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%

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.

Let A be the annual savings.

6.

A x FVIFA (12%, 10 years) =

A x 17.549
=

1,000,000
1,000,000

So, A = 1,000,000 / 17.549 =

Rs.56,983.

1,000 x FVIFA (r, 6 years)

10,000

FVIFA (r, 6 years)

10,000 / 1000 = 10
1

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=

x 4% = 20.3%
(10.980 9.930)

7.

1,000 x FVIF (r, 10 years)

FVIF (r,10 years)

=
=

5,000
5,000 / 1000 = 5

From the tables we find that

FVIF (16%, 10 years) =
FVIF (18%, 10 years) =

4.411
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

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The amount that can be withdrawn annually is: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)
PVIFA (18%, 10 years)
Using linear interpolation we get:
5.019 5.00
r = 15% +
---------------5.019 4.494

=
=

5.019
4.494

x 3%

= 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
3

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.

FV5

=
=
=
=

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

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

18.

FV5

=
=
=
=

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

Rs.5,000 (1.03)20
Rs.5,000 x 1.806
Rs.9,030

19

A
Stated rate (%)

B
12

24

Frequency of compounding 6 times

Effective rate (%)

Difference between the

effective rate and stated
rate (%)
20.

4 times

24
12 times

(1 + 0.12/6)6- 1 (1+0.24/4)4 1 (1 + 0.24/12)12-1

= 12.6

= 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

= Rs.12,000 / 0.12 = Rs.100,000

To have a sum of Rs.100,000 at the end of 8th year , the amount to be deposited
Rs.100,000
Rs.100,000
=
= Rs.40,388
PVIF(12%, 8 years)
2.476
21.

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

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.

FV10

= Rs.10,000 [1 + (0.10 / 2)]10x2

= Rs.10,000 (1.05)20
= Rs.10,000 x 2.653
= Rs.26,530

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

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

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)
=

21.244
6

= 20

PVIFA (2%, 24)

18.914

Using a linear interpolation

21.244 20.000
r = 1% +
---------------------21.244 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.

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

n=7+

5.000 4.868
----------------5.335 4.868

x 1 = 7.3 years

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

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
-----------------------i-g

1 (1.06)15 / (1.16)15
0.16 0.06

= Rs.300 million x (0.74135 / 0.10)

= Rs.2224 million
8

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
=

FVIFA (10%, 15 years)

= 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

= 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
7
t=1
(1.12)
(1.12)

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

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
= 18% + ----------- x 2%
82 74.9

Yield to maturity

= 18.56%
5.
P =

12

t=1

100
+

(1.08)

(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 post-tax interest and maturity value are calculated below:

12

Bond A
*

Post-tax interest (C )

12(1 0.3)
=Rs.8.4

Post-tax maturity value (M) 100 [ (100-70)x 0.1]

=Rs.97

Bond B
10 (1 0.3)
=Rs.7
100 [ (100 60)x 0.1]
=Rs.96

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

Post-tax YTM =
=

Bond B :

Post-tax YTM =
=

8.4 + (97-70)/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

= 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.

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

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

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

Rs.35.33

Since the growth rate of 6% applies to dividends as well as market price, the
price at the end of the 2nd year will be:
P2

=
=

Po x (1 + g)2 = Rs.35.33 (1.06)2

Rs.39.70
13

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

= 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:
B:
C:

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.

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
=
=

B=

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

Rs.5.74

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

P8 / (1.14)8
P8 = D9 / (r g) =

3.21 (1.05)/ (0.14 0.05) = Rs.37.45

So
C

Thus,
Po
=

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

A + B + C = 5.74 + 4.89 + 13.14
14

=
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:

Present value of the market price expected at the end of 10 years.

A=

2.00 (1.15) 2.00 (1.15)2 2.00 (1.15)3 2.00(1.15)4 2.00 (1.15)5

------------- + ------------- +-------------- + ------------- + ------------(1.12)
(1.12)2
(1.1.2)3
(1.1.2)4
(1.12)5

=
=
B=
=
=
C=
=

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
------------ + ---------------- + ------------- + --------------- + --------------(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
D11
1
6.48 (1.05)
-------- x --------------- = ------------------- x 1/(1.12)10
rg
(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

15

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
900 (1 + r)4
r
15.

= 1709.24
= 0.1739 or 17.39%

Intrinsic value of the equity share (using the 2-stage growth model)
(1.18)6
2.36 x
1 - ----------2.36 x (1.18)5 x (1.12)
6
(1.16)
=
--------------------------------- + ----------------------------------0.16 0.18
(0.16 0.12) x (1.16)6

16.

2.36 x

Rs.74.80

- 0.10801
----------- + 62.05
- 0.02

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

16

equation

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 (Ri)

10%

20%

30%

Probability (pi)

0.4

0.4

0.2

Note that the rate of return is defined as:

Dividend + Terminal price
-------------------------------- - 1
Initial price
(c )

The standard deviation of rate of return is : = pi (Ri R)2

The of the rate of return on MVMs stock is calculated below:
--------------------------------------------------------------------------------------------------Ri
pi
pI ri
(Ri-R)
(R i- R)2
pi (Ri-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 = pi Ri
pi (Ri-R)2
= 56
= 56 = 7.48%

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

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

17

=
=

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 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 =

(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 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.

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

=
Rs.84.41
For Rs.700, 14 shares of Alphas stock can be acquired; likewise for Rs.300, 6
shares of Betas stock can be acquired. The probability distribution of this
option is:

18

Return (Rs)

Probability

(14 x 55) + (6 x 75)

(14 x 50) + (6 x 65)
(14 x 60) + (6 x 50)
(14 x 70) + (6 x 40)

=
=
=
=

1,220
1,090
1,140
1,220

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

0.3
0.3
0.2
0.2

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

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

3.

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

ratio.

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

6

= 7.83%

B:

0.08 + 0.04 + 0.15 +.12 + 0.10 + 0.06

6

= 0.0917

= 9.17%

C:

0.07 + 0.08 + 0.12 + 0.09 + 0.06 + 0.12

6

= 0.0900

= 9.00%

D:

0.09 + 0.09 + 0.11 + 0.04 + 0.08 + 0.16

6

= 0.095

= 9.50%

(a)

Return on portfolio consisting of stock A

(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%
19

= 7.83%

4.

(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%

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

RA-RA
-0.09
-21.09
2.91
14.91
0-3.09
9.91
-13.09
4.91
2.91
8.91
-7.09

RM-RM
-3.18
-14.18
-1.18
8.82
0.82
14.82
-18.18
8.82
-0.18
6.82
-3.18

(RA-RA)
0.01
444.79
8.47
222.31
9.55
98.21
171.35
24.11
8.47
79.39
50.27

(RM-RM)
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

RA-RA/RM-RM
0.29
299.06
-3.43
131.51
-2.53
146.87
237.98
43.31
-0.52
60.77
22.55

Equation of the characteristic line is

RA = 0.52 + 0.96 RM
5.

The required rate of return on stock A is:

RA

=
=
=

RF + A (RM RF)
0.10 + 1.5 (0.15 0.10)
0.175

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

Given Do = Rs.2.00, g = 0.08, r = 0.175
2.00 (1.08)
Intrinsic value per share of stock A =
0.175 0.08
=
6.

Rs.22.74

The SML equation is RA = RF + A (RM RF)

Given RA = 15%.

RF = 8%, RM = 12%, we have

0.15 = .08 + A (0.12 0.08)

0.07
i.e.A =

= 1.75
0.04

Beta of stock A = 1.75

7.

The SML equation is: RX = RF + X (RM RF)

We are given 0.15 = 0.09 + 1.5 (RM 0.09) i.e., 1.5 RM = 0.195
or RM = 0.13%
Therefore return on market portfolio = 13%

8.

RM = 12%

X = 2.0

RX =18% g = 5%

Po = D1 / (r - g)
Rs.30 = D1 / (0.18 - .05)
21

Po = Rs.30

So D1 = Rs.39 and Do = D1 / (1+g) = 3.9 /(1.05) = Rs.3.71

Rx

Rf + x (RM Rf)

0.18

Rf + 2.0 (0.12 Rf)

So Rf = 0.06 or 6%.
Original
Rf
RM Rf
g
x

Revised

6%
6%
5%
2.0

8%
4%
4%
1.8

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

Price per share of stock X, given the above changes is
3.71 (1.04)
= Rs.34.45
0.152 0.04

Chapter 10
OPTIONS AND THEIR VALUATION

22

1.

S = 100

u = 1.5

d = 0.8

E = 105

r = 0.12

R = 1.12

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

follows:

Cu Cd

=
(u d) S

Cu

Max (150 105, 0)

45

Cd

Max (80 105, 0)

45 0

45

=
0.7 x 100

=
70

0.6429

14

u.Cd d.Cu
B

=
(u-d) R
(1.5 x 0) (0.8 x 45)
=
0.7 x 1.12
-36
=

= - 45.92
0.784

=
=
=

S+B
0.6429 x 100 45.92
Rs.18.37

Value of the call option = Rs.18.37

2.

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

Max (32 45, 0)

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)

Substituting (1) in (2) we get

8
8
or B

=
=
=

(-0.034365 x 40) B + B
-0.375 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
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 Black-Scholes model we get the following results:
ln (S/E) + rt + 2 t/2
d1
=
24

d2

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

0.4

0.08701 + 0.14 + 0.08

0.4

0.7675

=
=
=

d1 - t
0.7675 0.4
0.3675

N(d1) =
N (d2) =

N (0.7675) ~ N (0.77) = 0.80785

N (0.3675) ~ N (0.37) = 0.64431

So N(d1) E. e-rt. N(d2)

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.

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.

Value of put option

=
Value of the call option
+
Present value of the exercise price
25

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)

6000 N (d1) 5000 e 0.1 N(d2)

ln (6000 / 5000) + (0.1 x 1) + (0.18/2)

--------------------------------------------- 0.18 x 1
ln (1.2) + 0.19

=
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)

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
27

----------(1.14)3
=
(b)

---------(1.14)4

---------(1.14)5

- 44837

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)

=
=

2.

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

- 27264

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

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

b)

NP V =

=
=
c)

9 years

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

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)
29

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)

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

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) 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

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)
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

25000 x PVIF (15,1)

40000 x PVIF (15,2)
50000 x PVIF (15,3)
31

8.

+
+
=

40000 x PVIF (15,4)

30000 x PVIF (15,5)
122646

(A)

Investment

100,000

(B)

Benefit cost ratio

1.23 [= (A) / (B)]

The NPVs of the three projects are as follows:

P

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)

Discount rate (%)

0
2950
500
5
1876
208
10
1075
- 28
15
471
- 222
20
11
- 382
(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'

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)

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

NPV (P)
NPV (Q)

=
=

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 investment-related costs
=

1000 x PVIF (12,0)

+ 1200 x PVIF (12,1) + 600 x PVIF (12,2)
+ 250 x PVIF (12,3)
=
2728
TV of cash inflows =
2000 x (1.12) + 4000 =
6240
The MIRR of the project P is given by the equation:
2728 =
6240 x PVIF (MIRR,5)
(1 + MIRR)5 =
2.2874
MIRR = 18%
(c)

Project Q
PV of investment-related 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

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)

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.
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

=
=
=

12% per annum

33.93
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
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)

12% per annum

- 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

= 10% per annum

= 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.
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)

Project Cash Flows

Year

1. Plant & machinery

(150)

(Rs. in million)

3. Revenues

250

250

250

250

250

250

250

4. Costs (excluding depreciation & 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

2. Working capital

(50)

9. Net salvage value of

plant & machinery

48

10. Recovery of working

capital
11. Initial outlay (=1+2)
12. Operating CF (= 8 + 5)

50
(200)
116.25 113.44 111.33 109.75 108.56 107.6 107.00

13. Terminal CF ( = 9 +10)

98

14.

NCF

(200) 116.25 113.44 111.33 109.75 108.56 107.67 205

(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

+107.67 x PVIF (r,6) + 205 x PVIF (r,7)

Through a process of trial and error, we get r = 55.17%. The IRR of the project is 55.17%.
2.

Post-tax Incremental Cash Flows

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+18-19+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

30.55 41.46 52.80 39.25 25.94 14.00

10

10

(10)

(10)

(10)
41

(140) 10.20 20.55 31.46 62.80 49.25 35.94 55.00

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

38

3.
(a)

A.

Initial outlay (Time 0)

i.
ii.
iii
iv.

B.

Cost of new machine

Salvage value of old machine
Incremental working capital requirement
Total net investment (=i ii + iii)

3,000,000
900,000
500,000
2,600,000

Operating cash flow (years 1 through 5)

Year

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

455,000

455,000

455,000

455,000

ii. Incremental
depreciation

550,000

412,500

309,375

232,031

174,023

165,000

123,750

92,813

69,609

52,207

620,000

578,750

547,813

524,609

507,207

iii. Tax shield on

incremental dep.
iv. Operating cash
flow ( i + iii)
C.

Terminal cash flow (year 5)

i.
ii.
iii.
iv.

(b)

Rs.

Salvage value of new machine

Salvage value of old machine
Recovery of incremental working capital
Terminal cash flow ( i ii + iii)

Rs.

D.

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

Year
NCF

0
(2,600,000)

1
620000

2
578750

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

39

3
547813

4
524609

1,500,000
200,000
500,000
1,800,000

5
2307207

4.

Tax shield (savings) on depreciation (in Rs)

Depreciation
Tax shield
Year
charge (DC)
=0.4 x DC

PV of tax shield
@ 15% p.a.

25000

10000

8696

18750

7500

5671

14063

5625

3699

10547

4219

2412

7910

3164

1573
---------22051
----------

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

5.

A.

B.

Initial outlay (at time 0)

i.
Cost of new machine
ii.
Salvage value of the old machine
iii.
Net investment

Rs.

400,000
90,000
310,000

Operating cash flow (years 1 through 5)

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

iv. Tax savings on

incremental
depreciation
( 0.35 x (iii))

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

Salvage value of new machine

Salvage value of old machine
Incremental salvage value of new
machine = Terminal cash flow

8494

Rs.

25000
10000
15000

Net cash flows associated with the replacement proposal.

0
(310000)

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)

12. Initial outlay

13. Operating cash

(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

b. Cash flows form the point of equity investors

Rs.in million
Item
1. Equity funds
2. Revenues
3. Costs (other than
depreciation and
interest)
4. Loss of rental
5. Depreciation
6. Interest on working
capital advance
7. Interest on term
loans
8. Profit before tax
9. Tax
10. Profit after tax
11. Net salvage value
of fixed assets
12. Net salvage value
of current assets
13. Repayment of term
term loans
14. Repayment of bank
advance
15. Retirement of trade
creditors
16. Initial investment
17. Operating cash
inflow
18. Liquidation and
retirement cash
flows
19. Net cash flow

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)

NPV of the project

(b)

NPVs under alternative scenarios:

=
=

-250 + 50 x PVIFA (13,10)

Rs.21.31 million

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)

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.

43

(c)

Accounting break even point (under expected scenario)

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)

2.
(a)

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

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.a
and useful life of
5 years

(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

Sensitivity of NPV with respect to variations in unit price.

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

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

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

Accounting break-even point

i.
ii.
iii.

Fixed costs + depreciation

Contribution margin ratio
Break-even level of sales

= Rs.5000
= 10 / 30 = 0.3333
= 5000 / 0.3333
= Rs.15000

Financial break-even point

3.

i.
ii.

Annual cash flow

PV of annual cash flow

iii.
iv.

Initial investment
Break-even level of sales

= 0.5 x (0.3333 Sales 5000) = 2000

= (i) x PVIFA (10,5)
= 0.6318 sales 1896
= 30000
= 31896 / 0.6318 = Rs.50484

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

A1

=
=

4 x 0.4 + 5 x 0.5 + 6 x 0.1

4.7

A2

5 x 0.4 + 6 x 0.4 + 7 x 0.2

45

5.8

A3

=
=

3 x 0.3 + 4 x 0.5 + 5 x 0.2

3.9

NPV

=
=

4.7 / 1.1 +5.8 / (1.1)2 + 3.9 / (1.1)3 10

Rs.2.00 million

12

0.41

22

0.56

32

0.49
12

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)
=

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

+ 8,000 / (1.08)4 25,000

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

- 25,000
7,708

Standard deviation of NPV

4
t

t=1 (1.08)t
=
=
=
5.

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

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

=
=

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

3,900

A3

=
=

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

4,900

A4

=
=

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

3,200

Substituting these values in (1) we get

Expected NPV = NPV
=

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

- 10,000 = Rs.3,044

The variance of NPV is given by the expression

2t

2 (NPV) =
t=1 (1.06)2t
12

=
=

22

=
=

32

=
=

42

=
=

.. (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
[(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
[(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
[(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
47

Substituting these values in (2) we get

490,000 / (1.06)2 + 690,000 / (1.06)4
+ 490,000 / (1.06)6 + 560,000 / (1.08)8
[ 490,000 x 0.890 + 690,000 x 0.792
+ 490,000 x 0.705 + 560,000 x 0.627 ]
= 1,679,150
NPV = 1,679,150 = Rs.1,296
NPV NPV
Prob (NPV < 0) = Prob.
= Prob

NPV
0 3044
Z<
1296

0 - NPV
<

NPV

= Prob (Z < -2.35)

The required probability is given by the shaded area in the following normal
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 (P1 > 1.2)

Prob (PV / I > 1.2)

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

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

Prob (Z > - 0.81)
The required probability is given by the shaded area of the following normal
curve:
P(Z > - 0.81) =
0.5 + P(-0.81 < Z < 0)
=
0.5 + P(0 < Z < 0.81)
=
0.5 + 0.2910
=
0.7910
So the probability of P1 > 1.2 as 0.7910

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

=
=
=

[ 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
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

VARIABLE COST (V)

NPV
Rando Corres- 1.8955 Q(P-V)m
pondin 31,895.5
Numbe g value
r
17
15
-24,314
24
15
2,224
03
15
-18,627
83
40
-58,433
11
15
-20,523
30
20
13,597
41
20
-9,150
52
20
-31,896
15
15
-18,627
VARIABLE COST (V)
NPV
Rando Corres1.8955 Q(P-V)m
pondin
31,895.5
Numbe g value
r
38
20
2,224
36
20
-9,150
83
40
-84,970
72
20
-12,941
81
40
-62,224
40
20
13,597
67
20
-9,150
99
40
-1,568
64
20
-5,359
19
15
-18,627
22
15
7,910
96
40
-54,642
75
20
-31,896
88
40
-5,359
35
20
13,597
27
15
-9,150
69
20
-1,568
16
15
7,910
39
20
13,597
38
20
-5,359
46
20
-9,150

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

VARIABLE COST (V)

NPV
Rando Corres1.8955 Q(P-V)m
pondin
31,895.5
Numbe g value
r
59
25
29
21
79
77
31
10
52
19
87
70
97
43

NPV
50
1/ 50 NPVi
i=1
1/50 (-7,20,961)
14,419
50
(NPVi NPV)2
i=1

1/50

=
=

1/50 [27,474.047 x 106]

549.481 x 106
51

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

Standard deviation of NPV

7.

=
=

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

Most likely value

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

[Q (30-20) 3,000 2,000] x 0.5 + 2,000

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

Sensitivity analysis with reference to P

The relationship between P and NPV, given the most likely values of other variables is defined as
follows:
NPV

5
=
t=1

[1,400 (P-20) 3,000 2,000] x 0.5 + 2,000

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 and IRR for the two projects are as follows:

Project

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 co-efficients for the five years are as follows
Year

Certainty equivalent coefficient

t = 1 0.06 t
1 = 0.94
2 = 0.88
3 = 0.82
4 = 0.76
5 = 0.70

1
2
3
4
5

The present value of the project calculated at the risk-free rate of return is :
5 (1 0.06 t) At

t=1
(1.08)t
7,000 x 0.94
+
(1.08)

8,000 x 0.88 9,000 x 0.82 10,000 x 0.76 8,000 x 0.70

+
+
+
2
3
4
(1.08)
(1.08)
(1.08)
(1.08)5
54

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

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 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

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

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 pre-tax cost of debt. Using the approximate yield formula, rD
calculated as follows:
rD

(b) After tax cost =

2.

5.

12.60 x (1 0.35) = 8.19%

WACC

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

0.1085 (or) 10.85%

0.4 x 13% x (1 0.35)

+ 0.6 x 18%
14.18%

=
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)

10% + 1.2 x 7% = 18.4%

Pre-tax cost of debt

14%

After-tax cost of debt =

14% x (1 0.35) = 9.1%

Debt equity ratio

2:3

WACC

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

14.68%

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

Using the SML equation we get

11% + 8% x = 14.9%
where denotes the beta of Azeezs equity.
Solving this equation we get = 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 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 pre-tax cost of debt.

(b)

Given
13% x (1 0.3) x 4/9 + rE x 5/9 = 15%
rE = 19.72%, where rE represents the cost of equity.

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.

The cost of equity and retained earnings

rE
=
D1/PO + g
= 1.50 / 20.00 + 0.07 = 14.5%
The cost of preference capital, using the approximate formula, is :
11 + (100-75)/10
rE

= 15.9%
0.6 x 75 + 0.4 x 100

61

The pre-tax cost of debentures, using the approximate formula, is :

13.5 + (100-80)/6
rD

= 19.1%
0.6x80 + 0.4x100

The post-tax cost of debentures is

19.1 (1-tax rate) = 19.1 (1 0.5)
= 9.6%
The post-tax cost of term loans is
12 (1-tax rate) = 12 (1 0.5)
= 6.0%
The average cost of capital using book value proportions is calculated below :
Source of capital
Equity capital
Preference capital
Retained earnings
Debentures
Term loans

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)

Market value Market value Product of

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

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

=
=

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 non-interest bearing liabilities
b. Pre-tax cost of debt & post-tax cost of debt
10 + (100 112) / 8
rd =

8.5
=

0.6 x 112 + 0.4 x 100

= 7.93
107.2

rd (1 0.3) = 5.55
c. Post-tax 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

= 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%

64

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

=
=
=
3.

2709185 / PVIFA (13,5)

2709185 / 3.517
Rs.770 311

EAC [ Standard overhaul]

=
=
=

500 000 / PVIFA (14,6)

500 000 / 3.889
Rs.128568

(A)

(B)

EAC [Less costly overhaul]

=
=
=

200 000 / PVIFA (14,2)

200 000 / 1.647
Rs.121433

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

65

4.
(a)

Base case NPV

=
=
=

(b)

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

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

Issue costs = 6,000,000 / 0.88 - 6,000,000

=

Rs.818 182

Adjusted NPV after adjusting for issue costs

=
=
(c)

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

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
6,000,000
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

Present value of tax shield

5.
(a)

= Rs.1,022,076

Base case BPV

=
=

(b)

Present value of
tax shield
274,590
232,697
172,538
125,339
88,513
60,005
37,715
21,546
9,133

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

- Rs.1,004,000

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
66

(c)

The present value of interest tax shield is calculated below :

Year
1
2
3
4
5
6

Debt outstanding at
the beginning
5,000,000
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

Present value of tax shield

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 cum-rights stock would simply be
Rs.220
b.

The theoretical value per share of the ex-rights stock is :

68

NPo+S

4 x 220 +150
=

= Rs.206

N+1

4+1

c. The theoretical value of each right is :

Po 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.

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 ex-rights value per share if the subscription price is Rs.160
NPo + S
5 x 180 + 160
=
= Rs.176.7
N+1
5+1
c. The theoretical value per share, ex-rights, if the subscription price is
Rs.180? 100?
5 x 180 + 180
= Rs.180
5+1
5 x 180 + 100
= Rs.166.7
5+1

69

Chapter 19
CAPITAL STRUCTURE AND FIRM VALUE
1.

Net operating income (O)

Interest on debt (I)
Equity earnings (P)
Cost of equity (rE)

:
:
:
:

Rs.30 million
Rs.10 million
Rs.20 million
15%

Cost of debt (rD)

Market value of equity (E)
Market value of debt (D)
Market value of the firm (V)

:
:
:
:

10%
Rs.20 million/0.15 =Rs.133 million
Rs.10 million/0.10 =Rs.100 million
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%
13.33
13.33

= 15%

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
Interest on debt
Equity earnings
Cost of equity

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%

(c) If Cox Corporation sells Rs.10 million of additional equity to retire

Rs.10 million of debt , it will become an all-equity company. So its
average cost of capital will simply be equal to its cost of equity,
which is 15%.
3.

4.

rE
=
20
=
So D/E = 2

rA + (rA-rD)D/E
12 + (12-8) 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

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

71

6.

7.

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
The average cost of capital(without considering agency and bankruptcy cost)
at various leverage ratios is given below.
D

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

b. The average cost of capital considering agency and bankruptcy costs is

given below
.
D
E
E
D
rD
rE
rA =
rE +
rD
D+E
D+ E
%
%
D+E
D+E
(%)
0
1.00
4.0
12.0
0.10
0.90
4.0
12.0
0.20
0.80
4.0
13.0
0.30
0.70
4.2
14.0
0.40
0.60
4.4
15.0
0.50
0.50
4.6
16.0
0.60
0.40
4.8
17.0
0.70
0.30
5.2
18.0
0.80
0.20
6.0
19.0
0.90
0.10
6.8
20.0
8. The tax advantage of one rupee of debt is :

12.0
11.2
11.2
11.06
10.76
10.30
9.68
9.04
8.60
8.12 Optimal

72

1-(1-tc) (1-tpe)

(1-0.55) (1-0.05)
=

1 -

(1-tpd)

(1-0.25)
= 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) (1-t) Preference dividend
EPS =
No. of shares
(7,200,000 0 ) (1-t) 600,000
Rs.2 =
1,500,000
Hence t = 0.5 or 50 per cent
The EPS under the two financing plans is :
Financing Plan A : Issue of 1,000,000 shares
(EBIT - 0 ) ( 1 0.5) - 600,000
EPSA =
2,500,000
Financing Plan B : Issue of Rs.10 million debentures carrying 15 per cent
interest
(EBIT 1,500,000) (1-0.5) 600,000
EPSB =
1,500,000
The EPS EBIT indifference point can be obtained by equating EPSA and EPSB
(EBIT 0 ) (1 0.5) 600,000

(EBIT 1,500,000) (1 0.5) 600,000

73

=
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)
EPSA =
2,000,000
(b) EPS EBIT equation for alternative B
EBIT ( 1 0.5 ) 440,000
EPSB =
1,600,000
(c)

EPS EBIT equation for alternative C

(EBIT 1,200,000) (1- 0.5)
EPSC =
1,200,000

(d) The three alternative plans of financing ranked in terms of EPS over varying
Levels of EBIT are given the following table
Ranking of Alternatives
EBIT
(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

Equating EPSA and EPSB , we get

(EBIT 0 ) (1 0.6)
(EBIT 1,500,000) (1 0.6)
=
1,800,000
1,000,000
Solving this we get EBIT = 3,375,000 or 3.375 million
Thus the debt alternative is better than the equity alternative when
EBIT > 3.375 million
EBIT EBIT
Prob(EBIT>3,375,000) = Prob

3.375 7.000
>

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.
7. a.

18 = [ ROI + ( ROI 8 ) 0.7 ] ( 1 0.5)

ROI = 24.47 per cent
EBIT
Interest coverage ratio =
Interest on debt
150
=
40
= 3.75
EBIT + Depreciation

b.

Cash flow coverage ratio =

Loan repayment instalment

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
=

133.00 + 49.14 +95.80

95.80 + 72.00

=
=
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

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)

77

3.

Next years price

Dividend
Current price
Capital appreciation
Post-tax capital appreciation
Post-tax dividend income
Total return

Current price (obtained by solving

the preceding equation)

P
80
0
P
(80-P)
0.9(80-P)
0
0.9 (80-P)
P
= 14%
P = Rs.69.23

78

Q
74
6
Q
(74-Q)
0.9 (74-Q)
0.8 x 6
0.9 (74-Q) + 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(A-C)

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
(E-D)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
(D-C)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.

According to the Lintner model

Dt = cr EPSt + (1-c)Dt 1
EPSt =3.00, c= 0.7, r=0.6 , and Dt-1

80

Hence
Dt = 0.7 x 0.6 x 3.00 + (1-0.7)1.20
= Rs.1.62
4.

The bonus ratio (b) must satisfy the following constraints :

(R-Sb)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
(100-60 b) 0.4 x 60 (1+b)
(1a)
0.3 x 600.1 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

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

(b) Net proceeds of the new bonds

Gross proceeds
Issue costs

250,000,000
10,000,000
240,000,000

(c) Tax savings on tax-deductible expenses

Tax rate[Call premium+Unamortised issue cost on
the old bonds]
0.4 [ 15,000,000 + 8,000,000]
Initial outlay i(a) i(b) i(c)
(ii)

Annual Net Cash Savings

(a) Annual net cash outflow on old bonds
Interest expense
- Tax savings on interest expense and amortisation of
issue expenses
0.4 [42,500,000 + 8,000,000/10]

9,200,000
15,800,000

42,500,000
17,400,000
25,100,000

(b) Annual net cash outflow on new bonds

Interest expense
- Tax savings on interest expense and amortisation of
issue cost
0.4 [ 37,500,000 10,000,000/8]

37,500,000
15,500,000
22,000,000
3,100,000

Annual net cash savings : ii(a) ii(b)

82

(iii)

Present Value of the Annual Cash Savings

Present value of an 8-year annuity of 3,100,000 at a
discount rate of 9 per cent which is the post tax cost
of new bonds 3,100,000 x 5.535

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).
2. (i) Initial Outlay
(a) Cost of calling the old bonds
Face value of the old bonds
Call premium

17,158,500

(iv)

17,158,500
15,800,000
1,358,500
120,000,000
4,800,000
124,800,000

(b) Net proceeds of the new issue

Gross proceeds
Issue costs

120,000,000
2,400,000

(c) Tax savings on tax-deductible expenses

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)
(ii)

Annual Net Cash Savings

(a) Annual net cash out flow on old bonds
Interest expense
- Tax savings on interest expense and amortisation of
issue costs
0.4[19,200,000 + 3,000,000/5]

117,600,000
3,120,000

4,080,000

19,200,000
7,920,000
11,280,000

(b) Annual net cash outflow on new bonds

Interest expense
- Tax savings on interest expense and amortistion of issue
costs
0.4[18,000,000 + 2,400,000/5]

7,392,000
10,608,000
672,000

Annual net cash savings : ii(a) ii(b)

(iii)

18,000,000

Present Value of the Annual Net Cash Savings

83

Present value of a 5 year annuity of 672,000 at

as discount rate of 9 per cent, which is the post-tax
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)

3. Yield to maturity of bond P

8
160
918.50 =
+
t
t=1 (1+r)

2,614,080

cost of

2,614,080
4,080,000
- 1,466,000

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
1
2
3
4
5
6
7
8

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

Duration of bond Q is calculated below

Year

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

The YTM for bonds of various maturities is

Maturity

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

Solving this for r2 we get r2 = 13.94%

To get the forward rate for year 3, r3, the following equation may be set up :
13,000
99,500

13,000

113,000

+
(1.1236)

+
(1.1236)(1.1394)

(1.1236)(1.1394)(1+r3)

Solving this for r3 we get r3 = 13.49%

To get the forward rate for year 4, r4 , the following equation may be set up :
13,500
100,050

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.

The product of the standard deviation and square root of time is :

t = 0.35
2 = 0.495
The ratio of the stock price to the present value of the exercise price is :
Stock price

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

Then, interpolation between 1.75 and 2.00 gives

1.75
0.495

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
(Rt-Ct-Dt)
6.Profit after tax: 5(1-t)
7.Net salvage value
8.Net cash flow
(1+6+4+7)
9.Discount factor
at 11 percent
10.Present value (8x9)

NPV of the Purchase Option

0
(1,500)

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

NPV(Purchases)= - 1500+639.7+495.3+458.1+398.3+527.5 = 1018.9

NPV of the Leasing Option
Year
1.Revenues(Rt)
2.Costs(other than
lease rentals)(Ct)
3.Lease rentals(Lt)
4.Profit before tax
(Rt-Ct-Lt)
5.Profit after tax (which

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

also reflects the net

cash flow)(1-t)
6.Discount factor at
13 per cent
7.Present value(5x6)

-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

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

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
1
2
3

Hire purchase instalment

Interest
Rs.906,667
Rs.395,676
Rs.906,667
Rs.240,000
Rs.906,667
Rs. 84,324

89

Principal repayment
Rs. 510,991
Rs. 666,667
Rs. 822,343

The lease rental will be as follows :

Rs. 560,000 per year for the first 5 years
Rs. 20,000 per year for the next 5 years

The cash flows of the leasing and hire purchse options are shown below
Year

Leasing
- LRt (1-tc)

High Purchase
-It(1-tc)
-PRt

Dt(tc)

1 -560,000(1-.4)=-336,000 -395,676(1-.4) -510,991

2 -560,000(1-.4)=-336,000 -240,000(1-.4) -666,667
3 -560,000(1-.4)=-336,000 - 84,324(1-.4) -822,343
4 -560,000(1-.4)=-336,000
5 -560,000(1-.4)=-336,000
6 - 20,000(1-.4)= - 12,000
7 - 20,000(1-.4)= - 12,000
8 - 20,000(1-.4)= - 12,000
9 - 20,000(1-.4)= - 12,000
10 - 20,000(1-.4)= - 12,000

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)

Present value of the leasing option

5 336,000
= -
t=1 (1.10)t

10

t=6

12,000
= - 1,302,207
(1.10)t

Present value of the hire purchase option

548,397
=-

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(1-tc)-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

=
=

62.9 + 61.3 = 124.2 days

124.2 43.43 = 80.77 days
(110+120)/2

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

Operating cycle = 56.0 + 52.9 = 108.9 days

Cash cycle
= 108.9 30.7 = 78.2 days
3.

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

2. Cash manufacturing expenses

(80,000 x 12)
3. Depreciation : (1) (2)
4. Total cash cost
Total manufacturing cost
Less: Depreciation
Cash manufacturing cost
Add: Administration and sales
promotion expenses

960,000
120,000
2,700,000
120,000
2,580,000
360,000
2,940,000

A : Current Assets

Rs.

Total cash cost

Debtors

2,940,000
x 2

12
Material cost
Raw material
stock

2=

490,000

1=

75,000

900,000
x 1

12

12

Cash manufacturing cost

Finished goods
stock

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

One months cash

manufacturing expenses

80,000

Wages outstanding

One months wages

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)

November December January February March April May June

1. Sales
120
2. Credit sales
84
3. Cash sales
36
4. Collection of receivables
(a) Previous month
(b) Two months earlier
5. Sale of machine
6. Interest on securities
7. Total receipts
(3+4+5+6)

120
84
36
33.6

150
105
45

150
105
45

150
105
45

200
140
60

42.0 56.0 56.0

63.0 63.0 84.0
70.0
3.0
235.0 179.0 203.0

33.6
50.4

42.0
50.4

42.0
63.0

129.0

137.4

150.0

200
140
60

Forecast of Cash Payments

December
1. Purchases
60
2. Payment of accounts
payable
3. Cash purchases
4. Wage payments
5. Manufacturing
expenses
6. General, administrative

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

& selling expenses

7. Dividends
8. Taxes
9. Acquisition of
machinery

15

15

15

15

15

15
30
35

135

155

220

80

Total payments(2to9)

135

135

215

Summary of Cash Forecast

1. Opening balance
2. Receipts
3. Payments
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)

(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

= 49,695 + 100,000 = Rs.149,695

97

UL = 3RP 2LL = 3 x 149,695 2 x 100,000

= Rs.249,085

Chapter 28
CREDIT MANAGEMENT
1.

RI = [S(1-V)- Sbn](1-t)- 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(1-0.85)- 10,000,000 x 0.08 ] (1-0.4)
-0.15 x 10,000,000 x 60 x 0.85
360
= Rs. 207,500

2.

RI = [S(1-V)- Sbn] (1-t) k I

So
I = (ACPN ACPo)

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(1-0.8) 1,500,000 x 0.05] (1-.45)
-0.15

(60-45) 15,000,000 + 0.8 x 60 x 1,500,000

360
= 123750 123750 = Rs. 0
3.

360

RI = [S(1-V) DIS ] (1-t) + k I

DIS = pn(So+S)dn poSodo
So

I =

(ACPo-ACPN) 360

x ACPN x V
360

So =Rs.12 million, ACPo=24, V=0.80, t= 0.50, r=0.15, po=0.3, pn=0.7,

ACPN=16, S=Rs.1.2 million, do=.01, dn= .02
Hence
RI = [ 1,200,000(1-0.80)-{0.7(12,000,000+1,200,000).020.3(12,000,000).01}](1-0.5)
12,000,000
+ 0.15

(24-16)
360

1,200,000
360

x 16 x 0.80

= Rs.79,200
4.

RI = [S(1-V)- BD](1-t) k I
BD=bn(So+S) boSo
So
I =

S
(ACPN ACPo) +

360

x ACPN x V
360

So=Rs.50 million, ACPo=25, V=0.75, k=0.15, bo=0.04, S=Rs.6 million,

ACPN=40 , bn= 0.06 , t = 0.3
RI = [ Rs.6,000,000(1-.75) {.06(Rs.56,000,000)-.04(Rs.50,000,000)](1-0.3)

99

Rs.50,000,000
- 0.15

Rs.6,000,000
(40-25) +

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(1-V)- DIS](1-t) 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
(24-20) +

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.

The decision tree for granting credit is as follows :

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

9. Profit when the customer pays = Rs.10,000 - Rs.8,000 = Rs.2000

Loss when the customer does not pay = Rs.8000
Expected profit = p1 x 2000 (1-p1)8000
Setting expected profit equal to zero and solving for p1 gives :
p1 x 2000 (1- p1)8000 = 0
p1 = 0.80
Hence the minimum probability that the customer must pay is 0.80
MINICASE
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
101

Post-tax cost of capital : 12 percent

ACP on credit sales : 20 days
Effect of Relaxing the Credit Standards on Residual Income
Incremental sales
: Rs.50 million
Bad debt losses on incremental sales: 12 percent
ACP remains unchanged at 20 days

RI = [S(1 V) - Sbn] (1 t) R I
S
where I =

x ACP x V
360

RI = [50,000,000 (1-0.8) 50,000,000 x 0.12] (1 0.3)

50,000,000
- 0.12 x

x 20 x 0.8
360

= 2,800,000 266,667 = 2,533,333

Effect of Extending the Credit Period on Residual Income
RI = [S(1 V) - Sbn] (1 t) R I
So
where I = (ACPn ACPo)

S
+ V (ACPn)

360

360

RI = [50,000,000 (1 0.8) 50,000,000 x 0] (1 0.3)

800,000,000
- 0.12

(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

where I = savings in receivables investment

So
S
=
(ACPo ACPn) V
x ACPn
360
360
800,000,000
=

20,000,000
(20 16) 0.8 x

x 16

360

360

= 8,888,889 711,111 = 8,177,778

DIS = increase in discount cost
= pn (So + S) dn po So do
= 0.7 (800,000,000 + 20,000,000) x 0.02 0.5 x 800,000,000 x 0.01
= 11,480,000 4,000,000 = 7,480,000
So, RI = [20,000,000 (1 0.8) 7,480,000] (1 0.3) + 0.12 x 8,177,778
= - 2,436,000 + 981,333
= - 1,454,667

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

Carrying Cost Total Cost

Q/2xPxC
of Ordering
(where
and Carrying
PxC=Rs.30)
Rs.
Rs.

200
400
1,000
2,000

3,750
1,875
750
375

2 UF
103

2x250x200

3,950
2,275
1,750
2,375

b. Economic Order Quantity (EOQ) =

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

b. Number of orders that will be placed is

= 10.20

980
Note that though fractional orders cannot be placed, the number of orders
relevant for the year will be 10.2 . In practice 11 orders will be placed during the year. However,
the 11th order will serve partly(to the extent of 20 percent) the present year and partly(to the
extent of 80 per cent) the following year. So only 20 per cent of the ordering cost of the 11th
order relates to the present year. Hence the ordering cost for the present year will be 10.2 x
Rs.300

3.

c. Total cost of carrying and ordering inventories

980
= [ 10.2 x 300 +
x 6.25 ] = Rs.6122.5
2
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

= UD +

Q*

Q(P-D)C
F-

Q* PC
-

2
6,000

2
6,000

= 6000 x .5 +

490

x 400
1,000

1,000 (95)0.2

490 x 100 x 0.2

-

104

= 30,000 + 2498 4600 = Rs.27898

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
= 5000 x 1.5 +

5,000
-

707

1,000

1000 x 28.5 x 0.2

-

x 300
707 x 30 x 0.2

= 7500 + 622-729 =Rs.7393

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

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(0.6)

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

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
= 30 x 40 + 2.00

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

Cumulative Value of Items & Usage

Item
No.

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(CA-CL) = 0.75(36-12) = Rs.18 million
Method 2 : 0.75(CA)-CL = 0.75(36-12 = Rs.15 million
Method 3 : 0.75(CA-CCA)-CL = 0.75(36-18)-12 = Rs.1.5 million

110

Chapter 31
WORKING CAPITAL MANAGEMENT :EXTENSIONS
1.(a)

The discriminant function is :

Zi = aXi +
where Zi =
Xi =
Yi =

bYi
discriminant score for the ith account
quick ratio for the ith account
EBDIT/Sales ratio for the ith account

The estimates of a and b are :

y2. dx - xy . dy
a =
x 2. y 2 - xy . xy
x 2. dy xy . dx
b

x 2 . y 2

xy . xy
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

(Xi-X)2

(Yi-Y)2

(Xi-X)(Yi-Y)

X = 0.7924

Y = 15.64

= 0.8311

=1661.76

= 10.007

Account
Number

Xi

Yi

(Xi-X)

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

Sum of Xi for group 1

(Yi-Y)

(Xi-X)2

(Yi-Y)2 (Xi-X)(Yi-Y)

-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

n-1

25-1
(Yi Y) =

1661.76

n-1
1
n-1

9.60

10
2

xy =

96

Y2 =

y =

19.67

15

Sum of Yi for group 2

295

Y1 =

0.6390

10

Sum of Yi for group 1

x =

6.39
=

0.8947

15

X2 =

69.24

25-1
(Xi-X)(Yi-Y) =

10.0007
=

0.4167

25-1

dx = X1 - X2 = 0.8947 0.6390 = 0.2557

dy = Y1 Y2 = 19.67 9.60 = 10.07
Substituting these values in the equations for a and b we get :
69.24 x 0.2557 0.4167 x 10.07
a =

= 6.079
0.0346 x 69.24 0.4167 x 0.4167
0.0346 x 10.07 0.4167 x 0.2557

b=

0.1089

0.0346 x 69.24 0.4167 x 0.4167

Hence , the discriminant function is :
113

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

The Zi scores arranged in an ascending order are shown below

Account Number

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 mid-point between the
Zi scores of account numbers 19 and 4 results in the minimum number of misclassifications . This Zi
score is :
5.7292 + 6.6918
= 6.2105
2
Given this cut-off Zi score, there is just one misclassification (Account number 5)

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

= 1-0.7 = 0.3
Total assets

= 1/0.3

116

2.

PBT

Rs.40 million
PBIT

Times interest covered =

= 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.

Average daily credit sales =

= 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

Acid-test ratio =

= 1.2
Current liabilities

Current liabilities

= 800,000
Sales
Inventory turnover ratio =
= 5
Inventories
Current assets - Inventories
Acid-test 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

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
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
Days 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
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
Acid-test 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

Cash & bank balances + Receivables + Inventories + Pre-paid expenses

8. (i) Current ratio =
Short-term 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
(ii) Acid-test ratio =

22,500,000
=

= 0.75

Current liabilities

30,000,000

Long-term debt + Current liabilities

(iii) Debt-equity 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

(v) Inventory turnover period

72,000,000
=

Inventory
365
120

= 3.6
20,000,000

(vi) Average collection period =

Net sales/Accounts receivable
365
= 57.6 days
95,000,000/15,000,000

Net sales
(vii) Total assets turnover ratio

95,000,000

= 1.27

Total assets

75,000,000

Profit after tax

(ix) Net profit margin

5,100,000
=

= 5.4%

Net sales
PBIT

95,000,000

15,100,000

(x) Earning power =

=
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
Acid-test ratio
Debt-equity 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%

Note that solutions to problems 10 & 11 are not given

MINICASE
Solution:

121

Standard
1.5
0.80
1.5
3.5
4.0
60 days
1.0
6%
18%
15%

(a) Key ratios for 20 X 5

12.4
Current ratio =
= 0.93
13.4
8.8 + 6.7
Debt-equity 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

Net sales +/Non-op. surplus
deficit 57.8

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

(c) Common size and common base financial statements

Common Size Financial Statements
Profit and Loss Account

Net sales
Cost of goods sold
Gross profit
Operating expenses
Operating profit
Non-operating surplus /
deficit
PBIT
Interest
PBT

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

5.0
2.0
3.0
123

Common Size (%)

20 X 4
20 X 5
100
100
78
80
22
20
13
12
9
8
1
1
11
4
7

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

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

Net sales
Cost of goods sold
Gross profit
Operating expenses
Operating profit
Non-operating surplus /
deficit
PBIT
Interest
PBT
Tax

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
-

5.0
2.0
3.0
124

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

122
133
115
100

 Profit after tax

2.6

3.0

100

115

Balance Sheet

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 Base Year(%)

20 X 4
20 X 5
100
114
100
115
100
114
100
118
100
112
100
89
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 companys revenues tied to one key customer?

125

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
BREAK-EVEN ANALYSIS AND LEVERAGES
1.

a.

EBIT = Q(P-V)-F
= 20,000(10-6)-50,000 = Rs.30,000

b.

EBIT = 12,000(50-30)-200,000 = Rs.40,000

2.

EBIT = Q(P-V)-F
EBIT=Rs.30,000 , Q=5,000 , P=Rs.30 , V=Rs.20
So, 30,000 = 5,000(30-20)-F
So,
F
= Rs.20,000.

3.

DOL =

Q(P-V)

126

Q(P-V)-F
P=Rs.1,000 ,V=Rs.600, F=Rs.100,000
400(1,000-600)
DOL(Q=400) =

= 2.67
400(1,000-600)-100,000
600(1,000-600)

DOL(Q=600) =

= 1.71
600(1,000-600)-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 =
=
P-V
12-7

=10,000 units

Break even point in rupees:

Q x P = 10,000 x Rs.12 = Rs,120,000
To earn a pre-tax income of Rs.60,000 the number of units to be sold is
F + Target pre-tax income
Q =
P-V
= 50,000 + 60,000
= 22,000 units
12-7
To earn an after-tax income of Rs.60,000 if the tax rate is 40 per cent, the
127

Pre-tax income must be

Rs.60,000

= Rs.100,000
1-.4
Hence the number of units to be sold to earn an after-tax income of Rs.60,000
is :
50,000 + 100,000
Q =
= 30,000 units
12-7
6.

P-V
= 0.30

P-V = Rs.6

F=20,000

P
20000
Q =

6
= 3,333 P =

= Rs.20
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
30-16

(b) Profit when the quantity is 3000 bags

Profit =3,000(30-16)-10000 = Rs.32000
10 per cent increase in production means that the quantity is 3300 bags
At that production
Profit = 3,300(30-16)-10,000 = Rs.36200
So, the percentage change in profit is :
36200-32000
= 13.1%
32000
(c) A 10 per cent increase in selling price means that P= Rs.33
Break-even point when P= Rs.33
128

10,000
Q =

= 588.2 bags
33-16

(d) A 50 per cent increase in fixed costs means that F=Rs.15,000

Break-even point when F= Rs.15,000
15,000
Q =
= 882.4 bags
33-16
(e) If V= Rs.20, the break-even point is :
10,000
Q =
= 1000 bags
30-20
8.

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
Break-even point in units
4000
Break-even 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

9. (a) Break-even point for product P

30,000
= 3,000 units
30-20
Break-even point for product Q
100,000
= 5,000 units
50-30
Break-even point for product R
200,000
= 5,000 units
80-40
(b) The weighted contribution margin is :
129

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.40-Rs.24)=Rs.320,000
Rs.320,000
DFL(Q=20,000) =
Rs.10,000
Rs.320,000-Rs.30,000 (1-.5)
=

11. (a)

(b)

EBIT

1.185
Q(P-V) F

Firm A : 20,000(Rs.20-Rs.15) Rs.40,000 = Rs.60,000

Firm B : 10,000(Rs.50-Rs.30) - Rs.70,000 = Rs.130,000
Firm C : 3,000(Rs.100-Rs.40)- Rs.100,000 = Rs.80,000
(EBIT-I) (1-T) - Dp
EPS =
n
(Rs.60,000-Rs.10,000)(1-.4)-Rs.5,000
Firm A :

Rs.1.9

Rs.4.17

Rs.0.40

10,000
(Rs.130,000-Rs.20,000)(1-.5)-Rs.5,000
Firm B :
12,000
(Rs.80,000-Rs.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(P-V)

(d)

DOL =
Q(P-V)-F
20,000(Rs.20-Rs.15)
Firm A :

1.67

1.54

20,000(Rs.20-Rs.15)- Rs.40,000
10,000(Rs.50-Rs.30)
Firm B

:
10,000(Rs.50-Rs.30)-Rs.70,000
3,000(Rs.100-Rs.40)

Firm C :

= 2.25
3,000(Rs.100-Rs.40)-Rs.100,000
EBIT

(e)

DFL =
Dp
EBIT I (1-T)
Rs.60,000
Firm A :

= 1.44
Rs.5000
Rs.60,000-Rs.10,000 (1-.4)
Rs.130,000

Firm B :

= 1.30

131

Rs.5,000
Rs.130,000-Rs.20,000 (1-.5)
Rs.80,000
Firm C :

= 5.333
Rs.10,000
Rs.80,000-Rs.40,000(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
of sales

Net sales
Cost of goods sold
Gross profit
Selling expenses
General & administration expenses

Proforma income statement

for year 3 assuming sales of
1020

100.0
76.33
23.67
7.40
6.63

1020.0
778.57
241.43
75.48
67.63
132

Depreciation
Operating profit
Non-operating 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
Non-operating surplus/deficit
Earnings before interest and taxes
Interest

100.0
76.33
23.67
7.40
Budgeted
Budgeted
1.07
Budgeted
133

Proforma income statement

for year 3
1020.0
778.57
241.43
75.48
55.00
60.00
50.95
10.91
61.86
12.0

Earnings before tax

Tax
Earnings after tax
Dividends (given)
Retained earnings

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

Projections for year 3

based on a forecast
sales of 1400

Net sales

100.0

1020.0

ASSETS
Fixed assets (net)
Investments

40.23
No change

410.35
20.00

Current assets, loans & advances :

Cash and bank
Receivables
Inventories

1.54
22.49
21.60

15.71
229.40
220.32

5.09

51.92

Prepaid expenses
134

Miscellaneous expenditure & losses

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

External funds requirement

Balancing figure

48.96
961.7

A
4.

EFR =

L
-

S
800
=

190
-

1000

S m S1 (1-d)

300 0.06 x 1,300 (1-0.5)

1000

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

= 183 39 = Rs.144.
Projected Income Statement for Year Ending 31st December , 2001
Sales
Profits before tax
Taxes

1,300
195
117
135

Profit after tax (6% on sales)

Dividends
Retained earnings

78
39
39

Projected Balance Sheet as at 31.12 2001

Liabilities

Assets

Share capital
Retained earnings
Term loans (80+72)
Short-term 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)

x 80 (0.625) x 240 x (0.5)

160

= (60 7.5) = 52.5

(b) Projected Balance Sheet as on 31.12.20X1
Liabilities
Share capital
Retained earnings
(40 + 7.5)
Term loans
Short-term bank
borrowings
Trade creditors
Provisions

Assets

56.25
47.50

Net fixed assets

Inventories

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

20 0.0625 x 180 x 0.5

160

9.38
150 x (1.125)

EFR 20X2 =

30 x 1.125
-

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)
EFR 20X3

33.75 x (1.11)

200

200

187.31
=
=

37.46
-

200

20 0.0625 x 220 x 0.5

x 20 6.88
200

8.11
187.31 x (1.1)

37.46 x (1.1)
137

EFR 20X4 =

x 20 0.0625 x 240 x 0.5

220
=

220

7.49
Balance Sheet as on 31st December, 20X4

Liabilities

Rs.

Assets

Rs.

Share capital
46.87
Net fixed assets
90.00
(30+16.87)
(60 x 240/160)
Retained earnings
Inventories
(40.00+5.63+6.25+6.88+7.50) 66.26
(50x240/160)
75.00
Term loans(20+16.87)
36.87
Debtors (30x240/160)
45.00
Short-term bank borrowings 30.00
Cash (10x240/160)
15.00
Trade creditors
37.50
Provisions
7.50
225.00
6.

EFR

225.00

m (1+g) (1-d)
-

S
S
S
g
Given A/S= 0.8 , L/S= 0.5 , m= 0.05 , d= 0.6 and EFR = 0 we have,
(0.05)(1+g)(0.4)
(0.8-0.5) -

=0
g
(0.05)(1+g)(0.4)

i.e. 0.3 -

=0
g

Solving the above equation we get g = 7.14%

A
7.

(a)

EFR =

L
-

S
320
=

70
-

400

S mS1 (1-d)

x 100 (0.05) (500) (0.5)

400
138

= Rs.50
(b)

i.

Let CA = denote Current assets

CL
= Current liabilities
SCL = Spontaneous current liabilities
STL = Short-term bank borrowings
FA
= Fixed assets
and LTL = Long-term loans
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) 237.50
or 1.25 STL 237.50 (8.50 x 1.25)
1285.125
or STL =
1.25
i.e STL 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
or LTL = Rs.130
1.25
If STL and LTL denote the maximum increase in ST borrowings & LT
borrowings , we have :
STL = STL (20X1) STL (20X1) = 102.50 60.00 = 42.50
139

 LTL = LTL (20X1)- LTL (20X1) = 130.00 80.00 = 50.00

Hence, the suggested mix for raising external funds will be :
Short-term borrowings
42.50
Long-term loans
7.50
Additional equity issue
-50.00
A
8.

EFR =

L
-

S m S1 (1-d)

S
A

Therefore, mS1(1-d)

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 (1-0.6) 1,000 = 150
10,000
10,000
A 3,000
= (0.06) (0.4) (11,000) 150 = 114
10
or A = (1,140 + 3,000) = 4,140
The total assets of Videosonics must be 4,140
9.

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

m (1-d)A/E
(a)

g=

.05 (1-0.6) 2.5

=

A/S m(1-d)A/E

3.70 per cent

1.4 -.05 (1-0.6) 2.5

.05 (1-0.6) x A/E

(b)

0.5 =

A/E = 3.33
2.4 - .05 (1-0.6) A/E

d = 0.466
The dividend payout ratio must be reduced from 60 per cent to 46.6 per cent
.05 (1-0.6) x A/E
140

(c)

.05 =

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

The A/E ratio must increase from 2.5 to 3.33

m (1-0.6) 2.5
(d)

.06 =

m = 7.92 per cent

1.4 m (1-0.6) x 2.5

The net profit margin must increase from 5 per cent to 7.92 per cent
.05 (1-0.6) 2.5
(e)

.06 =

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

The asset to sales ratio must decrease from 1.4 to 0.883

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)
- Non-operating 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)

- Tax on non-operating income

Tax on EBIT
NOPLAT
Net investment
Non-operating cash flow (post-tax)
FCFF

(2)
29.6

(4)
33.2

65.4
(50)
3
18.4

71.8
(50)
6
27.8

(b) The financing flow for years 2 and 3 is as follows :

Year 2
After-tax interest expense
14.4
Cash dividend
30
- Net borrowings
(30)
+ Excess marketable securities
30
- After-tax income on excess
(6)
marketable securities
- Share issue
(20)
18.4
(c)

27.8

Year 2
310
360
65.4
400
50

Invested capital (Beginning)

Invested capital (Ending)
NOPLAT
Turnover
Net investment

Post-tax operating margin

Capital turnover
ROIC
Growth rate
FCF
2.

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 (1-t)
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
(3-4-6)
Discount factor
Present value

400

480
80
11

576
96
13

691
115
16

829
138
19

912
83
273

0.876 0.767 0.672

.589
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 =
=
0.1355 0.10
0.0355

= 7690

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
1
2
3
4
5
kd(1-t)

kd(1-t) = 15% (1-t)

15 (0.94) = 14.1%
15 (0.88) = 13.2%
15 (0.82) = 12.3%
15 (0.76) = 11.4%
15 (0.70) = 10.5%

ke = Rf + x Market risk premium ka = wd kd (1-t)+ we ke

12 + 1.3 x 7
= 21.1%
0.5 x 14.1 + 0.5 x 21.1 = 17.6%
21.1%
0.5 x 13.2 + 0.5 x 21.1 = 17.2%
21.1%
0.5 x 12.3 + 0.5 x 21.1 = 16.7%
21.1%
0.5 x 11.4 + 0.5 x 21.1 = 16.3%
21.1%
0.5 x 10.5 + 0.5 x 21.1 = 15.8%

WACC in the transition period

= 14 (1 0.3) = 9.8%
143

ke
ka

= 11 + 1.1 x 6 = 17.6%
= 0.44 x 9.8 + 0.56 x 17.6 = 14.2%

kd(1-t)
ke
ka

WACC for the stable growth period

= 13 (1 0.3) = 9.1%
= 11 + 1.0 x 5 = 16%
= 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 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
(1-t)

Cap. Dep. WC FCFF D/E Beta WACC PV

exp.
%
Factor

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

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
144

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

Present value of continuing value =

= 1249
(1.14)

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
145

Chapter 33
VALUE BASED MANAGEMENT
1. The value created by the new strategy is calculated below :
Current
Values
(Year 0)

Income Statement Projection

1

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

Balance Sheet Projections

672
753
843
944
672
753
843
944
1344 1505 1696 1888
1344 1505 1686 1888

944
944
1888
1888

Cash Flow Projections

188
211
236
60
67
75
132
148
166
72
81
90
44
49
55

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
Pre-strategy value
Value of the strategy

=
=
=
=
=
=

147
264 / 0.15 = 1760
1760 / (1.15)4 = 1007
147 + 1007 = 1154
168/0.15 = 1120
1154 1120 = 34

2. According to the Marakon approach

M
rg
146

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 (Non-interest 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

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

147

2. Costs
1,400 1,400 1,400 1,400 1,400
3. PBDIT
600
600
600
600
600
4. Depreciation
200
200
200
200
200
5. PBIT
400
400
400
400
400
6. NOPAT
240
240
240
240
240
7. Cash flow (4+6)
440
440
440
440
440
8. Capital at charge
1,000
800
600
400
200
9. Capital charge (8x0.14)
140
112
84
56
28
10. EVA (6-9)
100
128
156
184
212
5
440
NPV =
- 1000 = 440 x 3.433 1000 = 510.5
t
t=1 (1.14)
NPV =

EVAt
(1.14)

6.

= 100 x 0.877 + 128 x 0.769 + 156 x 0.675 + 184 x 0.592 +

212 x 0.519
= 510.3

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
Annuity amount =

881,600
=

PVIFA14%, 4yrs

2.914

= Rs.302,540

Capital
Depreciation
Capital charge
Sum
7.

Investment
Life

Depreciation charge under sinking fund method

1
2
3
4
1,000,000
837,460
652,164
440,927
162,540
185,296
212,237
240,810
140,000
117,244
91,303
61,730
302,540
302,540
302,540
302,540
: Rs.2,000,000
: 10 years
148

Cost of capital : 15 per cent

Salvage value : 0
2,000,000
Economic depreciation

=
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

PVIFA(5yrs,12%) = 3.605 ; Annuity amount = 5,000,000 / 3.605 = 1,386,963

Capital
Depreciation
Capital charge
Sum

1
5,000,000
786,963
600,000
1,386,963

Depreciation charge under sinking fund method

2
3
4
5
4,213,037
3,331,638
2,344,472
1,238,846
881,399
987,166
1,105,626
1,238,301
505,564
399,797
281,336
148,662
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
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%)

Profit after tax

Depreciation
Cash flow
Book capital100
(Beginning)
ROCE
ROGI
CFROI

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 pre-amalgamation 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

2. Post-merger EPS of International Corporation will be

2 x 100,000 + 2 x100,000
100,000 + ER x 100,000
Setting this equal to Rs.2.5 and solving for ER gives
ER = 0.6
3. PVA = Rs.25 million, PVB = Rs.10 million
Benefit = Rs.4 million, Cash compensation = Rs.11 million
Cost = Cash compensation PVB = Rs.1 million
NPV to Alpha = Benefit Cost = Rs.3 million
151

NPV to Beta = Cash Compensation PVB = Rs.1 million

4. Let A stand for Ajeet and J for Jeet
PVA = Rs.60 x 300,000 = Rs.18 million
PVJ = Rs.25 x 200,000 = Rs.5 million
Benefit = Rs.4 million
PVAJ = 18 + 5 + 4 = Rs.23 million
Exchange ratio = 0.5
The share of Jeet in the combined entity will be :
100,000

=
= 0.25
300,000 + 100,000
a) True cost to Ajeet Company for acquiring Jeet Company
Cost = PVAB - PVB
= 0.25 x 27 - 5
= Rs.1.75 million
b) NPV to Ajeet
= Benefit - Cost
=
4 - 1.75 = Rs.2.25 million
c) NPV to Jeet = Cost = Rs.1.75 million
5.

a) PVB = Rs.12 x 2,000,000 = Rs.24 million

The required return on the equity of Unibex Company is the value of k in the
equation.
Rs.1.20 (1.05)
Rs.12

=
k - .05

= 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
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.

So shareholders of Unibex will end up with

0.667
=

= 0.1177 or 11.77 per cent

5+0.667

shareholding of the combined entity,

The present value of the combined entity will be
PVAB = PVA + PVB + Benefit
= Rs.225 million + Rs.24 million + Rs.6.2 million
= Rs.255.2 million
So the cost of the merger is :
Cost = PVAB
- PVB
= .1177 x 255.2 - 24 = Rs.6.04 million
6. The expected profile of the combined entity A&B after the merger is shown in the last column
below.
A
5000
Rs.45000
Rs.90000
2

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

7. (a) The maximum exchange ratio acceptable to shareholders of Vijay Limited is :

S1
ER1

(E1+E2) PE12
+

S2

P1S2

12
=

(36+12) 8
+

= 0.1
30 x 8

(b) The minimum exchange ratio acceptable to shareholders of Ajay Limited is :

P2 S1
153

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.

The present value of FCF for first seven years is

16.00
14.30
PV(FCF)
=
2
(1.15)
(1.15)
0

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
=

0.15-0.08

= Rs.257.1 million
0.15 0.08

1
PV (VH) = 257.1 x

=
(1.15)

The value of the division is

Rs.96.7 million

:
154

- 20.4 + 96.7 = Rs.76.3 million

MINICASE
Solution:
(a)
Modern Pharma

Magnum Drugs

Book value per share

2300

650

Earnings per share

20
450

= Rs.115

= Rs.65
10
95

= Rs.22.5
20
Rs.320

Market price per share

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

0.57 + 0.42 + 0.32

=

= 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

If there is a synergy gain of 5 percent, the post-merger EPS of Modern Pharma is

(450 + 95) (1.05)
20 + ER X 10
Equating this with Rs.22.5, we get
(450 + 95) (1.05)
= 22.5
20 + 10ER
This gives ER = 0.54
Thus the maximum exchange ratio Modern Pharma should accept to avoid initial dilution of EPS is
0.54
(d) Post-merger EPS of Modern Pharma if the exchange ratio is 1:4, assuming no
synergy gain:
450 + 95
= Rs.24.2
20 + 0.25 x 10
(e) The maximum exchange ratio acceptable to the shareholders of Modern Pharma if
the P/E ratio of the combined entity is 13 and there is no synergy gain
-S1
ER1 =

(E1 + E2) P/E12

+

S2

P1 S2

- 20
=
10
(f)

(450 + 95) 13
+

= 0.21
320 x 10

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

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

(E1 + E2) P/E12

+

P2S1
=

S2

P1S2

- 20

P/E12 (E1 + E2) P2S2

(450 +95) P/E12

+

102 x 20
=

10

320 x 10

P/E12 (450 +95) 1020

- 6400 + 545 P/E12

2040
=

3200

545 P/E12 1020

(545 P/E12 1020) (545 P/E12 6400) = 2040 x 3200

297025 P/E212 3488000 P/E12 555900 P/E12
+6528000
= 6528000
2
297025 P/E 12 = 4043900 P/E
297025 P/E12
= 4043900
P/E12
= 13.61

157

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

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 30-days 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

1 + domestic interest rate

=

Spot rate

1 + foreign interest rate

107

1 + domestic interest rate in Japan

=

106

1.03

Domestic interest rate in Japan = .0397 = 3.97 per cent

4.

S0 = Rs.46 , rh = 11 per cent , rf = 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
0
1
2
3
4
5

Cash flow in dollars Expected exchange

(million)
rate
-200
46
50
48.17
70
50.44
90
52.82
105
55.31
80
57.92

Cash flow in rupees

(million)
-9200
2408.5
3530.8
4753.8
5807.6
4633.6

Given a rupee discount rate of 20 per cent, the NPV in rupees is :

2408.5
NPV

-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

The dollar NPV is :

3406.2 / 46 = 74.05 million dollars
5.

Forward rate

1 + domestic interest rate

=

Spot rate
F

1 + foreign interest rate

1 + .015

=
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
(1 + expected inflation in Japan)2

8.
Expected spot rate = Current spot rate x
2 years from now
(1.01)2
= 170 x

(1 + expected inflation in UK)2

= 163.46 yen /

(1.03)2
9. (i) Determine the present value of the foreign currency liability (100,000) by using
90-day money market lending rate applicable to the foreign country. This works
out to :
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 90-day money market borrowing rate of 2 per cent.
100,000
= 98039
(1.02)
(ii) Borrow 98039 in the UK money market and convert them to dollars in the spot
market.
(iii) Repay the borrowing of 98039 which will compound to 100000 after 90 days
with the collection of the receivable
11. A lower interest rate in the Swiss market will be offset by the depreciation of the US
dollar vis--vis 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

Spot price x Dividend yield

= Spot price -

(1+Risk-free rate)0.5

(1+Risk-free rate)0.5

4200

4000 x Dividend yield

= 4000 -

(1.145) 0.5

(1.145) 0.5

The dividend yield on a six months basis is 2 per cent. On an annual basis it is
approximately 4 per cent.
3.

Futures price
(1+Risk-free rate)1

= Spot price + Present value of

Present value
storage costs
of convenience yield

5400
= 5000 + 250 Present value of convenience yield
(1.15)

Hence the present value of convenience yield is Rs.554.3 per ton.

162

163

164