Name: Duration: 2 Hours Sec:

Finance II Mid-Term Exam Feb 2016

Answer the questions in the answer booklet only. Marks will be awarded only for showing ALL
relevant steps. Put up appropriate justification for your assumptions wherever applicable.
Untidy work will be penalized. Rough work should be done at the end of answer booklet only.
Calculators are allowed. Do NOT write with pencil.
Part – A (25 Marks)
1. Alok had joined Sagar Manufacturing Private Ltd. (SMPL) as a General Manager last month,
after completing his MBA from IIM Indore. Mr. Vinod Saxena, the young and energetic CEO of
SMPL, had approached him last week, and asked him to evaluate two mutually exclusive and
standalone projects, one of which SMPL would eventually pursue. SMPL was a privately owned,
domestic manufacturing company, which Mr. Saxena had set up in the early 90s. Alok was going
through the details of the projects, and was wondering as to which one of these two projects he should
recommend to Mr. Saxena to maximize the value of his firm.
Case 1: Project Base
Alok is required to calculate the Net Present Value of cash flows generated by Project Base. The life
of the project is 3 years. Alok made a quick note for himself, to put the structure of his project
evaluation and analysis on pen and paper:
(a) Estimation of Revenues: Under Project Base, SMPL is expected to sell a total volume of 1
million units of its products during the next three years. 30% of the total sales would come by the
end of the first year, another 30% during the second year, and remaining volume in the third
year. The average selling price per unit of product is expected to remain constant at Rs. 80 per
unit in each of these years.

(b) Estimation of Operating Expenses: The cost of goods sold per unit of product is expected to
remain constant at Rs. 40 per unit. Further, the project will require hiring of 500 labourers on
contract from the very beginning, and maintaining the strength at that level till the end. Average
labourer salary is expected to be Rs. 1,000 per month over the life of the project. The incremental
rental expense and utility charges for the project would be Rs. 60,000 and Rs. 20,000 per month
respectively, during each of these three years. For the purpose of NPV calculation, all such
monthly cash flows would be annualized, and assumed to occur at the end of the corresponding
year.

(c) Information on Capital Expenditure and Working Capital Requirements: For this project,
SMPL would require to purchase 15 machines, each costing Rs. 500,000. Half of the payment for
purchasing the machines have to be paid up front, while the remaining 50% would be paid at the
end of first year. Depreciation would be charged as per SLM assumptions, assuming 5 years of
useful life and zero salvage value thereafter. Since all the machines would be deployed
immediately upon purchase, the depreciation schedule for all the machines would start from the
beginning of the first year itself. SMPL expected to sell these machines in the open market for a
combined value of Rs. 5 million at the end of the project. However, SMPL would be required to
pay 20% capital gains tax on its capital gains from any asset sales. Additionally, the firm would
require to invest in net working capital at the beginning of any year, which would be roughly
equal to 15% of the total project revenues to be earned in that year. The entire working capital
remaining at the end of three years would be sold off at book value at the end of the project.
(d) Cost of Capital Assumptions: The risk-free rate could be assumed to be 7.0%, which is the
current yield on 10-Year government bonds. The equity risk premium is expected to be 5.5%.
The project would be financed by 35% debt and 65% equity, in market value terms. The debt
raised in this project would carry a default risk that is equivalent to that of an A-rated long term
bond. Information on credit spreads and beta of comparable firms, with similar risk profile as
Project Base, is provided in Exhibits 1 and 2, respectively. The effective tax rate applicable for
SMPL would be 34%.
Under the given assumptions, you are required to calculate the following: [13 marks]
(i) Operating Profit from the project during Years 1, 2 and 3 (3 marks)
(ii) Net Cash Flow from the project during Years 0, 1, 2 and 3 (4 marks)
(iii) Pre-tax cost of debt (1 mark)
(iv) Levered beta of the project (2 marks)
(v) Cost of equity of the project (1 mark)
(vi) Average Cost of Capital of the project (1 mark)
(vii) NPV of the project (1 marks)
Case 2: Project Extended
SMPL was also thinking of an alternate project (mutually exclusive), which would also have a project
life of three years, and would generate a combined sales volume of 1.2 million units of its products,
with 350,000 units of sales in first year, 400,000 units of sales in second year, and the remaining sales
coming from the last year. The added sales volume would come largely from marketing and brand
promotion campaign which is expected to cost Rs. 1 million, with 60% expense incurring in the first
year, 30% expense in second year, and 10% in the last year. As a part of the marketing campaign,
SMPL would also be offering a price discount of 10% due to which the average selling price would
come down to Rs. 72 per unit of product.
The firm was expected to procure premium version of machines in this project to meet the higher
production capacity requirement. Each of the 15 machines procured under this project would be 50%
more expensive, and the entire money have to be given up front to the vendor. These expensive
machines would have a useful life of 3 years, and zero salvage value beyond that. However, using the
expensive version of machines would generate two additional benefits for the project. First, it would
reduce the cost of goods sold to Rs. 30 per unit of product. Second, it would reduce the manpower
requirement to only 400 contractual labourers at any point of time in this project. Labour cost per
person, rental expense, utility charges and depreciation recognition method would remain unchanged,
as before.
Project Extended would be financed by 40% debt and 60% equity, in market value terms. Although
the leverage would marginally increase due to this, debt raised in this project would be rated higher,
and its default risk would be considered equivalent to that of an AA-rated long term bond due to
significant improvement in the operating margins. All the other assumptions related to cost of capital
calculations could be assumed to remain unchanged, as earlier.
Under the given assumptions, you are required to calculate the following: [11 marks]
(viii) Operating Profit from the project during Years 1, 2 and 3 (3 marks)
(ix) Net Cash Flow from the project during Years 0, 1, 2 and 3 (4 marks)
(x) Levered beta of the project (1 mark)
(xi) Cost of equity of the project (1 mark)
(xii) Average Cost of Capital of the project (1 mark)
(xiii) NPV of the project (1 marks)
Final Recommendation: [1 mark]
Comparing the NPV of the two projects, which one would you suggest Alok to recommend to Mr.
Saxena to pursue? Why? (1 mark)

Part – B (15 Marks)

1. State whether True or False. Wrong answers will attract 50% negative marks:
[10 X 1 = 10 Marks]
a. Pecking order theory implies that external financing is always favoured over internal
financing.
b. The holder of an INR 1,000 face value bond can exchange the bond any time till its
maturity for 25 shares of stock. Then, the conversion ratio of such a convertible bond
is 40.
c. Under no tax, no bankruptcy costs and perfect capital market assumptions,
Modigliani-Miller proposition states that any firm would be indifferent to whether it
issues stock or it issues debt.
d. Issuing convertible bonds instead of straight bonds will increase the agency conflicts
between the bondholders and the shareholders of the issuing firm.
e. The IRR of normal1 Project X is equal to the IRR of normal Project Y, and both IRRs
are 25%. At zero cost of capital the NPV of X is much greater than Y. Thus, at any
cost of capital less than the IRR, X should be generally preferred over Y.
f. The coupon rate on a convertible bond is higher than an otherwise identical straight
bond.
g. A project that has been accepted based on Payback period approach may have an IRR
that is lower than its discount rate.
h. If the IRR of normal1 Project X is greater than the IRR of mutually exclusive Project
Y (also normal), we can conclude that the firm will select Project X rather than
Project Y if Project X has a positive NPV.
i. Payback period approach is biased towards long term projects.
j. When warrants are exercised, it brings in additional cash to the firm which has issued
the warrants, and also increases the number of shares outstanding of the firm.
Note: 1. Normal projects are investing type projects whose first cash flow is negative and all remaining cash
flows are positive.

2. You are considering two mutually exclusive options for buying a pantry equipment:

Option Eat-well Option Cook-well

Initial cost INR 150,000 INR 210,000
Annual maintenance cost INR 9,000 INR 6,000
Life 2 years 3 years

a. If the discount rate is 10% and the benefits derived from the usage of the two pantry
equipment are exactly similar, which of the above alternatives would you pick for
your capital expenditure decision? (2 marks)
b. What is the IRR of a stream of cash flows, which are all negative, and exactly similar
to Option Eat-well? (1 mark)
 3. Your firm has only INR 40 million available for investments this year. The available
new-investment opportunities for your firm are listed below:

Investment option Initial investment NPV

(INR millions) (INR millions)
Option 1 20 6
Option 2 10 5
Option 3 30 8
Option 4 10 8

Which investment option(s) would you pick based on the profitability index? (2 marks)
*****

Exhibit 1: Debt Ratings and Default Spreads

Rating on Long Term Debt Default Spread (above Risk-free Rate),

in basis points1
AAA 50
AA 100
A 150
BBB 200
BB 250
B 300
Notes:
1. 100 basis points is equivalent to 1 percentage point.

Exhibit 2: Information on Comparable Manufacturing Firms

Name of Firm Assets Levered Beta Debt-to-Total Capital

(INR millions) Ratio (%)
Hans Raj Ltd. 2,000 2.0 30%
Apollo Ltd. 3,000 1.5 40%
Jindal Ltd. 2,500 1.8 25%
Moser Ltd. 1,500 1.3 29%