Value five years hence of a deposit of Rs.1,000 at various interest rates is as follows:
r
8%
FV5
Rs.1469
10%
FV5
Rs.1611
12%
FV5
Rs.1762
15%
FV5
Rs.2011
2.
30 years
3.
In 12 years Rs.1000 grows to Rs.8000 or 8 times. This is 23 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.
6.
1,000,000
1,000,000
Rs.56,983.
10,000
10,000 / 1000 = 10
1
=
=
9.930
10.980
x 4% = 20.3%
(10.980 9.930)
7.
=
=
5,000
5,000 / 1000 = 5
4.411
5.234
= 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
r = 15%
PV
9.
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
12.
13.
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.
=
=
5.019
4.494
x 3%
= 15.1%
16.
FV5
=
=
=
=
18.
FV5
=
=
=
=
19
A
Stated rate (%)
B
12
24
4 times
24
12 times
= 26.2
= 26.8
0.6
2.2
2.8
Investment required at the end of 8th year to yield an income of Rs.12,000 per year from the
end of 9th year (beginning of 10th year) for ever:
Rs.12,000 x PVIFA(12%, )
4
now is:
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
FV10
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.
Rs.50,000
FVIFA(12%, 10 years) x (1.12)
Rs.50,000
= Rs.2544
17.549 x 1.12
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
27.
Rs.14,998
Rs.14,998
Rs.14,998
 = Rs.8254
1.817
21.244
6
= 20
18.914
x 1%
= 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.
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
5.000 4.868
5.335 4.868
x 1 = 7.3 years
30.
= 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*
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
Rs.300 million
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
= Rs.300 million x
= Rs.300 million x
1 (1 + g)n / (1 + i)n
ig
1 (1.06)15 / (1.16)15
0.16 0.06
assuming a
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?
Rameshs 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
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 Rameshs life time earnings?
400,000
46
1
400,000(1.12)14
400,000(1.12)
2
15
1.12
15
1
1.08
= 400,000
0.08 0.12
= Rs.7,254,962
10
Chapter 8
VALUATION OF BONDS AND STOCKS
1.
P =
t=1
11
100
+
(1.15)
(1.15)5
(ii)
Note that when the discount rate and the coupon rate are the same the value is
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
7
t=1 (1+r)
(1+r)
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
11
equal to
Thus the value of r at which the RHS becomes equal to Rs.750 lies between 18% and 20%.
Using linear interpolation in this range, we get
771.44 750.00
Yield to maturity = 18% + 771.44 711.60
x 2%
= 18.7%
4.
80 =
10 14
100
+
t
t=1 (1+r)
(1+r)10
Yield to maturity
= 18.56%
5.
P =
12
t=1
100
+
(1.08)
(1.08)12
6.
Bond A
*
Posttax interest (C )
12(1 0.3)
=Rs.8.4
Bond B
10 (1 0.3)
=Rs.7
100 [ (100 60)x 0.1]
=Rs.96
The posttax YTM, using the approximate YTM formula is calculated below
Bond A :
Posttax YTM =
=
Bond B :
Posttax YTM =
=
8.4 + (9770)/10
0.6 x 70 + 0.4 x 97
13.73%
7 + (96 60)/6
0.6x 60 + 0.4 x 96
17. 47%
7.
P =
14
t=1
100
+
(1.08) t
(1.08)14
Since the growth rate of 6% applies to dividends as well as market price, the
price at the end of the 2nd year will be:
P2
=
=
market
9.
10.
11.
Po
Po
=
=
D1 / (r g)
=
Do (1 + g) / (r g)
Rs.12.00 (1.10) / (0.15 0.10)
=
D1 / (r g)
Rs.32 =
g
=
Rs.2 / 0.12 g
0.0575 or 5.75%
Po
Do
So
8
D1/ (r g) = Do(1+g) / (r g)
Rs.1.50, g = 0.04, Po = Rs.8
=
=
Rs.264
The market price per share of Commonwealth Corporation will be the sum of three
components:
A:
B:
C:
A=
B=
P8 / (1.14)8
P8 = D9 / (r g) =
So
C
Thus,
Po
=
=
13.
Rs.23.77
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:
A=
=
=
B=
=
=
C=
=
15
= 1709.24
= 0.1739 or 17.39%
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)
6
(1.16)
=
 + 0.16 0.18
(0.16 0.12) x (1.16)6
16.
2.36 x
Rs.74.80
 0.10801
 + 62.05
 0.02
4.00 (1.20)
4.00 x 4 x (0.10)
 + 0.18 0.10
0.18 0.10
=
=
60 + 20
Rs.80
16
equation
Chapter 9
RISK AND RETURN
1 (a)
(b)
10%
20%
30%
Probability (pi)
0.4
0.4
0.2
2 (a) For Rs.1,000, 20 shares of Alphas stock can be acquired. 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 = 1,100
20 x 50 = 1,000
20 x 60 = 1,200
20 x 70 = 1,400
=
Probability
0.3
0.3
0.2
0.2
=
=
For Rs.1,000, 20 shares of Betas stock can be acquired. The probability distribution of the
return on 20 shares is:
Economic condition
Return (Rs)
Probability
High growth
Low growth
Stagnation
Recession
20 x 75 = 1,500
20 x 65 = 1,300
20 x 50 = 1,000
20 x 40 = 800
0.3
0.3
0.2
0.2
Expected return =
For Rs.500, 10 shares of Alphas stock can be acquired; likewise for Rs.500, 10
shares of Betas 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 +
d.
18
Return (Rs)
Probability
=
=
=
=
1,220
1,090
1,140
1,220
Expected return
=
=
Standard deviation
0.3
0.3
0.2
0.2
3.
Option `d is the most preferred option because it has the highest return to risk
ratio.
follows:
A:
= 7.83%
B:
= 0.0917
= 9.17%
C:
= 0.0900
= 9.00%
D:
= 0.095
= 9.50%
(a)
(b)
= 7.83%
4.
(c )
(d)
Define RA and RM as the returns on the equity stock of Auto Electricals Limited a and Market
portfolio respectively. The calculations relevant for calculating the beta of the stock are
shown below:
Year
1
2
3
4
5
6
7
8
9
10
11
RA
15
6
18
30
12
25
2
20
18
24
8.
RA = 15.09
RM
12
1
14
24
16
30
3
24
15
22
12
RARA
0.09
21.09
2.91
14.91
03.09
9.91
13.09
4.91
2.91
8.91
7.09
RMRM
3.18
14.18
1.18
8.82
0.82
14.82
18.18
8.82
0.18
6.82
3.18
(RARA)
0.01
444.79
8.47
222.31
9.55
98.21
171.35
24.11
8.47
79.39
50.27
(RMRM)
10.11
201.07
1.39
77.79
0.67
219.63
330.51
77.79
0.03
46.51
10.11
RM = 15.18
(RA RA)2 = 1116.93 (RM RM) 2 = 975.61 (RA RA) (RM RM) = 935.86
Beta of the equity stock of Auto Electricals
(RA RA) (RM RM)
(RM RM) 2
=
Alpha =
=
935.86
975.61
0.96
R A A R M
15.09 (0.96 x 15.18)=
0.52
20
RARA/RMRM
0.29
299.06
3.43
131.51
2.53
146.87
237.98
43.31
0.52
60.77
22.55
=
=
=
RF + A (RM RF)
0.10 + 1.5 (0.15 0.10)
0.175
Rs.22.74
= 1.75
0.04
8.
RM = 12%
X = 2.0
RX =18% g = 5%
Po = D1 / (r  g)
Rs.30 = D1 / (0.18  .05)
21
Po = Rs.30
Rf + x (RM Rf)
0.18
So Rf = 0.06 or 6%.
Original
Rf
RM Rf
g
x
Revised
6%
6%
5%
2.0
8%
4%
4%
1.8
Chapter 10
OPTIONS AND THEIR VALUATION
22
1.
S = 100
u = 1.5
d = 0.8
E = 105
r = 0.12
R = 1.12
follows:
Cu Cd
=
(u d) S
Cu
45
Cd
45 0
45
=
0.7 x 100
=
70
0.6429
14
u.Cd d.Cu
B
=
(ud) R
(1.5 x 0) (0.8 x 45)
=
0.7 x 1.12
36
=
=  45.92
0.784
=
=
=
S+B
0.6429 x 100 45.92
Rs.18.37
S = 40
R = 1.10
u=?
E = 45
d = 0.8
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.
Given the above data
23
Cd
Cu Cd
=
B
x
u Cd d Cu
Cu 0
=
C
8
S
1.10
x
0.8Cu
() 0.034375
=
=
=
 0.34375 B
S+B
x 40 + B
40
(1)
(2)
=
=
=
(0.034365 x 40) B + B
0.375 B
 21.33
3.
Using the standard notations of the BlackScholes model we get the following results:
ln (S/E) + rt + 2 t/2
d1
=
24
d2
0.7675
=
=
=
d1  t
0.7675 0.4
0.3675
N(d1) =
N (d2) =
=
=
=
=
Value of the call as per the Black and Scholes model is Rs.35.33.
4.
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
stock price to be 14.1 per cent. Hence the value of the call option is
0.141 x 80 = Rs.11,28.
5.
option and
Stock price
(A)
The value of the call option gives an exercise price of Rs.85 can be obtained as
t
follows:
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.
So
d1
Vo N(d1) B1 e rt N (d2)
=
0.4243
=
N(d1) =
d2
=
=
0.8775 = 0.88
N (0.88)
d1  t
0.8775 
0.81057
0.18
26
0.4532 =
0.45
N (d2) =
So
=
=
N (0.45) = 0.67364
6000 x 0.81057 (5000 x 0.9048 x 0.67364)
1816
B0
V0 S0
60000 1816
4184
=
=
=
Chapter 11
TECHNIQUES OF CAPITAL BUDGETING
1.(a)
(1.14)3
=
(b)
(1.14)4
(1.14)5
 44837
 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)
=
=
2.
Investment A
a)
b)
c)
Payback period
NPV
=
5 years
=
40000 x PVIFA (12,10) 200 000
=
26000
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
28
PVIFA (15,10)
PVIFA (16,10)
=
=
5.019
4.883
BCR
=
=
=
Investment B
a)
Payback period
b)
NP V =
=
=
c)
9 years
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
c)
 210,000
=
111,371
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
=
c)
d)
BCR
PVB / I
282,840 / 320,000
0.88
Comparative Table
Investment
a) Payback period
(in years)
2.88
8.5
b) NPV @ 12% pa
26000
105339
111371
37160
c) IRR (%)
15.14
1.37
29.29
8.45
30
d) BCR
1.13
0.65
1.53
0.88
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)
NCF
6.
500000
500000 / 5.335
93271
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.e., I
7.
=
=
=
PV of benefits (PVB) =
+
+
=
=
I
141256
8.
+
+
=
(A)
Investment
100,000
(B)
Project
Q
0%
5%
400
223
500
251
600
312
10%
15%
69
 66
40
 142
70
 135
25%
30%
 291
 386
 435
 555
 461
 591
Discount rate
9.
(a)
NPV profiles for Projects P and Q for selected discount rates are as follows:
Project
P
b)
The IRR (r') of project Q can be obtained by solving the following equation for r'
32
1600 + 200 x PVIF (r',1) + 400 x PVIF (r',2) + 600 x PVIF (r',3)
+ 800 x PVIF (r',4) + 100 x PVIF (r',5)
=
0
Through a process of trial and error we find that r' = 9.34%.
c)
=
=
1075
 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
=
Project Q
PV of investmentrelated costs
1600
2772
2772
33
MIRR
10
(a)
11.62%
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)
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.
34
(b)
Project M
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.a
24.97
47.75
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
PV of cash flows up to the end of year 1
PV of cash flows up to the end of year 2
=
=
=
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
NPV
=
=
=
(d)
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.
Project M
Cost of capital
= 10% per annum
NPV
= Rs.25.02 million
Project N
Cost of capital
NPV
(e)
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.
Project M
Cost of capital =
15% per annum
35
NPV
16.13 million
Project N
Cost of capital:
15% per annum
NPV
=
Rs.17.23 million
Again the two projects are mutually exclusive. So we choose the project with the
higher NPV, i.e., choose project N.
(f)
Project M
Terminal value of the cash inflows: 114.47
MIRR of the project is given by the equation
50 (1 + MIRR)4
=
114.47
i.e., MIRR = 23.01%
Project N
Terminal value of the cash inflows: 115.41
MIRR of the project is given by the equation
50 ( 1+ MIRR)4
=
115.41
i.e., MIRR
=
23.26%
36
Chapter 12
ESTIMATION OF PROJECT CASH FLOWS
1.
(a)
Year
(150)
(Rs. in million)
3. Revenues
250
250
250
250
250
250
250
100
100
100
100
100
100
100
5. Depreciation
37.5
6.67
7. Tax
2. Working capital
(50)
48
50
(200)
116.25 113.44 111.33 109.75 108.56 107.6 107.00
98
14.
NCF
(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)
37
Through a process of trial and error, we get r = 55.17%. The IRR of the project is 55.17%.
2.
Year
1. Capital equipment
(120)
2. Level of working capital 20
30
(ending)
3. Revenues
80
4. Raw material cost
24
5. Variable mfg cost.
8
6. Fixed operating & maint.
10
cost
7. Variable selling expenses
8
8. Incremental overheads
4
9. Loss of contribution
10
10.Bad debt loss
11. Depreciation
30
12. Profit before tax
14
13. Tax
4.2
14. Profit after tax
9.8
15. Net salvage value of
capital equipments
16. Recovery of working
capital
17. Initial investment
(120)
18. Operating cash flow
20.2
(14 + 10+ 11)
19. Working capital
20
10
20. Terminal cash flow
21. Net cash flow
(17+1819+20)
(b)
(Rs. in million)
40
50
40
30
20
120
36
12
10
160
48
16
10
200
60
20
10
160
48
16
10
120
36
12
10
12
6
10
16
8
10
20
10
10
16
8
10
12
6
10
22.5
11.5
3.45
8.05
16.88
35.12
10.54
24.58
80
24
8
10
8
4
10
4
12.66 9.49 7.12 5.34
57.34 42.51 26.88 6.66
17.20 12.75 8.06 2.00
40.14 29.76 18.82 4.66
25
16
10
(10)
(10)
(10)
41
NPV of the net cash flow stream @ 15% per discount rate
=
=
38
3.
(a)
A.
B.
3,000,000
900,000
500,000
2,600,000
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
165,000
123,750
92,813
69,609
52,207
620,000
578,750
547,813
524,609
507,207
(b)
Rs.
Rs.
D.
Net cash flows associated with the replacement project (in Rs)
Year
NCF
0
(2,600,000)
1
620000
2
578750
39
3
547813
4
524609
1,500,000
200,000
500,000
1,800,000
5
2307207
4.
PV of tax shield
@ 15% p.a.
25000
10000
8696
18750
7500
5671
14063
5625
3699
10547
4219
2412
7910
3164
1573
22051

A.
B.
Rs.
400,000
90,000
310,000
Year
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
28700
21210
15656
11540
8494
v. Operating cash
40
flow
C.
28700
21210
Terminal cash flow (year 5)
i.
ii.
iii.
D.
Year
NCF
15656
11540
8494
Rs.
25000
10000
15000
1
28700
21210
15656
4
11540
5
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
1. Fixed assets
2. Net working
capital
3. Revenues
4. Costs (other than
depreciation and
interest)
5. Loss of rental
6. Depreciation
7. Profit before tax
8. Tax
9. Profit after tax
10. Salvage value of
fixed assets
11. Net recovery of
working capital
(15)
(23)
30
30
30
30
30
20
1
3.750
5.250
1.575
3.675
20
1
2.813
6.187
1.856
4.331
20
1
2.109
6.891
2.067
4.824
20
1
1.582
7.418
2.225
5.193
20
1
1.187
7.813
2.344
5.469
(8)
5.000
8.000
41
inflow
14. Terminal cash
flow
15. Net cash flow
7.425
(23)
7.144
7.425
7.144
6.933
6.933
6.775
6.656
6.775
13.000
19.656
30
30
30
30
30
20
1
3.75
20
1
2.813
20
1
2.109
20
1
1.582
20
1
1.187
0.70
0.70
0.70
0.70
0.70
1.20
3.35
1.005
2.345
1.125
4.362
1.309
3.053
0.825
5.366
1.610
3.756
0.525
6.193
1.858
4.335
0.225
6.888
2.066
4.822
(10)
5.000
10.000
2.000
2.000
2.000
2.000
5.000
2.000
(10)
(10)
6.095
5.866
5.865
5.917
6.009
6.095
(2.0)
3.866
(2.0)
3.865
(2.0)
3.917
6.00
12.009
42
Chapter 13
RISK ANALYSIS IN CAPITAL BUDGETING
1.
(a)
(b)
=
=
Pessimistic
(Rs. in million)
Expected
Optimistic
Investment
Sales
Variable costs
Fixed costs
Depreciation
Pretax profit
Tax @ 28.57%
Profit after tax
Net cash flow
Cost of capital
300
150
97.5
30
30
 7.5
 2.14
 5.36
24.64
14%
250
200
120
20
25
35
10
25
50
13%
200
275
154
15
20
86
24.57
61.43
81.43
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)
(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.
43
(c)
2.
(a)
i.
ii.
iii.
Initial investment
= 200
iv.
= 238.74 / 1.1628
(b)
= Rs.205.31 million
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
Initial investment
Sale revenue
Pessimistic
Expected
Optimistic
30000
28000
30000
42000
30000
70000
44
Variable costs
Fixed costs
Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV
(c)
28000
3000
2000
9000
4500
4500
6500
() 5360
28000
3000
2000
37000
18500
18500
20500
47711
Initial investment
Sale revenue
Variable costs
Fixed costs
Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV
(d)
28000
3000
2000
5000
2500
2500
 500
 31895
Pessimistic
Expected
Optimistic
30000
42000
56000
3000
2000
11000
5500
5500
3500
43268
30000
42000
28000
3000
2000
9000
4500
4500
6500
 5360
30000
42000
21000
3000
2000
16000
8000
8000
10000
7908
= Rs.5000
= 10 / 30 = 0.3333
= 5000 / 0.3333
= Rs.15000
3.
i.
ii.
iii.
iv.
Initial investment
Breakeven level of sales
=
=
A2
5.8
A3
=
=
NPV
=
=
12
0.41
22
0.56
32
0.49
12
2 NPV =
+
2
22
+
4
(1.1)
(1.1)6
32
(1.1)
= 1.00
(NPV) = Rs.1.00 million
4.
Expected NPV
4
At
=
 25,000
t
t=1 (1.08)
=
t=1 (1.08)t
=
=
=
5.
Expected NPV
46
4
=
t=1
A1
=
=
At
 10,000
. (1)
(1.06)
2,000 x 0.2 + 3,000 x 0.5 + 4,000 x 0.3
3,100
A2
=
=
A3
=
=
A4
=
=
2 (NPV) =
t=1 (1.06)2t
12
=
=
22
=
=
32
=
=
42
=
=
.. (2)
NPV
0 3044
Z<
1296
0  NPV
<
NPV
48
curve.
6.
Given values of variables other than Q, P and V, the net present value model of Bidhan
Corporation can be expressed as:
[Q(P V) 3,000 2,000] (0.5)+ 2,000
NPV
t =1
0
+
(1.1)t
 30,000
(1.1)5
0.5 Q (P V) 500
5
t=1
  30,000
(1.1)t
=
=
=
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
Valu Pro
e b
800
1,00
0
1,20
0
1,40
0
1,60
0
1,80
0
0.1
0
0.1
0
0.2
0
0.3
0
0.2
0
0.1
0
PRICE
Cumulati
ve Prob.
Two digit
random
numbers
0.10
Valu
e
Pro
b
00 to 09
20
0.20
10 to 19
30
0.40
20 to 39
40
0.70
40 to 69
50
0.4
0
0.4
0
0.1
0
0.1
0
0.90
70 to 89
1.00
90 to 99
49
Cumulati
ve Prob.
Two digit
random
numbers
Value
0.40
00 to 39
15
0.80
40 to 79
20
0.90
80 to 89
40
1.00
90 to 99
VARIABLE COST
Two digit
Cum random
Pro
unumbers
b
lative
Prob.
0.3
0.30 00 to 29
0
0.5
0.80 30 to 79
0
0.2
1.00 80 to 99
0
Exhibit 2
Simulation Results
Ru
n
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
QUANTITY (Q)
Rando
Corresm
ponding
Numb
Value
er
03
800
32
1,200
61
1,400
48
1,400
32
1,200
31
1,200
22
1,200
46
1,400
57
1,400
QUANTITY (Q)
Rando
Corresm
ponding
Numb
Value
er
92
1,800
25
1,200
64
1,400
14
1,000
05
800
07
800
34
1,200
79
1,600
55
1,400
57
1,400
53
1,400
36
1,200
32
1,200
49
1,400
21
1,200
08
.800
85
1,600
61
1,400
25
1,200
51
1,400
32
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
31
32
33
34
35
36
Ru
n
37
38
39
40
41
42
43
44
45
46
47
48
49
50
52
76
43
70
67
26
1,400
1,600
1,400
1,600
1,400
1,200
61
18
04
11
35
63
30
20
20
20
20
30
58
41
49
59
26
22
QUANTITY (Q)
Random
Corre
Number
spondi
ng
Value
89
1,600
94
1,800
09
.800
44
1,400
98
1,800
10
1,000
38
1,200
83
1,600
54
1,400
16
1,000
20
1,200
61
1,400
82
1,600
90
1,800
PRICE (P)
Random
CorresNumber
ponding
value
Expected NPV
86
00
15
84
23
53
44
30
71
70
65
61
48
50
=
=
=
Variance of NPV
40
20
20
40
20
30
30
20
30
30
30
30
30
30
5,359
31,896
31,896
31,896
18,627
2,224
NPV
50
1/ 50 NPVi
i=1
1/50 (7,20,961)
14,419
50
(NPVi NPV)2
i=1
1/50
=
=
20
20
20
20
15
15
20
15
15
15
20
20
20
15
20
15
40
20
40
20
28,761
14,836
24,314
34,447
31,896
12,941
9,150
16,732
5,359
3,463
54,642
5,359
62,224
2,224
=
=
549.481 x 106
23,441
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
I
k
F
D
T
N
S
Q
Rs.30,000 Rs.30,000
Rs.30,000
10%  10%
10%
Rs.3,000 Rs.3,000
Rs.3,000
Rs.2,000 Rs.2,000
Rs.2,000
0.5 0.5
0.5
55
5
00
0
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
probability associated with them
highest
** 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
NPV
5
=
t=1
5
=
t=1
0
+
(1.1)t
 30,000
(1.1)5
5Q  500
 30,000
(1.1)
The net present values for various values of Q are given in the following table:
52
Q
NPV
800
16,732
1,000
12,941
1,200
9,150
1,400
5,359
1,600
1,568
1,800
2,224
5
=
t=1
0
+
(1.1)
5
=
t=1
 30,0
(1.1)
700 P 14,500
 30,000
(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
(Rs.in lakhs)
PI
0.9
10
15
20
1.00
1.10
1.20
1.30
1.40
Prob.
0.03
0.10
0.40
0.30
0.15
0.02
6
Expected PI = PI = (PI)j P j
j=1
=
1.24
6
(PIj  PI) 2 P j
j=1
= .01156
= .1075
The standard deviation of P1 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.
Standard deviation of P1 =
53
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
6
3,000
Project A:
NPV =
 10,000 = Rs.2,333
t
t=1
(1.12)
Project B:
NPV
t=1
as follows:
11,000
 30,000 = Rs.7,763
(1.14)t
PI
IRR
1.23
20%
1.26
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
1
2
3
4
5
The present value of the project calculated at the riskfree rate of return is :
5 (1 0.06 t) At
t=1
(1.08)t
7,000 x 0.94
+
(1.08)
6,580
7,040
7,380
+
(1.08)2
(1.08)
=
7,600
+
5,600
+
(1.08)3
(1.08)4
(1.08)5
27,386
= (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 D2:
0.8 (15000) + 0.2 (1600)
Expand : NPV =  4400 +
1.12
= 6600
0.8 (6500) + 0.2 (2400)
Do not expand : NPV =
1.12
= 5071
55
Second, truncate the do not expand option as it is inferior to the expand option. This
means that the NPV at decision point D2 will be 6600
Third, calculate the NPV of the piston engine aircraft option.
0.65 (2500+6600) + 0.35 (800)
NPV = 5500 +
1.12
= 7857
1.12
56
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
57
from 929 to 1406. Hence the value of the abandonment option is 477.
58
Chapter 14
THE COST OF CAPITAL
1(a) Define rD as the pretax cost of debt. Using the approximate yield formula, rD
calculated as follows:
rD
5.
WACC
9 + (100 92)/6
0.4 x100 + 0.6x92
=
4.
14 + (100 108)/10
 x 100 = 12.60%
0.4 x 100 + 0.6x108
Define rp as the cost of preference capital. Using the approximate yield formula rp can be
calculated as follows:
rp
3.
can be
Cost of equity
=
(using SML equation)
14%
2:3
WACC
14.68%
Given
0.5 x 14% x (1 0.35) + 0.5 x rE = 12%
where rE is the cost of equity capital.
Therefore rE 14.9%
59
The cost of debt of 12% represents the historical interest rate at the time the debt was
originally issued. But we need to calculate the marginal cost of debt (cost of raising new
debt); and for this purpose we need to calculate the yield to maturity of the debt as on the
balance sheet date. The yield to maturity will not be equal to12% unless the book value of
debt is equal to the market value of debt on the balance sheet date.
(b)
The cost of equity has been taken as D1/P0 ( = 6/100) whereas the cost of equity is (D1/P0)
+ g where g represents the expected constant growth rate in dividend per share.
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.
Project
Beta
P
Q
R
S
0.6
0.9
1.5
1.5
Required return
based on SML
equation (%)
14.8
17.2
22.0
22.0
Expected
return (%)
13
14
16
20
Given a hurdle rate of 18% (the firms 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
60
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
rD x (1 0.3) x 4/9 + 20% x 5/9 = 15%
rD = 12.5%,where rD represents the pretax cost of debt.
(b)
Given
13% x (1 0.3) x 4/9 + rE x 5/9 = 15%
rE = 19.72%, where rE represents the cost of equity.
10.
Cost of equity =
D1/P0 + g
=
3.00 / 30.00 + 0.05
=
15%
(a) The first chunk of financing will comprise of Rs.5 million of retained earnings costing 15
percent and Rs.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.
= 15.9%
0.6 x 75 + 0.4 x 100
61
= 19.1%
0.6x80 + 0.4x100
Component
Cost
(1)
14.5%
15.9%
14.5%
9.6%
6.0%
Book value
Rs. in million
(2)
100
10
120
50
80
360
Book value
Product of
proportion
(1) & (3)
(3)
0.28
4.06
0.03
0.48
0.33
4.79
0.14
1.34
0.22
1.32
Average cost11.99%
capital
The average cost of capital using market value proportions is calculated below :
Source of capital
Equity capital
and retained earnings
Preference capital
Debentures
Term loans
Component
cost
(1)
14.5%
15.9%
9.6%
6.0%
200
7.5
40
80
0.62
0.02
0.12
0.24
327.5
12
62
Average cost
capital
8.99
0.32
1.15
1.44
11.90%
(a)
WACC
=
=
(b)
(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
rd =
8.5
=
= 7.93
107.2
rd (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
63
64
Chapter 15
CAPITAL BUDGETING : EXTENSIONS
1.
EAC
(Plastic Emulsion)
=
=
=
EAC
(Distemper Painting) =
=
=
Since EAC of plastic emulsion is less than that of distemper painting, it is the preferred
alternative.
2.
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
(A)
(B)
Since (B) < (A), the less costly overhaul is preferred alternative.
65
4.
(a)
(b)
Rs.818 182
 2,022,000 818,182
 Rs.2,840,182
Debt outstanding at
the beginning
6,000,000
6,000,000
5,250,000
4,500,000
3,750,000
3,000,000
2,225,000
1,500,000
750,000
Interest
Tax shield
1,080,000
1,080,000
945,000
810,000
675,000
540,000
400,500
270,000
135,000
324,000
324,000
283,000
243,000
202,000
162,000
120,000
81,000
40,500
= Rs.1,022,076
(b)
Present value of
tax shield
274,590
232,697
172,538
125,339
88,513
60,005
37,715
21,546
9,133
(c)
Debt outstanding at
the beginning
5,000,000
5,000,000
4,000,000
3,000,000
2,000,000
1,000,000
Interest
Tax shield
750,000
750,000
600,000
450,000
300,000
150,000
300,000
300,000
240,000
180,000
120,000
60,000
67
Present value of
tax shield
260,880
226,830
157,800
102,924
59,664
25,938
Rs.834,036
Chapter 18
RAISING LONG TERM FINANCE
1
Underwriting
commitment
Shares
procured
Excess/
shortfall
Credit
Net
shortfall
70,000
50,000
(20,000)
4919
(15081)
50,000
30,000
(20,000)
3514
(16486)
40,000
30,000
(10,000)
2811
(7189)
25,000
12,000
(13,000)
1757
(11243)
15,000
28,000
13,000
2.
3.
Underwriting
commitment
Shares
procured
Excess/
Shortfall
Credit
Net
shortfall
50,000
20,000
(30,000)
14286
(15714)
20,000
10,000
(10,000)
5714
(4286)
C 30,000
50,000
20,000
Po = Rs.220 S = Rs.150
N=4
a. The theoretical value per share of the cumrights stock would simply be
Rs.220
b.
NPo+S
4 x 220 +150
=
= Rs.206
N+1
4+1
Po = Rs.180
N=5
a. The theoretical value of a right if the subscription price is Rs.150
Po S
180 150
=
= Rs.5
N+1
5+1
b. The exrights value per share if the subscription price is Rs.160
NPo + S
5 x 180 + 160
=
= Rs.176.7
N+1
5+1
c. The theoretical value per share, 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
69
Chapter 19
CAPITAL STRUCTURE AND FIRM VALUE
1.
:
:
:
:
Rs.30 million
Rs.10 million
Rs.20 million
15%
:
:
:
:
10%
Rs.20 million/0.15 =Rs.133 million
Rs.10 million/0.10 =Rs.100 million
Rs.233 million
2.
Box
Cox
= 15%
Rs.6,000,000
Rs.3,000,000
Rs.3,000,000
15%
70
Cost of debt
Market value of equity
Market value of debt
Market value of the firm
Average cost of capital
20
30
15% x
+ 10%
50
50
10%
Rs.20 million
Rs.30 million
Rs.50 million
= 12%
4.
rE
=
20
=
So D/E = 2
rA + (rArD)D/E
12 + (128) D/E
D+E
D+E
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
rE
(%)
rD
(%)
11.0
11.0
11.5
12.5
13.0
14.0
15.0
16.0
18.0
20.0
6.0
6.5
7.0
7.5
8.5
9.5
11.0
12.0
13.0
14.0
rA =
E
rE +
D+E
D
rD
D+E
11.00
10.55
10.60
11.00
11.20
11.75
12.60
13.20
14.00
14.20
71
6.
7.
D+E
D+ E
rD
%
rE
%
0
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
12.0
12.0
12.5
13.5
13.5
14.0
14.5
15.0
15.5
16.0
rA =
rE +
D+E
(%)
D
rD
D+E
12.0
11.2
10.8
10.36
9.86
9.30
8.68
8.14
7.90
7.72 Optimal
12.0
11.2
11.2
11.06
10.76
10.30
9.68
9.04
8.60
8.12 Optimal
72
1(1tc) (1tpe)
(10.55) (10.05)
=
1 
(1tpd)
(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
EPSA =
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
EPSB =
1,500,000
The EPS EBIT indifference point can be obtained by equating EPSA and EPSB
(EBIT 0 ) (1 0.5) 600,000
=
2,500,000
1,500,000
Solving the above we get EBIT = Rs.4,950,000 and at that EBIT, EPS is Rs.0.75
under both the plans
(b)
2.
(a)
(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.)
EPSA
(Rs.)
2,000,000
2,160,000
3,000,000
4,000,000
4,400,000
More than 4,400,000
3.
EPSB
(Rs.)
0.50(I)
0.54(I)
0.75(I)
1.00(II)
1.10(II)
(III)
0.35(II)
0.40(II)
0.66(II)
0.98(III)
1.10(II)
(II)
EPSC
(Rs.)
0.33(III)
0.40(II)
0.75(I)
1.17(I)
1.33(I)
(I)
Plan A : Issue 0.8 million equity shares at Rs. 12.5 per share.
Plan B : Issue Rs.10 million of debt carrying interest rate of 15 per cent.
(EBIT 0 ) (1 0.6)
EPSA
=
74
1,800,000
(EBIT 1,500,000) (1 0.6)
EPSB
=
1,000,000
3.375 7.000
>
EBIT
3.000
5.
6.
7. a.
b.
75
Int.on debt +
(1 Tax rate)
= 150 + 30
40 + 50
8.
= 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
=
=
=
9.
277.94
167.80
1.66
(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 = Rs.80 million, = Rs.40 million , and the Z value corresponding to the risk
tolerance limit of 5 per cent is 1.645, the cash available from the operations to service the
debt is equal to X which is defined as :
X 80
76
=  1.645
40
X = Rs.14.2 million
Given 15 per cent interest rate, the debt than be serviced is
14.2
= Rs. 94.67 million
0.15
Chapter 21
DIVIDEND POLICY AND FIRM VALUE
1.
Payout ratio
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
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)
77
3.
P
80
0
P
(80P)
0.9(80P)
0
0.9 (80P)
P
= 14%
P = Rs.69.23
78
Q
74
6
Q
(74Q)
0.9 (74Q)
0.8 x 6
0.9 (74Q) + 4.8
Q
=14%
Q = Rs.68.65
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
b.
10,000
8,000
4,000
12,000
7,000
3,500
9,000
10,000
5,000
15,000
8,000
4,000
6,000
1.20
8,500
1.70
4,000
0.80
11,000
2.20
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
10,000
12,000
9,000
15,000
A.
Net income
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
79
F.
External financing
requirement
3,000
(ED)if E > D or 0 otherwise
c.
500
6,500
Nil
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
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
4,000
2,200
6,400
2,000
1.20
1.44
1.08
1.80
E. External financing
(DC)if D>C, or 0
otherwise
F. Dividends per share
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.
80
Hence
Dt = 0.7 x 0.6 x 3.00 + (10.7)1.20
= Rs.1.62
4.
81
Chapter 23
Debt Analysis and Management
1. (i) Initial Outlay
(a) Cost of calling the old bonds
Face value of the old bonds
Call premium
250,000,000
15,000,000
265,000,000
250,000,000
10,000,000
240,000,000
9,200,000
15,800,000
42,500,000
17,400,000
25,100,000
37,500,000
15,500,000
22,000,000
3,100,000
(iii)
17,158,500
(iv)
17,158,500
15,800,000
1,358,500
120,000,000
4,800,000
124,800,000
120,000,000
2,400,000
117,600,000
3,120,000
4,080,000
19,200,000
7,920,000
11,280,000
7,392,000
10,608,000
672,000
18,000,000
2,614,080
cost of
2,614,080
4,080,000
 1,466,000
1000
(1+r)8
1000
(1+r)5
Cash flow
160
160
160
160
160
160
160
160
Present Value
Proportion of
Proportion of bonds
at 18%
bonds value
Value x Time
135.5
114.9
97.4
82.6
69.9
59.2
50.2
308.6
0.148
0.125
0.106
0.090
0.076
0.064
0.055
0.336
0.148
0.250
0.318
0.360
0.380
0.384
0.385
2.688
4.913
Cash flow
Present Value
at 20%
Proportion of
bonds value
84
Proportion of bonds
Value x Time
1
2
3
4
5
120
120
120
120
1120
100.0
83.2
69.5
57.8
450.2
0.131
0.109
0.091
0.076
0.592
0.131
0.218
0.273
0.304
2.960
3.886
Volatility of bond P
4.913
= 4.16
1.18
4.
Volatility of bond Q
3.886
= 3.24
1.20
YTM(%)
12.36
13.10
13.21
13.48
13.72
Graphing these YTMs against the maturities will give the yield curve
The one year treasury bill rate , r1, is
1,00,000
 1
12.36 %
89,000
To get the forward rate for year 2, r2, the following equation may be set up :
12500
99000
112500
+
(1.1236)
(1.1236)(1+r2)
85
13,000
113,000
+
(1.1236)
+
(1.1236)(1.1394)
(1.1236)(1.1394)(1+r3)
13,500
13,500
+
(1.1236)
+
(1.1236)(1.1394)
(1.1236)(1.1394)(1.1349)
113,500
+
(1.1236)(1.1394)(1.1349)(1+r4)
Solving this for r4 we get r4 = 14.54%
To get the forward rate for year 5, r5 , the following equation may be set up :
13,750
100,100
13,750
+
(1.1236)
13,750
+
(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+r5)
Solving this for r5 we get r5 = 15.08%
86
Chapter 25
HYBRID FINANCING
1.
40
=
PV (Exercise price)
1.856
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
87
45.23
1.856
47.78
2.00
51.25
Chapter 24
LEASING, HIRE PURCHASE, AND PROJECT FINANCE
1.
Year
1.Investment(I)
2.Revenues(Rt)
3.Costs(other than
(Depreciation)(Ct)
4.Depreciation(Dt)
5.Profit before tax
(RtCtDt)
6.Profit after tax: 5(1t)
7.Net salvage value
8.Net cash flow
(1+6+4+7)
9.Discount factor
at 11 percent
10.Present value (8x9)
1,700
1,700
3
1,700
(Rs.in 000)
4
1,700
1,700
900
500
900
333.3
900
222.2
900
148.1
900
98.8
300
210
466.7
326.7
577.8
404.5
651.9
456.3
701.2
490.8
300
(1,500)
710
610
626.7
604.4
889.6
1.000
(1,500)
0.901
639.7
0.812
495.3
0.731
458.1
0.659
398.3
0.593
527.5
0

(Rs. in 000)
4
5
1,700
1,700
1
1,700
2
1,700
3
1,700
420
900
420
900
420
900
420
900
420
900
0
420
380
380
380
380
800
88
294
266
266
266
266
560
1.000
294
0.885
235.4
0.783
208.3
0.693
184.3
0.613
163.1
0.543
304.1
2.
x Rs.720,000
= Rs.395,676
666
222
2
x Rs.720,000 = Rs.240,000
666
78
x Rs.720,000 = Rs.84,324
666
Rs.906,667
3
The annual hire purchase instalments would be split as follows
Year
1
2
3
89
Principal repayment
Rs. 510,991
Rs. 666,667
Rs. 822,343
The cash flows of the leasing and hire purchse options are shown below
Year
Leasing
 LRt (1tc)
High Purchase
It(1tc)
PRt
Dt(tc)
500,000(0.4)
375,000(0.4)
281,250(0.4)
210,938(0.4)
158,203(0.4)
118,652(0.4)
88,989(0.4)
66,742(0.4)
50,056(0.4)
37,542(0.4)
10
t=6
12,000
=  1,302,207
(1.10)t
660,667
760,437
(1.10)2
(1.10)
63,281
(1.10)3
47,461
+
(1.10)5
84,375
35,596
+
(1.10)6
(1.10)4
26,697
+
(1.10)7
(1.10)8
90
NSVt
200,000
It(1tc)PRt+
Dt(tc)+NSVt
548,397
660,667
760,437
84,375
63,281
47,461
35,596
26,697
20,023
215,017
20,023
215,017
+
(1.10.9
(1.10)10
=  1,369,383
Since the leasing option costs less than the hire purchase option , Apex should choose the
leasing option.
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
Cash cycle
=
=
2.
Inventory period
=
750/365
91
56.0 days
(140+150)/2
Accounts receivable =
period
52.9 days
30.7 days
1000/365
(60+66)/2
Accounts payable
period
=
750/365
1.
Rs.
3,600,000
900,000
2,700,000
Sales
Less : Gross profit (25 per cent)
Total manufacturing cost
Less : Materials
900,000
Wages
720,000
Manufacturing expenses
1,620,000
1,080,000
960,000
120,000
2,700,000
120,000
2,580,000
360,000
2,940,000
A : Current Assets
Rs.
2,940,000
x 2
12
Material cost
Raw material
stock
2=
490,000
1=
75,000
900,000
x 1
12
12
x
12
2,580,000
x1=
12
12
92
1=
215,000
Cash balance
A predetermined amount
Sales promotion expenses
Prepaid sales
promotion
expenses
Cash balance
100,000
x 1.5 =
15,000
100,000
995,000
120,000
x 1.5 =
12
12
A predetermined amount
A : Current Assets
B : Current Liabilites
Material cost
Sundry creditors
Rs.
900,000
x 2=
12
= 150,000
12
Manufacturing
expenses outstanding
80,000
Wages outstanding
60,000
B : Current liabilities
290,000
Working capital (A B)
Add 20 % safety margin
Working capital required
705,000
141,000
846,000
93
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 000s)
120
84
36
33.6
150
105
45
150
105
45
150
105
45
200
140
60
33.6
50.4
42.0
50.4
42.0
63.0
129.0
137.4
150.0
200
140
60
January
February
March
200
140
60
(Rs. in 000s)
April
May
June
60
60
60
60
60
60
80
60
80
80
80
80
3
25
3
25
3
25
3
25
3
25
3
25
32
32
32
32
32
32
94
15
15
15
15
15
15
30
35
135
155
220
80
Total payments(2to9)
135
135
215
1. Opening balance
2. Receipts
3. Payments
4. Net cash flow(23)
5. Cumulative net cash flow
6. Opening balance +
Cumulative net cash flow
7. Minimum cash balance
required
8. Surplus/(Deficit)
(Rs.in 000s)
January
February
March
28
129.0
135.0
(6.0)
(6.0)
137.4
135.0
2.4
(3.6)
150.0
215.0
(65.0)
(68.6)
22.0
24.4
30.0
(8.0)
30.0
(5.6)
April
May
June
235.0
135.0
100.0
31.4
179.0
155.0
24.0
55.4
203.0
220.0
(17.0)
(38.4)
(40.6)
59.4
83.4
66.4
30.0
(70.6)
30.0
29.4
30.0
53.0
30.0
36.4
2. The projected cash inflows and outflows for the quarter, January through March, is shown below
.
Month
December
(Rs.)
Inflows :
Sales collection
Outflows :
Purchases
Payment to sundry creditors
Rent
Drawings
Salaries & other expenses
Purchase of furniture
22,000
January
(Rs.)
February
(Rs.)
March
(Rs.)
50,000
55,000
60,000
20,000
22,000
5,000
5,000
15,000

22,000
20,000
5,000
5,000
18,000
25,000
25,000
22,000
5,000
5,000
20,000

95
Total outflows(2to6)
47,000
73,000
52,000
Given an opening cash balance of Rs.5000 and a target cash balance of Rs.8000, the
surplus/deficit in relation to the target cash balance is worked out below :
January
(Rs.)
1. Opening balance
2. Inflows
3. Outflows
4. Net cash flow (2  3)
5. Cumulative net cash flow
6. Opening balance + Cumulative
net cash flow
7. Minimum cash balance required
8. Surplus/(Deficit)
February
(Rs.)
March
(Rs.)
5,000
50,000
47,000
3,000
3,000
55,000
73,000
(18,000)
(15,000)
60,000
52,000
8,000
(7,000)
8,000
8,000

(10,000)
8,000
(18,000)
(2,000)
8,000
(10,000)
3. The balances in the books of Datta co and the books of the bank are shown below:
(Rs.)
1
10
30,00
0
20,00
0
46,00
0
20,00
0
62,00
0
20,00
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
20,000
20,000
20,000
20,000
20,000
20,000
4,000
46,00
0
4,000
62,00
0
4,000
78,00
0
4,000
94,000 1,10,0
00
4,000
1,26,00
0
4,000
1,42,0
00
4,000
1,58,0
00
4,000
1,74,0
00
4,000
1,90,0
00
Books of Datta
Co:
Opening
Balance
Add: Cheque
received
Less: Cheque
issued
Closing
Balance
20,000
4,000
Books of the
Bank:
96
Opening
Balance
Add: Cheques
realised
Less: Cheques
debited
Closing
Balance
30,00
0

30,00
0

30,00
0

30,00
0
30,00
0
30,00
0
30,000 30,000
30,000
50,000
70,000
20,000
20,000
20,000
50,000
70,000
90,000
30,000 30,000
90,000
1,06,0
00
20,000
20,000
4,000
1,06,0
00
4,000
1,22,0
00
From day 9 we find that the balance as per the banks books is less than the balance as per Datta
Companys 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 b2
RP =
+ LL
4I
UL = 3 RP 2 LL
I = 0.12/360 = .00033, b = Rs.1,500, = Rs.6,000, LL = Rs.100,000
3 3 x 1500 x 6,000 x 6,000
RP =
+ 100,000
4 x .00033
Chapter 28
CREDIT MANAGEMENT
1.
RI = [S(1V) Sbn](1t) k I
S
I =
x ACP x V
360
S = Rs.10 million, V=0.85, bn =0.08, ACP= 60 days, k=0.15, t = 0.40
Hence, RI = [ 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.
S
+V(ACPN)
360
360
98
S=Rs.1.5 million, V=0.80, bn=0.05, t=0.45, k=0.15, ACPN=60, ACPo=45, So=Rs.15 million
Hence RI = [1,500,000(10.8) 1,500,000 x 0.05] (1.45)
0.15
360
= 123750 123750 = Rs. 0
3.
360
I =
(ACPoACPN) 360
x ACPN x V
360
(2416)
360
1,200,000
360
x 16 x 0.80
= Rs.79,200
4.
RI = [S(1V) BD](1t) k I
BD=bn(So+S) boSo
So
I =
S
(ACPN ACPo) +
360
x ACPN x V
360
99
Rs.50,000,000
 0.15
Rs.6,000,000
(4025) +
x 40 x 0.75
360
360
=  Rs.289.495
5. 30% of sales will be collected on the 10th day
70% of sales will be collected on the 50th day
ACP = 0.3 x 10 + 0.7 x 50 = 38 days
Rs.40,000,000
Value of receivables =
x 38
360
= Rs.4,222,222
Assuming that V is the proportion of variable costs to sales, the investment in
receivables is :
Rs.4,222,222 x V
6. 30% of sales are collected on the 5th day and 70% of sales are collected on the
25th 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,
RI = [S(1V) DIS](1t) kI
So=Rs.50 million, S=Rs.10 million, do=0.02, po=0.70, dn=0.03,pn=0.60,
ACPo=20 days, ACPN=24 days, V=0.85, k=0.12 , and t = 0.40
DIS = 0.60 x 60 x 0.03 0.70 x 50 x 0.2
= Rs.0.38 million
50
I=
10
(2420) +
360
x 24 x 0.85
360
= Rs.1.2222 million
RI = [ 10,000,000 (1.85) 380,000 ] (1.4) 0.12 x 1,222,222
100
= Rs.525,333
8.
Grant credit
Customer pays(0.95)
Profit 1500
Customer pays(0.85)
Grant credit
Profit 1500
Customer defaults(0.05)
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
Initial order
Probability of payment
and repeat order
{ 0.85(1500)0.15(8500)} +
=
0
+
Expected profit on
repeat order
0.85 {0.95(1500).05(8500)}
850
= Rs.850
RI = [S(1 V)  Sbn] (1 t) R I
S
where I =
x ACP x V
360
x 20 x 0.8
360
S
+ V (ACPn)
360
360
(50 20) x
50,000,000
+ 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
102
20,000,000
(20 16) 0.8 x
x 16
360
360
Chapter 29
INVENTORY MANAGEMENT
1.
a.
No. of
Orders Per
Year
(U/Q)
1
2
5
10
Order
Quantity
(Q)
Ordering Cost
(U/Q x F)
Units
Rs.
250
125
50
25
200
400
1,000
2,000
3,750
1,875
750
375
2 UF
103
2x250x200
3,950
2,275
1,750
2,375
PC
= 58 units (approx)
2UF
30
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
= 10.20
980
Note that though fractional orders cannot be placed, the number of orders
relevant for the year will be 10.2 . In practice 11 orders will be placed during the year. However,
the 11th order will serve partly(to the extent of 20 percent) the present year and partly(to the
extent of 80 per cent) the following year. So only 20 per cent of the ordering cost of the 11th
order relates to the present year. Hence the ordering cost for the present year will be 10.2 x
Rs.300
3.
= 490 units
20
U
= UD +
Q*
Q(PD)C
F
Q* PC

2
6,000
2
6,000
= 6000 x .5 +
490
x 400
1,000
1,000 (95)0.2
104
= 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
= 5000 x 1.5 +
5,000

707
1,000
x 300
707 x 30 x 0.2
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 x 3.0 +
707
= 15,000 +1372 3279
5.
5000

2000x27x0.2
x 300
2000
707x30x0.2

= Rs.13,093
5(0.6)
10(0.2)
15(0.2)
4(0.3)
6(0.5)
8(0.2)
20*(0.18)
30 (0.30)
40 (0.12)
40(0.06)
60(0.10)
80(0.04)
60(0.06)
90(0.10)
120(0.04)
105
Note that if the DUR is 4 units with a probability of 0.3 and the LT is 5 days with
a probability of 0.6, the requirement for the combination DUR = 4 units and LT =
5 days is 20 units with a probability of 0.3x0.6 = 0.18. We have assumed that the
probability distributions of DUR and LT are independent. All other entries in the
table are derived similarly.
The normal (expected) consumption during the lead time is :
20x0.18 + 30x0.30 + 40x0.12 + 40x0.06 + 60x0.10 + 80x0.04 + 60x0.06 + 90x0.10 +
120x0.04 = 46.4 tonnes
a. Costs associated with various levels of safety stock are given below :
Safety
Stock*
Stock
outs(in
tonnes)
Stock out
Cost
Probability
Tonnes
73.6
43.6
33.6
13.6
Expected
Stock out
5
[3x4]
Carrying
Cost
Total Cost
6
[(1)x1,000]
7
[5+6]
Rs.
73,600
43,600
Rs.
73,600
48,400
0
30
0
120,000
0
0.04
Rs.
0
4,800
10
40
40,000
160,000
0.10
0.04
10,400
33,600
44,000
20
30
60
80,000
120,000
240,000
0.04
0.10
0.04
24,800
13,600
38,400
106
13.6
33.6
43.6
73.6
54,400
134,400
174,400
294,400
0.16
0.04
0.10
43,296
43,296
SR (L)
30 x 1,000 x 40
= 3,391 units
7.
Item
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Annual Usage
(in Units)
400
15
6,000
750
1,200
25
300
450
1,500
1,300
900
1,600
600
30
45
Price per
Unit
Rs.
Annual
Usage Value
Rs.
20.00
150.00
2.00
18.00
25.00
160.00
2.00
1.00
4.00
20.00
2.00
15.00
7.50
40.00
20.00
8,000
2,250
12,000
13,500
30,000
4,000
600
450
6,000
26,000
1,800
24,000
4,500
1,200
900
107
Ranking
6
10
5
4
1
9
14
15
7
2
11
3
8
12
13
1,35,200
Rank
5
10
12
4
3
1
9
13
6
2
11
1
2
3
4
5
6
7
8
9
10
11
Annual
UsageValue
(Rs.)
30,000
26,000
24,000
13,500
12,000
8,000
6,000
4,500
4,000
2,250
1,800
Cumulative
Annual Usage
Value (Rs.)
30,000
56,000
80,000
93,500
105,500
113,500
119,500
124,000
128,000
130,250
132,050
Cumulative Cumulative
% of Usage % of Items
Value
22.2
41.4
59.2
69.2
78.0
83.9
88.4
91.7
94.7
96.3
97.7
108
6.7
13.3
20.0
26.7
33.3
40.0
46.7
53.3
60.0
66.7
73.3
14
15
7
8
12
13
14
15
Class
1,200
900
600
450
No. of Items
A
B
C
133,250
134,150
134,750
135,200
% to the Total
4
3
18
98.6
99.2
99.7
100.0
Annual Usage
Value Rs.
26.7
20.0
53.3
80.0
86.7
93.3
100.0
% to Total Value
93,500
26,000
15,700
15
69.2
19.2
11.6
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
b.
0.99
20
0.02
360
x
c.
0.98
20
0.03
360
x
= 0.182
= 18.2%
= 0.367
36.7%
= 0.318
31.8%
109
d.
0.97
35
0.01
360
x
0.99
= 0.364
36.4%
0.104
10.4%
0.21
21%
0.223
22.3%
14.5%
10
2.
a.
0.01
360
x
0.99
b.
35
0.02
360
x
0.98
c.
35
0.03
360
x
0.97
d.
=
50
0.01
360
x
= 0.145
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
110
Chapter 31
WORKING CAPITAL MANAGEMENT :EXTENSIONS
1.(a)
bYi
discriminant score for the ith account
quick ratio for the ith account
EBDIT/Sales ratio for the ith account
x 2 . y 2
xy . xy
111
The basic calculations for deriving the estimates of a and b are given
the accompanying table.
Drawing on the information in the accompanying table we find that
G
R
O
U
P
I
G
R
O
U
P
II
Xi = 19.81
Yi= 391
(XiX)2
(YiY)2
(XiX)(YiY)
X = 0.7924
Y = 15.64
= 0.8311
=1661.76
= 10.007
Account
Number
Xi
Yi
(XiX)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
0.90
0.75
1.05
0.85
0.65
1.20
0.90
0.84
0.93
0.78
0.96
1.02
0.81
0.76
1.02
15
0.1076
20 0.0424
10 0.2576
14
0.0576
16 0.1424
20
0.4076
24
0.1076
26
0.0476
11
0.1376
18 0.0124
12
0.1676
25
0.2276
26
0.0176
30 0.0324
28
0.2276
16
17
18
19
20
21
22
23
24
25
0.76
0.68
0.56
0.62
0.92
0.58
0.70
0.52
0.45
0.60
10 0.0324
12 0.1124
4 0.2324
18 0.1724
4 0.1276
20 0.2124
8 0.0924
15 0.2724
6 0.3424
7 0.1924
19.81
391
(YiY)
(XiX)2
(YiY)2 (XiX)(YiY)
0.64
0.0116
0.4096
4.36
0.0018 19.0096
5.64
0.0664 31.8096
1.64 0.0033
2.6896
0.36 0.0203
0.1296
4.36 0.1661
19.0096
8.36 0.0116
69.8896
10.36 0.0023 107.3296
4.64
0.0189
21.5296
2.36
0.0002
5.5696
3.64
0.0281
13.2496
9.36 0.0518
87.6096
10.36 0.0003 107.3296
14.36 0.0010
206.2096
12.36 0.0518
152.7696
5.64
3.64
11.64
2.36
19.64
4.36
 7.64
0.64
9.64
8.64
0.0010
0.0126
0.0540
0.0297
0.0163
0.0451
0.0085
0.0742
0.1172
0.0370
0.8311
13.42
112
0.0689
0.1849
1.4529
0.0945
0.513
1.7771
0.8995
0.4931
0.6385
0.0293
0.6101
2.1303
0.1823
0.4653
2.8131
31.8069
0.1827
13.2496
0.4091
135.4896
2.7051
5.5696 0.4069
385.7296 2.5061
19.0096 0.9261
58.3696 0.7059
0.4096 0.1743
92.9296 3.3007
74.6496 1.6623
1661.76
9.539
X1 =
=
15
Sum of Xi for group 2
10
=
15
=
10
(Xi X) =
0.8311
= 0.0346
n1
251
(Yi Y) =
1661.76
n1
1
n1
9.60
10
2
xy =
96
Y2 =
y =
19.67
15
295
Y1 =
0.6390
10
x =
6.39
=
0.8947
15
X2 =
69.24
251
(XiX)(YiY) =
10.0007
=
0.4167
251
= 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
Zi = 6.079 Xi + 0.1089 Yi
(b) Choice of the cutoff point
The Zi score for various accounts are shown below
Zi scores for various accounts
Account No.
Zi Score
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
7.1046
6.7373
7.4720
6.6918
5.6938
9.4728
8.0847
7.9378
6.8514
6.7018
7.1426
8.9231
7.7554
7.8870
9.2498
5.7090
5.4405
3.8398
5.7292
5.1571
5.7038
5.1265
4.7946
3.3890
4.4097
Zi Score
24
18
25
3.3890
3.8398
4.4097
Good(G)
or
Bad (B)
B
B
B
114
23
22
20
17
5
21
16
19
4
10
2
9
1
11
3
13
14
8
7
12
15
6
4.7946
5.1265
5.1571
5.4405
5.6938
5.7038
5.7090
5.7292
6.6918
6.7018
6.7373
6.8514
7.1046
7.1426
7.4720
7.7554
7.8870
7.9378
8.0847
8.9231
9.2498
9.4728
B
B
B
B
G
B
B
B
G
G
G
G
G
G
G
G
G
G
G
G
G
G
From the above table, 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 . This Zi
score is :
5.7292 + 6.6918
= 6.2105
2
Given this cutoff Zi score, there is just one misclassification (Account number 5)
115
Chapter 4
ANALYSING FINANCIAL PERFORMANCE
Net profit
1.
Return on equity =
Equity
=
Net profit
Net sales
Total assets
x
Net sales
=
0.05
Debt
Note :
x
Total assets
1
x 1.5
0.3
Equity
= 0.25 or 25 per cent
Equity
= 0.7
Total assets
Hence Total assets/Equity
So
= 10.7 = 0.3
Total assets
= 1/0.3
116
2.
PBT
Rs.40 million
PBIT
= 6
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.
= 2740
365
160000
ACP =
= 58.4
117
2740
If the accounts receivable has to be reduced to 120,000 the ACP must be:
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 =
Current liabilities
Current assets
= 1.2
Inventories
This means
Current liabilities
= 1.2
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
118
x 40
= 29,333
360
Cost of goods sold
Inventory turnover ratio =
211,200
=
Inventory
= 5
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
Equity capital
Retained earnings
Debt(Current liabilities)
Balance Sheet
50,000
Plant & equipment
60,000
Inventories
66,000
Accounts receivable
Cash
119
54,560
42,240
29,333
49,867
176,000
Sales
Cost of goods sold
176,000
264,000
211,200
1.42
30,000,000
Current assets Inventories
(ii) Acidtest ratio =
22,500,000
=
= 0.75
Current liabilities
30,000,000
= 1.31
10,000,000 + 22,500,000
Profit before interest and tax
= 3.02
5,000,000
Cost of goods sold
72,000,000
=
Inventory
365
120
= 3.6
20,000,000
Net sales
(vii) Total assets turnover ratio
95,000,000
= 1.27
Total assets
75,000,000
5,100,000
=
= 5.4%
Net sales
PBIT
95,000,000
15,100,000
=
Total assets
Equity earning
(xi) Return on equity =
20.1%
75,000,000
5,100,000
=
Net worth
= 15.7%
32,500,000
The comparison of the Omexs 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
1.42
0.75
1.31
3.02
3.6
57.6 days
1.27
5.4%
20.1%
15.7%
121
Standard
1.5
0.80
1.5
3.5
4.0
60 days
1.0
6%
18%
15%
= 0.98
6.5 + 9.3
57.4
= 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
Net profit
margin
5.2%
Net profit
3.0
Total costs
54.8
Net sales
57.4
Return on
total assets
10.2%
122
Net sales
57.4
Total asset
turnover
1.96
Average
fixed assets
21.4
+
Average total
assets
29.35
Average
net current
assets 54.0
+
Average
other assets
2.55
Net sales
Cost of goods sold
Gross profit
Operating expenses
Operating profit
Nonoperating surplus /
deficit
PBIT
Interest
PBT
5.0
2.0
3.0
123
9
3
5
Tax
Profit after tax
2.6
3.0
Balance Sheet
Shareholders funds
Loan funds
Total
Net fixed assets
Net current assets
Other assets
Total
Net sales
Cost of goods sold
Gross profit
Operating expenses
Operating profit
Nonoperating surplus /
deficit
PBIT
Interest
PBT
Tax
5.0
2.0
3.0
124
122
133
115
100
2.6
3.0
100
115
Balance Sheet
Shareholders funds
Loan funds
Total
Net fixed assets
Net current assets
Other assets
Total
(f) The qualitative factors relevant for evaluating the performance and prospects of a
company are as follows:
To what extent are the companys revenues tied to one key product?
To what extent does the company rely on a single supplier?
What percentage of the companys 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?
Chapter 5
BREAKEVEN ANALYSIS AND LEVERAGES
1.
a.
EBIT = Q(PV)F
= 20,000(106)50,000 = Rs.30,000
b.
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.
3.
DOL =
Q(PV)
126
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
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.
=10,000 units
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
6.
PV
= 0.30
PV = Rs.6
F=20,000
P
20000
Q =
6
= 3,333 P =
= Rs.20
0.30
10,000
7. (a) P = Rs.30 ,V=Rs.16, F=Rs.10,000 Q =
= 714.3 bags
3016
10,000
Q =
= 588.2 bags
3316
A
Selling price per unit
Rs.10
Variable cost per unit
Rs.6
Contribution margin per unit
Rs.4
Contribution margin ratio
0.4
Total fixed costs
Rs.16000
Breakeven point in units
4000
Breakeven sales(Rs.)
Rs.40000
Net income(loss)before tax
Rs.30000
No.of units sold
11500
B
C
D
Rs.16.66
Rs.20
Rs.10
Rs.8.33
Rs.12
Rs.5
Rs.8.33
Rs.8
Rs.5
0.5
0.4
0.5
Rs.100000 Rs.160000
Rs.60000
12000
20000
12000
Rs.200000 Rs.400000 Rs.120000
Rs.80000 Rs.(40000)
Rs.40000
21600
15000
20000
5000
8,000
x Rs.10
19000
10.
6,000
x Rs.20 +
19000
x Rs.40
= Rs.23.68
19000
EBIT
DFL =
Dp
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)
=
11. (a)
(b)
EBIT
1.185
Q(PV) F
Rs.1.9
Rs.4.17
Rs.0.40
10,000
(Rs.130,000Rs.20,000)(1.5)Rs.5,000
Firm B :
12,000
(Rs.80,000Rs.40,000)(1.6)Rs.10,000
Firm C :
15,000
F+I
(c)
BEP
=
PV
130
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
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
1.54
20,000(Rs.20Rs.15) Rs.40,000
10,000(Rs.50Rs.30)
Firm B
:
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 =
Dp
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
131
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(1.6)
(f)
DTL
= DOL x DFL
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
of sales
Net sales
Cost of goods sold
Gross profit
Selling expenses
General & administration expenses
100.0
76.33
23.67
7.40
6.63
1020.0
778.57
241.43
75.48
67.63
132
Depreciation
Operating profit
Nonoperating surplus/deficit
Earnings before interest and taxes
Interest
Earnings before tax
Tax
Earnings after tax
Dividends (given)
Retained earnings
2.
6.75
2.90
1.07
3.96
68.85
29.58
10.91
40.39
1.24
2.72
1.00
1.72
12.65
27.74
10.20
17.54
8.00
9.54
The proforma income statement of Modern Electronics for year 3 using the
the combination method is given below :
Average per cent
of sales
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
100.0
76.33
23.67
7.40
Budgeted
Budgeted
1.07
Budgeted
133
3.
49.86
10.20
39.66
8.00
31.66
1.00
Budgeted
The proforma balance sheet of Modern Electronics Ltd for year 3 is given below
Average of percent
of sales or some
other basis
Net sales
100.0
1020.0
ASSETS
Fixed assets (net)
Investments
40.23
No change
410.35
20.00
1.54
22.49
21.60
15.71
229.40
220.32
5.09
51.92
Prepaid expenses
134
No change
14.00
961.70
LIABILITIES :
Share capital :
Equity
Reserves & surplus
No change
Proforma income
statement
150.00
160.66
Secured loans:
Term loans
Bank borrowings
No change
No change
175.00
199.00
Current liabilities :
Trade creditors
Provisions
17.33
5.03
176.77
51.31
Balancing figure
48.96
961.7
A
4.
EFR =
L

S
800
=
190

1000
S m S1 (1d)
1,300
195
117
135
78
39
39
Assets
Share capital
Retained earnings
Term loans (80+72)
Shortterm bank borrowings
(200 + 72)
Accounts payable
Provisions
150
219
152
272
Fixed assets
Inventories
Receivables
Cash
520
260
195
65
182
65
1,040
A
5.
(a)
EFR =
L

150
30
160
1,040
S m S1 (1 d)
Assets
56.25
47.50
90
75
46.25
30.00
Debtors
Cash
45
15
37.50
7.50
136
225.00
225.00
(c)
i)
ii)
iii)
20X0
1.50
0.53
14.3%
Current ratio
Debt to total assets ratio
Return on equity
20X1
1.80
0.54
14.5%
(d)
A
EFR 20X1=
S mS1 (1 d)
150
30
160
9.38
150 x (1.125)
EFR 20X2 =
30 x 1.125

180
180
168.75
=
33.75

180
180
= 8.75
168.75 x (1.11)
EFR 20X3
33.75 x (1.11)
200
200
187.31
=
=
37.46

200
x 20 6.88
200
8.11
187.31 x (1.1)
37.46 x (1.1)
137
EFR 20X4 =
220
=
220
7.49
Balance Sheet as on 31st December, 20X4
Liabilities
Rs.
Assets
Rs.
Share capital
46.87
Net fixed assets
90.00
(30+16.87)
(60 x 240/160)
Retained earnings
Inventories
(40.00+5.63+6.25+6.88+7.50) 66.26
(50x240/160)
75.00
Term loans(20+16.87)
36.87
Debtors (30x240/160)
45.00
Shortterm bank borrowings 30.00
Cash (10x240/160)
15.00
Trade creditors
37.50
Provisions
7.50
225.00
6.
EFR
225.00
m (1+g) (1d)

S
S
S
g
Given A/S= 0.8 , L/S= 0.5 , m= 0.05 , d= 0.6 and EFR = 0 we have,
(0.05)(1+g)(0.4)
(0.80.5) 
=0
g
(0.05)(1+g)(0.4)
i.e. 0.3 
=0
g
(a)
EFR =
L

S
320
=
70

400
S mS1 (1d)
= Rs.50
(b)
i.
ii.
EFR =
L

S m S1 (1d)
S
A
Therefore, mS1(1d)
S
S represents surplus funds
S
S
Given m= 0.06, S1 =11,000, d= 0.6 , L= 3,000 S= 10,000 and
surplus funds = 150 we have
A
3,000
(0.06) 11,000 (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.
g=
A/S m(1d)A/E
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
140
(c)
.05 =
A/E = 3.33
1.4 .05 (10.6) A/E
.06 =
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
Chapter 32
CORPORATE VALUATION
1. (a) The calculations for Hitech Limited are shown below :
Year 2
EBIT
PBT
86
+ Interest expense
24
 Interest income
(10)
 Nonoperating income
(5)
EBIT
95
Tax on EBIT
Tax provision on income statement 26
+ Tax shield on interest expense
9.6
 Tax on interest income
(4)
141
Year3
102
28
(15)
(10)
105
32
11.2
(6)
(2)
29.6
(4)
33.2
65.4
(50)
3
18.4
71.8
(50)
6
27.8
27.8
Year 2
310
360
65.4
400
50
Year 3
16.8
40
(30)
10
(9)
Year 3
360
410
71.8
460
50
16.35%
1.29
21.1%
16.1%
15.4
15.61%
1.28
19.9%
13.9%
21.8
Televista Corporation
0
Base year
1.
2.
3.
4.
Revenues
EBIT
EBIT (1t)
Cap. exp.
 Depreciation
1600
240
156
200
120
1920
288
187
240
144
2304
346
225
288
173
2765
415
270
346
207
3318
498
323
415
249
3650
547
356

142
5. Working capital
6. Working capital
7. FCFF
(346)
Discount factor
Present value
400
480
80
11
576
96
13
691
115
16
829
138
19
912
83
273
= 7690
ke
ka
= 11 + 1.1 x 6 = 17.6%
= 0.44 x 9.8 + 0.56 x 17.6 = 14.2%
kd(1t)
ke
ka
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 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)
Present
value
118
155
203
263
339
454
581
709
822
905
995
100
140
196
274
384
538
721
922
1125
1305
1436
1580
30.6
27.6
27.4
20.8
12.0
13.4
15.4
16.7
16.9
16.6
476
60
84
118
165
230
323
432
553
675
783
862
948
26
39
50
70
98
132
169
206
239
263
289
36
38
44
39
26
33
43
53
61
68
74
1:1 1.3
1:1 1.3
1:1 1.3
1:1 1.3
1:1 1.3
0.8:1 1.1
0.8:1 1.1
0.8:1 1.1
0.8:1 1.1
0.8:1 1.1
0.5: 1.1
1.0
17.6
17.2
16.7
16.3
15.8
14.2
14.2
14.2
14.2
14.2
13.7
.850
.726
.622
.535
.462
.405
.354
.310
.272
.238
673.4
The present value of continuing value is :
FCF11
74
x PV factor 10 years =
kg
x 0.238
= 476
0.137 0.100
MINI CASE
Solution:
Solution:
1. Revenues
2. PBIT
3. NOPAT = PBIT
(1 .35)
4. Depreciation
5. Gross cash flow
6. Gross investment
in fixed assets
7. Investment in net
current assets
8. Total investment
9. FCFF (5) (8)
1
950
140
91
2
1,000
115
74.8
3
1,200
130
84.5
4
1,450
222
144.3
5
1,660
245
159.3
6
1,770
287
186.6
55
146
100
85
159.8
250
80
164.5
85
83
227.3
100
85
244.3
105
87
273.7
120
10
15
70
70
70
54
155
9.5
170
57.3
175
69.3
174
99.6
110
36
265
(105.2)
0.4
WACC =
1.0
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
= 1249
(1.14)
+
+
+
+
(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
145
Chapter 33
VALUE BASED MANAGEMENT
1. The value created by the new strategy is calculated below :
Current
Values
(Year 0)
Sales
Gross margin (20%)
Selling and general
administration (8%)
Profit before tax
Tax
Profit after tax
2000
400
160
2240
448
179
2509
502
201
2810
562
225
3147
629
252
3147
629
252
240
72
168
269
81
188
301
90
211
337
101
236
378
113
264
378
113
264
Fixed assets
Current assets
Total assets
Equity
600
600
1200
1200
944
944
1888
1888
=
=
=
=
=
=
147
264 / 0.15 = 1760
1760 / (1.15)4 = 1007
147 + 1007 = 1154
168/0.15 = 1120
1154 1120 = 34
264
84
185
101
62
264
94
94
264
=
B
kg
r  .10
k  .10
r  .10 = 2k  .20
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
r
c*
T
=
=
=
=
Rs.200 million
0.40
0.20
5 years
200 (0.40 0.20) 5
2. Costs
1,400 1,400 1,400 1,400 1,400
3. PBDIT
600
600
600
600
600
4. Depreciation
200
200
200
200
200
5. PBIT
400
400
400
400
400
6. NOPAT
240
240
240
240
240
7. Cash flow (4+6)
440
440
440
440
440
8. Capital at charge
1,000
800
600
400
200
9. Capital charge (8x0.14)
140
112
84
56
28
10. EVA (69)
100
128
156
184
212
5
440
NPV =
 1000 = 440 x 3.433 1000 = 510.5
t
t=1 (1.14)
NPV =
EVAt
(1.14)
6.
881,600
=
PVIFA14%, 4yrs
2.914
= Rs.302,540
Capital
Depreciation
Capital charge
Sum
7.
Investment
Life
=
FVIFA(10yrs, 15%)
2,000,000
=
= 98,503
20.304
8.
Investment
Life
Cost of capital
Salvage value
:
:
:
:
Rs.5,000,000
5 years
12 per cent
Nil
Capital
Depreciation
Capital charge
Sum
1
5,000,000
786,963
600,000
1,386,963
Economic depreciation
=
FVIFA(5yrs, 12%)
5,000,000
=
= Rs.787,030
6.353
9.
Investment
Net working capital
Life
Salvage value
Annual cash flow
Cost of capital
Straight line depreciation
=
=
=
=
=
=
=
Rs.100 million
Rs.20 million
8 yrs
Rs.20 million (Net working capital)
Rs.21.618 million
15%
Rs.10 million per year
80
Economic depreciation
80
=
149
= Rs.5.828 million
FVIFA(8, 15%)
Year 1
11.618
10.000
21.618
Year 4
11.618
10.000
21.618
70
11.62%
21.62%
15.79%
16.59%
21.62%
15.79%
150
13.727
Chapter 34
MERGERS, ACQUISITIONS AND RESTRUCTURING
1. The preamalgamation balance sheets of Cox Company and Box Company and the postamalgamation 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
Pooling method
Purchase
method
35
45
27.5
30
2.5
62.5
77.5
Cox
Box
Fixed assets
Current assets
Goodwill
Total assets
25
20
10
7.5
45
17.5
Share capital
(face value @ Rs.10)
Reserves & surplus
Share premium
Debt
20
25
20
10
15
45
10
2.5
17.5
20
17.5
42.5
10
17.5
77.5
=
= 0.25
300,000 + 100,000
a) True cost to Ajeet Company for acquiring Jeet Company
Cost = PVAB  PVB
= 0.25 x 27  5
= Rs.1.75 million
b) NPV to Ajeet
= Benefit  Cost
=
4  1.75 = Rs.2.25 million
c) NPV to Jeet = Cost = Rs.1.75 million
5.
=
k  .05
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
152
(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.
Number of shares
Aggregate earnings
Market value
P/E
B
2000
Rs.4000
Rs.24000
6
A&B
6333
Rs.49000
Rs.114000
2.33
(E1+E2) PE12
+
S2
P1S2
12
=
(36+12) 8
+
= 0.1
30 x 8
ER2
=
(PE12) (E1+E2)  P2 S2
9 x 12
=
= 0.3
9 (36+12)  9 x 8
(c)
12
ER1
(48) PE12
= 
+
8
240
9 x 12
ER2
=
PE12 (48)  72
Equating ER1 and ER2 and solving for PE12 gives, PE12 = 9
When PE12 = 9
ER1 = ER2 = 0.3
Thus ER1 and ER2 intersect at 0.3
8.
9.7
(1.15)3
10.2
0
+
(1.15)4
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
FCF8
V4
18
=
0.150.08
= Rs.257.1 million
0.15 0.08
1
PV (VH) = 257.1 x
=
(1.15)
Rs.96.7 million
:
154
MINICASE
Solution:
(a)
Modern Pharma
Magnum Drugs
2300
650
20
450
= Rs.115
= Rs.65
10
95
= Rs.22.5
20
Rs.320
Exchange
Ratio
65
115
9.5
= Rs.9.5
10
Rs.102
22.5
102
320
Exchange ratio that gives equal weightage to book value per share, earnings per share, and market
price per share
65
9.5
+
115
102
+
22.5
320
= 0.44
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
155
= Rs.22.5
20
S2
P1 S2
 20
=
10
(f)
(450 + 95) 13
+
= 0.21
320 x 10
156
102 x 20
=
12 (450 + 95) (1.02) 102 X 10
= 0.36
(g)
The level of P/E ratio where the lines ER1 and ER2 intersect.
To get this, solve the following for P/E12
 S1
P2S1
=
S2
P1S2
 20
102 x 20
=
10
320 x 10
2040
=
3200
157
Chapter 37
INTERNATIONAL FINANCIAL MANAGEMENT
1. The annualised premium is :
Forward rate Spot rate
12
x
Spot rate
46.50 46.00
=
12
x
46.00
2.
= 4.3%
3
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
158
(b) The most likely spot rate 6 months hence will be : 107 yen / dollar
(c) Futures rate
Spot rate
107
106
1.03
9200
3530.8
+
(1.18)2
5807.6
+
(1.18)3
4633.6
+
(1.18)5
4753.8
+
(1.18)6
= Rs.3406.2 million
159
(1.18)4
Forward rate
Spot rate
F
=
1.60
1 + .020
F = $ 1.592 /
6.
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
(1 + expected inflation in Japan)2
8.
Expected spot rate = Current spot rate x
2 years from now
(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 :
160
100,000
= 98522
(1.015)
(ii) Obtain 98522 on todays spot market
(iii) Invest 98522 in the UK money market. This investment will grow to
100,000 after 90 days
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 visvis the Swiss franc. So Mr.Sehgals argument is not tenable.
161
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
(1+Riskfree rate)0.5
(1+Riskfree rate)0.5
4200
(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
(1+Riskfree rate)1
5400
= 5000 + 250 Present value of convenience yield
(1.15)
162
163
164
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