1.

A Project costs ₹ 1,00,000 and is expected to generate cash inflows as:

Year Cash inflows(₹)
1 20,000
2 22,000
3 25,000
4 28,000
5 20,000
The cost of capital is 12%. Calculate Profitability Index and suggest whether project
should be accepted or not.

Answer:Profitability Index
Profitability index is also known as benefit cost ratio. Profitability index is theratio of the present
value of cash inflows to initial cash outlay. The discountfactor based on the required rate of
return is used to discount the cashinflows.
P1= Present value of cash inflows / initial cash outlay

Accept or reject criteria

 Accept the project if PI is greater than 1
 Reject the project if PI is less than 1
If profitability index is 1 then the management may accept the projectbecause the sum of the
present value of cash inflows is equal to the sum ofpresent value of cash outflows. It neither adds
nor reduces the existingwealth of the company.

Merits of PI
 It takes into account the time value of money
 It is consistent with the principle of maximisation of share holderswealth
 It measures the relative profitability

Demerits of PI
 Estimation of cash flows and discount rate cannot be doneaccurately with certainty
 A conflict may arise between NPV and profitability index if a choicebetween mutually
exclusive projects has to be made.

Present value of cash Outflow

YEAR PV FACTOR @ 12% CASH FLOW PV OF CASH FLOW
0 1 100000 100000

Present value of cash Inflows

YEAR PV FACTOR @ 12% CASH FLOW PV OF CASH FLOW
1 0.893 20000 17860
2 0.797 22000 17534
3 0.712 25000 17800
4 0.636 28000 17808
5 0.567 20000 11340
82342
PI = Total of present value of cash inflows/Total of present value of cash outflows

= 82342/100000

= 0.82

Conclusion: The project should not be accepted, because the profitability index is less than 1 i.e
the project will result in a net loss of Rs. 17,658(100000-82342).

2. Alok works in an organization which has debt and equity in its capital structure. The net
income of the firm is ₹ 2,00,000. The organization pays ₹ 50,000 every year as interest
component to debenture holders. Calculate the weighted average cost of capital if the cost
of equity is 12% and cost of debt is 9%. If the company’s new project will provide a return
of 10%, suggest whether company should make the investment or not.

Answer:Weighted Average Cost of Capital

The term cost of capital refers to theoverall composite cost of capital or the weighted average
cost of eachspecific type of fund. The purpose of using weighted average is to considereach
component in proportion of their contribution to the total fund available.

Use of weighted average is preferable to simple average method for thereason that firms do not
procure funds equally from various sources andtherefore simple average method is not used. The
following steps areinvolved to calculate the WACC
Step I: Calculate the cost of each specific source of fund, that of debt,equity, preference capital
and term loans.
Step II: Determine the weights associated with each source.
Step III: Multiply the cost of each source by the appropriate weights.
Step IV: WACC = We Ke + Wr Kr + WpKp + WdKd + WtKt

Assignment of weights
Weights can be assigned based on any of the following methods
 The book value of the sources of the funds in capital structure
 Present market value of funds in the capital structure and
 Adoption of finance planned for capital budget for the next period

As per the book value approach, weights assigned would be equal to eachsource’s proportion in
the overall funds. The book value method ispreferable. The market value approach uses the
market values of eachsource and the disadvantage in this method is that these values changevery
frequently.

Solution: E = equity;
D = debt
V= value of the organization
Given:
Net income = NI =Rs. 200000
Interest on debenture = Rs. 50000
Cost of equity =Ke = 12%
Cost of debt =Kd = 9%
Rate of return = 10%

The value of the firm is equal to the sum of values of all securities:
E = NI - interest
Ke

= 200000 - 50000
0.12

= 150000
0.12

= 1250000

D = Interest / Kd

= 50000/0.09

= 555555

V=E+D

= 1250000 + 555555

= 1805555

The weighted average cost of capital, ko, is:

K0 = NI/V

= 200000/1805555

= 0.1108 OR 11.08%

Therefore, WACC of the organisation is 11.08%

Conclusion: Company use WACC as a tool to decide whether to invest or not. The WACC
represents the minimum rate of return at which a company produces value for its project. By
contrast, if the company’s return is less than WACC, the company is shedding value, which
indicates that the company should put their money elsewhere and not to invest in that project. In
our problem WACC is 11.08% and rate of return is 10%. Therefore, the company should not
accept the project.
3. Mr. Sharma was working with Delta Ltd for the past five years. The company was
planning for expansion and required a funding of ₹ 20,00,000 for the same. He was
considering two financial plans and expected EBIT due to expansion was ₹ 8,00,000. Apart
from equity(Face value ₹10) , if the company raised debt, cost of debt was 8%. Tax rate is
35%. Calculate EPS for each financial plan and suggest which financial plan is better for
the firm.
3a) Plan A: Funding through 100% equity
3b) Plan B: Funding through 50% Equity and 50 % Debt

Answer:EPS is calculated by dividing profit after taxes, EAT, (also called net income, NI)by the
number of shares outstanding. EAT is found out in two steps. First, theinterest on debt, INT, is
deducted from the earnings before interest and taxes,EBIT, to obtain the profit before taxes,
PBT. Then, taxes are computed on andsubtracted from EBT to arrive at the figure of EAT. The
formula for calculatingEPS is as follows:

Earnings per share = Profit after tax/ Number of shares

Calculation of EPS
PARTICULARS OPTION A OPTION B
Equity share capital 2000000 1000000
Debentures - 1000000
Total funds 2000000 2000000
EBIT 800000 800000
Less: Interest - 80000
EBT 800000 720000
Less: Tax @ 35% 280000 252000
EAT 520000 468000
No. of Equity shares (Equity shares/face value) 200000 100000
EPS(EAT/No. of equity shares) 2.6 4.68

Conclusion: Mr. Sharma was working with Delta Ltd for the past five years. The company was
planning for expansion and required a funding of ₹ 20,00,000 for the same. So, Out of the two
option available, option 2 is better because of higher EPS i.e 4.68 as compared to option 1 having
a lower EPS of 2.6.