MB0045

Question no 1:
Theories of capitalization:
There are two theories of capitalization viz.
1. Cost theory
2. Earnings theory
Cost theory: under this theory the total amount of capitalization of a new company is the sum
of:
Cost of fixed assets
Cost of establishing the business
Amount of working capital required
Merits Demerits
1. It helps promoters to estimate the
amount of capital required for
incorporation of company, conducting
market surveys, preparing detailed
project report, procuring funds,
procuring assets both fixed and current,
running a trial production and
successfully producing, positioning and
marketing its products or rendering of
services.
1. If the firm establishes its production
facilities at inflated prices, the
productivity of the firm will become less
than that of the industry.
2. If done systematically it will lay the
foundation for successful initiation of
the working of the firm
2. Net worth of a company is decided by
the investors and earnings of a
company. Earning capacity on based
net worth helps a firm to arrive at the
total capital in terms of the industry-
specific yardstick (operating capital
based on benchmarks in that industry).
Cost theory fails in this respect.

Earnings theory: earnings are forecasted and capitalized at a rate of return, which actually is
the representative of the industry. Earnings theory involves two steps:
1. Estimation of average annual future earnings
2. Estimation of the normal earning rate of the industry to which the company belongs to
Merits Demerits
1. Earnings theory is superior to cost
theory because of its lesser chances of
being either over or under
capitalization.
1. The major challenge that a new firm
faces in deciding on capitalization and
its division thereof into various
procurement sources.
2. Comparison of earnings approach to
that of cost approach will make the
management to be cautious in
negotiating the technology and the cost
of procuring and establishing the new
business.
2. Arriving at the capitalization rate is
equally a formidable task because the
investors perception of established
companies cannot be really unique of
what the investors perceive from the
earning power of the new company

Due to these shortcomings, most of the new companies are forced to adopt the cost theory of
capitalization.









Question no.2:
A) Solution:
Purchase price: Rs. 500/-
D1: Rs.25/-
Price gain: Rs.50/- i.e. (550-500)
Holding period return = (D1 + Price gain/ loss) / purchase price
= (25 + 50)/ 500
= 15%
The return at the end of the year will be 15%.

B) Solution:
P = Int*PVIFA (15%, 3y) + Redemption value* PVIF (15%, 3y)
P = 150*2.283 + 1000*0.0658
P= 342.45 + 658
P= 1000.45
The market price of bond is Rs. 1000/-
Question no.3:
b. factors affecting capital structure:
The initial capital structure should be designed very carefully. The management of the
company should set a target capital structure and the subsequent financing decisions should
be made with a view to achieve the target capital structure.
The major factor affecting the capita; structure is leverage. There is also a few other factors
affecting them.
1. Leverage: the use of sources of funds that have a fixed cost attached to them such as
preference shares, loans from banks and financial institutions and debentures in the
capital structure is known as trading on equity for financial leverage.
2. Cost of capital: high cost funds should be avoided. However attractive an investment
proposition may look like the profits earned may be eaten away by interest repayment.
3. Cash flow projections of the company: decisions should be taken in the light of cash flow
projected for the next 3 -5 years. The company official should not get carried away at
the immediate results expected.
4. Dilution of control: the top management should have the flexibility to take appropriate
decisions at the right time. Fear of having to share control and thus being interfered by
others often delays the decision of the closely held companies to go public.
5. Floatation cost: these are incurred when the funds are raised. Generally the cost of
floating a debt is less than the cost of floating an equity issue. Effectively the amount of
money raised by any issue will be lower than the amount expected because of the
presence of the floatation cost.






Question no.4:
Solution:
Year Uncertain cash inflows CE Certain Cash
Flows
PV factor at
10%
PV of certain
cash inflows
1 32000 0.9 28800 0.909 26179
2 27000 0.6 16200 0.826 13381
3 20000 0.5 10000 0.751 7510
4 100001 0.3 3000 0.683 2049
PV of
certain
cash
inflows
49119
Initial (50000)
Cash
Layout
NPV (881)
The project has negative NPV, therefore it is rejected.
If the internal rate of return (IRR) is used, the rate of discount at which NPV is equal to zero is
computed and then compared with the minimum (required) risk free rate. If IRR is greater
than the specified minimum risk free rate, the project is accepted otherwise rejected.








Question no.5:
A. Determining EOQ:
K = Rs. 20
K
C
= Rs. 10
D = 30,000
Formula: Q
x
=

Q
x
=

= 346 units.
B. Total number of orders in a year
D = 30,000
EOQ = 346
Total number of orders in a year= Demand/ EOQ
=

=87 0rders.

C. Time gap between two orders
= 365/ total no of orders in a year
=365/ 87
=4 days.