Chapter 2

2.1

Nominal rate(%)(NR) 5 10 20 60
Inflation rate(%) ( IR) 2 4 10 40
Real rate by the rule of thumb(%) 3 6 10 20
= NR - IR
Correct real rate (%) 2.94 5.77 9.09 14.29
=(1+NR)/(1+IR) -1
Error from using the rule of thumb(%) 0.06 0.23 0.91 5.71
 Chapter 3
FINANCIAL STATEMENTS, TAXES AND CASH FLOW

3.1.

Rs. in million
A. CASH FLOW FROM OPERATING ACTIVITIES
PROFIT BEFORE TAX 90
Adjustments for:
Depreciation and amortization 30
Finance costs 30
OPERATING PROFIT BEFORE WORKING CAPITAL CHANGES 150
Adjustments for changes in working capital:
Trade receivables -20
Inventories -20
Trade payables 20
CASH GENERATED FROM OPERATIONS 130
Direct taxes paid -30
NET CASH FROM OPERATING ACTIVITIES 100
B.CASH FLOW FROM INVESTING ACTIVITIES
Purchase of fixed assets -50
NET CASH USED IN INVESTING ACTIVITIES -50
C.CASH FLOW FROM FINANCING ACTIVITIES
Increase in share capital 20
Increase in long- term debt -10
Increase in short-term debt 20
Dividend paid -40
Finance costs -30
NET CASH FROM FINANCING ACTIVITIES -40
NET CASH GENERATED (A+B+C) 10
CASH AND CASH EQUIVALENTS AT THE BEGINNING OF PERIOD 20
CASH AND CASH EQUIVALENTS AT THE END OF PERIOD 30
 Chapter 4
ANALYSING FINANCIAL PERFORMANCE

Net profit
4.1. Return on equity =
Equity

= Net profit Total revenues Total assets

x x
Total revenues Total assets Equity

1
= 0.05 x 1.5 x = 0.25 or 25 per cent
0.3

Debt Equity
Note : = 0.7 So = 1-0.7 = 0.3
Total assets Total assets

Hence Total assets/Equity = 1/0.3

4.2. PBT = Rs.40 million

PBIT
Times interest earned = = 6
Interest

So PBIT = 6 x Interest
PBIT – Interest = PBT = Rs.40 million
6 x Interest = Rs.40 million
Hence Interest = Rs.8 million

4.3
Sales = Rs.7,000,000
Net profit margin = 6 per cent
Net profit = Rs.7000000 x 0.06 = 420,000
Tax rate = 60 per cent
420,000
So, Profit before tax = = Rs.1,050,000
(1-.6)
Interest charge = Rs.150,000
 So Profit before interest and taxes = Rs.1,200,000
Hence
1,200,000
Times interest earned ratio = = 8
150,000

4.4. CA = 1500 CL = 600

Let BB stand for bank borrowing

CA+BB
= 1.5
CL+BB

1500+BB
= 1.5
600+BB

BB = 1200

1,000,000
4.5. Average daily credit sales = = 2740
365

If the accounts receivable has to be reduced to 120,000 the ACP must be:

120,000
= 43.8days
2740

Current assets
4.6. Current ratio = = 1.5
Current liabilities
 Current assets - Inventories
Acid-test ratio = = 1.2
Current liabilities
Current liabilities = 800,000
Sales
Inventory turnover ratio = = 5
Inventories
Current assets - Inventories
Acid-test ratio = = 1.2
Current liabilities

Current assets Inventories

This means - = 1.2
Current liabilities Current liabilities

Inventories
1.5 - = 1.2
800,000

Inventories
= 0.3
800,000

Inventories = 240,000

Sales
= 5 So Sales = 1,200,000
2,40,000

4.7. Debt/equity = 0.60

Equity = 50,000 + 60,000 = 110,000
So Debt = Short term bank borrowing = 0.6 x 110,000 = 66,000
Hence Total assets = 110,000+66,000 = 176,000
 Total assets turnover ratio = 1.5
So revenue from operations = 1.5 x 176,000 = 264,000
Cost of goods sold as a percentage of total revenues = 80 per cent
So Cost of goods sold = 0.8 x 264,000 = 211,200
Days’ sales outstanding in trade receivables = 40 days
revenue from operations
So trade receivables = x 40
360

264,000
= x 40 = 29,333
360

Cost of goods sold 211,200

Inventory turnover ratio = = = 5
Inventory Inventory

So Inventory = 42,240

As short-term bank borrowing is a current liability as well,

Cash and cash equivalents + trade receivables

Acid-test ratio =
Current liabilities

Cash and cash equivalents + 29,333

= = 1.2
66,000
So Cash and cash equivalents = 49867

Plant and equipment = Total assets - inventories – trade s receivables – cash and cash equivalents
= 176,000 - 42240 - 29333 – 49867
= 54560

Putting together everything

Balance Sheet
Equity capital 50,000
Retained earnings 60,000
Short-term bank borrowing 66,000

176,000

Plant & equipment 54,560

Inventories 42,240
Cash and cash equivalents 49,867
Trade receivables 29,333

176,000

Revenue from operations 264,000

Cost of goods sold 211,200

4.8.

(Amounts in Rs.)

Liabilities and Equity

Equity capital 10,000,000
Reserves and surplus 22,500,000
Long-term debt 12,500,000
Short-term bank borrowing 15,000,000
Trade creditors 10,000,000
Provisions 5,000,000
Total 75,000,000
Assets
Fixed assets (net) 30,000,000
Current assets
Cash and bank 5,000,000
Receivables 15,000,000
Inventories 20,000,000
Pre-paid exp 2,500,000
Others 2,500,000
Total 75,000,000

(i) Current ratio

 = Current assets/ Current liabilities

45,000,000
= = 1.5
30,000,000
Current assets – Inventories 25,000,000
(ii) Acid-test ratio = = = 0.83
Current liabilities 30,000,000

Long-term debt + Short-term bank borrowings+Trade creditors+Provisions

(iii) Debt-equity ratio =

Equity capital + Reserves & surplus

12,500,000 + 15,000,000+10,000,000+5,000,000
= =1.31
10,000,000 + 22,500,000
 Profit before interest and tax
(iv) Times interest coverage ratio =
Interest

15,100,000
= = 3.02
5,000,000

Cost of goods sold 72,000,000

(v) Inventory turnover period = = = 3.6
Inventory 20,000,000
365
(vi) Average collection period =
Net sales/Accounts receivable
365
= = 57.6 days
95,000,000/15,000,000

(vii)
Net sales 95,000,000
Total assets turnover ratio = = = 1.27
Total assets 75 ,000,000

Profit after tax 5,100,000

(ix) Net profit margin = = = 5.4%
Net sales 95,000,000

PBIT 15,100,000
(x) Earning power = = = 20.13 %
Total assets 75,000,000

Equity earning 5,100,000

(xi) Return on equity = = = 15.7%
Net worth 32,500,000
The comparison of the Omex’s ratios with the standard is given below

Omex Standard
Current ratio 1.5 1.5
Acid-test ratio 0.8 0.8
Debt-equity ratio 1.3 1.5
Times interest covered ratio 3.0 3.5
Inventory turnover ratio 3.6 4.0
Average collection period 57.6 days 60 days
Total assets turnover ratio 1.3 1.0
Net profit margin ratio 5.4% 6%
Earning power 20.1% 18%
Return on equity 15.7% 15%

4.9
20X1 20X2 20X3 20X4 20X5
Current ratio 1.68 1.47 1.50 1.53 1.67
Debt-equity
ratio 1.23 1.32 1.38 1.44 1.37
Total assets
turnover ratio 0.84 0.84 0.79 0.87
Net profit
margin 5.00% 6.56% 3.85% 5.49% 6.25%
15.07 10.75 11.35 15.56
Earning power % % % %
Return on 12.50 10.53 13.08
equity % 7.59% % %
 MINICASE: 1
a)
Common Base Balance Sheets
Regular( in crore) Common Base (%)
2,016 2017 2018 2016 2017 2018
Fixed assets 328,222 420,860 482,251 100 128 147
Inventory 46,486 48,951 60,837 100 105 131
Trade receivables 4,465 8,177 17,555 100 183 393
All other assets 219,824 234,351 255,705 100 107 116
Total 598,997 712,339 816,348 100 119 136
Equity 234,912 266,626 297,045 100 114 126
Borrowings 165,192 183,676 181,604 100 111 110
Trade Payables 60,296 76,595 106,861 100 127 177
All other liabilities 138,597 185,442 230,838 100 134 167
Total 598,997 712,339 816,348 100 119 136

Common Base Statement of Profit and Loss

Regular( in crore) Common Base (%)
2,016 2017 2018 2016 2017 2018
Total revenues 305,351 339,623 418,214 100 111 137
Cost of material 158,199 175,087 207,448 100 111 131
consumed
Employee benefits expense 7,407 8,388 9,523 100 113 129
Finance costs 3,691 3,849 8,052 100 104 218
Total expenses 266,614 299,589 368,788 100 112 138
PBIT 38,737 40,034 49,426 100 103 128
Profit for the year 29,861 29,833 36,080 100 100 121

Common Size Balance Sheets

Regular( in crore) Common Size (%)
2,016 2017 2018 2016 2017 2018
Fixed assets 328,222 420,860 482,251 55 59 59
Inventory 46,486 48,951 60,837 8 7 7
Trade receivables 4,465 8,177 17,555 1 1 2
All other assets 219,824 234,351 255,705 37 33 31
Total 598,997 712,339 816,348 100 100 100
Equity 234,912 266,626 297,045 39 37 36
Borrowings 165,192 183,676 181,604 28 26 22
Trade Payables 60,296 76,595 106,861 10 11 13
All other liabilities 138,597 185,442 230,838 23 26 28
Total 598,997 712,339 816,348 100 100 100

Common Size Statement of Profit and Loss

Regular( in crore) Common Size (%)
2,016 2017 2018 2016 2017 2018
Total revenues 305,351 339,623 418,214 100 100 100
Cost of material 158,199 175,087 207,448 52 52 50
consumed
Employee benefits expense 7,407 8,388 9,523 2 2 2
Finance costs 3,691 3,849 8,052 1 1 2
Total expenses 266,614 299,589 368,788 87 88 88
PBIT 38,737 40,034 49,426 13 12 12
Profit for the year 29,861 29,833 36,080 10 9 9
b)

Ratio analysis
2015-16 2016-17 2017-18
Current ratio 0.69 0.62 0.59
Debt-equity ratio 1.55 1.67 1.75
Asset turnover ratio 0.56 0.52 0.55
Return on equity(%) 13.4 11.9 12.8
Return on capital employed(%) 6.1 5.2 6.0
c)
Net profit margin(%) 9.8 8.8 8.6
Observations from the comparative statements:
In the last two years fixed assets proportion has significantly increased and both the borrowings
and receivables have doubled. Total expenses and the net profit as a proportion of revenues
slightly worsened in the last two years as compared to 2016 but are steady thereafter. However
while the revenues increased by only 11 percent in 2017 that rate doubled during 2018 .
Observations from the ratios:
Liquidity and solvency are not quite good and have been steadily worsening in the past two years.
Being a company with more than half the investment in fixed assets, the asset turnover ratio of
0.55 may be considered satisfactory and the same is almost steady. Also for the fixed asset heavy
company, the return on capital employed of 6 percent is quite good and so is the return on equity
of 12.8 percent. The profitability which had taken a slight dip in 2017 has since recovered to its
previous levels, though not the net profit margin which is slowly declining.
 MINICASE: 2
a.
Ratio Formula 31-3-2018
Current ratio =3440/2434 1.41
Acid-test ratio =(3440-1256)/2434 0.90
Debt-equity ratio =(534+2434)/5733 0.52
Debt ratio =(534+2434)/8702 0.34
Interest coverage ratio =(1693+53)/53 32.91
Inventory turnover =7748/((1107+1256)/2) 6.56
Debtors turnover =7748/((650+706)/2) 11.42
Fixed assets turnover =7748/((1576+1648)/2) 4.81
Average collection period in
days =365/11.43 31.95
Total assets turnover =8054/((7732+8702)/2) 0.98
Net profit margin =1358/8054 16.9%
Return on assets =1358/((7732+8702)/2) 16.52%
Earning power =(1693+53)/((7732+8702)/2) 21.3%
Return on capital employed =0.2125x(1-371/1693) 16.6%
Return on equity =1358/((4872+5733)/2) 25.6%
Price-earnings ratio =328/(1358/176) 42.55
Yield =(2.3+(328-277))/277 19.24%
Market value to book value
ratio =328/(5733/176) 10.08
b)
Du Pont Chart (Amounts in Rs. crore)

- Total Revenues
8054

Net Profit
1358 ÷
X
x Net Profit Total Costs
Margin 6696
16.86 %
Total Revenues
+
8054

Return on
Assets Average Non-
16.52 % current assets
4940
Total Revenues
c)
Common Base Balance Sheets
Regular( in crore) Common Base (%)

2017 2018 2017 2018

Fixed assets 1,576 1,648 100 105
Inventory 1,107 1,256 100 114
Trade receivables 650 706 100 109
All other assets 4,399 5,092 100 116
Total 7,732 8,702 100 113
Equity 4,872 5,733 100 118
Borrowings 911 829 100 91
Trade Payables 1,310 1,410 100 108
All other liabilities 639 729 100 114
Total 7,732 8,702 100 113

Common Base Statement of Profit and Loss

Regular( in crore) Common Base (%)
2017 2018 2017 2018
Total revenues 8,000 8,054 100 101
Cost of material consumed 3,025 3,220 100 106
Employee benefits expense 790 793 100 100
Finance costs 54 53 100 98
Total expenses 6,389 6,346 100 99
PBIT 1,611 1,708 100 106
PAT 1,280 1,358 100 106

Common Size Balance Sheets

Regular( in crore) Common Size (%)
 2017 2018 2017 2018
Fixed assets 1,576 1,648 20 19
Inventory 1,107 1,256 14 14
Trade receivables 650 706 8 8
All other assets 4,399 5,092 57 59
Total 7,732 8,702 100 100
Equity 4,872 5,733 63 66
Borrowings 911 829 12 10
Trade Payables 1,310 1,410 17 16
All other liabilities 639 729 8 8
Total 7,732 8,702 100 100

Common Size Statement of Profit and Loss

Regular( in crore) Common Size (%)
2017 2018 2017 2018
Total revenues 8,000 8,054 100 100
Cost of material consumed 3,025 3,220 38 40
Employee benefits expense 790 793 10 10
Finance costs 54 53 1 1
Total expenses 6,389 6,346 80 79
PBIT 1,611 1,708 20 21
PAT 1,280 1,358 16 17

d) Financial strengths and weaknesses

As at 31-3-2018:
Strengths: High profitability with return on assets over 17 percent and return on equity of 26
percent. Good liquidity position with even quick ratio at 0.9. Leverage moderate at 0.6 and debt
servicing capacity very comfortable with an interest cover as high as 33. The receivables collection
period is around one month which is quite good.
The comparative statements show that there has been no significant changes in the structural
position and operations of the company in the last two years.
Weakness: The assets turnover ratio is just 1. But for this, the return on assets would have been
much higher.
 Chapter 5
FINANCIAL PLANNING AND FORECASTING

5.1 Pro Forma Statement of Profit and Loss for Modern Electronics for year 3 Based on Per
cent of Sales Method

Average Pro forma statement of

Historical data profit and loss of year 3
per cent
Year1 Year2 assuming revenues from
of sales
operations of 1400
Revenues from Operations 800 890 100 1020
Other income
Total revenues 800 890 100.00 1020
Expenses
Material expenses 407 453 50.89 519
Employee benefit expenses 203 227 25.44 259
Finance costs 10 11 1.24 13
Depreciation and 50 64 6.72 69
amortisation expenses
Other expenses 120 117 14.07 144
Total expenses 790 872 98.36 1003
Profit before exceptional items and other income 10 18 1.64 17
Exceptional Items 8 10 1.06 11
Profit before Extraordinary Items and Tax 18 28 2.70 28
Extraordinary Items
Profit Before Tax 18 28 2.70 28
Tax Expense 7 10 1.00 10
Profit (Loss) for the period 11 18 1.70 17
Dividends 6 7 8
Retained earnings 5 11 9

5.2 Pro Forma Statement of Profit and Loss for Modern Electronics for year 3
Combination Method
Historical data
Average Pro forma statement of
per cent profit and loss of year 3
of sales assuming revenues from
Year 1 Year 2 operations of 1400
Revenues from Operations 800 890 100 1,020.00
Other income 0.00 0.00
Total revenues 800 890 @ 1,020.00
Expenses
Material expenses 407 453 50.89 519.05
Employee benefit expenses 203 227 25.44 259.49
Finance costs 10 11 Budgeted 12.00
Depreciation and 50 64 Budgeted 60.00
amortisation expenses
Other expenses 120 117 Budgeted 124.00
Total expenses 790 872 @ 974.54
Profit before exceptional items and other income 10 18 @ 45.46
Exceptional Items 8 10 1.06 10.83
Profit before Extraordinary Items and Tax 18 28 @ 56.29
Extraordinary Items
Profit Before Tax 18 28 @ 56.29
Tax Expense 7 10 1.00 10.19
Profit (Loss) for the period 11 18 @ 46.10
Dividends 6 7 Budgeted 8.00
Retained earnings 5 11 @ 38.10
@ These items are obtained using accounting identities.

5.3 Pro Forma Balance Sheet of Modern Electronics at the end of year 3
Historical data Average Pro forma balance sheet
per cent of of year 3 assuming
of sales revenues from operations
Year 1 Year 2 of 1020
Revenues from operations 800 890 100 1020
EQUITY AND LIABILITIES
Shareholders’ Funds
No
150 150
Share capital (Par value Rs.10) change 150
Pro forma
118 129 statement
Reserves and surplus of P&L 167
Non-current Liabilities
Long-term borrowings 144 175 18.83 192
No
13 19
Long-term provisions change 19
Current Liabilities
 Short-term borrowings 150 180 19.49 199
Trade payables 126 167 17.26 176
Short-term provisions 40 45 5.03 51
External funds requirement 5
959
ASSETS
Non-current Assets
Fixed assets 300 380 40.10 409
No
20 20
Non-current investments change 20
Long-term loans and advances 15 14 1.72 18
Current Assets
No
21 20
Current investments change 20
Inventories 173 192 21.60 220
Trade receivables 180 200 22.49 229
Cash and cash equivalents 12 14 1.54 16
Short-term loans and advances 20 25 2.65 27
959

A L
5.4. EFR = - S – m S1 (1-d)
S S
(1)

800 190
= - 300 – 0.06 x 1,300 (1-0.5)
1000 1000

= (0.61 x 300) – (0.06) x 1,300 x (0.5)

= 183 – 39 = Rs.144.
(2)
Projected Income Statement for Year Ending 31st December , 20X1

Sales 1,300
Profits before tax 195
Taxes 117
Profit after tax (6% on sales) 78
Dividends 39
Retained earnings 39

Projected Balance Sheet as at 31.12 20X1

Liabilities Assets

Share capital 150 Fixed assets 520

Retained earnings 219 Inventories 260
Term loans (80+72) 152 Receivables 195
Short-term bank borrowings 272 Cash 65
(200 + 72)
Accounts payable 182
Provisions 65

1,040 1,040

A L
5.5. (a) EFR = - S – m S1 (1 –d)
S S

150 30
= - x 80 – (0.0625) x 240 x (0.5)
160 160

= (60 – 7.5) = 52.5

In this problem it is assumed that the par value of an equity share is 10 and that the
various ratios for the year 20X1 remain unchaged as mentioned in the previous
problem
 (b) Projected Balance Sheet as on 31.12.20X1

Liabilities Assets

Share capital 56.25 Net fixed assets 90

Retained earnings 47.50 Inventories 75
(40 + 7.5)
Term loans 46.25 Debtors 45
Short-term bank 30.00 Cash 15
borrowings
Trade creditors 37.50
Provisions 7.50

225.00 225.00

(c) 20X0 20X1

i) Current ratio 1.50 1.80
ii) Debt to total assets ratio 0.53 0.54
iii) Return on equity 14.3% 14.5%

(d)
A L
EFR 20X1= - S – mS1 (1 – d)
S S

150 30
= - 20 – 0.0625 x 180 x 0.5
160 160

= 9.38

150 x (1.125) 30 x 1.125

EFR 20X2 = - x 20 – 0.0625 x 200 x 0.5
180 180

168.75 33.75
= - x 20 –0.0625 x 220 x 0.5
180 180

= 8.75
 168.75 x (1.11) 33.75 x (1.11)
EFR 20X3 = - 20 – 0.0625 x 220 x 0.5
200 200

187.31 37.46
= - x 20 – 6.88
200 200

= 8.11

187.31 x (1.1) 37.46 x (1.1)

EFR 20X4 = - x 20 – 0.0625 x 240 x 0.5
220 220

= 7.49

Balance Sheet as on 31st December, 20X4

Liabilities Rs. Assets Rs.

Share capital 46.87 Net fixed assets 90.00

(30+16.87) (60 x 240/160)
Retained earnings Inventories
(40.00+5.63+6.25+6.88+7.50)66.26 (50x240/160) 75.00
Term loans(20+16.87) 36.87 Debtors (30x240/160) 45.00
Short-term bank borrowings 30.00 Cash (10x240/160) 15.00
Trade creditors 37.50
Provisions 7.50

225.00 225.00

5.6. EFR A L m (1+g) (1-d)

= - -
S S S g
Given A/S= 0.8 , L/S= 0.5 , m= 0.05 , d= 0.6 and EFR = 0 we have,

(0.05)(1+g)(0.4)
(0.8-0.5) - =0
g
(0.05)(1+g)(0.4)
i.e. 0.3 - =0
g
 Solving the above equation we get g = 7.14%

A L
5.7. (a) EFR = - S – mS1 (1-d)
S S

320 70
= - x 100 – (0.05) (500) (0.5)
400 400

= Rs.50

(b) Let CA = denote Current assets

CL = Current liabilities
SCL = Spontaneous current liabilities
STL = Short-term bank borrowings
FA = Fixed assets
and LTL = Long-term loans

i. Current ratio 

CA
 i.e greater than or equal to 1.25 or
CL

CA

 STL +SCL

As at the end of 20X1, CA = 20x0 x 1.25 = 237.50

SCL = 70 x 1.25 = 87.50
Substituting these values, we get
1.25 (STL + 87.5) 237.50
or 1.25 STL x

  
or STL =
1.25
i.e STL  Rs.102.50
ii. Ratio of fixed assets to long term loans 1.25
FA

LTL
At the end of 20X1 FA = 130 x 1.25 = 162.5
162.5
LTL  or LTL = Rs.130
1.25
If  STL and  LTL denote the maximum increase in ST borrowings & LT
borrowings, we have :
 STL = STL (20X1) – STL (20X0) = 102.50 – 60.00 = 42.50
LTL = LTL (20X1)- LTL (20X0) = 130.00 – 80.00 = 50.00
Hence, the suggested mix for raising external funds will be :
Short-term borrowings 42.50
Long-term loans 7.50
Additional equity issue --

50.00

A L
5.8. EFR = -  S – m S1 (1-d)
S S
A S
Therefore, mS1(1-d) – - S represents surplus funds
S S
Given m= 0.06, S1 =11,000, d= 0.6 , L= 3,000 S= 10,000 and
surplus funds = 150 we have
A 3,000
(0.06) 11,000 (1-0.6) - - 1,000 = 150
10,000 10,000

A – 3,000
= (0.06) (0.4) (11,000) – 150 = 114
10

or A = (1,140 + 3,000) = 4,140

The total assets of Videosonics must be 4,140

5.9. m= .05 , d = 0.6 , A/E = 2.5 , A/S = 1.4

 m (1-d)A/E .05 (1-0.6) 2.5
(a) g= = = 3.70 per cent
A/S –m(1-d)A/E 1.4 -.05 (1-0.6) 2.5

.05 (1-d) x 2.5

(b) 0.5 =
1.4 - .05 (1-0.6) 2.5

d = 0.466
The dividend payout ratio must be reduced from 60 per cent to 46.6 per cent

.05 (1-0.6) x A/E

(c) .05 = A/E = 3.33
1.4 -.05 (1-0.6) A/E

The A/E ratio must increase from 2.5 to 3.33

m (1-0.6) 2.5
(d) .06 = m = 7.92 per cent
1.4 – m (1-0.6) x 2.5

The net profit margin must increase from 5 per cent to 7.92 per cent

.05 (1-0.6) 2.5

(e) .06 = A/S = .883
A/S - .05 (1-0.6) 2.5

The asset to sales ratio must decrease from 1.4 to 0.883

MINICASE

At present : DER = 1.31( Int. bearing debt to equity), Current ratio= 0.89
For the first year : S = 2400x 0.2 =480, S1= 2880, m = 192/2400 = 0.08
A L
EFR = [ -- - - ]S - m S1 (1-d) = 0
 S S
(1240/2400 - 340/2400)x 480 = 0.08 x 2880 x (1-d)
1-d = 0.78125 or d = 21.9 %
Projected abridged income statement and balance sheet for year 1
Income Statement:
Sales 2880.0
Profits before tax 329.1
Taxes (30%) 98.7
Profit after tax (8% on sales) 230.4
Dividends (21.9%) 50.5
Retained earnings 179.9
Balance sheet:
Share capital 100 = 100 Fixed assets 620 x 1.2=744
Retained Earnings 290 + 179.9 = 470 Inventories 360 x 1.2 = 432
Term Loans 150 = 150 Receivables 170 x 1.2 = 204
Short-term Bank Borrowings 360 = 360 Cash 90 x 1.2 = 108
Accounts Payable 250 x1.2 = 300
Provisions 90 x 1.2 = 108
1488 1488
DER = 510 / 570 = 0.89 Current ratio = 744/768=0.97
For the second year:
S1 = 2x 2400=4800 , S= (4800 - 2880) =1920
EFR = (1488/2880 - 408/2880)1920 - 0.08 x 4800 x(1-0.40) = 489.6
Projected abridged income statement:
Sales 4800.0
Profits before tax 548.6
Taxes (30%) 164.6
Profit after tax (8% on sales) 384
Dividends (40%) 153.6
Retained earnings 230.4

At the end of year two, if the entire external funds required is sought by way of an additional term
loan then the total interest bearing debt would be 510 +489.6 = 999.6 and equity would be 570 +
230.4 = 800.4 and consequently DER would be 999.6/800.4=1.25. As this ratio is above the bank’s
norm they would insist on a reduced loan amount.
Let x be the amount that should be reduced from debt and added to equity to have a DER = 1
((510 +(489.6 -x)) / (569.9 + 230.4 +x) =1
i.e 999.6 - x = 800.4 + x
2x = 199.2 or x = 99.6 or say 100
So the additional term loan to be sought is 389.6
Projected balance sheet for year 2:
Share capital 100 + 100 = 200.0 Fixed assets 744 x 4800/2880= 1240.0
Retained Earnings 470 + 230.4 = 700.4 Inventories 432 x 4800/2880 = 720.0
Term Loans 150+ (489.6-100)=539.6 Receivables 204 x 4800/2880 = 340.0
Short-term Bank Borrowings = 360.0 Cash 108 x4800/2880 = 180.0
Accounts Payable 300 x 4800/2880= 500.0
Provisions 108 x 4800/2880 = 180.0
2480.0 2480.0
DER = 899.6 /900.4 = 1.0 CR = 1240/1040 = 1.19

Chapter 6
TIME VALUE OF MONEY
6.1 Value five years hence of a deposit of Rs.1,000 at various interest rates is as follows:

r = 8% FV5 = 1000 x FVIF (8%, 5 years)

= 1000 x 1.469 = Rs.1469

r = 10% FV5 = 1000 x FVIF (10%, 5 years)

= 1000 x 1.611 = Rs.1611

r = 12% FV5 = 1000 x FVIF (12%, 5 years)

= 1000 x 1.762 = Rs.1762

r = 15% FV5 = 1000 x FVIF (15%, 5 years)

= 1000 x 2.011 = Rs.2011

6.2. Rs.160,000 / Rs. 5,000 = 32 = 25

According to the Rule of 72 at 12 percent interest rate doubling takes place

approximately in 72 / 12 = 6 years

So Rs.5000 will grow to Rs.160,000 in approximately 5 x 6 years = 30 years

6.3. Doubling period = 0.35 +69/interest rate(%)

Rs.1000 will double 3 times in 12 years
So the doubling period is 4 years
We have : 4 = 0.35 + 69/interest rate

interest rate = 69/(4-0.35) = 18.9%

6.4 Saving Rs.2000 a year for 5 years and Rs.3000 a year for 10 years thereafter is equivalent to
saving Rs.2000 a year for 15 years and Rs.1000 a year for the years 6 through 15.
Hence the savings will cumulate to:
2000 x FVIFA (10%, 15 years) + 1000 x FVIFA (10%, 10 years)
= 2000 x 31.772 + 1000 x 15.937 = Rs.79481.

6.5. Let A be the annual savings.

A x FVIFA (12%, 10 years) = 1,000,000

A x 17.549 = 1,000,000

So, A = 1,000,000 / 17.549 = Rs.56,983.

6.6. 1,000 x FVIFA (r, 6 years) = 10,000

FVIFA (r, 6 years) = 10,000 / 1000 = 10

From the tables we find that

FVIFA (20%, 6 years) = 9.930

FVIFA (24%, 6 years) = 10.980

Using linear interpolation in the interval, we get:

20% + (10.000 – 9.930)

r= x 4% = 20.3%
(10.980 – 9.930)

6.7. 1,000 x FVIF (r, 10 years) = 5,000

FVIF (r,10 years) = 5,000 / 1000 = 5

From the tables we find that

FVIF (16%, 10 years) = 4.411

FVIF (18%, 10 years) = 5.234

Using linear interpolation in the interval, we get:

(5.000 – 4.411) x 2%
r = 16% + = 17.4%
(5.234 – 4.411)
6.8 The present value of Rs.10,000 receivable after 8 years for various discount rates (r ) are:
r = 10% PV = 10,000 x PVIF(r = 10%, 8 years)
= 10,000 x 0.467 = Rs.4,670

r = 12% PV = 10,000 x PVIF (r = 12%, 8 years)

= 10,000 x 0.404 = Rs.4,040

r = 15% PV = 10,000 x PVIF (r = 15%, 8 years)

= 10,000 x 0.327 = Rs.3,270

6.9 Assuming that it is an ordinary annuity, the present value is:

2,000 x PVIFA (10%, 5years)
= 2,000 x 3.791 = Rs.7,582

6.10 The present value of an annual pension of Rs.10,000 for 15 years when r = 15% is:
10,000 x PVIFA (15%, 15 years)
= 10,000 x 5.847 = Rs.58,470

The alternative is to receive a lumpsum of Rs.50,000.

Obviously, Mr. Jingo will be better off with the annual pension amount of Rs.10,000.

6.11. The amount that can be withdrawn annually is:

100,000 100,000
A = ------------------ ------------ = ----------- = Rs.10,608
PVIFA (10%, 30 years) 9.427

6.12 The present value of the income stream is:

1,000 x PVIF (12%, 1 year) + 2,500 x PVIF (12%, 2 years)
+ 5,000 x PVIFA (12%, 8 years) x PVIF(12%, 2 years)

= 1,000 x 0.893 + 2,500 x 0.797 + 5,000 x 4.968 x 0.797 = Rs.22,683.

6.13 The present value of the income stream is:

2,000 x PVIFA (10%, 5 years) + 3000/0.10 x PVIF (10%, 5 years)
= 2,000 x 3.791 + 3000/0.10 x 0.621
= Rs.26,212

6.14 To earn an annual income of Rs.5,000 beginning from the end of 15 years from now, if the
deposit earns 10% per year a sum of
Rs.5,000 / 0.10 = Rs.50,000
is required at the end of 14 years. The amount that must be deposited to get this sum is:
Rs.50,000 / FVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,165
6.15 Rs.20,000 =- Rs.4,000 x PVIFA (r, 10 years)
PVIFA (r,10 years) = Rs.20,000 / Rs.4,000 = 5.00

From the tables we find that:

PVIFA (15%, 10 years) = 5.019
PVIFA (18%, 10 years) = 4.494
 Using linear interpolation we get:
5.019 – 5.00
r = 15% + ---------------- x 3%
5.019 – 4.494

= 15.1%

6.16 PV (Stream A) = Rs.100 x PVIF (12%, 1 year) + Rs.200 x

PVIF (12%, 2 years) + Rs.300 x PVIF(12%, 3 years) + Rs.400 x
PVIF (12%, 4 years) + Rs.500 x PVIF (12%, 5 years) +
Rs.600 x PVIF (12%, 6 years) + Rs.700 x PVIF (12%, 7 years) +
Rs.800 x PVIF (12%, 8 years) + Rs.900 x PVIF (12%, 9 years) +
Rs.1,000 x PVIF (12%, 10 years)

= Rs.100 x 0.893 + Rs.200 x 0.797 + Rs.300 x 0.712

+ Rs.400 x 0.636 + Rs.500 x 0.567 + Rs.600 x 0.507
+ Rs.700 x 0.452 + Rs.800 x 0.404 + Rs.900 x 0.361
+ Rs.1,000 x 0.322

= Rs.2590.9

Similarly,
PV (Stream B) = Rs.3,625.2
PV (Stream C) = Rs. 2,825.1

6.17. FV5 = Rs.10,000 [1 + (0.16 / 4)]5x4

= Rs.10,000 (1.04)20
= Rs.10,000 x 2.191
= Rs.21,910

6.18. FV5 = Rs.5,000 [1+( 0.12/4)] 5x4

= Rs.5,000 (1.03)20
= Rs.5,000 x 1.806
= Rs.9,030
6.19 A B C

Stated rate (%) 12 24 24

Frequency of compounding 6 times 4 times 12 times

Effective rate (%) (1 + 0.12/6)6- 1 (1+0.24/4)4 –1 (1 + 0.24/12)12-1

= 12.6 = 26.2 = 26.8

Difference between the

effective rate and stated
rate (%) 0.6 2.2 2.8

6.20 Investment required at the end of 8th year to yield an income of Rs.12,000 per year from the
end of 9th year (beginning of 10th year) for ever:

Rs.12,000 x PVIFA(12%, ∞ )
= Rs.12,000 / 0.12 = Rs.100,000

To have a sum of Rs.100,000 at the end of 8th year , the amount to be deposited now is:
Rs.100,000 Rs.100,000
= = Rs.40,388
PVIF(12%, 8 years) 2.476

6.21 The interest rate implicit in the offer of Rs.20,000 after 10 years in lieu of Rs.5,000 now
is:
Rs.5,000 x FVIF (r,10 years) = Rs.20,000

Rs.20,000
FVIF (r,10 years) = = 4.000
Rs.5,000

From the tables we find that

FVIF (15%, 10 years) = 4.046

This means that the implied interest rate is nearly 15%.

I would choose Rs.20,000 after 10 years from now because I find a return of 15%
quite acceptable.
6.22. FV10 = Rs.10,000 [1 + (0.10 / 2)]10x2
= Rs.10,000 (1.05)20
= Rs.10,000 x 2.653
= Rs.26,530

If the inflation rate is 8% per year, the value of Rs.26,530 10 years from now, in terms of
the current rupees is:
Rs.26,530 x PVIF (8%,10 years)
= Rs.26,530 x 0.463 = Rs.12,283

6.23. A constant deposit at the beginning of each year represents an annuity due.
PVIFA of an annuity due is equal to : PVIFA of an ordinary annuity x (1 + r)
To provide a sum of Rs.50,000 at the end of 10 years the annual deposit should
be , assuming an interest rate of 12 percent:

Rs.50,000
A = FVIFA(12%, 10 years) x (1.12)

Rs.50,000
= = Rs.2544
17.549 x 1.12

6.24 The discounted value of Rs.20,000 receivable at the beginning of each year from 2025 to
2029, evaluated as at the beginning of 2024 (or end of 2023) is:
Rs.20,000 x PVIFA (12%, 5 years)
= Rs.20,000 x 3.605 = Rs.72,100.

The discounted value of Rs.72,100 evaluated at the end of 2020 is

Rs.72,100 x PVIF (12%, 3 years)
= Rs.72,100 x 0.712 = Rs.51,335

If A is the amount deposited at the end of each year from 2015 to 2020 then
A x FVIFA (12%, 6 years) = Rs.51,335
A x 8.115 = Rs.51,335
A = Rs.51,335 / 8.115 = Rs.6326

6.25 The discounted value of the annuity of Rs.2000 receivable for 30 years, evaluated as at the
end of 9th year is:
Rs.2,000 x PVIFA (10%, 30 years) = Rs.2,000 x 9.427 = Rs.18,854

The present value of Rs.18,854 is:

Rs.18,854 x PVIF (10%, 9 years)
= Rs.18,854 x 0.424
= Rs.7,994
6.26 30 per cent of the pension amount is
0.30 x Rs.6000 = Rs.1800

Assuming that the monthly interest rate corresponding to an annual interest rate of 12% is
1%, the discounted value of an annuity of Rs.1800 receivable at the end of each month for 180
months (15 years) is:
Rs.1800 x PVIFA (1%, 180)

(1.01)180 - 1
Rs.1800 x ---------------- = Rs.149,980
.01 (1.01)180

If Mr. Ramesh borrows Rs.P today on which the monthly interest rate is 1%

P x (1.01)60 = Rs.149,980
P x 1.817 = Rs.149,980

Rs.149,980
P = ------------ = Rs.82,540
1.817

6.27 Rs.3000 x PVIFA(r, 24 months) = Rs.60,000

PVIFA (r,24) = Rs.60000 / Rs.3000 = 20

From the tables we find that:

PVIFA(1%,24) = 21.244
PVIFA (2%, 24) = 18.914

Using a linear interpolation

21.244 – 20.000
r = 1% + ---------------------- x 1%
21.244 – 18,914

= 1.53%

Thus, the bank charges an interest rate of 1.53% per month.

The corresponding effective rate of interest per annum is
[ (1.0153)12 – 1 ] x 100 = 20%

6.28 The discounted value of the debentures to be redeemed between 8 to 10 years evaluated at
the end of the 5th year is:
Rs.1000 million x PVIF (8%, 3 years)
+ Rs.1000 million x PVIF (8%, 4 years)
 + Rs.1000 million x PVIF (8%, 5 years)

= Rs.1000 million (0.794 + 0.735 + 0.681)

= Rs. 2210 million

If A is the annual deposit to be made in the sinking fund for the years 1 to 5,
then
A x FVIFA (8%, 5 years) = Rs.2210 million
A x 5.867 = Rs.2210 million
A = Rs.2210 million / 5.867 = Rs.376.68 million

6.29 Let `n’ be the number of years for which a sum of Rs.200,000 can be withdrawn annually.

Rs.200,000 x PVIFA (10%, n) = Rs.1,000,000

PVIFA (10 %, n) = Rs.1,000,000 / Rs.200,000 = 5.000

From the tables we find that

PVIFA (10%, 7 years) = 4.868
PVIFA (10%, 8 years) = 5.335

Thus n is between 7 and 8. Using a linear interpolation we get

5.000 – 4.868
n=7+ ----------------- x 1 = 7.3 years
5.335 – 4.868

6.30 Equated annual installment = 500000 / PVIFA(14%,4)

= 500000 / 2.914
= Rs.171,585

Loan Amortisation Schedule

Beginning Annual Principal Remaining

Year amount installment Interest repaid balance
------ ------------- --------------- ----------- ------------- -------------
1 500000 171585 70000 101585 398415
2 398415 171585 55778 115807 282608
3 282608 171585 39565 132020 150588
4 150588 171585 21082 150503 85*

(*) rounding off error

6.31 Define n as the maturity period of the loan. The value of n can be obtained from the
equation.

200,000 x PVIFA(13%, n) = 1,500,000

PVIFA (13%, n) = 7.500

From the tables or otherwise it can be verified that PVIFA(13,30) = 7.500

Hence the maturity period of the loan is 30 years.

6.32. Expected value of iron ore mined during year 1 = Rs.300 million

Expected present value of the iron ore that can be mined over the next 15 years
assuming a price escalation of 6% per annum in the price per tonne of iron

1 – (1 + g)n / (1 + i)n
= Rs.300 million x ------------------------
i-g

= Rs.300 million x 1 – (1.06)15 / (1.16)15

0.16 – 0.06

= Rs.300 million x (0.74135 / 0.10)

= Rs.2224 million
6.33 (a) PV = Rs.500,000
(b) PV = 1,000,000PVIF10%,6yrs = 1,000,000 x 0.564 = Rs.564,000
(c ) PV = 60,000/r = 60,000/0.10 = Rs.600,000
(d) PV = 100,000 PVIFA10%,10yrs = 100,000 x 6.145 = Rs.614,500
(e) PV = C/(r-g) = 35,000/(0.10-0.05) = Rs.700,000
Option e has the highest present value viz. Rs.700,000

6.34. (a) PV = c/(r – g) = 12/[0.12 – (-0.03)] = Rs.80 crore

1+g n
1 - -------
(b) 1+r
PV = A(1+g) ----------------- = 12 x 0.9725 / 0.15 = Rs.77.8 crore
r- g

6.35. It may be noted that if g1 is the growth rate in the no. of units and g2 the growth rate in
price per unit, then the growth rate of their product, g = (1+g1)(1+g2) - 1
 In this problem the growth rate in the value of oil produced, g = (1- 0.05)(1 +0.03) - 1 = -
0.0215

Present value of the well’s production =

1+g n
1 - -------
1+r
PV = A(1+g) -----------------
r- g

= (50,000 x 50) x ( 1-0.0215)x 1 – (0.9785 / 1.10)15

0.10 + 0.0215

= $ 16,654,633
6.36.
The growth rate in the value of the oil production g = (1- 0.06)(1 +0.04) - 1
= - 0.0224

Present value of the well’s production =

1+g n
1 - -------
1+r
PV = A(1+g) -----------------
r- g

= (80,000 x 60) x ( 1-0.0224)x 1 – (0.9776 / 1.12)20

0.12 + 0.0224

= $ 30,781,328.93

6.37. Future Value Interest Factor for Growing Annuity,

( 1+ i )n – ( 1 + g)n
FVIFGA =
i-g
(1. 09)20 – ( 1.08)20
So the value of the savings at the end of 20 years = 100,000 x
0.09 – 0.08

= Rs. 9,434,536
6.38
Assuming 52 weeks in an year, the effective interest rate is

52
0.08
1 + - 1 = 1.0832 - 1 = 8.32 percent
52

6.39
We have ( 1+ r/365)365x7 = 2
( 1+ r/365)2555 = 2
r = (21/2555- 1)x365 = 0.099 or 9.9 percent

6.40
If A is the equated annual instalment, we have A x PVIFA(9.5%,5 yrs) = 100,000
A x[ (1- 1/1.0955)/0.095] = 100,000
A x 3.8397 = 100,000 or A = Rs.26,044

Loan amortisation schedule Amounts in Rs.

Beginning Annual Principal Remaining
Year amount instalment Interest repayment balance
1 100,000 26,044 9500 16,544 83,456
2 83,456 26,044 7928 18,116 65,340
3 65,340 26,044 6207 19,837 45,504
4 45,504 26,044 4323 21,721 23,782
5 23,782 26,044 2259 23,785 -2

6.41
Future Value Interest Factor for Growing Annuity,
( 1+ i )n – ( 1 + g)n
FVIFGA =
i-g
Let us try say 5 years
(1. 08)6 – ( 1.10)6
Savings at the end of 6 years = 10,00,000 x
0.08 – 0.10

= 10,00,000 x 9.2343 = 92,343,000

(1. 08)7 – ( 1.10)7
Savings at the end of 7 years = 10,00,000 x
0.08 – 0.10
 = 10,00,000 x 11.7446 = 117,446,000

So the time needed = 6 + 17,446,000/(117,446,000 – 92,343,000) = 6.69 years

James will have to wait for at least 7 years.

6.42 If Rs 50 million is required after 20 years, the current requirement at a discount rate
of 9% is Rs 50,000,000/ (1.09)20 = Rs 8,921,544. If  percentage is saved annually the
first saving will be  x 30,0000 at the end of year 1. This wil grow at a rate of 10 percent
(g = 0.10). It will earn 9 percent (r = 0.09). This will continue for 20 years (n = 20). The
present value of this growing annuity should be Rs. 8,921,544.

1 – (1.10)20
(1.09)20
 x 3,000,000
.09 - .10
= 8,921,544
 = 0.1484

6.43
100000
85000 =
(1+r)
100000
1+ r = = 1.1765
85000
So r = 0.1765 or 17.65 percent

6.44

1
500000 1– r = 300000
(1+r)10 r
 1
500000 1- = 300000
(1+r)10

500000 – 500000 = 300000

(1+r)10
500000 = 200000
(1+r)10
(1+r)10 = 2.50
r = .09596 or 9.596%

6.45
The interest rate for a four year period is
ern – 1 = 0.6161 or 61.61 percent
We have to calculate the present value of a Rs. 1,000,000 annuity over 10 periods (40/4)
with an interest rate of 61.61 percent. This works out to
1
1-
(1.6161)10
1,000,000 = 1,609,757
0.6161
 MINICASE--1

Solution:

1. How much money would Ramesh need 15 years from now?

500,000 x PVIFA (10%, 15years)

+ 1,000,000 x PVIF (10%, 15years)
= 500,000 x 7.606 + 1,000,000 x 0.239
= 3,803,000 x 239,000
= Rs.4,042,000

2. How much money should Ramesh save each year for the next 15 years to be able to meet his
investment objective?

Ramesh’s current capital of Rs.600,000 will grow to :

600,000 (1.10)15 = 600,000 x 4.177 = Rs 2,506,200

This means that his savings in the next 15 years must grow to :

4,042,000 – 2,506,200 = Rs 1,535,800

So, the annual savings must be :

1,535,800 1,535,800
= = Rs.48,338
FVIFA (10%, 15 years) 31.772

3. How much money would Ramesh need when he reaches the age of 60 to meet his donation
objective?

200,000 x PVIFA (10% , 3yrs) x PVIF (10%, 11yrs)

= 200,000 x 2.487 x 0.317 = 157,676

4. What is the present value of Ramesh’s life time earnings?

400,000 400,000(1.12) 400,000(1.12)14

46
1 2 15

15
1.12
 1–
1.08
= 400,000
0.08 – 0.12

= Rs.7,254,962

MINICASE--2

Solution: 1)
Re.1 deposit each at the
end of month 0 1 2 3 4 5 6 9 12 40 44

becomes Rs.3.0402 Rs.3.0402 Rs.3.0402 Rs.3.0402 Rs.3.0402 Rs.3.0402

MBA expenses for year I at present = 20 lakhs. After 10 years it would be = 20(1+0.05) 10 = 32.58 lakhs
MBA expenses for year II at present = 25 lakhs. After 11 years it would be = 25(1+0.05) 11 = 42.76 lakhs
At the end of 3 months, each 1 Rupee deposited in the RD account becomes = FVIFA(0.08/12,3)
= [{(1+0.08/12)3 -1} / (0.08/12)] x (1+0.08/12) = {(1.00667)3-1}/0.00667 x 1.00667 = Rs.3.0402 which when
compounded quarterly becomes at the end of 10 years = 3.0402 x [(1+0.08/4)4x10 - 1]/ (0.08/4)
= 3.0402 x [(1.02)40 – 1] / 0.02 = Rs. 183.634
For a RD maturity value of Rs.183.634 if the deposit to be made is Rs.1, for a maturity value of
Rs.32.58 lakhs, the monthly deposit to be made will be = 32,58,000/183.634 = Rs.17,742
Similarly for a maturity value of Rs.42.76 lakhs the monthly deposit needed .will be
= 42,76,000 / [3.0402 x {(1.02)44 – 1} / 0.02] = Rs. 20,236
2)
Amount required for Jasleen’s marriage at the end of 20 years = Rs.300 lakhs
Cumulative fixed deposit to be made now to get the above amount = 300,00,000 / (1+0.08/4) 4x20
= Rs.61,53,292

3)

Annuity Period
Year end 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

What deposit? Annuity Payments 12L 12L 12L 12L 12L 12L 12L 12L 12L 12L
Annuity needed per annum at the beginning of each year in real terms after 10 years = Rs.12 lakhs
With inflation at 5 percent, in nominal terms, this may be considered as a growing annuity for
10 years at a growth rate of 5 percent and discount rate of 10 percent.
Present value of the annuity , as at the beginning of the 10th year from now
= 12,00,000 x (1+0.05)[ 1 –(1+0.05)/(1+0.10)10 /(0.10-0.05)] = Rs.93,74,163
Amount to be deposited in cumulative fixed deposit now, to have a maturity value of
Rs.93,74,163 at the end of 9 years = 93,74,163/(1+0.08/4)4x9 = Rs.45,95,432
 Chapter 7

VALUATION OF BONDS AND STOCKS

7.1. 5 11 100
P =  +
t=1 (1.15)t (1.15)5

= Rs.11 x PVIFA(15%, 5 years) + Rs.100 x PVIF (15%, 5 years)

= Rs.11 x 3.352 + Rs.100 x 0.497
= Rs.86.7

7.2.(i) When the discount rate is 14%

7 12 100
P =  +
t=1 (1.14) t (1.14)7

= Rs.12 x PVIFA (14%, 7 years) + Rs.100 x PVIF (14%, 7 years)

= Rs.12 x 4.288 + Rs.100 x 0.4
= Rs.91.46

(ii) When the discount rate is 12%

7 12 100
P =  + = Rs.100
t 7
t=1 (1.12) (1.12)

Note that when the discount rate and the coupon rate are the same the value is equal to
par value.

7.3. The yield to maturity is the value of r that satisfies the following equality.
7 120 1,000
Rs.750 =  +
t
t=1 (1+r) (1+r)7

Try r = 18%. The right hand side (RHS) of the above equation is:
Rs.120 x PVIFA (18%, 7 years) + Rs.1,000 x PVIF (18%, 7 years)
= Rs.120 x 3.812 + Rs.1,000 x 0.314
= Rs.771.44

Try r = 20%. The right hand side (RHS) of the above equation is:
Rs.120 x PVIFA (20%, 7 years) + Rs.1,000 x PVIF (20%, 7 years)
= Rs.120 x 3.605 + Rs.1,000 x 0.279
= Rs.711.60
 Thus the value of r at which the RHS becomes equal to Rs.750 lies between 18% and 20%.

Using linear interpolation in this range, we get

771.44 – 750.00
Yield to maturity = 18% + 771.44 – 711.60 x 2%

= 18.7%

7.4.
10 14 100
80 =  +
t=1 (1+r) t (1+r)10

Try r = 18%. The RHS of the above equation is

Rs.14 x PVIFA (18%, 10 years) + Rs.100 x PVIF (18%, 10 years)

= Rs.14 x 4.494 + Rs.100 x 0.191 = Rs.82

Try r = 20%. The RHS of the above equation is

Rs.14 x PVIFA(20%, 10 years) + Rs.100 x PVIF (20%, 10 years)
= Rs.14 x 4.193 + Rs.100 x 0.162
= Rs.74.9

Using interpolation in the range 18% and 20% we get:

82 - 80
Yield to maturity = 18% + ----------- x 2%
82 – 74.9

= 18.56%

7.5
12 6 100
P =  +
t=1 (1.08) t (1.08)12

= Rs.6 x PVIFA (8%, 12 years) + Rs.100 x PVIF (8%, 12 years)

= Rs.6 x 7.536 + Rs.100 x 0.397
= Rs.84.92
7.6 The post-tax interest and maturity value are calculated below:

Bond A Bond B

* Post-tax interest (C ) 12(1 – 0.3) 10 (1 – 0.3)

=Rs.8.4 =Rs.7

* Post-tax maturity value (M) 100 - 100 -

[ (100-70)x 0.1] [ (100 – 60)x 0.1]
=Rs.97 =Rs.96

The post-tax YTM, using the approximate YTM formula is calculated below

8.4 + (97-70)/10
Bond A : Post-tax YTM = --------------------
0.6 x 70 + 0.4 x 97

= 13.73%

7 + (96 – 60)/6
Bond B : Post-tax YTM = ----------------------
0.6x 60 + 0.4 x 96

= 17. 47%

7.7
14 6 100
P =  +
t=1 (1.08) t (1.08)14

= Rs.6 x PVIFA(8%, 14) + Rs.100 x PVIF (8%, 14)

= Rs.6 x 8.244 + Rs.100 x 0.341
= Rs.83.56

7.8 Do = Rs.2.00, g = 0.06, r = 0.12

Po = D1 / (r – g) = Do (1 + g) / (r – g)

= Rs.2.00 (1.06) / (0.12 - 0.06)

= Rs.35.33

Since the growth rate of 6% applies to dividends as well as market price, the market price
at the end of the 2nd year will be:
 P2 = Po x (1 + g)2 = Rs.35.33 (1.06)2
= Rs.39.70

7.9. Po = D1 / (r – g) = Do (1 + g) / (r – g)
= Rs.12.00 (1.10) / (0.15 – 0.10) = Rs.264

7.10. Po = D1 / (r – g)

Rs.32 = Rs.2 / (0.12 – g)

g = 0.0575 or 5.75%

7.11. Po = D1/ (r – g) = Do(1+g) / (r – g)

Do = Rs.1.50, g = -0.04, Po = Rs.8
So
8 = 1.50 (1- .04) / (r-(-.04)) = 1.44 / (r + .04)

Hence r = 0.14 or 14 per cent

7.12 The market price per share of Commonwealth Corporation will be the sum of three
components:

A: Present value of the dividend stream for the first 4 years

B: Present value of the dividend stream for the next 4 years
C: Present value of the market price expected at the end of 8 years.

A= 1.50 (1.12) / (1.14) + 1.50 (1.12)2 / (1.14)2 + 1.50(1.12)3 / (1.14)3 +

+ 1.50 (1.12)4 / (1.14)4

= 1.68/(1.14) + 1.88 / (1.14)2 + 2.11 / (1.14)3 + 2.36 / (1.14)4

= Rs.5.74

B= 2.36(1.08) / (1.14)5 + 2.36 (1.08)2 / (1.14)6 + 2.36 (1.08)3 / (1.14)7 +

+ 2.36 (1.08)4 / (1.14)8

= 2.55 / (1.14)5 + 2.75 / (1.14)6 + 2.97 / (1.14)7 + 3.21 / (1.14)8

= Rs.4.89

C = P8 / (1.14)8

P8 = D9 / (r – g) = 3.21 (1.05)/ (0.14 – 0.05) = Rs.37.45

So

C = Rs.37.45 / (1.14)8 = Rs.13.14

 Thus,
Po = A + B + C = 5.74 + 4.89 + 13.14
= Rs.23.77

7.13 Let us assume a required rate of return of 12 percent. Using the two stage formula, the
intrinsic value of the equity share will be :

Intrinsic value of the equity share (using the 2-stage growth model)

(1.15)5
2.30 x 1 - ----------- 2.30 x (1.15)4 x (1.10)
5
(1.12)
= --------------------------------- + -----------------------------------
0.12 – 0.15 (0.12 – 0.10) x (1.12)5

- 0.1413
= 2.30 x ----------- + 125.54
- 0.03

= Rs.136.37

7.14 Terminal value of the interest proceeds

= 140 x FVIFA (16%,4)
= 140 x 5.066
= 709.24

Redemption value = 1,000

Terminal value of the proceeds from the bond = 1709.24

Define r as the yield to maturity. The value of r can be obtained from the equation

900 (1 + r)4 = 1709.24

r = 0.1739 or 17.39%

7.15 Intrinsic value of the equity share (using the 2-stage growth model)

(1.18)6
2.36 x 1 - ----------- 2.36 x (1.18)5 x (1.12)
6
(1.16)
= --------------------------------- + -----------------------------------
 0.16 – 0.18 (0.16 – 0.12) x (1.16)6

- 0.10801
= 2.36 x ----------- + 62.05
- 0.02

= Rs.74.80

7.16 Intrinsic value of the equity share (using the H model)

4.00 (1.10) 4.00 x 4 x (0.10)

= -------------- + ---------------------
0.18 – 0.10 0.18 – 0.10

= 55 + 20
= Rs.75
7.17.

Po = D1
r–g

Po
Rs. 8 = Rs. 266.7
=
0.15-0.12

Po = E1 + PVGO
r

Po = Rs. 20 + PVGO
0.15
Rs. 266.7 = Rs. 133.3 + PVGO

So, PVGO = Rs. 133.4

7.18
Terminal value of the coupon proceeds of a bond
= 5.5 x FVIFA (4.5%,10)
= 5.5 x (1.045)10-1)/0.045
= 5.5 x 12.29
= Rs.67.59

Redemption value = Rs.100

 Terminal value of the proceeds from the bond =Rs. 167.59

Define r as the yield to maturity. The value of r can be obtained from the equation

100 (1 + r)5 = 167.59

r = (1.6759)(1/5) -1 = .10.88%

7.19
Post-tax interest (C ) = 100(1 – 0.3) = Rs.70

Post-tax maturity value (M) 1000 - (1000-880)x 0.09]

=Rs. 989.2

The post-tax YTM, using the approximate YTM formula is calculated below

70 + (989.2 -880)/8
Post-tax YTM = --------------------
0.6 x 880 + 0.4 x 989.2

= 9.06 %

7.20
Net profit expected = 800 x 0.10 = Rs.80 million
Dividend next expected = 80 x 0.4 = Rs.32 million
P0 = (32/10) / (0.14 – 0.09) = Rs.64

Po = E1 + PVGO
r

= 8/0.14 + PVGO
So PVGO = 64 – 8/0.14 =Rs. 6.86

7.21
Dividend next expected = 200 x1.30x 0.12 x0.10 = Rs.3.12 crore
DPS next year = 3.12/0.8 = Rs.3.9

Intrinsic value of the equity share (using the 2-stage growth model)

(1.30)3
3.9 x 1 - ----------- 3.9 x (1.30)2 x (1.10)
(1.16)3
 = --------------------------------- + -----------------------------------
0.16 – 0.30 (0.16 – 0.10) x (1.16)3
= 11.35 +77.41

= Rs.88.76

7.22
Do = Rs.6.00, g = 0.05, r = 0.20

Po = D1 / (r – g) = Do (1 + g) / (r – g)

= Rs.6.00 (1.05) / (0.20 - 0.05)

= Rs.42

The market price at the end of the 2nd year will be:

P2 = Po x (1 + g)2 = Rs.42 (1.05)2

= Rs.46.3

7.23
100 + (-50/12)
= 9.30 percent
0.4 x 1000 + 0.6 x 1050

7.24

5 100 1000
Price of Bond A =  +
t=1 (1.09)t(1.09)5
= 100 x 3.890 + 1000 x 0.650
= 389 + 650 = Rs 1039

5 80 1000
Price of Bond B =  +
t=1 (1.09)t (1.09)5
= 80 x 3.890 + 1000 + 0.650
= Rs 961
 100
Current yield of A = = 9.62%
1039
80
Current yield of B = = 8.32%
961
Price of Bond A, a year hence “
5 100 1000
 +
t=1 (1.09) t (1.09)4
= 100 x 3.240 = 1000 x 0.708
= Rs 1032
Capital gains yield for Bond A
1032 -1039
Over the next year = = -0.67%
1039
Price of Bond B, a year hence:

4 80 1000
 +
t=1 (1.09)t (1.09)4
= 80 x 3.240 + 1000 + 0.708
= Rs 967.2
Capital gains yield for Bond B over the next year :
967.2 – 961.0
= 0.65%
961. 0

7.25
Implicit yield at the time of issue :
100,000 1/20
- 1 = 12.20%
10,000
1. Return to investor who sells on January 1, 2019:
30,040 1/9
- 1 = 13 %
10,000
 2. Return expected by an investor who buys on January 1,2019
100,000 1/11
- 1 = 11.55%
30,040

7.26
Given that investors require a return of 14 percent and the constant dividend growth rate
is 8 percent, the dividend yield is 6%. On the current price of Rs. 90, the dividend
expected a year from now will be Rs. 90 x 0.06 = Rs 5.4. This means that the dividend
paid per share recently was = Rs 5.4 = Rs 5.00
(1.08)

MINICASE 1

(a) The value of a bond is calculated using the formula

n C M
P =  +
t=1 (1+r)t (1+r)n
where P is the value (in rupees), n is the number of years to maturity, C is the annual coupon
payment (in rupees), r is the periodic required return, M is the maturity value, and t is the time
when the payment is received

(b) Value of the bond = 100 PVIFA8% , 5years + 1000 PVIF8% , 5years
= 100 x 3.993 + 1000 x 0.681 = Rs.1080.30
 100 + ( 1000 – 1060)/8
(c) Approximate YTM = = 8.93%
0.4 x 1000 + 0.6 x 1060

(d) 100 + ( 1050 – 1060)/2

Approximate YTC = = 9%
0.4 x 1050 + 0.6 x 1060

(e) The general formula for valuing any stock is :

 Dt
P0 = 

t=1 (1+r)t

(f) A constant growth stock is valued using the formula

D1
P0 =
r-g

where D1 is the dividend expected a year hence, r is the required rate of return and g is the
constant growth rate

(g)
(i) The expected value of the stock a year from now
D2 6 x (1+0.12)2
P1 = = = Rs.250.88
r- g 0.15 – 0.12
6 x 1.12
(ii) Price of the stock at present, P0 = = Rs.224
0.15 – 0.12

Expected dividend in the first year = 6 x1.12 = Rs.6.72

6.72
Dividend yield = x 100 = 3 %
224
Expected capital gains in the first year = P1 –P0 = 250.88 – 224 = Rs.26.88
26.88
Capital gains yield = x 100 = 12 %
224

(h) Present value of the stock is :

 n
1+g1
1 -
1+r D1 (1+g1)n-1 (1+g2) 1
P0 = D1 +
r - g1 r - g2 (1+r)n

4
1.25
1 - 1.16 (10 x 1.25) x (1.25)3 x 1.10 1
= (10 x 1.25) + x
0.16 – 0.10 (1.16)4
0.16 – 0.25

= 48.38 + 447.59 /1.81 = Rs. 295.67

(i) Intrinsic value per share:

D0 [(1+gn) + H (ga-gn)]
P0 =
r - gn

8[ 1.10 + 1.5 x (0.20 – 0.10]

= = Rs. 250
0.14 – 0.10

MINICASE 2

Solution:
1)
The approximate yield to maturity of the existing unsecured bonds is the return required by the
investors on the company’s bonds. The same is:
= [8+ (100-90)/5]/ (0.4 x 100 + 0.6 x 90) = 10.64 %
So the company will have to offer a coupon rate of 10.64 percent to issue the new debentures at
par.
2)
Addition Additional Additional debt
to assets = retained +
earnings

A0g = m S0 (1+g) b + m S0 (1+g) b (D/E)

530g = 0.08 x 625 x(1+g)x 0.4+100
530g = 20+20g +100 g = 23.53%
If we can arrange an additional debt of Rs.10 crores, a growth rate of 23.53 percent can be
sustained. The EPS for the current year will be = [625 x 1.2353 x 0.08] /(250/10)
= 61.76/25 = Rs.2.47
P/E = 24.7/2.47 = 10.
This is much below the industry average P/E multiple of 14.
As per the dividend discount model:
The required rate of return = 1.2 x1.2353 /24.7 + 0.2353 = 29.53 %
That is, the market capitalisation rate is 29.53 percent.
The ROE for the current year will be = 61.76/ (330 + 61.76x0.4) = 17.41 %
As the expected return on equity is much less than the market capitalisation rate, there is no scope
for improvement of the share price in the present business where the net profit margin is only 8
percent.
3) The dividend in the first year after diversification = 1.2 x 1.2353 x 1.4 = Rs.2.075
 n
1+g1
2 -
1+r D2 (1+g1)n-1 (1+g2) 1
P1 = D2 +
r - g1 r - g2 (1+r)n

4
1.4
1 -
1.15 2.075 (1.4)3 (1.12) 1
= 2.075 +
0.15 – 0.4 0.15 – 0.12 (1.15)4

= 9.93 + 121.54 = 131.47

E2
P1 = + PVGO
r
131.47 =( 2.47 x 1.4) / 0.15 + PVGO
PVGO = Rs. 108.42 million

-----------------------------------------------------------------------------------------------------------------------
 Chapter 8
RISK AND RETURN

8.1 (a) Expected price per share a year hence will be:

= 0.4 x Rs.10 + 0.4 x Rs.11 + 0.2 x Rs.12 = Rs.10.80

(b) Probability distribution of the rate of return is

Rate of return (Ri) 10% 20% 30%

Probability (pi) 0.4 0.4 0.2

Note that the rate of return is defined as:

Dividend + Terminal price

-------------------------------- - 1
Initial price

8.2 (a) For Rs.1,000, 20 shares of Alpha’s stock can be acquired. The probability distribution of
the return on 20 shares is

Economic Condition Return (Rs) Probability

High Growth 20 x 55 = 1,100 0.3
Low Growth 20 x 50 = 1,000 0.3
Stagnation 20 x 60 = 1,200 0.2
Recession 20 x 70 = 1,400 0.2

Expected return = (1,100 x 0.3) + (1,000 x 0.3) + (1,200 x 0.2) + (1,400 x 0.2)

= 330 + 300 + 240 + 280

= Rs.1,150

Standard deviation of the return = [(1,100 – 1,150)2 x 0.3 + (1,000 – 1,150)2 x

0.3 + (1,200 – 1,150)2 x 0.2 + (1,400 – 1,150)2 x 0.2]1/2

= Rs.143.18

(b) For Rs.1,000, 20 shares of Beta’s stock can be acquired. The probability distribution of the
return on 20 shares is:
 Economic condition Return (Rs) Probability

High growth 20 x 75 = 1,500 0.3

Low growth 20 x 65 = 1,300 0.3
Stagnation 20 x 50 = 1,000 0.2
Recession 20 x 40 = 800 0.2

Expected return = (1,500 x 0.3) + (1,300 x 0.3) + (1,000 x 0.2) + (800 x 0.2)
= Rs.1,200

Standard deviation of the return = [(1,500 – 1,200)2 x .3 + (1,300 – 1,200)2 x .3

+ (1,000 – 1,200)2 x .2 + (800 – 1,200)2 x .2]1/2 = Rs.264.58

(c ) For Rs.500, 10 shares of Alpha’s stock can be acquired; likewise for Rs.500, 10
shares of Beta’s stock can be acquired. The probability distribution of this option is:
Return (Rs) Probability
(10 x 55) + (10 x 75) = 1,300 0.3
(10 x 50) + (10 x 65) = 1,150 0.3
(10 x 60) + (10 x 50) = 1,100 0.2
(10 x 70) + (10 x 40) = 1,100 0.2

Expected return = (1,300 x 0.3) + (1,150 x 0.3) + (1,100 x 0.2) +

(1,100 x 0.2)
= Rs.1,175
Standard deviation = [(1,300 –1,175)2 x 0.3 + (1,150 – 1,175)2 x 0.3 +

(1,100 – 1,175)2 x 0.2 + (1,100 – 1,175)2 x 0.2 ]1/2

= Rs.84.41
d. For Rs.700, 14 shares of Alpha’s stock can be acquired; likewise for Rs.300, 6
shares of Beta’s stock can be acquired. The probability distribution of this
option is:

Return (Rs) Probability

(14 x 55) + (6 x 75) = 1,220 0.3

(14 x 50) + (6 x 65) = 1,090 0.3
(14 x 60) + (6 x 50) = 1,140 0.2
(14 x 70) + (6 x 40) = 1,220 0.2

Expected return = (1,220 x 0.3) + (1,090 x 0.3) + (1,140 x 0.2) + (1,220 x 0.2)
= Rs.1,165
 Standard deviation = [(1,220 – 1,165)2 x 0.3 + (1,090 – 1,165)2 x 0.3 +
(1,140 – 1,165)2 x 0.2 + (1,220 – 1,165)2 x 0.2]1/2
= Rs.57.66

The expected return to standard deviation of various options are as follows :

Expected return Standard deviation Expected / Standard
Option (Rs) (Rs) return deviation
a 1,150 143 8.04
b 1,200 265 4.53
c 1,175 84 13.99
d 1,165 58 20.09

Option `d’ is the most preferred option because it has the highest return to risk ratio.

8.3.(a) Define RA and RM as the returns on the equity stock of Auto Electricals Limited a and
Market portfolio respectively. The calculations relevant for calculating the beta of the
stock are shown below:

Year RA RM RA-RA RM-RM (RA-RA) (RM-RM) RA-RA/RM-RM

1 15 12 -0.09 -3.18 0.01 10.11 0.29
2 -6 1 -21.09 -14.18 444.79 201.07 299.06
3 18 14 2.91 -1.18 8.47 1.39 -3.43
4 30 24 14.91 8.82 222.31 77.79 131.51
5 12 16 0-3.09 0.82 9.55 0.67 -2.53
6 25 30 9.91 14.82 98.21 219.63 146.87
7 2 -3 -13.09 -18.18 171.35 330.51 237.98
8 20 24 4.91 8.82 24.11 77.79 43.31
9 18 15 2.91 -0.18 8.47 0.03 -0.52
10 24 22 8.91 6.82 79.39 46.51 60.77
11 8. 12 -7.09 -3.18 50.27 10.11 22.55

RA = 15.09 RM = 15.18

 (RA – RA)2 = 1116.93  (RM – RM) 2 = 975.61  (RA – RA) (RM – RM) = 935.86

Beta of the equity stock of Auto Electricals

 (RA – RA) (RM – RM)

 (RM – RM) 2
 = 935.86 = 0.96
975.61
(b)
Alpha = RA – βA RM

= 15.09 – (0.96 x 15.18) = 0.52

Equation of the characteristic line is

RA = 0.52 + 0.96 RM

8.4 The required rate of return on stock A is:

RA = RF + βA (RM – RF)
= 0.10 + 1.5 (0.15 – 0.10)
= 0.175

Intrinsic value of share = D1 / (r- g) = Do (1+g) / ( r – g)

Given Do = Rs.2.00, g = 0.08, r = 0.175

2.00 (1.08)
Intrinsic value per share of stock A =
0.175 – 0.08

= Rs.22.74

8.5 The SML equation is RA = RF + βA (RM – RF)

Given RA = 15%. RF = 8%, RM = 12%, we have

0.15 = .08 + βA (0.12 – 0.08)

0.07
i.e.βA = = 1.75
0.04

Beta of stock A = 1.75

8.6 The SML equation is: RX = RF + βX (RM – RF)

We are given 0.15 = 0.09 + 1.5 (RM – 0.09) i.e., 1.5 RM = 0.195
or RM = 0.13%

Therefore return on market portfolio = 13%

8.7. RM = 12% βX = 2.0 RX =18% g = 5% Po = Rs.30

Po = D1 / (r - g)

Rs.30 = D1 / (0.18 - .05)

So D1 = Rs.2.10 and Do = D1 / (1+g) = 2.1/(1.05) = Rs.2

Rx = Rf + βx (RM – Rf)

0.18 = Rf + 2.0 (0.12 – Rf)

So Rf = 0.06 or 6%.

Original Revised

Rf 6% 8%
RM – Rf 6% 4%
g 5% 4%
βx 2.0 1.8

Revised Rx = 8% + 1.8 (4%) = 15.2%

Price per share of stock X, given the above changes is

3.71 (1.04)
= Rs.34.45
0.152 – 0.04
8.8

We know that:

Debt (1-tc)
β equity = β assets 1 +
Equity
i.e
β equity 1.1
β assets = = = 0.71
Debt(1-tc) 4
1 + ----------- 1 + --- ( 1 – 0.30)
Equity 5
8.9
Average for A = 9.833
Standard Deviation of A = 12.88%
Variance of A = 165.77

Average for B = 8.333

Standard deviation for B = 14.51%
Variance of B = 210.67

8.10
6+ 42 – 10 + 25 – 5
Arithmetic mean return = = 11.6%
5
Geometric mean return = (1.06) (1.42) (0.90) (1.25) (0.95) 1/5 – 1
= .0.10 or 10%

8.11
Expected return = 7 + 1.2 (13 -7) = 14.2%
8.12
13.3 = RFR + 0.9 (14 – RFR)
= 12.6 + 0.1 RFR
0.1 RFR = 0.7
So RFR = 7.0

MINICASE 1
a)
Month Monthly returns on

Tata Motors TCS Hindustan Uniliver Nifty

R(TM)(%) R(TCS)(%) R(HUL)(%) R(M)(%)
2016 June
July 9.57% 2.59% 2.67% 4.23%
August 6.86% -4.12% -0.60% 1.71%
September -0.53% -3.21% -5.37% -1.99%
October -0.54% -1.64% -3.31% 0.17%
November -13.66% -4.81% 0.58% -4.65%
December 2.77% 3.93% -2.09% -0.47%
2017 January 10.92% -5.74% 3.52% 4.59%
February -12.76% 10.60% 1.23% 3.72%
 March 1.99% -1.40% 5.30% 3.31%
April -1.49% -6.52% 2.54% 1.42%
May 3.76% 12.03% 14.12% 3.41%
June -9.16% -7.24% 1.18% -1.04%
July 2.79% 5.48% 7.05% 5.84%
August -15.31% 0.18% 5.54% -1.58%
September 6.63% -2.42% -3.76% -1.30%
October 6.70% 7.72% 5.41% 5.59%
November -5.66% 0.50% 2.83% -1.05%
December 6.85% 2.43% 7.50% 2.97%
2018 January -7.49% 15.22% 0.11% 4.72%
February -7.41% -2.48% -3.77% -4.85%
March -11.64% -6.13% 1.18% -3.61%
April 4.15% 23.97% 13.17% 6.19%
May -17.01% -1.42% 6.80% -0.03%
June -4.67% 6.13% 1.84% -0.20%
July -1.93% 5.00% 5.51% 5.99%
August 1.29% 7.12% 2.80% 2.85%
September -16.37% 5.07% -9.65% -6.42%
October -19.94% -11.24% 0.83% -4.98%
November -3.99% 1.55% 8.16% 4.72%
December 0.44% 0.72% 3.74% -0.13%
ΣR(T M)= ΣR(TCS)= ΣR(HUL)= ΣR(M)=
-84.86% 51.90% 75.07% 29.11%

Mean return R'(T M) R'(TCS) R'(HUL) R'(M)

Arithmetic Mean
= -2.83% 1.73% 2.50% 0.97%
 b)
Tata Motors:
The Arithmetic mean monthly return = - 0.2.83 percent
The geometric mean monthly return =
(1.0957x 1.0686x0.9947 x0.9946 x0.8634 x1.0277 x1.1092 x0.8724 x1.0199
x 0.9851 x1.0376 x0.9084 x1.0279 x0.8469 x1.0663 x1.0670 x0.9434 x1.0685
x 0.9251 x0.9259 x0.8836 x1.0415 x0.8299 x0.9533 x0.9807 x1.0129 x0.8363
x 0.8006 x0.9601 x1.0044 )1/30-1 = (0.3760)1/30-1 = -0.0321 or – 3.21 %
TCS:
The Arithmetic mean monthly return = 1.73 percent
The geometric mean monthly return =
(1.0259 x 0.9588 x0.9679 x0.9836 x0.9519 x1.0393 x0.9426 x1.1060 x0.9860
x 0.9348 x1.1203 x0.9276 x1.0548 x1.0018 x0.9758 x1.0772 x1.0050 x1.0243
x 1.1522 x0.9752 x0.9387 x1.2397 x0.9858 x1.0613 x1.0500 x1.0712 x1.0507
x 0.8876 x 1.0155 x 1.0072) 1/30-1 = (1.5529)1/30-1 = 0.0148 or 1.48 %
Hindustan Unilever:
The Arithmetic mean monthly return = 2.50 percent
The geometric mean monthly return =
(1.0267 x0.9940 x0.9463 x0.9669 x1.0058 x0.9791 x1.0352 x1.0123 x1.0530
x 1.0254 x1.1412 x1.0118 x1.0705 x1.0554 x0.9624 x1.0541 x1.0283 x1.0750
x 1.0011 x0.9623 x1.0118 x1.1317 x1.0680 x1.0184 x1.0551 x1.0280 x0.9035
x1.0083 x1.0816 x1.0374) 1/30-1 = (2.0251)1/30-1 = 0.0238 or 2.38 %

Nifty:
The Arithmetic mean monthly return = 0.97 percent
The geometric mean monthly return =
(1.0423 x1.0171 x0.9801 x1.0017 x0.9535 x0.9953 x1.0459 x1.0372 x1.0331
x 1.0142 x1.0341 x0.9896 x1.0584 x0.9842 x0.9870 x1.0559 x0.9895 x1.0297
x 1.0472 x0.9515 x0.9639 x1.0619 x0.9997 x0.9980 x1.0599 x1.0285 x0.9358
x 0.9502 x1.0472 x0.9987) 1/30-1 = (1.3107)1/30-1 = 0.0091 or 0.91 %
c)
Month R(TM) R(TCS) R(HUL) R(Nifty) (R( TM)- (R(TCS)- (R(HUL)- (R(Nifty-
(%) (%) (%) (%) R'( TM))2 R'(TCS))2 R'(HUL))2 R'(Nifty))2

2016
June
July 9.57% 2.59% 2.67% 4.23% 0.0154 0.0001 0.0000 0.0011
August 6.86% -4.12% -0.60% 1.71% 0.0094 0.0034 0.0010 0.0001

September -0.53% -3.21% -5.37% -1.99% 0.0005 0.0024 0.0062 0.0009

October -0.54% -1.64% -3.31% 0.17% 0.0005 0.0011 0.0034 0.0001

November -13.66% -4.81% 0.58% -4.65% 0.0117 0.0043 0.0004 0.0032

December 2.77% 3.93% -2.09% -0.47% 0.0031 0.0005 0.0021 0.0002

2017
January 10.92% -5.74% 3.52% 4.59% 0.0189 0.0056 0.0001 0.0013

February -12.76% 10.60% 1.23% 3.72% 0.0099 0.0079 0.0002 0.0008

March 1.99% -1.40% 5.30% 3.31% 0.0023 0.0010 0.0008 0.0005
April -1.49% -6.52% 2.54% 1.42% 0.0002 0.0068 0.0000 0.0000
May 3.76% 12.03% 14.12% 3.41% 0.0043 0.0106 0.0135 0.0006
June -9.16% -7.24% 1.18% -1.04% 0.0040 0.0080 0.0002 0.0004
July 2.79% 5.48% 7.05% 5.84% 0.0032 0.0014 0.0021 0.0024
August -15.31% 0.18% 5.54% -1.58% 0.0156 0.0002 0.0009 0.0007

September 6.63% -2.42% -3.76% -1.30% 0.0089 0.0017 0.0039 0.0005

October 6.70% 7.72% 5.41% 5.59% 0.0091 0.0036 0.0008 0.0021

November -5.66% 0.50% 2.83% -1.05% 0.0008 0.0002 0.0000 0.0004

December 6.85% 2.43% 7.50% 2.97% 0.0094 0.0000 0.0025 0.0004

2018
January -7.49% 15.22% 0.11% 4.72% 0.0022 0.0182 0.0006 0.0014

February -7.41% -2.48% -3.77% -4.85% 0.0021 0.0018 0.0039 0.0034

March -11.64% -6.13% 1.18% -3.61% 0.0078 0.0062 0.0002 0.0021
April 4.15% 23.97% 13.17% 6.19% 0.0049 0.0495 0.0114 0.0027
May -17.01% -1.42% 6.80% -0.03% 0.0201 0.0010 0.0018 0.0001
June -4.67% 6.13% 1.84% -0.20% 0.0003 0.0019 0.0000 0.0001
July -1.93% 5.00% 5.51% 5.99% 0.0001 0.0011 0.0009 0.0025
August 1.29% 7.12% 2.80% 2.85% 0.0017 0.0029 0.0000 0.0004

September -16.37% 5.07% -9.65% -6.42% 0.0183 0.0011 0.0148 0.0055

October -19.94% -11.24% 0.83% -4.98% 0.0293 0.0168 0.0003 0.0035

November -3.99% 1.55% 8.16% 4.72% 0.0001 0.0000 0.0032 0.0014

December 0.44% 0.72% 3.74% -0.13% 0.0011 0.0001 0.0002 0.0001

ΣR(TM)= ΣR(TCS= ΣR(HUL)= ΣR(M) Sum = Sum = Sum = Sum =
=
-84.86% 51.90% 75.07% 29.11% 0.2151 0.1594 0.0752 0.0388

Mean R'(T M) R'(TCS) R'(HUL) R'(M)

return
Arithmetic
Mean = -2.83% 1.73% 2.50% 0.97%

Standard deviation of the returns of Tata Motors = [0.2151/29]1/2 = 8.61 %

Standard deviation of the returns of TCS = [0.1594/29]1/2 = 7.41 %
Standard deviation of the returns of Hindustan Unilever = [0.0752/29]1/2 = 5.09 %
Standard deviation of the returns of Nifty = [0.0388/29]1/2 = 3.66 %
d)
Month (R( TM)- (R(TCS)- (R(HUL)- (R(Nifty- (1) X (4) (2) X (4) (3) X (4)
R'( TM)) R'(TCS)) R'(HUL)) R'(Nifty))
% (1) % (2) % (3) % (4)
2016 January
February 12.40 0.86 0.17 3.26 40.44 2.81 0.55
March 9.68 -5.85 -3.10 0.74 7.16 -4.33 -2.29
April 2.30 -4.94 -7.87 -2.96 -6.81 14.62 23.31
May 2.29 -3.37 -5.81 -0.80 -1.83 2.70 4.66
June -10.83 -6.54 -1.92 -5.62 60.88 36.76 10.82
July 5.59 2.20 -4.59 -1.44 -8.06 -3.17 6.62
August 13.75 -7.47 1.01 3.62 49.73 -27.01 3.66
September -9.93 8.87 -1.27 2.75 -27.28 24.38 -3.50
October 4.82 -3.13 2.79 2.34 11.29 -7.32 6.54
November 1.34 -8.25 0.04 0.45 0.60 -3.71 0.02
December 6.59 10.30 11.62 2.44 16.07 25.12 28.34
2017 January -6.33 -8.97 -1.32 -2.01 12.74 18.05 2.66
February 5.61 3.75 4.55 4.87 27.35 18.27 22.17
March -12.48 -1.55 3.04 -2.55 31.82 3.95 -7.74
April 9.45 -4.15 -6.26 -2.27 -21.50 9.44 14.24
May 9.53 5.99 2.91 4.61 43.97 27.64 13.43
June -2.83 -1.23 0.33 -2.02 5.73 2.50 -0.66
July 9.68 0.70 4.99 2.00 19.40 1.41 10.01
August -4.66 13.49 -2.39 3.75 -17.48 50.58 -8.97
September -4.58 -4.21 -6.27 -5.82 26.66 24.53 36.50
October -8.81 -7.86 -1.32 -4.58 40.38 36.01 6.04
November 6.97 22.24 10.66 5.22 36.38 116.00 55.62
December -14.18 -3.15 4.29 -1.00 14.18 3.15 -4.29
2018 January -1.84 4.40 -0.66 -1.17 2.16 -5.16 0.77
February 0.90 3.27 3.01 5.02 4.51 16.44 15.13
March 4.12 5.39 0.30 1.88 7.75 10.15 0.56
April -13.55 3.34 -12.15 -7.39 100.12 -24.66 89.80
May -17.11 -12.97 -1.68 -5.95 101.73 77.15 9.96
June -1.16 -0.18 5.66 3.75 -4.36 -0.66 21.20
 July 3.26 -1.01 1.24 -1.10 -3.59 1.11 -1.37
SUM = 570.13 446.72 353.79
Variance of Nifty Covariance Covariance Covariance
=(3.66)^2 = 13.40 =570.13/29 =446.72/29 =353.79/29
=19.66 =15.40 =12.20

Beta of Tata Motors = 19.66/13.40 = 1.47

Beta of TCS = 15.40/13.40 = 1.15

Beta of Hindustan Unilever = 12.20/13.40 = 0.91

MINICASE 2

For NTPC:

Financial
year (Annual
Price per Dividend Dividend Capital Annual 1+Annual
ended return -
share per share yield gain return return
A.M)2

2008 196.60 3.50

2009 179.85 3.60 1.83% -8.52% -6.69% 0.9331 0.0080

2010 207.25 3.80 2.11% 15.23% 17.35% 1.1735 0.0227

2011 193.10 3.80 1.83% -6.83% -4.99% 0.9501 0.0053
2012 162.75 4.30 2.23% -15.72% -13.49% 0.8651 0.0248
2013 141.95 4.25 2.61% -12.78% -10.17% 0.8983 0.0155
2014 119.90 6.00 4.23% -15.53% -11.31% 0.8869 0.0184
2015 146.85 2.50 2.09% 22.48% 24.56% 1.2456 0.0497
2016 128.85 3.35 2.28% -12.26% -9.98% 0.9002 0.0150
2017 166.00 4.36 3.38% 28.83% 32.22% 1.3222 0.0897
2018 169.70 4.90 2.95% 2.23% 5.18% 1.0518 0.0008
Product
sum = 22.68% = 1.1182 sum = 0.2500
= =(0.25/9)0.5 =
22.68/10 (1.1182)1/10- 0.1667 or
A.M = =2.27% G.M = 1 = 1.12% Std.devn= 16.67%
 For Escorts:

Financial
year
ended Price per Dividend Dividend Capital Annual 1+Annual (Annual return -
share per share yield gain return return A.M)2

2008 85.70 0.00

2009 35.25 0.00 0.00% -58.87% -58.87% 0.4113 1.6197
2010 149.65 1.00 2.84% 324.54% 327.38% 4.2738 6.7068
2011 141.65 1.50 1.00% -5.35% -4.34% 0.9566 0.5292
2012 68.60 1.50 1.06% -51.57% -50.51% 0.4949 1.4140
2013 49.50 1.20 1.75% -27.84% -26.09% 0.7391 0.8929
2014 115.25 1.20 2.42% 132.83% 135.25% 2.3525 0.4469
2015 127.35 0.60 0.52% 10.50% 11.02% 1.1102 0.3293
2016 139.25 1.20 0.94% 9.34% 10.29% 1.1029 0.3377
2017 538.75 1.20 0.86% 286.89% 287.76% 3.8776 4.8117
2018 818.10 1.50 0.28% 51.85% 52.13% 1.5213 0.0265
Product
sum = 684.00% = 10.4500 sum = 17.1147
=(17.1147/9)0.5
=
= (10.4500)1/10- 1.3790 or
A.M = 68.40% G.M = 1 = 26.45% Std.devn= 137.9%

For MRF:

Financial
year Price per Dividend Dividend Capital Annual 1+Annual (Annual return
ended share per share yield gain return return - A.M)2

2008 3989.05 20.00

2009 1738.75 20.00 0.50% -56.41% -55.91% 0.4409 1.2237
2010 6784.35 25.00 1.44% 290.19% 291.62% 3.9162 5.6127
2011 6271.10 50.00 0.74% -7.57% -6.83% 0.9317 0.3787
2012 9932.65 25.00 0.40% 58.39% 58.79% 1.5879 0.0017
2013 11971.80 25.00 0.25% 20.53% 20.78% 1.2078 0.1151
2014 21788.75 30.00 0.25% 82.00% 82.25% 1.8225 0.0758
2015 38750.65 50.00 0.23% 77.85% 78.08% 1.7808 0.0546
2016 38296.75 6.00 0.02% -1.17% -1.16% 0.9884 0.3121
2017 60954.45 100.00 0.26% 59.16% 59.42% 1.5942 0.0022
2018 73122.45 60.00 0.10% 19.96% 20.06% 1.2006 0.1201
Product
sum = 547.11% = 18.9446 sum = 7.8968
=(7.8968/9)0.5
= =
(18.9446)1/10-1 0.9367 or
A.M = 54.71% G.M = = 34.20% Std.devn= 93.67%
 Chapter 9
RISK AND RETURN: PORTFOLIO THEORY AND ASSET PRICING MODELS
9.1(a)
E (R1) = 0.2(-5%) + 0.3(15%) + 0.4(18%) + .10(22%)
= 12.9 %
E (R2) = 0.2(10%) + 0.3(12%) + 0.4(14%) + .10(18%)
= 13%
σ(R1) = [.2(-5 –12.9)2 + 0.3 (15 –12.9)2 + 0.4 (18 –12.9)2 + 0.1 (22 – 12.9)2]½
= [64.08 + 1.32 + 10.40 + 8.28]½ = 9.17%
σ(R2) = [.2(10 –13)2 + 0.3(12 – 13)2 + 0.4 (14 – 13)2 + 0.1 (18 – 13)2] ½
= [1.8 + 0.3 + 0.4 + 2.5] ½ = 2.24%

(b) The covariance between the returns on assets 1 and 2 is calculated below
State of Probability Return on Deviation Return on Deviation Product of
nature asset 1 of return asset 2 of the deviation
on asset 1 return on times
from its asset 2 probability
mean from its
mean
(1) (2) (3) (4) (5) (6) (2)x(4)x(6)
1 0.2 -5% -17.9% 10% -3% 10.7
2 0.3 15% 2.1% 12% -1% -0.6
3 0.4 18% 5.1% 14% 1% 2.0
4 0.1 22% 9.1% 18% 5% 4.6
Sum = 16.7

Thus the covariance between the returns of the two assets is 16.7.

(c) The coefficient of correlation between the returns on assets 1 and 2 is:
Covariance12 16.7
= = 0.81
σ1 x σ 2 9.17 x 2.24

9.2. Expected rates of returns on equity stock A, B, C and D can be computed as follows:

A: 0.10 + 0.12 + (-0.08) + 0.15 + (-0.02) + 0.20 = 0.0783 = 7.83%

6

B: 0.08 + 0.04 + 0.15 +.12 + 0.10 + 0.06 = 0.0917 = 9.17%

6

C: 0.07 + 0.08 + 0.12 + 0.09 + 0.06 + 0.12 = 0.0900 = 9.00%

 D: 0.09 + 0.09 + 0.11 + 0.04 + 0.08 + 0.16 = 0.095 = 9.50%
6

(a) Return on portfolio consisting of stock A = 7.83%

(b) Return on portfolio consisting of stock A and B in equal

proportions = 0.5 (0.0783) + 0.5 (0.0917)
= 0.085 = 8.5%

(c ) Return on portfolio consisting of stocks A, B and C in equal

proportions = 1/3(0.0783 ) + 1/3(0.0917) + 1/3 (0.090)
= 0.0867 = 8.67%

(d) Return on portfolio consisting of stocks A, B, C and D in equal

proportions = 0.25(0.0783) + 0.25(0.0917) + 0.25(0.0900) +
0.25(0.095)
= 0.08875 = 8.88%

9.3. The standard deviation of portfolio return is:

p= [w1212 + w22 22 + w3232 + 42 42 + 2 w1 w2 12 1 2 + 2 w1 w3 13 1 3 + 2 w1 w4

14 14 + 2 w2 w3 23 2 3 + 2 w2 w4 24 2 4 + 2 w3 w4 34 3 4 ]1/2
= [0.22 x 42 + 0.32 x 82 + 0.42 x 202 + 0.12 x 102 + 2 x 0.2 x 0.3 x 0.3 x 4 x 8
+ 2 x 0.2 x 0.4 x 0.5 x 4 x 20 + 2 x 0.2 x 0.1 x 0.2 x 4 x 10
+ 2 x 0.3 x 0.4 x 0.6 x 8 x 20 + 2 x 0.3 x 0.1 x 0.8 x 8 x 10
+ 2 x 0.4 x 0.1 x 0.4 x 20 x 10]1/2
= 10.6%

9.4

Prob (p) RP dP dP2 pxdP2 RQ dq dq2 pxdq2

0.3 -4% -16.2 262.44 79.73 10% -1.6 2.56 0.77
0.4 14 1.58 3.24 1.30 17 5.4 29.16 11.66
0.3 26% 13.8 190.44 57.13 6 -5.6 31.36 9.41
RP=12.20 137.16 RQ = 11.6 21.84½
P (137.16)½ Q (21.84)1/2
= 11.71 = 4.67

p p.dp.dq
0.3 7.78
 0.4 3.89
0.3 -23.18
p.dp.dq = -11.51

COV (P,Q) – 11.51

PQ = = = -0.21
P x Q 11.71 x 4.67

9.5
P2 = WA2 A2 + WB2 B2 + 2AB A B
= 0.52 x 202 + 0.52 x 252 + 2 x 0.4 x 20 x 25
= 100 + 156.25 + 400 = 656.25
P = (656.25)1/2 = 25.62

9.6
RFR = 8%, E (RM) = 14%
The expected return of a portfolio that comprises of the risk – free return and the
market portfolio is:

E(RP) =  x Rf + (1- ) E(RM)

11% =  x 8% + (1 –  ) x 14%
So  =0.5
This means that the portfolio comprises of the risk- free security and the market
portfolio in equal proportions
If P = 0.12 and  0.5, it
means M = 24
If the standard deviation of security i is 25 percent and it has a correlation of 0.6 with
the market portfolio them:
iM
P=
iM
iM
0.6 =
25x 24
This means iM = 0.6 x 25x 24 = 360
iM
=
M2
 360
i = = 0.63
576
Required return = 8 + 0.63 x 6
= 11.75%

MINICASE
a. For stock A:

Expected return = (0.2 x -15) + (0.5 x 20) + (0.3 x 40) = 19

Standard deviation = [ 0.2 ( -15 -19)2 + 0.5 (20-19)2 + 0.3 (40 – 19)2 ] 1/2

= [231.2 + 0.5 + 132.3]1/2 = 19.08

For stock B:

Expected return = (0.2 x 30) + (0.5 x 5) + [ 0.3 x (-) 15] = 4

Standard deviation = [0.2 ( 30 – 4)2 + 0.5 (5 -4)2 + 0.3 (-15–4)2]1/2

= (135.2 + 0.5 + 108.3) ½ = 15.62

For stock C:

Expected return = [0.2 x (-5)] + (0.5 x 15) + (0.3 x 25)] = 14

Standard deviation = [0.2 (-5 – 14)2 + 0.5 (15 -14)2 + 0.3 (25-14)2] ½
= [72.2 + 0.5 + 36.3] ½ = 10.44

For market portfolio:

 Expected return = [0.2 x (-)10] + (0.5 x 16) + (0.3 x 30) = -2 + 8 + 9 = 15

Standard deviation = [0.2 (-10-15)2 + 0.5(16-15)2 + 0.3 (30 – 15)2] ½

= ( 125 + 0.5 + 67.5 ) ½ = 13.89

b.

State of the Prob- Return on Return RA-E(RA) RB-E(RB) p

Economy ability (p) A (%) (RA) B (%) (RB) x [RA-E(RA)]
x[RB-E(RB)]

Recession 0.2 -15 30 -34 26 -176.8

Normal 0.5 20 5 1 1 0.5
Boom 0.3 40 -15 21 -19 - 119.7
total = - 296.00

Covariance between the returns of A and B is (-) 296

State of the Prob- Return on A Return C RA-E(RA) RC-E(RC) p

Economy ability (p) (%) (RA) (%) (RC) x [RA-E(RA)]
x[RC-E(RC)]

Recession 0.2 -15 - 5.0 -34 -19 129.2

Normal 0.5 20 15.0 1. 1 0.5
Boom 0.3 40 25.0 21 11 69.3
total = 199.0

Covariance between the returns of A and C is 199

 (-) 296
c. Coefficient of correlation between the returns of A and B = = (-) 1
19.08 x 15.62

199
Coefficient of correlaton between the returns of A and C = = 1
19.08 x 10.44

d. Portfolio in which stocks A and B are equally weighted:

Economic condition Probability Overall expected return

Recession 0.2 0.5 x (-) 15 + 0.5 x 30 = 7.5
Normal 0.5 0.5 x 20 + 0.5 x 5 = 12.5
Boom 0.3 0.5 x 40 + 0.5 x (-)15 = 12.5

Expected return of the portfolio = (0.2 x 7.5) + (0.5 x 12.5) + (0.3 x 12.5)
= 0.7 + 6.25 + 4.5 = 11.5

Standard deviation of the portfolio

= [ 0.2 (7.5 – 11.5)2 + 0.5 (12.5 – 11.5)2 + 0.3 (12.5 – 11.5)2]1/2

= [ 3.2 + 0.5 + 0.3] ½ = 2

Portfolio in which weights assigned to stocks A, B and C are 0.4, 0.4 and 0.2 respectively.

Expected return of the portfolio = (0.4 x 19.0) + (0.4 x 4) + (0.2 x 14))

= 12

For calculating the standard deviation of the portfolio we also need covariance between B and
C, which is calculated as under:

State of the Prob- Return on Return on RB-E(RB) RC-E(RC) p

Economy ability (p) B (%) (RB) C (%) x[RB-E(RB)]
(RC) x[RC-E(RC)]

Recession 0.2 30 - 5.0 26 -19 (-) 98.8

Normal 0.5 5 15.0 1 1 0.50
Boom 0.3 (-)15 25.0 (-)19 11 (-) 62.7
total = (-)161

Covariance between the returns of B and C is (-)161

We have the following values:
WA = 0.4 WB = 0.4 WC = 0.2
σA = 19.08 σB = 15.62 σC = 10.44
σAB = (-)296 σAC = 199 σBC = (-) 161

Standard deviation

= [ (0.4 x 19.08)2 + (0.4 x 15.62)2 + (0.2 x 10.44)2 + [ 2 x 0.4 x 0.4 x (-) 296 ] +
+ [2 x 0.4 x 0.2 x 199] + [2 x 0.4 x 0.2 x (-) 161]1/2

= (58.25 + 39.04 + 4.36– 94.72 + 31.84 – 25.76)1/2 = 3.61

e.

(i) Risk-free rate is 6% and market risk premium is 15 – 6 = 9%

The SML relationship is
Required return = 6% + β x 9%

(ii) For stock A:

Required return = 6 % + 1.2 x 9 % = 16.8 %; Expected return = 19 %
Alpha = 19 – 16.8 = 2.2 %

For stock B:
Required return = 6 % - 0.70 x 9 % = - 0.3 %; Expected return = 4 %
Alpha = 4 + 0.3 = 4.3 %

For stock C:
Required return = 6% + 0.9 x 9 % = 14.1 %; Expected return = 14%
Alpha = 14 – 14.1 = (-) 0.1 %

f.

2
Period RD (%) RM (%) RD-RD RM-RM (RM-RM ) (RD-RD) (RM-RM)
1 -12 -5 -18.4 -11.2 125.44 206.08
2 6 4 -0.4 -2.2 4.84 0.88
3 12 8 5.6 1.8 3.24 10.08
4 20 15 13.6 8.8 77.44 119.68
5 6 9 -0.4 2.8 7.84 -1.12
Mean= 6.4 6.2 SUM= 218.8 335.6

σ2m = 218.8/4 = 54.7 Cov (D,M) = 335.6/4 = 83.9 ß = 83.9 / 54.7 = 1.53
Interpretation: The change in return of D is expected to be 1.53 times the expected change in
return on the market portfolio.

h.

CAPM assumes that return on a stock/portfolio is solely influenced by the market factor whereas
the APT assumes that the return is influenced by a set of factors called risk factors.
 Chapter 10
OPTIONS AND THEIR VALUATION

10.1. S = 100 u = 1.5 d = 0.8

E = 105 r = 0.12 R = 1.12

The values of ∆ (hedge ratio) and B (amount borrowed) can be obtained as follows:

Cu – Cd
∆ =
(u – d) S

Cu = Max (150 – 105, 0) = 45

Cd = Max (80 – 105, 0) = 0

45 – 0 45 9
∆ = = = = 0.6429
0.7 x 100 70 14

u.Cd – d.Cu
B =
(u-d) R

(1.5 x 0) – (0.8 x 45)

=
0.7 x 1.12

-36
= = - 45.92
0.784

C = ∆S+B
= 0.6429 x 100 – 45.92
= 18.37

Value of the call option = Rs.18.37

10.2. S = 40 u=? d = 0.8

R = 1.10 E = 45 C=8

We will assume that the current market price of the call is equal to the pair value of the call
as per the Binomial model.
 Given the above data

Cd = Max (32 – 45, 0) = 0

∆ Cu – Cd R
= x
B u Cd – d Cu S

∆ Cu – 0 1.10
= x
B -0.8Cu 40

= (-) 0.034375

∆ = - 0.34375 B (1)
C = ∆S+B
8 = ∆ x 40 + B (2)

Substituting (1) in (2) we get

8 = (-0.034365 x 40) B + B
8 = -0.375 B
or B = - 21.33

∆ = - 0.034375 (-21.33) = 0.7332

The portfolio consists of 0.7332 of a share plus a borrowing of Rs.21.33 (entailing a

repayment of Rs.21.33 (1.10) = Rs.23.46 after one year). It follows that when u occurs either u x
40 x 0.7332 – 23.46 = u x 40 – 45
-10.672 u = -21.54
u = 2.02

or

u x 40 x 0.7332 – 23.46 = 0
u = 0.8

Since u > d, it follows that u = 2.02.

Put differently the stock price is expected to rise by 1.02 x 100 = 102%.

10.3 Using the standard notations of the Black-Scholes model we get the following results:
ln (S/E) + rt + σ2 t/2
 d1 =
 t

= ln (120 / 110) + 0.14 + 0.42/2

0.4

= 0.08701 + 0.14 + 0.08

0.4

= 0.7675

d2 = d1 -  t
= 0.7675 – 0.4
= 0.3675

N(d1) = N (0.7675) = 0.7786

N (d2) = N (0.3675) = 0.6434

C = So N(d1) – E. e-rt. N(d2)

= 120 x 0.7786 – 110 x e-0.14 x 0.6434
= (120 x 0.7786) – (110 x 0.86936 x 0.6434)
= 31.90

Value of the call as per the Black and Scholes model is Rs.31.90.
10.4
l (S/E) + (r + σ2 /2) t
d1 =
 t

= ln (80 / 82) + [0.1503 + (0.2)2/2]

0.2

= -0.0247 + 0.1703
0.2

= 0.7280

d2 = d1 -  t
= 0.7280 – 0.2
= 0.5280

N(d1) = N (0.7280).
From the tables we have N(0.70) = 1- 0.2420 = 0.7580
and N(0.75)= 1- 0.2264 = 0.7736
By linear extrapolation, we get
N(0.7280) = 0.7580 + (0.7280 – 0.7000)(0.7736-0.7580)/0.05
= 0.7580 + 0.008736 = 0.7667
N(d2) = N(0.5280)
From the tables we have N(0.50) = 1- 0.3085 = 0.6915
N(0.55) = 1- 0.2912 = 0.7088
By linear extrapolation, we get
N(0.5280) = 0.6915 + (0.5280 – 0.5000)(0.7088 – 0.6915)/0.05
= 0.6915 + 0.009688 = 0.7012
E/ert = 82/1.1622 = 70.5558
C = So N(d1) – E. e-rt. N(d2)
= 80 x 0.7667 -70.5558 x 0.7012 = 11.86

10.5

l (S/E) + (r + σ2 /2) t
d1 =
 t

= ln (80 / 85) + [0.1503 + (0.2)2/2]

0.2

= -0.060625 + 0.1703
0.2
= 0.5484

d2 = d1 -  t
= 0.5484 – 0.2
= 0.3484

N(d1) = N (0.5484).
From the tables we have N(0.50) = 1- 0.3085 = 0.6915
and N(0.55)= 1- 0.2912 = 0.7088
By linear extrapolation, we get
N(0.5484) = 0.6915 + (0.5484 – 0.5000)(0.7088-0.6915)/0.05
= 0.6915 + 0.0167 = 0.7082
N(d2) = N(0.3484)
From the tables we have N(0.30) = 1- 0.3821 = 0.6179
N(0.35) = 1- 0.3632 = 0.6368
By linear extrapolation, we get
N(0.3484) = 0.6179 + (0.3484 – 0.3000)(0.6368 – 0.6179)/0.05
= 0.6179 + 0.0183= 0.6362
rt
E/e = 85/1.1622 = 73.1372
C = So N(d1) – E. e-rt. N(d2)
 = 80 x 0.7082 -73.1372 x 0.6362 = 10.13
P = C –S + E/ert
= 10.13 – 80 + 73.1372 = 3.27

Value of the put option = Rs.3.27

MINICASE
b)
Call options with strike prices 280, 300 and 320 and put options with
strike prices 340and 360 are in - the – money.
Call options with strike prices 340 and 360 and put options with strike
prices 280, 300 and 320 are out of – the – money.

c) (i) If Pradeep Sharma sells Jan/340 call on 1000 shares, he will earn a
call premium of Rs.5000 now. However, he will forfeit the gains
that he would have enjoyed if the price of Newage Hospitals rises
above Rs.340.
(ii) If Pradeep Sharma sells Mar/300 call on 1000 shares, he will earn
a call premium of Rs.41,000 now. However, he will forfeit the gains
he would have enjoyed if the price of Newage Hospital remains
above Rs.300.
d) Let s be the stock price, p1 and p2 the call premia for March/ 340 and
March/ 360 calls respectively. When s is greater than 360, both the calls
will be exercised and the profit will be { s-340-p1} – { s-360-p2 } =Rs. 11
The maximum loss will be the initial investment , i.e. p1-p2 =Rs. 9
The break even will occur when the gain on purchased call equals the
net premium paid
i.e. s-340 = p1 – p2 =9 Therefore s= Rs. 349

e) If the stock price goes below Rs.300, Mr. Sharma can execute the put option and ensure that
his portfolio value does not go below Rs. 300 per share. However , if stock price goes above
Rs. 340, the call will be exercised and the stocks in the portfolio will have to be delivered/
sold to meet the obligation, thus limiting the upper value of the portfolio to Rs. 340 per share.
So long as the share price hovers between R. 300 and Rs. 340, Mr. Sharma will be gainer
by Rs. 8 ( net premium received).
 Pay off
Profit

0
Stock price
305 340 375
·

f). Other things remaining constant, value of a call option

- increases when the current price of the stock increases.
- decreases when the exercise price increases.
- increases when option term to maturity increases.
- increases when the risk-free interest rate increases.
- increases when the variability of the stock price increases.

g). The three equations are

E
C0 = S0 N(d1) - ------ N (d2)
ert

S0 σ2
ln ------ + r + -----
E 2

d1 =
σ t

d2 = d1 - σ √ t

S0 = 325 E =320 t =0.25 r = 0.06 σ =0.30

325 (0.30)2
ln + 0.06 + x 0.25
320 2
d1 =
0.30 x  0.25

= ( 0.0155 + 0.02625) / 0.15 = 0. 2783

d2 = 0.2783 -0.30 √0.25 = 0.2783 – 0.15 = 0.1283
Using normal distribution table

N (d1) = 1 – [ 0.3821 + ( 0.4013- 0. 3821) ( 0.30 – 0.2783 ) /( 0.30 – 0.25) ]

=1- [ 0.3821 + 0. 0192 x 0.0217 / 0.05 ] = 0.6096

N ( d2 ) = 1- [ 0. 4404 + ( 0. 4602- 0.4404) ( 0. 15 – 0. 1283 /( 0. 15- 0.10 ) ]

= 1- [ 0.4404 + 0.0198 x 0.0217 / 0.05 ] = 0. 5510
E / ert = 320 / e0.06 x 0. 25 = 320 / 1. 0151 = 315. 24

C0 = 325 x 0.6096 – 315.24 x 0. 5510 = 198.12 – 173. 70 = Rs. 24.42

 Chapter 11
TECHNIQUES OF CAPITAL BUDGETING

11.1(a) NPV of the project at a discount rate of 14%.

= - 1,0000,000 + 100,000 + 200,000

---------- ------------
(1.14) (1.14)2
+ 300,000 + 600,000 + 300,000
----------- ---------- ----------
(1.14)3 (1.14)4 (1.14)5

= - 44837

(b) NPV of the project at time varying discount rates

= - 1,000,000

+ 100,000

(1.12)

+ 200,000

(1.12) (1.13)

+ 300,000

(1.12) (1.13) (1.14)

+ 600,000

(1.12) (1.13) (1.14) (1.15)

+ 300,000

(1.12) (1.13) (1.14)(1.15)(1.16)

= - 1,000,000 + 89286 + 158028 + 207931 + 361620 + 155871

= - 27264

11.2 IRR (r) can be calculated by solving the following equations for the value of r.
60000 x PVIFA (r,7) = 300,000
 i.e., PVIFA (r,7) = 5.000
Through a process of trial and error it can be verified that r = 9.20% pa.

11.3 The IRR (r) for the given cashflow stream can be obtained by solving the following equation
for the value of r.

-3000 + 9000 / (1+r) – 3000 / (1+r) = 0

Simplifying the above equation we get

r = 1.61, -0.61; (or) 161%, (-)61%

NOTE: Given two changes in the signs of cashflow, we get two values for the
IRR of the cashflow stream. In such cases, the IRR rule breaks down.

11.4 Define NCF as the minimum constant annual net cashflow that justifies the purchase of the
given equipment. The value of NCF can be obtained from the equation

NCF x PVIFA (10,8) = 500000

NCF = 500000 / 5.335
= 93721

11.5 Define I as the initial investment that is justified in relation to a net annual cash
inflow of 25000 for 10 years at a discount rate of 12% per annum. The value
of I can be obtained from the following equation

25000 x PVIFA (12,10) = I

i.e., I = 141256

11.6. The NPVs of the three projects are as follows:

Project
P Q R
Discount rate
0% 400 500 600
5% 223 251 312
10% 69 40 70
15% - 66 - 142 - 135
25% - 291 - 435 - 461
30% - 386 - 555 - 591
11.7 NPV profiles for Projects P and Q for selected discount rates are as follows:
(a)
Project
P Q
Discount rate (%)
0 2950 500
5 1876 208
10 1075 - 28
15 471 - 222
20 11 - 382

b) (i) The IRR (r ) of project P can be obtained by solving the following

equation for `r’.

-1000 -1200 x PVIF (r,1) – 600 x PVIF (r,2) – 250 x PVIF (r,3)
+ 2000 x PVIF (r,4) + 4000 x PVIF (r,5) = 0

Through a process of trial and error we find that r = 20.13%

(ii) The IRR (r') of project Q can be obtained by solving the following equation for r'

-1600 + 200 x PVIF (r',1) + 400 x PVIF (r',2) + 600 x PVIF (r',3)
+ 800 x PVIF (r',4) + 100 x PVIF (r',5) = 0

Through a process of trial and error we find that r' = 9.34%.

c) From (a) we find that at a cost of capital of 10%

NPV (P) = 1075

NPV (Q) = - 28

Given that NPV (P) . NPV (Q); and NPV (P) > 0, I would choose project P.

From (a) we find that at a cost of capital of 20%

NPV (P) = 11

NPV (Q) = - 382

Again NPV (P) > NPV (Q); and NPV (P) > 0. I would choose project P.
d) Project P

PV of investment-related costs

= 1000 x PVIF (12,0)

+ 1200 x PVIF (12,1) + 600 x PVIF (12,2)
+ 250 x PVIF (12,3)
= 2728

TV of cash inflows = 2000 x (1.12) + 4000 = 6240

The MIRR of the project P is given by the equation:

2728 = 6240 x PVIF (MIRR,5)

(1 + MIRR)5 = 2.2874

MIRR = 18%

Project Q

PV of investment-related costs = 1600

TV of cash inflows @ 12% p.a. =

200(1.12)4+400(1.12)3+600(1.12)2+800(1.12)+100 = 2624

The MIRR of project Q is given by the equation:

1600 (1 + MIRR)5 = 2624

MIRR = 10.41%

11.8.
(a) Project A

NPV at a cost of capital of 12%

= - 100 + 25 x PVIFA (12,6)
= Rs.2.79 million

IRR (r ) can be obtained by solving the following equation for r.

25 x PVIFA (r,6) = 100
i.e., r = 12,98%
 Project B

NPV at a cost of capital of 12%

= - 50 + 13 x PVIFA (12,6)
= Rs.3.45 million

IRR (r') can be obtained by solving the equation

13 x PVIFA (r',6) = 50
i.e., r' = 14.40% [determined through a process of trial and error]

(b) Difference in capital outlays between projects A and B is Rs.50 million

Difference in net annual cash flow between projects A and B is Rs.12 million.
NPV of the differential project at 12%
= -50 + 12 x PVIFA (12,6) ==-50 +12 x4.111

= - Rs.0.67 million

IRR (r'') of the differential project can be obtained from the equation
12 x PVIFA (r'', 6) = 50
i.e., r'' = 11.53%
11.9.
(a) Project M
The pay back period of the project lies between 2 and 3 years. Interpolating in
this range we get an approximate pay back period of 2.63 years/

Project N
The pay back period lies between 1 and 2 years. Interpolating in this range we
get an approximate pay back period of 1.55 years.

(b) Project M
Cost of capital = 12% p.a
PV of cash flows up to the end of year 1 = 9.82
PV of cash flows up to the end of year 2 = 24.97
PV of cash flows up to the end of year 3 = 47.75
PV of cash flows up to the end of year 4 = 71.26

Discounted pay back period (DPB) lies between 3 and 4 years. Interpolating in this range
we get an approximate DPB of 3.1 years.

Project N
Cost of capital = 12% per annum
PV of cash flows up to the end of year 1 = 33.93
PV of cash flows up to the end of year 2 = 51.47
 DPB lies between 1 and 2 years. Interpolating in this range we get an approximate
DPB of 1.92 years.

(c ) Project M
Cost of capital = 12% per annum
NPV = - 50 + 11 x PVIF (12,1)
+ 19 x PVIF (12,2) + 32 x PVIF (12,3)
+ 37 x PVIF (12,4)
= Rs.21.26 million

Project N
Cost of capital = 12% per annum
NPV = Rs.20.63 million

Since the two projects are independent and the NPV of each project is (+) ve,
both the projects can be accepted. This assumes that there is no capital constraint.

(d) Project M
Cost of capital = 10% per annum
NPV = Rs.25.02 million

Project N
Cost of capital = 10% per annum
NPV = Rs.23.08 million

Since the two projects are mutually exclusive, we need to choose the project with the
higher NPV i.e., choose project M.

NOTE: The MIRR can also be used as a criterion of merit for choosing between the two
projects because their initial outlays are equal.

(e) Project M
Cost of capital = 15% per annum
NPV = 16.13 million

Project N
Cost of capital: 15% per annum
NPV = Rs.17.23 million

Again the two projects are mutually exclusive. So we choose the project with the
higher NPV, i.e., choose project N.
(f) Project M
Terminal value of the cash inflows: 114.47
MIRR of the project is given by the equation
50 (1 + MIRR)4 = 114.47
i.e., MIRR = 23.01%

Project N
Terminal value of the cash inflows: 115.41
MIRR of the project is given by the equation
50 ( 1+ MIRR)4 = 115.41
i.e., MIRR = 23.26%

11.10

Let the IRR be r%.

We then have: 120/(1+r) + 400/(1+r)2 + 480/(1+r)3+380/(1+r)4+300/(1+r)5 =1000

Trying r = 17%,
LHS = 120/(1.17) + 400/(1.17)2 + 480/(1.17)3+380/(1.17)4+300/(1.17)5
= 1034
Trying r = 18%,
LHS = 120/(1.18) + 400/(1.18)2 + 480/(1.18)3+380/(1.18)4+300/(1.18)5
= 1008
Trying r = 19%,
LHS = 120/(1.19) + 400/(1.19)2 + 480/(1.19)3+380/(1.19)4+300/(1.19)5
= 983
By linear interpolation:
r = 18 % + (1008-1000)/(1008-983) % =18.32 %

b) We have the terminal value of cash inflows with interest rate as the cost of capital
= 120(1.10) 4 + 400(1.1)3 + 480(1.1)2+380(1.1)+300 = 2007.89
Present value of costs = 1000
So, 1000(1+MIRR)5 =2007.89
(1+MIRR)5 =2.00789
MIRR = 2.007891/5 -1 = 14.96 %

11.11
Let the IRR be r percent.
We have -50-200PVIF(r,1) + 80PVIFA(r,5)x PVIF(r,1) = 0
Trying r = 16%, LHS = -50-200 x 0.862 + 80x 3.274 x 0.862 = 3.38
Trying r = 17%, LHS = -50-200 x 0.855 + 80x 3.199 x 0.855 = -2.19
By linear interpolation
r = 16+ 3.38/(3.38+2.19) = 16.61 percent

11.12
PV of the net cash flow = 40/1.06 +60/1.06 2+ 100/1.063 +70/1.064 +60/1.065
= Rs.275.38 lakhs
NPV of the project = 275.38 – 200 = Rs.75.38 lakhs
NBCR = 275.38/200 -1 = 0.38

11.13
The IRR rules breaks down.

11.14

Given the reinvestment requirement, the cash flows will be as follows:

0 3 4 5 6
-800,000 330,750 396,900 474,075 330,750

330,750 396,900 474,075 330,750

NPV = + + +
(1.15)3 (1.15)4 (1.15)5 (1.15)6
- 800,000 = 23,094
IRR is the value of r in:
330,750 396,900 470075 330750
- 800,000 = + + +
(1+r) 3 (1+r) 4 (1+r) 5 (1+r)6

r = 0.15 75 or 15.75%
 MINICASE
(a) Project A

Cumulative Discounting Cumulative net

Cash net cash factor Present cash flow after
Year flow inflow @12% value discounting
0 (15,000) (15,000) 1.000 (15,000) (15,000)
1 11,000 (4,000) 0.893 9,823 (5,177)
2 7,000 3,000 0.797 5,579 402
3 4,800 0.712 3,418

Payback period is between 1 and 2 years. By linear interpolation we get the payback
period = 1 + 4,000 /(4,000 + 3,000) = 1.57 years.
Discounted payback period = 1 + 5,177 / ( 5,177 + 402) = 1.93 years
Project B
Cumulative Discounting Cumulative net
Cash net cash factor Present cash flow after
Year flow inflow @12% value discounting
0 (15,000) (15,000) 1.000 (15,000) (15,000)
1 3,500 (11,500) 0.893 3,126 (11,875)
2 8,000 (3,500) 0.797 6,376 (5,499)
3 13,000 9,500 0.712 9,256 3,757

Payback period is between 2 and 3 years. By linear interpolation we get the payback period = 2 +
3,500 /(3,500 + 9,500) = 2.27 years.
Discounted payback period = 2 + 5,499 / ( 5,499 + 3,757) = 2.59 years
(b)Project A
Discounting
Cash factor Present
Year flow @12% value
0 (15,000) 1.000 (15,000)
1 11,000 0.893 9,823
2 7,000 0.797 5,579
3 4,800 0.712 3,418
Net present value= 3,820

Project B

Discounting
Cash factor Present
Year flow @12% value
0 (15,000) 1.000 (15,000)
1 3,500 0.893 3,126
2 8,000 0.797 6,376
3 13,000 0.712 9,256
Net present value= 3,758
Project C
Discounting
Cash factor Present
Year flow @12% value
0 (15,000) 1.000 (15,000)
1 42,000 0.893 37,506
2 (4,000) 0.797 (3,188)
3
Net present value= 19,318

(c)
Project A

IRR is the value of r in the following equation.

11,000 / (1+r) + 7,000 / (1+r)2 + 4,800 / (1+r)3 = 15,000
Trying r = 28 %, the LHS = 11,000 / (1.28) + 7,000 / (1.28)2 + 4,800 / (1.28)3
= 15,155
As this value is slightly higher than 15,000, we try a higher discount rate of 29%
for r to get 11,000 / (1.29) + 7,000 / (1.29)2 + 4,800 / (1.29)3
= 14,970
By linear interpolation we get r = 28 + (15,155 – 15,000) / (15,155 – 14,970) =
28.84 %
Project B

IRR is the value of r in the following equation.

3,500 / (1+r) + 8,000 / (1+r)2 + 13,000 / (1+r)3 = 15,000
Trying r = 23 %, the LHS = 3,500 / (1.23) + 8,000 / (1.23)2 + 13,000 / (1.23)3
= 15,119

As this value is slightly higher than 15,000, we try a higher discount rate of 24%
for r to get 3,500 / (1.24) + 8,000 / (1.24)2 + 13,000 / (1.24)3
= 14,844

By linear interpolation we get r = 23 + (15,119 – 15,000) / (15,119 – 14,844) =

23. 43 %

Project C

IRR rule breaks down as the cash flows are non conventional.

(d) Calculation of MIRR for the three projects.

Project A
Terminal value of cash flows if reinvested at the cost of capital of 12% is
= 11,000 x (1.12)2 + 7,000 x 1.12 + 4,800 = 26,438
MIRR is the value of r in the equation: 26,438 / (1+r)3 =15,000
r = (26,438 / 15,000)1/3 -1 = 20.8%
Therefore MIRR = 20.8%

Project B
Terminal value of cash flows if reinvested at the cost of capital of 12% is
= 3,500 x (1.12)2 + 8,000 x 1.12 + 13,000 = 26,350
MIRR is the value of r in the equation: 26,350 / (1+r) 3 =15,000
r = (26,350 / 15,000)1/3 -1 = 20.7 %
Therefore MIRR = 20.7 %

Project C
Terminal value of cash flow if reinvested at the cost of capital of 12% is
= 42,000 x 1.12 = 47,040
Present value of the costs = 15,000 + 4,000 / (1.12) 2 = 18,189
MIRR is the value of r in the equation: 47,040 / (1+r) 2 =18,189
r = (47,040 / 18,189)1/2 -1 = 60.8 %
Therefore MIRR = 60.8 %
 Chapter 12
ESTIMATION OF PROJECT CASH FLOWS
12.1.
(a) Project Cash Flows (Rs. in million)

Year 0 1 2 3 4 5 6 7

1. Plant & machinery (150)

2. Working capital (50)

3. Revenues 250 250 250 250 250 250 250

4. Costs (excluding de-

preciation & interest) 100 100 100 100 100 100 100

5. Depreciation 37.5 28.13 21.09 15.82 11.87 8.90 6.67

6. Profit before tax 112.5 121.87 128.91 134.18 138.13 141.1143.33

7. Tax 33.75 36.56 38.67 40.25 41.44 42.33 43.0

8. Profit after tax 78.75 85.31 90.24 93.93 96.69 98.77100.33

9. Net salvage value of

plant & machinery 48

10. Recovery of working 50

capital

11. Initial outlay (=1+2) (200)

12. Operating CF (= 8 + 5) 116.25 113.44 111.33 109.75 108.56 107.6 107.00

13. Terminal CF ( = 9 +10) 98

14. NCF (200) 116.25 113.44 111.33 109.75 108.56 107.67 205
(b) IRR (r) of the project can be obtained by solving the following equation for r
-200 + 116.25 x PVIF (r,1) + 113.44 x PVIF (r,2)

+ 111.33 x PVIF (r,3) + 109.75 x PVIF (r,4) + 108.56 x PVIF (r,5)

+107.67 x PVIF (r,6) + 205 x PVIF (r,7) = 0
 Through a process of trial and error, we get r = 55.17%. The IRR of the project is
55.17%.

12.2. Post-tax Incremental Cash Flows (Rs. in million)

Year 0 1 2 3 4 5 6 7

1. Capital equipment (120)

2. Level of working capital 20 30 40 50 40 30 20
(ending)
3. Revenues 80 120 160 200 160 120 80
4. Raw material cost 24 36 48 60 48 36 24
5. Variable mfg cost. 8 12 16 20 16 12 8
6. Fixed operating & maint. 10 10 10 10 10 10 10
cost
7. Variable selling expenses 8 12 16 20 16 12 8
8. Incremental overheads 4 6 8 10 8 6 4
9. Loss of contribution 10 10 10 10 10 10 10
10.Bad debt loss 4
11. Depreciation 30 22.5 16.88 12.66 9.49 7.12 5.34
12. Profit before tax -14 11.5 35.12 57.34 42.51 26.88 6.66
13. Tax -4.2 3.45 10.54 17.20 12.75 8.06 2.00
14. Profit after tax -9.8 8.05 24.58 40.14 29.76 18.82 4.66
15. Net salvage value of
capital equipments 25
16. Recovery of working 16
capital
17. Initial investment (120)
18. Operating cash flow 20.2 30.55 41.46 52.80 39.25 25.94 14.00
(14 + 10+ 11)
19.  Working capital 20 10 10 10 (10) (10) (10)
20. Terminal cash flow 41

21. Net cash flow (140) 10.20 20.55 31.46 62.80 49.25 35.94 55.00
(17+18-19+20)

(b) NPV of the net cash flow stream @ 15% per discount rate

= -140 + 10.20 x PVIF(15,1) + 20.55 x PVIF (15,2)

+ 31.46 x PVIF (15,3) + 62.80 x PVIF (15,4) + 49.25 x PVIF (15,5)
+ 35.94 x PVIF (15,6) + 55 x PVIF (15,7)
= Rs.1.70 million
12.3.

(a) A. Initial outlay (Time 0)

i. Cost of new machine Rs. 3,000,000

ii. Salvage value of old machine 900,000
iii Incremental working capital requirement 500,000
iv. Total net investment (=i – ii + iii) 2,600,000

B. Operating cash flow (years 1 through 5)

Year 1 2 3 4 5

i. Post-tax savings in
manufacturing costs 455,000 455,000 455,000 455,000 455,000

ii. Incremental
depreciation 550,000 412,500 309,375 232,031 174,023

iii. Tax shield on

incremental dep. 165,000 123,750 92,813 69,609 52,207

iv. Operating cash

flow ( i + iii) 620,000 578,750 547,813 524,609 507,207

C. Terminal cash flow (year 5)

i. Salvage value of new machine Rs. 1,500,000

ii. Salvage value of old machine 200,000
iii. Recovery of incremental working capital 500,000
iv. Terminal cash flow ( i – ii + iii) 1,800,000

D. Net cash flows associated with the replacement project (in Rs)

Year 0 1 2 3 4 5

NCF (2,600,000) 620000 578750 547813 524609 2307207

(b) NPV of the replacement project

= - 2600000 + 620000 x PVIF (14,1)
+ 578750 x PVIF (14,2)
+ 547813 x PVIF (14,3)
+ 524609 x PVIF (14,4)
+ 2307207 x PVIF (14,5)
 = Rs.267849
12.4. Tax shield (savings) on depreciation (in Rs)
Depreciation Tax shield PV of tax shield
Year charge (DC) =0.4 x DC @ 15% p.a.

1 25000 10000 8696

2 18750 7500 5671

3 14063 5625 3699

4 10547 4219 2412

5 7910 3164 1573

----------
22051
----------

Present value of the tax savings on account of depreciation = Rs.22051

12.5. A. Initial outlay (at time 0)

i. Cost of new machine Rs. 400,000
ii. Salvage value of the old machine 90,000
iii. Net investment 310,000

B. Operating cash flow (years 1 through 5)

Year 1 2 3 4 5
i. Depreciation
of old machine 18000 14400 11520 9216 7373

ii. Depreciation
of new machine 100000 75000 56250 42188 31641

iii. Incremental
depreciation
( ii – i) 82000 60600 44730 32972 24268

iv. Tax savings on

incremental
depreciation
( 0.35 x (iii)) 28700 21210 15656 11540 8494

v. Operating cash
 flow 28700 21210 15656 11540 8494
C. Terminal cash flow (year 5)

i. Salvage value of new machine Rs. 25000

ii. Salvage value of old machine 10000
iii. Incremental salvage value of new
machine = Terminal cash flow 15000

D. Net cash flows associated with the replacement proposal.

Year 0 1 2 3 4 5

NCF (310000) 28700 21210 15656 11540 23494

 MINICASE
Solution:

a. Cash flows from the point of all investors (which is also called the explicit cost funds point of
view)
Rs.in million

Item 0 1 2 3 4 5

1. Fixed assets (15)

2. Net working
capital (8)
3. Revenues 30 30 30 30 30
4. Costs (other than
depreciation and
interest) 20 20 20 20 20
5. Loss of rental 1 1 1 1 1
6. Depreciation 3.750 2.813 2.109 1.582 1.187
7. Profit before tax 5.250 6.187 6.891 7.418 7.813
8. Tax 1.575 1.856 2.067 2.225 2.344
9. Profit after tax 3.675 4.331 4.824 5.193 5.469
10. Salvage value of
fixed assets 5.000
11. Net recovery of
working capital 8.000

12. Initial outlay (23)

13. Operating cash
inflow 7.425 7.144 6.933 6.775 6.656
14. Terminal cash
flow 13.000
15. Net cash flow (23) 7.425 7.144 6.933 6.775 19.656
b. Cash flows form the point of equity investors

Rs.in million

Item 0 1 2 3 4 5

1. Equity funds (10)

2. Revenues 30 30 30 30 30
3. Costs (other than
depreciation and
interest) 20 20 20 20 20
4. Loss of rental 1 1 1 1 1
5. Depreciation 3.75 2.813 2.109 1.582 1.187
6. Interest on working
capital advance 0.70 0.70 0.70 0.70 0.70
7. Interest on term
loans 1.20 1.125 0.825 0.525 0.225
8. Profit before tax 3.35 4.362 5.366 6.193 6.888
9. Tax 1.005 1.309 1.610 1.858 2.066
10. Profit after tax 2.345 3.053 3.756 4.335 4.822
11. Net salvage value
of fixed assets 5.000
12. Net salvage value
of current assets 10.000
13. Repayment of term
term loans 2.000 2.000 2.000 2.000
14. Repayment of bank
advance 5.000
15. Retirement of trade
creditors 2.000
16. Initial investment (10)
17. Operating cash
inflow 6.095 5.866 5.865 5.917 6.009
18. Liquidation and
retirement cash
flows (2.0) (2.0) (2.0) 6.00
19. Net cash flow (10) 6.095 3.866 3.865 3.917 12.009
 Minicase 2

(Rs.in lakhs)
Year 0 1 2 3 4 5
Equity 15
Revenues 80 100 120 110 80
Expenses
Depreciation on computer & accessories 12 4.8 1.92 0.768 0.307
Depreciation on furniture & fixtures 3 2.7 2.43 2.187 1.968
Rent paid 5 5
Opportunity cost of rent foregone 5 5 5
Transportation expenses 3 3 3 3 3
Salary 50 54 58.32 62.99 68.02
Opportunity cost of salary foregone 15 16.2 17.5 18.9 20.41
Electricity & water charges 1.5 1.5 1.5 1.5 1.5
Misc. expenses 1 1 1 1 1
Term loan interest 3.6 3.6 2.7 1.8 0.9
Relocation expenses 2
Total expenses 94.1 91.8 95.37 97.14 102.1
Profit before tax -14.1 8.2 24.63 12.86 -22.1
Tax @ 33% -4.653 2.71 8.129 4.245 -7.3
Profit after tax -9.447 5.49 16.5 8.619 -14.8
Rent deposit -2
Rent deposit refund 2
NSV of fixed assets 25
NSV of current assets 0.25
Refund of deposits and advances 2
Term Loan instalment -10 -10 -10 -10
Initial cash flow -15
Operational cash flow 5.553 15.7 20.85 11.57 -12.5
terminal cash flow -2 -8 -10 -10 17.25
Net cash flow -15 3.553 4.99 10.85 1.574 4.714

if the irr is r, we have:

3.553/(1+r) + 4.99/(1+r)2 + 10.85/(1+r)3+ 1.57/(1+r)4+ 4.71/(1+r)5 = 15
Trying r as 20 percent: LHS = 3.553/(1.20) + 4.99/(1.20)2 + 10.85/(1.20)3+ 1.57/(1.20)4+
4.71/(1.20)5 = 15.36
Trying r as 22 percent: LHS = 3.553/(1.22) + 4.99/(1.22)2 + 10.85/(1.22)3+ 1.57/(1.22)4+
4.71/(1.22)5 = 14.69
irr = 20 + [(15.36- 15)/(15.36-14.69)]x 2 = 21.07 %
As the irr is attractive it is a financially worthwhile project.

Chapter 13
RISK ANALYSIS IN CAPITAL BUDGETING

13.1.
NPV of the project = -250 + 50 x PVIFA (13,10)
= Rs.21.31 million

(a) NPVs under alternative scenarios:

(Rs. in million)
Pessimistic Expected Optimistic

Investment 300 250 200

Sales 150 200 275
Variable costs 97.5 120 154
Fixed costs 30 20 15
Depreciation 30 25 20
Pretax profit - 7.5 35 86
Tax @ 28.57% - 2.14 10 24.57
Profit after tax - 5.36 25 61.43
Net cash flow 24.64 50 81.43
Cost of capital 14% 13% 12%

NPV - 171.47 21.31 260.10

Assumptions: (1) The useful life is assumed to be 10 years under all three
scenarios. It is also assumed that the salvage value of the
investment after ten years is zero.
 (2) The investment is assumed to be depreciated at 10% per annum; and
it is also assumed that this method and rate of depreciation are
acceptable to the IT (income tax) authorities.

(3) The tax rate has been calculated from the given table i.e. 10 / 35 x 100
= 28.57%.

(4) It is assumed that only loss on this project can be offset against the
taxable profit on other projects of the company; and thus the company
can claim a tax shield on the loss in the same year.

(b) Accounting break even point (under ‘expected’ scenario)

Fixed costs + depreciation = Rs. 45 million
Contribution margin ratio = 80 / 200 = 0.4
Break even level of sales = 45 / 0.4 = Rs.112.5 million

Financial break even point (under ‘expected’ scenario)

i. Annual net cash flow = 0.7143 [ 0.4 x sales – 45 ] + 25

= 0.2857 sales – 7.14

ii. PV (net cash flows) = [0.2857 sales – 7.14 ] x PVIFA (13,10) 5.426
= 1.5502 sales – 38.74

iii. Initial investment = 250

iv. Financial break even level

of sales = 288.74 / 1.5502 = Rs.186.26 million

13.2.
(a) (i) Sensitivity of NPV with respect to quantity manufactured and sold:
(in Rs)
Pessimistic Expected Optimistic

Initial investment 30000 30000 30000

Sale revenue 24000 42000 54000
Variable costs 16000 28000 36000
Fixed costs 3000 3000 3000
Depreciation 2000 2000 2000
Profit before tax 3000 9000 13000
Tax 1500 4500 6500
Profit after tax 1500 4500 6500
Net cash flow 3500 6500 8500
NPV at a cost of
 capital of 10% p.a
and useful life of
5 years -16732 - 5360 2222

(ii) Sensitivity of NPV with respect to variations in unit price.

Pessimistic Expected Optimistic

Initial investment 30000 30000 30000

Sale revenue 28000 42000 70000
Variable costs 28000 28000 28000
Fixed costs 3000 3000 3000
Depreciation 2000 2000 2000
Profit before tax -5000 9000 37000
Tax -2500 4500 18500
Profit after tax -2500 4500 18500
Net cash flow - 500 6500 20500
NPV - 31895 (-) 5360 47711

(iii) Sensitivity of NPV with respect to variations in unit variable cost.

Pessimistic Expected Optimistic

Initial investment 30000 30000 30000

Sale revenue 42000 42000 42000
Variable costs 56000 28000 21000
Fixed costs 3000 3000 3000
Depreciation 2000 2000 2000
Profit before tax -11000 9000 16000
Tax -5500 4500 8000
Profit after tax -5500 4500 8000
Net cash flow -3500 6500 10000
NPV -43268 - 5360 7908

(b) Accounting break-even point

i. Fixed costs + depreciation = Rs.5000

ii. Contribution margin ratio = 10 / 30 = 0.3333
iii. Break-even level of sales = 5000 / 0.3333
= Rs.15000
Financial break-even point

i. Annual cash flow = 0.5 x (0.3333 Sales – 5000) +2000

 ii. PV of annual cash flow = (i) x PVIFA (10,5) = (i) x 6.105
= 0.6318 sales – 1896
iii. Initial investment = 30000
iv. Break-even level of sales = 31896 / 0.6318 = Rs.50484

13.3 Define At as the random variable denoting net cash flow in year t.

A1 = 4 x 0.4 + 5 x 0.5 + 6 x 0.1

= 4.7

A2 = 5 x 0.4 + 6 x 0.4 + 7 x 0.2

= 5.8

A3 = 3 x 0.3 + 4 x 0.5 + 5 x 0.2

= 3.9

NPV = 4.7 / 1.1 +5.8 / (1.1)2 + 3.9 / (1.1)3 – 10

= Rs.2.00 million

12 = 0.41

22 = 0.56

32 = 0.49

12 22 32

2NPV = + +
(1.1)2 (1.1)4 (1.1)6

= 1.00
 (NPV) = Rs.1.00 million

13.4 Expected NPV

4 At
=  - 25,000
t
t=1 (1.08)

= 12,000/(1.08) + 10,000 / (1.08)2 + 9,000 / (1.08)3

+ 8,000 / (1.08)4 – 25,000

= [ 12,000 x .926 + 10,000 x .857 + 9,000 x .794 + 8,000 x .735]

- 25,000
= 7,708
 Standard deviation of NPV
4 t

t=1 (1.08)t

= 5,000 / (1.08) + 6,000 / (1.08)2 + 5,000 / (1,08)3 + 6,000 / (1.08)4

= 5,000 x .926 + 6,000 x .857 + 5000 x .794 + 6,000 x .735
= 18,152

13.5 (a) Expected NPV

4 At
=  - 10,000 …. (1)
t
t=1 (1.06)
A1 = 2,000 x 0.2 + 3,000 x 0.5 + 4,000 x 0.3
= 3,100

A2 = 3,000 x 0.4 + 4,000 x 0.3 + 5,000 x 0.3

= 3,900

A3 = 4,000 x 0.3 + 5,000 x 0.5 + 6,000 x 0.2

= 4,900

A4 = 2,000 x 0.2 + 3,000 x 0.4 + 4,000 x 0.4

= 3,200
[

Substituting these values in (1) we get

Expected NPV = NPV

= 3,100 / (1.06)+ 3,900 / 1.06)2 + 4,900 / (1.06)3 + 3,200 / (1,06)4

- 10,000 = Rs.3,044
(b)
The variance of NPV is givenby the expression
4 2t
 (NPV) = 
2
…….. (2)
t=1 (1.06)2t

12 = [(2,000 – 3,100)2 x 0.2 + (3,000 – 3,100)2 x 0.5

+ (4,000 – 3,100)2 x 0.3]
= 490,000
 22 = [(3,000 – 3,900)2 x 0.4 + (4,000 – 3,900)2 x 0.3
+ (5,000 – 3900)2 x 0.3]
= 690,000

32 = [(4,000 – 4,900)2 x 0.3 + (5,000 – 4,900)2 x 0.5

+ (6,000 – 4,900)2 x 0.2]
= 490,000

42 = [(2,000 – 3,200)2 x 0.2 + (3,000 – 3,200)2 x 0.4

+ (4,000 – 3200)2 x 0.4]
= 560,000
Substituting these values in (2) we get
490,000 / (1.06)2 + 690,000 / (1.06)4
+ 490,000 / (1.06)6 + 560,000 / (1.06)8
[ 490,000 x 0.890 + 690,000 x 0.792
+ 490,000 x 0.705 + 560,000 x 0.627 ]
= 1,679,150
NPV = 1,679,150 = Rs.1,296

NPV – NPV 0 - NPV

Prob (NPV < 0) = Prob. <
NPV NPV
0 – 3044
= Prob Z <
1296

= Prob (Z < -2.35)

The required probability is given by the shaded area in the following normal curve.

P (Z < - 2.35) = 0.5 – P (-2.35 < Z < 0)

= 0.5 – P (0 < Z < 2.35)
= 0.5 – 0.4906
= 0.0094
(c)
So the probability of NPV being negative is 0.0094

Prob (P1 > 1.2) Prob (PV / I > 1.2)

Prob (NPV / I > 0.2)
Prob. (NPV > 0.2 x 10,000)
Prob (NPV > 2,000)

Prob (NPV >2,000)= Prob (Z > 2,000- 3,044 / 1,296)

Prob (Z > - 0.81)
 The required probability is given by the shaded area of the following normal
curve:
P(Z > - 0.81) = 0.5 + P(-0.81 < Z < 0)
= 0.5 + P(0 < Z < 0.81)
= 0.5 + 0.2090
= 0.7090

So the probability of P1 > 1.2 as 0.7090

MINICASE

Solution:
1. The expected NPV of the turboprop aircraft

0.65 (5500) + 0.35 (500)

NPV = - 11000 +
(1.12)

0.65 [0.8 (17500) + 0.2 (3000)] + 0.35 [0.4 (17500) + 0.6 (3000)]
+
(1.12)2
= 2369

2. If Southern Airways buys the piston engine aircraft and the demand in year 1 turns out to be
high, a further decision has to be made with respect to capacity expansion. To evaluate the
piston engine aircraft, proceed as follows:

First, calculate the NPV of the two options viz., ‘expand’ and ‘do not expand’ at decision
point D2:

0.8 (15000) + 0.2 (1600)

Expand : NPV = - 4400 +
1.12

= 6600
0.8 (6500) + 0.2 (2400)
Do not expand : NPV =
 1.12
= 5071

Second, truncate the ‘do not expand’ option as it is inferior to the ‘expand’ option. This
means that the NPV at decision point D2 will be 6600

Third, calculate the NPV of the piston engine aircraft option.

0.65 (2500+6600) + 0.35 (800)

NPV = – 5500 +
1.12

0.35 [0.2 (6500) + 0.8 (2400)]

+
(1.12)2

= – 5500 + 5531 + 898 = 929

3. The value of the option to expand in the case of piston engine aircraft
If Southern Airways does not have the option of expanding capacity at the end of year 1, the
NPV of the piston engine aircraft would be:

0.65 (2500) + 0.35 (800)

NPV = – 5500 +
1.12

0.65 [0.8 (6500) + 0.2 (2400)] + 0.35 [0.2 (6500) + 0.8 (2400)]
+
(1.12)2

= - 5500 + 1701 + 3842 = 43

Thus the option to expand has a value of 929 – 43 = 886

4. Value of the option to abandon if the turboprop aircraft can be sold for 8000 at the end of year
1

If the demand in year 1 turns out to be low, the payoffs for the ‘continuation’ and
‘abandonment’ options as of year 1 are as follows.

0.4 (17500) + 0.6 (3000)

Continuation: = 7857
 1.12

Abandonment : 8000

Thus it makes sense to sell off the aircraft after year 1, if the demand in year 1 turns out to be
low.

The NPV of the turboprop aircraft with abandonment possibility is

0.65 [5500 +{0.8 (17500) + 0.2 (3000)}/ (1.12)] + 0.35 (500 +8000)
NPV = - 11,000 +
(1.12)

12048 + 2975
= - 11,000 + = 2413
1.12

Since the turboprop aircraft without the abandonment option has a value of 2369, the
value of the abandonment option is : 2413 – 2369 = 44

5 The value of the option to abandon if the piston engine aircraft can be sold for 4400 at the
end of year 1:

If the demand in year 1 turns out to be low, the payoffs for the ‘continuation’ and
‘abandonment’ options as of year 1 are as follows:

0.2 (6500) + 0.8 (2400)

Continuation : = 2875
1.12

Abandonment : 4400

Thus, it makes sense to sell off the aircraft after year 1, if the demand in year 1 turns out to
be low.

The NPV of the piston engine aircraft with abandonment possibility is:

0.65 [2500 + 6600] + 0.35 [800 + 4400]

NPV = - 5500 +
1.12
 5915 + 1820
= - 5500 + = 1406
1.12

For the piston engine aircraft the possibility of abandonment increases the NPV from 929 to
1406. Hence the value of the abandonment option is 477.

Minicase 2

a)
Sensitivity analysis (Rs.in lakhs)
Year 0 Years 1-10
On 10 % fall
Projected
in sales
Initial investment -400.00
Sales 500.00 450.00
Variable costs(60 % of sales) 300.00 270.00
Fixed costs 20.00 20.00
Depreciation 40.00 40.00
Profit bef ore tax 140.00 120.00
Tax (33 %) 46.20 39.60
profit after tax 93.80 80.40
NPV at cost of capital 12 % 129.99 54.28
For a 10 percent in sales, the NPV would fall by:
(1 – 54.28/129.99) x 100 = 58.24 percent.
b)
Financial break even point for an IRR of 25 percent:
Annual net cash flow = 0.67 [ 0.4 x sales – 60 ] + 40
= 0.268 sales – 0.2
PV (net cash flows) = [0.268 sales – 0.2 ] x PVIFA (25%,10) = [0.268
sales – 0.2 ] x 3.57
= 0.957 sales – 0.714
Initial investment = 400
Financial break-even level of sales = 400.714 / 0.957 = Rs.418 million
So the annual sales could come down by: (1-418/500) or 16.4 percent.
 Chapter 14
THE COST OF CAPITAL

14.1(a) Define rD as the pre-tax cost of debt. Using the approximate yield formula, rD
can be calculated as follows:

14 + (100 – 108)/10
rD = ------------------------ x 100 = 12.60%
0.4 x 100 + 0.6x108

(b) After tax cost = 12.60 x (1 – 0.35) = 8.19%

14.2 Define rp as the cost of preference capital. Using the approximate yield formula rp can be
calculated as follows:

9 + (100 – 92)/6
rp = --------------------
0.4 x100 + 0.6x92

= 0.1085 (or) 10.85%

14.3. WACC = 0.4 x 13% x (1 – 0.35)

+ 0.6 x 18%
= 14.18%

14.4. Cost of equity = 10% + 1.2 x 7% = 18.4%

(using SML equation)

Pre-tax cost of debt = 14%

After-tax cost of debt = 14% x (1 – 0.35) = 9.1%

Debt equity ratio = 2:3

WACC = 2/5 x 9.1% + 3/5 x 18.4%

= 14.68%

14.5. Given
0.5 x 14% x (1 – 0.35) + 0.5 x rE = 12%

where rE is the cost of equity capital.

Therefore rE – 14.9%
 Using the SML equation we get

11% + 8% x β = 14.9%

where β denotes the beta of Azeez’s equity.

Solving this equation we get β = 0.4875.

14.6(a) The cost of debt of 12% represents the historical interest rate at the time the debt was
originally issued. But we need to calculate the marginal cost of debt (cost of raising new
debt); and for this purpose we need to calculate the yield to maturity of the debt as on the
balance sheet date. The yield to maturity will not be equal to12% unless the book value of
debt is equal to the market value of debt on the balance sheet date.

(b) The cost of equity has been taken as D1/P0 ( = 6/100) whereas the cost of equity is
(D1/P0) + g where g represents the expected constant growth rate in dividend per share.

14.7. (a) The book value and market values of the different sources of finance are
provided in the following table. The book value weights and the market value
weights are provided within parenthesis in the table.

(Rs. in million)
Source Book value Market value
Equity 800 (0.54) 2400 (0.78)
Debentures – first series 300 (0.20) 270 (0.09)
Debentures – second series 200 (0.13) 204 (0.06)
Bank loan 200 (0.13) 200 (0.07)
Total 1500 (1.00) 3074 (1.00)

(b) I would use weights based on the market value because to justify its valuation Samanta
must earn competitive returns for investors on its market value

14.8.
(a) Given
rD x (1 – 0.3) x 4/9 + 20% x 5/9 = 15%
rD = 12.5%,where rD represents the pre-tax cost of debt.

(b) Given
13% x (1 – 0.3) x 4/9 + rE x 5/9 = 15%
rE = 19.72%, where rE represents the cost of equity.
14.9. Cost of equity = D1/P0 + g
= 3.00 / 30.00 + 0.05
= 15%
(a) The first chunk of financing will comprise of Rs.5 million of retained earnings costing
15 percent and Rs.2.5 million of debt costing 14 (1-.3) = 9.8 per cent
The second chunk of financing will comprise of Rs.5 million of additional equity
costing 15 per cent and Rs.2.5 million of debt costing 15 (1-.3) = 10.5 per cent

(b) The marginal cost of capital in the first chunk will be :

5/7.5 x 15% + 2.5/7.5 x 9.8% = 13.27%

The marginal cost of capital in the second chunk will be :

5/7.5 x 15% + 2.5/7.5 x 10.5% = 13.50%

Note : We have assumed that

(i) The net realisation per share will be Rs.25, after floatation costs, and
(ii) The planned investment of Rs.15 million is inclusive of floatation costs

14.10 (a) (i) The cost of equity and retained earnings

rE = D1/PO + g
= 1.50 / 20.00 + 0.07 = 14.5%
The cost of preference capital, using the approximate formula, is :

11 + (100-75)/10
rP = = 15.9%
0.6 x 75 + 0.4 x 100
The pre-tax cost of debentures, using the approximate formula, is :

13.5 + (100-80)/6
rD = = 19.1%
0.6x80 + 0.4x100

The post-tax cost of debentures is

19.1 (1-tax rate) = 19.1 (1 – 0.5)
= 9.6%

The post-tax cost of term loans is

12 (1-tax rate) = 12 (1 – 0.5)
= 6.0%
The average cost of capital using book value proportions is calculated below:

Source of capital Component Book value Book value Product of

Cost Rs. in million proportion (1) & (3)
(1) (2) (3)
Equity capital 14.5% 100 0.28 4.06
Preference capital 15.9% 10 0.03 0.48
Retained earnings 14.5% 120 0.33 4.79
Debentures 9.6% 50 0.14 1.34
Term loans 6.0% 80 0.22 1.32
360 Average cost 11.99%
capital

(ii) The average cost of capital using market value proportions is calculated below :

Source of capital Component Market value Market value Product of

cost Rs. in million proportion
(1) (2) (3) (1) & (3)

Equity capital
and retained earnings 14.5% 200 0.62 8.99
Preference capital 15.9% 7.5 0.02 0.32
Debentures 9.6% 40 0.12 1.15
Term loans 6.0% 80 0.24 1.44

327.5 Average cost 11.90%

capital

(b)
The Rs.100 million to be raised will consist of the following:
Retained earnings Rs.15 million
Additional equity Rs. 35 million
Debt Rs. 50 million
The first batch will consist of Rs. 15 million each of retained earnings
and debt costing 14.5 percent and 14(1-0.5)= 7 percent respectively. The
second batch will consist of Rs. 10 million each of additional equity and
debt at 14.5 percent and 7percent respectively. The third chunk will
consist of Rs.25 million each of additional equity and debt costing 14.5
percent and 15(1-0.5) = 7.5 percent respectively.
The marginal cost of capital in the chunks will be as under
First batch: (0.5x14.5 ) + (0.5 x 7) = 10.75 %
Second batch: (0.5x14.5 ) + (0.5 x 7) = 10.75 %
Third batch : (0.5x14.5 ) + (0.5 x 7.5) = 11 %
The marginal cost of capital schedule for the firm will be as under.
Range of total financing Weighted marginal cost of
( Rs. in million) capital ( %)
0 - 50 10.75
50-100 11.00
Here it is assumed that the Rs.100 million to be raised is inclusive of floatation costs.

14.11
(a) WACC = 1/3 x 13% x (1 – 0.3)
+ 2/3 x 20%
= 16.37%

(b) Weighted average floatation cost

= 1/3 x 3% + 2/3 x 12%
= 9%

(c) NPV of the proposal after taking into account the floatation costs

= 130 x PVIFA (16.37, 8) – 500 / (1 - 0.09)

= Rs.8.55 million

14.12. Required return

based on SML Expected
Project Beta equation (%) return (%)

P 0.6 14.8 13
Q 0.9 17.2 14
R 1.5 22.0 16
S 1.5 22.0 20

Given a hurdle rate of 18% (the firm’s cost of capital), projects P, Q and R would have been
rejected because the expected returns on these projects are below 18%. Project S would be accepted
because the expected return on this project exceeds 18%. An appropriate basis for accepting or
rejecting the projects would be to compare the expected rate of return and the required rate of return
for each project. Based on this comparison, we find that all the four projects need to be rejected.
rejected because the expected returns on these projects are below 18%. Project S would be accepted
because the expected return on this project exceeds 18%. An appropriate basis for accepting or
rejecting the projects would be to compare the expected rate of return and the required rate of return
for each project. Based on this comparison, we find that all the four projects need to be rejected.
 MINICASE

Solution:

Pre-tax cost of debt & post-tax cost of debt

10 + (100 – 112) / 8 8.5

rd = = = 7.93
0.6 x 112 + 0.4 x 100 107.2

rd (1 – 0.3) = 5.55

Post-tax cost of preference

9 + (100 – 106) / 5 7.8

= = 7.53%
0.6 x 106 + 0.4 x 100 103.6

Cost of equity using the DDM

2.80 (1.10)
+ 0.10 = 0.385 + 0.10
80
= 0.1385 = 13.85%

. Cost of equity using the CAPM

7 + 1.1(7) = 14.70%

WACC
0.50 x 14.70 + 0.10 x 7.53 + 0.40 x 5.55
= 7.35 + 0.75 + 2.22
= 10.32%

Cost of capital for the new business

0.5 [7 + 1.5 (7)] + 0.5 [ 11 (1 – 0.3)]

8.75 + 3.85
= 12.60%

Summing up:
a. Post-tax cost of debt = 5.55 %
. Post-tax cost of preference= 7.53%
b.
Cost of equity as per the dividend discount model = 13.85%
Cost of equity as per CAPM= 14.70%
c.
WACC, using CAPM for the cost of equity = 10.32%

d.
WACC for the new business = 12.60%

Chapter 15
CAPITAL BUDGETING: EXTENSIONS

15.1. Let us assume that the cost of capital is 12 percent.

EAC
(Plastic Emulsion) = 300000 / PVIFA (12,7)
= 300000 / 4.564
= Rs.65732

EAC
(Distemper Painting) = 180000 / PVIFA (12,3)
= 180000 / 2.402
= Rs.74938

Since EAC of plastic emulsion is less than that of distemper painting, it is the preferred
alternative.

15.2
PV of the net costs associated with the internal transportation system

= 1 500 000 + 300 000 x PVIF (13,1) + 360 000 x PVIF (13,2)
+ 400 000 x PVIF (13,3) + 450 000 x PVIF (13,4)
+ 500 000 x PVIF (13,5) - 300 000 x PVIF (13,5)
= 2709185

EAC of the internal transportation system

= 2709185 / PVIFA (13,5)

= 2709185 / 3.517
= Rs.770 311

15.3. EAC [ Standard overhaul]

 = 500 000 / PVIFA (14,6)
= 500 000 / 3.889
= Rs.128568 ……… (A)

EAC [Less costly overhaul]

= 200 000 / PVIFA (14,2)

= 200 000 / 1.647
= Rs.121433 ……… (B)

Since (B) < (A), the less costly overhaul is preferred alternative.

15.4.
NOTE: In the problem it has been omitted to mention that an amount of Rs.6,000,000 can be
raised by way of a term loan to partly finance the project.
(a) Base case NPV

= -12,000,000 + 3,000,000 x PVIFA (20,6)

= -12,000,000 + 997,8000
= (-) Rs.2,022,000

(b) Issue costs = 6,000,000 / 0.88 - 6,000,000

= Rs.818 182

Adjusted NPV after adjusting for issue costs

= - 2,022,000 – 818,182
= - Rs.2,840,182

(c) The present value of interest tax shield is calculated below :

Year Debt outstanding at Interest Tax shield Present value of

the beginning tax shield
1 6,000,000 1,080,000 324,000 274,590
2 6,000,000 1,080,000 324,000 232,697
3 5,250,000 945,000 283,000 172,538
4 4,500,000 810,000 243,000 125,339
5 3,750,000 675,000 202,000 88,513
6 3,000,000 540,000 162,000 60,005
7 2,225,000 400,500 120,000 37,715
8 1,500,000 270,000 81,000 21,546
 9 750,000 135,000 40,500 9,133

Present value of tax shield = Rs.1,022,076

15.5.
(a) Base case BPV

= - 8,000,000 + 2,000,000 x PVIFA (18,6)

= - Rs.1,004,000

(b) Adjusted NPV after adjustment for issue cost of external equity

= Base case NPV – Issue cost

= - 1,004,000 – [ 3,000,000 / 0.9 – 3,000,000]
= - Rs.1,337,333
(c) The present value of interest tax shield is calculated below :

Year Debt outstanding at Interest Tax shield Present value of

the beginning tax shield
1 5,000,000 750,000 300,000 260,880
2 5,000,000 750,000 300,000 226,830
3 4,000,000 600,000 240,000 157,800
4 3,000,000 450,000 180,000 102,924
5 2,000,000 300,000 120,000 59,664
6 1,000,000 150,000 60,000 25,938

Present value of tax shield = Rs.834,036

15.6. Let us assume a discount rate 0f 12 percent

UAE of plastic emulsion = 200,000/PVIFA(12%,6)= 200,000/4.111 =Rs.48,650
UAE of distemper painting = 140,000/PVIFA(12%,3)=140,000/2.402. = Rs.58,285

As the UAE of plastic emulsion is cheaper, that would be the better option.

15.7
EAC [ first offer]

= 600 000 / PVIFA (12,4)

= 600 000 / 3.037
= Rs.197,563 ……… (A)
 EAC [second offer]

= 500 000 / PVIFA (12,3)

= 500 000 / 2.402
= Rs.208,160 ……… (B)

Since (A) < (B), the first offer is the better alternative.

15.8
Base case NPV
= -40,000,000 + 20,000,000 x PVIFA (18%,5 yrs)
= -40,000,000 + 20,000,000 x 3.127
= Rs.22,540,000
Issue costs = 20,000,000 / 0.95 - 20,000,000
= Rs. 1,052,632
The present value of interest tax shield is calculated below :

Year Debt outstanding at Interest Tax shield Present value of

the beginning tax shield
1 20,000,000 2,400,000 720,000 642,857
2 20,000,000 2,400,000 720,000 573,980
3 15,000,000 1,800,000 540,000 384,361
4 10,000,000 1,200,000 360,000 228,787
5 5,000,000 600,000 180,000 102,137
Present value of tax shield = Rs.1,932,122

Adjusted NPV after adjusting for issue costs and tax shield on loan interest
= Rs. 22,540,000- 1,052,632 + 1,932,122 = Rs. 23,419,490

MINICASE

Solution:
1. Import option:
To raise Rs.800 million an amount of 800,000,000/0.92 =Rs. 869,565,217
would have to be raised by way of equity
 So the NPV of the imported plant
= - 869,565,217+ 176,500,000 PVIFA(14%, 10yrs) +
50,000,000PVIF(14%,10 yrs)
= - 869,565,217+ 177,000,000 x 5.216 + 50,000,000 x 0.270
= Rs. 64,558,783

2. Base case NPV = -980,000,000 +189,000,000 x PVIFA (14,10)

= -980,000,000 + 189,000,000 x 5.216
= Rs. 5,824,000

Issue costs = 400,000,000 / 0.92 - 400,000,000 = Rs. 34,782,609

 Term loan Interest on Tax shield on PV of
at the term interest on term tax
Year beginning loan@10% loan PVIF shield
1 480 48 15.36 0.909 13.964
2 480 48 15.36 0.826 12.694
3 480 48 15.36 0.751 11.540
4 420 42 13.44 0.683 9.180
5 360 36 11.52 0.621 7.153
6 300 30 9.6 0.564 5.419
7 240 24 7.68 0.513 3.941
8 180 18 5.76 0.467 2.687
9 120 12 3.84 0.424 1.629
10 60 6 1.92 0.386 0.740
Total
= 68.947

Interest on working capital per year = 100 x 0.13 = Rs. 13 million

Tax shield on the above each year = 13 x 0.32 = Rs 4.16 million
PV of the above tax shields =4.16 x PVIFA(13%, 10yrs)
= 4.16 x 5.426 = Rs. 22.572 million

PV of all tax shields = 68.947 + 22.572 = Rs. 91.519 million

Adjusted present value of the project
=5,824,000 – 34,782,609 + 91,519,000= Rs. 62,560,391

2.
As the adjusted NPV of the SIDCO offer is only very slightly less than the import option and it
would indeed be worthwhile to oblige the regulator, I would accept their proposal in principle,
subject to confirmation after a detailed study of their offer.
 Chapter 18
RAISING LONG TERM FINANCE

18.1. Po = Rs.180 N=5

a. The theoretical value of a right if the subscription price is Rs.150
N ( Po – S ) 5 (180 – 150)
= = Rs 25
N+1 5+1

b. The ex-rights value per share if the subscription price is Rs.160

NPo + S 5 x 180 + 160
= = Rs.176.7
N+1 5+1

c. The theoretical value per share, ex-rights, if the subscription price is

Rs.180? 100?
5 x 180 + 180
= Rs.180
5+1

5 x 180 + 100
= Rs.166.7
5+1
 Chapter 19
CAPITAL STRUCTURE AND FIRM VALUE

19.1. Net operating income (O) : Rs.30 million

Interest on debt (I) : Rs.10 million
Equity earnings (P) : Rs.20 million
Cost of equity (rE) : 15%

Cost of debt (rD) : 10%

Market value of equity (E) : Rs.20 million/0.15 =Rs.13 million
Market value of debt (D) : Rs.10 million/0.10 =Rs.100 million
Market value of the firm (V) : Rs.233 million

19.2. Box Cox

Market value of equity 2,000,000/0.15 1,500,000/0.15

= Rs.13.33 million = Rs.10.00 million
Market value of debt 0 500,000/0.10
=Rs.5 million
Market value of the firm Rs.13.33million = 15 million

(a) Average cost of capital for Box Corporation

13.33. 0
x 15% + x 10% = 15%
13.33 13.33

Average cost of capital for Cox Corporation

10 5.00
x 15% + x 10% = 13.33 %
15 15

(b) If Box Corporation employs Rs.30 million of debt to finance a project that yields
Rs.4 million net operating income, its financials will be as follows.

Net operating income Rs.6,000,000

Interest on debt Rs.3,000,000
Equity earnings Rs.3,000,000
Cost of equity 15%
Cost of debt 10%
Market value of equity Rs.20 million
Market value of debt Rs.30 million
Market value of the firm Rs.50 million
 Average cost of capital
20 30
15% x + 10% = 12%
50 50

(c) If Cox Corporation sells Rs.5 million of additional equity to retire

Rs.5 million of debt , it will become an all-equity company. So its
average cost of capital will simply be equal to its cost of equity,
which is 15%.

19.3. rE = rA + (rA-rD)D/E
20 = 12 + (12-8) D/E
So D/E = 2

19.4. (a) If you own Rs.10,000 worth of Bharat Company, the levered company
which is valued more, you would sell shares of Bharat Company, resort
to personal leverage, and buy the shares of Charat Company.
(b) The arbitrage will cease when Charat Company and Bharat Company
are valued alike

19.5. The value of Ashwini Limited according to Modigliani and Miller

hypothesis is
Expected operating income 15
= = Rs.125 million
Discount rate applicable to the 0.12
risk class to which Aswini belongs
19..6. The tax advantage of one rupee of debt is :
( note: tc is assumed here to be 55% and not 5%)
1-(1-tc) (1-tpe) (1-0.50) (1-0.05)
= 1 -
(1-tpd) (1-0.25)

= 0.37 rupee
 Chapter 20
CAPITAL STRUCTURE DECISION

20.1
.(a) Currently
No. of shares = 1,500,000
EBIT = Rs 7.2 million
Interest = 0
Preference dividend = Rs.12 x 50,000 = Rs.0.6 million
EPS = Rs.2

(EBIT – Interest) (1-t) – Preference dividend

EPS =
No. of shares

(7,200,000 – 0 ) (1-t) – 600,000

Rs.2 =
1,500,000

Hence t = 0.5 or 50 per cent

The EPS under the two financing plans is :

Financing Plan A : Issue of 1,000,000 shares

(EBIT - 0 ) ( 1 – 0.5) - 600,000

EPSA =
2,500,000

Financing Plan B : Issue of Rs.10 million debentures carrying 15 per cent

interest

(EBIT – 1,500,000) (1-0.5) – 600,000

EPSB =
1,500,000

The EPS – EBIT indifference point can be obtained by equating EPSA and EPSB

(EBIT – 0 ) (1 – 0.5) – 600,000 (EBIT – 1,500,000) (1 – 0.5) – 600,000

=
2,500,000 1,500,000

Solving the above we get EBIT = Rs.4,950,000 and at that EBIT, EPS is Rs.0.75
 under both the plans

(b) As long as EBIT is less than Rs.4,950,000 equity financing maximixes EPS.
When EBIT exceeds Rs.4,950,000 debt financing maximises EPS.

20.2.
(a) EPS – EBIT equation for alternative A
EBIT ( 1 – 0.5)
EPSA =
2,000,000
(b) EPS – EBIT equation for alternative B
EBIT ( 1 – 0.5 ) – 440,000
EPSB =
1,600,000

(c) EPS – EBIT equation for alternative C

(EBIT – 1,200,000) (1- 0.5)
EPSC =
1,200,000

(d) The three alternative plans of financing ranked in terms of EPS over varying
Levels of EBIT are given the following table

Ranking of Alternatives

EBIT EPSA EPSB EPSC

(Rs.) (Rs.) (Rs.) (Rs.)

2,000,000 0.50(I) 0.35(II) 0.33(III)

2,160,000 0.54(I) 0.40(II) 0.40(II)
3,000,000 0.75(I) 0.66(II) 0.75(I)
4,000,000 1.00(II) 0.98(III) 1.17(I)
4,400,000 1.10(II) 1.10(II) 1.33(I)
More than 4,400,000 (III) (II) (I)

20.3 Plan A : Issue 0.8 million equity shares at Rs. 12.5 per share.
Plan B : Issue Rs.10 million of debt carrying interest rate of 15 per cent.
 (EBIT – 0 ) (1 – 0.6)
EPSA =
1,800,000
(EBIT – 1,500,000) (1 – 0.6)
EPSB =
1,000,000

Equating EPSA and EPSB , we get

(EBIT – 0 ) (1 – 0.6) (EBIT – 1,500,000) (1 – 0.6)
=
1,800,000 1,000,000

Solving this we get EBIT = 3,375,000 or 3.375 million

Thus the debt alternative is better than the equity alternative when
EBIT > 3.375 million

EBIT – EBIT 3.375 – 7.000

Prob(EBIT>3,375,000) = Prob >
EBIT 3.000

= Prob [z > - 1.21]

= 0.8869

20.4 ROE = [ ROI + ( ROI – r ) D/E ] (1 – t )

15 = [ 14 + ( 14 – 8 ) D/E ] ( 1- 0.5 )
D/E = 2.67

20.5
ROE = [12 + (12 – 9 ) 0.6 ] (1 – 0.6)
= 5.52 per cent

20.6. 18 = [ ROI + ( ROI – 12 ) 0.7 ] ( 1 – 0.5)

ROI = 26.12 per cent
EBIT
20.7. a. Interest coverage ratio =
Interest on debt

15
=
4
= 3.75
 EBIT + Depreciation
b. Cash flow coverage ratio =
Loan repayment instalment
Int.on debt +
(1 – Tax rate)
= 15 + 3

4+5

= 2

20.8 The debt service coverage ratio for Pioneer Automobiles Limited is given by :
5
 PAT i + Depi + Inti)
i=1
DSCR = 5
Inti + LRIi)
i=1

= 133.00 + 49.14 +95.80

95.80 + 72.00

= 277.94
167.80
= 1.66

20.9 (a) If the entire outlay of Rs. 300 million is raised by way of debt carrying 15 per cent
interest, the interest burden will be Rs. 45 million.
Considering the interest burden the net cash flows of the firm during
a recessionary year will have an expected value of Rs. 35 million (Rs.80 million - Rs. 45
million ) and a standard deviation of Rs. 40 million .
Since the net cash flow (X) is distributed normally
X – 35

40
has a standard normal deviation
Cash flow inadequacy means that X is less than 0.
0.35
Prob(X<0) = Prob (z< ) = Prob (z<- 0.875)
40
= 0.1909
(b) Since µ = Rs.80 million, = Rs.40 million , and the Z value corresponding to the risk
tolerance limit of 5 per cent is – 1.645, the cash available from the operations to service the
debt is equal to X which is defined as :
X – 80
= - 1.645
40
X = Rs.14.2 million
Given 15 per cent interest rate, the debt than be serviced is
14.2
= Rs. 94.67 million
0.15
20.10
The effect of alternative financing plans on share price is as under:

Plan A Plan B
PBIT 36 36
Int 6 9.6
PBT 30 26.4
Tax 15 13.2
PAT 15 13.2
No of equity Shares 5m 4m
EPS 3.00 4.40
P/E 10.20 9.8
M.P 30.60 33.34
20.11
DOL ( Q = 8000) = 1.75, DFL (Q = 8000) = 1.23, DTL (Q= 8000) = 2.15
DOL (Q = 10000) = 1.52, DFL (Q = 10000) = 1.15, DTL (Q= 10000) = 1.75

MINICASE

(a) If the firm chooses the equity option, it will have to issue 2 crore shares and its interest
burden will remain at the current level of Rs.20 crore. If the firm chooses the debt option,
the interest burden will go upto Rs.36 crore, but the number of equity shares will remain
unchanged at 14 crore. So, the EPS – PBIT indifference point is the value of PBIT in the
following equation.

(PBIT -20)( 1- 0.3) (PBIT – 36)( 1-0.3)

=
16 14

PBIT = Rs. 148 crore

(b) The projected EPS under the two financing options is given below

Projected
Current Equity option Debt option
Revenues 800 1040 1040
Variable costs 480 624 624
Contribution margin 320 416 416
Fixed operating costs 180 230 230
PBIT 140 186 186
Interest 20 20 36
PBT 120 166 150
Tax 36 55.33 50
PAT 84 110.67 100
No.of equity shares 14 16 14
EPS 6 6.92 7.14
(c)

Contribution margin
The degree of total leverage (DTL) is defined as :
PBIT
So, the DTL will be as follows:

DTL

Current = 320/140 = 2.67

Equity option = 416/166 = 2.51
Debt option = 416/150 = 2.77
 Chapter 21
DIVIDEND POLICY AND FIRM VALUE

21.1.(a) Payout ratio Price per share

3(0.5)+3(0.5) 0.15
0.5
0.12
= Rs. 28.13
0.12

3(0.7 5)+3(0.25) 0.15

0.12
0.75 = Rs. 26.56
0.12

3(1.00)
1.00 = Rs. 25.00
0.12
(b)

Dividend Price as per Gordon model P0

payout ratio =E1(1-b)/(k-br)
25% = 3 x 0.25/(0.12 - 0.75x 0.15) =Rs. 100
=Rs.
50% = 3 x 0.50/(0.12 - 0.50x 0.15) 33.33
=Rs.
75% = 3 x 0.75/(0.12 - 0.25x 0.15) 27.27

21.2.
P Q
 Next year’s price 80 74
 Dividend 0 6
 Current price P Q
 Capital appreciation (80-P) (74-Q)
 Post-tax capital appreciation 0.9(80-P) 0.9 (74-Q)
 Post-tax dividend income 0 0.8 x 6
 Total return 0.9 (80-P) 0.9 (74-Q) + 4.8
P Q
= 14% =14%
 Current price (obtained by solving P = Rs.69.23 Q = Rs.68.65
the preceding equation)
 Chapter 22
DIVIDEND DECISION

22.1. a. Under a pure residual dividend policy, the dividend per share over the 4 year
period will be as follows:

DPS Under Pure Residual Dividend Policy

( in Rs.)

Year 1 2 3 4

Earnings 10,000 12,000 9,000 15,000

Capital expenditure 8,000 7,000 10,000 8,000
Equity investment 4,000 3,500 5,000 4,000
Pure residual
dividends 6,000 8,500 4,000 11,000
Dividends per share 1.20 1.70 0.80 2.20

b. The external financing required over the 4 year period (under the assumption that the
company plans to raise dividends by 10 percents every two years) is given below :
Required Level of External Financing
(in Rs.)

Year 1 2 3 4

A. Net income 10,000 12,000 9,000 15,000

B. Targeted DPS 1.00 1.10 1.10 1.21

C. Total dividends 5,000 5,500 5,500 6,050

D. Retained earnings(A-C) 5,000 6,500 3,500 8,950

E. Capital expenditure 8,000 7,000 10,000 8,000

F. External financing
requirement 3,000 500 6,500 Nil
(E-D)if E > D or 0 otherwise

c. Given that the company follows a constant 60 per cent payout ratio, the dividend per share
and external financing requirement over the 4 year period are given below
 Dividend Per Share and External Financing Requirement
(in Rs.)

Year 1 2 3 4

A. Net income 10,000 12,000 9,000 15,00

B. Dividends 6,000 7,200 5,400 9,000

C. Retained earnings 4,000 4,800 3,600 6,000

D. Capital expenditure 8,000 7,000 10,000 8,000

E. External financing
(D-C)if D>C, or 0 4,000 2,200 6,400 2,000
otherwise

F. Dividends per share 1.20 1.44 1.08 1.80

22.2
Given the constraints imposed by the management, the dividend per share has to
be between Rs.1.00 (the dividend for the previous year) and Rs.1.60 (80 per
cent of earnings per share)
Since share holders have a preference for dividend, the dividend should be
raised over the previous dividend of Rs.1.00 . However, the firm has substantial
investment requirements and it would be reluctant to issue additional equity
because of high issue costs ( in the form of underpricing and floatation costs)
Considering the conflicting requirements, it seems to make sense to pay
Rs.1.20 per share by way of dividend. Put differently the pay out ratio may be
set at 60 per cent.

MINICASE

(a) Plausible Reasons for Paying Dividends

(i) Investor preference for dividends

(ii) Information signaling
(iii) Clientele effect
(iv) Agency costs
Dubious Reasons for Paying Dividends
(i) Bird-in-hand fallacy
(ii) Temporary excess cash
(b)
(i) Funds requirement
(ii) Liquidity
(iii) Access to external sources of financing
(iv) Shareholder preference
(v) Difference in the cost of external equity and retained earnings
(vi) Control
(vi) Taxes
(vii) Stability

(c)
Rs.in million
1 2 3 4 5 Total
Earnings 96 108 84 115 147 550
Net investments 104 94 90 108 192 588
Equity investment 69.33 62.67 60.00 72.00 128.00 392
Pure residual
dividends 26.67 45.33 24.00 43.00 19.00 158
Dividends under fixed
dividend payout ratio 28.8 32.4 25.2 34.5 44.1 165
Dividends under
smoothed residual
dividend policy 30 30 30 34 34 158

(d)
DPS for the current year : Dt = cr EPSt + (1-c) Dt-1
= 0.6 x 0.3 x 9 + (1-0.6) x 2 = Rs.2.42

(e)
Bonus Issue
 The par value of the share is unchanged
 A part of reserves is capitalised
 The shareholders' proportional
ownership remains unchanged
 The book value per share, the earnings
per share, and the market price per
share decline
 The market price per share is brought
within a popular trading range.
Stock Split
 The par value of the share is reduced.
 There is no capitalisation of reserves
 The shareholders' proportional
ownership remains unchanged
 The book value per share, the earnings
per share, and the market price per share
decline
 The market price per share is brought
within a more popular trading range.
 Chapter 23
WORKING CAPITAL POLICY

Average inventory
23.1 Inventory period =
Annual cost of goods sold/365

(60+64)/2
= = 62.9 days
360/365

Average accounts receivable

Accounts receivable =
period Annual sales/365

(80+88)/2
= = 61.3 days
500/365

Average accounts payable

Accounts payable =
period Annual cost of goods sold/365

(40+46)/2
= = 43.43 days
360/365

Operating cycle = 62.9 + 61.3 = 124.2 days

Cash cycle = 124.2 – 43.43 = 80.77 days

(110+120)/2
23.2. Inventory period = = 56.0 days
750/365

(140+150)/2
Accounts receivable = = 52.9 days
period 1000/365

(60+66)/2
Accounts payable = = 30.7 days
period 750/365

Operating cycle = 56.0 + 52.9 = 108.9 days

Cash cycle = 108.9 – 30.7 = 78.2 days
23.3. .
Solution
A. Current Assets
Item Calculation Amount

Debtors Total cash cost 2440,000 x 2

x2= 406,667
12 12
Raw material stock Material cost 700,000
x 2 = x2 116,667
12 12
Finished good stock Cash manufacturing cost 2140,000x2
x2= 356,667
12 12
Pre-paid sales promotional Quarterly sales promotional expenses 25,000
expenses
Cash balance A predetermined amount 80,000

A : Current Assets 985,000

B. Current Liabilities

Item Calculation Amount

Sundry creditors Material cost 700,000 x 2

x2= 116,667
12 12
Manufacturing expenses One month’s cash manufacturing expenses 70,000
outstanding
Wages outstanding One month’s wages 50,000
Total administrative One month’s total administrative
expenses outstanding expenses 16,667

B : Current Liabilities 253,334

Working capital (A – B) 731,667

Add 15 percent (assumed) safety margin 109,750

Working capital required 841,417

Working Notes
1. Manufacturing expenses
Sales 3000,000
Less : Gross profit (20%) 600,000
Total manufacturing cost 2400,000
Less: Materials 700,000
Wages 600,000
1300,000
 Manufacturing expenses 1100,000
2. Cash manufacturing expenses 840,000
(Rs.70,000 x 12)
3. Depreciation: (1) –(2) 260,000
4. Total cash cost
Total manufacturing cost 2400,000
Less : Depreciation 260,000
Cash manufacturing cost 2140,000
Add Total administrative expenses 200,000
Sales promotion expenses 100,000
Total cash cost 2440,000

MINICASE

(1)

For the current year we have the following:

Rs. in million
Projected sales 800
Less: Gross profit [800x (701-552)/701] 170
Total manufacturing cost 630

Less Depreciation 30
Cash manufacturing cost 600
Add Administration and selling expenses 30
Total cash cost 630
Raw material purchase = 800 x 449/701 = 512
Wages = 68 x 1.10 = 75
Other cash manufacturing expenses = 600 – 512 -75 = 13
(Total cash manufacturing cost – material purchase-wages)
(2)
A: Current Assets
Rs. in million

Item Calculation Amount

Debtors Total cash cost 630 x 47

x 47 = 81.1
365 365

Raw material Material cost 512 x59

stock x59 = 82.8
365 365

Finished goods Cash manufacturing cost 600x11

stock x11 = 18.1
365 365

Cash balance Predetermined amount 5.0

A : Current assets 187.0

B: Current Liabilities

Rs. in million
Item Calculation Amount

Sundry creditors Material cost 512 x 55

x 55 = 77.2
365 365

Manufacturing One month's other cash manufacturing

expenses outstanding expenses(13/12) 1.1

Wages outstanding One month's wages(75/12) 6.3

B : Current Liabilities 84.6

Working capital (A - B) 102.4

Add 5 percent safety margin 5.1

Working capital required 107.5

 Chapter 24
CASH AND LIQUIDITY MANAGEMENT

24.1 The projected cash inflows and outflows for the quarter, January through March, is shown
below .

Month December January February March

(Rs.) (Rs.) (Rs.) (Rs.)

Inflows :
Sales collection 50,000 55,000 60,000

Outflows :
Purchases 22,000 20,000 22,000 25,000
Payment to sundry creditors 22,000 20,000 22,000
Rent 5,000 5,000 5,000
Drawings 5,000 5,000 5,000
Salaries & other expenses 15,000 18,000 20,000
Purchase of furniture - 25,000 -

Total outflows(2to6) 47,000 73,000 52,000

Given an opening cash balance of Rs.5000 and a target cash balance of Rs.8000, the
surplus/deficit in relation to the target cash balance is worked out below :

January February March

(Rs.) (Rs.) (Rs.)

1. Opening balance 5,000

2. Inflows 50,000 55,000 60,000
3. Outflows 47,000 73,000 52,000
4. Net cash flow (2 - 3) 3,000 (18,000) 8,000
5. Cumulative net cash flow 3,000 (15,000) (7,000)
6. Opening balance + Cumulative
net cash flow 8,000 (10,000) (2,000)
7. Minimum cash balance required 8,000 8,000 8,000
8. Surplus/(Deficit) - (18,000) (10,000)
 24.2 The balances in the books of Datta co and the books of the bank are shown below:

(Rs.)
1 2 3 4 5 6 7 8 9 10
Books of
Datta
Co:

30,000 46,000 62,000 78,000 94,000 1,10,000 1,26,000 1,42,000 1,58,000 1,74,000
Opening
Balance
Add: 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Cheque
received
Less: 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000
Cheque
issued
46,000 62,000 78,000 94,000 1,10,000 1,26,000 1,42,000 1,58,000 1,74,000 1,90,000
Closing
Balance

Books of
the
Bank:

30,000 30,000 30,000 30,000 30,000 30,000 50,000 70,000 90,000 1,06,000
Opening
Balance
Add: - - - - - 20,000 20,000 20,000 20,000 20,000
Cheques
realised
Less: - - - - - - - - 4,000 4,000
Cheques
debited
30,000 30,000 30,000 30,000 30,000 50,000 70,000 90,000 1,06,000 1,22,000
Closing
Balance

From day 9 we find that the balance as per the bank’s books is less than the balance as per Datta
Company’s books by a constant sum of Rs.68,000. Hence in the steady situation Datta Company has
a negative net float of Rs.68,000.
24.3. Optimal conversion size is
2bT
C =
I
b = Rs.1200, T= Rs.2,500,000, I = 5% (10% dividend by two)

So,
2 x 1200 x 2,500,000
C = = Rs.346,410
0.05

24.4.
3 b2
RP = 3 + LL
4I

UL = 3 RP – 2 LL

I = 0.12/360 = .00033, b = Rs.1,500,  = Rs.6,000, LL = Rs.100,000

3 x 1500 x 6,000 x 6,000

RP = 3 + 100,000
4 x .00033

= 49,695 + 100,000 = Rs.149,695

UL = 3RP – 2LL = 3 x 149,695 – 2 x 100,000

= Rs.249,085

24.5
. Optimal conversion size is
2bT
C =
I
b = Rs.2800, T= Rs.35,000,000, I = 5% (10% dividend by two)
So,
2 x 2800 x 35,000,000
C = = Rs.1,979,899
0.05
24.6

3 3 b2
RP = + LL
4I

UL = 3 RP – 2 LL

I = 0.12/360 = .00033, b = Rs.3,200,  = Rs.22,000, LL = Rs.800,000

3 3 x 3200 x 22,000 x 22,000

RP = + 800,000
4 x .00033

= 152,118 + 800,000 = Rs.952,118

UL = 3RP – 2LL = 3 x 952,118 – 2 x 800,000

= Rs.1,256,354

MINICASE

Forecast of Cash Receipts (Rs. in millions)

November December January February March April May

20X0 20X0 20X1 20X1 20X1 20X1 20X1

Sales 30.00 40.00 40.00 45.00 50.00 50.00 55.00

Credit sales-with 12.00 16.00 16.00 18.00 20.00 20.00 22.00
discount
Credit sales-without 18.00 24.00 24.00 27.00 30.00 30.00 33.00
discount
Collection of
receivables
(a) of same month 8.23 11.20 11.20 12.60 14.00 14.00 15.40
(b) of previous 18.53 24.70 24.70 27.79 30.88 30.88
month
( c) of earlier months 2.40 3.20 3.20 3.60 4.00
Total receipts 38.30 40.50 44.99 48.48 50.28
 Forecast of Cash Payments (Rs. in millions)
November December January February March April May
20X0 20X0 20X1 20X1 20X1 20X1 20X1
Cost of materials 16.00 18.00 20.00 20.00 22.00 20.00 18.00
Other vaiable costs 4.00 4.50 5.00 5.00 5.50 5.00 4.50
Payment for
purchases
(a) in the next month 8.00 9.00 10.00 10.00 11.00 10.00
(b) in the following 8.00 9.00 10.00 10.00 11.00
month
Payment for variable 4.00 4.50 5.00 5.00 5.50 5.00 4.50
production costs
Factory overheads 1.00 1.00 1.00 1.00 1.00
Selling & adm, 2.00 2.00 2.00 2.00 2.00
expenses
Interest 9.00
Acquisition of 30.00
machinery
Dividend
Total payments 25.00 27.00 37.50 59.00 28.50

Summary of Cash Payments (Rs. in millions)

January February March April May
20X1 20X1 20X1 20X1 20X1 June 20X1
Opening balance 12.00
Receipts 38.30 40.50 44.99 48.48 50.28 51.97
Payments 25.00 27.00 37.50 59.00 28.50 50.00
Net cash flow (2-3) 13.30 13.50 7.49 -10.52 21.78 1.97
Cumulative net cash 13.30 26.81 34.30 23.78 45.56 47.53
flow
Opening balance + 25.30 38.81 46.30 35.78 57.56 59.53
cumulative net cash
flow
Minimum cash 12.00 12.00 12.00 12.00 12.00 12.00
balance required
Surplus / (Deficit) 13.30 26.81 34.30 23.78 45.56 47.53
 Chapter 25
CREDIT MANAGEMENT

25.1 Δ RI = [ΔS(1-V)- ΔSbn](1-t)- k ΔI

ΔS
ΔI = x ACP x V
360
Δ S = Rs.10 million, V=0.85, bn =0.08, ACP= 60 days, k=0.15, t = 0.40

Hence, ΔRI = [ 10,000,000(1-0.85)- 10,000,000 x 0.08 ] (1-0.4)

-0.15 x 10,000,000 x 60 x 0.85

360
= Rs. 207,500

25.2. Δ RI = [ΔS(1-V)- ΔSbn] (1-t) – k Δ I

So ΔS
Δ I = (ACPN – ACPo) +V(ACPN)
360 360

ΔS=Rs.1.5 million, V=0.80, bn=0.05, t=0.45, k=0.15, ACPN=60, ACPo=45, So=Rs.15

million
Hence ΔRI = [1,500,000(1-0.8) – 1,500,000 x 0.05] (1-.45)

-0.15 (60-45) 15,000,000 + 0.8 x 60 x 1,500,000

360 360
= 123750 – 123750 = Rs. 0

25.3. Δ RI = [ΔS(1-V) –Δ DIS ] (1-t) + k Δ I

Δ DIS = pn(So+ΔS)dn – poSodo

So ΔS
ΔI = (ACPo-ACPN) - x ACPN x V
360 360

So =Rs.12 million, ACPo=24, V=0.80, t= 0.50, r=0.15, po=0.3, pn=0.7,

ACPN=16, ΔS=Rs.1.2 million, do=.01, dn= .02
Hence
ΔRI = [ 1,200,000(1-0.80)-{0.7(12,000,000+1,200,000).02-
0.3(12,000,000).01}](1-0.5)
 12,000,000 1,200,000
+ 0.15 (24-16) - x 16 x 0.80
360 360

= Rs.79,200

25.4 Δ RI = [ΔS(1-V)- ΔBD](1-t) –kΔ I

ΔBD=bn(So+ΔS) –boSo

So ΔS
ΔI = (ACPN –ACPo) + x ACPN x V
360 360

So=Rs.50 million, ACPo=25, V=0.75, k=0.15, bo=0.04, ΔS=Rs.6 million,

ACPN=40 , bn= 0.06 , t = 0.3

ΔRI = [ Rs.6,000,000(1-.75) –{.06(Rs.56,000,000)-.04(Rs.50,000,000)](1-0.3)

Rs.50,000,000 Rs.6,000,000
- 0.15 (40-25) + x 40 x 0.75
360 360

= - Rs.289,495

25.5 30% of sales will be collected on the 10th day

70% of sales will be collected on the 50th day
ACP = 0.3 x 10 + 0.7 x 50 = 38 days

Rs.40,000,000
Value of receivables = x 38
360

= Rs.4,222,222
Assuming that V is the proportion of variable costs to sales, the investment in
receivables is :
Rs.4,222,222 x V

25.6 30% of sales are collected on the 5th day and 70% of sales are collected on the
25th day. So,
(a) ACP = 0.3 x 5 + 0.7 x 25 = 19 days
 Rs.10,000,000
Value of receivables = x 19
360

= Rs.527,778
(b) Investment in receivables = 0.7 x 527,778
= Rs.395,833

25.7 Since the change in credit terms increases the investment in receivables,
ΔRI = [ΔS(1-V)- ΔDIS](1-t) + kΔI
So=Rs.50 million, ΔS=Rs.10 million, do=0.02, po=0.70, dn=0.03,pn=0.60,
ACPo=20 days, ACPN=24 days, V=0.85, k=0.12 , and t = 0.40
ΔDIS = 0.60 x 60 x 0.03 – 0.70 x 50 x 0.2
= Rs.0.38 million

50 10
ΔI= (20-24) - x 24 x 0.85
360 360

= -Rs.1.1222 million
Δ RI = [ 10,000,000 (1-.85) – 380,000 ] (1-.4) - 0.12 x 1,122,222
= Rs. 537,333

25.8. The decision tree for granting credit is as follows :

Customer pays(0.95)
Grant credit Profit 1500
Customer pays(0.85)
Grant credit Customer defaults(0.05)
Profit 1500 Refuse credit
Loss 8500
Customer defaults(0.15)
Loss 8500
Refuse credit

The expected profit from granting credit, ignoring the time value of money, is :

Expected profit on + Probability of payment x Expected profit on

Initial order and repeat order repeat order

{ 0.85(1500)-0.15(8500)} + 0.85 {0.95(1500)-.05(8500)}

= 0 + 850 = Rs.850
25.9 Profit when the customer pays = Rs.10,000 - Rs.8,000 = Rs.2000
Loss when the customer does not pay = Rs.8000
Expected profit = p1 x 2000 –(1-p1)8000
Setting expected profit equal to zero and solving for p1 gives :
p1 x 2000 – (1- p1)8000 = 0 p1 = 0.80
Hence the minimum probability that the customer must pay is 0.80

MINICASE I
Solution:

Present Data
 Sales : Rs.800 million
 Credit period : 30 days to those deemed eligible
 Cash discount : 1/10, net 30
 Proportion of credit sales and cash sales are 0.7 and 0.3. 50 percent of the credit customers
avail of cash discount
 Contribution margin ratio : 0.20
 Tax rate : 30 percent
 Post-tax cost of capital : 12 percent
 ACP on credit sales : 20 days

Effect of Relaxing the Credit Standards on Residual Income

Incremental sales : Rs.50 million

Bad debt losses on incremental sales: 12 percent
ACP remains unchanged at 20 days

∆RI = [∆S(1 – V) - ∆Sbn] (1 – t) – R ∆ I

∆S
where ∆ I = x ACP x V
360

∆ RI = [50,000,000 (1-0.8) – 50,000,000 x 0.12] (1 – 0.3)

50,000,000
- 0.12 x x 20 x 0.8
360

= 2,800,000 – 266,667 = 2,533,333

Effect of Extending the Credit Period on Residual Income

∆ RI = [∆S(1 – V) - ∆Sbn] (1 – t) – R ∆ I

So ∆S
where ∆I = (ACPn – ACPo) + V (ACPn)
360 360

∆RI = [50,000,000 (1 – 0.8) – 50,000,000 x 0] (1 – 0.3)

800,000,000 50,000,000
- 0.12 (50 – 20) x + 0.8 x 50 x
360 360

= 7,000,000 – 8,666,667
= - Rs.1,666,667

Effect of Relaxing the Cash Discount Policy on Residual Income

∆RI = [∆S (1 – V) - ∆ DIS] (1 – t) + R ∆ I

where ∆ I = savings in receivables investment
So ∆S
= (ACPo – ACPn) – V x ACP n
360 360

800,000,000 20,000,000
= (20 – 16) – 0.8 x x 16
360 360

= 8,888,889 – 711,111 = 8,177,778

∆ DIS = increase in discount cost

= pn (So + ∆S) dn – po So do
= 0.7 (800,000,000 + 20,000,000) x 0.02 – 0.5 x 800,000,000 x 0.01
= 11,480,000 – 4,000,000 = 7,480,000

So, ∆RI = [20,000,000 (1 – 0.8) – 7,480,000] (1 – 0.3) + 0.12 x 8,177,778

= - 2,436,000 + 981,333
= - 1,454,667

MINICASE II

Average collection period under the new policy = 0.70 x10 + 0.3 x 20 = 13 days
 Old policy New policy
Sales 12,000,000 15,600,000
Variable cost(40%) 4,800,000 6,240,000
Contribution 7,200,000 9,360,000
Bad debts 360,000 156,000
Discount on online payment 187,200
Discount on cheque payment 15,600
Cashier salary 180,000 300,000
Collection staff salary 120,000
Investment in receivables
(Sales/365)x ACP x 0.40 394,521 222,247

Increase in contribution net of bad debts = (9,360,000 – 156,000) – (7,200,000 – 360,000)

= Rs.2,364,000
Reduction in investment in receivables = 394,521– 222,247 = Rs.172,274
Savings in investment in receivables = 172,274 x 0.30 = Rs. 51,682
Net additional costs = discounts + increase in cashier salary
- collection staff salary
= 187,200 + 15,600 + 120,000 – 120,000
= Rs.202,800
Increase in residual profit = 2,364,000 x 0.7 + 51,682 - 202,800 = Rs.1,503,682

Chapter 26
INVENTORY MANAGEMENT

26.1.
a. No. of Order Ordering Cost Carrying Cost Total Cost
Orders Per Quantity (U/Q x F) Q/2xPxC of Ordering
Year (Q) (where and Carrying
(U/Q) PxC=Rs.30)
Units Rs. Rs. Rs.

1 250 200 3,750 3,950

2 125 400 1,875 2,275
5 50 1,000 750 1,750
10 25 2,000 375 2,375
 2 UF 2x250x200
b. Economic Order Quantity (EOQ) = =
PC 30
2UF = 58 units (approx)
26.2. a EOQ =
PC
U=10,000 , F=Rs.300, PC= Rs.25 x 0.25 =Rs.6.25

2 x 10,000 x 300
EOQ = = 980
6.25
10000
b. Number of orders that will be placed is = 10.20
980
Note that though fractional orders cannot be placed, the number of orders
relevant for the year will be 10.2 . In practice 11 orders will be placed during the year.
However, the 11th order will serve partly(to the extent of 20 percent) the present year and
partly(to the extent of 80 per cent) the following year. So only 20 per cent of the ordering cost
of the 11th order relates to the present year. Hence the ordering cost for the present year will be
10.2 x Rs.300

c.
Here it is assumed that what was intended in the question was to calculate the total cost if the order
is of EOQ
Total cost of carrying and ordering inventories
980
= [ 10.2 x 300 + x 6.25 ] = Rs.6122.5
2

26.3 U=6,000, F=Rs.400 , PC =Rs.100 x 0.2 =Rs.20

2 x 6,000 x 400
EOQ = = 490 units
20

U U Q’(P-D)C Q* PC
Δπ = UD + - F- -
Q* Q’ 2 2

6,000 6,000
= 6000 x 5 + - x 400
 490 1,000

1,000 (95)0.2 490 x 100 x 0.2

- -
2 2

= 30,000 + 2498 – 4600 = Rs.27898

As the change in profit is positive, it should seek quantity discount

26.4 U=5000 , F= Rs.300 , PC= Rs.30 x 0.2 = Rs.6

2 x 5000 x 300
EOQ = = 707 units
6
If 1000 units are ordered the discount is : .05 x Rs.30 = Rs.1.5 Change in
profit when 1,000 units are ordered is :

5,000 5,000
Δπ = 5000 x 1.5 + - x 300
707 1,000

1000 x 28.5 x 0.2 707 x 30 x 0.2

- - = 7500 + 622-729 =Rs.7393
2 2

If 2000 units are ordered the discount is : .10 x Rs.30 = Rs.3 Change in profit
when 2,000 units are ordered is :

5000 5000 2000x27x0.2 707x30x0.2

Δπ = 5000 x 3.0 + - x 300- -
707 2000 2 2

= 15,000 +1372 – 3279 = Rs.13,093

As the change in profit is more when the order quantity is 2000, it should go for that discount
offer.

26.5 The quantities required for different combinations of daily usage rate(DUR) and lead
times(LT) along with their probabilities are given in the following table
 LT
(Days)
DUR 5(0.6) 10(0.2) 15(0.2)
(Units)

4(0.3) 20*(0.18) 40(0.06) 60(0.06)

6(0.5) 30 (0.30) 60(0.10) 90(0.10)
8(0.2) 40 (0.12) 80(0.04) 120(0.04)
*
Note that if the DUR is 4 units with a probability of 0.3 and the LT is 5 days with
a probability of 0.6, the requirement for the combination DUR = 4 units and LT =
5 days is 20 units with a probability of 0.3x0.6 = 0.18. We have assumed that the
probability distributions of DUR and LT are independent. All other entries in the
table are derived similarly.
The normal (expected) consumption during the lead time is :
20x0.18 + 30x0.30 + 40x0.12 + 40x0.06 + 60x0.10 + 80x0.04 + 60x0.06 + 90x0.10
+ 120x0.04 = 46.4 tonnes
a. Costs associated with various levels of safety stock are given below :

Safety Stock Stock out Probability Expected Carrying Total Cost

Stock* outs(in Cost Stock out Cost
tonnes)

1 2 3 4 5 6 7
[3x4] [(1)x1,000] [5+6]

Tonnes Rs. Rs. Rs.

73.6 0 0 0 0 73,600 73,600
43.6 30 120,000 0.04 4,800 43,600 48,400

33.6 10 40,000 0.10

40 160,000 0.04 10,400 33,600 44,000

13.6 20 80,000 0.04

30 120,000 0.10 24,800 13,600 38,400
60 240,000 0.04

0 13.6 54,400 0.16

33.6 134,400 0.04 43,296 0 43,296
43.6 174,400 0.10
73.6 294,400 0.04

Safety stock = Maximum consumption during lead time – Normal

*

consumption during lead time

So the optimal safety stock= 13.6 tonnes
Reorder level = Normal consumption during lead time + safety stock
K= 46.4 + 13.6 = 60 tonnes

b. Probability of stock out at the optimal level of safety stock = Probability

(consumption being 80 or 90 or 120 tonnes)

Probability (consumption = 80 tonnes) + Probability (consumption = 90 tonnes) +

Probability (consumption = 120 tonnes)
= 0.04 +0.10+0.04 = 0.18
26.6.

Item Annual Usage Price per Annual Ranking

(in Units) Unit Usage Value
Rs. Rs.

1 400 20.00 8,000 6

2 15 150.00 2,250 10
3 6,000 2.00 12,000 5
4 750 18.00 13,500 4
5 1,200 25.00 30,000 1
6 25 160.00 4,000 9
7 300 2.00 600 14
8 450 1.00 450 15
9 1,500 4.00 6,000 7
10 1,300 20.00 26,000 2
11 900 2.00 1,800 11
12 1,600 15.00 24,000 3
13 600 7.50 4,500 8
14 30 40.00 1,200 12
15 45 20.00 900 13

1,35,200

Cumulative Value of Items & Usage

Item Rank Annual Cumulative Cumulative Cumulative
No. UsageValue Annual Usage % of Usage % of Items
(Rs.) Value (Rs.) Value

5 1 30,000 30,000 22.2 6.7

10 2 26,000 56,000 41.4 13.3
12 3 24,000 80,000 59.2 20.0
4 4 13,500 93,500 69.2 26.7
3 5 12,000 105,500 78.0 33.3
1 6 8,000 113,500 83.9 40.0
9 7 6,000 119,500 88.4 46.7
13 8 4,500 124,000 91.7 53.3
6 9 4,000 128,000 94.7 60.0
2 10 2,250 130,250 96.3 66.7
11 11 1,800 132,050 97.7 73.3
14 12 1,200 133,250 98.6 80.0
15 13 900 134,150 99.2 86.7
7 14 600 134,750 99.7 93.3
8 15 450 135,200 100.0 100.0

Class No. of Items % to the Total Annual Usage % to Total Value

Value Rs.

A 4 26.7 93,500 69.2

B 3 20.0 26,000 19.2
C 8 53.3 15,700 11.6

15 135,200
 MINICASE
(a) The normal usage is:
[Average daily usage] [Average lead time in days]
[4(0.3) + 5(0.5) + 6(0.2)] [15(0.4) + 20(0.3) + 28(0.3)]
= 100 tons

The possible levels of usage which are higher than 100 tonnes are underlined in the third column of the
following table. The safety stock required to meet these levels of usage is shown in the last column of the
following table.
The possible levels of usage are shown below:

Daily usage rate ( Lead time in days Possible levels of usage ( Safety
tonnes) tonnes) stock(tonnes)
15 60
4 20 80
28 112
15 75
5 20 100
28 140 40
15 90
6 20 120 20
28 168 68

(b)
The stockout cost, carrying cost, and total cost for different levels of safety stock are shown below:

Safety Stockout Stockout Probability Expected Carrying Total

stock cost (Rs.) stockout cost cost
(tonnes) cost
68 0 0 0 0 Rs.204,000 Rs.204,000
40 28 Rs.168,000 0.06 Rs.10,080 120,000 130,080
20 48 Rs.288,000 0.06 Rs.17,280 60,000 95,280
20 Rs.120,000 0.15 Rs.18,000

35,280
0 68 Rs.408,000 0.06 24,480 0 67,680
40 Rs.240,000 0.15 36,000
20 Rs.120,000 0.06 7,200

67,280

The optimal level of safety stock is 0 tonnes because at that level the cost is minimised.
The probability of stockout when there is no safety stock is: (0.06 + 0.15+0.06) = 0.27

So, in hindsight, I was right in not holding any safety stocks last year, though my reasons for doing so were
quite different.
(c)
Annual usage (U) = 1,300 tonnes
Fixed cost per order (F) = Rs.30,000
Price pre unit (P) = Purchase price per unit = Rs.80,000

Carrying cost per unit Rs.3,000

Percent carrying cost (C) = = = 0.0375
Price per unit Rs.80,000

2FU 2 x 30,000 x 1,300

EOQ = = = 162 tonnes
PC 80,000 x 0.0375

Average inventory = EOQ + safety stock = 162 +0 = 162 tonnes.

 Chapter 27
WORKING CAPITAL FINANCING

27.1. Annual interest cost is given by ,

Discount % 360
x
1- Discount % Credit period – Discount period

Therefore, the annual per cent interest cost for the given credit terms will be as
follows:

a. 0.01 360
x = 0.182 = 18.2%
0.99 20

b. 0.02 360
x = 0.367 = 36.7%
0.98 20

c. 0.03 360
x = 0.318 = 31.8%
0.97 35

d. 0.01 360
x = 0.364 = 36.4%
0.99 10

27.2.
a.
0.01 360
x = 0.104 = 10.4%
0.99 35

b. 0.02 360
x = 0.21 = 21%
0.98 35

c. 0.03 360
x = 0.223 = 22.3%
0.97 50
 d. 0.01 360
x = 0.145 = 14.5%
0.99 25
27.3 The maximum permissible bank finance under the three methods suggested by
The Tandon Committee are :

Method 1 : 0.75(CA-CL) = 0.75(36-12) = Rs.18 million

Method 2 : 0.75(CA)-CL = 0.75(36)-12 = Rs.15 million
Method 3 : 0.75(CA-CCA)-CL = 0.75(36-18)-12 = Rs.1.5 million

MINICASE
1)
Raw materials and stores consumed = 180
Cost of production = Cost of goods sold +
Opening stock of work-in-process – Closing stock of work-in-process
= 380 + 10 – 20 = 370
Cost of sales = Cost of production + Opening stock of finished goods – Closing stock of finished
goods
= 370 + 60 – 50 = 380
Holding level of raw material and stores and spares(months consumption)
=( 60 x 12) / 180 = 4 months
Holding level of work-in-process ( months cost of production)
= ( 20 x 12) / 370 = 0.6 months
Holding level of finished goods(months cost of sales)
= (50 x 12)/ 380 = 1.6 months
Holding level of receivables = 240 x 12/700 = 4.1 months
Level of credit taken = 130 x 12/190 = 8.2 months.
[raw material and stores consumed = Opening stock of raw materials and stores + Purchases –
closing stock of raw material and stores]
So, purchases = 180-50 + 60 = 190]

2)

RM --- 180 x 3/12 = 45

WIP – 370 x 0.5/12 = 15.4
FG – 380 x 2/12 = 63.3
Debtors – 700 x3/12 = 175
OCA = 0.03 x 298.7 = 9.0

Total current assets = 307.7

Less trade credit available = 130
Working capital gap = 177.7
Less: 25% of the current assets from
own sources = 76.9
MPBF = 100.8
3)
As the borrower is already enjoying a working capital limit of Rs.140 lacs, there is no question of
sanctioning any enhancement, as per the norms already set by the bank.

It may be pointed out to the borrower that his working capital has been tied up in maintaining
stocks and receivables much in excess of the industry norms and he has to make rigorous efforts to
reduce the storage level and tighten the collection mechanism. Also he should bring the working
capital borrowing to within the permissible level of Rs.101 lacs immediately by reducing the
dividend payout suitably . .
 Chapter 28
WORKING CAPITAL MANAGEMENT: EXTENSIONS

28.1.(a) The discriminant function is :

Zi = aXi + bYi
where Zi = discriminant score for the ith account
Xi = quick ratio for the ith account
Yi = EBDIT/Sales ratio for the ith account

The estimates of a and b are :

y2. dx -  xy . dy
a =
x 2. y 2 - xy . xy

x 2. dy  xy . dx
b =
x 2 y 2 xy xy

The basic calculations for deriving the estimates of a and b are given
the accompanying table.

Drawing on the information in the accompanying table we find that

Xi = 19.81 Yi= 391 (Xi-X)2 Yi-Y)2 Xi-X)(Yi-Y)

X = 0.7924 Y = 15.64 = 0.8311 =1661.76 = 10.007

 Account Xi Yi (Xi-X) (Yi-Y) (Xi-X)2 (Yi-Y)2 (Xi-X)(Yi-Y)
Number

1 0.90 15 0.1076 -0.64 0.0116 0.4096 -0.0689

2 0.75 20 -0.0424 4.36 0.0018 19.0096 -0.1849
3 1.05 10 -0.2576 -5.64 0.0664 31.8096 -1.4529
4 0.85 14 0.0576 -1.64 0.0033 2.6896 -0.0945
G 5 0.65 16 -0.1424 0.36 0.0203 0.1296 -0.513
R 6 1.20 20 0.4076 4.36 0.1661 19.0096 1.7771
O 7 0.90 24 0.1076 8.36 0.0116 69.8896 0.8995
U 8 0.84 26 0.0476 10.36 0.0023 107.3296 0.4931
P 9 0.93 11 0.1376 -4.64 0.0189 21.5296 -0.6385
10 0.78 18 -0.0124 2.36 0.0002 5.5696 -0.0293
I 11 0.96 12 0.1676 -3.64 0.0281 13.2496 -0.6101
12 1.02 25 0.2276 9.36 0.0518 87.6096 2.1303
13 0.81 26 0.0176 10.36 0.0003 107.3296 0.1823
14 0.76 30 -0.0324 14.36 0.0010 206.2096 -0.4653
15 1.02 28 0.2276 12.36 0.0518 152.7696 2.8131

16 0.76 10 -0.0324 -5.64 0.0010 31.8069 0.1827

17 0.68 12 -0.1124 -3.64 0.0126 13.2496 0.4091
G 18 0.56 4 -0.2324 -11.64 0.0540 135.4896 2.7051
R 19 0.62 18 -0.1724 2.36 0.0297 5.5696 -0.4069
O 20 0.92 -4 0.1276 -19.64 0.0163 385.7296 -2.5061
U 21 0.58 20 -0.2124 4.36 0.0451 19.0096 -0.9261
P 22 0.70 8 -0.0924 - 7.64 0.0085 58.3696 0.7059
23 0.52 15 –0.2724 -0.64 0.0742 0.4096 0.1743
II 24 0.45 6 –0.3424 -9.64 0.1172 92.9296 3.3007
25 0.60 7 –0.1924 -8.64 0.0370 74.6496 1.6623

19.81 391 0.8311 1661.76 9.539

Sum of Xi for group 1 13.42

X1 = = = 0.8947
15 15

Sum of Xi for group 2 6.39

X2 = = = 0.6390
10 10
 Sum of Yi for group 1 295
Y1 = = = 19.67
15 15

Sum of Yi for group 2 96

Y2 = = = 9.60
10 10

1 0.8311
x 2 = Xi –X)2 = = 0.0346
n-1 25-1

1 1661.76
y =
2
Yi – Y) =
2
= 69.24
n-1 25-1

1 10.0007
xy = Xi-X)(Yi-Y) = = 0.4167
n-1 25-1

dx = X1 - X2 = 0.8947 – 0.6390 = 0.2557

dy = Y1 – Y2 = 19.67 – 9.60 = 10.07

Substituting these values in the equations for a and b we get :

69.24 x 0.2557 – 0.4167 x 10.07

a = = 6.079
0.0346 x 69.24 – 0.4167 x 0.4167

0.0346 x 10.07 – 0.4167 x 0.2557

b= = 0.1089
0.0346 x 69.24 – 0.4167 x 0.4167

Hence , the discriminant function is :

Zi = 6.079 Xi + 0.1089 Yi

(b) Choice of the cutoff point

The Zi score for various accounts are shown below
 Zi scores for various accounts

Account No. Zi Score

1 7.1046
2 6.7373
3 7.4720
4 6.6918
5 5.6938
6 9.4728
7 8.0847
8 7.9378
9 6.8514
10 6.7018
11 7.1426
12 8.9231
13 7.7554
14 7.8870
15 9.2498
16 5.7090
17 5.4405
18 3.8398
19 5.7292
20 5.1571
21 5.7038
22 5.1265
23 4.7946
24 3.3890
25 4.4097

The Zi scores arranged in an ascending order are shown below

 Good(G)
Account Number Zi Score or
Bad (B)

24 3.3890 B
18 3.8398 B
25 4.4097 B
23 4.7946 B
22 5.1265 B
20 5.1571 B
17 5.4405 B
5 5.6938 G
21 5.7038 B
16 5.7090 B
19 5.7292 B
4 6.6918 G
10 6.7018 G
2 6.7373 G
9 6.8514 G
1 7.1046 G
11 7.1426 G
3 7.4720 G
13 7.7554 G
14 7.8870 G
8 7.9378 G
7 8.0847 G
12 8.9231 G
15 9.2498 G
6 9.4728 G

From the above table, it is evident that a Zi score which represents the mid-point between
the Zi scores of account numbers 19 and 4 results in the minimum number of misclassifications .
This Zi score is :

5.7292 + 6.6918
= 6.2105
2
Given this cut-off Zi score, there is just one misclassification (Account number 5)
 CA
28.2 WCL =
(CA + NFA)– 0.2 CA

Dividing both the numerator and denominator by CA, we get

1
=1
1 +( NFA/CA) -0.2

0.8 +NFA/CA = 1 or NFA/CA =0.2

28.3
Account ROE(%)
Number Xi DER Yi (X i -X) (Y i -Y) (X i -X )2 (Y i -Y )2 (X i -X)(Y i -Y)
G 1 20 0.5 11.3125 -0.6250 127.9727 0.3906 -7.0703
O 2 18 0.6 9.3125 -0.5250 86.7227 0.2756 -4.8891
O 3 24 0.8 15.3125 -0.3250 234.4727 0.1056 -4.9766
D 4 15 0.9 6.3125 -0.2250 39.8477 0.0506 -1.4203
A 5 12 0.8 3.3125 -0.3250 10.9727 0.1056 -1.0766
C 6 9 0.5 0.3125 -0.6250 0.0977 0.3906 -0.1953
C 7 19 1 10.3125 -0.1250 106.3477 0.0156 -1.2891
T 8 16 1.2 7.3125 0.0750 53.4727 0.0056 0.5484
B 9 -6 2 -14.6875 0.8750 215.7227 0.7656 -12.8516
A 10 4 1.5 -4.6875 0.3750 21.9727 0.1406 -1.7578
D 11 2 0.9 -6.6875 -0.2250 44.7227 0.0506 1.5047
A 12 -5 1.8 -13.6875 0.6750 187.3477 0.4556 -9.2391
C 13 11 1.6 2.3125 0.4750 5.3477 0.2256 1.0984
C 14 7 0.8 -1.6875 -0.3250 2.8477 0.1056 0.5484
T 15 3 1.2 -5.6875 0.0750 32.3477 0.0056 -0.4266
16 -10 1.9 -18.6875 0.7750 349.2227 0.6006 -14.4828

From the above table we get the following

Xi = 139 Yi= 18 (Xi-X)2 Yi-Y)2 Xi-X)(Yi-Y)

X = 8.6875 Y = 1.125 = 1519.438 = 3.69 = -55.975

Sum of Xi for Good Accts. 133
X1 = = = 16.625
8 8

Sum of Xi for Bad Accts. 6

X2 = = = 0.75
8 8

Sum of Yi for Good Accts. 6.3

Y1 = = = 0.7875
8 8

Sum of Yi for Bad Accts. 11.7

Y2 = = = 1.4625
8 8
1 1519.438
x 2 = Xi –X)2 = = 101.30
n-1 16-1
 1 3.69
y =
2
Yi – Y) =
2
= 0.246
n-1 16-1

1 -55.975
xy = Xi-X)(Yi-Y) = = - 3.73
n-1 16 -1

dx = X1 - X2 = 16.625 – 0.75 = 15.875

dy = Y1 – Y2 = 0.7875 – 1.4625 = - 0.675

Substituting these values in the equations for a and b we get :

0.246 x 15.875 - 3.73 x 0.675

a = = 0.1261
101.30 x 0.246 – 3.73 x 3.73

-101.30 x 0.675 + 3.73 x 15.875

b= = - 0.8325
101.30 x 0.246 – 3.73 x 3.73
Hence , the discriminant function is :
Zi = 0.1261 Xi - 0.8325 Yi

Chapter 29
Debt Analysis and Management
29.1 (i) Initial Outlay
(a) Cost of calling the old bonds
Face value of the old bonds 250,000,000
Call premium 15,000,000
265,000,000
(b) Net proceeds of the new bonds
Gross proceeds 250,000,000
Issue costs 10,000,000

240,000,000
(c) Tax savings on tax-deductible expenses
Tax rate[Call premium+Unamortised issue cost on
the old bonds] 9,200,000
0.4 [ 15,000,000 + 8,000,000]
 Initial outlay i(a) – i(b) – i(c) 15,800,000

(ii) Annual Net Cash Savings

(a) Annual net cash outflow on old bonds
Interest expense 42,500,000
- Tax savings on interest expense and amortisation of
issue expenses 17,400,000
0.4 [42,500,000 + 8,000,000/10]
25,100,000
(b) Annual net cash outflow on new bonds
Interest expense 37,500,000
- Tax savings on interest expense and amortisation of
issue cost 15,500,000
0.4 [ 37,500,000 – 10,000,000/8]
22,000,000
Annual net cash savings : ii(a) – ii(b) 3,100,000

(iii) Present Value of the Annual Cash Savings

Present value of an 8-year annuity of 3,100,000 at a
discount rate of 9 per cent which is the post –tax cost
of new bonds 3,100,000 x 5.535 17,158,500

(iv) Net Present Value of Refunding the Bonds

(a) Present value of annual cash savings 17,158,500
(b) Net initial outlay 15,800,000
(c) Net present value of refunding the bonds :
iv(a) – iv(b). 1,358,500
29.2.
Here it is assumed that the call premium is 4 percent, the issue cost of the new bonds is Rs.2.4
million and the unamortised issue costs on the old bond is Rs.3 million
(i) Initial Outlay
(a) Cost of calling the old bonds
Face value of the old bonds 120,000,000
Call premium 4,800,000

124,800,000
(b) Net proceeds of the new issue
Gross proceeds 120,000,000
Issue costs 2,400,000

117,600,000
(c) Tax savings on tax-deductible expenses 3,120,000
Tax rate[Call premium+Unamortised issue costs on
the old bond issue]
 0.4 [ 4,800,000 + 3,000,000]
Initial outlay i(a) – i(b) – i(c) 4,080,000

(ii) Annual Net Cash Savings

(a) Annual net cash out flow on old bonds
Interest expense 19,200,000
- Tax savings on interest expense and amortisation of
issue costs 7,920,000
0.4[19,200,000 + 3,000,000/5]
11,280,000

(b) Annual net cash outflow on new bonds

Interest expense 18,000,000
- Tax savings on interest expense and amortistion of issue
costs 7,392,000
0.4[18,000,000 + 2,400,000/5]
10,608,000
Annual net cash savings : ii(a) – ii(b) 672,000

(iii) Present Value of the Annual Net Cash Savings

Present value of a 5 year annuity of 672,000 at
as discount rate of 9 per cent, which is the post-tax 2,614,080
cost of new bonds

(iv) Net Present Value of Refunding the Bonds

(a) Present value of annual net cash savings 2,614,080
(b) Initial outlay 4,080,000
(c) Net present value of refunding the bonds : - 1,466,000
iv(a) – iv(b)
As the NPV of refunding the bond is negative the company should not refund the debt.

29.3. Yield to maturity of bond P

8 160 1000
920 =  +
t=1 (1+r)t (1+r)8

r or yield to maturity is 17.96 percent

Yield to maturity of bond Q

5 120 1000
800 =  +
t
t=1 (1+r) (1+r)5
 r or yield to maturity is 18.46 per cent

Duration of bond P is calculated below

Present Proportion
Cash value of Proportion of of bond's
Year
flow cash flow bond's value value x
@17.96% time
1 160 135.64 0.147 0.147
2 160 114.99 0.125 0.250
3 160 97.48 0.106 0.318
4 160 82.64 0.090 0.360
5 160 70.06 0.076 0.380
6 160 59.39 0.065 0.390
7 160 50.35 0.055 0.385
8 1,160 309.44 0.336 2.688
Duration of the bond sum 4.92 years

Duration of bond Q is calculated below

Present Proportion
Cash value of Proportion of of bond's
Year
flow cash flow bond's value value x
@18.46% time
1 120 101.30 0.13 0.13
2 120 85.51 0.11 0.21
3 120 72.19 0.09 0.27
4 120 60.94 0.08 0.30
5 1,120 480.13 0.60 3.00
 Duration of the bond sum 3.92 years

Volatility of bond P Volatility of bond Q

4.92 3.92
= 4.17 = 3.31
1.1796 1.1846
29.4
Forward rate for year 1 = 7.00%
Forward rate for year 2 = (1+0.072)2/(1+0.070)1-1 = 7.40 %
Forward rate for year 3 = (1+0.073)3/(1+0.072)2-1 = 7.50 %
Forward rate for year 4 = (1+0.074)4/(1+0.073)3-1 = 7.70 %
Forward rate for year 5 = (1+0.075)5/(1+0.074)4-1 = 7..90 %

MINICASE

(i) Initial Outlay

(d) Cost of calling the outstanding bonds
Face value of the outstanding bonds 400,000,000
Call premium 20,000,000
420,000,000
(e) Net proceeds of the new bonds
Gross proceeds 400,000,000
Issue costs 12,000,000

388,000,000
(f) Tax savings on tax-deductible expenses
Tax rate[Call premium+Unamortised issue cost on
the existing bonds] 9,600,000
0.32 [ 20,000,000 + 10,000,000]
Initial outlay i(a) – i(b) – i(c) 22,400,000

(v) Annual Net Cash Savings

(c) Annual net cash outflow on outstanding bonds
Interest expense 48,000,000
- Tax savings on interest expense and amortisation of
issue expenses 16,000,000
0.32[48,000,000 + 20,000,000/10]
32,000,000
(d) Annual net cash outflow on new bonds
 Interest expense 36,000,000
- Tax savings on interest expense and amortisation of
issue cost 12,288,000
0.32 [ 36,000,000 + 12,000,000/5]
23,712,000
Annual net cash savings : ii(a) – ii(b) 8,288,000

(vi) Present Value of the Annual Cash Savings

Present value of an 5-year annuity of 8,288,000 at a
discount rate of 6.12 per cent which is the post –tax cost
of new bonds 8,288,000 x 4.199 34,801,312
[ { 1- (1/1.0612)5}/0.0612] =4.199]
(vii) Net Present Value of Refunding the Bonds
(a) Present value of annual cash savings 34,801,312
(b) Net initial outlay 22,400,000
(c) Net present value of refunding the bonds : Rs.12,401,312
iv(a) – iv(b).
 Chapter 30
LEASING, HIRE PURCHASE, AND PROJECT FINANCE

30.1

Post-tax cost of debt 8%

33.333333
Depreciation rate(WDV) %
Marginal rate of tax 30%
Lease contract cash flows
Rs. In
million
Year 0 1 2 3 4 5
Cost of the machine 1.500
0.50 0.33 0.14 0.09
Depreciation 0 3 0.222 8 9
- - - -
0.15 0.10 0.04 0.03
Loss of depreciation tax shield 0 0 -0.067 4 0
- - - -
0.42 0.42 0.42 0.42
Lease payment 0 0 -0.420 0 0
0.12 0.12 0.12 0.12
Tax shield on lease payment 6 6 0.126 6 6
-
0.30
Loss of salvage value 0
- - - -
0.44 0.39 0.63 0.62
Cash flow of lease 1.500 4 4 -0.361 8 4
NAL of lease -0.429
As the net advantage of leasing is negative it is
not worthwhile to go for leasing.

30.2. Under the hire purchase proposal the total interest payment is
2,000,000 x 0.12 x 3 = Rs. 720,000
The interest payment of Rs. 720,000 is allocated over the 3 years period using
the sum of the years digits method as follows:
Year Interest allocation

366
1 x Rs.720,000 = Rs.395,676
666

222
2 x Rs.720,000 = Rs.240,000
666

78
3 x Rs.720,000 = Rs.84,324
666

The annual hire purchase instalments will be :

Rs.2,000,000 + Rs.720,000
= Rs.906,667
3

The annual hire purchase instalments would be split as follows

Year Hire purchase instalment Interest Principal repayment

1 Rs.906,667 Rs.395,676 Rs. 510,991
2 Rs.906,667 Rs.240,000 Rs. 666,667
3 Rs.906,667 Rs. 84,324 Rs. 822,343

The lease rental will be as follows :

Rs. 560,000 per year for the first 5 years
Rs. 20,000 per year for the next 5 years
The cash flows of the leasing and hire purchse options are shown below

Year Leasing Hire Purchase -It(1-tc)-PRt+

- LRt (1-tc) -It(1-tc) -PRt Dt(tc) NSVt Dt(tc)+NSVt

1 -560,000(1-.4)=-336,000 -395,676(1-.4) -510,991 500,000(0.4) -548,397

2 -560,000(1-.4)=-336,000 -240,000(1-.4) -666,667 375,000(0.4) -660,667
3 -560,000(1-.4)=-336,000 - 84,324(1-.4) -822,343 281,250(0.4) -760,437
4 -560,000(1-.4)=-336,000 210,938(0.4) 84,375
5 -560,000(1-.4)=-336,000 158,203(0.4) 63,281
6 - 20,000(1-.4)= - 12,000 118,652(0.4) 47,461
7 - 20,000(1-.4)= - 12,000 88,989(0.4) 35,596
8 - 20,000(1-.4)= - 12,000 66,742(0.4) 26,697
9 - 20,000(1-.4)= - 12,000 50,056(0.4) 20,023
10 - 20,000(1-.4)= - 12,000 37,542(0.4) 200,000 215,017

Present value of the leasing option

5 336,000 10 12,000
= -   = - 1,302,207
t=1 (1.10)t t=6 (1.10) t

Present value of the hire purchase option

548,397 660,667 760,437 84,375

=- - - -
(1.10) (1.10)2 (1.10)3 (1.10)4

63,281 47,461 35,596 26,697

+ + +
(1.10)5 (1.10)6 (1.10)7 (1.10)8

20,023 215,017
+
(1.10)9 (1.10)10

= - 1,369,383

Since the leasing option costs less than the hire purchase option , Apex should choose the
leasing option.
 MINICASE

(a)
Year 1 2 3 4 5 6 7 8 9 10
Principal repayment -6 -6 -6 -6 -6
Interest payment -3.6 -2.88 -2.16 -1.44 -0.72
Depreciation 12 7.20 4.32 2.59 1.56 0.93 0.56 0.34 0.20 0.12
Tax shield on depn. 4.00 2.40 1.44 0.86 0.52 0.31 0.19 0.11 0.07 0.04
Post tax interest
payment -2.4 -1.92 -1.44 -0.96 -0.48
Net salvage value 6
Net cash flow -4.40 -5.52 -6.00 -6.10 -5.96 0.31 0.19 0.11 0.07 6.04
Present value of the cash ‘ borrowing cum buying option’ is
4.40 5.52 6.00 6.10 5.96 0.31 0.19 0.11 0.07 6.04
= - ----- - ------ - ------ - ----- - ----- + ----- + ------ + ------ + ------- + ------
(1.08) (1.08)2 (1.08)3 (1.08)4 (1.08)5 (1.08)6 (1.08)7 (1.08)8 (1.08)9 (1.08)10

= - 4.07 – 4.73 – 4.76 – 4.48 – 4.06 + 0.20 + 0.11 + 0.06 + 0.04 + 2.80
= - 18.89 million

(b)
Present value of lease cash flows =-7(1-0.3333)PVIFA8%, 5years –0.5(1- 0.3333)PVIFA8%, 5years
PVIF8% , 5years

= -7 x 0.6667 x 3.993 – 0.5 x 0.6667 x 3.993 x 0.681 = -

19.54million

(c) Total interest =30,000,000 x 0.08 x 3 = Rs.720,000

Monthly HP instalment = (30,000,000 + 720,000) / 36 = Rs.853,333
Annual instalment = (30,000,000 + 720,000) / 3 = Rs.10,240,000
Proportions for interest allocation:
36 +35+-----------------+ 25 366
I year = =
36 +35+-----------------+ 1 666

24 +23 +-----------------+13 222

II year = =
36 +35+-----------------+ 1 666
 12 +35+-----------------+ 1 78
III year = =
36 +35+-----------------+ 1 666
Interest allocations for the three years:

I year = 720,000 x 366/666 = Rs.395,676

II year = 720,000 x 222/666 = Rs.240,000
IIIyear = 720,000 x 78/666 = Rs .84,324
The cash flows under the HP option:

Year -It(1-Tc) -Pr Dt(Tc) NSV Total CF PVIF PV

1 -263,797 -9,844,324 3,999,600 -6,108,521 0.9259 -5,656,038
2 -160,008 -10,000,000 2,399,760 -7,760,248 0.8573 -6,653,162
3 -56,219 -10,155,676 1,439,856 -8,772,039 0.7938 -6,963,527
4 863,914 863,914 0.7350 635,002
5 518,348 518,348 0.6806 352,779
6 311,009 311,009 0.6302 195,988
7 186,605 186,605 0.5835 108,882
8 111,963 111,963 0.5403 60,490
9 67,178 67,178 0.5002 33,606
10 40,307 6,000,000 6,040,307 0.4632 2,797,831
---
15,088,148
Total=

Present value of the cash flows under the HP option = - Rs.15.09 million
 Chapter 31
HYBRID FINANCING
31.1.
l (S/E) + (r + σ2 /2) t
d1 =
 t

= ln (40 / 25) + [0.16 + (0.35)2/2]2

0.35(2)1/2

= 0.4700 + 0.4425
0.4950

= 1.8434

d2 = d1 -  t
= 1.8434 – 0.35
= 1.3484

N(d1) = N (1.8434).
From the tables we have N(1.80) = 1- 0.0359 = 0.9641
and N(1.85)= 1- 0.0322= 0.9678
By linear extrapolation, we get
N(1.8434) = 0.9641 + (1.8434 – 1.8000)(0.9678-0.9641)/0.05
= 0.9641 + 0.003212 = 0.9673
N(d2) = N(1.3484)
From the tables we have N(1.30) = 1- 0.0968 = 0.9032
N(1.35) = 1- 0.0885 = 0.9115
By linear extrapolation, we get
N(1.3484) = 0.9032 + (1.3484 – 1.3000)(0.9115 – 0.9032)/0.05
= 0.9032 + 0.008034 = 0.9112
rt
E/e = 25/1.3771 = 18.1541
C = So N(d1) – E. e-rt. N(d2)
= 40 x 0.9673 – 18.1541 x 0.9112= 22.15
Value of the warrant is Rs.22.15.

31.2
l (S/E) + (r + σ2 /2) t
d1 =
 t

= ln (50 / 30) + [0.12 + (0.4)2/2]2

0.4(2)1/2
 = 0.5108 + 0.4
0.5657

= 1.6100

d2 = d1 -  t
= 1.6100 – 0.40
= 1.0443

N(d1) = N (1.6100).
From the tables we have N(1.60) = 1- 0.0548 = 0.9452
and N(1.65)= 1- 0.0495= 0.9505
By linear extrapolation, we get
N(1.6100) = 0.9452 + (1.6100 – 1.6000)(0.9505-0.9452)/0.05
= 0.9452 + 0.00106 = 0.9463
N(d2) = N(1.0443)
From the tables we have N(1.00) = 1- 0.1587 = 0.8413
N(1.05) = 1- 0.1469 = 0.8531
By linear extrapolation, we get
N(1.0443) = 0.8413 + (1.0443 – 1.0000)(0.8531 – 0.8413)/0.05
= 0.8413 + 0.01045 = 0.8517
E/ert = 30/1.2712 = 23.60
C = So N(d1) – E. e-rt. N(d2)
= 50 x 0.9463 – 23.60 x 0.8517= 27.21
Value of the warrant = Rs.27.21

31.3.
(a) No.of shares after conversion in one year = 2
Value of the shares at the price of Rs.150 = 2 x 150 = Rs.300
PV of the convertible portion at the required rate of 15% = 300/1.15 = Rs.260.87
Payments that would be received from the debenture portion:
Year Payments PVIF10%,t PV
1 60 0.909 54.55
2 40 0.826 33.06
3 40 0.751 30.05
4 40 0.683 27.32
5 240 0.621 149.02
6 220 0.564 124.18
Total= 418.18

Value of the convertible debenture = 260.87 + 418.18 = Rs. 679.05

(b)
The cash flow for Shiva is worked out as under:
Year Cash flow
0 600
-
1 =-240-60*(1-0.3) 282
2 =-40*(1-0.3) -28
3 =-40*(1-0.3) -28
4 =-40*(1-0.3) -28
-
5 =-40*(1-0.3)-200 228
-
6 =-20*(1-0.3)-200 214

The post-tax cost of the convertible debenture to Shiva is the IRR of the above
cash flow stream.
Let us try a discount rate of 9%. The PV of the cash flow will then be
= 600 – 282/(1.09) -28/(1.09)2 - 28/(1.09)3 -28/(1.09)4-228/(1.09)5-214/(1.09)6
= 600 – 258.72 – 23.57 – 21.62 – 19.84 – 148.18 – 127.60 = 0.47 which is very near to zero.
So the post –tax cost of the convertible debenture to Shiva is 9%

MINICASE
1.
The straight debt cost is 12%. At a coupon rate of 10 percent, the straight debt value of the
convertible at the time of issue will be:

= 30x PVIFA(12%, 6 yrs) + 300 x PVIF(12%, 6 yrs)

= 30 x 4.111 + 300 x 0.507 = 275.43
So the in-built premium is 300 – 275.43 = Rs.24.57 or 8.2%
2.
Cost of equity = (1.5 x 1.15)/40 + 0.15 = 19.31 %
Cost of the straight debt is 12% p.a
3.
Conversion price at the end of the third year = 40 x 1.15 3 x 6 = Rs.365
Cost of the convertible, assuming conversion at the end of the 3rd year
is the value of r in the following equation:
300 = 30 PVIFA(r%, 3yrs) + 395x PVIF(r%,3 yrs)
r works out to 16.17%

4.
If the coupon on the convertible is 9.5 percent, the cost of the convertible at the end of the 3 rd year
will be the value of r in the following equation:
300 = 28.5 PVIFA(r%, 3yrs) + 393 .5x PVIF(r%,3 yrs)
r works out to 15.7 %
5.
At a coupon of 10% and conversion at the end of the 4 th year the cost of the convertible will be the
value of r in the following equation:
300 = 30 PVIFA(r%, 4yrs) + (40x1.154 x6 + 30)x PVIF(r%,4 yrs)
r works out to 17.69%

As the company has no worthwhile track record to show off and the investor sentiment towards it
evidently lukewarm as seen by its share price languishing at the same price for a long period, it
would be prudent to make the issue as attractive as possible to the investors, even at the prospects
of incurring higher costs ( which can always be made good in due course, on other occasions! ). So,
I will recommend a convertible issue of Rs.300 par at a coupon of 10 percent and a maturity of 6
years at a conversion ratio of 6, which can be called from the end of the 4 th year at a price of Rs.330
which would reduce by Rs.10 per year thereafter.
 Chapter 32
CORPORATE VALUATION

32.1. (a) The calculations for Hitech Limited are shown below :
Year 2 Year3
EBIT
PBT 86 102
+ Interest expense 24 28
- Interest income (10) (15)
- Non-operating income (5) (10)
EBIT 95 105

Tax on EBIT
Tax provision on income statement 26 32
+ Tax shield on interest expense 9.6 11.2
- Tax on interest income (4) (6)
- Tax on non-operating income (2) (4)
Tax on EBIT 29.6 33.2

NOPLAT 65.4 71.8

Net investment (50) (50)
Non-operating cash flow (post-tax) 3 6
FCFF 18.4 27.8

(b) The financing flow for years 2 and 3 is as follows :

Year 2 Year 3
After-tax interest expense 14.4 16.8
Cash dividend 30 40
- Net borrowings (30) (30)
+  Excess marketable securities 30 10
- After-tax income on excess (6) (9)
marketable securities
- Share issue (20) -
18.4 27.8

(c) Year 2 Year 3

Invested capital (Beginning) 310 360
Invested capital (Ending) 360 410
NOPLAT 65.4 71.8
Turnover 400 460
Net investment 50 50
 Post-tax operating margin 16.35% 15.61%
Capital turnover 1.29 1.28
ROIC 21.1% 19.9%
Growth rate 16.1% 13.9%
FCF 15.4 21.8

32.2. Televista Corporation

0 1 2 3 4 5
Base year

1. Revenues 1600 1920 2304 2765 3318 3650

2. EBIT 240 288 346 415 498 547
3. EBIT (1-t) 156 187 225 270 323 356
4. Cap. exp. 200 240 288 346 415 -
- Depreciation 120 144 173 207 249
5. Working capital 400 480 576 691 829 912
6. Working capital 80 96 115 138 83
7. FCFF 11 13 16 19 273
(3-4-6)

Discount factor 0.876 0.767 0.672 .589

Present value 9.64 9.97 10.76 11.19

Cost of capital for the high growth period

0.4 [12% + 1.25 x 7%] + 0.6 [15% (1 - .35)]

8.3% + 5.85%
= 14.15%

Cost of capital for the stable growth period

0.5 [12% + 1.00 x 6%] + 0.5 [14% (1 - .35)]
9% + 4.55%
= 13.55%

Present value of FCFF during the explicit forecast period

= 9.64 + 9.97 + 10.76 + 11.19 = 41.56
273 273
Horizon value = = = 7690
0.1355 – 0.10 0.0355
Present value of horizon value = 4529.5

Value of the firm = 41.56 + 4529.50 = Rs.4571.06 million

 32.3. The WACC for different periods may be calculated :

WACC in the high growth period

Year kd(1-t) = 15% (1-t) ke = Rf +  x Market risk premium ka = wd kd (1-t)+ we ke

1 15 (0.94) = 14.1% 12 + 1.3 x 7 = 21.1% 0.5 x 14.1 + 0.5 x 21.1 = 17.6%
2 15 (0.88) = 13.2% 21.1% 0.5 x 13.2 + 0.5 x 21.1 = 17.2%
3 15 (0.82) = 12.3% 21.1% 0.5 x 12.3 + 0.5 x 21.1 = 16.7%
4 15 (0.76) = 11.4% 21.1% 0.5 x 11.4 + 0.5 x 21.1 = 16.3%
5 15 (0.70) = 10.5% 21.1% 0.5 x 10.5 + 0.5 x 21.1 = 15.8%

WACC in the transition period

kd(1-t) = 14 (1 – 0.3) = 9.8%
ke = 11 + 1.1 x 6 = 17.6%
ka = 0.44 x 9.8 + 0.56 x 17.6 = 14.2%

WACC for the stable growth period

kd(1-t) = 13 (1 – 0.3) = 9.1%
ke = 11 + 1.0 x 5 = 16%
ka = 1/3 x 9.1 + 2/3 x 16 = 13.7%

The FCFF for years 1 to 11 is calculated below. The present value of the
FCFF for the years 1 to 10 is also calculated below.
Forecasted FCF (amounts in Rupees million)
Capital
Growth expend
Period rate EBIT(1-t) iture Depn. NWC ∆NWC FCF WACC PV factor Present value of FCF
1 40% 126 140.0 84 89.6 25.6 44.4 17.60% 0.85034 37.76
2 40% 176.4 196.0 117.6 125.4 35.8 62.2 17.15% 0.725856 45.12
3 40% 246.96 274.4 164.64 175.6 50.2 87.0 16.70% 0.621984 54.13
4 40% 345.74 384.2 230.50 245.9 70.2 121.8 16.25% 0.53504 65.19
5 40% 484.042 537.8 322.69 344.2 98.3 170.6 15.80% 0.462038 78.81
6 34% 648.62 720.7 432.41 461.2 117.0 243.3 14.13% 0.404823 98.50
7 28% 830.23 922.5 553.49 590.4 129.1 332.1 14.13% 0.354693 117.79
8 22% 1012.88 1125.4 675.25 720.3 129.9 432.8 14.13% 0.310771 134.51
9 16% 1174.94 1305.5 783.29 835.5 115.2 537.5 14.13% 0.272288 146.35
10 10% 1292.43 1436.0 861.62 919.1 83.6 634.5 14.13% 0.23857 151.36
SUM = 929.51

The present value of continuing value is :

 FCF11 634.5x1.10
x PV factor 10 years = x 0.23857 = 4,500.26
k–g 0.137 – 0.10

The value of the firm = 929.51 + 4,500.26 = Rs.5,429.77 million

 MINI CASE I

Solution:
1 2 3 4 5 6
1. Revenues 950 1,000 1,200 1,450 1,660 1,770
2. PBIT 140 115 130 222 245 287
3. NOPAT = PBIT 91 74.8 84.5 144.3 159.3 186.6
(1 – .35)
4. Depreciation 55 85 80 83 85 87
5. Gross cash flow 146 159.8 164.5 227.3 244.3 273.7
6. Gross investment 100 250 85 100 105 120
in fixed assets
7. Investment in net 10 15 70 70 70 54
current assets
8. Total investment 110 265 155 170 175 174
9. FCFF (5) – (8) 36 (105.2) 9.5 57.3 69.3 99.6

0.4 1.0
WACC = x 12 x (1 – 0.35) + {8 + 1.06 (8)}
1.4 1.4

= 14%

99.6 (1.10)
Continuing Value = = 2739.00
0.14 – 0.10

2739
Present value of continuing value = = 1249
(1.14)6

PV of the FCFF during the explicit forecast period

3.6 105.2 9.5 57.3 69.3 99.6
= – + + + +
(1.14) (1.14)2 (1.14)3 (1.14)4 (1.14)5 (1.14)6

= 72.4
Firm value = 72.4 + 1249 = 1321.4

Value of equity = 1321.4 – 200 = 1121.4 million

 MINI CASE II

International Elegant Modern

a Enterprise =[240x96.8+5060] =[200x68.4+5150] =[180x/43.2+4500]
value/EBITDA /2840 /2520 /1675
= 9.96 = 7.47 = 7.33
b Retrospective P/E ratio =90/[1588/240] =70.5/[1098/200] =39.2/[791/180]
= 13.60 =12.84 =8.92
Pospective P/E ratio =96.8/[1588/240] =68.4/[1098/200] =43.2/[791/180]
= 14.63 =12.46 =9.83

(c). The key factors that explain the differences in the valuation ratios of the three firms
are profitability, financial leverage, expected EPS growth, and size.
(d). Sundaram Paints, compares favourably with all the three listed companies in terms of
net profit margin, debt- equity ratio, and expected EPS growth.
Among the three listed companies, International Paints has the best profitability,
leverage, and growth numbers. Further it has the largest size (measured in terms of
revenues, profits, and assets). Hence it commands the highest EV/EBITDA (9.96) and P/E
(14.63) multiples. Sundaram Paints compares slightly favaourably with even International
Paints in terms of profitability, financial leverage, and expected EPS growth. However, size-
wise it is significantly smaller.
Considering everything, Sundaram Paints should command multiples which are a
notch below (say 5 percent below) that of International Paints. So, the valuation metrics
for Sundaram Paints would be as follows:

EV – EBITDA multiple 9.96 x 0.95 = 9.46

Retrospective PE multiple 14.63 x 0.95 = 13.90

Applying these multiples to Sundaram Paints results in the following value for equity
share

EV – EBITDA Approach P/E Approach

EV = 9.46 x 1890 = Rs 17879mn EPS = 886/144 = Rs. 6.15
Less : Loan Funds = Rs. 2880 mn P/E = 13.9
Equity Value = Rs. 14999 mn Value per share =Rs. 85.5
Number of Equity Shares = 144 mn
Value per share = Rs.104.2

Taking an arithmetric average of the two value estimates we get

 104.2 + 85.5 = Rs.94.85

Sundaram may price its IPO at a discount of 5 percent over its value of Rs. 94.85. This
works out to Rs. 90.11. The same can be rounded to Rs. 90.00

Chapter 33
VALUE BASED MANAGEMENT
33.1 The value created by the new strategy is calculated below :
Current Income statement projections
values
Year 0 1 2 3 4 5
Sales 2,000 2,240 2,509 2,810 3,147 3,147
Gross margin 400 448 502 562 629 629
Selling and general 160 179 201 225 252 252
administration
Profit before tax 240 269 301 337 378 378
Tax 72 81 90 101 113 113
Profit after tax 168 188 211 236 264 264
Balance sheet projections
Fixed assets 600 672 753 843 944 944
Current assets 600 672 753 843 944 944
Total assets 1,200 1,344 1,505 1,686 1,888 1,888
Equity 1,200 1,344 1,505 1,686 1,888 1,888
Cash Flow projections
Profit after tax 188 211 236 264 264
Depreciation 72 81 90 101 101
Capital expenditure 144 161 181 202 101
Increase in net current 72 81 90 101
assets
Operating cash flow 44 49 55 62 264
Present value of the operating cash flow = 147
Residual value = 264 / 0.15 = 1760
Present value of residual value = 1760 / (1.15)4 = 1007
Total shareholder value = 147 + 1007 = 1154
Pre-strategy value = 168/0.15 = 1120
Value of the strategy = 1154 – 1120 = 34

33.2
I = Rs.200 million
r = 0.40
c* = 0.20
T = 5 years
200 (0.40 – 0.20) 5
Value of forward plan =
0.20 (1.20)

= Rs.833.3 million

33.3(a)
Cost of capital = 0.5 x 0.10 + 0.5 x 0.18 = 0.14 or 14 per cent

1. Revenues 2,000 2,000 2,000 2,000 2,000

2. Costs 1,400 1,400 1,400 1,400 1,400
3. PBDIT 600 600 600 600 600
4. Depreciation 200 200 200 200 200
5. PBIT 400 400 400 400 400
6. NOPAT 240 240 240 240 240
7. Cash flow (4+6) 440 440 440 440 440
8. Capital at charge 1,000 800 600 400 200
9. Capital charge (8x0.14) 140 112 84 56 28
10. EVA (6-9) 100 128 156 184 212
5 440
(b)
NPV = ∑ - 1000 = 440 x 3.433 – 1000 = 510.5
t=1 (1.14)t

EVAt
NPV = ∑ = 100 x 0.877 + 128 x 0.769 + 156 x 0.675 + 184 x 0.592 +
(1.14)t 212 x 0.519
= 510.3
33.4. Equipment cost = 1,000,000
Economic life = 4 years
Salvage value = Rs.200,000
Cost of capital = 14 per cent

Present value of salvage value = 200,000 x 0.592

= 118,400

Present value of the annuity = 1,000,000 – 118,400

= 881,600

881,600 881,600
Annuity amount = =
PVIFA14%, 4yrs 2.914

= Rs.302,540

Depreciation charge under sinking fund method

1 2 3 4
Capital 1,000,000 837,460 652,164 440,927
Depreciation 162,540 185,296 212,237 240,810
Capital charge 140,000 117,244 91,303 61,730
Sum 302,540 302,540 302,540 302,540

33.5. Investment : Rs.2,000,000

Life : 10 years
Cost of capital : 15 per cent
Salvage value : 0

2,000,000
Economic depreciation =
FVIFA(10yrs, 15%)

2,000,000
= = 98,503
20.304

33.6.
Investment : Rs.5,000,000
Life : 5 years
Cost of capital : 12 per cent
 Salvage value : Nil

PVIFA(5yrs,12%) = 3.605 ; Annuity amount = 5,000,000 / 3.605 = 1,386,963

Depreciation charge under sinking fund method

1 2 3 4 5
Capital 5,000,000 4,213,037 3,331,638 2,344,472 1,238,846
Depreciation 786,963 881,399 987,166 1,105,626 1,238,301
Capital charge 600,000 505,564 399,797 281,336 148,662
Sum 1,386,963 1,386,963 1,386,963 1,386,963 1,386,963

5,000,000
Economic depreciation =
FVIFA(5yrs, 12%)

5,000,000
= = Rs.787,030
6.353

33.7. (a) Investment = Rs.100 million

Net working capital = Rs.20 million
Life = 8 yrs
Salvage value = Rs.20 million (Net working capital)
Annual cash flow = Rs.21.618 million
Cost of capital = 15%
Straight line depreciation = Rs.10 million per year

80 80
Economic depreciation = = = Rs.5.828 million
FVIFA(8, 15%) 13.727

Year 1 Year 4
 Profit after tax 11.618 11.618
 Depreciation 10.000 10.000
 Cash flow 21.618 21.618
 Book capital100 70
(Beginning)
 ROCE 11.62% 16.59%
 ROGI 21.62% 21.62%
 CFROI 15.79% 15.79%
(b)
Year 1 Year 4

EVA 11.618 – 100 x 0.15 11.618 - 70 x 0.15

= - 3.382 million = 1.118 million
CVA (11.618 + 10) – 5.828-(100x0.15) (11.618+10)-5.828- (100x0.15)
= 0.79 million = 0.79 million

33.8

I = Rs.400 million
r = 0.50
c* = 0.15
T = 6 years
400 (0.50 – 0.15) 6
Value of forward plan =
0.15 (1.15)

= Rs.4869.6 million
33.9
Cost of capital = (2/3) x 0.09 + (1/3) x 0.20 = 0.1267 or 12.67 per cent
(Rs.in million)
Year 1 2 3 4 5
1.Revenues 3,000 3,000 3,000 3,000 3,000
2. Costs 1,200 1,200 1,200 1,200 1,200
3. PBDIT 1,800 1,800 1,800 1,800 1,800
4. Depreciation 400 400 400 400 400
5. PBIT 1,400 1,400 1,400 1,400 1,400
6. NOPAT 980 980 980 980 980
7. Cash flow(4+6) 1380 1380 1380 1380 1380
8. Capital at charge 2000 1600 1200 800 400
9. Capital charge(
8x0.1267) 253.4 202.72 152.04 101.36 50.68
(i) EVA(6-9) 726.6 777.28 827.96 878.64 929.32

(i) NPV = 1380 PVIFA(0.1267,5yrs) = 1380((1-1/1.12675)/0.1267) – 20000

= Rs.2893.12million.
NPV = 726.6/1.1267 + 777.28/1.12672 + 827.96/1.12673 +878.64 /1.12674 + 929.32/1.12675

33.10
Equipment cost = 10,000,000
Economic life = 5 years
Salvage value = Rs.3,000,000
Cost of capital = 16 per cent
Present value of salvage value = 3,000,000 /1.165
= 1,428,339

Present value of the annuity = 10,000,000 – 1,428,339

= 8,571,661

8,571,661 8,571,661
Annuity amount = =
PVIFA16%, 5yrs 3.274

= Rs.2,618,100

Depreciation charge under sinking fund method

1 2 3 4 5
Capital 10,000,000 8,981,900 7,800,904 6,430,949 4,841,801
Depreciation 1,018,100 1,180,996 1,369,955 1,589,148 1,843412
Capital charge 1,600,000 1,437,104 1,248,145 1,028,952 774,688
Sum 2,618,100 2,618,100 2,618,100 2,618,100 2,618,100

33.11

. (a) Investment = Rs.400 million

Net working capital = Rs.100 million
Life = 10 yrs
Salvage value = Rs.100 million (Net working capital)
Annual cash flow = Rs. 100 million
Cost of capital = 16%
Straight line depreciation = Rs.30 million per year

300 300
Economic depreciation = = = Rs. 14.07 million
FVIFA(10, 16%) 21.3215

Note: All amounts in Rs.million.

Year 1 Year 5
 Cash flow 100 100
 Depreciation 30 30
 NOPAT 70 70
 Book capital 400 280
(Beginning)
a)
ROCE in year 1 = NOPAT/Capital employed = 70/400= 17.50 %
ROCE in year 5 = NOPAT/Capital employed = 70/280= 25 %
ROGI in year 1 = (NOPAT + Depreciation)/Cash invested = (70+30)/400= 25 %
ROGI in year 5 =( NOPAT + Depreciation)/Cash invested = (70+30)/400= 25 %
CFROI in year 1 =( Cash flow – economic depreciation)/ Cash invested
= (100-14.07)/400 = 21.48 %
CFROI in year 5 = (100-14.07)/400 = 21.48 %
b)
EVA in year 1 = NOPAT – Capital charge = 70 -4000 x 0.16 = 6
EVA in year 5 = 70 – 280 x 0.16 = 25.2
CVA in year 1
= Operating cash flow – economic depreciation –capital charge on gross investment
= 100 – 14.07 – 400 x 0.16 = 21.93
CVA in year 5 = = 100 – 14.07 – 400 x 0.16 = 21.93
 MINICASE

1. Generally, in EVA calculation NOPAT is defined as PBIT (1-T). HUL defines it as PAT
+ INT (1-T)
The two, however, are equivalent because
PBIT (1-T) = (PBT + INT) (1-T)
= PBT (1-T) + INT (1-T)
= PAT + INT (1-T)

2. HUL has not specified how it calculated the Market risk premium or Beta variant.
The Market risk premium figure of 11% used by HUL seems to be somewhat high.
The Beta variant of 0.481 used by HUL seems to be somewhat low. Given the
compensating errors in these two, it appears that the product of 11% and 0.481 i.e.
5.29% is not much off the mark.

Chapter 34
MERGERS, ACQUISITIONS AND RESTRUCTURING

1. The pre-amalgamation balance sheets of Cox Company and Box Company and the post-
amalgamation balance sheet of the combined entity, Cox and Box Company, under the ‘pooling’
method as well as the ‘purchase’ method are shown below :
(amounts in Rs.million unless otherwise mentioned)
Before amalgamation After amalgamation
Pooling Purchase
Cox Company Box Company method method
Fixed assets 25 10 35 45
Current assets 20 7.5 27.5 30
Total assets 45 17.5 62.5 75
Share capital (face value Rs.10) 20 5 25 30
Reserve and surplus 10 10 20 27.5
Debt 15 2.5 17.5 17.5
Total liabilities 45 17.5 62.5 75
2.
Post-merger EPS of International Corporation will be

2 x 100,000 + 2 x100,000

100,000 + ER x 100,000
 Setting this equal to Rs.2.5 and solving for ER gives
ER = 0.6

34.3
PVA = Rs.25 million, PVB = Rs.10 million
Benefit = Rs.4 million, Cash compensation = Rs.11 million
Cost = Cash compensation – PVB = Rs.1 million
NPV to Alpha = Benefit – Cost = Rs.3 million
NPV to Beta = Cash Compensation – PVB = Rs.1 million

34.4 Let A stand for Ajeet and J for Jeet

PVA = Rs.60 x 300,000 = Rs.18 million
PVJ = Rs.25 x 200,000 = Rs.5 million
Benefit = Rs.4 million
PVAJ = 18 + 5 + 4 = Rs.23 million
Exchange ratio = 0.5
The share of Jeet in the combined entity will be :
100,000
= = 0.25
300,000 + 100,000

a) True cost to Ajeet Company for acquiring Jeet Company

Cost = PVAB - PVB
= 0.25 x 27 - 5 = Rs.1.75 million

b) NPV to Ajeet
= Benefit - Cost
= 4 - 1.75 = Rs.2.25 million

c) NPV to Jeet = Cost = Rs.1.75 million

34.5. a) PVB = Rs.12 x 2,000,000 = Rs.24 million

The required return on the equity of Unibex Company is the value of k in the
equation.

Rs.1.20 (1.05)
Rs.12 =
k - .05

k = 0.155 or 15.5 per cent.

If the growth rate of Unibex rises to 7 per cent as a sequel to merger, the intrinsic
value per share would become :
 1.20 (1.07)
= Rs.15.11
0.155 - .07
Thus the value per share increases by Rs.3.11 Hence the benefit of the
acquisition is
2 million x Rs.3.11 = Rs.6.22 million

(b) (i) If Multibex pays Rs.15 per share cash compensation, the cost of the
merger is 2 million x (Rs.15 – Rs.12) = Rs.6 million.

(ii) If Multibex offers 1 share for every 3 shares it has to issue 2/3 million
shares to shareholders of Unibex.

So shareholders of Unibex will end up with

0.667
 = 0.1177 or 11.77 per cent
5+0.667

shareholding of the combined entity,

The present value of the combined entity will be
PVAB = PVA + PVB + Benefit
= Rs.225 million + Rs.24 million + Rs.6.2 million
= Rs.255.2 million

So the cost of the merger is :

Cost =  PVAB - PVB
= .1177 x 255.2 - 24 = Rs.6.04 million

34.6

The expected profile of the combined entity A&B after the merger is shown in the last column
below.

A B A&B
Number of shares 5000 2000 6333
Aggregate earnings Rs.45000 Rs.4000 Rs.49000
Market value Rs.90000 Rs.24000 Rs.114000
P/E 2 6 2.33

34.7.
It is assumed that the discount rate applicable to the acquisition is 12 percent
Value of Alpha Limited’s equity as a stand-alone company.

50 55 60 64 70 70 (1.06) 1
+ + + + + x
(1.12) (1.12)2 (1.12)3 (1.12)4 (1.12)5 0.12 – 0.06 (1.12)5

= Rs. 912.79 million

Value of the equity of the combined company.

80 90 105 120 135 135 (1.05) 1

+ + + + + x
(1.12) (1.12)2 (1.12)3 (1.12)4 (1.12)5 0.12 – 0.05 (1.12)5

= Rs. 1518.98 million

Let a be the maximum exchange ratio acceptable to the shareholders of Alpha Limited. Since the
management of Alpha Limited wants to ensure that the net present value of equity-related cash flows
increases by at least 5 percent, the value of a is obtained as follows.

10
x 1518.98 = 1.05 x 912.79
10 + a 8

Solving this for a we get

a = 0.7311

Note that the number of outstanding shares of Alpha Limited and Beta Limited are 10 million and 8
million respectively.

34.8. (a) The maximum exchange ratio acceptable to shareholders of Vijay Limited is :

S1 (E1+E2) PE12
ER1 = - +
S2 P1S2

12 (36+12) 8
= - + = 0.1
8 30 x 8

(b) The minimum exchange ratio acceptable to shareholders of Ajay Limited is :

P2 S1
 ER2 =
(PE12) (E1+E2) - P2 S2

9 x 12
= = 0.3
9 (36+12) - 9 x 8

(c) 12 (48) PE12

ER1 = - +
8 240
9 x 12
ER2 =
PE12 (48) - 72

Equating ER1 and ER2 and solving for PE12 gives, PE12 = 9
When PE12 = 9
ER1 = ER2 = 0.3
Thus ER1 and ER2 intersect at 0.3

34.9. The present value of FCF for first seven years is

16.00 14.30 9.7 0
PV(FCF) = - - - +
(1.12) (1.12)2 (1.12)3 (1.12)4

0 10.2 16.7
+ + +
(1.12)5 (1.12)6 (1.12)7

= - Rs.19.90 million
The horizon value at the end of seven years, applying the constant growth model is

FCF8 18
V4 = = = Rs.450 million
0.12-0.08 0.12 – 0.08

1
PV (VH) = 450 x = Rs.203.6 million
7
(1.12)

The value of the division is :

- 19.9 + 203.6 = Rs.183.7 million
 MINICASE

(a)
Modern Pharma Magnum Drugs Exchange
Ratio
Book value per share 2300 650 65
= Rs.115 = Rs.65
20 10 115
Earnings per share 450 95 9.5
= Rs.22.5 = Rs.9.5
20 10 22.5
Market price per share Rs.320 Rs.102 102

320

Exchange ratio that gives equal weightage to book value per share, earnings per share, and market
price per share

65 9.5 102
+ +
115 22.5 320 0.57 + 0.42 + 0.32
= = 0.44
3 3

(b) An exchange ratio based on earnings per share fails to take into account the
following:

(i) The difference in the growth rate of earnings of the two companies.
(ii) The gains in earnings arising out of merger.
(iii) The differential risk associated with the earnings of the two companies.

(c) Current EPS of Modern Pharma

450
= = Rs.22.5
20

If there is a synergy gain of 5 percent, the post-merger EPS of Modern Pharma is

(450 + 95) (1.05)

20 + ER X 10
Equating this with Rs.22.5, we get
 (450 + 95) (1.05)
= 22.5
20 + 10ER
This gives ER = 0.54

Thus the maximum exchange ratio Modern Pharma should accept to avoid initial dilution of EPS is
0.54

(d) Post-merger EPS of Modern Pharma if the exchange ratio is 1:4, assuming no
synergy gain:

450 + 95
= Rs.24.2
20 + 0.25 x 10

(e) The maximum exchange ratio acceptable to the shareholders of Modern Pharma if
the P/E ratio of the combined entity is 13 and there is no synergy gain

-S1 (E1 + E2) P/E12

ER1 = +
S2 P1 S 2

- 20 (450 + 95) 13
= + = 0.21
10 320 x 10

(f) The minimum exchange ratio acceptable to the shareholders of Magnum Drugs if
the P/E ratio of the combined entity is 12 and the synergy benefit is 2 percent
P2S1
ER2 =
(P/E12) (E1 + E2) (1 + S) – P2S2

102 x 20
=
12 (450 + 95) (1.02) – 102 X 10
= 0.36

(g) The level of P/E ratio where the lines ER1 and ER2 intersect.

To get this, solve the following for P/E12

- S1 (E1 + E2) P/E12 P2S1
+ =
S2 P1S2 P/E12 (E1 + E2) – P2S2

- 20 (450 +95) P/E12 102 x 20

+ =
10 320 x 10 P/E 12 (450 +95) – 1020

- 6400 + 545 P/E12 2040

=
3200 545 P/E12 – 1020

(545 P/E12 – 1020) (545 P/E12 – 6400) = 2040 x 3200

297025 P/E212 – 3488000 P/E12 – 555900 P/E12

+6528000 = 6528000
297025 P/E212 = 4043900 P/E
297025 P/E12 = 4043900
P/E12 = 13.61
 Chapter 37
INTERNATIONAL FINANCIAL MANAGEMENT

37.1 The annualised premium is :

Forward rate – Spot rate 12

x
Spot rate Forward contract length in months

70.50 – 70.00 12
= x = 2.86 %
70.00 3

37.2 Let F be the forward rate that makes investing in the two countries have the same return.
We then have :
( F/1.320) = (1.02/1.016) So, F = (1.02/1.016)x 1.320 = 1.3252

37.3.

(a) The annual percentage discount of the dollar on the yen may be calculated with
reference to 30-day forwards
118 – 112 360
x = 61.02 %
118 30

(b) The most likely spot rate 6 months hence will be : 103 yen / dollar

(c) Forward rate 1 + domestic interest rate

=
Spot rate 1 + foreign interest rate

103 1 + domestic interest rate in Japan

=
118 1.008

Domestic interest rate in Japan = (103/118)x 1.008-1= -0.12 per cent

37.4. S0 = Rs.70 , rh = 7 per cent , rf = 1.5 per cent

Hence the forecasted spot rates are :
Year Forecasted spot exchange rate
1 Rs. 70 (1.07 / 1.015)1 = Rs.73.79
2 Rs. 70 (1.07 / 1.015)2 = Rs.77.79
3 Rs. 70 (1.07 / 1.015)3 = Rs.82.01
4 Rs. 70 (1.07 / 1.015)4 = Rs.86.45
5 Rs. 70 (1.07 / 1.015)5 = Rs.91.13
 The expected rupee cash flows for the project

Year Cash flow in dollars Expected exchange Cash flow in rupees

(million) rate (million)
0 -200 70.00 -14,000
1 50 73.79 3689.5
2 70 77.79 5445.3
3 90 82.01 7380.9
4 105 86.45 9077.2
5 80 91.13 7290.4

Given a rupee discount rate of 18 per cent, the NPV in rupees is :

3689.5 5445.3 7380.9

NPV = -14000 + + +
(1.18) (1.18)2 (1.18)3

9077.2 7290.4
+ +
(1.18)4 (1.18)5

= Rs. 5398.29 million

37.5. Forward rate 1 + domestic interest rate

=
Spot rate 1 + foreign interest rate

F 1 + .0055
=
1.32 1 + .004
F = $ 1.3220 / £

37.6. Expected spot rate a year from now 1 + expected inflation in home country
=
Current spot rate 1 + expected inflation in foreign country

Expected spot rate a year from now 1.06

=
Rs.96 1.02

So, the expected spot rate a year from now is : 96 x (1.06 / 1.02) = Rs.99.76

37.7.
(a) The spot exchange rate of one US dollar should be :
28,000
 = Rs.38.89
720
(b) One year forward rate of one US dollar should be :
36,000
= Rs.45
800

37.8. (1 + expected inflation in Japan)2

Expected spot rate = Current spot rate x
2 years from now (1 + expected inflation in UK)2

(1.007)2
= 144 x = 140.35 yen / £
(1.02)2

37.9 (i) Determine the present value of the foreign currency liability (£100,000) by using
90-day money market lending rate applicable to the foreign country. This works
out to :
£100,000
= £ 98522
(1.015)
(ii) Obtain £98522 on today’s spot market
(iii) Invest £98522 in the UK money market. This investment will grow to
£100,000 after 90 days

37.10. (i) Determine the present value of the foreign currency asset (£100,000) by using
the 90-day money market borrowing rate of 2 per cent.
100,000
= £98039
(1.02)

(ii) Borrow £98039 in the UK money market and convert them to dollars in the spot
market.

(iii) Repay the borrowing of £98039 which will compound to £100000 after 90 days
with the collection of the receivable

37.11
. A lower interest rate in the Swiss market will be offset by the depreciation of theUS
dollar vis-à-vis the Swiss franc. So Mr.Sehgal’s argument is not tenable.
37. 12
INR/GBP = (INR/USD) x (USD/GBP) = 0.0141 x 0.7692 = 0.0108

37.13
As the forward bid in points is more than the offer rate in points the forward rate is at a
discount. So we have to subtract the points from the respective spot rate. The outright one
month forward quotation for USD/INR is therefore: 70.3524 / 70.3534
( Note that one swap point = 0.0001)
37.14

USD/INR Spot midrate = (71.3424 + 71.3435)/2 = 71.34295

USD/INR 1 month forward midrate = ( 71.8050 + 71.8060)/2 = 71.8055
As the forward rate indicates more rupee for a dollar, the rupee is at a discount.
The annual percentage of discount = [(71.8055 – 71.34295)/ 71.34295] x 12 = 7.78 %

MINICASE

a)
Proceeds of the DD at TT buying rate = 10,000 x 71.19 = Rs. 711,900
b)
Outright 6 month USD/INR forward rate = (71.62 + 2.30) / (71.65 + 2.35)
=73.92 / 74.00
Mid spot rate = (71.62 + 71.65) /2 = 71.635
Mid forward rate = (73.92 + 74.00) /2 = 73.96
Premium on USD as indicated by the forward rate = [(73.96 – 71.635) / 71.635] x2 x100
= 6.49 %
c)
Expected 6 month forward buying rate as indicated by the CIP:
= 71.62 x (1+ 0.0765/2) / (1 + 0.0260/2)
= 73.41
As this rate is worse than the one based on the prevailing market forward rate, it is advantageous to leave the exposure
uncovered..
d)
EUR / USD 3months outright forward ask rate: 1.1290 – 0.0032 = 1.1258
USD / INR 3months outright forward ask rate: 71.65 + 1.33 = 72.98
EUR /INR = [EUR / USD] x [ USD / INR ]
EUR / INR three months forward ask rate = 1.1258 x 72.98 = 82.16
Rupee cost of the import = 7,000 x 82.16 = Rs. 575,120
e)
Bill discounting proceeds (gross) = 40,000 x 73.92 = Rs.29,56,800
Total cost of export = 12, 63,000 + 575,120+ 29, 56,800 x 0.01 = Rs.18,67,688
Percentage of gross profit made = (711,900+ 29,56,800– 18,67,688) / (711,900+ 29,56,800)
= 49.1%

Chapter 40
CORPORATE RISK MANAGEMENT
40.1 (a) The investor must short sell Rs.1.43 million (Rs.1 million / 0.70) of B
(b) His hedge ratio is 0.70
(c) To create a zero value hedge he must deposit Rs.0.43 million

40.2. Futures price Spot price x Dividend yield

= Spot price -
(1+Risk-free rate)0.5 (1+Risk-free rate)0.5

4200 4000 x Dividend yield

= 4000 -
(1.145) 0.5 (1.145) 0.5

The dividend yield on a six months basis is 2 per cent. On an annual basis it is approximately 4
per cent.

40.3. Futures price

= Spot price + Present value of – Present value
(1+Risk-free rate)1 storage costs of convenience yield

5400
= 5000 + 250 – Present value of convenience yield
(1.15)1

Hence the present value of convenience yield is Rs.554.3 per ton.

40.4
LIBOR -25BP SWAP LIBOR - 25BP
BANK

5.25% 5%

EXCEL APPLE
EXCEL CORPN. LTD.

LIBOR+ 50BP 5%

Integrated Case on ITC

1
a)
Ratio 31-3-2016 31-3-2017 31-3-2018
Current ratio 3.73 3.69 2.85
Acid-test ratio 2.37 2.55 2.04
Debt-equity ratio 0.20 0.20 0.22
Debt ratio 0.17 0.17 0.18
Interest coverage ratio 278.22 660.52 194.63
Inventory turnover 6.27 6.83 6.11
Debtors turnover 28.27 26.74 18.50
Fixed assets turnover 3.29 3.27 2.37
Average collection period in
days 12.91 13.65 19.73
Total assets turnover 1.15 1.12 0.82
Net profit margin 16.8% 17.3% 23.2%
 Return on assets 19.34% 19.47% 19.12%
Earning power 30.4% 29.8% 29.1%
Return on capital employed 19.8% 19.5% 19.3%
Return on equity 23.3% 23.4% 23.1%
Price-earnings ratio 27.80 32.50 27.13
Yield 2.65% 30.68% -7.15%
Market value to book value ratio 6.15 10.93 8.85

b)
Comments on the ratios and their trend:
Liquidity: The liquidity position is very sound with even the acid-test ratio above 2 as it should be for a rather
conservative company of such standing. In the last three years, the excess liquidity is getting trimmed, perhaps to put
the assets to more profitable use.
Solvency: The solvency is very high with debt-equity ratio at around just 0.2 and a steady debt ratio of 0.18 is an
indicator of the company’s policy of relying mostly on own funds. The interest coverage ratio is very high because of
their almost insignificant borrowings.
Utilisation of assets: The following turnover ratios indicate the asset utilisation ( 2016 to 2018)
Inventory turnover 6.27 6.83 6.11
Debtors turnover 28.27 26.74 18.50
Fixed assets turnover 3.29 3.27 2.37
Average collection period in
days 12.91 13.65 19.73
Total assets turnover 1.15 1.12 0.82

For a multi-product company like ITC, inventory turnover which is maintained above 6, seems to be satisfactory. The
total assets turnover, which is just 0.82 in 2018, is showing a declining trend as the increase in fixed assets is not
matched by the revenue growth. In FY 2008, the company had purchased a five star hotel in Goa and this raised the
fixed assets by around Rs.2,000 crores, the revenues thereof yet to materialise. So the decline in total turnover does not
seem to be indicative any emerging weakness in operations. But there is a clear declining trend in the efficiency of
their collection mechanism, what with the average collection period increasing from 13 to 20 days, unless of course
the same is attributable to some deliberate strategy or to trade compulsions.
Profitability:
Net profit margin 16.8% 17.3% 23.2%
Return on assets 19.34% 19.47% 19.12%
Earning power 30.4% 29.8% 29.1%
Return on capital employed 19.8% 19.5% 19.3%
Return on equity 23.3% 23.4% 23.1%

All the profitability ratios are high and steady over the three years. The increase in net profit margin in 2018 should be
ignored as it is only due to the rearrangement of figures in the income statement on account of the introduction of GST
etc. which decreased the denominator of that ratio for that year.
c)
DuPont chart for 2017-18:
ITC 2017-18 DuPont Chart

- Net profit Total Revenues

11,493 cr. 49,933 cr.

- -

============================================== 
Net Profit Total Costs
Margin ÷
23.02%
X 38,440 cr.
Total Revenues
49,933 cr.

Return on ÷
+
Assets Average Non-
19.11 % current assets
33,785 cr.
Total Revenues
49,933 cr.
Total Assets ÷
Turnover Average
0.83
Total +
Assets Average
+
60,117 cr. current assets
26,332 cr.

2.
For
ITC
year ITC Nifty
DPS adjusted Adjusted Nifty ITC Nifty total
ended Nifty Market Bonus Split price
(Rs.) price DPS (Rs.) yield(%) return return
March Price(Rs.) return
(Rs.)
31

1998 1117 711 4 711 4

1999 1078 975 4.5 975 4.5 1.48% 37.76% -3.49% -2.01%
 2000 1528 741 5.5 741 5.50 1.05% -23.44% 41.74% 42.79%
2001 1148 814 7.5 814 7.5 1.13% 10.86% -24.87% -23.74%
2002 1130 697 10 697 10 1.34% -13.14% -1.57% -0.23%
2003 978 628 13.5 628 13.5 2.93% -7.96% -13.45% -10.52%
2004 1772 1043 15 1043 15 1.77% 68.47% 81.19% 82.96%
2005 2036 1342 20 1342 20 1.97% 30.58% 14.90% 16.87%
10 :
2006 3403 195 3.1 1:2 1 2925 31 1.33% 120.27% 67.14% 68.47%
2007 3822 151 2.65 2265 39.75 1.25% -21.21% 12.31% 13.56%
2008 4734 206 3.1 3090 46.5 1.06% 38.48% 23.86% 24.92%
2009 3021 184 3.5 2760 52.5 1.85% -8.98% -36.19% -34.34%
2010 5249 263 3.7 3945 55.5 0.94% 44.95% 73.75% 74.69%
2011 5834 182 10 1:1 5460 150 1.07% 42.21% 11.14% 12.21%
2012 5296 227 4.45 6810 133.5 1.50% 27.17% -9.22% -7.72%
2013 5683 309 4.5 9270 135 1.46% 38.11% 7.31% 8.77%
2014 6704 353 5.25 10590 157.5 1.37% 15.94% 17.97% 19.34%
2015 8491 326 6 9780 180 1.28% -5.95% 26.66% 27.94%
2016 7738 328 6.25 9840 187.5 1.49% 2.53% -8.87% -7.38%
2017 9174 280 8.5 1:2 12600 255 1.25% 30.64% 18.56% 19.81%
2018 10114 256 4.75 11520 213.75 1.29% -6.88% 10.25% 11.54%

R(M) -
Year ended R(ITC) R(M) R(ITC) -R'(ITC)
R'(M) 3x4 [R(M)-R'(M)]2
31 March (1) (2) (3)
(4)

1998
-
1999 0.3776 0.0201 0.1674 -0.1891 -0.0317 0.0358
2000 -0.2344 0.4279 -0.4446 0.2590 -0.1151 0.0671
-
2001 0.1086 0.2374 -0.1016 -0.4064 0.0413 0.1651
-
2002 -0.1314 0.0023 -0.3417 -0.1712 0.0585 0.0293
-
2003 -0.0796 0.1052 -0.2898 -0.2742 0.0795 0.0752
2004 0.6847 0.8296 0.4745 0.6606 0.3135 0.4364
2005 0.3058 0.1687 0.0956 -0.0003 0.0000 0.0000
2006 1.2027 0.6847 0.9925 0.5158 0.5119 0.2660
2007 -0.2121 0.1356 -0.4223 -0.0333 0.0141 0.0011
2008 0.3848 0.2492 0.1746 0.0803 0.0140 0.0064
-
2009 -0.0898 0.3434 -0.3000 -0.5123 0.1537 0.2625
 2010 0.4495 0.7469 0.2393 0.5779 0.1383 0.3340
2011 0.4221 0.1221 0.2118 -0.0468 -0.0099 0.0022
-
2012 0.2717 0.0772 0.0615 -0.2462 -0.0151 0.0606
2013 0.3811 0.0877 0.1709 -0.0813 -0.0139 0.0066
2014 0.1594 0.1934 -0.0508 0.0244 -0.0012 0.0006
2015 -0.0595 0.2794 -0.2697 0.1104 -0.0298 0.0122
-
2016 0.0253 0.0738 -0.1849 -0.2427 0.0449 0.0589
2017 0.3064 0.1981 0.0962 0.0291 0.0028 0.0008
2018 -0.0688 0.1154 -0.2790 -0.0536 0.0150 0.0029
R'(ITC) 0.2102 R'(M) 0.1690 sum 1.1705 1.8237

Covariance 0.0616 Variance 0.0960

=0.0616/0.0960
= Standard
Beta 0.6418 deviation =(0.0960)0.5 = 0.3098

3
Year 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
adjusted
DPS 4 4.5 5.5 7.5 10 13.5 15 20 31 39.75 46.5 52.5
Year 2010 2011 2012 2013 2014 2015 2016 2017 2018
adjusted
DPS 55.5 150 133.5 135 157.5 180 187.5 255 213.8
CAGR of dividends = (213.8/4)1/20- 1 = 22.01 percent
As the borrowings are not significant, the cost of capital may be set equal to the cost of equity. The
H Model of the dividend discount method is used as follows:
Cost of equity using CAPM = 7.76 + 0.6418(16.9 – 7.76) = 13.63 %
WACC = 13.63 %

4.75 (1.10) 4.75 x 5 x (0.1201)

Intrinsic value = ----------------- + ---------------------
0.1363 – 0.10 0.1363 – 0.10

= Rs.223

4
Rs.in crore
Year ending March 31 2016 2017 2018
Cost of materials consumed 11,169 11,979 11,944
 Purchases of Stock-in-Trade 2,595 3,478 2,884
Changes in inventories -195 593 1,028
Employee benefits expense
(assuming 50%) 1,720 1,816 1,880
Other expenses (assuming
50%) 3,862 3,830 3,675
Cost of goods sold 19,151 21,695 21,411
2016 2017 2018 2016 2017 2018
Sales 55,061 58,705 47,689 Inventory 9,062 8,116 7,495
COGS 19,151 21,695 21,411 Trade receivable 1,917 2,474 2,682
Trade payable 2,339 2,659 3,496
2016-17 2017-18
Inventory period (days) 144.50 133.07 improved
Accounts receivable
period(days) 13.65 19.73 worsened
Accounts payable period
(days) 42.05 52.47 improved
Operating cycle (days) 158.16 152.80 improved

5.
:

Year ended March 31 2012 2013 2014 2015 2016* 2017 2018
Payout ratio 56.22% 54.52% 53.67% 51.85% 69.01% 55.07% 54.69%
The payout ratio is steady at around 54 percent which corroborates the company’s stated policy of striving to declare a
steady stream of dividends to their shareholders. It could be that the high networth individuals and
institutions are staying invested for stable, safe and steady dividend income besides capital gains.
In this sense there clearly is a clientele effect.
i)
There were three bonus issues and one stock split in the past thirteen years. The stock cannot be split any further. Half
of all the earnings are being paid out steadily to the shareholders. The compounded annual growth rate of dividends is
22 percent. The picture one gets is that of a sturdy and steady investor friendly company.

6.
Cigarettes fall under the highest tax bracket and all tobacco products are required to carry pictorial warning covering
most of their packaging space. The anti-smoking lobby will only gain more strength in future resulting in still higher
penalties. This is a mounting threat to the profitability and even the sustainability of their main cigarette business. In
such a scenario the company’s strategy seems to be to attain a position where it would not be dependent on its
tobacco/cigarette income for growth, by entering various other lucrative segments. As cigarettes are considered ‘sin
goods’ and ITC is the undisputed leader in that segment, they are making persistent efforts to shed their ‘cigarette
company’ image, lest the notoriety thereof rubs on their reputation in the new businesses.
Way back in 1990, ITC had decided to focus only on areas where they could lead viz. cigarettes/tobacco, hotels,
packaging and paper. The segments chosen for diversification have been those where their organisational strengths
like the well-knit distribution network could be effectively leveraged. Also those segments are the ones having
backward integration with established existing businesses as can be seen from the following value chains:
Agriculture - tobacco – cigarettes- hotels-lifestyle products etc.
- e- choupal – IT- rural connect- agricultural procurements- branded food products etc.
- paper-notebooks- stationery etc.
Despite relatively heavy investment in the non-cigarette FMCG segment, about 80 percent of the company’s profit is
still derived from the cigarettes segment even after sixteen years.

7.
It is seen that 96.7 percent of the shareholders are holding less than 10,000 shares and their combined shareholding is
just 3.2 percent. The fact that there is no promoter and there is a predominance of institutional investors ensures that
the company is professionally managed. For that same reason, the equity analysts would be after this stock regularly
which would reduce the scope for any sudden large fluctuations of the share price. As the stock is almost wholly held
by very strong long term players, its beta would necessarily be low.

8.
a)
As per the company’s Annual Report, the important risk factors at the business level and the
measures used to manage them are as under:
i) Commodities:
The risk assessment framework consists of monitoring market dynamics on an ongoing basis,
continuous tracking of net open positions & ‘value at risk’ against approved limits and hedging
with futures contracts as applicable. Also they go in for backward integration where feasible in
respect of sourcing of agri commodities and paper besides protecting margins by suitable
management of product mix and input prices. For agricultural commodities held for trading
futures contracts are used to hedge price risk.
ii) Treasury operations:
The Company has established risk management policies to hedge the volatility arising from
exchange rate fluctuations in respect of firm commitments and highly probable forecast
transactions, through foreign exchange forwards and plain vanilla options contracts with reputed
banks as counterparties. The proportion of forecast transactions that are to be hedged is decided
based on the size of the forecast transaction and market conditions. Investment of its large
temporary surplus is supported by appropriate control mechanisms including independent check of
100% of transactions by its audit department. Both market risk, and interest rate risk are not
significant as it is not an active investor in equity markets and also is almost debt free. The
company’s debt investments are centralised and are made within ‘acceptable’ risk parameters
under a set of approved policies and procedures after due evaluation. Such investments are mostly
in bonds/debentures, fixed deposits and debt mutual funds, all with government undertakings,
reputed banks/companies with investment grade credit ratings and for short durations. As such the
price risk, credit risk and counterparty risk are not significant. Credit concentration risk is also
negligible as its customer base is large and diverse.
b.
The company’s borrowings are negligible and so there is no effort at managing financial risk. As to
business risk, the management of the same is made an integral part of the strategy for developing a
business portfolio.
The Risk Management Committee, constituted by the Board, monitors and reviews the strategic
risk management plans of the Company as a whole. Independent Internal Audit at the corporate
level carries out risk focused audits across all businesses. The Audit Committee of the Board
reviews Internal Audit findings and the Audit Compliance Review Committee monitors the
internal control environment.