Capital Budgeting Capital Budgeting Process

Tax Shield Education Centre
MAFA-1
CAPITAL BUDGETING
CAPITAL BUDGETING PROCESS
Capital budgeting is a complex process which may be divided into the following phases :
Identification of potential investment opportunities
Assembling of proposed investments
Decision making
Preparation of capital budget and appropriations
Implementation
Performance review
Identification of Potential Investment Opportunities

The capital budgeting process begins with the identification of potential investment opportunities. Typically,
the planning body (it may be an individual or a committee organised formally or information) develops estimates of
future sales which serve as the basis for setting production targets. This information, in helpful in identifying required
investments in plant and equipment.
For imaginative identification of investment ideas it is helpful to (i) monitor external environment regularly to
scout investment opportunities, (ii) formulate a well defined corporate strategy based on a thorough analysis of
strengths, weakness, opportunities, and threats, (iii) share corporate strategy and perspectives with persons who are
involved in the process of capital budgeting, and 9iv) motivate employees to make suggestions.
Assembling of Investment Proposals
Investment proposals identified by the production department and other departments are usually submitted in a
standardised capital investment proposal form. Generally, most of the proposals, before they reach the capital
budgeting committee or some body which assembles them, are routed through several persons. The purpose of routing
a proposal through several persons is primarily to ensure that the proposal is viewed from different angles. It also helps
in creating a climate for bringing about co-ordination of interrelated activities.
Investment proposals are usually classified into various categories for facilitating decision-making, budgeting,
and control. An illustrative classification is given below.
1. Replacement investments
2. Expansion investments
3. New product investments
4. Obligatory and welfare investments
Decision Making
A system of rupee gateways usually characterises capital investment decision making . Under this system,
executives are vested with the power to okay investment proposals up to certain limits. For example, in one company
the plant superintendent can okay investment outlays up to Rs.200,000, the works manager up to Rs.500,000, and the
managing director up to Rs.2,000,000. Investment requiring higher outlays need the approval of the board of directors.
Preparation of Capital Budget and Appropriations
Projects involving smaller outlays and which can be decided by executives at lower levels are often covered by
a blanket appropriation for expeditious action. Projects involving larger outlays are included in the capital budget after
necessary approvals. Before undertaking such projects an appropriation order is usually required. The purpose of this
MAFA-2
check is mainly to ensure that the funds position of the firm is satisfactory at the time of implementation. Further, it
provides an opportunity to review the project at the time of implementation.
Implementation
Translating an investment proposal into a concrete project is a complex, time-consuming, and risk-fraught task.
Delays in implementation, which are common, can lead to substantial cost-overruns. For expeditious implementation
at a reasonable cost, the following are helpful.
1. Adequate formulation of projects
The major reason for delay is inadequate formulation of projects. Put differently, if necessary homework in
terms of preliminary studies and comprehensive and detailed formulation of the project is not done, many
surprises and shocks are likely to spring on the way. Hence the need for adequate formulation of the project
cannot be over-emphasised.
2. Use of the principle of responsibility accounting
Assigning specific responsibilities to project managers for completing the project within the defined timeframe and cost limits is helpful for expeditious execution and cost control.
3. Use of network techniques
For project planning and control several network techniques like PERT (Programme Evaluation Review
Technique) and CPM (Critical path Method) are available. With the help of these techniques, monitoring
becomes easier.
Performance Review
Performance review, or post-completion audit, is a feedback device. It is a means for comparing actual
performance with projected performance. It may be conducted, most appropriately, when the operations of the project
have stabilised. It is useful in several ways : (i) it throws light on how realistic were the assumptions underlying the
project; (ii) it provides a documented log of experience that is highly valuable for decision-making; (iii) it helps in
uncovering judgmental biases; and 9iv) it induces a desired caution project sponsors.
Some Important Conceptions
Cash Flow
1.
2.
Movement of cash during the project period. Cash flows are of two types
Cash outflow
(a) Capital nature

(b) Revenue nature.
In general discussion, investment in fixed asset and working capital are known as cash outflow. Investment
on a project is not a matter of one day. However for simplicity purpose, it is assumed that the total investment
is made at the starting of the project i.e. the day when commercial production starts. Cash outflow of revenue
nature are adjusted with the revenue cash inflows.
Cash inflow = Profit After Tax ( PAT) + Depreciation.
Calculation of cash inflow
PBDT
less: Depreciation
PBT
less: Tax @ -- %
PAT
Add: Depreciation
Cash Inflow
Rs.
NOTE :: Depreciation is a non-cash item. Depreciation is a deduction from profit, it will save certain amount of
cash outflow through savings of tax. This savings in tax payment is denoted as tax shield. If there is
no tax rate given in the problem do not charge depreciation in the calculation of cash Inflow, rather
Cash-Inflow = PBDT.
3.
Cash inflow at the end of the project :
MAFA-3
(i) Working capital will be recovered in full (unless otherwise stated in the problem) and hence it is cash
inflow at the end of the project.
(ii) Sale of machinery at the end of the project
(a)
If the asset is fully depreciated, then sales value is the cash inflow or scrap value is the
cash inflow. But if the sale value is more than the scrap value or book value, then there
will be profit of short term mature and tax will be paid on that item.
Therefore cash in flow = sale proceeds tax on profit.
(b)
If the asset is sold in an earlier year & sale proceed is less than book value, then the difference
will be treated as loss on sale of asset.
This loss can be set off against business income (from same or different project of the company) to
produce tax shield i.e. cash inflow in terms of opportunity gain.
(iii)
4.
Selling of the old asset at the beginning of the project:

(a)
If block of asset concept is not applied then pay tax on profit or losses in 1 st year , But only sale
proceeds of old assets is the cash inflow of the 0 th year and utilised for the purpose of reducing
the cash outflow in the 0th year. Tax on the profit is paid in the next year.
(b)
If block of assets concept is applied

Depreciation is calculated on remaining value of assets
No tax will be paid on profit or loss of on sale of fixed assets. However, the effect of such will
be realised through difference in depreciation from coming years.
Choice of cut-off rates & Discounted cash - flow :

Cost of rate given
Cut off not given
Loan investment
No cash outflow
In 0th year
Cash outflow in 0th

year as interest
Rate = cut off rate.
Interest on loan
is a part of PBT
i.e. PBT = PBIT I
is not a part of PBT i.e.

PBT i.e. PBIT = PBT
Loan repayment
Cash out-flow at the

Year of payment
is not considered
Cash outflow.
5. Working Capital (WC) : Investment in WC is cash outflow this is generally made at the beginning of the
project . If subsequent increase in WC is required during the project life then it will be considered as cash
outflow of the year of impact. We know,
WC = Stock + Debtors + Cash + Bank Sundry Creditors
If the change in element of WC are specifically mentioned in the problems then corresponding cash inflow
and outflow following their changes are to be noted for the purpose of NPV & DCF calculations
Different techniques
The Capital Budgeting techniques are :
1. When Cash flows are certain
A. Traditional Approach.
B. Time Value of Money Approach (TVM) or Discounted cash Flow Technique ( DCF ).
2. When Cash flows are un-certain :
MAFA-4
A. GENERAL TECHNIQUE
B. Quantitatives Techniques .
1(A). Traditional Approach :
(1) Pay Back Period Method
(a) When cash inflows are uniform throughout the project lifePay Back Period = Original Investment Cash Inflow p.a.
Lower the Pay Back period higher the acceptability.
(b) When cash Inflows are not uniform through out the project life:
Apply the method of simple interpolation for pay back period calculation .
REQUIRED TIME - LOWER LIMIT = REQUIRED INVESTMENT - LOWER LIMIT
UPPER LIMIT - LOWER LIMIT
UPPER LIMIT - LOWER LIMIT
(2) Average rate of return ( ARR):
ARR =
Average PAT Average Investment
NOTE : Sometimes , ARR = Average PAT / INVESTMENT
(3) Debt service coverage ratio (DSCR) =
( PAT + DEPRECIATION + INTEREST )

DEBT REPAID + INTEREST on debt repaid
(4) Pay Back reciprocal : amount of cash in-flow after the investment is over.
(B) DISCOUNTED CASH FLOW TECHNIQUE :
1. NET PRESENT VALUE METHOD ( NPV )
2. INTERNAL RATE OF RETURN ( IRR )
3. PROFITABILITY INDEX
( PI )
4. TERMINAL VALUE METHOD
( TVM )
5. DISCOUNTED PAY BACK
6. DISCOUNTED PAY BACK PROFITABILITY
DERIVATIONA OF ANNUITY FORMULA
Future value of an annuity :
(1 + k)n 1
k
Present value of an annuity :
(1 + k)n 1
k (1 + k)n
Present value of a perpetuity :
A.
k
The derivations of these formulae are discussed below.
Future Value of an Annuity
The future value of an annuity is :
FVn = A(1 + k)n-1 + A(1 + k)n-2 + + A(1 + k) + A
Multiplying both the sides of Eq. (4A.1) by (1 + k) gives :
FVAn (1 + k) = A(1 + k)n + A(1 + k)n-1 + + A(1 + k)2 + A(1 + k)
Subtracting Eq. (4A.1) from Eq. (4A.2) yields :
MAFA-5
FVAn k = A [(1 + k)n 1 ]
Dividing both the sides of Eq. (4A.3) by k yields :

FVAn = A
(1 + k)n 1
k
Present Value of an Annuity

The present value of an annuity is :
PVAn = A(1 + k) -1 + A(1 + k)-2 + + A(1 + k) n
PVAn (1 + k) = A + A(1 + k) 1 + + A(1 + k) n+1
PVAnk = A [1 (1 + k) n] = A
(1 + k)n 1
(1 + k)n
Dividing both the sides of Eq. (4A.7) by k results in :

PVAn = A
(1 + k)n 1
k(1 + k)n
Present Value of a perpetuity

A perpetuity is an annuity of an infinite duration. Hence the present value of a perpetuity is expressed
as :
PVA = A(1 + k) 1 + A(1 + k) 2 + + A(1 + k) -+1 + A(1 + k) -
PVA (1 + k) = A + A(1 + k) 1 + + A(1 + k) -+1
PVAk = A [ 1 (1 + k) - ]
As (1 + k) - 0, Eq. (4A.1) becomes :
PVAk = A
This means :
PVA = A .
K
Equation (4A.13) implies that the present value of a perpetuity of Re.1 is simply :
1.
k
CONTINUOUS COMPOUNDING AND DISCOUNTING

Continuous Compounding
In Chapter 4, the following relationship was established for a case where compounding occurred m times a year.
r = 1+ k.
m
-1

where
r
k
m
=
=
=
MAFA-6
effective rate of interest

nominal rate of interest
frequency with which compounding is done in a year
Equation may be expressed as

r
=
1+ k .
m/k
-1
m/k
Putting x = m/k in Eq. (4B.2), we get

r = 1+ 1 .
x
-1
In continuous compounding m . This means x in Eq.

Lim
X
1+1.
x
= e = 2.71828
So from Eq. we get

r = ek 1
This leads to
(1 + r) = ek
Thus, the equation for future value, when continuous compounding is done, is a follows :
FVn = PV x ekn
To illustrate, the future value of Rs.50,000 deposited today for 5 years at 8 percent, compounded
continuously, is equal to :
FV5 =
=
=
Rs.50,000 (2.71828) .08x5

Rs.50,000 (1.49182)
Rs.74,591
Continuous Discounting
Employing the about reasoning the present value of a future sum, when continuous discounting is done, is
given by the following formula :
PV =
where
PV
FVn
k
=
=
=
FVn x e kn
present value of a future sum

future sum at the end of n years
nominal discount rate
To illustrate, the present value of a future sum of Rs.50,000 receivable after 7 years, when discounting is
done at 12 percent on a continuous basis, is equal to
PV =
=
=
Methods under DCF Technique :
Rs.50,000 x 2.71828 12x7

Rs.50,000 x .431711
Rs.21,585.55
MAFA-7
(1) Net Present Value Method : (NPV) = Total Discounted cash Inflow - Total Discounted Cash outflow
Comment :Higher the NPV higher the acceptability.
(2) Internal Rate of Return : (IRR) It is that rate of return where total discounted cash in-flow = total
discounted cash outflow . Select two rates of return where NPVs of the project is just positive & just negative ,
then apply method of interpolation .
(3) Terminal Value Method : Here future cash inflows are reinvested in such a way , that it is compounded
and received on the closing date of the project. So all the cash inflows occur at the and of the project life. Then
this total amount is discounted with the desired rate of return for a proper comparison with its O th year
investments.
(4) Profitability Index : (PI) = Total Discounted cash Inflow Total Discounted Cash Outflow
NOTE : In problems where decisions are different following different methods, then select that project according
to the following priority list :
(i)
Profitability index
(ii) NPV
(iii) IRR
NOTE :P.I.
= DCIF DCOF
Again , NPV = DCIF DCOF
Or, DCIF = NPV + DCOF
Or, NPV = (PI 1) x DCOF
(5) DISCOUNTED PAY BACK = TOTAL DISCOUNTED CASH OUT-FLOW
DISCOUNTED CASH IN-FLOW p.a.
If discounted cash inflows are not uniform , apply method of simple interpolation .
(6) Discounted Pay Back Profitability = DISCOUNTED CASH INFLOW AFTER PAY-BACK PERIOD
RISK Analysis in Capital Budgeting
In our previous discussion, we assumed, for the sale of expository convenience, that all investments had
equal risk and the average cost of capital for the firm could be used for evaluating investment proposals.
Investment proposals, however, differ in risk. An investment proposal to manufacture a new product, for
example, is likely to be more risky than one involving replacement of anexisting plant. In view of such
differences, variations in risk need to be considered in capital investment appraisal. To underscore this
point, let us consider an example. Suppose you have a choice between two alternatives, A and B :
A
B
Possible Outcome
Probability
Rs.8,000
Rs.0
Rs.4,000
0.5
0.5
1
Which would you choose ? If you are a typical decision maker you would choose B. Why ? While the
expected gain of both A and B is the same, 1 As outcome is highly variable, whereas Bs outcome is certain.
You choose B because risk (variability) matters per se.
This chapter, concerned with risk analysis of capital investments, one of the most complex, controversial,
and slippery areas in finance, is divided into six sections. The first section describes various measures
used to denote risk; the second explains the method of mathematical analysis for assessing risk; the third
presents the technique of sensitivity analysis used popularly to guage the riskless of investment projects;
the fourth discusses the method of monte carlo simulation for analysing the risk of investment projects; the
fifth dwells on various approaches to selection of projects, given information about their return and risk
characteristics; finally, the sixth describes risk analysis in practice.
MEASURES OF RISK
Risk refers to variability, of which there are several measures. The important ones are :
MAFA-8
Range
Mean absolute deviation
Standard deviation
Coefficient of variation
Semi-variance
The various measures of risk are defined below :
Measure
Definiton
Range
Mean absolute deviation
Standard deviation
Coefficient of variation
Where
Rb
RI
Pi
Ri
(Ri - )
=
=
=
=
=
=
=
Rg = Rb R1
MAD = pi I Rt - I
= [ pi(Rt - )]
CV = /
(9.1)
(9.2)
(9.3)
(9.4)
highest value of the distribution

Lowest value of the distribution
probability associated with the ith possible value
ith possible value of the variable
arithmetic mean
(Ri - ) when Ri <
when
Ri >
Out of the above measures of risk, the standard deviation is most commonly used in financial analysis.
We shall also look at the standard deviation in our subsequent discussion.
Use of Subjective Probabilities
For measuring the expected value and dispersion of a variable, its probability distribution is required. In
some cases the probability distribution can be defined with a fairly high degree of objectivity on the basis of
past evidence. A wildcatter, for example, may be able to define with a high degree of objectivity, the
probabilities associated with certain states of nature if sufficient records for similar ventures are available.
Since such a probability distribution is substantially based on objective facts, it may be referred to as an
objective probability distribution.
However, in most of the real life situations, such objective evidence may not be available for defining
probability distributions. In such cases knowledge persons may pool their experience and judgement to
define the probability distributions. Since there is likely to be a high element of subjectivity in these
distributions, such distributions are generally referred to as subjective probability distributions.
ANALYTICAL DERIVATION OR SIMPLE ESTIMATION
Under certain circumstances, the expected net present value and the standard deviation of net present
value may be obtained through analytical derivation or simple estimation. Three cases of such analysis
are discussed here : (i) no correlation among cash flows, (ii) perfect correlation among cash flows, and (iii)
moderate correlation among cash flows.
Uncorrelated Cash Flows
When the cash flows of different years are uncorrelated, the cash flow for year t is independent of the cash
for year t r. Put differently, there is no relationship between cash flows from one period to another. In
MAFA-9
this case the expected net present value and the standard deviation of net present value are defined as
follows :
n
NPV =
t=1
t
(1 + i)t
. I
(NPV) =
2t
.
2t
(1 + i)
expected net present value
expected cash flow for year t
risk-free interest rate
initial outlay
standard deviation of net present value
standard deviation of the cash flow for year t
t=1
where NPV
t
i
I
(NPV)
t
=
=
=
=
=
=
In the above formulae, it may be noted, the discount rate is the risk-free interest rate because we try to
separate the time value of money and the risk factor. The risk of the project, reflected in (NPV), is
considered in conjunction with NPV computed with the risk-free discount rate. If NPV is computed using a
risk-adjusted discount rate and then if this is viewed along with (NPV), the risk factor would be double
counted.
Example
A project involving an outlay of Rs.10,000 has the following benefits associated with it :
Year 1
.
Net cash flow
flow
Probability
Rs.3000
Year 2
Probability
0.3
Year 3
Net cash flow
Rs.20,000
Probability
0.2
Rs.3000
Net cash
0.3
Perfectly Correlated Cash Flows

If cash flows are perfectly correlated, the behaviors of cash flows in all periods is alike. This means that if
the actual cash flow in one year is standard deviations to the left of its expected value, cash flows in
other years will also be standard deviations to the left of their respective expected values. Put in other
words, cash flows of all years are linearly related to one another. The expected value and the standard
deviation of net present value, when cash flows are perfectly correlated, are as follows :
NPV =
t . 1
(1 + i)t
t=1
(NPV) =
t=1
t . 1
(1 + i)t
Example An investment project involves a current outlay of Rs.10,000. The mean and standard deviation
of cash flows, which are perfectly correlated, are as follows :
Year
1
2
3
4
t
Rs.5,000
3,000
4,000
3,000
t
1,500
1,000
2,000
1,200
MAFA-10
Calculate NPV and (NPV), assuming a risk-free interest rate of 6 percent.

Moderately Correlated Cash Flows
When the cash flows are moderately correlated and hence do not conform to the two patterns
independence and perfect correlation described above, simple and convenient formulae cannot be used
for assessing and risk. Moderately correlated cash flows may be evaluated with the help of a series of
conditional probability distributions. To illustrate this approach, let us consider a project which involves an
outlay of Rs.100,000. The cash inflows expected to be generated by the project are shown in Table 9.1.
From this table we find that there are eight possible cash slows streams. The first cash flow stream
consists of Rs.30,000 in year 1, Rs.30,000 possible cash flow streams. The first cash flow
Conditional Probability Distribution Approach
Year 1
Net
Joint
Cash
Flow
30,000
Initial
Year 2
Net
Conditional
probability
cash
probability
P(1)
flow
P(1,2,3)
0.5
30,000
40,000
Year 3
Net
probability
P(2/1)
0.8
0.2
35,000
40,000
45,000
Conditional Cash
cash
flow
probability
flow
P(3/2,1) stream
0.6
0.4
0.5
1
2
3
0.24
0.16
0.05
stream consists of Rs.30,000 in year 1, Rs.30,000 in year 2, and Rs.35,000 in year 3, the second cash flow
stream consists of Rs.30,000 in year 1, Rs.30,000 in year 2, and Rs.40,000 in year3, so on and so forth.
The probabilities associated with these cash flow streams are given in the last column of the exhibit. It
may be noted that the probability with which a cash flow stream occurs is simply the joint probability of the
individual elements in that cash flow stream. The probability of the first cash flow stream, for example, is 1
P (Rs.30,000 in year 1) x P (Rs.30,000 in year 2/Given
Rs.30,000 in year 1) x P (Rs.35,000 in year 3/Given
Rs.30,000 in year 1 and Rs.30,000 in year 2)
= (0.5) (0.8) (0.6) = 0.24
The probability distribution of the net present value of this project, given a risk-free interest rate of 6
percent, is shown in Table 9.2. From this probability distribution we find that :
NPV
= Rs.21,186
(NPV) = Rs.33,647
Standardising the Distribution
Knowledge of NPV and (NPV) is very useful for evaluating the risk characteristics of a project. If the NPV
of a project is approximately normally distributed, we can calculate the probability of NPV being less than
or more than a certain specified value. This probability is obtained by finding the area under the probability
distribution curve to the left or right of the specified value. Suppose the probability distribution of NPV is as
shown in Fig. 9.1. if we want to calculate the probability of NVP being less than a specified value, say 0,
we have to obtain the area under the probability distribution curve to the left of 0 this is indicated by the
shaded region on the left. If we are interested in finding the probability that NPV exceeds a certain value,
say Rs.2 mln, we calculate the area under the probability curve to the right of Rs.2 mln this area is shown
as the shaded region on the right.
How can we calculate the area to the left or right of a specified ? To calculate the area to the left or right of
a specified point, we use the following procedure.
MAFA-11
Step 1 : Standardise the difference between the specified point and NPV. To do this the difference between the
specified point and NPV is divided by (NPV). The standardised difference may be referred to as Z. The purpose of
standardisation is to transform the actual distribution of NPV into a standard normal distribution. The standard normal
distribution has a mean of 0 and standard deviation of 1. Figure 9.2 shows the standard normal distribution and Table
9.3 gives cumulative probability.
Step 2 : Refer to the standard normal distribution table and find the probability to the left (or right depending on our
interest) of the Z value obtained in step 1.
To illustrate the above procedure suppose that a projects NPV and (NPV) are Rs.96,000 and Rs.60,000 respectively
and we want to find the probability that BPV will be less than 0. This may be done as follows.
Step 1 : The standardised difference between specified point (NPV = 0) and NPV = Rs.96,000 is :
0 96,0000 = 1.6
60,000
Step 2 : The cumulative probability up to Z = 1.6 as seen from the standard normal distribution given in Table 21.3
is .055. This means that there is a 5.5 percent change that NPV will be equal to or less than 0.
Cumulative probability up to Z for Standard Normal Distribution
Z
-3.0
-2.8
-2.6
-2.4
-2.2
-2.0
-1.8
-1.6
-1.4
-1.2
-1.0
-0.8
-0.6
-0.4
-0.0
Cumulative
probability
0.001
0.003
0.005
0.008
0.014
0.023
0.036
0.055
0.081
0.115
0.159
0.212
0.274
0.345
0.500
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
2.2
2.4
2.6
2.8
Cumulative
probabbility
0.579
0.655
0.726
0.788
0.841
0.885
0.919
0.945
0.964
0.977
0.986
0.992
0.995
0.997
SENSITIVITY ANALYSIS
Sensitivity analysis, sometimes called what if analysis, answers questions like :
What will happen to net present value (or some other criterion of merit) if sales are only 50,000 units
rather than the expected 75,000 units ?
What will happen to net present value if the economic life of the project is only five years, rather than
the expected eight years ?
Procedure
Fairly simple, sensitivity analysis consists of the following steps :
MAFA-12
1.
Set up the relationship between the basic underlying factors (like the quantity sold, unit selling price,
life of the project, etc.) and net present value (or some other criterion of merit).
2.
Estimate the range of variation and the most likely value of each of the basic underlying factors.
3.
Study the effect on net present value of variations in the basic variables. (Typically one factor is
varied at a time).
Illustration
Anischit Enterprises is analysing an investment proposal. The following net present value relationship has
been set up :
n
NPV =
t=1
where NPV
Q
P
V
F
D
T
k
n
S
I
=
=
=
=
=
=
=
=
=
=
=
[ Q(P V) F D] (1 T) + D +
S
(1 + k)t
(1 + n)n
-1
net present value of the project

number of units sold annually
selling price per unit
variable cost per unit
total fixed costs, excluding depreciation and interest
annual depreciation charge
income tax rate
cost of capital
project life in years
net salvage value
initial cost
The range and most likely value of each of the basic variables are given in Table 9.4.
Range and Most Likely Value of Basic Variables
Variable
value
Range
Q
P
V
F
D
T
k
1,000 2,000
Rs.600 Rs.1,000
Rs.300 Rs.500
Rs.120,000 Rs.120,000
Rs.160,000 Rs.160,000
0.60 0.60
0.08 0.11
Most
Likely
1,600
Rs.750
Rs.400
Rs.120,000
Rs.160,000
0.60
0.10
Given the range and most likely value of basic variables, we can study the impact of variation in each
variable on net present value, holding other variables constant at their most likely levels. To illustrate the
nature of this analysis we shall look at the relationship between (i) k and NPV, and (iii) P and NPV.
k and NPV
The relationship between k and NPV given the most likely values of other variables is :
n
NPV =
t=1
[1,600(750 400) 120,000 160,000] (1 0.6) + 160,000

(1 + k)t
+ 400,000 - 1,200,000
(1 + k)5
n
=
t=1
272,000 + 400,000 - 1,200,000

(1 + k)t
(1 + k)5
MAFA-13
The net present value for various values of k is shown below. The same relationship is shown graphically
as below
k
11%
8%
9%
10%
Relationship between k and NPV

P and NPV
The relationship between P and NPV, given the most likely values of other factors, is :
NPV =
t=1
[1,600(P 400) 120,000 160,000] (1 0.6) + 160,000

(1.10)t
+ 400,000 - 1,200,000
(1.10)5
n
=
t=1
640 P - 208,00 + 400,00 1,200,000

(1.10)t t = 1 (1.10)t
(1.10)5
The net present value for various values of P is shown below.
P
NPV
600
-Rs.284,384
700
750
-41,760
800
79,552
The same relationship is shown graphically as below
900
200,864
1,000
443,488
MAFA-14
Relationship between P and NPV

A useful way of presenting the results of sensitivity analysis is to show how net present value behaves for
different percentages of unfavourable changes (from their most likely values) in the basic variables. The
behaviour of net present value when there is 5 percent, 10 percent, 15 percent, and 20 percent
unfavourable change in k, other factors remaining unchanged at their most likely levels, is shown as
follows :
Percentage unfavourable
variation
5
10
15
20
Value of k
10.5
11.0
11.5
12.0
Net present value

60,418
42,700
24,681
7.575
The behaviour of net present value when there is 5 percent, 10 percent, 15 percent, and 20 percent
unfavourable variation in P is shown as follows :
Percentage unfavourable
variation
5
10
15
20
Value of P
713
675
638
600
Net present value

(10,308)
(102,500)
(192,267)
(284,384)
Figure 9.5 shows graphically the behaviour of net present value for various unfavourable percentage
variations of k and P. Such a visual presentation is helpful in identifying variables which are crucial for the
success of the project.
Evaluation
Sensitivity analysis, a popular method for assessing risk, has certain merits :
It forces management to identify the underlying variables and their interrelationships.
It shows how robust or vulnerable a project is to changes in the underlying variables.
It indicates the need for further work. If the net present value or internal rate of return is highest
sensitive to changes in some variable, it is desirable to gather further information about that variable.
Sensitivity analysis, however, suffers from severe limitations :
It may fail to provide leads if sensitivity analysis merely presents a complicated set of switching
values it may not shed light on the risk characteristics of the project.
The study of the impact of variation in one factor at a time, holding other factors constant, may not be
very meaningful when the underlying factors are likely to be interrelated. What sense does it make to
consider the effect of variation in price while holding quantity (which is likely to be closely related to
price) unchanged ?
SIMULATION ANALYSIS
Sensitivity analysis indicates the sensitivity of the criterion of merit (NPV, IRR, or any other) to variations in
basic factors and provides information of the following type : If the quantity produced and sold decreases
by 1 percent, other things being equal, the NPV falls by 6 percent. Such information, though useful, may
not be adequate for decision making. The decision maker would also like to know the likelihood of such
MAFA-15
occurrences. This information can be generated by simulation analysis which may e used for developing
the probability profile of a criterion of merit by random combining values of variables which have a bearing
on the chosen criterion.
Procedure
The steps involved in simulation analysis are given below :
1. Model the project. The model of the project shows how the net present value is related to the
parameters and the exogenous variables. (Parameters are input variable specified by the decision
maker and held constant over all simulation runs. Exogenous variables are input variables which are
stochastic in nature and outside the control of the decision maker.)
2. Specify the values of parameters and the probability distributions of the exogenous variables.
3. Select a value, at random, form the probability distributions of each of the exogenous variables.
4. Determine the net present value corresponding to the randomly generated values of exogenous
variables and pre-specified parameter values.
5. repeat steps (3) and (4) a number of times to get a large number of simulated net present values.
6. Plot the frequency distribution of the net present value.
Illustration
To illustrate the nature of simulation a simple example is given here. Zenith Chemicals is evaluating an
investment project. There is uncertainty associated with two aspects of this project : annual net cash flow
and life of the project. The net present value model for the project is :
n
NPV =
t=1
CFt
(1 + i)t
(9.11)
In the net present value model embodied in Eq.(9.11), t, the risk-free interest rate, and I, the initial
investment, are parameters (i = 10 percent and I = Rs.13,000) whereas CF, and n are stochastic
exogenous variables with the following distributions.
Annual Cash Flow
Value
Project Life
Prbability
Rs.1,000
1,500
2,000
2,500
3,000
3,500
4,000
0.02
0.03
0.15
0.15
0.30
0.20
0.15
Value
Probability
3 years
4
5
6
7
8
9
0.05
0.10
0.30
0.25
0.15
0.10
0.03
The firm wants to perform 10 manual simulation runs for this project. To perform the simulation funs,
we have to generate values, at random, for the two exogenous variables : annual cash flow and
project life. For this purpose, we have to (i) set up the correspondence between the values of
exogenous variables and random numbers, and (ii) choose random number generating device.
Table 9.5 shows the correspondence between various values of exogenous variables and
Correspondence between Values of Exogenous Variables and two Digit Random Numbers
Annual Cash Flow

Value
Probability
Rs.
1,000
1,500
2,000
2,500
3,000
3,500
4,000
.02
.03
.15
.15
.30
.20
.15
Cumulative
probability
.02
.05
.20
.35
.65
.85
1.00
Project Life
Two degit
random
numbers
00 to 01
02 to 04
05 to 19
20 to 34
35 to 64
65 to 84
86 to 99
Value
Probability
Years
3
4
5
6
7
8
9
10
.05
.10
.30
.25
.15
.10
.03
.02
Cumulative
probability
.05
.15
.45
.70
.85
.95
.98
1.00
Two degit
random
numbers
00 to 04
05 to 14
15 to 44
45 to 69
70 to 84
85 to 94
95 to 97
98 to 99
MAFA-16
two digits random numbers. Table below presents a table of random digits that will be used for obtaining
two random numbers.1
53479
97344
66023
99776
30176
81874
19839
09337
31151
81115
70328
38277
75723
48979
83339
90630
33435
58295
Random Numbers
98036
12217
58116
91964
74523
71118
03172
43112
92153
38416
14988
99937
71863
95053
53869
52769
40823
41330
59526
26240
84892
83086
42436
13213
55532
18801
21093
Now we are ready for simulation. In order to obtain random numbers from Table 9.6 we may begin
anywhere at random in the table and read any pair of adjacent columns (since we are interested in a twodigit random number) and read column-wise or row-wise.
For our example , let us use the first two columns of Table 9.6. Starting from the top, we will read down the
column. For the first simulation run we need two two-digit random numbers, one for annual cash flow, and
the other for project life. These numbers are 53 and 97 and the corresponding values for annual cash flow
and project life are Rs.3,000 and 9 years respectively. We go future in this manner. Table 9.7 shows the
random numbers so obtained and the results of simulation.
Simulation Results
Annual Cash Flow

Run
present
Random
number
value
Project Life
Corresponding
Random
value of
Corresponding
number
annual flow
value
Net
of
project life
1
53
3,000
2
66
3,500
3
30
2,500
Life Disparity
4
19
2,000
5 In some cases
31 the mutually
2,500
exclusive alternatives
97
9
4277
99
10
8506
81
7
(829)
09
4
(7660)
67 varying lives :6distemper painting
(2112)
have
versus plastic
emulsion painting, re-building a plant versus replacing it. Life disparity may lead to conflict in ranking. To
illustrate, consider two projects, P and Q, being evaluated by a firm which has a cost of capital of 12
percent :
Initial outlay
Cash inflows
Year 1
Year 2
Year 3
Project P
Rs.200,000
Project Q
Rs.200,000
300,000
80,000
80,000
280,000
MAFA-17
The NPV, PI, and IRR for projects P and Q are :

Initial outlay
Present value of
Cash inflows
NPV
PI
IRR
Project P
Rs.200,000
Project Q
Rs.200,000
Rs.267,857
Rs. 67,857
1,339
50%
Rs.334,512
Rs.134,512
1,673
40%
Which project should be selected when there is a life disparity ? One approach is to compare alternatives
on the basis of their equivalent annual benefit (EAB) and select the alternative with the highest EAB of a
project is equal to :
Net present value x capital recovery factor
To illustrate, the EAB of the projects P and Q are calculated below :
Net present value
Life
Capital recovery factor1
(given k = 10%)
EAB
Project P
Rs.67,857
1 year
Project Q
Rs.134,512
3 years
1.100
Rs.74,643
0.402
Rs.54,074
While the EAB concept appealing because it expresses the gains from the project in an annualised form
and hence renders easy comparison between projects with differing lives, it is based on a certain
assumption which is crucial to its validity : It assumes that each investment will be replaced with another
investment which will be equally profitable. When this assumption is suspect, we have to compare the two
alternatives in a common horizon time-frame using appropriate re-investment rate assumptions. Suppose
in our preceding illustration, a re-investment rate of 20 percent is considered reasonable. The NPV* for the
two alternatives, using a three year time horizon, is worked out below :
Projet P
Terminal value
Rs.491,200
Project Q
Rs.432,000
Multiple Rates of Return

The equation of internal rate of return is :
n
t=0
CFt . = 0
(1 + r)t
where CFt = cash flow at the end of year t

r = the internal rate of return
Expanding Eq. (10.5) and multiplying every term in it by (1 + r) n we get
CF0(1 + r)n + CF1(1 + r) r-1 + + CFn = 0
This is a polynomial expression of the nth degree in (1 + r). If the initial cash flow is an outflow (this means
that CF0 is negative) and the subsequent cash flows are inflows (this means that CF 1, CF2, CFn are all
positive) the polynomial expression has only change in sign. Hence, it has only real root. If the cash flow
stream has multiple changes of sign there may be more than one internal rate of return. Consider a project
will the following cash flow stream :1
Year
0
1
Cash Flow
(1,600)
10,000
MAFA-18
The internal rate of return equation for this cash flow stream is :
-16,00 + 10,000 10,000 = 0
(1 = r) (1 + r)2
Multiplying this equation by (1 + r)2, we get
1,600 (1 + r)2 + 10,000 (1 + r) 10,000 = 0
This equation has two changes in sign. Hence, it has two roots. These are 1.25 and 5.00. The internal
rates of return corresponding to these roots are 25 percent and 400 percent. This is illustrated vividly by
the net present value profile of the project shown in Fig. 10.1. When the discount rate is 0 percent the net
present value is :
- 1,600 + 10,000 10,000
(1 + 0) (1 + 0)2
As the discount rate rises, the first term, - 16,000, is unaffected, the second term, 10,000 declines,
(1 + r)
and the third term, - 10,000, increases. The increase in the term is more rapid than the decline in the
( 1 = r)2
second term. The effect of these changes is to push the net present value upwards. The net present
value of the project turns positive when the discount rate exceeds 25 percent. The net present value
continues to increase till the discount rate rises to 100 percent. Thereafter the present value of future flows
(flows for years 1 and 2) declines in importance in relation to the initial flow of 1,600. As a result of this, the
net present value decline. The net present value becomes zero when the discount rate touches 400
percent and turns negative thereafter.
In general, if a polynomial of the nth degree has k changes in sign it has k real roots and n k imaginary
roots. Since our interest is only in real roots which are > because values of (1 = r) I do not make
economic sense, we ask : which of the k earl rooks are > 1 ? Only such roots are of interest to us. It is
likely that through there are several changes in sign (and consequently several real roots), there may be
only one real root 1. For example, there is only one real root 1 for the following cash flow stream
through there are two changes in sign :
Illustration
Year
0
1
3
Cash Flow
Rs. (10,000)
15,000
(2,600)
The technique of decision tree analysis may be explained with the help of an illustration. An oil wildcatter,
evaluating a particular basin, is considering three alternatives : (i) He may drill. (ii) He may conduct a
seismic experiment to find the nature of the underlying soil structure and decide on that basis. (iii) He may
nor do anything.
If he drills, he is likely to find one of the following oil-bearing states ; dry, wet, or soaking. A dry well hardly
yields anything, a wet well provides a moderate quantity of oil, and a soaking well generates a substantial
quantity of oil.
If he conducts as seismic experiment, he can learn about the underlying soil structure before deciding
whether to drill or not. The underlying soil structure, or closed structure. If no structure is discovered the
MAFA-19
prospects of finding oil are bleak; if open structure is found the prospects of finding oil are fair, and if closed
structure is discovered the prospects of finding oil are bright.
The decision tree corresponding to this situation is shown in Fig.10.2. Note that as a convention a decision
fork is represented by a square and a chance fork by a circle.
The decision tree delineated, the next phase of analysis calls for gathering information about probabilities
and monetary values associated with various outcomes in the decision tree. The oil wildcatter reviews his
experiences, analyses statistics relating to oil discovers, and consults geological experts. He comes up
with the following information :
Probabilities for various Oil bearing States
probabilities for various oil-bearing states are :
If he drills without conducting seismic experiments, the
Oil Bearing State
Probability
Dry
Wet
Soaking
.50
.25
.25
Probabilities for Various Soil Structures If he conducts a seismic experiment (which costs Rs.200,000) he
is likely to find the following underlying geological structure with probabilities mentioned against them :
Geological Structure
Probability
No structure (NS)
Open structure (OS)
Closed structure (CS)
.40
.30
.30
Relationship Between the Underlying Geological Structures and Oil bearing States
The relationship
between the underlying geological structures and oil-bearing states expressed in terms of joint probabilities
is as follows :
Underlying Geological Structure

Oil-bearing
Marginal
State
probability
No
Open
structure
Closed
structure
structure
of state
Dry
Wet
.32
.04
.15
.10
.03
.11
.50
.25
Monetary Values of Outcomes The net present value of cash flows, calculated at 12 percent discount rate,
associated with the three states for 5 years (which is the maximum duration of oil drilling) is given below :
State
Net Present Value
Dry
Wet
Soaking
Rs.6 mln
Rs.8 mln
Rs.24 mln
Figure 10.3 shows the decision tree incorporating information regarding probabilities and monetary values
of outcomes discussed above. With this decision tree we evaluate the alternative courses of action as
follows :

1.
MAFA-20
Starting at the right-hand end of the tree, the expected monetary values at chance forks, C 1, C3, C4,
and C5, which come first as we proceed leftwards, are determined :
EMV (C1) = Rs.5.00 mln EMV (C3) = - Rs.1.60 mln
EMV (C4) = Rs.3.67 mln EMV (C5) = Rs.15.13 mln
2.
Given the above expected monetary values, the alternatives at the last stage decision points and their
expected monetary values are defined as follows :
Decision Point
monetary value
D2
Alternatives
Expected
D12 (Drill)
D22 (Do not drill)
D31 (Drill)
D32 (Do not drill)
D41 (Drill)
D3
D4
- Rs.1.6 mln
0
4.67 mln
0
15,13 mln
3.
On the basis of the above information, the alternatives selected at the decision points D 2, D3, and D4
are D22 (do not drill), D31 (drill), and D41 (drill), respectively. The values assigned to the decision points
D2, D3, and D4 are 0, Rs.4.67 mln, and Rs.15.13 mln, respectively.
4.
Proceeding leftward the expected monetary value at chance fork C 2 is calculated.

Expected monetary value at C2
= .4 x 0 + .3 x 4.67 + .3 x 15.13
= Rs.5.64 mln
5.
Moving leftward the first-stage decision point is reached.

monetary values, at this decision point, are :
Alternative
D11 (Drill)
D12 (Conduct seismic
experiments)
D13 (Do nothing)
The alternatives and their expected
Expected monetary value

Rs.5 mln
Rs.5.44 mln
0
Looking at the expected monetary values we find that D 12 (conduct seismic experiments) is the most
desirable alternative at the first-stage decision point.
Below shows the decision tree with expected values at change points and decision points.
Based on the above evaluation of alternatives, we find that the optimal decision strategy is as follows :
Choose D12 (conduct seismic experiments) at decision point D 1 and wait for the outcome at chance point
C2. If the outcome at C2 is C21 (no structure), then choose D22 (do not drill); if the outcome at C2 is C22
(open structure), then choose D 31 (drill); if the outcome at C 2 is C23 (closed structure), then choose D41
(drill).
Following the above decision strategy, the decision-maker may, depending on the outcome at chance
points, traverse paths shown in Table 10.1.
The mean and standard deviations of the above distribution are NPV = Rs.5.44 mln, (NPV) = Rs.10.44
mln.
2A . General Techniques:
MAFA-21
(1) Risk Adjusted discount rate : Calculate NPVs with risk full rate &/or risk less rate , then decide
accordingly
(2) Certainty equivalent co- efficiant = Risk less cash flow Risky cash flow
Here, cash inflows are taken as risk full cash inflowes. So calculate NPV on the basis of risk-less cash
inflowes .
2B. QUANTITATIVE TECHNIQUES
1) SENSITIVITY ANALYSIS
for each factor , Sensitivity Index = Net Present Value
. x 100
Discounted cash flow of the factor
On market basis Sensitivity, market is classified as : Pecemistic , Most likely & Optimistic .
Decisions are taken on the nature of the entrepreneurs after calculating NPV under each case.
2) EXPECTED VALUE APPROACH ( E.V . )
When discounting factors are not given EV = Pi Xi
When discounting factors are given EV =(Pi Xi x Discounting factor) - Discounted cash outflow
3) STANDARD DEVIATION
When discounting factors are not given
SD = Pi Xi 2 - { Pi Xi }2
When discounting factors are given

SD = Variance of NPV
2
where variance of NPV = PiXi - ( PiXi )2 . - Variance of discounted cash outflow
( 1 + int rate)2n
4) CO- EFFICIENT OF VARIATION = Standard Deviation Mean 100
Accept that project where co - efficient of variation is low . Here, mean defines NPV when discounting
factors are given
5 ) DECISION TREE ANALYSIS :: FOLLOW Operation research
Hillers Model:
Hiller argues that the uncertainty or the risk associated with a capital expenditure proposal is
shown by the standard deviation of the expected cash flows. In other words, the more certain a
project is lesser would be the deviation of various cash flows from the mean cash flows. Let us
take the example of a bank deposit where the rate of interest stipulated is subject to changes
according to the Reserve Bank Regulations. It is also known with a fair degree of certainty that
even if the rate of interest is revised downwards, the existing deposits will normally be
protected. Similarly, it is known that if the rate of interest is revised upwards there is some
probability that the existing deposits may also be covered. Now there are at best two or three
possible cash flows: the first at the contracted rate of interest, the second at a rate of interest
one step higher and third at a rate of interest two steps higher. It is quite obvious that the
standard deviation of this proposal would be much lower as compared to the standard deviation
of a proposal whereby the same money is invested in a small scale unit exporting garments. In
the latter case there are a large number of variables which would affect the cash inflows and
therefore, the range of cash inflows would be much larger in numbers resulting in a higher
standard deviation. Hillier thus argues that working out the standard deviation of the various
ranges of cash flow would be helpful in the process of taking cognisance of uncertainty involved
with future projects.
Hillier has developed a model to evaluate the various alternative cash flows that may arise from
a capital expenditure proposal. He takes into account the mean of present value of the cash
flows and the standard deviation of such cash flows, which may be determined with the help of
the following formulae:
n
M = (1 + r) -1 Mi
i=0
MAFA-22
n
2 = (1 + r) -2I 2 i
i=0
Where, Mi is the i-th period.

R is the discounting factor and 2 i is the variance of cash flows.
Illustration
Assume that discount rate is 10 percent and the cash flows are as follows:
Period (i)
0
1
2
Mean (Mi) (Rs.)

- 16000
1500
1000
Standard deviation (i) (Rs.)

400
500
600
Note : M I is reached by taking an average of the various probable estimates of cash flows for a
particular year.
(a) Compute the mean of the present value distribution.
(b) Compute the standard deviation of the present value distribution.
Hertzs Model
Hertz has suggested that simulation technique which is a highly flexible tool of operational
research may be used in capital budgeting exercise. He argues that planning problems of a firm
are so complex that they cannot be described by a mathematical model. Even if we do so we
may make certain inherent assumption because of which the solution is not reliable for practical
purposes. Moreover, in most of the solutions due to the uncertainties involved, a satisfactory
mathematical model cannot be built. He, therefore suggests that a simulation model may be
developed for the investment decision making also. The suggested model for introduction of a
new product developed by Hertz is given below:
1.
2.
3.
4.
5.
6.
7.
8.
9.
Market size
Selling prices
Market growth rate
Eventual share of market
Total investment required
(for computing its cost)
Useful life of facilities
Residual value
Operating cost
Fixed cost
Range
1,00,000 3,40,000
385 575
0 6%
3 17%
7 10
5 13
35 50
370 545
253 375
(Expected value)
(1,50,000)
(1,50,000)
(510)
(3%)
(9.5)
(10)
(45)
(450)
(300)
PROBLEMS:
1.
X Ltd. is considering the purchase of a new machine which will carry out some operations at present performed by
labour. Two alternative models - A and B - are available for the purpose. From the following information, prepare a
profitability statement using pay Back Period and Pay Back Profitability for submission to management :
Machine A
Machine B
Estimated life (years)
5
6
Cost of machine
(Rs.)
80,000
1,50,000
Estimated additional costs (Rs.( :
Maintenance (per month)
500
750
Indirect materials (p.a.)
2,000
3,000
Supervision (per quarter)
3,000
4,500
Estimated savings in scrap (p.a.) (Rs.)
8,000
12,000
Estimated savings in direct wages per annum:
Employees not required
10
15
Wages per employee
(Rs.)
7,200
7,200
MAFA-23
Depreciation is calculated using straight line method. Taxation may be taken at 50% of profit (net savings).
2.
A Company manufacturing agricultural Tractors has a capacity to reduce 6,000 tractors annually. The capital
employed in the project as on date is Rs. 20 crores. With increasing cost of production and reducing margins the
company is fast narrowing its margin of safety. The return on capital employed fell from 10% in the previous year to
6% in the current year, i.e., the current year profit is Rs. 1.20 crores. The company wants to maintain the original cut
off rate of 12% and various possibilities have been examined for this propose.
The company is at present manufacturing and marketing 6,000 tractors annually though there is imbalance in
the plant. The company has the following major production departments with percentage capacity ultisation for the
present production :
Production Dept.
Capacity utilized
Machine Shop
75%
Assembly Shop
100%
Heat treatment Shop
75%
Induction hardening
50%
The Company operates a single shift of 8 hours per day on an average for 300 days in a year. For technical
reason the plant will have to operate on single shift basis only.
The two alternatives which have emerged after a detailed study are :
(a) To hire out the surplus capacity in the productions shops for which constant demand exists. The following income
and expenditure projections are drawn out :
Hire charges per hour
Incremental cost per hour
Rs.
Rs.
Machine Shop
10,000
2,000
Heat-treatment Shop
7,500
1,500
Induction-hardening
5,000
1,000
(b) To increase the installed capacity to 8,000 tractors by spending Rs. 2 crores on additional machinery for the
assembly for the assembly shop. The incremental revenue from the additional sale will be Rs. 5,000 per tractor. The
cost of additional finance will be 12% being the cost of existing capital employed. In addition tax benefits on an
average will work out to 1% of additional investment.
Your are required :
(I) To work out the profitability, i.e., average rate of return of the two alternatives and recommend the better
alternative, (ii) To comment on the advisability of maintaining an imbalance plant from a long-term point of view.
3.
BS ELECTRONICS is considering a proposal to replace one of its machines. In this connection, the following
information is available :
The existing machine was bought 3 years ago for Rs. 10 lakhs, It was depreciated at 25% p.a., on reducing
balance basis. It has remaining life of 5 years, but its maintenance cost is expected to increase by Rs. 50,000 p.a. from
the 6th year of its installation. its present realisable value is Rs. 6 lakhs.
The new machine costs Rs. 15 lakhs and is subject to the same rate of depreciation. On sale after 5 years, it
is expected to net Rs. 9 lakhs. With the new machine, opening costs (excluding depreciation) are expected to decrease
by Rs. 1 lakh p.a. In addition, the speed of the new machine would increase productivity on account of which net
revenues would increase by Rs. 1.5 lakhs p.a. The tax rate applicable is 40% and the cost of capital 10%.
Is the proposal financially viable ? Please advise the firm on the basis of Net Present Value of the proposal.
4.
The capital budgeting committee of the board of directors of Khalifa Ltd. is considering the acquisition of a
unit of equipment costing Rs. 76,000. Shipping and installation costs are estimated at an additional Rs. 4,000. The
equipment is expected to have a useful life of 5 years with a salvage, value of Rs. 5,000 at the end of 5 years. Before
considering the effect of depreciation, the annual cash flow returns after income tax from the use of this equipment
are estimated at Rs. 20,000.
One member of the committee believes that the equipment now in service of this production can be used for
another year. A new and improved model is expected in another year that can be acquired at a cost of Rs. 91,000.
Shipping and installation costs are also estimated at Rs. 4,000, and the estimated salvage value at the end of the
expected 5-year life is Rs. 5,000. Annual cash flow returns after income-tax but before considering the effect of
depreciation are estimated at Rs. 23,000.
The company has set a minimum rate of return objective of 18%. Depreciation is to be deducted by the sum
of the years digits method. The income tax rate is 40%.
Does it appear that the equipment should be purchased now, or should the company wait for a year for the
new model. use the net present value method and show computations.

5.
SCL Limited, a highly profitable company is engaged in the manufacture of power intensive conductors. As part
of its iversification plans, the company proposes to put up a Windmill to generate electricity. The details of the
scheme are as follows :
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
6.
7.
MAFA-24
Cost of the Windmill

Rs.
300 lakhs
Cost of Land
Rs.
15 lakhs
Subsidy from State Government to be received at the end of first year of installation
Rs. 15 lakhs
Cost of electricity will be Rs. 2.25 per unit in year 1. This will increase by Re. 0.25 per unit every year till
year 7 . After that it will increase by Re. 0.50 per unit.
Maintenance cost will be Rs. 4 lakhs in year 1 and the same will increase by Rs. 2 lakhs every year.
Estimated life 10 years with cost of capital 15%. Tax rate 40%.
Residual value of Windmill will be nil. However land value will go up to Rs. 60 lakhs, at the end of year 10.
Depreciation will be 100% of the cost of the Windmill in year 1 and it will be allowed for tax purposes.
As Windmills are expected to work based on wind velocity, the efficiency is expected to be an average 30%.
Gross electricity generated at this level will be 25 lakhs units per annum. 4% of this electricity generated will
be committed free to the State Electricity Board as per the agreement.
From the above information you are required to calculate the net present value.
Elite Builders, a leading construction company have been approached by a Foreign Embassy to build for them a block
of six flats to be used as guest houses. As per the terms of contract the Foreign Embassy would provide Elite Builders
the plans and the land costing Rs. 25 lakhs. Elite Builders would build the flats at their own cost and lease them out to
the Foreign Embassy for 15 years at the end of which the flats will be transferred to the Foreign Embassy for a
nominal value of Rs. 8 lakhs. Elite Builders estimates the cost of construction as follows :
Area per flat
1,000 sq.ft.
Construction cost
Rs. 400 per sq. ft.
Registration and other costs
2.5% of cost of construction.
Elite Builders will also incur Rs. 4 lakhs each in year 14 and 15 towards repairs.
Elite builders proposes to charge the lease rentals as follows :
Years
Rentals
1 to 5
Normal
6 to 10
120% of Normal
11 to 15
150% of Normal
Elite Builders present tax rate averages at 35%. The full cost of construction and registration will be written off over
15 years and will be allowed for tax purposes.
You are required to calculate the normal lease rental per annum per flat. For your exercise assume :
(a) Minimum desired return of 10%
(b) Rentals & repairs will arise on the last day of the year.]
(c) Construction registration and other costs will be incurred at time O.
(d) The relevant discount factors are :
A Limited Company is manufacturing a product Hindon with the help of a group of machines having a
book value of Rs. 65,000 after deducting depreciation on straight line basis. The company is considering the
replacement of these machines by new ones. The new machines would cost Rs. 1,00,000 while the old machines
could be sold only for Rs. 45,000. The new machines would have a life of four years. The existing machines could
also be kept in operation for four more years provided it would be economical to do so. The scrap values of both the
new and old machines would be zero after four years.
The current costs per unit of manufacturing Hindon on the existing and new machine would be as under :
Existing Machines
New Machines
Materials
Rs.
22.00
Rs.
20.00
Labour (32 hours @ Rs.1.25)
40.00
(16 hrs.@Rs.1.25)
20.00
Overhead(32 hours @ Re.0.60)
19.20
(16 hrs@Rs.1.80)28.80
Total cost
81.20
68.80
Overheads are charged to products on the basis of direct labour hour rate method comprising :
Existing Machine
New Machine
Variable Overhead
Re. 0.25
Re. 0.625
Fixed Overhead(including depreciation)
0.35
Rs. 1.175
The present sales of Hindon are 1,000 units per annum @ Rs. 90 each. In the event of new machines being
purchased, the output would increase to 1,200 units and selling price would stand reduced to Rs. 80.
A Limited requires a minimum rate of return on investment at 20% per annum ( ignore tax) in money terms.
materials costs, overhead costs and selling prices will increase at the rate of 15% per annum. Labour costs would
MAFA-25
increase by 20% per annum. it may be assumed that receipts and payments would accrue at the end of each year.
Advise .
8.
The Directors of Alpha Cement Works Ltd. have before them the following two schemes of expansion. They
request you to ascertain which of the schemes will be more beneficial to the Company in a total period of 14 years.
Scheme 1
By adoption of a device in which the capacity of the plant will be increased to a production of 600 tonnes per day
from 400 tonnes (now). The following information is available :
Rs.
(1) Written down value of a portion of the present plant which will not be required
30,00,000
(2) Estimated scrap value
15,00,000
(3) Cost of new portion of the plant
1,00,00,000
(4) Cost of erection
10,00,000
(5) Estimated life of the plant (i.e., the period in which 95% of
the cost can be written off)
15 years of 300 working days
(6) Net sale price per ton
Rs.
150
(7) Other costs per ton (excluding interest)
120
(8) Interest @ 10% on Rs. 70,00,000 to be borrowed payable in 5 years in equal
installments plus interest-the first installment being payable after a year.
Scheme II
By installing a new plant with a capacity of manufacturing 300 tonnes of cement per day. The following
information is available
(1) Cost of new plant
Rs
2,00,00,000
(2) Cost of erection
35,00,000
(3) Estimated life(i.e. the period during which 95% of the
cost can be written off)
20 years of 300 working days
(4) Net sale price per tonne
Rs.
150
(5) Other costs per tonne (excluding interest)
120
(6) Interest-10% on Rs. 1,80,00,000 payable in 9 years in equal annual installments plus interest-the first installment
being payable after a year.
9.
A company is setting up a project at cost of Rs. 300 lakhs. It has to decide whether to locate the plant in a Forward
Area (FA) or Backward Area (BA). Locating in Backward Area means a cash subsidy of Rs. 15 lakhs from the
Central Govt. Besides the taxable profits to the extent of 20% is exempt from tax for 10 years. The project envisages
a borrowing of Rs. 200 lakhs in either case. The cost of borrowing will be 12% in Forward Area and 10% in
Backward Area. However, the revenue costs are bound to be higher in Backward Area. The borrowings have to be
repaid in 4 equal annual installments beginning from the end of the 4th year. With the help of following information
and by using DCF techniques, you are required to suggest the proper location for the Project :
year
Profit (Loss) before Interest and Depreciation

Present Value
(Rs. in lakhs)
Factor
FA
BA
(at 15%)
1
(6.00)
(50.00)
0.87
2
34.00
(20.00)
0.76
3
54.00
10.00
0.66
4
74.00
20.00
0.57
5
108.00
45.00
0.50
6
142.00
100.00
0.43
7
156.00
155.00
0.38
8
230.00
190.00
0.33
9
330.00
230.00
0.28
10
430.00
330.00
0.25
The annual depreciation may be taken at Rs. 30 lakhs. Interest on borrowings may be worked out at the
respective rates. Average Rte of Tax may be taken as 35%. Also calculate DSCR.
10.
A theaters, with some surplus accommodation, proposes to extend its catering facilities to provide light meals to its
patrons. The management is prepared to make the initial funds available to cover the capital costs. It requires that
these be repaid over a period of five years at a rate of interest of 14% per annum.
MAFA-26
The capital costs are estimated at Rs. 60,000 for equipment that will have a life of 5 years and no residual
value. Running costs of staff etc. will be Rs. 20,000 in the first year, increasing by Rs. 2,000 in each subsequent year.
The management proposes to charge Rs. 5,000 per annum for electricity and other expenses and wants a nominal Rs.
2,500 per annum to cover any unforeseen contingencies. Apart from this, the management is not looking for any
profit as such from the extension of these facilities because it believes that these will enable more tickets to be sold
for the cinema shows at the theaters. It is proposed that costs should be recovered by setting prices for the food at
double the direct cost.
It is not expected that the full sales level will be reached until year 3. The proportion of that level reached in
year 1 and 2 are 35% and 65% respectively.
You are required to calculate the sales that need to be achieved in each of the five years to meet the
managements targets. Ignore inflation and taxation.
11.
Swastik Ltd. manufactures of special purpose machine tools, have two divisions which are periodically assisted by
visiting teams of consultants. The management is worried about the steady increase of expenses in this regard over
the year. An analysis of last years expenses reveals the
Rs.
Consult ants Remuneration
2,50,000
Travel and Conveyance
1,50,000
Accommodation Expenses
6,00,000
Boarding Charges
2,00,000
Special Allowances
50,000
12,50,000
The management estimates accommodation expenses to increase by Rs. 2,00,000 annually.
As part of a cost reduction drive, Swastik Ltd. are proposing to construct a consultancy centre to take care of the
accommodation requirements of the consultants. This centre will additionally save the company Rs. 50,000 in
boarding charges and Rs. 2,00,000 in the cost of Executive Training Programmes hitherto conducted outside the
companys premises, every year.
The following details are available regarding the construction and maintenance of the new centre :
(a) Land : at a cost of Rs. 8,00,000 already owned by the company, will be used.
(b) Construction cost: Rs. 15,00,000 including special furnishings.
(c) Cost of annual maintenance : Rs. 1,50,000
(d) Construction cost will be written off over 5 years being the useful life.
Assuming that the write-off of construction cost as aforesaid will be accepted for tax purposes, that the rate of tax will
be 40% and that the desired rate of return is 15%; you are required to analyse the feasibility of the proposal and make
recommendations.
12.
The Electric Gadgets Division of Home Appliances Ltd. is considering production and sell a mini personal
computer for household use. The plant to be purchased for this project will cost Rs. 2,40,000 Project analysis done by
the Divisional Accountant give the following figures :
Year
Sales (Rs. 000)
Costs (Rs. 000)
Materials :
Opening Stock
Add : Purchases
Less : Closing Stock
Cost of Material used
Labour
Production Expenses
Depreciation
Group Administration Allowed
Interest
Net Profit
1
400
2
600
3
800
4
600
40
200
240
80
160
80
80
40
54
22
----436
(36)
80
240
320
80
240
120
90
40
76
22
---588
12
80
300
380
60
320
120
92
40
74
22
----688
132
60
180
240
240
80
100
40
74
22
-----556
44
(I) The plant used for this product is highly specialised and is unlikely to have any terminal value after meeting
dismantling costs at the end of its four-year working life. However, depreciation is based on a six-year life using the
straight line method.
MAFA-27
(ii) The opening stock has to be purchased before the project starts.
(iii) Production expenses is inclusive of a proportion of fixed factory overheads charged out as 25% of labour costs.
The remaining production expenses are all incremental cash costs.
(iv) When the project is commissioned, existing old machinery will become redundant, since the new plant can do the
work of the old machinery in its spare time, at a cost saving of Rs. 36,000 per annuam. The old machinery which is
completely written down for tax purposes, has a book value of Rs. 60,000 but could be sold at once for Rs. 20,000
which will be subject to tax. These cost savings are ignored in the above analysis except that the disposal proceeds
have been deducted from the envisaged external incremental borrowings and are reflected in a reduced interest
charge.
(v) Home Appliances Ltd. requires a return of 14% on capital projects to equal the cost of capital for the Division.
The Marketing Director has expressed his reservation to the project on the grounds that the calculation excludes :
(i) An advertising campaign to launch the product costing an estimated Rs. 40,000 before production commences,
with supplementary expenditure of Rs. 10,000 per annum in the first three years of the project.
(ii) The new product will compete with an electronic calculator, already marketed by the Division and will force a
revision of budgeted sales as under :
Year
Original Forecast
Revised Forecast
1
5,000 X Rs. 160
5,000 X Rs. 150
2
4,000 X Rs. 120
3,000 X Rs. 100
3
2,000 X Rs. 80
4
Production Costs are Budgeted as follows :
Year
1
2
3
Variable Costs (Rs.)
120
90
60
Fixed Costs allocated
20
20
20
140
110
80
(iii) The Marketing Director has his own doubts about 14% as the cost of capital of the Division.
In the light of the above observations and figures supplied, you are required to advise whether the project is
viable at 14% as the cost of capital and also comment at what cost of capital the product ceases to be viable. Assume
Corporate Tax is 40% for the next five years.
13.
Cost of Machine
= Rs. 10,000
Estimate life of Machine
= 4 Years
Cash inflows
= Rs. 6,000 in first year & increased by Rs.1,000 p.a.
Cost of Capital r
= 15%
Expected interest rates, at which cash inflows shall be re-invested :
Year end
Percentage
1
12%
2
12%
3
10%
4
13%
Whether the project should be accepted under terminal Value Method ?
14.
From the following data, state which project is better:

Project
Cash flows:
Year
0
-10,000
-10,000
1
4,000
5,000
2
4,000
5,000
3
2,000
3,000
Risk less discount rate is 5%. Project A is less risky as compared to Project B. The management considers risk
premium rates at 5% and 10% respectively appropriate for discounting the cash inflows.
15.
Using the information given in above illustration , state which project is better if certainty equivalent coefficient are:
Project A
Project B
1 st
.90
.80
2 nd
.80
.70
MAFA-28
3 rd
.60
.50
3. M/s. GLOBE INDIA LTD. uses a mixing machine on its production line ( project life 5 years )and intends to
replace the existing obsolete machine by a new high technology version. The company wishes to determine
the optimum replacement cycle for the new machine which has the following costs :
4.
Age of machine (hears)
0
1
2
3
(Rs.)
(Rs.)
(Rs.)
(Rs.)
------------------------------------------------------Cost
80,000
Re sale value
52,000
40,000
32,000
Running costs
16,000
20,000
40,000
The asset will never be kept for longer than 3 years. The replacements will be identical assets. There is no inflation and
the discount rate is 12 percent, Ignore taxation.
5.
The Hypothetical Company Limited has given the following possible cash inflows for two of their projects
X and Y out of which one they wish to undertake together with their associated probabilities. Both the
projects will require an equal investment of Rs. 5,000. You are requested to give your considered opinion
regarding the selection of the project.
Project X
Project Y
Possible Event
Cash Inflows
Probability
Cash Inflows
Probability
.
A
4,000
.10
12,000
.10
B
5,000
.20
10,000
.15
C
6,000
.40
8,000
.50
D
7,000
.20
6,000
.15
E
8,000
.10
4,000
.10
.
18.
ABC Company Limited is attempting to evaluate two mutually exclusive project A & B. Each project requires a
net investment of Rs. 10,000 and the annual cash inflows from each of the project is estimated at Rs. 2,000 per
annuam in the next 15 years. The Companys is cost of capital may be taken at 10%. The management has made the
following optimistic, most likely and pessimistic estimates of the annual cash inflows associated with each of these
projects :
Project A
Project B
Initial Investment
Rs.
10,000
Rs.
10,000
Estimated cash inflows (per annum)
Pessimistic
1,500
Most likely
2,000
2,000
Optimistic
2,500
4,000
You are required to give your considered opinion for helping the management in arriving at a decision.
19.
Pace Setter Ltd. manufactures certain sophisticated gadgets. These rapidly become obsolete and the
company follows the policy of redesigning or abandoning each type of gadget after a life of 4 years in order to avoid
uneconomic levels of output. One gadget Housewifes helper is under review now. The Research and Development
Department has produced a new design HH4 at a cost of Rs. 23,000. Selling Price would be set at Rs. 60 per unit and
it is estimated that variable costs will be Rs. 25 per unit and that fixed cost of the firm would be reduced by Rs.
55,000 per annum if the product were to be abandoned.
Sales of previous models HH1, HH2, HH3, all of which have been sold at Rs. 60 per unit have been as under :
HH 1
Year
1990
1991
1992
1993
HH2
Units
1800
2100
2800
2100
Year
1994
1995
1996
1997
HH3
Units
1200
2000
3400
2200
Year
1998
1999
2000
2001
A trend line fitted to the sales data using linear regression analysis has been estimated as follows :
Units
1300
2300
3600
2500
MAFA-29
Sales volume in year n = 1564 + 98 (n 1989 ). The cost of capital of Pace Setter Ltd. is 20% per annum. Sales
may be assumed to occur and production costs to be incurred on the last day of each year.
Your are required :
(I) to predict the volume of sales of HH4 for each of the four years 1992 to 1995 assuming the sales
fluctuate around the trend line given above to the extent that depends on the age of the model.
(ii) to calculate the maximum outlay at which the introduction of the new model HH4 could just he
preferable to abandonment. Ignore taxation.
20.
M/s Light Home Limited have estimated the following probabilities for the net cash flows generated by a project. You
are required to calculate the present value of the expected monetary cash flows & co-efficient of variance at 10%
discount rate. The following information has been made available to you :
1st year
Cash inflow(Rs)
Rs. 100
200
300
400
21.
Probability
.30
.20
.30
.20
2nd year
Cash in flow
100
200
300
400
Probability
.20
.30
.40
.10
3rd year
Cash inflows
Probability
100
.30
200
.40
300
.20
400
.10
The Management of Premier Tyres Ltd. which has assets of about Rs. 15,00,000 is considering two possible
investment projects. Only one project has to be chosen.
The initial cash outlay required for each project is as
follows :
Project A : Rs. 1,00,000
Project B : Rs. 6,00,000
For each projects in each year only two potential after-tax cash flows are available. The after-tax cash flows and their
estimated probabilities of accruing are :
Each of first 3 years
Each of the next 3 years
Each of last 3 years
Probability
Amount
Probability
Amount
Probability Amount
Project A
.50
45,000
.75
20,000
.50
10,000
.50
15,000
.25
0
.50
0
Project B
.50
.50
75,000
15,000
.60
.40
50,000
2,00,000
.75
.25
1,00,000
4,00,000
Although, no internal funds are available for the financing of either of the proposed project, the company can
obtain enough outside funds for either at a cost that would leave the companys overall after-tax cost of capital at its
present level of 8%. On the basis of expected net present value only, which proposed projects, if either, should
management choose. Submit your calculations.
22.
ABC Limited, a manufacturing company, is considering the market potential for a new product Jai Prakash. The
Sales Manager is of the opinion that the total sales of the new machine during the period of five years will not be less
than 5,000 units per annum. The maximum capacity of the plant is likely to be 80,000 units per annum. The Sales
Manager reports that there are two chances in five for a sales volume of 50,000 units per annum. The probability that
the sales volume will exceed 50,000 units if four times the probability that it will be less that 50,000.
If sales exceed 50,000 units, volumes of 60,000 and 80,000 units are equally likely. However, a sales volume
of 70,000 units if four times as likely as either of the two given above.
The marginal production costs are estimated at Rs. 30 per unit. The selling price is likely to be Rs. 50 per
unit and special manufacturing equipment (without any salvage volume or alternative use) costs Rs. 8 lakhs. You may
presume that the above mentioned are only possible sales volumes.
You are required to advise ABC Limited whether they should take up the new product or not. Your
recommendations should be supported by detailed computations.
23.
Forward Planning Ltd. is considering whether to invest in a project which would entail immediate expenditure on
capital equipment of Rs. 40,000.
Expected Sales from the project are as follows :
Probability
Sales Volume (Units)
0.10
2,000
0.25
6,000
MAFA-30
0.40
0.15
0.10
8,000
10,000
14,000
Once sales are established at a certain volume in the first year, they will continue at that same volume in subsequent
years. The unit selling prices will be Rs. 10, the unit variable cost Rs. 6 and the additional fixed costs will be Rs.
20,000 (all cash items).
The project would have a life of 6 years after which the equipment would be sold for scrap which would fetch Rs.
3,000.
You are required to find out (a) the expected value of the NPV of the project.
(b) the minimum volume of sales per annum required to justify the project.
The cost of capital of the company is 10%. Ignore Taxation.
24.
The Shortsight Company is at attempting to decide whether or not to invest in a project that requires an initial outlay
of Rs. 4 lakhs. The cash flows of the project are known to be made up of two parts, one of which varies independently
over time and the other one which displays perfect positive correlation. The cash flows for the six year life of the
project are :
Year
1
2
3
4
5
6
25.
26.
Perfectly Correlated Components

Mean
Standard Deviation
Rs.
Rs.
40,000
4,400
50,000
4,500
48,000
3,000
48,000
3,200
55,000
4,000
60,000
4,000
Independent Component
Mean
Standard Deviation
Rs.
Rs.
42,000
4,000
50,000
4,400
50,000
4,800
50,000
4,000
52,000
4,000
52,000
3,600
(I) Find out the expected value of the NPV and its standard deviation, using a discount rate of 10%.
(ii) Also find the probability that the project will be successful, i.e. P (NPV >0) and state the assumptions under which
this probability can be determined.
Following is the data regarding six securities :
A
B
C
D
E
F
Return (%)
8
8
12
4
9
8
Risk (%)
4
5
12
4
5
6
(Standard Deviation)
(I) Which of the securities will be selected ?
(ii) Assuming perfect correlation, analyse whether it is preferable to invest 75% in security A and 25% in security C.
The following statements give quantitative considerations relevant for the ranking of projects A and B :
Criteria
Investment
Internal Rate of Return
Net present value at 6%
discount factor
Net present value at 12%
discount factor
Project A
Project B
Rs.
400
Nearly 18%
Rs.
300
Nearly 20%
Rs.
142.7
Rs.
121.2
Rs.
60.5
Rs.
60.5
Project A required an investment of Rs. 400 and was expected to have cash inflow of Rs. 110, Rs. 120, Rs.
130, Rs. 140 and Rs. 150 over its 5 year economic life. Project B involved an investment of Rs. 300 and was expected
to have cash inflows of Rs. 100 each year over its five year economic life.
Which of the two project will you select if cost of capital is (I) 10% ii) 12% and (iii) 15%? Give reasons in
support of your decision. Present value table may be consulted for relevant P.V. factors.
MAFA-31
27.
Alpha Limited is considering five capital projects for the years 1994 and 1995. The company is financed by equity
entirely and its cost of capital is 12%. The expected cash flows of the projects are as below :
Year and Cash flows (Rs. 000)
Project
1994
1995
1996
1997
A
(70)
35
35
20
B
(40)
(30)
45
55
C
(50)
(60)
70
80
D
(90)
55
65
E
(60)
20
40
50
Note : Figures in brackets represent cash outflows.
All projects are divisible i.e. size of investment can be reduced, if necessary in relation to availability of
funds. None of the projects can be delayed or undertaken more than once.
Calculate which project Alpha Limited should undertake if the capital available for investment is limited to
Rs. 1,10,000 in 1994 and with no limitation in subsequent years . For your analysis, use the following present value
factors :
28.
S. Ltd. Has Rs. 10,00,000 allocated for capital budgeting purposes. The following proposals and associated profitability
indexes have been determined :
Project
Amount(Rs)
Profitability Index
1
3,00,000
1.22
2
1,50,000
0.95
3
3,50,000
1.20
4
4,50,000
1.18
5
2,00,000
1.20
6
4,00,000
1.05
Which of the above investments should be undertaken? Assume that projects are indivisible and there is no
alternative use of the money allocated for capital budgeting.
29.
Traffic lights control the flow of traffic across and between two busy highways A and B. It is estimated that
50% of the traffic on each highway is delayed; the average loss of time per car delayed is 1 minute on highway A and
1.2 minutes on highway B. The traffic on A averages 5000 cars a day and on B 400. 20% of the cars are trucks and
commercial vehicles, the rest are private. Whether on business or pleasure the occupants time has to be viewed as
valuable. The cost of time for commercial vehicles is estimated at Rs. 5 an hour and private at Rs. 2. The cost of a
stop and start is estimated to be 6 paise per commercial and 4 paise per private cars. Two fatal accidents due to failure
to obey traffic signals occurred in the last 4 years and the insurance settlements were Rs. 50,000 for each accident.
Forty non-fatal accidents averaging a claim of Rs. 1,500 occurred in the same period. These accidents resulted from
traffic light violations and will be eliminated by an overpass.
The overpass is designed to replace the intersection and will add a quarter of mile to the distance of 15% of
the total traffic. The overpass will Cost Rs. 7,50,000 and the extra maintenance will be Rs. 2,500 a year. The
incremental operating cost for commercial vehicles will be 25 paise a mile and for non-commercial 6 paise a mile.
The Cost of operating the traffic lights is Rs. 6,000 a year and a police man spends 2 hours a day at the
crossing and the cost is apportioned at Rs. 3 per hour. No policeman will be needed at the overpass.
The expected economic life of overpass is 25 years with a salvage value of Zero. The cost of Capital is 7%
(The corresponding capital recovery factor is 0.0858). Compute the Benefit Cost Ratio.
30.
X Ltd. is considering the acquisition of new plant as part of a expansion programme. The estimated cost of
the plant is Rs. 80,000 and the terms of purchase require payment of 50% with order, and the balance 30 days after
delivery and installation. Delivery and installation is expected three months after receipt of the order and production
will start one month after delivery and installation. It is estimated that sales of products which the new plant will
produce will be as follows :
Annual Sales
10000 units
15000 units
20000 units
25000 units
30000 units
Probability
0.1
0.2
0.3
0.3
0.1
MAFA-32
The estimated selling price and variable costs of these product is as follows :
Average selling price
Average variable costs
Rs. 5
- Material Rs. 2
Labour
Re. 1
Re. 3
Contribution
Rs. 2
Total fixed cost excluding depreciation are estimated at Rs. 10,000 per annum. Debtors will take on average
one month to pay and the company will take two months credit from its suppliers. Apart from the production required
to meet sales there will be an investment in stocks of Rs. 20,000. It is company practice in assessing projects to
assume that only 90% of investment in stocks and debtors is recovered.
In addition to the expenditure included above the sales forecast is based on the assumption that there will be
special sales promotion at the beginning of the first two sales years of Rs. 10,000 and Rs. 12,000 respectively. If this
sales promotion expenditure is not incurred it is estimated that sales will be as follows :
Annual Sales
10000 units
15000 units
20000 units
25000 units
30000 units
Probability
0.3
0.3
0.2
0.2
0.0
Although the plant has an estimated technical life of ten years, the sales life of the product is uncertain and
the market research department can only give general guidance that it will almost certainly be longer than six years
but less than ten. The companys long run projected capital structure on which the cost of capital is based is as
follows :
Type
Estimated Net Cost
Amount
Equity
17%
Rs.
1,00,00,000
Loans
14%
Rs.
50,00,000
You are required to advise on the suitability or otherwise of embarking on this project assuming
(a) a life of six years
(b) a life of nine years.
Present value factors :
At
16% for 1 year
0.862 ; for 6 years
0.410 ; for 9 years
0.263 ;
Annuity at 16% for 6 years
3.684 ; and
for 9 years 4.606.
31.
The present annual sales of a company are 50 lakh units at profit of Rs. 60 per unit. In order to meet increased
competition , it is faced with the choice of two routes ;
X Maintaining quality of its products but reducing its price or
Y Improving its quality to maintain or increase sales.
If it follows route X, it assumes that its volume of sales will react in the following way to price reductions :
Price Reduction
Effect on Sales Volume
(I) Rs. 2.00 per unit
Reduction of 10%
(ii) Rs. 3.50 per unit
Reduction of 5%
(iii)Rs. 5.00 per unit
Stays at present level
If quality is improved in option Y, it can increase its price as below :
Price Increase
Effect on Sales Volume
(I) Rs. 3.50 per unit
Stays at present level
(ii) Rs. 3.00 per unit
Increase in sales volume by 3.5%
Route Y would involve investment in a product improvement project with the following characteristics :
(I) Capital expenditure on plant of Rs. 15 crores at 31st March, 1994 values,
(ii) Plant is expected to come into operation on 31st March, 1996 and the phasing of capital expenditure is expected
to be 60% in 1994-95 and 40% in 1995-96,
(iii) Expected annual rate of price increase for this type of capital expenditure :4.5% in 1994-95 and 2.5% in 1995-96.
4 (iv) Variable operating costs are likely to increase by Rs. 2,00 p.u. on 31st March, 1996 and then remain at that level
5 The required rate of return of the company is 11% for next 6 years.
6
32.
TSL Ltd. a highly profitable and tax paying company is planning to expand its present capacity by 100%. The
estimated cost of the project is Rs. 1,000 lakhs out of which Rs. 500 lakhs is to be met out of loan funds. The company has
received two offers from their bankers:
Option 1
Option 2
MAFA-33
Value of loan
Rs. 500 lakhs
US $ 14 lakhs equal to Rs. 500 lakhs.
Interest
15% payable yearly
6% payable (fixed) yearly in US$.
Period
5 years
5 years
Repayment
(In 5 installments. First installment is payable 1 year after draw back down)
Other expenses
1% of the value of the
1% at US$ = Rs. 36
(To be treated as revenue
loan
(Average)
Expenditure)
Future exchange rate-End of 1 year 1 US $ = Rs. 38 thereafter to increase by Rs. 2 per annum
The company is liable to pay Income- tax at 35% and eligible for 25% depreciation on W. D. value. You may assume
that at the end of the 5 th year the company will be able to claim balance in WDV for tax purposes. The company follows
According Standard AS-11 for accounting changes in Foreign Exchange Rate.
(1) Compare the total outflow of cash under the above options.
(2) Using discounted cash flow technique, evaluate the above offers.
(3) Is there any risk, which the company should take care of?
(4) Is case TSL has large volume of exports would your advise be different.
33.
34.
Following are the data on a capital project being evaluated by the management of X Ltd. :
Project M
Annual cost saving
Rs. 40,000
Useful life
4 years
I. R. R.
15%
Profitability Index (PI)
1.064
NPV
?
Cost of capital
?
Cost of project
?
Payback
?
Salvage value
0
Find the missing values considering the following table of discount factor only:
Discount factor
15%
14%
13%
1 year
0.869
0.877
0.885
2 years
0.756
0.769
0.783
3 years
0.658
0.675
0.693
4 years
0.572
0.592
0.613
2.855
2.913
2.974
12%
0.893
0.797
0.712
0.636
3.038
A public company responsible for the supply of domestic gas has been approached by several prospective customers
in a rural area adjacent to a high-pressure main. As a condition of its license to operate as a utility, the company is
obliged to respond positively to current needs provided the financial viability of the company is not put at risk. New
customers are charged Pounds250 each for connection to the system.
Once a meter is installed, a standing charge of Pounds10 per quarter is billed. Charges for gas are levied at Pounds400
per 1,000 metered units.
A postal survey of the area containing, according to the rating authority, 5,000 domestic units, elicited a 40% response
rate. 95% of those who responded confirmed that they wished to become gas users and expressed their willingness to
pay the connection charge.
Although it is recognised that a small percentage of those willing to pay for connection may not actually
choose to use gas, it is expected that the average household will burn 50 metered units per month.
There will be some seasonal differences.
The companys marginal cost of capital is 17% pa and supplies of bulk gas cost the company Pounds0,065 per
metered unit. Wastage of 15% has to be allowed for
(a) Determine what the maximum capital project cost can be to allow the company to provide the service required.
(b) Explain what other factors the company would take into account in reaching its decision whether or not to
provide the requested service.
(c) Discuss the credence which can be accorded to the outcome of the postal survey.
35. ABC plc is classified as a small company for corporation tax purposes and is liable to tax at 25%. The company is
considering the purchase of a new computer system. The Chief Executive has been advised that it might be advantageous
to lease the computer system rather than buy with a secured bank loan. The before-tax cost of a bank loan to ABC plc
would be 12%. Apart from the possible financial benefits which might arise, he has been told that leasing provides a
hedge against obsolescence.
MAFA-34
The capital cost of the computer would be 50,000. The leasing company, which is not the supplier of manufactuer of
the equipment, has offered what it considers to be very favourable terms for the lease of the computer. Payments would be
15,000 per annum for five years. The first payment would be made at the beginning of the lease contract. This world be
followed by four further payments at the beginning of each of the next four years. Insurance and maintenance of the
computer would be the responsibility of the lesses. At the end of year 5, the second hand value of the computer is
expected to be 5,000.
The leasing company payes tax at the marginal rate of 33%. Writing down allowances are available on the computer at
25% on a reducing balance basis. The companys required rate of return on equity is 15% and it considers this deal to be
of about the average risk of its commercial ventures. The lessor will be able to finance the purchase of the computer from
retained earnings.
REQUIREMENTS :Evaluate the financial decision concerning the lease from the point of view of both the lesses and
the lessor.
36.
Paraffin Wax Ltd.(PWL) produces different grades of lube-base stocks of various grades. These stocks are dewaxed to
remove paraffinic waxes as slack waxes to meet certain technical specifications. The slack waxes are presently merely
blended into furnace oil. PWL now (2000) proposes to install a solvent deoiling plant to refine slack waxes to produce
paraffin wax. The residual oil will be routed to furnace oil again.
The estimated investment cost for the new plant is Rs. 4.54 crores, (financed internally) of which the foreign
exchange component is Rs. 1.68 crores. No extra land is required for this plant. The plant will employ 30 people. The sum
of $300,000 as royalty for foreign technology, included in Rs. 1.68 crores will be paid in three equal installments (I) upon
execution of licence agreement, (ii) upon the start up of the licensed unit, and (iii) on the first anniversary of the start up.
The proposed plant will have a production capacity of 20,000 TPA.
The finance department of PWL has gone about working out of the detailed financial projections of the new plant. It
finds that the working capital requirement is Rs. 26.3 lacs, ad the annual operating costs of the plant are Rs. 90.4 lacs. The
details of capital cost are
Rs./lacs
Foreign Exchange Cost/Dollars/lacs
263.00
4.61
18.00
--50.00
5.50
70.25
4.80
52.50
3.50
453.75
18.41
The total outlay on the project was to be spread over three years as Rs. 1.5, Rs. 2.00 and Rs. 1.04
crores. In the first year of operation 80% of the capacity would be utilised. Thereafter, it would be 100%. The price
formula for sales is assumed to allow a return of 15% on net fixed assets and 15% return on working capital, in addition
to covering other operational costs. Depreciation of fixed assets is assumed @ 10@ p.a. on income tax method (i.e.,
written down value method) for pricing. In the first year of operation raw material cost is 16,000 Mts. @ Rs.598.16,
and in subsequent years Rs. 20,000 Mts. @ Rs. 598.16. Other operating costs excluding depreciation, for the first year
are Rs. 78.6 lacs, and for subsequent years Rs. 90.4 lacs.
Equipment
Tankage
Packaging facilities
Royalties (including GOI taxes @ 40%)
Engineering Fees (including GOI taxes @ 40%)
Working Capital is assumed at 1.5 months of all manufacturing costs. For computing the internal rate of return for the
enterprise a debt/equity ratio of 1;1 has been assumed. Terminal value after 15 years of operation is assumed @ 30% of
capital cost. The GOI holds 75% of the share capital of PWL. The new project will enjoy a tax concession for first 5 years
of operations on profits equal to 7.5% on capital employed. There is also an investment allowance @ 25% permissible for
the first year operation. Corporate income tax rate is applicable at the rate of 57.75%. Compute the I.R.R(internal rate of
return) for the project how would you assess if the IRR is good enough or not?
SNMP-633
37.
A cement company employs 12 trucks of tonnes capacity each for transport of limestone from the nearby which is
situated at a distance of 5 Kilometres from the factory. The vehicles run empty on the outward journey and return with
limestone. Each truck makes five trips to the quarry and back in a day. In an average month of 25 working days during a
year; one day is lost by each truck on an average for repairs and maintenance. The other particulars are as under:-
MAFA-35
Fuel: 2.50 Kilometres per litre of diesel at Rs. 2/-- per litre.
Purchase price of each truck: Rs. 72,000/-.
Life of each of the trucks :12 years but all the trucks have completed 5 years of service.
Drivers salary: Rs. 800/- per month each.
One cleaner is employed for all the trucks at a salary of Rs. 500/- per month.
Repairs and maintenance: Rs. 2,400/- per annum per truck.
Fixed expenses like taxes, tyres, batteries etc.: Rs. 6,000/- per annum per truck.
The company processes to replace these 12 trucks by 6 new trucks of 10 tonnes capacity each. The new trucks will also
remain idle for one day a month for repair and maintenance. The other particulars relating to the new trucks are:Fuel: 2 Kilometres per litre of diesel.
Repairs and maintenance: Rs. 2,400/- per annum per truck.
Fixed expenses like taxed, tyres, batteries etc. Rs. 7,200/- per annum per truck.
Purchase price: Rs. 1,40,000/- each.
Life: 7 years.
The old trucks can be sold at 10% of the book value calculated on straight the method of depreciation. The drivers
rendered surplus in the change over the proposed to be retrenched on payment of a compensation of Rs. 15,000/-each
immediately after the replacement proposal is put through. Interest is ignored. Required:
(i) Prepare a comparative cost statement showing the operating cost per tonne of limestone in the existing situation and
under the replacement proposed using straight line method of depreciation.
Advise your management on the economics of the replacement the future cash inflows at expected return of 12% on
capital employed.
RO-2.54
38.
A company is considering the purchase of a new machine for Rs. 3,50,000. It feels quite confident that it can sell the
goods produced by the machine so as to yield an annual cash surplus of Rs. 1,00,000. There is however some uncertainty
as to the machines working life. A recently published Trade Association Survey shows that members of the Association
have between them owned 250 of these machines and have found the lives of the machines vary as under:
----------------------------------------------------------------------------------------------------------------------------------------No. of years of Machine life
No of Machines having given life
3
20
4
50
5
100
6
70
7
10
------250
----------------------------------------------------------------------------------------------------------------------------------------Assuming a discount rate of 10%, the net present value for each different machine life is as follows:
----------------------------------------------------------------------------------------------------------------------------------------Machine life
NPV ( Rs.)
3
(1,01,000)
4
(33,000)
5
29,000
6
86,000
7
1,37,000
----------------------------------------------------------------------------------------------------------------------------------------You are required to advise whether the Company should purchase a new machine or not. SNM-649
39.
Cosy Comforts Associates propose to install a central air-conditioning system in their city office building. As part of
the Companys long range plan, the office building is due to be disposed off on 31st December 2001 and the company
believes that whichever system is installed, it will add some Rs. 1 lakh to the resale value at that time. Cosy Comforts
Associates estimate that the costs of installing and running the three systems are as follows:
MAFA-36
(I) Installation costs (payable on 1st January 1999):

Rs.
Gas
1,70,000
Oil
1,50,000
Soli6 Fuel
1,40,000
(ii) Annual Fuel costs (payable at the end of each year):
Annual fuel costs will depend on the severity of the weather each year and on the rate of increase in fuel prices. At the
prices expected to exist during 1999, annual fuel costs will be :
Severe weather
Mild weather
Rs.
Rs.
Gas
40,000
24,000
Oil
53,000
37,000
Solid Fuel
45,000
36,000
The company estimates that in each year there is a 70% chance of severe weather and a 30% chance of mild weather. The
chance of particular weather in any one year is independent of the weather in other years.
Fuel prices during 1999 and 2000 are expected to increase at either 15% per annum (probability equal to 0.4) or 25% per
annum (probability equal to 0.6). Whichever rate of price increase obtains in 2000 will be repeated in 2001.
(iii) Maintenance costs (payable at the end of the year in which they are incurred)
Rs.
Gas
2,500
per annum
Oil
2,000
per annum
Solid Fuel
10,000
in 1989
All maintenance costs are fixed by contract when the system is installed. Cosy Comforts Associated feel that the systems
are equivalent for air-conditioning purposes. They have a cost capital of 20% per annum in money terms.
(a) Prepare calculations showing which central air-conditioning system should be installed, assuming that the decision
will be based on the expected present values of the costs o each system.
The discounting factors at 20% for years 1,2 and 3 are 0.833, 0.694 and 0.579 respectively. 12-87-2
40.
An automobile ancillary unit is proposing to set up a manufacturing establishment whose project cost Rs. 320 lacs.
The cost of land and buildings included in the project cost is Rs. 40 lacs, whose break up is as follows :Rs.
Land (4,400 sq. yards)
15 lacs
Buildings (Areas 25,000 sq. feet)
25 lacs
It is anticipated that in the first 4 years profitability will be low due to time required for cultivating the market. To meet
the situation management is planning to hire factory premises of the same size at Re. 0.80 per square foot per month for
the first four years, instead of own buildings. Repairs and Maintenance, Taxes etc. to be borne by the Landlord.
In the present project, provision has been made for depreciation at 7% p.a. on original cost of Buildings. Provision has
also been made for Repairs, Maintenance Taxes, etc. on Buildings at Rs. 1,20,000 p.a.
The annual sales and profit figures as projected in the project report are as follows :Year
Sales
Net Profit
Capacity
(Rs. in lacs)
(Rs. in lacs)
Utilization
I year
200
(--5)
60%
II year
274
5
75%
III Year
350
10
90%
IV year
450
20
100%
After the 4th year the profit is expected to be steady at Rs. 40 lacs per annum. Institutional finance is available upto
Rs. 200 Lacs under both alternatives.
(a) You are required to work out the average rate of return for the first four years on shareholders initial investment,
under both alternative
MAFA-37
(b) If the Lease is available for 4 years only, would you recommend leasing the premises if it is anticipated that the cost
of land will increase by 40% and cost of construction by 30% at the end of the four year period ? For this purpose,
opportunity cost of finance may be taken at 10% p.a. Following are the present values of 1 Rupee at the end of each
year for 4 years.
At the end of
--------------------------------------------------------------------------------------------------------------I Year
II year
III year
IV year
Present value of Re. 1
0.909
0.826
0.751
0.683
5-80-1
41.
Hulk Petroleum Company Ltd (HPC) has constructed a collection platform at an oil and gas field
known as Gibson 6. This field holds reserves of oil and gas, both of which may be extracted and carried to
an onshore terminal along the same pipeline. Gas collected at the platform is converted into liquid
petroleum gas (LPG) for transport.
Oil and LPG received at the terminal are processed and transported 300 miles by rail to refineries. Details
of annual capacities are :
Pipeline capacity :
If the pipeline is used exclusively to transport oil, then a maximum of 100,000 barrels of oil can be
transported. 1.4 barrels of LPG can be transported in place of each barrel of oil.
Processing capacity :
If processing facilities are used exclusively to process oil, then a maximum of 150,000 barrels of oil
can be processed. 0.5333 barrels of LPG can be processed instead of each 1 barrel of oil up to a
maximum of 70,000 barrels of LPG. No more than 70,000 barrels of LPG can be processed.
Rail transport capacity :

If rail transport capacity is used exclusively to transport oil, then a maximum of 12,000 barrels of oil
can be transported. 1 barrel of LPG can be transported, using specialised wagons, instead of each 1
barrel of oil, up to a maximum of 20,000 barrels of LPG. Transporting amounts of LPG in excess of
20,000 barrels involves transporting 0.65 barrels of LPG instead of each 1 barrel of oil, using generalpurpose wagons.
The initial capital cost of developing extraction capability is 40,000 per 1,000 barrels of oil per year and
60,000 per 1,000 barrels of LPG per year. Once developed, an extraction capability can be operated for
at least 10 years. Contribution generated by the two products is 8 per barrel for oil and 11.50 per barrel
for LPG. HPC evaluates projects using a 12% p.a. discount rate and a 10-year time horizon.
REQUIREMENTS :
(a)
Identify the annual output combination of oil and LPG at which pet present value is maximised.
(b)
State whether or not HPC should invest in a new pump to increase the capacity of the Gibson 6 pipeline by
10%. The pump costs 50,000. Support your answer with relevant calculations. MAA 26 May 1999
1.
MAFA-38
SENSITIVITY ANALYSIS
Pioneer Products, a sports goods manufacturer in collaboration with a software house, is considering the launch of a
new porting immolator based on videotapes linked to a personal computer. Two proposals are being considered. Both use
the same production facilities and, as these are limited, only one product can be launched.
The following data are the best estimates the firm has been able to obtain :
Football Simulator
Cricket Simulator
Annual volume (units)
40,000
30,000
Selling Price per unit
Rs.
130
200
Variable Production Costs per unit
Rs.
80
100
Fixed Production Costs
Rs.
6,00,000
6,00,000
Fixed Selling & Admn. Costs
Rs.
4,50,000
13,50,000
The higher selling and administrative costs for the cricket simulator reflect the additional advertising an promotion costs
expected to be necessary to sell the more expensive cricket system.
The firm has a minimum target of Rs. 200,000 profit per year for new products. The management recognises the
uncertainty in the above estimates and wishes to explore the sensitivity of the profit on each product to changes in the values
of the variables (volume. price. variable cost per unit. fixed costs).
You are required :
(a) to calculate the expected profit from each product.
(b) to calculate the critical value for each variable (i.e. the value at which the firm will earn Rs. 2,00,000). assuming that all
other variables are as expected (express this as an absolute value and as a percentage change from the expected value),
(c) to discuss the factors which should be considered in making a choice between the two products
2.
Toys for Tiny Tots Ltd. manufacturers high-quality toys for children, which are sold by mail order and through
departmental stores.
Kiddy Products is prepared to sell the design and manufacturing rights for three products. However it will only sell the
rights to one product, not two or three. The costs of the rights are
Rs.
Pussy Cat
62,500
Teddy Bear
75,000
Jack in Box
52,500
Toys for Tiny Tots Ltd. feel that any of these products would make an attractive addition to its range, though the products
would have a sales life of only one year and wish to select the best of the three products. The following information has been
made available:
Pussy Cat
Teddy Bear Jack in Box
Rs.
Rs.
Rs.
Selling Price per unit
199
140
115
Variable Cost per unit
98
75
65
Fixed Production Costs
70,000
95,000
60,000
Advertising
55,000
40,000
20,000
These figures have been worked out with great care and circumspection. But when it comes to sale volumes, the Sales
Manager could provide only the following analysis of possibilities :
Pussy Cat
Teddy Bear
Jack in Box
MAFA-39
Volume
Probability
Volume Probability
Volume Probability
(units)
(units)
(units)
2,000
0.7
Nil
0.1
2,500
0.1
3,000
0.2
3,000
0.4
3,000
0.3
4,000
0.1
6,000
0.5
4,000
0.4
5,000
0.2
You are required to
(a) advise the Company of the best course of action based on the above information.
(b) In case Teddy Bear , it is felt that the company should launch a market research study costing Rs. 20,000 which will
able to determine precisely whether sales would be nil , 300, or 6000 units Is it worth while to conduct the study ?
Assume all costs are avoidable .
3. XYZ Ltd. Is considering the introduction of a new product and has compiled the following information :
Variable
Expected
Standard
value
deviation
Sales quantity
5,000
400
Selling price per unit (Rs.)
300
5
Fixed costs (Rs.)
580,000
10,000
Variable costs per unit (Rs.)
175
55
(For simplicity, assume that all the random variables are independent and that the probability distributions are normal).
Required :
(a) Calculate, using breakeven analysis and expected values, the breakeven volume and the expected profit for the
period.
(b) Explain how you would carry out a simulation to arrive at an approximate distribution of profits. Illustrate your
answer by using the cumulative normal distribution below and the following random numbers 20, 96, 68, 59 to obtain
our simulated figure for profits.
Cumulative Normal Distribution Table
Random
Number
00
01
02
03
04
05
06
07
08
09-10
11-12
13-14
15-16
17-18
19-21
Number of
deviations
from mean
-2.5
-2.3
-2.0
-1.9
-1.8
-1.7
-1.6
-1.5
-1.4
-1.3
-1.2
-1.1
-1.0
-0.9
-0.8
Random
number
22-24
25-27
28-31
32-34
35-38
39-42
43-46
47-53
54-57
58-61
62-65
66-68
69-72
73-75
76-78
Number of
deviations
from mean
-0.7
-0.6
-0.7
-0.4
-0.3
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
Random
number
79-81
82-83
84-85
86-87
88-89
90-91
92
93
94
95
96
97
98
99
Number of
deviations
from mean
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2.0
2.3
MAFA-40
DIVIDEND POLICY
Introduction
Dividend Policy is one of the major decision-areas of financial management. A firm has choose between distributing
profits to the shareholders and ploughing them back into the business. The ultimate choice would, however, depend upon the
effect of the decision on maximization of the value of the firm or that of its shares. In formulating the dividend policy of the
firm a number of factors are to be taken into consideration.
THEORIES OF DIVIDEND POLICY
Over time many theories on dividend policy, often controversial ones, have emerged. The central area of controversy
has, and continues to be, concerned with whether or not there is a real connection between dividend policy and the
market value of the firm. In this section we will review the following main theories of dividend policy :
1
the residual theory of dividend policy;
dividend irrelevancy theory;
the bird-in-the hand theory;
dividend signalling theory;
the dividend clientele effect;
The residual theory of dividend policy

The essence of the residual theory of dividend policy is that the firm will only pay dividends from residual earnings,
that is, from earnings left over after all suitable (positive NPV) investment opportunities have been financed.
Motives for a residual policy
The motives for a residual, or higher retentions, dividend policy commonly include :
A high retentions policy reduces the need to raise fresh capital (debt or equity), thus saving on associated issue
and flotation costs.
A fresh equity issue may dilute existing ownership control; this may be avoided if retentions are consistently
high.
A high retentions policy may enable a company to finance a more rapid and higher rate of growth.
When the effective rate of tax on dividend income is higher than the tax on capital gains, some shareholders,
because of their personal tax positions, may prefer a high retention / low payout policy.
Residual policy in practice
MAFA-41
There is some evidence in the real world supporting the residual approach to dividend policy. Established, mature
companies with limited growth prospects tend to have higher dividend payout ratios than young, rapidly growing
companies.
However, this does not mean that young, growing companies, with numerous attractive investment opportunities,
necessarily have erratic dividend payment patterns. Observed dividend payment patterns simply do not fluctuate as
markedly as the adoption of a pure residual policy would imply.
Dividend irrelevancy theory
Dividend irrelevancy theory assets that a firms dividend policy has no effect on its market value or its cost of capital.
As we discussed in the preceding section, dividend irrelevancy is implied by the residual theory, which suggests that
dividends should only be paid if funds are available after all positive NPV projects have been financed.
The theory of dividend irrelevancy was perhaps most elegantly argued by its chief proponents, Modigliani and Miller
(usually referred to as M&M) in their seminal paper in 1961.
In the same manner in which they argued for capital structure irrelevancy , M&M assert that the value of a firm is
primarily determined by its ability to generate earnings from its investments and by its level of business and financial
risk. They argue that dividend policy is a passive residual which is determined by a firms need for investment funds.
According to M&Ms irrelevancy theory does not matter how a firm divides its earnings between dividend payments
to shareholders and internal retentions. In the M&M view the dividend decision is one over which managers need not
agonise, trying to find the optimal dividend policy, because an optimal dividend policy does not exist.
The bird-in-the hand theory
The essence of the bird-in-the hand theory of dividend policy (advanced by John Linter in 1962 and Myron Gordon
in 1963) is that shareholders are risk-averse and prefer to receive dividend payments rather than future capital gains.
Shareholders consider dividend payments to be more certain that future capital gains thus a bird in the hand is worth
more than two in the bush.
Gordon contended that the payment of current dividends resolves investor uncertainty. Investors have a preference
for a certain level of income now, rather than the prospect of a higher, but less certain, income at some time in the
future.
The key implication, as argued by Lintner and Gordon, is that because of the less risky nature of dividends,
shareholders and investors will discount the firms dividend stream at a lower rate of return, r, thus increasing the value
of the firms shares.
Recall from Chapter 8 that, according to the constant growth dividend valuation (or Gordons growth) model, the
value of an ordinary share, Svo, is given by :
Svo =
D1 .
(r g)
where the constant dividend growth rate is denoted by g, r is the investors required rate of return, and D 1 represents
the next dividend payment. Thus the lower r is in relation to the value of the dividend payment D 1, the greater the
share' value. In the investor' view, according to Linter and Gordon, r, the return from the dividend, is less risky than
the future growth rate g.
Dividend signalling theory
In practice, changes in a firms dividend policy can be observed to have an effect on its share price an increases in
dividends producing a increase in share price and a reduction in dividends producing a decrease in share price. This
pattern led many observers to conclude, contrary to M&Ms model, that shareholders do indeed prefer dividends to
future capital gains. Needless to say M&M disagreed.
M&M suggested that the change in share price following a change in dividend payment, is due to the informational
content of the dividend payment, rather than the dividend payment itself.
MAFA-42
In other words, the change in dividend payment is to be interpreted as a signal to shareholders and investors about the
future earnings prospects of the firm. Generally a rise in dividend payment is viewed as a positive signal, conveying
positive information about a firms future earnings prospects resulting in an increase in share price. Conversely a
reduction in dividend payment is viewed as a negative signal about future earnings prospects, resulting in a decrease in
share price.
The dividend clientele effect
The dividend clientele effect is a feature of M&Ms dividend irrelevancy theory. In relation to dividend policy,
M&M argued for the existence of a clientele effect, where the nature of a firms dividend policy will attract a particular
clientele of shareholders.
Investors who prefer income to capital growth will be attracted to companies with high dividend payout policies and
vice versa. For example, many charities, pension funds and retired senior citizens, have a need for a stable, regular
income to meet their operating expenses and other financial commitments.
With regard to charities (and also other institution such as universities which receive endowments and legacies) often
the terms and conditions of endowments will prohibit a charitys trustees from spending the capital sum endowment
therefore has to be invested, in perpetuity, to generate income. In such circumstances, investing in high dividend
paying companies has its appeal.
In contrast, other groups of investors who (perhaps for taxation reasons, where an investors capital gains may be
taxed at a lower rate than the investors income) may prefer capital growth to income, will be attracted to firms with
high earnings retention and low dividend payout policies.
In the main, the existence, or otherwise, of investor clienteles is generally considered to have no effect on an
individual firms share value. M&M stated that : each corporation would tend to attract itself a clientele consisting of
those preferring its particular dividend payout ratio, but one clientele would be as good as another in terms of the
valuation it would imply for firms.
Agency cost theory
In Chapter 2, where the nature of the agency relationship was first discussed, agency costs were defined as those
incurred in attempting to minimise the agency problem. The agency problem is the potential for conflict in objectives
which exists in a principal-agent relationship. In the corporate finance world, the principals are the shareholders who
own the firm and managers act as their agents.
For the shareholders of a firm where ownership is separate from managerial control, the agency problem is that
managers, who are in day-to-day control of the firm, may tend to act in their own personal best interests rather than
those of the shareholders, the firms owners.
Recall that a firms owners will incur agency costs whenever they introduce procedures and mechanisms aimed at
reducing the potential for conflict between the personal objectives of the owners. Incurring agency costs has the effect
of reducing shareholder value.
Seeking additional equity from the financial markets required managers to justify the reasons for the equity issue.
This process is helpful to owners and reduces their agency costs, as managers are less likely to engage in activities
which are not consistent with shareholder wealth maximisation if they know that the firm will be regularly exposed to
this type of external scrutiny.
In this context, where the payment of dividends (like the raising of debt finance in the capital structure
debate), at least in an indirect way, leads to the activities of managers being subjected to closer external
investigation, then dividend (and financing) policy may indeed have a beneficial effect on the value of the
firm. Agency cost theory would imply that firms adopt high dividend payout policies, after all suitable
investment projects have been financed.
MAFA-43
Dividend Policy: Stability

Irrespective of the long-run payout ratio followed, the fluctuations in the year-to-year dividends may be
demanded mainly by one of the following guidelines:
Stable dividend payout ratio According to this policy, the percentage of earnings paid out as
dividends remain constant. As a result, dividends fluctuate in line with earnings. Figure 15.1 shows
the behaviour of dividends when such a policy is adopted. It is clear that such a policy results in
transmission of the variability of earnings to dividends. Hence such a policy is rarely adopted by
business firms.
Stable dividends or steadily changing dividends As per this policy, the rupee level of dividends
remains stable or gradually increases (mostly) or decreases (rarely). Figure above shows the
behaviour of dividends per share in response to changes in earnings per share when such a policy is
followed. Such a policy seems to be followed widely by business firms.
Rational for Dividend Stability

Why do firms follow a policy of stable dividends or gradually rising dividends? Several explanations may be
offered:
1.
Many individual investors depend on dividend income to meet a portion of their living expenses. Since
these expenses remain stable or increase gradually over time they prefer a similar behavioural
pattern in dividends. Sharp changes in dividend income may entail selling of some shares, if
dividends fall steeply, or reinvestment of a portion of dividend income, if dividends rise substantially. In
both the cases investors have to incur transaction costs and put up with some inconvenience. These
are avoided if the dividend stream is stable and predictable.
2.
The dividend decision of the firm has come to be regarded as an important means by which the
management conveys information about the prospects of the firm: an increase in dividends indicates
improved earnings prospects, a decrease in dividends implies lowered earnings expectation, and a
lack of change in dividends means unchanged prospects. Put differently, the dividend decision of the
firm resolves uncertainty in the minds of stockholders. If a firm varies dividends widely in response to
MAFA-44
certain transient influences, its dividend decision would lack the uncertainty-resolving power. Hence,
firms vary dividend only gradually in response to certain long-term changes in prospects.
3.
Institutional investors often view a record of steady dividend payment as a highly desirable feature
they may even regard this as a precondition before considering equity or debt investment in the firm.
DIVIDEND AS A RESIDUAL PAYMENT

Since internal equity ( in the form of retained earnings) is cheaper than external equity, an important
dividend prescription advocates a residual policy to dividends. According to this policy, the equity earnings
of the firm are first applied to provide equity finance required for supporting investments. The surplus, if
any, left after meeting the equity investment needs is distributed as dividends. Put differently, dividends are
merely treated as a residual payment after equity investment needs are fulfilled.
Firms subscribing to the residual dividend policy may adopt one of the following approaches: (i) pure
residual dividend policy approach, (ii) fixed dividend payout ratio approach, and (iii) smoothed residual
dividend approach. For describing these approaches, we will employ the following variables:
Et =
Ite =
Dt =
Pt =
earnings in year t
equity support required for financing the investment in year t
dividends paid in year t
dividend payout ratio for year t (Dt/Et)
Pure Residual Dividend Approach

According to this approach, the dividends paid in year t, D t, will be as follows:
If Iet > Et
If Iet < Et
Dt = 0
Dt = Et - Iet
(15.1)
(15.2)
Fixed Dividend Payout Ratio Approach

According to this approach, dividends are set equal to a constant proportion of equity earnings. This can
be represented as:
Dt = Pt Et
(15.3)
The proportion Pt is set in such a manner that in the long run dividends are equal to equity earnings minus
equity finance required to support investments.
Smoothed Residual Dividend Approach
Under this approach, dividends are varied gradually over time. The levels of dividends is so set that in the
long run the total dividends paid are equal to total earnings less equity finance required to support
investments.
Table below shows dividends for a period of six years under each of the above three approaches:
Dividend Stream Under Different Approaches
1
Earnings Et
Investment budget
Equity investment Iet
Pure residual dividends
Dt
Fixed dividedn payout
Ratio Dt (Pt = 0.55)
Total
150.0
137.0
68.5
190.0
160.0
80.0
140.0
180.0
90.0
220.0
200.0
100.0
280.0
210.0
105.0
250.0
220.0
110.0
1230.0
1107.0
553.5
81.5
110.0
50.0
120.0
175.0
140.0
676.5
82.5
104.0
77.0
121.0
154.0
137.5
676.5
MAFA-45
The pure residual dividend approach tends to produce highly fluctuating dividends because the variability
of equity earnings and investment budget (given a certain debt-equity ratio) is transmitted to dividends. (Of
course, when the fluctuations in equity earnings and investment budget are identical in nature, dividends
are stabilised. This, indeed, is a very rare possibility). Likewise the fixed dividend payout ratio generates a
fluctuating dividend stream because the variability of earnings is transmitted to dividends.
Since investors are generally averse to fluctuating dividends for various reasons, the pure residual
dividend approach and the fixed dividend payout ratio approach are often not advisable in practice. The
smoothed residual dividend approach, which produces a stable and steadily growing stream of dividends,
often appears to be the most sensible approach in practice.
BONUS SHARES AND STOCK SPLITS

Bonus Stares
Bonus shares are shares issued to existing shareholders as a result of capitalisation of reserves. Table
15.2 illustrates teh nature of this capitalisation. Part A of the table shows the equity portion of the balance
sheet before the bonus issue and Part B of the table shows the equity portion of the balance sheet after
the bonus issue.
Effects of a Bonus Issue on the Equity Portion of the Balance Sheet

Part A: Equity Portion Before Bonus Issue
Paid-up Share Capital
Rs. 10,000,000
1,000,000 Shares of Rs. 10 Each fully Paid

Reserves and Surplus
Rs. 30,000,000
Part B: Equity Portion After Bonus Issue in the Ratio 1 : 1
Paid-up share Capital
Rs. 20,000,000
20,000,000 Shares of Rs. 10 Each Fully Paid

Rs. 20,000,000
In the Wake of a bonus issue:

1.
The shareholders proportional ownership remains unchanged.
2.
The book value per share, the earnings per share, and the market price per share decrease, but the
number of shares increases.
Reasons for Issuing Bonus Shares

From the foregoing it seems that the issue of bonus shares is more or less a financial gimmick without any
real impact on the welfare of equity shareholders. Still firms issue bonus shares and shareholders look
forward to issue of bonus shares. Why?
1.
The bonus issue tends to bring the market price per share within a more popular range.
2.
It increases the number of outstanding shares. This promotes more active trading.
3.
The nominal rate of dividend tends to decline. This may dispel the impression of profiteering.
4.
The share capital base increases and the company may achieve a more respectable size in the eyes
of the investing community.
MAFA-46
5.
Shareholders regard a bonus issue as a firm indication that the prospects of the company have
brightened and they can reasonably look for an increase in total dividends.
6.
It improves the prospects of raising additional funds. In recent years many firms have issued bonus
shares prior to the issue of convertible debentures or other financing instruments.
Regulation of Bonus Issues

The key regulatory provisions governing the issue of bonus shares are as follows:
The bonus issue is made out of free reserves built out of genuine profits or share premium collected
in cash only.
The residual reserves after the proposed capitalisation shall be at least 40 percent of the increased
paid-up capital.
30 percent of the average profits before tax of the company for the previous three years should yield
a rate of dividend on the expanded capital base of the company at 10%.
Determining the Maximum Bonus Ratio

Looking at the regulations on bonus issue, we find that the restrictions that are likely to be critical is most
situations are the residual reserve requirement (the reserves after the proposed capitalisation should be at
least 40 percent of the increased paid-up capital) and the profitability requirement (30 per cent of the
average amount of pre-tax profits of the company in the previous 3 years should yield a return of at least
10 percent on the increased capital). Hence, the maximum ratio of bonus that the company can declare is
the value of b which satisfies the following constraints.
Residual Reserve Requirement (R Sb) 0.4 S(1 + bs)
Profitability Requirement:
0.3 PBT 0.1 S(1+b)
where
R = reserves before bonus declaration

S = paid-up capital before bonus declaration
b = bonus ratio
PBT = average profit before tax of the company in the previous 3 years.
To illustrate, consider a company for which the following data are available:
Paid-up share capital (S)
Reserves (R)
Average profit before tax in the previous three year (PBT)
Rs. 100 million

Rs. 150 million
Rs. 80 million
Plugging the above values in the expressions for residual reserve requirement and profitability
requirement, we get:
150 100b 0.4 100 (1 + b)
0.3 80 0.1 100 (1 + b)
The above reduce to:
11
14
b and b
14
10
Since 11/14 b is more restrictive than 14/10b, we find that the maximum bonus ratio is 11/14. This may
be checked as follows: when the bonus ratio is 11/14, the paid-up share capital and reserves after the
bonus issue are Rs. 178.6 and Rs. 71.4 million, respectively. Thus the residual reserve to increase share
capital is just 40 percent.
MAFA-47
Stock Splits
In a stock split the par value per share is reduced and the number of shares is increased proportionately.
Table below illustrates the nature of this change.
Comparison Between Bonus Issue and Stock Split
A comparison between a bonus issue and a stock split is given below:
Bonus Issue
The par value of the share is unchanged

The part of reserves is capitalised
The shareholders proportional ownership remains unchanged
Stock Split
The par value of the share is reduced

There is no capitalisation of reserves
The shareholders proportional ownership remains unchanged
Effects of a Stock Split on the Equity Portion of the Balance Sheet

Part A: Equity Portion Before Stock Split
Rs. 5,000,000
100,000 Shares of Rs. 50 Each fully Paid

Rs. 10,000,000
Part B: Equity Portion After Stock Split in the Ratio 5 : 1
Rs. 5,000,000
5,000 Shares of Rs. 10 Each Fully Paid

Rs. 10,000,000
Bonus Issue
The book value per share, the earnings

per share, and the market price per
share decline
The market price per share is brought
within a more popular trading range
Stock Split
The book value per share, the earnings

per share, and the market price per
share decline
The market price per share is brought
within a more popular trading rage
In nutshell, a stock split is similar to a bonus issue from the economic point of view, though there are some
differences from the accounting point of view.
Proportionate Rule Voting
Under this system of voting the number of votes enjoyed by a shareholder is equal to the number of shares
held by him times the number of directors to be elected. For example, if a shareholder holds 1,000 shares
and the number of directors to be elected is seven, the shareholders will have 7,000 votes. He may spread
his votes in any manner 7,000 votes just for one candidate, or 5,000 votes for one candidate and 2,000
votes for a second candidate, or 1,000 votes for each of the seven candidates of his choice, etc.
The principal difference between the majority rule and proportionate rule voting systems is that under the
former a majority is able to elect all members of the board whereas under the latter a significant minority, if
it casts its votes intelligently, is assured of some representation on the board.
Is there a way of determining the number of shares needed to guarantee the election of a certain number
of directors? Yes, the following formula helps in doing precisely that:
Number of shares
Number of shares
Number of directors

Required to elect
a certain number
of directors
MAFA-48
shares outstanding
desired to be elected
= + 1
Total number of directors
to be elected
+1
To illustrate, consider the following information about a company: (i) number of outstanding shares: 1
million, (ii) directors positions: 7, and (iii) directors desired to be elected: 2. The number of shares required
to guarantee the election of two directors is:
1,000,000 2
+ 1 = 250,001
7+1
Walters Model
According to Walter, the dividend policy must be evaluated in the light of the objective of the firm, namely, to maximize
the price of the share in the market. He argues that the choice of dividend policies almost always affects the value of the firm.
According to him, the dividend policy should be determined solely by the profitability of investments. In other words, if the
firm has an abundance of profitable investment opportunities, there should be no cash dividends, for the earnings will be the
source of fund in this case. In the reverse case, all earnings (100 per cent) should be distributed to shareholders in the form of
dividends because in this case the funds are not need for financing. For situations between these two extremes, the dividend
pay out ratio will be a fraction between 0 and 1.
Walters model is based on the following assumptions:
1. All investments are financed by the firm through retained earnings; debt or share capital is not issued.
2. The firms internal rates of return, r, and the cost of capital k, are constant so that business risk is not changed with
additional investment proposals.
3. All earnings are either reinvested internally or distributed as dividends.
4. There is not change in the key factors, namely, beginning earnings per share, E, and dividends per share, D. The value of
E and D may be changed in the model to determine results, but any given values of E and D are assumed to remain
constant in determining a given value.
5. The firm has a very long or perpetual life.
One of the formulae given by Walter is:
P=
D+ r . (E D)
k
.
K
Where, P = market price per equity share

D = dividend per share
E = earnings per share
.
r = return in investment
.
k = cost of capital or market capitalization rate.
Gordons Model
P= E (1 b)
K br
Where P= price of shares

E= Earning per share
.
b= Retention ratio i.e. percentage of earnings retained
.
k= Cost of capitalization rate
.
br = g = Growth rate in r.
.
r= rate of return on investment.
Illustration
Cost of capital (k) = 10%. Earnings per share (E) = Rs. 10
Assumed rate of return on investment (r): (i) 15%
(ii) 10% and
Determine the value per share assuming the following retention ratio (R/E):
Retention ratio
Pay out ratio (D/E)
.
b= R/E (%)
i.e., (1 b) (%)
(a)
0
100
(b)
10
90
(iii) 8% respectively.

(c)
(d)
(e)
MAFA-49
30
50
60
70
50
40
The value per share for different retention ratios for three alternative values of r, i.e. (i) r>k, (ii) r = k (iii) r<k is shown in the
following table using the equation:
P = E (1 b)
K br
Proof of M M Hypothesis
P0 = 1
. (D1 + P1)
(1 + k)
V= nP0 = n (D1 + P1)

(1 + k)
and mP1 = I (E nD1)
(1)
Where, P0 = market price per share at time 0;
.
k = cost of capital or capitalization rate ( = r) ;
D1= dividend per share at time 1;
P1 = market price per share at time 1.
(2)
(4)
Where, I = total new investments during period 1.

E= earnings of the firm for the period.
Illustration
Omega Company has a cost of equity capital of 10% the current market value of the firm (V) is Rs. 20,000 (Rs. 20
per share). Assumed values for I (new investment), Y (earnings) and D (dividends) at the end of the year are I = Rs. 6,80,000,
Y = Rs.1, 50,000 and D = Re. 1 per share. Show that under the M M (Modigliani - Miller) assumptions the payment of D
does not affect the value of the firm.
Problems Dividend Policies and Decisions pg 218 bhalla

1.
K.D. group has 1,00,000 equity shares outstanding. Last year it had earnings per share of rs.3 and paid
dividends of re.1 per share. If the companys equity share is selling for Rs.40.00 per share, how any equity
shares would the company need to sell if all of the earnings had been paid as dividends ?
2.
D.P. manufacturing pays a current dividend of Rs.2.00 which should grow at a 0.05 rate in the future.
D.P.s
required rate of return is 0.12. What is the value of a share of D.P.s stock ?
3.
Many Industries declares a 5 percent stock dividend. What should be the ex-dividend price of the stock, if
the price on the day before ex-dividend is Rs.50 ? What is the net wealth of an investor with 100 shares
before
and after the dividend ?
4.
5.
6.
ABC Company expects some degree of certainty to generate the following net income and to have the
following capital expenditure during the next five years (in thousands).
A firm has new investment opportunities requiring an aggregate outlay of Rs.10,00,000. The firm has
decided
that the appropriate debt / equity ratio, given the nature of its business and its operating risk, is
0.30.
Historically, it has paid out 65% of its earnings as dividends. Its earnings for the period just ended
were
Rs.12,00,000. Determine for each of the four policy alternatives the external financing
requirements (debt and
equity) and the debt and equity levels after external financing is completed.
Super Industries had capitalisation as shown :
Equity share capital (Rs.10 par, 10,00,000 shares)
Paid-up capital
Rs. 1,00,00,000
5,00,00,000
MAFA-50
Retained earnings
Total owners equity
per
14,00,00,000
Rs.20,00,00,000
Super paid a 20 per cent stock dividend. At the time of the stock dividend, the stock was selling at Rs.60
share. Show the net capitalisation.
7.
Sudha Textiles earned Rs.30,00,000 after taxes in 1992 and paid out 50% of this in cash dividends. The
price of the firms equity share on December 31, 1992 was Rs.50. The capital structure of Sudhas on
December
31, 1992 was as follows
Equity share capital (Rs.10 par, 10,00,000 shares)
Capital surplus
Retained earnings
Net worth
Rs.1,00,00,000
30,00,000
1,70,00,000
Rs.3,00,00,000
a. If the firm declared a stock dividend of 20 per cent on December 31, 1992 what would the reformulated
capital structure be ?
b. If the firm declared a 50 per cent stock dividend rather than 20% dividend, what would the
reformulated capital structure be ?
c.
Assuming the firm paid no stock dividend, how much would earnings per share for 1992 be ? How
much dividends per share be ?
d. Assuming a 20 per cent stock dividend, what would the EPS and DPS be for 1992 ? Assuming a 50
per cent dividend ?
e. What would the price of the share be after 20% dividend ? After the 50% dividend ?
8.
The Capital of XYZ Ltd. is as follows :

9% Preference shares of Rs.10 each
=
Rs.3,00,000
Equity Shares of Rs.10 each
=
Rs.8,00,000
The following further informations are available :
(.i)
Profit after tax
Rs.2,70,000
(ii)
Equity Dividend paid 20%
(iii)
Market price of Equity Shares Rs.40 each.
You are required to workout the following indices. Show your workings.
(.i)
Dividend yield on Equity Shares.
(ii)
Cover for Preference & Equity Dividend.
(iii)
Earning per Equity Share &
(iv)
Price Earning Ratio.
9.
Firm E is studying the possible acquisition of Firm F by way of merger. The following data are available in
respect of the firms.
Firm E
Firm F
Earning after tax (Rs.
2,00,000
60,000
No. of Equity Shares
40,000
10,000
Market value per share (Rs.)
15
12
(.i)
If the merger goes through by exchange of equity share and the exchanges ratio is based on the
current market prices, what is the new earnings per share for Firm E ?
(ii)
Firm F wants to be sure that its earnings available to the shareholders will not be diminished by the
merger. What should be the exchange ratio in that case ?
10.
Two companies X Ltd. and Y Ltd. are in the same industry with identical earning per share for the last five
years. X Ltd. has a policy of paying 40 per cent of earnings as dividend while the Y Ltd. pays a constant
amount of dividend per share. There is disparity between the market price of the shares of two companies.
The price of Xs share is generally lower than of Y, even through in some years X paid more dividend than
Y. The data on earnings and dividends per share and market prices for the two companies are as under :
Year
X Ltd.
T Ltd.
X Ltd.
Y Ltd.
X Ltd.
Y Ltd.
1982
1983
1984
1985
1986
MAFA-51
EPS
Rs.
EPS
Rs.
DPS
Rs.
DPS
Rs.
4.00
1.50
5.00
4.00
8.00
4.00
1.50
5.00
4.00
8.00
1.60
0.60
2.00
1.60
3.20
1.80
1.80
1.80
1.80
1.80
Market Price
Rs.
12.00
8.50
13.50
11.50
14.50
Market Price
Rs.
13.50
12.50
12.50
12.50
15.00
(a) What are the reasons for the differences in the market price of the two companies Shares ?
(b) What can be done by X Ltd. to increase the market price of its shares ?
11.
ML plc is an expanding clothes retailing company. It is all equity-financed by ordinary share capital of 10
million in shares of 50p nominal. The companys results to the end of march 1999 have just been announced.
Pre-tax profits were 4.6 million. The Chairmans statement included a forecast that earnings might be
expected to rise by 5% p.a. in the coming year and for the foreseeable future.
Co plc, a childrens clothes group, has an issued ordinary share capital of 33 million in 1 shares. Pre-tax
profits for the year to 31 March 1999 were 5.2 million. Because of a recent programme of re-organisation
and rationalisation, no growth is forecast for the current year but subsequently constant growth in earnings
of approximately 6% p.a. is predicted. Co plc has had an erratic growth and earnings record in the past
and has not always achieved its often-ambitions forecasts.
ML plc has approached the shareholders of Co plc with a bid of 2 new shares in ML plc for every 3 CO plc
shares. There is a cash alternative of 135 pence per share.
Following the announcement of the bid, the market price of ML plc shares fell while the price of shares in
CO plc rose. Statistics for ML plc, CO plc and two other listed companies in the same industry immediately
prior to the bid announcement are shown below. All share prices are in pence.
1998
High
Low
225
145
187
230
185
115
122
159
Company
Dividend yield
%
P/E
ML plc
CO plc
HR plc
SZ plc
3.4
3.6
6.0
2.4
15
13
12
17
Both ML plc and CO plc pay tax at 33%.

ML plcs cost of capital is 12% p.a. and CO plcs is 11% p.a.
REQUIREMENT :
Assume you are a financial analyst with a major fund manager. You have funds invested in both ML plc
and CO plc.
Assess whether the proposed share-for-share offer is likely to be beneficial to the shareholders in ML
plc and CO plc, and recommend an investment strategy based on your calculations.
Comment on other information that would be useful in your assessment of the bid. Assume that the
estimates of growth given above are achieved and that the new company plans no further issues of
equity.
State any assumptions that you make.
SFM 25 May 1999

Capital Budgeting Capital Budgeting Process

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Capital Budgeting Capital Budgeting Process

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Identification of potential investment opportunities

Assembling of proposed investments

Preparation of capital budget and appropriations

Identification of Potential Investment Opportunities

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(a) Capital nature

Cash inflow at the end of the project :

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Selling of the old asset at the beginning of the project:

If block of assets concept is applied

Choice of cut-off rates & Discounted cash - flow :

Cut off not given

Cash outflow in 0th

is not a part of PBT i.e.

Cash out-flow at the

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(3) Debt service coverage ratio (DSCR) =

( PAT + DEPRECIATION + INTEREST )

Present value of an annuity :

Present value of a perpetuity :

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Dividing both the sides of Eq. (4A.3) by k yields :

Present Value of an Annuity

Dividing both the sides of Eq. (4A.7) by k results in :

Present Value of a perpetuity

CONTINUOUS COMPOUNDING AND DISCOUNTING

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effective rate of interest

Equation may be expressed as

Putting x = m/k in Eq. (4B.2), we get

In continuous compounding m . This means x in Eq.

So from Eq. we get

Rs.50,000 (2.71828) .08x5

present value of a future sum

Rs.50,000 x 2.71828 12x7

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Mean absolute deviation

The various measures of risk are defined below :

highest value of the distribution

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Net cash flow

Perfectly Correlated Cash Flows

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Calculate NPV and (NPV), assuming a risk-free interest rate of 6 percent.

Conditional Probability Distribution Approach

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Cumulative probability up to Z for Standard Normal Distribution

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net present value of the project

Range and Most Likely Value of Basic Variables

[1,600(750 400) 120,000 160,000] (1 0.6) + 160,000

272,000 + 400,000 - 1,200,000

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Relationship between k and NPV

[1,600(P 400) 120,000 160,000] (1 0.6) + 160,000

640 P - 208,00 + 400,00 1,200,000

The net present value for various values of P is shown below.

The same relationship is shown graphically as below

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Relationship between P and NPV

Net present value