Practice test 3 for Section A: Financial Management covering Investment Decisions - Payback Period, Investment Decisions - Net Present Value, Investment Decisions - Profitability Index, Dividend Decisions - Walter's Model, Dividend Decisions - Gordon's Model, Dividend Decisions - MM Dividend Irrelevance Theory.
8 questions across 6 chapters, 15 marks and 30 minutes in the timed paper. Every answer below is shown with the working behind it and the authority it rests on.
Law and standards used: ICAI Study Material for CA Intermediate Paper 6: Financial Management and Strategic Management (relevant for January 2027 attempt).
Questions
8
Marks
15
Time limit
30 minutes
Attempt
January 2027
Group
Group 2
Law basis
ICAI Study Material for CA Intermediate Paper 6: Financial Management and Strategic Management (relevant for January 2027 attempt)
Content as of
2026-11-04
Chapters covered
Investment Decisions - Payback Period (1 Q)
Investment Decisions - Net Present Value (1 Q)
Investment Decisions - Profitability Index (1 Q)
Dividend Decisions - Walter's Model (3 Q)
Dividend Decisions - Gordon's Model (1 Q)
Dividend Decisions - MM Dividend Irrelevance Theory (1 Q)
Questions, answers and explanations
Question 1 · 2 marks · Investment Decisions - Payback Period · medium
Scenario. Pragati Infra Ltd. is evaluating two mutually exclusive capital investment proposals, Project Alpha and Project Beta. Project Alpha requires an initial investment of ₹10 lakh and is expected to generate cash inflows of ₹7 lakh at the end of each of the next two years. Project Beta requires an initial investment of ₹14 lakh and is expected to generate cash inflows of ₹8 lakh in Year 1 and ₹9 lakh in Year 2. Both projects have a two-year economic life, no salvage value and no additional cash outflows. The company's cost of capital is 10 percent. The relevant present value interest factors at 10 percent are 0.909 for Year 1 and 0.826 for Year 2. The management is required to evaluate the proposals using the traditional payback method and discounted cash flow methods. Since the projects involve unequal initial investments, the management also wishes to compare their relative profitability through the Profitability Index.
Using the traditional payback method, calculate the payback period of Project Alpha.
1.30 years
1.43 years (correct answer)
1.50 years
2.00 years
Answer: B — 1.43 years
Working. Step 1: Initial investment = ₹10 lakh. Step 2: Year 1 cash inflow = ₹7 lakh. Step 3: Unrecovered investment = ₹10 lakh - ₹7 lakh = ₹3 lakh. Step 4: Year 2 cash inflow = ₹7 lakh. Step 5: Fraction of Year 2 = ₹3 lakh / ₹7 lakh = 0.4286 years. Step 6: Payback Period = 1 + 0.4286 = 1.4286 years = approximately 1.43 years.
Explanation. The correct option is (b), 1.43 years. The initial outlay is ₹10 lakh. After receiving ₹7 lakh at the end of Year 1, ₹3 lakh remains unrecovered. The second-year cash inflow is ₹7 lakh, so the fraction of Year 2 required is 3/7 = 0.4286 years. Therefore, the payback period is 1.4286 years, approximately 1.43 years. Option (a) 1.30 years incorrectly expresses the unrecovered amount as a fraction of the original investment rather than the Year 2 cash inflow. Option (c) 1.50 years assumes that half of Year 2 is needed instead of calculating the actual fraction. Option (d) 2.00 years ignores the fact that the investment is recovered during Year 2 and incorrectly assumes that the entire second year is necessary.
Where it goes wrong. Students frequently divide the unrecovered investment by the original investment instead of dividing it by the next year's cash inflow. Another common error is reporting the full second year rather than interpolating the fractional year.
Authority. Chapter 7: Investment Decisions - Section 8.1 Traditional or Non-Discounting Techniques: Payback Period
Question 2 · 2 marks · Investment Decisions - Net Present Value · medium
Calculate the Net Present Value of Project Beta using the given present value factors. Select the nearest value in lakh rupees.
Explanation. The correct option is (d), ₹0.71 lakh. Under the NPV method, present values of the expected cash inflows are added and the initial investment is deducted. Year 1 cash inflow has a present value of ₹8 lakh × 0.909 = ₹7.272 lakh, while Year 2 cash inflow has a present value of ₹9 lakh × 0.826 = ₹7.434 lakh. Total present value of inflows is ₹14.706 lakh. After deducting the initial investment of ₹14 lakh, NPV is positive ₹0.706 lakh, approximately ₹0.71 lakh. Option (a) reverses the sign even though discounted inflows exceed the investment. Option (b) incorrectly discounts both inflows using the Year 1 factor, thereby failing to recognise the different timing of the cash flows. Option (c) states the present value of the inflows without deducting the initial investment, so it represents neither NPV nor the net project value.
Where it goes wrong. A frequent error is to report the total present value of inflows as NPV without deducting the initial outlay. Applying the same discount factor to cash flows occurring in different years is another common error.
Authority. Chapter 7: Investment Decisions - Section 9.1 Discounting Techniques: Net Present Value Technique
Question 3 · 2 marks · Investment Decisions - Profitability Index · hard
Pragati Infra Ltd. wishes to compare the relative profitability of Projects Alpha and Beta using the Profitability Index. Which option correctly calculates the indices and identifies the proposal with the higher present value of inflows per rupee invested?
Alpha: 1.215; Beta: 1.050; Alpha has the higher index. (correct answer)
Alpha: 1.050; Beta: 1.215; Beta has the higher index.
Alpha: 0.823; Beta: 0.952; Beta has the higher index.
Alpha: 2.145; Beta: 0.706; Alpha has the higher index.
Answer: A — Alpha: 1.215; Beta: 1.050; Alpha has the higher index.
Explanation. The correct option is (a). Profitability Index is calculated by dividing the present value of cash inflows by the initial cash outlay. For Alpha, the present value of inflows is ₹12.145 lakh and the initial investment is ₹10 lakh, producing a PI of 1.2145. For Beta, the present value of inflows is ₹14.706 lakh and the initial investment is ₹14 lakh, producing a PI of 1.0504. Alpha therefore generates a higher present value of cash inflows per rupee invested. Option (b) reverses the indices belonging to the two projects. Option (c) calculates the inverse ratio by dividing initial investment by present value of inflows; this is not the ICAI Profitability Index formula. Option (d) reports the NPVs of the two projects rather than their profitability indices, and therefore compares absolute net gains rather than relative profitability.
Where it goes wrong. The central trap is confusing NPV with PI. NPV is an absolute measure, whereas PI is a relative measure. Another frequent error is inverting the PI formula by placing the initial cash outlay in the numerator.
Authority. Chapter 7: Investment Decisions - Section 9.2 Profitability Index or Desirability Factor or Present Value Index Method
Question 4 · 2 marks · Dividend Decisions - Walter's Model · medium
Scenario. Sigma Chemtech Ltd. is examining its dividend policy under Walter's Model. The management has identified three business conditions. Growth Division G has earnings per share of ₹10, an internal rate of return on retained earnings of 15 percent, a cost of equity of 10 percent and a current dividend payout ratio of 20 percent. Declining Division D has earnings per share of ₹12, an internal rate of return of 8 percent, a cost of equity of 12 percent and a current dividend payout ratio of 75 percent. Normal Division N has earnings per share of ₹10, an internal rate of return of 12 percent, a cost of equity of 12 percent and a current dividend payout ratio of 40 percent. Assume that Walter's Model assumptions hold throughout the evaluation. The management wants to calculate the market value per share under the existing payout policies and determine the theoretically optimal dividend payout policy for each business condition.
Using Walter's Model, determine the market value per equity share of Growth Division G under its existing dividend policy.
₹100
₹110
₹140 (correct answer)
₹160
Answer: C — ₹140
Working. Step 1: EPS = ₹10. Step 2: Dividend payout ratio = 20%. Step 3: Dividend per share D = ₹10 × 20% = ₹2. Step 4: Retained earnings per share = E - D = ₹10 - ₹2 = ₹8. Step 5: r/Ke = 15%/10% = 1.5. Step 6: Walter's Model: P = [D + (r/Ke) × (E - D)]/Ke. Step 7: P = [2 + 1.5 × 8]/0.10 = [2 + 12]/0.10 = ₹14/0.10 = ₹140 per share.
Explanation. The correct option is (c), ₹140 per share. Walter's Model uses the relationship between dividend per share, retained earnings, internal rate of return and cost of equity. Growth Division G has r greater than Ke, so the return earned on retained earnings exceeds the shareholders' required return. Under its existing 20 percent payout, the dividend is ₹2 and retained earnings per share are ₹8. Substitution into Walter's formula gives ₹140. Option (a) ₹100 assumes a 100 percent payout of earnings, which is not the existing policy and ignores the contribution of retained earnings. Option (b) ₹110 uses retained earnings of ₹6 instead of the correct ₹8, thereby understating the reinvested earnings contribution. Option (d) ₹160 uses a dividend of ₹4 and retained earnings of ₹6, effectively applying a 40 percent payout rather than the stated 20 percent.
Where it goes wrong. Students often confuse the dividend payout ratio with the retention ratio. The retention ratio must be calculated as 1 minus payout ratio. Another trap is incorrectly dividing by the internal rate of return instead of the cost of equity in Walter's formula.
Question 5 · 2 marks · Dividend Decisions - Walter's Model · hard
For Declining Division D, calculate the market value per share under its existing 75 percent payout policy and identify the theoretically optimal payout ratio under Walter's Model.
₹91.67 per share and 100 percent payout (correct answer)
₹100 per share and 75 percent payout
₹91.67 per share and zero percent payout
₹100 per share and 100 percent payout
Answer: A — ₹91.67 per share and 100 percent payout
Working. Step 1: EPS = ₹12. Step 2: Existing dividend payout = 75%. Step 3: D = ₹12 × 75% = ₹9. Step 4: Retained earnings per share = ₹12 - ₹9 = ₹3. Step 5: r/Ke = 8%/12% = 0.6667. Step 6: Walter's Model: P = [D + (r/Ke) × (E - D)]/Ke. Step 7: P = [9 + 0.6667 × 3]/0.12 = [9 + 2]/0.12 = 11/0.12 = ₹91.67 approximately. Step 8: Since r = 8% < Ke = 12%, optimal payout ratio = 100 percent.
Explanation. The correct option is (a). Declining Division D earns 8 percent on retained earnings, whereas its cost of equity is 12 percent. Since r is less than Ke, retention earns less than the shareholders' required return. Under Walter's Model, the theoretically optimal dividend payout ratio for a declining company is 100 percent. Under the existing 75 percent payout, dividend per share is ₹9 and retained earnings are ₹3. The calculated market price is approximately ₹91.67. Option (b) incorrectly reports ₹100, which is the price under a 100 percent payout, while also incorrectly treating the existing 75 percent payout as optimal. Option (c) applies the zero payout rule applicable to a growth company, not a declining company. Option (d) identifies the correct optimal payout but gives the full-payout share value instead of the value under the existing 75 percent policy.
Where it goes wrong. The main conceptual trap is applying the growth-company payout recommendation to a declining company. When r is below Ke, retention destroys value relative to distributing the earnings to shareholders. Students must also distinguish the current market price under the existing payout from the price under the theoretically optimal payout.
Question 6 · 2 marks · Dividend Decisions - Walter's Model · medium
Normal Division N earns an internal rate of return exactly equal to its cost of equity. Using Walter's Model, determine the share price under its existing dividend policy and the theoretical dividend payout implication.
₹83.33 per share and only a 100 percent payout is optimal
₹100 per share and every payout ratio is optimal
₹75 per share and only a zero percent payout is optimal
₹83.33 per share and every payout ratio is optimal (correct answer)
Answer: D — ₹83.33 per share and every payout ratio is optimal
Working. Step 1: EPS = ₹10. Step 2: Payout ratio = 40%. Step 3: D = ₹10 × 40% = ₹4. Step 4: Retained earnings = ₹10 - ₹4 = ₹6. Step 5: r/Ke = 12%/12% = 1. Step 6: Walter's Model: P = [4 + 1 × 6]/0.12 = ₹10/0.12 = ₹83.33 approximately. Step 7: Since r = Ke, every payout ratio produces the same theoretical value per share.
Explanation. The correct option is (d). Here r equals Ke at 12 percent. Under Walter's Model, the return on retained earnings is exactly equal to the shareholders' required return. Consequently, changing the dividend payout ratio does not change the theoretical market value per share. Under the existing 40 percent payout, dividend per share is ₹4 and retained earnings are ₹6. Substitution gives a market value of ₹83.33 per share. Option (a) calculates the share price correctly but incorrectly states that only a 100 percent payout is optimal. Option (b) correctly identifies that payout is irrelevant but calculates the share price incorrectly as ₹100. Option (c) incorrectly assumes that a zero payout is optimal and also uses an incorrect valuation.
Where it goes wrong. Students frequently confuse a normal company with a growth or declining company. Where r = Ke, there is no preference for either retention or distribution under Walter's theoretical framework; every payout ratio is equally acceptable.
Question 7 · 2 marks · Dividend Decisions - Gordon's Model · hard
Scenario. Prism Technologies Ltd. is examining dividend valuation under Gordon's Model and the dividend irrelevance proposition under the Modigliani-Miller hypothesis. For the Gordon's Model calculation, the company expects next year's earnings per share of ₹12, maintains a retention ratio of 60 percent, earns an internal rate of return of 15 percent on retained earnings and has a cost of equity of 12 percent. For the MM illustration, MM Ltd. has 50,000 existing equity shares, a current market price of ₹90 per share and expected annual earnings of ₹4,00,000. The company requires ₹6,75,000 for a new investment and proposes to distribute a dividend of ₹4 per existing equity share. Its cost of equity is 10 percent. Assume perfect capital markets and the other assumptions of the MM hypothesis. The company cannot use debt financing and will issue new equity shares at the calculated end-of-period market price to meet any funding shortfall after retained earnings.
Using Gordon's dividend valuation model, calculate the current value per equity share of Prism Technologies Ltd. Assume next year's EPS is ₹12 and the stated retention and return assumptions remain constant.
Explanation. The correct option is (b), ₹160. Gordon's Model values the share using the next expected dividend divided by the difference between the cost of equity and the constant growth rate. The growth rate is obtained from the retention ratio multiplied by the rate of return on retained earnings. With a retention ratio of 60 percent and return of 15 percent, growth is 9 percent. The payout ratio is 40 percent, giving a next-year dividend of ₹4.80. Dividing ₹4.80 by the 3 percent difference between Ke and g produces ₹160. Option (a) ₹80 treats the 40 percent payout ratio as the retention ratio when calculating growth, resulting in an incorrect growth rate of 6 percent. Option (c) ₹100 incorrectly uses the cost of equity instead of the internal rate of return to calculate growth. Option (d) ₹120 incorrectly uses a growth rate of 8 percent instead of the correct 9 percent.
Where it goes wrong. The major trap is using the payout ratio instead of the retention ratio in calculating growth. Another error is using the cost of equity in the growth formula. Gordon's growth rate is g = b × r, and its valuation denominator is Ke - g.
Question 8 · 1 marks · Dividend Decisions - MM Dividend Irrelevance Theory · medium
Under the MM dividend irrelevance approach, determine the number of additional equity shares MM Ltd. must issue to meet its investment requirement after using retained earnings. The end-of-period share price is calculated as ₹95.
Explanation. The correct option is (c), 5,000 additional shares. The company distributes ₹2,00,000 as dividend and retains the remaining ₹2,00,000 out of its annual earnings. Therefore, ₹4,75,000 of additional funds are required. At an issue price of ₹95 per share, 5,000 shares must be issued. This is consistent with the MM financing expression for external equity issuance when retained earnings are insufficient for the planned investment. Option (a) divides ₹4,75,000 by the original ₹100 assumed issue price rather than the calculated end-of-period price of ₹95. Option (b) divides the entire investment requirement by ₹95 without first deducting available retained earnings. Option (d) incorrectly subtracts the entire annual earnings of ₹4,00,000 from the investment requirement, ignoring the dividend already distributed.
Where it goes wrong. The principal trap is failing to deduct retained earnings after the proposed dividend. Students may also incorrectly use the beginning market price instead of the end-of-period market price for determining the number of shares issued.
