Chapter-1

Financial Planning and Forecasting of

Financial Statement
 Strategic Plans
• Strategic plans are the stream of long term plans to help
achieve corporate objectives.
• Strategic planning is a tools for organizing the present on
the basis of the projections of the desire future.
• Strategic plan is a road map to lead an organization from
where it is now to where it would like to be five or ten
years.
• Strategic planning is the process of clarifying an
organization’s mission, then identifying goals, strategies
and resources needed to achieve that mission.
• Strategic planning is an important function of top-
management.
 Strategic planning enables the
manager to answer several questions
including:
• What is the organization’s position in the
market?
• What does the organization want the position
to be?
• What trends and changes are occurring in the
market?
• What are the best alternatives to help achieve
these goals?
 Elements of Strategic Plans

-Attaining 50% market share

-20% ROE
-10% ROE

Strategies -We exits to create

Plans value our
-Assessing situation shareholders
-SWOT analysis

-Limits its production so soft drinks, but on a global geography

scale
• The corporate purpose states the general
philosophy of the business.
• The corporate scope states the line of
business and geographical area of operation
of a business.
• The objectives are goals that guide
management to achieve desired outcomes.
• The strategies are broad action plans to attain
the goals.
 Operating Plans
• Operating plans provide detailed implementation
guidance, based on the corporate strategy, to
help meet the corporate objectives.
• Operating plan is a detail guideline for effective
implementation of corporate strategies, which
helps achieve corporate objectives.
• Operating plans could be formulated for any time
horizon; however, five year planning horizon is
the most common practices.
 Operating plans
Policy
-Motivated Budget
-Guidance -Statement of cost &
-Limitation of workers income

Operating
Plans
Rules Process
-No smoking -Received order
No entry with out -called tender
permission -Selection of suppler
-Send the procurement order
-Check of inventory
-Payment of bill
 Financial Plans
• The financial plan refers to the projection of
future financial course of action carried out for
efficient execution of operating plans and
effective accomplishment of corporate objectives.
• Financial plan is the important part of operating
and existence of any firm as it provides road map
for guiding, co-ordating and controlling the firm’s
financial action in order to achieve its objectives.
 Process of Financial Plans
Projecting financial statement

Determine Funds Required

Forecasting Funds Availability

Financial
Establishing and maintaining a
plans
system of control

Developing procedures for

adjusting the basic plans

Establishing performance
based compensation system
 Sales Forecast
• Sales forecasts are the forecast of firm’s units and rupees
for some future period; it is generally based on past and
recent sales trends plus forecasts of the economic
prospects for the nation, region, industry and so forth.
• There are some of the factors which should be considered
well before making or developing sales forecast;
-Divisional forecast
-Economic activity forecast
-Forecasting marketing strategy
-Combination of inflation with sales growth
-Advertising campaigns, promotional discounts, credit terms
etc.
Financial Planning and Forecasting
• Financial planning is the projection of sales, income
and assets based on alternative production and
marketing as well as the determination of the
resources needed to achieve these projections.
• Financial forecasting is an integral part of financial
planning. It uses past data to estimates the future
financial requirements.
• The process of estimating the fund requirement of the
firm and determining the sources of fund is called
financial planning and forecasting, the implementation
of financial planning is called financial control.
 Methods of Financial Forecasting
• There are various methods of financial
forecasting. The one of the most method is
percent of sales method.
• It is one of the simple methods of forecasting
financial statement variables.
• Application of this method is based on the two
basic assumptions;
-Frist, all items of balance sheet except some
liabilities are proportionately related to sales
volume.
-Second, most of the current balance sheet items
are justifiable for the current sales volume.
 Percentage Sales Methods
Step 1. Forecasted income statement:
The first step in using the percentage of sales method is to forecast
the next year’s income statement to estimate income and additional to
retained earnings. Forecasted income statements are the following
assumption.
• The percentage of sales method assumes initially that all costs
except depreciation are a specified percentage of sales.
• Fixed cost will be increased, if the company operate at fully
capacity.
• Interest amount and tax rate are remained constant but interest
amounts are changed when external financing requirement are
analyze in a later steps.
• If all income is not paid in dividend then retained earnings will
increase.
 Illustration 1

Income statement of XYZ Company for 2016

Sales revenue Rs.500,000
Cost of goods sold (200,000)
Gross profit 300,000
Fixed operating cost (Depreciation) (100,000)
EBIT 200,000
Interest (50,000)
EBT 150,000
Tax (40%) (60,000)
Net income 90,000
Dividend (60%) (54,000)
Additional to returned earnings 36,000
In 2017, the sales are expected to increased by 25%
Required:
(i) Prepare forecasted income statement assuming that the company is operating at fully capacity.
(ii) Prepare forecasted income statement assuming that the company is not operating at fully
capacity.
Solution :
(i) Forecasted Income Statement of xyz company for 2017 (Fully capacity
assumption)
Particular Forecast for 2006
Sales revenue (1.25) 625,000
Less: Cost of goods sold (1.25) 250,000
Gross profit 375,000
Less: Fixed operating expenses (1.25) 125,000
EBIT 250,000
Less: Interest 50,000
EBT 200,000
Less: Tax (40%) 80,000
Net Income 120,000
Less: Dividend (60%) 72,000
Additional to Return earning 48000
Note: if dividend payout ratio is not given:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 54000
DPR or D/P ratio = = =0.60 or 60%
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 90000
𝑁𝑒𝑤 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 −𝑂𝑙𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
Growth rate in dividend(g) = ×100
𝑂𝑙𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
72000 −54000
= ×100 = 33.33%
54000
(ii)Forecasted Income Statement for 2017 (Sufficient idle capacity assumption)
Particular Forecasted for 2006
Sales (1.25) 625,000
Less: Cost of goods sold (1.25) 250,000
Gross profit 375,000
Less: Fixed operating expenses 100,000
EBIT 275,000
Less: Interest 50,000
EBT 225,000
Less: Tax (40%) 90,000
Net Income 135,000
Less: Dividend (60%) 81,000
Additional to Return earning 54000
Step 2. Forecast the balance sheets :
The second step in using the percentage of sales methods is to forecast the next year’s balance sheet to estimate the
additional fund needed. Forecast the balance sheets are the follows assumptions.
• All assets accounts can be assumed to increase directly as percentage of sales, if firm operating at fully capacity
used.
• If the firm is not operating at fully capacity used then fixed assets will not change but all current assets will
increase as a percentage of sales.
• All current liabilities accounts (i.e. account payables, creditors, bills–payable, and accruals except notes–payable)
can be expected to increase spontaneously with sales.
• All other financial accounts such as note–payable, long–term debts, preferred stocks and common stocks are not
directly related to sales.
• AFN can be determined the projected the total assets minus projected total liabilities and equity capital.
• The firm raises the AFN through borrowing or by selling new common stocks.
• Additional retained earnings can be calculated by using the following equation.
Additional retained earnings = S1  M  b
Where,
S1 = Projected sales
M = Profit margin
b = retention ratio
b = 1 – D/P ratio
D/P ratio = Dividend payout ratio
 illustration

The balance sheet of a company as on 31st Dec. 2016 is shown below:

Liabilities Amount Assets Amount
Account payable 2000 Cash 500
Notes payable 500 Receivable 4500
Accrued wages and taxes 2500 Inventories 10000
Total current liabilities 5000 Total current asset 15000
Mortgage bonds 7500 Net fixed assets 15000
Share capital 2500
Retained earnings 15000
Total liabilities and equity 30000 Total assets 30,000

The company is operating at fully capacity and sales amounting Rs.20,000. The profit margin on
sales was 10% and distributed 60% after tax profit to the shareholders. The company expects sales to
increase to Rs.30,000. How much additional financing will the capacity required?
Given,
Old sales (So) = Rs.20,000
Profit margin (M) = 10%
Dividend payout ratio (DPR) = 60%
Retention ratio (b) = 1- DPR = 1-0.60= 0.40
New sales (S1) = Rs.30000
𝑆1−𝑆𝑜
Growth rate in sales (g) = = 𝑅𝑠.30000−𝑅𝑠.20000 × 100 = 50%
𝑆𝑜 𝑅𝑠.20000

Additional fund needed (AFN) = ?

 Projected Balance Sheet
Liabilities Amount Assets Amount
Account payable(1.50) 3000 Cash(1.50) 750
Notes payable 500 Receivable(1.50) 6750
Accrued wages and taxes(1.50) 3750 Inventories(1.50) 15000
Total current liabilities 7250 Total current asset 22500
Mortgage bonds 7500 Net fixed assets(1.50) 22500
Share capital 2500
Retained earnings(15000+1200) 16200
Additional funds 11550*
Total liabilities and equity 45,000 Total assets 45,000
Working note:
Additional retained earning = S1× M×b = Rs.30000×0.10×0.40 = Rs.1200
Illustration 3.
The company planned to tap 25% of funds from notes payable, 60% through issue of common
stock and rest from issue of bond. Prepare the balance sheet after adjusting above financing sources.
Solution:
Projected Balance Sheet

Liabilities Amount Assets Amount

Account payable 3000 Cash 750
Notes payable 3387.5 Receivable 6750
Accrued wages and taxes 3750 Inventories 15000
Total current liabilities 10137.5 Total current asset 22500
Mortgage bonds 9232.5 Net fixed assets 22500
Share capital 9430.
Retained earnings 16200
Total liabilities and equity 45,000 Total assets 45,000
Financing plan:
25
Notes payable =  Rs.11550 = Rs.2887.5
100
15
Bonds =  Rs.11550 = Rs.1732.5
100
60
Common stock =  Rs.11550 = Rs.6930
100
Most firms forecast there capital requirement by
construction pro–forma income statements and
balance sheets as described above. If the ratios
are expected to remain constant, then the
following formula can be used to forecast
financial requirement.
𝐴∗ 𝐿∗
AFN = ( - ) S – S1  M  b
𝑆0 𝑆0
AFN = (A*% – L*%)  S – S1  M  b
A* = A designates total assets ,if the firm is operating at fully capacity.
S0 = Sales during the last year
𝐴∗
= Assets to sales ratio or capital intensity ratio.
𝑆𝑜
L* = Current liability except notes payables
𝐿∗
= Liabilities that increase spontaneously as a percentage of sales or
𝑆0
spontaneously generate financing per Rs.1 increase in sales.
S1 = Total projected sales for next year.
S = Change in sales = S1 – S0
M= Profit margin or profit per Rs.1 of sales (M = )
b= Retention ratio
b = 1- D/P ratio (DPR)
𝐷𝑃𝑆 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
D/P ratio = or
𝐸𝑃𝑆 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
 𝐴∗
1. Capital intensity ratio =
𝑆0
𝐴∗
2. Additional investment in assets = × S
𝑆0
𝐿∗
3. Additional amount of spontaneous financing = × S
𝑆0
4. Additional to retained earning = S1  M  b
Solution:
𝐴∗ 𝐿∗
AFN = ( - ) S – S1  M  b
𝑆0 𝑆0
𝑅𝑠.30000 𝑅𝑠.4500
= ( - ) Rs.10000 – Rs.30000  0.10  0.40
𝑅𝑠.20000 𝑅𝑠.20000
= Rs.11550
5. Total assets =Total debt + Total equity
[Link] debt = Current liability + Long term debt
[Link] equity = Common stock + Retained earning
 Percentage of external fund
requirement (PEFR)
Percentage of increase in sales that will have to be financed externally
(percentage of external fund required or PEFR) as a function of the
critical variables involved in calculated by using following formula.
𝐴∗ 𝐿∗ 𝑀𝑏
PEFR = ( - ) – (1 + g)
𝑆0 𝑆0 𝑔

Illustration 5.
Sakha company has the percentage of relevant assets on sales is 65
percent and percentage of trade liabilities on sales is 25 percent. The
profit margin of the company is 8 percent and dividend payout ratio is
50 percent. If its growth rate on sales is 15 percent per year. Find the
percentage of the sales increase in coming year must be financed
externally.
 solution
Given
Percentage of relevant assets on sales (A*/S0) = 60% or 0.65
Percentage of trade liabilities on sales (L*/S0) = 25% or 0.25
Profit margin (M) = 8% or 0.08
Dividend payout ratio = 50% or 0.50
Retention ratio (b) = 1 – 0.50 = 0.50
Growth rate on sales (g) = 15% or 0.15
PEFR =?
We have,
𝐴∗ 𝐿∗ 𝑀𝑏
PEFR = (𝑆0 - 𝑆0) – (1 + g)
𝑔
0.08×0.50
= (0.65 – 0.25) – 0.15 × (1 + 0.15)
= 0.40 – 0.3067 = 0.0933 or 9.33%
Therefore, 9.33% of sales increase must be financed externally when sales
increase by 15% per year.
 Factor affecting the AFN
(a) Sales growth (S) :
Rapidly growing companies require large increases in assets, other things held constant, hence the
higher the need for external financing.
(b) Capital intensity :
The amount of the assets required per rupee of sales, is called Capital intensity ratio. This ratio has a
major effect on capital requirements. Companies with higher assets to sales ratios require more assets
for a given increase in sales, hence a greater need for external financing.
(c) Spontaneous liabilities to sales ratio :
Companies that spontaneously generate a large amount of liabilities from accounts payable and
accruals will have a relatively small need for external financing.
(d) Profit margin (M) :
The higher profit margin, the larger the net income available to support increases in assets, hence the
lower the need external financing.
(e) Retention ratio (b):
Companies that retain more their earnings as opposed to paying them out as dividend will generate
more retained earning and thus have less need for external financing.
𝐴∗ 𝐿∗
AFN =( - ) S – S1  M  b
𝑆0 𝑆0
 Excess capacity adjustment Method
Illustration 8.
XYZ Company has Rs.3 million in sales and Rs.1.5 million in fixed assets. Currently, the company’s fixed
assets are operating at 90 percent of capacity.
(a) What level of sales could xyz have obtained if it has been operating at full capacity?
(b) What is XYZ‘s target assets / sales ratio?
(c) If XYZ’s sales increase 15 percent, how large of an increase in fixed assets would the
company need in order to meet its target fixed sales ratio.
Solution:
Given,
Sales = Rs.3million or Rs.30,00,000
Fixed assets = Rs.1.5 Million or Rs.15,00,000
Fixed assets operating capacity = 90% or 0.90
(a) Level sales for fully capacity
We have,
𝐴𝑐𝑡𝑢𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝑅𝑠.30,00,000
Fully capacity sales = = =Rs.33,33,333.33
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦 𝑢𝑠𝑒𝑑 0.90
(b) Target fixed assets/ Sales ratio
We have,
𝐴𝑐𝑡𝑢𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 𝑅𝑠.15,00,000
Target fixed assets to sales = 𝐹𝑢𝑙𝑙 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦 𝑠𝑎𝑙𝑒𝑠 = 𝑅𝑠.33,33,333.33 = 0.45 or 45%
(c) Percentage increase in sales = 15%
Old fixed assets = Rs.1500000
Old sales = Rs.3000000
Increase in fixed assets =?
Now,
New sales = Old sales (1 + % increased in sales)
= Rs.3000000 (1 + 0.15) = Rs.3450000
Required level of fixed assets (new fixed assets)
= (Target fixed assets to sales ratio)  Projected sales
= 0.45  Rs.3450000 = Rs.1552500
Increase in fixed assets = New fixed assets – old fixed assets
= Rs.1552500 – Rs.1500000 = Rs.52500
 Complied by
Shiva Raj Ghimire
Saraswati Multiple Campus
Lakhanathmarg, Kathmandu
Unit 2 : Portfolio Theory and Capital assets Pricing Model

Meaning of portfolio
Portfolio means making investment in more than one alternative at the same time. It is also called
investment diversification or combination of investment. The portfolio theory was developed by Harry
M. Markowitz on 1952, so it is also explain as the Markowitz portfolio. He was received the ‘Nobel
prize in economics’ in 1990 for developing ‘the theory of portfolio selection’.

‘Do not put all your eggs in one basket’. If whole fund is invested in a particular asset or stock (share),
risks become higher. But the investment is made in more than one asset, risk become lover because
port from one area can compensate the loss in another asset. So investors, banks and other financial
institutions prefer investment diversification. The main objective of portfolio is ; (a) Minimizing risk (b)
Maximizing return. Based on investors’ attitude towards risk, there are three types of investors.

a. Risk averter (who prefer less risky investment because they shy away from risk) – low CV.
b. Risk seeker (who prefer high risky investment because they enjoy risk) – High CV.
c. Risk neutral (risk neutrals investors are indifferent to risk)

Portfolio Return
1. Portfolio realized return
RP = WA × RA + WA × RB
2. Portfolio expected or average return

RP = WA × RA + WB × RB

WA + W B =1

WA = Weight on investment A

WB = Weight on Investment B

The portfolio returns on N assets case

RP = WA × RA + WB × RB + WC × RC

Illustration 7

Suppose Mr. Sharma purchase 200 shares of stock XYZ at Rs 200 each and 300 shares of stock ABC at Rs
200 each he expects the rate of return from XYZ and ABC are 15% and 20% respectively, Calculate his
portfolio return.

Solution :

First : Calculation of weighted for each stock

Stock No. of shares Price per share Value of shares Weighted (w)
 XYZ 200 Rs 200 Rs 4000 0.40 or 40%
ABC 300 Rs 200 6000 0.60 or 60%
Total 10000 1or 100%

RP = WA × RA + WB × RB

= 0.40× 15% +0.60×20% =18%

Portfolio Risk(standard deviation)

P = WA2 . A2 + WB2 . B2 + 2COVAB WA . WB

Illustration 8

There are two assets and three states of economy with following probabilities and rate of return on
stock R and stock S.
State of economy Probability of state of Rate of return on
economy stock
A B
Recession 0.20 –15% 20%
Normal 0.50 20 30
Boom 0.30 60 40
(a) Find out the expected return on each stock.
(b) Find out standard deviation on each stock.
(c) Find out expected return and standard deviation on portfolio if you put Rs.15000 in stock A and
Rs.5000 in stock B given total investment of Rs.20000.
Solution
Ps RA RB [Link] RA –RA Ps(RA –RA)2 [Link] RB –RB Ps(RB –RB)2 PS( RA –RA)( RB –RB)
0.20 -15% 20% -3 -40 320 4 -11 24.2 88
0.50 10 30 10 -5 12.5 15 -1 0.5 2.5

0.30 60 40 18 35 367.5 12 9 24.3 94.5

PS( RA –RA)( RB –RB)= 185
∑PS. RA =25 ∑PS.(RA–RA)2= 700 ∑PS. RB =
11.6 ∑PS. (RB – RB)2 = 49
a. Expected return on stock A (RA) = ∑PS. RA = 25%; 
Expected return on stock B (RB) = ∑PS. RB = 11.6%

b. Standard deviation of stock A (A ) = ∑PS. (RA –RA)2 = 700 = 26.46%

Standard deviation of stock B (B ) = ∑PS. (RB – RB)2 = 49 = 7%
COVAB = PS( RA –RA)( RB –RB)= 185
 c. Investment amount of stock A = Rs.15000
Investment amount of stock B = Rs.5000
Total investment = Rs.15000 + Rs.5000 = Rs.20000
Rs15000
Weighted of stock A = Rs20000 = 0.75
Rs.5000
Weighted of stock B = Rs.20000 = 0.25
Now

RP = WA × RA + WB × RB

= 0.75 × 25% + 0.25 × 31% = 26.5%

P = WA2 . A2 + WB2 . B2 + 2COVAB WA . WB

= (0.75)2  (26.46)2 + (0.25)2  (7)2 + 2  185  0.75  25

= 393.824 + 3.0625 + 69.375 = 21.59%

Illustration 9
Stocks A and B have the following historical returns:
Year Stock A's Returns, kA Stock B's Returns, kB
2010 (18.00)% (14.50)%
2011 33.00 21.80
2012 15.00 30.50
2013 (0.50) (7.60)
2014 27.00 26.30
(a) Calculate the average rate of return for each stock during the period 2010 through 2014.
(b) Assume that someone held a portfolio consisting of 50 percent of stock A and 50 percent of Stock
B. What would have been the realized rate of return on the portfolio in each year from 2010
through 2014? What would have been the average return on the portfolio during this period?
(c) Calculate the standard deviation of returns for each stock and for the portfolio.
(d) Calculate the coefficient of variation for each stock and for the portfolio.
(e) If you were a risk-averse investor, would you prefer to hold Stock A, Stock B, or the portfolio?
Why?
Solution

a. Average rate of return for each stock

Year RA RB
2010 -18% -14.5%
2011 33 21.8
2012 15 30.5
2013 -0.50 -7.60
2014 27 26.30
 n=5 ∑RA = 56.5 ∑RB = 56.5

RA 56.5 RB 56.5

RA = n = 5 = 11.3% RB = n = 5 = 11.3%

b. Realized rate of return on portfolio

Year RA RB RP = WA × RA + WA × RB

2010 -18% -14.5% 0.50 × -18% + 0.50 × -14.5% = -16.25%

2011 33 21.8 0.50 × 33 + 0.50 × 21.8 = 27.4
2012 15 30.5 0.50 × 15 + 0.50 × 30.5 = 22.75
2013 -0.50 -7.60 0.50 × -0.50 + 0.50 × -7.60 = -4.05
2014 27 26.30 0.50 × 27 + 0.50 × 26.30 = 26.65
∑RP = 56.5
Expected return on portfolio (RP) = WA × RA + WB × RB
= 0.50 × 11.3% + 0.50 × 11.3% = 11.3%
RP 56.5
Or RP = n = 5 = 11.3%
c. Calculation of standard deviation for each stock and portfolio.
Year RA –RA (RA –RA)2 RB –RB (RB –RB)2 (RA –RA)( RB –RB)

2010 -29.3 858.49 -25.8 665.64 755.94

2011 21.7 470.89 10.5 110.25 227.85
2012 3.7 13.69 19,2 368.64 71.04
2013 -11.8 139.34 -18.9 357.21 223.02
2014 15.7 246.49 15 225 235.5
n=5 ∑(RA–RA)2= 1728.80 ∑(RB–RB)2 = 1726.74 ( RA –RA)( RB –RB)=1513.35

∑(RA –RA)2 1728.80

A = n –1 = 5 – 1 = 20.8%

∑(RB – RB)2 1726.74

B = n –1 = 5 – 1 = 20.8%

(RA – RA) (RB – RB) 1513.35

COVAB = n–1 = 5 –1 = 378.3375

COVAB 378.3375
rAB = = = 0.874
AB 20.8  20.8

Portfolio risk or portfolio standard deviation

P = WA2 . A2 + WB2 . B2 + 2COVAB WA . WB
= (0.50)2  (20.8)2 + (0.50)2  (20.8)2 + 2  378.3375  0.50  0.50
= 20.1%
 d. Coefficient of variation
A 20.8
CVA = = = 1.84
RA 11.3
B 20.8
CVB = = = 1.84
RB 11.3
P 20.1
CVP = = = 1.78
RP 11.3

e. If I am a risk- averse investor, i would prefer to hold the portfolio because standard deviation
and coefficient of variation for the portfolio are lower than stock A and B.
Alternatively

Year RP RP –RP (RP –RP)2

2010 -16.25%
2011 27.4
2012 22.75
2013 -4.05
2014 26.65
n=5 ∑(RB–RB)2 = 1726.74

∑(RP –RP)2
P = n –1 =

Minimum variance of portfolio

B2 – COVAB
WA =
A + B2 –2 COVAB 2

WB = 1 - WA
For example

Stock Expected Return Standard deviation Covariance

A 20% 30% 45
B 12% 15%
Calculate the expected return and risk(SD) of portfolio if WA =
100%,80%,60%,40%,20%,0%.

25

20
Portfolio return (%)

15

10

5
Efficient Portfolios
Efficient portfolio may be defined as the portfolio which;

• Provides the highest possible expected return for any degree of risk
• The lowest possible degree of risk for any expected return.
Portfolio Expected return Standard deviation (Risk)

A 8% 4%
B 8 6
C 10 4
Risk- Return Indifferent Curve
An indifference curve is the line connecting different portfolio (based on risk and return of portfolio)
providing an equal level of satisfactory or utility to the investors. In other words, an indifference curve is
defined as the line connecting different portfolio which the same utility or level of satisfaction to the
[Link] can be drawn on two dimension figure where the horizontal line indicates risk as measured
by the standard deviation and the vertical axis indicates reward as measured by expected rate of return.
Risk return indifference curve have been presented in following figure.

▪ Every point which lies on same indifference curve gives the same satisfaction.
▪ The upper risk return indifference curve gives higher level of satisfaction.
 ▪ In the above figure IC2 gives higher satisfaction than IC1 and IC3 gives higher satisfaction than
IC2.
▪ Indifference curves cannot intersect with each other.
▪ Investors attempts to select higher indifference curve over the lower indifference curve.
▪ An investor may have more than one indifference curves representing different level of
satisfaction.

Opportunity set
Opportunity set is that area which is occupied by the curve connecting both efficient and inefficient
portfolio. In other words, the collective name for the risk and return of all possible portfolios from the
given assets is known as portfolio opportunity set. It is also known as attainable set or feasible set.

In the above the collection of all possible portfolio options represented by the broken egg-shaped region
is referred to as the feasible or attainable set. Thus the point circle of A, B, C,D,E,F,G and H are
opportunity set.

Efficient Frontier
The line connecting an efficient portfolio having the highest return in the same level of risk (or lowest
risk at same level of return) is known as efficient frontier.
 ▪ When comparing portfolio B and G , risk is almost same but every investor selects B because B
has more return than G.
▪ But comparing A and B, A has lowest return as well as risk where B has higher return and risk. So
both points are efficient portfolio.
▪ Comparing B,C and I: B and I have similar return but risk in B is lower than I. so, investor choose
portfolio B . But comparing C and I one chooses C.
However, all these portfolio(A,B,C,D,E,F,G,H and I) are not suitable for selection. Out of them,
those portfolios (A,B,C and D) which are suitable for selection are called efficient portfolio and
line connecting those superior set of portfolio is called efficient frontier.

Optimal portfolio
Optimal portfolio is that combination of investment in assets which helps investors to minimize risk if
return is same or to maximize return if risk is same. The optimal portfolio is selected involving the risk
return indifferent curve from above efficient frontier. The tangent point of risk return indifferent curve
of efficient frontier is an optimal portfolio.
In the ab0ve figure, the portfolio C lies in the tangent point of IC2 and the efficient frontier is the optimal
portfolio. Portfolio on indifference curve IC1 would not be selected because investor utility is higher for
portfolio on IC2 those on IC1. Portfolios on IC3, which have even higher utility, are not attainable. Thus,
portfolio C is optimal for an investor.

Beta coefficient
The total risk of an asset can be partitioned into systematic and unsystematic risk. Systematic risk can’t
be diversified whereas unsystematic risk can be. The systematic risk or systematic part of the risk can be
calculated by using a tool that is known as beta coefficient. It is an indicator of systematic risk of an
asset. It measured sensitivity of return on risky assets to market return. The betas are used to calculate
the required rate of return. The beta coefficient is found by dividing the combined risk (covariance
between asset’s return and market return) by variance of market return.

Mathematically, the systematic risk beta is measured as the covariance of the stock returns with
the market returns expressed per unit of market variance as follow,

COVjm rjm . j . m rjm . j

j = = =
m2 m m m

j = Beta coefficient for asset j

COVjm = Covariance between return of asset j and market

j = standard deviation of asset j

rjm = correlation coefficient between return of assets and market.

m2 = Variance of market return.

Note that the market return of security market such as NEPSE (Nepal stock exchange).

The beta of market portfolio (m) is always equal to 1. Because covariance between markets
returns with itself is the variance of the market (m2). The market beta is also called average sock's
beta. The asset or stock that has beta less than 1 is trended as defensive assets (less risky than market).
The asset that has beta higher than 1 is trended as aggressive asset (more risky than market).

If j > 1 is considered to be aggressive (more risk and return than market portfolio)

If j < 1 is considered to be defensive (less risk and return than market portfolio)

If j = 1 is considered to be indifferent (risk and return equal to market portfolio)e known,

CovjM
j =
M2

Substitute the value j = m

COVMM rMM . M . M
M = = = rMM = 1
M2 M . M

Note : The correlation of the rate of return on the market portfolio with itself must be positive
and perfect i.e. rMM = 1

The portfolio beta is weighted average beta of individual assets of the portfolio. The weight
being the percentage of portfolio value is invested each asset. The portfolio beta can be calculated by
the following equation.

P = WA × A + WB + B + ............ + Wn × n

Illustration 10

You are given the following sets of historical returns of stock A and Nepal Stock Exchange (NEPSE)

Period 1 2 3 4 5
Return of Stock A -14% 23 17.5 2 8.1
Return of NEPSE -26.5% 37.2 23.8 7.2 6.6
Determine the stock A's beta coefficient.
Solution.

Calculation of beta coefficient

Year RA RA –RA (RA –RA)2 RM RM –RM (RM –RM)2 (RA –RA)( RM –RM)
- -26.5%
1 14%
2 23 37.2
3 17.5 23.8
4 2 7.2
5 8.1 6.6
∑(RA–RA)2= ∑(RM –RM)2 = ( RA –RA)( RM –RM)=
 ∑(RM – RM)2
sM = n –1

(RA – RA) (RM – RM)

COVAM = n–1 =

CovAM
A =
M2

Capital assets pricing Model (CAPM)

The CAPM was developed by William F. Sharpe in 1964. He was received the noble price in economics.
The CAPM specifies the relationship between risk and required rate of return on assets when they are
held in well diversified portfolio. According to CAPM, any asset’s required rate of return is equal to risk
free rate or return plus risk premium proportional to systematic risk measured by beta. The model can
be express in equitation form as below:

E(Rj) = Rf + [RM – Rf] j

E(Rj) = Rf + [E(RM) – Rf] j

Required rate of return E(Rj) of an asset is the rate that an investor expects to earn to compensate the
risk borne by investor on investing on the assets. In other words, it is the minimum rate of return an
investor considers acceptable on assets.

Risk-free rate (Rf) is the rate of interest that is earned default-free assets (or zero risk assets). The rate
of interest on Treasury securities are considered as risk free rates.

Return on market E(RM) is the return on all assets available in the market or market index portfolio or
NEPSE index.

Beta (j) is the coefficient determined by regressing the return of assets j on the return of the market
index.

The last term [E(RM) – Rf]j is known as security’s risk premium which is equal to beta times the market
risk premium. The market risk premium is defined as the difference between return on market portfolio
and risk free rate i.e E(RM) – Rf.

Assumptions of CAPM
Some assumptions of the CAPM are as under.

i. The a model assume that all investors are risk averse

ii. It is assumed that investors have no constraints on borrowing and lending
iii. All investors have homogenous expectations
iv. All investors have common investment horizon
v. All investments are infinitely divisible and marketable
 vi. The capital markets are in a state of equilibrium or striving towards equilibrium.

Security Market Line (SML)

The algebraic equitation is known as CAPM and it calculates the required rate of return is also
represented by graph, which is known as security market line. SML shows the relationship between risks
measured beta and the required rate of return for individual securities. The beta coefficient increases,
the required rate of return also increases. The slope of SML is:

Slope of SML = E(RM) – Rf)/ M

The figure shows the linear relationship between beta and required rate or return of particular assets. As
shown in above figure, any assets having beta equal to 1 will have the required rate of return equal to the
market portfolio. The asset having beta to less than 1 will have required rate of return less than the market
portfolio return and vice-versa.

Capital Market Line(CML)

When we introduce a risk free asset into Markowitz portfolio, the efficient frontier is change from a
curve to a straight line. The new efficient frontier is called a capital market line.

Slope of SML = E(RM) – Rf)/ M

PRACTICE PROBLEMS

◼◼ Short Problems (SP)

SP-1

Rate of return; Suppose a stock had an initial price of Rs 62 per share, paid a dividend of Rs 1.50 per
share during the year, and had an ending price of Rs 51. Compute the percentage total return.

SP-2

Dividend yield and capital gain yield; In problem 1 what was the dividend yield ? The capital gain yield ?

SP-3

Average return; You have observed the following returns on BC Computer's stock over the past five
years; –8 percent, 13 percent, 5 percent, 16 percent and 32 percent. What was the average return on
BC's stock over the five year period ?

SP-4

Weighted of portfolio; What are the portfolio weights for portfolio that has 90 shares of stock A that
sell for Rs 35 per share and 70 shares of stock B that sells for Rs 25 per share ?

SP-5
Expected return on portfolio; You own a portfolio that has Rs 700 invested in stock A and Rs 2400
invested in stock B. If the expected return on these stocks are 11 percent and 18 percent, respectively,
what is the expected return on the portfolio ?

SP-6

Expected return on portfolio; You own a portfolio that is 50 percent invested in stock X, 30 percent in
stock Y and 20 percent in stock Z. The expected return on these stocks are 10 percent, 18 percent, and
13 percent, respectively. What is the expected return an portfolio ?

SP-7

Correlation coefficient; Covariance between stock A and B is 120 and their standard deviation is 10
percent and 12 percent. What is its correlation coefficient ?

SP-8

Variance; If standard deviation of the return of security is 5 percent what is its variance ?

SP-9

Portfolio beta; You own a stock portfolio invested 25 percent in stock Q, 20 percent in stock R, 15
percent in stock S and 40 percent in stock T. The betas for these four stock are 0.9, 1.4, 1.1 and 1.8
respectively. What is the portfolio beta ?

SP-10

Expected return on stock; A stock has beta of 1.5, the expected return on market is 14 percent and risk
free rate is 5 percent. What must expected return on this stock be ?

SP-11

Beta; A stock has expected return of 13 percent, the risk free rate is 5 percent and market risk premium
is 7 percent. What must the beta of this stock be ?

SP-12

Expected return on market; A stock has an expected return of 10 percent, its beta is 0.9 and risk free
rate is 6 percent. What must the expected return on market be ?

SP-13

Risk free rate; A stock has expected return of 14 percent, a beta of 1.6 and expected return on market is
11 percent, what must the risk free rate be ?

SP-14
Required rate of return; Stock Y has a beta of 1.45 and expected return of 17 percent. If the risk free
rate is 6 percent and market risk premium is 7.5 percent, is the stock correctly priced ?

◼◼ Long Problems (LP)

LP-1 (WBB-5.4)

Expected returns; The market and Stock J have the following probability distributions:
Probability KM KJ
0.3 15% 20%
0.4 9 5
0.3 18 12
(a) Calculate the expected rates of return for the market and Stock J.
(b) Calculate the standard deviations for the market and Stock J.
(c) Calculate the coefficients of variation for the market and Stock J.
LP-2 (BH-5.6)

Expected returns; Stocks X and Y have the following probability distributions of expected future
returns:
Probability X Y
0.1 (10)% (35)%
0.2 2 0
0.4 12 20
0.2 20 25
0.1 38 45
(a) Calculate the expected rate of return for Stock Y (K_x = 12%).
(b) Calculate the standard deviation of expected returns for Stock X (Y = 20.35%). Now calculate the
coefficient of variation for Stock Y. Is it possible that most investors might regard Stock Y as being
less risky than Stock X? Explain.

LP-3

Expected returns, standard deviation and coefficient of variation; The Birat Company has a new
investment project. The project returns are estimated as follows:
Year Project return (KJ)
2010 10%
2011 17
2012 24
2013 20
2014 14

Calculate:
 (a) The expected return on the investment.

(b) The variance of return

(c) The standard deviation of return

(d) The coefficient of variation of return of the Barfield Company.

LP-4

Expected return and Standard deviation; NCC Bank's stock and Nabil Bank's Stock have the
following probability distributions of expected future returns:
Probability 0.1 0.2 0.4 0.2 0.1
Return (NCC) –12.5% 5% 10% 25% 35%
Return (Nabil) –20% 0% 15% 30% 36%
(a) Calculate the expected rate of return for each bank's stock.

(b) Calculate the standard deviation of expected returns for each bank's stock.

(c) In which stock you prefer to invest and why?

LP-5

Expected return, Standard deviation and Coefficient of variation; Stock A and B have the
following probability distribution of expected future returns :
State of economy Probability Stock A Stock B
Recession 0.3 –5% –5%
Average 0.4 15 10
Boom 0.3 35 25
(a) Which stock is more profitable ?

(b) Which stock is more risker in absolute term ?

(c) Which stock is more risker in relative term ?

(d) Which stock would you prefer ?

LP-6 (BH-5.19)

Expected returns; Suppose you won the Pokhara lottery and were offered (1) Rs.0.5 million or
(2) a gamble in which you would get Rs.1 million if a head were flipped but zero if a tail came up.

(a) What is the expected value of the gamble?

(b) Would you take the sure Rs.0.5 million or the gamble?
(c) If you choose the sure Rs.0.5 million, are you a risk averter or a risk seeker?
Solution:

(a) Calculation of expected value of the Gamble.

Expected value = PS  K
PS Outcomes (K) PS  K
0.50 Rs.10,00,000 Rs.500,000
0.50 0 0
Expected value = Rs.500,000
Therefore, the expected value of the Gamble is Rs.500,000.

(b) I would take sure Rs. 0.5 million because the expected value in both is equal but the Gamble is
riskness then sure.

(c) If I choose the sure Rs.0.5 million, I am a risk averter not a risk seeker.

LP-7

Covariance and correlation coefficient; The Mc Himal has developed the following data regarding a
project to add new production facilities.
State Probability Market return Project return
1 0.05 -20 –30
2 0.25 10 5
3 0.35 15 20
4 0.20 20 25
5 0.15 25 30
Calculate:

(a) Expected return on the project and market.

(b) The variance of the project and market returns.
(c) The standard deviation of project and market returns,
(d) The coefficient of variation of project and market returns.
(e) The covariance of the project returns with the market returns.
(f) The correlation coefficient between project returns and market returns.
LP-8

Consider the Probability distribution of alternative rates of return associated with stock A and B
given in the following.
State of economy Probability Stock A Stock B
1 0.3 10% -10%
2 0.4 15 20
 3 0.3 20 30
(a) Calculate the expected return and standard deviation of stock A and stock B.
(b) What are the covariance and correlation coefficient between stock A and stock B?
(c) If you form a portfolio of stock A and stock B comprising 70 percent wealth in stock A
and the rest in stock B, calculate the risk and return of your portfolio.
(d) Which investment would you prefer? Stock A or Stock B or the portfolio?
(ans. a.14.5%,4.15% &11%,17.58% b.70.50,0.966 c.13.45,8.12%)
LP-9

You have observed the following returns over the past five year of stock B and N.
Year Stock B Stock N
2015 12% 14%
2016 18 9
2017 14 -7
2018 6 -4
2019 20 -10
Required:
a) Calculate the average returns and standard deviation of each stock.
b) Calculate the coefficient of variation of each stock.
c) Calculate the covariance and correlation between stock B and N.
d) Calculate the average rate of return for the portfolio if equal amount of money is
invested in each stock. Also calculate the portfolio standard deviation.
LP-10

Consider the Probability distribution of alternative rates of return associated with stock A and B
given in the following.
State of economy Probability Stock A Stock B
1 0.3 15% -5%
2 0.4 10% 15%
3 0.3 5 35
a) Calculate the expected return and standard deviation of stock A and stock B.
b) Which stock would you prefer? Why?
c) What are the covariance and correlation coefficient between stock A and stock B?
d) Would you think that forming a portfolio of these two stocks reduces the risk? Why
or why not? Explain.
e) If you form a portfolio of stock A and stock B comprising 70 percent wealth in stock
A and the rest in stock B, calculate the risk and return of your portfolio. Are you able
to diversify the risk forming the portfolio?
 f) Covariance between stock B and market is 140 and standard deviation of market is 9
percent. If risk free rate is 6 percent and market risk premium is also 4 percent,
calculate required rate of return on stock B. is stock B overpriced or underpriced?

LP-11 (VH-7)

Portfolio expected return; Sita Sharma invests the following sums of money in common stocks
having expected returns as follows:
Security Amount Invested Expected Return
Everest Bank Rs.6000 14%
Himalayan Bank 11000 16
Investment Bank 9000 17
Bank of Kathmandu 7000 13
Citizen Bank 5000 20
Prabhu bank 13000 15
NIC Asia bank 9000 18
(a) What is the expected return (percentage) on her portfolio?
(b) What would be her expected return if she quadrupled her investment in Citizen Bank while
leaving everything else the same?

LP-12

Portfolio expected return and Risk; The rate of return on two stock X and Y along with their
probabilities are given below :
State of economy Probabilities Rate of return %

X Y

1 0.10 –10 –20

2 0.20 5 –5

3 0.40 10 15

4 0.20 15 30

5 0.10 20 30

(a) Calculate the expected return and standard deviation of stock X and Y.

(b) What are the covariance and correlation coefficients between X and Y.

(c) What are the expected return and risk (standard deviation) of a portfolio contain stock X and Y
with 30 percentage of wealth invested in stock X and rest in stock Y ?
 (d) What is the expected risk (Standard deviation) of this portfolio if the correlation coefficient for the
two stocks have;

(i) A perfect positive correlation

(ii) A perfect negative correlation

LP-13 (BH-5.21)

Realized rates of return; Stocks A and B have the following historical returns:
Year Stock A's Returns, kA Stock B's Returns, kB
2010 (18.00)% (14.50)%
2011 33.00 21.80
2012 15.00 30.50
2013 (0.50) (7.60)
2014 27.00 26.30
(f) Calculate the average rate of return for each stock during the period 2010 through 2014.
(g) Assume that someone held a portfolio consisting of 50 percent of stock A and 50 percent of Stock
B. What would have been the realized rate of return on the portfolio in each year from 2010
through 2014? What would have been the average return on the portfolio during this period?
(h) Calculate the standard deviation of returns for each stock and for the portfolio.
(i) Calculate the coefficient of variation for each stock and for the portfolio.
(j) If you were a risk-averse investor, would you prefer to hold Stock A, Stock B, or the portfolio?
Why?

LP-14

Portfolio average return and risk; Consider the following historical rate of return for Asset A and Asset B:
Year Asset A returns Asset B
returns
2005 16% 12%
2006 5 (2)
2007 5 10
2008 6 6
2009 (4) 11
2010 6 3
2011 0 (1)
2012 3 16
2013 (2) 14
2014 11 16
Using historical returns for asset A and asset B, calculate each asset's
 (a) (i) mean return, (ii) variance, (iii), standard deviation, (iv) the covariance of asset A and B, and
(v) the correlation coefficient between A and B.

(b) Suppose that asset A and B are combined in equal proportions, to form a portfolio (that is, 50
percent of the portfolio value is invested in Asset A, and 50 percent in asset B). Calculate the
expected return and risk of the portfolio.

(c) What is the expected return and risk if all wealth were invested in Assets A ?

(d) What is the expected return and risk if all wealth invested in Assets B ?

LP-15

Portfolio expected return and risk; The probability distribution and expected return on Stock M and Stock
N are provided below:
State of economy Probability Return on stock
Stock M Stock N
1 0.15 –10% 15%
2 0.20 5 10
3 0.30 10 5
4 0.35 20 0
Assuming that investors have Rs.2,000,000 to invest in total Rs. 1,500,000 in Stock M and Rs.500,000 in
Stock N. (i) Calculate expected return on each stock, variance of each stock and standard deviation of each stock.
(ii) Calculate portfolio return, variance of the portfolio, covariance of portfolio and standard deviation of portfolio.

LP-16

Portfolio expected return and risk; There are two assets and three states of economy with
following probabilities and rate of return on stock R and stock S.
State of economy Probability of state of Rate of return on
economy stock
R S
Recession 0.20 –15% 20%
Normal 0.50 20 30
Boom 0.30 60 40
(a) Find out the expected return on each stock.
(b) Find out standard deviation on each stock.
(c) Find out expected return and standard deviation on portfolio if you put Rs.15000 in stock R and
Rs.5000 in stock S given total investment of Rs.20000.

LP-17

You are planning to invest Rs. 200000 in a portfolio of securities. Two securities, A and B are available
with the following estimates of probability distribution of return
 Security A Security B
PA RA PB RB
0.1 -10% 0.1 -30
0.2 5 0.2 0
0.4 15 0.4 20
0.2 25 0.2 40
0.1 40 0.1 70
RA=? RB=20%
σA=? σB=25.7%

a) The expected return for security B is RB = 20 percent, and the standard deviation is σB=25.7
percent. Find RA and σA.
b) Find the value of weight of A, WA that produces minimum risk of the portfolio. Assume the
correlation between A and B, ρAB= -0.5.
c) Determine the expected return and standard deviation of minimum variance portfolio?
LP-18

You are given the following sets of historical returns of stock A and Nepal Stock Exchange (NEPSE)

Period 1 2 3 4 5
Return of Stock A -14% 23 17.5 2 8.1
Return of NEPSE -26.5% 37.2 23.8 7.2 6.6
Required.
a) Determine the stock A's beta coefficient.
b) Explain the volatility of stock return with respect to market return as explain by beta.

LP-19 (WBB-5.6)

Required rate of return; Suppose KRF = 8%, KM = 11%, and KB = 14%.

(a) Calculate Stock B's beta.

(b) If Stock B's beta were 1.5, what would be B's new required rate of return?

LP-20 (BH-5.7)

Required rate of return; Suppose KRF = 9%, KM = 14%, and βJ = 1.3

(a) What is Kj the required rate of return on stock J?

(b) Now suppose KRF (1) increases to 10 percent or (2) decreases to 8 percent. The slope of the SML
remains constant. How would this affect KM and Kj?
(c) Now assume KRF remains at 9 percent but KM (1) increases to 16 percent or (2) falls to 13 percent.
The slope of the SML does not remain constant. How would these changes affect Kj?

LP-21 (BH-5.9)

Portfolio required return; Suppose you are the money manager of a Rs.4 million investment
fund. The fund consists of 4 stocks with the following investments and betas:
Stock Investment Beta
A Rs.400,000 1.50
B 600,000 (0.50)
C 1,000,000 1.25
D 2,000,000 0.75
If the market required rate of return is 14 percent and the risk-free rate is 6 percent. What is the
fund's required rate of return?

LP-22 (BH-5.10)

Required rate of return; Stock R has a beta of 1.5. Stock S has a beta of 0.75, the expected rate of return
on an average stock is 15 percent, and the risk-free rate of return is 9 percent. By how much does the
required return on the riskier stock exceed the required return on the less risky stock?

LP-23 (BH-5.8)

Portfolio beta; Suppose you hold a diversified portfolio consisting of a Rs.7,500 investment in each of 20
different common stocks. The portfolio beta is equal to 1.12. Now suppose you have decided to sell one
of the stocks in your portfolio with a beta equal to 1.0 for Rs.7,500 and to use these proceeds to buy
another stock for your portfolio. Assume the new stock's beta is equal to 1.75. Calculate your portfolio's
new beta.

LP-24 (BH-5.20)

Security Market Line; The Mr Johan Shrestha Investment Fund has total capital of Rs.500 million
invested in five stocks:
Stock Investment Stock's Beta Coefficient
A Rs.160 million 0.5
B 120 million 2.0
C 80 million 4.0
D 80 million 1.0
E 60 million 3.0
 The current risk-free rate is 8 percent, whereas market returns have the following estimated
probability distribution for the next period:
Probability Market Return

0.1 10%

0.2 12

0.4 13

0.2 16

0.1 17

(a) Compute the expected return for the market.

(b) Compute the beta coefficient for the investment fund. (Remember, this a portfolio.)
(c) What is the estimated equation for the security Market Line (SML)?
(d) Compute the fund's required rate of return for the next period.

LP-25 (VH-6)

Required rate of return; At present, suppose the risk-free rate is 10 percent and the expected
return on the market portfolio is 15 percent. The expected returns for four stocks are listed together
with their expected betas.
Stock Expected Return Expected Beta
Himalaya Corporation 17.0% 1.3
Asian Paint Company 14.5 0.8
National Auto Mobile 15.5 1.1
Company
Palpa Electronics, Inc. 18.0 1.7
(a) On the basis of these expectations, which stocks are overvalued? Which are undervalued?
(b) If the risk free rate to rise to 12 percent and the expected return on the market portfolio to 16
percent, which would be undervalued? (Assume the expected returns and the betas stay the
same.)

LP-26 (BH-ST-3)

Beta and required rate of return; Karnali Corporation is a holding company with four main
subsidiaries. The percentage of in business coming from each of the subsidiaries, and their respective
betas, are as follows:

Subsidiary Percentage of Business Beta

Electric utility 60% 0.70

Cable company 25 0.90

 Real estate 10 1.30

International/special projects 5 1.50

(a) What is the holding company's beta?

(b) Assume that the risk-free rate is 6 percent and the market risk premium is 5 percent. What is the
holding company's required rate of return?

LP-27

Stock X and Y have the following probability distribution of expected future returns:
Probability 0.1 0.2 0.3 0.3 0.1

Return on X (%) (10) 2 12 20 38

Return on Y(%) (35) 0 20 25 45

(a) Calculate the expected rate of return for stock X. (Given expected rate of return for Y
is 14.5%)
(b) Calculate the standard deviation of expected rate of return for Y. Given variance of X
is 154.56)
(c) Is it possible that most investors might regard stock Y as being more risky than stock
X? Explain.

Answer Sheet
Short problems

1. –15.32% 2. 2.42%; –17.74% 4. 11.60% 5. 0.64; 0.36 6. 16.42% 7. 13%

8. 1 9. 25% 10. 1.39 11. 18.5% 12. 1.14 13. 10.44% 14. 6% 15. 16.875 (not correctly priced)

Long problems

1. (a) kM = 13.5%; kJ = 11.6% (b) σM = 3.85%; σJ = 6.22%

(c) CVM = 0.29; CVJ = 0.54.

2. (a) kY = 14% (b) σX = 12.20%

(c) CVX = 1.02, CVY = 1.45, (No. it is not possible that must investor might regard stock Y as being
risky than stock X because according to above calculation CVX < CVY i.e. The co-efficient of variation
of stock are greater than that stock X.)
3. K_j = 0.17 or 17%, 2j = 0.0029 or 29%, j = 0.00539, 5.39%, CVj = 0.317

4. (a) K_NC = 12.25%, K_NA = 13.6% (b) NC = 12.57%, NA = 15.96% (c) CVNC = 1.026, CVNA = 1.174 (I
would preferred to invest of NCC bank's stock because CV of NCC Bank is lower than CV of Nabil
Bank.

5. (a) K_A = 15%, K_B = 10% (Stock A) (b) A = 15.49% B = 11.62% (Stock A) (c) CVA = 1.03,
(CVB = 1.16 (Stock B) (d) Stock A

7. (a) K_j = 0.1625 or 16.25%, K_m = 0.1450 or 14.50% (b) j2 = 0.1872 or 187.2% 2m = 0.0087 or 87%
(c) j = 0.1368 or 13.68%, m = 0.0933 or 9.33% (d) CVj = 0.84, CVm = 0.643 (e) COVjm = 0.0126 (f) rjm
= 0.9871

11. (a) 16.014% (b) 16.82%

12. (a) K_x = 9% K_y = 12%, x = 7.68%, y = 16.16% (b) COVxy = 117, xy = 0.9427 (c) K_P = 11.1%, p =
13.50% (d) (i) 13.61% (ii) 9%

13. (a) K_A = 11.30%, K_B = 11.30%

(b) 1991 = –16.25%, 1992 = 27.4%, 1993 = 22.75%, 1994 = –4.05%, 1995 = 26.65%, K_p =
11.3%

(c) σA = 20.8%; σB = 20.8%; σP = 20.1%

(d) CVA = 1.84, CVB = 1.84, CVP = 1.78

(e) If I am a risk averse investor, I would prefer to hold the portfolio because the standard deviation
and coefficient of variation for the portfolio is the lessess (i.e. p < B, A and CVP < CVA < CVA)

14. (a) (i) 4.60%, 8.50% (ii) 35.16, 44.50 (iii) 5.93%, 6.68% (iv) 5.22 (v) 0.132 (b) 6.55%, 4.75%

(c) 4.60%, 5.93% (d) 8.50%, 6.68%

15. (i) K_m = 9.5%, K_N = 5.75%, 2m = 99.75, 2N = 28.1876, m = 9.987%, N = 5.31%

(ii) COVMN = –52.125, K_p = 8.5625%, 2p = 38.3242%, p = 6.19%

16. (a) K_R = 25%, K_S = 31% (b) R = 26.46%, S = 7% (c) K_P = 26.5%, P = 21.59%, COVRS = 185

19. (a) B = 2 (b) kB = 12.5%

20. (a) kJ = 15.5% (b) (i) kJ = 16.5% (ii) KJ = 14.5%

(c) (i) kJ = 18.1% (ii) KJ = 14.2% Note: According to the capital asset pricing model (CAPM) the
increase in KRF also cause an equal increase in market return. i.e. in this case RF increase by 1% as
result Km = 15% (i.e. 14% + 1%) This increase in FR would be increase Km and Kj

21. P = 0.7625; kP = 12.1%

22. 4.5% (As we know that the stock R is riskier than the stock S because stock R's beta is higher than
S's beta. Therefore rate of return on the stock R exceeds the required rate of return on the stock S
by 4.5% (i.e. 18% – 13.5%)

23. New = 1.16

24. (a) 13.5% (b) 1.8 (c) kF = 8% + 5.5% J (d) 17.9% (e) The new stock should not be purchased
because its required rate of return is greater than expected rate of return (i.e. 19% and 18%) Johan
Shrestha would be indifferent purchasing the stock at 19% expected return because the expected
rate of return is equal to required rate of return.

25. (a) 16.5%, 14%, 15.5%, and 18.5% (stock Palpa Electronic Inc., is over valued) (b) 17.2%, 15.2%,
16.4%, and 18.8% (all stocks are overvalued)

26. (a) 0.85; (b) 10.25%

 Chapter 3 and 4

Basics of Capital budgeting

or
Cash flow estimation
 Meaning of capital budgeting
• Capital budgeting is the process of acquiring
the fixed assets or process of investment in
capital projects.
• The process of capital budgeting includes the
identification of the investment opportunity,
estimation of relevant costs and benefits of
the identified projects, evaluation of the
projects, approval and monitoring of the
projects.
 Cond….
• The planning for capital expenditure is know as
capital budgeting.
• It is a decision making process for an investment
on long term project.
• Capital budgeting is the process of investment,
evaluating, planning and financing major
investment project of an organization
• The capital budgeting decision means a decision
as to whether or not money should invested in
long-term projects
 Features of Capital Budgeting
• The exchange of current funds for future
benefits.
• The funds are invested in long term activities
• The future benefits will occur to the firm over
a series of years.
• Capital budgeting requires large amount of
funds (resources)
• Capital budgeting decisions are not reversible.
 Classification of projects
[Link] expansion
A company adds capacity to its existing product lines to
expand existing operations is called project expansion. Expansion of
new business requires invested in new product and new kind of
production activity with in the firm
2. Replacement project
Assets become outdated and obsolete with technological
changes. The firm must decide to replace those assets with new assets
that operate more economically is call replacement decision
3. New project
New project may be related with the establishment of a new
business like selection of new location, building, plant, arranging
furniture's and so on.
 Cond….
4. Independent project
Independent projects serve different purposes and do not
compete with each other. The firm may select all the projects if all are
profitable. But if all projects are not profitable then all projects are
rejected.
5. Mutually exclusive project
Mutually exclusives projects serve the same purpose or same
task and compete with each other. If one investment is under taken,
others will have to be excluded.
5. Diversification
Expansion having with different variety of product or business
is known as diversification. Each business firm wants to earn more. For
this, firm may add different product line to cover larger market and
minimizing risk is called diversification project.
 Techniques of capital budgeting
1. Traditional or non-discounting cash flow
method
a) Payback period (PBP)
b) Accounting rate of return (ARR)
2. Time-adjusted or discounting cash flow method
a) Discounted payback period (DPBP)
b) Net present value (NPV)
c) Profitability index (PI)
d) Internal rate of return (IRR)
e) Modified internal rate of return (MIRR)
 Basics Capital Structure Decision
Financial structure and capital structure
A firm’s total assets are financed from equity and debt. Equity capital is owners’ money and consists of
stock, paid in capital and retained earnings. Debt capital is borrowed money and can be classified as short
term debt and long term debt. Thus, liabilities and equity section of balance sheet is composed of short
term debt, long term debt and equity. The composition of short term debt, long term debt and equity is
called financial structure.
The term capital structure is used to refer to the mix of long term sources of capital. The long term debt
and equity capital are the long term sources of capital. In other words, capital structure is the composition
of long term source of financing. A general rule of capital structure, the use of higher debt financing
maximizes the earnings per share of stockholders because the cost of debt financing is relatively cheaper
and limited. However, it also increases the financial risk. Therefore, capital structure can affect the value
of the firm and cost of capital. As a result, the financial manager should attempt to maintain optimal
capital structure that maximizes the value of the firm and minimizes the cost of capital. Business risk, tax
rate, interest rate, manager attitudes, financial flexibility, stability of sales etc. are the main factors that
affecting the optimal capital structure.
.

Financial structure

Liabilities side of balance sheet

+
Short–terms sources Long–term sources

+ Equity
Long–term debt Preferred stock
+

Capital structure

Capital structure = Financial structure – Current liabilities (Short term debt)

Business Risk
Risk is variability in return. Return on investment varies due to the number of factors such as in demand
of the product and cost of inputs, economic condition, market competition and so on. These are the
inherent attributes in the operation of the business and cause the variation between realized return and
expected return on investment over the years. Business risk is the variation in the return due to the
inherent attributes of operation of a firm. So, this is called operating risk.
Business risk is defined as uncertainty inherent in projection of future return on assets (ROA) or return on
equity (ROE) if the firm uses no debt. Business risk refers to the uncertainly about the operating income
(EBIT) by the nature of the business. Business risk depend a number of factors the more important of
which are the following:
a) Demand Variability
b) Sales price variability
c) Inputs cost variability
d) Ability to develop new products in a timely, cost effective manner
e) Ability to adjust output prices for charges in input cost

Financial Risk
Financial risk is the additional risk placed on the common stockholders as a result of using financial
leverage, which results when a firm uses fixed income securities (i.e. debt and preferred stock) to raise
capital. Financial risk is associated with the creation of fixed obligation to the firm by using debt element
in the capital structure. Financial risk is introduced by the use of financial leverage.
Companies that issue more debt instruments would have higher financial risk than companies
financed mostly or entirely by equity. Financial risk can be measured by ratios such as the firm's financial
leverage multiplier, total debt to assets ratio or degree of financial leverage.

Operating Leverage
The term ‘Leverage’ is derived from physics, it refers to the use of a lever to raise a heavy object with
relatively small forces. In finance, operating leverage refers to the potential use of fixed operating costs. It
shows the responsiveness of changes in operating profit to the change in sales. A given change in sales
may bring more proportionate change in EBIT. In other words, operating leverage can be defined as the
use of fixed operating costs in a firm’s operation that result into more than proportional changes into
firm’s EBIT foe a given changes in sales.
Degree of operating leverage (DOL) provides a numerical measure of firm’s operating leverage. It is the
quantitative measure of the responsiveness of change in firm’s to change in sales.
Percentage change in EBIT
Degree of operating leverage =
Percentage change in sales
CM Q (S – V)
or, DOL = or, DOL =
EBIT Q (S – V) – F

Illustration 4.
Given the following information:
Selling price per units (S) = Rs. 100
Variable cost per unit (V) = Rs. 50
Fixed cost (FC) = Rs. 50,000
Production and sales units (Q) = 2000 units.
Required:
(a) Calculate degree of operating leverage.
(b) Calculate the percentage change in EBIT if sales increase by 20%.
Solution :
(a) Degree of operating leverage (DOL)
 Sales (2000 × Rs. 100) Rs. 200,000
less: variable cost (2000 × Rs. 50) 100,000
Contribution margin 100,000
less: fixed cost 50,000
EBIT Rs. 50,000
We have,
CM R 100000
DOL = = == 2 times
EBIT Rs 50000
Q(S – V) 2000 (Rs. 100 – Rs. 50)
DOL = = = 2 times
Q(S – V) – FC 2000 (Rs. 100 – Rs. 50 – Rs. 50000)
(b) The DOL 2 times which indicates that a 1% increase/decrease in sales will result 2% increase/decrease in
operating income (EBIT). Here, DOL is 2 and percentage increase in sales is 20% then percentage in EBIT is
40%
Percentage changes in EBIT = DOL × % change in sales = 2 × 20% = 40%
New EBIT = old EBIT (1 + % change in EBIT)
= Rs. 50,000 (1 + 0.40) = Rs. 70,000
or, New EBIT = Rs. 50,000 + 40% of Rs. 50,000 = Rs. 70,000
Verification
Existing New
Level of sales unit (Q) 2000 2400
Sales revenue Rs. 200000 Rs. 240000
Less; variable cost 100,000 120000
CM 100,000 120,000
Less : fixed cost 50,000 50,000
EBIT Rs. 50000 Rs. 70000
% change in EBIT – 40%
10% change in EBIT 40%
DOL = = = 2 tims.
% change in sales 20%

Financial Leverage
Financial leverage explains how a given change in operating income of a firm affects its earnings per
share and earnings to common stockholders. It is the responsiveness of change in firm’s EPS to change in
EBIT. Financial leverage exists because of the use of fixed charge bearing securities, such as, bond and
preferred stock. One measure of financial leverage is to debt to assets ratio. Higher debt ratio indicates
higher financial leverage. The financial manager should know how and to what extent the use of fixed
charge bearing securities influence the earning and risk.
The degree of financial leverage (DFL) is a quantitative measure of the sensitivity of a firm’s earnings per
share to a change in the firm’s operating profit (EBIT). It is a numerical measure of responsiveness of
change in EPS or EBT to the change in EBIT.
% Change in EPS
Degree of financial leverage (DFL) =
% Change in EBIT
Sales – Variable cost – Fixed cost EBIT EBIT
DFL = = =
Sales – Variable cost – Fixed cost – Interest EBIT – Interest EBT
 Q (S – V) – FC
DFL =
Q(S – V) – FC – I
If preferred stock dividend is given,
EBIT
DFL =
Pd
EBIT – I –
(1 – T)

DFL of 2 (suppose) indicate that if there is 1 percentage change in EBIT it will cause 2 percent change in net
income or earning available to shareholder (EPS).
% change in EPS = DFL × % change in EBIT
EPSnew = EPSold (1 + DFL × % change in EBIT)

Illustration 5.
Given the following information,
Selling price per unit (S) Rs.5
Variable cost (% of selling price) 75%
Fixed operating cost Rs.50,000
Interest expenses Rs.10,000
Preferred stock dividend Rs.0
Marginal tax rate 40%
Number of common shares 20,000
Production and sales unit (Q) 60,000 units
Required :
(a) Income statement
(b) Degree financial leverage (DFL)
(c) If actual EBIT increased to Rs 30,000, calculate the new EPS based on DFL
(d) DFL if preferred stock divided is Rs 1000
Solution :
(a) Income statement
Sales (60,000 × Rs 5) Rs 300,000
Less : Variable cost (75% of sales or 60,000 × Rs 3.75) 225,000
CM 75,000
Less : Fixed cost 50,000
EBIT 25,000
Less : Interest 10,000
EBT 15,000
Less : Taxes (40%) 6,000
Net income 9,000
Less : Preferred stock divided 0
EAC Rs 9,000
Earnings available to common stockholders (EAC) Rs 9000
 EPS = = = Rs 0.45
No. of common shares 20000
EBIT Rs 25000
(b) Degree of operating leverage (DFL) = = = 1.6667 times
EBT Rs 15000
Q (S – V) – FC
or, DFL =
Q (S – V) – FC – I
60000 (Rs 5 – Rs 3.75) Rs 25000
= = = 1.6667 times
(Rs 5 – Rs 3.75) – Rs 50000 – Rs 10000 Rs 15000
(c) If actual EBIT Increased to Rs 30,000, the new earning per share based on DFL = ?
New EBIT – Old EBIT 30000 – 25000
% Change in EBIT = = = 20%
Old EBIT 25000
New EPS = Old EPS (1 + DFL  % change in EBIT)
= Rs 0.45 (1 + 1.66667  0.20) = Rs 0.60
(d) DFL if preferred stock divided is Rs 1000
EBIT Rs 25000 Rs 25000
DFL = = = = 1.8750 times.
Pd Rs 1000 Rs 13333.33
EBIT – I – Rs 25000 – Rs 10000 –
1–t 1 – 0.40

Total or Combine Leverage

It is to be noted that the operating leverage considers operating section of income statement, whereas
financial leverage considers the financial section. The combined use of operating and financial leverage
causes considerable change in net income and EPS even there is only a small change in sales is called
total leverage. Such combined effect of operating and financial leverage is numerically measured by
degree of total leverage (DTL)
% Change in EBIT % Change in EPS % Change in EPS
DCL =  =
% Change in sales % Change in EBIT % Change in Sales
CM EBIT CM Q (S – V)
DCL = DOL  DFL = × = =
EBIT EBT EBT Q (S – V) – FC – I
If there is preferred stock dividend
CM
Or, DCL =
Pd
EBIT – I –
(1 – T)
 The degree of total leverage is the combination of both DOL and DFL and shows the total impact. This value
5 (suppose) indicates that 1 percent change in sales volume will result in 5% change in EPS.
% change in EPS = DTL × % change in sales
New EPS = old EPS (1 + % change in EPS)
or, New EPS = old EPS (1 + % change in sales × DTL)

ILLUSTRATION 6.
Given the following information
Selling price per unit (S) Rs.5
Variable cost (% of selling price) 75%
Fixed operating cost Rs.50,000
Interest expenses Rs.10,000
Preferred stock dividend Rs.0
Marginal tax rate 40%
Number of common shares 20,000
Production and sales unit (Q) 60,000 units
Required :
(a) Degree of combined leverage (DCL)
(b) If actual sales actually turnout to be Rs 270,000, compute the new EPS based on DTL.
Solution :
CM Q (S – V)
(a) DCL = or,
EBT Q (S – V) – FC – I
60000 (Rs 5 – Rs 3.75) 75000
= = =5
60000 (Rs 5 – Rs 3.75) – 50000 – 10000 15000
(b) If the sales actually turn out to be Rs.270,000, the new earnings per share based on degree of total leverage ?
[Q(S – V) – FC – I ](1 – t)
EPS0 =
No. of shares
[60000 (Rs.5 – Rs.3.75) – Rs.50000 – Rs.10000] (1 – 0.40)
= = Rs.0.45
20000
New sales – Old sales 270000 – 300000
% Change in sales = = = –10%
Old sales 300000
Now,
New EPS = EPSold [1 + (% change in sales  DCL)]
= Rs.0.45 [ 1 + (– 0.10  5)] = Rs.0.45  [ 1 – 0.50] = Rs.0.225
 Table showing effect of leverage
Leverage Change Effect on
Operating Sales EBIT
Financial EBIT or NOL Net income / EPS
Total or combined Sales NI / EPS

 Distinguish between operating leverage and financial leverage

Operating leverage Financial leverage
1. Operating leverage represented the 1. Financial leverage represented the relationship
relationship between operating profit and between operating profit and earning available
sales. to shareholder (EPS).
2. DOL can be calculate based on fixed cost 2. DFL can be calculate based on financial cost
3. DOL is measured the business risk. 3. DFL is measured the financial risk.

Estimating Optimal Capital Structure

The optimal capital structure is the combination of debt, preferred stock and common equity that
minimize the weighted average cost of capital (WACC). As the capital structure where the WACC is
minimized, the value of the firm’s securities is maximized. As a result, the minimum cost of capital
structure is called optimal capital structure.
It is difficult to estimate that how a given change in capital structure will affect the stock price. It is noted,
that capital structure that maximizes the stock price is also the one that minimize the WACC. WACC is
calculated by using following equitation:
WACC = WD*Kdt + WP*KP + WE*KE

Breakeven Analysis
The relationship between sales volume and operating profitability is explored in cost volume profit
planning or operating break-even analysis. Break–even point represents the levels of production and sales
where operating income (EBIT) is zero. It is the point where revenues from sales just equal total operating
cost. Operating break-even analysis is a method of determining the point at which sales will just covers
operating cost. It is also shows the magnitude of the firm's operating profits or losses if sales exceeds or
falls below that point. Break-even analysis is important in the planning and control process because that
cost volume profit relationship can be influenced greatly by the production of the firm's investment in
assets, which are fixed.
Condition Result
Actual sales is equal to break-even No Loss, No Profit [EBIT =
sales 0]
Actual sales exceeds to break-even Profit
sales
Actual sales is less than break-even Loss
sales
Generally, break-even point analysis provides answer to question such as:
(i) What sales volume is needed to avoid losses?
(ii) What sales volume is necessary to earn a desired profit
(iii) What will be the effects of change is prices?
Determination of BEP
Break-even point represents the level of sales where operating profit is zero. It is the point where revenue
from sales equal to total operating cost. It is also called operating break-even point, profit or income break-even
point and accounting break-even point. The break-even point may be determined by using a formula, table and graph
method or a graph. We can determine the break-even point by using formulas:
At break point occurs when the operating profit is zero. For finding this situation revenue must be equal to
total cost.
Sales revenue = Total cost
Sales revenue = Fixed cost + Variables cost
Or, Selling price per unit  Sales unit = Fixed cost + Variable cost per unit  Sales units
Or, S  Q = FC + V  Q
Or, S  Q – V  Q = FC
Or, Q (S – V) = FC
FC
Or, Q =
S–V
FC
 Break-even point in units (QBE) =
S–V
Break-even point in Rupees (SBE) = BEP unit  S
FC
Or, BEP in Rupees (SBE) =
V
1–
S
V
P/V ratio or contribution margin ratio = 1 –
S
Operating profit or EBIT (gain or loss) = sales – variable cost – fixed cost
= Q  S – Q  V – FC = Q (S – V) – FC
After tax operating profit = [Q (S – V) – FC] (1 – t)
Where,
SBE = Break-even point in Rs
QBE = Break-even point in units
S = Selling price per unit
V = Variable cost per unit
FC = Fixed operating cost
EBIT = Earnings before interest and taxes
t = tax rate

Illustration 1.
Consider the following information:
Fixed cost = Rs. 700,000
Variables cost per unit = Rs 10
Selling price per unit = Rs 15
Calculate:
(a) Break-even point in units
(b) Break-even point in Rupees
(c) Gain or loss at break-even point
(d) Gain or loss at sales is 150000 units
(e) Gain or loss at sales is 130,000 units.
Solution :
(a) Calculation of BEP in units (QBE)
 We have,
FC Rs 700000
QBE = = = 1,40,000 units.
S – V Rs 15 – Rs 10
(b) Calculation of BEP in rupees (SBE)
We have,
FC Rs 700000
SBE = = = Rs 2100,000
V Rs 10
1– 1–
S Rs 15
Alternatively
SBE = QBE  S = 140,000 units  Rs 15 = Rs 2100,000
(c) Calculation of gain or loss at sales of 140,000 units (equal to BEP units)
Gain or loss = Q (S – V) – FC
= 1,40,000 (Rs 15 – Rs 10) – Rs 700,000
= Rs 7,00000 – Rs 7,00000 = Rs 0
(d) Calculation of gain or loss at sales of 150,000 units
Gain or loss = 150,000 (Rs 15 – Rs 10) – Rs 7,00000 = Rs 50,000
(e) Calculation of gain or loss of sales of 130,000 units
Gain or loss = 130,000(Rs 15 – Rs 10) – Rs 700000 = –Rs 50,000
 loss = Rs 50,000.
Alternatively
Level of sales unit (Q) 140,000 150,000 130,000
Sales revenues (Q×V) 2100,000 2250,000 1950,000
Less : Variables cost (Q×V) 1400,000 1500,000 1300,000
Contribution margin (CM) 700,000 750,000 650,000
Less : Fixed cost 700,000 700,000 700,000
EBIT Rs 0 Rs 50,000 (Rs 50,000)

Cost and Revenue

(in Rs '000) Gain
TR
TC

2500
BEP (rupees)
21,00,000
2000 EBIT = 0
VC
1500
Loss
1000

500 BEP (rupees) FC

=1,40,000
0
50 100 150 200

Sales (in '000 units)

Applications of cost–volume–profit analysis in business are as follows:

 (a) Calculation of sales volume to produce desired profit.
Fixed cost + Desire profit
Require sales in units =
CMPU (S–V)
Fixed cost + Desire profit
Require sales in rupees =
P/V ratio
V
P/V ratio = 1-
S
DPAT
FC +
1–t
(b) Required sales (in units) for desire profit after tax =
S–V
Where, DPAT = Desire profit after tax
t = tax rate
Cash Break–even Point
If the firm that have fixed costs which include a large amount of non-cash expenses (form of depreciation)
often find it useful to compute the cash break-even point. The purpose of computing the cash operating break-even
point is to determine the level of sales necessary to cover cash operating cost. When break-even point is calculated
considering only the cash fixed cost the resulting break-even point is called cash break-even point. To calculate the
cash break-even point we have to deduct non–cash outlay (depreciation) from the fixed operating cost. Therefore,
cash break-even point is lower than the usual break-even point. Cash break-even point can be determined applying
the following equation.
FC – Non cash outlay FC – Depreciation
QCBE = =
S–V S–V
Non–cash outlay includes specially depreciation,
FC – Non cash outlay (Depreciation)
SCBE =
V
1–
S
or, SCBE = QCBE × S

Illustration 2.
Selling price per unit = Rs. 45
Total fixed cost = Rs. 175000 (including depreciation)
Depreciation Rs= 110,000
Variable cost per unit (V) = Rs 20
Calculate:
(a) Operating break-even point
(b) Cash break-even point
Solution :
(a) Operating break-even point:
FC Rs 175000
(i) BEP in units (QBE) = = = 7000 units
S – V Rs. 45 – Rs. 20
FC Rs 175000
(ii) BEP in rupees (SBE) = = = Rs 315000
V Rs 20
1– 1–
S Rs 45
(b) Cash break-even point:
FC – Depreciation Rs. 175000 – Rs 110000
(i) Cash BEP in units (QCBE) = = = 2600 units
S–V Rs 45 – Rs 20
 FC – Depreciation Rs 175000 – Rs 110000
(ii) Cash BEP in rupee (SCBE) = = = Rs. 117000
V Rs 20
1– 1–
S Rs 45
Here the cash BEP is Rs.117000. The cash BEP is the level of sales needed to cover cash operating costs. If
actual sales of firm equal to cash BEP, there will be operating loss. But the firm still becomes able to meet all cash
operating expenses.

◼◼ Short Problems (SP)

SP-1
P/V ratio; You are given the following information.
Sales Rs 800,000
Variable cost Rs 500,000
Fixed cost Rs 150,000
Required : P/V ratio

SP-2
CMPU, BEP and sales; The following information are given to you
Fixed cost Rs 90,000
Variable cost per unit Rs 9
Selling price per unit Rs 12
Required :
(a) Contribution margin per unit
(b) BEP in units and rupees
(c) Required sales units to earn desire profit of Rs 45,000

SP-3
Profit or loss and BEP; The Company produces baby balls which are sold for Rs 30 each, the fixed costs are
Rs 150,000 and variable cost are Rs 18 per unit.
Required :
(a) What is the firm's profit or loss at sales of 20,000 units
(b) What is the breakeven point ?

SP-4
PV ratio, BEP and profit; The following information is taken from of Pradhan Corporation.
Fixed cost Rs 50,000
Variable cost Rs 6 per unit
Selling price Rs 10 per unit
Compute :
(a) P/V ratio
(b) BEP sales units and rupees
(c) Profit if sales are Rs 150,000
(d) Sales to make a profit after tax of Rs 6000 at a current tax rate is 40%

SP-5
 Degree of operating leverage; Find out degree of operating leverage from the following data.
Sales Rs 50,000
Variable cost 60%
Fixed cost Rs 12,000

SP-6
Degree of operating leverage; The following information is provided
Seles units 2000
Selling price per unit 100
Variable cost per unit Rs 50
Fixed cost 50,000
Required
(a) Degree of operating leverage
(b) Percentage change in EBIT when sales increase by 20%

SP-6
A firm has a fixed operating cost of Rs 50,000 and variable cost per unit is Rs 4. If the selling price per unit is Rs 9,
calculate the sales volume in units to earn zero profit. (ans; 10000 units)

◼◼ Long Problems (LP)

LP-1 (BH–13.1)
Break–even quantity; A company estimates that its fixed operating costs are Rs.500,000, and its variable
costs are Rs.3.00 per unit sold. Each unit produced sells for Rs.4.00. What is the company's break-even point? In
other words, how many units must it sell before its operating income becomes positive?

LP-2 (BH–13.4)
Operating break-even analysis: The Butwal Watch Company manufactures a line of ladies watches that is
sold through discount houses. Each watch is sold for Rs.25; the fixed costs are Rs.140,000 for 30,000 watches or
less; variable costs are Rs.15 per watch.
(a) What is the firms gain or loss at sale of 8,000 watches? of 18,000 watches?
(b) What is the operating breakeven point? Illustrate by means of a chart.
(c) What is the degree of operating leverage at sales of 8,000 units? Or 18,000 units?
(d) What happens to the operating breakeven point if the selling price rises to Rs.31?
(e) What happens to the operating breakeven point if the selling price rises to Rs.31 but variable costs rise to
Rs.23 a unit?

LP-3 (WBB–4.6)
Operating break-even analysis; The following relationship exit for S.K. manufacturer of electronic
components. Each unit of output is sold for Rs.45; the fixed costs are Rs.175,000 , of which Rs.110,000 are annual
deprecation charges: variable costs are Rs.20 per unit.
(a) What is the firm's gain or loss at sales of 5,000 units? Of 12,000 units?
(b) What is the operating income breakeven point?
(c) What is the cash breakeven point?
LP-4 (WBB–4.3)
Degree of leverage: Lumbini Auto-Parts Supplier's Inc's 2013 income statement is shown below.
Income Statement for December 31, 2013(Thousands of rupees)
Sales Rs.36,000
Cost of goods sold (25,200)
Gross profit 10,800
Fixed opening costs (6,480)
Earning before interest and taxes 4,320
Interest (2,880)
Earning before taxes 1,440
Taxes (40%) (576)
Net income 864
Dividends (50%) 432
(a) Compute the degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of total
leverage (DTL) for firm.
(b) Interpret the meaning of each of the numerical values you computed in part a.
(c) Briefly discuss some ways firm can reduce its degree of total leverage.

LP-5 (WBB–4.8)
Operating leverage; The National Corporation produces, teakettles, which it sells for Rs.15 each. Fixed
costs are Rs.700,000 for up to 400,000 units of output. Variable costs are Rs.10 per kettle.
(a) What is the firm's gain or loss at sales of 125,000 units? Or 175,000 units?
(b) What is the breakeven point? Illustrate by means of a chart.
(c) What is Corporations degree of operating leverage at sales of 125,000 units? Or 150,000 units? Or 175,000
units?

LP-6 (WBB–4.12)
Break–even analysis and leverage; SA Company manufactures golf balls. The following income statement
information is relevant for SA in 2012.
Selling price per sleeve of balls (p) Rs.5.00
Variable cost of goods sold (% of price, p) 75%
Fixed operating costs Rs.50,000
Interest expense Rs.10,000
Preferred dividends Rs.0.00
Marginal tax rate 40 %
Number of common shares 20,000
(a) What level of sales dose SA needs to achieve in 2012 to breakeven with respect to operating income?
(b) At its operating breakeven, what will be the EPS for SA?

LP-7 (VH–SC–1)
 Operating break-even analysis; Asian Paint Company has fixed operating costs of RS.3 million a year.
Variable operating costs are Rs.1.75 per half–pint of pint produced, and the average selling price is Rs.2 per half–
pint.
(a) What is the annual operating break-even point in half–pint, (QBE)? In rupees of sales (QBE)?
(b) If variable operating costs decline to Rs.1.68 per half–pints, what would happen to the operating break-even
point (QBE)?
(c) If fixed costs increase to Rs.3.75 million per year, what would be the effect on the operating break-even point
(QBE)?
(d) Compute the degree of operating leverage (DOL) at the current sales level of 16 million half–pints.
(e) If sales are expected to increase by 15 percent from the current sales position of 16 million half pints, what
would be the resulting percentage change in operating profit (EBIT) from its current position?

LP-8
Break-even analysis; The following information is given for the purpose of calculating break-even point:
Sell price per unit Rs 5
Variable cost per unit Rs 3
Fixed cost (including depreciation of Rs 8000) Rs 24,000
You are required to calculate (i) operating break-even point, (ii) cash break-even point, (iii) operating break-
even point if the desired profit is Rs 30000 and (iv) desired profits after income tax is Rs 20000 and income tax is 40
percent.
LP-9

Cosmic Airline's fixed operating costs are Rs 5.8 million and its variable cost ratio is 0.20. The firm has Rs 2 million
in bonds outstanding with a coupon interest rate of 8 percent and 1 million, 5 percent bank loan. Cosmic has 30,000
shares of preferred stock outstanding, which pays a Rs 2.00 annual dividend. There are 100,000 shares of common
stock outstanding. Revenues for the firm are Rs 8 million, and the firm is in the 40 percent tax rate.
(a) Compute Cosmic's degree of operating leverage.
(b) Compute its degree of financial leverage.
(c) If sales increase to Rs 10 million forecast Cosmic Airline's earnings per share.
(ans. a.10.67 times b. 2.069 times c. Rs.11.34)

LP-10
Everest Sugar Mills has degree of operating leverage (DOL) of 2 at its current production and sales level of 10000
units. The resulting operating income figure is Rs 1000.
(a) If sales are expected to increase by 20 percent from the current 10000 units sales position, what would be the
resulting operating profit figures ?
(b) At the company's new sales position of 12000 units, what is the firm's new DOL figure ?
(ans. a. Rs.1400 b.1.71 times)
LP-11

The capital structure of the Progressive Company Ltd. consists of an ordinary share capital of Rs. 1,000,000. (shares
of Rs.100 par value) and Rs. 1000,000 of 10% debentures. The unit sales increased by 20% from 100,000 units to
120,000'units, the selling price is Rs.10 per unit, variable cost amount to Rs.6 per unit and fixed operating expense
amount to Rs.200,000. The income tax rate. is assumed to be 35%. You are required to calculate:
(a) The percentage increase in EPS
(b) The degree of financial leverage at 100,000 units and 120,000. units.
 (c) The degree of operating leverage at 100,000 units and 120,000 units.
(ans. a. 80% b. 2 & 1.56 times c. 2 & 1.714 times)

LP-12

Given, the following information of firm A and B

Firm A:
Break-even point in units = 25000;
Total fixed cost = Rs.80000
Total revenue at BEP = Rs.200000
Firm B:
Break-even point in units = 30000;
Total fixed cost = Rs.120000
Total revenue at BEP = Rs.240000
(a) Which firm has the higher operating leverage at only given level of sales? Explain.
(b) At what level of sales in units do both firm’s earn the same operating profit?

(c) If both the company require an after tax profit Rs.36000; what is the target units of sales required in each
company? Assume corporate tax rate is 40%. (ans. a. Firm B b.50000 units c. 43,750 and 45,000 units)

LP-13
A newly employed manager of the ABC Company holds an MBA degree from a reputed university. Upon joining
the company, he thought it would be better to gather some relevant information before he makes decisions on any
matter. He found that the company is running at a contribution margin of 50 percent which account for Rs.3 per unit.
He was told that the company's break-even profit is about 9,000 units and the fixed cost runs about Rs. 12,000. It is
expected that the total sales will reach to Rs. 15,000 during the current year.
(a) Are the information given to him consistent?
(b) If the break–even point as given is correct, what is the correct amount of fixed cost of the company?
(c) What is selling price ?
(d) What is the anticipated profit ?
( ans. a.4000 units (not consistent) b. Rs 27000 c. Rs 6 d. – Rs 4500 )

LP-14

A project is projected of break-even on an accounting basis in its third year. Sales for the third year are
projected at 12000 units. Depreciation at that time will be Rs.13000. the price per unit less variable
cost per unit is Rs.15. what will be the fixed costs? If fixed cost is increased by 10 percent, what is
its break-even point in units?

LP-15

Dream inc. has expected annual free cash flow (FCF) of Rs 350,000 for indefinite future. The average cost of capital
is 10% and the market value of debt is Rs 500,000. Calculate the market value of equity.
Solution
 FCF 350000
Value of the firm = = = Rs 3500000
Ko 0.10
Value of the equity = Value of the firm – Value of the debt = Rs 3500000 – Rs 500000 = Rs 3000000

Answer Sheet
Short problems
1. 0.375 2. (a) Rs 3 (b) 30,000 units; Rs 360,000 (c) 45000 units 3. (a) Rs 90,000 (b) 12500 units;
Rs 375000 4. (a) 0.40 (b) 12500 units; Rs 125000 (c) Rs 10,000 (d) Rs 150,000 5. 2.5 times
6. (a) 2 times (b) 40%

Long problems
1. 500000 units
2. (a) (i) – Rs.60000 (ii) Rs.40000 (b) 14000 watches, Rs.350000
(c) (i) – 1.33 (ii) 4.5 (d) (i) 8750 units (ii) Rs. (e) 17500 units, Rs.542500
3. (a) – Rs.50,000, Rs.125,000 (b) 7000 units, Rs.315,000 (c) 2600 units, Rs.117,000
4. (a) DOL = 2.5, DFL = 3, DTL = 7.5
5. (a) –Rs.75,000, Rs.175,000 (b) 140,000 units, Rs.2100,000 (c) –8.33, 5
6. (a) 40,000 balls (b) –Rs.0.30 (c) 48,000 units
(d) (i) EPS = Rs.0.45, DOL = 3, DFL = 1.67, DTL = 5 (ii) Rs.0.23
7. (a) 12 million half pints, Rs.24 million (b) 9.375 million half pints
(c) 15 million half pints (d) 4 (e) 60% increase in EBIT
 Units - 6

Dividend Decision
 Meaning of dividend Policy

• Companies that earn a profit can decide either of three ways: pay
that profit out to shareholders, reinvest it in the business through
expansions ,debt reductions or share repurchased, or both.
• When a portion of the profit is paid out to the shareholders, the
payment is known as dividend. Dividend is the earnings or profit
distributed to the shareholders by a company.
• It is distributed in cash and securities or combination of these.
• Dividends are paid quarterly, half yearly or annually. Similarly the
dividend is distributed to preference shareholders and equity
shareholders.
• The dividend paid to the preference shareholders is called
preference share dividend, which is generally fixed or constant and
distributed before distributing to the common shareholders.
• The percentage of earnings paid out in the
form of cash dividends is known as dividend
payout ratio and its calculate as follows:
• Dividend payout ratio = dividends/ net income
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 −𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
• Retention ratio=
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
• Retention ratio= 1- Dividend payout ratio
 Con…..
• The policy of a company on the division of its
profit between distribution to shareholders as
dividend and retention for its investment is
known as dividend policy.
• Dividend policy is to determine the amount of
earnings to distribute to shareholders and the
amount to be retained or reinvestment in the
firms.
• Any change in dividend policy has both favorable
and unfavorable effects on the firm's stock price.
 Cond…
• For example shareholders get excess dividend
in present that increases market value of
shares, which is favorable aspect.
• But in future, the firm can not invest in
profitable project due to lack of internal
capital (Retained earnings).
• As the result the future growth rate of the
firm decreases that causes unfavorable effects
in share value.
DIVIDEND PAYMENT PROCEDURES
1. Declaration date
2. Record date or holder of record date
3. Ex-dividend date
4. Payment date
 Cond…
1. Declaration date
This is the day on which the board of directors
declares the dividend. At this time they set the
amount of the dividend to be paid, the holder-of
–record date, and payment date. Generally, the
dividend is announced as a percentage of the
par value of the stock.
 Cond….
2. Holder-of record date
This is the date the company opens the
ownership books to determine who will receive
the dividend; the stockholders of record on this
date received the dividend.
 Cond…
3. Ex-dividend date
This date is four days prior to the record date.
Shares purchased after the ex-dividend date are
not entitled to the dividend.
2. Payment date
This is date when dividend checks are actually
mailed to the holders of record.
 01/28 02/23 02/27 03/17
Declearation Ex-dividend date Holder or record Payment date
date date
 FACTORS AFFECTING DIVIDED POLICY
1. Desire of shareholders
2. Legal rules
3. Liquidity position
4. Need to repay debt
5. Restriction in debt contracts
6. Rate of asset expansion
7. Profit rate
8. Stability of earning
9. Access to the capital market
10. Policy of Control
11. Tax position of stock holders
 DIVIDEND PAYOUT SCHEME OR
DIVIDEND PAYOUT POLICIES

• Residual dividend policy

• Constant dividend per share
• Constant payout ratio
• Low regular dividend plus extra policy
1. Residual dividend Policy
If a company has profitable investment
opportunities (r > k ), the company invest the
required amount of the earning and the
remaining amount of the earnings is distributed
as dividend. Such types of policy is called
dividend policy. A firm using residual policy
would follow these four steps:
 Cond…
i. Determine the optimal budget/ investment.
ii. Determine the amount of equity needed to
finance that budget or capital structure.
iii. To uses retained earning to meet equity
requirement.
iv. To pay dividends if more earnings are
available than are needed to support the
optimal capital budget.
 Earnings available to common stock holders (EAC) xxx
Less : Equity financing needs :
Total financing requirement xxx
Less : funds from debt xxx
Funds from equity/Equity financing needs xxx xxx
Residual dividend if '+' External equity requirement if '–' + xxx
Divided payment = Net income –(Total capital budget  target equity ratio)
= Net income – (Investment opportunity  retained earning ratio)
Residual divided
Dividend payout (D/P) ratio =  100
Total earnings after tax
Ncell Telecommunications has a target capital
structure that consists of 70 percent debt and 30
percent equity. The company anticipates that its
capital budget for the upcoming year will be
Rs.3,000,000. If Ncell reports net income of
Rs.2,000,000 and it follows a residual dividend
payout policy, what will be its dividend payout
ratio?
 Cond…
[Link] dividend per share
Constant dividend policy is based on the payment
of a fixed rupee dividend. The policy of paying
fixed amount per share as dividend every period,
without fluctuation in the earning of the company.
This policy does not imply that dividend per share
will never increase. When the company reaches the
new level of earnings, the annual dividend per
share will increase. It is suitable for that investor
whose only income source is dividend.
The net income of the ABC company for different years are given below :
Year 2006 2007 2008 2009 2010
Net income Rs 60,000 Rs 40,000 Rs 30,000 Rs 50,000 Rs 70,000
The ABC company has 10,000 shares outstanding and the dividend for each share has been fixed
for Rs 3. Calculate earnings per share and dividend per share for each year.
Solution :
Calculation of earnings per share and dividend per share for each year.
Year 2006 2007 2008 2009 2010
Net income Rs 60,000 40,000 30,000 50,000 70,000
Dividend 30,000 30,000 30,000 30,000 30,000
EPS Rs 6 4 3 5 7
DPS Rs 3 3 3 3 3
Dividend
DPS =
No. of shares
Net income
EPS =
No. of shares
 Cond…
3. Constant payout ratio
if the fixed percentages of earnings are paid as
dividend in every period, the policy is called
constant payout ratio. The earnings fluctuate
that means rupee amount of dividend will
fluctuate. It ensures that dividends are paid
when profit are earned and avoided when losses
incur.
The net income of the ABC company for different years are given below :
Year 2006 2007 2008 2009 2010
Net income Rs 60,000 Rs 40,000 Rs 30,000 Rs 50,000 Rs 70,000
The ABC company has 10,000 shares outstanding and the dividend for each share has been fixed
for Rs 60% computed earnings per share and dividend per share for each year.
Solution :
Calculation of earnings per share and dividend per share for each year.
Year 2006 2007 2008 2009 2010
Net income Rs 60,000 40,000 30,000 50,000 70,000
Dividend Rs 36000 24,000 18,000 30,000 42,000
EPS Rs 6 4 3 5 7
DPS 3.60 2.40 1.80 3.0 4.20
 Cond…
4. Low regular dividend plus extra policy
this policy is the compromise between the
two policy mentioned above (2 & 3). If the firm’s
earnings are volatile, however, the policy will be
the best choice. The low regular dividend can
usually be maintained even when earning
decline and extra dividend can be paid when
excess funds are available.
The net income of the ABC company for different years are given below :
Year 2006 2007 2008 2009 2010
Net income Rs 60,000 Rs 40,000 Rs 30,000 Rs 50,000 Rs 70,000
The ABC company has 10,000 shares outstanding and the company policy is paying a regular
dividend of Rs 2 per share and extra dividend 40% of earning per share is provided. Calculate earnings
per share and dividend per share for each year.
Solution :
Calculation of earnings per share and dividend per share for each year.
Year 2006 2007 2008 2009 2010
Net income Rs 60,000 40,000 30,000 50,000 70,000
EPS Rs 6 4 3 5 7
Regular DPS (given) Rs 2 2 2 2 2
DPS [40% of EPS] 2.4 1.6 1.2 2 2.8
Extra DPS 0.4 00 0.0 0 0.8
Total DPS (Regular DPS + extra DPS Rs 2.4 2.0 2.0 2.0 2.8
 TYPES OF DIVIDEND

• Cash Dividend
• Stock Dividend
 Cond….
1. Cash Dividend
cash dividend is the dividend, which is
distributed to shareholder in cash out of the
earning of company. When cash dividend is
distributed both total assets and net
worth(shareholders’ equity) of the company
decreases as cash and earning decrease . The
market price of the share drops in must case by
the amount of the cash dividend distributed.
A firm has 400000 outstanding shares of Rs.2
per common stock, a contributed capital in
excess of par account of Rs.6.4 million and
retained earnings of Rs.32 million all before the
declaration of dividends. The board of directors
declared a Rs.3 per share cash dividend. What
are the balances in equity accounts if the fair
market value of stock is Rs.25 per share?
 Cond….
2. Stock Dividend
An issue of shares to existing shareholder instead
of paying a cash dividend is known as stock
dividend. It is also known as bonus shares.
Company issues stock dividend if they have no
sufficient cash balance to pay cash dividend. The
numbers of shares increase by distributing the stock
dividend. It is only transferring of fund from
retained earnings to capital account therefore it
does not affect the wealth of shareholders.
 MPS before stock dividend
(a) MPS after stock dividend =
1 + % of stock dividend
Total value of share before stock dividend P0  N
or, MPS after stock divided = =
Total No. of shares after stock dividend N + n
Where, N = No. of outstanding shares before stock dividend
n = No. of shares under stock dividend or bonus shares.
EPS before stock dividend
(b) EPS after stock dividend =
1 + % of stock dividend
DPS before stock dividend
(c) DPS after stock dividend =
1 + % of stock dividend
 Cond…
Effect of stock Dividend
• Increased in number of shares.
• Retained earnings transfer to share capital.
• Decreased in retained earnings.
• Par value of shares remain unchanged.
• Do not change in shareholders equity fund.
• DPS, EPS, will decreased if the total profit does
not increased.
• MPS will decreased.
 Cond…
Significant of stock dividend
The company gives stock dividend if they have no
sufficient cash balance to pay cash dividend. Others
reason of issuing stock dividends are as follows:
– To bring the share price at reasonable ranged (or
trading range)
– To provide psychological value to the investors
– To provide tax benefit to the investors
– To increase share capital
– To reserve cash in organization
 A firm has 400000 outstanding shares of
Rs.2 per common stock, a contributed capital in
excess of par account of Rs.6.4 million and
retained earnings of Rs.32 million all before the
declaration of dividends. The board of directors
declared a 25% stock dividend. What are the
balances in equity accounts if the fair market
value of stock is Rs.25 per share?
 Stock Split
Stock split is sub division of share with which the
number of shares are increased with the
proportional reduction in par value of stock
without any change in owner’s equity or net
worth. For example, in a 2 for 1 stock split, an
investor will own 100 shares valued at Rs.100
per share before the stock split will owns 200
shares valued at Rs. 50 per share after the split.
 Cond…
Effect of stock split
• Number of shares increased .
• Market price per share decreased.
• Earnings and dividend per share are decreased.
• Additional paid on capital and retained earnings
are remain unchanged.
• Total wealth position of the shareholders remains
unchanged.
 Cond…
Significant of stock split
Company goes for stock split, when price of
stock exceptionally high. The basic objective of
stock split is to bring down the market price of
share into the tradable (or reasonable) range. As
a result small investor can purchase the
company's shares.
SPM company has outstanding shares of
Rs.20,00,000 with a par value per share Rs.4
each. The premium recorded Rs.64,00,000 and
the retained earnings amounting to
Rs.232,00,000. The board of director declared
Rs.0.50 as cash dividend per share and 25% as
stock dividend. The market value per share is
raised to Rs.10. Find out effect of change in
equity premium and retained earnings. Also
show effect of 8 for 2 stocks split.
 Reverse Stock Split
A decrease in a firm’s number of shares outstanding
without any change in owner’s equity is called reverse
stock split. Where reduction of numbers of shares occurs
with proportionate increases in par value. For example, in
a 1 for 2 reverse stock split, an investor will own 100
shares valued at Rs.50 per share before the reverse stock
split will owns 50 shares valued at Rs. 100 per share after
the reverse stock split.
The purpose of reverse stock split, if the market price of
the stock is relatively low. The basic objective of reverse
split is to increase in the price of share from certain level.
 Cond…
Effect of reverse stock split
• Number of share decreased.
• Par value per share increased.
• EPS, DPS, and MPS are decreased.
• Additional paid in capital and retained
earnings are remain unchanged.
• Total wealth position of shareholder's remain
unchanged .
SPM company has outstanding shares of
Rs.20,00,000 with a par value per share Rs.4
each. The premium recorded Rs.64,00,000 and
the retained earnings amounting to
Rs.232,00,000. The company has MPS, EPS and
DPS are Rs.10, Rs.2and Rs.1 respectively. Find
out effect of change in equity share holder
account, MPS, EPS and DPS after 1 for 2 stock
reverse.
 Re-purchase of stock
Stock repurchase is buying back its own shares
by company from the markets. Stock re-
purchased by the issuing firm is called treasury
stock and does not pay dividend and voting
rights. When the company needs money future
then the treasuring stock (re-purchased stock)
can be resold. If a firm has excess cash and
insufficient profitable investment opportunities
may use to re-purchases of stock as an
alternative to the cash dividend.
 Cond…
Reasons for stock re-purchase
A company repurchases its own stock due to
number of reasons such as:
▪ to bring a change in the existing capital structure
(use more debt),
▪ to increase the value of stock in future,
▪ to benefit tax for certain shareholders
▪ to distribute temporary excess cash
▪ to manage excess liquidity.
 Cond…
Method of stock repurchase
Stock re-purchases are usually made in one of
the three ways :
• A publicly owned firm can buy back its own
stock through a broker on the open market.
• The firm can make a tender offer.
• The firm can purchase a block of shares from
one large holder on negotiated basis.
The Bank of Kathmandu is planning to re-purchased 40,000 shares out of its 400,000 shares outstanding.
Prior to the shares re-purchase announcement, the share price Rs 1500 each what is the equilibrium price
after re-purchase ?
Solution:
Given, Number of shares to be re-purchased (N) = 40000
Number of shares outstanding (S) = 400,000
Current market price per share (PC) = Rs 1500
Equilibrium price after re-purchased (P) = ?
We know that,
S  PC 400000  Rs 1500
Equilibrium price after re-purchased (P) = = = Rs 1666.67
S–N 400000 – 40000
 Units - 7
Working Capital Management
 Meaning of working capital
• Working capital means capital required for day to day operation of an
enterprise.
• It is concerned with current assets and current liabilities.
• The term current assets refer to those assets which can be converted into
cash with in one operating cycle or accounting period without undergoing
a diminution in value and without disrupting the operations of the firm.
• The major current assets are cash, marketable securities, account
receivable and inventory.
• Current liabilities which are payable within one operating cycle or
accounting period.
• The basic current liabilities are account payable, bills payable, bank
overdraft and outstanding expenses.
• Therefore the goal of working capital management is to manage the firm's
current assets and liabilities in such a way that satisfactory level of
working capital is minted
 Types of Working Capital
Gross Working Capital
Gross working capital refers to the total investment in the
current assets of the firm. Current assets refer to those assets, which
can be converted into cash within one year. For example cash
marketable securities, inventory, account receivable etc. Gross working
capital is also known as total working capital. According to gross
concept working capital = Total current assets.
Net Working Capital
Net working capital is the difference between current assets
and current liabilities, which are paid within a year, for example,
account payable, bills payable, bank overdraft and outstanding
expenses.
• Net working capital = Total current assets – Total current
liabilities
 Con…..
Permanent Working Capital
The minimum amount of current assets which
the firm has to hold for all time to come to carry an
operation at any time is termed as permanent or
regular working capital.
Temporary Working Capital
It represents the additional assets which are
required at different time during the operating year.
It is also called variable or fluctuating working
capital.
 Importance and significant of WC
• The working capital is the life blood of any business enterprise. Without
adequate working capital no business enterprise can run successfully. The
importance of working capital is as follows:
• To run the day to day operation the business activities:
• To make quick payment and helps in creating and maintaining good will of
the firm.
• To make regular and timely payment of wages, salaries as well as meet day
to day operational expense.
• To ensures regular supply of raw materials and helps to continue the
production process.
• To obtain credit facility from suppliers.
• It enables a concern to pay regular divided.
• It enables a concern to face business crisis.
• It enables to avail earn discount as purchase.
• It helps in maintaining solvency of the business.
 Factors affecting the WC
1. Size and nature of business
2. Production cycle
3. Business up-down
4. Organization's credit policy
5. Growth and expansion of attitudes
6. Profit and dividend distribution policy
7. Change in price
8. Work efficiency
Cash Conversation Cycle

Figure : Working capital management process

Raw material (Create Work in process (accrued Finished goods

Account payable ) wages /expenses) (accrued wages/expenses)

Credit sales (create

Cash
account receivable)
 Con….
• In the above figure, working capital cash flow cycle or
cash conversion cycle is the length time between the
companies makes payments and when it receives the
cash payment. The time duration required to complete
one cycle of business is called working capital cash flow
cycle. Usually a company acquires inventory on credit,
which result in account payable. A company can also
sells products on credit, which result in account
receivable. Cash therefore is not involved until the
company the accounts payable and collected accounts
receivable. So the cash conversion cycle measured the
time between outlay of cash and cash recovery.
 Con…..
1. Inventory Conversion Period (ICP)
The inventory conversion period is the average
length of time required to convert raw material
into finished goods and them to sell those goods
360 days Inventory  360 days
ICP = =
Cost of goods sold cost of goods sold
Inventory
If cost of goods sold is not given
Inventory  360 days
ICP =
sales
days in year
or, ICP =
Inventory turnover
2. Receivable Conversion or Collection Period
(RCP)
The receivable conversion period is the average
length of time required to convert the firm's
receivable into cash. It is also called day's sales
outstanding (DSO) or average collection period
(ACP). Receivable Receivbale  360 days
RCP = =
Credit sales / 360 days Credit sales
Days in year
RCP =
Account receivable turnover ratio
 3. Payable Deferred Period (PDP)
The payable deferral period is the average
length of time between the purchase of raw
material and labour and then payment of cash
for them. It can be calculate as under.
Account payable Account payable  360
PDP = =
credit purchase / 360 credit purchased
Account payable  360
If credit purchased is not given
cost of goods sold
Days in year
PDP =
Account payable turnover ratio
4. Cash Conversion Cycle (CCC) or Cash Cycle
(CC)
It is the length of the time between paying for
raw material and receiving cash from the sales
of finished goods.
CCC = ICP + RCP – PDP
Operating cycle = ICP + RCP
 Con….
The CCC can be shortened by;
• Reducing the inventory conversion period by
processing and selling goods more quickly.
• Reducing the receivable collection period by
speeding up collections.
• Lengthening the payables deferral period by
slowing down, its own payments.
Useful Ratios
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
1. Inventory turnover ratio =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝑑𝑎𝑦𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟
2. Inventory Turnover ratio =
𝐼𝑇𝑅
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
3. Return on assets =
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
4. Return on equity
𝐸𝑞𝑢𝑖𝑡𝑦
5. Working capital requirement = working capital per day× CCC
6. Equity = common stock + Retained earning
7. Total assets = current assets + fixed assets
8. Current assets = Cash and marketable securities + receivable +
inventory
 ALTERNATIVE CURRENT ASSETS
INVESTMENT POLICIES

(a) Conservative current assets investment policy

Conservative current assets policy carries a high level of current assets to
support the given level of sales. It uses less short-term debt and more long-term debt
for current asset financing. Therefore conservative policy lower risk and lower
profitability than aggressive policy. This policy is also known as relaxed policy.
(b) Aggressive current asset investment policy
Aggressive current assets policy carries a low level of current assets to
support the given level of sales. It uses more short-term debt and less long-term debt
for current assets financing. Therefore aggressive policy is riskier and profitable than
conservative policy. This policy is also known as tight or restricted policy.
(c) Moderate current asset investment policy
Moderate current assets policy carries a moderate level (average level) of
current assets to given level of sales. Moderate policy uses average/ mid range of
short-term and long-term debt of the above two policies. Therefore the moderate
policy results in mid range risk and return. This policy is known as average policy.
 Short term investment
Fund available for one year or less and use to finance
working capital is called short term financing. The major
sources of short term financing are short term bank loan,
trade credit (creditors and bills payable) and outstanding
expenses.
2/10 net 30
Annual percent cost of trade credit
𝑑 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟
= ×
100−𝑑 𝐶𝑃−𝐷𝑃
Where, d= discount rate; CP = credit or net period; DP =
discount period
=2/98 ×365/20 = 37.24%
 Cash Management
The term cash includes coins, currency and cheques held by the firm
and balances in bank accounts. Sometimes near cash items (that can
easily be converted into cash), such as marketable securities or bank
time-deposits are also included in cash. Cash is the important current
assets for the operation of the business. On the other hand cash is
non-earnings asset. Therefore the firm should keep sufficient cash,
neither more or less. More cash balance earns nothing but it earns if it
is invested in marketable securities and insufficient cash balance
creates problem to run business because the firm needs cash to pay
for credit purchased, wages, salary, taxes, rent and so on. Therefore
the adequate cash balance is necessary to run business organization
efficiently and effectively. The major function of the financial manager
is to maintain a sound cash position.
 Motives for holding cash
• Transaction motive
• Compensation motive
• Precautionary motive
• Speculative motive
 Functions of Cash Management
• Cash planning
• Managing the cash flows
• Determination of optimum cash balance
• Investing surplus cash
 Cash Budget
A cash budget is schedule or statement showing
cash receipts, cash disbursement and cash balance
for a firm over a specified time period. A cash
budget is a summary statement of the firm's
expected cash inflows and outflows over a
projected time period. It gives information as the
timing and magnitude of expected cash flow and
cash balance over the projected period. This
information helps the financial manager to
determine the future cash needs of the firm, plan
for the financing of these needs and exercise
control over the cash and liquidity of the firm.
 Specimen of cash budget
Particular January February
A. Receipts section
Opening balance b/d ---- ----
Cash sales ---- ----
Collection from debtors ---- ----
Sales of securities/ assets ---- ----
Interest /dividend received ---- ----
Other cash receipts ---- ----
Total cash receipts ---- ----
B. Disbursement section
Cash purchased ---- ----
Payment to creditors ---- ----
Salaries and administrative expenses ---- ----
Payment to securities ---- ----
All other cash payment ---- ----
Total cash disbursement ---- ----
C. Cash surplus or Deficit section
Closing Balance (A-B) ---- -------
Prepare a cash budget of a company for April, May and June 2010.
Months Sales (Rs) Wages (Rs) Purchase (Rs) Expenses (R)
Actual January 80,000 20,000 44,000 4,000
February 80,000 16,000 40,000 8,000
March 70,000 22,000 44,000 6,000
Budget April 88,000 20,000 44,000 8,000
May 84,000 20,000 44,000 6,000
June 88,000 18,000 36,000 4,000

Additional information
(a) 20% of sales are cash 50% of remaining is collected in same month and balance after 1 month.
(b) 20% of purchase are for cash and remaining are paid after and 1 month.
(c) Wages are paid half monthly. Expenses and paid after one month.
(d) The rent of Rs 1000 is not included in expenses. The rent is paid monthly.
(e) Cash balance on April, 2010 may be assumed to be Rs 20,000.
 Cash Budget
For April, May and July 2010
Particulars April (Rs) May (Rs) June (Rs)
Opening balance b/d 20,000 28,800 41,400
Add : Receipts :
Cash sales 17,600 16,800 16,000
Collection from debtors :
Current month 35,200 33,600 32,000
Last month 28,000 35,200 33,600
(A) Total receipts 100,800 114,400 123,000
Less : Payments :
Cash purchase 8,800 8,800 7,200
Payments of creditors 35,200 35,200 35,200
Wages :
Current month 10,000 10,000 9,000
Last month 11,000 10,000 10,000
Rent 1,000 1,000 1,000
(B) Total payment 72,000 73,000 68,400
Closing balance (A – B) 28,800 41,400 54,600
 Cash Management Techniques
1. Speedy cash collections
(a) Prompt Payment by Customers.
(b) Early Conversion of Payments into Cash:
(i) Concentration Banking
(ii) Lock Box System
 Con…
2. Slowing disbursements
(a) Avoidance of Early payment
(b) Centralized Disbursement
(c) Float
-Disbursement Float
-Collection Float
-Net Float
(d) paying from a distant bank
(e) Cheque-encashment analysis
(f) Accruals
 Local area 1 Local area 2

Customer A Customer B Customer C Customer B

Post office (Lock box) Post office (Lock box)

Local Banks 1 Local Banks 2

Concentration Bank

Corporate office

Local Bank 4 Local Bank 3

Post office (Lock box) Post office (Lock box)

Customer G Customer H Customer E Customer F

Local area 4 Local area 3

Each business day, on average, a company writes cheques totaling Rs.12,000 to pay its suppliers. The
usual clearing time for these cheques it five days. Meanwhile, the company is receiving payments from its
customers each day, in the form of cheques, totaling Rs.15,000. The cash from the payments is available
to the firm after three days. Calculate the company's disbursement float, collection float, and net float and
also interpret the results.
Solution:
Given;
Daily cheque written on average = Rs.12000
Disbursement delay = 5 days
Daily cheque received on average = Rs.15000
Collection delay = 3 days
Calculation of the disbursement float, collections float and Net float
Disbursement float in rupees = disbursement delay  daily check written
= 5 days  Rs.12,000 = Rs.60,000
Collection float in rupees = Collection delay  daily check received
= 3 days  Rs.15,000 = Rs.45,000
Net float in rupees = Disbursement float – Collection float
= Rs.60,000 – Rs.45,000 = Rs.15,000
This company has positive net float i.e. Rs.15000. It means there fast collection and slow
disbursement of cash in this company. It proves that there is efficient cash management in this company
and we can used this excess of Rs 1500 without any cost.
 Inventory Management
• The word 'inventory' means the stock of various types of goods. The
various forms of material held by an enterprise are known as inventory. It
includes raw material, work in progress, finished goods, daily consuming
goods and so on. Inventories represent the major element in the working
capital of an enterprise.
• Both excessive and inadequate inventories are not desirable i.e. these are
two dangerous points within which the firm should operate. The excessive
level of inventories consume the funds of the firm, which cannot be used
for any other purposes and thus, involves an opportunity cost. Maintaining
an inadequate level of inventories is also dangerous. If the inventories are
not sufficient to meet the demand of the customers regularly, the
customers may shift to the competitors which will amount to a permanent
lose to the firm.
• The aim of inventory management, thus, should be avoid excessive and
inadequate levels of inventories and to maintain sufficient inventory for
the smooth productions and sales operations.
 TYPES OF INVENTORY

• Raw materials
Raw materials are those basic inputs that are converted into finished
products through manufacturing process. In other words raw material
inventories are those units, which has been purchased and stored for
future production.
• Work-in- progress
Working progress inventories are semi-manufactured products they
represent products that need more work before they become finished
products for sales.
• Finished goods
Finished goods inventories are those completely manufactured
products, which are ready for sales. Stock of raw materials and
working progress facilitate production, while stock of finished goods is
required for smooth marketing operations.
 OBJECTIVE OF HOLDING INVENTORIES
• Transaction motive
Every firm holds adequate amount of inventories to facilitate smooth production and
sales operation. Adequate amount of inventories are necessary to meet the day to day
requirement of sales, production process, customer demand and so on.

• Precautionary motive
It guards against the risk of predictable changes in demand and supply forces and
other factors such as strike, transport disturbances, short supply. In such situations,
the firm holds the adequate amount of inventories to continue production operation
• Speculative motive
It influences the decision to increase or reduce inventory levels to take advantages of
price fluctuations. It helps the firm to earn extra profit in the case of expected price
rise in market and sufficient level of inventory may helpful to earn profit in case of
expected shortage in the market. To get quantity discount, the firm may purchased
inventories in a larger quantity.
 Economic Order Quantity(EOQ)
EOQ is that inventory level which minimizes the
total cost of ordering and carrying. At the
optimal order size the total ordering cost is
equal to total carrying cost. Determining an
optimum inventory level involves two types of
costs.
1. Carrying cost
2. Ordering cost
 2AO
a. EOQ =
C
EOQ
b. Average inventory = + Safety stock
2
c. Maximum inventory = EOQ + safety stock
A
d. No. of order =
EOQ
Days in year
e. Period of order =
No. of order
f. Total Cost = Ordering cost + carrying cost
A EOQ
= × O +[ + Safety stock] × C
EOQ 2
A EOQ
= ×O+ × C + Safety stock × C
EOQ 2
If safety stock is not given
A EOQ
Total cost = = ×O+ ×C
EOQ 2
g. Re-order point = (Safety stock + (Average usage  LT) – GIT
Annual requirement
h. Average usage =
Days in year or week
 Receivable Management
• The term receivable is defined as debt owned to the
firm by customers arising from the credit sales of goods
or services in the ordinary course of business. When a
firm makes an ordinary sales of goods or services and
does not receive payment, the firm is granting trade
credit and creates account receivable which could be
collected in the future.
• This credit is known as receivable. It is also called
book debts. The objective of receivable management is
to promote sales and profits until that point is reached
where the return on investment in further funding
receivable is less than cost of funds raised to finance
that additional credit i.e. cost of capital.
 Elements of Credit Policy
• Credit period
• Cash discount
• Credit standard
(i) The five Cs systems.
Character
Capacity
Collateral
Capital
Condition
(ii) Credit scoring system
▪ Collection policy
 Monitoring the credit policy
• Day sales outstanding
• Aging schedule
 Day sales outstanding

The period within which the credit amount is

collected after the day of sales is called DSO or
average collection period. DSO is calculated using
following equation:
A/c receivable  360 days
DSO =
Sales

After DSO is calculated DSO and credit period are

compared. If DSO and credit period are very near
then credit policy is said to be effectively operating
and vice versa. This fact is shown by following
example.
When DSO and credit period are compared the
credit policy of firm X is seen more effective the
credit period (30 days) and DSO (31 days) are
almost similar. The receivable management of
firm Y is not effective because of the difference
of DSO and credit period.
 Aging schedule

The method of dividing the credit amount/ receivable

into different time periods showing that what percentage
of credit is collected within what period of time is called
aging schedule. In others word; it is a report showing how
long accounts receivable have been outstanding. The
report divides receivables into specified periods, which
provides information about the proportion of receivables
that are current and the proportion that are past due for
given lengths of time. If the aging schedule shows that
more of credit is collected at the initial period and slowly
the rate goes on decreasing at later periods then it will
show the stronger aspect of credit policy and vice-versa.
The following example is shown to make this clear.
 Age of A/R Firm X Firm Y
(days) Outstanding % of total Outstanding % of total
receivables (Rs) amount (Rs) receivables (Rs) amount (Rs)
0 – 30 500,000 50% 200,000 18.18%
31 – 45 200,000 20 300,000 27.27
46 – 60 150,000 15 200,000 18.18
61 – 90 100,000 10 300,000 27.27
Over 90 50,000 5 100,000 9
Total 1000,000 100 1100,000 100
The above aging schedule shows that the 50% of total credit of term X is collected within the first
month and remaining 50% of total credit is collected within 45 days whereas in firm Y 18.18% of total
credit is collected within the just month. The credit of firm X is only 20% after 2 months whereas it is
27.27% for firm Y. This fact shows that the credit policy of X is effective whereas the credit policy of Y
needs re-thinking. In this way DSO and aging schedule help to show the implementation of credit policy,
which helps to improve and monitor the credit policy.
DSO = % of customer taking discount  discount
period + % of customer not taking discount 
Net period + % of customer paying late  total
late period
Rautahat Rice company sells on terms of net 30.
Total sales for the year are Rs.912500. Forty percent
of the customer pay on the 10th day and take
discount: the other 60% pay on average, 40 days
after their purchases.
• What is the day’s sale outstanding?
• What is the average amount of receivables?
• What would happen to average receivable if
company tough end up on its collection policy
with the result that all non-discount customers
paid on the 30th day.
Given;
Credit terms = 3/10 Net 30
Sales = Rs.912,500
Discount taking customer = 40%
Non-Discount taking customer = 60% pay 10 day later that late period 40days.
(a) Day sales outstanding (DSO)
DSO = % of DTC  DP + % of paying late  late period
= 0.40  10 + 0.60  40 = 28 days
DSO  Sales 28  Rs.912500
(b) Account receivable = = = Rs.70,000
365 days 365 days
(c) If non-discount customer pay in net period 30 days
DSO = % of DTC  DP + % of NDT  NP = 0.40  10 + 0.60  30 = 22 days
DSO  Sales 22  Rs.912500
Receivable = = = Rs.55,000
365 days 365 days
If the credit term is tightened receivable amount decreases from is Rs.70,000 to Rs.55,000.