Test 1: answer key

Question 1 · 2 marks · Ratio Analysis - Liquidity Ratios · medium

Scenario. Navkar Logistics Ltd. operates a nationwide warehousing and transportation business. The finance manager is reviewing its liquidity, inventory management and profitability before recommending an expansion of its distribution network. The following information relates to the financial year ended 31 March 2026. Current assets comprise closing inventory of ₹210 lakh, trade receivables of ₹140 lakh, cash and bank balances of ₹60 lakh, and prepaid expenses of ₹10 lakh. Current liabilities are ₹240 lakh. Opening inventory was ₹150 lakh. Opening trade receivables were ₹100 lakh. Annual sales were ₹1,200 lakh, entirely on credit, and the gross profit margin was 25% of sales. For a separate profitability analysis, the company reported sales of ₹1,500 lakh, EBIT of ₹180 lakh and interest expense of ₹30 lakh. The corporate tax rate was 30%. Average total assets were ₹700 lakh and average equity shareholders' funds were ₹350 lakh. The finance manager intends to use the traditional Du Pont model to understand the sources of return on equity.

Using Navkar Logistics Ltd.'s year-end balance sheet information, what are its current ratio and quick ratio respectively?

1. 1.75:1 and 0.83:1 (correct answer)
2. 1.75:1 and 1.75:1
3. 0.83:1 and 0.83:1
4. 0.83:1 and 1.75:1

Answer: A — 1.75:1 and 0.83:1

Working. Step 1: Calculate total current assets = Inventory + Trade receivables + Cash and bank + Prepaid expenses = 210 + 140 + 60 + 10 = ₹420 lakh. Step 2: Current ratio = Current assets / Current liabilities = 420 / 240 = 1.75:1. Step 3: Quick assets = Current assets - Inventory - Prepaid expenses = 420 - 210 - 10 = ₹200 lakh. Step 4: Quick ratio = Quick assets / Current liabilities = 200 / 240 = 0.8333:1, approximately 0.83:1.

Explanation. Option (a) is correct. Current ratio measures the relationship between total current assets and current liabilities. Quick ratio measures the ability to meet current obligations through readily convertible assets. Inventory and prepaid expenses are excluded from quick assets under the ICAI formula. Option (b) incorrectly treats the current ratio and quick ratio as identical, effectively retaining inventory and prepaid expenses in quick assets. Option (c) incorrectly uses quick assets instead of total current assets for calculating the current ratio. Option (d) reverses the two computed ratios. The quick ratio is lower because inventory and prepaid expenses do not qualify as quick assets under the given assumptions.

Where it goes wrong. The common error is deducting inventory but forgetting prepaid expenses when computing quick assets. Another error is swapping the numerators of the current ratio and quick ratio. Do not automatically assume that inventories are immediately convertible into cash.

Authority. Chapter 3: Financial Analysis and Planning - Ratio Analysis, Section 3.1 Liquidity Ratios - Current Ratio and Quick Ratio

Question 2 · 2 marks · Ratio Analysis - Activity Ratios · hard

Navkar Logistics Ltd. wishes to measure inventory utilisation and the time taken to collect credit sales. Using the 360-day year convention, what are the inventory turnover ratio and average debtor collection period respectively?

1. 5.00 times and 30 days
2. 5.00 times and 36 days (correct answer)
3. 4.29 times and 36 days
4. 5.00 times and 48 days

Answer: B — 5.00 times and 36 days

Working. Step 1: Gross profit = 25% of ₹1,200 lakh = ₹300 lakh. Step 2: Cost of goods sold = Sales - Gross profit = 1,200 - 300 = ₹900 lakh. Step 3: Average inventory = (Opening inventory + Closing inventory) / 2 = (150 + 210) / 2 = ₹180 lakh. Step 4: Inventory turnover = COGS / Average inventory = 900 / 180 = 5 times. Step 5: Average receivables = (Opening receivables + Closing receivables) / 2 = (100 + 140) / 2 = ₹120 lakh. Step 6: Average daily credit sales = 1,200 / 360 = ₹3.3333 lakh. Step 7: Average collection period = Average receivables / Average daily credit sales = 120 / 3.3333 = 36 days.

Explanation. Option (b) is correct. The inventory turnover ratio relates cost of goods sold to average inventory, not merely closing inventory. The average debtor collection period is calculated using average accounts receivable and average daily credit sales. Option (a) uses opening receivables alone instead of average receivables, thereby understating the collection period. Option (c) uses closing inventory rather than average inventory to calculate inventory turnover. Option (d) incorrectly uses cost of goods sold instead of credit sales to calculate average daily credit sales. The distinction between cost of goods sold and credit sales is essential because receivables arise from credit sales.

Where it goes wrong. A frequent examination error is using closing stock in place of average stock or using COGS instead of credit sales in the debtor collection calculation. The 360-day convention must also be used consistently rather than switching to 365 days.

Authority. Chapter 3: Financial Analysis and Planning - Ratio Analysis, Section 3.3 Activity Ratios - Inventory Turnover Ratio; Chapter 3: Financial Analysis and Planning - Ratio Analysis, Section 3.3 Activity Ratios - Receivables Turnover and Receivables Velocity/Average Collection Period

Question 3 · 2 marks · Ratio Analysis - Return on Equity and Du Pont Analysis · hard

The finance manager wants to calculate Navkar Logistics Ltd.'s return on equity using the traditional Du Pont model. Based on the separate profitability information in the scenario, what is the correct ROE?

1. 15.00%
2. 7.00%
3. 30.00% (correct answer)
4. 42.86%

Answer: C — 30.00%

Working. Step 1: Earnings before tax = EBIT - Interest = 180 - 30 = ₹150 lakh. Step 2: Tax = 30% of ₹150 lakh = ₹45 lakh. Step 3: PAT = 150 - 45 = ₹105 lakh. Step 4: Net profit margin = PAT / Sales = 105 / 1,500 = 7%. Step 5: Asset turnover = Sales / Average total assets = 1,500 / 700 = 2.142857 times. Step 6: Equity multiplier = Average total assets / Average equity shareholders' funds = 700 / 350 = 2 times. Step 7: Du Pont ROE = Net profit margin × Asset turnover × Equity multiplier = 0.07 × 2.142857 × 2 = 0.30 = 30%.

Explanation. Option (c) is correct. The traditional Du Pont model decomposes ROE into net profit margin, asset turnover and equity multiplier. Net profit margin must reflect profit after tax for the purpose of the traditional ROE calculation. EBIT is reduced by interest and tax before computing net income available to equity shareholders. Option (a) omits the equity multiplier and therefore measures the return generated by profit margin and asset utilisation without incorporating financial leverage. Option (b) merely reports the net profit margin and mistakes it for ROE. Option (d) uses the pre-tax profit margin instead of the after-tax net profit margin, ignoring the 30% tax rate. The equity multiplier explains the additional leverage effect on shareholders' return.

Where it goes wrong. Do not use EBIT as net income in the Du Pont net profit margin. Interest and tax must be deducted before calculating PAT. Another frequent error is omitting the equity multiplier or using average total assets as the denominator for ROE instead of equity shareholders' funds.

Authority. Chapter 3: Financial Analysis and Planning - Ratio Analysis, Section 3.4.2 Profitability Ratios Related to Overall Return on Assets/Investments - Return on Equity using the Du Pont Model

Question 4 · 2 marks · Cost of Capital - Cost of Debt and Preference Capital · hard

Scenario. Zenith Power Systems Ltd. is evaluating the cost of financing a new power-generation project. Its proposed capital structure consists of redeemable debentures, redeemable preference shares and equity shares. The company proposes to issue 10% debentures having a face value of ₹100 each at an issue price of ₹100 per debenture. Flotation costs are ₹4 per debenture. The debentures will be redeemed at par after five years. The corporate tax rate is 25%, and only annual interest is assumed to be tax deductible for the approximation method. The company also proposes to issue 8% redeemable preference shares of ₹100 each at an issue price of ₹100 per share, with flotation costs of ₹5 per share. They will be redeemed at par after five years. Preference dividends are not tax deductible. The equity shares currently trade at ₹50 each. The expected dividend next year is ₹3.18 per share, following a current dividend of ₹3 per share, with an expected constant growth rate of 6%. The risk-free rate is 7%, the expected market return is 12%, and the company's beta is 1.20. For WACC computation, the finance director has directed that the CAPM-based cost of equity be used because systematic risk is explicitly incorporated in the financing assessment. The market values of debt, preference capital and equity are ₹30 lakh, ₹10 lakh and ₹60 lakh respectively.

Using the approximation methods prescribed in the ICAI Study Material, calculate the after-tax cost of redeemable debentures and the cost of redeemable preference shares respectively. Assume that only debenture interest is tax deductible.

1. 7.50% and 8.00%
2. 8.47% and 8.00%
3. 7.81% and 9.23%
4. 8.47% and 9.23% (correct answer)

Answer: D — 8.47% and 9.23%

Working. Step 1: Annual debenture interest = 10% of ₹100 = ₹10. Step 2: Net proceeds of debenture = Issue price - Flotation cost = 100 - 4 = ₹96. Step 3: After-tax interest = 10 × (1 - 0.25) = ₹7.50. Step 4: Annual redemption adjustment = (RV - NP) / n = (100 - 96) / 5 = ₹0.80. Step 5: Average investment = (RV + NP) / 2 = (100 + 96) / 2 = ₹98. Step 6: Kd = [I(1 - t) + (RV - NP)/n] / [(RV + NP)/2] = (7.50 + 0.80) / 98 = 8.4694%, approximately 8.47%. Step 7: Annual preference dividend = 8% of ₹100 = ₹8. Net preference proceeds = 100 - 5 = ₹95. Step 8: Annual redemption adjustment = (100 - 95)/5 = ₹1. Average investment = (100 + 95)/2 = ₹97.50. Step 9: Kp = [PD + (RV - NP)/n] / [(RV + NP)/2] = (8 + 1) / 97.50 = 9.2308%, approximately 9.23%.

Explanation. Option (d) is correct. Net proceeds of debentures are the issue price less flotation costs. The redeemable debt formula incorporates the post-tax interest and the annualised difference between redemption value and net proceeds. For redeemable preference shares, the annual preference dividend and redemption adjustment are considered without an income-tax reduction because preference dividends are appropriations of after-tax profits. Option (a) ignores flotation costs and the redemption adjustment for both sources. Option (b) correctly calculates debt cost but uses only the stated preference dividend divided by face value, ignoring flotation costs and the redemption adjustment. Option (c) correctly calculates preference cost but calculates debt cost by considering only the post-tax coupon over net proceeds, omitting the annualised redemption shortfall.

Where it goes wrong. The critical distinction is that interest on debt receives a tax adjustment, while preference dividend does not. Do not apply the tax shield to preference dividends. Also, do not confuse face value with net proceeds after flotation costs.

Authority. Chapter 4: Cost of Capital, Section 5.3 Cost of Redeemable Debentures using Approximation Method; Chapter 4: Cost of Capital, Section 6.2 Cost of Redeemable Preference Shares

Question 5 · 2 marks · Cost of Capital - Cost of Equity · medium

Zenith Power Systems Ltd. wishes to estimate its cost of equity using both CAPM and Gordon's growth model. Which of the following statements gives the correct estimates and the appropriate CAPM interpretation when beta is explicitly available?

1. CAPM: 13.00%; Gordon's model: 12.36%; CAPM incorporates systematic risk through beta. (correct answer)
2. CAPM: 12.00%; Gordon's model: 12.36%; beta is not required when the market risk premium is known.
3. CAPM: 13.00%; Gordon's model: 12.00%; Gordon's model uses the current dividend instead of the next expected dividend.
4. CAPM: 7.00%; Gordon's model: 6.36%; both methods exclude the risk premium and dividend growth respectively.

Answer: A — CAPM: 13.00%; Gordon's model: 12.36%; CAPM incorporates systematic risk through beta.

Working. Step 1: CAPM formula: Ke = Rf + β(Rm - Rf). Step 2: Ke = 7% + 1.20(12% - 7%) = 7% + 1.20 × 5% = 13%. Step 3: Gordon's growth model: Ke = D1/P0 + g. Step 4: D1 = ₹3.18, P0 = ₹50 and g = 6%. Step 5: Ke = 3.18/50 + 0.06 = 0.0636 + 0.06 = 12.36%. Thus, CAPM gives 13.00% and Gordon's growth model gives 12.36%.

Explanation. Option (a) is correct. CAPM incorporates systematic risk through beta and calculates the cost of equity by adding the risk premium adjusted for beta to the risk-free rate. Gordon's model uses next year's expected dividend divided by the current market price, plus the constant growth rate. Option (b) incorrectly assumes beta is one and consequently uses the market risk premium without adjustment. Option (c) uses the current dividend D0 instead of the next expected dividend D1 in Gordon's formula. Option (d) omits the risk premium from CAPM and the growth element from Gordon's model. The two approaches may produce different estimates because they use different assumptions and inputs.

Where it goes wrong. In Gordon's model, use D1, not D0. Under CAPM, beta multiplies the market risk premium. Do not simply add the entire market risk premium to the risk-free rate unless beta is exactly one.

Authority. Chapter 4: Cost of Capital, Section 7.3 Growth Approach or Gordon's Model; Chapter 4: Cost of Capital, Section 7.5 Capital Asset Pricing Model (CAPM) Approach

Question 6 · 2 marks · Cost of Capital - Weighted Average Cost of Capital · hard

For the purpose of WACC, Zenith Power Systems Ltd. has directed that the CAPM-based cost of equity be used. Using the market values and component costs given in the scenario, what is the weighted average cost of capital?

1. 11.14%
2. 11.26% (correct answer)
3. 11.72%
4. 10.88%

Answer: B — 11.26%

Working. Step 1: Total market value of capital = 30 + 10 + 60 = ₹100 lakh. Step 2: Debt weight = 30/100 = 30%; preference weight = 10/100 = 10%; equity weight = 60/100 = 60%. Step 3: After-tax cost of debt = 8.47%; cost of preference capital = 9.23%; CAPM-based cost of equity = 13%. Step 4: WACC = (Wd × Kd) + (Wp × Kp) + (We × Ke). Step 5: WACC = (0.30 × 8.47) + (0.10 × 9.23) + (0.60 × 13). Step 6: WACC = 2.541 + 0.923 + 7.800 = 11.264%, approximately 11.26%.

Explanation. Option (b) is correct. WACC is the weighted average of the component costs of capital using each source's proportion in the total capital. The market-value weights are 30%, 10% and 60% for debt, preference capital and equity respectively. The debt cost is after tax, preference cost is not adjusted for tax, and the CAPM-based equity cost of 13% is used because the scenario explicitly directs the finance manager to use it. Option (a) uses the preference dividend rate of 8% without accounting for the flotation and redemption adjustments. Option (c) uses the gross debenture coupon rate without adjusting for the interest tax shield. Option (d) substitutes the Gordon growth estimate for the CAPM-based cost of equity despite the explicit instruction to use CAPM.

Where it goes wrong. Do not calculate WACC using equal weights or book-value weights when market values are specified. Also, do not apply the tax shield to preference dividends or equity returns. For debt, use the after-tax component cost.

Authority. Chapter 4: Cost of Capital, Section 9 Weighted Average Cost of Capital (WACC); Chapter 4: Cost of Capital, Section 9.1 Choice of Weights - Market Value Weights

Question 7 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A company is considering raising ₹20 lakh for a capacity-expansion project. It currently has 3,00,000 equity shares outstanding. Under Financing Plan E, it will raise the entire ₹20 lakh through an issue of 2,00,000 equity shares at ₹10 per share. Under Financing Plan D, it will issue ₹20 lakh of 12% debentures, leaving the existing equity share capital unchanged. The corporate tax rate is 30%. The expected EBIT from the project is ₹8 lakh. The management is comparing the alternatives on the basis of EPS, financial risk and the EBIT-EPS indifference point. It recognises that debt financing provides an interest tax shield but also creates a fixed financial obligation, whereas equity financing avoids compulsory interest payments but increases the number of shares outstanding.

Calculate the EBIT-EPS indifference point between Financing Plan E and Financing Plan D. Also determine the financing plan that provides the higher EPS when expected EBIT is ₹8 lakh.

1. ₹4.20 lakh; equity plan provides higher EPS.
2. ₹5.00 lakh; debt plan provides higher EPS.
3. ₹6.00 lakh; debt plan provides higher EPS. (correct answer)
4. ₹6.00 lakh; equity plan provides higher EPS.

Answer: C — ₹6.00 lakh; debt plan provides higher EPS.

Working. Step 1: Financing Plan E shares = Existing shares + New shares = 3,00,000 + 2,00,000 = 5,00,000 shares. Step 2: Financing Plan D interest = ₹20 lakh × 12% = ₹2.40 lakh. Plan D shares remain 3,00,000. Step 3: Indifference condition: EPS under Plan E = EPS under Plan D. Step 4: [EBIT × (1 - 0.30)]/5,00,000 = [(EBIT - 2.40) × (1 - 0.30)]/3,00,000. Step 5: Cancelling the common tax factor and expressing EBIT in lakh: EBIT/5 = (EBIT - 2.40)/3. Step 6: 3EBIT = 5EBIT - 12; 2EBIT = 12; EBIT = ₹6 lakh. Step 7: At EBIT ₹8 lakh, Plan E EPS = 8 × 0.70 / 5 = ₹1.12. Plan D EPS = (8 - 2.40) × 0.70 / 3 = 3.92/3 = ₹1.3067. Therefore, Plan D provides higher EPS.

Explanation. Option (c) is correct. The indifference point is the EBIT at which EPS under the two financing plans is equal. Since both alternatives are subject to the same tax rate and there are no preference dividends, the common tax factor cancels when the EPS expressions are equated. The resulting indifference EBIT is ₹6 lakh. At the expected EBIT of ₹8 lakh, EBIT exceeds the indifference point, so debt financing generates a higher EPS because fewer equity shares are outstanding. Option (a) incorrectly uses after-tax interest in the EBIT indifference calculation. Option (b) uses a 10% interest rate instead of the stated 12% debenture rate. Option (d) correctly identifies the indifference EBIT but reverses the financing recommendation for EBIT above the indifference point. Debt financing may increase EPS at the specified EBIT, but it also increases financial risk due to the fixed interest obligation.

Where it goes wrong. The interest amount used in the EBIT-EPS indifference equation is the contractual interest before tax, not its after-tax amount. Also, remember that debt generally benefits EPS above the indifference point, whereas equity financing is relatively advantageous below it, subject to the assumptions of the model.

Authority. Chapter 5: Financing Decisions - Capital Structure, EBIT-EPS Analysis and Indifference Point; Chapter 5: Financing Decisions - Capital Structure, Choice between Debt and Equity Financing

Question 8 · 1 marks · Financing Decisions - Capital Structure · medium

What is the financial break-even EBIT under Financing Plan D?

1. Nil
2. ₹1.68 lakh
3. ₹6.00 lakh
4. ₹2.40 lakh (correct answer)

Answer: D — ₹2.40 lakh

Working. Step 1: Financial break-even EBIT under debt-only financing = Annual interest expense. Step 2: Interest = ₹20 lakh × 12% = ₹2.40 lakh. Step 3: Financial break-even EBIT = ₹2.40 lakh.

Explanation. Option (d) is correct. Financial break-even EBIT is the level of EBIT at which earnings available to equity shareholders become zero. Under Plan D, there are no preference dividends, so EBIT must exactly cover the fixed interest expense of ₹2.40 lakh. Option (a) represents the absence of financial charges and is not applicable to Plan D. Option (b) incorrectly uses interest after tax, whereas the break-even calculation considers the full contractual interest obligation. Option (c) is the EBIT-EPS indifference point, not the financial break-even point.

Where it goes wrong. Do not confuse financial break-even with the EBIT-EPS indifference point. The former covers fixed financial charges, while the latter is the EBIT at which EPS under two financing plans becomes equal.

Authority. Chapter 5: Financing Decisions - Capital Structure, Financial Break-even Point