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Chapter 7
TIME VALUE OF MONEY

1. Value five years hence of a deposit of Rs.1,000 at various interest rates is as follows:

r = 8% FV
5
= Rs.1469

r = 10% FV
5
= Rs.1611

r = 12% FV
5
= Rs.1762

r = 15% FV
5
= Rs.2011

2. 30 years

3. In 12 years Rs.1000 grows to Rs.8000 or 8 times. This is 2
3
times the initial deposit. Hence
doubling takes place in 12 / 3 = 4 years.

According to the Rule of 69, the doubling period is:

0.35 + 69 / Interest rate

Equating this to 4 and solving for interest rate, we get

Interest rate = 18.9%.

4. Saving Rs.2000 a year for 5 years and Rs.3000 a year for 10 years thereafter is equivalent to
saving Rs.2000 a year for 15 years and Rs.1000 a year for the years 6 through 15.
Hence the savings will cumulate to:
2000 x FVIFA (10%, 15 years) + 1000 x FVIFA (10%, 10 years)
= 2000 x 31.772 + 1000 x 15.937 = Rs.79481.

5. Let A be the annual savings.

A x FVIFA (12%, 10 years) = 1,000,000
A x 17.549 = 1,000,000

So, A = 1,000,000 / 17.549 = Rs.56,983.

6. 1,000 x FVIFA (r, 6 years) = 10,000

FVIFA (r, 6 years) = 10,000 / 1000 = 10
2

From the tables we find that
FVIFA (20%, 6 years) = 9.930
FVIFA (24%, 6 years) = 10.980

Using linear interpolation in the interval, we get:

20% + (10.000 – 9.930)
r = x 4% = 20.3%
(10.980 – 9.930)

7. 1,000 x FVIF (r, 10 years) = 5,000
FVIF (r,10 years) = 5,000 / 1000 = 5

From the tables we find that

FVIF (16%, 10 years) = 4.411
FVIF (18%, 10 years) = 5.234

Using linear interpolation in the interval, we get:

(5.000 – 4.411) x 2%
r = 16% + = 17.4%
(5.234 – 4.411)

8. The present value of Rs.10,000 receivable after 8 years for various discount rates (r ) are:
r = 10% PV = 10,000 x PVIF(r = 10%, 8 years)
= 10,000 x 0.467 = Rs.4,670

r = 12% PV = 10,000 x PVIF (r = 12%, 8 years)
= 10,000 x 0.404 = Rs.4,040

r = 15% PV = 10,000 x PVIF (r = 15%, 8 years)
= 10,000 x 0.327 = Rs.3,270

9. Assuming that it is an ordinary annuity, the present value is:
2,000 x PVIFA (10%, 5years)
= 2,000 x 3.791 = Rs.7,582

10. The present value of an annual pension of Rs.10,000 for 15 years when r = 15% is:
10,000 x PVIFA (15%, 15 years)
= 10,000 x 5.847 = Rs.58,470

3

The alternative is to receive a lumpsum of Rs.50,000.

Obviously, Mr. Jingo will be better off with the annual pension amount of Rs.10,000.

11. The amount that can be withdrawn annually is:
100,000 100,000
A = ------------------ ------------ = ----------- = Rs.10,608
PVIFA (10%, 30 years) 9.427

12. The present value of the income stream is:
1,000 x PVIF (12%, 1 year) + 2,500 x PVIF (12%, 2 years)
+ 5,000 x PVIFA (12%, 8 years) x PVIF(12%, 2 years)

= 1,000 x 0.893 + 2,500 x 0.797 + 5,000 x 4.968 x 0.797 = Rs.22,683.

13. The present value of the income stream is:
2,000 x PVIFA (10%, 5 years) + 3000/0.10 x PVIF (10%, 5 years)
= 2,000 x 3.791 + 3000/0.10 x 0.621
= Rs.26,212

14. To earn an annual income of Rs.5,000 beginning from the end of 15 years from now, if the
deposit earns 10% per year a sum of
Rs.5,000 / 0.10 = Rs.50,000
is required at the end of 14 years. The amount that must be deposited to get this sum is:
Rs.50,000 / PVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,165

15. Rs.20,000 =- Rs.4,000 x PVIFA (r, 10 years)
PVIFA (r,10 years) = Rs.20,000 / Rs.4,000 = 5.00

From the tables we find that:
PVIFA (15%, 10 years) = 5.019
PVIFA (18%, 10 years) = 4.494

Using linear interpolation we get:
5.019 – 5.00
r = 15% + ---------------- x 3%
5.019 – 4.494

= 15.1%

16. PV (Stream A) = Rs.100 x PVIF (12%, 1 year) + Rs.200 x
PVIF (12%, 2 years) + Rs.300 x PVIF(12%, 3 years) + Rs.400 x
4

PVIF (12%, 4 years) + Rs.500 x PVIF (12%, 5 years) +
Rs.600 x PVIF (12%, 6 years) + Rs.700 x PVIF (12%, 7 years) +
Rs.800 x PVIF (12%, 8 years) + Rs.900 x PVIF (12%, 9 years) +
Rs.1,000 x PVIF (12%, 10 years)

= Rs.100 x 0.893 + Rs.200 x 0.797 + Rs.300 x 0.712
+ Rs.400 x 0.636 + Rs.500 x 0.567 + Rs.600 x 0.507
+ Rs.700 x 0.452 + Rs.800 x 0.404 + Rs.900 x 0.361
+ Rs.1,000 x 0.322

= Rs.2590.9

Similarly,
PV (Stream B) = Rs.3,625.2
PV (Stream C) = Rs.2,851.1

17. FV
5
= Rs.10,000 [1 + (0.16 / 4)]
5x4

= Rs.10,000 (1.04)
20

= Rs.10,000 x 2.191
= Rs.21,910

18. FV
5
= Rs.5,000 [1+( 0.12/4)]
5x4

= Rs.5,000 (1.03)
20

= Rs.5,000 x 1.806
= Rs.9,030

19 A B C

Stated rate (%) 12 24 24

Frequency of compounding 6 times 4 times 12 times

Effective rate (%) (1 + 0.12/6)
6
- 1 (1+0.24/4)
4
–1 (1 + 0.24/12)
12
-1

= 12.6 = 26.2 = 26.8

Difference between the
effective rate and stated
rate (%) 0.6 2.2 2.8

20. Investment required at the end of 8
th
year to yield an income of Rs.12,000 per year from the
end of 9
th
year (beginning of 10
th
year) for ever:

Rs.12,000 x PVIFA(12%, ∞ )
5

= Rs.12,000 / 0.12 = Rs.100,000

To have a sum of Rs.100,000 at the end of 8
th
year , the amount to be deposited now is:
Rs.100,000 Rs.100,000
= = Rs.40,388
PVIF(12%, 8 years) 2.476

21. The interest rate implicit in the offer of Rs.20,000 after 10 years in lieu of Rs.5,000 now is:
Rs.5,000 x FVIF (r,10 years) = Rs.20,000

Rs.20,000
FVIF (r,10 years) = = 4.000
Rs.5,000

From the tables we find that
FVIF (15%, 10 years) = 4.046

This means that the implied interest rate is nearly 15%.
I would choose Rs.20,000 for 10 years from now because I find a return of 15% quite
acceptable.

22. FV
10
= Rs.10,000 [1 + (0.10 / 2)]
10x2

= Rs.10,000 (1.05)
20

= Rs.10,000 x 2.653
= Rs.26,530

If the inflation rate is 8% per year, the value of Rs.26,530 10 years from now, in terms of
the current rupees is:
Rs.26,530 x PVIF (8%,10 years)
= Rs.26,530 x 0.463 = Rs.12,283

23. A constant deposit at the beginning of each year represents an annuity due.
PVIFA of an annuity due is equal to : PVIFA of an ordinary annuity x (1 + r)
To provide a sum of Rs.50,000 at the end of 10 years the annual deposit should
be

Rs.50,000
A = FVIFA(12%, 10 years) x (1.12)

Rs.50,000
= = Rs.2544
17.549 x 1.12

6

24. The discounted value of Rs.20,000 receivable at the beginning of each year from 2005 to
2009, evaluated as at the beginning of 2004 (or end of 2003) is:
Rs.20,000 x PVIFA (12%, 5 years)
= Rs.20,000 x 3.605 = Rs.72,100.

The discounted value of Rs.72,100 evaluated at the end of 2000 is
Rs.72,100 x PVIF (12%, 3 years)
= Rs.72,100 x 0.712 = Rs.51,335

If A is the amount deposited at the end of each year from 1995 to 2000 then
A x FVIFA (12%, 6 years) = Rs.51,335
A x 8.115 = Rs.51,335
A = Rs.51,335 / 8.115 = Rs.6326

25. The discounted value of the annuity of Rs.2000 receivable for 30 years, evaluated as at the
end of 9
th
year is:
Rs.2,000 x PVIFA (10%, 30 years) = Rs.2,000 x 9.427 = Rs.18,854
The present value of Rs.18,854 is:
Rs.18,854 x PVIF (10%, 9 years)
= Rs.18,854 x 0.424
= Rs.7,994
26. 30 per cent of the pension amount is
0.30 x Rs.600 = Rs.180
Assuming that the monthly interest rate corresponding to an annual interest rate of 12% is
1%, the discounted value of an annuity of Rs.180 receivable at the end of each month for 180
months (15 years) is:
Rs.180 x PVIFA (1%, 180)

(1.01)
180
- 1
Rs.180 x ---------------- = Rs.14,998
.01 (1.01)
180

If Mr. Ramesh borrows Rs.P today on which the monthly interest rate is 1%

P x (1.01)
60
= Rs.14,998
P x 1.817 = Rs.14,998
Rs.14,998
P = ------------ = Rs.8254
1.817

27. Rs.300 x PVIFA(r, 24 months) = Rs.6,000
PVIFA (4%,24) = Rs.6000 / Rs.300 = 20

From the tables we find that:
PVIFA(1%,24) = 21.244
7

PVIFA (2%, 24) = 18.914

Using a linear interpolation
21.244 – 20.000
r = 1% + ---------------------- x 1%
21.244 – 18,914

= 1.53%

Thus, the bank charges an interest rate of 1.53% per month.
The corresponding effective rate of interest per annum is
[ (1.0153)
12
– 1 ] x 100 = 20%

28. The discounted value of the debentures to be redeemed between 8 to 10 years evaluated at
the end of the 5
th
year is:
Rs.10 million x PVIF (8%, 3 years)
+ Rs.10 million x PVIF (8%, 4 years)
+ Rs.10 million x PVIF (8%, 5 years)

= Rs.10 million (0.794 + 0.735 + 0.681)
= Rs.2.21 million

If A is the annual deposit to be made in the sinking fund for the years 1 to 5,
then
A x FVIFA (8%, 5 years) = Rs.2.21 million
A x 5.867 = Rs.2.21 million
A = 5.867 = Rs.2.21 million
A = Rs.2.21 million / 5.867 = Rs.0.377 million

29. Let `n’ be the number of years for which a sum of Rs.20,000 can be withdrawn annually.

Rs.20,000 x PVIFA (10%, n) = Rs.100,000
PVIFA (15%, n) = Rs.100,000 / Rs.20,000 = 5.000

From the tables we find that
PVIFA (10%, 7 years) = 4.868
PVIFA (10%, 8 years) = 5.335

Thus n is between 7 and 8. Using a linear interpolation we get

5.000 – 4.868
n = 7 + ----------------- x 1 = 7.3 years
5.335 – 4.868

8

30. Equated annual installment = 500000 / PVIFA(14%,4)
= 500000 / 2.914
= Rs.171,585

Loan Amortisation Schedule

Beginning Annual Principal Remaining
Year amount installment Interest repaid balance
------ ------------- --------------- ----------- ------------- -------------
1 500000 171585 70000 101585 398415
2 398415 171585 55778 115807 282608
3 282608 171585 39565 132020 150588
4 150588 171585 21082 150503 85*

(*) rounding off error

31. Define n as the maturity period of the loan. The value of n can be obtained from the
equation.

200,000 x PVIFA(13%, n) = 1,500,000
PVIFA (13%, n) = 7.500

From the tables or otherwise it can be verified that PVIFA(13,30) = 7.500
Hence the maturity period of the loan is 30 years.

32. Expected value of iron ore mined during year 1 = Rs.300 million

Expected present value of the iron ore that can be mined over the next 15 years assuming a
price escalation of 6% per annum in the price per tonne of iron

1 – (1 + g)
n
/ (1 + i)
n

= Rs.300 million x ------------------------
i - g

= Rs.300 million x 1 – (1.06)
15
/ (1.16)
15

0.16 – 0.06

= Rs.300 million x (0.74135 / 0.10)
= Rs.2224 million
9

MINICASE

Solution:

1. How much money would Ramesh need 15 years from now?

500,000 x PVIFA (10%, 15years)
+ 1,000,000 x PVIF (10%, 15years)
= 500,000 x 7.606 + 1,000,000 x 0.239
= 3,803,000 x 239,000
= Rs.4,042,000

2. How much money should Ramesh save each year for the next 15 years to be able to meet his
investment objective?

Ramesh’s current capital of Rs.600,000 will grow to :

600,000 (1.10)
15
= 600,000 x 4.177 = Rs 2,506,200

This means that his savings in the next 15 years must grow to :

4,042,000 – 2,506,200 = Rs 1,535,800

So, the annual savings must be :
1,535,800 1,535,800
= = Rs.48,338
FVIFA (10%, 15 years) 31.772

3. How much money would Ramesh need when he reaches the age of 60 to meet his donation
objective?

200,000 x PVIFA (10% , 3yrs) x PVIF (10%, 11yrs)

= 200,000 x 2.487 x 0.317 = 157,676

4. What is the present value of Ramesh’s life time earnings?

400,000 400,000(1.12) 400,000(1.12)
14

46
1 2 15

10

1.12
15

1 –
1.08
= 400,000
0.08 – 0.12

= Rs.7,254,962

11

Chapter 8

VALUATION OF BONDS AND STOCKS

1. 5 11 100
P = ¿ +
t=1 (1.15) (1.15)
5

= Rs.11 x PVIFA(15%, 5 years) + Rs.100 x PVIF (15%, 5 years)
= Rs.11 x 3.352 + Rs.100 x 0.497
= Rs.86.7

2.(i) When the discount rate is 14%
7 12 100
P = ¿ +
t=1 (1.14)
t
(1.14)
7

= Rs.12 x PVIFA (14%, 7 years) + Rs.100 x PVIF (14%, 7 years)
= Rs.12 x 4.288 + Rs.100 x 0.4
= Rs.91.46

(ii) When the discount rate is 12%
7 12 100
P = ¿ + = Rs.100
t=1 (1.12)
t
(1.12)
7

Note that when the discount rate and the coupon rate are the same the value is equal to
par value.

3. The yield to maturity is the value of r that satisfies the following equality.
7 120 1,000
Rs.750 = ¿ + = Rs.100
t=1 (1+r)
t
(1+r)
7

Try r = 18%. The right hand side (RHS) of the above equation is:
Rs.120 x PVIFA (18%, 7 years) + Rs.1,000 x PVIF (18%, 7 years)
= Rs.120 x 3.812 + Rs.1,000 x 0.314
= Rs.771.44

Try r = 20%. The right hand side (RHS) of the above equation is:
Rs.120 x PVIFA (20%, 7 years) + Rs.1,000 x PVIF (20%, 7 years)
= Rs.120 x 3.605 + Rs.1,000 x 0.279
= Rs.711.60
Thus the value of r at which the RHS becomes equal to Rs.750 lies between 18% and 20%.
12

Using linear interpolation in this range, we get

771.44 – 750.00
Yield to maturity = 18% + 771.44 – 711.60 x 2%

= 18.7%
4.
10 14 100
80 = ¿ +
t=1 (1+r)
t
(1+r)
10

Try r = 18%. The RHS of the above equation is

Rs.14 x PVIFA (18%, 10 years) + Rs.100 x PVIF (18%, 10 years)
= Rs.14 x 4.494 + Rs.100 x 0.191 = Rs.82

Try r = 20%. The RHS of the above equation is
Rs.14 x PVIFA(20%, 10 years) + Rs.100 x PVIF (20%, 10 years)
= Rs.14 x 4.193 + Rs.100 x 0.162
= Rs.74.9

Using interpolation in the range 18% and 20% we get:

82 - 80
Yield to maturity = 18% + ----------- x 2%
82 – 74.9

= 18.56%

5.
12 6 100
P = ¿ +
t=1 (1.08)
t
(1.08)
12

= Rs.6 x PVIFA (8%, 12 years) + Rs.100 x PVIF (8%, 12 years)
= Rs.6 x 7.536 + Rs.100 x 0.397
= Rs.84.92

6. The post-tax interest and maturity value are calculated below:

Bond A Bond B
13

* Post-tax interest (C ) 12(1 – 0.3) 10 (1 – 0.3)
=Rs.8.4 =Rs.7

* Post-tax maturity value (M) 100 - 100 -
[ (100-70)x 0.1] [ (100 – 60)x 0.1]
=Rs.97 =Rs.96

The post-tax YTM, using the approximate YTM formula is calculated below

8.4 + (97-70)/10
Bond A : Post-tax YTM = --------------------
0.6 x 70 + 0.4 x 97

= 13.73%

7 + (96 – 60)/6
Bond B : Post-tax YTM = ----------------------
0.6x 60 + 0.4 x 96

= 17. 47%

7.
14 6 100
P = ¿ +
t=1 (1.08)
t
(1.08)
14

= Rs.6 x PVIFA(8%, 14) + Rs.100 x PVIF (8%, 14)
= Rs.6 x 8.244 + Rs.100 x 0.341
= Rs.83.56

8. D
o
= Rs.2.00, g = 0.06, r = 0.12

P
o
= D
1
/ (r – g) = D
o
(1 + g) / (r – g)

= Rs.2.00 (1.06) / (0.12 - 0.06)
= Rs.35.33

Since the growth rate of 6% applies to dividends as well as market price, the market
price at the end of the 2
nd
year will be:

P
2
= P
o
x (1 + g)
2
= Rs.35.33 (1.06)
2

= Rs.39.70

14

9. P
o
= D
1
/ (r – g) = D
o
(1 + g) / (r – g)
= Rs.12.00 (1.10) / (0.15 – 0.10) = Rs.264

10. P
o
= D
1
/ (r – g)

Rs.32 = Rs.2 / 0.12 – g
g = 0.0575 or 5.75%

11. P
o
= D
1
/ (r – g) = D
o
(1+g) / (r – g)
D
o
= Rs.1.50, g = -0.04, P
o
= Rs.8
So
8 = 1.50 (1- .04) / (r-(-.04)) = 1.44 / (r + .04)

Hence r = 0.14 or 14 per cent

12. The market price per share of Commonwealth Corporation will be the sum of three
components:

A: Present value of the dividend stream for the first 4 years
B: Present value of the dividend stream for the next 4 years
C: Present value of the market price expected at the end of 8 years.

A = 1.50 (1.12) / (1.14) + 1.50 (1.12)
2
/ (1.14)
2
+ 1.50(1.12)
3
/ (1.14)
3
+
+ 1.50 (1.12)
4
/ (1.14)
4

= 1.68/(1.14) + 1.88 / (1.14)
2
+ 2.11 / (1.14)
3
+ 2.36 / (1.14)
4

= Rs.5.74

B = 2.36(1.08) / (1.14)
5
+ 2.36 (1.08)
2
/ (1.14)
6
+ 2.36 (1.08)
3
/ (1.14)
7
+
+ 2.36 (1.08)
4
/ (1.14)
8

= 2.55 / (1.14)
5
+ 2.75 / (1.14)
6
+ 2.97 / (1.14)
7
+ 3.21 / (1.14)
8
= Rs.4.89

C = P
8
/ (1.14)
8

P
8
= D
9
/ (r – g) = 3.21 (1.05)/ (0.14 – 0.05) = Rs.37.45
So

C = Rs.37.45 / (1.14)
8
= Rs.13.14

Thus,
P
o
= A + B + C = 5.74 + 4.89 + 13.14
= Rs.23.77
15

13. The intrinsic value of the equity share will be the sum of three components:

A: Present value of the dividend stream for the first 5 years when the
growth rate expected is 15%.

B: Present value of the dividend stream for the next 5 years when the
growth rate is expected to be 10%.

C: Present value of the market price expected at the end of 10 years.

2.00 (1.15) 2.00 (1.15)
2
2.00 (1.15)
3
2.00(1.15)
4
2.00 (1.15)
5

A =

------------- + ------------- +-------------- + ------------- + -------------
(1.12) (1.12)
2
(1.1.2)
3
(1.1.2)
4
(1.12)
5

= 2.30 / (1.12) + 2.65 / (1.12)
2
+ 3.04 / (1.12)
3
+ 3.50 / (1.12)
4
+ 4.02/(1.12)
5

= Rs.10.84

4.02(1.10) 4.02 (1.10)
2
4.02(1.10)
3
4.02(1.10)
4
4.02 (1.10)
5
B = ------------ + ---------------- + ------------- + --------------- + ---------------
(1.12)
6
(1.12)
7
(1.12)
8
(1..12)
9
(1.12)
10

4.42 4.86 5.35 5.89 6.48
= --------- + -------------- + --------------- + ------------- + -------------
(1.12)
6
(1.12)
7
(1.12)
8
(1.1.2)
9
(1.12)
10

= Rs.10.81

D
11
1 6.48 (1.05)

C = -------- x --------------- = ------------------- x 1/(1.12)
10
r – g (1 +r)
10
0.12 – 0.05

= Rs.97.20

The intrinsic value of the share = A + B + C
= 10.84 + 10.81 + 97.20 = Rs.118.85

14. Terminal value of the interest proceeds
= 140 x FVIFA (16%,4)
= 140 x 5.066
= 709.24

Redemption value = 1,000

16

Terminal value of the proceeds from the bond = 1709.24

Define r as the yield to maturity. The value of r can be obtained from the equation

900 (1 + r)
4
= 1709.24
r = 0.1739 or 17.39%

15. Intrinsic value of the equity share (using the 2-stage growth model)

(1.18)
6

2.36 x 1 - ----------- 2.36 x (1.18)
5
x (1.12)
(1.16)
6

= --------------------------------- + -----------------------------------
0.16 – 0.18 (0.16 – 0.12) x (1.16)
6

- 0.10801
= 2.36 x ----------- + 62.05
- 0.02

= Rs.74.80

16. Intrinsic value of the equity share (using the H model)

4.00 (1.20) 4.00 x 4 x (0.10)
= -------------- + ---------------------
0.18 – 0.10 0.18 – 0.10

= 60 + 20
= Rs.80
17

Chapter 9
RISK AND RETURN

1 (a) Expected price per share a year hence will be:

= 0.4 x Rs.10 + 0.4 x Rs.11 + 0.2 x Rs.12 = Rs.10.80

(b) Probability distribution of the rate of return is

Rate of return (R
i
) 10% 20% 30%

Probability (p
i
) 0.4 0.4 0.2

Note that the rate of return is defined as:

Dividend + Terminal price
-------------------------------- - 1
Initial price

(c ) The standard deviation of rate of return is : σ = ¿p
i
(R
i
– R)
2

The σ of the rate of return on MVM’s stock is calculated below:
---------------------------------------------------------------------------------------------------
R
i
p
i
p
I
r
i
(R
i
-R) (R
i
- R)
2
p
i
(R
i
-R)
2
---------------------------------------------------------------------------------------------------
10 0.4 4 -8 64 25.6
20 0.4 8 2 4 1.6
30 0.2 6 12 144 28.8
---------------------------------------------------------------------------------------------------
R = ¿ p
i
R
i
¿ p
i
(R
i
-R)
2

= 56
σ = \56 = 7.48%

2 (a) For Rs.1,000, 20 shares of Alpha’s stock can be acquired. The probability distribution of the
return on 20 shares is

Economic Condition Return (Rs) Probability
High Growth 20 x 55 = 1,100 0.3
Low Growth 20 x 50 = 1,000 0.3
Stagnation 20 x 60 = 1,200 0.2
Recession 20 x 70 = 1,400 0.2

Expected return = (1,100 x 0.3) + (1,000 x 0.3) + (1,200 x 0.2) + (1,400 x 0.2)

18

= 330 + 300 + 240 + 280
= Rs.1,150

Standard deviation of the return = [(1,100 – 1,150)
2
x 0.3 + (1,000 – 1,150)
2
x

0.3 + (1,200 – 1,150)
2
x 0.2 + (1,400 – 1,150)
2
x 0.2]
1/2
= Rs.143.18

(b) For Rs.1,000, 20 shares of Beta’s stock can be acquired. The probability distribution of the
return on 20 shares is:

Economic condition Return (Rs) Probability

High growth 20 x 75 = 1,500 0.3
Low growth 20 x 65 = 1,300 0.3
Stagnation 20 x 50 = 1,000 0.2
Recession 20 x 40 = 800 0.2

Expected return = (1,500 x 0.3) + (1,300 x 0.3) + (1,000 x 0.2) + (800 x 0.2)
= Rs.1,200

Standard deviation of the return = [(1,500 – 1,200)
2
x .3 + (1,300 – 1,200)
2
x .3
+ (1,000 – 1,200)
2
x .2 + (800 – 1,200)
2
x .2]
1/2
= Rs.264.58

(c ) For Rs.500, 10 shares of Alpha’s stock can be acquired; likewise for Rs.500, 10
shares of Beta’s stock can be acquired. The probability distribution of this option is:
Return (Rs) Probability
(10 x 55) + (10 x 75) = 1,300 0.3
(10 x 50) + (10 x 65) = 1,150 0.3
(10 x 60) + (10 x 50) = 1,100 0.2
(10 x 70) + (10 x 40) = 1,100 0.2

Expected return = (1,300 x 0.3) + (1,150 x 0.3) + (1,100 x 0.2) +
(1,100 x 0.2)
= Rs.1,175
Standard deviation = [(1,300 –1,175)
2
x 0.3 + (1,150 – 1,175)
2
x 0.3 +

(1,100 – 1,175)
2
x 0.2 + (1,100 – 1,175)
2
x 0.2 ]
1/2

= Rs.84.41
d. For Rs.700, 14 shares of Alpha’s stock can be acquired; likewise for Rs.300, 6
shares of Beta’s stock can be acquired. The probability distribution of this
option is:

19

Return (Rs) Probability

(14 x 55) + (6 x 75) = 1,220 0.3
(14 x 50) + (6 x 65) = 1,090 0.3
(14 x 60) + (6 x 50) = 1,140 0.2
(14 x 70) + (6 x 40) = 1,220 0.2

Expected return = (1,220 x 0.3) + (1,090 x 0.3) + (1,140 x 0.2) + (1,220 x 0.2)
= Rs.1,165

Standard deviation = [(1,220 – 1,165)
2
x 0.3 + (1,090 – 1,165)
2
x 0.3 +
(1,140 – 1,165)
2
x 0.2 + (1,220 – 1,165)
2
x 0.2]
1/2

= Rs.57.66

The expected return to standard deviation of various options are as follows :

Option
Expected return
(Rs)
Standard deviation
(Rs)
Expected / Standard
return deviation
a 1,150 143 8.04
b 1,200 265 4.53
c 1,175 84 13.99
d 1,165 58 20.09

Option `d’ is the most preferred option because it has the highest return to risk ratio.

3. Expected rates of returns on equity stock A, B, C and D can be computed as follows:

A: 0.10 + 0.12 + (-0.08) + 0.15 + (-0.02) + 0.20 = 0.0783 = 7.83%
6

B: 0.08 + 0.04 + 0.15 +.12 + 0.10 + 0.06 = 0.0917 = 9.17%
6

C: 0.07 + 0.08 + 0.12 + 0.09 + 0.06 + 0.12 = 0.0900 = 9.00%
6

D: 0.09 + 0.09 + 0.11 + 0.04 + 0.08 + 0.16 = 0.095 = 9.50%
6

(a) Return on portfolio consisting of stock A = 7.83%

(b) Return on portfolio consisting of stock A and B in equal
proportions = 0.5 (0.0783) + 0.5 (0.0917)
= 0.085 = 8.5%

20

(c ) Return on portfolio consisting of stocks A, B and C in equal
proportions = 1/3(0.0783 ) + 1/3(0.0917) + 1/3 (0.090)
= 0.0867 = 8.67%

(d) Return on portfolio consisting of stocks A, B, C and D in equal
proportions = 0.25(0.0783) + 0.25(0.0917) + 0.25(0.0900) +
0.25(0.095)
= 0.08875 = 8.88%

4. Define R
A
and R
M
as the returns on the equity stock of Auto Electricals Limited a and Market
portfolio respectively. The calculations relevant for calculating the beta of the stock are
shown below:

Year R
A
R
M
R
A
-R
A
R
M
-R
M
(R
A
-R
A
) (R
M
-R
M
) R
A
-R
A
/R
M
-R
M

1 15 12 -0.09 -3.18 0.01 10.11 0.29
2 -6 1 -21.09 -14.18 444.79 201.07 299.06
3 18 14 2.91 -1.18 8.47 1.39 -3.43
4 30 24 14.91 8.82 222.31 77.79 131.51
5 12 16 0-3.09 0.82 9.55 0.67 -2.53
6 25 30 9.91 14.82 98.21 219.63 146.87
7 2 -3 -13.09 -18.18 171.35 330.51 237.98
8 20 24 4.91 8.82 24.11 77.79 43.31
9 18 15 2.91 -0.18 8.47 0.03 -0.52
10 24 22 8.91 6.82 79.39 46.51 60.77
11 8. 12 -7.09 -3.18 50.27 10.11 22.55

R
A
= 15.09 R
M
= 15.18

¿ (R
A
– R
A
)
2
= 1116.93 ¿ (R
M
– R
M
)
2
= 975.61 ¿ (R
A
– R
A
) (R
M
– R
M
) = 935.86

Beta of the equity stock of Auto Electricals
¿ (R
A
– R
A
) (R
M
– R
M
)

¿ (R
M
– R
M
)
2

= 935.86 = 0.96
975.61

Alpha = R
A
– β
A
R
M

= 15.09 – (0.96 x 15.18) = 0.52

21

Equation of the characteristic line is

R
A
= 0.52 + 0.96 R
M

5. The required rate of return on stock A is:

R
A
= R
F
+ β
A
(R
M
– R
F
)
= 0.10 + 1.5 (0.15 – 0.10)
= 0.175

Intrinsic value of share = D
1
/ (r- g) = D
o
(1+g) / ( r – g)

Given D
o
= Rs.2.00, g = 0.08, r = 0.175
2.00 (1.08)
Intrinsic value per share of stock A =
0.175 – 0.08

= Rs.22.74

6. The SML equation is R
A
= R
F
+ β
A
(R
M
– R
F
)

Given R
A
= 15%. R
F
= 8%, R
M
= 12%, we have

0.15 = .08 + β
A
(0.12 – 0.08)

0.07
i.e.β
A
= = 1.75
0.04

Beta of stock A = 1.75

7. The SML equation is: R
X
= R
F
+ β
X
(R
M
– R
F
)

We are given 0.15 = 0.09 + 1.5 (R
M
– 0.09) i.e., 1.5 R
M
= 0.195
or R
M
= 0.13%

Therefore return on market portfolio = 13%

8. R
M
= 12% β
X
= 2.0 R
X
=18% g = 5% P
o
= Rs.30

P
o
= D
1
/ (r - g)

Rs.30 = D
1
/ (0.18 - .05)

22

So D
1
= Rs.39 and D
o
= D
1
/ (1+g) = 3.9 /(1.05) = Rs.3.71

R
x
= R
f
+ β
x
(R
M
– R
f
)

0.18 = R
f
+ 2.0 (0.12 – R
f
)

So R
f
= 0.06 or 6%.

Original Revised

R
f
6% 8%
R
M
– R
f
6% 4%
g 5% 4%
β
x
2.0 1.8

Revised R
x
= 8% + 1.8 (4%) = 15.2%

Price per share of stock X, given the above changes is

3.71 (1.04)
= Rs.34.45
0.152 – 0.04

Chapter 10
OPTIONS AND THEIR VALUATION

1. S = 100 u = 1.5 d = 0.8
23

E = 105 r = 0.12 R = 1.12

The values of ∆ (hedge ratio) and B (amount borrowed) can be obtained as follows:

C
u
– C
d
∆ =
(u – d) S

C
u
= Max (150 – 105, 0) = 45

C
d
= Max (80 – 105, 0) = 0

45 – 0 45 9
∆ = = = = 0.6429
0.7 x 100 70 14

u.C
d
– d.C
u
B =
(u-d) R

(1.5 x 0) – (0.8 x 45)
=
0.7 x 1.12

-36
= = - 45.92
0.784

C = ∆ S + B
= 0.6429 x 100 – 45.92
= Rs.18.37

Value of the call option = Rs.18.37

2. S = 40 u = ? d = 0.8
R = 1.10 E = 45 C = 8

We will assume that the current market price of the call is equal to the pair value of the call
as per the Binomial model.

Given the above data

C
d
= Max (32 – 45, 0) = 0
24

∆ Cu – Cd R
= x
B u C
d
– d C
u
S

∆ C
u
– 0 1.10
= x
B -0.8C
u
40

= (-) 0.034375

∆ = - 0.34375 B (1)
C = ∆ S + B
8 = ∆ x 40 + B (2)

Substituting (1) in (2) we get

8 = (-0.034365 x 40) B + B
8 = -0.375 B
or B = - 21.33

∆ = - 0.034375 (-21.33) = 0.7332

The portfolio consists of 0.7332 of a share plus a borrowing of Rs.21.33 (entailing a
repayment of Rs.21.33 (1.10) = Rs.23.46 after one year). It follows that when u occurs either u x 40
x 0.7332 – 23.46 = u x 40 – 45
-10.672 u = -21.54
u = 2.02

or

u x 40 x 0.7332 – 23.46 = 0
u = 0.8

Since u > d, it follows that u = 2.02.
Put differently the stock price is expected to rise by 1.02 x 100 = 102%.

3. Using the standard notations of the Black-Scholes model we get the following results:
l
n
(S/E) + r
t
+ σ
2
t/2
d
1
=
o \ t
25

= l
n
(120 / 110) + 0.14 + 0.4
2
/2
0.4

= 0.08701 + 0.14 + 0.08
0.4

= 0.7675

d
2
= d
1
- o \ t
= 0.7675 – 0.4
= 0.3675

N(d
1
) = N (0.7675) ~ N (0.77) = 0.80785
N (d
2
) = N (0.3675) ~ N (0.37) = 0.64431

C = So N(d
1
) – E. e
-rt
. N(d
2
)
= 120 x 0.80785 – 110 x e
-0.14
x 0.64431
= (120 x 0.80785) – (110 x 0.86936 x 0.64431)
= 35.33

Value of the call as per the Black and Scholes model is Rs.35.33.

4. o \t = 0.2 x \ 1 = 0.2

Ratio of the stock price to the present value of the exercise price
80
= -------------------------
82 x PVIF (15.03,1)

80
= ----------------------
82 x 0.8693
= 1.122

From table A6 we find the percentage relationship between the value of the call option and
stock price to be 14.1 per cent. Hence the value of the call option is
0.141 x 80 = Rs.11,28.

5. Value of put option
= Value of the call option
+ Present value of the exercise price
- Stock price ……… (A)

26

The value of the call option gives an exercise price of Rs.85 can be obtained as follows:

o \t = 0.2 \ 1 = 0.2

Ratio of the stock price to the present value of the exercise price

80
= ---------------------
85 x PVIF (15.03,1)

= 80 / 73.89 = 1.083

From Table A.6, we find the percentage relationship between the value of the call option and
the stock price to be 11.9%

Hence the value of the call option = 0.119 x 80 = Rs.9.52

Plugging in this value and the other relevant values in (A), we get

Value of put option = 9.52 + 85 x (1.1503)
-1
– 80

= Rs.3.41

6. S
o
= V
o
N(d
1
) – B
1
e
–rt
N (d
2
)

= 6000 N (d
1
) – 5000 e
– 0.1
N(d
2
)

l
n
(6000 / 5000) + (0.1 x 1) + (0.18/2)
d
1
= ----------------------------------------------
\ 0.18 x \ 1

l
n
(1.2) + 0.19
=
0.4243

= 0.8775 = 0.88

N(d
1
) = N (0.88) = 0.81057
d
2
= d
1
- t
= 0.8775 - 0.18
= 0.4532 = 0.45

27

N (d
2
) = N (0.45) = 0.67364
So = 6000 x 0.81057 – (5000 x 0.9048 x 0.67364)
= 1816

B
0
= V
0
– S
0

= 60000 – 1816
= 4184

Chapter 11
TECHNIQUES OF CAPITAL BUDGETING

1.(a) NPV of the project at a discount rate of 14%.

= - 1,000,000 + 100,000 + 200,000
---------- ------------
(1.14) (1.14)
2

+ 300,000 + 600,000 + 300,000
----------- ---------- ----------
(1.14)
3
(1.14)
4
(1.14)
5
28

= - 44837

(b) NPV of the project at time varying discount rates

= - 1,000,000

+ 100,000

(1.12)

+ 200,000

(1.12) (1.13)

+ 300,000

(1.12) (1.13) (1.14)

+ 600,000

(1.12) (1.13) (1.14) (1.15)

+ 300,000

(1.12) (1.13) (1.14)(1.15)(1.16)

= - 1,000,000 + 89286 + 158028 + 207931 + 361620 + 155871
= - 27264

2. Investment A

a) Payback period = 5 years
b) NPV = 40000 x PVIFA (12,10) – 200 000
= 26000
c) IRR (r ) can be obtained by solving the equation:
40000 x PVIFA (r, 10) = 200000
i.e., PVIFA (r, 10) = 5.000

From the PVIFA tables we find that
PVIFA (15,10) = 5.019
PVIFA (16,10) = 4.883
29

Linear interporation in this range yields
r = 15 + 1 x (0.019 / 0.136)
= 15.14%

d) BCR = Benefit Cost Ratio
= PVB / I
= 226,000 / 200,000 = 1.13
Investment B

a) Payback period = 9 years

b) NP V = 40,000 x PVIFA (12,5)
+ 30,000 x PVIFA (12,2) x PVIF (12,5)
+ 20,000 x PVIFA (12,3) x PVIF (12,7)
- 300,000

= (40,000 x 3.605) + (30,000 x 1.690 x 0.567)
+ (20,000 x 2.402 x 0.452) – 300,000
= - 105339

c) IRR (r ) can be obtained by solving the equation
40,000 x PVIFA (r, 5) + 30,000 x PVIFA (r, 2) x PVIF (r,5) +
20,000 x PVIFA (r, 3) x PVIF (r, 7) = 300,000

Through the process of trial and error we find that
r = 1.37%

d) BCR = PVB / I
= 194,661 / 300,000 = 0.65

Investment C

a) Payback period lies between 2 years and 3 years. Linear interpolation in this
range provides an approximate payback period of 2.88 years.

b) NPV = 80.000 x PVIF (12,1) + 60,000 x PVIF (12,2)
+ 80,000 x PVIF (12,3) + 60,000 x PVIF (12,4)

+ 80,000 x PVIF (12,5) + 60,000 x PVIF (12,6)
+ 40,000 x PVIFA (12,4) x PVIF (12.6)
- 210,000
= 111,371
30

c) IRR (r) is obtained by solving the equation
80,000 x PVIF (r,1) + 60,000 x PVIF (r,2) + 80,000 x PVIF (r,3)
+ 60,000 x PVIF (r,4) + 80,000 x PVIF (r,5) + 60,000 x PVIF (r,6)
+ 40000 x PVIFA (r,4) x PVIF (r,6) = 210000

Through the process of trial and error we get
r = 29.29%

d) BCR = PVB / I = 321,371 / 210,000 = 1.53

Investment D

a) Payback period lies between 8 years and 9 years. A linear interpolation in this
range provides an approximate payback period of 8.5 years.

8 + (1 x 100,000 / 200,000)

b) NPV = 200,000 x PVIF (12,1)
+ 20,000 x PVIF (12,2) + 200,000 x PVIF (12,9)
+ 50,000 x PVIF (12,10)
- 320,000
= - 37,160

c) IRR (r ) can be obtained by solving the equation
200,000 x PVIF (r,1) + 200,000 x PVIF (r,2)
+ 200,000 x PVIF (r,9) + 50,000 x PVIF (r,10)
= 320000

Through the process of trial and error we get r = 8.45%

d) BCR = PVB / I = 282,840 / 320,000 = 0.88

Comparative Table

Investment A B C D

a) Payback period
(in years) 5 9 2.88 8.5

b) NPV @ 12% pa 26000 -105339 111371 -37160

c) IRR (%) 15.14 1.37 29.29 8.45

d) BCR 1.13 0.65 1.53 0.88
31

Among the four alternative investments, the investment to be chosen is ‘C’
because it has the Lowest payback period
Highest NPV
Highest IRR
Highest BCR
3. IRR (r) can be calculated by solving the following equations for the value of r.
60000 x PVIFA (r,7) = 300,000

i.e., PVIFA (r,7) = 5.000

Through a process of trial and error it can be verified that r = 9.20% pa.

4. The IRR (r) for the given cashflow stream can be obtained by solving the following equation
for the value of r.

-3000 + 9000 / (1+r) – 3000 / (1+r) = 0

Simplifying the above equation we get

r = 1.61, -0.61; (or) 161%, (-)61%

NOTE: Given two changes in the signs of cashflow, we get two values for the
IRR of the cashflow stream. In such cases, the IRR rule breaks down.

5. Define NCF as the minimum constant annual net cashflow that justifies the purchase of the
given equipment. The value of NCF can be obtained from the equation

NCF x PVIFA (10,8) = 500000
NCF = 500000 / 5.335
= 93271

6. Define I as the initial investment that is justified in relation to a net annual cash
inflow of 25000 for 10 years at a discount rate of 12% per annum. The value
of I can be obtained from the following equation

25000 x PVIFA (12,10) = I
i.e., I = 141256

7. PV of benefits (PVB) = 25000 x PVIF (15,1)
+ 40000 x PVIF (15,2)
+ 50000 x PVIF (15,3)
+ 40000 x PVIF (15,4)
+ 30000 x PVIF (15,5)
32

= 122646 (A)

Investment = 100,000 (B)

Benefit cost ratio = 1.23 [= (A) / (B)]

8. The NPV’s of the three projects are as follows:

Project
P Q R

Discount rate

0% 400 500 600
5% 223 251 312

10% 69 40 70
15% - 66 - 142 - 135

25% - 291 - 435 - 461
30% - 386 - 555 - 591

9. NPV profiles for Projects P and Q for selected discount rates are as follows:
(a)
Project
P Q
Discount rate (%)
0 2950 500
5 1876 208
10 1075 - 28
15 471 - 222
20 11 - 382
b) (i) The IRR (r ) of project P can be obtained by solving the following
equation for `r’.

-1000 -1200 x PVIF (r,1) – 600 x PVIF (r,2) – 250 x PVIF (r,3)
+ 2000 x PVIF (r,4) + 4000 x PVIF (r,5) = 0

Through a process of trial and error we find that r = 20.13%

(ii) The IRR (r') of project Q can be obtained by solving the following equation for r'

-1600 + 200 x PVIF (r',1) + 400 x PVIF (r',2) + 600 x PVIF (r',3)
+ 800 x PVIF (r',4) + 100 x PVIF (r',5) = 0
33

Through a process of trial and error we find that r' = 9.34%.

c) From (a) we find that at a cost of capital of 10%

NPV (P) = 1075
NPV (Q) = - 28

Given that NPV (P) . NPV (Q); and NPV (P) > 0, I would choose project P.

From (a) we find that at a cost of capital of 20%

NPV (P) = 11

NPV (Q) = - 382

Again NPV (P) > NPV (Q); and NPV (P) > 0. I would choose project P.

d) Project P

PV of investment-related costs

= 1000 x PVIF (12,0)
+ 1200 x PVIF (12,1) + 600 x PVIF (12,2)
+ 250 x PVIF (12,3)
= 2728
TV of cash inflows = 2000 x (1.12) + 4000 = 6240
The MIRR of the project P is given by the equation:
2728 = 6240 x PVIF (MIRR,5)
(1 + MIRR)
5
= 2.2874
MIRR = 18%

(c) Project Q

PV of investment-related costs = 1600

TV of cash inflows @ 15% p.a. = 2772

The MIRR of project Q is given by the equation:

16000 (1 + MIRR)
5
= 2772

MIRR = 11.62%

34

10
(a) Project A

NPV at a cost of capital of 12%
= - 100 + 25 x PVIFA (12,6)
= Rs.2.79 million

IRR (r ) can be obtained by solving the following equation for r.
25 x PVIFA (r,6) = 100
i.e., r = 12,98%

Project B

NPV at a cost of capital of 12%
= - 50 + 13 x PVIFA (12,6)
= Rs.3.45 million

IRR (r') can be obtained by solving the equation
13 x PVIFA (r',6) = 50
i.e., r' = 14.40% [determined through a process of trial and error]

(b) Difference in capital outlays between projects A and B is Rs.50 million
Difference in net annual cash flow between projects A and B is Rs.12 million.
NPV of the differential project at 12%
= -50 + 12 x PVIFA (12,6)
= Rs.3.15 million

IRR (r'') of the differential project can be obtained from the equation
12 x PVIFA (r'', 6) = 50
i.e., r'' = 11.53%

11
(a) Project M
The pay back period of the project lies between 2 and 3 years. Interpolating in
this range we get an approximate pay back period of 2.63 years/

Project N
The pay back period lies between 1 and 2 years. Interpolating in this range we
get an approximate pay back period of 1.55 years.

(b) Project M
35

Cost of capital = 12% p.a
PV of cash flows up to the end of year 2 = 24.97
PV of cash flows up to the end of year 3 = 47.75
PV of cash flows up to the end of year 4 = 71.26

Discounted pay back period (DPB) lies between 3 and 4 years. Interpolating in this range we
get an approximate DPB of 3.1 years.

Project N
Cost of capital = 12% per annum
PV of cash flows up to the end of year 1 = 33.93
PV of cash flows up to the end of year 2 = 51.47

DPB lies between 1 and 2 years. Interpolating in this range we get an approximate
DPB of 1.92 years.

(c ) Project M
Cost of capital = 12% per annum
NPV = - 50 + 11 x PVIFA (12,1)
+ 19 x PVIF (12,2) + 32 x PVIF (12,3)
+ 37 x PVIF (12,4)
= Rs.21.26 million

Project N
Cost of capital = 12% per annum
NPV = Rs.20.63 million
Since the two projects are independent and the NPV of each project is (+) ve,
both the projects can be accepted. This assumes that there is no capital constraint.
(d) Project M
Cost of capital = 10% per annum
NPV = Rs.25.02 million

Project N
Cost of capital = 10% per annum
NPV = Rs.23.08 million

Since the two projects are mutually exclusive, we need to choose the project with the higher
NPV i.e., choose project M.
NOTE: The MIRR can also be used as a criterion of merit for choosing between the two
projects because their initial outlays are equal.
(e) Project M
Cost of capital = 15% per annum
NPV = 16.13 million

36

Project N
Cost of capital: 15% per annum
NPV = Rs.17.23 million
Again the two projects are mutually exclusive. So we choose the project with the
higher NPV, i.e., choose project N.

(f) Project M
Terminal value of the cash inflows: 114.47
MIRR of the project is given by the equation
50 (1 + MIRR)
4
= 114.47
i.e., MIRR = 23.01%

Project N
Terminal value of the cash inflows: 115.41
MIRR of the project is given by the equation
50 ( 1+ MIRR)
4
= 115.41
i.e., MIRR = 23.26%

37

Chapter 12
ESTIMATION OF PROJECT CASH FLOWS
1.
(a) Project Cash Flows (Rs. in million)

Year 0 1 2 3 4 5 6 7

1. Plant & machinery (150)

2. Working capital (50)

3. Revenues 250 250 250 250 250 250 250

4. Costs (excluding de-
preciation & interest) 100 100 100 100 100 100 100

5. Depreciation 37.5 28.13 21.09 15.82 11.87 8.90 6.67

6. Profit before tax 112.5 121.87 128.91 134.18 138.13 141.1143.33

7. Tax 33.75 36.56 38.67 40.25 41.44 42.33 43.0

8. Profit after tax 78.75 85.31 90.24 93.93 96.69 98.77100.33

9. Net salvage value of
plant & machinery 48

10. Recovery of working 50
capital

11. Initial outlay (=1+2) (200)

12. Operating CF (= 8 + 5) 116.25 113.44 111.33 109.75 108.56 107.6 107.00

13. Terminal CF ( = 9 +10) 98

14. N C F (200) 116.25 113.44 111.33 109.75 108.56 107.67 205

(c) IRR (r) of the project can be obtained by solving the following equation for r
-200 + 116.25 x PVIF (r,1) + 113.44 x PVIF (r,2)

+ 111.33 x PVIF (r,3) + 109.75 x PVIF (r,4) + 108.56 x PVIF (r,5)
+107.67 x PVIF (r,6) + 205 x PVIF (r,7) = 0

38

Through a process of trial and error, we get r = 55.17%. The IRR of the project is 55.17%.

2. Post-tax Incremental Cash Flows (Rs. in million)

Year 0 1 2 3 4 5 6 7

1. Capital equipment (120)
2. Level of working capital 20 30 40 50 40 30 20
(ending)
3. Revenues 80 120 160 200 160 120 80
4. Raw material cost 24 36 48 60 48 36 24
5. Variable mfg cost. 8 12 16 20 16 12 8
6. Fixed operating & maint. 10 10 10 10 10 10 10
cost
7. Variable selling expenses 8 12 16 20 16 12 8
8. Incremental overheads 4 6 8 10 8 6 4
9. Loss of contribution 10 10 10 10 10 10 10
11. Depreciation 30 22.5 16.88 12.66 9.49 7.12 5.34
12. Profit before tax -14 11.5 35.12 57.34 42.51 26.88 6.66
13. Tax -4.2 3.45 10.54 17.20 12.75 8.06 2.00
14. Profit after tax -9.8 8.05 24.58 40.14 29.76 18.82 4.66
15. Net salvage value of
capital equipments 25
16. Recovery of working 16
capital
17. Initial investment (120)
18. Operating cash flow 20.2 30.55 41.46 52.80 39.25 25.94 14.00
(14 + 10+ 11)
19. A Working capital 20 10 10 10 (10) (10) (10)
20. Terminal cash flow 41

21. Net cash flow (140) 10.20 20.55 31.46 62.80 49.25 35.94 55.00
(17+18-19+20)

(b) NPV of the net cash flow stream @ 15% per discount rate

= -140 + 10.20 x PVIF(15,1) + 20.55 x PVIF (15,2)
+ 31.46 x PVIF (15,3) + 62.80 x PVIF (15,4) + 49.25 x PVIF (15,5)
+ 35.94 x PVIF (15,6) + 55 x PVIF (15,7)
= Rs.1.70 million

3.
(a) A. Initial outlay (Time 0)
39

i. Cost of new machine Rs. 3,000,000
ii. Salvage value of old machine 900,000
iii Incremental working capital requirement 500,000
iv. Total net investment (=i – ii + iii) 2,600,000

B. Operating cash flow (years 1 through 5)

Year 1 2 3 4 5

i. Post-tax savings in
manufacturing costs 455,000 455,000 455,000 455,000 455,000

ii. Incremental
depreciation 550,000 412,500 309,375 232,031 174,023

iii. Tax shield on
incremental dep. 165,000 123,750 92,813 69,609 52,207
iv. Operating cash
flow ( i + iii) 620,000 578,750 547,813 524,609 507,207

C. Terminal cash flow (year 5)

i. Salvage value of new machine Rs. 1,500,000
ii. Salvage value of old machine 200,000
iii. Recovery of incremental working capital 500,000
iv. Terminal cash flow ( i – ii + iii) 1,800,000

D. Net cash flows associated with the replacement project (in Rs)

Year 0 1 2 3 4 5

NCF (2,600,000) 620000 578750 547813 524609 2307207

(b) NPV of the replacement project
= - 2600000 + 620000 x PVIF (14,1)
+ 578750 x PVIF (14,2)
+ 547813 x PVIF (14,3)
+ 524609 x PVIF (14,4)
+ 2307207 x PVIF (14,5)
= Rs.267849

40

4. Tax shield (savings) on depreciation (in Rs)
Depreciation Tax shield PV of tax shield
Year charge (DC) =0.4 x DC @ 15% p.a.

1 25000 10000 8696

2 18750 7500 5671

3 14063 5625 3699

4 10547 4219 2412

5 7910 3164 1573
----------
22051
----------

Present value of the tax savings on account of depreciation = Rs.22051

5. A. Initial outlay (at time 0)
i. Cost of new machine Rs. 400,000
ii. Salvage value of the old machine 90,000
iii. Net investment 310,000

B. Operating cash flow (years 1 through 5)

Year 1 2 3 4 5
i. Depreciation
of old machine 18000 14400 11520 9216 7373

ii. Depreciation
of new machine 100000 75000 56250 42188 31641

iii. Incremental
depreciation
( ii – i) 82000 60600 44730 32972 24268

iv. Tax savings on
incremental
depreciation
( 0.35 x (iii)) 28700 21210 15656 11540 8494

v. Operating cash
flow 28700 21210 15656 11540 8494
41

C. Terminal cash flow (year 5)

i. Salvage value of new machine Rs. 25000
ii. Salvage value of old machine 10000
iii. Incremental salvage value of new
machine = Terminal cash flow 15000

D. Net cash flows associated with the replacement proposal.

Year 0 1 2 3 4 5

NCF (310000) 28700 21210 15656 11540 23494

MINICASE
Solution:

a. Cash flows from the point of all investors (which is also called the explicit cost funds point of
view)
Rs.in million

Item 0 1 2 3 4 5

1. Fixed assets (15)
2. Net working
capital (8)
3. Revenues 30 30 30 30 30
4. Costs (other than
depreciation and
interest) 20 20 20 20 20
5. Loss of rental 1 1 1 1 1
6. Depreciation 3.750 2.813 2.109 1.582 1.187
7. Profit before tax 5.250 6.187 6.891 7.418 7.813
8. Tax 1.575 1.856 2.067 2.225 2.344
9. Profit after tax 3.675 4.331 4.824 5.193 5.469
10. Salvage value of
fixed assets 5.000
11. Net recovery of
working capital 8.000

12. Initial outlay (23)
13. Operating cash
inflow 7.425 7.144 6.933 6.775 6.656
42

14. Terminal cash
flow 13.000
15. Net cash flow (23) 7.425 7.144 6.933 6.775 19.656

b. Cash flows form the point of equity investors

Rs.in million

Item 0 1 2 3 4 5

1. Equity funds (10)
2. Revenues 30 30 30 30 30
3. Costs (other than
depreciation and
interest) 20 20 20 20 20
4. Loss of rental 1 1 1 1 1
5. Depreciation 3.75 2.813 2.109 1.582 1.187
6. Interest on working
capital advance 0.70 0.70 0.70 0.70 0.70
7. Interest on term
loans 1.20 1.125 0.825 0.525 0.225
8. Profit before tax 3.35 4.362 5.366 6.193 6.888
9. Tax 1.005 1.309 1.610 1.858 2.066
10. Profit after tax 2.345 3.053 3.756 4.335 4.822
11. Net salvage value
of fixed assets 5.000
12. Net salvage value
of current assets 10.000
13. Repayment of term
term loans 2.000 2.000 2.000 2.000
14. Repayment of bank
creditors 2.000
16. Initial investment (10)
17. Operating cash
inflow 6.095 5.866 5.865 5.917 6.009
18. Liquidation and
retirement cash
flows (2.0) (2.0) (2.0) 6.00
19. Net cash flow (10) 6.095 3.866 3.865 3.917 12.009

43

Chapter 13
RISK ANALYSIS IN CAPITAL BUDGETING

1.
(a) NPV of the project = -250 + 50 x PVIFA (13,10)
= Rs.21.31 million

(b) NPVs under alternative scenarios:
(Rs. in million)
Pessimistic Expected Optimistic

Investment 300 250 200
Sales 150 200 275
Variable costs 97.5 120 154
Fixed costs 30 20 15
Depreciation 30 25 20
Pretax profit - 7.5 35 86
Tax @ 28.57% - 2.14 10 24.57
Profit after tax - 5.36 25 61.43
Net cash flow 24.64 50 81.43
Cost of capital 14% 13% 12%

NPV - 171.47 21.31 260.10

Assumptions: (1) The useful life is assumed to be 10 years under all three
scenarios. It is also assumed that the salvage value of the
investment after ten years is zero.

(2) The investment is assumed to be depreciated at 10% per annum; and it
is also assumed that this method and rate of depreciation are
acceptable to the IT (income tax) authorities.

(3) The tax rate has been calculated from the given table i.e. 10 / 35 x 100
= 28.57%.

(4) It is assumed that only loss on this project can be offset against the
taxable profit on other projects of the company; and thus the company
can claim a tax shield on the loss in the same year.

(c) Accounting break even point (under ‘expected’ scenario)
44

Fixed costs + depreciation = Rs. 45 million
Contribution margin ratio = 60 / 200 = 0.3
Break even level of sales = 45 / 0.3 = Rs.150 million

Financial break even point (under ‘xpected’ scenario)

i. Annual net cash flow = 0.7143 [ 0.3 x sales – 45 ] + 25
= 0.2143 sales – 7.14

ii. PV (net cash flows) = [0.2143 sales – 7.14 ] x PVIFA (13,10)
= 1.1628 sales – 38.74

iii. Initial investment = 200

iv. Financial break even level
of sales = 238.74 / 1.1628 = Rs.205.31 million

2.
(a) Sensitivity of NPV with respect to quantity manufactured and sold:
(in Rs)
Pessimistic Expected Optimistic

Initial investment 30000 30000 30000
Sale revenue 24000 42000 54000
Variable costs 16000 28000 36000
Fixed costs 3000 3000 3000
Depreciation 2000 2000 2000
Profit before tax 3000 9000 13000
Tax 1500 4500 6500
Profit after tax 1500 4500 6500
Net cash flow 3500 6500 8500
NPV at a cost of
capital of 10% p.a
and useful life of
5 years -16732 - 5360 2222

(b) Sensitivity of NPV with respect to variations in unit price.

Pessimistic Expected Optimistic

Initial investment 30000 30000 30000
Sale revenue 28000 42000 70000
Variable costs 28000 28000 28000
45

Fixed costs 3000 3000 3000
Depreciation 2000 2000 2000
Profit before tax -5000 9000 37000
Tax -2500 4500 18500
Profit after tax -2500 4500 18500
Net cash flow - 500 6500 20500
NPV - 31895 (-) 5360 47711

(c) Sensitivity of NPV with respect to variations in unit variable cost.

Pessimistic Expected Optimistic

Initial investment 30000 30000 30000
Sale revenue 42000 42000 42000
Variable costs 56000 28000 21000
Fixed costs 3000 3000 3000
Depreciation 2000 2000 2000
Profit before tax -11000 9000 16000
Tax -5500 4500 8000
Profit after tax -5500 4500 8000
Net cash flow -3500 6500 10000
NPV -43268 - 5360 7908

(d) Accounting break-even point

i. Fixed costs + depreciation = Rs.5000
ii. Contribution margin ratio = 10 / 30 = 0.3333
iii. Break-even level of sales = 5000 / 0.3333
= Rs.15000
Financial break-even point

i. Annual cash flow = 0.5 x (0.3333 Sales – 5000) = 2000
ii. PV of annual cash flow = (i) x PVIFA (10,5)
= 0.6318 sales – 1896
iii. Initial investment = 30000
iv. Break-even level of sales = 31896 / 0.6318 = Rs.50484

3. Define A
t
as the random variable denoting net cash flow in year t.

A
1
= 4 x 0.4 + 5 x 0.5 + 6 x 0.1
= 4.7

A
2
= 5 x 0.4 + 6 x 0.4 + 7 x 0.2
= 5.8
46

A
3
= 3 x 0.3 + 4 x 0.5 + 5 x 0.2
= 3.9

NPV = 4.7 / 1.1 +5.8 / (1.1)
2
+ 3.9 / (1.1)
3
– 10
= Rs.2.00 million

o
1
2
= 0.41

o
2
2
= 0.56

o
3
2
= 0.49

o
1
2
o
2
2
o
3
2

o
2
NPV = + +
(1.1)
2
(1.1)
4
(1.1)
6

= 1.00
o (NPV) = Rs.1.00 million

4. Expected NPV
4 A
t

= ¿ - 25,000
t=1 (1.08)
t

= 12,000/(1.08) + 10,000 / (1.08)
2
+ 9,000 / (1.08)
3

+ 8,000 / (1.08)
4
– 25,000

= [ 12,000 x .926 + 10,000 x .857 + 9,000 x .794 + 8,000 x .735]
- 25,000
= 7,708

Standard deviation of NPV
4 o
t

¿
t=1 (1.08)
t

= 5,000 / (1.08) + 6,000 / (1.08)
2
+ 5,000 / (1,08)
3
+ 6,000 / (1.08)
4
= 5,000 x .926 + 6,000 x .857 + 5000 x .794 + 6,000 x .735
= 18,152

5. Expected NPV
4 A
t

47

= ¿ - 10,000 …. (1)
t=1 (1.06)
t

A
1
= 2,000 x 0.2 + 3,000 x 0.5 + 4,000 x 0.3
= 3,100

A
2
= 3,000 x 0.4 + 4,000 x 0.3 + 5,000 x 0.3
= 3,900

A
3
= 4,000 x 0.3 + 5,000 x 0.5 + 6,000 x 0.2
= 4,900

A
4
= 2,000 x 0.2 + 3,000 x 0.4 + 4,000 x 0.4
= 3,200

Substituting these values in (1) we get

Expected NPV = NPV

= 3,100 / (1.06)+ 3,900 / 1.06)
2
+ 4,900 / (1.06)
3
+ 3,200 / (1,06)
4
- 10,000 = Rs.3,044

The variance of NPV is given by the expression

4 o
2
t

o
2
(NPV) = ¿ …….. (2)
t=1 (1.06)
2t

o
1
2
= [(2,000 – 3,100)
2
x 0.2 + (3,000 – 3,100)
2
x 0.5
+ (4,000 – 3,100)
2
x 0.3]
= 490,000

o
2
2
= [(3,000 – 3,900)
2
x 0.4 + (4,000 – 3,900)
2
x 0.3
+ (5,000 – 3900)
2
x 0.3]
= 690,000

o
3
2
= [(4,000 – 4,900)
2
x 0.3 + (5,000 – 4,900)
2
x 0.5
+ (6,000 – 4,900)
2
x 0.2]
= 490,000

o
4
2
= [(2,000 – 3,200)
2
x 0.2 + (3,000 – 3,200)
2
x 0.4
+ (4,000 – 3200)
2
x 0.4]
= 560,000
Substituting these values in (2) we get
48

490,000 / (1.06)
2
+ 690,000 / (1.06)
4
+ 490,000 / (1.06)
6
+ 560,000 / (1.08)
8

[ 490,000 x 0.890 + 690,000 x 0.792
+ 490,000 x 0.705 + 560,000 x 0.627 ]
= 1,679,150
o NPV = 1,679,150 = Rs.1,296

NPV – NPV 0 - NPV
Prob (NPV < 0) = Prob. <
o NPV o NPV
0 – 3044
= Prob Z <
1296

= Prob (Z < -2.35)

The required probability is given by the shaded area in the following normal curve.

P (Z < - 2.35) = 0.5 – P (-2.35 < Z < 0)
= 0.5 – P (0 < Z < 2.35)
= 0.5 – 0.4906
= 0.0094

So the probability of NPV being negative is 0.0094

Prob (P
1
> 1.2) Prob (PV / I > 1.2)
Prob (NPV / I > 0.2)
Prob. (NPV > 0.2 x 10,000)
Prob (NPV > 2,000)

Prob (NPV >2,000)= Prob (Z > 2,000- 3,044 / 1,296)
Prob (Z > - 0.81)

The required probability is given by the shaded area of the following normal
curve:
P(Z > - 0.81) = 0.5 + P(-0.81 < Z < 0)
= 0.5 + P(0 < Z < 0.81)
= 0.5 + 0.2910
= 0.7910

So the probability of P
1
> 1.2 as 0.7910

6. Given values of variables other than Q, P and V, the net present value model of Bidhan
Corporation can be expressed as:
49

[Q(P – V) – 3,000 – 2,000] (0.5)+ 2,000 0
5
NPV ¿ + - 30,000
t =1 (1.1)
t
(1.1)
5

0.5 Q (P – V) – 500
5
¿ = ------------------------------------ - 30,000
t=1 (1.1)
t

= [ 0.5Q (P – V) – 500] x PVIFA (10,5) – 30,000
= [0.5Q (P – V) – 500] x 3.791 – 30,000
= 1.8955Q (P – V) – 31,895.5

Exhibit 1 presents the correspondence between the values of exogenous variables and the two
digit random number. Exhibit 2 shows the results of the simulation.
Exhibit 1
Correspondence between values of exogenous variables and
two digit random numbers

QUANTITY PRICE VARIABLE COST

Valu
e

Pro
b

Cumulati
ve Prob.
Two digit
random
numbers

Valu
e

Pro
b

Cumulati
ve Prob.
Two digit
random
numbers

Value

Pro
b

Cumu
-
lative
Prob.
Two digit
random
numbers
800 0.1
0
0.10 00 to 09 20 0.4
0
0.40 00 to 39 15 0.3
0
0.30 00 to 29
1,00
0
0.1
0
0.20 10 to 19 30 0.4
0
0.80 40 to 79 20 0.5
0
0.80 30 to 79
1,20
0
0.2
0
0.40 20 to 39 40 0.1
0
0.90 80 to 89 40 0.2
0
1.00 80 to 99
1,40
0
0.3
0
0.70 40 to 69 50 0.1
0
1.00 90 to 99
1,60
0
0.2
0
0.90 70 to 89
1,80
0
0.1
0
1.00 90 to 99

50

Exhibit 2
Simulation Results

QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Ru
n
Rando
m
Numbe
r
Corres-
ponding
Value
Random
Number
Corres-
ponding
value
Rando
m
Number
Corres-
pondin
g value
1.8955 Q(P-V)-
31,895.5
1 03 800 38 20 17 15 -24,314
2 32 1,200 69 30 24 15 2,224
3 61 1,400 30 20 03 15 -18,627
4 48 1,400 60 30 83 40 -58,433
5 32 1,200 19 20 11 15 -20,523
6 31 1,200 88 40 30 20 13,597
7 22 1,200 78 30 41 20 -9,150
8 46 1,400 11 20 52 20 -31,896
9 57 1,400 20 20 15 15 -18,627
QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Ru
n
Rando
m
Numbe
r
Corres-
ponding
Value
Random
Number
Corres-
ponding
value
Rando
m
Number
Corres-
pondin
g value
1.8955 Q(P-V)-
31,895.5
10 92 1,800 77 30 38 20 2,224
11 25 1,200 65 30 36 20 -9,150
12 64 1,400 04 20 83 40 -84,970
13 14 1,000 51 30 72 20 -12,941
14 05 800 39 20 81 40 -62,224
15 07 800 90 50 40 20 13,597
16 34 1,200 63 30 67 20 -9,150
17 79 1,600 91 50 99 40 -1,568
18 55 1,400 54 30 64 20 -5,359
19 57 1,400 12 20 19 15 -18,627
20 53 1,400 78 30 22 15 7,910
21 36 1,200 79 30 96 40 -54,642
22 32 1,200 22 20 75 20 -31,896
23 49 1,400 93 50 88 40 -5,359
24 21 1,200 84 40 35 20 13,597
25 08 .800 70 30 27 15 -9,150
26 85 1,600 63 30 69 20 -1,568
27 61 1,400 68 30 16 15 7,910
28 25 1,200 81 40 39 20 13,597
29 51 1,400 76 30 38 20 -5,359
30 32 1,200 47 30 46 20 -9,150
51

31 52 1,400 61 30 58 20 -5,359
32 76 1,600 18 20 41 20 -31,896
33 43 1,400 04 20 49 20 -31,896
34 70 1,600 11 20 59 20 -31,896
35 67 1,400 35 20 26 15 -18,627
36 26 1,200 63 30 22 15 2,224

QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Ru
n
Random
Number
Corres
-
pondin
g
Value
Random
Number
Corres-
ponding
value
Rando
m
Number
Corres-
pondin
g value
1.8955 Q(P-V)-
31,895.5
37 89 1,600 86 40 59 20 28,761
38 94 1,800 00 20 25 15 -14,836
39 09 .800 15 20 29 15 -24,314
40 44 1,400 84 40 21 15 34,447
41 98 1,800 23 20 79 20 -31,896
42 10 1,000 53 30 77 20 -12,941
43 38 1,200 44 30 31 20 -9,150
44 83 1,600 30 20 10 15 -16,732
45 54 1,400 71 30 52 20 -5,359
46 16 1,000 70 30 19 15 -3,463
47 20 1,200 65 30 87 40 -54,642
48 61 1,400 61 30 70 20 -5,359
49 82 1,600 48 30 97 40 -62,224
50 90 1,800 50 30 43 20 2,224

Expected NPV = NPV
50
= 1/ 50 ¿ NPV
i

i=1
= 1/50 (-7,20,961)
= 14,419

50
Variance of NPV = 1/50 ¿ (NPV
i
– NPV)
2

i=1

= 1/50 [27,474.047 x 10
6
]
= 549.481 x 10
6

52

Standard deviation of NPV = 549.481 x 10
6

= 23,441

7. To carry out a sensitivity analysis, we have to define the range and the most likely values of
the variables in the NPV Model. These values are defined below

Variable Range Most likely value

I Rs.30,000 – Rs.30,000 Rs.30,000
k 10% - 10% 10%
F Rs.3,000 – Rs.3,000 Rs.3,000
D Rs.2,000 – Rs.2,000 Rs.2,000
T 0.5 – 0.5 0.5
N 5 – 5 5
S 0 – 0 0
Q Can assume any one of the values - 1,400*
800, 1,000, 1,200, 1,400, 1,600 and 1,800
P Can assume any of the values 20, 30, 30**
40 and 50
V Can assume any one of the values 20*
15,20 and 40
----------------------------------------------------------------------------------------
* The most likely values in the case of Q, P and V are the values that have the
highest probability associated with them

** In the case of price, 20 and 30 have the same probability of occurrence viz 0.4. We
have chosen 30 as the most likely value because the expected value of the
distribution is closer to 30

Sensitivity Analysis with Reference to Q

The relationship between Q and NPV given the most likely values of other
variables is given by

5 [Q (30-20) – 3,000 – 2,000] x 0.5 + 2,000 0
NPV = ¿ + - 30,000
t=1 (1.1)
t
(1.1)
5

5 5Q - 500
= ¿ - 30,000
t=1 (1.1)
t

The net present values for various values of Q are given in the following table:
53

Q 800 1,000 1,200 1,400 1,600 1,800
NPV -16,732 -12,941 -9,150 -5,359 -1,568 2,224

Sensitivity analysis with reference to P

The relationship between P and NPV, given the most likely values of other variables is defined as
follows:

5 [1,400 (P-20) – 3,000 – 2,000] x 0.5 + 2,000 0
NPV = ¿ + - 30,0
t=1 (1.1)
t
(1.1)
5

5 700 P – 14,500
= ¿ - 30,000
t=1 (1.1)
t

The net present values for various values of P are given below :
P (Rs) 20 30 - 40 50
NPV(Rs) -31,896 -5,359 21,179 47,716

8. NPV - 5 0 5 10 15 20
(Rs.in lakhs)
PI 0.9 1.00 1.10 1.20 1.30 1.40

Prob. 0.02 0.03 0.10 0.40 0.30 0.15

6
Expected PI = PI = ¿ (PI)
j
P
j

j=1
= 1.24

6
Standard deviation of P
1
= ¿ (PI
j
- PI)
2
P
j

j=1
= \ .01156
= .1075
The standard deviation of P
1
is .1075 for the given investment with an expected PI of 1.24.
The maximum standard deviation of PI acceptable to the company for an investment with an
expected PI of 1.25 is 0.30.

54

Since the risk associated with the investment is much less than the maximum risk acceptable
to the company for the given level of expected PI, the company must should accept the
investment.

9. The NPVs of the two projects calculated at their risk adjusted discount rates are as follows:
6 3,000
Project A: NPV = ¿ - 10,000 = Rs.2,333
t=1 (1.12)
t

5 11,000
Project B: NPV = ¿ - 30,000 = Rs.7,763
t=1 (1.14)
t

PI and IRR for the two projects are as follows:

Project A B

PI 1.23 1.26
IRR 20% 24.3%

B is superior to A in terms of NPV, PI, and IRR. Hence the company must choose B.

10. The certainty equivalent co-efficients for the five years are as follows

Year Certainty equivalent coefficient

o
t
= 1 – 0.06 t

1 o
1
= 0.94
2 o
2
= 0.88
3 o
3
= 0.82
4 o
4
= 0.76
5 o
5
= 0.70

The present value of the project calculated at the risk-free rate of return is :
5 (1 – 0.06 t) A
t

¿
t=1 (1.08)
t

7,000 x 0.94 8,000 x 0.88 9,000 x 0.82 10,000 x 0.76 8,000 x 0.70
+ + + +
(1.08) (1.08)
2
(1.08)
3
(1.08)
4
(1.08)
5

55

6,580 7,040 7,380 7,600 5,600
+ + + +
(1.08) (1.08)
2
(1.08)
3
(1.08)
4
(1.08)
5

= 27,386

Net present value of the Project = (27,386 – 30,000
= Rs. –2,614

MINICASE

Solution:
1. The expected NPV of the turboprop aircraft

0.65 (5500) + 0.35 (500)
NPV = - 11000 +
(1.12)

0.65 [0.8 (17500) + 0.2 (3000)] + 0.35 [0.4 (17500) + 0.6 (3000)]
+
(1.12)
2

= 2369

2. If Southern Airways buys the piston engine aircraft and the demand in year 1 turns out to be
high, a further decision has to be made with respect to capacity expansion. To evaluate the
piston engine aircraft, proceed as follows:

First, calculate the NPV of the two options viz., ‘expand’ and ‘do not expand’ at decision
point D
2
:

0.8 (15000) + 0.2 (1600)
Expand : NPV = - 4400 +
1.12

= 6600

0.8 (6500) + 0.2 (2400)
Do not expand : NPV =
1.12
= 5071

56

Second, truncate the ‘do not expand’ option as it is inferior to the ‘expand’ option. This
means that the NPV at decision point D
2
will be 6600

Third, calculate the NPV of the piston engine aircraft option.

0.65 (2500+6600) + 0.35 (800)
NPV = – 5500 +
1.12

0.35 [0.2 (6500) + 0.8 (2400)]
+
(1.12)
2

= – 5500 + 5531 + 898 = 929

3. The value of the option to expand in the case of piston engine aircraft
If Southern Airways does not have the option of expanding capacity at the end of year 1, the
NPV of the piston engine aircraft would be:

0.65 (2500) + 0.35 (800)
NPV = – 5500 +
1.12

0.65 [0.8 (6500) + 0.2 (2400)] + 0.35 [0.2 (6500) + 0.8 (2400)]
+
(1.12)
2

= - 5500 + 1701 + 3842 = 43

Thus the option to expand has a value of 929 – 43 = 886

4. Value of the option to abandon if the turboprop aircraft can be sold for 8000 at the end of year
1

If the demand in year 1 turns out to be low, the payoffs for the ‘continuation’ and
‘abandonment’ options as of year 1 are as follows.

0.4 (17500) + 0.6 (3000)
Continuation: = 7857
1.12

57

Abandonment : 8000

Thus it makes sense to sell off the aircraft after year 1, if the demand in year 1 turns out to be
low.

The NPV of the turboprop aircraft with abandonment possibility is

0.65 [5500 +{0.8 (17500) + 0.2 (3000)}/ (1.12)] + 0.35 (500 +8000)
NPV = - 11,000 +
(1.12)

12048 + 2975
= - 11,000 + = 2413
1.12

Since the turboprop aircraft without the abandonment option has a value of 2369, the
value of the abandonment option is : 2413 – 2369 = 44

5. The value of the option to abandon if the piston engine aircraft can be sold for 4400 at the
end of year 1:

If the demand in year 1 turns out to be low, the payoffs for the ‘continuation’ and
‘abandonment’ options as of year 1 are as follows:

0.2 (6500) + 0.8 (2400)
Continuation : = 2875
1.12

Abandonment : 4400

Thus, it makes sense to sell off the aircraft after year 1, if the demand in year 1 turns out to
be low.

The NPV of the piston engine aircraft with abandonment possibility is:

0.65 [2500 + 6600] + 0.35 [800 + 4400]
NPV = - 5500 +
1.12

5915 + 1820
= - 5500 + = 1406
1.12

For the piston engine aircraft the possibility of abandonment increases the NPV
58

from 929 to 1406. Hence the value of the abandonment option is 477.

59

Chapter 14
THE COST OF CAPITAL

1(a) Define r
D
as the pre-tax cost of debt. Using the approximate yield formula, r
D
can be
calculated as follows:

14 + (100 – 108)/10
r
D
= ------------------------ x 100 = 12.60%
0.4 x 100 + 0.6x108

(b) After tax cost = 12.60 x (1 – 0.35) = 8.19%

2. Define r
p
as the cost of preference capital. Using the approximate yield formula r
p
can be
calculated as follows:

9 + (100 – 92)/6
r
p
= --------------------
0.4 x100 + 0.6x92

= 0.1085 (or) 10.85%

3. WACC = 0.4 x 13% x (1 – 0.35)
+ 0.6 x 18%
= 14.18%

4. Cost of equity = 10% + 1.2 x 7% = 18.4%
(using SML equation)

Pre-tax cost of debt = 14%

After-tax cost of debt = 14% x (1 – 0.35) = 9.1%

Debt equity ratio = 2 : 3

WACC = 2/5 x 9.1% + 3/5 x 18.4%

= 14.68%

5. Given
0.5 x 14% x (1 – 0.35) + 0.5 x r
E
= 12%

where r
E
is the cost of equity capital.

Therefore r
E
– 14.9%
60

Using the SML equation we get

11% + 8% x β = 14.9%

where β denotes the beta of Azeez’s equity.

Solving this equation we get β = 0.4875.

6(a) The cost of debt of 12% represents the historical interest rate at the time the debt was
originally issued. But we need to calculate the marginal cost of debt (cost of raising new
debt); and for this purpose we need to calculate the yield to maturity of the debt as on the
balance sheet date. The yield to maturity will not be equal to12% unless the book value of
debt is equal to the market value of debt on the balance sheet date.

(b) The cost of equity has been taken as D
1
/P
0
( = 6/100) whereas the cost of equity is (D
1
/P
0
)
+ g where g represents the expected constant growth rate in dividend per share.

7. The book value and market values of the different sources of finance are
provided in the following table. The book value weights and the market value
weights are provided within parenthesis in the table.
(Rs. in million)
Source Book value Market value
Equity 800 (0.54) 2400 (0.78)
Debentures – first series 300 (0.20) 270 (0.09)
Debentures – second series 200 (0.13) 204 (0.06)
Bank loan 200 (0.13) 200 (0.07)
Total 1500 (1.00) 3074 (1.00)

8. Required return
based on SML Expected
Project Beta equation (%) return (%)

P 0.6 14.8 13
Q 0.9 17.2 14
R 1.5 22.0 16
S 1.5 22.0 20

Given a hurdle rate of 18% (the firm’s cost of capital), projects P, Q and R would have been
rejected because the expected returns on these projects are below 18%. Project S would be
accepted because the expected return on this project exceeds 18%.An appropriate basis for
61

accepting or rejecting the projects would be to compare the expected rate of return and the
required rate of return for each project. Based on this comparison, we find that all the four
projects need to be rejected.

9.
(a) Given
r
D
x (1 – 0.3) x 4/9 + 20% x 5/9 = 15%
r
D
= 12.5%,where r
D
represents the pre-tax cost of debt.

(b) Given
13% x (1 – 0.3) x 4/9 + r
E
x 5/9 = 15%
r
E
= 19.72%, where r
E
represents the cost of equity.

10. Cost of equity = D
1
/P
0
+ g
= 3.00 / 30.00 + 0.05
= 15%
(a) The first chunk of financing will comprise of Rs.5 million of retained earnings costing 15
percent and Rs.25 million of debt costing 14 (1-.3) = 9.8 per cent
The second chunk of financing will comprise of Rs.5 million of additional equity costing
15 per cent and Rs.2.5 million of debt costing 15 (1-.3) = 10.5 per cent

(b) The marginal cost of capital in the first chunk will be :
5/7.5 x 15% + 2.5/7.5 x 9.8% = 13.27%

The marginal cost of capital in the second chunk will be :
5/7.5 x 15% + 2.5/7.5 x 10.5% = 13.50%

Note : We have assumed that
(i) The net realisation per share will be Rs.25, after floatation costs, and
(ii) The planned investment of Rs.15 million is inclusive of floatation costs

11. The cost of equity and retained earnings
r
E
= D
1
/P
O
+ g
= 1.50 / 20.00 + 0.07 = 14.5%
The cost of preference capital, using the approximate formula, is :

11 + (100-75)/10
r
E
= = 15.9%
0.6 x 75 + 0.4 x 100

62

The pre-tax cost of debentures, using the approximate formula, is :

13.5 + (100-80)/6
r
D
= = 19.1%
0.6x80 + 0.4x100

The post-tax cost of debentures is
19.1 (1-tax rate) = 19.1 (1 – 0.5)
= 9.6%

The post-tax cost of term loans is
12 (1-tax rate) = 12 (1 – 0.5)
= 6.0%

The average cost of capital using book value proportions is calculated below :

Source of capital Component Book value Book value Product of
Cost Rs. in million proportion (1) & (3)
(1) (2) (3)
Equity capital 14.5% 100 0.28 4.06
Preference capital 15.9% 10 0.03 0.48
Retained earnings 14.5% 120 0.33 4.79
Debentures 9.6% 50 0.14 1.34
Term loans 6.0% 80 0.22 1.32
360 Average cost11.99%
capital

The average cost of capital using market value proportions is calculated below :

Source of capital Component Market value Market value Product of
cost Rs. in million
(1) (2) (3) (1) & (3)

Equity capital
and retained earnings 14.5% 200 0.62 8.99
Preference capital 15.9% 7.5 0.02 0.32
Debentures 9.6% 40 0.12 1.15
Term loans 6.0% 80 0.24 1.44

327.5 Average cost 11.90%
capital

12
63

(a) WACC = 1/3 x 13% x (1 – 0.3)
+ 2/3 x 20%
= 16.37%

(b) Weighted average floatation cost
= 1/3 x 3% + 2/3 x 12%
= 9%

(c) NPV of the proposal after taking into account the floatation costs
= 130 x PVIFA (16.37, 8) – 500 / (1 - 0.09)
= Rs.8.51 million

MINICASE

Solution:

a. All sources other than non-interest bearing liabilities

b. Pre-tax cost of debt & post-tax cost of debt

10 + (100 – 112) / 8 8.5
r
d
= = = 7.93
0.6 x 112 + 0.4 x 100 107.2

r
d
(1 – 0.3) = 5.55

c. Post-tax cost of preference
9 + (100 – 106) / 5 7.8
= = 7.53%
0.6 x 106 + 0.4 x 100 103.6
d. Cost of equity using the DDM

2.80 (1.10)
+ 0.10 = 0.385 + 0.10
80
= 0.1385 = 13.85%

e. Cost of equity using the CAPM

7 + 1.1(7) = 14.70%

f. WACC
0.50 x 14.70 + 0.10 x 7.53 + 0.40 x 5.55
64

= 7.35 + 0.75 + 2.22
= 10.32%

g. Cost of capital for the new business

0.5 [7 + 1.5 (7)] + 0.5 [ 11 (1 – 0.3)]
8.75 + 3.85
= 12.60%

65

Chapter 15
CAPITAL BUDGETING : EXTENSIONS

1. EAC
(Plastic Emulsion) = 300000 / PVIFA (12,7)
= 300000 / 4.564
= Rs.65732

EAC
(Distemper Painting) = 180000 / PVIFA (12,3)
= 180000 / 2.402
= Rs.74938

Since EAC of plastic emulsion is less than that of distemper painting, it is the preferred
alternative.

2. PV of the net costs associated with the internal transportation system

= 1 500 000 + 300 000 x PVIF (13,1) + 360 000 x PVIF (13,2)
+ 400 000 x PVIF (13,3) + 450 000 x PVIF (13,4)
+ 500 000 x PVIF (13,5) - 300 000 x PVIF (13,5)
= 2709185

EAC of the internal transportation system

= 2709185 / PVIFA (13,5)
= 2709185 / 3.517
= Rs.770 311

3. EAC [ Standard overhaul]

= 500 000 / PVIFA (14,6)
= 500 000 / 3.889
= Rs.128568 ……… (A)

EAC [Less costly overhaul]

= 200 000 / PVIFA (14,2)
= 200 000 / 1.647
= Rs.121433 ……… (B)

Since (B) < (A), the less costly overhaul is preferred alternative.

66

4.
(a) Base case NPV

= -12,000,000 + 3,000,000 x PVIFA (20,6)
= -12,000,000 + 997,8000
= (-) Rs.2,022,000

(b) Issue costs = 6,000,000 / 0.88 - 6,000,000

= Rs.818 182

= - 2,022,000 – 818,182
= - Rs.2,840,182

(c) The present value of interest tax shield is calculated below :

Year Debt outstanding at Interest Tax shield Present value of
the beginning tax shield
1 6,000,000 1,080,000 324,000 274,590
2 6,000,000 1,080,000 324,000 232,697
3 5,250,000 945,000 283,000 172,538
4 4,500,000 810,000 243,000 125,339
5 3,750,000 675,000 202,000 88,513
6 3,000,000 540,000 162,000 60,005
7 2,225,000 400,500 120,000 37,715
8 1,500,000 270,000 81,000 21,546
9 750,000 135,000 40,500 9,133

Present value of tax shield = Rs.1,022,076

5.
(a) Base case BPV

= - 8,000,000 + 2,000,000 x PVIFA (18,6)
= - Rs.1,004,000

= Base case NPV – Issue cost
= - 1,004,000 – [ 3,000,000 / 0.9 – 3,000,000]
= - Rs.1,337,333
67

(c) The present value of interest tax shield is calculated below :

Year Debt outstanding at Interest Tax shield Present value of
the beginning tax shield
1 5,000,000 750,000 300,000 260,880
2 5,000,000 750,000 300,000 226,830
3 4,000,000 600,000 240,000 157,800
4 3,000,000 450,000 180,000 102,924
5 2,000,000 300,000 120,000 59,664
6 1,000,000 150,000 60,000 25,938

Present value of tax shield = Rs.834,036

68

Chapter 18
RAISING LONG TERM FINANCE

1 Underwriting Shares Excess/ Credit Net
commitment procured shortfall shortfall

A 70,000 50,000 (20,000) 4919 (15081)

B 50,000 30,000 (20,000) 3514 (16486)

C 40,000 30,000 (10,000) 2811 (7189)

D 25,000 12,000 (13,000) 1757 (11243)

E 15,000 28,000 13,000

2.
Underwriting Shares Excess/ Credit Net
commitment procured Shortfall shortfall

A 50,000 20,000 (30,000) 14286 (15714)

B 20,000 10,000 (10,000) 5714 (4286)

C 30,000 50,000 20,000 - -

3. P
o
= Rs.220 S = Rs.150 N = 4
a. The theoretical value per share of the cum-rights stock would simply be
Rs.220

b. The theoretical value per share of the ex-rights stock is :
69

NP
o
+S 4 x 220 +150
= = Rs.206
N+1 4+1

c. The theoretical value of each right is :
P
o
– S 220 – 150
= = Rs.14
N+1 4+1
The theoretical value of 4 rights which are required to buy 1 share is Rs.14x14=Rs.56.

4. P
o
= Rs.180 N = 5
a. The theoretical value of a right if the subscription price is Rs.150
P
o
– S 180 – 150
= = Rs.5
N+1 5+1

b. The ex-rights value per share if the subscription price is Rs.160
NP
o
+ S 5 x 180 + 160
= = Rs.176.7
N+1 5+1

c. The theoretical value per share, ex-rights, if the subscription price is
Rs.180? 100?
5 x 180 + 180
= Rs.180
5+1

5 x 180 + 100
= Rs.166.7
5+1

70

Chapter 19
CAPITAL STRUCTURE AND FIRM VALUE

1. Net operating income (O) : Rs.30 million
Interest on debt (I) : Rs.10 million
Equity earnings (P) : Rs.20 million
Cost of equity (r
E
) : 15%

Cost of debt (r
D
) : 10%
Market value of equity (E) : Rs.20 million/0.15 =Rs.133 million
Market value of debt (D) : Rs.10 million/0.10 =Rs.100 million
Market value of the firm (V) : Rs.233 million

2. Box Cox

Market value of equity 2,000,000/0.15 2,000,000/0.15
= Rs.13.33 million = Rs.13.33 million
Market value of debt 0 1,000,000/0.10
=Rs.10 million
Market value of the firm Rs.13.33million =23.33 million

(a) Average cost of capital for Box Corporation
13.33. 0
x 15% + x 10% = 15%
13.33 13.33

Average cost of capital for Cox Corporation
13.33 10.00
x 15% + x 10% = 12.86%
23.33 23.33

(b) If Box Corporation employs Rs.30 million of debt to finance a project that yields
Rs.4 million net operating income, its financials will be as follows.

Net operating income Rs.6,000,000
Interest on debt Rs.3,000,000
Equity earnings Rs.3,000,000
Cost of equity 15%
71

Cost of debt 10%
Market value of equity Rs.20 million
Market value of debt Rs.30 million
Market value of the firm Rs.50 million

Average cost of capital
20 30
15% x + 10% = 12%
50 50

(c) If Cox Corporation sells Rs.10 million of additional equity to retire
Rs.10 million of debt , it will become an all-equity company. So its
average cost of capital will simply be equal to its cost of equity,
which is 15%.

3. r
E
= r
A
+ (r
A
-r
D
)D/E
20 = 12 + (12-8) D/E
So D/E = 2

4. E D E D
r
E
r
D
r
A
=

r
E
+

r
D

D+E D+E (%) (%) D+E D+E

1.00 0.00 11.0 6.0 11.00
0.90 0.10 11.0 6.5 10.55
0.80 0.20 11.5 7.0 10.60
0.70 0.30 12.5 7.5 11.00
0.60 0.40 13.0 8.5 11.20
0.50 0.50 14.0 9.5 11.75
0.40 0.60 15.0 11.0 12.60
0.30 0.70 16.0 12.0 13.20
0.20 0.80 18.0 13.0 14.00
0.10 0.90 20.0 14.0 14.20

The optimal debt ratio is 0.10 as it minimises the weighted average
cost of capital.

5. (a) If you own Rs.10,000 worth of Bharat Company, the levered company
which is valued more, you would sell shares of Bharat Company, resort
to personal leverage, and buy the shares of Charat Company.
(b) The arbitrage will cease when Charat Company and Bharat Company
are valued alike

72

6. The value of Ashwini Limited according to Modigliani and Miller
hypothesis is
Expected operating income 15
= = Rs.125 million
Discount rate applicable to the 0.12
risk class to which Aswini belongs
7. The average cost of capital(without considering agency and bankruptcy cost)
at various leverage ratios is given below.

D E E D
r
D
r
E
r
A
=

r
E
+ r
D

D + E D+ E % % D+E D+E
(%)

0 1.00 4.0 12.0 12.0
0.10 0.90 4.0 12.0 11.2
0.20 0.80 4.0 12.5 10.8
0.30 0.70 4.0 13.5 10.36
0.40 0.60 4.0 13.5 9.86
0.50 0.50 4.0 14.0 9.30
0.60 0.40 4.0 14.5 8.68
0.70 0.30 4.0 15.0 8.14
0.80 0.20 4.0 15.5 7.90
0.90 0.10 4.0 16.0 7.72 Optimal

b. The average cost of capital considering agency and bankruptcy costs is
given below
.
D E E D
r
D
r
E
r
A
=

r
E
+ r
D

D + E D+ E % % D+E D+E
(%)

0 1.00 4.0 12.0 12.0
0.10 0.90 4.0 12.0 11.2
0.20 0.80 4.0 13.0 11.2
0.30 0.70 4.2 14.0 11.06
0.40 0.60 4.4 15.0 10.76
0.50 0.50 4.6 16.0 10.30
0.60 0.40 4.8 17.0 9.68
0.70 0.30 5.2 18.0 9.04
0.80 0.20 6.0 19.0 8.60
0.90 0.10 6.8 20.0 8.12 Optimal
8. The tax advantage of one rupee of debt is :
73

1-(1-t
c
) (1-t
pe
) (1-0.55) (1-0.05)
= 1 -
(1-t
pd
) (1-0.25)

= 0.43 rupee

Chapter 20
CAPITAL STRUCTURE DECISION

1.(a) Currently
No. of shares = 1,500,000
EBIT = Rs 7.2 million
Interest = 0
Preference dividend = Rs.12 x 50,000 = Rs.0.6 million
EPS = Rs.2

(EBIT – Interest) (1-t) – Preference dividend
EPS =
No. of shares

(7,200,000 – 0 ) (1-t) – 600,000
Rs.2 =
1,500,000

Hence t = 0.5 or 50 per cent

The EPS under the two financing plans is :

Financing Plan A : Issue of 1,000,000 shares

(EBIT - 0 ) ( 1 – 0.5) - 600,000
EPS
A
=
2,500,000

Financing Plan B : Issue of Rs.10 million debentures carrying 15 per cent
interest

(EBIT – 1,500,000) (1-0.5) – 600,000
EPS
B
=
1,500,000

The EPS – EBIT indifference point can be obtained by equating EPS
A
and EPS
B

(EBIT – 0 ) (1 – 0.5) – 600,000 (EBIT – 1,500,000) (1 – 0.5) – 600,000
74

=
2,500,000 1,500,000

Solving the above we get EBIT = Rs.4,950,000 and at that EBIT, EPS is Rs.0.75
under both the plans

(b) As long as EBIT is less than Rs.4,950,000 equity financing maximixes EPS.
When EBIT exceeds Rs.4,950,000 debt financing maximises EPS.

2.
(a) EPS – EBIT equation for alternative A
EBIT ( 1 – 0.5)
EPS
A
=
2,000,000
(b) EPS – EBIT equation for alternative B
EBIT ( 1 – 0.5 ) – 440,000
EPS
B
=
1,600,000

(c) EPS – EBIT equation for alternative C
(EBIT – 1,200,000) (1- 0.5)
EPS
C
=
1,200,000

(d) The three alternative plans of financing ranked in terms of EPS over varying
Levels of EBIT are given the following table

Ranking of Alternatives

EBIT EPS
A
EPS
B
EPS
C

(Rs.) (Rs.) (Rs.) (Rs.)

2,000,000 0.50(I) 0.35(II) 0.33(III)
2,160,000 0.54(I) 0.40(II) 0.40(II)
3,000,000 0.75(I) 0.66(II) 0.75(I)
4,000,000 1.00(II) 0.98(III) 1.17(I)
4,400,000 1.10(II) 1.10(II) 1.33(I)
More than 4,400,000 (III) (II) (I)

3. Plan A : Issue 0.8 million equity shares at Rs. 12.5 per share.
Plan B : Issue Rs.10 million of debt carrying interest rate of 15 per cent.

(EBIT – 0 ) (1 – 0.6)
EPS
A
=
75

1,800,000
(EBIT – 1,500,000) (1 – 0.6)
EPS
B
=
1,000,000

Equating EPS
A
and EPS
B
, we get
(EBIT – 0 ) (1 – 0.6) (EBIT – 1,500,000) (1 – 0.6)
=
1,800,000 1,000,000

Solving this we get EBIT = 3,375,000 or 3.375 million

Thus the debt alternative is better than the equity alternative when
EBIT > 3.375 million

EBIT – EBIT 3.375 – 7.000
Prob(EBIT>3,375,000) = Prob >
o EBIT 3.000

= Prob [z > - 1.21]
= 0.8869

4. ROE = [ ROI + ( ROI – r ) D/E ] (1 – t )
15 = [ 14 + ( 14 – 8 ) D/E ] ( 1- 0.5 )
D/E = 2.67

5. ROE = [12 + (12 – 9 ) 0.6 ] (1 – 0.6)
= 5.52 per cent

6. 18 = [ ROI + ( ROI – 8 ) 0.7 ] ( 1 – 0.5)
ROI = 24.47 per cent
EBIT
7. a. Interest coverage ratio =
Interest on debt

150
=
40
= 3.75
EBIT + Depreciation
b. Cash flow coverage ratio =
Loan repayment instalment
76

Int.on debt +
(1 – Tax rate)
= 150 + 30

40 + 50

= 2
8. The debt service coverage ratio for Pioneer Automobiles Limited is given by :
5
¿ ( PAT
i
+ Dep
i
+ Int
i
)
i=1
DSCR = 5
¿ (Int
i
+ LRI
i
)
i=1

= 133.00 + 49.14 +95.80

95.80 + 72.00

= 277.94
167.80
= 1.66

9. (a) If the entire outlay of Rs. 300 million is raised by way of debt carrying 15 per cent
interest, the interest burden will be Rs. 45 million.
Considering the interest burden the net cash flows of the firm during
a recessionary year will have an expected value of Rs. 35 million (Rs.80 million - Rs. 45
million ) and a standard deviation of Rs. 40 million .
Since the net cash flow (X) is distributed normally
X – 35

40
has a standard normal deviation
Cash flow inadequacy means that X is less than 0.
0.35
Prob(X<0) = Prob (z< ) = Prob (z<- 0.875)
40
= 0.1909

(b) Since µ = Rs.80 million, o= Rs.40 million , and the Z value corresponding to the risk
tolerance limit of 5 per cent is – 1.645, the cash available from the operations to service the
debt is equal to X which is defined as :
X – 80
= - 1.645
77

40
X = Rs.14.2 million
Given 15 per cent interest rate, the debt than be serviced is
14.2
= Rs. 94.67 million
0.15

Chapter 21
DIVIDEND POLICY AND FIRM VALUE

1. Payout ratio Price per share

3(0.5)+3(0.5) 0.15
0.5
0.12
= Rs. 28.13
0.12

3(0.7 5)+3(0.25) 0.15
0.12
0.75 = Rs. 26.56
0.12

3(1.00)
1.00 = Rs. 25.00
0.12

2. Payout ratio Price per share

8(0.25)
0.25 = undefined
0.12 – 0.16(0.75)
8(0.50)

0.50 = Rs.100
0.12 – 0.16(0.50)
8(1.00)
1.0 =Rs.66.7
0.12 – 0.16 (0)

78

3.
P Q
- Next year’s price 80 74
- Dividend 0 6
- Current price P Q
- Capital appreciation (80-P) (74-Q)
- Post-tax capital appreciation 0.9(80-P) 0.9 (74-Q)
- Post-tax dividend income 0 0.8 x 6
- Total return 0.9 (80-P)
P
= 14%
0.9 (74-Q) + 4.8
Q
=14%
- Current price (obtained by solving
the preceding equation)
P = Rs.69.23 Q = Rs.68.65

79

Chapter 22
DIVIDEND DECISION

1. a. Under a pure residual dividend policy, the dividend per share over the 4 year
period will be as follows:

DPS Under Pure Residual Dividend Policy
( in Rs.)

Year 1 2 3 4

Earnings 10,000 12,000 9,000 15,000
Capital expenditure 8,000 7,000 10,000 8,000
Equity investment 4,000 3,500 5,000 4,000
Pure residual
dividends 6,000 8,500 4,000 11,000
Dividends per share 1.20 1.70 0.80 2.20

b. The external financing required over the 4 year period (under the assumption that the
company plans to raise dividends by 10 percents every two years) is given below :
Required Level of External Financing
(in Rs.)

Year 1 2 3 4

A . Net income 10,000 12,000 9,000 15,000

B . Targeted DPS 1.00 1.10 1.10 1.21

C . Total dividends 5,000 5,500 5,500 6,050

D . Retained earnings(A-C) 5,000 6,500 3,500 8,950

E . Capital expenditure 8,000 7,000 10,000 8,000

80

F . External financing
requirement 3,000 500 6,500 Nil
(E-D)if E > D or 0 otherwise

c. Given that the company follows a constant 60 per cent payout ratio, the dividend per share
and external financing requirement over the 4 year period are given below

Dividend Per Share and External Financing Requirement
(in Rs.)

Year 1 2 3 4

A. Net income 10,000 12,000 9,000 15,00

B. Dividends 6,000 7,200 5,400 9,000

C. Retained earnings 4,000 4,800 3,600 6,000

D. Capital expenditure 8,000 7,000 10,000 8,000

E. External financing
(D-C)if D>C, or 0 4,000 2,200 6,400 2,000
otherwise

F. Dividends per share 1.20 1.44 1.08 1.80

2. Given the constraints imposed by the management, the dividend per share has to
be between Rs.1.00 (the dividend for the previous year) and Rs.1.60 (80 per
cent of earnings per share)
Since share holders have a preference for dividend, the dividend should be
raised over the previous dividend of Rs.1.00 . However, the firm has substantial
investment requirements and it would be reluctant to issue additional equity
because of high issue costs ( in the form of underpricing and floatation costs)
Considering the conflicting requirements, it seems to make sense to pay
Rs.1.20 per share by way of dividend. Put differently the pay out ratio may be
set at 60 per cent.

3. According to the Lintner model
D
t
= cr EPS
t
+ (1-c)D
t

–1
EPS
t
=3.00, c= 0.7, r=0.6 , and D
t-1

Hence
D
t
= 0.7 x 0.6 x 3.00 + (1-0.7)1.20
81

= Rs.1.62

4. The bonus ratio (b) must satisfy the following constraints :
(R-S
b
)≥0.4S (1+b) (1)
0.3 PBT ≥0.1 S(1+b) (2)

R = Rs.100 million, S= Rs.60 million, PBT = Rs.60 million
Hence the constraints are
(100-60 b) ≥ 0.4 x 60 (1+b) (1a)
0.3 x 60≥0.1 x 60 (1+b) (2a)

These simplify to
b ≥ 76/84
b ≥ 2

The condition b ≥ 76/84 is more restructive than b≥ 2
So the maximum bonus ratio is 76/84 or 19/21

82

Chapter 23
Debt Analysis and Management

1. (i) Initial Outlay
(a) Cost of calling the old bonds
Face value of the old bonds 250,000,000
265,000,000
(b) Net proceeds of the new bonds
Gross proceeds 250,000,000
Issue costs 10,000,000

240,000,000
(c) Tax savings on tax-deductible expenses
Tax rate[Call premium+Unamortised issue cost on
the old bonds] 9,200,000
0.4 [ 15,000,000 + 8,000,000]
Initial outlay i(a) – i(b) – i(c) 15,800,000

(ii) Annual Net Cash Savings
(a) Annual net cash outflow on old bonds
Interest expense 42,500,000
- Tax savings on interest expense and amortisation of
issue expenses 17,400,000
0.4 [42,500,000 + 8,000,000/10]
25,100,000
(b) Annual net cash outflow on new bonds
Interest expense 37,500,000
- Tax savings on interest expense and amortisation of
issue cost 15,500,000
0.4 [ 37,500,000 – 10,000,000/8]
22,000,000
Annual net cash savings : ii(a) – ii(b) 3,100,000

(iii) Present Value of the Annual Cash Savings
Present value of an 8-year annuity of 3,100,000 at a
83

discount rate of 9 per cent which is the post –tax cost
of new bonds 3,100,000 x 5.535 17,158,500

(iv) Net Present Value of Refunding the Bonds
(a) Present value of annual cash savings 17,158,500
(b) Net initial outlay 15,800,000
(c) Net present value of refunding the bonds :
iv(a) – iv(b). 1,358,500
2. (i) Initial Outlay
(a) Cost of calling the old bonds
Face value of the old bonds 120,000,000

124,800,000
(b) Net proceeds of the new issue
Gross proceeds 120,000,000
Issue costs 2,400,000

117,600,000
(c) Tax savings on tax-deductible expenses 3,120,000
Tax rate[Call premium+Unamortised issue costs on
the old bond issue]
0.4 [ 4,800,000 + 3,000,000]
Initial outlay i(a) – i(b) – i(c) 4,080,000

(ii) Annual Net Cash Savings
(a) Annual net cash out flow on old bonds
Interest expense 19,200,000
- Tax savings on interest expense and amortisation of
issue costs 7,920,000
0.4[19,200,000 + 3,000,000/5]
11,280,000

(b) Annual net cash outflow on new bonds
Interest expense 18,000,000
- Tax savings on interest expense and amortistion of issue
costs 7,392,000
0.4[18,000,000 + 2,400,000/5]
10,608,000
Annual net cash savings : ii(a) – ii(b) 672,000

(iii) Present Value of the Annual Net Cash Savings
Present value of a 5 year annuity of 672,000 at
84

as discount rate of 9 per cent, which is the post-tax 2,614,080 cost of
new bonds

(iv) Net Present Value of Refunding the Bonds
(a) Present value of annual net cash savings 2,614,080
(b) Initial outlay 4,080,000
(c) Net present value of refunding the bonds : - 1,466,000
iv(a) – iv(b)

3. Yield to maturity of bond P
8 160 1000
918.50 =¿ +
t=1 (1+r)
t
(1+r)
8

r or yield to maturity is 18 percent

Yield to maturity of bond Q
5 120 1000
761 = ¿ +
t=1 (1+r)
t
(1+r)
5

r or yield to maturity is 20 per cent

Duration of bond P is calculated below

Year Cash flow Present Value Proportion of Proportion of bond’s
at 18% bond’s value Value x Time

1 160 135.5 0.148 0.148
2 160 114.9 0.125 0.250
3 160 97.4 0.106 0.318
4 160 82.6 0.090 0.360
5 160 69.9 0.076 0.380
6 160 59.2 0.064 0.384
7 160 50.2 0.055 0.385
8 160 308.6 0.336 2.688

4.913

Duration of bond Q is calculated below

Year Cash flow Present Value Proportion of Proportion of bond’s
at 20% bond’s value Value x Time

85

1 120 100.0 0.131 0.131
2 120 83.2 0.109 0.218
3 120 69.5 0.091 0.273
4 120 57.8 0.076 0.304
5 1120 450.2 0.592 2.960

3.886

Volatility of bond P Volatility of bond Q
4.913 3.886
= 4.16 = 3.24
1.18 1.20

4. The YTM for bonds of various maturities is

Maturity YTM(%)

1 12.36

2 13.10

3 13.21

4 13.48

5 13.72

Graphing these YTMs against the maturities will give the yield curve

The one year treasury bill rate , r
1
, is

1,00,000
- 1 = 12.36 %
89,000

To get the forward rate for year 2, r
2
, the following equation may be set up :

12500 112500
99000 = +
(1.1236) (1.1236)(1+r
2
)

Solving this for r
2
we get r
2
= 13.94%
86

To get the forward rate for year 3, r
3
, the following equation may be set up :

13,000 13,000 113,000
99,500 = + +
(1.1236) (1.1236)(1.1394) (1.1236)(1.1394)(1+r
3
)

Solving this for r
3
we get r
3
= 13.49%

To get the forward rate for year 4, r
4
, the following equation may be set up :

13,500 13,500 13,500
100,050 = + +
(1.1236) (1.1236)(1.1394) (1.1236)(1.1394)(1.1349)

113,500
+
(1.1236)(1.1394)(1.1349)(1+r
4
)

Solving this for r
4
we get r
4
= 14.54%

To get the forward rate for year 5, r
5
, the following equation may be set up :

13,750 13,750 13,750
100,100 = + +
(1.1236) (1.1236)(1.1394) (1.1236)(1.1394)(1.1349)

13,750
+
(1.1236)(1.1394)(1.1349)(1.1454)

113,750
+
(1.1236)(1.1394)(1.1349)(1.1454)(1+r
5
)

Solving this for r
5
we get r
5
= 15.08%

87

Chapter 25
HYBRID FINANCING

1. The product of the standard deviation and square root of time is :
o t = 0.35 2 = 0.495
The ratio of the stock price to the present value of the exercise price is :

Stock price 40
= = 1.856
PV (Exercise price) 25/(1.16)

The ratio of the value of call option to stock price corresponding to numbers
0.495 and 1.856 can be found out from Table A.6 by interpolation. Note the
table gives values for the following combinations

1.75 2.00

0.45 44.6 50.8

0.50 45.3 51.3

Since we are interested in the combination 0.495 and 1.856 we first interpolate
between 0.450 and 0.500 and then interpolate between 1.75 and 2.00

Interpolation between 0.450 and 0.500 gives

1.75 2.00

0.450 44.6 50.8

0.495 45.23 51.25

0.500 45.3 51.3

88

Then, interpolation between 1.75 and 2.00 gives

1.75 1.856 2.00

0.495 45.23 47.78 51.25

Chapter 24
LEASING, HIRE PURCHASE, AND PROJECT FINANCE

1. NPV of the Purchase Option
(Rs.in ‘000)
Year 0 1 2 3 4 5
1.Investment(I) (1,500)
2.Revenues(R
t
) 1,700 1,700 1,700 1,700 1,700
3.Costs(other than
(Depreciation)(C
t
) 900 900 900 900 900
4.Depreciation(D
t
) 500 333.3 222.2 148.1 98.8
5.Profit before tax
(R
t
-C
t
-D
t
) 300 466.7 577.8 651.9 701.2
6.Profit after tax: 5(1-t) 210 326.7 404.5 456.3 490.8
7.Net salvage value 300
8.Net cash flow
(1+6+4+7) (1,500) 710 610 626.7 604.4 889.6
9.Discount factor
at 11 percent 1.000 0.901 0.812 0.731 0.659 0.593
10.Present value (8x9) (1,500) 639.7 495.3 458.1 398.3 527.5

NPV(Purchases)= - 1500+639.7+495.3+458.1+398.3+527.5 = 1018.9

NPV of the Leasing Option
(Rs. in ‘000)
Year 0 1 2 3 4 5
1.Revenues(R
t
) - 1,700 1,700 1,700 1,700 1,700
2.Costs(other than
lease rentals)(C
t
) 900 900 900 900 900
3.Lease rentals(L
t
) 420 420 420 420 420 0
4.Profit before tax
(R
t
-C
t
-L
t
) -420 380 380 380 380 800
5.Profit after tax (which
also reflects the net
89

cash flow)(1-t) -294 266 266 266 266 560
6.Discount factor at
13 per cent 1.000 0.885 0.783 0.693 0.613 0.543
7.Present value(5x6) -294 -235.4 208.3 184.3 163.1 304.1

NPV(Leasing) = -294+235.4+208.3+184.3+163.1+304.1 = 801.2

2. Under the hire purchase proposal the total interest payment is
2,000,000 x 0.12 x 3 = Rs. 720,000

The interest payment of Rs. 720,000 is allocated over the 3 years period using
the sum of the years digits method as follows:
Year Interest allocation

366
1 x Rs.720,000 = Rs.395,676
666

222
2 x Rs.720,000 = Rs.240,000
666

78
3 x Rs.720,000 = Rs.84,324
666

The annual hire purchase instalments will be :

Rs.2,000,000 + Rs.720,000
= Rs.906,667
3

The annual hire purchase instalments would be split as follows

Year Hire purchase instalment Interest Principal repayment
1 Rs.906,667 Rs.395,676 Rs. 510,991
2 Rs.906,667 Rs.240,000 Rs. 666,667
3 Rs.906,667 Rs. 84,324 Rs. 822,343

The lease rental will be as follows :
90

Rs. 560,000 per year for the first 5 years
Rs. 20,000 per year for the next 5 years

The cash flows of the leasing and hire purchse options are shown below

Year Leasing High Purchase -I
t
(1-t
c
)-PR
t
+
- LR
t
(1-t
c
) -I
t
(1-t
c
) -PR
t
D
t
(t
c
) NSV
t
D
t
(t
c
)+NSV
t

1 -560,000(1-.4)=-336,000 -395,676(1-.4) -510,991 500,000(0.4) -548,397
2 -560,000(1-.4)=-336,000 -240,000(1-.4) -666,667 375,000(0.4) -660,667
3 -560,000(1-.4)=-336,000 - 84,324(1-.4) -822,343 281,250(0.4) -760,437
4 -560,000(1-.4)=-336,000 210,938(0.4) 84,375
5 -560,000(1-.4)=-336,000 158,203(0.4) 63,281
6 - 20,000(1-.4)= - 12,000 118,652(0.4) 47,461
7 - 20,000(1-.4)= - 12,000 88,989(0.4) 35,596
8 - 20,000(1-.4)= - 12,000 66,742(0.4) 26,697
9 - 20,000(1-.4)= - 12,000 50,056(0.4) 20,023
10 - 20,000(1-.4)= - 12,000 37,542(0.4) 200,000 215,017

Present value of the leasing option

5 336,000 10 12,000
= - ¿ ÷ ¿ = - 1,302,207
t=1 (1.10)
t
t=6 (1.10)
t

Present value of the hire purchase option

548,397 660,667 760,437 84,375
= - - - -
(1.10) (1.10)
2
(1.10)
3
(1.10)
4

63,281 47,461 35,596 26,697

+ + +
(1.10)
5
(1.10)
6
(1.10)
7
(1.10)
8

20,023 215,017
91

+
(1.10)9 (1.10)
10

= - 1,369,383

Since the leasing option costs less than the hire purchase option , Apex should choose the
leasing option.

Chapter 26
WORKING CAPITAL POLICY

Average inventory
1 Inventory period =
Annual cost of goods sold/365

(60+64)/2
= = 62.9 days
360/365

Average accounts receivable
Accounts receivable =
period Annual sales/365

(80+88)/2
= = 61.3 days
500/365

Average accounts payable
Accounts payable =
period Annual cost of goods sold/365

(40+46)/2
= = 43.43 days
360/365

Operating cycle = 62.9 + 61.3 = 124.2 days
Cash cycle = 124.2 – 43.43 = 80.77 days

(110+120)/2
2. Inventory period = = 56.0 days
750/365

(140+150)/2
92

Accounts receivable = = 52.9 days
period 1000/365

(60+66)/2
Accounts payable = = 30.7 days
period 750/365

Operating cycle = 56.0 + 52.9 = 108.9 days
Cash cycle = 108.9 – 30.7 = 78.2 days
Rs.
3. 1. Sales 3,600,000
Less : Gross profit (25 per cent) 900,000
Total manufacturing cost 2,700,000
Less : Materials 900,000
Wages 720,000 1,620,000
Manufacturing expenses 1,080,000

2. Cash manufacturing expenses 960,000
(80,000 x 12)
3. Depreciation : (1) – (2) 120,000
4. Total cash cost
Total manufacturing cost 2,700,000
Less: Depreciation 120,000
Cash manufacturing cost 2,580,000
promotion expenses 360,000

2,940,000

A : Current Assets Rs.

Total cash cost 2,940,000
Debtors x 2 = x 2 = 490,000
12 12

Material cost 900,000
Raw material x 1 = x 1 = 75,000
stock 12 12

Cash manufacturing cost 2,580,000
Finished goods x 1 = x 1 = 215,000
stock 12 12

93

Cash balance A predetermined amount = 100,000

Sales promotion expenses 120,000
Prepaid sales x 1.5 = x 1.5 = 15,000
promotion 12 12
expenses
Cash balance A predetermined amount = 100,000

A : Current Assets = 995,000

B : Current Liabilites Rs.

Material cost 900,000
Sundry creditors x 2 = x 2 = 150,000
12 12

Manufacturing One month’s cash
expenses outstanding manufacturing expenses = 80,000

Wages outstanding One month’s wages = 60,000

B : Current liabilities 290,000

Working capital (A – B) 705,000
Add 20 % safety margin 141,000
Working capital required 846,000

94

Chapter 27
CASH AND LIQUIDITY MANAGEMENT

1. The forecast of cash receipts, cash payments, and cash position is prepared in the
statements given below

Forecast of Cash Receipts (Rs. in 000’s)

November December January February March April May June

1. Sales 120 120 150 150 150 200 200 200
2. Credit sales 84 84 105 105 105 140 140 140
3. Cash sales 36 36 45 45 45 60 60 60
4. Collection of receivables
(a) Previous month 33.6 33.6 42.0 42.0 42.0 56.0 56.0
(b) Two months earlier 50.4 50.4 63.0 63.0 63.0 84.0
5. Sale of machine 70.0
6. Interest on securities 3.0
7. Total receipts 129.0 137.4 150.0 235.0 179.0 203.0
(3+4+5+6)

Forecast of Cash Payments (Rs. in 000’s)

December January February March April May June

1. Purchases 60 60 60 60 80 80 80
2. Payment of accounts 60 60 60 60 80 80
payable
3. Cash purchases 3 3 3 3 3 3
4. Wage payments 25 25 25 25 25 25
5. Manufacturing
expenses 32 32 32 32 32 32
& selling expenses 15 15 15 15 15 15
95

7. Dividends 30
8. Taxes 35
9. Acquisition of
machinery 80

Total payments(2to9) 135 135 215 135 155 220

Summary of Cash Forecast (Rs.in 000’s)

January February March April May June

1. Opening balance 28
2. Receipts 129.0 137.4 150.0 235.0 179.0 203.0
3. Payments 135.0 135.0 215.0 135.0 155.0 220.0
4. Net cash flow(2-3) (6.0) 2.4 (65.0) 100.0 24.0 (17.0)
5. Cumulative net cash flow (6.0) (3.6) (68.6) 31.4 55.4 (38.4)
6. Opening balance +
Cumulative net cash flow 22.0 24.4 (40.6) 59.4 83.4 66.4
7. Minimum cash balance
required 30.0 30.0 30.0 30.0 30.0 30.0
8. Surplus/(Deficit) (8.0) (5.6) (70.6) 29.4 53.0 36.4

2. The projected cash inflows and outflows for the quarter, January through March, is shown below
.

Month December January February March
(Rs.) (Rs.) (Rs.) (Rs.)

Inflows :
Sales collection 50,000 55,000 60,000

Outflows :
Purchases 22,000 20,000 22,000 25,000
Payment to sundry creditors 22,000 20,000 22,000
Rent 5,000 5,000 5,000
Drawings 5,000 5,000 5,000
Salaries & other expenses 15,000 18,000 20,000
Purchase of furniture - 25,000 -

Total outflows(2to6) 47,000 73,000 52,000
96

Given an opening cash balance of Rs.5000 and a target cash balance of Rs.8000, the
surplus/deficit in relation to the target cash balance is worked out below :

January February March
(Rs.) (Rs.) (Rs.)

1. Opening balance 5,000
2. Inflows 50,000 55,000 60,000
3. Outflows 47,000 73,000 52,000
4. Net cash flow (2 - 3) 3,000 (18,000) 8,000
5. Cumulative net cash flow 3,000 (15,000) (7,000)
6. Opening balance + Cumulative
net cash flow 8,000 (10,000) (2,000)
7. Minimum cash balance required 8,000 8,000 8,000
8. Surplus/(Deficit) - (18,000) (10,000)

3. The balances in the books of Datta co and the books of the bank are shown below:

(Rs.)
1 2 3 4 5 6 7 8 9 10
Books of Datta
Co:

Opening
Balance
30,00
0
46,00
0
62,00
0
78,000
94,000
1,10,00
0
1,26,0
00
1,42,0
00
1,58,0
00
1,74,0
00
20,00
0
20,00
0
20,00
0
20,000
20,000

20,000

20,000

20,000

20,000

20,000
Less: Cheque
issued

4,000

4,000

4,000
4,000
4,000

4,000

4,000

4,000

4,000

4,000
Closing
Balance
46,00
0
62,00
0
78,00
0
94,000 1,10,0
00
1,26,00
0
1,42,0
00
1,58,0
00
1,74,0
00
1,90,0
00

Books of the
Bank:

Opening 30,00 30,00 30,00 30,000 30,000 30,000 50,000 70,000 1,06,0
97

Balance 0 0 0 90,000 00
realised
- - - - - 20,000 20,000 20,000
20,000

20,000
Less: Cheques
debited
- - - - - - - -
4,000

4,000
Closing
Balance
30,00
0
30,00
0
30,00
0
30,000 30,000 50,000 70,000 90,000 1,06,0
00
1,22,0
00

From day 9 we find that the balance as per the bank’s books is less than the balance as per Datta
Company’s books by a constant sum of Rs.68,000. Hence in the steady situation Datta Company has
a negative net float of Rs.68,000.

4. Optimal conversion size is
2bT
C =
I
b = Rs.1200, T= Rs.2,500,000, I = 5% (10% dividend by two)

So,
2 x 1200 x 2,500,000
C = = Rs.346,410
0.05

5.
3 3 bo
2

RP = + LL
4I

UL = 3 RP – 2 LL

I = 0.12/360 = .00033, b = Rs.1,500, o = Rs.6,000, LL = Rs.100,000

3 3 x 1500 x 6,000 x 6,000
RP = + 100,000
4 x .00033

= 49,695 + 100,000 = Rs.149,695

UL = 3RP – 2LL = 3 x 149,695 – 2 x 100,000
98

= Rs.249,085

Chapter 28
CREDIT MANAGEMENT

1. Δ RI = [ΔS(1-V)- ΔSb
n
](1-t)- k ΔI
Δ S
Δ I = x ACP x V
360
Δ S = Rs.10 million, V=0.85, b
n
=0.08, ACP= 60 days, k=0.15, t = 0.40

Hence, ΔRI = [ 10,000,000(1-0.85)- 10,000,000 x 0.08 ] (1-0.4)

-0.15 x 10,000,000 x 60 x 0.85

360
= Rs. 207,500

2. Δ RI = [ΔS(1-V)- ΔSb
n
] (1-t) – k Δ I

S
o
ΔS
Δ I = (ACP
N
– ACPo) +V(ACP
N
)
360 360

99

ΔS=Rs.1.5 million, V=0.80, b
n
=0.05, t=0.45, k=0.15, ACP
N
=60, ACP
o
=45, S
o
=Rs.15 million
Hence ΔRI = [1,500,000(1-0.8) – 1,500,000 x 0.05] (1-.45)

-0.15 (60-45) 15,000,000 + 0.8 x 60 x 1,500,000

360 360
= 123750 – 123750 = Rs. 0

3. Δ RI = [ΔS(1-V) –Δ DIS ] (1-t) + k Δ I
Δ DIS = p
n
(S
o
+ΔS)d
n
– p
o
S
o
d
o

S
o
ΔS
Δ I = (ACP
o
-ACP
N
) - x ACP
N
x V
360 360

S
o
=Rs.12 million, ACP
o
=24, V=0.80, t= 0.50, r=0.15, p
o
=0.3, p
n
=0.7,
ACP
N
=16, ΔS=Rs.1.2 million, d
o
=.01, d
n
= .02
Hence
ΔRI = [ 1,200,000(1-0.80)-{0.7(12,000,000+1,200,000).02-
0.3(12,000,000).01}](1-0.5)

12,000,000 1,200,000
+ 0.15 (24-16) - x 16 x 0.80
360 360

= Rs.79,200

4. Δ RI = [ΔS(1-V)- ΔBD](1-t) –kΔ I
ΔBD=b
n
(S
o
+ΔS) –b
o
S
o

S
o
ΔS
ΔI = (ACP
N
–ACP
o
) + x ACP
N
x V
360 360

S
o
=Rs.50 million, ACP
o
=25, V=0.75, k=0.15, b
o
=0.04, ΔS=Rs.6 million,
ACP
N
=40 , b
n
= 0.06 , t = 0.3

ΔRI = [ Rs.6,000,000(1-.75) –{.06(Rs.56,000,000)-.04(Rs.50,000,000)](1-0.3)

Rs.50,000,000 Rs.6,000,000
- 0.15 (40-25) + x 40 x 0.75
100

360 360

= - Rs.289.495

5. 30% of sales will be collected on the 10
th
day
70% of sales will be collected on the 50
th
day
ACP = 0.3 x 10 + 0.7 x 50 = 38 days

Rs.40,000,000
Value of receivables = x 38
360

= Rs.4,222,222
Assuming that V is the proportion of variable costs to sales, the investment in
receivables is :
Rs.4,222,222 x V

6. 30% of sales are collected on the 5
th
day and 70% of sales are collected on the
25
th
day. So,
ACP = 0.3 x 5 + 0.7 x 25 = 19 days

Rs.10,000,000
Value of receivables = x 19
360

= Rs.527,778
Investment in receivables = 0.7 x 527,778
= Rs.395,833

7. Since the change in credit terms increases the investment in receivables,
ΔRI = [ΔS(1-V)- ΔDIS](1-t) – kΔI
S
o
=Rs.50 million, ΔS=Rs.10 million, d
o
=0.02, p
o
=0.70, d
n
=0.03,p
n
=0.60,
ACP
o
=20 days, ACP
N
=24 days, V=0.85, k=0.12 , and t = 0.40
ΔDIS = 0.60 x 60 x 0.03 – 0.70 x 50 x 0.2
= Rs.0.38 million

50 10
Δ I = (24-20) + x 24 x 0.85
360 360

= Rs.1.2222 million
Δ RI = [ 10,000,000 (1-.85) – 380,000 ] (1-.4) – 0.12 x 1,222,222
= Rs.525,333

101

8. The decision tree for granting credit is as follows :

Customer pays(0.95)
Grant credit Profit 1500
Customer pays(0.85)
Grant credit Customer defaults(0.05)
Profit 1500 Refuse credit
Loss 8500
Customer defaults(0.15)
Loss 8500
Refuse credit

The expected profit from granting credit, ignoring the time value of money, is :

Expected profit on + Probability of payment x Expected profit on
Initial order and repeat order repeat order

{ 0.85(1500)-0.15(8500)} + 0.85 {0.95(1500)-.05(8500)}
= 0 + 850 = Rs.850

9. Profit when the customer pays = Rs.10,000 - Rs.8,000 = Rs.2000
Loss when the customer does not pay = Rs.8000
Expected profit = p
1
x 2000 –(1-p
1
)8000
Setting expected profit equal to zero and solving for p
1
gives :
p
1
x 2000 – (1- p
1
)8000 = 0 p
1
= 0.80
Hence the minimum probability that the customer must pay is 0.80

MINICASE
Solution:

Present Data
- Sales : Rs.800 million
- Credit period : 30 days to those deemed eligible
- Cash discount : 1/10, net 30
- Proportion of credit sales and cash sales are 0.7 and 0.3. 50 percent of the credit customers
avail of cash discount
- Contribution margin ratio : 0.20
- Tax rate : 30 percent
- Post-tax cost of capital : 12 percent
- ACP on credit sales : 20 days
102

Effect of Relaxing the Credit Standards on Residual Income

Incremental sales : Rs.50 million
Bad debt losses on incremental sales: 12 percent
ACP remains unchanged at 20 days

∆RI = [∆S(1 – V) - ∆Sb
n
] (1 – t) – R ∆ I

∆S
where ∆ I = x ACP x V
360

∆ RI = [50,000,000 (1-0.8) – 50,000,000 x 0.12] (1 – 0.3)

50,000,000
- 0.12 x x 20 x 0.8
360

= 2,800,000 – 266,667 = 2,533,333

Effect of Extending the Credit Period on Residual Income

∆ RI = [∆S(1 – V) - ∆Sb
n
] (1 – t) – R ∆ I

S
o
∆S
where ∆I = (ACP
n
– ACP
o
) + V (ACP
n
)
360 360

∆RI = [50,000,000 (1 – 0.8) – 50,000,000 x 0] (1 – 0.3)

800,000,000 50,000,000
- 0.12 (50 – 20) x + 0.8 x 50 x
360 360

= 7,000,000 – 8,666,667
= - Rs.1,666,667

Effect of Relaxing the Cash Discount Policy on Residual Income

∆RI = [∆S (1 – V) - ∆ DIS] (1 – t) + R ∆ I
where ∆ I = savings in receivables investment
S
o
∆S
103

= (ACP
o
– ACP
n
) – V x ACP
n

360 360

800,000,000 20,000,000
= (20 – 16) – 0.8 x x 16
360 360

= 8,888,889 – 711,111 = 8,177,778

∆ DIS = increase in discount cost
= p
n
(S
o
+ ∆S) d
n
– p
o
S
o
d
o
= 0.7 (800,000,000 + 20,000,000) x 0.02 – 0.5 x 800,000,000 x 0.01
= 11,480,000 – 4,000,000 = 7,480,000

So, ∆RI = [20,000,000 (1 – 0.8) – 7,480,000] (1 – 0.3) + 0.12 x 8,177,778
= - 2,436,000 + 981,333
= - 1,454,667

Chapter 29
INVENTORY MANAGEMENT

1.
a. No. of Order Ordering Cost Carrying Cost Total Cost
Orders Per Quantity (U/Q x F) Q/2xPxC of Ordering
Year (Q) (where and Carrying
(U/Q) PxC=Rs.30)
Units Rs. Rs. Rs.

1 250 200 3,750 3,950
2 125 400 1,875 2,275
5 50 1,000 750 1,750
10 25 2,000 375 2,375

2 UF 2x250x200
b. Economic Order Quantity (EOQ) = =
PC 30
104

2UF = 58 units (approx)
2. a EOQ =
PC
U=10,000 , F=Rs.300, PC= Rs.25 x 0.25 =Rs.6.25

2 x 10,000 x 300
EOQ = = 980
6.25
10000
b. Number of orders that will be placed is = 10.20
980
Note that though fractional orders cannot be placed, the number of orders
relevant for the year will be 10.2 . In practice 11 orders will be placed during the year. However,
the 11
th
order will serve partly(to the extent of 20 percent) the present year and partly(to the
extent of 80 per cent) the following year. So only 20 per cent of the ordering cost of the 11
th

order relates to the present year. Hence the ordering cost for the present year will be 10.2 x
Rs.300

c. Total cost of carrying and ordering inventories
980
= [ 10.2 x 300 + x 6.25 ] = Rs.6122.5
2
3. U=6,000, F=Rs.400 , PC =Rs.100 x 0.2 =Rs.20

2 x 6,000 x 400
EOQ = = 490 units
20

U U Q’(P-D)C Q* PC
Δπ = UD + - F- -
Q* Q’ 2 2

6,000 6,000
= 6000 x .5 + - x 400
490 1,000

1,000 (95)0.2 490 x 100 x 0.2
- -
2 2

= 30,000 + 2498 – 4600 = Rs.27898

105

4. U=5000 , F= Rs.300 , PC= Rs.30 x 0.2 = Rs.6

2 x 5000 x 300
EOQ = = 707 units
6
If 1000 units are ordered the discount is : .05 x Rs.30 = Rs.1.5 Change in
profit when 1,000 units are ordered is :

5,000 5,000
Δπ = 5000 x 1.5 + - x 300
707 1,000

1000 x 28.5 x 0.2 707 x 30 x 0.2
- - = 7500 + 622-729 =Rs.7393
2 2

If 2000 units are ordered the discount is : .10 x Rs.30 = Rs.3 Change in profit
when 2,000 units are ordered is :

5000 5000 2000x27x0.2 707x30x0.2
Δπ = 5000 x 3.0 + - x 300- -
707 2000 2 2

= 15,000 +1372 – 3279 = Rs.13,093

5. The quantities required for different combinations of daily usage rate(DUR)
and lead times(LT) along with their probabilities are given in the following
table

LT
(Days)
DUR 5(0.6) 10(0.2) 15(0.2)
(Units)

4(0.3) 20*(0.18) 40(0.06) 60(0.06)
6(0.5) 30 (0.30) 60(0.10) 90(0.10)
8(0.2) 40 (0.12) 80(0.04) 120(0.04)

*
Note that if the DUR is 4 units with a probability of 0.3 and the LT is 5 days with
106

a probability of 0.6, the requirement for the combination DUR = 4 units and LT =
5 days is 20 units with a probability of 0.3x0.6 = 0.18. We have assumed that the
probability distributions of DUR and LT are independent. All other entries in the
table are derived similarly.
The normal (expected) consumption during the lead time is :
20x0.18 + 30x0.30 + 40x0.12 + 40x0.06 + 60x0.10 + 80x0.04 + 60x0.06 + 90x0.10 +
120x0.04 = 46.4 tonnes

a. Costs associated with various levels of safety stock are given below :

Safety Stock Stock out Probability Expected Carrying Total Cost
Stock* outs(in Cost Stock out Cost
tonnes)

1 2 3 4 5 6 7
[3x4] [(1)x1,000] [5+6]

Tonnes Rs. Rs. Rs.
73.6 0 0 0 0 73,600 73,600
43.6 30 120,000 0.04 4,800 43,600 48,400

33.6 10 40,000 0.10
40 160,000 0.04 10,400 33,600 44,000

13.6 20 80,000 0.04
30 120,000 0.10 24,800 13,600 38,400
60 240,000 0.04

0 13.6 54,400 0.16
33.6 134,400 0.04 43,296 0 43,296
107

43.6 174,400 0.10
73.6 294,400

*
Safety stock = Maximum consumption during lead time – Normal
So the optimal safety stock= 13.6 tonnes
Reorder level = Normal consumption during lead time + safety stock
K= 46.4 + 13.6 = 60 tonnes

b. Probability of stock out at the optimal level of safety stock = Probability
(consumption being 80 or 90 or 120 tonnes)

Probability (consumption = 80 tonnes) + Probability (consumption = 90 tonnes) +
Probability (consumption = 120 tonnes)
= 0.04 +0.10+0.04 = 0.18

6. Reorder point is given by the formula : S(L) + F SR (L)

= 30 x 40 + 2.00 30 x 1,000 x 40 = 3,391 units

7.
Item Annual Usage Price per Annual Ranking
(in Units) Unit Usage Value
Rs. Rs.

1 400 20.00 8,000 6
2 15 150.00 2,250 10
3 6,000 2.00 12,000 5
4 750 18.00 13,500 4
5 1,200 25.00 30,000 1
6 25 160.00 4,000 9
7 300 2.00 600 14
8 450 1.00 450 15
9 1,500 4.00 6,000 7
10 1,300 20.00 26,000 2
11 900 2.00 1,800 11
12 1,600 15.00 24,000 3
13 600 7.50 4,500 8
14 30 40.00 1,200 12
15 45 20.00 900 13

1,35,200
108

Cumulative Value of Items & Usage

Item Rank Annual Cumulative Cumulative Cumulative
No. UsageValue Annual Usage % of Usage % of Items
(Rs.) Value (Rs.) Value

5 1 30,000 30,000 22.2 6.7
10 2 26,000 56,000 41.4 13.3
12 3 24,000 80,000 59.2 20.0
4 4 13,500 93,500 69.2 26.7
3 5 12,000 105,500 78.0 33.3
1 6 8,000 113,500 83.9 40.0
9 7 6,000 119,500 88.4 46.7
13 8 4,500 124,000 91.7 53.3
6 9 4,000 128,000 94.7 60.0
2 10 2,250 130,250 96.3 66.7
11 11 1,800 132,050 97.7 73.3
14 12 1,200 133,250 98.6 80.0
15 13 900 134,150 99.2 86.7
109

7 14 600 134,750 99.7 93.3
8 15 450 135,200 100.0 100.0

Class No. of Items % to the Total Annual Usage % to Total Value
Value Rs.

A 4 26.7 93,500 69.2
B 3 20.0 26,000 19.2
C 18 53.3 15,700 11.6

15 135,200

Chapter 30
WORKING CAPITAL FINANCING

1. Annual interest cost is given by ,
Discount % 360
x
1- Discount % Credit period – Discount period

Therefore, the annual per cent interest cost for the given credit terms will be as
follows:

a. 0.01 360
x = 0.182 = 18.2%
0.99 20

b. 0.02 360
x = 0.367 = 36.7%
0.98 20

c. 0.03 360
x = 0.318 = 31.8%
0.97 35

110

d. 0.01 360
x = 0.364 = 36.4%
0.99 10

2.
a.
0.01 360
x = 0.104 = 10.4%
0.99 35

b. 0.02 360
x = 0.21 = 21%
0.98 35

c. 0.03 360
x = 0.223 = 22.3%
0.97 50

d. 0.01 360
x = 0.145 = 14.5%
0.99 25
3. The maximum permissible bank finance under the three methods suggested by
The Tandon Committee are :

Method 1 : 0.75(CA-CL) = 0.75(36-12) = Rs.18 million
Method 2 : 0.75(CA)-CL = 0.75(36-12 = Rs.15 million
Method 3 : 0.75(CA-CCA)-CL = 0.75(36-18)-12 = Rs.1.5 million

111

Chapter 31
WORKING CAPITAL MANAGEMENT :EXTENSIONS

1.(a) The discriminant function is :

Z
i
= aX
i
+ bY
i

where Z
i
= discriminant score for the ith account
X
i
= quick ratio for the ith account
Y
i
= EBDIT/Sales ratio for the ith account

The estimates of a and b are :
o
y
2
. dx - o
xy
. dy
a =
o
x

2
. o
y
2
- o
xy
.o
xy

o
x
2
. dy ÷ o
xy
. dx
b =
o
x
2
. o
y
2
÷ o
xy
. o
xy

The basic calculations for deriving the estimates of a and b are given
the accompanying table.
112

Drawing on the information in the accompanying table we find that

¿X
i
= 19.81 ¿Y
i
= 391 ¿(X
i
-X)
2
¿(Y
i
-Y)
2
¿(X
i
-X)(Y
i
-Y)

X = 0.7924 Y = 15.64 = 0.8311 =1661.76 = 10.007

Account X
i
Y
i
(X
i
-X) (Y
i
-Y) (X
i
-X
)2
(Y
i
-Y
)2
(X
i
-X)(Y
i
-Y)
Number

1 0.90 15 0.1076 -0.64 0.0116 0.4096 -0.0689
2 0.75 20 -0.0424 4.36 0.0018 19.0096 -0.1849
3 1.05 10 -0.2576 -5.64 0.0664 31.8096 -1.4529
4 0.85 14 0.0576 -1.64 0.0033 2.6896 -0.0945
G 5 0.65 16 -0.1424 0.36 0.0203 0.1296 -0.513
R 6 1.20 20 0.4076 4.36 0.1661 19.0096 1.7771
O 7 0.90 24 0.1076 8.36 0.0116 69.8896 0.8995
U 8 0.84 26 0.0476 10.36 0.0023 107.3296 0.4931
P 9 0.93 11 0.1376 -4.64 0.0189 21.5296 -0.6385
10 0.78 18 -0.0124 2.36 0.0002 5.5696 -0.0293
I 11 0.96 12 0.1676 -3.64 0.0281 13.2496 -0.6101
12 1.02 25 0.2276 9.36 0.0518 87.6096 2.1303
13 0.81 26 0.0176 10.36 0.0003 107.3296 0.1823
14 0.76 30 -0.0324 14.36 0.0010 206.2096 -0.4653
15 1.02 28 0.2276 12.36 0.0518 152.7696 2.8131

16 0.76 10 -0.0324 -5.64 0.0010 31.8069 0.1827
17 0.68 12 -0.1124 -3.64 0.0126 13.2496 0.4091
G 18 0.56 4 -0.2324 -11.64 0.0540 135.4896 2.7051
R 19 0.62 18 -0.1724 2.36 0.0297 5.5696 -0.4069
O 20 0.92 -4 0.1276 -19.64 0.0163 385.7296 -2.5061
U 21 0.58 20 -0.2124 4.36 0.0451 19.0096 -0.9261
P 22 0.70 8 -0.0924 - 7.64 0.0085 58.3696 0.7059
23 0.52 15 –0.2724 -0.64 0.0742 0.4096 0.1743
II 24 0.45 6 –0.3424 -9.64 0.1172 92.9296 3.3007
25 0.60 7 –0.1924 -8.64 0.0370 74.6496 1.6623

19.81 391 0.8311 1661.76 9.539

Sum of X
i
for group 1 13.42
X
1
= = = 0.8947
15 15

113

Sum of X
i
for group 2 6.39
X
2
= = = 0.6390
10 10

Sum of Y
i
for group 1 295
Y
1
= = = 19.67
15 15

Sum of Y
i
for group 2 96
Y
2
= = = 9.60
10 10

1 0.8311
o
x

2
= ¿(X
i
–X)
2
= = 0.0346
n-1 25-1

1 1661.76
o
y
2
= ¿(Y
i
– Y)
2
= = 69.24
n-1 25-1

1 10.0007
o
xy
= ¿(X
i
-X)(Y
i
-Y) = = 0.4167
n-1 25-1

dx = X
1
- X
2
= 0.8947 – 0.6390 = 0.2557

dy = Y
1
– Y
2
= 19.67 – 9.60 = 10.07

Substituting these values in the equations for a and b we get :

69.24 x 0.2557 – 0.4167 x 10.07
a = = 6.079
0.0346 x 69.24 – 0.4167 x 0.4167

0.0346 x 10.07 – 0.4167 x 0.2557
b = = 0.1089
0.0346 x 69.24 – 0.4167 x 0.4167

Hence , the discriminant function is :
Z
i
= 6.079 X
i
+ 0.1089 Y
i

(b) Choice of the cutoff point
The Z
i
score for various accounts are shown below
114

Z
i
scores for various accounts

Account No. Z
i
Score

1 7.1046
2 6.7373
3 7.4720
4 6.6918
5 5.6938
6 9.4728
7 8.0847
8 7.9378
9 6.8514
10 6.7018
11 7.1426
12 8.9231
13 7.7554
14 7.8870
15 9.2498
16 5.7090
17 5.4405
18 3.8398
19 5.7292
20 5.1571
21 5.7038
22 5.1265
23 4.7946
24 3.3890
25 4.4097

The Z
i
scores arranged in an ascending order are shown below

Good(G)
Account Number Z
i
Score or

24 3.3890 B
18 3.8398 B
25 4.4097 B
23 4.7946 B
22 5.1265 B
20 5.1571 B
17 5.4405 B
115

5 5.6938 G
21 5.7038 B
16 5.7090 B
19 5.7292 B
4 6.6918 G
10 6.7018 G
2 6.7373 G
9 6.8514 G
1 7.1046 G
11 7.1426 G
3 7.4720 G
13 7.7554 G
14 7.8870 G
8 7.9378 G
7 8.0847 G
12 8.9231 G
15 9.2498 G
6 9.4728 G

From the above table, it is evident that a Z
i
score which represents the mid-point between the
Z
i
scores of account numbers 19 and 4 results in the minimum number of misclassifications . This Z
i
score is :

5.7292 + 6.6918
= 6.2105
2
Given this cut-off Z
i
score, there is just one misclassification (Account number 5)

116

Chapter 4
ANALYSING FINANCIAL PERFORMANCE

Net profit
1. Return on equity =
Equity

= Net profit Net sales Total assets
x x
Net sales Total assets Equity

1
= 0.05 x 1.5 x = 0.25 or 25 per cent
0.3

Debt Equity
Note : = 0.7 So = 1-0.7 = 0.3
Total assets Total assets

Hence Total assets/Equity = 1/0.3

2. PBT = Rs.40 million
PBIT
Times interest covered = = 6
117

Interest

So PBIT = 6 x Interest
PBIT – Interest = PBT = Rs.40 million
6 x Interest = Rs.40 million
Hence Interest = Rs.8 million

3. Sales = Rs.7,000,000
Net profit margin = 6 per cent
Net profit = Rs.7000000 x 0.06 = 420,000
Tax rate = 60 per cent
420,000
So, Profit before tax = = Rs.1,050,000
(1-.6)
Interest charge = Rs.150,000

So Profit before interest and taxes = Rs.1,200,000
Hence

1,200,000
Times interest covered ratio = = 8
150,000

4. CA = 1500 CL = 600
Let BB stand for bank borrowing
CA+BB
= 1.5
CL+BB

1500+BB
= 1.5
600+BB

BB = 120

1,000,000
5. Average daily credit sales = = 2740
365
160000
ACP = = 58.4
2740

If the accounts receivable has to be reduced to 120,000 the ACP must be:
118

120,000
x 58.4 = 43.8days
160,000

Current assets
6. Current ratio = = 1.5
Current liabilities

Current assets - Inventories
Acid-test ratio = = 1.2
Current liabilities

Current liabilities = 800,000
Sales
Inventory turnover ratio = = 5
Inventories
Current assets - Inventories
Acid-test ratio = = 1.2
Current liabilities

Current assets Inventories
This means - = 1.2
Current liabilities Current liabilities

Inventories
1.5 - = 1.2
800,000

Inventories
= 0.3
800,000

Inventories = 240,000

Sales
= 5 So Sales = 1,200,000
2,40,000

7. Debt/equity = 0.60
Equity = 50,000 + 60,000 = 110,000
So Debt = 0.6 x 110,000 = 66,000
Hence Total assets = 110,000+66,000 = 176,000
119

Total assets turnover ratio = 1.5
So Sales = 1.5 x 176,000 = 264,000
Gross profit margin = 20 per cent
So Cost of goods sold = 0.8 x 264,000 = 211,200
Day’s sales outstanding in accounts receivable = 40 days
Sales
So Accounts receivable = x 40
360

264,000
= x 40 = 29,333
360

Cost of goods sold 211,200
Inventory turnover ratio = = = 5
Inventory Inventory

So Inventory = 42,240

Assuming that the debt of 66,000 represent current liabilities
Cash + Accounts receivable
Acid-test ratio =
Current liabilities

Cash + 29,333
= = 1.2
66,000
So Cash = 49867

Plant and equipment = Total assets - Inventories – Accounts receivable – Cash
= 176,000 - 42240 - 29333 – 49867
= 54560

Pricing together everything we get

Balance Sheet
Equity capital 50,000 Plant & equipment 54,560
Retained earnings 60,000 Inventories 42,240
Debt(Current liabilities) 66,000 Accounts receivable 29,333
Cash 49,867

176,000 176,000

Sales 264,000
120

Cost of goods sold 211,200

Cash & bank balances + Receivables + Inventories + Pre-paid expenses
8. (i) Current ratio =
Short-term bank borrowings + Trade creditors + Provisions

5,000,000+15,000,000+20,000,000+2,500,000
=
15,000,000+10,000,000+5,000,000

42,500,000
= = 1.42
30,000,000

Current assets – Inventories 22,500,000
(ii) Acid-test ratio = = = 0.75
Current liabilities 30,000,000

Long-term debt + Current liabilities
(iii) Debt-equity ratio =
Equity capital + Reserves & surplus

12,500,000 + 30,000,000
= = 1.31
10,000,000 + 22,500,000

Profit before interest and tax
(iv) Times interest coverage ratio =
Interest

15,100,000
= = 3.02
5,000,000

Cost of goods sold 72,000,000
(v) Inventory turnover period = = = 3.6
Inventory 20,000,000
365
(vi) Average collection period =
Net sales/Accounts receivable
365
= = 57.6 days
121

95,000,000/15,000,000

Net sales 95,000,000
(vii) Total assets turnover ratio = = = 1.27
Total assets 75,000,000

Profit after tax 5,100,000
(ix) Net profit margin = = = 5.4%
Net sales 95,000,000

PBIT 15,100,000
(x) Earning power = = = 20.1%
Total assets 75,000,000

Equity earning 5,100,000
(xi) Return on equity = = = 15.7%
Net worth 32,500,000

The comparison of the Omex’s ratios with the standard is given below

Omex Standard
Current ratio 1.42 1.5
Acid-test ratio 0.75 0.80
Debt-equity ratio 1.31 1.5
Times interest covered ratio 3.02 3.5
Inventory turnover ratio 3.6 4.0
Average collection period 57.6 days 60 days
Total assets turnover ratio 1.27 1.0
Net profit margin ratio 5.4% 6%
Earning power 20.1% 18%
Return on equity 15.7% 15%

Note that solutions to problems 10 & 11 are not given

MINICASE

Solution:

(a) Key ratios for 20 X 5
12.4
Current ratio = = 0.93
13.4
122

8.8 + 6.7
Debt-equity ratio = = 0.98
6.5 + 9.3

57.4
Total assets turnover ratio = = 1.96
[(34 – 6.6) + (38 – 6.7)] / 2

3.0
Net profit margin = = 5.2 percent
57.4

5
Earning power = = 17.0 percent
[(34 – 6.6) + (38 – 6.7)] / 2

3.0
Return on equity = = 20.2 percent
(13.9 + 15.8) / 2

(b) Dupont Chart for 20 x 5

÷

Return on
total assets
10.2%
Net profit
margin
5.2%
Net profit
3.0

Net sales
57.4
Net sales
57.4
Net sales +/-
Non-op. surplus
deficit 57.8
Total costs
54.8
123

÷

+

+

(c) Common size and common base financial statements

Common Size Financial Statements
Profit and Loss Account

Regular (in million) Common Size (%)
20 X 4 20 X 5 20 X 4 20 X 5
- Net sales 39.0 57.4 100 100
- Cost of goods sold 30.5 45.8 78 80
- Gross profit 8.5 11.6 22 20
- Operating expenses 4.9 7.0 13 12
- Operating profit 3.6 4.6 9 8
- Non-operating surplus /
deficit
0.5 0.4 1 1
- PBIT 4.1 5.0 11 9
- Interest 1.5 2.0 4 3
- PBT 2.6 3.0 7 5
- Tax - - - -
- Profit after tax 2.6 3.0 7 5

Balance Sheet
Total asset
turnover
1.96

Average total
assets
29.35

Average
fixed assets
21.4

Average
net current
assets 54.0
Average
other assets
2.55
124

Regular (in million) Common Size (%)
20 X 4 20 X 5 20 X 4 20 X 5
- Shareholders’ funds 13.9 15.8 51 50
- Loan funds 13.5 15.5 49 50
Total 27.4 31.3 100 100
- Net fixed assets 19.6 23.2 72 74
- Net current assets 5.1 5.7 19 18
- Other assets 2.7 2.4 10 8
Total 27.4 31.3 100 100

Common Base Year Financial Statements
Profit and Loss Account

Regular (in million) Common Base Year(%)
20 X 4 20 X 5 20 X 4 20 X 5
- Net sales 39.0 57.4 100 147
- Cost of goods sold 30.5 45.8 100 150
- Gross profit 8.5 11.6 100 136
- Operating expenses 4.9 7.0 100 43
- Operating profit 3.6 4.6 100 128
- Non-operating surplus /
deficit
0.5 0.4 100 80
- PBIT 4.1 5.0 100 122
- Interest 1.5 2.0 100 133
- PBT 2.6 3.0 100 115
- Tax - - 100 100
- Profit after tax 2.6 3.0 100 115

Balance Sheet

Regular (in million) Common Base Year(%)
20 X 4 20 X 5 20 X 4 20 X 5
125

- Shareholders’ funds 13.9 15.8 100 114
- Loan funds 13.5 15.5 100 115
Total 27.4 31.3 100 114
- Net fixed assets 19.6 23.2 100 118
- Net current assets 5.1 5.7 100 112
- Other assets 2.7 2.4 100 89
Total 27.4 31.3 100 114

(d) The financial strengths of the company are:

- Asset productivity appears to be good.
- Earning power and return on equity are quite satisfactory
- Revenues have grown impressively over 20 x 4 – 20 x 5

The financial weaknesses of the company are:

- Current ratio is unusually low
- While revenues grew impressively, costs rose even faster: As a result profit margins
declined
- The company did not have any tax liability in the last two years. If the company has to
bear the burden of regular taxes, its return on equity will be adversely impacted

(e) The following are the problems in financial statement analysis

- There is no underlying theory
- It is difficult to find suitable benchmarks for conglomerate firms
- Firms may resort to window dressing
- Financial statements do not reflect price level changes
- Diversity of accounting policies may vitiate financial statement analysis
- It is somewhat difficult to judge whether a certain ratio is ‘good’ or ‘bad’

(f) The qualitative factors relevant for evaluating the performance and prospects of a
company are as follows:

- Are the company’s revenues tied to one key customer?
- To what extent are the company’s revenues tied to one key product?
- To what extent does the company rely on a single supplier?
- What percentage of the company’s business is generated overseas?
- How will competition impact the company?
- What are the future prospects of the firm?
- What could be the effect of the changes in the legal and regulatory environment?

126

Chapter 5
BREAK-EVEN ANALYSIS AND LEVERAGES

1. a. EBIT = Q(P-V)-F
= 20,000(10-6)-50,000 = Rs.30,000

b. EBIT = 12,000(50-30)-200,000 = Rs.40,000

2. EBIT = Q(P-V)-F
EBIT=Rs.30,000 , Q=5,000 , P=Rs.30 , V=Rs.20
So, 30,000 = 5,000(30-20)-F
So, F = Rs.20,000.

Q(P-V)
3. DOL =
Q(P-V)-F

P=Rs.1,000 ,V=Rs.600, F=Rs.100,000

400(1,000-600)
DOL(Q=400) = = 2.67
400(1,000-600)-100,000

127

600(1,000-600)
DOL(Q=600) = = 1.71
600(1,000-600)-1,00,000

4. DOL(Q=15000) = 2.5
EBIT(Q=15000) = Rs.3,00,000

Percentage change in EBIT = DOL x Percentage change in Q
If the percentage change in Q is –10%
Percentage change in EBIT = 2.5 x –10% = - 25%
If the percentage change in Q is + 5%
Percentage change in EBIT = 2.5 x 5% = 12.5%

Hence the possible forecast errors of EBIT in percentage terms is –25% to
12.5%
The corresponding value range of EBIT is Rs.225,000 to Rs.337,500

5. Break even point in units
F 50,000
Q = = =10,000 units
P-V 12-7

Break even point in rupees:
Q x P = 10,000 x Rs.12 = Rs,120,000
To earn a pre-tax income of Rs.60,000 the number of units to be sold is

F + Target pre-tax income
Q =
P-V
= 50,000 + 60,000
= 22,000 units
12-7
To earn an after-tax income of Rs.60,000 if the tax rate is 40 per cent, the
Pre-tax income must be Rs.60,000
= Rs.100,000
1-.4
Hence the number of units to be sold to earn an after-tax income of Rs.60,000
is :
50,000 + 100,000
Q = = 30,000 units
12-7
128

6. P-V
= 0.30 P-V = Rs.6 F=20,000
P

20000 6
Q = = 3,333 P = = Rs.20
6 0.30

Break even point in rupees = Rs.66,666

When net income is Rs.60,000
20,000 +60,000
Q = = 13,333
6
Sales in rupees = 13,333 x Rs.20 = Rs.266,666

10,000
7. (a) P = Rs.30 ,V=Rs.16, F=Rs.10,000 Q = = 714.3 bags
30-16

(b) Profit when the quantity is 3000 bags
Profit =3,000(30-16)-10000 = Rs.32000
10 per cent increase in production means that the quantity is 3300 bags
At that production
Profit = 3,300(30-16)-10,000 = Rs.36200
So, the percentage change in profit is :
36200-32000
= 13.1%
32000

(c) A 10 per cent increase in selling price means that P= Rs.33
Break-even point when P= Rs.33

10,000
Q = = 588.2 bags
33-16

(d) A 50 per cent increase in fixed costs means that F=Rs.15,000
Break-even point when F= Rs.15,000
15,000
129

Q = = 882.4 bags
33-16
(e) If V= Rs.20, the break-even point is :
10,000
Q = = 1000 bags
30-20

8. A B C D
Selling price per unit Rs.10 Rs.16.66 Rs.20 Rs.10
Variable cost per unit Rs.6 Rs.8.33 Rs.12 Rs.5
Contribution margin per unit Rs.4 Rs.8.33 Rs.8 Rs.5
Contribution margin ratio 0.4 0.5 0.4 0.5
Total fixed costs Rs.16000 Rs.100000 Rs.160000 Rs.60000
Break-even point in units 4000 12000 20000 12000
Break-even sales(Rs.) Rs.40000 Rs.200000 Rs.400000 Rs.120000
Net income(loss)before tax Rs.30000 Rs.80000 Rs.(40000) Rs.40000
No.of units sold 11500 21600 15000 20000

9. (a) Break-even point for product P
30,000
= 3,000 units
30-20

Break-even point for product Q
100,000
= 5,000 units
50-30
Break-even point for product R
200,000
= 5,000 units
80-40

(b) The weighted contribution margin is :
5000 8,000 6,000
x Rs.10 + x Rs.20 + x Rs.40 = Rs.23.68
19000 19000 19000

10. EBIT
DFL =
D
p

130

EBIT – I -
T
at Q = 20000
EBIT= 20000(Rs.40-Rs.24)=Rs.320,000

Rs.320,000
DFL(Q=20,000) =
Rs.10,000
Rs.320,000-Rs.30,000 -
(1-.5)
= 1.185

11. (a) EBIT = Q(P-V) – F

Firm A : 20,000(Rs.20-Rs.15) – Rs.40,000 = Rs.60,000
Firm B : 10,000(Rs.50-Rs.30) - Rs.70,000 = Rs.130,000
Firm C : 3,000(Rs.100-Rs.40)- Rs.100,000 = Rs.80,000
(EBIT-I) (1-T) - D
p

(b) EPS =
n

(Rs.60,000-Rs.10,000)(1-.4)-Rs.5,000
Firm A : = Rs.1.9
10,000

(Rs.130,000-Rs.20,000)(1-.5)-Rs.5,000
Firm B : = Rs.4.17
12,000

(Rs.80,000-Rs.40,000)(1-.6)-Rs.10,000
Firm C : = Rs.0.40
15,000
F + I
(c) BEP =
P – V

Rs.40,000 + Rs.10,000
Firm A : = 10,000 units
Rs.20 – Rs.15

Rs.70,000 + Rs.20,000
Firm B : = 4,500 units
131

Rs.50 – Rs.30

Rs.100,000 + Rs.40,000
Firm C : = 2,333 units
Rs.100 – Rs.40

Q(P-V)
(d) DOL =
Q(P-V)-F

20,000(Rs.20-Rs.15)
Firm A : = 1.67
20,000(Rs.20-Rs.15)- Rs.40,000

10,000(Rs.50-Rs.30)
Firm B : = 1.54
10,000(Rs.50-Rs.30)-Rs.70,000

3,000(Rs.100-Rs.40)
Firm C : = 2.25
3,000(Rs.100-Rs.40)-Rs.100,000

EBIT
(e) DFL =
D
p

EBIT – I -
(1-T)

Rs.60,000
Firm A : = 1.44
Rs.5000
Rs.60,000-Rs.10,000 -
(1-.4)

Rs.130,000
Firm B : = 1.30
Rs.5,000
Rs.130,000-Rs.20,000 -
(1-.5)

Rs.80,000
Firm C : = 5.333
Rs.10,000
Rs.80,000-Rs.40,000-
132

(1-.6)
(f) DTL = DOL x DFL

Firm A : 1.67 x 1.44 = 2.40
Firm B : 1.54 x 1.30 = 2.00
Firm C : 2.25 x 5.333 = 12.00

Chapter 6
FINANCIAL PLANNING AND BUDGETING

1. The proforma income statement of Modern Electronics Ltd for year 3 based on the per cent
of sales method is given below

Average per cent Proforma income statement
of sales for year 3 assuming sales of
1020

Net sales 100.0 1020.0
Cost of goods sold 76.33 778.57
Gross profit 23.67 241.43
Selling expenses 7.40 75.48
General & administration expenses 6.63 67.63
Depreciation 6.75 68.85
Operating profit 2.90 29.58
Non-operating surplus/deficit 1.07 10.91
Earnings before interest and taxes 3.96 40.39
Interest 1.24 12.65
Earnings before tax 2.72 27.74
Tax 1.00 10.20
Earnings after tax 1.72 17.54
133

Dividends (given) 8.00
Retained earnings 9.54

2. The proforma income statement of Modern Electronics for year 3 using the
the combination method is given below :

Average per cent Proforma income statement
of sales for year 3

Net sales 100.0 1020.0
Cost of goods sold 76.33 778.57
Gross profit 23.67 241.43
Selling expenses 7.40 75.48
General & administration expenses Budgeted 55.00
Depreciation Budgeted 60.00
Operating profit 50.95
Non-operating surplus/deficit 1.07 10.91
Earnings before interest and taxes 61.86
Interest Budgeted 12.0
Earnings before tax 49.86
Tax 1.00 10.20
Earnings after tax 39.66
Dividends (given) Budgeted 8.00
Retained earnings 31.66

134

3. The proforma balance sheet of Modern Electronics Ltd for year 3 is given below

Average of percent Projections for year 3
of sales or some based on a forecast
other basis sales of 1400

Net sales 100.0 1020.0

ASSETS
Fixed assets (net) 40.23 410.35
Investments No change 20.00

Current assets, loans & advances :
Cash and bank 1.54 15.71
Receivables 22.49 229.40
Inventories 21.60 220.32

Prepaid expenses 5.09 51.92
Miscellaneous expenditure & losses No change 14.00

961.70

LIABILITIES :

135

Share capital :
Equity No change 150.00
Reserves & surplus Proforma income 160.66
statement

Secured loans:
Term loans No change 175.00
Bank borrowings No change 199.00

Current liabilities :
Provisions 5.03 51.31

External funds requirement Balancing figure 48.96

961.7

A L
4. EFR = - AS – m S
1
(1-d)
S S

800 190
= - 300 – 0.06 x 1,300 (1-0.5)
1000 1000

= (0.61 x 300) – (0.06) x 1,300 x (0.5)

= 183 – 39 = Rs.144.

Projected Income Statement for Year Ending 31
st
December , 2001

Sales 1,300
Profits before tax 195
Taxes 117
Profit after tax (6% on sales) 78
Dividends 39
Retained earnings 39

136

Projected Balance Sheet as at 31.12 2001

Liabilities Assets

Share capital 150 Fixed assets 520
Retained earnings 219 Inventories 260
Term loans (80+72) 152 Receivables 195
Short-term bank borrowings 272 Cash 65
(200 + 72)
Accounts payable 182
Provisions 65

1,040 1,040

A L
5. (a) EFR = - AS – m S
1
(1 –d)
S S

150 30
= - x 80 – (0.625) x 240 x (0.5)
160 160

= (60 – 7.5) = 52.5

(b) Projected Balance Sheet as on 31.12.20X1

Liabilities Assets

Share capital 56.25 Net fixed assets 90
Retained earnings 47.50 Inventories 75
(40 + 7.5)
Term loans 46.25 Debtors 45
Short-term bank 30.00 Cash 15
borrowings
Provisions 7.50

225.00 225.00

137

(c) 20X0 20X1
i) Current ratio 1.50 1.80
ii) Debt to total assets ratio 0.53 0.54
iii) Return on equity 14.3% 14.5%

(d)
A L
EFR 20X1= - AS – mS
1
(1 – d)
S S

150 30
= - 20 – 0.0625 x 180 x 0.5
160 160

= 9.38

150 x (1.125) 30 x 1.125
EFR 20X2 = - x 20 – 0.0625 x 200 x 0.5
180 180

168.75 33.75
= - x 20 –0.0625 x 220 x 0.5
180 180

= 8.75

168.75 x (1.11) 33.75 x (1.11)
EFR 20X3 = - 20 – 0.0625 x 220 x 0.5
200 200

187.31 37.46
= - x 20 – 6.88
200 200

= 8.11

187.31 x (1.1) 37.46 x (1.1)
EFR 20X4 = - x 20 – 0.0625 x 240 x 0.5
220 220

= 7.49
138

Balance Sheet as on 31
st
December, 20X4

Liabilities Rs. Assets Rs.

Share capital 46.87 Net fixed assets 90.00
(30+16.87) (60 x 240/160)
Retained earnings Inventories
(40.00+5.63+6.25+6.88+7.50) 66.26 (50x240/160) 75.00
Term loans(20+16.87) 36.87 Debtors (30x240/160) 45.00
Short-term bank borrowings 30.00 Cash (10x240/160) 15.00
Provisions 7.50

225.00 225.00

6. EFR A L m (1+g) (1-d)
= - -
AS S S g
Given A/S= 0.8 , L/S= 0.5 , m= 0.05 , d= 0.6 and EFR = 0 we have,

(0.05)(1+g)(0.4)
(0.8-0.5) - = 0
g

(0.05)(1+g)(0.4)
i.e. 0.3 - = 0
g

Solving the above equation we get g = 7.14%

A L
7. (a) EFR = - AS – mS
1
(1-d)
S S

320 70
= - x 100 – (0.05) (500) (0.5)
400 400

= Rs.50

(b) Let CA = denote Current assets
139

CL = Current liabilities
SCL = Spontaneous current liabilities
STL = Short-term bank borrowings
FA = Fixed assets
and LTL = Long-term loans

i. Current ratio > 1.25
CA
i.e greater than or equal to 1.25 or
CL

CA
> 1.25
STL +SCL

As at the end of 20X1, CA = 20x0 x 1.25 = 237.50
SCL = 70 x 1.25 = 87.50
Substituting these values, we get
1.25 (STL + 87.5) s 237.50
or 1.25 STL s 237.50 ÷ (8.50 x 1.25)

1285.125
or STL =
1.25
i.e STL s Rs.102.50

ii. Ratio of fixed assets to long term loans > 1.25
FA
> 1.25
LTL
At the end of 20X1 FA = 130 x 1.25 = 162.5
162.5
LTL s or LTL = Rs.130
1.25
If A STL and A LTL denote the maximum increase in ST borrowings & LT

borrowings , we have :
A STL = STL (20X1) – STL (20X1) = 102.50 – 60.00 = 42.50
A LTL = LTL (20X1)- LTL (20X1) = 130.00 – 80.00 = 50.00
Hence, the suggested mix for raising external funds will be :
Short-term borrowings 42.50
Long-term loans 7.50
140

50.00

A L
8. EFR = - A S – m S
1
(1-d)
S S
A S
Therefore, mS
1
(1-d) – - AS represents surplus funds
S S
Given m= 0.06, S
1
=11,000, d= 0.6 , L= 3,000 S= 10,000 and
surplus funds = 150 we have
A 3,000
(0.06) 11,000 (1-0.6) - - 1,000 = 150
10,000 10,000

A – 3,000
= (0.06) (0.4) (11,000) – 150 = 114
10

or A = (1,140 + 3,000) = 4,140

The total assets of Videosonics must be 4,140

9. m= .05 , d = 0.6 , A/E = 2.5 , A/S = 1.4

m (1-d)A/E .05 (1-0.6) 2.5
(a) g = = = 3.70 per cent
A/S –m(1-d)A/E 1.4 -.05 (1-0.6) 2.5

.05 (1-0.6) x A/E
(b) 0.5 = A/E = 3.33
2.4 - .05 (1-0.6) A/E

d = 0.466
The dividend payout ratio must be reduced from 60 per cent to 46.6 per cent

.05 (1-0.6) x A/E
(c) .05 = A/E = 3.33
1.4 -.05 (1-0.6) A/E

The A/E ratio must increase from 2.5 to 3.33

m (1-0.6) 2.5
141

(d) .06 = m = 7.92 per cent
1.4 – m (1-0.6) x 2.5

The net profit margin must increase from 5 per cent to 7.92 per cent

.05 (1-0.6) 2.5
(e) .06 = A/S = .883
A/S - .05 (1-0.6) 2.5

The asset to sales ratio must decrease from 1.4 to 0.883

Chapter 32
CORPORATE VALUATION

1. (a) The calculations for Hitech Limited are shown below :
Year 2 Year3
EBIT
PBT 86 102
+ Interest expense 24 28
- Interest income (10) (15)
- Non-operating income (5) (10)
EBIT 95 105

Tax on EBIT
Tax provision on income statement 26 32
+ Tax shield on interest expense 9.6 11.2
- Tax on interest income (4) (6)
- Tax on non-operating income (2) (4)
Tax on EBIT 29.6 33.2

NOPLAT 65.4 71.8
Net investment (50) (50)
Non-operating cash flow (post-tax) 3 6
142

FCFF 18.4 27.8

(b) The financing flow for years 2 and 3 is as follows :
Year 2 Year 3
After-tax interest expense 14.4 16.8
Cash dividend 30 40
- Net borrowings (30) (30)
+ A Excess marketable securities 30 10
- After-tax income on excess (6) (9)
marketable securities
- Share issue (20) -
18.4 27.8

(c) Year 2 Year 3
Invested capital (Beginning) 310 360
Invested capital (Ending) 360 410
NOPLAT 65.4 71.8
Turnover 400 460
Net investment 50 50

Post-tax operating margin 16.35% 15.61%
Capital turnover 1.29 1.28
ROIC 21.1% 19.9%
Growth rate 16.1% 13.9%
FCF 15.4 21.8

2. Televista Corporation

0 1 2 3 4 5
Base year

1. Revenues 1600 1920 2304 2765 3318 3650
2. EBIT 240 288 346 415 498 547
3. EBIT (1-t) 156 187 225 270 323 356
4. Cap. exp. 200 240 288 346 415 -
- Depreciation 120 144 173 207 249
5. Working capital 400 480 576 691 829 912
6. AWorking capital 80 96 115 138 83
7. FCFF 11 13 16 19 273
(3-4-6)

Discount factor 0.876 0.767 0.672 .589
143

Present value 9.64 9.97 10.76 11.19

Cost of capital for the high growth period

0.4 [12% + 1.25 x 7%] + 0.6 [15% (1 - .35)]
8.3% + 5.85%
= 14.15%

Cost of capital for the stable growth period
0.5 [12% + 1.00 x 6%] + 0.5 [14% (1 - .35)]
9% + 4.55%
= 13.55%

Present value of FCFF during the explicit forecast period
= 9.64 + 9.97 + 10.76 + 11.19 = 41.56

273 273
Horizon value = = = 7690
0.1355 – 0.10 0.0355

Present value of horizon value = 4529.5

Value of the firm = 41.56 + 4529.50 = Rs.4571.06 million

3. The WACC for different periods may be calculated :

WACC in the high growth period

Year k
d
(1-t) = 15% (1-t) k
e
= R
f
+ | x Market risk premium k
a
= w
d
k
d
(1-t)+ w
e
k
e

1 15 (0.94) = 14.1% 12 + 1.3 x 7 = 21.1% 0.5 x 14.1 + 0.5 x 21.1 = 17.6%
2 15 (0.88) = 13.2% 21.1% 0.5 x 13.2 + 0.5 x 21.1 = 17.2%
3 15 (0.82) = 12.3% 21.1% 0.5 x 12.3 + 0.5 x 21.1 = 16.7%
4 15 (0.76) = 11.4% 21.1% 0.5 x 11.4 + 0.5 x 21.1 = 16.3%
5 15 (0.70) = 10.5% 21.1% 0.5 x 10.5 + 0.5 x 21.1 = 15.8%

WACC in the transition period
k
d
(1-t) = 14 (1 – 0.3) = 9.8%
k
e
= 11 + 1.1 x 6 = 17.6%
k
a
= 0.44 x 9.8 + 0.56 x 17.6 = 14.2%

WACC for the stable growth period
k
d
(1-t) = 13 (1 – 0.3) = 9.1%
k
e
= 11 + 1.0 x 5 = 16%
144

k
a
= 1/3 x 9.1 + 2/3 x 16 = 13.7%

The FCFF for years 1 to 11 is calculated below. The present value of the
FCFF for the years 1 to 10 is also calculated below.

Multisoft Limited

Period Growth
rate (%)
EBIT Tax
rate
(%)
EBIT
(1-t)
Cap.
exp.
Dep. AWC FCFF D/E Beta WACC
%
PV
Factor
Present
value
0 90 100 60
1 40 126 6 118 140 84 26 36 1:1 1.3 17.6 .850 30.6
2 40 176 12 155 196 118 39 38 1:1 1.3 17.2 .726 27.6
3 40 247 18 203 274 165 50 44 1:1 1.3 16.7 .622 27.4
4 40 346 24 263 384 230 70 39 1:1 1.3 16.3 .535 20.8
5 40 484 30 339 538 323 98 26 1:1 1.3 15.8 .462 12.0
6 34 649 30 454 721 432 132 33 0.8:1 1.1 14.2 .405 13.4
7 28 830 30 581 922 553 169 43 0.8:1 1.1 14.2 .354 15.4
8 22 1013 30 709 1125 675 206 53 0.8:1 1.1 14.2 .310 16.7
9 16 1175 30 822 1305 783 239 61 0.8:1 1.1 14.2 .272 16.9
10 10 1292 30 905 1436 862 263 68 0.8:1 1.1 14.2 .238 16.6
11 10 1421 30 995 1580 948 289 74 0.5:
1.0
1.1 13.7 476
673.4
The present value of continuing value is :

FCF
11
74
x PV factor 10 years = x 0.238 = 476
k – g 0.137 – 0.100

This is shown in the present value cell against year 11.

The value of the firm is equal to :
Present value of FCFF during + Present value of continuing
The explicit forecast period of 10 years value

This adds up to Rs.685.4 million as shown below

MINI CASE

Solution:
Solution:
145

Chapter 33
VALUE BASED MANAGEMENT

1. The value created by the new strategy is calculated below :
1 2 3 4 5 6
1. Revenues 950 1,000 1,200 1,450 1,660 1,770
2. PBIT 140 115 130 222 245 287
3. NOPAT = PBIT
(1 – .35)
91 74.8 84.5 144.3 159.3 186.6
4. Depreciation 55 85 80 83 85 87
5. Gross cash flow 146 159.8 164.5 227.3 244.3 273.7
6. Gross investment
in fixed assets
100 250 85 100 105 120
7. Investment in net
current assets
10 15 70 70 70 54
8. Total investment 110 265 155 170 175 174
9. FCFF (5) – (8) 36 (105.2) 9.5 57.3 69.3 99.6

0.4 1.0
WACC = x 12 x (1 – 0.35) + {8 + 1.06 (8)}
1.4 1.4

= 14%

99.6 (1.10)
Continuing Value = = 2739.00
0.14 – 0.10

2739
Present value of continuing value = = 1249
(1.14)
6

PV of the FCFF during the explicit forecast period
3.6 105.2 9.5 57.3 69.3 99.6
= – + + + +
(1.14) (1.14)
2

(1.14)
3
(1.14)
4
(1.14)
5
(1.14)
6

= 72.4
Firm value = 72.4 + 1249 = 1321.4

Value of equity = 1321.4 – 200 = 1121.4 million

146

Current Income Statement Projection
Values
(Year 0) 1 2 3 4 5

- Sales 2000 2240 2509 2810 3147 3147
- Gross margin (20%) 400 448 502 562 629 629
- Selling and general 160 179 201 225 252 252
- Profit before tax 240 269 301 337 378 378
- Tax 72 81 90 101 113 113
- Profit after tax 168 188 211 236 264 264

Balance Sheet Projections
- Fixed assets 600 672 753 843 944 944
- Current assets 600 672 753 843 944 944
- Total assets 1200 1344 1505 1696 1888 1888
- Equity 1200 1344 1505 1686 1888 1888

Cash Flow Projections
- Profit after tax 188 211 236 264 264
- Depreciation 60 67 75 84 94
- Capital expenditure 132 148 166 185 94
- Increase in current assets 72 81 90 101 -
- Operating cash flow 44 49 55 62 264

- Present value of the operating cash flow = 147
- Residual value = 264 / 0.15 = 1760
- Present value of residual value = 1760 / (1.15)
4
= 1007
- Total shareholder value = 147 + 1007 = 1154
- Pre-strategy value = 168/0.15 = 1120
- Value of the strategy = 1154 – 1120 = 34

2. According to the Marakon approach
M r – g
=
B k – g

r - .10
2 =
k - .10
r - .10 = 2k - .20
147

r = 2k - .10
r/k = 2 - (.10/k)

Thus r/k is a function of k. Unless k is specified r/k cannot be determined.

3. (a) NOPAT for 20X1
PBIT (1 – T) = 24 (0.65) = 15.6

(b) Return on capital for 20X1
NOPAT 15.6
= = 15.6%
Capital employed 120 – 20 (Non-interest bearing liabilities)

(c) Cost of equity
6% + 0.9 (6%) = 1.4%

(d) Average cost of capital
0.5 x 8% (1 - .35) + 0.5 x 11.4% = 8.3%

(e) EVA for 20X1
NOPAT - Average cost of capital x Capital employed
15.6 - .083 x 100 = 7.3

4.
I = Rs.200 million
r = 0.40
c* = 0.20
T = 5 years
200 (0.40 – 0.20) 5
Value of forward plan =
0.20 (1.20)

= Rs.833.3 million

5. Cost of capital = 0.5 x 0.10 + 0.5 x 0.18 = 0.14 or 14 per cent

1. Revenues 2,000 2,000 2,000 2,000 2,000
2. Costs 1,400 1,400 1,400 1,400 1,400
3. PBDIT 600 600 600 600 600
4. Depreciation 200 200 200 200 200
5. PBIT 400 400 400 400 400
6. NOPAT 240 240 240 240 240
7. Cash flow (4+6) 440 440 440 440 440
8. Capital at charge 1,000 800 600 400 200
148

9. Capital charge (8x0.14) 140 112 84 56 28
10. EVA (6-9) 100 128 156 184 212
5 440
NPV = ¿ - 1000 = 440 x 3.433 – 1000 = 510.5
t=1 (1.14)
t

EVA
t

NPV = ¿ = 100 x 0.877 + 128 x 0.769 + 156 x 0.675 + 184 x 0.592 +
(1.14)
t
212 x 0.519
= 510.3

6. Equipment cost = 1,000,000
Economic life = 4 years
Salvage value = Rs.200,000
Cost of capital = 14 per cent

Present value of salvage value = 200,000 x 0.592
= 118,400

Present value of the annuity = 1,000,000 – 118,400
= 881,600

881,600 881,600
Annuity amount = =
PVIFA
14%, 4yrs
2.914

= Rs.302,540

Depreciation charge under sinking fund method
1 2 3 4
Capital 1,000,000 837,460 652,164 440,927
Depreciation 162,540 185,296 212,237 240,810
Capital charge 140,000 117,244 91,303 61,730
Sum 302,540 302,540 302,540 302,540

7. Investment : Rs.2,000,000
Life : 10 years
Cost of capital : 15 per cent
Salvage value : 0

2,000,000
Economic depreciation =
FVIFA
(10yrs, 15%)

149

2,000,000
= = 98,503
20.304

8. Investment : Rs.5,000,000
Life : 5 years
Cost of capital : 12 per cent
Salvage value : Nil

PVIFA
(5yrs,12%)
= 3.605 ; Annuity amount = 5,000,000 / 3.605 = 1,386,963

Depreciation charge under sinking fund method
1 2 3 4 5
Capital 5,000,000 4,213,037 3,331,638 2,344,472 1,238,846
Depreciation 786,963 881,399 987,166 1,105,626 1,238,301
Capital charge 600,000 505,564 399,797 281,336 148,662
Sum 1,386,963 1,386,963 1,386,963 1,386,963 1,386,963

5,000,000
Economic depreciation =
FVIFA
(5yrs, 12%)

5,000,000
= = Rs.787,030
6.353

9. Investment = Rs.100 million
Net working capital = Rs.20 million
Life = 8 yrs
Salvage value = Rs.20 million (Net working capital)
Annual cash flow = Rs.21.618 million
Cost of capital = 15%
Straight line depreciation = Rs.10 million per year

80 80
Economic depreciation = = = Rs.5.828 million
FVIFA
(8, 15%)
13.727

Year 1 Year 4
- Profit after tax 11.618 11.618
- Depreciation 10.000 10.000
- Cash flow 21.618 21.618
150

- Book capital 100 70
(Beginning)
- ROCE 11.62% 16.59%
- ROGI 21.62% 21.62%
- CFROI 15.79% 15.79%

151

Chapter 34
MERGERS, ACQUISITIONS AND RESTRUCTURING

1. The pre-amalgamation balance sheets of Cox Company and Box Company and the post-
amalgamation balance sheet of the combined entity, Cox and Box Company, under the ‘pooling’
method as well as the ‘purchase’ method are shown below :

Before Amalgamation After Amalgamation
Cox & Box Company
Cox Box Pooling method Purchase
method
Fixed assets 25 10 35 45
Current assets
Goodwill
20 7.5 27.5 30
2.5
Total assets 45 17.5 62.5 77.5

Share capital
(face value @ Rs.10)

20

5

25

20
Reserves & surplus 10 10 20 10
Share premium 15 2.5 17.5 17.5
Debt 45 17.5 42.5 77.5

2. Post-merger EPS of International Corporation will be

2 x 100,000 + 2 x100,000

100,000 + ER x 100,000

Setting this equal to Rs.2.5 and solving for ER gives
ER = 0.6

3. PV
A
= Rs.25 million, PV
B
= Rs.10 million
Benefit = Rs.4 million, Cash compensation = Rs.11 million
Cost = Cash compensation – PV
B
= Rs.1 million
NPV to Alpha = Benefit – Cost = Rs.3 million
NPV to Beta = Cash Compensation – PV
B
= Rs.1 million

4. Let A stand for Ajeet and J for Jeet
PV
A
= Rs.60 x 300,000 = Rs.18 million
PV
J
= Rs.25 x 200,000 = Rs.5 million
Benefit = Rs.4 million
PV
AJ
= 18 + 5 + 4 = Rs.23 million
152

Exchange ratio = 0.5
The share of Jeet in the combined entity will be :
100,000
o = = 0.25
300,000 + 100,000

a) True cost to Ajeet Company for acquiring Jeet Company
Cost = o PV
AB
- PV
B

= 0.25 x 27 - 5 = Rs.1.75 million

b) NPV to Ajeet
= Benefit - Cost
= 4 - 1.75 = Rs.2.25 million

c) NPV to Jeet = Cost = Rs.1.75 million

5. a) PV
B
= Rs.12 x 2,000,000 = Rs.24 million
The required return on the equity of Unibex Company is the value of k in the
equation.

Rs.1.20 (1.05)
Rs.12 =
k - .05

k = 0.155 or 15.5 per cent.

If the growth rate of Unibex rises to 7 per cent as a sequel to merger, the intrinsic value
per share would become :

1.20 (1.07)
= Rs.15.11
0.155 - .07

Thus the value per share increases by Rs.3.11 Hence the benefit of the
acquisition is
2 million x Rs.3.11 = Rs.6.22 million

(b) (i) If Multibex pays Rs.15 per share cash compensation, the cost of the
merger is 2 million x (Rs.15 – Rs.12) = Rs.6 million.

(ii) If Multibex offers 1 share for every 3 shares it has to issue 2/3 million
shares to shareholders of Unibex.

So shareholders of Unibex will end up with
153

0.667
o = = 0.1177 or 11.77 per cent
5+0.667

shareholding of the combined entity,
The present value of the combined entity will be
PV
AB
= PV
A
+ PV
B
+ Benefit
= Rs.225 million + Rs.24 million + Rs.6.2 million
= Rs.255.2 million

So the cost of the merger is :
Cost = o PV
AB
- PV
B

= .1177 x 255.2 - 24 = Rs.6.04 million

6. The expected profile of the combined entity A&B after the merger is shown in the last column
below.

A B A&B
Number of shares 5000 2000 6333
Aggregate earnings Rs.45000 Rs.4000 Rs.49000
Market value Rs.90000 Rs.24000 Rs.114000
P/E 2 6 2.33

7. (a) The maximum exchange ratio acceptable to shareholders of Vijay Limited is :

S
1
(E
1
+E
2
) PE
12

ER
1
= - +
S
2
P
1
S
2

12 (36+12) 8
= - + = 0.1
8 30 x 8

(b) The minimum exchange ratio acceptable to shareholders of Ajay Limited is :
P
2
S
1

ER
2
=
(PE
12
) (E
1
+E
2
) - P
2
S
2

9 x 12
= = 0.3
9 (36+12) - 9 x 8

154

(c) 12 (48) PE
12

ER
1
= - +
8 240
9 x 12
ER
2
=
PE
12
(48) - 72

Equating ER
1
and ER
2
and solving for PE
12
gives, PE
12
= 9
When PE
12
= 9
ER
1
= ER
2
= 0.3
Thus ER
1
and ER
2
intersect at 0.3

8. The present value of FCF for first seven years is
16.00 14.30 9.7 0
PV(FCF) = - - - +
(1.15) (1.15)
2
(1.15)
3
(1.15)
4

0 10.2 16.7
+ + +
(1.15)
5
(1.15)
6
(1.15)
7

= - Rs.20.4 million
The horizon value at the end of seven years, applying the constant growth model is

FCF
8
18
V
4
= = = Rs.257.1 million
0.15-0.08 0.15 – 0.08

1
PV (V
H
) = 257.1 x = Rs.96.7 million
(1.15)
7

The value of the division is :
- 20.4 + 96.7 = Rs.76.3 million

155

MINICASE

Solution:
(a)
Modern Pharma Magnum Drugs Exchange
Ratio
Book value per share 2300 650
= Rs.115 = Rs.65
20 10
65

115
Earnings per share 450 95
= Rs.22.5 = Rs.9.5
20 10
9.5

22.5
Market price per share Rs.320 Rs.102 102

320

Exchange ratio that gives equal weightage to book value per share, earnings per share, and market
price per share

65 9.5 102
+ +
115 22.5 320 0.57 + 0.42 + 0.32
= = 0.44
3 3

(b) An exchange ratio based on earnings per share fails to take into account the
following:

(i) The difference in the growth rate of earnings of the two companies.
(ii) The gains in earnings arising out of merger.
(iii) The differential risk associated with the earnings of the two companies.

(c) Current EPS of Modern Pharma
450
= = Rs.22.5
20

If there is a synergy gain of 5 percent, the post-merger EPS of Modern Pharma is

(450 + 95) (1.05)

20 + ER X 10
156

Equating this with Rs.22.5, we get

(450 + 95) (1.05)
= 22.5
20 + 10ER
This gives ER = 0.54

Thus the maximum exchange ratio Modern Pharma should accept to avoid initial dilution of EPS is
0.54

(d) Post-merger EPS of Modern Pharma if the exchange ratio is 1:4, assuming no
synergy gain:

450 + 95
= Rs.24.2
20 + 0.25 x 10

(e) The maximum exchange ratio acceptable to the shareholders of Modern Pharma if
the P/E ratio of the combined entity is 13 and there is no synergy gain

-S
1
(E
1
+ E
2
) P/E
12

ER
1
= +
S
2
P
1
S
2

- 20 (450 + 95) 13
= + = 0.21
10 320 x 10

(f) The minimum exchange ratio acceptable to the shareholders of Magnum Drugs if
the P/E ratio of the combined entity is 12 and the synergy benefit is 2 percent
P
2
S
1

ER
2
=
(P/E
12
) (E
1
+ E
2
) (1 + S) – P
2
S
2

102 x 20
=
12 (450 + 95) (1.02) – 102 X 10
= 0.36

(g) The level of P/E ratio where the lines ER
1
and ER
2
intersect.

To get this, solve the following for P/E
12
157

- S
1
(E
1
+ E
2
) P/E
12
P
2
S
1

+ =
S
2
P
1
S
2
P/E
12
(E
1
+ E
2
) – P
2
S
2

- 20 (450 +95) P/E
12
102 x 20
+ =
10 320 x 10 P/E
12
(450 +95) – 1020

- 6400 + 545 P/E
12
2040
=
3200 545 P/E
12
– 1020

(545 P/E
12
– 1020) (545 P/E
12
– 6400) = 2040 x 3200

297025 P/E
2
12
– 3488000 P/E
12
– 555900 P/E
12

+6528000 = 6528000
297025 P/E
2
12
= 4043900 P/E
297025 P/E
12
= 4043900
P/E
12
= 13.61

158

Chapter 37
INTERNATIONAL FINANCIAL MANAGEMENT

1. The annualised premium is :

Forward rate – Spot rate 12
x
Spot rate Forward contract length in months

46.50 – 46.00 12
= x = 4.3%
46.00 3

2. 100
100 (1.06) = x 1.07 x F
1.553

106 x 1.553
F = = 1.538
107
A forward exchange rate of 1.538 dollars per sterling pound will mean indifference between
investing in the U.S and in the U.K.

3. (a) The annual percentage premium of the dollar on the yen may be calculated with
reference to 30-days futures
105.5 – 105 12
x = 5.7%
105 1

(b) The most likely spot rate 6 months hence will be : 107 yen / dollar

(c) Futures rate 1 + domestic interest rate
=
Spot rate 1 + foreign interest rate

107 1 + domestic interest rate in Japan
=
159

106 1.03

Domestic interest rate in Japan = .0397 = 3.97 per cent

4. S
0
= Rs.46 , r
h
= 11 per cent , r
f
= 6 per cent
Hence the forecasted spot rates are :
Year Forecasted spot exchange rate
1 Rs.46 (1.11 / 1.06)
1
= Rs.48.17
2 Rs.46 (1.11 / 1.06)
2
= Rs.50.44
3 Rs.46 (1.11 / 1.06)
3
= Rs.52.82
4 Rs.46 (1.11 / 1.06)
4
= Rs.55.31
5 Rs.46 (1.11 / 1.06)
5
= Rs.57.92

The expected rupee cash flows for the project

Year Cash flow in dollars Expected exchange Cash flow in rupees
(million) rate (million)
0 -200 46 -9200
1 50 48.17 2408.5
2 70 50.44 3530.8
3 90 52.82 4753.8
4 105 55.31 5807.6
5 80 57.92 4633.6

Given a rupee discount rate of 20 per cent, the NPV in rupees is :

2408.5 3530.8 4753.8
NPV = -9200 + + +
(1.18)
2
(1.18)
3
(1.18)
4

5807.6 4633.6
+ +
(1.18)
5
(1.18)
6

= Rs.3406.2 million

The dollar NPV is :
3406.2 / 46 = 74.05 million dollars

5. Forward rate 1 + domestic interest rate
=
Spot rate 1 + foreign interest rate

F 1 + .015
160

=
1.60 1 + .020
F = \$ 1.592 / £

6. Expected spot rate a year from now 1 + expected inflation in home country
=
Current spot rate 1 + expected inflation in foreign country

Expected spot rate a year from now 1.06
=
Rs.70 1.03

So, the expected spot rate a year from now is : 72 x (1.06 / 1.03) = Rs.72.04

7. (a) The spot exchange rate of one US dollar should be :
12000
= Rs.48
250
(b) One year forward rate of one US dollar should be :
13000
= Rs.50
260

8. (1 + expected inflation in Japan)
2

Expected spot rate = Current spot rate x
2 years from now (1 + expected inflation in UK)
2

(1.01)
2

= 170 x = 163.46 yen / £
(1.03)
2

9. (i) Determine the present value of the foreign currency liability (£100,000) by using
90-day money market lending rate applicable to the foreign country. This works
out to :
£100,000
= £ 98522
(1.015)
(ii) Obtain £98522 on today’s spot market
(iii) Invest £98522 in the UK money market. This investment will grow to
£100,000 after 90 days

161

10. (i) Determine the present value of the foreign currency asset (£100,000) by using
the 90-day money market borrowing rate of 2 per cent.
100,000
= £98039
(1.02)

(ii) Borrow £98039 in the UK money market and convert them to dollars in the spot
market.

(iii) Repay the borrowing of £98039 which will compound to £100000 after 90 days
with the collection of the receivable

11. A lower interest rate in the Swiss market will be offset by the depreciation of the US
dollar vis-à-vis the Swiss franc. So Mr.Sehgal’s argument is not tenable.

162

Chapter 40
CORPORATE RISK MANAGEMENT

1. (a) The investor must short sell Rs.1.43 million (Rs.1 million / 0.70) of B
(b) His hedge ratio is 0.70
(c) To create a zero value hedge he must deposit Rs.0.43 million

2. Futures price Spot price x Dividend yield
= Spot price -
(1+Risk-free rate)
0.5
(1+Risk-free rate)
0.5

4200 4000 x Dividend yield
= 4000 -
(1.145)
0.5
(1.145)
0.5

The dividend yield on a six months basis is 2 per cent. On an annual basis it is
approximately 4 per cent.

3. Futures price
= Spot price + Present value of – Present value
(1+Risk-free rate)
1
storage costs of convenience yield

5400
= 5000 + 250 – Present value of convenience yield
(1.15)
1

Hence the present value of convenience yield is Rs.554.3 per ton.

163

164

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