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Q. 3 Alpha Ltd., has decided to install a new lathe machine. The machine costs Rs. 1,200,000 and it
would have a useful life of five years with a scrap value of Rs. 240,000 at the end of the fifth year.
A decision has now to be taken on the method of financing the project. The two under
consideration proposals are as under:
(i) The company could purchase the machine for cash, using bank loan facilities on which the
current rate of interest is 9% after tax.
(ii) The company could lease the machine under an agreement which would entail payment of
Rs. 288,800 at the end of each year for the next five years.
The company can claim depreciation allowances of 25% on reducing balance basis over the
machine’s five year, life, if it is purchased. Depreciation is also deductible for tax purpose in case
of lease and the company uses straight-line depreciation method in its accounts under lease
arrangement. The implicit interest at 6.4% of the lease payments is also deductible for tax
purposes. The company falls under the tax regime of 35%.
Required:
Calculate the present value of the lathe machine cost under lease and purchase option. What
method of financing would you recommend and why? 17
Q. 4 (a) In the beginning of the current year, the total market value of the Syed Limited was
Rs. 170 million. The company’s market value capital structure, shown below, is considered
to be optimal. Assume that there is no short-term debt.
Rupees
Debt 70,000,000
Common equity 100,000,000
Total capital 170,000,000
Syed Limited is considering a project that will result in initial after-tax cash savings of
Rs. 14 million at the end of the first year and these savings will grow at a rate of 5% per
year indefinitely. The firm has a target debt-equity ratio of 0.70, cost of equity of 13% and
after-tax cost of debt of 5.5%. The cost-saving proposal is some what riskier than the usual
projects the firm undertakes; management uses the subjective approach and applies an
adjustment factor of plus 2% to the cost of capital for such risky projects.
Required:
(i) Should the company take on the project if the initial investment is Rs. 200 million?
What would be the outcome of the project? (Show all your computations.) 07
(ii) Syed Limited is to raise Rs. 200 million for a new project externally and its flotation
costs for selling debt and equity are 2% and 16%, respectively. If flotation costs are
considered, what is the true initial investment of the new project? Is the project viable
considering the flotation cost? 05
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Marks
(b) A feasibility study, covering all aspects of a project undertaken by a carefully selected team
is vital in assessing whether an investment is worthwhile or not. Feasibility studies are
essential for investments and projects that are likely to be long-term in nature and
complicated. State five key areas in which a project must be feasible, if it is to be selected.
Also briefly explain any two (2) key areas out of five. 08
Q. 5 (a) National Packages Limited has to decide between two mutually exclusive investment
projects. The project cost of Rs. 15,500,000 each and has an expected life of 3 years.
Annual net cash flows from each project begin one (1) year after the initial investment is
made and have the following probability distributions: Rs. ‘000’
Project ‘A’ Project ‘B’
Probability Net Cash Flows Probability Net Cash Flows
0.2 14,000 0.2 0
0.6 15,500 0.6 15,500
0.2 17,000 0.2 38,000
The company has decided to evaluate the more risky project at 12% rate and the less risky
project at 10% rate.
Required:
(i) What is the expected value of the annual net cash flows from each project? What is the
coefficient of variation? 07
(ii) What is the risk-adjusted NPV of each project? Which project the company should
accept? 02
(iii) If it were known that Project ‘B’ was negatively correlated with other cash flows of the
firm whereas Project ‘A’ was positively correlated, how would this knowledge affect the
decision for opting the project? 01
(b) ABC Ltd., is considering an investment in a small project that has a cost of Rs. 300,000.
The project will produce 1,000 cartons of Product-X per year indefinitely. The current sales
price is Rs. 276 per carton. The current variable cost per carton is Rs. 210. The tax rate of
the firm is 35%. The sales price and cost are expected to rise at a rate of 6% per annum.
The firm uses only equity, and its cost of capital is 15%. You may assume that there would
be no fixed cost or depreciation.
Required:
Would you recommend ABC Ltd., to accept the project? 05
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