MOUNT CARMEL COLLEGE I.S.D.C.

DIVIDEND POLICY

There are basically 2 options which a business has for utilising its profits. The company
may retain the entire profits and plough it back into the business or distribute them to
the shareholders as dividend. Where the company needs funds to finance their long term
project, the company may decide to retain the profits and plough them back into the
business. However, such projects should have enough growth potential and sufficient
profitability. On the other hand, if profits are distributed as dividends to shareholders, then
it amounts to maximisation of shareholders wealth.
The dividend policy of the firm gains importance especially due to unambiguous relationship
that exists between the dividend policy and the equity returns. The firm's decision should
meet the investor's expectations.

TRADITIONAL POSITION
The traditional approach to the dividend policy, lays a clear emphasis on the relationship
between the dividends and the stock market. According to this approach, the stock value
responds positively to higher dividends and negatively when there are low dividends. The
following expression given by traditional approach, establishes the relationship between the
market price and dividends using a multiplier.
P = m (D + E/3)
Where, P = Market Price, m = Multiplier; D = Dividend per share; E = Earnings per share
Limitations :
This approach, states that, the P/E ratios are directly related to the Dividend-Payout
Ratios i.e. a high dividend payout ratio will increase the P/E ratio and vice versa. However
this may not be true in all situations. A company's share price may rise even in case of
a low payout ratio, if its earnings are increasing. Similarly, for a company having a high
payout ratio, with a slow growth rate there will be a negative impact on the market price.
These conflicting factors that have not been properly explained for the major shortcomings
of the dividend policy given by the traditional approach.

WALTER'S MODEL
Just like the Traditional approach, James E Walter also considers that dividends are
relevant and they do affect the share price. In this model, he studied the relationship
between the internal rate of return (r) and the cost of capital of the firm (k) to give a
dividend policy that maximises the shareholders wealth.
Assumptions :
1) Retained earnings is the only source of finance available to the company, with no
outside debt or additional equity used.
2) r and k are assumed to be constant and thus additional investments made by the firm
will not change the risk and return profiles.
3) Company has an infinite life.
4) For a given value of the company, the dividend per share and the earnings per share
remain constant.
The model studies the relevance of the dividend policy in three situations :

A.F.M. 1 C.A. Prabodh Nayak

[C.A., M.B.A.,C.F.A., P.G.D.T.F.M., C.M.A. (US), C.P.A.]
MOUNT CARMEL COLLEGE I.S.D.C.

(i) r > k (ii) r < k and (iii) r = k. According to the Walter Model, when the return on
investment is more than the cost of equity capital (r > k), the earnings can be retained by
the company since it has better and more profitable investment opportunities than the
investors. Thus, when the r > k, the companies are considered to be growth companies
and the dividend policy that suits such companies is the one which has a zero payout
ratio.
In the second case, the return on investment is less than the cost of equity capital (r < k)
and in such situation, the investor will have a better investment opportunity than the firm.
This suggests a dividend policy of 100% payout.
Finally when the firm has a rate of return that is equal to the cost of equity capital,
the firm's dividend policy will not affect the value of the firm. The optimum dividend policy
for such normal firms will range between zero to 100% payout ratio, since the value of
the company will remain constant in all cases.
According to Walter the market price of the share is calculated as follows :
P = D + r ( E - D) / k
k k
where, P = Market Price per share, D = dividend per share, E = Earnings per share, r = Internal
rate of return, k = Cost of Equity Capital, g = growth rate of earnings.
Limitations :
All the assumptions of the model itself become the limitations. The first assumption of
exclusive financing by retained earnings makes the model suitable only for all-equity firms.
Secondly, the model assumes that the rate of returns on investment will be constant. This
will not be true for companies making high investments. Similarly business risk cannot be
ignored as it has a direct impact on the value of the company. Thus, k cannot be constant.

GORDON'S DIVIDEND EQUALISATION MODEL

Myron Gordon used the dividend equalisation approach to study the effect of the firm's
dividend policy on the stock price. The model is based on the following assumptions :
1) The firm will be an all-equity firm with the new investment proposals being
financed solely by the retained earnings.
2) Return on investment (r) and the cost of capital (k) remains constant.
3) The firm has an infinite life.
4) The retention ratio remains constant and hence the growth rate also is constant.
5) k > g, i.e. cost of equity capital is greater than growth rate.
This model assumes that the investors are rational and risk-averse. They prefer certain
returns to uncertain returns and thus put a premium on certain returns and discount the
uncertain returns. Thus, investors would prefer current dividends and avoid risk. Retained
earnings involve risk and so the investor discounts the future dividends. This risk will also
affect the stock value of the firm. Thus, the investors follow the argument that "a bird in
hand is worth two in the bush". According to Gordon, the share price is calculated as
follows :
P = E (1 - b )
k - g
where P = Share Price, E = Earnings per Share, b = Retention Ratio,

A.F.M. 2 C.A. Prabodh Nayak

[C.A., M.B.A.,C.F.A., P.G.D.T.F.M., C.M.A. (US), C.P.A.]
MOUNT CARMEL COLLEGE I.S.D.C.

( 1 - b ) = Dividend Payout Ratio, k = Cost of Equity Capital and

g = Growth Rate in the rate of return on investment.

MILLER AND MODIGLIANI APPROACH

Miller and Modigliani argue that the value of a company is determined solely by the
earning capacity of the company's assets, or its investment policy and that the manner in
which the earnings are split between dividends and retained earnings does not affect this
value. They have propounded the MM Hypothesis to explain the irrelevance of a firm's
dividend policy. This theory is based on certain assumptions :
• The first assumption is the existence of a perfect market in which all investors are
rational. In perfect market condition there is easy access to information and the
floatation and transaction costs do not exist.
• Secondly, it is assumed that there are no taxes, implying that there are differential
tax rates for the dividend income and capital gains.
• The third assumption is a constant investment policy of the firm which will not
change the risk complexion nor the rate of return even in cases where the
investments are funded by the retained earnings.
• Finally, it was also assumed that the investors are able to forecast the future
earnings, the dividends and the share value of the firm with certainty. This assumption
was however, dropped out of the model.
Based on these assumptions and using the process of arbitrage, Miller and Modigliani
have explained the irrelevance of the dividend policy. The process of arbitrage completely
balances or offsets two transactions which are entered into simultaneously. Arbitrage can
be applied to the investment function of the firm. As can be understood, firms have two
options for utilizing its post tax profits – retain the earnings and plough back for investment
purposes or distribute the earnings as cash dividends.
If the firm selects the second option, and declares dividend then it will have to raise
capital for financing its investment decisions by issuing new shares. Here, the arbitrage
process will neutralize the increase in the share value due to cash dividends and the
capital gains since the share value of the firm depends more on the future earnings of
the firm, than on its dividend policy. Thus, if there are two firms having similar risks and
return profiles the market value of their shares will be similar inspite of different payout
ratios.

FACTORS AFFECTING DIVIDEND POLICY

At the offset, it has been seen that profits of a business may be distributed as dividends
to shareholders which will maximise the shareholders net worth or it may be retained in
the business and ploughed back, provided the business invests the amount in an investment
proposal which will lead to growth and development of the business and yield sufficient
profits in the future. To bring about a balance between the desires and expectations of
the shareholders and the needs of the company, a suitable dividend policy must be
adopted. Following are some of the factors that generally influence the dividend policy of
the firm.
(1) Shareholders Expectations

A.F.M. 3 C.A. Prabodh Nayak

[C.A., M.B.A.,C.F.A., P.G.D.T.F.M., C.M.A. (US), C.P.A.]
MOUNT CARMEL COLLEGE I.S.D.C.

(2) Financial Needs of the Company

(3) Legal Restrictions
(4) Liquidity
(5) Access to Capital Markets
(6) Restrictions in Loan Agreements
(7) Inflation
(8) Taxation
(9) Control
(10) Nature of Company

DIVIDEND POLICIES
a) Constant Payout Ratio Dividend Policy - In this case, the company pays dividend at a
fixed rate of earnings of the company after tax. In other words, dividend is paid at a
fixed (constant) dividend payout ratio. Thus, the dividend paid will vary with the earnings
of each year. For example the company may decide upon a payout ratio of 40%.
EARNINGS AFTER TAX DIVIDEND
1,00,000 40,000
2,50,000 1,00,000
1,75,000 70,000
b) Constant Rate Dividend Policy - This is the most popular kind of dividend policy that
advocates the payment of dividend at a constant rate, even when earnings vary from
year to year. For this purpose the company normally maintains a "Dividend Equalisation
Reserve". The amount transferred to this reserve account is normally invested outside
the business, so as to manage the liquidity of the necessary funds in times of need.
Thus, in this case, the dividend per share is normally fixed. It may be increased when
the earnings of the company increase in future and then maintained at the new rate.
c) Small Constant Dividend Per Share Plus Extra Dividend - Companies with stable
earnings usually adopt the policy of paying constant dividend per share, since such a
policy sets a high level / amount of dividend. For companies with fluctuating earnings,
the policy to pay a minimum dividend plus an extra dividend is suitable. The small
amount of fixed dividend helps to ensure that a company never misses a dividend
payment and the extra dividend in periods prevents the investors from expecting that
the dividend increase is an established dividend amount. This policy allows flexibility in
the amount of dividend.
d) Uniform Cash Dividend Plus Bonus Share Policy - This policy is usually adopted in
case of companies having fluctuating earnings. Under this method, a minimum rate of
dividend per share is paid in cash plus bonus shares are issued out of accumulated
reserves. But the issue of bonus shares is not on annual basis. It depends upon the
amount kept in reserves over a period of 3 - 5 years.
e) Residual Policy - The residual dividend policy is used by a lot of firms to set a long
run target payout. Under this, the firm follows an investment policy of accepting all
positive NPV projects and paying out dividends only if funds are available. If the firm
treats dividend as residual, the dividend will vary highly from period to period depending
on the investment plan and operating results of the firm.

A.F.M. 4 C.A. Prabodh Nayak

[C.A., M.B.A.,C.F.A., P.G.D.T.F.M., C.M.A. (US), C.P.A.]
MOUNT CARMEL COLLEGE I.S.D.C.

TYPES OF DIVIDEND
1) Interim Dividend - An interim dividend is one which is declared between two final
dividends i.e. before the declaration of final dividend. Interim dividend is a dividend
which is declared between two annual general meetings. The Board of Directors may,
from time to time pay to the members such interim dividend as appears to it to be
justified by the profits of the company. The Directors must take into consideration the
future prospects of the profits of the company, before declaration of interim dividend,
otherwise if profits are insufficient and interim dividends are paid, it may amount to
payment out of capital.
2) Final / Annual Dividend - At the end of the accounting period, the accounts of the
company are prepared to ascertain the amount of profit earned by the company. The
directors, taking into consideration, the final position of the company's future prospects,
provision for resources etc decide to recommend to the shareholders at the AGM the
dividend to be paid to them.

DIVIDEND IRRELEVANCE POLICY

(MODIGLIANI-MILLER THEORY)
The irrelevance of dividend policy for valuation of the firm has been most comprehensively
presented by Modigliani and Miller. They have argued that the market price of a share is
affected by the earnings of the firm and not by the income distribution pattern. The
dividend policy is irrelevant and is of no consequence to the value of the firm. That is the
way a firm splits its earnings into dividend and retained earnings has no effect on the
value of the firm. Their theory is based on the following assumptions :
• The first assumption is the existence of a perfect market in which all investors are
rational. In perfect market condition there is easy access to information and the
floatation and transaction costs do not exist.
• Secondly, it is assumed that there are no taxes, implying that there are differential
tax rates for the dividend income and capital gains. There are no transactions costs
and securities are perfectly divisible and can be split into any fraction.
• The third assumption is a constant investment policy of the firm which will not
change the risk complexion nor the rate of return even in cases where the
investments are funded by the retained earnings.
• Finally, it was also assumed that the investors are able to forecast the future
earnings, the dividends and the share value of the firm with certainty. This assumption
was however, dropped out of the model.
The MM Theory is thus explained :
The market price of a share is the present value of expected dividend for year 1 and
expected market price at the end of year 1.
Therefore P0 = 1 x (D1 + P1)
(1 + k)
where : - P0 = Present market price of a share
D1 = Expected dividend at the end of year 1
P1 = Expected market price of the share at the end of year 1
k = Cost of equity shares

A.F.M. 5 C.A. Prabodh Nayak

[C.A., M.B.A.,C.F.A., P.G.D.T.F.M., C.M.A. (US), C.P.A.]
MOUNT CARMEL COLLEGE I.S.D.C.

If the company has "n" number of equity shares outstanding, then the value of the
firm is n times P0 i.e.
nP0 = 1 x (nD1 + nP1)
(1 + k)
Now, the company can finance its investment proposals either by retained earnings or
by issue of new shares. Suppose the company plans to issue "m" number of equity shares
at a price of P1 and raising funds equal to mP1 to finance the investment opportunities
at the end of year 1, the value of the firm will be :
nP0 = 1 x (nD1 + nP1 + mP1 - mP1 )
(1 + k)
nP0 = 1 x [ nD1 + (n + m)P1 - mP1 ]
(1 + k)
But mP1 is equal to the funds raised by the firm by the issue of new shares at year 1
and also equal to the total investment at the end of year 1 less the amount of retained
earnings. i.e. mP1 = I - (E - nD1)
nP0 = 1 x [ nD1 + (n + m)P1 - I + (E - nD1)]
(1 + k)
nP0 = 1 x [ nD1 + (n + m)P1 - I + E - nD1]
(1 + k)
nP0 = 1 x (n + m)P1 - I + E
(1 + k)
Thus, it can be seen that in the final equation Dividend D1 is not present and the other
variables are all independent of D1. The MM theory thus concludes that the value of the
firm does not depend upon the dividend decision and hence the dividend policy is
irrelevant.

Example 1
The following information relates to Navya Ltd. :
Earnings of the Company $20,00,000
Dividend Pay-out Ratio 60%
No. of shares outstanding 4,00,000
Rate of Return on Investment 15%
Equity Capitalization rate 12%
Required :
(i) Determine what would be the market value per share as per Walter’s Model.
(ii) Compute optimum Dividend Pay-out Ratio according to Walter’s Model and the market
value of the Company’s share at that pay-out ratio.
Solution :
(i) Walter’s Model is given by :
P = D + ( E - D)(r / ke)
ke
where, P = Market Price per share,
D = Dividend per share = 60% of 5 = $3
E = Earnings per share = $20,00,000 ÷ 4,00,000 = $5

A.F.M. 6 C.A. Prabodh Nayak

[C.A., M.B.A.,C.F.A., P.G.D.T.F.M., C.M.A. (US), C.P.A.]
MOUNT CARMEL COLLEGE I.S.D.C.

r = Return on investment = 15%

ke = Cost of Equity Capital = 12%

∴ P = 3 + (5 - 3) x (0.15 / 0.12)
0.12
= $45.83
(ii) According to Walter’s Model when the rate on investment is more than the cost of
the equity capital, the price per share increases as the dividend pay-out ratio decreases.
Hence, the optimum pay-out ratio in this case is nil. So, at a pay-out ratio of zero, the
market value of the share will be :
0 + (5 - 0) x (0.15 / 0.12) = $52.08
0.12

Example 2
The following figures are collected from XYZ Ltd. :
Net Profit $30 lakhs
Outstanding 12% Preference Shares $100 lakhs
Number of Equity Shares 3 lakhs
Return on Investment 20%
Cost of Capital (Ke) 16%
Calculate Price per Share using Gordan’s Model when dividend payout is (i) 25%; (ii) 50%
and (iii) 100%.
Solution :
$ in lakhs
Net Profit 30
Less : Preference Dividend 12
Earnings for Equity Shareholders 18
∴ Earnings Per Share = 18 /3 = $6.00
Price per Share according to Gordon’s Model is calculated as follows :
P0 = E1(1 - b)
Ke –br
Here, E1 = 6 ; Ke = 16%
(i) When Dividend pay-out is 25%,
P0 = 6 x 0.25 = $150
0.16 – (0.75 x 0.2)
(ii) When Dividend pay-out is 50%,
P0 = 6 x 0.5 = $50
0.16 – (0.5 x 0.2)
(iii) When Dividend pay-out is 100%,
P0 = 6x1 = $37.50
0.16 – (0 x 0.2)

A.F.M. 7 C.A. Prabodh Nayak

[C.A., M.B.A.,C.F.A., P.G.D.T.F.M., C.M.A. (US), C.P.A.]
MOUNT CARMEL COLLEGE I.S.D.C.

PRACTICAL PROBLEMS
QUESTION 1
Vishwas Engineering Ltd has the chance to invest in the five projects listed below:
Project Capital Outlay DCF yield rate
A 70,000 18%
B 100,000 17%
C 130,000 16%
D 50,000 15%
E 100,000 14%
The company's cost of capital is 16%. Its optimal debt to total funds ratio is 30% and
the current year's profit available to equity shareholders is $350,000.
Required:
(a) State which projects would be accepted, and what is the total finance required for
those projects.
(b) Assuming that the company wishes to maintain its gearing ratio, how much of the
required finance will be borrowed? gearing = debt/ total funds ratio
(c) How much of this year's profit can be distributed?

QUESTION 2
Following is the earnings per share (EPS) record of M/s DEEPAK Ltd over the past 10
years.
YEAR EPS YEAR EPS
10 20.00 5 12.00
9 19.00 4 6.00
8 16.00 3 9.00
7 15.00 2 - 2.00 loss per share
6 16.00 1 1.00
Required :
1) Determine the annual dividend paid each year in the following cases :
(a) If the firm's dividend policy is based on a constant dividend payout ratio of 50%
for all years.
(b) Pay dividend $8 per share & increase to $10 when earnings exceed $14 per share
for 2 consecutive years. $ 8 is constant
(c) Pay dividend $7 per share each year except when EPS exceeds $14 per share,
when an extra dividend equal to 80% of earnings beyond $14 per share would be
paid.
2) Which type of dividend policy will you recommend to the company ?

QUESTION 3
A company expects to generate the following net income and incur the following capital
expenditure in the next 5 years as per the following details : ($ in lakhs)
Year → 1 2 3 4 5
Net Profit 75 60 45 40 25
Capital Expenditure 40 45 55 47 50

A.F.M. 8 C.A. Prabodh Nayak

[C.A., M.B.A.,C.F.A., P.G.D.T.F.M., C.M.A. (US), C.P.A.]
MOUNT CARMEL COLLEGE I.S.D.C.

The total number of outstanding shares are 18,00,000 and current dividend is $6.5 per
share; you are required to :
a) Determine the dividend per share if the company follows a residual dividend policy.
b) Determine the amount of external financing required if the current dividend is maintained.
b)$6.5
c) Determine the amount of external financing if the company maintains a 50% dividend
payout ratio. 50% of net profit paid as dividend
d) Identify under which of the above three policies the aggregate dividends are
maximized and under which policy the amount of external financing is minimized ?

QUESTION 4
XYZ Company’s Shareholders' funds are made up as follows :
12% Preference Shares Capital $100,000
Equity Share Capital $400,000
Securities Premium $ 40,000
Retained Earnings $300,000
The earnings available for equity shareholders from the current years' operations are
$150,000 which are included in the Retained earnings.
Required :
a) What is the maximum dividend per share that the company can pay ?
b) If the company has $60,000 in cash, what is the largest DPS it can pay without
borrowings ?
c) Indicate, what accounts if any, will be affected if the company pays the dividends
indicated in (b) above ?

QUESTION 5
Given the following information about Zed Ltd show the effect of the dividend policy on
the market price of the shares using Walters Model.
Equity Capitalisation Rate (k) = 12%
Earnings Per share (E) = $8
Assumed return on investments (r) is as follows :
(i) r = 15% (ii) r = 10% (iii) r = 12%

QUESTION 6
From the following information supplied to you, ascertain whether the firm's dividend payout
ratio is optimal according to Walter. The firm has started a year ago with equity capital
of $20 lakhs.
Earnings of the firm $2,00,000
Dividend Paid $1,50,000
Price Earnings Ratio 12.5
Number of shares outstanding is 20,000 @ $100 each.
The firm is expected to maintain its current rate of earnings on investment.
i) What should be the price earning ratio at which dividend payout ratio will have no effect
on the value of the share ?
ii) Will your decision be changed if the P/E ratio is 8 instead of 12.5 ?

A.F.M. 9 C.A. Prabodh Nayak

[C.A., M.B.A.,C.F.A., P.G.D.T.F.M., C.M.A. (US), C.P.A.]
MOUNT CARMEL COLLEGE I.S.D.C.

QUESTION 7
Calculate the market price of a share of ABC Ltd under
(i) Walter's Formula and
(ii) Dividend Growth model, from the following data
Earning per share - $5 and Dividend per share - $3
Cost of Capital - 16%
Internal Rate of Return on Investment - 20%
Retention Ratio 40%

QUESTION 8
Sony Ltd belongs to a risk-class for which the appropriate capitalisation rate is 10%. It
currently has 25,000 shares outstanding at $100 each. The firm is contemplating the
declaration of dividend of $5 per share at the end of the current financial year. The
company expects to have a net income of $250,000 and a proposal for making new
investments of $500,000. Show that under MM assumptions the payment of dividend does
not affect the value of the firm.

QUESTION 9
M F Hussain Fashions Ltd belongs to a risk class for which the appropriate the PE ratio
is 10. It currently has 50,000 shares outstanding selling at $100 each. The firm is
contemplating the declaration of $8 dividend at the end of the current fiscal year which
has just started. Given the assumptions of the MM Model, answer the following questions:
(i) What will be the price of the share at the end of the year if (a) dividend is not declared
and (ii) dividend is declared ? P1 calculation
(ii) Assuming that the firm pays the dividend and has a net income of $500,000 and
makes new investments of $1,000,000 during the period, how many new shares must
be issued ? value of m
(iii) What would be the current value of the firm if (a) if a dividend is declared and (b) if
dividend is not declared ?

QUESTION 10
Subhash & Co earns $8 per share having capitalization rate of 10% and has a return on
investment of 20%. According to Walter's model, what should be the price per share at
25% DPR? Is this optimum payout ratio as per Walter?

QUESTION 11
X Ltd has 1,000 shares of $10 each raised at a premium of $15 per share. The company's
retained earnings are $5,525. The company's stock sells for $20 per share.
a) If a 10% stock dividend is declared, how many new shares would be issued?
b) What would be the market price after the stock dividend?
c) How would the equity change?
d) If a 25% stock dividend is declared what changes will take place?
e) If the company instead, declares a 5:1 stock split, how many shares will be outstanding?
What would be the new par value? What would be the new market price?

A.F.M. 10 C.A. Prabodh Nayak

[C.A., M.B.A.,C.F.A., P.G.D.T.F.M., C.M.A. (US), C.P.A.]
MOUNT CARMEL COLLEGE I.S.D.C.

f) If the company declares a 1:4 reverse split, how many shares will be outstanding? What
would be the new par value? What would be the new market price?
g) If the company declares a dividend of $2 per share and the stock goes ex-dividend
tomorrow, what will be the price at which it will sell?

❑❑❑

QUESTION 1
L. B. Inc. is considering a new plant in the Netherlands. The plant will cost 26 Million Guilders.
Incremental cash flows are expected to be 3 Million Guilders per year for the first 3 years, 4 Million
Guilders the next three, 5 Million Guilders in year 7 through 9, and 6 Million Guilders in years 10
through 19, after which the project will terminate with no residual value. The present exchange
rate is 1.90 Guilders per dollar. The required rate of return on repatriated $ is 16%. a) If the
exchange rate stays at 1.90, what is the project net present value ? b) If the guilder appreciates
to 1.84 for years 1 – 3 to 1.78 for years 4 – 6 to 1.72 years 7.9 and to 1.65 for years 10 - 19, what
happens to the present value?

QUESTION 2
OJ Ltd. is a supplier of leather goods to retailers in the UK and other Western European countries.
The company is considering entering into a joint venture with a manufacturer in South America.
The two companies will each own 50% of the limited liability company JV(SA) and will share profits
equally. £4,50,000 of the initial capital is being provided by OJ Ltd. and the equivalent in South
American dollars (SA$) is being provided by the foreign partner. The managers of the joint venture
expect the following net operating cash flows which are in nominal terms:

For tax reasons JV (SV) the company to be formed specifically for the joint venture will be
registered in South America. Ignore taxation in your calculations.
Requirements :
Assume you are the financial advisor retained by OJ Limited to advise on the proposed joint
venture. Calculate the NPV of the project under the two assumptions explained below. Use a
discount rate of 18% for both assumptions.
Assumption 1: The South America country has exchange controls which prohibits the payment
of dividends above 50% of the annual cash flows for the first three years of the project. The
accumulated balance can be repatriated at the end of the third year.

A.F.M. 11 C.A. Prabodh Nayak

[C.A., M.B.A.,C.F.A., P.G.D.T.F.M., C.M.A. (US), C.P.A.]
MOUNT CARMEL COLLEGE I.S.D.C.

Assumption 2: The Government of the South American country is considering removing

exchange controls and restriction on repatriation of profits. If this happens all cash flows will be
distributed as dividend to the partner companies at the end of each year.

QUESTION 3
You have been engaged to evaluate an investment project overseas in a country called East
Africa, which is a politically stable country. The project involves an initial cost of East African dollar
2.5 crores (EA $) and it is expected to earn post tax cash flows as follows :

Further, the following information is available :

a) Current spot rate is EA $ 2 per $ 1.
b) Risk free rate of interest in East Africa is 7% and in India 9%.
c) Required return from the project is 16%. You may make suitable (generally acceptable)
assumptions in order to evaluate the project.

QUESTION 4
Butler Company a UK company is considering undertaking a new project in Australia. The project
would require immediate capital expenditure of A$ 10million plus A$ 5m of working capital which
would be recovered at the end of the project’s four-year life. The net cash flows expected to be
generated from the project are A$ 13m before tax. Straight – line depreciation over the life of the
project are allowable expense against company tax in Australia, which is charged at the rate of
50% payable each year without delay. The project will have zero scrap value. Butler Company
will not have to pay any UK tax on the project due to a double – taxation avoidance agreement.
The A$/UKP spot rate is 2.0 and UKP is expected to appreciate against the A$ by 10% per year.
A similar risk, UK – based project would be expected to generate a minimum return of 20% after
tax.

QUESTION 5
Sun Ltd is planning to import an equipment from Japan at a cost of 3,400 lakh Yen. The company
may avail loans at 18% p.a. with quarterly rests with which it can import the equipment. The
company has also an offer from Osaka branch of an India based bank extending credit of 180
days at 2% p.a. against opening of an irrevocable letter of credit.
Additional Information
Present exchange rate $100 = 340 Yen
180-day's Forward Rate $100 = 345 Yen
Commission charges for letter of credit at 2% per 12 months
Advise the company whether the offer from the foreign branch should be accepted.



A.F.M. 12 C.A. Prabodh Nayak

[C.A., M.B.A.,C.F.A., P.G.D.T.F.M., C.M.A. (US), C.P.A.]