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CAP-II, Financial Management, June 2013

Suggested Answer
Roll No.

Maximum Marks - 100

Total No. of Questions 7

Total No. of Printed Pages 4

Time Allowed 3 Hours


Marks
Attempt all questions.
Working notes should form part of the answer. Make assumptions wherever necessary.
1. BRT Co. has developed a new confectionery line that can be sold for Rs. 5 per box
and that is expected to have continuing popularity for many years. The finance
manager of the company proposed that the investment in the new product should be
evaluated over a four year time horizon, even though sales would continue after the
fourth year on the ground that cash flows after fourth years are too uncertain to be
included in the evaluation.
The average variable and fixed costs will depend on sales volume as follows:
less than 1
million
Variable cost (Rs. per box)
280
Total fixed costs (Rs. in million)
1
Sales volume (boxes)

119
million
300
18

229
million
300
28

339
million
305
38

Forecast sales volumes are as follows:


Year
Sales Volume (boxes)

1
07
million

2
16
million

3
21
million

4
30
million

The production equipment for the new confectionery line would cost Rs. 2 million
and an additional initial investment of Rs. 750,000 would be needed for working
capital. Capital allowances (tax-allowable depreciation) on a 25% reducing balance
basis could be claimed on the cost of equipment. Profit tax of 25% per year will be
payable one year in arrear. A balancing allowance would be claimed in the fourth
year of operation. BRT Co. uses a nominal after-tax cost of capital of 12% to appraise
new investment projects.
Required:
(12+8=20)
a) Assuming that production only lasts for four years, calculate the net present value
of investing in the new product line using a nominal terms approach and advise
on its financial acceptability (work to the nearest Rs. 1,000).
b) Comment briefly on the proposal to use a four-year time horizon to evaluate the
project, and calculate and discuss a value that could be placed on the after-tax
cash flows arising after fourth year of operation, using a perpetuity approach.
Assume, for this part of the question only, that before-tax cash flows and profit
tax are constant from year five onwards, profit taxes are payable in the same year
and that capital allowances and working capital can be ignored.
Answer No. 1
a) Net present value evaluation of new confectionery investment (Rs. 000)
Year
Sales (WN1)

1
3,500
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2
8,000

3
10,500

4
15,000
P.T.O.

(2)
Variable cost(WN2)
Fixed costs (WN3)
Taxable cash flow
Less: Tax@ 25%
Add: CA tax benefit(WN4)
Add: Working capital released
PVIF@12%
Present values

(1,960)
1,540
(1,000)
540
540
540
0.893
482

(4,800)
3,200
(1,800)
1,400
(135)
125
1,390
1,390
0.797
1,108

Sum of present values


Less: cost of Equipment [At year
(2,000) (2,0001.00)
0]=
WC tied up [At year 0]
= (7501.00)
Net present value

(6,300)
4,200
(2,800)
1,400
(350)
94
1,144
1,144
0.712
815
(Rs. 0000)
4,008

(9,150)
5,850
(3,800)
2,050
(350)
70
1,770
750
2,520
0.636
1,603

=(2,000)
=(750)
1,258

Advice: The proposed investment in the new product is financially acceptable, as the NPV is
positive.
Working Notes:
1)Calculation of sales
Year
4
1
2
3
Sales volume (boxes)
selling price (/box) (Rs.)
Sales (/yr) Rs. 000
2)calculation of variable cost
Year
Sales volume (boxes)
Variable cost per box (Rs.)

700,000
5
3,500

1
700,000

1,600,000
5
8,000

2,100,000
5
10,500

1,600,000

3,000,000
5
15,000

2,100,000

3,000,000

3.00

3.00

305

Variable cost (/yr) Rs. 000

2.80
1,960

4,800

6,300

9,150

3)Calculation of fixed costs


Year
Sales volume (boxes)
Fixed costs (Rs. 000)

1
700,000
1,000

2
1,600,000
1,800

3
2,100,000
2,800

4
3,000,000
3,800

4)Calculation of Deprecation & tax


Year
Capital allowance(Depn)
Tax benefit (25%)
Tax benefit (Rs. 000)

benefits
1
500,000
125,000
125

2
375,000
93,750
94

4
281,250
843,750
70,312.50 210,937.50
211
70

b) The proposal to use a four-year time horizon


The finance manager believes that cash flows are too uncertain after four years to be included in
the net present value calculation, even though sales will continue beyond four years. While it is
true that uncertainty increases with project life, cutting off the analysis after four years will
underestimate the value of the investment to the extent that cash flows after the cut-off point are
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(3)
ignored. Furthermore, since the new confectionery line is expected to be popular, cash flows
after year four could be substantial, increasing the extent of the under valuation. Artificially
terminating the evaluation after four years has accelerated the recovery of working capital and
has also led to a large balancing allowance. These increased cash flows, which arise in years
four and five respectively, will overestimate the value of the investment.
The value of cash flows after the fourth year of operation:
The approach here should be to calculate the present value of the expected future cash flows
beyond year four. If the before-tax cash flows are assumed to be constant and if the one-year
delay in tax liabilities is ignored, the year four present value of future cash flows beyond year
four can be estimated using a perpetuity approach. The year four present value of cash flows
from year five onwards will be: 2,050 x (1 025)/012 = 12,813 (Rs. 000)
The year zero present value of these cash flows = 12,813x 0636 = 8,149 (Rs. 000)
Although these calculations ignore the capital allowance tax benefits (which will decrease each
year) and the incremental investment in working capital (which will increase slightly each year),
the present value of cash flows after year four is still substantial.
2.
a) Answer the following, supporting the same with proper reasoning:
(32.5=7.5)
i) Whether the present value decreases at a linear rate, at an increasing rate, or at
a decreasing rate with the discount rate and why?
ii) Which ratio would a rich investor interested in investing in equity shares most
likely consult while considering the financing of seasonal inventory?
iii) The credit policy of Firm A is A high percentage of bad-debt loss but
normal receivable turnover and credit rejection rate. What is the effect of this
policy on sales and profit?
b) Ciron Limited has the following capital structure:
9% Debentures
Rs. 275,000
11% Preference Shares
Rs. 225,000
Equity Shares (face value Rs. 10 per share)
Rs. 500,000
Rs. 1,000,000
Additional information:
i) Rs. 100 per debenture redeemable at par have 2% floatation cost and 10 years
of maturity. The market price per debenture is Rs. 105.
ii) Rs. 100 per preference share redeemable at par has 3% floatation cost and 10
years of maturity. The market price per preference share is Rs. 106.
iii) Equity share has Rs. 4 floatation cost and market price per share of Rs. 24.
The next year expected dividend is Rs. 2 per share with annual growth of 5%.
The firm has a practice of paying all earnings in the form of dividends.
iv) Corporate income-tax rate is 35%.
Required:
7.5
Calculate Weighted Average Cost of Capital (WACC) using market value
weights.
Answer No. 2
a)
i) The present value decreases at a decreasing rate with discount rate. As the discount rate
increases, the discount factor goes on decreading. It is because the denominator of the
present value equation increases at an increasing rate with multiple of increase in period
n.

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ii) While considering the financing of seasonal inventory, the rich equity investor would be
consulting the profitability ratios and ratios that provide information about risk relating to
the investment because he is mostly cautious of balancing the risk-return trade off..
iii) The effect of this policy is that the sales remain unaffected while profits decrease. This
policy indicates that the firm has poor collection policy. Accounts that are collectable are
being written off too soon. Therefore, the turnover is being maintained at the expense of
increased bad debt losses.
b)
Cost of Equity (Ke)
 =



+g



Rs. 2
+ 5%
Rs. 24 Rs. 4
=15%
=

Cost of Debt (Kd)

Kd =
=
=

/
 !"/#

:;.<=;;:>/;

[where p0=Market price floatation cost)

%'(',
$*+ = *',''-./0' +.01' 9
23 = 2'4 5661' 7(58'

?@@AB/#

=.>=;.C;
AA

=6.11%
Cost of Preference Shares (Kp )
Kp =

/
 !"/#

;;:E/;

%'(',
$*+ = *',''-./0' +.01' 9
23 = 2'4 5661' 7(58'

?@@AF/#

.<;

= AB.G@

=11.47%

Calculation of WACC using Market Value Weights


Source of Capital
Market
Weights to
Specific
Total Cost
Value (Rs.) Total Capital Cost
Debenture ( Rs.105 per debenture)
2,88,750
0.1672
0.0611
0.0102
Preference shares ( Rs.106 per preference
2,38,500
0.1381
0.1147
0.0158
shares)
Equity Shares ( Rs.24 per share)
12,00,000
0.6947
0.1500
0.1042
17,27,250
1
0.1302
WACC = 13.02%
3.

a) Vikas Engineering Ltd., currently has 100,000 outstanding shares selling at


Rs. 100 each. The firm has net profit of Rs. 1,000,000 and wants to make new
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investments of Rs. 2,000,000 during the period. The firm is also thinking of
declaring a dividend of Rs. 5 per share at the end of the current fiscal year. The
firms opportunity cost of capital is 10 percent.
Required:
i) What will be the price of the share at the end of the year if a dividend is not
declared, and if a dividend is declared? What will be the impact on
shareholders wealth?
ii) How many new shares must be issued when dividend is declared?

(6+2=8)

b) P has an expected return of 22 percent and standard deviation of 40 percent. Q has


an expected return of 24 percent and standard deviation of 38 percent. P has a
beta of 0.86 and that of Q is 1.24. The correlation between the returns of P and Q
is 0.72. The standard deviation of the market return is 20 percent.
Required:
(2+2+2+1=7)
i) Is investing in Q better than investing in P?
ii) If you invest 30 percent in Q and 70 percent in P, what is your expected rate
of return and the portfolio standard deviation?
iii) What is the market portfolios expected rate of return and how much is the
risk-free rate?
iv) What is the beta of portfolio if Ps weight is 70 percent and Q's 30 percent?
Answer No. 3
a)
i) The price of the share at the end of the current fiscal year is determined as follows:
HIJK

P0 =
L
P1= P0 (1+K) DIV1
The value of P, when dividend is not paid, is:
P1 = Rs 100 (1.10) - 0 = Rs 110
When dividend is paid it is:
P1 = Rs 100 (1.10) - Rs 5 = Rs 105.
It can be observed that whether dividend is paid or not the wealth of shareholders remains
the same. When the dividend is not paid the shareholder will get Rs 110 by way of the
price per share at the end of the current fiscal year. On the other hand, when dividend is
paid, the shareholder will realize Rs 105 by way of the price per share at the end of the
current fiscal year plus Rs 5 as dividend.
ii) The number of new shares to be issued by the company to finance its investments is
determined as follows:
mP1 = I (E-n DIV1)
m105=[2,000,000 {1,000,000 (100,00050}]
105m = 2,000,000 (1,000,000 -500,000)
105m = 1,500,000
m= 1,500,000/105 =14,286 shares.
Where,
m= No. of new shares to be issued
I= Investment
N=No. of existing shares
DIV1= Dividend per share
E=earning
b)
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i) P has lower return and higher standard deviation than Q. Therefore, investing in Q will
give more return with less volatility. However, investing in both will yield diversification
advantage.
(ii) Expected rate of return (rp) = 22 0.7 + 24 0.3 = 22.6%
Portfolio standard deviation S )
=T%KC UKC + %VC UVC + 2%K %V (KV UK UV

=0.7C 0.4C 0.3C 0.38C + 2 0.7 0.3 0.72 0.4 0.38


=0.0784 + 0.0129960 + 0.0459648
=0.1373608
=0.37
=37%

iii) The risk- free rate will be the same for P and Q. Their rates of return are given as follows:
rp, 22=rf +(rm-rf) 0.86
rq, 24=rf+(rm-rf) 1.24
rp-rq , -2= (rm-rf) (-0.38)
rm-rf ,-2/-0.38=5.26%
rp , 22=rf+(5.26) 0.86
rf = 17.5%
rq = 24=rf+(5.26) 1.24
rf = 17.5%
rm 17.5 =5.26
rm = 22.76%
Market portfolio expected return (rm) = 22.76%
Risk-free rate (rf) = 17.5%

iv) \ pq = \ p ]p+\ q ]q =0.86 0.7 + 1.24 0.3 = 0.974


4.
a) Nepal Gas Company franchise NP Gas stations in east and west sites of Nepal.
All payments by franchises for gas product, which average Rs. 420,000 a day are
by cheque. Presently, the overall time between mailing of the cheque and the time
the company has collected or available funds at its bank is six days.
Required:
(1+3+3=7)
i) How much money is tied up in this interval of time?
ii) To reduce this delay, the company is considering daily pickups of cheques
from the stations. In all, three cars would be needed and three additional
people would be hired. This daily pick up would cost Rs. 93,000 on an annual
basis and it would reduce the overall delay by two days. Currently, the
opportunity cost of funds is 9% that being the interest rate on marketable
securities. Should the company inaugurate the prick up plan? Why?
iii) Rather than mailing cheques to its bank, the company could deliver them by
messenger service. This would reduce the overall delay by one day and would
cost Rs. 10,300 annually. Should the company undertake this plan? Why?
b) Kathmandu Medical Hospital is planning to introduce a new CT scan machine
which costs Rs. 16 million. Expected annual revenue of the machine is projected
to be Rs. 18 million. Variable cost is 60% of sales and fixed costs are Rs. 2
million. The firm is planning to finance the fund requirement by bank loan of Rs.
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5 million @ 12%, by issue of debenture of Rs. 5 million @ 8% and remaining by
equity shares which will be issued at Rs. 10 (par) per share. The taxation rate
applicable to the firm is 25%.
Required:
i) Calculate operating leverage, financial leverage and combined leverage.
ii) Briefly explain the inter-linkage between leverage, profit and risk.

(5+3=8)

Answer No. 4
a)

Average daily payment by cheque= Rs. 420,000


Required time for collection of fund= 6 days
i) Cash tied up= Rs. 420,0006 days= Rs. 2,520,000
ii) Calculation of annual net cost/benefit for pick up plan:
Opportunity cost savings = Rs. 420,000 2 days 9% = Rs. 75,600
Less: Annual cost of pick up plan
= (Rs. 93,000)
Net annual loss
= (Rs. 17,400)
Since this option brings loss, the company should not start pick up plan.
iii) Calculation of annual net cost/benefit by employing messenger:
Opportunity cost savings (Rs. 420,000 1 day 9% = Rs. 37,800
Less: Annual cost of messenger service
= (Rs. 10,300)
Annual Net savings
=Rs. 27,500
Since this option brings net savings to the company, this is a viable option for
the company.
b)
i)

Calculation of leverages
Int Rate
Cost of Project
Annual Sales
Variable Cost
Contribution
Fixed Cost
Earnings before interest and taxes
interest
Earning before tax
Tax
Earning after tax
Operating Leverage
Financial Leverage
Combined Leverage

5,000,000
5,000,000
25%
(Cont/EBIT)
(EBIT/EBT)
(DFL X DOL)

12%
8%

Rs.
16,000,000
18,000,000
10,800,000
7,200,000
2,000,000
5,200,000
600,000
400,000
4,200,000
1,050,000
3,150,000
1.38
1.24
1.71

ii) Interlinkage between leverage, return and risk


Leverage is a position when capital is funded largely by external sources like debt, bank
loan. The higher the livered firm, higher the profit. This is because, if the firm is funded
by debt sources, it is a cheaper source of finance as debt interest are tax deductible. But is
the firm is unlevered, i.e. funded by equity, profit will be lower as dividend to
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shareholders is not tax deductible from income tax purpose. However, if the firm is too
levered, there is a risk of solvency because debt funds are repayable. The firm will be in
risk of fund at the times when debts are matured. Hence, an optimal mix of debt and
equity is required to maintain adequate profitability with solvency.
5.
a) Beta 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. Priceearnings ratio before redemption
is 20:1 and anticipated price-earnings ratio after redemption is 25:1. Number of
shares outstanding prior to redemption are 10,000. EBIT amounts to Rs. 200,000.
The company is in the 35% tax bracket. Should the company convert bond into
shares? Support your analytical comments with required calculations.
b) A company offers a fixed deposit scheme whereby Rs. 10,000 matures to
Rs. 12,625 after 2 years, on a half-yearly compounding basis. If the company
wishes to amend the scheme by compounding interest every quarter, what will be
the revised maturity value?

c) Following are the ratios of the business of Ganesh Traders Ltd., dealing in the
machineries, for the year ended 31st Ashadh, 2069:
Average Collection Period
Stock Turnover
Average Payment Period
Gross Profit Ratio
Opening Receivables

3 months
1.5 times
2 months
25%
Rs. 600,000

Gross Profit for the year ended 31st Ashadh, 2069 amounted to Rs. 800,000.
Closing stock of the year is Rs. 20,000 above the opening stock.
Closing bills receivable amounted to Rs. 50,000 and bills payable to Rs. 20,000.
Required: calculate
i) Sales
ii) Sundry Debtors
iii) Closing Stock
iv) Sundry Creditors

(1+3+2+2=8)

Answer No. 5
a)
Particulars
EBIT (Rs.)
Interest @14% (Rs.)
Taxable Income (Rs.)
Less: Tax @ 35 percent (Rs.)
Net Income after Tax (Rs.)
Outstanding Shares ( Nos)
EPS (Rs.)
P/E Ratio
Market Price per share (Rs.)
(i.e. price-earnings ratio timesEPS)

Pre- redemption
Post-redemption
2,00,000
2,00,000
70,000
Nil
1,30,000
2,00,000
45,500
70,000
84,500
1,30,000
10,000
15,000
8.45
8.66
20:1
25:1
169
216.50

Comment:
This is two-in-one benefit 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.216.50 than the pre-redemption market price of Rs.169.
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Moreover the debenture holder/ bondholders would receive Rs.1, 690 in stock (i.e. 16910
shares, in place of receiving cash Rs.1, 080 only)
b)
Computation of Revised Maturity Value
Principal = Rs. 10,000
Amount = Rs. 12,625
C,_C=

10,000= ^`a b
Pn = A (PVFn, i)
10,000 = 12,625 (PVF4, i)
0.7921 = (PVF4, i)
According to the Table on Present Value Factor (PVF4,i) of a lump sum of Re. 1, a PVF of
0.7921 for half year at interest (i) = 6 percent. Therefore, the annual interest rate is 2 0.06 = 12
percent.
i = 6% for half year
i = 12% for full year.
Therefore, Rate of Interest = 12% per annum
 Cd

C

Revised Maturity Value = 1000 c1 + ;; de


= 1000 f1 +

3 >
g
100

= 10001.03>

=10,0001.267 [considering (CVF 8,3)=1.267]


Revised Maturity Value = 12,670.
c)
i)

Calculation of Total Sales

Gross Profit Ratio

=^

hijkk ijl`m
nm opqnk

b 100

>,;;,;;;

25 =^nm opqnkb 100


Net Sales

= Rs.32,00,000

ii)
Calculation of Sundry Debtors
Average Collection Period
Average Collection period
3 month
Debtors Turnover Ratio (DTR)
Debtors Turnover Ratio (DTR)
4

= 3 months
= No of months in year/ Debtors Turnover Ratio (DTR)
=12 Months/Debtors Turnover ratio (DTR)
= 12 Months/3 Months= 4 times
= Net Credit Sales/ Average Accounts Receivables
= 32, 00,000/Average Accounts Receivable

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Average Accounts Receivable= Rs.32,00,000/4 =Rs.8,00,000
(Opening Receivables + Closing Receivables)/2 = Rs.8, 00,000
(Opening Receivables + Closing Receivables) = Rs.8, 00,0002
(6,00,000 + Closing Receivables)
= Rs.16, 00,000
Closing Receivables
= Rs.16, 00,000-Rs.6, 00,000
=Rs.10, 00,000
Sundry Debtors
= Closing Receivables- Bills Receivables
=Rs.10, 00,000-50,000
=Rs.9, 50,000
iii)
Calculation of Closing Stock
Stock Turnover Ratio (STR)
= 1.5 times
STR
=Cost of Goods sold/ Average stock
Cost of goods sold
= Sales- Gross Profit
1.5
=24, 00,000/ Average Stock
Average Stock
=24, 00,000/1.5
=Rs.16, 00,000
Average Stock
= (Opening Stock +Closing Stock)/2
Rs.16, 00,000
= (Opening Stock + Closing Stock)/2
Opening Stock + Closing Stock
=Rs.16, 00,0002
Closing Stock is higher than opening stock by Rs.20, 000
Then opening Stock
= (Rs.32, 00,000-Rs.20, 000)/2
Opening Stock
= 31, 80,000/2=Rs.15, 90,000
Hence Closing Stock
=Rs.15, 90,000+ Rs.20, 000
=Rs.16, 10,000
iv)
Calculation of Sundry Creditors
Credit Purchase
= Cost of goods sold+ Closing Stock- Opening Stock
=Rs.24, 00,000+Rs.16, 10,000-Rs.15, 90,000= Rs.24, 20,000
Credit Turnover Ratio
= 12 Months/ 2 months= 6 months
Credit Turnover Ratio (CTR)
= Net Credit Purchase /Average Payables
Average Payables
= 24, 20,000/6= Rs.4, 03,333
Creditors
= Accounts Payable- Bills Payable
=Rs.403, 333-Rs.20, 000
=Rs.383, 333
(42.5=10)

6. Write short notes on:


a) Security market line
b) Gearing ratio
c) Bridge finance
d) Project under capital rationing
Answer No. 6
a)

Security market line


Security market line (Beta function) is simply an index of Systematic Risk which
cannot be reduced by Portfolio Diversification. The slope of the SML indicates the
change in excess return of the stock over the change in excess return on the market
portfolio. The Beta of the portfolio is simply a weighted average of the individual
stock Betas of the portfolio. It shows the sensitivity of return on the stock to change
in return on market portfolio.
Results of Beta Function:
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 If the Beta=1.0, this implies that the excess return for the stock varies
proportionally with the excess return for the market portfolio.
 If the Beta>1.0, this implies that the excess return for the stock varies more than
proportionally with the excess return for the market portfolio. (Aggressive)
 If the Beta<1.0, this implies that the excess return for the stock varies less than
proportionally with the excess return for the market portfolio. (Defensive).
b) Gearing ratio
A general term describing a financial ratio that compares some form of owner's equity (or
capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the
degree to which a firm's activities are funded by owner's funds versus creditor's funds.
The higher a company's degree of leverage, the more the company is considered risky. As
for most ratios, an acceptable level is determined by its comparison to ratios
of companies in the same industry. The best known examples of gearing ratios include
the debt-to-equity ratio (total debt / total equity), times interest earned (EBIT / total
interest), equity ratio (equity / assets), and debt ratio (total debt / total assets).
A company with high gearing (high leverage) is more vulnerable to downturns in the
business cycle because the company must continue to service its debt regardless of how
bad sales are. A greater proportion of equity provides a cushion and is seen as a measure
of financial strength.
c)

Bridge Finance
Bridge Finance refers, normally to loans taken by a business, usually from commercial
banks for a short period, pending disbursement of terms loan by financial institutions.
Normally, it takes time for the financial institution to finalize procedures of creation of
security, tie-up participation with other institution etc., even though a positive appraisal
of project has been made. However, once the loans are approved in principal, firms, in
order not to lose further time in starting their projects, arrange for bridge finance. Such
temporary loan is normally repaid out of the proceeds of the principal term loans.
Generally the rate of interest on bridge finance is 1% or 2% higher than on normal term
loans.

d)

Project under Capital Rationing


The capital rationing situation refers to the choice of investment proposals under financial
constraints in terms of given size of capital expenditure budget. The objective to select
the combination of projects would be the maximization of 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 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 individual project; a divisible project, on
the other hand, can be accepted/ rejected in part.

7. Distinguish between:
a) Return on Equity and Return on Capital Employed
b) Business Risk and Financial Risk
c) Global Depository Receipts and Euro Convertible Bonds
d) Over Capitalization and Under Capitalization
Answer No. 7
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a) Return on equity and Return on capital employed

Return on equity (ROE) measures the rate of return on the ownership interest (shareholders'
equity) of the common stock owners. It measures a firm's efficiency at generating profits
from every unit of shareholders' equity (also known as net assets or assets minus liabilities).
ROE shows how well a company uses investment funds to generate earnings growth. ROEs
between 15% and 20% are generally considered good. Return on equity reveals how much
profit a company earned in comparison to the total amount of shareholder equity found on
the balance sheet. If you think back to lesson three, you will remember that shareholder
equity is equal to total assets minus total liabilities. It's what the shareholders "own".
Shareholder equity is a creation of accounting that represents the assets created by the
retained earnings of the business and the paid-in capital of the owners.
Return on capital employed (ROCE) is an accounting ratio used in finance, valuation, and
accounting. Return on capital employed (ROCE) is a measure of the returns that a business
is achieving from the capital employed, usually expressed in percentage terms. Capital
employed equals a company's Equity plus Non-current liabilities (or Total Assets Current
Liabilities), in other words all the long-term funds used by the company. ROCE indicates
the efficiency and profitability of a company's capital investments. ROCE should always be
higher than the rate at which the company borrows otherwise any increase in borrowing will
reduce shareholders' earnings, and vice versa; a good ROCE is one that is greater than the
rate at which the company borrows. It can be calculated as follows:
b) Business Risk and Financial Risk
Business risk refers to the risk associated with the firms operations. It is an unavoidable risk
because of the environment in which the firm has to operate and the business risk 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 firms products, variations in prices and proportion of fixed cost in total cost.
Whereas, financial risk refers to the additional risk placed on firms shareholders as a result
of debt use in financing. Companies that issue more debt instruments would have higher
financial risk than companies financed mostly by equity. Financial risk can be measured by
ratios such as firms financial leverage multiplier, total debt to assets ratio etc.
Business risk is the relative dispersion in the firms expected earnings before interest and
taxes. Whereas, financial risk is the additional variability in the earnings available to the
firms common stockholders and additional chance of insolvency borne by the common
stockholders caused by the use of financial leverage.
c) Global Depository Receipts and Euro Convertible Bonds
Global Depository Receipts (GDR) is a negotiable certificate denominated in US dollars
which represents a Non-US companys publically traded local currency equity shares. GDR
are created when the local currency shares of an Indian company are delivered to
Depositorys local custodian Bank against which the Depository bank issues depository
receipts in US dollars. The GDR may be traded freely in the overseas market like any other
dollar-expressed security either on a foreign stock exchange or in the over-the-counter
market or among qualified institutional buyers.
Whereas, Euro Convertible bonds are quasi-debt securities (unsecured) which can be
converted into depository receipts or local shares. ECBs offer the investor an option to
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convert the bond into equity at a fixed price after the minimum lock-in period. The price of
equity shares at the time of conversion will have a premium element. The bonds carry a fixed
rate of interest. These are bearer securities and generally the issue of such bonds may carry
two options viz. call option and put option. In the case of ECBs, the payment of interest and
the redemption of the bonds will be made by the issuer company in US dollars. ECBs issues
are listed at London or Luxemburg stock exchanges.
d) Over capitalization and Under capitalization
Overcapitalization is a situation in which actual profits of a company are not sufficient
enough to pay interest on debentures, on loans and pay dividends on shares over a period of
time. This situation arises when the company raises more capital than required. A part of
capital always remains idle. With a result, the rate of return shows a declining trend. The
causes can be High promotion cost , Purchase of assets at higher prices, companys floatation
n boom period, Inadequate provision for depreciation, liberal dividend policy and overestimation of earnings.
Under Capitalization is the situation where exceptionally high profits are earned as compared
to other firms in the industry. An undercapitalized company situation arises when the
estimated earnings are very low as compared to actual profits. This gives rise to additional
funds, additional profits, high goodwill, high earnings and thus the return on capital shows an
increasing trend. The causes can be Low promotion costs, Purchase of assets at deflated
rates, conservative dividend policy, Floatation of company in depression stage, High
efficiency of directors, adequate provision of depreciation and large secret reserves are
maintained.

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