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Chapter 7
TIME VALUE OF MONEY
1. Value five years hence of a deposit of Rs.1,000 at various interest rates is as follows:
r = 8% FV
5
= Rs.1469
r = 10% FV
5
= Rs.1611
r = 12% FV
5
= Rs.1762
r = 15% FV
5
= Rs.2011
2. 30 years
3. In 12 years Rs.1000 grows to Rs.8000 or 8 times. This is 2
3
times the initial deposit. Hence
doubling takes place in 12 / 3 = 4 years.
According to the Rule of 69, the doubling period is:
0.35 + 69 / Interest rate
Equating this to 4 and solving for interest rate, we get
Interest rate = 18.9%.
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.
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. 1,000 x FVIFA (r, 6 years) = 10,000
FVIFA (r, 6 years) = 10,000 / 1000 = 10
2
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)
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)
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
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
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
3
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.
11. The amount that can be withdrawn annually is:
100,000 100,000
A =   =  = Rs.10,608
PVIFA (10%, 30 years) 9.427
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.
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
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 / PVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,165
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%
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
4
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.2,851.1
17. FV
5
= Rs.10,000 [1 + (0.16 / 4)]
5x4
= Rs.10,000 (1.04)
20
= Rs.10,000 x 2.191
= Rs.21,910
18. FV
5
= Rs.5,000 [1+( 0.12/4)]
5x4
= Rs.5,000 (1.03)
20
= Rs.5,000 x 1.806
= Rs.9,030
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
20. Investment required at the end of 8
th
year to yield an income of Rs.12,000 per year from the
end of 9
th
year (beginning of 10
th
year) for ever:
Rs.12,000 x PVIFA(12%, ∞ )
5
= Rs.12,000 / 0.12 = Rs.100,000
To have a sum of Rs.100,000 at the end of 8
th
year , the amount to be deposited now is:
Rs.100,000 Rs.100,000
= = Rs.40,388
PVIF(12%, 8 years) 2.476
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 for 10 years from now because I find a return of 15% quite
acceptable.
22. FV
10
= 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
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
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 2005 to
2009, evaluated as at the beginning of 2004 (or end of 2003) 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 2000 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 1995 to 2000 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
25. The discounted value of the annuity of Rs.2000 receivable for 30 years, evaluated as at the
end of 9
th
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
26. 30 per cent of the pension amount is
0.30 x Rs.600 = Rs.180
Assuming that the monthly interest rate corresponding to an annual interest rate of 12% is
1%, the discounted value of an annuity of Rs.180 receivable at the end of each month for 180
months (15 years) is:
Rs.180 x PVIFA (1%, 180)
(1.01)
180
 1
Rs.180 x  = Rs.14,998
.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.14,998
P x 1.817 = Rs.14,998
Rs.14,998
P =  = Rs.8254
1.817
27. Rs.300 x PVIFA(r, 24 months) = Rs.6,000
PVIFA (4%,24) = Rs.6000 / Rs.300 = 20
From the tables we find that:
PVIFA(1%,24) = 21.244
7
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%
28. The discounted value of the debentures to be redeemed between 8 to 10 years evaluated at
the end of the 5
th
year is:
Rs.10 million x PVIF (8%, 3 years)
+ Rs.10 million x PVIF (8%, 4 years)
+ Rs.10 million x PVIF (8%, 5 years)
= Rs.10 million (0.794 + 0.735 + 0.681)
= Rs.2.21 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.2.21 million
A x 5.867 = Rs.2.21 million
A = 5.867 = Rs.2.21 million
A = Rs.2.21 million / 5.867 = Rs.0.377 million
29. Let `n’ be the number of years for which a sum of Rs.20,000 can be withdrawn annually.
Rs.20,000 x PVIFA (10%, n) = Rs.100,000
PVIFA (15%, n) = Rs.100,000 / Rs.20,000 = 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
8
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
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.
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
9
MINICASE
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
10
1.12
15
1 –
1.08
= 400,000
0.08 – 0.12
= Rs.7,254,962
11
Chapter 8
VALUATION OF BONDS AND STOCKS
1. 5 11 100
P = ¿ +
t=1 (1.15) (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
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=1 (1.12)
t
(1.12)
7
Note that when the discount rate and the coupon rate are the same the value is equal to
par value.
3. The yield to maturity is the value of r that satisfies the following equality.
7 120 1,000
Rs.750 = ¿ + = Rs.100
t=1 (1+r)
t
(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%.
12
Using linear interpolation in this range, we get
771.44 – 750.00
Yield to maturity = 18% + 771.44 – 711.60 x 2%
= 18.7%
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%
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
6. The posttax interest and maturity value are calculated below:
Bond A Bond B
13
* Posttax interest (C ) 12(1 – 0.3) 10 (1 – 0.3)
=Rs.8.4 =Rs.7
* Posttax maturity value (M) 100  100 
[ (10070)x 0.1] [ (100 – 60)x 0.1]
=Rs.97 =Rs.96
The posttax YTM, using the approximate YTM formula is calculated below
8.4 + (9770)/10
Bond A : Posttax YTM = 
0.6 x 70 + 0.4 x 97
= 13.73%
7 + (96 – 60)/6
Bond B : Posttax YTM = 
0.6x 60 + 0.4 x 96
= 17. 47%
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
8. D
o
= Rs.2.00, g = 0.06, r = 0.12
P
o
= D
1
/ (r – g) = D
o
(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 2
nd
year will be:
P
2
= P
o
x (1 + g)
2
= Rs.35.33 (1.06)
2
= Rs.39.70
14
9. P
o
= D
1
/ (r – g) = D
o
(1 + g) / (r – g)
= Rs.12.00 (1.10) / (0.15 – 0.10) = Rs.264
10. P
o
= D
1
/ (r – g)
Rs.32 = Rs.2 / 0.12 – g
g = 0.0575 or 5.75%
11. P
o
= D
1
/ (r – g) = D
o
(1+g) / (r – g)
D
o
= Rs.1.50, g = 0.04, P
o
= Rs.8
So
8 = 1.50 (1 .04) / (r(.04)) = 1.44 / (r + .04)
Hence r = 0.14 or 14 per cent
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 = P
8
/ (1.14)
8
P
8
= D
9
/ (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,
P
o
= A + B + C = 5.74 + 4.89 + 13.14
= Rs.23.77
15
13. The intrinsic value of the equity share will be the sum of three components:
A: Present value of the dividend stream for the first 5 years when the
growth rate expected is 15%.
B: Present value of the dividend stream for the next 5 years when the
growth rate is expected to be 10%.
C: Present value of the market price expected at the end of 10 years.
2.00 (1.15) 2.00 (1.15)
2
2.00 (1.15)
3
2.00(1.15)
4
2.00 (1.15)
5
A =
 +  + +  + 
(1.12) (1.12)
2
(1.1.2)
3
(1.1.2)
4
(1.12)
5
= 2.30 / (1.12) + 2.65 / (1.12)
2
+ 3.04 / (1.12)
3
+ 3.50 / (1.12)
4
+ 4.02/(1.12)
5
= Rs.10.84
4.02(1.10) 4.02 (1.10)
2
4.02(1.10)
3
4.02(1.10)
4
4.02 (1.10)
5
B =  +  +  +  + 
(1.12)
6
(1.12)
7
(1.12)
8
(1..12)
9
(1.12)
10
4.42 4.86 5.35 5.89 6.48
=  +  +  +  + 
(1.12)
6
(1.12)
7
(1.12)
8
(1.1.2)
9
(1.12)
10
= Rs.10.81
D
11
1 6.48 (1.05)
C =  x  =  x 1/(1.12)
10
r – g (1 +r)
10
0.12 – 0.05
= Rs.97.20
The intrinsic value of the share = A + B + C
= 10.84 + 10.81 + 97.20 = Rs.118.85
14. Terminal value of the interest proceeds
= 140 x FVIFA (16%,4)
= 140 x 5.066
= 709.24
Redemption value = 1,000
16
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%
15. Intrinsic value of the equity share (using the 2stage growth model)
(1.18)
6
2.36 x 1   2.36 x (1.18)
5
x (1.12)
(1.16)
6
=  + 
0.16 – 0.18 (0.16 – 0.12) x (1.16)
6
 0.10801
= 2.36 x  + 62.05
 0.02
= Rs.74.80
16. Intrinsic value of the equity share (using the H model)
4.00 (1.20) 4.00 x 4 x (0.10)
=  + 
0.18 – 0.10 0.18 – 0.10
= 60 + 20
= Rs.80
17
Chapter 9
RISK AND RETURN
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 (R
i
) 10% 20% 30%
Probability (p
i
) 0.4 0.4 0.2
Note that the rate of return is defined as:
Dividend + Terminal price
  1
Initial price
(c ) The standard deviation of rate of return is : σ = ¿p
i
(R
i
– R)
2
The σ of the rate of return on MVM’s stock is calculated below:

R
i
p
i
p
I
r
i
(R
i
R) (R
i
 R)
2
p
i
(R
i
R)
2

10 0.4 4 8 64 25.6
20 0.4 8 2 4 1.6
30 0.2 6 12 144 28.8

R = ¿ p
i
R
i
¿ p
i
(R
i
R)
2
= 56
σ = \56 = 7.48%
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)
18
= 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:
19
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 :
Option
Expected return
(Rs)
Standard deviation
(Rs)
Expected / Standard
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.
3. 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%
6
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%
20
(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%
4. Define R
A
and R
M
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 R
A
R
M
R
A
R
A
R
M
R
M
(R
A
R
A
) (R
M
R
M
) R
A
R
A
/R
M
R
M
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 03.09 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
R
A
= 15.09 R
M
= 15.18
¿ (R
A
– R
A
)
2
= 1116.93 ¿ (R
M
– R
M
)
2
= 975.61 ¿ (R
A
– R
A
) (R
M
– R
M
) = 935.86
Beta of the equity stock of Auto Electricals
¿ (R
A
– R
A
) (R
M
– R
M
)
¿ (R
M
– R
M
)
2
= 935.86 = 0.96
975.61
Alpha = R
A
– β
A
R
M
= 15.09 – (0.96 x 15.18) = 0.52
21
Equation of the characteristic line is
R
A
= 0.52 + 0.96 R
M
5. The required rate of return on stock A is:
R
A
= R
F
+ β
A
(R
M
– R
F
)
= 0.10 + 1.5 (0.15 – 0.10)
= 0.175
Intrinsic value of share = D
1
/ (r g) = D
o
(1+g) / ( r – g)
Given D
o
= 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
6. The SML equation is R
A
= R
F
+ β
A
(R
M
– R
F
)
Given R
A
= 15%. R
F
= 8%, R
M
= 12%, we have
0.15 = .08 + β
A
(0.12 – 0.08)
0.07
i.e.β
A
= = 1.75
0.04
Beta of stock A = 1.75
7. The SML equation is: R
X
= R
F
+ β
X
(R
M
– R
F
)
We are given 0.15 = 0.09 + 1.5 (R
M
– 0.09) i.e., 1.5 R
M
= 0.195
or R
M
= 0.13%
Therefore return on market portfolio = 13%
8. R
M
= 12% β
X
= 2.0 R
X
=18% g = 5% P
o
= Rs.30
P
o
= D
1
/ (r  g)
Rs.30 = D
1
/ (0.18  .05)
22
So D
1
= Rs.39 and D
o
= D
1
/ (1+g) = 3.9 /(1.05) = Rs.3.71
R
x
= R
f
+ β
x
(R
M
– R
f
)
0.18 = R
f
+ 2.0 (0.12 – R
f
)
So R
f
= 0.06 or 6%.
Original Revised
R
f
6% 8%
R
M
– R
f
6% 4%
g 5% 4%
β
x
2.0 1.8
Revised R
x
= 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
Chapter 10
OPTIONS AND THEIR VALUATION
1. S = 100 u = 1.5 d = 0.8
23
E = 105 r = 0.12 R = 1.12
The values of ∆ (hedge ratio) and B (amount borrowed) can be obtained as follows:
C
u
– C
d
∆ =
(u – d) S
C
u
= Max (150 – 105, 0) = 45
C
d
= Max (80 – 105, 0) = 0
45 – 0 45 9
∆ = = = = 0.6429
0.7 x 100 70 14
u.C
d
– d.C
u
B =
(ud) 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
= Rs.18.37
Value of the call option = Rs.18.37
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
C
d
= Max (32 – 45, 0) = 0
24
∆ Cu – Cd R
= x
B u C
d
– d C
u
S
∆ C
u
– 0 1.10
= x
B 0.8C
u
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%.
3. Using the standard notations of the BlackScholes model we get the following results:
l
n
(S/E) + r
t
+ σ
2
t/2
d
1
=
o \ t
25
= l
n
(120 / 110) + 0.14 + 0.4
2
/2
0.4
= 0.08701 + 0.14 + 0.08
0.4
= 0.7675
d
2
= d
1
 o \ t
= 0.7675 – 0.4
= 0.3675
N(d
1
) = N (0.7675) ~ N (0.77) = 0.80785
N (d
2
) = N (0.3675) ~ N (0.37) = 0.64431
C = So N(d
1
) – E. e
rt
. N(d
2
)
= 120 x 0.80785 – 110 x e
0.14
x 0.64431
= (120 x 0.80785) – (110 x 0.86936 x 0.64431)
= 35.33
Value of the call as per the Black and Scholes model is Rs.35.33.
4. o \t = 0.2 x \ 1 = 0.2
Ratio of the stock price to the present value of the exercise price
80
= 
82 x PVIF (15.03,1)
80
= 
82 x 0.8693
= 1.122
From table A6 we find the percentage relationship between the value of the call option and
stock price to be 14.1 per cent. Hence the value of the call option is
0.141 x 80 = Rs.11,28.
5. Value of put option
= Value of the call option
+ Present value of the exercise price
 Stock price ……… (A)
26
The value of the call option gives an exercise price of Rs.85 can be obtained as follows:
o \t = 0.2 \ 1 = 0.2
Ratio of the stock price to the present value of the exercise price
80
= 
85 x PVIF (15.03,1)
= 80 / 73.89 = 1.083
From Table A.6, we find the percentage relationship between the value of the call option and
the stock price to be 11.9%
Hence the value of the call option = 0.119 x 80 = Rs.9.52
Plugging in this value and the other relevant values in (A), we get
Value of put option = 9.52 + 85 x (1.1503)
1
– 80
= Rs.3.41
6. S
o
= V
o
N(d
1
) – B
1
e
–rt
N (d
2
)
= 6000 N (d
1
) – 5000 e
– 0.1
N(d
2
)
l
n
(6000 / 5000) + (0.1 x 1) + (0.18/2)
d
1
= 
\ 0.18 x \ 1
l
n
(1.2) + 0.19
=
0.4243
= 0.8775 = 0.88
N(d
1
) = N (0.88) = 0.81057
d
2
= d
1
 t
= 0.8775  0.18
= 0.4532 = 0.45
27
N (d
2
) = N (0.45) = 0.67364
So = 6000 x 0.81057 – (5000 x 0.9048 x 0.67364)
= 1816
B
0
= V
0
– S
0
= 60000 – 1816
= 4184
Chapter 11
TECHNIQUES OF CAPITAL BUDGETING
1.(a) NPV of the project at a discount rate of 14%.
=  1,000,000 + 100,000 + 200,000
 
(1.14) (1.14)
2
+ 300,000 + 600,000 + 300,000
  
(1.14)
3
(1.14)
4
(1.14)
5
28
=  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
2. Investment A
a) Payback period = 5 years
b) NPV = 40000 x PVIFA (12,10) – 200 000
= 26000
c) IRR (r ) can be obtained by solving the equation:
40000 x PVIFA (r, 10) = 200000
i.e., PVIFA (r, 10) = 5.000
From the PVIFA tables we find that
PVIFA (15,10) = 5.019
PVIFA (16,10) = 4.883
29
Linear interporation in this range yields
r = 15 + 1 x (0.019 / 0.136)
= 15.14%
d) BCR = Benefit Cost Ratio
= PVB / I
= 226,000 / 200,000 = 1.13
Investment B
a) Payback period = 9 years
b) NP V = 40,000 x PVIFA (12,5)
+ 30,000 x PVIFA (12,2) x PVIF (12,5)
+ 20,000 x PVIFA (12,3) x PVIF (12,7)
 300,000
= (40,000 x 3.605) + (30,000 x 1.690 x 0.567)
+ (20,000 x 2.402 x 0.452) – 300,000
=  105339
c) IRR (r ) can be obtained by solving the equation
40,000 x PVIFA (r, 5) + 30,000 x PVIFA (r, 2) x PVIF (r,5) +
20,000 x PVIFA (r, 3) x PVIF (r, 7) = 300,000
Through the process of trial and error we find that
r = 1.37%
d) BCR = PVB / I
= 194,661 / 300,000 = 0.65
Investment C
a) Payback period lies between 2 years and 3 years. Linear interpolation in this
range provides an approximate payback period of 2.88 years.
b) NPV = 80.000 x PVIF (12,1) + 60,000 x PVIF (12,2)
+ 80,000 x PVIF (12,3) + 60,000 x PVIF (12,4)
+ 80,000 x PVIF (12,5) + 60,000 x PVIF (12,6)
+ 40,000 x PVIFA (12,4) x PVIF (12.6)
 210,000
= 111,371
30
c) IRR (r) is obtained by solving the equation
80,000 x PVIF (r,1) + 60,000 x PVIF (r,2) + 80,000 x PVIF (r,3)
+ 60,000 x PVIF (r,4) + 80,000 x PVIF (r,5) + 60,000 x PVIF (r,6)
+ 40000 x PVIFA (r,4) x PVIF (r,6) = 210000
Through the process of trial and error we get
r = 29.29%
d) BCR = PVB / I = 321,371 / 210,000 = 1.53
Investment D
a) Payback period lies between 8 years and 9 years. A linear interpolation in this
range provides an approximate payback period of 8.5 years.
8 + (1 x 100,000 / 200,000)
b) NPV = 200,000 x PVIF (12,1)
+ 20,000 x PVIF (12,2) + 200,000 x PVIF (12,9)
+ 50,000 x PVIF (12,10)
 320,000
=  37,160
c) IRR (r ) can be obtained by solving the equation
200,000 x PVIF (r,1) + 200,000 x PVIF (r,2)
+ 200,000 x PVIF (r,9) + 50,000 x PVIF (r,10)
= 320000
Through the process of trial and error we get r = 8.45%
d) BCR = PVB / I = 282,840 / 320,000 = 0.88
Comparative Table
Investment A B C D
a) Payback period
(in years) 5 9 2.88 8.5
b) NPV @ 12% pa 26000 105339 111371 37160
c) IRR (%) 15.14 1.37 29.29 8.45
d) BCR 1.13 0.65 1.53 0.88
31
Among the four alternative investments, the investment to be chosen is ‘C’
because it has the Lowest payback period
Highest NPV
Highest IRR
Highest BCR
3. 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.
4. 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.
5. 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
= 93271
6. 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
7. PV of benefits (PVB) = 25000 x PVIF (15,1)
+ 40000 x PVIF (15,2)
+ 50000 x PVIF (15,3)
+ 40000 x PVIF (15,4)
+ 30000 x PVIF (15,5)
32
= 122646 (A)
Investment = 100,000 (B)
Benefit cost ratio = 1.23 [= (A) / (B)]
8. The NPV’s 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
9. 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
33
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 investmentrelated 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%
(c) Project Q
PV of investmentrelated costs = 1600
TV of cash inflows @ 15% p.a. = 2772
The MIRR of project Q is given by the equation:
16000 (1 + MIRR)
5
= 2772
MIRR = 11.62%
34
10
(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)
= Rs.3.15 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
(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
35
Cost of capital = 12% p.a
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 PVIFA (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
36
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%
37
Chapter 12
ESTIMATION OF PROJECT CASH FLOWS
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. N C F (200) 116.25 113.44 111.33 109.75 108.56 107.67 205
(c) 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
38
Through a process of trial and error, we get r = 55.17%. The IRR of the project is 55.17%.
2. Posttax 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. A 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+1819+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
3.
(a) A. Initial outlay (Time 0)
39
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. Posttax 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
40
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
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
41
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
42
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
43
Chapter 13
RISK ANALYSIS IN CAPITAL BUDGETING
1.
(a) NPV of the project = 250 + 50 x PVIFA (13,10)
= Rs.21.31 million
(b) 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.
(c) Accounting break even point (under ‘expected’ scenario)
44
Fixed costs + depreciation = Rs. 45 million
Contribution margin ratio = 60 / 200 = 0.3
Break even level of sales = 45 / 0.3 = Rs.150 million
Financial break even point (under ‘xpected’ scenario)
i. Annual net cash flow = 0.7143 [ 0.3 x sales – 45 ] + 25
= 0.2143 sales – 7.14
ii. PV (net cash flows) = [0.2143 sales – 7.14 ] x PVIFA (13,10)
= 1.1628 sales – 38.74
iii. Initial investment = 200
iv. Financial break even level
of sales = 238.74 / 1.1628 = Rs.205.31 million
2.
(a) 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
(b) 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
45
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
(c) 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
(d) Accounting breakeven point
i. Fixed costs + depreciation = Rs.5000
ii. Contribution margin ratio = 10 / 30 = 0.3333
iii. Breakeven level of sales = 5000 / 0.3333
= Rs.15000
Financial breakeven point
i. Annual cash flow = 0.5 x (0.3333 Sales – 5000) = 2000
ii. PV of annual cash flow = (i) x PVIFA (10,5)
= 0.6318 sales – 1896
iii. Initial investment = 30000
iv. Breakeven level of sales = 31896 / 0.6318 = Rs.50484
3. Define A
t
as the random variable denoting net cash flow in year t.
A
1
= 4 x 0.4 + 5 x 0.5 + 6 x 0.1
= 4.7
A
2
= 5 x 0.4 + 6 x 0.4 + 7 x 0.2
= 5.8
46
A
3
= 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
o
1
2
= 0.41
o
2
2
= 0.56
o
3
2
= 0.49
o
1
2
o
2
2
o
3
2
o
2
NPV = + +
(1.1)
2
(1.1)
4
(1.1)
6
= 1.00
o (NPV) = Rs.1.00 million
4. Expected NPV
4 A
t
= ¿  25,000
t=1 (1.08)
t
= 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 o
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
5. Expected NPV
4 A
t
47
= ¿  10,000 …. (1)
t=1 (1.06)
t
A
1
= 2,000 x 0.2 + 3,000 x 0.5 + 4,000 x 0.3
= 3,100
A
2
= 3,000 x 0.4 + 4,000 x 0.3 + 5,000 x 0.3
= 3,900
A
3
= 4,000 x 0.3 + 5,000 x 0.5 + 6,000 x 0.2
= 4,900
A
4
= 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
The variance of NPV is given by the expression
4 o
2
t
o
2
(NPV) = ¿ …….. (2)
t=1 (1.06)
2t
o
1
2
= [(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
o
2
2
= [(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
o
3
2
= [(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
o
4
2
= [(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
48
490,000 / (1.06)
2
+ 690,000 / (1.06)
4
+ 490,000 / (1.06)
6
+ 560,000 / (1.08)
8
[ 490,000 x 0.890 + 690,000 x 0.792
+ 490,000 x 0.705 + 560,000 x 0.627 ]
= 1,679,150
o NPV = 1,679,150 = Rs.1,296
NPV – NPV 0  NPV
Prob (NPV < 0) = Prob. <
o NPV o 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
So the probability of NPV being negative is 0.0094
Prob (P
1
> 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 + 0.2910
= 0.7910
So the probability of P
1
> 1.2 as 0.7910
6. Given values of variables other than Q, P and V, the net present value model of Bidhan
Corporation can be expressed as:
49
[Q(P – V) – 3,000 – 2,000] (0.5)+ 2,000 0
5
NPV ¿ +  30,000
t =1 (1.1)
t
(1.1)
5
0.5 Q (P – V) – 500
5
¿ =   30,000
t=1 (1.1)
t
= [ 0.5Q (P – V) – 500] x PVIFA (10,5) – 30,000
= [0.5Q (P – V) – 500] x 3.791 – 30,000
= 1.8955Q (P – V) – 31,895.5
Exhibit 1 presents the correspondence between the values of exogenous variables and the two
digit random number. Exhibit 2 shows the results of the simulation.
Exhibit 1
Correspondence between values of exogenous variables and
two digit random numbers
QUANTITY PRICE VARIABLE COST
Valu
e
Pro
b
Cumulati
ve Prob.
Two digit
random
numbers
Valu
e
Pro
b
Cumulati
ve Prob.
Two digit
random
numbers
Value
Pro
b
Cumu

lative
Prob.
Two digit
random
numbers
800 0.1
0
0.10 00 to 09 20 0.4
0
0.40 00 to 39 15 0.3
0
0.30 00 to 29
1,00
0
0.1
0
0.20 10 to 19 30 0.4
0
0.80 40 to 79 20 0.5
0
0.80 30 to 79
1,20
0
0.2
0
0.40 20 to 39 40 0.1
0
0.90 80 to 89 40 0.2
0
1.00 80 to 99
1,40
0
0.3
0
0.70 40 to 69 50 0.1
0
1.00 90 to 99
1,60
0
0.2
0
0.90 70 to 89
1,80
0
0.1
0
1.00 90 to 99
50
Exhibit 2
Simulation Results
QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Ru
n
Rando
m
Numbe
r
Corres
ponding
Value
Random
Number
Corres
ponding
value
Rando
m
Number
Corres
pondin
g value
1.8955 Q(PV)
31,895.5
1 03 800 38 20 17 15 24,314
2 32 1,200 69 30 24 15 2,224
3 61 1,400 30 20 03 15 18,627
4 48 1,400 60 30 83 40 58,433
5 32 1,200 19 20 11 15 20,523
6 31 1,200 88 40 30 20 13,597
7 22 1,200 78 30 41 20 9,150
8 46 1,400 11 20 52 20 31,896
9 57 1,400 20 20 15 15 18,627
QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Ru
n
Rando
m
Numbe
r
Corres
ponding
Value
Random
Number
Corres
ponding
value
Rando
m
Number
Corres
pondin
g value
1.8955 Q(PV)
31,895.5
10 92 1,800 77 30 38 20 2,224
11 25 1,200 65 30 36 20 9,150
12 64 1,400 04 20 83 40 84,970
13 14 1,000 51 30 72 20 12,941
14 05 800 39 20 81 40 62,224
15 07 800 90 50 40 20 13,597
16 34 1,200 63 30 67 20 9,150
17 79 1,600 91 50 99 40 1,568
18 55 1,400 54 30 64 20 5,359
19 57 1,400 12 20 19 15 18,627
20 53 1,400 78 30 22 15 7,910
21 36 1,200 79 30 96 40 54,642
22 32 1,200 22 20 75 20 31,896
23 49 1,400 93 50 88 40 5,359
24 21 1,200 84 40 35 20 13,597
25 08 .800 70 30 27 15 9,150
26 85 1,600 63 30 69 20 1,568
27 61 1,400 68 30 16 15 7,910
28 25 1,200 81 40 39 20 13,597
29 51 1,400 76 30 38 20 5,359
30 32 1,200 47 30 46 20 9,150
51
31 52 1,400 61 30 58 20 5,359
32 76 1,600 18 20 41 20 31,896
33 43 1,400 04 20 49 20 31,896
34 70 1,600 11 20 59 20 31,896
35 67 1,400 35 20 26 15 18,627
36 26 1,200 63 30 22 15 2,224
QUANTITY (Q) PRICE (P) VARIABLE COST (V) NPV
Ru
n
Random
Number
Corres

pondin
g
Value
Random
Number
Corres
ponding
value
Rando
m
Number
Corres
pondin
g value
1.8955 Q(PV)
31,895.5
37 89 1,600 86 40 59 20 28,761
38 94 1,800 00 20 25 15 14,836
39 09 .800 15 20 29 15 24,314
40 44 1,400 84 40 21 15 34,447
41 98 1,800 23 20 79 20 31,896
42 10 1,000 53 30 77 20 12,941
43 38 1,200 44 30 31 20 9,150
44 83 1,600 30 20 10 15 16,732
45 54 1,400 71 30 52 20 5,359
46 16 1,000 70 30 19 15 3,463
47 20 1,200 65 30 87 40 54,642
48 61 1,400 61 30 70 20 5,359
49 82 1,600 48 30 97 40 62,224
50 90 1,800 50 30 43 20 2,224
Expected NPV = NPV
50
= 1/ 50 ¿ NPV
i
i=1
= 1/50 (7,20,961)
= 14,419
50
Variance of NPV = 1/50 ¿ (NPV
i
– NPV)
2
i=1
= 1/50 [27,474.047 x 10
6
]
= 549.481 x 10
6
52
Standard deviation of NPV = 549.481 x 10
6
= 23,441
7. To carry out a sensitivity analysis, we have to define the range and the most likely values of
the variables in the NPV Model. These values are defined below
Variable Range Most likely value
I Rs.30,000 – Rs.30,000 Rs.30,000
k 10%  10% 10%
F Rs.3,000 – Rs.3,000 Rs.3,000
D Rs.2,000 – Rs.2,000 Rs.2,000
T 0.5 – 0.5 0.5
N 5 – 5 5
S 0 – 0 0
Q Can assume any one of the values  1,400*
800, 1,000, 1,200, 1,400, 1,600 and 1,800
P Can assume any of the values 20, 30, 30**
40 and 50
V Can assume any one of the values 20*
15,20 and 40

* The most likely values in the case of Q, P and V are the values that have the
highest probability associated with them
** In the case of price, 20 and 30 have the same probability of occurrence viz 0.4. We
have chosen 30 as the most likely value because the expected value of the
distribution is closer to 30
Sensitivity Analysis with Reference to Q
The relationship between Q and NPV given the most likely values of other
variables is given by
5 [Q (3020) – 3,000 – 2,000] x 0.5 + 2,000 0
NPV = ¿ +  30,000
t=1 (1.1)
t
(1.1)
5
5 5Q  500
= ¿  30,000
t=1 (1.1)
t
The net present values for various values of Q are given in the following table:
53
Q 800 1,000 1,200 1,400 1,600 1,800
NPV 16,732 12,941 9,150 5,359 1,568 2,224
Sensitivity analysis with reference to P
The relationship between P and NPV, given the most likely values of other variables is defined as
follows:
5 [1,400 (P20) – 3,000 – 2,000] x 0.5 + 2,000 0
NPV = ¿ +  30,0
t=1 (1.1)
t
(1.1)
5
5 700 P – 14,500
= ¿  30,000
t=1 (1.1)
t
The net present values for various values of P are given below :
P (Rs) 20 30  40 50
NPV(Rs) 31,896 5,359 21,179 47,716
8. NPV  5 0 5 10 15 20
(Rs.in lakhs)
PI 0.9 1.00 1.10 1.20 1.30 1.40
Prob. 0.02 0.03 0.10 0.40 0.30 0.15
6
Expected PI = PI = ¿ (PI)
j
P
j
j=1
= 1.24
6
Standard deviation of P
1
= ¿ (PI
j
 PI)
2
P
j
j=1
= \ .01156
= .1075
The standard deviation of P
1
is .1075 for the given investment with an expected PI of 1.24.
The maximum standard deviation of PI acceptable to the company for an investment with an
expected PI of 1.25 is 0.30.
54
Since the risk associated with the investment is much less than the maximum risk acceptable
to the company for the given level of expected PI, the company must should accept the
investment.
9. The NPVs of the two projects calculated at their risk adjusted discount rates are as follows:
6 3,000
Project A: NPV = ¿  10,000 = Rs.2,333
t=1 (1.12)
t
5 11,000
Project B: NPV = ¿  30,000 = Rs.7,763
t=1 (1.14)
t
PI and IRR for the two projects are as follows:
Project A B
PI 1.23 1.26
IRR 20% 24.3%
B is superior to A in terms of NPV, PI, and IRR. Hence the company must choose B.
10. The certainty equivalent coefficients for the five years are as follows
Year Certainty equivalent coefficient
o
t
= 1 – 0.06 t
1 o
1
= 0.94
2 o
2
= 0.88
3 o
3
= 0.82
4 o
4
= 0.76
5 o
5
= 0.70
The present value of the project calculated at the riskfree rate of return is :
5 (1 – 0.06 t) A
t
¿
t=1 (1.08)
t
7,000 x 0.94 8,000 x 0.88 9,000 x 0.82 10,000 x 0.76 8,000 x 0.70
+ + + +
(1.08) (1.08)
2
(1.08)
3
(1.08)
4
(1.08)
5
55
6,580 7,040 7,380 7,600 5,600
+ + + +
(1.08) (1.08)
2
(1.08)
3
(1.08)
4
(1.08)
5
= 27,386
Net present value of the Project = (27,386 – 30,000
= Rs. –2,614
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 D
2
:
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
56
Second, truncate the ‘do not expand’ option as it is inferior to the ‘expand’ option. This
means that the NPV at decision point D
2
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
57
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
58
from 929 to 1406. Hence the value of the abandonment option is 477.
59
Chapter 14
THE COST OF CAPITAL
1(a) Define r
D
as the pretax cost of debt. Using the approximate yield formula, r
D
can be
calculated as follows:
14 + (100 – 108)/10
r
D
=  x 100 = 12.60%
0.4 x 100 + 0.6x108
(b) After tax cost = 12.60 x (1 – 0.35) = 8.19%
2. Define r
p
as the cost of preference capital. Using the approximate yield formula r
p
can be
calculated as follows:
9 + (100 – 92)/6
r
p
= 
0.4 x100 + 0.6x92
= 0.1085 (or) 10.85%
3. WACC = 0.4 x 13% x (1 – 0.35)
+ 0.6 x 18%
= 14.18%
4. Cost of equity = 10% + 1.2 x 7% = 18.4%
(using SML equation)
Pretax cost of debt = 14%
Aftertax 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%
5. Given
0.5 x 14% x (1 – 0.35) + 0.5 x r
E
= 12%
where r
E
is the cost of equity capital.
Therefore r
E
– 14.9%
60
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.
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 D
1
/P
0
( = 6/100) whereas the cost of equity is (D
1
/P
0
)
+ g where g represents the expected constant growth rate in dividend per share.
7. 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)
8. 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
61
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.
9.
(a) Given
r
D
x (1 – 0.3) x 4/9 + 20% x 5/9 = 15%
r
D
= 12.5%,where r
D
represents the pretax cost of debt.
(b) Given
13% x (1 – 0.3) x 4/9 + r
E
x 5/9 = 15%
r
E
= 19.72%, where r
E
represents the cost of equity.
10. Cost of equity = D
1
/P
0
+ 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.25 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
11. The cost of equity and retained earnings
r
E
= D
1
/P
O
+ g
= 1.50 / 20.00 + 0.07 = 14.5%
The cost of preference capital, using the approximate formula, is :
11 + (10075)/10
r
E
= = 15.9%
0.6 x 75 + 0.4 x 100
62
The pretax cost of debentures, using the approximate formula, is :
13.5 + (10080)/6
r
D
= = 19.1%
0.6x80 + 0.4x100
The posttax cost of debentures is
19.1 (1tax rate) = 19.1 (1 – 0.5)
= 9.6%
The posttax cost of term loans is
12 (1tax 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 cost11.99%
capital
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
(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
12
63
(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.8.51 million
MINICASE
Solution:
a. All sources other than noninterest bearing liabilities
b. Pretax cost of debt & posttax cost of debt
10 + (100 – 112) / 8 8.5
r
d
= = = 7.93
0.6 x 112 + 0.4 x 100 107.2
r
d
(1 – 0.3) = 5.55
c. Posttax cost of preference
9 + (100 – 106) / 5 7.8
= = 7.53%
0.6 x 106 + 0.4 x 100 103.6
d. Cost of equity using the DDM
2.80 (1.10)
+ 0.10 = 0.385 + 0.10
80
= 0.1385 = 13.85%
e. Cost of equity using the CAPM
7 + 1.1(7) = 14.70%
f. WACC
0.50 x 14.70 + 0.10 x 7.53 + 0.40 x 5.55
64
= 7.35 + 0.75 + 2.22
= 10.32%
g. 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%
65
Chapter 15
CAPITAL BUDGETING : EXTENSIONS
1. 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.
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
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.
66
4.
(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
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
67
(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
68
Chapter 18
RAISING LONG TERM FINANCE
1 Underwriting Shares Excess/ Credit Net
commitment procured shortfall shortfall
A 70,000 50,000 (20,000) 4919 (15081)
B 50,000 30,000 (20,000) 3514 (16486)
C 40,000 30,000 (10,000) 2811 (7189)
D 25,000 12,000 (13,000) 1757 (11243)
E 15,000 28,000 13,000
2.
Underwriting Shares Excess/ Credit Net
commitment procured Shortfall shortfall
A 50,000 20,000 (30,000) 14286 (15714)
B 20,000 10,000 (10,000) 5714 (4286)
C 30,000 50,000 20,000  
3. P
o
= Rs.220 S = Rs.150 N = 4
a. The theoretical value per share of the cumrights stock would simply be
Rs.220
b. The theoretical value per share of the exrights stock is :
69
NP
o
+S 4 x 220 +150
= = Rs.206
N+1 4+1
c. The theoretical value of each right is :
P
o
– S 220 – 150
= = Rs.14
N+1 4+1
The theoretical value of 4 rights which are required to buy 1 share is Rs.14x14=Rs.56.
4. P
o
= Rs.180 N = 5
a. The theoretical value of a right if the subscription price is Rs.150
P
o
– S 180 – 150
= = Rs.5
N+1 5+1
b. The exrights value per share if the subscription price is Rs.160
NP
o
+ S 5 x 180 + 160
= = Rs.176.7
N+1 5+1
c. The theoretical value per share, exrights, 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
70
Chapter 19
CAPITAL STRUCTURE AND FIRM VALUE
1. Net operating income (O) : Rs.30 million
Interest on debt (I) : Rs.10 million
Equity earnings (P) : Rs.20 million
Cost of equity (r
E
) : 15%
Cost of debt (r
D
) : 10%
Market value of equity (E) : Rs.20 million/0.15 =Rs.133 million
Market value of debt (D) : Rs.10 million/0.10 =Rs.100 million
Market value of the firm (V) : Rs.233 million
2. Box Cox
Market value of equity 2,000,000/0.15 2,000,000/0.15
= Rs.13.33 million = Rs.13.33 million
Market value of debt 0 1,000,000/0.10
=Rs.10 million
Market value of the firm Rs.13.33million =23.33 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
13.33 10.00
x 15% + x 10% = 12.86%
23.33 23.33
(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%
71
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.10 million of additional equity to retire
Rs.10 million of debt , it will become an allequity company. So its
average cost of capital will simply be equal to its cost of equity,
which is 15%.
3. r
E
= r
A
+ (r
A
r
D
)D/E
20 = 12 + (128) D/E
So D/E = 2
4. E D E D
r
E
r
D
r
A
=
r
E
+
r
D
D+E D+E (%) (%) D+E D+E
1.00 0.00 11.0 6.0 11.00
0.90 0.10 11.0 6.5 10.55
0.80 0.20 11.5 7.0 10.60
0.70 0.30 12.5 7.5 11.00
0.60 0.40 13.0 8.5 11.20
0.50 0.50 14.0 9.5 11.75
0.40 0.60 15.0 11.0 12.60
0.30 0.70 16.0 12.0 13.20
0.20 0.80 18.0 13.0 14.00
0.10 0.90 20.0 14.0 14.20
The optimal debt ratio is 0.10 as it minimises the weighted average
cost of capital.
5. (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
72
6. 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
7. The average cost of capital(without considering agency and bankruptcy cost)
at various leverage ratios is given below.
D E E D
r
D
r
E
r
A
=
r
E
+ r
D
D + E D+ E % % D+E D+E
(%)
0 1.00 4.0 12.0 12.0
0.10 0.90 4.0 12.0 11.2
0.20 0.80 4.0 12.5 10.8
0.30 0.70 4.0 13.5 10.36
0.40 0.60 4.0 13.5 9.86
0.50 0.50 4.0 14.0 9.30
0.60 0.40 4.0 14.5 8.68
0.70 0.30 4.0 15.0 8.14
0.80 0.20 4.0 15.5 7.90
0.90 0.10 4.0 16.0 7.72 Optimal
b. The average cost of capital considering agency and bankruptcy costs is
given below
.
D E E D
r
D
r
E
r
A
=
r
E
+ r
D
D + E D+ E % % D+E D+E
(%)
0 1.00 4.0 12.0 12.0
0.10 0.90 4.0 12.0 11.2
0.20 0.80 4.0 13.0 11.2
0.30 0.70 4.2 14.0 11.06
0.40 0.60 4.4 15.0 10.76
0.50 0.50 4.6 16.0 10.30
0.60 0.40 4.8 17.0 9.68
0.70 0.30 5.2 18.0 9.04
0.80 0.20 6.0 19.0 8.60
0.90 0.10 6.8 20.0 8.12 Optimal
8. The tax advantage of one rupee of debt is :
73
1(1t
c
) (1t
pe
) (10.55) (10.05)
= 1 
(1t
pd
) (10.25)
= 0.43 rupee
Chapter 20
CAPITAL STRUCTURE DECISION
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) (1t) – Preference dividend
EPS =
No. of shares
(7,200,000 – 0 ) (1t) – 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
EPS
A
=
2,500,000
Financing Plan B : Issue of Rs.10 million debentures carrying 15 per cent
interest
(EBIT – 1,500,000) (10.5) – 600,000
EPS
B
=
1,500,000
The EPS – EBIT indifference point can be obtained by equating EPS
A
and EPS
B
(EBIT – 0 ) (1 – 0.5) – 600,000 (EBIT – 1,500,000) (1 – 0.5) – 600,000
74
=
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.
2.
(a) EPS – EBIT equation for alternative A
EBIT ( 1 – 0.5)
EPS
A
=
2,000,000
(b) EPS – EBIT equation for alternative B
EBIT ( 1 – 0.5 ) – 440,000
EPS
B
=
1,600,000
(c) EPS – EBIT equation for alternative C
(EBIT – 1,200,000) (1 0.5)
EPS
C
=
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 EPS
A
EPS
B
EPS
C
(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)
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)
EPS
A
=
75
1,800,000
(EBIT – 1,500,000) (1 – 0.6)
EPS
B
=
1,000,000
Equating EPS
A
and EPS
B
, 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 >
o EBIT 3.000
= Prob [z >  1.21]
= 0.8869
4. ROE = [ ROI + ( ROI – r ) D/E ] (1 – t )
15 = [ 14 + ( 14 – 8 ) D/E ] ( 1 0.5 )
D/E = 2.67
5. ROE = [12 + (12 – 9 ) 0.6 ] (1 – 0.6)
= 5.52 per cent
6. 18 = [ ROI + ( ROI – 8 ) 0.7 ] ( 1 – 0.5)
ROI = 24.47 per cent
EBIT
7. a. Interest coverage ratio =
Interest on debt
150
=
40
= 3.75
EBIT + Depreciation
b. Cash flow coverage ratio =
Loan repayment instalment
76
Int.on debt +
(1 – Tax rate)
= 150 + 30
40 + 50
= 2
8. The debt service coverage ratio for Pioneer Automobiles Limited is given by :
5
¿ ( PAT
i
+ Dep
i
+ Int
i
)
i=1
DSCR = 5
¿ (Int
i
+ LRI
i
)
i=1
= 133.00 + 49.14 +95.80
95.80 + 72.00
= 277.94
167.80
= 1.66
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, o= 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
77
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
Chapter 21
DIVIDEND POLICY AND FIRM VALUE
1. 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
2. Payout ratio Price per share
8(0.25)
0.25 = undefined
0.12 – 0.16(0.75)
8(0.50)
0.50 = Rs.100
0.12 – 0.16(0.50)
8(1.00)
1.0 =Rs.66.7
0.12 – 0.16 (0)
78
3.
P Q
 Next year’s price 80 74
 Dividend 0 6
 Current price P Q
 Capital appreciation (80P) (74Q)
 Posttax capital appreciation 0.9(80P) 0.9 (74Q)
 Posttax dividend income 0 0.8 x 6
 Total return 0.9 (80P)
P
= 14%
0.9 (74Q) + 4.8
Q
=14%
 Current price (obtained by solving
the preceding equation)
P = Rs.69.23 Q = Rs.68.65
79
Chapter 22
DIVIDEND DECISION
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(AC) 5,000 6,500 3,500 8,950
E . Capital expenditure 8,000 7,000 10,000 8,000
80
F . External financing
requirement 3,000 500 6,500 Nil
(ED)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
(DC)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
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.
3. According to the Lintner model
D
t
= cr EPS
t
+ (1c)D
t
–1
EPS
t
=3.00, c= 0.7, r=0.6 , and D
t1
Hence
D
t
= 0.7 x 0.6 x 3.00 + (10.7)1.20
81
= Rs.1.62
4. The bonus ratio (b) must satisfy the following constraints :
(RS
b
)≥0.4S (1+b) (1)
0.3 PBT ≥0.1 S(1+b) (2)
R = Rs.100 million, S= Rs.60 million, PBT = Rs.60 million
Hence the constraints are
(10060 b) ≥ 0.4 x 60 (1+b) (1a)
0.3 x 60≥0.1 x 60 (1+b) (2a)
These simplify to
b ≥76/84
b ≥ 2
The condition b ≥ 76/84 is more restructive than b≥ 2
So the maximum bonus ratio is 76/84 or 19/21
82
Chapter 23
Debt Analysis and Management
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 taxdeductible 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 8year annuity of 3,100,000 at a
83
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
2. (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 taxdeductible 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
84
as discount rate of 9 per cent, which is the posttax 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)
3. Yield to maturity of bond P
8 160 1000
918.50 =¿ +
t=1 (1+r)
t
(1+r)
8
r or yield to maturity is 18 percent
Yield to maturity of bond Q
5 120 1000
761 = ¿ +
t=1 (1+r)
t
(1+r)
5
r or yield to maturity is 20 per cent
Duration of bond P is calculated below
Year Cash flow Present Value Proportion of Proportion of bond’s
at 18% bond’s value Value x Time
1 160 135.5 0.148 0.148
2 160 114.9 0.125 0.250
3 160 97.4 0.106 0.318
4 160 82.6 0.090 0.360
5 160 69.9 0.076 0.380
6 160 59.2 0.064 0.384
7 160 50.2 0.055 0.385
8 160 308.6 0.336 2.688
4.913
Duration of bond Q is calculated below
Year Cash flow Present Value Proportion of Proportion of bond’s
at 20% bond’s value Value x Time
85
1 120 100.0 0.131 0.131
2 120 83.2 0.109 0.218
3 120 69.5 0.091 0.273
4 120 57.8 0.076 0.304
5 1120 450.2 0.592 2.960
3.886
Volatility of bond P Volatility of bond Q
4.913 3.886
= 4.16 = 3.24
1.18 1.20
4. The YTM for bonds of various maturities is
Maturity YTM(%)
1 12.36
2 13.10
3 13.21
4 13.48
5 13.72
Graphing these YTMs against the maturities will give the yield curve
The one year treasury bill rate , r
1
, is
1,00,000
 1 = 12.36 %
89,000
To get the forward rate for year 2, r
2
, the following equation may be set up :
12500 112500
99000 = +
(1.1236) (1.1236)(1+r
2
)
Solving this for r
2
we get r
2
= 13.94%
86
To get the forward rate for year 3, r
3
, the following equation may be set up :
13,000 13,000 113,000
99,500 = + +
(1.1236) (1.1236)(1.1394) (1.1236)(1.1394)(1+r
3
)
Solving this for r
3
we get r
3
= 13.49%
To get the forward rate for year 4, r
4
, the following equation may be set up :
13,500 13,500 13,500
100,050 = + +
(1.1236) (1.1236)(1.1394) (1.1236)(1.1394)(1.1349)
113,500
+
(1.1236)(1.1394)(1.1349)(1+r
4
)
Solving this for r
4
we get r
4
= 14.54%
To get the forward rate for year 5, r
5
, the following equation may be set up :
13,750 13,750 13,750
100,100 = + +
(1.1236) (1.1236)(1.1394) (1.1236)(1.1394)(1.1349)
13,750
+
(1.1236)(1.1394)(1.1349)(1.1454)
113,750
+
(1.1236)(1.1394)(1.1349)(1.1454)(1+r
5
)
Solving this for r
5
we get r
5
= 15.08%
87
Chapter 25
HYBRID FINANCING
1. The product of the standard deviation and square root of time is :
o t = 0.35 2 = 0.495
The ratio of the stock price to the present value of the exercise price is :
Stock price 40
= = 1.856
PV (Exercise price) 25/(1.16)
The ratio of the value of call option to stock price corresponding to numbers
0.495 and 1.856 can be found out from Table A.6 by interpolation. Note the
table gives values for the following combinations
1.75 2.00
0.45 44.6 50.8
0.50 45.3 51.3
Since we are interested in the combination 0.495 and 1.856 we first interpolate
between 0.450 and 0.500 and then interpolate between 1.75 and 2.00
Interpolation between 0.450 and 0.500 gives
1.75 2.00
0.450 44.6 50.8
0.495 45.23 51.25
0.500 45.3 51.3
88
Then, interpolation between 1.75 and 2.00 gives
1.75 1.856 2.00
0.495 45.23 47.78 51.25
Chapter 24
LEASING, HIRE PURCHASE, AND PROJECT FINANCE
1. NPV of the Purchase Option
(Rs.in ‘000)
Year 0 1 2 3 4 5
1.Investment(I) (1,500)
2.Revenues(R
t
) 1,700 1,700 1,700 1,700 1,700
3.Costs(other than
(Depreciation)(C
t
) 900 900 900 900 900
4.Depreciation(D
t
) 500 333.3 222.2 148.1 98.8
5.Profit before tax
(R
t
C
t
D
t
) 300 466.7 577.8 651.9 701.2
6.Profit after tax: 5(1t) 210 326.7 404.5 456.3 490.8
7.Net salvage value 300
8.Net cash flow
(1+6+4+7) (1,500) 710 610 626.7 604.4 889.6
9.Discount factor
at 11 percent 1.000 0.901 0.812 0.731 0.659 0.593
10.Present value (8x9) (1,500) 639.7 495.3 458.1 398.3 527.5
NPV(Purchases)=  1500+639.7+495.3+458.1+398.3+527.5 = 1018.9
NPV of the Leasing Option
(Rs. in ‘000)
Year 0 1 2 3 4 5
1.Revenues(R
t
)  1,700 1,700 1,700 1,700 1,700
2.Costs(other than
lease rentals)(C
t
) 900 900 900 900 900
3.Lease rentals(L
t
) 420 420 420 420 420 0
4.Profit before tax
(R
t
C
t
L
t
) 420 380 380 380 380 800
5.Profit after tax (which
also reflects the net
89
cash flow)(1t) 294 266 266 266 266 560
6.Discount factor at
13 per cent 1.000 0.885 0.783 0.693 0.613 0.543
7.Present value(5x6) 294 235.4 208.3 184.3 163.1 304.1
NPV(Leasing) = 294+235.4+208.3+184.3+163.1+304.1 = 801.2
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 :
90
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 High Purchase I
t
(1t
c
)PR
t
+
 LR
t
(1t
c
) I
t
(1t
c
) PR
t
D
t
(t
c
) NSV
t
D
t
(t
c
)+NSV
t
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
91
+
(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.
Chapter 26
WORKING CAPITAL POLICY
Average inventory
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
2. Inventory period = = 56.0 days
750/365
(140+150)/2
92
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
Rs.
3. 1. Sales 3,600,000
Less : Gross profit (25 per cent) 900,000
Total manufacturing cost 2,700,000
Less : Materials 900,000
Wages 720,000 1,620,000
Manufacturing expenses 1,080,000
2. Cash manufacturing expenses 960,000
(80,000 x 12)
3. Depreciation : (1) – (2) 120,000
4. Total cash cost
Total manufacturing cost 2,700,000
Less: Depreciation 120,000
Cash manufacturing cost 2,580,000
Add: Administration and sales
promotion expenses 360,000
2,940,000
A : Current Assets Rs.
Total cash cost 2,940,000
Debtors x 2 = x 2 = 490,000
12 12
Material cost 900,000
Raw material x 1 = x 1 = 75,000
stock 12 12
Cash manufacturing cost 2,580,000
Finished goods x 1 = x 1 = 215,000
stock 12 12
93
Cash balance A predetermined amount = 100,000
Sales promotion expenses 120,000
Prepaid sales x 1.5 = x 1.5 = 15,000
promotion 12 12
expenses
Cash balance A predetermined amount = 100,000
A : Current Assets = 995,000
B : Current Liabilites Rs.
Material cost 900,000
Sundry creditors x 2 = x 2 = 150,000
12 12
Manufacturing One month’s cash
expenses outstanding manufacturing expenses = 80,000
Wages outstanding One month’s wages = 60,000
B : Current liabilities 290,000
Working capital (A – B) 705,000
Add 20 % safety margin 141,000
Working capital required 846,000
94
Chapter 27
CASH AND LIQUIDITY MANAGEMENT
1. The forecast of cash receipts, cash payments, and cash position is prepared in the
statements given below
Forecast of Cash Receipts (Rs. in 000’s)
November December January February March April May June
1. Sales 120 120 150 150 150 200 200 200
2. Credit sales 84 84 105 105 105 140 140 140
3. Cash sales 36 36 45 45 45 60 60 60
4. Collection of receivables
(a) Previous month 33.6 33.6 42.0 42.0 42.0 56.0 56.0
(b) Two months earlier 50.4 50.4 63.0 63.0 63.0 84.0
5. Sale of machine 70.0
6. Interest on securities 3.0
7. Total receipts 129.0 137.4 150.0 235.0 179.0 203.0
(3+4+5+6)
Forecast of Cash Payments (Rs. in 000’s)
December January February March April May June
1. Purchases 60 60 60 60 80 80 80
2. Payment of accounts 60 60 60 60 80 80
payable
3. Cash purchases 3 3 3 3 3 3
4. Wage payments 25 25 25 25 25 25
5. Manufacturing
expenses 32 32 32 32 32 32
6. General, administrative
& selling expenses 15 15 15 15 15 15
95
7. Dividends 30
8. Taxes 35
9. Acquisition of
machinery 80
Total payments(2to9) 135 135 215 135 155 220
Summary of Cash Forecast (Rs.in 000’s)
January February March April May June
1. Opening balance 28
2. Receipts 129.0 137.4 150.0 235.0 179.0 203.0
3. Payments 135.0 135.0 215.0 135.0 155.0 220.0
4. Net cash flow(23) (6.0) 2.4 (65.0) 100.0 24.0 (17.0)
5. Cumulative net cash flow (6.0) (3.6) (68.6) 31.4 55.4 (38.4)
6. Opening balance +
Cumulative net cash flow 22.0 24.4 (40.6) 59.4 83.4 66.4
7. Minimum cash balance
required 30.0 30.0 30.0 30.0 30.0 30.0
8. Surplus/(Deficit) (8.0) (5.6) (70.6) 29.4 53.0 36.4
2. 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
96
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)
3. 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:
Opening
Balance
30,00
0
46,00
0
62,00
0
78,000
94,000
1,10,00
0
1,26,0
00
1,42,0
00
1,58,0
00
1,74,0
00
Add: Cheque
received
20,00
0
20,00
0
20,00
0
20,000
20,000
20,000
20,000
20,000
20,000
20,000
Less: Cheque
issued
4,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000
Closing
Balance
46,00
0
62,00
0
78,00
0
94,000 1,10,0
00
1,26,00
0
1,42,0
00
1,58,0
00
1,74,0
00
1,90,0
00
Books of the
Bank:
Opening 30,00 30,00 30,00 30,000 30,000 30,000 50,000 70,000 1,06,0
97
Balance 0 0 0 90,000 00
Add: Cheques
realised
     20,000 20,000 20,000
20,000
20,000
Less: Cheques
debited
       
4,000
4,000
Closing
Balance
30,00
0
30,00
0
30,00
0
30,000 30,000 50,000 70,000 90,000 1,06,0
00
1,22,0
00
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.
4. 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
5.
3 3 bo
2
RP = + LL
4I
UL = 3 RP – 2 LL
I = 0.12/360 = .00033, b = Rs.1,500, o = Rs.6,000, LL = Rs.100,000
3 3 x 1500 x 6,000 x 6,000
RP = + 100,000
4 x .00033
= 49,695 + 100,000 = Rs.149,695
UL = 3RP – 2LL = 3 x 149,695 – 2 x 100,000
98
= Rs.249,085
Chapter 28
CREDIT MANAGEMENT
1. Δ RI = [ΔS(1V) ΔSb
n
](1t) k ΔI
Δ S
Δ I = x ACP x V
360
Δ S = Rs.10 million, V=0.85, b
n
=0.08, ACP= 60 days, k=0.15, t = 0.40
Hence, ΔRI = [ 10,000,000(10.85) 10,000,000 x 0.08 ] (10.4)
0.15 x 10,000,000 x 60 x 0.85
360
= Rs. 207,500
2. Δ RI = [ΔS(1V) ΔSb
n
] (1t) – k Δ I
S
o
ΔS
Δ I = (ACP
N
– ACPo) +V(ACP
N
)
360 360
99
ΔS=Rs.1.5 million, V=0.80, b
n
=0.05, t=0.45, k=0.15, ACP
N
=60, ACP
o
=45, S
o
=Rs.15 million
Hence ΔRI = [1,500,000(10.8) – 1,500,000 x 0.05] (1.45)
0.15 (6045) 15,000,000 + 0.8 x 60 x 1,500,000
360 360
= 123750 – 123750 = Rs. 0
3. Δ RI = [ΔS(1V) –Δ DIS ] (1t) + k Δ I
Δ DIS = p
n
(S
o
+ΔS)d
n
– p
o
S
o
d
o
S
o
ΔS
Δ I = (ACP
o
ACP
N
)  x ACP
N
x V
360 360
S
o
=Rs.12 million, ACP
o
=24, V=0.80, t= 0.50, r=0.15, p
o
=0.3, p
n
=0.7,
ACP
N
=16, ΔS=Rs.1.2 million, d
o
=.01, d
n
= .02
Hence
ΔRI = [ 1,200,000(10.80){0.7(12,000,000+1,200,000).02
0.3(12,000,000).01}](10.5)
12,000,000 1,200,000
+ 0.15 (2416)  x 16 x 0.80
360 360
= Rs.79,200
4. Δ RI = [ΔS(1V) ΔBD](1t) –kΔ I
ΔBD=b
n
(S
o
+ΔS) –b
o
S
o
S
o
ΔS
ΔI = (ACP
N
–ACP
o
) + x ACP
N
x V
360 360
S
o
=Rs.50 million, ACP
o
=25, V=0.75, k=0.15, b
o
=0.04, ΔS=Rs.6 million,
ACP
N
=40 , b
n
= 0.06 , t = 0.3
ΔRI = [ Rs.6,000,000(1.75) –{.06(Rs.56,000,000).04(Rs.50,000,000)](10.3)
Rs.50,000,000 Rs.6,000,000
 0.15 (4025) + x 40 x 0.75
100
360 360
=  Rs.289.495
5. 30% of sales will be collected on the 10
th
day
70% of sales will be collected on the 50
th
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
6. 30% of sales are collected on the 5
th
day and 70% of sales are collected on the
25
th
day. So,
ACP = 0.3 x 5 + 0.7 x 25 = 19 days
Rs.10,000,000
Value of receivables = x 19
360
= Rs.527,778
Investment in receivables = 0.7 x 527,778
= Rs.395,833
7. Since the change in credit terms increases the investment in receivables,
ΔRI = [ΔS(1V) ΔDIS](1t) – kΔI
S
o
=Rs.50 million, ΔS=Rs.10 million, d
o
=0.02, p
o
=0.70, d
n
=0.03,p
n
=0.60,
ACP
o
=20 days, ACP
N
=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
Δ I = (2420) + x 24 x 0.85
360 360
= Rs.1.2222 million
Δ RI = [ 10,000,000 (1.85) – 380,000 ] (1.4) – 0.12 x 1,222,222
= Rs.525,333
101
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
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 = p
1
x 2000 –(1p
1
)8000
Setting expected profit equal to zero and solving for p
1
gives :
p
1
x 2000 – (1 p
1
)8000 = 0 p
1
= 0.80
Hence the minimum probability that the customer must pay is 0.80
MINICASE
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
 Posttax cost of capital : 12 percent
 ACP on credit sales : 20 days
102
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)  ∆Sb
n
] (1 – t) – R ∆ I
∆S
where ∆ I = x ACP x V
360
∆ RI = [50,000,000 (10.8) – 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)  ∆Sb
n
] (1 – t) – R ∆ I
S
o
∆S
where ∆I = (ACP
n
– ACP
o
) + V (ACP
n
)
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
S
o
∆S
103
= (ACP
o
– ACP
n
) – 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
= p
n
(S
o
+ ∆S) d
n
– p
o
S
o
d
o
= 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
Chapter 29
INVENTORY MANAGEMENT
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
104
2UF = 58 units (approx)
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 11
th
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 11
th
order relates to the present year. Hence the ordering cost for the present year will be 10.2 x
Rs.300
c. Total cost of carrying and ordering inventories
980
= [ 10.2 x 300 + x 6.25 ] = Rs.6122.5
2
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’(PD)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
105
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 + 622729 =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
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
106
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
107
43.6 174,400 0.10
73.6 294,400
*
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
6. Reorder point is given by the formula : S(L) + F SR (L)
= 30 x 40 + 2.00 30 x 1,000 x 40 = 3,391 units
7.
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
108
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
109
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 18 53.3 15,700 11.6
15 135,200
Chapter 30
WORKING CAPITAL FINANCING
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
110
d. 0.01 360
x = 0.364 = 36.4%
0.99 10
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
3. The maximum permissible bank finance under the three methods suggested by
The Tandon Committee are :
Method 1 : 0.75(CACL) = 0.75(3612) = Rs.18 million
Method 2 : 0.75(CA)CL = 0.75(3612 = Rs.15 million
Method 3 : 0.75(CACCA)CL = 0.75(3618)12 = Rs.1.5 million
111
Chapter 31
WORKING CAPITAL MANAGEMENT :EXTENSIONS
1.(a) The discriminant function is :
Z
i
= aX
i
+ bY
i
where Z
i
= discriminant score for the ith account
X
i
= quick ratio for the ith account
Y
i
= EBDIT/Sales ratio for the ith account
The estimates of a and b are :
o
y
2
. dx  o
xy
. dy
a =
o
x
2
. o
y
2
 o
xy
.o
xy
o
x
2
. dy ÷ o
xy
. dx
b =
o
x
2
. o
y
2
÷ o
xy
. o
xy
The basic calculations for deriving the estimates of a and b are given
the accompanying table.
112
Drawing on the information in the accompanying table we find that
¿X
i
= 19.81 ¿Y
i
= 391 ¿(X
i
X)
2
¿(Y
i
Y)
2
¿(X
i
X)(Y
i
Y)
X = 0.7924 Y = 15.64 = 0.8311 =1661.76 = 10.007
Account X
i
Y
i
(X
i
X) (Y
i
Y) (X
i
X
)2
(Y
i
Y
)2
(X
i
X)(Y
i
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 X
i
for group 1 13.42
X
1
= = = 0.8947
15 15
113
Sum of X
i
for group 2 6.39
X
2
= = = 0.6390
10 10
Sum of Y
i
for group 1 295
Y
1
= = = 19.67
15 15
Sum of Y
i
for group 2 96
Y
2
= = = 9.60
10 10
1 0.8311
o
x
2
= ¿(X
i
–X)
2
= = 0.0346
n1 251
1 1661.76
o
y
2
= ¿(Y
i
– Y)
2
= = 69.24
n1 251
1 10.0007
o
xy
= ¿(X
i
X)(Y
i
Y) = = 0.4167
n1 251
dx = X
1
 X
2
= 0.8947 – 0.6390 = 0.2557
dy = Y
1
– Y
2
= 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 :
Z
i
= 6.079 X
i
+ 0.1089 Y
i
(b) Choice of the cutoff point
The Z
i
score for various accounts are shown below
114
Z
i
scores for various accounts
Account No. Z
i
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 Z
i
scores arranged in an ascending order are shown below
Good(G)
Account Number Z
i
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
115
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 Z
i
score which represents the midpoint between the
Z
i
scores of account numbers 19 and 4 results in the minimum number of misclassifications . This Z
i
score is :
5.7292 + 6.6918
= 6.2105
2
Given this cutoff Z
i
score, there is just one misclassification (Account number 5)
116
Chapter 4
ANALYSING FINANCIAL PERFORMANCE
Net profit
1. Return on equity =
Equity
= Net profit Net sales Total assets
x x
Net sales Total assets Equity
1
= 0.05 x 1.5 x = 0.25 or 25 per cent
0.3
Debt Equity
Note : = 0.7 So = 10.7 = 0.3
Total assets Total assets
Hence Total assets/Equity = 1/0.3
2. PBT = Rs.40 million
PBIT
Times interest covered = = 6
117
Interest
So PBIT = 6 x Interest
PBIT – Interest = PBT = Rs.40 million
6 x Interest = Rs.40 million
Hence Interest = Rs.8 million
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 covered ratio = = 8
150,000
4. CA = 1500 CL = 600
Let BB stand for bank borrowing
CA+BB
= 1.5
CL+BB
1500+BB
= 1.5
600+BB
BB = 120
1,000,000
5. Average daily credit sales = = 2740
365
160000
ACP = = 58.4
2740
If the accounts receivable has to be reduced to 120,000 the ACP must be:
118
120,000
x 58.4 = 43.8days
160,000
Current assets
6. Current ratio = = 1.5
Current liabilities
Current assets  Inventories
Acidtest ratio = = 1.2
Current liabilities
Current liabilities = 800,000
Sales
Inventory turnover ratio = = 5
Inventories
Current assets  Inventories
Acidtest 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
7. Debt/equity = 0.60
Equity = 50,000 + 60,000 = 110,000
So Debt = 0.6 x 110,000 = 66,000
Hence Total assets = 110,000+66,000 = 176,000
119
Total assets turnover ratio = 1.5
So Sales = 1.5 x 176,000 = 264,000
Gross profit margin = 20 per cent
So Cost of goods sold = 0.8 x 264,000 = 211,200
Day’s sales outstanding in accounts receivable = 40 days
Sales
So Accounts receivable = 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
Assuming that the debt of 66,000 represent current liabilities
Cash + Accounts receivable
Acidtest ratio =
Current liabilities
Cash + 29,333
= = 1.2
66,000
So Cash = 49867
Plant and equipment = Total assets  Inventories – Accounts receivable – Cash
= 176,000  42240  29333 – 49867
= 54560
Pricing together everything we get
Balance Sheet
Equity capital 50,000 Plant & equipment 54,560
Retained earnings 60,000 Inventories 42,240
Debt(Current liabilities) 66,000 Accounts receivable 29,333
Cash 49,867
176,000 176,000
Sales 264,000
120
Cost of goods sold 211,200
Cash & bank balances + Receivables + Inventories + Prepaid expenses
8. (i) Current ratio =
Shortterm bank borrowings + Trade creditors + Provisions
5,000,000+15,000,000+20,000,000+2,500,000
=
15,000,000+10,000,000+5,000,000
42,500,000
= = 1.42
30,000,000
Current assets – Inventories 22,500,000
(ii) Acidtest ratio = = = 0.75
Current liabilities 30,000,000
Longterm debt + Current liabilities
(iii) Debtequity ratio =
Equity capital + Reserves & surplus
12,500,000 + 30,000,000
= = 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
121
95,000,000/15,000,000
Net sales 95,000,000
(vii) 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 = = = 20.1%
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 1.42 1.5
Acidtest ratio 0.75 0.80
Debtequity ratio 1.31 1.5
Times interest covered ratio 3.02 3.5
Inventory turnover ratio 3.6 4.0
Average collection period 57.6 days 60 days
Total assets turnover ratio 1.27 1.0
Net profit margin ratio 5.4% 6%
Earning power 20.1% 18%
Return on equity 15.7% 15%
Note that solutions to problems 10 & 11 are not given
MINICASE
Solution:
(a) Key ratios for 20 X 5
12.4
Current ratio = = 0.93
13.4
122
8.8 + 6.7
Debtequity ratio = = 0.98
6.5 + 9.3
57.4
Total assets turnover ratio = = 1.96
[(34 – 6.6) + (38 – 6.7)] / 2
3.0
Net profit margin = = 5.2 percent
57.4
5
Earning power = = 17.0 percent
[(34 – 6.6) + (38 – 6.7)] / 2
3.0
Return on equity = = 20.2 percent
(13.9 + 15.8) / 2
(b) Dupont Chart for 20 x 5
–
÷
Return on
total assets
10.2%
Net profit
margin
5.2%
Net profit
3.0
Net sales
57.4
Net sales
57.4
Net sales +/
Nonop. surplus
deficit 57.8
Total costs
54.8
123
÷
+
+
(c) Common size and common base financial statements
Common Size Financial Statements
Profit and Loss Account
Regular (in million) Common Size (%)
20 X 4 20 X 5 20 X 4 20 X 5
 Net sales 39.0 57.4 100 100
 Cost of goods sold 30.5 45.8 78 80
 Gross profit 8.5 11.6 22 20
 Operating expenses 4.9 7.0 13 12
 Operating profit 3.6 4.6 9 8
 Nonoperating surplus /
deficit
0.5 0.4 1 1
 PBIT 4.1 5.0 11 9
 Interest 1.5 2.0 4 3
 PBT 2.6 3.0 7 5
 Tax    
 Profit after tax 2.6 3.0 7 5
Balance Sheet
Total asset
turnover
1.96
Average total
assets
29.35
Average
fixed assets
21.4
Average
net current
assets 54.0
Average
other assets
2.55
124
Regular (in million) Common Size (%)
20 X 4 20 X 5 20 X 4 20 X 5
 Shareholders’ funds 13.9 15.8 51 50
 Loan funds 13.5 15.5 49 50
Total 27.4 31.3 100 100
 Net fixed assets 19.6 23.2 72 74
 Net current assets 5.1 5.7 19 18
 Other assets 2.7 2.4 10 8
Total 27.4 31.3 100 100
Common Base Year Financial Statements
Profit and Loss Account
Regular (in million) Common Base Year(%)
20 X 4 20 X 5 20 X 4 20 X 5
 Net sales 39.0 57.4 100 147
 Cost of goods sold 30.5 45.8 100 150
 Gross profit 8.5 11.6 100 136
 Operating expenses 4.9 7.0 100 43
 Operating profit 3.6 4.6 100 128
 Nonoperating surplus /
deficit
0.5 0.4 100 80
 PBIT 4.1 5.0 100 122
 Interest 1.5 2.0 100 133
 PBT 2.6 3.0 100 115
 Tax   100 100
 Profit after tax 2.6 3.0 100 115
Balance Sheet
Regular (in million) Common Base Year(%)
20 X 4 20 X 5 20 X 4 20 X 5
125
 Shareholders’ funds 13.9 15.8 100 114
 Loan funds 13.5 15.5 100 115
Total 27.4 31.3 100 114
 Net fixed assets 19.6 23.2 100 118
 Net current assets 5.1 5.7 100 112
 Other assets 2.7 2.4 100 89
Total 27.4 31.3 100 114
(d) The financial strengths of the company are:
 Asset productivity appears to be good.
 Earning power and return on equity are quite satisfactory
 Revenues have grown impressively over 20 x 4 – 20 x 5
The financial weaknesses of the company are:
 Current ratio is unusually low
 While revenues grew impressively, costs rose even faster: As a result profit margins
declined
 The company did not have any tax liability in the last two years. If the company has to
bear the burden of regular taxes, its return on equity will be adversely impacted
(e) The following are the problems in financial statement analysis
 There is no underlying theory
 It is difficult to find suitable benchmarks for conglomerate firms
 Firms may resort to window dressing
 Financial statements do not reflect price level changes
 Diversity of accounting policies may vitiate financial statement analysis
 It is somewhat difficult to judge whether a certain ratio is ‘good’ or ‘bad’
(f) The qualitative factors relevant for evaluating the performance and prospects of a
company are as follows:
 Are the company’s revenues tied to one key customer?
 To what extent are the company’s revenues tied to one key product?
 To what extent does the company rely on a single supplier?
 What percentage of the company’s business is generated overseas?
 How will competition impact the company?
 What are the future prospects of the firm?
 What could be the effect of the changes in the legal and regulatory environment?
126
Chapter 5
BREAKEVEN ANALYSIS AND LEVERAGES
1. a. EBIT = Q(PV)F
= 20,000(106)50,000 = Rs.30,000
b. EBIT = 12,000(5030)200,000 = Rs.40,000
2. EBIT = Q(PV)F
EBIT=Rs.30,000 , Q=5,000 , P=Rs.30 , V=Rs.20
So, 30,000 = 5,000(3020)F
So, F = Rs.20,000.
Q(PV)
3. DOL =
Q(PV)F
P=Rs.1,000 ,V=Rs.600, F=Rs.100,000
400(1,000600)
DOL(Q=400) = = 2.67
400(1,000600)100,000
127
600(1,000600)
DOL(Q=600) = = 1.71
600(1,000600)1,00,000
4. DOL(Q=15000) = 2.5
EBIT(Q=15000) = Rs.3,00,000
Percentage change in EBIT = DOL x Percentage change in Q
If the percentage change in Q is –10%
Percentage change in EBIT = 2.5 x –10% =  25%
If the percentage change in Q is + 5%
Percentage change in EBIT = 2.5 x 5% = 12.5%
Hence the possible forecast errors of EBIT in percentage terms is –25% to
12.5%
The corresponding value range of EBIT is Rs.225,000 to Rs.337,500
5. Break even point in units
F 50,000
Q = = =10,000 units
PV 127
Break even point in rupees:
Q x P = 10,000 x Rs.12 = Rs,120,000
To earn a pretax income of Rs.60,000 the number of units to be sold is
F + Target pretax income
Q =
PV
= 50,000 + 60,000
= 22,000 units
127
To earn an aftertax income of Rs.60,000 if the tax rate is 40 per cent, the
Pretax income must be Rs.60,000
= Rs.100,000
1.4
Hence the number of units to be sold to earn an aftertax income of Rs.60,000
is :
50,000 + 100,000
Q = = 30,000 units
127
128
6. PV
= 0.30 PV = Rs.6 F=20,000
P
20000 6
Q = = 3,333 P = = Rs.20
6 0.30
Break even point in rupees = Rs.66,666
When net income is Rs.60,000
20,000 +60,000
Q = = 13,333
6
Sales in rupees = 13,333 x Rs.20 = Rs.266,666
10,000
7. (a) P = Rs.30 ,V=Rs.16, F=Rs.10,000 Q = = 714.3 bags
3016
(b) Profit when the quantity is 3000 bags
Profit =3,000(3016)10000 = Rs.32000
10 per cent increase in production means that the quantity is 3300 bags
At that production
Profit = 3,300(3016)10,000 = Rs.36200
So, the percentage change in profit is :
3620032000
= 13.1%
32000
(c) A 10 per cent increase in selling price means that P= Rs.33
Breakeven point when P= Rs.33
10,000
Q = = 588.2 bags
3316
(d) A 50 per cent increase in fixed costs means that F=Rs.15,000
Breakeven point when F= Rs.15,000
15,000
129
Q = = 882.4 bags
3316
(e) If V= Rs.20, the breakeven point is :
10,000
Q = = 1000 bags
3020
8. A B C D
Selling price per unit Rs.10 Rs.16.66 Rs.20 Rs.10
Variable cost per unit Rs.6 Rs.8.33 Rs.12 Rs.5
Contribution margin per unit Rs.4 Rs.8.33 Rs.8 Rs.5
Contribution margin ratio 0.4 0.5 0.4 0.5
Total fixed costs Rs.16000 Rs.100000 Rs.160000 Rs.60000
Breakeven point in units 4000 12000 20000 12000
Breakeven sales(Rs.) Rs.40000 Rs.200000 Rs.400000 Rs.120000
Net income(loss)before tax Rs.30000 Rs.80000 Rs.(40000) Rs.40000
No.of units sold 11500 21600 15000 20000
9. (a) Breakeven point for product P
30,000
= 3,000 units
3020
Breakeven point for product Q
100,000
= 5,000 units
5030
Breakeven point for product R
200,000
= 5,000 units
8040
(b) The weighted contribution margin is :
5000 8,000 6,000
x Rs.10 + x Rs.20 + x Rs.40 = Rs.23.68
19000 19000 19000
10. EBIT
DFL =
D
p
130
EBIT – I 
T
at Q = 20000
EBIT= 20000(Rs.40Rs.24)=Rs.320,000
Rs.320,000
DFL(Q=20,000) =
Rs.10,000
Rs.320,000Rs.30,000 
(1.5)
= 1.185
11. (a) EBIT = Q(PV) – F
Firm A : 20,000(Rs.20Rs.15) – Rs.40,000 = Rs.60,000
Firm B : 10,000(Rs.50Rs.30)  Rs.70,000 = Rs.130,000
Firm C : 3,000(Rs.100Rs.40) Rs.100,000 = Rs.80,000
(EBITI) (1T)  D
p
(b) EPS =
n
(Rs.60,000Rs.10,000)(1.4)Rs.5,000
Firm A : = Rs.1.9
10,000
(Rs.130,000Rs.20,000)(1.5)Rs.5,000
Firm B : = Rs.4.17
12,000
(Rs.80,000Rs.40,000)(1.6)Rs.10,000
Firm C : = Rs.0.40
15,000
F + I
(c) BEP =
P – V
Rs.40,000 + Rs.10,000
Firm A : = 10,000 units
Rs.20 – Rs.15
Rs.70,000 + Rs.20,000
Firm B : = 4,500 units
131
Rs.50 – Rs.30
Rs.100,000 + Rs.40,000
Firm C : = 2,333 units
Rs.100 – Rs.40
Q(PV)
(d) DOL =
Q(PV)F
20,000(Rs.20Rs.15)
Firm A : = 1.67
20,000(Rs.20Rs.15) Rs.40,000
10,000(Rs.50Rs.30)
Firm B : = 1.54
10,000(Rs.50Rs.30)Rs.70,000
3,000(Rs.100Rs.40)
Firm C : = 2.25
3,000(Rs.100Rs.40)Rs.100,000
EBIT
(e) DFL =
D
p
EBIT – I 
(1T)
Rs.60,000
Firm A : = 1.44
Rs.5000
Rs.60,000Rs.10,000 
(1.4)
Rs.130,000
Firm B : = 1.30
Rs.5,000
Rs.130,000Rs.20,000 
(1.5)
Rs.80,000
Firm C : = 5.333
Rs.10,000
Rs.80,000Rs.40,000
132
(1.6)
(f) DTL = DOL x DFL
Firm A : 1.67 x 1.44 = 2.40
Firm B : 1.54 x 1.30 = 2.00
Firm C : 2.25 x 5.333 = 12.00
Chapter 6
FINANCIAL PLANNING AND BUDGETING
1. The proforma income statement of Modern Electronics Ltd for year 3 based on the per cent
of sales method is given below
Average per cent Proforma income statement
of sales for year 3 assuming sales of
1020
Net sales 100.0 1020.0
Cost of goods sold 76.33 778.57
Gross profit 23.67 241.43
Selling expenses 7.40 75.48
General & administration expenses 6.63 67.63
Depreciation 6.75 68.85
Operating profit 2.90 29.58
Nonoperating surplus/deficit 1.07 10.91
Earnings before interest and taxes 3.96 40.39
Interest 1.24 12.65
Earnings before tax 2.72 27.74
Tax 1.00 10.20
Earnings after tax 1.72 17.54
133
Dividends (given) 8.00
Retained earnings 9.54
2. The proforma income statement of Modern Electronics for year 3 using the
the combination method is given below :
Average per cent Proforma income statement
of sales for year 3
Net sales 100.0 1020.0
Cost of goods sold 76.33 778.57
Gross profit 23.67 241.43
Selling expenses 7.40 75.48
General & administration expenses Budgeted 55.00
Depreciation Budgeted 60.00
Operating profit 50.95
Nonoperating surplus/deficit 1.07 10.91
Earnings before interest and taxes 61.86
Interest Budgeted 12.0
Earnings before tax 49.86
Tax 1.00 10.20
Earnings after tax 39.66
Dividends (given) Budgeted 8.00
Retained earnings 31.66
134
3. The proforma balance sheet of Modern Electronics Ltd for year 3 is given below
Average of percent Projections for year 3
of sales or some based on a forecast
other basis sales of 1400
Net sales 100.0 1020.0
ASSETS
Fixed assets (net) 40.23 410.35
Investments No change 20.00
Current assets, loans & advances :
Cash and bank 1.54 15.71
Receivables 22.49 229.40
Inventories 21.60 220.32
Prepaid expenses 5.09 51.92
Miscellaneous expenditure & losses No change 14.00
961.70
LIABILITIES :
135
Share capital :
Equity No change 150.00
Reserves & surplus Proforma income 160.66
statement
Secured loans:
Term loans No change 175.00
Bank borrowings No change 199.00
Current liabilities :
Trade creditors 17.33 176.77
Provisions 5.03 51.31
External funds requirement Balancing figure 48.96
961.7
A L
4. EFR =  AS – m S
1
(1d)
S S
800 190
=  300 – 0.06 x 1,300 (10.5)
1000 1000
= (0.61 x 300) – (0.06) x 1,300 x (0.5)
= 183 – 39 = Rs.144.
Projected Income Statement for Year Ending 31
st
December , 2001
Sales 1,300
Profits before tax 195
Taxes 117
Profit after tax (6% on sales) 78
Dividends 39
Retained earnings 39
136
Projected Balance Sheet as at 31.12 2001
Liabilities Assets
Share capital 150 Fixed assets 520
Retained earnings 219 Inventories 260
Term loans (80+72) 152 Receivables 195
Shortterm bank borrowings 272 Cash 65
(200 + 72)
Accounts payable 182
Provisions 65
1,040 1,040
A L
5. (a) EFR =  AS – m S
1
(1 –d)
S S
150 30
=  x 80 – (0.625) x 240 x (0.5)
160 160
= (60 – 7.5) = 52.5
(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
Shortterm bank 30.00 Cash 15
borrowings
Trade creditors 37.50
Provisions 7.50
225.00 225.00
137
(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=  AS – mS
1
(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
138
Balance Sheet as on 31
st
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
Shortterm bank borrowings 30.00 Cash (10x240/160) 15.00
Trade creditors 37.50
Provisions 7.50
225.00 225.00
6. EFR A L m (1+g) (1d)
=  
AS 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)
(0.80.5)  = 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
7. (a) EFR =  AS – mS
1
(1d)
S S
320 70
=  x 100 – (0.05) (500) (0.5)
400 400
= Rs.50
(b) Let CA = denote Current assets
139
CL = Current liabilities
SCL = Spontaneous current liabilities
STL = Shortterm bank borrowings
FA = Fixed assets
and LTL = Longterm loans
i. Current ratio > 1.25
CA
i.e greater than or equal to 1.25 or
CL
CA
> 1.25
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) s 237.50
or 1.25 STL s 237.50 ÷ (8.50 x 1.25)
1285.125
or STL =
1.25
i.e STL s Rs.102.50
ii. Ratio of fixed assets to long term loans > 1.25
FA
> 1.25
LTL
At the end of 20X1 FA = 130 x 1.25 = 162.5
162.5
LTL s or LTL = Rs.130
1.25
If A STL and A LTL denote the maximum increase in ST borrowings & LT
borrowings , we have :
A STL = STL (20X1) – STL (20X1) = 102.50 – 60.00 = 42.50
A LTL = LTL (20X1) LTL (20X1) = 130.00 – 80.00 = 50.00
Hence, the suggested mix for raising external funds will be :
Shortterm borrowings 42.50
Longterm loans 7.50
Additional equity issue 
140
50.00
A L
8. EFR =  A S – m S
1
(1d)
S S
A S
Therefore, mS
1
(1d) –  AS represents surplus funds
S S
Given m= 0.06, S
1
=11,000, d= 0.6 , L= 3,000 S= 10,000 and
surplus funds = 150 we have
A 3,000
(0.06) 11,000 (10.6)   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
9. m= .05 , d = 0.6 , A/E = 2.5 , A/S = 1.4
m (1d)A/E .05 (10.6) 2.5
(a) g = = = 3.70 per cent
A/S –m(1d)A/E 1.4 .05 (10.6) 2.5
.05 (10.6) x A/E
(b) 0.5 = A/E = 3.33
2.4  .05 (10.6) A/E
d = 0.466
The dividend payout ratio must be reduced from 60 per cent to 46.6 per cent
.05 (10.6) x A/E
(c) .05 = A/E = 3.33
1.4 .05 (10.6) A/E
The A/E ratio must increase from 2.5 to 3.33
m (10.6) 2.5
141
(d) .06 = m = 7.92 per cent
1.4 – m (10.6) x 2.5
The net profit margin must increase from 5 per cent to 7.92 per cent
.05 (10.6) 2.5
(e) .06 = A/S = .883
A/S  .05 (10.6) 2.5
The asset to sales ratio must decrease from 1.4 to 0.883
Chapter 32
CORPORATE VALUATION
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)
 Nonoperating 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 nonoperating income (2) (4)
Tax on EBIT 29.6 33.2
NOPLAT 65.4 71.8
Net investment (50) (50)
Nonoperating cash flow (posttax) 3 6
142
FCFF 18.4 27.8
(b) The financing flow for years 2 and 3 is as follows :
Year 2 Year 3
Aftertax interest expense 14.4 16.8
Cash dividend 30 40
 Net borrowings (30) (30)
+ A Excess marketable securities 30 10
 Aftertax 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
Posttax 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
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 (1t) 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. AWorking capital 80 96 115 138 83
7. FCFF 11 13 16 19 273
(346)
Discount factor 0.876 0.767 0.672 .589
143
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
3. The WACC for different periods may be calculated :
WACC in the high growth period
Year k
d
(1t) = 15% (1t) k
e
= R
f
+  x Market risk premium k
a
= w
d
k
d
(1t)+ w
e
k
e
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
k
d
(1t) = 14 (1 – 0.3) = 9.8%
k
e
= 11 + 1.1 x 6 = 17.6%
k
a
= 0.44 x 9.8 + 0.56 x 17.6 = 14.2%
WACC for the stable growth period
k
d
(1t) = 13 (1 – 0.3) = 9.1%
k
e
= 11 + 1.0 x 5 = 16%
144
k
a
= 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.
Multisoft Limited
Period Growth
rate (%)
EBIT Tax
rate
(%)
EBIT
(1t)
Cap.
exp.
Dep. AWC FCFF D/E Beta WACC
%
PV
Factor
Present
value
0 90 100 60
1 40 126 6 118 140 84 26 36 1:1 1.3 17.6 .850 30.6
2 40 176 12 155 196 118 39 38 1:1 1.3 17.2 .726 27.6
3 40 247 18 203 274 165 50 44 1:1 1.3 16.7 .622 27.4
4 40 346 24 263 384 230 70 39 1:1 1.3 16.3 .535 20.8
5 40 484 30 339 538 323 98 26 1:1 1.3 15.8 .462 12.0
6 34 649 30 454 721 432 132 33 0.8:1 1.1 14.2 .405 13.4
7 28 830 30 581 922 553 169 43 0.8:1 1.1 14.2 .354 15.4
8 22 1013 30 709 1125 675 206 53 0.8:1 1.1 14.2 .310 16.7
9 16 1175 30 822 1305 783 239 61 0.8:1 1.1 14.2 .272 16.9
10 10 1292 30 905 1436 862 263 68 0.8:1 1.1 14.2 .238 16.6
11 10 1421 30 995 1580 948 289 74 0.5:
1.0
1.1 13.7 476
673.4
The present value of continuing value is :
FCF
11
74
x PV factor 10 years = x 0.238 = 476
k – g 0.137 – 0.100
This is shown in the present value cell against year 11.
The value of the firm is equal to :
Present value of FCFF during + Present value of continuing
The explicit forecast period of 10 years value
This adds up to Rs.685.4 million as shown below
MINI CASE
Solution:
Solution:
145
Chapter 33
VALUE BASED MANAGEMENT
1. The value created by the new strategy is calculated below :
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
(1 – .35)
91 74.8 84.5 144.3 159.3 186.6
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
in fixed assets
100 250 85 100 105 120
7. Investment in net
current assets
10 15 70 70 70 54
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
146
Current Income Statement Projection
Values
(Year 0) 1 2 3 4 5
 Sales 2000 2240 2509 2810 3147 3147
 Gross margin (20%) 400 448 502 562 629 629
 Selling and general 160 179 201 225 252 252
administration (8%)
 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 1200 1344 1505 1696 1888 1888
 Equity 1200 1344 1505 1686 1888 1888
Cash Flow Projections
 Profit after tax 188 211 236 264 264
 Depreciation 60 67 75 84 94
 Capital expenditure 132 148 166 185 94
 Increase in current assets 72 81 90 101 
 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
 Prestrategy value = 168/0.15 = 1120
 Value of the strategy = 1154 – 1120 = 34
2. According to the Marakon approach
M r – g
=
B k – g
r  .10
2 =
k  .10
r  .10 = 2k  .20
147
r = 2k  .10
r/k = 2  (.10/k)
Thus r/k is a function of k. Unless k is specified r/k cannot be determined.
3. (a) NOPAT for 20X1
PBIT (1 – T) = 24 (0.65) = 15.6
(b) Return on capital for 20X1
NOPAT 15.6
= = 15.6%
Capital employed 120 – 20 (Noninterest bearing liabilities)
(c) Cost of equity
6% + 0.9 (6%) = 1.4%
(d) Average cost of capital
0.5 x 8% (1  .35) + 0.5 x 11.4% = 8.3%
(e) EVA for 20X1
NOPAT  Average cost of capital x Capital employed
15.6  .083 x 100 = 7.3
4.
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
5. 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
148
9. Capital charge (8x0.14) 140 112 84 56 28
10. EVA (69) 100 128 156 184 212
5 440
NPV = ¿  1000 = 440 x 3.433 – 1000 = 510.5
t=1 (1.14)
t
EVA
t
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
6. 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 = =
PVIFA
14%, 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
7. 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%)
149
2,000,000
= = 98,503
20.304
8. 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
9. 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
150
 Book capital 100 70
(Beginning)
 ROCE 11.62% 16.59%
 ROGI 21.62% 21.62%
 CFROI 15.79% 15.79%
151
Chapter 34
MERGERS, ACQUISITIONS AND RESTRUCTURING
1. The preamalgamation 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 :
Before Amalgamation After Amalgamation
Cox & Box Company
Cox Box Pooling method Purchase
method
Fixed assets 25 10 35 45
Current assets
Goodwill
20 7.5 27.5 30
2.5
Total assets 45 17.5 62.5 77.5
Share capital
(face value @ Rs.10)
20
5
25
20
Reserves & surplus 10 10 20 10
Share premium 15 2.5 17.5 17.5
Debt 45 17.5 42.5 77.5
2. Postmerger 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
3. PV
A
= Rs.25 million, PV
B
= Rs.10 million
Benefit = Rs.4 million, Cash compensation = Rs.11 million
Cost = Cash compensation – PV
B
= Rs.1 million
NPV to Alpha = Benefit – Cost = Rs.3 million
NPV to Beta = Cash Compensation – PV
B
= Rs.1 million
4. Let A stand for Ajeet and J for Jeet
PV
A
= Rs.60 x 300,000 = Rs.18 million
PV
J
= Rs.25 x 200,000 = Rs.5 million
Benefit = Rs.4 million
PV
AJ
= 18 + 5 + 4 = Rs.23 million
152
Exchange ratio = 0.5
The share of Jeet in the combined entity will be :
100,000
o = = 0.25
300,000 + 100,000
a) True cost to Ajeet Company for acquiring Jeet Company
Cost = o PV
AB
 PV
B
= 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
5. a) PV
B
= 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
153
0.667
o = = 0.1177 or 11.77 per cent
5+0.667
shareholding of the combined entity,
The present value of the combined entity will be
PV
AB
= PV
A
+ PV
B
+ Benefit
= Rs.225 million + Rs.24 million + Rs.6.2 million
= Rs.255.2 million
So the cost of the merger is :
Cost = o PV
AB
 PV
B
= .1177 x 255.2  24 = Rs.6.04 million
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
7. (a) The maximum exchange ratio acceptable to shareholders of Vijay Limited is :
S
1
(E
1
+E
2
) PE
12
ER
1
=  +
S
2
P
1
S
2
12 (36+12) 8
=  + = 0.1
8 30 x 8
(b) The minimum exchange ratio acceptable to shareholders of Ajay Limited is :
P
2
S
1
ER
2
=
(PE
12
) (E
1
+E
2
)  P
2
S
2
9 x 12
= = 0.3
9 (36+12)  9 x 8
154
(c) 12 (48) PE
12
ER
1
=  +
8 240
9 x 12
ER
2
=
PE
12
(48)  72
Equating ER
1
and ER
2
and solving for PE
12
gives, PE
12
= 9
When PE
12
= 9
ER
1
= ER
2
= 0.3
Thus ER
1
and ER
2
intersect at 0.3
8. The present value of FCF for first seven years is
16.00 14.30 9.7 0
PV(FCF) =    +
(1.15) (1.15)
2
(1.15)
3
(1.15)
4
0 10.2 16.7
+ + +
(1.15)
5
(1.15)
6
(1.15)
7
=  Rs.20.4 million
The horizon value at the end of seven years, applying the constant growth model is
FCF
8
18
V
4
= = = Rs.257.1 million
0.150.08 0.15 – 0.08
1
PV (V
H
) = 257.1 x = Rs.96.7 million
(1.15)
7
The value of the division is :
 20.4 + 96.7 = Rs.76.3 million
155
MINICASE
Solution:
(a)
Modern Pharma Magnum Drugs Exchange
Ratio
Book value per share 2300 650
= Rs.115 = Rs.65
20 10
65
115
Earnings per share 450 95
= Rs.22.5 = Rs.9.5
20 10
9.5
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 postmerger EPS of Modern Pharma is
(450 + 95) (1.05)
20 + ER X 10
156
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) Postmerger 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
S
1
(E
1
+ E
2
) P/E
12
ER
1
= +
S
2
P
1
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
P
2
S
1
ER
2
=
(P/E
12
) (E
1
+ E
2
) (1 + S) – P
2
S
2
102 x 20
=
12 (450 + 95) (1.02) – 102 X 10
= 0.36
(g) The level of P/E ratio where the lines ER
1
and ER
2
intersect.
To get this, solve the following for P/E
12
157
 S
1
(E
1
+ E
2
) P/E
12
P
2
S
1
+ =
S
2
P
1
S
2
P/E
12
(E
1
+ E
2
) – P
2
S
2
 20 (450 +95) P/E
12
102 x 20
+ =
10 320 x 10 P/E
12
(450 +95) – 1020
 6400 + 545 P/E
12
2040
=
3200 545 P/E
12
– 1020
(545 P/E
12
– 1020) (545 P/E
12
– 6400) = 2040 x 3200
297025 P/E
2
12
– 3488000 P/E
12
– 555900 P/E
12
+6528000 = 6528000
297025 P/E
2
12
= 4043900 P/E
297025 P/E
12
= 4043900
P/E
12
= 13.61
158
Chapter 37
INTERNATIONAL FINANCIAL MANAGEMENT
1. The annualised premium is :
Forward rate – Spot rate 12
x
Spot rate Forward contract length in months
46.50 – 46.00 12
= x = 4.3%
46.00 3
2. 100
100 (1.06) = x 1.07 x F
1.553
106 x 1.553
F = = 1.538
107
A forward exchange rate of 1.538 dollars per sterling pound will mean indifference between
investing in the U.S and in the U.K.
3. (a) The annual percentage premium of the dollar on the yen may be calculated with
reference to 30days futures
105.5 – 105 12
x = 5.7%
105 1
(b) The most likely spot rate 6 months hence will be : 107 yen / dollar
(c) Futures rate 1 + domestic interest rate
=
Spot rate 1 + foreign interest rate
107 1 + domestic interest rate in Japan
=
159
106 1.03
Domestic interest rate in Japan = .0397 = 3.97 per cent
4. S
0
= Rs.46 , r
h
= 11 per cent , r
f
= 6 per cent
Hence the forecasted spot rates are :
Year Forecasted spot exchange rate
1 Rs.46 (1.11 / 1.06)
1
= Rs.48.17
2 Rs.46 (1.11 / 1.06)
2
= Rs.50.44
3 Rs.46 (1.11 / 1.06)
3
= Rs.52.82
4 Rs.46 (1.11 / 1.06)
4
= Rs.55.31
5 Rs.46 (1.11 / 1.06)
5
= Rs.57.92
The expected rupee cash flows for the project
Year Cash flow in dollars Expected exchange Cash flow in rupees
(million) rate (million)
0 200 46 9200
1 50 48.17 2408.5
2 70 50.44 3530.8
3 90 52.82 4753.8
4 105 55.31 5807.6
5 80 57.92 4633.6
Given a rupee discount rate of 20 per cent, the NPV in rupees is :
2408.5 3530.8 4753.8
NPV = 9200 + + +
(1.18)
2
(1.18)
3
(1.18)
4
5807.6 4633.6
+ +
(1.18)
5
(1.18)
6
= Rs.3406.2 million
The dollar NPV is :
3406.2 / 46 = 74.05 million dollars
5. Forward rate 1 + domestic interest rate
=
Spot rate 1 + foreign interest rate
F 1 + .015
160
=
1.60 1 + .020
F = $ 1.592 / £
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.70 1.03
So, the expected spot rate a year from now is : 72 x (1.06 / 1.03) = Rs.72.04
7. (a) The spot exchange rate of one US dollar should be :
12000
= Rs.48
250
(b) One year forward rate of one US dollar should be :
13000
= Rs.50
260
8. (1 + expected inflation in Japan)
2
Expected spot rate = Current spot rate x
2 years from now (1 + expected inflation in UK)
2
(1.01)
2
= 170 x = 163.46 yen / £
(1.03)
2
9. (i) Determine the present value of the foreign currency liability (£100,000) by using
90day 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
161
10. (i) Determine the present value of the foreign currency asset (£100,000) by using
the 90day 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
11. A lower interest rate in the Swiss market will be offset by the depreciation of the US
dollar visàvis the Swiss franc. So Mr.Sehgal’s argument is not tenable.
162
Chapter 40
CORPORATE RISK MANAGEMENT
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
2. Futures price Spot price x Dividend yield
= Spot price 
(1+Riskfree rate)
0.5
(1+Riskfree 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.
3. Futures price
= Spot price + Present value of – Present value
(1+Riskfree 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.
163
164
From the tables we find that FVIFA (20%, 6 years) = FVIFA (24%, 6 years) =
9.930 10.980
Using linear interpolation in the interval, we get: 20% + (10.000 – 9.930) r= (10.980 – 9.930) 7. 1,000 x FVIF (r, 10 years) FVIF (r,10 years) From the tables we find that FVIF (16%, 10 years) = FVIF (18%, 10 years) = 4.411 5.234 = = 5,000 5,000 / 1000 = 5 x 4% = 20.3%
Using linear interpolation in the interval, we get: (5.000 – 4.411) x 2% r = 16% + (5.234 – 4.411) 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 = 10,000 x PVIF (r = 15%, 8 years) = 10,000 x 0.327 = Rs.3,270 = 17.4%
r = 15%
PV
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 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
10.
2
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. 11. The amount that can be withdrawn annually is: 100,000 100,000 A =   =  = Rs.10,608 PVIFA (10%, 30 years) 9.427
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.
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 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 / PVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,165 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) PVIFA (18%, 10 years) Using linear interpolation we get: 5.019 – 5.00 r = 15% + 5.019 – 4.494 = 15.1%
14.
15.
= =
5.019 4.494
x 3%
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
3
2 = 26. 9 years) + Rs.21. ∞ ) 4 .9 Similarly.900 x PVIF (12%.700 x 0.200 x 0.12/6)6.000 x 1.2 PV (Stream C) = Rs.24/4)4 –1 (1 + 0.1 (1+0.12.000 [1 + (0.2.100 x 0.800 x PVIF (12%.851.000 per year from the end of 9th year (beginning of 10th year) for ever: Rs.10.000 x 2.5.712 + Rs. FV5 19 Frequency of compounding 6 times Effective rate (%) (1 + 0.2590. 7 years) + Rs.404 + Rs.452 + Rs.567 + Rs.600 x 0.400 x 0.000 x PVIF (12%.507 + Rs.10.6 2.1.191 Rs.000 (1.9.893 + Rs.1.000 x 0.300 x 0.806 Rs.797 + Rs.2 2.04)20 Rs. 4 years) + Rs.636 + Rs.700 x PVIF (12%. 8 years) + Rs.3. 6 years) + Rs. PV (Stream B) = Rs.322 = Rs. 10 years) = Rs.000 (1.24/12)121 = 12.625.5. 5 years) + Rs.12.16 / 4)]5x4 Rs.910 Rs.600 x PVIF (12%.8 Difference between the effective rate and stated rate (%) 20.6 = 26.PVIF (12%.000 x PVIFA(12%.5.900 x 0.10.1 17.03)20 Rs. 0.12/4)] 5x4 Rs.361 + Rs.500 x PVIF (12%. FV5 = = = = = = = = Rs.030 A Stated rate (%) 12 B 24 4 times C 24 12 times 18.800 x 0.8 Investment required at the end of 8th year to yield an income of Rs.000 [1+( 0.500 x 0.
000 x FVIF (r.476 now is: 21. A constant deposit at the beginning of each year represents an annuity due.283 23.50. the amount to be deposited Rs. FV10 = Rs.5.12 = Rs.000 FVIFA(12%.100.40.20.50.5.000 for 10 years from now because I find a return of 15% quite acceptable.10.12.12 = Rs.530 x PVIF (8%. in terms of the current rupees is: Rs.100.26.000 FVIF (r.000 Rs.26. I would choose Rs.653 = Rs.530 If the inflation rate is 8% per year.000 22.5. PVIFA of an annuity due is equal to : PVIFA of an ordinary annuity x (1 + r) To provide a sum of Rs.12) Rs.10.000 at the end of 8th year .000 Rs.000 From the tables we find that FVIF (15%.000 at the end of 10 years the annual deposit should be Rs. The interest rate implicit in the offer of Rs. 8 years) 2.549 x 1.05)20 = Rs.10 years) = Rs.12. 10 years) = 4.20.20. = 4.2544 A = 5 .000 (1.463 = Rs.046 This means that the implied interest rate is nearly 15%.26. the value of Rs.000 = = Rs.000 after 10 years in lieu of Rs.000 x 2.10 years) = Rs.000 = 17.530 x 0.10 / 2)]10x2 = Rs.26.388 PVIF(12%.000 To have a sum of Rs.= Rs.000 / 0.100.20.50.530 10 years from now.100. 10 years) x (1.10.000 now is: Rs.10 years) = Rs.000 [1 + (0.
24.
The discounted value of Rs.20,000 receivable at the beginning of each year from 2005 to 2009, evaluated as at the beginning of 2004 (or end of 2003) 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 2000 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 1995 to 2000 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
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 26. 30 per cent of the pension amount is 0.30 x Rs.600 = Rs.180 Assuming that the monthly interest rate corresponding to an annual interest rate of 12% is 1%, the discounted value of an annuity of Rs.180 receivable at the end of each month for 180 months (15 years) is: Rs.180 x PVIFA (1%, 180) (1.01)180  1 Rs.180 x  = Rs.14,998 .01 (1.01)180 If Mr. Ramesh borrows Rs.P today on which the monthly interest rate is 1% P x (1.01)60 = P x 1.817 = P = Rs.14,998 Rs.14,998 Rs.14,998  = Rs.8254 1.817
27.
Rs.300 x PVIFA(r, 24 months) = Rs.6,000 PVIFA (4%,24) = Rs.6000 / Rs.300 From the tables we find that: PVIFA(1%,24) =
= 20
21.244
6
PVIFA (2%, 24)
=
18.914
Using a linear interpolation 21.244 – 20.000 r = 1% + 21.244 – 18,914 = 1.53%
x 1%
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% 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.10 million x PVIF (8%, 3 years) + Rs.10 million x PVIF (8%, 4 years) + Rs.10 million x PVIF (8%, 5 years) = Rs.10 million (0.794 + 0.735 + 0.681) = Rs.2.21 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.2.21 million A x 5.867 = Rs.2.21 million A = 5.867 = Rs.2.21 million A = Rs.2.21 million / 5.867 = Rs.0.377 million 29. Let `n’ be the number of years for which a sum of Rs.20,000 can be withdrawn annually. Rs.20,000 x PVIFA (10%, n) = Rs.100,000 PVIFA (15%, n) = Rs.100,000 / Rs.20,000 = 5.000 From the tables we find that PVIFA (10%, 7 years) = PVIFA (10%, 8 years) =
4.868 5.335
Thus n is between 7 and 8. Using a linear interpolation we get 5.000 – 4.868 5.335 – 4.868
n=7+
x 1 = 7.3 years
7
30.
Equated annual installment
= 500000 / PVIFA(14%,4) = 500000 / 2.914 = Rs.171,585 Loan Amortisation Schedule
Year 1 2 3 4
Beginning amount 500000 398415 282608 150588
Annual installment 171585 171585 171585 171585
Interest 70000 55778 39565 21082
Principal repaid 101585 115807 132020 150503
Remaining balance 398415 282608 150588 85*
(*) rounding off error
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) PVIFA (13%, n) = = 1,500,000 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. 32. Expected value of iron ore mined during year 1 = Rs.300 million assuming a
Expected present value of the iron ore that can be mined over the next 15 years price escalation of 6% per annum in the price per tonne of iron 1 – (1 + g)n / (1 + i)n ig
= Rs.300 million x
= 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
8
000 2.600.487 x 0. 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. the annual savings must be : 1.506. How much money would Ramesh need 15 years from now? 500.800 = Rs.042.10)15 = 600.535.12)14 2 15 9 .000 46 1 400.000 x 2. How much money would Ramesh need when he reaches the age of 60 to meet his donation objective? 200.48.000 (1.239 = 3.317 = 157.000 x 0.12) 400.200 = Rs 1.200 This means that his savings in the next 15 years must grow to : 4.606 + 1. 11yrs) = 200.000 x 239.772 1.800 = FVIFA (10%.676 4.535.506.177 = Rs 2.000 will grow to : 600.535.000 x PVIFA (10%.800 So.MINICASE Solution: 1.000 x PVIFA (10% .4.000 x 4. What is the present value of Ramesh’s life time earnings? 400.338 3.000.000(1.000. 15years) = 500.803.000 x PVIF (10%.000 = Rs.000 – 2. 15 years) 31. 3yrs) x PVIF (10%.000 x 7.000(1.042. 15years) + 1.
12 = Rs.1.254.12 1– 1.08 = 400.7.000 0.962 15 10 .08 – 0.
Chapter 8 VALUATION OF BONDS AND STOCKS 1.100 t 7 t=1 (1+r) (1+r) Try r = 18%.1.000 x PVIF (20%.100 t 7 t=1 (1.1.14)7 = Rs. The yield to maturity is the value of r that satisfies the following equality.000 x 0.(i) When the discount rate is 14% 7 12 100 P = + t=1 (1.352 + Rs.60 Thus the value of r at which the RHS becomes equal to Rs.000 x PVIF (18%.15) (1. 7 years) + Rs.314 = Rs. 7 years) = Rs.1.12) (1.4 = Rs. The right hand side (RHS) of the above equation is: Rs.100 x PVIF (15%.605 + Rs.1.100 x PVIF (14%. 7 120 1. 5 years) = Rs.711.812 + Rs.12) equal to Note that when the discount rate and the coupon rate are the same the value is par value. 7 years) + Rs.000 Rs.100 x 0.46 (ii) When the discount rate is 12% 7 12 100 P = + = Rs.000 x 0.120 x 3.11 x PVIFA(15%.288 + Rs.120 x PVIFA (20%.750 lies between 18% and 20%.100 x 0.44 Try r = 20%. 7 years) = Rs.11 x 3.771.12 x PVIFA (14%.86.750 = + = Rs.14) t (1.7 2.15)5 100 = Rs. 5 years) + Rs.91.12 x 4. 7 years) = Rs. The right hand side (RHS) of the above equation is: Rs.120 x 3.497 = Rs. P = 5 t=1 11 + (1. 3.279 = Rs. 7 years) + Rs.120 x PVIFA (18%. 11 .
80 = 18% + .14 x PVIFA (18%.100 x 0.397 = Rs.14 x 4.193 + Rs.44 – 711.100 x PVIF (8%.Using linear interpolation in this range.100 x 0. 10 years) + Rs. The RHS of the above equation is Rs.74.56% 5.100 x PVIF (18%.14 x 4.92 6.82 Try r = 20%.84.60 x 2% = 18.08) t Yield to maturity 100 (1.9 Using interpolation in the range 18% and 20% we get: 82 .08)12 = Rs. we get 771.00 Yield to maturity = 18% + 771. 10 years) + Rs.191 = Rs.14 x PVIFA(20%. 80 = 10 14 100 + t=1 (1+r) t (1+r)10 Try r = 18%.6 x PVIFA (8%. P = 12 t=1 6 + (1. The posttax interest and maturity value are calculated below: Bond A 12 Bond B . 10 years) = Rs.536 + Rs.9 = 18.494 + Rs. 12 years) + Rs.x 2% 82 – 74. The RHS of the above equation is Rs.6 x 7.44 – 750. 12 years) = Rs.100 x 0. 10 years) = Rs.162 = Rs.7% 4.100 x PVIF (20%.
r = 0.56 8.7 100 [ (100 – 60)x 0.100 x PVIF (8%.6x 60 + 0.39.70 13 .6 x 70 + 0. using the approximate YTM formula is calculated below 8.0.73% 7 + (96 – 60)/6 0.3) =Rs. 14) + Rs.3) =Rs.33 market Since the growth rate of 6% applies to dividends as well as market price.4 10 (1 – 0.12 Po = D1 / (r – g) = Do (1 + g) / (r – g) = = Rs.6 x PVIFA(8%.6 x 8.06.4 x 97 13.00 (1.35.4 x 96 17.100 x 0.08)14 100 = Rs.08) t (1. g = 0.8. 47% Bond A : Posttax YTM = = Bond B : Posttax YTM = = 7. the price at the end of the 2nd year will be: P2 = = Po x (1 + g)2 = Rs.2.1] =Rs. Do = Rs.341 = Rs.83.35.33 (1.1] =Rs. P = 14 t=1 6 + (1.96 * Posttax maturity value (M) 100 [ (10070)x 0.97 The posttax YTM.06)2 Rs. 14) = Rs.06) / (0.* Posttax interest (C ) 12(1 – 0.06) Rs.4 + (9770)/10 0.00.2.12 .244 + Rs.
14)3 + + 1.75 / (1. Rs.14)5 + 2.50(1.74 + 4.8 Rs.264 10. Po Po = = = D1 / (r – g) = Do (1 + g) / (r – g) Rs.89 + 13.36 / (1.14) + 1.1.14)8 P8 = D9 / (r – g) = 3.08)3 / (1.77 14 .14)2 + 2..12 – g 0.68/(1.13. g = 0.14)6 + 2.45 C = So C = Rs.04) Hence r = 0.14)3 + 2. Po Do So 8 = = = 1.04)) = 1.14 or 14 per cent 12.37.32 = g = 11.14)2 + 1.36 (1.14)6 + 2.10) = D1 / (r – g) Rs.08)2 / (1. Po = Rs.50 (1.14)5 + 2.4.50 (1.2 / 0.50 (1.37.14)7 + 3.36 (1.36(1.88 / (1.14)4 Rs.12)3 / (1.14)8 = = 2.14)7 + + 2.05) = Rs.36 (1.44 / (r + .89 P8 / (1.0575 or 5.11 / (1.21 / (1.74 2.14 Rs.50.50 (1. 1.12)4 / (1.14) + 1.04.9.00 (1.08)4 / (1.14 – 0.23.75% D1/ (r – g) = Do(1+g) / (r – g) Rs.15 – 0.12) / (1. Po = = A + B + C = 5.14 Thus.14)4 = = B= 1.97 / (1.05)/ (0.12.04) / (r(.08) / (1.12)2 / (1.55 / (1. The market price per share of Commonwealth Corporation will be the sum of three components: A: B: C: A= Present value of the dividend stream for the first 4 years Present value of the dividend stream for the next 4 years Present value of the market price expected at the end of 8 years.14)8 Rs.45 / (1.5.10) / (0.14)8 = Rs.21 (1.
10) 4.20 B= = = C= = The intrinsic value of the share = A + B + C = 10.48 .1.+ .89 6.118.12)10 r–g (1 +r)10 0.+ .00 (1.+ (1.02(1.42 4.066 = 709.00 (1.85 14.12)5 B: C: A= = 2.12)6 (1.12)8 (1.50 / (1.+ .02 (1..10)2 4.2)4 (1.12)8 (1.12)6 (1.12)2 + 3.02(1.65 / (1.05 Rs.10)3 4.15)3 2.12)5 = Rs.+ (1. The intrinsic value of the equity share will be the sum of three components: A: Present value of the dividend stream for the first 5 years when the growth rate expected is 15%.2)3 (1.2)9(1.12)7 (1.04 / (1.12)4 + 4.+ .13.30 / (1.= .+ (1. Terminal value of the interest proceeds = 140 x FVIFA (16%.x .10)5 .x 1/(1.+ . Present value of the dividend stream for the next 5 years when the growth rate is expected to be 10%.81 D11 1 6.24 Redemption value = 1.+ .00 (1.02 (1.05) .000 15 .20 = Rs. 2.35 5.12)3 + 3.10.12)7 (1.1.02(1.97.48 (1.00(1.15)4 2.12) (1.15)5 .15)2 2.12)10 Rs.00 (1.12) + 2.10.12 – 0.+ .81 + 97.+.84 + 10.02/(1.12)2 (1.12)10 4.4) = 140 x 5. Present value of the market price expected at the end of 10 years.15) 2.84 4.12)9(1.1.+ .10)4 4.86 5.
16 – 0.0.18 (0.12) (1.18 – 0.24 Define r as the yield to maturity.+ 62.39% equation Intrinsic value of the equity share (using the 2stage growth model) (1.18 – 0.18)5 x (1.36 x 1 .10 0.80 Intrinsic value of the equity share (using the H model) 4.10801 .36 x (1. The value of r can be obtained from the 900 (1 + r)4 r 15.0.05 . Rs.00 x 4 x (0.74.00 (1.20) 4.Terminal value of the proceeds from the bond = 1709.80 = = = 16 .12) x (1.+ 0.16 – 0.02 = 2.10) . = 1709.24 = 0.10 60 + 20 Rs.2.1739 or 17.36 x = 16.+ 0.16)6 = .18)6 2.16)6 .
The probability distribution of the return on 20 shares is Economic Condition High Growth Low Growth Stagnation Recession Expected return = Return (Rs) 20 x 55 = 1.R)2 pi (RiR)2 10 0.4 4 8 64 25.10.48% 2 (a) For Rs.000 20 x 60 = 1.2 6 12 144 28. 20 shares of Alpha’s stock can be acquired.2 0.6 30 0.4 20% 0.4 x Rs.200 20 x 70 = 1.400 Probability 0..3 0.10 + 0.2 x Rs.000.1.100 20 x 50 = 1.100 x 0.2 (1.4 30% 0.400 x 0.Chapter 9 RISK AND RETURN 1 (a) Expected price per share a year hence will be: = 0.4 8 2 4 1.8 R = pi Ri pi (RiR)2 = 56 σ = 56 = 7.000 x 0.2) + (1.1 Initial price (c ) The standard deviation of rate of return is : σ = pi (Ri – R)2 The σ of the rate of return on MVM’s stock is calculated below: Ri pi pI ri (RiR) (R i.200 x 0.80 (b) Probability distribution of the rate of return is Rate of return (Ri) Probability (pi) 10% 0.6 20 0.2) 17 .3 0.4 x Rs.11 + 0.3) + (1.12 = Rs.3) + (1.2 Note that the rate of return is defined as: Dividend + Terminal price .
100 0.000 – 1.150 – 1.000.2) = Rs. likewise for Rs.100 – 1.3) + (1.200)2 x .3 + (1.150)2 x 0.1. The probability distribution of this option is: Return (Rs) Probability (10 x 55) + (10 x 75) = 1.150 0.500 – 1.500.2 (1.58 (c ) For Rs.2 + (800 – 1.2) = Rs.2 Expected return = (1.300.100 – 1.200)2 x .500 20 x 65 = 1.300 –1.3 (10 x 50) + (10 x 65) = 1. 10 shares of Beta’s stock can be acquired.1.2 0.300 x 0.2 + (1.175)2 x 0.100 x 0.100 x 0.200)2 x .2 ]1/2 = Rs.175)2 x 0. 20 shares of Beta’s stock can be acquired.3 + (1.84.3 + (1. 10 shares of Alpha’s stock can be acquired.264.3 0.500.2]1/2 = Rs.= = 330 + 300 + 240 + 280 Rs.18 (b) For Rs.2 (10 x 70) + (10 x 40) = 1. 6 shares of Beta’s stock can be acquired.150 Standard deviation of the return = [(1.3 + (1.3 + (1.143.150 x 0. 18 .2) + (1. The probability distribution of this option is: d.200 Standard deviation of the return = [(1.100 – 1.100 0.300 0.3) + (1.175 Standard deviation = [(1.200)2 x .300 – 1.000 – 1. 14 shares of Alpha’s stock can be acquired. likewise for Rs.150)2 x 0.41 For Rs.200 – 1.175)2 x 0.175)2 x 0.150)2 x 0.300 x 0.1.000 x 0.3) + (1.1.150)2 x 0.000 20 x 40 = 800 Probability 0.500 x 0.2 + (1.300 20 x 50 = 1.700.3 0.400 – 1.3 (10 x 60) + (10 x 50) = 1. The probability distribution of the return on 20 shares is: Economic condition High growth Low growth Stagnation Recession Expected return = Return (Rs) 20 x 75 = 1.2]1/2 = Rs.3 + (1.3) + (1.2) + (800 x 0.
165)2 x 0.2) Rs.140 – 1.150 143 8.08 + 0.00% D: = 0. follows: B: = 9.0900 = 9.5 (0.17% C: = 0.04 + 0.090 – 1.165)2 x 0.99 d 1.140 1.11 + 0.12 + 0.2 + (1.66 Standard deviation The expected return to standard deviation of various options are as follows : Expected return Standard deviation Expected / Standard Option (Rs) (Rs) return deviation a 1.57.53 c 1.09 + 0.04 + 0.12 + 0.3) + (1.220 Probability 0.2 (1.16 6 Return on portfolio consisting of stock A Return on portfolio consisting of stock A and B in equal proportions = 0.12 6 0. Expected rates of returns on equity stock A.3 + (1.165 58 20.83% 19 .3 + (1.220 – 1.3 0.08) + 0.09 Option `d’ is the most preferred option because it has the highest return to risk 3.02) + 0.12 + (0.165 [(1.08 + 0.2]1/2 Rs.165)2 x 0.090 1.0783 6 0.Return (Rs) (14 x 55) + (6 x 75) (14 x 50) + (6 x 65) (14 x 60) + (6 x 50) (14 x 70) + (6 x 40) Expected return = = = = = = = = 1.220 1.08 + 0.220 x 0.07 + 0.0783) + 0.04 b 1.83% ratio.0917 = 7.165)2 x 0.20 = 0.140 x 0.095 = 9.090 x 0.06 + 0.175 84 13.09 + 0.3) + (1.15 +.5% = 0.10 + 0.2) + (1.200 265 4. C and D can be computed as A: 0.0917) = 0.085 = 8.220 – 1.2 0.5 (0.10 + 0.09 + 0.3 0.220 x 0.06 6 0. B.1.15 + (0.50% (a) (b) = 7.
67 219.11 8.98 43. RM 12 1 14 24 16 30 3 24 15 22 12 RARA 0.18) = 0.47 79.91 13.09 4.0917) + 0.63 330.77 22.18 (RARA) 0.31 0.25(0.86 Beta of the equity stock of Auto Electricals (RA – RA) (RM – RM) (RM – RM) 2 = 935.06 3.11 RARA/RMRM 0.07 1. B.01 444.09 2.39 77.0783 ) + 1/3(0.91 2.25(0.090) = 0.51 10.08875 = 8.82 3.18 14.86 975.09 – (0.25(0.67% Return on portfolio consisting of stocks A.61 (RA – RA) (RM – RM) = 935. The calculations relevant for calculating the beta of the stock are shown below: Year 1 2 3 4 5 6 7 8 9 10 11 RA 15 6 18 30 12 25 2 20 18 24 8.0867 = 8.96 x 15.0917) + 1/3 (0.09 RMRM 3.52 60.0783) + 0.82 14.27 (RMRM) 10.82 0.18 6.55 98.91 7.51 77.31 9.51 2.35 24.79 0.(c ) Return on portfolio consisting of stocks A.88% (d) 4. B and C in equal proportions = 1/3(0.18 1.55 RA = 15. C and D in equal proportions = 0.87 237.21 171.79 8.09 21.79 0.11 201.09 RM = 15.96 Alpha = = 20 .53 146.29 299.03 46.47 222.09 9.18 (RA – RA)2 = 1116. Define RA and RM as the returns on the equity stock of Auto Electricals Limited a and Market portfolio respectively.61 RA – βA RM 15.095) = 0.91 03.18 8.91 14.25(0.91 8.18 8.82 18.43 131.39 50.82 0.0900) + 0.52 = 0.93 (RM – RM) 2 = 975.
195 or RM = 0..08) Intrinsic value per share of stock A = 0.00.18 .0 RX =18% g = 5% Po = Rs.e.e. 1.12 – 0.22. r = 0.04 Beta of stock A = 1.09 + 1.08.g) = Do (1+g) / ( r – g) Given Do = Rs.g) Rs.96 RM 5. The SML equation is: RX = RF + βX (RM – RF) We are given 0.2. RF = 8%.175 2.10) 0.09) i.08 + βA (0.52 + 0. The required rate of return on stock A is: RA = = = RF + βA (RM – RF) 0.30 = D1 / (0.175 – 0.5 RM = 0.15 = 0. RM = 12% βX = 2.00 (1.75 Po = D1 / (r .07 i.74 0.. we have Rs.08) 0.15 – 0.08 = 6.5 (0. The SML equation is RA = RF + βA (RM – RF) Given RA = 15%.15 = .10 + 1.13% Therefore return on market portfolio = 13% 8.75 7. RM = 12%.βA = 0. g = 0.30 = 1.175 Intrinsic value of share = D1 / (r.Equation of the characteristic line is RA = 0.05) 21 .5 (RM – 0.
given the above changes is 3.04) = Rs.45 0.04 Chapter 10 OPTIONS AND THEIR VALUATION 1. S = 100 u = 1.2% Price per share of stock X.8 Revised Rx = 8% + 1.152 – 0.39 and Do = D1 / (1+g) = 3.18 = = Rf + βx (RM – Rf) Rf + 2.71 (1.06 or 6%.So D1 = Rs.5 d = 0.0 Revised 8% 4% 4% 1.0 (0.34.71 Rx 0.8 22 .8 (4%) = 15. Original Rf RM – Rf g βx 6% 6% 5% 2.05) = Rs.3.9 /(1.12 – Rf) So Rf = 0.
0) 45 – 0 = 0.92 Rs. 0) = 23 0 .92 = 70 = = 45 = 14 45 0 9 = 0.18.12 36 = 0.18. 0) Max (80 – 105.10 u=? E = 45 d = 0.7 x 100 u.8 x 45) = 0. S = 40 R = 1.37 2.12 follows: The values of ∆ (hedge ratio) and B (amount borrowed) can be obtained as ∆ Cu – Cd = (u – d) S Cu Cd ∆ = = Max (150 – 105.12 R = 1.45.7 x 1.37 = .784 C = = = ∆S+B 0.Cd – d.8 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.6429 x 100 – 45.Cu B = (ud) R (1.6429 Value of the call option = Rs.E = 105 r = 0.5 x 0) – (0. Given the above data Cd = Max (32 – 45.
Using the standard notations of the BlackScholes model we get the following results: ln (S/E) + rt + σ2 t/2 d1 = t 24 . It follows that when u occurs either u x 40 x 0.34375 B ∆S+B ∆ x 40 + B 40 1.02 or u x 40 x 0.7332 of a share plus a borrowing of Rs.10 R S (1) (2) Substituting (1) in (2) we get 8 8 or B ∆ = = = = (0.46 u = 0.02 x 100 = 102%.33 . 3.7332 – 23.33) = 0. it follows that u = 2.21.034365 x 40) B + B 0.0.46 = u x 40 – 45 10.33 (1.034375 .54 u = 2.034375 (21.0.672 u = 21.8 = 0 Since u > d.7332 The portfolio consists of 0.10) = Rs.02.33 (entailing a repayment of Rs.21.7332 – 23.46 after one year).∆ = B ∆ = B = ∆ C 8 = = = Cu – Cd x u Cd – d Cu Cu – 0 x 0.23. Put differently the stock price is expected to rise by 1.375 B .21.8Cu () 0.
3675 N (0.4 0. 4.141 x 80 = Rs.= ln (120 / 110) + 0.122 option and = = From table A6 we find the percentage relationship between the value of the call stock price to be 14. t 0. Value of put option = Value of the call option + Present value of the exercise price Stock price ……… (A) 25 .8693 1.7675 – 0.80785 N (0.42/2 0.77) = 0.28.4 0.11.14 x 0. 5.33 = = d2 = = = N(d1) = N (d2) = C = = = = Value of the call as per the Black and Scholes model is Rs.03.08 0.80785) – (110 x 0. ert.37) = 0. t = 0.64431) 35.08701 + 0.4 0.2 x 1 = 0.33.1) 80 82 x 0.2 Ratio of the stock price to the present value of the exercise price 80 = 82 x PVIF (15.86936 x 0. N(d2) 120 x 0.7675 d1 .7675) ~ N (0.1 per cent. Hence the value of the call option is 0.14 + 0.35.80785 – 110 x e0.14 + 0.64431 So N(d1) – E.3675) ~ N (0.64431 (120 x 0.
119 x 80 = Rs.6.1) 80 / 73.41 6.88 d1 = N(d1) = d2 = = = N (0.18 0.52 Plugging in this value and the other relevant values in (A).2 1 = 0. So = = Vo N(d1) – B1 e –rt N (d2) 6000 N (d1) – 5000 e – 0.81057 26 .88) d1 .1 N(d2) ln (6000 / 5000) + (0.083 = = From Table A. we get Value of put option = 9.3.8775 0.45 0.89 = 1.18 x 1 ln (1.19 = 0.85 can be obtained as t = 0.8775 = 0.4243 = 0.9. we find the percentage relationship between the value of the call option and the stock price to be 11.2 follows: Ratio of the stock price to the present value of the exercise price 80 85 x PVIF (15.52 + 85 x (1.The value of the call option gives an exercise price of Rs.18/2) 0.03.1503)1 – 80 = Rs.4532 = = 0.1 x 1) + (0.2) + 0.t 0.9% Hence the value of the call option = 0.
9048 x 0.1.(1.(a) NPV of the project at a discount rate of 14%.14)2 + 300.3 4 (1.000.14)5 27 .67364) 1816 V0 – S0 60000 – 1816 4184 Chapter 11 TECHNIQUES OF CAPITAL BUDGETING 1.000 . = .67364 6000 x 0.N (d2) = So = = B0 = = = N (0.000 + 100.14) (1.000 + 300.000 + 200.14) (1.000 .81057 – (5000 x 0.000 + 600.14) (1.45) = 0.
14)(1.13) (1.= (b) .10) = 5.13) (1.000 (1.000.10) – 200 000 = 26000 IRR (r ) can be obtained by solving the equation: 40000 x PVIFA (r.000 (1.14) (1. 10) = 200000 i.13) + 300.000 From the PVIFA tables we find that PVIFA (15.14) + 600.883 28 .000 + 100.15)(1.12) (1.000 (1.000 (1.16) = = . PVIFA (r. Investment A a) b) c) Payback period NPV = 5 years = 40000 x PVIFA (12.000.000 (1.12) + 200.000 + 89286 + 158028 + 207931 + 361620 + 155871 .1.12) (1.12) (1.44837 NPV of the project at time varying discount rates = .13) (1.10) = 4.1.27264 2.12) (1.15) + 300.e. 10) = 5..019 PVIFA (16.
4) x PVIF (12.000 x 3. 5) + 30. 3) x PVIF (r.000 x PVIF (12.3) x PVIF (12.000 x PVIF (12.000 = 0.14% d) BCR = = = Benefit Cost Ratio PVB / I 226.37% d) BCR = = PVB / I 194.000 x PVIFA (12.000 x PVIFA (12.1) + 60.000 x 2.000 x 1.5) + 20. NPV = 80.2) + 80.000 x PVIF (12.402 x 0.567) + (20.000 Through the process of trial and error we find that r = 1.019 / 0.371 29 b) = .13 Investment B a) b) Payback period NP V = = 9 years 40.5) + 20.210.000 x PVIFA (12.000 x PVIF (12. 7) = 300.690 x 0.000 x PVIFA (r.000 x PVIF (12.000 111.Linear interporation in this range yields r = 15 + 1 x (0. Linear interpolation in this range provides an approximate payback period of 2.136) = 15.4) + 80.000 x PVIF (12.3) + 60.000 x PVIFA (r.65 Investment C a) Payback period lies between 2 years and 3 years.000 (40.5) + 60.300.7) .2) x PVIF (12.000 . 2) x PVIF (r.452) – 300.000 x PVIFA (12.661 / 300.105339 = = c) IRR (r ) can be obtained by solving the equation 40.000 = 1.6) .88 years.6) + 40.000 x PVIFA (r.5) + 30.605) + (30.000 / 200.
000 x PVIF (12.5) + 60.13 9 105339 1. A linear interpolation in this range provides an approximate payback period of 8.65 30 2.29 1.45% d) BCR = PVB / I = 282.53 8.37.840 / 320.160 = c) IRR (r ) can be obtained by solving the equation 200. 8 + (1 x 100.14 1.000 x PVIF (r.000 = 1.88 Comparative Table Investment a) Payback period (in years) b) NPV @ 12% pa c) IRR (%) d) BCR A B C D 5 26000 15.45 0.000 = 0.10) = 320000 Through the process of trial and error we get r = 8.000 x PVIF (r.1) + 20.000 x PVIF (12.53 Investment D a) Payback period lies between 8 years and 9 years.000 .88 111371 29.5 37160 8.000 / 200.6) = 210000 Through the process of trial and error we get r = 29.9) + 50.000 x PVIF (r.000 x PVIF (r.1) + 200.2) + 200.3) + 60.000 x PVIF (r.000 x PVIF (12.000 x PVIF (r.000 x PVIF (r.29% d) BCR = PVB / I = 321.c) IRR (r) is obtained by solving the equation 80.88 .000 x PVIF (12.000) b) NPV = 200.4) + 80.000 x PVIF (r.6) + 40000 x PVIFA (r.000 x PVIF (r.320.371 / 210.1) + 60.000 x PVIF (r.5 years.4) x PVIF (r.9) + 50.10) .37 0.2) + 200.2) + 80.
0.5) 31 .000 Through a process of trial and error it can be verified that r = 9..4) 30000 x PVIF (15.e.2) 50000 x PVIF (15. The IRR (r) for the given cashflow stream can be obtained by solving the following equation for the value of r.7) = 300. ()61% NOTE: Given two changes in the signs of cashflow. Define NCF as the minimum constant annual net cashflow that justifies the purchase of the given equipment.e. 4. The value of NCF can be obtained from the equation NCF x PVIFA (10. we get two values for the IRR of the cashflow stream.000 i. IRR (r) can be calculated by solving the following equations for the value of r.335 93271 6. 5. the investment to be chosen is ‘C’ because it has the Lowest payback period Highest NPV Highest IRR Highest BCR 3.. the IRR rule breaks down. PVIFA (r.8) NCF = = = 500000 500000 / 5.61. The value of I can be obtained from the following equation 25000 x PVIFA (12.3) 40000 x PVIF (15. PV of benefits (PVB) = + + + + 25000 x PVIF (15. I = = I 141256 7. 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. In such cases.1) 40000 x PVIF (15.7) = 5.20% pa.61. 3000 + 9000 / (1+r) – 3000 / (1+r) = 0 Simplifying the above equation we get r = 1. 60000 x PVIFA (r.Among the four alternative investments.10) i. (or) 161%.
382 (i) The IRR (r ) of project P can be obtained by solving the following equation for `r’.23 [= (A) / (B)] (A) (B) The NPV’s of the three projects are as follows: Project Q P Discount rate 0% 5% 10% 15% 25% 30% 9. 1000 1200 x PVIF (r.2) + 600 x PVIF (r'.1) – 600 x PVIF (r. = = 122646 100.461 .555 600 312 70 .222 20 11 .3) + 800 x PVIF (r'.13% (ii) The IRR (r') of project Q can be obtained by solving the following equation for r' 1600 + 200 x PVIF (r'.435 .1) + 400 x PVIF (r'.291 .4) + 4000 x PVIF (r.5) = 0 32 b) .135 .591 NPV profiles for Projects P and Q for selected discount rates are as follows: Project P Q Discount rate (%) 0 2950 500 5 1876 208 10 1075 .4) + 100 x PVIF (r'.000 1.66 .3) + 2000 x PVIF (r.386 R 500 251 40 .28 15 471 .= Investment Benefit cost ratio 8. (a) 400 223 69 .5) = 0 Through a process of trial and error we find that r = 20.142 .2) – 250 x PVIF (r.
12) + 4000 = 6240 The MIRR of the project P is given by the equation: 2728 = 6240 x PVIF (MIRR.a. and NPV (P) > 0.2874 MIRR = 18% (c) Project Q PV of investmentrelated costs TV of cash inflows @ 15% p.Through a process of trial and error we find that r' = 9. = = 1600 2772 = The MIRR of project Q is given by the equation: 16000 (1 + MIRR)5 MIRR = = 2772 11. I would choose project P. I would choose project P. c) From (a) we find that at a cost of capital of 10% NPV (P) NPV (Q) = = 1075 .382 Again NPV (P) > NPV (Q).34%.62% 33 .5) (1 + MIRR)5 = 2.2) + 250 x PVIF (12. From (a) we find that at a cost of capital of 20% NPV (P) NPV (Q) = = 11 .0) + 1200 x PVIF (12.28 Given that NPV (P) . and NPV (P) > 0.1) + 600 x PVIF (12. d) Project P PV of investmentrelated costs 1000 x PVIF (12. NPV (Q).3) = 2728 TV of cash inflows = 2000 x (1.
6) = 100 i.e. r' = 14. Interpolating in this range we get an approximate pay back period of 1. Interpolating in this range we get an approximate pay back period of 2. r = 12..45 million IRR (r') can be obtained by solving the equation 13 x PVIFA (r'. 25 x PVIFA (r..10 (a) Project A NPV at a cost of capital of 12% = . NPV of the differential project at 12% = 50 + 12 x PVIFA (12.2.6) = Rs.50 million Difference in net annual cash flow between projects A and B is Rs.3. r'' = 11.98% Project B NPV at a cost of capital of 12% = .e. 6) = 50 i.55 years.15 million IRR (r'') of the differential project can be obtained from the equation 12 x PVIFA (r''.6) = 50 i.6) = Rs.79 million IRR (r ) can be obtained by solving the following equation for r.6) = Rs.12 million.40% [determined through a process of trial and error] (b) Difference in capital outlays between projects A and B is Rs.50 + 13 x PVIFA (12. (b) Project M 34 .53% 11 (a) Project M The pay back period of the project lies between 2 and 3 years.e.100 + 25 x PVIFA (12.63 years/ Project N The pay back period lies between 1 and 2 years..3.
25.47 DPB lies between 1 and 2 years.23.75 71.50 + 11 x PVIFA (12. Project M Cost of capital = 10% per annum NPV = Rs. NOTE: The MIRR can also be used as a criterion of merit for choosing between the two projects because their initial outlays are equal.13 million 35 . choose project M.20.4) Rs.Cost of capital PV of cash flows up to the end of year 2 PV of cash flows up to the end of year 3 PV of cash flows up to the end of year 4 = = = = 12% p.97 47.02 million Project N Cost of capital NPV = 10% per annum = Rs.e. This assumes that there is no capital constraint. Project N Cost of capital PV of cash flows up to the end of year 1 PV of cash flows up to the end of year 2 = = = 12% per annum 33.21.08 million (e) Since the two projects are mutually exclusive.1 years.63 million Since the two projects are independent and the NPV of each project is (+) ve.3) + 37 x PVIF (12.1) + 19 x PVIF (12.92 years.26 million (d) Project N Cost of capital = 12% per annum NPV = Rs.93 51.2) + 32 x PVIF (12.a 24. (c ) Project M Cost of capital NPV = = = 12% per annum . both the projects can be accepted. we need to choose the project with the higher NPV i. Interpolating in this range we get an approximate DPB of 1.26 Discounted pay back period (DPB) lies between 3 and 4 years.. Project M Cost of capital = 15% per annum NPV = 16. Interpolating in this range we get an approximate DPB of 3.
41 MIRR of the project is given by the equation 50 ( 1+ MIRR)4 = 115.47 i.01% Project N Terminal value of the cash inflows: 115... (f) Project M Terminal value of the cash inflows: 114.26% 36 . MIRR = 23. i. So we choose the project with the higher NPV.e. MIRR = 23.47 MIRR of the project is given by the equation 50 (1 + MIRR)4 = 114.e..41 i. choose project N.17.Project N Cost of capital: 15% per annum NPV = Rs.e.23 million Again the two projects are mutually exclusive.
75 108. Revenues 4. Profit before tax 7.56 107.5) +107. Terminal CF ( = 9 +10) 14. Initial outlay (=1+2) 12.13 141.5 121.33 109.75 x PVIF (r.44 111. Plant & machinery 2.67 40.24 93.75 108.33 x PVIF (r.00 98 (200) 116. Working capital 3.Chapter 12 ESTIMATION OF PROJECT CASH FLOWS 1. Costs (excluding depreciation & interest) 5.18 138.75 85.82 11.25 x PVIF (r.93 96.87 8.2) + 111.25 113.7) = 0 37 .33 109.67 205 0 (150) (50) 250 250 250 250 250 250 250 Project Cash Flows 1 2 3 4 (Rs.56 107.44 x PVIF (r. (a) Year 1.75 36.56 x PVIF (r. Operating CF (= 8 + 5) 13.13 21.25 113.67 x PVIF (r.77100.1143.0 78.4) + 108.31 90.3) + 109. in million) 5 6 7 100 37.1) + 113.56 38.44 111. Tax 8.33 48 50 IRR (r) of the project can be obtained by solving the following equation for r 200 + 116. Profit after tax 9.90 112.6 107.33 43.67 28.33 33.87 128. (c) NCF (200) 116.44 42. Depreciation 6.09 15.5 100 100 100 100 100 100 6. Net salvage value of plant & machinery 10. Recovery of working capital 11.25 41.91 134.69 98.6) + 205 x PVIF (r.
6) + 55 x PVIF (15. 8 6.66 17. Initial investment (120) 18.70 million = 3.34 57. Operating cash flow 20. Net salvage value of capital equipments 16.05 50 160 48 16 10 16 8 10 16.25 x PVIF (15.75 8. Terminal cash flow 21. 2. Profit after tax 9.51 26.14 29. 10 cost 7.20 20. Profit before tax 14 13.94 x PVIF (15.55 31. Revenues 80 4. Variable mfg cost. in million) 6 7 1. The IRR of the project is 55.76 18.25 35.Through a process of trial and error.55 x PVIF (15.00 40. Initial outlay (Time 0) 38 .45 8.00 NPV of the net cash flow stream @ 15% per discount rate = 140 + 10.46 62.54 24.25 25.80 39.46 52. Fixed operating & maint.94 14. Level of working capital 20 30 (ending) 3. Working capital 20 10 20.20 12. we get r = 55.5 3.12 5.49 7.1) + 20.58 40 200 60 20 10 20 10 10 30 160 48 16 10 16 8 10 20 120 36 12 10 12 6 10 80 24 8 10 8 4 10 4 12.3) + 62.34 42.8 15.94 55.4) + 49.1.82 4.5 11.55 41.66 9. Recovery of working capital 17.17%. Variable selling expenses 8 8.2) + 31.20 x PVIF(15. Loss of contribution 10 10.66 25 16 30.Bad debt loss 11.2 14.88 6. Year Posttax Incremental Cash Flows 0 1 2 3 4 5 (Rs.2 (14 + 10+ 11) 19.5) + 35. Raw material cost 24 5.80 x PVIF (15.06 2. Incremental overheads 4 9.46 x PVIF (15. Depreciation 30 12. Tax 4.00 10 10 (10) (10) (10) 41 (140) 10. Capital equipment (120) 2.12 10.17%.88 35.80 49. (a) A. Net cash flow (17+1819+20) (b) 40 120 36 12 10 12 6 10 22.7) Rs.
iv.813 547.000 550.i. Salvage value of new machine Salvage value of old machine Recovery of incremental working capital Terminal cash flow ( i – ii + iii) Rs.000) 1 620000 2 578750 3 547813 4 524609 5 2307207 NPV of the replacement project = .000 ii.207 Terminal cash flow (year 5) i.813 69. Operating cash flow ( i + iii) C.600.000 500.3) + 524609 x PVIF (14.000 Operating cash flow (years 1 through 5) Year 1 2 3 4 5 i.000 1. Year NCF (b) Net cash flows associated with the replacement project (in Rs) 0 (2. iv.000 455. B.031 174.000 200.5) = Rs. Incremental depreciation iii. 1. ii.000 500. 455.000 455. iii.2600000 + 620000 x PVIF (14.000 123. Tax shield on incremental dep.2) + 547813 x PVIF (14.600.609 524.207 507. Posttax savings in manufacturing costs 455.800.000 412. Cost of new machine Salvage value of old machine Incremental working capital requirement Total net investment (=i – ii + iii) Rs. ii.4) + 2307207 x PVIF (14. iii iv.375 232.750 92.000 620.750 578.023 165.500. 3.000 900.1) + 578750 x PVIF (14.000 D.500 309.000 2.609 52.000 455.267849 39 .000.
Depreciation of old machine ii.000 B.35 x (iii)) v.000 90. Tax shield (savings) on depreciation (in Rs) Depreciation Tax shield Year charge (DC) =0. Cost of new machine ii.a. A. Net investment Operating cash flow (years 1 through 5) 1 18000 2 14400 3 11520 4 9216 5 7373 Rs. Salvage value of the old machine iii. Depreciation of new machine iii.4.4 x DC 1 2 3 4 5 25000 18750 14063 10547 7910 10000 7500 5625 4219 3164 PV of tax shield @ 15% p.000 310. 8696 5671 3699 2412 1573 22051  Present value of the tax savings on account of depreciation = Rs. Year i. Tax savings on incremental depreciation ( 0.22051 5. 400. Initial outlay (at time 0) i. Incremental depreciation ( ii – i) iv. Operating cash flow 100000 75000 56250 42188 31641 82000 60600 44730 32972 24268 28700 21210 15656 11540 8494 28700 21210 40 15656 11540 8494 .
813 6.250 1.750 5.575 3.000 (23) 7.418 2.193 20 1 1. Salvage value of new machine Salvage value of old machine Incremental salvage value of new machine = Terminal cash flow Rs.225 5. Profit before tax 8.425 7.331 20 1 2.813 2.109 6. Tax 9. Year NCF Net cash flows associated with the replacement proposal.344 5.856 4.656 . ii. Initial outlay 13.675 20 1 2. Depreciation 7. Profit after tax 10.891 2. Costs (other than depreciation and interest) 5. Loss of rental 6. 25000 10000 15000 D. Revenues 4.582 7.824 20 1 1. iii.144 41 6. Net working capital 3.187 1.775 6. Terminal cash flow (year 5) i.933 6.067 4. Salvage value of fixed assets 11. Operating cash inflow (15) (8) 30 30 30 30 30 20 1 3. Fixed assets 2.000 8. Net recovery of working capital 12.187 7.in million Item 0 1 2 3 4 5 1.C. Cash flows from the point of all investors (which is also called the explicit cost funds point of view) Rs. 0 (310000) 1 28700 2 21210 3 15656 4 11540 5 23494 MINICASE Solution: a.469 5.
Cash flows form the point of equity investors Rs.000 2.144 6.35 1.70 0.000 5. Terminal cash flow 15.362 1.309 3. Retirement of trade creditors 16.109 0.0) 3.933 6.000 2.70 0.193 1.345 20 1 2.187 0.366 1. Repayment of term term loans 14.000 2.917 6.066 4. Loss of rental 5.005 2.775 13.095 (2.000 10.888 2.865 (2.009 (10) 6. Liquidation and retirement cash flows 19.822 5.75 0. Net cash flow (10) 30 30 30 30 30 20 1 3. Tax 10.00 12.866 5.813 0.0) 3.656 b. Interest on working capital advance 7. Equity funds 2.525 6.582 0.858 4. Net cash flow (23) 7. Net salvage value of fixed assets 12.000 2.125 4.335 20 1 1.225 6. Operating cash inflow 18.825 5. Interest on term loans 8.000 (10) 6. Initial investment 17.610 3.425 7. Profit before tax 9.053 20 1 2.000 2.756 20 1 1.000 19. Revenues 3.in million Item 0 1 2 3 4 5 1. Depreciation 6.70 1.20 3.14.866 (2.095 5.917 6.0) 3.70 1. Costs (other than depreciation and interest) 4. Net salvage value of current assets 13.865 5.009 42 .70 0. Repayment of bank advance 15. Profit after tax 11.
10 Assumptions: (1) The useful life is assumed to be 10 years under all three scenarios.64 14% . (3) (4) (c) Accounting break even point (under ‘expected’ scenario) 43 .7.57 61. It is also assumed that the salvage value of the investment after ten years is zero.21. and thus the company can claim a tax shield on the loss in the same year.e.57%.5 30 30 .10) Rs. and it is also assumed that this method and rate of depreciation are acceptable to the IT (income tax) authorities.43 81. (2) The investment is assumed to be depreciated at 10% per annum.43 12% 260.2.171. in million) Expected Optimistic 250 200 120 20 25 35 10 25 50 13% 21.57% Profit after tax Net cash flow Cost of capital NPV 300 150 97. It is assumed that only loss on this project can be offset against the taxable profit on other projects of the company.31 200 275 154 15 20 86 24.Chapter 13 RISK ANALYSIS IN CAPITAL BUDGETING 1.36 24.31 million (b) NPVs under alternative scenarios: Pessimistic Investment Sales Variable costs Fixed costs Depreciation Pretax profit Tax @ 28.14 .47 (Rs. The tax rate has been calculated from the given table i. (a) NPV of the project = = 250 + 50 x PVIFA (13.5 . 10 / 35 x 100 = 28.5.
Fixed costs + depreciation Contribution margin ratio Break even level of sales = Rs.10) = 1.7143 [ 0.74 / 1.1628 = Rs.1628 sales – 38. Pessimistic Initial investment Sale revenue Variable costs 30000 28000 28000 Expected 30000 42000 28000 44 Optimistic 30000 70000 28000 . PV (net cash flows) iii.31 million 2. Annual net cash flow = 0.a and useful life of 5 years 30000 24000 16000 3000 2000 3000 1500 1500 3500 30000 42000 28000 3000 2000 9000 4500 4500 6500 30000 54000 36000 3000 2000 13000 6500 6500 8500 16732 .5360 2222 (b) Sensitivity of NPV with respect to variations in unit price.74 = 200 ii.205. 45 million = 60 / 200 = 0.3 = 45 / 0. iv. Initial investment Financial break even level of sales = 238.3 = Rs.3 x sales – 45 ] + 25 = 0.2143 sales – 7.14 = [0. (a) Sensitivity of NPV with respect to quantity manufactured and sold: (in Rs) Pessimistic Expected Optimistic Initial investment Sale revenue Variable costs Fixed costs Depreciation Profit before tax Tax Profit after tax Net cash flow NPV at a cost of capital of 10% p.150 million Financial break even point (under ‘xpected’ scenario) i.14 ] x PVIFA (13.2143 sales – 7.
5360 Optimistic 30000 42000 21000 3000 2000 16000 8000 8000 10000 7908 (d) Accounting breakeven point i.5 x (0.500 .3333 Sales – 5000) = 2000 = (i) x PVIFA (10.Fixed costs Depreciation Profit before tax Tax Profit after tax Net cash flow NPV (c) 3000 2000 5000 2500 2500 . ii.4 + 6 x 0.31895 3000 2000 9000 4500 4500 6500 () 5360 3000 2000 37000 18500 18500 20500 47711 Sensitivity of NPV with respect to variations in unit variable cost. Pessimistic Initial investment Sale revenue Variable costs Fixed costs Depreciation Profit before tax Tax Profit after tax Net cash flow NPV 30000 42000 56000 3000 2000 11000 5500 5500 3500 43268 Expected 30000 42000 28000 3000 2000 9000 4500 4500 6500 . A1 A2 = = = = 4 x 0. ii.4 + 5 x 0.7 5 x 0.15000 = 0.6318 sales – 1896 = 30000 = 31896 / 0.4 + 7 x 0.5 + 6 x 0. iv. Fixed costs + depreciation Contribution margin ratio Breakeven level of sales = Rs.5000 = 10 / 30 = 0.6318 = Rs.1 4.3333 = 5000 / 0.5) = 0.2 5.8 45 .50484 Financial breakeven point i. iii. 3.3333 = Rs. Annual cash flow PV of annual cash flow Initial investment Breakeven level of sales Define At as the random variable denoting net cash flow in year t. iii.
08)4 5. Expected NPV 4 At = .000 / (1.25.000 / (1.708 = = Standard deviation of NPV 4 t t=1 (1.000 [ 12.00 million 4.1)4 (1.794 + 8.000/(1.152 5.08)3 + 6.08)2 + 9.000 / (1.1.1)6 32 NPV = + (1.735 18.56 0.000 x .857 + 9.2.794 + 6.000 / (1.1 +5.49 12 22 + (1.08) + 10.1)2 = 1.25.9 4.000 x . Expected NPV 4 At 46 .1)3 – 10 Rs.000 x .926 + 6.000 x .7 / 1.00 (NPV) = Rs.8 / (1.857 + 5000 x .1)2 + 3.08)4 – 25.9 / (1.08) + 6.41 0.000 x .926 + 10.08)3 + 8.A3 NPV 12 22 32 2 = = = = = = = 3 x 0.08)2 + 5.08)t = = = 5.2 3.000 x .000 / (1.08) = 12.735] .5 + 5 x 0.00 million 0.000 t t=1 (1.000 7.000 / (1.3 + 4 x 0.000 x .000 / (1.
000 [(2.000 – 4.000 = Rs.5 + 6.000 x 0.100 3.06)3 + 3.3 3.000 – 3.100)2 x 0.000 (1.3 + 5.4 + 4.3 + 5.900)2 x 0.000 – 3200)2 x 0.900 / 1. (2) [(2.000 x 0.= A1 A2 A3 A4 t=1 = = = = = = = = .100)2 x 0.3] 690.000 – 3.2] 490.06)2t 12 = = 22 = = 32 = = 42 = 2t …….000 x 0.000 Substituting these values in (2) we get 47 .900 / (1.000 x 0.000 x 0.06)4 .4 + (4.2 4.06) 2.000 x 0.4 + 4.000 x 0.3.000 – 3.3 + (5.000 – 3.044 The variance of NPV is given by the expression 4 2 (NPV) = t=1 (1.000 x 0.900)2 x 0.000 x 0.5 + (6.900 4.3 + (5.900)2 x 0.4 3.3 3.000 x 0.200)2 x 0.4 + (4.100)2 x 0.000 [(4.06)2 + 4.10.900)2 x 0.2 + 3.06)+ 3.900 2.000 [(3. (1) Substituting these values in (1) we get Expected NPV = NPV = 3.4] = 560.2 + (3.000 – 4.2 + (3.5 + (4.2 + 3.200 t ….000 – 3900)2 x 0.000 x 0.000 – 3.5 + 4.200 / (1.3] 490.000 – 4.200)2 x 0.10.900)2 x 0.000 – 3.000 x 0..100 / (1.000 – 3.
490.000 / (1.5 – 0.000) Prob (NPV > 2.705 + 560.2) Prob (NPV / I > 0.0094 curve.3.81 < Z < 0) = 0.000 / (1.2) Prob.296) Prob (Z > .4906 0.0. (NPV > 0.35 < Z < 0) 0.2910 = 0.5 + 0.81) = 0.2. < NPV 0 .5 – P (0 < Z < 2.296 NPV – NPV Prob (NPV < 0) = Prob.679. Given values of variables other than Q.1.7910 So the probability of P1 > 1.150 NPV = 1.35) = = = = 0.0094 Prob (P1 > 1.06)6 + 560.000.044 / 1.000 / (1.06)2 + 690.35) The required probability is given by the shaded area in the following normal P (Z < . P and V.2 as 0.000) Prob (NPV >2.000 x 0.679.81) The required probability is given by the shaded area of the following normal curve: P(Z > .150 = Rs.5 – P (2.000)= Prob (Z > 2. NPV 0 – 3044 = Prob Z < 1296 = Prob (Z < 2.0.627 ] = 1.06)4 + 490.000 / (1.000 x 0.08)8 [ 490.NPV So the probability of NPV being negative is 0.000 x 0.2) Prob (PV / I > 1.35) 0.792 + 490.81) = 0. the net present value model of Bidhan Corporation can be expressed as: 48 .5 + P(0 < Z < 0.7910 6.5 + P(0.2 x 10.000 x 0.890 + 690.
895.000 (1.80 0.4 0 0.30 00 to 29 0 0.00 00 to 09 10 to 19 20 to 39 40 to 69 70 to 89 90 to 99 0.20 0.40 0.1)5 = = = [ 0.30.00 0 1.1)t 0 .2 0 0.70 0.30. Two digit random numbers VARIABLE COST Two digit Cumu random Pro numbers b lative Prob.4 0 0.1 0 Valu e 20 30 40 50 Pro b 0.90 1.00 80 to 99 0 Valu e 800 1.80 0 Pro b 0.1 0 Value 0.2 1.000 (1.1 0 0.20 0 1.90 1.000 [0.5 Q (P – V) – 500 5 t=1 = .3 0 0. Exhibit 2 shows the results of the simulation.3 0.1 0 0.000 – 2.[Q(P – V) – 3. 0.000 5 NPV t =1 + (1.000 1. Two digit random numbers PRICE Cumulati ve Prob.8955Q (P – V) – 31.2 0 0.80 30 to 79 0 0.791 – 30.5Q (P – V) – 500] x PVIFA (10.40 0 1..5)+ 2.10 0.40 0.5 Exhibit 1 presents the correspondence between the values of exogenous variables and the two digit random number.00 00 to 39 40 to 79 80 to 89 90 to 99 15 20 40 49 . Exhibit 1 Correspondence between values of exogenous variables and two digit random numbers QUANTITY Cumulati ve Prob.1 0 0.60 0 1.5Q (P – V) – 500] x 3.5) – 30.1)t 0.5 0.000] (0.
200 79 1.000 05 800 07 800 34 1.5 Number g value 17 15 24.314 24 15 2.800 85 1.224 13.400 36 1.224 9.597 41 20 9.400 53 1.400 25 1.359 9.5 Number g value 38 36 83 72 81 40 67 99 64 19 22 96 75 88 35 27 69 16 39 38 46 20 20 40 20 40 20 20 40 20 15 15 40 20 40 20 15 20 15 20 20 20 2.200 61 1.800 25 1.150 84.600 55 1.359 13.896 15 15 18.642 31.200 32 1.523 30 20 13.400 21 1.400 57 1.1.627 7.895.400 14 1.568 7.910 54.400 QUANTITY (Q) Rando Corresm ponding Numbe Value r 92 1.400 57 1.568 5.400 32 1.359 18.224 03 15 18.597 9.150 1 2 3 4 5 6 7 8 9 Ru n 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 .970 12.895.200 49 1.200 64 1.200 31 1.200 08 .200 22 1.600 61 1.597 5.Exhibit 2 Simulation Results QUANTITY (Q) Rando Corresm ponding Numbe Value r 03 800 32 1.200 51 1.941 62.433 11 15 20.8955 Q(PV)m pondin 31.400 48 1.200 PRICE (P) Random CorresNumber ponding value 38 20 69 30 30 20 60 30 19 20 88 40 78 30 11 20 20 20 PRICE (P) Random CorresNumber ponding value 77 65 04 51 39 90 63 91 54 12 78 79 22 93 84 70 63 68 81 76 47 30 30 20 30 20 50 30 50 30 20 30 30 20 50 40 30 30 30 40 30 30 50 Ru n VARIABLE COST (V) NPV Rando Corres.150 52 20 31.896 5.8955 Q(PV)m pondin 31.150 1.400 32 1.627 83 40 58.627 VARIABLE COST (V) NPV Rando Corres1.910 13.597 9.200 46 1.150 1.
20.5 Number g value 86 00 15 84 23 53 44 30 71 70 65 61 48 50 = = = = NPV 40 20 20 40 20 30 30 20 30 30 30 30 30 30 59 25 29 21 79 77 31 10 52 19 87 70 97 43 20 15 15 15 20 20 20 15 20 15 40 20 40 20 28.400 1.600 90 1.474.732 5.896 18.800 09 .600 54 1.961) 14.400 82 1.224 Ru n 37 38 39 40 41 42 43 44 45 46 47 48 49 50 QUANTITY (Q) Random Corres Number pondin g Value 89 1.463 54.447 31.000 38 1.896 12.359 62.000 20 1.642 5.600 94 1.419 50 NPVi – NPV)2 i=1 Variance of NPV = 1/50 = = 1/50 [27.400 98 1.200 61 1.800 44 1.200 61 18 04 11 35 63 30 20 20 20 20 30 58 41 49 59 26 22 20 20 20 20 15 15 5.400 1.481 x 106 51 .600 1.600 1.800 Expected NPV PRICE (P) Random CorresNumber ponding value VARIABLE COST (V) NPV Rando Corres1.836 24.047 x 106] 549.761 14.8955 Q(PV)m pondin 31.224 50 1/ 50 NPVi i=1 1/50 (7.896 31.896 31.224 2.200 83 1.150 16.800 10 1.359 31.941 9.895.359 3.400 16 1.627 2.400 1.31 32 33 34 35 36 52 76 43 70 67 26 1.314 34.
600 and 1.000 – Rs.30.10% 10% Rs.5 5–5 5 0–0 0 Can assume any one of the values 1.5 – 0.000 NPV The net present values for various values of Q are given in the following table: 52 .200.000.30. P and V are the values that have the probability associated with them ** In the case of price.000 Rs.1)t (1.3. 1.400* 800.000 10% .000 – Rs. These values are defined below Variable I k F D T N S Q Range Most likely value highest Rs.000 (1.4.000 Rs.30.000] x 0.2. 1.3.000 – 2. To carry out a sensitivity analysis.5 0.30.441 7.000 Rs. we have to define the range and the most likely values of the variables in the NPV Model.400.5 + 2.800 P Can assume any of the values 20.481 x 106 23.20 and 40 * The most likely values in the case of Q. 1.2.3.000 + (1.1)5 0 .000 0.1)t 5Q . 1.500 . 30.30.Standard deviation of NPV = = 549. 20 and 30 have the same probability of occurrence viz 0. 30** 40 and 50 V Can assume any one of the values 20* 15. We have chosen 30 as the most likely value because the expected value of the distribution is closer to 30 Sensitivity Analysis with Reference to Q The relationship between Q and NPV given the most likely values of other variables is given by 5 = t=1 5 = t=1 [Q (3020) – 3.000 – Rs.000 Rs.2.
NPV 5 (Rs.25 is 0.40 50 NPV(Rs) 31.1)t 700 P – 14.600 1.568 1.400 5.0 (1.000 – 2. The maximum standard deviation of PI acceptable to the company for an investment with an expected PI of 1.000] x 0.01156 = .1075 for the given investment with an expected PI of 1.500 . 0.00 0.24 6 (PIj .20 0.1) t 0 .000 12.02 0 1. Standard deviation of P1 = 53 .Q NPV 800 16.000 (1. given the most likely values of other variables is defined as follows: 5 NPV = t=1 [1.15 6 Expected PI = PI = (PI)j P j j=1 = 1.30.PI) 2 P j j=1 = .000 + (1.716 8.732 1.800 2.24.224 Sensitivity analysis with reference to P The relationship between P and NPV.30 0.896 5.40 15 1.03 5 1.9 Prob.10 10 1.30 20 1.359 1.30.40 0.941 1.5 + 2.200 9.10 0.1)5 = 5 t=1 The net present values for various values of P are given below : P (Rs) 20 30 .1075 The standard deviation of P1 is .400 (P20) – 3.359 21.30.179 47.in lakhs) PI 0.150 1.
30. 9.000 = Rs.000 x 0.000 x 0.08)5 54 .76 8.000 Project A: NPV = .06 t 1 2 3 1 = 0. Hence the company must choose B.26 24.3% B is superior to A in terms of NPV.000 x 0.94 2 = 0.Since the risk associated with the investment is much less than the maximum risk acceptable to the company for the given level of expected PI. The NPVs of the two projects calculated at their risk adjusted discount rates are 6 3.000 x 0.70 + + + + 2 3 4 (1. 10.000 x 0. PI.14) t as follows: Project B: NPV = PI and IRR for the two projects are as follows: Project PI IRR A 1.08) (1. the company must should accept the investment.94 8.08) (1. and IRR.23 20% B 1.10.76 5 = 0.70 The present value of the project calculated at the riskfree rate of return is : 5 (1 – 0.82 10.88 3 = 0.2.88 9. The certainty equivalent coefficients for the five years are as follows Year Certainty equivalent coefficient t = 1 – 0.333 t t=1 (1.763 (1.82 4 = 0.06 t) At t=1 (1.08) (1.08)t 7.000 = Rs.08) (1.7.000 .12) 5 t=1 11.
4 (17500) + 0..4400 + 1. To evaluate the piston engine aircraft.65 [0. proceed as follows: First.8 (15000) + 0. calculate the NPV of the two options viz.600 + (1. –2.12 = 5071 55 .08)4 5.386 – 30.386 7.08)2 7.2 (2400) Do not expand : NPV = 1.6.380 + (1.2 (3000)] + 0.6 (3000)] + (1.040 + (1.08)3 7.580 + (1. If Southern Airways buys the piston engine aircraft and the demand in year 1 turns out to be high.8 (6500) + 0. a further decision has to be made with respect to capacity expansion.12 = 6600 0.12) 0.11000 + (1. ‘expand’ and ‘do not expand’ at decision point D2: 0.000 = Rs.614 MINICASE Solution: 1.2 (1600) Expand : NPV = . The expected NPV of the turboprop aircraft 0.08) = 27.12)2 = 2369 2.65 (5500) + 0.35 [0.8 (17500) + 0.35 (500) NPV = .08)5 Net present value of the Project = (27.600 (1.
the NPV of the piston engine aircraft would be: 0.8 (6500) + 0. 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.Second. truncate the ‘do not expand’ option as it is inferior to the ‘expand’ option.65 (2500+6600) + 0. 0.5500 + 1701 + 3842 = 43 Thus the option to expand has a value of 929 – 43 = 886 4.12 0.12 = 7857 56 .2 (6500) + 0.65 [0.6 (3000) Continuation: 1.2 (2400)] + 0. the payoffs for the ‘continuation’ and ‘abandonment’ options as of year 1 are as follows.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. 0.8 (2400)] + (1.4 (17500) + 0.35 (800) NPV = – 5500 + 1.12)2 = .2 (6500) + 0.35 [0.65 (2500) + 0.35 (800) NPV = – 5500 + 1.12 0. This means that the NPV at decision point D2 will be 6600 Third.35 [0.8 (2400)] + (1. calculate the NPV of the piston engine aircraft option.
35 (500 +8000) NPV = .8 (2400) Continuation : 1. if the demand in year 1 turns out to be low. The NPV of the piston engine aircraft with abandonment possibility is: 0.11. the payoffs for the ‘continuation’ and ‘abandonment’ options as of year 1 are as follows: 0.12 Since the turboprop aircraft without the abandonment option has a value of 2369.000 + (1.35 [800 + 4400] NPV = . The NPV of the turboprop aircraft with abandonment possibility is 0.8 (17500) + 0.2 (6500) + 0.65 [2500 + 6600] + 0.000 + 1. the value of the abandonment option is : 2413 – 2369 = 44 5.Abandonment : 8000 Thus it makes sense to sell off the aircraft after year 1.12) 12048 + 2975 = .2 (3000)}/ (1.11.12)] + 0. 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.12 5915 + 1820 = .12 For the piston engine aircraft the possibility of abandonment increases the NPV 57 = 2413 = 2875 = 1406 . if the demand in year 1 turns out to be low.5500 + 1. it makes sense to sell off the aircraft after year 1.5500 + 1.12 Abandonment : 4400 Thus.65 [5500 +{0.
58 .from 929 to 1406. Hence the value of the abandonment option is 477.
WACC = = 4.2 x 7% = 18.18% 10% + 1.4 x 13% x (1 – 0.1% + 3/5 x 18.4 x 100 + 0. Given 0.35) = 8.68% Aftertax cost of debt = Debt equity ratio WACC = = = 5.Chapter 14 THE COST OF CAPITAL 1(a) Define rD as the pretax cost of debt.60% 0. Using the approximate yield formula rp can be calculated as follows: 9 + (100 – 92)/6 0.85% 0.1085 (or) 10.4% 14. Define rp as the cost of preference capital.19% can be rD = (b) After tax cost = 2.35) = 9.6 x 18% 14.4% rp = = 3. Using the approximate yield formula.4 x100 + 0. Cost of equity = (using SML equation) Pretax cost of debt = 14% 14% x (1 – 0.60 x (1 – 0.35) + 0.5 x 14% x (1 – 0. Therefore rE – 14.x 100 = 12.6x108 12.9% 59 .35) + 0.1% 2:3 2/5 x 9.5 x rE = 12% where rE is the cost of equity capital. rD calculated as follows: 14 + (100 – 108)/10 .6x92 0.
Project S would be accepted because the expected return on this project exceeds 18%.06) Bank loan 200 (0. But we need to calculate the marginal cost of debt (cost of raising new debt). 8.2 22.0 Expected return (%) 13 14 16 20 Given a hurdle rate of 18% (the firm’s cost of capital). 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. 6(a) The cost of debt of 12% represents the historical interest rate at the time the debt was originally issued.13) 200 (0.Using the SML equation we get 11% + 8% x β = 14. (Rs.09) Debentures – second series 200 (0.9 1.78) Debentures – first series 300 (0. in million) Source Book value Market value Equity 800 (0.9% where β denotes the beta of Azeez’s equity. projects P. Q and R would have been rejected because the expected returns on these projects are below 18%.54) 2400 (0. The book value weights and the market value weights are provided within parenthesis in the table.20) 270 (0.5 Required return based on SML equation (%) 14. and for this purpose we need to calculate the yield to maturity of the debt as on the balance sheet date. Project P Q R S Beta 0.00) (b) 7.4875.8 17.0 22.07) Total 1500 (1. Solving this equation we get β = 0.An appropriate basis for 60 .6 0. The book value and market values of the different sources of finance are provided in the following table.00) 3074 (1.13) 204 (0. 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.5 1.
4 x 100 = 15. The cost of equity and retained earnings rE = D1/PO + g = 1.50 / 20. 9. (b) Given 13% x (1 – 0.00 + 0.5 x 15% + 2. where rE represents the cost of equity.5/7.5% = 13.00 + 0.07 = 14.accepting or rejecting the projects would be to compare the expected rate of return and the required rate of return for each project. after floatation costs.25. Based on this comparison.6 x 75 + 0. Cost of equity = D1/P0 + g = 3.9% 61 .3) = 10.5 x 9.15 million is inclusive of floatation costs 11. using the approximate formula.5 million of additional equity costing 15 per cent and Rs. is : 11 + (10075)/10 rE = 0.5% The cost of preference capital.5%. and (ii) The planned investment of Rs.05 = 15% (a) The first chunk of financing will comprise of Rs.25 million of debt costing 14 (1. 10.where rD represents the pretax cost of debt.3) x 4/9 + 20% x 5/9 = 15% rD = 12.72%.5 x 15% + 2.5 per cent (b) The marginal cost of capital in the first chunk will be : 5/7.2.3) x 4/9 + rE x 5/9 = 15% rE = 19.8% = 13.3) = 9.50% Note : We have assumed that (i) The net realisation per share will be Rs.5 million of debt costing 15 (1.27% The marginal cost of capital in the second chunk will be : 5/7. (a) Given rD x (1 – 0.00 / 30.8 per cent The second chunk of financing will comprise of Rs.5 million of retained earnings costing 15 percent and Rs.5 x 10. we find that all the four projects need to be rejected.5/7.
4x100 The posttax cost of debentures is 19. in million (2) 100 10 120 50 80 360 Book value Product of proportion (1) & (3) (3) 0.5 40 80 327.44 11.12 0.33 4.22 1.5 + (10080)/6 rD = 0.5) = 9.99% capital = 19.9% 9.6% 6.02 0.48 0.03 0.32 Average cost11. in million (2) (3) (1) & (3) Equity capital and retained earnings Preference capital Debentures Term loans 14.0% Book value Rs.79 0.6% The posttax cost of term loans is 12 (1tax rate) = 12 (1 – 0.15 1.6x80 + 0.1 (1tax rate) = 19.1 (1 – 0.5) = 6.90% 12 62 .5% 15.62 0.1% Equity capital Preference capital Retained earnings Debentures Term loans The average cost of capital using market value proportions is calculated below : Source of capital Component cost (1) Market value Market value Product of Rs.5% 9. is : 13.24 Average cost capital 8.The pretax cost of debentures.06 0.0% 200 7.0% The average cost of capital using book value proportions is calculated below : Source of capital Component Cost (1) 14.9% 14.28 4.6% 6. using the approximate formula.32 1.5% 15.99 0.5 0.14 1.34 0.
6 x 112 + 0.37.85% e.70% f.50 x 14. Pretax cost of debt & posttax cost of debt 10 + (100 – 112) / 8 rd = 0. Cost of equity using the CAPM 7 + 1. All sources other than noninterest bearing liabilities b.6 d.53 + 0.6 x 106 + 0.10 = 0.09) = Rs.51 million MINICASE (c) Solution: a. Posttax cost of preference 9 + (100 – 106) / 5 7.5 = 107.3) = 5.1(7) = 14. Cost of equity using the DDM 2.55 63 8.8 = = 7. 8) – 500 / (1 .4 x 100 rd (1 – 0.37% (b) Weighted average floatation cost = 1/3 x 3% + 2/3 x 12% = 9% NPV of the proposal after taking into account the floatation costs = 130 x PVIFA (16.93 .55 c. WACC 0.8.53% 0.80 (1.40 x 5.385 + 0.2 = 7.10) + 0.0.(a) WACC = = 1/3 x 13% x (1 – 0.10 80 = 0.3) + 2/3 x 20% 16.4 x 100 103.10 x 7.1385 = 13.70 + 0.
5 [7 + 1.32% g.85 = 12.60% 64 .= 7.22 = 10.5 (7)] + 0.5 [ 11 (1 – 0.75 + 2.75 + 3.3)] 8.35 + 0. Cost of capital for the new business 0.
EAC (Plastic Emulsion) = = = 300000 / PVIFA (12. 2709185 / PVIFA (13.402 Rs.121433 ……… (B) Since (B) < (A).Chapter 15 CAPITAL BUDGETING : EXTENSIONS 1.5) .889 Rs.5) 2709185 = EAC of the internal transportation system = = = 3. 65 . PV of the net costs associated with the internal transportation system = 1 500 000 + 300 000 x PVIF (13.74938 Since EAC of plastic emulsion is less than that of distemper painting.7) 300000 / 4.300 000 x PVIF (13.3) + 450 000 x PVIF (13. it is the preferred alternative.65732 EAC (Distemper Painting) = = = 180000 / PVIFA (12.4) + 500 000 x PVIF (13.5) 2709185 / 3.3) 180000 / 2.770 311 EAC [ Standard overhaul] = = = 500 000 / PVIFA (14. 2.2) 200 000 / 1.2) + 400 000 x PVIF (13.564 Rs.1) + 360 000 x PVIF (13.128568 ……… (A) EAC [Less costly overhaul] = = = 200 000 / PVIFA (14.6) 500 000 / 3. the less costly overhaul is preferred alternative.517 Rs.647 Rs.
000 120.1.022.000 + 3.250.000 5.1.337.000 x PVIFA (20.000 Interest 1.004.000.2.000 x PVIFA (18.000 + 997.000.080.004.000 – 818.000 400.Rs.000.000 1.000 / 0.840.005 37.Rs.500.333 66 .076 Base case BPV = = .022.500 Present value of tax shield 274.000 (b) Adjusted NPV after adjustment for issue cost of external equity = = = Base case NPV – Issue cost .715 21.022.Rs.000 750.000.000.133 Present value of tax shield 5.546 9.339 88.750.000 40.538 125.4.000 324.697 172. (a) = Rs.6) .000.000.000 675.500.182 .1.080.000 – [ 3.000 945.9 – 3. (a) Base case NPV = = = 12.000 Tax shield 324.000 135.182 The present value of interest tax shield is calculated below : Year 1 2 3 4 5 6 7 8 9 Debt outstanding at the beginning 6.000 283.000 6.1.000 + 2.513 60.8.000 (b) Issue costs = 6.6) 12.000 3.225.000 4.88 .000 1.000 243.000.8000 () Rs.000.000.2.000 = Rs.000 162.590 232.6.2.000 81.000 / 0.000 3.818 182 Adjusted NPV after adjusting for issue costs = = (c) .000] .000.500 270.000 2.000 202.000 540.000 810.000.
000.036 Present value of tax shield 67 .938 Rs.(c) The present value of interest tax shield is calculated below : Year 1 2 3 4 5 6 Debt outstanding at the beginning 5.000.880 226.664 25.924 59.000 2.000 600.000.000 = Present value of tax shield 260.000.000 750.000 300.000 60.834.000 Interest 750.000 4.000 Tax shield 300.000 450.000 180.000 240.000.000 300.000 150.000.000 3.000 1.000 120.800 102.830 157.000 5.
000) (13.000 Credit Net shortfall (15081) (16486) (7189) (11243) 4919 3514 2811 1757 2.000) (20. The theoretical value per share of the exrights stock is : 68 .000 Shares procured 20.000 B 20.000 50.000 12.000) (10.000) 13.000 40.000 30.000 50.000 C 30.220 S = Rs.000 Credit Net shortfall (15714) (4286)  14286 5714  3. The theoretical value per share of the cumrights stock would simply be Rs.000 25.000 Excess/ Shortfall (30.000) (10.000 28.000 15. Po = Rs. Underwriting commitment A 50.150 N=4 a.Chapter 18 RAISING LONG TERM FINANCE 1 Underwriting commitment A B C D E 70.220 b.000 10.000 30.000 Excess/ shortfall (20.000) 20.000 Shares procured 50.
The theoretical value of each right is : Po – S 220 – 150 = = Rs.7 5+1 69 . The theoretical value per share.180? 100? 5 x 180 + 180 = Rs.56. The exrights value per share if the subscription price is Rs. The theoretical value of a right if the subscription price is Rs.180 N=5 a.14x14=Rs. Po = Rs.14 N+1 4+1 The theoretical value of 4 rights which are required to buy 1 share is Rs.206 4+1 c.160 NPo + S 5 x 180 + 160 = = Rs. if the subscription price is Rs.180 5+1 5 x 180 + 100 = Rs.150 Po – S 180 – 150 = = Rs.5 N+1 5+1 b. exrights.176. 4.7 N+1 5+1 c.NPo+S = N+1 4 x 220 +150 = Rs.166.
30 million Rs.33 = 15% Average cost of capital for Cox Corporation 13.33 23.13.3.10 million Market value of the firm Rs.33 million (a) Average cost of capital for Box Corporation 13.4 million net operating income.000/0.10 million/0. Net operating income Interest on debt Equity earnings Cost of equity 70 Rs.3.233 million Box Cox Market value of equity 2.133 million Rs.33million =23.33 million Market value of debt 0 1. : : : : : : : : Rs. 0 x 15% + x 10% 13.000/0.000/0.33.15 2.000.20 million 15% 10% Rs.Chapter 19 CAPITAL STRUCTURE AND FIRM VALUE 1.13.000 Rs.33 13.100 million Rs.000 15% .000.15 =Rs.33 million = Rs.33 (b) If Box Corporation employs Rs.30 million of debt to finance a project that yields Rs.000.86% 23.00 x 15% + x 10% = 12.000.10 million Rs.10 =Rs.33 10.20 million/0.15 = Rs. its financials will be as follows.000.000.10 =Rs.13.000 Rs.6. Net operating income (O) Interest on debt (I) Equity earnings (P) Cost of equity (rE) Cost of debt (rD) Market value of equity (E) Market value of debt (D) Market value of the firm (V) 2.
which is 15%.50 0.5 11. So its average cost of capital will simply be equal to its cost of equity.0 rA = 11.Cost of debt Market value of equity Market value of debt Market value of the firm 10% Rs.50 million Average cost of capital 20 30 15% x + 10% 50 50 = 12% (c) If Cox Corporation sells Rs.20 11.60 11.10 D D+E 0.20 0. you would sell shares of Bharat Company. (a) If you own Rs.0 rD (%) 6.10 million of additional equity to retire Rs.70 0.75 12. and buy the shares of Charat Company.20 million Rs.30 0.0 20.00 0.5 9.60 13.40 0.30 million Rs.10. the levered company which is valued more.0 11.10 as it minimises the weighted average cost of capital. E rE + D+E D rD D+E The optimal debt ratio is 0.40 0.00 0.5 13.5 7.5 8.80 0.0 18.00 11.20 14.90 rE (%) 11.5 12.20 rA + (rArD)D/E 12 + (128) D/E 4.0 11.80 0.10 million of debt .0 6.60 0. rE = 20 = So D/E = 2 E D+E 1.70 0.00 14.0 14.50 0. it will become an allequity company.0 12. (b) The arbitrage will cease when Charat Company and Bharat Company are valued alike 71 . resort to personal leverage. 3.10 0.0 16.20 0.0 13.000 worth of Bharat Company.90 0.00 10.0 14.0 7.30 0.0 15.60 0. 5.55 10.
0 12.5 16.80 0.0 14.90 1.0 0.0 12.50 4.0 12.40 4.50 0.76 10.0 0.50 0.40 0.40 0.12 Optimal .86 9.0 0.0 19. 7.68 9.0 8.50 0.0 0.06 10.0 12.60 0.00 4.10 4.60 0.2 11.70 0.14 7.30 0. D E E D rD rE rA = rE + rD D+E D+ E % % D+E D+E (%) 0 1.30 8.30 0.0 4.60 8. The tax advantage of one rupee of debt is : 72 12.20 0.80 0.90 4.20 6.8 20.2 11.5 14.36 9.2 14.0 13.80 0.0 4.10 0.4 15.12 risk class to which Aswini belongs The average cost of capital(without considering agency and bankruptcy cost) at various leverage ratios is given below. The value of Ashwini Limited according to Modigliani and Miller hypothesis is Expected operating income 15 = = Rs.40 0.70 4.30 9.0 4.125 million Discount rate applicable to the 0.5 13.8 17.90 7.68 8.0 15.6 16.90 0.90 0.0 12.0 0.60 0.30 5.6.0 4.60 4.0 11.5 15.0 4.2 18.0 12.72 Optimal b. The average cost of capital considering agency and bankruptcy costs is given below .0 4.0 4.04 8.0 0.0 11.70 0.0 4.8 10.5 13.0 0.80 4.00 0.0 0.70 0.0 0.10 6.20 0.2 10.30 0.20 0.10 0.0 4. D D+E E D+ E rD % rE % rA = E rE + D+E (%) D rD D+E 0 0.
5) – 600.6 million EPS = Rs.000. of shares = 1.5) – 600.000 Rs.2 (EBIT – Interest) (1t) – Preference dividend EPS = No.500.500.600.0.000 Financing Plan B : Issue of Rs.000 The EPS – EBIT indifference point can be obtained by equating EPSA and EPSB (EBIT – 0 ) (1 – 0.200.000 EBIT = Rs 7.000 EPSA = 2.5 or 50 per cent The EPS under the two financing plans is : Financing Plan A : Issue of 1.000 shares (EBIT .05) (10.000 – 0 ) (1t) – 600.55) (10.(a) Currently No.25) Chapter 20 CAPITAL STRUCTURE DECISION 1.5) – 600.10 million debentures carrying 15 per cent interest (EBIT – 1.000 73 .12 x 50.1(1tc) (1tpe) = (1tpd) = 0.500.500.000 (EBIT – 1.000 EPSB = 1.0 ) ( 1 – 0.000 = Rs.5) .2 million Interest = 0 Preference dividend = Rs.000) (10.000 Hence t = 0.43 rupee 1  (10. of shares (7.500.000) (1 – 0.2 = 1.500.
000 4. When EBIT exceeds Rs.200.98(III) 1.0.4. (EBIT – 0 ) (1 – 0.000.600.000) (1. EPSA (Rs. 2.) 0.8 million equity shares at Rs. 12.) 0.17(I) 1.75(I) 1.4.160.66(II) 0.) 2.400.000 More than 4.10 million of debt carrying interest rate of 15 per cent.10(II) (III) EPSB (Rs.000 3.5 ) – 440.10(II) (II) EPSC (Rs.950.33(III) 0.54(I) 0.00(II) 1.50(I) 0.5) EPSC = 1.000 4.4.= 2.000.950.500. EPS – EBIT equation for alternative A EBIT ( 1 – 0.40(II) 0.33(I) (I) Plan A : Issue 0.000 debt financing maximises EPS.000 equity financing maximixes EPS.35(II) 0.000 and at that EBIT.) 0.000 Solving the above we get EBIT = Rs.0.5 per share.000 1.500.000 3.75(I) 1.000.000 2.5) EPSA = 2.000 (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 (Rs.400.000.950.40(II) 0.000 (a) (c) EPS – EBIT equation for alternative C (EBIT – 1.000 (b) EPS – EBIT equation for alternative B EBIT ( 1 – 0. EPS is Rs.75 under both the plans (b) As long as EBIT is less than Rs.6) EPSA = 74 . Plan B : Issue Rs.200.000 EPSB = 1.
75 .375.5) ROI = 24.375 million Thus the debt alternative is better than the equity alternative when EBIT > 3. Cash flow coverage ratio = Loan repayment instalment > 3.375.6) (EBIT – 1.6) EPSB = 1.500.000.800.000 (EBIT – 1.375 – 7.800.000 3.000.5 ) D/E = 2.7 ] ( 1 – 0. 6.000 5.8869 4. we get (EBIT – 0 ) (1 – 0.000) = Prob EBIT = Prob [z > .52 per cent 18 = [ ROI + ( ROI – 8 ) 0.000) (1 – 0.67 ROE = [12 + (12 – 9 ) 0.75 EBIT + Depreciation b.6) = 1.000 Equating EPSA and EPSB .000 Solving this we get EBIT = 3.000) (1 – 0.000 or 3. 7.6) = 5.0.500.21] = 0. ROE = [ ROI + ( ROI – r ) D/E ] (1 – t ) 15 = [ 14 + ( 14 – 8 ) D/E ] ( 1.1.000 1.1. a.47 per cent EBIT Interest coverage ratio = Interest on debt 150 = 40 = 3.6 ] (1 – 0.375 million EBIT – EBIT Prob(EBIT>3.
80 95.80 million.00 + 49. = Rs. the interest burden will be Rs.0.80 1.645 76 .66 8. (a) If the entire outlay of Rs.645. 277.00 = = 9.on debt + (1 – Tax rate) = 150 + 30 40 + 50 = 2 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 = 133.94 167. 0. the cash available from the operations to service the debt is equal to X which is defined as : X – 80 = .Rs. 35 million (Rs. Considering the interest burden the net cash flows of the firm during a recessionary year will have an expected value of Rs. 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 0.80 + 72. 300 million is raised by way of debt carrying 15 per cent interest.1.1909 (b) Since µ = Rs.80 million . 45 million.40 million .875) 40 = 0.14 +95.35 Prob(X<0) = Prob (z< ) = Prob (z<. 40 million . 45 million ) and a standard deviation of Rs. and the Z value corresponding to the risk tolerance limit of 5 per cent is – 1.Int.
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 Chapter 21 DIVIDEND POLICY AND FIRM VALUE 1. Payout ratio Price per share 3(0.5)+3(0.5) 0.5 0.12 = Rs. 28.13 0.12 3(0.7 5)+3(0.25) 0.15 0.12 0.75 0.12 3(1.00) 1.00 0.12 2. Payout ratio Price per share 8(0.25) 0.25 0.12 – 0.16(0.75) 8(0.50) 0.50 0.12 – 0.16(0.50) 8(1.00) 1.0 0.12 – 0.16 (0) =Rs.66.7 = Rs.100 = undefined = Rs. 25.00 = Rs. 26.56 0.15
77
3. Next year’s price Dividend Current price Capital appreciation Posttax capital appreciation Posttax dividend income Total return P 80 0 P (80P) 0.9(80P) 0 0.9 (80P) P = 14% P = Rs.69.23 Q 74 6 Q (74Q) 0.9 (74Q) 0.8 x 6 0.9 (74Q) + 4.8 Q =14% Q = Rs.68.65
Current price (obtained by solving the preceding equation)
78
Chapter 22 DIVIDEND DECISION 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 Earnings Capital expenditure Equity investment Pure residual dividends Dividends per share 1 10,000 8,000 4,000 6,000 1.20 2 12,000 7,000 3,500 8,500 1.70 3 9,000 10,000 5,000 4,000 0.80 4 15,000 8,000 4,000 11,000 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 10,000 1.00 5,000 5,000 8,000 2 12,000 1.10 5,500 6,500 7,000 3 9,000 1.10 5,500 3,500 10,000 4 15,000 1.21 6,050 8,950 8,000
A. B. C. D. E.
Net income Targeted DPS Total dividends Retained earnings(AC) Capital expenditure
79
or 0 otherwise F. 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. r=0.000 7. Dividends C. Net income B.7 x 0. Given that the company follows a constant 60 per cent payout ratio.F.000 3 9.80 2. the dividend should be raised over the previous dividend of Rs.00 + (10.20 1.000 4.800 7.000 8.000 5.6 x 3.1.00. Put differently the pay out ratio may be set at 60 per cent.00 (the dividend for the previous year) and Rs.) Year A.20 per share by way of dividend.7. Dividends per share 1 10.200 6. External financing requirement 3.60 (80 per cent of earnings per share) Since share holders have a preference for dividend.00 9. According to the Lintner model Dt = cr EPSt + (1c)Dt –1 EPSt =3. .6 . Given the constraints imposed by the management.000 8. the dividend per share has to be between Rs.400 2.500 Nil c. External financing (DC)if D>C.1.000 6.000 2 12. and Dt1 Hence Dt = 0.1.200 4. it seems to make sense to pay Rs.000 4. c= 0.1.00 .20 80 3.000 1.400 3. Retained earnings D.000 6.000 2.600 10.44 1. 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.000 4 15.08 1. However. Capital expenditure E.000 (ED)if E > D or 0 otherwise 500 6.7)1.
3 x 60≥0.1 x 60 (1+b) (2a) These simplify to b ≥ 76/84 b ≥ 2 The condition b ≥ 76/84 is more restructive than b≥ 2 So the maximum bonus ratio is 76/84 or 19/21 81 .60 million Hence the constraints are (10060 b) ≥ 0.100 million.1 S(1+b) (2) R = Rs.4 x 60 (1+b) (1a) 0. PBT = Rs.62 4.= Rs.1.4S (1+b) (1) 0. The bonus ratio (b) must satisfy the following constraints : (RSb)≥0.60 million.3 PBT ≥0. S= Rs.
000 37.000 .000.000 22.000 at a 82 9.Tax savings on interest expense and amortisation of issue expenses 0.000 240.4 [ 37.000.4 [ 15.000 + 8.000/8] Annual net cash savings : ii(a) – ii(b) (iii) Present Value of the Annual Cash Savings Present value of an 8year annuity of 3.000 25.000 3.000.000.000.400.000.000.000 42.000 15.000.000/10] (b) Annual net cash outflow on new bonds Interest expense .800.000.4 [42.500.000 10.000] Initial outlay i(a) – i(b) – i(c) (ii) Annual Net Cash Savings (a) Annual net cash outflow on old bonds Interest expense .000.Chapter 23 Debt Analysis and Management 1.000 (c) Tax savings on taxdeductible expenses Tax rate[Call premium+Unamortised issue cost on the old bonds] 0.000 – 10.100.500.500.000 + 8.000 15.500.100.500. (i) Initial Outlay (a) Cost of calling the old bonds Face value of the old bonds Call premium (b) Net proceeds of the new bonds Gross proceeds Issue costs 250.100.Tax savings on interest expense and amortisation of issue cost 0.200.000.000 250.000 15.000 265.000 17.
200.358.000.4[18.discount rate of 9 per cent which is the post –tax cost of new bonds 3.100.158.280.200.000 2.158.000 4.800.4[19.000 1.000 10.000 7. 2.000 (c) Tax savings on taxdeductible expenses Tax rate[Call premium+Unamortised issue costs on the old bond issue] 0.000 (b) Annual net cash outflow on new bonds Interest expense .535 Net Present Value of Refunding the Bonds (a) Present value of annual cash savings (b) Net initial outlay (c) Net present value of refunding the bonds : iv(a) – iv(b).500 120.000 83 .000 19.000 (b) Net proceeds of the new issue Gross proceeds Issue costs 120.000 124.000 x 5.800.000.400.800.500 17.080.Tax savings on interest expense and amortistion of issue costs 0. (i) Initial Outlay (a) Cost of calling the old bonds Face value of the old bonds Call premium (iv) 17.920.000] Initial outlay i(a) – i(b) – i(c) (ii) Annual Net Cash Savings (a) Annual net cash out flow on old bonds Interest expense .000 + 3.000.120.000 11.000.400.000 + 3.000 7.500 15.600.000.000 + 2.000 672.000 3.800.000/5] 4.000/5] Annual net cash savings : ii(a) – ii(b) (iii) Present Value of the Annual Net Cash Savings Present value of a 5 year annuity of 672.000.000 at 18.000 117.Tax savings on interest expense and amortisation of issue costs 0.4 [ 4.392.608.
336 Proportion of bond’s Value x Time 0.000 .2 50.9 59.090 0.148 0.688 4.318 0.106 0.380 0.2 308.080 cost of 2.466. Yield to maturity of bond P 8 160 918.148 0.5 114.384 0.055 0.614.913 Duration of bond Q is calculated below Year Cash flow Present Value at 20% Proportion of bond’s value Proportion of bond’s Value x Time 1 2 3 4 5 6 7 8 160 160 160 160 160 160 160 160 84 .250 0.4 82.064 0.614.080.080 4.076 0.1.6 0.360 0.000 3.as discount rate of 9 per cent.6 69.9 97. which is the posttax new bonds (iv) Net Present Value of Refunding the Bonds (a) Present value of annual net cash savings (b) Initial outlay (c) Net present value of refunding the bonds : iv(a) – iv(b) 2.50 = + t t=1 (1+r) 1000 (1+r)8 r or yield to maturity is 18 percent Yield to maturity of bond Q 5 120 761 = + t=1 (1+r)t 1000 (1+r)5 r or yield to maturity is 20 per cent Duration of bond P is calculated below Year Cash flow Present Value Proportion of at 18% bond’s value 135.125 0.385 2.
913 = 4.091 0.2 0.5 57.886 = 3.36 13.36 % Solving this for r2 we get r2 = 13.000 .16 1.20 The YTM for bonds of various maturities is Maturity 1 2 3 4 5 YTM(%) 12. r2.48 13. the following equation may be set up : 12500 99000 = (1.273 0.00.1236) + (1.1 89.94% 85 .24 1.960 3. is 1.076 0.000 To get the forward rate for year 2.1236)(1+r2) 112500 = 12.2 69. Volatility of bond Q 3.592 0.304 2.0 83.218 0.72 Graphing these YTMs against the maturities will give the yield curve The one year treasury bill rate .886 Volatility of bond P 4.18 4.131 0.8 450.1 2 3 4 5 120 120 120 120 1120 100.21 13.131 0. r1.109 0.10 13.
1394)(1.1454) 113.500 + (1.1236)(1.1394) 13.1349)(1.100 = (1.750 + (1.1236)(1.1236)(1.1394)(1.1394)(1.000 99.To get the forward rate for year 3.1394)(1+r3) 113. the following equation may be set up : 13.49% To get the forward rate for year 4.750 (1.1349) 13.1394) 13.1349)(1+r4) Solving this for r4 we get r4 = 14. the following equation may be set up : 13. r3.1349) 13.1236) + (1.500 + (1.1236)(1.1236)(1.54% To get the forward rate for year 5.500 100.750 + (1.1236)(1. the following equation may be set up : 13.000 Solving this for r3 we get r3 = 13.500 = (1.1394)(1.050 = (1.000 + (1.1236)(1.1394) 13.1236) + 13.1236) + (1. r5 .1236)(1.08% 86 .500 113.750 100.1394)(1.1454)(1+r5) Solving this for r5 we get r5 = 15. r4 .1349)(1.750 + (1.1236)(1.
500 and then interpolate between 1.856 The ratio of the value of call option to stock price corresponding to numbers 0.500 gives 1.00 Interpolation between 0.6 by interpolation.23 45.450 and 0.8 51.495 and 1.00 50.Chapter 25 HYBRID FINANCING 1.25 51.16) 40 = 1.6 45.8 51.856 we first interpolate between 0.35 2 = 0.75 0.856 can be found out from Table A.45 0.495 0.6 45.3 2.00 50.495 The ratio of the stock price to the present value of the exercise price is : Stock price = PV (Exercise price) 25/(1.75 0.3 2.450 and 0.500 44.75 and 2.450 0.3 Since we are interested in the combination 0.50 44. The product of the standard deviation and square root of time is : t = 0. Note the table gives values for the following combinations 1.495 and 1.3 87 .
Profit after tax: 5(1t) 7.700 900 98.5 (1.7+495.Costs(other than lease rentals)(Ct) 3.1500+639.700 900 148.500) 1 1. AND PROJECT FINANCE 1.3 5 1.8 404.Investment(I) 2.Profit before tax (RtCtLt) 5.Net salvage value 8.856 47.75 0.500) 1.2 577.700 900 420 380 900 0 800 420 420 88 .Depreciation(Dt) 5.78 2.3 466.659 398.7 610 0.9 NPV of the Leasing Option Year 1.Costs(other than (Depreciation)(Ct) 4.in ‘000) 4 1.Revenues(Rt) 2.23 1.00 51.731 458.Net cash flow (1+6+4+7) 9.1 651.700 900 333.00 gives 1.3+527.8 701.1+398.5 = 1018.Then.700 900 222.8 300 889. in ‘000) 4 5 1.6 0.5 (Rs.25 Chapter 24 LEASING.000 (1.700 900 420 380 (Rs.700 1.2 490.Present value (8x9) NPV of the Purchase Option 0 (1.901 639.Profit before tax (RtCtDt) 6.7 326.Profit after tax (which also reflects the net 0 1 1. interpolation between 1.1 604.500) 710 0.7 3 1. HIRE PURCHASE.3 NPV(Purchases)= . Year 1.495 45.3+458.812 495.593 527.75 and 2.4 0.Revenues(Rt) 3.7 0.700 900 500 300 210 2 1.Discount factor at 11 percent 10.9 456.700 900 420 380 3 1.Lease rentals(Lt) 4.700 900 420 380 2 1.3 626.
1+304. 822.4+208.Present value(5x6) 294 1.667 Rs.000 The interest payment of Rs.667 Rs.906.676 Rs.906.000.3 266 0.395.991 Rs.906.667 Rs.1 560 0.324 x Rs.000 = Rs.000 = Rs.3+163.543 304.000 + Rs.Discount factor at 13 per cent 7. Under the hire purchase proposal the total interest payment is 2.2. 720.000 = Rs.12 x 3 = Rs.906.000 = Rs.000 x 0.667 Rs.4 266 0.cash flow)(1t) 6.395.240.000 is allocated over the 3 years period using the sum of the years digits method as follows: Year Interest allocation 366 1 666 x Rs.000.720.000 The lease rental will be as follows : 89 .885 235.720.000 Rs.676 222 2 666 78 3 666 The annual hire purchase instalments will be : Rs. 510. 84.2 2.343 x Rs.693 184.3 266 0.240.720. 720.324 Principal repayment Rs.720.84.1 NPV(Leasing) = 294+235.613 163.1 = 801.667 3 The annual hire purchase instalments would be split as follows Year 1 2 3 Hire purchase instalment Interest Rs.783 208.000 294 266 0. 666.3+184.
697 (1.000(1. 20.000(1.281 + (1.652(0.203(0.4) 281.12.461 35. t=1 (1.4) 118.017 Dt(tc) NSVt 1 560.20.343 4 560.000 6 .4)= .023 215.10)5 20.397 660.938(0.4)= .12.207 (1.4) 510.000 .4) 37.4)=336.461 +  760.000 7 .324(1.10)t Present value of the hire purchase option 548.4)= .375 63.Rs.000 8 .302.667 760.4)=336.000 10 = .LRt (1tc) High Purchase It(1tc) PRt It(1tc)PRt+ Dt(tc)+NSVt 548.000(1.4) 88.4) 666.000 per year for the next 5 years The cash flows of the leasing and hire purchse options are shown below Year Leasing .017 90 660.000 10 .000 9 .000 = .10)8 .437 84.000(0.000 per year for the first 5 years Rs.12.000(1.4)= .000 240.4)=336.397 =(1.991 2 560.023 (1.4) 50.250(0.281 47.676(1.4) 200.20.4) 822.667 (1.000 5 560.000(0.667 3 560.742(0.596 26.20.12.1.10) 63.000(1.84.4) 375.000 395.000(1.000(1.12.4)=336.056(0.10)6 215.989(0.542(0.20.000 Present value of the leasing option 5 336.4) 66.437 (1.20.375 (1.4) 158.10)t t=6 12.697 20.000(1.4)= .10)3 35.10)4 26.10)2 47. 560.4) 210.000 500.000(1.596 + (1.10)7 84.000(1.4)=336.000(1.
1. Inventory period = 750/365 (140+150)/2 91 = 62.9 days = 61.43 days = 56.77 days (110+120)/2 2.369.10)9 = .383 Since the leasing option costs less than the hire purchase option .43 = 80.9 + 61.3 days = 43.2 – 43.2 days 124. (1.10)10 Chapter 26 WORKING CAPITAL POLICY Average inventory 1 Inventory period = Annual cost of goods sold/365 (60+64)/2 = 360/365 Average accounts receivable Accounts receivable = period Annual sales/365 (80+88)/2 = 500/365 Average accounts payable Accounts payable period = Annual cost of goods sold/365 (40+46)/2 = 360/365 Operating cycle Cash cycle = = 62. Apex should choose the leasing option.0 days .+ (1.3 = 124.
000 Wages 720.000 2.940.000 Manufacturing expenses Rs.000 2.000 x 1= x 2 = 12 900.000 1.000 2.7 = 78.000 x 12) 3.Accounts receivable = period = 1000/365 (60+66)/2 52. Total cash cost Total manufacturing cost Less: Depreciation Cash manufacturing cost Add: Administration and sales promotion expenses A : Current Assets Total cash cost Debtors 12 Material cost Raw material stock x 1 12 Cash manufacturing cost Finished goods stock x1= 12 12 = 12 2.580.080.000 120.000 960. Depreciation : (1) – (2) 4.580.000 2. Cash manufacturing expenses (80.000 900.000 x 1= 2.9 = 108.9 – 30.000 120.600.000 x 2= Rs.000 1.2 days 3.9 days Cash cycle = 108.9 days Accounts payable period = 750/365 = 30.000 215.7 days Operating cycle = 56. Sales Less : Gross profit (25 per cent) Total manufacturing cost Less : Materials 900.700. 1.000 75.620.0 + 52.000 92 .000 360. 490.940.700.000 2. 3.
000 B : Current Liabilites Material cost Sundry creditors 12 x 2= 12 900.000 Prepaid sales promotion expenses Cash balance x 1.000 141.Cash balance A predetermined amount Sales promotion expenses 120.000 93 .000 x 2 = 150.000 995. Manufacturing expenses outstanding Wages outstanding One month’s cash manufacturing expenses One month’s wages 290.000 846.000 B : Current liabilities Working capital (A – B) Add 20 % safety margin Working capital required 705.5 = 15.000 Rs.000 = = 80.5 = 12 A predetermined amount A : Current Assets 12 = 100.000 x 1.000 60.000 = = 100.
0 56.0 42.0 56. cash payments. administrative & selling expenses January 60 60 3 25 32 15 February 60 60 3 25 32 15 94 (Rs. Sale of machine 6.6 150 105 45 33.0 3. The forecast of cash receipts.0 179.0 70. Purchases 60 2.0 84.0 137. Credit sales 84 3.0 Forecast of Cash Payments December 1. Collection of receivables (a) Previous month (b) Two months earlier 5. General. Payment of accounts payable 3.6 50.4 150 105 45 42. Cash purchases 4. in 000’s) April 80 60 3 25 32 15 May 80 80 3 25 32 15 June 80 80 3 25 32 15 March 60 60 3 25 32 15 .4 150. in 000’s) November December January February March April May June 1.0 63. Cash sales 36 4.0 63.0 203. Total receipts (3+4+5+6) 120 84 36 33.0 235.0 200 140 60 200 140 60 200 140 60 129. and cash position is prepared in the statements given below Forecast of Cash Receipts (Rs.4 150 105 45 42. Wage payments 5. Manufacturing expenses 6. Sales 120 2.Chapter 27 CASH AND LIQUIDITY MANAGEMENT 1. Interest on securities 7.0 50.0 63.
6) (40.4 30.0 31.0 155.0 24.000 5.0 55.0 30.4 179.000 25.000 20. Dividends 8.0) (38. Payments 4.0 100.000 5. is shown below .000 22.0 2. January through March.0 (65.0) February March April (Rs.000 20.0 (8.4 (3.in 000’s) May June 137.) January (Rs.0 29.0 36. The projected cash inflows and outflows for the quarter.000 22.000 60.4 2.4 30. Opening balance 2.4 83.0 215.000 55.6) 235.000 .0 (70.6) 150.) March (Rs.000 5.4 59.000 73.) February (Rs.0) 22.4) 66.000 15.0 135.000 5. Taxes 9.000 47.0 203.0 53.0 220. Receipts 3.4 30.) Inflows : Sales collection Outflows : Purchases Payment to sundry creditors Rent Drawings Salaries & other expenses Purchase of furniture Total outflows(2to6) 50.0 (6.000 5. Cumulative net cash flow 6.0) (6.0) (68.000 95 22. Month December (Rs.0 (5.0 135.000 18.0 (17.000 5.4 135. Opening balance + Cumulative net cash flow 7.7.000 20.000 22.000 52. Acquisition of machinery Total payments(2to9) 135 135 30 35 80 215 135 155 220 Summary of Cash Forecast January 1.000 25. Surplus/(Deficit) 28 129. Minimum cash balance required 8.4 30. Net cash flow(23) 5.6) 30.6) 24.
74.5000 and a target cash balance of Rs.00 30.00 0 20.0 00 1. Surplus/(Deficit) 5.000 46.00 0 4.8000.0 00 20. The balances in the books of Datta co and the books of the bank are shown below: (Rs.000 8. Net cash flow (2 .0 00 20.0 00 1.000 50.000 50.Given an opening cash balance of Rs.000 4.42.000) (10.000 4.10.) March (Rs.000 1.000 4.000 1.000 1.000 4.000 62.26.000 1. Opening balance 2.000 30. Cumulative net cash flow 6.000  February (Rs.00 0 4.) 55.000) 60.0 00 20.00 0 46. Inflows 3.0 .000 4.0 00 20.000) 8.90.000 (7.58.000 52.000 20.0 00 1.0 00 1.000) 8.000 1.58.000 47.00 30.00 0 1. the surplus/deficit in relation to the target cash balance is worked out below : January (Rs.3) 5.42.00 0 62.000 (10.000 1.000 8.) 1 Books of Datta Co: Opening Balance Add: Cheque received Less: Cheque issued Closing Balance Books of the Bank: Opening 30.00 30.000) (2.000 (18.10.000 (18.000 94. Minimum cash balance required 8.0 00 30.000) (15.000 3.) 1.000) 3.26.000 70. Opening balance + Cumulative net cash flow 7. Outflows 4.000 1.00 0 20.000 4.000 96 2 3 4 5 6 7 8 9 10 30.000 20.06.000 8.000 73.00 0 20.000 78.00 0 78.00 0 4.00 0 20.000 4.74.000 3.000 94.
00 0 0 30.06. Optimal conversion size is 2bT C = I b = Rs.695 + 100.000 90.00 0 20.100.000.000 97 + 100.000 C = 0.Balance Add: Cheques realised Less: Cheques debited Closing Balance 0 30. b = Rs.000 20.149.000 90.68. 2 x 1200 x 2.000 50.22. LL = Rs.000 4.000 = Rs. 3 RP = 4I UL = 3 RP – 2 LL I = 0.1200.000 20.000 x 6.2.000 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.000.000.000 1.000 . = Rs.1.000 RP = 4 x .000 30. T= Rs.0 00 00 20.500. 4.000 4.500.00 0 0 30.68. Hence in the steady situation Datta Company has a negative net float of Rs.000 70.500. I = 5% (10% dividend by two) So.000 3 b2 + LL 3 3 x 1500 x 6.05 = Rs.12/360 = .6.695 UL = 3RP – 2LL = 3 x 149.000 20.0 00 30.695 – 2 x 100.00033.410 5.00033 = 49.346.000.000 1.
Δ RI = [ΔS(1V).000.k ΔI ΔS ΔI = x ACP x V 360 Δ S = Rs.40 Hence.85. V=0.15 x 10.000 x 0.ΔSbn] (1t) – k Δ I Δ I = (ACPN – ACPo) So +V(ACPN) 360 360 ΔS 98 .085 Chapter 28 CREDIT MANAGEMENT 1.000. ΔRI = [ 10.10.85 360 = Rs.ΔSbn](1t). Δ RI = [ΔS(1V).500 2. t = 0.000(10.10 million. k=0.15.4) 0.08 ] (10.08. ACP= 60 days.249.000 x 60 x 0. bn =0.000.= Rs. 207.85).
000 360 360 = 123750 – 123750 = Rs.6 million. t=0.80 360 Δ RI = [ΔS(1V). So=Rs.02 Hence ΔRI = [ 1.ΔBD](1t) –kΔ I ΔBD=bn(So+ΔS) –boSo ΔI = So 360 ΔS (ACPN –ACPo) + 360 x ACPN x V So=Rs.05. ACPo=25. Δ RI = [ΔS(1V) –Δ DIS ] (1t) + k Δ I Δ DIS = pn(So+ΔS)dn – poSodo ΔI = So (ACPoACPN) 360 360 ΔS x ACPN x V So =Rs.75.000. ACPo=45.3(12. V=0.500. ACPo=24.200.000+1. do=.000 x 40 x 0.000)](10.3.75 . k=0.000.50. 0 3.8) – 1. pn=0. bn= 0.04.000(10. (2416)  1.06(Rs.7. bn=0.15 (6045) 15.000(10.05] (1.000.0.3) Rs.5 million. ACPN=60.6. ACPN=40 . ACPN=16.8 x 60 x 1. bo=0.80. ΔS=Rs.75) –{.80){0.1. dn= .45) 0.2 million. r=0.80.000).200.5) 12.000 + 0.06 .000.3 ΔRI = [ Rs.15.15 million Hence ΔRI = [1.500.500.200.7(12.6.000).000 + 0.000(1. t= 0.15.000.01}](10.000.000 x 16 x 0.000 x 0. t = 0. po=0.50.50 million. ΔS=Rs.000.200 4.15 (4025) + 99 Rs.12 million.15 360 = Rs. V=0.000.000).45.15. V=0.ΔS=Rs.04(Rs.50. k=0.020.000.01.79.56.1.000 .
000 ] (1.pn=0.222.395.40.12 .222.10 million.60.222 = Rs. do=0.000 (1.525.778 = Rs.Rs.3 x 10 + 0. Since the change in credit terms increases the investment in receivables.4) – 0.60 x 60 x 0. ΔRI = [ΔS(1V). 30% of sales will be collected on the 10th day 70% of sales will be collected on the 50th day ACP = 0.40 ΔDIS = 0.ΔDIS](1t) – kΔI So=Rs.10.03 – 0. the investment in receivables is : Rs.527.222 Assuming that V is the proportion of variable costs to sales.12 x 1.70 x 50 x 0.000. k=0.222.289.222 x V 6.000. ACPo=20 days.2222 million Δ RI = [ 10.85 x 19 x 38 = Rs.70.2 = Rs. ACPN=24 days.000 Value of receivables = 360 = Rs.3 x 5 + 0.85.7 x 50 = 38 days Rs.02.000 Value of receivables = 360 = Rs. V=0.7 x 527.38 million 50 ΔI= 360 (2420) + 360 10 x 24 x 0. ACP = 0. ΔS=Rs.4.03.1.4.85) – 380.360 = . So.7 x 25 = 19 days Rs.333 100 . po=0.778 Investment in receivables = 0. 30% of sales are collected on the 5th day and 70% of sales are collected on the 25th day.495 360 5.000.833 7.0. dn=0. and t = 0.50 million.
Rs. The decision tree for granting credit is as follows : Grant credit Customer pays(0.85) Grant credit Profit 1500 Customer pays(0.8. is : Expected profit on Initial order + Probability of payment and repeat order x Expected profit on repeat order { 0.05(8500)} 850 = Rs.8000 Expected profit = p1 x 2000 –(1p1)8000 Setting expected profit equal to zero and solving for p1 gives : p1 x 2000 – (1.000 .05) Refuse credit Loss 8500 Customer defaults(0. Profit when the customer pays = Rs.800 million Credit period : 30 days to those deemed eligible Cash discount : 1/10.7 and 0.3. net 30 Proportion of credit sales and cash sales are 0.80 Hence the minimum probability that the customer must pay is 0.2000 Loss when the customer does not pay = Rs.10.95) Profit 1500 Customer defaults(0.80 MINICASE Solution: Present Data Sales : Rs.95(1500).p1)8000 = 0 p1 = 0.85(1500)0.8.850 9. 50 percent of the credit customers avail of cash discount Contribution margin ratio : 0.000 = Rs.85 {0.20 Tax rate : 30 percent Posttax cost of capital : 12 percent ACP on credit sales : 20 days 101 .15) Loss 8500 Refuse credit The expected profit from granting credit. ignoring the time value of money.15(8500)} + = 0 + 0.
667 + 0.50 million Bad debt losses on incremental sales: 12 percent ACP remains unchanged at 20 days ∆RI = [∆S(1 – V) .000.12] (1 – 0.666.8 x 50 x 50.000 x 0] (1 – 0.000.000 x 0.333 Effect of Extending the Credit Period on Residual Income ∆ RI = [∆S(1 – V) .12 x 360 = 2.533.Rs.000.∆ DIS] (1 – t) + R ∆ I where ∆ I = savings in receivables investment So ∆S 102 .3) 800.Effect of Relaxing the Credit Standards on Residual Income Incremental sales : Rs.12 (50 – 20) x 360 = 7.0.8) – 50.667 = 2.800.8 x ACP x V ∆RI = [50.3) 50.∆Sbn] (1 – t) – R ∆ I ∆S where ∆ I = 360 ∆ RI = [50.667 = .000.000 (1 – 0.000 – 8.1.000.000 .000 .000 (10.000.666.000.000 – 266.8) – 50.000.0.000 360 Effect of Relaxing the Cash Discount Policy on Residual Income ∆RI = [∆S (1 – V) .∆Sbn] (1 – t) – R ∆ I where ∆I = (ACPn – ACPo) So + V (ACPn) 360 360 ∆S x 20 x 0.
436.12 x 8.1.778 ∆ DIS = increase in discount cost = pn (So + ∆S) dn – po So do = 0.667 Chapter 29 INVENTORY MANAGEMENT 1. Rs.7 (800.3) + 0.000 + 20. 3.000) x 0.000.480.000.000.000.375 1 2 5 10 250 125 50 25 2 UF b.778 = .000.000 – 4.000 So. 200 400 1. Economic Order Quantity (EOQ) = PC 103 2x250x200 = 30 .000 + 981.000 = 7.480.5 x 800.333 = .000 = 360 (20 – 16) – 0.000.= 360 (ACPo – ACPn) – V 360 800.750 1.2.000.889 – 711. ∆RI = [20.8) – 7.000 x ACPn 20.111 = 8. of Orders Per Year (U/Q) Order Quantity (Q) Units Ordering Cost (U/Q x F) Rs. a.177.750 2.000 (1 – 0.888.000 2.000] (1 – 0.02 – 0.8 x 360 x 16 = 8.454.000 Carrying Cost Total Cost Q/2xPxC of Ordering (where and Carrying PxC=Rs. No.000 x 0.950 2.177.275 1.875 750 375 3.480.30) Rs.01 = 11.
000 x 400 EOQ = 20 U Δπ = UD + Q* Q’ U F2 Q’(PD)C 2 Q* PC = 490 units = 980 3. However. PC =Rs.000 = 6000 x .2 x Rs.2 =Rs.000.20 980 Note that though fractional orders cannot be placed.300 c.27898 104 . 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.300. F=Rs.000 . In practice 11 orders will be placed during the year.25 2 x 10. Hence the ordering cost for the present year will be 10. the number of orders relevant for the year will be 10.25 =Rs. 6. F=Rs.6122. Number of orders that will be placed is = 10.2 2  490 x 100 x 0.100 x 0. So only 20 per cent of the ordering cost of the 11th order relates to the present year.25 10000 b.2 2 = 30.000 + 2498 – 4600 = Rs.000 1.2UF 2.25 x 0.2 .5 + 490  6.25 ] = Rs.6. Total cost of carrying and ordering inventories 980 = [ 10.5 2 U=6.400 .000 x 400 1.2 x 300 + x 6.20 2 x 6. PC= Rs.000 (95)0. a EOQ = = 58 units (approx) PC U=10.000 x 300 EOQ = 6.
2 2 2 1.300 .12) 40(0.04) 60(0.2) 4(0.6 2 x 5000 x 300 EOQ = = 707 units 6 If 1000 units are ordered the discount is : .18) 30 (0.30 = Rs.2 = 7500 + 622729 =Rs.06) 90(0.000 units are ordered is : 5000 Δπ = 5000 x 3.000 Δπ = 5000 x 1.000 +1372 – 3279 5.13.2) 15(0.4.0 + 707 = 15.1.  5000 x 3002000 = Rs.30) 40 (0.5 Change in profit when 1.2 = Rs.7393 5.000 units are ordered is : 5.5) 8(0.10 x Rs.5 + 707 1000 x 28. U=5000 .093 2000x27x0.3) 6(0.05 x Rs.3 and the LT is 5 days with 105 .30 x 0.10) 120(0.5 x 0. PC= Rs.3 Change in profit when 2.6) 10(0. F= Rs.2 2 707x30x0.2 2 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 (Units) 5(0.000 707 x 30 x 0.30 = Rs.2) * 20*(0.06) 60(0.04) Note that if the DUR is 4 units with a probability of 0.000 x 300 If 2000 units are ordered the discount is : .10) 80(0.
400 33.000 120.04 0.800 6 [(1)x1.400 0 43.04 10.04 0. We have assumed that the probability distributions of DUR and LT are independent.06 + 90x0.18 + 30x0.296 106 0 43.000 160.600 44.04 0.04 = 46.600 43.000 54.04 0.6 33.6 43.12 + 40x0.000 80.6. 73.000] Rs.600 38.3x0.04 + 60x0.296 .000 240.6 0 30 10 40 20 30 60 13. All other entries in the table are derived similarly.18.4 tonnes a.16 0.10 0.10 0.a probability of 0.000 40.600 48.000 13.600 7 [5+6] Rs. the requirement for the combination DUR = 4 units and LT = 5 days is 20 units with a probability of 0.400 0 0. Costs associated with various levels of safety stock are given below : Safety Stock* Stock outs(in tonnes) 2 Stock out Cost Probability Expected Stock out Carrying Cost Total Cost 1 3 4 5 [3x4] Rs.10 + 80x0.400 Tonnes 73. 0 4.6 33.30 + 40x0.800 13.6 0 120.6 = 0.400 134.06 + 60x0.10 + 120x0.6 24. 73. The normal (expected) consumption during the lead time is : 20x0.
00 2.00 7.4 + 13. 8. Reorder point is given by the formula : S(L) + F = 30 x 40 + 2.000 1.6 * 174.50 40.000 26.00 2.43.6 tonnes Reorder level = Normal consumption during lead time + safety stock K= 46.04 +0.000 600 450 6.00 18.18 6.00 150.400 0.00 Annual Usage Value Rs.10+0. Item Annual Usage (in Units) Price per Unit Rs.400 294.800 24.00 2.300 900 1.00 1.000 13.000 750 1.00 20.00 25.6 73.04 = 0.500 1.200 107 Ranking 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 400 15 6.000 x 40 7.200 900 1. 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) = 0.35.000 4.00 160.00 20.600 600 30 45 6 10 5 4 1 9 14 15 7 2 11 3 8 12 13 .6 = 60 tonnes b.500 30.00 4.200 25 300 450 1.000 4.10 Safety stock = Maximum consumption during lead time – Normal consumption during lead time So the optimal safety stock= 13.250 12.391 units 30 x 1. 20.00 SR (L) = 3.500 1.000 2.00 15.
7 73.3 80.0 83.000 13.500 105.0 66.500 12.000 80.3 40.3 60.2 41.500 113.3 97.000 4.500 4.250 1.250 132.7 96.000 130.000 24.000 93.000 6.000 8.000 2. Rank Annual UsageValue (Rs.2 6.) Cumulative Annual Usage Value (Rs.7 53.500 119.0 26.0 86.800 1.7 98.2 69.000 26.200 900 30.500 124.4 59.9 88.250 134.000 56.7 13.6 99.0 46.Cumulative Value of Items & Usage Item No.150 108 22.2 78.000 128.) Cumulative Cumulative % of Usage % of Items Value 5 10 12 4 3 1 9 13 6 2 11 14 15 1 2 3 4 5 6 7 8 9 10 11 12 13 30.7 .050 133.4 91.7 94.3 20.7 33.
200 % to Total Value A B C 4 3 18 15 26.Discount % Credit period – Discount period Therefore.3 100. Annual interest cost is given by .8% 20 360 = 0. 0. 93.99 b. of Items % to the Total Annual Usage Value Rs.200 99.6 Chapter 30 WORKING CAPITAL FINANCING 1.367 = 36.98 c.7 20.7% 360 = 0. 0.000 15.750 135.03 x 0.7 8 14 15 600 450 134.3 69.0 Class No.0 53. 0.7 100.0 93.2 19.2% 109 .182 = 18.02 x 0.500 26.2 11. Discount % 360 x 1.01 x 0.97 35 20 360 = 0.700 135.318 = 31. the annual per cent interest cost for the given credit terms will be as follows: a.
3% 35 360 = 0. a.d. 0.98 c.4% 2.02 x 0.75(CACCA)CL = 0.01 x 0.4% d.01 x 0.03 x 0.364 10 = 36.104 = 10.99 360 = 0.18 million Method 2 : 0.75(3612) = Rs.75(CA)CL = 0.1.01 x 360 = 0.75(3612 = Rs. 0.75(3618)12 = Rs.75(CACL) = 0. 0.5% 0.99 b.97 50 35 360 = 0. 0.21 = 21% 360 = 0. 0.99 25 3. The maximum permissible bank finance under the three methods suggested by The Tandon Committee are : Method 1 : 0.223 = 22.5 million 110 .145 = 14.15 million Method 3 : 0.
dx b = x 2 y 2 xy xy The basic calculations for deriving the estimates of a and b are given the accompanying table. y 2 . xy x 2.Chapter 31 WORKING CAPITAL MANAGEMENT :EXTENSIONS 1. dy a = x 2. dx .(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. dy xy . xy . 111 .xy .
3007 74.0096 8.1296 4.62 0.36 0.3424 7 –0.64 0.0540 0.6623 1661.7059 0.42 = 15 0.52 0.2096 12.36 0.0370 0.7696 5.Drawing on the information in the accompanying table we find that Xi = 19.1924 391 0.1303 0.92 0.1724 4 0.8311 G R O U P II 31.7.1124 4 0.8947 112 .4896 2.0451 0.0281 13.64 0.1661 19.0003 107.58 0.4091 135.7051 5.2496 0.6096 10.1424 20 0.76 0.05 0.64 0.1172 0.0189 21.2324 18 0.0476 11 0.78 0.93 0.1823 0.2496 9.2276 26 0.3296 4.64 3.0124 12 0.36 0.81 0.8311 (YiY) YiY)2 =1661.36 0.0010 206.5061 19.1376 18 0.96 1.6101 2.4076 24 0.0324 28 0.36 0.64 8.0924 15 –0.76 (XiX)2 XiX)(YiY) = 10.84 0.64 0.539 Sum of Xi for group 1 X1 = 15 = 13.6385 0.9296 3.02 0.0096 5.36 19.0018 19.1827 13.8995 0.0002 5.0126 0.1849 1.2276 10 0.4096 4.0664 31.1676 25 0.0096 0.64 11.6896 0.02 0.0176 30 0.60 19.45 0.4529 0.5296 2.0116 69.65 1.5696 3.64 Yi (XiX) (XiX)2 = 0.64 0.64 2.4653 2.0010 0.1076 20 0.0945 0.8096 1.1276 20 0.36 .007 (YiY)2 (XiX)(YiY) 0.64 0.0518 152.0324 12 0.0518 87.0085 0.70 0.4069 385.5696 0.81 X = 0.20 0.0203 0.0033 2.2124 8 0.2724 6 –0.68 0.0023 107.64 0.7296 2.0163 0.0689 0.513 1.8069 0.81 Yi= 391 Y = 15.36 0.64 9.6496 1.8896 10.0576 16 0.56 0.90 0.3696 0.7924 Account Number 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Xi 0.85 0.4931 0.90 0.0424 10 0.2576 14 0.0297 0.36 0.0293 0.76 1.7771 0.9261 58.36 0.4096 0.8131 G R O U P I 15 0.36 0.0116 0.76 9.3296 14.64 4.36 0.0742 0.1076 26 0.75 1.1743 92.
8947 – 0.4167 Hence .4167 x 10.24 – 0.24 x 0.24 251 10.079 Xi + 0.079 = 0.6390 = 0.2557 b= 0. the discriminant function is : Zi = 6.2557 dy = Y1 – Y2 = 19.4167 x 0.4167 x 0.2557 – 0.0346 x 69.0346 x 69.4167 x 0.76 = 69.6390 = 0.24 – 0.8311 = = = 6.1089 .60 19.1089 Yi (b) Choice of the cutoff point The Zi score for various accounts are shown below 113 = 6.07 Substituting these values in the equations for a and b we get : 69.0346 x 10.67 – 9.X2 = 0.4167 0.60 = 10.0007 = 0.0346 251 1661.07 a = 0.39 = 10 295 = 15 96 = 10 9.4167 251 dx = X1 .67 0.Sum of Xi for group 2 X2 = 10 Sum of Yi for group 1 Y1 = 15 Sum of Yi for group 2 Y2 = 10 1 x 2 = n1 1 y2= n1 1 xy = n1 XiX)(YiY) = Yi – Y)2 = Xi –X)2 = 0.07 – 0.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Zi Score 7.8398 5.1571 5.6938 9.2498 5.7090 5.4720 6.1426 8.Zi scores for various accounts Account No.7018 7.4405 3.6918 5.7554 7.4405 114 Good(G) or Bad (B) B B B B B B B 24 18 25 23 22 20 17 .1265 4.7292 5.9378 6.7946 3.4097 The Zi scores arranged in an ascending order are shown below Account Number Zi Score 3.7038 5.9231 7.4097 4.1046 6.8870 9.1571 5.3890 3.3890 4.7946 5.4728 8.1265 5.8398 4.0847 7.8514 6.7373 7.
it is evident that a Zi score which represents the midpoint between the Zi scores of account numbers 19 and 4 results in the minimum number of misclassifications .6918 6.6918 = 6.1046 7.5 21 16 19 4 10 2 9 1 11 3 13 14 8 7 12 15 6 5.2105 2 Given this cutoff Zi score. there is just one misclassification (Account number 5) 115 .7292 + 6.4720 7.8514 7.7090 5.7554 7.7292 6.0847 8.6938 5.1426 7.2498 9. This Zi score is : 5.9378 8.7018 6.4728 G B B B G G G G G G G G G G G G G G From the above table.9231 9.7038 5.8870 7.7373 6.
Chapter 4 ANALYSING FINANCIAL PERFORMANCE Net profit 1. Return on equity = Equity = Net profit x Net sales Total assets Net sales x Equity Total assets
=
1 0.05 x 1.5 0.3 Equity
x
= 0.25 or 25 per cent
Debt Note : Total assets = 0.7 So
= 10.7 = 0.3 Total assets
Hence Total assets/Equity = 1/0.3 2. PBT = Rs.40 million PBIT Times interest covered = = 6
116
Interest So PBIT = 6 x Interest PBIT – Interest = PBT = Rs.40 million 6 x Interest = Rs.40 million Hence Interest = Rs.8 million 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 covered ratio = 150,000 4. CA = 1500 CL = 600 Let BB stand for bank borrowing CA+BB = 1.5 CL+BB 1500+BB = 600+BB BB = 120 1,000,000 5. Average daily credit sales = 365 160000 ACP = 2740 If the accounts receivable has to be reduced to 120,000 the ACP must be:
117
= 8
1.5
= 2740
= 58.4
120,000 x 58.4 = 43.8days 160,000
Current assets 6. Current ratio = Current liabilities Current assets  Inventories Acidtest ratio = Current liabilities Current liabilities = 800,000 Sales Inventory turnover ratio = = 5 Inventories Current assets  Inventories Acidtest ratio = Current liabilities Current assets This means Current liabilities Current liabilities Inventories 1.5 800,000 = 1.2 Inventories = 1.2 = 1.2 = 1.5
= 1.2
Inventories = 0.3 800,000 Inventories = 240,000 Sales =5 2,40,000 7. Debt/equity = 0.60 Equity = 50,000 + 60,000 = 110,000 So Debt = 0.6 x 110,000 = 66,000 Hence Total assets = 110,000+66,000 = 176,000
118
So Sales = 1,200,000
240 29.240 Assuming that the debt of 66.867 176.000 176.000 = 264.000 60.333 49.000 represent current liabilities Cash + Accounts receivable Acidtest ratio = Current liabilities Cash + 29.333 = 66.Total assets turnover ratio = 1.560 42.000 66.200 = 5 x 40 = 29.000 42240 29333 – 49867 = 54560 Pricing together everything we get Balance Sheet Plant & equipment Inventories Accounts receivable Cash = 1.000 = 211.000 119 .2 = Inventory 211.Inventories – Accounts receivable – Cash = 176.333 Equity capital Retained earnings Debt(Current liabilities) 50.5 x 176.000 = 360 Cost of goods sold Inventory turnover ratio = Inventory So Inventory = 42.000 Gross profit margin = 20 per cent So Cost of goods sold = 0.200 Day’s sales outstanding in accounts receivable = 40 days Sales So Accounts receivable = x 40 360 264.5 So Sales = 1.8 x 264.000 So Cash = 49867 Plant and equipment = Total assets .000 54.000 Sales 264.
500.000 = 10. (i) Current ratio = Shortterm bank borrowings + Trade creditors + Provisions 5.42 Longterm debt + Current liabilities (iii) Debtequity ratio = Equity capital + Reserves & surplus 12.000 + 22.6 = .000 Cost of goods sold (v) Inventory turnover period = Inventory 365 (vi) Average collection period = Net sales/Accounts receivable 365 = 57.000.000.000.000+5.000.000 = 0.000.200 Cash & bank balances + Receivables + Inventories + Prepaid expenses 8.75 = 1.000+15.000 = 20.000.500.000.100.02 72.000.500.000.000.Cost of goods sold 211.000.000 = 30.000+2.500.000 Current assets – Inventories (ii) Acidtest ratio = Current liabilities = 30.000 22.000 + 30.6 days 120 = 1.000 Profit before interest and tax (iv) Times interest coverage ratio = Interest 15.000.000.000+10.000 = 5.000 = 3.500.000 = 15.000+20.31 = 3.000 42.
000.80 1.27 5.4% 20.4% 95.5 0.75 1.6 days 1.000/15.5 4.31 3.1% 15.0 6% 18% 15% Note that solutions to problems 10 & 11 are not given MINICASE Solution: (a) Key ratios for 20 X 5 12.000.000 = 15.000 = 20.93 13.42 0.000.500.6 57.000 5.5 3.4 121 .1% = 95.0 60 days 1.000.000 = 75.000 = 5.100.4 Current ratio = = 0.100.95.000.27 5.100.7% Standard 1.000 = Net worth 32.7% The comparison of the Omex’s ratios with the standard is given below Current ratio Acidtest ratio Debtequity ratio Times interest covered ratio Inventory turnover ratio Average collection period Total assets turnover ratio Net profit margin ratio Earning power Return on equity Omex 1.000 Net sales (vii) Total assets turnover ratio = Total assets Profit after tax (ix) Net profit margin = Net sales PBIT (x) Earning power = Total assets Equity earning (xi) Return on equity = = 75.000.000 = 1.000 15.02 3.
8 Net profit 3.98 (b) Dupont Chart for 20 x 5 Net sales +/Nonop. surplus deficit 57.0 – Net profit margin 5.4 Total assets turnover ratio = [(34 – 6.8 Return on total assets 10.7)] / 2 3.2 percent = 1.2% ÷ Net sales 57.8.5 + 9.6) + (38 – 6.7)] / 2 3.4 5 Earning power = [(34 – 6.7 Debtequity ratio = 6.4 Total costs 54.96 = 0.3 57.2 percent = 17.0 percent = 5.0 Return on equity = (13.9 + 15.4 122 .8 + 6.2% Net sales 57.0 Net profit margin = 57.8) / 2 = 20.6) + (38 – 6.
0 3.4 + Average total assets 29.6 4.0 Common Size (%) 20 X 4 20 X 5 100 100 78 80 22 20 13 12 9 8 1 1 11 4 7 7 9 3 5 5 Net sales Cost of goods sold Gross profit Operating expenses Operating profit Nonoperating surplus / deficit PBIT Interest PBT Tax Profit after tax Balance Sheet 123 .4 30.6 2.0 57.8 8.9 7.55 (c) Common size and common base financial statements Common Size Financial Statements Profit and Loss Account Regular (in million) 20 X 4 20 X 5 39.6 0.96 ÷ Average fixed assets 21.6 5.0 + Average other assets 2.0 2.6 4.Total asset turnover 1.5 0.35 Average net current assets 54.1 1.0 3.5 2.5 45.0 3.5 11.4 4.
Shareholders’ funds Loan funds Total Net fixed assets Net current assets Other assets Total
Regular (in million) 20 X 4 20 X 5 13.9 15.8 13.5 15.5 27.4 31.3 19.6 23.2 5.1 5.7 2.7 2.4 27.4 31.3
Common Size (%) 20 X 4 20 X 5 51 50 49 50 100 100 72 74 19 18 10 8 100 100
Common Base Year Financial Statements Profit and Loss Account Regular (in million) 20 X 4 20 X 5 39.0 57.4 30.5 45.8 8.5 11.6 4.9 7.0 3.6 4.6 0.5 0.4 4.1 1.5 2.6 2.6 5.0 2.0 3.0 3.0 Balance Sheet Regular (in million) 20 X 4 20 X 5
124
Net sales Cost of goods sold Gross profit Operating expenses Operating profit Nonoperating surplus / deficit PBIT Interest PBT Tax Profit after tax
Common Base Year(%) 20 X 4 20 X 5 100 147 100 150 100 136 100 43 100 128 100 80 100 100 100 100 100 122 133 115 100 115
Common Base Year(%) 20 X 4 20 X 5
Shareholders’ funds Loan funds Total Net fixed assets Net current assets Other assets Total
13.9 13.5 27.4 19.6 5.1 2.7 27.4
15.8 15.5 31.3 23.2 5.7 2.4 31.3
100 100 100 100 100 100 100
114 115 114 118 112 89 114
(d) The financial strengths of the company are: Asset productivity appears to be good. Earning power and return on equity are quite satisfactory Revenues have grown impressively over 20 x 4 – 20 x 5 The financial weaknesses of the company are: Current ratio is unusually low While revenues grew impressively, costs rose even faster: As a result profit margins declined The company did not have any tax liability in the last two years. If the company has to bear the burden of regular taxes, its return on equity will be adversely impacted
(e) The following are the problems in financial statement analysis There is no underlying theory It is difficult to find suitable benchmarks for conglomerate firms Firms may resort to window dressing Financial statements do not reflect price level changes Diversity of accounting policies may vitiate financial statement analysis It is somewhat difficult to judge whether a certain ratio is ‘good’ or ‘bad’
(f) The qualitative factors relevant for evaluating the performance and prospects of a company are as follows: Are the company’s revenues tied to one key customer? To what extent are the company’s revenues tied to one key product? To what extent does the company rely on a single supplier? What percentage of the company’s business is generated overseas? How will competition impact the company? What are the future prospects of the firm? What could be the effect of the changes in the legal and regulatory environment?
125
Chapter 5 BREAKEVEN ANALYSIS AND LEVERAGES 1. a. EBIT = Q(PV)F = 20,000(106)50,000 = Rs.30,000 b. EBIT = 12,000(5030)200,000 = Rs.40,000
2.
EBIT = Q(PV)F EBIT=Rs.30,000 , Q=5,000 , P=Rs.30 , V=Rs.20 So, 30,000 = 5,000(3020)F So, F = Rs.20,000. Q(PV)
3.
DOL = Q(PV)F P=Rs.1,000 ,V=Rs.600, F=Rs.100,000 400(1,000600) DOL(Q=400) = 400(1,000600)100,000 = 2.67
126
000 to Rs.000 + 100.60.600(1.60.4 Hence the number of units to be sold to earn an aftertax income of Rs.5 x 5% = 12.25% If the percentage change in Q is + 5% Percentage change in EBIT = 2.000 4.225.000 is : 50.100.000 units 127 127 .60.000 x Rs.500 = 1.000 To earn a pretax income of Rs.000 + 60.000 1.3.337.000 the number of units to be sold is F + Target pretax income Q = PV = 50.000 = Rs.000 = 22.000 if the tax rate is 40 per cent.12 = Rs.000 Q = = PV 127 =10.5% The corresponding value range of EBIT is Rs.000 units Break even point in rupees: Q x P = 10.5% Hence the possible forecast errors of EBIT in percentage terms is –25% to 12.000 Q = = 30.5 x –10% = .5 EBIT(Q=15000) = Rs.000600) DOL(Q=600) = 600(1.00.60. DOL(Q=15000) = 2.000600)1.000 Percentage change in EBIT = DOL x Percentage change in Q If the percentage change in Q is –10% Percentage change in EBIT = 2.00.120. Break even point in units F 50. the Pretax income must be Rs.71 5.000 units 127 To earn an aftertax income of Rs.
F=Rs.333 6 Sales in rupees = 13.10.266.3 bags = 588.2 bags .000 128 = 714.000 20.66.20 = Rs.000 = Rs. the percentage change in profit is : 3620032000 = 13.36200 So.000 Break even point in rupees = Rs.333 x Rs.666 10.000 15.20 PV = Rs.000 Q = 3316 (d) A 50 per cent increase in fixed costs means that F=Rs.30 P 20000 Q = 6 = 3.000 Q = 3016 (b) Profit when the quantity is 3000 bags Profit =3.6.60.6 F=20.300(3016)10.30 .32000 10 per cent increase in production means that the quantity is 3300 bags At that production Profit = 3.666 When net income is Rs.33 Breakeven point when P= Rs. (a) P = Rs.30 6 = Rs.000 Q = = 13.000 Breakeven point when F= Rs.15.15.V=Rs.000 7.16.333 P = 0.000(3016)10000 = Rs. PV = 0.33 10.000 +60.1% 32000 (c) A 10 per cent increase in selling price means that P= Rs.
(40000) Rs.000 = 5.000 units 8040 (b) The weighted contribution margin is : 5000 8.400000 Rs.000 units 5030 Breakeven point for product R 200.10 Rs.80000 Rs.16.16000 4000 Rs.12 Rs.4 0.40000 Rs.23.) Net income(loss)before tax No.000 Q = = 1000 bags 3020 8. the breakeven point is : 10.40 = Rs. Selling price per unit Variable cost per unit Contribution margin per unit Contribution margin ratio Total fixed costs Breakeven point in units Breakeven sales(Rs.8 Rs.5 Rs.4 0.40000 21600 15000 20000 9.000 = 5. (a) Breakeven point for product P 30.5 Rs.20.60000 12000 20000 12000 Rs.4 Rs.4 bags 3316 (e) If V= Rs. DFL = EBIT Dp 129 .000 x Rs.200000 Rs.33 Rs.5 0.160000 Rs.100000 Rs.10 + x Rs.10 Rs.000 6.of units sold A Rs.68 10.8.33 Rs.20 + 19000 19000 19000 x Rs.5 0.20 Rs.8.6 Rs.120000 Rs.000 units 3020 Breakeven point for product Q 100.Q = = 882.66 Rs.000 = 3.30000 11500 B C D Rs.
20Rs. (a) EBIT = 1.Rs.Dp EPS = n (Rs.40.000 Rs.000 DFL(Q=20.000 units Rs.20.000Rs.17 = Rs.000 = Rs.15 = 10.000 + Rs.000 Firm B : 12.000 = Rs.320.320.Rs.20 – Rs.000 Firm A : 10.000) = Rs.000 (EBITI) (1T) .000 Rs.10.130.6)Rs.000 Firm B : = 4.70.5.100Rs.185 Q(PV) – F (b) Firm A : 20.1.000 + Rs.5)Rs.4)Rs.100.0.000 = Rs.40).000 (Rs.70.40.000(Rs.40.EBIT – I T at Q = 20000 EBIT= 20000(Rs.000(Rs.10.000(Rs.000 (Rs.000Rs.4.320.9 (c) BEP = P–V Rs.60.15) – Rs.20.000Rs.000 F+I = Rs.000)(1.000Rs.000 Firm A : Rs.50Rs.000 Firm C : 15.80.130.30) .000)(1.5) = 11.000)(1.80.5.40 = Rs.30.10.24)=Rs.10.40Rs.000 Firm B : 10.500 units 130 .60.000 (1.000 Firm C : 3.
5.333 .000 (1.000 EBIT (e) DFL = EBIT – I Dp (1T) Rs.50Rs.44 = 1.10.000(Rs.70.000(Rs.100.000(Rs.100 – Rs.000 3.000 Firm A : Rs.000 + Rs.40.130.80.40)Rs.50 – Rs.100.5) Rs.000(Rs.000(Rs.80.54 = 2.10.4) Rs.000 10.20Rs.30) Firm B : 10.000Rs.40 Q(PV) (d) DOL = Q(PV)F 20.67 = 1.5000 Rs.000(Rs.000131 = 2.000 (1.130.60.30)Rs.40) Firm C : 3.Rs.333 units = 1.100Rs.000 Firm B : Rs.20.15).30 = 5.000 Firm C : Rs.000Rs.000 Firm C : Rs.20Rs.100Rs.25 = 1.000 Rs.30 Rs.15) Firm A : 20.000 Rs.000Rs.50Rs.40.40.Rs.60.
63 68.75 2.74 10.25 x 5.91 40.6) (f) DTL = DOL x DFL Firm A : 1.57 241.54 x 1.20 17.333 = 12.30 = 2.0 778.00 1.40 6.(1.72 1.39 12.07 3.96 1.67 x 1.58 10.67 7.33 23.65 27.54 .85 29.63 6.90 1. The proforma income statement of Modern Electronics Ltd for year 3 based on the per cent of sales method is given below Average per cent of sales Proforma income statement for year 3 assuming sales of 1020 Net sales Cost of goods sold Gross profit Selling expenses General & administration expenses Depreciation Operating profit Nonoperating surplus/deficit Earnings before interest and taxes Interest Earnings before tax Tax Earnings after tax 100.48 67.00 Firm C : 2.44 = 2.40 Firm B : 1.24 2.72 132 1020.0 76.00 Chapter 6 FINANCIAL PLANNING AND BUDGETING 1.43 75.
91 61.57 241.66 8.00 31.66 133 .20 39.0 778.0 49.43 75.86 10.00 9.40 Budgeted Budgeted 1.0 76. The proforma income statement of Modern Electronics for year 3 using the the combination method is given below : Average per cent of sales Proforma income statement for year 3 Net sales Cost of goods sold Gross profit Selling expenses General & administration expenses Depreciation Operating profit Nonoperating surplus/deficit Earnings before interest and taxes Interest Earnings before tax Tax Earnings after tax Dividends (given) Retained earnings 100.33 23.00 50.48 55.Dividends (given) Retained earnings 8.67 7.86 12.07 Budgeted 1.00 60.95 10.54 2.00 Budgeted 1020.
0 40.54 22.49 21.60 5.0 Net sales ASSETS Fixed assets (net) Investments Current assets.40 220.00 961. The proforma balance sheet of Modern Electronics Ltd for year 3 is given below Average of percent of sales or some other basis Projections for year 3 based on a forecast sales of 1400 1020.35 20.09 No change 15. loans & advances : Cash and bank Receivables Inventories Prepaid expenses Miscellaneous expenditure & losses 100.00 1.32 51.3.71 229.23 No change 410.70 LIABILITIES : 134 .92 14.
Projected Income Statement for Year Ending 31st December .300 x (0.00 160. EFR = S  L S S – m S1 (1d) 800 = 1000  190 300 – 0. 2001 Sales Profits before tax Taxes Profit after tax (6% on sales) Dividends Retained earnings 1.61 x 300) – (0.31 48.06) x 1.5) = 183 – 39 = Rs.7 A 4.96 961.144.00 17.03 Balancing figure 176.66 Secured loans: Term loans Bank borrowings Current liabilities : Trade creditors Provisions External funds requirement No change No change 175.00 199.06 x 1.Share capital : Equity Reserves & surplus No change Proforma income statement 150.300 (10.300 195 117 78 39 39 135 .5) 1000 = (0.77 51.33 5.
00 37.25 47.12.25 30.5 (b) Projected Balance Sheet as on 31.20X1 Liabilities Share capital Retained earnings (40 + 7.5) = 52.625) x 240 x (0.5) 160 = (60 – 7.5) Term loans Shortterm bank borrowings Trade creditors Provisions 56.040 Fixed assets Inventories Receivables Cash Assets 520 260 195 65 1.040 A 5. (a) EFR = S  L S S – m S1 (1 –d) 150 = 160  30 x 80 – (0.50 46.50 225.Projected Balance Sheet as at 31.50 7.12 2001 Liabilities Share capital Retained earnings Term loans (80+72) Shortterm bank borrowings (200 + 72) Accounts payable Provisions 150 219 152 272 182 65 1.00 225.00 Assets Net fixed assets Inventories Debtors Cash 90 75 45 15 136 .
11) EFR 20X3 = 200 187.50 0.46 x (1.0625 x 220 x 0.80 0.0625 x 180 x 0.88 37.75 x (1.75  33.75 x 20 –0.5 168.31 x (1.5 200 x 20 – 6.5 137 .75 = 180 = 8.5 x 20 – 0.0625 x 220 x 0.0625 x 200 x 0.54 14.1) EFR 20X4 = 220 = 7.49 220 200 37.(c) i) ii) iii) (d) A EFR 20X1= S 150 = 160 = 9.125 160 S 30 L Current ratio Debt to total assets ratio Return on equity 20X0 1.46  33.5% S – mS1 (1 – d) 20 – 0.75 x (1.125) EFR 20X2 = 180 180 30 x 1.53 14.11) 20 – 0.0625 x 240 x 0.31 = 200 = 8.5 180 168.3% 20X1 1.1) x 20 – 0.11 187.38 150 x (1.
0. (0.87 Net fixed assets 90.88+7.4) (0.50 (b)  70 x 100 – (0.3 g Solving the above equation we get g = 7.00 (30+16. Assets Rs.63+6.00 6.00 Trade creditors 37. L/S= 0.6 and EFR = 0 we have.00 Cash (10x240/160) 15.50 Provisions 7.26 (50x240/160) 75.05)(1+g)(0.00+5.5) 400 Let CA = denote Current assets 138 .8 .87) (60 x 240/160) Retained earnings Inventories (40.5) g (0.87) 36.00 225. Share capital 46. EFR = A  L  m (1+g) (1d) S S S g Given A/S= 0.80.5 . 20X4 Liabilities Rs. (a) EFR = S S L S – mS1 (1d) =0 =0 320 = 400 = Rs.05) (500) (0.e.4) i.00 Term loans(20+16.87 Debtors (30x240/160) 45. d= 0.50) 66.05 .Balance Sheet as on 31st December.14% A 7.50 225. m= 0.25+6.05)(1+g)(0.00 Shortterm bank borrowings 30.
25 FA LTL At the end of 20X1 FA = 130 x 1.50 or 1.00 = 42. the suggested mix for raising external funds will be : Shortterm borrowings 42.50 – 60.5 162.50 Additional equity issue 139 ii.25 or CL CA STL +SCL As at the end of 20X1.5 LTL or LTL = Rs. we get 1.LTL (20X1) = 130.25 = 87.50 LTL = LTL (20X1).00 – 80. CA = 20x0 x 1.25 = 162.50 Longterm loans 7.50 SCL = 70 x 1.25 = 237.CL SCL STL FA and LTL i.00 = 50.00 Hence. = Current liabilities = Spontaneous current liabilities = Shortterm bank borrowings = Fixed assets = Longterm loans Current ratio CA i.50 Substituting these values.25 (STL + 87.25 If STL and LTL denote the maximum increase in ST borrowings & LT borrowings . . we have : STL = STL (20X1) – STL (20X1) = 102.e greater than or equal to 1.130 1.5) 237.50 Ratio of fixed assets to long term loans 1.e STL Rs.25 i.25 STL x or STL = 1.102.
140 The total assets of Videosonics must be 4.000 (0.06) 11.05 (10.05 .70 per cent A/E = 3.000 S= 10..6 per cent . A/E = 2.140 + 3.000 = (0.06) (0. A/S = 1. d= 0.6) 1.6) x A/E (c) .33 .5 to 3.4 m (1d)A/E (a) g= A/S –m(1d)A/E .000) = 4.000. m= .140 9.5 = 3.6) x A/E (b) 0.5 = 2.05 (10.05 = 1. d = 0.000 10.4) (11.00 A 8.05 (10. EFR = S  L S – m S1 (1d) S A S S represents surplus funds Therefore.466 The dividend payout ratio must be reduced from 60 per cent to 46.6) 2.4 .05 (10.4 .000) – 150 = 114 10 or A = (1.33 A/E = 3.000 and surplus funds = 150 we have A 3.33 m (10. S1 =11.06.000 (10.5 140 .6) A/E The A/E ratio must increase from 2.6) 2.50. L= 3. mS1(1d) – S S Given m= 0.5 .4 .000 = 150 10.6 .6) 2.6) A/E d = 0.05 (10.000 A – 3.6 .5 = 1.05 (10.
. (a) The calculations for Hitech Limited are shown below : Year 2 EBIT PBT 86 + Interest expense 24 .883 Chapter 32 CORPORATE VALUATION 1.5 (e) .883 A/S = .05 (10.92 per cent The net profit margin must increase from 5 per cent to 7.Tax on nonoperating income Tax on EBIT NOPLAT Net investment Nonoperating cash flow (posttax) 141 Year3 102 28 (15) (10) 105 26 9.2 71.6 65.5 m = 7.Nonoperating income (5) EBIT 95 Tax on EBIT Tax provision on income statement + Tax shield on interest expense .Tax on interest income .6) 2.8 (50) 6 .5 The asset to sales ratio must decrease from 1.Interest income (10) .4 – m (10.92 per cent .6) 2.4 (50) 3 32 11.05 (10.06 = A/S .06 = 1.6) x 2.4 to 0.2 (6) (4) 33.(d) .6 (4) (2) 29.
Net borrowings (30) + Excess marketable securities 30 .672 .1% 15. exp. FCFF (346) Discount factor 1600 240 156 200 120 400 1 2 3 4 5 1920 288 187 240 144 480 80 11 2304 346 225 288 173 576 96 13 2765 415 270 346 207 691 115 16 3318 498 323 415 249 829 138 19 3650 547 356 912 83 273 0. 2.Share issue (20) 18.589 .8 40 (30) 10 (9) 27.29 21. Working capital 6. .35% 1.FCFF 18.4 27. 16.876 0.767 142 0.Aftertax income on excess (6) marketable securities . Working capital 7.Depreciation 5.9% 21. 4.28 19.8 460 50 Posttax operating margin Capital turnover ROIC Growth rate FCF 2. Revenues EBIT EBIT (1t) Cap.9% 13.1% 16.8 0 Base year 1. 3.8 Year 3 360 410 71.61% 1.4 400 50 Year 3 16.4 Televista Corporation 15.8 (b) The financing flow for years 2 and 3 is as follows : Year 2 Aftertax interest expense 14.4 (c) Invested capital (Beginning) Invested capital (Ending) NOPLAT Turnover Net investment Year 2 310 360 65.4 Cash dividend 30 .
5 [14% (1 .5 x 21.2 + 0.64 9.44 x 9.19 Cost of capital for the high growth period 0.1 + 0.5 x 21.76 + 11.35)] 9% + 4.2% 21.6 = 14.15% Cost of capital for the stable growth period 0.1355 – 0.25 x 7%] + 0.1% 0.5 x 10.6 [15% (1 .56 + 4529.5 x 14.56 273 273 = 7690 Horizon value = = 0.19 = 41.5 x 21.2% WACC for the stable growth period = 13 (1 – 0.56 x 17.1% 15 (0.0355 Present value of horizon value = 4529.5 Value of the firm = 41.5 x 21.5 x 13.0 x 5 = 16% 143 . The WACC for different periods may be calculated : WACC in the high growth period Year 1 2 3 4 5 kd(1t) = 15% (1t) 15 (0.85% = 14.00 x 6%] + 0.76 11.97 + 10.4 [12% + 1.1 = 17.5 x 12.1% 0.5 x 11.1% 0.1 = 15.06 million 3.5% ke = Rf + x Market risk premium ka = wd kd (1t)+ we ke 12 + 1.3) = 9.3% 15 (0.1% 0.1 = 16.1 = 16.4571.1 x 6 = 17..10 0.70) = 10.55% = 13.50 = Rs.Present value 9.4 + 0.1% = 11 + 1.6% 21.3% 21.4% 15 (0.97 10.5 + 0..55% Present value of FCFF during the explicit forecast period = 9.3 + 0.3 x 7 = 21.7% 21.8 + 0.8% = 11 + 1.1 = 17.76) = 11.35)] 8.94) = 14.5 x 21.88) = 13.64 + 9.2% 15 (0.8% kd(1t) ke ka kd(1t) ke WACC in the transition period = 14 (1 – 0.3% + 5.6% = 0.82) = 12.3) = 9.1% 0.5 [12% + 1.
100 74 x 0.1 + 2/3 x 16 = 13.3 1:1 1.1 0.1 0.2 14.535 .0 17.3 1:1 1.7 16.238 30.9 16.ka = 1/3 x 9.4 16.238 = 476 This is shown in the present value cell against year 11.8 12.4 15.2 13.1 0.8:1 1.2 16. WC FCFF D/E Beta WACC PV exp.6 476 673.4 The present value of continuing value is : FCF11 x PV factor 10 years = k–g 0.2 14.8:1 1.7% The FCFF for years 1 to 11 is calculated below. Multisoft Limited Period Growth EBIT Tax rate (%) rate (%) 0 90 1 40 126 6 2 40 176 12 3 40 247 18 4 40 346 24 5 40 484 30 6 34 649 30 7 28 830 30 8 22 1013 30 9 16 1175 30 10 10 1292 30 11 10 1421 30 EBIT (1t) Cap.1 0. % Factor 100 140 196 274 384 538 721 922 1125 1305 1436 1580 60 84 118 165 230 323 432 553 675 783 862 948 Present value 118 155 203 263 339 454 581 709 822 905 995 26 39 50 70 98 132 169 206 239 263 289 36 38 44 39 26 33 43 53 61 68 74 1:1 1.4 million as shown below MINI CASE Solution: Solution: 144 .462 .3 1:1 1.7 . The present value of the FCFF for the years 1 to 10 is also calculated below.310 .2 14.1 1.3 1:1 1.7 16.622 .6 27.850 .8:1 1.8:1 1.354 .8 14.1 0.0 13. Dep.3 0.405 .3 15.8:1 1. The value of the firm is equal to : Present value of FCFF during + Present value of continuing The explicit forecast period of 10 years value This adds up to Rs.726 .137 – 0.272 .685.2 14.4 20.6 27.5: 1.6 17.
2 9.35) 4.200 130 84.4 + 1249 = 1321.6 87 273.4 Firm value = 72.14)3 (1. Total investment 9.450 222 144.14)6 = 72.3 100 70 170 57.4 million Chapter 33 VALUE BASED MANAGEMENT 1. Revenues 2.4 {8 + 1.14 – 0.0 4 1.3 69.8 250 15 265 (105. Gross investment in fixed assets 7. Gross cash flow 6. PBIT 3.14)2 (1.1.6 = – + + + + (1.4 = 14% 1 950 140 91 55 146 100 10 110 36 2 1. Depreciation 5. NOPAT = PBIT (1 – .10) Continuing Value = 0.35) + 1.000 115 74.3 6 1.5 57.14)5 (1.3 5 1.3 83 227. FCFF (5) – (8) 0.8 85 159.660 245 159.6 105.6 (1.5 85 70 155 9.2) 3 1.5 80 164.3 85 244.4 – 200 = 1121.770 287 186.14)6 = 1249 = 2739.4 WACC = 1.6 x 12 x (1 – 0.10 2739 Present value of continuing value = (1.14)4 (1.5 1.3 99. Investment in net current assets 8.7 120 54 174 99.4 Value of equity = 1321.06 (8)} 99.14) (1. The value created by the new strategy is calculated below : 145 .00 PV of the FCFF during the explicit forecast period 3.3 105 70 175 69.
.15 = 1120 1154 – 1120 = 34 944 944 1888 1888 264 84 185 101 62 264 94 94 264 . According to the Marakon approach M r–g = B k–g r .15)4 = 1007 147 + 1007 = 1154 168/0..10 2 = k .Current Values (Year 0) Sales Gross margin (20%) Selling and general administration (8%) Profit before tax Tax Profit after tax Fixed assets Current assets Total assets Equity Profit after tax Depreciation Capital expenditure Increase in current assets Operating cash flow Present value of the operating cash flow Residual value Present value of residual value Total shareholder value Prestrategy value Value of the strategy 2.10 r ..15 = 1760 1760 / (1.10 = 2k .20 146 Income Statement Projection 1 2240 448 179 269 81 188 2 2509 502 201 301 90 211 3 2810 562 225 337 101 236 4 3147 629 252 378 113 264 5 3147 629 252 378 113 264 2000 400 160 240 72 168 600 600 1200 1200 Balance Sheet Projections 672 753 843 944 672 753 843 944 1344 1505 1696 1888 1344 1505 1686 1888 Cash Flow Projections 188 211 236 60 67 75 132 148 166 72 81 90 44 49 55 = = = = = = 147 264 / 0..
20) 5 Value of forward plan = 0..6 = = 15.4% (d) Average cost of capital 0.40 – 0.35) + 0.9 (6%) = 1.5 x 11.833. 8.000 1. Revenues Costs PBDIT Depreciation PBIT NOPAT Cash flow (4+6) Capital at charge 2.400 1.18 = 0.000 800 600 400 200 147 ..20 5 years 200 (0.6 .65) = 15.400 1.3 million 5.14 or 14 per cent 1.000 2. 6..(. (a) NOPAT for 20X1 PBIT (1 – T) = 24 (0.200 million 0.000 2.6% Capital employed 120 – 20 (Noninterest bearing liabilities) (c) Cost of equity 6% + 0.10/k) Thus r/k is a function of k.r = 2k .000 2.4% = 8.400 600 600 600 600 600 200 200 200 200 200 400 400 400 400 400 240 240 240 240 240 440 440 440 440 440 1. Unless k is specified r/k cannot be determined.20 (1. 7.Average cost of capital x Capital employed 15.20) = Rs.40 0.10 + 0. 5.400 1.3 4.083 x 100 = 7. 4. I r c* T = = = = Rs.3% (e) EVA for 20X1 NOPAT . 3.000 2.6 (b) Return on capital for 20X1 NOPAT 15.10 r/k = 2 .400 1.5 x 0. Cost of capital = 0.5 x 0.5 x 8% (1 . 3. 2.
540 302.675 + 184 x 0.433 – 1000 = 510.460 652. Investment Life Cost of capital Salvage value 148 .164 440.927 162.303 61.540 185.296 212.730 302.540 302.5 t=1 (1.14)t = 100 x 0.592 + 212 x 0.600 Capital Depreciation Capital charge Sum 7.000 117.540 Depreciation charge under sinking fund method 1 2 3 4 1.000. 4yrs = Rs. 15%) = 2.2.600 881.000 837.592 = 118.000.914 881.000.000 x 0. EVA (69) 100 128 156 184 212 5 440 NPV = .14) 140 112 84 56 28 10.9.244 91.000 Economic depreciation = FVIFA(10yrs.000 – 118.302.600 Annuity amount = PVIFA14%.519 = 510.810 140. Capital charge (8x0.14)t NPV = EVAt (1.000 Economic life = 4 years Salvage value = Rs.540 : : : : Rs.000.237 240.000 10 years 15 per cent 0 2.877 + 128 x 0.200.3 6.540 302.000 Cost of capital = 14 per cent Present value of salvage value = 200.000.769 + 156 x 0.400 = 881. Equipment cost = 1.400 Present value of the annuity = 1.1000 = 440 x 3.
386.963 600.000 1.000. 15%) Year 1 11.037 3.963 1 5. Investment Net working capital Life Salvage value Annual cash flow Cost of capital Straight line depreciation = = = = = = = Rs.787.2.000.963 1.000 Economic depreciation = FVIFA(5yrs.638 2.618 10.000 / 3.238.564 399.331.000.503 PVIFA(5yrs.386.618 10.605 .386.963 5.828 million Profit after tax Depreciation Cash flow .21. Investment Life Cost of capital Salvage value : : : : Rs.846 881.000.301 505.618 149 80 = 13.238.000 5 years 12 per cent Nil = 98.5.353 9.000.336 148.386.166 1.000 = 6.12%) = 3. Annuity amount = 5. 12%) 5.5.000 = 20.344.399 987.000.000 786.618 Year 4 11.472 1.727 = Rs.20 million 8 yrs Rs.386.797 281.304 8.20 million (Net working capital) Rs.000 21.386.626 1.10 million per year = Rs.213.662 1.605 = 1.618 million 15% Rs.963 1.963 Depreciation charge under sinking fund method 2 3 4 5 4.100 million Rs.963 1.105.000 21.030 Capital Depreciation Capital charge Sum 80 Economic depreciation = FVIFA(8.
62% 15.79% 150 . Book capital 100 (Beginning) ROCE ROGI CFROI 70 11.79% 16.62% 15.62% 21.59% 21.
4 million.5 2.5 5 10 2.5 77.25 million.10 million Benefit = Rs. ACQUISITIONS AND RESTRUCTURING 1.5 17.18 million PVJ = Rs.Chapter 34 MERGERS.3 million NPV to Beta = Cash Compensation – PVB = Rs. Let A stand for Ajeet and J for Jeet PVA = Rs.5 30 2.5 After Amalgamation Cox & Box Company Pooling method Purchase method 35 45 27.23 million 151 . Cash compensation = Rs.5 42.000 Setting this equal to Rs.5 20 10 17. Postmerger EPS of International Corporation will be 2 x 100.000 + 2 x100.6 3.5 17.1 million NPV to Alpha = Benefit – Cost = Rs.4 million PVAJ = 18 + 5 + 4 = Rs. The preamalgamation balance sheets of Cox Company and Box Company and the postamalgamation balance sheet of the combined entity.5 77.5 62.000 100.5 million Benefit = Rs.5 and solving for ER gives ER = 0.10) Reserves & surplus Share premium Debt 25 20 45 20 10 15 45 Box 10 7. under the ‘pooling’ method as well as the ‘purchase’ method are shown below : Before Amalgamation Cox Fixed assets Current assets Goodwill Total assets Share capital (face value @ Rs.25 x 200.2.5 25 20 17.000 + ER x 100.11 million Cost = Cash compensation – PVB = Rs.1 million 4.000 = Rs.000 = Rs. Cox and Box Company. PVB = Rs.60 x 300. PVA = Rs.
75 million 5.11 Hence the benefit of the acquisition is 2 million x Rs.05) Rs.75 = Rs.3.07) = 0.25 x 27 .25 million c) NPV to Jeet = Cost = Rs.07 Thus the value per share increases by Rs.1. Rs.000 = = 0. the cost of the merger is 2 million x (Rs.6 million.15. If the growth rate of Unibex rises to 7 per cent as a sequel to merger.5 per cent.6.1. the intrinsic value per share would become : 1.Cost = 4 .000 + 100.PVB = 0.05 k = 0.2. a) PVB = Rs.155 or 15.000.000 = Rs. If Multibex offers 1 share for every 3 shares it has to issue 2/3 million shares to shareholders of Unibex.5 The share of Jeet in the combined entity will be : 100.155 ..1.75 million b) NPV to Ajeet = Benefit .11 = Rs.22 million (b) (i) If Multibex pays Rs.3.12) = Rs.12 x 2.24 million The required return on the equity of Unibex Company is the value of k in the equation. Rs.1.12 = k .5 = Rs.20 (1.15 per share cash compensation.25 300.20 (1..15 – Rs.11 (ii) So shareholders of Unibex will end up with 152 .000 a) True cost to Ajeet Company for acquiring Jeet Company Cost = PVAB .Exchange ratio = 0.
667 shareholding of the combined entity.PVB = .24 = Rs.4000 Rs.2 million = Rs.90000 2 B 2000 Rs.9 x 8 = 0.1177 x 255.45000 Rs.225 million + Rs.49000 Rs.3 153 . The present value of the combined entity will be PVAB = PVA + PVB + Benefit = Rs.24 million + Rs.77 per cent Number of shares Aggregate earnings Market value P/E 7. The expected profile of the combined entity A&B after the merger is shown in the last column below.33 = 0.1177 or 11.P2 S2 9 x 12 = 9 (36+12) . A 5000 Rs.0.114000 2.6.04 million 6.1 (E1+E2) PE12 (b) The minimum exchange ratio acceptable to shareholders of Ajay Limited is : P2 S1 ER2 = (PE12) (E1+E2) . (a) The maximum exchange ratio acceptable to shareholders of Vijay Limited is : S1 ER1 = S2 12 = 8 + 30 x 8 + P1S2 (36+12) 8 = 0.2 million So the cost of the merger is : Cost = PVAB .255.24000 6 A&B 6333 Rs.667 5+0.6.2 .
Rs.7 million = 0.15)7 = .3 Thus ER1 and ER2 intersect at 0.76.7 (1.08 1 PV (VH) = 257.3 8.15) (1.4 + 96.20.7 = Rs.1 x = (1.257.20. applying the constant growth model is FCF8 V4 = 0. The present value of FCF for first seven years is 16.00 14.96.15)6 16.15)5 + 10.150.72 Equating ER1 and ER2 and solving for PE12 gives.15)3 0 (1. PE12 = 9 When PE12 = 9 ER1 = ER2 = 0.7 + (1.(c) ER1 ER2 =  12 + 8 (48) PE12 240 9 x 12 = PE12 (48) .3 million 154 .30 PV(FCF) = 2 (1.15) 9.1 million The value of the division is : .2 + (1.08 18 = Rs.15)4 0 + (1.15)7 Rs.4 million The horizon value at the end of seven years.15 – 0.
32 = 0.MINICASE Solution: (a) Modern Pharma Book value per share 2300 = Rs. and market price per share 65 + 115 22. (c) Current EPS of Modern Pharma 450 = = Rs.9.22.102 22.42 + 0. (iii) The differential risk associated with the earnings of the two companies.320 10 95 = Rs. earnings per share.57 + 0.05) 20 + ER X 10 155 .5 10 Rs.5 + 320 = 3 0.5 102 320 Exchange ratio that gives equal weightage to book value per share. (ii) The gains in earnings arising out of merger.5 Exchange Ratio 65 (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.115 Earnings per share 20 450 = Rs.22.65 115 9.5 Market price per share 20 Rs.44 102 Magnum Drugs 650 = Rs.5 3 9.5 20 If there is a synergy gain of 5 percent. the postmerger EPS of Modern Pharma is (450 + 95) (1.
36 (g) The level of P/E ratio where the lines ER1 and ER2 intersect. we get (450 + 95) (1.5.2 20 + 0.02) – 102 X 10 = 0.21 (E1 + E2) P/E12 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. To get this.20 = 10 (f) + 320 x 10 + P1 S2 (450 + 95) 13 = 0.5 20 + 10ER This gives ER = 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 ER1 = S2 .22.54 Thus the maximum exchange ratio Modern Pharma should accept to avoid initial dilution of EPS is 0.24. assuming no synergy gain: 450 + 95 = Rs. solve the following for P/E12 156 .54 (d) Postmerger EPS of Modern Pharma if the exchange ratio is 1:4.05) = 22.Equating this with Rs.
61 157 ..S1 + S2 .20 + 10 (E1 + E2) P/E12 = P1S2 (450 +95) P/E12 = 320 x 10 P2S1 P/E12 (E1 + E2) – P2S2 102 x 20 P/E12 (450 +95) – 1020 2040 = 545 P/E12 – 1020 .6400 + 545 P/E12 3200 (545 P/E12 – 1020) (545 P/E12 – 6400) = 2040 x 3200 297025 P/E212 – 3488000 P/E12 – 555900 P/E12 +6528000 = 6528000 2 297025 P/E 12 = 4043900 P/E 297025 P/E12 = 4043900 P/E12 = 13.
7% 105 1 (b) The most likely spot rate 6 months hence will be : 107 yen / dollar (c) Futures rate = Spot rate 107 = 158 12 Forward contract length in months 12 x 3 = 4. The annualised premium is : Forward rate – Spot rate x Spot rate 46.3% 100 x 1.07 x F 1 + domestic interest rate 1 + foreign interest rate 1 + domestic interest rate in Japan .538 dollars per sterling pound will mean indifference between investing in the U.538 107 A forward exchange rate of 1.553 106 x 1. 100 (1.K.5 – 105 12 x = 5.Chapter 37 INTERNATIONAL FINANCIAL MANAGEMENT 1.50 – 46.00 2.06) = 1. (a) The annual percentage premium of the dollar on the yen may be calculated with reference to 30days futures 105.S and in the U.00 = 46. 3.553 F = = 1.
rf = 6 per cent Hence the forecasted spot rates are : Year Forecasted spot exchange rate 1 Rs.06)2 = Rs.44 3 Rs.6 Given a rupee discount rate of 20 per cent.11 / 1.31 80 57.46 (1.31 5 Rs.5 NPV = 9200 + (1.05 million dollars 5.18)3 + 4753.17 2 Rs.0397 = 3.3406.11 / 1.11 / 1.18)2 5807.06)1 = Rs.52.46 .8 5807.5 3530. rh = 11 per cent .46 (1.18)5 = Rs.48.106 1.6 + (1.50.015 159 3530.11 / 1.03 Domestic interest rate in Japan = .8 (1.92 The expected rupee cash flows for the project Year 0 1 2 3 4 5 Cash flow in dollars Expected exchange (million) rate 200 46 50 48.97 per cent 4.2 million The dollar NPV is : 3406.06)4 = Rs. Forward rate = Spot rate F 1 + foreign interest rate 1 + .46 (1.55.11 / 1.6 + (1.82 105 55.57.8 + (1.92 Cash flow in rupees (million) 9200 2408. S0 = Rs.44 90 52.82 4 Rs.2 / 46 = 74.46 (1. the NPV in rupees is : 2408.18)4 4633.8 4753.17 70 50.06)3 = Rs.06)5 = Rs.6 4633.46 (1.18)6 1 + domestic interest rate .
015) (ii) Obtain £98522 on today’s spot market (iii) Invest £98522 in the UK money market. This investment will grow to £100.50 260 8. the expected spot rate a year from now is : 72 x (1. Expected spot rate = Current spot rate x 2 years from now (1.03) = Rs.48 250 (b) One year forward rate of one US dollar should be : 13000 = Rs.60 1 + .= 1. Expected spot rate a year from now = Current spot rate Expected spot rate a year from now = Rs.03 So.03) 2 (1 + expected inflation in Japan)2 (1 + expected inflation in UK)2 = 163.020 F = $ 1. This works out to : £100.06 / 1. (a) The spot exchange rate of one US dollar should be : 12000 = Rs.46 yen / £ 9.592 / £ 6.04 7.06 1. (i) Determine the present value of the foreign currency liability (£100.000 after 90 days 160 .70 1 + expected inflation in home country 1 + expected inflation in foreign country 1.72.000 = £ 98522 (1.000) by using 90day money market lending rate applicable to the foreign country.01)2 = 170 x (1.
000 = £98039 (1. (iii) Repay the borrowing of £98039 which will compound to £100000 after 90 days with the collection of the receivable 11.10. 161 . 100. (i) Determine the present value of the foreign currency asset (£100.Sehgal’s argument is not tenable. So Mr. A lower interest rate in the Swiss market will be offset by the depreciation of the US dollar visàvis the Swiss franc.000) by using the 90day money market borrowing rate of 2 per cent.02) (ii) Borrow £98039 in the UK money market and convert them to dollars in the spot market.
5 4200 = 4000 (1.5 (1+Riskfree rate)0.0. = Spot price + Present value of – Present value storage costs of convenience yield 162 . (a) The investor must short sell Rs.5 4000 x Dividend yield Spot price x Dividend yield The dividend yield on a six months basis is 2 per cent.554.1 million / 0.145) 0.70 (c) To create a zero value hedge he must deposit Rs. Futures price = Spot price (1+Riskfree rate)0.145) 0.5 (1.43 million (Rs.43 million 2. On an annual basis it is approximately 4 per cent.Chapter 40 CORPORATE RISK MANAGEMENT 1.70) of B (b) His hedge ratio is 0.3 per ton.1.15)1 Hence the present value of convenience yield is Rs. Futures price (1+Riskfree rate)1 5400 = 5000 + 250 – Present value of convenience yield (1. 3.
163 .
164 .
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