Whether to Install Equipment for Further Processing of Iron Ore
(a) Cash Outflow
Cost of equipment
Plus, additional working capital
10,000,000
1,000,000
1,100,000
372 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
(b)
Cash inflows (CFAT)
Year
1
2
3
4
7,000,000
7,000,000
7,000,000
7,000,000
2,500,000
2,500,000
2,500,000
2,500,000
2,500,000
2,000,000
1,875,000
2,625,000
1,406,250
3,093,750
1,054,688
3,445,312
700,000
918,750
1,082,813
1,205,859
Earnings after taxes (EAT)
1,300,000
1,706,250
2,010,938
2,239,453
Add depreciation ,
2,500,000
1,875,000
1,406,250
1,054,688
CFAT
3,800,000
3,581,250
3,417,188
3,294,141
Incremental revenue
[(Rs 1,600 x 20,000) - Rs 1,000 x
25,000)
Less incremental costs:
Processing costs (Rs 100 x 25,000
tons)
Depreciation (working note 1)
Earnings before taxes
Less taxes (0.35)
(c)
Year
Cash
Cash
Cash
Determination of NPV (Salvage Value = Rs 10 Lakh)
PV factor
CFAT
(0.15
Flow in Year 1
3,800,000
0.870
Flow in Year 2
3,581,250
0.756
Flow in Year 3
3,417,187
0.658
Cash Flow in Year 4
Cash Flow in Year 5
Salvage value
Tax benefit on short term capital loss
(0.35 X (Rs 31,64,062 – Rs
10,00,000))
Recovery of working capital
Less cash outflows
Net present value (NPV)
Total PV
3,306,000
2,707,425
2,248,509
3,294,141
2,925,000
1,000,000
0.572
0.497
0.497
1,884,249
1,453,725
497,000
757,422
0.497
376,439
1,000,000
0.497
497,000
12,970,346
11,000,000
1,970,346
Recommendation: The company is advised to install the equipment as it promises a
positive NPV
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(d) Determination of NPV (Salvage Value = Zero)
Year
CFAT
PV factor
(0.15
Total PV
Cash Flow in Year 1
3,800,000
0.87
3,306,000
Cash Flow in Year 2
3,581,250
0.756
2,707,425
Cash Flow in Year 3
3,417,187
0.658
2,248,509
Cash Flow in Year 4
3,294,141
0.572
1,884,249
Cash Flow in Year 5
2,925,000
0.497
1,453,725
Tax benefit on short term capital
loss ( Rs 31,64,062 x 0.35 )
1,107,422
0.497
550,389
Recovery of working capital
1,000,000
0.497
497,000
12,647,296
Less cash outflows
Net present value (NPV)
11,000,000
1,647,296
Since the NPV is still positive, the company is advised to install the equipment.
Working Note:
2. Depreciation Schedule
Year
Depreciation base of equipment
Depreciation @ 25% on WDV
1
Rs 100,00,00
Rs 25,00,000
2
75,00,000
18,75,000
3
56,25,000
14,06,250
4
42,18,750
10,54,688
5
31,64,062
Nil
As the block consists of a single asset, no depreciation is to be charged in the terminal
year of the project
Knowledge Test 11- Answer
(a) Cash outflows would remain unchanged.
(b) The annual depreciation will also remain the same for the first 4 years.
In year 5 the depreciation =(opening WDV of equipment – Salvage value) X Tax rate
= ( Rs 31,64,062 – Rs 10,00,000)X 0.25
= Rs 5,41,016.
(c) The CFAT (operating) for years. 1-4 will not change. In year 5, it will be shown as below.
374 |The Institute of Chartered Accountants of Nepal
Capital Investment Decision
Particulars
CFAT (t = 5)
Incremental revenue
Less incremental costs:
Processing costs
Depreciation
Earnings before taxes
Less taxes (0.35)
EAT
CFAT
Rs 70,00,000
25,00,000
5,41,016
39,58,984
13,85,644
25,73,340
31,14,356
d) Determination of NPV (salvage Value = Rs. 10 Lakh)
Year
CFAT
PV factor
1
2
3
4
5
Salvage value
Recovery of
capital
working
Total PV
38,00,000
35,81,250
34,17,187
32,94,141
31,14,356
10,00,000
0.87
0.76
0.66
0.57
0.50
0.50
33,06,000
27,07,425
22,48,509
18,84,249
15,47,835
4,97,000
10,00,000
0.50
4,97,000
Less cash outflows
126,88,018
110,00,000
Net present value (NPV)
16,88,018*
*
In fact, the NPV of the equipment is likely to be higher as tax advantage will accrue on the
eligible depreciation of Rs 16,23,046, i.e. (Rs 21,64,062 – Rs 5,41,016) in future years.
The company should install the equipment.
(e) Determination of NPV (salvage value = 0)
(i) For the first 4 years, depreciation amount will remain unchanged. In the fifth-year,
depreciation
= Rs 31, 64,062 (Rs 31, 64,062, opening WDV less zero salvage value) x 0.25
= Rs 7,91,015.
(ii) Operating CFAT for years 1 - 4 will remain unchanged. The CFAT for 5th year would be Rs
32,01,855 as shown below:
Incremental revenues
Rs 70,00,000
Less incremental total costs (Rs 25,00,000+Rs 7,91,015
32,91,015
EBIT
37,08,985
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Less taxes (0.35)
EAT
Add depreciation
CFAT
Year
12,98,145
24,10,840
7,91,015
32,01,855
CFAT
PV factor
Total PV
1
2
3
4
38,00,000
35,81,250
34,17,187
32,94,141
0.870
0.756
0.658
0.572
33,06,000
27,07,425
22,48,509
18,84,249
5
Recovery of working capital
32,01,855
10,00,000
0.497
0.497
15,91,322
497,000
1,22,34,505
1,10,00,000
Less cash outflows
Net present value (NPV)
12,34,505
In effect, NPV would be higher as tax advantage will accrue on depreciation of Rs 23,73,047
in future years.
Decision: The decision does not change, as NPV is positive.
Knowledge Test 12- Answer
Financial Evaluation of Proposals, X and Y
Calculation of Net Present Value of Proposal X:
i.
Cash Outflow
Particular
Cost price of machine
Additional working capital
Initial investment (Cash Out Flows)
ii.
Rs
150,000
50,000
2,00,000
Present value of Incremental sales revenue
Particular
Incremental sales revenue
Less cash expenses
Incremental cash profit before taxes
376 |The Institute of Chartered Accountants of Nepal
Rs
130,000
30,000
100,000
Capital Investment Decision
Less taxes (0.35)
CFA (t = 1 - 5)
(x) PV factor of annuity for 5 years (0.12)
Present value
35,000
65,000
3.6050
234,325
(ii) Present Value of tax savings due to depreciation
Year
Depreciation
Tax savings @ 35%
PVF
Present value
1
2
3
37,500
28,125
21,094
13,125
9,844
7,383
0.893
0.797
0.712
11,721
7,845
5,257
4
15,820
5,537
0.636
3,522
Total Present value of Tax saving
28,344
(iii) PV of tax savings on short-term capital loss (STCL):
Particular
Rs
Short-Term Capital Loss
47,461
Tax saving @ 35%
Present value Factor
16,611
0.567
Present value of Short-Term Capital Loss
9,419
Calculation of Net Present Value
Particular
Rs
Present value of Incremental sales revenue
234,325
Present Value of tax savings due to depreciation
PV of tax savings on short-term capital loss (STCL):
Release of working capital (Rs 50,000 x 0.567)
Total present value
Less cash outflows
28,344
9,419
28,350
300,438
200,000
Net Present Value
100,438
Calculation of Net Present Value of Proposal of Y:
Cash outflows
Particular
Cost price of machine
Rs
250,000
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Financial Management
Additional working capital
70,000
Initial investment (Cash Out Flows)
320,000
Calculation of Incremental Sales Revenue
Particular
Rs
Incremental sales revenue
Less cash expenses
Incremental cash profit before taxes
Less taxes (0.35)
CFA (t = 1 - 5)
200,000
50,000
150,000
52,500
97,500
(x) PV factor of annuity for 5 years (0.12)
3.6050
Present value
(i)
351,488
PV of tax savings due to depreciation:
Year
Depreciation
Tax savings @ 35%
PVF
Present value
1
2
3
62,500
46,875
35,156
21,875
16,406
12,305
0.893
0.797
0.712
19,534
13,076
8,761
4
26,367
9,228
0.636
5,869
Total Present value of Tax saving
47,240
(iii) PV of tax savings on short-term capital loss (STCL):
Particular
short-term capital loss
Tax saving @ 35%
Present value Factor
Present value of Short-Term Capital Loss
Calculation of Net Present Value
Particular
Present value of Incremental sales revenue
Present Value of tax savings due to depreciation
PV of tax savings on short-term capital loss (STCL):
378 |The Institute of Chartered Accountants of Nepal
Rs
79,103
27,686
0.567
15,698
Rs
351,488
47,240
15,698
Capital Investment Decision
Release of working capital (Rs70,000 x 0.567)
Total present value
39,690
454,116
Less cash outflows
320,000
Net Present Value
134,116
Advice ; Project Y should be accepted as it has higher NPV
Alternatively, (Incremental Cash flow Approach)
i.
Incremental cash outflows
Investment required in Proposal Y
Rs 3,20,000
Less investment required in Proposal X
2,00,000
1,20,000
ii.
Incremental Sales Revenue
Incremental sales revenue (Y- X)
Less incremental cash expenses (Y - X)
Incremental cash profit before taxes
Less taxes (0.35)
Incremental CFAT (t = 1 - 5)
70,000
20,000
50,000
17,500
32,500
(x) PV of annuity for 5 years (0.12)
3.605
Incremental present value
iii.
117,163
PV of tax savings due to incremental depreciation
Year
Incremental depreciation
Tax savings
PVF
Present value
1
2
3
25,000
18,750
14,062
8750
6562.5
4921.7
0.893
0.797
0.712
7,814
5,230
3,504
4
10,547
3691.45
0.636
2,348
18,896
Total of Present Value
iv.
PV of tax savings on short-term capital loss (STCL):
Particular
Rs
short-term capital loss
Tax saving @ 35%
31,641
11,074
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Present value Factor
0.567
Present value of Short-Term Capital Loss
6,279
Calculation of Net Present Value
Particular
Rs
Present value of Incremental sales revenue
Present Value of tax savings due to depreciation
PV of tax savings on short-term capital loss (STCL):
Release of working capital (Rs 70,000 - Rs 50,000) x 0.567
117,163
18,896
6,279
11,340
Total present value
153,678
Less cash outflows
120,000
Net Present Value
33,678
Recommendation: Proposal Y is better.
Financial Evaluation of Proposals, Assuming Salvage Value of Machines X and Y
(Incremental Approach)
Particular
Rs.
(a) Sum of PV of items (i), (ii) and (iv) (Rs 1,17,162 + Rs 18,896 + Rs 11,340)*
(b) PV of incremental salvage value (Rs 15,000 x 0.567)
(c) PV of tax savings on incremental STCL@ (Rs 54,102 - Rs 37,461) x 0.35 x
0.567**
Incremental present value
Less incremental cash outflows
Incremental NPV
147,398
8,505
3,302
159,205
120,000
39,205
Decision: Decision (superiority of proposal Y) remains unchanged.
*
Items (i), (ii) and (iv) when there is no salvage will not change due to salvage value.
**As a result of salvage value, the amount of short-term capital loss (STCL) will change.
380 |The Institute of Chartered Accountants of Nepal
Working Capital Management & Finanical Forecasting
Chapter 6
Working Capital Management & Finanical Forecasting
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Chapter 6
Financial Management
6.1 Estimation of Working Capital
6.1.1 Learning Objectives
Upon completion of this chapter student will be able to:








Define the working capital and identify its elements
Understand the factors which determine the working capital
Learn the methods of estimating working capital
State the approaches of estimating the working capital
Understand the working capital cycle
Define permanent and temporary working capital
Understand the determinant of working capital
Discuss the effect of the industry in which the organization operates on the length of
the working capital.
6.1.2 Chapter Overview
Management
of Working
Capital
Approaches of
estimation in
working capital
Inventory
Management
Working
Capital Cycles
Receivable/
Payable
Management
Cash
Management
Factor
Determing
Credit Policy
Baumal Model
Financing of
Receivables
Miller Orr
Model
Monitoring of
Payable/
Receivables
Fig: Chapter Overview of Management of Working Capital
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6.1.3 Introduction
Working capital is the capital available for conducting the day-to-day operations of an
organization; normally the excess of current assets over current liabilities.
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
Current Assets
Current
Liabilities
Inventories
Payables
Receivable
Bank OD
Working
Capital
Cash
The primary purpose of working capital management is to enable the company to maintain
sufficient cash flow to meet its short-term operating costs and short-term debt obligations.The
management of working capital involves managing inventories, accounts receivable and
payable,cash and prepaid expenses.
The term current assets refer to those assets which in the ordinary course of business can be, or
will be, converted into cash within operating cycle of the firm(normally period of one year)
without undergoing a diminution in value and without disrupting the operations of the firm. The
major current assets are cash, marketable securities, accounts receivable and inventory.
Current liabilities are those liabilities which are intended, at their inception, to be paid in the
ordinary course of business, within normal operating cycle of the firm (normally one year), out
of the current assets or earnings of the concern. The basic current liabilities are accounts payable,
bills payable, bank overdraft, and outstanding expenses.
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In general, working capital management is to manage the firm's current assets and liabilities in
such a way that a satisfactory level of working capital is maintained. This is so because if the
firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and
may even be forced into bankruptcy. The current assets should be large enough to cover its
current liabilities in order to ensure a reasonable margin of safety. Each of the current assets
must be managed efficiently in order to maintain the liquidity of the firm while not keeping too
high a level of any one of them. Each of the short-term sources of financing must be
continuously managed to ensure that they are obtained and used in the best possible way. The
interaction between current assets and current liabilities is, therefore, the main theme of the
theory of working management.
The basic ingredients of the theory of working capital management may be said to include its
definition, need, optimum level of current assets, the trade-off between profitability and risk
which is associated with the level of current assets and liabilities, financing-mix strategies and so
on.
Concepts and Definitions of Working Capital
Working
Capital
On the basis
of value
On the basis
of time
Gross
Permanent
Net
Fluctuating
On the Basis of Value
Gross working capital:
The term gross working capital, also referred to as working capital, means the total current
assets.
384 |The Institute of Chartered Accountants of Nepal
Working Capital Management & Finanical Forecasting
Net working capital:
Most common definition of net working capital (NWC) is the difference between current assets
and current liabilities.
A positive working capital indicates the company‘s ability to pay its short-term liabilities. On the
other hand, a negative working capital shows inability of an entity to meet its short-term
liabilities.
On the Basis of time:
From the point of view of time, working capital can be divided into two categories viz.,
Permanent and Fluctuating (temporary).
Permanent working capital refers to the base working capital, which is the minimum level of
investment in the current assets that is always carried by the entity to carry its day to day
activities.
Temporary working capital refers to that part of total working capital, which is required by an
entity in addition to the permanent working capital.It is also called variable working capital
which is used to finance the short-term working capital requirements which arises due to
fluctuation in sales volume.The position of the required working capital is needed to meet
fluctuations in demand consequent upon changes in production and sales as a result of seasonal
changes.
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The Figure above shows that the permanent level is constant, while temporary working capital is
fluctuating-increasing and decreasing in accordance with seasonal demands. In the case of an
expanding firm, the permanent working capital line may not be horizontal. This is because the
demand for permanent current assets might be increasing (or decreasing) to support a rising level
of activity
The task of the financial manager in managing working capital efficiently is to ensure sufficient
liquidity in the operations of the enterprise. The liquidity of a business firm is measured by its
ability to satisfy short-term obligations as they become due. The three basic measures of a firm's
overall liquidity are (i) the current ratio, (ii) the acid-test ratio, and (iii) the net working capital.
The suitability of the first two measures has already been discussed in detail in Chapter 3. In
brief, they are very useful in interfirm comparisons of liquidity. Net working capital (NWC), as a
measure of liquidity, is not very useful for comparing the performance of different firms, but it is
quite useful for internal control. The NWC helps in comparing the liquidity of the same firm
over time. For purpose of working capital management, therefore, NWC can be said to measure
the liquidity of the firm. In other words, the goal of working capital management is to manage
the current assets and liabilities in such a way that an acceptable level of NWC is maintained.
Efficient working capital management requires that firms should operate with some amount of
Net Working Capital, the exact amount varying from firm to firm and depending, among other
things, on the nature of industry. The theoretical justification for the use of Net Working Capital
to measure liquidity is based on the premise that the greater the margin by which the current
assets cover the short-term obligations, the more is the ability to pay obligations when they
become due for payment.
The Net Working Capital is necessary because the cash outflows and inflows do not coincide. In
other words, it is the no synchronous nature of cash flows that makes Net Working Capital
necessary. In general, the cash outflows resulting from payment of current liabilities are
relatively predictable. The cash inflows are, however, difficult to predict. The more predictable
the cash inflows are, the less Net Working Capital will be required.
6.1.4 Trade Off Between Profitability and Risk
In evaluating a firm's Net Working Capital position, an important consideration is the trade-off
between profitability and risk. In other words, the level of Net Working Capital has a bearing on
profitability as well as risk. The term profitability used in this context is measured by profits
after expenses. The term risk is defined as the probability that a firm will become technically
insolvent so that it will not be able to meet its obligations when they become due for payment.
The risk of becoming technically insolvent is measured using Net Working Capital. It is assumed
that the greater the amount of Net Working Capital, the less risk-prone the firm is. Or, the greater
the Net Working Capital, the more liquid is the firm and, therefore, the less likely it is to become
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Working Capital Management & Finanical Forecasting
technically insolvent. Conversely, lower levels of Net Working Capital and liquidity are
associated with increasing levels of risk. The relationship between liquidity, Net Working
Capital and risk is such that if either NWC or liquidity increases, the firm's risk decreases.
Nature of Trade-off
If a firm wants to increase its profitability, it must also increase its risk. If it is to decrease risk, it
must decrease profitability. The trade-off between these variables is that regardless of how the
firm increases its profitability through the manipulation of working capital, the consequence is a
corresponding increase in risk as measured by the level of Net Working Capital.
The effects of changing current assets and current liabilities on profitability-risk trade-off are
discussed first and subsequently they have been integrated into an overall theory of working
capital management.
In evaluating the profitability-risk trade-off related to the level of Net Working Capital, three
basic assumptions, which are generally true, are: (i) that we are dealing with a manufacturing
firm; (ii) that current assets are less profitable than fixed assets; and (iii) that short-term funds are
less expensive than long-term funds.
a. Effect of the Level of Current Assets on the Profitability-Risk Trade-off
The effect of the level of current assets on profitability-risk and trade-off can be shown, using
the ratio of current assets to total assets. This ratio indicates the percentage of total assets that are
in the form of current assets. A change in the ratio will reflect a change in the amount of current
assets. It may either increase or decrease.
b. Effect of Increase/Higher RatioAn increase in the ratio of current assets to total assets will lead to a decline in profitability
because current assets are assumed to be less profitable than fixed assets. A second effect of the
increase in the ratio will be that the risk of technical insolvency would also decrease because the
increase in current assets, assuming no change in current liabilities, will increase Net Working
Capital.
c. Effect of Decrease/Lower Ratio
A decrease in the ratio of current assets to total assets will result in an increase in profitability as
well as risk. The increase in profitability is primarily due to the corresponding increase in fixed
assets which are likely to generate higher returns. Since the current assets decrease without a
corresponding reduction in current liabilities, the amount of Net Working Capital will decrease,
thereby increasing risk.
d. Effect of Change in Current Liabilities on Profitability-Risk Trade-off: As in the case of current assets, the effect of a change in current liabilities can also be
demonstrated by using the ratio of current liabilities to total assets. This ratio will indicate the
percentage of total assets financed by current liabilities.
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Chapter 6
The effect of a change in the level of current liabilities would be that the current liabilities-total
asset ratio will either (i) increase, or (ii) decrease.
i. Effect of an Increase in the Ratio
one effect of an increase in the ratio of current liabilities to total assets would be that profitability
will increase. The reason for the increased profitability lies in the fact that current liabilities,
which are a short-term source of finance, will increase, whereas the long-term sources of finance
will be reduced. As short-term sources of finance are less expensive than long-run sources,
increase in the ratio will, in effect, mean substituting less expensive sources for more expensive
sources of financing. There will, therefore, be a decline in cost and a corresponding rise in
profitability.
The increased ratio will also increase the risk. Any increase in the current liabilities, assuming no
change in current assets, would adversely affect the NWC. A decrease in NWC leads to an
increase in risk. Thus, as the current liabilities-total assets ratio increases, profitability increases,
but so does risk.
ii. Effect of a Decrease in the Ratio
The consequences of a decrease in the ratio are exactly opposite to the results of an increase.
That is, it will lead to a decrease in profitability as well as risk. The use of more long-term funds
which, by definition, are more expensive will increase the cost; by implication, profits will also
decline. Similarly, risk will decrease because of the lower level of current liabilities on the
assumption that current assets remain unchanged.
e.
Combined Effect of Changes in Current Assets and Current Liabilities on
Profitability-Risk Trade-off
The combined effects of changes in current assets and current liabilities can be measured by
considering them simultaneously. We have shown in the preceding sections the effects of a
decrease in the current assets-total assets ratio and the effects of an increase in the current
liabilities-total assets ratio. These changes, when considered independently, lead to an increased
profitability coupled with a corresponding increase in risk. The combined effect of thesechanges
should, logically, be to increase overall profitability as also risk and at the same time decrease
NWC.
6.1.5 Significance of Working Capital
Proper management of working capital is essential to a company‘s fundamental financial health
and operational success as a business. A hallmark of good business management is the ability to
utilize working capital management to maintain a solid balance between growth, profitability
and liquidity.
A business uses working capital in its daily operations; working capital is the difference between
a business's current assets and current liabilities or debts. Working capital serves as a metric for
how efficiently a company is operating and how financially stable it is in the short-term. The
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working capital ratio, which divides current assets by current liabilities, indicates whether a
company has adequate cash flow to cover short-term debts and expenses.
6.1.5.1 The Importance of Working Capital Management
Working capital is a daily necessity for businesses, as they require a regular amount of cash to
make routine payments, cover unexpected costs, and purchase basic materials used in the
production of goods.
Efficient working capital management helps maintain smooth operations and can also help to
improve the company's earnings and profitability. Management of working capital includes
inventory management and management of accounts receivables and accounts payables. The
main objectives of working capital management include maintaining the working capital
operating cycle and ensuring its ordered operation, minimizing the cost of capital spent on the
working capital, and maximizing the return on current asset investments.
Working capital is a prevalent metric for the efficiency, liquidity and overall health of a
company. It reflects the results of various company activities, including revenue collection, debt
management, inventory management and payments to suppliers. This is because it includes
inventory, accounts payable and receivable, cash, portions of debt due within the period of a year
and other short-term accounts.
When a company does not have enough working capital to cover its obligations, financial
insolvency can result and lead to legal troubles, liquidation of assets and potential bankruptcy.
Thus, it is vital to all businesses to have adequate management of working capital.
Working capital management is essentially an accounting strategy with a focus on the
maintenance of a sufficient balance between a company‘s current assets and liabilities. An
effective working capital management system helps businesses not only cover their financial
obligations but also boost their earnings.
Managing working capital means managing inventories, cash, accounts payable and accounts
receivable. An efficient working capital management system often uses key performance ratios,
such as the working capital ratio, the inventory turnover ratio and the collection ratio, to help
identify areas that require focus in order to maintain liquidity and profitability.
Maintaining adequate working capital is not just important in the short term. Enough liquidity
must be maintained in order to ensure the survival of the business in the long-term as well. When
businesses make investment decisions, they must not only consider the financial outlay involved
with acquiring the new machine or the new building, etc., but must also take account of the
additional current assets that are usually required with any expansion of activity. For e.g.: 


Increased production leads to holding of additional stocks of raw materials and work-inprogress.
An increased sale usually means that the level of debtors will increase.
A general increase in the firm‘s scale of operations tends to imply a need for greater
levels of working capital.
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Adequacy of Working Capital
Risk of too high amount of working capital
 It results in unnecessary accumulation of inventories and gives chance to inventory
mishandling, wastage, pilferage, theft, etc., and losses increase.
 Excess working capital means idle funds which earns no profits for the business.
 It shows a defective credit policy of the company resulting in higher incidence of bad
debts and adversely affects Profitability.
 It results in overall inefficiency.
Risk of inadequate working capital
 It becomes difficult to implement operating plans and achieve the firm‘s profit target.
 It stagnates growth and it will become difficult to the firm to undertake profitable
ventures for non-availability of working capital funds.
 It may not be in a position to meet its day-to-day current obligations and results in
operational inefficiencies.
 The Return on Investment falls due to underutilization of fixed assets and other
capacities of the business concern.
 Credit facilities in the market will be lost due to faulty working capital.
 The reputation and goodwill of the firm will also be impaired considerable.
6.1.5.2 Balancing Profitability and Liquidity
Liquidity in the context of working capital management means having enough cash or ready
access to cash to meet all payment obligations when these falls due. The main sources of
liquidity are usually:




Cash in the bank
Short term investments that can be cashed in easily and quickly.
Cash inflows from normal trading operation (cash sales and payments by receivables for
credit sales)
An overdraft facility or other ready source of extra borrowings
The basic of the tradeoff is where a company is able to improve its profitability but at the
expenses of tying up cash


Receiving bulk purchase discount from the suppliers (improved profitability) for buying
more inventory than is currently required (reduced liquidity)
Offering credit to customers (attracts more customers so improves profitability but
reduces liquidity
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Balancing act between liquidity and profitability
Component of working
capital
Inventory
Advantages of Keeping it
high
 few stockouts
 bulk purchase discounts
 reduced ordering costs
Advantages of Keeping it
low
 less cash tied-up in
inventory
 lower storage costs
Receivables
 profitable as it attracts
higher amount of sales
for
customer
 easier
retention
 less cash ties up
 less
chance
of
irrecoverable debts
 reduced cost of credit
control
Cash
 able to pay bill on time
 take
advantages
of
unexpected opportunities
 avoid high borrowing
costs
 can invest surplus to earn
higher returns
 less
vulnerable
to
takeover
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Trade payables
 preserves own cash-  can take advantage of
cheap sources of finance
prompt payment discounts
 retain good credit status
 move favorable supplier
treatment
6.1.6 Objective of Working Capital Management
There are 3 primary objectives of working capital management. They are;
6.1.6.1 Smooth Operating Cycle
Working Capital Cycle may vary from industry to industry. Take any industry but the objective
would always be to keep this cash conversion cycle as smooth as possible. The bottleneck in any
of the activities would break the business supply chain and increase the cycle. If the following 6
points can be managed, this operating cycle can be managed well.
 It means raw material should be present on the requirement and it should not be a cause
to stoppages of production.
 All other requirements of production should be in place before time.
 The finished goods should be sold as early as possible once they are produced and
inventoried.
 The accounts receivable should be collected on time.
 Accounts payable should be paid when due without any delay.
 Cash should be available as and when required along with some cushion.
6.1.6.2 Optimize Investment in Working Capital
Working capital here refers to the current assets less current liabilities (net working capital). It
should be optimized because higher working capital means higher interest cost and lower
working capital means a risk of disturbance of the operating cycle.The money that you have
borrowed for the smooth running of the operating cycle carries interest cost or you may have
your own funds, then it has an opportunity cost. Any delay in any of the activities would be
costly to the business and directly attack the profit margins. There is a great potential for
optimizing each activity in the operating cycle and consequently optimize the investment in WC.
In nutshell, a firm should have adequate working capital to run its business operations. Both
excessive as well as inadequate working capital positions are dangerous.
6.1.6.3 Minimize Cost of Working Capital Financing
There are many ways of financing the WC needs. It may be through long-term financing options
like equities, long-term debt etc. One can take help of short-term financing options like WC
loans, factoring, cash credit, letter of credit etc. The third is to have a combination of both long
as well as short-term finance. Objective of Working Capital Management also includes
balancing of carrying cost of working capital.
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6.1.7 Determinants of Working Capital
A firm should always maintain a requisite amount of working capital for smooth and efficient
functioning of its operations. The total working capital requirement is determined by a wide
variety of factors. These factors affect different enterprises differently. They also vary from time
to time.
In general, the following factors are to be considered in determining the working capital
requirement of a firm:
a) Nature of Business:
The working capital requirements of a firm are widely influenced by the nature of
business. Public utilities like bus service, railways, water supply etc. have the lowest
requirements for working capital partly because of the cash nature of their business and
partly because of their rendering service rather than manufacturing product and there is
no need of maintaining any inventory or book debt except capital assets.
On the contrary, trading concerns are required to maintain more working capital because
they must carry stock-in-trade, receivables and liquid cash. Manufacturing concerns also
require large amount of working capital because of the time lag involved in the
conversion of raw materials into finished products and, finally, into cash.
b) Size of the Business:
The amount of working capital requirement also depends upon the size of the business.
The size can be measured in terms of the scale of operations. A large firm with a high
scale of operation will require to maintain a large amount of working capital than a firm
with a small scale of operation.
c) Production Cycle:
Production cycle is the time involved in manufacturing or processing a product. It starts
when raw materials are put in the production process and ends with the completion of
manufacturing of the product. Longer the production cycle, higher is the need of
working capital.
This is because funds remain blocked in work-in-progress for long periods of time. For
example, the working capital needs of a ship-building industry will be much longer than
those of a bakery.
d) Business Cycle:
The working capital requirements are also determined by the nature of the business
cycle. During the boom period, the need for working capital will increase to meet the
requirements of increased production and sales. On the other hand, in a slack period, the
reduced volume of operation will require relatively lower amount of working capital.
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e) Credit terms of Purchase and Sale:
The period of credit given by the suppliers and the period of credit granted to the
customers will affect the working capital needs of a firm. If a firm allows a very short
credit period, cash will be realized very soon from debtors. So, the need for the working
capital will be less.
On the other hand, a liberal credit policy will result in higher amount of book debts.
Higher book debts will mean more working capital requirement. If the firm must
purchase raw materials in cash or gets credit for shorter period, it has to arrange for
relatively higher amount of working capital.
f)
Seasonal Variations:
There are industries like cold drinks, ice-cream and woolen where the goods are either
produced or sold seasonally. So, in such industries, working capital requirements during
production or sale seasons will be large and these will start decreasing when the season
starts coming-to end.
However, much depends on the policy of management about production or sale of
goods. For example, the management of a woolen industry wants to carry on production
evenly throughout the year rather than concentrating on its production only in the busy
season. In that case the working capital requirements will be low.
g) Operating Efficiency:
If the operating efficiency of a firm is very high, the resources will be properly utilized.
As a result, it improves the profitability of the firm which ultimately, helps in releasing
the pressure of working capital. On other hand, inefficiency compels the firm to
maintain relatively a high level of working capital.
h) Dividend Policy:
Another appropriation of profits which has a bearing on working capital is dividend
payment. The payment of dividend consumes cash resources and, thereby, affects
working capital to that extent. Conversely, if the firm does not pay dividend but retains
the profits, working capital increases. In planning working capital requirements,
therefore, a basic question to be decided is whether profits will be retained or paid out to
shareholders. In theory, a firm should retain profits to preserve cash resources and, at the
same time, it must pay dividends to satisfy the expectations of investors. When profits
are relatively small, the choice is between retention and payment
i)
Price level changes:
If prices of input rise, the firm requires additional working capital to maintain the same
level of production as compared to previous period.
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j)
Growth and Expansion of the Business
Every concern wants to grow over a period and with the increase in its size, so the
working capital requirements are bound to increase. A growing firm would require
greater working capital than a static one.
k) Relationship of Material Cost to Total Cost:
In manufacturing concerns, where raw material costs bear a large proportion to the total
cost of production, a greater amount of working capital will have to be maintained. For
example, in industries like textile and electronics, large sums are required to maintain
the inventory of such raw materials.
6.1.8 Significance of Working Capital Strategies/ Approaches
Apart from the profitability-risk trade-off, another important ingredient of the theory of working
capital management is determining the financing mix. One of the most important decisions, in
other words, involved in the management of working capital is how current assets will be
financed. There are, broadly speaking, two sources from which funds can be raised for current
asset financing; (i) short-term sources (current liabilities), and (ii) long-term sources, such as
share capital, long-term borrowings, internally generated resources like retained earnings and so
on. What proportion of current assets should be financed by current liabilities and how much by
long-term resources? Decisions on such questions will determine the financing mix.
There are three basic approaches to determine an appropriate financing mix: (a) Hedging
approach, also called the Matching approach; (b) Conservative approach, and (c) Aggressive
approach
a) Hedging Approach: The term `hedging' is often used in the sense of a risk-reducing
investment strategy involving transactions of a simultaneous but opposing nature so that the
effect of one is likely to counterbalance the effect of the other. With reference to an
appropriate financing-mix, the term hedging can be said to refer to the process of matching
maturities of debt with the maturities of financial needs. This approach to the financing
decision to determine an appropriate financing mix is, therefore, also called as Matching
approach.
According to this approach, the maturity of the source of funds should match the nature of
the assets to be financed. For the purpose of analysis, the current assets can be broadly
classified into two classes:
i. those which are required in a certain amount for a given level of operation and, hence,
do not vary over time – Permanent working capital
ii. those which fluctuate over time- temporary working capital
Long term funds will finance = Fixed Assets + Permanent Working Capital
Short term funds will finance = temporary working capital
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Month
(1)
January
February
March
April
May
June
July
August
September
October
November
December
Estimated Total Funds Requirements of Hypothetical Ltd
Total funds
Permanent
Seasonal
required
requirements
requirement
s
(2)
(3)
(4)
Rs 8,500
8,000
7,500
7,000
6,900
7,150
8,000
8,350
8,500
9,000
8,000
7,500
Rs 6,900
6,900
6,900
6,900
6,900
6,900
6,900
6,900
6,900
6,900
6,900
6,900
Rs 1,600
1,100
600
100
0
250
1,100
1,450
1,600
2,100
1,100
600
11,600
According to the hedging approach, the permanent portion of funds required (Col.3) should
be financed with long-term funds and the seasonal portion (Col.4) with short-term funds.
With this approach, the short-term financing requirements (current assets) would be just
equal to the short-term financing available (current liabilities). There would, therefore, be no
NWC.
b) Conservative Approach
As the name suggests, it is a conservative strategy of financing the working capital with low
risk and low profitability. In this strategy, apart from the fixed assets and permanent current
assets, a part of temporary working capital is also financed by long-term financing sources.
It has the lowest liquidity risk at the cost of higher interest outlay
Long term funds will finance = Fixed Assets + Permanent Working Capital + part of
temporary working capital
Short term funds will finance = part of temporary working capital
c) Aggressive Approach
This strategy is the most aggressive strategy out of all the three. The complete focus of the
strategy is in profitability. It is a high-risk high profitability strategy. In this strategy, the
dearer funds i.e. long-term funds are utilized only to finance fixed assets and a part of the
permanent working capital. Complete temporary working capital and a part of permanent
working capital also are financed by the short-term funds.
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It saves the interest cost at the cost of high risk. Here, funds are applied as below and can be
clearly seen in the above diagram.
Long Term Funds will finance = FA + Part of permanent working capital
Short Term Funds will finance = Remaining Part of permanent working capital +
Temporary working capital
Three Strategies of Working Capital Financing
Factors
Conservative
Aggressive
Liquidity
High
Low
Profitability
Comparatively Less
More
Risk
Very Low
High
Assets Utilization
High
Low
Working Capital
More
Less
Hedging
Balanced
Balanced
Balanced
Balanced
Balanced
Comparison of Hedging Approach with Conservative Approach A comparison of the two
approaches can be made on the basis ofrisk considerations.
Risk Considerations
The two approaches can also be contrasted on the basis of the risk involved.
Hedging Approach
The hedging approach is riskier in comparison to the conservative approach. There are two
reasons for this. First, there is, as already observed, no NWC with the hedging approach because
no long-term funds are used to finance short-term seasonal needs, that is, current assets are just
equal to current liabilities. On the other hand, the conservative approach has a fairly high level of
NWC. Secondly, the hedging plan is risky because it involves almost full utilization of the
capacity to use short term funds and in emergency situations it may be difficult to satisfy the
short-term needs.
Conservative Approach
With the conservative approach, in contrast, the company does not use any of its short-term
borrowings. Therefore, the firm has sufficient short-term borrowing capacity to cover
unexpected financial needs and avoid technical insolvency.
To summarize, the hedging approach is a high profit (low cost)-high risk (no NWC) approach to
determine an appropriate financing-mix. In contrast, the conservative approach is low profit
(high cost)-low risk (high NWC). The contrast between these approaches is indicative of the
need for trade-off between profitability and risk.
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Illustration No. 1
A firm has the following data for the year ending 31st Aashadh 2076
Particulars
Sales (100,000) @ NRs 20
Earnings before interest and tax
Fixed Assets
Amount
20,00,000
2,00,000
5,00,000
The three possible current assets holdings of the firm are NRs 5,00,000, NRs 4,00,000 and
NRs 3,00,000. It is assumed that fixed assets level is constant, and profits do not vary with
current assets levels. Analyze the effect of the three alternative current assets policies.
Illustration No. 1- Solution
Working Capital Policy
Sales
EBIT
Current Assets
Fixed Assets
Total Assets
Return on total Assets
(EBIT/ total assets)
Current assets /fixed
assets
Conservative
2,000,000
200,000
500,000
500,000
1,000,000
20%
Moderate
2,000,000
200,000
400,000
500,000
900,000
22.22%
Aggressive
2,000,000
200,000
300,000
500,000
8,00,000
25%
1.00
0.80
0.60
The aforesaid calculation shows that the conservative policy provides greater liquidity
(solvency) to the firm, but lower return on total assets. On the other hand, the aggressive
policy gives higher return, but low liquidity and thus is very risky. The moderate policy
generates return higher than Conservative policy but lower than aggressive policy. This is less
risky than aggressive policy but riskier than conservative policy.
In determining the optimum level of current assets, the firm should balance the profitability –
solvency tangle by minimizing total costs Cost of liquidity and cost of illiquidity.
6.1.9 Working Capital Ratios
Two key measures, the current and quick ratios are used to assess short term liquidity, generally
a higher ratio indicates better liquidity. Detail calculation of liquidity ratios are already discussed
in chapter 3.
Liquidity ratios
Current ratio: measure how much of the total current assets are financed by current liabilities
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𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝑡𝑡 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
Quick ratio: measures how well current liabilities are covered by liquid assets. It is particularly
useful where inventory holding periods are long and therefore distort the current ratio.
𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 =
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 − 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙
In general, high current and quick ratio are considered good in that they mean that an
organization has the resources to meet its commitment they fall due. However, it may indicate
that working capital is not being used efficiently, for example, there may be too much idle
cash that should be invested to earn a return.
6.1.10 Working Capital Cycle
The Working Capital Cycle (cash operating cycle) for a business is the length of time it takes to
convert the total net working capital (current assets less current liabilities) into cash. Businesses
typically try to manage this cycle by selling inventory quickly, collecting revenue from
customers quickly, and paying bills slowly to optimize cash flow.
It is the length of time between the company‘s outlay on raw materials, wages, and other
expenditure and the inflow of cash from the sale of goods. The lower the cycle of working
capital, lower the investment in working capital.
Cash
Sales/
receivable
Finished
good
Raw
Material
WIP
Based on the above chart, working capital cycle formula is;
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 + 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
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Calculation of the cash operating cycle for manufacturing business;
Raw materials holding period
Less: payables payment period
WIP holding period
Finished goods holding period
Receivable collection period
XX
(XX)
XX
XX
XX
XX
Calculation of the cash operating cycle for trading business
Inventory holding period
Less: payables payment period
Receivable collection period
Cash operating cycle
XX
(XX)
XX
XX
Component required for operating cycles is calculated as below;
S. N
1)
2)
3)
Particulars
Raw Material
holding period
WIP holding
period
Inventory
holding period
Calculation
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑜𝑜𝑜𝑜 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
=
∗ 365
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
=
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑊𝑊𝑊𝑊𝑊𝑊 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
∗ 365
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Trade
Receivable days
Or,
4)
5)
Trade payable
days
=
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
∗ 365
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠
=
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
∗ 365
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠
=
=
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
∗ 365
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
∗ 365
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
400 |The Institute of Chartered Accountants of Nepal
Remarks
The length of time raw
materials is held
between purchase and
being used in
production
The length of time
goods spends in
production
The length of time
inventory is held
between
manufactured/
purchase and sale
The length of time
credit is extended to
customers.
The average period of
extended by suppliers
Working Capital Management & Finanical Forecasting
Illustration No. 2
From the following information, extracted from the books of a manufacturing company,
compute the operating cycle in days;
Period covered: 365 days
Average period of credit allowed by suppliers: 16 days. Other data are as follows:
Particulars
Average debtors (outstanding)
Raw material consumption
Total Production costs
Total cost of sales
Sales for the year
Value of Average Stock
Raw Material
WIP
Finished goods
Illustration No. 2- solution
S. N Particulars
1
Raw Material Holding
Period
2
Less: Creditor payment
3
WIP holding period
4
Finished goods holding
period
5
Debtors collection period
Amount in NRs ―000‖
480
4,400
10,000
10,500
16,000
320
350
260
Calculation
= 320/4,400*365days
Amount
27 days
Given
= 350/10,000*365
= 260/10,000*365
(16 days)
13 days
9 days
= 480/16,000*365 [assumed all sales are
on credit]
Total duration of working capital
11 days
44 days
6.1.11 Changes in Working Capital
The changes in the level of working capital occur for the following three basic reasons:
(i)
(ii)
(iii)
changes in the level of sales and/or operating expenses,
policy changes, and
changes in technology.
6.1.11.1 Changes in Sales and Operating Expenses
The first factor causing a change in the working capital requirement is a change in the sales and
operating expenses. The changes in this factor may be due to three reasons: First, there may be a
long-run trend of change. For instance, the price of a raw material, say oil, may constantly rise,
necessitating the holding of a large inventory. The secular trends would mainly affect the need
for permanent current assets. In the second place, cyclical changes in the economy leading to ups
and downs in business activity influence the level of working capital, both permanent and
The Institute of Chartered Accountants of Nepal | 401
Financial Management
Chapter 6
temporary. The third source of change is seasonality in sales activity. Seasonality-peaks and
troughs-can be said to be the main source of variation in the level of temporary working capital. '
The change in sales and operating expenses may be either in the form of an increase or decrease.
An increase in the volume of sales is bound to be accompanied by higher levels of cash,
inventory and receivables. The decline in sales has exactly the opposite effect-a decline in the
need for working capital. A change in the operating expenses-rise or fall-has a similar effect on
the levels of working capital.
6.1.11.2 Policy Changes
The second major cause of changes in the level of working capital is because of policy changes
initiated by the management. There is a wide choice in the matter of current assets policy. The
term current asset policy may be defined as the relationship between current assets and sales
volume. A firm following a conservative policy in this respect having a very high level of
current assets in relation to sales may deliberately opt for a less conservative policy and vice
versa. These conscious managerial decisions certainly have an impact on the level of working
capital.
6.1.11.3 Technological Changes
Finally, technological changes can cause significant changes in the level of working capital. If a
new process emerges as a result of technological developments, which shortens the operating
cycle, it reduces the need for working capital and vice versa.
6.1.12 Computation of Working Capital
The two components of working capital (WC) are current assets (CA) and current liabilities
(CL). They have a bearing on the cash operating cycle. In order to calculate the working capital
needs, what is required is the holding period of various types of inventories, the credit collection
period and the credit payment period.
Working capital also depends on the budgeted level of activity in terms of production/sales. The
calculation of WC is based on the assumption that the production/sales is carried on evenly
throughout the year and all costs accrue similarly. As the working capital requirements are
related to the cost excluding depreciation and not to the sale price, WC is computed with
reference to cash cost. The cash cost approach is comprehensive and superior to the operating
cycle approach based on holding period of debtors and inventories and payment period of
creditors. Some problems have been solved, however, using the operating cycle approach also.
The steps involved in estimating the different items of CA and CL are as follows:
i.
Estimation of Current Assets
a. Raw Materials Inventory
The investment in raw materials inventory is estimated on the basis of following form
=
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃 𝑃𝑃𝑃𝑃 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
∗ 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅 ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
12 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚ℎ𝑠𝑠 𝑜𝑜𝑜𝑜 52 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑜𝑜𝑜𝑜 365 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
402 |The Institute of Chartered Accountants of Nepal
Working Capital Management & Finanical Forecasting
b. Work-in-process (W/P) Inventory
The relevant costs to determine work-in-process inventory are the proportionate share of cost of
raw materials and conversion costs (labor and manufacturing overhead costs excluding
depreciation). Symbolically.
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑢 𝑢𝑢𝑢𝑢𝑢𝑢 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
∗ 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑊𝑊𝑊𝑊𝑊𝑊 ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
12 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚ℎ𝑠𝑠 𝑜𝑜𝑜𝑜 52 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑜𝑜𝑜𝑜 365 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
c. Finished Goods Inventory
Working capital required to finance the finished goods inventory is given by factors summed up
in Eq.
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑢 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑛𝑛 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑑𝑑𝑑𝑑𝑑𝑑𝑛𝑛
∗ 𝐴𝐴𝐴𝐴𝐴𝐴. 𝐹𝐹𝐹𝐹 ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
12 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚ℎ𝑠𝑠 𝑜𝑜𝑜𝑜 365 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑜𝑜𝑜𝑜 52 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤
d. Debtors
The WC tied up in debtors should be estimated in relation to total cost price (excluding
depreciation) symbolically,
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑢 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
(𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢)
∗ 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
12 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚ℎ𝑠𝑠, 52 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤, 265 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
e. Cash and Bank Balance
Apart from WC needs for financing inventories and debtors, firms also find it useful to have
some minimum cash balances with them. It is difficult to lay down the exact procedure of
determining such an amount. This should primarily be based on the motives for holding cash
balancesof the business firm, attitude of management toward risk, the access to the borrowing
sources in times of need and past experience, and so on.
ii. Estimation of Current Liabilities
The working capital needs of business firms are lower to the extent that such needs are met
through the current liabilities (other than bank credit) arising in the ordinary course of business.
The important current liabilities (CL), in this context are trade-creditors, wages and overheads.
a.
Trader Creditors: Trade payable can be estimated on the basis of material purchase budget
and the credit purchase.
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 ×𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
12 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 ℎ𝑠𝑠/365 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
∗ 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴ℎ𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
The Institute of Chartered Accountants of Nepal | 403
Chapter 6
Financial Management
Note: Proportional adjustment should be made to cash purchases of raw materials.
b. Direct Wages
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵
×𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
12 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 ℎ𝑠𝑠/365 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
∗ 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
The average credit period for the payment of wages approximates to a half-a-month in the case
of monthly wage payment. The first days‘ monthly wages are paid on the 30th day of the month,
extending credit for 29 days, the second day‘s wages are again, paid on the 30th extending credit
for 28 days, and so on. Average credit period approximates to half-a-month.
c.
Overheads (Other Than Depreciation and Amortization)
(𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑋𝑋 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢)
12 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚ℎ / 365 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
Working capital requirement estimation based on cash cost:
We have already seen that working capital is the difference between current assets and current
liabilities. To estimate requirements of working capital, we have to forecast the amount required
for each item of current assets and current liabilities. However, in practice another approach may
also be useful in estimating working capital requirements. This approach is based on the fact that
in the case of current assets, like sundry debtors and finished goods, etc., the exact amount of
funds blocked is less than the amount of such current assets. Thus,
 if we have sundry debtors worth Rs.1 lakh and our cost of production is Rs.75,000, the
actual amount of funds blocked in sundry debtors is Rs.75,000 the cost of sundry debtors,
the rest (Rs.25,000) is profit.
 Again, some of the cost items also are non-cash costs; depreciation is a non-cash cost
item. Suppose out of Rs.75,000, Rs.5,000 is depreciation; then it is obvious that the actual
funds blocked in terms of sundry debtors totaling Rs.1 lakh is only Rs.70,000. In other
words, Rs.70, 000 is the amount of funds required to finance sundry debtors worth Rs.1
lakh.
 Similarly, in the case of finished goods which are valued at cost, non-cash costs may be
excluded to work out the amount of funds blocked.
Many experts, therefore, calculate the working capital requirements by working out the cash
costs of finished goods and sundry debtors. Under this approach, the debtors are calculated not
as a percentage of sales value but as a percentage of cash costs. Similarly, finished goods are
valued according to cash costs.
Illustration No. 3
The following annual figures relate to XYZ Co.,
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Working Capital Management & Finanical Forecasting
Particulars
Sales (at two months‘ credit)
Amount in NRs
3,600,000.00
Materials consumed (suppliers extend two months‘ credit)
900,000.00
Wages paid (monthly in arrear)
720,000.00
Manufacturing expenses outstanding at the end of the year
80,000.00
(Cash expenses are paid one month in arrear)
Total administrative expenses, paid as above
240,000.00
Sales promotion expenses, paid quarterly in advance
120,000.00
The company sells its products on gross profit of 25% counting depreciation as part of the cost
of production. It keeps one months‘ stock each of raw materials and finished goods, and a cash
balance of Rs.1,00,000.
Assuming a 20% safety margin, work out the working capital requirements of the company on
cash cost basis. Ignore work-in-process.
Illustration No. 3 Solution
Statement of Working Capital requirements (cash cost basis)
Particular
Rs
A. Current Asset
Materials
Finished Goods
Debtors
Cash
Prepaid expenses (Sales promotion)
Total Current Assets
B. Current Liabilities:
Creditors for materials
Wages outstanding
Manufacturing expenses
Administrative expenses
Total Current Liabilities
Net working capital (A-B)
(Rs. 9,00,000 ÷12)
(Rs. 25,80,000 ÷12)
75,000
215,000
(Rs.29,40,000÷6)
490,000
100,000
30,000
910,000
(Rs. 1,20,000÷4)
(Rs.9,00,000÷6)
(Rs.7,20,000÷ 12)
(Rs.2,40,000÷12)
150,000
60,000
80,000
20,000
310,000
600,000
Add safety margin 20%
120,000
Total working capital requirements
720,000
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Working Notes:
(i) Computation of Annual Cash cost of Production
Particular
Rs.
Material consumed
900,000
Wages
Manufacturing expenses (Rs.80,000 x 12)
720,000
960,000
Total cash cost of production
(ii) Computation of Annual Cash cost of sales: Rs.
Particular
Cash cost of production as in (i) above
Administrative Expenses
Sales promotion expenses
Total cash cost of sales
2,580,000
Rs.
25,80,000
2,40,000
1,20,000
29,40,000
Effect of Double Shift Working on Working Capital requirements:
Increase in the number of hours of production has an effect on the working capital requirements.
The greatest economy in introducing double shift is the greater use of fixed assets-little or
marginal funds may be required for additional assets.
It is obvious that in double shift working, an increase in stocks will be required as the production
rises. However, it is quite possible that the increase may not be proportionate to the rise in
production since the minimum level of stocks may not be very much higher. Thus, it is quite
likely that the level of stocks may not be required to be doubled as the production goes up twofold.
The amount of materials in process will not change due to double shift working since work
started in the first shift will be completed in the second; hence, capital tied up in materials in
process will be the same as with single shift working. As such the cost of work-in-process, will
not change unless the second shift‘s workers are paid at a higher rate. Fixed overheads will
remain fixed whereas variable overheads will increase in proportion to the increased production.
Semi-variable overheads will increase according to the variable element in them.
However, in examinations the students may increase the amount of stocks of raw materials
proportionately unless instructions are to the contrary.
Illustration No. 4
Ram Sharan Enterprises has been operating its manufacturing facilities till 31.3.2076 on a
single shift working with the following cost structure:
406 |The Institute of Chartered Accountants of Nepal
Working Capital Management & Finanical Forecasting
Per Unit Rs.
Particulars
Cost of Materials
Wages (out of which 40% fixed)
Overheads (out of which 80% fixed)
Profit
Selling Price
6
5
5
2
18
Sales during 2075-76 – Rs.4,32,000. As at 31.3.2076 the company held:
Rs.
Stock of raw materials (at cost)
36,000
Work-in-progress (valued at prime cost)
Finished goods (valued at total cost)
Sundry debtors
22,000
72,000
108,000
In view of increased market demand, it is proposed to double production by working an extra
shift. It is expected that a 10% discount will be available from suppliers of raw materials in
view of increased volume of business. Selling price will remain the same. The credit period
allowed to customers will remain unaltered. Credit availed of from suppliers will continue to
remain at the present level i.e., 2 months. Lag in payment of wages and expenses will continue
to remain half a month.
You are required to assess the additional working capital requirements, if the policy to
increase output is implemented.
Illustration No. 4 Solution
Statement of cost at single shift and double shift working
24,000 units
48,000 Units
Per unit Rs.
Raw materials
Wages – Variable
Fixed
Overheads - Variable
Fixed
Total cost
Profit
Total Rs.
Per unit Rs.
Total Rs.
6
3
2
1
4
16
2
1,44,000
72,000
48,000
24,000
96,000
3,84,000
48,000
5.4
3
1
1
2
12.4
5.6
2,59,200
1,44,000
48,000
48,000
96,000
5,95,200
2,68,800
18
4,32,000
18
8,64,000
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Sales in units 2075-76
=
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
=
432,000
= 24,000
18
Stock of Raw Materials in units on 31.3.2076
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 36000
=
= 6000 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
6
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
Stock of work-in-progress in units on 31.3.2076
22000
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉
=
= 2000 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
11
𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Stock of finished goods in units 2075-76
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉ℎ𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 72000
=
= 4500 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
16
Comparative Statement of Working Capital Requirement
Single Shift
Double Shift
Unit
Rate
Amount Rs.
Unit
Rate
Amount Rs.
6000
2000
4500
6000
6
11
16
18
36,00
22,000
72,000
1,08,000
12000
2000
9000
12000
5.4
9.4
12.4
18
64,800
18,800
1,11,600
2,16,000
Current Assets
Inventories Raw Materials
Work-in-Progress
Finished Goods
Sundry Debtors
Total Current Assets: (A)
Current Liabilities
Creditors for Materials
Creditors for Wages
Creditors for Expenses
Total Current Liabilities:
(B)
2,38,000
4000
1000
1000
6
5
5
408 |The Institute of Chartered Accountants of Nepal
24,000
5,000
5,000
34,000
4,11,200
8000
2000
2000
5.4
4
3
43,200
8,000
6,000
57,200
Working Capital Management & Finanical Forecasting
Working Capital: (A) –
(B)
Less: Profit included in
Debtors
2,04,000
6000
2
12,000
3,54,000
12,000
5.6
192000
67,200
2,86,800
Increase in Working Capital requirement is (Rs.2,86,800 – Rs.1,92,000) or Rs.94,800
Notes:
(i) The quantity of material in process will not change due to double shift working since work
started in the first shift will be completed in the second shift.
(ii) The valuation of work-in-progress based on prime cost as per the policy of the company is
as under.
Particulars
Single shift
Double shift
Rs.
Rs.
Materials
6.00
5.40
Wages – Variable
Fixed
3.00
2.00
3.00
1.00
11.00
9.40
Knowledge test 1
The following data relate to Radhye Shyam Co, a manufacturing company.
Particulars
Sales revenue for year:
Costs as percentage of sales:
Direct materials
Direct labor
Variable overheads
Fixed overheads
Selling and distribution
Amount/ Percentage
NRs 1,500,000
30%
25%
10%
15%
5%
Average statistics relating to working capital are as follows:




receivables take 2½ months to pay
raw materials are in inventory for three months
WIP represents two months‘ half produced goods
finished goods represent one month‘s production
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Credit taken
 Material
 Direct Labor
 Variable overhead
 Fixed overhead
 Selling and distribution
2 months
1 week
1 months
1 months
½ month
WIP and finished goods are valued at the cost of material, labor and variable expenses.
Compute the working capital requirement of Mugwump Co if the labor force is paid for 50
working weeks in each year.
Knowledge Test 1- Answer
Particulars
Cost Incurred
Direct materials
Direct labor
Variable overheads
Fixed overheads
Selling and distribution
Calculation
Amount
30% of NRs 1,500,000
25% of NRs 1,500,000
10% of NRs 1,500,000
15% of NRs 1,500,000
5% of NRs 1,500,000
450,000
375,000
150,000
225,000
75,000
Average value of current assets
Particulars
Finished goods
Raw material
WIP – 2 months at half produced
(i.e. 1-month period)
Receivables
Total
Calculation
=1/12*975,000
=3/12*450,000
=1/12*975,000
Amount in NRs
81,250
112,500
81,250
=5/24*1500,000
312,500
587,500
Average value of current liabilities
Particulars
Payment to material purchase
Labor
Variable overhead
Fixed Overhead
Selling and Distribution
Total
Working Capital
Calculation
=2/12*450,000
=1/50*375,000
=1/12*150,000
=1/12*225,000
= 1/24*75,000
410 |The Institute of Chartered Accountants of Nepal
Amount in NRs
75,000
7,500
12,500
18,750
3,125
(116,875)
470,625
Working Capital Management & Finanical Forecasting
6.2 Inventory Management
6.2.1 Learning Objectives
Upon completion of this chapter student will be able to:




explain the objective of inventory management
define and explain lead time and buffer inventory
explain and apply the basic economic order quantity (EOQ)
define and calculate the reorder level
6.2.2 Chapter Overview
Working Capital
Management - Inventory
control
Objective- the balancing act
Calculate the reorder level
Econmic Order Quantity
Fig: Chapter Overview of Inventory Management
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6.2.3 Introduction
Inventory management refers to the process of ordering, storing, and using a company's
inventory. These include the management of raw materials, components, and finished products,
as well as warehousing and processing such items.
Inventory is a major investment for many companies. Manufacturing companies can easily be
carrying inventory equivalent to between 50% and 100% of the revenue of the business. It is
therefore essential to reduce the level of inventory held to the necessary minimum.
Fig: Balancing act between liquidity and profitability – Inventory management
6.2.4 Objective of Inventory Management
The main objective of inventory management is to maintain inventory at appropriate level to
avoid excessive or shortage of inventory because both the cases are undesirable for business.
Thus, management is faced with the following conflicting objectives:
1) To keep inventory at sufficiently high level to perform production and sales activities
smoothly.
2) To minimize investment in inventory at minimum level to maximize profitability.
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Other objectives of inventory management are explained as under: 1. To ensure that the supply of raw material & finished goods will remain continuous so
that production process is not halted and demands of customers are duly met.
2. To minimize carrying cost of inventory.
3. To keep investment in inventory at optimum level.
4. To reduce the losses of theft, obsolescence & wastage etc.
5. To make arrangement for sale of slow-moving items.
6. To minimize inventory ordering costs.
The objective of good inventory management is therefore to determine:
a) the optimum re-order level – how many items are left in inventory when the next order
is placed, and
b) the optimum re-order quantity – how many items should be ordered when the order is
placed.
In practice, this means striking a balance between holding costs on the one hand and stockou
t and re-order costs on the other.
The balancing act between liquidity and profitability, which might also be considered to be a tr
ade-off between holding costs and stockout/reorder costs, is key to any discussion on inventory
management.
6.2.5 Maintenance of Optimum Inventory Level
1. Disadvantages of having high inventory levels
a) Poor Turnover: Companies typically want to produce or maintain only enough
inventory to meet immediate demands and to avoid stockouts. When companies have
excessive amounts of inventory, they are generally not selling enough to prevent
inventory buildup. This is not a good situation as businesses need to turn over
inventory efficiently to maintain reasonably high profit margins and to avoid the
costs and other disadvantages that come with high levels of inventory.
b) High Costs: Carrying excess inventory has significant costs. One of the highest costs
for many companies is financing the purchase and holding of inventory. Also, the
more inventory you hold, the more you have to spend on labor to manage it, space to
hold it, and in some cases, insurance to protect against its loss or damage. Physically
counting and monitoring the levels of inventory you hold also takes time and has
costs.
c) Loss or Damage: Related to the high costs of high inventory, some inventory can
also go bad after a certain amount of time and go to waste. When retailers buy excess
inventory of perishable food items, for instance, they may have to throw out
inventory that spoils or becomes rotten. When you carry high inventory, you also
have greater exposure to lost or damaged product. Thieves have more products to
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choose from and you have greater potential for product to turn up missing or broken
when you count inventory.
d) Strategic Planning Time: Company leaders typically have to spend more time in
strategic planning meetings when the company has high inventory levels.
Management must figure out how to communicate with suppliers, how to improve
ordering processes or how to increase market demand to reduce the high levels of
inventory. This problem takes away from the ability of these managers to focus on
other proactive or more important strategic decisions to move the company forward.
Dealing with inventory problems is a more reactive strategy to resolve the issue at
hand.
2. Disadvantages of having low inventory levels
a) Missing out on sales – Consumer demand can be difficult to predict; even the best
forecasts rest on assumptions and demand can only be approximated. Many
businesses carry a little extra stock than they expect to need in any given period to
insulate against the risk of selling out. Although this has a cost, carrying some safety
stock is important for many businesses – the rationale being that if you develop a
reputation for running out of stock, your business will struggle to reach its full
potential.
b) Missing out on discounts – Often, companies that buy raw materials, component
parts, or finished products in large quantities can secure discounts from their
suppliers. Companies that stock too little or even just enough of these goods run the
risk of missing out on these price breaks. Also, companies that place large orders
infrequently, rather than small orders frequently, can reduce shipping and clerical
costs.
c) Losing consumer loyalty – If your company consistently under-stocks what
customers want, it runs the risk of losing their future business.
d) Re-order/setup costs: each time inventory runs out; new supplies must be acquired.
If the goods are bought in, the costs that arise areassociated with administration –
completion of a purchase requisition, authorization of the order, placing the order
with the supplier, taking and checking the delivery and final settlement of the
invoice. If the goods are to be manufactured, the costs of setting up the machinery
will be incurred each time a new batch is produced.
6.2.6 Economic Order Quantity
Economic order quantity (EOQ) is the ideal order quantity a company should purchase to
minimize inventory costs such as holding costs, shortage costs, and order costs. This
production-scheduling model was developed in 1913 by Ford W. Harris and has been refined
over time.
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In other words, it represents the optimal quantity of inventory a company should order each
time in order to minimize the costs associated with ordering and holding inventory.
If the economic order quantity model is applied, the following assumptions should be met:
 The rate of demand is constant, and total demand is known in advance.
 The ordering cost is constant.
 The unit price of inventory is constant, i.e., no discount is applied depending on order
quantity.
 Delivery time is constant.
 Replacement of defective units is instantaneous.
 There is no safety stock level, i.e., the minimum stock level is zero.
Calculation
Economic order quantity can be more quickly found using a formula;
Where,
A = Annual demand of inventory
𝐸𝐸𝐸𝐸𝐸𝐸 =
2𝐴𝐴𝐴𝐴
𝐶𝐶
O= ordering cost per order
C= carrying cost per unit
Total cost of Inventory = Ordering costs + carrying costs
The two most significant inventory management costs are ordering costs and carrying costs.
Ordering costs are costs incurred on placing and receiving a new shipment of inventories. These
include communication costs, transportation costs, transit insurance costs, inspection costs,
accounting costs, etc. Carrying costs represent costs incurred on holding inventory in hand.
These include opportunity cost of money held-up in inventories, storage costs such as warehouse
rent, insurance, spoilage costs, etc.
Ordering costs and carrying costs are opposite in nature. To minimize its inventory carrying
costs, a company must place small orders. But small order size means that the company must
place more orders which increases its total ordering costs. Similarly, if a company wants to cut
its ordering costs, it must reduce the number of orders placed which is possible only when order
size is large. But increase in order size means that average inventory balance on hand will be
high which increases total carrying costs for the period.
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a) Ordering costs: - The order quantity increases, there is a fall in the number of orders
required which reduces the total ordering costs.
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑜 𝑜𝑜𝑜𝑜. 𝑜𝑜𝑜𝑜 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
b) Holding costs (carrying costs): The model assumes that it costs a certain amount to
hold a unit of inventory for a year. Therefore, as the average inventory increases, so too
will the total annual holding costs have incurred.
Where,
𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 =
𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞
2
Illustration No: 1
A company requires 1,000 units of material X per month. The cost per order is NRS 30
regardless of the size of the order. The holding costs are NRs 2.88 per unit per annum.
Also, investigate the total cost of buying the material in quantities of 400, 500 or 600 units at
one time.
Illustration No. 1- solution
Given,
Annual requirement (A) = 1000*12 = 12,000 per annum
Ordering costs (o) = NRs 30 per order
Carrying costs (c) = NRs 2.88 per unit
We know that,
𝐸𝐸𝐸𝐸𝐸𝐸 =
𝐸𝐸𝐸𝐸𝐸𝐸 =
Particulars
400 units
Average inventory
200
Holding costs
2𝐴𝐴𝐴𝐴
𝐶𝐶
2 ∗ 12,000 ∗ 30
= 500
2.88
12000
∗ 30
400
=900
=
416 |The Institute of Chartered Accountants of Nepal
500 units
600 units
250
300
12000
∗ 30
500
= 720
=
12000
∗ 30
600
=600
=
Working Capital Management & Finanical Forecasting
Carrying costs
Total cost
= 200 ∗ 2.88
= 576
1,476
= 250 ∗ 2.88
=720
1,440
= 300 ∗ 2.88
=864
1,464
Therefore, the best option is to order 500 units each time.
Note: that this is the point at which total cost is minimized and the holding costs and order
costs are equal
6.2.7 Reorder Level
In management accounting, reorder level (or reorder point) is the inventory level at which a
company would place a new order or start a new manufacturing run.
Reorder level depends on a company‘s work-order lead time and its demand during that time and
whether the company maintain a safety stock. Work-order lead time is the time the company‘s
suppliers take in manufacturing and delivering the ordered units.
Identifying the correct reorder level is important. If a company places a new order too soon, it
may receive the ordered units earlier than expected and it would have to bear additional carrying
costs in the form of warehousing rent, opportunity cost, etc. However, if the company places an
order too late, it will result in stock-out costs, for example lost sales, etc.
Reorder level depends on whether a safety stock is maintained.
If there is no safety stock, reorder level can be worked out using the following formula:
Reorder Level = Average Demand × Lead Time
Both demand and lead time must be in the same unit of time i.e. both should in in days or weeks,
etc.
If a company maintains a safety stock, reorder level calculation changes are follows:
Reorder Level = Average Demand × Lead Time + Safety Stock
Illustration No. 2
ABC Ltd. is a retailer of footwear. It sells 500 units of one of a famous brand daily. Its
supplier takes a week to deliver any ordered units.
The inventory manager should place an order before the inventories drop below 3,500 units
(500 units of daily usage multiplied with 7 days of lead time) in order to avoid a stock-out.
Illustration No. 3
ABC Ltd. has decided to hold a safety stock equivalent to average usage of 5 days. Calculate
the reorder level.
The Institute of Chartered Accountants of Nepal | 417
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Safety stock which ABC Ltd. has decided to hold equals 2,500 units (500 units of daily usage
multiplied by 5 days).
In this scenario, reorder level would be 6,000 units (2,500 of safety stock plus 3,500 units
based on 7 days of lead time).
Illustration No. 4
A local TV repairs shop uses 36,000 units of a part each year (A maximum consumption of
100 units per working day). It costs Rs. 20 to place and receive an order. The shop orders in
lots of 400 units. It cost Rs. 4 to carry one unit per year of inventory.
Requirements
(1) Calculate total annual ordering cost
(2) Calculate total annual carrying cost
(3) Calculate total annual inventory cost
(4) Calculate the Economic Order Quantity
(5) Calculate the total annual cost inventory cost using EOQ inventory Policy
(6) How much save using EOQ
(7) Compute ordering point assuming the lead time is 3 days
Illustration No. 4 Solution
1) Calculate total annual ordering costs
𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 ∗ 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑜𝑜𝑜𝑜 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 20 ∗
2) Calculate total annual carrying costs
36,000
= 𝑁𝑁𝑁𝑁𝑁𝑁 1800
400
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑐𝑐 ∗
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝑁𝑁𝑁𝑁𝑁𝑁 4 ∗
3) Calculate total annual inventory costs
𝐸𝐸𝐸𝐸𝐸𝐸
2
400
= 𝑁𝑁𝑁𝑁𝑁𝑁 800
2
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 + 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 1800 + 800 = 𝑁𝑁𝑁𝑁𝑁𝑁 2600
4) Calculate the Economic Order Quantity
𝐸𝐸𝐸𝐸𝐸𝐸 =
418 |The Institute of Chartered Accountants of Nepal
2𝐴𝐴𝐴𝐴
𝐶𝐶
Working Capital Management & Finanical Forecasting
𝐸𝐸𝐸𝐸𝐸𝐸 =
2 ∗ 36000 ∗ 20
= 600 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
4
5) Calculate the total annual cost inventory cost using EOQ inventory Policy
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 + 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 =
36000
600
∗ 20 +
∗4
600
2
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 1200 + 1200 = 𝑁𝑁𝑁𝑁𝑁𝑁 2,400
6) How much save using EOQ
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 2600 − 2400 = 𝑁𝑁𝑁𝑁𝑁𝑁 200
7) Compute ordering point assuming the lead time is 3 days
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 = 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 ∗ 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 = 100 ∗ 3 = 300 𝑝𝑝𝑝𝑝𝑝𝑝 𝑑𝑑𝑑𝑑𝑑𝑑
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6.3 Management of Account Receivable and Account Payable
6.3.1 Learning Objectives
Upon completion of this chapter student will be able to:
explain how to establish and implement a credit policy for account receivable
differentiate credit standard and credit policy
explain the credit analysis and investigation
categorize the different short-term sources of finance
define and explain the feature of factoring and Invoice Discounting
discuss the advantages and disadvantages of factoring
discuss the advantages and disadvantages of trade credit as a source of short term
finance
 differentiate between the forfeiting and factoring
 explain the concept of packing credit facility
 define the concept of commercial paper, certificate of deposit
explain the specific factors to be considered when managing foreign accounts receivables and
payables







6.3.2 Chapter Overview
Account
Receivable and
Accounts Payable
Account
Receivable
Cost of Financing
Receivable
Factoring
Account Payable
Credit
Management
Credit Policy
Invoice
Discounting
Assessing Credit
Worthiness
Forfeiting
Cost of Financing
Receivable
Credit Terms
Short Term
Finances
Collection Policy
Fig: Chapter Overview of Receivable Management
420 |The Institute of Chartered Accountants of Nepal
Trade Credit
Bank Credit
Working Capital Management & Finanical Forecasting
6.3.3 Introduction
The receivables represent an important componentof current assets. They generally occupy the
second place, in order of investment among the various components of working capital in
manufacturing and trading units. "Management of trade credit is commonly known as
management of receivables". The trade credit is considered to be an important marketing tool
acting as a bridge for-the movement of goods from production and distribution stages to
customers finally. Trade credit is granted to protect sales from competitors and to attract
potential customers to buy the product at favorable terms and conditions. Granting credit and
creating receivables amount to the blocking of firm's funds. The interval period between the date
of sale and the date of receipt of payment has to be financed out of working capital funds.
Therefore, receivables represent investment. As substantial amounts are tied up in receivables,
they need a careful analysis and proper management.
6.3.4 Meaning of Receivable
The term receivable is defined as `debt owed to the firm by customers arising from sale of goods
or services in the ordinary course of business'.' When a firm makes an ordinary sale of goods or
services and does not receive payment, the firm grants trade credit and creates accounts
receivable which could be collected in the future. Receivables management is also called trade
credit management. Thus, accounts receivable represents an extension of credit to customers,
allowing them a reasonable period of time in which to pay for the goods received.
The maintenance of receivables involves direct and indirect costs. The direct costs include the
cost of investments, allowances and concessions to customers and also lose on account of bad
debts. On the other hands administrative costs connected with the collection of receivables,
recording of bills and preparing statements, inflationary costs and delinquency costs in the form
of delayed collection and cost of giving remainder, legal expenses, if necessary, etc. are indirect
costs. However, to compute all these costs precisely is not quite easy.
6.3.5 Objective of Maintaining Receivables
The purpose of granting credit is to facilitate sales. It is valuable to customers as it augments
their resources. It is particularly appealing to those customers who cannot borrow from other
sources or find it very expensive or cumbersome to do so. In brief, the main objectives of
maintaining receivables are as follow,
a. Expansion of Sales
Though, it is a good policy to affect cash sales to the maximum possible extent. However, it may
not always be possible to do so. Customers may not be willing to buy goods on cash basis. They
have, therefore, to be encouraged with the offer of credit terms. In the absence of such an offer, a
firm may not be able to sell goods at a desired level. Receivables enable it to push its sales
effectively in the market.
b. Increase in Profits:
If the level of sales increases, the profit will also increase. This is ordinarily so because the
marginal contribution-affected by an increase in sales is higher than the additional costs
associated with such an increase.
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c. Maintaining Liquidity:
The concept of operating cycles explains the fact that receivables are one step ahead of
inventories. So, it facilitates the task of maintaining liquidity in business because it can be easily
converted into cash.
6.3.6 Cost of Maintaining Receivables
The maintenance of receivables involves a credit sanction which means to tie up funds with it.
The main costs associated with receivables are as follows.
The major categories of costs associated with the extension of credit and accounts receivable are:
(i) collection cost, (ii) capital cost, (iii) delinquency cost, and (iv) default cost.
(i)
Collection Cost
Collection costs are administrative costs incurred in collecting the receivables from the
customers to whom credit sales have been made. Included in this category of costs are: (a)
additional expenses on the creation and maintenance of a credit department with staff,
accounting records, stationery, postage and other related items; (b) expenses involved in
acquiring credit information either through outside specialist agencies or by the staff of the firm
itself. These expenses would not be incurred if the firm does not sell on credit.
(ii)
Capital Cost
The increased level of accounts receivable is an investment in assets. They have to be financed
thereby involving a cost. There is a time-lag between the sale of goods to, and payment by, the
customers. Meanwhile, the firm has to pay employees and suppliers of raw materials, thereby
implying that the firm should arrange for additional funds to meet its own obligations while
waiting for payment from its customers. The cost on the use of additional capital to support
credit sales, which alternatively could be profitably employed elsewhere, is, therefore, a part of
the cost of extending credit or receivables.
(iii)
Delinquency Cost
This cost arises out of the failure of the customers to meet their obligations when payment on
credit sales become due after the expiry of the credit period. Such costs are called delinquency
costs. The important components of this cost are: (i) blocking-up of funds for an extended
period, (ii) cost associated with steps that have to be initiated to collect the overdue, such as,
reminders and other collection efforts, legal charges, where necessary, and so on.
(iv)
Default Cost
Finally, the firm may not be able to recover the overdues because of the inability of the
customers. Such debts are treated as bad debts and have to be written off as they cannot be
realized. Such costs are known as default costs associated with credit sales and accounts
receivable.
422 |The Institute of Chartered Accountants of Nepal
Working Capital Management & Finanical Forecasting
6.3.7 Objectives of Receivable Management
The basic objective of receivable management is to maximize the overall return on investments.
The purpose of any commercial enterprise is earning of profit. Credit in itself is utilized to
increase sales, but sales must return a profit.
The emergence of receivables in business operations creates revenues and costs. Hence the
volume, composition and movement of receivables are required to be so designed and
maintained that these ultimately help maximization of the value of a firm which is the long
standing and accepted principle of financial management. To put it otherwise, it may be said that
the basic objective of receivable management is to achieve a trade oftheir liquidity and
profitability aspects. In fact, the, receivables in a firm should be managed in a way that the sales
are expanded to an extent where risk remains within an acceptable limit. Precisely, the goals ff
receivables management are enumerated as below;
i.
ii.
iii.
iv.
to maintain an optimum level of investment in receivables
to keep down the average collection period
to obtain the optimum volume of sales and
to control the cost of credit allowed and to keep it at the minimum possible level
The purpose of receivables management is not sales maximization. But an efficient and effective
management of receivable does help to expand sales and can prove to be an effective tool of
marketing. It helps to retain old customers and win new ones. Well administered receivable
management means profitable credit accounts. The objective of receivable management is, "to
promote sales and profit until that point is, reached where the return on investments in further
funding of receivables is less than the cost of funds raised to finance that additional credit (i.e.
cost of capital.
6.3.8 Credit Management
In order that the credit sales are properly managed it is necessary to determine following factors:
a. Credit Policies
b. Credit Terms
c. Collection Policies
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Chapter 6
Financial Management
Credit
Management
Credit
Policies
Credit
standard
credit Terms
Credit
Analysis
Collection
Costs
Obtaining
Credit
Information
Avereage
Collcection
Period
Analysis of
Credit
Information
Collection
Policies
Cash
Discounts
Degree of
Collection
efforts
Credit Period
Types of
Collection
efforts
Bad Debt
Expenses
Sales Volume
Fig: Credit Management chart
6.3.8.1 Credit Policies
In the preceding discussions it has been clearly shown that the firm's objective with respect to
receivables management is not merely to collect receivables quickly, but attention should also be
given to the cost-benefit trade-off involved in the various areas of accounts receivable
management. The first decision-area is Credit Policies.
Factor Influencing Credit Policy
a) Competition
Credit practices within an industry influence the formal credit policy of any individual
company. Competitive conditions place a high degree of importance on credit
availability. The credit policy of a company is important for maintaining or improving
its competitive position. Even where credit is not generally a competitive tool, an
individual company can use it in this manner if it is willing to do so.
b) Customer Type
The type of customer has a direct limiting influence on the credit policies of all
companies in an industry. Where the buyers‘ line of business is characteristically short
424 |The Institute of Chartered Accountants of Nepal
Working Capital Management & Finanical Forecasting
of capital, it is unrealistic for credit policy to be unduly restrictive. A company that
operates on that basis will not maintain its market.
c) Merchandise
The type of merchandise affects the credit policy of the seller in a number of ways.
There is a tendency to sell on a more liberal basis if the merchandise has a relatively
high profit margin or high price. Also, terms may be somewhat more liberal if the
merchandise can be repossessed or returned inward in the same condition as it was sold.
On the other hand of the shelf life is shorter of the merchandise then most probably the
credit terms will provide shorter credit period.
d) Profit margin:
When the profit margin is slim, the credit department may be more careful in the
selection of its accounts. High mark-up goods should, at least in theory, encourage
credit professionals to approve sales to marginal credit risk accounts. In other words, the
higher the gross profit margin, the more tolerant of credit risk the credit manager should
be. This is a general statement and not always true.
e) Unit Price:
It is easier to establish a uniform liberal policy that applies to all customers when the
unit price of merchandise is relatively low. Even on a wrong decision, the dollar amount
of risk is low credit exposure is greater. A more detailed analysis is usually conducted
before a customer order is approved.
f)
Government Regulation:
In the case of particular commodities, such as spirits and liquors, government
regulations specify credit policies or procedures which must be followed by the seller.
There, the overall policy must take the regulations into consideration. In avery general
way, expected long-range trends in the economy also influence credit policy
g) Economic Condition:
Economic or business conditions are of much greater significance, however, in
determining how policy is to be applied over a shorter period of time. When times are
prosperous, ability of debtors to pay their bills is somewhat improved; however, there is
a danger that they may tend to overbuy. During slack business periods, debtors tend to
delay payment of their bills and credit requirements may tend to be stricter.
Concurrently, as sales drop, the company is faced with the problem of maintaining
volume in the face of decreasing sales and more demanding selection of credit
customers.
The credit policy of a firm provides the framework to determine (a) whether or not to extend
credit to a customer and (b) how much credit to extend. The credit policy decision of firm has
The Institute of Chartered Accountants of Nepal | 425
Financial Management
Chapter 6
two broad dimensions: (i) Credit standards and (ii) Credit analysis. A firm has to establish and
use standards in making credit decisions, develop appropriate sources of credit information and
methods of credit analysis. We illustrate below how these two aspects are relevant to the account
receivable management of a firm.
 Credit Standards
The term credit standards represent the basic criteria for the extension of credit to customers. The
quantitative basis of establishing credit standards are factors such as credit ratings, credit
references, average payments period and certain financial ratios.' To illustrate the effect, we have
divided the overall standards into (a) tight or restrictive, and (b) liberal or nonrestrictive. Our aim
is to show what happens to the trade-off when standards are relaxed or, alternatively, tightened.
The trade-off with reference to credit standards covers
(i) the collection cost, (ii) the average collection period/investment in accounts receivable, (iii)
level of bad debt losses, and (iv) level of sales. These factors should be considered while
deciding whether to relax credit standards or not. If standards are relaxed, it means more credit
will be extended while if standards are tightened, less credit will be extended. The implications
of the four factors are elaborated below.
i. Collection Costs
The implications of relaxed credit standards are (i) more credit, (ii) a large credit department to
service accounts receivable and related matters, (iii) increase in collection costs. The effect of
tightening of credit standards will be exactly the opposite. These costs are likely to be semivariable. This is because up to a certain point the existing staff will be able to carry on the
increased workload, but beyond that, additional staff would be required. These costs are assumed
to be included in the variable cost per unit and need not be separately identified.
ii. Investments in Receivables or the Average Collection Period
The investment in accounts receivable involves a capital cost as funds have to be arranged by the
firm to finance them till customers make payments. Moreover, the higher the average accounts
receivable, the higher is the capital or carrying cost. A change in the credit standardsrelaxation or
tighteningleads to a change in the level of accounts receivable either (a) through a change in
sales, or (b) through a change in collections.
A relaxation in credit standard, as already stated, implies an increase in sales which, in turn,
would lead to higher average accounts receivable. Further, relaxed standards would mean that
credit is extended liberally so that it is available to even less credit-worthy customers who will
take a longer period to pay over dues. The extension of trade credit to slow-paying customers
would result in a higher level of accounts receivable.
In contrast, a tightening of credit standards would signify (i) a decrease in sales and lower
average accounts receivable, and (ii) an extension of credit limited to more credit-worthy
426 |The Institute of Chartered Accountants of Nepal
Working Capital Management & Finanical Forecasting
customers who can promptly pay their bills and, thus, a lower average level of accounts
receivable.
Thus, a change in sales and change in collection period together with a relaxation in standards
would produce a higher carrying costs, while changes in sales and collection period result in
lower costs when credit standards are tightened. These basic reactions also occur when changes
in credit terms or collection procedures are made. We have discussed these in the subsequent
sections of this chapter.
iii. Bad Debt Expenses
Another factor which is expected to be affected by changes in the credit standards is bad debt
(default) expenses. They can be expected to increase with relaxation in credit standards and
decrease if credit standards become more restrictive.
iv. Sales Volume
Changing credit standards can also be expected to change the volume of sales. As standards are
relaxed, sales are expected to increase; conversely, a tightening is expected to cause a decline in
sales.
The basic changes and effects on profits arising from a relaxation of credit standards are
summarized in Exhibit below. If the credit standards are tightened, the opposite effects, as shown
in the brackets, would follow.
Item
Direction of
Change (Increase = I
Decrease = D)
Effect on
Profits (Positive +
Negative -)
1. Sales Volume
I(D)
+(-)
2.Average Collection Period
3. Bad Debt
I(D)
I(D)
-(+)
-(+)
The effect of alternative credit standards is illustrated in Example 1
Illustration No. 1
A firm is currently selling a product @ Rs 10 per unit. The most recent annual sales (all credit)
were 30,000 units. The variable cost per unit is Rs .6 and the average cost per unit, given a
sales volume of 30,000 units, is Rs 8. The total fixed cost is Rs 60,000. The average collection
period may be assumed to be 30 days.
The firm is contemplating a relaxation of credit standards that is expected to result in a 15 per
cent increase in units‘ sales; the average collection period would increase to 45 days with no
change in bad debt expenses. It is also expected that increased sales will result in additional
net working capital to the extent of Rs 10,000. The increase in collection expenses may be
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assumed to be negligible. The required return on investment is 15 per cent.
Should the firm relax the credit standard?
Illustration No. 1- Solution
The decision to put the proposed relaxation in the credit standards into effect should be based
on a comparison of (i) additional profits on sales and (ii) cost of the incremental investments
in receivables. If the former exceeds the latter, the proposal should be implemented, otherwise
not.
i.
Profit on Incremental SalesThis can be computed in two ways: (i) long approach, and
(ii) shortcut-method.
Alternative 1: Long Approach
According to this approach, the costs and profits on both the present and the proposed sales
level are calculated and the difference in profit at the two levels will be the incremental profit.
Long Method to Calculate Marginal Profits
Particular
(A) Proposed Plan:
1.
Sales revenue (34.500 x units Rs 10)
2.
less Costs
(a) Variable (34,500x Rs 6)
(b) Fixed
3.
Profits from sales (I)
(B)
Current Plan:
1.
Sales revenue (30,000 x unit per 10)
2.
less costs:
(a) Variable (30,000 x Rs 6)
(b) Fixed
3.
Profits from sales (II)
(C) Marginal profits with new plant (I-II)
Rs.
Rs
3,45,500
2,07,000
60,000
2,67,000
78,000
300,000
1,80,000
60,000
2,40,000
60,000
18,000
Alternative 2; Short-Cut Method
The profits on sales will increase by an amount equal to the product of the additional units
sold and additional profit per unit. Since the 30,000 units representing the current level of
sales absorb all the fixed costs, any additional units sold will cost only the variable cost per
unit. The marginal profit per unit will be equal to the difference between the sales price per
unit (Rs 10) and the variable cost per unit (Rs 6). The marginal profit/contribution margin per
unit would, therefore, be Rs 4. The total additional (marginal) profits from incremental sales
will be Rs 18,000 (Rs 4,500 x Rs 4).
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ii. Cost of Marginal/Incremental Investment in Receivables: The second variable relevant
to the decision to relax credit standards is the cost of marginal investment in accounts
receivable. This cost can be computed by finding the difference between the cost of carrying
receivables before and after the proposed relaxation in credit standards. It can be calculated as
follows:
(a) Turnover of accounts receivable:
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
360
= 8 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
45
360
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
= 12 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
30
=
(b) Total cost of sales:
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑖𝑖𝑖𝑖 𝑡𝑡ℎ𝑒𝑒 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑜𝑜𝑜𝑜 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 ∗ 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
= 30,000 ∗ 𝑁𝑁𝑁𝑁𝑁𝑁 8 = 𝑁𝑁𝑁𝑁𝑁𝑁 240,000
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑜𝑜𝑜𝑜 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 ∗ 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
= 30,000 ∗ 𝑁𝑁𝑁𝑁𝑁𝑁 8 + (45,000 ∗ 6) = 𝑁𝑁𝑁𝑁𝑁𝑁 267,000
(c) Average investment in accounts receivable:
Present plan = Rs 2,40,000/12 = Rs 20,000
Proposed plan = Rs 2,67,000/8 = Rs 33,375
(d) The cost of marginal investments in accounts receivable:
This is the difference between the average investments in accounts receivable under (i) the
proposed plan and (ii) under the present plan. It is calculated as follows:
Average investments with proposed plan
Less average investment with present plan
Marginal investments
Rs 33,375
20,000
13,375
Marginal investments represent the amount of additional funds required to finance incremental
accounts receivable if the proposal to relax the credit standards is implemented. The additional
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cost of Rs 13,375 is the cost of marginal investment in accounts receivable.
Given 15 per cent as required return on the investments, the cost = 𝑅𝑅𝑠𝑠13,375𝑋𝑋 (15/100)
=𝑅𝑅𝑠𝑠2,006.25
This is an opportunity cost that the firm would earn this amount from alternative uses if the
funds are not tied up in additional accounts receivable.
(e) Cost of working capital: Rs 10,000 x 0.15 = Rs 1,500.
Since, the additional profits on increased sales as a result of relaxed credit standards (Rs
18,000) is considerably more than the cost of incremental investments in accounts receivable
(Rs 2,006.25) and working capital (Rs 1,500), the firm should relax its credit standards. Such
an action would lead to an overall increase in the profits of the firm by Rs 14,493.75 (Rs
18,000 - Rs 2,006.25 - Rs 1,500).
The effect of tightening credit standards would be just the opposite and can be illustrated on
the above lines.
6.3.8.2 Credit Analysis
Besides establishing credit standards, a firm should develop procedures for evaluating credit
applicants. The second aspect of credit policies of a firm is credit analysis and investigation.
Two basic steps are involved in the credit investigation process: (a) obtaining credit information,
and (b) analysis of credit information. It is on the basis of credit analysis that the decisions to
grant credit to a customer as well as the quantum of credit would be taken.
(a) Obtaining Credit Information
The first step in credit analysis is obtaining credit information on which to base the evaluation of
a customer. The sources of information, broadly speaking, are (i) internal, and (ii) external.
i.
InternalUsually, firms require their customers to fill various forms and documents giving
details about financial operations. They are also required to furnish trade references with
whom the firms can have contacts to judge the suitability of the customer for credit. This
type of information is obtained from internal sources of credit information. Another internal
source of credit information is derived from the records of the firms contemplating an
extension of credit. It is likely that a particular customer/applicant may have enjoyed credit
facility in the past. In that case, the firm would have information on the behavior of the
applicant(s) in terms of the historical payment pattern. This type of information may not be
adequate and may, therefore, have to be supplemented by information from other sources.
ii. ExternalThe availability of information from external sources to assess the creditworthiness
of customers depends upon the development of institutional facilities and industry practices.
In Nepal, the external sources of credit information are not as developed as in the
industrially advanced countries of the world. Depending upon the availability, the following
external sources may be employed to collect information.
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iii. Financial Statements One external source of credit information is the published financial
statements, that is, the balance sheet and the profit and loss account. The financial statements
contain very useful information. They throw light on an applicant's financial viability,
liquidity, profitability and debt capacity. Although the financial statements do not directly
reveal the past payment record of the applicant, they are very helpful in assessing the overall
financial position of a firm, which significantly determines its credit standing.
iv. Bank References Another useful source of credit information is the bank of the firm which
is contemplating the extension of credit. The modus operandi here is that the firm's banker
collects the necessary information from the applicant's banks. Alternatively, the applicant
may be required to ask his banker to provide the necessary information either directly to the
firm or to its bank
v. Trade References These refer to the collection of information from firms with whom the
applicant has dealings and who on the basis of their experience would vouch for the
applicant.
vi. Credit Bureau Reports Finally, specialist credit bureau reports from organizations
specializing in supplying credit information can also be utilized.
(b) Analysis of Credit Information
once the credit information has been collected from different sources, it should be analyzed to
determine the creditworthiness of the applicant. Although there are no established procedures to
analyze the information, the firm should devise one to suit its needs. The analysis should cover
two aspects: (i) quantitative, and (ii) qualitative.
i.
Quantitative Analysis: The assessment of the quantitative aspects is based on the factual
information available information. It from the financial statements, the past records of the
firm, and so on. The first step involved in this type of assessment is to prepare an Aging
Schedule of the accounts payable of the applicant as well as calculate the average age of
the accounts payable. This exercise will give an insight into the past payment pattern of
the customer. Another step in analyzing the credit information is through a ratio analysis
of the liquidity, the information of profitability and debt capacity of the applicant. These
ratios should be compared with the industry average.
ii.
Qualitative Analysis:The quantitative assessment should be supplemented by a
qualitative/subjective interpretation and details about of the applicant's creditworthiness.
The subjective judgment would cover aspects relating to the quality of the firms can have
management. Here, the references from other suppliers, bank references and specialist
bureau reports, would from internal form the basis for the conclusions to be drawn. In the
ultimate analysis, therefore, the decisions whether to the records of extend credit to the
applicant and what amount to extend will depend upon the subjective interpretation of
applicant may have his credit standing.
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b. Credit Terms
Another decision-area, the financial managers should make in accounts receivable management
is the credit terms. After the credit standards have been established, the creditworthiness of the
customers has been assessed, the management of a firm must determine the terms and conditions
on which trade credit will be made available. The stipulations under which goods are sold on
credit are referred to as credit terms. These relate to the repayment of the amount under the credit
sale. Thus, credit terms specify the repayment terms of receivables.
Credit terms have three components:
(i) credit period, in terms of the duration of time for which trade credit is extended-during the
period overdue amount must be paid by the customer;
(ii) cash discount, if any, which the customer can take advantage of, that is, the overdue amount
will be reduced by this amount; and
(iii) cash discount period, which refers to the duration during which the discount can be availed
of.
These terms are usually written in abbreviations, for instance, `2/10 net 30'. The three
numerals are explained below:
 2 signifies the rate of cash discount (2 per cent), which will be available to the
customers if they pay the overdue within the stipulated time;
 10 represents the time duration (10 days) within which a customer must pay to be
entitled to the discount;
 30 means the maximum period for which credit is available and the amount must be
paid in any case before the expiry of 30 days.
In other words, the abbreviation 2/10 net 30 means that the customer is entitled to 2 per cent
cash discount (discount rate) if he pays within 10 days (discount period) after the beginning of
the credit period (30 days). If, however, he does not want to take advantage of the discount, he
may pay within 30 days. If the payment is not made within a maximum period of 30 days, the
customer would be deemed to have defaulted.
The credit terms, like the credit standards, affect the profitability as well as the cost of a firm. A
firm should determine the credit terms on the basis of cost-benefit trade-off. We illustrate below
how the three components of credit terms, namely, rate of discount, period of discount and the
credit period, affect the trade-off. It should be noted that our focus in analyzing the credit terms
is from the viewpoint of suppliers of trade credit and not the recipients for whom it is a source of
financings
Cash Discount
The cash discount has implications for the sales volume, average collection period/average
investment in receivables, bad debt expenses and profit per unit. In taking a decision regarding
the grant of cash discount, the management has to see what happens to these factors if it initiates
increase or decrease in the discount rate. The changes in the discount rate would have both
positive and negative effects. The implications of increasing or initiating cash discount are as
follows:
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i.
ii.
iii.
The sales volume will increase. The grant of discount implies reduced prices. If the demand
for the products is elastic, reduction in prices will result in higher sales volume.
Since the customers, to take advantage of the discount, would like to pay within the
discount period, the average collection period would be reduced. The reduction in the
collection period would lead to a reduction in the investment in receivables as also the cost.
The decrease in the average collection period would also cause a fall in bad debt expenses.
As a result, profits would increase.
The discount would have a negative effect on the profits. This is because the decrease in
prices would affect the profit margin per unit of sale.
The effects of increase in the cash discount are summarized in Table below. The effect of
decrease in cash discount will be exactly opposite.
Effects of Increase in Cash Discounts
Item
Direction of Change
(I = Increase D = Decrease)
Sales Volume
I
Average Collection Period
D
Bad Debt Expenses
D
Profit per unit
D
Effect on Profits
(Positive+ or negative-)
+
+
+
-
Illustration No. 2
Assume that the firm in our illustration 1 is contemplating to allow 2 per cent discount for
payment within 10 days after a credit purchase. It is expected that if discounts are offered,
sales will increase by 15 per cent and the average collection period will drop to 15 days.
Assume bad debt expenses will not be affected; return on investment expected by the firm is
15 per cent; 60 per cent of the total sales will be on discount. Should the firm implement the
proposal?
Illustration No. 2 Solution
(i) Profit on sales:The profit on sale = sale of additional units multiplied by the difference
between the sales price and the variable cost per unit
= 4,500 (Rs 10 - Rs 6) = 4,500 x Rs 4= Rs 18,000
(ii) Saving on average collection period:This saving is what would have been earned on
the reduced investments in accounts receivable as a result of the cash discount.
Present plan (without discount)
Account Receivable = Sales unit X Variable Cost per Unit
= 30,000 * 8
=Rs 2,40,000
Average investment in accounts Receivable = Cost of sales / Receivables turnover
= 2,40,000/ 12
=𝑅𝑅𝑠𝑠 20,000
Proposed plan (with discount)
Account Receivable = Sales unit X Variable Cost per Unit
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= (30,000 * Rs 8) + (4500 X Rs 6)
=Rs 2,67,000
Turnover of Account receivable = Number of days in year / Average collection period
= 360/ 15
= 24
Average investment in accounts Receivable = Cost of sales / Receivables turnover
= 2,67,000/ 24
=𝑅𝑅𝑠𝑠11,125
Thus, if cash discount is allowed, the average investments in receivables will decline by Rs
8,875 (i.e. Rs 20,000 - Rs 11,125). Given a 15 per cent rate of return, the firm could earn Rs
1,331.25 on Rs 8,875. Thus, the saving resulting from a drop in the average collection period
is Rs 1,331.25.
(iii) The total benefits associated with the cash discount:
Profit on additional sale
Saving in cost
Total
Rs 18,000.00
1,331.25
19,331.25
(iv) Cash discount: The cost involved in the cash discount on credit sales, that is, 2 per cent
of credit sales
Current Sales = 30,000 X Rs 10
= 3,00,000
Addition of 15 % due to cash discount
= 3,00,000 *115/100
=3,45,000
Credit Sales = 60% * Rs 3,45,000
= Rs 2,07,000
Cash discount = 0.02 * Rs 2,07,000
= Rs 4,140
Thus, against a cost of Rs 4,140, the benefit from initiating cash discount is Rs 19,331.25; that
is, there is a net gain of Rs 15,191.25 (Rs 19,331.25 - Rs 4,140). The firm should, therefore,
implement the proposal to allow 2 per cent cash discount for payment within 10 days of the
credit purchase by the customers.
A similar type of analysis can be made to illustrate the effect of either reduction or elimination
of cash discount.
Credit Period
The second component of credit terms is the credit period. The expected effect of an increase in
the credit period is shown below
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Effect of Increase in Credit Period
Item
Direction of Change
(I = Increase D = Decrease)
Effect on Profits
(Positive or Negative)
Sales Volume
Average Collection Period
Bad Debt Expenses
I
I
I
+
-
A reduction in the credit period is likely to have an opposite effect. The credit period decision is
illustrated in Example 3.
Illustration No. 3
Suppose the firm in illustration 1 is contemplating an increase in the credit period from 30 to
60 days. The average collection period which is at present 45 days is expected to increase to
75 days. It is also likely that the bad debt expenses will increase from the current level of 1 per
cent to 3 per cent of sales. Total credit sales are expected to increase from the level of 30,000
units to 34,500 units. The present average cost per unit is Rs 8, the variable cost and sales per
unit is Rs 6 and Rs 10 per unit respectively. Assume the firm expects a rate of return of 15 per
cent.
Should the firm extend the credit period?
Illustration No. 3- solution
1. Profit on additional sales: (Rs 4 x 4,500) = Rs 18,000
2. Cost of additional investments in receivables: = Average investments with the proposed
credit period less average investments in receivables with the present credit period:
Proposed plan
Account Receivable = Sales unit X Variable Cost per Unit
= (30,000 * Rs 8) + (4500 X Rs 6)
=Rs 2,67,000
Turnover of Account receivable = Number of days in year / Average collection period
= 360/ 75
= 4.8
Average investment in accounts Receivable = Cost of sales / Receivables turnover
= 2,67,000/ 4.8
=𝑅𝑅𝑠𝑠55,625
Present Plan
Account Receivable = Sales unit X Variable Cost per Unit
= 30,000 * 8
=Rs 2,40,000
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Turnover of Account receivable = Number of days in year / Average collection period
= 360/ 45
=8
Average investment in accounts Receivable = Cost of sales / Receivables turnover
= 2,40,000/ 8
=𝑅𝑅𝑠𝑠 30,000
Additional investment in accounts receivable = Rs 55,625 - Rs 30,000 = Rs 25,625
Cost of additional investment at 15 per cent = 0.15 x Rs 25,625 = Rs 3,843.75.
3. Additional bad debt expenses: This is the difference between the bad debt expenses with
the proposed and present credit periods.
Bad debt with proposed credit period = 0.03 x Rs 3,45,000 = Rs 10,350
Bad debt with present credit period = 0.01 x Rs 3,00,000 = Rs 3,000
Additional bad debt expense = (Rs 10,350 - Rs 3,000) = Rs 7,350
Thus, the incremental cost associated with the extension of the credit period is Rs 11,193.75
(Rs 3,843.75 + Rs 7,350). As against this, the benefits are Rs 18,000. There is, therefore, a net
gain of Rs 6,806.25, that is, (Rs 18,000 - Rs 11,193.75). The firm would be well-advised to
extend the credit period from 30 to 60 days.
The effect of a decrease in the credit period can be similarly analyzed.
6.3.8.3 Collection Policies
The third area involved in the accounts receivable management is collection policies. They refer
to the procedures followed to collect accounts receivable when, after the expiry of the credit
period, they become due. These policies cover two aspects: (i) degree of effort to collect the
overdues, and (ii) type of collection efforts.
i. Degree of Collection Effort
To illustrate the effect of the collection effort, the credit policies of a firm may be categorized
into (i) strict/ tight and (ii) lenient. The collection policy would be tight if very rigorous
procedures are followed. A tight collection policy has implications which involve benefits as
well costs. The management has to consider a trade-off between them. Likewise, a lenient
collection effort also affects the cost-benefit trade-off. The effect of tightening the collection is
discussed below.
In the first place, the bad debt expenses (default cost) would decline. Moreover, the average
collection period will be reduced. As a result of these two effects, the firm will benefit, and its
profits will increase. But there would be negative effects also. A very rigorous collection strategy
would involve increased collection costs. Yet another negative effect may be in the form of a
decline in the volume of sales. This may be because some customers may not like the pressure
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and intense efforts initiated by the firm and may switch to other firms. These effects are
tabulated below
Basic Trade-off from Tight Collection Effort
Item
Direction of Change
(I = Increase D = Decrease)
Bad Debt Expenses
Average collection period
Sales Volume
Collection Expenditure
D
D
D
I
Effect on Profits
[Positive (+) or Negative
(N)]
+
+
-
The effect of the lenient policy will be just the opposite. We illustrate the basic trade-off in
Illustration no. 4.
Illustration No. 4
Super Sports, dealing in sports goods, has an annual sale of Rs 50 lakh and 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.
The firm is, therefore, considering shifts in credit policy. The following information is
available:
The average collection period now is 30 days.
Variable costs, 80 per cent of sales.
Fixed costs, Rs 6 lakh per annum
Required (pre-tax) return on investment: 20 per cent
Credit policy
A
B
C
D
Average collection period (days)
45
60
75
90
Annual sales (Rs lakh)
56
60
62
63
Determine which policy the company should adopt.
Illustration No. 4- Solution
Evaluation of Proposed Credit Policies (Amount in Rupees lakhs)
Present
Proposed (Number of days)
(30)
A(45) B(60) C(75) D(90)
(a)Sales revenue
50
56
60
62
63
Less variable costs (80% of sales)
40
44.8
48
49.6
50.4
Total contribution
10
11.2
12
12.4
12.6
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Less fixed costs
Profit
Increase in profits due to increase
In total contribution (20% of sales)
Compared to present profit
(b) Investment in debtors:
Total cost (VC + FC)
Debtors turnover (DT) (360 day
Collection period
Average investment (total cost
+DT
Additional investment compared
to
Present level
6
4
6
5.2
6
6
6
6.4
6
6.6
—
1.2
2
2.4
2.6
46
50.8
54
55.6
56.4
12
3.83
8
6.35
6
9
4.8
11.58
4
14.10
—
2.52
7.75
10.27
Cost of additional investment
—
0.50
1.55
2.05
(c) incremental profit (a-b)
—
0.70
0.85
0.55
5.17
1.03
0.97
Policy B (average collection period 60 days) should be adopted as it yields maximum profit.
Knowledge Test 1
XYZ Corporation is considering relaxing its present credit policy and is in the process of
evaluating two alternative policies. Currently, the firm has annual credit sales of Rs 50 lakh
and accounts receivable turnover ratio of 4 times a year. The current level of loss due to bad
debts is Rs 1,50,000. The firm is required to give a return of 25 per cent on the investment in
new accounts receivable. The company's variable costs are 70 per cent of the selling price.
Given the following information, which is a better option?
Present policy
Policy option I
Policy option II
Annual credit sales
Rs 50,00,000
Rs 60,00,000
Rs 67,50,000
Accounts receivable turnover ratio 4
3
2.4
Bad debt losses
1,50,000
3,00,000
4,50,000
Type of Collection Efforts
The second aspect of collection policies relates to the steps that should be taken to collect
overdues from the customers. A well-established collection policy should have clear-cut
guidelines as to the sequence of collection efforts. After the credit period is over and payment
remains due, the firm should initiate measures to collect them. The effort should in the beginning
be polite, but, with the passage of time, it should gradually become strict. The steps usually taken
are (i) letters, including reminders, to expedite payment; (ii) telephone calls for personal contact;
(iii) personal visits; (iv) help of collection agencies; and finally, (v) legal action. The firm should
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take recourse to very stringent measures, like legal action, only after all other avenues have been
fully exhausted. They not only involve a cost but also affect the relationship with the customers.
The aim should be to collect as early as possible; genuine difficulties of the customers should be
given due consideration.
Illustration No. 5
ABC Pvt. Ltd. has a turnover of NRS 900,000 (90% of which is on credit) and receivable days
are currently 42 despite the company only offering 30-days‘ credit. ABC Pvt. Ltd finances its
receivables using its overdraft which has an annual interest cost of 8% and has a contribution
margin of 30%.
ABC Pvt. Ltd is considering the introduction of an early settlement discount at the same time
as extending their standard credit terms to 50 days. The company would offer customers a 1%
discount for payment within 14 days. It is anticipated that 40% of customers will take the
discount, while those that do not take the discount will keep to the new standard credit terms.
As a result of the extended credit terms, credit sales are expected to rise by 10%. Due to the
extra administration involved it is thought that administration costs will rise by NRS 10,000
per year.
Evaluate whether or not ABC Pvt. Ltd. should offer the discount.
Illustration No. 5- Solution
Status of Revised Sales
Existing credit sales
NRS 900,000 × 90% = NRS 810,000
Expected increase in credit sales NRS 810,000 × 10% = NRS 81,000
Revised credit sales
NRS 810,000 + NRS 81,000 = NRS 891,000
Contribution earned in extra sales
NRS 81,000 × 30% = NRS 24,300
The proportion of customers expected to take the 1% discount
NRS 891,000 × 40% × 1% = NRS 3,564
Finance saving on reduced receivables
Present situation:
Receivable days given as 42 days Receivables
= NRS 810,000 × 42/365
= NRS 93,205
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Note: Remember to use the existing credit sales
Annual finance cost
= NRS 93,205 × 8%
= NRS 7,456
Note: receivables have not yet been received, so they make the overdraft higher than
it would otherwise be, and so incur an interest cost.
Proposed situation
Receivable days
= ((14 days × 40%) + (50 days × 60%))
= 35.6 days
Note: the new receivable days are simply an average of the credit period taken by customers
taking the discount, and the credit period taken by those refusing the discount weighted by the
proportion of customers taking and refusing the discount respectively.
Account Receivables
= NRS 891,000 ×35.6/365
= NRS 86,903
Note: Remember to use the revised credit sales. It could be argued that the credit sales should
be reduced by the discount cost; otherwise you are calculating a finance cost on an amount
which will never be collected. However, this adjustment makes little difference so is often
ignored.
Annual finance cost
= NRS 86,903 × 8%
= NRS 6,952
Annual finance saving
= NRS 7,456 – NRS 6,952
= NRS 504
Shorter Way:
Reduction in receivables NRS 6,302 (93,205 -86,903)
Annual finance saving
NRS 504 (6,302 × 8%)
Annual benefits
Annual Finance saving on reduced receivables
Contribution on extra sales
81,000 × 30%
Annual costs
Extra administration costs
Discount cost – 891,000 × 40% × 1%
Net benefit/ (cost)
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504
24,300
(10,000)
(3,564)
11,420
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Comment
Having calculated a net benefit, ABC Pvt. Ltd can be advised that the proposed early
settlement discount appears worthwhile.
6.3.9 Sources of Short-Term Finance
After determining the level of working capital, a firm has to decide how it is to be financed. The
need for financing arises mainly because the investment in working capital/current assets, that is,
raw materials, work/stock-in-process, finished goods and receivables typically fluctuates during
the year. Although long-term funds partly finance current assets and provide the margin money
for working capital, such assets/working capital are virtually exclusively supported by short-term
sources. The main sources of working capital financing, namely, trade credit, bank credit,
advances, factoring and commercial papers etc.
6.3.9.1 Trade Credit
Trade credit refers to the credit extended by the supplier of goods and services in the normal
course of transaction/ business/sale of the firm. According to trade practices, cash is not paid
immediately for purchases but after an agreed period of time. There are no legal instruments/
acknowledgements of debt which are granted on an open account basis. Such credit appears in
the records of the buyer of goods as sundry creditors/accounts payable.
Features of Trade Credit
1. There are no formal legal instruments/acknowledgements of debt.
2. It is an internal arrangement between the buyer and seller.
3. It is a spontaneous source of financing.
4. It is an expensive source of finance, if payment is not made within the discount period.
Advantages of Trade Credit
1. It is easy and automatic source of short-term finance
2. It reduces the capital requirements
3. It helps the business focus on core activities
4. It does not require any negotiation or formal agreements
Disadvantages of Trade Credit
1. Trade credit is available only to those companies that have a good track record of repayment
in the past.
2. For a new business, it is very difficult to finance working capital through trade credit.
3. It is very expensive, if payment is not made on the due date.
To sum up, as the cost of trade credit is generally very high beyond the discount period, firms
should avail of the discount on prompt payment. If, however, they are unable to avail of
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discount, the payment of trade credit should be delayed till the last day of the credit (net) period
and beyond without impairing their creditworthiness. But a precondition for obtaining trade
credit particularly by a new company is cultivating good relationship with suppliers of goods and
obtaining their confidence by honoring commitments.
Trade credit is probably the easiest and most important source of short-term finance
available to businesses.
Trade credit means many things, but the simplest definition is an arrangement to buy
goods and/or services on account without making immediate cash or cheque payments.
Trade credit is a helpful tool for growing businesses, when favorable terms are agreed
with a business‘s supplier. This arrangement effectively puts less pressure on cashflow
that immediate payment would make. This type of finance is helpful in reducing and
managing the capital requirements of a business.
The reverse situation also needs to be considered; this is where your customers or clients
may request favorable trade credit terms. Put simply, any terms agreed with your
customers or clients will reduce the benefit you have obtained through trade credit
negotiations with your suppliers. For example, if you have agreed trade credit terms of 45
days with your suppliers and trade credit terms of 30 days with your customers or clients,
the net benefit will be 15 days. It is the net amount that affects a business‘s working
capital and a negative capital situation will need additional funding.
When a business enters into a trade credit arrangement with its suppliers, a limit is usually
set, commonly called credit terms. For example, you could set cash, cheque or bank
transfer payments to be made within 15 days from the date of the invoice, hopefully
allowing you to still qualify for any early payment discount. If payments are not made
within the terms, all outstanding amounts are required to be settled within the normal time
period set from the date of purchase.
Credit terms will differ from business to business and industry to industry. Businesses that
receive payments on delivery, for example online shopping sites, may have a shorter credit
term than an industrial manufacturer. In that case, projects are spread over a longer period of
time and payments may be received periodically on completion of certain pre-decided time
slots.
6.3.9.2 Bank Credit
Bank credit is the primary institutional source of working capital finance. In fact, it represents
the most important source for financing of current assets.
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Bank Credit
Cash Credit /
Overdraft
Purchase
/discount bills
Letter of
Credit
Working
Capital Loan
Fig : - Forms of Credit issued by Bank
i. Cash Credit/Overdraft
Under cash credit/overdraft form/ arrangement of bank finance, the bank specifies a
predetermined borrowing credit limit. The borrower can draw/borrow up to the stipulated credit/
overdraft limit. Within the specified limit, any number of drawls/drawings are possible to the
extent of his requirements periodically. Similarly, repayments can be made whenever desired
during the period. The interest is determined on the basis of the running balance/amount actually
utilized by the borrower and not on the sanctioned limit. However, a minimum (commitment)
charge may be payable on the unutilized balance irrespective of the level of borrowing for
availing of the facility. This form of bank financing of working capital is highly attractive to the
borrowers because, when the borrowed funds are no longer required, they can quickly and easily
be repaid.
ii. Bills Purchased/Discounted
The seller of goods draws the bill on the purchaser of goods, payable on demand or after a
usance period not exceeding 90 days. On acceptance of the bill by the purchaser, the seller offers
it to the bank for discount/purchase. On discounting the bill, the bank releases the funds to the
seller. The bill is presented by the bank to the purchaser/acceptor of the bill on due date for
payment. The bills can also be rediscounted with the other banks/NRB. However, this form of
financing is not popular in the country.
iii. Letter of Credit
While the other forms of bank credit are direct forms of financing in which banks provide funds
as well as bear risk, letter of credit is an indirect form of working capital financing and banks
assume only the risk, the credit being provided by the supplier himself.
The purchaser of goods on credit obtains a letter of credit from a bank. The bank undertakes the
responsibility to make payment to the supplier in case the buyer fails to meet his obligations.
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Thus, the modus operandi of letter of credit is that the supplier sells goods on credit/extends
credit (finance) to the purchaser, the bank gives a guarantee and bears risk only in case of default
by the purchaser.
Further analysis of Letter of Credit
This is a further way of reducing the investment in foreign accounts receivable and can give a
business a risk-free method of securing payment for goods and services.






There are a number of steps arranging a letter of credit:
Both parties set the terms for the sale of goods or services
The purchase (importer) requests their bank to issue a letter of credit in favor of the seller
(exporter)
The letter of credit is issued to the seller‘s bank, guaranteeing payment to the seller once the
conditions specified in the letter have been complied with. Typically, the conditions relate to
presenting shipping documentation and dispatching the goods before a certain date
The goods are dispatched to the customer and shipping documentation is sent to the
purchaser‘s bank
The bank then issues a banker‘s acceptance
The seller can either hold the banker‘s acceptance until maturity or sell it on the money market
at a discounted value.
As can be seen from the above process, letter of credit takes up a significant amount of time
and therefore are slow to arrange and must be in place before the sale occurs. The use of letter
of credit may be considered necessary if there is a high level of non-payment risk.
iv. Working Capital
A working capital loan is a loan used by companies to cover day-to-day operational
expenses.Working capital loans are used for normal operations rather than big purchases. In
accounting terms, working capital means your current assets minus your current liabilities.
Current assets include things like cash, accounts receivable, and inventory. Current liabilities
include things like payroll or vendor invoices that you need to pay within the next year.
6.3.9.3 Factoring
Factoring can broadly be defined as an agreement in which receivables arising out of sale of
goods/services are sold by a firm (client) to the ―factor‖ (a financial intermediary) as a result of
which the title of the goods/services represented by the said receivables passes on to the factor.
Henceforth, the factor becomes responsible for all credit control, sales accounting and debt
collection from the buyer(s). In a full-service factoring concept (without recourse facility), if any
of the debtors fails to pay the dues as a result of his financial inability/insolvency/bankruptcy, the
factor has to absorb the losses.
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Credit sales generate the factoring business in the ordinary course of business dealings.
Realization of credit sales is the main function of factoring services. Once a sale transaction is
completed, the factor steps in to realize the sales. Thus, the factor works between the seller and
the buyer and sometimes with the seller‘s banks together.
Company
Factor
Customer
Fig: Factoring arrangement
How Factoring Works
1) The company sells goods to the customer payable in 30 days
2) The company sells the debt to the factor
3) The customer pays the factor after 30 days
4) The factor pays the company less an administration fee
Factors including finance
1) The company sells goods to the customer payable in 30 days
2) The company sells the debt to the factor
3) Up to 80% of the debt is paid to the company in advance
4) The customer pays the factor after 30 days
5) The factor pays the company the balance less an administration fee and finance fee
Functions of a Factor
Depending on the type/form of factoring, the main functions of a factor, in general terms, can be
classified into five categories:
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i.
Financing Trade Debts:
The unique feature of factoring is that a factor purchases the book debts of his client at a price
and the debts are assigned in favor of the factor who is usually willing to grant advances to the
extent of, say, 80 per cent of the assigned debts. Where the debts are factored with recourse, the
finance provided would become refundable by the client in case of non-payment of the buyer.
However, where the debts are factored without recourse, the factor‘s obligation to the seller
becomes absolute on the due date of the invoice whether or not the buyer makes the payment.
ii.
Administration of Sales ledger:
The factor maintains the clients‘ sales ledgers. On transacting a sales deal, an invoice is sent by
the client to the customer and a copy of the same is sent to the factor. The ledger is generally
maintained under the open-item method in which each receipt is matched against the specific
invoice. The customer‘s account clearly reflects the various open invoices outstanding on any
given date. The factor also gives periodic (fortnightly/weekly depending on the volume of
transactions) reports to the client on the current status of his receivables, receipts of payments
from the customers and other useful information. In addition, the factor also maintains a
customer-wise record of payments spread over a period of time so that any change in the
payment pattern can be easily identified.
iii.
Provision of Collection Facility:
The factor undertakes to collect the receivables on behalf of the client relieving him of the
problems involved in collection and enables him to concentrate on other important functional
areas of the business. This also enables the client to reduce the cost of collection by way of
savings in manpower, time and efforts. The use of trained manpower with sophisticated
infrastructural backup enables a factor to systematically follow up and make timely demands on
the debtors to make payments, Also, the debtors are more responsible to the demands from a
factor being a credit institution .
Collection of receivables can be considered as the most important function of a factor. He is
generally not required to consult the client with regard to the collection procedure. But he may
consult the silent if legal action has to be initiated in case of non-payment and so on.
iv.
Credit control and credit Restriction:
Assumption of credit risk is one of the important functions of a factor. This service is provided
where debts are factored without recourse. The factor in consultation with the client fixes credit
limits for approved customers. Within these limits, the factor undertakes to purchase all trade
debts of the customer without recourse. In other words, the factor assumes the risk of default in
payment by the customer. Arising from this function of the factor, there are two important
incidental benefits accruing to the client:
 First, factoring relieves the silent of the collection work;
 Second, with access to extensive information available on the financial standing and
credit rating of individual customers and their track record of payments, the factor is able
to advise the client on the credit worthiness of potential customers leading to better credit
control.
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v.
Advisory Services:
These services are a spin-off of the close relationship between a factor and a client. By virtue of
their specialized knowledge and experience in finance and credit dealings and access to
extensive credit information. Factors can provide a variety of incidental advisory services to their
clients:
 Customer‘s perception of the client‘s products, changes in the marketing strategies,
emerging trends and so on;
 Audit of the procedures followed for invoicing, delivery and dealing with sales returns;
 Introduction to the credit department of bank/subsidiaries of banks engaged in leasing,
hire-purchase and merchant banking.
vi.
Cost of Service:
The factors provide various services at a charge, the charge for collection and sales ledger
administration is in the form of a commission expressed as a value of debt purchased. It is
collected up-front/in advance. The commission for short-term financing as advance part-payment
is in the form of interest charge for the period between the date of advance payment and the date
of collection/guaranteed payment date. It is also known as discount charge.
Advantages and Evaluation
Factoring has several positive features from the point of view of the firm (client of the factor).
Some of these advantages are briefly discussed as follows:
i.
Off-balance Sheet Financing:
As the client‘s debts are purchased by the factor, the finance provided by him is off the balance
sheet and appears in the balance sheet only as a contingent liability in the case of recourse
factoring. In case of non-recourse factoring, it does not appear anywhere in the financial
statements of the borrower.
ii. Reduction of Current Liabilities:
From the factoring proceeds can be used for paying off bank loan, other current liabilities
comprising of trade creditors for goods and services, creditors for expenses, loan installments
payable, statutory liabilities and provisions.
iii. Improvement in Current Ratio:
As the factoring transaction is off the balance sheet, it removes from the asset side the
receivables factored to the extent of the prepayment made and on the liabilities side, the current
liabilities are also reduced.
iv. Higher Credit standing:
There are several reasons why factoring should improve a client‘s standing with cash flow
accelerated by factoring the client is able to meet his liabilities promptly as and when they arise.
The factor‘s acceptance of the client‘s receivables itself speaks highly of the quality of the
receivables. In the case of non-recourse factoring the factor‘s assumption of credit risk relieves
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the client to a significant extent, from the problem of bad debts. This enables him to minimize
his bad debts reserve.
v. Improved Efficiency:
In order to accelerate cash flow, it is essential to ensure the flow of critical information for
decision making and follow up and eliminate delays and wastage of man hours. This requires
sophisticated infrastructure for high level specialization in credit control and sales ledger
administration. Small and medium sized units are likely to face a resource constraint in this area.
Factoring is designed to place such units on the same level of efficiency in the areas of credit
control and sales ledger administration as that of the more sophisticated large companies.
vi. More Time for Planning and production:
In any business concern, it is inevitable that a certain proportion of management time has to be
diverted to credit control. Large companies can afford to have special departments for the
purpose. However, smaller units cannot effort it. The factor undertakes the responsibility for
credit control, sales ledger administration and debt collection problems. Thus, the client can
concentrate on functional areas of the business line planning, purchase, production, marketing
and finance.
vii. Reduction of Cost and Expenses:
Since the client need not have a special administrative set up to look after credit control, he can
have the benefit of reduced overheads by way of savings on manpower, time and efforts. With
the steady and reliable cash flow facilitated by factoring, the clients have many opportunities to
cut costs and expenses like taking supplier‘s prompt payment and quantity discounts, ordering
for materials at the right time and at the right place, avoidance of disruption in the production
schedule, and so on.
viii. Additional Source:
The supplier gets an additional source of funding the receivables which eliminates the
uncertainty associated with the collection cycle. More importantly, a fund from a factor is an
additional source of finance for the client outside the purview of bank credit.
ix. Evaluation Framework:
The distinct advantages of factoring notwithstanding, it does involve costs. The evaluation
framework should be on a consideration of the relative costs and benefits associated with the two
alternatives to receivables management. They are: (i) in house management by the firm itself, (ii)
Factoring services, either recourse or non-recourse. The relevant costs and benefits associated
with these are listed below.
Cost Associated with in-house Management:
 cash discount
 cost of funds invested in receivables
 bad debts.
 lost contribution on foregone sales and
 avoidable costs of sales ledger administration and credit monitoring.
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Cost Associated with Recourse and Non- recourse factoring:
 factoring commission,
 discount charge and
 cost of long-term funds invested in receivables.
Benefits Associated with Recourse Factoring:
They are in terms of the costs associated with the in-house management alternative with the
exception of item (iii) namely, bad debt loss.
Benefit Associated with non-recourse factoring:
The above plus the bad debt losses relevant to in house management of receivables.
Advantages of Factoring
1. Saving in administration costs
2. Reduction in the need for management
control
3. Particularly useful for small and fastgrowing businesses where the credit
control department may not be able to
keep pace with volume growth
Disadvantages of Factoring
1. Likely to be costlier than an efficiently
run internal credit control department
2. Customer may not wish to deal with a
factor
3. Once the company start factoring, it is
difficult to revert easily to an internal
credit control system
Knowledge Test 2- Factoring
Bishal Co. is a medium- sized company producing a range of engineering products, which it
sells to wholesale distributors. Recently, its sales have begun to rise rapidly due to economic
recovery. However, it is considered about its liquidity position and looking at ways of
improving cash flows.
Its sales are 16,000,000 per annum, and average receivables are 3,300,000 (representing about
75 days of sales)
One way of speeding up collection from receivables is to use a factor
Required
Determine the relative costs and benefits of using the factor in each of the following scenarios
a) The factor will operate on a service – only basis, administering and collecting payment
from Bishal Co‘s customers. This is expected to generate administrative savings of NRs
100,000 each year
The factor has undertaken to pay outstanding debts after 45 days, regardless of whether
the customers have actually paid or not. The factor will make a service charge of 1.75%
of the company‘s revenue
b) It is now considering a factoring arrangement with a different factor where 80% of the
book value of invoices is paid immediately, with finance costs charged on an advance at
10% per annum.
Suppose that this factor will charge 1% of sales as their fee for managing the sales
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ledger, that there will be administrative savings of NRs 100,000 as before, but that
outstanding balances will be paid after 75 days (i.e. there is no change in the typical
payment pattern by customers this time)
6.3.9.4 Bridge Finance
Bridge Finance refers to loans taken by a company normally from commercial banks for a "short
period, pending disbursement of loans sanctioned by financial institutions." When a promoter or
an enterprise approaches a financial institution for a long-term loan, there may be some time
delays in project evaluation, administrative and procedural paperwork and final sanction.
 Since the project commencement cannot be delayed, the promoter may start his
activities after receiving "in-principle" approval from the term lending institution.
 To meet his temporary fund requirements for starting the project, the promoter may
arrange short term loans from commercial banks or from the term lending institution
itself.
 Such temporary finance, pending sanction of the long-term loan, is called as "Bridge
Finance".
6.3.9.5 Short- term finance from Banks
Bank advances are in the form of loan, overdraft, cash credit and bills purchased / discounted
etc. The terms, conditions and norms for lending are based on the general policy laid down by
the NRB and also by the schemes of the concerned Bank. Advances are granted against
securities which can be classified as:
 Primary Security: Hypothecation of stocks, book debts, equitable mortgage of fixed
assets. Pro-notes etc.
 Collateral Security: Equitable mortgage of Land. Buildings or other property
belonging to the enterprise or its promoters.
 Guarantees: Personal Guarantees of the concerned promoters, partners or Directors
6.3.9.6 Loans:
It is a single advance, wherein the entire amount of loan is disbursed at one time by transfer to
the current account of the borrower. Interest and other charges like inspection, Insurance,
processing charges etc. are charged to this account. Repayment of installments by the
borrower as per the agreed schedule is credited to this account. Loan accounts arc not running
accounts like overdraft and cash credit accounts.
6.3.9.7 Overdraft:
Under this facility, a fixed limit is granted within which the borrower is allowed to overdraw
from this account. Technically, overdrafts are repayable on demand, but they generally
continue for longer periods by annual renewal of limits. The borrower can use and draw up to
the extent of limit sanctioned according to his requirements. Interest is charged on daily
balances. These accounts are operative like cash credit and current accounts and hence cheque
books are provided.
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6.3.9.8 Cash Credits
It is an arrangement under which a customer is allowed an advance to certain limit against credit
granted by bank. The customer need not borrow the entire amount of advance at one time: he can
only draw to the extent of his requirements and deposit surplus funds in his account. Interest is
charged only on the amount availed of by the customer and not on the full amount. Generally,
cash credit limit is sanctioned against pledge or hypothecation of goods. Technically, Cash
Credit Advances are repayable on demand, but these are continued and also enhanced from timeto-time by the borrower and the bank as part of working capital financing.
6.3.9.9 Advances against goods:
Under this arrangement Bank grants advance as a percentage of value of goods offered as
security. The term 'goods' includes all forms of movables which are offered to the bank as
security. They may be agricultural commodities or industrial raw materials or partly finished
goods.When goods are provided as security, they provide a reliable source of repayment.
Advances against them are safe and liquid. Also, there is a quick turnover in goods, as they are
in constant demand. Generally, goods are charged to the bank either by way of pledge or by way
of hypothecation. For the purpose of calculation of drawing limits, valuation of the goods made
from time to time. The bank also takes periodical statements of stocks from tile borrower.
6.3.9.10 Bills Purchased / Discounted:
These advances are allowed against the security of bills, which may be clean or documentary.
This arrangement operates as under:
 Borrower (manufacturer) supplies goods to his customers and raises supply bills
(Invoices) on them, falling due for payment on a future date.
 The bank discounts supply bills (invoices) by paying the amount of the bill after
deducting its margin and discounting charges. For example, for a bill of Rs. 1000, the
bank may advance Rs.870 (Rs.1000 less 10% margin Rs.100 less discounting charge
Rs. 30).
 Upon collection of amounts due from the customer, the bank takes the full amount of
the bill and credits the balance amount earlier withheld as margin. In the above case
the bank may credit Rs.92/- (Rs. 100 margin less Charges Rs. 8).
 The difference between the amounts collected (Rs. 1000) and tile amounts credited
(Rs.870 + Rs.92) represents earnings of the bankers for the period. This item of
income is called 'discount'.
Although the term 'bills purchased' gives the impression that the bank becomes the owner or
purchaser of such bills, in actual practice the bank holds bills only as security for advance. The
borrower is ultimately liable on the advance, in case of default by the customer. The bank, in
addition to the rights against the parties liable, can also exercise a pledgee's rights over goods
covered by the documents. Sometimes, overdraft or cash credit limits may also be allowed
against the security of bills, after maintaining a Suitable margin. Here the bill is not a primary
security but only a collateral security. The banker in the case does not become a party to the bill,
but merely collects it as an agent for its customer.
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6.3.9.11 Advance against documents of title to goods:
A document becomes a document of title to goods when its possession is recognized by law or
business custom as possession of the goods. Examples of documents of title to goods are bill of
lading, warehouse keeper's certificate, railway receipt, etc. A person in possession of a document
to goods can enable another person to take delivery of the goods in his right, by endorsement or
delivery (or both) of the document. An advance against the pledge of such documents is
equivalent to an advance against the pledge of goods themselves.
6.3.9.12 Advance against supply of bills:
Banks may also provide advances against bills raised on government or semi government
departments. Some types of bills are:
 Bills for supply of goods against firm orders after acceptance of tender.
 Bills from contractors for work executed either wholly or partially under firm
contracts
Generally, these bills are accompanied by inspection notes from representatives of government
agencies for having inspected the goods before they are dispatched. If bills are without the
inspection report, banks examine them with the accepted tender or contract to verify that the
goods supplied under the bills strictly conform to the terms and conditions. These bills represent
a debt in favor of suppliers/contractors, due from the Government Agency. This debt is assigned
to the bank by endorsement of supply bills and executing an irrevocable power of attorney in
favor of the banks for receiving the amount due from the Government departments. The power
of attorney has to be registered with the Government department concerned. The banks also take
a separate letter from the suppliers/contractors instructing the government body to pay the
amount of bills direct to the bank. Supply bills do not enjoy the legal status of negotiable
instruments because they are not bills of exchange. The security available to a banker is by way
of assignment of debts represented by the supply bills.
6.3.9.13 Packing Credit Facility
Packing Credit is an advance extended by banks to an exporter for the purpose of buying
manufacturing, processing, packing, shipping goods to overseas
Applicability:
a) If an exporter has a firm export order placed with him by his foreign customer (buyer)
or all irrevocable Letter of Credit opened in his favor, he can approach a Bank for
Packing Credit Facility.
b) The letter of credit and firm sale contracts serve as evidence of a definite arrangement
for realization of the export proceeds and also indicate the amount of' finance required
by the exporter. Packing credit, in the case of customers of long standing, may also be
granted against firm contracts entered into by them with overseas buyers.
c) An advance so taken by an exporter is required to be liquidated within 180 days the date
of its commencement by negotiation of export bills or receipt of export proceeds in an
approved manner. Thus, packing credit is essentially a short-term advance.
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Types of Packing Credit
(1)
Clean Packing Credit:




This facility is extended only on production of a firm export order or a letter of'
credit.
There is no charge or control over raw material or finished goods that constitute
the supply.
The Bank takes into consideration trade requirements, credit worthiness of
exporter and its margin.
Export Credit Guarantee Corporation (ECGC) insurance cover should be obtained
by the bank
(2)
Packing credit against hypothecation or goods:
 This facility is extended on production of a firm export order or a letter of credit.
 The goods which constitute the supply arc hypothecated to the Bank as security.
With stipulated margin.
 The goods shall be exported by the borrower. The Bank does not have any
effective possession of the same.
 The exporter has to submit stock statements at the time of sanction and also
periodically and for whenever there is any movement in stocks.
(3)
Packing credit against pledge of goods:
 This facility is extended on production of a firm export order or a letter of credit.
 The goods which constitute the supply are pledged to the Bank as security, with
the stipulated margin.
 The goods shall be handed over to approve clearing agents who ship the same
from time to time as required by the exporter.
 The effective possession of the goods so pledged lies the bank and are kept under
its lock and key.
6.3.10 Post-Shipment Finance
Post-shipment finance, i.e. after shipment of goods, can be in the following forms:
6.3.10.1 Purchase/ discounting of documentary export bills:
a) Just like discounting / purchasing of local supply bills, Banks provide finance to exporters
by purchasing export bills drawn payable at sight or by discounting usance export bills.
b) Such bills should be based on confirmed sales orders and Supported by documentary
evidence for actual export like packing list, bill of lading, post parcel receipts, or air
consignment notes.
c) The documents he obtained in this regard are:
 Letter of hypothecation covering the goods, and
 General guarantee of directors or partners of the firm as the case may he.
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 Guarantee against risks by taking a contract shipment (comprehensive risks) policy
covering both political and commercial risks.
6.3.10.2 Advance against export bills sent for collection
Banks also provide advance to exporters against export bills forwarded through them for
collection. The evaluation actors include the creditworthiness of the party, nature of goods
exported, usance, standing of drawee, margin etc. The documents to be obtained are: (i) Demand
promissory note: (ii) Letter of, continuity: (iii) Letter of hypothecation covering bills; (iv)
General Guarantee of directors or partners.
6.3.10.3 Advance against duty drawback, cash subsidy, etc.
Banks also provide advance against duty draw-back, cash subsidy, etc., receivable by exporters
against export performance. Such advances arc of clean nature hence necessary precaution
should be exercised. It is insisted that the export bills are either negotiated r forwarded for
collection through the Bank, so that the Bank is in a position to verify the exporter's claims for
duty draw - backs, cash subsidy, etc. An advance so availed of b} all exporter should be settled
within 180 days from the (late of shipment of the relative goods. The documents to be obtained
are: (i) Demand promissory note; (ii) Letter of' continuity (iii) General Guarantee of' directors of
partners; (iv) Undertaking from the borrowers that they will deposit the cheques / payments
received from the appropriate authorities. Immediately with the bank and not use them m any
other Manner.
6.3.11 Other Facilities by Banks
(i)
Letters of Credit: On behalf of approved exporters, hanks establish letters of credit on
their overseas or up-country suppliers.
(ii)
Guarantees: Guarantees for waiver of excise duty, due performance of contracts, bond
in lieu of cash security deposit, guarantees for advance payments etc. are also issued by banks to
approved clients.
(iii)
Deferred Payment Finance: Banks provide finance to approved clients undertaking
exports on deferred payment terms.
(iv)
Credit Reports: Banks also try to secure for their exporter-customers, status reports of
their buyers and trade information on various commodities through their Correspondents.
(v)
General Information: Banks also provide economic intelligence on various Countries
to their exporter clients.
Mode of Security
Banks provide credit on the basis of the following modes of security:
i. Hypothecation:
Under this mode of security, the banks provide credit to borrowers against the security of
movable property, usually inventory of goods. The goods hypothecated, however, continue to be
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in the possession of the owner of these goods (i.e., the borrower). The rights of the lending bank
(hypothecate) depend upon the terms of the contract between the borrower and the lender.
Although the bank does not have physical possession of the goods, it has the legal right to sell
the goods to realize the outstanding loan. Hypothecation facility is normally not available to new
borrowers.
ii.
Pledge:
Pledge, as a mode of security, is different from hypothecation in that in the former, unlike in the
latter, the goods which are offered as security are transferred to the physical possession of the
lender. An essential prerequisite of pledge, therefore, is that the goods are in the custody of the
bank. The borrower, who offers the security is, called a`pawnor' (pledgor), while the bank is
called the 'Pawnee' (pledgee). The lodging of the goods by the pledgor to the pledgee is a kind of
bailment. Therefore, pledge creates some liabilities for the bank. It must take reasonable care of
goods pledged with it. The term `reasonable care' means care which a prudent person would take
to protect his property. He would be responsible for any loss or damage if he uses the pledged
goods for his own purposes. In case of non-payment of the loans, the bank enjoys the right to sell
the goods.
iii.
Lien:
The term `lien' refers to the right of a party to retain goods belonging to another party until a debt
due to him is paid. Lien can be of two types: (i) particular lien, and (ii) general lien. Particular
lien is a right to retain goods until a claim pertaining to these goods is fully paid. On the other
hand, general lien can be applied till all dues of the claimant are paid. Banks usually enjoy
general lien.
iv.
Mortgage:
It is the transfer of a legal/equitable interest in specific immovable property for securing the
payment of debt. The person who parts with the interest in the property is called `mortgagor' and
the bank in whose favor the transfer takes place is the `mortgagee'. The instrument of transfer is
called the `mortgage deed'. Mortgage is, thus, conveyance of interest in the mortgaged property.
The mortgage interest in the property is terminated as soon as the debt is paid. Mortgages are
taken as an additional security for working capital credit by banks.
v.
Charge:
Where immovable property of one person is, by the act of parties or by the operation of law,
made security for the payment of money to another and the transaction does not amount to
mortgage, the latter person is said to have a charge on the property and all the provisions of
simple mortgage will apply to such a charge meaning that A charge is not the transfer of interest
in the property though it is security for payment. But mortgage is a transfer of interest in the
property.
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b. Commercial Paper
A Commercial Paper (CP) is a short-term usance promissory note issued by a company,
negotiable by endorsement and delivery, issued at a discount on face value, as may be
determined by the issuing company. It is issued at a discount and redeemed at face Value.
Example: A commercial paper for Rs.5 lakhs is issued for Rs. 4, 83,500. The investor pays Rs.
4, 83,500 initially and is repaid Rs. 5 lakhs. The difference between investment amount and
redemption value constitutes his interest income for the period.
Broad features of Commercial Paper
a. Short Term (i.e. 3 to 6 months): It is a short -term money market instrument. The
minimum Maturity period shall be three months and the maximum period shall be six
months from the date of issue. No grace period is allowed for repayment. (unlike a bill of
exchange)
b. Promissory Note: It is essentially a usance promissory note with a fixed maturity
value.
c. Unsecured: It is a certificate evidencing an unsecured corporate debt of short-term
maturity. Assets are not pledged against CP's.
d. Issued at Discount: It is issued at a discount on face value, but it can also be issued in
interest hearing form. Each CP will have a denomination of Rs.5 lakhs and a single
borrower may subscribe to at least Rs.25 lakhs in the primary market.
e. Procedure: It can be issued directly by a company to investors or through banks
merchant bankers. Each CP will bear a certificate from the bank verifying the signatures
of the executants.
Eligibility conditions for issue of CP
The issue of CP is subject to the norms a d conditions stipulated by NRB from time to time.
The broad conditions are:
1) Listing: The Issuing Company Should be listed in at least one recognized stock
exchange. However, relaxation from this rule is given to (a) Public Sector Companies
and (b) Closely held companies.
2) Credit Rating: The Issuing Company should obtain the necessary credit rating from
agencies like ICRA, CRISIL etc. Application to NRB for approval should be made
within two months of obtaining the rating.
3) Standard Asset: In addition to credit rating', the issuing company should be classified as
"Standard Asset" (as opposed to sub-standard, loss asset etc.) by its bankers / lending
financial institutions.
4) Net Worth: The Issuer should have a minimum Tangible Net Worth of Rs.5 crores as
per recent audited Balance Sheet. Net Worth = Paid up Capital + Free Reserves Accumulated Losses and Fictitious Assets.
5) Working Capital: The fund based working capital limit should be minimum of Rs.5
Crores.
6) Current Ratio: The minimum current ratio should be 1.33:1
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7) Issue expenses: All issue expenses like dealer's fees, credit rating agency fee etc. shall be
borne by the issuer company.
Procedure for Issue of Commercial Paper
1) Application to NRB: The Company shall apply to the NRB, through the financing
bank. It has to meet all eligibility criteria, including sound credit rating.
2) Approval by NRB: NRB shall grant approval to the issue if it is satisfied that the
issuing Company meets all the eligibility conditions.
3) Private Placement: The Issuing Company shall make arrangements for private
placement of the issue. The process should be completed within two weeks from the
date of approval from NRB.
4) Intimation of Compliance: Within three weeks of approval, the Company shall
intimate the NRB on the completion of issue and compliance with all necessary
conditions.
Advantages of Commercial Paper
1) Simplicity: The advantage of CP lies in its simplicity. Documentation involved is
minimum.
2) Cash Flow management: The issuer can issue commercial paper with the maturities
tailored to match the cash flow of the company.
3) Diversification from bank finance: A well-rated company can diversify its sources
of finance from banks to short term money markets at relatively cheaper cost.
4) Incentive for financial strength: Companies which raise funds through CP become
better known in the financial world and are thereby placed in a more favorable
position for raising long term capital also. Thus, there is an in-built incentive for
companies to remain financially strong.
5) Returns to Investors: CP's provide investors with higher returns than the banking
system.
f. ICD's, CD's and Public Deposits
(1)
Inter corporate deposits : (ICD's)
a. Companies can borrow funds for a short period, for example 6 months or less, from
other companies which have surplus liquidity.
b. Such deposits made by one company in another are called Inter-Corporate Deposits
(ICD's ).
c. The rate of interest on inter corporate deposits Varies depending upon the amount
involved and time period.
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(2)
Certificate of Deposit (CD)
a. The certificate of deposit is a document of title similar to a fixed deposit receipt
(FDR) issued by a bank.
b. There is no prescribed interest rate On Such It is based on the prevailing market
conditions.
c. The main advantage of a CD is that the banker is not required to encash the deposit
before maturity period. But the investor is assured of liquidity because he can sell
the CD in Secondary market.
(3)
Public Deposits
a. Public deposits are a very important Source for short-term and medium-term
finance.
b. A Company can accept public deposits from members of the public 3;nd
shareholders, subject to the stipulations of NRB from time to time.
c. The maximum amount that can be raised by way of Public Deposits is 35% of its
paid-up capital and reserves,
d. The maturity period of these deposits may he for a period of six months to three
Years.
e. These deposits are unsecured loans and are used for working capital requirements.
They should not be used for acquiring fixed assets since they are too, he repaid
within a period of 3 years.
Knowledge Test 1- Solution
Solution
Relative Suitability of Policy Options
Sales revenue
Less variable cost (70%)
Contribution margin (manufacturing)
Present policy
Policy option I
Policy option II
Rs 50,00,000
35,00,000
15,00,000
Rs 60,00,000
42,00,000
18,00,000
Rs 67,50,000
47,25,000
20,25,000
Less other relevant costs:
1,50,000
3,00,000
4,50,000
Bad debt losses
Investment cost (see working notes)
2,18,750
3;50,000
4,92,187.50
Contribution margin (final)
11,31,250
11,50,000
10,82,812.50
The firm is advised to adopt policy option I (extend credit terms to 4 months).
Working notes
Calculation of Investment Cost
Strictly speaking, investment in accounts receivable should be determined with reference to
total cost of goods sold on credit. However, fixed costs are not given. It is assumed that there
are no fixed costs and investment in debtors/receivables is determined with reference to
variable costs only.
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Present policy 𝑅𝑅𝑠𝑠35,00,000 / 4 = Rs 8,75,000
= Rs 8,75,000 x 0.25
= Rs 2,18,750
Policy option I 𝑅𝑅𝑠𝑠42,00,000 / 3 = Rs 14,00,000
= Rs 14,00,000 x 0.25
= Rs 3,50,000
Policy option II 𝑅𝑅𝑠𝑠47,25,000 / 2.4 = Rs 19,68,750
= Rs 19,68,750 x 0.25
= Rs 4,92,187.5
Knowledge Test 2- Solution (Factoring)
a) Reduction in receivables days = 75 days- 45 days = 30 days
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑖𝑖𝑖𝑖 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 =
30
∗ 16,000,000 = 𝑁𝑁𝑁𝑁𝑁𝑁 1,315,068
365
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑖𝑖𝑖𝑖 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = (8% ∗ 𝑁𝑁𝑁𝑁𝑁𝑁 1,315,068 = 𝑁𝑁𝑁𝑁𝑁𝑁 105,205
= NRs 105,000 (approx.)
Administrative Charges
= NRs 100,000
Summary
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = 1.75% ∗ 16,000,000 = 𝑁𝑁𝑁𝑁𝑁𝑁 280,000
Service Charges
Finance costs saved by reducing receivable
Administrative costs saved
Net annual costs of the service
NRs 280,000
NRs 105,000
NRs 100,000
(75,000)
Bishal Co. will have to balance this cost against the security offered by improved cash
flows and greater liquidity
b)
Sales ledger administration ( 1% * 16m)
Administration
Cost of factor finance 10% *80* 3.3 m
Overdraft finance costs 8%*80%*3.3 m
Net cost of factors
Cost of factoring
160,000
264,000
424,000
112,800
Savings
100,000
211,200
311,200
As before the firm will have to balance this cost against the security offered by improved cash
flows and greater liquidity
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6.4 Management of Cash & Marketable Securities
6.4.1 Learning Objectives
Upon completion of this chapter student will be able to:
explain the main reasons for a business to hold cash
define and explain the use of cash budgets and cash flow forecasts
state the objectives of cash Management
understand the factors affecting cash requirements
calculate the optimum cash requirement under Baumol Model
explain the logic of the Miller-Orr cash management model
calculate the optimum cash management strategy using the Miller-Orr cash management
mode
 understand the basic strategies of cash management
 explain the concept of marketable securities







6.4.2 Chapter Overview
Cash Management
& Marketable
Securities
Cash Management
Technique
Reason for holding
cash
Objectives of Cash
Management
Cash Management
Model
Cash Budgets
Basic Strategies of
Cash Management
Baumol Model
Miller -Orr
Fig: Chapter Overview of Cash Management & Marketable Securities
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6.4.3 Introduction of Cash Management
Cash management is the efficient collection, disbursement, and investment of cash in an
organization while maintaining the company‘s liquidity. In other words, it is the way in which a
particular organization manages its financial operations such as investing cash in different shortterm projects, collection of revenues, payment of expenses, and liabilities while ensuring it has
sufficient cash available for future use.
Cash management is one of the key areas of working capital management. Apart from the fact
that it is the most liquid current asset, cash is the common denominator to which all current
assets can be reduced because the other major liquid assets, that is, receivables and inventory get
eventually converted into cash. This underlines the significance of cash management.
Motives for holding cash
6.4.4 Motives for Holding Cash
The term cash with reference to cash management is used in two senses. In a narrow sense, it is
used broadly to cover currency and generally accepted equivalents of cash, such as cheques,
drafts and demand deposits in banks. The broad view of cash also includes near-cash assets, such
as marketable securities and time deposits in banks. The main characteristic of these is that they
can be readily sold and converted into cash. There are three primary motives for maintaining
cash balances: (i) Transaction motive; (ii) Precautionary motive; and (iii) Speculative motive
Transaction Motive
Precautionary Motive
Speculative Motive
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6.4.4.1 Transaction Motive
An important reason for maintaining cash balances is the transaction motive. This refers to the
holding of cash to meet routine cash requirements to finance the transactions which a firm
carries on in the ordinary course of business. The transaction motive refers to the cash required
by a firm to meet the day to day needs of its business operations. In an ordinary course of
business, the firm requires cash to make the payments in the form of salaries, wages, interests,
dividends, goods purchased, etc.
Likewise, it also receives cash from its sales, debtors, investments. Often the firm‘s cash inflows
and outflows do not match, and hence, the cash is held up to meet its routine commitments.
6.4.4.2 Precautionary Motive
The precautionary motive refers to the tendency of a firm to hold cash, to meet the contingencies
or unforeseen circumstances arising in the course of business.
Since the future is uncertain, a firm may have to face contingencies such as an increase in the
price of raw materials, labor strike, lockouts, change in the demand, etc. Thus, in order to meet
with these uncertainties, the cash is held by the firms to have an uninterrupted business
operation.
 Floods, strikes and failure of important customers;
 Bills may be presented for settlement earlier than expected;
 Unexpected slowdown in collection of accounts receivable;
 Cancellation of some order for goods as the customer is not satisfied; and
 Sharp increase in cost of raw materials.
6.4.4.3 Speculative Motive
The firms hold cash for the speculative purposes to avail the benefit of bargain purchases that
may arise in the future. For example, if the firm feels the prices of raw material are likely to fall
in the future, it will hold cash and wait till the prices actually fall.
Thus, a firm holds cash to exploit the possible opportunities that are out of the normal course of
business. These opportunities could be in the form of the low-interest rate charged on the
borrowed funds, expected fall in the raw material prices or favorable change in the government
policies.
 An opportunity to purchase raw materials at a reduced price on payment of immediate
cash;
 A chance to speculate on interest rate movements by buying securities when interest
rates are expected to decline;
 Delay purchases of raw materials on the anticipation of decline in prices; and
 Make purchase at favorable prices.
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6.4.4.4 Functions of Treasury Functions
The treasury department occupies a central role in the finances of the modern corporation. It
takes responsible for the company‘s liquidityensures that a company has enough cash available
at all times to meet the needs of its primary business operations.
a) Cash Forecasting:
This is the beginning of all other roles carried on the operation of a treasury department.
Dislike the accounting staffs who handle the cash receipt and disbursement activities on
daily basis, treasury staffs need to draw all those accounting staff‘s records (within the
organization including its subsidiaries if any), and compile it to generate a cash forecast
(short and long-range). The forecast and all its components are needed to:
 determine if more cash is needed. If that is the case, then they can go on to plan
for fund inquiry either through the use of debt or equity.
 plan for investment purposes, if the forecast results in surplus and cash excess
shows up.
 plan its hedging operations by using the information at the individual currency
level.
b) Working Capital Management
Major usage of company‘s cash is in the working capital area. Working capital is a key
component of cash forecasting. It involves changes in the levels of current assets and
current liabilities in response to a company‘s general level of sales. The treasurer should
be aware of working capital levels and trends and advise management on the impact of
proposed policy changes on working capital levels.
c) Cash Management
Combining information in the cash forecast and working capital management activities,
Treasury staff is able to ensure that sufficient cash is available for operational needs.
d) Investment Management
When the forecast shows some excess funds at, the treasury staffs are responsible for the
proper investment of it. Three primary goals of the role are: (a) maximum return on
investment; (b) matching the maturity dates of investments with a company‘s projected
cash needs; and most importantly is (c) not putting funds at risk.
e) Treasury Risk Management
The treasury staffs are also responsible to create risk management strategies and
implement hedging tactics to mitigate the whole company‘s risk—particularly in
anticipating (a) market‘s interest rates may rise and leave the company pays on its debt
obligations; and (b) company‘s foreign exchange positions that could also be at risk if
exchange rates suddenly worsen.
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f)
Chapter 6
Credit Rating Agency Relations
A company may issue marketable debt. In this case a credit rating agency will review
the company‘s financial condition and assign a credit rating to the debt. The treasury
staff would need to show quick responds to information requests from the credit
agency‘s review team.
g) Bank Relation
A long-term relationship can lead to some degree of bank cooperation if a company is
having financial difficulties and may sometimes lead to modest reductions in bank fees.
The treasurers should therefore, often meets with the representatives of any bank that
the company uses to: discuss the company‘s financial condition, the bank ‘ s fee
structure, any debt granted to the company by the bank, and foreign exchange
transactions, hedges, wire transfers, cash pooling, and so on.
h) Fund Raising
Maintaining an excellent relations with the investment community for fund raising
purposes, is important—from the (a) brokers and investment bankers who sell the
company‘s debt and equity offerings; to the (b) the investors, pension funds, and other
sources of cash, who buy the company‘s debt and equity.
Other than those main roles, fundamentally the treasury staffs also monitor market
conditions constantly, and therefore is an excellent resource for the management team
should they want to know about interest rates that the company is likely to pay on new
debt offerings, the availability of debt, and probable terms that equity investors will
want in exchange for their investment in the company.
If a company engages in mergers and acquisitions on a regular basis, then the treasury
staff should have expertise in integrating the treasury systems of acquirees into those of
the company. Another activity is the maintenance of all types of insurance on behalf of
the company.
6.4.5 Objectives of Cash Management
Following are the basic objectives of cash management.
 Fulfil Working Capital Requirement: The organization needs to maintain ample
liquid cash to meet its routine expenses which possible only through effective cash
management.
 Planning Capital Expenditure: It helps in planning the capital expenditure and
determining the ratio of debt and equity to acquire finance for this purpose.
 Handling Unorganized Costs: There are times when the company encounters
unexpected circumstances like the breakdown of machinery. These are unforeseen
expenses to cope up with; cash surplus is a lifesaver in such conditions.
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 Initiates Investment: The other aim of cash management is to invest the idle funds in
the right opportunity and the correct proportion.
 Better Utilization of Funds: It ensures the optimum utilization of the available funds
by creating a proper balance between the cash in hand and investment.
 Avoiding Insolvency: If the business does not plan for efficient cash management, the
situation of insolvency may arise. It is either due to lack of liquid cash or not making a
profit out of the money available.
6.4.6 Cash Management Models
While it is true that financial managers need not necessarily follow cash management models
exactly but a familiarity with them provides an insight into the normative framework as to how
cash management should be conducted. This section, therefore, attempts to outline the following
analytical models for cash management: (i) Baumol Model, (ii) Miller-Orr Model
Baumol Model
Cash Management
Model
Miller Orr
6.4.6.1 Baumol Model
William J. Baumol developed a model (The Transactions Demand for Cash: An Inventory
Theoretic Approach) which is usually used in inventory management but has its application in
determining the optimal cash balance also. Baumol found similarities between inventory
management and cash management.
The purpose of this model is to determine the minimum cost amount of cash that a financial
manager can obtain by converting securities to cash, considering the cost of conversion and the
counter-balancing cost of keeping idle cash balances which otherwise could have been invested
in marketable securities.
Assumptions:
 Cash use is steady and predictable
 Cash inflows are known and regular
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 Day to day cash need are funded from current account
 Buffer cash is held in short-term investments
The formula calculates the amount of funds to inject into the current account or to transfer into
short-term investments at one time:
𝑄𝑄 =
2𝐴𝐴𝐴𝐴𝐴𝐴
𝐶𝐶ℎ
Where,
Co= transaction costs (brokerage, commission etc.)
A = Demand for cash over the period
Ch = cost of holding cash
The total cost associated with cash management, according to this model, has two elements:
(i)
(ii)
cost of converting marketable securities into cash and
the opportunity cost.
(i)
cost of conversion
The conversion costs are incurred each time marketable securities are converted into cash.
Symbolically, total conversion cost per period.
𝑇𝑇𝑇𝑇
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 =
𝐶𝐶
Where,
b= cost per conversion assumed to be independent of the size of the transaction
T= total transaction cash needs for the period
C= value of marketable securities sold at each conversion.
(ii)
Opportunity Costs
The opportunity cost is derived from the lost/forfeited interest rate (denoted as i) that could have
been earned on the investment of cash balances. The total opportunity cost is the interest rate
times the average cash balance kept by the firm.
Symbolically, the average lost opportunity cost.
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝑖𝑖 𝑖
𝑐𝑐
2
Where
i = interest rate that could have been earned.
C/2 = the average cash balance that is, the beginning cash (C) plus the ending cash balance of the
period (zero) divided by 2.
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The total cost associated with cash management comprising total conversion cost plus
opportunity cost of not investing cash until needed in interest-bearing instruments can be
symbolically expressed as:
𝑐𝑐 𝑇𝑇𝑇𝑇
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = 𝑖𝑖 𝑖 +
2
𝑐𝑐
Illustration No. 1
A Company generates NRs 10,000 per month excess cash, which it intends to invest in shortterm securities. The interest rate it can expect to earn on its investment is 5%. The transaction
cost associated with each separate investment of funds is constant at NRs 50.
Required,
a)
b)
c)
d)
What is the optimum amount of cash to be invested in each transaction?
How many transactions will arise each year?
What is the cost of making those transactions pa.?
What is the opportunity cost of holding cash pa?
Illustration No. 1- solution
a)
𝑄𝑄 =
2 ∗ 50 ∗ 10,000 ∗ 12
= 𝑁𝑁𝑁𝑁𝑁𝑁15,492
0.05
b) Number of transactions per annum;
120,000
= 7.75 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑡𝑡𝑡𝑡 8 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
𝑁𝑁𝑁𝑁. 𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 =
15,492
c) Annual Transaction costs = 7.75 *50 = NRs 387
d) 𝐀𝐀𝐀𝐀𝐀𝐀𝐀𝐀𝐀𝐀𝐀𝐀 𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨𝐨 𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜 𝐡𝐡𝐡𝐡𝐡𝐡𝐡𝐡𝐡𝐡𝐡𝐡𝐡𝐡 𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜 = 5% ∗
15492
2
= 𝑁𝑁𝑁𝑁𝑁𝑁 387
Illustration No. 2
The ABC Ltd requires Rs 30 lakh in cash to meet its transaction needs during the next threemonth cash planning period. It holds marketable securities of an equal amount. The annual
yield on these marketable securities is 20 per cent. The conversion of these securities into cash
entails a fixed cost of Rs 3,000 per transaction. Using Baumol model, compute the amount of
marketable securities converted into cash per order. Assuming ABC Ltd can sell its
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marketable securities in any of the five lot sizes: 1,50,000, 3,00,000, 6,00,000, 7,50,000 and
15,00,000, prepare a table indicating the economic lot size using numerical analysis.
Illustration No. 2- Solution
We Know that,
𝑄𝑄 =
2𝐴𝐴𝐴𝐴𝐴𝐴
𝐶𝐶ℎ
Where,
Co= transaction costs (brokerage, commission etc.)
A = Demand for cash over the period
Ch = cost of holding cash
Optimal Cash Conversion Size/Lot
1. Total annual cash requirement (Rs lakh)
30
30
30
30
30
2. Lot size (Rs lakh)
1.5
3
6
7.5
15
3. Number of lots (1 / 2)
20
10
5
4
2
4. Conversion cost per lot (Rs thousand)
3,000
3,000
3,000
3,000
3,000
5. Total conversion cost (3 x 4) (Rs thousand)
60,000 30,000 15,000
12,000 6,000
6. Average lot size (Rs lakh)
0.75
1.5
3
3.75
7. Interest cost (6 x 0.05) (Rs)
3,750
7,500
15,000
18,750 37,500
8. Total cost (5 + 7) (Rs)
63,750 37,500 30,000
30,750 42,500
7.5
The optimal cash conversion size is Rs 6 lakh.
Working note
1. Number of conversions during the planning period =𝑇𝑇𝑜𝑜𝑡𝑡𝑎𝑎𝑙𝑙𝑐𝑐𝑎𝑎𝑠𝑠ℎ𝑟𝑟𝑒𝑒𝑞𝑞𝑢𝑢𝑖𝑖𝑟𝑟𝑒𝑒𝑚𝑚𝑒𝑒𝑛𝑛𝑡𝑡30
𝑙𝑙𝑎𝑎𝑘𝑘ℎ𝐶𝐶𝑎𝑎𝑠𝑠ℎ𝑐𝑐𝑜𝑜𝑛𝑛𝑣𝑣𝑒𝑒𝑟𝑟𝑠𝑠𝑖𝑖𝑜𝑜𝑛𝑛𝑙𝑙𝑜𝑜𝑡𝑡
2. Average cash balance = Cash conversion size/2.
3. Interest income foregone = Average cash balance x interest rate for the cash planning
period; interest rate = annual yield/4.
4. Cost of cash conversion = Number of conversions x cost per conversion.
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5. Total cost of converting and holding cash = Interest income foregone + cost of cash
conversion.
Knowledge Test 1
A Company faces a constant demand for cash totaling 2,00,000 pa. It replenishes its
current account (which pays no interest) by selling constant amount of treasury bills,
which are held as an investment earnings 6% pa. The cost per sale of treasury bills is a
fixed 15 per sale.
What is the optimum amount of treasury bills to be sold each time an injection of cash is
needed in the current account; how many transfers will be needed and what will the overall
transaction cost be?
6.4.6.2 Miller-Orr Model
The Miller-Orr model of cash management is developed for businesses with uncertain cash
inflows and outflows. This approach allows lower and upper limits of cash balance to be set and
determine the return point (target cash balance). This is different from the Baumol-Tobin model,
which is based on the assumption that the cash spending rate is constant.
Assumptions
The Miller-Orr model of cash management can be used if the following assumptions are
met:
 The cash inflows and cash outflows are stochastic. In other words, each day a business
may have both different cash payments and different cash receipts.
 The daily cash balance is normally distributed, i.e., it occurs randomly.
 There is a possibility to invest idle cash in marketable securities.
 There is a transaction fee when marketable securities are bought or sold.
 A business maintains the minimum acceptable cash balance, which is called the lower
limit.
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Fig: Miller Orr Cash Management Model
The lower limit, L is set by management depending upon how much risk of a cash shortfall the
firm is willing to accept; and this, in turn depends both on access to borrowing and on the
consequences of a cash shortfall.
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑍𝑍 = 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 +
1
∗ 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
3
3
∗ 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑐 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐ℎ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 3 4
𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
1
3
Note: Variance and interest rates should be expressed in daily terms.
This model is designed to determine the time and size of transfers between an investment
account and cash account. In this model control limits are set for cash balances. These limits
may consist of h as upper limit, z as the return point; and zero as the lower limit.
 When the cash balance reaches the upper limit, the transfer of cash equal to h – z is
invested in marketable securities account.
 When it touches the lower limit, a transfer from marketable securities account to cash
account is made.
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The high and low limits of cash balance are set up on the basis of fixed cost associated with the
securities transactions, the opportunity cost of holding cash and the degree of likely fluctuations
in cash balances. These limits satisfy the demands for cash at the lowest possible total costs.
Illustration No. 3
The minimum cash balance of NRs 20,000 is required at Miller Orr Co and transferring
money to or from the bank costs 50 per transactions. Inspection of daily cash flows over the
past year suggests that the standard deviation is 3,000 per day. The interest rate is 0.03% per
day.
Calculate:
i.
The spread between the upper and lower limits
ii.
The upper limits
iii.
The return point
Illustration No. 3- Solution
i.
The spread between the upper and lower limits
3
∗ 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 ∗ 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐ℎ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 3 4
𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
3
∗ 50 ∗ 9,000,000
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 3 4
0.0003
ii.
iii.
The upper limits
1
3
1
3
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 𝑁𝑁𝑁𝑁𝑁𝑁 31,201
𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 = 20,000 + 31,201 = 𝑁𝑁𝑁𝑁𝑁𝑁 51,201
The Return Point = 20,000 + 31,201/3 = NRs 30,400.
6.4.7 Cash Planning
Cash planning and control of cash is the central point of finance functions. Maintenance of
adequate cash is one of the prime responsibilities of the financial manager. It is possible only
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through the preparation of cash planning. Cash control is also included in cash planning. Since
planning and control are the twins of management. Cash planning is a technique to plan and
control the use of cash. A projected cash flow statement prepared based on expected cash
receipts and payments, is the anticipation of the financial condition of the firm. Cash planning
may be prepared on the daily, weekly, monthly or quarterly basis. The period for which the cash
planning is prepared depends on the size of the firms and management‘s philosophy. Large firms
prepare daily and weekly forecasts. Medium size firms prepare weekly and monthly forecasts.
Small firms may not prepare cash forecasts due to non-availability of data and less scale of
operations. But in a short period, they may service but over a long period, they have to prepare
cash planning for the success of the firm.
6.4.8 Cash Budget
A firm is well advised to hold adequate cash balances but should avoid excessive balances. The
firm has, therefore, to assess its need for cash properly. The cash budget is probably the most
important tool in cash management. It is a device to help a firm to plan and control the use of
cash. It is a statement showing the estimated cash inflows and cash outflows over the planning
horizon. In other words, the net cash position (surplus or deficiency) of a firm as it moves from
one budgeting sub period to another is highlighted by the cash budget.
Cash forecast is used as a method to predict future cash flow because it deals with the estimation
of cash flows (i.e., cash inflows and cash outflows) at different stages and offers the management
an advance notice to take appropriate and timely action. The cash budget is an important tool for
the flow of cash in any firm over a future period of time. In other words, it is a statement
showing the estimated cash inflows and cash outflows over a planning period. It pinpoints the
surplus or deficit cash of a firm as it moves from one period to another period. The surplus of
deficit data helps the financial manager to determine the future cash needs of the firm, plan for
the financing of those needs and exercise control over the cash and liquidity of the firm. The
cash budget is also known as short-term cash forecasting.
6.4.8.1 Purpose of Cash Budget
Cash budget has proved to be of great help and benefit in the following areas:
1. Estimating cash requirements
2. Planning short-term finance planning
3. Scheduling payments, in respect of acquiring capital goods
4. Planning and phasing the purchase of raw materials
5. Evolving and implementing credit policies
6. Checking and verifying the accuracy of long-term cash forecasting.
Elements/Preparation of Cash Budget
The above benefit areas clear that the main aim of preparing cash budget is to predict the cash
flows over a given period of time and to determine whether at any point of time there is likely to
be surplus or deficit of cash. Preparation of cash budget involves the following steps:
Step 1: Selection of period of time (planning horizon). The planning horizon is that period for
which cash budget is prepared. There are no fixed rules for cash budget preparation. The
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planning horizon of a cash budget may differ from firm to firm, depending upon the size of the
firm. Cash budget period should not be too short or too long. If it is too short many important
events may come out in the planning period and cannot be accounted for the preparation of cash
budget, which becomes expensive. On the other hand, if it is too long the estimates will be
inaccurate. Then how to determine planning horizon? It is determined on the basis of the
situation and the necessity of a particular case. A firm whose business is affected by seasonal
variations may prepare monthly cash budgets. If the cash flow fluctuates, daily or weekly cash
budgets should be prepared. Longer period cash budgets may be prepared when the cash flows
are stable in nature.
Step 2: Selection of factor that has bearing on cash flows. The factors that generate cash
flows are divided into two broad categories:
a. Operating, and
b. Financial.
a. Operating Cash Flows: Operating cash inflows are cash sales, a collection of accounts
receivables and disposal of fixed assets and the operating cash outflows are billed payables,
purchase of raw materials, wages, factory expenses, administrative expenses, maintenance
expenses and purchase of fixed assets.
The main operating factors/items which generate cash outflows and inflows over the time span
of a cash budget are tabulated below
Exhibit operating Cash budget are tabulated
Inflow/Cash Receipts
Outflows/Disbursements
2. Cash sales
3. Collection of accounts receivable
4. Disposal of fixed assets
1.
2.
3.
4.
5.
6.
7.
Accounts payable/Payable payments
Purchase of raw materials
Wages and salary (payroll)
Factory expenses
Administrative and selling expenses
Maintenance expenses
Purchase of fixed assets
Among the operating factors affecting cash flows, are the collection of accounts receivable
(inflow) and accounts payable (outflows). The terms of credit and the speed with which the
customers pay would determine the lag between the creation of the accounts receivable and their
collection. Also, discounts and allowances for early payments, returns from customers and bad
debts affect cash inflows. Similarly, in the case of accounts payable relating to credit purchase,
cash outflows are affected by the purchase terms.
The calculation of the collection on credit sales and payments on credit purchases, is generally
done in budget. It is the form of a statement known as the worksheet. The results are
subsequently incorporated in the cash periods within budget. We illustrate in Example below
how the credit policy of a firm and the purchase terms affect cash flows.
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Illustration No. 4
A firm sells goods on credit and allows a cash discount for payments made within 20 days. If
the discount is not availed of, the buyer must pay the full amount in 40 days. However, the
firm finds that some of its customers delay payments up to 90 days. The experience has been
that on 20 per cent of sales, payment is made during the month in which the sale is made, on
70 per cent of the sales payment is made during the second month after sale and on 10 per cent
of sales payment is made during the third month.
The raw materials and other supplies required for production amount to 70 per cent of sales
and are bought in the month before the firm expects to sell its finished products. Its purchase
terms allow the firm to delay payment on its purchases for one month. The credit sales of the
firm are: (Rs Lakh)
May
10
August
30
November
20
June
10
September
40
December
10
July
20
October
20
January
10
Prepare a worksheet, showing the anticipated cash inflows on account of collection of
receivables and disbursement of payables.
Illustration No. 4- Answer
The expected cash inflows through collection of receivables and the anticipated outflows on
account of accounts payable are presented in the form of a worksheet.
Worksheet Showing Cash collection and Payment
May June July Aug. Sept. Oct. Nov. Dec. Jan.
1. Credit sales
10 10 20 30 40- 20 20
10 10
2. Collections:
During month of sale (20%)
During the first month after
sale (70%)
2
2
4
6
8
4
4
2
2
-
7
7
14
21
28
14
14
7
During second month after
sale (10%)
-
-
1
1
2
3
4
2
2
Total collections
2
9
12
21
31
35
22
18
11
7
14
21
28
14
14
7
7
—
7
14
21
28
14
14
7
7
—
7
14
21
28
14
14
7
7
3. Payments:
Credit purchases (70% of
Next month‘s sale)
Payment (one-month lag)
Total payment
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Working Capital Management & Finanical Forecasting
b. Financial Cash Flows: Loans and borrowings, the sale of securities, dividend received,
refund of tax, rent received, interest received and the issue of new shares and debentures
cash outflows are a redemption of the loan, repurchase of shares, income tax payments,
interest paid and dividend paid. The major financial factors/items affecting the generation of
cash flows are depicted in Exhibit
S. N
Cash Inflows/ Receipt
S. N
Cash Outflows/Payments
1
Loans/Borrowings
1
Income tax payments
2
Sales of securities
2
Redemption of loan
3
Interest received
3
Repurchase of shares
4
Dividend received
4
Interest paid
5
Rent received
5
Dividends paid
6
Refund of tax
7
Issue of new share and securities
Preparation of Cash BudgetAfter the time span of the cash budget has been decided and
pertinent operating and financial factors have been identified, the final step is the construction of
the cash budget. The preparation of a cash budget is illustrated in Examples below.
Illustration No. 5
A firm adopts a six-monthly time span, subdivided into monthly intervals for its cash budget.
(A) The following information is available in respect of its operations: (Rs lakh)
1.
2.
3.
4.
5.
6.
7.
Sales
Purchases
Direct labor
Manufacturing overheads
Administrative expenses
Distribution
Raw materials (30 days credit)
1
40
1
6
13
2
2
14
2
50
1.50
7
13.5
2
3
15
3
60
2
8
14
2
4
16
Months
4
60
2
8
14
2
4
16
5
60
2
8
14
2
4
16
6
60
1
6
13
2
2
15
(B) Assume the following financial flows during the period:
(a) Inflows:
1. Interest received in month 1 and month 6, Rs 1 lakh each;
2. Dividend received during months 3 and 6, Rs 2 lakh each;
3. Sales of shares in month 6, Rs 160 lakh.
(b) Outflows:
1. Interest paid during month 1, Rs 0.4 lakh;
2. Dividends paid during months 1 and 4, Rs 2 lakh each;
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3. Installment payment on machine in month 6, Rs 20 lakh;
4. Repayment of loan in month 6, Rs.80 lakhs.
(c) Assume that 10 per cent of each month's sales are for cash; the balance 90 per cent are on
credit. The terms and credit experience of the firm are:
1. No cash discount;
2. 1 per cent of credit sales is returned by the customers;
3. 1 per cent of total accounts receivable is bad debt;
4. 50 per cent of all accounts that are going to pay, do so within 30 days;
5. 100 per cent of all accounts that are going to pay, do so within 60 days.
Using the above information prepare a cash budget.
Illustration No. 5- Solution
Statement showing Cash Budget for the Six Months
Months
1
2
3
4
5
6
1. Cash sales (10% of total)
4
5
6
6
6
6
2. Receivables collection
-
17.64
39.68
48.5
52.92
52.92
3. Interest received
1
-
-
-
-
1
4. Dividends received
-
-
2
-
-
2
5. Sale of shares
-
-
-
-
-
160
Total (A)
5
22.64
47.68
54.5
58.92
221.92
1. Purchases
1
1.5
2
2
2
1
2. Labor
6
7
8
8
8
6
3. Manufacturing overheads
13
13.5
14
14
14
13
4. Administrative expenses
2
2
2
2
2
2
5. Distribution charges
6. Raw materials (30 days
credit)
7. Interest paid
2
3
4
4
4
2
14
15
16
16
16
-
-
20
80
48
46
140
(A) Cash inflows:
(B) Cash outflows:
8. Dividend paid
0.4
2
2
9. Installment of machine
10. Repayment of loan
Total (B)
26.4
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Working Capital Management & Finanical Forecasting
(C) Net Receipt or
(Payment) (A–B)
21.4
18.36
2.68
6.5
12.92
81.92
It can be seen from above example that the cash budget helps to reconcile the need for cash
with the financing arrangement. For instance, in the first two months, the cash receipts fall
below the disbursements and the firm obviously needs temporary financing which it will be
able to pay in the subsequent months. In month 6, it has, in fact, excess cash for which
temporary investment will have to be made until the funds can be employed in business.
Illustration No. 6
The following information is available in respect of a firm:
(A) Statement of Financial Position as on Aashadh 31
Liabilities
Accrued salaries
Other liabilities
Capital
Amount
500.00
2,500.00
65,000.00
Assets
Cash
Inventory
Other assets
Less depreciation
68,000.00
Amount
3,000.00
8,000.00
70,000.00
(13,000.00)
68,000.00
Inventory Consists of Rs 2,000 minimum inventory plus Rs 6,000 of inventory scheduled to
be sold next month
(B)
Sales Forecast
April
Rs 10,000
July
Rs 50,000
May
20,000
August
40,000
June
30,000
September
20,000
October
5,000
(C)
April
May
June
Rs 10,000
2,000
30,000
Salary Expenses Budget
July
Rs 50,000
August
3,000
September
2,000
(D) The firm is expected to operate on the following lines:
 Other expenses approximate 12 per cent of sales (paid in the same month).
 Sales will be 80 per cent cash and 20 percent credit. The all credit sales will be
collected in the following month and no bad debts are expected.
 All inventory purchases will be paid for during the month in which they are made.
 A basic inventory of Rs 2,000 (at cost) will be maintained. The firm will follow a
policy of purchasing additional inventory each month to cover the following month‘s
sale.
 A minimum cash balance of Rs 3,000 will be maintained.
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 New orders for equipment amounting to Rs 20,000 scheduled for May 1 delivery and
Rs 10,000 for June 1 delivery have been made. Payment will be made at the time of
delivery.
 Accrued salaries and other liabilities will remain unchanged.
 Gross profit margin is 40 per cent of sales.
Prepare a cash budget for 6 months (April to September). Borrowings are made in
thousands of rupees. Ignore interest.
Illustration No. 6- Solution
Cash Budget (Amount in ‗000 rupees)
(A) Cash Inflows:
April May
June
July
1.
Cash sales (0.80)
2.
Accounts
receivablecollections (0.2)
Total
(B)
1
2
3
Cash outflows:
Inventory
Salary
Expenses
4
Equipment
Total
(C)
Net monthly cash gain or
loss by end of month (A B)
Cumulative cash gain or
loss by end of month
Cumulative
borrowing
(month-end)
Aug.
Sept.
8
16
24
40
32
16
–
2
4
6
10
8
8
18
28
46
42
24
12
1.2
1.2
18
2
2.4
30
2.5
3.6
24
4
6
12
3
4.8
3
2
2.4
-
20
10
14.4
42.4
46.1
34
19.8
7.4
-6.4
-24.4
-18.1
12
22.2
16.6
-6.7
-31.1
-49.2
-37.2
-15
1.6
7
32
50
38
15
Illustration No. 7
The directors of Kingston & Co. were concerned about the company‘s cash flow. They
requested their accountant to prepare a cash budget for the four months ending 31st Shrawan
2076.
The following sales figures are for the months of Falgun 2075 to Ashwin 2076. The figures
from Baisakh 2076 onward are estimated:
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Particulars
Actual Sales
Falgun 2075
Chaitra 2075
Estimated
Baisakh 2076
Jestha 2076
Aashadh 2076
Shrawan 2076
Bhadra 2076
Ashwin 2076
Amount in NRs
60,000
64,000
65,000
70,000
72,500
76,250
80,000
78,750
i. Half the sales are normally paid for in the month in which they occur, and the customers
are rewarded with a 5% cash discount. The remaining sales are paid for net in the month
following the sale.
ii. (Goods are sold at a mark-up of 25% on the goods purchased one month before sale.
Half of the purchases are paid for in the month of purchase and a 4% prompt settlement
discount is received. The remainder is paid in full in the following month.
iii. Wages of NRs 12000 per month are paid in the month in which they are earned. It is
expected that the wages will be increased by 10% from 1 Aashadh 2076.
iv. Rent will cost NRs 60000 per annum payable three monthly in advance in Baisakh,
Shrawan, Kartik and Poush each year.
v. The directors have arranged a bank loan of NRs 60000 which would be credited to
company‘s current account in Jestha 2076.
vi. The half-yearly interest on 200000, 8% debentures of 1 each is due to be paid on 15
Baisakh 2076.
vii. The ordinary dividend of NRs 12000 for the year 2075 will be paid in Aashadh 2076.
viii. The bank balance at 31 Chaitra 2075 is NRs 12000.
Required:
Prepare a cash budget for the four months ended 30 Shrawan 2076. Give your answers to the
nearest rupee.
Illustration No. 7 Solution
Cash Budget
For the month ending 31st Shrawan 2076
Particulars
Sales (Current months sales*
50%*95%)
(Last month sales *50%)
Bank Loan
Total Receipt
Baisakh
30,875
Jestha
33,250
Aashadh
34,438
Shrawan
36,219
32,000
32,500
60,000
125,750
35,000
36,250
69,438
72,469
62,875
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Purchases (current month
purchases * 50%*96%)
Direct Wages
Rent
Debenture Interest
(200,000*8%*6/12)
Other dividends
Total Payments
Net (Receipt-Payment)
Bank Balance at start
Bank Balance at the end
26,880
27,840
29,280
30,720
12,000
15,000
8,000
12,000
13,200
13,200
15,000
12,000
67,840
57,910
(13,005)
44,905
83,840
(14,042)
44905
30,863
89,420
(16,951)
30863
13,912
87,880
(25,005)
12,000
(13,005)
Knowledge Test 2
In the near future, a company will purchase a manufacturing business for NRs 315,000, this
price to include goodwill NRs 150,000, equipment and fittings NRs 120,000, and inventory of
raw materials and finished goods NRs 45000.
A delivery van will be purchased for NRs 15000 as soon as the business purchase is
completed. The delivery van will be paid for in the second month of operations.
The following forecasts have been made for the business following purchase:
(i)
Sales (before discounts) of the business‘s single product, at a mark-up of 60% on
production cost will be:
Month
1
2
3
4
5
6
(―000‖)
96
96
92
96
100
104
26% of sales will be for cash, the remainder will be on credit, for settlement in the month
following that of sale. A discount of 10% will be given to selected credit customers, who
represent 25% of gross sales.
(ii)
Production cost will be NRs 5 per unit. The production cost will be made up of :
Raw materials
NRs 2.50
Direct labor
NRs 1.50
Fixed overhead
NRs 1.00
(iii)
(iv)
Production will be arranged so that closing inventory at the end of any month is
sufficient to meet sales requirement int the following month. A value of NRs
30,000 is placed on the inventory of finished goods, which was acquired on the
purchase of business. This valuation is based on the forecast of production cost
per unit given in (I) above.
The single raw material will be purchased so that inventory at the end of a month
is sufficient to meet half of the following month‘s production requirements. Raw
materials inventory acquired on purchase of the business NRs 15,000 is valued at
the cost per unit that is forecast as given by (ii) above. Raw materials will be
purchased on one month‘s credit.
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(v)
(vi)
(vii)
Costs of direct labor will be met as they are incurred in production.
The fixed production overhead rate of NRs 1.00 per unit is based upon a forecast
of the first year‘s production of 150,000 units. This rate includes depreciation of
equipment and fittings on a straight-line basis over the next five years. Fixed
production overhead is paid in the month incurred.
Selling and administrative overheads are all fixed and will be NRs 208000 in the
first year. These overheads include depreciation of the delivery van at 30% pa on
a reducing balance basis, and paid in the month incurred, with the exception of
rent and rates. NRs 25000 is payable for the year ahead in month one for rent and
rates.
Required:
(a) Prepare a monthly cash flow forecast. You should include the business purchase and the
first four months of operation following purchase.
(b) Calculate the inventory, receivables and payables balances at the end of the four –month
period. Comment briefly upon the liquidity situation.
6.4.9 Cash Management: Basic Strategies
Cash management strategies are intended to minimize the operating cash balance requirement.
The basic strategies that can be employed to do the needful are as follows:
c. Stretching Accounts Payable,
d. Efficient Inventory-Production Management,
e. Speedy Collection of Accounts Receivable, and
f.
Combined Cash Management Strategies.
We spell out the implications of these strategies to the minimum cash balance and the associated
cost with the underlying assumption that a firm should adopt such cash management strategies as
will lead to the minimizing of the operating cash requirement. In other words, efficient cash
management implies minimum cash balances consistent with the need to pay bills when they
become due.
a. Stretching Accounts Payable
One basic strategy of efficient cash management is to stretch the accounts payable. In other
words, a firm should pay its accounts payable as late as possible without damaging its credit
standing. It should, however, take advantage of the cash discount available on prompt payment.
b. Efficient Inventory-Production Management
Another strategy is to increase the inventory turnover, avoiding stock-outs, that is, and shortage
of stock. This can be done in the following ways:
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1. Increasing the raw materials turnover by using more efficient inventory control
techniques.
2. Decreasing the production cycle through better production planning, scheduling and
control techniques; it will lead to an increase in the work-in-progress inventory turnover.
3. Increasing the finished goods turnover through better forecasting of demand and a better
planning of production.
c. Speeding Collection of Accounts Receivable
Yet another strategy for efficient cash management is to collect accounts receivable as quickly as
possible without losing future sales because of high-pressure collection techniques. The average
collection period of receivables can be reduced by changes in (i) credit terms, (ii) credit
standards, and (iii) collection policies. These are elaborated in the next chapter. In brief, credit
standards represent the criteria for determining to whom credit should be extended. The
collection policies determine the effort put forth to collect accounts receivable promptly.
d. Combined Cash Management Strategies
We have shown the effect of individual strategies on the efficiency of cash management. Each
one of them has a favorable effect on the operating cash requirement. We now illustrate their
combined effect, as firms will be well advised to use a combination of these strategies.
The foregoing discussion clearly shows that the three basic strategies of cash management,
related to (1) accounts payable, (2) inventory, and (3) accounts receivable, lead to a reduction in
the cash balance. But they imply certain problems for the management. First, if the accounts
payable are postponed too long, the credit standing of the firm may be adversely affected.
Secondly, a low level of inventory may lead to a stoppage of production as sufficient raw
materials may not be available for uninterrupted production, or the firm may be short of enough
stock to meet the demand for its product, that is, 'stock-out'. Finally, restrictive credit standards.
credit terms and collection policies may jeopardize sales. These implications should be
constantly kept in view while working out cash management strategies.
6.4.10 Cash Management Techniques/Processes
The basic strategies of cash management have been outlined in the preceding section. It has been
shown that the strategic aspects of efficient cash management are: (i) efficient inventory
management, (ii) speedy collection of accounts receivable, and (iii) delaying payments on
accounts payable. There are some specific techniques and processes for speedy collection of
receivables from customers and slowing disbursements. We discuss them in the present section.
a. Speedy Cash Collections
In managing cash efficiently, the cash inflow process can be accelerated through systematic
planning and refined techniques. There are two broad approaches to do this. In the first place, the
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customers should be encouraged to pay as quickly as possible. Secondly, the payment from
customers should be converted into cash without any delay.
b. Prompt Payment by Customers
One way to ensure prompt payment by customers is prompt billing. What the customer has to
pay, and the period of payment should be notified accurately and in advance. The use of
mechanical devices for billing along with the enclosure of a self-addressed return envelope will
speed up payment by customers. Another, and more important, technique to encourage prompt
payment by customers, is the practice of offering cash discounts. The availability of discount
implies considerable saving to the customers. To avail of the facility, the customers would be
eager to make payment early.
c. Early Conversion of Payments into Cash
Once the customer makes the payment by writing a cheque in favor of the firm, the collection
can be expedited by prompt encashment of the cheque. There is a lag between the time a cheque
is prepared and mailed by the customer and the time the funds are included in the cash reservoir
of the firm.
The collection of accounts receivable can be considerably accelerated, by reducing transit,
processing and collection time. An important cash management technique is reduction in deposit
float. This is possible if a firm adopts a policy of decentralized collections. We discuss below
some of the important processes that ensure decentralized collection so as to reduce (i) the
amount of time that elapses between the mailing of a payment by a customer, and (ii) the point
the funds become available to the firm for use. The principal methods of establishing a
decentralized collection network are (a) Concentration Banking, and (b) Lock-box System.
i. Concentration Banking
In this system of decentralized collection of accounts receivable, large should be firms which
have a large number of branches at different places, select some of the strategically located
branches as collection centers for receiving payment from customers. Instead of all the payments
being collected at the head office of the firm, the cheques for a certain geographical area are
collected at a specified local collection center. Under this arrangement, the customers are
required to send their payments (cheques) to the collection center covering the area in which
they live, and these are deposited in the local account of the concerned collection center, after
meeting local expenses, if any. Funds beyond a predetermined minimum are transferred daily to
a central or disbursing or concentration bank or account. A concentration bank is one with which
the firm has a major accountusually a disbursement account." Hence, this arrangement is referred
to as concentration banking.
ii. Look-Box System
The concentration banking arrangement is instrumental in reducing the time involved in mailing
and collection. But with this system of collection of accounts receivable, processing for purpose
of internal accounting is involved, that is, sometime elapses before a cheque is deposited by the
local collection center in its account. The lock-box system takes care of this kind of problem.
Under this arrangement, firms hire a post office lockbox (the important collection centers). The
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customers are required to remit payments to the post office lockbox. The local banks of the firm,
at the respective places, are authorized to open the box and pick up the remittances (cheques)
received from the customers. Usually, the authorized banks pick up the cheques several times a
day and deposit them in the firm's accounts. After crediting the account of the firm, the banks
seen deposit slip along with the list of payments and other enclosures, if any, to the firm by way
of proof and record of the collection.
Illustration No. 8
A firm uses a continuous billing system that results in an average daily receipt of Rs
40,00,000. It is contemplating the institution of concentration banking, instead of the current
system of centralised billing and collection. It is estimated that such a system would reduce
the collection period of accounts receivable by 2 days.
Concentration banking would cost Rs 75,000 annually and 8 per cent can be earned by the
firm on its investments. It is also found that a lock-box system could reduce its overall
collection time by four days and could cost annually Rs 1,20,000.
b.
How much cash would be released with the concentration banking system?
c.
How much money can be saved due to reduction in the collection period by 2 days?
Should the firm institute the concentration banking system?
d.
How much cash would be freed by lock-box system?
e.
Between concentration banking and lock-box system, which is better?
Illustration No. 8- Solution
Solution
(i) Cash released by the concentration banking system = Rs 40,00,000 x 2 days = Rs
80,00,000
(ii) Saving = 0.08 x Rs 80,00,000 = Rs 6,40,000.
The firm should institute the concentration banking system. It costs only Rs 75,000 while
the savings expected are Rs 6,40,000..
(iii) Cash released by the lock-box system = Rs 40,00,000 x 4 days = Rs 1,60,00,000
(iv) Saving in lock-box system: 0.08 x Rs 1,60,00,000 = Rs 12,80,000
(v) Lock-box system is better. Its net savings Rs 11,60,000 (Rs 12,80,000 -Rs 1,20,000) are
higher than that of concentration banking.
d. Slowing Disbursements
Apart from speedy collection of accounts receivable, the operating cash requirement can be
reduced by slow disbursements of accounts payable. In fact, slow disbursements represent a
source of funds requiring no interest payments. There are several techniques to delay payment of
accounts payable, namely, (i) avoidance of early payments; (ii) centralised disbursements; (iii)
floats; and (iv) accruals.
i. Avoidance of Early Payments
One way to delay payments is to avoid early payments. According to the terms of credit, a firm
is required to make a payment within a stipulated period. It entitles a firm, to cash discounts. If,
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Working Capital Management & Finanical Forecasting
however, payments are delayed beyond the due date, the credit standing may be adversely
affected so that the firms would find it difficult to secure trade credit later. But if the firm pays
its accounts payable before the due date it has no special advantage. Thus, a firm would be well
advised not to make payments early that is, before the due date.
ii. Centralised Disbursements
Another method to slow down disbursements is to have centralised disbursements. All the
payments should be made by the head office from a centralised disbursement account. Such an
arrangement would enable a firm to delay payments and conserve cash for several reasons.
Firstly, it involves increase in the transit time. The remittance from the head office to the
customers in distant places would involve more mailing time than a decentralized payment by
the local branch. The second reason for reduction in operating cash requirement is that since the
firm has a centralised bank account, a relatively smaller total cash balance will be needed. In the
case of a decentralized arrangement, a minimum cash balance will have to be maintained at each
branch which will add to a large operating cash balance. Finally, schedules can be tightly
controlled, and disbursements made exactly on the right day.
iii. Float
A very important technique of slow disbursements is float. The term float refers to the amount of
money tied up in cheques that have been written but have yet to be collected and encased.
Alternatively, float represents the difference between the bank balance and book balance of cash
of a firm. The difference between the balance as shown by the firm's record and the actual bank
balance is due to transit and processing delays. There is a time-lag between the issue of a cheque
by the firm and its presentation to its bank by the customer's bank for payment. The implication
is that although the cheque has been issued, cash would be required later when the cheque is
presented for encashment. Therefore, a firm can send remittances although it does not have cash
in its bank at the time of issuance of the cheque. Meanwhile, funds can be arranged to make
payment when the cheque is presented for collection after a few days. Float used in this sense is
called as cheque kiting. There are two ways of doing it: (a) paying from a distant bank, (b)
scientific cheque-cashing analysis.
a) Paying from a Distant Bank
The firm may issue a cheque on banks away from the creditor's bank. This would involve
relatively longer transit time for the creditor's bank to get payment and, thus, enable the firm to
use its funds longer.
b) Cheque-encashment Analysis
Another way to make use of float is to analyses, on the basis of past experience, the time-lag in
the issue of cheques and their encashment. For instance, cheques issued to pay wages and salary
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may not be encashed immediately; it may be spread over a few days, say, 25 per cent on one day,
50 per cent on the second day and the balance on the third day. It would mean that the firm
should keep in the bank not the entire amount of a payroll but only a fraction represented by the
actual withdrawal each day. This strategy would enable the firm to save operating cash.
iv. Accruals
Finally, a potential tool for stretching accounts payable is accruals which are defined as current
liabilities that represent a service or goods received by a firm burnout yet paid for. For instance,
payroll, that is, remuneration to employees who render service in advance and receive payment
later. In a way, they extend credit to the firm for a period at the end of which they are paid, say, a
week or a month. The longer the period after which payment is made, the greater is the amount
of free financing consequently and the smaller is the amount of cash balances required. Thus,
less frequent payrolls, that is, weekly as compared to monthly, are an important source of
accrual. They can be manipulated to slow down disbursements. Other examples of accrual are
rent to lessors and taxes to government. But these can be utilized only to a limited extent as there
are legal constraints beyond which such payments cannot be extended.
6.4.11 Marketable Securities
Once the optimum level of cash balance of a firm has been determined, the residual of its liquid
assets is invested in marketable securities. Such securities are short-term investment instruments
to obtain a return on temporarily idle funds. In other words, they are securities which can be
converted into cash in a short period of time, typically a few days. The basic characteristics of
marketable securities affect the degree of their marketability/ liquidity. To be liquid, a security
must have two basic characteristics: a ready market and safety of principal. Ready marketability
minimizes the amount of time required to convert a security into cash. A ready market should
have both breadth in the sense of a large number of participants scattered over a wide
geographical area as well as depth as determined by its ability to absorb the purchase/sale of
large amounts of securities.
.
The second determinant of liquidity is that there should be little or no loss in the value of a
marketable security over time. Only those securities that can be easily converted into cash
without any reduction in the principal amount qualify for short-term investments. A firm would
be better off leaving the balances in cash if the alternative were to risk a significant reduction in
principal.
Selection Criterion
A major decision confronting the financial managers involves the determination of the mix of
cash and marketable securities. Some of the quantitative models for determining the optimum
amounts of marketable securities to hold in certain circumstances have been outlined in an
earlier section. In general, the choice of the mix is based on a trade-off between the opportunity
to earn a return on idle funds (cash) during the holding period, and the brokerage costs
associated with the purchase and sale of marketable securities. For example, take the case of a
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firm paying Rs 350 as brokerage costs to purchase and sell Rs 45,000 worth of marketable
securities, yielding an annual return of 8 per cent and held for one month. The interest earned on
the securities works out at Rs 300 (1/12 x .08 x Rs 45,000). Since this amount is less than the
cost of the transaction (Rs 350), it is not advisable for the firm to make the investments. This
trade-off between interest returns and brokerage costs is a key factor in determining what
proportion of liquid assets should be held in the form of marketable securities.
There are three motives for maintaining liquidity (cash as well as marketable securities) and,
therefore, for holding marketable securities: transaction motive, safety/ precautionary motive and
speculative motive. Each motive is based on the premise that a firm should attempt to earn a
return on temporarily idle finds. The type of marketable security purchased will depend on the
motive for the purchase. An assessment of certain criteria can provide the financial manager with
a useful framework for selecting a proper marketable securities mix. These considerations
include evaluation of (i) financial risk, (ii) interest rate risk, (iii) taxability, (iv) liquidity, and (v)
yield among different financial assets.
Financial/Default Risk
It refers to the uncertainty of expected returns from a security attributable to possible changes in
the financial capacity of the security-issuer to make future payments to the security-owner. If the
chance of default on the terms of the investment is high (low), then the financial risk is said to be
high (low). As the marketable securities portfolio is designed to provide a return on funds that
would be otherwise tied up in idle cash held for transaction or precautionary purposes, the
financial manager will not usually be willing to assume such financial/default risk in the hope of
greater return within the makeup of the portfolio.
The uncertainty that is associated with the expected returns from a financial instrument
attributable to changes in interest rate is known as interest rate risk. Of particular concern to the
corporate financial manager is the price volatility associated with instruments that have long, as
opposed to short, terms to maturity.
If prevailing interest rates rise compared with the date of purchase, the market price of the
securities will fall to bring their yield to maturity in line with what financial managers could
obtain by buying a new issue of a given instrument, for instance, treasury bills. The longer the
maturity of the instrument, the larger will be the fall in prices. To hedge against the price
volatility caused by interest rate risk, the market securities portfolio will tend to be composed of
instruments that mature over short periods.
Taxability
Another factor affecting observed difference in market yields is the differential impact of taxes.
Securities, income on which is tax-exempt, sell in the market at lower yields to maturity than
other securities of the same maturity. A differential impact on yields arises also because interest
income is taxed at the ordinary tax rate while capital gains are taxed at a lower rate. As a result,
fixed-interest securities that sell at a discount because of low coupon rate in relation to the
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prevailing yields are attractive to taxable investors. The reason is that part of the yield to
maturity is a capital gain. Owing to the desirability of discount on low-interest fixed-income
securities, their yield to maturity tends to be lower than the yield on comparable securities with
higher coupon rates. The greater the discount, the greater is the capital gains attraction and the
lower is its yield relative to what it would be if the coupon rate were such that the security was
sold at par.
Liquidity
With reference to marketable securities portfolio, liquidity refers to the ability to transform a
security into cash. Should an unforeseen event require that a significant amount of cash be
immediately available, a sizeable portion of the portfolio might have to be sold. The financial
manager will want the cash quickly and will not want to accept a large price reduction in order to
convert the securities. Thus, in the formulation of preferences for the inclusion of particular
instruments in the portfolio, consideration will be given to (i) the time period needed to sell the
security and (ii) the likelihood that the security can be sold at or near its prevailing market price.
The latter element, here, means that `thin' markets, where relatively few transactions take place
or where trades are accomplished only with large price changes between transaction, should be
avoided.
Yield The final selection criterion is the yields that are available on the different financial assets
suitable for inclusion in the marketable/near-cash portfolio. All the four factors listed above,
financial risk, interest rate risk, liquidity and taxability, influence the available yields on
financial instruments. Therefore, the yield criterion involves a weighing of the risks and benefits
inherent in these factors. If a given risk is assumed, such as lack of liquidity, then a higher yield
may be expected on the instrument lacking the liquidity characteristics.
In brief, the finance manager must focus on the risk-return trade-offs associated with, the four
factors on yield through his analysis. Coming. to grips with these trade-offs will enable the
finance manager to determine the proper marketable securities mix for his firm.
Marketable Security Alternatives
In this section, we describe briefly the more prominent marketable/near-cash securities available
for investment. Our concern is with money market instruments.
i. Treasury Bills
There are obligations of the government. They are sold on a discount basis. The investor does
not receive an actual interest payment. The return is the difference between the purchase price
and the face (par) value of the bill.
The treasury bills are issued only in bearer form. They are purchased, therefore, without the
investors' name upon them. This attribute makes them easily transferable from one investor to
another. A very active secondary market exists for these bills. The secondary market for bills not
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only makes them highly liquid but also allows purchase of bills with very short maturities. As
the bills have the full financial backing of the government, they are, for all practical purposes,
risk-free. The negligible financial risk and the high degree of liquidity makes their yield lower
than those on the other marketable securities. Due to their virtually risk-free nature and because
of active secondary market for them, treasury bills are one of the most popular marketable
securities even though the yield on them is lower.
ii. NegotiableCertificates of Deposit (CDs)
These are marketable receipts for funds that have been deposited in a bank for a fixed period of
time. The deposited funds earn a fixed rate of interest. The denomination and maturities are
tailored to the investors' need. The CDs are offered by banks on a basis different from treasury
bills, that is, they are not sold at a discount. Rather, when the certificates mature, the owner
receives the full amount deposited plus the earned interest. A secondary market exists for the
CDs. While CDs may be issued in either registered or bearer form, the latter facilitates
transactions in the secondary market and, thus, is the most common. The default risk is that of
the bank failure, a possibility that is low in most cases.
iii. Commercial Paper
It refers to short-term unsecured promissory note sold by large business firms to raise cash. As
they are unsecured, the issuing side of the market is dominated by large companies which
typically maintain sound credit ratings. Commercial papers (CPs) can be sold either directly or
through dealers. Companies with high credit rating can sell directly to investors. The
denominations in which they can be bought vary over a wide range. They can be purchased
similarly with varying maturities. These papers are generally sold on discount basis in bearer
form although at times commercial papers can be issued carrying interest and made payable to
the order of the investor. For all practical purposes, there is no active trading in secondary
market for commercial paper although direct sellers of CPs often repurchase it on request. This
feature distinguishes CPs from all of the previously discussed short-term investment vehicles.
When, therefore, a financial manager evaluates these for possible inclusion in marketable
securities portfolio, he should plan to hold it to maturity. Owing to its lack of marketability, CPs
provide a yield advantage over other near-cash assets of comparable maturity.
iv. Bankers' Acceptances
These are drafts (order to pay) drawn on a specific bank by an exporter in order to obtain
payment for goods he has shipped to a customer who maintains an account with that specific
bank. They can also be used in financing domestic trade. The draft guarantees payment by the
accepting bank at a specific point of time. The seller who holds such acceptance may sell it at a
discount to get immediate funds. Thus, the acceptance becomes a marketable security. Since
acceptances are used to finance the acquisition of goods by one party, the document is not
`issued' in specialized denominations; its size/ denomination is determined by the cost of goods
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being purchased. They serve a wide range of maturities and are sold on a discount basis, payable
to the bearer. A secondary market for the acceptances of large banks does exist. Owing to their
greater financial risk and lesser liquidity, acceptances provide investors a yield advantage over
treasury bills of like maturity. In fact, the acceptances of major banks are a very safe investment,
making the yield advantage over treasury bills worth looking for marketable securities portfolio.
v. Repurchase Agreements
These are legal contracts that involve the actual sale of securities by a borrower to the lender
with a commitment on the part of the former to repurchase the securities at the current price plus
a stated interest charge. The securities involved are government securities and other money
market instruments. The borrower is either a financial institution or a security dealer.
There are two major reasons why a firm with excess cash prefers to buy repurchase agreements
rather than a marketable security. First, the original maturities of the instrument being sold can,
in effect, be adjusted to suit the particular needs of the investing firm. Therefore, funds available
for a very short period, that is, one/two days can be employed to earn a return. Closely related to
the first is the second reason, namely, since the contract price of the securities that make up the
arrangement is fixed for the duration of the transaction, the firm buying the repurchase
agreement is protected against market fluctuations throughout the contract period. This makes it
a sound alternative investment for funds that are surplus for only short periods.
i. Inter corporate Deposits
Interoperate deposits, that is, short-term deposits with other companies is a fairly attractive form
of investment of short-term funds in terms of rate of return which currently ranges between 12
and 15 per cent. However, apart from the fact that one month's time is required to convert them
into cash, intercorporate deposits suffer from high degree of risk.
ii. Bills Discounting
Surplus funds may be deployed to purchase/discount bills. Bills of exchange are drawn by seller
(drawer) on the buyer (drawee) for the value of goods delivered to him. During the pendency of
the bill, if the seller is in need of funds, he may get it discounted. On maturity, the bill should be
presented to the drawee for payment. A bill of exchange is a self-liquidating instrument. Bill
discounting is superior to intercorporate deposits for investing surplus funds. While parking
surplus funds in bills discounting, it should be ensured that the bills are trade bills arising out of
genuine commercial transaction and, as far as possible, they should be backed by letter of
credit/acceptance by banks to ensure absolute safety of funds.
iii. Call Market
It deals with funds borrowed/lent overnight/one-day (call) money and notice money for periods
up to 14 days. It enables corporate to utilize their float money gainfully. However, the returns
(call rates) are highly volatile. The stipulations pertaining to the maintenance of cash reserve
ratio (CRR) by banks is the major determinant of the demand of funds and is responsible for
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volatility in the call rates. Large borrowings by them to fulfil their CRR requirements pushes up
the rates and a sharp decline takes place once these funds are met.
Additional Question for Practice
Additional Question- 1 (Cash Management Model)
The annual cash requirement of A Ltd. is Rs. 10 Lakhs. The company has marketable
securities in lot sizes of Rs. 50,000, Rs. 1,00,000, Rs. 2,00,000, Rs. 2,50,000 and Rs.
5,00,000. Cost of conversion of marketable securities per lot is Rs. 1,000. The company
can earn 5% annual yield on its securities.
You are required to prepare a table indicating which lot size will have to be sold by the
company.
Also show that the economic lot size can be obtained by the Baumal Model.
Additional Question- 2 (Cash Budget)
You are required to prepare the cash budget of ABC & Co. Limited forthe period of
Shrawan/Bhadra/Ashwin by using following information.
All figure is in NRs
Month
Sales
Jestha
4,000,000
Aashadh
4,600,000
Shrawan
5,100,000
Bhadra
5,700,000
Ashwin
6,400,000
Purchases
2,400,000
2,800,000
3,100,000
3,500,000
4,100,000
Salaries and Wages
8,00,000
950,000
1,400,000
1,500,000
1,900,000
Admin overhead
240,000
280,000
310,000
330,000
410,000
Additional information;
 60% of the sales of respective months will be on credit basis.
 Company‘s policy is to allow 80% of customers to settle the dues within one month
and 15% of customers to settle the dues within two months after the sales transaction
being performed.
 50% of the purchases are on credit basis and external suppliers allowed one month to
settle the payment.
 Total amount of salaries and wages will be paid in the same month they arise.
 Total amount of administrationexpenditures also settles in the same month
they arise.Depreciation on machinery is included in every month under
administration expenditure
 Companyhas procured machineryfor the value of NRs 2,600,000.00 in last year.
Useful lifetime of the machine will be 10 years and scrap value after 10 years will be
NRs 200,000.00
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6.4.12 Answer of Knowledge Tests
Knowledge Test 1 - Answer
The Optimum amount of treasury bills sold, Q for each cash injection into the current account
will be:
𝑄𝑄 =
2 ∗ 200,000 ∗ 15
= 𝑁𝑁𝑁𝑁𝑁𝑁 10,000
0.06
The total number of transactions will be
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 =
200,000
= 20 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
100,000
And the total transaction costs will be 20*15 = NRs 300.
Knowledge Test 2 - Answer
(a) monthly cash budget
Particulars
Month 1
Month 2
Month 3
Month 4
Particulars
Amount in
NRs
Amount in
NRs
Amount in
NRs
Amount in
NRs
Cash inflows:
Cash sales
Credit sales
24,000.00
24,000.00
72,000.00
23,000.00
72,000.00
24,000.00
69,000.00
24,000.00
(2,400.00)
93,600.00
(2,400.00)
92,600.00
(2,300.00)
90,700.00
27,000.00
10,500.00
44,375.00
17,250.00
10,500.00
29,375.00
18,000.00
10,500.00
30,625.00
18,750.00
10,500.00
39,875.00
14,875.00
14,875.00
14,875.00
Less: discount
Total inflow
Cash outflows:
Purchases(w1)
Labor(w1)
Production overhead (w2)
Selling and administration
overhead(w3)
Purchase of business
Purchase of van
Total outflow
-
315,000.00
392,375.00
492 |The Institute of Chartered Accountants of Nepal
15,000.00
102,000.00
-
72,750.00
74,750.00
Working Capital Management & Finanical Forecasting
Net cash flow for the month
Opening balance
(W1)
(363,875.00)
(368,375.00)
(8,400.00)
(376,775.00)
(373,775.00)
(356,925.00)
(356,925.00)
(340,975.00)
Month 1
Month 2
Month 3
Month 4
Month 5
Month 6
Sales in NRs
96,000
96,000
92,000
96,000
100,000
104,000
Sales units
12,000
12,000
11,500
12,000
12,500
13,000
+Closing inventory
12,000
11,500
12,000
12,500
13,000
-Opening inventory
6,000
12,000
11,500
12,000
12,500
Production (units)
18,000
11,500
12,000
12,500
13,000
Raw material
usage(production* NRs 2.50)
45,000
28,750
30,000
31,250
32,500
+ Closing inventory
14,375
15,000
15,625
16,250
-Opening inventory
15,000
14,375
15,000
15,625
Purchase (one-month delay)
44,375
29,375
30,625
31,875
Labor cost(production*1.50)
27,000
17,250
18,000
18,750
13,000
(W2) Production overheads
Amount in NRs
Annual overheads (150000*NRs 1)
150,000
Depreciation
(24,000)
12,600
Monthly cash outflow (126000/12)
10,500
W3 Selling and administrative overheads
Annual overheads
Amount in NRs
150,000
Depreciation (15000*0.3)
(4,500)
203,500
Less: Rent and rates in month 1
25,000
Monthly cash outflow – months
2,3,4(178500/12)
178,500
14,875
Month 1: 25,000+14,875
39,875
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(a) Closing balances:
Inventory:
Finished goods (12500*NRs 5)
Raw materials
Receivables:
Month 4 credit sales (96000*0.75)
Less: Discount (10%*0.25*96000)
Payables
494 |The Institute of Chartered Accountants of Nepal
Amount in NRs
62,500
16,250
78,750
72000
(2400)
69600
31875
Dividend Decision
Chapter 7
Dividend Decision
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7.1 Learning Objectives
Upon completion of this chapter student will be able to:







Understand the meaning of Dividend Decisions
Understand the traditional theory of dividend decisions
Explain the theory of dividend irrelevance
Explain the theories of dividend relevance
Discuss the influence of legal constraints on the dividend decisions
Discuss the influence of Shareholder expectations on the dividend decision
Explain the types of dividend
7.2 Chapter Overview
Financial
Decision
Dvidend
Decision
M.M.
Hypothesis
Walter Model
Gordon
Model
Traditional
Theory
Residual
Theory
Graham & Dodd
Model
Linter Model
Fig: Chapter Overview -Dividend Decisions
496 |The Institute of Chartered Accountants of Nepal
Dividend Decision
7.3 Introduction of Dividend Decisions
The firm‘s dividend policy must be isolated from other problems of financial management. The
dividend policy is a trade-off between retained earnings on the one hand and paying out cash and
issuing shares on the other. We know that the retained earnings are an important source of
finance for both long term and short-term purposes, they have no issue costs, they are flexible,
and they don‘t result in a dilution of control.
However, for any company, the decision to use retained earnings as a source of finance will have
a direct impact on the amount of dividends it will pay to shareholders.
The dividend policy of a company determines what proportion of earnings is distributed to the
shareholders by way of dividends, and what proportion is ploughed back for reinvestment
purposes. Since the main objective of financial management is to maximize the shareholder
wealth, one key area of study is the relationship between the dividend policy and market price of
equity shares. In this regard dividend policy assumes significance.
There are three main theories concerning what impact a cut in a dividend will have on a
company and its shareholders
 Dividend irrelevance theory- MM theory
 Dividend relevance theory- Walter & Gordon Model
 Dividend residual theory
Theories of
Dividend
Decision
Dividend
Irrelevance
Theory
MM Approach
Dividend
Relevance
Theory
Residual Theory
Gordon
Approach
Walter Approach
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7.4 Significance of Dividend Policy
Dividend Policy of the firm is governed by;
a) Long term Financing Decision
b) Shareholder‘s Wealth Maximization
a) Long term Financing Decision
One of the financing options is ‗Equity‘. Equity can be raised externally through issue of equity
shares or can be generated internally through retained earnings. But retained earnings are
preferable because they do not involve floatation costs. But whether to retain or distribute the
profits forms the basis of this decision. Since payment of cash dividend reduces the amount of
funds necessary to finance profitable investment opportunities thereby restricting it to find other
avenues of finance.
Under this head, the decision is based on the following:
i.
Whether the organization has opportunities in hand to invest the amount of profits, if
retained?
ii.
Whether the return on such investment (ROI) will be higher than the expectations of
shareholders i.e. Ke.
b) Shareholder‘s Wealth Maximization
Here we face the problem of amount of dividend to be distributed i.e. the Dividend Payout ratio
(D/P) in relation to Market price of the shares (MPS). Due to market imperfections and
uncertainty, shareholders give higher value to near dividends than future dividends and capital
gains. Payment of dividends influences the market price of the share. Higher dividends increase
value of shares and low dividends decrease it. A proper balance has to be made between the two
approaches. When the firm increases retained earnings, shareholders‘ dividends decrease and
consequently market price is affected. Use of retained earnings to finance profitable investments
increases future earnings per share. On the other hand, increase in dividends may cause the firm
to forego investment opportunities due to paucity of funds and thereby decrease the future
earnings per share.
Thus, management should develop a dividend policy which divides net earnings into
dividendsand retained earnings in anoptimum way to achieve the objectiveof wealth
maximization for shareholders. Such policy will be influenced by investment opportunities
available to the firm and value of dividends as against capital gains to shareholders.
7.5 Relationship Between the Retained Earnings and Growth
The higher the level of retention in the business, the higher the potential growth rate.
The formula is
𝑔𝑔 = 𝑏𝑏 𝑏 𝑏𝑏𝑏𝑏
Where, g= growth rate
b= retention ration or b= (1-dividend payout ratio)
re=rate of return on investment
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Dividend Decision
Illustration 1
Consider the following summarized financial statements for XYZ Co.
Statement of financial position as at 32 Aashadh 2075
Particulars
Amount in ‗000‘
Particulars
Assets
200
Ordinary Shares
Reserves
Total
200
Amount in ‗000‘
100
100
200
Profit after tax for the year ended 31 Aashadh 2076 is NRs 20,000. Dividend of 8% payout for
the FY 2076.
If the Company‘s return on equity and earnings on investments remain the same, what will be
the growth rate of dividends in the next year 2077.
Illustration 1 Answer
Profit after tax as a % of capital employed will be 20/200 =10%
Dividend for FY 2075-76 will be =8% of 100,000 =NRs 8000
Retention Ratio= [1-8000/2000] =0.60=60%
Growth rate = b*re =0.6*10=6%
7.6 Theories of Dividend Policy
7.6.1 Residual theory
A residual dividend is a dividend policy that companies use when calculating the dividends to be
paid to shareholders. Companies that use a residual dividend policy fund capital expenditure
with available earnings before paying dividends to shareholders. This means the amount of
dividends paid to investors each year will vary. It follows that only after a firm has invested in
all NPV projects should a dividend be paid if there are any fund remaining. Retentions should be
used for project finance with dividends as a residual. This theory still takes some assumptions
that may not be deemed realistic. This includes no taxation and no market imperfections.
A residual dividend policy means companies use earnings to pay for capital expenditures first,
with dividends paid with any remaining earnings generated. A company‘s capital structure
typically includes both long-term debt and equity, where capital expenditures can be financed
with a loan (debt) or by issuing more stock (equity).
7.6.2 Dividend Irrelevance Theory (MM Approach)
Assumptions of M.M. Hypothesis
MM hypothesis is based on the following assumptions:
 Perfect Capital Market-The firm operates in a market in which all investors are
rational, and information is freely available to all.
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 No taxes or no tax discrimination between dividend income and
capitalappreciation (capital gain).
 Risk of uncertainty does not exist. Investors are able to forecast future prices and
dividend with certainty and one discount rate is appropriate for all securities and all
time periods.
 There are no floatation or transaction costs.
According to this model, as founded by Miller and Modigliani, the market price of the share does
not depend on the dividend payout, i.e. the dividend policy is irrelevant. This model explains the
irrelevance of the dividend policy in the following manner. MM argues that in a perfect capital
market (no taxation, no transaction costs, no market imperfections), existing shareholders will
only be concerned about increasing their wealth but will be indifferent as to whether that
increase comes from in the form of dividend or through capital growth.
As a result, company can pay any level of dividend, with any funds shortfall being met through a
new equity issue, provided it is investing in all available positive NPV projects.
According to MM hypothesis;
Market value of equity shares of its firm depends solely on its earning power and is not influence
by the manner in which its earnings are split between dividends and retained earnings.
Market value of equity shares is not affected by dividend size.
MM hypothesis is primarily based on the arbitrage argument. Throughthe arbitrage process,
MM hypothesis discusses how the value of the firm remains same whether the firm pays
dividend or not. Here;
Where,
P0=Price in the beginning of the period.
P1=Price at the end of the period
D1=Dividend at the end of the period
Ke=Cost of equity
𝑃𝑃0 =
𝑃𝑃1 + 𝐷𝐷1
1 + 𝐾𝐾𝐾𝐾
As per MM Hypothesis, the value of the firm will remain unchanged due to dividend decision.
This can be computed with the help of the following formula:
𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝑛𝑛𝑛𝑛0 =
𝑛𝑛 + ∆𝑛𝑛 𝑃𝑃1 − 𝐼𝐼 + 𝐸𝐸
1 + 𝐾𝐾𝐾𝐾
Where,
Vf=Value for firm in the beginning of the period
N = number of shares in the beginning of the period
∆n = number of shares issued to raise the funds required
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Dividend Decision
I = Amount required for investments
E= total earnings during the period
Analysis- MM Hypothesis
Any investors requiring a dividend could earn their own by selling part of their shareholding.
Equally, any shareholder wanting retentions when a dividend is paid can buy more shares with
the dividend declared.
Suppose a firm which pays dividends will have to raise funds externally to finance its
investment plans, MM's argument, that dividend policy does not affect the wealth of the
shareholders, implies that when the firm pays dividends, its advantage is offset by external
financing. This means that the terminal value of the share declines when dividends are paid.
Thus, the wealth of the shareholders - dividends plus terminal price - remains unchanged. As
a result, the present value per share after dividends and external financing is equal to the
present value per share before the payments of dividends.Thus,theshareholders are indifferent
between payment of dividends and retention of earnings.
Illustration No. 2
Let us assume that Mrs. X holds 80 shares in a company whose share price after it declared a
dividend of NRs 2 per share is NRs 42. You would expect the ex-dividend price to become
NRs 40 after the record date. Mrs. X does not like NRs 2 per share – she had expected NRs
3 per share and, therefore, she resorts to ‗home made dividends‘ What is this ‗home made
dividends‘?
Illustration No. 2 Answer
 Mrs. X‘s current wealth is NRs 42 x 80 = NRs 3,360 Mrs. X‘s post dividend wealth
would be NRs 40 x 80 + NRs 160 = NRs 3,360 (i.e. market price + dividend on hand),
if she is happy with the NRs 2 per share dividend.
 She can derive the same value by selling 2 shares at ex-dividend price of NRs 40 x 2 =
NRs 80. Her wealth now is NRs 40 x 78 + NRs 160 + NRs 80 = NRs 3,360
 If the company, in deference to the wishes of Mrs. X had declared NRs 3 per share as
dividend, her post dividend wealth would be NRs 39x78 + NRs 240 = NRs 3,360
 In all cases above, the wealth of the shareholder never changed, although the amount of
dividend varies.
Hence, any shareholder can always resort to 'home made dividends' to realize his returns from
the investment. The amount of dividend declared by the Board is irrelevant to his/her wealth.
Illustration No. 3
P.L. Engineering Ltd. belongs to a risk class for which the capitalization rate is 10 per cent. It
currently has outstanding 10,000 shares selling at NRs 100 each. The firm is contemplating
thedeclaration of a dividend of NRs 5 per share at the end of the current financial year. It
expects to have a net income of NRs 1,00,000 and has a proposal for making new investments
of NRs 2,00,000. Show how under M - M Hypothesis, the payment of dividend does not affect
the value of the firm.
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Illustration No. 3- Solution
a) Value of the firm when dividends are not paid:
i.
Price per share at the end of the year 1.
Therefore, P1=110
ii.
𝑁𝑁𝑁𝑁𝑁𝑁 100 =
𝑃𝑃1
1.1
Amount required to be raised from the issue of new shares.
∆nP1= (NRs 200,000-NRs 100,000)
= NRs 100,000
iii.
Number of additional shares to be issued.
100,000 10,000
𝑁𝑁𝑁𝑁𝑁𝑁
=
𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
110
11
iv.
Value of the firm
10,000 10,000
1 + 11 110 − 200,000 + 100,000
1.10
10,99,999
= 9,99,999 = 𝑁𝑁𝑁𝑁𝑁𝑁 10,00,000
1.1
b) Value of the firm, when dividends are paid:
i.
=
Price per share at the end of year 1
1
(𝐷𝐷1 + 𝑃𝑃1)
1 + 𝐾𝐾𝐾𝐾
𝑁𝑁𝑁𝑁𝑁𝑁 100 =
1
𝑁𝑁𝑁𝑁𝑁𝑁 5 + 𝑃𝑃1
1.1
NRs 110=5+P1
P1=105
ii.
Amount required to be raised from the issue of new shares
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∆nP1=I-(E-nD1)
=NRs 2,00,000 – (NRs 100,000-10,000*5) = NRs 150,000
iii.
Number of additional shares to be issued
∆n =
iv.
NRs150,000 10,000
=
105
7
Value of the firm
10,000 10,000
+ 7
105 − 200,000 + 100,000
1
1.10
10,99,999
= 9,99,999 = 𝑁𝑁𝑁𝑁𝑁𝑁 10,00,000
1.1
Thus, it can be seen that the value of the firm remains the same whether dividends are paid or
not.
Further, the illustration clearly demonstrates that the shareholders are indifferent
between the retention of profits and the payment of dividend.
Illustration No. 4- MM hypothesis
RST Ltd. Has a capital of NRS 10,00,000 in equity shares of NRS 100 each. The shares are
currently quoted at par. The company proposes to declare a dividend of NRS 10 per share at
the end of the current financial year. The capitalization rate for the risk class of which the
company belongs is 12% what will be the market price of the share at the end of the year, if
a)
b)
c)
a dividend is not declared.
a dividend is declared.
assuming that the company pays the dividend and has net profits of NRS 5,00,000 and
makes new investments of NRS 10,00,000 during the period, how many new shares must
be issued? Use the MM model.
Illustration No. 4-MM Hypothesis- Solution
As per MM model, the current market price of equity share is:
P0 =
a) If the dividend is not declared:
100 =
1
∗ ( D1 + p1)
1 + Ke
1
∗ ( 0 + p1)
1 + 0.12
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100 =
P1 = NRS 112
P1
1.12
The market price of the equity share at the end of the year would be NRS 112.
b) If the dividend is declared:
100 =
112= 10 + P1
1
(10 + P1)
1 + 0.12
100 =
P1 = 112 – 10 = NRS 102
(10 + P1)
1.12
The market price of the equity share at the end of the year would be NRS 102.
c) In case the firm pays dividend of NRS 10 per share out of total profits of NRS 5,00,000
and plans to make new investment of NRS 10,00,000 the number of shares to be issued may
be found as follows:
Total Earnings
Dividend paid
Retained earnings
Total funds required
Fresh funds to be raised
Market price of the share
500,000
100,000
400,000
1,000,000
600,000
102
Number of shares to be issued (NRS 6,00,000 / 102) = Rs 5,882.35
Or, the firm would issue 5,883 shares at the rate of NRS 102
Knowledge Test 1
ABC Ltd. Has 50,000 outstanding shares. The current market price per share is NRS 100 each.
It hopes to make a net income of NRS 5,00,000 at the end of current year. The Company‘s
Board is considering a dividend of NRS 5 per share at the end of current financial year. The
company belongs to a risk class for which the capitalization rate is 10%
Show, how the M-M approach affects the value of firm if the dividends are paid or not paid.
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Current Dividend Vs Retention Earnings
The crux of M&M‘s position is that the effect of dividend payments on shareholder wealth is
exactly offset by other means of financing. Let us first consider selling additional common
stock to raise equity capital instead of simply retaining earnings. After the firm has made its
investment decision, it must decide whether (1) to retain earnings or (2) to pay dividends and
sell new stock in the amount of these dividends in order to finance the investments. M&M
suggest that the sum of the discounted value per share of common stock after financing plus
current dividends paid is exactly equal to the market value per share of common stock before
the payment of current dividends. In other words, the common stock‘s decline in market price
because of the dilution caused by external equity financing is exactly offset by the payment of
the dividend. Thus, the shareholder is said to be indifferent between receiving dividends and
having earnings retained by the firm.
Knowledge Test 2
M Ltd. Belongs to a risk class for which the capitalization rate is 10%. It has 25,000
outstanding shares and the current market price is NRS 100. It expects a net profit of NRS
2,50,000 for the year and the Board is considering dividend of NRS 5 per share.
M Ltd. requires to raise NRS 5,00,000 for an approved investment expenditure. Show, how
the MM approach affects the value of M Ltd If dividends are paid or not paid.
Knowledge Test 3
KTM City Ltd., has 8 lakhs equity shares outstanding at the beginning of the year 2076. The
current market price per share is NRs 120. The Board of Directors of the company is
contemplating NRs 6.4 per share as dividend. The rate of capitalization, appropriate to the
risk-class to which the company belongs, is 9.6%:
i.
Based on M-M Approach, calculate the market price of the share of the company,
when the dividend is – (a) declared; and (b) not declared.
ii.
How many new shares are to be issued by the company, if the company desires to
fund an investment budget of NRs 3.20 crores by the end of the year assuming net
income for the year will be NRs 1.60 crores?
7.6.3 Dividend relevance Theory
i.
Walter Approach
ii.
Gordon‘s Approach
iii.
Linter Approach
7.6.3.1 Walter Approach
Prof. James E Walter formed a model for share valuation that states that the dividend policy of a
company has an effect on its valuation. He categorized two factors that influence the price of the
share viz. dividend payout ratio of the company and the relationship between the internal rate of
return of the company and the cost of capital.
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According to Walter‘s theory, the dividend payout in relation to (Internal Rate of Return) ‗r‘ and
(Cost of Capital) ‗k‘ will impact the value of the firm in the following ways:
Company
Condition of
r vs Ke
Growth
Constant
r > Ke
r = Ke
Correlation between size of
Dividend and Market Price of
share
Negative
No correlation
Decline
r < Ke
Positive
Optimum Dividend
Payout Ratio
Zero
Every Payout Ratio is
optimum
100 %
Where, r = Internal Rate of Return
Ke = Cost of Capital
Assumptions of Walter Approach
Walter‘s model is based on the following assumption:
 Internal Financing: All the investments are financed by the firm through retained
earnings. No new equity is issued for the same.
 Constant IRR and Cost of Capital: The internal rate of return (r) and the cost of
capital (k) of the firm are constant. The business risks remain same for all the
investment decisions.
 Constant EPS and DPS: Beginning earnings and dividends of the firm never change.
Though different values of EPS and DPS may be used in the model, but they are
assumed to remain constant while determining a value.
 Capital Market is perfect: It means that information about all securities are available
to all investors in equal proportion. Due to this assumption, there is no over pricing or
underpricing of the security. Further it means that all investors are rational. It means all
investors want to increase their return and reduce their risk.
 No Flotation Cost, no transaction cost, no Corporate Dividend Tax:
It is assumed that, there is no cost to the company in issuing a security, there is no cost
to investor to buy or sell a security and there is no corporate dividend tax. All of them
have been eliminated because these things do not remain same for all the companies
universally and this theory is to be applied universally.
 Only Equity Finance:
A company can have only equity finance. It includes equity share capital and reserves
and surplus. There is no source of finance like preference share capital or debentures.
Preference share capital is a hybrid source of finance, it includes certain features of debt
and certain features of equity. So, it is eliminated by making this assumption. Further, in
case of debt financing there is a chance of trading on equity, so with that rate of earning
of the company will keep on changing. Hence it is also eliminated. Trading on equity
means borrowing at a lower rate and earning at a higher rate.
Walter Approach Valuation Formula;
Walter‘s formula to calculate the market price per share (P) is:
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𝑃𝑃 =
𝑟𝑟
𝐷𝐷 + 𝐾𝐾𝐾𝐾 𝐸𝐸 𝐸 𝐸𝐸
𝐾𝐾𝐾𝐾
Where,
P=Market price per share
E= Earnings per share
D=Dividend per share
Ke=Cost of equity
r= internal rate of return/return on Investments
If the internal return of retained earnings is higher than market capitalization rate, the value of
ordinary shares would be high even if dividends are low. However, if the internal return within
the business is lower than what the market expects, the value of the share would be low. In such
a case, shareholders would prefer a higher dividend so that they can utilize the funds so obtained
elsewhere in more profitable opportunities.
Illustration 5
A company has an EPS of Rs. 15. The market rate of discount applicable to the company is
12.5%. Retained earnings can be reinvested at IRR of 10%. The company is paying out Rs.5
as a dividend.
Calculate the market price of the share using Walter‘s model.
Illustration 5- solution
Given,
Dividend = NRs 5
Earnings per share = NRs 15
Cost of equity (Ke) = 12.5%
Internal rate of return (IRR) = 10%
As per Walter,
𝑃𝑃 =
𝑃𝑃 =
𝐷𝐷 +
5+
P = 104
𝑟𝑟
𝐸𝐸 − 𝐷𝐷
𝐾𝐾𝐾𝐾
𝐾𝐾𝐾𝐾
0.1
15 − 5
0.125
0.125
Illustration No. 6
The following information is supplied to you:
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Particular
NRS
Total Earnings
2,00,000
No. of equity shares (of NRS 100 each)
20,000
Dividend paid
1,50,000
Price/Earnings ratio
12.5
(i) Ascertain whether the company is the following an optimal dividend policy.
(ii) Find out what should be the P/E ratio at which the dividend policy will have no effect on
the value of the share.
(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5?
Illustration No. 6- Solution
i) The EPS of the firm is NRS 10 (i.e., NRS 2,00,000/20,000). The P/E Ratio is given at
12.5 and the cost of capital, ke, may be taken at the inverse of P/E ratio. Therefore, ke is 8
(i.e., 1/12.5). The firm is distributing total dividends of NRS 1,50,000 among 20,000
shares, giving a dividend per share of NRS 7.50. the value of the share as per Walter‘s
model may be found as follows:
D + (r/ke) (E − D)
P=
ke
=
0 + (0.10/0.80) (10 − 0)
0.08
= NRS 156.2
So, theoretically the market price of the share can be increased by adopting a zero payout.
ii) The P/E ratio at which the dividend policy will have no effect on the value of the share is
such that the ke would be equal to the rate of return, r, of the firm. The ke would be 10%
(=r) at the P/E ratio of 10. Therefore, at the P/E ratio of 10, the dividend policy would
have no effect on the value of the share.
iii) If the P/E is 8 instead of 12.5, then the ke which is the inverse of P/E ratio, would be 12.5
and in such a situation ke > r and the market price, as per Walter‘s model would be
=
P=
D + (r/ke) (E − D)
ke
7.50 + (0.10/0.125) (10 − 7.5)
0.125
= NRS 76
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The optimal dividend policy for the firm would be to pay 100% dividend and market price of
share in such case would be
10 + (0.10/0.125) (10 − 10)
=
0.125
= NRS 80
Knowledge Test 4
The following information pertains to M/s Excellent Ltd.
Total Earnings of the Company
NRs 500,000
Retention Ratio
No of Shares Outstanding
0.40
1,00,000
Cost of Equity
12%
Rate of Investments
15%
i)
ii)
What would be the market value per share as per Walter‘s model?
What is the optimum dividend payout ratio according to Walter‘s model and the
market value of Company‘s share at that payout ratio?
Knowledge Test 5
Rhino & Co. earns NRs 6 per share having capitalization rate of 10 per cent and has a return
on investment at the rate of 20 per cent. According to Walter‘s model, what should be the
price per share at 30 per cent dividend payout ratio? Is this the optimum payout ratio as per
Walter?
Implications of Walter‘s Model
Walter‘s model has important implications for firms in various levels of growth as described
below:
 Growth Firm
Growth firms are characterized by an internal rate of return > cost of the capital i.e. r > k. These
firms will have surplus profitable opportunities to invest. Because of this, the firms in growth
phase can earn more return for their shareholders in comparison to what the shareholders could
earn if they reinvested the dividends somewhere else. Hence, for growth firms, the optimum
payout ratio is 0%.
 Normal Firm
Normal firms have an internal rate of return = cost of the capital i.e. r = k. The firms in normal
phase will make returns equal to that of a shareholder. Hence, the dividend policy is of no
relevance in such a scenario. It will have no influence on the market price of the share. So, there
is no optimum payout ratio for firms in the normal phase. Any payout is optimum.
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 Declining Firm
Declining firms have an internal rate of return < cost of the capital i.e. r < k. Declining firms
make returns that are less than what shareholders can make on their investments. So, it is
illogical to retain the company‘s earnings. In fact, the best scenario to maximize the price of the
share is to distribute entire earnings to their shareholders. The optimum dividend payout ratio, in
such situations, is 100%.
Criticism of Walter‘s Model
Walter‘s theory is critiqued for the following unrealistic assumptions in the model:
 No External Financing
Walter‘s assumption of complete internal financing by the firm through retained earnings is
difficult to follow in the real world. The firms do require external financing for new investments.
 Constant r and k
It is very rare to find the internal rate of return and the cost of capital to be constant. The
business risks will change with more investments which are not reflected in this assumption.
 Conclusion of retaining 100 % of earning
Conclusion of Walter Model that, if r exceeds ke, than retain 100 % of earning is unrealistic.
Considering dividend payment by other companies, it is necessary to make equity dividend
payment otherwise company‘s stock will be out of favor. Cash return will give psychological
more satisfaction, in comparison to change in price of security.
 Other unrealistic assumptions
Assuming that there is no debt financing, preference share capital financing, no flotation cost,
transaction cost, capital market is perfect are impractical assumptions.
7.6.3.2 Gordon’s Approach
Assumptions of Gordon‘s Model
 No Debt
The model assumes that the company is an all equity company, with no proportion of debt in the
capital structure.
 No External Financing
The model assumes that all investment of the company is financed by retained earnings and no
external financing is required.
 Constant IRR
The model assumes a constant Internal Rate of Return (r), ignoring the diminishing marginal
efficiency of the investment.
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 Constant Cost of Capital
The model is based on the assumption of a constant cost of capital (k), implying the business risk
of all the investments to be the same.
 Perpetual Earnings
Gordon‘s model believes in the theory of perpetual earnings for the company.
 Corporate Taxes
Corporate taxes are not accounted for in this model.
 Constant Retention Ratio
The model assumes a constant retention ratio (b) once it is decided by the company. Since the
growth rate (g) = b*r, the growth rate is also constant by this logic.
 Cost of Capital is greater than growth rate
Gordon‘s model assumes that the cost of capital (k) > growth rate (g). This is important for
obtaining the meaningful value of the company‘s share.
Valuation Formula for Gordon‘s Model and Its Denotations
Gordon‘s formula to calculate the market price per share (P)
Or,
P = market price per share
E1 = earnings per share
b= retention ratio of the firm
r= internal rate of return
(1-b) = payout ratio of the firm
k = cost of capital of the firm
g = growth rate of the firm = b*r
𝑃𝑃0 =
𝑃𝑃0 =
𝐸𝐸1 1 − 𝑏𝑏
𝐾𝐾𝐾𝐾 𝐾𝐾𝐾𝐾𝐾
𝐷𝐷𝐷𝐷 1 + 𝑔𝑔
𝐾𝐾𝐾𝐾 𝐾𝐾𝐾
The above model indicates that the market value of the company‘s share is the sum total of the
present values of infinite future dividends to be declared. The Gordon‘s model can also be used
to calculate the cost of equity, if the market value is known and the future dividends can be
forecasted.
Illustration No. 7
The EPS of the company is Rs. 15. The market rate of discount applicable to the company is
12%. The dividends are expected to grow at 10% annually. The company retains 70% of its
earnings. Calculate the market value of the share using Gordon‘s model.
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Illustration No. 7- Solution
Here,
E = 15
b = 70%
k = 12%
g = 10%
𝑃𝑃0 =
𝑃𝑃0 =
𝐸𝐸1 1 − 𝑏𝑏
𝐾𝐾𝐾𝐾 − 𝑔𝑔
15 1 − 0.7
0.12 − 0.10
P0 =NRs 225
Illustration No. 8
A Company pays dividend of NRS 2.00 per share with a growth rate of 7%. The risk-free rate
is 9% and the market rate of return is 13%. The Company has a beta factor of 1.50. However,
due to a decision of the Finance Manager, beta is likely to increase to 1.75. Find out the
present as well as the likely value of the share after the decision.
Illustration No. 8 - Solution
In order to find out the value of a share with constant growth model, the value of Ke should be
ascertained with the help of CAPM model as follows:
Ke = Rf + β (Km - Rf)
Where,
Ke = Cost of equity
Rf = Risk free rate of return
β = Portfolio Beta i.e. market sensitivity index
Km = Expected return on market portfolio
By substituting the figures, we get
Ke
= 0.09 + 1.5 (0.13 – 0.09)
= 0.15 or 15%
And the value of the share as per constant growth model is
P 0 = D1
(Ke – g)
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Where,
P0 = Price of a share
D1 = Dividend at the end of the year 1
Ke = Cost of equity
G = growth
𝑃𝑃0 =
2.00
(0.15– 0.07)
= NRS 25.00
However, if the decision of finance manager is implemented, the beta (β) factor is likely to
increase to 1.75 therefore, Ke would be
Ke = Rf + β (Km - Rf)
= 0.09 + 1.75 (.013 – 0.09) = 0.16 or 16%
The value of share is
𝑃𝑃0 =
𝑃𝑃0 =
𝐷𝐷1
(𝐾𝐾𝐾𝐾 − 𝑔𝑔)
2.00
(0.16 – 0.07)
= NRS 22.22
Implications of Gordon‘s Model
Gordon‘s model believes that the dividend policy impacts the company in various scenarios as
follows:
 Growth Firm
A growth firm‘s internal rate of return (r) > cost of capital (k). It benefits the shareholders more
if the company reinvests the dividends rather than distributing it. So, the optimum payout ratio
for growth firms is zero.
 Normal Firm
A normal firm‘s internal rate of return (r) = cost of the capital (k). So, it does not make any
difference if the company reinvested the dividends or distributed to its shareholders. So, there is
no optimum dividend payout ratio for normal firms.
However, Gordon revised this theory later and stated that the dividend policy of the firm impacts
the market value even when r=k. Investors will always prefer a share where more current
dividends are paid.
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 Declining Firm
The internal rate of return (r) < cost of the capital (k) in the declining firms. The shareholders are
benefitted more if the dividends are distributed rather than reinvested. So, the optimum dividend
payout ratio for declining firms is 100%.
Company
r vs ke
Growth
Constant
Declining
r > ke
r = ke
r < ke
Optimum dividend payout
ratio
Zero
There is no optimum ratio
100%
Criticism of Gordon‘s Model
Gordon‘s theory on dividend policy is criticized mainly for the unrealistic assumptions made in
the model.
 Constant Internal Rate of Return and Cost of Capital
The model is inaccurate in assuming that r and k always remain constant. A constant r means
that the wealth of the shareholders is not optimized. A constant k means the business risks are
not accounted for while valuing the firm.
 No External Financing
Gordon‘s belief of all investments being financed by retained earnings is faulty. This reflects
sub-optimum investment and dividend policies.
Illustration No. 9
Mr. Shyam is contemplating purchase of 1,000 equity shares of a Company. His expectation
of return is 10% before tax by way of dividend with an annual growth of 5%. The Company‘s
last dividend was NRs 2 per share. Even as he is contemplating, Mr. Shyam suddenly finds,
due to a budget announcement dividend have been exempted from tax in the hands of the
recipients. But the imposition of dividend Distribution tax on the Company is likely to lead to
a fall in dividend of 20 paise per share. Shyam‘s marginal tax rate is 30%.
Required:Calculate what should be Mr. Shyam‘s estimates of the price per share before and
after the Budget announcement?
Illustration No. 9 -Solution
The formula for determining value of a share based on expected dividend is:
𝑃𝑃0 =
𝐷𝐷𝐷𝐷 1 + 𝑔𝑔
𝐾𝐾𝐾𝐾 − 𝑔𝑔
Price estimate before budget announcement:
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Dividend Decision
𝑃𝑃0 =
2 1 + 0.05
0.10 − 0.05
P0 = NRs 42.00
Price estimate After budget announcement:
𝑃𝑃0 =
1.80 1 + 0.05
0.07 − 0.05
P0 = 94.50
Knowledge Test 6
Ram Laxman & Company pays a dividend of NRs 2.00 per share with a growth rate of 7%.
The risk-free rate is 9% and the market rate of return is 13%. The Company has a beta factor
of 1.50. However, due to a decision of the Finance Manager, beta is likely to increase to 1.75.
Find out the present as well as the likely value of the share after the decision.
Dividend Relevance
Practical influences, including market imperfections, means that changes in dividend policy,
particularly reductions in dividends paid, can have an adverse effect on shareholders wealth:
 Reductions in dividend can convey ‗bad news‘ to shareholders (dividend signaling)
 Changes in dividend policy, particularly reductions, may conflict with investor
liquidity requirements
 Changes in dividend policy may upset investor tax planning (clientele effect)
Illustration No. 10
A firm had been paid dividend at Rs 2 per share last year. The estimated growth of the
dividends from the company is estimated to be 5% p.a. Determine the estimated market price
of the equity share if the estimated growth rate of dividends (i) rises to 8% and (ii) falls to 3%.
Also find out the present market price of the share, given that the required rate of return of the
equity investors is 15.5%.
Illustration No. 10- Solution
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In this case the company has paid dividend of Rs 2 per share during the last year. The growth
rate (g) is 5%. Then, the current year dividend (D1) with the expected growth rate of 5% will
be Rs 2.10
The share price is,
P0 =
D1
Ke − g
2.10
0.155 − 0.05
= NRS 20
=
In case the growth rate rises to 8% then the dividend for the current year. (D1) would be NRS
2.16 and market price would be2.16
0.155 − 0.08
= NRS 28.80
=
In case the growth rate rises to 3% then the dividend for the current year. (D1) would be NRS
2.06 and market price would be2.06
0.155 − 0.03
= NRS 16.48
=
So, the market price of the share is expected to vary in response to change in expected growth
rate is dividends.
7.6.4 Traditional Model
7.6.4.1 Graham and Dodd Model
This model postulates that the market price of a share is a function of its dividends and earnings.
However, the model assigns higher weightage to dividends as against retained earnings. Weight
attached to dividends is equal to 4 times the weight attached to retained earnings. The equity
valuation model proposed by them is as follows:
𝑃𝑃 = 𝑚𝑚 𝑚𝑚𝑚 +
𝐸𝐸
3
Where,
P = Market price per share
D = Dividend per share
E = Earnings per shares
m = multiplier (assumed appropriate capitalization rate)
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Dividend Decision
A liberal payout policy has a favorable impact on the stock price. the stock price is positively
affected by higher dividends and negatively affected by lower dividends.A variation of price
may range up to four times its minimal value if the amount is distributed as dividends as
opposed to be kept as retained earnings. This is called the ―Bird in the Hand‖ argument,
coming from the famous expression "A bird in the hand is worth two in the bush". The idea is
that there is a preference for what is certain, and dividends have a more tangible value for a
stockholder than any other possible future appreciation.
Illustration No. 11
The earnings per share of a company is NRs 30 and dividend payout ratio are 60%. Multiplier
is 2.
Determine the price per share as per Graham & Dodd model.
Illustration No. 11 Solution
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝 = 𝑚𝑚 𝐷𝐷 +
𝑃𝑃 = 2 30 ∗ 0.6 +
P = NRs 56
30
0
𝐸𝐸
3
7.6.4.2 Linter Model
In 1956, John Lintner, Harvard University‘s Professor of Economics and Business
Administration, proposed the Lintner model for corporate dividend policy, which focused on two
core notions:
 A company's target payout ratio
 The speed at which current dividends adjust to the target
𝐷𝐷1 = 𝐷𝐷0 + 𝐸𝐸𝐸𝐸𝐸𝐸 𝐸 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 − 𝐷𝐷0 ∗ 𝐴𝐴𝐴𝐴
Where,
D1 = Dividend in year 1
D0 = Dividend in year 0 (Last year dividend)
EPS = Earnings per share
AF = Adjustment Factor or speed for adjustment
Assumptions:
While developing the model, he considered the following assumptions:
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 The companies have a long-term dividend payout ratio. They maintain a fixed dividend
payout over a long term. Mature companies with stable earnings may have high payouts
and growth companies usually have low payouts.
 Managers are more concerned with changes in dividends than the absolute amountsof
dividends. A manager may easily decide to pay a dividend of NRs 2 per share if last
year too it was NRs 2 but paying NRs 3 dividend if last year dividend was NRs 2 is an
important financial management decision.
 Dividend changes follow the changes in the long run on sustainable earnings.
 Managers are reluctant to affect dividend changes that may have to be reversed.
Knowledge Test 7
ABC Ltd. has been maintaining a growth rate of 10 percent in dividends. The company has
paid dividend @ NRS 3 per share. The rate of return on market portfolio is 12 percent and the
risk-free rate of return in the market has been observed as 8 percent. The Beta co-efficient of
company‘s share is 1.5.
You are required to calculate the expected rate of return on company‘s shares as per CAPM
model and equilibrium price per share by dividend growth model.
Knowledge Test 8
The following information relates to Maya Ltd:
Earnings of the company
NRS 10,00,000
Dividend payout ratio
60%
No. of Shares outstanding
2,00,000
Rate of return on investment
15%
Equity capitalization rate
12%
(i)
What would be the market value per share as per Walter‘s model?
(ii)
What is the optimum dividend payout ratio according to Walter‘s model and the
market value of company‘s share at that payout ratio?
Dividends may be declared in the form of cash, stock and scrips, we shall discuss each of these
forms.
1. Cash Dividends
Cash dividend is, by far, the most important form of dividend. In cash dividends stockholders
receive cheques for the amounts due to them. Cash generated by business earnings is used to pay
cash dividends. Sometimes the firm may issue additional stock to use proceeds so derived to pay
cash dividends or approach bank for the purpose. Generally, stockholders have strong preference
for cash dividends.
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Dividend Decision
Cash dividends are investments that offer a cash payout to investors/shareholders from the
company earnings based on the number of shares owned by the investor. This payout is taxable
income, and it means that the company doesn‘t have this money to use for growth or operations.
2. Stock Dividends
Stock dividends rank next to cash dividends in respect of their popularity. In this form of
dividends, the firm issues additional shares of its own stock to the stockholders in proportion to
the number of shares held in lieu of cash dividends. The payment of stock dividends neither
affects cash and earnings position of the firm nor is ownership of stockholders changed. Indeed,
there will be transfer of the amount of dividend from surplus account to the capital stock account
which tantamount to capitalization of retained earnings. The net effect of this would be an
increase in number of shares of the current stockholders. But there will be no change in their
equity. With payment of stock dividends, the stockholders have simply more shares of stock to
represent the same interest as it was before issuing stock dividends. Thus, there will be merely an
adjustment in the firm‘s capital structure in terms of both book value and market price of the
common stock.
3. Stock Splits
A stock split is a change in the number of outstanding shares of stock achieved through a
proportional reduction of increase in the par value of the stock. When a company declares a
stock split, the number of shares of that company increases, but the market cap remains the
same. Existing shares split, but the underlying value remains the same. As the number of shares
increases, price per share goes down.Stock split is done to infuse liquidity and to make shares
affordable for various investors who could not buy the shares of that company before due to high
prices.
Knowledge Test 9
The following information is giving for QB Ltd.
Earnings per share
Dividend per share
Cost of capital
Internal Rate of Return on investment
Retention Ratio
Calculate the market price per share using
a)
b)
NRS 12
NRS 3
18%
22%
40%
Gordons formula
Walters formula
Solutions for Knowledge Test
Knowledge Test 1- Solution
c) When dividends are paid
i) Price per share at the end of year 1
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100
= (5 +P1)/ (1 + 0.10)
Market Price per Share (P1) = NRS 105/-.
ii) Value of firm
= D1 + P 1
1 + Ke
=50000x5+50000x105
1 + 0.10
= 250000 +5250000
1.10
= NRS 50,00,000
d) When dividend is not paid
i) Price per share at the end of year 1
100
= 1/1.1 x P1
Market Price per Share (P1) = NRS 110/ii) Value of firm
= 50000x0+50000x110
1 + 0.10
= 0 +5500000
1.10
= NRS 50,00,000/-
M.M Approach indicates that the value of the firm in both the situations will be same.
Knowledge Test 2- Solution
Answer
a. When dividend is paid
i) Price per share at the end of year 1
100 =
1(NRS 5+P1)
1.10
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Dividend Decision
110 = NRS 5 + P1
P1 = 105
iv) Amount required to be raised from issue of new shares
NRS 5,00,000 – (2,50,000 – 1,25,000)
NRS 5,00,000 – 1,25,000 = NRS 3,75,000
v) Number of additional shares to be issued
3,75,000 = 75,000 shares or say 3572 shares
105
vi)
21
Value of M Ltd.
(Number of shares x Expected Price per share)
i.e., (25,000 + 3,572) x NRS 105 = NRS 30,00,060
B
When dividend is not paid
(i)
price per share at the end of year 1
100 =
P1.
1.10
P1 = 110
(ii)
Amount required to be raised from issue of new shares
NRS 5,00,000 – 2,50,000 = 2,50,000
(iii)
Number of additional shares to be issued
2,50,000 =
110
(iv)
25,000 shares or say 2273 shares.
11
Value of M Ltd.,
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(25,000 + 2273) x NRS 110
= NRS 30,00,060
M.M Approach indicates that the value of the firm in both the situations will be same.
Knowledge Test 3- Solution
Modigliani and Miller (M-M) – Dividend Irrelevancy Model:
𝑃𝑃1 + 𝐷𝐷1
1 + 𝐾𝐾𝐾𝐾
Where,
P0=Price in the beginning of the period is NRs 120.
P1=Price at the end of the period to be determined
D1=Dividend at the end of the period NRs 6.4
Ke=Cost of equity is 9.6%
i.
a) Calculation of share price when dividend is declared:
𝑃𝑃0 =
𝑃𝑃0 =
𝑃𝑃1 + 𝐷𝐷1
1 + 𝐾𝐾𝐾𝐾
120 =
𝑃𝑃1 + 6.4
1 + 0.096
P1= 125.12
b) Calculation of share price when dividend is not declared:
120 =
𝑃𝑃1 + 0
1 + 𝐾𝐾𝐾𝐾
P1= 131.52
ii.
Calculation of No. of shares to be issued
Particulars
(NRs in lakhs)
If dividend declared
Net Income
Less: Dividend paid
160
If dividend not declared
160
51.20
Retained earnings
108.80
160
Investment budget
320
320
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Dividend Decision
Amount to be raised by issue of
new shares (i)
211.20
160
Market price per share (ii)
125.12
131.52
1,68,797.95
1,21,654.50
1,68,798
1,21,655
No. of new shares to be issued
(ii)
Or say
Knowledge Test 4- Solution
M/S Excellent Limited
i)
As per Walter Approach
Where,
𝑃𝑃 =
𝑟𝑟
𝐷𝐷 + 𝐾𝐾𝐾𝐾 𝐸𝐸 − 𝐷𝐷
𝐾𝐾𝐾𝐾
P=Market price per share.
E=Earnings per share = NRs 5 (NRs 500,000/100000)
D=Dividend per share = NRs 3 (Dividend Payout= (1-retention ratio) =0.6
r =Return earned on investment = 15%
Ke=Cost of equity capital = 12%
𝑃𝑃 =
3+
P = 45.83
ii)
0.15
5−3
0.12
0.12
According to Walter‘s model when the return on investment is more than the cost of
equity capital, the price per share increases as the dividend pay-out ratio decreases.
Hence, the optimum dividend pay-out ratio in this case is nil
So, at a pay-out ratio of zero, the market value of the company‘s share will be
𝑃𝑃 =
0.15
0 + 0.12 5 − 0
P = 52.08
0.12
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Knowledge Test 5- Solution
As per Walter Approach,
𝑟𝑟
𝐸𝐸 − 𝐷𝐷
𝐾𝐾𝐾𝐾
𝑃𝑃 =
𝐾𝐾𝐾𝐾
0.20
1.80 + 0.10 6 − 1.8
𝑃𝑃 =
0.10
𝐷𝐷 +
P = 102
This is not the optimum payout ratio because r>ke and therefore value of the share can further
go up if payout ratio is reduced (zero).
Knowledge Test 6 Solution
In order to find out the value of a share with constant growth model, the value of Ke should be
as curtained with the help of ‗CAPM‘ model as follows: Ke = Rf + β (Rm –Rf)
Where,
Ke = Cost of equity
Rf = Risk free return
Rm= expected return on market portfolio
Β = Portfolio Beta i.e. market sensitivity index
By substituting the figures, we get,
Ke = 0.09 + 1.5 (0.13 - 0.09) = 0.15 or 15%
And the value of share as per constant growth model
𝑃𝑃0 =
𝑃𝑃0 =
𝐷𝐷𝐷𝐷 1 + 𝑔𝑔
𝐾𝐾𝐾𝐾 − 𝑔𝑔
2.00
0.15 − 0.07
P0 = NRs 25.0
However, if the decision of finance manager is implemented, the beta (β) factor is likely to
increase to 1.75 therefore, Ke would be,
Ke= Rf + β (Km–Rf)
= 0.09 + 1.75 (0.13 – 0.09) = 0.16 or 16%
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Dividend Decision
The value of share is,
𝑃𝑃0 =
𝑃𝑃0 =
𝐷𝐷𝐷𝐷 1 + 𝑔𝑔
𝐾𝐾𝐾𝐾 − 𝑔𝑔
2.00
0.16 − 0.07
P0 = NRs 22.22
Knowledge Test 7- Answer
CAPM formula for calculation of Expected Rate or Return is:
ER = Rf + β (Rm - Rf)
= 8 + 1.5 (12 – 8)
= 8 + 1.5 (4)
=8+6
= 14% or 0.14
Applying Dividend Growth Model for the calculation of per share equilibrium price:
D1
𝐸𝐸𝐸𝐸 =
+ 𝑔𝑔
𝑃𝑃0
0.14 =
0.04 P0= 3.30
3 ∗ 1.10
+ 0.10
𝑃𝑃0
0.14 − 0.10 =
NRS 82.50
𝑃𝑃0 =
3.30
𝑃𝑃0
3.30
0.04
Per share equilibrium price will be NRS 82.50
Knowledge Test – 8 Answer
(i)
Walter‘s model is given by –
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P =
Where, p = Market price per share,
E = Earnings per share
D = Dividend per share
‫ = ץ‬Return earned on investment
Ke = Cost of equity capital
D + (E – D)(γ/ke)
Ke
NRS 5
NRS 3
15%
12%
3 + (5 – 3)( 0.15 / 0.12)
0.12
P =
3 + 2 ∗ ( 0.15 / 0.12)
0.12
= NRS 45.83
=
(ii)
According to Walter‘s model when the return on investment is more than cost of
equity capital, the price per share increases as the dividend pay-out ratio decreases. Hence, the
optimum dividend pay-out ratio in this case is Nil. So, at a payout ratio of zero, the market
value of the company‘s share will be: 0 + (5 − 0) ∗ ( 0.15 / 0.12)
0.12
= NRS 52.08
P =
Knowledge Test – 9 Answer
Answers
a)
P0
Gordons Formula
P0 =
= present value of Market price per share
E = Earnings per share
E(1 − b)
Ke − br
K = Cost of capital
B = Retention Ratio (%)
R = IRR
Br
= Growth Rate
P0 =
526 |The Institute of Chartered Accountants of Nepal
12(1 − 0.4)
0.18 − (0.40 ∗ 0.22)
Dividend Decision
=
7.20
0.18 − 0.088
=
7.20
0.092
= NRS 78.26
b)
Vc
D
Ra
Rc
E
Walter Formula
= Market Price
= Dividend per share
= Internal Rate of Return
= Cost of Capital
= Earnings per share
𝑉𝑉𝑉𝑉 =
𝑉𝑉𝑉𝑉 =
D + Ra / Rc ∗ (E – D)
𝑅𝑅𝑅𝑅
NRS 3 + 0.22 / 0.18 (NRS12 − NRS3)
0.18
=
NRS 3 + NRS 11
0.18
= NRS 77.77
.
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Chapter 8
Overview of Capital Market
528 |The Institute of Chartered Accountants of Nepal
Overview of Capital Market
8.1 Overview of Capital Market
8.1.1 Learning Objectives
Upon completion of this chapter student will be able to:








Overview of Nepalese Financial System
understand capital market/securities market
differentiate capital markets and money markets
define the venture financing and lease financing
understand settlement and settlement cycles
state the concept of clearing house
understand various capital market instruments
understand recent developments in Nepalese capital markets
8.1.2 Chapter Overview
Overview of Capital
Market
Recent Development
in Nepalese Capital
Market
Capital Market
Money Market
Source of Financing in
International Market
Stock Exchange
Equity Capital
Preference Capital
Bond and Debenture
Fig: Chapter Overview of Capital Market
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Chapter 8
8.1.3 Financial Market
Financial markets refer broadly to any marketplace where the trading of securities occurs,
including the stock market, bond market, forex market, and derivatives market, among others.
Financial markets are vital to the smooth operation of capitalist economies.
Financial markets play a vital role in facilitating the smooth operation of capitalist economies by
allocating resources and creating liquidity for businesses and entrepreneurs. The markets make it
easy for buyers and sellers to trade their financial holdings. Financial markets create securities
products that provide a return for those who have excess funds (Investors/lenders) and make
these funds available to those who need additional money (borrowers).
Some financial markets are small with little activity, and others, like the New York Stock
Exchange (NYSE), NASDAQ, Tokyo Stock Exchanges etc. trade trillions of dollars of securities
daily. The equities (stock) market is a financial market that enables investors to buy and sell
shares of publicly traded companies. The primary stock market is where new issues of stocks,
called initial public offerings (IPOs), are sold. Any subsequent trading of stocks occurs in the
secondary market, where investors buy and sell securities that they already own.
8.1.3.1 Various Products available in the Financial Market
a) Equity Capital
Companies registered under The Companies Act, 2063, can raise finance by way of Equity
Capital. Subject to the regulations laid down in the Companies Act and related laws.
Features: The features of equity capital are :
(a) Risk: The shares are to be paid off only upon liquidation. So, risk is the least.
(b) Cost: Equity Shareholders are entitled to residual income, i.e. Profit after tax and their
expectations are high. Therefore, the cost of equity capital is high.
(c) Control: Equity Shareholders are the owners of the Company and have Control over the
management of the Company.
Advantages:
 Ordinary- share capital also provides a security (equity base) to other suppliers of funds.
So, a Company with a high paid-up equity capital can raise further funds from other
sources easily.
 It is a permanent source of finance. It is to be repaid only in the event of liquidation.
 There are no committed payments to holders of equity shares. Dividends are
discretionary and is not mandatory like interest on debentures etc.
b) Preference Share Capital
These are a special kind of shares where the shareholders enjoy priority or priority or
preference over equity shareholders as regards:
(a) Payment of dividend at a fixed rate; and
(b) Repayment of capital on the winding up of the company
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Features :
 Cumulative Option: Preference shares may be issued as cumulative, i.e., the dividend
payable in a year of loss, gets carried over to subsequent years till there are adequate
profits to pay the accumulated dividends. Non-cumulative preference shares may also be
issued.
 Redeemability and Convertibility: Generally, preference shares carry a stipulation of
repayment at the end of a tine period. Sometimes, they may carry the option of' conversion
into equity share capital also.
 Preference Dividend: The rate of dividend on preference shares is normally higher than
the rate of interest on debentures, loans etc. This is an appropriation of profits and not a
charge against profits.
 Hybrid Form of financing: Preference Capital has features of both debt and equity. It can
be compared with debt since the rate of dividend is fixed and the capital is repayable at the
end of a period. It can also be likened to equity because dividend is not tax-deductible.
Advantages :
 It is no dilution of' EPS on the enlarged capital base. Issue of further equity capital will
reduce the EPS and affect market perception about the company.
 There is leveraging advantage as it bears a fixed charge.
 There is no risk of takeover or loss of control.
 Preference capital can be redeemed after a specified period.
c) Debentures and Bonds
Public Limited Companies raise funds from public by issuing debentures or bonds. They are
issued on the basis of a debenture trust deed that lays down the terms and conditions of issue.
Debentures are normally secured against the assets of the company. Interest Rate on debentures
is low when compared to rate of preference dividend or Cost of Equity Capital. Debentures are
issued with new inventive schemes like warrants, options, convertibility etc. Credit Rating is
compulsory for public issue of debentures or private placement to mutual funds. The rating is
based on track record, profitability, debt servicing, capacity, credit worthiness and the risk of
lending
Advantages of debentures :
 Cost of Debt Capital is lower when compared to equity or preference capital. Thus,
Gearing is advantageous.
 Debenture financing does not result in dilution of control.
 in a period of rising prices, debenture issue is advantageous. The fixed monetary outgo
decreases in real terms as the price level increases.
Disadvantages of debenture
 Debenture interest and capital repayment are obligatory payments.
 There may be restrictive covenants in a Debenture Trust Deed.
 Debenture Financing enhances the financial risk associated with the firm.
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d) Long Term Loan
Specialized Financial Institutions and Commercial Banks provide long term financial assistance
to industry. The enterprise or applicant has to satisfy the lending institution as regards feasibility
of the project in the following aspects: (a) Technical, (b) Commercial, (c) Economic. (d)
Financial and (e) Managerial.
The rates of interest charged by the institutions differ under various schemes. The loans are to be
repaid according to a stipulated repayment schedule. The loans are fully secured.
e) Term Loans by banks:
 Commercial Banks grant term loans for small projects failing under priority sector, small
scale sector etc.
 Term Loans are granted after careful project analysis and evaluation of credit worthiness
of the borrower.
 The loans shall be repayable over a period of time in monthly / quarter / half yearly or
yearly installments.
 The loan period is granted on a case-to-case basis, normally for 3 to 7 years and
sometimes even more.
 The loans are granted on the security of fixed assets and other suitable collateral securities.
f)
Unsecured loans
 Unsecured Loans constitute a significant part of long-term finance available to all
enterprises.
 These loans are used to meet the financial requirement to the rescue of the enterprise, in
case the financial institution does not sanction the required funds in full. For example, if a
term loan of' Rs.50 lakhs is applied for, but only Rs.40 lakhs is sanctioned, the balance of
Rs. 10 lakhs may be raised as unsecured loans.
 Thus, Unsecured loans are typically provided by promoters to meet the promoter‘s
contribution norm. Unsecured loans are considered as part of the equity for the purpose of
calculating debt equity ratio.
 These loans are subordinate to institutional loans. Hence,
 Rate of interest on these loans should be less than or equal to the rate of interest on
institutional loans.
 Interest can be paid only after payment of institutional dues.
 Repayment of unsecured loans is possible only with the prior approval of' the
financial institutions.
 Unsecured loans are not backed by the tangible securities.
g) Venture Capital Financing
Venture Capital Financing refers to financing of high-risk ventures promoted by new qualified
entrepreneurs who require funds to give shape to their ideas. Here, a financier (called Venture
Capitalist) invests in the equity or debt of an entrepreneur (Promoter / Venture Capital
Undertaking) who has a potentially successful business idea but does not have the desired track
record or financial backing.
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Overview of Capital Market
Generally, venture capital funding is associated with heavy initial investment business like
energy conservation, quality up gradation or with growing and potential sectors like
information technology.
i. Types of Venture Capital Financing
The various types of venture capital are classified as per their applications at various stages of
a business. The three principal types of venture capital are early stage financing, expansion
financing and acquisition/buyout financing.
Venture Capital
Financing
Early Stage
Financing
Later Stage
Financing
Seed Capital
Bridge
Financing
Start- Up
Buy-outs
Second Round
Finance
Turnaround
a) Early stage financing has three subdivisions seed financing, start up financing and first
stage financing.
 Seed financing is defined as a small amount that an entrepreneur receives for the
purpose of being eligible for a startup loan.
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 Start up financing is given to companies for the purpose of finishing the
development of products and services.
 First Stage financing: Companies that have spent all their starting capital and need
finance for beginning business activities at the full-scale are the major beneficiaries
of the First Stage Financing.
b) Expansion Financing:
Expansion financing may be categorized into second-stage financing, bridge financing and
third stage financing or mezzanine financing.
Second-stage financing is provided to companies for the purpose of beginning their
expansion. It is also known as mezzanine financing. It is provided for the purpose of
assisting a particular company to expand in a major way. Bridge financing may be provided
as a short-term interest only finance option as well as a form of monetary assistance to
companies that employ the Initial Public Offers as a major business strategy.
c) Acquisition or Buyout Financing:
Acquisition or buyout financing is categorized into acquisition finance and management or
leveraged buyout financing. Acquisition financing assists a company to acquire certain parts
or an entire company. Management or leveraged buyout financing helps a particular
management group to obtain a particular product of another company.
ii. Advantages and Disadvantages of Venture Capital Financing:
Advantages
 Opportunity for Expansion of Company
 Valuable guidance and expertise
 Helpful in building networks and
connections
 No obligation for repayment
 Venture capitalists are trustworthy
Disadvantages
 Dilution of Ownership and Control
 Early redemption by Venture Capitalists
 Venture Capitalists take a long time to
decide
 May require high return on original
investments
 May require high return on original
investments
iii. Methods of venture capital financing:
(i)
Equity Financing : The Venture Capital Undertakings generally require funds for a
longer period but may not be able to provide returns to the investors during initial stages. Hence,
equity share capital financing is advantageous. The investor's contribution does not exceed 49%
of the total equity capital of the undertaking. Hence, the effective control and ownership remains
with the entrepreneur.
(ii)
Conditional loan : A conditional loan is repayable in the form of a royalty after the
venture is able to generate sales. No interest is paid on such loans. The rate of royalty may range
between 2% and 15% based on factors like gestation period cash flow patterns, extent of risk,
534 |The Institute of Chartered Accountants of Nepal
Overview of Capital Market
etc. Sometimes, the entrepreneur has a choice of paying a high rate of interest (say 20%) instead
of royalty on sales once the activity becomes commercially sound.
(iii)
Income note: It is a hybrid type of finance, which combines the features of both
conventional loan and conditional loan. The entrepreneur has to pay both interest and royalty on
sales but at substantially low rates.
(iv)
Participating debentures: Interest on such debentures is payable at three different rates
based on the phase of operations as under:
(a) Startup phase NIL Interest
(b) Next stage -Low rate of interest
(c) After a particular level of operations -High rate of interest.
h) Crowd Funding
Crowdfunding is the use of small amounts of capital from a large number of individuals to
finance a new business venture. Crowdfunding makes use of the easy accessibility of vast
networks of people through social media and crowdfunding websites to bring investors and
entrepreneurs together, with the potential to increase entrepreneurship by expanding the pool
of investors beyond the traditional circle of owners, relatives and venture capitalists.
i)
Benefits of Crowd Funding
From tapping into a wider investor pool to enjoying more flexible fundraising options, there
are a number of benefits to crowdfunding over traditional methods. Here are just a few of the
many possible advantages, which we‘ll cover in greater detail later in this guide:
 Reach – By using a crowdfunding platform like Fundable, you have access to thousands
of accredited investors who can see, interact with, and share your fundraising campaign.
 Presentation – By creating a crowdfunding campaign, you go through the invaluable
process of looking at your business from the top level—its history, traction, offerings,
addressable market, value proposition, and more—and boiling it down into a polished,
easily digestible package.
 PR & Marketing – From launch to close, you can share and promote your campaign
through social media, email newsletters, and other online marketing tactics. As you and
other media outlets cover the progress of you fundraise, you can double down by steering
traffic to your website and other company resources.
 Validation of Concept – Presenting your concept or business to the masses affords an
excellent opportunity to validate and refine your offering. As potential investors begin to
express interest and ask questions, you‘ll quickly see if there‘s something missing that
would make them more likely to buy in.
 Efficiency – One of the best things about online crowdfunding is its ability to centralize
and streamline your fundraising efforts. By building a single, comprehensive profile to
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which you can funnel all your prospects and potential investors, you eliminate the need to
pursue each of them individually. So instead of duplicating efforts by printing documents,
compiling binders, and manually updating each one when there‘s an update, you can
present everything online in a much more accessible format, leaving you with more time
to run your business instead of fundraising.
j) Debt Securitization
It is a mode of financing wherein securities are issued on the basis of a package of assets (called
Asset Pool). In this method of recycling funds, assets generating steady cash flows are packaged
together and against this asset pool, market securities can be issued.
The debt securitization process has the following functions / activities:
i. File Origination Function: A borrower seeks a loan from a lending institution (finance
company or bank). The credit worthiness of the borrower is evaluated, and the loan is
sanctioned. A contract is signed between the parties, with repayment schedule spread over
the life of the loan. The lender is called the Originator, to whom the loan constitutes an asset
(receivable).
ii. The Pooling Function: The Originator (Lender) clubs together similar loans or receivables,
to create an underlying pool of assets. This pool is transferred in favor of a SPV (Special
Purpose Vehicle), which acts as a trustee for the investor. Once the assets are transferred,
they are held in the Originators' portfolios.
iii. The Securitization Function: Now, the SPV issues securities on the basis of the asset pool.
The securities carry a coupon and an expected maturity which can be asset based or
mortgage based. These are generally sold to investors through merchant bankers.
Features:
 Generally institutional investors like mutual funds (not individuals) are interested in
Debt Securitization.
 File Originator usually keeps the spread available (i.e. difference) between yield from
secured assets (interest received from borrowed) and interest paid to investors (of
securities). This constitutes originator's income.
 The securitization process is generally without recourse i.e. the investor bears the credit
risk or risk of default and the issuer is under an obligation to pay to investors only - if
the cash flows arc received by him from the asset pool.
 The Originator, however, has a right to legal recourse against the borrower in the event
of default.
 The risk run by the investor can be further reduced through credit enhancement
facilities like insurance, letters of credit and guarantees.
 In a simple "pass through structure", the investor owns a proportionate share of the
asset pool and the cash flows when generated are passed oil directly to the investor.
This is done by issuing "pass through certificates".
 In mortgage or asset backed bonds, the investor has a lien on the underlying asset pool.
The SPV accumulates collections from borrowers from time to time and makes
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payments to investors at regular predetermined intervals. The SPV can invest the funds
received in short term
 The assets are shifted off the balance sheet, thus giving the originator recourse to
off balance sheet funding.
 It converts illiquid assets to liquid portfolio.
 Its facilities better balance sheet management as assets are transferred off
balance sheet facilitating satisfaction of capital adequacy norms.
k) Lease Financing.
Leasing is a contract where one party (owner / Lessor / leasing Company) purchases the assets
and permits its use by another party (Lessee) over a specified period of time. Thus, leasing is an
alternative to the purchase of an asset out of own or borrowed funds.
The Lessee pays a specified rent at periodical intervals as consideration for the use of the asset.
The Lessee claims Lease Rental Charges as his revenue expenses. The Lessor is entitled to claim
depreciation as he is the owner of the asset.
Advantages to Lessee:
 Immediate Cash Outflow i.e. investment in Capital Asset is eliminated.
 Lease Rentals are tax deductible expenses.
l)
Subsidy / Capital Incentive, a source of financing
Types of Incentives: In order to promote balanced regional and economic development,
special Incentives are provided to units set up in backward areas. Such incentives may
either be (a) lumpsum subsidy or (b) deferment of sales tax and octroi duty etc. The
more backward the area, higher will be the incentive.
ii.
Conditions: These incentives are sanctioned by the implementing agency as a
percentage of the fixed capital investment subject to an overall ceiling. It forms part of
the long-term means of finance for the project. These are sanctioned and released to the
units only after they have complied with the requirements the relevant scheme. The
requirements may be classified into initial effective steps and final effective steps.
i.
Initial Effective Steps:
 Formation of the firm / company,
 Acquisition of land in the backward area and
 Registration for manufacture of the products
Final Effective Steps:
 Obtaining relevant clearances from appropriate statutory bodies for setting up of the
unit.
 Conversion of Letter of Intent to Industrial License,
 Tie up of the means of finance i.e. in-principle sanction of various finance providers.
 Incurring aggregate expenditure greater than 25% of the project cost and at least 10%
of the fixed assets should have been created or acquired at site.
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iii.
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Project Viability : The viability of the project must not be dependent on the quantum
and availability of incentives. During project appraisal, the impact of special capital
incentives should not be considered for analyzing cash flows and profitability.
Deep Discount Bonds (DDB)
a) Deep Discount Bonds is a form of zero-interest bonds, which are sold at a discounted
value (i.e. below par) and on maturity the face value is paid to investors.
b) For example, a bond of a face value of Rs. 1 lakh may be issued for Rs. 2700 initially.
"The investor pays Rs. 2700 at first. He realizes the maturity value of Rs. 1 lakh at the
end of the holding period, say 25 years.
c) Sometimes, the issuing company may give options for redemption at periodical Intervals
say, after 5 years, 10 years, 15 years, 20 years etc.
d) There is no interest payment during the lock in period.
e) These bonds can be traded in the market. Hence, the Investor can also sell the bonds in
Stock market and realize the difference between initial investment and market price.
Some new financial instruments.
In addition to Deep Discount Bonds and Commercial Papers, the following are the new financial
instruments.
i.
Secured Premium Notes (SPN's) :
Secured Premium Notes is issued along with a detachable warrant and is redeemable after a
notified period, say 4 to 7 years. There is an option to convert the SPN's into equity shares. The
conversion of detachable warrant into equity shares will have to be done within the time period
notified by the company.
ii.
Zero interest fully convertible debentures :
 These are fullyconvertible debentures, which do not carry any interest.
 The debentures are compulsorily and automatically converted after a specified period of
time and its holders are entitled to new equity shares of the company at the
predetermined price.
 The Company is benefited since no interest is to be paid on it. The investor is benefited
if the market price of the Company's shares is very high since he tends to get equity
shares of the company at an agreed lower rate.
iii. Zero Coupon Bond:
Zero Coupon Bonds do not carry any interest. It is sold by the issuing company at a discount.
The difference between the discounted value and maturing or face value represents the interest to
be earned by the investor on such bonds. It operates in the same manner as a DDB, but the lockin period is comparatively lesser.
iv. Double Option Bonds :
These were first issued by the IDBI. The face value of each bond is Rs.5.000. The bond carries
interest at 15 % per annum compounded half yearly from the date of allotment. The bond has a
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maturity period of 10 years. Each bond has two parts in the form of two separate certificates, one
for principal of' Rs.5.000 and other for interest including redemption premium) of Rs.16.500.
Both these certificates are listed on all major, stock exchanges. The Investor has the Facility of
selling either one or both parts at any time he wishes so.
v.
Option Bonds :
These are cumulative and non-cumulative bonds where interest is payable on maturity or
periodically. Redemption premium is also offered to attract investors. These were issued by
institutions like IDBI, ICICI etc.
vi.
Inflation Bonds :
Inflation Bonds are bonds in -which interest rate is adjusted for inflation. Thus, the investor / gets
an interest free from the effects of inflation. For example, if the interest rate is 11 per cent and
the inflation is 5 per cent, the investor will earn 16 per cent meaning thereby that the investor is
protected against inflation.
vii. Floating Rate Bonds
In this type of bond, the interest rate is not fixed and is allowed to float depending upon the
market conditions. This is an ideal instrument which can be resorted to by the issuing companies
to hedge themselves against the volatility the Interest rates.
New financial instruments crop up, as institutions offer investors more advantages and facilities
in order to attract the vital resource viz. cash from the investors.
Major sources of foreign currency funds
The major sources of foreign currency funds are :
a) Commercial banks: Commercial Banks extend foreign currency loans for international
operations, just like rupee loans (domestic loans). The banks also provide facilities for
overdraft.
b) International agencies: International agencies like the International Finance Corporation
(IFC), The International Bank for Reconstruction & Development (IBRD ). Asian
Development Bank (ADB). The International Monetary Fund (IMF) etc. provide indirect
assistance for obtaining foreign currency.
c) International Capital Markets : Savings of individual investors can be effectively m
tapped by issue of Shares of debentures in the world market and not just in the local market.
International capital markets in Tokyo. London, Luxembourg, New York caters to the needs
of Multi-National Corporations and Transnational Corporations to raise substantial sums
from investors spread across the globes not just in one country.
8.1.3.2 Source of financing in International market
In the International market, the availability of foreign currency is ensured in the following ways:
a) Euro-currency market
b) Export Credit Facilities
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c) Bonds Issues
d) Financial Instruments
a) Euro-Currency Market
The origin of the Euro-currency market was with the dollar denominated bank deposits & loans
in Europe particularly in London. Euro-dollar deposits are dollar denominated time deposits
available at foreign branches of US bank and at some foreign Banks. Banks based in Europe
accept dollar denominated deposits and make dollar-denominated advances to the clients. This
forms the backbone of the Euro-currency market all over the globe. In this market, funds are
made available as loans through syndicated Euro-credit instruments.
The eurocurrency market is the money market in which currency held in banks outside of the
country where it is legal tender is borrowed and lent by banks. The eurocurrency market is
utilized by banks, multinational corporations, mutual funds and hedge funds that wish to
circumvent regulatory requirements, tax laws and interest rate caps often present in domestic
banking, particularly in the United States. The term eurocurrency has nothing to do with the
euro currency or Europe, and the market functions in many financial centers around the world.
Financial Instruments in the international market
a) Euro Bonds: Euro bonds are debt instruments denominated in a currency issued outside
the country of that currency. For example, a Rupee Bond floated in France, a Yen Bond
floated in Germany.
b) ForeignBonds: These are debt instruments denominated in a Currency which is foreign
to the borrower and is sold in the country of that currency. Example A British firm
placing Dollar denominated bonds in USA.
c) FullyHedged Bonds: In foreign bonds, the risk of currency fluctuations exists. Fully
hedged bonds eliminate the risk by selling entire stream of principal and interest
payments in forward markets.
d) Floating Rate Notes: These are issued up to seven years maturity. Interest rates are
adjusted to reflect the prevailing exchange rates. They provide cheaper money than
foreign loans.
e) Euro Commercial Papers : ECP's are short- term money market instruments with a
maturity period of less than one year. They are usually designated in US Dollars.
f) Foreign Currency option: A Foreign Currency Option is the right to buy or sell, spot,
future or forward, a specified foreign currency. It provides a hedge against financial
and economic risks.
g) Foreign Currency Futures: These are obligations to buy or sell a specified currency in the present for settlement at a future date.
 GDR's, & ADR's
Finance can be raised by Global Depository Receipts (GDR's) Foreign Currency Convertible
Bonds (FCCB's) and pure debt bonds. However- GDR's and FCCB's are more popular. GDR's do
not carry voting rights and hence there is no dilution of control.
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Global Depository Receipts : (GDR's)
 A Depository Receipt (DR) is basically a negotiable certificate, denominated in US
Dollars that represents a non-US companies publicly traded local currency (Nepalese
Rupee) Equity share.
 DR's are created when the local currency shares of a Nepalese Company are delivered to
the depository's local custodian bank, against which the depository bank issues DR's in
US Dollars.
 These DR's may be freely traded in the overseas markets like any other dollar
denominated security through either a foreign stock exchange or through over the
Counter (OTC) market or among restricted groups like qualified institutional buyers.
GDR with Warrants:
These receipts are more attractive than plain GDRs inview of additional value of attached
warrants.
American Depository Deposit (ADR's) :
Depository Receipts issued by a company in the USA are known as ADR's. Such receipts have
to be issued in accordance with the provisions stipulated by the Securities Exchange
Commission (SEC) of the USA which is a regulatory body like the SEBON in Nepal.
Since the conditions laid down by SEC are stringent, Nepalese companies have, chosen the
indirect route to tap the vast American financial market through private placement of GDR's
listed in London and Luxembourg Stock Exchanges.
Types of international issues
a) Foreign Euro Bonds: In domestic capital markets of various countries the Bond issues
referred to above are known by different names such as Yankee Bonds in the US, Swiss
Frances in Switzerland, Samurai Bonds in Tokyo and Buldogs in UK.
b) Euro Convertible Bonds: It is a Euro-Bond, a debt instrument which gives the bondholders
an option to convert them into a pre-determined number of Equity shares of the company.
Usually the price of the Equity Share at the time of conversion will have a call option (where
the issuer company has the option of calling/buying the bonds for redemption prior to the
maturity date) or a Put Option (which gives the holder the option to put/sell his bonds to the
issuer company at a pre-determined date and price)
.
c) Plain Euro Bonds:Plain Euro Bonds are nothing but debt instruments. These are not
attractive for an investor who desires to have valuable additions to his investment.
d) Euro Convertible Zero Bonds:These bonds are structured as a convertible bond. No
interest is payable on the bonds. But conversion of bonds takes place on maturity at a predetermined price. Usually there is a five years maturity period and they are treated as a
deferred Equity issue.
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e) Euro Bonds with Equity Warrants:These bonds carry a coupon rate determined by market
rates. The warrants are detachable. Pure bonds are traded at a discount. Fixed Income Funds
Management may like to invest for the purposes of regular income.
Classification of Financial markets
Financial markets may be classified on the basis of
 types of claims – debt and equity markets
 maturity – money market and capital market
 trade – spot market and delivery market
 deals in financial claims – primary market and secondary market
8.1.4 Capital Market
The Capital market is that segment of the market in which long term financial assets (securities
with more than one year to maturity such as government and corporate bonds, stock, etc.) are
traded. The capital markets can be subdivided into two categories:
a. Primary Market:
The Primary Market, also known as a New Issue Market, is where new securities are
issued, it is part of the capital market. Corporations, national and local governments, and
other public sector institutions can get financing through the sale of new stock or bond
issues through the primary market. Put simply, the primary market creates new
securities and offers them for sale to the public (Initial Public Offering).
All companies require capital for their operations. This capital (money) can be in the form of
equity or debt. Equity is the stock capital (share capital) of a company. Debt consists of all the
loans taken by the business.
In other words, the first public offering of equity shares or convertible securities by a
company, which is followed by the listing of a company‘s shares on a stock exchange,
is known as an initial public offering (IPO). The Primary market also includes issue of
further capital by companies whose shares are already listed on the stock exchange.
b. Secondary Market:
Secondary market refers to a market where securities are traded after being initially offered to
the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is
done in the secondary market. It essentially comprises of the stock exchanges which provide
platform for trading of securities and a host of intermediaries who assist in trading of securities
and clearing and settlement of trades. The securities are traded, cleared and settled as per
prescribed regulatory framework under the supervision of the Exchanges and SEBON.
The stock exchanges are the exclusive centers for trading of securities. Listing of companies on a
Stock Exchange is mandatory to provide an opportunity to investors to invest in the securities of
local companies. In Nepal, secondary market is observed by the Nepal Stock Exchange Ltd., a
public company established under Securities Act 2063 under the oversight of SEBON.
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Differences between Primary and Secondary Markets
i.
Nature of Securities:
The primary markets deal with new securities, that is, securities, which were not previously
available and are, therefore, offered to the investing public for the first time. The market,
therefore, derives its name from the fact that it makes available a new book of securities for
public subscription. The secondary market, on the other hand, is a market for old securities,
which may be defined as securities, which have been issued already and granted stock exchange
quotation. The stock exchanges, therefore, provide a regular and continuous market for buying
and selling of securities.
ii.
Nature of Financing:
Another aspect related to the separate functions of these two parts of the securities market is the
nature of their contribution to industrial financing. Since the primary market is the concerned
with new securities, it provides additional funds to the issuing companies either for starting a
new enterprise or for the expansion or diversification of the existing one and, therefore, its
contribution to company financing is direct. In contrast, the secondary markets can in on
circumstance supply additional funds since the company is not involved in the transaction. This,
however, does not mean that the stock market does not have relevance in the process of transfer
of resources from savers to investors. Their role regarding the supply of capital is indirect. The
usual course in the development of industrial enterprise seem to be that those who bear the initial
burden of financing a new enterprise pass it on to others when the enterprise becomes well
established. The existence of secondary markets which provide institutional facilities for the
continuously purchase and sale of securities and, to that extent, lend liquidity and marketability
which play an important part in process.
iii.
Organizational Differences:
The stock exchanges have physical existence and are located in a particular geographical area.
The primary market is not rooted in any particular spot and has no geographical existence. The
primary market has neither any tangible form i.e. any administrative organizational setup like
that of stock exchanges, nor is it sub