WARM UP Advanced Financial Management

WARM UP
QUESTION 1: Financing Decision (Debt Equity Swap – Leveraged Buyback)
DCL Soft Drinks Company is an all equity firm with 200,000 shares outstanding. Its profit after tax is
Rs. 11.2 million and the market value is Rs. 100 million. The firm is now intending to take debt of Rs.
60 million. DCL approached Bank of Punjab for loan and came to know that 50% of the loan amount
would be financed at 10% but for the remaining half of the fund the bank would charge 2% more.
The firm has agreed to accept the financing from Bank of Punjab. DCL is planning to use these
entire funds to repurchase its shares from the market. The tax rate for the company is 30%.
You are required to
a. Determine the effect on earning per share, on the action.
b. Estimate the interest rate on the debt that would disappear the effect on earning per share.

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ANSWER:
a. EPS (current)= 11200,000/200,000= Rs.56.
Market price of the shares is Rs 100,000,000/200000 = Rs. 500.
So, with Rs, 60 million the firm can repurchase Rs 60,000,000/500 = 120000 shares
So, after the repurchase number of outstanding shares would be 200000 – 120000 = 80000
EPS (after taking debt and repurchases of share)
Existing PAT – Post Tax additional interest expense
=
Post Buyback no. of shares

11.2  0.7  %  0.5  12%)  

= = Rs.82.25
0.08

b. Equating EPS before and after the repurchase we get,

11.2  0.7   r%  0.5  r+2)%)  
= = 56
0.08
Or, r = 15%
So, if the rate of interest on debt becomes 15% on first Rs. 30 million and 17% on second Rs. 30
million then effect on EPS would disappear.

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QUESTION 2: Capital Budgeting (Make or buy involving TVM and Taxation)

Auto Lamps Ltd. (ALL) is in the business of specialty lamps for automobiles. Most of its products are
made in its own factory while some are outsourced. Currently ALL wants to introduce a new Lamp
for two wheelers, which can be made in its factory or bought from its suppliers.
If ALL wants to produce the Lamp it requires an investment of Rs. 20,00,000 in plant and machinery,
which can be fully depreciated on a straight-line basis over its useful life of 10 years. The cost of
production (excluding depreciation) per Lamp is expected to be Rs. 50. A supplier is quoting a price
of Rs.60 per Lamp and is ready to supply any quantity at the same price. The company’s cost of
capital is 15% and the tax rate is 40%. Assume all cash flows are certain.
You are required to
a. Advise the company (with detailed working notes) whether to Make or Buy the Lamps if the
market demand is for 50,000 Lamps per annum
b. What should be the annual demand (quantity) so that the company can produce on its own and
the NPV is not negative?

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 WARM UP Advanced Financial Management

ANSWER:

a. Advantage/(Disadvantage) of Making
= Post-tax savings in cost of production due to making + Depreciation tax shield
= {(PVIFA 10 Years, 15%) x Q (P – C) x (1 – t)} + {Dt x (PVIFA 10 Years, 15%) – I}
= {(5.019) x 50,000 (60 – 50) x (1 – 0.40)} + {2,00,000 x 0.40 (5.019) – 20,00,000)}
= (Rs. 92,780)
As making results in losses it is better to Outsource.
P = Purchase price per unit
C = Cost of production per unit
Q = Quantity demanded in the market
t = Tax rate
D = Depreciation per annum = I (1/10)
I = Investment in Fixed assets
PVIFA = Present Value Interest Factor of Annuity

b. Minimum demand to avoid losses (Q)
Dt  (PVIFA10 Years,15%) - I
=
(PVIFA10 Years,15%)  (P - C)  (1 - t)
2,00,000  0.40(5.019) - 20,00,000
=
(5,019)  (60 - 50)  (1 - 0.40)
= 53,081 units.

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