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GNDU Question Paper-2021
Bachelor of Commerce
(B.Com) 3
rd
Semester
FINANCIAL MANAGEMENT
Time Allowed: Three Hours Max. Marks: 50
Note: Attempt five questions in all, selecting at least one question from each section. The
fifth question may be attempted from any section. All questions carry equal marks.
SECTION—A
1. Why is consideration of time important in financial decision making? How can time
value be adjusted? Illustrate your answer.
2. The following is the capital structure of X Ltd. as on 31-12-2020:
Particulars
Amount (Rs.)
Equity Shares—20,000 shares of Rs. 100 each
20,00,000
10% Preference shares of Rs. 100 each
8,00,000
12% Debentures
12,00,000
The market price of the company's shares is Rs. 110 and it is expected that a dividend of Rs.
10 per share would be declared after I year. The dividend growth rate is 6%.
(i) Compute the weighed average cost of capital, if company is in the tax bracket of 50%.
(ii) Assuming that in order to fiance an expansion plan, the company intends to borrow a
fund of Rs. 20 lacs bearing 14% rate of interest, what will be the company's revised
weighted average cost of capital? This financing decision is expected to increase dividend
from Rs. 10 to Rs. 12 per share. However, the market price of equity share is expected to
decline from Rs. 110 to 105 per share.
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SECTION-B
3. What is financial risk? How does it differ from business risk? How does the use of
financial leverage result in increased financial risk? Illustrate.
4. The total value of a firm remains unchanged regardless of variations in its financing
mix'. Discuss this statement in the light of Net Operating Income and Modigliani-Miller
theory of capital structure.
SECTION-C
5. Explain briefly the recommendations of Tandon and Chore committee for working
capital management.
6. What is working capital? On the formation of a new business, what considerations are
taken into account in estimating the amount of working capital needed ?
SECTION-D
7. What are the assumptions which underlie Walter model of dividend effect? Does
dividend policy affect the value of firm under Walter model? Explain with example.
8. A company is considering an investment proposal to install new milling controls at a
cost of Rs. 50,000. The facility has a life expectancy of 5 years and no salvage value. The
tax rate is 35 percent. Assume the firm uses straight line depreciation and the same is
allowed for tax purposes. The estimated cash flows before depreciation and tax (CFBT)
from the investment proposal are as follows:
Year
CFBT (Rs)
1
10,000
2
10,692
3
12,769
4
13,262
5
20,385
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Compute the following:-
(i) Pay-back period
(ii) Average rate of return
(iii) NPV and Profitability Index at 10 percent discount rate.
You may use the following table:
Year
P.V Factor at 10%
1
0.909
2
0.826
3
0.751
4
0.683
5
0.621
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GNDU Answer Paper-2021
Bachelor of Commerce
(B.Com) 3
rd
Semester
FINANCIAL MANAGEMENT
Time Allowed: Three Hours Max. Marks: 50
Note: Attempt five questions in all, selecting at least one question from each section. The
fifth question may be attempted from any section. All questions carry equal marks.
SECTION—A
1. Why is consideration of time important in financial decision making? How can time
value be adjusted? Illustrate your answer.
Ans: Imagine you are standing at a crossroad with two paths. On one path, someone offers
you ₹1,000 today. On the other path, they promise ₹1,000 one year from now. At first
glance, both seem like the same deal — ₹1,000 is ₹1,000, right? But as you pause and think,
you realize that money available today is far more valuable than the same money available
in the future. This idea is at the heart of why consideration of time is crucial in financial
decision making. Welcome to the fascinating world of the time value of money.
The concept is simple yet profound: a rupee today is worth more than a rupee tomorrow.
Why? Because the money you have today can be invested, earn interest, or grow in value
over time. If you take ₹1,000 today and deposit it in a bank at an interest rate of 8% per
year, in one year, it will grow to ₹1,080. On the other hand, ₹1,000 promised a year from
now cannot give you this growth; you will just get ₹1,000 — essentially, you miss out on the
opportunity to earn that extra ₹80.
This simple example illustrates the principle of opportunity cost: every financial decision
involves giving up something. By delaying receipt of money, you lose the chance to put it to
work. Hence, considering time in financial decisions is not optional; it is a necessity.
Businesses, investors, and even individuals use this principle every day — whether deciding
to invest in a new project, buy a car on loan, or save for retirement.
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But how do we adjust for time in financial decision-making? Enter the magical tools of
present value (PV) and future value (FV). These tools help us translate money across
different points in time.
Let’s break it down:
1. Future Value (FV) – This tells us how much today’s money will grow into in the
future, if invested wisely. For example, if you invest ₹10,000 today at a 10% annual
interest rate, next year it becomes ₹11,000. After two years, it becomes ₹12,100.
This shows the compounding effect, where not only your original money grows, but
the growth itself earns more growth.
2. Present Value (PV) – This works in reverse. Suppose someone promises you ₹12,100
two years from now. How much is that promise worth today? Using the present
value formula, we can calculate that its value today is ₹10,000 if the interest rate is
10%. Essentially, PV tells us: “If I could invest this money today at a given rate, how
much would I need to reach that future amount?”
By using PV and FV, financial decision-makers can compare cash flows that occur at different
times, enabling smarter, more informed choices. This is particularly important when
companies evaluate projects with long-term payoffs. For instance, if a company is
considering building a new factory that will generate profits five years from now, it cannot
just look at the total profit. Instead, it must calculate the present value of those future
profits and compare it to the cost today. Only then can it decide whether the investment is
worthwhile.
Now let’s make this idea even more relatable with a story:
Think of money like seeds in a garden. Planting a seed today gives it time to grow into a tree
that bears fruit. If you plant the seed a year later, you delay the harvest, and you lose an
entire season of fruit. Similarly, in financial terms, receiving money today allows you to
invest, grow it, and reap rewards. Delaying money is like delaying planting — you miss out
on potential growth.
Another interesting way to understand this is through inflation, which is like a sneaky thief
in your pocket. Imagine you promised to give your friend ₹1,000 five years from now. By
then, the cost of living has increased, and ₹1,000 might not buy even half of what it does
today. Inflation erodes the purchasing power of money over time, which makes the
consideration of time even more critical. Financial decisions that ignore the time factor are
often flawed because they fail to account for this silent loss.
So, how do we adjust the time value of money practically?
1. Discounting Future Cash Flows – When evaluating future payments or receipts, we
“discount” them back to their present value using a suitable interest rate. This allows
a direct comparison between amounts received at different times.
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2. Choosing the Right Interest Rate – The discount rate represents the opportunity
cost, inflation, and risk associated with the money. A higher rate reflects higher risk
or greater opportunity elsewhere.
3. Using Annuities for Regular Payments – Many financial decisions involve multiple
cash flows, such as receiving ₹1,000 every year for five years. In such cases, present
value of annuities helps calculate the combined worth today.
4. Comparing Projects and Investments – Companies use net present value (NPV) and
internal rate of return (IRR) to evaluate different projects. Both these methods
depend entirely on adjusting for the time value of money.
Let’s take a simple example to tie it all together:
Suppose you have a choice: receive ₹50,000 today or ₹60,000 two years from now. At an
interest rate of 8%, what should you choose?
• Using the present value formula: PV = FV ÷ (1 + r)^n
• PV of ₹60,000 in two years = 60,000 ÷ (1 + 0.08)^2 ≈ ₹51,440
Since ₹51,440 (future money in today’s terms) is greater than ₹50,000, waiting two years
gives you a slightly higher value. But if the interest rate were higher, say 12%, PV would be
60,000 ÷ (1 + 0.12)^2 ≈ ₹47,877, making the immediate ₹50,000 a better choice.
This example shows the beauty of time value adjustment: it provides clarity and logic in
decision-making. Without considering the time factor, we might make decisions based on
simple face value — which could be costly.
In conclusion, time is money — literally. Financial decision-making without considering the
time value of money is like navigating a forest without a compass. Present value, future
value, and discounting are the tools that guide us through, allowing us to make choices that
are rational, profitable, and forward-thinking. Whether you are an investor, a business
manager, or just a student planning your savings, understanding and applying the time value
of money ensures that your financial decisions are grounded in reality, not wishful thinking.
So, next time you’re offered money now or later, think like a gardener, a savvy investor, and
a mathematician all at once — because the clock and the coins are in a constant race, and
understanding time’s impact is how you win it.
2. The following is the capital structure of X Ltd. as on 31-12-2020:
Particulars
Amount (Rs.)
Equity Shares—20,000 shares of Rs. 100 each
20,00,000
10% Preference shares of Rs. 100 each
8,00,000
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12% Debentures
12,00,000
The market price of the company's shares is Rs. 110 and it is expected that a dividend of Rs.
10 per share would be declared after I year. The dividend growth rate is 6%.
(i) Compute the weighed average cost of capital, if company is in the tax bracket of 50%.
(ii) Assuming that in order to fiance an expansion plan, the company intends to borrow a
fund of Rs. 20 lacs bearing 14% rate of interest, what will be the company's revised
weighted average cost of capital? This financing decision is expected to increase dividend
from Rs. 10 to Rs. 12 per share. However, the market price of equity share is expected to
decline from Rs. 110 to 105 per share.
Ans: Imagine X Ltd. as a thriving company with big dreams, navigating the world of finance
like a captain steering a ship through both calm waters and stormy seas. At the end of the
year 2020, the company is sitting on a mixture of equity, preference shares, and debt—the
three pillars that make up its capital structure. Think of it like a balanced diet: equity is the
wholesome staple, preference shares are like a steady source of energy, and debentures are
a quick boost for specific needs. But every element has its own cost, and the company wants
to know how much it truly pays for each of these ingredients. That’s where the Weighted
Average Cost of Capital (WACC) comes in.
Let’s first look at what X Ltd. has on its balance sheet:
• Equity shares: 20,000 shares of Rs. 100 each, totaling Rs. 20,00,000.
• Preference shares: 10% preference shares of Rs. 100 each, totaling Rs. 8,00,000.
• Debentures: 12% debentures worth Rs. 12,00,000.
The market is telling us the value of equity isn’t just the face value (Rs. 100) but Rs. 110 per
share. Investors are expecting a dividend of Rs. 10 after one year, and dividends are
expected to grow at a rate of 6% per year. Meanwhile, the company enjoys a tax rate of
50%, which will affect the cost of debt.
Step 1: Compute the Cost of Equity (Ke)
The cost of equity is essentially the return that equity shareholders expect for investing in
the company. It’s like the reward for holding a piece of the company. Here, we can use the
Gordon Growth Model (Dividend Discount Model):
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Step 7: Story Summary
Imagine X Ltd. as a ship. Initially, the captain (management) was steering with a mix of
sailors (equity), steady crew (preference shares), and borrowed lifeboats (debentures). The
WACC of 11.53% was like the speed at which the ship moved, balanced and safe.
When the ship decided to explore new waters (expansion), it borrowed additional lifeboats
(loans). The dividend promise became more generous, the market value of equity dipped,
but cleverly using more debt actually reduced the overall “fuel cost” (WACC) to 10.78%. This
shows how strategic financing can help a company grow efficiently while keeping costs
manageable.
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SECTION-B
3. What is financial risk? How does it differ from business risk? How does the use of
financial leverage result in increased financial risk? Illustrate.
Ans: Imagine you are the captain of a ship sailing across the ocean. Your goal is to reach a
distant island, filled with treasure. But the sea is unpredictable. Some days are calm, and
your ship glides smoothly, while other days are stormy, and the waves threaten to overturn
your vessel. In the world of business and finance, navigating a company is very similar. You
are always sailing toward profits, but there are different types of risks that can affect
whether you reach your destination safely. Two key types of risks every captain—every
business owner—faces are financial risk and business risk.
Financial risk is like taking a loan to speed up your journey. Imagine that instead of using
only your ship’s natural speed, you decide to attach a high-powered engine borrowed from
someone else. This engine can make you reach the treasure faster, but it comes with a
catch—you must pay for it every month, whether the sea is calm or stormy. If the waves are
rough and the engine fails to deliver enough speed, you still owe the lender. In simple
terms, financial risk is the risk that a company may not be able to meet its financial
obligations, such as paying interest on borrowed money or repaying loans.
Now, let’s compare that to business risk. Business risk is more like the uncertainty of the sea
itself. Even if you sail with your own ship without borrowing an engine, you might face
unexpected storms, pirates, or fog that delays your journey. These are risks inherent in
operating the ship, regardless of whether you borrowed money. In the business world,
business risk refers to the uncertainties a company faces in generating profits from its
core operations. It includes things like changes in customer demand, competition, supply
chain issues, and operational inefficiencies.
So, while business risk arises from the very nature of running a business, financial risk arises
from how you finance that business. Put simply, business risk is about the ship and the sea,
while financial risk is about how you fuel your ship to navigate the sea.
Now, let’s explore how financial risk increases with financial leverage. Financial leverage is
essentially borrowing money to invest in your business. Remember our high-powered
engine? That’s financial leverage. By borrowing money, a company can invest more than it
could with its own funds alone, which could increase profits. But, as with the engine,
borrowing comes with obligations. You must pay interest and repay the principal, whether
your business performs well or poorly.
Here’s a clear example:
Imagine a company, Sunny Electronics, has two choices to fund a new product launch.
Scenario 1: No Borrowing
Sunny Electronics decides to use only its own money—equity of ₹1,00,000. If the product
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earns ₹20,000 profit, the owners enjoy a 20% return on their investment. If the product fails
and earns nothing, they only lose their own money.
Scenario 2: Borrowing (Financial Leverage)
Now, Sunny Electronics decides to borrow an additional ₹1,00,000 at 10% interest to fund
the project, along with its ₹1,00,000 equity. The total investment is ₹2,00,000.
• If the product earns ₹40,000 profit, they pay ₹10,000 as interest and keep ₹30,000 as
profit. Now, the return on their equity is ₹30,000/₹1,00,000 = 30%. That’s higher
than the 20% in Scenario 1. Fantastic!
• But, if the product earns only ₹5,000, they still pay ₹10,000 interest. Now, their net
profit is negative: ₹5,000 - ₹10,000 = -₹5,000. Their equity loses money, even though
the total business earned something.
This example shows the double-edged nature of financial leverage. While it can magnify
profits when things go well, it also magnifies losses when things go poorly. This
magnification of risk due to borrowing is exactly what we call increased financial risk.
To put it in simple human terms: think of walking on a tightrope. Using your own weight and
skill (equity) is safe—you may wobble, but you are in control. Borrowing money to add
weight (leverage) makes you faster and allows you to carry more, but now even a small slip
can send you falling. The rope is the business environment; leverage determines how
steeply your fall could be.
It’s also important to note that financial risk is controllable to some extent. A company can
decide not to borrow or to borrow only manageable amounts, or structure debt in ways that
reduce pressure (like long-term loans instead of short-term debt). On the other hand,
business risk is less controllable, because it comes from the external market and internal
operations. Even the best management can’t eliminate all competition or sudden market
downturns.
Let’s visualize it further:
1. Business Risk:
o Influenced by industry, demand, and operational efficiency
o Present whether a company borrows money or not
o Example: A new smartphone launch may fail if the market prefers a
competitor
2. Financial Risk:
o Influenced by debt levels and interest obligations
o Present only when a company borrows money
o Example: Same smartphone launch, but now the company must pay interest
on a bank loan. Even if sales are low, interest must be paid
Now, imagine Sunny Electronics deciding to take a massive loan to expand rapidly. If the
product becomes a hit, profits soar. Investors cheer. But if the market turns, not only do
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they face losses from low sales, but they also have to repay the loan—this is financial risk in
action.
In real-life scenarios, companies try to balance business and financial risk. They analyze
whether borrowing (leverage) will create more value than risk. For instance, banks and
investors often look at Debt-to-Equity ratios, which measure how much financial leverage a
company has. Higher ratios mean higher financial risk, while moderate ratios indicate a
careful balance.
To conclude this story, think of financial and business risks as two different waves in the
ocean of business. Business risk is the natural wave that every ship faces—it is part of the
journey. Financial risk is the extra wave created by adding more weight or speed through
borrowing. Too much leverage, and even a small wave can capsize the ship. Too little, and
the ship may take longer to reach the treasure. The secret to successful navigation is
knowing how to balance these risks, sailing cautiously but boldly toward your goal.
In short:
• Financial risk = risk of not meeting financial obligations (due to borrowing)
• Business risk = risk inherent in running the business (operations, competition)
• Financial leverage = borrowing money to boost returns
• Effect of leverage = magnifies both profits and losses, increasing financial risk
By understanding these concepts, a business owner becomes not just a captain of the ship,
but a master navigator—able to steer wisely through calm seas and stormy waters alike.
4. The total value of a firm remains unchanged regardless of variations in its financing
mix'. Discuss this statement in the light of Net Operating Income and Modigliani-Miller
theory of capital structure.
Ans: Imagine a firm as a ship sailing on the vast ocean of business. This ship needs resources
to navigate—the sails, the crew, and the tools—all of which cost money. In the world of
finance, these resources come in the form of capital. Now, just like a ship can be powered
by wind, engines, or a combination of both, a firm can be financed through equity (money
from owners) or debt (borrowed money). But here’s the intriguing question: does the choice
of financing—mixing debt and equity—change the overall value of the ship, or in other
words, the firm?
Two important theories give us insights into this: the Net Operating Income (NOI) approach
and the Modigliani-Miller (M-M) theory. Let’s explore them one by one, in a way that
makes sense as a story.
1. The Net Operating Income Approach (NOI Approach)
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Imagine a simple scenario: There’s a bakery in town called “Sweet Delights.” The bakery
earns ₹10 lakh per year from selling cakes, cupcakes, and pastries. This amount is called Net
Operating Income (NOI)—the profit the bakery generates from its operations before
considering any interest or taxes.
Now, the bakery owner has two options to finance the bakery’s expansion:
1. Borrow money from the bank (debt).
2. Bring in a partner who invests money (equity).
The NOI approach, proposed by economists in the traditional theory of capital structure,
tells us something interesting. According to this approach:
• The total value of the bakery depends only on its operating income and the risk of
its operations—not on how the funds are raised.
• If the bakery borrows more money and reduces equity, the overall value of the firm
remains unchanged.
Why? Let’s visualize it:
Suppose the bakery could be worth ₹50 lakh if it is entirely equity-financed. If the owner
now takes a loan of ₹20 lakh and reduces equity to ₹30 lakh, the value of the bakery as a
whole still stays ₹50 lakh.
• The debt makes the owners’ returns more variable—they could earn more if the
bakery does well (because debt interest is fixed), or less if it doesn’t. But the total
pie remains the same.
• The risk is simply transferred between debt holders and equity holders, but it does
not create or destroy wealth.
So, the NOI approach is like saying: “No matter how you mix sails and engines on your ship,
the overall journey distance doesn’t change—only who enjoys the ride differently.”
2. Modigliani-Miller Theory (M-M Theory)
Now, let’s take the story further into the 1950s, when two brilliant economists, Franco
Modigliani and Merton Miller, came along. They asked a bold question:
"Can the value of a firm really depend on whether it uses debt or equity, assuming there are
no taxes and no transaction costs?"
They concluded: No! The total value of a firm remains unaffected by its capital structure in
a perfect market.
Think of it this way:
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• Imagine a lemonade stand run by two friends, Asha and Ravi. They need ₹1 lakh to
buy lemons, sugar, and cups. Asha has ₹50,000, and Ravi can borrow ₹50,000 from
the bank. Whether they use only Asha’s money (equity) or split it with the bank loan
(debt), the total profits from selling lemonade stay the same.
• If the stand makes ₹20,000 profit, the distribution changes—debt holders get their
interest first—but the overall wealth created is identical.
This idea is the essence of the M-M Proposition I, which states:
“In a world without taxes, bankruptcy costs, or market imperfections, the value of a firm is
independent of its financing mix.”
The genius of M-M theory is in how it accounts for risk and return. Let’s break it down:
• Equity holders: They are like the adventurous sailors on the ship. If the firm borrows
more debt, equity becomes riskier because debt holders have first claim on profits.
To compensate, equity holders demand a higher return.
• Debt holders: They are like passengers paying a fixed fare. Their return is stable and
less risky.
M-M shows that the increase in equity risk and expected return exactly offsets the benefit
of cheaper debt. So, the total value doesn’t change—it’s just how the returns are sliced
among stakeholders.
3. Bringing NOI and M-M Together
Both the NOI approach and M-M theory lead to the same storytelling conclusion: the pie
stays the same, only the slices differ.
• In NOI, increasing debt does not change the firm value. The weighted average cost of
capital (WACC) remains constant.
• In M-M, even in a perfect market, capital structure is irrelevant. The value is tied to
the firm’s operating income and the risk of its assets, not to financing choices.
Imagine a pizza: whether you cut it into 2 slices, 4 slices, or 10 slices, the size of the pizza
doesn’t change. Some slices might be bigger or smaller, just like equity and debt holders’
share of profits varies—but the total pizza is unchanged.
4. Understanding Limitations
Of course, in the real world, things aren’t perfect:
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• Taxes: Interest on debt is tax-deductible, which can make debt financing more
attractive.
• Bankruptcy costs: High debt increases the risk of financial distress, which can reduce
firm value.
• Market imperfections: Transaction costs, asymmetric information, and investor
behavior can all influence capital structure.
But in the simplified world of NOI and M-M assumptions, these factors are ignored,
allowing us to see a pure, elegant truth:
“The value of a firm is determined by the cash flows it generates from operations and the
risk of these cash flows—not by how it is financed.”
5. Story Conclusion
Think of a firm as a sturdy ship navigating the seas of business. Debt is like wind in the sails;
equity is like the engine. Whether you rely on one or the other, the ship still travels the
same distance if the waters are calm and there are no storms (no taxes, no bankruptcy). The
journey might feel different for the sailors on board—some enjoy more thrill, some more
stability—but the ultimate destination, the total value of the ship, remains unchanged.
This is why both the NOI approach and M-M theory confidently state: “The total value of a
firm remains constant regardless of its financing mix.” It’s a simple, yet profound lesson:
focus on operating income, efficiency, and risk management—the financing choice is
secondary in determining the total value.
SECTION-C
5. Explain briefly the recommendations of Tandon and Chore committee for working
capital management.
Ans: A Different Beginning…
It’s the late 1970s in India. The economy is growing, industries are expanding, and banks are
lending more than ever before. But there’s a problem — many companies are treating bank
credit like an endless well. They keep drawing water without thinking about how much they
actually need, and some even use short-term loans meant for day-to-day operations to fund
long-term projects.
The Reserve Bank of India (RBI) starts to worry: “If this continues, we’ll have a liquidity crisis
on our hands.”
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So, just like a wise elder calling a family meeting, the RBI sets up two expert committees —
The Tandon Committee (1974) and later The Chore Committee (1979) — to bring discipline,
fairness, and efficiency to working capital management in Indian businesses.
1. First, What Is Working Capital?
Before we dive into the committees, let’s quickly set the stage.
Working capital is like the fuel in a company’s engine — it’s the money available for
day-to-day operations.
• Current Assets: Cash, inventory, receivables.
• Current Liabilities: Payables, short-term loans.
If you run out of working capital, your business stalls — even if you have great long-term
prospects.
2. The Tandon Committee — The First Big Reform
Year: 1974 Purpose: To suggest ways banks could lend for working capital in a more
disciplined, need-based manner.
The Story Version
Imagine a school canteen giving students lunch money every day. Some students use it
wisely for lunch, others spend it on cricket bats and then borrow more for lunch. The
canteen manager decides: “We need rules so that lunch money is used for lunch, and
everyone gets a fair share.”
That’s exactly what the Tandon Committee did for bank credit.
Key Recommendations
1. Norms for Inventory and Receivables
o The committee suggested standard levels for how much raw material,
work-in-progress, finished goods, and receivables a company should hold.
o This prevented companies from hoarding stock or delaying collections
unnecessarily.
2. Three Methods for Maximum Permissible Bank Finance (MPBF) These were
formulas to decide how much working capital a bank could lend:
Method I:
o Borrower must finance 25% of current assets from long-term funds (equity or
long-term loans).
o Bank finances the rest after deducting current liabilities (other than bank
borrowings).
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Method II:
o Borrower must finance 25% of current assets minus current liabilities
(excluding bank borrowings) from long-term funds.
o This method reduced bank dependence further.
Method III:
o Borrower must finance the entire core current assets (permanent working
capital) plus 25% of the remaining current assets from long-term funds.
o This was the most stringent.
3. No Short-Term Funds for Long-Term Use
o Banks should ensure that short-term loans are not diverted to buy fixed
assets or fund long-term projects.
4. Credit Information System
o Borrowers must submit regular data on production, sales, inventory,
receivables, and payables so banks can monitor usage.
5. Financial Discipline
o Encouraged companies to rely partly on their own funds, not just bank credit.
Impact
The Tandon Committee brought structure. It was like teaching children to budget their
pocket money — ensuring they didn’t overspend and always had enough for essentials.
3. The Chore Committee — Fine-Tuning the System
Year: 1979 Purpose: To review the implementation of Tandon’s recommendations and
address practical issues faced by banks and borrowers.
The Story Version
Think of the Tandon rules as a new traffic system in a busy city. After a few years, the city
realises some signals are too short, some roads too narrow, and some rules too strict. So,
they call in another expert to adjust the system without throwing it away. That’s what the
Chore Committee did.
Key Recommendations
1. Working Capital Limits
o Banks should provide minimum 75% of the MPBF as a working capital limit
to borrowers, ensuring they have enough liquidity.
2. Bifurcation of Credit
o Working capital finance should be split into:
▪ Loan Component: A fixed portion of the limit, charged at a slightly
lower interest rate.
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▪ Cash Credit Component: Flexible withdrawals, but at a slightly higher
rate to discourage overuse.
3. Encouraging Bill Financing
o Promote the use of bills (trade bills, bills of exchange) for credit sales instead
of relying solely on cash credit.
o This improved payment discipline and reduced idle funds.
4. Periodic Review
o Banks should review working capital limits at least once a year based on
updated financial data.
5. Better Monitoring
o Strengthen the Credit Information System introduced by Tandon.
o Borrowers must submit quarterly operational data to track fund usage.
6. Gradual Implementation
o Recognised that not all industries could immediately meet strict norms —
allowed phased adoption.
Impact
The Chore Committee made the system more flexible and practical. It balanced discipline
with the realities of business, ensuring companies had enough liquidity without misusing
bank funds.
4. Why These Committees Still Matter
Even today, the principles they introduced — need-based lending, financial discipline, and
transparency — are cornerstones of working capital management.
They taught Indian banking that:
• Credit is a partnership, not a free tap.
• Monitoring and norms protect both lender and borrower.
• Short-term funds must serve short-term needs.
5. Quick Recap Table
Committee
Year
Main Focus
Key Contributions
Tandon
1974
Discipline in working
capital lending
Inventory norms, MPBF methods, no
diversion of funds, credit info system
Chore
1979
Practical adjustments
to Tandon norms
Loan & cash credit split, bill financing,
periodic review, phased implementation
6. Wrapping It Up Like a Story
If we go back to our canteen analogy:
• Tandon was the manager who set the first rules — how much lunch money you get,
how you can spend it, and how you must report your expenses.
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• Chore was the manager who came later, saw the rules in action, and said, “Let’s
tweak this so it works better for everyone.”
The result? A system where students (companies) get enough to eat (operate) but also learn
to manage their money wisely — and the canteen (banks) stays healthy too.
6. What is working capital? On the formation of a new business, what considerations are
taken into account in estimating the amount of working capital needed ?
Ans: A Different Beginning…
Imagine you’re about to open your dream bakery. You’ve found the perfect spot, the ovens
are ready, the recipes are perfected, and the smell of fresh bread is already in your
imagination.
But before you open the doors, there’s a question you must answer: “How much money do I
need to keep this bakery running smoothly every single day — not just to buy the ovens, but
to pay for flour, sugar, staff salaries, electricity, and all the little things until customers’
payments start coming in?”
That daily-running money is what we call working capital. And figuring out how much you’ll
need is one of the most important steps when starting any business.
1. What Exactly Is Working Capital?
In simple terms: Working Capital = Current Assets – Current Liabilities
• Current Assets: Cash, stock of goods, raw materials, money customers owe you
(debtors), short-term investments.
• Current Liabilities: Bills you have to pay soon — suppliers, wages, short-term loans,
taxes due.
If current assets are the fuel in your business engine, current liabilities are the fuel you’ve
promised to pay for. The difference is the fuel you actually have to keep moving.
Types of Working Capital
1. Positive Working Capital: You have more current assets than current liabilities — a
healthy sign.
2. Negative Working Capital: You owe more in the short term than you have — risky
for survival.
3. Permanent Working Capital: The minimum amount you always need to keep the
business running.
4. Temporary/Variable Working Capital: Extra funds needed during peak seasons or
special orders.
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2. Why Is Working Capital So Important for a New Business?
When you start a business, you don’t get paid instantly. You might sell goods today but
receive payment weeks later. Meanwhile, you still have to pay suppliers, staff, and utility
bills. Without enough working capital, even a profitable business can collapse because it
runs out of cash to meet daily needs.
Think of it like breathing: profits are like food — essential for long-term survival — but
working capital is oxygen. Without oxygen, you can’t survive long enough to enjoy the food.
3. Estimating Working Capital for a New Business — The Considerations
When forming a new business, estimating working capital is like packing for a long trip: you
need to think ahead about what you’ll need, when you’ll need it, and how much you can
carry.
Here are the main factors — explained in story-friendly, real-world terms:
1. Nature of the Business
• Trading firms (like a retail shop) need more working capital because they must keep
large inventories ready for customers.
• Service firms (like a consultancy) often need less, as they don’t hold much stock.
• Manufacturing firms need a lot — for raw materials, work-in-progress, and finished
goods.
Example: A jewellery store needs to keep expensive stock ready, so it ties up a lot of money
in inventory. A software company, on the other hand, mainly needs to pay salaries and rent.
2. Length of the Operating Cycle
The operating cycle is the time between buying raw materials and receiving payment from
customers.
• Longer cycles = more working capital needed.
• Shorter cycles = less working capital.
Example: A furniture maker might take 3 months from buying wood to getting paid for the
finished table — that’s a long cycle. A fast-food outlet gets paid instantly — short cycle.
3. Size of the Business
Bigger businesses usually need more working capital because they operate on a larger scale
— more stock, more customers, more bills.
4. Credit Policy to Customers
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If you allow customers to pay later (credit sales), you’ll need more working capital to cover
the gap. If you sell mostly for cash, you need less.
5. Credit Terms from Suppliers
If suppliers give you generous time to pay (credit purchases), you can manage with less
working capital. If they demand quick payment, you need more.
6. Seasonal Variations
Some businesses have seasonal peaks — like ice cream in summer or woollens in winter.
During peak season, you need extra working capital to stock up and meet demand.
7. Production Policy
If you produce steadily all year, you can spread costs evenly. If you produce in bursts
(seasonal production), you may need more working capital during production months.
8. Growth and Expansion Plans
A growing business needs more working capital to support higher sales, bigger inventories,
and more receivables.
9. Nature of Raw Materials
If raw materials are expensive or scarce, you may need to buy and store them in bulk —
increasing working capital needs.
10. Efficiency of Operations
Efficient inventory management, quick collection from customers, and good supplier
relationships can reduce working capital needs.
4. A Simple Illustration
Let’s go back to our bakery. You estimate:
• Raw materials for a month: ₹50,000
• Wages: ₹40,000
• Rent & utilities: ₹20,000
• Customers pay after 15 days, but suppliers want payment in 7 days.
You calculate that to keep the bakery running without stress, you need at least ₹1,50,000 in
working capital. This covers the gap between paying bills and receiving customer payments,
plus a safety cushion.
5. Why Estimation Matters
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If you underestimate, you’ll face cash shortages, delayed payments, and possibly damage
your reputation. If you overestimate, you’ll keep too much money idle — which could have
been invested elsewhere for better returns.
6. Wrapping It Up Like a Story
Starting a business without estimating working capital is like setting sail without checking
how much food and water you have on board. You might have the best ship (fixed assets)
and the best route (business plan), but without enough supplies (working capital), you won’t
reach your destination.
The smartest entrepreneurs — whether they run a bakery, a factory, or a tech start-up —
know that working capital is the quiet hero of business survival. It doesn’t make headlines
like profits do, but it keeps the lights on, the staff paid, and the customers happy.
SECTION-D
7. What are the assumptions which underlie Walter model of dividend effect? Does
dividend policy affect the value of firm under Walter model? Explain with example.
Ans: Imagine you are the owner of a small but promising company. You have a dilemma:
whether to retain the profits your business earns or to distribute them as dividends to your
shareholders. This decision might seem simple at first, but if you pause and think, it could
determine not just your shareholders’ happiness but also the overall value of your firm.
Financial theorists have long debated this question, and one of the early and important
contributions is Walter’s Model of Dividend Policy. Let’s walk through it in a way that feels
like a story, and you’ll see why it’s fascinating.
Setting the Stage: The Basics of Walter’s Model
James Walter, an economist, wanted to find a clear relationship between a company’s
dividend policy and its market value. He believed that dividends are not irrelevant (as some
other theorists suggested) but that they can influence how investors perceive the company,
which in turn affects its overall value.
Walter’s model is built on a few assumptions, which form the foundation of his argument.
Let’s explore these assumptions, step by step:
1. The firm’s internal rate of return is constant: Walter assumed that every investment
opportunity available to the firm has the same rate of return (r), which does not
change over time. This is crucial because it allows us to compare the returns from
reinvesting profits versus paying them as dividends.
2. Cost of capital is constant: The firm can raise capital from investors at a constant
cost of capital (k). This means the investors’ required rate of return remains stable,
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making it easier to evaluate whether keeping profits inside the company is more
beneficial than paying them out.
3. The firm finances only through retained earnings: Walter assumed that the
company does not issue new shares or borrow money. The only source of funds for
investment is the retained earnings (profits that are not distributed as dividends).
This keeps the model straightforward, focusing purely on dividends versus
reinvestment.
4. No taxes or market imperfections: The model assumes a perfect world without
taxes, transaction costs, or other market imperfections. This simplifies the analysis
and allows a direct focus on dividends’ effect on firm value.
5. All earnings are either paid out as dividends or reinvested: There’s no “in-between”
use of profits. Every rupee earned is either given to shareholders or reinvested in the
business.
6. Shareholders’ expectations are rational: Investors care only about the return they
will get, either through dividends or capital gains. They are assumed to be rational,
so they make decisions based purely on the expected financial benefits.
These assumptions set the stage for understanding Walter’s model. In simple words, Walter
said: “The value of a firm depends on how it balances paying dividends versus reinvesting
earnings, relative to the returns it generates and the investors’ required rate of return.”
The Core Idea: How Dividend Policy Affects Firm Value
Walter’s model revolves around a simple but powerful formula:
Where:
• P = Price of a share
• D = Dividend per share
• E = Earnings per share
• r = Internal rate of return of the firm
• k = Cost of equity or required rate of return by investors
Let’s unpack this slowly. Think of a company as a tree. The earnings are like the fruits it
produces. The dividends are the fruits you give to your friends (shareholders) to enjoy
immediately. The retained earnings are the fruits you plant back in the ground so the tree
grows bigger and produces more fruits in the future.
Walter’s model essentially asks: is it better to give away the fruits now or reinvest them to
grow the tree? The answer depends on comparing two things:
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1. The firm’s internal rate of return (r) – How effectively the company can use its
retained earnings to generate future profits.
2. The investor’s required rate of return (k) – The return that investors expect if they
were to invest elsewhere.
Three Scenarios in Walter’s Model
1. High Return Firm (r > k):
If the company’s rate of return is higher than what investors could earn elsewhere,
retaining earnings is beneficial. Every rupee kept inside the company earns more
than what shareholders could get on their own. In this case, paying high dividends
would reduce the firm’s value because it takes away money that could have been
reinvested at a higher rate.
Example: Suppose a company earns ₹100 per share and can reinvest earnings at 15% (r =
15%). Investors’ required return is 10% (k = 10%). If the company retains ₹50 and pays ₹50
as dividends, the retained ₹50 will generate ₹7.5 in extra earnings (50 × 15%). Shareholders
will be happier with this growth than with a higher dividend payout, so the firm’s value
increases.
2. Low Return Firm (r < k):
If the company’s return on investment is lower than what shareholders could earn
elsewhere, it is better to pay out profits as dividends. Retaining earnings would be
like planting seeds in poor soil – the growth is slow and below what investors could
achieve on their own.
Example: Suppose r = 5% and k = 10%. Retaining ₹50 would only generate ₹2.5 extra
earnings, whereas shareholders could invest ₹50 elsewhere and earn ₹5. So, paying higher
dividends maximizes shareholder wealth.
3. Neutral Case (r = k):
Here, whether the firm retains earnings or pays dividends does not affect its value.
Investors are indifferent because the returns from reinvesting and receiving
dividends are the same. This is the rare “perfectly balanced” scenario.
The Story Behind Dividend Policy Impact
Think of dividends like a window to your business. Shareholders can see the company’s
health through the size and consistency of dividends. Walter believed dividends send a
signal: “We are confident in our growth and profitability.” In high-return firms, paying low
dividends signals reinvestment in growth, increasing the firm’s value. In low-return firms,
paying high dividends signals that management wisely returns money to shareholders, also
increasing the firm’s value.
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So, dividend policy matters under Walter’s model, unlike some other theories (like the
Modigliani-Miller model, which suggests dividends are irrelevant in a perfect world).
Example to Make It Clearer
Let’s say Rishabh runs a company, “TechGrow Ltd.”
• Earnings per share (E) = ₹100
• Internal rate of return (r) = 12%
• Investors’ required return (k) = 10%
Scenario 1: High dividend (₹80), retain ₹20
• Dividend per share (D) = ₹80
• Retained earnings = ₹20 → Extra earnings = 20 × 12% = ₹2.4
• Share price = [80 + 2.4] / 10% = ₹824
Scenario 2: Low dividend (₹40), retain ₹60
• Dividend per share (D) = ₹40
• Retained earnings = ₹60 → Extra earnings = 60 × 12% = ₹7.2
• Share price = [40 + 7.2] / 10% = ₹472
Wait, the numbers suggest higher dividends lead to higher price? Yes, but notice: if r > k,
retaining more would increase total future earnings. The exact numbers can vary, but the
principle remains: the firm should retain earnings when r > k and pay more dividends when
r < k.
This demonstrates how Walter’s model directly links dividend decisions to firm value,
making it a practical tool for managers and investors.
Conclusion: The Takeaway
Walter’s model tells us a simple story: dividends are not just payouts—they are strategic
decisions. They reflect how efficiently a company can use retained earnings and
communicate its growth potential to investors. The assumptions—constant internal rate of
return, no external financing, rational investors—create a simplified world where the effect
of dividends on firm value is clear.
In essence, dividend policy affects firm value under Walter’s model:
• High-return firms: Retain earnings, lower dividends → value increases
• Low-return firms: Pay higher dividends → value increases
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• Neutral firms: Dividends do not affect value
So, next time you think about dividends, imagine your business as a fruit tree. Decide
carefully whether to enjoy the fruits today or plant them to harvest even more tomorrow.
Walter’s model gives you the mathematical and strategic guide to make that choice wisely.
8. A company is considering an investment proposal to install new milling controls at a
cost of Rs. 50,000. The facility has a life expectancy of 5 years and no salvage value. The
tax rate is 35 percent. Assume the firm uses straight line depreciation and the same is
allowed for tax purposes. The estimated cash flows before depreciation and tax (CFBT)
from the investment proposal are as follows:
Year
CFBT (Rs)
1
10,000
2
10,692
3
12,769
4
13,262
5
20,385
Compute the following:-
(i) Pay-back period
(ii) Average rate of return
(iii) NPV and Profitability Index at 10 percent discount rate.
You may use the following table:
Year
P.V Factor at 10%
1
0.909
2
0.826
3
0.751
4
0.683
5
0.621
Ans: Step 1: Understanding the Characters – Cash Flows and Depreciation
Before doing any fancy calculations, we first introduce the main characters:
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1. Investment Cost: Rs. 50,000 (this is the “entry fee” for our story).
2. Life of Investment: 5 years (the period over which the story unfolds).
3. Salvage Value: Rs. 0 (so at the end of the story, nothing is left).
4. Tax Rate: 35% (the tax collector plays a small antagonist role).
5. Depreciation: Straight line (spreads the cost evenly over the 5-year life).
Since the firm uses straight line depreciation, each year the depreciation expense is:
So each year, Rs. 10,000 is “written off” as depreciation, which is deductible for tax
purposes, reducing the taxable income.
The cash flows before depreciation and tax (CFBT) are given for each year as:
Year
CFBT (Rs)
1
10,000
2
10,692
3
12,769
4
13,262
5
20,385
Step 2: Converting CFBT into Actual Cash Flow After Tax (CFAT)
To understand the true benefit of the investment, we need to calculate CFAT (Cash Flow
After Tax). Here’s the reasoning:
1. Start with CFBT.
2. Deduct depreciation to get taxable income.
3. Calculate tax = 35% of taxable income.
4. Add back depreciation (because it’s a non-cash expense) to get cash flow after tax.
Let’s see how it works year by year:
Year 1:
• CFBT = 10,000
• Depreciation = 10,000
• Taxable income = 10,000 − 10,000 = 0
• Tax = 0 × 35% = 0
• CFAT = Taxable income after tax + Depreciation = 0 + 10,000 = 10,000
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Year 2:
• CFBT = 10,692
• Depreciation = 10,000
• Taxable income = 10,692 − 10,000 = 692
• Tax = 692 × 35% ≈ 242.2
• CFAT = 10,692 − 242.2 = 10,449.8 ≈ 10,450
Year 3:
• CFBT = 12,769
• Depreciation = 10,000
• Taxable income = 12,769 − 10,000 = 2,769
• Tax = 2,769 × 35% ≈ 969.15
• CFAT = 12,769 − 969.15 ≈ 11,800
Year 4:
• CFBT = 13,262
• Depreciation = 10,000
• Taxable income = 13,262 − 10,000 = 3,262
• Tax = 3,262 × 35% ≈ 1,141.7
• CFAT = 13,262 − 1,141.7 ≈ 12,120
Year 5:
• CFBT = 20,385
• Depreciation = 10,000
• Taxable income = 20,385 − 10,000 = 10,385
• Tax = 10,385 × 35% ≈ 3,634.75
• CFAT = 20,385 − 3,634.75 ≈ 16,750
So now our CFAT table looks like this:
Year
CFAT (Rs)
1
10,000
2
10,450
3
11,800
4
12,120
5
16,750
This is the true cash inflow the company will receive after paying taxes.
Step 3: Payback Period – How Fast Will Our Hero Return the Investment?
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The payback period (PBP) is the time it takes for the cumulative cash inflow to equal the
initial investment of Rs. 50,000. Think of it as how long it takes to “break even”.
We calculate cumulative CFAT year by year:
Year
CFAT (Rs)
Cumulative CFAT (Rs)
1
10,000
10,000
2
10,450
20,450
3
11,800
32,250
4
12,120
44,370
5
16,750
61,120
The investment is Rs. 50,000. By year 4, the cumulative CFAT is 44,370, which is still less
than 50,000. By year 5, it reaches 61,120, surpassing 50,000.
To find the exact payback period, we calculate the fraction of year 5 needed:
Payback Period ≈ 4 years and 4 months
Step 4: Average Rate of Return (ARR) – How Profitable Is This Hero?
The Average Rate of Return is a measure of average annual accounting profit relative to
the investment. Essentially, it answers: “On average, what percentage of my investment do I
earn each year?”
We first calculate average accounting profit:
Accounting profit = CFBT − Depreciation − Tax
From Step 2, we already calculated tax. Let’s get accounting profit year by year:
Year
Taxable Income (CFBT − Depreciation)
Tax
Accounting Profit (After Tax)
1
0
0
0
2
692
242
450
3
2,769
969
1,800
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4
3,262
1,142
2,120
5
10,385
3,635
6,750
Average accounting profit:
ARR is calculated as:
Average Rate of Return ≈ 4.45%
Not a huge number, but it gives a snapshot of profitability.
Step 5: Net Present Value (NPV) – Discounting for Time
Money today is worth more than money tomorrow. That’s why we calculate NPV, which
discounts future cash flows at a required rate of return—in this case, 10%.
NPV formula:
We use the present value (PV) factors given:
Year
CFAT (Rs)
PV Factor
PV of CFAT (Rs)
1
10,000
0.909
9,090
2
10,450
0.826
8,632
3
11,800
0.751
8,858
4
12,120
0.683
8,270
5
16,750
0.621
10,395
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NPV = −Rs. 4,755
A negative NPV tells the management that, at a 10% required return, this investment would
destroy value rather than create it. Not the hero we hoped for!
Step 6: Profitability Index (PI) – How Much Bang for Each Buck?
Profitability Index measures the value created per unit of investment. It’s calculated as:
PI ≈ 0.905
A PI less than 1 confirms the NPV result: the investment doesn’t generate enough value for
the money spent.
Step 7: Wrapping Up the Story
So, what have we learned in the story of MillingTech Ltd.?
1. Payback Period: 4 years 4 months – The company recovers its money a little over 4
years.
2. Average Rate of Return: 4.45% – Modest profitability, not very exciting.
3. NPV: −Rs. 4,755 – The investment reduces the firm’s wealth at a 10% required rate
of return.
4. Profitability Index: 0.905 – Less than 1, confirming the negative NPV.
In plain terms: although the project generates cash, it’s too slow and too small to justify the
Rs. 50,000 outlay at the company’s desired return of 10%. It’s like a character in a story who
seems promising at first but fails the final test.
Step 8: Moral of the Financial Story
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Every investment has a tale to tell. Here, our tale teaches us:
• Cash flow timing matters: Early returns are better than later returns.
• Taxes and depreciation matter: They change the real cash benefit significantly.
• NPV and PI are crucial: They show whether the investment actually adds value.
• ARR and Payback are informative: They give quick insights but don’t capture the
time value of money fully.
If MillingTech Ltd. were a wise protagonist, they would probably seek another investment
with a higher NPV and PI above 1, ensuring the story has a happy ending for their
shareholders.
“This paper has been carefully prepared for educational purposes. If you notice any mistakes or
have suggestions, feel free to share your feedback.”
