CHAPTER – 1 Basic Concepts, COC, Ratio 1A.

1.1 Business Risk or Financial Risk

1. Business Risk:
Business risk is associated with the firm's operations.
It is the uncertainty about the future operating income (EBIT), i.e. how well can the operating incomes
be predicted?
2. Financial Risk:
It is additional risk placed on shareholders as a result of debt use.
Companies that issue more debt instruments would have higher financial risk than companies financed
mostly or entirely by equity.

1.1.1 Meaning and Types of Leverage

1. Meaning of Leverage:
Leverage refers to the ability of a firm in employing long term funds having a fixed cost, to enhance
returns to the owners.
The term Leverage in general refers to a relationship between two interrelated variables.
In financial analysis it represents the influence of one financial variable over some other related
financial variable. These financial variables may be costs, output, sales revenue, EBIT, EPS etc.
2. A firm with debt in its capital structure is said to be levered firm.
A firm with no debt is said to be unlevered firm.
3. Type of Leverage

There are 3 types of Leverage

Operating Leverage (OL) Financial Leverage (FL) Combined Leverage (CL)

It is the effect of change in sales on the It is the effect of changes in EBIT on EBT It is the effect of change in sales on the
EBIT or EPS. EBT, EPS

FL occurs when a firm has fixed finance

OL occurs when a firm has fixed costs. costs.
If there is no fixed cost, then OL will not If there is no fixed finance cost, then FL
work will not work

FL = EBIT
OL = Contribution/EBIT or [EBT-(PD*(1+CDT)] CL = OL*FL
DOL = % change in EBIT (1-TR) CL = % change in EPS/EBT
% Change in Sales % Change in Sales
DFL = % change in EPS/EBT
Operating Break Even Point (OBEP) % Change in EBIT
Combined Break Even Point (CBEP)
It the level of sales at which EBIT is
zero Financial Break Even Point (FBEP) It the level of total sales at which
It the level of sales at which PATESH is PATESH is zero
zero
OBEP (Units) = Fixed Cost/
Contribution per unit FBEP (Units) = [Intt + PD*(1+CDT)/(1- CBEP = OBEP + FBEP
OBEP (Amt) = Fixed Cost/PV Ratio TR)]/(Contribution per unit)
OBEP (Amt) = [Intt + PD*(1+CDT)/(1-
TR)]/PV Ratio
At OBEP
Contribution = Fixed Cost or
At FBEP
EBIT = 0
EBIT = Intt + PD*(1+CDT)/(1-TR)
PATESH = 0

Other Points

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.2

a) When the firm has fixed costs, the % change in profits due to change in sales level is greater
than the % change in sales.
b) The operating leverage at any level of sales is called its Degree. The Degree of operating leverage
varies with a change in the level of sales.
C) The fixed financial charges do not vary with the EBIT. They are fixed and are to be paid irrespective of
level of EBIT.

Question-1***
Equity Share Capital of Rs.10 each Rs.100000
10% Debt Rs.50000
12% PSC Rs.100000
Total Capital Invested in Business Rs.250000
Sales Rs.100000
Variable Cost Rs.40000
Fixed Cost includes depreciation Rs.10000
Fixed Cost excludes (Depreciation) Rs.7000
Equity Dividend Rs.5000
Tax Rate 30%
CDT 10%
Solution-1
Rs.
Sales 100,000
Less: Variable Cost-40% 40,000
PV Ratio = Contribution/Sales =
Contribution-60% (Profit Volume Ratio) 60,000 60000/100000 = 0.6
Less: Fixed Cost (Excluding Depreciation) 7,000
Less: Depreciation 3,000
Business Profit. EBIT does not change with
change in Capital Structure. But it changes
EBIT or Operating Profit or Profit of Business 50,000 with changes with change in total capital.
Less: Intt 5,000 Profit to debt
EBT/PBT 45,000
Less: Tax-30% 13,500
EAT/PAT 31,500
Less: Preference Dividend 12,000
Profit to Equity. It changes with change in
PATESH 19,500 CS.
No of Equity Shares 10,000
EPS (Earning per Equity Share) = PATESH/No of Equity Share 1.95

It says that if sales increases by 1% than

(i) Degree of Operating Leverage = C/EBIT =60000/50000 1.2 Times EBIT will increase by 1.2%
If sales is at Rs.16,667.67, then EBIT will be
(ii) Operating BEP = Fixed Cost/PVR = 10,000/0.6 16,666.67 0

(iii) Degree of Financial Leverage =

EBIT
[EBT-(PD*(1+CDT)]
(1-TR)
= 50,000/[45,000-(12000*1.1)/0.7] = 50,000/(45,000-18,857) = 50,000/26,143 = 1.91
It says that if EBIT increases by 1% than EBT will increase by 1.91%

(vi) Financial BEP =

[EBT-(PD*(1+CDT)/(1-TR)]/PVR = 26,143/0.6 = Rs.43,571

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.3
(v) Degree of Combined Leverage = OL*FL = 1.2*1.91 = 2.292
It says that if Sales increases by 1% than (EBT-Fixed Finance Cost) will increase by 2.292%

(vi) Combined BEP = OBEP + FBEP = 16,666 + 43,571 = Rs.60,237

1.1.2 Measurement of various terms from business’s point of view

[Dec-2010] [M-5-CS] Distinguish between Return on capital employed and return on net worth
[ROE]

Relevant Measurement from Business's Point of View

Profit of Business (Amt) Return of Business (%)

Capital Employed in Business (CE)

EBIT - It is profit against total capital ROI - Return on Investment =

employed in business
Equity Fund+Debt+Preference
It is known as profit of Business before
deducting finance cost
EBIT does not change with change in
Capital Structure
EBIT*100/CE
It is a profit against Rs.100 capital
employed
ROI does not change with the change
in capital structure but changes with
change in total capital

ROI (BT) = EBIT*100/CE

It changes with change in total capital
ROI (AT) = EBIT*(1-TR)*100/CE

ROI [Before Tax] = 50000*100/250000 20% It shows business is earning 20% on Rs.100 of Capital Employed
ROI [After Tax] = 20%*0.7 14%

1.1.3 Measurement of various terms from Equity’s point of view

Relevant Measurement from Equity's Point of View

Capital Employed in
Equity
(Equity Fund/Equity)
Equity = ESC + R&S +
PL ± Change in Value
of Assets and
Liabilities - Fictitious
Assets
Equity = MV of Assets
- MV of Liabilties
Profit for Equity (Amt) Return of Equity (%)
EPS
PATESH - It is profit ROE (r) =
against total Equity PATESH/Equity Fund
Fund EPS = PATESH/No of
Equity Share
It is known as profit of It is a profit against
Equity after deducting Rs.100 Equity Fund
fixed finance cost
It is a profit against 1
ROE changes with the Equity Share
PATESH change with change in capital
change in Capital structure & total
Structure & Total capital
It changes with the
Capital change in capital
ROE is always after structure & total
tax capital

a) Calculation of ROE segment wise

ROIAfter Tax + [(ROIAfter Tax - KdAfter Tax)]*Debt/Equity + [(ROIAfter Tax - Kp)]*Preference/Equity

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.4

Return on Equity = ROE (r) = 19500/100000 = 19.50% It says return on Equity Fund

1.1.4 Trading on Equity

a) Shareholders gain in a situation where the company earns a high rate of return on business and pays a
lower rate of return to the supplier of long term funds. Financial Leverage in such cases is therefore
also called 'Trading on equity’.

b) Financial leverage is favourable when ROI > Kd It is known as trading on equity

c) Financial leverage is unfavourable when ROI < Kd
c) Financial leverage is neutral when ROI = Kd

Example Why ROE is more than ROI [After tax]

Solution:
It is because, Firm is earning 14%% on its entire capital while it is paying 7% to Debt and 12% to PSC, saving in Debt
and PSC is reason for increase in ROE.

ROE Segment wise = ROIAfter Tax + [(ROIAfter Tax - KdAfter Tax)]*Debt/Equity + [(ROIAfter Tax - Kp)]*Preference/Equity
For present case = 14% + [14% - 7%]*50000/100000 + [14%-12%]*100000/100000
= 14% + 3.5% + 2% = 19.50%

ROE is more because of trading on equity.

1.1.5 DuPont Model

a) This breaks ROE into several components so that one can see how changes in one area of the business
changes return on equity.
ROE = (Net Income/Revenue)*(Revenue/Total Assets)*(Total Assets/Equity Fund)
Here Net Income = PATESH

1.1.6 Book Value per share or Intrinsic Value per share or Net Assets Value
a) It is calculated on the basis of Assets and liabilities appearing in the balance sheet.
b) Market Value of Assets & Liabilities is taken for calculation of intrinsic value of share
c) If Market Value is not given, then book value of Assets and Liabilities is taken.
d) Equity Fund = (MV of all Assets – MV of Liabilities – Value of Debt)
Equity Fund = (ESC + R&S +- Change in value of Assets and Liabilities – Fictitious Assets)
e) BVPS or Intrinsic Value = Equity Fund/No of Equity Shares = 100000/10000 = Rs.10

1.1.7 Distribution of Profit of Equity Shareholder

Distribution of Profit to Equity Shareholder

PATESH = (EBIT - I)*(1-TR) - PD

EPS = PATESH/N If EPS = Rs.1
PATESH = Dividned + Retained
EPS = DPS + RPPS 1 = DPR + RR
Profit

Dividend = PATESH - Retained Profit DPS = Total Dividend/N DPR = (1-b) = DPS/EPS

Retained Profit = PATESH - Dividend RPPS = Total Retained Profit/N RR (b) = RPPS/EPS or (1-b)

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.5

a) PATESH – It is the profit available to Equity Shareholder

b) Dividend – Profit distributed to Equity shareholder from PATESH
c) Retained Profit - Profit left for future investment after dividend

Working
PATESH = Rs.19500 EPS = 19500/10000 = Rs.1.95 If EPS = Rs.1
Dividend = Rs.5000 DPS = 5000/10000 = Rs.0.50 DPR = DPS/EPS = 0.5/1.95 = 0.25
Retained Profit = Rs.14500 RPPS = 13500/10000 = Rs.1.45 RR (b) = RPPS/EPS = 1.45/1.95 = 0.75

1.1.8 Calculation of EPS

Calculation of EPS

EPS = PATESH/Equity No of EPS = Retained Profit Per

EPS = ROE*BVPS EPS = DPS/DP Ratio
Share Share/Retention Ratio

Working
EPS = 19500/10000 = Rs.1.95 EPS = ROE*BVPS = Rs.10*19.5% = Rs.1.95 EPS = DPS/DPR = 0.25/0.50 = Rs.1.95

1.1.9 Calculation of DPS

Calculation of DPS

If PATESH is given If Rate of dividend is given If Dividend Yield is given If DP Ratio is given

DPS = PATESH/n DPS = Face Value*Rate of Div DPS = MPS*Div Yield DPS = EPS*DP Ratio

Total Per share Per Rs. of EPS

Profit 19,500 19,500/10,000 = Rs.1.95 EPS = DPR + RR = 0.50 + 1.45 = 1.95
Dividend 5,000 5,000/10,000 = Rs.0.5 DP Ratio = DPS/EPS = 0.5/1.95 = 0.25
Retained Profit 14,500 14,500/10,000 = Rs.1.45 Retention Ratio = RPS/EPS = 1.45/1.05 = 0.75

Summary of Question
Relationship between Profit and Capital
Purpose Name of Profit Capital
Business EBIT = 50000 TCE = 250000
Business ROI = 14% TCE = 100
Equity PATESH = 19500 Equity Fund = 100000
Equity ROE = 19.5% Equity Fund = 100
Equity EPS = Rs.1.95 Equity Fund = FV of equity Share = Rs.10

Breakup of PATESH
Particulars Distributed Profit Retained Profit
PATESH Equity Dividend Retained Profit
EPS DPS RPS
If EPS = 1 DP Ratio Retention Ratio

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.6
Question-1A [SP]
Equity Capital of Rs.10 each = Rs.200000
Debt – 12% = Rs.80000
Sales – Rs.150000
Variable Cost = 50% of sales
Fixed Cost = Rs.20000
Dividend = Rs.20000
Tax Rate = 30%
Calculate OL, FL, CL, Operating BEP, FBEP, CBEP, ROI, ROE, ROE Segment wise, EPS, DPS, DP Ratio etc

Question-2 [ICWA-J08-6] [SP]

The Financial highlights of AMTEK Ltd for the year 2007-08 are given as under:
EBDIT Rs.830 Cr
Depreciation Rs.6 Cr
Tax Rate 30%
EPS Rs.4
Book Value Rs.30 per share
No of shares outstanding 33 Cr
D/E ratio 1.5:1
Required
(a) Calculate DOFL
(b) What is the Financial Break even point
(c) What should be the impact of EPS if the EBIT is increased by 5%.

[Calculation of Financial Leverage and Financial Break even Point if there is preference share
capital]
Question-3 [M02-10] [ICWA-D01-10] [SP]
The net Sales of A Ltd. is Rs.30 crores. EBIT of the company as a percentage of net sales is 12%. The
capital employed comprises Rs.10 crores of equity, Rs.2 cores of 13% Cumulative Preference Share Capital
and 15% Debentures of Rs.6 crores. Income-tax rate is 40%.
Calculate the Return-on-equity for the company and indicate its segments due to the presence of Preference
Share Capital and Borrowing (Debentures). [Ans: 13.6%] [M-6]
Calculate the Operating Leverage of the Company given that combined leverage is 3. [Ans: 1.89]

Question-4 [CS-D11-12] [SP]

From the following prepare Income statement of Company A, B and C.
Company A B C
Financial Leverage 3:1 4:1 2:1
Interest Rs.200 Rs.300 Rs.1,000
Operating Leverage 4:1 5:1 3:1
Variable cost as a percentage to sales 662/3% 75% 50%
Income tax rate 45% 45% 45%

1.2 Capital Structure

1.2.1 Optimum Capital Structure

[CS-D09-5] [CS-J12-5] Write short notes on Optimal Capital Structure
Solution
Optimal capital structure mean capital structure which is suitable for long term and short term objective of
the firm.
It helps in minimizing cost of capital and maximizing wealth of shareholder.

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.7
1.3 Cost of Capital (%)
Q No ICAI RTP PM
5
6
7
8
8A
8B
9
10
11
11A

BALANCE SHEET
Share Capital Equity Fund Shareholder’s Fund Capital Employed in Business
Reserves and Surplus
Preference Share Capital
Term Loan from Financial Institution Other Borrowings External Borrowings
(Debentures, Bonds, Other Debts instruments) Debt Capital

a) Cost of capital is the finance cost (Interest, Dividend) that is paid to capital provider on debt, equity,
preference from EBIT
b) Cost of capital for business will be return for capital provider.
c) Cost of capital is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc.

Under Standing of Various Term and their uses

Preference Share
Term Equity Debt Business
Capital

Capital Equity Fund Debt Amt PSC Equity+Debt+PSC

Intt Amt = Face PD = Face

Profit PATESH EBIT
Value*CR Value*CR

Cost of Capital Ke Kd Kp WACC

Return for
ROE CR CR ROI
Investor

1.3.1 Cost of debt (Kd)

a) Cost of debt is the interest amount and capital loss p.a. paid by business to its loan provider

1.3.1.1 Features of debentures or bonds

1. Face Value: Debentures or Bonds are denominated with some value; this denominated value is called
face value of the debenture.
2. Interest (Coupon) Rate (CR): Debenture/bonds bears a fixed interest (coupon) rate (except Zero
coupon bond and Deep discount bond).
Interest Amt p.a. payable to debenture holder = FV*CR
3. Maturity period: Debentures or Bonds has a fixed maturity period for redemption. However, in case of
irredeemable debentures maturity period is taken as infinite.
4. Redemption value of Bond (RV) : The Face value of bond is repaid at the end of maturity period, is

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.8
known as redemption value of bond.
A bond may be redeemed at par, at premium or at discount.
5. Debt has an implicit cost also. This arises due to the fact that if the debt content rises above the
optimal level, investors will start considering the company to be too risky and, therefore, expectations
from equity shares will rise. This rise in the cost of equity shares is actually the implicit cost of debt.
6. Incidence of tax on cost of Debt
Interest is deductible from profit for income tax purpose. If cost of debt is 15% and tax rate is 40%, tax
saved is 40% of 15% i.e. 6%, hence cost of debt is 60% of 15%, i.e. 9%.

Example (Rs. in lacs)

Particulars X Ltd Y Ltd
Equity 1500 1000
8% Debenture - 500
Capital Employed 1500 1500

Understanding of impact of tax on interest

Particulars X Y Impact of Interest on Tax Interest (NOT)
Ltd Ltd
EBIT 100 100
Less: Interest = - 40 Tax Saving on Interest = Interest*TR = 40*30% 40-12 = 28 =Interest*(1-
500*8% = 12 t)
EBT 100 60
Tax @ 30% 30 18 Tax Saving due to interest = (30-18) = 12
PAT 70 42

Cost of Debt (Kd)

Irredeemable Debtenture: Which are not Redeemable Debenture : Redeemable after

redeemed maturity period

Apply formula of constant cash flow for indefinite Apply formula of actual return of cash flow for
period definite period
Kd = Constant CO p.a./Issue Price or Net Actual Kd (AT) = YTM = LR + (NPVLR/NPVLR –
Proceeds NPVHR)*(HR-LR)

If there is not issue expenses App Kd

Kd (BT) = IR = Coupon rate Kd (AT) = [I*(1-t) + (RV – NP)÷n]/[(RV+NP)÷2]
Kd (AT) = IR*(1-t) If only interest is tax deductable

If there is issue expenses Kd (AT) = [I + (RV – NP)÷n]/[(RV+NP)÷2]*(1-t)

Kd (BT) = I/NP Discount/ Premium on redemption are tax
Kd (AT) = I*(1-t)/Net Proceeds deductible

Note: In absence of any specific information, students may use any of the above formulae to calculate the
Cost of Debt (Kd) with logical assumption.
I Annual interest payment = IR*FV
t Tax Rate
NP/P0 Net proceeds of debentures or current market price = Issue Price – Floatation Cost
RV Redemption Value
n Life of Debenture
LR Lower Discount rate

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.9

HR Higher Discount Rate

Floatation The new issue of a security (debt or equity) involves some expenditure in the form of
Cost underwriting or brokerage fees, legal and administrative charges, registration fees, printing
expenses etc. The sum of all these cost is known as floatation cost.
Floatation cost is adjusted to arrive at net proceeds for the calculation of cost of capital.

Question-5 [SM-1] [Cost of Irredeemable Debenture]***

A company issues Rs.10,00,000 16% debentures of Rs.100 each. The company is in 35% tax bracket. You
are required to calculate the cost of debt after tax. If debentures are issued at (i) Par, (ii) 10% discount and
(iii) 10% premium. [Ans: 10.4%, 11.55%, 9.45%]
If brokerage is paid at 2% what will be cost of debentures if issue is at par. [Ans: 10.61%]

Question-6 [Redeemable Debenture]***

ABC Ltd. issues 15% debentures of face value of Rs. 100 each, redeemable at the end of 7 years. The
debentures are issued at a discount of 5% and the floatation cost is 1%. Find out the cost of debentures
given that the firm has 50% tax rate.

1.3.2 Cost of Preference Capital (Kp)

1. In preference share capital dividend is paid at a specified rate on face value of preference shares.
Payment of dividend to the preference shareholders are not mandatory but are given priority over the
equity shareholder.
2. Preference Dividend is appropriation of profit but not charge
Preference Dividend are not charged as expenses but treated as appropriation of after tax profit. Hence,
preference dividend does not reduce the tax liability to the company.
Dividend of preference shares is not allowed as deduction from income for income tax purposes, hence
tax advantage in the case of cost of preference shares is not available.
3. In case of Dividend, Company pays Corporate dividend tax (CDT)
4. Cost of redeemable preference share is similar to the cost of redeemable debentures with the exception
that the dividends paid to the preference shareholders are not tax deductible.

Cost of Preference Share (Kp)

Irredeemable Preference Share Redeemable Preference Share

Apply formula of actual return of cash flow for definite period

Apply formula of constant cash flow for indefinite period
Actual Kp (AT) = YTM = LR + (NPVLR/NPVLR – NPVHR)*Diff of
Kp = Constant CO p.a./Issue Price or Net Proceeds
Rate

If there is no issue expenses App

Kp (AT) = Dividend Rate*(1+CDT) KP (AT)= [PD*(1+CDT) + (RV – NP)/n]÷[(RV+NP)/2]

Kp (AT) = PD*(1+CDT)/NP

Note
1. Cost of redeemable preference share could also be calculated as the discount rate that equates the net
proceeds of the sale of preference shares with the present value of the future dividends and principal
payments.
2. As per the Companies Act 2013, issuances of irredeemable preference shares are not allowed but for
the academic knowledge it is studied here

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.10
Question-7**
ABC Ltd. issues 15% preference shares of the face value of Rs.100 each at a flotation cost of 4%. Find out
the cost of capital of preferences shares if (i) the preferences shares are irredeemable, and (ii) if the
preference shares are redeemable after 10 years at a premium of 10%. [Ans: 15.62%, 15.92%]

1.3.3 Cost of Equity Capital (Covered in SA)

1.3.3.1 Cost of Equity

a) In case of equity shares, there is no fixed rate of interest or dividend against ordinary shares. Hence
cost of equity can be based on various methods

1.3.3.2 Various Methods for calculation of cost of equity/ Equity Capitalisation Rate
Calculation of Ke Existing Shares

If dividend is constant for indefinite period Ke = D1/Po

If growth rate is constant for indefinite period Ke = D1/Po + g

On the basis of PE ratio Ke = 1/PE ratio = 1/MP/EPS = EPS/MP *[Earning Price Ratio]

On the basis of Realised yield approach Ke = [Capital Gain + Dividend]/Initial Investment

[P1 – P0 + D1]/P0

On the basis of wealth ratio Ke = Wealth Ratio – 1 [from above]

Wealth Ratio = [P1 + D1]/P0

On the Basis of CAPM Model Ke = Rf + Be(Rm – Rf)

On the Basis of APT Model Ke = Rf + λ1βi1+λ2βi2

Calculation of Ke of New Shares

If dividend is constant for indefinite period Ke = D1/(Po – Issue Expenses)

If growth rate is constant for indefinite period Ke = D1/(Po – Issue Expenses) + g

Question-8 [Constant Growth]***

ABC Ltd. has just declared and paid a dividend at the rate of 15% on the equity share of Rs.100 each. The
expected future growth rate in dividends is 12%. Find out the cost of capital of equity shares given that the
present market value of the share is Rs.168.

Question-8A
A company's share is quoted in market at Rs.40 currently. A company pays a dividend of Rs.2 per share and
investors expect a growth rate of 10% per year, compute:
(a) The company's cost of equity capital or Equity Capitalisation Rate.

Question-8B [SP]
The share of ABC Ltd. is presently traded at Rs.50 and the company is expected to pay dividend of Rs.4 per
share with a growth rate of 8% p.a. It plans to raise fresh equity share capital at a discount of Rs.1 and the
floating cost is Rs.0.50 per share. Find out the cost of existing equity shares as well as the new equity.

Question-9
MP of share = Rs.150
EPS = Rs.10
Calculate Ke

Question-10
Po = Rs.100
P1 = Rs.120
D1 = Rs.10

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.11
Calculate Ke

1.3.3.3 Cost of Retained Earnings

[CS-D11-5] Write short notes on cost of retained earning
a) Like equity share capital, the retained earnings are also funds provided by equity shareholders.
b) The cost of retained earning is therefore same as of existing equity.
c) In absence of any information on personal tax (tp):
Cost of Retained Earnings (Ks) = Cost of Equity Shares (Ke)

1.3.4 Weighted Average Cost of Capital

a) The overall cost of capital of a firm is the weighted average of the costs of various sources of funds.
b) WACC = Ke*We + Kd*Wd + Kp*Wp
c) WACC = Rf + BA(Rm-Rf) [To be discussed in Portfolio]
d) Market value weights should be used. If Market value is not given, then book value weight may be
considered.
e) After tax costs of the individual components of firm’s capital structure is to be taken.
f) Weight = Amount of each Component/Total Capital Employed
g) WACC represents the minimum rate of return at which a company produces value for its investors.

Question-11
Suppose following is the capital structure of a firm:
Rs
Equity capital 5,00,000
Reserves 2,00,000
Debt 3,00,000
10,00,000

The component costs (before tax) are: Equity capital 18%, Debt 10%. Tax Rate = 30%

Question–11A [N95] [SP]

Three companies A, B & C are in the same type of business and hence have similar operating risks.
However, the capital structure of each of them is different and the following are the details:
A B C
No of Equity Share [Face value Rs.10 per share] Rs. 4,00,000 2,50,000 5,00,000
Market value per share Rs. 15 20 12
Dividend per share Rs. 2.70 4 2.88
No of Debentures [Face value per debenture Rs.100] Rs. Nil 10,000 25,000
Market value per debenture Rs. - 125 80
Interest rate - 10% 8%

Assume that the current levels of dividends are generally expected to continue indefinitely and the income
tax rate at 50%.
You are required to compute the weighted average cost of capital of each company.

1.4 Ratio
Q No ICAI RTP PM
12 N12-5b-8, M09-O-1b-6 56
12A M03-6c-8
13 57

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.12
1.4.1 Various Liquidity Ratios
Current Ratio (CR) Current Assets It is one of the best known measures of short
Current Liabilities term solvency. It is the most common measure
of short-term liquidity.
Ideal ratio is 2:1.
Quick Ratio/Acid- Quick Assets It measures the ability to meet current debt
test Ratio Current Liabilities immediately.
Ideal ratio is 1:1.
Cash Ratio or Cash and Bank Bal + Marketable Securities It measures absolute liquidity of the business
Absolute Liquidity Current Liabilities
Ratio
Basic Defense Cash and Bank Bal + Marketable Securities It measures the ability of the business to meet
Interval Operating Expenses ÷ No. of days regular cash expenditures.

Interval Measure Current Assets - Inventories

Daily Operating Expenses
Net Working Capital Current Assets – Current Liabilities (excluding It is a measure of cash flow to determine the
Ratio short-term bank borrowing) ability of business to survive financial crisis.

1.4.2 Capital Structure Ratios

These ratios provide an insight into the financing techniques used by a business and focus, as a
consequence, on the long-term solvency position.
Equity Ratio Shareholders' Equity It indicates owner’s fund in companies to total fund
Capital Employed invested.
Traditionally, it is believed that higher the proportion of
owners’ fund lower is the degree of risk.
Debt Ratio Total outside liabilities It is an indicator of use of outside funds.
(Total Debt + Net worth)
OR
Total Debt/Net Assets
Debt to equity Total Outside Liabilities It indicates the composition of capital structure in terms of
Ratio Share holders' Equity debt and equity.

Debt to Total Total Outside Liabilities It measures how much of total assets is financed by the
assets Ratio Total Assets debt.
Or
Total Debt/Total Assets
Capital Gearing PSC + Deb + Other Borrowed funds Proportion of fixed interest (dividend) bearing capital to
Ratio ESC + R&S – Losses funds belonging to equity shareholders i.e. equity funds or
net worth
Proprietary Ratio Proprietary Fund It measures the proportion of total assets financed by
Total Assets shareholders.

1.4.3 Coverage Ratios (Long Term Solvency Ratio/ Leverage Ratio)

Debt Service Earnings available for debt It measures the ability to meet the commitment of various
Coverage Ratio services/Interest + Instalments debt services like interest, instalment etc. Ideal ratio is 1.5
(DSCR) to 2.
Fund from operation (or cash from operation) before
interest and taxes also can be considered as per the
requirement.
Interest Coverage EBIT/Interest This ratio also known as “times interest earned ratio”
Ratio indicates the firm’s ability to meet interest (and other fixed-
charges) obligations
Preference Dividend Net Profit / PAT It measures the ability to pay the preference shareholders’
Coverage Ratio Preference dividend liability dividend. Ideal ratio is > 1.

Fixed Charges EBIT + Depreciation This ratio shows how many times the cash flow before
Coverage Ratio [Intt + Repayment of loan/(1-TR)] interest and taxes covers all fixed financing charges. The
ideal ratio is > 1.

1.4.4 Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio

Total Asset Sales/COGS A measure of total asset utilisation. It helps to answer the question -

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.13
Turnover Ratio Total Assets What sales are being generated by each rupee’s worth of assets
invested in the business?
Fixed Assets Sales/COGS This ratio is about fixed asset capacity. A reducing sales or profit
Turnover Ratio Fixed Assets being generated from each rupee invested in fixed assets may
indicate overcapacity or poorer-performing equipment.
Capital Turnover Sales/COGS This indicates the firm’s ability to generate sales per rupee of long
Ratio Net Assets term investment.

Working Capital Sales /COGS It measures the efficiency of the firm to use working capital.
Turnover Ratio Working Capital
Inventory/Stock COGS/Sales It measures the efficiency of the firm to manage its inventory.
Turnover Ratio Average Inventory
Debtors Turnover Credit Sales It measures the efficiency at which firm is managing its receivables.
Ratio Average Receivable
Receivables Average Receivables It measures the velocity of collection of receivables. It indicates the
(Debtors’) Average Daily Credit Sales average collection period
Velocity
Or
12 months/360 days
Receivable Turnover Ratio
Payables Credit Purchases It measures the velocity of payables payment.
Turnover Ratio Average Payables
Payable Velocity/ Average Payable
Average payment Avg Daily Credit Purchases
period Or
12months/52weeks/360days
Payables Turnover Ratio

1.4.5 Profitability Ratios based on Sales

Gross Profit Gross Profit*100 This ratio tells us something about the business's ability
Ratio Sales consistently to control its production costs or to manage the
margins it makes on products it buys and sells.
Net Profit Ratio Net Profit*100 It measures the relationship between net profit and sales of the
Sales business.

Operating Operating Profit*100 It measures operating performance of business.

Profit Ratio Sales
Cost of Goods COGS*100
Sold (COGS) Sales
Ratio
Operating (Adm Exp.+ Selling & Dis OH)*100 Portion of a particular expenses in comparison to sales. It
Expenses Ratio Sales excludes taxes, loss due to theft, goods destroyed by fire etc.

Operating (COGS + Operating expenses)*100

Ratio Sales
Financial Financial expenses*100
Expenses Ratio Sales

Question-12 [N12-5b-8] [M09-O-1b-6] [PM-J15-56]**

Tiger Ltd is presently working with an EBIT of Rs.90 lakhs. Its present borrowings are as follows
Rs. In lakhs
12% term loan 300
Working capital borrowings
Borrowing from bank at 15% 200
Public deposits at 11 % 100
The sales of the company are growing and to support this, the company proposes to obtain additional
borrowing of Rs.100 lakhs at a cost of 15%. The increase in EBIT is expected to be 16%. Calculate the
present and the revised interest coverage ratio and comment.

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CHAPTER – 1 Basic Concepts, COC, Ratio 1A.14
Question-12A [M03-6c-8]
A company is presently working with an EBIT of Rs.45 Lakhs. Its present borrowings are:
(Rs. Lakhs)
12% term loan 150
Working capital
Borrowing from bank at 15% 100
Public deposit at 11% 45

The sales of the company is growing and to support this the company proposes to obtain additional
borrowing of Rs. 50 Lakhs expected to cost 16%. The increase in EBIT is expected to be 16%.
Calculate the change in interest coverage ratio after the additional borrowing and commitment.

Question-13 [PM-J15-57]
XYZ Ltd. has Rs.8 Cr of 10% mortgage bonds outstanding. The additional bonds to be issued as long as all
the following conditions are met:
(a) Pre-tax interest coverage [EBIT/ bond interest] remains greater than 4.
(b) Net depreciated value of mortgaged assets remains more than twice the amount of mortgage debt.
(c) Debt-to-equity ratio remains below 5.
XYZ Ltd. has net income after taxes of Rs.2 Cr and a 40% tax rate. Rs.40 Cr in equity, and Rs.30 Cr in
depreciated assets, covered by the mortgage.
How much more 10% debt could be sold under each of the three conditions assuming that 50% of the
proceeds of a new issue would be added to the base of mortgaged assets? Which condition is protective?

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