FM05

Corporate Finance
Assignment II

Assignment Code: 2010FM05A2 Last Date of Submission: 15th May 2010

Maximum
Marks: 100

Attempt all the questions. All questions are compulsory and carry equal marks.

Section A
1. What is the significance of Capital structure? Describe its kinds and points need to be kept in mind
while deciding the Capital structure of a firm.
ANSWER
In finance, capital structure refers to the way a corporation finances its assets through some combination of
equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its
liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20%
equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is
referred to as the firm's leverage. In reality, capital structure may be highly complex and include tens of
sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the
business finance, e.g. by taking a short term loan etc.

The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for
modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it
assumes away many important factors in the capital structure decision. The theorem states that, in a perfect
market, how a firm is financed is irrelevant to its value. This result provides the base with which to
examine real world reasons why capital structure is relevant, that is, a company's value is affected by the
capital structure it employs. These other reasons include bankruptcy costs, agency costs, taxes, information
asymmetry, to name some. This analysis can then be extended to look at whether there is in fact an optimal
capital structure: the one which maximizes the value of the firm.
If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be
the cause of its relevance. The theories below try to address some of these imperfections, by relaxing
assumptions made in the M&M model.
Trade-off theory
Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with
debt (namely, the tax benefit of debts) and that there is a cost of financing with debt (the bankruptcy costs
of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal
cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing
how much debt and equity to use for financing. Empirically, this theory may explain differences in D/E
ratios between industries, but it doesn't explain differences within the same industry. Pecking order theory

Pecking Order theory tries to capture the costs of asymmetric information. It states that companies
prioritize their sources of financing (from internal financing to equity) according to the law of least effort,
or of least resistance, preferring to raise equity as a financing means “of last resort”. Hence: internal debt is
used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more
debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and
prefer internal financing when available, and debt is preferred over equity if external financing is required.
Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order
theory is popularized by Myers (1984)[1] when he argues that equity is a less preferred means to raise
capital because when managers (who are assumed to know better about true condition of the firm than
investors) issue new equity, investors believe that managers think that the firm is overvalued and managers
are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity
issuance..
There are four main theories about capital structure in financial management

1-Net income (NI) approach

According to this approach, capital structure is relevant with cost of equity as it will change it will lead to
higher or lower risky combination and as the risk will rise required rate of return by investors will also rise
resulting increase in cost of capital for example as the leverage will increase the percentage of debt which
is low cost source (as it is secured) will increase and equity which is high cost source (not-secured) and so
according to this approach the firm can obtain a optimistic mix that minimize its cost of capital and as a
result the value of the firm will be highest According to this approach

2-Net Operating Income (NOI) Approach

This approach is totally opposite to NI approach; according to this approach capital structure is totally
irrelevant with the both cost of capital and value of the firm as this argue that as the leverage will increase it
will lead to increase in financial risk of the shareholders (As share-holders are responsible to pay that debt
back) and as a result they will require higher rate of return on their investment and increase in cost of
equity will be balanced will less cost of debt as according to this approach cost of debt is composed of two
elements (a) Explicit, represented by rate of interest (b) Implicit, the increase in cost of equity causes by an
increase in degree of leverage So as a result the advantage gained in terms of load cost of debt (explicit
cost) will be neutralized by the disadvantage in term of high cost of equity (implicit cost) therefore the cost
of debt and equity will be same in all capital structures and all capital structures are optimum

3-Modigilani and Miller (MM) approach

This approach is akin to NOI approach and MM describe arbitrage process as their argue behind this theory
According to this the investors are able to substitute their investments for comparative leverage

For example

When the value of levered firm is higher then (steps in arbitrage process)

* 1 = an Investor will sell his investment held in that firm

* 2 = he will borrow propionate to his share of the debt of the levered firm (at same interest rate)(ref1)
* 3 = he will purchase securities of the un-levered firm equal to his percentage equity holding in the
levered firm
* 4 = in this switching process, he will earn from the un-levered firm the same as compare to levered
firm with reduced investment outlay or higher income as compare to levered firm with full investment
outlay

(ref1)Actually these words are not mentioned in theory but in process of proving this theory this has been
implicated

When the value of un-levered firm is higher (steps in arbitrage process)

* 1 = an investor will sell his investment held in that firm

* 2 = he will buy securities of the levered firm equal to his percentage holding in un-levered firm (both
equity shares and debt)(ref2)
* 3 = in this process he will gain same income as compare to levered firm with reduced outlay or higher
income as compare to levered firm with full investment outlay
(ref2)Actually these words are not mentioned in theory but in process of proving this theory this has been
implicated

4-Traditional approach

This approach follow the mid-way describing that the firms can increase their value by increasing leverage
according to NI approach but till certain point after that point the value will start to decrease due to
increased risk

for details see detailed cases and discussions

Agency Costs

There are three types of agency costs which can help explain the relevance of capital structure.

 Asset substitution effect: As D/E increases, management has an increased incentive to undertake
risky (even negative NPV) projects. This is because if the project is successful, share holders get all
the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are
undertaken, there is a chance of firm value decreasing and a wealth transfer from debt holders to
share holders.
 Underinvestment problem: If debt is risky (e.g., in a growth company), the gain from the project will
accrue to debtholders rather than shareholders. Thus, management have an incentive to reject
positive NPV projects, even though they have the potential to increase firm value.
 Free cash flow: unless free cash flow is given back to investors, management has an incentive to
destroy firm value through empire building and perks etc. Increasing leverage imposes financial
discipline on management.
2. Write short notes on:

(a) Profitability Index

ANSWER
Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the
ratio of investment to payoff of a proposed project. It is a useful tool for ranking projects because it allows
you to quantify the amount of value created per unit of investment.
The ratio is calculated as follows:

another formula to calculate Profitability index (P.I) is

Assuming that the cash flow calculated does not include the investment made in the project, a profitability
index of 1 indicates breakeven. Any value lower than one would indicate that the project's PV is less than
the initial investment. As the value of the profitability index increases, so does the financial attractiveness
of the proposed project.
Rules for selection or rejection of a project:
 If PI > 1 then accept the project
 If PI < 1 then reject the project

(b) Sensitivity Analysis

ANSWER
Sensitivity analysis (SA) is the study of how the variation (uncertainty) in the output of a mathematical
model can be apportioned, qualitatively or quantitatively, to different sources of variation in the input of a
model . Put another way, it is a technique for systematically changing parameters in a model to determine
the effects of such changes.
In more general terms uncertainty and sensitivity analyses investigate the robustness of a study when the
study includes some form of mathematical modelling. Sensitivity analysis can be useful to computer
modellers for a range of purposes, including:

 support decision making or the development of recommendations for decision makers (e.g. testing
the robustness of a result);
 enhancing communication from modellers to decision makers (e.g. by making recommendations
more credible, understandable, compelling or persuasive);
 increased understanding or quantification of the system (e.g. understanding relationships between
input and output variables); and
 model development (e.g. searching for errors in the model).

While uncertainty analysis studies the overall uncertainty in the conclusions of the study, sensitivity
analysis tries to identify what source of uncertainty weights more on the study's conclusions. For example,
several guidelines for modelling (see e.g. one from the US EPA) or for impact assessment (see one from the
European Commission) prescribe sensitivity analysis as a tool to ensure the quality of the
modelling/assessment.

(c) Linear Programming and Capital Budgeting

ANSWER
Linear programming (LP) is a mathematical method for determining a way to achieve the best outcome
(such as maximum profit or lowest cost) in a given mathematical model for some list of requirements
represented as linear equations.

More formally, linear programming is a technique for the optimization of a linear objective function,
subject to linear equality and linear inequality constraints. Given a polyhedron and a real-valued affine
function defined on this polyhedron, a linear programming method will find a point on the polyhedron
where this function has the smallest (or largest) value if such point exists, by searching through the
polyhedron vertices.

Linear programs are problems that can be expressed in canonical form:

Maximize \mathbf{c}^T \mathbf{x}

Subject to A\mathbf{x} \leq \mathbf{b}.
where \mathbf{x} represents the vector of variables (to be determined), \mathbf{c} and \mathbf{b} are
vectors of (known) coefficients and \mathbf{A} is a (known) matrix of coefficients. The expression to be
maximized or minimized is called the objective function (\mathbf{c}^T \mathbf{x} in this case). The
equations A\mathbf{x} \leq \mathbf{b} are the constraints which specify a convex polytope over which the
objective function is to be optimized.

Linear programming can be applied to various fields of study. It is used most extensively in business and
economics, but can also be utilized for some engineering problems. Industries that use linear programming
models include transportation, energy, telecommunications, and manufacturing. It has proved useful in
modeling diverse types of problems in planning, routing, scheduling, assignment, and design.
Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's
long term investments such as new machinery, replacement machinery, new plants, new products, and
research development projects are worth pursuing. It is budget for major capital, or investment,
expenditures.
Many formal methods are used in capital budgeting, including the techniques such as
 Accounting rate of return
 Net present value
 Profitability index
 Internal rate of return
 Modified internal rate of return
 Equivalent annuity
These methods use the incremental cash flows from each potential investment, or project Techniques based
on accounting earnings and accounting rules are sometimes used - though economists consider this to be
improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid
methods are used as well, such as payback period and discounted payback period.

(d) Capital Rationing

ANSWER
The act of placing restrictions on the amount of new investments or projects undertaken by a company. This
is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on
the specific sections of the budget.
Companies may want to implement capital rationing in situations where past returns of investment were
lower than expected. For example, suppose ABC Corp. has a cost of capital of 10% but that the company
has undertaken too many projects, many of which are incomplete. This causes the company's actual return
on investment to drop well below the 10% level. As a result, management decides to place a cap on the
number of new projects by raising the cost of capital for these new projects to 15%. Starting fewer new
projects would give the company more time and resources to complete existing projects.

3. Explain different methods of appraising project profitability. Which method is considered to be the
best?

ANSWER
A project is a specific plan or design presented for consideration. UNIDO defines a project as a proposal for
an investment to crate and or develop certain facilities in order to increase the production of goods/services
in a community certain period of time. Burns and Tolbet define the term projects discrete package of
investments, policy measures and institutional and other actions designed to achieve a specific development
objectives. Projects are common term used by many flexibly to denote specific action plans. There are
projects to develop a new road, new car, new motorbike, marketing plan, construction of buildings,
transport and communication etc. A project can be long term or short term, limited or comprehensive,
single sector concentrated or multi sector concentrated. While all of these projects have a general goal with
macro and micro directives with specific time frame. This particular article concentrates more on the
general project management.
Project: can be defined thus as

* A scientifically evolved work plan

* Devised to achieve a specific objectives

* Within specified time limit

* Consuming planned resources

Project Questions
Before the formulation of project problem, many questions to be asked by the project initiators. These
questions can be summarized as follows:
 What for: The objectives of the project
 How: The process, and the internal and external resources
 Who: For whom, By whom – Project partners, stake holders
 When: The time factor
 Where: The location
 What: The activity
Identifying the Project
The first phase of project management is the concerned with identifying the project to achieve the desired
objectives. The initial task coming under project identification is to find out the sources of the project.
Agencies like government organisations, international institutions like WHO, World Bank, UNDP, Non
Governmental Organisations etc can be better source of projects.
Project Need Analysis
The factors included under project need analysis are the, problem, solutions, beneficiaries and decisions.
The problem should exhibit an immediate intervention. The focus should be to identify the beneficiaries.
The solutions should be based on the original problem. The decision to take up the project lies on how these
three factors problem, solutions and beneficiaries are important to project intervention.
Problem formulation and Statement of the Problem
The crux of the project lies in the problem formulation process. The project team should have detailed
understanding of the problem, scope, intervention areas and the out come of the project to be hypothesized.
Based on a multi phased understanding and analysis, describe the problem to be addressed and resolved.
The macro level objectives and micro level objectives to be separated and should give differential wastages
Project Planning
 Project planning: can be defined as

* A scientific and systematic process, in which

* Logical linkages are clearly established, among

* Various element of projects

Successful implementation of the project lies on effective project plan. Based on the anticipated goals and
objectives the project planning to be made. The project plan is the blue print of the project. Effective
planning gives proper direction in the implementation of the project and it further helps in adequate
monitoring and evaluation. For the implementation of plan, an activity chart to be prepared. The activity
chart consists of all the proposed activities in the implementation process, including the start date, calendar
for the entire project, dates of monitoring and evaluation periods, finishing stages, series of out puts, slack
time, responsible person to be coordinate the activities etc.
Project Budget
The project budgeting phase is in the project formulation phase. Two types of budgets are to be made. The
prior one is the cost category budget (materials, administration, capital; expenditures etc) and the later is
the activity budget. This project budget is to calculate the cost of each project out put. Keep in mind the
cash flow of the project, considering the contingencies like, technical shortage, shortage of raw materials,
delays in the activity implementation etc. The estimation of the project cost should be made on fairly
realistic sense of financial values. In the multi year projects the inflation rate also to be anticipated in
advance.
Feasibility of the Projects

1. Management Appraisal
Management appraisal is related to the technical and managerial competence, integrity, knowledge of the
project, managerial competence of the promoters etc. The promoters should have the knowledge and ability
to plan, implement and operate the entire project effectively. The past record of the promoters is to be
appraised to clarify their ability in handling the projects.

2. Technical Feasibility
Technical feasibility analysis is the systematic gathering and analysis of the data pertaining to the technical
inputs required and formation of conclusion there from. The availability of the raw materials, power,
sanitary and sewerage services, transportation facility, skilled man power, engineering facilities,
maintenance, local people etc are coming under technical analysis. This feasibility analysis is very
important since its significance lies in planning the exercises, documentation process, risk minimization
process and to get approval.

3. Financial feasibility
One of the very important factors that a project team should meticulously prepare is the financial viability
of the entire project. This involves the preparation of cost estimates, means of financing, financial
institutions, financial projections, break-even point, ratio analysis etc. The cost of project includes the land
and sight development, building, plant and machinery, technical know-how fees, pre-operative expenses,
contingency expenses etc. The means of finance includes the share capital, term loan, special capital
assistance, investment subsidy, margin money loan etc. The financial projections include the profitability
estimates, cash flow and projected balance sheet. The ratio analysis will be made on debt equity ration and
current ratio.
4. Commercial Appraisal
In the commercial appraisal many factors are coming. The scope of the project in market or the
beneficiaries, customer friendly process and preferences, future demand of the supply, effectiveness of the
selling arrangement, latest information availability an all areas, government control measures, etc. The
appraisal involves the assessment of the current market scenario, which enables the project to get adequate
demand. Estimation, distribution and advertisement scenario also to be here considered into.

5. Economic Appraisal
How far the project contributes to the development of the sector, industrial development, social
development, maximizing the growth of employment, etc. are kept in view while evaluating the economic
feasibility of the project.

6. Environmental Analysis
Environmental appraisal concerns with the impact of environment on the project. The factors include the
water, air, land, sound, geographical location etc.
Project Implementation
This is the period in which all the activities that are planned in the initial phases of the project get
materialized through operation. Here the role of the project managers comes in to the picture. It is the task
of the project managers to schedule the activities one by one and establish functional relationship of the
project activities in the fulfillment of the project. The techniques like PERT (Programme Evaluation and
Review Technique), CPM (Critical Path Method) etc are the various network techniques the managers
make utilize to implement the activities planned in the project considering the cost and time.
Monitoring and Evaluation
Monitoring is the process of observing progress and resource utilization and anticipating deviations from
planned performance. (UNIDO, 1993). In the monitoring and controlling phase the project managers have
to monitor the technical performance, time and cost performance in addition to the organisational
performance. Correction, re-planning and cancellation of the activities are the control actions expected
from this phase in order to get the expected outcome. The monitoring is periodical by fixing milestones in
the project phases.
Evaluation
The final stage is the evaluation of the project. Upon the conclusion of the project success in attaining the
goals, and to determine how future projects could be managed. Here the effeteness of the degree of the
objective achievement, the efficiency of the financial, human, and time resources to be observed. The
impact of the project, the major concern of the project, i.e. whether the project reach up to the beneficiaries
with quality and quantity is to be measured. Different types of evaluation are there like performance
appraisal, work audit, result evaluation, cost benefit evaluation, impact analysis etc. Evaluation is done to
ensure the effective mutilation of all resources for the accomplishment of the project.
4. (a) What similarities and the conceptual differences are there between the risk- adjusted
discounted rate method and the certainty equivalent method?
ANSWER

Risk-adjusted Discount Rate

To allow a risk, businessman required a premium over and above an alternative which was risk free.
Accordingly, more uncertain the returns in future, the greater the risk & greater premium required.
Based on this reasoning, it is proposed that risk premium be incorporated into capital budgeting
analysis through discount rate. That is, if time preference for money is to be recognised by
discounting estimated future cash flows, at same risk-free rate, to their present value, than, to allow
for riskiness of those future cash flows a risk premium rate may be added to risk free discount rate.
Such a composite discount rate, called risk-adjusted discount rate, will allow for both time
preference & risk preference & will be a sum of risk-free rate & risk-premium rate reflecting the
investors attitude towards risk. The risk adjusted discount rate method can be expressed as follows:

We begin with the most conceptually straightforward method: first, learn the T and R functions by
exploring the environment and keeping statistics about the results of each action; next, compute an
optimal policy using one of the methods of Section . This method is known as certainty equivlance
There are some serious objections to this method:
 It makes an arbitrary division between the learning phase and the acting phase.
 How should it gather data about the environment initially? Random exploration might be
dangerous, and in some environments is an immensely inefficient method of gathering data,
requiring exponentially more data than a system that interleaves experience gathering with policy-
building more tightly The possibility of changes in the environment is also problematic. Breaking
up an agent's life into a pure learning and a pure acting phase has a considerable risk that the
optimal controller based on early life becomes, without detection, a suboptimal controller if the
environment changes.

A variation on this idea is certainty equivalence, in which the model is learned continually through the
agent's lifetime and, at each step, the current model is used to compute an optimal policy and value
function. This method makes very effective use of available data, but still ignores the question of
exploration and is extremely computationally demanding, even for fairly small state spaces.
Fortunately, there are a number of other model-based algorithms that are more practical.
 (b) Discuss the comparative advantages and disadvantages of each.
ANSWER
Advantages:-

1) Simple to understand.
2) Has a great deal of intuitive appeal for risk averse businessman.
3) It incorporates an attitude towards uncertainity.

Disadvantages:-

1) There is no easy way of deriving a risk-adjusted discount rate.

2) It does not make any risk adjustment is numerator for cash flows that are for cast over future
years.
3) It is based on assumption that investors are risk-averse. Though it is generally true, there exists a
category of risk seekers who do not demandpremium for assuming risks, they are willing to pay a
premium to take risks. Accordingly, composite discount rate would be reduced, not increased, as the
level of risk increases.

 It is based on the assumption that investors are risk averse. Though it is generally true, there exists
a category or risk seekers who do not demandpremium for assuming risks; they are willing to pay
a premium to take risk. Accordingly, the composite discount rate would be reduced, not increased,
as the level of risk increases.
 Section B

Case Study

5 M/s Trans Asia Ltd. has Rs.1,00,000 to invest. The company has received the following proposal for
consideration. The expected cost of capital for the company is estimated to be 15%.

Project Initial Outlay Annual Cash Flow Life of Project

Rs. Rs. (years)
A 50000 12500 10
B 35000 10000 8
C 15000 3000 20
D 25000 7500 10
E 25000 6000 20

Rank the above projects on the basis of

(i) Pay-back method

Project Initial Outlay Annual Cash Life of Project Payback Period
Flow
Rs. Rs. (years) Rs.
A 50000 12500 10 10869.57
B 35000 10000 8 8695.65
D 15000 7500 10 6521.74
E 25000 6000 20 5217.39
C 25000 3000 20 2608.7

(ii) Profitability Index method

Project Initial Annual Life of Profitability

Outlay Cash Project Index
Flow method
Rs. Rs. (years) Rs.
B 35000 10000 8 2.22
D 25000 7500 10 2.49
A 50000 12500 10 1.75
E 25000 6000 20 1.75
C 15000 3000 20 1.66
 (iii) NPV method

Project Initial Annual Life of NPV

Outlay Cash Project
Flow
Rs. Rs. (years) Rs.
B 35000 10000 8 42563.39
A 50000 12500 10 37453.08
D 25000 7500 10 37359.24
E 25000 6000 20 18666.02
C 15000 3000 20 9888.02

Present value of annuity of Rs. 1 received in steady steam discount at the rate of 15%

8 years = 4.6586
10 years = 5.1790
20 years = 6.3345
.