Solutions To End of Chapter Problems

Chapter 2
2.1
Nominal rate(%)(NR)
Inflation rate(%) ( IR)
Real rate by the rule of thumb(%)
= NR - IR
Correct real rate (%)
=(1+NR)/(1+IR) -1
Error from using the rule of thumb(%)
5
2
3
10
4
6
20
10
10
60
40
20
2.94 5.77 9.09 14.29

0.06 0.23 0.91 5.71
Chapter 3
FINANCIAL STATEMENTS, TAXES AND CASH FLOW
3.1.
(a)
A.
B.
Classified cash flow statement

For the Period 01.04.20 X 0 to 31.03.20 X 1 (Rs. in million)
-----------------------------------------------------------------------------------------------------------Cash flow from operating activities
Net profit before tax and extraordinary items
150
Adjustments for
Interest paid
30
Depreciation
30
Operating profit before working capital changes
210
Adjustments for
Inventories
(20)
Debtors
(20)
Trade creditors
20
Cash generated from operations
190
Income tax paid
(30)
Cash flow before extraordinary items
160
Extraordinary item
(60)
Net cash flow from operating activities
100
Cash flow from investing activities
Purchase of fixed assets
(50)
Net cash flow from investing activities
(50)
C.
D.
Cash flow from financing activities\

Additional share capital
Proceeds loans
Interest paid
Dividends paid
Net cash flow from financing activities
20
10
(30)
(40)
(40)
Net increase in cash and cash equivalents

Cash and cash equivalents as on 31.03.2000
10
20
30
(b)
A.
B.
C.
Cash flow from assets

Operating cash flow
Net capital spending
Change in net working capital
120
(50)
(30)
40
Cash flow to creditors

Interest paid
Net new borrowing
30
(10)
20
Cash flow to shareholders

Dividends paid
Net new equity raised
40
(20)
20
We find that
(A)
(B) + ( C)
i.e., Cash flow from assets
Cash flow to creditors + Cash flow to shareholders
3.2.
(a)
A.
Classified cash flow statement

For the Period 01.04.20 X 0 to 31.03.20 X 1 (Rs. in million)
-----------------------------------------------------------------------------------------------------------Cash flow from operating activities
Net profit before tax and extraordinary items
100
B.
C.
Adjustments for
Interest paid
Depreciation
Operating profit before working capital changes
Adjustments for
Inventories
Debtors
Trade creditors
Provisions
Increase in other assets
Cash generated from operations
Income tax paid
Cash flow before extraordinary items
Extraordinary item
Net cash flow from operating activities
Cash flow from investing activities
Purchase of fixed assets
Net cash flow from investing activities
Cash flow from financing activities
Repayment of term loans
Interest paid
Dividends paid
Net cash flow from financing activities
30
20
150
10
(10)
10
(5)
(5)
160
(20)
140
(50)
90
(30)
(30)
(15)
(30)
(20)
(65)
D.
Net increase in cash and cash equivalents

(5)
20
15
Note
It has been assumed that other assets represent other current assets.
(b)
B.
B.

Operating cash flow
Net capital spending
Change in net working capital
Interest paid
Repayment of debt
80
(30)
(5)
45
30
(5)
25
C.

Dividends paid
Net new equity raised
20
0
20
We find that
(A)
(B) + ( C)
i.e., Cash flow from assets
Cash flow to creditors + Cash flow to shareholders
Chapter 4
ANALYSING FINANCIAL PERFORMANCE
Net profit
1.
Return on equity =
Equity
=
Net profit
Net sales
Total assets
x
Net sales
x
Total assets
Equity
1
=
0.05
x 1.5 x
0.3
Debt
Note :
Equity
= 0.7
So
Total assets
= 1-0.7 = 0.3
Total assets
Hence Total assets/Equity = 1/0.3

2.
PBT
= Rs.40 million
PBIT
Times interest covered =
= 6
Interest
So PBIT = 6 x Interest
PBIT Interest = PBT = Rs.40 million
6 x Interest = Rs.40 million
Hence Interest = Rs.8 million
3.
= 0.25 or 25 per cent
Sales = Rs.7,000,000
Net profit margin = 6 per cent
Net profit = Rs.7000000 x 0.06 = 420,000

Tax rate = 60 per cent
420,000
So, Profit before tax =
= Rs.1,050,000
(1-.6)
Interest charge = Rs.150,000
So Profit before interest and taxes = Rs.1,200,000
Hence
1,200,000
Times interest covered ratio =
= 8
150,000
4.
CA = 1500
CL = 600
Let BB stand for bank borrowing
CA+BB
= 1.5
CL+BB
1500+BB
=
1.5
600+BB
BB = 120
1,000,000
5.
Average daily credit sales =
= 2740
365
160000
ACP =
= 58.4
2740
If the accounts receivable has to be reduced to 120,000 the ACP must be:
120,000
x 58.4 = 43.8days
160,000
Current assets
6.
Current ratio =
= 1.5
Current liabilities
Current assets - Inventories
Acid-test ratio =
= 1.2
Current liabilities
Current liabilities = 800,000

Sales
Inventory turnover ratio =
= 5
Inventories
Current assets - Inventories
Acid-test ratio =
= 1.2
Current liabilities
Current assets
Inventories
This means
Current liabilities
= 1.2
Current liabilities
Inventories
1.5
= 1.2
800,000
Inventories
= 0.3
800,000
Inventories = 240,000
Sales
=5
So Sales = 1,200,000
2,40,000
7.
Debt/equity = 0.60
Equity = 50,000 + 60,000 = 110,000
So Debt = Short term bank borrowing = 0.6 x 110,000 = 66,000
Hence Total assets = 110,000+66,000 = 176,000
Total assets turnover ratio = 1.5
So Sales = 1.5 x 176,000 = 264,000
Gross profit margin = 20 per cent
So Cost of goods sold = 0.8 x 264,000 = 211,200
Days sales outstanding in accounts receivable = 40 days
Sales
So Accounts receivable =
x 40
360
264,000
=
x 40
360
= 29,333
Cost of goods sold

Inventory turnover ratio =
211,200
=
Inventory
= 5
Inventory
So Inventory = 42,240
As short-term bank borrowing is a current liability as well,
Cash + Accounts receivable
Acid-test ratio =
Current liabilities
Cash + 29,333
=
= 1.2
66,000
So Cash = 49867
Plant and equipment = Total assets - Inventories Accounts receivable Cash
= 176,000 - 42240 29333
49867
= 54560
Pricing together everything we get
Equity capital
Retained earnings
Short-term bank borrowing
Balance Sheet
50,000
Plant & equipment
60,000
Inventories
66,000
Accounts receivable
Cash
176,000
Sales
Cost of goods sold
8.
54,560
42,240
29,333
49,867
176,000
264,000
211,200
For purposes of ratio analysis, we may recast the balance sheet into report form as under.
Let assume that Others in the balance sheet represents other current assets.
Liabilities and Equity

Equity capital
Reserves and surplus
Long-term debt
10,000,000
22,500,000
12,500,000
Short-term bank borrowing

15,000,000
Total
60,000,000
Assets
Fixed assets (net)
30,000,000
Current assets
Cash and bank
5,000,000
Receivables
15,000,000
Inventories
20,000,000
Pre-paid exp
2,500,000
Others
2,500,000 45,000,000
Less: Current liablilities
Trade creditors
10,000,000
Provisions
5,000,000 15,000,000
Net current assets
30,000,000
Total
60,000,000
(i) Current ratio

= Current assets/ Current liabilities
45,000,000
=
=
1.5
30,000,000
Note: Please note that for the purpose of calculation of current ratio and acid test ratio, we have
to include short-term bank borrowings in current liabilities.
Current assets Inventories
(ii) Acid-test ratio =
Current liabilities
25,000,000
=
30,000,000
Long-term debt + Short-term bank borrowings

(iii) Debt-equity ratio =
Equity capital + Reserves & surplus
12,500,000 + 15,000,000
=
= 0.8
10,000,000 + 22,500,000
= 0.8
Profit before interest and tax

(iv) Times interest coverage ratio =
Interest
15,100,000
=
= 3.02
5,000,000
Cost of goods sold
(v) Inventory turnover period
72,000,000
=
Inventory
365
= 3.6
20,000,000
(vi) Average collection period =

Net sales/Accounts receivable
365
= 57.6 days
95,000,000/15,000,000
=
(vii)
Total assets =Equity + Total debt =( 10,000,000 + 22,500,000 ) +(12,500,000+15,000,000)

= 60,000,000
Net sales
95,000,000
=
60 ,000,000
Total assets turnover ratio =

Total assets
Profit after tax
(ix) Net profit margin
5,100,000
=
Net sales
PBIT
(x) Earning power =
= 5.4%
95,000,000
15,100,000
=
Total assets
= 25.2%
60,000,000
Equity earning
(xi) Return on equity =
5,100,000
=
Net worth
= 15.7%
32,500,000
= 1.6
The comparison of the Omexs ratios with the standard is given below
Omex
1.5
0.8
0.8
3.02
3.6
57.6 days
1.6
5.4%
25.2%
15.7%
Current ratio
Acid-test ratio
Debt-equity ratio
Times interest covered ratio
Inventory turnover ratio
Average collection period
Total assets turnover ratio
Net profit margin ratio
Earning power
Return on equity
9.
Standard
1.5
0.8
1.5
3.5
4.0
60 days
1.0
6%
18%
15%
We may rearrange the balance sheet figures in the report form as under, for purposes of ratio
analysis. It is assumed that Other assets are other current assets.
Share capital
Reserves and surplus
Long-term debt
Short-term
bank
borrowing
Total
Assets
Net fixed assets
Current assets
Cash and bank
Receivables
Inventories
Other assets
Less:
Current
liabilities
Net current assets
Total
0.5
1.5
2
0.2
1.3
20X
1
2.4
0.6
1.2
20X
2
2.4
1
1.3
20X
3
3
1.5
2
20X4
3
2
2.3
20X5
3.2
2.5
2.6
1.2
1.4
2.1
2.5
2.6
5.4
6.1
8.6
9.8
10.9
2.5
3.2
4.4
4.7
4.8
4.2
1.3
2.9
5.4
0.6
1.6
2.2
0.3
1.8
4.7
1.8
2.9
6.1
0.7
2.3
3
0.3
2.1
6.3
2.1
4.2
8.6
0.8
2.6
3.7
0.4
2.4
7.5
2.4
5.1
9.8
0.7
3.2
4.2
0.6
2.6
8.7
2.6
6.1
10.9
20X1
20X5
Current ratio
Debt-equity ratio
Total assets turnover
ratio
Net profit margin(%)
Earning power (%)
Return on equity (%)
20X2
20X3
20X4
1.68
0.80
1.47
0.79
1.50
0.91
1.53
0.96
1.67
0.91
0.74
5.00
9.26
1.00
6.56
18.03
0.91
3.85
11.63
0.93
5.49
13.27
1.03
6.25
18.35
6.67
11.76
6.67
10.00
12.28
MINICASE
Solution:
(a) Key ratios for 20 X 5
12.4
Current ratio = ---------- = 0.67
6.7+11.7
3.8 + 11.7
Debt-equity ratio =
= 0.98
6.5 + 9.3
57.4
Total assets turnover ratio =
= 1.96
[(34 6.6) + (38 6.7)] / 2
3.0
Net profit margin =
= 5.2 percent
57.4
5
Earning power =
= 17.0 percent
[(34 6.6) + (38 6.7)] / 2
3.0
Return on equity =
= 20.2 percent
(13.9 + 15.8) / 2
(b) Dupont Chart for 20 x 5

Net sales +/Non-op. surplus
deficit 57.8
Net profit
3.0
Net profit
margin
5.2%
Total costs
54.8
Net sales
57.4
Return on
total assets
10.2%
Net sales
57.4
Total asset
turnover
1.96
Average
fixed assets
21.4
+
Average total
assets
29.35
Average
net current
assets 54.0
+
Average
other assets
2.55
(c) Common size and common base financial statements

Common Size Financial Statements
Profit and Loss Account
Net sales
Cost of goods sold
Gross profit
Operating expenses
Operating profit
Non-operating surplus /
deficit
PBIT
Interest
PBT
Tax
Profit after tax
Regular (in million)

20 X 4
20 X 5
39.0
57.4
30.5
45.8
8.5
11.6
4.9
7.0
3.6
4.6
0.5
0.4
4.1
1.5
2.6
2.6
5.0
2.0
3.0
3.0
Common Size (%)

20 X 4
20 X 5
100
100
78
80
22
20
13
12
9
8
1
1
11
4
7
7
9
3
5
5
Balance Sheet
Shareholders funds
Loan funds
Total
Net fixed assets
Net current assets
Other assets
Total

20 X 4
20 X 5
13.9
15.8
13.5
15.5
27.4
31.3
19.6
23.2
5.1
5.7
2.7
2.4
27.4
31.3
Common Size (%)

20 X 4
20 X 5
51
50
49
50
100
100
72
74
19
18
10
8
100
100
Common Base Year Financial Statements

Profit and Loss Account
Net sales
Cost of goods sold
Gross profit
Operating expenses
Operating profit
Non-operating surplus /
deficit
PBIT
Interest
PBT
Tax
Profit after tax

20 X 4
20 X 5
39.0
57.4
30.5
45.8
8.5
11.6
4.9
7.0
3.6
4.6
0.5
0.4
4.1
1.5
2.6
2.6
Common Base Year(%)

20 X 4
20 X 5
100
147
100
150
100
136
100
43
100
128
100
80
5.0
2.0
3.0
3.0
100
100
100
100
100
122
133
115
100
115
Balance Sheet
Shareholders funds
Loan funds
Total
Net fixed assets
Net current assets
Other assets
Total

20 X 4
20 X 5
13.9
15.8
13.5
15.5
27.4
31.3
19.6
23.2
5.1
5.7
2.7
2.4
27.4
31.3
Common Base Year(%)

20 X 4
20 X 5
100
114
100
115
100
114
100
118
100
112
100
89
100
114
(d) The financial strengths of the company are:
Asset productivity appears to be good.

Earning power and return on equity are quite satisfactory
Revenues have grown impressively over 20 x 4 20 x 5
The financial weaknesses of the company are:
Current ratio is unusually low

While revenues grew impressively, costs rose even faster: As a result profit margins
declined
The company did not have any tax liability in the last two years. If the company has to
bear the burden of regular taxes, its return on equity will be adversely impacted
(e) The following are the problems in financial statement analysis
There is no underlying theory

It is difficult to find suitable benchmarks for conglomerate firms
Firms may resort to window dressing
Financial statements do not reflect price level changes
Diversity of accounting policies may vitiate financial statement analysis
It is somewhat difficult to judge whether a certain ratio is good or bad
(f) The qualitative factors relevant for evaluating the performance and prospects of a company are
as follows:
Are the companys revenues tied to one key customer?

To what extent are the companys revenues tied to one key product?
To what extent does the company rely on a single supplier?
What percentage of the companys business is generated overseas?
How will competition impact the company?
What are the future prospects of the firm?
What could be the effect of the changes in the legal and regulatory environment?
Chapter 5
FINANCIAL PLANNING AND FORECASTING
1.
The proforma income statement of Modern Electronics Ltd for year 3 based on the per cent
of sales method is given below
Average per cent
of sales
Net sales
Cost of goods sold
Gross profit
Selling expenses
General & administration expenses
Depreciation
Operating profit
Non-operating surplus/deficit
Earnings before interest and taxes
Interest
Earnings before tax
Tax
Earnings after tax
Dividends (given)
Retained earnings
100.0
76.33
23.67
7.40
6.63
6.75
2.90
1.07
3.96
1.24
2.72
1.00
1.72
Proforma income statement

for year 3 assuming sales of
1020
1020.0
778.57
241.43
75.48
67.63
68.85
29.58
10.91
40.39
12.65
27.74
10.20
17.54
8.00
9.54
2.
The proforma income statement of Modern Electronics for year 3 using the combination
method is given below:
Average per cent
Proforma income statement
of sales
for year 3
Net sales
Cost of goods sold
Gross profit
Selling expenses
General & administration expenses
Depreciation
Operating profit
Non-operating surplus/deficit
Earnings before interest and taxes
Interest
Earnings before tax
Tax
Earnings after tax
Dividends (given)
Retained earnings
3.
100.0
76.33
23.67
7.40
Budgeted
Budgeted
1020.0
778.57
241.43
75.48
55.00
60.00
50.95
10.91
61.86
12.0
49.86
10.20
39.66
8.00
31.66
1.07
Budgeted
1.00
Budgeted
The proforma balance sheet of Modern Electronics Ltd for year 3 is given below
Average of percent
of sales or some
other basis
Projections for year 3

based on a forecast
sales of 1400
Net sales
100.0
1020.0
ASSETS
Fixed assets (net)
Investments
40.23
No change
410.35
20.00
Current assets, loans & advances :

Cash and bank
Receivables
Inventories
1.54
22.49
21.60
15.71
229.40
220.32
Prepaid expenses
Miscellaneous expenditure & losses
5.09
No change
51.92
14.00
961.70
LIABILITIES:
Share capital:
Equity
Reserves & surplus
No change
Proforma income
statement
150.00
160.66
No change
No change
175.00
199.00
Secured loans:
Term loans
Bank borrowings
Current liabilities:
Trade creditors
Provisions
17.33
External funds requirement
Balancing figure
176.77
5.03
51.31
48.96
961.7
A
4.
EFR =
L
-
800
=
190
-
1000
S m S1 (1-d)
300 0.06 x 1,300 (1-0.5)

1000
= (0.61 x 300) (0.06) x 1,300 x (0.5)

= 183 39 = Rs.144.
Projected Income Statement for Year Ending 31st December , 2001

Sales
Profits before tax
Taxes
Profit after tax (6% on sales)
Dividends
Retained earnings
1,300
195
117
78
39
39
Projected Balance Sheet as at 31.12 2001

Liabilities
Assets
Share capital
Retained earnings
Term loans (80+72)
Short-term bank borrowings
(200 + 72)
Accounts payable
Provisions
150
219
152
272
Fixed assets
Inventories
Receivables
Cash
182
65
1,040
A
5. (a)
EFR =
L
-
150
=
1,040
S m S1 (1 d)
30
-
160
520
260
195
65
x 80 (0.0625) x 240 x (0.5)

160
= (60 7.5) = 52.5
(b)
Projected Balance Sheet as on 31.12.20X1

Liabilities
Share capital
Retained earnings
(40 + 7.5)
Term loans
Short-term bank
borrowings
Trade creditors37.50
Provisions
Assets
56.25
47.50
Net fixed assets

Inventories
90
75
46.25
30.00
Debtors
Cash
45
15
7.50
225.00
225.00
(c)
i)
ii)
iii)
20X0
1.50
0.53
14.3%
Current ratio
Debt to total assets ratio
Return on equity
20X1
1.80
0.54
14.5%
(d)
A
EFR 20X1=
S mS1 (1 d)
150
=
30
-
160
20 0.0625 x 180 x 0.5

160
= 9.38
150 x (1.125)
EFR 20X2 =
30 x 1.125
-
x 20 0.0625 x 200 x 0.5
180
168.75
=
33.75
-
180
= 8.75
180
x 20 0.0625 x 220 x 0.5

180
EFR 20X3
168.75 x (1.11)
200
187.31
37.46
x 20 6.88
200
=
200
8.11
187.31 x (1.1)
EFR 20X4 =
37.46 x (1.1)
-
x 20 0.0625 x 240 x 0.5
220
=
33.75 x (1.11)
20 0.0625 x 220 x 0.5
200
220
7.49
Balance Sheet as on 31st December, 20X4
Liabilities
Rs.
Share capital
(30+16.87)
Retained earnings
46.87
66.26
Term loans(20+16.87)
36.87
Short-term bank borrowings 30.00
Trade creditors
37.50
Provisions
7.50
(40.00+5.63+6.25+6.88+7.50)
Assets
Net fixed assets

90.00
(60 x 240/160)
Inventories
(50x240/160)
75.00
Debtors (30x240/160)45.00
Cash (10x240/160)
15.00
225.00
6.
EFR
Rs.
225.00
m (1+g) (1-d)
=
S
S
S
g
Given A/S= 0.8 , L/S= 0.5 , m= 0.05 , d= 0.6 and EFR = 0 we have,
(0.05)(1+g)(0.4)
(0.8-0.5) -
=0
g
(0.05)(1+g)(0.4)
i.e. 0.3 -
=0
g
Solving the above equation we get g = 7.14%

A
7. (a)
EFR =
L
-
320
=
S mS1 (1-d)
70
-
400
x 100 (0.05) (500) (0.5)

400
= Rs.50
(b)
i.
Let CA = denote Current assets

CL
= Current liabilities
SCL = Spontaneous current liabilities
STL = Short-term bank borrowings
FA
= Fixed assets
and LTL = Long-term loans
Current ratio 1.25
CA
i.e
greater than or equal to 1.25 or
CL
CA
1.25
STL +SCL
As at the end of 20X1, CA = 20x0 x 1.25 = 237.50
SCL = 70 x 1.25 = 87.50
Substituting these values, we get
1.25 (STL + 87.5) 237.50
or 1.25 STL 237.50 (8.50 x 1.25)
or STL =
1 2 85.125
1.25
i.e STL Rs.102.50
ii.
Ratio of fixed assets to long term loans 1.25

FA
1.25
LTL
At the end of 20X1 FA = 130 x 1.25 = 162.5
162.5
LTL
or LTL = Rs.130
1.25
If STL and LTL denote the maximum increase in ST borrowings & LT
borrowings , we have :
STL = STL (20X1) STL (20X0) = 102.50 60.00 = 42.50
LTL = LTL (20X1)- LTL (20X0) = 130.00 80.00 = 50.00
Hence, the suggested mix for raising external funds will be :
Short-term borrowings
42.50
Long-term loans
7.50
Additional equity issue
-50.00
A
8.
EFR =
L
-
S m S1 (1-d)
A
S represents surplus funds

S
S
Given m= 0.06, S1 =11,000, d= 0.6 , L= 3,000 S= 10,000 and
surplus funds = 150 we have
A
3,000
(0.06) 11,000 (1-0.6) 1,000 = 150
10,000
10,000
Therefore, mS1(1-d)
A 3,000
= (0.06) (0.4) (11,000) 150 = 114
10
or A = (1,140 + 3,000) = 4,140
The total assets of Videosonics must be 4,140
9.
m= .05 , d = 0.6 , A/E = 2.5 , A/S = 1.4
m (1-d)A/E
(a)
g=
.05 (1-0.6) 2.5

=
A/S m(1-d)A/E
3.70 per cent
1.4 -.05 (1-0.6) 2.5
.05 (1-0.6) x A/E

(b)
0.5 =
A/E = 3.33
2.4 - .05 (1-0.6) A/E
d = 0.466
The dividend payout ratio must be reduced from 60 per cent to 46.6 per cent
.05 (1-0.6) x A/E
(c)
.05 =
A/E = 3.33
1.4 -.05 (1-0.6) A/E
The A/E ratio must increase from 2.5 to 3.33

m (1-0.6) 2.5
(d)
.06 =
m = 7.92 per cent

1.4 m (1-0.6) x 2.5
The net profit margin must increase from 5 per cent to 7.92 per cent
.05 (1-0.6) 2.5
(e)
.06 =
A/S = .883
A/S - .05 (1-0.6) 2.5
The asset to sales ratio must decrease from 1.4 to 0.883

10
m= .06 , b = 0.8 , S0/A= 1/0.9 =1.11

m ( S0 /A0 ) b
g = ---------------------------- =
1 m ( S0 / A0 ) b
0.06 x 1.11 x 0.8

----- ------------------1 0.06 x 1.11 x 0.8
= 0.0563
or 5.63 percent
Chapter 6
TIME VALUE OF MONEY
1.
2.
Value five years hence of a deposit of Rs.1,000 at various interest rates is as follows:
r
8%
FV5
=
=
1000 x FVIF (8%, 5 years)

1000 x 1.469 =
Rs.1469
10%
FV5
=
=
1000 x FVIF (10%, 5 years)

1000 x 1.611 =
Rs.1611
12%
FV5
=
=
1000 x FVIF (12%, 5 years)

1000 x 1.762 =
Rs.1762
15%
FV5
=
=
1000 x FVIF (15%, 5 years)

1000 x 2.011 =
Rs.2011
Rs.160,000 / Rs. 5,000 = 32 = 25
According to the Rule of 72 at 12 percent interest rate doubling takes place approximately in
72 / 12 = 6 years
So Rs.5000 will grow to Rs.160,000 in approximately 5 x 6 years
3.
= 30 years
In 12 years Rs.1000 grows to Rs.8000 or 8 times. This is 23 times the initial deposit. Hence
doubling takes place in 12 / 3 = 4 years.
According to the Rule of 69, the doubling period is:
0.35 + 69 / Interest rate
Equating this to 4 and solving for interest rate, we get
Interest rate = 18.9%.
4.
Saving Rs.2000 a year for 5 years and Rs.3000 a year for 10 years thereafter is equivalent to
saving Rs.2000 a year for 15 years and Rs.1000 a year for the years 6 through 15.
Hence the savings will cumulate to:
2000 x FVIFA (10%, 15 years) + 1000 x FVIFA (10%, 10 years)
=
2000 x 31.772 + 1000 x 15.937
=
Rs.79481.
5.
Let A be the annual savings.

A x FVIFA (12%, 10 years)
1,000,000
A x 17.549
6.
1,000,000
So, A = 1,000,000 / 17.549 =
Rs.56,983.
1,000 x FVIFA (r, 6 years)
10,000
FVIFA (r, 6 years)
10,000 / 1000 = 10
=
=
9.930
10.980
From the tables we find that

FVIFA (20%, 6 years)
Using linear interpolation in the interval, we get:

20% + (10.000 9.930)
r=
x 4% = 20.3%
(10.980 9.930)
7.
1,000 x FVIF (r, 10 years)

FVIF (r,10 years)
=
=
5,000
5,000 / 1000 = 5

FVIF (16%, 10 years) =
FVIF (18%, 10 years) =
4.411
5.234
Using linear interpolation in the interval, we get:

(5.000 4.411) x 2%
r = 16% +
= 17.4%
(5.234 4.411)
8.
9.
The present value of Rs.10,000 receivable after 8 years for various discount rates (r ) are:
r = 10%
PV
= 10,000 x PVIF(r = 10%, 8 years)
= 10,000 x 0.467 = Rs.4,670
r = 12%
PV
= 10,000 x PVIF (r = 12%, 8 years)

= 10,000 x 0.404 = Rs.4,040
r = 15%
PV
= 10,000 x PVIF (r = 15%, 8 years)

= 10,000 x 0.327 = Rs.3,270
Assuming that it is an ordinary annuity, the present value is:
2,000 x PVIFA (10%, 5years)

= 2,000 x 3.791 = Rs.7,582
10.
The present value of an annual pension of Rs.10,000 for 15 years when r = 15%
10,000 x PVIFA (15%, 15 years)
= 10,000 x 5.847 = Rs.58,470
is:
The alternative is to receive a lumpsum of Rs.50,000.

Obviously, Mr. Jingo will be better off with the annual pension amount of Rs.10,000.
11.
The amount that can be withdrawn annually is:

100,000
100,000
A = ------------------ ------------ = ----------- = Rs.10,608
PVIFA (10%, 30 years)
9.427
12.
The present value of the income stream is:

1,000 x PVIF (12%, 1 year) + 2,500 x PVIF (12%, 2 years)
+ 5,000 x PVIFA (12%, 8 years) x PVIF(12%, 2 years)
= 1,000 x 0.893 + 2,500 x 0.797 + 5,000 x 4.968 x 0.797 = Rs.22,683.
13.
The present value of the income stream is:

2,000 x PVIFA (10%, 5 years) + 3000/0.10 x PVIF (10%, 5 years)
= 2,000 x 3.791 + 3000/0.10 x 0.621
= Rs.26,212
14.
To earn an annual income of Rs.5,000 beginning from the end of 15 years from now, if the
deposit earns 10% per year a sum of
Rs.5,000 / 0.10 = Rs.50,000
is required at the end of 14 years. The amount that must be deposited to get this
sum is:
Rs.50,000 / FVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,165
15.
Rs.20,000 =- Rs.4,000 x PVIFA (r, 10 years)

PVIFA (r,10 years) = Rs.20,000 / Rs.4,000 = 5.00
From the tables we find that:
=
=
5.019
4.494
Using linear interpolation we get:

5.019 5.00
r = 15% +
---------------5.019 4.494
x 3%
= 15.1%
16.
PV (Stream A) = Rs.100 x PVIF (12%, 1 year) + Rs.200 x

PVIF (12%, 2 years) + Rs.300 x PVIF(12%, 3 years) + Rs.400 x
PVIF (12%, 4 years) + Rs.500 x PVIF (12%, 5 years) +
Rs.600 x PVIF (12%, 6 years) + Rs.700 x PVIF (12%, 7 years) +
Rs.800 x PVIF (12%, 8 years) + Rs.900 x PVIF (12%, 9 years) +
Rs.1,000 x PVIF (12%, 10 years)
= Rs.100 x 0.893 + Rs.200 x 0.797 + Rs.300 x 0.712
+ Rs.400 x 0.636 + Rs.500 x 0.567 + Rs.600 x 0.507
+ Rs.700 x 0.452 + Rs.800 x 0.404 + Rs.900 x 0.361
+ Rs.1,000 x 0.322
= Rs.2590.9
Similarly,
PV (Stream B) = Rs.3,625.2
PV (Stream C) = Rs.2,851.1
17.
FV5
=
=
=
=
Rs.10,000 [1 + (0.16 / 4)]5x4

Rs.10,000 (1.04)20
Rs.10,000 x 2.191
Rs.21,910
18.
FV5
=
=
=
=
Rs.5,000 [1+( 0.12/4)] 5x4

Rs.5,000 (1.03)20
Rs.5,000 x 1.806
Rs.9,030
19
Stated rate (%)
12
24
24
Frequency of compounding
6 times
4 times
12 times
Effective rate (%)
(1 + 0.12/6)6- 1 (1+0.24/4)4 1 (1 + 0.24/12)12-1
Difference between the

effective rate and stated
rate (%)
20.
= 12.6
= 26.2
= 26.8
0.6
2.2
2.8
Investment required at the end of 8th year to yield an income of Rs.12,000 per year from the
end of 9th year (beginning of 10th year) for ever:
Rs.12,000 x PVIFA(12%, )
= Rs.12,000 / 0.12 = Rs.100,000
To have a sum of Rs.100,000 at the end of 8th year , the amount to be deposited
Rs.100,000
Rs.100,000
=
= Rs.40,388
PVIF(12%, 8 years)
2.476
21.
The interest rate implicit in the offer of Rs.20,000 after 10 years in lieu of
is:
Rs.5,000 x FVIF (r,10 years) = Rs.20,000
now is:
Rs.5,000 now
Rs.20,000
FVIF (r,10 years) =
= 4.000
Rs.5,000

FVIF (15%, 10 years) = 4.046
This means that the implied interest rate is nearly 15%.
I would choose Rs.20,000 after 10 years from now because I find a return of 15% quite
acceptable.
22.
FV10
= Rs.10,000 [1 + (0.10 / 2)]10x2

= Rs.10,000 (1.05)20
= Rs.10,000 x 2.653
= Rs.26,530
If the inflation rate is 8% per year, the value of Rs.26,530 10 years from now, in
the current rupees is:
Rs.26,530 x PVIF (8%,10 years)
= Rs.26,530 x 0.463 = Rs.12,283
23.
terms of
A constant deposit at the beginning of each year represents an annuity due.

PVIFA of an annuity due is equal to : PVIFA of an ordinary annuity x (1 + r)
To provide a sum of Rs.50,000 at the end of 10 years the annual deposit should
be
A
Rs.50,000
FVIFA(12%, 10 years) x (1.12)
Rs.50,000
= Rs.2544
17.549 x 1.12
24.
The discounted value of Rs.20,000 receivable at the beginning of each year from 2005 to
2009, evaluated as at the beginning of 2004 (or end of 2003) is:
Rs.20,000 x PVIFA (12%, 5 years)
=
Rs.20,000 x 3.605 = Rs.72,100.
The discounted value of Rs.72,100 evaluated at the end of 2000 is
Rs.72,100 x PVIF (12%, 3 years)
=
Rs.72,100 x 0.712 = Rs.51,335
If A is the amount deposited at the end of each year from 1995 to 2000 then
A x FVIFA (12%, 6 years) = Rs.51,335
A x 8.115 = Rs.51,335
A = Rs.51,335 / 8.115
=
Rs.6326
25.
The discounted value of the annuity of Rs.2000 receivable for 30 years, evaluated as at the
end of 9th year is:
Rs.2,000 x PVIFA (10%, 30 years) = Rs.2,000 x 9.427 = Rs.18,854
The present value of Rs.18,854 is:
Rs.18,854 x PVIF (10%, 9 years)
=
Rs.18,854 x 0.424
=
Rs.7,994
26.
30 per cent of the pension amount is

0.30 x Rs.600 = Rs.180
Assuming that the monthly interest rate corresponding to an annual interest rate of 12% is
1%, the discounted value of an annuity of Rs.180 receivable at the end of each month for 180 months
(15 years) is:
Rs.180 x PVIFA (1%, 180)
(1.01)180 - 1
Rs.180 x
---------------- = Rs.14,998
.01 (1.01)180
If Mr. Ramesh borrows Rs.P today on which the monthly interest rate is 1%
P x (1.01)60 =
P x 1.817
=
P
27.
Rs.14,998
Rs.14,998
Rs.14,998
------------ = Rs.8254
1.817
Rs.300 x PVIFA(r, 24 months) = Rs.6,000

PVIFA (r,24) =
Rs.6000 / Rs.300
From the tables we find that:
PVIFA(1%,24)
=
PVIFA (2%, 24)
=
= 20
21.244
18.914
Using a linear interpolation

21.244 20.000
r = 1% +
---------------------21.244 18,914
x 1%
= 1.53%
Thus, the bank charges an interest rate of 1.53% per month.
The corresponding effective rate of interest per annum is
[ (1.0153)12 1 ] x 100 = 20%
28.
The discounted value of the debentures to be redeemed between 8 to 10 years evaluated at

the end of the 5th year is:
Rs.10 million x PVIF (8%, 3 years)
+ Rs.10 million x PVIF (8%, 4 years)
+ Rs.10 million x PVIF (8%, 5 years)
= Rs.10 million (0.794 + 0.735 + 0.681)

= Rs.2.21 million
If A is the annual deposit to be made in the sinking fund for the years 1 to 5,
then
A x FVIFA (8%, 5 years) = Rs.2.21 million
A x 5.867 = Rs.2.21 million
A = 5.867 = Rs.2.21 million
A = Rs.2.21 million / 5.867 = Rs.0.377 million
29.
Let `n be the number of years for which a sum of Rs.20,000 can be withdrawn annually.
Rs.20,000 x PVIFA (10%, n) = Rs.100,000
PVIFA (10 %, n) = Rs.100,000 / Rs.20,000 = 5.000
PVIFA (10%, 7 years) =
PVIFA (10%, 8 years) =
4.868
5.335
Thus n is between 7 and 8. Using a linear interpolation we get

n=7+
30.
5.000 4.868
----------------- x 1 = 7.3 years
5.335 4.868
Equated annual installment
= 500000 / PVIFA(14%,4)
= 500000 / 2.914
= Rs.171,585
Loan Amortisation Schedule
Year
-----1
2
3
4
Beginning
Annual
Principal
amountinstallment
Interestrepaid
balance
--------------------------- ----------------------50000017158570000
101585398415
39841517158555778
115807282608
28260817158539565
132020150588
15058817158521082
150503
85*
Remaining
-------------
(*) rounding off error

31.
Define n as the maturity period of the loan. The value of n can be obtained from the
equation.
200,000 x PVIFA(13%, n)
PVIFA (13%, n)
=
=
1,500,000
7.500
From the tables or otherwise it can be verified that PVIFA(13,30) = 7.500

Hence the maturity period of the loan is 30 years.
32.
Expected value of iron ore mined during year 1
Rs.300 million
Expected present value of the iron ore that can be mined over the next 15 years
a price escalation of 6% per annum in the price per tonne of iron
= Rs.300 million x
= Rs.300 million x
33
34.
35.
assuming
1 (1 + g)n / (1 + i)n
-----------------------i-g
1 (1.06)15 / (1.16)15
0.16 0.06
= Rs.300 million x (0.74135 / 0.10)

= Rs.2224 million
(a) PV = Rs.500,000
(b) PV = 1,000,000PVIF10%,6yrs = 1,000,000 x 0.564 = Rs.564,000
(c ) PV = 60,000/r = 60,000/0.10 = Rs.600,000
(d) PV = 100,000 PVIFA10%,10yrs = 100,000 x 6.145 = Rs.614,500
(e) PV = C/(r-g) = 35,000/(0.10-0.05) = Rs.700,000
Option e has the highest present value viz. Rs.700,000
(a)
PV = c/(r g) = 12/[0.12 (-0.03)] = Rs.80 million
(b)
1+g n
1 - ------1+r
PV = A(1+g) ----------------r- g
= 12 x 0.97 x 0.9725 / 0.15 = Rs.75.466 million
It may be noted that if g1 is the growth rate in the no. of units and g2 the growth rate in price
per unit, then the growth rate of their product, g = (1+g1)(1+g2) - 1
In this problem the growth rate in the value of oil produced, g = (1- 0.05)(1 +0.03) - 1 = 0.0215
Present value of the wells production =

1+g n
1 - ------1+r
PV = A(1+g) ----------------r- g
= (50,000 x 50) x ( 1-0.0215)x 1 (0.9785 / 1.10)15
0.10 + 0.0215
= $ 16,654,633
36.
The growth rate in the value of the oil production g = (1- 0.06)(1 +0.04) - 1
= - 0.0224
Present value of the wells production =
1+g n
1 - ------1+r
PV = A(1+g) ----------------r- g
= (80,000 x 60) x ( 1-0.0224)x 1 (0.9776 / 1.12)20
0.12 + 0.0224
= $ 30,781,328.93
37.
Future Value Interest Factor for Growing Annuity,

( 1+ i )n ( 1 + g)n
FVIFGA =
i-g
(1. 09)20 ( 1.08)20
So the value of the savings at the end of 20 years = 100,000 x
0.09 0.08
= Rs. 9,434,536
38
Assuming 52 weeks in an year, the effective interest rate is
0.08
1 +
52
- 1 = 1.0832 - 1 = 8.32 percent

52
MINICASE
Solution:
1. How much money would Ramesh need 15 years from now?
500,000 x PVIFA (10%, 15years)
+ 1,000,000 x PVIF (10%, 15years)
= 500,000 x 7.606 + 1,000,000 x 0.239
= 3,803,000 x 239,000
= Rs.4,042,000
2. How much money should Ramesh save each year for the next 15 years to be able to meet his
investment objective?
Rameshs current capital of Rs.600,000 will grow to :
600,000 (1.10)15 = 600,000 x 4.177 = Rs 2,506,200
This means that his savings in the next 15 years must grow to :
4,042,000 2,506,200 = Rs 1,535,800
So, the annual savings must be :
1,535,800
1,535,800
=
= Rs.48,338
31.772
3. How much money would Ramesh need when he reaches the age of 60 to meet his donation
objective?
200,000 x PVIFA (10% , 3yrs) x PVIF (10%, 11yrs)
= 200,000 x 2.487 x 0.317 = 157,676
4. What is the present value of Rameshs life time earnings?
400,000
46
1
400,000(1.12)
2
1.12
1
1.08
= 400,000
0.08 0.12
= Rs.7,254,962
400,000(1.12)14
15
15
Chapter 7
VALUATION OF BONDS AND STOCKS
1.
P =
t=1
11
100
+
(1.15)t
(1.15)5
= Rs.11 x PVIFA(15%, 5 years) + Rs.100 x PVIF (15%, 5 years)

= Rs.11 x 3.352 + Rs.100 x 0.497
= Rs.86.7
2.(i)
When the discount rate is 14%

7
12
100
P =
+
t
t=1
(1.14)
(1.14)7
= Rs.12 x PVIFA (14%, 7 years) + Rs.100 x PVIF (14%, 7 years)
= Rs.12 x 4.288 + Rs.100 x 0.4
= Rs.91.46
(ii)
When the discount rate is 12%

7
12
100
P =
+
= Rs.100
t=1
(1.12) t (1.12)7
Note that when the discount rate and the coupon rate are the same the value is
par value.
3.
The yield to maturity is the value of r that satisfies the following equality.
7 120
1,000
Rs.750 =
+
t=1 (1+r) t
(1+r)7
Try r = 18%. The right hand side (RHS) of the above equation is:
Rs.120 x PVIFA (18%, 7 years) + Rs.1,000 x PVIF (18%, 7 years)
=
Rs.120 x 3.812 + Rs.1,000 x 0.314
=
Rs.771.44
Try r = 20%. The right hand side (RHS) of the above equation is:
Rs.120 x PVIFA (20%, 7 years) + Rs.1,000 x PVIF (20%, 7 years)
= Rs.120 x 3.605 + Rs.1,000 x 0.279
= Rs.711.60
equal to
Thus the value of r at which the RHS becomes equal to Rs.750 lies between 18% and 20%.
Using linear interpolation in this range, we get
Yield to maturity = 18% +
771.44 750.00
771.44 711.60
x 2%
= 18.7%
4.
80 =
10 14
100
+
t=1 (1+r) t
(1+r)10
Try r = 18%. The RHS of the above equation is

Rs.14 x PVIFA (18%, 10 years) + Rs.100 x PVIF (18%, 10 years)
=
Rs.14 x 4.494 + Rs.100 x 0.191 = Rs.82
Try r = 20%. The RHS of the above equation is
Rs.14 x PVIFA(20%, 10 years) + Rs.100 x PVIF (20%, 10 years)
= Rs.14 x 4.193 + Rs.100 x 0.162
= Rs.74.9
Using interpolation in the range 18% and 20% we get:
Yield to maturity
82 - 80
= 18% + ----------x 2%
82 74.9
= 18.56%
5.
P =
12
t=1
100
+
(1.08) t
(1.08)12
= Rs.6 x PVIFA (8%, 12 years) + Rs.100 x PVIF (8%, 12 years)

= Rs.6 x 7.536 + Rs.100 x 0.397
= Rs.84.92
6.
The post-tax interest and maturity value are calculated below:

Bond A
Bond B
Post-tax interest (C )
12(1 0.3)
=Rs.8.4
10 (1 0.3)
=Rs.7
Post-tax maturity value (M)
100 [ (100-70)x 0.1]

=Rs.97
100 [ (100 60)x 0.1]

=Rs.96
The post-tax YTM, using the approximate YTM formula is calculated below
Bond A :
Post-tax YTM =
=
Bond B :
Post-tax YTM =
=
8.4 + (97-70)/10
-------------------0.6 x 70 + 0.4 x 97
13.73%
7 + (96 60)/6
---------------------0.6x 60 + 0.4 x 96
17. 47%
7.
P =
14
t=1
100
+
(1.08) t
(1.08)14
= Rs.6 x PVIFA(8%, 14) + Rs.100 x PVIF (8%, 14)

= Rs.6 x 8.244 + Rs.100 x 0.341
= Rs.83.56
8.
Do = Rs.2.00, g = 0.06, r = 0.12

Po = D1 / (r g) =
=
=
Do (1 + g) / (r g)
Rs.2.00 (1.06) / (0.12 - 0.06)

Rs.35.33
Since the growth rate of 6% applies to dividends as well as market price, the
price at the end of the 2nd year will be:
market
P2
=
=
Po x (1 + g)2 = Rs.35.33 (1.06)2

Rs.39.70
9.
Po
=
=
D1 / (r g)
=
Do (1 + g) / (r g)
Rs.12.00 (1.10) / (0.15 0.10)=
Rs.264
10.
Po
D1 / (r g)
11.
Rs.32 =
g
=
Rs.2 / (0.12 g)
0.0575 or 5.75%
Po
Do
So
8
D1/ (r g) = Do(1+g) / (r g)
Rs.1.50, g = -0.04, Po = Rs.8
=
=
= 1.50 (1- .04) / (r-(-.04)) = 1.44 / (r + .04)
Hence r = 0.14 or 14 per cent

12.
The market price per share of Commonwealth Corporation will be the sum of three
components:
A:
B:
C:
Present value of the dividend stream for the first 4 years

Present value of the dividend stream for the next 4 years
Present value of the market price expected at the end of 8 years.
A=
1.50 (1.12) / (1.14) + 1.50 (1.12)2 / (1.14)2 + 1.50(1.12)3 / (1.14)3 +

+ 1.50 (1.12)4 / (1.14)4
=
=
B=
1.68/(1.14) + 1.88 / (1.14)2 + 2.11 / (1.14)3 + 2.36 / (1.14)4

Rs.5.74
2.36(1.08) / (1.14)5 + 2.36 (1.08)2 / (1.14)6 + 2.36 (1.08)3 / (1.14)7 +

+ 2.36 (1.08)4 / (1.14)8
=
=
2.55 / (1.14)5 + 2.75 / (1.14)6 + 2.97 / (1.14)7 + 3.21 / (1.14)8

Rs.4.89
P8 / (1.14)8
P8 = D9 / (r g) =
3.21 (1.05)/ (0.14 0.05) = Rs.37.45
So
C
Rs.37.45 / (1.14)8 = Rs.13.14
Thus,
Po
=
=
13.
A + B + C = 5.74 + 4.89 + 13.14

Rs.23.77
Let us assume a required rate of return of 12 percent. The intrinsic value of the equity share
will be the sum of three components:
A:
Present value of the dividend stream for the first 5 years when the
growth rate expected is 15%.
B:
Present value of the dividend stream for the next 5 years when the
growth rate is expected to be 10%.
C:
Present value of the market price expected at the end of 10 years.
A=
2.00 (1.15) 2.00 (1.15)2 2.00 (1.15)3 2.00(1.15)4 2.00 (1.15)5

------------- + ------------- +-------------- + ------------- + ------------(1.12)
(1.12)2
(1.1.2)3
(1.1.2)4
(1.12)5
= 2.30 / (1.12) + 2.65 / (1.12)2 + 3.04 / (1.12)3 + 3.50 / (1.12)4 + 4.02/(1.12)5

=
Rs.10.84
B=
=
=
C=
=
4.02(1.10) 4.02 (1.10)2 4.02(1.10)3 4.02(1.10)4 4.02 (1.10)5

------------ + ---------------- + ------------- + --------------- + --------------(1.12)6
(1.12)7
(1.12)8
(1..12)9 (1.12)10
4.42
4.86
5.35
5.89
6.48
--------- + -------------- + --------------- + ------------- + ------------(1.12)6
(1.12)7
(1.12)8
(1.1.2)9 (1.12)10
Rs.10.81
D11
1
6.48 (1.05)
-------- x --------------- = ------------------- x 1/(1.12)10
rg
(1 +r)10
0.12 0.05
Rs.97.20
The intrinsic value of the share = A + B + C

=
10.84 + 10.81 + 97.20 =
Rs.118.85
14.
Terminal value of the interest proceeds

=
140 x FVIFA (16%,4)
=
140 x 5.066
=
709.24
Redemption value = 1,000

Terminal value of the proceeds from the bond = 1709.24
Define r as the yield to maturity. The value of r can be obtained from the equation
900 (1 + r)4
r
15.
= 1709.24
= 0.1739 or 17.39%
Intrinsic value of the equity share (using the 2-stage growth model)
(1.18)6
2.36 x
1 - ----------2.36 x (1.18)5 x (1.12)
6
(1.16)
= --------------------------------- + ----------------------------------0.16 0.18
(0.16 0.12) x (1.16)6
16.
2.36 x
Rs.74.80
- 0.10801
----------- + 62.05
- 0.02
Intrinsic value of the equity share (using the H model)

=
4.00 (1.20)
4.00 x 4 x (0.10)
-------------- + --------------------0.18 0.10
0.18 0.10
=
=
60 + 20
Rs.80
17.
Po =
D1
rg
Po =
Rs. 8
0.15-0.12
Po =
E1
r
+ PVGO
Rs. 266.7
Po =
Rs. 20 +
PVGO
0.15
Rs. 266.7 = Rs. 133.3 + PVGO
So, PVGO = Rs. 133.4

MINICASE
(a) The value of a bond is calculated using the formula
n
C
M
P =
+
t=1 (1+r)t
(1+r)n
where
P is the value (in rupees), n is the number of years to maturity, C is the annual
coupon payment (in rupees), r is the periodic required return, M is the maturity value, and t is the
time when the payment is received
(b) Value of the bond = 100 PVIFA8% , 5years + 1000 PVIF8% , 5years
= 100 x 3.993 + 1000 x 0.681 = Rs.1080.30
100 + ( 1000 1060)/8
(c) Approximate YTM =
= 8.93%
0.4 x 1000 + 0.6 x 1060
(d)
100 + ( 1050 1060)/2

Approximate YTC =
= 9%
0.4 x 1050 + 0.6 x 1060
(e) The general formula for valuing any stock is :
Dt
P0 =
t=1
(1+r)t
(f) A constant growth stock is valued using the formula

D1
P0 =
r-g
where D1 is the dividend expected a year hence, r is the required rate of return and g is the
constant growth rate
(g)
(i) The expected value of the stock a year from now
D2
6 x (1+0.12)2
P1 =
=
= Rs.250.88
r- g
0.15 0.12
6 x 1.12
(ii) Price of the stock at present, P0 =
0.15 0.12
= Rs.224
Expected dividend in the first year = 6 x1.12 = Rs.6.72

6.72
Dividend yield =
x 100 = 3 %
224
Expected capital gains in the first year = P1 P0 = 250.88 224 = Rs.26.88
26.88
Capital gains yield =
x 100 = 12 %
224
(h) Present value of the stock is :
1+g1
1
1+r
P0 =
D1
D1 (1+g1)n-1 (1+g2)
r - g2
(1+r)n
+
r - g1
1.25
1 - 1.16
= (10 x 1.25)
(10 x 1.25) x (1.25)3 x 1.10

+
x
0.16 0.10
0.16 0.25
= 48.38 + 447.59 /1.81 = Rs. 295.67
1
(1.16)4
(i)
Intrinsic value per share:

D0 [(1+gn) + H (ga-gn)]
P0 =
r - gn
8[ 1.10 + 1.5 x (0.20 0.10]
=
= Rs. 250
0.14 0.10
-----------------------------------------------------------------------------------------------------------------------
Chapter 8
RISK AND RETURN
1 (a)
Expected price per share a year hence will be:

= 0.4 x Rs.10 + 0.4 x Rs.11 + 0.2 x Rs.12 = Rs.10.80
(b)
Probability distribution of the rate of return is

Rate of return (Ri)
10%
Probability (pi)0.4
20%
0.4
30%
0.2
Note that the rate of return is defined as:

Dividend + Terminal price
-------------------------------- - 1
Initial price
2 (a) For Rs.1,000, 20 shares of Alphas stock can be acquired. The probability
the return on 20 shares is
Economic Condition
High Growth
Low Growth
Stagnation
Recession
Expected return
Return (Rs)
20 x 55 = 1,100
20 x 50 = 1,000
20 x 60 = 1,200
20 x 70 = 1,400
distribution of
Probability
0.3
0.3
0.2
0.2
(1,100 x 0.3) + (1,000 x 0.3) + (1,200 x 0.2) + (1,400 x 0.2)
=
=
330 + 300 + 240 + 280

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

0.3 + (1,200 1,150)2 x 0.2 + (1,400 1,150)2 x 0.2]1/2
=
Rs.143.18
(b)
For Rs.1,000, 20 shares of Betas stock can be acquired. The probability distribution of the
return on 20 shares is:
Economic condition
Return (Rs)
Probability
High growth
Low growth
Stagnation
Recession
20 x 75 = 1,500
20 x 65 = 1,300
20 x 50 = 1,000
20 x 40 = 800
0.3
0.3
0.2
0.2
Expected return =
(1,500 x 0.3) + (1,300 x 0.3) + (1,000 x 0.2) + (800 x 0.2)

= Rs.1,200
Standard deviation of the return = [(1,500 1,200)2 x .3 + (1,300 1,200)2 x .3

+ (1,000 1,200)2 x .2 + (800 1,200)2 x .2]1/2 = Rs.264.58
(c )
For Rs.500, 10 shares of Alphas stock can be acquired; likewise for Rs.500, 10
shares of Betas stock can be acquired. The probability distribution of this option is:
Return (Rs)
Probability
(10 x 55) + (10 x 75) =
1,300
0.3
(10 x 50) + (10 x 65) =
1,150
0.3
(10 x 60) + (10 x 50) =
1,100
0.2
(10 x 70) + (10 x 40) =
1,100
0.2
Expected return
=
(1,300 x 0.3) + (1,150 x 0.3) + (1,100 x 0.2) +
(1,100 x 0.2)
=
Rs.1,175
Standard deviation
=
[(1,300 1,175)2 x 0.3 + (1,150 1,175)2 x 0.3 +
d.
(1,100 1,175)2 x 0.2 + (1,100 1,175)2 x 0.2 ]1/2

=
Rs.84.41
For Rs.700, 14 shares of Alphas stock can be acquired; likewise for Rs.300, 6
shares of Betas stock can be acquired. The probability distribution of this
option is:
Return (Rs)
Probability
(14 x 55) + (6 x 75)

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

Rs.1,165
Standard deviation
=
=
[(1,220 1,165)2 x 0.3 + (1,090 1,165)2 x 0.3 +

(1,140 1,165)2 x 0.2 + (1,220 1,165)2 x 0.2]1/2
Rs.57.66
The expected return to standard deviation of various options are as follows :

Expected return (Rs) Standard deviation
Expected / Standard
Option
(Rs)
return deviation
a
1,150
143
8.04
b
1,200
265
4.53
c
1,175
84
13.99
d
1,165
58
20.09
Option `d is the most preferred option because it has the highest return to risk
3.(a)
ratio.
Define RA and RM as the returns on the equity stock of Auto Electricals Limited a and Market
portfolio respectively. The calculations relevant for calculating the beta of the stock are
shown below:
Year
1
2
3
4
5
6
7
8
9
10
11
RA
15
-6
18
30
12
25
2
20
18
24
8.
RA = 15.09
RM
12
1
14
24
16
30
-3
24
15
22
12
RA-RA
-0.09
-21.09
2.91
14.91
0-3.09
9.91
-13.09
4.91
2.91
8.91
-7.09
RM-RM
-3.18
-14.18
-1.18
8.82
0.82
14.82
-18.18
8.82
-0.18
6.82
-3.18
(RA-RA)
0.01
444.79
8.47
222.31
9.55
98.21
171.35
24.11
8.47
79.39
50.27
(RM-RM)
10.11
201.07
1.39
77.79
0.67
219.63
330.51
77.79
0.03
46.51
10.11
RM = 15.18
(RA RA)2 = 1116.93 (RM RM) 2 = 975.61 (RA RA) (RM RM) = 935.86
Beta of the equity stock of Auto Electricals
(RA RA) (RM RM)
(RM RM) 2
RA-RA/RM-RM
0.29
299.06
-3.43
131.51
-2.53
146.87
237.98
43.31
-0.52
60.77
22.55
935.86
975.61
0.96
(b)
Alpha =
=
RA A RM
15.09 (0.96 x 15.18) =
0.52
Equation of the characteristic line is

RA = 0.52 + 0.96 RM
4
The required rate of return on stock A is:

RA
=
=
=
RF + A (RM RF)
0.10 + 1.5 (0.15 0.10)
0.175
Intrinsic value of share = D1 / (r- g) = Do (1+g) / ( r g)

Given Do = Rs.2.00, g = 0.08, r = 0.175
2.00 (1.08)
Intrinsic value per share of stock A
=
0.175 0.08
=
5.
Rs.22.74
The SML equation is RA = RF + A (RM RF)

Given RA = 15%.
RF = 8%,
RM = 12%, we have
0.15 = .08 + A (0.12 0.08)

0.07
i.e.A =
= 1.75
0.04
Beta of stock A = 1.75

6.
The SML equation is: RX = RF + X (RM RF)

We are given 0.15 = 0.09 + 1.5 (RM 0.09) i.e., 1.5 RM = 0.195
or RM = 0.13%
Therefore return on market portfolio = 13%
7.
RM = 12%
X = 2.0
RX =18% g = 5%
Po = Rs.30
Po = D1 / (r - g)
Rs.30 = D1 / (0.18 - .05)
So D1 = Rs.39 and Do = D1 / (1+g) = 3.9 /(1.05) = Rs.3.71
Rx
Rf + x (RM Rf)
0.18
Rf + 2.0 (0.12 Rf)
So Rf = 0.06 or 6%.
Original
Rf
RM Rf
g
x
Revised
6%
6%
5%
2.0
8%
4%
4%
1.8
Revised Rx = 8% + 1.8 (4%) = 15.2%

Price per share of stock X, given the above changes is
3.71 (1.04)
= Rs.34.45
0.152 0.04
8
We know that:
Debt (1-tc)
equity
assets
+
Equity
i.e
equity
assets
1.1
=
Debt(1-tc)
1 + ----------Equity
= 0.71
4
1 + --- ( 1 0.30)
5
9
Period
RB(%)
RM(%)
RB-R B
1
2
3
4
5
6
7
8
9
10
15
25
-10
20
15
30
-5
20
16
12
12
20
-5
24
10
25
-10
15
17
10
1.2
11.2
-23.8
6.2
1.2
16.2
-18.8
6.2
2.2
-1.8
RB=138
RB=13.8
RM=118
RM= 11.8
( RM-RM)
0.2
8.2
-16.8
12.2
-1.8
13.2
-21.8
3.2
5.2
-1.8
= 132.4
CovB,M
0.24
91.84
399.84
75.64
-2.16
213.84
409.84
19.84
11.44
3.24
(RB-RB)(RM-RM)=1223.6
n-1
Beta : =
RM-R M (RB-R B )(R M-R M)
CovB,M
(RB-RB)(RM-RM)
=
n-1
136
= 1 . 03
1 3 2.4
Alpha = B = RB - RM = 13.8 1.03 x 11.8 = 1.65%
The characteristic line for stock B is : RB = 1.65 + 1.03 RM
2
(RM-RM)2
0.04
67.24
282.24
148.84
3.24
174.24
475.24
10.24
27.04
3.24
(RM-RM)2=1191.6
= 136
Chapter 9
RISK AND RETURN: PORTFOLIO THEORY AND ASSET PRICING MODELS
1. (a)
E (R1) = 0.2(-5%) + 0.3(15%) + 0.4(18%) + .10(22%)
= 12%
E (R2) = 0.2(10%) + 0.3(12%) + 0.4(14%) + .10(18%)
= 13%
(R1) = [.2(-5 12)2 + 0.3 (15 12)2 + 0.4 (18 12)2 + 0.1 (22 12)2]
= [57.8 + 2.7 + 14.4 + 10] = 9.21%
(R2) = [.2(10 13)2 + 0.3(12 13)2 + 0.4 (14 13)2 + 0.1 (18 13)2]
= [1.8 + 0.09 + 0.16 + 2.5] = 2.13%
The covariance between the returns on assets 1 and 2 is calculated below
State of
Probability Return on Deviation Return on Deviation Product of
nature
asset 1
of return
asset 2
of the
deviation
on asset 1
return on
times
from its
asset 2
probability
mean
from its
mean
(1)
(2)
(3)
(4)
(5)
(6)
(2)x(4)x(6)
1
0.2
-5%
-17%
10%
-3%
10.2
2
0.3
15%
3%
12%
-1%
-0.9%
3
0.4
18%
6%
14%
1%
2.4
4
0.1
22%
10%
18%
5%
5
Sum =
16.7
(b)
Thus the covariance between the returns of the two assets is 16.7.
(c)
2.
The coefficient of correlation between the returns on assets 1 and 2 is:

Covariance12
16.7
=
= 0.85
1 x 2
9.21 x 2.13
Expected rates of returns on equity stock A, B, C and D can be computed as
A:
0.10 + 0.12 + (-0.08) + 0.15 + (-0.02) + 0.20 = 0.0783

6
= 7.83%
B:
0.08 + 0.04 + 0.15 +.12 + 0.10 + 0.06 = 0.0917

6
C:
0.07 + 0.08 + 0.12 + 0.09 + 0.06 + 0.12
= 0.0900
= 9.00%
D:
0.09 + 0.09 + 0.11 + 0.04 + 0.08 + 0.16
= 0.095
= 9.50%
= 9.17%
follows:
6
(a)
Return on portfolio consisting of stock A
= 7.83%
(b)
Return on portfolio consisting of stock A and B in equal

proportions =
0.5 (0.0783) + 0.5 (0.0917)
=
0.085 =
8.5%
(c )
Return on portfolio consisting of stocks A, B and C in equal

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

proportions =
0.25(0.0783) + 0.25(0.0917) + 0.25(0.0900) +
0.25(0.095)
=
0.08875 = 8.88%
3. The standard deviation of portfolio return is:

p = [w1212 + w2222 + w3232 + 4242 + 2 w1 w2 12 1 2 + 2 w1 w3 13 1 3 + 2 w1 w4
14 14 + 2 w2 w3 23 2 3 + 2 w2 w4 24 2 4 + 2 w3 w4 34 3 4 ]1/2
= [0.22 x 42 + 0.32 x 82 + 0.42 x 202 + 0.12 x 102 + 2 x 0.2 x 0.3 x 0.3 x 4 x 8
+ 2 x 0.2 x 0.4 x 0.5 x 4 x 20 + 2 x 0.2 x 0.1 x 0.2 x 4 x 10
+ 2 x 0.3 x 0.4 x 0.6 x 8 x 20 + 2 x 0.3 x 0.1 x 0.8 x 8 x 10
+ 2 x 0.4 x 0.1 x 0.4 x 20 x 10]1/2
= 10.6%
MINICASE
a. For stock A:
Expected return
= (0.2 x -15) + (0.5 x 20) + (0.3 x 40) = 19
Standard deviation = [ 0.2 ( -15 -19)2 + 0.5 (20-19)2 + 0.3 (40 19)2 ] 1/2
= [231.2 + 0.5 + 132.3]1/2 = 19.08
For stock B:
Expected return
= (0.2 x 30) + (0.5 x 5) + [ 0.3 x (-) 15] = 4
Standard deviation = [0.2 ( 30 4)2 + 0.5 (5 -4)2 + 0.3 (-154)2]1/2
= (135.2 + 0.5 + 108.3) = 15.62
For stock C:
Expected return
= [0.2 x (-5)] + (0.5 x 15) + (0.3 x 25)] = 14
Standard deviation = [0.2 (-5 14)2 + 0.5 (15 -14)2 + 0.3 (25-14)2]
= [72.2 + 0.5 + 36.3] = 10.44
For market portfolio:
Expected return
= [0.2 x (-)10] + (0.5 x 16) + (0.3 x 30) = -2 + 8 + 9 = 15
Standard deviation = [0.2 (-10-15)2 + 0.5(16-15)2 + 0.3 (30 15)2]

= ( 125 + 0.5 + 67.5 ) = 13.89
b.
State of the
Economy
Probability (p)
Return on
A (%) (RA)
Return
B (%) (RB)
Recession
Normal
Boom
0.2
0.5
0.3
-15
20
40
30
5
-15
RA-E(RA)
-34
1
21
RB-E(RB)
26
1
-19
total =
p
x [RA-E(RA)]
x[RB-E(RB)]
-176.8
0.5
- 119.7
- 296.00
Covariance between the returns of A and B is (-) 296

State of the
Economy
Probability (p)
Return on A
(%) (RA)
Recession
Normal
Boom
0.2
0.5
0.3
-15
20
40
Return C
(%) (RC)
- 5.0
15.0
25.0
Covariance between the returns of A and C is 199
RA-E(RA)
-34
1.
21
RC-E(RC)
-19
1
11
total =
p
x [RA-E(RA)]
x[RC-E(RC)]
129.2
0.5
69.3
199.0
(-) 296
c.
Coefficient of correlation between the returns of A and B =
= (-) 1
19.08 x 15.62
199
Coefficient of correlaton between the returns of A and C =
= 1
19.08 x 10.44
d. Portfolio in which stocks A and B are equally weighted:

Economic condition
Recession
Normal
Boom
Probability
0.2
0.5
0.3
Overall expected return

0.5 x (-) 15 + 0.5 x 30 = 7.5
0.5 x 20 + 0.5 x 5
= 12.5
0.5 x 40 + 0.5 x (-)15 = 12.5
Expected return of the portfolio = (0.2 x 7.5) + (0.5 x 12.5) + (0.3 x 12.5)
= 0.7 + 6.25 + 4.5 = 11.5
Standard deviation of the portfolio
= [ 0.2 (7.5 11.5)2 + 0.5 (12.5 11.5)2 + 0.3 (12.5 11.5)2]1/2
= [ 3.2 + 0.5 + 0.3] = 2
Portfolio in which weights assigned to stocks A, B and C are 0.4, 0.4 and 0.2 respectively.
Expected return of the portfolio = (0.4 x 19.0) + (0.4 x 4) + (0.2 x 14))
= 12
For calculating the standard deviation of the portfolio we also need covariance between B and C,
which is calculated as under:
State of the
Economy
Probability (p)
Recession
Normal
Boom
0.2
0.5
0.3
Return on
B (%) (RB)
30
5
(-)15
Return on RB-E(RB)
C (%) (RC)
- 5.0
15.0
25.0
Covariance between the returns of B and C is (-)161
26
1
(-)19
RC-E(RC)
-19
1
11
total =
p
x[RB-E(RB)]
x[RC-E(RC)]
(-) 98.8
0.50
(-) 62.7
(-)161
We have the following values:

WA = 0.4
WB = 0.4
A = 19.08
B = 15.62
AB = (-)296
AC = 199
WC = 0.2
C = 10.44
BC = (-) 161
Standard deviation
= [ (0.4 x 19.08)2 + (0.4 x 15.62)2 + (0.2 x 10.44)2 + [ 2 x 0.4 x 0.4 x (-) 296 ] +
+ [2 x 0.4 x 0.2 x 199] + [2 x 0.4 x 0.2 x (-) 161]1/2
= (58.25 + 39.04 + 4.36 94.72 + 31.84 25.76)1/2 = 3.61
e.
(i) Risk-free rate is 6% and market risk premium is 15 6 = 9%
The SML relationship is
Required return = 6% + x 9%
(ii) For stock A:
Required return = 6 % + 1.2 x 9 % = 16.8 %; Expected return = 19 %
Alpha = 19 16.8 = 2.2 %
For stock B:
Required return = 6 % - 0.70 x 9 % = - 0.3 %; Expected return = 4 %
Alpha = 4 + 0.3 = 4.3 %
For stock C:
Required return = 6% + 0.9 x 9 % = 14.1 %; Expected return = 14%
Alpha = 14 14.1 = (-) 0.1 %
f.
2
Period RD (%) RM (%) RD-RD RM-RM (RM-RM ) (RD-RD) (RM-RM)

1
2
3
4
5
Mean=
-12
6
12
20
6
6.4
-5
4
8
15
9
6.2
-18.4
-0.4
5.6
13.6
-0.4
-11.2
-2.2
1.8
8.8
2.8
SUM=
125.44
4.84
3.24
77.44
7.84
218.8
2m = 218.8/4 = 54.7 Cov (D,M) = 335.6/4 = 83.9
206.08
0.88
10.08
119.68
-1.12
335.6
= 83.9 / 54.7 = 1.53
Interpretation: The change in return of D is expected to be 1.53 times the expected change in
return on the market portfolio.
h.
CAPM assumes that return on a stock/portfolio is solely influenced by the market factor whereas
the APT assumes that the return is influenced by a set of factors called risk factors.
Chapter 10
OPTIONS AND THEIR VALUATION
1.
S = 100
u = 1.5
d = 0.8
E = 105
r = 0.12
R = 1.12
The values of (hedge ratio) and B (amount borrowed) can be obtained as follows:
Cu Cd
=
(u d) S
Cu
Max (150 105, 0)
45
Cd
Max (80 105, 0)
45 0
45
=
0.7 x 100
u.Cd d.Cu
=
(u-d) R
(1.5 x 0) (0.8 x 45)
=
0.7 x 1.12
-36
=
= - 45.92
0.784
S+B
9
=
70
=
14
0.6429
=
=
0.6429 x 100 45.92

Rs.18.37
Value of the call option = Rs.18.37

2.
S = 40
R = 1.10
u=?
E = 45
d = 0.8
C=8
We will assume that the current market price of the call is equal to the pair value of the call
as per the Binomial model.
Given the above data
Cd
Max (32 45, 0)
Cu Cd
=
B
x
u Cd d Cu
Cu 0
=
C
8
S
1.10
x
-0.8Cu
(-) 0.034375
=
=
=
- 0.34375 B
S+B
x 40 + B
40
(1)
(2)
Substituting (1) in (2) we get

8
8
or B
=
=
=
(-0.034365 x 40) B + B
-0.375 B
- 21.33
- 0.034375 (-21.33) = 0.7332
The portfolio consists of 0.7332 of a share plus a borrowing of Rs.21.33 (entailing a

repayment of Rs.21.33 (1.10) = Rs.23.46 after one year). It follows that when u occurs either u x 40
x 0.7332 23.46 = u x 40 45
-10.672 u
=
-21.54
u
=
2.02
or
u x 40 x 0.7332 23.46
u
=
0.8
Since u > d, it follows that u = 2.02.

Put differently the stock price is expected to rise by 1.02 x 100 = 102%.
3.
Using the standard notations of the Black-Scholes model we get the following results:
ln (S/E) + rt + 2 t/2
d1
=
t
d2
ln (120 / 110) + 0.14 + 0.42/2

0.4
0.08701 + 0.14 + 0.08

0.4
0.7675
=
=
=
d1 - t
0.7675 0.4
0.3675
N(d1) =
N (d2) =
N (0.7675) ~ N (0.77) = 0.80785

N (0.3675) ~ N (0.37) = 0.64431
So N(d1) E. e-rt. N(d2)

120 x 0.80785 110 x e-0.14 x 0.64431
(120 x 0.80785) (110 x 0.86936 x 0.64431)
35.33
=
=
=
=
Value of the call as per the Black and Scholes model is Rs.35.33.
4
l (S/E) + (r + 2 /2) t
d1
=
t
=
ln (80 / 82) + [0.1503 + (0.2)2/2]

0.2
d2
-0.0247 + 0.1703
0.2
0.7280
=
=
=
d1 - t
0.7280 0.2
0.5280
N(d1) =
N (0.7280).
From the tables we have N(0.70) = 1- 0.2420 = 0.7580
and
N(0.75)= 1- 0.2264 = 0.7736
By linear extrapolation, we get
N(0.7280) = 0.7580 + (0.7280 0.7000)(0.7736-0.7580)/0.05
= 0.7580 + 0.008736 = 0.7667
N(d2) = N(0.5280)
N(0.55) = 1- 0.2912 = 0.7088
N(0.5280) = 0.6915 + (0.5280 0.5000)(0.7088 0.6915)/0.05
= 0.6915 + 0.009688 = 0.7012
E/ert = 82/1.1622 = 70.5558
C = So N(d1) E. e-rt. N(d2)
= 80 x 0.7667 -70.5558 x 0.7012 = 11.86
5
l (S/E) + (r + 2 /2) t
d1
=
t
d2
ln (80 / 85) + [0.1503 + (0.2)2/2]

0.2
=
=
-0.060625 + 0.1703
0.2
0.5484
=
=
=
d1 - t
0.5484 0.2
0.3484
N(d1) =
N (0.5484).
and
N(0.55)= 1- 0.2912 = 0.7088
N(0.5484) = 0.6915 + (0.5484 0.5000)(0.7088-0.6915)/0.05
= 0.6915 + 0.0167 = 0.7082
N(d2) = N(0.3484)
N(0.35) = 1- 0.3632 = 0.6368
N(0.3484) = 0.6179 + (0.3484 0.3000)(0.6368 0.6179)/0.05
= 0.6179 + 0.0183= 0.6362
rt
E/e = 85/1.1622 = 73.1372
= 80 x 0.7082 -73.1372 x 0.6362 = 10.13
P = C S + E/ert
= 10.13 80 + 73.1372 = 3.27
Value of the put option = Rs.3.27
6.
So
d1
Vo N(d1) B1 e rt N (d2)
6000 N (d1) 5000 e 0.1 N(d2)
ln (6000 / 5000) + (0.1 x 1) + (0.18/2)

--------------------------------------------- 0.18 x 1
ln (1.2) + 0.19
=
0.4243
=
0.8775 = 0.88
N(d1) =
d2
=
=
=
N (0.88)
=
d1 - t
0.8775 - 0.18
0.4532 =
0.45
N (d2) =
So
=
=
N (0.45) = 0.67364
6000 x 0.81057 (5000 x 0.9048 x 0.67364)
1816
B0
V0 S0
0.81057
6000 1816
4184
MINICASE
b)
Call options with strike prices 280, 300 and 320 and put options with
strike prices 340and 360 are in - the money.
Call options with strike prices 340 and 360 and put options with strike
prices 280, 300 and 320 are out of the money.
c) (i) If Pradeep Sharma sells Jan/340 call on 1000 shares, he will earn a
call premium of Rs.5000 now. However, he will forfeit the gains
that he would have enjoyed if the price of Newage Hospitals rises
above Rs.340.
(ii) If Pradeep Sharma sells Mar/300 call on 1000 shares, he will earn
a call premium of Rs.41,000 now. However, he will forfeit the gains
he would have enjoyed if the price of Newage Hospital remains
above Rs.300.
d)
Let s be the stock price, p1 and p2 the call premia for March/ 340 and
March/ 360 calls respectively. When s is greater than 360, both the calls
will be exercised and the profit will be { s-340-p1} { s-360-p2 } =Rs. 11
The maximum loss will be the initial investment , i.e. p1-p2 =Rs. 9
The break even will occur when the gain on purchased call equals the
net premium paid
i.e. s-340 = p1 p2 =9 Therefore s= Rs. 349
e)
If the stock price goes below Rs.300, Mr. Sharma can execute the put option and ensure that
his portfolio value does not go below Rs. 300 per share. However , if stock price goes above
Rs. 340, the call will be exercised and the stocks in the portfolio will have to be delivered/
sold to meet the obligation, thus limiting the upper value of the portfolio to Rs. 340 per share.
So long as the share price hovers between R. 300 and Rs. 340, Mr. Sharma will be gainer
by Rs. 8 ( net premium received).
Profit
Pay off
Stock price
305
340 375
f). Other things remaining constant, value of a call option

- increases when the current price of the stock increases.
- decreases when the exercise price increases.
- increases when option term to maturity increases.
- increases when the risk-free interest rate increases.
- increases when the variability of the stock price increases.
g). The three equations are
E
C0 = S0 N(d1) - ------ N (d2)
ert
ln
S0
2
------ + r + ----E
2
d1 =
d2 = d1 - t
S0 = 325
E =320 t =0.25 r = 0.06 =0.30

(0.30)2
325
ln
+ 0.06 +
320
x 0.25
2
d1 =
0.30 x 0.25
= ( 0.0155 + 0.02625) / 0.15 = 0. 2783

d2 = 0.2783 -0.30 0.25 = 0.2783 0.15 = 0.1283
Using normal distribution table
N (d1) = 1 [ 0.3821 + ( 0.4013- 0. 3821) ( 0.30 0.2783 ) /( 0.30 0.25) ]
=1- [ 0.3821 + 0. 0192 x 0.0217 / 0.05 ] = 0.6096
N ( d2 ) = 1- [ 0. 4404 + ( 0. 4602- 0.4404) ( 0. 15 0. 1283 /( 0. 15- 0.10 ) ]
= 1- [ 0.4404 + 0.0198 x 0.0217 / 0.05 ] = 0. 5510
rt
E / e = 320 / e0.06 x 0. 25 = 320 / 1. 0151 = 315. 24
C0 = 325 x 0.6096 315.24 x 0. 5510 = 198.12 173. 70 = Rs. 24.42
Chapter 11
TECHNIQUES OF CAPITAL BUDGETING
1.(a)
(b)
NPV of the project at a discount rate of 14%.

=
- 1,000,000 + 100,000 + 200,000

---------- -----------(1.14)
(1.14)2
+ 300,000 + 600,000 + 300,000
----------- ---------- ---------(1.14)3
(1.14)4
(1.14)5
- 44837
NPV of the project at time varying discount rates

=
- 1,000,000
+ 100,000
(1.12)
+ 200,000
(1.12) (1.13)
+ 300,000
(1.12) (1.13) (1.14)
+ 600,000
(1.12) (1.13) (1.14) (1.15)
+ 300,000
(1.12) (1.13) (1.14)(1.15)(1.16)
=
- 1,000,000 + 89286 + 158028 + 207931 + 361620 + 155871
=
- 27264
2. IRR (r) can be calculated by solving the following equations for the value of r.
60000 x PVIFA (r,7) =
300,000
i.e., PVIFA (r,7)
5.000
Through a process of trial and error it can be verified that r = 9.20% pa.
3. The IRR (r) for the given cashflow stream can be obtained by solving the following equation for
the value of r.
-3000 + 9000 / (1+r) 3000 / (1+r) = 0
Simplifying the above equation we get
r = 1.61, -0.61; (or) 161%, (-)61%
NOTE: Given two changes in the signs of cashflow, we get two values for the
IRR of the cashflow stream. In such cases, the IRR rule breaks down.
4. Define NCF as the minimum constant annual net cashflow that justifies the purchase of the given
equipment. The value of NCF can be obtained from the equation
NCF x PVIFA (10,8) =
NCF
500000
=
500000 / 5.335
=
93271
5. Define I as the initial investment that is justified in relation to a net annual cash
inflow of 25000 for 10 years at a discount rate of 12% per annum. The value
of I can be obtained from the following equation
25000 x PVIFA (12,10)
i.e., I
6.
=
=
I
141256
Let us assume a discount rate of 15 %.

PV of benefits (PVB) =
+
+
+
+
=
25000 x PVIF (15,1)

40000 x PVIF (15,2)
50000 x PVIF (15,3)
40000 x PVIF (15,4)
30000 x PVIF (15,5)
122646
Investment
100,000
Benefit cost ratio
1.23 [= (A) / (B)]
(A)
(B)
7.
The NPVs of the three projects are as follows:

P
Project
Q
0%
5%
400
223
500
251
600
312
10%
15%
69
- 66
40
- 142
70
- 135
25%
30%
- 291
- 386
- 435
- 555
- 461
- 591
Discount rate
NPV profiles for Projects P and Q for selected discount rates are as follows:
(a)
Project
Discount rate (%)
0
5
10
15
20
b)
2950
1876
1075
471
11
500
208
- 28
- 222
- 382
(i)
The IRR (r ) of project P can be obtained by solving the following
equation for `r.
-1000 -1200 x PVIF (r,1) 600 x PVIF (r,2) 250 x PVIF (r,3)
+ 2000 x PVIF (r,4) + 4000 x PVIF (r,5)
=
0
Through a process of trial and error we find that r = 20.13%
(ii)
The IRR (r') of project Q can be obtained by solving the following equation for r'
-1600 + 200 x PVIF (r',1) + 400 x PVIF (r',2) + 600 x PVIF (r',3)
+ 800 x PVIF (r',4) + 100 x PVIF (r',5)
=
0
Through a process of trial and error we find that r' = 9.34%.

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

NPV (P)
NPV (Q)
=
=
1075
- 28
Given that NPV (P) . NPV (Q); and NPV (P) > 0, I would choose project P.
From (a) we find that at a cost of capital of 20%
NPV (P)
11
NPV (Q)
- 382
Again NPV (P) > NPV (Q); and NPV (P) > 0. I would choose project P.
d)
Project P
PV of investment-related costs
=
=
1000 x PVIF (12,0)

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

2728
6240 x PVIF (MIRR,5)

(1 + MIRR)5
MIRR = 18%
2.2874
6240
Project Q
PV of investment-related costs
1600
TV of cash inflows @ 15% p.a.
2772
The MIRR of project Q is given by the equation:

16000 (1 + MIRR)5
MIRR
9.
(a)
2772
11.62%
Project A
NPV at a cost of capital of 12%
=
- 100 + 25 x PVIFA (12,6)
=
Rs.2.79 million
IRR (r ) can be obtained by solving the following equation for r.
25 x PVIFA (r,6)
=
100
i.e., r = 12,98%
Project B
NPV at a cost of capital of 12%
=
- 50 + 13 x PVIFA (12,6)
=
Rs.3.45 million
IRR (r') can be obtained by solving the equation
13 x PVIFA (r',6)
=
50
i.e.,
r' = 14.40% [determined through a process of trial and error]
(b)
Difference in capital outlays between projects A and B is Rs.50 million

Difference in net annual cash flow between projects A and B is Rs.12 million.
NPV of the differential project at 12%
=
-50 + 12 x PVIFA (12,6)
=
Rs.3.15 million
IRR (r'') of the differential project can be obtained from the equation
12 x PVIFA (r'', 6)
=
50
i.e.,
r''
=
11.53%
10.
(a)
Project M
The pay back period of the project lies between 2 and 3 years. Interpolating in
this range we get an approximate pay back period of 2.63 years/
Project N
The pay back period lies between 1 and 2 years. Interpolating in this range we
get an approximate pay back period of 1.55 years.
(b)
Project M
Cost of capital
PV of cash flows up to the end of year 1
=
=
=
=
=
12% p.a
9.82
24.97
47.75
71.26
Discounted pay back period (DPB) lies between 3 and 4 years. Interpolating in this range we
get an approximate DPB of 3.1 years.
Project N
Cost of capital
=
=
=
12% per annum

33.93
51.47
DPB lies between 1 and 2 years. Interpolating in this range we get an approximate DPB of
1.92 years.
(c )
Project M
Cost of capital
NPV
=
=
=
Project N
Cost of capital
NPV
12% per annum

- 50 + 11 x PVIF (12,1)
+ 19 x PVIF (12,2) + 32 x PVIF (12,3)
+ 37 x PVIF (12,4)
Rs.21.26 million
= 12% per annum

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

= Rs.25.02 million
Project N
Cost of capital
NPV
= 10% per annum

= Rs.23.08 million
Since the two projects are mutually exclusive, we need to choose the project with the higher
NPV i.e., choose project M.
NOTE: The MIRR can also be used as a criterion of merit for choosing between the two
projects because their initial outlays are equal.
(e)
Project M
Cost of capital =
NPV
=
15% per annum

16.13 million
Project N
Cost of capital:15% per annum
NPV
=
Rs.17.23 million
Again the two projects are mutually exclusive. So we choose the project with the
higher NPV, i.e., choose project N.
(f)
Project M
Terminal value of the cash inflows: 114.47
MIRR of the project is given by the equation
50 (1 + MIRR)4
=
114.47
i.e., MIRR = 23.01%
Project N
Terminal value of the cash inflows: 115.41
MIRR of the project is given by the equation
50 ( 1+ MIRR)4
=
115.41
i.e., MIRR
=
23.26%
MINICASE
(a) Project A
Year
0
1
2
3
Cash
flow
(15,000)
11,000
7,000
4,800
Cumulative
net cash
inflow
(15,000)
(4,000)
3,000
Discounting
factor
@12%
1.000
0.893
0.797
0.712
Present
value
(15,000)
9,823
5,579
3,418
Cumulative net
cash flow after
discounting
(15,000)
(5,177)
402
Payback period is between 1 and 2 years. By linear interpolation we get the payback
period = 1 + 4,000 /(4,000 + 3,000) = 1.57 years.
Discounted payback period = 1 + 5,177 / ( 5,177 + 402) = 1.93 years
Project B
Year
0
1
2
3
Cash
flow
(15,000)
3,500
8,000
13,000
Cumulative
net cash
inflow
(15,000)
(11,500)
(3,500)
9,500
Discounting
factor
@12%
1.000
0.893
0.797
0.712
Present
value
(15,000)
3,126
6,376
9,256
Cumulative net
cash flow after
discounting
(15,000)
(11,875)
(5,499)
3,757
Payback period is between 2 and 3 years. By linear interpolation we get the payback period = 2 +
3,500 /(3,500 + 9,500) = 2.27 years.
Discounted payback period = 2 + 5,499 / ( 5,499 + 3,757) = 2.59 years
(b)Project A
Year
0
1
2
3
Discounting
Cash
factor
flow
@12%
(15,000)
1.000
11,000
0.893
7,000
0.797
4,800
0.712
Net present value=
Present
value
(15,000)
9,823
5,579
3,418
3,820
Project B
Year
0
1
2
3
Discounting
Cash
factor
flow
@12%
(15,000)
1.000
3,500
0.893
8,000
0.797
13,000
0.712
Net present value=
Present
value
(15,000)
3,126
6,376
9,256
3,758
Project C
Year
0
1
2
3
Discounting
factor
@12%
1.000
0.893
0.797
Present
value
(15,000)
37,506
(3,188)
Net present value=
19,318
Cash
flow
(15,000)
42,000
(4,000)
(c)
Project A
IRR is the value of r in the following equation.
11,000 / (1+r) + 7,000 / (1+r)2 + 4,800 / (1+r)3 = 15,000
Trying r = 28 %, the LHS = 11,000 / (1.28) + 7,000 / (1.28)2 + 4,800 / (1.28)3
= 15,155
As this value is slightly higher than 15,000, we try a higher discount rate of 29% for
r to get 11,000 / (1.29) + 7,000 / (1.29)2 + 4,800 / (1.29)3
= 14,970
By linear interpolation we get r = 28 + (15,155 15,000) / (15,155 14,970) =
28.84 %
Project B
IRR is the value of r in the following equation.

3,500 / (1+r) + 8,000 / (1+r)2 + 13,000 / (1+r)3 = 15,000
Trying r = 23 %, the LHS = 3,500 / (1.23) + 8,000 / (1.23)2 + 13,000 / (1.23)3
= 15,119
As this value is slightly higher than 15,000, we try a higher discount rate of 24% for
r to get 3,500 / (1.24) + 8,000 / (1.24)2 + 13,000 / (1.24)3
= 14,844
By linear interpolation we get r = 23 + (15,119 15,000) / (15,119 14,844) = 23.
43 %
Project C
IRR rule breaks down as the cash flows are non conventional.
(d) Calculation of MIRR for the three projects.
Project A
Terminal value of cash flows if reinvested at the cost of capital of 12% is
= 11,000 x (1.12)2 + 7,000 x 1.12 + 4,800 = 26,438
MIRR is the value of r in the equation: 26,438 / (1+r)3 =15,000
r = (26,438 / 15,000)1/3 -1 = 20.8%
Therefore MIRR = 20.8%
Project B
Terminal value of cash flows if reinvested at the cost of capital of 12% is
= 3,500 x (1.12)2 + 8,000 x 1.12 + 13,000 = 26,350
r = (26,350 / 15,000)1/3 -1 = 20.7 %
Therefore MIRR = 20.7 %
Project C
Terminal value of cash flow if reinvested at the cost of capital of 12% is
= 42,000 x 1.12 = 47,040
Present value of the costs = 15,000 + 4,000 / (1.12)2 = 18,189
r = (47,040 / 18,189)1/2 -1 = 60.8 %
Therefore MIRR = 60.8 %
Chapter 12
ESTIMATION OF PROJECT CASH FLOWS

1.
(a)
Project Cash Flows
Year
1. Plant & machinery
(150)
(Rs. in million)
3. Revenues
250
250
250
250
250
250
250
4. Costs (excluding depreciation & interest)
100
100
100
100
100
100
100
5. Depreciation
37.5
28.13 21.09 15.82 11.87 8.90
6.67
6. Profit before tax
112.5 121.87 128.91 134.18 138.13 141.1143.33
7. Tax
33.75 36.56 38.67 40.25 41.44 42.33 43.0
8. Profit after tax
78.75 85.31 90.24 93.93 96.69 98.77100.33
2. Working capital
(50)
9. Net salvage value of

plant & machinery
48
10. Recovery of working

capital
11. Initial outlay (=1+2)
12. Operating CF (= 8 + 5)
50
(200)
116.25 113.44 111.33 109.75 108.56 107.6 107.00
13. Terminal CF ( = 9 +10)
98
14.
NCF
(200) 116.25 113.44 111.33 109.75 108.56 107.67 205
IRR (r) of the project can be obtained by solving the following equation for r
-200 + 116.25 x PVIF (r,1) + 113.44 x PVIF (r,2)
+ 111.33 x PVIF (r,3) + 109.75 x PVIF (r,4) + 108.56 x PVIF (r,5)
+107.67 x PVIF (r,6) + 205 x PVIF (r,7)
=
0
Through a process of trial and error, we get r = 55.17%. The IRR of the project is 55.17%.
2.
Post-tax Incremental Cash Flows
Year
1. Capital equipment
2. Level of working capital
(ending)
3. Revenues
4. Raw material cost
5. Variable mfg cost.
6. Fixed operating & maint.
cost
7. Variable selling expenses
8. Incremental overheads
9. Loss of contribution
10.Bad debt loss
11. Depreciation
13. Tax
14. Profit after tax
15. Net salvage value of
capital equipments
16. Recovery of working
capital
17. Initial investment
18. Operating cash flow
(14 + 10+ 11)
19. Working capital
20. Terminal cash flow
(120)
20
30
21. Net cash flow

(17+18-19+20)
(140) 10.20 20.55 31.46 62.80 49.25 35.94 55.00
(b)
10
-4.2
40
50
40
30
20
80
24
8
10
120
36
12
10
160
48
16
10
200
60
20
10
160
48
16
10
120
36
12
10
80
24
8
10
8
4
10
12
6
10
16
8
10
20
10
10
16
8
10
12
6
10
8
4
30
-14
3.45
-9.8
4
22.5 16.88 12.66 9.49 7.12 5.34
11.5 35.12 57.34 42.51 26.88 6.66
10.54 17.20 12.75 8.06 2.00
8.05 24.58 40.14 29.76 18.82 4.66
25
16
(120)
20
20.2
30.55 41.46 52.80 39.25 25.94 14.00
10
10
10
(10)
(10)
(10)
41
NPV of the net cash flow stream @ 15% per discount rate
=
3.
(a)
(Rs. in million)
-140 + 10.20 x PVIF(15,1) + 20.55 x PVIF (15,2)

+ 31.46 x PVIF (15,3) + 62.80 x PVIF (15,4) + 49.25 x PVIF (15,5)
+ 35.94 x PVIF (15,6) + 55 x PVIF (15,7)
Rs.1.70 million
A.
Initial outlay (Time 0)
i.
ii.
iii
iv.
B.
Cost of new machine

Salvage value of old machine
Incremental working capital requirement
Total net investment (=i ii + iii)
i. Post-tax savings in
manufacturing costs 455,000
455,000
455,000
455,000
455,000
ii. Incremental
depreciation
550,000
412,500
309,375
232,031
174,023
iii. Tax shield on

incremental dep.
165,000
123,750
92,813
69,609
52,207
iv. Operating cash

flow ( i + iii)
620,000
578,750
547,813
524,609
507,207
C.
Terminal cash flow (year 5)

i.
ii.
iii.
iv.
D.
Salvage value of new machine

Recovery of incremental working capital
Terminal cash flow ( i ii + iii)
Rs.
1,500,000
200,000
500,000
1,800,000
Net cash flows associated with the replacement project (in Rs)
Year
NCF
4.
3,000,000
900,000
500,000
2,600,000
Operating cash flow (years 1 through 5)

Year
(b)
Rs.
0
(2,600,000)
1
620000578750
3
547813
NPV of the replacement project

=
- 2600000 + 620000 x PVIF (14,1)
+ 578750 x PVIF (14,2)
+ 547813 x PVIF (14,3)
+ 524609 x PVIF (14,4)
+ 2307207 x PVIF (14,5)
=
Rs.267849
Tax shield (savings) on depreciation (in Rs)
Depreciation
Tax shield
Year
charge (DC)
=0.4 x DC
524609
4
2307207
PV of tax shield
@ 15% p.a.
25000
10000
8696
18750
7500
5671
14063
5625
3699
10547
4219
2412
7910
3164
1573
---------22051
----------
Present value of the tax savings on account of depreciation = Rs.22051

5.
B.
C.
A.
Initial outlay (at time 0)

i.
Cost of new machine
ii.
Salvage value of the old machine
iii.
Net investment
Rs.
400,000
90,000
310,000
Operating cash flow (years 1 through 5)

Year
i. Depreciation
of old machine
18000
14400
11520
9216
7373
ii. Depreciation
of new machine
100000
75000
56250
42188
31641
iii. Incremental
depreciation
( ii i)
82000
60600
44730
32972
24268
iv. Tax savings on

incremental
depreciation
( 0.35 x (iii))
28700
21210
15656
11540
8494
21210
15656
11540
8494
v. Operating cash
flow
28700
Terminal cash flow (year 5)
i.
ii.
Salvage value of new machine

Rs.
25000
10000
iii.
D.
Incremental salvage value of new

machine = Terminal cash flow
15000
Net cash flows associated with the replacement proposal.

Year
NCF
0
(310000)
1
28700
21210
15656
4
11540
5
23494
MINICASE
Solution:
a. Cash flows from the point of all investors (which is also called the explicit cost funds point of
view)
Rs.in million
Item
1. Fixed assets
(15)
2. Net working
capital
3. Revenues
4. Costs (other than
depreciation and
interest)
5. Loss of rental
6. Depreciation
8. Tax
9. Profit after tax
10. Salvage value of
fixed assets
11. Net recovery of
working capital
12. Initial outlay
13. Operating cash
inflow
14. Terminal cash
flow
15. Net cash flow
30
30
30
30
30
20
1
3.750
5.250
1.575
3.675
20
1
2.813
6.187
1.856
4.331
20
1
2.109
6.891
2.067
4.824
20
1
1.582
7.418
2.225
5.193
20
1
1.187
7.813
2.344
5.469
(8)
5.000
8.000
(23)
(23)
7.425
7.144
6.933
6.775
6.656
7.425
7.144
6.933
13.000
6.775 19.656
b. Cash flows form the point of equity investors

Rs.in million
Item
1. Equity funds
2. Revenues
3. Costs (other than
depreciation and
interest)
4. Loss of rental
5. Depreciation
6. Interest on working
capital advance
7. Interest on term
loans
9. Tax
10. Profit after tax
11. Net salvage value
of fixed assets
12. Net salvage value
of current assets
13. Repayment of term
term loans
14. Repayment of bank
advance
15. Retirement of trade
creditors
16. Initial investment
17. Operating cash
inflow
18. Liquidation and
retirement cash
flows
19. Net cash flow
30
30
30
30
30
20
1
3.75
20
1
2.813
20
1
2.109
20
1
1.582
20
1
1.187
0.70
0.70
0.70
0.70
0.70
1.20
3.35
1.005
2.345
1.125
4.362
1.309
3.053
0.825
5.366
1.610
3.756
0.525
6.193
1.858
4.335
0.225
6.888
2.066
4.822
(10)
5.000
10.000
2.000
2.000
2.000
5.000
2.000
(10)
(10)
6.095
5.866 5.865
6.095
(2.0)
3.8663.865
5.917
6.009
(2.0)
(2.0)
6.00
3.917 12.009
Chapter 13
RISK ANALYSIS IN CAPITAL BUDGETING
1.
2.000
NPV of the project
=
=
-250 + 50 x PVIFA (13,10)

Rs.21.31 million
(a) NPVs under alternative scenarios:

Pessimistic
(Rs. in million)
Expected
Optimistic
Investment
Sales
Variable costs
Fixed costs
Depreciation
Pretax profit
Tax @ 28.57% - 2.14
Profit after tax
Net cash flow
Cost of capital
300
150
97.5
30
30
- 7.5
250
200
120
20
25
35
- 5.36
24.64
14%
25
50
13%
61.43
81.43
12%
NPV
- 171.47
21.31
260.10
10
200
275
154
15
20
86
24.57
Assumptions: (1)
The useful life is assumed to be 10 years under all three
scenarios. It is also assumed that the salvage value of the
investment after ten years is zero.
(b)
(2)
The investment is assumed to be depreciated at 10% per annum; and it

is also assumed that this method and rate of depreciation are
acceptable to the IT (income tax) authorities.
(3)
The tax rate has been calculated from the given table i.e. 10 / 35 x 100
= 28.57%.
(4)
It is assumed that only loss on this project can be offset against the
taxable profit on other projects of the company; and thus the company
can claim a tax shield on the loss in the same year.
Accounting break even point (under expected scenario)

Fixed costs + depreciation
= Rs. 45 million
Contribution margin ratio
= 80 / 200 = 0.4
Break even level of sales
= 45 / 0.4 = Rs.112.5 million
Financial break even point (under xpected scenario)
i.
Annual net cash flow
= 0.7143 [ 0.3 x sales 45 ] + 25

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

= 1.1628 sales 38.74
iii.
Initial investment
= 200
iv.
Financial break even level

of sales
= 238.74 / 1.1628
= Rs.205.31 million
2.
(a)
(i) Sensitivity of NPV with respect to quantity manufactured and sold:

(in Rs)
Pessimistic
Expected
Optimistic
Initial investment
Sale revenue
Variable costs
Fixed costs
Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV at a cost of
capital of 10% p.a
and useful life of
5 years
30000
24000
16000
3000
2000
3000
1500
1500
3500
30000
42000
28000
3000
2000
9000
4500
4500
6500
30000
54000
36000
3000
2000
13000
6500
6500
8500
-16732
- 5360
2222
(ii) Sensitivity of NPV with respect to variations in unit price.
Initial investment
Sale revenue
Variable costs
Fixed costs
Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV
Pessimistic
Expected
Optimistic
30000
28000
28000
3000
2000
-5000
-2500
-2500
- 500
- 31895
30000
42000
28000
3000
2000
9000
4500
4500
6500
(-) 5360
30000
70000
28000
3000
2000
37000
18500
18500
20500
47711
(iii)
Sensitivity of NPV with respect to variations in unit variable cost.

Pessimistic
Initial investment
Sale revenue
Variable costs
Fixed costs
Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV
(b)
30000
42000
56000
3000
2000
-11000
-5500
-5500
-3500
-43268
Expected
Optimistic
30000
42000
28000
3000
2000
9000
4500
4500
6500
- 5360
30000
42000
21000
3000
2000
16000
8000
8000
10000
7908
Accounting break-even point

i.
ii.
iii.
Fixed costs + depreciation

Contribution margin ratio
Break-even level of sales
= Rs.5000
= 10 / 30 = 0.3333
= 5000 / 0.3333
= Rs.15000
Financial break-even point
3.
i.
ii.
Annual cash flow

PV of annual cash flow
iii.
iv.
Initial investment
Break-even level of sales
= 0.5 x (0.3333 Sales 5000) = 2000

= (i) x PVIFA (10,5)
= 0.6318 sales 1896
= 30000
= 31896 / 0.6318 = Rs.50484
Define At as the random variable denoting net cash flow in year t.

A1
=
=
4 x 0.4 + 5 x 0.5 + 6 x 0.1

4.7
A2
=
=
5 x 0.4 + 6 x 0.4 + 7 x 0.2

5.8
A3
=
=
3 x 0.3 + 4 x 0.5 + 5 x 0.2

3.9
NPV
=
=
4.7 / 1.1 +5.8 / (1.1)2 + 3.9 / (1.1)3 10

Rs.2.00 million
12
0.41
22
0.56
32
0.49
2 NPV =
12
22
32
+
2
(1.1)
+
(1.1)
(1.1)6
= 1.00
(NPV) = Rs.1.00 million
4.
Expected NPV
4
At
=
- 25,000
t
t=1 (1.08)
=
12,000/(1.08) + 10,000 / (1.08)2 + 9,000 / (1.08)3

+ 8,000 / (1.08)4 25,000
[ 12,000 x .926 + 10,000 x .857 + 9,000 x .794 + 8,000 x .735]

- 25,000
7,708
Standard deviation of NPV

4
t
t=1 (1.08)t
=
=
=
5.
(a)
5,000 / (1.08) + 6,000 / (1.08)2 + 5,000 / (1,08)3 + 6,000 / (1.08)4

5,000 x .926 + 6,000 x .857 + 5000 x .794 + 6,000 x .735
18,152
Expected NPV
4
At
=
- 10,000
t
t=1 (1.06)
. (1)
A1
=
=
2,000 x 0.2 + 3,000 x 0.5 + 4,000 x 0.3

3,100
A2
=
=
3,000 x 0.4 + 4,000 x 0.3 + 5,000 x 0.3

3,900
A3
=
=
4,000 x 0.3 + 5,000 x 0.5 + 6,000 x 0.2

4,900
A4
=
=
2,000 x 0.2 + 3,000 x 0.4 + 4,000 x 0.4

3,200
Substituting these values in (1) we get

Expected NPV = NPV
=
3,100 / (1.06)+ 3,900 / 1.06)2 + 4,900 / (1.06)3 + 3,200 / (1,06)4

- 10,000 = Rs.3,044
(b)
The variance of NPV is givenby the expression
4 2t
2
(NPV) =
t=1 (1.06)2t
12
=
=
22
=
=
32
=
=
42
.. (2)
[(2,000 3,100)2 x 0.2 + (3,000 3,100)2 x 0.5

+ (4,000 3,100)2 x 0.3]
490,000
[(3,000 3,900)2 x 0.4 + (4,000 3,900)2 x 0.3
+ (5,000 3900)2 x 0.3]
690,000
[(4,000 4,900)2 x 0.3 + (5,000 4,900)2 x 0.5
+ (6,000 4,900)2 x 0.2]
490,000
[(2,000 3,200)2 x 0.2 + (3,000 3,200)2 x 0.4

+ (4,000 3200)2 x 0.4]
=
560,000
Substituting these values in (2) we get
490,000 / (1.06)2 + 690,000 / (1.06)4
+ 490,000 / (1.06)6 + 560,000 / (1.06)8
[ 490,000 x 0.890 + 690,000 x 0.792
=
+ 490,000 x 0.705 + 560,000 x 0.627 ]

= 1,679,150
NPV
= 1,679,150 = Rs.1,296
NPV NPV
Prob (NPV < 0) = Prob.
0 - NPV
<
NPV
0 3044
= Prob Z <
1296
NPV
= Prob (Z < -2.35)

The required probability is given by the shaded area in the following normal
P (Z < - 2.35) =
=
=
=
0.5 P (-2.35 < Z < 0)

0.5 P (0 < Z < 2.35)
0.5 0.4906
0.0094
(c)
So the probability of NPV being negative is 0.0094
Prob (P1 > 1.2)Prob (PV / I > 1.2)
Prob (NPV / I > 0.2)
Prob. (NPV > 0.2 x 10,000)
Prob (NPV > 2,000)
Prob (NPV >2,000)= Prob (Z > 2,000- 3,044 / 1,296)
Prob (Z > - 0.81)
The required probability is given by the shaded area of the following normal
curve:
P(Z > - 0.81) =
0.5 + P(-0.81 < Z < 0)
=
0.5 + P(0 < Z < 0.81)
=
0.5 + 0.2910
=
0.7910
So the probability of P1 > 1.2 as 0.7910
curve.
6
Certainty
Equivalent Certainty
Discount
Factor: t Equivalent Factor
Present
=1 - 0.06t value
at 8%
Value
1
(30,000)
1 (30,000.00)
0.94
6,580
0.9259
6,092.59
0.88
7,040
0.8573
6,035.67
0.82
7,380
0.7938
5,858.48
0.76
7,600
0.7350
5,586.23
0.7
5,600
0.6806
3,811.27
NPV
=
(2,615.77)
Yea Cash
r
Flow
0 (30,000)
1
7,000
2
8,000
3
9,000
4
10,000
5
8,000
MINICASE
Solution:
1. The expected NPV of the turboprop aircraft
0.65 (5500) + 0.35 (500)
NPV = - 11000 +
(1.12)
0.65 [0.8 (17500) + 0.2 (3000)] + 0.35 [0.4 (17500) + 0.6 (3000)]
+
(1.12)2
= 2369
2. If Southern Airways buys the piston engine aircraft and the demand in year 1 turns out to be
high, a further decision has to be made with respect to capacity expansion. To evaluate the
piston engine aircraft, proceed as follows:
First, calculate the NPV of the two options viz., expand and do not expand at decision
point D2:
0.8 (15000) + 0.2 (1600)
Expand : NPV = - 4400 +
1.12
= 6600
0.8 (6500) + 0.2 (2400)

Do not expand : NPV =
1.12
= 5071
Second, truncate the do not expand option as it is inferior to the expand option. This
means that the NPV at decision point D2 will be 6600
Third, calculate the NPV of the piston engine aircraft option.
0.65 (2500+6600) + 0.35 (800)
NPV = 5500 +
1.12
0.35 [0.2 (6500) + 0.8 (2400)]
+
(1.12)2
= 5500 + 5531 + 898 = 929
3.
The value of the option to expand in the case of piston engine aircraft
If Southern Airways does not have the option of expanding capacity at the end of year 1, the
NPV of the piston engine aircraft would be:
0.65 (2500) + 0.35 (800)
NPV = 5500 +
1.12
0.65 [0.8 (6500) + 0.2 (2400)] + 0.35 [0.2 (6500) + 0.8 (2400)]
+
(1.12)2
= - 5500 + 1701 + 3842 = 43
Thus the option to expand has a value of 929 43 = 886
4.
Value of the option to abandon if the turboprop aircraft can be sold for 8000 at the end of year
1
If the demand in year 1 turns out to be low, the payoffs for the continuation and
abandonment options as of year 1 are as follows.
0.4 (17500) + 0.6 (3000)

Continuation:
= 7857
1.12
Abandonment : 8000
Thus it makes sense to sell off the aircraft after year 1, if the demand in year 1 turns out to be
low.
The NPV of the turboprop aircraft with abandonment possibility is
0.65 [5500 +{0.8 (17500) + 0.2 (3000)}/ (1.12)] + 0.35 (500 +8000)
NPV = - 11,000 +
(1.12)
12048 + 2975
= - 11,000 +
= 2413
1.12
Since the turboprop aircraft without the abandonment option has a value of 2369, the
value of the abandonment option is : 2413 2369 = 44
5
The value of the option to abandon if the piston engine aircraft can be sold for 4400 at the
end of year 1:
If the demand in year 1 turns out to be low, the payoffs for the continuation and
abandonment options as of year 1 are as follows:
0.2 (6500) + 0.8 (2400)
Continuation :
= 2875
1.12
Abandonment : 4400
Thus, it makes sense to sell off the aircraft after year 1, if the demand in year 1 turns out to
be low.
The NPV of the piston engine aircraft with abandonment possibility is:
0.65 [2500 + 6600] + 0.35 [800 + 4400]
NPV = - 5500 +
1.12
5915 + 1820
= - 5500 +
= 1406
1.12
For the piston engine aircraft the possibility of abandonment increases the NPV from 929 to
1406. Hence the value of the abandonment option is 477.
Chapter 14
THE COST OF CAPITAL
1(a) Define rD as the pre-tax cost of debt. Using the approximate yield formula, rD
calculated as follows:
rD
(b) After tax cost =

2.
14 + (100 108)/10
------------------------ x 100 = 12.60%
0.4 x 100 + 0.6x108
12.60 x (1 0.35) = 8.19%
Define rp as the cost of preference capital. Using the approximate yield formula rp can be
calculated as follows:
rp
9 + (100 92)/6
-------------------0.4 x100 + 0.6x92
0.1085 (or) 10.85%
3.
WACC=
4.
Cost of equity
=
(using SML equation)
10% + 1.2 x 7% = 18.4%
Pre-tax cost of debt
14%
0.4 x 13% x (1 0.35)

+ 0.6 x 18%
=
14.18%
After-tax cost of debt =
14% x (1 0.35) = 9.1%
Debt equity ratio
2:3
WACC
2/5 x 9.1% + 3/5 x 18.4%
=
5.
can be
14.68%
Given
0.5 x 14% x (1 0.35) + 0.5 x rE = 12%
where rE is the cost of equity capital.
Therefore rE 14.9%
Using the SML equation we get

11% + 8% x = 14.9%
where denotes the beta of Azeezs equity.
Solving this equation we get = 0.4875.
6(a)
The cost of debt of 12% represents the historical interest rate at the time the debt was
originally issued. But we need to calculate the marginal cost of debt (cost of raising new
debt); and for this purpose we need to calculate the yield to maturity of the debt as on the
balance sheet date. The yield to maturity will not be equal to12% unless the book value of
debt is equal to the market value of debt on the balance sheet date.
(b)
The cost of equity has been taken as D1/P0 ( = 6/100) whereas the cost of equity
+ g where g represents the expected constant growth rate in dividend per share.
7.
(a) The book value and market values of the different sources of finance are
provided in the following table. The book value weights and the market value
weights are provided within parenthesis in the table.
Source
Book value
Equity
800 (0.54)
Debentures first series
300 (0.20)
Debentures second series 200 (0.13)
Bank loan
200 (0.13)
Total
1500 (1.00)
is (D1/P0)
(Rs. in million)
Market value
2400 (0.78)
270 (0.09)
204 (0.06)
200 (0.07)
3074 (1.00)
(b) I would use weights based on the market value because to justify its valuation Samanta
must earn competitive returns for investors on its market value
8.
(a)
Given
rD x (1 0.3) x 4/9 + 20% x 5/9 = 15%
rD = 12.5%,where rD represents the pre-tax cost of debt.
(b)
Given
13% x (1 0.3) x 4/9 + rE x 5/9 = 15%
rE = 19.72%, where rE represents the cost of equity.
9.
Cost of equity =
D1/P0 + g
=
3.00 / 30.00 + 0.05
=
15%
(a) The first chunk of financing will comprise of Rs.5 million of retained earnings costing 15
percent and Rs.2.5 million of debt costing 14 (1-.3) = 9.8 per cent
The second chunk of financing will comprise of Rs.5 million of additional equity costing
15 per cent and Rs.2.5 million of debt costing 15 (1-.3) = 10.5 per cent
(b) The marginal cost of capital in the first chunk will be :
5/7.5 x 15% + 2.5/7.5 x 9.8% = 13.27%
The marginal cost of capital in the second chunk will be :
5/7.5 x 15% + 2.5/7.5 x 10.5% = 13.50%
Note : We have assumed that
(i) The net realisation per share will be Rs.25, after floatation costs, and
(ii) The planned investment of Rs.15 million is inclusive of floatation costs
9.1
(a) (i) The cost of equity and retained earnings

rE
=
D1/PO + g
= 1.50 / 20.00 + 0.07 = 14.5%
The cost of preference capital, using the approximate formula, is :
11 + (100-75)/10
rP
= 15.9%
0.6 x 75 + 0.4 x 100

The pre-tax cost of debentures, using the approximate formula, is :
13.5 + (100-80)/6
rD
= 19.1%
0.6x80 + 0.4x100
The post-tax cost of debentures is

19.1 (1-tax rate) = 19.1 (1 0.5)
= 9.6%
The post-tax cost of term loans is
12 (1-tax rate) = 12 (1 0.5)
= 6.0%
The average cost of capital using book value proportions is calculated below:
Source of capital
Equity capital
Preference capital
Retained earnings
Debentures
Term loans
Component
Cost
(1)
14.5%
15.9%
14.5%
9.6%
6.0%
360
Book value
Book value
Rs. in million proportion
(2)
(3)
100
0.28
10
0.03
120
0.33
50
0.14
80
0.22
Average cost
capital
Product of
(1) & (3)
4.06
0.48
4.79
1.34
1.32
11.99%
(ii) The average cost of capital using market value proportions is calculated below :
Source of capital
Equity capital
and retained earnings
Preference capital
Debentures
Term loans
Component
cost
(1)
Market value Market value Product of

Rs. in million proportion
(2)
(3)
(1) & (3)
14.5%
15.9%
9.6%
6.0%
200
7.5
40
80
327.5
0.62
0.02
0.12
0.24
Average cost
capital
(b)
The Rs.100 million to be raised will consist of the following:
Retained earnings Rs.15 million
Additional equity Rs. 35 million
Debt Rs. 50 million
The first batch will consist of Rs. 15 million each of retained earnings
and debt costing 14.5 percent and 14(1-0.5)= 7 percent respectively. The
second batch will consist of Rs. 10 million each of additional equity and
debt at 14.5 percent and 7percent respectively. The third chunk will
consist of Rs.25 million each of additional equity and debt costing 14.5
percent and 15(1-0.5) = 7.5 percent respectively.
The marginal cost of capital in the chunks will be as under
First batch: (0.5x14.5 ) + (0.5 x 7)
= 10.75 %
Second batch: (0.5x14.5 ) + (0.5 x 7) = 10.75 %
Third batch : (0.5x14.5 ) + (0.5 x 7.5) = 11 %
8.99
0.32
1.15
1.44
11.90%
The marginal cost of capital schedule for the firm will be as under.
Range of total financing
Weighted marginal cost of
( Rs. in million)
capital ( %)
0 - 50
10.75
50-100
11.00
Here it is assumed that the Rs.100 million to be raised is inclusive of floatation costs.
10
(a)
WACC=
1/3 x 13% x (1 0.3)

+ 2/3 x 20%
=
16.37%
(b)
Weighted average floatation cost

= 1/3 x 3% + 2/3 x 12%
= 9%
(c)
NPV of the proposal after taking into account the floatation costs
=
=
11.
Project
Beta
P
Q
R
S
0.6
0.9
1.5
1.5
130 x PVIFA (16.37, 8) 500 / (1 - 0.09)

Rs.8.51 million
Required return
based on SML
equation (%)
14.8
17.2
22.0
22.0
Expected
return (%)
13
14
16
20
Given a hurdle rate of 18% (the firms cost of capital), projects P, Q and R would have been
rejected because the expected returns on these projects are below 18%. Project S would be accepted
because the expected return on this project exceeds 18%.
An appropriate basis for accepting or
rejecting the projects would be to compare the expected rate of return and the required rate of return
for each project. Based on this comparison, we find that all the four projects need to be rejected.
MINICASE
Solution:
a. All sources other than non-interest bearing liabilities
b. Pre-tax cost of debt & post-tax cost of debt
10 + (100 112) / 8
rd =
8.5
=
0.6 x 112 + 0.4 x 100
= 7.93
107.2
rd (1 0.3) = 5.55
c. Post-tax cost of preference
9 + (100 106) / 5
7.8
=
0.6 x 106 + 0.4 x 100
= 7.53%
103.6
d. Cost of equity using the DDM

2.80 (1.10)
+ 0.10 = 0.385 + 0.10
80
= 0.1385 = 13.85%
e. Cost of equity using the CAPM
7 + 1.1(7) = 14.70%
f. WACC
0.50 x 14.70 + 0.10 x 7.53 + 0.40 x 5.55
= 7.35 + 0.75 + 2.22
= 10.32%
g. Cost of capital for the new business
0.5 [7 + 1.5 (7)] + 0.5 [ 11 (1 0.3)]
8.75 + 3.85
= 12.60%
Chapter 15
CAPITAL BUDGETING: EXTENSIONS
1.
Let us assume that the cost of capital is 12 percent.

EAC
(Plastic Emulsion)
=
300000 / PVIFA (12,7)
=
300000 / 4.564
=
Rs.65732
EAC
(Distemper Painting) =
=
=
180000 / PVIFA (12,3)

180000 / 2.402
Rs.74938
Since EAC of plastic emulsion is less than that of distemper painting, it is the preferred
alternative.
2.
PV of the net costs associated with the internal transportation system

=
=
1 500 000 + 300 000 x PVIF (13,1) + 360 000 x PVIF (13,2)
+ 400 000 x PVIF (13,3) + 450 000 x PVIF (13,4)
+ 500 000 x PVIF (13,5) - 300 000 x PVIF (13,5)
2709185
EAC of the internal transportation system

=
=
=
3.
2709185 / PVIFA (13,5)

2709185 / 3.517
Rs.770 311
EAC [ Standard overhaul]

=
=
=
500 000 / PVIFA (14,6)

500 000 / 3.889
Rs.128568
(A)
(B)
EAC [Less costly overhaul]

=
=
=
200 000 / PVIFA (14,2)

200 000 / 1.647
Rs.121433
Since (B) < (A), the less costly overhaul is preferred alternative.
4.
(a)
Base case NPV

=
=
=
(b)
-12,000,000 + 3,000,000 x PVIFA (20,6)

-12,000,000 + 997,8000
(-) Rs.2,022,000
Issue costs = 6,000,000 / 0.88 - 6,000,000

=
Rs.818 182
Adjusted NPV after adjusting for issue costs

=
=
(c)
- 2,022,000 818,182
- Rs.2,840,182
The present value of interest tax shield is calculated below :

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

=
=
(b)
= Rs.1,022,076
- 8,000,000 + 2,000,000 x PVIFA (18,6)

- Rs.1,004,000
Adjusted NPV after adjustment for issue cost of external equity

=
=
=
Base case NPV Issue cost

- 1,004,000 [ 3,000,000 / 0.9 3,000,000]
- Rs.1,337,333
(c)
The present value of interest tax shield is calculated below :

Year
1
2
3
4
5
6
Debt outstanding at
Interest
Tax shield
Present value of
the beginning
tax shield
5,000,000
750,000
300,000
260,880
5,000,000
750,000
300,000
226,830
4,000,000
600,000
240,000
157,800
3,000,000
450,000
180,000
102,924
2,000,000
300,000
120,000
59,664
1,000,000
150,000
60,000
25,938
Present value of tax shield
Rs.834,036
Chapter 18
RAISING LONG TERM FINANCE
1
Underwriting
commitment
2.
a.
Shares
procured
Excess/
shortfall
Credit
Net
shortfall
70,000
50,000
(20,000)
4919
(15081)
50,000
30,000
(20,000)
3514
(16486)
40,000
30,000
(10,000)
2811
(7189)
25,000
12,000
(13,000)
1757
(11243)
15,000
28,000
13,000
Po = Rs.180
N=5
The theoretical value of a right if the subscription price is Rs.150
Po S
180 150
=
= Rs.5
N+1
5+1
b. The ex-rights value per share if the subscription price is Rs.160

NPo + S
5 x 180 + 160
=
= Rs.176.7
N+1
5+1
c.
The theoretical value per share, ex-rights, if the subscription price is

Rs.180? 100?
5 x 180 + 180
= Rs.180
5+1
5 x 180 + 100
= Rs.166.7
5+1
Chapter 19
CAPITAL STRUCTURE AND FIRM VALUE
1.
Net operating income (O)

Interest on debt (I)
Equity earnings (P)
Cost of equity (rE)
Cost of debt (rD)
Market value of equity (E)
Market value of debt (D)
Market value of the firm (V)
:
:
:
:
Rs.30 million
Rs.10 million
Rs.20 million
15%
10%
Rs.20 million/0.15 =Rs.13 million
Rs.10 million/0.10 =Rs.100 million
Rs.233 million
:
:
:
2.
Box
Cox
Market value of equity2,000,000/0.152,000,000/0.15

= Rs.13.33 million
= Rs.13.33 million
Market value of debt
0
1,000,000/0.10
=Rs.10 million
Market value of the firm
Rs.13.33million
=23.33 million
(a) Average cost of capital for Box Corporation
13.33.
0
x 15% +
x 10%
13.33
13.33
= 15%
Average cost of capital for Cox Corporation

13.33
10.00
x 15% +
x 10% = 12.86%
23.33
23.33
(b) If Box Corporation employs Rs.30 million of debt to finance a project that yields
Rs.4 million net operating income, its financials will be as follows.
Net operating income
Interest on debt
Equity earnings
Cost of equity
Cost of debt
Market value of equity
Market value of debt
Market value of the firm
Rs.6,000,000
Rs.3,000,000
Rs.3,000,000
15%
10%
Rs.20 million
Rs.30 million
Rs.50 million
Average cost of capital

20
30
15% x
+ 10%
50
50
= 12%
(c) If Cox Corporation sells Rs.10 million of additional equity to retire

Rs.10 million of debt , it will become an all-equity company. So its
average cost of capital will simply be equal to its cost of equity,
which is 15%.
3.
4.
rE
=
20
=
So D/E = 2
E
D+E
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
rA + (rA-rD)D/E
12 + (12-8) D/E
D
D+E
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
rE
(%)
rD
(%)
11.0
11.0
11.5
12.5
13.0
14.0
15.0
16.0
18.0
20.0
6.0
6.5
7.0
7.5
8.5
9.5
11.0
12.0
13.0
14.0
rA =
E
rE +
D+E
D
rD
D+E
11.00
10.55
10.60
11.00
11.20
11.75
12.60
13.20
14.00
14.20
The optimal debt ratio is 0.10 as it minimises the weighted average

cost of capital.
5. (a) If you own Rs.10,000 worth of Bharat Company, the levered company
which is valued more, you would sell shares of Bharat Company, resort
to personal leverage, and buy the shares of Charat Company.
(b) The arbitrage will cease when Charat Company and Bharat Company
are valued alike
6.
The value of Ashwini Limited according to Modigliani and Miller

hypothesis is
Expected operating income
15
=
= Rs.125 million
Discount rate applicable to the
0.12
risk class to which Aswini belongs
7. The tax advantage of one rupee of debt is :

1-(1-tc) (1-tpe)
(1-0.55) (1-0.05)
=
1 (1-tpd)
(1-0.25)
= 0.43 rupee
Chapter 20
CAPITAL STRUCTURE DECISION
1.(a) Currently
No. of shares = 1,500,000
EBIT
= Rs 7.2 million
Interest
= 0
Preference dividend = Rs.12 x 50,000 = Rs.0.6 million
EPS
= Rs.2
(EBIT Interest) (1-t) Preference dividend
EPS =
No. of shares
(7,200,000 0 ) (1-t) 600,000
Rs.2 =
1,500,000
Hence t = 0.5 or 50 per cent
The EPS under the two financing plans is :
Financing Plan A : Issue of 1,000,000 shares
(EBIT - 0 ) ( 1 0.5) - 600,000
EPSA =
2,500,000
Financing Plan B : Issue of Rs.10 million debentures carrying 15 per cent
interest
(EBIT 1,500,000) (1-0.5) 600,000
EPSB =
1,500,000
The EPS EBIT indifference point can be obtained by equating EPSA and EPSB
(EBIT 0 ) (1 0.5) 600,000
(EBIT 1,500,000) (1 0.5) 600,000

=
2,500,000
1,500,000
Solving the above we get EBIT = Rs.4,950,000 and at that EBIT, EPS is Rs.0.75
under both the plans
(b)
As long as EBIT is less than Rs.4,950,000 equity financing maximixes EPS.

When EBIT exceeds Rs.4,950,000 debt financing maximises EPS.
2.
(a)
(b)
EPS EBIT equation for alternative A

EBIT ( 1 0.5)
EPSA =
2,000,000
EPS EBIT equation for alternative B
EBIT ( 1 0.5 ) 440,000
EPSB =
1,600,000
(c)
EPS EBIT equation for alternative C

(EBIT 1,200,000) (1- 0.5)
EPSC =
1,200,000
(d)
The three alternative plans of financing ranked in terms of EPS over varying
Levels of EBIT are given the following table
Ranking of Alternatives
EBIT
(Rs.)
2,000,000
2,160,000
3,000,000
4,000,000
4,400,000
More than 4,400,000
3.
EPSA
(Rs.)
0.50(I)
0.54(I)
0.75(I)
1.00(II)
1.10(II)
(III)
EPSB
(Rs.)
0.35(II)
0.40(II)
0.66(II)
0.98(III)
1.10(II)
(II)
EPSC
(Rs.)
0.33(III)
0.40(II)
0.75(I)
1.17(I)
1.33(I)
(I)
Plan A : Issue 0.8 million equity shares at Rs. 12.5 per share.
Plan B : Issue Rs.10 million of debt carrying interest rate of 15 per cent.
(EBIT 0 ) (1 0.6)
EPSA
=
1,800,000
(EBIT 1,500,000) (1 0.6)
EPSB
=
1,000,000
Equating EPSA and EPSB , we get

(EBIT 0 ) (1 0.6)
(EBIT 1,500,000) (1 0.6)
=
1,800,000
1,000,000
Solving this we get EBIT = 3,375,000 or 3.375 million
Thus the debt alternative is better than the equity alternative when
EBIT > 3.375 million
EBIT EBIT
Prob(EBIT>3,375,000) = Prob
EBIT
= Prob [z > - 1.21]
= 0.8869
4.
ROE = [ ROI + ( ROI r ) D/E ] (1 t )

15 = [ 14 + ( 14 8 ) D/E ] ( 1- 0.5 )
D/E = 2.67
5.
ROE = [12 + (12 9 ) 0.6 ] (1 0.6)

= 5.52 per cent
6.
7. a.
18 = [ ROI + ( ROI 8 ) 0.7 ] ( 1 0.5)

ROI = 24.47 per cent
EBIT
Interest coverage ratio =
Interest on debt
15
=
4
= 3.75
3.375 7.000
>
3.000
EBIT + Depreciation
b.
Cash flow coverage ratio =

Loan repayment instalment
Int.on debt +
(1 Tax rate)
= 15 + 3
4+5
8.
= 2
The debt service coverage ratio for Pioneer Automobiles Limited is given by :
5
( PAT i + Depi + Inti)
i=1
DSCR
=
5
( Inti + LRIi)
i=1
=
133.00 + 49.14 +95.80

95.80 + 72.00
277.94
=
9.
167.80
1.66
(a) If the entire outlay of Rs. 300 million is raised by way of debt carrying 15 per cent
interest, the interest burden will be Rs. 45 million.
Considering the interest burden the net cash flows of the firm during
a recessionary year will have an expected value of Rs. 35 million (Rs.80 million - Rs. 45
million ) and a standard deviation of Rs. 40 million .
Since the net cash flow (X) is distributed normally
X 35
40
has a standard normal deviation
Cash flow inadequacy means that X is less than 0.
0.35
Prob(X<0) = Prob (z< )
= Prob (z<- 0.875)
40
= 0.1909
(b)
Since = Rs.80 million, = Rs.40 million , and the Z value corresponding to the risk
tolerance limit of 5 per cent is 1.645, the cash available from the operations to service the
debt is equal to X which is defined as :
X 80
= - 1.645
40
X = Rs.14.2 million
Given 15 per cent interest rate, the debt than be serviced is
14.2
= Rs. 94.67 million
0.15
MINICASE
(a)
If the firm chooses the equity option, it will have to issue 2 crore shares and its interest
burden will remain at the current level of Rs.20 crore. If the firm chooses the debt option, the
interest burden will go upto Rs.36 crore, but the number of equity shares will remain
unchanged at 14 crore. So, the EPS PBIT indifference point is the value of PBIT in the
following equation.
(PBIT -20)( 1- 0.3)
(PBIT 36)( 1-0.3)

=
16
14
PBIT = Rs. 148 crore
(b)
The projected EPS under the two financing options is given below
Revenues
Variable costs
Contribution margin
Fixed operating costs
PBIT
Interest
PBT
Tax
PAT
No.of equity shares
EPS
Current
800
480
320
180
140
20
120
36
84
14
6
Projected
Equity option Debt option
1040
1040
624
624
416
416
230
230
186
186
20
36
166
150
55.33
50
110.67
100
16
14
6.92
7.14
(c)
Contribution margin
The degree of total leverage (DTL) is defined as :
PBIT
So, the DTL will be as follows:
DTL
Current= 320/140 = 2.67
Equity option = 416/166 = 2.51
Debt option = 416/150 = 2.77
Chapter 21
DIVIDEND POLICY AND FIRM VALUE
1.(a)
Payout ratio
Price per share

3(0.5)+3(0.5) 0.15
0.5
0.12
= Rs. 28.13
0.12
3(0.7 5)+3(0.25) 0.15
0.12
0.75
= Rs. 26.56
0.12
3(1.00)
1.00
= Rs. 25.00
0.12
(b)
Dividend
payout ratio
25%
Price as per Gordon model P0

=E1(1-b)/(k-br)
= 3 x 0.75/(0.12 - 0.75x 0.15)
50%
= 3 x 0.50/(0.12 - 0.50x 0.15)
75%
= 3 x 0.25/(0.12 - 0.25x 0.15)
=Rs. 300
=Rs.
33.33
=Rs.
9.09
2.
Next years price

Dividend
Current price
Capital appreciation
Post-tax capital appreciation
Post-tax dividend income
Total return
Current price (obtained by solving

the preceding equation)
P
80
0
P
(80-P)
0.9(80-P)
0
0.9 (80-P)
P
= 14%
P = Rs.69.23
Chapter 22
Q
74
6
Q
(74-Q)
0.9 (74-Q)
0.8 x 6
0.9 (74-Q) + 4.8
Q
=14%
Q = Rs.68.65
DIVIDEND DECISION
1. a.
Under a pure residual dividend policy, the dividend per share over the 4 year
period will be as follows:
DPS Under Pure Residual Dividend Policy
( in Rs.)
Year
Earnings
Capital expenditure
Equity investment
Pure residual
dividends
Dividends per share
b.
10,000
8,000
4,000
12,000
7,000
3,500
9,000
10,000
5,000
15,000
8,000
4,000
6,000
1.20
8,500
1.70
4,000
0.80
11,000
2.20
The external financing required over the 4 year period (under the assumption that the
company plans to raise dividends by 10 percents every two years) is given below :
Required Level of External Financing
(in Rs.)
Year
10,000
12,000
9,000
15,000
A.
Net income
B.
Targeted DPS
1.00
1.10
1.10
1.21
C.
Total dividends
5,000
5,500
5,500
6,050
D.
Retained earnings(A-C)
6,500
3,500
8,950
E.
Capital expenditure
8,000
7,000
10,000
8,000
F.
External financing
requirement
3,000
(E-D)if E > D or 0 otherwise
500
6,500
Nil
c.
5,000
Given that the company follows a constant 60 per cent payout ratio, the dividend per share
and external financing requirement over the 4 year period are given below
Dividend Per Share and External Financing Requirement

(in Rs.)
Year
A. Net income
10,000
12,000
9,000
15,00
B. Dividends
6,000
7,200
5,400
9,000
C. Retained earnings
4,000
4,800
3,600
6,000
D. Capital expenditure
8,000
7,000
10,000
8,000
4,000
2,200
6,400
2,000
1.20
1.44
1.08
1.80
E. External financing
(D-C)if D>C, or 0
otherwise
F. Dividends per share
2.
Given the constraints imposed by the management, the dividend per share has to
be between Rs.1.00 (the dividend for the previous year) and Rs.1.60 (80 per
cent of earnings per share)
Since share holders have a preference for dividend, the dividend should be
raised over the previous dividend of Rs.1.00 . However, the firm has substantial
investment requirements and it would be reluctant to issue additional equity
because of high issue costs ( in the form of underpricing and floatation costs)
Considering the conflicting requirements, it seems to make sense to pay
Rs.1.20 per share by way of dividend. Put differently the pay out ratio may be
set at 60 per cent.
MINICASE
(a)
Plausible Reasons for Paying Dividends
(i) Investor preference for dividends

(ii) Information signaling
(iii) Clientele effect
(iv) Agency costs
Dubious Reasons for Paying Dividends
(i) Bird-in-hand fallacy
(ii) Temporary excess cash
(b)
(i) Funds requirement
(ii) Liquidity
(iii) Access to external sources of financing
(iv) Shareholder preference
(v) Difference in the cost of external equity and retained earnings
(vi) Control
(vi) Taxes
(vii) Stability
(c)
Earnings
Net investments
Equity investment
Pure residual
dividends
Dividends under
fixed dividend
payout ratio
Dividends under
smoothed residual
dividend policy
1
96
104
69.33
2
108
94
62.67
3
84
90
60.00
Rs.in million
4
5 Total
115
147
550
108
192
588
72.00 128.00
392
26.67
45.33
24.00
43.00
19.00
158
28.8
32.4
25.2
34.5
44.1
165
30
30
30
34
34
158
(d)
DPS for the current year : Dt = cr EPSt + (1-c) Dt-1
= 0.6 x 0.3 x 9 + (1-0.6) x 2 = Rs.2.42
(e)
Bonus Issue
The par value of the share is
unchanged
A part of reserves is capitalised
The shareholders' proportional
ownership remains unchanged
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 popular trading range.
Stock Split
The par value of the share is
reduced.
There is no capitalisation of reserves
The shareholders' proportional
ownership remains unchanged
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.
Chapter 23
Debt Analysis and Management
1. (i) Initial Outlay
(a) Cost of calling the old bonds
Face value of the old bonds
Call premium
(b) Net proceeds of the new bonds
Gross proceeds
Issue costs
250,000,000
15,000,000
265,000,000
250,000,000
10,000,000
240,000,000
(c) Tax savings on tax-deductible expenses

Tax rate[Call premium+Unamortised issue cost on
the old bonds]
0.4 [ 15,000,000 + 8,000,000]
Initial outlay i(a) i(b) i(c)
(ii)
Annual Net Cash Savings

(a) Annual net cash outflow on old bonds
Interest expense
- Tax savings on interest expense and amortisation of
issue expenses
0.4 [42,500,000 + 8,000,000/10]
9,200,000
15,800,000
42,500,000
17,400,000
25,100,000
(b) Annual net cash outflow on new bonds

Interest expense
issue cost
0.4 [ 37,500,000 10,000,000/8]
(iii)
(iv)
37,500,000
15,500,000
Annual net cash savings : ii(a) ii(b)
22,000,000
3,100,000
Present Value of the Annual Cash Savings

Present value of an 8-year annuity of 3,100,000 at a
discount rate of 9 per cent which is the post tax cost
of new bonds 3,100,000 x 5.535
17,158,500
Net Present Value of Refunding the Bonds

(a) Present value of annual cash savings
(b) Net initial outlay
17,158,500
15,800,000
(c) Net present value of refunding the bonds :

iv(a) iv(b).
2. (i) Initial Outlay
(a) Cost of calling the old bonds
Face value of the old bonds
Call premium
1,358,500
120,000,000
4,800,000
124,800,000
(b) Net proceeds of the new issue

Gross proceeds
Issue costs
120,000,000
2,400,000
117,600,000
3,120,000
(c) Tax savings on tax-deductible expenses

Tax rate[Call premium+Unamortised issue costs on
the old bond issue]
0.4 [ 4,800,000 + 3,000,000]
Initial outlay i(a) i(b) i(c)
(ii)
4,080,000
Annual Net Cash Savings

(a) Annual net cash out flow on old bonds
Interest expense
issue costs
0.4[19,200,000 + 3,000,000/5]
19,200,000
7,920,000
11,280,000
(b) Annual net cash outflow on new bonds

Interest expense
- Tax savings on interest expense and amortistion of issue
costs
0.4[18,000,000 + 2,400,000/5]
Annual net cash savings : ii(a) ii(b)
(iii)
(iv)
Present Value of the Annual Net Cash Savings

Present value of a 5 year annuity of 672,000 at
as discount rate of 9 per cent, which is the post-tax
cost of new bonds
Net Present Value of Refunding the Bonds

(a) Present value of annual net cash savings
(b) Initial outlay
(c) Net present value of refunding the bonds :
18,000,000
7,392,000
10,608,000
672,000
2,614,080
2,614,080
4,080,000
- 1,466,000
iv(a) iv(b)
3. Yield to maturity of bond P
8
160
918.50 =
+
t
t=1 (1+r)
1000
(1+r)8
r or yield to maturity is 18 percent

Yield to maturity of bond Q
5
120
1000
761 =
+
t=1 (1+r)t
(1+r)5
r or yield to maturity is 20 per cent
Duration of bond P is calculated below
Year
1
2
3
4
5
6
7
8
Cash flow
160
160
160
160
160
160
160
160
Present Value
Proportion of
Proportion of bonds
at 18%
bonds value
Value x Time
135.5
114.9
97.4
82.6
69.9
59.2
50.2
308.6
0.148
0.125
0.106
0.090
0.076
0.064
0.055
0.336
0.148
0.250
0.318
0.360
0.380
0.384
0.385
2.688
4.913
Duration of bond Q is calculated below

Year
1
2
3
4
5
Cash flow
120
120
120
120
1120
Present Value
at 20%
100.0
83.2
69.5
57.8
450.2
Proportion of
bonds value
0.131
0.109
0.091
0.076
0.592
Proportion of bonds
Value x Time
0.131
0.218
0.273
0.304
2.960
3.886
Volatility of bond P
4.913
= 4.16
1.18
4.
Volatility of bond Q
3.886
= 3.24
1.20
The YTM for bonds of various maturities is

Maturity
YTM(%)
12.36
13.10
13.21
13.48
13.72
Graphing these YTMs against the maturities will give the yield curve
The one year treasury bill rate , r1, is
1,00,000
- 1
12.36 %
89,000
To get the forward rate for year 2, r2, the following equation may be set up :
12500
99000
112500
+
(1.1236)(1+r2)
(1.1236)
Solving this for r2 we get r2 = 13.94%

To get the forward rate for year 3, r3, the following equation may be set up :
13,000
99,500
13,000
+
(1.1236)
113,000
+
(1.1236)(1.1394)
(1.1236)(1.1394)(1+r3)

To get the forward rate for year 4, r4 , the following equation may be set up :
13,500
100,050
13,500
+
(1.1236)
13,500
+
(1.1236)(1.1394)
(1.1236)(1.1394)(1.1349)
113,500
+
(1.1236)(1.1394)(1.1349)(1+r4)
To get the forward rate for year 5, r5 , the following equation may be set up :
13,750
100,100
13,750
+
(1.1236)
+
(1.1236)(1.1394)
13,750
(1.1236)(1.1394)(1.1349)
13,750
+
(1.1236)(1.1394)(1.1349)(1.1454)
113,750
+
(1.1236)(1.1394)(1.1349)(1.1454)(1+r5)
Chapter 24
LEASING, HIRE PURCHASE, AND PROJECT FINANCE
1
Year
0
Cost of the
1 asset
2 Depreciation
Loss of
depreciation
3 tax shield
Lease
4 payment
Tax shield
on lease
5 payment
Loss of
salvage
6 value
Cash flow of
7 lease
NAL of lease
=
499,950.00 333,316.67
222,222.22 148,155.55
98,775.31
166,633.34 111,094.44
-74,066.67
-49,380.25
-420,000
-420,000
1,500,000
-420,000
-420,000
-420,000
139,986.00 139,986.00 139,986.00 139,986.00
139,986.00
1,080,000. 446,647.34 391,108.44 354,080.67 329,394.25
300,000.00
192,935.81
1,080,000 -
446,647.34
1.08
391,108.44
( 1.08)2
354,080.67
3
( 1.08)
329,394.25
192,935.81
( 1.08)4
( 1.08)5
= 1,080,000 413,562.35 335,312.45 281,080.65 242,114.61 131,308.87

= - 323,378.93
.
2.
-32,921.81
Under the hire purchase proposal the total interest payment is

2,000,000 x 0.12 x 3 = Rs. 720,000
The interest payment of Rs. 720,000 is allocated over the 3 years period using
the sum of the years digits method as follows:
Year
Interest allocation
366
x Rs.720,000 = Rs.395,676
666
222
2
x Rs.720,000 = Rs.240,000
666
78
x Rs.720,000 = Rs.84,324
666
The annual hire purchase instalments will be :

Rs.2,000,000 + Rs.720,000
= Rs.906,667
3
The annual hire purchase instalments would be split as follows
Year
1
2
3
Hire purchase instalment

Interest
Rs.906,667
Rs.395,676
Rs.906,667
Rs.240,000
Rs.906,667
Rs. 84,324
The lease rental will be as follows :

Rs. 560,000 per year for the first 5 years
Rs. 20,000 per year for the next 5 years
Principal repayment
Rs. 510,991
Rs. 666,667
Rs. 822,343
The cash flows of the leasing and hire purchse options are shown below
Year
Leasing
- LRt (1-tc)
Hire Purchase
-It(1-tc)
-PRt
1 -560,000(1-.4)=-336,000 -395,676(1-.4) -510,991

2 -560,000(1-.4)=-336,000 -240,000(1-.4) -666,667
3 -560,000(1-.4)=-336,000 - 84,324(1-.4) -822,343
4 -560,000(1-.4)=-336,000
5 -560,000(1-.4)=-336,000
6 - 20,000(1-.4)= - 12,000
7 - 20,000(1-.4)= - 12,000
8 - 20,000(1-.4)= - 12,000
9 - 20,000(1-.4)= - 12,000
10 - 20,000(1-.4)= - 12,000
Dt(tc)
-It(1-tc)-PRt+
NSVt
Dt(tc)+NSVt
500,000(0.4)
375,000(0.4)
281,250(0.4)
210,938(0.4)
158,203(0.4)
118,652(0.4)
88,989(0.4)
66,742(0.4)
50,056(0.4)
37,542(0.4) 200,000
-548,397
-660,667
-760,437
84,375
63,281
47,461
35,596
26,697
20,023
215,017
Present value of the leasing option

5 336,000
= -
t=1 (1.10)t
10
t=6
12,000
(1.10)t
= - 1,302,207
Present value of the hire purchase option

548,397
660,667
=-
760,437
-
(1.10)2
(1.10)
63,281
(1.10)3
47,461
+
(1.10)6
20,023
215,017
(1.10)4
35,596
+
(1.10)5
84,375
26,697
+
(1.10)7
(1.10)8
+
(1.10.9
(1.10)10
= - 1,369,383
Since the leasing option costs less than the hire purchase option , Apex should choose the
leasing option.
MINICASE
(a)
Year
1
2
3
4
5
6
7
8
9
10
Principal repayment
-6
-6
-6
-6
-6
Interest payment
-3.6 -2.88 -2.16 -1.44 -0.72
Depreciation
12
7.20
4.32
2.59
1.56 0.93 0.56 0.34 0.20 0.12
Tax shield on depn.
4.00
2.40
1.44
0.86
0.52 0.31 0.19 0.11 0.07 0.04
Post tax interest
payment
-2.4 -1.92 -1.44 -0.96 -0.48
Net salvage value
6
Net cash flow
-4.40 -5.52 -6.00 -6.10 -5.96 0.31 0.19 0.11 0.07 6.04
Present value of the cash borrowing cum buying option is
4.40 5.52 6.00 6.10 5.96 0.31 0.19 0.11 0.07 6.04
= - ----- - ------ - ------ - ----- - ----- + ----- + ------ + ------ + ------- + -----(1.08) (1.08)2 (1.08)3 (1.08)4 (1.08)5 (1.08)6
(1.08)7 (1.08)8 (1.08)9 (1.08)10
= - 4.07 4.73 4.76 4.48 4.06 + 0.20 + 0.11 + 0.06 + 0.04 + 2.80
= - 18.89 million
(b)
Present value of lease cash flows =-7(1-0.3333)PVIFA8%,
PVIF8% , 5years
5years
0.5(1- 0.3333)PVIFA8%,
5years
= -7 x 0.6667 x 3.993 0.5 x 0.6667 x 3.993 x 0.681 =

-19.54million
(c) Total interest =30,000,000 x 0.08 x 3 = Rs.720,000
Monthly HP instalment = (30,000,000 + 720,000) / 36 = Rs.853,333
Annual instalment = (30,000,000 + 720,000) / 3 = Rs.10,240,000
Proportions for interest allocation:
36 +35+-----------------+ 25
366
I year =
=
36 +35+-----------------+ 1
666
24 +23 +-----------------+13
II year =
222
=
36 +35+-----------------+ 1
666
12 +35+-----------------+ 1
III year =
78
=
36 +35+-----------------+ 1
Interest allocations for the three years:
666
I year = 720,000 x 366/666 = Rs.395,676

II year = 720,000 x 222/666 = Rs.240,000
IIIyear = 720,000 x 78/666 = Rs .84,324
The cash flows under the HP option:
Year
1
2
3
4
5
6
7
8
9
10
-It(1-Tc)
-263,797
-160,008
-56,219
-Pr
-9,844,324
-10,000,000
-10,155,676
Dt(Tc)
NSV
Total CF
3,999,600
-6,108,521
2,399,760
-7,760,248
1,439,856
-8,772,039
863,914
863,914
518,348
518,348
311,009
311,009
186,605
186,605
111,963
111,963
67,178
67,178
40,307 6,000,000 6,040,307
Present value of the cash flows under the HP option = - Rs.15.09 million
PVIF
PV
0.9259 -5,656,038
0.8573 -6,653,162
0.7938 -6,963,527
0.7350
635,002
0.6806
352,779
0.6302
195,988
0.5835
108,882
0.5403
60,490
0.5002
33,606
0.4632
2,797,831
--15,088,148
Total=
Chapter 25
HYBRID FINANCING
1.
l (S/E) + (r + 2 /2) t
d1
=
t
d2
ln (40 / 25) + [0.16 + (0.35)2/2]2

0.35(2)1/2
0.4700 + 0.4425
0.4950
1.8434
=
=
=
d1 - t
1.8434 0.352
1.3484
N(d1) =
N (1.8434).
and
N(1.85)= 1- 0.0322= 0.9678
N(1.8434) = 0.9641 + (1.8434 1.8000)(0.9678-0.9641)/0.05
= 0.9641 + 0.003212 = 0.9673
N(d2) = N(1.3484)
N(1.35) = 1- 0.0885 = 0.9115
N(1.3484) = 0.9032 + (1.3484 1.3000)(0.9115 0.9032)/0.05
= 0.9032 + 0.008034 = 0.9112
E/ert = 25/1.3771 = 18.1541
= 40 x 0.9673 18.1541 x 0.9112= 22.15
Value of the warrant is Rs.22.15.
2
l (S/E) + (r + 2 /2) t
d1
=
t
=
ln (50 / 30) + [0.12 + (0.4)2/2]2

0.4(2)1/2
d2
0.5108 + 0.4
0.5657
1.6100
=
=
=
d1 - t
1.6100 0.402
1.0443
N(d1) =
N (1.6100).
and
N(1.65)= 1- 0.0495= 0.9505
N(1.6100) = 0.9452 + (1.6100 1.6000)(0.9505-0.9452)/0.05
= 0.9452 + 0.00106 = 0.9463
N(d2) = N(1.0443)
N(1.05) = 1- 0.1469 = 0.8531
N(1.0443) = 0.8413 + (1.0443 1.0000)(0.8531 0.8413)/0.05
= 0.8413 + 0.01045 = 0.8517
E/ert = 30/1.2712 = 23.60
= 50 x 0.9463 23.60 x 0.8517= 27.21
Value of the warrant = Rs.27.21
3.
(a)
No.of shares after conversion in one year = 2

Value of the shares at the price of Rs.150 = 2 x 150 = Rs.300
PV of the convertible portion at the required rate of 15% = 300/1.15 = Rs.260.87
Payments that would be received from the debenture portion:
Year
Payments PVIF10%,t PV
1
60
0.909
54.55
2
40
0.826
33.06 Value of the convertible debenture = 260.87 +
3
40
0.751
30.05 418.18 = Rs. 679.05
4
40
0.683
27.32
5
240
0.621 149.02
6
220
0.564 124.18
Total= 418.18
(b)
Year
The cash flow for Shiva is worked out as under:

Cash flow
0
600
1
=-240-60*(1-0.3) 282
2
=-40*(1-0.3) -28
3
=-40*(1-0.3) -28
4
=-40*(1-0.3) -28
5
=-40*(1-0.3)-200 228
6
=-20*(1-0.3)-200 214
The post-tax cost of the convertible debenture to Shiva is the IRR of the above
cash flow stream.
Let us try a discount rate of 9%. The PV of the cash flow will then be
= 600 282/(1.09) -28/(1.09)2 - 28/(1.09)3 -28/(1.09)4-228/(1.09)5-214/(1.09)6
= 600 258.72 23.57 21.62 19.84 148.18 127.60 = 0.47 which is very near to zero.
So the post tax cost of the convertible debenture to Shiva is 9%
Chapter 26
WORKING CAPITAL POLICY
Average inventory
1
Inventory period =
Annual cost of goods sold/365
(60+64)/2
=
= 62.9 days
360/365
Average accounts receivable
Accounts receivable =
period
Annual sales/365
(80+88)/2
= 61.3 days
500/365
Average accounts payable
Accounts payable
period
=
Annual cost of goods sold/365
(40+46)/2
=
= 43.43 days
360/365
Operating cycle
Cash cycle
=
=
62.9 + 61.3 = 124.2 days

124.2 43.43 = 80.77 days
(110+120)/2
2.
Inventory period
56.0 days
52.9 days
30.7 days
750/365
(140+150)/2
Accounts receivable
period
=
1000/365
(60+66)/2
Accounts payable
period
=
750/365
Operating cycle = 56.0 + 52.9 = 108.9 days

Cash cycle
= 108.9 30.7 = 78.2 days
3.
This is a repetition of the solved problem 26.1 .
Chapter 27
CASH AND LIQUIDITY MANAGEMENT
1
The projected cash inflows and outflows for the quarter, January through March, is shown
below .
Month
December
(Rs.)
Inflows :
Sales collection
Outflows :
Purchases
Payment to sundry creditors
Rent
Drawings
Salaries & other expenses
Purchase of furniture
22,000
Total outflows(2to6)
January
(Rs.)
February
(Rs.)
March
(Rs.)
50,000
55,000
60,000
20,000
22,000
5,000
5,000
15,000
-
22,000
20,000
5,000
5,000
18,000
25,000
25,000
22,000
5,000
5,000
20,000
-
47,000
73,000
52,000
Given an opening cash balance of Rs.5000 and a target cash balance of Rs.8000, the
surplus/deficit in relation to the target cash balance is worked out below :
January
(Rs.)
1. Opening balance
2. Inflows
3. Outflows
4. Net cash flow (2 - 3)
5. Cumulative net cash flow
6. Opening balance + Cumulative
net cash flow
7. Minimum cash balance required
8. Surplus/(Deficit)
February
(Rs.)
March
(Rs.)
5,000
50,000
47,000
3,000
3,000
55,000
73,000
(18,000)
(15,000)
60,000
52,000
8,000
(7,000)
8,000
8,000
-
(10,000)
8,000
(18,000)
(2,000)
8,000
(10,000)
2 The balances in the books of Datta co and the books of the bank are shown below:
(Rs.)
1
10
Books of
Datta
Co:
Ope 30,000 46,000 62,000 78,000
ning
Balance
Add:
Cheque
received
Less:
Cheque
issued
Clo
sing
Balance
20,000 20,000 20,000 20,000

4,000
4,000
4,000
4,000
94,000 1,10,000 1,26,000 1,42,000 1,58,000 1,74,000

20,000
20,000
20,000
20,000
20,000
20,000
4,000
4,000
4,000
4,000
4,000
4,000
46,000 62,000 78,000 94,000 1,10,000 1,26,000 1,42,000 1,58,000 1,74,000 1,90,000
Books of
the
Bank:
Ope 30,000 30,000 30,000 30,000 30,000
ning
Balance
Add:
Cheques
realised
Less:
Cheques
debited
Clo 30,000 30,000 30,000 30,000 30,000
sing
Balance
30,000
50,000
70,000
90,000
1,06,000
20,000
20,000
20,000
20,000
20,000
4,000
4,000
50,000
70,000
90,000
1,06,000 1,22,000
From day 9 we find that the balance as per the banks books is less than the balance as per Datta
Companys books by a constant sum of Rs.68,000. Hence in the steady situation Datta Company has
a negative net float of Rs.68,000.
3. Optimal conversion size is

2bT
C =
I
b = Rs.1200, T= Rs.2,500,000, I = 5% (10% dividend by two)
So,
2 x 1200 x 2,500,000
C =
= Rs.346,410
0.05
4.
3
3 b2
RP =
+ LL
4I
UL = 3 RP 2 LL
I = 0.12/360 = .00033, b = Rs.1,500, = Rs.6,000, LL = Rs.100,000
3 3 x 1500 x 6,000 x 6,000
RP =
+ 100,000
4 x .00033
= 49,695 + 100,000 = Rs.149,695

UL = 3RP 2LL = 3 x 149,695 2 x 100,000
= Rs.249,085
5
. Optimal conversion size is
2bT
C =
I
b = Rs.2800, T= Rs.35,000,000, I = 5% (10% dividend by two)
So,
2 x 2800 x 35,000,000
C =
= Rs.1,979,899
0.05
6
3
3 b2
RP =
+ LL
4I
UL = 3 RP 2 LL
I = 0.12/360 = .00033, b = Rs.3,200, = Rs.22,000, LL = Rs.800,000
3 3 x 3200 x 22,000 x 22,000
RP =
+ 800,000
4 x .00033
= 152,118 + 800,000 = Rs.952,118

UL = 3RP 2LL = 3 x 952,118 2 x 800,000
= Rs.1,256,354
Chapter 28
CREDIT MANAGEMENT
1.
RI = [S(1-V)- Sbn](1-t)- k I
S
I =
x ACP x V
360
S = Rs.10 million, V=0.85, bn =0.08, ACP= 60 days, k=0.15, t = 0.40
Hence, RI = [ 10,000,000(1-0.85)- 10,000,000 x 0.08 ] (1-0.4)
-0.15 x 10,000,000 x 60 x 0.85
360
= Rs. 207,500
2.
RI = [S(1-V)- Sbn] (1-t) k I

So
I = (ACPN ACPo)
S
+V(ACPN)
360
360
S=Rs.1.5 million, V=0.80, bn=0.05, t=0.45, k=0.15, ACPN=60, ACPo=45, So=Rs.15 million
Hence RI = [1,500,000(1-0.8) 1,500,000 x 0.05] (1-.45)
-0.15 (60-45) 15,000,000 + 0.8 x 60 x 1,500,000
360
= 123750 123750 = Rs. 0
3.
360
RI = [S(1-V) DIS ] (1-t) + k I

DIS = pn(So+S)dn poSodo
So
I =
S
(ACPo-ACPN) -
360
x ACPN x V
360
So =Rs.12 million, ACPo=24, V=0.80, t= 0.50, r=0.15, po=0.3, pn=0.7,

ACPN=16, S=Rs.1.2 million, do=.01, dn= .02
Hence
RI = [ 1,200,000(1-0.80)-{0.7(12,000,000+1,200,000).020.3(12,000,000).01}](1-0.5)
12,000,000
1,200,000
+ 0.15
(24-16) -
x 16 x 0.80
360
360
= Rs.79,200
4.
RI = [S(1-V)- BD](1-t) k I
BD=bn(So+S) boSo
So
I =
S
(ACPN ACPo) +
360
x ACPN x V
360
So=Rs.50 million, ACPo=25, V=0.75, k=0.15, bo=0.04, S=Rs.6 million,

ACPN=40 , bn= 0.06 , t = 0.3
RI = [ Rs.6,000,000(1-.75) {.06(Rs.56,000,000)-.04(Rs.50,000,000)](1-0.3)
Rs.50,000,000
- 0.15
Rs.6,000,000
(40-25) +
360
x 40 x 0.75
360
= - Rs.289,495
5.
30% of sales will be collected on the 10th day

70% of sales will be collected on the 50th day
ACP = 0.3 x 10 + 0.7 x 50 = 38 days
Rs.40,000,000
Value of receivables =
x 38
360
= Rs.4,222,222
Assuming that V is the proportion of variable costs to sales, the investment in
receivables is :
Rs.4,222,222 x V
6.
30% of sales are collected on the 5th day and 70% of sales are collected on the
25th day. So,
(a) ACP = 0.3 x 5 + 0.7 x 25 = 19 days
Rs.10,000,000
Value of receivables =
x 19
360
= Rs.527,778
(b) Investment in receivables = 0.7 x 527,778
= Rs.395,833
7. Since the change in credit terms increases the investment in receivables,
RI = [S(1-V)- DIS](1-t) kI
So=Rs.50 million, S=Rs.10 million, do=0.02, po=0.70, dn=0.03,pn=0.60,
ACPo=20 days, ACPN=24 days, V=0.85, k=0.12 , and t = 0.40
DIS = 0.60 x 60 x 0.03 0.70 x 50 x 0.2
= Rs.0.38 million
50
I=
10
(24-20) +
360
x 24 x 0.85
360
= Rs.1.2222 million
RI = [ 10,000,000 (1-.85) 380,000 ] (1-.4) 0.12 x 1,222,222
= Rs.525,333
8. The decision tree for granting credit is as follows :
Grant credit
Customer pays(0.95)
Profit 1500
Customer pays(0.85)
Grant credit
Profit 1500
Customer defaults(0.05)
Refuse credit
Loss 8500
Customer defaults(0.15)
Loss 8500
Refuse credit
The expected profit from granting credit, ignoring the time value of money, is :
Expected profit on
Initial order
+ Probability of payment x
and repeat order
Expected profit on
repeat order
{ 0.85(1500)-0.15(8500)} + 0.85 {0.95(1500)-.05(8500)}

=
0
+ 850
= Rs.850
9. Profit when the customer pays = Rs.10,000 - Rs.8,000 = Rs.2000

Loss when the customer does not pay = Rs.8000
Expected profit = p1 x 2000 (1-p1)8000
Setting expected profit equal to zero and solving for p1 gives :
p1 x 2000 (1- p1)8000 = 0
p1 = 0.80
Hence the minimum probability that the customer must pay is 0.80
MINICASE
Solution:
Present Data
Sales : Rs.800 million

Credit period : 30 days to those deemed eligible
Cash discount : 1/10, net 30
Proportion of credit sales and cash sales are 0.7 and 0.3. 50 percent of the credit customers
avail of cash discount
Contribution margin ratio : 0.20
Tax rate : 30 percent
Post-tax cost of capital : 12 percent
ACP on credit sales : 20 days
Effect of Relaxing the Credit Standards on Residual Income
Incremental sales
: Rs.50 million
Bad debt losses on incremental sales: 12 percent
ACP remains unchanged at 20 days
RI = [S(1 V) - Sbn] (1 t) R I
S
where I =
x ACP x V
360
RI = [50,000,000 (1-0.8) 50,000,000 x 0.12] (1 0.3)

50,000,000
- 0.12 x
x 20 x 0.8
360
= 2,800,000 266,667 = 2,533,333

Effect of Extending the Credit Period on Residual Income
RI = [S(1 V) - Sbn] (1 t) R I
So
where I = (ACPn ACPo)
S
+ V (ACPn)
360
360
RI = [50,000,000 (1 0.8) 50,000,000 x 0] (1 0.3)

800,000,000
- 0.12
(50 20) x
50,000,000
+ 0.8 x 50 x
360
360
= 7,000,000 8,666,667
= - Rs.1,666,667
Effect of Relaxing the Cash Discount Policy on Residual Income
RI = [S (1 V) - DIS] (1 t) + R I
where I = savings in receivables investment
So
S
=
(ACPo ACPn) V
x ACPn
360
360
800,000,000
=
20,000,000
(20 16) 0.8 x
360
x 16
360
= 8,888,889 711,111 = 8,177,778

DIS = increase in discount cost
= pn (So + S) dn po So do
= 0.7 (800,000,000 + 20,000,000) x 0.02 0.5 x 800,000,000 x 0.01
= 11,480,000 4,000,000 = 7,480,000
So, RI = [20,000,000 (1 0.8) 7,480,000] (1 0.3) + 0.12 x 8,177,778
= - 2,436,000 + 981,333
= - 1,454,667
Chapter 29
INVENTORY MANAGEMENT
1.
a.
No. of
Order
Orders Per Quantity
Year
(Q)
(U/Q)
Units
1
2
5
10
250
125
50
25
Ordering Cost
(U/Q x F)
Rs.
200
400
1,000
2,000
Carrying Cost Total Cost

Q/2xPxC
of Ordering
(where and Carrying
PxC=Rs.30)
Rs.
Rs.
3,750
1,875
750
375
3,950
2,275
1,750
2,375
2 UF
2x250x200
=
PC
30
= 58 units (approx)
b. Economic Order Quantity (EOQ) =

2UF
2. a EOQ =
PC
U=10,000 , F=Rs.300, PC= Rs.25 x 0.25 =Rs.6.25
2 x 10,000 x 300
EOQ =
= 980
6.25
10000
b. Number of orders that will be placed is
= 10.20
980
Note that though fractional orders cannot be placed, the number of orders
relevant for the year will be 10.2 . In practice 11 orders will be placed during the year. However,
the 11th order will serve partly(to the extent of 20 percent) the present year and partly(to the
extent of 80 per cent) the following year. So only 20 per cent of the ordering cost of the 11th
order relates to the present year. Hence the ordering cost for the present year will be 10.2 x
Rs.300
c. Total cost of carrying and ordering inventories
980
= [ 10.2 x 300 +
x 6.25 ] = Rs.6122.5
2
3.
U=6,000, F=Rs.400 , PC =Rs.100 x 0.2 =Rs.20

2 x 6,000 x 400
EOQ =
= 490 units
20
U
= UD +
Q(P-D)C
Q*
F-
Q* PC
-
2
6,000
2
6,000
= 6000 x .5 +
490
x 400
1,000
1,000 (95)0.2
490 x 100 x 0.2

-
= 30,000 + 2498 4600 = Rs.27898

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

2 x 5000 x 300
EOQ =
= 707 units
6
If 1000 units are ordered the discount is : .05 x Rs.30 = Rs.1.5 Change in
profit when 1,000 units are ordered is :
5,000
= 5000 x 1.5 +
707
1000 x 28.5 x 0.2

-
5,000
x 300
1,000
707 x 30 x 0.2
= 7500 + 622-729 =Rs.7393

2
If 2000 units are ordered the discount is : .10 x Rs.30 = Rs.3 Change in profit
when 2,000 units are ordered is :
5000
= 5000 x 3.0 +
5000
-
707
2000x27x0.2
x 300-
2000
707x30x0.2
-
= 15,000 +1372 3279 = Rs.13,093

The quantities required for different combinations of daily usage rate(DUR) and lead times(LT)
along with their probabilities are given in the following table
5.
LT
(Days)
DUR
(Units)
4(0.3)
6(0.5)
8(0.2)
*
5(0.6)
10(0.2)
15(0.2)
20*(0.18)
30 (0.30)
40 (0.12)
40(0.06)
60(0.10)
80(0.04)
60(0.06)
90(0.10)
120(0.04)
Note that if the DUR is 4 units with a probability of 0.3 and the LT is 5 days with
a probability of 0.6, the requirement for the combination DUR = 4 units and LT =
5 days is 20 units with a probability of 0.3x0.6 = 0.18. We have assumed that the
probability distributions of DUR and LT are independent. All other entries in the
table are derived similarly.
The normal (expected) consumption during the lead time is :
20x0.18 + 30x0.30 + 40x0.12 + 40x0.06 + 60x0.10 + 80x0.04 + 60x0.06 + 90x0.10 +
120x0.04 = 46.4 tonnes
a.
Costs associated with various levels of safety stock are given below :
Safety
Stock*
Stock
outs(in
tonnes)
Stock out
Cost
Probability
Tonnes
73.6
43.6
0
30
0
120,000
0
0.04
10
40
40,000
160,000
0.10
0.04
20
30
60
80,000
120,000
240,000
0.04
0.10
0.04
13.6
33.6
43.6
54,400 0.16
134,400 0.04
174,400
294,400
43,296
0.10
0.04
33.6
13.6
73.6
Expected Carrying
Stock out
Cost
5
[3x4]
Total Cost
6
[(1)x1,000]
7
[5+6]
Rs.
0
4,800
Rs.
73,600
43,600
Rs.
73,600
48,400
10,400
33,600
44,000
24,800
13,600
38,400
43,296
Safety stock = Maximum consumption during lead time Normal

consumption during lead time
So the optimal safety stock= 13.6 tonnes
Reorder level = Normal consumption during lead time + safety stock
K= 46.4 + 13.6 = 60 tonnes
b. Probability of stock out at the optimal level of safety stock = Probability
(consumption being 80 or 90 or 120 tonnes)
Probability (consumption = 80 tonnes) + Probability (consumption = 90 tonnes) +
Probability (consumption = 120 tonnes)
= 0.04 +0.10+0.04 = 0.18
6.
Item
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Annual Usage
(in Units)
Price per
Unit
Rs.
Annual
Usage Value
Rs.
400
15
6,000
750
1,200
25
300
450
1,500
1,300
900
1,600
600
30
45
20.00
150.00
2.00
18.00
25.00
160.00
2.00
1.00
4.00
20.00
2.00
15.00
7.50
40.00
20.00
8,000
2,250
12,000
13,500
30,000
4,000
600
450
6,000
26,000
1,800
24,000
4,500
1,200
900
1,35,200
Ranking
6
10
5
4
1
9
14
15
7
2
11
3
8
12
13
Cumulative Value of Items & Usage

Item
No.
Rank
5
10
12
4
3
1
9
13
6
2
11
14
15
7
8
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Class
A
B
C
Annual
UsageValue
(Rs.)
30,000
26,000
24,000
13,500
12,000
8,000
6,000
4,500
4,000
2,250
1,800
1,200
900
600
450
No. of Items
4
3
18
15
Cumulative
Annual Usage
Value (Rs.)
30,000
56,000
80,000
93,500
105,500
113,500
119,500
124,000
128,000
130,250
132,050
133,250
134,150
134,750
135,200
% to the Total
26.7
20.0
53.3
Cumulative Cumulative
% of Usage % of Items
Value
22.2
41.4
59.2
69.2
78.0
83.9
88.4
91.7
94.7
96.3
97.7
98.6
99.2
99.7
100.0
Annual Usage
Value Rs.
93,500
26,000
15,700
135,200
6.7
13.3
20.0
26.7
33.3
40.0
46.7
53.3
60.0
66.7
73.3
80.0
86.7
93.3
100.0
% to Total Value
69.2
19.2
11.6
7. The quantities required for different combinations of daily usage rate(DUR) and lead times(LT)
along with their probabilities are given in the following table
LT
(Days)
DUR
(Units)
2(0.2)
3(0.6)
4(0.2)
5(0.4)
8(0.4)
12(0.2)
10 (0.08)
15 (0.24)
20 (0.08)
16(0.08)
24(0.24)
32(0.08)
24(0.04)
36(0.12)
48(0.04)
The normal (expected) consumption during the lead time is :

10x0.08 + 15 x0.24 + 20x0.08 + 16x0.08 + 24x0.24 + 32 x0.08 + 24x0.04 + 36 x0.12
+ 48 x0.04 = 22.8 tonnes
c.
Costs associated with various levels of safety stock are given below :
Safety
Stock*
Stock
outs(in
tonnes)
Stock out
Cost
Probability
Tonnes
25.2
13.2
0
12
9.2
1.2
Expected Carrying
Stock out
Cost
5
[3x4]
Total Cost
6
[(1)x1,500]
7
[5+6]
60,000
0
0.04
Rs.
0
2,400
Rs.
37,800
19,800
Rs.
37,800
22,200
4
16
20,000
80,000
0.12
0.04
5,600
13,800
19,400
8
12
24
40,000
60,000
120,000
0.08
0.12
0.04
15,200
1,800
17,000
1.2
9.2
13.2
25.2
6,000
46,000 0.08
66,000
126,000
0.28
18,320
18,320
0.12
0.04
Safety stock = Maximum consumption during lead time Normal

consumption during lead time
a) So the optimal safety stock= 1.2 tonnes

Reorder level = Normal consumption during lead time + safety stock
K= 22.8 + 1.2 = 24 tonnes
b) Probability of stock out at the optimal level of safety stock = Probability
(consumption being 32 or 36 or 48 tonnes)
= 0.08 +0.12+0.04 = 0.24
Chapter 30
WORKING CAPITAL FINANCING
1. Annual interest cost is given by ,
Discount %
360
x
1- Discount % Credit period Discount period
Therefore, the annual per cent interest cost for the given credit terms will be as
follows:
a.
0.01
360
x
b.
0.99
20
0.02
360
x
0.98
c.
= 18.2%
= 0.367
= 36.7%
= 0.318
= 31.8%
= 0.364
= 36.4%
= 0.104
= 10.4%
20
0.03
360
x
0.97
d.
= 0.182
35
0.01
360
x
0.99
10
0.01
360
2.
a.
x
b.
0.99
35
0.02
360
x
0.98
c.
0.03
21%
360
x
0.97
0.21
35
= 0.223
50
= 22.3%
d.
0.01
360
x
= 0.145
= 14.5%
0.99
25
3. The maximum permissible bank finance under the three methods suggested by
The Tandon Committee are :
Method 1 : 0.75(CA-CL) = 0.75(36-12) = Rs.18 million
Method 2 : 0.75(CA)-CL = 0.75(36-12 = Rs.15 million
Method 3 : 0.75(CA-CCA)-CL = 0.75(36-18)-12 = Rs.1.5 million
4. Raw material and stores and spares consumed (RMC)= Opening stock of raw materials and
stores and spares + purchases closing stock of raw materials and stores and spares
= 524 + 1821 540 = 1805
Cost of production = RMC + Other operating expenses(including depreciation) +
Opening stock of work-in-process Closing stock of work-in-process
= 1805 + 674 + 218 226 = 2471
Cost of sales = Cost of production + Opening stock of finished goods Closing stock of finished
goods
= 2471 + 485 588 = 2368
Holding level of raw material and stores and spares(months consumption)
=( 540 x 12) / 1805 = 3.59 months
Holding level of work-in-process ( months cost of production)
= ( 226 x 12) / 2471 = 1.10 months
Holding level of finished goods(months cost of sales)
= (588 x 12)/ 2368 = 2.98 months
Chapter 31
WORKING CAPITAL MANAGEMENT :EXTENSIONS
1.(a)
The discriminant function is :

Zi = aXi +
where Zi =
Xi =
Yi =
bYi
discriminant score for the ith account
quick ratio for the ith account
EBDIT/Sales ratio for the ith account
The estimates of a and b are :

y2. dx - xy . dy
a =
x 2. y 2 - xy . xy
b
x 2. dy xy . dx
x 2 . y 2
xy . xy
The basic calculations for deriving the estimates of a and b are given
the accompanying table.
Drawing on the information in the accompanying table we find that
G
R
O
U
P
I
( Yi-Y)2
Xi = 19.81 Yi= 391
(Xi-X)2
X = 0.7924 Y = 15.64
= 0.8311 =1661.76
Account
Number
Xi
Yi
(Xi-X)
1
2
3
4
5
6
7
8
9
10
11
0.90
0.75
1.05
0.85
0.65
1.20
0.90
0.84
0.93
0.78
0.96
15
20
10
14
16
20
24
26
11
18
12
0.1076
-0.0424
-0.2576
0.0576
-0.1424
0.4076
0.1076
0.0476
0.1376
-0.0124
0.1676
(Yi-Y)
(Xi-X)2
( Xi-X)(Yi-Y)
= 10.007
(Yi-Y)2 (Xi-X)(Yi-Y)
-0.64 0.0116 0.4096

4.36 0.0018 19.0096
-5.64 0.0664 31.8096
-1.64 0.0033
2.6896
0.36 0.0203
0.1296
4.36 0.1661 19.0096
8.36 0.0116 69.8896
10.36 0.0023 107.3296
-4.64 0.0189 21.5296
2.36 0.0002
5.5696
-3.64 0.0281 13.2496
-0.0689
-0.1849
-1.4529
-0.0945
-0.513
1.7771
0.8995
0.4931
-0.6385
-0.0293
-0.6101
G
R
O
U
P
II
12
13
14
15
1.02
0.81
0.76
1.02
25 0.2276
26 0.0176
30 -0.0324
28 0.2276
9.36
10.36
14.36
12.36
0.0518
0.0003
0.0010
0.0518
87.6096
2.1303
107.3296 0.1823
206.2096 -0.4653
152.7696 2.8131
16
17
18
19
20
21
22
23
24
25
0.76
0.68
0.56
0.62
0.92
0.58
0.70
0.52
0.45
0.60
10 -0.0324
12 -0.1124
4 -0.2324
18 -0.1724
-4 0.1276
20 -0.2124
8 -0.0924
15 0.2724
6 0.3424
7 0.1924
-5.64
-3.64
-11.64
2.36
-19.64
4.36
- 7.64
-0.64
-9.64
-8.64
0.0010
0.0126
0.0540
0.0297
0.0163
0.0451
0.0085
0.0742
0.1172
0.0370
31.8069
13.2496
135.4896
5.5696
385.7296
19.0096
58.3696
0.4096
92.9296
74.6496
0.1827
0.4091
2.7051
-0.4069
-2.5061
-0.9261
0.7059
0.1743
3.3007
1.6623
0.8311
1661.76
9.539
19.81 391
Sum of Xi for group 1
X1 =
13.42
=
15
Sum of Xi for group 2
10
Y1 =
Y2 =
y =
9.60
10
( Xi X) =
0.8311
( Yi Y) =
= 0.0346
25-1
1661.76
n-1
96
10
19.67
15
Sum of Yi for group 2
295
15
n-1
0.6390
10
Sum of Yi for group 1
x =
6.39
=
0.8947
15
X2 =
= 69.24
25-1
1
xy =
n-1
( Xi-X)(Yi-Y) =
10.0007
= 0.4167
25-1
dx = X1 - X2 = 0.8947 0.6390 = 0.2557

dy = Y1 Y2 = 19.67 9.60 = 10.07
Substituting these values in the equations for a and b we get :
69.24 x 0.2557 0.4167 x 10.07
a =
= 6.079
0.0346 x 69.24 0.4167 x 0.4167
0.0346 x 10.07 0.4167 x 0.2557
b=
0.1089
0.0346 x 69.24 0.4167 x 0.4167

Hence , the discriminant function is :
Zi = 6.079 Xi + 0.1089 Yi
(b) Choice of the cutoff point
The Zi score for various accounts are shown below
Zi scores for various accounts
Account No.
Zi Score
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
7.1046
6.7373
7.4720
6.6918
5.6938
9.4728
8.0847
7.9378
6.8514
6.7018
7.1426
8.9231
7.7554
7.8870
9.2498
16
17
18
19
20
21
22
23
24
25
5.7090
5.4405
3.8398
5.7292
5.1571
5.7038
5.1265
4.7946
3.3890
4.4097
The Zi scores arranged in an ascending order are shown below

Account Number
Zi Score
24
18
25
23
22
20
17
5
21
16
19
4
10
2
9
1
11
3
13
14
8
7
12
15
6
3.3890
3.8398
4.4097
4.7946
5.1265
5.1571
5.4405
5.6938
5.7038
5.7090
5.7292
6.6918
6.7018
6.7373
6.8514
7.1046
7.1426
7.4720
7.7554
7.8870
7.9378
8.0847
8.9231
9.2498
9.4728
Good(G)
or
Bad (B)
B
B
B
B
B
B
B
G
B
B
B
G
G
G
G
G
G
G
G
G
G
G
G
G
G
From the above table, it is evident that a Zi score which represents the mid-point between the
Zi scores of account numbers 19 and 4 results in the minimum number of misclassifications . This Zi
score is :
5.7292 + 6.6918
= 6.2105
2
Given this cut-off Zi score, there is just one misclassification (Account number 5)
CA
2
WCL =
(CA + NFA) 0.2 CA
Dividing both the numerator and denominator by CA, we get
1
=1
1 +( NFA/CA) -0.2
0.8 +NFA/CA = 1 or NFA/CA =0.2
31.3
Account
Number
G
O
O
D
A
C
C
T
B
A
D
A
C
C
T
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
ROE(%)
Xi
20
18
24
15
12
9
19
16
-6
4
2
-5
11
7
3
-10
DER Y i
0.5
0.6
0.8
0.9
0.8
0.5
1
1.2
2
1.5
0.9
1.8
1.6
0.8
1.2
1.9
(X i -X)
11.3125
9.3125
15.3125
6.3125
3.3125
0.3125
10.3125
7.3125
-14.6875
-4.6875
-6.6875
-13.6875
2.3125
-1.6875
-5.6875
-18.6875
(Y i -Y)
-0.6250
-0.5250
-0.3250
-0.2250
-0.3250
-0.6250
-0.1250
0.0750
0.8750
0.3750
-0.2250
0.6750
0.4750
-0.3250
0.0750
0.7750
(X i -X
)2
127.9727
86.7227
234.4727
39.8477
10.9727
0.0977
106.3477
53.4727
215.7227
21.9727
44.7227
187.3477
5.3477
2.8477
32.3477
349.2227
(Y i -Y
)2
0.3906
0.2756
0.1056
0.0506
0.1056
0.3906
0.0156
0.0056
0.7656
0.1406
0.0506
0.4556
0.2256
0.1056
0.0056
0.6006
(X i -X)(Y i -Y)
-7.0703
-4.8891
-4.9766
-1.4203
-1.0766
-0.1953
-1.2891
0.5484
-12.8516
-1.7578
1.5047
-9.2391
1.0984
0.5484
-0.4266
-14.4828
From the above table we get the following

Xi = 139 Yi= 18
(Xi-X)2
X1 =
X2 =
Y1 =
X = 8.6875 Y = 1.125 = 1519.438

Sum of Xi for Good Accts.
133
=
=
8
8
Sum of Xi for Bad Accts.
=
8
Sum of Yi for Good Accts.

=
8
6.3
Sum of Yi for Bad Accts.
11.7
Y2 =
8
n-1
1
y =
2
n-1
n-1
= -55.975
16.625
0.75
0.7875
1.4625
8
1519.438
( Yi Y) =
= 101.30
16-1
3.69
1
xy =
( Xi X)2 =
= 3.69
( Xi-X)(Yi-Y)
=
1
x 2 =
( Yi-Y)2
( Xi-X)(Yi-Y) =
= 0.246
16-1
-55.975
= - 3.73
16 -1
dx = X1 - X2 = 16.625 0.75 = 15.875

dy = Y1 Y2 = 0.7875 1.4625 = - 0.675
Substituting these values in the equations for a and b we get :
0.246 x 15.875 - 3.73 x 0.675
a =
= 0.1261
101.30 x 0.246 3.73 x 3.73
-101.30 x 0.675 + 3.73 x 15.875
b=
=
101.30 x 0.246 3.73 x 3.73
- 0.8325
Hence , the discriminant function is :

Zi = 0.1261 Xi - 0.8325 Yi
Chapter 32
CORPORATE VALUATION
1. (a) The calculations for Hitech Limited are shown below :
Year 2
EBIT
PBT
86
+ Interest expense
24
- Interest income
(10)
- Non-operating income
(5)
EBIT
95
Tax on EBIT
Tax provision on income statement 26
+ Tax shield on interest expense
9.6
- Tax on interest income
(4)
- Tax on non-operating income
(2)
Tax on EBIT
29.6
NOPLAT
Net investment
Non-operating cash flow (post-tax)
FCFF
(c)
Invested capital (Beginning)
Invested capital (Ending)
NOPLAT
Turnover
33.2
71.8
(50)
3
18.4
The financing flow for years 2 and 3 is as follows :

Year 2
After-tax interest expense
14.4
Cash dividend
30
- Net borrowings
(30)
+ Excess marketable securities
30
- After-tax income on excess
(6)
marketable securities
- Share issue
(20)
18.4
(b)
102
28
(15)
(10)
105
32
11.2
(6)
(4)
65.4
(50)
Year3
Year 2
310
360
65.4
400
6
27.8
Year 3
16.8
40
(30)
10
(9)
27.8
Year 3
360
410
71.8
460
Net investment
50
Post-tax operating margin

Capital turnover
ROIC
Growth rate
FCF
2.
16.35%
1.29
21.1%
16.1%
15.4
3.
4.
5.
6.
7.
15.61%
1.28
19.9%
13.9%
21.8
Televista Corporation
0
Base year
1.
2.
50
Revenues
EBIT
EBIT (1-t)
Cap. exp.
- Depreciation
Working capital
Working capital
FCFF
(3-4-6)
Discount factor
Present value
1600
240
156
200
120
400
1920
288
187
240
144
480
80
11
2304
346
225
288
173
576
96
13
2765
415
270
346
207
691
115
16
3318
498
323
415
249
829
138
19
3650
547
356
-
0.876 0.767 0.672

.589
9.64 9.97 10.76 11.19
Cost of capital for the high growth period

0.4 [12% + 1.25 x 7%] + 0.6 [15% (1 - .35)]
8.3%
+
5.85%
= 14.15%
Cost of capital for the stable growth period
0.5 [12% + 1.00 x 6%] + 0.5 [14% (1 - .35)]
9%
+
4.55%
= 13.55%
Present value of FCFF during the explicit forecast period
= 9.64 + 9.97 + 10.76 + 11.19 = 41.56
273
273
Horizon value =
=
= 7690
0.1355 0.10
0.0355
912
83
273
Present value of horizon value = 4529.5

Value of the firm = 41.56 + 4529.50 = Rs.4571.06 million
3. The WACC for different periods may be calculated :
WACC in the high growth period
Year
1
2
3
4
5
kd(1-t) = 15% (1-t)

15 (0.94) = 14.1%
15 (0.88) = 13.2%
15 (0.82) = 12.3%
15 (0.76) = 11.4%
15 (0.70) = 10.5%
ke = Rf + x Market risk premium ka = wd kd (1-t)+ we ke

12 + 1.3 x 7 = 21.1%
0.5 x 14.1 + 0.5 x 21.1 = 17.6%
21.1%
0.5 x 13.2 + 0.5 x 21.1 = 17.2%
21.1%
0.5 x 12.3 + 0.5 x 21.1 = 16.7%
21.1%
0.5 x 11.4 + 0.5 x 21.1 = 16.3%
21.1%
0.5 x 10.5 + 0.5 x 21.1 = 15.8%
kd(1-t)
ke
ka
WACC in the transition period

= 14 (1 0.3) = 9.8%
= 11 + 1.1 x 6 = 17.6%
= 0.44 x 9.8 + 0.56 x 17.6 = 14.2%
kd(1-t)
ke
ka
WACC for the stable growth period

= 13 (1 0.3) = 9.1%
= 11 + 1.0 x 5 = 16%
= 1/3 x 9.1 + 2/3 x 16 = 13.7%
The FCFF for years 1 to 11 is calculated below. The present value of the
FCFF for the years 1 to 10 is also calculated below.
3
Multisoft Limited
Period Growth EBIT Tax
rate (%)
rate
(%)
0
90
1
40
126
6
2
40
176
12
3
40
247
18
4
40
346
24
5
40
484
30
6
34
649
30
7
28
830
30
8
22
1013 30
EBIT
(1-t)
Cap. Dep. WC FCFF D/E Beta WACC

exp.
%
PV
Factor
Present
value
118
155
203
263
339
454
581
709
100
140
196
274
384
538
721
922
1125
.850
.726
.622
.535
.462
.405
.354
.310
30.6
27.6
27.4
20.8
12.0
13.4
15.4
16.7
60
84
118
165
230
323
432
553
675
26
39
50
70
98
132
169
206
36
38
44
39
26
33
43
53
1:1 1.3
1:1 1.3
1:1 1.3
1:1 1.3
1:1 1.3
0.8:1 1.1
0.8:1 1.1
0.8:1 1.1
17.6
17.2
16.7
16.3
15.8
14.2
14.2
14.2
9
10
11
16
10
10
1175
1292
1421
30
30
30
822
905
995
1305 783
1436 862
1580 948
239
263
289
61
68
74
0.8:1 1.1
0.8:1 1.1
0.5: 1.1
1.0
14.2
14.2
13.7
.272
.238
16.9
16.6
476
673.4
The present value of continuing value is :

FCF11
74
x PV factor 10 years =
kg
x 0.238
= 476
0.137 0.100
This is shown in the present value cell against year 11.

The value of the firm is equal to :
Present value of FCFF during
+ Present value of continuing
The explicit forecast period of 10 years
value
This adds up to Rs.685.4 million as shown below
MINI CASE
Solution:
1. Revenues
2. PBIT
3. NOPAT = PBIT
(1 .35)
4. Depreciation
5. Gross cash flow
6. Gross investment
in fixed assets
7. Investment in net
current assets
8. Total investment
9. FCFF (5) (8)
1
950
140
91
2
1,000
115
74.8
3
1,200
130
84.5
4
1,450
222
144.3
5
1,660
245
159.3
6
1,770
287
186.6
55
146
100
85
159.8
250
80
164.5
85
83
227.3
100
85
244.3
105
87
273.7
120
10
15
70
70
70
54
155
9.5
170
57.3
175
69.3
174
99.6
110
36
265
(105.2)
0.4
WACC =
1.0
x 12 x (1 0.35)
{8 + 1.06 (8)}
1.4
1.4
= 14%
99.6 (1.10)
Continuing Value =
= 2739.00
0.14 0.10
2739
Present value of continuing value =
= 1249
6
(1.14)
PV of the FCFF during the explicit forecast period

3.6
105.2
9.5
57.3
69.3
99.6
=
+
+
+
+
(1.14)
(1.14)2
(1.14)3 (1.14)4
(1.14)5 (1.14)6
= 72.4
Firm value = 72.4 + 1249 = 1321.4
Value of equity = 1321.4 200 = 1121.4 million
Chapter 33
VALUE BASED MANAGEMENT
1. The value created by the new strategy is calculated below :
Sales
Gross margin (20%)
Selling and general
administration (8%)
Profit before tax
Tax
Profit after tax
Fixed assets
Current assets
Total assets
Equity
Current
Values
(Year 0)
Income Statement Projection

1
2000
400
160
2240
448
179
2509
502
201
2810
562
225
3147
629
252
3147
629
252
240
72
168
269
81
188
301
90
211
337
101
236
378
113
264
378
113
264
Balance Sheet Projections

672
753
843
944
672
753
843
944
1344 1505 1696 1888
1344 1505 1686 1888
944
944
1888
1888
600
600
1200
1200
Profit after tax

Depreciation
Capital expenditure
Increase in current assets
Operating cash flow
Present value of the operating cash flow

Residual value
Present value of residual value
Total shareholder value
Pre-strategy value
Value of the strategy
2. According to the Marakon approach
Cash Flow Projections

188
211
236
60
67
75
132
148
166
72
81
90
44
49
55
=
=
=
=
=
=
147
264 / 0.15 = 1760
1760 / (1.15)4 = 1007
147 + 1007 = 1154
168/0.15 = 1120
1154 1120 = 34
264
84
185
101
62
264
94
94
264
rg
=
kg
r - .10
=
k - .10
r - .10 = 2k - .20
r = 2k - .10
r/k = 2 - (.10/k)
Thus r/k is a function of k. Unless k is specified r/k cannot be determined.
NOPAT for 20X1
PBIT (1 T) = 24 (0.65) = 15.6
Cost of equity
6% + 0.9 (6%) = 11.4%
Average cost of capital
0.5 x 8% (1 - .35) + 0.5 x 11.4% = 8.3%
EVA for 20X1
NOPAT - Average cost of capital x Capital employed
15.6 - .083 x 100 = 7.3
4.
I
r
c*
T
=
=
=
=
Rs.200 million
0.40
0.20
5 years
200 (0.40 0.20) 5
Value of forward plan =

0.20 (1.20)
= Rs.833.3 million
5. Cost of capital = 0.5 x 0.10 + 0.5 x 0.18 = 0.14 or 14 per cent
1.
2.
3.
4.
5.
Revenues
Costs
PBDIT
Depreciation
PBIT
2,000 2,000 2,000 2,000 2,000

1,400 1,400 1,400 1,400 1,400
600
600
600
600
600
200
200
200
200
200
400
400
400
400
400
6. NOPAT
240
240
240
240
240
7. Cash flow (4+6)
440
440
440
440
440
8. Capital at charge
1,000 800
600
400
200
9. Capital charge (8x0.14)
140
112
84
56
28
10. EVA (6-9)
100
128
156
184
212
5 440
NPV =
- 1000 = 440 x 3.433 1000 = 510.5
t
t=1 (1.14)
EVAt
NPV =
6.
= 100 x 0.877 + 128 x 0.769 + 156 x 0.675 + 184 x 0.592 +

212 x 0.519
= 510.3
(1.14)
Equipment cost = 1,000,000

Economic life = 4 years
Salvage value = Rs.200,000
Cost of capital = 14 per cent
Present value of salvage value = 200,000 x 0.592
= 118,400
Present value of the annuity
= 1,000,000 118,400
= 881,600
881,600
Annuity amount =
881,600
=
PVIFA14%, 4yrs
2.914
= Rs.302,540
Depreciation charge under sinking fund method
1
2
3
4
1,000,000
837,460
652,164
440,927
162,540
185,296
212,237
240,810
140,000
117,244
91,303
61,730
302,540
302,540
302,540
302,540
Capital
Depreciation
Capital charge
Sum
7.
Investment
Life
Cost of capital
Salvage value
:
:
:
:
Rs.2,000,000
10 years
15 per cent
0
2,000,000
Economic depreciation =
FVIFA(10yrs, 15%)
2,000,000
=
= 98,503
20.304
8.
Investment
Life
Cost of capital
Salvage value
:
:
:
:
Rs.5,000,000
5 years
12 per cent
Nil
PVIFA(5yrs,12%) = 3.605 ; Annuity amount = 5,000,000 / 3.605 = 1,386,963
Capital
Depreciation
Capital charge
Sum
1
5,000,000
786,963
600,000
1,386,963
Depreciation charge under sinking fund method

2
3
4
5
4,213,037
3,331,638
2,344,472
1,238,846
881,399
987,166
1,105,626
1,238,301
505,564
399,797
281,336
148,662
1,386,963
1,386,963
1,386,963
1,386,963
5,000,000
FVIFA(5yrs, 12%)
5,000,000
=
= Rs.787,030
6.353
9. (a)
Investment
Net working capital
Life
Salvage value
Annual cash flow
Cost of capital
Straight line depreciation
=
=
=
=
=
=
= Rs.100 million
Rs.20 million
8 yrs
Rs.20 million (Net working capital)
Rs.21.618 million
15%
Rs.10 million per year
80
80
=
FVIFA(8, 15%)
= Rs.5.828 million
13.727
Year 1
Profit after tax 11.618
Depreciation 10.000
Cash flow
21.618
Book capital 100

(Beginning)
ROCE
11.62%
ROGI
21.62%
CFROI
15.79%
Year 4
11.618
10.000
21.618
70
16.59%
21.62%
15.79%
(b)
Year 1
EVA
11.618 100 x 0.15

= - 3.382 million
CVA (11.618 + 10) 5.828-(100x0.15)
= 0.79 million
Year 4
11.618 - 70 x 0.15
= - 8.882 million
(11.618+10)-5.828- (100x0.15)
= 0.79 million
MINICASE
1. Both HLL and Infosys have excluded extraordinary or exceptional items.
2. HLL calculated NOPAT as:
PAT (1- T) + INT (1-T)
Remember that NOPAT can be calculated as
PBIT (1-T) or
as PAT (1-T) + INT (1-T). The two are equivalent.
Infosys calculated NOPAT as:
OPERATING PROFIT LESS TAXES
Since Infosys is a zero debt company with nil interest, operating profit less taxes
equivalent to PBIT (1-T).
is
3. For calculating the cost of equity both HLL and Infosys have used the Capital Asset Pricing
Model. However, they have used somewhat different inputs for the risk-free rate and the
market risk premium.
HLL used a risk-free rate of 6.95% whereas Infosys used a risk-free rate
of 7.50%. To some extent this difference may be because HLLs financial year ended on
31/12/2005 and Infosyss financial year ended on 31/3/2006.
HLL assumed a market risk premium of 9% whereas Infosys used a

market risk premium of 7%. This difference is, however, substantial.
4. Both HLL and Infosys have used a beta variant without explaining how the same has been
calculated. HLL has used a beta variant of 0.95 for the year 2005. It seems reasonable for an
FMCG major like HLL. Infosys has used a beta variant of 0.78 for 2006. Interestingly, the
beta variant of Infosys was 1.41 in 2006 and declined steadily to 0.78 in 2006. This reflects
the diminished riskiness of Infosys.
5. On the whole, the procedures used by the two companies seem reasonable. However, one
would have liked to know the rationale of their assumptions and the exact method for the
calculation of beta variant.
Chapter 34
MERGERS, ACQUISITIONS AND RESTRUCTURING
1. The pre-amalgamation balance sheets of Cox Company and Box Company and the postamalgamation balance sheet of the combined entity, Cox and Box Company, under the pooling
method as well as the purchase method are shown below :
Before Amalgamation
After Amalgamation
Cox & Box Company
Pooling method
Purchase
method
35
45
27.5
30
2.5
62.5
77.5
Cox
Box
Fixed assets
Current assets
Goodwill
Total assets
25
20
10
7.5
45
17.5
Share capital
(face value @ Rs.10)
Reserves & surplus
Debt
20
25
20
10
15
45
10
2.5
17.5
20
17.5
42.5
10
17.5
77.5
2. Post-merger EPS of International Corporation will be

2 x 100,000 + 2 x100,000
100,000 + ER x 100,000
Setting this equal to Rs.2.5 and solving for ER gives
ER = 0.6
3.
PVA = Rs.25 million, PVB = Rs.10 million

Benefit = Rs.4 million, Cash compensation = Rs.11 million
Cost = Cash compensation PVB = Rs.1 million
NPV to Alpha = Benefit Cost = Rs.3 million
NPV to Beta = Cash Compensation PVB = Rs.1 million
4.
Let A stand for Ajeet and J for Jeet
PVA = Rs.60 x 300,000 = Rs.18 million

PVJ = Rs.25 x 200,000 = Rs.5 million
Benefit = Rs.4 million
PVAJ = 18 + 5 + 4 = Rs.23 million
Exchange ratio = 0.5
The share of Jeet in the combined entity will be :
100,000
=
= 0.25
300,000 + 100,000
a)
True cost to Ajeet Company for acquiring Jeet Company

Cost = PVAB - PVB
= 0.25 x 27 - 5
= Rs.1.75 million
b)
NPV to Ajeet
= Benefit - Cost
=
4 - 1.75 = Rs.2.25 million
c) NPV to Jeet = Cost = Rs.1.75 million
5. a) PVB = Rs.12 x 2,000,000 = Rs.24 million
The required return on the equity of Unibex Company is the value of k in the
equation.
Rs.1.20 (1.05)
Rs.12 =
k - .05
k = 0.155 or 15.5 per cent.
If the growth rate of Unibex rises to 7 per cent as a sequel to merger, the intrinsic value
per share would become :
1.20 (1.07)
=
Rs.15.11
0.155 - .07
Thus the value per share increases by Rs.3.11 Hence the benefit of the
acquisition is
2 million x Rs.3.11 = Rs.6.22 million
(b)
(i)
If Multibex pays Rs.15 per share cash compensation, the cost of the
merger is 2 million x (Rs.15 Rs.12) = Rs.6 million.
(ii)
If Multibex offers 1 share for every 3 shares it has to issue 2/3 million
shares to shareholders of Unibex.
So shareholders of Unibex will end up with
0.667
= 0.1177 or 11.77 per cent

5+0.667
shareholding of the combined entity,

The present value of the combined entity will be
PVAB = PVA + PVB + Benefit
= Rs.225 million + Rs.24 million + Rs.6.2 million
= Rs.255.2 million
So the cost of the merger is :
Cost = PVAB
- PVB
= .1177 x 255.2 - 24 = Rs.6.04 million
The expected profile of the combined entity A&B after the merger is shown in the last column
below.
6.
A
5000
Rs.45000
Rs.90000
2
Number of shares
Aggregate earnings
Market value
P/E
7.
B
2000
Rs.4000
Rs.24000
6
A&B
6333
Rs.49000
Rs.114000
2.33
Value of Alpha Limiteds equity as a stand-alone company.
50
55
60
64
70
70 (1.06)
+
+
+
+
+
x
(1.12) (1.12)2 (1.12)3
(1.12)4 (1.12)5
0.12 0.06
1
(1.12)5
= Rs. 912.79 million

Value of the equity of the combined company.
80
90
+
(1.12) (1.12)2
105
+
120
+
(1.12)3
= Rs. 1518.98 million
+
(1.12)4
135135 (1.05)
1
+
x
5
(1.12)
0.12 0.05
(1.12)5
Let a be the maximum exchange ratio acceptable to the shareholders of Alpha Limited. Since the
management of Alpha Limited wants to ensure that the net present value of equity-related cash flows
increases by at least 5 percent, the value of a is obtained as follows.
10
x 1518.98 = 1.05 x 912.79
10 + a 8
Solving this for a we get
a = 0.7311
Note that the number of outstanding shares of Alpha Limited and Beta Limited are 10 million and 8
million respectively.
8. (a) The maximum exchange ratio acceptable to shareholders of Vijay Limited is :
S1
ER1
(E1+E2) PE12
+
S2
P1S2
12
=
(36+12) 8
+
= 0.1
30 x 8
(b) The minimum exchange ratio acceptable to shareholders of Ajay Limited is :

P2 S1
ER2
=
(PE12) (E1+E2) - P2 S2
9 x 12
=
= 0.3
9 (36+12) - 9 x 8
(c)
12
ER1
= -
(48) PE12
+
240
9 x 12
ER2
=
PE12 (48) - 72
Equating ER1 and ER2 and solving for PE12 gives, PE12 = 9
When PE12 = 9
ER1 = ER2 = 0.3
Thus ER1 and ER2 intersect at 0.3
9. The present value of FCF for first seven years is
16.00
14.30
PV(FCF)
= (1.15)
(1.15)2
0
+
9.7
-
0
+
(1.15)3
10.2
(1.15)4
16.7
(1.15)5
(1.15)6
(1.15)7
= - Rs.20.4 million
The horizon value at the end of seven years, applying the constant growth model is
FCF8
V4
18
=
0.15-0.08
PV (VH) = 257.1 x
= Rs.257.1 million
0.15 0.08
1
= Rs.96.7 million
(1.15)7
The value of the division is :

- 20.4 + 96.7 = Rs.76.3 million
MINICASE
Solution:
(a)
Modern Pharma
Magnum Drugs
Book value per share
2300
650
Earnings per share
20
450
= Rs.115
= Rs.65
10
95
= Rs.22.5
20
Rs.320
Market price per share
Exchange
Ratio
65
115
9.5
= Rs.9.5
10
Rs.102
22.5
102
320
Exchange ratio that gives equal weightage to book value per share, earnings per share, and market
price per share
65
9.5
+
115
102
+
22.5
320
0.57 + 0.42 + 0.32

=
= 0.44
3
(b) An exchange ratio based on earnings per share fails to take into account the
following:
(i) The difference in the growth rate of earnings of the two companies.
(ii) The gains in earnings arising out of merger.
(iii) The differential risk associated with the earnings of the two companies.
(c) Current EPS of Modern Pharma
450
=
= Rs.22.5
20
If there is a synergy gain of 5 percent, the post-merger EPS of Modern Pharma is
(450 + 95) (1.05)
20 + ER X 10
Equating this with Rs.22.5, we get
(450 + 95) (1.05)

= 22.5
20 + 10ER
This gives ER = 0.54
Thus the maximum exchange ratio Modern Pharma should accept to avoid initial dilution of EPS is
0.54
(d) Post-merger EPS of Modern Pharma if the exchange ratio is 1:4, assuming no
synergy gain:
450 + 95
= Rs.24.2
20 + 0.25 x 10
(e) The maximum exchange ratio acceptable to the shareholders of Modern Pharma if
the P/E ratio of the combined entity is 13 and there is no synergy gain
-S1
ER1 =
(E1 + E2) P/E12

+
S2
P1 S2
- 20
=
(450 + 95) 13
+
10
= 0.21
320 x 10
(f) The minimum exchange ratio acceptable to the shareholders of Magnum Drugs if
the P/E ratio of the combined entity is 12 and the synergy benefit is 2 percent
P2S1
ER2 =
(P/E12) (E1 + E2) (1 + S) P2S2
102 x 20
=
12 (450 + 95) (1.02) 102 X 10
= 0.36
(g) The level of P/E ratio where the lines ER1 and ER2 intersect.
To get this, solve the following for P/E12
- S1
(E1 + E2) P/E12

+
S2
P1S2
- 20
P/E12 (E1 + E2) P2S2
(450 +95) P/E12

+
10
P2S1
102 x 20
=
320 x 10
P/E12 (450 +95) 1020
- 6400 + 545 P/E12
2040
=
3200
545 P/E12 1020
(545 P/E12 1020) (545 P/E12 6400) = 2040 x 3200

297025 P/E212 3488000 P/E12 555900 P/E12
+6528000
= 6528000
2
297025 P/E 12 = 4043900 P/E
297025 P/E12
= 4043900
P/E12
= 13.61
Chapter 37
INTERNATIONAL FINANCIAL MANAGEMENT
1. The annualised premium is :
Forward rate Spot rate
12
x
Spot rate
Forward contract length in months
46.50 46.00
=
12
x
46.00
2.
= 4.3%
3
100
100 (1.06) =
x 1.07 x F
1.553
106 x 1.553
F =
= 1.538
107
A forward exchange rate of 1.538 dollars per sterling pound will mean indifference between
investing in the U.S and in the U.K.
3. (a) The annual percentage premium of the dollar on the yen may be calculated with
reference to 30-days futures
105.5 105
12
x
= 5.7%
105 1
(b)
The most likely spot rate 6 months hence will be : 107 yen / dollar
(c)
Forward rate
1 + domestic interest rate

=
Spot rate
107
1 + foreign interest rate

1 + domestic interest rate in Japan
=
105
1.03
Domestic interest rate in Japan = .0496 = 4.96 per cent

4.
S0 = Rs.46 , rh = 11 per cent , rf = 6 per cent

Hence the forecasted spot rates are :
Year
1
2
3
4
5
Forecasted spot exchange rate

Rs.46 (1.11 / 1.06)1 = Rs.48.17
Rs.46 (1.11 / 1.06)2 = Rs.50.44
Rs.46 (1.11 / 1.06)3 = Rs.52.82
Rs.46 (1.11 / 1.06)4 = Rs.55.31
Rs.46 (1.11 / 1.06)5 = Rs.57.92
The expected rupee cash flows for the project

Year
0
1
2
3
4
5
Cash flow in dollars

(million)
-200
50
70
90
105
80
Expected exchange
rate
46
48.17
50.44
52.82
55.31
57.92
Cash flow in rupees

(million)
-9200
2408.5
3530.8
4753.8
5807.6
4633.6
Given a rupee discount rate of 20 per cent, the NPV in rupees is :

2408.5
NPV =
-9200
+
(1.18)
5807.6
3530.8
+
(1.18)2
4633.6
+
(1.18)4
(1.18)5
= Rs.3291.06 million
The dollar NPV is :
3291.06 / 46 = 71.54 million dollars
5.
Forward rate
1 + domestic interest rate

=
Spot rate
F
1 + foreign interest rate

1 + .015
=
1.60
1 + .020
F = $ 1.592 /
4753.8
(1.18)3
6.
Expected spot rate a year from now
1 + expected inflation in home country

=
Current spot rate
1 + expected inflation in foreign country
Expected spot rate a year from now
1.06
=
Rs.70
1.03
So, the expected spot rate a year from now is : 72 x (1.06 / 1.03) = Rs.72.04
7. (a) The spot exchange rate of one US dollar should be :
12000
= Rs.48
250
(b)
One year forward rate of one US dollar should be :
13000
= Rs.50
260
(1 + expected inflation in Japan)2
8.
Expected spot rate = Current spot rate x
2 years from now
(1 + expected inflation in UK)2
(1.01)2
= 163.46 yen /
= 170 x
(1.03)
9.
(i) Determine the present value of the foreign currency liability (100,000) by using
90-day money market lending rate applicable to the foreign country. This works
out to :
100,000
= 98522
(1.015)
(ii) Obtain 98522 on todays spot market
(iii) Invest 98522 in the UK money market. This investment will grow to
100,000 after 90 days
10. (i) Determine the present value of the foreign currency asset (100,000) by using
the 90-day money market borrowing rate of 2 per cent.
100,000
= 98039
(1.02)
(ii) Borrow 98039 in the UK money market and convert them to dollars in the spot
market.
(iii) Repay the borrowing of 98039 which will compound to 100000 after 90 days
with the collection of the receivable
11. A lower interest rate in the Swiss market will be offset by the depreciation of the US
dollar vis--vis the Swiss franc. So Mr.Sehgals argument is not tenable.
12
INR/CHF = (INR/USD) x (USD/CHF) = 0.0248 x 1.2056 = 0.0299
13
As the forward bid in points is more than the offer rate in points the forward rate is at a
discount. So we have to subtract the points from the respective spot rate. The outright one
month forward quotation for USD/INR is therefore: 41.3524 / 41.3534
( Note that one swap point = 0.0001)
14
USD/INR Spot midrate
= (41.3424 + 41.3435)/2 = 41.34295
USD/INR 1 month forward midrate = ( 41.2050 + 41.2060)/2 = 41.2055
As the forward rate indicates lesser rupee for a dollar, the rupee is at a premium.
The annual percentage of premium = [(41.34295 41.2055)/ 41.34295] x 12 = 0.0399
MINICASE
Outright rates
JPY per USD
INR per USD
Rupee receivable per JPY
Spot
117.43/117.45
44.86/44.87
44.87/117.43
=0.3821
Annualised Premium
Required annualised return
Interest rate per annum to be quoted
( B - A)
Price to be quoted in Yen
for immediate payment
5,000/0.3821
=13,085.58
90 days
180 days
115.83/116.03 113.55/114.73
45.14/45.17
45.32/45.35
45.17/115.83
45.35/113.55
0.3900
0.3994
8.27 %
9.06 %
12%
3.73 %
12%
2.94 %
Chapter 40
CORPORATE RISK MANAGEMENT
(A)
(B)
1.
(b)
(c)
2.
(a) The investor must short sell Rs.1.43 million (Rs.1 million / 0.70) of B
His hedge ratio is 0.70
To create a zero value hedge he must deposit Rs.0.43 million
Futures price
Spot price x Dividend yield

= Spot price -
(1+Risk-free rate)0.5
(1+Risk-free rate)0.5
4200
4000 x Dividend yield

= 4000 -
(1.145) 0.5
(1.145) 0.5
The dividend yield on a six months basis is 2 per cent. On an annual basis it is approximately 4
per cent.
3.
Futures price
(1+Risk-free rate)1
= Spot price + Present value of Present value

storage costs
of convenience yield
5400
= 5000 + 250 Present value of convenience yield
(1.15)1
Hence the present value of convenience yield is Rs.554.3 per ton.
4
LIBOR -25BP
5.25%
EXCEL
EXCEL
CORPN.
LIBOR+ 50BP
SWAP
BANK
LIBOR - 25BP
5%
APPLE
LTD.
5%

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Chapter 2

2.94 5.77 9.09 14.29

Classified cash flow statement

Cash flow from financing activities\

Net increase in cash and cash equivalents

Cash flow from assets

Cash flow to creditors

Cash flow to shareholders

i.e., Cash flow from assets

Cash flow to creditors + Cash flow to shareholders

Classified cash flow statement

Net increase in cash and cash equivalents

Cash flow from assets

Cash flow to shareholders

i.e., Cash flow from assets

Cash flow to creditors + Cash flow to shareholders

Hence Total assets/Equity = 1/0.3

Times interest covered =

= 0.25 or 25 per cent

Net profit = Rs.7000000 x 0.06 = 420,000

Average daily credit sales =

Current liabilities = 800,000

Cost of goods sold

Liabilities and Equity

Short-term bank borrowing

(i) Current ratio

Long-term debt + Short-term bank borrowings

Profit before interest and tax

(v) Inventory turnover period

(vi) Average collection period =

Total assets =Equity + Total debt =( 10,000,000 + 22,500,000 ) +(12,500,000+15,000,000)

Total assets turnover ratio =

(b) Dupont Chart for 20 x 5

(c) Common size and common base financial statements

Regular (in million)

Common Size (%)

Regular (in million)

Common Size (%)

Common Base Year Financial Statements

Regular (in million)

Common Base Year(%)

Regular (in million)

Common Base Year(%)

(d) The financial strengths of the company are:

Asset productivity appears to be good.

Current ratio is unusually low

(e) The following are the problems in financial statement analysis

There is no underlying theory

Are the companys revenues tied to one key customer?

Proforma income statement

Projections for year 3

Current assets, loans & advances :

External funds requirement

300 0.06 x 1,300 (1-0.5)

= (0.61 x 300) (0.06) x 1,300 x (0.5)

Projected Income Statement for Year Ending 31st December , 2001

Projected Balance Sheet as at 31.12 2001

x 80 (0.0625) x 240 x (0.5)

= (60 7.5) = 52.5

Projected Balance Sheet as on 31.12.20X1

Net fixed assets

20 0.0625 x 180 x 0.5

x 20 0.0625 x 200 x 0.5