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CAIIB-Financial Management- MODULE B STUDY OF FINANCIAL STATEMENTS M Syed Kunmir email – [email protected] “Financial management involves the application of general management principles to particular financial operation”. - Howard and Upton . Attending to investment decisions

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CAIIB-Financial Management- MODULE BSTUDY OF FINANCIAL STATEMENTSM Syed Kunmiremail – [email protected]


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“Financial management involves the application of general management principles to particular financial operation”.

- Howard and Upton


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Attending to investment decisions management principles to particular financial operation”.

- as to when and

- how to acquire and allocate funds

- for short-term and long-term assets keeping

- in view the profit generation of the business

- through which repayment obligation can be met.


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Objectives and basic consideration of management principles to particular financial operation”.

Financial management.

  • Though profit maximisation is the objective of financial management

  • The long-term goal of the business entity is to achieve maximising the shareholder value of the firm

  • Because the “principle of maximisation of shareholder wealth provides a rational guide for running a business and for efficient allocation of resources in society”.


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Maximisation of the value of the company is also known as maximisation of the wealth of the owners.


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To achieve maximisation of value of the company, finance manager has to take careful decisions in respect of

-Financing

-Investment

-Dividend

-Current asset management.


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  • Financing decision- manager has to take careful decisions in respect of

  • Has to decide on sources of funds for business.

  • It is to be decided whether entire capital should be raised from equity capital or a part is to be raised from loan.

  • Hence Debt/Equity ratio or Leverage are important since each source has in them associated risk factors involved.


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  • Investment decision manager has to take careful decisions in respect of

  • It relates to acquisition of assets.

  • Assets are classified into

    • real assets such as

      - land

      - building

      - plant

      - equipment etc.

      and

      - the financial assets are

      - shares and

      - debentures etc.

  • It indicates available mix of financing to fund company’s activities.

  • Such decisions on investment in projects come within the field of capital budgeting which is derived from net present value of assets.


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  • Dividend decision- manager has to take careful decisions in respect of

    - It is basically a financing decision.

    - This is because profit is a source of fund.

    - By not paying dividend, the “retained earnings”or ‘reserve’ can be increased which could be otherwise available for investment.

  • This ultimately lead to maximisation of wealth of the organisation provided decisions on investments are correct.


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  • Current Asset Management- manager has to take careful decisions in respect of

  • This is necessary to maintain balance between current assets and current liability,

  • The liquidity of the business is interrupted because of holding too much fund in current assets.


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Wealth maximisation &value maximisation manager has to take careful decisions in respect of

  • The goal of financial management is to maximise the value of companies.

  • This is generally expressed in terms of maximising the value of the ownership shares of the company

  • In short,maximising share price.

  • Thus,better performing companies can raise additional funds under more favourable terms.

  • This basic objective of maximising the price of the company’s shares is called ‘value maximisation’.


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  • Social responsibility is also an important goal of manager has to take careful decisions in respect of

    a company which requires

    -Maximising share-price by efficient,well-

    managed operations related to consumer

    demand parameters.

    -Efficiency & innovation leads to value

    maximisation which leads to new

    products,new technologies and better

    employment.

    -External factors like pollution,product safety and

    job safety have achieved added dimensions in

    relation to value maximisation.


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Profit maximisation manager has to take careful decisions in respect ofvs.Wealth maximisation

  • Long run vs.Short run Profits.

  • Convert total corporate profits to earning per share(EPS).

  • EPS is total profits divided by number of shares outstanding.

  • Assume the firm earns Rs.10 mn.and has 1mn.shares outstanding.The EPS will work out to Rs.10.

  • Profit maximisation is a short-term concept,

  • while wealth maximisation emphasises the long-term view point.


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State whether true or false manager has to take careful decisions in respect of

  • The income statement depicts the financial position of the firm at a given point of time

  • The balance sheet gives the financial performance of the firm over a given period of time.

  • These statements are prepared every week.

  • Funds Flow statement gives the liquidity position of the firm.


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  • Cash Flow statement tells from where the money comes and where it is used.

  • The prime objective of financial management is wealth maximisation,and not profit maximisation.

  • What is earnings per share?

    a)Net Profit

    b)Profit before interest and tax

    c)Total earnings divided by investment

    d)Net profit divided by equity


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CAPITAL EXPENDITURE DECISIONS AND PROFITABILITY STUDY term funds?

  • It represents the important decisions taken by the firm.

  • Importance due to the following issues

    -Long-term effects

    -Irreversibility

    -Substantial outlays


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Difficulties term funds?

-Measurement problems

-Uncertainty

-Temporal spread


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Phases of capital budgeting term funds?

-Capital budgeting is a complex process which

may be divided into five broad phases.

1) Planning

2) Analysis

3) Selection

4) Implementation

5) Review.


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  • Levels of Decision Making term funds?

    -Operating decisions

    -Administrative decisions

    -Strategic decisions

  • Profitability Study important facets are

    -Market analysis

    -Technical analysis

    -Financial analysis

    -Economic analysis

    -Ecological analysis


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The basic characteristic of a capital project is that it typically involves

- A current outlay(or current and future outlays)of funds

- In expectation of a stream of benefits

- Extending far into future.


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Accounting rate of return method typically involves

- A selection criterion using average net income and investment outlay to compute a rate of return for a project.

- This method ignores the time value of money & cash flows.


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Net Present Value method typically involves

- A selection method using the difference between the present value of the cash inflows of the project and the investment outlay.

- The method evaluates the differential cash flow between proposals.


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Internal rate of return method typically involves

A selection method using the compounding rate of return on the cash flow of the project.


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Payback method typically involves

- A selection method in which a firm sets a maximum payback period during which cash inflow must be sufficient to recover the initial outlay.

- This method ignores the time value of money and cash flow beyond the pay back period.


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  • What are the three important factors which arise from capital expenditure decisions?

    a)Long-term effects e)Debt

    b)Profitability f)Substantial outlays

    c)Irreversibility g)Short-term effects.

    d)Risk

  • Why are capital expenditure decisions difficult?

    i)Uncertainity in predicting costs&benefits

    ii)Difficulty in measurement of costs&benefits

    iii)Risk involved

    iv)Problems in estimating discount rates

    v)All the above


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Sources of finance and (11.4% should we reject or accept the project). Yes/No. cost of capital

For what purposes a firm needs a finance?

- Since the cash receipts lag behind cash

payments necessitating

- loans,bonds,overdrafts etc.

- the firm needs finance for short term and long term requirements-

- fixed assets and working capital.

Permanent sources of finance Share capital and retained profits.


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Study of financial statements (11.4% should we reject or accept the project). Yes/No.

  • Who are the party interested in firm’s financial condition?

    - Shareholders

    - Creditors/suppliers

    - Financiers

    - Employees

    - Tax authorities.


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Long term sources (11.4% should we reject or accept the project). Yes/No.

- Preference shares

- Bonds

- Debentures

and

- Long term loans from financial institutions..


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Various sources of short term finance- (11.4% should we reject or accept the project). Yes/No.

- Cash credit

- Overdraft

- Billsdiscounting

- Commercial papers and

- Trade credit.


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Short term & long term cash forecasts (11.4% should we reject or accept the project). Yes/No.

Time periods involved -

- Yearly for long term forecasts

- Monthly for short term forecasts.


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Factors considered in equity financing (11.4% should we reject or accept the project). Yes/No.

- Issue costs

- servicing costs such as paying out

dividends

- when there is retained earnings

there will be capital appreciation of sharevalues.


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Preference Shares (11.4% should we reject or accept the project). Yes/No.

- These shareholders get a fixed return and their risk is less than the equity Shareholders.

- They have a right to the first slice

of dividend.

- Obligation to redeem the preference

shares after its time period.

- They do not have a right to vote.


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Debentures or loan financing (11.4% should we reject or accept the project). Yes/No.

- the firm will have to pay fixed interest every year.

- There is an obligation to redeem it at the end of the period.

- There is also an advantage of tax deductibility of interest paid which makes it cheaper.


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Bills rediscounting (11.4% should we reject or accept the project). Yes/No.

- The buyer can repay in a long period of time

- while seller gets his money back by discounting the bills.

- For the seller, this helps him to go ahead with production and increase the turnover.


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Working capital term loan (11.4% should we reject or accept the project). Yes/No.

  • A part of working capital has to be with the manufacturer since there is a time lag between ordering and procuring.

  • This particular portion (say25%)can be financed by long term funds.

  • When firm is not able to infuse its own funds for this purpose,it gets a long term loan from the bank.

  • This carries fixed interest and for a fixed period.


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Overdraft and bank loan- (11.4% should we reject or accept the project). Yes/No.

- Overdraft is a running account

- whereas bank loan instalment are fixed.


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Trade credit (11.4% should we reject or accept the project). Yes/No.

- When materials are bought from suppliers,the trade credit is extended for few days or a couple of months.

- The supplier is willing to wait to collect money.

- This also depends on the suppliers’ financial position and

- The buyers credit worthiness.


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Commercial paper (11.4% should we reject or accept the project). Yes/No.

- These are short term promissory notes with fixed maturity period.

- They are issued by very large companies

- Who are reputed and

- Have high credit worthiness.

- Credit rating agencies certify their credit rating.


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  • Firms’cost of capital-A firm’s is the average cost of capital is the weighted average arithmetic mean of the cost of resources from various sources.

    Questions:

    a)Long term sources are banks and financial

    institutions (T/F)

    b)Current liabilities should be repaid within a

    financial year(T/F)

    c)Fixed assets are generally financed with

    current liabilities(T/F)


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  • Equity Shareholders bear the greatest risk(T/F) capital is the weighted average arithmetic mean of the cost of resources from various sources.

  • Bills discounting scheme has been introduced to ease flow of funds in the economy(T/F)

  • Trade creditors are suppliers of goods and services to whom the firm is yet to pay.(T/F)

  • Accounts Receivables should be less than trade creditors(T/F).

  • Bills of Exchange is same as cash credit(T/F).

  • Equity and Preference shares are one and the same(T/F)

  • A part of working capital can be financed by long term sources(T/F)


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  • A firm borrows Rs.20,000 from bank @8% and floats a debenture for Rs.60,000 @6%,for a special project,what is the cost of capital of the project?

    a)5.5% b)6.5% c)7.5% d)8.5%

  • If a firm borrows Rs.2 lac @10% and has a tax rate of 40%.What is the cost of capital?

    a)5% b)6% c)7% d)8%


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Data for analyzing the situations of the firm debenture for Rs.60,000 @6%,for a special project,what is the cost of capital of the project?

Balance Sheet

Income Statement

Fund flow statement


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Basic concepts while preparing balance sheet debenture for Rs.60,000 @6%,for a special project,what is the cost of capital of the project?

- Entity concept

- Money measurement concept

- Going concern concept

- Cost concept

- Consevatism concept

- Dual aspect concept

- Accounting period concept

- Accrual concept

- Realisation concept

- Matching concept


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What is revenue reserve & capital reserve? debenture for Rs.60,000 @6%,for a special project,what is the cost of capital of the project?

  • Revenue reserves are accumulated earnings from profits and normal business operations.

  • Capital reserves arise due to capital gains from revaluation of assets or due to premium on issue of shares.


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Elements of financial statements debenture for Rs.60,000 @6%,for a special project,what is the cost of capital of the project?

Main financial statements:

  • Balance Sheet

  • Income statement

  • Statement of Sources of funds and Uses of funds


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Typical Limited debenture for Rs.60,000 @6%,for a special project,what is the cost of capital of the project?

Balance Sheet

as at 30 June 2002

2002

2001

Rm

Rm

ASSETS

Non-Current Assets

Property, plant & equipment

1,227

1,137

Current Assets

Inventories

65

60

Receivables

122

108

Cash assets

21

15

Total Current Assets

208

183

Total Assets

1,435

1,320

EQUITY AND LIABILITIES

Equity

Share Capital (500m shares of R1 each)

500

500

Retained earnings

415

340

Total Equity

915

840

Non-current Liabilities

Long-term borrowings

400

380

Total non-current liabilities

400

380

Current Liabilities

Trade and other payables

98

88

Short-term borrowings

22

12

Total current liabilities

120

100

Total Equity and Liabilities

1,435

1,320

Balance Sheet


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Typical Limited debenture for Rs.60,000 @6%,for a special project,what is the cost of capital of the project?

Income Statement

For the year ended 30 June 2002

2002

2001

Rm

Rm

Sales revenue

3,573

2,320

Cost of Sales

2,036

1,206

Gross Profit

1,537

1,114

Distribution, selling and marketing expenses

679

394

Administration and general expenses

322

186

Other expenses

254

116

Profit (earnings) before interest and tax expense

282

418

Finance costs

100

80

Profit before tax

182

338

Income tax expense

54

101

Profit for the period

128

237

Earnings per share

0.256

0.474

Statement of changes in equity

for the year ended 30 June 2002

Balance at 30 June 2001

340

202

Profit for the period

128

237

468

439

Dividends

-53

-99

Balance at 30 June 2002

415

340

Income Statement


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Sources and Uses of Funds debenture for Rs.60,000 @6%,for a special project,what is the cost of capital of the project?


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  • Accounts payable-These are current liabilities payable within one year from date of balance sheet.

  • Fund Flow Statement-It shows the sources and uses of funds during a given accounting period.

  • Horizontal analysis and Vertical analysis-

    Horizontal analysis is comparing the operations over a time period ie.comparing past performance with current position for predicting the future performance.


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In vertical analysis we use percentages to show within one year from date of balance sheet.

the relationship between various items in the

balance sheet.

a)X contributes Rs.10,000 to his properietory concern and the amount is deposited in the bank.What is the nature of liability?

i)Owner’s equity

ii)Loan

iii)Short term finance

iv)Fixed Asset.


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  • Provisions for taxes and accrued expenses to be paid within a year are current assets(T/F)

  • Debtors(also known as accounts receivable)represent the amount of money to be paid by the firm to the suppliers(T/F)

  • Fund Flow statements can be prepared without the basis of balance sheets(T/F).

  • Fund flow statements represent only bank borrowing and trade credit(T/F)


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  • State whether following are sources or uses a year are current assets(T/F)

    -Buying materials

    -Payment of dividend to shareholders

    -Advance received from buyer of goods

    -Investment in machinery

    -Issue of debentures

    -Retained earnings

    -Increase in Inventories

    -Sale of old machinery


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Tools of Analysis a year are current assets(T/F)

Horizontal Analysis

Comparing a company’s financial condition and performance across time

Time


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Horizontal Analysis a year are current assets(T/F)

Now, let’s look at some ways to use horizontal analysis.

Time

The term horizontal analysis arises from left-to-right (or right-to-left) movement of our eyes as we review comparative financial statements across time.


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Since we are measuring the amount of the change between 2003 and 2004, the dollar amounts for 2003 become the “base”period amounts.

Comparative Statements

Calculate Change in Dollar Amount

Dollar

Change

Analysis Period

Amount

Base Period

Amount

=


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Comparative Statements and 2004, the dollar amounts for

Calculate Change as a Percent

Percent

Change

Dollar Change

Base Period Amount

×

100%

=


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$12,000 – $23,500 = $(11,500) and 2004, the dollar amounts for

($11,500 ÷ $23,500) × 100% = 48.9%


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Now, let’s review the dollar and percent changes for the liabilities and shareholders’ equity accounts.


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Now, let’s look at trend analysis! liabilities and shareholders’ equity accounts.


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Trend liabilities and shareholders’ equity accounts.

Percent

Analysis Period Amount

Base Period Amount

×

100%

=

Trend Analysis

Also called trend percent analysis or index number trend analysis.

Trend analysisis used to reveal patterns in data covering successive periods.


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Trend Analysis liabilities and shareholders’ equity accounts.

Berry Products

Income Information

For the Years Ended 31 December

2000 is the base period so its amounts will equal 100%.


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Trend Analysis liabilities and shareholders’ equity accounts.

Berry Products

Income Information

For the Years Ended 31 December


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Trend Analysis liabilities and shareholders’ equity accounts.

Berry Products

Income Information

For the Years Ended 31 December

How would this trend analysis look on a line graph?


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We can use the trend percentages to construct a graph so we can see the trend over time.

Trend Analysis


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V can see the trend over time.

e

r

t

i

c

a

l

A

n

a

l

y

s

i

s

Vertical Analysis

Vertical Analysis is also called as common-size analysis

The term vertical analysis arises from the up-down (down-up) movement of our eyes as we review common-size financial statements.


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Financial Statement Base Amount can see the trend over time.

Balance Sheet Total Assets

Income Statement Revenues

Common-Size Statements

Calculate Common-size Percent

Common-size

Percent

Analysis Amount

Base Amount

×

=

100%


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($12,000 ÷ $315,000) × 100% = 3.8% can see the trend over time.

($23,500 ÷ $289,700) × 100% = 8.1%


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ABC co.paid Rs.30,000 as deposit to the suppliers for a period of 3 months.

i)Liability

ii)Current Asset

iii)Trade Credit

iv)Debenture

Materials costing Rs.2000 destroyed by fire

i) Reduction in Asset

ii)Reduction in liability


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Profit maximization is a period of 3 months.

  • Short term concept

  • long term concept

  • both

  • none of the above


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Wealth maximization is a period of 3 months.

  • Short term concept

  • long term concept

  • either a or b

  • both a& b.


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Criterion for payback period period of 3 months.

  • Accept PBP>target period

  • Accept PBP<target period

  • Accept PBP=target period

  • d) none of the above


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Criterion for accounting rate of return period of 3 months.

  • Accept ARR>target rate

  • Accept ARR< target rate

  • Accept ARR=target rate.

  • none of the above


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Criterion for Net Present Value period of 3 months.

a)Accept NPV>0

b) Accept NPV<0

c) Accept NPV=0

d) none of the above


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Criterion for IRR(Internal Rate of Return) period of 3 months.

  • Accept IRR>Cost of capital

  • Accept IRR <Cost of capital

  • Accept IRR= Cost of capital

  • none of the above


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Criterion for benefit cost ratio period of 3 months.

  • Accept BCR >1

  • Accept BCR<1

  • Accept BCR=1

  • none of the above


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Common size statements are period of 3 months.

  • Financial Statements that depict financial data in the form of verticlepercentages

  • Financial Statements that depict financial data in the form of horizontal percentages

  • Both a & b

  • none of the above.


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Horizontal Analysis is period of 3 months.

a)Changes in financial statements

b) percentage analysis of increase & decrease in corresponding items in comparative financial statements.

c) Financial statements which depict financial data.

d)none of the above.


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Fund Flow is period of 3 months.

a) Sources & Uses statement

b) Sources Statement

c) Uses Statement

d) none of the above.


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Economic Income is defined as period of 3 months.

a) Change in wealth

b) Change in income

c) Change in profit

d) none of the above


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THANK YOU period of 3 months.

Email – [email protected]


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