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Q1. A. What is the cost of retained earnings? Cost of Retained Earnings Cost of retained earnings (ks) is the return stockholders require on the company’s common stock. There are three methods one can use to derive the cost of retained earnings: a) Capital-asset-pricing-model (CAPM) approach b) Bond-yield-plus-premium approach c) Discounted cash flow approach a) CAPM Approach To calculate the cost of capital using the CAPM approach, you must first estimate the riskfree rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected rate of return on the market (rm). The next step is to estimate the company’s beta (bi), which is an estimate of the stock’s risk. Inputting these assumptions into the CAPM equation, you can then calculate the cost of retained earnings.
b) Bond-Yield-Plus-Premium Approach This is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the interest rate of the firm’s long-term debt and add a risk premium (typically three to five percentage points):
ks = long-term bond yield + risk premium
Discounted Cash Flow where: ApproachAls D1 = next year’s dividend o known as g = firm’s constant growth rate the “dividend P0 = price yield plus growth approach”. Explain Miler Q3. Using the dividend-growth model, you can rearrange the terms as follows to determine ks.
ks = D1 + g; P0
Q1. B. A company issues new debentures of Rs. 2 million, at par; the net proceeds being Rs. 1.8 million. It has a 13.5 per cent rate of interest and 7 years maturity. The company’s tax rate is 52 per cent. What is the cost of debenture issue? What will be the cost in 4 years if the market value of debentures at that time is Rs. 2.2 million? Ans:Cost of capital = 2 million Net proceeds = 1.8 million Interest rate = 13.5% Tax rate = 52% Interest = 2million× 13.5⁄100 =2270000 1. Kd =I (1-T)⁄NP 270000 (1―0.52)⁄1.8 million 270000×0.48⁄1800000 =0.072 = 7.2% 2. kd =I (1―T) ⁄MP = 270000(1―0.52)⁄ 2200000 = 270000×0.48 ⁄2200000 =0.0589 =5.89%
2. Volga is a large manufacturing company in the private sector. In 2007 the company had a gross sale of Rs.980.2 crore. The other financial data for the company are given below: Items Net worth Borrowing EBIT Interest Fixed cost (excluding interest) Rs. In crore 152.31 165.47 43.17 34.39 118.23
You are required to calculate: a. Debt equity ratio b. Operating leverage c. Financial leverage d. Combined leverage. Interpret your results and comment on the Volga’s debt policy. Ans:a.) debt equity ratio = net worth/ Borrowing 152.31/ 165.45 =0.92 b.) operating leverage = contribution / EBIT contribution = fixed assets + EBIT 118.23+ 43.17 = 161.40 OL =161.49 / 43.17 =3.738 c.) financial leverage = EBIT / EBI EBI = EBIT ― interest = 43.17― 34.39 = 8.78 FL = 43.17 / 8.78
=4.916 d.) combined leverage = operating leverage × financial leverage = 3.738 × 4.916 =18.376 • • The investor may take debt- equity ratio as quite satisfactory if share holders funds are equal to borrowed funds. Operating leverage may be favorable or unfavorable. High degree of operating leverage indicates high degree of risk. It is good when revenues are rising and bed when then they are falling. Operating risk is the risk of the firm not being able to cover its fixed operating costs. In this question operating leverage is high so it is a high risk to investment money.
Q3. Explain Miler and Modigliani Approach to capital structure theory? Ans- The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance Principle Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions. Miller was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for their "work in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory of corporate finance." Historical background Miller and Modigliani derived the theorem and wrote their path breaking article when they were both professors at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University. In contrast to most other business schools, GSIA put an emphasis on an academic approach to business questions. The story goes that Miller and Modigliani were set to teach corporate finance for business students despite the fact that they had no prior experience in corpora the finance. When they read the material that existed they found it inconsistent so they sat down together to try to figure it out. The result of this was the article in the American Economic Review and what has later been known as the MM theorem. Propositions The theorem was originally proved under the assumption of no taxes. It is made up of two propositions which can also b e extended to a situation with taxes. Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value of the two firms is the same. Without taxes Proposition I: where VU is the value of an unlevered firm = price of buying a firm composed only of equity, and VL is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity. To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual
returns to either of these i investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt. This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information or in the absence of efficient markets.
Q4. How to estimate cash flows? What are the components of incremental cash flows? Cash flow estimation Cash flow estimation is a must for assessing the investment decisions of any kind. To evaluate these investment decisions there are some principles of cash flow estimation. In any kind of project, planning the outputs properly is an important task. At the same time, the profits from the project should also be very clear to arrange finances in a proper way. These forecasting are some of the most difficult steps involved in the capital budgeting. These are very important in the major projects because any kind of fault in the calculations would result in huge problems. The project cash flows consider almost every kind of inflows of cash. The capital budgeting is done through the coordination of a wide range of professionals who are going to be involved in the project. The engineering departments are responsible for the forecasting of the capital outlays. On the other hand, there are the people from the production team who are responsible for calculating the operational cost. The marketing team is also involved in the process and they are responsible for forecasting the revenue. Next comes the financial manager who is responsible to collect all the data from the related departments. On the other hand, the finance manager has the responsibility of using the set of norms for better estimation. One of these norms uses the principles of cash flow estimation for the process. There are a number of principles of cash flow estimation. These are the consistency principle, separation principle, post-tax principle and incremental principle. The separation principle holds that the project cash flows can be divided in two types named as financing side and investment side. On the other hand, there is the consistency principle. According to this principle, some kind consistency is necessary to be maintained between the flow of cash in a project and the rates of discount that are applicable on the cash flows. At the same time, there is the post-tax principle that holds that the forecast of cash flows for any project should be done through the after-tax method. Incremental Principle The incremental principle is used to measure the profit potential of a project. According to this theory, a project is sound if it increases total profit more than total cost. To have a proper estimation of profit potential by application of the incremental principle, several guidelines should be maintained: Incidental Effects: Any kind of project taken by a company remains related to the other activities of the firm. Because of this, the particular project influences all the other activities carried out, either negatively or positively. It can increase the profits for the firm or it may cause losses. These incidental effects must be considered. Sunk Costs: These costs should not be considered. Sunk costs represent an expenditure done by the firm in the past. These expenditures are not related with any particular project. These
costs denote all those expenditures that are done for the preliminary work related to the project, unrecoverable in any case. Overhead Cost: All the costs that are not related directly with a service but have indirect influences are considered as overhead charges. There are the legal and administrative expenses, rentals and many more. Whenever a company takes a new project, these costs are assigned. Working Capital: Proper estimation is essential and should be considered at the time when the budget for the project's profit potential is prepared. 5. What are the steps involved in capital rationing? AnsCapital rationing:- capital rationing means the allocation of the limited funds available for financing the capital projects to only some of the profitable project in such a manner that the long term returns are maximized. In other words, it means the selection of only some of the profitable investment proposals or projects out of several profitable investment proposals available. Objective of capital rationing The main objective of capital rationing is, to ensure the selection of only those profitable investment proposals that will provide the maximum long term returns. Effect of capital rationing
1. When there is capital rationing, a firm will not be able to undertake all the profitable
investment proposals. It has accept only some of the profitable investment proposals and reject the other profitable investment proposals. 2. When the capital rationing, it will be possible for the firm to maximize the wealth of the owners and to maximize the market value per share. Steps involved in capital rationing Capital rationing involves two important steps. They are:a. Ranking of the different investment proposals:- the different investment proposals
or capital project available, should be ranked on the basis of their profitability (i.e, on the basis of their net present value or profitability index or the internal rate of return), in the descending order. b. Selection of some of the profitable proposals:- on the basis of their profitability in the descending order, the selection of that combination of profitable investment proposals, which would provide the highest profitability, should be made subject to the budget constraint for the period.
6. Equipment A has a cost of Rs.75,000 and net cash flow of Rs.20000 per year for six years. A substitute equipment B would cost Rs.50,000 and generate net cash flow of Rs.14,000 per year for six years. The required rate of return of both equipments is 11 per cent. Calculate the IRR and NPV for the equipments. Which equipment should be accepted and why? Ans-
Project ( A) Year Cost of inflow PV factor @11% Present value
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
20000 20000 20000 20000 20000 20000
0.901 0.812 0.731 0.656 0.593 0.535 Total
18020 16240 14620 13120 11860 10700 84560
NPV=PV of cash inflow ―cash outflow =84560―75000 = 9560
Project (B) Year Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Cost of inflow 14000 14000 14000 14000 14000 14000 PV factor @11% 0.901 0.812 0.731 0.656 0.593 0.535 Present value 12614 11368 10234 9184 8302 7490
NPV=PV of cash inflow ―cash outflow = 59192― 50000 = 9192 Yeat 1 2 3 4 5 6 Project A 20000 20000 20000 20000 20000 20000 Project B 14000 14000 14000 14000 14000 14000
Project A Avg. of annual cash inflow = total cash inflow ⁄ no. Of year 120000 ⁄6 =20000 Divide the initial investment by the average of annual cash inflows = 75000 ⁄20000 =3.57 From the PVIFA table for 6 years, the annuity factors very near to 15% and above to 16%
Project A year Cash inflow 20000 20000 20000 20000 20000 20000 PV factor @15% 0.870 0.756 0.658 0.572 0.497 0.432 @16 0.826 0.743 0.641 0552 0.476 0.410 PV of cash flow @15% 17400 15120 13160 11440 9940 8640 75700 @16% 17240 14860 12280 11040 9520 8200 73140
1 2 3 4 5 6 total
IRR =minimum rate of interest+[diff. between PV of cash inflow x ― cash out flow ⁄diff. b/w of x and y] × 1 = 15+[75700 ― 75000/75700―73140]×1
= 15+0.273 = 15.273%
Project B Avg. of annual cash inflow = total cash inflow ⁄ no. Of year 84000 ⁄6 = 14000 Divide the initial investment by the average of annual cash inflows = 50000 ⁄14000 =3.571 From the PVIFA table for 6 years , the annui ty factors very near to 16% and above to 18%
Project B year Cash inflow 14000 14000 14000 14000 14000 14000 PV factor @16% 0.826 0.743 0.641 0.552 0.476 0.410 @18% 0.847 0.718 0.609 0516 0.437 0.370 @16% 12080 10402 8974 7728 6664 5740 51576 PV of cash flow @18% 11858 10052 8526 7224 8118 5180 48952
1 2 3 4 5 6 total
IRR =minimum rate of interest+[diff. between PV of cash inflow x ― cash out flow ⁄diff. b/w of x and y] × 1 = 16+[51576 ― 50000/51576―48952]×1
= 16+0.60 = 16.60% •
The internal rate of return is greater than the firm’s cost of capital, accept the proposal. Otherwise reject the proposal Based on NPV both project A and B are eligible to be accept. However, project A is preferable because its NPV is more than that of project B.
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