NMIMS

CORPORATE FINANCE
APPLICABLE FOR JUNE 2022 EXAMINATIONS

1. Determine the present value of INR 2500 invested today assuming a rate of return of
10%. Define the concept of Present value. Compute- the Present value received one year
from now, received at the end of 5 years, received at the end of 10 years. Discuss with
reason, which of the three values, is the lowest one.

Answer:

The present value is used to describe how much a future value is worth at the present time
given a specific discount rate.

PV=FV/ (1+r)^n

If the future value, FV, is Rs. 2500 and the discount rate is 10%, then

i) Present value received one year from now

PV=Rs.2500/(1+0.1)^1

PV=Rs. 2272.73+

ii) Present value received at the end of 5 years

PV=Rs. 2500/(1+0.1)^5

PV=Rs. 1552.30

iii) Present value received at the end of 10 years

PV=Rs. 2500/ (1+0.1)^10

PV=Rs. 963.86

The present value at the end of ten years from now is the lowest. This is because the more the
amount is being compounded, the lesser it is.

2. For a business firm leverage is about the fixed operating cost and the fixed finance
costs in the cost structure of the firm. For the given details, identify for which firm the
degree of operating leverage and degree of financial leverage are higher and why so:

Firms Amrit Baayu

Sales (Rs.) 3,60,000 7,50,000
Variable cost 20 150
p.u 72,000 1,40,000
Fixed cost (Rs.) 6,000 1,500
Output (units) 40,000 80,000
Interest

Answer:

Degree of operating leverage

Particulars Amrit Baayu

36000
Sales 750000
0
12000
Less: Variable cost (p.u*output) 225000
0
24000
Contribution 525000
0
 Less: Fixed cost 72000 140000
16800
EBIT 385000
0
Less: Interest 40000 80000
12800
EBT 305000
0

Amrit

DOL = {Q(S—V)} / {Q(S—V)—F}

= [6000(240000)]/ [6000(240000)- 72000]

= 1440000000/1440000000-72000

= 1440000000/1439928000

= 1.00005 (Approx)

Baayu

DOL = {Q(S—V)} / {Q(S—V)—F}

= [1500 (525000)/ [1500 (525000) – 140000

= 787500000/787500000-140000

= 787500000/ 7873600000

= 1.00018

Degree of financial leverage

Amrit

EBIT/EBT

= 168000/128000

= 1.31

Baayu

EBIT/ EBT

= 385000/ 305000

= 1.26

The degree of operating leverage measures how much a company's operating income
changes in response to a change in sales. The DOL ratio assists analysts in determining the
impact of any change in sales on company earnings. A company with high operating leverage
has a large proportion of fixed costs, meaning a big increase in sales can lead to outsized
changes in profits. The company with higher degree of operating leverage is better.
Therefore, Baayu’s degree of operating leverage is Slightly better than Amrit..

Degree of financial leverage shows that a 1% change in the company’s leverage will change
the company’s operating income by 1.31% for Amrit and 1.26% for Baayu. This ratio
indicates that the higher the degree of financial leverage, the more volatile earnings will be.
The use of financial leverage varies greatly by industry and by the business sector. High
degree of financial leverage means the company is using more debts. High degree of leverage
indicates higher financial risk. So in terms of financial leverage Baayu is better than Amrit.

As per the interpretation above Baayu is better than Amrit in terms of degree of operating and
financial leverage.
3. Project costs Rs 180,000 and is expected to generate cash inflows as:
Yea Cash Inflows (Rs.)
r
1 20000
2 24000
3 30000
4 36000
5 40000

a. Discuss the characteristics of long term capital budgeting decisions

b. Calculate the Net Present Value of the project if the cost of capital is 12% and
conclude.

Answer:

A)

Capital budgeting decision may be defined as the firm's decision to invest its funds in the
long term assets in anticipation of an expected flow of benefits over a number of years. It
involves a current outlay or series of outlays of cash resources in return for an anticipated
flow of future benefits.

As per Robert N. Anthony, “Capital Budget is essentially a list of what management believes
to be worthwhile projects for the acquisition of new capital assets with the estimated cost of
each product”. Hence, Capital Budgeting may be defined as the decision making process by
which firms evaluate the purchase of major fixed assets, including buildings, machinery, and
equipment or investment in any project or extension of existing capacity, etc.

Capital investment involves a cash outflow in the immediate future in anticipation of returns
at a future date. The capital investment decisions assume vital significance in view of their
marked bearing on corporate profitability needs no emphasis. The investment proposals need
to be related to the underlying corporate objectives and strategies. A key challenge for all
organizations is to identify projects which fit these strategies and promise to be profitable in
the broadest sense i.e., to create wealth for the organization. Capital investment decisions
usually involve large sums of money, have long time-spans and carry some degree of risk and
uncertainty.

Characteristics of long-term capital budgeting decisions:

(а) It involves huge outflow of funds or capital.

(b) There is a time gap between the investment of funds and’ anticipated or future benefits.

(c) Involves a high degree of risk as the decisions have a long term effect on the profitability
of a company.

(d) Most of the capital budgeting decisions are of irreversible nature i.e., once the firm has
initiated the investment, it cannot revert back otherwise it has to incur heavy losses.

(e) It helps an enterprise from making over investment and under investment relative to its
size of business.

Because of aforesaid features of the capital budgeting decisions, they constitute most
important decisions in corporate management and are exercised with great caution. Any
decision taken under capital budgeting has long term effect on the functioning and
profitability of the company.

If the decision taken goes in the right direction, it will have positive impact on the
profitability of the company and if it goes in the wrong direction it will have negative impact
on the profitability of the company. Reversing the decisions already initiated leads to
unnecessary heavy loss to the company.

B)

Net present value of the project:

 Yea PV factor @
Cash Inflows (Rs.) Present Value of cash flows
r 12%
1 20000 0.893 17860
2 24000 0.797 19128
3 30000 0.712 21360
4 36000 0.636 22896
5 40000 0.567 22680
Present value of outflow 103924

NPV of Project:
Particulars Amount (Rs.)
Present Value of inflow 180000
Present Value of outflow 103924
NPV -76076

As the NPV is negative, we should not accept the project.