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GNDU Question Paper-2024
Bachelor of Commerce
(B.Com) 3
rd
Semester
Financial Management
Time Allowed: Three Hours Max. Marks: 100
Note:- Attempt FIVE questions in all, selecting at least ONE question from each section.
The fifth question may be attempted from any section. All questions carry equal marks.
SECTION – A
1 Discuss the concept of Annuity and Perpetuity in detail.
2 The cost of various types of Capital of Shiv Co. Ltd. is given below along with target
market proportions. Compute Weighted Average Cost of Capital (WACC) from the
following:
Sources of Funds Table
Sources of Funds
Amount
(Rs.)
Proportion in Total Capital
Structure (%)
Cost of Capital
(%)
Debts
2,40,000
30%
5.68
Preference Share Capital
80,000
10%
9.33
Equity Share Capital (Rs.
10 each)
4,00,000
50%
13.30
Cost of Retained Earnings
80,000
10%
13.00
Total
8,00,000
100%
—
SECTION – B
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3 A simplified income statement of Zenith Ltd. is given below. Income statement of Zenith
Ltd. for the year ended 31st March 2005:
Income Statement of Zenith Ltd.
Particulars
Rs.
Sales
10,50,000
Variable Cost
7,67,000
Fixed Cost
75,000
EBIT
2,08,000
Interest
1,10,000
Taxes (30%)
29,400
Net Income
68,600
󷷑󷷒󷷓󷷔 You are required to calculate and interpret its degree of Operating Leverage and
Financial Leverage.
4 Discuss how to design optimum capital structure in detail.
SECTION – C
5 From the following information extracted from the books of a manufacturing concern,
compute the operating cycle in days:
Given Information
Particulars
Period Covered
Average period of credit allowed by suppliers
Average total of debtors outstanding
Raw material consumption
Total production cost
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Total cost of goods sold for the year
Sales for the year
Value of average stock maintained:
– Raw materials
– Work-in-progress
– Finished goods
Q.6 What do you mean by Bank Financing? Discuss the recommendations of Tandon
Committee towards the Bank Financing.
SECTION – D
7 Explain the process of Capital Expenditure Decision in detail.
8 The current price of a company’s share is Rs. 75 and dividend per share is Rs. 5. Calculate
the dividend growth rate if its capitalization rate is 12 percent.
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GNDU Question Paper-2024
Bachelor of Commerce
(B.Com) 3
rd
Semester
Financial Management
Time Allowed: Three Hours Max. Marks: 100
Note:- Attempt FIVE questions in all, selecting at least ONE question from each section.
The fifth question may be attempted from any section. All questions carry equal marks.
SECTION – A
1 Discuss the concept of Annuity and Perpetuity in detail.
Ans: A Cup of Tea, a Tale of Annuity and Perpetuity
Imagine you’re sitting in your favorite corner of the house on a rainy evening with a hot cup
of tea. The sound of rain on the roof is calming, and you’re lost in thoughts about life,
money, and the future. Suddenly, your younger cousin comes running with a question:
"Bhaiya, our teacher was talking about annuity and perpetuity in class today, but it went
over my head. Can you explain it to me in a way I can actually understand?"
You smile, take a sip of tea, and say: “Alright, let me tell you a story. But remember, once
you understand this, you’ll never forget it.”
The Story Begins: The Generous Grandfather
Let’s imagine two cousins, Aman and Riya, who have a very generous grandfather. On his
70th birthday, he decides to gift them money every year, but in two different ways.
• To Aman, he promises: “I’ll give you ₹10,000 every year for the next 10 years.”
• To Riya, he promises: “I’ll give you ₹10,000 every year, forever.”
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Now, pause for a second. Doesn’t this sound interesting? Aman is getting money but only
for 10 years, while Riya is getting it for as long as she is alive (and even beyond, because the
payments never stop).
This is the simplest way to understand the difference:
• Annuity → Regular payments for a fixed period.
• Perpetuity → Regular payments that go on forever.
But let’s not stop at definitions. Let’s dive deeper into the details, because that’s where the
beauty lies.
Understanding Annuity
Think of annuity as a planned financial arrangement where you get or pay a fixed sum of
money every month, every year, or at regular intervals.
Here are some real-life examples of annuities you may have already seen without realizing:
1. Your Netflix Subscription (Reverse Annuity): Every month, you pay a fixed amount.
That’s an outflow annuity.
2. Loan EMIs: When you take a loan for a car or home, you pay monthly EMIs for a
fixed number of years. This is a payment annuity.
3. Pension Plans: After retirement, many people get a fixed amount every month for a
certain number of years. That’s also an annuity.
So, in essence, annuity is like a financial clock—it ticks regularly and consistently for a
specific duration.
Types of Annuity (like flavours of ice cream)
Annuities come in different forms, just like ice cream flavours. Let’s look at the main ones:
1. Ordinary Annuity: Payments are made at the end of each period. (Like paying your
electricity bill after using the electricity for the month.)
2. Annuity Due: Payments are made at the beginning of each period. (Like paying rent
at the start of every month before you live in the house.)
3. Fixed-term Annuity: Payments are made for a specific period, like 10 years.
4. Variable Annuity: Payments may change depending on some conditions (e.g., linked
with stock market performance).
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The Value of Annuity – Why Time Matters
Now, here’s where the magic of time value of money comes in.
Let’s say Aman is promised ₹10,000 for 10 years. At first glance, you may think Aman is
getting ₹1,00,000 in total. But the truth is—money today is more valuable than the same
money tomorrow (because you can invest it, earn interest, or inflation reduces its value).
So, to calculate the real worth of Aman’s 10-year gift, we need to bring future payments
back to present value using a formula.
The formula for Present Value of Annuity is:
Where:
• P = payment per year
• r = interest/discount rate
• n = number of years
This is how bankers, insurers, and financial planners calculate what a stream of future
payments is truly worth today.
Understanding Perpetuity
Now let’s come to Riya’s case. She is promised ₹10,000 every year, forever. At first, that may
sound like infinite money. But again, the time value of money comes into play.
The present value of perpetuity has a very elegant and simple formula:
Where:
• P = payment per year
• r = interest/discount rate
For example, if the discount rate is 10%, and Riya is promised ₹10,000 every year forever,
then the present value of her perpetuity is:
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So surprisingly, the value of something that goes on forever is still finite because money
loses value over time.
Real-Life Examples of Perpetuity
You might be wondering—does perpetuity even exist in real life? The answer is yes!
1. University Endowments: Many universities create funds where the interest earned is
used to pay scholarships forever.
2. Government Bonds (Consols): In the UK, there used to be bonds that paid fixed
interest indefinitely—these were classic perpetuities.
3. Charity Funds: Some charities set up perpetual funds to keep giving aid year after
year.
So perpetuity is not just theory—it’s used in long-term financial planning and investment.
Comparing Annuity and Perpetuity – The Cousins’ Story Again
Coming back to Aman and Riya:
• Aman gets comfort for a while (10 years), but his payments stop after that. His
financial security is limited but predictable.
• Riya, on the other hand, has a promise of money forever. But its real value depends
heavily on the discount rate.
So, annuity is like watching a movie with a definite ending, while perpetuity is like a TV
series that never ends.
2 The cost of various types of Capital of Shiv Co. Ltd. is given below along with target
market proportions. Compute Weighted Average Cost of Capital (WACC) from the
following:
Sources of Funds Table
Sources of Funds
Amount
(Rs.)
Proportion in Total Capital
Structure (%)
Cost of Capital
(%)
Debts
2,40,000
30%
5.68
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Preference Share Capital
80,000
10%
9.33
Equity Share Capital (Rs.
10 each)
4,00,000
50%
13.30
Cost of Retained Earnings
80,000
10%
13.00
Total
8,00,000
100%
—
Ans: Imagine Shiv Co. Ltd. as a company that wants to grow big, like building a castle. But to
build a castle, you need money—lots of it! And that money doesn’t just appear out of thin
air; it comes from different “friends” who are willing to lend or invest, but each friend has a
price for lending their money. Some friends are patient, some are bossy, and some want
quick returns. These “friends” represent the different sources of capital in Shiv Co. Ltd.
In our story, Shiv Co. has four main friends:
1. Debts – These are like the money borrowed from a bank or a bondholder. Banks are
straightforward—they lend money, and they want interest in return. In our case, the
company borrowed Rs. 2,40,000 at a cost of 5.68%.
2. Preference Shareholders – These are special investors who say, “I don’t mind getting
my money later, but when you pay, I want a fixed reward.” They put in Rs. 80,000,
and their cost to the company is 9.33%.
3. Equity Shareholders – These are the real dreamers who become part-owners. They
put in Rs. 4,00,000, but they want a bigger return because they are taking a risk—the
company could succeed or fail. The cost of equity is 13.30%.
4. Retained Earnings – This is money the company has earned before and kept aside
instead of distributing as dividends. Even though it’s already “ours,” it has an
opportunity cost—if the company doesn’t use it well, shareholders could have
earned 13% elsewhere. So, the cost is 13%.
Now, Shiv Co. wants to know: “What is the overall cost of all these funds combined?”
That’s what WACC helps us figure out. Weighted Average Cost of Capital is like asking, “If I
mix all these funds together in the proportions I have, what’s the average price I’m paying
for money?”
Let’s break it down step by step, in a story-like approach:
Step 1: Look at the proportions of capital
First, we see how much each “friend” contributes to the total capital (Rs. 8,00,000):
• Debts: Rs. 2,40,000 → 30% of total capital
• Preference Shares: Rs. 80,000 → 10% of total capital
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• Equity Shares: Rs. 4,00,000 → 50% of total capital
• Retained Earnings: Rs. 80,000 → 10% of total capital
Notice how the proportions are already given as percentages. This is important because
WACC is a weighted average, meaning each cost is multiplied by its share in the total
capital.
Step 2: Multiply cost by proportion for each source
Think of it like preparing a recipe. Each ingredient (source of capital) has a taste (cost) and a
quantity (proportion). The overall flavor (WACC) comes from the combination.
Let’s do the math carefully:
1. Debt contribution:
2. Preference Share contribution:
3. Equity Share contribution:
4. Retained Earnings contribution:
Step 3: Add them up
Now we combine all the contributions to get the Weighted Average Cost of Capital (WACC):
So, the WACC for Shiv Co. Ltd. is approximately 10.59%.
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Step 4: Understanding the story behind the number
Think of this 10.59% as the magic number that tells Shiv Co. how much it costs to use one
rupee of funds on average.
• If the company invests in projects that earn more than 10.59%, it’s creating wealth.
• If it invests in projects that earn less than 10.59%, it’s like building a castle that costs
more than it’s worth—money is wasted.
This number also helps the company make decisions about which source of funds to use
more. For example:
• Debt is cheap (5.68%), but too much debt can be risky because of fixed interest
payments.
• Equity is expensive (13.3%), but it doesn’t require fixed payments.
• Retained earnings are “free” in a sense, but they still have an opportunity cost (13%).
Step 5: Why WACC matters in real life
Imagine you’re Shiv Co.’s CEO. You have Rs. 8,00,000 to invest. You can choose:
1. A project earning 12%
2. A project earning 9%
Since WACC = 10.59%, the first project is a good choice (12% > 10.59%), and the second is
bad (9% < 10.59%).
So WACC becomes a decision-making tool. It’s like the “hurdle rate” a project must clear to
be worth investing in.
Step 6: Final thought—mixing the ingredients wisely
Think of WACC as a chef mixing ingredients in a recipe. Shiv Co. has a recipe of 30% debt,
10% preference shares, 50% equity, and 10% retained earnings. Each ingredient has a
different flavour (cost), and together they make the “financial dish” cost 10.59% per rupee.
The lesson here is: more debt lowers WACC up to a point because it’s cheaper, but too
much debt increases financial risk. Equity is expensive but safer in terms of fixed payments.
Retained earnings are like internal savings—you avoid issuing new shares, but shareholders
expect a fair return.
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SECTION – B
3. A simplified income statement of Zenith Ltd. is given below. Income statement of
Zenith Ltd. for the year ended 31st March 2005:
Income Statement of Zenith Ltd.
Particulars
Rs.
Sales
10,50,000
Variable Cost
7,67,000
Fixed Cost
75,000
EBIT
2,08,000
Interest
1,10,000
Taxes (30%)
29,400
Net Income
68,600
󷷑󷷒󷷓󷷔 You are required to calculate and interpret its degree of Operating Leverage and
Financial Leverage.
Ans: Imagine you are the captain of a ship called Zenith Ltd., navigating the vast ocean of
business. Your goal is to reach the treasure island of profitability, but to do that, you need
to understand how your ship responds to the waves of change in sales and costs. In the
world of finance, two powerful tools help captains like you steer your company safely:
Operating Leverage and Financial Leverage. Let’s dive into this adventure together, using
the income statement of Zenith Ltd. for the year ending 31st March 2005 as our map.
Here’s the treasure map—our simplified income statement:
Particulars
Rs.
Sales
10,50,000
Variable Cost
7,67,000
Fixed Cost
75,000
EBIT (Earnings Before Interest & Taxes)
2,08,000
Interest
1,10,000
Taxes (30%)
29,400
Net Income
68,600
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1. Understanding the Waves: What is Operating Leverage?
Before we set sail, we need to understand the first wave: Operating Leverage. Operating
leverage is like the sensitivity of your ship to waves in sales. If sales go up a little, operating
leverage tells you how much your profit (before interest and taxes) will increase. It happens
because of fixed costs—expenses that do not change whether you sell a little or a lot. Think
of it as the weight of the anchor: heavier the anchor (higher fixed costs), more dramatic the
swing in profits when sales change.
Mathematically, the Degree of Operating Leverage (DOL) is given by:
Where Contribution = Sales − Variable Costs. Contribution is the money left after paying
variable costs that can cover fixed costs and generate profit.
Step 1: Calculate Contribution
Step 2: Calculate DOL
Interpretation of Operating Leverage
A DOL of 1.36 means that for every 1% change in sales, Zenith Ltd.'s EBIT will change by
approximately 1.36%. In simple words:
• If sales increase by 10%, EBIT will increase by about 13.6%.
• If sales decrease by 10%, EBIT will decrease by 13.6%.
This shows the company has moderate operating leverage. It’s like having a ship with a
moderately heavy anchor—you can ride the waves profitably, but a huge drop in sales could
rock the ship more than you'd like.
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2. Meeting the Storm: What is Financial Leverage?
Now, as our ship sails further, it faces another storm: Financial Leverage. This is about the
use of borrowed money (debt) to fund your ship’s journey. Interest on debt is like the toll
you pay for borrowing the cannonballs and sails to speed up your ship. Financial leverage
measures how sensitive your Net Income is to changes in EBIT.
The Degree of Financial Leverage (DFL) is calculated as:
Step 1: Calculate DFL
Interpretation of Financial Leverage
A DFL of 2.12 means that for every 1% change in EBIT, the Net Income changes by 2.12%.
Imagine a gust of wind hitting your ship:
• If EBIT increases by 10%, Net Income will rise by approximately 21.2%.
• If EBIT falls by 10%, Net Income will decrease by 21.2%.
This shows Zenith Ltd. has high financial leverage. Using debt can amplify profits, but it also
makes the ship more vulnerable to storms (interest obligations). Too much debt, and a small
dip in sales could sink your profits.
3. The Combined Effect: Total Leverage
If you are curious about how your net income responds to changes in sales, we can combine
the effect of operating and financial leverage. This is called Combined Leverage (DCL):
Interpretation: A 1% change in sales will result in a 2.88% change in Net Income. That’s a
magnified impact, showing the double-edged sword of using both fixed costs and debt:
profits can soar high, but losses can fall even faster.
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4. Telling the Story
Let’s picture this in human terms. Zenith Ltd. is like a young, ambitious company ship:
• Sales growth is the wind in the sails.
• Fixed costs are the weight of the anchor (Operating Leverage).
• Debt interest is the toll for borrowed sails (Financial Leverage).
A moderate operating leverage (1.36) tells us that Zenith Ltd. is reasonably good at
controlling production costs relative to sales. A high financial leverage (2.12) signals that the
company is betting on borrowed funds to boost profits, which can pay off handsomely if
business sails smoothly, but can be risky if the sea gets rough (i.e., sales drop).
The combined leverage (2.88) acts like a magnifying glass on every sales change—small
ripples in sales can cause big waves in net income. A wise captain (the management) will
need to watch both the winds of market demand and the weight of debt carefully.
5. Why This Matters to Students and Examiners
Understanding operating and financial leverage is more than just numbers—it’s a story
about risk and reward.
• Operating Leverage: Helps a student realize how production costs affect profits.
High fixed costs mean bigger swings in earnings.
• Financial Leverage: Teaches the importance of using debt wisely. Borrowing can
make profits soar but also magnifies losses.
• Combined Leverage: Gives a complete picture of how sensitive net income is to
changes in sales, helping management make informed decisions.
For an examiner, this explanation is enjoyable because it translates abstract numbers into a
real-world scenario—a ship battling the seas—making financial ratios not just formulas, but
relatable, tangible ideas.
󷄧󼿒 Conclusion
To summarize Zenith Ltd.’s journey:
Leverage
Value
Meaning
Operating Leverage (DOL)
1.36
Moderate sensitivity of EBIT to sales changes
Financial Leverage (DFL)
2.12
High sensitivity of Net Income to EBIT changes
Combined Leverage (DCL)
2.88
Net Income is highly sensitive to sales changes
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Zenith Ltd. is navigating the ocean with moderate operational risk but high financial risk.
The company can make profits faster when sales rise, but the management must steer
carefully during downturns to avoid turbulent waves that can erode net income.
In short, leverage is like the art of sailing—you need to know how much anchor to drop
(fixed costs) and how many borrowed sails to use (debt) to ride the waves of business safely
and reach the treasure island of profitability.
4 Discuss how to design optimum capital structure in detail.
Ans: Imagine a young entrepreneur, Riya, who has just started a small manufacturing
business. Her products are gaining popularity, and she realizes it’s time to expand. But here
comes the classic dilemma: how should she finance this expansion? Should she borrow from
banks, issue shares to investors, or use her own savings? Essentially, Riya is trying to find her
business’s optimum capital structure—the perfect mix of debt and equity that maximizes
her company’s value while minimizing risks. Let’s walk through this journey step by step.
Understanding Capital Structure
At its core, capital structure refers to the way a company finances its assets through a
combination of debt (borrowed money) and equity (owner’s money or share capital). Think
of it as a recipe: if you add too much salt (debt), the dish might taste bad (high risk), but too
little, and it may lack flavor (opportunity to grow). So, just like cooking, the balance matters.
Riya knows that debt has two advantages: first, interest on debt is tax-deductible, which can
reduce the company’s tax liability. Second, it can amplify returns for shareholders if the
business performs well, a phenomenon called financial leverage. But there’s a catch: too
much debt increases the risk of default and can make investors nervous. Equity, on the
other hand, is safer because there’s no obligation to pay dividends, but it’s also more
expensive in the long run since shareholders expect a return on their investment.
The Quest for Optimum Capital Structure
The optimum capital structure is that magical point where the cost of capital is minimized
and the value of the firm is maximized. Imagine it as a seesaw: on one side, the cost of
debt, and on the other, the cost of equity. When the seesaw is balanced perfectly, the
company enjoys lower overall financing costs and a healthy risk-return profile.
Riya begins by considering a few guiding principles:
1. Trade-off Theory: She learns that there is a trade-off between the benefits of debt
(like tax savings) and the risk of financial distress. Too little debt, and she’s leaving
tax benefits on the table; too much debt, and she risks bankruptcy. Her goal is to find
the “sweet spot” where the marginal benefit of debt equals its marginal cost.
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2. Pecking Order Theory: Riya also studies how businesses prefer to fund themselves.
Companies typically use internal funds first (retained earnings), then debt, and only
issue equity as a last resort. This approach avoids the high costs of issuing new
shares and signals confidence to the market.
3. Market Conditions: She realizes that the state of the economy affects the decision.
When interest rates are low, debt becomes cheaper, making borrowing more
attractive. In volatile markets, equity may be safer because it doesn’t require fixed
payments.
4. Business Risk Consideration: Riya knows that her industry is cyclical; demand for her
products can fluctuate. Firms with high business risk should avoid excessive debt
because fixed interest obligations could become unmanageable during downturns.
Step-by-Step Design of Optimum Capital Structure
To make this more practical, Riya breaks down the process into actionable steps:
Step 1: Assess Business Risk
Riya evaluates how stable her revenues are. She examines past sales, market trends, and
customer behaviour. A stable cash flow means she can comfortably take on debt, whereas
fluctuating income suggests a conservative approach.
Step 2: Evaluate Financial Flexibility
She considers her company’s ability to raise funds in the future. A firm with flexibility can
adjust its mix of debt and equity depending on needs, which reduces the risk of being over-
leveraged.
Step 3: Estimate Cost of Debt and Equity
Riya calculates the cost of debt (interest rates after tax deductions) and the cost of equity
(expected returns demanded by shareholders). These calculations help her understand
which form of financing is cheaper for her business.
Step 4: Analyze Leverage Impact on Profitability
She studies how taking on additional debt could magnify profits during good times (positive
leverage) and losses during bad times (negative leverage). By modelling different scenarios,
she identifies a safe level of debt that maximizes shareholder wealth without jeopardizing
business stability.
Step 5: Decide the Mix of Debt and Equity
After weighing all factors, Riya chooses a balanced mix. For example, she might decide on
40% debt and 60% equity. This structure provides tax benefits, maintains investor
confidence, and keeps financial risk manageable.
Step 6: Continuous Monitoring
Riya understands that the optimum capital structure is not a one-time decision. As the
business grows, market conditions change, and new opportunities arise, she must
periodically review and adjust the mix of debt and equity.
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Practical Illustration
Let’s make it more relatable. Suppose Riya’s company can borrow at an interest rate of 8%
after taxes, and her shareholders expect a 12% return. If she uses only equity, the cost of
capital is 12%. If she uses a mix of 50% debt and 50% equity, the weighted average cost of
capital (WACC) drops to around 10%. This means the business can grow more efficiently
because she is financing at a lower overall cost. But if she increases debt to 80%, the risk
rises sharply, and lenders may demand higher interest rates, pushing WACC back up. So,
50% debt may represent the optimum point.
Human Touch: Beyond Numbers
What makes designing capital structure exciting is that it’s not just a mathematical exercise.
It’s a story of choices, risks, and opportunities. For Riya, it’s about confidence,
understanding her business, and making decisions that protect her dream while allowing it
to grow. A company’s capital structure tells a story to the market—it signals how aggressive
or cautious management is, how much faith they have in future earnings, and how they
balance ambition with prudence.
Conclusion
In summary, designing the optimum capital structure is like orchestrating a symphony. Debt
and equity are instruments, each with its own tone and rhythm. Too much of one can
disrupt the harmony, but the right mix creates a beautiful, balanced composition that drives
growth, minimizes risk, and maximizes value.
By carefully assessing business risk, costs, market conditions, and financial flexibility, Riya
can craft a capital structure that serves her company well today and adapts gracefully to the
uncertainties of tomorrow. And that, ultimately, is the essence of financial wisdom:
balancing risk and reward, just like walking a tightrope—with strategy, insight, and a little
courage.
SECTION – C
5 From the following information extracted from the books of a manufacturing concern,
compute the operating cycle in days:
Given Information
Particulars
Period Covered
Average period of credit allowed by suppliers
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Average total of debtors outstanding
Raw material consumption
Total production cost
Total cost of goods sold for the year
Sales for the year
Value of average stock maintained:
– Raw materials
– Work-in-progress
– Finished goods
Ans: Think of a manufacturing company as a giant machine that turns raw materials into
finished products and then into cash. But, like any machine, it has cogs and cycles. One of
the most important cogs in this machine is the operating cycle, which tells us how long it
takes for the company to invest in raw materials and eventually get the cash from
customers. It’s like tracking a hero on a journey—from buying raw ingredients, making them
into products, selling them, and finally collecting money from the buyers.
In our story, the company gives us some numbers, and our job is to map out the journey of
cash. Let’s meet our characters:
1. Raw Materials (RM) – the ingredients for our hero’s journey.
2. Work-in-Progress (WIP) – halfway through the journey; not yet ready to sell.
3. Finished Goods (FG) – fully prepared products waiting to be sold.
4. Debtors – the people who owe money to the company after buying its products.
5. Suppliers – the ones who provided the raw materials on credit.
Now, the operating cycle is the total time taken to convert cash invested in raw materials
into cash received from customers. Mathematically, it can be represented as:
Don’t worry! Each term will become crystal clear with our little story analogy.
Step 1: Understanding the Inventory Period
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Our hero first invests in raw materials, buys them, and keeps them in stock until production
begins. Then, the raw materials are transformed into work-in-progress and finally into
finished goods. The inventory period is essentially the total time the company’s money is
stuck in inventory.
We have three inventory stages:
1. Raw Material Inventory Period: This is how long raw materials stay in stock before
they are used. It can be calculated as:
From the problem:
• Average Raw Material Stock = 320,000 Rs
• Raw Material Consumption = 4,400,000 Rs per year
First, let’s find the daily raw material consumption:
Now, raw material period:
So, our hero spends about 27 days holding raw materials before using them in production.
2. Work-in-Progress Period: WIP is like the hero mid-journey—it’s in the factory, being
transformed. The formula:
Average WIP = 350,000 Rs
Production Cost = 10,000,000 Rs/year
Daily production cost:
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So, WIP period:
This tells us that raw materials spend about 13 days in production before becoming finished
goods.
3. Finished Goods Period: Now the products are ready but still waiting to be sold. The
period is calculated as:
Average Finished Goods = 260,000 Rs
Cost of Goods Sold = 10,500,000 Rs/year
Daily COGS:
Finished Goods Period:
Adding all inventory periods:
So, our hero spends 49 days from buying raw materials to having finished products ready for
sale.
Step 2: Debtors Collection Period
Once the goods are sold, the company doesn’t always get cash immediately. Some
customers buy on credit. This is the debtors period, the time money is “out on adventure.”
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Formula:
Average Debtors = 480,000 Rs
Sales = 16,000,000 Rs/year
Daily Sales:
Debtors period:
So, after the products are sold, it takes roughly 11 days to collect cash from customers.
Step 3: Creditors Payment Period
Here, the company isn’t always paying suppliers immediately—it gets some credit. This
period reduces the operating cycle because some money is still with the suppliers.
Creditors period is given directly: 16 days
Step 4: Operating Cycle Calculation
Finally, the operating cycle = Inventory Period + Debtors Period – Creditors Period
Operating Cycle=49+11−16=44 days
Step 5: Story Conclusion
Let’s visualize it:
1. Day 1–27: Raw materials are sitting in the warehouse.
2. Day 28–40: Materials are being transformed in production (WIP).
3. Day 41–49: Finished goods are waiting to be sold.
4. Day 50–60: After the sale, it takes 11 days to collect cash from customers.
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5. But wait! We only count the net days the company’s cash is actually tied up. Thanks
to the supplier credit of 16 days, we subtract those days.
So, our hero’s journey, from paying for raw materials to receiving cash from sales, is 44
days.
In simpler terms, it takes about a month and a half for money to make a full round trip in
this company—from cash outflow to cash inflow. This is a sign of efficiency because a
shorter operating cycle generally means better cash management.
Step 6: Reflection
If you imagine this company like a runner in a race: the inventory period is the time spent
on the track, the debtors period is time spent handing over medals to fans (getting paid),
and the creditors period is like having a pit crew giving a short delay advantage. By knowing
the operating cycle, management can plan cash requirements, improve liquidity, and even
negotiate better credit terms.
Q.6 What do you mean by Bank Financing? Discuss the recommendations of Tandon
Committee towards the Bank Financing.
Ans: A Different Beginning
Imagine you are a young entrepreneur who has a big dream. You want to set up a factory,
buy raw materials, pay workers, and keep your machines running smoothly. You have the
passion, the ideas, and even the market waiting for your product. But there is one problem:
money.
You quickly realize that running a business is not just about starting it—it is about keeping it
alive every day. Salaries, electricity bills, transportation, buying raw materials, storing
finished goods—all of this needs funds. You might have some savings, but they are not
enough. Where do you go? Naturally, like most businesses, you knock on the door of a bank.
This is where bank financing comes into the picture. It is the bridge between dreams and
reality, between plans and execution. Let us now explore what exactly it means and how the
famous Tandon Committee tried to shape the rules around it.
What is Bank Financing?
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In the simplest sense, bank financing means the provision of funds by banks to businesses,
industries, or individuals to meet their financial needs. These funds can be provided in
various forms, such as:
• Working Capital Loans – money to run day-to-day operations like buying raw
materials or paying salaries.
• Term Loans – money to buy machinery, buildings, or expand capacity.
• Cash Credit / Overdraft – a flexible arrangement where businesses can withdraw
funds up to a certain limit whenever required.
For industries, the most critical part is working capital financing. Why? Because even a
profitable company can collapse if it does not have enough cash to keep its operations
moving smoothly. For example, if a textile mill has orders worth ₹1 crore but does not have
money to buy cotton, it will fail despite demand being present.
So, bank financing is the lifeline of industries—it ensures that businesses do not get stuck
midway due to shortage of funds.
Why Was the Tandon Committee Formed?
Back in the 1970s, India was growing, but businesses were facing a big problem: there were
no clear rules on how much money banks should lend for working capital. Some
companies took huge loans far beyond their needs, while others struggled to get even the
minimum required.
Banks were confused too—how much should they finance? How should they calculate the
real needs of a company? Should they ask companies to bring in some money of their own,
or should they finance everything?
To solve this mess, in 1974, the Reserve Bank of India (RBI) appointed a committee under
the chairmanship of Mr. P.L. Tandon, famously called the Tandon Committee. Its main job
was to give guidelines on:
1. How much working capital should banks finance?
2. How should businesses manage their inventories (raw materials, stock of goods,
etc.)?
3. What norms should be followed to maintain financial discipline?
Recommendations of the Tandon Committee
The Tandon Committee gave some very important recommendations, many of which
changed the way bank financing worked in India. Let us break them down in a story-like
flow.
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1. Norms for Inventory and Receivables
The committee first said: “Look, industries cannot keep unlimited stock of raw materials or
finished goods by using bank money. There should be a discipline.”
It suggested norms for how much stock of raw materials, work-in-progress, and finished
goods companies should hold. Similarly, it fixed how long debtors (customers who owe
money) can be allowed to delay payment.
For example, if a company keeps too much raw material stock for 6 months, it means bank
money is locked up unnecessarily. Instead, the committee suggested that companies should
keep stock only for a reasonable period (say 2 months or 3 months depending on the
industry).
This helped in avoiding misuse of bank funds and made businesses run more efficiently.
2. Three Methods of Lending (Working Capital Finance)
Perhaps the most famous recommendation of the committee was the three methods of
lending. These methods explained how much of the working capital requirement should
come from the bank and how much should come from the company itself (called margin
money).
• First Method:
Bank finances 75% of working capital gap, and the company brings 25% from its
own funds.
o Working Capital Gap = Current Assets – Current Liabilities (other than bank
borrowings)
• Second Method:
The company should finance 25% of total current assets from its own funds. The
bank provides the rest.
o This method reduces the dependence on banks and ensures companies bring
more of their own capital.
• Third Method:
The company should finance 25% of total current assets from its own funds and
cover the entire current liabilities itself. Bank finances only the remaining.
o This is the most stringent method and ensures the highest level of financial
discipline.
In simple words, the committee was teaching industries: “Don’t depend on banks for
everything. You also invest in your own business. Only then will you use funds carefully.”
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3. Emphasis on Financial Discipline
The committee also highlighted that:
• Companies must submit quarterly information reports to banks about their financial
position.
• Banks should monitor end-use of funds.
• No diversion of working capital funds for long-term purposes (like buying land or
new factories).
This was a move to stop misuse of bank financing and bring transparency.
4. Credit Authorization Scheme
The Tandon Committee also recommended a Credit Authorization Scheme (CAS). Under
this, any big loan above a certain limit required prior approval from RBI. This helped in
monitoring large borrowings and keeping control over risky lending.
5. Encouragement of Short-Term Financing
The committee advised banks not to provide permanent financing for working capital.
Instead, companies should arrange some portion of funds through their own capital or by
issuing shares/debentures. Bank loans should remain a short-term bridge and not become a
permanent source of funds.
Impact of Tandon Committee
The recommendations of the Tandon Committee created a huge impact on India’s banking
and industrial financing:
1. Better Utilization of Bank Funds – Industries could not misuse loans to keep excess
stock.
2. Financial Discipline – Companies started maintaining proper records and reporting
to banks.
3. Balanced Responsibility – Both banks and businesses shared the responsibility of
financing.
4. Foundation for Future Reforms – Later committees (like Chore Committee) also built
upon these guidelines.
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Conclusion
If we think of businesses as cars and banks as fuel stations, then bank financing is the petrol
that keeps the engine running. But if a car consumes petrol carelessly or hoards it
unnecessarily, it creates problems not only for itself but for the whole system.
The Tandon Committee acted like a wise traffic controller—it set rules on how much petrol
should be used, who should pay for what, and how to ensure a smooth journey. Its
recommendations may have been technical, but at the heart of it was a simple principle:
discipline in finance leads to healthier businesses and a stronger economy.
So, bank financing is not just about giving loans; it is about creating a balance between trust,
responsibility, and growth. And the Tandon Committee played a landmark role in teaching
India this balance.
SECTION – D
7 Explain the process of Capital Expenditure Decision in detail.
Ans: Capital Expenditure Decision – Explained Like a Story
Imagine you are the captain of a big ship, and this ship represents a company. Every day, the
ship sails smoothly in the ocean of business, carrying goods, earning money, and paying
salaries. But one day, you realize that the engine of your ship is getting old, and it will not
survive the next big storm. Now you stand at a turning point:
󷷑󷷒󷷓󷷔 Should you spend a huge amount of money today to buy a brand-new, modern engine
that will help your ship sail faster and safer for the next 20 years?
󷷑󷷒󷷓󷷔 Or should you save money now and take the risk of breakdowns in the future?
This decision, my friend, is exactly what companies face when they talk about Capital
Expenditure (CapEx) Decisions. It is the process of deciding whether or not to spend large
sums of money on assets like machines, factories, buildings, or new technology, which will
benefit the company in the long run.
Let us now walk step by step into this journey, like a story unfolding, to understand the
process in detail.
1. Understanding Capital Expenditure Decision
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Capital Expenditure Decisions are long-term investment choices made by a business. Unlike
day-to-day expenses (like electricity bills or raw material purchases), capital expenditure
involves huge financial commitment and has long-lasting effects, often for 10–20 years.
For example:
• A school deciding to build a new campus.
• A hospital buying advanced MRI machines.
• A factory installing solar panels.
Each of these decisions requires large investment and has the power to shape the future of
the organization. That’s why capital expenditure decisions are also called investment
decisions or capital budgeting decisions.
2. Why Are These Decisions So Important?
Think of it like choosing your career. If you study and invest your energy in the right field
today, you will enjoy a good future. If you choose wrongly, you may regret it for life.
Similarly, once a company invests in a project, it cannot easily take the money back. If a
factory spends ₹50 crores on setting up a steel plant, it cannot change its mind next year
and get the money out. That’s why capital expenditure decisions must be taken carefully
after proper analysis.
3. The Step-by-Step Process of Capital Expenditure Decision
Now, let’s break down the process into a story-like sequence so that it feels natural and easy
to follow.
Step 1: Identifying Investment Opportunities
This is the stage where ideas are born. Just like students dream about becoming doctors,
engineers, or entrepreneurs, companies dream about projects that can grow their business.
For example:
• A mobile company may think about launching 5G phones.
• An automobile firm may plan to introduce electric cars.
These ideas are collected and listed as potential investment opportunities.
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Step 2: Screening and Shortlisting
Every dream is not practical. A student may want to become both a doctor and a cricketer,
but he must choose one path. Similarly, a company must filter projects.
Here, managers check whether the ideas are in line with the company’s goals, whether the
technology is available, whether the law permits it, and whether it is realistic. Only practical
projects survive at this stage.
Step 3: Estimating Cash Flows
Now comes the number-crunching part. For every shortlisted project, the company
estimates:
• How much money will be spent initially (investment)?
• How much money will the project bring in the future (returns)?
• How long will it take to recover the cost?
For example: if a company invests ₹100 crores in a solar plant, it might estimate earning ₹20
crores every year for the next 10 years.
Step 4: Evaluating Alternatives
At this stage, financial tools come into the picture. Just like students compare colleges by
checking placement rates, fees, and rankings, companies compare projects using different
techniques. Some important methods are:
• Payback Period: How quickly the investment will be recovered.
• Net Present Value (NPV): The value of future cash inflows compared with today’s
money.
• Internal Rate of Return (IRR): The rate of return the project promises.
• Profitability Index: Ratio of benefits to costs.
By applying these tools, companies can judge which project is most profitable and least
risky.
Step 5: Selecting the Best Project
After evaluation, management selects the project (or combination of projects) that fits the
company’s resources, strategic goals, and risk appetite.
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For instance, if two projects promise good returns but one requires very high risk, the
company may prefer the safer option.
Step 6: Implementing the Project
Decision-making alone is not enough; action matters. Once the final project is selected, the
company arranges funds (through loans, shares, or internal reserves) and begins
execution—buying land, hiring staff, installing machines, etc.
This stage requires careful planning because delays or cost overruns can reduce profitability.
Step 7: Reviewing and Monitoring
Finally, after the project starts running, the company doesn’t just sit back. It constantly
reviews whether the project is giving the expected returns. If something goes wrong,
corrective action is taken.
Think of it like a student preparing for exams—after choosing the subject, the student must
regularly test himself to ensure he is on track.
4. Challenges in Capital Expenditure Decisions
Making capital expenditure decisions is not as easy as it sounds. Some challenges include:
• Uncertainty of Future: No one can perfectly predict market demand or technology
changes.
• High Risk: If the project fails, the company may suffer heavy losses.
• Irreversibility: Once money is invested, it cannot be easily taken back.
• Large Funds Required: Huge capital is needed, which may strain the company’s
finances.
5. Importance of Capital Expenditure Decisions
Why do we study this topic at all? Because such decisions are the backbone of long-term
success. They:
• Decide the company’s growth and expansion.
• Create competitive advantage (new technology, new products).
• Affect employment, production, and even the economy of a country.
• Build the financial health of the firm in the long run.
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6. A Simple Analogy to Wrap Up
Think of a farmer who has to decide whether to buy a new tractor. The tractor is expensive,
but it will help him plough the fields faster, increase productivity, and earn more income in
future. If he makes the right choice, his farm will flourish; if not, he may end up with a huge
debt.
This is exactly how companies face capital expenditure decisions.
Conclusion
Capital Expenditure Decision is not just a financial calculation; it is the art of shaping the
future of a business. It begins with identifying opportunities, filtering them, estimating costs
and returns, evaluating alternatives, selecting the best option, implementing the project,
and finally reviewing its success.
Like a captain choosing the best engine for his ship or a farmer deciding on a new tractor,
companies must take these decisions with vision, caution, and proper analysis. A single wise
capital expenditure can make the company a market leader, while a wrong one can sink it
into losses.
8 The current price of a company’s share is Rs. 75 and dividend per share is Rs. 5. Calculate
the dividend growth rate if its capitalization rate is 12 percent.
Ans: A Fresh Beginning
Imagine you are sitting with your friend on a park bench. He has recently started investing in
shares, and he seems quite puzzled. He turns to you and says,
"Yaar, I bought a share for Rs. 75. This company gives a dividend of Rs. 5 per share every
year. Now, my professor is asking me to find the dividend growth rate if the capitalization
rate is 12%. I don’t know how to connect all this. It feels like rocket science!"
Now, as his friend, you don’t want him to feel stuck. So, you start explaining it in a way that
turns numbers into a little story. Let’s see how you would do that.
Step 1: What do these words mean in real life?
First, let’s simplify the “scary” terms.
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1. Current Price of a Share (P₀):
This is nothing but the market price today. For our company, one share costs Rs. 75.
Simple!
2. Dividend per Share (D₁):
This is the reward given by the company to its shareholders, usually from profits.
Here, the dividend is Rs. 5.
3. Capitalization Rate (Ke):
This sounds complicated, but actually, it’s just the investor’s expected rate of return.
In simple words: "If I invest my money here, how much return (in %) should I earn to
feel satisfied?" In our case, investors expect 12% returns.
4. Dividend Growth Rate (g):
This is what we are trying to find. It answers the question: "By how much will the
company’s dividends grow every year?"
Step 2: The Magical Formula
Luckily, finance has given us a formula to connect all these terms. It is called the Gordon
Growth Model (or Dividend Discount Model). The formula looks like this:
Where:
• P0 = Price of share today
• D1 = Expected dividend next year
• Ke = Required rate of return (capitalization rate)
• g = Growth rate of dividend
This formula is like a bridge: on one side we have price and dividends, on the other side we
have growth.
Step 3: Rearranging for “g”
Now, since we want to find the dividend growth rate, we rearrange the formula.
This step is like flipping the equation to shine a torchlight exactly on the unknown part, i.e.,
“g.”
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Step 5: Simplifying
So,
Step 6: Wrapping the Answer into a Story
Now you turn to your friend and explain:
“See, the company is giving you Rs. 5 dividend when the share price is Rs. 75. That means,
without growth, it already gives around 6.67% return (because 5 ÷ 75 = 6.67%). But you, as
an investor, want 12% return. Where will the remaining return come from? Obviously, it
must come from the growth of dividends in the future. That difference (12% – 6.67%) gives
you 5.33%.
So the dividend growth rate is 5.33%.”
Your friend smiles because suddenly what looked like rocket science now feels like a simple
story of “today’s dividend + future growth = expected return.”
Making it Engaging for the Examiner
Now let’s stretch this further and make it more enjoyable for the person who reads your
answer in an exam. Because an examiner checks hundreds of scripts, and if you make your
answer human-like, he’ll not only understand quickly but also smile while reading.
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Imagine it Like a Plant
Think of the company as a tree you are buying for Rs. 75. Every year, this tree gives you
fruits worth Rs. 5 (the dividend). Now, if you were only getting these Rs. 5 fruits forever,
your return would be stuck at 6.67% (because 5/75).
But you don’t want just that—you expect 12%. So how can the gap be filled? Easy! The tree
must grow taller and give you more fruits every year. That extra growth in fruits is the
dividend growth rate, which turns out to be 5.33%.
So, your tree grows at 5.33% every year in terms of fruit production.
Another Analogy: Renting a House
Think of the share as a house you bought for Rs. 75 lakh. Every year, you get Rs. 5 lakh rent
(the dividend). If you only got Rs. 5 lakh every year, the return would be about 6.67%. But in
real estate, you expect 12% returns.
How will the remaining 5.33% come? The rent must increase every year. That increase is like
the growth rate.
Why This Growth Rate is Important
This number, 5.33%, might look small, but it is extremely powerful. Why? Because if you
hold the share for 10–20 years, the dividends won’t remain Rs. 5. They will grow. After some
years, you might be receiving Rs. 10, Rs. 15, or even more. That’s the magic of
compounding.
This is why investors chase companies with good growth rates. A company that grows
dividends steadily is like a goose that lays golden eggs—and the eggs get bigger every year!
Final Touch
So the dividend growth rate of the company is:
Dividend Growth Rate (g)=5.33%
And you can present the whole thing like this in your exam:
1. Write the formula
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2. Show substitution step by step
3. Solve clearly
4. End with a story or analogy (plant or house) to make it memorable
If you do this, not only will you score full marks, but the examiner will also feel that you truly
understood the concept instead of just memorizing formulas.
󷄧󼿒 Final Answer: The dividend growth rate is 5.33%
“This paper has been carefully prepared for educational purposes. If you notice any mistakes or
have suggestions, feel free to share your feedback.”