Problems

Financial Management Practice Problem Cost of Capital 1. A 5 years Rs.100 debenture of a firm can be sold for a net price of 96.50. The coupon rate of interest is 14% p.a. and it will be redeemed at 5% premium on maturity. The firm tax rate is 40%. Compute after-tax cost of debenture.

kd

I(1- t)

F-P 105 - 96.50 14(1- 0.40) 5 n 100 100 = 9.35% 105 96.5 FP 2 2

Where Cost of debenture = Kd Annul Interest payment per debenture capital = I Corporate tax rate =t Redemption Price per debenture = F Net amount realized per debenture= P Maturity period =n 2. A Company issues 10000 10% preference shares of Rs. 100 each redeemable after 10 years at a premium of 5%. Calculate the cost of preference capital.

kp

105 - 100 F-P 10 10 n 100 100 = 11.71% 105 100 FP 2 2

Kp = Cost Of Preference Capital. D = Preference Dividend Per Share F = Redemption Price P = Net Amount Realized Per Share. N = Maturity Period. 3. A company issues 1000 7% preference shares of Rs. 100 each at a premium of 10% redeemable after 5 years at par. Compute the cost of preference capital.

kp

100 - 110 F-P 7 5 n 100 100 = 4.76% 100 110 FP 2 2

Kp = Cost Of Preference Capital. D = Preference Dividend Per Share F = Redemption Price P = Net Amount Realized Per Share. N = Maturity Period.

4. Dell Ltd. has Rs.100 preference share redeemable at a premium of Rs.10% with 15 years maturity. The coupon rate is 12%. Sale price is Rs.95. calculate the cost of preference shares.

kp

110 - 95 F-P 12 15 100 = 12.68% n 100 110 95 FP 2 2

Kp = Cost Of Preference Capital. D = Preference Dividend Per Share F = Redemption Price P = Net Amount Realized Per Share. N = Maturity Period. 5. The share of a company is selling at Rs. 40 per share and it had paid a dividend of Rs. 4 per share last year. The investors market expects a growth rate of 5% per year. Compute the cost of equity.

ke

D1 4(1.05) g 0.05 = 0.155 = 15.50% Pe 40

D1=Expected at the end of the first year. g =Constant growth rate applicable to dividends. Pe= Current market price.

6. Sun Ltd. has its share of Rs. 10 each quoted at Rs.24 on the stock exchange. The last dividend paid Rs.1.60. The subsequent growth in dividends is expected at the rate of 10%. Calculate the cost of equity capital.

ke

D1 1.76 g 0.10 = 0.17= 17% Pe 24

D1=Expected at the end of the first year. g =Constant growth rate applicable to dividends. Pe= Current market price. 7. The equity of mercury Ltd. is traded in the market at Rs. 90 each. The expected current year dividend per share is Rs.18. The subsequent growth in dividends is expected at the rate of 6%. Calculate the cost of equity capital.

ke

D1 18 g 0.06 = 0.26= 26% Pe 90

D1=Expected at the end of the first year. g =Constant growth rate applicable to dividends. Pe= Current market price. 8. XYZ Ltd. has the following book value Capital Structure Equity Capital (Rs. 10 each fully paid) 11% Preference Shares (Rs.100 each fully paid) Retained earnings 13.5% Debenture 15% term loan (Rs in crores) 15 1 20 10 12.5

The next expected dividend on equity shares per share is Rs.3.60 and the dividend per share is expected to grow at the rate of 7%. The market price per share is Rs.40. Preference stock, redeemable after six years, is currently selling at Rs.75 per share. Debentures, redeemable after six years, are selling at Rs. 80 per debenture. The income tax for the company is 40% .Calculate WACC.

D1 3.60 g = 0.07 = 0.16 or 16% Pe 40 F-P 100 - 75 11 D 10 100 = 0.1543 or 15.43% n 100 = Cost of Preference k p FP 100 75 2 2 100 - 80 F-P 13.5(1- 0.40) I(1- t) 6 n 100 = Cost of Debentures k d 100 FP 100 80 2 2
Cost of equity

ke

=11.22% Cost of term loan k t I (1 t ) = 0.15(1-0.40) = 0.09 or 9% Cost of retained earnings = 16%

WACC= (Ke x We )+ (Kp x Wp) +(Kd x Wd) + (Kt x Wt)

WAAC (Market Value Weightage) Source Market value Weight Cost W.C Equity Capital 60.00 0.739 0.1600 0.1182 11% Preference Shares 0.75 0.009 0.1543 0.0014 13.5% Debenture 8.00 0.098 0.1122 0.0110 15% term loan 12.50 0.154 0.0900 0.0139 81.25 1.000 WACC= 0.1445 WACC = 14.45% 9. The Capital Structure of Hindustan Traders Ltd. as on 31-03-2010 is as follows: Equity Capital (Rs. 10 each fully paid) 1000000 12% Preference Shares (Rs.100 each fully paid) 200000 14% Debenture(Rs.100 each fully paid) 300000 For the year ended 31-03-2010 the company has paid equity dividend at 20%. As the company is a market leader with good future, dividend is likely to grow b 5% every year. The equity shares are now traded at Rs.80per share in the stock exchange. Preference stock, redeemable after 10 years, is currently selling at Rs.95 per share Debentures, redeemable after 5 years, are selling at Rs. 90 per debenture. Income tax rate applicable to the company is 50%. You are required to a) The weighted cost of capital on the basis of book value. b) The company plans to raise Rs.500000 by a way of long term loan at 16%. When this takes place the market value of the equity shares is expected to fall Rs.70 per share. What will be the new WACC of the company?

D1 2.10 g = 0.07 = 9.63% Pe 80 F-P 100 - 95 D 12 10 100 = 12.82% n 100 = Cost of Preference k p 100 95 FP 2 2 100 - 90 F-P 14(1- 0.50) I(1- t) 5 100 =9.47% n 100 = Cost of Debentures k d FP 100 90 2 2 WACC= (Ke x We )+ (Kp x Wp) +(Kd x Wd) + (Kt x Wt)
Cost of equity

ke

WAAC (Book Value Weightage) Source Book value Weight Cost W.C Equity Capital 1000000 0.667 0.0963 0.0642 12% Preference Shares 200000 0.133 0.1282 0.0171 14% Debenture 300000 0.200 0.0947 0.0189 1500000 1.000 WACC= 0.0984 WACC = 9.84%

D1 2.10 g = 0.07 = 10% Pe 70 Cost of term loan k t I (1 t ) = 0.16(1-0.50) = 0.08 or 8%

Cost of equity

ke

Source Equity Capital 12% Preference Shares 14% Debenture 16% term loan WACC = 10.60%

Book value Weight Cost W.C 1000000 0.500 0.1000 0.0500 200000 0.100 0.1282 0.0171 300000 0.150 0.0947 0.0189 500000 0.250 0.0800 0.0200 2000000 1.000 WACC= 0.1060

Capital Budgeting
1. An investment of Rs.40000 in a project is expected t o produce cash flow of Rs.8000 for 10 years. Calculate Pay Back Period of Project.

Ans: Pay Back Period of Project =5 Years 2. A Project costing Rs.560000 is expected to produce annual cash flow of Rs.80000 over a period of 15 years. Calculate Pay Back Period of Project. Ans: Pay Back Period of Project =7 Years 3. From the following information Calculate Pay Back Period of Project. Year Cash Flow 0 -70000 1 10000 2 20000 3 30000 4 45000 5 60000 Ans: Pay Back Period of Project = 4.22 Years 4. From the following information Calculate Pay Back Period of Project A and B. Year 0 1 2 3 4 5 6 Ans: Pay Back Period of Project A = 3years Pay Back Period of Project B = 4.25 Years 5. Rank the of the following projects based on Pay Back Period, each requiring a cash out lay of Rs.1,00,000. Year Cash flows Project A Project B Project C 1 30000 30000 10000 2 30000 40000 20000 3 30000 20000 30000 4 30000 10000 30000 5 30000 5000 50000 Ans: Pay Back Period of Project A = = 3.33 Years Pay Back Period of Project B = 4 years Pay Back Period of Project C = = 4.20 Years 6. A project requires an investment of Rs. 500000. Estimated life of project is 5 years. . The tax rate is 35%. Assume the firm uses straight line depreciation and same is allowed for tax purposes. It is expected to yield profits before depreciation and taxes during the 5 years Cash flows Project A Project B -100000 -100000 50000 20000 30000 20000 20000 20000 10000 30000 10000 40000 -----50000

amounting to Rs.140000, Rs.160000, Rs.170000, Rs. 150000 and Rs.130000. Calculate ARR of Project. Determination of cash flows after taxes (CFAT) Solution : Year CFBT Depreciation PBT Taxes PAT 1 140000 100000 40000 14000 26000 2 160000 100000 60000 21000 39000 3 170000 100000 70000 24500 45500 4 150000 100000 50000 17500 32500 5 130000 100000 30000 10500 19500 Total 162500

ARR

Average Annual Profit after depreciation & taxes 32500 100 = 100 =13% Average Investment 250000

Average Investment = Investment / 2 Average Annual Profit after Depreciation & taxes = PAT /years of life of project
7. A Company is considering an investment proposal to invest new milling controls at a cost of Rs.50000. The facility has a life expectancy of 5 years and no salvage value. The tax rate is 35%. Assume the firm uses straight line depreciation and same is allowed for tax purposes. The estimated cash flows before depreciation and Tax (CFBT) from the investment proposal are as follows Year CFBT 1 10000 2 10692 3 12769 4 13462 5 20385 Compute Average rate of return Solution : Year CFBT Depreciation PBT Taxes PAT 1 10000 10000 0 0 0 2 10692 10000 692 242 450 3 12769 10000 2769 969 1800 4 13462 10000 3462 1212 2250 5 20385 10000 10385 3635 6750 Total 11250

ARR

Average Annual Cash inflows after depreciation & taxes 2250 100 = 100 = 9 Avarage Investment 25000

8. From the information calculate the NPV and Benefit Cost Ratio of the project @ 12% discount rate.

Year 0 1 2 3 4 5 Solution : PV of the project is Year 1 2 3 4 5

Cash Flow -12000 4000 5000 7000 6000 5000

Cash Flow PVIF 4000 5000 7000 6000 5000

PV 0.893 0.797 0.712 0.636 0.567 3572 3985 4984 3816 2835 19192

NPV = 19192-12000 = 7192 Benefit Cost Ratio = 19192/12000 = 1.60 NPV = Present Value of Future Cash Flows - Initial Investment. BCR or Profitability Index Present Value of Future Cash Flows / Initial Investment.

9. From the information calculate the NPV and Benefit Cost ratio of the project @ 10% discount rate. Year Cash Flow 0 -1000000 1 200000 2 200000 3 300000 4 300000 5 350000 PV of the project is Year 1 2 3 4 5

Cash Flow PVIF 200000 200000 300000 300000 350000

0.909 0.826 0.751 0.683 0.621

PV 181800 165200 225300 204900 217350 994550

NPV = 994550-1000000 =5450 Benefit Cost Ratio = 994550/1000000 = 0.995 NPV = Present Value of Future Cash Flows - Initial Investment. BCR or Profitability Index

Present Value of Future Cash Flows / Initial Investment. 10. Information of projects A and B are as follows : Year Cash Flows Project A Project B 0 20000 30000 1 2000 3000 2 1500 2000 3 1500 2000 4 1000 1000 5 ----1000 Calculate NPV and Benefit Cost ratio of the project by assuming cost of capital is 10%. Solution : Year 1 2 3 4 5 Project A 2000 1500 1500 1000 ----D.F 0.909 0.826 0.751 0.683 0.621 PV 1818 1239 1127 683
4867

Project B 3000 2000 2000 1000 1000

D.F 0.909 0.826 0.751 0.683 0.621

PV 2727 1652 1502 683 621

7185

NPV Project A = 4867 20,000 = -15133 Project B = 7185 30,000 = 22,815 BCR Project A = 4867/20000 = 0.243 Project B = 7185/30,000 = 0.239 NPV = Present Value of Future Cash Flows - Initial Investment. BCR or Profitability Index Present Value of Future Cash Flows / Initial Investment.

11.From the following information calculate the net present value of the two projects and suggest which of the two projects should be accepted assuming a discount rate of 10%. Also find Benefit Cost Ratio. Year Cash flows Project A Project B

0 1 2 3 4 5 6 NPV of the project A is Year 1 2 3 4 5 6

-20000 5000 10000 10000 3000 2000 1000

-30000 20000 10000 5000 3000 2000 2000

Cash Flow PVIF 5000 10000 10000 3000 2000 1000

PV 0.909 0.826 0.751 0.683 0.621 0.564 4545 8260 7510 2049 1242 564 24170

NPV = 24170-20000 = 4170 Benefit Cost Ratio =24170/200000 = 1.21 NPV of the project B is Year Cash Flow PVIF 1 20000 2 10000 3 5000 4 3000 5 2000 6 2000 NPV = 34614-30000 = 4614 Benefit Cost Ratio = 34614/30000 = 1.15

0.909 0.826 0.751 0.683 0.621 0.564

PV 18180 8260 3755 2049 1242 1128 34614

NPV = Present Value of Future Cash Flows - Initial Investment. BCR or Profitability Index Present Value of Future Cash Flows / Initial Investment.

12. From the information calculate the IRR of Project. Year Cash Flow 0 100000 1 30000 2 30000 3 40000 4 45000

Solution :

ICO

CIF3 CIFn CIF1 CIF2 .......... . 1 2 3 (1 r ) (1 r ) (1 r ) (1 r ) n 30000 30000 40000 45000 1 2 3 (1 r ) (1 r ) (1 r ) (1 r ) 4

ICO = 26100+22680+26320+25740 = 100840

100000
If r = 15% If r =16%

ICO = 25860+22290+25640+24840 = 98630 By using interpolation tool,

15% (16% - 15%) 100840 100000 = 15.38% 100840 - 98630

IRR = LRD + NPVL x R PV LRD = Lower Rate Discount NPVL = Net Present Value at Lower rate PV= Difference between the PV at lower rate and the PV at higher rate R= Difference between the discount rates.

13. From the following data calculate Internal Rate of Return Years Outflows Inflows 0 60,000 ------1 ------15,000 2 ------20,000 3 ------30,000 4 ------20,000
ICO CIF3 CIFn CIF1 CIF2 .......... . 1 2 3 (1 r ) (1 r ) (1 r ) (1 r ) n

60000

15000 20000 30000 20000 1 2 3 (1 r ) (1 r ) (1 r ) (1 r ) 4

year 1 2 3 4 Total

Annual Discount Rate 14% Cash flow PVF PV 15,000 0.877 20,000 0.769 30,000 0.674 20,000 0.592

13,155 15,380 20,220 11,840 60,595

Discount Rate 15% PVF PV 0.869 0.756 0.657 0.571

13,035 15,120 19,170 11,420 59,285

By using interpolation tool,

IRR 14 % (15 % 14 %)

IRR = LRD + NPVL PV

60,595 - 60,000 = 14.22% 60,595 - 59285 x R

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LRD = Lower Rate Discount NPVL = Net Present Value at Lower rate PV= Difference between the PV at lower rate and the PV at higher rate R= Difference between the discount rates. 14. From the following data calculate Internal Rate of Return Years Outflows Inflows 0 1,00,000 ------1 ------30,000 2 ------40,000 3 ------60,000 4 ------40,000
ICO CIF3 CIFn CIF1 CIF2 .......... . 1 2 3 (1 r ) (1 r ) (1 r ) (1 r ) n

100000
year 1 2 3 4 Total

30000 40000 60000 40000 1 2 3 (1 r ) (1 r ) (1 r ) (1 r ) 4 Annual Discount Rate 14% Discount Rate 15% Cash flow PVF PV PVF PV 30,000 0.877 26310 0.869 40,000 0.769 30760 0.756 60,000 0.674 40440 0.657 40,000 0.592 23680 0.571
121190

26070 30240 39420 22840

118570

By using interpolation tool,

IRR 14 % (15 % 14 %)

1,21,190 - 1,00,000 = 1,21,190 - 1,18,570

IRR = LRD + NPVL x R PV LRD = Lower Rate Discount NPVL = Net Present Value at Lower rate PV= Difference between the PV at lower rate and the PV at higher rate R= Difference between the discount rates.

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