Risk/Stages High Growth Period Stable Period Average

Business Risk
Financial Risk

Durign high growth periods, a firm can afford to take

higher levels of debts. This is due to the fact that as the
amount of debt increases, there is an icreased risk of
volatility of earnings and bankrupcy. Due to these fears,
shareholders and creditors start demanding higer
compensation. A firm can afford this if it is expecting
above average growth rate and has adequate cash flows.
Also the higher growth rate can instill a feeling of
confidence in shareholders that the strategies adopted by
management are good for the firm. This enables the firm
to raise more capital at an optimal price
 negatuve impact due to possible reasons
1. the extent that a company's cost is lower than company"s return os assets ROA, the shareholders will prefer to borrow mone
2. possibility that ROE of company is lower than company's cost of debt after debt is taken
3. too much debt is a bad thing for companies and shareholders because it inhibits a company's ability to create a cash surplus
4. high debt levels may negatively affect common stockholders, who are last in line for claiming payback from a company that b
that becomes insolvent.
issuing mileage credi
the fair value of the o
Reporting Standards
Incremental Cost Me
eligible award passen
issuing mileage credits to traveling passengers. The Deferred Revenue Method recognizes a liability for
the fair value of the outstanding mileage credits (with “fair value” defined under International Financial
Reporting Standards (IFRS) as “the amount for which the award credits could be sold separately”). The
Incremental Cost Method recognizes a liability for the marginal cost of providing air transportation to
eligible award passengers (i.e. the cost of taxes, fuel, food, etc. to fly one additional passenger on a seat
that otherwise would have been empty—generally a nominal amount)
 for
ncial
The
to
seat
The terminal value forms a major chunk of the enterprise value at 92%
Ideally, this value should be at around 70% mark
However, this may be caused by the fact that we are only considering the 3 years of transition period and not looking at the ca
eriod and not looking at the cashflows during the high growth period
EPS is not a good measure of performance because it does not consider the opportunity cost of capital and can be manipulate

Let us take an example. Assume that a company has 20,000 outstanding shares and earnings available to shareholders is Rs 20
If we consider the effect of increase in cost of equity in our calculations, then this conclusion can be wrong as the increase in E

The companies can manipulate the EPS by reducing the number of outstanding shares by buying back their own shares or reve
EPS per se doesn’t capture the performance of the company as it fails to take into account the price of the share. EPS along wi
Management knows investors rely on using EPS as a guidance for company performance so they’ll naturally want the EPS figur
EPS also doesn’t consider cash flow. Management may focus so much on increasing the earnings figure, they start selling to ba
EPS also ignores inflation, the price of goods and services generally may be increasing, so this could be contributing to the goo
capital and can be manipulated by short-term actions.

ailable to shareholders is Rs 200,000. The EPS is (Rs 2,00,000/ 20,000), or Rs 10. Assume that the company borrows Rs 10,00,000 at an inte
n be wrong as the increase in EPS and increase in cost of equity, these two effects cancel out exactly and the return on invested capital (RO

back their own shares or reverse splitting of stocks.

rice of the share. EPS along with the share price can be used to check the rate of return.
’ll naturally want the EPS figure to appear as high as possible in the short term. They may make decisions to maximise the EPS figure in the
s figure, they start selling to bad customers who don’t pay or sell at lower margins. If the company can’t earn cash to pay its bills, no matte
uld be contributing to the good EPS figure, but this growth might be misleading if the company can’t buy as many goods this year as it cou
orrows Rs 10,00,000 at an interest rate of 8 per cent to buy back 10,000 shares. Assuming an income tax rate of 40 per cent, the earnings a
return on invested capital (ROIC) and the cost of capital do not change with a change in the capital structure. Therefore economic profit (E

maximise the EPS figure in the short term, which may damage the entity’s prospects in the long term.
n cash to pay its bills, no matter how large the earnings are, it may be insolvent.
many goods this year as it could last yea
e of 40 per cent, the earnings available to shareholders after the shares are bought back will be [Rs 2,00,000 - (1.00 - 0.40) x Rs. 80,000] or
e. Therefore economic profit (EVA) remains same with the change in the capital structure
- (1.00 - 0.40) x Rs. 80,000] or 1.52,000. Accordingly, EPS will be reported at [Rs 1,52,000/10,000] or Rs 15.20. What this calculation misses
0. What this calculation misses is the increase in the cost of equity that has taken place because of the company's decision to substitute eq
any's decision to substitute equity by debt. Increasing the proportion of debt in the capital structure of a firm reduces the equity base, wh
m reduces the equity base, which faces this variability of earnings, thereby increasing the riskiness and hence the cost of equity even while
e the cost of equity even while increasing its expected returns. Therefore, it is not correct to conclude that the increase in EPS always refle
he increase in EPS always reflects better performance by the company as it is resulting in indirect cost accreation.
 a) What rate would you adopt to discount the cash flows of Care Infra for transition period and stabl

For transition period

Debt/Equity 0.70

Debt/Asset 0.41
Equity/Asset 0.59

Borrowing type Amount borrowedRate of interest interest cost

Short Term 200 3% 6
Long term 100 5% 5

Interest cost 11
total borrowing 300
Effective borrowing rate,Kd 3.67%
Tax rate 25%

Rf 6%
Beta 0.9
Market risk premium, Rm - Rf 7%
Re (From CAPM) 12.3%

WACC 8.37%

For stable Period

Debt/Equity 0.67

Debt/Asset 0.4
Equity/Asset 0.6

Borrowing type Amount borrowedRate of interest interest cost

Short Term 200 3% 6
Long term 100 5% 5

Interest cost 11
total borrowing 300
Effective borrowing rate,Kd 3.67%
Tax rate 25%

Rf 5%
Beta 0.8
Market risk premium, Rm - Rf 7%
Re (From CAPM) 10.6%

WACC 7.46%
ansition period and stable period.
*Amount is in INR million

Assumptions
Transition Period length 3 years

Short Term WACC 8.37%

Long term WACC 7.46%

2016 (base year) 2017 2018 2019

Growth Rate in revenue 15% 12% 9%
Tax rate (constant) 25% 25% 25% 25%
Capex growth rate 15% 10% 5%
Capex 500
Depreciation as % of capex 25% 25% 25% 25%

Working Capital calculation

Debtors 300
Inventory 200

Accounts Payables 200

Short term Borrowings 200
Working capital 100
% working capital as % of revenue 2.0% 2.0% 2.0% 2.0%

Base Year (2016) 2017 2018 2019

Year 0 1 2 3

Revenue 5000.0 5750.0 6440.0 7019.6

COGS+Depreciation+SG&A 3500.0 4025.0 4508.0 4913.7
EBIT 1500.0 1725.0 1932.0 2105.9
NOPAT 1125.0 1293.8 1449.0 1579.4

FCFF
Add : NOPAT 1293.8 1449.0 1579.4
Add : Depreciation 143.75 158.13 166.03
Less : Capex 500.00 575.00 632.50 664.13
Less : Increase in working capital 15.00 13.80 11.59

FCFF 847.5 960.8 1069.7

FCFF Terminal value 45658.96

PV factor 0.922785 0.851531 0.78578

FCFF PV 782.06 818.1727 36718.48
Total FCFF 38318.71
2020
5%
25%
5%

25%

2.0%