FM & SM

Detail Test-4 (FM- Ch- 4,5 SM-2)

Suggested Answer Sheet

Total Marks-45

Ans-1 Equity = 60% of ₹ 25,00,000 = ₹ 15,00,000

Debt = 40% of ₹ 25,00,000 = ₹ 10,00,000

The capital structure after raising additional finance:

Particulars Amount (₹)

Shareholders’ Funds

- Equity Capital (₹ 15,00,000 – ₹ 5,25,000) 9,75,000

- Retained Earnings 5,25,000

Debt

- Interest at 8% p.a. 2,50,000

- Interest at 10% p.a. (₹ 5,00,000 – ₹ 2,50,000) 2,50,000

- Interest at 12% p.a. (₹ 10,00,000 – ₹ 5,00,000) 5,00,000

Total Funds 25,00,000

(i) Determination of post-tax average cost of additional debt:

K d = I (1 − t)

Were,

I = Interest Rate

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t = tax-rate

On ₹ 2,50,000 = 8% (1 – 0.3) = 5.6% or 0.056

On ₹ 2,50,000 = 10% (1 – 0.3) = 7% or 0.07

On ₹ 5,00,000 = 12% or 0.12

Average Cost of Debt

(Rs. 2,50,000 × 0.056) + (Rs. 2,50,000 × 0.070) + (Rs. 5,00,000 × 0.12)

= × 100
Rs. 10,00,000
= 9.15%

(ii) Determination of cost of retained earnings and cost of equity by applying Dividend
growth model:

D1 D0 (l + g)
K e Or K r = +g= =g
P0 P0

Where,

D0 = Dividend paid = 60% of EPS = 60% × ₹ 50 = ₹ 30

g = Growth rate = 15%

P0 = Current market price per share = ₹ 500

Rs. 30(1 + 0.15)

So, K e Or K r = + 0.15 = 0.069 + 0.15 = 21.9%
Rs. 500

(iii) Computation of overall weighted average after tax cost of additional finance:

Particulars Amount (₹) Weights Cost of Weighted

Funds (%) Cost (%)

Equity (including retained 15,00,000 0.60 21.9% 13.14

earnings)

Debt 10,00,000 0.40 9.15% 3.66

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 WACC 25,00,000 16.80

Alternative Presentation

Particulars (1) Amount Cost of Funds (%) Product (₹) (2 ×

(₹)(2) (3) 3)

Equity (including retained earnings) 15,00,000 21.9% 3,28,500

Debt 10,00,000 9.15% 91,500

Total 25,00,000 4,20,000

WACC = (Product / Total book value) x 100 = (4,20,000 / 25,00,000) x 100 = 16.8%

Alternative Solution for 1(ii) and 4(iii)

If we assume expected growth rate of Dividend as 5%.

(ii) Determination of cost of retained earnings and cost of equity by applying Dividend growth
model:

D1 D0 (l + g)
K e Or K r = +g= =g
P0 P0

D0 = Dividend paid = 60% of EPS = 60% × ₹ 50 = ₹ 30

g = Growth rate = 5%

P0 = Current market price per share = ₹ 500

Rs. 30(1 + 0.05)

So, K e Or K r = + 0.5 = 0.063 + 0.05 = 11.3%
Rs. 500

(iii) Computation of overall weighted average after tax cost of additional finance:

Particulars Amount (₹) Weights Cost of Weighted

Funds (%) Cost (%)

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 Equity (including retained 15,00,000 0.60 11.3% 6.78
earnings)

Debt 10,00,000 0.40 9.15% 3.66

WACC 25,00,000 10.44

Alternative Presentation

Particulars (1) Amount Cost of Funds (%) Product (₹) (2 ×

(₹)(2) (3) 3)

Equity (including retained earnings) 15,00,000 11.3% 1,69,500

Debt 10,00,000 9.15% 91,500

Total 25,00,000 2,61,000

WACC = (Product / Total book value) x 100 = (2,61,000 / 25,00,000) x 100 = 10.44%

(6 marks)

Ans-2

i Calculation of Cost of Capital for each source of capital:

a. Cost of Equity share capital:

D0(1+g) 25% ×Rs. 100(1+0.05)

Ke = +g= + 0.05
P0 𝑅s. 200

Rs. 26.25
= + 0.05 = 0.18125 or 18.125%
Rs. 200

b. Cost of Preference share capital (K p ) = 9%

c. Cost of Debentures (K d ) = r (1 – t) = 11% (1-0.3) = 7.7%

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ii. Weighted Average Cost of Capital on the basis of book value weights

After tax Cost WACC (%) (c) =

Source Amount (Rs.) Weights (a)
of capital (%) (a) x (b)
(b)

Equity share 80,00,000 0.40 18.125 7.25

9% Preference share 20,00,000 0.10 9.000 0.90

11% Debentures 60,00,000 0.30 7.700 2.31

Retained earnings 40,00,000 0.20 18.125 3.625

2,00,00,000 1.00 14.085

iii. Weighted Average Cost of Capital on the basis of market value weights

After tax Cost WACC (%) (c) =

Source Amount (Rs.) Weights (a)
of capital (%) (a) x (b)
(b)

Equity share 1,60,00,000 0.640 18.125 11.60

9% Preference share 24,00,000 0.096 9.000 0.864

11% Debentures 66,00,000 0.264 7.700 2.033

2,50,00,000 1.000 14.497

(6 marks)

Ans-3

i. Computation of Earnings per Share (EPS)

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 Plans P (Rs.) Q (Rs.) R (Rs.)

Earnings before interest & tax (EBIT) 18,00,000 18,00,000 18,00,000

Less: Interest charges - 2,00,000 -

Earnings before tax (EBT) 18,00,000 16,00,000 18,00,000

Less : Tax @ 50% 9,00,000 8,00,000 9,00,000

Earnings after tax (EAT) 9,00,000 8,00,000 9,00,000

Less : Preference share dividend - - 2,00,000

Earnings available for equity 9,00,000 8,00,000 7,00,000

shareholders (a)

No. of shares (b) 2,00,000 1,00,000 1,00,000

E.P.S (Rs.) = (a ÷ b) 4.5 8 7

ii. Computation of Financial Break-even Points

Proposal ‘P’ = 0
Proposal ‘Q’ = Rs. 2,00,000 (Interest charges)
Proposal R = Earnings required for payment of preference share dividend i.e. Rs. 2,00,000 ÷
0.5 (Tax Rate) = Rs. 4,00,000

iii. Computation of Indifference Point between the Proposals

( EBIT − I1 )(1 − T) ( EBIT − I2 )(1 − T)
The indifference point − =
E1 E2
Where,
EBIT = Earnings before interest and tax
I1 = Fixed Charges (Interest) under Proposal ‘P’
I2 = Fixed charges (Interest) under Proposal ‘Q’

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T = Tax Rate
E1 = Number of Equity shares in Proposal P
E2 = Number of Equity shares in Proposal Q

Combination of Proposals
a. Indifference point where EBIT of proposal “P” and proposal ‘Q’ is equal

( EBIT − 0)(1 − 0.5) ( EBIT − 2,00,000)(1 − 0.5)

=
2,00,000 1,00,000

0.5 EBIT (1,00,000) = (0.5 EBIT - 1,00,000) 2,00,000

0.5 EBIT = EBIT - 2,00,000

EBIT = Rs. 4,00,000

b. Indifference point where EBIT of proposal ‘P’ and Proposal ‘R’ is equal:

( EBIT − 0)(1 − 0.5) ( EBIT − 0)(1 − 0.5) − 2,00,000

=
2,00,000 1,00,000

0.5 EBIT 0.5 EBIT − 2,00,000

=
2,00,000 1,00,000

0.25 EBIT = 0.5 EBIT - 2,00,000

EBIT = 2,00,000 ÷ 0.25 = Rs. 8,00,000

c. Indifference point where EBIT of proposal ‘Q’ and proposal ‘R’ are equal

( EBIT − 2,00,000)(1 − 0.5) ( EBIT − 0)(1 − 0.5) − 2,00,000

=
1,00,000 1,00,000

0.5 EBIT - 1,00,000 = 0.5 EBIT – 2,00,000

There is no indifference point between proposal ‘Q’ and proposal ‘R’

Analysis: It can be seen that Financial proposal ‘Q’ dominates proposal ‘R’, since the financial
break-even-point of the former is only Rs. 2,00,000 but in case of latter, it is Rs. 4,00,000.

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 (7 marks)

Ans-4

(i) Valuation of companies under net income approach.

Particulars X (Rs.) Y (Rs.)

EBIT @ 20% on Rs. 30,00,000 6,00,000 6,00,000

Less: Interest 1,80,000 —

EBT 4,20,000 6,00,000

Less: Tax @ 50% 2,10,000 3,00,000

EAT (available to equity holders) 2,10,000 3,00,000

Value of equity (capitalized @ 15%) 14,00,000 20,00,000

X = (2,10,000 × 100 / 15) Y = (3,00,000 × 100 / 15)

Value of Debt 18,00,000 —

Total Value of Company 32,00,000 20,00,000

(ii) Valuation of companies under net operating income approach

Particulars X (Rs.) Y (Rs.)

Capitalization of earnings at 15% 20,00,000 20,00,000

6,00,000 × (1–0.5)/0.15

Less: Value of debt 9,00,000 —

18,00,000 × (1–0.5)

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 Value of equity 11,00,000 20,00,000

Add: Value of debt 18,00,000 —

Total value of company 29,00,000 20,00,000

(5 marks)

Ans-5 XYZ Corporation is aiming to transform into a dominant technology company under the
leadership of Mohan, the new CEO. He aims to develop competencies for managers for
achieving better performance and a competitive advantage for the corporation. Mohan is also
well aware of the importance of resources and capabilities in generating and sustaining the
competitive advantage. Therefore, he must focus on characteristics of resources and
capabilities of the corporation.
The sustainability of competitive advantage and a firm’s ability to earn profits from it
depends, to a great extent, upon four major characteristics of resources and capabilities
which are as follows:
1. Durability: The period over which a competitive advantage is sustained depends in part on
the rate at which a firm’s resources and capabilities deteriorate. In industries where the rate
of product innovation is fast, product patents are quite likely to become obsolete. Similarly,
capabilities which are the result of the management expertise of the CEO are also vulnerable
to his or her retirement or departure. On the other hand, many consumer brand names have
a highly durable appeal.
2. Transferability: Even if the resources and capabilities on which a competitive advantage is
based are durable, it is likely to be eroded by competition from rivals. The ability of rivals to
attack position of competitive advantage relies on their gaining access to the necessary
resources and capabilities. The easier it is to transfer resources and capabilities between
companies, the less sustainable will be the competitive advantage which is based on them.
3. Imitability: If resources and capabilities cannot be purchased by a would-be imitator, then
they must be built from scratch. How easily and quickly can the competitors build the
resources and capabilities on which a firm’s competitive advantage is based? This is the true

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test of imitability. Where capabilities require networks of organizational routines, whose
effectiveness depends on the corporate culture, imitation is difficult.
4. Appropriability: Appropriability refers to the ability of the firm’s owners to appropriate
the returns on its resource base. Even where resources and capabilities are capable of offering
sustainable advantage, there is an issue as to who receives the returns on these resources.

(6 marks)

Ans-6 Competition makes organizations work harder, however, it is neither a coincidence nor
bad luck. All organizations have competition and its benefit are enjoyed by the markets. The
customers are able to get better products at lower costs. They get better value for their
money because of competition. A powerful and widely used tool for systematically
Diagnosing the significant competitive pressures in a market and assessing the strength and
importance of each is the Porter’s five-force model of competition. This model holds that the
state of competition in an industry is a composite of competitive pressures operating in five
areas of the overall market as follows:
i Rivalry among current players: Competitive pressures associated with the market
maneuvering and jockeying for buyer patronage that goes on among rival sellers in the
industry.
ii Threat of new entrants: Competitive pressures associated with the threat of new entrants
into the market.
iii Threats from substitutes: Competitive pressures coming from the attempts of companies
in other industries to win buyers over to their own substitute products.
iv Bargaining power of suppliers: Competitive pressures stemming from supplier bargaining
power and supplier-seller collaboration.
v Bargaining power of customers: Competitive pressures stemming from buyer bargaining
power and seller-buyer collaboration.
(5 marks)

Ans-7 MCQ

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1. (D) 20.62%

Reason:

Current PAT = 1750 x 20% = 350

Current PBT = Future EBIT = 350/0.7 = 500

Future PBT = 500 – 275 x 15% = 458.75

Future PAT = 458.75 x 70% = 321.125

Value (L) = Value (UL) + Debt x t = 1750 + 275 x 30% = 1832.5

Value of Equity= 1832.5 - 275 = 1557.5

K e = 321.125/1557.5 = 20.62%

2. (C) As an appropriation of after-tax profit.

Reason:

Dividend paid to preference shareholders is not treated as an expense in the profit and loss
account because it is not an operating cost. Instead, it is a distribution of profits.

It is paid out of the profits available for distribution after tax and is recorded as an
appropriation in the statement of changes in equity or as a note to the financial statements.

Preference dividends are not tax-deductible, unlike interest on debt, as they are considered
a distribution to equity holders rather than a cost of financing.

3. D) 14%

Reason: To calculate the overall cost of capital (WACC) for the firm, we use the weighted
average cost of capital formula:

WACC = (K d × D/V) + (K e × E/V)

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WACC= (0.20×10%) + (0.80×15%)

WACC= (0.20×0.10) + (0.80×0.15)

WACC=0.02 + 0.12

WACC=0.14 or 14%

4. (c) Product diversification and differentiation strategies

Explanation:

When products reach the maturity phase of the product life cycle, the market growth slows
down significantly because most potential customers have already adopted the product. At
this stage:

 Sales tend to stabilize or grow very slowly, but they do not typically decline sharply yet
(so option (a) is not fully accurate since sales may be high but usually stable or plateauing
rather than sharply declining).
 The number of competitors usually reaches a peak and may start to decrease due to
market saturation, consolidation, or some competitors exiting (so (b) is partially true but not
the key characteristic).
 Companies focus heavily on product diversification and differentiation to maintain their
market share and extend the product’s life in the market. They may introduce new features,
variations, or related products to attract different customer segments and fend off
competition. This is a key strategy in maturity to sustain interest and profitability, making (c)
the best fit.
 Price skimming (d) is typically an early-stage strategy used during product introduction to
maximize profits from early adopters, not during maturity when prices tend to be competitive
or even discounted.

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5. (c) It indicates that unit costs decline as cumulative output increases, giving cost advantage
to experienced firms.

Explanation:

The Experience Curve concept is based on the observation that unit costs tend to decline as
a company produces more over time. This is due to several factors such as:

 Learning effects (workers become more efficient with repetition),

 Economies of scale (lower per-unit fixed costs),
 Product and process improvements, and
 Technological advancements.

This leads to a cost advantage for firms with more experience and higher cumulative
production, making it harder for new entrants to compete, thus creating an entry barrier. It
also explains why firms may pursue strategies to rapidly increase market share — to move
down the experience curve faster.

(2×5 = 10 marks)

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