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GNDU Question Paper-2022
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 and the
Fifth question may be attempted from any of the Four sections. All questions carry equal marks
SECTION-A
1. X Ltd. has the following Capital Structure on October 31, 2021:
Source of Capital Rs.
Equity Share Capital (1,00,000 shares Rs.of Rs. 10 each) 10,00,000
Reserves and Surplus 10,00,000
12% Preference Shares 5,00,000
9% Debentures 15,00,000
40,00,000
The market price of Equity Share is Rs. 50. It is expected that the company will pay a
dividend of Rs. 5 per share next year which is expected to grow at 7%. Assume 30%
income tax rate. You are required to compute weighted average Cost of Capital using
market value weights.
2. What is risk? What are the types of risks involved in an investment ? Analyse the risk
and return relationship in taking investment decisions.
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SECTION-B
3. Relevant information about BIL Ltd. is given below:
Annual production capacity (Units) 1,00,000
Capacity utilisation and sales 75%
Unit Selling Price (Rs.) 40
Unit Variable Cost (Rs.) 15
Fixed Cost p.a. (Rs.) 2,00,000
Equity Capital (1,000 shares) (Rs.) 5,00,000
15% Debentures (Rs.) 1,00,000
Calculate operating leverage, financial leverage and combined leverage.
4. Critically appraise the traditional approach and the Modigliani-Miller approach to the
problem of capital structure.
SECTION-C
5. From the following details you are required to make an assessment of average amount
of working capital requirement of AB Ltd. :
Items
Average period of credit
Estimate for first year (Rs.)
Purchase of Material
6 weeks
26,00,000
Wages
𝟏
𝟏
𝟐
⁄
19,50,000
Overheads:
Rent, rates etc .
6 months
1,00,000
Salaries
1 months
8,00,000
Other Overheads
2 months
7,50,000
Sales (Cash)
-
2,00,000
Sales (Credit)
2 months
4,00,000
Average amount of stock and working progress
3,00,000
Average amount of undrawn profit
6. Define Working Capital. What lactors are to be considered in determining the Working
Capital need of a concern?
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SECTION-D
7. A company has two investment proposals, each costing Rs. 1,00,000 and each having
expected cash inflows as follows:
Year
Project A (Rs.)
Project B (Rs.)
1
50,000
20,000
2
40,000
40,000
3
30,000
50,000
4
10,000
60,000
After giving due consideration to project scenario, the management has decided that
project A should be evaluated at 10% cost of capital and project B should be evaluated at
15% cost of capital. Compute, NPV, Payback Period, Profitability Index for both the
projects and suggest the course of action for the management if:
(a) Both the projects are independent
(b) Both the projects are mutually exclusive.
8. Critically discuss Walter dividend model. Does dividend policy affect the value of firm
under Walter model? Illustrate.
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GNDU Answer Paper-2022
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 and the
Fifth question may be attempted from any of the Four sections. All questions carry equal marks
SECTION-A
1. X Ltd. has the following Capital Structure on October 31, 2021:
Source of Capital Rs.
Equity Share Capital (1,00,000 shares Rs.of Rs. 10 each) 10,00,000
Reserves and Surplus 10,00,000
12% Preference Shares 5,00,000
9% Debentures 15,00,000
40,00,000
The market price of Equity Share is Rs. 50. It is expected that the company will pay a
dividend of Rs. 5 per share next year which is expected to grow at 7%. Assume 30%
income tax rate. You are required to compute weighted average Cost of Capital using
market value weights.
Ans: The Beginning of the Story
There was once a company called X Ltd., standing tall in the corporate world. Just like a
human body is made up of bones, muscles, and nerves, X Ltd. was made up of capital—
different sources of funds that kept it alive and running. On October 31, 2021, we peek into
its financial heart, and we see four big pillars of capital:
1. Equity Share Capital – 1,00,000 shares of ₹10 each = ₹10,00,000
2. Reserves and Surplus = ₹10,00,000
3. 12% Preference Shares = ₹5,00,000
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4. 9% Debentures = ₹15,00,000
So, in total, the company had funds worth ₹40,00,000 (10,00,000 + 10,00,000 + 5,00,000 +
15,00,000).
But here’s the twist—when we calculate the Weighted Average Cost of Capital (WACC), we
don’t just blindly look at what’s written in the books (the book value). Instead, we go by the
market value, because that’s what investors truly care about. Imagine you’re trying to value
your favourite cricket player. You wouldn’t just look at what’s written in the record books,
you’d look at his current performance in the market. Similarly, WACC cares about the
market’s voice.
The Hero of the Story: WACC
Now, before we get into the math, let’s understand what WACC is in a simple way.
Think of WACC as the average price a company has to pay for the money it borrows or
raises, whether from shareholders, preference shareholders, or debenture holders.
• If a company uses equity, it must pay dividends (or at least give growth).
• If it uses preference shares, it must pay a fixed dividend.
• If it uses debentures, it must pay interest (and here, tax benefits come into play).
So WACC is like blending different juices—mango, apple, and orange. Each has a different
sweetness (cost), and the glass you finally drink (the company’s cost of capital) is the
average sweetness, but weighted by how much of each juice is in the mix.
Step 1: Find Market Values of Each Source
1. Equity (Shares + Reserves)
o Total number of shares = 1,00,000
o Market price per share = ₹50
o So, Market Value of Equity = 1,00,000 × 50 = ₹50,00,000
Notice something? In the books, equity (shares + reserves) was ₹20,00,000. But the
market says, “No, the true value is ₹50,00,000.”
2. Preference Shares
o These are fixed at ₹5,00,000 (since preference shares usually don’t fluctuate
much like equity).
So, Market Value of Preference Shares = ₹5,00,000
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3. Debentures (Debt)
o Given in books = ₹15,00,000. Unless specified, we assume market value =
book value.
So, Market Value of Debt = ₹15,00,000
Therefore, Total Market Value = 50,00,000 + 5,00,000 + 15,00,000 = ₹70,00,000
Step 2: Cost of Each Component
Now let’s calculate the “sweetness level” (cost) of each juice.
1. Cost of Equity (Ke)
For equity, we use the Gordon Growth Model (Dividend Discount Model):
o D1 = Dividend expected next year = ₹5 per share
o P0 = Market Price per share = ₹50
o g = Growth rate = 7%
So,
The cost of equity = 17%
2. Cost of Preference Shares (Kp)
o Dp = Dividend = 12% of ₹100 = ₹12 (since preference shares are usually of
₹100 face value, unless stated otherwise)
o Pp = Market Price = ₹100 (taken as par here)
So,
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The cost of preference shares = 12%
3. Cost of Debt (Kd)
o Interest (I) = 9% of ₹100 = ₹9
o Tax rate = 30%
o Effective interest = 9 × (1 - 0.3) = 9 × 0.7 = ₹6.3
So,
The cost of debt = 6.3%
Step 3: Weights of Each Component
Now, we assign weights based on market value:
• Weight of Equity = 50,00,000 / 70,00,000 = 0.714 (71.4%)
• Weight of Preference = 5,00,000 / 70,00,000 = 0.071 (7.1%)
• Weight of Debt = 15,00,000 / 70,00,000 = 0.214 (21.4%)
Step 4: Calculate WACC
Finally, the grand moment—let’s mix the juices!
So, the Weighted Average Cost of Capital = 14.34%
Wrapping the Story with a Moral
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Think of WACC as the minimum return that X Ltd. must earn on its investments to keep all
its investors—shareholders, preference shareholders, and debenture holders—happy. If the
company earns less than 14.34%, investors will feel cheated. But if it earns more, wealth is
being created, and the company becomes a hero in the financial world.
This entire journey teaches us that finance is not about mugging formulas. It’s about
understanding relationships:
• Equity investors want growth and dividends.
• Preference shareholders want steady dividends.
• Debenture holders want safe interest, and they give the company a tax shield.
When all these demands are blended according to their weights, you get the company’s
“true cost of capital.”
So next time you see a WACC problem, don’t panic. Just imagine you are making a fruit juice
where each fruit is a source of capital, each has its sweetness (cost), and the glass of juice is
the final WACC—balanced, blended, and meaningful.
Final Answer: WACC = 14.34%
2. What is risk? What are the types of risks involved in an investment ? Analyse the risk
and return relationship in taking investment decisions.
Ans: Risk and Return in Investment: A Story-Like Explanation
Imagine you are standing at the edge of a playground. In front of you, there are three
different rides: a see-saw, a roller coaster, and a merry-go-round. Each ride looks fun, but
also a little different. The see-saw feels balanced, the roller coaster looks exciting but scary,
and the merry-go-round feels safe but maybe a little boring.
This playground is very similar to the world of investments. Every investment option—like
stocks, bonds, real estate, or gold—is just like one of those rides. Some are safe, some are
thrilling, and some are in-between. But no matter which ride you choose, one thing is
always there: risk.
What is Risk?
Risk, in the simplest words, is the possibility that things might not go as planned.
Suppose you decide to invest ₹10,000 in the stock market, hoping it will grow to ₹15,000 in
a year. But instead of going up, the stock price falls and your money reduces to ₹8,000. That
difference between what you expected and what you got is called risk.
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In real life, risk is everywhere. Crossing a busy road involves risk, starting a business involves
risk, even lending money to a friend involves risk. But when it comes to investments, risk is
more structured—it comes in different forms, and each type affects your money in a
different way.
Types of Risks in Investment
Let’s imagine risk as a group of characters in a story. Each character behaves differently, but
together they make the story unpredictable.
1. Market Risk
This is like the mood swings of the roller coaster ride. Sometimes the ride is smooth,
but suddenly it dips and rises. Market risk refers to the ups and downs in the overall
market due to factors like economic slowdown, global crisis, inflation, or even a war.
For example, during the COVID-19 pandemic, even strong companies saw their stock
prices fall sharply.
2. Credit Risk
Imagine lending your bicycle to a friend who promises to return it in a week, but
never does. That’s credit risk—the chance that someone who borrowed money (like
a company or a government) may not pay it back. This is especially common in bonds
and loans.
3. Liquidity Risk
Suppose you own a beautiful painting worth ₹50,000, but when you suddenly need
money, you cannot find anyone ready to buy it quickly. That’s liquidity risk—the
difficulty of converting an investment into cash without losing value.
4. Inflation Risk
Think about saving ₹100 today. After five years, you still have ₹100, but prices of
everything—food, clothes, travel—have doubled. Your money now buys only half of
what it once did. That’s inflation risk, where the purchasing power of money
decreases over time.
5. Interest Rate Risk
This mainly affects people who invest in bonds or fixed deposits. If interest rates in
the market go up, the value of older bonds (with lower rates) goes down. It’s like
booking a hotel at ₹3,000 a night, only to realize later that the same hotel is offering
rooms at ₹2,000.
6. Political or Regulatory Risk
Imagine playing cricket where the umpire keeps changing the rules in the middle of
the game. Similarly, sudden changes in government policies, laws, or taxation can
affect investments.
7. Business Risk
This is specific to companies. For example, if you invest in a mobile company and it
fails to compete with new technology, your investment suffers.
So, risks are like different spices in a dish—sometimes they add flavor, but sometimes they
can spoil the taste completely.
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The Risk and Return Relationship
Now, let’s talk about the most interesting part: the relationship between risk and return.
Think of it like this: if you want to climb a small hill, it’s safe, but the view at the top is
limited. On the other hand, if you want to climb Mount Everest, the journey is dangerous,
but the view from the top is breathtaking. Similarly, low-risk investments usually give lower
returns, while high-risk investments have the potential for higher returns.
• Low Risk, Low Return:
Example – Fixed deposits, government bonds. These are like the merry-go-round.
Safe and steady, but not very exciting.
• Medium Risk, Medium Return:
Example – Mutual funds, blue-chip stocks. These are like the see-saw. A bit of up and
down, but manageable.
• High Risk, High Return:
Example – Stock trading, cryptocurrencies, startups. These are the roller coaster—
thrilling, but also nerve-wracking.
Why Do Investors Take Risks Then?
A smart question arises: if risk means the chance of losing money, why does anyone take it?
The answer is opportunity. Just like people still ride roller coasters for the thrill, investors
take risks for the chance of earning higher returns. Imagine if no one ever took risks—there
would be no new businesses, no innovation, no growth. Risk is the price we pay for
opportunity.
But smart investors don’t take risks blindly. They analyze their own goals, income, and risk-
taking capacity. This is called risk appetite. For example:
• A young student might invest in risky stocks because they have time to recover
losses.
• A retired person might prefer safe investments because they need steady income.
How Risk and Return Guide Investment Decisions
When investors make decisions, they look at both sides of the coin:
1. Return – How much can I potentially earn?
2. Risk – How much can I potentially lose?
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The trick is to find a balance. Just like you wouldn’t put all your money in a lottery ticket,
you also shouldn’t keep it all locked in a savings account. That’s why financial advisors
always suggest diversification—spreading your money across different types of investments
to reduce overall risk.
Conclusion
To sum up, risk is nothing but the uncertainty of the future in investments—the possibility
that what we expect may not happen. It comes in many forms: market risk, credit risk,
inflation risk, and more. But risk is not always the villain of the story. Without risk, there is
no return, and without return, investments would have no meaning.
The golden rule is: higher the risk, higher the potential return—but also higher the chance
of loss.
So, making investment decisions is like choosing your ride in the playground. Some prefer
the safe merry-go-round, some like the balanced see-saw, and some love the thrill of the
roller coaster. The best choice depends on your courage, your goals, and your financial
strength.
In the end, a wise investor is not someone who avoids risk completely, but someone who
understands, manages, and balances risk with return—just like a skilled player who knows
when to play safe and when to hit a six.
SECTION-B
3. Relevant information about BIL Ltd. is given below:
Annual production capacity (Units) 1,00,000
Capacity utilisation and sales 75%
Unit Selling Price (Rs.) 40
Unit Variable Cost (Rs.) 15
Fixed Cost p.a. (Rs.) 2,00,000
Equity Capital (1,000 shares) (Rs.) 5,00,000
15% Debentures (Rs.) 1,00,000
Calculate operating leverage, financial leverage and combined leverage.
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Ans: A Fresh Beginning: A Tale of BIL Ltd.
Imagine you are the owner of a company named BIL Ltd.. You’ve set up a factory that can
produce 1,00,000 units every year. That’s your maximum strength—like saying you can run
at full speed if needed. But, as of now, your business doesn’t always run at 100%. In fact,
you’re currently using 75% of your capacity. So instead of producing 1,00,000 units, you’re
producing only 75,000 units.
Now, each unit sells for Rs. 40, and it costs you Rs. 15 to make one (that’s your variable cost
per unit). On top of that, whether you produce or not, you must bear some fixed costs like
salaries, rent, etc., which are Rs. 2,00,000 per year.
So far so good, right?
But wait, the story isn’t complete without looking at how your company is financed. You
have raised money through two sources:
• Equity Capital: Rs. 5,00,000 (divided into 1,000 shares)
• Debentures: Rs. 1,00,000 at 15% interest
Now, with these ingredients in hand, let’s explore how your company is affected by
operating leverage, financial leverage, and combined leverage.
Step 1: Understanding the Concept through a Story
Before we jump into calculations, let’s imagine leverage as a magnifying glass.
• Operating leverage is like a magnifying glass for your business operations. If your
sales increase slightly, how much will your operating profit (EBIT) increase?
• Financial leverage is like a magnifying glass for your financing structure. If your EBIT
increases slightly, how much will your Earnings Per Share (EPS) increase?
• Combined leverage is like combining both magnifying glasses. It shows the total
effect: if your sales change, how much will your EPS change?
In short:
Operating leverage = Power of costs (Fixed costs)
Financial leverage = Power of loans (Debt and interest)
Combined leverage = Power of both costs + debt
Step 2: Start with Sales and Profits
Now let’s calculate everything step by step.
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(a) Sales Revenue
Units sold = 75% of 1,00,000 = 75,000 units
Selling Price per unit = Rs. 40
So, Sales = 75,000 × 40 = Rs. 30,00,000
(b) Variable Cost
Variable Cost per unit = Rs. 15
Total Variable Cost = 75,000 × 15 = Rs. 11,25,000
(c) Contribution
Contribution = Sales – Variable Cost
= 30,00,000 – 11,25,000 = Rs. 18,75,000
(d) EBIT (Earnings Before Interest and Tax)
EBIT = Contribution – Fixed Cost
= 18,75,000 – 2,00,000 = Rs. 16,75,000
So, the company earns Rs. 16.75 lakh before paying interest.
Step 3: Operating Leverage
Operating leverage tells us:
Here, Contribution = 18,75,000 and EBIT = 16,75,000
So,
This means if sales increase by 1%, EBIT will increase by about 1.06%.
The story version: Your fixed costs are not too heavy compared to your contribution, so your
operating leverage is small. Your business doesn’t feel too much pressure from fixed costs—
it’s flexible.
Step 4: Financial Leverage
Financial leverage tells us:
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Now, let’s calculate EBT (Earnings Before Tax):
Interest on Debentures = 15% of 1,00,000 = 15,000
EBT = EBIT – Interest = 16,75,000 – 15,000 = 16,60,000
So,
This means if EBIT increases by 1%, EBT (and ultimately EPS) will increase by about
1.009%.
The story version: Your debt is very small (only Rs. 1 lakh), so the interest burden is almost
negligible. That’s why your financial leverage is tiny—your company is not taking much risk
from debt.
Step 5: Combined Leverage
Combined leverage tells us:
Contribution = 18,75,000
EBT = 16,60,000
So,
This means if sales increase by 1%, EPS will increase by about 1.13%.
The story version: Since both your operating leverage and financial leverage are low, your
combined leverage is also small. This shows your company is low risk—not much danger
from either fixed costs or debt.
Step 6: Interpret the Results like a Story
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Now let’s interpret what all this really means in human terms:
1. Operating Leverage (1.06): Your company has some fixed costs, but they’re not very
high compared to your total contribution. This means your profits don’t depend too
heavily on achieving very high sales. You are not trapped by huge fixed costs—your
business can breathe.
2. Financial Leverage (1.009): Since you have taken very little loan (just Rs. 1 lakh
compared to Rs. 5 lakh equity), your company doesn’t have much financial risk. Even
if profits fall a little, you can easily pay the interest. This makes you a safe and
conservative business in the eyes of investors.
3. Combined Leverage (1.13): Together, the overall risk is very low. If sales fluctuate,
your earnings per share won’t fluctuate too wildly. It’s a stable, low-risk company—
not a roller coaster ride.
4. Critically appraise the traditional approach and the Modigliani-Miller approach to the
problem of capital structure.
Ans: The Story of “DreamTech Ltd.”
Once upon a time, there was a company called DreamTech Ltd. It was doing really well—
great products, loyal customers, and big dreams for the future. But as the company grew,
the owner faced an important question:
“How should we finance our growth—through equity, debt, or a mix of both?”
This was not just a random question. In fact, it was one of the oldest puzzles in corporate
finance: the problem of capital structure.
Capital structure simply means the combination of debt (like loans and bonds) and equity
(like shares) that a company uses to finance its operations. Choosing the right mix is crucial
because it affects not only profitability but also risk, value of the firm, and even the
shareholders’ wealth.
To solve this puzzle, DreamTech Ltd. sought the wisdom of two legendary schools of
thought: the Traditional Approach and the Modigliani-Miller (M-M) Approach. Both had
their own philosophies, and both told very different stories.
The Traditional Approach – “Balance is the Key”
The first advisor, Mr. Traditionalist, said:
“Listen, DreamTech. There is such a thing as an optimal capital structure. If you balance
debt and equity wisely, you can minimize the overall cost of capital and maximize the value
of your firm.”
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He explained it with an example:
• Debt is cheaper than equity. Why? Because lenders take less risk (they get fixed
interest), and also because interest is tax-deductible, reducing the company’s tax
burden.
• But too much debt is dangerous. If you borrow too much, lenders demand higher
interest, the company becomes riskier, and even shareholders feel insecure.
• Equity is safer but more expensive. Shareholders want higher returns because they
take more risk.
So, according to the Traditional Approach, a company should mix both debt and equity in
just the right proportion. At first, adding debt lowers the cost of capital (because debt is
cheaper). But after a point, the cost of financial distress (risk of bankruptcy) starts rising.
Thus, there is a U-shaped relationship:
• At very low or very high debt, cost of capital is high.
• At a certain “sweet spot” (the optimal capital structure), the cost of capital is lowest,
and the value of the firm is highest.
DreamTech liked this idea because it made sense intuitively—like cooking a recipe where
too much salt or too little ruins the dish, but the right amount makes it perfect.
The Modigliani-Miller Approach – “Capital Structure Doesn’t Matter”
Then came the second advisor, Professor Modigliani-Miller (M-M), with a bold and almost
shocking statement:
“My dear DreamTech, under certain conditions, capital structure is irrelevant. It doesn’t
matter whether you finance with 100% equity, 100% debt, or a mix of both—the value of
your firm remains the same.”
The boardroom was stunned. How could that be possible?
Professor M-M smiled and explained:
• Imagine a world with no taxes, no bankruptcy costs, no transaction costs, and
perfect information.
• In this “perfect world,” investors are rational and can create their own “homemade
leverage.”
• If they want more risk, they can borrow money on their own and buy shares. If they
want less, they can adjust their personal investments.
• Therefore, it doesn’t matter what the company’s capital structure is—the firm’s
value depends only on its earning power and business risk, not on how it is
financed.
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This was called the M-M Proposition I (without taxes).
Later, M-M refined their theory. They admitted, “Okay, in the real world, taxes do exist.”
And since interest on debt is tax-deductible, using more debt gives a tax shield that
increases the firm’s value.
So, with taxes, the M-M Proposition II said:
• The more debt you take, the cheaper the weighted average cost of capital (WACC)
becomes.
• The value of the firm rises with leverage.
• In this case, the extreme conclusion is that a firm should use 100% debt financing to
maximize value.
Comparing the Two Approaches
Now DreamTech had heard both advisors and faced the classic debate. Let’s compare them:
1. On Optimal Capital Structure
o Traditional Approach: Yes, there is an optimal mix of debt and equity where
cost of capital is minimized.
o M-M (without taxes): No, capital structure is irrelevant; value doesn’t change
with debt-equity mix.
o M-M (with taxes): More debt = higher firm value, suggesting maximum debt
is best.
2. On Cost of Capital
o Traditional Approach: WACC decreases initially with debt, then increases
after a certain point (U-shaped).
o M-M (without taxes): WACC remains constant irrespective of capital
structure.
o M-M (with taxes): WACC keeps falling as debt increases, since tax shield
reduces cost.
3. On Realism
o Traditional Approach: More practical because it acknowledges both benefits
and dangers of debt.
o M-M: The “no tax” version is unrealistic, while the “with tax” version ignores
bankruptcy risk and other market imperfections.
4. Investor Perception
o Traditional Approach: Believes companies can attract investors by choosing
the right mix.
o M-M: Believes investors are smart enough to adjust leverage themselves, so
company decisions don’t matter much.
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The Criticism and Reality
After listening carefully, DreamTech realized:
• The Traditional Approach seems practical but is criticized for not giving a clear
method of finding the exact optimal point. It’s like saying, “Balance is important” but
not telling you exactly how much salt to add to the recipe.
• The M-M Approach is elegant and mathematically strong but works only in an
imaginary perfect world. Real-life companies face taxes, bankruptcy costs, agency
problems, and market imperfections, which the original M-M theory ignores.
Therefore, the truth lies somewhere in between. In practice, companies cannot ignore taxes
and bankruptcy risks. They usually adopt a moderate capital structure that balances tax
benefits of debt with the risk of financial distress.
Conclusion – The Wisdom for DreamTech Ltd.
In the end, DreamTech realized that both approaches offered valuable lessons:
• From the Traditional Approach, it learned the importance of balance—too much or
too little debt is harmful, and there exists a reasonable range of optimal capital
structure.
• From the M-M Approach, it learned that ultimately, the real driver of value is the
company’s earnings and investment decisions, not just financing choices.
So the final takeaway is:
A company must carefully weigh the benefits of debt (like tax savings) against the costs (like
bankruptcy and loss of flexibility). There is no single formula for everyone—the optimal
capital structure depends on the company’s industry, risk profile, and long-term strategy.
And that is why, even today, the debate between the Traditional Approach and the M-M
Approach continues—just like two wise philosophers arguing, both partly right and partly
wrong, but together helping us understand the fascinating puzzle of capital structure.
SECTION-C
5. From the following details you are required to make an assessment of average amount
of working capital requirement of AB Ltd. :
Items
Average period of credit
Estimate for first year (Rs.)
Purchase of Material
6 weeks
26,00,000
Wages
𝟏
𝟏
𝟐
⁄
19,50,000
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Overheads:
Rent, rates etc .
6 months
1,00,000
Salaries
1 months
8,00,000
Other Overheads
2 months
7,50,000
Sales (Cash)
-
2,00,000
Sales (Credit)
2 months
4,00,000
Average amount of stock and working progress
3,00,000
Average amount of undrawn profit
Ans: Imagine AB Ltd. as a small town where “Money” is the citizen who never sits still. Every
morning Money clocks in as raw materials, strolls through wages and overheads, puts on a
new outfit as finished goods, visits customers as “credit sales,” and finally returns home as
cash. Working capital is the travel money you must keep in Money’s pocket so this daily trip
never stops. Our job is to estimate how much travel money (average working capital) AB
Ltd. really needs, given the rhythms (credit periods) and the size of each stream.
We have these yearly figures and the time each one stays “in the pipeline” before being paid
or received:
• Purchases of materials: ₹26,00,000; suppliers give 6 weeks’ credit.
• Wages: ₹19,50,000; paid after 1½ weeks on average.
• Overheads:
o Rent & rates: ₹1,00,000; paid after 6 months (i.e., 6 months credit).
o Salaries: ₹8,00,000; paid after 1 month.
o Other overheads: ₹7,50,000; paid after 2 months.
• Sales:
o Cash sales: ₹2,00,000 (cash comes immediately).
o Credit sales: ₹4,00,000; customers pay after 2 months.
• Average Stock + Work-in-Progress (WIP): ₹3,00,000 (already given as an average
holding).
• Average undrawn profit: not provided (so we cannot adjust for it—more on this
later).
The map of the journey: Current Assets vs. Current Liabilities
Working capital = Current Assets (CA) − Current Liabilities (CL).
We’ll compute each “at any point in time,” using the credit/holding periods.
Step 1: Debtors (a Current Asset)
Only credit sales become debtors; cash sales are realized right away and do not sit as
receivables.
• Annual credit sales = ₹4,00,000
• Collection period = 2 months
• Average Debtors = ₹4,00,000 × (2/12) = ₹66,667 (approx.)
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Step 2: Stock & WIP (a Current Asset)
Given directly as an average: ₹3,00,000.
For this question, we accept this figure as it is. If details of cost structure or profit in WIP
were provided, we might adjust for the profit element, but we don’t have that information.
Step 3: Total Current Assets (so far)
We are not asked to maintain a specific minimum cash balance, and nothing else is given as
an asset. So:
• Current Assets (CA) = Debtors (₹66,667) + Stock & WIP (₹3,00,000)
= ₹3,66,667
Step 4: Trade Creditors and Accruals (Current Liabilities)
These are the bills we haven’t paid yet. Each item’s “average period of credit” tells us how
much of the annual figure is typically outstanding at any time.
To convert weeks to a fraction of the year, we’ll use 52 weeks = 1 year.
1. Creditors for Materials
Annual purchases = ₹26,00,000
Credit = 6 weeks
Outstanding = 26,00,000 × (6/52) = ₹3,00,000 (neatly!)
2. Outstanding Wages
Annual wages = ₹19,50,000
Lag = 1½ weeks = 1.5/52 of a year
Outstanding = 19,50,000 × (1.5/52) = ₹56,250 (approx.)
3. Outstanding Rent & Rates
Annual rent = ₹1,00,000
Credit = 6 months = 6/12 of a year
Outstanding = 1,00,000 × (6/12) = ₹50,000
4. Outstanding Salaries
Annual salaries = ₹8,00,000
Credit = 1 month = 1/12 of a year
Outstanding = 8,00,000 × (1/12) = ₹66,667 (approx.)
5. Outstanding Other Overheads
Annual other OH = ₹7,50,000
Credit = 2 months = 2/12 of a year
Outstanding = 7,50,000 × (2/12) = ₹1,25,000
Now sum up all current liabilities:
• Materials creditors: ₹3,00,000
• Wages outstanding: ₹56,250
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• Rent outstanding: ₹50,000
• Salaries outstanding: ₹66,667
• Other OH outstanding: ₹1,25,000
Total CL = ₹3,00,000 + ₹56,250 + ₹50,000 + ₹66,667 + ₹1,25,000
= ₹5,97,917 (approx.)
Step 5: Net Working Capital (the punchline)
NWC = CA − CL = ₹3,66,667 − ₹5,97,917 = ₹(−2,31,250) (approx.)
Yes, that’s a negative working capital requirement of about ₹2.31 lakh. What does that
mean in plain English?
What a negative figure really says
Think again about Money’s daily lap around the business. Here, suppliers and expense lags
are so generous that they finance more than the company’s current assets tied up in stock
and debtors. Put differently, the funds we owe (to suppliers and for unpaid expenses)
exceed the funds others owe us (debtors), plus the stock we hold. So, on average, AB Ltd.
doesn’t need extra cash to keep the short-term cycle moving; the cycle is self-financed by
trade credit and accruals.
This can happen in businesses that negotiate long credit on purchases and expenses, keep
lean inventories, and sell a big chunk for cash or collect quickly. In our numbers, notice:
• The materials credit alone is ₹3,00,000 outstanding—already as big as the entire
stock.
• Rent, salaries, and other overheads together leave sizable amounts unpaid at any
moment because their credit periods (especially 6 months for rent) are generous.
• Debtors are small (only ₹66,667) because credit sales are modest (₹4,00,000
annually) and get collected within 2 months. Cash sales don’t create receivables.
A quick reality check on the inputs
Two honest observations:
1. The sales figures (₹2,00,000 cash + ₹4,00,000 credit = ₹6,00,000 total) are smaller
than the combined annual costs given (purchases + wages + overheads). In real life,
that would raise a red flag: either the sales line is missing a zero (e.g., meant to be
₹20,00,000 and ₹40,00,000), or the costs reflect a larger scale than the sales. Since
the question explicitly labels them “Estimate for first year (₹),” we have to accept
them as printed for this exercise.
2. The line “Average amount of undrawn profit” is blank. Often, when we compute
working capital on a cost basis, we exclude the profit element because profit isn’t a
cash outlay; it doesn’t need financing in the same way. If the question had given a
profit margin or an average undrawn profit, we would have adjusted debtors and
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stock/WIP to remove the profit element (reducing the CA side). Here, with no data,
we cannot and should not guess—so we leave CA as given (which, if anything, makes
our CA a bit higher than it would be after profit adjustment). That means our
negative working capital is, if anything, a little conservative.
Presenting the numbers cleanly
Current Assets (CA):
• Debtors (2 months on ₹4,00,000 p.a.) ………………… ₹66,667
• Stock + WIP (given average) ………………………… ₹3,00,000
Total CA ……………………………………………………… ₹3,66,667
Current Liabilities (CL):
• Creditors for materials (6 weeks on ₹26,00,000) …… ₹3,00,000
• Outstanding wages (1.5 weeks on ₹19,50,000) ……… ₹56,250
• Outstanding rent & rates (6 months on ₹1,00,000) … ₹50,000
• Outstanding salaries (1 month on ₹8,00,000) ……… ₹66,667
• Outstanding other overheads (2 months on ₹7,50,000) ₹1,25,000
Total CL ……………………………………………………… ₹5,97,917
Net Working Capital (CA − CL) …………………… ₹(−2,31,250)
How to interpret for management (the “story ending”)
If you’re the finance manager, a negative working capital estimate isn’t automatically bad
news. In fact, it can be a sign of:
• Strong supplier credit (they are financing your cycle),
• Tight control over inventories, and
• Quick conversion of sales to cash.
However, it also carries cautions:
• If any one creditor tightens terms (say, rent is no longer 6 months in arrears), the
“free” financing shrinks and cash pressure appears.
• If credit sales suddenly rise or customers start paying slower, debtors balloon and
turn the figure positive (i.e., you’ll need more working capital).
• If stock levels rise (e.g., due to seasonality or mismatch in supply/demand), CA rises
and working capital need can flip positive.
In practice, you’d keep a small buffer (a contingency margin), and you’d revisit this estimate
whenever sales mix, credit terms, or inventory policy changes. But for the given data as it
stands, the arithmetic says the cycle finances itself and the average working capital
requirement is negative ~₹2.31 lakh.
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Final takeaway—told in one breath
Money in AB Ltd. does a neat lap: suppliers let it hang around for 6 weeks, wages wait 1½
weeks, rent and other costs politely stand in line for months, while customers, few in
number on credit, pay within two months. Stock levels are modest. All this means the
“waiting-to-be-paid” crowd (creditors and accrued expenses) is bigger than the “waiting-to-
be-received” crowd (debtors + stock). So the town of AB Ltd. doesn’t need extra pocket
money to keep the daily walk going—the town’s friends are already footing the bill. Hence,
average working capital required by AB Ltd. on these figures: nil in cash terms (indeed,
negative ~₹2.31 lakh).
6. Define Working Capital. What lactors are to be considered in determining the Working
Capital need of a concern?
Ans: The Story of Working Capital
One fine morning, a young entrepreneur named Aarav decided to start his own bakery. He
had big dreams: cakes, cookies, bread, pastries – everything fresh and delicious. But soon,
he realized that running a bakery was not just about baking; it was also about managing
money smartly.
Every day he needed flour, sugar, butter, and electricity. He also had to pay his workers their
salaries. On the other hand, customers bought cakes but sometimes paid late if they
ordered in bulk for weddings or parties. Aarav noticed something interesting: even if his
bakery looked profitable on paper, sometimes he didn’t have enough cash in hand to buy
raw materials or pay bills on time. That is when his mentor explained to him the magical
concept of Working Capital.
What is Working Capital?
In the simplest words, Working Capital is the money a business needs for its day-to-day
operations. Think of it like the daily fuel that keeps a machine running smoothly.
Formally, working capital is calculated as:
Working Capital = Current Assets – Current Liabilities
• Current Assets are resources like cash, bank balance, inventory (flour, sugar, butter
for the bakery), and money receivable from customers.
• Current Liabilities are short-term obligations like bills payable, salaries, rent, and
suppliers who need to be paid soon.
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If Aarav’s bakery has more current assets than liabilities, he has positive working capital,
which means he can smoothly run his business. But if liabilities are more, then he has
negative working capital, which signals trouble – he might struggle to pay his bills.
So, working capital is like the bloodstream of a business. No matter how good the bakery is,
without healthy working capital, it cannot survive.
Why is Working Capital Important?
To understand this, let’s imagine two bakers:
1. Aarav (who manages working capital well)
o He always has enough flour, sugar, and butter in stock.
o He pays his workers on time.
o Customers are happy because deliveries are on schedule.
o His business grows steadily.
2. Rahul (who ignores working capital)
o Sometimes he runs out of flour because he didn’t have money to buy it in
advance.
o His workers get their salaries late and start looking for new jobs.
o Customers cancel orders because cakes are delayed.
o Even though Rahul has a nice bakery, he slowly starts losing his reputation.
This little comparison shows that working capital is not just about money – it is about the
smooth functioning and survival of the business.
Factors Affecting the Need for Working Capital
Now let’s dive into the second part of the question. Every business, whether small like
Aarav’s bakery or huge like a car manufacturing company, needs to carefully determine how
much working capital is required. But the need is not the same for everyone. It depends on
several factors. Let’s explore them like different characters in Aarav’s bakery story.
1. Nature of Business
Some businesses need more working capital than others.
• Aarav’s bakery (manufacturing + selling food) needs regular raw materials and
ingredients. So he requires more working capital.
• But a software company that just needs laptops, internet, and skilled programmers
doesn’t need to store flour or sugar. Its working capital needs are relatively lower.
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So, the more the business depends on raw materials and inventory, the more working
capital it will need.
2. Size of Business
Larger businesses usually need more working capital. Aarav’s small bakery in one lane
requires less working capital than a bakery chain with 50 outlets across the city. Bigger the
size, bigger the cash requirement for smooth operations.
3. Production Cycle
The production cycle means the time between buying raw materials and selling the finished
product.
• In a bakery, Aarav buys flour today, bakes bread tomorrow, and sells it within 2 days.
So the cycle is short, and his working capital requirement is moderate.
• But in shipbuilding, where a single ship takes years to build, the working capital
requirement is huge because money gets stuck for a long time before sales happen.
4. Credit Policy
Suppose Aarav sells cakes to local customers on cash, but for weddings, he gives credit of 30
days. During those 30 days, his money is stuck, and he still has to pay suppliers. If he is too
generous in giving credit, his working capital requirement will increase.
On the other hand, if customers always pay instantly, his need for working capital will be
lower.
5. Seasonal Demand
During Diwali, Christmas, or wedding season, Aarav’s bakery gets flooded with orders. He
needs extra ingredients, extra packaging, and even extra staff. So, during festivals, his
working capital requirement shoots up. But in the off-season, the requirement is less.
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6. Operating Efficiency
If Aarav manages his stock properly (not over-buying flour or letting bread go stale), he
saves money and reduces his working capital need. Efficient businesses require less working
capital, while poorly managed businesses waste money and need more.
7. Business Growth and Expansion
If Aarav decides to open three new bakery outlets, he will need additional raw materials,
furniture, machines, and staff. Rapidly growing businesses require higher working capital to
fuel their expansion.
8. Nature of Raw Materials and Finished Goods
Some raw materials are perishable, like milk and eggs, which cannot be stored for long.
Aarav has to keep buying them frequently, which means steady working capital usage. But
industries dealing with non-perishable goods (like steel) can store stock for longer, reducing
frequent working capital needs.
9. External Factors
Economic conditions, inflation, government policies, and market competition also affect
working capital needs. For example, if sugar prices suddenly rise due to government tax
changes, Aarav will need more working capital to buy the same amount of sugar.
Wrapping It Up Like a Story Ending
So, in Aarav’s bakery tale, we learned that working capital is like oxygen for a business. It
may not be directly visible like profit or loss, but without it, survival becomes difficult.
To summarize in simple words:
• Working Capital = Current Assets – Current Liabilities
• It ensures smooth day-to-day operations of a business.
• Factors like nature of business, size, production cycle, credit policy, seasonal
demand, and efficiency decide how much working capital is needed.
If a business manages its working capital wisely, it runs like a well-oiled machine. If ignored,
even the best ideas can collapse.
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So, whether it’s a tiny bakery on the corner of the street or a giant automobile company,
working capital is the heartbeat that keeps the business alive.
SECTION-D
7. A company has two investment proposals, each costing Rs. 1,00,000 and each having
expected cash inflows as follows:
Year
Project A (Rs.)
Project B (Rs.)
1
50,000
20,000
2
40,000
40,000
3
30,000
50,000
4
10,000
60,000
After giving due consideration to project scenario, the management has decided that
project A should be evaluated at 10% cost of capital and project B should be evaluated at
15% cost of capital. Compute, NPV, Payback Period, Profitability Index for both the
projects and suggest the course of action for the management if:
(a) Both the projects are independent
(b) Both the projects are mutually exclusive.
Ans: A Story of Two Competing Investments
Once upon a time, there was a company with some extra money in hand—Rs. 1,00,000 to
be exact. The management was excited but also cautious. They had two golden
opportunities (Project A and Project B) in front of them. Each project required exactly Rs.
1,00,000 of investment, but the way they promised to return money was completely
different.
Here’s how these two projects promised to pay back over 4 years:
Year
Project A (Rs.)
Project B (Rs.)
1
50,000
20,000
2
40,000
40,000
3
30,000
50,000
4
10,000
60,000
The twist in the story?
• Management said: “Project A is a bit less risky, so we will evaluate it at 10% cost of
capital.”
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• And for Project B: “This one is slightly riskier, so we’ll evaluate it at 15% cost of
capital.”
Now, the company had three important questions to answer:
1. How much wealth will each project add? (That’s called Net Present Value – NPV)
2. How quickly can we recover our money? (That’s Payback Period)
3. How attractive is each project per rupee invested? (That’s Profitability Index – PI)
And finally, the big decision:
• If the projects are independent (both can be taken), should we accept both?
• If the projects are mutually exclusive (only one can be chosen), which one should we
pick?
Let’s solve this puzzle step by step like detectives.
Step 1: Net Present Value (NPV)
Formula:
For Project A (Discount rate = 10%)
We discount each year’s inflow at 10%:
Total PV of inflows = 45,450 + 33,040 + 22,530 + 6,830 = 1,07,850
So,
For Project B (Discount rate = 15%)
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We discount each inflow at 15%:
Total PV of inflows = 17,400 + 30,240 + 32,900 + 34,320 = 1,14,860
So,
Conclusion: Project B gives a higher NPV than Project A.
Step 2: Payback Period (PP)
Formula:
For Project A
• End of Year 1: 50,000 recovered. (Still 50,000 left)
• End of Year 2: +40,000 → Total 90,000 recovered. (Still 10,000 left)
• End of Year 3: +30,000 → Already crossed 1,00,000.
So, payback happens in Year 3.
More precisely:
For Project B
• End of Year 1: 20,000 recovered. (Still 80,000 left)
• End of Year 2: +40,000 → Total 60,000 recovered. (Still 40,000 left)
• End of Year 3: +50,000 → Already crossed 1,00,000.
So, payback happens in Year 3.
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More precisely:
Conclusion: Project A recovers faster than Project B.
Step 3: Profitability Index (PI)
Formula:
Conclusion: Project B is more profitable per rupee invested.
Final Comparison
Criteria
Project A
Project B
Better
NPV
Rs. 7,850
Rs. 14,860
B
Payback Period
2.33 years
2.8 years
A
Profitability Index
1.0785
1.1486
B
Decision Making
(a) If projects are independent:
• Since both NPVs are positive, both projects add wealth.
• The company should accept both Project A and Project B.
(b) If projects are mutually exclusive:
• We have to pick the better one.
• Project A is quicker in returning money, but Project B gives a much higher NPV and
PI.
• Management’s goal is wealth maximization → so choose Project B.
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8. Critically discuss Walter dividend model. Does dividend policy affect the value of firm
under Walter model? Illustrate.
Ans: A Cup of Tea and a Question
Imagine you are sitting in a small tea shop with your friend. As you sip your hot tea, your
friend suddenly asks:
“Do you think a company’s decision to pay dividends or to keep the profits for reinvestment
really changes the value of the company?”
At first, it sounds like a tricky question. After all, both actions involve the same money —
either it is handed to shareholders today or kept within the business to grow tomorrow. But
this question is exactly what James E. Walter tried to answer through his famous Walter’s
Dividend Model. His theory became one of the most talked-about discussions in finance,
sparking debates on whether dividend policy truly affects the value of a firm.
So, let’s walk through this model together like a story — who Walter was, what he said, why
he said it, and finally, whether dividends really change a company’s worth.
The Heart of Walter’s Idea
Walter’s model is built on a very simple logic: the choice between distributing profits as
dividends or reinvesting them depends on the relationship between two key rates:
1. r = the internal rate of return on investments (basically, how much profit the
company can generate from reinvesting earnings).
2. k = the cost of capital or required rate of return (basically, what shareholders expect
to earn on their money elsewhere).
Now, according to Walter:
• If the company can earn more on reinvested profits (r > k), it should retain earnings
instead of paying dividends.
• If the company earns less on reinvestments (r < k), it should pay dividends instead,
because shareholders can earn more by investing elsewhere.
• If both are equal (r = k), then it doesn’t matter — dividend policy becomes irrelevant.
Thus, Walter linked the firm’s value directly to the dividend decision.
The Formula – Not as Scary as It Looks
Walter expressed his model through this formula:
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Where:
• P = Price of the share (or value of the firm)
• D = Dividend per share
• E = Earnings per share
• r = Internal rate of return
• k = Cost of capital
This formula shows that the share’s price depends not only on dividends (D) but also on how
much profit is retained (E – D) and reinvested at return r.
Let’s Understand With a Simple Story Example
Think of a small bakery owned by Ramesh. Every year, the bakery earns ₹10,000 as profit.
Now Ramesh has two choices:
1. He can pay the whole ₹10,000 to himself as dividend.
2. Or he can reinvest the money into the bakery — maybe buy a new oven, add new
recipes, or open a small stall.
• If his bakery business gives him 20% return (r = 20%), but banks only give 10%
interest (k = 10%), then clearly Ramesh should reinvest. Keeping profits in the bakery
increases the overall value of his business more than simply taking it out as
dividends.
• On the other hand, if his bakery is only able to earn 8% return (r = 8%), while banks
give 10% (k = 10%), then Ramesh is better off taking dividends and investing that
money elsewhere.
This simple bakery example is exactly what Walter explained for companies: the dividend
policy matters, and the firm’s value changes depending on r and k.
Situations Under Walter’s Model
1. Growth Firm (r > k):
o Here, the company’s projects earn more than shareholders expect elsewhere.
o Best decision → Retain profits.
o Result → Firm value increases as reinvestment generates wealth.
o Example: Think of an IT start-up that can reinvest profits into AI projects
yielding 25% return, while shareholders expect only 15%. Such a firm should
avoid paying dividends.
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2. Declining Firm (r < k):
o The company’s projects earn less than what shareholders could earn outside.
o Best decision → Pay dividends.
o Result → Shareholders can invest their dividends in better opportunities.
o Example: A traditional textile company earning only 8% while investors
expect 12%. Paying dividends is wiser.
3. Normal Firm (r = k):
o Both options give the same result.
o Dividend policy is irrelevant.
o The firm’s value remains unchanged whether it pays dividends or reinvests.
Does Dividend Policy Really Affect the Value?
Now comes the big question: Does dividend policy affect the value of the firm under
Walter’s model?
The answer is: Yes, but conditionally.
• In the real world, most companies are not in the exact “r = k” situation.
• For growth firms, retention boosts value.
• For declining firms, dividends boost value.
Thus, under Walter’s framework, dividend policy plays a critical role in determining
firm value.
Criticisms of Walter’s Model
Though elegant, Walter’s model is not perfect. It assumes an overly simple world. Let’s look
at its major limitations:
1. All-financing from retained earnings: Walter assumes firms rely only on retained
profits for investment and never use external funds. In reality, companies often
borrow or issue shares.
2. Constant r and k: He assumes the rate of return and cost of capital remain constant,
which rarely happens in dynamic markets.
3. No taxes: The model ignores corporate taxes, capital gains tax, and dividend
distribution tax, which play a huge role in real decision-making.
4. Infinite life of firm: It assumes firms continue forever with constant profitability.
Reality is more uncertain.
Despite these limitations, Walter’s model remains important because it opened the
discussion on how dividends can affect valuation.
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The Human Side of the Model
Think about it this way: Walter was essentially telling managers and investors — “Don’t just
blindly love dividends or hate them. Look at the company’s ability to reinvest. That’s what
decides whether dividends add or destroy value.”
It’s like in life: if you have an opportunity to invest in yourself (say, a skill that gives you
double returns later), you should reinvest your earnings instead of spending them
immediately. But if your opportunities are weak, better take the money and put it where it
grows more.
Conclusion
Walter’s Dividend Model may look like a finance formula, but at its core, it is a simple life
lesson: the value of money depends on how effectively it is used.
• If a company can use money better than shareholders, retain it.
• If shareholders can use it better, distribute it.
• If both are equal, the dividend decision doesn’t matter.
So yes, under Walter’s model, dividend policy does affect the value of the firm — but only
because of the relationship between the firm’s return (r) and shareholders’ expectation (k).
Even though the model has limitations, it continues to be a foundation stone in finance
theory. It reminds managers to think carefully before declaring dividends and shows
investors how to judge a firm’s decision.
Just like Ramesh at his bakery, every company faces the same timeless question: Should I
keep the profits for growth, or should I return them to my people? Walter gave us a lens to
answer it logically, and that’s why his model is still studied, debated, and respected today.
“This paper has been carefully prepared for educational purposes. If you notice any mistakes or
have suggestions, feel free to share your feedback.”
